(1) Adjusted to reflect a three-for-two stock split in May 1996 and a five- for-one stock split in 1995. For additional information relating to income per share, see Note 2 of Notes to Consolidated Financial Statements.
THE COMPANY - RTW, Inc. (RTW) and its wholly owned insurance subsidiary, American Compensation Insurance Company (ACIC), provide disability management services to employers. Collectively, "we", "our" and "us" will refer to these entities in this "Management's Discussion and Analysis of Financial Condition and Results of Operations".
We developed a proprietary management system, the RTW SOLUTION-Registered Trademark-, designed to lower employers' workers' compensation costs and return injured employees to work as soon as possible. We combine our management system with insurance products underwritten by our insurance subsidiary to offer services to customers. We currently provide workers' compensation management services solely to employers insured through our insurance subsidiary. We operated in Minnesota, Colorado, Missouri, Michigan, Massachusetts, Illinois and Wisconsin during 1997.
We continued our focus on growth in 1997 resulting in a 12.8% growth in premiums in force. This focus, combined with increased earnings on our investment portfolio, resulted in record revenues of $88.3 million in 1997,
- Continued price declines due to legislative benefit changes and increased competition in our markets; - Increased final audit premiums; - Declining average cost per claim; - Increased agent commissions as a percent of premiums earned; - Increased operating costs resulting from opening the Michigan office in late 1996 and the Massachusetts office in the second quarter of 1997; and - Decreased effective income tax rates resulting from the decrease in net income.
TOTAL REVENUES: Our total revenues include premiums earned and investment income.
PREMIUMS EARNED - Premiums on workers' compensation insurance policies are our largest source of revenue. Premiums earned are the gross premiums earned by us on in force workers' compensation policies, net of the effects of ceded premiums under reinsurance agreements.
Reinsurance agreements allow us to share certain risks with other insurance companies. The primary purpose of ceded reinsurance is to protect us from potential losses in excess of the level we are willing to accept. Our primary ceded reinsurance is excess of loss coverage that limits our per incident exposure. We expect the companies to which we have ceded reinsurance to honor their obligations. In the event that these companies are unable to honor their obligations to us, we will be required to pay these obligations ourselves. We are not aware of any developments with respect to any of our reinsurers that would prevent them from honoring any of their obligations to us.
TOTAL EXPENSES: Our expenses include claim and claim settlement expenses, policy acquisition costs, general and administrative expenses, interest expense and income taxes.
GROSS PREMIUMS EARNED: The premium we charge a policyholder is a function of their payroll, industry and prior workers' compensation claims experience. In underwriting a policy, we receive policyholder payroll estimates for the ensuing year. We record premiums written on an installment basis matching billing to the policyholder and earn premiums on a daily basis over the life of each insurance policy based on the payroll estimate. We record the excess of premiums billed over premiums earned for each policy as unearned premiums on our balance sheet. When a policy expires, we audit employer payrolls for the policy period and adjust the estimated payroll to its actual value. The result is a "final audit" adjustment recorded to premiums earned when the adjustment becomes known.
Our gross premiums earned in 1997 increased 27.6% to $81.4 million from $63.8 million in 1996. This increase resulted, in part, from the 12.8% increase in premiums in force to $78.4 million at December 31, 1997 from $69.5 million at December 31, 1996. Additionally, gross premiums earned increased as we recognized $7.5 million of final audit premiums in 1997 compared to $500,000 recognized in 1996.
Gross premiums earned in 1996 increased 34.2% to $63.8 million from $47.5 million in 1995. This increase resulted from the 34.4% increase in premiums in force to $69.5 million at December 31, 1996 from $51.7 million at December 31, 1995. Additionally, final audit premiums decreased to $500,000 in 1996 from $1.2 million in 1995.
- We continue to experience reduced pricing on renewal policies due, in part, to our success in lowering our policyholders' loss experience which then improves their claims history, lowering the premium that they have to pay for insurance. The improvement that we do for our customers also has the effect of making them more desirable to our competition, thus increasing price competition on these accounts.
PREMIUMS CEDED: We pay reinsurers, under excess of loss reinsurance policies, to limit our per incident exposure and record this cost as a reduction to gross premiums earned. We are required to purchase excess of loss coverage for Minnesota policies from the Minnesota Workers' Compensation Reinsurance Association (WCRA). Our selected retention levels in Minnesota were approximately $1.1 million in 1997, $1.0 million in 1996 and $450,000 in 1995. In other states, we have chosen to limit our per incident exposure to $500,000 and purchased this coverage from various reinsurers.
