The table below provides some comparative information about trends in revenue, profitability and capacity for primary insurance companies and reinsurers as well as some general economic and financial market trends:
ZRC's statutory combined ratio for 1996 declined to 103.7% from 106.5% for 1995, primarily due to the lower loss and commission ratio discussed above. ZRC's statutory combined ratio for 1995 declined 8.1 percentage points from 114.6% in 1994 due to the absence of significant catastrophe losses and the improvement in the underwriting expense ratio. ZRC's statutory combined ratio differs from the Company's GAAP combined ratio primarily due to the deferral of certain acquisition costs and the inclusion of certain holding company expenses, each of which is considered in the Company's GAAP combined ratio.
Net investment income for 1996 was $92.2 million, a 15.2% increase over 1995. Growth in net investment income continues as the cash and invested asset base expands due to strong cash flows, primarily attributable to underwriting operations. In addition, profit from the Company's investment in Insurance Partners, L.P., increased 1996 operating results by $3.3 million, compared to $0.7 million in 1995. The 1996 after-tax annualized net investment income yield of 4.1% was consistent with 1995. Net investment income for 1995 increased 56.8% to $80.0 million due to an increased invested asset base resulting from strong cash flows and Re Capital's acquired assets (after payments to stockholders and holders of Re Capital's 5 1/2% Convertible Debentures due August 1, 2000).
Interest and amortization expense for 1996 was $15.5 million compared to $15.9 million in 1995. The decline is primarily due to the conversion of Re Capital's 5 1/2% Convertible Debentures, due August 1, 2000 (the "Convertible Debentures") offset by an increase in amortization expense related to the acquisition of Re Capital. Interest and amortization expense for 1995 was $15.9 million representing an increase of 11.2% from 1994, due to the Company's assumption of the Convertible Debentures and increased amortization expense discussed above.
The Company's cash and invested assets increased 15.6% during 1996 to $1,748.0 million. The increase is principally due to cash flows from operations. As of December 31, 1996, approximately 69% of the Company's cash and investment portfolio was invested in fixed maturity securities, 10% in equity securities and 21% in short-term investments and cash and cash equivalents, compared with 74%, 9% and 17%, respectively, as of December 31, 1995. As of December 31, 1996, the composition of ZRC's investment portfolio complied with the pertinent provisions of the NAIC's Investments of Insurers Model Act. Consistent with previous years, the Company maintains a high quality fixed maturity portfolio with approximately 83% invested in U.S. government obligations or securities rated "triple-A" by Moody's or S&P as of December 31, 1996. The balance of the fixed maturity portfolio was invested in "A" rated fixed maturities. The duration of the Company's fixed maturity portfolio of 4.2 years at December 31, 1996 approximated the 4.3 years duration at December 31, 1995. The Company's investment strategy is to maximize total investment return consistent with appropriate safety, diversification, tax and regulatory considerations, and to provide sufficient liquidity to enable the Company to meet its obligations on a timely basis. As a result of the Company's investment strategy, fixed maturities are classified as available-for-sale and are carried at market value.
The Company limits the extent of prepayment or extension risks by generally avoiding securities with costs significantly in excess of par value, by purchasing securities that are backed by stable collateral, and by concentrating on securities with enhanced priority in their trust structure. The Company has no securities such as interest only securities ("IOs"), principal only securities ("POs") 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. In addition to MBS, the Company may also enter into forward commitment mortgage-backed security dollar roll transactions ("dollar rolls"). Such transactions are typically for one month and effectively provide the Company with the price exposure of the underlying MBS. The Company manages this exposure by establishing duration guidelines for the total portfolio and the duration of the dollar rolls is
Stockholders' equity at December 31, 1996 was $711.9 million compared to $681.6 million as of December 31, 1995. The increase in stockholder's equity is primarily attributable to after-tax operating income partially offset by the declaration of a regular $0.10 per share annual dividend, or $2.6 million, in December 1996.
Net cash used in financing activities of $9.7 million in 1996 resulted from the Company's repurchase of its Common Stock, a regular dividend payment and the conversion of the remaining Re Capital Convertible Debentures. Net cash used in financing activities was $71.9 million in 1995 due to the conversion of the Convertible Debentures. There were no cash flows from financing activities in 1994.
