There has been a shift in both the market landscape and customer demand. The growth in traditional reinsurance has slowed as changes and consolidation in the primary insurance market have intensified shifts in customer demand. As a result, innovative and sophisticated ways to handle increasingly complex risks continue to emerge. Those reinsurers wanting to meet these emerging challenges and compete effectively must adapt to the evolving marketplace and leverage their expertise to assume new roles in the insurance and reinsurance arenas. We continue to identify and pursue opportunities to help long-standing clients through new fee-based services and other nontraditional approaches.
On February 15, 1999, NAC Re and XL signed a definitive agreement whereby NAC Re will merge into a wholly-owned subsidiary of XL in an all stock transaction. This transaction is subject to regulatory and stockholder approvals and other customary closing conditions. It is expected that the merger will be completed by late second calendar quarter or early third quarter of 1999.
The Company's premium revenue for its domestic and international operations is as follows:
Worldwide gross premiums written were $704.7 million in 1998 compared to $723.9 million in 1997 and $714.1 million in 1996. The 2.6% decrease in 1998 was primarily attributable to NAC's continued strong underwriting discipline reflected by the non-renewal of unprofitable accounts amid prolonged soft market conditions. The 1.4% increase in 1997 was principally attributable to an increase in domestic specialty primary business.
The following charts set forth statutory composite ratios for the Company.
The 1998 domestic primary composite ratio increased to 126.6% compared to 119.0% in 1997 and 96.5% in 1996. The increase in the claims and claims expense ratio was attributable to the overall rate environment but was also impacted by one program that the Company has since terminated. Other operating expenses decreased by 28.8% in 1998 due to an increased premium base.
The domestic reinsurance segment represents the reinsurance of property, casualty, and specialty lines of business, including general liability, professional liability, automobile and workers' compensation, and commercial and personal property risks, including fidelity/surety and ocean marine. The Company's domestic operation includes business written in the United States and Canada. The Company principally conducts its business through reinsurance brokers, however, facultative business is handled through direct placement.
(Dollars in millions) 1998 1997 1996 ---------- ---------- ---------- Assets $2,397.5 $2,360.9 $2,056.1 Pretax Net Investment Income $ 110.1 $ 103.8 $ 87.6 Pretax Income Excluding Realized Gains $ 92.4 $ 84.2 $ 65.2
The 1998 net investment income increased 6.8% due to the growth in the portfolio. The 1997 increase of 18.5% was largely due to the investment benefit on cash flow derived in 1997 from two retrocessional program terminations.
(Dollars in millions) 1998 1997 1996 ------ ------- ------- Assets $82.7 $78.4 $82.0 Pretax Net Investment Income $ 3.3 $ 3.2 $ 2.8 Pretax (Loss) Income Excluding Realized Gains $(0.8) $ 0.1 $ 2.5
NAC Reinsurance International commenced writing non-U.S. property and casualty treaty business in 1994, subsequently building a facultative operation starting in 1996. Clients are also serviced through a branch operation in Sydney, Australia and a contact office in Madrid, Spain. The international reinsurance segment writes non-U.S. property and casualty reinsurance business. In 1998, the Company acquired Denham Syndicate Management Limited, the Lloyd's managing agency that manages Denham Syndicate 990. Denham underwrites a specialized book of international business, concentrating on long-tail casualty lines and non-marine physical damage. In 1997, the Company formed Stonebridge Underwriting Ltd., a subsidiary of NAC Reinsurance International, which is a corporate capital vehicle participating on the Denham Syndicate. This segment includes gross 1998 premiums of $12 million generated by Stonebridge Underwriting Ltd. It is estimated that Stonebridge Underwriting Ltd. will generate premiums of approximately $40 million in 1999.
Gross premiums written from international operations totaled $72.7 million in 1998, of which $60.7 million represents reinsurance gross premiums written compared to $62.5 million in 1997, and $61.6 in 1996. The increase of 16.4% in 1998 reflects the addition of international primary premiums generated from Stonebridge Underwriting which offset the competitive market conditions in both casualty and property business. The 1.4% increase in 1997 was largely due to an increase in casualty business partly offset by a decline in property business.
Net investment income increased to $15.7 million in 1998 compared to $14.0 million in 1997 and $11.1 million in 1996. The increase in the invested asset base comprised the growth over the three years.
The Company's underwriting philosophy of long-term partnerships with quality core clients as well as further expansion of its client base continues to underscore the Company's success. Insurers rated A- or better by A.M. Best comprised the top 30 clients of the Company in 1998. However, no single client generated more than 7% of premium volume in 1998, and the top 10 clients represented approximately 40% of premiums compared to 57% four years prior. Given this client depth, the Company does not believe that any future reduction of business assumed from any one client will have a materially adverse effect on its future financial condition or results of operations due
The fact that the Company's exposure to claims generally begins excess of its client's exposure contributes to the uncertainty of its claims estimates. With this excess coverage, claims occur less frequently than coverages which attach within the primary insurance coverages, thereby providing less credible historical claims experience from which to estimate ultimate claims costs. Further, the Company writes coverage in certain volatile casualty lines of business, such as general liability, director's and officer's liability and medical malpractice. Claims activity for these lines is characterized by lengthy litigation, the ultimate cost of which can be influenced significantly by future court rulings.
