The Company owns a three-story office building in Rock Hill, New York, in which its executive offices and insurance operations for Frontier are located, a one-story building in Rock Hill, New York, which it uses for storage, a portion of which is rented, and a one-story office building in Charlotte, North Carolina from which Regency conducts its operations. The Company also owns an airplane and a hanger at a local airport.
The Company leases office space at 39 locations in 18 states at an aggregate monthly rental of approximately $376,000.
The following discussion and analysis should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this Annual Report.
The following table sets forth the expense components of the Company's combined ratio calculated as a percentage of net premiums earned on the basis of generally accepted accounting principles ("GAAP Combined Ratio") for the three years indicated:
The increase in general liability net premiums earned was primarily attributable to increased business written in the Environmental, Excess and Surplus Lines Division, primarily due to the acquisition of ECI, and to increased writings in the Specialty Programs Division in various programs such as camp, pest control and artisan contractors. These increases were partially offset by decreases in the Specialty Programs Division, primarily due to a discontinued program for apartment owners, and to decreased writings of excess workers' compensation in the Alternative Risk Division due to competition.
The growth in commercial multi-peril net premiums earned was due to increased writings in the Health Care Division, primarily in day care and other health care facilities and institutions.
The growth in specialty personal lines and credit-related products was due to increased volume as a result of the acquisitions of Lyndon and Acceleration and to increased business in the mobile homeowners program.
Net investment income before realized capital gains and losses increased 31.0% due principally to increased cash flow from operations and the contribution to net investment income from the acquisitions made in 1997, partially offset by the interest charge on funds held by the Company for the benefit of the reinsurer of the Company's aggregate excess of loss reinsurance contract.
The increase in losses and LAE was primarily due to a $155 million reserve strengthening in the medical malpractice, general liability and surety lines of business. The increase in medical malpractice losses and LAE was primarily due to poor results in business written for individual physician malpractice in various states, primarily in the state of Ohio, and to adverse reserve development in the large account program. The increase in losses and LAE in the general liability and surety lines was primarily due to adverse reserve development in LAE for accident years prior to 1998 in the Alternative Risk, Health Care, and Specialty Programs Divisions for general liability and for surety in the Surety Division.
The foregoing changes resulted in a net loss before taxes of $90.9 million for the year ended 1998 versus net income before taxes of $45.8 million for 1997.
Net premiums earned for the workers' compensation line decreased primarily as a result of decreases in the specialty niche programs for the cotton gin and feed lots written in the Specialty Programs Division and in the Health Care Division in programs associated with social services due to price competition. This decrease was partially offset by increases in the captive and rent-a-captive programs written in the Alternative Risk Division.
The growth in specialty personal lines and in the credit-related products lines was due to increased volume written in the Personel and Credit-Related Division as a result of the acquisition of Lyndon and to increased business in the mobile homeowner's program.
The increase in losses and LAE was primarily due to a $35 million reserve increase in the medical malpractice line in the Health Care Division, primarily due to adverse reserve development in accident years prior to 1995.
The Company limits the extent of its credit risk by purchasing securities backed by stable collateral with enhanced priority in the securitization structure. The credit risk is minimized as the majority of the Company's mortgage-backed portfolio is guaranteed by U.S. government-sponsored entities or are supported in the securitization structure by junior securities resulting in bonds with high investment grade ratings. The portfolio is actively managed to minimize the Company's exposure to prepayment and extension risk. As of December 31, 1998, the Company's asset and mortgage-backed holdings were rated Aa1 and Aaa, respectively, by Moody's.
The liquidity needs of the Company's insurance subsidiaries are generally met through cash provided by operating activities. However, during 1998, additional funds of approximately $62.6 million were contributed to the insurance subsidiaries as a result of significant reserve strengthening and the need to maintain certain minimum surplus levels. Such funds were obtained through the Company's $150 million credit facility with Deutsche Bank AG, New York Branch, of which $58 million remained available to the Company at December 31, 1998. Under the terms of the credit facility, the Company is subject to certain financial and non-financial covenants, some of which restrict its ability to dispose of assets, incur additional indebtedness and require the maintenance of a minimum level of consolidated shareholders' equity.
Cash flow needs at the holding company level primarily include corporate operating expenses and interest payments on outstanding debt, for which funding is provided through management fees charged to the Company's subsidiaries. Net proceeds of $144.5 million from a Common Stock offering in 1997 and $166.7 million from the sale of Convertible TOPrS during 1996 provided the principal funding for the strategic acquisitions completed during the three years ended December 31, 1998 (see Note C of the Notes to the Consolidated Financial Statements).
The Company has authorized a stock repurchase plan for up to 3 million shares of its Common Stock under which it repurchased 668,300 shares at a cost of $8.5 million during 1998. Although the Company plans to continue to repurchase its Common to the extent market conditions make such repurchases strategically advantageous, it has no commitment or obligation to purchase any particular number of shares and the program may be suspended at the Company's discretion.
The Company continually monitors existing and alternative financing sources to support the Company's capital and liquidity needs, including, but not limited to debt issuance and preferred or Common Stock issuance.
