(1) Based on net income divided by stockholders' equity as reported at the beginning of each year. (2) Data prior to 1997 restated per SFAS No. 128. See Note 12 of the Notes to Consolidated Financial Statements with respect to the computation of earnings per share.
Abundant capacity and significant price competition continued to characterize the reinsurance industry during 1998. Excess capital and limited opportunities for organic growth in traditional markets continued to generate merger and acquisition activity as companies attempt to maintain or improve market share and performance. Reinsurers have also actively pursued investments in the Lloyd's market during 1998. Perhaps more than ever, the Company, together with the industry, faces a tough challenge in achieving profitable growth. Despite adverse market forces, the Company's strong 1998 results were achieved through continued attention to disciplined underwriting, expense reduction initiatives, and the benefit of a stop loss provision in its retrocessional program.
The Company is well positioned to take advantage of these and other opportunities. Its strong underwriting capabilities, sound financial fundamentals, and service-driven focus provide the flexibility to adapt to market dynamics. Responding to these changes in the market, the Company made several equity based investments in insurance service related entities during 1998: a leading property/casualty insurance asset management firm, a Lloyd's managing agency, an internet financial services firm, and an internet claims support firm for the property/casualty insurance industry. These investments are intended to enhance the Company's ability to provide solutions to its clients and help it to grow more profitably.
Net income was $96.1 million for 1998, $95.7 million for 1997, and $70.5 million for 1996. On a basic per share basis, net income was $5.25, $5.21, and $3.74 for 1998, 1997, and 1996, respectively. On a diluted per share basis, net income was $4.78, $4.77, and $3.51 for 1998, 1997, and 1996, respectively. Net income for 1998 includes after-tax realized investment gains of $22.8 million or $1.10 per diluted share compared to $28.0 million or $1.35 per diluted share in 1997 and $12.7 million or $.61 per diluted share in 1996.
One traditional means of measuring the underwriting performance of a property/casualty insurer is the statutory composite ratio. This ratio, which is based on statutory accounting practices (which differ from generally accepted accounting principles), reflects underwriting experience, but does not reflect income from investments. A composite ratio of under 100% generally indicates underwriting profitability while a composite ratio exceeding 100% generally indicates an underwriting loss.
The increase in the Company's 1998 domestic reinsurance composite ratio is due to an increase in other operating expenses coupled with a lower premium base stemming from both difficult market conditions and the Company's decision not to renew accounts with unsatisfactory returns. In addition, the ratio reflected an increase of approximately 1.2 percentage points related to property catastrophes resulting primarily from Hurricane Georges. The increase in the 1997 domestic reinsurance composite ratio reflects an increase in the claims and claims expense ratio and other operating expense ratios. Overall, operating expenses increased in 1998, 1997, and 1996, reflecting business expansion, investment in technology, and the investment in facultative business.
The international composite ratio was 111.2% in 1998 compared to 108.9% in 1997 and 105.6% in 1996. The 1998 ratio reflects approximately 2.5 percentage points due to Hurricane Georges. The increase in the 1997 composite ratio compared to 1996 is principally attributable to increases in the international operating expense ratio. The Australian branch of the international reinsurance subsidiary did not commence writing premium until 1997, contributing to this increase. The Company generally expects a higher expense ratio in the start-up of an operation. As anticipated, the expense ratio of the international subsidiary slightly declined in 1998 as it began to leverage its investment in infrastructure and generate increases in premium revenues.
In accordance with SFAS No. 131 "Disclosures about Segments of an Enterprise and Related Information" adopted at December 31, 1998, the Company has three reportable segments: domestic reinsurance, domestic primary insurance, and international operations. See Note 2 of the Notes to Consolidated Financial Statements for further details.
The Company evaluates performance and allocates resources based on profit or loss from operations before income taxes, excluding gains and losses on the Company's investment portfolio. Segment information is reviewed on a statutory accounting basis which differs from generally accepted accounting principles. Gross premiums written, assets, pretax net investment income, and pretax income (loss) are identified for each segment.
The Company's primary revenues consist of business generated from Greenwich and Indian Harbor. Greenwich, licensed to write property/casualty insurance throughout the United States, distributes its products through a network of managing general agents and general agents who write specialized products with an emphasis on domestic casualty products. Indian Harbor, an excess and surplus lines carrier licensed in North Dakota, writes primary business on a non-admitted basis in selected states. Its focus is on seasoned profitable program business. The principal lines of primary business written include automobile, auto warranty, aviation, multiple peril and inland marine.
