RCHI is the holding company for Risk Capital Reinsurance, its wholly owned subsidiary which is domiciled in Nebraska. RCHI was incorporated in March 1995 and commenced operations during September 1995 upon completion of the Offerings. RCHI received aggregate net proceeds from the Offerings of approximately $335 million, of which $328 million was contributed to the capital of Risk Capital Reinsurance. On November 6, 1995, Risk Capital Reinsurance was licensed under the insurance laws of the State of Nebraska. As of December 31, 1998, the statutory surplus of Risk Capital Reinsurance was approximately $359 million. In July 1998, Risk Capital Reinsurance capitalized its wholly owned subsidiary, Cross River Insurance Company ("Cross River"), with $20 million. Cross River received its Nebraska insurance license in October 1998, and intends to seek authorization to operate in most other states as an excess and surplus lines insurer.
The Company had consolidated comprehensive loss of $4.4 million for the year ended December 31, 1998 and consolidated comprehensive income of $47.1 million and $9.8 million for the years ended December 31, 1997 and 1996, respectively. Comprehensive income for the Company is composed of net income and the change in unrealized appreciation of investments. Net income for the years ended December 31, 1998, 1997 and 1996 was $3.1 million, $2.0 million and $4.1 million, respectively. After-tax realized investment gains (losses) of $16.4 million, ($0.5 million) and $0.8 million were also included in net income for 1998, 1997 and 1996, respectively. Net income for the years ended December 31, 1998, 1997 and 1996 included losses of $1.1 million, $0.2 million and $0.2 million, respectively, representing the Company's equity in the net loss of investee companies accounted for under the equity method of accounting.
Following is a table of per share data for the years ended December 31, 1998, 1997 and 1996 on an after-tax basis:
The Company's assumed and ceded premiums written for the years ended December 31, 1998, 1997 and 1996 were as follows:
Consistent with the Company's strategy of writing a small number of large treaties for its core business, three clients contributed approximately $74 million, or 32%, of the Company's 1998 total net premiums written, with the largest client contributing approximately 18% and the remaining two contributing 8% and 6%, respectively. The business written from the client that contributed 18% is part of an integrated transaction, and such business is subject to renewal at the Company's option for five years. In 1997, five clients contributed approximately $68 million, or 45%, of the Company's total net premiums written, with the largest client contributing approximately 18% and the remaining four contributing from 5% to 8%.
The Company's ceded premiums increased to $25.8 million in 1998, compared to $3 million in 1997. This increase was primarily due to the Company's expansion in 1997 into marine and aviation and space reinsurance business, for which the Company seeks to reduce its exposure to large and catastrophic losses. See "--Results of Operations--Risk Retention" and "Business--Retrocessional Arrangements."
Approximately $32.9 million, or 46%, of net premiums written in 1996 resulted from unearned premium portfolios and other non-recurring transactions. This amount included $11.9 million of specialty premiums written from contracts pursuant to which the Company reinsures a portion of one underlying policy for multiple years. Such premiums will be earned over the multiple periods as the exposures expire. In 1998 and 1997, there were no significant unearned premium portfolios or other non-recurring transactions included in net premiums written.
Set forth below are the Company's statutory composite ratios for the years ended December 31, 1998, 1997 and 1996 and the estimated aggregate statutory composite ratios for domestic reinsurers and domestic broker market reinsurers based on data reported by the RAA as of such dates:
Years Ended December 31, ---------------------------------------- 1998 1997 1996 ------ ------ ------ Claims and claims expenses 85.4% 68.4% 67.3% Commissions and brokerage 24.2 28.8 23.7 ------ ------ ------ 109.6 97.2 91.0 Other operating expenses 6.8 9.1 15.3 ------ ====== ====== Statutory composite ratio 116.4% 106.3% 106.3% ====== ====== ======
Domestic reinsurer aggregate Statutory composite ratios 104.4% 102.3% 103.1% ====== ====== ======
The frequency of satellite failures during 1998 has far exceeded the previous worst year in the history of this line of business. In order to mitigate the impact of possible future loss activity, in the fourth quarter of 1998, the Company commenced the process of re-underwriting and reducing its satellite business and seeking
additional retrocessional protection. There can be no assurances that any such retrocessional protection, if purchased, will be sufficient to preclude the occurrence of additional underwriting losses.
