Year Ended December 31, 1998 versus Year Ended December 31, 1997
Net income including income or loss from discontinued operations for the year ended December 31, 1998 decreased to $41.5 million from $70.1 million for the same period of the prior year. On a per share basis, basic and diluted net income including income or loss from discontinued operations decreased to $1.30 and $1.27, respectively, for the year ended December 31, 1998 from $2.21 and $2.16, respectively, for the same period of 1997, or, in each case, 41.2%.
The decrease in the year end 1998 financial results was primarily due to two separate financial guaranty losses. First, the Corporation established a $10.0 million pre-tax case basis loss reserve for losses arising from the bankruptcy of the Delaware Valley Obligated Group, a unit of Pittsburgh based Allegheny Health, Education and Research Foundation ("Allegheny"). Under the reinsurance treaty with its ceding company, the Corporation has reinsured Allegheny bonds with an outstanding principal amount of $14.6 million. In November, the Corporation made loss and loss adjustment payments of $1.0 million in respect of the Allegheny bonds. As a result, the aggregate case basis loss and loss adjustment expense reserve for Allegheny as of December 31, 1998 decreased to $9.0 million. The Corporation expects that the reserve will cover all anticipated present value losses arising from its exposure to Allegheny. The second loss was a $44.1 million pre-tax increase in Capital Re's case basis loss reserve for losses arising from the reinsurance of three issues of asset-backed securities serviced by Commercial Financial Services, Inc. ("CFS"). As of December 31, 1998, the Corporation had $153.3 million in reinsured principal outstanding to the CFS securities. The $44.1 million reserve represents the Corporation's best estimate of all currently anticipated and probable losses. Notwithstanding the Allegheny and CFS losses, the Corporation's total revenues increased to $234.9 million for the year ended December 31, 1998 from $181.5 million in 1997, or 29.4%, principally due to growth in net premiums earned and net investment income.
Gross premiums written increased 25.9% to $213.9 million for the year ended December 31, 1998 from $169.9 million for the same period of 1997. This increase was primarily due to growth in non-municipal bond reinsurance business. This growth was due to a significant increase in premiums written in the credit default swaps sector of that business. The Corporation has expanded its traditional municipal and non-municipal financial guaranty bond reinsurance lines of business to include credit default swaps. A credit default swap is a transaction whereby one counterparty pays a periodic fee in fixed basis points on a notional amount in return for a contingent payment by the other counterparty in the event one or more defined credit events occurs with respect to one or more third party reference securities or loans. A credit event is defined as failure to pay, bankruptcy, cross acceleration (generally accompanied by a failure to pay), repudiation, restructuring, or similar nonpayment event. Credit default swap premium grew to $6.8 million for the year ended December 31, 1998 from $0.7 million in the prior year. In addition, growth in the non-municipal bond reinsurance line was attributable to a large reinsurance transaction the Corporation entered into in the fourth quarter of 1998 which provided credit enhancement of $74.6 million of investment grade asset backed securities. The Corporation received upfront premium of $10.4 million for this transaction. Mortgage guaranty reinsurance premium decreased in 1998 from 1997 due to an increase in mortgage prepayments caused by lower interest rates as well as the Corporation's shift away from assuming quota share
In 1997, the Corporation added a financial solutions line of business. The financial solutions business is focused on providing highly structured solutions to problems of financial and risk management through reinsurance, including credit enhancement, excess of loss and surplus management covers. Gross premiums written attributable to the financial solutions line increased to $11.0 million for the year ended December 31, 1998 from $2.7 million for the same period of 1997. The following table shows gross premiums written by line of business for the years ended December 31, 1998 and December 31, 1997.
Financial Risks Division: Mortgage 66.8 70.8 Credit 35.3 23.0 Financial Solutions 11.0 2.7 Title 5.7 4.0 ------ ------
Net premiums written increased by 28.2% to $210.6 million for the year ended December 31, 1998 from $164.3 million for the same period in 1997. This increase is commensurate with the increase in gross premiums written explained above. The following table shows net premiums written by line of business for the years ended December 31, 1998 and December 31, 1997.
Net Premiums Written Year Ended December 31, 1998 1997 ---- ---- (dollars in millions)
For the year ended December 31, 1998, net premiums earned increased 46.1% to $168.4 million from $115.3 million for the comparable 1997 period. This increase was primarily due to growth in net premiums earned in the municipal, non-municipal (including credit default swaps), credit, and financial solutions lines of business. For the year ended December 31, 1998, net refunded earned premium increased to $16.5 from $4.8 million for the comparable period in 1997. Excluding the effects of net refunded municipal earned premium, net premiums earned increased 37.5% to $151.9 million for the year ended December 31, 1998 from $110.5 million for the year ended December 31, 1997. A refunding extinguishes the Corporation's reinsurance liability for the refunded obligation and the Corporation then recognizes revenue equal to the remaining related deferred premium revenue. Net premiums earned from credit default swaps, which are earned as written, increased to $6.8 million for the year ended December 31, 1998 from $0.7 million in the prior year. For the years ended December 31, 1998 and 1997, ceded earned premium was $13.7 million and $17.7 million, respectively. The following table shows net premiums earned by line of business for the years ended December 31, 1998 and December 31, 1997.
