ZRC is party to a sublease agreement, dated as of January 1, 1994, and amended as of January 26, 1996 (the "Sublease") with a subsidiary of Zurich. Under the Sublease, ZRC leases approximately 60,000 rentable square feet of space in New York City for its underwriting, actuarial and certain executive offices (the "Office Space"). The Sublease has a term of approximately seventeen years. Together with another Zurich affiliate which occupies space contiguous to the Office Space, ZRC has guaranteed the performance of the tenants' obligations under the lease covering the Office Space. Under this guarantee, ZRC is contingently liable for 36.2% of monetary obligations to the lessor in respect of the Office Space and other contiguous space leased thereby (together with the Office Space, the "Group Office Space"). This percentage represents the approximate percentage which the Office Space bears to the Group Office Space. In addition, ZRC occupies approximately 40,000 square feet of office space in Stamford, Connecticut. The Company believes that its facilities are adequate for the conduct of its current and expected business.
INDUSTRY OVERVIEW The property and casualty reinsurance industry's revenue and profitability is influenced by financial and market trends concerning its client insurers, by prevailing general economic and capital market conditions as well as by recent trends in the reinsurance sector including increased competition, continued consolidation and the introduction of financial market instruments as alternatives to reinsurance. The industry is also subject to other developments concerning risks insured and reinsured such as natural disasters (including hurricanes, windstorms, earthquakes) and the emergence of latent casualty exposures (including environmental and asbestos-related claims).
The demand for reinsurance will depend on the underwriting results, capital adequacy, perceived exposure of primary insurers, perceived attractiveness of available reinsurance terms and prevailing general economic conditions. Each of these factors affects liability retention decisions by primary insurers. The degree of competition among reinsurers is driven in part by many of the same or similar factors. Industry capacity is a function largely of aggregate capitalization, which in turn fluctuates based on, among other things, pricing adequacy on current business, reserve development with respect to historical business, market interest rates and new capital entrants.
(1) Review Preview, Best Week Property and Casualty Supplement, A.M. Best, January, 1997 and 1996.
The Company's pre-tax operating income (excluding realized capital gains and losses) increased 101.6% to $46.8 million in 1996. The increase is primarily due to growth in net investment income and improved underwriting results. The Company's pre-tax operating income for 1995 was $23.2 million compared to a pre-tax operating loss of $6.3 million for 1994. This increase was primarily due to growth in net investment income and the absence of significant catastrophe losses. The Company incurred no significant catastrophe losses in either 1996 or 1995. Results for 1994 reflect the impact of pre-tax catastrophe losses of $12.2 million.
Net income was $29.3 million for 1996 compared to $43.4 million for 1995, due to a $30.4 million decline in after-tax realized capital gain (loss) activity offset by a $16.3 million increase in after-tax operating income. Net income was $43.4 million for 1995 compared to net loss of $31.2 million for 1994, due to a $55.3 million increase in after-tax realized capital gain (loss) activity and a $19.3 million increase in after-tax operating income.
Gross premiums written in 1996 were $737.4 million, a 20.1% increase over 1995. The Company entered into a domestic whole account quota share treaty with members of the Zurich American Insurance Group (the "ZA Quota Share Agreement") during the third quarter of 1995. The ZA Quota Share Agreement contributed $181.8 million and $93.3 million to 1996 and 1995 gross premiums written, respectively. Net premiums written in 1996 were $729.3 million, representing an increase of 21.1% over 1995. The growth exhibited by net premiums written was consistent with that of gross premiums written since there were no significant changes in the Company's retention levels or retrocessional programs during 1996 or 1995. Net premiums earned in 1996 were $684.3 million, a 36.2% increase over 1995. Net premiums written increased less on a percentage basis than net premiums earned due to the maturing of the Company's book of business, including the ZA Quota Share Agreement. For 1995, net premiums written increased to $602.3 million or 94.5% over 1994, and net premiums earned increased to $502.6 million or 123.8% over 1994. The 1995 premium growth was due to an increasing proportion of renewal business as well as new bound business, including the ZA Quota Share Agreement.
