(2) Earnings per share and net operating earnings per share are calculated on a diluted basis by using the weighted average number of common shares outstanding during the period. 1996 and 1995 disclosures have been restated in order to comply with SFAS No. 128--"Earnings per Share".
(3) Book value per share is equal to total shareholders' equity divided by the number of common shares outstanding at the end of the period.
The following discussion addresses the principal factors affecting the earnings and financial condition of the Company. All references herein to the "Company" are to Terra Nova (Bermuda) Holdings Ltd. ("Bermuda Holdings") and all of its direct and indirect subsidiaries, including Terra Nova Insurance (UK) Holdings plc ("UK Holdings"), Terra Nova Insurance Company Limited ("Terra Nova"), Terra Nova (Bermuda) Insurance Company Ltd. ("Terra Nova (Bermuda)"), Compagnie de Reassurance d'Ile de France ("Corifrance"), Octavian Syndicate Management Limited ("Octavian") and Terra Nova Capital Limited ("Terra Nova Capital").
The Company's mix of business for the years ended December 31, 1997, 1996 and 1995 and the key ratios by major line of business are as set forth in the following table:
The Company's functional currency is the U.S. dollar. The changes in line item amounts from year to year as discussed below are all affected by the movement in exchange rates, principally the dollar/sterling average rate which varied from $1.64 for 1997, $1.57 for 1996 and $1.58 for 1995.
(a) Increased writings by Terra Nova Capital to $162.8 million (excluding orphaned syndicate business and reinsurance to close premiums) in 1997 from $36.8 million in 1996 due to the Company's increased participation in the Octavian Syndicates from 11% in 1996 to approximately 47% in 1997;
Reinsurance ceded increased by 33.8% to $66.7 million in 1997 from $49.8 million in 1996. However, reinsurance ceded as a proportion of gross premiums written decreased to 12.1% in 1997 from 13.8% in 1996. The decrease was due to lower reinsurance costs at Terra Nova in 1997 due to structural changes on the non- marine property program and rate reductions obtained on the non-marine property, non-marine casualty and marine programs, partially offset by a higher level of reinsurance purchased by Terra Nova Capital in 1997.
Losses and Loss Adjustment Expenses. Losses and LAE increased 58.5%, to $282.5 million in 1997 from $178.3 million in 1996. As a percentage of net premiums earned, losses and LAE increased 3.4 percentage points, to 67.4% in 1997 from 64.0% in 1996. The loss and LAE ratio for non-marine property business increased
Other Operating Expenses. Other operating expenses increased 34.7% to $13.7 million in 1997 from $10.2 million in 1996. Other operating expenses as a percentage of net premiums earned decreased to 3.3% in 1997 from 3.7% in 1996.
Other Expenses. Other expenses remained constant at $5.3 million in both 1997 and 1996.
Income Tax Expense. Income tax expense marginally decreased $0.2 million, to $17.6 million in 1997 from $17.8 million in 1996, as a consequence of a reduction in the rate of U.K. Corporation Tax from 33% to 31% from April 1997.
Income from Continuing Operations. Income from continuing operations increased $8.5 million, to $73.4 million in 1997 from $64.9 million in 1996, as a result of the factors described above.
Combined Ratios. The Company's combined ratios were 98.2% for 1997 and 97.2% for 1996 reflecting the absence of significant large loses and any adverse development of prior year claims in both 1997 and 1996.
(a) increased writings by Terra Nova (Bermuda) to $33.3 million in 1996 from $6.9 million in 1995 as a consequence of a full year of marketing prior to the January renewals. At least 95% of the business written by Terra Nova (Bermuda) is property business comprising catastrophe, proportional treaty and risk excess business on a world-wide basis. The increases in the property writings at Terra Nova (Bermuda) and increases in proportional treaty and direct business written by Terra Nova have resulted in property gross premiums written increasing to $178.9 million in 1996 from $139.3 million in 1995.
Net premiums written increased by 26.0% to $311.2 million in 1996 from $247.0 million in 1995, as a consequence of the increase in gross premiums written referred to above and lower reinsurance costs. Net premiums earned increased 10.7%, to $278.8 million in 1996 from $251.9 million in 1995.