Financial Risks Division: Mortgage 59.3 53.2 Credit 28.7 17.2 Financial Solutions 11.0 0.1 Title 5.7 3.6 ------ ------
For the year ended December 31, 1998, net investment income increased 14.9% to $64.9 million from $56.5 million for the comparable period in 1997. Growth in investment income was primarily attributable to a larger investment portfolio caused by an increase in invested assets from positive operating cash flows during the twelve months ended December 31, 1998. In addition, the Corporation recognized net realized losses of $1.5 million for the year ended December 31, 1998 compared to net realized gains of $8.0 million for the same period in 1997. The net realized losses recorded in 1998 were a result of a $7.5 million write-down of the Corporation's investment in CGA Group, Ltd. ("CGA") based on the Corporation's estimate of a permanent impairment in the carrying value of that investment.
Loss and loss adjustment expenses increased to $86.6 million from $15.6 million for the years ended December 31, 1998 and 1997, respectively. The increase in losses recorded for the year ended December 31, 1998 was primarily attributable to the $10.0 million Allegheny loss and the $44.1 million CFS loss explained above, as well as expected loss development commensurate with the growth in net premiums earned. Ceded losses for the years ended December 31, 1998 and 1997 were $4.8 million and $6.6 million, respectively. The loss ratio was 51.4% for the year ended December 31, 1998 compared to 13.6 % for the prior year. Excluding the Allegheny and CFS losses, the loss ratio for the year ended December 31, 1998 was 19.3%.
Total expenses, including loss and loss adjustment expenses, increased 114.4% to $180.1 million for the year ended December 31, 1998 from $84.0 million for the same period of 1997. This increase was primarily attributable to the Allegheny and CFS losses as well as the amortization of acquisition expenses associated with the increased level of
Net income from continuing operations for the year ended December 31, 1997 increased 24.1% to $70.8 million from $57.0 million for the same period of 1996. The Corporation adopted Statement of Financial Standards No. 128, "Earnings per Share" ("FAS 128"), as of December 31, 1997. FAS 128 requires the calculation and presentation on the face of the income statement of basic earnings per share and, if applicable, diluted earnings per share. Basic earnings per share is calculated based on the weighted average common shares outstanding. All potentially dilutive securities such as stock options and convertible securities are excluded from the basic earnings per share calculation. In calculating diluted earnings per share, the number of shares is increased to include all potentially dilutive securities, including stock options and convertible securities. On a per share basis, basic and diluted net income from continuing operations increased to $2.23 and $2.18, respectively, for the year ended December 31, 1997 from $1.82 and $1.79, respectively, for the same period of 1996, or 22.5% and 21.8%, respectively.
In addition, net operating income from continuing operations (net income from continuing operations excluding realized gains and losses) increased 18.1% to $65.9 million for the year ended December 31, 1997 from $55.8 million for the same period in 1996. On a per share basis, basic and diluted net operating income increased to $2.07 and $2.03, respectively, for the year ended December 31, 1997 from $1.78 and $1.75, respectively, for the same period of 1996, or 16.3% and 16.0%, respectively. Growth in net premiums earned to $115.3 million from $92.4 million, or 24.8%, was the principal cause of the increase in net income. Growth in net premiums earned was a result of growth in the financial guaranty, mortgage, trade credit and other specialty reinsurance lines of business.
Gross Premiums Written Year Ended December 31, 1997 1996 ---- ---- (dollars in millions)
Net premiums written increased by 56.3% to $164.3 million for the year ended December 31, 1997 from $105.2 million for the same period in 1996. This increase is commensurate with the increase in gross premiums written explained above as well as the recording of a large ceded premium installment on a municipal portfolio paid in the fourth quarter of 1996. The following table shows net premiums written by line of business for the years ended December 31, 1997 and December 31, 1996.
Net Premiums Written Year Ended December 31, 1997 1996 ---- ---- (dollars in millions)
Financial Risks Division: Mortgage 70.5 40.9 Credit 22.9 14.9 Financial Solutions 0.1 0.0 Title 4.0 1.8 --- ---
million, respectively. The following table shows net premiums earned by line of business for the years ended December 31, 1997 and December 31, 1996.
Total expenses, including loss and loss adjustment expenses, increased 22.8% to $84.0 million for the year ended December 31, 1997 from $68.4 million in the same period of 1996. This increase was primarily attributable to commissions associated with the increased level of premiums written and normal loss development from the mortgage and credit lines of business. Furthermore, the combined ratio, excluding expenses associated with non-insurance operations, increased to 61.2% for the year ended December 31, 1997 from 60.7% for the comparable 1996 period. This increase is an expected result of the Corporation's mix of business, which is producing more business from lines with relatively higher combined ratios than that of the financial guaranty reinsurance business. For the year ended December 31, 1997, the total federal tax provision increased to $26.6 million from $20.9 million for the same period in 1996. In addition, the effective tax rate increased slightly to 27.3% for the year ended December 31, 1997 from 26.8% in the same period of 1996.
