The Company is headquartered in Lakeland, Florida, where it leases approximately 80,000 square feet of space in a campus of nine buildings. The Company also leases office space including approximately 2,000 square feet in Lexington, Kentucky; and approximately 1,000 square feet in Ft. Lauderdale, Florida.
The conversion and recapitalization transactions described above are considered to be similar to pooling of interests transactions. The historical cost basis accounting of the predecessor companies has been retained and the Company's financial statements have been presented using pooling of interests basis accounting. The conversion and recapitalization transactions had no impact upon previously reported net income of the consolidated entities.
The Company's managed care workers' compensation insurance operations are comprised primarily of the Administrative Subsidiaries and the Insurance Subsidiaries. The Company's income is generated principally from three sources: fees earned from the management of the Non-affiliated Entities, underwriting profits derived from premiums earned on insurance policies written by the Insurance Subsidiaries and investment income generated by invested assets related to insurance underwriting.
Florida. Effective January 1, 1994 (with subsequent certain amendments), Florida enacted new legislation (the "New Florida Law") that changed the underwriting environment for workers' compensation by, among other things: (i) limiting certain benefits that must be provided; (ii) eliminating wage loss benefits in favor of a system of benefits based upon a schedule of impairment ratings plus supplemental benefits; (iii) obligating employers to rehire injured workers; (iv) adopting new procedures for dispute resolution designed to reduce litigation costs; and (v) redefining permanent impairment.
In addition, the New Florida Law authorized insurers and self-insured groups to apply to the Florida DOI for permission to offer premium credits of up to 10% from January 1, 1994 through December 31, 1996 to insured employers who participated in approved managed care arrangements and, effective January 1, 1997, required all insured employers to participate in managed care arrangements. The New Florida Law also authorized premium credits for insured employers who participate in safety and drug-free workplace programs. In response to the New Florida Law, which was expected to result in savings to self-insured groups and insurers, the Florida DOI ordered a 10.6% overall rate decrease, effective January 1, 1994. In addition, the New Florida Law eliminated the residual market assessment that was levied against insurance companies to support the involuntary workers' compensation market and replaced it with a self-funded joint underwriting association. As a result, the financial obligation of funding deficits in the residual market mechanism was shifted from traditional insurance entities to employers who are insured by the joint underwriting association. While the long term impact of the New Florida Law cannot be determined, the Company believes that it has resulted in: (i) a more competitive workers' compensation market in Florida; (ii) conversions by some of the larger self-insured groups to traditional insurance entities; and (iii) loss portfolio transfers by self-insured groups to insurance companies.
The Insurance Subsidiaries have entered into certain Quota Share Reinsurance agreements pursuant to which 75% of Bridgefield and 80% of Bridgefield Casualty's net premiums have been ceded to the respective reinsurers. While such reinsurance agreements have enabled the Insurance Subsidiaries to underwrite a larger number of policies than they could otherwise write, the ceding of a percentage of the premiums of such policies to the reinsurers has resulted in lower premium income, as well as lower losses and LAE, to the Company than in prior years. However, the Company has received a ceding commission related to the Quota Share Reinsurance agreements which is reflected as a reduction of operating expenses. Management does not currently anticipate that the net income of the Company will be adversely effected by such agreements.
Prior to the Acquisition, ESIF and SHC were unaffiliated entities. Although SHC (through its wholly owned subsidiary, SCI) had provided all administrative and management services required to operate ESIF since ESIF's inception in 1978, the two organizations had different financial objectives and reported historical financial results independently. ESIF used a fiscal year ending on March 31, and SHC used a fiscal year ending on December 31. As a result of the Acquisition, SHC became a wholly owned subsidiary of ESIF, and management began to implement an integrated strategic plan. The discussion below in "--Results of Operations" includes SHC from and after the date of the Acquisition.
On August 20, 1997, the Board of Directors of Summit determined to change the fiscal year end of Summit from March 31 to December 31.