Claims payments were $333.8 million in 1998 compared to $78.9 million in 1997 and $190.4 million in 1996. The 1997 claim payments of $78.9 million reflect the impact of two retrocessional terminations in January 1997 totaling approximately $225 million representing the total consideration received, partially offset by several commutations of assumed business during 1997.
The Company's net favorable claims development for business written since 1986 continued to emerge during 1998, 1997, and 1996. The Company's total net claims and claims expenses for each year reflect favorable claims development from prior years of $38.1 million in 1998, $38.6 million in 1997, and $33.3 million in 1996. This favorable development is driven by several factors, some of which are interdependent. A principal factor is the strength of the actuarial assumptions underlying the business written, particularly with respect to social and economic inflation. These actuarial assumptions are utilized to establish the initial expected target loss ratio employed in the actuarial methodologies from which the reserves for claims and claims expenses are derived. Such loss ratios are periodically adjusted to reflect comparisons of actuarially-computed expected claims to actual claims
An important area of focus in the reinsurance and insurance industries is exposure to asbestos and environmental claims. The Company's reserving process includes a supplemental evaluation of the potential impact on claims liabilities from exposure to asbestos and environmental claims, including related loss adjustment expenses. The Company recorded claims and claims expenses incurred relating to asbestos and environmental claims of $5.5 million in 1998, $8.1 million in 1997, and $10.7 million in 1996, inclusive of paid claims of $3.5 million, $3.8 million, and $4.2 million, respectively. The Company's claims and claims expense reserves for such exposures, net of reinsurance, as of December 31, 1998, 1997, and 1996 were $34.9 million, $32.8 million, and $28.5 million, respectively. A reconciliation of the Company's gross and net liabilities for such exposures for the three years ending December 31, 1998 is set forth in Note 4 of the Notes to Consolidated Financial Statements.
The Company believes it has made a reasonable provision for its asbestos and environmental exposures and is unaware of any specific issues which would materially affect its claims and claims expense estimate. The estimation of claims and claims expense liabilities for asbestos and environmental exposures is subject to a much greater uncertainty than is normally associated with the establishment of liabilities for certain other exposures due to several factors, including: i) uncertain legal interpretation and application of insurance and reinsurance coverage and liability; ii) the lack of reliability of available historical claims data as an indicator of future claims development; iii) an uncertain political climate which may impact, among other areas, the nature and amount of costs for remediating waste sites; and iv) the potential of insurers and policyholders to reach agreements in order to avoid further significant legal costs. Due to the potential significance of these uncertainties, the Company believes that no meaningful range of claims and claims expense liabilities beyond recorded reserves can be established. The Company believes that these issues are not likely to be resolved in the near future. However, as they are resolved, additional reserve provisions, which could be material in amount, may be necessary.
The Company is aware of certain evolving potential exposures, generally referred to as other mass tort liabilities, and to the extent appropriate, the Company has considered these exposures in its claims and claims expense reserves.
The Company is unaware of any specific, unusual and significant circumstances affecting claims reserve estimates, except to the extent disclosed.
The Company purchases reinsurance to increase premium capacity and to reduce the risk of loss on reinsurance underwritten. Historically, the Company has obtained reinsurance for itself primarily through excess of loss reinsurance agreements. The Company has also obtained reinsurance protection against liability on a single event arising from different treaty obligations or from related losses involving more than one reinsured or contract. To help manage its exposure to credit risk, the Company evaluates the financial condition of its retrocessionnaires periodically. Based on this analysis, a reserve for potential and actual non-recovery from retrocessionnaires unable to meet their obligation under the retrocession agreement is included in claims and claims expenses. Charges to earnings for potential and actual non-recoveries amounted to $1.2 million, $3.7 million, and $1.2 million for 1998, 1997, and 1996, respectively, and reflect a provision for paid and unpaid claims, inclusive of IBNR claims. These charges relate to reinsurance purchased prior to 1986.
catastrophic events could have a material adverse effect on the financial condition and results of operations of the Company.
Net investment income increased 6.8% in 1998 compared to 17.9% in 1997 and 16.8% in 1996. The 1998 increase reflects a continued increase in the invested asset base. The 1997 increase was principally attributable to the benefit derived from investment of the proceeds of approximately $180 million resulting from two retrocessional program terminations in early 1997. The Company's after-tax investment yield was 4.6% in 1998 compared to 4.7% in 1997 and 4.4% in 1996. The Company anticipates moderate growth in investment income during 1999 due to a higher invested asset base. However, this growth will be tempered by the decreasing yields available in the current interest rate environment.
