-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, LsQT6VR/Xs1mHy3C5TziGLThw3cLTPzjYbgkFdCk377Z5f3RaXjD4DffxOstsPeg aiWaV7AQ9yWCKSwbOLAbQg== 0000898080-04-000126.txt : 20040303 0000898080-04-000126.hdr.sgml : 20040303 20040302183440 ACCESSION NUMBER: 0000898080-04-000126 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 20031231 FILED AS OF DATE: 20040303 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SCOTTISH RE GROUP LTD CENTRAL INDEX KEY: 0001064122 STANDARD INDUSTRIAL CLASSIFICATION: LIFE INSURANCE [6311] IRS NUMBER: 000000000 STATE OF INCORPORATION: E9 FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-16855 FILM NUMBER: 04644056 BUSINESS ADDRESS: STREET 1: GRAND PAVILION COMMERCIAL CENTRE STREET 2: 802 WEST BAY RD GEORGE TOWN GRAND CAYMAN CITY: GRAND CAYMAN CAYMAN STATE: E9 ZIP: 00000 BUSINESS PHONE: 3459492800 MAIL ADDRESS: STREET 1: P O BOX HM 2939 CITY: HAMILTON STATE: D0 ZIP: HM MX FORMER COMPANY: FORMER CONFORMED NAME: SCOTTISH LIFE HOLDINGS LTD DATE OF NAME CHANGE: 19980615 10-K 1 form10k.txt ============================================================================== UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 --------------------------------------------- FORM 10-K For Annual and Transition Reports Pursuant to Sections 13 or 15(d) of the Securities Exchange Act of 1934 [X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended December 31, 2003 [ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Transition period from to Commission File Number 0-29788 --------------------------------------------- SCOTTISH RE GROUP LIMITED (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) Cayman Islands 98-0362785 (State or Other (I.R.S. Employer Jurisdiction of Identification No.) Incorporation or Organization) Crown House, Third Floor 4 Par-la-Ville Road Hamilton HM12, Bermuda Not Applicable (Address of Principal (Zip Code) Executive Office) Registrant's telephone number, including area code: (441) 295-4451 Securities Registered Pursuant to Section 12(b) of the Act: Title of Each Class Name of Each Exchange on Which Registered ------------------- ------------------------ Ordinary Shares, par value New York Stock Exchange $0.01 per share Hybrid Capital Units New York Stock Exchange Securities Registered Pursuant to Section 12(g) of the Act: None Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ] The aggregate market value of the voting stock held by non-affiliates of the Registrant as of June 30, 2003 was $553,007,079. As of February 23, 2004, Registrant had 35,350,745 ordinary shares outstanding. DOCUMENTS INCORPORATED BY REFERENCE Certain information required by Items 10, 11, 12, 13 and 14 of Form 10-K is incorporated by reference into Part III hereof from the registrant's proxy statement for its 2004 Annual Meeting of Shareholders, which is expected to be filed with the Securities and Exchange Commission (the "SEC") within 120 days of the close of the registrant's fiscal year ended December 31, 2003. ============================================================================== TABLE OF CONTENTS Page PART I........................................................................1 Item 1: BUSINESS.............................................................1 Item 2: PROPERTIES..........................................................29 Item 3: LEGAL PROCEEDINGS...................................................29 Item 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.................30 PART II......................................................................31 Item 5: MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES...................31 Item 6: SELECTED FINANCIAL DATA.............................................32 Item 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS...............................................33 Item 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK..........60 Item 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.........................63 Item 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE................................................63 Item 9A: DISCLOSURE CONTROLS AND PROCEDURES..................................63 PART III.....................................................................64 Item 10: DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT......................64 Item 11: EXECUTIVE COMPENSATION..............................................64 Item 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS, MANAGEMENT AND RELATED STOCKHOLDER MATTERS.....................................64 Item 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS......................64 Item 14: PRINCIPAL ACCOUNTANT FEES AND SERVICES..............................64 PART IV......................................................................64 Item 15: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.................................................................64 i PART I Item 1: BUSINESS Overview On August 28, 2003, we changed our name to Scottish Re Group Limited, which we call Scottish Re, from Scottish Annuity & Life Holdings, Ltd. In addition, our wholly owned subsidiaries World-Wide Holdings Limited and World-Wide Reassurance Company Limited changed their names to Scottish Re Holdings Limited and Scottish Re Limited, respectively. Scottish Re is a holding company organized under the laws of the Cayman Islands with its principal executive office in Bermuda. Through our operating subsidiaries, we are engaged in the reinsurance of life insurance, annuities and annuity-type products. These products are written by life insurance companies and other financial institutions located in the United States, as well as in many other countries around the world. We refer to this portion of our business as life reinsurance. To a lesser extent, we directly issue variable life insurance and variable annuities and similar products to high net worth individuals and families for insurance, investment and estate planning purposes. We refer to this portion of our business as wealth management. We have operating companies in Bermuda, the Cayman Islands, Guernsey, Ireland, the United Kingdom and the United States. Our flagship subsidiaries are Scottish Annuity & Life Insurance Company (Cayman) Ltd., Scottish Re (U.S.), Inc. and Scottish Re Limited. Scottish Annuity & Life Insurance Company (Cayman) Ltd., Scottish Re (U.S.), Inc. and Scottish Re Limited are each rated "A- (excellent)" for financial strength by A.M. Best Company, which is fourth highest of sixteen rating levels, "A (strong)" for financial strength by Fitch Ratings, which is sixth highest of twenty-two rating levels, and "A- (strong)" for financial strength by Standard & Poor's, which is seventh highest of twenty-two rating levels. Scottish Annuity & Life Insurance Company (Cayman) Ltd. and Scottish Re (U.S.), Inc. are also rated "A3 (good)" for financial strength by Moody's, which is seventh highest of twenty-one rating levels. These ratings are based upon factors of concern to policyholders, treaty holders, retrocessionaires, agents and intermediaries and are not directed toward the protection of investors. On December 22, 2003, we completed the acquisition of 95% of the outstanding capital stock of ERC Life Reinsurance Corporation, which we call ERC Life, for $151.0 million in cash, subject to certain post closing adjustments. ERC Life was a subsidiary of General Electric's Employers Reinsurance Corporation, which we call GE ERC, and was one of the companies through which GE ERC conducted life reinsurance business in the United States. Upon completion of the acquisition, ERC Life's business consisted primarily of a closed block of traditional life reinsurance with a face amount of approximately $155.6 billion. At the date of acquisition, ERC Life had $1.4 billion in total assets. GE ERC has agreed to administer the business of ERC Life for a fixed monthly fee for up to nine months from the date of acquisition and to assist with the transition of the business to Scottish Re's systems. No GE ERC employees will transfer to Scottish Re. The transaction has increased the number of lives reinsured in North America from approximately 2.1 million to approximately 6.2 million and has increased our gross face amount of in-force business in North America from approximately $119.4 billion to approximately $275.0 billion. ERC Life is rated "A- (excellent)" for financial strength by A.M. Best Company, which is the fourth highest of sixteen rating levels. We have grown to be one of the 10 largest life reinsurers serving the U.S. market (based on the amount of new life reinsurance business assumed in 2002) since our formation in 1998. On December 31, 2001, we expanded our business outside of North America by acquiring Scottish Re Holdings Limited and its subsidiary, Scottish Re Limited from Pacific Life Insurance Company, which we call Pacific Life. Scottish Re Limited, formed in 1964, is a U.K.-based reinsurer of group life insurance, individual life insurance and aircrew loss of license insurance in Asia, Europe, Latin America, the Middle East and North Africa. As of December 31, 2003, we had consolidated assets of $6.1 billion and consolidated shareholders' equity of $659.8 million. Our website address is www.scottishre.com. Forms 10-K, Forms 10-Q, Forms 8-K and all amendments to those reports are available free of charge on our website. These reports are posted to the website as soon as reasonably practical after they have been filed with the SEC. We will also provide electronic or paper copies of these reports on request. Information contained on our website does not constitute part of this Annual Report on Form 10-K. Our Business Life Reinsurance Reinsurance is an arrangement under which an insurance company known as the reinsurer agrees in a contract called a treaty to assume specified risks of another insurance company known as the ceding company. The reinsurer may assume all or a portion of the insurance underwritten by the ceding company. In exchange for assuming the risks of the ceding company, the reinsurer receives some or all of the premium and, in certain cases, investment income derived from the assets supporting the reserves of the reinsured policies. Reinsurance permits primary insurers to diversify their risks over larger pools of risks, and to write insurance policies in amounts larger than they are willing or able to retain. Also, reinsurers have the ability to structure treaties that allow the ceding companies to achieve other business and financial objectives such as: o decreasing the volatility of their earnings, o improving their capital position by reducing the financial strain associated with new business production or by increasing their risk-based capital ratios, o entering new lines of business and offering new products, and o exiting discontinued lines of business. In addition, reinsurers may also purchase reinsurance, or "retrocession" coverage, to limit their own risk exposure. We have two categories of life reinsurance lines of business, which we call Traditional Solutions and Financial Solutions. o Traditional Solutions. In our Traditional Solutions business, we reinsure the mortality risk on life insurance policies written by primary insurers. This business is often referred to as traditional life reinsurance. We write our Traditional Solutions business predominantly on an automatic basis with respect to newly written life insurance policies. This means that we automatically reinsure all policies written by a ceding company that meet the underwriting criteria specified in the treaty with the ceding company. In the North American market, our direct sales force targets the top 60 life insurance companies. We count 46 of these 60 as current customers. These companies are responsible for originating the majority of all term life insurance written in that market. Scottish Re Limited offers traditional life reinsurance products outside of North America, focusing primarily on the reinsurance of short-term, group life policies in niche market sectors. o Financial Solutions. In our Financial Solutions business, we offer reinsurance solutions that improve the financial position of our clients by increasing their capital availability and statutory surplus. These solutions include contracts under which we assume the investment and persistency risks of existing, as well as newly written, blocks of business. The products reinsured include annuities and annuity-type products, cash value life insurance and, to a lesser extent, disability products that are in a pay-out phase. This line of business includes acquired solutions products in which we provide our clients with exit strategies for discontinued lines, closed blocks, or lines not providing a good fit for our client's growth strategies. With our assuming full responsibility and management of these contracts, our clients can focus and concentrate their full efforts and resources on their core strategies. 2 The traditional life reinsurance industry has experienced significant growth over the past several years. According to an industry survey, the face amount of traditional life reinsurance assumed in the United States has grown from approximately $261 billion in 1995 to approximately $1.1 trillion in 2002, a 23% compounded annual growth rate. During the same period, the face amount of life insurance written in the United States has grown from approximately $1.1 trillion in 1995 to approximately $1.8 trillion in 2002, a 7% compounded annual growth rate. Many other of the international markets in which we operate have also enjoyed significant growth in recent years. We believe that the following trends have contributed and will continue to contribute to the increasing demand for life reinsurance and increased business opportunities for us: o Consolidation in the life insurance industry. Consolidation in the life insurance industry may create opportunities for life reinsurers. Life reinsurers provide financial reinsurance to help acquirors finance the cash portion of an acquisition, and we expect that any additional consolidation in the life insurance business may result in incremental opportunities for life reinsurers. In addition, in the context of an acquisition, an acquiror may focus on the most promising lines of business and divest non-core lines of business through reinsurance. o Consolidation in the life reinsurance industry. There have been a number of merger and acquisition transactions within the life reinsurance industry in recent years. The consolidation of the life reinsurance industry has reduced the amount of life reinsurance capacity available and caused primary insurers to be exposed to concentrated counter-party risk with the larger consolidating reinsurers. We believe that consolidation will continue and ceding companies will reinsure a portion of their business with smaller reinsurers like us in order to reduce their counter-party risk. o Increased capital sensitivity. We believe that insurance companies are now more focused on capital efficiency and return on capital. As a result, primary insurers are increasingly utilizing the outside capital provided by reinsurance to help finance growth and to free up capital to pursue new businesses. We believe that the demutualization of life insurance companies contributes to this trend as these newly publicly traded companies are motivated to improve their operating performance for their investor base. o Flight to quality. Particularly in the wake of the terrorist attacks in the United States on September 11, 2001, we believe that ceding companies are increasingly focused on the financial strength ratings of their reinsurers, as well as the aggregate amount of capital maintained by their reinsurers. o Expanding overseas markets. We believe that the trends described above in the North American market are also influencing the reinsurance industry throughout the world. In addition, we believe there are increasing opportunities in markets such as Asia, Europe, Latin America, the Middle East, and North Africa, where the life reinsurance industry is either developing or expanding. o Changing demographics. We expect that the increasing number of "baby boomers" reaching middle and late middle age will increase the demand for products which address retirement planning, estate planning and survivorship issues. In addition, we believe that longer life expectancies and the reduction in government and employer sponsored benefit programs will increase the demand for life insurance and annuities. We expect this increased demand for insurance to increase demand for reinsurance products. Wealth Management Our variable life insurance and variable annuity products offer high net worth clients the benefits of investment-oriented insurance products for use in tax and estate planning. Offering our products from companies based in Bermuda and the Cayman Islands provides us greater flexibility in structuring these products. We receive fee income based on the assets associated with our products. Our products are targeted towards high net worth 3 individuals and families who generally have a liquid net worth of more than $10 million. The wealth management business requires relatively little capital and we believe that it generates a stable source of fee income. Our Strategy Our strategy is to use our experience, and structural advantages to focus on life reinsurance and insurance products where we can deliver specialized advice and products to our customers. We plan to increase the value of our franchise by focusing on the following: o Expanding the size and depth of our reinsurance client base. We will continue to expand our core North American business by attempting to gain a larger share of the North American life reinsurance market both by adding new clients and expanding the business relationships with existing clients. In addition, we may pursue selected strategic acquisitions of other life reinsurance businesses. o Growing our international business. We will continue to leverage the specialized knowledge and established relationships of Scottish Re Limited to gain a larger share of the life reinsurance markets outside of North America. We will explore opportunities in new markets as well as seeking to add new clients and expand business relationships with existing clients. In addition, we may pursue selected strategic acquisitions of other life reinsurance businesses. o Enhancing our financial strength. We will continue to enhance our capital position and financial strength to meet the security needs of our customers and the capital requirements of rating agencies. By enhancing our financial strength and capital resources, we would expect to have opportunities to participate in reinsurance transactions in which we might not be currently eligible to participate. We also expect that enhancing our financial position will allow us to reduce our cost of, and improve our access to, capital. o Capitalizing on our reinsurance experience. We will continue to focus our marketing efforts on products that allow us to capitalize on the extensive experience of our management and key employees. o Leveraging efficient operating structure and organizational flexibility. We will continue to leverage our ability to conduct business in multiple jurisdictions, which provides us with a flexible and efficient operating platform. Moreover, as we grow our businesses and leverage the capabilities of our corporate infrastructure, we expect to improve our operating margins. Products Offered Life Reinsurance North America In our Life Reinsurance North America segment we reinsure a broad range of life insurance and annuity products. Life insurance products that we reinsure include yearly renewable term, term with multi-year guarantees, ordinary life and variable life. Retail annuity products that we reinsure include fixed immediate annuities and fixed deferred annuities. In addition, we reinsure and may issue directly institutional annuity-type products such as funding agreements, guaranteed investment contracts, and pension termination and structured settlement annuities. We do not accept mortality or longevity guarantees associated with variable annuity products. For these products, we write reinsurance generally in the form of yearly renewable term, coinsurance or modified coinsurance. Under yearly renewable term, we share only in the mortality risk for which we receive a premium. In a coinsurance or modified coinsurance arrangement, we generally share proportionately in all material risks inherent in the underlying policies including mortality, lapses and fluctuations in investments. Under such agreements, we agree to indemnify the primary insurer for all or a portion of the risks associated with the underlying insurance policy in exchange for a proportionate share of premiums. Coinsurance differs from modified coinsurance with respect to ownership of the assets supporting the reserves. Under our coinsurance arrangements, ownership of 4 these assets is transferred to us, whereas, in modified coinsurance arrangements, the ceding company retains ownership of these assets, but we share in the investment income and risk associated with the assets. Our reinsurance treaties are written predominantly on an automatic basis. An automatic treaty provides for a ceding company to cede contractually agreed-upon risks on specific blocks of business to us. The reinsurance may be solicited directly by us or through reinsurance intermediaries and may be written on either: o a proportional basis under which a specified percentage of each risk in the reinsured class of risk is assumed by us from the ceding company, along with our portion of the underlying premiums in proportion to such assumed risk; or o an excess of loss basis under which we indemnify the ceding company, up to a contractually specified amount, for a portion of claims exceeding a specified retention amount, in consideration of non-proportional premiums being paid. In order to diversify our mortality exposure, we seek to limit our consolidated enterprise wide retained exposure under life policies to no more than $500,000 per life for life reinsurance written in our North American operations. Our reinsurance treaties may provide for recapture rights, permitting the ceding company to reassume all or a portion of the risk ceded to us after an agreed-upon period of time (generally 10 years), subject to certain other conditions. Some of our reinsurance treaties allow the ceding company to recapture the ceded risk if we fail to maintain a specified rating or if other financial conditions relating to us are not satisfied. Recapture of business previously ceded does not affect premiums ceded prior to the recapture of such business and typically involves the payment of a recapture fee to us. Nevertheless, we may need to liquidate substantial assets in order to return the assets supporting the reserves to the ceding company, and we may also have to accelerate the amortization of unamortized deferred acquisition costs associated with the recaptured business, which would reduce our earnings. The potential adverse effects of recapture rights are mitigated by the following factors: o By recapturing reinsurance, ceding companies increase the amount of risk they retain. o Ceding companies generally must recapture the same amount of risk on each policy reinsured under a treaty once a retention increase is made after the treaty stated non-recapture period expires and a recapture program is undertaken. o We price our treaties with the goal of achieving our target return before the recapture date. International Life Reinsurance Through our subsidiary, Scottish Re Limited, we reinsure life reinsurance and aircrew loss of license products. Life insurance products that we reinsure include short-term group and individual life and, to a lesser extent, disability and critical illness. Aircrew loss of license products that we reinsure are on a short-term group basis. While our international business does include a small amount of automatic treaty business written in a very similar way to that in our Life Reinsurance North America segment, the bulk of our risks are written on a facultative basis. A facultative approach provides for a ceding company to offer risks for which we may either quote terms or, alternatively, decline. They, in turn, are not obliged to cede any risk to us. Our principal international market is the Middle East, where we have been active since the early 1990s. For the year ended December 31, 2003, approximately 20% of total written premiums in the international business originated from Bahrain, Jordan, Kuwait, Lebanon, Oman, Qatar, Saudi Arabia and the United Arab Emirates. In Latin America, we do business primarily in Argentina, Columbia and Peru, and to a lesser extent in Chile and Ecuador. In Asia, our target niche market is in Japan, which is experiencing the development of small affinity group mutual organizations known as kyosai, as a parallel sector to large insurance companies. 5 We also reinsure aircrew loss of license coverage, which entails the payment of lump sum benefits if aircrew cannot perform their job for medical reasons, as well as temporary benefits for the period of time during which the aircrew is grounded and waiting for the results of the medical examination. We attempt to diversify mortality risk in our Life Reinsurance International segment by limiting our consolidated enterprise wide retained exposure under life policies to no more than $250,000 per life for our international life reinsurance business. Wealth Management Our wealth management business consists of the issuance of variable life insurance policies and variable annuities and similar products to high net worth individuals and families. Variable insurance products are often used in connection with estate and investment planning strategies. Premiums, net of expenses, paid by the policyholder with respect to our variable products are placed in a separate account for the benefit of the policyholder. We invest premiums in each separate account with one or more investment managers, some of whom the policyholder may recommend and all of whom are appointed by us in our sole discretion. The policyholder retains the benefits of favorable investment performance, as well as the risk of adverse investment results. Assets held in the separate accounts are generally not subject to the claims of our general creditors. We do not provide any investment management or advisory services directly to any individual variable life or variable annuity policyholder. Our revenues earned from these policies consist of insurance and administrative fees assessed against the assets in each separate account. Our variable products do not guarantee investment returns. Marketing Life Reinsurance In our life reinsurance business, we market to life insurance and life reinsurance companies. We also target institutions, such as pension plans, that have life insurance-related risks and that we believe would benefit from our reinsurance products based on our analysis of publicly available information and other industry data. Where permitted by law, we actively market our reinsurance products primarily on a direct basis. We also seek to capitalize on the relationships developed by our executive officers and marketing staff with members of the actuarial profession and senior insurance company executives, at both primary insurers and other reinsurers. Finally, we work with reinsurance intermediaries, brokers and consultants who are engaged in obtaining reinsurance on behalf of their clients. Wealth Management In our wealth management business, we seek to write variable life insurance and variable annuity products for high net worth individuals and families with at least $10.0 million of liquid net worth. Because we offer variable products that we believe comply with U.S. Internal Revenue Code requirements for insurance products, we typically insure U.S. persons, individuals with U.S. beneficiaries or non-U.S. persons with a U.S. tax presence. Our wealth management subsidiaries are not licensed to conduct insurance business in any jurisdiction in the United States, and therefore cannot utilize traditional life insurance marketing channels such as agents, nor can we use mail-order or other direct-marketing channels to conduct business with persons in the United States or certain other jurisdictions. Accordingly, we rely primarily on referrals by financial advisors, investment managers, private bankers, attorneys and other intermediaries to generate wealth management business. None of these intermediaries represents us as agent or in any other capacity, nor do they receive any commissions or other remuneration from us for activities undertaken on our behalf in the United States. 6 Risk Management Life Reinsurance We bear five principal classes of risk in our life reinsurance products: o mortality risk, o investment risk, o persistency risk, o expense risk, and o counter-party risk. Mortality risk is the risk that death claims exceed what we expect. A greater frequency or higher average size of death benefits than we expected can cause us to pay greater death benefits, adversely affecting our profitability. Even if the total death benefits paid over the life of our contracts do not exceed the expected amount, sporadic timing of deaths can cause us to pay more death benefits in a given time period than expected, adversely impacting our profitability in that period. We address these risks through selection, diversification and retrocession. We analyze each block of business based on an evaluation of the ceding company's history, management, target market, products and underwriting criteria relative to the industry. In North America, we target primarily first dollar quota share pools of top producing direct writing companies so that we participate proportionately with other reinsurers on all of the ceded risks. In addition, we diversify our risks by participating in annuity and disability products in the payout stage where the mortality risk is the risk of later, rather than earlier, deaths than expected. A mix of these products with life products can help offset general trends in population mortality. We mitigate our risk of exposure to any one block of business or any one individual life by limiting our share to generally 20-25% in any one pool. We further address the risk of any one large claim by utilizing retrocession above our retention of $500,000 per life for life reinsurance written in our Life Reinsurance North America segment and approximately $250,000 per life for life reinsurance written by our Life Reinsurance International segment. In addition, we maintain catastrophe cover on our entire retained life reinsurance business, which provides reinsurance for losses of $19.3 million in excess of $750,000. This catastrophe cover includes protection for nuclear, biological and chemical risks. Our investments, which primarily consist of fixed income securities, are subject to market value, reinvestment and liquidity risk. Our invested assets are funded not only by capital but also by the proceeds of reinsurance transactions, some of which entail substantial deposits of funds or assets. The policies that we reinsure contain provisions that tend to increase benefits to customers depending on movements in interest rates. We analyze the potential results of a transaction, including the cash flows of the liabilities and of the related assets and any risk mitigation measures, and we price transactions to cover our costs, including estimated credit losses, and earn a desirable risk-adjusted return under various scenarios. Although we have not done so in the past, we may use interest rate swaps and other hedging instruments as tools to mitigate these risks. We may also retrocede some risks to other reinsurers. Persistency risk is the risk that policyholders maintain their policies for either longer or shorter periods than expected. Persistency can be affected by surrenders and policy lapses. Surrenders are the voluntary termination of a policy by the policyholder and lapses are the termination of the policy due to non-payment of the premium. Surrenders usually involve the return of the policy's cash surrender value to the policyholder. The risk is that actual persistency is significantly different from the persistency we assumed in pricing. Persistency significantly higher than priced for can cause us to pay greater than expected death benefits in future years, adversely impacting our profitability. Persistency significantly lower than priced for can cause our deferred acquisition costs to be unrecoverable, possibly causing loss recognition that would adversely impact our profitability. For policies with cash surrender benefits, surrenders significantly greater from expected will also cause increased liquidity risk. We address these risks through diversification and surrender charges. 7 Expense risk is the risk that actual expenses will be higher than those covered in pricing. The risk is that expenses per policy reinsured are higher as a result of a lower number of policies than anticipated, or that our operations are less efficient than anticipated. We address this risk through the use of automation, bulk reporting and management of general expenses. Counter-party risk is the risk that retrocessionaires will be unable to pay claims as they become due. We limit and diversify our counter-party risk by spreading our retrocession over a pool comprised of highly rated retrocessionaires. Our underwriting guidelines provide that any retrocessionaire to whom we cede business must have a financial strength rating of at least "A-" or higher from A.M. Best or an equivalent rating by another major rating agency. However, even if a retrocessionaire does not pay a claim submitted by us, we are still responsible for paying that claim to the ceding company. Wealth Management The four principal risks associated with our wealth management business are: o mortality risk, o counter-party risk, o persistency risk, and o expense risk. Since we do not have the direct investment risks associated with our wealth management products, the principal risk in our variable life insurance business is mortality risk. The death benefits provided by our variable life insurance policies vary based on the investment return of the underlying separate account assets invested by the investment managers. The difference between the value of the assets in the underlying separate account and the policy's stated death benefit, known as the "net amount at risk," represents a general liability of the insurance subsidiary. Mortality risk tends to be more stable when spread across large numbers of insureds. We expect that our variable life insurance policies will have relatively large face amounts and will be held by a relatively small number of policyholders. Consequently, our associated mortality risk exposure will be greater in the aggregate, and our probability of loss less predictable, than an insurer with a broader risk pool. Therefore, pursuant to our underwriting guidelines, we reinsure substantially all of the mortality risk associated with our variable life insurance business with highly rated reinsurers and accordingly rely upon our reinsurers' obligation and ability to pay death claims. The counter-party risk is that one or more of our reinsurers may fail to pay a reinsured death claim under a variable life insurance policy. Investment Portfolio General Our general account investment portfolio consists of investments and cash and cash equivalents, which we control, and funds withheld at interest, which are associated with modified coinsurance agreements. In modified coinsurance transactions, the ceding insurance company retains the assets supporting the ceded business and manages them for our account. Although the ceding company must adhere to general standards agreed to by us for the management of these assets, we do not control the selection of the specific investments or the timing of the purchase or sale of investments made by the ceding company. The portfolio that we control consists primarily of investment-grade fixed income securities and cash. We seek to generate attractive levels of investment income while limiting exposure to risks of changing interest rates, excess default experience and adverse changes in asset values. Third party investment managers manage the portfolio. Although we retain control over asset-liability management, investment policy and strategy, compliance and evaluation of results, we may not be able to effectively manage investment results and risks in an asset-liability 8 context, which could adversely affect our ability to support our businesses, our results of operations and our financial condition. Investment Oversight Our Finance and Investment Committee reviews our investment portfolio and the performance of our investment managers. In addition, our Finance and Investment Committee approves changes in the investment policy proposed by management and oversees compliance with the investment policy. Our Finance and Investment Committee can approve exceptions to our investment policy and periodically reviews our investment policy in light of prevailing market conditions. The investment managers and our investment policy may be changed from time to time as a result of such reviews. Investment Policy Our investment policy includes limits requiring diversification by asset class, fixed income sector and single issuers and limits exposure to lower-rated securities. It also limits reinvestment risk and requires effective asset-liability management processes including the maintenance of adequate liquidity to meet potential cash outflows. We are exposed to three primary sources of investment risk on fixed income investments: market value, reinvestment and liquidity risk. Market value risk is the risk that our invested assets will decrease in value due to a change in the yields realized on our assets, a change in the prevailing market yields for similar assets, an unfavorable change in the liquidity of the investment or an unfavorable change in the financial prospects or a downgrade in the credit rating of the issuer of the investment. Reinvestment risk is the risk that interest rates will decline and funds reinvested will earn less than expected. Liquidity risk is the risk that liabilities are surrendered or mature sooner than anticipated, requiring us to sell assets at an undesirable time to provide for policyholder surrenders or withdrawals. We manage these risks through industry and issuer diversification, overall limits on the amounts of credit risk taken and asset-liability management, which we refer to as ALM. Our primary ALM practices include: o modeling the cash flows necessary to service each existing and newly written reinsurance liability by considering various interest rate scenarios; o targeting new investments with cash flows suitable for new and existing liabilities; o evaluating and quantifying the risks to earnings and the economic value of shareholders' equity created by gaps between the projected cash flows from existing assets and those required by in-force liabilities; o reducing the risks caused by mismatches by opportunistically buying matching new investments. We may use foreign denominated securities to manage currency risk if the related reinsurance transaction has a foreign currency component. We do not currently invest in any derivative securities, but we may enter into interest rate swaps, futures, forwards and other hedging transactions to manage our risks. We will use derivatives only to manage interest rate risk rather than as a speculative investment. Investment Managers As of December 31, 2003, we utilized four asset managers to manage the portion of our investment portfolio that we control. General Re-New England Asset Management, which we refer to as NEAM, managed 63%; Principal Capital Management, managed 22%; Asset Allocation and Management, managed 14% and Stephens Capital Management, managed 1%. We may engage other asset managers to manage some or all of our controlled investment portfolio in the future. In the instances where we enter modified coinsurance transactions we 9 do not directly control the underlying investment portfolio. Instead, the investments are held and managed by the ceding company for our account in accordance with contractually agreed upon standards. Competition and Ratings Competition in the life reinsurance industry is based on price, financial strength ratings, reputation, experience, relationships and service. Because we currently rely on a small but growing number of clients in both our life reinsurance and wealth management businesses and expect to continue to do so for the near future, we are more susceptible to the adverse effects of competition than life reinsurers with larger client bases. Our wealth management products primarily compete with those issued by U.S. life insurance companies. We believe that the most important competitive factor affecting the marketability of our products is the degree to which these products meet customer expectations, in terms of low expenses, returns (after fees and expenses), flexibility and customer service. Many companies offering these products are significantly larger, have longer operating histories, have more extensive distribution capability and have access to greater financial and other resources than we do. Insurance ratings are used by prospective purchasers of insurance policies, insurers and reinsurance intermediaries in assessing the financial strength and quality of insurers and reinsurers. Rating organizations periodically review the financial performance and condition of insurers, including our insurance subsidiaries. Rating organizations assign ratings based upon several factors. While most of the factors considered relate to the rated company, some of the factors take into account general economic conditions and circumstances outside the rated company's control. Scottish Annuity & Life Insurance Company (Cayman) Ltd., Scottish Re (U.S.), Inc., and Scottish Re Limited are each rated "A- (excellent)" for financial strength by A.M. Best Company, which is fourth highest of sixteen rating levels, "A (strong)" for financial strength by Fitch Ratings, which is sixth highest of twenty-two rating levels, and "A- (strong)" for financial strength by Standard & Poor's, which is seventh highest of twenty-two rating levels. Scottish Annuity & Life Insurance Company (Cayman) Ltd. and Scottish Re (U.S.), Inc. are also rated "A3 (good)" by Moody's, which is seventh highest of twenty-one rating levels. ERC Life is rated "A- (excellent)" for financial strength by A.M. Best Company, which is the fourth highest of sixteen rating levels. These ratings are based upon factors of concern to policyholders, treaty holders, retrocessionaires, agents and intermediaries and are not directed toward the protection of investors. ERC Life is rated "A- (excellent)" for financial strength by A.M. Best Company, which is the fourth highest of sixteen rating levels. A.M. Best assigns an "A- (excellent)" rating to companies that have, in its opinion, on balance, excellent balance sheet strength, operating performance and business profile, as well as a strong ability to meet their ongoing obligations to policyholders. A.M. Best maintains a letter scale rating system ranging from "A++ (superior)" to "F (in liquidation)." "A- (excellent)" is the fourth highest designation of A.M. Best's 16 rating levels. Fitch assigns an "A (strong)" or "A- (strong)" rating to companies that it characterizes as having, in its opinion, strong capacity to meet policyholder and contract obligations and moderate risk factors and where the impact of any adverse business and economic factors is expected to be small. Fitch's insurer financial strength ratings range from "AAA (exceptionally strong)" to "D (distressed)." "A (strong)" is the sixth highest of Fitch's twenty-two rating levels. Moody's assigns an "A3 (good)" rating to companies that offer, in its opinion, good financial security, but possess elements that suggest a susceptibility to impairment sometime in the future. Moody's long term insurance financial strength ratings range from "Aaa (exceptional)" to "C (lowest)." "A3 (good)" is the seventh highest designation of Moody's twenty-one rating levels. Standard & Poor's assigns an "A- (strong)" rating to companies that have, in its opinion, a strong capacity to meet financial commitments, but are somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than insurers with higher ratings. Standard & Poor's insurer financial strength ratings range from "AAA (extremely strong)" to "R (under regulatory supervision)." "A- (strong)" is the seventh highest designation of Standard & Poor's twenty-two rating levels. Employees As of February 23, 2004, we employed approximately 142 full time employees. 10 Regulation General U.S. State Supervision Various state insurance departments enforce insurance and reinsurance regulation. The extent and nature of regulation varies from state to state. Scottish Re (U.S.), Inc. is a Delaware-domiciled reinsurer, which is licensed, accredited, approved or authorized to write reinsurance in 49 states and the District of Columbia. ERC Life is a Missouri-domiciled reinsurer, which is licensed, accredited, approved or authorized to conduct reinsurance in 50 states, the District of Columbia, Guam and the Federated States of Micronesia. Insurance Holding Company Regulation Scottish Re, Scottish Re (U.S.), Inc. and ERC Life are subject to regulation under the insurance holding company laws of Delaware and Missouri. Scottish Re (U.S.), Inc. was also subject to the insurance holding company laws of California, but as of July 23, 2003, Pacific Life ceased to own a 10% or more interest in Scottish Re, and thus neither Scottish Re nor ERC Life are currently subject to regulation under the California insurance holding company laws. The insurance holding company laws and regulations vary from state to state, but generally require insurers and reinsurers that are subsidiaries of insurance holding companies to register and file with state regulatory authorities certain reports including information concerning their capital structure, ownership, financial condition and general business operations. Generally, all transactions between Scottish Re (U.S.), Inc. and/or ERC Life and their affiliates must be fair and, if material, require prior notice and approval or non-disapproval by the Delaware and/or Missouri state insurance departments. Further, state insurance holding company laws typically place limitations on the amounts of dividends or other distributions payable by insurers and reinsurers. Delaware, the jurisdiction in which Scottish Re (U.S.), Inc. is domiciled, provides that, unless the prior approval of the state insurance commissioner has been obtained, dividends may be paid only from earned surplus and the maximum annual amount payable is limited to the greater of 10% of policyholder surplus at the end of the prior year or 100% of statutory net gain from operations for the prior year. Missouri, the jurisdiction in which ERC Life is domiciled, provides that, unless prior approval of the state insurance commissioner has been obtained, dividends may be paid only from earned surplus and the maximum annual amount payable is limited to the greater of 10% of policyholder surplus at the end of the prior year or 100% of statutory net gain from operations for the prior year. State insurance holding company laws also require prior notice or state insurance department approval of changes in control of an insurer or reinsurer or its holding company. The insurance laws of Delaware and Missouri provide that no person, including a corporation, may acquire control of a domestic insurance or reinsurance company unless it has given notice to such company and obtained prior written approval of the state insurance commissioner. Any purchaser of 10% or more of the outstanding voting securities of an insurance or reinsurance company or its holding company is presumed to have acquired control, unless this presumption is rebutted. Therefore, an investor who intends to acquire 10% or more of our outstanding voting securities may need to comply with these laws and would be required to file notices and reports with the Delaware Insurance Commission and/or the Missouri Director of Insurance prior to such acquisition. In addition, many state insurance laws require prior notification to the state insurance department of a change in control of a non-domiciliary insurance company licensed to transact insurance business in that state. While these pre-notification statutes do not authorize the state insurance departments to disapprove the change in control, they authorize regulatory action in the affected state if particular conditions exist such as undue market concentration. Any future transactions that would constitute a change in control of Scottish Re (U.S.), Inc. and ERC Life or any of their U.S. insurance subsidiaries may require prior notification in the states that have adopted pre-acquisition notification laws. U.S. Reinsurance Regulation Scottish Re (U.S.), Inc. and ERC Life are subject to insurance regulation and supervision that in many respects is similar to the regulation of licensed primary insurers. Generally, state regulatory authorities monitor compliance with, and periodically conduct examinations regarding, state mandated standards of solvency, licensing requirements, investment limitations, restrictions on the size of risks which may be reinsured, deposits of securities for the benefit of reinsureds, methods of accounting, and reserves for unearned premiums, losses and other purposes. 11 However, in contrast with primary insurance policies, which are regulated as to rate, form, and content, the terms and conditions of reinsurance agreements are generally not subject to regulation by state insurance regulators. Scottish Re (U.S.), Inc. is licensed, accredited, approved or authorized to write reinsurance in 49 states and the District of Columbia. ERC Life is licensed, accredited, approved and authorized to write reinsurance in all 50 states, the District of Columbia, Guam, and the Federated States of Micronesia. The ability of any primary insurer to take credit for the reinsurance placed with reinsurers is a significant component of reinsurance regulation. Typically, a primary insurer will only enter into a reinsurance agreement if it can obtain credit on its statutory financial statements for the reinsurance ceded to the reinsurer. Credit is usually granted when the reinsurer is licensed, accredited, approved or authorized to write reinsurance in the state where the primary insurer is domiciled. In addition, many states allow credit for reinsurance ceded to a reinsurer if the reinsurer is licensed in another jurisdiction and meets certain financial requirements, or if the primary insurer is provided with collateral in the form of letters of credit, trusts, "funds withheld" or modified coinsurance contracts, to secure the reinsurer's obligations. U.S. Reinsurance Regulation of our Non-U.S. Reinsurance Subsidiaries Our non-U.S. reinsurance subsidiaries also assume reinsurance from primary U.S. insurers. In order for primary U.S. insurers to obtain financial statement credit for the reinsurance obligations of our non-U.S. reinsurers, our non-U.S. reinsurance subsidiaries must satisfy reinsurance requirements. Non-U.S. reinsurers that are not licensed in a state generally may become accredited by filing certain financial information with the relevant state commissioner and maintaining a U.S. trust fund for the payment of valid reinsurance claims. In addition, unlicensed and unaccredited reinsurers may secure the primary U.S. insurer with funds equal to its reinsurance obligations in the form of cash, securities, letters of credit or reinsurance trusts. U.S. Insurance Regulation of our Non-U.S. Insurance Subsidiaries Our non-U.S. insurance subsidiaries which sell wealth management products are not licensed to conduct insurance business in any jurisdiction in the United States. Therefore, they cannot utilize traditional life insurance marketing channels such as agents, nor can they use mail-order or other direct marketing channels to conduct business with persons in the United States or certain other jurisdictions. Accordingly, they rely primarily on referrals by financial advisors, investment managers, private bankers, attorneys and other intermediaries in the United States to generate wealth management business. None of these intermediaries represents us as agent or in any other capacity, nor do they receive any commissions or other remuneration from us for activities undertaken in the United States. In addition, policy solicitation, issuance and servicing must occur outside of the United States. NAIC Ratios The National Association of Insurance Commissioners, which we refer to as the NAIC, has developed a set of financial relationships or tests known as the NAIC Insurance Regulatory Information System to assist state regulators in monitoring the financial condition of insurance companies and identifying companies that require special attention or action by insurance regulatory authorities. A second set of confidential ratios, called Financial Analysis Solvency Tracking System, "FAST," are also used for monitoring. Insurance companies generally submit data quarterly to the NAIC, which in turn analyzes the data using prescribed financial data ratios, each with defined "usual ranges." If an insurance company's results vary significantly from expected ranges, regulators may make further inquiries. Regulators have the authority to impose remedies ranging from increased monitoring to certain business limitations to various degrees of supervision. Our U.S. reinsurance subsidiaries are not currently subject to increased regulatory scrutiny based on these ratios. Risk-Based Capital The Risk-Based Capital (RBC) for Insurers Model Act, or the Model Act, as it applies to insurers and reinsurers, was adopted by the NAIC in 1993. The main purpose of the Model Act is to provide a tool for insurance regulators to evaluate the capital of insurers relative to the risks assumed by them and determine whether there is a need for possible corrective action. U.S. insurers and reinsurers are required to report the results of their risk-based capital calculations as part of the statutory annual statements filed with state insurance regulatory authorities. 