- --------------- (1) Excludes costs incurred in connection with the acquisition and closing of the brokerage operations of Sullivan Kelly Inc. and the closing of the Paris office of Executive Risk N.V.
Management's discussion and analysis of financial condition and results of operations compares certain financial results for the year ended December 31, 1998 with the corresponding periods for 1997 and 1996. The results of the Company include the consolidated results of ERMA, Executive Re and Executive Re's insurance subsidiaries, ERII, ERSIC, ERNV, Quadrant and Executive Risk (Bermuda) Ltd., a Bermuda insurance company owned by Executive Re. In addition, the Company's results include Executive Risk Capital Trust (the "Trust"), a Delaware statutory business trust, Sullivan Kelly Inc., a California corporation formed in September 1997 to acquire the assets of Sullivan, Kelly & Associates, Inc., Insurance Brokers, a California underwriting agency and insurance broker, and a 50% interest in UAP Executive Partners ("UPEX"), a French underwriting agency which was a joint venture between the Company and Union des Assurances de Paris -- Incendie Accidents, a subsidiary of AXA-UAP Group. The joint venture agreement between the Company and UAP was terminated on December 31, 1997. In conjunction with such termination, the Company transferred its 50% interest in UPEX to AXA-UAP Group and in exchange received a cash payment in the amount of $1.1 million. The Company also received $0.7 million from AXA-UAP Group in exchange for the Company agreeing not to compete for a period of one year with AXA-UAP Group on certain policies underwritten by UPEX and in force on December 31, 1997. No realized gain or loss resulted from this termination. The Company does not believe that the termination of the UPEX joint venture agreement, including the non-compete agreement, will have a material adverse impact on the Company's business or financial condition. In the third quarter of 1998, the Company announced the closing of the Sullivan Kelly brokerage operation and the Paris France office of ERNV. In connection with these closings, $5.8 million of charges were recorded.
On February 6, 1999 the Company entered into a definitive merger agreement with The Chubb Corporation ("Chubb"). The agreement provides that ERI stockholders will receive, upon closing, 1.235 shares of Chubb common stock in exchange for each share of Company common stock. The consummation of the transaction is subject to customary closing conditions and the approval of ERI's stockholders and regulatory approvals. It is anticipated that all approvals will be received by the end of the second quarter of 1999. Also in the first quarter of 1999, the Company restructured certain of its reinsurance treaties. The restructured reinsurance program generally makes greater use of excess of loss reinsurance, rather than quota share reinsurance, to reduce exposure to loss severity. The reinsurance restructuring resulted in the non-renewal of several in-force reinsurance treaties commensurate with the effective dates of the new treaties. The restructuring of the reinsurance treaties is not expected to have a material adverse effect on the Company's financial position or results of operations.
The Company's financial position and results of operations are subject to fluctuations due to a variety of factors. Abnormally high severity or frequency of claims in any period could have a material adverse effect on the Company. Also, reevaluations of the Company's loss reserves could result in an increase or decrease in reserves and a corresponding adjustment to earnings. Additionally, the insurance industry is highly competitive. The Company competes with domestic and foreign insurers and reinsurers, some of which have greater financial, marketing and management resources than the Company, and it may compete with new market entrants in the future. Competition is based on many factors, including the perceived market strength of the insurer, pricing and other terms and conditions, services provided, the speed of claims payment, the reputation and experience of the insurer, and ratings assigned by independent rating organizations (including A.M. Best Company, Inc. and Standard & Poor's). ERII, ERSIC, Quadrant and ERNV's current rating from A.M. Best is "A (Excellent)", and their current financial strength rating from S&P is "A+". These ratings are based upon factors of concern to policyholders, including financial condition and solvency, and are not directed to the protection of investors.
Ceded premiums increased $63.1 million, or 37%, to $232.6 million in 1998 from $169.5 million in 1997. The rate of growth in ceded premiums exceeded that of gross premiums written due to a smaller percentage of the 1998 premium writings being in D&O compared to 1997. D&O premiums are ceded at a lower rate than other products, and, therefore, as the D&O premium shrinks as a percentage of the total premium, the ceded premiums rise relative to gross premiums written.
