The following is a summary of properties leased by the Company at December 31, 1998:
The consolidated statements of operations data set forth below for each of the three years in the period ended December 31, 1998, and the consolidated balance sheet data at December 31, 1998 and 1997 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, 1995, and the consolidated balance sheet data at December 31, 1996, 1995 and 1994, 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.
- ------------------------ (1) 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."
The following table provides an overview of our key operating results (000's):
The single largest item affecting our 1998 operating results was the addition of $11.0 million to unpaid claim and claim settlement expenses to cover adverse development of 1997 and prior year open claims in Minnesota, Colorado and Missouri. This addition was recorded $3.0 million to the first quarter of 1998, $400,000 to the second quarter of 1998 and the remainder to the fourth quarter of 1998. This adverse development was the result of changes in our internal claim reserving standards, new claim petitions for previously injured workers, the need for further surgical procedures and rehabilitation treatment, as well as new litigation on existing claims. The adjustment made for 1997 and prior years also increased our estimate for 1998 unpaid claim and claim settlement expenses. We will continue to aggressively manage prior year open claims to diminish the likelihood that prior year reserves will increase in the future. We believe that our reserves are adequate to cover costs for claims reported and for those incurred but not reported at December 31, 1998.
TOTAL REVENUES: Our total revenues include premiums earned, investment income and net realized investment gains.
The following table summarizes the components of our revenues and premiums in force (000's);
The premium we charge a policyholder is a function of their payroll, industry and prior workers' compensation claims experience. In underwriting a policy, we receive policyholder payroll estimates for the ensuing year. We record premiums written on an installment basis matching our billing to the policyholder and earn premiums on a daily basis over the life of each insurance policy based on the payroll estimate. We record the excess of premiums billed over premiums earned for each policy as unearned premiums on our balance sheet. When a policy expires, we audit employer payrolls for the policy period and adjust the estimated payroll to its actual value. The result is a "final audit" adjustment recorded to premiums earned when the adjustment becomes known. Final audit premiums recognized during the period include billed final audit premiums plus (or minus) the change in estimate for premiums on unexpired and expired unaudited policies.
Underlying these increases in gross premiums earned is another trend. The premium rate that we charge policyholders per payroll dollar has declined for several years. This is the result, in part, of the following:
- As the loss cost structure of workers' compensation has declined, more insurance companies have entered or re-entered the workers' compensation insurance market, resulting in increased competition; and
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.
Premiums ceded to reinsurers decreased to $342,000 in 1997 from $697,000 in 1996. The decrease in premiums ceded resulted from (i) reduced premium rates in 1997 from 1996 for our selected excess of loss reinsurance coverage levels in Minnesota, (ii) reduced premiums for excess of loss coverage in other states, and (iii) the recognition of a refund received from the WCRA of $358,000 in 1997.
1999 OUTLOOK: The 1999 outlook for gross premiums earned and premiums ceded include the following factors:
- We expect continued growth in premiums in force in our non-Minnesota markets offset by decreasing premiums in force in Minnesota which will lead to moderate overall growth in premiums in force and moderate growth in gross premiums earned;
- Premiums ceded will increase due to reducing our selected retention level to $25,000 in all our states from $280,000 in Minnesota and $500,000 in our non-Minnesota states. This reduction will result in additional excess of loss policy cost and significantly reduce premiums earned; and
INVESTMENT INCOME AND NET REALIZED INVESTMENT GAINS: Our investment income includes earnings on our investment portfolio. Net realized investment gains include gains and losses from sales of available-for-sale securities and are
displayed separately on our Consolidated Statement of Operations. We currently invest entirely in U.S. domiciled investment grade taxable and tax-exempt fixed maturity investments and classify our investments as available-for-sale. We intend to hold our available-for-sale investments to maturity, but may sell before maturity in response to changes in interest rates, prepayment risk and funding sources or terms, or to address liquidity needs. Our primary investment objective is to maintain a diversified, high-quality, fixed-investment portfolio structured to maximize our after-tax investment income without taking inappropriate credit risk. For further discussion of investments, see the "Investments" section of this Management's Discussion and Analysis.