Domestic primary gross premiums written increased to $161.2 million in 1998 compared to $130.7 million in 1997 and $81.8 million in 1996. The 23.3% increase in 1998 largely represents expanded opportunities on existing accounts as well as new account business. The 1997 increase of 59.9% emanated largely from increased growth from an auto warranty program.
Worldwide ceded premiums recorded for retrocession agreements were $151.0 million, $130.2 million, and $140.1 million in 1998, 1997, and 1996, respectively. The Company continually evaluates its retrocessional programs based on market conditions, pricing, and its own risk tolerance. In 1998, the increase in ceded premium was primarily due to reinstatement premium in connection with 1998 catastrophes as well as an increase in specific retrocessional coverages principally related to the Company's primary operations. The 1997 decrease in ceded premium was primarily due to improved pricing for the Company's catastrophe and per risk retrocessional programs and the termination of two retrocessional programs, partially offset by growth in certain primary programs with specific reinsurance protection.
to the Company's competitive position in the marketplace and the continuing availability of other sources of business.
Generally, claims and claims expenses represent the Company's most significant and uncertain costs. Claims and claims expense reserves are estimates involving actuarial and statistical projections, at a given point in time, of what the Company expects the ultimate settlement and administration of claims will cost based on facts and circumstances then known. The reserves are based on estimates of claims and claims expenses incurred and, therefore, the amount ultimately paid may be more or less than such estimates. These expenses are principally based on NAC's analysis of reports and individual case estimates received from ceding companies. A provision, on the basis of past experience, claims audits, and other factors, is included for losses and loss adjustment expenses incurred but not reported ("IBNR"). The Company expects to refine such estimates in subsequent accounting periods based upon facts and circumstances then known.
Estimates of claims and claims expenses are based in part on a prediction of future events, estimates of future trends in claims severity and frequency as well as other variable factors. The Company's ability to predict future trends based solely upon its own historical claims experience is inherently difficult because of its substantial growth in premiums since 1985. Therefore, for purposes of evaluating future trends and providing an estimate of ultimate claims costs, the Company has supplemented its historical claims experience to a certain extent with claims experience derived from external sources, such as reinsurance industry data. As the Company's book of business continues to mature, its own historical claims experience achieves greater credibility and enhances its ability to evaluate future trends. Accordingly, the Company believes its reserving process improves with additional claims experience.
Claims and claims expenses incurred were $351.9 million in 1998 compared to $379.5 million in 1997 and $339.0 million in 1996. The decrease in 1998 reflects a decline in earned premium and a flat claims and claims expense ratio in 1998 compared to 1997. The increase in 1997 was principally attributable to growth in earned premium and a higher claims and claims expense ratio.
and claims expense development, inflation and other considerations. This favorable development has offset certain unfavorable development on business written prior to 1986, principally related to asbestos and environmental claims.
During 1998, the Company maintained catastrophe reinsurance protection of $97 million in excess of the Company's initial retention of $5 million on a first and second event. For 1999, the Company has obtained catastrophe reinsurance protection of approximately $83 million ($65 million with respect to claims outside the U.S. and Canada) in excess of a $5 million initial net retention, subject to a graduated increase of approximately $16.9 million in additional net retention once losses within the U.S. and Canada exceed $40 million. In addition, the Company has accident year stop loss protection which can reduce the Company's net property catastrophe claims to a maximum retention of $5 million. The Company evaluates its potential catastrophe exposure, including both gross loss estimates and the impact of available reinsurance protection. While the Company believes its management of catastrophe exposures and underwriting guidelines are adequate, an extremely large catastrophic event or multiple
The balance of the Company's investment portfolio at December 31, 1998, consisting of cash, short term investments and equity securities, amounted to $265.8 million. As of December 31, 1998, the Company held $115.1 million or 4.7% of cash and invested assets in equity securities, representing 15.6% of statutory surplus. This was compared to $142.5 million or 6.1% of invested assets in equity securities at December 31, 1997, representing 20.3% of statutory surplus.
