The Company occupies leased space in Schaumburg, Illinois where its principal executive offices are located. IIC leases space in London where a branch office is maintained. IIC also leases space for regional offices in New York City, Tampa, Florida and Woodland Hills, California. Intercargo Insurance Company H.K. Ltd. leases office space in Hong Kong.
1998 resulted in a net loss of $3.4 million or $0.44 per share as compared to net income of $31.8 million or $4.14 per share in 1997 and $6.4 million or $0.84 per share in 1996. During 1998 the Company faced many challenges. The insurance market in the U.S. remains highly capitalized which continues to foster soft market conditions for product pricing and intense competition for premiums. In January of 1998 the president of IAS resigned and with several other employees formed an operation whose announced purpose is to compete with IAS in the marketing and distribution of transportation related insurance and surety products. Litigation costs related to this added to the overall operating costs. The departure of these employees presented the Company with the opportunity to re-evaluate its focus. To this end the Company determined that it should concentrate its focus on underwriting and that its primary distribution method should be the use of independent brokers and agents. This led to the decision to sell all of the domestic insurance brokerage agency business of IAS in consideration for cash, convertible preferred stock and a secured installment note, totaling approximately $7.9 million. The transaction was effected through the sale of the capital stock of seven subsidiaries of IAS. The purchase price, which is equivalent to approximately one times the commission revenue of the transferred agencies, is subject to adjustment based on the commission revenue of the transferred agencies for the twelve month period ending June 30, 1999.
Surety (U.S. Customs bonds, contract and miscellaneous surety bonds) net premium written increased 12.5% in 1998. Contract and miscellaneous surety net premium written increased $3.2 million or 116.1% due to an increase of $845 thousand or 13.3% in gross premium written and to the discontinuance of a 50% quota share reinsurance treaty under which the Company had ceded business prior to 1998. U.S. Customs bonds net premium written declined $1.2 million or 8.4% due to competitive pressures. Such pressures are expected to continue for both U.S. Customs bonds and contract surety bonds. In 1997, surety net premium written declined 28.0%. Gross premiums written for U.S. Customs bonds were $3.1 million or 17.4% lower in 1997 than 1996. This was due to the move to rates which are net of brokers' commissions, and to competitive pressures on overall price structures. Gross premiums written for contract and miscellaneous surety bonds were $2.4 million or 27.7% lower in 1997 than 1996. During the first half of 1997 the Company was reviewing the strategic position of the contract and miscellaneous surety line. During that period of evaluation marketing and sales efforts remained static, and some sales momentum was lost. The Company subsequently determined that these products can be viable and should remain a part of the overall product portfolio. Sales and marketing efforts were then reinvigorated, resulting in the increased premium volume shown in 1998. Marine net written premium declined 2.4% in 1998, while it had increased only 2.8% in 1997. These results reflect the market pressures on price levels. It is expected that the marine cargo insurance line will continue to experience such pressures in the foreseeable future. Professional liability net written premium decreased 11.3% in 1998 after having increased 44.5% in 1997. The decline in 1998 is due primarily to the continuing efforts to re-underwrite this line of business. At the time of renewal unprofitable accounts are being given appropriate rate increases or are being cancelled. The increase in 1997 was attributable to significant rate actions taken late in 1996 and extending into 1997 as well as the circumstance that 1996 net written premiums were negatively impacted by $1.4 million in retrospective reinsurance premiums applicable to the development of prior period coverages. Other property and casualty net premium written decreased 30.2% in 1998 as compared to an increase of 62.8% in 1997. The decrease in 1998 is due to a decrease of $4.5 million in net premium written related to a program providing liability coverage on cranes. This same program was the primary factor affecting the increase in net premiums written in 1997. Absent the effects of this crane liability program, other property and casualty net premiums written would have increased $1.8 million or 42.8% in 1998 due primarily to increased volume in truck liability and physical damage coverages.
Insurance premium income, or earned premium, decreased $4.9 million or 8.6% in 1998 to $52.5 million. In 1997, earned premium declined $3.6 million or 6.0% to $57.4 million from $61.0 million in 1996. Premiums are earned over the effective period of policy coverages and reflect the recognition of income from the changing levels of net premium written.
