The Company generally owns real property only for investment or sale. The Company's principal real estate investments consist of two office buildings with a combined book value of approximately $4.1 million. These office buildings serve as the Company's headquarters, and are located at 2028 Village Lane (25,000 square feet) and 2029 Village Lane (13,000 square feet), Solvang, California. The Company currently leases 6,000 square feet of space in one of these buildings to the YMCA at an annual rent of approximately $54,000 (subject to adjustment) under a two-year lease which commenced November 1, 1996, and which has three one-year renewal options. In addition, effective April 3, 1998, the Company entered into a five-year lease with a physical therapy operation with respect to approximately 4,000 square feet of space in one of the buildings, at an annual rent of $45,000 (subject to adjustment). The Company from time to time has solicited offers to purchase the office buildings and would be willing to sell the properties to a buyer with whom the Company would enter into a sale-leaseback arrangement if appropriate terms could be agreed upon. At the present time, the Company has not identified such a purchaser.
TCO previously leased office space in Chicago, Illinois. In August 1996, TCO defaulted in its obligations under the lease, but continued to occupy the premises. Exstar may have been deemed to be a guarantor of TCO's obligations or otherwise may have been deemed to be obligated under the lease. The Company is currently in the process of negotiating a new lease with respect to a portion of the premises leased by TCO, and a settlement of all obligations under the existing lease. Based on such negotiations, management expects that, retroactive to August 1, 1997, WESTCAP would enter into a new five year lease with respect to approximately 7,800 square feet of the 16,400 square feet previously occupied by TCO, at a rental rate of $13.50 per square foot per year (as compared to approximately $38 per square foot per year under the TCO lease). It is anticipated that such lease would be terminable by the landlord at any time two years or more following its execution, on six months' prior written notice to WESTCAP, in the event Exstar's stockholders' equity were below $12 million at the time notice of termination were given. It is further anticipated that, in settlement of all obligations under the prior lease with TCO, Exstar would issue 150,000 shares of its Common Stock to the landlord, and that the landlord would have the right to put such stock back to Exstar at a per share price of $7.50 at any time on or after July 31, 1999. (Effective April 1, 1997, TCO had transferred all 536,000 shares of Exstar common stock owned by it to Exstar for consideration of $0.01 per share.) As of December 31, 1997, the Company had accrued liabilities for the lease obligations on the basis that the lease continued in effect in accordance with its original terms.
The Company's ability to continue to operate as it currently is operating depends on generating sufficient revenues and cash flows from the Company's risk-bearing activities, currently consisting of Alpine's operations; the Company's insurance producing activities, currently consisting of WESTCAP's operations; and the Company's claims servicing activities, currently consisting of Claims Control's operations.
Second, even if the sale of Alpine is not consummated, Alpine met the minimum regulatory requirements it was required to meet at December 31, 1997, to continue to operate. Alpine's financial condition and regulatory compliance position, additionally, will improve if the $6.6 million Schedule P penalty drops off as expected over time ($2.5 million relating to the 1995 accident year will drop off in 1998 if the loss ratio for Alpine's 1995 accident year remains at the level estimated as of December 31, 1997 -- see "-- Losses and Loss Adjustment Expenses"). Exstar, additionally, currently has the ability to contribute certain real estate assets with a statutory net asset value of up to $1.7 million at December 31, 1997, to Alpine if necessary to increase Alpine's statutory policyholders' surplus. Alpine's statutory policyholders' surplus, liquidity and financial condition generally also are expected to benefit from continuation of the Quota Share Arrangement, entered into on April 1, 1997. Frontier also has been willing to release under the Quota Share Arrangement a portion of the funds held it otherwise would have been entitled to retain under the Quota Share Arrangement, $2.0 million of which was released by early April 1998, and has agreed to release another $1.0 million in early May. Alpine may have difficulty meeting the "reserve requirement" in 1998, depending on how the new statutory provision ultimately is interpreted, but believes, based on discussions with the Illinois DOI, that it may be able to comply sufficiently with the requirement to avoid any increase in the Illinois DOI's current level of oversight.
result from increased oversight by the Illinois DOI, regulatorily required termination of some or all of Alpine's current business operations and relationships, termination of the Quota Share Arrangement by the Frontier Companies and potentially Alpine's being placed in receivership. While the Company expects Alpine to be able to avoid crossing such thresholds, the expectations are based on a number of assumptions, including, among others, assumptions about cash flows, investment yields, asset values, ultimate loss and loss adjustment expenses and payout patterns, competition, the Illinois DOI's potential regulatory responses and Frontier's Best ratings. Because Alpine is relatively close to certain of the regulatory thresholds, there is little room for adverse fluctuations in the foregoing assumptions. In this regard, it should be noted that Alpine's financial condition weakened significantly in 1997, as evidenced by the drop in Alpine's statutory policyholders' surplus to $5.3 million at December 31, 1997, from $12.6 million at December 31, 1996, and Alpine's risk-based capital being at 117% of its authorized control level risk-based capital at December 31, 1997, compared to 173% of its authorized control level risk-based capital at December 31, 1996.