The Company believes that ZRCH, ZRC and ZCIC have sufficient cash flow and liquid investments to meet both short- and long-term liquidity needs. In planning for its liquidity needs, the Company distinguishes between capital funds and liability funds. The Company considers the duration of its reinsurance liabilities in the investment of funds supporting those liabilities. Management believes that ZRCH's investment income and liquid investments will be sufficient to offset interest and other expense payments. The amount of future cash flow available to ZRCH from ZRC may be influenced by a variety of factors, including cyclical changes in the property and casualty reinsurance market, insurance regulatory changes and changes in general economic conditions. ZRC's ability to pay dividends to ZRCH is subject to provisions of the Connecticut Insurance Code restricting the ability of Connecticut insurance companies to make certain dividends and distributions without prior regulatory notification
Schedules other than those listed above are omitted for the reason that they are not applicable or that the information has been included in the financial statements.
We have audited the accompanying consolidated balance sheets of Zurich Reinsurance Centre Holdings, Inc. and Subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1996. Our audits also included the financial statement schedules listed in the index at Item 8. These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
ZURICH REINSURANCE CENTRE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in thousands except per share data)
ZURICH REINSURANCE CENTRE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Dollars in thousands)
Forward commitment mortgage-backed security dollar rolls ("dollar rolls") which are purchased to provide the Company with the price exposure of the underlying security, are reflected in the financial statements on a settlement date basis as the Company does not intend to take delivery of the underlying securities. The Company manages this exposure by establishing duration guidelines for the total portfolio and the duration of these commitments is included in the overall duration. There is no leverage related to these transactions since sufficient cash equivalents are retained to cover settlement of the underlying position. Changes in the market values between the trade date and settlement date for such securities are recorded currently in net income as realized capital gains or losses. As of December 31, 1996, the cost and market value of dollar rolls held were $270.1 million and $269.0 million, respectively.
Acquisition costs, principally consisting of commissions and brokerage expenses, net of allowances from retrocessionaires, and certain other acquisition costs incurred at the time a contract is issued, are deferred and amortized over the period in which the related premiums are earned. Deferred policy acquisition costs are limited to their estimated realizable value based on the related unearned premiums and consider anticipated losses and loss adjustment expenses and anticipated investment income.
LOSSES AND LOSS ADJUSTMENT EXPENSES The Company's liability for losses and loss adjustment expenses is based on reports and individual case estimates received from ceding companies. An amount is included for losses and loss adjustment expenses incurred but not reported on the basis of past experience of the Company, its ceding companies and the reinsurance industry. The Company discounts certain tabular workers' compensation indemnity reserves to present value using a 5% interest rate. Losses and loss adjustment expense estimates are reviewed regularly and, as experience develops and new information becomes known, the reserves are adjusted as necessary. Such adjustments, if any, are reflected in results of operations in the period in which they become known.
RETROCESSIONS In the normal course of business, the Company sometimes seeks to reduce losses that could arise from events that cause unfavorable underwriting results by reinsuring certain levels of risk with retrocessionaires. Amounts recoverable from retrocessionaires are estimated in a manner consistent with the claim liability associated with the reinsured policy.
Recoverables, if any, under the Company's aggregate excess of loss reinsurance contracts with Zurich Insurance Company ("Zurich") (together, the "Stop Loss Agreement"), which are retroactive contracts, will be recognized immediately since the Company is reimbursed on an incurred basis. Refer to Footnote 12 for further discussion of the Stop Loss Agreement.
GOODWILL Goodwill represents the excess of cost over the fair value of net assets acquired and is amortized on a straight line basis over twenty years. At December 31, 1996 and 1995, the amount of goodwill included in other assets was $23.8 million and $22.0 million, respectively. The amortization of goodwill for the years ended December 31, 1996 and 1995 was $1.2 million and $0.8 million, respectively. Refer to Footnote 3 for a further discussion of the acquisition of Re Capital Corporation ("Re Capital").
