Selected consolidated income statement data and ending balance sheet data for each of the five years ended December 31, 2000, follows:
(a) Includes the acquisitions of PCA and Risk Capital as well as the gain on the Dexia Sale. (b) Includes gains resulting from the VGI Sale and the Mortgage Banking Sale. (c) Includes the interim period income statement and ending balance sheet of Folksamerica which was consolidated during 1998. (d) Reflects a significant repayment of long-term debt by Folksamerica during 2000. See Note 7. (e) Deferred credits added during 1999 resulted from the purchase of IAG and exercises of FSA Options. See Note 1. (f) Deferred credits added during 1998 resulted from the consolidation of Folksamerica. See Note 1. (g) Reflects reductions in shareholders' equity resulting from significant repurchases of Shares from 1996 to 1999. (h) As adjusted for the dilutive effects of outstanding options and warrants to acquire Shares. (i) Book value per Share plus unamortized deferred credits less goodwill per Share.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998
White Mountains reported net income from continuing operations of $312.9 million for the year ended December 31, 2000, which compares to $108.4 million for 1999 and $51.1 million for 1998. Net income from continuing operations for 2000 and 1999 includes $385.8 million and $103.9 million, respectively, in pretax gains from sales of subsidiaries and insurance assets.
Net income was $407.9 million for the year ended December 31, 2000, which compares to $121.0 million for 1999 and $78.5 million for 1998. Net income for 2000, 1999 and 1998 includes income from discontinued operations of $95.0 million, $12.6 million and $27.4 million, respectively.
Folksamerica's results for the three years ended December 31, 2000, 1999 and 1998 included $312.5 million, $211.0 million and $238.1 million of earned reinsurance premiums, respectively, and $275.9 million, $182.2 million and $170.3 million of losses and loss adjustment expenses, respectively. For 2000 Folksamerica's statutory combined ratio was 126.3% versus a statutory combined ratio of 122.5% and 108.0% for the comparable 1999 and 1998 periods.
Folksamerica's 2000 statutory combined ratio of 126.3% reflects the effects of $111.1 million in premiums ceded in the 2000 fourth quarter to a third party insurer coupled with prior year reserve strengthening and increased loss estimates for the current underwriting year. Prior year reserve strengthening of $22.9 million affected most of Folksamerica's segments including the portfolios acquired with USF Re and Risk Capital. In the fourth quarter of 2000 Folksamerica purchased reinsurance coverage from Imagine Re which was designed to reduce its statutory operating leverage and provide adverse development protection on the run-off of loss and unearned premium reserves acquired in the Risk Capital transaction and any additional premium reported for the 2000 underwriting year, as well as the reserves remaining from the USF Re acquisition and remaining environmental and asbestos exposures. Folksamerica holds a letter of credit and funds held as collateral for amounts due from Imagine Re. Folksamerica's 1999 statutory combined ratio of 122.5% included approximately $20.1 million in pretax losses associated with USF Re's loss reserves, $4.0 million of pretax property catastrophe losses and higher than anticipated asbestos and environmental losses. These significant 1999 adverse loss developments resulted primarily from business acquired through Folksamerica's prior acquisitions (mainly USF Re).
As previously mentioned, Folksamerica underwrites each reinsurance contract anticipating an element of underwriting profit. The anticipated degree of underwriting profit varies by contract and is based on a variety of factors which can include some degree of float. Despite this expectation on an individual contract basis, Folksamerica's reported results for the years ended December 31, 2000, 1999 and 1998 yielded underwriting losses due to the following: (i) actual results on some accounts or classes have produced higher than anticipated loss costs (considering the highly competitive market conditions, there has been insufficient margin in profitable accounts to absorb higher loss costs produced by other accounts); (ii) higher than anticipated property catastrophe losses and (iii) continued strengthening of reserve portfolios relating to acquired companies. However, as previously mentioned, Folksamerica has various protections into its prior acquisition structures at its holding company which are designed to mitigate such losses but are not recorded in a manner that offsets Folksamerica's underwriting results.
Since reinsurance claims settlement periods generally extend over long periods of time, Folksamerica earns significant amounts of investment income on the float generated by its reinsurance operations. When considering investment income and other comprehensive income items at the Folksamerica holding company level, the Company's reinsurance operations reported comprehensive net income of $24.2 million, $13.4 million and $54.3 million during those periods, respectively. This resulted in an after tax return on Folksamerica's equity of 9.7%, 5.7% and 20.9% for 2000, 1999 and 1998, respectively.