Realized investment gains, net of tax, were $1.10 per diluted share for 1998, $1.35 per diluted share for 1997, and $.61 per diluted share for 1996. Gains and losses on the sale of investments are recognized as a component of operating income, but the timing and recognition of such gains and losses are unpredictable and are not indicative of future operating results.
The Company's investment strategy is focused principally on income predictability and asset value stability. The Company's emphasis on high quality, fixed maturity investments reflects this strategy. Tactical shifts between taxable and tax-exempt bonds may occur in order to maximize after-tax investment returns without compromising balance sheet integrity. At the end of 1998, the Company's fixed maturity investments amounted to $2.2 billion, which approximates 89% of cash and invested assets. Approximately 94% of such investments are rated investment grade with an average rating of Aa2/AA by Moody's Investor Services, Inc. or Standard & Poor's. The duration of the 1998 fixed maturity portfolio is 5.7 years, relatively consistent with the 1997 duration.
During 1998, the Company purchased interests in three separate entities that transact business within the property/casualty insurance arena. The aggregate investment was $9.6 million as of December 31, 1998. These long term investments are expected to enhance the Company's ability to offer solutions to the specialized needs of its property/casualty clients as well as to provide opportunities for additional services to clients.
The Company purchased an equity interest in Prime Advisors Inc., a market leader in property/casualty insurance asset management. Prime provides valuable client services through the development of investment strategies and investment performance optimization.
The Company also purchased an interest in cyber$ettle.com, Inc. which provides Internet claims support for the property/casualty insurance industry. Its flagship product enables subscribing insurance companies, self-insureds, and municipalities to effect efficient and inexpensive settlements on claims bound for litigation.
The Company's effective tax rate decreased to 18.5% in 1998 compared to 22.1% in 1997 and 20.8% in 1996. Excluding investment gains, the Company's 1998 effective tax rate was 11.5% compared to 15.6% in 1997 and 16.8% in 1996. The 1998 decrease reflects the combination of increased foreign tax credits utilized in 1998 and the benefits of a shift to tax-exempt fixed maturities. The decrease in the 1997 effective rate compared to 1996 is also attributed to a shift to tax-exempt fixed maturities in 1997. Note that the Company's future tax position is subject to changes in the tax laws.
As a holding company, NAC Re's assets consist primarily of its common stock investment in NAC. Cash flow within NAC Re consists of investment income, operating and interest expenses, dividends to stockholders, and dividends and tax reimbursements from NAC. These dividends are subject to statutory restrictions as described in Note 11 of the Notes to Consolidated Financial Statements.
The Company's quarterly dividend on its Common Stock increased 20% in June 1998 to $.09 per share from $.075 per share. It is anticipated that the cash dividend level will leave sufficient retained earnings to meet the Company's future financial needs.
The Company is exposed to various market risks, including changes in interest rates and foreign currency exchange rates. Market risk is the potential loss arising from adverse changing interest rates and foreign currency exchange rates. The Company manages its market risks based on guidelines established by management. The Company does not enter into derivatives or other financial instruments for trading purposes.
Since the Company's cash and invested assets exceed its long term debt, the exposure to interest rate risk relates primarily to its investment portfolio. The main objectives of managing the investment portfolio of the Company are to maximize after tax investment income in a manner consistent with the expected maturities of the liabilities the investments support and to ensure liquidity and provide income predictability. At December 31, 1998, the Company's fixed maturity portfolio totaled $2.2 billion. The Company's fixed securities are categorized as assets held for sale and have a duration of approximately 5.5 years.
Generally, the fair market value of fixed income securities will increase as interest rates fall and decrease as interest rates rise. The estimated value of the Company's fixed income securities resulting from an immediate 100 basis point shift in the treasury yield curve will result in an unrealized loss of approximately $104 million.
See Note 15 of the Notes to Consolidated Financial Statements of NAC Re for a discussion on subsequent events.
NAC Re and its domestic subsidiaries are subject to regulatory oversight under the insurance statutes and regulations of the jurisdictions in which they conduct business, including all states of the United States and Canada. NAC Re International is subject to the regulatory authority of the United Kingdom Department of Trade and Industry and its Australian branch office is also subject to the Australian Insurance and Supervisory Commission's solvency and regulatory authority. These regulations vary from jurisdiction to jurisdiction and are generally designed to protect ceding insurance companies and policyholders by regulating the Company's financial integrity and solvency in its business transactions and operations. Many of the insurance statutes and regulations applicable to the Company relate to reporting and disclosure standards which allow insurance regulators to closely monitor the Company's performance. Typical required reports include information concerning the Company's capital structure, ownership, financial condition, and general business operations.
