In addition, the Surety Company has applied for a license to underwrite bonds in Alabama, Georgia, North Carolina and West Virginia, and anticipates filing license applications in various other states.
Year ended December 31, 1996 compared to year ended December 31, 1995: During the year ended December 31, 1996, the Surety Company generated $7,829,171 of gross written premiums, compared to $4,671,677 of gross written premiums during the year ended December 31, 1995, representing an increase of $3,157,494 or 68%. Management attributes the increase in gross written premiums primarily to the Surety Company's increased penetration of the states in which the Surety Company became licensed prior to 1996. Because the Surety Company either began marketing efforts or became licensed in the other states listed above relatively late in 1996, its expansion in these markets did not significantly impact gross written premiums in 1996.
period was primarily the result of the increase in gross written premiums as well as an increase in reinsurance coverage limits and reinstatements.
Effective November 1, 1995, the Company secured a new reinsurance treaty that increased the Company's maximum single bond limit and work program aggregate imit from $3 million and $4.5 million, respectively, to $5 million and $7.5 million, respectively. In addition, the Company's reinsurance coverage limits and reinstatements were increased. Under this treaty (effective from November 1995 through October 1996) the ceded reinsurance premiums represented approximately 16.75% of gross written premiums, adjusted for the Company's 5% participation in the first layer. Effective November 1, 1996, the Company secured a new reinsurance treaty that increased the Company's work program aggregate limit from $7.5 million to $10 million. Under the new reinsurance treaty (effective from November 1996 through October 1997), the maximum single bond limit remains at $5 million. However, the Company's aggregate reinsurance coverage limits and reinstatements are increased, and ceded reinsurance premiums are expected to represent approximately 15.26% of gross written premiums, adjusted for the Company's 5% participation in the first and second layers.
Of the $519,708 of claims and claim adjustment expenses incurred in 1996, $340,784 relates to known claims, most of which is associated with two bonded principals, and $178,924 relates to the increase in reserves for IBNR, which is primarily driven by net earned premiums in force at December 31, 1996.
For the year ended December 31, 1996, the Company incurred approximately $144,128 for professional services and $705,188 for other operating expenses, compared to $131,715 and $451,054, respectively, for the similar period in 1995. This increase reflected legal, accounting, auditing, and various other expenses incurred to comply with regulatory reporting obligations, licensure and tax requirements in states in which the Company is licensed to transact business, licensing of additional agents, and required infrastructure changes to support the Company's current and expected future levels of gross written premiums.
Interest expense (associated with a note payable in the original amount of $170,000) for 1996 and 1995 was $0 and $4,517, respectively. The note was repaid in April 1995.
The provision for income taxes for 1996 was $593,831 (an effective tax rate of 34.3%), as compared to $172,206 (an effective tax rate of 19.6%) for 1995. The 1995 effective tax rate was reduced by the elimination in 1995 of the deferred tax asset valuation allowance in the amount of $112,895. The valuation allowance was eliminated due to management's favorable assessment of the earnings potential of the Company.
Initial operations of the Surety Company were financed by contributions from the Company, principally from the sale of common stock by the Company. Continuing operations have been financed by internally generated cash flow from operations. Costs incurred by the Company are shared with the Surety Company under a services agreement which provides for the Surety Company to reimburse the Company for costs paid by the Company which are deemed to benefit the Surety Company. As in 1996, the Surety Company may elect to pay dividends in the future, subject to the dividend restrictions of the Commonwealth of Pennsylvania insurance laws and regulations. The Company expects to maintain a high level of liquidity through, among other things, the continued investment in U.S. government securities and other high-grade investment instruments.
During 1996, approximately $1,018,000 of the Company's cash and investment portfolio was converted to U.S. Treasury instruments in conjunction with the final licensure requirements of the Commonwealth of Kentucky and the State of Illinois. Management anticipates that additional "deposit" requirements will be required to be satisfied in those states in which the Surety Company intends to seek a license to write surety bonds.
The Surety Company requires capital to support its bond underwriting. Management believes that the statutory surplus of the Surety Company, which was approximately $7,975,000 at December 31, 1996, will be sufficient to support the Surety Company's current and anticipated premiums and losses.
Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 1996 and 1995 15
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of changes in shareholders' equity and of cash flows present fairly, in all material respects, the financial position of Mountbatten, Inc. and its subsidiary at December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
Year ended December 31, ------------ 1996 1995 Underwriting: Gross written premiums $7,829,171 $4,671,677 Premiums ceded (1,287,308) (717,741) ----------- -----------
Mountbatten, Inc. and Subsidiary Consolidated Statements of Changes in Shareholders' Equity December 31, 1996
Financing activities: Repayment of note payable - (170,000) ----------- ------------ Net cash provided by financing activities - (170,000) ----------- ------------
Cash and cash equivalents at beginning of period 755,639 172,670 ----------- ----------- Cash and cash equivalents at end of period $759,749 $755,639
Supplemental disclosure of cash flow information: The Company made payments of $503,680 during the year ended December 31, 1996 for federal income taxes. Payments of $4,517 and $211,401 were made by the Company during the year ended December 31, 1995 for interest and federal income taxes, respectively.
Under the new fair value method, compensation cost is measured at the grant date based on the value of the award and is recognized over the service (or vesting) period. Under the intrinsic value based method, compensation cost is the excess, if any, of the quoted market price of the stock at the grant date over the amount an employee must pay to acquire the stock.
The Company has elected to adopt the disclosure option under SFAS No. 123 and will continue to account for stock-based compensation using the intrinsic value based method under APB No. 25. See Note 9 to the consolidated financial statements for additional information.
November 30, 1995. This reclassification did not have a material effect on the consolidated financial statements.