Changes in market interest rates during 1998 resulted in an increase in the market value of the Company's investment securities. Net unrealized appreciation of investments, net of tax, was $57.7 million or $3.14 per share at December 31, 1998 compared to $55.0 million or $3.00 per share at December 31, 1997. The unrealized appreciation was primarily attributable to the market value fluctuations in the Company's fixed income securities, which are recorded at their fair market values.
Uncertainties exist regarding interest rates and inflation and their potential impact on the market values of the Company's fixed income securities. The Company actively considers the risks and financial rewards associated with the maturity distribution of its fixed income portfolio. In this regard, the Company takes into consideration the pattern of expected claims payments and the Company's future cash flow projections in evaluating its investment opportunities.
An investment was made in Net Earnings, an Internet company that combines proprietary Web technology and small business expertise to offer small businesses and the financial institutions serving them, a portfolio of online financial services.
The Company's debt-to-capital ratio declined to 29.4% in 1998 from 32.3% in 1997. In late 1995, the Company issued $100 million of 7.15% Notes due November 15, 2005 and raised approximately $49 million on the issuance of 1,530,000 shares of Common Stock. Previously, the Company had raised $200 million in 1992 through the issuance of $100 million of 5.25% Convertible Subordinated Debentures due December 2002 and $100 million of 8% Notes due June 1999. The Company intends to refinance the 8% Notes before they are due. As a result of the transactions and borrowings described above, pretax interest expense including amortization expense was $21.7 million in 1998, $21.7 million in 1997, and $22.3 million in 1996.
The Company periodically reviews its credit arrangements for renewal based on its working capital requirements and other financing needs. In December 1998, the Company canceled its $15 million line of credit for its reinsurance subsidiary and increased NAC Re's revolving credit agreement and term loan bank facility to $50 million as of December 31, 1998. A commitment fee of 1/4 of 1% per year is paid on the unused credit line. Borrowings of $12.9 million were outstanding at December 31, 1998 and were principally used in connection with repurchases of the Company's common stock. The facility is scheduled to be reduced on a quarterly basis beginning in January 1999.
During 1998, the Company repurchased approximately 223,000 shares of NAC Re Common Stock under the stock repurchase program for an aggregate purchase price of approximately $11.0 million. As of December 31, 1998, approximately 433,000 shares remained authorized for repurchase under the program.
Consolidated stockholders' equity totaled $750.7 million or $40.86 per basic share at December 31, 1998 compared to $657.1 million or $35.89 per basic share at December 31, 1997.
The Company's insurance operations create liquidity in that premiums are received substantially in advance of the time claims are paid. Over the most recent three years, cash flow provided by operating activities totaled over $590 million, including 1998 cash flow of $109.6 million. The cash flow for 1998 decreased from 1997 principally due to additional cash flow of approximately $180 million in 1997 from the termination of two retrocessional programs, coupled with higher claim payments in 1998.
See Note 1 of the Notes to Consolidated Financial Statements of NAC Re for a discussion on accounting pronouncements.
The Company's exchange rate exposure results primarily from its investments in the Company's international operation in London, England. This exposure stems from transaction gain and loss risk with respect to that entities' cash flows conducted in currencies other than the functional currency. The Company's foreign subsidiaries maintain a policy of matching asset and liability risk with respect to both currency and interest rate exposure. The Company is also exposed to the extent change in currency rates affect its net investment in foreign subsidiaries.
In 1993, the National Association of Insurance Commissioners (the "NAIC"), by adopting a model risk-based capital act, intended to provide an additional tool for regulators to evaluate the capital of property and casualty insurers and reinsurers with respect to the risks assumed by them and determine whether there is a perceived need for corrective action. The nature of the corrective action depends upon the extent of the calculated risk-based capital deficiency and ranges from requiring the Company to submit a comprehensive plan to placing the insurer under regulatory control. While the model risk-based capital act has not yet been adopted in New York, NAC's domicile, New York has issued a circular letter requiring the filing of risk-based capital reports by property and casualty insurers and reinsurers. The NAIC also adopted a proposal that requires property and casualty insurers and reinsurers to report the results of their risk-based capital calculations as part of the statutory annual statements filed with state regulatory authorities. Surplus (as calculated for statutory annual statement purposes) for each of the Company's domestic subsidiaries is well above the risk-based capital thresholds that would require either company or regulatory action.