12 The Model Act provides for four different levels of regulatory actions based on annual statements, each of which may be triggered if an insurer's Total Adjusted Capital, as defined in the Model Act, is less than a corresponding level of risk-based capital, which we call RBC. o The Company Action Level is triggered if an insurer's Total Adjusted Capital is less than 200% of its Authorized Control Level RBC, as defined in the Model Act. At the Company Action Level, the insurer must submit a plan to the regulatory authority that discusses proposed corrective actions to improve its capital position. o The Regulatory Action Level is triggered if an insurer's Total Adjusted Capital is less than 150% of its Authorized Control Level RBC. At the Regulatory Action Level, the regulatory authority will perform a special examination of the insurer and issue an order specifying corrective actions that must be followed. o The Authorized Control Level is triggered if an insurer's Total Adjusted Capital is less than 100% of its Authorized Control Level RBC, and at that level the regulatory authority is authorized (although not mandated) to take regulatory control of the insurer. o The Mandatory Control Level is triggered if an insurer's Total Adjusted Capital is less than 70% of its Authorized Control Level RBC, and at that level the regulatory authority must take regulatory control of the insurer. Regulatory control may lead to rehabilitation or liquidation of an insurer. As of December 31, 2003, the Total Adjusted Capital of Scottish Re (U.S.), Inc. and ERC Life exceeded applicable minimum RBC levels. The Gramm-Leach-Bliley Act In November 1999, the Gramm-Leach-Bliley Act of 1999, or the GLBA, was enacted, implementing fundamental changes in the regulation of the financial services industry in the United States. The GLBA permits the transformation of the already converging banking, insurance and securities industries by permitting mergers that combine commercial banks, insurers and securities firms under one holding company, a "financial holding company." Bank holding companies and other entities that qualify and elect to be treated as financial holding companies may engage in activities, and acquire companies engaged in activities, that are "financial" in nature or "incidental" or "complementary" to such financial activities. Such financial activities include acting as principal, agent or broker in the underwriting and sale of life, property, casualty and other forms of insurance and annuities. However, although a bank cannot act as an insurer nor can it own an insurer as a subsidiary in most circumstances, a financial holding company can own any kind of insurer, insurance broker or agent. Under the GLBA, national banks retain their existing ability to sell insurance products in some circumstances. Under state law, the financial holding company must apply to the insurance commissioner in the insurer's state of domicile for prior approval of the acquisition of the insurer. Under the GLBA, no state may prevent or restrict affiliations between banks and insurers, insurance agents or brokers. Further, states cannot prevent or significantly interfere with bank or bank subsidiary sales activities. Finally, both bank and bank affiliates can obtain licenses as producers. Until the passage of the GLBA, the Glass-Steagall Act had limited the ability of banks to engage in securities-related businesses, and the Bank Holding Company Act had restricted banks from being affiliated with insurers. With the passage of the GLBA, among other things, bank holding companies may acquire insurers, and insurance holding companies may acquire banks. The ability of banks to affiliate with insurers may materially affect our U.S. reinsurance subsidiary's product lines by substantially increasing the number, size and financial strength of potential competitors. 13 Possible Initiatives Relating to the September 11th Events The terrorist attacks in the United States on September 11, 2001 have resulted in significant losses for the insurance and reinsurance industries. In response to the attacks and a resulting decline in the availability of terrorism insurance, Congress enacted the Terrorism Risk Insurance Act of 2002. The Act, commonly referred to as TRIA, provides U.S. Federal reinsurance of "commercial property and casualty" coverage written to protect against losses which result from a specified category of foreign terrorist acts. At present, the protections of TRIA are available only to defined "commercial property and casualty" insurers. However, should the Secretary of the Treasury determine that "adequate and affordable catastrophe reinsurance" is not currently available to life insurers that issue group life insurance, TRIA instructs the Secretary of the Treasury to extend U.S. Federal reinsurance protection to group life insurance. In order to make this determination, the Secretary of the Treasury solicited public comment through January 10, 2003. The Secretary of the Treasury is expected to make a determination regarding the extension of TRIA protections to group life insurance at any time. By its own terms, all reinsurance is specifically excluded from the protections available through TRIA. Therefore, absent the possible extension of TRIA protections to group life insurance, TRIA is not expected to provide any protection for providers of life reinsurance. To the extent that TRIA protections are extended to group life insurance, the availability of U.S. Federal reinsurance for terrorism losses would relieve some of the economic pressure to reinsure terrorism losses that life reinsurers may currently experience. We have no information regarding other proposed or enacted federal or state legislation that would restrict insurers' ability to exclude or limit coverage for terrorism risks. Bermuda Our Bermuda subsidiaries are subject to regulation under the Bermuda Companies Act of 1981, and our Bermuda insurance subsidiaries are subject to regulation under the Bermuda Insurance Act of 1978, as amended by the Insurance Amendment Act 1995 (which we refer to as the Bermuda Insurance Act), and the regulations promulgated thereunder. They are required, among other things, to meet and maintain certain standards of solvency, to file periodic reports in accordance with Bermuda statutory accounting rules, to produce annual audited financial statements and to maintain a minimum level of statutory capital and surplus. In general, the regulation of insurers in Bermuda relies heavily upon the auditors, directors and managers of the Bermuda insurer, each of which must certify that the insurer meets the solvency and capital requirements of the Bermuda Insurance Act of 1978. Under the Bermuda Insurance Act, a Bermuda insurance company carrying on long-term business (which includes the writing of annuity contracts and life insurance policies with respect to human life) must hold all receipts in respect of its long-term business and earnings thereon in a separate long-term business fund. Payments from such long-term business fund may not be made directly or indirectly for any purpose other than those of the insurer's long-term business, except in so far as such payment is made out of surplus certified by the insurer's approved actuary to be available for distribution other than to policyholders. In addition, our Bermuda subsidiaries are authorized by private acts of the Bermuda Legislature (the Scottish Annuity & Life International Insurance Company (Bermuda) Ltd. Consolidation and Amendment Act 2001 and the Scottish Annuity & Life Insurance Company (Bermuda) Limited Consolidation and Amendment Act 2001, which we refer to as the private acts) to establish separate accounts in respect of one or more life insurance policies or annuity contracts. In the event of an inconsistency between the Bermuda Insurance Act and our private acts, the terms of the private acts control subject, however, to later amendments of the Bermuda Insurance Act or other relevant laws. Under our private acts, each insurance subsidiary is permitted to credit to relevant separate accounts such portion of the premiums and other receipts from the related policy or contract, and any property of the insurance subsidiary derived from or purchased with such premiums, as the related policies or contracts stipulate. To the extent provided in the relevant policies or contracts, income, interest or other gains earned from, and any property acquired by, the investing or dealing in the assets of the separate account are credited to the separate account, and all expenses, fees or losses relating to the separate account are charged against the separate account. The assets and property held in the separate account are to be used for the sole purpose of paying any and all claims arising from or under the related policies or contracts, and no other person has any right or interest in such assets. Upon the termination of policies or contracts related to a separate account, and the discharge of obligations under the policies or contracts, the insurance subsidiary may terminate the separate account, and credit any remaining assets or property to its general account. In the event of insolvency of one of our Bermuda subsidiaries, the liquidator is bound to recognize the separate nature of each 14 separate account, and is not empowered to apply property identified as the property of any one separate account to pay the claims of creditors of the insurance company or policyholders other than the policyholder to whom the separate account relates. The private acts also permit our Bermuda subsidiaries to issue certain securities based on separate accounts that are subject to similar provisions. Cayman Islands Our Cayman Islands subsidiaries are subject to regulation as licensed insurance companies under Cayman Islands law. These subsidiaries hold unrestricted Class B insurance licenses under Cayman Islands Insurance Law and may therefore carry on an insurance business from the Cayman Islands, but may not engage in any Cayman Islands domestic insurance business. Unless specifically exempted, a Cayman Islands insurance company must engage a licensed insurance manager operating in the Cayman Islands to provide insurance expertise and oversight. Our subsidiaries are exempt from this requirement. In addition, under the Cayman Islands Insurance Law, a Cayman Islands insurance company carrying on long-term business (which includes the writing of life insurance policies) must hold all receipts in respect of its long-term business and earnings thereon in a separate long-term business fund. Payments from such long-term business fund may not be made directly or indirectly for any purpose other than those of the insurer's long-term business except in so far as such payments can be made out of any surplus disclosed on an actuarial valuation and certified by an actuary to be distributable otherwise than to policyholders. Every Cayman Islands insurance company carrying on long-term business may establish any number of separate accounts in respect of premiums paid to it to provide (i) annuities on human life and (ii) contracts of insurance on human life, and such respective premiums shall be kept segregated one from the other and independent of all other funds of the Cayman Islands insurer, and, notwithstanding the provisions of any other written law to the contrary, are not chargeable with any liability arising from any other business of the insurer. The scope and the validity of the Cayman Islands law regarding separate accounts has not been tested in the courts of the Cayman Islands. Guernsey Scottish Re PCC Limited is a protected cell company incorporated under the laws of the Island of Guernsey that is licensed by the Guernsey Financial Services Commission ("GFSC") to carry on international insurance business under the Insurance Business (Bailiwick of Guernsey) Law, 2002. The activities of Scottish Re PCC Limited are supervised by the GFSC. Insurers in Guernsey are required to maintain a minimum margin of solvency and to ensure that they have funds available sufficient to meet a total annual aggregate risk retention together with any forecasted annual expenses. Insurance companies are also required to report annually to the GFSC and must also retain a general representative. The GFSC also has powers to investigate and intervene in the affairs of insurance companies in Guernsey. Ireland Scottish Re (Dublin) Limited has been entitled to carry on insurance business in Ireland since December 2000 and is subject to regulation under the Insurance Act 2000 of Ireland, which requires companies registered in Ireland, other than authorized Insurance companies, to obtain official authorization before they can engage in reinsurance business. Reinsurance companies are not at present subject to a formal solvency supervision; however, the Department of Enterprise, Trade and Employment has the power to order a reinsurance company to cease writing business if it is not satisfied with the manner in which it is conducting its business. The principal legislation and regulations governing the insurance activities of Irish insurance companies are the Insurance Acts 1909 to 1990 and a comprehensive network of regulations and statutory provisions empowering the making of regulations. United Kingdom Scottish Re Limited is a U.K. insurance company incorporated and registered in England and Wales and subject to regulation and supervision in the United Kingdom under English domestic and European Community law. The Insurance Companies Act of 1982 of the United Kingdom, as amended, imposes solvency and liquidity standards and auditing and reporting requirements on insurance and reinsurance companies organized under English law, and on companies that own such insurance companies, and further grants to the U.K. Financial Services Authority powers to supervise, investigate and intervene in the affairs of insurance companies. Scottish Re Limited is authorized to carry on long-term business and certain classes of general business. An insurance company carrying on long-term business (which includes the writing of life insurance policies) must hold all receipts in respect of its long-term business and earnings thereon in a separate long-term business fund. Payments from such long-term business funds may not be made directly or indirectly for any purpose other than those of the insurer's long-term business. An exception exists wherein payments may be made from a surplus in the long-term business fund. In such instance the insurer must disclose the surplus on an actuarial valuation and have the valuation certified by its appointed actuary in order to distribute the surplus. 15 New Jurisdictions If Scottish Re or any of our subsidiaries were to become subject to the laws of a new jurisdiction where Scottish Re or that subsidiary is not presently admitted, they may not be in compliance with the laws of the new jurisdiction. Any failure to comply with applicable laws could result in the imposition of significant restrictions on our ability to do business, and could also result in fines and other sanctions, any or all of which could adversely affect our financial results and operations. RISK FACTORS Investing in our ordinary shares and Hybrid Capital Units involves a high degree of risk. Potential investors should consider carefully the following risk factors, in addition to the other information set forth in this Form 10-K, prior to investing in our ordinary shares. Risks Related to Our Business A downgrade in the financial ratings of our insurance subsidiaries could make us less competitive. Ratings are an important factor in attracting business in both our life reinsurance and wealth management businesses. Rating organizations periodically review the financial performance and condition of insurers, including our insurance subsidiaries. Rating organizations assign ratings based upon several factors. Although most of the factors considered relate to the rated company, some of the factors take into account general economic conditions and circumstances outside the rated company's control. Scottish Annuity & Life Insurance Company (Cayman) Ltd., Scottish Re (U.S.), Inc., and Scottish Re Limited are each rated "A- (excellent)" for financial strength by A.M. Best, which is fourth highest of sixteen rating levels, "A (strong)" for financial strength by Fitch Ratings, which is sixth highest of twenty-two rating levels, and "A- (strong)" for financial strength by Standard & Poor's, which is seventh highest of twenty-two rating levels. Scottish Annuity & Life Insurance Company (Cayman) Ltd. and Scottish Re (U.S.), Inc. are also rated "A3 (good)" for financial strength by Moody's, which is seventh highest of twenty-one rating levels. ERC Life is rated "A- (excellent)" for financial strength by A.M. Best Company, which is the fourth highest of sixteen rating levels. The objective of ratings organizations is to provide an opinion of an insurer's financial strength and ability to meet ongoing obligations to its policyholders. These ratings are subject to periodic review by the relevant rating agency and may be revised downward or withdrawn at the sole discretion of the rating agency. In addition, these ratings are not an evaluation directed to investors in our ordinary shares and Hybrid Capital Units and are not recommendations to buy, sell or hold our ordinary shares and Hybrid Capital Units. Although since our formation in 1998, none of our operating subsidiaries has been downgraded, a downgrade in or withdrawal of one or more ratings of any one of our insurance subsidiaries could adversely affect its ability to sell products, retain existing business (through recapture provisions and non-renewal) and compete for attractive acquisition opportunities. Inadequate risk analysis and underwriting may result in a decline in our profits. Our success depends on our ability to assess accurately and manage the risks associated with the business that we reinsure. We have developed risk analysis and underwriting guidelines, policies, and procedures with the objective of controlling the quality of the business as well as the pricing of the risk we are assuming. Among other things, these processes rely heavily on our underwriting, our analysis of mortality trends and lapse rates, and our understanding of medical improvements and their impact on mortality. If these processes are inadequate or are based on inadequate information, we may not establish appropriate premium rates and our reserves may not be adequate to cover our losses. In addition, we are dependent on the original underwriting decisions made by, and information provided to us by, ceding companies. For example, we incurred a charge to net income of $10.4 million in the third quarter of 2003 when we discovered that one of our ceding insurers had systematically underreported death claims to us over a three-year period. We are also subject to the risk that the ceding clients may not have adequately evaluated the risks to be reinsured and that the premiums ceded may not adequately compensate us for the risks we assume. To the 16 extent actual claims exceed our underlying assumptions, we will be required to increase our liabilities, which will reduce our profits in the period in which we identify the deficiency. Reserves are estimates based on actuarial and statistical projections at a given point in time of what we ultimately expect to pay out on claims and benefits, based on facts and circumstances then known, predictions of future events, estimates of future trends in mortality, morbidity and other variable factors such as persistency, inflation and interest rates. Because of the many assumptions and estimates involved in establishing reserves, the reserving process is inherently uncertain. Our estimation of reserves may be less reliable than the reserve estimations of a reinsurer with a greater volume of business and more established loss history. Actual losses and benefits may deviate, perhaps substantially, from estimates of reserves contained in our financial statements and could at times exceed our reserves. If our losses and benefits exceed our reserves, our earnings may significantly decline. Our life reinsurance contracts and variable life insurance policies expose us to mortality risk. Adverse mortality risk is the risk that death claims may differ from the amount we assumed in pricing our reinsurance contracts and our variable life insurance policies. Mortality experience that is less favorable than the mortality rates that we assumed will negatively affect our net income. Our variable life insurance policies, which provide a death benefit, are purchased by a relatively small group of high net worth individuals. Our risk exposure is greater with a narrow risk pool having a small number of high net worth individuals because this group is a subset of the general population. Additionally, our risk exposure is higher because we retain an average coverage per life of $130,000 on these policies, as opposed to an average coverage per life in our life reinsurance contracts of $29,000. Additionally, we are a relatively new company and many of our competitors for reinsurance contracts and variable life insurance policies are significantly larger, have larger operating histories and a broader risk pool. As a consequence, our associated mortality risk exposure is likely to be greater in the aggregate, and its probability of loss less predictable, than that of a competitor with a broader risk pool. Furthermore, with mortality exposure, even if the total benefits paid over the life of the contract do not exceed the expected amount, sporadic timing of deaths can cause us to pay more benefits in a given accounting period than expected, adversely impacting short-term profitability in any particular quarter or year. If our investment strategy is not successful, we could suffer unexpected losses. The success of our investment strategy is crucial to the success of our business. Specifically, we are subject to: o market value risk, which is the risk that our invested assets will decrease in value. This decrease in value may be due to a change in the yields realized on our assets and prevailing market yields for similar assets, an unfavorable change in the liquidity of the investment or an unfavorable change in the financial prospects or a downgrade in the credit rating of the issuer of the investment; o reinvestment risk, which is the risk that interest rates will decline and funds reinvested will earn less than expected; and o liquidity risk, which is the risk that liabilities are surrendered or mature sooner than anticipated and that we may have to sell assets at an undesirable time to provide for policyholder surrenders or withdrawals. We attempt to address such risks in product pricing and in establishing policy reserves. If our assets do not properly match our anticipated liabilities or our investments do not provide sufficient returns to enable us to satisfy our guaranteed fixed benefit obligations then our profits and financial condition would deteriorate. Also, declines in the 17 value of our investments that provide collateral for reinsurance contracts would require us to post additional collateral. In addition, our investment portfolio includes mortgage-backed securities, known as MBSs, and collateralized mortgage obligations, known as CMOs. As of December 31, 2003, MBSs and CMOs constituted approximately 14% of our invested assets. As with other fixed income investments, the fair value of these securities fluctuates depending on market and other general economic conditions and the interest rate environment. Changes in interest rates can expose us to prepayment risks on these investments. In periods of declining interest rates, mortgage prepayments generally increase and MBSs and CMOs are prepaid more quickly, requiring us to reinvest the proceeds at the then current market rates. Although we have not done so in the past, we may also enter into foreign currency, interest rate and credit derivatives and other hedging transactions in an effort to manage risks. Structuring these derivatives and hedges so as to effectively manage these risks is an inherently uncertain process. If our calculations are incorrect, or if we do not properly structure our derivatives or hedges, we may have unexpected losses and our assets may not be adequate to meet our needed reserves, which could adversely affect our business, earnings and financial condition. General economic conditions affect the markets for interest-rate-sensitive securities, including the level and volatility of interest rates and the extent and timing of investor participation in such markets. Unexpected changes in general economic conditions could create volatility or illiquidity in these markets in which we hold positions and harm our investment return. In certain reinsurance contracts we do not maintain control of the invested assets, which may limit our ability to control investment risks on these assets and may expose us to credit risk of the ceding company. As part of our business we enter into reinsurance agreements on a modified coinsurance and funds withheld coinsurance basis. In these transactions, the ceding insurance company retains the assets supporting the ceded business and manages them for our account. As of December 31, 2003, $1.5 billion of assets were held by ceding companies under such agreements and were recorded under "funds withheld at interest" on our balance sheet. Although the ceding company must adhere to general standards agreed to by us for the management of these assets, we do not control the selection of the specific investments or the timing of the purchase or sale of investments made by the ceding company. Accordingly, we may be at risk if the ceding company selects investments that deviate from our agreed standards or if the ceding company performs poorly in the purchase, sale and management of those assets. In addition, these assets are not segregated from the ceding company's other assets, and we may not be able to recover all of these assets in the event of the insolvency of the ceding insurer. In certain other reinsurance arrangements, we may place assets in a trust in order to provide the ceding company with credit for reinsurance on its financial statements. Although we generally have the right to direct the investment of assets in these trusts, in the event of the insolvency of the ceding company, its receiver may attempt to take control of those assets. Interest rate fluctuations could lower the income we derive from the difference between the interest rates we earn on our investments and interest we pay under our reinsurance contracts. Significant changes in interest rates expose us to the risk of not earning income or experiencing losses based on the difference between the interest rates earned on investments and the credited interest rates paid on outstanding reinsurance contracts. Both rising and declining interest rates can negatively affect the income we derive from these interest rate spreads. During periods of falling interest rates, our investment earnings will be lower because new investments in fixed maturity securities will likely bear lower interest rates. We may not be able to fully offset the decline in investment earnings with lower crediting rates on our contracts that reinsure life insurance policies or annuities with cash value components. A majority of our annuity and certain other products have multi-year guarantees and guaranteed floors on their crediting rates. During periods of rising interest rates, we may be contractually obligated to increase the crediting rates on our contracts that reinsure life insurance policies or annuities with cash value components. We may not, however, 18 have the ability to immediately acquire investments with interest rates sufficient to offset the increased crediting rates under our reinsurance contracts. Although we develop and maintain asset/liability management programs and procedures designed to reduce the volatility of our income when interest rates are rising or falling, significant changes in interest rates caused by factors beyond our control such as changes in governmental monetary policy or political conditions may negatively affect our interest rate spreads. Changes in interest rates may also affect our business in other ways. Lower interest rates may result in lower sales of certain insurance and investment products of our customers, which would reduce the demand for our reinsurance of these products. A prolonged economic downturn could reduce the demand for annuity and life insurance products, which could substantially reduce our revenues. A prolonged general economic downturn or poor performance of the equity and other capital markets, such as the U.S. economy has recently experienced, or similar conditions in the future, could lower the demand for many annuity and life insurance products. Because we obtain substantially all of our revenues through reinsurance arrangements that cover a portfolio of life insurance products, as well as annuities, our business would be harmed if the demand for annuities or life insurance decreased. Policyholder withdrawals or recaptures of reinsurance treaties could force us to sell investments at a loss and take a larger than anticipated charge for amortization of deferred acquisition costs. Some of the products offered by our insurance subsidiaries and some of the products offered by primary insurance companies that we reinsure allow policyholders and contract holders to withdraw their funds under defined circumstances. In addition, our reinsurance agreements may provide for recapture rights on the part of our insurance company customers. Recapture rights permit these customers to reassume all or a portion of the risk formerly ceded to us after an agreed upon time, usually 10 years, subject to various conditions or upon a downgrade of any of our financial strength ratings or our failure to satisfy other financial conditions. Recapture of business previously ceded does not affect premiums ceded prior to the recapture, but may result in immediate payments to our insurance company customers. In addition, when we issue a new insurance policy or annuity contract or write a reinsurance contract, we defer a portion of the related acquisition costs by establishing a deferred acquisition cost asset on the balance sheet. This asset is amortized over the expected term of the acquired business based on certain assumptions about the performance and persistency of that business and investment experience. To the extent surrender, withdrawal or recapture activity is greater than we assumed, or investment experience is worse than we assumed we may incur a non-cash charge to write down the deferred acquisition cost asset. Any such charge may be partially offset by recapture and surrender fees. One of our customers exercised a right of recapture in April 2001, requiring us to pay $185.7 million to the customer. Because we had expected the recapture, we did not have to dispose of assets at a loss and we had already fully amortized the deferred acquisition costs. In December 2002, another of our customers exercised a right of recapture requiring us to pay $49.3 million to the customer. In that case, we did not have to dispose of assets at a loss and we recovered all of our unamortized deferred acquisition costs relating to the transaction. However, because recapture rights can be triggered by circumstances, which may be unforeseeable, such as rating decreases or production shortfalls, we may not be able to anticipate future recaptures and make adequate preparations to reduce their impact on us. If recaptures occur and we do not make adequate preparations, our earnings and financial condition could decline. We take counter-party risk with respect to our retrocessionaires. We cede some of the business that we reinsure to other reinsurance companies, known as retrocessionaires. We assume the risk that the retrocessionaire will be unable to pay amounts due to us because of its own financial difficulties. The failure of our retrocessionaires to pay amounts due to us will not absolve us of our responsibility to 19 pay ceding companies for risks that we reinsure. Failure of retrocessionaires to pay us could materially harm our business, results of operations and financial condition. Terrorist attacks and related events may adversely affect our business and results of operations. The terrorist attacks on the United States and ensuing events or any future attacks may have a negative impact on our business and results of operations due to the loss of lives that we insure or reinsure and the impact on the U.S. and global economies and the demand for our products. Our reinsurance programs, including our catastrophe coverage limited our net losses in individual life claims relating to the September 11, 2001 terrorist attacks to approximately $750,000. We continue to utilize reinsurance programs, including catastrophe coverage, to limit any future losses relating to such events. We cannot assure you, however, that if there are future terrorist attacks, our business, financial condition or results of operations will not be adversely affected. Economic and political instability in developing countries could harm our business prospects. We conduct our business in various developing countries within Asia, Latin America, the Middle East, North Africa and Southern and Eastern Europe. We plan to continue to expand our business in these locations. Political and economic instability as well as armed conflict in these countries could adversely impact our ability to write new business originating in these countries. Such adverse impact, if significant, could reduce our earned premiums and, accordingly, could reduce our net income. Any future acquisitions may expose us to operational risks. We have made, and may in the future make, strategic acquisitions, either of other companies or selected blocks of business. Any future acquisitions may expose us to operational challenges and risks, including: o integrating financial and operational reporting systems; o establishing satisfactory budgetary and other financial controls; o funding increased capital needs and overhead expenses; o obtaining management personnel required for expanded operations; o funding cash flow shortages that may occur if anticipated sales and revenues are not realized or are delayed, whether by general economic or market conditions or unforeseen internal difficulties; and o the value of assets acquired may be lower than expected or may diminish due to credit defaults or changes in interest rates and liabilities assumed may be greater than expected. Our failure to manage successfully these operational challenges and risks may impact our results of operations. The loss of any of our key employees or our inability to retain them could negatively impact our business. Our success substantially depends upon our ability to attract and retain qualified employees and upon the ability of our senior management and other key employees to implement our business strategy. We believe there are only a limited number of available qualified executives in the business lines in which we compete. We rely substantially upon the services of Michael C. French, our Chief Executive Officer, Scott E. Willkomm, our President, David Huntley, our Chief Executive Officer of Scottish Re Limited, Elizabeth A. Murphy, our Chief Financial Officer, Oscar R. Scofield, the Chief Executive Officer of Scottish Re (U.S.), Inc., Thomas A. McAvity, Jr., our Chief Investment Officer and Clifford J. Wagner, our Chief Actuary. Each of the foregoing members of senior management have employment agreements and we maintain $5,000,000 key man life insurance policies for each of Mr. French and Mr. Scofield and $2,500,000 key man life insurance policies for each of Mr. Willkomm, Ms. Murphy, and Mr. Wagner. 20 The loss of the services of members of our senior management, or our inability to hire and retain other talented personnel from the very limited pool of qualified insurance professionals, could delay or prevent us from fully implementing our business strategy which could harm our financial performance. We are exposed to foreign currency risk. Our functional currency is the United States dollar. However, our U.K. subsidiaries, Scottish Re Holdings Limited and Scottish Re Limited, maintain a part of their investment portfolio and operating expense accounts in British pounds and receive other currencies in payment of premiums. All of Scottish Re Limited's original U.S. business is settled in United States dollars, all Canadian, Latin American and certain Asia and Middle East business is converted and settled in United States dollars, and all other currencies are converted and settled in British pounds. The results of the business in British pounds are then translated to United States dollars. Scottish Re Limited attempts to limit substantial exposures to foreign currency risk, but does not actively manage currency risks. To the extent our foreign currency exposure is not properly managed or otherwise hedged, we may experience exchange losses, which in turn would lower our results of operations and harm our financial condition. Our insurance subsidiaries are highly regulated, and changes in these regulations could harm our business. Our insurance and reinsurance subsidiaries are subject to government regulation in each of the jurisdictions in which they are licensed or authorized to do business. Governmental agencies have broad administrative power to regulate many aspects of the insurance business, which may include trade and claim practices, accounting methods, premium rates, marketing practices, advertising, policy forms, and capital adequacy. These agencies are concerned primarily with the protection of policyholders rather than shareholders. Moreover, insurance laws and regulations, among other things: o establish solvency requirements, including minimum reserves and capital and surplus requirements; o limit the amount of dividends, tax distributions, intercompany loans and other payments our insurance subsidiaries can make without prior regulatory approval; o impose restrictions on the amount and type of investments we may hold; and o require assessments to pay claims of insolvent insurance companies. The National Association of Insurance Commissioners, which we call the NAIC, continuously examines existing laws and regulations. We cannot predict the effect that any NAIC recommendations or proposed or future legislation or rule making in the United States or elsewhere may have on our financial condition or operations. If Scottish Re or any of our subsidiaries were to become subject to the laws of a new jurisdiction where Scottish Re or that subsidiary is not presently admitted, they may not be in compliance with the laws of the new jurisdiction. Any failure to comply with applicable laws could result in the imposition of significant restrictions on our ability to do business, and could also result in fines and other sanctions, any or all of which could harm our financial results and operations. Life reinsurance is a highly competitive industry, which could limit our ability to gain or maintain our competitive position. The life reinsurance industry is highly competitive, and we encounter significant competition from other reinsurance companies, as well as competition from other providers of financial services. Competition in the reinsurance business is based on price, financial strength ratings, reputation, experience, relationships and service. Many of our competitors are significantly larger, have greater financial resources and have longer operating histories than we do. Competition from other reinsurers could adversely affect our competitive position. We consider our major competitors to include Swiss Re, Reinsurance 21 Group of America Inc., Munich American Reassurance Company, ING Reinsurance and Transamerica Reinsurance. Our ability to pay dividends is limited. We are a holding company, with our principal assets consisting of the stock of our insurance company subsidiaries. Our ability to pay dividends on the ordinary shares and Hybrid Capital Units depends significantly on the ability of our insurance company subsidiaries, our principal sources of cash flow, to declare and distribute dividends or to advance money to us in the form of intercompany loans. Our insurance company subsidiaries are subject to various state and foreign government statutory and regulatory restrictions, applicable to insurance companies generally, that limit the amount of cash dividends, loans and advances that those subsidiaries may pay to us. If insurance regulators at any time determine that payment of a dividend or any other payment to an affiliate would be detrimental to an insurance subsidiary's policyholders or creditors, because of the financial condition of the insurance subsidiary or otherwise, the regulators may block dividends or other payments to affiliates that would otherwise be permitted without prior approval. Our ordinary shares are subject to voting and transfer limitations. Under our articles of association, our board of directors (or its designee) is required, except for transfers of ordinary shares executed on any recognized securities exchange or inter-dealer quotation system, including the NYSE, to decline to register any transfer of ordinary shares, if our directors have any reason to believe that such transfer would result in a person (or any group of which such person is a member) beneficially owning, directly or indirectly, 10% or more of any class of our shares, except that Pacific Life (as defined in our articles of association), is permitted to transfer ordinary shares to other Pacific Life entities, so long as the number of ordinary shares beneficially owned directly or indirectly by the Pacific Life entities in the aggregate does not exceed 24.9% of a class of our shares. With respect to a transfer of ordinary shares executed on any recognized securities exchange or inter-dealer quotation system, including the NYSE, if our directors have any reason to believe that such transfer would result in a person (or any group of which such person is a member) beneficially owning, directly or indirectly, 10% or more of any class of our shares, the directors may demand that such person surrender the ordinary shares to an agent designated by the directors, who will sell the ordinary shares on any recognized securities exchange or inter-dealer quotation system, including the NYSE. After applying the proceeds of the sale toward reimbursing the transferee for the price paid for the ordinary shares, the agent will pay the remaining proceeds to certain charitable organizations designated by the directors. The proceeds of such sale may be used to reimburse the agent for its duties. Similar restrictions apply to issuances and repurchases of ordinary shares by us. Our directors (or their designee) also may, in their absolute discretion, decline to register the transfer of any ordinary shares, except for transfers of ordinary shares executed on any recognized securities exchange or inter-dealer quotation system, including the NYSE, if they have reason to believe that such transfer may expose us, our subsidiaries or shareholders or any person insured or reinsured or proposing to be insured or reinsured by us to adverse tax or regulatory treatment in any jurisdiction or if they have reason to believe that registration of such transfer under the Securities Act, under any state "blue sky" or other U.S. securities laws or under the laws of any other jurisdiction is required and such registration has not been duly effected. With respect to a transfer of ordinary shares executed on any recognized securities exchange or inter-dealer quotation system, including the NYSE, if our directors have any reason to believe that such transfer may expose us, our subsidiaries or shareholders or any person insured or reinsured or proposing to be insured or reinsured by us to adverse tax or regulatory treatment in any jurisdiction, the directors may demand that such person surrender the ordinary shares to an agent designated by the directors, who will sell the ordinary shares on any recognized securities exchange or inter-dealer quotation system, including the NYSE. After applying the proceeds of the sale toward reimbursing the transferee for the price paid for the ordinary shares, the agent will pay the remaining proceeds to certain charitable organizations designated by the directors. The proceeds of such sale may be used to reimburse the agent for its duties. A transferor of ordinary shares will be deemed to own such shares for dividend, voting and reporting purposes until a transfer of such ordinary shares has been registered on our register of members. We are authorized to request information from any holder or prospective acquiror of ordinary shares as necessary to effect registration of any such transaction, and may decline to register any such transaction if complete and accurate information is not received as requested. In addition, our articles of association generally provide that any person (or any group of which such person is a member) other than the Pacific Life entities, holding directly, or by attribution, or otherwise beneficially 22 owning our voting shares carrying 10% or more of the total voting rights attached to all of our outstanding voting shares, will have the voting rights attached to its voting shares reduced so that it may not exercise more than approximately 9.9% of such total voting rights. In addition, in the event the Pacific Life entities hold directly or by attribution or otherwise beneficially own voting shares with more than 24.9% of the total voting rights of our voting shares, the voting rights of the Pacific Life entities will be reduced so that they may not exercise in the aggregate more than approximately 24.9% of the total voting rights of our voting shares at any given time. Because of the attribution provisions of the Code and the rules of the SEC regarding determination of beneficial ownership, this requirement may have the effect of reducing the voting rights of a shareholder whether or not such shareholder directly holds of record 10% or more of our voting shares. Further, our board of directors (or its designee) has the authority to request from any shareholder certain information for the purpose of determining whether such shareholder's voting rights are to be reduced. Failure to respond to such a notice, or submitting incomplete or inaccurate information, gives our board of directors (or its designee) discretion to disregard all votes attached to such shareholder's ordinary shares. Our articles of association make it difficult to replace directors and to effect a change of control. Our articles of association contain certain provisions that make it more difficult for the shareholders to replace directors even if the shareholders consider it beneficial to do so. In addition, these provisions may make more difficult the acquisition of control of Scottish Re by means of a tender offer, open market purchase, a proxy fight or otherwise, including by reason of the limitation on transfers of ordinary shares and voting rights described above. While these provisions are designed to encourage persons seeking to acquire control to negotiate with our board of directors, they could have the effect of discouraging a prospective purchaser from making a tender offer or otherwise attempting to obtain control and may prevent a shareholder from receiving the benefit from any premium over the market price of our ordinary shares offered by a bidder in a potential takeover. Examples of provisions in our articles of association that could have such an effect include: o election of our directors is staggered, meaning that the members of only one of three classes of our directors are elected each year; o the total voting power of any shareholder owning 10% or more of the total voting rights attached to our ordinary shares will be reduced to approximately 9.9% of the total voting rights of our ordinary shares; o our directors must decline to register the transfer of ordinary shares on our share register that would result in a person owning 10% or more of any class of our shares and may declined certain transfers that they believe may have adverse tax or regulatory consequences; o shareholders do not have the right to act by written consent; and o our directors have the ability to change the size of the board of directors. Even in the absence of an attempt to effect a change in management or a takeover attempt, these provisions may adversely affect the prevailing market price of our ordinary shares if they are viewed as discouraging changes in management and takeover attempts in the future. 