The following financial information has been derived from the audited Consolidated Financial Statements and notes thereto which appear elsewhere in this or previously filed Annual Reports on Form 10-K and should be read in conjunction with such financial statements and related notes thereto.
The following information for the Company is as of and for the years ended December 31 (dollars in thousands, except per share data):
Western Surety specializes in writing small fidelity and noncontract surety bonds, referred to as "miscellaneous" bonds, and errors and omissions ("E&O") liability insurance and is licensed to write fidelity, surety and casualty insurance in all 50 states and the District of Columbia. Western Surety is rated A+ (Superior) by A.M. Best Company, Inc. ("A.M. Best"). Bonds underwritten by Western Surety are relatively low-risk, low-premium products where prompt service, easy-to-use forms and availability of an extensive array of bond products are emphasized. One of the largest writers of miscellaneous bonds in the United States, Western Surety has experienced overall growth in gross written premiums since 1990 in spite of the soft market. This growth is attributable to its product specialization, including new products and programs, underwriting expertise and broad distribution network as well as to legislatively mandated bond limit increases, and to bonding requirements legislated by various states and municipalities. Substantially all of Western Surety's bonds are mandated by various state statutes and local ordinances. Such factors have largely insulated Western Surety from the effects of prevailing market conditions in the broader commercial property and casualty insurance industry. Management believes, with respect to 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.
On May 22, 1996, the Company consummated the sale of United Capitol Holding Company ("UCHC") and its subsidiaries, United Capitol Insurance Company ("United Capitol"), United Capitol Managers, Inc. and Fischer Underwriting Group, Incorporated ("Fischer"), to a subsidiary of Frontier Insurance Group, Inc. The operating results of UCHC and its subsidiaries are reflected in Capsure's results through the closing date. Net proceeds to Capsure of $77 million, which included the purchase price for the capital stock of UCHC and the release of United Capitol's excess statutory surplus at closing, approximated Capsure's carrying value. The goodwill associated with the 1990 acquisition of United Capitol was previously reduced to estimated net realizable value as of December 31, 1995, resulting in a $13.2 million impairment of goodwill in 1995.
On September 11, 1996, the Company declared a special cash distribution in the amount of $10 per share of common stock, payable to all holders of record as of September 25, 1996. The special distribution was paid on October 4, 1996 and was funded from $62 million of borrowings under Capsure's revolving credit
Underwriting results are summarized in the following table (dollars in thousands):
Net earned premiums decreased 6.3%, or $6.2 million, for the year ended December 31, 1996, reflecting a decrease of $10.5 million at United Capitol, partially offset by an increase of $4.3 million in surety and fidelity operations, primarily attributable to strong growth in contract surety. Net earned premiums at Universal Surety increased 22.3% to $17.9 million in 1996. Net earned premiums at Western Surety increased 1.4% to $71.3 million in 1996.
December 31, 1995 and 1994 were increased by $2.6 million and $2.5 million, respectively, for contingent premiums recognized under its reinsurance agreements.
Underwriting income decreased $25.6 million for the year ended December 31, 1996, reflecting a decrease of $1.5 million in surety and fidelity underwriting income, and a decrease of $24.1 million for United Capitol. The consolidated combined ratio increased to 79.2% in 1996 from 54.6% in 1995. The consolidated loss ratio increased to 10.9% in 1996 from (7.5)% in 1995. The surety and fidelity loss ratio increased moderately to 9.5% in 1996 from 8.9% in 1995, principally due to a higher level of net favorable development of prior years' loss reserves in 1995. Generally, the favorable loss trends recognized in the fourth quarter of 1995 continued in 1996.
Net investment income for the years ended December 31, 1996, 1995 and 1994 was $16.4 million, $20.5 million and $19.1 million, respectively. The decrease in 1996 primarily reflected a net decrease in invested assets as a result of the sale of United Capitol. The average pretax yields of the portfolio for the years ended December 31, 1996, 1995 and 1994 were 7.0%, 6.8% and 6.5%, respectively.
In connection with the payment of the $10 per share special cash distribution on October 4, 1996, the Board of Directors also authorized a corresponding repricing of all outstanding stock options. This resulted in a new measurement date for the stock options under applicable accounting pronouncements and required the Company to record in the third quarter of 1996 a non-recurring compensation charge of $4.1 million, after applicable income taxes, or 25 cents per share of which $3.6 million, or 22 cents per share, was non-cash.
Income taxes were $8.2 million, $19.7 million and $9.4 million for the years ended December 31, 1996, 1995 and 1994, respectively. The effective income tax rates were 37.9%, 49.0% and 39.5%, respectively. The decrease in the 1996 effective tax rate was principally attributable to a decreased level of nondeductible goodwill amortization. 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 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 $1.2 million for the year ended December 31, 1996, $0.7 million for the year ended December 31, 1995 and $0.6 million for the year ended December 31, 1994.
collected premiums, generating investment income, until such time cash is needed to pay claims and associated expenses.