Information Technology Systems Readiness: The Company began assessing the impact of the Year 2000 issue on its computer hardware and software systems in 1995. The Company completed its inventory and assessment of all information technology ("IT") systems (including embedded technology) in 1998. Certain systems were identified
Contingency Planning: Management is currently revising its existing business continuity plans to address how certain potential material internal or external Year 2000-related failures may impact the Company's critical processes. The Company acknowledges that, among other things, Year 2000-related failures could lead to temporary reliance on manual systems to process business transactions; delayed regulatory reporting of material financial and other information; delayed receipt of premiums and payment of claims; and disruptions in the management of the Company's bank accounts and investment portfolios. At this time, the Company does not expect such worst-case Year 2000 disruptions to occur, based upon the information currently available to it. However, the Company intends to address these scenarios in its contingency plans. In addition, the contingency plans will take into account, but not be limited to, the following issues: (1) staffing requirements at year-end 1999 and throughout 2000; (2) retention programs for critical personnel, as deemed necessary; (3) proactive procedures and routines that can be performed to detect problems as early as possible; and (4) procedures for policy issuance and claims handling in case temporary failures of our managing general agents and third-party administrator systems occur. The Company intends to challenge and test its contingency plans in the third quarter of 1999.
In connection with the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 (the "Act"), the Company sets forth below cautionary statements identifying important factors that could cause the Company's actual results to differ materially from those which might be projected, forecasted, or estimated or otherwise implied in the Company's forward-looking statements, as defined in the Act, made by or on behalf of the Company in press releases, written statements or documents filed with the Securities and Exchange Commission, or in its communications and discussions with investors and analysts in the normal course of business through meetings, telephone calls and conference calls. Such statements may include, but are not limited to, projections of premium revenue, investment income, other revenue, losses, expenses, earnings (including earnings per share), cash flows, plans for future operations, common shareholders' equity, financing needs, capital plans, dividends, plans relating to products or services of the Company, and estimates concerning the effects of litigation or other disputes, as well as assumptions for any of the foregoing and are generally expressed with words such as "believes," "estimates," "expects," "anticipates," "could have," "may have," and similar expressions.
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:
In Thousands, except per share amounts - -------------------------------------------------------------------------------- Year ended December 31, -------------------------------------- 1998 1997 1996 -------------------------------------- PREMIUMS AND OTHER REVENUES Net premiums written $ 553,666 $ 593,656 $ 574,004 Increase in unearned premiums (20,820) (19,009) (47,662) - -------------------------------------------------------------------------------- Premiums earned 532,846 574,647 526,342 Net investment income 131,459 123,050 104,330 Net investment gains 35,074 42,675 19,569 - -------------------------------------------------------------------------------- Total revenues 699,379 740,372 650,241 - --------------------------------------------------------------------------------
PER SHARE DATA Basic:* Average shares outstanding 18,282 18,378 18,855 Operating income/net income $ 5.25 $ 5.21 $ 3.74 ================================================================================ Diluted (assuming conversion of dilutive convertible securities):* Average shares outstanding 20,844 20,809 21,115 Operating income/net income $ 4.78 $ 4.77 $ 3.51 ================================================================================ Cash dividends declared per share $ 0.345 $ 0.285 $ 0.23 ================================================================================
See Notes to Consolidated Financial Statements. * 1996 data restated per SFAS No. 128.
The Company categorizes all of its fixed maturity and equity securities as available for sale in order to provide the Company with the flexibility to respond to various factors, including changes in market conditions and tax planning considerations. Unrealized appreciation or depreciation of the securities available for sale, net of applicable deferred income taxes, is excluded from income, and recorded as a separate component of accumulated other comprehensive income in stockholders' equity.
basis of past experience of the Company and the reinsurance/insurance industry. These estimates are reviewed regularly and, as claims develop 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 and are accounted for as changes in estimates. Reserves are generally recorded without consideration of potential salvage or subrogation recoveries which are estimated to be immaterial; such recoveries, when realized, are reflected as a reduction of claims incurred. Certain workers' compensation case reserves are considered fixed and determinable and are subject to tabular reserving. Such tabular reserves are discounted using an interest rate of 7%.
