The Company leases its principal executive offices at 1105 North Market Street, Suite 1230, Wilmington, Delaware under an operating lease expiring in November 1999. RSLIC owns its home office building at 2501 Parkway, Philadelphia, Pennsylvania, which consists of approximately 100,000 square feet. SNCC also owns its home office building at 2043 Woodland Parkway, Suite 200, St. Louis, Missouri, which consists of approximately 58,000 square feet. DCM and FRSLIC lease their offices at 153 East 53rd Street, 49th Floor, New York, New York under an operating lease expiring in July 2008. The Company also maintains sales and administrative offices throughout the country to provide nationwide sales support and service existing business.
(1) Reflects the acquisitions of Unicover and Matrix in 1998 and SNCC in 1996. See Note B to the Consolidated Financial Statements. Amounts for 1994 include individual life insurance business, which the Company exited in July 1994.
(6) Diluted book value per share is calculated by dividing shareholders' equity, as increased by the proceeds and tax benefit from the assumed exercise of outstanding stock options, by total shares outstanding, also increased by shares issued upon the assumed exercise of the options and deferred shares.
(7) Return on average shareholders' equity is calculated by dividing income from continuing operations, excluding after-tax realized investment gains and losses, by average shareholders' equity, excluding after-tax realized investment gains and losses, discontinued operations, extraordinary items and changes in accounting principles, as determined as of the beginning and end of each year.
(8) The interest coverage ratio is calculated by dividing income from continuing operations before interest and income tax expense and dividends on the Capital Securities by interest expense (1996 excludes interest paid in connection with the settlement of prior-year federal income taxes).
The Unicover acquisition has been accounted for using the purchase accounting method, and goodwill recorded in connection therewith is presently being amortized on a straight-line basis over 25 years. However, due to the uncertainties discussed above as to Unicover's future business, the Company will on an ongoing basis review and assess, in light of future developments, the extent, if any, to which future additional consideration relating to the acquisition will be recorded as goodwill and the manner in which goodwill associated with this business is amortized or recovered. Any future determinations by the Company to decrease or eliminate amounts recorded as goodwill or to accelerate the amortization of goodwill would correspondingly increase the Company's expenses for the relevant period or periods. However, it is not possible at this time to predict whether any such determinations will be made or the extent of any related impact on future expenses. See Note B to the Consolidated Financial Statements.
Net Investment Income. Net investment income in 1997 was $162.4 million as compared to $157.0 million in 1996, an increase of 3%. The increase is primarily due to an increase in average invested assets as a result of the acquisition of SNCC, the investment of a portion of the proceeds from the issuance of the Capital Securities and net cash provided by operating activities, partially offset by a decrease in the weighted average yield. The 1996 investment results reflect strong performance by the Company's independent investment managers program. The weighted average annual yield on invested assets, excluding realized and unrealized investment gains and losses, was 7.9% on average invested assets of $2,048.2 million in 1997 and 8.6% on average invested assets of $1,822.1 million in 1996.
Net Realized Investment Gains (Losses). The Company's investment strategy results in periodic sales of securities and the recognition of realized investment gains and losses. Net realized investment gains were $14.6 million in 1997 as compared to net realized investment losses of $2.7 million in 1996. During 1997, the Company reevaluated the amortization period for deferred futures losses associated with its mortgage-backed securities portfolio due to a decline in market interest rates to record low levels and accelerated the amortization by $9.9 million.
Dividends on Capital Securities. In March 1997, Delphi Funding issued $100.0 million of Capital Securities in a public offering. See Note J to the Consolidated Financial Statements.
Other sources of liquidity at the holding company level include interest and principal payments made on a surplus debenture (the "Surplus Debenture") issued by RSLIC-Texas to the Company, dividends paid from subsidiaries, primarily generated from operating cash flows and investments, and borrowings available under the Credit Agreement. At December 31, 1998, the unpaid principal balance of the Surplus Debenture, which is payable in quarterly installments through September 1999, was $18.3 million. Payments on the Surplus Debenture are generally funded by dividend payments made by RSLIC to RSLIC-Texas. During 1999, RSLIC will be permitted, without prior regulatory approval, to make dividend payments of $19.6 million. In addition, SNCC will be permitted, without regulatory or other approval, to make dividend payments of $20.7 million in 1999. Additional
dividends may also be paid by RSLIC and SNCC with the requisite approvals. See "Business-Regulation." In general, dividends from the Company's non-insurance subsidiaries are not subject to regulatory or other restrictions. As of December 31, 1998, the Company had $71.0 million of borrowings available to it under the Credit Agreement.
