Although TCO is not a direct or indirect subsidiary of Exstar, its income or loss is included in the Company's consolidated GAAP financial statements in accordance with a form of equity accounting. The Company's adoption of this form of accounting in 1995 (applied retroactively) was based on the historical interdependence and common control of the Company and TCO, including the Company's exertion of significant influence over the operations of TCO, TCO's limited financial resources and TCO's need for financial support from the Company. In accordance with this form of equity accounting, the Company's GAAP net income and stockholders' equity are directly affected by certain changes in TCO's income and stockholder's equity (i.e., certain losses and gains of TCO reduce and increase, respectively, the Company's GAAP net income and stockholders' equity). With respect to the Company's historical GAAP financial statements, the effect of the adoption of this accounting treatment was to reduce the Company's total stockholders' equity and net income from that reported in the Company's consolidated financial statements previously filed with the Securities and Exchange Commission ("SEC"). For 1992, the effect of this accounting treatment, as a result of TCO's losses, was to reduce stockholders' equity and net income by $2.5 million. For 1993, the effect of this accounting treatment, as a result of TCO's losses, was to reduce stockholders' equity and net income by an additional $11.6 million. For 1994, the effect of this accounting treatment, as a result of TCO's losses, was to further reduce the Company's total stockholders' equity and net income by $7.1 million. In 1995 and 1996 TCO was profitable, such that this treatment served to increase the Company's total stockholders' equity and net income by $1.7 million and $1.1 million, respectively. At December 31, 1996, the cumulative effect of this accounting treatment was to reduce the Company's total stockholders' equity by $18.4 million. Under this accounting method, if TCO were to generate income in the future up to a certain threshold amount (currently approximately $3 million), the Company's GAAP income and stockholders' equity would increase by the amount of such income recognized by TCO even without any repayments of amounts owed by TCO to the Company. Conversely, unless the cumulative amount of TCO's losses since July 1, 1992 falls below the cumulative amount of TCO's indebtedness to the Company incurred since July 1, 1992, any repayments of debt by TCO to the Company generally would not increase the Company's GAAP net income or stockholders' equity. See Note 11 of Notes to Consolidated Financial Statements.
Combination of the Syndicate with Alpine. In late 1996, in view of a perceived decrease in the benefits associated with IIE membership and in an effort to reduce the costs involved in the operation of two separate insurance entities, management determined that it was in the best interests of the Company to cause the Syndicate to withdraw as a syndicate member of the IIE and to merge its operations with its wholly-owned subsidiary, Alpine. Accordingly, effective December 31, 1996, the Syndicate withdrew as a syndicate member of the IIE, transferred all of its assets (other than the stock of Alpine) and liabilities to Alpine and changed its name to Alpine Holdings, Inc. Pursuant to an agreement with the IIE, certain of the Syndicate's assets transferred to Alpine were placed in trust as security for the payment of claims of policyholders and other obligations of the Syndicate. The agreement also provides for continuing IIE Guaranty Fund protection with regard to policyholders of the Syndicate. As a result of this change, Alpine is the Company's only licensed insurer and its only significant operating entity. Alpine Holdings, Inc. conducts no activities other than serving as a direct holding company for the stock of Alpine. The following chart depicts the Company's current organizational structure:
Exstar Financial Corporation | | 100% | Alpine Holdings, Inc. | | 100% | Alpine Insurance Company | | 100% | ------------------------ | | | | Transco Premium Alpine Premium Finance Co., Inc. Finance Co., Inc.
In addition to performing services directly for the Company, the majority of the Company's employees are performing services for Transre and E&S in connection with the Limited Agency Agreement. In this regard, and in accordance with a plan filed by Alpine with and approved by the Illinois DOI in connection with its review of Alpine (see "-- Regulation -- Illinois Order"), the salaries and benefit costs associated with these employees, as well as general and administrative costs (including rent, utilities, insurance costs and licensing fees), are currently being allocated among Alpine, Transre and E&S. The total amount reimbursed by Transre and E&S to the Company during 1996 (covering the period from the beginning of the allocation on August 1, 1996 through December 31, 1996) was approximately $1.2 million. The amount payable by Claims Control to the Company for 1996 with respect to revenues received from UCIC was approximately $4,000. The allocations are based on management's estimates of the relative amounts of employee time and Company resources devoted to the operations. For example, the majority of the Company's salary expense relating to its underwriting department has been allocated to Transre and E&S, because the underwriting department's principal activities involve producing new business for UCIC, while the underwriting department's activities with respect to the Company's prior business are limited. Conversely, salaries for management, accounting, administration and other departments are allocated as much as 80% to Alpine.
