AVEMCO's activities are carried out from its 40,000 square foot headquarters, owned by AVEMCO and located adjacent to the Frederick Municipal Airport in Frederick, Maryland. AVEMCO also owns and occupies a 48,200 square foot office building and storage complex in St. Peters, Missouri, a two-story 12,000 square foot office building in Ithaca, New York, and a one-story building in Fort Worth, Texas, containing approximately 2,500 square feet. AVEMCO leases approximately 64,000 square feet of office space at 20 other locations throughout the United States, Canada, China, and the United Kingdom.
The Registrant's insurance subsidiaries underwrite aviation and other specialty line insurance products. Non-aviation lines include lenders single interest, short-term health and pleasure marine. The insurance services businesses complement the insurance operations.
To augment the aviation business, the Registrant continues to develop, both internally and through acquisition, the growth of its other specialty lines and its insurance services business.
Net operating cash flow of $5.8 million for 1996 was below that of 1995. 1996 operating cash flow was affected by the realized gains on the sale of investments and the realized gain on the sale of a subsidiary, which were excluded from operating activities and included in cash flow from investment activities. In addition, 1996 operating cash flow was further impacted by one- time refund payments of $2.4 million related to the settlement of California Proposition 103 matters. The Registrant's insurance subsidiaries had fully provided for such refund amounts in prior years. Net operating cash
Capital expenditures for property and equipment additions were $700,000, $1.9 million, and $700,000, in 1996, 1995, and 1994, respectively. 1996 additions were mainly computer equipment upgrades. 1995 expenditures consisted primarily of costs associated with two subsidiary office relocations and assets acquired through two acquisitions. 1994 additions were primarily comprised of computer hardware upgrades. The Registrant does not anticipate a significant level of property and equipment capital expenditures during 1997. Other expenditures include the 1994 $2.0 million acquisition of assets from International Group Services, Inc., a third party administrator that specializes in short-term health insurance programs. All expenditures were financed principally by internally-generated funds.
The Registrant's investment portfolio represents 69% of its total assets. The Registrant follows investment guidelines which, in addition to providing for an acceptable after-tax return on its investments, are structured to preserve capital, maintain sufficient liquidity to meet obligations, and maintain what is considered an ample margin of capital and surplus to sustain planned writings of insurance. At December 31, 1996, 76% of the Registrant's investments were in fixed income securities, 7% in equities, and 17% in short-term investments. The Registrant's only real estate investments are in its operating facilities. Fixed income securities consist principally of high investment grade securities with an average maturity of about eight years. The Registrant does not use derivative instruments, such as mortgage derivatives, options and structured notes, to leverage its investment portfolio.
The Registrant had $3.2 million of realized investment gains in 1996 compared to a nominal realized investment gain of $575,000 in 1995. Decisions to sell securities are governed by considerations such as surplus exposure, tax consequences and investment opportunities. As a result, realized investment gains or losses can vary significantly from period to period. The majority of the 1996 realized investment gains arose from the Registrant's decision to liquidate its common equity portfolio. Additional information regarding the Registrant's investment portfolio is detailed on pages 52 through 54, and page 66.
The development of unpaid loss and loss adjustment expense refers to the difference between original estimates for unpaid losses and loss adjustment expenses and the re-evaluation of those estimates in subsequent years as loss payments are made and open claims adjusted to reflect current information. Redundant or favorable development occurs when original estimates are higher than subsequently paid or adjusted.
During 1996, the Registrant experienced overall favorable development of $3.3 million on gross unpaid losses and loss adjustment expenses. The 1996 favorable development compares with favorable development of $2.5 million and $3.2 million in 1995 and 1994, respectively.
The Registrant's specialty lines of business, particularly aviation and pleasure marine, are volatile from both a rate and a claims perspective, leading to potentially wide swings in underwriting results. Accordingly, the Registrant is a party to several reinsurance arrangements. These reinsurance arrangements are utilized to assist in limiting maximum loss, provide greater diversification of risk, reduce exposures on larger risks, and provide a level of protection from catastrophic events. The Registrant routinely reviews and adjusts its reinsurance strategy, taking into account the anticipated future direction of its business, underwriting considerations such as rate and risk levels, conditions in the reinsurance marketplace and the cost-benefit relationship expected to be derived from such reinsurance arrangements. Most of the aviation business is covered under a quota share/surplus share reinsurance arrangement. Facultative reinsurance placements are also used, primarily on policies with limits larger than are covered by treaty reinsurance. The Registrant's retention on its aviation business varies according to policy limits. The largest net aggregate amount retained in any one risk is $1.6 million. The Registrant currently retains all of the pleasure marine business that it writes, subject to catastrophic reinsurance protections. Under its catastrophe reinsurance, which also covers the aviation business line, the Registrant absorbs the first $2.5 million in losses, with catastrophe reinsurance protection to $10.5 million. The lenders single interest and short-term health business participate in proportional treaty reinsurance. For 1996, the Registrant retained 86% of its premium production and ceded 14% to reinsurers under its various reinsurance arrangements. Approximately 63% of the net amounts recoverable from reinsurers at December 31, 1996, are attributable to reinsurance arrangements with three reinsurers. No significant amounts recoverable from reinsurers have been written off as uncollectible in the past three years. Additional information regarding reinsurance is detailed in Note 9 to the consolidated financial statements on page 61 and is incorporated herein by reference.