Investment income and net realized investment gains increased 27.4% to $7.2 million in 1997 from $5.7 million in 1996, due to increased funds available for investment and net realized investment gains totaling $399,000. Funds available for investment increased to $112.3 million at December 31, 1997, from $89.8 million at December 31, 1996, due to increased net cash provided by operating activities, resulting primarily from (i) the difference in timing between the receipt of premiums and the payment of claim and claim settlement expenses and (ii) net cash provided by investment income. Investment yields increased to 6.3% in 1997 from 6.2% in 1996.
1999 OUTLOOK: Barring significant changes in interest rates or operational cash flows, we expect that the 1999 pre-tax yield from our investment portfolio will be affected by the following:
- Our recognition of realized gains and losses will depend on the repositioning of the portfolio, if any, that occurs in 1999 as we continue to diversify our portfolio from U.S. government securities to other taxable and tax-exempt fixed maturity securities; and
- We will continue to include fixed maturity tax-exempt securities in our investment portfolio to increase after-tax yields. Fixed maturity, tax-exempt securities may have the effect of reducing investment income recognized and decrease pre-tax investment yields but are expected to contribute more to after-tax net income as a result of the favorable treatment tax-exempt municipal income receives for federal income tax purposes.
Claim and claim settlement expenses increased to $75.3 million in 1998 from $55.5 million in 1997. As a percent of premiums earned, claim and claim settlement expenses increased to 92.5% in 1998 from 68.5% in 1997. These changes are due to the following:
- Gross premiums earned increased to $89.9 million in 1998 from $81.4 million in 1997 resulting in increased claim and claim settlement expenses as we provided coverage for more employers;
- Reduced premiums due to legislative changes in estimated loss costs, increased competition and improving customer loss experience, have resulted in an increase in claim and claim settlement expenses as a percentage of premiums earned; and
- Average claim cost continued to decrease in 1998 due to realized operating efficiencies and effectiveness and legislative changes in benefits to claimants. These decreases did not keep pace, however, with decreases in pricing.
Claim and claim settlement expenses increased to $55.5 million in 1997 from $39.1 million in 1996. As a percent of premiums earned, claim and claim settlement expenses increased to 68.5% in 1997 from 62.0% in 1996.
- Gross premiums earned increased to $81.4 million in 1997 from $63.8 million in 1996 resulting in increased claim and claim settlement expenses as we provided coverage for more employers;
- Continued application of our claims management technology and methods to all open claims at December 31, 1998, may benefit future periods. The magnitude of any benefit realized cannot be quantified at this time.
reinsurance agreements, ceding commission is adjusted to the extent that actual claim and claim settlement expenses vary from levels specified in the agreements.
- Premium tax expense remained consistent at 2.0% of gross premiums earned in 1998 compared to 2.0% in 1997 and 2.1% in 1996. Premium tax expense was slightly higher in 1996 due to higher premium tax rates paid for premiums earned in Colorado;
- Other policy acquisition costs increased to 5.5% of gross premiums earned in 1998 from 4.5% in 1997 and 3.5% in 1996, 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 in 1999 to remain consistent with 1998; and
- We expect that other policy acquisition costs will be consistent with 1998 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 1999 realized through enhancements to our internal processes and procedures, including changes to our proprietary computer systems.
GENERAL AND ADMINISTRATIVE EXPENSES: Our general and administrative expenses include personnel costs, office rent, certain state administrative charges based on premiums and other costs and expenses not specific to claim and claim settlement expenses or policy acquisition costs.