23 Pacific Life owns approximately 8.5% of our outstanding ordinary shares. In addition, pursuant to a stockholder agreement, Pacific Life has the right to nominate two persons for election to our board of directors so long as Pacific Life and its affiliates own at least 15% of our outstanding ordinary shares and one such person so long as they own at least 10%. Pacific Life's share ownership and ability to nominate persons for election to our board of directors might provide Pacific Life with significant influence over potential change in control transactions. Applicable insurance laws make it difficult to affect a change of control. Under applicable Delaware insurance laws and regulations, no person may acquire control of Scottish Re or Scottish Re (U.S.), Inc., our Delaware insurance subsidiary, unless that person has filed a statement containing specified information with the Delaware Insurance Commissioner and approval for such acquisition is obtained. Under applicable laws and regulations, any person acquiring, directly by stock ownership or indirectly (by revocable proxy or otherwise), 10% or more of the voting stock of any other person is presumed to have acquired control of such person, and a person who beneficially acquires 10% or more of our ordinary shares without obtaining the approval of the Delaware Insurance Commissioner would be in violation of Delaware's insurance holding company act and would be subject to injunctive action requiring disposition or seizure of the shares and prohibiting the voting of such shares, as well as other action determined by the Delaware Insurance Commissioner. Under applicable Missouri insurance laws and regulations, no person may acquire control of ERC Life, our Missouri insurance subsidiary, unless that person has filed a statement containing specified information with the Missouri Director of Insurance and approval for such acquisition is obtained. Under applicable laws and regulations, any person who, directly or indirectly, owns, controls, holds with the power to vote or holds proxies representing, 10% or more of the voting stock of any other person is presumed to have acquired control of such person, and a person who acquires such control without obtaining the approval of the Missouri Insurance Commissioner would be in violation of Missouri's insurance holding company act and would be subject to injunctive action, as well as other action determined by the Missouri Director of Insurance. In addition, many state insurance laws require prior notification to the state insurance department of a change in control of a non-domiciliary insurance company licensed to transact insurance in that state. While these pre-notification statutes do not authorize the state insurance departments to disapprove the change in control, they authorize regulatory action in the affected state if particular conditions exist such as undue market concentration. Any future transactions that would constitute a change in control of us or Scottish Re (U.S.), Inc. and ERC Life may require prior notification in the states that have pre-acquisition notification laws. Any change in control of Scottish Re Limited would need the approval of the UK Financial Services Authority, which is the body responsible for the regulation and supervision of the UK insurance and reinsurance industry. The market price of our ordinary shares could decrease due to the significant number of shares eligible for future sale. As of February 23, 2004, we had 35,350,745 ordinary shares outstanding, 3,007,380 of which were held by Pacific Life. In addition, we had options outstanding to purchase an aggregate of 2,966,317 ordinary shares, Class A warrants to purchase an aggregate of 2,650,000 ordinary shares, 5,297,098 ordinary shares issuable upon conversion of the Senior Convertible Notes and 7,440,500 ordinary shares (at the current market price) issuable upon conversion of the Hybrid Capital Units. The ordinary shares held by Pacific Life, the ordinary shares issuable upon the exercise of the Class A warrants and the ordinary shares issuable upon conversion of our 4.50% Senior Convertible Notes have been registered pursuant to a registration statement that became effective on April 4, 2003, and they may be sold at any time and from time to time by the holders thereof in open market or privately negotiated transactions. The ordinary shares issuable upon settlement of the purchase contracts and the convertible preferred shares underlying the Hybrid Capital Units have been registered pursuant to the registration statement which became effective on April 24, 2003 and may be sold at any time and from time to time by the holders thereof in open market or privately negotiated transactions after the date of issuance. We cannot predict the effect, if any, that future sales of our ordinary shares, or the availability of ordinary shares for future sale, will have on the market price of the ordinary shares prevailing from time to time. Sales of 24 substantial amounts of ordinary shares in the public market following the offering, or the perception that such sales could occur, could lower the market price of our ordinary shares and may make it more difficult for us to sell our equity securities in the future at a time and at a price which we deem appropriate. If the persons holding the Class A warrants, or options cause a large number of the ordinary shares underlying such securities to be sold in the market, or if Pacific Life were to sell a large number of their ordinary shares, or if the convertible holders were able to convert to our ordinary shares and then sell those ordinary shares, such sales could cause a decline in the market price for the ordinary shares. Investors may have difficulties in suing or enforcing judgments against us in the United States. Scottish Re is a holding company organized under the laws of the Cayman Islands with its principal executive office in Bermuda. Certain of our directors and officers are residents of various jurisdictions outside the United States. All or a substantial portion of our assets and those of such directors and officers, at any one time, are or may be located in jurisdictions outside the United States. Although we have irrevocably agreed that we may be served with process in New York, New York with respect to actions arising out of or in connection with violations of United States Federal securities laws relating to offers and sales of ordinary shares made hereby, it could be difficult for investors to effect service of process within the United States on our directors and officers who reside outside the United States or to recover against us or such directors and officers on judgments of United States courts predicated upon the civil liability provisions of the United States federal securities laws. Risks Related to Taxation If Scottish Re or any of its non-U.S. subsidiaries is determined to be conducting business in the United States or if Scottish Re or any of its subsidiaries is treated as a personal holding company, we could be liable for U.S. federal income taxes. Scottish Re is a holding company organized under the laws of the Cayman Islands with its principal executive office in Bermuda. Scottish Re and its non-U.S. subsidiaries believe they have operated and intend to continue operating in a manner such that neither Scottish Re nor any of its non-U.S. subsidiaries should be treated as engaging in a trade or business in the United States and thus should not be subject to U.S. federal income taxation on net income. Because there are no definitive standards provided by the Internal Revenue Code of 1986, as amended (the "Code"), regulations or court decisions as to which activities constitute being engaged in the conduct of a trade or business within the United States and as the determination is essentially factual in nature, the United States Internal Revenue Service (which we refer to as the IRS) could contend that Scottish Re or one or more of its non-U.S. subsidiaries, is engaged in a trade or business in the United States for U.S. federal income tax purposes, and thus may be subject to U.S. federal income tax and "branch profits" tax on net income. The highest marginal federal income tax rates currently are 35% for a corporation's income that is effectively connected with a U.S. trade or business and 30% for the "branch profits" tax unless the "branch profits" tax is reduced by an applicable income tax treaty. Scottish Re or one of its non-U.S. subsidiaries might be subject to U.S. tax on a portion of its U.S. income if Scottish Re or one of its non-U.S. subsidiaries is considered a personal holding company ("PHC") for U.S. federal income tax purposes. This status will depend on whether 50% or more of our shares could be deemed to be owned (pursuant to certain constructive ownership rules) by five or fewer individuals and whether 60% or more of Scottish Re's income, or the income of any of its subsidiaries, as determined for U.S. federal income tax purposes, consists of "personal holding company income." We believe based upon the information made available to us regarding our existing shareholder base that neither Scottish Re nor any of its non-U.S. subsidiaries should be considered a PHC for U.S. federal income tax purposes immediately following the offering. Additionally, we intend to manage our business to minimize the possibility that we will meet the 60% income threshold so that neither Scottish Re nor any of its subsidiaries should be considered a PHC. However, because of the legal and factual uncertainties regarding the application of the constructive ownership rules, the makeup of our shareholder base, our gross income and other circumstances, we cannot be certain that Scottish Re and/or any of its subsidiaries will not be considered a PHC or that the amount of U.S. tax that would be imposed if this were not the case would be immaterial. If Scottish Re or any of its non-U.S. subsidiaries is treated as a controlled foreign corporation, a passive foreign investment company or foreign personal holding company or if any of our non-U.S. insurance 25 subsidiaries generate more than a permissible amount of related person insurance income, U.S. persons who own our convertible preferred shares or ordinary shares may be subject to U.S. federal income taxation on our undistributed earnings and may recognize ordinary income upon disposition of our convertible preferred shares or ordinary shares. We believe that we were not a controlled foreign corporation, a passive foreign investment company or a foreign personal holding company, nor have we generated an impermissible amount of related person insurance income for the year ended December 31, 2002. Although no assurances can be given, based upon (i) our current beliefs with respect to the dispersion of our share ownership and (ii) our financial information for the period ending September 30, 2003, we do not expect to be a controlled foreign corporation, passive foreign investment company, foreign personal holding company or to generate an impermissible amount of related person insurance income for the current year or in the future. Our shareholders who are U.S. persons may be required to include in gross income for U.S. federal income tax purposes our undistributed earnings if we are treated as a controlled foreign corporation, a passive foreign investment company, a foreign personal holding company or if we have generated more than a permissible amount of related person insurance income. In addition, in certain cases gain on the disposition of our convertible preferred shares or ordinary shares may be treated as ordinary income. Controlled Foreign Corporation. Each U.S. 10% holder of a controlled foreign corporation on the last day of the controlled foreign corporation's taxable year generally must include in gross income for U.S. federal income tax purposes such shareholder's pro-rata share of the controlled foreign corporation's subpart F income, even if the subpart F income has not been distributed. For purposes of this discussion, the term "U.S. 10% holder" includes only persons who, directly or indirectly through non-U.S. entities (or through the application of certain "constructive" ownership rules, which we refer to as constructively), own 10% or more of the total combined voting power of all classes of stock of the foreign corporation. In general, a non-U.S. company is treated as a controlled foreign corporation if such U.S. 10% holders collectively own more than 50% of the total combined voting power or value of the company's stock for an uninterrupted period of 30 days or more during any year and a non-U.S. insurance company is treated as a controlled foreign corporation if such U.S. 10% holders collectively own more than 25% of the total combined voting power or value of the company's stock for an uninterrupted period of 30 days or more during any year. We believe we currently have no U.S. 10% holders. In order to prevent Scottish Re or any of its non-U.S. subsidiaries from being treated as a controlled foreign corporation, our articles of association prohibit the ownership by any person of shares that would equal or exceed 10% (or, in the case of Pacific Life, Pacific Mutual Holding Company, Pacific LifeCorp and/or any direct or indirect wholly-owned subsidiary of Pacific Mutual Holding Company, each of which we call a Pacific Life Entity, that would exceed 24.9%) of any class of the issued and outstanding Scottish Re shares and provide a "voting cutback" that would, in certain circumstances, reduce the voting power with respect to Scottish Re shares to the extent necessary to prevent the Pacific Life entities from owning more than 24.9% of the voting power of Scottish Re, and any other person owning more than 9.9% of the voting power of Scottish Re. We believe, based upon information made available to us regarding our existing shareholder base, that the dispersion of our share ownership (other than with respect to the Pacific Life entities) and the provisions of our articles of association restricting the transfer, issuance and voting power of our shares should prevent any person (other than the Pacific Life entities) from becoming a U.S. 10% holder of Scottish Re; however, some of these provisions have not been directly passed on by the IRS, or by any court, in this context. If, however, one or more U.S. persons owning (directly, indirectly through non-U.S. entities or constructively) 10% or more of our voting stock were to acquire separately or in the aggregate 25% of the vote or value of the stock of Scottish Re, our non-U.S. insurance subsidiaries would be treated as controlled foreign corporations. In addition, Scottish Re and its other (non-insurance) non-U.S. subsidiaries would be characterized as controlled foreign corporations if such U.S. persons were to acquire more than 50% of the vote or value of the stock of Scottish Re. In either case, any such U.S. 10% shareholder would be required to include in gross income its allocable share of subpart F income of Scottish Re and/or its non-U.S. subsidiaries. Related Person Insurance Income. If (i) any of our non-U.S. insurance subsidiaries' related person insurance income, referred to as RPII, determined on a gross basis were to equal or exceed 20% of its gross 26 insurance income in any taxable year, (ii) direct or indirect insureds and persons related to such insureds were to own directly or indirectly 20% or more of the voting power or value of Scottish Re's stock or any of our non-U.S. insurance subsidiaries' stock, and (iii) U.S. persons (without regard to whether any U.S. person is a U.S. 10% holder) directly, indirectly or constructively own collectively by voting power or value 25% or more of our aggregate shares (taking into account the relative vote and value of our convertible preferred shares and ordinary shares), such U.S. persons who directly or indirectly own our convertible preferred shares or ordinary shares on the last day of the taxable year would be required to include the U.S. person's pro-rata share of our non-U.S. insurance subsidiaries' related person insurance income for the taxable year in its gross income for U.S. federal income tax purposes, determined as if such related person insurance income were distributed proportionately to U.S. persons at that date, taking into account any differences existing with respect to the distribution rights applicable to the convertible preferred shares and ordinary shares. Related person insurance income is generally underwriting premium and related investment income attributable to insurance or reinsurance policies when the direct or indirect insureds are direct or indirect U.S. shareholders or are related to such direct or indirect U.S. holders. At present we believe that our non-U.S. insurance subsidiaries should satisfy the 20% RPII ownership exception described herein because the direct or indirect ownership of the shares of Scottish Re or any of its non-U.S. insurance subsidiaries by any shareholders that are direct or indirect insureds of any of Scottish Re's non-U.S. insurance subsidiaries (or any person related to such insureds) should be less than 20% of the voting power or value of Scottish Re or any of its non-U.S. insurance subsidiaries. Even if the 20% RPII ownership exception described above is not met, although no assurances can be given, we do not believe that the 20% gross insurance income threshold has been met and we do not expect such threshold to be met in the future. If this is not, or will not continue to be, the case, such U.S. persons who directly or indirectly own our convertible preferred shares or ordinary shares on the last day of such taxable year would be required to include the U.S. person's pro-rata share of the relevant non-U.S. insurance subsidiaries' related person insurance income for the taxable year in its gross income for U.S. federal income tax purposes, determined as if such related person insurance income were distributed proportionately to such U.S. person at that date, taking into account any differences existing with respect to the distribution rights applicable to the convertible preferred shares and ordinary shares. Dispositions of Our Convertible Preferred Shares or Ordinary Shares. If we are considered to be a controlled foreign corporation, any gain from the sale or exchange by a U.S. 10% holder of our convertible preferred shares or ordinary shares may be treated as ordinary income to the extent of our earnings and profits during the period that such shareholder held our shares (with certain adjustments). If we are considered to have related person insurance income and U.S. persons (without regard to whether any U.S. person is a U.S. 10% holder) collectively own directly, indirectly or constructively 25% or more of the voting power or value of our aggregate shares (taking into account the relative vote and value of our convertible preferred shares and ordinary shares), any gain from the disposition by a U.S. holder of our convertible preferred shares or ordinary shares will generally be treated as ordinary income to the extent of such U.S. holder's portion of our undistributed earnings and profits that were accumulated during the period that the U.S. holder owned the shares (with certain adjustments). In addition, such U.S. holder will be required to comply with certain reporting requirements, regardless of the amount of shares owned directly or indirectly. However, because Scottish Re is not itself directly engaged in the insurance business and because proposed U.S. Treasury regulations applicable to this situation appear to apply only to sales of shares of corporations that are directly engaged in the insurance business, we do not believe that sale of Scottish Re shares should be subject to these rules. The IRS, however, could interpret the proposed regulations, or the proposed regulations could be promulgated in final form, in a manner that would cause these rules to apply to dispositions of our convertible preferred shares or ordinary shares. Passive Foreign Investment Company. In order to avoid significant potential adverse U.S. federal income tax consequences for any U.S. person who owns our convertible preferred shares or ordinary shares, we must not be subject to treatment as a passive foreign investment company, referred to as a PFIC, in any year in which such U.S. person is a shareholder. In general, a non-U.S. corporation is a PFIC for a taxable year if 75% or more of its income constitutes passive income or 50% or more of its assets produce passive income. Passive income generally includes interest, dividends and other investment income. Passive income does not, however, include income derived in the active conduct of an insurance business by a corporation that is predominantly engaged in an insurance business. This exception is intended to ensure that income derived by a bona fide insurance company is not treated as passive 27 income, except to the extent such income is attributable to financial reserves in excess of the reasonable needs of the insurance business. Although we believe that Scottish Re and its non-U.S. subsidiaries, taken as a whole, are engaged predominantly in insurance and reinsurance activities that involve significant risk transfer and that are otherwise activities of a type normally undertaken by insurance or reinsurance companies, and do not expect to have financial reserves in excess of the reasonable needs of their insurance businesses, it is possible that the IRS could take the position that we are a PFIC. Although we do not believe that we are or will be a passive foreign investment company, the IRS or a court could concur that we are a passive foreign investment company with respect to any given year. Foreign Personal Holding Company. If we were considered an FPHC it could have material adverse tax consequences for you if you are subject to U.S. federal income taxation, including potentially subjecting any dividend income inclusions to a greater tax liability than might otherwise apply and subjecting you to tax on amounts in advance of when tax would otherwise be imposed. In addition, if we were considered an FPHC, upon the death of any U.S. individual owning shares, such individual's heirs or estate would not be entitled to a "step-up" in the basis of the ordinary shares which might otherwise be available under U.S. federal income tax laws. Scottish Re and/or any of its non-U.S. subsidiaries could be considered to be an FPHC for U.S. federal income tax purposes if more than 50% of our shares could be deemed to be owned by five or fewer individuals who are citizens or residents of the United States, and 60% or more of Scottish Re's income, or that of its non-U.S. subsidiaries, consists of "foreign personal holding company income," as determined for U.S. federal income tax purposes. We believe, based upon information made available to us regarding our existing shareholder base, that neither Scottish Re nor any of its non-U.S. subsidiaries should be considered an FPHC immediately following the offering. Additionally, we intend to manage our business to minimize the possibility that we will meet the 60% income threshold so that neither Scottish Re nor any of its non-U.S. subsidiaries should be considered an FPHC. However, because of the legal and factual uncertainties regarding the application of the constructive ownership rules, the makeup of our shareholder base, our gross income and other circumstances, we cannot be certain that Scottish Re and/or any of its non-U.S. subsidiaries will not be considered an FPHC. If we are a controlled foreign corporation or if any of our non-U.S. insurance subsidiaries generate related person insurance income, U.S. tax-exempt organizations that own our convertible preferred shares or ordinary shares may recognize unrelated business taxable income. A U.S. tax-exempt organization may recognize unrelated business taxable income if a portion of our insurance income is allocated to the organization. In general, insurance income will be allocated to a U.S. tax-exempt organization if either we are a controlled foreign corporation and the tax-exempt shareholder is a U.S. 10% holder or there is related person insurance income and certain exceptions do not apply. Although we do not believe that any U.S. persons should be allocated subpart F insurance income, potential U.S. tax-exempt investors are advised to consult their own tax advisors. Changes in U.S. federal income tax law could materially adversely affect an investment in our convertible preferred shares or ordinary shares. Legislation has been introduced in the U.S. Congress intended to eliminate certain perceived tax advantages of companies (including insurance companies) that have legal domiciles outside the United States but have certain U.S. connections. In this regard, legislation has been introduced that includes a provision that permits the IRS to reallocate or recharacterize items of income, deduction or certain other items related to a reinsurance agreement between related parties to reflect the proper source, character and amount for each item (in contrast to current law, which only refers to source and character). While there are no currently pending legislative proposals which, if enacted, would have a material adverse effect on us or our shareholders, it is possible that broader-based legislative proposals could emerge in the future that could have an adverse impact on us, or our shareholders. Additionally, the U.S. federal income tax laws and interpretations regarding whether a company is engaged in a trade or business within the United States, or is a passive foreign investment company, or whether U.S. persons would be required to include in their gross income the subpart F income or the related person insurance income of a controlled foreign corporation are subject to change, possibly on a retroactive basis. There are currently no regulations regarding the application of the passive foreign investment company rules to insurance companies and the regulations regarding related person insurance income are still in proposed form. New regulations or 28 pronouncements interpreting or clarifying such rules may be forthcoming. We cannot be certain if, when or in what form such regulations or pronouncements may be provided and whether such guidance will have a retroactive effect. If we do not receive further undertakings from the Cayman Islands, we may become subject to taxes in the Cayman Islands in the future. Scottish Re and our Cayman Islands subsidiaries, Scottish Annuity & Life Insurance Company (Cayman) Ltd. and The Scottish Annuity Company (Cayman) Ltd., have received undertakings from the Governor-in-Council of the Cayman Islands pursuant to the provisions of the Tax Concessions Law, as amended (1999 Revision), that until the year 2018 with respect to Scottish Re and Scottish Annuity & Life Insurance Company (Cayman) Ltd., and until the year 2014 with respect to The Scottish Annuity Company (Cayman) Ltd., (1) no subsequently enacted Cayman Islands law imposing any tax on profits, income, gains or appreciation shall apply to Scottish Re and its Cayman Islands subsidiaries and (2) no such tax and no tax in the nature of an estate duty or an inheritance tax shall be payable on any shares, debentures or other obligations of Scottish Re and its Cayman Islands subsidiaries. We could be subject to Cayman Islands taxes after the applicable dates. If Bermuda law changes, we may become subject to taxes in Bermuda in the future. Bermuda currently imposes no income tax on corporations. The Bermuda Minister of Finance, under The Exempted Undertakings Tax Protection Act 1966 of Bermuda, has assured us that if any legislation is enacted in Bermuda that would impose tax computed on profits or income, or computed on any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance tax, then the imposition of any such tax will not be applicable to Scottish Re or any of our Bermuda subsidiaries until March 28, 2016. Scottish Re or any of our Bermuda subsidiaries could be subject to Bermuda taxes after that date. The impact of letters of commitment from Bermuda and the Cayman Islands to the Organization for Economic Cooperation and Development to eliminate harmful tax practices may impact us. The Organization for Economic Cooperation and Development, which is commonly referred to as the OECD, has published reports and launched a global dialogue among member and non-member countries on measures to limit harmful tax competition. These measures are largely directed at counteracting the effects of tax havens and preferential tax regimes in countries around the world. In the OECD's report dated April 18, 2002, Bermuda and the Cayman Islands were not listed as uncooperative tax haven jurisdictions because each had previously committed itself to eliminate harmful tax practices and to embrace international tax standards for transparency, exchange of information and the elimination of any aspects of the regimes for financial and other services that attract business with no substantial domestic activity. We are not able to predict what changes will arise from the commitment or whether such changes will subject us to additional taxes. Item 2: PROPERTIES We currently lease office space in Hamilton, Bermuda where our executive and principal offices are located and in Charlotte, North Carolina, George Town, Grand Cayman, Dallas, Texas and Windsor, England. Our life reinsurance business operates out of the Bermuda, Grand Cayman, Charlotte and Windsor offices while our wealth management business operates out of the Grand Cayman office. The Bermuda and Dallas leases expire in 2005, the Grand Cayman lease expires in 2006, the Charlotte lease expires in 2012 and the Windsor lease expires in 2023. We plan to increase our leased office space in Charlotte to meet our growth needs arising from the acquisition of ERC Life. We believe that the leases for our remaining operations are adequate to meet our needs for the foreseeable future. Item 3: LEGAL PROCEEDINGS In the normal course of our business, we and our subsidiaries are occasionally involved in litigation. The ultimate disposition of such litigation is not expected to have a material adverse effect on our financial condition, liquidity or results of operations. 29 Item 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Scottish Re did not submit any matter to the vote of shareholders during the fourth quarter of 2003. 30 PART II Item 5: MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES Market for the Ordinary Shares The ordinary shares, par value $0.01 per share, of Scottish Re have been traded on the New York Stock Exchange under the symbol "SCT" since January 23, 2002. Prior to our listing on the New York Stock Exchange our ordinary shares were listed and traded on the Nasdaq National Market under the symbol "SCOT" since November 24, 1998. This table shows for the indicated periods the high and low closing sales prices per share for our ordinary shares, as reported in The Wall Street Journal, and dividend declared per share.
Per Share High Low Dividend ---- --- -------- Year ended December 31, 2001 First Quarter.................................. $ 16.500 $ 11.125 $ 0.05 Second Quarter................................. 17.600 13.000 0.05 Third Quarter ................................. 18.900 13.900 0.05 Fourth Quarter................................. 19.350 15.000 0.05 Year ended December 31, 2002 First Quarter.................................. $ 19.000 $ 15.890 $ 0.05 Second Quarter................................. 21.630 18.530 0.05 Third Quarter ................................. 19.000 13.900 0.05 Fourth Quarter................................. 19.050 16.500 0.05 Year ended December 31, 2003 First Quarter.................................. $ 18.060 $ 16.550 $ 0.05 Second Quarter................................. 20.520 17.180 0.05 Third Quarter ................................. 24.150 20.000 0.05 Fourth Quarter................................. 24.500 19.300 0.05 Period Ended February 23, 2004 January 1, 2004 to February 23, 2004 $ 23.710 $ 20.300 $ -
As of December 31, 2003, Scottish Re had 29 record holders of its ordinary shares. Scottish Re paid cash dividends of $0.20 per ordinary share in each of 2003, 2002 and 2001. 31 Item 6: SELECTED FINANCIAL DATA The following selected financial data should be read in conjunction with the Consolidated Financial Statements, including the related Notes, and "Management's Discussion and Analysis of Financial Condition and Results of Operations." Consolidated balance sheet data as of December 31, 2001 reflect the acquisition of Scottish Re Holdings Limited, but consolidated statements of income data for the periods ended December 31, 2001, 2000 and 1999 and consolidated balance sheet data as of December 31, 1999 and 2000 do not reflect the results of Scottish Re Holdings Limited, as the transaction was completed at the close of business on December 31, 2001. Consolidated balance sheet data as of December 31, 2003 reflect the acquisition of ERC Life, but consolidated statement of income data for the years ended December 31, 1999 to December 31, 2002 and consolidated balance sheet data as of December 31, 1999 to 2002 do not reflect the acquisition of ERC Life, as the transaction was completed on December 22, 2003. Consolidated statement of income data for the year ended December 31, 2003 includes net income of $1.2 million in respect of ERC Life.
Year Year Year Year Year Ended Ended Ended Ended Ended December December December December December 31, 2003 31, 2002 31, 2001 31, 2000 31, 1999 -------- -------- -------- -------- -------- (dollars in thousands, except per share amounts) Consolidated statements of income data: Total revenues .............. $ 557,366 $ 306,212 $ 120,962 $ 83,935 $ 22,465 Total benefits and expenses . 519,621 274,871 103,729 68,074 13,632 Income before income taxes and minority interest .................. 37,745 31,341 17,233 15,861 8,833 Income from continuing operations before cumulative effect of change in accounting principle ................. 48,788 33,235 17,245 15,971 8,875 Net income .................. 27,280 32,524 16,839 15,971 8,875 Per share data: Basic earnings per share: Income from continuing operations before cumulative effect of change in accounting principle and discontinued operations $ 1.59 $ 1.32 $ 1.10 $ 1.01 $ 0.50 Cumulative effect of change in accounting principle ............... (0.64) -- (0.02) -- -- Discontinued operations .............. (0.06) (0.03) -- -- -- --------- --------- --------- --------- --------- Net income ............... $ 0.89 $ 1.29 $ 1.08 $ 1.01 $ 0.50 ========= ========= ========= ========= =========
32
Year Year Year Year Year Ended Ended Ended Ended Ended December December December December December 31, 2003 31, 2002 31, 2001 31, 2000 31, 1999 ------------ ------------ ------------ ------------ ------------ (dollars in thousands, except per share amounts) Diluted earnings per share: Income from continuing operations before cumulative effect of change in accounting principle and discontinued operations $ 1.51 $ 1.25 $ 1.05 $ 1.00 $ 0.50 Cumulative effect of change in accounting principle ............... (0.60) -- (0.03) -- -- Discontinued operations... (0.06) (0.02) -- -- -- ------------ ------------ ------------ ------------ ------------ Net income ............... $ 0.85 $ 1.23 $ 1.02 $ 1.00 $ 0.50 ============ ============ ============ ============ ============ Book value per share ........ $ 18.73 $ 18.24 $ 16.44 $ 15.34 $ 13.63 Market value per share ...... $ 20.78 $ 17.45 $ 19.35 $ 11.98 $ 8.19 Cash dividends per share .... $ 0.20 $ 0.20 $ 0.20 $ 0.20 $ 0.15 Weighted average number of shares outstanding: Basic ....................... 30,652,719 25,190,283 15,646,106 15,849,657 17,919,683 Diluted ..................... 32,228,001 26,505,611 16,485,338 15,960,542 17,919,683 Balance sheet data: Total fixed maturity investments ............... $ 2,014,719 $ 1,003,946 $ 583,890 $ 581,020 $ 546,807 Total assets ................ 6,053,517 3,291,226 2,141,566 1,168,518 856,634 Total liabilities ........... 5,242,450 2,800,134 1,810,284 921,673 637,973 Minority interest ........... 9,295 -- -- -- -- Mezzanine equity ............ 141,928 -- -- -- -- Total shareholders' equity .. $ 659,844 $ 491,092 $ 331,282 $ 239,564 $ 218,661 Actual number of ordinary shares outstanding ............ 35,228,411 26,927,456 20,144,956 15,614,240 16,046,740
Item 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview On August 28, 2003, we changed our name to Scottish Re Group Limited from Scottish Annuity & Life Holdings, Ltd. In addition, our wholly owned subsidiaries World-Wide Holdings Limited and World-Wide Reassurance Company Limited changed their names to Scottish Re Holdings Limited and Scottish Re Limited, respectively. We are a holding company organized under the laws of the Cayman Islands with our principal executive office in Bermuda. We are a reinsurer of life insurance, annuities and annuity-type products. These products are written by life insurance companies and other financial institutions located principally in the United States, as well as around the world. We refer to this 33 portion of our business as Life Reinsurance North America. Scottish Re Holdings Limited and its subsidiary, Scottish Re Limited, specialize in niche markets in developed countries and broader life insurance markets in the developing world. We refer to this portion of our business as Life Reinsurance International. Life Reinsurance North America and Life Reinsurance International together are a reporting operating segment. To a lesser extent, we directly issue variable life insurance and variable annuities and similar products to high net worth individuals and families for insurance, investment and estate planning purposes. We refer to this portion of our business as Wealth Management, which is another reportable operating segment. Other revenues and expenses not related to Life Reinsurance or Wealth Management are reported in the "Other" segment. On December 22, 2003, we completed the acquisition of 95% of the outstanding capital stock of ERC Life Reinsurance Corporation, which we refer to as ERC Life, for $151 million in cash, subject to certain closing adjustments. ERC Life was a subsidiary of General Electric's Employers Reinsurance Corporation, which we call GE ERC, and was one of the companies through which GE ERC conducted life reinsurance business in the United States. ERC Life's business consists primarily of a closed block of traditional life reinsurance with a face amount of $155.6 billion. At the date of acquisition, ERC Life had $1.4 billion in total assets. GE ERC has agreed to administer the business of ERC Life for a fixed monthly fee for up to nine months from the date of acquisition and to assist with the transition of the business to Scottish Re's systems. No GE ERC employees will transfer to Scottish Re. The transaction has increased the number of lives reinsured in North America from approximately 2.1 million to approximately 6.2 million and has increased our gross face amount of in-force business in North America from approximately $119.4 billion to approximately $275.0 billion. ERC Life is rated "A- (excellent)" by A.M. Best Company, which is the fourth highest of sixteen rating levels. All amounts are reported in thousands of United States dollars, except per share amounts. Revenues We derive revenue from four principal sources: o premiums from reinsurance assumed on life business; o fee income from our variable life insurance and variable annuity products and from financial reinsurance transactions; o investment income from our investment portfolio; and o realized gains and losses from our investment portfolio. Premiums from reinsurance assumed on life business are included in revenues over the premium paying period of the underlying policies. When we acquire blocks of in-force business, we account for these transactions as purchases, and our results of operations include the net income from these blocks as of their respective dates of acquisition. Reinsurance assumed on annuity business does not generate premium income but generates investment income over time on the assets we receive from the ceding company. We also earn fees in our financial reinsurance transactions with U.S. insurance company clients. Because some of these transactions do not satisfy the risk transfer rules for reinsurance accounting, the premiums and benefits are not reported in the consolidated statements of income. A deposit received on a funding agreement also does not generate premium income but does create income to the extent we earn an investment return in excess of our interest payment obligations thereon. In our Wealth Management business, when we sell a variable life insurance policy or a variable annuity contract, we charge mortality, expense and distribution risk fees that are based on total assets in each policyholder's separate account. In the case of variable life insurance policies, we also charge a cost of insurance fee based on the amount necessary to cover the death benefit under the policy. Our investment income includes interest earned on our fixed income investments and income from funds withheld at interest under modified coinsurance agreements. Under GAAP, because our fixed income investments are held as available for sale, these securities are carried at fair value, and unrealized appreciation and depreciation on these securities is not included in investment income on our statements of income, but is included in comprehensive income as a separate component of shareholders' equity. Realized gains and losses include gains and losses on investment securities that we sell during a period and write downs of securities deemed to be other than temporarily impaired. Expenses 34 We have five principal types of expenses: o claims and policy benefits under our reinsurance contracts; o interest credited to interest sensitive contract liabilities; o acquisition costs and other insurance expenses; o operating expenses; and o interest expense. When we issue a life reinsurance contract, we establish reserves for future benefits. These reserves are our estimates of what we expect to pay in claims and policy benefits and related expenses under the contract or policy. From time to time, we may change the reserves if our experience leads us to believe that benefit claims and expenses will ultimately be greater than the existing reserve. We report the change in these reserves as an expense during the period when the reserve or additional reserve is established. In connection with reinsurance of annuity and annuity-type products, we record a liability for interest sensitive contract liabilities, which represents the amount ultimately due to the policyholder. We credit interest to these contracts each period at the rates determined in the underlying contract, and the amount is reported as interest credited to interest sensitive contract liabilities on our consolidated statements of income. A portion of the costs of acquiring new business, such as commissions, certain internal expenses related to our policy issuance and underwriting departments and some variable selling expenses are capitalized. The resulting deferred acquisition costs asset is amortized over future periods based on our expectations as to the emergence of future gross profits from the underlying contracts. These costs are dependent on the structure, size and type of business written. For certain products, we may retrospectively adjust our amortization when we revise our estimate of current or future gross profits to be realized. The effects of this adjustment are reflected in earnings in the period in which we revise our estimate. Operating expenses consist of salary and salary related expenses, legal and professional fees, rent and office expenses, travel and entertainment, directors' expenses, insurance and other similar expenses, except to the extent capitalized in deferred acquisition costs. Interest expense consists of interest charges on our borrowings. Factors affecting profitability We seek to generate profits from two principal sources. First, in our Life Reinsurance business, we seek to receive reinsurance premiums and financial reinsurance fees that, together with income from the assets in which those premiums are invested, exceed the amounts we ultimately pay as claims and policy benefits, acquisition costs and ceding commissions. Second, within our investment guidelines, we seek to maximize the return on our unallocated capital. The following factors affect our profitability: o the volume of business we write; o our ability to assess and price adequately for the risks we assume; o the mix of different types of business that we reinsure, because profits on some kinds of business emerge later than on other types; o our ability to manage our assets and liabilities to manage investment and liquidity risk; and 35 o our ability to control expenses. In addition, our profits can be affected by a number of factors that are not within our control. For example, movements in interest rates can affect the volume of business that we write, the income earned from our investments, the interest we credit on interest sensitive contracts, the level of surrender activity on contracts that we reinsure and the rate at which we amortize deferred acquisition costs. Other external factors that can affect profitability include mortality experience that varies from our assumed mortality, changes in regulation or tax laws which may affect the attractiveness of our products or the costs of doing business and changes in foreign currency exchange rates. Critical Accounting Policies Statement of Financial Accounting Standard ("SFAS") No. 60 "Accounting and Reporting by Insurance Enterprises" applies to our traditional life policies with continuing premiums. For these policies, future benefits are estimated using a net level premium method on the basis of actuarial assumptions as to mortality, persistency and interest established at policy issue. Assumptions established at policy issue as to mortality and persistency are based on anticipated experience, which, together with interest and expense assumptions, provide a margin for adverse deviation. Acquisition costs are deferred and recognized as expense in a constant percentage of the gross premiums using these assumptions established at issue. Should the liabilities for future policy benefits plus the present value of expected future gross premiums for a product be insufficient to provide for expected future benefits and expenses for that product, deferred acquisition costs will be written off and thereafter, if required, a premium deficiency reserve will be established by a charge to income. Changes in the assumptions for mortality, persistency and interest could result in material changes to the financial statements. SFAS No. 97 "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments" applies to investment contracts, limited premium contracts, and universal life-type contracts. For investment and universal life-type contracts, future benefit liabilities are held using the retrospective deposit method, increased for amounts representing unearned revenue or refundable policy charges. Acquisition costs are deferred and recognized as expense as a constant percentage of gross margins using assumptions as to mortality, persistency, and expense established at policy issue without provision for adverse deviation and are revised periodically to reflect emerging actual experience and any material changes in expected future experience. Liabilities and the deferral of acquisition costs are established for limited premium policies under the same practices as used for traditional life policies with the exception that any gross premium in excess of the net premium is deferred and recognized into income as a constant percentage of insurance in force. Should the liabilities for future policy benefits plus the present value of expected future gross premiums for a product be insufficient to provide for expected future benefits and expenses for that product, deferred acquisition costs will be written off and thereafter, if required, a premium deficiency reserve will be established by a charge to income. Changes in the assumptions for mortality, persistency, maintenance expense and interest could result in material changes to the financial statements. Our premiums earned are recorded in accordance with information received from our ceding companies, or are estimated where this information is not current with the reporting period. These premium estimates are based on historical experience as adjusted for current treaty terms and other information. Actual results could differ from these estimates. Management monitors actual experience, and should circumstances warrant, will revise its estimates of premiums earned. The development of policy reserves and amortization of deferred acquisition costs for our products requires management to make estimates and assumptions regarding mortality, lapse, expense and investment experience. Such estimates are primarily based on historical experience and information provided by ceding companies. Actual results could differ materially from those estimates. Management monitors actual experience, and should circumstances warrant, will revise its assumptions and the related reserve estimates. In the normal course of business, we acquire in-force blocks of business. The determination of the fair value of the assets acquired and the liabilities assumed 36 require management to make estimates and assumptions regarding mortality, lapse rates and expenses. These estimates are based on historical experience, actuarial studies and information provided by the ceding companies. Actual results could differ materially from these estimates. Present value of in-force business is established upon the acquisition of a subsidiary and is amortized over the expected life of the business at the time of acquisition. The amortization each year will be a function of the gross profits or revenues each year in relation to the total gross profits or revenues expected over the life of business, discounted at the assumed net credit rate. The determination of the initial value and the subsequent amortization require management to make estimates and assumptions regarding the future business results that could differ materially from actual results. Estimates and assumptions involved in the present value of in-force business and subsequent amortization are similar to those necessary in the establishment of reserves and amortization of deferred acquisition costs. Goodwill is established upon the acquisition of a subsidiary. Goodwill is calculated as the difference between the price paid and the value of individual assets and liabilities on the date of acquisition. We account for goodwill in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets". Goodwill deemed to have an indefinite life is subject to an annual impairment test. Goodwill recognized in the consolidated balance sheet relates to our acquisition of Scottish Re Holdings Limited and has been tested for impairment. We have determined that there is no impairment. Fixed maturity investments are evaluated for other than temporary impairments in accordance with SFAS No. 115: "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115") and Emerging Issues Task Force 99-20: "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interest in Securitized Assets" ("EITF 99-20") as described in Note 3 to the consolidated financial statements. Under these pronouncements, realized losses are recognized on securities if the securities are determined to be other than temporarily impaired. Factors involved in the determination of potential impairment include fair value as compared to amortized cost, length of time the value has been below amortized cost, credit worthiness of the issuer, forecasted financial performance of the issuer, position of the security in the issuer's capital structure, the presence and estimated value of collateral or other credit enhancement, length of time to maturity, interest rates and our intent and ability to hold the security until the market value recovers. Our funds withheld at interest arise on modified coinsurance and funds withheld coinsurance transactions. Derivatives Implementation Group Issue No. B36 "Embedded Derivatives: Bifurcation of a Debt Instrument that Incorporates Both Interest Rate and Credit Rate Risk Exposures that are Unrelated or Only Partially Related to the Creditworthiness of the Issuer of that Instrument" ("DIG B36") indicates that these transactions contain embedded derivatives. The embedded derivative feature in our funds withheld treaties is similar to a fixed-rate total return swap on the assets held by the ceding companies. The swap consists of two parts. The first is the market value of the underlying asset portfolio and the second is a hypothetical loan to the ceding company. The hypothetical loan is based on the expected cash flows of the underlying reinsurance liability. We have developed models to systematically estimate the value of the total return swap. The fair value of the embedded derivative is affected by changes in expected cash flows, credit spreads of the assets and changes in "risk-free" interest rates. The change in fair value is included in our calculation of estimated gross profits and, therefore, also affects the amortization of deferred acquisition costs. In addition to our quota share indemnity funds withheld contracts, we have entered into various financial reinsurance treaties that, although considered funds withheld, do not transfer significant insurance risk and are recorded on a deposit method of accounting. As a result of the experience refund provisions of these treaties the value of the embedded derivative is currently considered immaterial. Changes in our expectations of future cash flows could result in material changes to the financial statements. Our accounting policies addressing premiums earned, reserves, deferred acquisition costs, value of business acquired, goodwill, investment impairment and embedded derivatives involve significant assumptions, judgments and estimates. Changes in these assumptions, judgments and estimates could create material changes in our consolidated financial statements. 37 Results of Operations Consolidated results of operations Our results of operations for the year ended December 31, 2001 do not include the results of operations of Scottish Re Holdings Limited, which we acquired at the close of business on December 31, 2001. Our results of operations for the years ended December 31, 2001 and 2002 do not include the results of operations of ERC Life, which we acquired on December 22, 2003. The results for the year ended December 31, 2003 include net income of $1.2 million in respect of the results of ERC Life for the period from December 22, 2003 to December 31, 2003.