Should Alpine's operations be curtailed significantly, or the Company's risk bearing activities otherwise be limited, the Company would be forced to rely more on its existing cash and on its WESTCAP and Claims Control activities to generate revenues and cash flows. A portion of the Company's cash needs would be able to be met out of Exstar's cash on hand, which was $1.6 million at December 31, 1997. The balance of the Company's cash needs would be met from WESTCAP's and Claims Control's revenues from ongoing operations.
or more beneficial to the Company will continue in effect for the reasonably foreseeable future. There can be no assurance, however, that the Limited Agency Agreements, the Claim Service Agreements or the Quota Share Arrangement will in fact remain in effect under their current terms or at all, or that the Potential Frontier Deal or other alternative arrangements will be consummated, either on terms at least as favorable to the Company as the current relationships or at all. Should the Company's relationships with the Frontier Companies be discontinued, or their terms and conditions be changed in a manner materially adverse to the Company, the Company could experience significant losses.
The Company's principal sources of revenue historically have been net premiums earned (net premiums are the balances remaining after deducting from gross written premiums amounts paid for unaffiliated reinsurance, and they are generally earned ratably over the policy periods) on insurance policies issued by the Company's insurance company subsidiaries, income derived from the Company's invested assets and miscellaneous other income. The Company's principal costs historically have consisted of reserves for loss and loss adjustment expenses (reserves for such loss and loss adjustment expenses, which initially are estimated based on a combination of the Company's historical data and industry averages, are reflected as expense in the periods in which they are initially estimated and as the estimates are revised the revisions are reflected as adjustments to expense in the periods in which the adjustments are made), commissions and other amounts paid by the Company's insurance company subsidiaries in connection with its producing and underwriting insurance policies issued by the Company's insurance company subsidiaries, and miscellaneous other expenses.
The Company reduced its underwriting expenses during 1996 by terminating its insurance company subsidiaries' management agreements with TCO, thereby terminating the Company's obligation to pay commissions and profit-sharing amounts to TCO, and such expenses were virtually eliminated for a time following the Company's decision to cease issuing new and renewal insurance policies in August 1996. However, the Company incurs significant underwriting expenses under the Quota Share Arrangement. Of the net premium assumed by Alpine, Alpine (i) generally allows UCIC to retain 30% as a ceding commission and (ii) generally pays approximately 3.75% to TCO Holdings as an override commission. Additionally, effective August 1, 1996, the Company began assuming a substantial amount of personnel costs and operating expenses previously borne by TCO. These expenses, which previously would have been included in the Company's underwriting expenses, have been included in the Company's other expenses since August 1, 1996. Until September 30, 1997, these expenses were offset in part by reimbursements from Transre and E&S. (See -- "Business - Overview of Current Business Operations" -- Item 1.)
Net premiums earned, consisting of premiums earned less premiums ceded (generally earned ratably over individual policy periods), were $6.7 million in 1997, a 68.0% decrease from $21.0 million in 1996. The decrease directly resulted from the decrease in gross written premiums, particularly during the period between August 1996, when the Company ceased writing direct insurance, and April 1997, when the Quota Share Arrangement incepted. Net premiums earned are expected to increase during 1998 as a consequence of the expected increase in written premiums, but at a slower rate because the premiums are earned over individual policy periods.
Net commission income for 1997 was $272,000 compared to no commission income in 1996 and prior years. This represented commission income earned by WESTCAP on insurance business produced for the Frontier Companies following WESTCAP's acquisition by Exstar on October 1, 1997, net of commissions due to WESTCAP's subproducers (generally earned ratably over the corresponding individual policy periods). Net commission income is expected to increase in 1998 because (i) WESTCAP will be owned by the Company for the full year and (ii) the commissions should increase proportionately with the anticipated increase in premiums. Net commission income also may increase disproportionately faster than the anticipated increase in premiums if the Company is successful in acquiring brokerage operations, some of which could produce business for entities other than the Frontier Companies, or writing lines of business for the Frontier Companies that are not reinsured by the Company.