Various other legislative and regulatory initiatives have been proposed from time-to-time that could impact the property/casualty insurance industry. Congress is expected to consider bills targeting financial services modernization, tax reform, Year 2000 liability, Superfund and product liability reform, and natural disaster protection. The NAIC continues to refine the risk-based capital formula for property/casualty insurers as well as adopt model legislation and regulations regarding insurer investments, accounting standards, and other regulatory matters. While the Company cannot quantify the impact of any of these legislative or regulatory measures on its operations, we believe the Company is adequately positioned to compete in an environment of more stringent regulation. To the extent that federal legislation, if passed, reduces litigation costs, it would be a favorable development for the Company.
as requiring an upgrade, and others have been designated for replacement with Year 2000-compliant versions. Plans are in place to complete these upgrades and replacements by the end of third quarter of 1999.
Critical Third-Party Constituent Readiness: The Company has contacted its critical customers, retrocessionnaires, reinsurance intermediaries, managing general agents, suppliers, and other constituents to determine the nature and extent of their Year 2000 readiness efforts, and whether their failure to resolve their own Year 2000 problems would have a material adverse affect on the Company's financial condition or results of operations. The majority of the critical third-party constituents reported that they were Year 2000-ready by December 31, 1998, while others expect that they will be ready at various dates in 1999. The Company resurveyed all critical third-party constituents in January 1999 to determine if the companies met, or still expect to meet, their previously reported readiness target dates. Their responses will be factored into the Company's business contingency plans.
Potential Claims Exposure: The Company is attempting, whenever possible, to avoid or otherwise limit its overall exposure to Year 2000-related risks in the context of both its assumed business and retrocessional protection; however, it may still have material exposure in its property and casualty operations to Year 2000-related claims. The Company has worked with its brokers and clients to assess potential Year 2000 exposures in both its new and existing business. If, in the Company's opinion, the Year 2000 exposure is minimal, or management believes the cedent is adequately underwriting that exposure, the Company may not exclude such exposures from its contracts. On the other hand, if the exposure is believed to be significant, or the cedent, in management's opinion, is not adequately underwriting the Year 2000 exposure, the Company will attempt to exclude those exposures or non-renew those contracts. It is not yet possible to estimate the potential financial impact on the Company of the Year 2000-related claims that may emerge in the future, or to determine whether such claims will be made against insurance or reinsurance contracts in which the Company participates, or if such claims will be held to have merit.
Other Year 2000 Considerations: Significant failures of certain essential services including, but not limited to, the telecommunications, utility, banking, securities, and transportation industries, due to their own Year 2000 problems are generally beyond the Company's control and could have a material adverse impact on the Company's financial condition or results of operations. All predictions regarding the impact of the Year 2000 issue on the Company, its critical third-party constituents, and attendant costs are inherently subject to unknown risks and uncertainties. While the Company is currently unaware of any material Year 2000 problems that it believes are reasonably likely to disrupt its operations, the Company cautions that the factors and assumptions described above, as well as unknown factors, may cause the Company's actual Year 2000 readiness results, costs and impact on its business, operations, or financial condition to differ materially from those discussed above.
(1) Changes in the level of competition in the reinsurance or primary insurance markets that adversely affect the volume or profitability of the Company's business. These changes include, but are not limited to, the intensification of price competition, the entry of new competitors, existing competitors exiting the market, and the development of new products by new and existing competitors; (2) Changes in the demand for reinsurance, including changes in ceding companies' retentions, and changes in the demand for primary and excess and surplus lines insurance coverages; (3) The ability of the Company to execute its business strategies; (4) Changes in the frequency and severity of catastrophes which could significantly impact the Company's business in terms of net income, reinsurance costs, and cash flow; (5) Adverse development on claims and claims expense liabilities related to business written in prior years, including, but not limited to, evolving case law and its effect on environmental and other latent injury claims, changing government regulations, newly identified toxins, newly reported claims, inflation, new theories of liability, or new insurance and reinsurance contract interpretations; (6) Changes in the Company's retrocessional arrangements; (7) Lower than estimated retrocessional or reinsurance recoveries on unpaid losses, including, but not limited to, losses due to a decline in the creditworthiness of the Company's retrocessionnaires or reinsurers; (8) Increases in interest rates, which cause a reduction in the market value of the Company's interest rate sensitive investments, including, but not limited to, its fixed income investment portfolio, and its common shareholders' equity and decreases in interest rates causing a reduction of income earned on new cash flow from operations and the reinvestment of the proceeds from sales, calls or maturities of existing investments;
(9) Declines in the value of the Company's common equity investments and credit losses on the Company's investment portfolio; (10) Gains or losses related to foreign currency exchange rate fluctuations; and (11) Adverse results in litigation matters including, but not limited to, litigation related to environmental, asbestos, other potential mass tort claims, and claims related to the Year 2000 problem.
In addition to the factors outlined above that are directly related to the Company's business, the Company is also subject to general business risks, including, but not limited to, adverse state, federal or foreign legislation and regulation, adverse publicity or news coverage, changes in general economic factors, and the loss of key employees.