Year Ended Year Ended Year Ended December December December 31, 2003 31, 2002 31, 2001 --------- --------- --------- Premiums earned ....................... $ 391,976 $ 202,536 $ 68,344 Investment income, net ................ 148,028 107,906 51,691 Fee income ............................ 7,907 6,574 4,809 Realized losses ....................... (4,448) (10,804) (3,882) Change in value of embedded derivatives 13,903 -- -- --------- --------- --------- Total revenues ........................ 557,366 306,212 120,962 --------- --------- --------- Claims and other policy benefits ...... 275,863 142,158 51,245 Interest credited to interest sensitive contract liabilities ........ 89,180 48,140 17,578 Acquisition costs and other insurance expenses, net ............... 116,000 60,073 24,328 Operating expenses .................... 31,021 23,086 9,173 Interest expense ...................... 7,557 1,414 1,405 --------- --------- --------- Total benefits and expenses ........... 519,621 274,871 103,729 --------- --------- --------- Income before income taxes and minority interest ..................... 37,745 31,341 17,233 Income tax benefit (expense) .......... 11,105 1,894 (59) --------- --------- --------- Income before minority interest ....... 48,850 33,235 17,174 Minority interest ..................... (62) -- 71 --------- --------- --------- Income from continuing operations before cumulative effect of change in accounting principle ............... 48,788 33,235 17,245 Cumulative effect of change in accounting principle ............................. (19,537) -- (406) Loss from discontinued operations ............................ (1,971) (711) -- --------- --------- --------- Net income ............................ $ 27,280 $ 32,524 $ 16,839 ========= ========= =========
During the year ended December 31, 2003, total revenues increased by 82% to $557.4 million. Total revenues include premiums earned in our Life Reinsurance operations, investment income on our invested assets, fee income on our Life Reinsurance and Wealth Management operations, realized losses on our investment portfolio and the change in the value of embedded derivatives. The increase in premiums earned is primarily due to continued growth in our Life Reinsurance North America and Life Reinsurance International segments. The increase in investment income is due to growth in our invested assets, which arises from business growth, our equity offering in July 2003 and our debt offerings in November and December 2002. The change in value of the embedded derivatives arises from the application of DIGB36. During the year ended December 31, 2002 revenues increased by $185.2 million or 153% to $306.2 million in comparison with the same period in 2001. The increase is primarily due to the acquisition of Scottish Re Holdings Limited, the growth in our Life Reinsurance North America operations and an increase in investment 38 income primarily due to the growth in our invested assets. The growth in our invested assets is due to the new business and the equity offering in April 2002. During the year ended December 31, 2003, total benefits and expenses increased by 89% to $519.6 million from 2002 to 2003. The increase was due to continued growth in our Life Reinsurance North America and Life Reinsurance International segments, a $12.5 million charge to account for revised reporting by a ceding company client in connection with two fixed annuity reinsurance contracts, additional operating costs required to meet the growth in our business and additional interest expense arising from the debt issuance in November and December 2002. Total benefits and expenses increased by 165% to $274.9 million from 2001 to 2002. The increase in benefits and expenses is primarily due to the acquisition of Scottish Re Holdings Limited and the growth in our Life Reinsurance North America operations. During the year ended December 31, 2003 we implemented the requirements of DIG B36 which addresses whether SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities" requires bifurcation of a debt instrument into a debt host contract and an embedded derivative if the debt instrument incorporates both interest rate risk and credit risk exposures that are unrelated or only partially related to the creditworthiness of the issuer of that instrument. Under DIG B36 modified coinsurance and coinsurance funds withheld reinsurance agreements where interest is determined by reference to a pool of fixed maturity assets, are arrangements containing embedded derivatives requiring bifurcation. In addition, reinsurance contacts with experience refunds are also considered to be arrangements containing embedded derivatives requiring bifurcation. DIG B36 was effective for fiscal quarters beginning October 1, 2003. We reviewed all contracts at October 1, 2003 and determined that the value of this derivative, net of related deferred acquisition costs, after taxation was a loss of $19.5 million. This is shown in the consolidated statements of income as a cumulative effect of change in accounting principle for the year ended December 31, 2003. The change in value of the derivative, net of related deferred amortization costs, during the quarter ended December 31, 2003 amounted to a gain of $13.9 million. During 2003, we decided to discontinue our Wealth Management operations in Luxembourg. We have transferred our Luxembourg Wealth Management business to third parties, closed the Luxembourg office and are in the process of liquidating our Luxembourg subsidiary. We have reported the results of the Luxembourg wealth management activities as discontinued operations. Losses incurred in respect of these operations in the year ended December 31, 2003 and 2002 amounted to $2.0 million and $0.7 million, respectively. During the year ended December 31, 2001 we implemented the requirements of EITF 99-20. EITF 99-20 applies to all securities, which represent beneficial interests in securitized assets, unless they meet certain exception criteria. A decline in fair value below the amortized cost basis is considered to be an other than temporary impairment whenever there is an adverse change in the amount or timing of cash flows to be received, regardless of the resulting yield, unless the decrease is solely a result of changes in market rates. At June 30, 2001 we reviewed all applicable securities and identified a write down of $406,000. This is shown in the consolidated statements of income as a cumulative effect of change in accounting principle. 39 Earnings per ordinary share
Year Ended December 31, ---------------------------------------------- 2003 2002 2001 ------------ ------------ -------------- (dollars in thousands, except per share data) Income from continuing operations before cumulative effect of change in accounting principle...................... .......... $ 48,788 $ 33,235 $ 17,245 Cumulative effect of change in accounting principle ................................ (19,537) -- (406) Loss from discontinued operations .......... (1,971) (711) -- ------------ ------------ -------------- Net income ................................. $ 27,280 $ 32,524 $ 16,839 ============ ============ ============== Basic earnings per share: Income from continuing operations before 0 cumulative effect of change in accounting principle and discontinued operations ... $ 1.59 $ 1.32 $ 1.10 Cumulative effect of change in accounting principle ............................. (0.64) -- (0.02) Discontinued operations ................. (0.06) (0.03) -- ------------ ------------ -------------- Net income .............................. $ 0.89 $ 1.29 $ 1.08 ============ ============ ============== Diluted earnings per share: Income from continuing operations before cumulative effect of change in accounting principle ............................... $ 1.51 $ 1.25 $ 1.05 Cumulative effect of change in accounting principle and discontinued operations ... (0.60) -- (0.03) Discontinued operations ................. (0.06) (0.02) -- ------------ ------------ -------------- Net income .............................. $ 0.85 $ 1.23 $ 1.02 ============ ============ ============== Weighted average number of ordinary shares outstanding: Basic .................................... 30,652,719 25,190,283 15,646,106 Diluted .................................. 32,228,001 26,505,611 16,485,338
Income from continuing operations for the year ended December 31, 2003 increased by 47% to $48.8 million from $33.2 million in 2002. Diluted earnings per ordinary share from continuing operations before cumulative effect of change in accounting principle amounted to $1.51 for the year ended December 31, 2003 and $1.25 per ordinary share in 2002, an increase of 21%. The growth in both income from continuing operations and diluted earnings per share arises from the reasons discussed above. The growth in diluted earnings per share from continuing operations was offset by the increase in the weighted average number of ordinary shares outstanding due to the public offering of 9,200,000 ordinary shares in July 2003 as discussed in Note 17 to the Consolidated Financial Statements. Diluted earnings per ordinary share amounted to $0.85 and $1.23 for the year ended December 31, 2003 and 2002, respectively. Diluted earnings per ordinary share for 2003 decreased due to the adoption of DIG B36 and the resultant cumulative effect of change in accounting principle. In addition, the number of weighted average shares outstanding increased mainly due to the public offering of 9,200,000 ordinary shares in July 2003 as discussed in Note 17 to the Consolidated Financial Statements. Income from continuing operations for the year ended December 31, 2002 increased 93% to $33.2 million from $17.2 million in 2001. The increase in 2002 is attributable to the inclusion of Scottish Re Holdings Limited for the first time since its acquisition, continued growth in our Life Reinsurance North America operations, and an increase in investment income primarily due to the increase in average invested assets. The contribution to net income from continuing operations by Scottish Re Holdings Limited amounted to $12.7 million for the year ended December 31, 2002. The increase in income from continuing operations was offset in part by an increase in realized losses on fixed maturity investments and unit-linked securities, and by losses incurred in our Wealth Management and Other segments. Realized losses were $10.8 million for the year ended December 31, 2002, compared to realized losses of 40 $3.9 million in the year ended December 31, 2001. The losses in our Wealth Management operations arose principally from increased commission costs and severance payments. The losses in our Other segment arose because of reductions in investment income as we deployed more capital in the Life Reinsurance North America segment and increased costs in the first full year of our operations in Bermuda. Diluted earnings per ordinary share from continuing operations before cumulative effect of change in accounting principle amounted to $1.25 for the year ended December 31, 2002 an increase of 19% from 2001. Diluted earnings per ordinary share for the year ended December 31, 2002 increased 21% to $1.23 from $1.02 in 2001. Diluted earnings per share increased as a result of the growth in net income described above. This increase has occurred despite the increase in the number of ordinary shares outstanding. The increase in the number of ordinary shares outstanding is a result of shares issued in the acquisition of Scottish Re Holdings Limited and the equity offering in April 2002 discussed in Note 17 to the Consolidated Financial Statements. Premiums earned Premiums earned during the year ended December 31, 2003 increased by 94% to $392.0 million from $202.5 million in 2002. Premiums earned in our Life Reinsurance North America segment during the year ended December 31, 2003 increased 88% to $230.7 million from $122.8 million in 2002. The increase is due to increases in the amounts of life insurance in-force on existing traditional solutions treaties and on new business written during the year. As of December 31, 2003, premiums earned in our Life Reinsurance North America segment (excluding ERC Life) relates to the reinsurance of approximately $117.3 billion of life insurance in-force on 2.0 million lives and our average benefit coverage per life of $60,000. As of December 31, 2002, we reinsured approximately $67.0 billion of life insurance in-force on 1.2 million lives and our average benefit coverage per life was $51,000. Premiums earned in our Life Reinsurance International segment during the year ended December 31, 2003 increased by 102% to $161.3 million in comparison with $79.7 million in 2002. Our Life Reinsurance International segment completed the acquisition of an in-force reinsurance transaction effective October 1, 2002. This transaction has contributed $28.0 million to premiums earned during the year compared to $4.8 million of premiums earned in 2002. Premiums earned on other life reinsurance business increased $48.4 million in the year ended December 31, 2003 in comparison with the prior year. The increase is due to an increase in the number of contracts to 2,115 in the current year from 1,387 in the prior year. Of the $48.4 million, $23.4 million relates to revisions in estimates of premiums earned. The majority of business in our Life Reinsurance International segment is in respect of short duration contracts. We have experienced considerable reporting delays from some of our cedents on this business. As part of the implementation of this segment's new administrative system, improved data has been compiled which allowed us to more accurately estimate our premium earned. Premiums earned on aircrew loss of license insurance increased to $23.6 million during the current year in comparison with $16.5 million in the prior year due principally to new business. At December 31, 2003, there were 252 loss of license contracts in comparison with 186 at December 31, 2002. Premiums earned during the year ended December 31, 2002 increased 196% to $202.5 million compared with the same period in 2001. Premiums earned in 2002 increased due to the acquisition of Scottish Re Holdings Limited and the growth in the number of clients in our Life Reinsurance North America operations. Scottish Re Holdings Limited's premiums earned during the year amounted to $79.7 million. Premiums earned on the Life Reinsurance North America segment during the year ended December 31, 2002 increased 80% to $122.8 million from the same period in 2001. Fee income Both Life Reinsurance and Wealth Management operations generate fee income. We earn fees in Life Reinsurance on certain of our financial reinsurance treaties that do not qualify under risk transfer rules for reinsurance accounting. 41 Fee income is as follows:
Year Ended December 31, ---------------------------------------------- 2003 2002 2001 ------------ ------------ -------------- (dollars in thousands) Life Reinsurance North America.............. $ 4,067 $ 3,148 $ 1,685 Wealth Management .......................... 3,840 3,426 3,124 ------------ ------------ -------------- Total ...................................... $ 7,907 $ 6,574 $ 4,809 ============ ============ ==============
Fee income in our Life Reinsurance North America segment increased by 29% to $4.1 million for the year ended December 31, 2003 in comparison with the prior year period. The increases are due to continued growth in fee generating business in our Life Reinsurance North America segment. Wealth Management fees increased by 12% to $3.8 million during the year ended December 31, 2003. The overall growth in fees is principally due to the growth in segregated account balances, which is due to improved investment performance. The number of clients has decreased from 164 at December 31, 2002 to 154 at December 31, 2003. Segregated assets amount to $743.1 million and $653.6 million at December 31, 2003 and 2002, respectively. Policy face amounts totaled $1.1 billion and $936.8 million at December 31, 2003 and 2002, respectively. Life reinsurance fees increased by 87% to $3.1 million during the year ended December 31, 2002 compared to the same period in 2001. The increase is due to the growth in the number of clients. Wealth Management fees increased by 10% to $3.4 million during the year ended December 31, 2002 compared to 2001. The growth in fees was principally due to the growth in segregated account balances, which was due to an increase in the number of clients offset in part by negative investment performance. The number of clients grew from 132 at December 31, 2001 to 164 at December 31, 2002. Segregated assets amounted to $653.6 million and $602.8 million at December 31, 2002 and 2001 respectively. Policy face amounted totaled $936.8 million and $812.4 million at December 31, 2002 and 2001 respectively. The change in the segregated assets is as follows:
Year Ended December 31, ---------------------------------------------- 2003 2002 2001 ------------ ------------ -------------- (dollars in thousands) Balance at beginning of year................. $ 653,588 $ 602,800 $ 409,660 Deposits.................................... 88,870 125,377 202,794 Withdrawals................................. (67,562) (54,112) (18,985) Investment performance...................... 68,241 (20,477) 9,331 ------------ ------------ ------------- Balance at end of year...................... $ 743,137 $ 653,588 $ 602,800 ============ ============ =============
Investment income Net investment income increased by $40.1 million or 37% to $148.0 million for the year ended December 31, 2003 from $107.9 million for the prior year. The increase is due to the growth in our average invested assets offset in part by decreases in realized yields during 2003. Our total invested assets have increased significantly because of growth in our Life Reinsurance North America financial solutions business and investment of the proceeds of the HyCU offering in December 2003, our equity offering in July 2003 and our long-term debt offerings in October and November 2003. Total invested assets, excluding ERC Life's invested assets, increased from $2.3 billion at December 31, 2002 to $3.4 billion at December 31, 2003. Funds withheld at interest excluding ERC Life's funds withheld grew from $1.1 billion at December 31, 2002 to $1.2 billion at December 31, 2003. Net investment income increased by $56.2 million or 109% to $107.9 million during the year ended December 31, 2002 compared to $51.7 million in the same period in 2001. The increase was due to the growth in 42 our average invested assets offset in part by decreases in realized yields. Our total invested assets increased significantly because of growth in our Life Reinsurance North America segment, assets acquired through the acquisition of Scottish Re Holdings Limited, investment of the proceeds of our equity offering in April 2002 and our convertible debt and capital securities offerings in November and December 2002. Total invested assets increased from $1.3 billion at December 31, 2001 to $2.3 billion at December 31, 2002. Funds withheld at interest grew from $562.4 million to $1.1 billion during 2002. During the year ended December 31, 2003, average book yields were lower than in 2002. On the $2.4 billion portfolio managed by our external investment managers the yields on fixed rate assets were 5.13% and 5.84% at December 31, 2003 and 2002, respectively. The reduction in yield was due primarily to the much lower market yields at which new cash flows were invested and proceeds of maturities and sales were reinvested. Yields on floating rate assets are indexed to LIBOR. The yield on our floating rate assets increased to 3.43% from 3.11%, and the yield on our cash and cash equivalents decreased to 1.01% from 1.48%. The market value of floating rate assets increased to $301.8 million in 2003 from $159.2 million in 2002 as a result of our increased floating rate funding agreements and our increased floating rate liabilities. During the year ended December 31, 2002, average book yields were lower than in 2001, particularly on floating rate assets and cash. On the $1.1 billion portfolio managed by our external investment managers the yields on fixed rate assets were 5.84% and 7.09% at December 31, 2002 and 2001, respectively. The reduction in yield was due primarily to the much lower market yields at which new cash flows were invested and proceeds of maturities and sales were reinvested. Yields on floating rate assets are indexed to LIBOR. The yield on our floating rate assets decreased to 3.11% from 4.43%, and the yield on our cash and cash equivalents decreased to 1.48% from 2.20%. The volume of floating rate assets increased in 2002 as a result of our investing the proceeds of a $100.0 million floating rate funding agreement to earn a spread over the cost of funds. The analysis of investment income by segment is as follows:
Year Ended December 31, ---------------------------------------------- 2003 2002 2001 ------------ ------------ -------------- (dollars in thousands) Life Reinsurance: North America.............................. $ 135,731 $ 97,406 $ 44,151 International.............................. 7,537 6,716 -- ------------ ------------ -------------- Total Life Reinsurance....................... 143,268 104,122 44,151 Wealth Management............................ 205 15 67 Other ....................................... 4,555 3,769 7,473 ------------ ------------ -------------- Total........................................ $ 148,028 $ 107,906 $ 51,691 ============ ============ ==============
Realized losses During the year ended December 31, 2003, realized losses amounted to $4.4 million in comparison with realized losses of $10.8 million in the same period in 2002. Realized losses recognized in the year ended December 31, 2001 amounted to $3.9 million. During the year ended December 31, 2003, we recognized $1.9 million in losses in respect of "other than temporary impairments" on investments, impairment losses of $4.4 million under EITF 99-20 and $2.9 million (net of related deferred acquisition costs) of "other than temporary impairment losses" notified by ceding companies on contracts written on a modified coinsurance basis. These losses were offset by realized exchange gains of $1.3 million and net gains and losses on disposals of investments amounting to $3.5 million. At December 31, 2002, we held unit-linked securities amounting to $16.5 million. These securities comprised investments in a unit trust denominated in British pounds. These securities were acquired as part of the purchase of Scottish Re Holdings Limited and were recorded at quoted market value. Changes in market value were recorded as net realized gains or losses. During 2003, we novated our liabilities on our unit-linked contracts as 43 discussed in "Claims and Other Policy Benefits". The liabilities were settled by transferring a portion of the unit-linked securities to the original ceding company. The remaining unit-linked securities were sold realizing a gain of $0.3 million during the year. During the year ended December 31, 2003, changes in market value of those securities of $0.8 million were recognized as realized losses. During the year ended December 31, 2002, realized losses amounted to $10.8 million net of associated amortization of deferred acquisition costs. The losses in 2002 consist of realized investment losses on unit linked securities held by Scottish Re Holdings Limited of $5.6 million, impairment losses recognized under EITF 99-20 of $6.7 million "and other than temporary impairments" on fixed maturity investments of $3.3 million. These losses were partially offset by net realized gains on the sales of fixed maturity investments of $4.8 million. During the year ended December 31, 2001 realized losses included amounts recognized as "other than temporary impairments" on fixed maturity investments of $6.9 million. The realization of losses in 2001 was due to the sale and write down of carrying values of securities, predominately securities issued by Enron and its affiliate, Osprey. These losses were offset in part by gains realized primarily for tax purposes on bonds in the portfolio of Scottish Re (U.S.), Inc. and gains of $529,000 on assets sold to fund part of the recapture of a block of business by one client on April 30, 2001. During 2001, we also recognized in income unrealized losses of $0.4 million on certain structured securities in accordance with the requirements of EITF 99-20. Management reviews securities with material unrealized losses and tests for "other than temporary impairments" on a quarterly basis. Factors involved in the determination of impairment include fair value as compared to amortized cost, length of time the value has been below amortized cost, credit worthiness of the issuer, forecasted financial performance of the issuer, position of the security in the issuer's capital structure, the presence and estimated value of collateral or other credit enhancement, length of time to maturity, interest rates and our intent and ability to hold the security until the market value recovers. We review all investments with fair values less than amortized cost, and pay particular attention to those that have traded continuously at less than 80% of amortized cost for at least six months or 90% of amortized cost for at least 12 months and other assets with material differences between amortized cost and fair value. Investments meeting those criteria are analyzed in detail for "other than temporary impairment." When a decline is considered to be "other than temporary" a realized loss is incurred and the cost basis of the impaired asset is adjusted to its fair value. Under EITF 99-20, a decline in fair value below "amortized cost" basis is considered to be an "other than temporary impairment" whenever there is an adverse change in the amount or timing of cash flow to be received, regardless of the resulting yield, unless the decrease is solely a result of changes in market interest rates. The following tables provide details of the sales proceeds, realized loss, the length of time the security had been in an unrealized loss position and reason for sale for securities sold during 2003, 2002 and 2001.
Year ended December 31, 2003 ------------------------------------------------------------------------------- Credit Concern Relative Value Other Total ---------------- ---------------- ---------------- ---------------- Days Proceeds Loss Proceeds Loss Proceeds Loss Proceeds Loss - ---- -------- ---- -------- ---- -------- ---- -------- ---- (dollars in thousands) 0-90 .... $ 924 $ (5) $15,389 $ (166) $20,686 $ (191) $36,999 $ (362) 91-180 .. 3,529 (295) 3,693 (35) 1,720 (15) 8,942 (345) 181-270 . 3,300 (251) 776 (29) 656 (4) 4,732 (284) 271-360 . -- -- 545 (12) 479 (55) 1,024 (67) Greater than 360 6,008 (951) 1,380 (116) -- -- 7,388 (1,067) ------- ------- ------- ------- ------- ------- ------- ------- Total ... $13,761 $(1,502) $21,783 $ (358) $23,541 $ (265) $59,085 $(2,125) ======= ======= ======= ======= ======= ======= ======= =======
44
Year ended December 31, 2002 ------------------------------------------------------------------------------- Credit Concern Relative Value Other Total ---------------- ---------------- ---------------- ---------------- Days Proceeds Loss Proceeds Loss Proceeds Loss Proceeds Loss - ---- -------- ---- -------- ---- -------- ---- -------- ---- (dollars in thousands) 0-90..... $ 7,708 $ (520) $21,488 $ (130) $ 3,377 $ (41) $32,573 $ (691) 91-180... 4,162 (196) 2,044 (45) -- -- 6,206 (241) 181-270.. 3,408 (213) -- -- -- -- 3,408 (213) Greater than 360. 5,284 (325) -- -- -- -- 5,284 (325) ------- ------- ------- ------- -------- ------- ------- ------- Total.... $20,562 $(1,254) $23,532 $ (175) $ 3,377 $ (41) $47,471 $(1,470) ======= ======= ======= ======= ======== ======= ======= =======
Year ended December 31, 2001 ------------------------------------------------------------------------------- Credit Concern Relative Value Other Total ---------------- ---------------- ---------------- ---------------- Days Proceeds Loss Proceeds Loss Proceeds Loss Proceeds Loss - ---- -------- ---- -------- ---- -------- ---- -------- ---- (dollars in thousands) 0-90..... $ 810 $(1,214) $14,204 $ (38) $28,570 $ (218) $43,584 $(1,470) 91-180... 1,409 (244) 1,521 -- -- -- 2,930 (244) Greater than 360. 4,917 (463) 6,607 (58) 12,628 (148) 24,152 (699) ------ ------- ------- ------- ------- ------- ------- ------- Total.... $7,136 $(1,921) $22,332 $ (96) $41,198 $ (366) $70,666 $(2,383) ====== ======= ======= ======= ======= ======= ======= =======
Credit Concern: transaction initiated due to a concern based on financial condition of issuer or industry Relative Value: transaction initiated to improve characteristics of the portfolio income Change in value of embedded derivatives During the year ended December 31, 2003, there were gains of $13.9 million in respect of the valuation of the embedded derivatives in our modified coinsurance and funds withheld coinsurance contracts. These gains have been calculated in accordance with DIG B36 and are stated net of related deferred acquisition costs. Claims and other policy benefits Claims and other policy benefits increased by 94% to $275.9 million in the year ended December 31, 2003 from $142.2 million in the same period of 2002. Claims and other policy benefits in our Life Reinsurance North America segment increased by 87% to $171.7 million in the year ended December 31, 2003 from $91.8 million in 2002. The increase is as a result of the increased number of clients and the increase in our traditional solutions business from these clients as previously described. Death claims are reasonably predictable over a period of many years, but are less predictable over shorter periods and are subject to fluctuation from year to year. Claims and other policy benefits in our Life Reinsurance International segment increased by 107% to $104.2 million in the year ended December 31, 2003 from $50.4 million in 2002. The increase is a result of the increased volume of business as previously described, the revisions of estimates of premiums earned as previously discussed together with the acquisition of an in-force block of business effective October 2002. Claims on the in-force block amounted to $18.8 million and $3.5 million for the year ended December 31, 2003 and 2002, respectively. The estimate process contributed a further $17.5 million to claims and other policy benefits. During 2003, through our Life Reinsurance International segment, we entered into an agreement to novate our unit-linked liabilities. The outstanding liabilities were settled by transferring an agreed number of unit-linked securities to the novation agreement counter-party. The settlement was less than the liability previously recorded of $15.5 million and therefore resulted in a release of liabilities of $3.4 million. 45 Claims and other policy benefits increased by 177% to $142.2 million in the year ended December 31, 2002 from $51.2 million in the same period of 2001. The increase is a result of the acquisition of Scottish Re Holdings Limited, the increased number of clients and the increase in our traditional solutions business from these clients in our Life Reinsurance North America segment. Scottish Re Holdings Limited's claims and other policy benefits were $50.4 million for the year ended December 31, 2002. Our targeted maximum corporate retention in our Life Reinsurance North America segment on any one life is $1 million, however, we currently retrocede any liability in excess of $500,000. Our targeted maximum corporate retention per life in our Life Reinsurance International segment is $250,000. In addition, we maintain catastrophe cover on our entire retained life reinsurance business, which provides reinsurance for losses of $19.3 million in excess of $750,000. This catastrophe cover includes protection for nuclear, biological and chemical risks. Interest credited to interest sensitive contract liabilities For the year ended December 31, 2003 interest credited to interest sensitive contract liabilities increased by $41.1 million or 85% to $89.2 million from $48.1 million in 2002. Included in interest credited to interest sensitive contract liabilities during the year ended December 31, 2003 is $12.5 million due to revised reporting by a ceding company client in connection with two fixed annuity reinsurance contracts. Interest credited includes interest in respect of funding agreements. The amounts due on funding agreements are included in interest sensitive contract liabilities on our balance sheet and amount to $330.7 million at December 31, 2003 in comparison with $100.0 million at December 31, 2002. Interest credited on these agreements was $2.4 million in 2003 in comparison with $1.2 million in 2002. The remaining increase is due to interest credited on new reinsurance treaties and increases in interest credited on existing treaties due to increasing average liability balances. Interest sensitive contract liabilities amounted to $2.6 billion at December 31, 2003 in comparison with $1.6 billion at December 31, 2002. For the year ended December 31, 2002 interest credited to interest sensitive contract liabilities increased by $30.5 million or 174% to $48.1 million from $17.6 million in 2001. Interest credited includes interest in respect of a funding agreement for $100.0 million that we wrote in mid-year. The increase was due to interest credited on new 2002 reinsurance treaties and the funding agreement and increases in interest credited on treaties which commenced in prior years due to increasing average liability balances. Acquisition costs and other insurance expenses During the year ended December 31, 2003 acquisition costs and other insurance expenses increased by $55.9 million or 93% to $116.0 million from $60.1 million in 2002. The increase was a result of the increased life and annuity business in our Life Reinsurance North America and International segments. Acquisition costs and other insurance expenses for our Life Reinsurance North America segment increased to $83.6 million in 2003 from $48.4 million in 2002. The increase was a result of the growth of our business as described above. As discussed in "Interest credited to interest sensitive contract liabilities" we incurred charges of $12.5 million this year due to revised reporting by a ceding company client in connection with two fixed annuity reinsurance contracts. In light of the impact of the revised reporting on the estimated gross profits of the two treaties in question, we have revised the amortization of deferred acquisition costs on the two treaties, along with two other related treaties. Acquisition costs and other insurance expenses for our Life Reinsurance International segment increased to $30.1 million in 2003 from $8.3 million in 2002. This was a result of the growth in our business as described above, the revision of estimates of premiums earned discussed above and the acquisition of an in-force block of business effective October 2002. Acquisition costs on the in-force block amounted to $5.7 million in 2003 and $0.3 million in 2002. The revision of estimates of premiums earned contributed a further $6.0 million to acquisition costs and other insurance expenses. Acquisition costs also includes the amortization of the present value of in-force business. As a result of the novation of the unit linked contract liabilities (as described in "Claims and Other Policy Benefits") the present value of the in-force on this business was fully amortized during 2003 resulting in an additional charge of $1.9 million in the year ended December 31, 2003. 46 During the year ended December 31, 2002 acquisition costs and other insurance expenses increased by $35.8 million or 147% to $60.1 million from $24.3 million in 2001. The increase was a result of the acquisition of Scottish Re Holdings Limited and the increased number of reinsurance clients in our Life Reinsurance North America segment. The components of these expenses are as follows:
Year Ended December 31, 2003 2002 2001 --------- --------- --------- (dollars in thousands) Commissions, excise taxes and other insurance expenses ........................................ $ 209,493 $ 158,424 $ 96,098 Deferral of expenses ............................ (172,658) (129,306) (83,092) --------- --------- --------- 36,835 29,118 13,006 Amortization-- Present value of in-force business 4,926 2,777 206 Amortization-- Deferred acquisition costs ....... 74,239 28,178 11,116 --------- --------- --------- Total ........................................... $ 116,000 $ 60,073 $ 24,328 ========= ========= =========
Commissions and excise taxes vary with premiums earned. Other insurance expenses include direct and indirect expenses of those departments involved in the marketing, underwriting and issuing of reinsurance treaties. Of these total expenses a portion is deferred and amortized over the life of the reinsurance treaty or, in the case of interest sensitive contracts, in relation to the estimated gross profit in respect of the contracts. Operating expenses The analysis of operating expenses between segments is as follows:
Year Ended December 31, 2003 2002 2001 --------- --------- --------- (dollars in thousands) Life Reinsurance: North America................................ $ 8,646 $ 7,323 $ 3,191 International................................ 11,518 6,647 -- --------- --------- --------- Total Life Reinsurance.......................... 20,164 13,970 3,191 Wealth Management............................... 468 1,017 897 Other........................................... 10,389 8,099 5,085 --------- --------- --------- Total........................................... $ 31,021 $ 23,086 $ 9,173 ========= ========= =========
Operating expenses increased to $31.0 million for the year ended December 31, 2003 compared to $23.1 million in 2002. The increase in operating expenses is due to increased personnel and other costs as we continued to grow our business. During 2002 and the first quarter of 2003, we continued to complete the staffing of our principal office in Bermuda. Total employees in our operations have grown from 120 at December 31, 2002 to 140 at December 31, 2003. The number of employees in our Life Reinsurance International segment has grown from 48 at December 31, 2002 to 58 at December 31, 2003. This growth has resulted in additional costs for office running expenses. In 2003, we experienced increased costs of our defined benefit pension plan at Scottish Re Holdings Limited, increased compensation costs for our board of directors, increased legal and professional fees arising as a result of corporate governance legislation, and have also incurred additional costs for directors' and officers' insurance. Our operations are geographically diverse with offices in Bermuda, the Cayman Islands, Charlotte, Dublin and Windsor. With the growth of our business operations, we have incurred additional travel, technology and communication expenses. Operating expenses increased to $23.1 million in the year ended December 31, 2002 compared to $9.2 million in 2001. The increase is a result of the acquisition of Scottish Re Holdings Limited, a smaller portion of costs being allocated to acquisition expenses and increased personnel costs and other operating costs as we 47 continued to grow our business. During 2002, we continued to set up our principal office in Bermuda. In addition, as a result of our acquisition of Scottish Re Holdings Limited on December 31, 2001, we have incurred increased operating expenses and additional travel costs. As we continue to grow our operations we have experienced increased personnel costs in all segments. Total employees in our operations, excluding Scottish Re Holdings Limited has grown from 66 employees at December 31, 2001 to 72 at December 31, 2002. Operating expenses in the year ended December 31, 2002 included $1.4 million of non-recurring expenses relating to severance arrangements with certain employees. Interest expense We incurred interest expense of $7.6 million during the year ended December 31, 2003 in comparison with $1.4 million during 2002. Interest expense in 2003 comprises principally of interest on the $115.0 million of convertible debt issued in November 2002 and the $17.5 million capital securities issued in December 2002. Interest expense in 2002 was in respect of borrowings under our credit facility and reverse repurchase arrangements. The credit facility borrowings were repaid in April 2002. Interest expense amounted to $1.4 million in both 2002 and 2001. Interest expense in 2002 includes interest on $115.0 million of convertible debt issued on November 22, 2002, $17.5 million of capital securities issued on December 4, 2002 and borrowings under our credit facilities and reverse repurchase agreement. We incurred interest expense for the first time in the year ended December 31, 2001 amounting to $1.4 million, reflecting the use of borrowings in 2001 under the credit facilities. These borrowings are more fully described under "Liquidity and Capital Resources." Income Taxes The 2003 and 2002 income tax benefits are in respect of certain of our U.S. taxable entities and are offset by income tax expenses arising on our United Kingdom, Dublin and other U.S. entities. Included in the 2003 income tax benefit is $2.1 million in respect of state taxes. The change in our effective tax rate is due primarily to the ratio of earnings on taxable jurisdictions to that in non-taxable jurisdictions. Currently, we do not believe that a valuation allowance is warranted with respect to any of our deferred tax assets as sufficient taxable income can be generated through tax planning strategies and future income to absorb the deferred tax assets in each taxable jurisdiction. Financial Condition Investments At December 31, 2003 the portfolio controlled by us consisted of $2.4 billion of fixed income securities, preferred stock and cash. The majority of these assets are traded, however $175.2 million represents investments in private securities. Of the total portfolio, $2.1 billion represented the fixed income portfolio managed by external investment managers and $262.7 million represented other cash balances. The portfolio includes $351.1 million in respect of assets acquired with ERC Life on December 22, 2003. At December 31, 2002 the portfolio controlled by us consisted of $1.1 billion of traded fixed income securities and cash. Of this total $1.0 billion represented the fixed income portfolio managed by external investment managers and $131.0 million represented other cash balances. At December 31, 2003, the average Standard & Poor's rating of the portfolio was "AA-," the average effective duration was 3.94 years and the average book yield was 4.46% as compared with an average rating of "AA-," an average effective duration 3.03 years and an average book yield of 4.93% at December 31, 2002. At December 31, 2003 the unrealized appreciation on investments, net of tax, was $16.8 million as compared with $8.9 million at December 31, 2002. The unrealized appreciation on investments is included in our consolidated balance sheet as part of shareholders' equity. 48 In the table below are the total returns earned by our portfolio for the year ended December 31, 2003, compared to the returns earned by three indices: the Lehman Brothers Global Bond Index, the S&P 500, and a customized index that we developed with New England Asset Management ("NEAM"), an external investment manager, to take into account our investment guidelines. We believe that this customized index is a more relevant benchmark for our portfolio's performance.
