The other information called for by this item can be found in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operation and Item 8, Financial Statements and Supplementary Data.
The property and casualty reinsurance industry is currently in its ninth consecutive year of soft market conditions. Competition has increased in recent years as a result of the ability of companies to raise additional capital through public and other financing and the use of both traditional and non-traditional reinsurance products. The level of excess capital has also been aided by favorable financial markets and the lower than normal number of major catastrophe losses in the last several years. These factors have mitigated any positive impact which may have occurred from the decline in the number of reinsurance companies through withdrawal or acquisition. Companies are now larger, offer significantly more capacity to ceding companies and have greater access to capital through capital markets or their parent organizations. Further, Lloyd's of London has rebounded from a period of uncertainty and is now aggressively competitive. The result is an oversupply of capacity in the reinsurance industry, which is more than capable of writing the current level of domestic premiums. In 1997, domestic premiums as reported by the RAA amounted to $19.9 billion, an increase of 5.3% compared to $18.9 billion, in 1996.
UNUM Corporation), the largest provider of accident and health reinsurance in the United States. As a result of these initiatives, Trenwick has established itself as one of the leading broker market reinsurers in the United States. On February 27, 1998, the Company expanded its product mix through the acquisition of SOREMA (UK) Limited (renamed Trenwick International Limited), a London market company, which underwrites specialty types of insurance and reinsurance on a worldwide basis.
Net and gross property business declined primarily as a result of PXRE Re's (the Company's strategic partner in the writing of catastrophe reinsurance) conservative response to continued erosion in pricing in that segment of the reinsurance business and represented approximately 10% of total premium writings for the year ended December 31, 1997. During 1995, Trenwick modified its process of estimating premiums from ceding companies, resulting in an increase in accruals for unreported premiums written at December 31, 1997 of $14.1 million as compared to 1996, and an increase of $15.1 million in 1996 over 1995. These estimated premiums did not materially affect the Company's earnings in 1997, 1996 or 1995.
The following table sets forth Trenwick's combined ratios and the components thereof calculated on a GAAP basis for the periods indicated, together with Trenwick America Re's combined ratios calculated on a statutory basis:
Net investment income in 1997 of $48.4 million increased 17% compared to net investment income of $41.2 million in 1996. Net investment income in 1996 increased 12% compared to net investment income of $36.8 million in 1995. Pre-tax yields on invested assets, excluding equity securities, increased to 6.4% in 1997 from 6.3% in 1996 and decreased from 6.5% in 1995. The fluctuation in yield reflected the composition of the maturing securities. During 1997, yields on the approximately $79 million of maturities were lower than yields on the approximately $63 million of maturities in 1996. In 1997, maturities included $31 million in principal repayments associated with Trenwick's portfolio of structured and agency pass-through securities compared to $24 million in 1996. As a result of the decrease in interest rates during 1997, principal repayments are expected to remain similar or increase marginally in 1998. The increase in investment income from 1996 to 1997 is due to the continued growth in Trenwick's invested asset base. This growth resulted primarily from funds received of $29.7 million from the aggregate excess of loss commutation recorded in December 1996, coupled with approximately $61 million of net funds received in January 1997 from Trenwick's private offering of $110 million in 8.82% Subordinated Capital Income Securities. The remaining proceeds were used to redeem the Company's convertible debentures. Investment income is expected to increase in 1998 as the Company's invested asset base continues to grow. During 1997, the Company sold approximately $31 million of U.S. government and agency securities and reinvested the proceeds primarily in structured securities in order to increase the overall yield of the portfolio.
Trenwick's income before extraordinary item was $36.3 million, or $3.12 per share compared to $33.8 million, or $3.40 per share for 1996. Weighted average shares outstanding for 1997 were increased by 1,784,000 common shares issued in February 1997 when $57.7 million of Trenwick's debentures converted. On a diluted basis, income before extraordinary item for 1997 was $3.01 per share, compared to $2.85 per share for 1996. In 1997, Trenwick recorded an extraordinary loss of $1.0 million, net of income taxes, associated with the redemption of $45.8 million principal amount of its 6% convertible debentures. There were no extraordinary items in 1996.
At December 31, 1997, Trenwick had investments and cash of $864.3 million, an increase of 15% compared to investments and cash of $754.2 million at December 31, 1996. This increase resulted principally from cash provided by financing and operations. In addition to dividends paid to stockholders, financing cash flow included $61 million of net funds received in January 1997 from Trenwick's private offering of $110 million in 8.82% Subordinated Capital Income Securities. The remaining proceeds were used to redeem the Company's convertible debentures. All debt and equity investments are classified as "available for sale" and reported at fair value, with the unrealized gain or loss, net of income taxes, reported in a separate component of stockholders' equity. Since December 31, 1996, the market value of the Company's debt and equity investments increased approximately $13.0 million. In 1996, Trenwick's investments and cash increased by $100.5 million or approximately 15% when compared to 1995. That increase resulted principally from cash provided by operations reduced by dividends paid to stockholders. Operating cash flow included $29.7 million received in December 1996 for the commutation of a reinsurance agreement covering the years 1989 through 1993.
