The Company acquired United Capitol in February 1990, Western Surety in August 1992 and Universal Surety in September 1994. The inclusion of the results of United Capitol, Western Surety and Universal Surety from their respective dates of acquisition affects the comparability of financial information. Such results are not necessarily indicative of future results. In 1993, the Company adopted Statement of Financial Accounting Standard ("SFAS") No. 109 and No. 113 and has restated prior years' financial information for the effects of these pronouncements. Effective January 1, 1994, the Company adopted SFAS No. 115. For a more detailed description of these transactions and their effects on the Company's financial data, see the audited Consolidated Financial Statements and related notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations appearing in this or previously issued Annual Reports on Form 10-K.
GENERAL The following is a discussion and analysis of Capsure Holdings Corp. and its subsidiaries' ("Capsure" or the "Company") operating results, financial condition, liquidity and capital resources. This discussion should be read in conjunction with the audited Consolidated Financial Statements and notes thereto, which contain additional information regarding the Company's operating results and financial condition.
Western Surety's products, that the Company's results of operations will not be significantly affected by new miscellaneous bond requirements or by the repeal of any existing legislated bonding requirements.
Surety and fidelity represents the combined results of Western Surety and Universal Surety, since its September 1994 acquisition. Surety and fidelity are the principal lines of business of Western Surety and Universal Surety. Excess and surplus lines represents the results of United Capitol. United Capitol's principal lines of business are other liability, product liability and commercial property primarily written on an excess and surplus lines basis.
Net earned premiums increased $6.2 million for the year ended December 31, 1995, principally due to the inclusion of the full year results of Universal Surety in 1995. Universal Surety contributed net earned premiums of $14.7 million in 1995. Western Surety's net earned premiums increased 1.6% in 1995 compared to 1994. United Capitol's net earned premiums decreased 28.7%, or $5.5 million in 1995, reflecting decreases in both gross written premiums and net retentions. The lower net retentions are due primarily to the increased use of reinsurance for primary casualty risks in an effort to limit the potential loss volatility associated with a diminished premium base. United Capitol's net earned premiums for the years ended December 31, 1995 and 1994 were increased by $2.6 million and $2.5 million, respectively, for contingent premiums recognized under its reinsurance agreements.
Gross written premiums increased $1.6 million for the year ended December 31, 1994. Western Surety experienced a 1.1% decrease in gross written premiums, mainly due to a decline in public official bond premiums as compared to 1993. This decline, which was expected, was caused by the cyclical nature of these bonds. Writings for this product typically increase every other year, following the November elections. Universal Surety contributed $4.0 million of gross written premiums since its acquisition in September 1994. United Capitol's gross written premiums decreased 5.8%, or $1.7 million, in 1994. Significant declines in the asbestos abatement and other primary casualty business were partially offset by the addition of $5.7 million in gross written premiums of D&O business produced by Fischer which was acquired in November 1993 by a subsidiary of United Capitol. United Capitol's premium volume, particularly in the increasingly competitive asbestos abatement line, continued to be significantly and adversely affected by prolonged soft market conditions.
Net earned premiums increased $6.5 million for the year ended December 31, 1994. Western Surety's net earned premiums increased 1.9% in 1994 compared to 1993. Universal Surety contributed net earned premiums of $4.0 million in 1994. United Capitol's net earned premiums increased 6.3%, or $1.1 million, in 1994, primarily as a result of the recognition of $2.5 million of contingent reinsurance premiums related to an excess of loss reinsurance treaty. Excluding the recognition of the contingent premiums, net earned premiums decreased 7.5% at United Capitol.
The consolidated expense ratio decreased to 58.3% in 1994, compared to 59.1% in 1993. The surety and fidelity expense ratio decreased to 67.7% in 1994 from 69.1% in 1993. Net commissions, brokerage and other underwriting expenses incurred at Western Surety were effectively controlled during 1994, offsetting increased costs associated with enhancing Western Surety's computer systems. United Capitol's expense ratio increased to 22.5% in 1994 compared to 21.6% in 1993.
INVESTMENT INCOME Net investment income for the years ended December 31, 1995, 1994 and 1993 was $20.5 million, $19.1 million and $19.8 million, respectively. The average pretax yields of the portfolio for the years ended December 31, 1995, 1994 and 1993 were 6.8%, 6.5% and 6.8%, respectively.