ZURICH REINSURANCE CENTRE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) The April 1995 acquisition of Re Capital increased the Company's gross loss and loss adjustment expense reserves and reinsurance recoverables on unpaid losses by $202.1 million and $8.5 million, respectively, as of the date of acquisition (refer to Footnote 3 for further discussion of the Re Capital acquisition).
Effective January 1, 1996, the Company discounts certain tabular workers' compensation indemnity reserves. This method is preferable as it is more representationally faithful to the economics of the underlying business and it will enhance comparability of the Company's financial statements as it is the prevalent method used in the reinsurance industry. Such reserves were discounted to present value using a 5% interest rate. Since the effect of such discount as of January 1, 1996 was $0.8 million, it has been reported as a component of earnings. Discounting had no material effect on net income for 1996 or on the proforma net income for 1995. Tabular workers' compensation indemnity reserves, net of discount, were $3.6 million as of December 31, 1996.
The Company believes that its exposure to environmental impairment liability and asbestos-related claims is minimal due to the diminutive amount of business written prior to 1987 and the protection provided by the Stop Loss Agreement (refer to Footnote 12 for further discussion).
The Company utilizes retrocessional agreements to reduce its total loss exposure. These agreements provide for recovery of a portion of losses and loss adjustment expenses from retrocessionaires. The Company is liable to reinsureds regardless of whether retrocessionaires meet their obligations under these retrocessional agreements. Failure of retrocessionaires to honor their obligations could result in losses to the Company; consequently, allowances are established for amounts considered potentially uncollectible, if any.
In 1996, the Company had realized capital losses of $5.1 million, which can be carried back and offset against capital gains generated in 1995. As of December 31, 1996, no capital loss carry forward remains.
As of December 31, 1996, the Company and its branch offices occupy office space under various operating leases that have remaining noncancelable lease terms in excess of one year. The Company recognizes rental expense on a straight line basis over the term of the lease. The Company also leases certain computer and communications equipment, software and office equipment under various operating leases with terms of one year or less. Rental expense was approximately $3.0 million, $2.9 million and $2.8 million for the years ended December 31, 1996, 1995 and 1994, respectively.
The future minimum rental payments as of December 31, 1996 are as follows (dollars in thousands):
During October 1993, the Company issued $200 million principal amount of non-convertible, unsecured, unsubordinated Senior Notes (the "Senior Notes"). The Senior Notes mature on October 15, 2023 and bear interest at the rate of 7 1/8%, payable semiannually in arrears on April 15 and October 15. Debt issuance costs of approximately $2.2 million incurred in connection with the issuance of the Senior Notes have been deferred and are being amortized over the term of the Senior Notes. The interest expense on the Senior Notes was $14.3 million during 1996, 1995 and 1994. Interest paid on the Senior Notes was $14.3 million in 1996 and 1995 and $14.1 million in 1994. The estimated fair value of the Senior Notes based on quoted market prices was approximately $190.7 million at December 31, 1996.
had reserved 450,000 shares under the Restricted Stock Plan. Grants of Restricted Stock will generally vest upon completion of three to four years of continuous employment with the Company from the date of grant. The Company recognizes the related expense, which is the market value of the shares at the date of grant, over the vesting period using the straight-line method. During 1996, the Company issued 171,065 shares of non-vested restricted stock, with a weighted-average grant date fair value of $29.47 per share. The expense for the Restricted Stock Plan was $3.6 million, $1.7 million and $1.0 million for the years ended December 31, 1996, 1995 and 1994, respectively.
Effective January 1, 1996, the Company adopted a stock option plan (the "Stock Option Plan") pursuant to which the Company may issue options for the purchase of up to 1,844,000 shares of Common Stock. Initial grants under the Stock Option Plan consist of two types of options, each having ten year terms and generally vesting over four years. "Type A" options may not be exercised unless the appreciation of the Company's Common Stock exceeds 150% of the effective yield on 5-year U.S. Treasury obligations. "Type B" options may not be exercised unless the appreciation of the Company's economic book value exceeds 150% of the effective yield on 5-year U.S. Treasury obligations.
