- -------- (1) See Note 13 to the Consolidated Financial Statements for an explanation of the method used to determine the number of shares used to compute per share amounts. (2) See Notes 6 and 7 to the Consolidated Financial Statements.
The components of fee income by business segment are illustrated in Table II.
Historically, workers' compensation has been the major line of business written by the Company in both its Corporate Risk and Program Business segments. Generally, competition for workers' compensation business increased in recent years. The resulting under-pricing of workers' compensation risks by traditional insurers reduced the incentive for insureds to enter alternative market vehicles such as those offered by the Company's Corporate Risk Management segment. Beginning in early 2000, the amount of competition for workers' compensation business declined and pricing began to improve. This was due to poor reported underwriting results in the workers' compensation market.
As a percentage of total fee income, workers' compensation decreased from over 80% at December 31, 1994 to 53% at December 31, 2000. This is a result of the Company writing accounts in other lines of coverage such as, accident and health, commercial, auto liability, auto physical damage and other liability coverages, as well as the expansion of the Company's Financial Services segment.
The Company's Specialty Brokerage business segment provides access to alternative risk transfer insurers and reinsurers in Bermuda, Europe and the U.S. Fees in this segment grew by 8% to $14.8 million in the year as a result of increased business placed in Bermuda and London. Profit margins decreased to 31% from 38% in 1999 due to increased operating expenses, but improved from 25% in 1998 as a result of increased revenues.
Premiums earned increased 40% to $254.5 million in 2000 from $177.7 million in 1999 and $157.3 million in 1998. These increases are attributable to the shift in business from the Corporate Risk Management segment to the Program Business segment and the strong growth within this segment. Program Business usually involves higher premiums than business derived from the Corporate Risk Management segment due to new policies constantly being added by agents. Premiums earned represent the net premiums retained by the Company on which it bears underwriting risk. The Company believes that, due to the nature of the business written and the structure of its reinsurance, both the volatility of underwriting profit or loss and the probability of experiencing a severe underwriting loss are less than would ordinarily be expected for a traditional property/casualty insurer. Historically, the level of premiums earned has been closely matched by the level of total insurance costs, resulting in small amounts of underwriting loss as a percentage of premiums earned. The fact that premiums earned have historically matched total insurance costs means that even a significant fluctuation in premiums earned should have a relatively insignificant impact on the Company's net income. However, in 1999 and 2000, losses incurred under certain programs, the charge against reinsurance recoverables and the increases in net loss reserves caused underwriting losses to be higher than historical levels.
In 2000, the Company established an additional provision of $69.0 million (1999--$12.3 million; 1998--Nil). This provision includes $35.0 million related to actual and anticipated losses incurred due to the failure or unwillingness of a small number of reinsurers to honor their obligations to the Company. While the Company is actively pursuing resolutions of these disputes with the reinsurers, the provision reflects what the Company believes is the likely cost of bringing such matters to a timely resolution. In order to bring these matters to resolution, the Company has included $9.0 million in the provision for estimated legal and other settlement costs. The provision also includes $18.0 million for additional terminated programs, credit exposures and the associated loss development on these programs. Finally, $7.0 million was set up for adverse net loss reserve development on prior underwriting years. The 1999 reserve amount of $12.3 million relates primarily to provisions established in the third quarter of 1999 on a number of terminated programs.
. the Company's retention of a portion of its main reinsurance treaty, which covers the specific and aggregate excess risk on most of the Company's Corporate Risk Management business written by Legion and some of Legion's Program Business; and
For risks retained under "limited risk" programs, the Company may experience an underwriting loss, but the volatility of this business is limited in nature. The portion of the Company's premiums earned that relate to this risk was $21.0 million in 2000, as compared with $1.7 million in 1999 and nil in 1998. The Company incurred an underwriting loss as a result of this risk of $0.4 million in 2000 (1999 and 1998--nil). This increase in "limited risk" premiums is primarily a result of a restructuring of the Company's Small Business Underwriters program.
In the normal course of operations, the Company establishes provisions as a result of its exposures from certain clients and programs. Depending on the nature of the exposure, these provisions generally reduce the amount of reinsurance recoverable and/or accounts receivable or increase the reserve for losses and loss expenses. On an inception-to-date basis, these provisions totaled $28.3 million at December 31, 2000, $18.0 million in 1999 and $7.3 million in 1998. The 1999 and 2000 provisions are net of a reinsurance recovery under a contingency excess of loss policy.
