The following is a summary of properties leased by the Company at December 31, 1999:
The consolidated statements of operations data set forth below for each of the three years in the period ended December 31, 1999, and the consolidated balance sheet data at December 31, 1999 and 1998 are derived from, and are qualified by reference to, the audited consolidated financial statements included elsewhere in this Form 10-K. The consolidated statements of operations data set forth below for each of the two years in the period ended December 31, 1996, and the consolidated balance sheet data at December 31, 1997, 1996 and 1995, are derived from audited consolidated financial statements not included herein. The information set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Company’s consolidated financial statements and related notes included elsewhere in this Form 10-K.
Adjusted to reflect a three-for-two stock split in May 1996 and a five-for-one stock split in 1995. For additional information relating to income (loss) per share, see Note 2 of Notes to Consolidated Financial Statements.
The Company - RTW, Inc. (RTW) and its wholly owned insurance subsidiary, American Compensation Insurance Company (ACIC), provide disability management services to employers. Collectively, “we,” “our” and “us” refers to these entities in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
This financial summary presents our discussion and analysis of the consolidated financial condition and results of operations of RTW, Inc. This review should be read in conjunction with the Consolidated Financial Statements.
Pricing pressure continued to affect premiums in force and decrease profit margins, especially in Minnesota. The pricing pressure is the result of increased competition in our markets; and
While we expect to continue to operate in a competitive pricing environment in 2000, we are working to improve profitability in all of our offices by continuing to aggressively manage expenses, refining our sales and distribution channels and improving our underwriting, including reviewing policy profitability at renewal and canceling unprofitable accounts.
The following table summarizes the components of our revenues and premiums in force (000’s):
decrease in premiums in force in our Minnesota and Missouri markets. We aggressively targeted selected policies for non-renewal or re-underwriting at more favorable rates during 1999 at policy expiration when the profitability of the policy did not meet our underwriting profit margin standards. For 1999, our aggressive re-underwriting resulted in $10.9 million of premiums renewed at higher prices as well as $10.8 million in premiums that were not renewed. We will continue to review business at policy expiration in 2000 and non-renew or re-underwrite at more favorable rates any business not meeting our standards.
Gross premiums earned in 1998 increased 10.4% to $89.9 million from $81.4 million in 1997. This increase resulted from the 4.7% increase in premiums in force to $82.1 million at December 31, 1998, from $78.4 million at December 31, 1997. Additionally, in force premiums grew less rapidly in 1998 than in 1997 resulting in a more stable, higher average in force premium during the year generating increased gross premiums earned. Final audit premiums earned during 1998 decreased to $7.2 million from $7.5 million in 1997.
Many state legislatures where we provide coverage have reduced benefits that injured employees are paid, resulting in lower loss costs of workers’ compensation insurance and decreased corresponding premiums paid by the policyholder;
We continue to experience reduced pricing on renewal policies due, in part, to our success in lowering our policyholders’ loss experience which, in turn, improves their claims history, lowering the premium that they have to pay for insurance. The improvement that we provide our customers also makes them more desirable to our competition, thus increasing price competition on these accounts.
Premiums Ceded: Reinsurance agreements allow us to share certain risks with other insurance companies. The primary purpose of ceded reinsurance is to protect us from potential losses in excess of the level we are willing to accept. Our primary ceded reinsurance is excess of loss coverage that limits our per-incident exposure. We expect the companies to which we have ceded reinsurance to honor their obligations. In the event that these companies are unable to honor their obligations to us, we will be required to pay these obligations ourselves. We are not aware of any developments with respect to any of our reinsurers that would prevent them from honoring any of their obligations to us.