The average maturity of debt securities at December 31, 1997 was 6.2 years compared to 6.0 years at December 31, 1996. During 1997, the proceeds from sales and maturities of taxable and tax-exempt securities of $117.8 million, together with cash provided by financing and operations, were invested primarily in taxable securities consisting of mortgage-backed securities of $72 million, asset-backed securities of $33 million, U.S. government and agency securities of $28 million and corporate bonds of $30 million. In addition, $39 million of tax-exempt securities were purchased along with $9 million of preferred stock and $6 million of common stock. Debt securities were invested in the average maturity range of between two to fifteen years. During 1996, the proceeds from sales and maturities of taxable and tax-exempt securities of $93.1 million, together with cash provided by operations, were invested primarily in taxable securities consisting of mortgage-backed securities of $41 million, asset-backed securities of $24 million, U.S. government securities of $18 million, preferred stock of $12 million and corporate bonds of $5 million. The proceeds were also used to invest in $87 million of tax-exempt securities.
Trenwick is a holding company whose principal asset is its investment in the common stock of Trenwick America Re. As a holding company, Trenwick's principal source of funds consists of permissible dividends and tax allocation payments from Trenwick America Re and investment income on Trenwick's fixed-income portfolio. Trenwick's principal uses of cash are dividends to its stockholders and servicing its debt obligations. Trenwick America Re receives cash from premiums, investment income and proceeds from sales and maturities of portfolio investments and utilizes cash to pay claims, purchase its own reinsurance protections, meet operating and capital expenses and purchase fixed-income and equity securities.
In January 1997, Trenwick completed a private offering of $110 million in 8.82% Subordinated Capital Income Securities due February 1, 2037 through Trenwick Capital Trust I, a Delaware statutory business trust. In connection with this offering, on February 20, 1997, Trenwick called for redemption all $103.5 million aggregate principal amount of the Company's 6% convertible debentures due December 15, 1999, at a redemption price of 102.57% principal amount plus accrued interest to the redemption date. Of the $103.5 million principal amount of debentures outstanding on that date, $45.8 million principal amount were redeemed and $57.7 million principal amount were converted into an aggregate of 1.8 million shares of Trenwick's common stock.
Cash provided by operating activities of $47 million in 1997 decreased approximately 57% as compared to $110.5 million in 1996. In 1996, Trenwick commuted an aggregate excess of loss retrocessional agreement covering the years 1989 through 1993 for which Trenwick received a total consideration of $29.7 million representing outstanding reserves of approximately the same amount. The commutation was recorded in 1996 as a paid loss recovery. Trenwick expects that its cash provided by operating activities will be sufficient to meet its operating and financing requirements in 1998 and its longer term operating needs.
At December 31, 1997, Trenwick's investments and cash of $864.3 million exceeded total liabilities, including gross reserves for claims and claims expenses of $518.4 million, by $244.1 million, compared to $99.2 million and $73.6 million at December 31, 1996 and 1995, respectively. At December 31, 1997, 1996 and 1995, Trenwick's net book value amounted to $357.6 million, $265.8 million and $240.8 million, respectively. Trenwick maintains a portion of its investment portfolio in cash equivalents which are available in the event of unanticipated changes in cash requirements. At December 31, 1997, Trenwick's investments consisted principally of fixed-income securities, 88% of which are rated Aa or better. Trenwick's general policy is to hold these securities to maturity. However, there may be business reasons which would cause all or a portion of these securities to be made available for sale prior to maturity; therefore, Trenwick records these investments at fair value, with market value fluctuations reflected in stockholders' equity, net of income taxes (see Note 1 to Consolidated Financial Statements).
The ratio of net premiums written to surplus, the "surplus ratio", relates to the amount of risk to which an insurer's or reinsurer's statutory capital is exposed, as measured by the amount of premiums written in relation to such surplus. Property and casualty reinsurance companies currently have a surplus ratio of approximately 0.7:1. Trenwick America Re's surplus ratios were 0.6:1 for 1997 and 0.8:1 for both 1996 and 1995. Accordingly, Trenwick has sufficient surplus capacity to write additional business without significantly exceeding the industry average.
Trenwick purchases reinsurance to reduce its exposure to catastrophe claims and the frequency and severity of claims in all lines of business. In 1997, Trenwick's reinsurance treaties consisted principally of an excess of loss treaty for its facultative casualty business and property catastrophe reinsurance treaties. In addition, Trenwick purchased an annual aggregate excess of loss ratio treaty for casualty business effective January 1, 1997. These coverages were renewed effective January 1, 1998.