Agency Income. This income consists of fees received by Octavian in respect of the managing of certain Lloyd's syndicates.
Other Operating Expenses. Other operating expenses increased 1.1% to $10.2 million in 1996 from $10.1 million in 1995. Other operating expenses as a percentage of net premiums earned decreased to 3.7% in 1996 from 4.0% in 1995.
For the years ended December 31, 1997 and 1996, the cashflow provided by operating activities of the Company and available for investment was $81.3 million and $30.6 million, respectively. The increase in cash flows provided by operating activities in 1997 was primarily due to:
(c) Corifrance providing $4.0 million of operating cash flow in 1997; partially offset by
(d) Higher income tax payments of $23.0 million in 1997 compared to $0.3 million in 1996 due to a tax refund of $12.0 million in 1996.
On May 7, 1997, S&P raised its claims-paying ability rating of the Terra Nova Group to "A" from "A-" and the senior debt rating of UK Holdings to "BBB" from "BBB-". The rating increases reflect the continued enhancement of the Company's overall profile, including a stronger than expected operating performance in 1996 and success in securing a significant participation in the "new" Lloyd's market, while maintaining a strong degree of capitalization.
On September 8, 1997, the Company announced that it had purchased all of the issued and outstanding shares of Corifrance, a French reinsurance company which transacts business internationally.
The Company's assets, liabilities, revenues and expenses, except for the majority of corporate overheads which are paid in British pounds, are predominantly in U.S. dollars. Accordingly, the Company's functional currency is the U.S. dollar. Certain other net translation adjustments are shown as a separate component of shareholders' equity.
Bermuda Holdings maintains an internal control structure designed to provide reasonable assurance that assets are safeguarded from loss or unauthorized use, that transactions are recorded in accordance with management's direction and that the financial records are reliable for the purposes of preparing financial statements and maintaining accountability of assets. The management of Bermuda Holdings applied the concept of reasonable assurance by weighing the cost of an internal control structure against the benefits to be derived. The internal control structure is supported by the careful selection, training and development of qualified personnel, an appropriate division of responsibilities and the dissemination of written policies and procedures throughout Bermuda Holdings. The internal control structure is continually reviewed and evaluated by qualified personnel and periodically assessed by Coopers & Lybrand, independent accountants, to the extent required under generally accepted auditing standards in connection with their annual audit of Bermuda Holdings financial statements.
To the Shareholders and Board of Directors of Terra Nova (Bermuda) Holdings Ltd.
Terra Nova (Bermuda) Holdings Ltd. ("Bermuda Holdings") was incorporated in Bermuda. All references herein to the "Company" are to Bermuda Holdings and all of its direct and indirect subsidiaries, including Terra Nova Insurance (UK) Holdings plc ("UK Holdings"), Terra Nova Insurance Company Limited ("Terra Nova"), Terra Nova (Bermuda) Insurance Company Ltd. ("Terra Nova (Bermuda)"), Octavian Syndicate Management Limited ("Octavian"), Terra Nova Capital Limited ("Terra Nova Capital") and Compagnie de Reassurance d'Ile de France ("Corifrance").
The Company is a specialty property, casualty, marine and aviation insurance and reinsurance company operating in the London market through its London based subsidiary, Terra Nova, in the Continental European Market through its French subsidiary, Corifrance, purchased on September 8, 1997, in the Bermuda market through its Bermuda based subsidiary, Terra Nova (Bermuda) and in the Lloyd's market through its London based subsidiary, Terra Nova Capital. Writings originate worldwide. The vast majority of insurance and reinsurance business is written through brokers authorized to place business at Lloyd's. Business is also written through non-Lloyd's brokers and with individual ceding companies. The broker is regarded as the agent of the insured or reinsured in placing the business. The Company also owns the business and assets of Octavian, a Lloyd's managing agent, consisting primarily of the rights to manage eight Lloyd's syndicates (the "Octavian syndicates"), for the 1998 year of account.
(c) Premiums: Premiums are earned on a pro-rata basis over the term of the related coverage. The balance of unearned premiums represents the portion of gross premiums written relating to the unexpired terms of coverage.