Losses and loss adjustment expenses ("LAE") incurred for 1996 increased to $485.8 million, a 29.1% increase over 1995. The Company incurred no significant catastrophe losses in either 1996 or 1995. Commissions were $184.7 million and $124.3 million for 1996 and 1995, respectively. The increase in both losses and commissions is due to significant growth in earned premiums as discussed above. The GAAP loss and commission ratios for 1996 and 1995 were 98.0% and 99.6%, respectively. The loss and commission ratio has trended downward due to refinement of the loss reserving process and a greater percentage of well performing renewal business. In addition, the components of the loss and commission ratio have shifted primarily due to a greater percentage of business written on a pro rata basis. Pro rata treaties generally have lower loss ratios but higher commission ratios than excess of loss treaties. The 1995 GAAP loss and commission ratio decreased to 99.6% from 105.1% in 1994. During
Other operating costs and expenses were $47.7 million in 1996 compared to $43.4 million in 1995 and $34.8 million in 1994. The GAAP expense ratios for 1996, 1995 and 1994 were 6.5%, 7.2% and 11.2%, respectively. The decrease in the GAAP expense ratio is attributable to growth in the Company's written premium volume as discussed above.
Pre-tax realized capital losses for 1996 were $5.1 million compared to pre-tax realized capital gains of $33.5 million for 1995 and pre-tax realized capital losses of $35.6 million for 1994. The realized capital gain (loss) activity is reflective of market conditions and is consistent with the Company's investment philosophy, whereby capital gains (losses) are realized to maximize the total investment return.
The Company's overall effective federal income tax rate for 1996 and 1995 was 29.9% and 23.5%, respectively. The Company's overall effective tax rate for 1996 and 1995 had both operating income and realized capital gain (loss) components. The 1996 and 1995 effective tax rate on operating income of 30.5% and 29.8%, respectively, differed from the federal statutory rate of 35.1% primarily due to tax-exempt investment income and dividends. The effective tax (benefit) on 1996 realized capital losses approximated the federal statutory rate of 35.1%. The effective tax rate on 1995 realized capital gains of 19.1% differed from the federal statutory rate of 35.1% due to the reversal of a valuation allowance previously established by the Company to offset potential tax benefits from realized capital losses. The Company's 1994 effective federal income tax (benefit) of (25.5)% varied from the federal statutory rate of 35.1% primarily because of the recognition of the valuation allowance discussed above.
Mortgage pass-through and collateralized mortgage-backed obligations ("MBS") represent approximately 17.8% (or $311.3 million) of the Company's cash and invested assets as of December 31, 1996. While the Company believes that there is negligible default risk associated with these securities since most are rated "triple-A", such investments are, however, subject to risks associated with the timing of principal payments. The degree to which a MBS is susceptible to either gains or losses is influenced by the difference between its amortized cost and par value, the relative sensitivity of the underlying assets backing the securities to prepayment in a changing interest rate environment and the repayment priority of the securities in the overall securitization structure. The net unamortized discount as of December 31, 1996 for such securities was approximately $6.6 million. Prepayment risk is associated with securities having an amortized cost greater than par value ("premium securities"), which are collateralized by assets that prepay faster than expected, as these securities will incur a reduction in yield or a loss. Conversely, securities having an amortized cost less than par value ("discount securities") that prepay faster than expected, will generate an increase in yield or a gain. As of December 31, 1996, the gross unamortized premium for MBS purchased at a premium to par (and thus subject to prepayment risk) was $3.1 million. There is also extension risk associated with MBS when rates increase and prepayments slow, since the maturity of these securities will be later than anticipated at the time of purchase, thereby delaying the point when proceeds can be reinvested at prevailing yields. Premium securities which are collateralized by assets that prepay slower than expected will generate an increase in yield or a gain. Conversely, discount securities that prepay slower than expected will generate a decrease in yield or a loss. As of December 31, 1996, the gross unamortized discount for MBS purchased at a discount to par (and thus subject to extension risk) was $9.7 million.
Liabilities for gross losses and loss adjustment expenses (together referred to as "loss reserves") amounted to $938.8 million at December 31, 1996, an increase of 36.1% over December 31, 1995. The increase in loss reserves in 1996 is principally due to the significant premium growth. Under the terms of the Stop Loss Agreement, Zurich has reinsured the adverse development, if any, of ZRC's net loss reserves as of May 31, 1993. As of December 31, 1996 and 1995 there were no accrued recoverables under the Stop Loss Agreement. Zurich has an "AA+" claims-paying ability rating from Standard & Poor's and a "Aa1" financial strength rating from Moody's. The Company believes that its exposure to environmental impairment liability and asbestos-related claims is minimal due to the diminutive amount of business written prior to 1987 and the protection provided by the Stop Loss Agreement.