The Corporation relies on dividends from Capital Reinsurance and Capital Credit to fund its payment of dividends on its capital stock and interest on its outstanding debt. The major sources of liquidity for Capital Reinsurance are funds generated from reinsurance premiums, net investment income and maturing investments. Capital Reinsurance is domiciled in the State of Maryland, and, under Maryland
insurance law, the amount of the surplus of Capital Reinsurance available for distribution as dividends is subject to certain statutory restrictions. The amount available for distribution from Capital Reinsurance during 1999 with notice to, but without prior approval of, the Maryland Insurance Commissioner is limited to 10% of Capital Reinsurance's policyholders' surplus as of December 31, 1998, or approximately $32.3 million. For the year ended December 31, 1998, Capital Reinsurance paid $8.0 million in dividends to the Corporation.
Capital Mortgage is subject to the dividend restrictions imposed under New York insurance law. Accordingly, dividends may only be declared and distributed out of earned surplus (as defined under New York insurance law). Additionally, no dividend may be declared or distributed by Capital Mortgage in an amount which, together with all dividends declared or distributed by Capital Mortgage during the preceding twelve months, exceeds the lesser of 10% of such company's surplus to policyholders as shown by its last Annual Statutory Statement on file with the New York insurance department, or 100% of adjusted net investment income (as defined under New York insurance law) during such period, unless, upon prior application, the New York Superintendent of Insurance approves a greater dividend distribution based upon his finding that Capital Mortgage will retain sufficient surplus to support its obligations and writings. KRE's dividends and distributions to its sole shareholder, Capital Mortgage, are governed by Bermuda law and are subject to the same restrictions as those for Capital Credit described in the preceding paragraph. To date, Capital Mortgage and KRE have not declared nor paid any dividends. The maximum dividend payable by Capital Mortgage during 1999 is $0 since its earned surplus was ($9.2) million as of December 31, 1998.
Due to unprecedented market conditions relating to credit spreads during the third and fourth quarters of 1998, the market values of the Managed Portfolios declined. As of September 30, 1998, the market values of the Managed Portfolios with collateral threshold triggers were not then below the collateral threshold triggers. Subsequent to September 30, market values further declined through mid-October and, as of October 18, 1998, CG Assurance's management prepared an estimate of market values of the Managed Portfolios, which indicated that if such market values were validated at the October 30, 1998 valuation date provided for in the bank loan agreements, substantial collateral would be required in the case of the Managed Portfolios subject to the collateral threshold triggers. As a result, certain institutional investors in CGA provided credit enhancements on various securities in the Managed Portfolios in the aggregate principal amount of $382 million. Of that aggregate amount, Capital Reinsurance credit enhanced $74.6 million of investment-grade asset-backed securities. Capital Reinsurance also credit enhanced the two other institutional investors that provided credit enhancement on the securities in the Managed Portfolios. Capital Reinsurance was paid a market rate premium for providing the reinsurance support. Market values of the Managed Portfolios have improved since October and, currently, the market values of the Managed Portfolios are above the relevant collateral threshold triggers. Throughout this period, CG Assurance was, and continues to be, rated triple-A by D&P.
The Corporation's Board of Directors authorized a quarterly common stock dividend rate of $0.04 per share, or $0.16 annually. For the year ended December 31, 1998, common stock dividends were declared and paid in the amount of $5.1 million or $0.16 per share.
Prepayment risk is an inherent risk of holding MBS. However, the degree of prepayment risk is particular to the type of MBS held. The Corporation limits its exposure to prepayments by purchasing less volatile types of MBS. As of December 31, 1998, $3.6 million, or approximately 1.9%, of the MBS portfolio was invested in collateralized mortgage obligations ("CMOs") which are characterized as planned amortization class CMOs ("PACs"). PACs are securities whose cash flows are designed to remain constant over a variety of mortgage prepayment environments. Other classes in the CMO security are structured to accept the volatility of mortgage prepayment changes, thereby insulating the PAC class. Of the remaining MBS portfolio, $190.0 million, or 98.1%, was invested in mortgage-backed pass-throughs or sequential CMOs. Pass-throughs are securities in which the monthly cash flows of principal and interest (both scheduled and prepayments) generated by the underlying mortgages are distributed on a pro-rata basis to the holders of securities. A sequential MBS is structured to divide the CMO security into sequentially ordered classes. Receipt of principal payments within classes is contingent on the retirement of all previously paying classes. Generally, interest payments are made currently on all classes. While these securities are more sensitive to prepayment risk than PACs, they are not considered highly volatile securities. While the Corporation may consider investing in any tranche of a sequential MBS, the individual security's characteristics (duration, relative value, underlying collateral, etc.) along with aggregate portfolio risk management determine which tranche of sequential MBS will be purchased. At December 31, 1998, the Corporation had no securities such as interest only securities, principal only securities, or MBS purchased at a substantial premium to par that have the potential for loss of a significant portion of the original investment due to changes in the prepayment rate of the underlying loans supporting the security.
Capital Reinsurance is party to a credit facility with Deutsche Bank AG (the "DB Credit Facility") pursuant to which Deutsche Bank AG provides up to $100.0 million specifically designed to provide rating agency qualified capital to further support Capital Reinsurance's claims-paying resources. This agreement expires January 27, 2006. The Corporation has not borrowed under the DB Credit Facility.
