In March 1996, we entered into a sublease agreement expiring in October 2002 for approximately 40,000 square feet of office space in Greenwich, Connecticut, where our offices are located. Future minimum rental charges for the remaining term of the sublease, exclusive of escalation clauses and maintenance costs and net of rental income, will be approximately $1,994,000. Our rental expense, net of sublease income, during 1999, 1998 and 1997 was approximately $576,000, 576,000 and $643,000, respectively.
Our and RCRe's selected consolidated historical financial data for the years ended December 31, 1999, 1998, 1997, 1996 and for the period from June 23, 1995 (date of inception) to December 31, 1995 should be read in conjunction with our audited consolidated financial statements and the related notes and unaudited pro forma condensed consolidated financial data contained elsewhere in this report.
The following unaudited pro forma statement of income and comprehensive income for the year ended December 31, 1999 reflects our historical accounts for that period, adjusted to give pro forma effect to the asset sale and the XL Capital stock repurchase as if those transactions had occurred on January 1, 1999.
The pro forma financial data and accompanying notes should be read in conjunction with the description of the asset sale and XL Capital stock repurchase contained in this report and our audited consolidated financial statements and related notes also included in this report as well as the description included in our special meeting proxy statement. We believe that the assumptions used in the following statements, which are set forth in the accompanying notes, provide a reasonable basis on which to present the pro forma financial data. The pro forma financial data is provided for informational purposes only and should not be construed to be indicative of our financial condition or results of operations had the asset sale and XL Capital stock repurchase been consummated on the dates assumed and are not intended to project our financial condition on any future date or results of operations for any future period.
1. Reflects our repurchase from XL Capital of all of the 4,755,000 shares of our common stock held by it for $59,200,000, or $12.45 per share, which represents 85% of our average closing market price of our common stock for the twenty day trading period between January 21, 2000 and February 17, 2000 in exchange for the following:
Repurchase of 4,755,000 shares of our outstanding common stock at $12.45 per share, recorded as a reduction to stockholders' equity as treasury stock, plus $59,200
4. Reflects the asset sale, pursuant to which Folksamerica Reinsurance Company will assume RCRe's liabilities under the reinsurance agreements transferred to it and RCRe will transfer to Folksamerica Reinsurance Company assets in an aggregate amount that is, in GAAP book value (as set forth on our estimated closing date balance sheet), equal to the GAAP book value (as set forth on our estimated closing date balance sheet) of the liabilities assumed. In consideration for the transfer of RCRe's book of business, Folksamerica will pay $20.335 million in cash at the closing, subject to adjustment under the circumstances described in our special meeting proxy statement under the heading "The Asset Purchase Agreement--Purchase Price."
Reduction in net deferred tax asset for elimination of temporary differences between financial statements and income tax return amounts resulting from the Folksamerica transaction $13,957 Less, estimated tax benefit resulting from the transaction 8,605 Net reduction in deferred tax asset $ 5,352 ========
9. The book value gain resulting from the Folksamerica transaction is calculated as follows (in thousands):
The pro forma accounting for this transaction assumes that none of RCRe's reinsureds will object to the release of RCRe under the transfer and assumption agreement and, accordingly, the gross liabilities for such business are removed from the accounts of RCRe for statutory and GAAP accounting purposes (see note 5 above). RCRe will continue to record gross liabilities in its accounts for reinsureds that object to the release of RCRe from its obligations to such reinsureds. This would result in a portion of the pre-tax gain on the transaction being deferred and amortized into income as the gross liabilities are extinguished.
10. Includes $20 million of fixed income securities deposited in an escrow account for a five year period primarily to reimburse Folksamerica for claims and claim expenses exceeding reserves recorded by RCRe as of the closing date resulting from business produced on behalf of RCRe by a certain managing underwriting agency. At December 31, 1999, such reserves approximated $38.3 million, which were recorded based on RCRe's actuarially determined best estimate for such business. We could record a loss to the extent that such reserves turn out to be deficient, due to our reimbursement of Folksamerica for such deficiency to the extent of the escrowed funds. Amounts in escrow may also be released to Folksamerica to satisfy its indemnification claims against us relating to undisclosed liabilities, RCRe's reinsurance agreements and the managing underwriting agency referred to above. Under the asset purchase agreement, we may be required to deposit an additional amount of up to $5 million into a supplemental escrow account a short time following the closing of the asset sale. The above unaudited pro forma condensed consolidated balance sheet has been prepared assuming that such supplemental escrow account will not be required.
