We and our subsidiaries operate out of leased premises, the most significant of which are in Philadelphia and Bermuda.
- -------- (1) See Note 14 of Notes to Consolidated Financial Statements for an explanation of the method used to determine the number of shares used to compute per share amounts. (2) See Note 6 and 7 of Notes to Consolidated Financial Statements. (3) All prior period results have been restated to reflect the pooling of interests following the acquisition of Captive Resources, Inc.
Consolidated Net income decreased by 22% to $50.4 million in 1999 from $64.5 million in 1998 which was in turn a 30% increase over the $49.5 million earned in 1997. The decline in earnings in 1999 is due to slower growth in the Program Business segment and a decline in Corporate Risk Management offset, in part, by growth in Specialty Brokerage and Financial Services. 1999 earnings were also adversely affected by the third quarter provisions related to net losses incurred on terminated programs of $8 million, net of tax. The increase in 1998 earnings was primarily attributable to the growth experienced in the Program Business and Financial Services segments.
Overall, pre-tax profit margins on Fee income fell in 1999 to 28% compared to 35% in 1998 and 37% in 1997.
Corporate Risk Management, the Company's original business segment, involves providing services to businesses and associations seeking to insure a portion of their risk in a loss sensitive Alternative Market structure. This segment, which accounted for 28% of total Fee income for 1999 compared to 33% in 1998 and 45% in 1997, has been the most affected by the extremely soft insurance market cycle for commercial risks. Corporate Risk Management Fees decreased in both 1998 and 1999 due to these soft market conditions. The number of Corporate Risk Management accounts decreased in 1999 to 103 from 118 in 1998 which was in turn down from 154 in 1997. Profit margins fell in 1999 to 32% compared to 39% in 1998 and 37% in 1997. The 1999 profit margin was negatively impacted by the decrease in Fees on Program Business because certain Operating expenses are not separately identified by segment, but rather are apportioned by Fee income.
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 53% at December 31, 1999 as a result of the Company writing accounts comprising other lines of coverage such as accident and health, 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, provides administrative services to offshore mutual funds and other companies. This segment also includes the Company's family of proprietary mutual funds as well as asset accumulation life insurance products for the high net worth market. Financial Services accounted for 11% of total Fee income for 1999, up from 9% for 1998 and 7% in 1997. Fees from Financial Services
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 and Corporate Risk 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. Lastly, the Company is exposed to underwriting risk if losses incurred under programs exceed their reinsurance limits or where there is a gap in purchased reinsurance cover.
During 1999, the Company initiated binding arbitration proceedings for the payment of reinsurance recoverables from a number of reinsurers who have withheld payment due to the Company. The amounts due to the Company relate primarily to reinsurance on workers' compensation coverage. The Company believes it will ultimately prevail in such arbitrations and any related actions that may arise.
programs exceeded their reinsurance limits and caused underwriting losses to be higher than historical levels. The fact that Premiums earned have historically matched Total insurance costs means that even a significant fluctuation in Premiums earned should have a relatively insignificant impact on the Company's Net income.
Other than the risks described above, 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 client's account. On this retained excess risk the Company may experience volatility in underwriting results. The portion of the Company's Premiums earned which relate to this risk was $4.1 million in 1999 as compared to $2.1 million in 1998 and $2.2 million in 1997, representing 2%, 2%, and 3% of Premiums earned in 1999, 1998 and 1997 respectively. The Company incurred an underwriting loss of $17.5 million in 1999, $2.4 million in 1998 and $1.5 million in 1997. The large loss in 1999 was principally due to the provisions on terminated programs described above. These underwriting losses were also a result of retained risk on the Company's treaties and underwriting expenses. The Company takes 100% of the risk within the first $1.25 million layer of the aggregate excess exposure on its main treaty up to a deductible amount equal to 1.5% of the Company's gross premiums (as defined) and 10% of the risk over a loss ratio of 120%, in the event that the loss ratio for the first layer exceeds 120%. The Company takes no share of the risk in the layer $3.75 million excess of $1.25 million per account. The maximum retention for specific excess losses is 10% of $.75 million excess of $.25 million per occurrence.