The annual dividends for 1996 and 1995 were $.48 per share and $.46 per share, respectively, marking the twenty-first and twentieth years in which the Registrant has paid an increased dividend.
The Registrant's common stock repurchase program reflects continued efforts to effectively manage its capital base and enhance shareholder value. Its capital needs vary from period to period recognizing the volatility in the underwriting of its specialty insurance products. The aviation insurance industry continues in the longest competitive cycle in its history. The Registrant acquired 520,000 of its common shares during 1996. Since inception of its stock repurchase program in the 1987 fourth quarter through the end of 1996, the Registrant has repurchased 6,727,380 shares of its stock at prices ranging from $9.75 to $22.00 per share.
The Registrant's ability to support substantial future growth is reflected in its insurance subsidiary's ratio of net premiums written to statutory policyholders' surplus, a measure used by insurance regulators and analysts to evaluate liquidity and capital resources. The insurance subsidiary's ratio is currently 1.19 to 1; a general maximum regulatory guideline is 3 to 1. The ratio of unpaid losses and expenses to surplus was .46 to 1. 1996 marked the 22nd consecutive year and the 33rd in 36 years in business where an underwriting profit was achieved. The Registrant currently is adequately capitalized to support future planned activities. The insurance subsidiary continues its "A+" (Superior) rating from A.M. Best. In addition, the insurance subsidiary's December 31, 1996, policyholders' surplus position substantially exceeded the minimum requirements as stipulated by insurance industry risk-based capital regulations.
On January 17, 1997, AVEMCO and HCC Insurance Holdings, Inc., ("HCCH") jointly announced that they had signed a Letter of Intent to merge AVEMCO with a wholly- owned subsidiary of HCCH in a stock-for-stock transaction, with AVEMCO becoming a wholly-owned subsidiary of HCCH. On February 28, 1997, AVEMCO and HCCH jointly announced that the Boards of Directors of AVEMCO and HCCH had executed an Agreement and Plan of Reorganization (the "Agreement"). Pursuant to the terms of the Agreement, each share of AVEMCO's common stock will be exchanged for one share of HCCH's common stock.
The proposed transaction is intended to be accounted for as a pooling of interests and to be a nontaxable exchange to AVEMCO's shareholders. It is subject to various conditions, including receipt of required regulatory approvals and the approval of the transaction by shareholders of both AVEMCO and HCCH. A special shareholders' meeting is anticipated to be held in the second quarter of 1997, and a proxy statement describing the transaction in detail is expected to be submitted to the shareholders shortly. There can be no assurance that the conditions to the proposed merger will be satisfied or that the shareholders will approve the transaction.
RESULTS OF OPERATIONS - 1996 COMPARED TO 1995 1996 marks the sixth consecutive year that the Registrant has grown its gross premiums writing base. Gross premiums written for 1996 increased over 1995 as follows:
Commission revenues, consisting primarily of commissions received on reinsurance ceded and commissions produced by agency operations, net of amounts paid to their agents, increased to $8.8 million in 1996 as compared to $7.0 million in 1995. The increase is mainly attributed to commissions generated by the Hinchcliff International division of Brooks-Shettle Company.
Computer product and service revenues generated by The Wheatley Group, Ltd., a consolidated subsidiary, was $9.9 million in 1996, slightly behind 1995's $10.2 million. Hardware equipment sales declined by $800,000, while Wheatley's core software revenues increased by $500,000. Hardware sales can vary significantly from period to period.
Other revenues increased to $8.2 million in 1996 as compared to $6.4 million in 1995. $1.0 million of the increase is directly attributed to MEDEX Assistance Corporation, a consolidated subsidiary that improved its revenue performance by 30% over 1995.
Commission expense, representing costs incurred to generate insurance business through the assumed reinsurance and independent agency markets increased to $7.1 million in 1996 as compared to $6.5 million in 1995. This increase is consistent with the upward trend in reinsurance assumed production.