(d) Deferred acquisition costs: Acquisition costs, which represent commission and other expenses directly related to the production of business, are deferred and amortized over the period in which the related premiums are earned. Deferred acquisition costs are limited to the amounts estimated to be recoverable from the applicable unearned premiums and the related anticipated investment income after giving effect to anticipated losses, loss adjustment expenses and expenses necessary to maintain the contracts in force.
(e) Losses and loss adjustment expenses: Losses and loss adjustment expenses are charged to income as incurred. The reserve for unpaid losses and loss adjustment expenses represents the accumulation of estimates for reported losses and includes provisions for losses incurred but not reported ("IBNR"). The adequacy of these estimates is assessed by reference to projections of the ultimate losses in respect of each accident year. The methods of determining such estimates and establishing reserves are continually reviewed and updated, and resulting adjustments are reflected in current operations.
(h) Insurance balances receivable and reinsurance recoverable on paid and unpaid losses: Receivable balances are stated net of allowances for doubtful accounts. Reinsurance recoverable on unpaid losses represents the estimated portion of such liabilities that will be recovered from reinsurers, determined in a manner consistent with the related liabilities.
(j) Prepaid reinsurance premiums: Prepaid reinsurance premiums represent the portion of premiums ceded to reinsurers applicable to the unexpired terms of reinsurance contracts. In respect of Terra Nova Capital reinsurance costs have been charged against income on the basis of the benefits derived in order to match the costs with the corresponding earned income.
Deferred compensation, which is recorded as shareholders' equity, represents the options that the Company expects to settle in stock.
(n) Goodwill: The goodwill in the Company's balance sheet has been calculated using the purchase method of accounting and is being amortized on a straight line basis over periods not exceeding 40 years.
On September 8, 1997, the Company purchased all of the issued and outstanding shares of Corifrance, a French reinsurance company, for a purchase price of $42.2 million. The acquisition was made by a French subsidiary of Terra Nova, the Group's U.K. operating insurance company.
Corifrance, which transacts business internationally, although mainly outside of the United States, had a gross written premium volume of $24.2 million in 1997. The Company's share of Corifrance's gross written premiums was $2.4 million. The goodwill in the Company's balance sheet includes the goodwill arising on the acquisition of Corifrance, which has been calculated using the purchase method of accounting and is being amortized on a straight line basis. The impact on the Company's results from the date of the acquisition included in the 1997 consolidated statements of operations comprise the following:
(a) Deposits: Securities with a carrying value of $74,832,873 and $48,741,933 at December 31, 1997 and 1996, respectively, were held in trust for the benefit of the Company's U.S. cedents and to facilitate the Company being accredited as an alien reinsurer by certain States.
The Company has contingent liabilities in respect of undrawn letters of credit supporting certain reinsurance business written by the Company in the U.S. of $121,020,906 and $166,577,765 at December 31, 1997 and 1996,
respectively. The Company has deposited cash and investments with a carrying value of $175,213,503 and $261,542,735 at December 31, 1997 and 1996 respectively, as collateral against these amounts.
The Company has contingent liabilities in respect of irrevocable undrawn letters of credit of $199,334,500 and $156,327,255 supporting the Company's underwriting activities on the Octavian syndicates for the 1997 and 1996 years of account, respectively. The Company has deposited cash and investments with a carrying value of $221,670,000 and $171,959,981 at December 31, 1997 and 1996, respectively, as collateral to support this commitment.
(b) The components of income tax expense attributable to continuing operations are as follows:
(c) Deferred tax liabilities and assets are provided for expected future tax consequences of events that have been recognized in the consolidated financial statements or tax returns. The measurement of current and deferred tax liabilities and assets is based on the difference between the financial statements and tax bases of assets and liabilities using enacted rates in effect for the years in which the differences are expected to reverse. The measurement of a deferred tax asset, if any, is subject to the expectation of future realization. The components of net deferred tax assets (liabilities) of the Company as at December 31, 1997 and 1996 were as follows:
an undertaking from the Minister of Finance in Bermuda that in the event of any such taxes being imposed, they will be exempted from such taxation until the year 2016.