While the Company believes that it is taking adequate steps to reduce its exposure to losses from its satellite business and business produced by the managing underwriting agency, there can be no assurances that such business will not continue to generate additional underwriting losses in the future or that significant loss activity will not develop from other areas of the Company's underwriting or other activities.
Claims and claims expenses generally represent the Company's most significant and uncertain costs. Reserves for these expenses are estimates involving actuarial and statistical projections at a given time of what the Company expects the ultimate settlement and administration of claims to cost based on facts and circumstances then known. The reserves are based on estimates of claims and claims expenses incurred and, therefore, the amount ultimately paid may be more or less than such estimates. The inherent uncertainties of estimating claim reserves are exacerbated for reinsurers by the significant periods of time (the "tail") that often elapse between the occurrence of an insured loss, the reporting of the loss to the primary insurer and, ultimately, to the reinsurer, and the primary insurer's payment of that loss and subsequent indemnification by the reinsurer. As a consequence, actual claims and claims expenses paid may deviate, perhaps substantially, from estimates reflected in the Company's reserves reported in its financial statements. The estimation of reserves by new reinsurers, such as the Company, may be less reliable than the reserve estimations of a reinsurer with an established volume of business and claims history. To the extent reserves prove to be inadequate, the Company may have to augment such reserves and incur a charge to earnings. See "--Results of Operations--Subsequent Underwriting Losses" below and Note 14 of the accompanying Notes to Consolidated Financial Statements of the Company.
Other operating expenses increased to $16.5 million in 1998, compared to $13.5 million and $11.4 million for the years ended December 31, 1997 and 1996, respectively. Assuming the successful execution
of the Company's business strategy, the Company expects other operating expenses to grow with maturing operations, but expects other operating expenses to decline moderately as a percentage of net premiums written because increases in premium writings are generally expected to exceed the growth in such expenses.
Pre-tax foreign exchange gains and losses are recorded separately from statutory underwriting results and are therefore excluded from the statutory composite ratio. Unhedged monetary assets and liabilities are translated at the exchange rate in effect at the balance sheet date, with the resulting foreign exchange gains or losses recognized in income. For the years ended December 31, 1998, 1997 and 1996, pretax foreign exchange gains and (losses) were $443,000, ($682,000) and $104,000, respectively. Such future gains or losses may be affected by changes in foreign exchange rates which are unpredictable and could be material. (For additional discussion, see "--Market Sensitive Instruments and Risk Management" below.)
Given the Company's current level of surplus, under its current underwriting guidelines, the maximum net retention on any one claim for a given property or casualty treaty risk is generally $10.0 million.
The Company monitors its earthquake and wind exposures and continuously reevaluates its estimated probable maximum pre-tax loss for such exposures through the use of modeling techniques. The Company generally seeks to limit its probable maximum pre-tax loss to no more than 10% of its statutory surplus for severe catastrophic events that could be expected to occur once in every 100 years. This limitation includes combined exposure to underwriting losses, reinstatement costs for retrocessional arrangements which may be in force at the time of the losses resulting from the catastrophic event, and losses that the Company may be
The Company continues to evaluate its potential catastrophe exposure, including both gross loss estimates and the impact of available reinsurance protection. While the Company believes its management of catastrophe exposures and underwriting guidelines are adequate, an extremely large catastrophic event, multiple catastrophic events or other unforeseen events could have a material adverse effect on the financial condition and results of operations of the Company.