While the Company evaluates the financial condition of its clients, brokers and reinsurers to minimize its exposure to losses from insolvencies, its exposure to such losses has increased significantly due to the following factors:
. the increase in the number of accounts and their inherent growth in premium volume;
. competitive factors, which have limited the amount of collateral that clients are willing to provide.
Gross investment income increased by $7.2 million in 2000 to $43.4 million from $36.2 million in 1999 and $35.2 million in 1998. Net investment income, after adjusting for investment income payable to others, increased by 17% to $39.3 million in 2000 from $33.6 million in 1999 and $29.6 million in 1998. The increase in net investment income for 2000 includes $3.7 million of investment income from a special purpose entity, Endeavour Real Estate Securities Ltd ("Endeavour") recorded in the first quarter of 2000. In the second quarter of 2000, the ownership structure of Endeavour was changed so that it is no longer consolidated on a line by line basis, but is accounted for on an equity basis. The increase in net investment income for 1999 is due, in part, to the inclusion of investment income from one of the Company's programs, accounted for as claims deposit liabilities, which added $2.8 million for the year. Net invested assets decreased slightly to
Operating expenses increased 26% to $128.5 million in 1999 and by 21% to $155.5 million in 2000. The primary factors responsible for the increases in operating expenses were:
. the increased cost of administering the Company's highly regulated policy-issuing subsidiaries, as the volume of policies issued increased;
In the first quarter of 2000, the Company repurchased $222.0 million face amount of its convertible exchangeable subordinated debentures due 2015 at a cost of $101.3 million. As a result, the Company incurred an extraordinary loss on the extinguishment of the debentures of $4.3 million, net of tax.
As mentioned previously, the Company is involved in ongoing arbitration. Some of the Company's business has been unprofitable to reinsurers and certain of these reinsurers have chosen to dispute their obligation to pay the Company. As a result, it has experienced delays in recovering reinsurance payments in its Program Business segment. At December 31, 2000, the Company was involved in five arbitration proceedings to collect disputed balances due from reinsurers. The Company had paid $56.1 million in losses and loss expenses, for which it had not been reimbursed. In addition, the Company estimates that it will ultimately pay another $83.3 million in unpaid losses and loss expenses in relation to the disputed business.
In addition to the reinsurance disputes discussed above, the Company was involved in a terminated property program written in 1998 and 1999, where the Company acted as both a reinsurer and a direct writer of property insurance. In 1999, the Company established a reserve with respect to this terminated program of $4.7 million. The Company and its lead reinsurers, which also issued some of this business directly, are presently investigating this business and negotiating a cooperation agreement. The Company has denied certain reinsurance claims presented to it, which will be subject to arbitration. In addition, one of the Company's quota share reinsurers, representing approximately 6% of the Company's quota share reinsurance, is questioning certain ceded claims, and this dispute will also be the subject of arbitration.
These disputes have adversely affected operating cash flow, however the Company still produced positive cash flow from operations of $12.9 million during 2000, as compared to $20.6 million in 1999 and $62.4 million in 1998. The inability of the Company to settle these disputes favorably or in a timely manner will continue to strain its operating cash flow. The Company will attempt to aggressively resolve these disputes on acceptable terms. Any future reinsurance disputes could significantly affect future operating cash flow. The Company believes that its cash flow from Corporate Risk Management, Specialty Brokerage and Financial Services will not be affected by disputes and will assist the Company in financing its current operations and meeting its commitments under its debt facilities.
At the end of 2000 and 1999, 64% and 61% respectively of the Company's total marketable investments were held by the Company's policy-issuing subsidiaries in the United States. These companies are restricted by regulation in the amount of dividends they can pay without prior regulatory approval to $46.0 million in 2001 (based on 2000 results) and will continue to face these restrictions in the future. During 2000, they paid a dividend of $8.0 million. They are also required to maintain certain deposits with, or supply letters of credit to, regulatory authorities which totaled $190.6 million at December 31, 2000 ($63.8 million of deposits and $126.8 million of letters of credit) as compared to $166.4 million at December 31, 1999 ($59.6 million of deposits and $106.8 million of letters of credit).
On December 26, 2000, A. M. Best Company ("A.M. Best") lowered its financial strength rating of Legion from A to A-. This rating also applies to the five members of IPC Group. A.M. Best has expressed concerns regarding Legion's exposure to a high level of reinsurance recoverables, operational strain caused by rapid growth in program business over the past few years, the ongoing need to augment capital in support of rapid growth and reduced cash flow stemming from disputed reinsurance recoverables. These issues, combined with A.M. Best's view that the Company's financial flexibility has been reduced, resulted in this rating action. In February 2001, A.M. Best placed their rating under review with negative implications. A.M. Best has indicated that Legion requires additional capital to support its rating and that affirmation of the group's A- rating is dependent on the Company raising and contributing capital to Legion over the near term.