The Company manages its portfolio on a total return basis, and, as such, its investments in equity securities are made for their perceived superior return potential over the long term. Growth in invested assets resulted primarily from cash flows from insurance operations. The nominal portfolio yield of the fixed maturity portfolio at December 31, 1998 was 5.85%, as compared to 6.07% at December 31, 1997. The tax-equivalent yields on the fixed maturity portfolio were 7.41% and 7.58% for these periods, respectively. The decrease in yields at year-end 1998 as compared to year-end 1997 was due principally to lower prevailing interest rates. See "Liquidity and Capital Resources." The Company's net realized capital gains were $6.7 million in 1998 as compared to $3.2 million in 1997. In 1998, net capital gains were realized principally from the sale of fixed maturity investments, equity mutual fund distributions and certain equity limited partnership investments.
Loss and loss adjustment expenses ("LAE") increased $26.1 million, or 18%, to $167.9 million in 1998 from $141.8 million in 1997 due to higher premiums earned partially offset by a slightly lower loss ratio. The Company's loss ratio decreased to 66.0% in 1998 from 67.1% in 1997. In connection with the Company's normal reserving review, which includes a reevaluation of the adequacy of reserve levels for prior years' claims, the Company reduced its unpaid loss and LAE reserves in 1998 for prior report years by approximately $17.3 million. In 1997, the Company reduced its unpaid loss and LAE reserves for prior report years by $10.3 million. These reductions produced corresponding increases in the Company's net income of approximately $11.2 million, or $0.96 per diluted share in 1998, and approximately $6.7 million, or $0.62 per diluted share in 1997. There is no assurance that reserve adequacy reevaluations will produce similar reserve reductions and net income increases in the future.
Policy acquisition costs increased $15.3 million, or 44%, to $50.3 million in 1998 from $35.0 million in 1997. The Company's ratio of policy acquisition costs to net premiums earned increased to 19.8% in 1998 from 16.6% in 1997. The increase in the policy acquisition cost ratio was primarily attributable to higher commission amounts paid to brokers and increased compensation and related expenses incurred in hiring additional underwriting staff to support growth in the Company's business. In addition, the Company incurred $1.9 million of non-recurring expenses in connection with the dissolution of Sullivan Kelly. The ratio of policy acquisition costs to premiums earned excluding the non-recurring expenses associated with Sullivan Kelly for the year ended December 31, 1998 was 19.0%.
and related overhead costs associated with the growth in premium volume and development of new products. In addition, $3.9 million of non-recurring expenses were incurred in connection with the discontinuance of Sullivan Kelly's brokerage operations and the closing of the Paris office of ERNV. The ratio of G&A expenses to net premiums earned increased from 13.5% in 1997 to 14.3% in 1998. Excluding the non-recurring expenses associated with Sullivan Kelly and ERNV, the ratio of G&A costs to premiums earned decreased by 0.8% to 12.7% for the year ended December 31, 1998 as compared to full year 1997.
As a result of the changes in the aforementioned ratios, the Company's GAAP combined ratio increased to 100.0% in 1998 from 97.2% in 1997. Excluding the non-recurring expenses associated with Sullivan Kelly and ERNV the Company's GAAP combined ratio for 1998 was 97.7%. A combined ratio below 100% indicates profitable underwriting prior to the consideration of investment income, capital gains and interest expense. A company with a combined ratio exceeding 100% can still be profitable due to such factors as investment income and realized capital gains.
Interest expense of $5.4 million in 1998 and $1.8 million in 1997 was attributable principally to the outstanding balances under the Company's senior notes payable and bank credit agreement. The outstanding balances under the Company's bank credit agreement were $70 million from January 1, 1997 to February 5, 1997. On February 5, 1997, the Company repaid the $70 million outstanding under the term loan portion of a senior credit facility (the "Senior Credit Facility") arranged through The Chase Manhattan Bank ("Chase"). On December 12, 1997, the Company sold $75 million aggregate amount of 7.125% senior notes payable. Minority interest in the Trust is attributable to distributions payable on the securities of the Trust. See "Liquidity and Capital Resources."