Net investment income for 1997 was $2.5 million, a decrease of $1.5 million, or 37.9% from $4.0 million in 1996. The decrease between the periods was caused principally by a 30.7% decrease in average investable assets from $76.4 million in 1996 to $53.1 million in 1997, resulting from the Company's need to make loss and expense payments and pay other expenses, and a decline in the average yield on investable assets to 4.7% in 1997 from 5.3% in 1996. Management generally anticipates a continued reduction in investment income in 1998 as a consequence of (i) loss payments and expenses reducing the Company's investable assets more quickly than investable assets increase under the Quota Share Arrangement or any similar replacement reinsurance arrangement with the Cayman Company, and (ii) expected relatively steady investment yields.
Other income was $3.5 million for 1997, compared to $100,000 for 1996. The other income in 1997, reflecting proceeds less certain related expenses, was principally a consequence of a one-time settlement of a lawsuit against the Company's former independent auditors. Management expects minimal other income for the foreseeable future.
Income tax expense was $510,000 in 1997 compared to a benefit of $1.7 million in 1996. Because of the numerous uncertainties facing the Company, management decided to increase the valuation allowance against the Company's deferred tax asset in 1997 by $4.4 million, compared to a reduction in the allowance of $1.3 million in 1996. Partially offsetting this increase was a benefit of $3.4 million from the settlement of the JBW & Co. loan and a tax benefit of $385,000 in 1997 resulting from a taxable loss for the current year. Management anticipates no significant income tax expense from the potential sale of Alpine to Frontier because of significant capital loss carryforwards. However, the sale, if it is consummated in accordance with the Potential Frontier Deal as currently contemplated, would transfer to Frontier $6.5 million of operating loss carryforwards which otherwise would have been available to offset income taxes on the Company's operating income (the Company expects ultimately to recoup certain tax benefits recognized by Frontier from the acquisition of Alpine, as and to the extent actually realized by Frontier). If the sale of Alpine is not consummated, and absent other changes in circumstances, management anticipates no income tax expense in 1998.
Equity in income or losses of affiliates, included in the Company's results due to the Company's adoption of a form of equity accounting in 1995, generally reflects TCO's net income or loss for the period after certain adjustments. Equity in income of affiliates was minimal for 1997 compared to $1.6 million for 1996. The smaller amount in 1997 reflects the significantly reduced revenues generated by TCO after Exstar's insurance company subsidiaries ceased issuing direct insurance in August 1996 and the management agreements with TCO were terminated. The Company anticipates that equity in income or losses of affiliates during 1998 will continue at a low level, as TCO is in complete run-off and consequently is expected to have virtually no revenues or expenses relating to operations. The Company believes, however, that additional equity in income of affiliates could be generated if TCO is successful in settling certain of its existing liabilities (other than liabilities to the Company) at less than their book values including TCO's obligations under the lease relating to office facilities at 311 South Wacker, Chicago, Illinois, which could generate income to the Company of as much as $525,000.
Net premiums earned were $21.0 million in 1996, a 46.3% decrease from $39.1 million in 1995. The decrease directly resulted from the decrease in gross written premiums, though the percentage decrease in net premiums earned between the periods was lower because premiums continued to be earned on previously written insurance after the Company ceased issuing direct insurance in August 1996.
Other underwriting expenses for 1996 were $6.4 million, a decrease of 62.1% from $16.9 million in 1995. The ratio of the Company's other underwriting expenses to net premiums earned was 30.5% in 1996 compared to 43.2% in 1995. The decrease in other underwriting expenses between the periods was principally attributable to reduced net expenses resulting from termination of the management agreements with TCO, the Company's earning in 1996 additional commission income under certain reinsurance agreements because of favorable loss development and the Company's payment in 1995 of profit sharing of approximately $3.7 million relating to the approximately $14.9 million reduction in loss and loss adjustment expense reserves at the end of 1995.
Other income declined in 1996 to $100,000 from $400,000 in 1995. Other income consists primarily of contingent commission income from and interest earned on funds on deposit with an unaffiliated insurance company which have been assigned to the Company by TCO. The decline in other income in 1996 was due to a reduction in the amount of business placed by TCO over the last several years with the unaffiliated insurance company and a disagreement between TCO and the unaffiliated insurance company as to the amounts due to TCO and assigned to the Company. Additionally, the amount of funds on deposit was significantly reduced in 1996 compared to 1995.