In 1998 loss and LAE decreased 6.3% following an increase of 7.9% in 1997. While the dollar level of loss and LAE declined in 1998, the overall loss ratio increased to 62.3% from 60.7% in 1997. During 1998 overall loss and LAE reserves were increased by $4.2 million. Reserves for certain lines were adjusted to reflect developing experience. Reserves were also increased to provide for additional margin. Loss and LAE reserves are estimated using a range of values and include a select point which represents the level of reserves deemed most likely to ultimately develop. The Company has consistently carried the overall level of reserves within such ranges. The actions taken in 1998 served to move the overall level of reserves to approximately the select point. Reserves in the surety segment were reduced $1.8 million reflecting ongoing development of U.S. Customs bonds claims. Marine loss reserves were increased $3.4 million to reflect emerging poor development primarily on current year business. Professional liability loss and LAE reserves were increased approximately $1.6 million to reflect emerging prior years' losses as well as to move the reserve level to a higher point in the range. Other property and casualty reserves were increased approximately $1.0 million. Workers' compensation reserves were decreased $631 thousand to reflect continuing favorable development. Reserves for the discontinued crane liability program were increased approximately $1.7 million to reflect adverse development. In 1997, loss and LAE increased $2.5 million or 7.9% as compared to 1996. During 1997, $3.0 million was added to loss and LAE reserves across several lines. This was done in response to the development of losses as well as to provide additional margins for adverse development. The loss ratio for the surety segment has shown improvement reflecting positive development for U.S. Customs bonds as well as the enhanced underwriting plus premium growth in contract and miscellaneous surety. The marine segment loss ratio deterioration is a reflection of the intense competitive pressures on pricing. The loss ratio in the professional liability segment in 1998 was negatively impacted by the increase in loss and LAE reserves noted previously. The Company continues to seek more appropriate pricing for covered risks under the professional liability program as it continues the efforts to improve the performance of this segment. The loss ratio for the other property and casualty segment of 79.1% for 1998 includes the previously mentioned reserve increase related to the crane liability program. Had this not been necessary the loss ratio for 1998 would have been 53.9%. This improvement reflects the continued positive development in the loss and LAE reserves in the workers' compensation line.
Policy acquisition and other issue costs were $16.1 million, $14.3 million and $17.4 million for 1998, 1997 and 1996 respectively. These costs as a percentage of earned premiums were 30.8%, 24.8% and 28.5% in 1998, 1997 and 1996, respectively. The rise in the percentage for 1998 is the result of two major factors. Prior to their April 30, 1998 sale, the Trade Insurance Services ("TIS") subsidiaries had produced a significant portion of the Company's premiums, accounting for 69% of the 1997 volume. Intercompany commission income of TIS was eliminated in consolidation against the commission expense of IIC. After the sale of TIS, such commissions are now paid to unrelated entities and, therefore, are no longer eliminated in consolidation. The other major factor changing in 1998 was the discontinuance of a quota share reinsurance agreement on contract surety business. Under that agreement, the Company received ceding allowances which served to offset a portion of acquisition expenses. Excluding these two items, the 1998 acquisition expenses would have been approximately 23.5% of earned premiums. The reduction in the percentage relationship of acquisition costs to earned premiums in 1997 was attributable to the change in the commission structure as pricing for certain products moved to a rate structure net of brokers' commissions.
Combined ratios on a GAAP basis are presented here as the Company feels this provides a conservative and consistent representation of the operational performance as a whole. A combined ratio of less than 100% generally indicates an underwriting profit. It's not uncommon in the property and casualty industry to have combined ratios well in excess of 100%. No assurance is made that loss and loss adjustment expense accruals upon which the Company's combined ratios are based may not prove to vary significantly from the ultimate results.
The Company began evaluating its readiness for the year 2000 in 1997 with a review of the operating and application software. The Company uses software that has been developed internally as well as software developed by third party vendors. During 1998 the Company received written certification from its primary third party vendors that their software is compliant with year 2000. The Company established a Year 2000 Steering Committee, chaired by the Vice President of Operations, which includes internal managers as well as
The various hardware, software and embedded chip inventories will be completed by the end of the first quarter of 1999, along with an initial assessment of the approaches to be taken in determining compliance with year 2000. Remediation, testing and certification is targeted for completion by the end of the third quarter of 1999. The Company believes that its year 2000 project is generally on schedule.
The Company also faces the risk that various customers or suppliers ("external relationships") will not be able to interact with the Company due to the third party's inability to resolve circumstances arising from year 2000 issues they may have failed to address. The Company has completed an inventory of business partners and risk rated the potential business impact. These include significant producers as well as suppliers of such services as telecommunications and banking. The Company is attempting to determine the overall year 2000 readiness of these external relationships.
The Company does not have sufficient information at this time to predict whether its external relationships will be year 2000 compliant. There can be no guarantee that the systems of other companies on which the Company's systems rely will be timely converted and would not have an adverse affect on the Company's systems.