At December 31, 1998, approximately 48% of the Company's invested assets consisted of fixed maturity and short-term investments, compared to 45% at December 31, 1997. Net investment income was approximately $15.7 million in 1998, compared to $14.4 million and $13.2 million in 1997 and 1996, respectively. Such amounts for 1998, 1997 and 1996 are net of investment expenses of $3.6 million, $2.2 million and $1.5 million, respectively. The investment expense amounts include investment advisory fees of $3.3 million, $1.8 million and $1.2 million, respectively. The amount of investment income from quarter to quarter may vary and could diminish as the Company continues to employ its strategy of investing a substantial portion of its investment portfolio in publicly traded and privately held equity securities, which generally yield less current investment income than fixed maturity investments.
Years Ended December 31, ----------------------------------------- 1998 1997 1996 ------ ------ ------ Investment yields: Pre-tax 3.4% 3.7% 3.8% Net of tax 2.5% 2.7% 2.8%
Assuming a stable interest rate environment, the Company anticipates such yields to slightly decline as funds invested in short-term securities continue to be allocated by the Company into investments in equity securities, which yield less current income than fixed maturity investments. Additionally, such investment yields exclude the Company's equity in the net income or loss of private equity investments accounted for under the equity method.
As a significant portion of the Company's investment portfolio will generally consist of equity securities issued by insurance and reinsurance companies and companies providing services to the insurance industry, the equity portfolio will lack industry diversification and will be particularly subject to the performance of the insurance industry. Unlike fixed income securities, equity securities such as common stocks, including the equity securities in which the Company may invest, generally are not and will not be rated by any nationally recognized rating service. The values of equity securities generally are more dependent on the financial condition of the issuer and less dependent on fluctuations in interest rates than are the values of fixed income securities. The market value of equity securities generally is regarded as more volatile than the market value of fixed income securities. The effects of such volatility on the Company's equity portfolio could be exacerbated to the extent that such portfolio is concentrated in the insurance industry and in relatively few issuers. (For additional discussion, see "--Market Sensitive Instruments and Risk Management.")
As the Company's investment strategy is to invest a significant portion of its investment portfolio in equity securities, its investment income in any fiscal period may be smaller, as a percentage of investments, and less predictable than that of other insurance and/or reinsurance companies, and net realized and unrealized gains (losses) on investments may have a greater effect on the Company's results of operations or stockholders' equity at the end of any fiscal period than other insurance and/or reinsurance companies. Since the realization of gains and losses on equity investments is not generally predictable, such gains and losses may differ significantly from period to period. Variability and declines in the Company's results of operations could be further exacerbated by private equity investments in start-up companies, which are accounted for under the equity method. Such start-up companies may be expected initially to generate operating losses.
Investments that are or will be included in the Company's private portfolio include securities issued by privately held companies and by publicly traded companies that are generally restricted as to resale or are otherwise illiquid and do not have readily ascertainable market values. The risk of investing in such securities is generally greater than the risk of investing in securities of widely held, publicly traded
At December 31, 1998, cash and invested assets totaled approximately $587.2 million, consisting of $120.9 million of cash and short-term investments, $174.5 million of publicly traded fixed maturity investments, $154.7 million of publicly traded equity securities, and $137.1 million of privately held securities. Included in privately held securities are investments totaling $53.6 million which are accounted for under the equity method.
At December 31, 1998, the Company's private equity portfolio consisted of 17 investments, with additional investment portfolio commitments in an aggregate amount of approximately $10.4 million. Since December 31, 1997, the portfolio increased by five additional investments and two follow-on investments, and was decreased by two divestments. In addition, the Company has written down the value of two investments to their net realizable value (one of which included the Company's investment in the managing underwriting agency discussed above).
In October 1998, the Company provided $5 million in financing on a fully secured basis to a managing general agency, and received a related reinsurance commitment expected to generate an aggregate of $90 million of reinsurance premiums over the next three years pursuant to terms and conditions that the Company believes are more favorable than those available in the open market.