Risk Capital Holdings, Inc. and Subsidiaries Pro Forma Condensed Consolidated Statement of Income and Comprehensive Income For the Year Ended December 31, 1999 (Dollars in thousands, except per share data)
1. Represents all revenue and expense and other comprehensive income items recorded during 1999 for LARC Holdings, Ltd. and Annuity and Life Re (Holdings), Ltd., which were disposed of in the XL Capital stock repurchase.
2. Represents all revenue and expense and other comprehensive income items recorded during 1999 related to the sale of our reinsurance business to Folksamerica Reinsurance Company. Net investment income, net realized investment gains (losses) and unrealized appreciation (depreciation) of investments have been allocated based on the proportion of the average amount of fixed maturities and short term investments related to the business that will be transferred to the average total fixed maturities and short term investments in 1999.
Please see the sections of our special meeting proxy statement entitled "Questions and Answers About the Asset Sale," "Risk Factors," "The Asset Sale," "The Asset Purchase Agreement" and "Other Transaction Agreements," which are incorporated by reference. In addition, we have filed the asset sale agreement, the voting agreements and other related agreements as exhibits to this annual report. The above summary of the proposed transaction is qualified by these agreements, which are incorporated by reference. Please also refer to "Unaudited Pro Forma Condensed Consolidated Financial Data."
The GAAP book value of the assets and liabilities to be transferred to Folksamerica recorded in the accompanying financial statements at December 31, 1999 are as follows:
Net book value of assets and liabilities to be transferred -- =======
The actual GAAP book value of the assets and liabilities transferred to Folksamerica will be determined as of the closing date of the asset sale, and will differ from that set forth above.
RCRe will continue to record gross liabilities in its accounts for reinsureds that object to the release of RCRe from its obligations to such reinsureds. In such instances, an offsetting accounts receivable amount from Folksamerica would be recorded as an asset equal to such gross liabilities. This would also result in a portion of any pre-tax gain on the asset sale being deferred and amortized into income as gross liabilities are extinguished.
On March 2, 2000, we repurchased from XL Capital, then our single largest stockholder, all of the 4,755,000 shares of our common stock held by it. Under the terms of a stock repurchase agreement with XL Capital, we paid $12.45 per share of our common stock, or a total of $59.2 million. The per share repurchase price was determined as the lesser of (1) 85% of the average closing market price of our common stock during the 20 trading days beginning on the third business day following public announcement of the stock repurchase and asset sale (January 21, 2000), which was $14.65, and (2) $15. We paid XL Capital the consideration for the repurchase with: our interest in privately held LARC Holdings, Ltd. (parent of Latin American Reinsurance Company Ltd.), valued at $25 million (which was carried by us at $24 million at December 31, 1999); and all of our interest in Annuity and Life Re (Holdings), Ltd., valued at $25.38 per share and $18.50 per warrant, or $37.8 million in the aggregate (which was carried by us at $38.2 million at December 31, 1999). XL Capital paid us in cash the difference (equal to $3.6 million) between our repurchase price and the value of our interests in LARC Holdings and Annuity and Life Re. The value per share of Annuity and Life Re was determined by taking the average of the closing price of Annuity and Life Re shares for the same period used in determining the repurchase price of our shares. The value of the warrants was determined using a Black Scholes
At January 1, 2000, RCRe had approximately 330 renewable in-force reinsurance treaties (such renewal is subject to negotiation and evaluation during the renewal period), with approximately $249.1 million of estimated annualized net premiums written, compared to $287.5 million at January 1, 1999 and $172.5 million at January 1, 1998, representing a decline of 13% and an increase of 67% over the prior year, respectively. Such in-force premiums at January 1, 2000 represent estimated annualized premiums from treaties entered into during 1999 and the January 1, 2000 renewal period that are expected to generate net premiums written during 2000. Such treaties at January 1, 2000 are estimated to generate approximately $210.6 million of net premiums written over the 12-month period ending December 31, 2000 without taking into account certain factors, including the possibilities that (i) several treaties entered into in 1999 that are scheduled to expire during the remainder of 2000 may be renewed and (ii) additional treaties may be bound during 2000.