Our general and administrative expenses decreased to $11.4 million in 1998 from $11.6 million in 1997 and increased from $8.5 million in 1996. As a percent of gross premiums earned, general and administrative expenses decreased to 12.6% in 1998 from 14.3% in 1997 and 13.3% in 1996. General and administrative expenses for 1998 and 1997 include benefits of $1.1 million recorded in the second quarter of 1998, $695,000 recorded in the fourth quarter of 1998 and $842,000 recorded in the third quarter of 1997, resulting from the reversal of 1998, 1997 and 1996 accruals for assessments by the Minnesota Insurance Guarantee Association (MIGA), an organization formed to fund Minnesota claims for insolvent insurance companies. MIGA did not assess its members in 1998 or 1997 for workers' compensation claim liabilities arising from current or prior insolvencies resulting in the accrual reversals and we do not expect an assessment in 1999. After adjusting for the accrual reversals, our general and administrative expenses increased to $12.4 million in 1998 from 11.4 million in 1997 and $7.7 million in 1996. These increases reflect:
- expenses incurred for expansion in Michigan and Massachusetts in 1998 and 1997 and Missouri in 1996, not offset by revenues from premiums in force in those states;
- additional personnel costs for new employees resulting from the growth in in force premium; and
- General and administrative expenses continue to improve as a percent of premiums earned, after adjusting for MIGA accrual reversals and one-time charges. Actions to reduce personnel costs were initiated in the first quarter of 1998 to bring operating expenses more in line with revenues. Other expenses continue to be managed aggressively and reduced where appropriate.
1999 OUTLOOK: We expect that general and administrative expenses will be affected by the following:
- We will continue to aggressively manage all general and administrative expenses in 1999;
- We have no plans to open additional state offices in 1999 and expect that growth in premiums in force in Michigan and Massachusetts will result in additional revenues to cover the fixed costs in those states; and
- We expect to increase operational efficiency during 1999 through enhancements to our internal processes and procedures, including changes to our internal proprietary computer systems.
INTEREST EXPENSE: We incurred interest charges on our Senior Notes in 1998, 1997 and 1996 and our Series 1991A and 1991B Notes in 1996. The Series 1991A and 1991B Notes were paid in full in December 1996. The Senior Notes mature in series during the years 1995 through 1999. We paid interest at rates ranging from 9.25% to 9.50% on the outstanding balance on our Senior Notes during 1998.
Interest expense decreased to $546,000 in 1998 from $777,000 in 1997 and $1.1 million in 1996 due to principal payments on the Senior Notes in December 1998, 1997 and 1996 and payments on the Series 1991A and 1991B Notes in December 1996. The Series 1991A and 1991B Notes were paid in full in 1996.
INCOME TAXES: We incur federal income taxes on our combined service organization (RTW) operations and insurance (ACIC) operations. We incur state income taxes on the results of our service organization's operations and incur premium taxes in lieu of state income taxes for substantially all of our insurance operations. In certain instances, we may incur state income taxes on our insurance operations. Additionally, certain provisions of the Internal Revenue Code adversely affect our taxable income by accelerating recognition and payment of income taxes. Adjustments to book income generating current tax liabilities include limitations on the deductibility of unpaid claim and claim settlement expenses, limitations on the deductibility of unearned premium reserves and limitations on deductions for bad debt reserves.
1999 OUTLOOK: Income tax expense (benefit) will vary based on (i) the income (loss) from operations we recognize for 1999, and will (ii) decrease as a percent of income (loss) before taxes relative to the statutory effective rate as we purchase additional tax-exempt municipal fixed investments for our investment portfolio. The ultimate change is unknown at this time.
Funds provided by our operating cash flows and investment cash flows are the source of growth in our investment portfolio. Operating cash flows consist of the excess of premiums collected over claim and claim settlement expenses and other operating expenses paid. Investment cash flows consist of income on existing investments and proceeds from sales and maturities of investments. Our investment portfolio grew 12.8% or $14.3 million to $126.6 million at December 31, 1998, from $112.3 million at December 31, 1997, as a result of these factors.