The Company has not invested in derivative financial instruments such as futures, forward contracts, swaps, or options or other financial instruments with similar characteristics such as interest rate caps or floors and fixed-rate loan commitments. The Company's portfolio includes market sensitive instruments, such as mortgage-backed securities, which are subject to prepayment risk and changes in market value in connection with changes in interest rates. The Company's investments in mortgage-backed securities, which amounted to approximately $33.5 million at December 31, 1998, or 6% of cash and invested assets, are classified as available for sale and are not held for trading purposes.
In accordance with the SEC's Financial Reporting Release No. 48, the following analysis presents hypothetical losses in cash flows, earnings and fair values of market sensitive instruments which are held by the Company as of December 31, 1998 and are sensitive to changes in interest rates, foreign exchange rates and equity security prices. This risk management discussion and the estimated amounts generated from the following sensitivity analysis represent forward-looking statements of market risk assuming certain adverse market conditions occur. Actual results in the future may differ materially from these projected results due to actual developments in the global financial markets. The analysis methods used by the Company to assess and mitigate risk should not be considered projections of future events of losses.
Market risk represents the risk of changes in the fair value of a financial instrument and is comprised of several components, including liquidity, basis and price risks. The focus of the SEC's market risk rules is on price risk. For purposes of specific risk analysis, the Company employs sensitivity analysis to determine the
effects that market risk exposures could have on the future earnings, fair values or cash flows of the Company's financial instruments.
The Company has foreign currency risk on both reinsurance balances receivable and reinsurance balances payable, including claims and claims expenses. The Company does not currently utilize derivative instruments to manage the Company's exposure to foreign currency movements. At December 31, 1998, the majority of the Company's net receivable/payable position was denominated in United States dollars. At such date, the largest foreign currency exposure related to cash and premiums receivable denominated in European Currency Units ("ECUs"; now effectively Eurodollars) in an amount equal to $10.6 million. A 10% decline in the ECU/United States dollar exchange rate would have resulted in a loss to the Company of $605,000. In addition, the Company had a net liability balance in Sterling equal to $3.1 million. A 10% increase in Sterling/United States dollar exchange rate would have resulted in a loss to the Company of $311,000. Given the Company's limited amount of net receivable balances in other foreign countries, no other currency movement has been considered for purposes of this discussion.
RCHI is a holding company and has no significant operations or assets other than its ownership of all of the capital stock of Risk Capital Reinsurance, whose primary and predominant business activity is providing reinsurance and other forms of capital to insurance and reinsurance companies and making investments in insurance-related companies. RCHI will rely on cash dividends and distributions from Risk Capital Reinsurance to pay any cash dividends to stockholders of RCHI and to pay any operating expense that RCHI may incur. The payment of dividends by RCHI will be dependent upon the ability of Risk Capital Reinsurance to provide funds to RCHI. The ability of Risk Capital Reinsurance to pay dividends or make distributions to RCHI is dependent upon Risk Capital Reinsurance's ability to achieve satisfactory underwriting and investment results and to meet certain regulatory standards of the State of Nebraska. There are presently no contractual restrictions on the payment of dividends or the making of distributions by Risk Capital Reinsurance to RCHI.
Net cash flow from operating activities for the years ended December 31, 1998, 1997 and 1996 was approximately $69 million, $49 million and $31 million, respectively, consisting principally of premiums received, investment income (excluding net realized investment gains), offset by operating costs and expenses. The primary sources of liquidity for Risk Capital Reinsurance are net cash flow from operating activities, principally premiums received, the receipt of dividends and interest on investments and proceeds from the sale or maturity of investments. The Company's cash flow is also affected by claims payments, some of which could be large. Therefore, the Company's cash flow could fluctuate significantly from period to period.