We had consolidated comprehensive losses of $52.3 million and $4.4 million for the years ended December 31, 1999 and 1998, respectively, and consolidated comprehensive income of $47.1 million for the year ended December 31, 1997. Our comprehensive income or loss is composed of net income and the change in unrealized appreciation of investments. Net loss for the year ended December 31, 1999 was $32.4 million and net income for the years ended December 31, 1998 and 1997 was $3.1 million and $2.0 million, respectively. After-tax realized investment gains (losses) of $11.2 million, $16.4 million and ($0.5 million) were also included in net income for 1999, 1998 and 1997, respectively. Net income for the years ended December 31, 1999, 1998 and 1997 included income (losses) of $0.7 million, ($1.1 million), and ($0.2 million), respectively, representing our equity in the net income (loss) of investee companies accounted for under the equity method of accounting. Net loss for the year ended December 31, 1999 also included a loss of $383,000 from a cumulative effect of an accounting change for start-up costs.
Net premiums written for the years ended December 31, 1999, 1998 and 1997 were as follows:
Approximately 30%, 32% and 29% of net premiums written in 1999, 1998 and 1997, respectively, were generated from companies in which we have invested or committed to invest funds ("integrated transactions").
Net premiums written in 1999 for other business was reduced by $10.6 million for the retrocession of a treaty which covers future multiple rocket launches that was recorded in 1996. The reduction of net premiums written resulting from this retrocession increased the commission and operating expense ratio components of the statutory composite ratio by 1.1 percentage points, but had no impact on operating results.
In 1998, three clients contributed approximately $74 million, or 32%, of 1998 total net premiums written, with the largest client contributing approximately 18% and the remaining two contributing 8% and 6%, respectively. In 1997, five clients contributed approximately $68 million, or 45%, of total net premiums written, with the largest client contributing approximately 18% and the remaining four contributing from 5% to 8%.
Years Ended December 31, ----------------------------------- 1999 1998 1997 ---- ---- ---- Claims and claims expenses 98.2% 85.4% 68.4% Commissions and brokerage 26.3% 24.2% 28.8% ---- ---- ---- 124.5% 109.6% 97.2% Other operating expenses 4.7% 6.8% 9.1% ----- ------ ----- Statutory combined ratio 129.2% 116.4% 106.3% ===== ===== =====
After-tax underwriting losses for the years indicated were as follows (dollars in millions):
Years Ended December 31, ----------------------------------- 1999 1998 1997 ---- ---- ---- After-tax underwriting loss Amount $ 58.4 $ 23.0 $ 7.7 Per Share (Basic) $ 3.42 $ 1.39 $ 0.45
As identified above, during 1999 and 1998, RCRe recorded after-tax underwriting losses of $19.7 million, or $1.15 per share, and $7.8 million, or $0.46 per share, respectively, for its space and aviation lines of business. During 1999, RCRe discontinued both lines of business.
The total estimated ultimate net premiums written and earned by RCRe for aviation business from inception in 1998 through December 31, 1999 are $26.8 million and $17.5 million, respectively, resulting in an inception to date after-tax underwriting loss of $14.3 million. Net reserves for aviation business approximated $26 million at December 31, 1999.
Included in the 1999 after-tax underwriting loss for aviation business are incurred losses for the 1998 Swiss Air and Korean Air crashes and certain 1999 crashes, including the Egypt Air, American Airlines, Korean Air and China Air crashes. The additional loss recorded in 1999 for the Swiss Air crash was based on a reallocation of the $642 million expected industry loss between the plane manufacturer and Swiss Air. This reallocation adversely affected RCRe's gross loss. The gross loss associated with the Swiss Air crash reported as of December 31, 1998 had exhausted RCRe's retrocessional protections applicable to this occurrence. Therefore, none of such additional loss reported was ceded to retrocessionaires. To the extent that either the expected industry loss increases or additional loss is allocated to the plane manufacturer, RCRe could record additional losses. For example, if the expected industry loss increases by approximately $100 million, and assuming additional loss reallocations such that one-third of the industry loss is allocated to the plane manufacturer, RCRe would record additional aggregate loss (net of additional reinstatement premiums) of approximately $2.7 million after-tax. However, we cannot be certain of the ultimate industry loss or the final allocation of liability between the plane manufacturer and Swiss Air, and there can be no assurances that the ultimate industry loss will not be larger or that the plane manufacturer will not be allocated a greater proportion of the industry loss. With respect to all other reinsured crashes which occurred through December 31, 1999, we currently believe that RCRe's gross loss will not exhaust RCRe's reinsurance protections (although RCRe's net loss could increase within these protections based on the ultimate industry loss, the ultimate allocation of losses between the plane manufacturers and the airlines and other factors).
