(4) The Company changed its method of accounting for investments to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," on December 31, 1993.
(6) Adjusted book value per share is not based on GAAP and is not a substitute for GAAP book value per share of Common Stock. Due to the present value of future revenues ("PFR") embedded in CapMAC's existing book of business, the book value per share has been adjusted to present additional information concerning the value of CapMAC. The adjusted book value is determined by adding to the GAAP book value the PFR per share reduced by the deferred acquisition costs net of the related tax effects. However, PFR is not earned until subsequent periods, and the amount actually realized may be less than the amount estimated.
CapMAC insures structured asset-backed, corporate, municipal and other financial obligations in the U.S. and international capital markets. CapMAC also provides financial guarantee reinsurance for structured asset-backed, corporate, municipal and other financial obligations written by other major insurance companies. CapMAC's claims-paying ability is rated triple-A by Moody's Investors Service, Inc. ("Moody's"), Standard & Poor's Ratings Services ("S&P"), Duff & Phelps Credit Rating Co. ("Duff & Phelps"), and Nippon Investors Service, Inc. ("Nippon"), a Japanese rating agency. Since it commenced operations, CapMAC has issued guarantees providing credit enhancement to over $73 billion of securities, both in the public and private capital markets.
Underwriting and operating expenses were $22.2 million in 1996, a 35% increase from $16.4 million in 1995. Underwriting and operating expenses consisted of gross underwriting and operating expenses, reduced by the deferral to future periods of certain costs related to CapMAC's acquisition of new business (Deferred Acquisition Costs - "DAC") and ceding commission income. Gross underwriting and operating expenses were $40.2 million in 1996, a 19% increase from $33.9 million in 1995. The increase in underwriting and operating expenses was due to increased compensation costs and operating expenses, partially offset by higher ceding commission income. Staff and benefit-related expenses, including the discretionary bonuses to employees, constituted approximately 74% of gross underwriting and operating expenses in 1996 compared to 73% in 1995. The Company maintains a discretionary bonus plan under which annual bonuses of $10.4 million and $7.8 million were awarded to employees in 1996 and 1995, respectively. Underwriting and operating expenses deferred by CapMAC were $18.0 million and $17.5 million in 1996 and 1995, respectively.
Total revenues in 1995 were $62.6 million, an increase of 41% from $44.6 million in 1994. This increase was primarily due to higher premiums earned and advisory fees.
Corresponding to the growth in the insured portfolio, the losses and loss adjustment expenses were $3.1 million in 1995 compared to $1.4 million in 1994.
Reinsurance arrangements provide a further source of liquidity to CapMAC. CapMAC actively pursues reinsurance as a means of diversifying and reducing risk, enhancing return on capital and adding underwriting capacity. At December 31, 1996, the majority of CapMAC's reinsurance capacity was held by reinsurers who were rated AA or better by S&P. CapMAC monitors the creditworthiness of all of its reinsurers on a regular basis. In addition to its facultative and treaty reinsurance agreements, CapMAC has a "stop-loss" reinsurance treaty with Mitsui Marine and Fire Insurance Co., Ltd. ("Mitsui") which indemnifies CapMAC for up to $50 million of incurred losses above $100 million. Effective January 1, 1997 the stop-loss reinsurance coverage increased to $75 million in excess of incurred losses above $150 million increasing annually based on increases in CapMAC's statutory qualified capital. The new stop-loss reinsurance is provided by Mitsui, AXA Re Finance S.A. ("AXA Re"), and Munchener Ruckversicherungs-Gesellschaft ("Munich Re").
CapMAC Financial Services. The primary sources of funds for CFS are payments by Holdings, CapMAC and CFS (Europe) under a service agreement (the "CFS Servicing Agreement") and the collection of advisory fees for providing advisory and structuring services to third parties. In addition, both CFS and CFS (Europe) generate earnings from their respective investment portfolios. At December 31, 1996, the amortized cost and fair value of the consolidated CFS portfolio was $7.3 million. The entire portfolio was highly liquid with maturities of less than one year. The primary use of the funds of CFS is to pay its operating expenses. All of the Company's personnel are employed by CFS. Under the CFS Servicing Agreement, CFS allocates expenses to Holdings, CapMAC and CFS (Europe) for services provided to these entities. It is intended that a portion of CFS' funds be used to pay dividends to Holdings in order that Holdings will have funds available to pay dividends and satisfy its other obligations.
Premiums and discounts are amortized or accreted over the life of the related security as an adjustment to yield using the effective interest method. Dividend and interest income are recognized when earned. Realized gains and losses are included in earnings and are derived using the FIFO (first-in, first-out) method for determining the cost of securities sold.
k) Reclassifications Certain prior year balances have been reclassified to conform to the current year presentation.
Taxes on foreign income have been provided for at the U.S. statutory Federal income tax rate of 35% in 1996 and 1995 and at 34% in 1994. The U.K. taxes corporate income at a 33% rate. For 1996, 1995 and 1994 income before tax for CFS (Europe) was $12.4 million, $7.5 million and $3.1 million, respectively. The difference between the U.S. and U.K. rates is provided to account for U.S. taxation (net of applicable foreign tax credits) on the future repatriation of these foreign earnings.
Total income tax expense differed from the amount computed by applying the U.S. Federal income tax rate of 35% in 1996 and 1995 and 34% in 1994:
Senior Notes The fair value of senior notes is based on prices believed by management to be currently charged for similar debt issues adjusted for changes in interest rates and credit quality that occurred subsequent to its issuance.
On July 21, 1995, the Company sold 500,001 shares of common stock to ORIX for $10.0 million, or $20 per share. In August 1995, net proceeds of $9.0 million from such transaction were contributed to CapMAC. In connection with the ORIX investment, the Company paid Dillon, Read & Co. Inc. an advisory fee of $500,000.