The following table presents the subsequent development of the year-end reinsurance losses for the ten-year period from 1990 to 2000. Section I of the table shows the estimated liabilities that were recorded at the end of each of the indicated years for all current and prior year unpaid losses and loss adjustment expenses ("LAE"). Section II shows the re-estimate of the liabilities made in each succeeding year. Section III shows the cumulative liabilities paid of such previously recorded liabilities. Section IV shows the cumulative deficiency representing the aggregate change in the liability from the original balance sheet dates:
The table above has been prepared in accordance with prescribed instructions, however, management believes that this information is not indicative of Folksamerica's actual loss development history for the following reasons: (i) with respect to 1992 through 2000, the information is presented prior to considering the benefit of significant amounts of ceded reinsurance recovered and recoverable from Folksamerica's reinsurers; (ii) the information includes the complete loss development history (whether favorable or unfavorable) for companies acquired by Folksamerica for all periods presented, including periods prior to Folksamerica's acquisition of such companies; and (iii) as previously described, the structure of Folksamerica's acquisitions often provides effective economic protections to offset potential post-acquisition loss development. In consideration of each of these factors, the table presented below is management's attempt to adjust the cumulative deficiencies presented above for the most recent five years:
Net realized investment losses for the year ended December 31, 2000 resulted principally from sales of fixed maturities in preparation for Folksamerica's acquisitions of PCA and Risk Capital during the first quarter of 2000. Net realized investment gains of $69.6 million for 1999 included $23.9 million of pretax gains from sales of San Juan Basin Royalty Trust units and $28.0 million of pretax gains from sales of various other common stocks and other investments in Folksamerica's operating portfolio. In addition, $9.4 million of pretax gains on sales of common stocks and fixed maturity investments were recorded in anticipation of or in connection with the VGI Sale. Net realized investment gains of $71.0 million for 1998 resulted principally from the sale of White Mountains' investment in White River Corporation.
White Mountains' net investment income is comprised primarily of interest income associated with the fixed maturity investments of its consolidated insurance and reinsurance operations and dividend income from its equity investments. The significant increase in net investment income from 1998 to 2000 is mainly attributable to White Mountains' growing portfolio of fixed maturity investments resulting from the consolidation of Folksamerica in August 1998, the 1999 acquisition of USF Re and the 2000 acquisitions of PCA and Risk Capital.
Net unrealized gains for investments held during 2000 of $65.1 million resulted principally from unrealized gains on fixed maturity investments whereby net unrealized investment losses for investments held during 1999 of $11.7 million resulted principally from losses on fixed maturity investments. The fluctuations in net investment gains from fixed maturity investments from 1999 to 2000 principally resulted from the effects of changes in market interest rates on Folksamerica's sizable fixed income portfolio. Net unrealized gains for investments held during 1998 of $25.0 million resulted from unrealized gains on both fixed maturity investments and common stocks.
Insurance losses and loss adjustment expenses totalled $287.7 million for 2000 versus $242.3 million for 1999 and $174.8 million for 1998. During 2000, 1999 and 1998, losses and loss adjustment expenses relating to prior years developed unfavorably by $23.6 million, $31.9 million and $7.8 million, respectively. Insurance and reinsurance acquisition expenses totalled $101.1 million for 2000 versus $73.4 million for 1999 and $54.8 million for 1998. The increase in these insurance expenses from 1999 to 2000 is primarily attributable to the acquisitions of PCA and Risk Capital during 2000. The increase in these insurance expenses from 1998 to 1999 is primarily attributable to the acquisitions of USF Re and IAG during 1999.
Compensation and benefits totalled $59.5 million for 2000 versus $67.8 million for 1999 and $51.5 million for 1998. Compensation and benefits expenses for 2000 include increased Share-based contingent compensation accruals resulting from the attainment of above-plan results as well as a significant increase in the market value of Shares during the year. The increase in compensation and benefits from 1998 to 1999 is due both to the inclusion of Folksamerica in the Company's consolidated results for the entire 1999 period and expenses incurred in connection with the Redomestication. See "Liquidity and Capital Resources".
General expenses totalled $28.4 million for 2000 versus $19.5 million for 1999 and $15.9 million for 1998. The increase in general expenses during 2000 is primarily attributable to the acquisitions of PCA and Risk Capital as well as various contingencies and expenditures associated with certain of the Company's acquisition and disposition activities during the period. The increase in general expenses during the 1999 period are primarily attributable to both the inclusion of Folksamerica in the Company's consolidated results for the entire 1999 period and expenses incurred in connection with the Redomestication.