For the year ended December 31, 1999, aviation assumed gross premiums earned, retroceded premiums earned, and net earned premiums were $43.7 million, $32.5 million and $11.2 million, respectively. While RCRe discontinued writing aviation business in 1999, RCRe currently has a number of assumed treaties that will continue to expose it to significant risk of aviation losses through 2001. Current estimates for gross aviation premiums that will be earned beyond 1999 aggregate approximately $20.5 million. Retrocessional premium charges to be recorded for retrocessional treaties presently in-force that expire during 2000 total approximately $15.4 million. Such retrocessional premium costs do not include additional retrocessional premium amounts that will be purchased to provide Folksamerica with additional retrocessional protection in connection with the sale of our reinsurance business to Folksamerica.
Except for multi-line business, all other classes of business also contributed to the 1999 underwriting loss, with the largest contribution from property business. The after-tax underwriting loss for property business approximated $4.9 million which included after-tax losses of $4.3 million for two large catastrophes in 1999 (Rouge steel plant in Dearborn, Michigan and French storm losses).
Estimates of prior accident year claims were increased by approximately $30 million in 1999 which added 10.2 points to the 1999 combined ratio. A substantial portion of this amount stemmed from (i) our review of additional claims information and our continuing underwriting and actuarial analysis of the business produced by the managing underwriting agency, (ii) notification of additional satellite losses received in 1999 pertaining to 1998, (iii) aviation losses, principally the previously discussed 1998 Swiss Air crash, and (iv) property losses reported on several international treaties that are in run-off.
Claims and claims expenses generally represent our most significant and uncertain costs. Reserves for these expenses are estimates involving actuarial and statistical projections at a given time of what we expect the ultimate settlement and administration of claims to cost based on facts and circumstances then known. The reserves are based on estimates of claims and claims expenses incurred and, therefore, the amount ultimately paid may be more or less than such estimates. The inherent uncertainties of estimating claim reserves are exacerbated for reinsurers by the significant periods of time (the "tail") that often elapse between the occurrence of an insured loss, the reporting of the loss to the primary insurer and, ultimately, to the reinsurer, and the primary insurer's payment of that loss and subsequent indemnification by the reinsurer. As a consequence, actual claims and claims expenses paid may deviate, perhaps materially, from estimates reflected in our reserves reported in our financial statements. The estimation of reserves by new reinsurers, such as us, may be less reliable than the reserve estimations of a reinsurer with an established volume of business and claims history. To the extent reserves prove to be inadequate, we may have to augment such reserves and incur a charge to earnings.
For 1999, the statutory operating expense ratio declined to 4.7%, compared with 6.8% for 1998 and 9.1% in 1997. The decline in our operating expense ratio was due to a decrease in other operating expenses and an increase in our net premiums written from the comparable prior year period. In addition, commencing in 1999, we allocated certain compensation and other operating expenses related to investment activities in the amount of $2.1 million to net investment income based on internal time studies. Such allocations were not made in prior periods. Due to such allocations, the 1999 statutory operating expense ratio improved by approximately one point and net investment income was reduced by approximately $0.08 per share, with no overall effect on operating results. On a pro-forma basis, the statutory operating expense ratios for 1998 and 1997 would have been 5.8% and 7.6%, respectively.