Premiums ceded to reinsurers decreased 50.9% to a cost of $342,000 in 1997 from a cost of $697,000 in 1996. The decrease in premiums ceded resulted from (i) reduced premium rates in 1997 from 1996 for our selected excess of loss reinsurance coverage levels in Minnesota, (ii) reduced premiums for excess of loss coverage in other states, and (iii) the recognition of a refund received from the WCRA of $358,000 in 1997.
1998 OUTLOOK: The 1998 outlook for gross premiums earned and premiums ceded include the following factors:
- We expect continued growth in premiums in force in our non-Minnesota markets which will lead to growth in gross premiums earned;
- Increased funds will become available for investment due to increased net cash provided by operating and investment activities;
CLAIM AND CLAIM SETTLEMENT EXPENSES: Claim and claim settlement expenses are our largest expense and result in our largest liability. We establish reserves that reflect our estimates of the total claim and claim settlement expenses we will ultimately have to pay under our workers' compensation insurance policies. These include claims that have been reported but not settled and claims that have been incurred but not yet reported to us. For further discussion of reserve determination, see the "Unpaid Claim and Claim Settlement Expenses" section of this Management's Discussion and Analysis.
Claim and claim settlement expenses increased to $55.5 million in 1997 from $39.1 million in 1996. As a percent of premiums earned, claim and claim settlement expenses increased to 68.5% in 1997 from 62.0% in 1996. These changes are due to the following:
- Premiums earned increased to $81.0 million in 1997 from $63.1 million in 1996 resulting in increased claim and claim settlement expenses as we provided coverage for more employers;
- During 1997, we reduced our estimate of the pre-1997 liability for unpaid claim and claim settlement expenses by $3.1 million as a result of favorable claims experience for those periods. This reduction was $5.0 million less than the reduction that we recorded in 1996. At December 31, 1997, we had gross reserves for unpaid claim and claim settlement expenses of $61.1 million including $36.7 million for 1997 claims and $24.4 million for claims relating to years prior to 1997;
- During the fourth quarter of 1996, we experienced the four largest claims in our history, incurring approximately $2.0 million of expense. Three of these occurred in Minnesota and one occurred in Missouri;
- Average claim costs are expected to have downward pressure in 1998 as a result of increases in operating efficiency and effectiveness realized through enhancements to our internal processes and procedures, including changes to our propriety computer systems. We also expect that legislative changes in estimated loss costs will create further downward pressure on average claim costs;
- Continued application of our claims management technology and methods to all open claims at December 31, 1997 will benefit future periods. The magnitude of that benefit cannot be quantified at this time.
The ultimate result of the above factors, combined with the change in premium rates, on 1998 claim and claim settlement expenses as a percent of premiums earned is unknown at this time.
- - Premium tax expense remained consistent at 2.0% of gross premiums earned in 1997 compared to 2.1% in 1996 and 2.0% in 1995. Premium tax expense was slightly higher in 1996 due to higher premium tax rates paid for premiums earned in Colorado. The rates in Colorado decreased from 2.25% in 1996 to 2.15% in 1997 and will be 2.10% in 1998;
- - Other policy acquisition costs increased to 4.5% of gross premiums earned in 1997 from 3.5% in 1996 and 2.2% in 1995, due to increased focus on marketing programs as we expanded into new states and continued to grow in our more established markets and increased personnel costs necessary for the growth in premiums in force; and
- - Total ceding commissions decreased to a cost of $1,000 from benefits of $1.9 million in 1996 and $1.7 million in 1995. We recognized adjustments to our claims experience for accident years 1992 through 1994 resulting in the 1996 and 1995 benefits realized.
- - We expect commission expense as a percent of gross premiums earned to increase during 1998 as the non-Minnesota states continue to grow in size relative to Minnesota;
- additional personnel costs for new employees resulting from the growth in in force premium;
- increased fees for professional services, primarily legal and consulting services.
INTEREST EXPENSE: We paid interest at rates ranging from 9.00% to 9.50% on the outstanding balance on our Senior Notes during 1997.
1998 OUTLOOK: Interest expense on the Senior Notes is expected to decrease from $777,000 in 1997 to $546,000 in 1998 as a result of principal payments of $2.0 million made in December 1997.
INCOME TAXES: The provision for income taxes was $2.9 million in 1997, $4.7 million in 1996 and $4.2 million in 1995. As a percent of income before income taxes, the provision for income taxes decreased to 33.1% in 1997 from 34.5% in 1996 and 37.5% in 1995. The decrease in 1997 is the result of decreased taxable net income from the service organization (RTW) in 1997 which is subject to both federal and state income taxes and decreases in the profitability of ACIC which paid state income taxes in 1995 in addition to premium taxes.