The 1998 net reserves for claim and claim settlement expenses shown in the preceding table as determined under Generally Accepted Accounting Principles (GAAP) were $3.3 million greater than the 1998 net reserves as determined under statutory accounting principles (SAP). The difference arises since SAP allows a reserves offset for retrospective reinsurance (see Results of Operations -- Premiums ceded) while GAAP requires the offset to be recorded prospectively over the life of the contract.
Cash provided by operating activities in 1998 was $9.8 million. This is primarily a result of an increase of $36.2 million in unpaid claim and claim settlement expenses which are non-cash accruals for future claims, offset by an increase of $14.2 million in amounts due from reinsurers and our net loss of $7.1 million. Net cash used in investing activities was $12.9 million, primarily the result of purchases of $77.6 million of investments, $800,000 in purchases of furniture and equipment offset by proceeds from sales of investments of $63.5 million and maturities of $2.0 million of investments. Net cash used in financing activities was $2.0 million, primarily due to payments totaling $2.5 million on outstanding Senior Notes in December 1998.
We believe that cash flow generated by our operations and our cash and investment balances will be sufficient to fund continuing operations, principal repayments and debt service on our outstanding Senior Notes, including principal repayments of $2.5 million due in December 1999, and capital expenditures for the next 12 months.
Our fixed maturity investments and notes payable are subject to interest rate risk. Increases and decreases in prevailing interest rates generally translate into decreases and increases in the fair value of these instruments. Also, fair values of interest rate sensitive instruments may be affected by the credit worthiness of the issuer, prepayment options, relative values of alternative instruments, the liquidity of the instrument and other general market conditions. We regularly evaluate interest rate risk in order to evaluate the appropriateness of our investments.
INFORMATION TECHNOLOGY SYSTEMS: Our insurance subsidiary operations began in 1992. After using third party software and services for several years, we developed our own internal computer systems to manage our claims and related claim settlement expenses (1996) and administer our policy information (1995). These computer systems are year 2000 compliant. Additionally, during the second quarter of 1998 we implemented third-party provided general ledger and accounts payable software, which is year 2000 compliant. Also, we are in the process of internally developing a billing and cash receipt system to be completed by the first quarter of 1999, which will be year 2000 compliant. These system replacements and software developments are occurring as a part of our ongoing operations and are not specifically occurring as a result of the year 2000 issue. We anticipate that our critical computer hardware and software systems will be fully year 2000 compliant in early 1999 and non-critical hardware and software systems will be compliant during the second quarter of 1999. The cost of any hardware and software changes required to comply with the year 2000, other than those contemplated as routine upgrades in our operations, are not expected to have a material adverse effect on our results of operations.
NON-INFORMATION TECHNOLOGY SYSTEMS: We have reviewed our operationally critical non-information technology systems (non-IT systems) which may have embedded technology that is reliant on the year 2000. We have developed a formal plan to address any non-IT system year 2000 issues. We expect that our non-IT systems will be fully year 2000 compliant by the end of the second quarter of 1999. We are currently unable to determine the ultimate costs relating to non-information technology systems.
Our insurance subsidiary is subject to substantial regulation by governmental agencies in the states in which we operate, and will be subject to such regulation in any state in which we provide workers' compensation products and services in the future. State regulatory agencies have broad administrative power with respect to all aspects of our business, including premium rates, benefit levels, policy forms, dividend payments, capital adequacy and the amount and type of investments. These regulations are primarily intended to protect covered employees and policyholders rather than the insurance company. Both the legislation covering insurance companies and the regulations adopted by state agencies are subject to change. At December 31, 1998, our insurance subsidiary was licensed to do business in Minnesota, South Dakota, Wisconsin, Colorado, Missouri, Illinois, Kansas, Michigan,
Indiana, Massachusetts, Connecticut, Rhode Island, Pennsylvania, Tennessee, Maryland, Arkansas, Iowa and Florida.