In addition, on August 20, 1996, the Corporation entered into a credit agreement with Chase Manhattan Bank for the provision of a $25.0 million credit facility (the "Chase Facility") which is available for general corporate purposes. Furthermore, on August 26, 1996, the Corporation utilized $16 million of the Chase Facility for purposes of paying subordinated notes that came due. Interest on the bank note issued under the Chase Facility is payable quarterly based upon the Corporation's chosen interest rate option under the terms of the Chase Facility. In November 1996, the Corporation utilized the remaining $9 million of the Chase Facility for purposes of acquiring RGB.
On March 10, 1999, Moody's Investors Service, Inc. ("Moody's") announced that it had downgraded the financial strength rating of Capital Reinsurance to Aa2 from Aaa. This action ended a review process that began on November 5, 1998. Moody's cited increased competition in the monoline financial guaranty reinsurance industry, an increased risk profile in business assumed and rising operating leverage as reasons for the downgrade. Under certain of its reinsurance agreements with two of its financial guaranty ceding companies, Capital Reinsurance has agreed to increase the ceding commission payable under such agreements as a result of the rating action by Moody's. The increase will apply to in-force and future business ceded by those companies. The financial impact of the increased ceding commission with respect to the in-force business at December 31, 1998 is not expected to exceed $2.0 million in 1999. The reinsurance agreements with the two ceding companies also give those companies an
option to reassume business previously ceded to Capital Reinsurance upon certain adverse rating actions; however, those options to fully reassume will not be triggered by Capital Reinsurance's March 10th downgrade. Additionally, one of the ceding companies may reassume a minor portion of its previously ceded business based on this rating action alone; however, that company has not indicated that it will exercise the option.
In February 1999, ACE Bermuda Insurance, Ltd., a subsidiary of ACE Limited, agreed to invest $75 million in the Corporation through a purchase of common stock. The proceeds will be used to augment the surplus of the Corporation's operating subsidiaries. Under the stock purchase agreement, as amended, the purchase price is determined as the lower of (i) fully diluted GAAP book value per share at December 31, 1998 (or $18.87 per share) and (ii) the average of the highest five consecutive market closing prices of the Corporation's common stock from March 12, 1999 through April 15, 1999. Closing is contingent on customary conditions and the affirmation of the S&P's financial strength ratings of the Corporation's major subsidiaries.
The main objectives in managing the investment portfolios of the Corporation and its operating subsidiaries are to maximize after-tax investment income and total investment returns while minimizing credit risks in order to provide maximum support to the reinsurance underwriting operations. Investment strategies are developed based on many factors including underwriting results and the Corporation's resulting tax position, regulatory requirements, fluctuations in interest rates and consideration of other market risks. Investment decisions are managed by outside investment professionals under discretionary investment management agreements and based on guidelines established by management and approved by the board of directors.
Market risk represents the potential for loss due to adverse changes in the fair value of financial instruments. The market risks related to financial instruments of the Corporation and its operating subsidiaries primarily relate to the investment portfolio, which exposes the Corporation to risks related to interest rates and, to a lesser extent, credit quality and prepayment. Analytical tools and monitoring systems are in place to assess each of these elements of market risk.
Long-term Fixed Maturities Expected Cash Flows of Principal Amounts (Dollars in millions)
The Corporation and its operating subsidiaries have consistently invested in high quality marketable securities. As a result, the Corporation believes that it has minimal credit quality risk. Taxable bonds in the Corporation's domestic portfolio consist of U.S. Treasury, government agency, mortgage-backed and corporate securities. At December 31, 1998, approximately 20.7% of taxable bonds were issued by the U.S. Treasury or U.S. government agencies and approximately 83.6% were rated AA or better by Moody's or S&P. Of the tax exempt bonds, approximately 99.0% were rated AA or better with more than 90.1% rated AAA. Less than 1.5% of the Corporation's bond portfolio was below investment grade at December 31, 1998. At December 31, 1998, both taxable and tax exempt bonds had a weighted average maturity of approximately 8.9 years.
The Corporation's taxable bond portfolio includes mortgage-backed securities, which comprised 17.8% of the portfolio at year-end 1998. Prepayment risk refers to the changes in prepayment patterns that can either shorten or lengthen the expected timing of the principal repayments and thus the average life and the effective yield of a security. Such risk exists primarily within the Corporation's portfolio of mortgage-backed securities. The Corporation invests primarily in those classes of mortgage-backed securities that are less subject to prepayment risk.
All of the above risks are monitored on an ongoing basis. A combination of in-house systems and proprietary models and externally licensed software are used to analyze individual securities as well as each portfolio. These tools provide management with information to assist them in the evaluation of the market risks of the portfolio.
The Corporation is actively pursuing its Year 2000 analysis and preparation. The Year 2000 issue involves potential complications related to computer systems, machinery and electronics that contain computer code, whether in software or embedded within microchips, that recognize years in two digit code, e.g. "98" for the year 1998. Software or microchips that recognize the Year 2000 as "00" or any year thereafter in its two digit equivalent, threatens date sensitive calculations by potentially misapplying the date (e.g. "00" could be applied as 1900 rather than 2000). Any coding that causes a date recognition error of this sort is commonly referred to as a Year 2000 bug.