The costs of furniture and equipment are charged against income over their estimated service lives. Leasehold improvements are amortized over the remaining terms of the office leases. Depreciation and amortization are computed using the straight-line method. Maintenance and repairs are charged to expense as incurred. Depreciation and amortization expense was approximately $4.5 million, $3.5 million and $3.0 million for the years ended December 31, 1998, 1997 and 1996, respectively.
The assets and liabilities of foreign operations are translated at the rate of exchange in effect at the balance sheet date. Revenues and expenses of foreign operations are translated at average exchange rates during the year. The effect of the translation adjustments for foreign operations is recorded, net of applicable deferred income taxes, as a separate component of accumulated other comprehensive income in stockholders' equity. Foreign currency transaction gains and losses are included in net income and are not material.
In August 1998, NAC Re acquired Denham Syndicate Management Limited ("Denham Syndicate") for 100,610 shares of NAC Re Common Stock. The acquisition was accounted for by the purchase method of accounting. The excess of cost over the fair value of net assets acquired of $5.2 million is being amortized over a period of twenty years.
In February 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits," which is effective for fiscal years beginning after December 15, 1997. This Statement does not change the recognition or measurement of pension or postretirement benefit plans, but standardizes disclosure requirements for pensions and other postretirement benefits. See Note 9 with respect to the Company's retirement plans.
The Company evaluates performance and allocates resources based on profit or loss from operations before income taxes, excluding gains and losses on the Company's investment portfolio. Segment information is reviewed on a statutory accounting basis.
In Thousands Year ended December 31, ----------------------------------- 1998 1997 1996 --------- --------- --------- Net Investment Income: Total segment net investment income $ 129,019 $ 120,915 $ 101,477 GAAP adjustments 2 38 38 Parent Co. investment income 2,438 2,097 2,815 --------- --------- --------- Total consolidated net investment income $ 131,459 $ 123,050 $ 104,330 ========= ========= ========= Income or Loss: Total segment pretax income $ 133,726 $ 136,426 $ 94,450 Segment income taxes (21,583) (56,856) (29,908) GAAP adjustments (778) 30,173 19,272 Parent Co. net loss (15,315) (14,066) (13,294) --------- --------- --------- Total consolidated income $ 96,050 $ 95,677 $ 70,520 ========= ========= =========
In Thousands December 31, ----------------------------------------- 1998 1997 1996 ----------- ----------- ----------- Assets: Total segment assets $ 2,795,859 $ 2,698,213 $ 2,377,571 GAAP adjustments 580,769 448,852 532,063 Parent Co./other assets 1,090,991 986,778 872,955 Intercompany elimination (1,239,987) (1,148,978) (1,036,958) ----------- ----------- ----------- Total consolidated assets $ 3,227,632 $ 2,984,865 $ 2,745,631 =========== =========== ===========
In Thousands Year ended December 31, ---------------------------------- 1998 1997 1996 --------- --------- --------- Fixed maturities $ 126,893 $ 112,738 $ 97,048 Equity securities 6,352 6,373 5,228 Cash and short-term investments 3,785 7,110 7,271 --------- --------- --------- Gross investment income 137,030 126,221 109,547 Interest expense (benefit) 172 (1,646) 472 Investment expenses 5,399 4,817 4,745 --------- --------- --------- Net investment income $ 131,459 $ 123,050 $ 104,330 ========= ========= =========
In Thousands December 31, 1998 -------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value ---------- ---------- ---------- ---------- Available for Sale: U.S. Treasury $ 20,775 $ 980 -- $ 21,755 Tax-exempt 1,265,247 60,279 $ (1,300) 1,324,226 Foreign Government 222,046 11,118 (14) 233,150 Corporate 404,778 15,154 (9,410) 410,522 Mortgage-backed 195,562 5,328 (359) 200,531 Subordinated convertibles 284 149 -- 433 ---------- ---------- ---------- ---------- Total fixed maturities 2,108,692 93,008 (11,083) 2,190,617 Equity securities 108,276 9,579 (2,791) 115,064 ---------- ---------- ---------- ---------- Total $2,216,968 $ 102,587 $ (13,874) $2,305,681 ========== ========== ========== ==========
Contractual maturities of fixed maturity securities are shown below. Expected maturities, which are best estimates, will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Mortage-backed securities 195,562 200,531 ---------- ---------- Total $2,108,692 $2,190,617 ========== ==========
The weighted average contractual and expected maturities, based on fair value, of the fixed maturity investments excluding convertible securities, as of December 31, 1998, were 11.4 years and 7.7 years, respectively.