The plan approved by the Illinois DOI anticipates that the allocations to Alpine will gradually decrease, and the allocations to Transre and E&S will gradually increase, over time, but no assurances can be given that such allocations will occur at any particular time, if at all. As circumstances change, revised allocations are expected to be implemented, subject to approval by the Illinois DOI.
The Company ceased issuing direct insurance in August 1996, and is not currently issuing any insurance policies directly to insureds. Its current business activities consist of: acting as a reinsurer (effective as of April 1, 1997) with respect to insurance policies issued by UCIC; handling claims under policies and reinsurance contracts previously issued by the Company and implementing mid-term adjustments to and cancellations of such policies; and related management, investment, reporting and accounting functions. In lieu of issuing direct insurance business, effective as of April 1, 1997, Alpine entered into the Quota Share Arrangement with UCIC. Pursuant to the Quota Share Arrangement, the Company assumes a portion of the business placed with UCIC by Transre and E&S. Although such business currently is within the lines of business from which the Company has historically derived premium revenue, the Company is exploring the possibility of expanding its reinsurance relationship with UCIC to include other niche lines of business produced through Transre and E&S. The business produced through Transre and E&S and reinsured by the Company under the Quota Share Arrangement is currently being written on more restrictive policy forms, and with higher pricing, than the business previously written directly by the Company, which management expects will improve the Company's loss ratio. See "-- Operating Ratios."
group included general contractors and several specialized classifications of contractors. Products liability insureds consisted generally of manufacturers, dealers/distributors and, to a lesser degree, others engaged in a wide variety of businesses including machinery and equipment, auto/vehicle products and sporting goods. Other specialized liability business written by the Company in 1996 and 1995 included employers liability, premises liability (O,L&T) for apartments, restaurants and property owners, and some small niche programs.
The Company's typical architects and engineers insured was an architectural firm with annual billings of approximately $301,000 not engaged in structural or project design work. The average policy had a premium of approximately $8,100, an average coverage limit of approximately $514,000 and an average deductible of approximately $8,300.
The architects and engineers insurance was written on a claims-made policy form pursuant to which claims had to be made to the Company within the time frame permitted by the policy (generally within the policy period, or any extended discovery period). Policies had aggregate limits, included expenses within policy limits and provided extended discovery periods where required by state insurance laws.
The fixed maturity assets have an average duration of approximately 3.7 years and an average maturity of approximately 4.4 years. The fixed maturities subject to call at December 31, 1996 had a market value and carrying value of $5.4 million.
Mortgage Loans. The Company's assets at December 31, 1996, included 16 mortgage loans with a total principal balance outstanding of approximately $5.3 million. The book value of these loans, net of a $188,000 reserve against losses and $33,000 of deferred loan origination fees, was $5.1 million. The reserve against losses for mortgage loans is calculated as the difference between the mortgage loan including accrued interest and the appraised value of the property securing the loan.
Of the total portfolio at December 31, 1996, $900,000 or 17.5%, consisted of six single-family residential construction and permanent loans, $3.9 million consisted of nine commercial loans, and $300,000 consisted of one residential tract development loan. The largest of the loans was $1.0 million, the smallest loan was $37,000 and the average loan was approximately $323,000.
The Company is no longer making or purchasing mortgage loans, except to facilitate sales of real estate owned or in connection with loan workouts.
Among the Company's properties are two commercial office buildings located in Solvang, California, which serve as headquarters for the Company and which were formerly leased to TCO. The buildings had a combined book value of $4.3 million and a combined fair value of $5.7 million at December 31, 1996. The TCO lease was terminated during 1996 after TCO-IL's revenues dropped and its employees transferred to the Company. The total rent paid by TCO under the lease was $228,000 in 1996, $584,000 in 1995 and $577,000 in 1994. The Company currently leases 6,000 square feet of space in one of these buildings to the YMCA at an annual rent of approximately $54,000 (subject to adjustment) under a two-year lease, with three one-year renewal options. Except for amounts it receives under the YMCA lease, the Company is currently bearing all costs associated with the properties (subject to the cost allocation with Transre and E&S as described under "-- Current and Future Operations and Organizational Structure" and "-- Expense Reductions/Reallocations and Staffing Changes"). The Company from time to time solicits offers to purchase these buildings, but no such offers on terms acceptable to the Company have been received. See "Properties" -- Item 2.