The Corporation has assembled a team consisting of officers and employees of the finance and information systems departments to oversee the Corporation's readiness for the Year 2000. The group has already completed the first phase of its analysis in which a comprehensive list of all the Corporation's own information technology systems and general technology was prepared. Additionally, the Corporation's clients and vendors were reviewed and a listing was prepared of those with information systems or other technology upon which the Corporation may rely and those which may be affected by the Year 2000 bug. The Corporation has made inquiries as to Year 2000 readiness with these clients and vendors and has received responses from a majority of them. It is currently evaluating these responses. However, all of the Corporation's ceding companies that have thus far responded report that they expected to be Year 2000 compliant by year-end 1998. The Corporation is now performing testing and remediation, as necessary, on its information technology systems, its general systems and any other technology that may be affected by the Year 2000 bug. This process is not yet complete, but is expected to be completed by mid-1999.
o In-house Applications: All key in-house applications have been tested and are Year 2000 compliant.
o Accounting Software: Vendors for the major accounting software packages used by the Corporation have stated that the software versions the Corporation uses are Year 2000 compliant.
o Administration/Human Resources; Operating System Software; Network/Lan Utilities; Desktop Hardware: Ninety-five percent of these applications will be Year 2000 compliant.
o General Office Services:. These systems will all be upgraded by mid-1999.
The Corporation has not had to defer any of its expected information technology or other technology installations, updates or enhancements in order to accommodate its Year 2000 review and remediation work.
Due to the youthfulness of the Corporation's information technology and other systems, testing and remediation have been fairly uncomplicated. Moreover, none of the Corporation's technology is mainframe computer based. Mainframes traditionally use older coding methodologies and, thus, are more likely to be double digit dated coded. No external consultants have been retained. Internal information technology personnel have overseen and implemented the testing and remediation of the systems and technology. The amount of additional time allocable to employees' efforts has been nominal. All system upgrade costs incurred would have been incurred by the Corporation as part of routine software upgrades and all patches have been provided without any material cost to the Corporation. The Corporation does not expect any material additional costs and expects that, including the cost
The Corporation does not have a prescribed contingency plan relative to Year 2000 bug issues. The Corporation does not predict that a failure of its information technology systems will materially affect daily operations or have an immediate impact on the Corporation's ability to conduct business. All internal financial reporting of the Corporation may be conducted by hand. As for any failure of a bond issuer that has been reinsured by the Corporation, the Corporation expects to handle such matters in the ordinary course of business. As the Corporation is a reinsurer, payments are requested in bulk by the Corporation's ceding insurers, and payment of reinsurance proceeds would be made in bulk. The Corporation is not required to make payment to individual bond obligees. Ultimately, all recovery efforts in the event of any Year 2000 bug related event can either be handled internally, or would require the intervention of hardware, software or other technology vendors. The Corporation maintains a list of the appropriate contacts at such vendors in the event such a need arises.
In November 1996, the Corporation acquired 100% of the issued shares of Tower Street Holdings Limited (now known as RGB Holdings, Ltd.), the holding company for RGB Underwriting Agencies Ltd. ("RGB"). RGB is a Lloyd's managing agency and presently manages four syndicates operating in the Lloyd's of London insurance market. In connection with its acquisition of RGB, the Corporation established a corporate name at Lloyd's. In 1998 the Corporation commenced a plan of divestiture of its Lloyd's operations and those operations are presented as a discontinued operation. See Note 3. Pending divestiture, the Corporation will continue to support its commitments to Lloyd's. See Note 16. For comparative purposes, all prior period financial statements have been restated.
In December 1996, the Corporation entered into a joint venture with Global Capital Reinsurance Limited, ("GCR") to form a Bermuda based insurer, Capital Global Underwriters Limited ("CGUL"), which specializes in financial lines reinsurance. In April 1997, GCR was acquired by EXEL Limited. In March 1998, EXEL sold its share of CGUL to Bermuda based ACE Bermuda Insurance, Ltd. and CGUL was renamed ACE Capital Re Ltd. The Corporation, through KRE, owns a 50% economic interest in ACE Capital Re Ltd. and controls 9.9% of its voting stock. The Corporation accounts for its investment in ACE Capital Re Ltd. under the equity method.
The Corporation invests in mortgage-backed securities, including collateralized mortgage obligations. The Corporation recognizes income for these securities using a constant effective yield based on anticipated prepayments and the estimated economic life of the securities. When actual prepayments differ significantly from anticipated prepayments, the effective yield is recalculated to reflect actual payments to date and anticipated future payments. The net investment in the security is adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the security. That adjustment is included in net investment income. Short-term investments are carried at cost, which approximates market value. Realized gains and losses on sale or maturity of investments and declines in value judged to be other-than-temporary are determined by specific identification and included in net realized gains.
The amortized cost of fixed maturity securities is adjusted for amortization of premiums and accretion of discounts. That amortization or accretion is included in net investment income.
Contingent Commissions: Under the terms of certain of the Corporation's reinsurance contracts, the Corporation is obligated to pay the ceding company a contingent commission based upon a specified percentage of the net underwriting profits. As of December 31, 1998 and 1997, the Corporation's liability for the present value of expected future payments is shown on the balance sheet under the caption "Profit commission liability."