Pre-tax foreign exchange gains and losses are recorded separately from statutory underwriting results and are therefore excluded from the statutory composite ratio. Unhedged monetary assets and liabilities are translated at the exchange rate in effect at the balance sheet date, with the resulting foreign exchange gains or losses recognized in income. For the years ended December 31, 1999, 1998 and 1997, pretax foreign exchange gains and (losses) were $198,000, $443,000 and ($682,000), respectively. Such future gains or losses may be affected by changes in foreign exchange rates which are unpredictable and could be material. For additional discussion, see "--Market Sensitive Instruments and Risk Management" below.
Given RCRe's current level of surplus, under its current underwriting guidelines, the maximum net retention on any one claim for a given property or casualty treaty risk is generally $10 million.
With respect to integrated solutions (where we combine an equity, equity-like or debt investment in a client company with the purchase by such client of reinsurance from RCRe), we generally limit RCRe's combined underwriting and investment exposure to pre-tax losses on any individual client to no more than 10% of RCRe's total statutory surplus.
Our investment yields are reflective of a significant allocation of the total investment portfolio in equity securities, which yield less current income than fixed maturity investments. At December 31, 1999 and 1998, investments in public and private equity securities approximated 41% and 49%, respectively, of total cash and invested assets. Additionally, such investment yields exclude our equity in the net income or loss of private equity investments accounted for under the equity method.
Our 1999 income tax benefit, 1998 effective tax rate of 5% and the 1997 income tax benefit are less than the 35% statutory rate on pre-tax operating income due primarily to tax exempt income and the dividends received deductions. The 1999, 1998 and 1997 gross deferred income tax benefits of approximately $10.5 million, $7.3 million and $2.1 million, respectively, which are assets considered recoverable from future taxable income, resulted from temporary differences between financial and taxable income.
While we believe that a valuation allowance is not necessary at December 31, 1999, continued future comprehensive losses or future decisions with respect to business strategy following the sale of our reinsurance business may result in the establishment of a valuation allowance in future financial statements.
As our investment strategy is to invest a significant portion of RCRe's investment portfolio in equity securities, our investment income in any fiscal period may be smaller, as a percentage of investments, and less predictable than that of other insurance and/or reinsurance companies, and net realized and unrealized gains (losses) on investments may have a greater effect on our results of operations or stockholders' equity at the end of any fiscal period than would be the case for other insurance and/or reinsurance companies. Since the realization of gains and losses on equity investments is not generally predictable, such gains and losses have differed and will differ significantly from period to period. Variability and declines in our results of operations could be further exacerbated by private equity investments in start-up companies which are accounted for under the equity method. Such start-up companies may be expected initially to generate operating losses.
Investments included in RCRe's private portfolio include securities issued by privately held companies and by publicly traded companies that are generally restricted as to resale or are otherwise illiquid and do not have readily ascertainable market values. The risk of investing in such securities is generally greater than the risk of investing in securities of widely held, publicly traded companies. Lack of a secondary market and resale restrictions may result in an inability by us to sell a security at a price that would otherwise be obtainable if such restrictions did not exist and may substantially delay the sale of a security we seek to sell.
$158.6 million of publicly traded equity securities, and $83.9 million of privately held securities. Included in privately held securities are investments totaling $42.6 million which are accounted for under the equity method.
At December 31, 1999, RCRe's private equity portfolio consisted of 12 investments, with additional investment portfolio commitments in an aggregate amount of approximately $23.2 million.
In 1999, we completed one integrated transaction with an existing client of RCRe, a follow-on investment in an existing investee and one additional investment commitment. In addition, we divested four of RCRe's investments. (See note 3 under the caption "Investment Information" of the accompanying notes to our audited consolidated financial statements.)
In October 1998, we provided $5 million in financing on a fully secured basis to a managing general agency, and received a related reinsurance commitment expected to generate an aggregate of $90 million of reinsurance premiums over three years pursuant to terms and conditions that we believe are more favorable than those available in the open market.
At December 31, 1999, approximately 88% of RCRe's fixed maturity and short-term investments were rated investment grade by Moody's or Standard & Poor's and had an average quality rating of AA and an average duration of approximately 3.7 years.