Interest expense totalled $16.1 million for 2000 versus $14.7 million for 1999 and $13.7 million for 1998. The increase in interest expense from 1999 to 2000 reflects higher average levels of indebtedness at Folksamerica for the period. The increase in interest expense from 1998 to 1999 reflects higher average levels of indebtedness at Folksamerica for the period, partially offset by the repayment of $15.0 million of indebtedness in May 1999 in connection with the VGI Sale.
The income tax provision related to pretax earnings for 2000, 1999 and 1998 represents an effective tax rate of 12.0%, 32.9% and 35.8%, respectively. The reduction in the effective rate for 1999 and 2000 resulted from an increase in White Mountains' non-United States net earnings to $395.9 million in 2000 versus $9.0 million in 1999.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts received for tax purposes. White Mountains recorded a deferred tax asset of $105.1 million (relating primarily to discounting of insurance loss reserves and net operating loss carryforwards) and a deferred tax liability of $2.8 million on its balance sheet as of December 31, 2000. White Mountains recorded a deferred tax asset of $52.5 million (relating primarily to discounting of insurance loss reserves) and a deferred tax liability of $37.5 million (relating primarily to unrealized investment gains) on its balance sheet as of December 31, 1999. Deferred income tax assets and liabilities are shown net in circumstances where a consolidated income tax return is filed.
In 1991, White Mountains sold Fireman's Fund to Allianz of America, Inc. Since 1991 the Company had carried a reserve related to various outstanding tax issues involving the sale. In September 2000, the Company was informed that the Internal Revenue Service agreed with the position taken by White Mountains in its 1991 tax return. On October 19, 2000, the Company received the Technical Advice Memorandum from the Internal Revenue Service's National Office confirming this conclusion. As a result, the Company released a $95.0 million reserve during 2000 which represents a gain from discontinued insurance operations.
The primary sources of cash inflows for the Company are investment income, sales of investment securities and dividends received from its operating subsidiaries. Under the insurance laws of the states and countries under which the Company's insurance subsidiaries are domiciled, an insurer is restricted with respect to the amount of dividends it may pay without prior approval by regulatory authorities. Accordingly, there is no assurance regarding the amount of such dividends that may be paid by such subsidiaries in the future.
On July 5, 2000 White Mountains concluded the sale of its indirect, wholly-owned subsidiary, White Mountains Holdings, Inc. (which controlled a substantial amount of its holdings of FSA) and all its other holdings of FSA Common Stock to Dexia for proceeds of $620.4 million.
During 1999 White Mountains purchased an additional 922,509 shares of the common stock of FSA at a price of $54.20 per share. The transaction was part of a private offering by FSA pursuant to which it sold a total of $140.0 million of its common stock to White Mountains, XL Capital, Ltd, The Tokio Marine and Fire Insurance Co., Ltd and an FSA management group.
During 1999 White Mountains concluded the Mortgage Banking Sale and recorded an $11.6 million after tax gain on the sale.
During 1999 the Company acquired IAG for $86.7 million in cash.
During 1999 the Company issued a total of 1,137,495 common shares to its Chairman and its key employees in satisfaction of the Chairman's warrant exercise and various employee benefit plan obligations. In order to entice the Chairman to exercise his warrants to acquire Shares early, the Company paid the Chairman $6.0 million to compensate him for the estimated interest cost of borrowing the strike price and the amounts required to prematurely pay his income taxes.
In connection with the Redomestication, White Mountains paid $104.1 million in certain compensation benefits to its current and former employees and Directors in October 1999 at an incremental after tax cost of $14.9 million. In connection with the compensation payments, White Mountains paid cash of $89.8 million (primarily to its former employees) and issued $14.3 million in Shares (primarily to its current employees, Directors and advisors). A significant portion of such compensation paid represented the acceleration of expenses that would have ordinarily been incurred in future periods which resulted in increased tax deductible expenses in 1999.
Completion of the CGU acquisition is subject to, among other matters, the receipt of regulatory approvals, the completion of financing and the satisfaction of other customary conditions. The stock purchase agreement dated September 25, 2000 and subsequent amendments thereto, terms of the note payable to CGNU (as amended on February 20, 2001), terms of the various equity commitments and the Credit Agreement are contained herein as Exhibits 10(a) through 10(f), and are incorporated by reference in their entirety.