Premiums earned were also impacted by an 11.2% rate reduction and the elimination of the 10% managed care credit which became effective January 1, 1997 for new and renewal policies. The net effect of these changes was a decrease in premium rates of approximately 4.5%.
Net Investment Income. Net investment income increased $1.5 million, or 15.7%, to $11.1 million for the nine months ended December 31, 1997 compared to $9.6 million for the same period in 1996. This increase was due to the increase in investment assets generated by the public offering on May 22, 1997 which provided net proceeds of approximately $57.8 million. The investment income included $2.6 million and $3.3 million from the municipal bond portfolio for the nine months ended December 31, 1996 and 1997, respectively.
LOSSES AND EXPENSES. The losses and expenses for the nine months ended December 31, 1996 and 1997 were $102.5 and $42.6 million, respectively. Set forth below is a breakdown of such expenses.
Amortization and Depreciation. Amortization and depreciation expense decreased $0.3 million between the nine-month period ended December 31, 1996 and 1997. The relative consistency in this expense is due to the lack of significant purchase and sale activity of property and equipment assets and intangibles. This decline of $0.3 million is primarily due to certain property and equipment assets becoming fully depreciated during the nine-month periods ended December 31, 1996 and 1997.
Interest Expense. In connection with the Acquisition, SHC borrowed $44 million from a commercial lender. In December 1997, a new $30 million revolver was negotiated with a different lender at more favorable terms. The outstanding debt at December 31, 1997 was approximately $16.5 million. The combination of the paydown on the debt and the new more favorable rates decreased the interest expense by $0.8 million to $1.9 million for the nine months ended December 31, 1997.
NET INCOME. The Company realized net income during the nine months ended December 31, 1997 of $8.6 million, or $1.40 per common share (on a diluted basis), compared to $3.2 million for the nine months ended December 31, 1996. Earnings per share is inapplicable to the 1996 period as it was prior to the Company's public offering. As explained above, this increase in net income is due primarily to growth in premium revenues written and earned, improvement in the Company's loss ratio, favorable reinsurance arrangements, and investment gains realized as a result of the continued strength in the U.S. security markets. Net income for the nine month ended December 31, 1996 was also reduced by a $1.2 million loss from discontinued operations and a $0.8 million extraordinary charge related to the costs of the Conversion.
REVENUE. Revenue was $140.3 million and $144.8 million for the fiscal years ended March 31, 1996 and 1997, respectively. Revenue increased by $4.5 million for the fiscal year ended March 31, 1997 as a result of $33.3 million of administrative fees generated by SHC in the 1997 period compared to $7.7 million of administrative fees generated by SHC in the 1996 period (January 16, 1996-March 31, 1996). Set forth below is a discussion of the composition of revenue for the periods indicated.
Premiums Earned. Premiums earned decreased by $17.6 million, or 15.3%, for the year ended March 31, 1997. These declines in premiums resulted in large part from: (i) lost accounts due to the market's increasing preference for non-assessable products, which ESIF, as a Florida group self-insurance fund, was unable to offer; (ii) increased competition; (iii) the effects of increasing participation in the premium credit programs; (iv) an adjustment in estimation of accrued retrospective premiums which reduced reported premiums for the fiscal year ended March 31, 1996 by approximately $9.3 million; and (v) a rate decrease of 11.2% effective January 1, 1997.
In January 1997, the 10% managed care premium credit was eliminated and a 11.2% premium rate reduction for new and renewal policies became effective.
Net Investment Income. Net investment income decreased from $13.2 million for the fiscal year ended March 31, 1996 to $12.8 million for the fiscal year ended March 31, 1997. The decrease in investment income for the fiscal year ended March 31, 1997 was due in part to a reduction of invested assets and a larger portion of those assets invested in municipal bonds.
The decrease for the fiscal year ended March 31, 1997 was primarily due to an increase in assets invested in municipal bonds from 32% in 1996 to 38% in 1997.
Realized Investment Gains. Realized investment gains decreased from $4.4 million for the fiscal year ended March 31, 1996 to $0.7 million for the fiscal year ended March 31, 1997 as a result of the sale of certain invested assets to finance the Acquisition.