The fair value of the options granted were estimated on the date of grant using recognized option-pricing models. These models were developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, these models do not necessarily provide a reliable measure of the fair value of the employee stock options. The Company's valuation method utilized the following assumptions: a risk-free interest rate of 5.3%, which was adjusted by the annual percentage increase in the exercise price for the Type B option, a dividend yield of 0.2%, expected volatility of 14% and an expected life of 4 years. Based on these assumptions, the options granted have a weighted-average grant-date fair value of $5.60 per share. The Company recognizes the related expense, which is the fair value of the options at the date of grant, over the vesting period using the straight-line method. The Company expensed $0.7 million related to the Stock Option Plan in 1996.
The Company maintains a tax-qualified employee stock purchase plan (the "Purchase Plan"). An aggregate of 100,000 shares of the Common Stock has been reserved for issuance under the Purchase Plan. Subject to certain restrictions, substantially all full-time and certain part-time employees are eligible to purchase shares of the Common Stock at 85% of fair market value by means of payroll deductions of up to 10% of their salary. At December 31, 1996, 52,730 shares were outstanding under the Purchase Plan.
The Company maintains a stock repurchase program pursuant to which the Company's Board of Directors has authorized the repurchase of 500,000 shares of Common Stock. During 1996, the Company repurchased 200,000 shares of Common Stock for approximately $29.50 per share. These shares were repurchased for issuance to employees under various benefit and compensation arrangements.
As of December 31, 1996, ZRC's total capital and surplus was $690.1 million and its earned surplus for purposes of certain general statutory dividend tests and, accordingly, its 1997 maximum dividend payment is $46.0 million. Dividends are declared only with prior approval of ZRC's Board of Directors. There were no dividends paid by ZRC to ZRCH during 1996.
The NAIC's model risk-based capital regulations (the "RBC Model Act") requires insurance companies to calculate and report information under a risk-based capital formula which measures statutory capital and surplus needs based on the risks in a company's mix of business and investment portfolio. Based on its calculation as of December 31, 1996, ZRC exceeds all of the capital levels prescribed in the RBC Model Act.
Effective July 1, 1995, the Company entered into a domestic whole account quota share treaty with Zurich American (the "ZA Quota Share Agreement") and concurrently an excess of loss reinsurance agreement with Zurich (the "Retrocessional Agreement"), primarily to provide an aggregate loss limitation on business assumed under the ZA Quota Share Agreement. As of December 31, 1996 and 1995, net premiums written under these agreements were $176.8 million and $90.8 million, respectively,
In February 1994, ZRCH committed to invest $25.0 million in the limited partnership interests of Insurance Partners, L.P., a Delaware limited partnership ("Insurance Partners"). Insurance Partners is an investment fund established to sponsor and participate in acquisitions, recapitalizations, demutualizations and other structured transactions in the insurance industry. As of December 31, 1996 and 1995, ZRCH had invested approximately $8.2 million and $4.0 million, respectively, in Insurance Partners. Affiliates of the Company have interests in the general partner of Insurance Partners.
Refer to Footnote 8 for a discussion of an affiliated office lease arrangement.
The following is a summary of quarterly financial data, in thousands of dollars except per share data. Such quarterly information includes all adjustments, consisting solely of normal recurring accruals, necessary to present fairly the results of operations for such periods. Quarterly results may be affected by changes in the interest rate environment and catastrophic losses.
During January 1997, Zurich announced a proposal to acquire all of the remaining shares of ZRCH not currently owned by Zurich for $36.00 per share (the "Proposed Transaction"). ZRCH's Board of Directors has appointed a special committee of its members to determine the advisability and fairness of that offer to ZRCH's other stockholders. The special committee has retained independent investment banking advisors and legal counsel to advise it on the fairness of the offer and is in the process of considering the offer. The special committee has indicated its intention to make a recommendation to ZRCH's Board of Directors with respect to the offer as soon as practicable. Consummation of the Proposed Transaction is subject to the approval of the Board of Directors and the stockholders of ZRCH and other conditions customary in this type of transaction. There can be no assurance that Zurich and the Board of Directors of ZRCH will reach an agreement with respect to the fairness of the Proposed Transaction or that, in the absence of such agreement, Zurich would proceed with the Proposed Transaction.