Set forth in Table I is an analysis of the components of the Company's revenues for each of the last three years.
Despite these competitive forces, the Company was successful in increasing its business as a result of the attractiveness of Program Business in this soft reinsurance market. The Company continued to diversify its business to reduce its reliance on the workers' compensation market and was successful in doing so. As a percentage of Total Fee income, workers' compensation accounts decreased from over 80% at December 31, 1994 to 57% at December 31, 1998 as a result of the Company writing accounts comprising other lines of coverage such as commercial, auto liability, auto physical damage and other liability coverages as well as the expansion of the Company's Financial Services segment.
Financial Services, the Company's newest business segment, is being built on the 1996 acquisition of The Hemisphere Group which provides administrative services to offshore mutual funds and other companies. The Financial Services segment also includes the Company's family of proprietary mutual funds and MRM Life. MRM Life was incorporated in 1997 to issue variable insurance products in Bermuda. This segment accounted for 10% of total Fee income for 1998, up from 8% for 1997 and 7% in 1996. Fees from Financial Services increased primarily as a result of an increase in the number of mutual funds under management from 85 in 1996
The Company generally requires each Corporate Risk Management client to indemnify it against an underwriting loss and the client normally provides collateral for at least the difference between the funds available in that client's account and the level of expected losses as actuarially determined by the Company, although in certain circumstances the collateral level is below the level of expected losses. The Company faces a credit exposure in the event that losses exceed their expected level and the client is unable or unwilling to honor its indemnity to the Company. The Company also faces credit exposure on both Program Business and Corporate Risk Management Business if its clients or brokers fail to pay the premium due, through failure of the program manager or broker to properly administer the program and through failure of reinsurers to honor their obligations.
Premiums earned increased by 21% in 1998 and 49% in 1997. These increases are attributable to the shift in business from the Corporate Risk Management segment to the Program Business segment and the strong growth within this segment. Program Business usually involves higher premiums than business derived from the Corporate Risk Management segment. Premiums earned represent the net premiums retained by the Company on which it bears underwriting risk. The Company believes that both the volatility of underwriting profit or loss and the probability of experiencing a severe underwriting loss are less than would ordinarily be expected for a traditional property/casualty insurer, due to the nature of the business written by the Company and the structure of its reinsurance. In the past, the level of Premiums earned has been closely matched by the level of Total insurance costs, resulting in small amounts of underwriting loss as a percentage of Premiums earned. The fact that Premiums earned are generally matched by Total insurance costs means that even a significant fluctuation in Premiums earned will have a relatively insignificant impact on the Company's Net income.
The Company's principal exposure to underwriting loss exists in relation to the premium associated with the Company's retention of a portion of the specific and aggregate excess risk on each Corporate Risk Management client's account. It is on this retained excess risk that the Company may experience the most significant volatility in underwriting results. The portion of the Company's Premiums earned which relate to this risk was $2.1 million in 1998 as compared to $2.2 million in 1997 and $3.3 million in 1996, representing 2%, 3% and 6% of Premiums earned in 1998, 1997 and 1996 respectively. The Company incurred an underwriting loss of $2.4 million in 1998, $1.5 million in 1997 and $.2 million in 1996 as a result of the retained risk on its
Gross investment income increased by $5.0 million or 17% to $34.9 million in 1998 from $29.9 million in 1997 and $27.6 million in 1996 as a result of increases in gross invested assets. Net investment income after adjusting for investment income which is payable to others, increased by 11% to $29.5 million in 1998 from $26.5 million in 1997 and $22.6 million in 1996. Net invested assets increased $36 million or 9% to $437 million in 1998 from $401 million in 1997 and $392 million in 1996. The yield on these assets increased to 6.9% in 1998 from 6.7% in 1997 and 6.1% in 1996. The Company's investment income is produced through the investment of its capital funds, long term debt, other funds held representing amounts due others and reserves held by the Company for unearned premiums and unpaid losses. The Company carries $37.4 million at December 31, 1998 and $42.4 million at December 31, 1997 on its Consolidated Balance Sheets as Claims deposit liabilities. These liabilities relate to loss obligations which, under SFAS 113, are not classified as insurance. Investment income on these funds of $2.2 million in 1998, $2.5 million in 1997 and $4.0 million in 1996 is credited directly to the Claims deposit liability account.
The breakdown of expenses for each of 1998, 1997 and 1996 is set forth in Table III.
The increases in Total insurance costs were the direct result of the increases in Premiums earned during these periods. Losses incurred increased as a direct result of the decreased use of large deductible policies and the increase in Program Business. The Company discounts its specific and aggregate workers' compensation reserves using a 4% rate recommended under Pennsylvania law where Legion is domiciled. The net effect of this discounting was to increase Net income after tax for the years ended December 31, 1998, 1997 and 1996 by $.9 million, $.1 million and $.2 million, respectively. Discounting also reduced net loss reserves by $4.7 million, $3.7 million and $3.5 million at December 31, 1998, 1997 and 1996, respectively. The 27% decrease in Acquisition costs from 1997 to 1998 is due to the reduction in the number of deductible programs, which have high expense levels; the loss of one large account that was fully retained; and reduction in expenses charged by the assigned risk pools. The 48% increase from 1996 to 1997 is a direct result of the 49% increase in Premiums earned.