LOSSES AND EXPENSES. The Company's losses and expenses decreased from $140.5 million for the fiscal year ended March 31, 1996 to $134.1 million for the fiscal year ended March 31, 1997. Set forth below is a breakdown of the total annual expenses.
Prior to the fiscal year ended March 31, 1995, management had recorded reserves in excess of reserve levels required by actuarial reports because the actuarial estimates for fund years
1991 and earlier had a history of increasing (or "adversely developing") as the fund years matured and more actual loss data became known. During the fiscal year ended March 31, 1995, ESIF began to record reserves at levels primarily supported by actuarial reviews since the actuarial estimates had by that time evidenced a trend of less adverse development with the maturity of the fund years. Management's determination that it was no longer necessary to increase reserves over the actuarial estimates, together with a reduction in premiums earned and a lower actuarial loss ratio, resulted in a $39.3 million decrease in losses and LAE for the fiscal year ended March 31, 1995 as compared to fiscal year ended March 31, 1994. The subsequent increase of $25.7 million in losses and LAE for the fiscal year ended March 31, 1996, was primarily the result of revised actuarial estimates for prior years. In the fiscal year ended March 31, 1997, losses and LAE decreased by $29.7 million as compared to the fiscal year ended March 31, 1996 primarily as a result of (i) the abnormally high losses and LAE in 1996 due to prior year adjustments all recorded in that year, and (ii) a reduction in premiums earned. The net loss ratio for the fiscal years ended March 31, 1996 and 1997 was 82.5%, and 66.9%, respectively.
Underwriting, General and Administrative Expenses. The increase in these expenses from $43.7 million to $60.7 million in the fiscal year ended March 31, 1997 was primarily due to the inclusion of the Acquisition as of January 16, 1996.
Interest Expense. In connection with the Acquisition, SHC borrowed $44.0 million from a commercial lender, and as a result, interest expense on a consolidated basis for the fiscal years ended March 31, 1996 and 1997 was $0.8 million and $3.5 million, respectively.
Amortization and Depreciation. In connection with the Acquisition, SHC recorded certain intangibles including software, noncompete agreements, customer contracts and goodwill. For the fiscal years ended March 31, 1996 and 1997, amortization of these intangible assets was $1.1 million and $3.8 million, respectively. The expense associated with amortization of these intangible assets is not deductible for federal income tax purposes.
Losses from discontinued operations of $0.2 million and $1.3 million were incurred for the years ended March 31, 1996 and 1997, respectively. In addition, an extraordinary charge of $1.5 million was incurred during the year ended March 31, 1997 related to the conversion of ESIF from a group of self-insurance fund to a stock insurance company. After inclusion of these nonrecurring items, net income was $0.2 million and $4.2 million for the years ended March 31, 1996 and 1997, respectively.
In connection with the Acquisition, SHC acquired a bank term loan and procured a revolving bank credit facility. On May 28, 1997, the date of ESIF's conversion, Summit entered into a new credit facility with First Union National Bank of North Carolina whereby the then-existing debt was restructured. Under this new credit facility, the outstanding debt pertaining to the term loan was established at $32.7 million, and the maximum amount available for borrowings under a revolving line of credit was established at $5.0 million. The interest rate applicable to this debt package was also established at the prime lending rate plus 1%.
cash of $11.3 million was used to reduce this debt. During the nine months ended December 31, 1996, net cash provided by operations was $10.7 million while net cash of $13.3 million was utilized in operations during the nine-month period ended December 31, 1997. For this 1996 period, the net cash provided was primarily due to the collection of $9.7 million of income taxes recoverable. The utilization of cash during the 1997 nine-month period was related primarily to the increase in reinsurance recoverables and the reduction of loss and LAE reserves.