RTW, INC. CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
RTW, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (IN THOUSANDS)
ORGANIZATION - RTW, Inc. (RTW) provides workers' compensation insurance coverage to employers through its wholly owned insurance subsidiary, American Compensation Insurance Company (ACIC). Collectively, "we," "our" and "us" will refer to these entities in these "Notes to Consolidated Financial Statements."
We benefit from our ability to reduce workers' compensation costs and provide employers the ability to control their workers' compensation programs. We are domiciled in Minnesota and were licensed in Minnesota, Colorado, Missouri, Michigan, Massachusetts, Illinois, Kansas, Connecticut, Wisconsin, Rhode Island, Florida, Iowa, Indiana, Arkansas, Pennsylvania, Tennessee, South Dakota and Maryland at December 31, 1998. We wrote policies primarily in Minnesota, Colorado, Missouri, Illinois, Kansas, Michigan, Massachusetts, Connecticut and Wisconsin during 1998. We also received our license to write workers' compensation insurance coverage for companies covered under the Longshoreman's Act in 1997.
ACCOUNTING PRINCIPLES - We prepare our financial statements in accordance with Generally Accepted Accounting Principles (GAAP).
CONSOLIDATION - Our consolidated financial statements include RTW and ACIC. We eliminate all intercompany accounts and transactions in consolidation.
AVAILABLE-FOR-SALE INVESTMENTS: We intend to hold our available-for-sale investments to maturity, but may sell before maturity in response to changes in interest rates, prepayment risk and funding sources or terms, or to address liquidity needs. Our available-for-sale investments are carried at fair value with unrealized gains or losses, net of deferred taxes, reported as other comprehensive income. The fair values of our investments are determined based upon quoted market prices as obtained through commercial pricing services or brokers who provide estimated fair values. In December 1997, we reclassified our entire held-to-maturity portfolio, invested in U.S. government securities with a historical cost, net of amortization of $53.8 million and a fair value of $54.7 million, to available-for-sale investments. We reclassified these securities to enable us to more actively manage our investment yield and overall portfolio risk.
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.
CASH AND CASH EQUIVALENTS - We generally consider all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.
DEPRECIATION - We depreciate furniture and equipment on a straight-line basis over the estimated useful lives of the assets (five to ten years). Accumulated depreciation in 1998 and 1997 was $2,951,000 and $2,309,000, respectively.
Our "Unpaid claim and claim settlement expenses" represent established, undiscounted reserves for the estimated total unpaid cost of claim and claim settlement expenses that cover events that occurred in 1998 and prior years. 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. Our estimates consider such variables as past loss experience, current claim trends and prevailing social, economic and legal environments. We have limited historical data to estimate our reserves for unpaid claim and claim settlement expenses due to commencing operations in 1992 and 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.
Effective December 1997, we adopted SFAS No. 128, "Earnings Per Share." SFAS No. 128 requires dual presentation of a basic income (loss) per share (IPS), which excludes dilution, and a diluted IPS, which reflects the potential dilution that could occur if actions taken with respect to dilutive securities resulted in the issuance of common stock. Dilutive securities consist of stock options and warrants. Basic IPS is computed by dividing net income (loss) by the weighted average number of common shares outstanding for the period. Diluted IPS is computed by dividing net income (loss) by the weighted average number of common shares and dilutive securities outstanding for the period. Dilutive securities issued after April 1995 are considered outstanding from the date of grant after applying the treasury stock method for determining the dilutive effect. Dilutive securities issued prior to that date are considered outstanding for all periods after applying the treasury stock method for determining the dilutive effect.
Options to purchase 1,894,811 shares of common stock at prices ranging from $2.00 to $28.75 were outstanding during 1998 but were not included in the computation of diluted IPS due to our net loss. Diluted weighted average shares outstanding would have increased by 219,000 shares had these shares not been antidilutive in the computation. These options were still outstanding at the end of 1998.
