Besides our home office, our principal office facilities are as follows:
(2) During 2000, we changed certain of our revenue recognition methods for our agencies and intermediaries to agree to guidance contained in Securities and Exchange Commission's Staff Accounting Bulletin Number 101 entitled "Revenue Recognition in Financial Statements". See Note (1) in the Notes to Consolidated Financial Statements.
Currently, our underwriting agencies underwrite life, accident and health, contingency (including contest indemnification, event cancellation, and weather coverages), directors and officers liability, individual disability (for athletes and other high profile individuals), kidnap and ransom and professional liability insurance and other specialty lines of business on behalf of our insurance companies and unaffiliated insurance companies. Our underwriting agency activities are fee based and non-risk bearing.
in a reduction in management fee income and the net earnings from our underwriting agency segment, but such reduction should be more than offset over time by increases in net earnings of our insurance company segment.
From 1999 through 2001, in response to adverse market conditions, we focused our acquisition activities on expanding our underwriting agency and intermediary operations for three principal reasons:
- to provide a future source of premium revenue to our insurance companies in existing and new specialty lines of business and greater control of premium distribution channels;
- to insulate us from a decline in our revenue growth rate as insurance premium rates became more competitive in our specialty lines of business and we became more selective in our underwriting, resulting in reduced earned premium;
During December, 1999, we acquired all of the outstanding shares of The Centris Group, Inc. in a transaction recorded using the purchase method of accounting. During October, 2001, we acquired all of the outstanding shares of ASU International, LLC and Marshall Rattner, Inc. and its operating subsidiary, Professional Indemnity Agency, Inc., which were also transactions recorded for using the purchase method of accounting. The results of operations and cash flows of these three companies are included in our consolidated results beginning on the effective date of each transaction.
During January, 2001, we acquired all of the outstanding shares of The Schanen Consulting Group, LLC. This business combination has been recorded using the pooling-of-interests method of accounting. Our consolidated financial statements have been restated to include the accounts and operations of The Schanen Consulting Group, LLC for all periods presented.
The following table sets forth certain premium revenue information for the three years ended December 31, 2001 (in thousands):
The following table sets forth the relationships of certain income statement items as a percent of total revenue for the three years ended December 31, 2001:
Total revenue increased 7% to $505.5 million for 2001 compared to 2000. The increase in the insurance company segment revenue resulting from increased business, greater retention levels and higher investment income was offset primarily by a reduction in the underwriting agency segment revenue as we consolidated the operations of three of our underwriting agencies into the operations of our insurance companies on January 1, 2001. We anticipate that total revenue will continue to increase in 2002 as earned premium continues to grow and revenue from recent acquisitions is included in our consolidated financial statements.
During 2001, we experienced three significant gross losses. The largest loss was as a result of the terrorist attacks on September 11, which produced the biggest loss to our insurance company operations in our history. Although we had no involvement in the insurance coverages of the airlines involved, we had significant exposure in our accident and health reinsurance account. Our estimates of ultimate exposure were developed through a review of policy coverages, consideration of the effect on the estimate if the attacks were considered multiple events rather than a single event, and communications from our clients and producers. We also have participations in property coverage on the World Trade Center and some of the surrounding buildings. In addition, we anticipate some claims from other business written in the New York City area. We also received some reported claims and estimates of losses for others. We have utilized this information together with known coverage and reinstatement premium information to establish our gross and net losses reserve of $141.0 million and $35.0 million, respectively. A charge for the net amount has been included in our 2001 consolidated financial statements. We continue to monitor the reserve and believe our estimates to be reasonable, but they may be subject to adjustment as we receive additional information, which could take several years to finalize. In addition, we have reviewed the estimated reinsurance recoverables related to this loss and believe that they are collectible in the normal course of business. Over 95% of the total amount of reinsurance recoverables from this loss are due from 38 companies and Lloyds' syndicates, each of which is rated "A-" or better by either A.M. Best Company, Inc. or Moody's Investors Services, Inc. The other two losses were the Petrobras (Brazilian offshore energy production platform) and Total (chemical factory near Toulouse, France) incidents, which produced gross losses of $55.0 million and $49.0 million, respectively. Because these policies were substantially reinsured, the net losses were not material to our results of operations. The Petrobras loss was paid during the third quarter of 2001 and all reinsurance recoverables related to it have been collected. We expect the reinsurance recoverables related to the Total loss to be collected in due course once the original claim is settled.