Other expenses were $7.3 million in 1996 compared to $6.3 million in 1995. This increase was principally due to (i) Exstar's incurring additional legal expenses for the lawsuit against the Company's former auditors (see "Legal Proceedings" -- Item 3), (ii) increases in legal, audit, actuarial and other fees (including approximately $500,000 of IIE withdrawal fees) in connection with the Illinois DOI's review of Alpine, withdrawal of the Syndicate from the IIE and reorganization of the Company's business and operations during 1996, and (iii) Alpine's assuming a portion of the personnel, general and administrative costs previously borne by TCO.
Equity in income (losses) of affiliates was $1.6 million in 1996 compared to $3.8 million in 1995. The smaller amount in 1996 reflects a reduction in TCO's revenues for 1996 following the Best rating downgrades and regulatory restrictions affecting the Company's insurance company subsidiaries, and the terminations of the management agreements between the Syndicate and TCO and Alpine and TCO. It also reflects reduced profit sharing of $1.3 million paid to TCO-IL in 1996 compared to the $5.2 million paid to TCO-IL in 1995. The difference between the $1.3 million payment to TCO-IL in 1996 and the $5.2 million payment in 1995 is principally attributable to reductions in net loss and loss adjustment expenses incurred, due, in significant part, to the $14.9 million reduction in the Company's loss reserves at December 31, 1995.
The foregoing $24.0 million included the following at December 31, 1997: (i) $11.0 million of fixed maturities (ii) $100,000 of cash and cash equivalents and (iii) $800,000 of short term investments which were required to be maintained as collateral for letters of credit and to satisfy insurance regulatory requirements. Also included in the $24.0 million was $10.2 million comprised of cash and various types of investments held in trust for the benefit of the Syndicate's policyholders and $2.0 million of cash and cash equivalents held in trust for the benefit of the Frontier Companies. (See "Business -- Regulation -- Combination of the Syndicate with Alpine" -- Item 1 and Note 4 of Notes to Consolidated Financial Statements.)
At December 31, 1997, $14.0 million, or 18.2% of the Company's total assets, consisted of real estate mortgages and real estate investments. This compared to $16.7 million of such investments, comprising 15.5% of the Company's total assets at December 31, 1996. The Company's intent is to transfer such assets to Frontier if the sale of Alpine is consummated, in accordance with the Potential Frontier Deal as currently contemplated, and if not to reduce the real estate mortgages and real estate owned investments in an aggressive but orderly manner. (See "Business -- Investments" -- Item 1.)
The decrease in cash and invested assets at December 31, 1997, compared to December 31, 1996, resulted from cash applied to operations. Cash applied to operations during 1997 was $22.6 million compared to $24.2 million for 1996, and $14.3 million for 1995. The continued high level of cash applied to operations in 1997 resulted principally from a continuing high level of payments of loss and loss adjustment expenses, and continued low premium revenues as a consequence of the Best rating downgrades, regulatory issues affecting the Syndicate and Alpine
and the Company's decision to cease writing direct insurance in August 1996. (See "Business" -- Item 1.)
In order to fund the cash applied to operations during 1997 and 1996, the Company liquidated investments at more accelerated rates than historically had been necessary. Net cash inflow from investing activities was $30.6 million in 1997 compared to $21.0 million in 1996 and cash applied to investing activities of $6.2 million in 1995.
Exstar, as a parent company, has historically relied on advances and tax agreement payments from its subsidiaries to fund its cash requirements. Exstar's cash was depleted during 1996 to pay for the suit against C&L, but as a consequence of Exstar's settling the suit in January 1997, Exstar received net cash, after related expenses not paid during 1996, of approximately $3 million. (See "Legal Proceedings" -- Item 3.) Management anticipates Exstar will receive small, if any, dividends from its subsidiaries for 1998, but that Exstar's cash needs, as a parent company, may be satisfied during the year out of its own resources. Exstar does not plan to pay cash dividends in the foreseeable future.