Proceeds from the sales of fixed maturity securities during 1998, 1997 and 1996 were $1,484.2 million, $1,470.0 million and $1,336.1 million, respectively. Gross gains of $30.0 million, $20.7 million and $16.3 million were realized on those sales during 1998, 1997 and 1996, respectively. Gross losses of $4.8 million, $10.3 million and $9.1 million were realized during 1998, 1997 and 1996, respectively.
Securities with a face amount of $68.7 million at December 31, 1998 were on deposit with various state or governmental insurance departments in order to comply with insurance laws.
Included in NAC Re's cash and invested assets at December 31, 1998 are approximately $22.4 million of assets held in a "holding company" escrow account arising from a tax allocation agreement between NAC Re and its domestic subsidiaries. The agreement provides that each subsidiary must remit to NAC Re its tax liability based upon its separate return. The excess of the taxes paid by the subsidiaries to NAC Re over the consolidated group's tax liability is restricted for current operating use, but may become available for unrestricted use two years following the filing of the consolidated tax return that generated the asset. Approximately $7 million of the escrow balance will become available for use in 1999.
The following table represents an analysis of paid and unpaid claims and claims expenses and a reconciliation of beginning and ending reserve balances for the years indicated.
GAAP and a 5% interest rate for statutory accounting purposes. The tabular reserving methodology results in applying a uniform and consistent criteria for establishing expected future indemnity and medical payments (including an explicit factor for inflation) and the use of mortality tables to determine expected payment periods.
Tabular reserves, net of reinsurance, reflected in the GAAP financial statements at December 31, 1998, 1997 and 1996 were $61.3 million, $42.4 million and $35.8 million, respectively. The related discounted case reserves, net of reinsurance, were $20.7 million, $16.1 million and $15.0 million as of December 31, 1998, 1997 and 1996, respectively.
The Company's reserving process includes a continuing evaluation of the potential impact on claims liabilities from exposure to asbestos and environmental claims, including related loss adjustment expenses. Liabilities are established to cover both known and incurred but not reported claims.
As of December 31, 1998 and 1997, the Company had approximately 400 and 380 open claim files, respectively, for potential asbestos exposures and 760 and 840 open claim files, respectively, for potential environmental exposures. Approximately 51% and 49% of the total open claim files for 1998 and 1997, respectively, are due to precautionary claim notices. Precautionary claim notices are submitted by the ceding companies in order to preserve their right to receive coverage under the reinsurance contract. Such notices do not contain an incurred loss amount to the Company. The Company actively evaluates potential exposure to asbestos and environmental claims and records claims and claims expense reserves as appropriate.
The Company believes it has made a reasonable provision for its asbestos and environmental exposures and is unaware of any specific issues which would materially affect its claims and claims expense estimate. The estimation of claims and claims expense liabilities for asbestos and environmental exposures is subject to a much greater uncertainty than is normally associated with the establishment of liabilities for certain other exposures due to several factors, including: i) uncertain legal interpretation and application of insurance and reinsurance coverage and liability; ii) the lack of reliability of available historical claims data as an indicator of future claims development; iii) an uncertain political climate which may impact, among other areas, the nature and amount of costs for remediating waste sites; and iv) the potential of insurers and policyholders to reach agreements in order to avoid further significant legal costs. Due to the potential significance of these uncertainties, the Company believes that no meaningful range of claims and claims expense liabilities beyond recorded
reserves can be established. As these uncertainties are resolved, additional reserve provisions, which could be material in amount, may be necessary.
The provision for federal income taxes has been determined on the basis of a consolidated tax return consisting of NAC Re and its subsidiaries.
The income tax provision in the consolidated statement of income gives effect to permanent differences between financial and taxable income. Due to the contribution of tax-exempt income and other factors as noted below, the Company's effective income tax rate is less than the statutory rate on operating income. An analysis of the Company's effective tax rate is as follows:
Significant components of the Company's deferred tax assets and liabilities as of December 31, 1998 and 1997 were as follows:
Stockholders' equity at December 31, 1998 and 1997 reflects tax benefits of $5.6 million and $4.5 million, respectively, related to compensation expense deductions for stock options exercised.