Cash flow at the parent company level is derived principally from dividend and tax sharing payments from its insurance subsidiaries. The principal obligations at the parent company level are to service debt and pay operating expenses. At December 31, 1996, the carrying value of the Company's invested assets of the non-insurance operations, principally at the parent company level, was comprised of $3.5 million of short-term investments and $1.3 million of cash. At December 31, 1995, the carrying value of the Company's invested assets of the non-insurance operations, principally at the parent company level, was comprised of $11.6 million of equity securities, $4.7 million of short-term investments and $0.3 million of cash. The decrease in investments at December 31, 1996 compared to the prior year related to the payment of the special cash distribution on October 4, 1996.
The Company's consolidated net cash flow provided by operating activities was $31.1 million, $30.7 million and $29.3 million for the years ended December 31, 1996, 1995 and 1994, respectively. Consolidated operating cash flow (pretax income excluding the write-off of deferred loan fees, non-recurring compensation and merger costs, net investment gains (losses) and amortization and impairment of goodwill and intangibles) for the year ended December 31, 1996, was $31.2 million as compared to $58.8 million in 1995 and $27.8 million in 1994.
On March 29, 1994, the Company entered into a senior reducing revolving credit agreement with a syndicate of banks for $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. The Company borrowed $28 million for the acquisition of Universal Surety in September 1994.
Concurrent with the sale of UCHC and its subsidiaries, Capsure and its lenders entered into an agreement to amend and restate the Credit Facility. The amendment reduced the commitment to $100 million from $135 million and permitted an initial draw of up to $70 million for a special distribution to stockholders. The remaining availability may be used for additional dividends, stock repurchases, acquisitions, and for general corporate purposes. Transaction costs totaled approximately $0.5 million. The credit available under the Credit Facility reduces semi-annually commencing March 31, 1997 and expires March 31, 2003. Interest on borrowings under the facility varies based on leverage.
On September 11, 1996, the Company declared a special cash distribution in the amount of $10 per share of common stock, payable to all holders of record as of September 25, 1996. The special distribution was paid on October 4, 1996 and was funded from $62 million of borrowings under the Credit Facility and approximately $94 million from available cash and marketable securities accumulated at the parent company level.
Capsure's insurance subsidiaries are subject to regulation and supervision by the various state insurance regulatory authorities in which they conduct business, including regulations with respect to the payment of dividends. Without prior regulatory approval in 1997, Capsure's insurance subsidiaries may pay stockholder dividends of $18.0 million in the aggregate. In 1996, 1995 and 1994, Capsure received $65.7 million (including $50.2 million of dividends requiring prior approval), $40.9 million (including $21.6 million of dividends requiring prior approval) and $21.0 million (including $5.0 million of dividends requiring prior approval), respectively, in dividends from its insurance subsidiaries. Capsure received $15.6 million, $21.9 million and $9.5 million in dividends from its surety and fidelity subsidiaries in 1996, 1995 and 1994, respectively.
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 $17.3 million, $12.8 million and $12.3 million in 1996, 1995 and 1994, respectively, of which $10.8 million, $8.3 million and $7.3 million, respectively, were from its surety and fidelity subsidiaries.
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 have been 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.
Another critical factor affecting the Company's financial condition is the Company's policies with respect to loss and loss adjustment expense reserves. Each of Capsure's insurance subsidiaries employs prudent reserving approaches in establishing the estimated liability for unpaid loss and loss adjustment expenses due to
the inherent difficulty and variability in the estimation process. The liability for unpaid losses and loss adjustment expenses is based on estimates of (a) the ultimate settlement value of reported claims, (b) IBNR claims, (c) future expenses to be incurred in the settlement of claims and (d) claim recoveries. The liability for unpaid losses and loss adjustment expenses is an accounting estimate and, similar to other accounting estimates, there is the potential that actual future loss payments will differ significantly from the initial estimate. The methods of determining such estimates and the resulting estimated liability are continually reviewed and updated. Changes in the estimated liability are reflected in operating income in the year in which such changes are determined.
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, 1996, 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. If the previously discussed pending business combination is consummated, an ownership change of the Company will occur. This will result in significant restrictions of the Company's ability to utilize NOLs during all taxable periods after the date of the business combination.
In February 1997, the FASB issued SFAS No. 128, "Earnings Per Share." SFAS No. 128 is effective for both interim and annual periods ending after December 15, 1997. SFAS No. 128 replaces APB Opinion No. 15, "Earnings Per Share." APB Opinion No. 15 required that entities with simple capital structures present a single earnings per common share ("EPS") on the face of the income statement, whereas those with complex capital structures had to present both primary and fully diluted EPS. SFAS No. 128 simplifies the computation of EPS by replacing the presentation of primary EPS with a presentation of basic EPS and requires dual presentation of basic and diluted EPS by entities with complex capital structures. Basic EPS includes no dilution and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period, whereas primary EPS includes the dilutive effect of common stock equivalents, such as stock options. Diluted EPS reflects the potential dilution of securities that could share in the earnings of an entity, similar to fully diluted EPS. The Company intends to present basic and diluted EPS in financial statements issued after the effective date.