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 $335.0 million, of which $328.0 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, 1996, the statutory surplus of Risk Capital Reinsurance was approximately $334.3 million.
The property and casualty reinsurance industry has been highly cyclical. This cyclicality has produced periods characterized by intense price competition due to excessive underwriting capacity as well as periods when shortage of capacity permitted favorable premium levels. Demand for reinsurance is influenced significantly by underwriting results of primary property and casualty insurers and prevailing general economic and market conditions, all of which affect liability retention decisions of primary insurers and reinsurance premium rates. The supply of reinsurance is related directly to prevailing prices and levels of surplus capacity, which, in turn, may fluctuate in response to changes in rates of return on investments being realized in the reinsurance industry. The cyclical trends in the industry and the industry's profitability can also be affected significantly by volatile and unpredictable developments, including changes in the propensity of courts to grant larger awards, natural disasters (such as catastrophic hurricanes, windstorms, earthquakes, floods and fires), fluctuations in interest rates and other changes in the investment environment that affect market prices of investments and the income and returns on investments, and inflationary pressures that may tend to affect the size of losses experienced by ceding primary insurers.
The amount of investment income earned that may offset underwriting losses from quarter to quarter could vary and 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 of insurance companies and insurance-related entities. Investments in equity securities yield less current investment income than fixed maturity investments. 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 to initially generate operating losses. Accordingly, the Company's results of operations for the year ending December 31, 1997 may vary from quarter to quarter and from the financial results reported by the Company in 1996, and could also produce operating losses.
Unrealized appreciation or depreciation of investments to the extent that it occurs for investments carried at fair value is recorded in a separate components of stockholders' equity, net of related deferred income taxes. Such gains or losses are recorded in net income to the extent investments are sold. The timing and recognition of such gains and losses are unpredictable and not indicative of future operating results.
Net premiums written for the year ended December 31, 1996 were as follows:
One traditional means of measuring the underwriting performance of a property/casualty insurer, such as the Company, is the statutory composite ratio. This ratio, which is based upon statutory accounting principles (which differ from generally accepted accounting principles in several respects), reflects underwriting experience, but does not reflect income from investments. A statutory composite ratio of under 100% indicates underwriting profitability, while a composite ratio exceeding 100% indicates an underwriting loss.
In pricing its reinsurance treaties, the Company focuses on many factors, including exposure to claims and commissions and brokerage expenses. Commissions and brokerage expenses are acquisition costs that generally vary by the type of treaty and line of business, and are considered by the Company's underwriting and actuarial staff in evaluating the adequacy of premium writings.
Other operating expenses increased to $11.3 million for the year ended 1996, compared to $3.9 million for the period June 23, 1995 (date of inception) to December 31, 1995. The other operating expense ratio component of the 1996 statutory composite ratio was reduced by 12.7 percentage points due to the premiums written generated from assumed unearned premium portfolios and other non-recurring transactions. Assuming the successful execution of the Company's business strategy, the Company expects other operating expenses to grow commensurate 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.
The Company will evaluate its retrocessional requirements periodically in relation to many factors, including its surplus capacity, gross line capacity and changing market conditions. Other than the Company's participation in "common account" retrocessional arrangements for certain reinsurance treaties, the Company currently does not maintain retrocessional arrangements on a per risk or per treaty basis, or for the purpose of limiting its exposure with respect to catastrophe losses or unusual accumulations of losses resulting from a single occurrence involving two or more reinsured policies. The Company believes that such exposures are currently adequately managed through appropriate terms and conditions and pricing of reinsurance contracts. Common -26 -
account retrocessional arrangements reduce the effect of individual or aggregate losses to all participating companies with respect to a reinsurance treaty, including the cedent.
With respect to integrated transactions (where the Company combines an equity or equity-like investment in a client company with the purchase by such client of reinsurance from the Company), the Company generally limits its combined underwriting and investment exposure to pre-tax losses on any individual client to no more than 10% of its total statutory surplus, and subjects these commitments to intensive scrutiny by the combined professional staffs of both the Company and Risk Capital Corp.
companies and companies providing services to the insurance industry. Cash and fixed maturity investments and, if necessary, the sale of marketable equity securities will be used to support short-term liquidity requirements.
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 cyclicality 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.
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 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. Because the realization of gains and losses on equity investments are not generally predictable, such gains and losses may differ significantly from period to period.
At December 31, 1996, cash and invested assets totaled approximately $392.9 million, consisting of $106.3 million of cash and short-term investments, $140.4 million of publicly traded fixed maturity investments, $117.4 million of publicly traded equity securities and $28.8 million of privately held securities. Included in privately held securities are two investments totaling $4.4 million which are accounted for under the equity method.
See Note 3 under the caption "Investment Information" of the accompanying Notes to Consolidated Financial Statements of the Company for certain information regarding the Company's publicly traded and privately held securities and their carrying values, and commitments made by the Company relating to its privately held securities. Over the long-term, the Company intends to continue to allocate a substantial portion of its cash and short-term investments into publicly traded and privately held equity securities, subject to market conditions and opportunities in the marketplace.
The fixed maturity and short-term investments were all rated investment grade by Moody's Investors Service, Inc. or Standard & Poor's Corporation and have an average quality rating of AA and an average duration of approximately 2.2 years.
At December 31, 1996, the Company is obligated under letters of credit approximating $34 million, which secure certain reinsurance obligations and investment commitments in amounts of approximately $22 million and $12 million, respectively. Securities with a carrying value of approximately $30 million have been pledged as collateral for a portion of these letters of credit.
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 its 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 year ended December 31, 1996 was approximately $31 million, consisting principally of premiums received, investment income and net 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.
compensation expense for stock issued to employees under its stock purchase plan. The alternative to APB No. 25 is the Financial Accounting Standards Board ("FASB") No. 123 "Accounting for Stock-Based Compensation," which requires fair value accounting for stock-based compensation. This alternative requires the use of option valuation models that were not developed for use in valuing employee stock options and employee stock purchase plans. Therefore, the Company believes that the existing models do not provide a reliable single measure of the fair value of employee stock options that have vesting provisions and are not transferable. For additional discussion, see Note 8 under the caption "Employee Benefits and Compensation Arrangements" of the accompanying Notes to the Consolidated Financial Statements of the Company.
Certain provisions of the Nebraska insurance laws are proposed to be amended through a bill that is currently before the Nebraska legislature. If such legislation is adopted, the proposed amendments could have a material impact on the investment strategy of the Company. See "Business--Insurance Regulation--Legislative and Regulatory Proposals."