Our portfolio consisted entirely of taxable fixed maturity securities at December 31, 1997 and included U.S. government securities (60.8%), corporate securities (20.0%), mortgage-backed securities (12.9%) and asset-backed securities (6.3%). After several years of purchasing solely U.S. government securities, we engaged an investment manager in the second quarter of 1997 to diversify our portfolio to other fixed maturity investments and maximize our after-tax investment income without taking inappropriate credit risk. We manage our fixed maturity portfolio conservatively, investing exclusively in investment grade (BBB or better rating from Standard and Poor's) securities. In 1998, we expect to further diversify our portfolio to investment grade tax-exempt securities. We do not invest in derivative securities. Additionally, in December 1997, we reclassified our entire held-to-maturity portfolio, invested in U.S. government securities with a historical cost, net of amortization, of $53.8 million and a fair value of $54.7 million, to available-for-sale investments. We reclassified these securities to enable us to more actively manage our investment yield and overall portfolio risk.
Funds provided by our operating cash flows and investment cash flows are the source of growth in our investment portfolio. Operating cash flows consist of the excess of premiums collected over claim and claim settlement expenses and other operating expenses paid. Investment cash flows consist of income on existing investments and proceeds from sales and maturities of investments. Our investment portfolio grew 25.0% or $22.5 million to $112.3 million at December 31, 1997 from $89.8 million at December 31, 1996 as a result of these factors. During 1997, we invested solely in available-for-sale securities and intend to continue this investment strategy for the foreseeable future.
The following table sets forth reserves on a gross (before reinsurance) basis (000's):
As determined under Generally Accepted Accounting Principles (GAAP), the 1997 year-end reserves of $61.1 million for claim and claim settlement expenses were $5.4 million more than the reserves of $55.7 million recorded on the basis of statutory accounting principles for reports provided to state regulatory authorities. The difference is the reinsurance recoverable from third-party reinsurance carriers totaling $5.4 million that reduces reserves for statutory reporting and is recorded as an asset, reinsurance recoverables, for GAAP reporting.
Liquidity refers to our ability to generate sufficient cash flows to meet the short and long-term cash requirements of our operations. Capital resources represent those funds deployed or available to be deployed to support our business operations.
State insurance regulations limit distributions, including dividends, from our insurance subsidiary to us. The maximum amount of dividends that can be paid by ACIC to us in any year is equal to the greater of: (i) 10% of ACIC's statutory surplus as of the end of the previous fiscal year, or (ii) the statutory net gain from operations (not
including realized capital gains) of ACIC in its most recent fiscal year. Based on this limitation, the maximum dividend that ACIC could pay to us in 1998, without regulatory approval, is approximately $4.5 million. (See Note 9 of Notes to Consolidated Financial Statements.) ACIC may be subject to more restrictive limitations on dividends as we enter additional states. ACIC has never paid a dividend to us and, for the foreseeable future, we intend to retain capital in the insurance subsidiary to enable us to expand our operations.
We believe that cash flow generated by our operations and our cash and investment balances will be sufficient to fund continuing operations, principal repayments and debt service on our outstanding Senior Notes, including principal repayments of $2.5 million due in December 1998, and capital expenditures for the next 12 months.
The cost of any hardware and software changes required to comply with the year 2000, other than those contemplated as routine upgrades in our operations, are not expected to have a material adverse effect on our results of operations.
Colorado, Missouri, Michigan, Massachusetts, Pennsylvania, Illinois, Kansas, Connecticut, South Dakota, Tennessee and Wisconsin. We received Indiana, Iowa, Rhode Island and Maryland licenses so far in 1998.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
RTW, INC. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1997 AND 1996 (IN THOUSANDS, EXCEPT SHARE DATA)
RTW, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995 (IN THOUSANDS)
We benefit from our ability to reduce workers' compensation costs and provide employers the ability to control their workers' compensation programs. We are domiciled in Minnesota and were licensed in Minnesota, Colorado, Missouri, Pennsylvania, Michigan, Massachusetts, Illinois, Kansas, Connecticut, Tennessee, South Dakota, and Wisconsin at December 31, 1997. We also received our license to write workers' compensation insurance coverage for companies covered under the Longshoreman's Act in 1997 and received Iowa, Indiana and Maryland licenses in January 1998. We wrote policies primarily in Minnesota, Colorado, Missouri, Illinois, Michigan, Massachusetts and Wisconsin during 1997.