Under our excess of loss reinsurance policies, we pay reinsurers to limit our per-incident exposure and record this cost to premiums ceded as a reduction to gross premiums earned. In Minnesota, we are required to purchase excess of loss coverage for our Minnesota policies from the Minnesota Workers’ Compensation Reinsurance Association (WCRA). We ceded Minnesota claims in excess of $290,000, $280,000 and $1.1 million per occurrence during 1999, 1998 and 1997, respectively, to the WCRA. In our non-Minnesota states, we decreased our per-incident exposure to $300,000 in 1999 from $500,000 in 1998 and 1997. We purchased this coverage from various reinsurers in 1998 and 1997 and limited the coverage to one insurer in 1999. Additionally, for claims occurring after June 30, 1998, we further limited our per incident exposure by purchasing excess of loss coverage for losses from $25,000 to the WCRA selected retention level in Minnesota and from $25,000 to $300,000 in other states from a single reinsurer. This agreement was finalized after its effective date and activity occurring from July 1, 1998 through September 30, 1998 was recorded on a retrospective basis resulting in the deferral of a gain totaling $2.0 million at December 31, 1998. We amortized $740,000 of the deferred gain as a reduction of claim and claim settlement expenses in 1999 resulting in an un-amortized deferred gain of $1.2 million at December 31, 1999. The deferred gain is being amortized into income using the effective interest rate inherent in the amounts paid to the reinsurer and the estimated timing and amounts of recoveries from the reinsurer. Activity occurring on or after October 1, 1998 is recorded prospectively.
Premiums ceded to reinsurers increased to $8.5 million in 1998 from $342,000 in 1997. This increased cost resulted from (i) increased excess of loss costs resulting from further limiting our exposure to $25,000, (ii) reducing our selected Minnesota excess of loss reinsurance coverage levels to $280,000 in 1998 from $1.1 million in 1997, (iii) increased excess of loss premium rates in Minnesota in 1998 from 1997, and (iv) increased excess of loss costs resulting from increased premiums earned in non-Minnesota states. This increase was offset by recognizing a $2.2 million refund received from the WCRA in 1998 as a reduction of premiums ceded, compared to a refund of $358,000 from the WCRA in 1997.
2000 Outlook: The 2000 outlook for gross premiums earned and premiums ceded include the following factors:
Our recognition of realized gains and losses will depend on sales of our investments, if any, to meet our short-term cash requirements; and
2000 Outlook: We expect that claim and claim settlement expenses will be affected by the following factors:
Continued favorable effects of ceding paid and unpaid claim and claim settlement expenses under our $25,000 to $300,000 excess of loss reinsurance agreements resulting in a reduction of claim and claim settlement expenses;
Claim costs will continue to be affected by (i) increases in medical and indemnity costs resulting from inflationary changes, (ii) severity experienced in future periods in our policy holder base, (iii) changes resulting from increases in operating efficiency and effectiveness realized through enhancements to our internal processes and procedures, including changes to our proprietary computer systems, and (iv) legislative changes in estimated loss costs;
Policy acquisition costs increased to $14.1 million in 1999 from $14.0 million in 1998 and $11.7 million in 1997. As a percent of gross premiums earned, policy acquisition costs increased to 15.8% in 1999 from 15.5% in 1998 and 14.3% in 1997. These increases reflect the following:
Premium tax expense remained consistent at 2.0% of gross premiums earned in 1999, 1998 and 1997;
Other policy acquisition costs decreased slightly to 5.4% of gross premiums earned in 1999 from 5.5% in 1998 and increased from 4.5% in 1997. Policy acquisition costs were consistent in 1999 and 1998, however, increased significantly from 1997 due to (i) increased personnel and overhead costs associated with improving our underwriting function, (ii) increased personnel costs necessary for the growth in premiums in force, and (iii) increased spending on marketing programs; and
We expect premium tax expense as a percent of gross premiums earned to remain consistent with 1999; and
We expect that other policy acquisition costs will be consistent with 1999 as a percent of gross premiums earned as we continue to improve our underwriting skills, increase premiums in force and generate additional revenues to cover the relatively fixed policy acquisition costs. We also expect that these costs will be offset on a limited basis from increases in operating efficiency and effectiveness during 2000 realized through enhancements to our internal processes and procedures, including changes to our proprietary computer systems.
Interest Expense: We incurred interest charges on our Senior Notes in 1999, 1998 and 1997. The Senior Notes were paid in full in December 1999. We paid interest at a rate of 9.50% on the outstanding balance on our Senior Notes
during 1999. Interest expense decreased to $266,000 in 1999 from $546,000 in 1998 and $777,000 in 1997 due to principal payments on the Senior Notes in December 1998, 1997 and 1996. The Senior Notes were paid in full in December 1999.