The NAIC requires insurance companies to calculate and report information under a risk-based capital ("RBC") formula that measures statutory capital and surplus needs based on the risks in a company's mix of business and investment portfolio. Based on its calculation as of December 31, 1996, ZRC exceeds all of the capital levels prescribed by the NAIC.
Net cash provided by operating activities for 1996 was $282.1 million compared to $242.5 million in 1995 and $154.1 million in 1994. The increase in cash flow is primarily attributable to underwriting operations and net investment income.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Zurich Reinsurance Centre Holdings, Inc. and Subsidiaries at December 31, 1996 and 1995, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
ZURICH REINSURANCE CENTRE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands)
Market values are based on quoted market prices, when available, or estimates based on market prices for similar securities when quotes are not available. Realized capital gains or losses on the sale or maturity of investments are determined on the basis of the specific identification method. Investment income, consisting of dividends and interest, is recognized when earned. Dividends on equity securities
are recorded on the ex-dividend date. The amortization of premium and accretion of discount for fixed maturity securities is computed using the interest method. For certain investments, such as mortgage-backed and certain other asset-backed securities, the Company considers estimates of future principal prepayments in the calculation of the constant effective yield necessary to apply the interest method. If a difference arises between the prepayments anticipated and the actual prepayments received, the Company recalculates the effective yield to reflect the actual payments to date and the anticipated future payments.
CASH AND CASH EQUIVALENTS The Company considers all short-term, highly liquid investments with a maturity date of three months or less to be cash equivalents. The carrying amount of cash and cash equivalents approximates fair market value due to their short maturity.
PREMIUM REVENUES AND RELATED EXPENSES Premiums are recognized over the terms of the related reinsurance contracts. Unearned premium reserves represent that portion of premiums written that relates to the unexpired terms of contracts in force. Such reserves are computed by pro rata methods based on statistical data or reports received from ceding companies. Premium and commission adjustments on contracts are accrued on an estimated basis throughout the terms of such contracts. Ceded premiums are expensed on a pro rata basis over the contract period.
The Company recognizes a liability or an asset to the extent that there is an obligation to pay or receive cash or other consideration that would not have been required absent experience under the contract.
During 1996, three reinsurance intermediaries produced approximately 22%, 18% and 12% of the Company's gross premiums written, respectively. Business produced by Zurich American Insurance Group ("Zurich American"), an affiliate (refer to Footnote 12 for further discussion of related party transactions), generated 29% of gross premiums written. No other intermediaries or ceding companies accounted for more than 10% of the Company's consolidated revenues for the year ended December 31, 1996.
The Company establishes a reserve for potentially uncollectible recoverables from retrocessionaires. In addition, the Company immediately charges operations for any recoverable balances that are deemed to be uncollectible. Collateral and other offsets are considered in determining the reserve or expense.
INCOME TAXES Income taxes have been provided under the liability method using the applicable enacted tax rate and laws. Deferred federal income taxes are recorded for differences between the tax basis of an asset or liability and its reported value in the financial statements and for loss carryforwards. A valuation allowance is recorded using the "more-likely-than-not" criterion when some or all of a deferred tax asset may not be realized.
EARNINGS PER SHARE Earnings per common share are determined by dividing net income available to common stockholders by the weighted average common shares outstanding during the relevant period. Common stock equivalents had no dilutive effect on net income (loss) per share for any of the periods presented.
RECLASSIFICATIONS The Company has reclassified the presentation of certain prior year information to conform with the current presentation.
In June 1996, the Financial Accounting Standards Board ("FASB") issued SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities." SFAS No. 125 provides accounting and reporting standards for sales, securitizations and servicing of receivables and other financial assets, for certain secured borrowing and collateral transactions, and for extinguishment of liabilities. The Statement establishes guidelines for determining whether a transfer of financial assets, including securities lending, constitutes a sale and if so, measurement of the gain or loss. SFAS No. 125 is effective for transactions occurring after December 31, 1996. (Note SFAS No. 127 "Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125" provides a one year deferral for certain sections of SFAS No. 125.) The Company does not expect that the provisions of SFAS No. 125 will have a material effect on its financial statements.