A.M. Best's and S&P's ratings are based on an analysis of financial condition and operations of an insurance company as they relate to the industry in general, are not designed for the protection of investors and do not constitute recommendations to buy, sell, or hold any security.
In its ongoing effort to improve solvency regulation, the NAIC and individual states have enacted certain laws and financial statement changes. The NAIC has adopted Risk-Based Capital ("RBC") requirements for insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks, such as asset quality, mortality and morbidity, asset and liability matching, benefit and loss reserve adequacy, and other business factors. The RBC formula is used by state insurance regulators as an early
At December 31, 1998 and 1997, the ratios of total adjusted capital to authorized control level RBC for the Company's insurance subsidiaries were in excess of 2.5 to 1.
In addition, state insurance statutes typically place restrictions on the maximum amount of dividends or other distributions that may be made by insurance companies to their shareholders without obtaining prior regulatory approval. Such restrictions are typically related to the insurance companies statutory capital and surplus. (See Note Q of the Notes to the Consolidated Financial Statements.)
Effective January 1, 1998, the Company entered into a stop loss reinsurance agreement with Zurich N.A. for the 1998 and 1999 accident years. The new agreement included selected programs underwritten by United Capitol, Western, and selected core programs of Frontier and Frontier Pacific, which were not part of the original 1995-1997 reinsurance agreement. Under the terms of the new agreement, Zurich N.A. provided reinsurance protection within certain contract aggregate dollar limits for losses and LAE in excess of a predetermined ratio of these expenses to earned premiums for a given accident year for the covered insurance programs.
Discussions are continuing with respect to the cases not included in the agreement with the State and, to the extent the amount of the actual recovery varies from the recorded subrogation recoveries of $12 million, such difference will be reported in the period recognized. The Company is continuing to defend all SUNY faculty members against malpractice claims that have been asserted and is maintaining reserves adjusted for the anticipated recoveries.
To date, the costs related to Year 2000 compliance efforts are approximately $2 million and have been expensed as incurred. Total costs are not expected to exceed $3 million and will continue to be funded out of operating cash flows. However, anticipated costs could be adversely affected by the continued need for availability of personnel and system resources, as well as any failure by third-party vendors, service providers, or agencies to properly address Year 2000 issues. The impact of achieving Y2K compliance has not caused a significant delay in other IT related development efforts.
The Company has also conducted a comprehensive review of its underwriting guidelines and is seeking regulatory approval of an endorsement to be added to all commercial property and casualty policies which would clarify that coverage is not afforded losses resulting from Year 2000 noncompliance by insureds. Upon approval, this endorsement is being added to each policy at either issuance or renewal. Underwriting policy and protocol have been developed to address nonapproving states and business situations that cannot be endorsed. To date, the Company has received endorsement approval from 41 states and the District of Columbia. For these reasons, the Company believes its exposure to Year 2000 claims will not be material to its operations or financial condition. However, due to social and legal trends, it is impossible to predict what, if any, exposure insurance companies generally may have relating to Year 2000 claims.
A contingency plan is currently being developed which will delineate the Company's responsibilities in the event that Year 2000 compliance is not achieved due to internal or external factors. These plans involve, among other things, manual workarounds, additional paper-based report development and adjusting staffing strategies. The Company recognizes the need for a contingency plan, but given the status of its current Y2K efforts does not anticipate having to rely on the plan. The Company expects to continue to conduct periodic tests of its systems throughout 1999 to complete testing for various conditions, and to further ensure continued Year 2000 compliance is maintained.
The Company believes it has an effective program in place to resolve Year 2000 issues in a timely manner. However, risks remain that as yet untested or undiscovered computer system problems will emerge. In addition, disruptions in the economy generally resulting from the Year 2000 could also materially adversely affect the Company, rendering it unable to receive premiums or settle its insureds' claims in a timely manner. In addition, the Company could be subject to litigation for claims related to its insureds' Year 2000 exposures.
Following the Company's November 5, 1994 announcement of its third-quarter financial results, the Company was served with seven purported class actions alleging violations of federal securities laws by the Company and, in some cases, by certain of its officers and directors. In September 1995, a pre-trial order was signed which consolidated all actions in the Eastern District of New York, appointed three law firms as co-lead counsel for the plaintiffs and set forth a timetable for class certification, motion practice and discovery. In November 1995, plaintiffs served a consolidated amended complaint alleging violations by the Company of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10(b)(5) thereunder, seeking to impose controlling person liability on certain of the Company's officers and directors, and further alleging insider sales, all premised on negative financial information that should have been publicly disclosed earlier. Plaintiffs seek an unspecified amount in damages to be proven at trial, reasonable attorney fees and expert witness costs. In April 1997, the Court certified the class. Plaintiffs have subpoenaed documents and deposed outside auditors and analysts. Plaintiffs have also taken depositions from current or former officers, directors and employees of the Company. The Company believes the suit is without merit, has retained special legal counsel to contest this suit vigorously and believes that the Company's exposure to liability, if any, thereunder would not have a material adverse effect on the Company's financial condition.