The National Association of Insurance Commissioners (NAIC) has adopted Risk-Based Capital (RBC) requirements for property and casualty insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, asset and liability matching, loss reserve adequacy and other business factors. The RBC formula is used by state insurance regulators as an early warning tool to identify, for the purpose of initiating regulatory action, insurance companies that potentially are inadequately capitalized. In addition, the formula defines minimum capital standards that supplement the system of low fixed minimum capital and surplus requirements on a state-by-state basis. Regulatory compliance is determined by a ratio of the enterprise's regulatory total adjusted capital to its authorized control level RBC, as defined by the NAIC. Enterprises below specific trigger points or ratios are classified within certain levels, each of which requires specific corrective action. The ratios of Total Adjusted Capital to Authorized Control Level RBC for Trenwick America Re exceeded all the RBC trigger points at December 31, 1997. Trenwick believes its capital will continue to exceed these RBC capital and surplus requirements for the foreseeable future.
Consolidated Statement of Income for the three years ended December 31, 1997................................30
Realized gains or losses on disposition of investments are determined on the basis of the specific identification method. Investment income consisting of dividends and interest, net of investment expenses, is recognized in income when earned. The amortization of premiums and accretion of discount for debt securities is computed utilizing the interest method. Structured securities, anticipated prepayments and expected maturities are used in applying the interest method. When actual prepayments differ significantly from anticipated prepayments, the effective yield is recalculated to reflect actual payments to date and anticipated future payments. The net investment in the security is adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the security and that adjustment is included in net investment income.
Policy acquisition costs are stated net of policy acquisition costs ceded and consist of commissions and brokerage expenses incurred at policy or contract issue date. These costs vary with, and are primarily related to, the acquisition of business and are deferred and amortized over the period in which the related premiums are earned. Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed recoverable amounts after allowing for anticipated investment income.
Effective December 31, 1997, Trenwick adopted a new accounting standard, "Earnings Per Share", which specifies the computation, presentation and disclosure requirements of earnings per share and supersedes the previous standard. It requires a dual presentation of basic and diluted earnings per share. Basic earnings per share, which excludes the effect of common stock equivalents, replaces primary earnings per share. Diluted earnings per share, which utilizes the average market price per share as opposed to the greater of the average market price per share or ending market price per share when applying the treasury stock method in determining common stock equivalents, replaces fully-diluted earnings per share. In this report, all per share amounts prior to 1997 have been restated to comply with this standard.
The fair value and amortized cost of debt securities at December 31, 1997 are shown below by contractual or expected maturity periods. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalty. The maturities for mortgage-backed and asset-backed securities are calculated using expected maturity dates, adjusted for anticipated prepayments.
Debt securities with a carrying value of $102,921,000 are being held in trust as collateral for certain reinsurance obligations. In addition, investments with a carrying value of $7,962,000 at December 31, 1997 were on deposit with various state or governmental insurance departments in order to comply with insurance laws.
NOTE 3 REINSURANCE ACTIVITY AND RESERVE FOR UNPAID CLAIMS AND CLAIMS EXPENSES
Activity in the reserve for unpaid claims and claims expenses, net of reinsurance recoverable, for the years ended December 31 is summarized below:
Due to the inherent uncertainties of estimating insurance company claim reserves, actual claims and claims expenses may deviate, perhaps substantially, from estimates of Trenwick's reserves reflected in Trenwick's consolidated financial statements. Trenwick's management believes that its claim reserve methods are reasonable and prudent and that Trenwick's reserve for claims and claims expenses at December 31, 1997 are adequate.
Trenwick's exposure to environmental claims, including asbestos and pollution liability, is primarily associated with its participation in business written by its predecessor company between 1978 and 1983. Exposure to environmental claims on Trenwick's business written since 1983 is generally limited by exclusions on its own reinsurance contracts and also by exclusions on policies issued by ceding companies. Casualty business written in 1983 and prior is not material to Trenwick's overall book of business. As of December 31, 1997, outstanding claims including incurred but not reported claims for environmental liability were approximately $8,800,000, approximately 2% of Trenwick's total net outstanding reserves.
(in thousands) 1997 1996 ---- ---- Paid claims $ 1,267 $ 1,505 Unpaid claims and claims expenses 139,036 80,290 Funds held liability (60,967) (33,353) Reinsurance balances payable (12,975) (670) --------- -------- Reinsurance recoverable balances, net $ 66,361 $ 47,772 ========= ========
Trenwick America Re purchases reinsurance to reduce its exposure to catastrophe losses and the frequency of large losses in all lines of business. Trenwick America Re, however, remains liable in the event that its retrocessionaires do not meet their contractual obligations.