VALUATION OF INVESTMENTS - The following tables present amortized cost, gross unrealized gains and losses and estimated fair values of investments (000's):
We ceded Minnesota claims in excess of $280,000, $1,080,000 and $1,040,000 per occurrence during 1998, 1997 and 1996, respectively, to the Minnesota Workers' Compensation Reinsurance Association. Non-Minnesota state claims in excess of $500,000 were ceded to various reinsurers in 1998, 1997 and 1996. Additionally, for claims occurring on or after July 1, 1998, we further limited our per incident exposure by purchasing excess of loss coverage for losses from $25,000 to $280,000 in Minnesota and from $25,000 to $300,000 in other states from a single reinsurer. This agreement was finalized after its effective date. As a result, activity occurring from July 1, 1998 through October 1, 1998 has been recorded on a retroactive basis resulting in the deferral of a gain totaling $1,990,000. Activity occurring on or after October 1, 1998 has been recorded prospectively. This gain will be amortized into income in future years using the effective interest rate inherent in the amounts paid to the reinsurer and the estimated timing and amounts of recoveries from the reinsurer.
Reinsurance contracts do not relieve us from our obligations to policyholders. We expect reinsurers to which we have ceded reinsurance to honor their obligations. Failure of these reinsurers to honor their obligations could result in losses to us. We do not anticipate any such losses and accordingly, no provision for amounts deemed uncollectible are included in our financial statements. We attempt to minimize our exposure to significant losses from reinsurer insolvency by monitoring the financial condition of our reinsurers. The reinsurance recoverable on unpaid claim and claim settlement expenses associated with reinsurers are as follows (000's):
Ceding commissions earned, which is based upon final settlement of claim and claim settlement expenses, will range between 10% and 48% during accident years 1994 and 1993 and between 15% and 25% during accident year 1992. Ceding commissions earned of $1,871,000 for fiscal year 1996 is reported as a reduction in policy acquisition costs in the Consolidated Statements of Operations.
The following table represents a reconciliation of beginning and ending unpaid claim and claim settlement expense reserves for each of the last three years (000's):
Changes in estimates of unpaid claim and claim settlement expenses for prior years 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 and $8,075,000 in 1997 and 1996, respectively.
Based on borrowing rates currently available to us for loans with similar terms and average maturities (prime at December 31, 1998 and 1997 was 7.75% and 8.50%, respectively), the fair value of notes payable was approximately $2,556,000 and $5,116,000 at December 31, 1998 and 1997, respectively.
We compute income taxes under the liability method. This means deferred income taxes reflect the estimated future tax effects of temporary differences between the carrying value of assets and liabilities for financial reporting purposes and the carrying value of assets and liabilities for income tax purposes.
Income taxes receivable at December 31, 1998 and 1997 were approximately $3,289,000 and $1,011,000, respectively.
Our liability for employee contributions withheld at December 31, 1998 and 1997 for the purchase of shares in April 1999 and April 1998 under the ESPP was $158,000 and $202,000, respectively.
The following table summarizes the options outstanding and exercisable in 1999:
These options were exercised in January 1999. We are permitted a tax deduction equal to the difference between the 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, we will record a reduction of income taxes payable and will increase common stock by $532,000 to reflect the January exercise. In 1998 and 1996, we recorded reductions in income taxes payable and increased common stock by $80,000 and $510,000, respectively, to reflect exercises during the year. No exercises occurred in 1997.
PRO FORMA INFORMATION - Had we calculated compensation expense for our option grants under the 1994 Stock Plan and stock purchases under the ESPP based on the fair value method described in SFAS No. 123, "Accounting for Stock-Based Compensation," our net income (loss), basic net income (loss) per share and dilutive net income (loss) per share would approximate the following pro forma amounts (in 000's, except per share data):
EMPLOYEE CONTRACT - We entered into a three-year employment agreement with our new 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 other officers. 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.
