The following discussion should be read in conjunction with, and is qualified in its entirety by, the consolidated financial statements of the Company and the related notes thereto included elsewhere in this report.
CGA Group, Ltd. (the "Company"), a holding company, was incorporated in Bermuda on June 21, 1996. The Company has two wholly owned subsidiaries. Commercial Guaranty Assurance, Ltd. ("CGA") was incorporated in Bermuda on October 22, 1996. CGA is licensed as a class 3 insurer under the Insurance Act 1978 of Bermuda (the "Act") which authorizes it to carry on insurance business of all classes in or from within Bermuda subject to its compliance with the solvency margin, liquidity ratio and other requirements imposed on it by the Act. CGA has a "Triple-A" "claims paying ability" rating from Duff & Phelps Credit Rating Company ("DCR") and has also been rated in the highest rating category assigned by each of the two Canadian rating agencies, Dominion Bond Ratings Service and Canadian Bond Ratings Service. CGA issues financial guaranty insurance policies, which are the functional equivalent of direct-pay letters of credit, to insure payment of interest, principal and other amounts payable in respect of notes, securities, and other financial obligations. CGA Investment Management, Inc. ("CGAIM") was incorporated in Delaware, U.S.A. in July 1996 by the founders of the Company and was acquired at nominal cost to the Company on June 9, 1997. CGAIM did not commence operations until after its acquisition by the Company. CGAIM is registered as an investment advisor with the United States Securities and Exchange Commission under the Investment Advisors Act of 1940, as amended. CGAIM provides investment management and financial advisory services primarily to specialized investment vehicles and for the U.S. and international structured finance markets. The Company and its subsidiaries were inactive until June 17, 1997, on which date the Company's private placement offering was completed and the Company was recapitalized with (i) two classes of preferred stock sold for an aggregate purchase price of $105 million, (ii) common stock sold for an aggregate purchase price of $45.5 million and (iii) commitments to purchase $60 million of additional preferred stock upon the occurrence of certain events.
Net premiums earned were derived from $49.2 million of gross premiums written, of which $39.4 million were ceded under reinsurance agreements. The gross premiums written and ceded premiums include approximately $39 million from one transaction. The transaction was entered into by CGA to mitigate risks related to its exposure in connection with guarantees of two credit facilities for St. George Investments I, Ltd. ("SGI") and St. George Investments III, Ltd. ("SG3") which are used to purchase asset backed and real estate backed securities. As a result of turmoil in certain areas of the capital markets during the month of October 1998, the spreads over treasuries at which investors were willing to purchase certain securities widened considerably. This spread widening caused a decrease in the market value of many of the securities used as collateral for the two insured credit facilities. The facilities have requirements that the lender's operating ratio, (the portfolio market value divided by the loan outstanding) be maintained above certain levels. In the event that an operating ratio falls below the required level and is not brought into compliance within a cure period, the lender may liquidate the collateral and require CGA to pay any remaining balance outstanding under the credit facility. On October 30, 1998 CGA provided asset specific guarantees and obtained third party credit support on a "cut-through" basis on approximately $382 million par amount of securities within the two insured investment portfolios. The three parties that provided such credit support are institutional investors in the Company. The effect of this third party credit support was to substantially increase the market value and reduce the future market value volatility of the credit enhanced securities. In connection with these arrangements, CGA received a premium of $38.95 million from its two clients, and ceded an aggregate of $38.7 million to the institutions that provided the cut-through credit enhancement.
Real estate investment trust debt $ 381,777 $ -- Consumer asset-backed securities 456,521 52,439 Corporate asset-backed securities 270,612 46,337 Commercial mortgage-backed securities 185,754 100,703 Sovereign debt 120,000 120,000 Corporate debt 75,000 -- REIT Preferred stock 70,000 --
"AAA" 4% -- "AA" 3% -- "A" 12% 7% "BBB" 67% 65% "BB" 11% 28% Not rated 3% --
The portfolio currently includes one problem credit consisting of four charged-off credit card receivable transactions. These transactions comprise three percent of CGA's net par insured portfolio as of December 31, 1998. CGA has established a case basis reserve for this exposure which is more fully described below.
Operating expenses for the year ended December 31, 1998 were $14 million compared to $6.5 million for the nine months ended December 31, 1997. These costs are primarily personnel-related which totaled $7.4 million for 1998. The majority of the other 1998 operating expenses were comprised of legal and financing costs incurred to set up investment programs for CGAIM's clients totaling $1.6 million, and professional fees of $1.3 million.