Earnings Per Share: Basic earnings per share is calculated based on the weighted average common shares outstanding. All potentially dilutive securities such as stock options are excluded from the basic earnings per share calculation. In calculating diluted earnings per share, the number of shares outstanding is increased to include all potentially dilutive securities. Basic and diluted net income per share of common stock are computed by dividing net income by the applicable weighted average number of shares of common stock outstanding during each year.
For the years ended 1998, 1997 and 1996, and in order to arrive at the number of weighted average diluted shares outstanding of 32,645, 32,505, and 31,892, employee stock option awards in the amount of 760, 759 and 580 were added to weighted average common shares outstanding for basic earnings per share of 31,885, 31,746, and 31,312, respectively. All figures are reported in thousands.
Years Ending December 31, 1998 1997 1996 -------------------------------------- (Dollars in Thousands) Total Revenues $ 56,437 $ 20,263 $ 138 Total Losses and Expenses 59,089 21,063 628 -------------------------------------- Loss Before Taxes (2,652) (800) (490) Income Taxes (7) (34) 0 -------------------------------------- Loss from Discontinued Operations $ (2,645) $ (766) $ (490)
The assets and liabilities of the discontinued operations at December 31, 1998 were:
Deferred Premium Revenue $54,990 Loss and LAE Reserves 55,664 Other Liabilities 14,727 ---------- Total Liabilities $125,381
In June 1997, the FASB also issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information", which is effective for fiscal years beginning after December 15, 1997, and supersedes SFAS No. 14, "Financial Reporting for Segments of a Business Enterprise." SFAS No. 131 establishes new standards for defining how operating segments are determined and requires more comprehensive disclosures about the Corporation's reportable operating segments. The Corporation's segment information is reported in Note 10.
Financial guaranty premiums are earned in direct proportion to the payment of debt service rather than pro-rata over the period of risk;
Investments in fixed maturity securities are reported at amortized cost or market value based on the National Association of Insurance Commissioners ("NAIC") rating; under GAAP, these fixed maturity investments are carried in accordance with SFAS 115 (see Note 2);
Year ended December 31, 1998 1997 1996 --------------------------------- (Dollars in Thousands)
GAAP stockholders' equity $ 610,826 $ 568,943 Premium revenue recognition (60,851) (44,345) Deferred acquisition costs (135,029) (127,637) Unrealized gain on fixed maturity securities available-for-sale (50,029) (45,218) Deferral of income taxes 79,237 72,879 Tax and loss bonds 18,737 Contingency reserve (211,455) (162,250) Long-term debt and Company obligated mandatorily redeemable preferred securities of Capital Re LLC 174,856 174,819 Net assets of discontinued operations (11,695) (17,046) Other, including noninsurance subsidiaries (89) (3,764) ---------------------- Consolidated statutory policyholders' surplus $ 395,771 $ 435,118 ======================
The reinsured portfolio contained exposures in each of the 50 states. Net par in force at December 31, 1998, by state, was as follows:
As part of its financial guaranty business, the Corporation participates in credit default swap transactions whereby one counterparty pays a periodic fee in fixed basis points on a notional amount in return for a contingent payment by the other counterparty in the event one or more defined credit events occurs with respect to one or more third party reference secuirities or loans. A credit event is defined as failure to pay, bankruptcy, cross acceleration (generally accompanied by a failure to pay), repudiation, restructuring or similar nonpayment event. The total notional amount of credit default swaps outstanding at December 31, 1998 and included in the Corporation's financial guaranty exposure above was $6.8 billion.
Mortgage Guaranty: At December 31, 1998, the Corporation's net mortgage guaranty insurance in force (representing the current principal balance of all mortgage loans that are currently reinsured) and direct primary net risk in force was approximately $7.6 billion and $2.4 billion, respectively. California represents the Corporation's largest U.S. risk concentration at approximately 23%, however, its total U.S. distribution of mortgage guaranty risk in force parallels that of the U.S. primary mortgage insurance industry.
On March 10, 1999, Moody's Investors Service, Inc. ("Moody's") announced that it had downgraded the financial strength rating of Capital Reinsurance to Aa2 from Aaa. This action ended a review process that began on November 5, 1998. Moody's cited increased competition in the monoline financial guaranty reinsurance industry, an increased risk profile in business assumed and rising operating leverage as the reasons for the downgrade. Under certain of its reinsurance agreements with two of its financial guaranty ceding companies, Capital Reinsurance has agreed to increase the ceding commission payable under such agreements as a result of the rating action by Moody's. The increase will apply to in-force and future business ceded by those companies. The financial impact of the increased ceding commission with respect to the in-force business at December 31, 1998 is not expected to exceed $2.0 million in 1999. The reinsurance agreements with the two ceding companies also give those companies an option to reassume business previously ceded to Capital Reinsurance upon certain adverse rating actions; however, those options to fully reassume will not be triggered by Capital Reinsurance's March 10th downgrade. Additionally, one of the ceding companies may reassume a minor portion of its previously ceded business based on this rating action alone; however, that company has not indicated that it will exercise the option.