Simultaneously with the Syndicate's original investment in Concord, Concord made a similar investment in preferred stock of a predecessor of Exstar. Such preferred stock was later converted into preferred stock of TCO Holdings, which preferred stock was to have been convertible, upon the occurrence of specified events, into debt of TCO Holdings. The aggregate stated value of the TCO Holdings preferred stock was approximately $10.8 million at December 31, 1996. Management believes the TCO Holdings preferred stock is currently held in a reinsurance trust between Geneva Assurance Syndicate ("Geneva"), a former IIE syndicate in liquidation, and Classic, and that the TCO Holdings preferred stock may comprise a substantial portion of Classic's estimated value. Demand has been made for conversion of the TCO Holdings preferred stock into debt of TCO Holdings, but the stock has not been converted and neither Geneva nor Classic has taken further action to cause its conversion (other than in connection with the overall settlement discussions described below). If the preferred stock were converted, Peter O'Shaughnessy and TCO Holdings could be required to pledge assets to secure repayment of the debt, including Exstar Common Stock held by Mr. O'Shaughnessy and TCO Holdings.
In view of the uncertainty surrounding the Company's ability to realize value with respect to the JBW & Co. Loan (and the collateral pledged to secure it), the Company has entered into negotiations with JBW & Co. and various insurance regulatory authorities with jurisdiction over the parties and has reached a tentative overall settlement of issues surrounding the JBW & Co. Loan and the TCO Holdings preferred stock. As currently contemplated, the settlement would involve a transfer to the Company of a mortgage note in the principal amount of approximately $2 million (or proceeds thereof) in full satisfaction of the JBW & Co. Loan. The mortgage note would be secured by real estate with an appraised value at September 1, 1996 of $9.0 million.
Concurrently with the foregoing transaction, TCO Holdings would convert the TCO Holdings preferred stock into a TCO Holdings promissory note in the principal amount of $2.5 million, with four percent annual interest on the principal balance outstanding, payable from commissions received by TCO Holdings in connection with the Quota Share Arrangement. See "-- Current and Future Operations and Organizational Structure." A letter of intent with respect to the foregoing settlement has been entered into by the parties. The settlement, however, is contingent upon the execution of formal agreements by the parties and final approval of the agreements by the applicable insurance regulatory authorities. There can be no assurance that such approval will be obtained or that the settlement will be consummated as currently contemplated.
In February 1995, in connection with Exstar's decision to commence full or partial compensation of certain TCO and Alpine employees who also are Exstar employees, including the Chief Executive Officer, the President, and the former Chief Financial Officer, the Company and TCO entered into an amendment to the Loan Agreement (i) creating a voting trust with respect to the common stock of TCO-IL and its affiliate, TCO Insurance Services ("TCO-CA"), with the outside director(s) of Exstar having the right to vote such shares in the event TCO-IL fails to make any two consecutive payments due under the Loan Agreement, and (ii) requiring TCO-IL to provide certain salary expense and transaction reports relating to TCO to the Company to assist the Company in monitoring TCO's financial condition.
Payments by TCO were current through December 31, 1996, leaving a principal balance of $4.6 million of which $2.2 million was payable to Exstar and $2.4 million was payable to Alpine. The Company believes that TCO may not currently or in the foreseeable future have the ability to repay all of this indebtedness, and does not believe that the collateral securing the indebtedness would satisfy the indebtedness, given the current value of the Exstar Common Stock. Accordingly, in an effort to help resolve financial issues between the Company and TCO and to provide the Company assets of value to the Company's continuing operations, Exstar is considering accepting from TCO, with respect to the $2.2 million of TCO debt owed to it, a transfer to the Company of certain computer systems, furniture, fixtures, properties and rights of TCO. The systems, furniture and fixtures which may be transferred constitute virtually all of TCO's systems, furniture and fixtures, have a current book value of approximately $200,000 and were independently appraised in October 1996 at a total value of approximately $2.4 million. Pursuant to its rights under the Master Agreement with TCO, Exstar currently has a license to use the systems that would be transferred to it by TCO. If the exchange is approved by the Board of Directors (Exstar currently has only one independent director), it is currently contemplated that it would become effective as of January 1, 1997. No resolution has been reached with respect to the $2.4 million of debt owed by TCO to Alpine, but a transfer of certain contingent assets of TCO (including a potential receivable from an unaffiliated insurance company and certain real property rights) in full or partial satisfaction of such debt is under consideration by the parties. Any offset or reduction of the TCO debt to Alpine would require the prior approval of the Illinois DOI.
reflected as an admitted asset of Alpine in its statutory financial statements. See Note 11 of Notes to Consolidated Financial Statements.
Fixed Maturity Investments. The table below sets forth the composition of the Company's portfolio of fixed maturity investments by rating at December 31, 1996.