At December 31, 1997, letters of credit in the amount of $1,945,000 have been arranged in favor of Trenwick America Re in respect of certain outstanding claims recoverable and the unearned portion of premiums ceded.
At December 31, 1997, approximately $76,346,000 and $33,517,000 of reinsurance recoverables on unpaid claims and claims expenses are recoverable from Centre Reinsurance Company of New York and Continental Casualty Company, respectively. There are no prepaid reinsurance premiums which relate to these reinsurers.
For the years ended December 31, 1997, 1996 and 1995, Trenwick America Re earned commissions on cessions to retrocessionaires of $4,503,000, $1,235,000 and $13,000, respectively.
Trenwick files a consolidated United States income tax return with its United States subsidiaries. In 1997, the income tax provision includes an income tax benefit of $558,000 applicable to an extraordinary loss on debt redemption. The components of the provision for income taxes for the years ended December 31 are as follows:
Trenwick's effective income tax rates were 23% for the years ended December 31, 1997 and 1996 and 22% for the year ended December 31, 1995. The income tax provision for each of the years presented differs from the amounts determined by applying the applicable U.S. statutory federal income tax rate of 35% to income before income taxes as a result of the following:
The components of the net deferred income tax provision for the years ended December 31 are as follows:
Deferred income tax assets (liabilities) are attributable to the following temporary differences as of December 31:
Trenwick's management has concluded that the deferred income tax assets are more likely than not to be realized. Therefore, no valuation allowance has been provided. Estimates used in the development of the net deferred income tax assets may change in the near term.
which has not already been paid out as dividends. The amount of dividends or other distributions that could be paid by Trenwick America Re without prior approval as of December 31, 1997 was $84,392,000.
The differences between GAAP and statutory accounting practices for Trenwick America Re are the treatment of acquisition costs, deferred income taxes, other deferred charges and the carrying value of debt securities. The following tables set forth a reconciliation of Trenwick America Re's net income and statutory surplus, as filed with the insurance regulatory authorities, to its net income and stockholders' equity as determined in accordance with GAAP for the years ended and as of December 31:
Trenwick has 2,000,000 shares of $.10 par value preferred stock authorized and none outstanding.
On March 6, 1997, Trenwick's Board of Directors approved a three-for-two common stock split which was paid on April 15, 1997 to stockholders of record at the close of business on March 18, 1997. An amount equal to the par value of the additional shares issued has been transferred from additional paid-in capital to common stock. All share and per share data have been retroactively restated to reflect the common stock split.
Trenwick applies the provisions of the previous opinion and related interpretations in accounting for its stock-based compensation plans. Since stock options under Trenwick's plans are issued at fair market value on the date of grant, no compensation expense has been recognized for these stock options. Had Trenwick applied the fair value based method, net income and net income per share would have been the pro forma amounts indicated below:
The pro forma adjustments relate to options granted during 1995, 1996, and 1997 for which a fair value on the date of grant was determined using the Black-Scholes option pricing model. No effect has been given to options granted prior to 1995. Valuation and related assumption information are presented below:
Trenwick awards restricted common stock to key employees, primarily under the terms of the 1989 Stock Plan. In 1997, 9,782 shares were awarded at an average value of $33.42 per share (approximately
Trenwick has a pension plan and a 401(k) savings plan for substantially all full-time employees. Effective July 1, 1995, Trenwick contributes 8% of an eligible employee's total compensation to the pension plan. Prior to this date, Trenwick contributed 4% of an eligible employee's total compensation, plus 3% of the eligible employee's total compensation above the FICA limit. No employee contributions are made to the plan. Effective January 1, 1996, Trenwick matches 100% of employees' contributions to the savings plan up to 6% of each eligible employee's total compensation. Prior to January 1, 1996, Trenwick matched 100% of employees' contributions up to the lesser of 6% of an eligible employee's total compensation or $2,000. Assets of both plans are administered by life insurance companies. Trenwick's contributions to the pension plan were $503,000, $432,000 and $297,000 for 1997, 1996 and 1995, respectively; its contributions to the savings plan were $330,000, $314,000 and $122,000 for 1997, 1996 and 1995, respectively.
In the event that an acquiror accumulates 15% or more of Trenwick's common stock, all rights holders except the acquiror may purchase, for the exercise price, in lieu of the Series B Junior Participating Preferred Stock, shares of common stock of Trenwick having a market value of twice the exercise price of each right. If Trenwick is acquired in a merger or other business combination after the acquisition of 15% of Trenwick's common stock, all rights holders except the acquiror may purchase the acquiror's shares at a similar discount. Trenwick is entitled to redeem the rights at $0.01 per right, subject to certain restrictions. The rights will expire on September 23, 2007.
A reconciliation of cash provided by operations for the three years ended December 31 is as follows:
Total office rent expense for the years ended December 31, 1997, 1996 and 1995 was $917,000, $918,000 and $883,000, respectively.