The following summarizes the Corporation's aggregate investment portfolio at December 31, 1997:
The amortized cost and estimated fair value of fixed maturity securities available-for-sale at December 31, 1998, by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Amortized Cost Fair Value ------------------------------- (Dollars in Thousands) Maturity: Due in 1999-2003 $ 138,517 $ 139,476 Due in 2004-2008 131,149 135,588 Due after 2008 576,912 618,207 Mortgage-backed securities 190,284 193,620 =============================== Total $1,036,862 $1,086,891 ===============================
In 1998, the Corporation realized gross gains and losses of $8.8 million and ($10.3) million, respectively. Included in realized losses was a $7.5 million write-down in the Corporation's investment in common and preferred shares of CGA, based on management's belief that its investment in CGA had suffered a permanent impairment. After the write-down, the carrying value of the CGA investment was $3.4 million. In 1997, the Corporation realized gross gains and losses of $12.4 million and ($4.4) million, respectively. In 1996, the Corporation realized gross gains and losses of $8.5 million and ($7.0) million, respectively.
reinsured companies and for the protection of policyholders in states in which they are not licensed. The carrying amount of such restricted balances amounted to approximately $109.2 million and $87.3 million at December 31, 1998 and 1997, respectively. Additionally, at December 31, 1998 and 1997, $4.5 million and $4.1 million, respectively, was on deposit with state insurance departments to satisfy regulatory requirements.
The Corporation provides reinsurance to primary insurers in various specialty insurance markets. For segment reporting purposes, the Corporation's reinsurance lines of business are organized into four discrete segments municipal financial guaranty, nonmunicipal financial guaranty, each of which include credit default swap transactions, mortgage guaranty and trade credit. Two additional lines, financial solutions and title reinsurance are combined into "Other" for segment reporting purposes. Operating procedures and corporate resources are tailored to the business and regulatory needs of each line of business or segment as necessary. In cases where practical, the same procedures and or resources may be utilized for more than one line of business.
Mortgage guaranty insurance is a specialized class of credit insurance, providing protection to mortgage lenders against default by borrowers on low down-payment residential mortgage loans. For the Corporation's proportional mortgage guaranty business, reinsurance premiums are paid on a monthly basis and fully recognized when written. A certain level of losses is expected in this business. For the non-proportional mortgage guaranty business, premiums are generally paid in full at contract inception and earned over the life, usually ten years. Generally, losses are not expected in this non-proportional mortgage guaranty business.
Credit insurance protects suppliers of goods and services from the risk of non-payment by their customers. Some level of losses are also expected in this business. This business is centered on blending participation in excess of loss reinsurance programs with traditional
Year Ended December 31, Reconciliation to Consolidated Results 1998 1997 1996 -------------------------------- (Dollars in Thousands) Net Segment Income $ 26,681 $ 65,957 $ 54,920 Investment Income and Net Realized Gains 63,348 64,535 53,029 Other Income 142 98 290 Operating Expense, net (22,167) (20,002) (17,709)
Interest Expense & Minority Int in Subs (13,150) (13,137) (12,603) --------------------------------
Consolidated Income Before Taxes $ 54,854 $ 97,451 $ 77,927 --------------------------------
The majority of the Corporation's gross premiums are for reinsurance risks located in the United States. Remaining gross written premiums are for other worldwide risks with a concentration in western Europe. The following table summarizes the Corporation's gross written premiums on a geographic basis:
Gross Written Premium Year Ended December 31, 1998 1997 1996 ------------------------------------------------------------ (Dollars in Thousands) United States $169,699 79.3% $130,842 77.0% $104,727 80.7% Non U.S. 44,242 20.7% 39,101 23.0% 25,091 19.3% ------------------------------------------------------------ $213,941 100.0% $169,943 100.0% $129,818 100.0%
Customer concentration occurs as a result of the fact that a large portion of the Corporation's total gross written premiums comes from the financial guaranty and mortgage guaranty reinsurance lines of business. These industries are composed of a small number of primary insurance companies writing primary financial guaranty and mortgage guaranty insurance.
The Debentures include certain covenants, none of which significantly restrict the Corporation's operating activities or dividend paying ability. During 1996, the Corporation entered into a $25 million credit facility with Chase Manhattan Bank, expiring August 20, 1999. The facility is renewable each year at the option of the Corporation. Interest on the facility is payable semi-annually at a rate equal to the then London Interbank offered rate plus 40 basis points.
A reconciliation from the tax provision calculated at the federal statutory rate of 35% in 1998, 1997 and 1996, to the total tax is as follows:
Year ended December 31, 1998 1997 1996 ---------------------------------- (Dollars in Thousands)
Deferral of acquisition costs $ 47,260 $ 44,673 Contingency reserve 33,437 33,437 Deferred premium revenue 4,834 1,517 Unrealized gain on fixed maturity securities available-for-sale 17,511 15,826 Investment writedown (2,663) Deferred compensation 0 (1,397) Other (107) (1,223) ----------------------- Effects of temporary differences 100,272 92,833 Credit for alternative minimum tax carryforwards (2,298) (1,217) Tax and loss bonds (18,737) (18,737) ----------------------- Liability for deferred federal income taxes $ 79,237 $ 72,879 =======================
Income taxes paid during 1998, 1997 and 1996 were approximately $16.1 million, $18.9 million and $7.9 million, respectively.