During the 2000 fourth quarter White Mountains provided $259.6 million of capital to Folksamerica through the contribution of ACIC and BICC and through the issuance of a $195.0 million inter-company note. Folksamerica subsequently contributed ACIC and $80.0 million of such cash to Folksamerica Reinsurance Company in order to provide the statutory capital needed to support its recent acquisitions of PCA and Risk Capital. The remaining $115.0 million was used by Folksamerica to repay its outstanding bank indebtedness. White Mountains intends to forgive the inter-company note at the closing of the CGU acquisition.
White Mountains' consolidated balance sheet includes a substantial amount of assets and liabilities whose fair values are subject to market risk. The term market risk refers to the risk of loss arising from adverse changes in: interest rates, foreign currency exchange rates and other relevant market rates and prices such as prices for common equity securities. Due to White Mountains' sizable investments in fixed maturity investments and common equity securities and its use of medium-term and long-term debt financing, market risk can have a significant effect on White Mountains' consolidated financial position.
Increases and decreases in prevailing interest rates generally translate into decreases and increases in fair values of fixed maturity investments, respectively. Additionally, fair values of interest rate sensitive instruments may be affected by the credit worthiness of the issuer, prepayment options, relative values of alternative investments, the liquidity of the instrument and other general market conditions. These investments are carried at fair value on the balance sheet with unrealized gains reported net of tax in a separate component of shareholders equity.
INDEBTEDNESS. White Mountains utilizes debt financing at many levels of its businesses. Increases and decreases in prevailing interest rates generally translate into decreases and increases in fair values of fixed rate indebtedness, respectively, particularly long-term debt. Additionally, fair values of interest rate sensitive instruments may be affected by the credit worthiness of the issuer, prepayment options, relative values of alternative investments, the liquidity of the instrument and other general market conditions.
Folksamerica operates a branch office in Toronto, Canada to service its Canadian customers and a portion of BICC's premiums are denominated in a foreign currencies. Net unrealized foreign currency translation gains and losses associated with Folksamerica and BICC are reported, after tax, as a net amount in a separate component of shareholders' equity. Changes in the values of these operations due to currency fluctuations, after tax, are reported on the income statement as a component of other comprehensive net income. At December 31, 2000 and 1999, Folksamerica's and BICC's net assets denominated in foreign currency represented less than one percent of the Company's shareholders' equity, therefore, any significant change in foreign currency rates would not have a material impact on White Mountains' financial position.
The carrying values of White Mountains' common equity securities and a significant portion of its other investments (primarily partnership interests invested in common equity securities) are based on quoted market prices or management's estimates of fair value (which is based, in part, on quoted market prices) as of the balance sheet date. Market prices of common equity securities are subject to fluctuations which could cause the amount to be realized upon sale of the investment to differ significantly from the current reported value. The fluctuations may result from perceived changes in the underlying economic characteristics of the investee, the relative price of alternative investments, general market conditions and supply and demand imbalances for a particular security.
ACCOUNTING FOR FSA OPTIONS AND FSA PREFERRED STOCK White Mountains accounted for its investment in FSA Common Stock on the equity method of accounting and accounted for its unexercised stock options and convertible securities to acquire FSA Common Stock at fair value. Upon the exercises of FSA Options during 1999, the Company was required to write its investments in the FSA Options exercised to their original cost in order to transition the investment from fair value accounting to equity accounting. In connection with this accounting transition, the Company reduced its after tax net unrealized gains at the time of exercise by $39.3 million and recorded a deferred credit of $14.2 million that was to be amortized to income over a five-year period. In July 2000 White Mountains sold its investments in FSA as part of the Dexia Sale which resulted in the immediate recognition of the related unamortized deferred credit balance.
RETIREMENT OF COMMON SHARES HELD IN TREASURY In conformance with Bermuda law, the Company retired all Shares held in its treasury at October 1999 and has retired all Shares repurchased thereafter. The retirement of treasury shares in 1999 resulted in a significant reclassification of several of the Company's various shareholders' equity accounts but did not affect total shareholders' equity.
YEAR 2000 UPDATE Neither White Mountains nor any of its unconsolidated insurance affiliates experienced any significant Year 2000 disruptions to its business operations. White Mountains' total pretax cost of its Year 2000 remediation, excluding its unconsolidated insurance affiliates, was approximately $3.0 million.