The Company incurred expenses of approximately $155,000 (before tax) in 1998 related to year 2000 initiatives. Such costs for 1999 are currently estimated to range from $265,000 to $664,000 depending upon the extent of remediation or replacement necessary. The Company expects to fund these costs through operating cash flows.
The Company is attempting to limit the potential impact of year 2000 issues by monitoring the progress of its own year 2000 project and those of its critical external relationships by developing contingency and recovery plans. The Company is addressing such areas as revenue collection, claims processing, financial reporting and outside service suppliers. In some instances manual processes can be used. The Company is expecting to have contingency plans in place by the end of the third quarter of 1999.
The Company cannot guarantee that it will be able to resolve all of its year 2000 issues. Any critical year 2000 issues at the Company or its external relationships could have material adverse effect on the Company's results of operations, liquidity or financial condition.
Periods of inflation have varying effects on the Company and other companies in the insurance industry. Because premium rates for the Company's U.S. Customs bond and marine cargo insurance products are usually tied to the value of cargo being imported or exported, an increase in price levels may result in revenue increases. In periods of inflation, the property and casualty industry generally experiences higher losses, loss adjustment expenses and operating costs. In contrast, the Company's U.S. Customs bond and marine cargo premiums and losses are tied to the value of goods as of the date of shipment and generally are not adversely affected by inflation.
The value of the dollar relative to other world currencies also affects the Company's U.S. Customs bond and marine cargo business. When the dollar is strong relative to other world currencies, imports generally increase and U.S. Customs bond volume increases. When the dollar is weak relative to other world currencies, exports generally increase and marine cargo insurance volume increases. The company's foreign operations expose the Company to changes in the relative value of the U.S. dollar to the local currencies. (Refer to Foreign Operations in Notes to the Consolidated Financial Statements.)
Operations in 1998, in a departure from recent years, used cash of approximately $7.9 million. In 1997 and 1996, cash flow from operations amounted to $575 thousand and $6.3 million, respectively. The use of cash in 1998 was due to factors including a net loss for the year as well as to increases in the level of premiums receivable, due to a temporary change in remittance terms, and in taxes recoverable. The decrease in the level of cash provided from operating activities in 1997 as compared to 1996 was due to higher levels of reinsurance balances recoverable and to decreases in various liabilities including accounts payable.
A financial instrument is cash or a contract that imposes or conveys a contractual obligation or right to deliver or receive cash or another financial instrument. Included at Note 17 of the Notes to Consolidated Financial Statements is information summarizing the Company's financial instruments and their estimated fair values. As indicated in the Note, the fair values of the Company's financial instruments approximate their carrying values.
The Company is subject to foreign exchange rate risk associated with translating financial statements of its foreign subsidiaries and branches into U.S. dollars. The Company's primary exposures are associated with the British Pound and the Hong Kong dollar. The Company does not use hedging transactions in managing these risks due to the relatively low level of exposure. Revenues from foreign operations of $5.8 million in 1998 and $4.9 million in 1997 represented 10.4% and 4.6% of total revenues, respectively, in those years. Identifiable foreign assets of $10.5 million at December 31, 1998 and $10.0 million at December 31, 1997 represented 6.9% and 6.4%, respectively, of total consolidated assets at those dates. A decrease of 10% in the foreign exchange rates would have increased net income by $14,000 in 1998 and $65,000 in 1997 due to net losses in foreign operations in those years. Such a decrease in foreign exchange rates would have reduced equity by $284,000 and $304,000 at year-end 1998 and 1997, respectively.
The valuation of the Company's fixed maturity portfolio is subject to long-term interest rate risk. In order to reduce the impact of changes in long-term interest rates on the market value of its portfolio, the Company invests in medium term obligations and endeavors to spread the maturity dates over its investment horizon. A hypothetical increase of 100 basis points in interest rates over the yield curve spectrum would decrease the market value of the fixed maturity portfolio at December 31, 1998 by approximately $345,000.
The valuation of the Company's equity portfolio is subject to market risk. At December 31, 1998 the equity portfolio had a fair value of $4.9 million, which was 3.0% of total assets. Of this amount, $2.5 million represented a private placement issue with limited market risk exposure. The Company has not entered into any transactions to hedge the price risk on the equity portfolio due to the relatively low level of exposure when compared to total assets.
We have audited the accompanying consolidated balance sheets of Intercargo Corporation and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, stockholders' equity, and cash flows for the years then ended. Our audits also included the financial statement schedules listed in the index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Intercargo Corporation and subsidiaries at December 31, 1998 and 1997, and the consolidated results of their operations and their cash flows for the years then ended, in conformity with generally accepted accounting principles. Also, in our opinion, the related 1998 and 1997 financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/ ERNST & YOUNG LLP Chicago, Illinois March 19, 1999
INTERCARGO CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA)
Intercargo Corporation ("the Company") is an insurance holding company incorporated in the State of Delaware whose wholly owned subsidiaries at December 31, 1998 consist of Intercargo Insurance Company ("IIC"), International Advisory Services, Inc. ("IAS"), and Intercargo International Limited ("IIL").