Income tax expense increased $1.1 million, or 14%, to $9.3 million in 1998 from $8.2 million in 1997. The Company's effective tax rate decreased to 17.6% in 1998 from 18.3% in 1997. The decrease in the effective tax rate was due principally to growth in tax-exempt investment income outpacing the increase in pre-tax income.
The nominal portfolio yield of the fixed maturity portfolio at December 31, 1997 was 6.07%, as compared to 6.18% at December 31, 1996. The tax-equivalent yields on the fixed maturity portfolio were 7.58% and 8.00% for these periods, respectively. See "Liquidity and Capital Resources." The Company's net realized capital gains were $3.2 million in 1997 as compared to $1.0 million in 1996. In 1997, net capital gains were realized principally from the sale of fixed maturity investments, equity mutual fund distributions and certain equity limited partnership investments.
Loss and LAE increased $36.5 million, or 35%, to $141.8 million in 1997 from $105.3 million in 1996 due to higher premiums earned partially offset by a slightly lower loss ratio. The Company's loss ratio decreased to 67.1% in 1997 from 67.6% in 1996. In connection with the Company's normal reserving review, which includes a reevaluation of the adequacy of reserve levels for prior years' claims, the Company reduced its unpaid loss and LAE reserves in 1997 for prior report years by approximately $10.3 million. In 1996, the Company reduced its unpaid loss and LAE reserves for prior report years by $6.8 million. These reductions produced corresponding increases in the Company's net income of approximately $6.7 million, or $0.62 per diluted share, in 1997 and $4.4 million, or $0.42 per diluted share, in 1996. There is no assurance that reserve adequacy reevaluations will produce similar reserve reductions and net income increases in the future.
Policy acquisition costs increased $7.2 million, or 26%, to $35.0 million in 1997 from $27.8 million in 1996. The Company's ratio of policy acquisition costs to net premiums earned declined to 16.6% in 1997 from 17.8% in 1996. The decrease in the policy acquisition cost ratio was primarily attributable to higher ceding commissions earned on the Company's reinsurance programs.
G&A expenses increased $11.5 million, or 68%, to $28.6 million in 1997 from $17.1 million in 1996. The increase in G&A costs was due primarily to increased compensation, benefit and related overhead costs associated with the growth in premium volume and development of new products. The ratio of G&A expenses to net premiums earned increased from 11.0% in 1996 to 13.5% in 1997.
As a result of the changes in the aforementioned ratios, the Company's GAAP combined ratio increased to 97.2% in 1997 from 96.4% in 1996.
Interest expense of $1.8 million in 1997 and $4.5 million in 1996 was attributable principally to the outstanding balances under the Company's senior notes payable and bank credit agreement. The outstanding balances under the Company's bank credit agreement were $25 million from January 1, 1996 to March 26, 1996 and $70 million from March 26, 1996 to February 5, 1997. Minority interest in the Trust is attributable to distributions payable on the securities of the Trust. See "Liquidity and Capital Resources."
Income tax expense increased $1.6 million, or 23%, to $8.2 million in 1997 from $6.6 million in 1996. The Company's effective tax rate decreased to 18.3% in 1997 from 19.1% in 1996. The decrease in the effective tax rate was due principally to growth in tax-exempt investment income outpacing the increase in pre-tax income.
ERI is a holding company, the principal asset of which is equity in its subsidiaries. ERI's cash flows depend primarily on dividends and other payments from its subsidiaries. ERI's sources of funds consist primarily of premiums received by the insurance subsidiaries, income received on investments and proceeds from the sales and redemptions of investments. Funds are used primarily to pay claims and operating
expenses, to purchase investments, to pay interest and principal under the terms of the Company's indebtedness for borrowed money and to pay dividends to common stockholders.