The carrying amount reported in the balance sheet for these instruments approximates fair value.
For financial guaranty losses, the carrying amount is composed of the present value of the expected cash flows for case basis claims and therefore represents the best estimate of fair value. The short-term nature of losses from the remaining lines of business indicate that the carrying value represents the best estimate of fair value. Accordingly, for all lines, the carrying amount is deemed the best estimate of fair value as of December 31, 1998.
The fair value of the Corporation's $75.0 million Company obligated mandatorily redeemable preferred securities of Capital Re LLC at December 31, 1998 was $74.6 million based on the closing price per share on the New York Stock Exchange at that date.
Capital Credit's and KRE's dividend distributions are governed by Bermuda law. Under Bermuda law and the By-Laws of Capital Credit and KRE, dividends may be paid out of the profits of Capital Credit and KRE (defined as accumulated realized profits less accumulated realized losses). Distributions to shareholders may also be paid out of Capital Credit's and KRE's surplus limited by requirements that Capital Credit and KRE must at all times (i) maintain the minimum share capital required under Bermuda law and (ii) have relevant assets in an amount equal to or greater than 75% of relevant liabilities, all as defined under Bermuda law. Since its organization, KRE has not declared or paid any dividends. During 1998 Capital Credit paid $4.0 million to the Corporation.
As part of the Corporation's agreement to invest in CGA, it has also committed to invest an additional $7.5 million in the form of the purchase of common shares in the event that maintenance of Commercial Guaranty Assurance Ltd.'s triple A rating from Duff & Phelps make such action necessary.
In January 1994, the Corporation formed and capitalized Capital Re LLC, a limited liability company organized under the laws of the Turks and Caicos Islands. Additionally, in January 1994, Capital Re LLC issued $75,000,000, 7.65% of cumulative monthly income preferred shares, the proceeds of which were loaned to the Corporation. The preferred shares were issued at $25 par value per share and are shown on the balance sheet under the caption "Company obligated mandatorily redeemable preferred securities of Capital Re LLC." The Corporation guarantees the payment of the monthly dividend as well as any amounts upon liquidation or redemption which cannot occur prior to January 31, 1999, at the Corporation's discretion. The Corporation has no plans to exercise its redemption option in the near or midterm. Capital Re LLC exists solely for the purpose of issuing preferred and common shares and lending the proceeds to the Corporation to fund its business operations. The total amount paid to preferred shareholders for each of the years ended 1998, 1997 and 1996 was approximately $5.7 million and is shown on the income statement under the caption "Minority interest in Capital Re LLC."
Prior to its initial public offering, the Corporation had a stock incentive plan wherein eligible employees were granted shares of restricted common stock. Shares awarded under the Plan amounted to 696,000 at December 31, 1991. For these awards, the difference between the price paid by the employees and the market value of the award at the date of grant, if any, was recorded
To enable recipients of awards under the stock incentive plan to meet tax obligations which may have resulted from such awards, the Corporation agreed to make loans to recipients, payable upon ultimate disposition of their shares or three years after their termination of employment. As of December 31, 1998 and 1997, total loans outstanding under all officer loan programs were approximately $0.9 million and $1.64 million, respectively, and are included under the caption "Other assets."
In 1993, the Corporation also adopted a stock option plan (the "Director's Plan") for the benefit of its outside directors. The terms of the plan are similar to those of the employee plan except that options become fully vested at the time of grant. According to the terms of the Director's Plan, the aggregate number of shares subject to option award shall not exceed 30,000.
The Corporation has elected to follow Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees" (APB 25) and related interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under FASB Statement No. 123, "Accounting for Stock-Based Compensation," requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of the Corporation's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized.
the Corporation's common stock of 21.35, 23.37 and 19.10; and an expected life of the options of 7 years.
Exercise prices for options outstanding as of December 31, 1998 ranged from $9.75 to $37.81. The weighted-average remaining contractual life of those options is approximately 6.0 years.
In 1996, the Corporation adopted a performance share plan for the benefit of senior executives of the Corporation. The plan is intended to align senior management with the interest of the shareholders. To achieve this objective, the plan ties awards granted under the plan with earning per share growth and with total shareholder return and share price. Awards under the plan are payable on December 31, 1999 and December 31, 2001. The Corporation recognized $3.0 million and $1.0 million in deferred compensation expense for the years ended December 31, 1997 and 1996. As of December 31, 1998, because the relevant targets had not been met, no accrued expense was recognized and expenses recognized in 1997 and 1996 were reversed. The Corporation maintains a savings incentive plan which is qualified under Section 401 of the Internal Revenue Code. The savings incentive plan is available to all full-time employees with a minimum of six months of service. Eligible participants may contribute 9% of their base salary subject to a maximum of $10,000 for 1998. Contributions are matched by the Corporation at a rate of 100%, up to 7% of the participants' contribution subject to certain limitations and vest at a rate of 25% per year starting with the second year of service. The Corporation contributed approximately $0.4 million in 1998 and $0.3 million in 1997 and 1996.