During 2001, we recorded a charge totaling $37.3 million related to lines of business that we are exiting, mainly our primary workers' compensation line of business. The composition of this charge is $18.8 million for loss and loss adjustment expense, $2.2 million for net policy acquisition costs and $16.3 million for other operating expense. Included in other operating expense is $15.0 million related to the impairment of goodwill associated with the primary workers' compensation line of business. The fair value of this line of business was calculated based upon the present value of future expected cash flows.
Other operating expense for 2001 included $16.3 million from charges related to lines of business being exited. Excluding these charges, other operating expense in 2001 was somewhat reduced for the same reasons as compensation expense, but to a much lesser extent, and the decrease was offset by a general increase in expenses in our operating subsidiaries as business grew. In addition, guarantee fund and other assessments increased $3.5 million in 2001 compared to 2000. Other operating expenses for 2000 also included a credit of $789,000 reflecting the reversal of some restructuring charges recorded during the previous year, whereas during 2001 we recorded $176,000 in merger expense resulting from an acquisition. Currency conversion gains amounted to $324,000 in 2001, compared to losses of $330,000 in 2000.
Income tax expense on earnings before the change in accounting was $30.2 million for 2001 down from $37.2 million for 2000 primarily due to the reduction in pre tax income. The unusual effective tax rate for 2001 of 50% compared to 39% for 2000, primarily results from the charge for the impairment of goodwill related to our exit from the primary workers' compensation line of business. That charge was not deductible for income tax purposes.
Gross written premium increased to $1.0 billion for 2001 from $967.5 million in 2000 with strong growth in the life, accident and health line of business and, to a lesser extent, in the marine, energy and property line of business, as rates continue to rise, offset by a planned decrease from exited lines. Gross written premium growth is not our focus in 2002, as we are able to grow our revenue simply by retaining more of the business we currently write. Net written premium for 2001 increased 31% to $373.0 million compared to the previous year, as our insurance companies have increased retentions on many of their lines of business as underwriting profitability improves. Net earned premium increased 28% to $342.8 million for the same reason. The increase in net written premium and net earned premium is expected to continue in 2002.
The net loss of our insurance companies was $2.9 million in 2001 compared to net income of $24.2 million for 2000. The 2001 results include after tax losses from September 11 of $22.8 million and expenses of $29.4 million.
Our net investment income increased 29% to $39.8 million in 2000 compared to 1999. This increase was primarily due to a higher level of invested assets which resulted from the greater retentions of premium underwritten by our insurance companies, the investment of cash received during the first quarter of 2000 from our commutation with a reinsurer and cash flow from operations.
Our interest expense was $20.3 million in 2000 compared to $13.0 million in 1999. This increase is a result of higher interest rates and increased debt outstanding, principally as a result of funding The Centris Group, Inc. acquisition.
Our book value per share was $10.29 as of December 31, 2000, up from $9.12 as of December 31, 1999.
Loss and loss adjustment expense incurred by our insurance companies increased to $198.5 million in 2000 from $109.7 million in 1999. The increase in net loss and loss adjustment expense is due to the higher level of net retained premium, net of the effect of improved underwriting results. The net loss ratio in accordance with generally accepted accounting principles decreased to 74.2% in 2000 from 77.6% in 1999. In 2000, we also recorded a $4.4 million increase in reserves for exited lines of business acquired with our 1999 acquisition of The Centris Group, Inc. This increase represents 1.6% of the 2000 net loss ratio. The gross loss ratio in accordance with generally accepted accounting principles decreased to 79.4% in 2000 from 116.5% in 1999. The general improvement in our loss ratios results from the effects of increased premium rates in certain lines of business, reduced writings in other unprofitable lines of business and a general improvement in market conditions, particularly in the domestic aviation and medical stop-loss lines of business. The combined ratio in accordance with generally accepted accounting principles of our insurance companies was 95.2% for 2000 compared to 129.3% (98.6% excluding effects of the provision for reinsurance) in 1999.