As a result of the merger of its previously existing parent into NAC Re in January 1987, $10.2 million of tax loss carryforwards are currently available for use to offset future taxable income of NAC Re under the separate return limitation year rules, with the following expiration dates: $6.2 million expiring in 1999, $3.9 million expiring in 2000 and $.1 million expiring in 2001. A deferred tax asset was not recorded for these loss carryforwards, as the Company expects these carryforwards to expire without being utilized.
The Company's balance sheet as of December 31, 1998 and 1997 reflects reinsurance recoverables as assets, net of available offsets, as follows:
In Thousands December 31, ---------------------- 1998 1997 --------- --------- Reinsurance recoverable balances: Paid claims $ 20,168 $ 10,646 Unpaid claims and claims expenses 292,256 196,836 Ceded balances payable (48,590) (34,305) Funds held liability (962) (900) --------- --------- Reinsurance recoverable balances, net $ 262,872 $ 172,277 ========= ========= Reinsurance recoverable on unearned premiums $ 49,962 $ 31,297 ========= =========
Effective January 1997, the Company terminated two retrocessional programs. The Company received total consideration of approximately $225 million, representing reinsurance recoverable balances for unpaid claims and claims expenses of approximately the same amount, with total cash and invested assets increasing by approximately $180 million.
The Company leases office space under noncancellable, and in most instances renewable, operating leases expiring at various dates through 2016. The following is a schedule of future minimum rental payments, exclusive of escalation clauses and rental income, as of December 31, 1998:
Rental expense, net of sublease rental income, was approximately $5.2 million for 1998, $4.4 million for 1997 and $3.9 million for 1996.
In 1998, the Company entered into consulting agreements with two investment banking firms with which two Directors of the Company are or had been associated.
The Company's $100 million of 7.15% Senior Notes due November 15, 2005, were issued in November 1995 through a public offering at a price of $99.9 million. The expenses incurred in the offering of approximately $.8 million were deferred and are being amortized over the life of the Notes. Interest and amortization costs were $7.2 million for 1998, 1997 and 1996. The fair value of the Notes, estimated based on quoted market prices, was approximately $106.6 million as of December 31, 1998.
Total interest expense paid in connection with the Company's long-term debt and financing arrangements was $21.4 million, $21.3 million and $22 million for the years ended December 31, 1998, 1997 and 1996, respectively.
The Company accounts for stock compensation plans in accordance with APB Opinion No. 25, "Accounting for Stock Issued to Employees." Accordingly, compensation expense for stock option grants and SARs is recognized to the extent that the fair value of the stock exceeds the exercise price of the option at the measurement date.
The Company maintains stock option plans which provide for the granting of options and SARs to purchase shares of Common Stock to certain officers of the Company. Under such plans, the Company had the authority to grant up to 3,675,000 options at December 31, 1998, of which 1,300,000 options related to a plan implemented during 1997. Options and SARs have generally been granted with a five or six-year vesting schedule. The majority of the options expire 10 years from the date of grant; the remainder of the options have no expiration. Outstanding SARs are generally converted by the Company to options prior to vesting.
The Company also maintains a stock option plan for non-employee directors that provides for automatic annual grants of options to eligible directors. Under such plan, the Company had the authority to grant up to 375,000 options at December 31, 1998. Options expire 10 years from the date of grant and are fully exercisable six months after their grant date.
The Company has restricted stock plans, pursuant to which employees have been granted approximately 25,900, 71,100 and 57,600 shares of Common Stock during 1998, 1997 and 1996, respectively. Vesting for such shares generally occurs
over a six-year period. In 1996, the Company also granted 20,000 shares of restricted stock to an executive in connection with his employment contract, 15,000 of which have vested due to the attainment of the stock appreciation performance measures; the remainder of the shares vest over a five year period. The Company incurred compensation expense, under APB 25, for the years ended December 31, 1998, 1997 and 1996 of approximately $1,092,000, $1,983,000 and $974,000, respectively, in connection with restricted stock grants.