December 31, 2003 ----------------- Portfolio performance............................... 5.02% Customized index.................................... 4.39% Lehman Brothers Global Bond Index................... 12.51% S&P 500............................................. 28.67%
The following table presents the fixed income investment portfolio (market value) credit exposure by category as assigned by Standard & Poor's.
December 31, 2003 December 31, 2002 ------------------ ------------------ Ratings $ in $ in - ------- millions % millions % --------- ----- -------- ----- AAA................................... $ 785.4 32.7% $ 405.7 35.8% AA.................................... 298.4 12.4 113.4 10.0 A..................................... 762.7 31.7 335.3 29.5 BBB................................... 540.8 22.5 252.4 22.2 BB or below........................... 16.6 0.7 28.1 2.5 --------- ----- -------- ----- Total................................. $ 2,403.9 100.0% $1,134.9 100.0% ========= ===== ======== =====
The following table illustrates the fixed income investment portfolio (market value) sector exposure.
December 31, 2003 December 31, 2002 ------------------ ------------------ Sector $ in $ in - ------ millions % millions % --------- ----- -------- ----- U.S. Treasury securities and U.S. government agency obligations....... $ 74.6 3.1% $ 13.8 1.3% Corporate securities.................. 1,119.6 46.6 549.9 48.5 Municipal bonds....................... 1.8 0.1 1.7 0.1 Mortgage and asset backed securities.. 818.7 34.0 438.5 38.6 Preferred stock......................... 126.5 5.3 -- -- --------- ----- -------- ----- 2,141.2 89.1 1,003.9 88.5 Cash.................................. 262.7 10.9 131.0 11.5 --------- ----- -------- ----- Total................................. $ 2,403.9 100.0% $1,134.9 100.0% ========= ===== ======== =====
The data in the tables above excludes the assets held by ceding insurers under modified coinsurance and funds withheld coinsurance agreements. At December 31, 2003 our fixed income portfolio had 1,375 positions and $14.6 million of gross unrealized losses. No single position had an unrealized loss greater than $1.6 million. There were $37.0 million of unrealized gains on the remainder of the portfolio. There were 34 private securities in an unrealized loss position totaling $805,000. At December 31, 2002 our fixed income portfolio had 930 positions and $16.1 million of gross unrealized losses. No single position had an unrealized loss greater than $1.3 million. There were $28.8 million of unrealized gains on the remainder of the portfolio. 49 The composition by category of securities that have an unrealized loss at December 31, 2003 and December 31, 2002 are presented in the tables below.
December 31, 2003 --------------------------------------- Estimated Unrealized Fair Value % Loss % -------- ----- -------- ----- Dollars in thousands Corporate securities ............... $223,555 41.4% $ (3,823) 26.2% Other structured securities ........ 154,065 28.5 (8,943) 61.3 Collateralized mortgage obligations 95,455 17.7 (863) 5.9 Governments ........................ 25,838 4.8 (400) 2.7 Preferred stock .................... 21,303 3.9 (299) 2.1 Mortgage backed securities ......... 19,900 3.7 (255) 1.8 -------- ----- -------- ----- Total .............................. $540,116 100.0% $(14,583) 100.0% ======== ===== ======== =====
December 31, 2002 --------------------------------------- Estimated Unrealized Fair Value % Loss % -------- ----- -------- ----- Dollars in thousands Other structured securities ........ $104,453 52.9% $(10,213) 63.3% Corporate securities ............... 68,503 34.7 (5,323) 33.0 Collateralized mortgage obligations 22,896 11.6 (608) 3.7 Municipal bonds .................... 1,658 0.8 (1) -- -------- ----- -------- ----- Total .............................. $197,510 100.0% $(16,145) 100.0% ======== ===== ======== =====
The following tables provide information on the length of time securities have been continuously in an unrealized loss position:
December 31, 2003 - ------------------------------------------------------------------------------- Estimated Book Fair Unrealized Days Value % Value % Loss % - ---- -------- ----- -------- ----- -------- ----- Dollars in thousands 0-90 ........... $308,267 55.6% $304,511 56.4% $ (3,756) 25.8% 91-180 ......... 115,702 20.9 113,405 21.0 (2,297) 15.8 181-270 ........ 56,362 10.1 55,243 10.2 (1,119) 7.7 271-360 ........ 13,486 2.4 13,064 2.4 (422) 2.9 Greater than 360 60,882 11.0 53,893 10.0 (6,989) 47.8 -------- ----- -------- ----- -------- ----- Total .......... $554,699 100.0% $540,116 100.0 $(14,583) 100.0% ======== ===== ======== ===== ======== =====
December 31, 2002 - ------------------------------------------------------------------------------- Estimated Book Fair Unrealized Days Value % Value % Loss % - ---- -------- ----- -------- ----- -------- ----- Dollars in thousands 0-90............. $ 81,724 38.3% $ 79,557 40.3% $ (2,167) 13.4% 91-180........... 53,663 25.1 50,082 25.4 (3,581) 22.2 181-270.......... 21,621 10.1 17,759 9.0 (3,862) 23.9 271-360.......... 7,227 3.4 6,212 3.1 (1,015) 6.3 Greater than 360. 49,420 23.1 43,900 22.2 (5,520) 34.2 -------- ----- -------- ----- -------- ----- Total $213,655 100.0% $197,510 100.0% $(16,145) 100.0% ======== ===== ======== ===== ======== =====
50 Unrealized losses on securities that have been in an unrealized loss position for periods greater than two years amounted to $2.0 million and $478,000 at December 31, 2003 and 2002, respectively. Unrealized losses on non-investment grade securities amounted to $3.0 million and $3.8 million at December 31, 2003 and 2002, respectively. Of these amounts non-investment grade securities with unrealized losses of $1.8 million at December 31, 2003 and $1.6 million at December 31, 2002 had been in an unrealized loss position for a period greater than one year and $895,000 at December 31, 2003 and $30,000 at December 31, 2002 had been in an unrealized loss position for periods greater than two years. The following tables illustrate the industry analysis of the unrealized losses at December 31, 2003 and 2002.
December 31, 2003 Estimated Amortized Fair Unrealized Cost % Value % Loss % -------- ----- -------- ----- -------- ----- Industry Dollars in thousands -------- Mortgage and asset backed securities ... $279,481 50.4% $269,420 49.9% (10,061) 69.0% Banking ........ 38,738 7.0 38,201 7.1 (537) 3.7 Consumer non-cyclical . 23,009 4.1 22,632 4.2 (377) 2.6 Communications . 27,401 4.9 27,055 5.0 (346) 2.4 Financial companies..... 21,900 3.9 21,539 4.0 (361) 2.5 Insurance ...... 17,467 3.1 17,289 3.2 (178) 1.4 Transportation . 7,382 1.3 6,534 1.2 (848) 5.8 Other .......... 139,321 25.3 137,446 25.4 (1,875) 12.6 -------- ----- -------- ----- -------- ----- Total .......... $554,699 100.0% $540,116 100.0% $(14,583) 100.0% ======== ===== ======== ===== ======== =====
December 31, 2002 Estimated Amortized Fair Unrealized Cost % Value % Loss % -------- ----- -------- ----- -------- ----- Industry Dollars in thousands -------- Mortgage and asset backed securities.... $139,830 65.4% $129,007 65.3% $(10,823) 67.0% Electric........ 16,967 7.9 16,637 8.4 (330) 2.0 Financial companies..... 11,591 5.4 11,354 5.7 (237) 1.5 Transportation.. 9,936 4.7 7,286 3.7 (2,650) 16.4 Consumer cyclical...... 7,763 3.6 7,235 3.7 (528) 3.3 Communications.. 7,130 3.3 6,767 3.4 (363) 2.2 Other........... 20,438 9.7 19,224 9.8 (1,214) 7.6 -------- ----- -------- ----- -------- ----- Total........... $213,655 100.0% $197,510 100.0% $(16,145) 100.0% ======== ===== ======== ===== ======== =====
- ------------------ Other industries each represent less than 2% of estimated fair value 51 The expected maturity dates of our fixed maturity investments that have an unrealized loss at December 31, 2003 and 2002 are presented in the table below.
December 31, 2003 ----------------------------------------------------------------- Estimated Book Fair Unrealized Maturity Value % Value % Loss % - -------- ---------- ----- --------- ----- --------- ----- Due in one year or less........... $ 36,746 6.9% $ 36,648 7.1% $ (98) 0.7% Due in one through five years..... 220,097 41.3 214,103 41.3 (5,994) 42.0 Due in five through ten years..... 232,231 43.5 225,844 43.5 (6,387) 44.7 Due after ten years............... 44,023 8.3 42,218 8.1 (1,805) 12.6 ---------- ----- --------- ----- --------- ----- Total............................. $ 533,097 100.0% $ 518,813 100.0% $(14,284) 100.0% ========== ===== ========= ===== ========= =====
December 31, 2002 ----------------------------------------------------------------- Estimated Book Fair Unrealized Maturity Value % Value % Loss % - -------- ---------- ----- --------- ----- --------- ----- Due in one year or less.......... $ 20,532 9.6% $ 20,067 10.2% $ (465) 2.9% Due in one through five years.... 112,591 52.7 103,679 52.5 (8,912) 55.2 Due in five through ten years.... 69,330 32.5 63,753 32.3 (5,577) 34.5 Due after ten years.............. 11,202 5.2 10,011 5.0 (1,191) 7.4 ---------- ----- --------- ----- -------- ----- Total............................ $ 213,655 100.0% $ 197,510 100.0% $(16,145) 100.0% ========== ===== ========= ===== ======== =====
At December 31, 2003 there were 409 securities with unrealized loss positions. There were two securities with a loss greater than $1 million. These are securitized assets and are tested for impairment under EITF 99-20. At December 31, 2003 these securities satisfied the impairment tests of EITF 99-20. At December 31, 2002 there were 193 securities with unrealized loss positions. There were two securities with unrealized losses greater than $1.0 million. These were also securitized assets and were tested for impairment under EITF 99-20. At December 31, 2002 these securities satisfied the impairment tests of EITF 99-20. At December 31, 2003 there were 12 securities with fair values that traded continuously at less than 80% of amortized cost for at least six months or 90% of amortized cost for at least 12 months. The total unrealized loss on these securities amounted to $7.2 million and the largest unrealized loss position was $1.6 million. At December 31, 2002 there were 5 securities with fair values that traded continuously at less than 80% of amortized cost for at least six months or 90% of amortized cost for at least 12 months. The total unrealized loss on these securities amounted to $1.1 million and the largest unrealized loss position was $0.5 million. Funds withheld at interest Funds withheld at interest arise on contracts written under modified coinsurance agreements and funds withheld coinsurance agreements. In each case, the business reinsured consists of fixed deferred annuities. In substance, these agreements are identical to coinsurance treaties except that the ceding company retains control of and title to the assets. The deposits paid to the ceding company by the underlying policyholders are held in a segregated portfolio and managed by the ceding company or by investment managers appointed by the ceding company. These treaties transfer a quota share of the risks. The funds withheld at interest represent our share of the ceding companies' statutory reserves. The cash flows exchanged with each monthly settlement are netted and include, among other items, our quota share of investment income on our proportionate share of the portfolio, realized losses, realized gains (amortized to reflect the statutory rules relating to interest maintenance reserve), interest credited and expense allowances. At December 31, 2003, funds withheld at interest were in respect of six fixed annuity reinsurance contracts with three ceding companies. At December 31, 2002, we had four modified coinsurance fixed annuity reinsurance contracts with two ceding companies. The new contracts for 2003 relate to contracts assumed on the acquisition of 52 ERC Life. At December 31, 2003 we had three contracts with Lincoln National Insurance Company that account for $1.3 billion (86%) of the funds withheld balances. The other contracts are with Illinois Mutual Insurance Company and American Founders Life Insurance Company. Lincoln National Insurance Company has financial strength ratings of "A+" from A.M. Best, "AA-" from Standard & Poor's, "Aa3" from Moody's and "AA" from Fitch. In the event of insolvency of the ceding companies on these arrangements we would need to exert a claim on the assets supporting the contract liabilities. However, the risk of loss is mitigated by our ability to offset amounts owed to the ceding company, which are included in interest sensitive contract liabilities, with the amounts owed to us by the ceding company. Interest sensitive contract liabilities relating to these fixed annuity reinsurance contracts amounted to $1.7 billion and $1.1 billion at December 31, 2003 and 2002, respectively. At December 31, 2003, funds withheld at interest totaled $1.5 billion with an average rating of "A-", an average effective duration of 5.06 years and an average book yield of 6.32% as compared with an average rating of "A", an average effective duration of 5.4 years and an average book yield of 6.49% at December 31, 2002. These are fixed income investments and include marketable securities, commercial mortgages, private placements and cash. Funds withheld at interest at December 31, 2003 includes $204.3 million arising on the acquisition of ERC Life. The market value of the funds withheld amounted to $1.6 billion at December 31, 2003. The investment objectives for these arrangements are included in the agreements. The primary objective is to maximize current income, consistent with the long-term preservation of capital. The overall investment strategy is executed within the context of prudent asset/liability management. The investment guidelines permit investments in fixed maturity securities, and include marketable securities, commercial mortgages, private placements and cash. The maximum percentage of below investment grade securities is 10% and other guidelines limit risk, ensure issuer and industry diversification as well as maintain liquidity and overall portfolio credit quality. According to data provided by our ceding companies, the following table reflects the market value of assets backing the funds withheld at interest portfolio using the lowest rating assigned by the three major rating agencies.
December 31, 2003 December 31, 2002 ----------------- ----------------- Ratings $ in $ in - ------- millions % millions % --------- ----- -------- ----- AAA................................... $ 216.6 13.9% $ 114.0 9.8% AA.................................... 76.9 4.9 52.7 4.5 A .................................... 528.6 34.0 418.7 35.8 BBB................................... 537.6 34.6 425.9 36.5 BB or below........................... 66.0 4.3 44.7 3.8 --------- ----- -------- ----- 1,425.7 91.7 1,056.0 90.4 Commercial mortgage loans............. 129.4 8.3 112.3 9.6 --------- ----- -------- ----- Total................................. $ 1,555.1 100.0% $1,168.3 100.0% ========= ===== ======== =====
============================================================================== According to data provided by our ceding companies, the following table reflects the market value of assets backing the funds withheld at interest portfolio by sector.
December 31, 2003 December 31, 2002 ----------------- ----------------- Sector $ in $ in - ------ millions % millions % --------- ----- -------- ----- U.S. Treasury securities and U.S. government agency obligations....... $ 32.0 2.1% $ 10.6 0.9% Corporate securities.................. 1,041.2 67.0 822.2 70.4 Municipal bonds....................... 23.1 1.5 0.5 0.1 Mortgage and asset backed securities.. 329.4 21.1 213.1 18.2 Commercial mortgage loans............. 129.4 8.3 112.3 9.6 Cash.................................. -- -- 9.6 0.8 --------- ----- -------- ----- Total $ 1,555.1 100.0% $1,168.3 100.0% ========= ===== ======== =====
53 Liquidity and Capital Resources Cash flow Cash provided by operating activities amounted to $88.5 million in 2003 in comparison with cash flow of $9.2 million used in operating activities in 2002. Operating cash flow includes cash inflows from premiums, fees and investment income, and cash outflows for benefits and expenses paid. In periods of growth of new business our operating cash flow may decrease due to first year commissions paid on new business generated. For income recognition purposes these commissions are deferred and amortized over the life of the business. The increase in operating cash flow from 2002 was $97.7 million. It related primarily to increases in premiums, fees, and investment income being greater than increases in benefits, reserve movements and expenses paid. Cash from premiums and fees increased by $116.3 million due to growth in our Life Reinsurance business. Cash from investment income increased by $68.7 million due to the growth in our invested asset base. The increase was offset by declining yields. Cash used to settle benefits increased by $66.9 million due to the growth in our Life Reinsurance business. This use of cash was offset by an increase in related reserves of $64.1 millions. Cash used to pay acquisition and other expenses , including commissions and interest, increased by $84.5 million. This increase related principally to new business written in our Life Reinsurance North America segment, increased operating expenses and increased debt. Acquisition costs include commissions on first year business that are deferred when paid and therefore do not impact net income until later years. Our cash flow from operations may be positive or negative in any period depending on the amount of new life reinsurance business written, the level of ceding commissions paid in connection with writing that business and the level of renewal premiums earned in the period. We used operating cash flow of $9.2 million in 2002 in comparison with operating cash flow generated of $31.3 million in 2001. The decrease in operating cash flow from 2001 to 2002 was primarily due to increases in benefits and expenses paid greater than increases in premiums, fees, and investment income. In addition there was a decrease in the cash flows from the acquisition of blocks of reinsurance. Cash from premiums and fees increased by $136.0 million due to the acquisition of Scottish Re Holdings Limited and the increase in the number of clients in our Life Reinsurance North America segment. Cash from investment income increased by $56.2 million due to the growth in our invested asset base. The acquisition of blocks of reinsurance business generated $81.3 million less in cash flows in 2002 compared to 2001. Cash used to pay benefits net of related reserves increased by $171.1 million due to the acquisition of Scottish Re Holdings Limited and the increase in the number of clients in our Life Reinsurance North America segment. Cash used to pay acquisition and other costs, including commissions, increased by $35.7 million. This increase related principally to new business written in our Life Reinsurance North America segment. These costs include commissions on first year business that are deferred when paid and therefore do not impact net income until later years. Capital and collateral At December 31, 2003, total capitalization was $964.3 million compared to $623.6 million at December 31, 2002. Total capitalization is analyzed as follows:
December 31, December 31, December 31, 2003 2002 2001 ------------ ------------ ------------ (dollars in thousands) Shareholders' equity.......... $ 659,844 $ 491,092 $ 331,282 Mezzanine equity 141,928 - - Long-term debt.. 162,500 132,500 - ------------ ------------ ------------ $ 964,272 $ 623,592 $ 331,282 ============ ============ ============
The $340.7 million increase in capitalization is due primarily to the net proceeds of our 2003 equity offering of $180.1 million, the net proceeds of the offering of Hybrid Capital Units which are included in mezzanine equity of $138.2 million, the trust preferred securities offerings of $30.0 million, net income for the year of $27.3 million and increases in other comprehensive income. These increases have been offset by dividends paid of $6.2 million. Other comprehensive income consists of the unrealized appreciation on investment, the 54 cumulative translation adjustment arising from the translation of Scottish Re Holdings Limited's balance sheet at exchange rates as of December 31, 2003 and a minimum pension liability adjustment at December 31, 2002 only. At December 31, 2002, total capitalization was $623.6 million compared to $331.3 million in 2001. The $292.3 million increase in capitalization is due primarily to the net proceeds of our 2002 equity offering of $114.3 million, the net proceeds of the convertible debt and capital securities offerings of $ 127.8 million and net income for the year of $32.5 million less dividends paid of $5.0 million and increases in comprehensive income. On April 4, 2002 we completed a public offering of 6,750,000 ordinary shares (which included the over-allotment option of 750,000 ordinary shares) in which we raised aggregate net proceeds of $114.3 million. We used the net proceeds of the offering to repay short-term borrowings of $40.0 million, which we had borrowed under a credit facility with a U.S. bank, and for general corporate purposes. On November 22, 2002 we completed the private offering of $115.0 million of 4.5% Senior Convertible Notes due 2022 (which included the over allotment option of $15.0 million) in which we raised aggregate net proceeds of $110.9 million. We used the net proceeds of the offering to repay short term borrowings of $23.5 million, under reverse repurchase agreements, and for general corporate purposes. On December 4, 2002 we privately placed $17.5 million of capital securities which were issued by a trust subsidiary holding a thirty year $18.0 million aggregate principal amount subordinated note of Scottish Holdings, Inc. which is guaranteed by Scottish Annuity & Life Insurance Company (Cayman) Ltd. Net proceeds were $16.9 million. Scottish Holdings, Inc. provided a $15.0 million capital infusion to its direct subsidiary, Scottish Re (U.S.), Inc. and used the remainder of the net proceeds for general corporate purposes. In April 2003, we filed and had declared effective a registration statement with the Securities and Exchange Commission utilizing a "shelf" registration process relating to a number of different types of debt and equity securities. This shelf enables us to sell securities described in the registration statement up to a total of $500.0 million. Subsequent to the equity and Hybrid Capital Units offerings described below we have $21.6 million remaining on the shelf capacity. On July 23, 2003, we completed a public offering of 9,200,000 ordinary shares (which included an over-allotment option of 1,200,000 ordinary shares) at an offering price of $20.75 per share in which we raised aggregate net proceeds of $180.1 million. The gross proceeds of this offering were $190.9 million. We used $30.0 million of these proceeds to repurchase 1,525,000 ordinary shares from Pacific Life at a purchase price of $19.66 per share. On August 20, 2003, the 200,000 Class B warrants originally issued as part of our initial public offering with a strike price of $15.00 were repurchased at a price of $8.00 per warrant or $1.6 million in aggregate. On October 29, 2003 and November 14, 2003 we privately placed $30.0 million of trust preferred securities which were issued by trust subsidiaries holding thirty year $30.9 million aggregate principal amount subordinated notes of Scottish Holdings, Inc. which is guaranteed by Scottish Annuity & Life Insurance Company (Cayman) Ltd. Net proceeds were $29.0 million. Scottish Holdings, Inc. provided a $21.0 million capital infusion to its direct subsidiary Scottish Re (U.S.), Inc. and used the remainder of the net proceeds for general corporate purposes. On December 17 and December 22, 2003, we completed a public offering of 5,750,000 (which included an over allotment option of 750,000) HyCUs. The net proceeds of the offering were $138.2 million. Each HyCU consists of a purchase contract issued by us and a convertible preferred share redeemable on May 21, 2007. The purchase contract obligates the holder to purchase from us, no later than February 15, 2007, for a price of $25 in cash, the following number of shares, subject to anti dilution adjustments: o if the average closing price of our ordinary shares over a 20 day trading period ending on the fourth trading day before February 15, 2007 exceeds $19.32, a number of ordinary shares, based on the 20 day average closing price, equal to $25.00; and 55 o if the average closing price during that period is less than or equal to $19.32, 1.294 ordinary shares. The proceeds of the sale of these ordinary shares will be used to redeem the convertible preferred shares on May 21, 2007. The convertible preferred shares will be convertible into 1.0607 ordinary shares per $25.00 liquidation preference only on May 21, 2007. Upon conversion we will deliver an amount of cash equal to the $25.00 liquidation preference of the convertible preferred share and ordinary shares for the value of the excess, if any, of the conversion value minus the liquidation preference. We will deliver ordinary shares only if the average closing price is greater than $23.57. In February 2004, we filed a registration statement with the Securities and Exchange Commission utilizing a "shelf" registration process relating to a number of different types of debt and equity securities. When declared effective, this shelf will enable us to sell securities described in the registration statement up to a total of $750.0 million. This shelf will increase our registration statement capacity from our previous shelf registration. During 2003 we paid quarterly dividends totaling $6.2 million or $0.20 per share. During 2002, we paid quarterly dividends totaling $5.0 million or $0.20 per share. During 2003, we renewed our credit facilities, which currently consist of: a) a credit facility totaling $50.0 million, of which $25.0 million is available on an unsecured basis and $25.0 million is available on a secured basis. The facility provides capacity for borrowings and letters of credit. The interest rates on amounts borrowed under the secured facility is LIBOR plus 50 basis points and under the unsecured facility is LIBOR plus 75 basis points. This facility expires in October 2004 but it is renewable upon the agreement of both parties. b) a secured credit facility totaling $50.0 million. This facility provides a combination of borrowings and letters of credit. Interest rates on amounts borrowed under this facility is LIBOR plus 45 basis points. This facility expires in September 2004 but is renewable upon the agreement of both parties. One of the facilities requires that Scottish Annuity & Life Insurance Company (Cayman) Ltd. maintain shareholder's equity of at least $340.0 million. At December 31, 2003, Scottish Annuity & Life Insurance Company (Cayman) Ltd.'s shareholder's equity was $779.7 million. The other facility requires that Scottish Re maintain consolidated net worth of $520.0 million, a maximum debt to total capitalization ratio of 30% and uncollateralised assets of 1.2 times any unsecured borrowings. At December 31, 2003, Scottish Re's net worth was $659.8 million and the ratio of debt to total capitalization was 16.9%. Our failure to comply with the requirements of the credit facilities would, subject to grace periods, result in an event of default, and we could be required to repay any outstanding borrowings. At December 31, 2003, there were no borrowings under the facilities. Outstanding letters of credit under these facilities amounted to $31.2 million. We must have sufficient assets available for use as collateral to support borrowings, letters of credit, and certain reinsurance transactions. With these reinsurance transactions, the need for collateral or letters of credit arises in four ways: o when Scottish Annuity & Life Insurance Company (Cayman) Ltd., Scottish Re (Dublin) Limited or Scottish Re Limited enters into a reinsurance treaty with a U.S. customer, we must contribute assets into a reserve credit trust with a U.S. bank or issue a letter of credit in order that the ceding company may obtain reserve credit for the reinsurance transaction; o when Scottish Re (U.S.), Inc. enters into a reinsurance transaction, it typically incurs a need for additional statutory capital This need can be met by its own capital surplus, an infusion of cash or assets from Scottish Re or an affiliate or by ceding a portion of the transaction to another company within the group or an unrelated reinsurance company, in which case that reinsurer must provide reserve credit by contributing assets in a reserve credit trust or a letter of credit; 56 o Scottish Re (U.S.), Inc. is licensed, accredited, approved or authorized to write reinsurance in 47 states and the District of Columbia. When Scottish Re (U.S.), Inc. enters into a reinsurance transaction with a customer domiciled in a state in which it is not a licensed, accredited, authorized or approved reinsurer, it likewise must provide a reserve credit trust or letter of credit; o ERC Life is licensed, accredited, approved or authorized to write reinsurance in 50 states, the District of Columbia, Guam and the Federated States of Micronesia. When ERC Life enters into a reinsurance transaction with a customer domiciled in a state in which it is not a licensed, accredited, authorized or approved reinsurer, it likewise must provide a reserve credit trust or letter of credit; and o even when Scottish Re (U.S.), Inc. is licensed, accredited, approved or authorized to write reinsurance in a state, it may agree with a customer to provide a reserve credit trust or letter of credit voluntarily to mitigate the counter-party risk from the customer's perspective, thereby doing transactions that would be otherwise unavailable or would be available only on significantly less attractive terms. Scottish Annuity & Life Insurance Company (Cayman) Ltd. has agreed with Scottish Re (U.S.), Inc. that it will (1) cause Scottish Re (U.S.), Inc. to maintain capital and surplus equal to the greater of $20.0 million or such amount necessary to prevent the occurrence of a Company Action Level Event under the risk-based capital laws of the state of Delaware and (2) provide Scottish Re (U.S.), Inc. with enough liquidity to meet its obligations in a timely manner. In addition, Scottish Annuity & Life Insurance Company (Cayman) Ltd. and Scottish Re have agreed with Scottish Re Limited that in the event Scottish Re Limited is unable to meet its obligations under its insurance or reinsurance agreements, Scottish Annuity & Life Insurance Company (Cayman) Ltd. (or if Scottish Annuity & Life Insurance Company (Cayman) Ltd. cannot fulfill such obligations, then Scottish Re) will assume all of Scottish Re Limited's obligations under such agreements. Scottish Re and Scottish Annuity & Life Insurance Company (Cayman) Ltd. have executed similar agreements for Scottish Re (Dublin) Limited and may, from time to time, execute additional agreements guaranteeing the performance and/or obligations of their subsidiaries. Our business is capital intensive. We expect that our cash and investments, together with cash generated from our businesses, will be sufficient to meet our current liquidity and letter of credit needs. However, if our business continues to grow significantly, we will need to raise additional capital. 57 Contractual Obligations and Commitments The following table shows our contractual obligations and commitments including our payments due by period:
Less More Than 1 4-5 Than 5 Year 1-3 Years Years Years Total --------- --------- --------- --------- --------- (dollars in thousands) Long-term debt......... $ - $ 115,000 $ 47,500 $ - $ 162,500 Mezzanine equity....... - - 143,750 - 143,750 Operating leases....... 1,905 3,409 3,056 6,746 15,116 Funding agreements..... - 50,000 260,000 20,000 330,000 ERC Life acquisition post closing adjustment .... 20,000 - - - 20,000 ERC Life transition services agreement..... 2,400 - - - 2,400 --------- --------- --------- --------- --------- $ 24,305 $ 168,409 $ 454,306 $ 26,746 $ 673,766 ========= ========= ========= ========= =========
Our long-term debt is described in Note 15 to the Consolidated Financial Statements. Long term debt includes $115.0 million 4.5% senior convertible notes which are due December 1, 2022. The notes are subject to repurchase by us at a holder's option at various dates, the earliest of which is December 6, 2006. Long term debt also includes capital securities with various maturities from 2032 onwards. They are however, redeemable at earlier dates. They have been included in the above table at the earliest redemption date. Our mezzanine equity is described in Note 16 to the Consolidated Financial Statements and consists of 5,750,000 HyCUs. On February 15, 2007, we shall receive proceeds from the sale of our ordinary shares of $143.8 million as required by the purchase contract forming part of each HyCU. The proceeds from this offering will be used by us to repay the convertible preferred shares of $143.8 million on May 21, 2007. We lease office space in the countries in which we operate. These leases expire at various dates through 2023. Amounts due under funding agreements are included in interest sensitive contract liabilities. These are agreements in which we earn a spread over LIBOR. The contractual repayment terms are detailed in the table above. On December 22, 2003, we completed the acquisition of ERC Life for $151.0 million in cash, subject to certain post closing adjustments. The adjustments are dependant on the completion of the audit of the 2003 financial statements of ERC Life prepared in accordance with U.S. statutory accounting principles. These financial statements are due to be delivered to us on March 31, 2004. We have estimated the post closing adjustment at approximately $20.0 million on the basis of information currently available. GE ERC has agreed to administer the business of ERC Life for up to nine months from the date of acquisition for a fee of $2.4 million. Off balance sheet arrangements We have no obligations, assets or liabilities other than those disclosed in the financial statements forming part of this Form 10-K; no trading activities involving non-exchange traded contracts accounted for at fair value; and no relationships and transactions with persons or entities that derive benefits from their non-independent relationship with us or our related parties. 58 Changes in Accounting Standards In December 2002, the Financial Accounting Standards Board ("FASB") issued SFAS No.148, "Accounting for Stock-Based Compensation - Transition and Disclosure, an Amendment of FASB Statement No. 123". In prior years, we applied the intrinsic value-based expense provisions set forth in ABP Opinion No. 25, "Accounting for Stock Issued to Employees". Effective January 1, 2003, we have prospectively adopted the fair value-based stock option expense provisions of SFAS No. 123 as amended by SFAS No. 148. This has resulted in a charge to income of $207,000 for the year ended December 31, 2003. In May 2003, FASB issued SFAS No. 150 "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equities". This SFAS establishes standards for classification of financial instruments with characteristics of both liabilities and equity. We have adopted the provisions of SFAS 150. There were no changes to our financial position or results of operations. In July 2003, the Accounting Standards Executive Committee issued Statement of Position 03-01 ("SOP"), "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Insurance Contracts and for Separate Accounts". This SOP provides guidance on accounting and reporting by insurance enterprises for certain nontraditional long-duration contracts and for separate accounts and is effective for financial statements for fiscal years beginning after December 15, 2003. At the date of initial application of this SOP, we are required to make various determinations, such as qualification for separate account treatment, classification of securities in separate account arrangements, significance of mortality and morbidity risk, adjustments to contract holder liabilities, and adjustments to estimated gross profits as defined in SFAS No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments". We do not believe the implementation of this SOP will have a material effect on our financial statements. The Derivative Implementation Group has released DIG B36 that addresses whether SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities" requires bifurcation of a debt instrument into a debt host contract and an embedded derivative if the debt instrument incorporates both interest rate risk and credit risk exposures that are unrelated or only partially related to the creditworthiness of the issuer of that instrument. Under DIG B36 modified coinsurance and funds withheld coinsurance reinsurance agreements where interest is determined by reference to a pool of fixed maturity assets are arrangements containing embedded derivatives requiring bifurcation. Our funds withheld at interest, which arise under modified coinsurance and coinsurance funds withheld agreements are therefore considered to contain embedded derivatives requiring bifurcation. The market value of funds withheld at interest was $1.6 billion at December 31, 2003 and its carrying value was $1.5 billion. We adopted DIG B36 on October 1, 2003. The initial adoption has resulted in a loss, after tax and after related amortization of deferred acquisition costs of $19.5 million. This has been recorded as a cumulative effect of change in accounting principle in our consolidated statement of income for the year ended December 31, 2003. The change in fair value of the derivative between October 1, 2003 and December 31, 2003 was a gain of $13.9 million, net of related amortization of deferred acquisition costs. Forward-Looking Statements Some of the statements contained in this report are not historical facts and are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. Forward looking statements include information with respect to our known and unknown risks, uncertainties and other factors, which may cause the actual results to differ materially from the forward-looking statements. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates," "may," "will," "continue," "project" and similar expressions, as well as statements in the future tense, identify forward-looking statements. These forward-looking statements are not guarantees of our future performance and are subject to risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements. These risks and uncertainties include: 59 o uncertainties relating to the ratings accorded to our insurance subsidiaries; o the risk that our risk analysis and underwriting may be inadequate; o exposure to mortality experience which differs from our assumptions; o risks arising from our investment strategy, including risks related to the market value of our investments, fluctuations in interest rates and our need for liquidity; o uncertainties arising from control of our invested assets by third parties; o developments in global financial markets that could affect our investment portfolio and fee income; o changes in the rate of policyholder withdrawals or recapture of reinsurance treaties; o the risk that our retrocessionaires may not honor their obligations to us; o terrorist attacks on the United States and the impact of such attacks on the economy in general and on our business in particular; o political and economic risks in developing countries; o the impact of acquisitions, including the ability to successfully integrate acquired businesses, the competing demands for our capital and the risk of undisclosed liabilities; o loss of the services of any of our key employees; o losses due to foreign currency exchange rate fluctuations; o uncertainties relating to government and regulatory policies (such as subjecting us to insurance regulation or taxation in additional jurisdictions); o the competitive environment in which we operate and associated pricing pressures; and o changes in accounting principles. The effects of these factors are difficult to predict. New factors emerge from time to time and we cannot assess the potential impact of any such factor on the business or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward-looking statement. Any forward-looking statement speaks only as of the date of this report and we do not undertake any obligation, other than as may be required under the Federal securities laws, to update any forward-looking statement to reflect events or circumstances after the date of such statement or to reflect the occurrence of unanticipated events. Item 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We measure and manage market risks and other risks as part of an enterprise-wide risk management process. The market risks described in this section relate to financial instruments, primarily in our investment portfolio, that are sensitive to changes in interest rates, credit risk premiums or spreads, foreign exchange rates and equity prices. Our investments, which are primarily fixed income securities, are subject to market value, reinvestment, and liquidity risk. Our invested assets are funded not only by capital but also by the proceeds of reinsurance transactions, some of which entail substantial deposits of funds or assets. The cash flows required to pay future 60 benefits are subject to actuarial uncertainties and, in some cases, the policies that we reinsure contain provisions that tend to increase benefits to customers depending on movements in interest rates. We analyze the potential results of a transaction, including the cash flows of the liabilities and of the related assets, and any risk mitigation measures, and we price transactions to cover our costs, including estimated credit losses, and earn a desirable risk-adjusted return under various scenarios. Although we have not done so in the past, we may use interest rate swaps and other hedging instruments as tools to mitigate these risks. We may also retrocede some risks to other reinsurers. Interest Rate Risk Interest rate risk consists of two components: (1) in a falling rate scenario, we have reinvestment risk, which is the risk that interest rates will decline and funds reinvested will earn less than is necessary to match anticipated liabilities; and (2) in a rising rate scenario, we have the risk that cash outflows will have to be funded by selling assets, which will then be trading at depreciated values. With some annuity liabilities, these risks are compounded by variability in liability cash flows arising from adverse experience in withdrawals, surrenders, mortality, and election of early retirement. We mitigate both components of risk through asset-liability management, including the technique of simulating future results under a variety of interest rate scenarios and modifying the investment and hedging strategy to mitigate downside risk to earnings. Our investment portfolio is composed of fixed-maturity bond investments, of which the majority are at fixed interest rates. For fixed-rate investments backing reinsurance liabilities, the maturity structure has been designed to have approximately the same exposure to changes in interest rates as the related liabilities. Floating-rate liabilities, including borrowings, are backed primarily by floating-rate assets. In the capital account, however, we own investments that are also sensitive to interest rate changes and this sensitivity is not offset by liabilities. Our overall objective is to limit interest rate exposure. Credit Risk Credit risk relates to the uncertainty associated with the continued ability of a given obligor to make timely payments of principal and interest. We measure and manage credit risk not only of bond issuers but also of counter-parties in reinsurance, retrocession and hedging transactions. In our investment portfolio, credit risk is manifested in three ways: o actual and anticipated deterioration in the creditworthiness of an issue, as may be reflected in downgrades in its ratings, tend to reduce its market value; o our managers might react to the actual or expected deterioration and/or downgrade of an issuer by selling some or all of our positions, realizing a loss (or a profit smaller than would have been realized if the deterioration or downgrade had not occurred); and o the issuer may go into default, ultimately causing us to realize a loss. One of our key objectives in managing credit risk is to keep actual credit losses below both the amounts that we have assumed and allowed for in pricing reinsurance transactions and the amounts we would have lost, given the general level of experience for comparably rated securities of the same type in the general market. We seek to prevent credit risk, in the aggregate, from becoming the dominant source of risk in our overall book of retained risks as a reinsurer. We mitigate credit risk by adopting an investment policy, approved by our board of directors, which limits overall exposure to credit risk and requires diversification by limiting exposure to any single issuer. We also use outside professional money management firms and monitor their capabilities, performance and compliance with our investment and risk management policies. 61 Foreign Currency Risk Our functional currency is the United States dollar. However, our U.K. subsidiaries, Scottish Re Holdings Limited and Scottish Re Limited, maintain a part of their investment portfolio and operating expense accounts in British pounds and receive other currencies in payment of premiums. All of Scottish Re Limited's original U.S. business is settled in United States dollars, all Canadian, Latin American and certain Asia and Middle East business is converted and settled in United States dollars, and all other currencies are converted and settled in British pounds. The results of the business in British pounds are then translated to United States dollars. Scottish Re attempts to limit substantial exposures to foreign currency risk, but does not actively manage currency risks. To the extent our foreign currency exposure is not properly managed or otherwise hedged, we may experience exchange losses, which in turn would adversely affect our results of operations and financial condition. We may enter into investment, insurance and reinsurance transactions in the future in currencies other than United States dollars. Our objective is to avoid substantial exposures to foreign currency risk. We will manage these risks using policy limits, asset-liability management techniques and hedging transactions. Sensitivity Analysis--Change In Interest Rates We regularly conduct analyses to gauge the financial impact of changes in interest rates on our financial condition. Techniques include, but are not limited to, comparison of option-adjusted duration of assets and liabilities and simulation of future asset and liability cash flows under multiple interest rate scenarios. Financial simulations are also used to evaluate exposure to credit spreads and will be used as we consider investments and liabilities denominated in foreign currencies. On a monthly basis, we measure the gap between the effective duration of the investments and the target duration. For assets supporting liabilities, we set the target duration to minimize interest rate risk for each liability transaction. Our investment policy limits the duration gap to 0.75 years. For floating-rate borrowings and liabilities, we target floating-rate assets, which have a duration near zero. For capital account assets, we target a duration of 3.0 years. Quantitative Disclosure Of Interest Rate Risk The following tables provide information as of December 31, 2003 about the interest rate sensitivity of the portion of our investment portfolio managed by external managers. The tables do not include other cash balances of $262.7 million, or modified coinsurance assets of $1.5 billion. The tables show the aggregate amount, by book value and fair value, of the securities that are expected to mature in each of the next five years and thereafter, as well as the weighted average book yield of those securities. The expected maturity is the weighted average life of a security and takes into consideration par amortization (for mortgage-backed securities), call features and sinking fund features. December 31, 2003 market interest rates were used as discounting rates in the estimation of fair value. 62
Expected Maturity Date ---------------------------------------------------------------------------- Total Fair Total 2004 2005 2006 2007 2008 Thereafter Total* Value* - ----- ------ ------ ------ ------ ------ -------- --------- -------- (dollars in millions) Principal amount $115.6 $184.0 $163.1 $247.7 $251.6 $1,351.6 $ 2,576.3 $2,403.9 Book value ..... 240.4 194.7 172.2 259.8 263.2 988.5 2,381.5 Weighted average book yield ..... 5.3% 4.4% 3.6% 4.9% 4.7% 5.2% 4.4% - ------------------
* Includes $262.7 million of cash and cash equivalents with a book yield of 1.01%.