Claims Control, a subsidiary of TCO Holdings, is currently providing claims management and administrative services to the Company, in exchange for the reimbursement of certain expenses of Claims Control by Alpine. Historically, such functions were handled primarily by TCO pursuant to the management agreements, which were terminated in 1996. See "-- Current and Future Operations and Organizational Structure -- Relationship with TCO."
The Company expects to retain all risk assumed by it under the Quota Share Arrangement with UCIC, and, thus, has not renewed its existing reinsurance agreements or entered into new agreements with reinsurers with respect to such risks. The Company continues to have protection, with respect to business previously written, under reinsurance agreements entered into in prior years.
To limit its exposure on large risks and increase capacity, the Company historically entered into certain reinsurance transactions that ceded a portion of risks underwritten to other insurance companies. In the event that any or all of the reinsurers were unable to meet their obligations, the Company would then be liable for such defaulted amounts. All reinsurance payable to the Company is due from Underwriters at Lloyd's, London or companies rated at least A- by Best. At December 31, 1996 the largest single amount recoverable for paid and unpaid losses was $24.4 million from Signet Star Reinsurance Company, an insurer with a Best rating of A and $257.6 million of policyholders' surplus at December 31, 1996.
Reinsurance for the Company's specialized liability business through December 31, 1996, is provided by six treaties. The first provides coverage for 1991 and 1992 by Signet Star Reinsurance
Reinsurance for the Company's architects and engineers professional liability business through 1995 is provided by treaties principally with Underwriters at Lloyd's, London. Treaties effective January 1, 1988, through December 31, 1993 and for 1995, provide coverage for losses incurred, including loss adjustment expenses, in excess of $250,000 per insured, per loss up to a maximum of $2.0 million per insured, per loss. The treaty for 1994 provides coverage for losses incurred, including loss adjustment expenses, in excess of $250,000 per insured, per loss up to a maximum of $1.0 million per insured, per loss. Reinsurance for the Company's architects and engineers business in 1996 is provided under the specialized liability treaty described above with Underwriters Reinsurance Company.
The Company's ocean marine business is reinsured through a series of annual treaties principally provided by Underwriters at Lloyd's, London. The current series of treaties expired February 28, 1997, and provided coverage for losses incurred, including loss adjustment expenses, in excess of $250,000 per insured, per loss, generally up to a maximum of $1.0 million per insured, per loss, up to a maximum aggregate limit of liability (excluding reinstatements) of $10.0 million. The expiring treaties have been extended to July 1997 to provide run off coverage up to a maximum of $2.0 million per insured, per loss. Treaties for prior annual periods provide similar coverages, but with reduced maximum aggregate limits of liability.
The Syndicate and Alpine provided letters of credit which were fully collateralized by cash and cash equivalents, fixed maturities and short-term investments in connection with assumed reinsurance agreements totaling $7,992,000, $8,746,000 and $8,839,000 at December 31, 1996, 1995 and 1994, respectively.
The following table reflects the effects of reinsurance on the Company's premiums:
The Company's premium finance subsidiaries, Alpine Premium Finance Co. ("APF") and Transco Premium Finance Co. ("TPF"), previously provided premium financing with respect to risks underwritten by Alpine, the Syndicate, and other insurers for which TCO provided underwriting or premium collection services. APF is licensed as a premium finance company in Illinois and TPF is licensed in California. Services of the premium finance subsidiaries currently are not being used in connection with the Quota Share Arrangement and it is uncertain whether these services will be utilized by the Company in the future.
Combined ratios. The combined ratio, which reflects underwriting results but not investment income, is a traditional measure of underwriting performance of a property and casualty insurer. A statutory combined ratio of less than 100% generally indicates statutory underwriting profitability (although, as was the case with the Company in 1994, a company may have a combined ratio of less than 100% and still incur a statutory underwriting loss due to the timing of the reporting of commission
The following table reflects, on a statutory basis, the consolidated loss and loss adjustment expense ratios, expense ratios and combined ratios of the Syndicate and Alpine for the years ended December 31, 1996, 1995 and 1994, and for the property and casualty insurance industry, and the other liability industry group of the property and casualty industry, for the years ended December 31, 1995 and 1994.
IRIS Ratios and Risk Based Capital. The National Association of Insurance Commissioners ("NAIC") utilizes eleven Insurance Regulatory Information System ("IRIS") ratios and has developed a risk-based capital formula to assist regulators in evaluating insurer performance and capital adequacy. Alpine failed certain IRIS ratio tests in 1995 and 1996, and its policyholders' surplus fell below a regulatorily prescribed early warning level of risk based capital in 1995 and 1996. See "-- Regulation -- Insurance Regulatory Information System Tests" and "-- Regulation -- Risk Based Capital."