Premiums are recognized as earned over the estimated period of bond performance or project completion, which is generally less than one year. Ceded reinsurance premiums are recognized on a similar basis. Unearned premiums represent the portion of net premiums applicable to the unexpired portion of the bond. The estimates are based primarily on management's understanding of a bonded project's stage of completion supplemented by historical completion patterns.
Reinsurance receivable is an estimate of an amount to be received from its reinsurer relating to unpaid claims and claims adjustment expenses, offset by an amount received from the reinsurer.
Income taxes are provided based on income reported in the financial statements. Deferred federal income taxes are provided based on an asset and liability approach in accordance with SFAS 109, "Accounting for Income Taxes," which requires the recognition of deferred income tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement carrying amounts and the tax basis of assets and liabilities.
The amortized cost and estimated fair values of fixed maturity investments at December 31, 1996 and 1995 are as follows:
The amortized cost and estimated fair value of fixed maturity investments at December 31, 1996 and 1995 are shown below by the expected maturity period:
Less than one year $3,968,458 $3,967,729 Due after one year through five 4,628,017 4,520,217 years ---------- -----------
entire deferred tax asset would be realized due to management's assessment of the Company's earnings potential. Adjustments to the valuation allowance are made if there is a change in management's assessment of the amount of the deferred tax asset that is realizable. During 1995, the valuation allowance of $112,895 was eliminated to reflect the reversal of certain temporary differences and management's assessment that the earnings potential of the Company was sufficient to provide positive evidence that the deferred tax asset will be realized.
The tax effect of temporary differences, which give rise to deferred income tax assets and liabilities as of December 31 were as follows:
Paid related to: Current Year 409,802 214,310 Prior Year 20,531 82,201 ---------- -------- Net reserve- December 31 221,800 132,428 Plus subrogation receivable 606,476 393,999 Plus reinsurance receivable 324,994 75,838 ---------- -------- Gross Reserves - December 31 $1,153,270 $602,265 ========== ========
As part of an ongoing process, the reserves have been re-estimated for all prior accident years and were decreased by $249,014 and $38,318 in 1996 and 1995, respectively.
In the normal course of business, the Company enters into contracts to cede reinsurance primarily to limit losses from large exposures and to permit recovery of a portion of direct losses; however, such a transfer of risk does not relieve the Company from contingent liability for these losses.
The Company's current reinsurance program provides four layers of reinsurance. Under the first layer, the Company retains 100% of all losses up to $150,000 and the reinsurer assumes 95% of the next $850,000, subject to a maximum annual recovery by the Company of $3,230,000. The second layer provides $1,000,000 of coverage (95% to be assumed by the reinsurer) on any loss discovered for any principal in excess of the first $1,000,000 of loss with an aggregate annual maximum of $2,850,000. The third layer provides $2,500,000 of coverage on any loss discovered for any principal in excess of the first $2,000,000 of loss with an aggregate annual maximum of $5,000,000. The fourth layer provides $3,000,000 of coverage on any loss discovered for any principal in excess of the first $4,500,000 with an aggregate annual maximum of $3,000,000.
Effective November 1995, the reinsurance program required that the Company not write any bond exceeding $5,000,000, or bonds on the same work program in favor of the principal exceeding $7,500,000 in the aggregate. The work program limit of $7,500,000 increased to $10,000,000 effective November 1996.
The Surety Company is subject to the minimum capital and surplus requirements of the Commonwealth of Pennsylvania insurance laws and regulations. Under applicable Pennsylvania laws and regulations, the Company is required to maintain a minimum of $1,125,000 of paid in capital. The maximum amount of dividends which can be paid by the Surety Company to shareholders without the prior approval of the Insurance Commissioner is subject to restrictions relating to statutory surplus. Statutory surplus at December 31, 1996 and 1995 was $7,975,119 and $6,691,311, respectively, and statutory net income for the years ended December 31, 1996 and 1995 was $1,260,999 and $601,970, respectively. In September 1996, the Surety Company paid a dividend of $336,242 to its shareholder. The maximum dividend that may be paid without the approval prior to October 1997 is approximately $332,000. After September 1997 the maximum dividend that may be paid without prior approval is approximately $798,000, less any dividends paid during the previous twelve months.
In November 1993 the Company granted incentive stock options to selected individuals to purchase 186,000 shares of common stock (35,000 shares and 151,000 shares at an exercise price of $4.95 and $4.50, respectively). 500 of these incentive stock options were cancelled in December 1995. These options become exercisable over a five-year period commencing one year after the date of grant.
The Company sold to the underwriter, for nominal consideration in connection with the initial public offering, warrants to purchase 100,000 shares of common stock at an exercise price of $6.00 per share. These warrants became exercisable during a four-year period commencing August 1995, and they expire August 1999.
In February 1995, the Company granted incentive stock options to an individual to purchase 15,000 shares of common stock at an exercise price of $5.50 per share. These options vest over a two-year period and are exercisable for a five-year period after the date of grant
In May 1996, the Company granted non-qualified stock options to selected individuals to purchase 8,000 shares of common stock at an exercise price of $5.50 per share. These options vest immediately, and are exercisable for a ten-year period after the date of grant.
In December 1996, the Company granted incentive stock options to selected individuals to purchase 28,000 shares of common stock at an exercise price of $8 per share. These options vest over a five-year period, and are exercisable for a ten-year period after the date of grant.
Net earnings - as reported $1,135,370 $705,125 Net earnings - pro forma $793,370 $497,206 Earnings per share - as reported $0.42 $0.27 Earnings per share - pro forma $0.29 $0.19
For 1996 and 1995, no compensation expense has been recognized for stock options under the intrinsic value based method under APB No. 25.
Dividend yield 0% 0% Expected volatility 50% 50% Risk-free interest rate 5.4% 6.2% Expected life of option 5 years 5 years