Lower variable interest rates combined with a lower level of bank borrowings during 1996 decreased interest expense to $3.8 million in 1996 from $4.2 million in 1995.
Selling, general, and administrative costs increased a modest 2.5% in 1996 as the Registrant incurred additional operating costs from the recently acquired Hinchcliff International, Inc. subsidiary while supporting increased revenue activities in its other business units without a significant increase in operating costs.
Gross premiums written on non-aviation lines were $31.1 million compared to $33.8 million in 1994. The drop in premium was principally attributable to the short-term health business, where there was a reduced level of participation in one profitable short-term health program, along with the discontinuance of another program that was not meeting the Registrant's underwriting objectives. These actions had the effect of reducing earned premium revenues when compared to 1994. The
Net premiums written for all lines of business reflect the business retained by the Registrant after its reinsurance arrangements are considered. Net premiums written increased over 1994 because of the growth in the aviation business. Earned premium revenues of $80.5 million increased over 1994's $75.5 million, consistent with the increase in net premium written.
Commission revenues increased to $7.0 million in 1995 as compared to $6.4 million in 1994, primarily as a result of the IGS acquisition.
Computer product and service revenues generated by The Wheatley Group, Ltd., a consolidated subsidiary, amounted to $10.2 million compared to $9.2 million for 1994. The revenue increase is principally attributable to an increase in hardware equipment sales.
Realized investment gains and or losses for 1995 and 1994 were nominal.
From a claims standpoint, the net loss ratio for 1995 was 69.1% compared to 61.3% for 1994.
Net incurred losses on aviation claims increased compared to 1994. Claim activity on the growing book of higher-valued aircraft was one principal reason for the increase. The Registrant experienced a difficult third quarter from a claims perspective. Historically, that quarter can be volatile since it is the peak season for aircraft and watercraft use. The Registrant incurred several large hull claims during that period. The Registrant did not experience an increase in claims frequency or severity on the liability side. Another reason for the increase in net incurred losses was due to the additional claim activity on the aviation book of business acquired from AUS during the first quarter of 1995.
Selling, general, and administrative expenses for 1995 increased over the prior year, primarily due to the acquisition of the AUS book of aviation business, the acquisition of the IGS business and additional costs incurred with the software business.
The Registrant's principal subsidiary, AVEMCO Insurance Company, settled its outstanding Proposition 103 matters with the California Department of Insurance during 1995. The Registrant had previously provided for a potential rollback impact in prior years such that the effect on 1995 net earnings of the ultimate settlement was not material.
In summary, increased claims activity in the aviation business and a reduced level of participation in two short-term health programs were the principal factors for the reduced level of earnings when compared to 1994.
Gross premiums written for aviation during 1994 were 2% under the prior year. During 1994, the Registrant strengthened underwriting criteria on certain classes of aviation business to increase its underwriting profitability. Additionally, the Registrant continued to emphasize rate discipline, recognizing that the aviation insurance sector had been engaged in an extremely competitive rate environment for quite some time. The Registrant has been unwilling to write aviation business at what it considers inadequate rates.
Gross premiums written for short-term health programs were $13.9 million in 1994 versus $5.8 million for 1993. The Registrant's experience in this market began a number of years ago with the development of the TravMed(R) product for United States citizens traveling abroad. In 1991 a similar product was developed for foreign students studying aviation curriculums in the United States. As an outgrowth of that activity, Brooks-Shettle Company, a consolidated subsidiary, with long-standing involvement in short-term health coverages, established an underwriting and reinsurance program for foreign nationals attending a broader range of studies in American colleges and universities. The Registrant participated as an assuming reinsurer in that business during 1994. Toward the end of 1994, the Registrant acquired certain assets of International Group Services, Inc. This third party administrator had approximately $12.3 million in short-term student health premiums under administration. The Registrant plans to increase its insurance participation in this line of business through the acquisition.
Commission revenues, net of amounts paid to agents, increased over 1993 primarily because of the substantial growth in the lenders single interest and short-term health businesses.
Realized losses on the sale of investments were $248,000 in 1994; realized gains on the sale of investments were $9.6 million in 1993. The majority of the 1993 gains arose from the sale of equity securities.
From a claims standpoint, the net loss ratio for 1994 was 61.3% compared to 66.2% for 1993.
Net incurred losses on aviation claims declined compared to 1993. During 1994, the Registrant strengthened underwriting criteria on certain classes of aviation business to increase underwriting profitability. Additionally, the Registrant did not incur any significant weather-related losses. Weather-related losses for 1993, after reinsurance recoveries, amounted to $1.2 million and were principally related to the "Blizzard of 1993" and the "Midwest Flooding." Net incurred losses on the