On March 1, 2001, Standard & Poor's Rating Services ("S&P") lowered its counter party credit and financial strength rating to A- and lowered its counter party credit and senior debt rating to BBB-. S&P also removed its CreditWatch status and gave these ratings a stable outlook.
A widely accepted factor used by regulators and rating agencies in evaluating insurance companies is the ratio of net premiums written to policyholders' surplus, which is an indication of the degree to which an insurer is leveraged. Because of the low level of net premiums written, the Company has experienced a relatively low ratio of approximately 0.6:1 in 2000, 0.6:1 in 1999 and 0.5:1 in 1998 and we expect to experience relatively low ratios in the future. Due to the nature of the Company's operations, a more appropriate indication of leverage is the ratio of gross premiums written to policyholders' surplus, which was 3.8:1 in 2000 and 3.6:1 in both 1999 and 1998. The National Association of Insurance Commissioners ("NAIC") has established that an "unusual value" for this ratio would be 9:1 or higher. The Company has adopted a policy that this ratio should not exceed 4:1.
NAIC has adopted a risk-based capital ("RBC") formula to be applied to all property/casualty insurance companies. The formula measures capital and surplus needs based on an insurance company's products and investment portfolio and is to be used as a tool to identify weakly capitalized companies. An insurance company that does not meet the threshold RBC measurement standards could be required to reduce the scope of its operations and ultimately could become subject to statutory receivership proceedings. At December 31, 2000, the Company's policy-issuing subsidiaries met the RBC requirements with a combined required risk-based capital of $161.9 million and an actual adjusted capital of $374.8 million (1999--$121.0 million and $347.4 million).
The Company does not believe its operations have been materially affected by inflation. The potential adverse impacts of inflation include: (a) a decline in the market value of the Company's fixed maturity investment portfolio; (b) an increase in the ultimate cost of settling claims which remain unresolved for a significant period of time; and (c) an increase in the Company's operating expenses. However, the Company generally holds its fixed-income investments to maturity and currently believes that an acceptable amount is included in the yield to compensate the Company for the risk of inflation. In addition, any increase from inflation in the ultimate cost of settling unpaid claims will be borne by the Company's clients and offset by investment income earned for the benefit of the client during the period that the claim is outstanding. Finally, the increase in operating expenses resulting from inflation should generally be matched by similar inflationary increases in the client's premium and the Company's fee income, which includes a fee based upon a percentage of the client's premium.
The tables below provide information about the Company's available for sale investments that are sensitive to changes in interest rates at December 31, 2000 and 1999, respectively. The tables present expected cash flows and related weighted-average interest rates by expected maturity dates. Separate account assets and liabilities are not included in this analysis as gains and losses related to these accounts generally accrue to the program holders. There were no material quantitative changes in market risk exposure between the current and preceding fiscal year with respect to available for sale investments.
During the year, the Company also entered into an agreement to acquire Valmet Group Ltd. ("Valmet"). Valmet is an independent fiduciary company, providing trust and corporate services through offices in the Isle of Man, Amsterdam, Geneva, Gibraltar, Cyprus, Dublin and Mauritius. Valmet employs 122 people and earned revenues of approximately $13.7 million in 2000. This transaction was completed in January 2001.
In June 1998, the Financial Accounting Standards Board issued Statement 133, "Accounting for Derivative Instruments and Hedging Activities" which was amended by Statement 138 in June 2000. The Statement requires the recording of all derivative instruments as assets or liabilities, measured at fair value and is effective for fiscal years beginning after June 15, 2000. The Company has had only limited involvement with derivative financial instruments and does not use them for trading or speculative purposes. They have been used to manage interest rate risk. The Company adopted FAS 133 on January 1, 2001. The Statement has not had a material impact on its financial position or results of operations.
The NAIC's codification of statutory accounting practices is effective for fiscal years beginning January 1, 2001. The rules affect the recording of certain assets and liabilities for statutory purposes, and, as a result, will have an impact on statutory surplus. The Company's adoption of this practice on January 1, 2001 has not decreased its statutory surplus.
Our consolidated financial statements for the years ended December 31, 2000, 1999 and 1998 are filed herewith in response to Item 14.