During 2000, we had net loss and loss adjustment expense redundancy of $9.6 million relating to prior year losses compared to a deficiency of $4.6 million in 1999 and we had gross loss and loss adjustment expense redundancy of $1.9 million compared to a deficiency of $90.0 million in 1999. The 1999 gross deficiency results from two principal conditions. The first is the development of large claims on individual policies which were either reported late or for which reserves were increased as subsequent information became available. However, as these policies were substantially reinsured, there was no material effect to our net earnings. Secondly, during 1999 in connection with the insolvency of one of the our reinsurers and with the commutation, finalized subsequent to year end, of all liabilities with another, we re-evaluated all loss reserves and incurred but not reported loss reserves related to business placed with these reinsurers to determine the ultimate losses we might conservatively expect. These reserves were then used as the basis for the determination of the provision for reinsurance recorded in 1999. The other deficiencies and redundancies in the reserves result from our continued review with our actuaries of loss reserves and the increase or reduction of such reserves as losses are finally settled and claims exposures are reduced. We continue to believe we have provided for all material net incurred losses.
During the fourth quarter of 2000, we also recorded a restructuring charge and associated expenses of $1.5 million. A total of 26 employees were terminated as a result of our restructuring of certain underwriting agency operations and their integration into our insurance company operations. The charges affected both segments and consisted of $557,000 accrued severance pay to be paid at various times throughout 2001 and $992,000 for the write down or write off of various impaired assets, primarily redundant computer software.
Our investment portfolio includes a high percentage of liquid investments and generates a significant amount of investment income, which serves as a source of cash flow. The average tax equivalent yield on investments was 5.6% in 2001, compared to 7.1% in 2000. The weighted average duration of the portfolio was four years as of December 31, 2001. Over 98% of our fixed income securities were rated A or better by Standard & Poor's Corporation. The value of our portfolio of fixed income securities is inversely correlated to changes in market interest rates. In addition, some of our fixed income securities have call or prepayment
On August 23, 2001, we issued an aggregate $172.5 million principal amount of 2% Convertible Notes due 2021 in a public offering. Each $1,000 principal amount of notes is convertible into 31.25 shares of our common stock, which represents an initial conversion price of $32.00 per share. The initial conversion price is subject to change under certain conditions. Interest is to be paid by us on March 1 and September 1 each year. Holders may surrender notes for conversion into shares of our common stock in any calendar quarter if, as of the last day of the preceding calendar quarter, the closing sale price of our common stock for at least 20 trading days in the period of 30 consecutive trading days ending on the last trading day of the quarter is more than 120% (currently $38.40 per share) of the conversion price per share of our common stock on the last trading day of the quarter. We can redeem the notes for cash at any time on or after September 1, 2006. Holders of the notes may require us to repurchase the notes on September 1, 2002, 2004, 2006, 2008, 2011 and 2016. If the holders exercise this option, we may choose to pay the purchase price in cash, in shares of our common stock, or a combination thereof. We paid $4.4 million in underwriting discounts and expenses in connection with the offering, which are being amortized from the issue date until September 1, 2002. We used the proceeds from this offering to repay our remaining indebtedness under the bank facility, assist in financing the recent acquisitions, make a $60.0 million capital contribution to our principal insurance companies and for general corporate purposes.