Expected Maturity Date ---------------------------------------------------------------------------- Total Fair Fixed Rate Only 2004 2005 2006 2007 2008 Thereafter Total* Value* - --------------- ------ ------ ------ ------ ------ -------- --------- -------- (dollars in millions) Principal amount... $81.3 $120.0 $119.3 $200.1 $226.9 $1,235.6 $2,245.9 $2,102.1 Book value......... 205.2 131.2 128.4 212.1 238.8 898.4 2,076.8 Weighted average book yield......... 5.6% 5.1% 4.1% 5.3% 4.9% 5.2% 4.6% - ------------------ * Includes $262.7 million of cash and cash equivalents with a book yield of 1.01%.
Expected Maturity Date ---------------------------------------------------------------------------- Total Fair Floating Rate Only 2004 2005 2006 2007 2008 Thereafter Total* Value* - ------------------ ------ ------ ------ ------ ------ -------- --------- -------- (dollars in millions) Principal amount... $34.3 $64.0 $43.8 $47.6 $24.7 $116.0 $330.4 $301.8 Book value......... 35.2 63.5 43.8 47.7 24.4 90.1 304.7 Weighted average book yield......... 3.4% 3.0% 2.3% 3.4% 3.1% 4.4% 3.4%
Item 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information called for by this item is set forth in "Item 15: Exhibits, Financial Statement Schedules and Reports on Form 8-K." Item 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There are no changes in or disagreements with accountants on accounting and financial disclosure for the fiscal year ended December 31, 2003. Item 9A: DISCLOSURE CONTROLS AND PROCEDURES Evaluation of disclosure controls and procedures. Based on their evaluation as of December 31, 2003, our principal executive officers and principal financial officer have concluded that Scottish Re's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities and Exchange Act of 1934 (the "Exchange Act")) are effective to ensure that information required to be disclosed by Scottish Re's 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 rules and forms. Changes in internal controls. There have been no changes in internal control over financial reporting that occurred during the year ended December 31, 2003 that have materially affected, or are reasonably likely to materially affect, Scottish Re's internal control over financial reporting. PART III Item 10: DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT The information required by this Item 10 will be set forth in our Proxy Statement for 2004 Annual Meeting of Shareholders (the "2003 Proxy Statement") under the captions "Proposal for Election of Directors," "Principal Shareholders and Management Ownership" and "Section 16(a) Beneficial Ownership Reporting Compliance" and is incorporated herein by reference. Item 11: EXECUTIVE COMPENSATION The information required by this Item 11 will be set forth in the 2004 Proxy Statement under the captions "Management Compensation" and "Report on Executive Compensation" and is incorporated herein by reference. Item 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS, MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by this Item 12 will be set forth in the 2004 Proxy Statement under the caption "Principal Shareholders and Management Ownership" and is incorporated herein by reference. Item 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item 13 will be set forth in the 2004 Proxy Statement under the caption "Certain Transactions" and is incorporated herein by reference. Item 14: PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by this Item 14 will be set forth in the 2004 Proxy Statement under the caption "Fees Billed to the Company by Ernst & Young LLP" and is incorporated herein by reference. PART IV Item 15: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K A. EXHIBITS Except as otherwise indicated, the following Exhibits are filed herewith and made a part hereof: Exhibit Number Description of Document - -------------- ----------------------- 3.1 Memorandum of Association of Scottish Re, as amended as of December 14, 2001 (incorporated herein by reference to Scottish Re's Current Report on Form 8-K/A).(6) 3.2 Articles of Association of Scottish Re, as amended as of December 14, 2001 (incorporated herein by reference to Scottish Re's Current Report on Form 8-K/A).(6) 4.1 Specimen Ordinary Share Certificate (incorporated herein by reference to Exhibit 4.1 to Scottish Re's Registration Statement on Form S-1).(1) 4.2 Form of Amended and Restated Class A Warrant (incorporated herein by reference to Exhibit 4.2 to Scottish Re's Registration Statement on Form S-1).(1) 4.3 Form of Amended and Restated Class B Warrant (incorporated herein by reference to Exhibit 4.3 to Scottish Re's Registration Statement on Form S-1).(1) 64 4.4 Form of Securities Purchase Agreement for the Class A Warrants (incorporated herein by reference to Exhibit 4.4 to Scottish Re's Registration Statement on Form S-1).(1) 4.5 Form of Warrant Purchase Agreement for the Class B Warrants (incorporated herein by reference to Exhibit 4.5 to Scottish Re's Registration Statement on Form S-1).(1) 4.6 Form of Securities Purchase Agreement between Scottish Re and the Shareholder Investors (incorporated herein by reference to Exhibit 4.10 to Scottish Re's Registration Statement on Form S-1).(1) 4.7 Form of Securities Purchase Agreement between Scottish Re and the Non-Shareholder Investors (incorporated herein by reference to Exhibit to Scottish Re's Registration Statement on Form S-1).(1) 4.8 Purchase Contract Agreement, dated December 17, 2003, by and among the Company and JPMorgan Chase Bank, as purchase contract agent and collateral agent (incorporated herein by reference to the Company's Current Report on form 8-K). (10) 4.9 Pledge Agreement, dated as of December 17, 2003, by and among the Company and JPMorgan Chase Bank, as collateral agent and custodial Agent, purchase contract agent, and securities intermediary (incorporated herein by reference to the Company's Current Report on form 8-K). (10) 4.10 Remarketing Agreement, dated as of December 17, 2003, by and among the Company and Bear, Stearns & Co. Inc., as remarketing agent (incorporated herein by reference to the Company's Current Report on form 8-K). (10) 4.11 Certificate of Designations of Convertible Preferred Shares of the Company (incorporated herein by reference to the Company's Current Report on form 8-K). (10) 10.1 Employment Agreement dated June 18, 1998 between Scottish Re and Michael C. French (incorporated herein by reference to Exhibit 10.1 to Scottish Re's Registration Statement on Form S-1).(1)(12) 10.2 Second Amended and Restated 1998 Stock Option Plan effective October 22, 1998 (incorporated herein by reference to Exhibit 10.3 to Scottish Re's Registration Statement on Form S-1).(1)(12) 10.3 Form of Stock Option Agreement in connection with 1998 Stock Option Plan (incorporated herein by reference to Exhibit 10.4 to Scottish Re's Registration Statement on Form S-1).(1)(12) 10.4 Investment Management Agreement dated October 22, 1998 between Scottish Re and General Re-New England Asset Management, Inc. (incorporated herein by reference to Exhibit 10.14 to Scottish Re's Registration Statement on Form S-1).(1) 10.5 Form of Omnibus Registration Rights Agreement (incorporated herein by reference to Exhibit 10.17 to Scottish Re's Registration Statement on Form S-1).(1) 10.6 1999 Stock Option Plan (incorporated herein by reference to Exhibit 10.14 to Scottish Re's 1999 Annual Report on Form 10-K).(2)(12) 10.7 Form of Stock Options Agreement in connection with 1999 Stock Option Plan (incorporated herein by reference to Exhibit 10.15 to Scottish Re's 1999 Annual Report on Form 10- 65 K).(2)(12) 10.8 Employment Agreement dated September 18, 2000 between Scottish Re and Oscar R. Scofield (incorporated herein by reference to Exhibit 10.16 to Scottish Re's 2000 Annual Report on Form 10-K).(3)(12) 10.9 Share Purchase Agreement by and between Scottish Re and Pacific Life dated August 6, 2001 (incorporated by reference to Scottish Re's Current Report on Form 8-K).(7) 10.10 Amendment No. 1, dated November 8, 2001, to Share Purchase Agreement dated August 6, 2001 by and between Scottish Re and Pacific Life (incorporated by reference to the Company's Current Report on Form 8-K).(5) 10.11 2001 Stock Option Plan (incorporated herein by reference to Exhibit 10.17 to Scottish Re's 2001 Annual Report on Form 10-K). (4)(12) 10.12 Form of Nonqualified Stock Option Agreement in connection with 2001 Stock Option Plan. (incorporated herein by reference to Exhibit 10.17 to Scottish Re's 2001 Annual Report on Form 10-K). (4)(12) 10.13 Service Agreement dated December 31, 2001 between Scottish Re Holdings, Paul Andrew Bispham and Scottish Re (4)(12) 10.14 Registration Rights Agreement dated December 31, 2001 between Scottish Re and Pacific Life (incorporated by reference to Scottish Re's Current Report on Form 8-K).(5) 10.15 Stockholder Agreement dated December 31, 2001 between Scottish Re and Pacific Life (incorporated by reference to Scottish Re's Current Report on Form 8-K).(5) 10.16 Tax Deed of Covenant dated December 31, 2001 between Scottish Re and Pacific Life (incorporated by reference to Scottish Re's Current Report on Form 8-K).(5) 10.17 Letter Agreement dated December 28, 2001 between Scottish Re and Pacific Life (incorporated by reference to Scottish Re's Current Report on Form 8-K).(5) 10.18 Form of Indemnification Agreement between Scottish Re and each of its directors and officers (incorporated by reference to Scottish Re's Amended Quarterly Report on Form 10-Q/A for the period ended June 30, 2002).(8)(12) 10.19 Employment Agreement dated July 1, 2002 between Scottish Annuity & Life Insurance Company (Cayman) Ltd. and Thomas A. McAvity, Jr. (incorporated by reference to Scottish Re's Amended Quarterly Report on Form 10-Q/A for the period ended June 30, 2002).(8)(12) 10.20 Employment Agreement dated June 1, 2002 between Scottish Re and Elizabeth Murphy (incorporated by reference to Scottish Re's Amended Quarterly Report on Form 10-Q/A for the period ended June 30, 2002).(8)(12) 10.21 Employment Agreement dated June 1, 2002 between Scottish Re and Clifford J. Wagner (incorporated by reference to Scottish Re's Amended Quarterly Report on Form 10-Q/A for the period ended June 30, 2002).(8)(12) 10.22 Employment Agreement dated July 8, 2002 between Scottish Re and Scott E. Willkomm (incorporated by reference to Scottish Re's Amended Quarterly Report on Form 10-Q/A for the 66 period ended June 30, 2002).(8)(12) 10.23 Employment Agreement dated February 10, 2003 between Scottish Re and Michael C. French. (12) 10.24 Employment Agreement dated February 10, 2003 between Scottish Re and Oscar R. Scofield. (12) 10.25 Amended Employment Agreement dated February 10, 2003 between Scottish Re and Thomas A. McAvity. (12) 10.26 Indenture, dated November 22, 2002, between Scottish Re and The Bank of New York (incorporated herein by reference to Scottish Re's Registration Statement on Form S-3). (9) 10.27 Registration Rights Agreement, dated November 22, 2002, between Scottish Re and Bear Stearns & Co. and Putnam Lovell Securities Inc. (incorporated herein by reference to Scottish Re's Registration Statement on Form S-3). (9) 10.28 Employment Agreement dated May 1, 2003 between Scottish Re Holdings Ltd. and David Huntley. (12) 10.39 Share Purchase Agreement dated July 3, 2003 by and between Scottish Re Group Limited and Pacific Life Insurance Company (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K filed with the SEC on July 8, 2003). 10.30 Stock Purchase Agreement, dated as of October 24, 2003, by and among Scottish Re, Scottish Holdings, Inc. and ERC (incorporated herein by reference to the Company's Current Report on form 8-K). (11) 10.31 Tax Matters Agreement, dated as of January 22, 2003, by and among Scottish Re, Scottish Holdings, Inc. and ERC (incorporated herein by reference to the Company's Current Report on form 8-K). (11) 10.32 Transition Services Agreement, dated as of January 22, 2003, by and among Scottish Holdings, Inc. and ERC (incorporated herein by reference to the Company's Current Report on form 8-K). (11) 23.1 Consent of Ernst & Young LLP. 31.1 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.3 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 67 32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.3 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 - ------------------ (1) Scottish Re's Registration Statement on Form S-1 was filed with the SEC on June 19, 1998, as amended. (2) Scottish Re's 1999 Annual Report on Form 10-K was filed with the SEC on April 3, 2000. (3) Scottish Re's 2000 Annual Report on Form 10-K was filed with the SEC on March 30, 2001. (4) Scottish Re's 2001 Annual Report on Form 10-K was filed with the SEC on March 5, 2002. (5) Scottish Re's Current Report on Form 8-K was filed with the SEC on December 31, 2001. (6) Scottish Re's Current Report on Form 8-K/A was filed with the SEC on January 11, 2002. (7) Scottish Re's Current Report on Form 8-K was filed with the SEC on August 9, 2001. (8) Scottish Re's Amended Quarterly Report on Form 10-Q/A was filed with the SEC on August 8, 2002. (9) Scottish Re's Registration Statement on Form S-3 was filed with the SEC on January 31, 2003, as amended. (10) Scottish Re's Current Report on Form 8-K was filed with the SEC on December 17, 2003. (11) Scottish Re's Current Report on Form 8-K was filed with the SEC on January 6, 2004. (12) This exhibit is a management contract or compensatory plan or arrangement. B. FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Report of Independent Auditors............................................. 69 Consolidated Balance Sheets................................................ 70 Consolidated Statements of Income.......................................... 71 Consolidated Statements of Comprehensive Income............................ 72 Consolidated Statements of Shareholders' Equity............................ 73 Consolidated Statements of Cash Flows...................................... 74 Notes to Consolidated Financial Statements................................. 75 All other schedules are omitted because they are either not applicable or the required information is included in the Management's Discussion and Analysis of Financial Condition and Results of Operations, Financial Statements or Notes thereto appearing elsewhere in this Form 10-K. C. REPORTS ON FORM 8-K The following reports on Form 8-K were filed with the SEC during the three months ended December 31, 2003: Current Report on Form 8-K filed on October 27, 2003 to report under Item 5 (Other Events and Required FD Disclosure) that Scottish Re had issued a press release announcing that it had entered into a Stock Purchase Agreement with Employers Reinsurance Corporation to acquire 95% of the capital stock of ERC Life Reinsurance Corporation. A copy of the press release was filed as Exhibit 99.1 thereto. Current Report on Form 8-K filed on December 17, 2003 pursuant to which Scottish Re filed (i) the Underwriting Agreement relating to its issuance of 5.875% Hybrid Capital Units (the "HyCUs") and (ii) the operative agreements governing the terms of the HyCUs. 68 Report of Independent Auditors To the Shareholders and Board of Directors Scottish Re Group Limited We have audited the accompanying consolidated balance sheets of Scottish Re Group Limited and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, comprehensive income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2003. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Scottish Re Group Limited and subsidiaries at December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 3 to the financial statements, in 2003 the Company changed its accounting related to its funds withheld at interest and in 2002 the Company changed its accounting for goodwill. /s/ ERNST & YOUNG Philadelphia, Pennsylvania February 10, 2004 69 SCOTTISH RE GROUP LIMITED CONSOLIDATED BALANCE SHEETS (Expressed in Thousands of United States Dollars)
December December ASSETS 31, 2003 31, 2002 ---------- ---------- Fixed maturity investments, available for sale, at fair value (Amortized cost $1,993,247; 2002 - $991,304)....... $2,014,719 $1,003,946 Preferred stock (Cost $125,460)...................... 126,449 - Investment in unit-linked securities................. - 16,497 Cash and cash equivalents............................ 298,149 149,666 Other investments.................................... 17,678 5,631 Funds withheld at interest........................... 1,469,425 1,101,836 ---------- ---------- Total investments.................................. 3,926,420 2,277,576 Accrued interest receivable.......................... 22,789 11,910 Reinsurance balances and risk fees receivable........ 196,192 39,805 Deferred acquisition costs........................... 308,591 213,516 Amounts recoverable from reinsurers.................. 737,429 22,608 Present value of in-force business................... 13,479 18,181 Goodwill............................................. 35,847 35,847 Fixed assets......................................... 11,800 6,493 Other assets......................................... 45,209 11,702 Deferred tax benefit................................. 12,624 - Segregated assets.................................... 743,137 653,588 ---------- ---------- Total assets....................................... $6,053,517 $3,291,226 ========== ========== LIABILITIES Reserves for future policy benefits.................. $1,502,415 $ 386,807 Interest sensitive contract liabilities.............. 2,633,346 1,567,176 Unit-linked contract liabilities..................... - 17,069 Accounts payable and accrued expenses................ 31,673 15,053 Reinsurance balances payable......................... 125,756 16,348 Other liabilities.................................... 30,546 649 Current income tax payable........................... 13,077 1,873 Deferred tax liability............................... - 9,071 Long term debt....................................... 162,500 132,500 Segregated liabilities............................... 743,137 653,588 ---------- ---------- Total liabilities.................................. 5,242,450 2,800,134 ---------- ---------- MINORITY INTEREST 9,295 - MEZZANINE EQUITY 141,928 - SHAREHOLDERS' EQUITY Share capital, par value $0.01 per share: Issued and fully paid: 35,228,411 ordinary shares (2002-26,927,456)................................ 352 269 Additional paid-in capital........................... 548,750 416,712 Accumulated other comprehensive income............... 29,034 13,467 Retained earnings.................................... 81,708 60,644 ---------- ---------- Total shareholders' equity......................... 659,844 491,092 ---------- ---------- Total liabilities and shareholders' equity........... $6,053,517 $3,291,226 ========== ==========
See Accompanying Notes to Consolidated Financial Statements 70 SCOTTISH RE GROUP LIMITED CONSOLIDATED STATEMENTS OF INCOME (Expressed in Thousands of United States Dollars, except per share data)
Year Ended Year Ended Year Ended December December December 31, 2003 31, 2002 31, 2001 ---------- ---------- ---------- Revenues Premiums earned......................... $ 391,976 $ 202,536 $ 68,344 Investment income, net.................. 148,028 107,906 51,691 Fee income.............................. 7,907 6,574 4,809 Realized losses......................... (4,448) (10,804) (3,882) Change in value of embedded derivatives. 13,903 - - ---------- ---------- ---------- Total revenues........................ 557,366 306,212 120,962 ---------- ---------- ---------- Benefits and expenses Claims and other policy benefits........ 275,863 142,158 51,245 Interest credited to interest sensitive contract liabilities.................. 89,180 48,140 17,578 Acquisition costs and other insurance expenses, net......................... 116,000 60,073 24,328 Operating expenses...................... 31,021 23,086 9,173 Interest expense........................ 7,557 1,414 1,405 ---------- ---------- ---------- Total benefits and expenses.......... 519,621 274,871 103,729 ---------- ---------- ---------- Income before income taxes and minority interest.............................. 37,745 31,341 17,233 Income tax benefit (expense)............ 11,105 1,894 (59) ---------- ---------- ---------- Income before minority interest..... 48,850 33,235 17,174 Minority interest....................... (62) - 71 ---------- ---------- ---------- Income from continuing operations before cumulative effect of change in accounting principle.................... 48,788 33,235 17,245 Cumulative effect of change in accounting principle (net of taxation of $3,415) ................................ (19,537) - (406) Loss from discontinued operations....... (1,971) (711) - ---------- ---------- ---------- Net income.............................. $ 27,280 $ 32,524 $ 16,839 ========== ========== ========== Basic earnings per share: Income from continuing operations before cumulative effect of change in accounting principle............. $ 1.59 $ 1.32 $ 1.10 Cumulative effect of change in accounting principle................ (0.64) - (0.02) Discontinued operations............. (0.06) (0.03) - ---------- ---------- ---------- Net income.......................... $ 0.89 $ 1.29 $ 1.08 ========== ========== ========== Diluted earnings per share: Income from continuing operations before cumulative effect of change in accounting principle............. $ 1.51 $ 1.25 $ 1.05 Cumulative effect of change in accounting principle................ (0.60) - (0.03) Discontinued operations............. (0.06) (0.02) - ---------- ---------- ---------- Net income.......................... $ 0.85 $ 1.23 $ 1.02 ========== ========== ========== Weighted average number of ordinary shares outstanding Basic.............................. 30,652,719 25,190,283 15,646,106 ========== ========== ========== Diluted............................ 32,228,001 26,505,611 16,485,338 ========== ========== ==========
See Accompanying Notes to Consolidated Financial Statements 71 SCOTTISH RE GROUP LIMITED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Expressed in Thousands of United States Dollars)
Year Ended Year Ended Year Ended December December December 31, 31, 2003 31, 2002 2001 --------- --------- --------- Net income............................. $ 27,280 $ 32,524 $ 16,839 --------- --------- --------- Other comprehensive income (loss), net of tax: Unrealized appreciation (depreciation) on investments....................... 10,270 18,049 (3,000) Add: reclassification adjustment for investment gains (losses) included in net income........................... (2,352) (5,493) 3,196 --------- --------- --------- Net unrealized appreciation on investments, net of income taxes of $2,222, $3,853 and $(1,376) 7,918 12,556 196 Cumulative translation adjustment ..... 6,277 5,908 -- Minimum pension liability adjustment, net of income taxes of $588 and ($588)............................. 1,371 (1,371) -- --------- --------- --------- Other comprehensive income............. 15,566 17,093 196 --------- --------- --------- Comprehensive income................... $ 42,846 $ 49,617 $ 17,035 ========= ========= =========
See Accompanying Notes to Consolidated Financial Statements 72 SCOTTISH RE GROUP LIMITED CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (Expressed in Thousands of United States Dollars, except for number of shares)
Year Ended Year Ended Year Ended December 31, December 31, December 31, 2003 2002 2001 ------------ ------------ ------------ Ordinary shares: Beginning of year ..................... 26,927,456 20,144,956 15,614,240 Ordinary shares issued ................ 9,200,000 6,750,000 4,532,380 Ordinary shares repurchased ........... (1,525,000) -- (100,000) Issuance to employees on exercise of options ............................... 425,955 32,500 98,336 Issuance on exercise of warrants ...... 200,000 -- -- ------------ ------------ ------------ End of year ........................... 35,228,411 26,927,456 20,144,956 ============ ============ ============ Share capital: Beginning of year ..................... $ 269 $ 201 $ 156 Ordinary shares issued ................ 92 68 45 Ordinary shares repurchased ........... (15) -- (1) Issuance to employees on exercise of options ............................... 4 -- 1 Issuance on exercise of warrants ...... 2 -- -- ------------ ------------ ------------ End of year ........................... 352 269 201 ------------ ------------ ------------ Additional paid in capital: Beginning of year ..................... 416,712 301,542 223,771 Ordinary shares issued ................ 179,995 114,252 77,955 Ordinary shares repurchased ........... (29,966) -- (1,483) Stock option expense .................. 207 639 -- Issuance to employees on exercise of options ............................... 4,575 279 1,299 Issuance on exercise of warrants ...... 2,998 -- -- Issuance of Hybrid Capital Units ...... (24,171) -- -- Warrants repurchased .................. (1,600) -- -- ------------ ------------ ------------ End of year ........................... 548,750 416,712 301,542 ------------ ------------ ------------ Accumulated other comprehensive income (loss): Unrealized appreciation on investments Beginning of year ................... 8,930 (3,626) (3,822) Change in period (net of tax) ....... 7,918 12,556 196 ------------ ------------ ------------ End of year ........................... 16,848 8,930 (3,626) ------------ ------------ ------------ Cumulative translation adjustment Beginning of year ................... 5,908 -- -- Change in period (net of tax) ....... 6,278 5,908 -- ------------ ------------ ------------ End of year ......................... 12,186 5,908 -- ------------ ------------ ------------ Minimum pension liability adjustment .. Beginning of year ................... (1,371) -- -- Change in period (net of tax) ....... 1,371 (1,371) -- ------------ ------------ ------------ End of year ......................... -- (1,371) -- ------------ ------------ ------------ Total accumulated other comprehensive income (loss) ......................... 29,034 13,467 (3,626) ------------ ------------ ------------ Retained earnings: Beginning of year ..................... 60,644 33,165 19,459 Net income ............................ 27,280 32,524 16,839 Dividends paid ........................ (6,216) (5,045) (3,133) ------------ ------------ ------------ End of year ........................... 81,708 60,644 33,165 ------------ ------------ ------------ Total shareholders' equity .............. $ 659,844 $ 491,092 $ 331,282 ============ ============ ============
See Accompanying Notes to Consolidated Financial Statements 73 SCOTTISH RE GROUP LIMITED CONSOLIDATED STATEMENTS OF CASH FLOWS (Expressed in Thousands of United States Dollars)
Year Ended Year Ended Year Ended December December December 31, 2003 31, 2002 31, 2001 ----------- --------- --------- Operating activities Income before cumulative effect of change in accounting principle.......... $ 46,817 $ 32,524 $ 17,245 Items not affecting cash: Net realized losses ................... 4,448 10,803 3,882 Changes in value of embedded derivatives ........................ 13,903 ---- ---- Amortization of investments ........... 5,619 667 (1,484) Amortization of deferred acquisition costs .............................. 74,239 28,179 11,117 Amortization of present value of in-force business .................. 4,926 2,777 206 Changes in assets and liabilities: Accrued interest ................... (6,731) (2,575) (19) Reinsurance balances and risk fees receivable ...................... (54,689) 29,019 (28,063) Deferred acquisition costs ......... (167,281) (127,797) (94,092) Deferred tax liability ............. (17,350) 863 (1,293) Other assets and liabilities ....... (25,561) (804) (8,218) Current income tax receivable and payable ......................... (1,459) 1,514 1,351 Reserves for future policy benefits 159,242 (1,377) 131,627 Interest sensitive contract liabilities, net of funds withheld at interest ............ 25,546 16,260 9,485 Unit linked contract liabilities ... -- (11,280) -- Accounts payable and accrued expenses ........................ 11,989 9,504 (9,388) Other .............................. 14,846 2,539 (1,076) ----------- --------- --------- Net cash provided by (used in) operating activities ............... 88,504 (9,184) 31,280 ----------- --------- --------- Investing Activities Purchase of fixed maturity investments ... (1,254,226) (710,791) (309,373) Proceeds from sales of fixed maturity investments ........................... 288,611 183,588 297,337 Proceeds from maturity of fixed maturity investments ........................... 216,617 122,000 86,135 Purchase of preferred stock .............. (82,717) -- -- Proceeds from sale of preferred stock .... 18,530 -- -- Proceeds from maturity of preferred stock 5,137 -- -- Sale (purchase) of other investments .... -- 5,291 (10,108) Cost of acquisition of subsidiary net of cash acquired ......................... (140,228) (2,270) 13,786 Purchase of fixed assets ................. (4,984) (1,034) (3,870) ----------- --------- --------- Net cash provided by (used in) investing activities ............... (953,260) (403,216) 73,907 ----------- --------- --------- Financing activities Deposits to interest sensitive contract liabilities ........................... 736,884 320,338 83,137 Withdrawals from interest sensitive contract liabilities .................. (40,783) (27,627) (200,751) Borrowings ............................... -- (65,145) 65,145 Issuance of ordinary shares .............. 187,666 114,599 1,299 Repurchase of ordinary shares ............ (29,981) -- (1,483) Repurchase of warrants ................... (1,600) -- -- Issuance of long term debt ............... 29,047 127,782 -- Net funds received on issuance of Hybrid Capital Units ......................... 138,223 -- -- Dividends paid ........................... (6,217) (5,045) (3,133) ----------- --------- --------- Net cash provided by (used in) financing activities ............................ 1,013,239 464,902 (55,786) ----------- --------- --------- Net change in cash and cash equivalents .. 148,483 52,502 49,401 Cash and cash equivalents, beginning of year .................................. 149,666 97,164 47,763 ----------- --------- --------- Cash and cash equivalents, end of year ... $ 298,149 $ 149,666 $ 97,164 =========== ========= ========= Supplemental cash flow information: Interest paid ............................ $ 6,195 $ 738 $ 1,311 =========== ========= =========
See Accompanying Notes to Consolidated Financial Statements 74 SCOTTISH RE GROUP LIMITED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2003 1. Change of Name On September 2, 2003, we changed our name to Scottish Re Group Limited from Scottish Annuity & Life Holdings, Ltd. At the same time, World-Wide Holdings Limited and World-Wide Reassurance Company Limited changed their names to Scottish Re Holdings Limited and Scottish Re Limited, respectively. 2. Organization, business and basis of presentation Organization Scottish Re is a holding company organized under the laws of the Cayman Islands with its principal executive office in Bermuda. We are a reinsurer of life insurance, annuities and annuity-type products. These products are written by life insurance companies and other financial institutions located principally in the United States, as well as around the world. We refer to this portion of our business as Life Reinsurance. To a lesser extent, we directly issue variable life insurance and variable annuities and similar products to high net worth individuals and families for insurance, investment and estate planning purposes. We refer to this portion of our business as Wealth Management. We have operating companies in Bermuda, the Cayman Islands, Guernsey, Ireland, the United Kingdom and the United States. Business Life Reinsurance In our Life Reinsurance North America segment, we provide solutions to insurance companies seeking reinsurance of life insurance, annuities and annuity-type products. We reinsure lines of business that may be subject to significant reserve or capital requirements by regulatory and rating agencies. We assume risks associated with primary life insurance policies and annuities, both in force and new business. We reinsure: (i) mortality, (ii) investment, (iii) persistency, and (iv) expense risks. Scottish Re (U.S.), Inc. originates reinsurance business predominantly by marketing its products and services directly to U.S. life insurance and reinsurance companies. Scottish Annuity & Life Insurance Company (Cayman) Ltd. originates reinsurance business predominantly through reinsurance brokers and intermediaries. In our Life Reinsurance International segment, we reinsure life and aircrew loss of license products. Life products that we reinsure include short term group and individual life and, to a lesser extent, disability and critical illness. In our Life Reinsurance International business we primarily target customers in developing markets as well as selected developed markets. The developing markets include Asia, Latin America, the Middle East, North Africa and Southern and Eastern Europe. In the more developed markets, we target "niche" market sectors that require a high degree of knowledge and experience. Scottish Re Limited markets its products through international brokers and its own marketing staff. Wealth Management In our Wealth Management business, we directly issue variable life insurance and variable annuities and similar products to high net worth individuals and families, for insurance, investment and estate planning purposes. For us, high net worth generally means individuals and families with a liquid net worth in excess of $10 million. Variable life insurance and variable annuities have a cash value component that is placed in a separate account and invested by us on behalf of the policyholder with a money manager. Through our Bermuda and Cayman Islands insurance companies, we have the flexibility to offer products that permit the use of private independent money managers to manage the separate accounts. The money managers can utilize investment strategies not typically available in variable insurance products issued to the general public. 75 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 2. Organization, business and basis of presentation (continued) Basis of presentation Accounting Principles--Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") and all amounts are reported in thousands of United States dollars (except per share amounts). Certain items in the prior year financial statements have been reclassified to conform with the current year presentation. Consolidation--We consolidate the results of all our subsidiaries. All significant intercompany transactions and balances have been eliminated on consolidation. Prior year amounts have been reclassified to conform to the current year presentation. Estimates, risks and uncertainties--The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported on the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Our most significant assumptions are for assumed reinsurance liabilities and deferred acquisition costs. We review and revise these estimates as appropriate. Any adjustments made to these estimates are reflected in the period the estimates are revised. 3. Summary of significant accounting policies The following are our significant accounting policies: A. Fixed maturity investments Fixed maturities are classified as available for sale, and accordingly, we carry these investments at fair values on our consolidated balance sheets. The fair value of fixed maturities is calculated using quoted market prices provided by independent pricing services. The cost of fixed maturities is adjusted for prepayments and the amortization of premiums and discounts. The unrealized appreciation (depreciation) is the difference between fair value and amortized cost and is recorded directly to equity with no impact to net income. The change in unrealized appreciation (depreciation) is included in accumulated other comprehensive income (loss) in shareholders' equity. Investment transactions are recorded on the trade date with balances pending settlement reflected in the balance sheet as a component of other assets or other liabilities. Interest is recorded on the accrual basis. Short-term investments are carried at cost, which approximates fair value. Realized gains (losses) on securities are determined on a specific identification method. We track the cost of each security purchased so that we are able to identify and record a gain or loss when it is subsequently sold. In addition, declines in fair value that are determined to be other than temporary are included in realized gains (losses) in the consolidated statements of income. Realized gains and losses are stated net of associated amortization of deferred acquisition costs. EITF Issue No. 99-20, "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets," ("EITF 99-20") applies to all securities, purchased or retained, which represent beneficial interests in securitized assets, unless they meet certain exception criteria. Such securities include many collateralized mortgage, bond, debt and loan obligations (CMO, CBO, CDO, and CLO), mortgage-backed securities and asset-backed securities. Under EITF 99-20, a decline in fair value below the "amortized cost" basis is considered to be an other than temporary impairment whenever there is an adverse change in the amount or timing of cash flows to be received, regardless of the resulting yield, unless the decrease is solely a result of changes in market interest rates. Interest income is based on prospective estimates of future cash flows. 