Relating to investing activities, cash was utilized in net amounts of $3.0 million and $26.0 million during the nine months ended December 31, 1996 and 1997, respectively, primarily the result of net purchases of investments. Cash of $11.0 million was used in financing activities during the nine months ended December 31, 1996 representing payments on debt. During the nine months ended December 31, 1997, net cash of $41.6 million was generated from financing activities. Of this amount, $16.1 million was used to reduce the Company's debt obligation and $57.7 million was provided as net proceeds on the sales of the Company's capital stock. The Company expects to redeem the Series A Preferred Stock from future surpluses in excess of statutorily required capital.
Although the SDTF has not charged adequate assessments to actuarially fund its claims liability, under a recent legislative enactment the SDTF law has been amended so that claims arising from accidents occurring on or after January 1, 1998 will not be accepted for reimbursement by the SDTF. The new legislation states the SDTF will be liable for reimbursement for applicable injuries that occur prior to January 1, 1998 and that assessments are to continue for funding purposes. The SDTF has not failed to make payments on accepted claims, and the Company has no reason to believe that the SDTF will fail to meet its obligations to pay accepted claims in the future, although there can be no assurance thereof. Should the SDTF fail to met such obligations, the Company believes that the existing reimbursement obligations of the SDTF would become general obligations of the State of Florida, although there is no assurance that a reviewing court would adopt that view. The SDTF has made no acknowledgment with regard to the enforceability of its reimbursement obligations to insurers such as the Company. See "ITEM 1. BUSINESS--Regulation--Special Disability Trust Fund."
The NAIC has recently adopted risk-based capital standards to establish the capital requirements of an insurance carrier based upon the risks inherent in its operations. The standards, which have become effective in Florida under a bill recently passed by the Florida legislature, require the computation of a risk-based capital amount which is then compared to a carrier's actual total adjusted capital. The computation involves applying various financial factors to address four primary risks: asset risk, insurance underwriting risk, credit risk and off-balance sheet risk. These standards provide for regulatory intervention when the percentage of total adjusted capital to authorized control level risk-based capital is below certain levels. In July 1997, the Florida legislature adopted the provisions of these risk-based capital standards. The Company exceeds such risk-based capitalization levels, as recommended by the NAIC.
The Company's Insurance Subsidiaries are subject to state insurance laws and regulations that limit the amount of dividends or distributions that may be paid by an insurance company to its shareholders. Pursuant to the Florida Insurance Code, the Insurance Subsidiaries may not, without the prior approval of the Florida DOI, pay to their shareholders dividends or other distributions of cash or property, the total fair market value of which exceeds generally the lesser of 10% of surplus or net income, not including realized capital gains. In addition, the conditions imposed by the Florida DOI in connection with the Conversion require that all dividends or distributions by the Insurance Subsidiaries be approved by the Florida DOI in advance, but provide that approval will be given for any dividend or distribution otherwise complying with the Florida Insurance Code. As a consequence of these legal restrictions and other business considerations, the amount of dividends that may be paid by the Insurance Subsidiaries to Summit may be limited, which may in turn limit the amount of cash available to Summit for servicing its debt and other purposes.
Some of the Company's older computer programs were written using two digits rather than four to define the applicable year. As a result, those computer programs have time-sensitive software that recognize a date using "00" as the year 1900 rather than the year 2000. This could cause a system failure or miscalculation causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices or engage in similar normal business activities.
The Company has completed an assessment and will have to modify or replace portions of its software so that its computer systems will function properly with respect to dates in the year 2000 and thereafter. The total Year 2000 project for the Company is estimated to cost approximately $0.5 million and is anticipated to be completed prior to the year 2000.
The following consolidated financial statements of the Company and the report of independent auditors thereon are set forth following the Index of Financial Statements on page of this report:
Consolidated Balance Sheets as of March 31, 1997 and December 31,
Consolidated Statements of Income for the years ended March 31, 1996 and 1997 and the nine months ended December 31, 1996 (unaudited) and December 31, 1997
Consolidated Statements of Changes in Equity for the years ended March 31, 1996 and 1997 and the nine months ended December 31, 1996 (unaudited) and December 31, 1997
Consolidated Statements of Cash Flows for the years ended March 31, 1996 and 1997 and the nine months ended December 31, 1996 (unaudited) and December 31, 1997