National Association of Insurance Commissioners. In addition to state-imposed insurance laws and regulations, Alpine is subject to the general statutory accounting practices and reporting formats established by the NAIC. The NAIC also promulgates model insurance laws and regulations relating to the financial and operational regulation of insurance companies. These rules and regulations generally are not directly applicable to an insurance company until they are adopted by applicable state legislatures and departments of insurance. NAIC model laws and regulations have become increasingly important in recent years, due primarily to the NAIC's Financial Regulatory Standards and Accreditation Program. Under this program, states which have adopted certain required model laws and regulations and meet various staffing and other requirements are "accredited" by the NAIC. Such accreditation is the
cornerstone of an eventual nationwide regulatory network, and there is a certain degree of political pressure on individual states to become accredited by the NAIC. Because the adoption of certain model laws and regulations is a prerequisite to accreditation, the NAIC's initiatives have taken on a greater level of practical importance in recent years. Illinois has been accredited by the NAIC, but the maintenance of its accreditation is contingent upon Illinois' substantial compliance with various NAIC model laws and regulations.
All states have adopted the NAIC's financial reporting form, which is typically referred to as the NAIC "annual statement." In this regard, the NAIC has a substantial degree of practical influence and is able to accomplish certain quasi-legislative initiatives through amendments to the NAIC annual statement and applicable accounting practices and procedures. For instance, the NAIC has required all insurance companies to have an annual statutory financial audit and actuarial certification as to loss and loss adjustment expense reserves by including such requirements within the annual statement instructions.
After adjustment for the overstatement of loss reserves for 1995, Alpine's adjusted capital amounts at December 31, 1996 and December 31, 1995 were approximately 173% and 170%, respectively, of its authorized control level risk based capital amounts. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" -- Item 7. Alpine's state of domicile, Illinois, did not require any action to be taken with respect to Alpine's 1995 risk based capital results, but did require action based on 1996 results. Because Alpine's December 31, 1996 adjusted capital was less than 200% of its authorized control level risk based capital, Alpine was required to submit a comprehensive financial plan to the Illinois DOI. The plan identifies, as the principal condition that contributed to Alpine's failure to meet the company action level of risk based capital, the amount of Alpine's net reserves for losses and loss adjustment expense relative to its policyholders' surplus and contains, as the proposed corrective actions, principally the changes to the Company's operations and organizational structure already implemented and consummation of the Quota Share Arrangement with UCIC. The plan includes projections indicating that, even if the Quota Share Arrangement were not in effect for 1997, Alpine's adjusted capital at December 31, 1997, and thereafter, is expected to exceed 200% of its authorized control level risk based capital. Management anticipates Alpine's comprehensive financial plan ultimately will be accepted by the Illinois DOI, based on discussions with Illinois DOI representatives; however, the Illinois DOI has not yet formally responded to the plan.
State Regulation. A number of states have acted to restrict or eliminate Alpine's ability to issue direct coverage in such states. On June 24, 1996, the California Department of Insurance withdrew Alpine's authorization to conduct insurance business and also denied Alpine's application for a Certificate of Authority to conduct insurance business in California on an admitted basis, citing concerns with respect to Alpine's financial strength and management competency. Historically, California has been Alpine's
The Company is directly liable for loss and loss adjustment expense payments under the terms of insurance policies that it has written and pursuant to reinsurance agreements under which it has assumed insurance business. For the Company's occurrence policies and occurrence policies reinsured by the Company, in many cases, several years may elapse between the occurrence of an insured loss, the reporting of the loss to the Company and the Company's payment of that loss. For the Company's claims made policies and claims made policies reinsured by the Company, the occurrence of the loss must be reported during the policy period or any extended reporting period. The Company reflects its liability for the ultimate payment of all incurred losses and loss adjustment expenses by establishing loss and loss adjustment expense reserves, which are balance sheet liabilities representing estimates of future amounts needed to pay claims and related expenses with respect to insured events that have occurred.
losses and loss adjustment expenses paid during the period to case loss and loss adjustment expense reserves and IBNR reserves (collectively, "loss reserves") at the end of the period, then subtracting loss reserves existing at the beginning of the period.