Interest expense decreased by 13.2%, or $0.6 million, to $4.1 million for the year ended December 31, 1995, reflecting the effect of reduced debt. The Company's average debt outstanding for the year ended December 31, 1995, was approximately $49.6 million compared to $70.5 million in 1994. The weighted average interest rates were 6.9% and 5.7% for the years ended December 31, 1995 and 1994, respectively. In connection with the early retirement of the Company's bank term loans in 1994, the Company incurred a $1.6 million write-off of unamortized deferred loan fees in the year ended December 31, 1994. Interest expense decreased 24.7%, or $1.6 million, for the year ended December 31, 1994, reflecting the effect of reduced debt. The Company's average debt outstanding for the year ended December 31, 1994, was approximately $70.5 million compared to $96.0 million in 1993. The weighted average interest rate was 5.7% for the year ended December 31, 1993.
INCOME TAXES Income taxes were $19.7 million, $9.4 million and $9.2 million for the years ended December 31, 1995, 1994 and 1993, respectively. The effective income tax rates were 49.0%, 39.5% and 36.2%, respectively. The increase in the 1995 effective tax rate over 1994 was primarily due to the $13.2 million write-down of nondeductible goodwill associated with the 1990 United Capitol acquisition. The increase in the 1994 effective tax rate over the prior year was attributable to an increased level of nondeductible goodwill amortization in connection with the acquisitions of Universal Surety and Fischer as well as certain delayed provisions of the Revenue Reconciliation Act of 1993. The Company's income tax expense does not approximate actual taxes paid, primarily due to the utilization of the Company's NOLs. Actual income taxes paid were $0.7 million for the year ended December 31, 1995 and $0.6 million for each of the years ended December 31, 1994 and 1993.
The Company believes total invested assets, including cash and short-term investments, are sufficient in the aggregate and have suitably scheduled maturities to satisfy all policy claims and other operating liabilities, including anticipated income tax sharing payments of its insurance operations. Management believes the duration of each insurance subsidiary's portfolio is properly matched with the expected duration of its liabilities. At December 31, 1995, the carrying value of the Company's invested assets of the insurance operations was comprised of $235.7 million of fixed maturities, $33.1 million of short-term investments, $16.2 million of equity securities, $3.2 million of other investments and $2.7 million of cash. At December 31, 1994, the carrying value of the Company's invested assets of the insurance operations was comprised of $246.6 million of fixed maturities, $20.6 million of equity securities, $17.5 million of short-term investments, $4.1 million of other investments and $3.8 million of cash. The increase in short-
On March 29, 1994, the Company formed a direct, wholly owned subsidiary, Capsure Financial Group, Inc. ("CFG"), to which Capsure contributed substantially all its assets and liabilities. Concurrently, CFG entered into a senior reducing revolving credit agreement with a syndicate of banks for the principal amount of $135 million (the "Credit Facility"). At closing, $68 million of funds drawn under the Credit Facility, together with a portion of the Company's cash, were used to repay $84.6 million of previously existing bank term debt. Paydowns of $71 million and borrowings of $28 million for the acquisition of Universal Surety have occurred since then. The remaining availability under the Credit Facility of $110 million may be used to finance future acquisitions and for general corporate purposes.
is expected to close in the second quarter of 1996. Prior to closing, the Company must obtain a waiver from the lenders under the Credit Facility or otherwise amend the agreement to permit the sale of United Capitol. The sale of United Capitol will liberate approximately $75 million of Capsure's capital. Capsure is considering alternative uses of this capital including funding of acquisitions, stock repurchases, payment of stockholder dividends and some combination of the foregoing.
Intercompany tax sharing agreements between Capsure and its subsidiaries provide that income taxes shall be allocated based upon separate return calculations in accordance with the Internal Revenue Code of 1986, as amended (the "Code"). Intercompany tax payments are remitted at such times as estimated tax payments would be required to be made to the Internal Revenue Service ("IRS"). Capsure received tax sharing payments from its subsidiaries of $12.8 million, $12.3 million and $13.0 million in 1995, 1994 and 1993, respectively.