Furthermore, the terms of each of the SNCC, Matrix and Uncover acquisitions provide for the payment of additional consideration to the former shareholders of each of the acquired companies based on, in the case of the SNCC and Matrix acquisitions, the attainment of certain earnings targets and, in the case of the Unicover acquisition, varying multiples of pre-tax cash flow. See Note B to the Consolidated Financial Statements.
At December 31, 1998, 35% of the Company's total invested assets were comprised of mortgage-backed securities, of which 40% are guaranteed by U.S. Government sponsored entities as to the full amount of principal and interest and the remaining 60% consists of investments in trusts created by banks and finance and mortgage companies. Ninety-eight percent of the Company's mortgage-backed securities portfolio, based on fair values, have been rated as investment grade by nationally recognized statistical rating organizations. The single largest investment in mortgage-backed securities backed by a single mortgage pool totaled $64.9 million, or 3% of total invested assets, at December 31, 1998.
The Company periodically analyzes the results of its asset/liability matching through cash flow analysis under multiple interest rate scenarios. These analyses enable the Company to measure the potential gain or loss in fair value of its interest-rate sensitive financial instruments due to hypothetical changes in interest rates. Based on these analyses, if interest rates were to increase by 10% from their December 31, 1998 levels, the fair value of the Company's interest-sensitive assets, net of corresponding changes in the fair value of cost of business acquired and insurance and investment-related liabilities, would decline by approximately $69.8 million. These analyses incorporate numerous assumptions and estimates and assume no changes in the Company's investment portfolio in reaction to such interest rate changes. Consequently, the results of this analysis will likely be different from the actual changes experienced under given interest rate scenarios, and those differences may be material.
The Company manages the composition of its borrowed capital by considering factors such as the ratio of borrowed capital to total capital, future debt requirements, the interest rate environment and other market conditions. Approximately 51% of the Company's corporate debt was issued at fixed interest rates. A hypothetical 10% decrease in market interest rates would cause a corresponding $2.1 million increase in the fair value of the Company's fixed-rate corporate debt. Because interest expense on the Company's floating-rate corporate debt fluctuates as prevailing interest rates change, changes in market interest rates would not materially affect its fair value.
The Company estimates that total internal (opportunity costs) and external (out-of-pocket) pre-tax costs for addressing the year 2000 issue will be approximately $7.4 million, of which $5.4 million will be expensed as incurred and $2.0 million will be capitalized and amortized over the life of the replacement computer systems. During 1997 and 1998, the Company incurred $5.4 million of costs to address the year 2000 issue of which $3.8 million was expensed and $1.6 million was capitalized.
The Company has also requested assurances of year 2000 compliance from third parties, the failure of whose computer systems to be year 2000 compliant may have a significant impact on the Company's operations, in an effort to identify and address potential problems arising from such non-compliance. There can be no assurance, however, that the Company's operations will not be adversely impacted by such non-compliance on the part of one or more such third parties.
Failure by the Company or significant third parties to successfully address year 2000 issues could have a material adverse impact on the operations and financial condition of the Company. During 1999, the Company expects to finalize and have ready for implementation appropriate contingency plans in the event any of the computer systems of the Company or significant third parties are not year 2000 compliant. If the Company's internal computer systems failed due to the year 2000 issue, the Company would be forced to return to a paper-based system on an interim basis until the problem could be resolved. With regard to third parties, the Company would attempt to implement alternative arrangements where possible if year 2000 problems are encountered as to these parties. The Company does not believe that these scenarios are reasonably likely due to planned testing and problem resolution of all mission critical systems prior to any anticipated material impact of the year 2000 issue; however, no assurance can be given in this regard.
In connection with, and because it desires to take advantage of, the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, the Company cautions readers regarding certain forward-looking statements in the above "Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere in
this Form 10-K and in any other statement made by, or on behalf of, the Company, whether or not in future filings with the Securities and Exchange Commission. Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results or other developments. Some forward-looking statements may be identified by the use of terms such as "expects," "believes," "anticipates," "intends" or "judgment." Forward-looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond the Company's control and many of which, with respect to future business decisions, are subject to change. Examples of such uncertainties and contingencies include, among other important factors, those affecting the insurance industry generally, such as the economic and interest rate environment, legislative and regulatory developments and market pricing and competitive trends, and those relating specifically to the Company and its businesses, such as the level of its insurance premiums and fee income, the claims experience of its insurance products, the performance of its investment portfolio, the successful completion by the Company of its year 2000 compliance program, acquisitions of companies or blocks of business, the ratings by major rating organizations of its insurance subsidiaries, and, as to its Unicover subsidiary, the uncertainties and related matters described in "Management's Discussion and Analysis of Financial Condition and Results of Operations." These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. The Company disclaims any obligation to update forward-looking information.