- --Consolidated Balance Sheet at December 31, 1998 and 1997. 32
- --Consolidated Statement of Income for the years ended December 31, 1998, 1997 and 1996. 33
- --Consolidated Statement of Stockholders' Equity for the years ended December 31, 1998, 1997 and 1996. 34
- --Consolidated Statement of Cash Flows for the years ended December 31, 1998, 1997 and 1996. 35
OPERATING COSTS AND EXPENSES Claims and claims expenses 351,888 379,495 338,953 Commissions and brokerage 137,996 151,152 143,324 Other operating expenses 69,897 65,160 56,606 Interest expense 21,716 21,735 22,322 - -------------------------------------------------------------------------------- Total operating costs and expenses 581,497 617,542 561,205 - --------------------------------------------------------------------------------
INCOME Operating income before income taxes 117,882 122,830 89,036 Federal and foreign income taxes: Current 17,120 50,556 23,310 Deferred 4,712 (23,403) (4,794) - -------------------------------------------------------------------------------- Income tax expense (benefit) 21,832 27,153 18,516 - -------------------------------------------------------------------------------- Operating income/net income $ 96,050 $ 95,677 $ 70,520 ================================================================================
The consolidated financial statements have been prepared on the basis of GAAP and include the accounts of NAC Re and its subsidiaries. All intercompany transactions and balances have been eliminated in consolidation.
The preparation of the financial statements in conformity with GAAP requires the use of estimates and assumptions that affect amounts reported in the financial statements and the accompanying notes. Actual results could differ from such estimates.
Property/casualty premiums are recognized as income over the terms of the related reinsurance and insurance contracts and policies. Unearned premium reserves represent the portion of premiums written that relate to the unexpired terms of contracts and policies in force. Such reserves are computed by pro rata methods based on statistical data or reports received from ceding companies. Certain of the Company's assumed and retrocession agreements include provisions that adjust premium payments based upon the experience under the contracts. Premiums are recorded based upon the expected ultimate experience under the agreements.
Acquisition costs, consisting principally of commissions and brokerage expenses incurred at the time a contract or policy is issued, are deferred and amortized over the contract period in which the related premiums are earned. Deferred policy acquisition costs are limited to their estimated realizable value based on the related unearned premiums and take into account anticipated claims and claims expenses, based on historical and current experience, and anticipated investment income.
Fixed maturities, which include bonds, notes and redeemable preferred stocks and equity securities, including common and non-redeemable preferred stocks, have been categorized as "available for sale" and recorded at their fair value. The fair value of publicly traded fixed maturity and equity securities is estimated using quoted market prices or dealer quotes. Investments in which the Company owns between 20% and 50% of the outstanding voting common stock of the issuer are carried under the equity method of accounting. Under this method, the Company records its proportionate share of income or loss for such investments in results of operations. Short-term investments, which have an original maturity of one year or less, are carried at cost, which approximates fair value.
Basic earnings per share is based on weighted average common shares and excludes any dilutive effects of options and convertible securities. Diluted earnings per share assumes the conversion of dilutive convertible securities and the exercise of all dilutive stock options. See Note 12 for information with respect to the computation of earnings per share.
The excess of cost over net assets acquired is amortized on a straight-line basis over a period of twenty years. Amortization charged to operating expenses was approximately $464,000 for the year ended December 31, 1998 and $368,000 for each of the years ended December 31, 1997 and 1996. Supplemental Cash Flow Information
In September 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which is required to be adopted in years beginning after June 15, 1999. The Company does not anticipate that the adoption of this Statement will have a material effect on the Company's financial position.
At December 31, 1998, the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." This Statement requires that companies report certain information about their operating segments in the interim and annual financial statements, including information about the products and services from which revenues are derived, the geographic areas of operation and information regarding major customers. The Statement defines operating segments based on internal management reporting and management's decisions about assessing performance and allocating resources.
The Company's operations are conducted in three reportable segments: domestic reinsurance, domestic primary insurance and the international operation. The domestic reinsurance segment generally writes property, casualty, fidelity/surety and ocean marine business through reinsurance brokers. The domestic primary insurance segment operates through managing and general agents and writes certain specialty classes such as auto warranty business. The primary operation consists of business generated by Greenwich Insurance Company and Indian Harbor Insurance Company. The international operation primarily writes non-U.S. property and casualty reinsurance business. Due to immateriality, the Company's international subsidiary, Stonebridge Underwriting, Ltd. ("Stonebridge"), which is participating as a corporate capital vehicle on a Lloyd's syndicate is included in the international operation segment.
* The domestic primary segment ceded approximately 85% of all underwriting activity to the domestic reinsurance segment pursuant to a quota share reinsurance arrangement.
The following table summarizes the Company's gross and net premiums written by type of business and by geographic area. Allocations to geographic areas have been made on the basis of subsidiary location.