For purposes of pro forma disclosures, the estimated fair value of each option is amortized to expense over the option's vesting period and does not include grants prior to January 1, 1995. As such, the pro forma net income and earnings per share are not indicative of future years. The Company's pro forma information is as follows:
The Company maintains two incentive compensation plans. The Long-term Incentive Plan provides for awards to eligible officers based on corporate performance over a three-year performance cycle. The Annual Incentive Plan for all employees (which was amended in 1996 to incorporate a previously separate plan for non-officers) provides for annual cash awards based on individual and corporate performance. Based on estimated performance levels, the Company expensed $9.6 million, $10.4 million and $8.5 million for the years ended December 31, 1998, 1997 and 1996, respectively, related to these plans.
The Company has severance agreements with officers and a severance program for non-officers to provide for severance payments and continuation of benefits in the event of employment termination following a change in control. The extent of the severance payments and when they are triggered vary depending upon the position of the employee and, in the case of non-officers, the length of tenure of the employee.
The projected benefit obligation, accumulated benefit obligation and fair value of assets for the pension plan with accumulated benefit obligations in excess of plan assets were $5.0 million, $2.5 million and $0, respectively, as of December 31, 1998 and $4.1 million, $2.1 million and $0, respectively, as of December 31, 1997.
The discount rates used in determining the actuarial present value of benefit obligations were 6.5% and 6.75% for 1998 and 1997, respectively. The rate of increase for future compensation levels was 5.5% for both 1998 and 1997. The assumed rate of return on plan assets was 9.0% for 1998 and 8.5% for 1997. Assets of the qualified plan are invested principally in equity securities and fixed maturities. Plan assets include approximately $673,000 and $700,000 of NAC Re Common Stock as of December 31, 1998 and 1997, respectively.
The Company maintains a qualified non-contributory defined contribution plan covering substantially all U.K. employees. Contributions under this plan are determined on the basis of salary, age and position within the organization. The Company also maintains an unfunded supplemental defined contribution plan designed to compensate individuals to the extent their benefits under the qualified plan are curtailed due to U.K. Inland Revenue limitations. The Company incurred expenses of $591,000, $563,000 and $436,000 for the years ended December 31, 1998, 1997 and 1996, respectively, related to these plans.
The balances of each classification, net of deferred taxes, within accumulated other comprehensive income were as follows:
In Thousands Year ended December 31, ----------------------------------- Net Income: 1998 1997 1996 --------- --------- --------- Domestic statutory net income $ 101,862 $ 70,292 $ 59,827 Domestic GAAP adjustments: Deferred acquisition costs 3,620 6,703 14,211 Deferred income taxes (8,245) 23,257 4,421 Other, net 1,349 (560) 401 --------- --------- --------- Domestic GAAP net income 98,586 99,692 78,860 International operation 12,779 10,051 4,954 Parent company operations (15,315) (14,066) (13,294) --------- --------- --------- Consolidated GAAP net income $ 96,050 $ 95,677 $ 70,520 ========= ========= =========
(1) Computed utilizing the average market price of the Common Stock for the period. (2) Reflects the assumed conversion of the Company's 5.25% Convertible Subordinated Debentures due 2002.
The Company maintains a stock repurchase program pursuant to which the Board of Directors has authorized the repurchase of approximately 4,082,000 shares of Common Stock. Since January 1, 1998, the Company repurchased approximately 223,000 shares of Common Stock, at an average cost of $49.52 per share. From its inception in 1988 through December 31, 1998, approximately 3,649,000 shares were repurchased at a cost of approximately $99.5 million or an average price of $27.27 per share. As of December 31, 1998, approximately 433,000 shares remained authorized for repurchase under the program.
In June 1998, coincident with the expiration of the Rights Agreement, as amended, adopted in June 1988, the Company declared a dividend of one Preferred Stock Purchase Right (a "Right") for each outstanding share of NAC Re Common Stock. The Rights will become exercisable only in the event, with certain exceptions, that a person or group of affiliated or associated persons accumulates 15% or more of NAC Re voting stock, or if a person or group announces an offer to acquire 15% or more (see Note 15). Each Right currently entitles the holder to purchase from the Company, for a price of $150.00 (the "Exercise Price"), 1/100 of a share of Series A Junior Preferred Stock (the "Series A Stock").
NAC Re will generally be entitled to redeem the Rights at $.01 per Right at any time until the tenth day following the acquisition of a 15% position in its voting stock. The Rights will expire on June 10, 2008.
*The first three quarters of 1997 earnings per share amounts have been restated to comply with SFAS No. 128.