FINANCIAL CONDITION A significant factor affecting the Company's financial condition is the Company's policy with respect to investing insurance-related funds. The Company's policy is to invest a substantial portion of such funds in high-quality, short-duration mortgage pass-through instruments, collateralized mortgage obligations ("CMOs") and other asset-backed securities. CMOs differ from traditional fixed maturities in that they may expose the investor to yield variability and even principal risk due to such factors as high mortgage prepayment rates and defaults and delinquencies in the underlying asset pool. Management believes it has reduced prepayment variability by investing only in short tranches and by owning a substantial amount of planned amortization class ("PAC") tranches which are structured largely to insulate the investor from prepayment risk. A PAC tranche is structured to amortize in a predictable manner and, therefore, the risk of prepayment of the underlying collateral is shifted to other tranches, whose owners are willing to accept such risk. Further, management believes it has minimized credit risk primarily by purchasing only securities rated A or better on the date of acquisition and which are collateralized or guaranteed by U.S. Government agencies or have substantial credit enhancement in the form of financial guarantees, mortgage insurance, letters of credit, over-collateralization, subordinated structures and excess servicing spreads. Management monitors the investment portfolio of the insurance subsidiaries and the current rating of each security owned on a monthly basis. Beginning in 1994, the Investment Committees of the Board of Directors of the Company and its insurance subsidiaries have approved the investment of up to $26 million in the aggregate by the insurance subsidiaries and at the parent company level in publicly traded nonaffiliated REIT equity securities. At December 31, 1995 and 1994, the carrying value of the Company's REIT portfolio was approximately $20.4 million and $24.3 million, respectively.
The following table sets forth the composition by ratings assigned by The Standard & Poors Corporation ("S&P") or Moody's Investor Services, Inc. ("Moody's") of the fixed income portfolio of the Company as of December 31, 1995 (dollars in thousands):
As a result of favorable claim settlements and changes in estimates of insured events in prior years, the provision for losses and loss adjustment expenses decreased by $34.6 million ($29.1 million, net of reinsurance) in 1995, $14.5 million ($8.3 million, net of reinsurance) in 1994 and $15.0 million ($11.3 million, net of reinsurance) in 1993. As described within Results of Operations - Insurance Underwriting, United Capitol reduced loss and loss adjustment expenses by $23.2 million in 1995 for net favorable development related to prior years.
The National Association of Insurance Commissioners ("NAIC") has promulgated Risk-Based Capital ("RBC") requirements for property and casualty insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, asset and liability matching, loss reserve adequacy, and other business factors. The RBC information will be used by state insurance regulators as an early warning tool to identify, for the purpose of initiating regulatory action, insurance companies that potentially are inadequately capitalized. In addition, the formula defines new minimum capital standards that will supplement the current system of fixed minimum capital and surplus requirements on a state-by-state basis. Regulatory compliance is determined by a ratio (the "Ratio") of the enterprise's regulatory total adjusted capital, as defined by the NAIC, to its authorized control level RBC, as defined by the NAIC. Generally, a Ratio in excess of 200% of authorized control level RBC requires no corrective actions on the behalf of the company or regulators. As of December 31, 1995, each of Capsure's insurance subsidiaries had a Ratio that was substantially in excess of the minimum RBC requirements.
The IRS has not examined the Company's tax returns for the years in which the Company reported net operating losses. Under Section 382 of the Code, certain restrictions on the utilization of NOLs will apply if there is an ownership change of a corporation entitled to use such carryovers. The Company believes that there is currently no restriction on the ability of the Company to utilize its NOLs. It is possible that future transactions involving the common stock or rights to acquire such stock could cause an ownership change of the Company resulting in restrictions of the Company's ability to utilize the NOLs during all taxable periods after the date of such ownership change. The Company has adopted provisions in its Certificate of Incorporation designed to facilitate the Company's ability to preserve and utilize its NOLs.
United Capitol, in the ordinary course of business, chooses to underwrite accounts which have hazardous, unique or unusual risk characteristics and applies a strict and specialized underwriting discipline to such risks. Since United Capitol's organization in 1986, its liability policies have included an absolute pollution coverage exclusion (except for policies offering pollution liability coverage to contractors involved in the remediation of preexisting pollution). In addition, except as discussed below, United Capitol's product liability and other primary general liability policies contain exclusions for coverage of claims for bodily injury or property damage caused by exposure to asbestos.
United Capitol provides coverage to asbestos abatement contractors against third parties who have alleged bodily injury or property damage as a result of exposure to asbestos. Employees of the insured
Management believes that Capsure is adequately reserved for risks associated with environmental liabilities although there can be no assurance that legal or other developments will not increase the Company's exposure to environmental liabilities.