Contractual maturities of fixed maturity securities are shown below. Expected maturities, which are best estimates, will differ from contractual maturities because certain borrowers may have the right to call or prepay obligations.
Approximately 83% and 84% of the fixed maturity portfolio as of December 31, 1996 and 1995, respectively, are U.S. government obligations or are rated "triple-A" by Moody's Investors Service or Standard & Poor's Corporation. The remaining 17% and 16%, respectively, are "A" rated fixed maturities. There are no investments in any entity in excess of 10% of the Company's stockholders' equity at December 31, 1996, other than investments issued or guaranteed by the U.S. government or its agencies.
The Company participates in a securities lending program, whereby certain securities from its portfolio are loaned to counterparties, with the Company retaining the right to recall such securities at will. A fee is paid to the Company by the borrower, which is reported as a component of net investment income. The program is designed to minimize the Company's exposure to credit and interest rate risk by including specification of collateral requirements and collateral investment criteria and limits on the amount of securities that can be lent subject to such arrangements to any single counterparty and in the aggregate, by requiring collateral to be maintained in excess of the market value of the loaned securities for the period that the loan is outstanding, and by specifying how the collateral can be invested. As of December 31, 1996, $236.7 million was on loan, with no single borrower's loan representing more than 5% of cash and invested assets or 10% of stockholders' equity.
The reconciliation of loss and loss adjustment expense reserves for each of the three years in the period ended December 31, 1996 is shown below.
(2) The Company estimates premiums for treaty accounts that are not yet due from its reinsureds. Prior year incurred loss development is primarily attributable to the corresponding development of premium estimates.
At December 31, 1996, there were no recoverables from any one retrocessionaire that exceeded 10% of stockholders' equity. The Company holds collateral under related reinsurance agreements in the form of letters of credit totaling $19.3 million that can be drawn on for amounts that remain unpaid for more than 120 days. Pursuant to the terms of the Stop Loss Agreement, in the event that retrocessional recoverables on business effected prior to June 1, 1993 are uncollectible from retrocessionaires due to insolvency, the Company will be reimbursed from Zurich. Refer to Footnote 12 for a further discussion of the retrocessional agreements with affiliates.
Federal income taxes paid were $25.5 million, $9.1 million and $0.7 million in 1996, 1995 and 1994, respectively.
An analysis of the Company's effective federal income tax rate (benefit) follows:
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts reported for income tax purposes. Significant components of the Company's deferred tax liabilities and assets as of December 31, 1996 and 1995 are as follows:
ZRC is party to a sublease agreement, dated as of January 1, 1994, and amended as of January 26, 1996 (the "Sublease") with a subsidiary of Zurich. Under the Sublease, ZRC leases approximately 60,000 rentable square feet of space in New York City for its underwriting, actuarial and certain executive offices (the "Office Space"). The Sublease has a term of approximately seventeen years. Together with another Zurich affiliate which occupies space contiguous to the Office Space, ZRC has guaranteed the performance of the tenants' obligations under the lease covering the Office Space. Under this guarantee, ZRC is contingently liable for 36.2% of monetary obligations to the lessor in respect of the Office Space and other contiguous space leased thereby (together with the Office Space, the "Group Office Space"). This percentage represents the approximate percentage which the Office Space bears to the Group Office Space.
The Company maintains a non-contributory defined contribution Money Purchase Pension Plan (the "Pension Plan") under which the Company contributes for each eligible employee an amount equal to the sum of (i) 4% of eligible compensation up to the taxable wage base (as such term is defined in the Pension Plan) (for 1997 set at $65,400) and (ii) 8% of eligible compensation in excess of the taxable wage base (up to the applicable earnings cap which for 1997 is $160,000). Substantially all employees of the Company are eligible for participation in the Pension Plan. The Company expensed $0.6 million, $0.7 million and $0.6 million for the years ended December 31, 1996, 1995, and 1994 respectively, related to the Pension Plan.