During 1998, three reinsurance brokers, AON Reinsurance Agency, Guy Carpenter and Company, Inc., and E.W. Blanch, Inc., generated 24%, 17% and 8%, respectively, of the Company's premiums assumed from client companies. These same reinsurance brokers generated 24%, 17% and 11%, respectively, during 1997, and 23%, 13% and 8%, respectively, during 1996, of the Company's assumed premiums. The Company does not believe that the reduction of business assumed from any one client or broker will have a materially adverse effect on the Company due to its competitive position in the marketplace and the continuing availability of other sources of business.
The following tables reconcile amortized cost to the estimated fair value (which equals carrying value) of fixed maturity securities and equity securities.
In Thousands December 31, 1998 ----------------------- Amortized Fair Cost Value ---------- ---------- Available for Sale:
Due after ten years 733,573 767,515 ---------- ---------- Subtotal 1,913,130 1,990,086
Approximately 94% of all fixed maturity investments held at December 31, 1998 were rated investment grade by Standard and Poor's or Moody's Investor Services, Inc.
Estimates of claims and claims expenses are based in part on a prediction of future events, estimates of future trends in claims severity and frequency as well as other factors. The Company's ability to predict future trends based upon its own historical claims experience is inherently difficult because of its substantial growth in premiums since 1985. Therefore, the Company has supplemented its historical claims experience to a certain extent with claims experience derived from external sources, such as reinsurance industry data, for purposes of evaluating future trends and providing an estimate of ultimate claims costs. As the Company's book of business continues to mature, its own historical claims experience achieves greater credibility and enhances its ability to evaluate future trends. Accordingly, the Company believes its reserving process improves as additional claims experience emerges.
The Company's incurred claims and claims expenses include a provision of $1.2 million, $3.7 million and $1.2 million in 1998, 1997 and 1996, respectively, for estimates of actual and potential non-recoveries from retrocessionnaires. Included in claims and claims expense reserves at December 31, 1998, 1997 and 1996 is a reserve for potential non-recoveries from retrocessionnaires of $14.5 million, $13.8 million and $12.7 million, respectively. Such charges for non-recoveries relate principally to retrocessional contracts for business written prior to 1986. See Note 6 - Retrocession Agreements.
Except for certain workers' compensation case reserves, the Company does not discount its claims and claims expense reserves. The Company utilizes tabular reserving for workers' compensation case reserves that are considered fixed and determinable and discounts such reserves using an interest rate of 7% for financial statements prepared in accordance with
A reconciliation of the beginning and ending reserves related to asbestos and environmental exposure claims for the years indicated is as follows:
Incurred but not reported claims and claims expense reserves (IBNR), net of reinsurance, included in the above table totaled $17.0 million in 1998, $16.6 million in 1997 and $13.4 million in 1996. Ceded liabilities reflect amounts expected to be recoverable from retrocessionnaires, after reduction for potential uncollectible amounts.
In Thousands Year Ended December 31, -------------------------------- 1998 1997 1996 -------- -------- -------- Current expense: Federal $ 10,490 $ 43,754 $ 19,879 Foreign 6,630 6,802 3,431 -------- -------- -------- Total current expense 17,120 50,556 23,310
Deferred expense (benefit): Federal 4,729 (23,205) (4,845) Foreign (17) (198) 51 -------- -------- -------- Total deferred expense (benefit) 4,712 (23,403) (4,794) -------- -------- -------- Total tax expense $ 21,832 $ 27,153 $ 18,516 ======== ======== ========
The Company's 1998 current federal taxable income is based on alternative minimum taxable income. The Company's current federal tax expense for the years 1997 and 1996 was based on regular taxable income. Federal and foreign taxes paid in the years 1998, 1997 and 1996 were $22 million, $35 million and $22 million, respectively.
In Thousands December 31, ------------------- 1998 1997 -------- -------- Deferred tax asset: Net claims reserve discount $ 84,008 $ 87,704 Net unearned premiums 19,888 18,854 Compensation liabilities 6,978 6,195 Other 3,331 2,631 -------- -------- Deferred tax asset 114,205 115,384 -------- --------
The Company utilizes retrocession agreements principally to increase aggregate premium capacity and to reduce the risk of loss on reinsurance underwritten. In addition, the Company maintains catastrophe reinsurance programs for the purpose of limiting its exposure with respect to multiple claims arising from a single occurrence or event. The Company's retrocession agreements provide for recovery of a portion of claims and claims expenses from retrocessionnaires. Reinsurance recoverables are recorded as assets, predicated on the retrocessionnaires' ability to meet their obligations under the retrocession agreements. If the retrocessionnaires are unable to satisfy their obligation under the agreements, the Company would be liable for such defaulted amounts.