Gross investment income increased by $.8 million in 1999 to $35.9 from $35.1 million in 1998 and $30.0 million in 1997 as a result of increases in gross invested assets. Net investment income, after adjusting for investment income which is payable to others, increased by 14% to $33.6 million in 1999 from $29.6 million in 1998 and $26.6 million in 1997. The increase in Net investment income for 1999 is due, in part, to the inclusion of investment income from one of the Company's programs, accounted for as Claims deposit liabilities, which added $2.8 million for the year. Net invested assets increased $88 million or 20% to $527 million in 1999 from $439 million in 1998 and $402 million in 1997. The yield on these assets remained steady at 6.9% in 1999 and 1998, which was up slightly from 6.7% in 1997. 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 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 increased; (b) increased personnel costs in all areas, caused by an increase in the number of full time employees from 743 in 1997 to 934 in 1998 to 1,143 in 1999, resulting from the growth of the Company's businesses as well as the impact of the Company's growth in revenues and profits on employee bonus plans; and (c) the acquisitions of SBU, Hugo Trust, Avreco, Capital Management and the Hemisphere expansions to Boston and Ireland.
At the end of 1999 and 1998, 61% and 56% of the Company's Total marketable investments were held by the Company's policy-issuing subsidiaries in the United States. These companies are restricted by regulation in the amount of dividends they can pay without prior regulatory approval to $35.0 million in 2000 (based on 1999 results) and will continue to face these restrictions in the future. During 1999 they paid a dividend of $7 million. They are also required to maintain certain deposits with or supply letters of credit to regulatory authorities which totaled $166 million at December 31, 1999 ($59 million of deposits and $107 million of letters of credit) as compared to $152 million at December 31, 1998 ($60 million of deposits and $92 million of letters of credit).
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 0.6:1 in 1999, 0.5:1 in 1998 and 0.4:1 in 1997 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 1999, 3.6:1 in 1998 and 3.0:1 in 1997. The National Association of Insurance Commissioners ("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.
The NAIC has adopted a risk-based capital ("RBC") formula to be applied to all property/casualty insurance companies. The formula measures capital and surplus needs based on an insurance company's products and investment portfolio and is to be used as a tool to identify weakly capitalized companies. An insurance company that does not meet the threshold RBC measurement standards could be required to reduce the scope of its operations and ultimately could become subject to statutory receivership proceedings. At December 31, 1999 the Company's policy-issuing subsidiaries met the RBC requirements with a combined required risk-based capital of $121.0 million and an actual adjusted capital of $347.4 million.
Market risk generally represents the risk of loss that may result from potential change 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 and on a bridging loan. The Company's exposure to movements in exchange rates and equity prices is limited. The Company does not hold or issue significant derivative financial instruments for trading or speculative purposes.
The Company is also exposed to interest rate risk on the $117 million bridging loan, which bears interest at LIBOR plus 0.75%. $110 million of this facility was contributed to the U.S. insurance companies and has been invested in a variable rate debt instrument with matching terms and maturity to cover the interest cost of the bridge loan financing.
Equity price risk arises from fluctuations in the value of securities held. Changes in the level or volatility of equity prices affect the value of equity securities held by the Company. Management does not believe the Company is exposed to a material risk from changes in equity prices due to its limited investment in equity securities.
The tables below provide information about the Company's available for sale investments that are sensitive to changes in interest rates at December 31, 1999 and 1998 respectively. The tables present expected cash flows and related weighted-average interest rates by expected maturity dates. Separate account assets and liabilities are not included in this analysis as gains and losses related to these accounts generally accrue to the program holders. There were no material quantitative changes in market risk exposure between the current and preceding fiscal year with respect to available for sale investments.
On March 1, 1999, the Company acquired Captive Resources, Inc., ("CRI") a provider of services to member owned group captive insurance companies. CRI has long-term contracts with more than 20 well established captives.
In October 1998, the Accounting Standards Executive Committee issued Statement of Position 98-7, "Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance
Risk". The Statement provides guidance on how to account for insurance and reinsurance contracts that do not transfer insurance risk under deposit accounting. The Statement is effective for fiscal years beginning after June 15, 1999 with early adoption encouraged. The Company does not expect the Statement to have a material impact on its financial position or results of operations.
In June 1998, the Financial Accounting Standards Board issued Statement 133, "Accounting for Derivative Instruments and Hedging Activities" which was amended by Statement 137 in June 1999. The Statement requires recording all derivative instruments as assets or liabilities, measured at fair value. The Statement is effective for fiscal years beginning after June 15, 2000. The Company does not expect the Statement to have a material impact on its financial position or results of operations.
Our consolidated financial statements for the years ended December 31, 1999, 1998 and 1997 are filed herewith in response to Item 14.