In February 2000, we entered into a $6.0 million, 90-day term loan with a bank in order to initiate the repurchase of shares from a group headed by our majority shareholder and Chairman, David C. Prosser. We expect to refinance this short-term term loan, obtain additional funding and close on the repurchase transaction in March 2000, by entering into an $8.0 million Term Loan agreement and a $2.0 million Revolving Credit Facility with a bank. These debt agreements are subject to interest, payable quarterly at an adjusted LIBOR rate (8.31% at February 29, 2000).
2000 Outlook: We expect to incur interest charges in 2000 on the Term Loan and Revolving Credit Facility totaling approximately $620,000, increasing from $266,000 in 1999.
Income tax expense was $1.9 million in 1999 compared to a benefit of $4.0 million in 1998 and an expense of $2.9 million in 1997. As a percent of income (loss) before income taxes, the income tax expense (benefit) was 23.8% of income before income taxes in 1999 compared to (35.8%) of the loss before income taxes in 1998 and 33.1% of income before income taxes in 1997. The income tax expense percent in 1999 has been affected by (i) our income from operations, (ii) decreased taxable net income from the service organization (RTW) which is subject to both federal and state income taxes, and (iii) the introduction of tax-exempt municipal income beginning in the second quarter of 1998.
Our portfolio of fixed maturity securities at December 31, 1999 included tax-exempt municipal securities (56.3%), U.S. government securities (14.0%), corporate securities (13.5%), mortgage-backed securities (14.4%), and asset-backed securities (1.8%). After several years of purchasing solely U.S. government securities, we engaged an investment manager in 1997 to diversify our portfolio to other taxable fixed maturity investments and to maximize our after-tax investment income without taking inappropriate credit risk. During the second quarter of 1998, we transferred our portfolio to a new investment manager and further diversified our portfolio by purchasing investment grade tax-exempt fixed maturity investments. We conservatively manage our fixed maturity portfolio, investing only in investment grade (BBB or better rating from Standard and Poor’s) securities of U.S. domiciled issuers. We do not invest in derivative securities.
Funds provided by our operating cash flows and investment cash flows have historically provided growth in our investment portfolio. Operating cash flows consist of the excess of premiums collected over claim and claim settlement expenses reduced by payments for reinsurance premiums as well as other operating expenses paid. Investment cash flows consist of income on existing investments and proceeds from sales and maturities of investments. We have historically generated positive net cash flows from operations due, in part, to timing differences between the receipt of premiums and the payment of claim and claim settlement expenses. These net cash flows decreased significantly in 1999 as we have focused on closing old claims, paying earlier to close claims. Combined with relatively flat premiums in force since December 1998, our cash flows from timing on claims payments have decreased. Additionally, as we lowered our reinsurance retention levels to $25,000 in mid-1998, we decreased our current period cash flows as a result of “pre-funding” quarterly premiums under that agreement. We expect this reduction in quarterly cash flow will continue until reimbursements for loss payments to claimants under these contracts equal disbursements for premium payments. Our investment portfolio decreased 14.7% or $18.5
Our unpaid claim and claim settlement expenses represent established, reserves for the estimated total unpaid cost of claim and claim settlement expenses, which cover events that occurred in 1999 and prior years. The reserves are primarily undiscounted, however, we discount reserves for selected claims that have fixed and determinable future payments at 8.0%. These reserves reflect our estimates of the total costs of claims that were reported, but not yet paid, and the cost of claims incurred but not yet reported (IBNR). For reported claims, we establish reserves on a “case” basis. For IBNR claims, we estimate reserves using established actuarial methods. Both our case and IBNR reserve estimates reflect such variables as past claims experience, current claim trends and prevailing social, economic and legal environments. Due to our commencing operations in 1992, we have limited historical data to estimate our reserves for unpaid claim and claim settlement expenses and, accordingly, we supplement our experience with external industry data, as adjusted, to reflect anticipated differences between our results and the industry. We reduce the unpaid claim and claim settlement expenses for estimated amounts of subrogation.
We believe our reserves for unpaid claim and claim settlement expenses are adequate to cover the ultimate costs of claim and claim settlement expenses. The ultimate cost of claim and claim settlement expenses may differ from the established reserves, particularly when claims may not be settled for many years. Reserves for unpaid claim and claim settlement expenses and assumptions used in their development are continually reviewed. We record adjustments to prior estimates of unpaid claim and claim settlement expenses to operations in the year in which the adjustments are made. See Notes 1 and 5 of Notes to Consolidated Financial Statements.