The Company believes that it has sufficient liquidity to meet its anticipated insurance obligations as well as its operating and capital expenditure needs. Such capital expenditure needs include the costs of an addition to the Company-owned office headquarters building in Simsbury, Connecticut. Total estimated costs for this project approximate $21.1 million. During 1998 the Company incurred $12.2 million in costs in connection with this addition. The project is targeted for completion in 1999.
The Company's investment strategy emphasizes quality, liquidity and diversification. With respect to liquidity, the Company considers liability durations, specifically loss reserves, when determining investment maturities. In addition, maturities have been staggered to produce a pre-planned pattern of cash flows for purposes of loss payments and reinvestment opportunities. Average investment duration of the fixed maturity portfolio at December 31, 1998, 1997 and 1996 was approximately 5.2, 4.6 and 4.6 years, respectively as compared to an expected loss reserve duration of 5.0 to 5.5 years for such dates. The Company's short-term investment pool was $34.3 million (2.7% of the total investment portfolio) at December 31, 1998 and $88.5 million (8.2% of the total investment portfolio) at December 31, 1997. The decrease in the short-term investment pool was due principally to the fact that approximately $40 million in senior notes had been held in short-term investments at year-end 1997, which were contributed to ERNV in February 1998. Cash and publicly traded fixed income securities constituted 94% of the Company's total investment portfolio at December 31, 1998.
On January 24, 1997, the Company formed the Trust, the common securities of which are wholly owned by the Company. On February 5, 1997, the Trust sold 125,000 8.675% Series A Capital Securities (liquidation amount of $1,000 per Capital Security) to certain qualified institutional buyers pursuant to SEC Rule 144A. The Trust used the $125 million of proceeds received from the sale of the Series A Capital Securities and the $3.9 million received from the sale to the Company of the common securities of the Trust to purchase $128.9 million aggregate principal amount of 8.675% Series A Junior Subordinated Deferrable Interest Debentures of the Company due February 1, 2027 (the "Series A Debentures"). The Company utilized the $123.5 million of net proceeds as follows: $70 million to repay the amount outstanding under the term loan portion of the Senior Credit Facility arranged through Chase, $45 million to make a surplus contribution to ERII and $8.5 million for general corporate purposes. On May 29, 1997, all of the Series A Capital Securities were exchanged for Series B Capital Securities (the "Capital Securities"). In addition, $125 million aggregate principal amount of the Series A Debentures were exchanged for a like aggregate principal amount of 8.675% Series B Junior Subordinated Deferrable Interest Debentures of the Company due February 1, 2027 (the "Series B Debentures" and together with the remaining $3.9 million aggregate principal amount of the outstanding Series A Debentures are hereinafter referred to as the "Debentures"). The terms of the Capital Securities are identical in all material respects to the terms of the Series A Capital Securities, except that the Capital Securities have been registered under the Securities Act of 1933 and are not subject to the $100,000 minimum liquidation amount transfer restriction and certain other transfer restrictions applicable to the Series A Capital Securities. The sole assets of the Trust are the Debentures.
On December 12, 1997, the Company issued $75 million aggregate principal amount of unsecured 7.125% senior notes (the "Senior Notes") maturing on December 15, 2007. Interest on the Senior Notes is payable semi-annually in arrears on June 15 and December 15, commencing on June 15, 1998. The Senior Notes may not be redeemed prior to maturity and are not subject to any sinking fund. The Company used the $74.2 million of net proceeds of the issue to make surplus contributions to current insurance company subsidiaries of the Company in order to support existing business lines and to finance entry into new business lines, and for general corporate purposes. In addition, the Company obtained through Chase a $25 million revolving credit facility. The Company has no plans to draw funds under the revolving credit facility.