USE OF ESTIMATES - We make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the financial statement date and the recorded amounts of revenues and expenses during the reporting period. Our most significant estimates are those relating to our unpaid claim and claim settlement expenses and accrual for premium adjustments. We continually review our estimates and assumptions and make adjustments as necessary, but actual results could vary significantly from what we envisioned when we made these estimates.
INVESTMENTS - We invest entirely in fixed maturity investments and classify our investments as available-for-sale or held-to-maturity in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities". We do not classify any of our securities as trading securities.
REALIZED INVESTMENT GAINS AND LOSSES: We include realized investment gains and losses in the "Investment income" section of our Consolidated Statements of Income. Cost of investments sold is determined by the specific identification method.
We continually monitor the difference between investment cost and fair value for each of our securities. If any security experienced a decline in value that is determined to be other than temporary, we would reduce the security's carrying value for the decline and record a realized loss in the Consolidated Statements of Income. No securities were reduced for declines in fair value in 1997 or 1996.
If deferred policy acquisition costs were to exceed the sum of unearned premiums and related anticipated investment income less expected claim and claim settlement expenses, we would immediately expense the excess costs.
UNPAID CLAIM AND CLAIM SETTLEMENT EXPENSES - Claim expenses refer to amounts that we paid or expect to pay to claimants for events that have occurred. The costs of investigating, resolving and processing these claims are referred to as claim settlement expenses. We record these expenses, net of amounts recovered under reinsurance contracts, to "Claim and claim settlement expenses" in the Consolidated Statements of Income.
PREMIUMS EARNED - Premiums on workers' compensation insurance policies are our largest source of revenue. We record premiums written on an installment basis matching billing to the policyholder and earn premiums on a daily basis over the life of each insurance policy. Premiums earned includes an estimate for earned but unbilled audit premiums. We record the excess of premiums billed over premiums earned for each policy as unearned premiums on our balance sheet.
Effective December 1997, we adopted SFAS No. 128, "Earnings Per Share." SFAS No. 128 requires dual presentation of a basic income per share (IPS), which excludes dilution, and a diluted IPS, which reflects the potential dilution that could occur if actions taken in respect of dilutive securities resulted in the issuance of common stock. Dilutive securities consist of stock options and warrants. Basic IPS is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted IPS is computed by dividing net income by the weighted average number of common shares and dilutive securities outstanding for the period. Dilutive securities issued after April 1995 are considered outstanding from the date of grant after applying the treasury stock method for determining the dilutive effect. Dilutive securities issued prior to that date are considered outstanding for all periods after applying the treasury stock method for determining the dilutive effect.
VALUATION OF INVESTMENTS - The following tables present amortized cost, gross unrealized gains and losses, and estimated fair values of investments (000's):
We ceded Minnesota claims in excess of $1,080,000, $1,040,000 and $450,000 per occurrence during 1997, 1996 and 1995, respectively, to the Minnesota Workers' Compensation Reinsurance Association. Non-Minnesota state claims in excess of $500,000 were ceded to various reinsurers in 1997, 1996 and 1995.
Reinsurance contracts do not relieve us from our obligations to policyholders. We expect reinsurers to which we have ceded reinsurance to honor their obligations. Failure of these reinsurers to honor their obligations could result in losses to us. We do not anticipate any such losses, and accordingly, no provision for amounts deemed uncollectible are included in our financial statements. We attempt to minimize our exposure to significant losses from reinsurer insolvency by monitoring the financial condition of our reinsurers. Reinsurance receivables associated with reinsurers are as follows (000's):
Changes in estimates of unpaid claim and claim settlement expenses for prior years decreased the provision for claim and claim settlement expenses by $3,085,000, $8,075,000 and $1,474,000 in 1997, 1996 and 1995, respectively. The incurred related to prior years in 1997, 1996 and 1995 reflects our ability to manage and close prior year claims more favorably than initially anticipated.
We may redeem some or all of the Senior Notes payable on any interest date at the principal amount of the redeemed notes plus accrued interest and a premium of 2% through December 15, 1998 and 1% thereafter.
SENIOR NOTES PAYABLE -- The Senior Notes payable contain various restrictive provisions which require that certain financial ratios, primarily debt coverage and net worth restrictions, be met before incurring additional indebtedness or paying dividends or other distributions to shareholders. At December 31, 1997, we were in compliance with these covenants.