The effect of retrocessional activity on premiums written and earned is set forth below:
The Company recorded ceded claims and claims expenses incurred of $129.6 million, $51.0 million and $123.2 million for the years ended December 31, 1998, 1997 and 1996, respectively. The decrease in 1997 from 1996 is due to the terminations of two retrocessional programs discussed later in this Note.
The Company is the beneficiary of letters of credit, trust accounts and funds withheld in the aggregate amount of $130 million at December 31, 1998, collateralizing reinsurance recoverables with respect to certain retrocessionnaires.
At December 31, 1998, the Company's reinsurance recoverables, exclusive of available offsets in the form of letters of credit, trust accounts and funds withheld, were $362.4 million, with approximately 173 domestic and 162 foreign retrocessionnaires. The Company had no amounts recoverable from a single entity or group of entities that exceeded 10% of stockholders' equity as of December 31, 1998.
The Company's maximum retention on any one claim for non-catastrophe property/casualty losses for 1999, 1998 and 1997 is generally $5 million (up to $10 million in certain limited circumstances). The Company's maximum retention for surety losses for 1999, 1998 and 1997 is $4 million per principal. Further, the Company's initial retention level for property catastrophe claims in 1999 remains the same as 1998 and 1997 at $5 million per event. For 1999, the Company has obtained $83 million of catastrophe protection ($65 million with respect to claims outside the U.S. and Canada). If claims within the U.S. and Canada exceed $40 million, the retrocession agreements provide for an increase to the Company's net retention of up to an additional $16.9 million. In addition to the above reinsurance protections, the Company has accident year stop loss protection which can reduce the Company's net property catastrophe claims to a maximum retention of $5.0 million.
The Company participates in the Lloyd's insurance market through its subsidiary, Stonebridge, which is participating as a corporate capital vehicle on the Denham Syndicate. A letter of credit has been provided to Lloyd's in satisfaction of Stonebridge's capital requirement. All corporate capital providers are required by Lloyd's to post funds at Lloyd's equal to a fixed percentage of the amount of committed insurance capacity. At December 31, 1998, the total amount of insurance capacity committed by Stonebridge was about (pound)29 million and Lloyd's requirement was 50% of that amount. The total insurance capacity was supported by a letter of credit for (pound)16 million.
The Company's $100 million of 5.25% Convertible Subordinated Debentures due December 15, 2002, were issued in December 1992 through a private offering. The Debentures are callable as of January 15, 1996 and are convertible into approximately 2 million shares of the Company's Common Stock at a conversion price of $49.50 per share. The expenses incurred in the offering of approximately $1.4 million were deferred and are being amortized over the life of the Debentures. Interest and amortization costs were $5.4 million annually for 1998, 1997 and 1996. The fair value of the Debentures, estimated based on quoted market prices, was approximately $106.8 million as of December 31, 1998.
The Company's $100 million of 8% Senior Notes due June 15, 1999 were issued in June 1992 through a public offering. The expenses incurred in the offering of approximately $.8 million were deferred and are being amortized over the life of the Notes. Interest and amortization costs were $8.1 million annually for 1998, 1997 and 1996. The fair value of the Notes, estimated based on quoted market prices, was approximately $101.1 million as of December 31, 1998.
Information concerning stock options (including SARs) for all of the Company's stock option plans is as follows:
The following table summarizes information about the Company's stock options (including SARs) for options outstanding as of December 31, 1998:
The Company has an employee stock purchase plan through which all employees have the option, subject to certain limitations, to purchase NAC Re Common Stock, at the end of each offering period at a discounted price. The discounted price is based on 85% of the lesser of the stock's market price at the beginning of the period or the market price at the end of the period. During the 1998, 1997 and 1996 plan years, employees purchased approximately 42,800, 46,400 and 28,400 shares of Common Stock, respectively. The Company's stock purchase plan qualifies as a non-compensatory plan under APB 25.
The weighted average assumptions for the stock option grants were as follows:
1998 1997 1996 ---------- -------- ----------- Expected life 7.5yrs 7.5yrs 7.5yrs Volatility 29% 30% 28% Dividend yield 0.76% 0.70% 0.67% Risk-free interest rate 5.5% 6.6% 6.3% Grant date fair value $19.33 $19.20 $15.32
1998 1997 1996 ---------- -------- ----------- Expected life 1yr 1yr 1yr Volatility 29% 30% 28% Dividend yield 0.79% 0.87% 0.72% Risk-free interest rate 4.6% 5.3% 5.3% Grant date fair value $11.88 $9.14 $8.75
The Company maintains a qualified non-contributory defined benefit pension plan covering substantially all U.S. employees. Pension benefits generally vest after five years of service. Benefits are based on years of service and compensation, as defined in the plan, during the highest consecutive three years of the employee's last ten years of employment.
The Company's policy is to make annual contributions to the plan that are deductible for federal income tax purposes and that meet the minimum funding standards required by law. This contribution level is determined by utilizing the entry age cost method and different actuarial assumptions than those used for pension expense purposes.