The primary factors responsible for the increases in Operating expenses were: (a) the increased cost of administering the Company's highly regulated policy-issuing subsidiaries, as the volume of policies issued
At December 31, 1998, the market value of the Company's Total marketable investments was $575 million, as compared to $477 million at December 31, 1997. In accordance with SFAS 115, Investments available for sale are reported at fair market value with unrealized gains and losses included as a separate component of Shareholders' equity. These Investments generally consist of investment grade fixed-income securities which the Company believes are readily marketable and could be liquidated to meet cash requirements, if necessary.
Cash flow from operations has historically provided the Company its principal source of liquidity. The Company has continued to produce a positive cash flow with $59.6 million of cash provided from operations during 1998, as compared to $55.3 million in 1997 and $63.5 million in 1996.
A widely accepted factor used by regulators and rating agencies in evaluating insurance companies is the ratio of net premiums written to policyholders' surplus which is an indication of the degree to which an insurer is leveraged. Because of the low level of net premiums written, they have produced a relatively low ratio on this basis of approximately 0.5:1 in 1998, 0.4:1 in 1997 and 0.3:1 in 1996 and should continue to produce relatively low ratios in the future. Due to the nature of the Company's operations, a more appropriate indication of leverage is the ratio of gross premiums written to policyholders' surplus, which amounted to 3.6:1 in 1998, 3.0:1 in 1997, and 2.4:1 in 1996. The NAIC has established that an "unusual value" for this ratio would be 9:1 or higher. The Company has adopted a policy that this ratio should not exceed 4:1.
Market risk generally represents the risk of loss that may result from potential changes in the value of a financial instrument due to a variety of market conditions. The Company's exposure to market risk is generally limited to potential losses arising from changes in the level or volatility of interest rates on market values of investment holdings. The Company's exposure to movements in exchange rates and equity prices is limited. The Company does not hold or issue derivative financial instruments for trading or speculative purposes.
Interest rate risk results from the Company's holdings in interest-rate- sensitive instruments. The Company is exposed to potential losses arising from changes in the level or volatility of interest rates on
The Company continues to assess the Year 2000 compliance of its critical business operations and products that could potentially be affected by the Year 2000 problem. The purpose of this review is to determine what impact, if any, the Year 2000 issue may have on the Company and its significant customers, suppliers, and others, and whether that impact will be material to the Company's financial condition or results of operations. The Company is in the process of contacting its critical customers, reinsurance intermediaries, managing general
agents, suppliers, and others to determine the nature and extent of their Year 2000 compliance efforts and to assess whether their failure to resolve their own Year 2000 issues would have a material adverse affect on the Company's financial condition or results of operations. Based on these assessments, management will take such further action as they deem appropriate including, but not limited to, the development of contingency plans.
The extent to which the Company's financial condition or results of operations may be materially affected by the Year 2000 problems of third parties depends on a variety of factors including, but not limited to, whether these third parties can resolve their own Year 2000 issues; whether their remediated systems remain compatible with the Company's systems; and the nature and extent to which the Company's systems may be affected by the third- party's non-compliant systems. Significant failures of certain essential services including, but not limited to, the telecommunications, utility, banking, securities, and transportation industries, due to their own Year 2000 problems are generally beyond the Company's control and could have an adverse material impact on the Company's financial condition or results of operations.
The Company also acquired Capital Management of Bermuda Ltd. ("Capital Management"), a company which issues pension and annuity products primarily for so called third country nationals. Capital Management has an investment portfolio of approximately $80 million relating to its pension products and will complement the Company's other initiatives in the offshore variable life and annuity business.
In the fourth quarter of 1998, the Company acquired the International Advisory Services Group ("IAS") of Companies. The principal companies within the IAS Group are International Advisory Services Ltd., a Bermuda company which provides management services to insurance companies, Hurst Holme Insurance Company Ltd., a Bermuda based rent-a-captive facility, and H & H Reinsurance Brokers Ltd., a Bermuda broker primarily providing reinsurance support for the managed companies and rent-a-captive clients of the IAS Group. International Advisory Services Ltd. is the largest independent insurance manager in Bermuda with over 100 clients having annual premiums in excess of $1.1 billion.
Forward-looking statements are inherently subject to risks and uncertainties. The Company cautions that factors which may cause the Company's results to differ materially from such forward-looking statements include, but are not limited to, the following: (a) Changes in the level of competition in the reinsurance or primary insurance markets that adversely affect the volume or profitability of the Company's business. These changes include, but are not limited to, the intensification of price competition, the entry of new competitors, existing competitors exiting the market, and the development of new products by new and existing competitors; (b) Changes in the demand for reinsurance, including changes in ceding companies' retentions, and changes in the demand for primary and excess and surplus lines insurance coverages; (c) The ability of the Company to execute its business strategies and its reliance on key personnel; (d) Adverse development on claims and claims expense liabilities related to business and the failure of clients, reinsurers or others to meet their obligations to the Company in connection with such losses.