On December 17, 1999, we entered into a $300.0 million Revolving Loan Facility with a group of banks. At our request, the amount available under the facility was reduced to $200.0 million by an amendment on June 6, 2001. We can borrow up to the maximum amount allowed by the facility on a revolving basis until the facility expires on December 17, 2004. Outstanding advances under the facility bear interest at agreed upon rates, which ranged between 2.6% and 3.1% as of December 31, 2001. The facility is collateralized in part by the pledge of the stock of two of our principal insurance companies, Houston Casualty Company and Avemco Insurance Company, and by the stock of and guarantees entered into by our principal underwriting agencies and intermediaries. The facility agreement contains certain restrictive covenants, including minimum net worth requirements for us and certain of our subsidiaries, restrictions on certain extraordinary corporate actions, notice requirements for certain material occurrences and required maintenance of specified financial ratios. We believe that the restrictive covenants and our obligations that are contained in the facility agreement are typical for financing arrangements comparable to our facility. As of December 31, 2001, there was no outstanding balance on this facility.
As of December 31, 2001, certain of our subsidiaries maintained revolving lines of credit with a bank in the combined maximum amount of $20.0 million available through December 17, 2004. Advances under the lines of credit are limited to amounts required to fund draws, if any, on letters of credit issued by the bank on behalf of the subsidiaries and short-term direct cash advances. The lines of credit are collateralized by securities having an aggregate market value of up to $25.0 million, the actual amount of collateral at any one time being 125% of the aggregate amount outstanding. Interest on the lines is payable at the bank's prime rate of interest (4.75% at December 31, 2001) for draws on the letters of credit and prime less 1% on short-term cash advances. As of December 31, 2001, letters of credit totaling $7.1 million had been issued to insurance companies by the bank on behalf of our subsidiaries, with total securities of $8.9 million collateralizing the lines.
The following is a summary of our various commitments and their expirations as of December 31, 2001 (in thousands):
Under the laws of the State of Maryland, Avemco Insurance Company may only pay dividends out of statutory earned surplus. The maximum amount of dividends that Avemco Insurance Company may pay without prior regulatory approval in any twelve-month period is the lesser of its statutory net investment income excluding realized capital gains for the prior calendar year or 10% of its statutory policyholders' surplus as of the prior year end. During 2002, Avemco Insurance Company will have an ordinary dividend capacity of approximately $7.2 million.
HCC Life Insurance Company is limited by the laws of the State of Indiana in the amount of dividends it may pay in any twelve-month period, without prior regulatory approval, to the greater of its statutory net gain from operations for the prior calendar year or 10% of its policyholders' surplus as of the prior year end. During 2002, HCC Life Insurance Company's ordinary dividend capacity will be approximately $15.1 million.
A number of reinsurers have delayed or suspended the payment of amounts recoverable under certain reinsurance contracts to which we are a party. Such delays have affected, although not materially to date, the investment income of our insurance companies, but not to any extent their liquidity. We limit our liquidity exposure by holding funds, letters of credit or other security such that net balances due are significantly less than the gross balances shown in our consolidated balance sheets. In some instances, the reinsurers have withheld payment without reference to a substantive basis for the delay or suspension. In other cases, the reinsurers have claimed they are not liable to for payment to us of all or part of the amounts due under the applicable reinsurance agreement. We believe these claims are without merit and expect to collect the full amounts recoverable. We are currently in negotiations with most of these parties, but if such negotiations do not result in a satisfactory resolution of the matters in question, we may seek or be involved in a judicial or arbitral determination of these matters. In some cases, the final resolution of such disputes through arbitration or litigation may extend over several years.
Regulatory guidelines suggest that a property and casualty insurer's annual statutory gross written premium should not exceed 900% of its statutory policyholders' surplus and net written premium should not exceed 300% of its statutory policyholders' surplus. However, industry standards and rating agency criteria place these ratios at 300% and 200%, respectively. In the past, our property and casualty insurance companies have maintained premium to surplus ratios generally lower than such guidelines and below industry norms. For the year ended December 31, 2001, our statutory gross written premium to policyholders' surplus was 252.8% compared to 298.0% for the year ended December 31, 2000. For the year ended December 31, 2001, our statutory net written premium to policyholders' surplus was 92.5% compared to 87.0% for the year ended December 31, 2000. The gross written premium ratio increased during 2000 with the acquisition of The Centris Group, Inc.'s book of medical stop-loss business and the increasing use of our insurance companies as the issuing company for business written by our underwriting agencies. This ratio is expected to decrease slowly from its current level as statutory policyholders' surplus increases due to the retention of earnings, capital contributions and other increases in policyholders' surplus. As of December 31, 2001, each of our domestic insurance companies' total adjusted capital was significantly in excess of the authorized control level risk-based capital level prescribed by the National Association of Insurance Commissioners.