RCRe has not invested in derivative financial instruments such as futures, forward contracts, swaps, or options or other financial instruments with similar characteristics such as interest rate caps or floors and fixed-rate loan commitments. RCRe's portfolio includes market sensitive instruments, such as mortgage-backed securities, which are subject to prepayment risk and changes in market value in connection with changes in interest rates. RCRe's investments in mortgage-backed securities, which amounted to approximately $27.3 million at December 31, 1999, or 4.7% of cash and invested assets, are classified as available for sale and are not held for trading purposes.
In accordance with the SEC's Financial Reporting Release No. 48, the following analysis presents hypothetical losses in cash flows, earnings and fair values of market sensitive instruments which are held by RCRe as of December 31, 1999 and are sensitive to changes in interest rates, foreign exchange rates and equity security prices. This risk management discussion and the estimated amounts generated from the following sensitivity analysis represent forward-looking statements of market risk assuming certain adverse market conditions occur. Actual results in the future may differ materially from these projected results due to actual developments in the global financial markets. The analysis methods used by us to assess and mitigate risk should not be considered projections of future events of losses.
Market risk represents the risk of changes in the fair value of a financial instrument and is comprised of several components, including liquidity, basis and price risks. The focus of the SEC's market risk rules is on price risk. For purposes of specific risk analysis, we employ sensitivity analysis to determine the effects that market risk exposures could have on the future earnings, fair values or cash flows of RCRe's financial instruments.
We are exposed to equity price risks on the public and private equity securities included in RCRe's investment portfolio. All of RCRe's publicly traded equity securities and privately held securities were issued by insurance and reinsurance companies or companies providing services to the insurance industry. We typically do not attempt to reduce or eliminate RCRe's market exposure on these securities. Investments included in RCRe's private portfolio include securities issued by privately held companies and securities issued by public companies that are generally restricted as to resale or are otherwise illiquid and do not have readily ascertainable market values. Investments in privately held securities issued by privately and publicly held companies may include both equity securities and securities convertible into, or exercisable for, equity securities (some of which may have fixed maturities).
At December 31, 1999, our consolidated stockholders' equity totaled $346.5 million, or $20.28 per share based on issued and outstanding shares, and $20.28 per share on a diluted basis which includes outstanding dilutive warrants and options. At such date, statutory surplus of RCRe was approximately $290 million. As a result of the XL Capital stock repurchase, stockholders' equity has been reduced by $59.4 million and book value per share has increased to $23.27 per share on a fully diluted basis. RCRe's statutory surplus was also reduced by $60 million to $230 million due to the sale to XL Capital of the stock and warrants in LARC Holdings, Ltd. and Annuity and Life Re Holdings, Ltd., based on their statutory carrying values at December 31, 1999. Based on data from the RAA, after giving effect to the XL Capital stock repurchase, RCRe was the 20th largest domestic broker market oriented reinsurer as measured by its $230 million of statutory surplus.
We will adopt this statement in the first quarter of 2001. Historically, we have not invested in derivative financial instruments. However, derivatives may be embedded in other financial instruments, such as convertible securities and prepayment options in mortgages. If the embedded derivative meets certain criteria, it must be bifurcated from the host contract and separately accounted for consistent with other derivatives.
Effective January 1, 1999, we changed our method of accounting for start-up costs in accordance with the Accounting Standards Executive Committee's Statement of Position ("SOP") 98-5 "Reporting on the Costs of Start-Up Activities." This statement requires costs of start-up activities, including organization costs, to be expensed as incurred. The change in accounting principle resulted in the write-off of the start-up costs capitalized as of January 1, 1999 for us and RCRe's investee companies carried under the equity method of accounting. The cumulative effect of the write-off, which totals $383,000, after-tax, or $0.02 per share, has been expensed and is included in the 1999 net loss. (See note 2 of the accompanying notes to our audited consolidated financial statements.)
reinsurers such as RCRe, there are several accounting practices that may be changed. The most significant change would involve accounting for deferred income taxes, which change would require a deferred tax liability to be recorded for unrealized appreciation of invested assets, net of available deferred tax assets, that would result in a reduction to statutory surplus. If such requirement had been in effect in 1999, the statutory surplus of RCRe at December 31, 1999 would have remained at $290 million.
The effects of inflation on us are implicitly considered in pricing and estimating reserves for unpaid claims and claims expenses. The actual effects of inflation on our results cannot be accurately known until claims are ultimately settled.