Corifrance provides two defined contribution plans for its managers and all other employees, respectively. The annual contribution rate for managers is 5.66% of pensionable salary and, for employees, is 1.43% of pensionable salary.
In February 1997, the Financial Accounting Standards Board issued SFAS No. 128 "Earnings per Share". SFAS No. 128 prescribes the basis for computing basic earnings per share ("EPS") and diluted EPS.
(a) The following table provides the components of the common shares of the Company at December 31, 1997 and 1996:
Each "B" ordinary share at the Company is convertible, at the option of the holder into an "A" ordinary share without payment or adjustment for accrued dividends.
On May 5, 1997, the Company's Board of Directors authorized the repurchase of up to $20 million of the Company's common shares. As at December 31, 1997 the Company had purchased 500,000 shares at a total cost of $10,020,000. The shares are to be held in trust for the satisfaction of employees' and directors' long term compensation plans and any other corporate purposes.
In addition, the Company converted 251,923 "B" shares into "A" shares.
A summary of the Company's fixed stock option plan as of December 31, 1997 and changes during the year then ended is presented below:
As of December 31, 1997, the fixed options outstanding under the Plan have exercise prices between $5.80 and $25.52 and a weighted-average remaining contractual life of 6.99 years.
Options outstanding and options exercisable at December 31, 1997 are summarized as follows:
In connection with the Octavian Acquisition in 1996, the Company established the Octavian Stock Option Plan providing for the grant of options to certain individual members of management of Octavian based on profit commissions received by Octavian for the 1996 to 2000 years of account. Under the Octavian Stock Option Plan, such members of management will receive annual option grants to purchase a number of Shares equal in the aggregate to (i) 90% of the profit commission received by Octavian from the Octavian Syndicates (less underwriters' and management bonuses relating thereto and corporate taxes) for each year of account (the "Profit Commission Component"), divided by (ii) the fully diluted net asset value (as defined in the Octavian Stock Option Plan) per ordinary shares of the Company as at the end of the applicable year of account. The aggregate Profit Commission Component for the 1996 to 2000 years of account is subject to a maximum of (Pounds)10 million ($16 million) and no further options shall be issued once such maximum has been reached. The options will be issued upon receipt of the profit commissions on closure of each year of account under applicable Lloyd's regulations, which currently are 1999 to 2003 for each of the years 1996 to 2000, respectively. The options have a nominal exercise price and become exercisable on or after the January, next succeeding the date of grant, commencing January 1, 2000, provided that all options issued after January 1, 2002 become immediately exercisable.
As of December 31, 1997, the 96,497 performance options outstanding under the Plan all have exercise prices of $nil and a weighted-average remaining contractual life of 7.25 years.
A credit risk exists with respect to reinsurance ceded to the extent that any reinsurer is unable to meet the obligations assumed under the reinsurance arrangements. As is customary in the London Market, collateral is not generally obtained from reinsurers. Reinsurance contracts do not relieve the ceding company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses; consequently allowances are established for amounts deemed uncollectible. The Company evaluates the financial condition of its reinsurers and monitors concentrations of credit risk arising from its exposure to individual reinsurers.
Management believes that its reserves for losses and loss adjustment expenses are adequate. Significant delays occur in the notification of certain claims and a substantial measure of experience and judgment is involved in assessing outstanding liabilities, the ultimate cost of which cannot be known with certainty at the balance sheet date. The reserve for unpaid losses and loss adjustment expenses is determined on the basis of information currently available; however, it is inherent in the nature of the business written that the ultimate liabilities may vary as a result of subsequent development.
Movement in unpaid losses and loss adjustment expenses for the years ended December 31, 1997, 1996 and 1995 is summarized as follows:
Incurred claims relating to prior years are offset by decreases to prior year net written and net earned premiums less related acquisition costs of $4,800,000, $3,550,000 and $6,396,000 for 1997, 1996 and 1995 respectively. When these revisions to prior written and earned premiums are taken into account, the Company experienced net prior year improvement of $5,596,000 in 1997, and deteriorations of $950,000 and $9,655,000 for 1996 and 1995, respectively.
adverse effect on its financial position, although there is no assurance that such losses will not materially affect the Company's results of operations for any period. However, management is not able to estimate the additional loss, or range of loss, that is reasonably possible.
