We currently lease approximately 7,500 square feet of office space in George Town, Grand Cayman where our executive and principal offices are located. The base term of the lease is seven years. We also lease approximately 8,000 square feet of office space in Charlotte, North Carolina where Harbourton's principal offices are located. We also currently lease approximately 400 feet of office space in Denver, Colorado where Harbourton currently has temporary offices. Theses offices will be closed prior to July 2000. We believe that these properties are adequate to meet our needs for the foreseeable future.
Scottish Holdings is an insurance holding company, and our principal assets include the ownership of Scottish Insurance, Harbourton and Scottish Annuity. Scottish Holdings was formed on May 12, 1998, and Scottish Insurance was formed on June 3, 1998, under the laws of the Cayman Islands. We commenced our insurance operations on November 30, 1998, immediately following our IPO. Harbourton was acquired effective as of September 30, 1999 and Scottish Annuity was acquired on December 31, 1999.
Our net income of $8,874,719 or $0.50 per share was driven by revenues from our investment portfolio and insurance administration fees. Our investment income in 1999 included $14,344,530 earned on our surplus and $9,723,710 earned in relation to our reinsurance activities. Comparisons to the prior period are not meaningful because of our limited period of operations after our November 1998 IPO.
Our investment portfolio is managed by two professional investment managers, Prudential Investment Corporation and Gen Re. Our investment guidelines are designed to diversify the portfolio to maximize investment income while minimizing risk. At December 31, 1999, the portfolio had an average quality rating of AA, an average duration of 2.98 years and an average book yield of 6.79%. At December 31, 1998, the portfolio had an average quality rating of AA+, an average duration of 3.67 years and an average book yield of 5.50%. Our fixed maturity portfolio increased from $178,520,719 to $546,806,744 principally as a result of the reinsurance transactions and acquisition of Harbourton. The duration of our portfolio was reduced from 3.67 years to 2.98 years as investments of short duration were acquired to match the duration of liabilities acquired through our reinsurance operations. The realized loss of $2,638,506 recorded for the year was due to portfolio restructuring. As at December 31, 1999 we had unrealized depreciation of $15.7 million, a result of the effect of the current interest rate environment on our fixed income portfolio.
During the year, we paid quarterly dividends of $928,822 or $0.05 per share, to the shareholders of record as at June 7, 1999 and September 6, 1999. We also paid $802,337 or $0.05 per share to shareholders of record as at December 6, 1999.
Many computer programs used only two digits to identify a year in the date field prior to December 31, 1999. These programs, if not corrected, could have failed or created erroneous results by or at the year 2000. This "Year 2000" Issue was believed to affect virtually all companies and organizations, including us. Because most of our computer hardware and software is less than three years old, we believed that our exposure with respect to our own computer systems to Year 2000-related problems was not significant, and we encountered no Year 2000 related problems. We are continuing to monitor our systems and those of our primary suppliers of data.
Our Variable Life & Annuity Insurance Business Is Dependent Upon Referral Sources.
We can, however, pay non-U.S. referral sources for activities undertaken outside the U.S. We expect to compensate referral sources based on a percentage of the revenue received from referrals. Subject to any regulatory limitations, we may provide referrals to persons or entities that provide referrals to us. We cannot assure you that we will receive a significant amount of referrals or, if so, that any referrals will result in actual sales of variable life and annuity insurance policies.
The Scottish Insurance business plan for reinsurance activities provides that one of our principal targets is reinsuring blocks of in-force fixed annuities issued by insurers that are no longer actively writing these contracts or that want to lessen the reserve and capital requirements associated with these contracts. Another principal target is reinsuring new issues of fixed annuities. Reinsurance of new business can be used to increase capacity, lessen reserve and capital requirements, improve the competativeness of the product, improve the return to the insurance company, or some combination of the above.
The Harbourton business plan primarily targets reinsurance of mortality risk associated with life insurance products issued by U.S. direct writers. While sales of life reinsurance have increased dramatically in recent years, the market is also well-established and competitive.
Third, the Proposal would reduce or eliminate the tax advantages of "corporate-owned life insurance."