In each of March, June, September and December of 1998, the Company paid dividends to common stockholders of record of $0.02 per share. Such Common Stock dividends totaled $0.9 million. ERII, ERSIC and Quadrant are subject to state regulatory restrictions that limit the amount of dividends payable by these companies. Subject to certain net income carryforward provisions, ERII must obtain approval of the Insurance Commissioner of the State of Delaware in order to pay, in any 12-month period, dividends that exceed the greater of 10% of surplus as regards policyholders as of the preceding December 31 and statutory net income less realized capital gains for the preceding calendar year. Dividends may be paid by ERII only out of earned surplus. ERSIC and Quadrant must obtain approval of the Insurance Commissioner of the State of Connecticut in order to pay, in any 12-month period, dividends that exceed the greater of 10% of surplus with respect to policyholders as of the preceding December 31 and statutory net income for the preceding calendar year. In addition, ERSIC and Quadrant may not pay any dividend or distribution in excess of the amount of its earned surplus, as reflected in its most recent statutory annual statement on file with the Connecticut Insurance Commissioner, without such Commissioner's approval. ERII, ERSIC and Quadrant are all required to provide notice to the Insurance Commissioners of the States of Delaware and Connecticut, as applicable, of all dividends to shareholders. Additionally, both Delaware and Connecticut law require that the statutory surplus of ERII, ERSIC or Quadrant, as applicable, following any dividend or distribution be reasonable in relation to its outstanding liabilities and adequate for its financial needs.
The Y2K problem is a worldwide issue facing virtually every organization that employs technology to achieve its goals, including the Company. The Y2K problem stems from the use of a two-digit code representing the year in computer-based systems, which could cause some computers to fail or malfunction after December 31, 1999. The Company's insurance policies contain date sensitive data, such as expiration dates, and internal systems rely on such date fields. Further, the Company's philosophy has long emphasized the use of technology, so it may be more heavily reliant upon computer systems than some other similarly
Internal: Management has taken steps to address Y2K as it affects the Company's own business systems. In addition to assigning senior Information Services staff resources exclusively to this project, the Company formed a Y2K Project Office, which includes the Chairman of the Board of Directors as well as representatives from all principal operations areas. Early in 1998, the Project Office began monitoring the Company's Y2K compliance project, a five-phase program incorporating assessment, remediation, testing, business partner compliance and corporate acceptance. Later during 1998, the Company retained an independent consultant, which advised and made recommendations as to the adequacy of planned testing protocols and test schedules. As of the date of this report, the Company has completed the assessment, remediation and testing phases of all mission-critical applications. It is on-schedule to complete the remaining testing, and currently plans to conduct a so-called "end to end" test of all information systems, by late second quarter or early third quarter 1999. Additionally, third-party business partners that have material vendor or customer relationships with the Company have been identified, and each has been contacted to determine its Y2K readiness. In particular, there are several insurance brokerage firms that produce a significant share of the Company's insurance business. An inability on the part of any such firm to process insurance applications due to a failure of their computer systems could materially affect the Company's financial results for the period in which such failure occurred. The Company's Y2K readiness project calls for contingency planning to identify actions to be taken should the Company's or its business partners' readiness efforts fail. Such plans are being formalized during the first half of 1999.
External: Because a significant portion of the Company's business is insuring executives of business organizations that rely on computer technology, business interruptions and other problems related to mismanagement of the Y2K issue could also affect the Company's claims experience in future years. In July 1998, a national rating agency revised its outlook on the rating of the Company's senior debt from "stable" to "negative," premised upon the agency's analysis of the D&O insurance industry's exposure to the Y2K issue. (Such negative ratings outlook has since been removed in light of the announced transaction with Chubb.) The Company acknowledges that Y2K entails a significant risk to the entities it insures. Y2K litigation is likely to cause some negative development in the Company's loss experience. Due to the general uncertainty inherent in the Y2K problem, however, the Company is unable to determine at this time whether such losses will have a material impact on the Company's results of operations or financial condition. The Company believes that its Y2K specific underwriting techniques, together with conservative reinsurance practices and loss reserving, should mitigate the impact of the Y2K problem.
-- Consolidated Statements of Income for the years ended December 31, 1998, 1997 and 1996.
-- Consolidated Statements of Stockholders' Equity for the years ended December 31, 1998, 1997 and 1996.