After discussions with the Illinois DOI in early 1996, the Company hired another independent actuarial firm to review and recertify the Company's loss reserves as of December 31, 1995. The recertification was completed in August 1996 and accepted by the Illinois DOI, following its commissioning of an additional independent actuarial review confirming the Company's review, in December 1996. Based upon the recertifications, the Company had an overstatement, or redundancy, of approximately $14.9 million in its loss reserves in its initially filed unaudited December 31, 1995
statutory statements. In September 1996, Alpine filed amended statutory statements eliminating substantially all of the redundancy. Because Alpine also non-admitted a substantial amount of assets in 1995 (principally receivables from TCO), the net effect to Alpine's surplus was a reduction of approximately $5 million. Pursuant to an understanding with the IIE, no amended statements for the Syndicate were prepared or filed.
The following table sets forth a reconciliation of beginning and ending loss reserves net of reinsurance. Consistent with the Company's adoption of Statement of Financial Accounting Standards No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long- Duration Contracts, the reserves are presented in the financial statements on a gross basis with reinsurance recoverable-unpaid losses and loss adjustment expenses presented as assets. The Company does not discount its loss reserves.
The following table sets forth a reconciliation from the Company's GAAP basis reserves to its reserves calculated in accordance with statutory accounting practices:
The following table presents the development of unpaid loss and loss adjustment expense reserves net of reinsurance from 1987 through 1996 for the Company. The top line of the table shows the estimated reserves for unpaid losses and loss adjustment expenses net of reinsurance at the balance sheet date for each of the indicated years. These figures represent the estimated amount of unpaid losses and loss adjustment expenses for claims arising in all prior years that were unpaid at the balance sheet date, including losses that had been incurred but not yet reported. The second line of the table, "Subsequent commutations and other adjustments not affecting development," represents reductions of the reserve credits as a result of commutations of reinsurance treaties subsequent to the year ended in each column and additions to reserves as a result of the acquisition of The Erie Syndicate, Inc. in 1989. These adjustments do not affect development as payments made against these reserves are classified in the appropriate year. The table also shows the re-estimated amounts of the previously recorded reserves based on experience as of the end of each succeeding year. The estimates change as more information becomes known about the frequency and severity of claims for individual years.
The following table presents loss reserves net of reinsurance with supplemental gross data:
At January 1, 1996, the Company and TCO, together, had 134 employees and total annualized payroll of approximately $7 million. At August 1, 1996, 85 employees remained (almost all of whom, other than the Claims Control employees, had become employees of the Company). The pay levels of many of the remaining employees (principally members of senior and middle management) were reduced. As a result, total annualized payroll at August 1, 1996 (before reimbursements from Transre and E&S) was approximately $4.5 million. Other operating expenses also were reduced substantially from prior
During 1996, to assist the Company in retaining sufficient staffing and to offset, in part, salary reductions instituted in 1996, Alpine sought approval from the Illinois DOI to pay bonuses to its employees. The Illinois DOI tentatively approved payment of the bonuses, up to a maximum aggregate amount of $400,000 payable by Alpine, but conditioned payment upon several assumptions and satisfaction of certain conditions, including the implementation of the Quota Share Arrangement (provided that it remained in effect for a period of time satisfactory to the Illinois DOI). The Company ultimately expects to pay some or all of the bonus amount to Alpine employees during 1997, but is unable to determine what amount will finally be approved by the Illinois DOI or when, if ever, it will be approved. In addition, management is considering a reduction in the exercise prices of certain outstanding options to acquire Exstar Common Stock held by its current employees. The Common Stock which is the subject of the options is owned by TCO and is available for purchase upon the exercise of options pursuant to the TCO Insurance Services 1992 Stock Incentive Plan ("TCO Plan").
(1) Shares used in the calculation for 1996, 1995 and 1994 are 5,498,000 shares outstanding; for 1993, 5,490,000 shares outstanding; for 1992, 3,846,000 shares outstanding. (2) Information is shown as of the end of each year presented. (3) In addition to usual differences between statutory accounting practices and GAAP, a significant portion of profit sharing expense is allocated as a reduction to investment income for statutory accounting practices. (4) Policyholders' surplus is reflected as of the end of each year presented on a consolidated basis after the elimination of the Syndicate's investment in Alpine. If the Syndicate's investments had not been subject to certain concentration limits under the IIE regulations, policyholders' surplus on a consolidated basis as of December 31, 1995 would have been $6,038,000.