The following table sets forth reserves on a gross (before reinsurance) basis (000’s):
Gross reserves for claim and claim settlement expenses, beginning of year
The following table sets forth reserves on a net (after reinsurance) basis (000’s):
The following loss reserve development table sets forth the change, over time, of reserves established for claim and claim settlement expenses at the end of the last seven years. The following loss reserve development table is cumulative and, therefore, ending balances should not be added since the amount at the end of each calendar year includes activity for both current and prior years (000’s):
The following table is derived from the loss reserve development table and summarizes the effect of reserve re-estimates, net of reinsurance, on calendar year operations for the same seven-year period ended December 31, 1999. The total of each column details the amount of reserve re-estimates made in the indicated calendar year and
Our primary sources of cash from operations are premiums collected and investment income. Our investment portfolio is also a source of liquidity, through the sale of readily marketable fixed maturity investments. Our primary cash requirements consist of payments for (i) reinsurance, (ii) claim and claim settlement expenses, (iii) policy acquisition costs, (iv) general and administrative expenses, (v) capital expenditures, (vi) income taxes, and (vii) debt service or principal repayment on our Senior Notes, Term Loan or Revolving Credit Facility. We have historically generated positive net cash from operations due, in part, to timing differences between the receipt of premiums and the payment of claim and claim settlement expenses. As we lowered our reinsurance retention levels to $25,000 in mid-1998, we decreased our current period cash flows as a result of “pre-funding” quarterly premiums under that agreement. We expect this reduction in quarterly cash flow will continue until reimbursements for loss payments to claimants under these contracts equal disbursements for premium payments. Cash generated is either invested in short-term cash and cash equivalents or longer term available-for-sale securities pending future payments for such expenses as indemnity, medical benefits and other operating expenses. Cash and cash equivalents consist of U.S. government securities acquired under repurchase agreements, tax-exempt municipal securities and corporate securities all with maturities of 90 days or less, with the remaining balances in cash and a money market fund that invests primarily in short-term government securities.
including realized capital gains) of ACIC in its most recent fiscal year. Based on this limitation, the maximum dividend that ACIC could pay to us in 2000, without regulatory approval, is approximately $4.6 million. (See Note 9 of Notes to Consolidated Financial Statements.) ACIC has never paid a dividend to us and we intend to retain capital in the insurance subsidiary.
On February 2, 2000, we entered into an agreement with participating members of the group (together, the “Prosser Selling Group”). Under the agreement, we agreed to repurchase from individual members of the Prosser Selling Group shares totaling approximately $7.8 million. On March 28, 2000, we repurchased 1,418,570 shares at $5.19 per share. At the closing, each member of the Prosser Selling Group signed a two year standstill and Voting Agreement under which each agreed, among other things, not to acquire additional Securities of RTW and not to initiate or support certain actions designed to effect fundamental changes in RTW policy or structure. In addition, David C. Prosser retired and resigned as Chairman and we paid him $225,000 as a termination benefit in conjunction with the closing. He is expected to remain as a member of our Board of Directors.
We expect the revolving credit facility will accrue interest, payable quarterly, at an adjusted LIBOR rate and mature in March 2001, but will be renewable annually at the discretion of the bank.
An increase of 100 basis points in prevailing interest rates would reduce the fair value of our interest rate sensitive instruments by approximately $5.4 million.
We have had no instances of system failure or interrupted operations resulting from system failures of our significant vendors in 2000 and expect no problems as we continue into the new millennium.
Information included in this annual report which can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “anticipate,” “estimate,” or “continue” or the negative thereof or other variations thereon or comparable terminology constitutes forward-looking information. The following important factors, among others, in some cases have affected and in the future could affect our actual results and could cause our actual financial performance to differ materially from that expressed in any forward-looking statement: (i) our ability to manage both our existing claims and our new claims in an effective manner, (ii) competition from traditional workers’ compensation insurance carriers, (iii) our ability to further penetrate our existing markets, (iv) changes in workers’ compensation regulation by states, including changes in mandated benefits or insurance company regulation, (v) our ability to retain our existing customers at favorable beneficial premium rates when their policies renew, and (vi) our ability to successfully introduce new products and services. This discussion of uncertainties is by no means exhaustive but is designed to highlight important factors that may impact our future performance.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
The following explain the accounting policies we use to arrive at some of the more significant amounts in our financial statements.