The Company maintains a tax-qualified employee thrift plan (the "Employee Thrift Plan"). Pursuant to Section 401(k) of the Internal Revenue Code, eligible employees of the Company are able to defer receipt of up to 12% of their annual salaries. Subject to limitations under applicable law, the Company matches up to 100% of the first 3% of annual salary deferred by employees and 50% of the next 3% of salary so deferred. The Company maintains a supplemental, non-qualified executive thrift plan (the "Executive Thrift Plan") under which members of executive management may defer certain amounts of base salary and receive limited matching contributions from the Company. Under the Executive Thrift Plan, ZRC matches, dollar-for-dollar, amounts deferred by participants under the Executive Thrift Plan up to 3% of annual salary in excess of $160,000 in 1997 and provides a 50% matching contribution for the next 3% of such excess salary so deferred. The Company expensed $0.7 million, $0.6 million and $0.5 million for the years ended December 31, 1996, 1995, and 1994, respectively, related to its Employee Thrift Plan and the Executive Thrift Plan.
The Company maintains a restricted stock plan (the "Restricted Stock Plan") pursuant to which participants may be granted an award of shares of the Company's Common Stock ("Restricted Stock") subject to certain restrictions including vesting requirements. As of December 31, 1996, the Company
Grants of 503,575 shares of Common Stock were authorized (half Type A and half Type B), with exercise prices ranging from $29.88 per share to $30.36 per share. All of these options remain outstanding at December 31, 1996 and have a remaining contractual life of 9 years. None of these options were exercisable during the year or at December 31, 1996.
DIVIDEND RESTRICTIONS The payment of dividends by ZRC is subject to restrictions set forth in the Connecticut Insurance Code (the "Connecticut Code") which limit the aggregate amount of dividends or other distributions that ZRC may declare or pay within any 12-month period absent prior regulatory notification and approval. The Connecticut Code provides that no dividend or other distribution may be paid by a subject insurer (i) when the surplus of such insurer is less than (a) the minimum surplus required under the Connecticut Code to write specified lines of insurance or (b) the amount of surplus which bears a reasonable relationship to such insurer's liabilities based upon the type, volume and nature of the insurance business transacted, or (ii) when the payment of a dividend or other distribution would reduce such insurer's surplus to less than such amounts. The Connecticut Code further provides that a subject insurer may not pay any dividend or other distribution, without the Connecticut Commissioner's prior approval, in an amount exceeding such insurer's earned surplus, determined in accordance with Statutory Accounting Principles ("SAP"), as of the prior year end (adjusted to reflect a discount of certain unrealized gains on investments). In addition, the Connecticut Code provides that subject insurers may not pay any "extraordinary" dividends or distributions until (i) 30 days after the Connecticut Commissioner has received notice of the declaration thereof and has not within such period disapproved such payment or (ii) the Connecticut Commissioner has approved such payment. The Connecticut Code provides that an extraordinary dividend or distribution means any dividend or distribution of cash or other property, whose fair market value, together with that of other dividends or distributions made within the preceding 12-month period, exceeds the greater of 10% of surplus with respect to policyholders as of December 31 of the preceding year or 100% of net income for the 12-month period ending December 31 of the preceding year, both determined in accordance with SAP.
Net income (loss) and statutory surplus of ZRC were as follows:
ZRC prepares its statutory financial statements in accordance with accounting practices prescribed by the Insurance Department of the State of Connecticut (the "Connecticut Department"). Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners ("NAIC"), as well as state laws, regulations, and general administrative rules.
In the normal course of business, the Company enters into both reinsurance and retrocessional agreements with its affiliates. The amounts assumed (net of cessions by the Company) pursuant to these agreements, including those discussed below, were as follows:
and net premiums earned were $152.8 million and $27.1 million, respectively. The terms of the ZA Quota Share Agreement and the Retrocessional Agreement were negotiated and evaluated by ZRC by application of the actuarial pricing methodologies generally used by ZRC in evaluating contracts.
The Company has entered into an investment management agreement (the "Investment Management Agreement") with Centre Investment Services, Limited ("CIS"), a wholly owned subsidiary of Zurich Centre Investments Limited, an indirect subsidiary of Zurich. Under the Investment Management Agreement, CIS manages a portion of the Company's investment portfolio in return for a fee based upon the average total market value of the assets under management as well as the performance of the portfolio. The 1996, 1995 and 1994 investment management fees related to CIS were $1.1 million, $1.0 million and $1.1 million, respectively.