The Company has instituted a comprehensive year 2000 compliance plan designed to help avoid unexpected interruption in conducting its business. The Company's year 2000 initiative includes the following strategic steps:
The Company has completed the assessment phase for its business systems and operating facilities, and is currently in the remediation and testing phases to ensure that the Company's systems and facilities are capable of processing information for the year 2000 and beyond. The Company does not currently anticipate any material year 2000 compliance problems with respect to its internal business systems and operating facilities. Based on information currently available, the cost of this internal compliance effort, while not quantified, is not expected to have a material adverse effect on the Company's financial position or results of operations.
However, due to the interdependent nature of systems and facilities, the Company may be adversely impacted depending upon whether its business partners and vendors address this issue successfully. Therefore, the Company is continuing to survey its key business partners and vendors in an attempt to determine their respective level of year 2000 compliance. As part of this initiative, the Company is evaluating the year 2000 exposures to insurers included in the Company's investment portfolio. The effect, if any, on the Company's financial position or results of operations from the possible failure of these entities to be year 2000 compliant is not determinable.
In addition, property and casualty reinsurance companies, like the Company, may have underwriting exposure related to the year 2000. The year 2000 issue is a risk for some of the Company's reinsureds and is therefore considered during the underwriting process similar to any other risk to which the Company's clients may be exposed. Due to a significant number of variables associated with the extent and severity of the year 2000 problem, the Company's potential underwriting exposure to year 2000 losses cannot be determined at this time. These variables include, but are not limited to, actual pervasiveness and severity of year 2000 system flaws, the magnitude of the amount of costs and expenses directly attributable to year 2000 failures, the portion of such amount (if any) that constitutes insurable losses, and the extent of governmental intervention. The Company's underwriting staff has considered the risks with respect to the year 2000 problem that might be associated with underwriting their various lines of business, and have developed internal guidelines intended to minimize these risks. The Company seeks to minimize its potential year 2000 underwriting exposures by (i) assisting clients in the evaluation of their potential year 2000 underwriting exposures, (ii) performing underwriting evaluations of its clients' potential year 2000 exposure, (iii) structuring contract language to mitigate potential exposure where appropriate and (iv) recommending technical support as appropriate. However, the Company cannot be certain that these steps will adequately minimize its year 2000 underwriting exposures. Given the possible extent and severity of the year 2000 problem, the Company may incur a significant amount of year 2000 related losses, and such losses may have a material adverse impact on the Company's financial condition or results of operations.
In June 1998, the Financial Accounting Standards Board issued Statement No. 133 "Accounting for Derivative Instruments and Hedging Activities." This statement requires that all derivative financial instruments be recognized in the statement of financial position as either assets or liabilities and measured at fair value.
The Company will adopt this statement in the first quarter of 2000. Generally, the Company has not invested in derivative financial instruments. However, derivatives may be embedded in other financial instruments, such as convertible securities and prepayment options in mortgages. If the embedded derivative meets certain criteria, it must be bifurcated from the host contract and separately accounted for consistent with other derivatives.
Start-up activities are defined broadly as those one-time activities related to opening a new facility, introducing a new product or service, conducting business in a new territory, conducting business with a new class of customer or beneficiary, initiating a new process in an existing facility or commencing some new operation. Start-up activities also include activities related to organizing a new entity.
From time to time various regulatory and legislative changes have been proposed in the insurance and reinsurance industry, some of which could have an effect on reinsurers. Among the proposals that have in the past been, or are at present being considered, are (i) the possible introduction of federal regulation in addition to, or in lieu of, the current system of state regulation of insurers and (ii) proposals in various state legislatures (some of which proposals have been enacted) to conform portions of their insurance laws and regulations to various model acts adopted by the NAIC. The Company is unable to predict whether any of such laws and regulations will be adopted, the form in which any such laws and regulations would be adopted, or the effect, if any, these developments would have on the operations and financial condition of the Company. See "Business--Insurance Regulation."