Accounting Principles - We prepare our financial statements in accordance with Generally Accepted Accounting Principles (GAAP).
Use of Estimates - We make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the financial statement date and the recorded amounts of revenues and expenses during the reporting period. Our most significant estimates are those relating to our unpaid claim and claim settlement expenses and accrual for premium adjustments. We continually review our estimates and assumptions and make adjustments as necessary, but actual results could vary significantly from these estimates.
Realized Investment Gains and Losses: Net realized investment gains are identified separately in our Consolidated Statements of Operations. Cost of investments sold is determined by the specific identification method.
Fixed Maturities by Maturity Date - The following table presents the amortized cost and fair value of investments by contractual maturity at December 31, 1999. Actual maturities may differ from those stated as a result of calls and prepayments (000’s):
The reinsurance recoverable on paid claim and claim settlement expenses consists solely of receivables from paid claim and claim settlement expenses at December 31, 1999 and 1998.
Changes in estimates of unpaid claim and claim settlement expenses for prior years decreased the provision for claim and claim settlement expenses by $8,113,000 in 1999, increased the provision for claim and claim settlement expenses by $10,979,000 in 1998 and decreased the provision for claim and claim settlement expenses by $3,085,000 in 1997.
Income taxes receivable at December 31, 1999 and 1998 were approximately $674,000 and $3,289,000, respectively.
The following table summarizes the options outstanding and exercisable at December 31, 1999:
We are permitted a tax deduction equal to the difference between the non-qualified option exercise price and the fair value on the option exercise date. Upon exercise, the proceeds and the amount of the deduction are recorded to common stock. In 1999 and 1998, we recorded reductions of income taxes payable and increased common stock by $532,000 and $80,000, respectively, to reflect the exercises.
The weighted average fair value of options granted under the ESPP and 1994 Stock Plan during 1999, 1998 and 1997 is estimated at $2.53, $3.14 and $4.06, respectively, on the date of grant using the Black-Scholes option-pricing model with the following assumptions: no dividend yield; volatility of 64.3% in 1999, 71.0% in 1998 and 76.1% in 1997; risk-free interest rates ranging from 4.51% to 7.70%; and an expected life of 1 to 5 years.
Employee Contract - We entered into a three-year employment agreement with our President and Chief Executive Officer beginning January 15, 1998. Under this agreement, he receives a base salary of $400,000, subject to review annually for increase by our Board of Directors. In addition to base salary, he is eligible for bonuses, reimbursements and fringe benefits including a $1,000,000 term life insurance policy and an additional payment sufficient to reimburse him for a long-term disability policy paying monthly benefits of $5,000. We also provide him with health, dental, life and disability insurance consistent with that provided to other officers and employees. Under this agreement, we have agreed to indemnify him for his actions on behalf of us. In the event of termination without cause or resignation for good reason, we are obligated to continue to pay his then-current base salary and bonuses for the remaining term of the agreement or twelve months, whichever is greater.
Employee Stock Ownership Component - We maintain an ESOP for our qualified employees. Our contributions are discretionary. We may contribute cash or shares of our common stock. No expense was recorded in 1999, 1998 or 1997.
Dividend Restrictions - Dividends are paid as determined by our Board of Directors. No dividends have ever been paid by us.
Operating Leases- We conduct our operations in leased office facilities under operating lease agreements. The agreements provide for monthly base lease payments plus contingent rentals based on an allocable portion of certain operating expenses incurred by the lessor.
Rent expense, including contingent rentals, was $2,124,000, $2,181,000 and $1,776,000 for 1999, 1998 and 1997, respectively.
Our comprehensive (loss) income includes only unrealized gains and losses on investments classified as available-for-sale. Changes in accumulated other comprehensive (loss) income and other comprehensive (loss) income were as follows (000’s):
The following tables present unaudited quarterly results of operations for the eight quarters ended December 31, 1999:
On November 2, 1999, we announced that a group consisting of David C. Prosser, Chairman, members of his family, and another of our directors retained an investment banker to explore a sale of the group’s shares to new strategic investors. The group held approximately 6,383,000 shares representing 52% of all outstanding shares. In conjunction with the process, our Board of Directors appointed a Special Committee of independent directors to evaluate any proposed transaction.