Finally, the Proposal would eliminate the "Crummey" rule, pursuant to which certain gifts to trusts for the payment of life insurance premiums are treated as present interests that are eligible for the annual exclusion from the gift tax. The elimination of this rule would eliminate the primary and most efficient method of making premium payments by insurance trusts. Because we expect that insurance trusts will purchase our variable life insurance policies, or such policies will be contributed to trusts, to provide liquidity for estate taxes and to effect the transfer of assets from one generation to another, adoption of this proposal could adversely affect the sales of these policies, which could adversely affect our results of operation and our financial condition.
In its most recent business plan, the IRS announced that it intends to issue guidance as to whether an annuity that is issued by an insurer that is not an "insurance company subject to tax under Subchapter L" (the provisions of the United States Internal Revenue Code that apply to insurance companies that do business in the United States) will be subject to the favorable tax treatment generally afforded annuity contracts, or instead will be treated as "debt instruments" that are not eligible for tax deferral. Were the IRS to adopt a rule or regulation treating annuities issued by Scottish Insurance or Scottish Annuity, which do not do business in the United States, as debt instruments, the market for such annuities could be adversely affected.
The principal risk associated with our planned life reinsurance business is mortality risk. Harbourton will reinsure various forms of life insurance products including term life, universal life and traditional life insurance. Mortality risk typically is more stable when spread across large numbers of insureds. As our life reinsurance business grows, we will initially have a relatively small number of lives covered and as a result, our mortality risk exposure is likely to be larger, and our probability of loss less predictable, than an insurer with a larger risk pool. As a result, we cannot assure you that our actual mortality experience will be consistent with our pricing expectation. Mortality risk is also a factor in our variable life insurance product, however, currently we reinsure 100% of the mortality risk on all variable life policies.
The principal risk associated with our fixed annuity reinsurance activities is investment risk. Specifically, we are subject to the following risks:
. the risk that invested assets supporting the reinsured business will decrease in value;
An additional risk associated with our reinsurance business is the risk that the ceding insurer will be unable to pay to us amounts due because of its own financial difficulties. We can give no assurance that the ceding insurers will be able to pay amounts due to us, which could have a material adverse effect on our business, results of operations or financial condition. In addition, we can give no assurance that the ceding companies will maintain appropriate interest crediting rates with respect to fixed annuities or interest rate-sensitive life insurance policies.
Our Business is Dependent on Our Ability To Manage Risks In Our Investment Activities.
Our fixed income investments are subject to the following two primary sources of investment risk:
. interest rate risk, relating to the market price and/or cash flow variability associated with changes in market interest rates.
We cannot assure you we will be able to effectively manage these risks. If we are unable to effectively manage these risks, our ability to support our planned variable insurance and reinsurance businesses, and our results of operations and financial condition, will be adversely affected.
Owners of Our Ordinary Shares May in Certain Circumstances Be Exposed to Adverse Personal United States Tax Risks.
If we have related person insurance income, and all United States persons own 25% or more of the voting power or value of our shares, any shareholder who is a United States person who owns 10% or more of our shares and disposes of the shares would have any gain from the disposition generally treated as ordinary income to the extent of the shareholder's portion of our undistributed earnings and profits that were accumulated during the period that the shareholder owned the shares. The shareholder also will be required to follow certain reporting requirements, regardless of the amount of shares owned by the shareholder. These rules should not apply to sales of our shares because we are not directly engaged in the insurance business and because proposed United States Treasury regulations applicable to this situation appear to apply only in the case of shares of corporations that are directly engaged in the insurance business. We can give no assurances however, that the IRS will interpret the proposed regulations in this manner or that the proposed regulations will not be promulgated in final form in a manner that would cause these rules to apply to dispositions of Ordinary Shares.
In addition, the Articles of Association generally provide that any person (or any group) holding 10% or more of the total voting rights of all of our outstanding capital shares, will have the voting rights of its voting shares reduced so that the person (or group) may not exercise more than approximately 9.9% of the total voting rights. Because of the attribution provisions of the U.S. tax code and the rules of the Securities and Exchange Commission regarding determination of beneficial ownership, this requirement may have the effect of reducing the voting rights of a shareholder whether or not the shareholder directly holds of record 10% or more of the voting shares. The directors also have the authority to request from any shareholder certain information for the purpose of determining whether such shareholder's voting rights are to be reduced. If the shareholder fails to respond to the notice, or submits incomplete or inaccurate information, the directors (or their designee) have the discretion to disregard all votes attached to the shareholder's Ordinary Shares.