In October, 1998 the credit ratings on asset-backed securities issued by various trusts established and serviced by Commercial Financial Services Inc. ("CFS"), a credit-card debt collection company, were withdrawn by the three credit rating companies that rate the securities issued by such trusts (the "CFS Securities"). The withdrawal of said ratings was in response to allegations of accounting and other irregularities at CFS. The rating agencies, investors and insurers, as well as the United States Securities and Exchange Commission have commenced an investigation into these allegations. Clients of CGA own approximately $201 million par amount of CFS Securities, which exposure has been guaranteed by CGA. CGA has reinsured approximately $154 million par amount of this exposure, leaving CGA with a net exposure of approximately $47 million par amount as of December 31, 1998. CGA has taken a case basis reserve in respect of the CFS Securities in the amount of $20.8 million. This amount represents Management's best estimate of potential losses in respect of the CFS Securities at this time.
The Accounting Standards Executive Committee issued Statement of Position 98-5, "Reporting on Costs of Start-Up Activities", effective for fiscal years beginning after December 15, 1998, which requires the Company to expense organization costs as incurred. The Company expensed the remaining unamortized organization costs totaling $3.9 million in July 1998 which is reflected in the financial statements as a change in accounting principle.
The Company has two reportable segments, CGA and CGAIM. CGA issues financial guaranty insurance policies and CGAIM provides investment management and advisory services. The tables below presents selected financial information for each of the operating segments:
EXPENSES Operating expenses 1,680,707 10,711,550 Acquisition costs 433,217 -- Losses & LAE 22,745,000 -- Extraordinary items 1,127,353 480,207 Commitment fees 600,000 -- Excess of loss facility 200,000 --
EXPENSES Operating expenses 597,883 5,313,368 Acquisition costs 53,590 -- Losses & LAE 55,000 -- Commitment fees 323,836 -- Excess of loss facility 107,671 --
On a consolidated basis, the Company generated $1.2 million of cash from operating activities during 1998 compared to using $9.4 million for the nine-month period ended December 31, 1997. This $10.6 million increase in cash flow from operations is the result of the Company moving from the start-up phase of operations during 1997 to producing cash flow from premiums and management fees during 1998.
The Company used $5.8 million of net cash in investing activities during 1998 which was the result of an effort to reduce cash balances and stay more fully invested in fixed maturities. During 1997 the Company used $123.3 million of net cash in investing activities which was the result of using the proceeds from the private placement offering to build CGA's investment portfolio. There were no cash flows from financing activities in 1998 and $139.7 million of net cash flows from financing activities in 1997 resulting from the net proceeds of the Company's private placement offering.
The Company does not expect to pay cash dividends to its shareholders. CGA's Board of Directors has passed a resolution that CGA will not declare or pay cash dividends during the first five years of operations. After such five-year period, CGA intends to comply with dividend restrictions, if any, imposed by DCR subject to covenants contained in the subscription agreements for the various classes of the Company's stock. In addition, CGA's dividend payments are subject to certain limitations under Bermudian insurance regulations that require minimum solvency margins and liquidity ratios.
On January 27, 1999 the Company held a Special General Meeting for all shareholders, which was both preceded and followed by meetings of its Board of Directors. The purpose of the meetings was primarily to approve and authorize the Company to seek to raise additional capital from existing shareholders and from one or more third party investors.
o That the Company create a new series of Preference Shares being Series C Convertible Cumulative Voting Preference Shares (the "Series C Preferred Stock") and offer up to $63 million to the existing holders of the Company's Common Stock and Series B Preferred Stock (the "Rights Offering");
o Concurrent with the closing of the Rights Offering all outstanding shares of Series B Preferred Stock, including accrued dividends thereon, shall be converted into shares of Common Stock based on a value of $3 per share of Common Stock;
The Company is also in the process of reviewing its exposure to Year 2000 issues resulting from its vendors' computer systems. The Company has contacted vendors regarding the state of their remediation activities for material Year 2000 issues. The Company does not expect that there will be material disruptions to its business or material costs associated with any Year 2000 disruption by its vendors. However, the cost and timing of third party Year 2000 compliance is not within the Company's control and no assurances can be given with respect to the cost or timing of such efforts or the potential effects of any failure to comply. The Company will continue to monitor Year 2000 compliance and formal contingency plans will be formulated if the Company identifies specific areas where there is a substantial risk of Year 2000 problems occurring. No such areas are identified as of this date.