IIC is a property and casualty insurer based in the United States, which primarily writes U.S. Customs bonds, commercial surety, marine cargo, professional liability and other property and casualty insurance. IIC conducts business in the United Kingdom through a branch office operation. Its products are sold to importers and exporters through customs brokers, freight forwarders, and other service firms engaged in the international and domestic movement of cargo. IIC also conducts business in Hong Kong through its wholly-owned subsidiary, Intercargo Insurance Company H.K. Limited ("IIC -- H.K."). IIC -- H.K. is a Hong Kong licensed insurer that underwrites marine cargo and professional liability insurance.
The consolidated financial statements of the Company have been prepared in accordance with generally accepted accounting principles. All significant intercompany balances and transactions have been eliminated.
The Company does not recognize into income its equity share of changes in an investee's reported net assets resulting from an investee's issuance of stock. Unconsolidated investees between 20% and 50% owned are accounted for under the equity method of accounting.
Premiums collected from insureds but not yet remitted to insurance carriers are restricted as to use by laws in certain states in which IAS operates. The amount of cash and cash equivalents so restricted was $1.2 million and $5.4 million at December 31, 1998, and 1997, respectively.
Goodwill is the excess of the fair value of consideration paid for companies acquired over the fair value of the related net assets acquired. Goodwill is amortized using the straight-line method over periods not exceeding 20 years.
The liability for losses and loss adjustment expenses represents estimates of the ultimate unpaid cost of all claims incurred through December 31, including claims incurred but not yet reported. These estimates are based upon historical experience of the business written by the Company and other direct writers reinsured by the Company, adjusted for current trends. Management believes that the provision for losses and loss adjustment expenses is adequate to cover the ultimate liability; however, such estimates may be more or less than the amount ultimately paid when the claims are settled. Reinsurance recoverables on unpaid losses and ceded unearned premiums are reported as assets instead of netting these against related reserves (see note 4).
Assets and liabilities relating to foreign operations are translated to U.S. dollars using current exchange rates. Revenues and expenses are translated to U.S. dollars using the average exchange rate as determined on a yearly basis. Translation adjustments for financial reporting in U.S. dollars are reported directly in stockholders' equity.
The Company recognizes commission income when the premiums are billed to the customer, or the effective date of the policy, whichever is later.
The Company applies the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25 ("APB No. 25") and related Interpretations in accounting for its stock-based compensation plans. Accordingly, no compensation cost has been recognized as the exercise prices of the options equaled the market prices at the grant dates. The effect of recording compensation cost for the Company's stock-based compensation plans based on the fair value method in Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123") results in net income and earnings per share that are not materially different from amounts reported.
In 1998, as a result of the net loss, the incremental shares from assumed conversions at average market price are antidilutive and are therefore excluded from diluted earnings per share.
The computations of basic and diluted earnings per share are presented below (in thousands for net income):
The Company adopted SFAS No. 130 "Reporting Comprehensive Income" ("SFAS No. 130") in 1998. SFAS No. 130 requires net unrealized gains or losses on investments and net foreign exchange translation adjustments, which previously were reported directly in stockholders' equity, to be included in accumulated other comprehensive income in the consolidated balance sheets and in the disclosure of comprehensive income. The totals of other comprehensive income items and comprehensive income (which includes net income), are displayed separately in the consolidated statements of stockholders' equity. The adoption of SFAS No. 130 had no effect on net income (loss) or stockholders' equity. The components of other comprehensive income (loss), and the related tax effects are as follows (in thousands):
Certain reclassifications have been made to the prior years' financial statements to conform with the current presentation.
Amortized cost, unrealized gains and losses, and estimated fair value of investments as of December 31, 1998 and 1997, are summarized as follows (in thousands):
Actual maturities may differ from contractual maturities because certain borrowers may have the right to call or to prepay obligations with or without call or prepayment penalties. Investment securities carried at $9.9 million and $9.4 million at December 31, 1998 and 1997, respectively, were on deposit or pledged to governmental authorities as required by law.
The sources of net realized gains are as follows (in thousands):
At December 31, 1998 and 1997, the net unrealized gains on available-for-sale securities were net of deferred tax liabilities of $915 thousand and $1.1 million, respectively. At December 31, 1996, the net unrealized loss on available-for-sale securities was net of a deferred tax benefit of $189 thousand.