76 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 3. Summary of significant accounting policies (continued) EITF 99-20 is effective for fiscal quarters beginning after March 15, 2001. We reviewed all applicable securities held at June 30, 2001 and identified a required write down in the amount of $406,000. This is shown in the consolidated statements of income as a cumulative effect of change in accounting principle. Management reviews securities with material unrealized losses and tests for other than temporary impairments on a quarterly basis. Factors involved in the determination of potential impairment include fair value as compared to cost, length of time the value has been below cost, credit worthiness of the issuer, forecasted financial performance of the issuer, position of the security in the issuer's capital structure, the presence and estimated value of collateral or other credit enhancement, length of time to maturity, interest rates and our intent and ability to hold the security until the market value recovers. When a decline is considered to be "other than temporary" a realized loss is incurred and the cost basis of the impaired asset is adjusted to its fair value. B. Investment in unit-linked securities Unit-linked securities were comprised of investments in a unit trust denominated in British pounds. These investments were acquired as part of the purchase of Scottish Re Holdings Limited on December 31, 2001 and were recorded at quoted market value. Changes in market value were recorded as realized gains or losses in total revenue. Investment income was recorded as revenue. The investment results of the unit-linked securities were generally passed on to the policyholder. During 2003, we sold the unit-linked securities as part of a novation of our unit-linked liabilities. (See Note 3L). C. Cash and cash equivalents Cash and cash equivalents include fixed deposits with an original maturity, when purchased, of three months or less. Cash and cash equivalents are recorded at face value, which approximates fair value. D. Funds withheld at interest Funds withheld at interest are funds held by ceding companies under modified coinsurance and coinsurance funds withheld agreements whereby we receive the interest income earned on the funds. The balance of funds held represents the statutory reserves of the ceding companies. These agreements are considered to include embedded derivatives as further discussed in Note 3S. E. Revenue recognition (i) Reinsurance premiums from traditional life policies and annuity policies with life contingencies are generally recognized as revenue when due from policyholders. Traditional life policies include those contracts with fixed and guaranteed premiums and benefits, and consist principally of whole life and term insurance policies. Our premiums earned are recorded in accordance with information received from our ceding companies, or are estimated where this information is not current with the reporting period. These premium estimates are based on historical experience as adjusted for current treaty terms and other information. Actual results could differ from these estimates. Management monitors actual experience, and should circumstances warrant, will revise its estimates of premiums earned. 77 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 3. Summary of significant accounting policies (continued) Benefits and expenses are matched with such income so as to result in the recognition of profits over the life of the contracts. This is achieved by means of the provision for liabilities for future policy benefits and deferral and subsequent amortization of policy acquisition costs. From time to time we acquire blocks of in-force business and account for these transactions as purchases. Results of operations only include the revenues and expenses from the respective dates of acquisition of these blocks of in-force business. The initial transfer of assets and liabilities is recorded on the balance sheet. Reinsurance assumed on annuity business does not generate premium insurance but generates investment income over time on the assets we receive from ceding companies. (ii) Fee income is recorded on an accrual basis: (iii) Investment income is reported on an accrual basis after deducting the related investment manager's fees. (iv) Realized capital gains and losses include gains and losses on the sale of investments available for sale and fixed assets and amounts recognized for other than temporary impairments on fixed maturities. Realized capital gains and losses are stated net of associated amortization of deferred acquisition costs. F. Deferred acquisition costs Costs of acquiring new business, which vary with and are primarily related to the production of new business, have been deferred to the extent that such costs are deemed recoverable from future premiums or gross profits. Such costs include commissions and allowances as well as certain costs of policy issuance and underwriting. We perform periodic tests to determine that the cost of business acquired remains recoverable, and the cumulative amortization is re-estimated and adjusted by a cumulative charge or credit to current operations. Deferred acquisition costs related to traditional life insurance contracts, substantially all of which relate to long-duration contracts, are amortized over the premium-paying period of the related policies in proportion to the ratio of individual period premium revenues to total anticipated premium revenues over the life of the policy. Such anticipated premium revenues are estimated using the same assumptions used for computing liabilities for future policy benefits. Deferred acquisition costs related to interest-sensitive life and investment-type policies are amortized over the lives of the policies, in relation to the present value of estimated gross profits from mortality, investment income, and expense margins. The development of and amortization of deferred acquisition costs for our products requires management to make estimates and assumptions. Actual results could differ materially from those estimates. Management monitors actual experience, and should circumstances warrant, will revise its assumptions and the related estimates. G. Present value of in-force business The present value of the in-force business is established upon the acquisition of a company and will be amortized over the expected life of the business as determined at acquisition. The amortization each year will be a 78 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 3. Summary of significant accounting policies (continued) function of the gross profits or revenues each year in relation to the total gross profits or revenues expected over the life of the business, discounted at the assumed net credit rate. H. Goodwill Goodwill is established upon the acquisition of a subsidiary. Goodwill is calculated as the difference between the price paid and the value of individual assets and liabilities on the date of acquisition. Goodwill and intangible assets deemed to have indefinite lives are subject to annual impairment tests. Goodwill was tested for impairment in 2002 and 2003. There was no impairment. During 2002 we finalized the goodwill arising on the acquisition of Scottish Re Holdings Limited. Goodwill arising on this acquisition amounts to $35.5 million in comparison with $30.6 million at December 31, 2001. The increase arose from additional legal, professional and other costs relating to the acquisition and finalization of the deferred tax balance existing at the date of the acquisition. I. Fixed assets and leasehold improvements Fixed assets include leasehold improvements, furniture and fittings and computer equipment. They are recorded at cost and are depreciated over their estimated useful lives ranging between 1 and 5 years on a straight-line basis. Accumulated depreciation at December 31, 2003 and 2002 amounted to $5.4 million and $2.9 million, respectively. J. Reserves for future policy benefits The development of policy reserves for our products requires management to make estimates and assumptions regarding mortality, lapse, expense and investment experience. Interest rate assumptions for individual life reinsurance reserves range from 2.5 to 7.0%. The interest assumptions for immediate and deferred annuities range from 4.0 to 6.5%. These estimates are based primarily on historical experience and information provided by ceding companies. Actual results could differ materially from those estimates. Management monitors actual experience, and where circumstances warrant, revises the assumptions and the related reserve estimates. For traditional life policies, future benefits are estimated using a net level premium method on the basis of actuarial assumptions as to mortality, persistency and interest established at policy issue. Assumptions established at policy issue as to mortality and persistency are based on anticipated experience, which, together with interest and expense assumptions, provide a margin for adverse deviation. If the liabilities for future policy benefits plus the present value of expected future gross premiums for a product are insufficient to provide for expected future benefits and expenses for that product, deferred acquisition costs will be written off and thereafter, if required, a premium deficiency reserve will be established by a charge to income. K. Interest sensitive contract liabilities The liabilities for interest sensitive contract liabilities equal the accumulated account values of the policies or contracts as of the valuation date and include funds received plus interest credited less funds withdrawn and interest paid. Benefit liabilities for fixed annuities during the accumulation period equal their account values; after annuitization, they equal the discounted present value of expected future payments. 79 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 3. Summary of significant accounting policies (continued) L. Unit-linked contract liabilities Unit-linked contract liabilities assumed by Scottish Re Limited were recorded at account value and represent contracts in which the investment results attained were generally passed through to the policyholder. The investment results are capital gains and losses, net of tax. Amounts were credited to these products based on the underlying investment results of the unit-linked securities. During 2003, our Life Reinsurance International segment entered into an agreement to novate our unit-linked liabilities. (see Note 3B). M. Income taxes Income tax liability and deferred tax assets are recorded in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109. In accordance with this statement we record deferred income taxes that reflect the net tax effect of the temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance is applied to deferred tax assets where the recoverability is uncertain. N. Stock-based compensation Effective January 1, 2003, we have prospectively adopted the fair value-based stock option expense provisions of Statement of Financial Accounting Standards ("SFAS") No. 148. "Accounting for Stock-Based Compensation - Transition and Disclosure, an Amendment to FASB Statement No. 123". In prior years, we applied the intrinsic value method as detailed in Accounting Principles Board ("APB") Opinion No. 25 and related interpretations in accounting for stock option plans. We did not recognize compensation cost because our options were issued with an exercise price equal to the market price of the stock on the date of issue. Note 18 contains a summary of the pro forma effects to reported net income and earnings per share for 2003, 2002 and 2001 had we elected to recognize compensation cost for all options based on the fair value of the options granted at grant date as prescribed by SFAS No. 123. O. Earnings per share In accordance with SFAS No. 128, "Earnings per Share" basic earnings per share is calculated based on weighted average ordinary shares outstanding and excludes any dilutive effects of options and warrants. Diluted earnings per share assume the exercise of all dilutive stock options and warrants using the treasury stock method. P. Segregated assets Separate account investments are in respect of wealth management clients and include the net asset values of the underlying funds plus separate cash and cash equivalent balances less separate account fees payable to us. The funds in the separate accounts are not part of our general funds and are not available to meet our general obligations. The assets and liabilities of these transactions move in tandem. The client bears the investment risk on the account and we receive an asset-based fee for providing this service that is recorded as fee income. Included in these accounts is a total return swap transaction totaling approximately $29.5 million on behalf of a wealth management client. 80 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 3. Summary of significant accounting policies (continued) Q. Segregated liabilities Separate account liabilities include amounts set aside to pay the deferred variable annuities and the cash values associated with life insurance policies. These balances consist of the initial premiums paid after consideration of the net investment gains/losses attributable to each separate account, less fees and withdrawals. These liabilities also include an amount in respect of a total return swap transaction totaling approximately $29.5 million. R. Fair value of financial instruments The fair value of assets and liabilities included on the consolidated balance sheets, which qualify as financial instruments under SFAS No. 107, "Disclosure About Fair Value of Financial Instruments," approximate the carrying amount presented in the consolidated financial statements. S. Derivatives Our funds withheld at interest arise on modified coinsurance and funds withheld coinsurance transactions. Derivatives Implementation Group Issue No. B36 "Embedded Derivatives: Bifurcation of a Debt Instrument that Incorporates Both Interest Rate and Credit Rate Risk Exposures that are Unrelated or Only Partially Related to the Creditworthiness of the Issuer of that Instrument" indicates that these transactions contain embedded derivatives. The embedded derivative feature in our funds withheld treaties is similar to a fixed-rate total return swap on the assets held by the ceding companies. The swap consists of two parts. The first is the market value of the underlying asset portfolio and the second is a hypothetical loan to the ceding company. The hypothetical loan is based on the expected cash flows of the underlying reinsurance liability. We have developed models to systematically estimate the value of the total return swap. The fair value of the embedded derivative is affected by changes in expected cash flows, credit spreads of the assets and changes in "risk-free" interest rates. The change in fair value is included in our calculation of estimated gross profits and, therefore, also affects the amortization of deferred acquisition costs. In addition to our quota share indemnity funds withheld contracts, we have entered into various financial reinsurance treaties that, although considered funds withheld, do not transfer significant insurance risk and are recorded on a deposit method of accounting. As a result of the experience refund provisions of these treaties the value of the embedded derivative is currently considered immaterial. We adopted DIG B36 on October 1, 2003. The initial adoption has resulted in a loss, after tax and after related amortization of deferred acquisition costs of $19.5 million. This has been recorded as a cumulative effect of change in accounting principle in our consolidated statement of income for the year ended December 31, 2003. The change in fair value of the derivative between October 1, 2003 and December 31, 2003 was a gain of $13.9 million, net of related amortization of deferred acquisition costs. The fair value of the derivative of $9.3 million at December 31, 2003 is included in other liabilities and other assets. 81 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 4. Business acquisitions On December 22, 2003, we completed the purchase of 95% of ERC Life for $151.0 million in cash subject to certain post closing adjustments. The adjustments are dependant on the completion of the audit of the 2003 financial statements of ERC Life prepared in accordance with U.S. statutory accounting principles. These financial statements are due to be delivered to us on March 31, 2004. We have estimated the post closing adjustment at approximately $20.0 million on the basis of information currently available. There was no goodwill arising on the acquisition. The balance sheet of ERC Life at the date of acquisition is as follows:
December 22, 2003 ---------------------- Fixed maturity investments $ 263,301 Funds withheld at interest 204,256 Cash and other investments 106,656 ---------------------- Total investments 574,213 Reinsurance balances receivable 105,242 Amounts recoverable from reinsurers 713,248 Other assets 45,370 ---------------------- Total assets $ 1,438,073 ====================== Reserves for future policy benefits $ 951,899 Interest sensitive contract liabilities 177,485 Reinsurance balances payable 108,894 Other liabilities 15,141 ---------------------- Total liabilities $ 1,253,419 ======================
The following pro forma information related to our acquisition of ERC Life for the years ended December 31, 2003 and 2002 illustrates the effects of the acquisition as if it had occurred at the beginning of the periods presented.
Year Year Ended Ended December December 31, 2003 31, 2002 -------- -------- Revenue...................... $768,223 $473,032 Net income................... $ 67,663 $ 29,127 Earnings per ordinary share - Basic......................... $ 2.21 $ 1.16 Earnings per ordinary share - Diluted...................... $ 2.10 $ 1.10
On December 31, 2001, we completed the purchase of Scottish Re Holdings Limited and its wholly owned subsidiary Scottish Re Limited. We issued 4,532,380 ordinary shares with a value of $78.0 million to Pacific Life in exchange for all of the outstanding shares of Scottish Re Holdings Limited. The excess of the purchase price over net assets acquired was $35.5 million, which is recorded as goodwill on the balance sheet at December 31, 2003 and 2002. 82 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 4. Business acquisitions (Continued) The following pro forma information related to our acquisition of Scottish Re Holdings Limited for the year ended December 31, 2001 illustrates the effects of the acquisition as if it had occurred at the beginning of the period presented. Scottish Re Holdings Limited's results are for the year ended September 30, 2001.
Year Ended December 31, 2001 ---------------------- Revenue.................... $ 157,661 Net income................. $ 18,904 Earnings per ordinary share - Basic ................... $ 0.94 Earnings per ordinary share - Diluted ................ $ 0.90
The acquisitions described above were accounted for by the purchase method of accounting. In accordance with APB Opinion No. 16, "Business Combinations," the accompanying consolidated statements of income do not include any revenues or expenses related to this acquisition prior to the closing date. 5. Discontinued operations During 2003, we decided to discontinue our Wealth Management operations in Luxembourg. We have transferred our Luxembourg Wealth Management business to third parties, closed the office and are in the process of liquidating the company. We have reported the results of the Luxembourg Wealth Management activities as discontinued operations. During the year ended December 31, 2003 losses from these operations amounted to $2.0 million in comparison with $0.7 million in 2002. 83 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 6. Business segments We report segments in accordance with SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information". Our main lines of business are Life Reinsurance North America, Life Reinsurance International and Wealth Management. The segment reporting for the lines of business is as follows:
Year Ended December 31, 2003 ----------------------------------------------------------------- Life Reinsurance Life North Reinsurance Wealth America International Management Other Total --------- --------- --------- --------- --------- Premiums earned ......... $ 230,708 $ 161,268 $ -- $ -- $ 391,976 Investment income, net .. 135,731 7,537 205 4,555 148,028 Realized gains (losses) . (6,124) 548 35 1,093 (4,448) Change in value of embedded derivative ..... 13,903 -- -- -- 13,903 Fee income .............. 4,067 -- 3,840 -- 7,907 --------- --------- --------- --------- --------- Total revenues ....... 378,285 169,353 4,080 5,648 557,366 --------- --------- --------- --------- --------- Claims and other policy benefits ................ 171,711 104,152 -- -- 275,863 Interest credited to interest sensitive contract liabilities .... 89,156 24 -- -- 89,180 Acquisition costs and other insurance expenses, net ..................... 83,594 30,143 2,263 -- 116,000 Operating expenses ...... 8,646 11,518 468 10,389 31,021 Interest expense ........ 1,109 -- -- 6,448 7,557 --------- --------- --------- --------- --------- Total benefits and expenses ............. 354,216 145,837 2,731 16,837 519,621 --------- --------- --------- --------- --------- Income (loss) before income taxes and minority interest ................ $ 24,069 $ 23,516 $ 1,349 $ (11,189) $ 37,745 ========= ========= ========= ========= =========
Year Ended December 31, 2002 ----------------------------------------------------------------- Life Reinsurance Life North Reinsurance Wealth America International Management Other Total --------- --------- --------- --------- --------- Premiums earned ......... $ 122,794 $ 79,742 $ -- $ -- $ 202,536 Investment income, net .. 97,406 6,716 15 3,769 107,906 Realized gains (losses) . (4,833) (5,942) (208) 179 (10,804) Fee income .............. 3,148 -- 3,426 -- 6,574 --------- --------- --------- --------- --------- Total revenues ....... 218,515 80,516 3,233 3,948 306,212 --------- --------- --------- --------- --------- Claims and other policy benefits ................ 91,774 50,384 -- -- 142,158 Interest credited to interest sensitive contract liabilities .... 48,140 -- -- -- 48,140 Acquisition costs and other insurance expenses, net ..................... 48,401 8,281 3,391 -- 60,073 Operating expenses ...... 7,323 6,647 1,017 8,099 23,086 Interest expense ........ -- -- -- 1,414 1,414 --------- --------- --------- --------- --------- Total benefits and expenses ............. 195,638 65,312 4,408 9,513 274,871 --------- --------- --------- --------- --------- Income (loss) before income taxes and minority interest ................ $ 22,877 $ 15,204 $ (1,175) $ (5,565) $ 31,341 ========= ========= ========= ========= =========
84 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 6. Business segments (continued)
Year Ended December 31, 2001 ----------------------------------------------------------------- Life Reinsurance Life North Reinsurance Wealth America International Management Other Total --------- --------- --------- --------- --------- Premiums earned ............$ 68,344 $ -- $ -- $ -- $ 68,344 Investment income, net ..... 44,151 -- 68 7,472 51,691 Realized gains (losses) .... (4,500) -- -- 618 (3,882) Fee income ................. 1,686 -- 3,123 -- 4,809 --------- ------ --------- --------- --------- Total revenues .......... 109,681 -- 3,191 8,090 120,962 --------- ------ --------- --------- --------- Claims and other policy benefits ................... 51,245 -- -- -- 51,245 Interest credited to interest sensitive contract liabilities ....... 17,578 -- -- -- 17,578 Acquisition costs and other insurance expenses, net ........................ 23,411 -- 917 -- 24,328 Operating expenses ......... 3,191 -- 897 5,085 9,173 Interest expense ........... -- -- -- 1,405 1,405 --------- ------ --------- --------- --------- Total benefits and expenses ................ 95,425 -- 1,814 6,490 103,729 --------- ------ --------- --------- --------- Income before income taxes and minority interest $ 14,256 $ -- $ 1,377 $ 1,600 $ 17,233 ========= ====== ========= ========= =========
December 31, December 31, Assets 2003 2002 -------------- -------------- Life Reinsurance: North America.............. $ 4,882,222 $ 2,236,089 International.............. 308,459 265,658 -------------- -------------- Total Life Reinsurance........... 5,190,681 2,501,747 Wealth Management................ 789,543 681,534 Other............................ 73,293 107,945 -------------- -------------- Total............................ $ 6,053,517 $ 3,291,226 ============== ==============
85 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 7. Foreign sales and operations Our operations include Bermuda, the Cayman Islands, Guernsey, Ireland, the United Kingdom and the United States. Financial information relating to geographic areas:
Year Ended Year Ended Year Ended December December December 31, 31, 2003 31, 2002 2001 ------------ ------------ ------------ Revenues U.S. business......................... $ 405,197 $ 218,515 $ 109,680 Non--U.S. business..................... 152,169 87,697 11,282 ------------ ------------ ------------ Total................................. $ 557,366 $ 306,212 $ 120,962 ============ ============ ============
8. Earnings per ordinary share The following table sets forth the computation of basic and diluted earnings per ordinary share:
Year Ended Year Ended Year Ended December 31, December 31, December 31, 2003 2002 2001 -------------- -------------- -------------- Numerator: Net income ......................... $ 27,280 $ 32,524 $ 16,839 ============== ============== ============== Denominator: Denominator for basic earnings per ordinary share Weighted average number of ordinary shares .................. 30,652,719 25,190,283 15,646,106 Effect of dilutive securities - Stock options .................. 885,552 839,387 660,387 - Warrants ....................... 689,730 475,942 178,845 -------------- -------------- -------------- Denominator for dilutive earnings per ordinary share ............... 32,228,001 26,505,612 16,485,338 ============== ============== ============== Basic earnings per share: Income from continuing operations $ 1.59 $ 1.32 $ 1.10 Cumulative effect of change in accounting principle ............ (0.64) -- (0.02) Discontinued operations ......... (0.06) (0.03) -- -------------- -------------- -------------- Net income ...................... $ 0.89 $ 1.29 $ 1.08 ============== ============== ============== Diluted earnings per share: Income from continuing operations $ 1.51 $ 1.25 $ 1.05 Cumulative effect of change in accounting principle ............ (0.60) -- (0.03) Discontinued operations ......... (0.06) (0.02) -- -------------- -------------- -------------- Net income ...................... $ 0.85 $ 1.23 $ 1.02 ============== ============== ==============
86 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 9. Investments The amortized cost, gross unrealized appreciation and depreciation and estimated fair values of our fixed maturity investments and preferred stock at December 31, 2003 and 2002 are as follows:
December 31, 2003 -------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Appreciation Depreciation Value ---------- ---------- ---------- ---------- U.S. Treasury securities and U.S. .. government agency obligations ... $ 74,548 $ 408 $ (400) $ 74,556 Corporate securities ............... 1,223,871 26,339 (4,122) 1,246,088 Municipal bonds .................... 1,800 5 -- 1,805 Mortgage and asset backed securities 818,488 10,292 (10,061) 818,719 ---------- ---------- ---------- ---------- Total .............................. $2,118,707 $ 37,044 $ (14,583) $2,141,168 ========== ========== ========== ==========
December 31, 2002 -------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Appreciation Depreciation Value ---------- ---------- ---------- ---------- U.S. Treasury securities and U.S. .. government agency obligations ... $ 12,943 $ 865 $ -- $ 13,808 Corporate securities ............... 537,601 17,657 (5,322) 549,936 Municipal bonds .................... 1,659 -- (1) 1,658 Mortgage and asset backed securities 439,101 10,265 (10,822) 438,544 ---------- ---------- ---------- ---------- Total .............................. $ 991,304 $ 28,787 $ (16,145) $1,003,946 ========== ========== ========== ==========
The contractual maturities of the fixed maturities are as follows (actual maturities may differ as a result of calls and prepayments):
December 31, 2003 ------------------------------ Amortized Estimated Cost Fair Value ------------- ------------- Due in one year or less........................... $ 51,076 $ 51,537 Due in one year through five years................ 409,451 419,879 Due in five years through ten years............... 596,079 604,697 Due after ten years............................... 118,153 119,888 ------------- ------------- 1,174,759 1,196,001 Mortgage and asset backed securities.............. 818,488 818,718 ------------- ------------- Total............................................. $ 1,993,247 $ 2,014,719 ============= =============
87 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 9. Investments (continued) Gross realized gains and losses are as follows:
Year Ended Year Ended Year Ended December December December 31, 2003 31, 2002 31, 2001 ------------ ------------ ------------ Proceeds from sale of investments...... $ 307,141 $ 183,588 $ 297,337 ============ ============ ============ Gross realized gains................... $ 7,796 $ 7,968 $ 5,160 Gross realized losses (1).............. (13,506) (18,595) (9,064) ------------ ------------ ------------ Net realized losses.................... (5,710) (10,627) (3,904) Other gains and losses................. 1,262 (177) 22 ------------ ------------ ------------ Realized losses........................ $ (4,648) $ (10,804) $ (3,882) ============ ============ ============
- ------------------ (1) Includes $ 6.3 million, $10.0 million and $4.0 million in 2003, 2002 and 2001, respectively in respect of fixed maturity investments written down to estimated realizable values and $2.9 million, $2.5 million and $2.9 million in 2003, 2002 and 2001 respectively in respect of modified coinsurance receivables written down to estimated realizable values. At December 31, 2003 and 2002, we did not have a material concentration of investments in fixed income securities in a single issuer, industry or geographic location. The following tables provide information on the length of time securities have been continuously in an unrealized loss position:
December 31, 2003 ---------------------------------------------------------------------- Estimated Fair Unrealized Days Book Value % Value % Loss % - ---- ---------- ----- -------- ----- -------- ----- Dollars in thousands 0-90 ........... $308,267 55.6% $304,511 56.4% $ (3,756) 25.8% 91-180 ......... 115,702 20.9 113,405 21.0 (2,297) 15.8 181-270 ........ 56,362 10.1 55,243 10.2 (1,119) 7.7 271-360 ........ 13,486 2.4 13,064 2.4 (422) 2.9 Greater than 360 60,882 11.0 53,893 10.0 (6,989) 47.8 -------- ----- -------- ----- -------- ----- Total .......... $554,699 100.0% $540,116 100.0 $(14,583) 100.0% ======== ===== ======== ===== ======== =====
December 31, 2002 ---------------------------------------------------------------------- Estimated Fair Unrealized Days Book Value % Value % Loss % - ---- ---------- ----- -------- ----- -------- ----- Dollars in thousands 0-90 ............ $ 81,724 38.3% $ 79,557 40.3% $ (2,167) 13.4% 91-180 .......... 53,663 25.1 50,082 25.4 (3,581) 22.2 181-270 ......... 21,621 10.1 17,759 9.0 (3,862) 23.9 271-360 ......... 7,227 3.4 6,212 3.1 (1,015) 6.3 Greater than 360 49,420 23.1 43,900 22.2 (5,520) 34.2 -------- ----- -------- ----- -------- ----- Total ........... $213,655 100.0% $197,510 100.0% $(16,145) 100.0% ======== ===== ======== ===== ======== =====
88 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 10. Funds withheld at interest At December 31, 2003, funds withheld at interest were in respect of six fixed annuity reinsurance contracts with three ceding companies. At December 31, 2002 we had four fixed annuity reinsurance contracts with two ceding companies. We had three contracts with Lincoln National Insurance Company that accounted for $1.3 billion at December 31, 2003 and $1.1 billion at December 31, 2002, which represented 86% and 98% of the funds withheld balances. The other contracts were with Illinois Mutual Insurance Company and American Founders Life Insurance Company. Lincoln National Insurance Company has financial strength ratings of "A+" from A.M. Best, "AA-" from Standard & Poor's, "Aa3" from Moody's and "AA" from Fitch. In the event of insolvency of the ceding companies on these arrangements we would need to exert a claim on the assets supporting the contract liabilities. However, the risk of loss is mitigated by our ability to offset amounts owed to the ceding company with the amounts owed to us by the ceding company. According to data provided by our ceding companies, the amortized cost, gross unrealized appreciation and depreciation and estimated fair values of assets, excluding cash, backing our funds withheld at interest at December 31, 2003 and 2002 are as follows:
December 31, 2003 ------------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Appreciation Depreciation Value ----------- ----------- ----------- ----------- U.S. Treasury securities and U.S. .. government agency obligations .... $ 31,577 $ 526 $ (144) $ 31,959 Corporate securities ............... 970,157 77,966 (2,074) 1,046,049 Municipal bonds .................... 22,481 835 (248) 23,068 Mortgage and asset backed securities 318,151 12,254 (1,482) 328,923 ----------- ----------- ----------- ----------- 1,342,366 91,581 (3,948) 1,429,999 Commercial mortgage loans .......... 120,178 9,694 (496) 129,376 ----------- ----------- ----------- ----------- Total .............................. $ 1,462,544 $ 101,275 $ (4,444) $ 1,559,375 =========== =========== =========== ===========
December 31, 2002 ------------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Appreciation Depreciation Value ----------- ----------- ----------- ----------- U.S. Treasury securities and U.S. .. government agency obligations .... $ 10,230 $ 343 $ -- $ 10,573 Corporate securities ............... 778,251 56,377 (12,468) 822,160 Municipal bonds .................... 501 8 -- 509 Mortgage and asset backed securities 201,887 11,364 (101) 213,150 ----------- ----------- ----------- ----------- 990,869 68,092 (12,569) 1,046,392 Commercial mortgage loans .......... 101,360 10,908 -- 112,268 ----------- ----------- ----------- ----------- Total .............................. $ 1,092,229 $ 79,000 $ (12,569) $ 1,158,660 =========== =========== =========== ===========
89 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 10. Funds withheld at interest (continued) According to data provided by our ceding companies, the contractual maturities (excluding cash) of the assets backing our funds withheld fixed maturities are as follows (actual maturities may differ as a result of calls and prepayments):
December 31, 2003 ------------------------------- Estimated Fair Amortized Cost Value ------------- -------------- Due in one year or less..................... $ 10,582 $ 10,938 Due in one year through five years.......... 268,943 288,941 Due in five years through ten years......... 665,959 720,158 Due after ten years......................... 78,731 81,039 ------------- -------------- 1,024,215 1,101,076 Mortgage and asset backed securities........ 318,151 328,923 ------------- -------------- Total ..................................... $ 1,342,366 $ 1,429,999 ============= ==============
11. Reinsurance ceded Premiums earned are analyzed as follows
Year ended Year ended Year ended December 31, December 31, December 31, 2003 2002 2001 ------------- -------------- -------------- Premiums assumed............ $ 415,653 $ 210,166 $ 68,581 Premiums ceded............... (23,677) (7,630) (237) ------------- -------------- -------------- Premiums earned.............. $ 391,976 $ 202,536 $ 68,344 ============= ============== ==============
Reinsurance contracts do not relieve us from our obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to us. We evaluate the financial condition of our reinsurers to minimize our exposure to losses from reinsurer insolvencies. Claims and other policy benefits are net of reinsurance recoveries of $21.4 million and $8.5 million during the years ended December 31, 2003 and 2002. 90 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 12. Present value of in-force business A reconciliation of the present value of in-force business is as follows:
December December December 31, 2003 31, 2002 31, 2001 -------- -------- -------- Balance at beginning of year................ $ 18,181 $ 20,383 $ 10,433 Acquisition of Scottish Re Holdings Limited. -- -- 10,156 Amortization................................ (4,926) (2,777) (206) Other....................................... 224 575 -- -------- -------- -------- Balance at end of year...................... $ 13,479 $ 18,181 $ 20,383 ======== ======== ========
Future estimated amortization of the present value of in-force business is as follows: Year ending December 31 ----------------------- 2004 .................. 2,418 2005 .................. 1,899 2006 .................. 2,057 2007 .................. 1,987 2008 .................. 2,284 Thereafter ............ 2,834 13. Reinsurance transactions The following table summarizes the acquisitions of in-force reinsurance transactions completed by us during 2002 and 2001. There were no acquisitions of in-force reinsurance transactions in 2003. These transactions are accounted for as purchases. Our results of operations include the effects of these purchases only from the respective acquisition dates.