The Company's operations and business underwent fundamental changes during 1996. See "Business -- Overview of Current Business Operations", "Business -- Financial Reporting; Delisting of Common Stock", "Business -- Background Concerning Changes in Operations", and "Business -- Current and Future Operations and Organizational Structure" -- Item 1. Because of these changes and changes that are continuing in 1997, differences in the Company's results of operations between 1995 and prior years, and its results of operations for 1996, are not necessarily indicative of trends or likely results of operations for 1997 or future years. The Company's 1996 Form 10-K contains certain "forward-looking statements" (within the meaning of the Private Securities Litigation Reform Act of 1995) that involve substantial risks and uncertainties. When used in this 1996 Form 10-K, the words "anticipate," "believe," "estimate" and "expect" and similar expressions as they relate to the Company and its management are intended to identify such forward-looking statements. A number of important factors could cause the actual results, performance or achievements of the Company for 1997 and beyond to differ materially from those expressed in such forward-looking statements. These factors include, without limitation, the discontinuation or a material adverse change in the terms and conditions of the Quota Share Arrangement, a material increase in competition, material changes to UCIC's financial condition or regulatory authority and material adverse changes in the Illinois DOI's oversight of Alpine.
Operations" -- Item 1), ceased issuing direct insurance in August 1996. This directly resulted in a sharp decline in the Company's earned premium revenue during the second half of 1996, and will cause a further decline in the Company's earned premium from direct insurance during the first half of 1997. The Company, however, will earn premium revenue through the Quota Share Arrangement effective April 1, 1997. The portion assumed by the Company initially will be 30% of the net premium accruing to UCIC on such business, including premiums unearned as of April 1, 1997 (estimated to be approximately $13.6 million) and premiums on policies issued after such date. The Company also will earn investment income on the funds held by UCIC under the Quota Share Arrangement. Because most of the premium funds will be held by UCIC, however, the Quota Share Arrangement will not benefit the Company's cash flow to the same extent it is expected to benefit the Company's net income (assuming the Quota Share Arrangement underwriting results are as profitable as or more profitable than TCO's underwriting results have been over the last three years).
The Company reduced its underwriting expenses during 1996 by terminating its insurance company subsidiaries' management agreements with TCO, thereby terminating the Company's obligation to pay commissions and profit-sharing amounts to TCO (subject to a final determination of obligations between the parties, if any), and such expenses were virtually eliminated following the Company's decision to cease issuing new and renewal insurance policies in August 1996. However, the Company will incur significant underwriting expenses under the Quota Share Arrangement. Of the net premium assumed by Alpine, Alpine will (i) allow UCIC to retain 30% as a ceding commission and (ii) pay approximately 3-4% to TCO Holdings as an override commission. Additionally, effective August 1, 1996, the Company began assuming a substantial amount of personnel costs and operating expenses previously borne by TCO. These expenses, which previously would have been included in the Company's underwriting expenses, have been included in the Company's other expenses since August 1, 1996. These expenses are being offset in part by reimbursements from Transre and E&S. See "Business -- Current and Future Operations and Organizational Structure" -- Item 1.
Other underwriting expenses historically have consisted of (i) policy acquisition costs, which equaled a fixed percentage of gross written premiums less reinsurance commissions, plus (ii) the allocated portion of profit sharing payments to TCO, which equaled a fixed percentage of underwriting profits determined on a statutory basis, a fixed percentage of the Syndicate's investment income and a fixed percentage of certain of Alpine's assets. Following termination of the management agreements between the Company's insurance company subsidiaries and TCO in 1996, the fees and commissions that otherwise would have been paid by the Company to TCO were eliminated and the Company began to bear directly certain personnel, general and administrative costs that otherwise would have been borne by TCO. The former are included in other underwriting expenses while the latter are included in other expenses.
Other income declined in 1996 to $100,000 from $400,000 in 1995. Other income consists primarily of contingent commission income from and interest earned on funds on deposit with an unaffiliated insurance company which have been assigned to the Company by TCO. The decline in other income in 1996 was due to a reduction in the amount of business placed by TCO over the last several years with the unaffiliated insurance company and a disagreement between TCO and the unaffiliated insurance company as to the amounts due to TCO and assigned to the Company. Additionally, the amount of funds on deposit was significantly reduced in 1996 compared to 1995. Management expects other income could be $4 million or more for 1997, principally as a consequence of settlement of the C&L suit (see "Legal Proceedings" -- Item 3) and resolution of the disagreement over the payments due from the unaffiliated insurance company to TCO.
Interest expense in 1996 was approximately $200,000, unchanged from 1995. Management expects this cost to remain relatively unchanged for 1997.
Gross written premiums were $64.3 million for 1995, an increase of 5.5% from $60.9 million in 1994. The specialized liability lines experienced the largest growth, with a $4.2 million increase in gross written premium, while ocean marine gross written premiums increased $100,000. Architects and engineers gross written premiums declined $600,000 reflecting continued severe competition in key states.