In the normal course of business, the Company assumes and cedes reinsurance with other insurers. Reinsurance is ceded primarily to limit losses from large exposures and to permit recovery of a portion of direct losses; however, such a transfer does not relieve the originating insurance company of contingent liability.
The components of income tax expense (benefit) are as follows (in thousands):
The tax effects of temporary differences that give rise to significant portions of the Company's net deferred tax asset at December 31, 1998 and 1997, are as follows (in thousands):
Income taxes paid (net of taxes recovered) were $201 thousand, $20.6 million, and ($88) thousand in 1998, 1997, and 1996, respectively. The actual income tax expense for 1998, 1997, and 1996 differed from the "expected" tax expense for those years as described below (in thousands). "Expected" tax expense is computed by applying the U.S. Federal corporate tax rate of 35% in 1997 and 34% in 1998 and 1996 to operating income.
The Company and its U.S. subsidiaries file a consolidated tax return. Federal income tax expenses are calculated on an entity basis and are allocated accordingly.
In February 1999, certain purported shareholders of the Company filed a lawsuit against the Company and its directors, seeking class action status and claiming, among other things, the directors breached their
fiduciary duties to the Company's shareholders in approving the definitive agreement to merge between the Company and a subsidiary of XL Capital and that they failed to adequately explore alternative transactions and maximize shareholder value. The lawsuit requests, among other things, injunctive relief and payment of damages to the class members. The Company believes that the lawsuit is without merit and intends to contest it vigorously.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumption used for grants in 1998, 1997 and 1996, respectively: dividend yields of 1.9 percent, 1.9 percent and 2.1 percent; risk free interest rates of 5.5 percent,
At December 31, 1996, the Company had a $15.0 million revolving bank line of credit. The outstanding balance on the line of credit amounted to approximately $9.7 million. In August 1997, this balance was extinguished using a portion of the proceeds from the Company's sale of a significant part of its holdings in Kingsway. The revolving line of credit has been discontinued.
Revenues, operating income, and identifiable assets included in the accompanying consolidated financial statements related to U.S. and foreign operations as of and for the years ended December 31, 1998, 1997, and 1996, were as follows (in thousands):
The Company sponsors a defined contribution plan covering substantially all employees. The plan provides for Company contributions at the discretion of the board of directors. For 1998, the Company contributed $1.00 for each $1.00 contributed by the participants up to 2.5% of employee base compensation. For 1997 and 1996, the Company contributed $0.50 for each $1.00 contributed by the participants up to 5% of employee base compensation. The Company's cost of this plan was $201 thousand, $139 thousand, and $116 thousand in 1998, 1997 and 1996, respectively.
In the normal course of business, the Company invests in various financial assets and incurs various financial liabilities. The fair value estimates of financial instruments presented below are not necessarily indicative of the amounts the Company might pay or receive in actual market transactions. Potential taxes and other transaction costs have not been considered in estimating fair value. As a number of the Company's significant assets and liabilities are not considered financial instruments, the disclosures that follow do not reflect the fair value of the Company as a whole.
The estimated fair values of the Company's financial instruments at December 31, 1997 are as follows (in thousands):
Fixed maturities and equity securities are valued at quoted market prices, where available, or from independent pricing sources. Cash and cash equivalents, premiums receivable, reinsurance recoverable on paid claims, funds held, income tax recoverable and supplemental duty deposits are valued at their carrying value due to their short-term nature. The carrying value of notes receivable approximates fair value as the notes bear floating rates of interest or are at current market rates.
DESCRIPTION OF THE TYPES OF PRODUCTS FROM WHICH EACH REPORTABLE SEGMENT DERIVES ITS REVENUES
The Company has four operating segments based on the type of product and a fifth nonoperating segment. The operating segments are: surety, marine, professional liability and other property and casualty. The surety segment provides various surety coverages, primarily U.S. Customs bonds, contract surety and miscellaneous surety. The marine segment provides ocean and inland marine cargo coverage and bill of lading liability coverage. The professional liability segment provides professional liability coverage for customs brokers and freight forwarders. The other property and casualty segment provides commercial property and casualty products to customs brokers, freight forwarders and other service firms engaged in the international movement of cargo. It also provides such products to meet the needs of the trucking industry.
The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on profit or loss from operations before income taxes. Revenues are all from external customers. Indirect costs of support units are allocated to segments. Investment income and realized investment gains are not allocated to segments and such income is not a component used to evaluate segments. Invested assets and cash are not allocated to segments.
The Company's reportable segments are business units that each offer different types of insurance coverage with different types of risk exposures.