December December 31, 2002 31, 2001 -------- -------- Fair value of assets acquired ... $ 26,032 $107,353 Deferred acquisition costs ...... 6,571 11,000 -------- -------- Total assets acquired ........... $ 32,603 $118,353 ======== ======== Fair value of liabilities assumed $ 32,603 $118,353 ======== ========
91 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 14. Deferred acquisition costs The change in deferred acquisition costs is as follows:
December December December 31, 2003 31, 2002 31, 2001 --------- --------- --------- Balance beginning of period ............. $ 213,516 $ 113,898 $ 30,922 Expenses deferred ....................... 167,185 129,306 83,092 Amortization expense .................... (74,239) (28,178) (11,116) Deferred acquisition costs on in-force reinsurance transactions purchased .... -- 6,571 11,000 Deferred acquisition costs on realized losses ................................ 2,129 (8,081) -- --------- --------- --------- Balance at end of year .................. $ 308,591 $ 213,516 $ 113,898 ========= ========= =========
15. Long-term debt Long-term debt consists of:
December December 31, 2003 31, 2002 --------- --------- 4.5% senior convertible notes due 2022............... $ 115,000 $ 115,000 Capital securities due 2032.......................... 17,500 17,500 Preferred trust securities due 2033.................. 20,000 - Trust preferred securities due 2033.................. 10,000 - --------- --------- $ 162,500 $ 132,500 ========= =========
4.5% Senior convertible notes On November 22, 2002 and November 27, 2002 we issued $115.0 million (which includes an over allotment option of $15.0 million) of 4.5% senior convertible notes, which are due December 1, 2022, to qualified institutional buyers. The notes are general unsecured obligations, ranking on parity in right of payment with all our existing and future unsecured senior indebtedness, and senior in right of payment with all our future subordinated indebtedness. Interest on the notes is payable on June 1 and December 1 of each year. The notes are rated Baa2 by Moody's and BBB- by Standard & Poor's. The notes are convertible into our ordinary shares initially at a conversion rate of 46.0617 ordinary shares per $1,000 principal amount of notes (equivalent to an initial conversion price of $21.71 per ordinary share), subject to our right to deliver, in lieu of our ordinary shares, cash or a combination of cash and our ordinary shares. The notes are redeemable at our option in whole or in part beginning on December 6, 2006, at a redemption price equal to 100% of the principal amount of the notes plus accrued and unpaid interest. The notes are subject to repurchase by us upon a change of control of Scottish Re or at a holder's option on December 6, 2006, December 1, 2010, December 1, 2012 and December 1, 2017, at a repurchase price equal to 100% of the principal amount of the notes plus accrued and unpaid interest. The notes are due on December 1, 2022 unless earlier converted, redeemed by us at our option or repurchased by us at a holder's option. 92 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 15. Long-term debt(continued) A holder may surrender notes for conversion prior to the stated maturity only under the following circumstances: o during any conversion period if the sale price of our ordinary shares for at least 20 trading days in the period of 30 consecutive trading days ending on the first day of the conversion period exceeds 120% of the conversion price in effect on that 30th trading day; o during any period in which the notes are rated by either Moody's Investors Service, Inc. or Standard & Poor's Rating Group and the credit rating assigned to the notes by either rating agency is downgraded by two levels or more, suspended or withdrawn; o if we have called those notes for redemption; or o upon the occurrence of the certain specified corporate transactions. Under a registration rights agreement, we agreed to file with the Securities and Exchange Commission, a shelf registration statement, for resale of the notes and our ordinary shares issuable upon conversion of the notes. This registration statement has been filed and later declared effective by the Securities and Exchange Commission on April 4, 2003. Capital securities On December 4, 2002, Scottish Holdings Statutory Trust I, a Connecticut statutory business trust ("Capital Trust I") issued and sold in a private offering $17.5 million Capital Floating Rate Capital Securities ("the capital securities"). All of the common shares of Capital Trust I are owned by Scottish Holdings, Inc., our wholly owned subsidiary. The capital securities mature on December 4, 2032. They are redeemable in whole or in part at any time after December 4, 2007. Interest is payable quarterly at a rate equivalent to 3 month LIBOR plus 4%. At December 31, 2003 and December 31, 2002, the interest rates were 5.15% and 5.38%, respectively. Prior to December 4, 2007, interest cannot exceed 12.5%. Capital Trust I may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than December 4, 2032. Any deferred payments would accrue interest quarterly on a compounded basis if Scottish Holdings, Inc. defers interest on the Debentures due December 4, 2032 (as described below). The sole assets of Capital Trust I consist of $18.0 million principal amount of Floating Rate Debentures (the "Debentures") issued by Scottish Holdings, Inc. The Debentures mature on December 4, 2032 and interest is payable quarterly at a rate equivalent to 3 month LIBOR plus 4%. At December 31, 2003 and December 31, 2002, the interest rates were 5.15% and 5.38%, respectively. Prior to December 4, 2007, interest cannot exceed 12.5%. Scottish Holdings, Inc. may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than December 4, 2032. Any deferred payments would accrue interest quarterly on a compounded basis. Scottish Holdings, Inc. may redeem the Debentures at any time after December 4, 2007 and in the event of certain changes in tax or investment company law. Scottish Annuity & Life Insurance Company (Cayman) Ltd. has guaranteed Scottish Holdings, Inc.'s obligations under the Debentures and distributions and other payments due on the capital securities. 93 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 15. Long-term debt(continued) Preferred trust securities On October 29, 2003, Scottish Holdings, Inc. Statutory Trust II, a Connecticut statutory business trust ("Capital Trust II") issued and sold in a private offering of $20.0 million Preferred Trust Securities ("the preferred trust securities"). All of the common shares of Capital Trust II are owned by Scottish Holdings, Inc. The preferred trust securities mature on October 29, 2033. They are redeemable in whole or in part at any time after October 29, 2003. Interest is payable quarterly at a rate equivalent to 3 month LIBOR plus 3.95%. At December 31, 2003, the interest rate was 5.10%. Prior to October 29, 2008, interest cannot exceed 12.45%. Capital Trust II may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than October 29, 2033. Any deferred payments would accrue interest quarterly on a compounded basis if Scottish Holdings, Inc. defers interest on the Floating Rate Debentures due October 29, 2033 (as described below). The sole assets of Capital Trust II consist of $20.6 million principal amount of Floating Rate Debentures issued by Scottish Holdings, Inc. The Floating Rate Debentures mature on October 29, 2033 and interest is payable quarterly at 3 month LIBOR plus 3.95%. At December 31, 2003 the interest rate was 5.10%. Prior to October 29, 2008, interest cannot exceed 12.45%. Scottish Holdings, Inc. may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than October 29, 2033. Any deferred payments would accrue interest quarterly on a compounded basis. Scottish Holdings, Inc. may redeem the Floating Rate Debentures at any time after October 29, 2008 and in the event of certain changes in tax or investment company law. Scottish Annuity & Life Insurance Company (Cayman) Ltd. has guaranteed Scottish Holdings, Inc.'s obligations under the Floating Rate Debentures and distributions and other payments due on the preferred trust securities. Trust Preferred Securities On November 14, 2003, GPIC Holdings Inc. Statutory Trust, a Delaware statutory business trust ("GPIC Trust") issued and sold in a private offering of $10.0 million Trust Preferred Securities ("the trust preferred securities"). All of the common shares of GPIC Trust are owned by Scottish Holdings, Inc. The trust preferred securities mature on September 30, 2033. They are redeemable in whole or in part at any time after September 30, 2008. Interest is payable quarterly at a rate equivalent to 3 month LIBOR plus 3.90%. At December 31, 2003, the interest rate was 5.05%. GPIC Trust may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than September 30, 2033. Any deferred payments would accrue interest quarterly on a compounded basis if Scottish Holdings, Inc. defers interest on the Junior Subordinated Notes due September 30, 2033 (as described below). The sole assets of GPIC Trust consist of $10.3 million principal amount of Junior Subordinated Notes issued by Scottish Holdings, Inc. The Notes mature on September 30, 2033 and interest is payable quarterly at 3 month LIBOR plus 3.90%. At December 31, 2003 the interest rate was 5.05%. Scottish Holdings, Inc. may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than September 30, 2033. Any deferred payments would accrue interest quarterly on a compounded basis. Scottish Holdings, Inc. may redeem the Notes at any time after September 30, 2008 and in the event of certain changes in tax or investment company law. Scottish Annuity & Life Insurance Company (Cayman) Ltd. has guaranteed Scottish Holdings, Inc.'s obligations under the Notes and distributions and other payments due on the trust preferred securities. 94 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 16. Mezzanine equity On December 17, and December 22, 2003, we issued in a public offering 5,750,000 HyCUs. The aggregate net proceeds were $141.9 million. Each HyCU consists of: o A purchase contract under which the holder agrees to purchase an agreed upon number of ordinary shares on February 15, 2007 at a purchase price of $25.00; and o A convertible preferred share with a liquidation preference of $25, convertible into ordinary shares, which we will settle in cash and ordinary shares on May 21, 2007. The agreed upon number of shares that a purchase contract will be settled for is called the "settlement rate". The settlement rate on each purchase contract is as follows: o If the average closing price per ordinary share on each of the 20 consecutive trading days ending on the fourth trading day preceding February 15, 2007 (the "Applicable Market Value"), is less than or equal to $19.32, then each purchase contract will be settled for 1.294 ordinary shares. o If the Applicable Market Value is greater than $19.32, then each purchase contract will be settled for a number of ordinary shares by dividing $25 by the Applicable Market Value. The convertible shares will be initially convertible into 1.0607 ordinary shares per $25 liquidation preference (referred to as the "conversion rate"), subject to anti-dilution adjustments. This reflects an initial conversion price of $23.57. Upon conversion we will deliver cash equal to the $25 liquidation preference and ordinary shares for the value of the excess, if any, of the conversion obligation minus the liquidation preference. The conversion obligation is the conversion rate at the time of conversion multiplied by the average trading price of our ordinary shares for a specified period following the redemption date. Amounts will accumulate under the HyCUs at a rate of 5.875% per year, payable quarterly beginning February 14, 2004. These amounts will consist of: o Quarterly contract adjustment payments at a rate of 4.875% per year; and o Dividends at a rate of 1.00% per year on the convertible preferred shares, payable quarterly when declared by our board of directors. We may defer contract adjustment payments until no later than the purchase contract settlement date. Each convertible preferred share is pledged to us to secure the holder's obligation under the purchase contract. A holder of the HyCU can obtain the release of the pledged convertible share by substituting zero-coupon treasury securities as security for the obligation under the purchase contract. The resulting unit is then known as a Treasury Unit. Holders of Treasury Units can recreate HyCUs by re-substituting the convertible preferred shares and withdrawing the treasury securities. The convertible preferred shares will be mandatorily redeemed on May 21, 2007. We have accounted for the HyCUs in accordance with SFAS No. 150 " Accounting for Certain Instruments with Characteristics of Debt and Equity". Accordingly, the HyCUs have been recorded as mezzanine equity of $141.9 million, which is net of issuance costs related to the convertible preferred shares. The present value of the 95 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 16. Mezzanine equity (continued) contract adjustment payments (discounted at a rate of 4.75%) of $20.5 million has been included in other liabilities and resulted in a decrease in additional paid-in capital at the date of issuance. Issue costs on the forward contract have also been included in additional paid-in capital. The dividends on the convertible preferred shares are included in interest expense. 17. Shareholders' equity Ordinary shares We are authorized to issue 100,000,000 ordinary shares of par value $0.01 each. During 2001 we issued 98,336 ordinary shares to employees upon the exercise of stock options. In September 2001, 100,000 ordinary shares were repurchased for $1.5 million. On December 31, 2001 we issued 4,532,380 ordinary shares to Pacific Life to acquire Scottish Re Holdings Limited, resulting in 20,144,956 outstanding ordinary shares. On April 4, 2002, we completed a public offering of 6,750,000 ordinary shares (which included the over-allotment option of 750,000 ordinary shares) in which we raised aggregate net proceeds of $114.3 million. We used the proceeds of the equity offering to repay short-term borrowings of $40 million and the remainder for general corporate purposes. During 2002, we issued 32,500 shares to employees upon the exercise of stock options. On July 23, 2003, we completed a public offering of 9,200,000 ordinary shares (which included an over-allotment option of 1,200,000 ordinary shares) in which we raised aggregate net proceeds of $180.1 million. We used $30.0 million of these proceeds to repurchase 1,525,000 ordinary shares from Pacific Life at a purchase price of $19.66 per share. During the year ended December 31, 2003 we issued 180,000 ordinary shares to employees upon the exercise of stock options. During the year ended December 31, 2003 we issued 200,000 ordinary shares upon the exercise of Class A warrants and we repurchased 200,000 Class B warrants for $3.0 million. At December 31, 2003, there were 35,228,411 outstanding ordinary shares. Preferred shares We are authorized to issue 50,000,000 preferred shares of par value $0.01 each. On December 17 and December 22, 2003, in connection with our HyCU offering, we issued 5,750,000 convertible preferred shares having a per share liquidation preference of $25 and an initial conversion rate of 1.067 ordinary shares per $25 liquidation preference, subject to anti-dilution adjustments. The convertible preferred shares have a 1% annual dividend rate and will be mandatorily redeemed by us on May 21, 2007. See Note 16 for additional description of the terms of the convertible preferred shares. 96 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 17. Shareholders' equity (continued) Warrants At December 31, 2002 there were 2,850,000 Class A warrants and 200,000 Class B warrants outstanding, each class with an exercise price of $15.00. During the year ended December 31, 2003 we issued 200,000 ordinary shares upon the exercise of Class A warrants and we repurchased 200,000 Class B warrants for $3.0 million. As at December 31, 2003 there are 2,650,000 Class A warrants outstanding. In connection with our initial capitalization, we issued Class A warrants to purchase an aggregate of 1,550,000 ordinary shares to related parties. The aggregate consideration of $0.1 million paid for these warrants is reflected as additional paid-in capital. In connection with our initial public offering, we issued an aggregate of 1,300,000 Class A warrants. All Class A warrants are exercisable at $15.00 per ordinary share, in equal amounts over a three-year period commencing November 1999 and expire in November 2008. 18. Employee benefit plans Pension plan We provide retirement benefits to the majority of employees, under defined contribution plans. Defined contribution plan expenses totaled $1.1 million, $878,000 and $414,000 for the years ended December 31, 2003, 2002 and 2001, respectively. In 2002 pension benefits were provided to Scottish Re Holdings Limited employees under a defined benefit pension plan. During 2003, we established a defined contribution plan for Scottish Re Holdings Limited. New employees in 2003 joined this plan and a number of employees transferred from the defined benefit scheme to the defined contribution scheme. A small number of employees remain in the defined benefit plan and, additionally, there are preserved benefits for some transferees and some ex-employees in the defined benefit plan. 97 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 18. Employee benefit plans (continued) The defined benefit plan asset activity and movement on the defined benefit plan obligation is as follows:
December December 31, 2003 31, 2002 ------- ------- Change in plan assets Fair value of plan assets at beginning of year $ 4,395 $ 3,838 Foreign currency translation adjustment ...... 712 -- Actual return on plan assets ................. 721 (515) Contributions ................................ 2,487 1,330 Benefits paid ................................ (72) (258) ------- ------- Fair value of plan assets at end of year ..... $ 8,243 $ 4,395 ======= =======
December December 31, 2003 31, 2002 ------- ------- Change in benefit obligation Benefit obligation at beginning of year $ 6,120 $ 4,155 Foreign currency translation adjustment 738 -- Service cost .......................... 508 314 Interest cost ......................... 363 243 Actuarial loss ........................ 524 1,666 Benefits paid ......................... (72) (258) ------- ------- Benefits obligation at end of year ..... $ 8,181 $ 6,120 ======= ======= Funded status .......................... $ 62 $(1,725) Unrecognized net loss .................. 2,747 2,475 ------- ------- Prepaid benefit cost ................... $ 2,809 $ 750 ======= ======= Amounts recognized in the statement of financial position consist of: Prepaid benefit cost ......................... $ 2,809 $ 750 Accumulated other comprehensive income ....... -- (1,959) ========= ========= Net amount recognized ........................ $ 2,809 $ (1,209) ========= ========= Weighted average assumptions as of December 31, 2003 and 2002 Weighted average discount rate ............. 5.50% 5.50% Expected return on plan assets ............. 6.50% 6.50% Rate of salary increases ................... 4.25% 4.25% Rate of inflation .......................... 2.5% 2.25%
98 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 18. Employee benefit plans (continued) Plan assets are invested in third party investment funds that are managed externally. The assets consist of equities, fixed maturities and cash. The components of net defined benefit pension costs are as follows:
Year Ended Year Ended December December 31, 2003 31, 2002 -------- -------- Service cost ................. $ 553 $ 314 Interest cost ................ 395 243 Expected return on plan assets (346) (295) Loss amortization ............ 115 -- -------- -------- Net periodic pension cost .. $ 717 $ 262 ======== ========
As a result of the accumulated benefit obligation being in excess of plan assets at December 31, 2002 a minimum pension liability adjustment, net of tax, of $1.4 million net was recorded in other accumulated comprehensive income. At December 31, 2003, plan assets were in excess of the accumulated benefit obligation resulting in a change in other comprehensive income of $1.4 million. 401(k) plan We sponsor a 401(k) plan in the U.S. in which employee contributions on a pre-tax basis are supplemented by matching contributions. These contributions are invested, at the election of the employee, in one or more investment portfolios. Expenses for the plan amounted to $482,000, $390,000 and $269,000, respectively, in the years ended December 31, 2003, 2002 and 2001. Stock option plans We have four stock option plans (the "1998 Plan", the "1999 Plan", the "Harbourton Plan" and the "2001 Plan", collectively the "Plans"), which allow us to grant non-statutory options, subject to certain restrictions, to certain eligible employees, non-employee directors, advisors and consultants. The minimum exercise price of the options will be equal to the fair market value, as defined in the Plans, of our ordinary shares at the date of grant. The term of the options is between seven and ten years from the date of grant. Unless otherwise provided in each option agreement, all granted options issued prior to December 31, 2001 become exercisable in three equal annual installments. Commencing January 1, 2002, all granted options will become exercisable in five equal installments commencing on the first anniversary of the grant date, except for annual grants of 2,000 to each director, which are fully exercisable on the date of grant. Total options authorized under the Plans are 3,750,000. In prior years, we adopted the provisions of APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for employee stock options. Since the exercise price of the stock options equals or exceeds the market price of the underlying stock on the date of grant, no compensation expense was recognized. In December 2002, the Financial Accounting Standards Board issued SFAS No.148, "Accounting for Stock-Based Compensation - Transition and Disclosure, an Amendment of FASB Statement No. 123". Effective 99 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 18. Employee benefit plans (continued) January 1, 2003, we adopted the modified prospective method of fair value-based stock option expense provisions of SFAS No. 123 as amended by SFAS No. 148. Compensation expense has been recognized for all stock options granted since January 1, 2003. This has resulted in a charge to income of $207,000 in the year ended December 31, 2003. Pro forma information regarding net income and earnings per share for all outstanding stock options is required by SFAS No. 148 and has been determined as if we accounted for all employee stock options under the fair value method of that Statement. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period using the Black-Scholes model. The Black-Scholes and Binomial option-pricing models were developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected price volatility. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our employee stock options. Option activity under all Plans is as follows:
Year Ended Year Ended Year Ended December 31, December 31, December 31, 2003 2002 2001 ---------- ---------- ---------- Outstanding, beginning of year 3,398,103 2,750,601 2,325,436 Granted ...................... 180,000 861,500 601,000 Exercised .................... (425,955) (32,500) (98,336) Cancelled .................... (64,831) (181,498) (77,499) ---------- ---------- ---------- Outstanding and exercisable, end of year .................. 3,087,317 3,398,103 2,750,601 ========== ========== ========== Weighted average exercise price per share: Granted ...................... $ 18.2515 $ 18.0262 $ 14.4486 Exercised .................... $ 10.7494 $ 8.5982 $ 13.2154 Cancelled .................... $ 18.2761 $ 14.2490 $ 10.6780 Outstanding and exercisable, end of year .................. $ 13.3634 $ 12.8706 $ 11.2963
100 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 18. Employee benefit plans (continued) Summary of options outstanding at December 31, 2003:
Weighted Weighted Weighted Average Number Weighted Average Year Number Average Remaining of Average Remaining of of Range of Exercise Contractual Shares Exercise Contractual Grant Shares Exercise Prices Price Life Vested Price Life --------- ------------------ ----------- ---- --------- ----------- ---- 1998 536,669 $ 15.0000 $ 15.00 4.92 536,669 $ 15.00 4.92 1999 566,850 $8.0625 - $15.0000 $ 9.57 4.01 566,850 $ 9.75 4.01 2000 679,333 $7.7500 - $ 9.7500 $ 8.22 5.87 679,333 $ 8.22 5.87 2001 396,165 $7.0000 - $18.7600 $ 14.52 6.39 259,018 $ 14.51 6.39 2002 728,300 $15.5000 - $21.5100 $ 18.05 8.15 176,300 $ 18.34 8.14 2003 180,000 $20.7600 - $17.1300 $ 18.25 9.43 14,000 $ 17.70 9.34 --------- ------------------ ----------- ---- --------- ----------- ---- 3,087,317 $7.0000 - $21.5100 $ 13.36 6.17 2,232,170 $ 11.78 5.43 ========= ================== =========== ==== ========= =========== ====
Option Option Plans Plans not Approved by Approved by Total Option Shareholders Shareholders Plans --------- --------- --------- Outstanding ................... 1,955,069 1,132,248 3,087,317 Weighted average exercise price $ 11.9778 $ 14.1659 $ 13.3634 Available for future issuance . 54,995 50,897 105,892
Pro forma information regarding net income and earnings per share is required by SFAS No. 148, and has been determined as if we accounted for all the employee stock options under the fair value method of that Statement. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, it requires the input of highly subjective assumptions including the expected price volatility. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our employee stock options. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period using the Black-Scholes model. Our pro forma information is as follows:
Year Year Year Ended Ended Ended December December December 31, 2003 31, 2002 31, 2001 -------- -------- -------- Net income-- as reported ....................... $ 27,280 $ 32,524 $ 16,839 Stock-based employee compensation cost, net of related tax effects, included in the determination of net income as reported ...... 207 639 -- Stock-based employee compensation cost, net of related tax effects, that would have been included in the determination of net income if the fair value based method had been applied to all awards ........................ (2,384) (3,432) (2,993) -------- -------- -------- Net income-- pro forma ......................... $ 25,103 $ 29,731 $ 13,846 ======== ======== ========
101 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 18. Employee benefit plans (continued)
Year Year Year Ended Ended Ended December December December 31, 2003 31, 2002 31, 2001 -------- -------- -------- Basic net income per share-- as reported...... $ 0.89 $ 1.29 $ 1.08 Basic net income per share-- pro forma........ $ 0.82 $ 1.17 $ 0.88 Diluted net income per share-- as reported.... $ 0.85 $ 1.23 $ 1.02 Diluted net income per share-- pro forma...... $ 0.78 $ 1.11 $ 0.84
The weighted average fair value of options granted in each year is as follows:
Year Ended Year Ended Year Ended December December December 31, 2003 31, 2002 31, 2001 --------- --------- --------- Discounted exercise price.................. -- -- -- Market price exercise price................ $ 6.8170 $ 6.5239 $ 6.7825 Premium exercise price..................... -- -- --
The fair value for the options was estimated at the date of grant using the Black-Scholes option-pricing model with the following assumptions:
2003 2002 2001 ------------- ------------ ------------- Expected dividend yield.................... 1.00% - 0.816% 1.00% 1.00% Risk free interest rate.................... 1.06% - 4.44% 1.09% - 4.14% 4.16% - 5.20% Expected life of options................... 7 years 7 years 7 years Expected volatility........................ 0.4 0.3 0.4
As of December 31, 2003, 60,501 options were outstanding in respect of non-employees (2002 - 89,001; 2001- Nil). In 2002 we modified the awards of certain employees on their termination of employment. The expense recorded in respect of this modification was $639,000. We apply the fair value method of SFAS No. 123 in accounting for stock options granted to non-employees who provide services to us. 19. Taxation There is presently no taxation imposed on income or capital gains by the Governments of Bermuda and the Cayman Islands. Our Bermuda companies have been granted an exemption from taxation in Bermuda until 2016. If any taxation were to be enacted in the Cayman Islands, Scottish Re and Scottish Annuity & Life Insurance Company (Cayman) Ltd. have been granted exemptions until 2018; and The Scottish Annuity Company (Cayman) Ltd. has been granted exemptions until 2014. These companies operate in a manner such that they will owe no U.S. tax other than premium excise taxes and withholding taxes on certain investment income. Undistributed earnings of our foreign subsidiaries are considered to be indefinitely reinvested and, accordingly, no provision for U.S. federal withholding taxes has been provided thereon. Upon distribution of current or accumulated earnings and profits in the form of dividends or otherwise, we would be subject to U.S. withholding taxes at a 5% rate. At December 31, 2003, we had net operating loss carryforwards of approximately $168.4 million (2002-$83.8 million) for income tax purposes that expire in years 2012 through 2018. These carryforwards resulted 102 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 19. Taxation (continued) primarily from our 1999 acquisition of Scottish Re (U.S.), Inc. and from current operations of Scottish Re (U.S.), Inc. Significant components of our deferred tax assets and liabilities are as follows:
December 31, December 31, 2003 2002 ------------ ------------ Deferred tax assets: Net operating losses....................... $ 61,077 $ 28,968 Reserves for future policy benefits........ 13,656 -- Unrealized depreciation on investments..... 483 -- Pension liability.......................... -- 363 Negative proxy deferred acquisition costs.. 1,816 389 Other...................................... 3,121 1,898 ------------ ------------ Total deferred tax assets.................... 80,153 31,618 ------------ ------------ Deferred tax liabilities:.................... Unrealized appreciation on investments..... (8,387) (5,147) Undistributed earnings of U.K. subsidiaries (6,315) (5,796) Deferred acquisition costs................. (21,893) (13,649) Pension liability.......................... (859) -- Reserves for future policy benefits........ (27,086) (13,415) Other...................................... (2,989) (2,682) ------------ ------------ Total deferred tax liabilities............... (67,529) (40,689) ------------ ------------ Net deferred tax asset (liability)........... $ 12,624 $ (9,071) ============ ============
For the years ended December 31, 2003, 2002 and 2001 we have income tax expense (benefit) from operations as follows:
Year Ended Year Ended Year Ended December December December 31, 2003 31, 2002 31, 2001 --------- --------- --------- Current tax payable.................... $ 1,075 $ 1,421 $ 1,351 Deferred tax benefit................... (12,180) (3,315) (1,292) --------- --------- --------- Total tax expense (benefit)............................. $ (11,105) $ (1,894) $ 59 ========= ========= =========
The income tax benefit in 2001 included $0.6 million related to a change in valuation allowance on capital loss carryforwards related to the purchase of Scottish Re (U.S.), Inc. that was due to management's ability to implement certain tax planning strategies to preserve the tax benefit of the losses. 103 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 19. Taxation (continued) Income tax expense (benefit) attributable to continuing operations differ from the amount of income tax expense (benefit) that would result from applying the federal statutory rates to pretax income from operating due to the following:
Year Ended Year Ended Year Ended December December December 31, 2003 31, 2002 31, 2001 --------- --------- --------- Pretax GAAP income at 34%.............. $ 12,833 $ 10,310 $ 5,859 Income not subject to tax at 34%....... (24,229) (16,819) (6,615) Foreign taxes.......................... 3,109 3,997 1,265 Negative DAC........................... (1,427) 695 61 Change in valuation allowance.......... -- -- (552) Other state taxes...................... (1,391) (77) 41 --------- --------- --------- Total tax (benefit) expense............ $ (11,105) $ (1,894) $ 59 ========= ========= =========
20. Statutory requirements and dividend restrictions Our Bermuda insurance companies are required to maintain a minimum capital of $0.25 million. Under The Insurance Law of the Cayman Islands, Scottish Annuity & Life Insurance Company (Cayman) Ltd. and The Scottish Annuity Company (Cayman) Ltd. must each maintain a minimum net capital worth of $0.24 million. Our ability to pay dividends depends significantly on the ability of Scottish Annuity & Life Insurance Company (Cayman) Ltd., The Scottish Annuity Company (Cayman) Ltd. and Scottish Re Holdings Limited to pay dividends to Scottish Re. While we are not subject to any significant legal prohibitions on the payment of dividends, Scottish Annuity & Life Insurance Company (Cayman) Ltd. and The Scottish Annuity Company (Cayman) Ltd. are subject to the Cayman Islands regulatory constraints, which affect their ability to pay dividends. Scottish Annuity & Life Insurance Company (Cayman) Ltd. and The Scottish Annuity Company (Cayman) Ltd. are prohibited from declaring or paying a dividend if such payment would reduce their net capital worth below $0.24 million. The maximum amount of dividends that can be paid by Scottish Re (U.S.), Inc. (a Delaware domiciled insurance company) without prior approval of the Insurance Commissioner is subject to restrictions relating to statutory surplus and operating earnings. The maximum dividend payment that may be made without prior approval is limited to the greater of the net gain from operations for the preceding year or 10% of statutory capital and surplus as of December 31 of the preceding year. The statutory surplus of Scottish Re (U.S.), Inc. at December 31, 2003 was $52.0 million (2002-$52.1 million). The maximum dividend that could be paid in 2003 without prior approval is $5.2 million (2002-$5.2 million). Scottish Re (U.S.), Inc.'s net assets, which are restricted by the above are $172.4 million (2002-$119.2 million). The maximum amount of dividends that can be paid by ERC Life (a Missouri domiciled insurance company) without prior approval of the Director of Insurance in any twelve month period is subject to restrictions relating to statutory surplus and operating earnings. The maximum dividend payment that may be made without prior approval is limited to the greater of the net gain from operations for the preceding year or 10% of policyholders surplus as of December 31 of the preceding year, provided however, that dividends may be paid only from earned surplus, although the Director of Insurance may permit the payment of dividends from other than earned surplus. The statutory surplus of ERC Life at December 31, 2003 was $143.8 million. As a result of previously paid dividends, however, ERC Life had negative unassigned surplus at December 31, 2003. Thus, the 104 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 20. Statutory requirements and dividend restrictions (continued) permission of the Director must be sought for the payment of any dividend in 2004. ERC Life intends to seek the Director's approval to restate unassigned surplus to zero pursuant to the certain reorganization provisions. The NAIC prescribes risk-based capital ("RBC") requirements for U.S. domiciled life and health insurance companies. As of December 31, 2003 and 2002, Scottish Re (U.S.), Inc. and ERC Life exceeded all minimum RBC requirements. In connection with the Insurance Companies Act 1982 of the United Kingdom, Scottish Re Limited is required to maintain statutory minimum net capital of approximately $34.0 million at December 31, 2003 (September 30, 2002 - $22.4 million). Scottish Re Limited had statutory capital of approximately $58.0 million at December 31, 2003 (September 30, 2002 - $34.9 million). 21. Commitments and contingencies Credit facilities During 2003, we renewed our credit facilities, which currently consist of: a) a credit facility totaling $50.0 million, of which $25.0 million is available on an unsecured basis and $25.0 million is available on a secured basis. The facility provides capacity for borrowings and letters of credit. The interest rates on amounts borrowed under the secured facility is LIBOR plus 50 basis points and under the unsecured facility is LIBOR plus 75 basis points. This facility expires in October 2004 but it is renewable upon the agreement of both parties. b) a secured credit facility totaling $50.0 million. This facility provides a combination of borrowings and letters of credit. Interest rates on amounts borrowed under this facility is LIBOR plus 45 basis points. This facility expires in September 2004 but is renewable upon the agreement of both parties. One of the facilities requires that Scottish Annuity & Life Insurance Company (Cayman) Ltd. maintains shareholder's equity of at least $340.0 million. At December 31, 2003, Scottish Annuity & Life Insurance Company (Cayman) Ltd's shareholder's equity was $779.7 million. The other facility requires that Scottish Re maintain consolidated net worth of $520.0 million, a maximum debt to total capitalization ratio of 30% and uncollateralised assets of 1.2 times any unsecured borrowings. At December 31, 2003, Scottish Re's net worth was $659.8 million and the ratio of debt to total capitalization was 16.9%. Our failure to comply with the requirements of the credit facilities would, subject to grace periods, result in an event of default, and we could be required to repay any outstanding borrowings. At December 31, 2003, there were no borrowings under the facilities. Outstanding letters of credit under these facilities amounted to $31.2 million (2002 - $9.1 million). We also have a reverse repurchase agreement with a major broker/dealer. Under this agreement, we have the ability to sell agency mortgage backed securities with the agreement to repurchase them at a fixed price, providing the dealer with a spread that equates to an effective borrowing cost linked to one-month LIBOR. This agreement is renewable monthly at the discretion of the broker/dealer. At December 31, 2003 and December 31, 2002, there were no borrowings under this agreement. 105 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 21. Commitments and contingencies (continued) Lease commitments Scottish Re and its subsidiaries lease office space in the countries in which they conduct business under operating leases that expire at various dates through 2023. Total rent expense with respect to these operating leases for the years ended December 31, 2003, 2002 and 2001, were approximately $1.7 million, $939,000 and $743,000, respectively Future minimum lease payments under the leases are expected to be: Year ending December 31 ------------------------------ ------- 2004 ......................... $ 1,905 2005 ......................... 1,799 2006 ......................... 1,610 2007 ......................... 1,610 2008 ......................... 1,446 Later years .................. 6,746 ------- Total future lease commitments $15,116 ======= Legal proceedings In the normal course of our business, we and our subsidiaries are occasionally involved in litigation. The ultimate disposition of such litigation is not expected to have a material adverse effect on our financial condition, liquidity or results of operations. 22. Quarterly financial data (Unaudited) Quarterly financial data for the year ended December 31, 2003 is as follows:
Quarter Ended ------------------------------------------------ December 31 September 30 June 30 March 31 --------- --------- --------- --------- Total revenue ....................... $ 196,464 $ 134,550 $ 129,539 $ 96,813 Income (loss) from continuing operations before income taxes and minority interest ................ 27,222 (6,383) 9,233 7,673 Income from continuing operations ... 30,266 1,782 9,317 7,423 Net income .......................... 10,540 1,625 7,872 7,243 Basic earnings per ordinary share ... $ 0.30 $ 0.05 $ 0.29 $ 0.27 Diluted earnings per ordinary share . $ 0.29 $ 0.05 $ 0.28 $ 0.26
106 SCOTTISH RE GROUP LTD. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2003 22. Quarterly financial data (Unaudited) (continued) Quarterly financial data for the year ended December 31, 2002 is as follows:
Quarter Ended December 31 September 30 June 30 March 31 ----------- ------------ ------- --------- Total revenue ....................... $109,196 $ 79,197 $ 64,359 $ 53,460 Income from continuing operations before income taxes and minority interest ......................... 11,068 6,907 8,061 5,305 Income from continuing operations ... 13,191 7,107 7,939 4,998 Net income .......................... 12,698 6,979 7,849 4,998 Basic earnings per ordinary share ... $ 0.47 $ 0.26 $ 0.29 $ 0.25 Diluted earnings per ordinary share . $ 0.45 $ 0.25 $ 0.28 $ 0.23
Computations of results per share for each quarter are made independently of results per share for the year. Due to rounding and transactions affecting the weighted average number of shares outstanding in each quarter, the sum of quarterly results per share does not equal results per share for the year. 107 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant, in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- /s/ MICHAEL C. FRENCH Chief Executive Officer and March 2, 2004 Director - ----------------------------- Michael C. French (Principal Executive Officer) March 2, 2004 /s/ SCOTT E. WILLKOMM - ----------------------------- Scott E. Willkomm President * - ----------------------------- Michael Austin Director * - ----------------------------- G. William Caulfeild-Browne Director * - ----------------------------- Robert M. Chmely Director * - ----------------------------- Lord Norman Lamont Director * - ----------------------------- Hazel R. O'Leary Director * - ----------------------------- Glenn S. Schafer Director * - ----------------------------- Khanh T. Tran Director * The undersigned, by signing his name hereto, does hereby sign this Annual Report on Form 10-K pursuant to the Powers of Attorney executed on behalf of the above named officers and directors of the Registrant and contemporaneously filed herewith with the Securities and Exchange Commission. /s/ MICHAEL C. FRENCH - --------------------------- Michael C. French Attorney-in-Fact 108 Exhibit 31.1 CERTIFICATION I, Michael C. French, Chief Executive Officer of Scottish Re Group Limited certify that: 1. I have reviewed this annual report on Form 10-K of Scottish Re Group Limited ("the registrant"); 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15(d)-15(f)) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls over financial reporting which are reasonable likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 2, 2004 /s/ Michael C. French Michael C. French Chief Executive Officer 109 Exhibit 31.2 CERTIFICATION I, Scott E. Willkomm, President of Scottish Re Group Limited certify that: 1. I have reviewed this annual report on Form 10-K of Scottish Re Group Limited (the "registrant"); 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15(d)-15(f)) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls over financial reporting which are reasonable likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 2, 2004 /s/ Scott E. Willkomm Scott E. Willkomm President 110 Exhibit 31.3 CERTIFICATION I, Elizabeth A. Murphy, Chief Financial Officer of Scottish Re Group Limited certify that: 1. I have reviewed this annual report on Form 10-K of Scottish Re Group Limited (the `registrant"); 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15(d)-15(f)) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls over financial reporting which are reasonable likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 2, 2004 /s/ Elizabeth A. Murphy Elizabeth A. Murphy Chief Financial Officer 111 Exhibit 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Scottish Re Group Limited (the "Company") on Form 10-K for the annual period ended December 31, 2003 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Michael C. French, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ Michael C. French Michael C. French Chief Executive Officer March 2, 2004 A signed original of this written statement required by Section 906 has been provided to Scottish Re Group Limited and will be retained by Scottish Re Group Limited and furnished to the Securities and Exchange Commission or its staff upon request. 112 Exhibit 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Scottish Re Group Limited (the "Company") on Form 10-K for the annual period ended December 31, 2003 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Scott E. Willkomm, President of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ Scott E. Willkomm Scott E. Willkomm President March 2, 2004 A signed original of this written statement required by Section 906 has been provided to Scottish Re Group Limited and will be retained by Scottish Re Group Limited and furnished to the Securities and Exchange Commission or its staff upon request. 113 Exhibit 32.3 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Scottish Re Group Limited (the "Company") on Form 10-K for the annual period ended December 31, 2003 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Elizabeth A. Murphy, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ Elizabeth A. Murphy Elizabeth A. Murphy Chief Financial Officer March 2, 2004 A signed original of this written statement required by Section 906 has been provided to Scottish Re Group Limited and will be retained by Scottish Re Group Limited and furnished to the Securities and Exchange Commission or its staff upon request. 114 Exhibit 21.1 List of Subsidiaries ERC Life Reinsurance Corporation Scottish Annuity & Life Holdings (Bermuda) Limited Scottish Annuity & Life Insurance Company (Bermuda) Limited Scottish Annuity & Life Insurance Company (Cayman) Ltd. Scottish Annuity & Life International Insurance Company (Bermuda) Ltd. Scottish Holdings (Barbados), Limited Scottish Holdings, Inc. Scottish Re (Dublin) Limited Scottish Re (U.S.), Inc. Scottish Re Holdings Limited Scottish Re Intermediaries (Canada) Limited Scottish Re Limited Scottish Solutions, LLC Tartan Holdings (UK) Limited Tartan Financial (UK) Tartan Wealth Management, Inc. The Scottish Annuity Company (Cayman) Ltd. World-Wide Insurance PCC Limited 115 Exhibit 24.1 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned, on behalf of Scottish Re Group Limited, a Cayman Islands company (the "Company"), hereby constitutes and appoints Michael C. French and Scott E. Willkomm, and each of them, the true and lawful attorney or attorneys-in-fact, with the full power of substitution and resubstitution, for the Company, to sign on behalf of the Company and on behalf of the undersigned in his or her capacity as an officer and/or a director of the Company, the Company's Annual Report on Form 10-K for the year ended December 31, 2003, and to sign any or all amendments thereto, to or with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934, as amended, and the regulations promulgated thereunder, granting unto said attorney or attorneys-in-fact, and each of them with or without the others, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises in order to effectuate the same as fully to all intents and purposes as the undersigned might or could in person, hereby ratifying and confirming all that said attorney or attorneys-in-fact, or any of them or their substitutes, may lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have executed this Power of Attorney as of March 2, 2004. /s/ MICHAEL C. FRENCH /s/ MICHAEL AUSTIN /s/ SCOTT E. WILLKOMM Michael C. French Michael Austin Scott E. Willkomm /S/ G. WILLIAM /S/ ROBERT M. CHMELY /S/ HAZEL R. O'LEARY CAULFEILD-BROWNE G.William Caulfeild-Browne Robert M. Chmely Hazel R. O'Leary /S/ KHANH T. TRAN /S/ LORD NORMAN LAMONT /S/ GLENN S. SCHAFER Khanh T. Tran Lord Norman Lamont Glenn S. Schafer 116 EX-99 3 ex23-1.txt CONSENT OF ERNST & YOUNG LLP Consent of Independent Auditors We consent to the incorporation by reference in the Registration Statement (Form S-8 No. 333-51496) pertaining to the Employee Stock Option Plan of Scottish Re Group Limited (the Company) (formerly Scottish Annuity & Life Holdings, Ltd) and the incorporation by reference in the Registration Statement (Form S-3 No. 333-113030) of the Company of our report dated February 10, 2004, with respect to the consolidated financial statements and schedules of the Company included in the Annual Report (Form 10-K) for the year ended December 31, 2003. /s/ Ernst & Young LLP Philadelphia, Pennsylvania March 2, 2004 -----END PRIVACY-ENHANCED MESSAGE-----