The Company also maintains a non-qualified unfunded supplemental defined benefit plan designed to compensate individuals to the extent their benefits under the Company's qualified plan are curtailed due to Internal Revenue Code limitations.
The following tables set forth the amounts recognized in the Company's financial statements with respect to the qualified and non-qualified pension plans.
In the first quarter of 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income," which requires that a company classify items that meet the definition of components of other comprehensive income in a financial statement and display the accumulated balance of other comprehensive income in the equity section of the statement of financial position. Comprehensive income includes all changes in equity during a period resulting from transactions and other events from nonowner sources. Reclassification of prior period financial statements is required for comparative purposes.
In Thousands ------------------------------------------------- Unrealized Accumulated Gains on Currency Other Comp Year ended December 31, 1998 Investments Translation Income ---------------- ------------- --------------- Beginning balance $55,000 $5,989 $60,989 Current period change 2,661 (872) 1,789 ---------------- ------------- --------------- Ending Balance $57,661 $5,117 $62,778 ================ ============= ===============
In Thousands ------------------------------------------------- Unrealized Accumulated Gains on Currency Other Comp Year ended December 31, 1997 Investments Translation Income ----------------- ------------ --------------- Beginning balance $31,700 $ 8,377 $40,077 Current period change 23,300 (2,388) 20,912 ----------------- ------------ --------------- Ending Balance $55,000 $ 5,989 $60,989 ================ ============= ===============
Consolidated statutory net income and surplus of NAC Reinsurance Corporation ("NAC"), as reported to the insurance regulatory authorities, differs in certain respects from the amounts as prepared in accordance with GAAP. The following schedules identify the significant reconciling differences:
Under the holding company structure, NAC Re is dependent upon the ability of its principal operating subsidiary, NAC, for the transfer of funds principally in the form of cash dividends and tax reimbursements. Such transactions, including the payment of cash dividends, are subject to restrictions imposed by New York insurance law. Generally, NAC may pay cash dividends only out of its statutory earned surplus which was $231.9 million at December 31, 1998. However, the maximum amount of dividends that may be paid in any twelve-month period without the prior approval of the New York Insurance Department is the lesser of net investment income or 10% of statutory surplus as such terms are defined in the New York insurance law. The maximum amount of cash dividends that NAC could pay without such regulatory approval, based on 10% of statutory surplus as of December 31, 1998, is approximately $73.7 million. During 1998, 1997 and 1996, NAC declared dividends of $55.9 million, $22.5 million and $38 million, respectively, to NAC Re.
In 1993, the National Association of Insurance Commissioners (the "NAIC"), by adopting a model risk-based capital act, intended to provide an additional tool for regulators to evaluate the capital of property and casualty insurers and reinsurers with respect to the risks assumed by them and to determine whether there is a perceived need for corrective action. The nature of the corrective action depends upon the extent of the calculated risk-based capital deficiency and ranges from requiring the company to submit a comprehensive plan to placing the insurer under regulatory control. While the model risk-based capital act has not yet been adopted in New York, NAC's domicile, New York has issued a circular letter requiring the filing of risk-based capital reports by property and casualty insurers and reinsurers. The NAIC also adopted a proposal that requires property and casualty insurers and reinsurers to report the results of their risk-based capital calculations as part of the statutory annual statements filed with state regulatory authorities. Surplus (as calculated for statutory annual statement purposes) for each of the Company's domestic subsidiaries is well above the risk-based capital thresholds that would require either company or regulatory action.
Year ended December 31, ----------------------------------------- 1998 1997 1996 ----------- ----------- ----------- Common Stock: Balance, beginning of year 21,707,223 21,463,982 21,341,053 Shares issued 284,196 243,241 122,929 ----------- ----------- ----------- Balance, end of year 21,991,419 21,707,223 21,463,982 ----------- ----------- -----------
At December 31, 1998, there were 18,374,355 Rights outstanding which, if exercised, would result in the issuance of approximately 183,700 shares of Series A Stock.
The following is a summary of quarterly financial data, in thousands, except per share data and stock prices:
On February 15, 1999, XL and NAC Re signed a definitive agreement whereby NAC Re will merge into a wholly-owned subsidiary of XL in an all stock transaction. Under the terms of the transaction, NAC Re stockholders will receive 0.915 of an XL Class A voting ordinary share for each share of NAC Re in a tax-free exchange of shares. XL plans to account for the merger as a "pooling-of-interests" under U.S. GAAP. The transaction is subject to the approval of the NAC Re stockholders, receipt of insurance, and other regulatory approvals and customary closing conditions. It is expected that the merger will be completed by late second calendar quarter or early third quarter of 1999.
The merger with XL will not cause the Preferred Stock Purchase Rights described in Note 13 to become exercisable, due to an amendment to NAC Re's Rights Agreement adopted in February 1999.