At January 1, 2002, and February 1, 2002, respectively, our onshore energy and property reinsurance protections were renewed without coverage for acts of terrorism. Therefore, to the extent that certain existing, in-force policies contain such coverage, then we would have a net exposure to any applicable losses. The actual amount of this exposure is not determinable but could represent a catastrophic loss, a risk for which we would usually purchase reinsurance protection. We do not believe that any loss would severely impact our capital. As each month goes by, existing in-force policies will expire and the overall exposure continues to reduce substantially.
Loss and loss adjustment expense payable by our insurance companies is based on estimates of payments to be made for reported and incurred but not reported losses and anticipated receipts from salvage and subrogation receipts. All reserves are recorded on an undiscounted basis, except for an immaterial amount of reserves acquired in a transaction recorded using the purchase method of accounting. Estimates for reported losses are based on all available information, including reports received from ceding companies on assumed business. Estimates for incurred but not reported losses are based both on our experience and the industry's experience. While we believe that amounts included in our financial statements are adequate, such estimates may be more or less than the amounts ultimately paid when the claims are settled. We continually review the estimates with our actuaries and any changes are reflected in the period of change.
When there is no significant future servicing obligation, management fees and commission income from our underwriting agencies and intermediaries, respectively, are recognized on the revenue recognition date, which is the later of the effective date of policy, the date when the premium can be reasonably established, or the date when substantially all the services relating to the insurance placement have been rendered to the client. Profit commissions based upon the profitability of business written are recorded as revenue at the end of each accounting period based upon the respective formula calculation. Such amounts are adjusted should experience change. When additional services are required, the service revenue is deferred and recognized over the service period. We also record an allowance for estimated return commissions which may be required to be paid upon the early termination of policies. These policies are consistent with policies that have become generally accepted accounting principles for insurance agents and brokers and with Securities and Exchange Commission Staff Accounting Bulletin Number 101 entitled "Revenue Recognition in Financial Statements."
We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. We regularly review our deferred tax assets for recoverability and establish a valuation allowance based on our history of earnings, expectations for future earnings, taxable income in carry back years and the expected timing of the reversals of existing temporary differences. Although realization is not assured, we believe it is more likely than not that we will be able to realize the benefit of our deferred tax assets. If there is a material change in the tax laws such that the actual effective tax rate changes or the time periods within which the underlying temporary differences become taxable or deductible change, we will need to reevaluate our assumptions which could result in a change in the valuation allowance required.
We assess the impairment of goodwill and intangible assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:
- significant underperformance relative to expected historical or projected future operating results;
When we determine that the carrying value of goodwill and other intangible assets may not be recoverable on an undiscounted cash flow basis, we will reduce the carrying value of the asset to estimated fair value, which is most often based on projected discounted cash flows using a discount rate we determine to be commensurate with the risk. Utilization of different assumptions to project cash flows and changes in interest rates could yield different estimates of discounted cash flow and fair value.
We adopted Statement of Financial Accounting Standards ("SFAS") No. 133 entitled "Accounting for Derivative Instruments and Hedging Activities" effective January 1, 2001. The cumulative effect adjustment due to this change in accounting is not material to our financial position, results of operations or cash flows. Since we utilize derivatives or hedging strategies on a limited basis, we do not expect the adoption of SFAS No. 133 to be material on an ongoing basis. SFAS No. 141 entitled "Business Combinations" was issued in June, 2001 and became effective July 1, 2001. SFAS No. 141 requires that all business combinations be accounted for using the purchase method of accounting, which requires that acquisitions be recorded at fair value as of the date of acquisition. The pooling-of-interests method of accounting allowed under prior standards, which reflected business combinations using historical financial information, is now prohibited.