Net premiums earned were $39.1 million in 1995, a 25.4% decrease from $52.5 million in 1994. The decrease in net premiums earned was the result of the two specialized liability reinsurance treaties entered into since the third quarter of 1994 described above, the effect of which more than offset the increased gross written premiums.
Net loss and loss adjustment expenses incurred during 1995 totaled $15.7 million, down 52.3% from $32.9 million in 1994. Net loss and loss adjustment expense incurred as a portion of net premiums earned was 40.0% in 1995 compared to 62.6% in 1994. The decreases were the result of a decrease in net premiums earned, as described above, and, more significantly, the reduction of $14.9 million in loss and loss adjustment expense reserves relating to prior year overstatements.
Net investment income for 1995 was $4.9 million, an increase of $1.0 million, or 25.6%, from $3.9 million in 1994. The increase was due to a 5.3% increase in average investable assets from $86.3 million in 1994 to $90.8 million in 1995. In addition, the average yield on investable assets increased to 5.4% in 1995 from 4.6% in 1994. The increase in the investment yield was due to an increase in the proportion of the portfolio invested in higher yielding fixed maturities, a decrease in the proportion of the portfolio invested in lower yielding cash and cash equivalents, and the Company's continuing efforts to liquidate non-income producing real estate and reinvestment of the proceeds into income producing investments.
Federal income tax (benefit) expense was an expense of $5.1 million in 1995 compared to an expense of $1.8 million in 1994. The difference primarily relates to a $6.6 million application of the valuation reserve against the Company's deferred tax asset in 1995, with no adjustment to the valuation
reserve in 1994, offset to some extent by the Company's expensing $8.4 million of receivables due from TCO and deemed uncollectible.
Equity in income (losses) of affiliates was income of $3.8 million in 1995 compared to a loss of $5.2 million in 1994. The improvement in 1995 related to an increase in TCO's revenues principally as a result of an increase of $3.7 million in profit sharing commission received from the Company relating to the $14.9 million reduction in reserves for losses and loss adjustment expenses, and a decrease in expenses due to general cost cutting by TCO and the shifting of certain employees from TCO to the Company.
At December 31, 1996, $16.3 million, or 15.1% of the Company's total assets, consisted of real estate mortgages and real estate investments. This compared to $19.2 million of such investments, comprising 13.4% of the Company's total assets at December 31, 1995. The Company's intent is to reduce the real estate mortgages and real estate owned investments in an aggressive but orderly manner. See "Business -- Investments" -- Item 1.
Management expects the Company will need for at least 1997 to continue to liquidate investments as the Company's principal source of cash to fund its operations. Based on historical loss payout patterns and expected operating costs, management anticipates these liquidations could result in realized losses on the liquidated investments, particularly if interest rates rise significantly during 1997. Notwithstanding the foregoing, because the Company has a substantial portion of its investments in mid-term fixed maturities, and because management expects the cash required for payments of loss and loss adjustment expenses to decline during 1997, the realized losses on liquidated investments are expected to be relatively small (less than $500,000, depending on interest rate movements).
Management anticipates Exstar will not receive any dividends from Alpine for the foreseeable future, but that Exstar's cash needs, as a parent company, may be satisfied during 1997 out of a combination of the cash proceeds from settlement of the Company's suit against C&L (see "Legal Proceedings" -- Item 3) and cash received from an unaffiliated reinsurer which has been assigned to Exstar by TCO (see "--1996 to 1995--Other Income"). Exstar does not plan to pay cash dividends in the foreseeable future.
After adjustment for the overstatement of loss reserves for 1995, Alpine's adjusted capital amounts at December 31, 1996, and December 31, 1995, were approximately 173% and 170%, respectively, of its authorized control level risk based capital amounts. Because Alpine's December 31, 1996 adjusted capital was less than 200% of its authorized control level risk based capital, Alpine submitted a comprehensive financial plan to the Illinois DOI. The plan identifies as the principal condition that contributed to Alpine's failure to meet the company action level of risk based capital, the amount of Alpine's net reserves for losses and loss adjustment expense relative to policyholders' surplus, and contains, as the proposed corrective actions, principally the changes to the Company's operations and organizational structure already implemented and consummation of the Quota Share Arrangement with UCIC. The plan includes projections indicating that, even if the Quota Share Arrangement were not in effect for 1997, Alpine's adjusted capital at December 31, 1997, and thereafter, is expected to exceed 200% of its authorized control level risk based capital. Management anticipates Alpine's comprehensive financial plan ultimately will be accepted by the Illinois DOI, based on discussions with Illinois DOI representatives; however, the Illinois DOI has not yet formally responded to the plan.
Information in response to this item is incorporated by reference from Item 14.