No valuation allowance was provided against the deferred tax assets recorded in 1997 or 1996, as we expect to generate sufficient taxable income in the future to offset reversing temporary differences.
Income taxes receivable at December 31, 1997 and 1996 were approximately $1,011,000 and $1,059,000, respectively.
1995 EMPLOYEE STOCK PURCHASE PLAN -- The ESPP provides employees the opportunity to purchase shares of our stock at option prices as set forth in the plan. We reserved 75,000 shares for distribution under the plan. The ESPP terminates in ten years and will be carried out in phases, each consisting of one year or a period of time approved by the board of directors. Any employee completing two weeks of service prior to commencing a phase of the plan may participate. Employees may elect to contribute from $10 to 10% of monthly salary to the plan through payroll withholdings. The following summarizes shares purchased and purchase prices for each phase completed through 1997:
SHARES PURCHASE PURCHASED PRICE --------- -------- Phase: Beginning April 1995, expiring April 1996 14,891 $8.67 Beginning April 1996, expiring April 1997 20,092 $7.65
The third one year phase began in April 1997 and expires in April 1998.
1994 STOCK PLAN -- The 1994 Stock Plan provides for awards of incentive and non-qualified stock options. In January 1997 the shares reserved for distribution under the plan were increased to 1,500,000. Option price, option term, vesting provisions and other limits and restrictions are determined at the time of grant by the board of directors or, if established, by a separate committee. The exercise price for all options granted was the market price of the common stock at the date of grant.
Each of the qualified options expire ten years from the date of grant, subject to continued employment with us. Each of the non-qualified options expire ten years from the date of grant. Certain of the options are subject to vesting provisions which restrict exercise of the option.
The following table summarizes the options outstanding and exercisable in 1997:
NON-QUALIFIED COMMON STOCK OPTIONS -- Certain non-qualified options were issued prior to the onset of the 1994 Stock Plan. These non-qualified options are all exercisable. Non-qualified options granted, exercised and outstanding are as follows:
PRO FORMA INFORMATION -- Had we calculated compensation expense for our option grants under the 1994 Stock Plan and stock purchases under the ESPP based on the fair value method described in SFAS No. 123, "Accounting for Stock-Based Compensation," our net income, basic net income per share and dilutive net income per share would approximate the following pro forma amounts (in 000's, except per share data):
The pro forma effect on net income for 1997, 1996 and 1995 is not representative of the pro forma effect on net income in future years because it does not include pro forma compensation expense related to pre-1995 option grants.
EMPLOYEE STOCK OWNERSHIP PLAN -- We maintain an Employee Stock Ownership Plan (ESOP) for our qualified employees. Any employee who had attained age 21 and was employed on May 1, 1993 became a participant in the ESOP on its effective date, May 1, 1993. All other employees are eligible to participate in the ESOP on the first day of the calendar quarter after completing 1,000 hours of service during 12 consecutive months with us and attaining age 21. Our contributions to the plan are discretionary. We may contribute cash or shares of our common stock.
COMBINED RETIREMENT PLAN -- In January 1998, we combined our 401(K) Retirement Plan and ESOP into a single retirement plan, the KSOP. The KSOP retains the features of each separate plan except for eligibility and vesting provisions. Under the plan, employees become eligible to participate in the plan on the first day of the month after beginning employment.
OTHER EMPLOYEE BENEFIT PLANS -- We maintained bonus plans in 1997, 1996 and 1995 under which all employees, including officers, were eligible for a bonus based on our operating results. These bonuses aggregated $643,000, $498,000, and $350,000 in 1997, 1996 and 1995, respectively.
On April 25, 1996, our board of directors approved a 3-for-2 stock split in the form of a 50 percent stock dividend to shareholders of record on the close of business on May 6, 1996. The shares were distributed to shareholders on May 17, 1996. Additionally, on February 2, 1995, we declared a five-for-one stock split, effective as of that date. All share and per share amounts have been adjusted to reflect the effect of the stock splits.
DIVIDEND RESTRICTIONS -- Dividends are paid as determined by our board of directors. No dividends have ever been paid us.
Under Minnesota insurance law regulating the payment of dividends by ACIC, any such payments must be an amount deemed prudent by ACIC's board of directors and, unless otherwise approved by the Commissioner of the
STOCK WARRANTS -- The Series 1991B notes payable, paid in full in December 1996, included attached warrants to purchase our common stock at an exercise price of $.53 per share. All remaining warrants were exercised in 1996.
Future minimum (base) rental payments required under the leases, as of December 31, 1997, are as follows (000's):