The reinsurance recoverables netted against the loss reserves for each of the years 1997, 1996 and 1995 are as follows:
(c) The Company entered into various lease agreements for office space. Certain leases have options permitting renewals for additional periods. In addition to minimum fixed rentals, certain leases contain escalation clauses related to the cost of living in future years. The future minimum aggregate rental commitments for office space at December 31, 1997 under non-cancelable operating leases are as follows:
Rental expense on property leases of $4,102,000, $3,802,000 and $2,257,000 was incurred for the periods to December 31, 1997, 1996 and 1995 respectively.
The Company's total outstanding consolidated indebtedness at December 31, 1997 was thus comprised of $175 million of the Senior Notes including the $100 million 10.75% Senior Notes due 2005, issued in 1995. The estimated fair value of these Senior Notes at December 31, 1997 was $188.0 million, comprising $76.5 million of 7.2% Senior Notes due 2007 and $111.5 million of 10.75% Senior Notes due 2005.
The 7.2% Senior Notes due 2007 may be redeemed at any time at the option of UK Holdings at a redemption price equal to the sum of: (i) the principal amount of the Senior Notes being redeemed plus accrued interest to the redemption date and (ii) the make-whole amount, if any.
from abandonment of Aviation business for periods up to December 31, 1994. However, as explained in Note 13, estimates of ultimate liabilities for losses and loss adjustment expenses may vary as a result of subsequent development. Following the Acquisition charges or credits resulting from changes in estimates after December 31, 1994 are reflected in continuing operations of the Company. Terra Nova estimates that in excess of 90% of Aviation liabilities will have been settled within three years after December 31, 1997.
As of December 31, 1997, Terra Nova's aggregate exposure in respect of reinsurance ceded to Lloyd's syndicates in relation to Aviation, including estimated reinsurance recoveries in respect of losses incurred but not reported, was approximately $15,530,000, all of which was ceded into Equitas with effect from September 4, 1996.
allocated to Aviation by applying the relevant U.K. corporation tax rates to the pre-tax loss on Aviation operations.
(a) Terra Nova files an annual audited return with the H.M. Treasury (the "Treasury") in the U.K. The Treasury has assumed the responsibilities for supervision of insurance companies previously undertaken by the D.T.I.. The Treasury requires U.K. insurance companies to comply with prescribed minimum solvency margins. Terra Nova's unaudited required minimum Treasury solvency margin and unaudited solvency margin at December 31, 1997 were $30,117,000 and $201,557,000, respectively. Terra Nova's unaudited and estimated Treasury Return policyholders' surplus and unaudited net income for the year ended December 31, 1997 and the audited Treasury Return policyholders' surplus and net income as reported in the annual returns to the Treasury for the years ended December 31, 1996 and 1995 are as follows:
Terra Nova's ability to pay dividends is limited by a Notice of Requirements issued by the Treasury, which requires Terra Nova to give 14 days' advance notice to the Treasury of its intention to declare and pay a dividend. In addition, Terra Nova must comply with the Companies Act 1985, which provides that dividends may only be paid out of distributable profits.
Terra Nova (Bermuda)'s statutory capital and surplus and minimum required statutory capital and surplus at December 31, 1997, 1996 and 1995 respectively were:
Bermuda Holdings' and UK Holdings' ability to meet their expenses and debt services requirements is dependent upon the ability of Terra Nova and Terra Nova (Bermuda) to pay dividends as described above.
UK Holdings was incorporated in the United Kingdom on November 7, 1994 for the purposes of acquiring Terra Nova. UK Holdings is the issuer of Senior Notes as described in Note 16. Bermuda Holdings is the guarantor of such notes. The Guarantee is full and unconditional.
Summarized consolidated balance sheet information as at December 31, 1997 and 1996 and summarized consolidated statements of operations information for the years December 31, 1997, 1996 and 1995 relating to UK Holdings is set out below.