The Company currently does not anticipate that it will issue direct insurance in the foreseeable future. Additionally, under the Quota Share Arrangement or any similar replacement reinsurance arrangement, including such an arrangement involving the Cayman Company, most of the premiums ultimately due to Alpine may be withheld by the Frontier Companies, reducing Alpine's cash available to satisfy current obligations. In March 1998, however, an understanding was reached between the Company and the Frontier Companies whereby some of the funds held by the Frontier Companies would be released to Alpine. Initially $1.0 million was released to Alpine in March 1998 and an additional $1.0 million was released to Alpine in April 1998. An additional $1.0 million is expected to be released at the beginning of May 1998, assuming the Potential Frontier Deal has not been consummated by such time. Management expects (but has no understanding with Frontier) that if the sale of Alpine should not be consummated, the Company may be able to obtain the accelerated release of some additional funds held over time. Investment income on the funds held by the Frontier Companies, although relatively insignificant, is being and will continue to be paid to Alpine. Should the Company not be able to obtain the release of additional funds held, or be obligated to replenish the funds previously released during 1998, the Company's liquidity would be adversely affected.
in the amounts of restricted cash and investments generally will be sufficient to fund payment of loss and loss adjustment expenses and other expenses. Cash received by the Company upon consummation of the sale of Alpine, should it occur, in accordance with the Potential Frontier Deal as currently contemplated, also would be available for obligations of the Company. Such sale, additionally, would terminate the Company's obligation to fund with cash Alpine's payment of losses.
The Company's future financial condition and prospects are heavily dependent on the Company's maintaining or improving its relationships with Frontier. Should the Company's relationships with the Frontier Companies be discontinued, or their terms and conditions be changed in a manner materially adverse to the Company, the Company experience significant losses. (See "Business -- Proposed Future Operations and Organizational Changes; Relationship with Frontier" -- Item 1 and " -- Results of Operations.")
As of December 31, 1997, the Company had no off-balance sheet obligations or capital commitments that were not reflected in the Company's financial statements.
Alpine's adjusted capital amounts at December 31, 1997, and December 31, 1996, were approximately 117% and 173%, respectively, of its authorized control level risk-based capital amounts. (See "Business -- Regulation" -- Item 1.) Because Alpine's December 31, 1996 adjusted capital was less than 200% of its authorized control level risk-based capital, Alpine was required to submit a comprehensive financial plan to the Illinois DOI. The plan identified, as the principal condition that contributed to Alpine's failure to meet the company action level of risk-based capital, the amount of Alpine's net reserves for losses and loss adjustment expense relative to its statutory policyholders' surplus and contained, as the proposed corrective actions, principally changes to the Company's operations and organizational structure already implemented and consummation of the Quota Share Arrangement with UCIC.
Alpine's comprehensive financial plan with respect to the year ended December 31, 1996 was filed with and not objected to by the Illinois DOI. As Alpine was below the regulatory action level at December 31, 1997, a similar comprehensive financial plan will be required to be submitted to the Illinois DOI by April 16, 1998. Management expects such plan to identify the $6.6 million Schedule P penalty incurred by Alpine in 1997 as one of the principal causes for Alpine's failure to meet or exceed the company action level of risk-based capital. Additionally, Alpine's statutory policyholders' surplus was reduced by an underwriting loss of $6.7 million in 1997 as a result of a relatively small volume of net premiums earned and $4.4 million of loss and loss adjustment expense reserve strengthening during the year. (See "Business - - Losses and Loss Adjustment Expenses" - Item 1.) Management expects the plan to propose, as principal corrective actions to increase Alpine's risk-based capital above the company action level, the continuation of Alpine's operations in 1998, during which Alpine (i) expects to experience an overall reduction in net reserves for losses and loss adjustment expense outstanding relative to its statutory policyholders' surplus, (ii) expects to eliminate approximately $2.5 million of the Schedule P penalty as the 1995 accident year becomes excluded from Alpine's Schedule P calculation, and (iii) expects to receive additional assets contributed by Exstar consisting principally of some or all of approximately $1.7 million of real estate investments owned directly by Exstar, if necessary. Consummation of the proposed sale of Alpine and merger
Over the last several years, the Company has been converting its computer systems to be Year 2000 compliant. The Year 2000 problem results from computer programs using two rather than four digits to define the applicable year (e.g., in many programs, each of 1900 and 2000 are defined by the digits "00"). The Company expects its conversion efforts to be completed by the end of 1999, and expects no material adverse impact internally from the Year 2000 problem. Management has made no effort, however, to attempt to estimate the impact on the Company of third parties' efforts to become, or lack of success in becoming, Year 2000 compliant. All of the insurance assumed by the Company is expected to exclude losses arising out of the Year 2000 problem. The Company has made no effort to track the cost of the Year 2000 conversion as the conversion is being accomplished in conjunction with routine upgrades of the Company's underwriting, claims and accounting systems.