COMBINED RETIREMENT PLAN - In January 1998, we combined our 401(K) Retirement Plan and ESOP into a single retirement plan, the KSOP. The KSOP retains the features of each separate plan except for eligibility and vesting provisions. Under the plan, employees become eligible to participate in the plan on the first day of the month after beginning employment and attaining age 21.
EMPLOYEE STOCK OWNERSHIP PLAN - We maintain an Employee Stock Ownership Plan (ESOP) for our qualified employees. Our contributions to the plan are discretionary. We may contribute cash or shares of our common stock.
OTHER EMPLOYEE BENEFIT PLANS - We maintained bonus plans in 1998, 1997 and 1996 under which all employees, including officers, were eligible for a bonus based on our operating results. These bonuses aggregated $267,000, $643,000 and $498,000 in 1998, 1997 and 1996, respectively.
On April 25, 1996, our Board of Directors approved a 3-for-2 stock split in the form of a 50 percent stock dividend to shareholders of record on the close of business on May 6, 1996. The shares were distributed to shareholders on May 17, 1996. All share and per share amounts have been adjusted to reflect the effect of the stock splits.
SHAREHOLDER RIGHTS PLAN - In April 1997, we adopted a shareholder rights plan and declared a dividend of one right for each outstanding share of common stock to shareholders of record at the close of business on June 30, 1997. The rights become exercisable only after any person or group (the "Acquiring Person") becomes the beneficial owner of 15% or more of the voting power of our common stock. Certain shares held by our Chairman and his wife are excluded from the computation for determining whether a person is an Acquiring Person. Each right entitles its registered holder to purchase from us one one-hundredth share of a new Series A Junior Participating Preferred Stock, no par value, at a price of $85 per one one-hundredth share, subject to adjustment. If any Acquiring Person acquires beneficial ownership of 15% or more of our voting power, each right will entitle its holder (other than such Acquiring Person) to purchase, at the then current purchase price of the right, that number of shares of our common
DIVIDEND RESTRICTIONS - Dividends are paid as determined by our Board of Directors. No dividends have ever been paid by us.
Our ability to pay cash dividends to shareholders may depend upon the amount of dividends received from our insurance subsidiary. ACIC's ability to pay dividends is restricted by law or subject to approval of the insurance regulatory authorities of Minnesota.
Under Minnesota insurance law regulating the payment of dividends by ACIC, any such payments must be an amount deemed prudent by ACIC's Board of Directors and, unless otherwise approved by the Commissioner of the Minnesota Department of Commerce (Commissioner), must be paid solely from the adjusted earned surplus of ACIC. Adjusted earned surplus means the earned surplus as determined in accordance with statutory accounting practices (unassigned funds), less 25% of the amount of such earned surplus which is attributable to unrealized capital gains. Further, without approval of the Commissioner, ACIC may not pay a dividend in any calendar year which, when combined with dividends paid in the preceding twelve months, exceeds the greater of (i) 10% of ACIC's statutory capital and surplus at the prior year end or (ii) 100% of ACIC's statutory net gain from operations (not including realized capital gains) for the prior calendar year. For 1999, dividends in excess of $4,188,000 would require prior consent of the Commissioner.
STATUTORY SURPLUS AND STATUTORY NET INCOME (LOSS) - Our insurance subsidiary is required to file financial statements with state regulatory agencies. The accounting principles used to prepare the statutory financial statements follow prescribed accounting practices that differ from GAAP. Statutory policyholders' surplus in 1998 and 1997, and statutory net income (loss) for 1998, 1997 and 1996 are as follows (000's):
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.
Future minimum (base) rental payments required under the leases, as of December 31, 1998, are as follows (000's):
Rent expense, including contingent rentals, was $2,181,000, $1,776,000 and $1,063,000 for 1998, 1997 and 1996, respectively.