The Company's principal and executive offices are located in Houston, Texas, in an approximately 52,000 square foot building owned by HC. HC also owns an 81,000 square foot building, acquired in 1998, adjacent to its home office building. The Company also maintains sales and administration offices or other facilities in over 30 locations elsewhere in the United States and in England, Turkey and Jordan. The majority of these additional locations are in leased facilities.
(1) On February 27, 1998, the Company acquired all of the outstanding stock of Kachler. This business combination has been accounted for as pooling-of-interests and, accordingly, the consolidated financial data shown in this table has been restated to include the accounts and operations of Kachler for all periods presented.
During recent years, the Company has substantially increased its shareholders' equity through the issuance of equity securities, incurrence of debt, and earnings, thereby enabling it to increase the underwriting capacity of its insurance company subsidiaries. The Company has utilized this additional equity by increasing underwriting activity across many of its core lines of business, emphasizing lines of business and individual opportunities with the most favorable underwriting characteristics at a particular point in time. In each line of business, as an insurer, the Company also cedes premium through the purchase of reinsurance in types and amounts appropriate to the line of business, market conditions and the Company's desired net risk retention profile.
Since 1996, the Company has focused its acquisition activities on expanding its underwriting agency and intermediary operations for three principal reasons. Firstly is an attempt to increase the management fees and commission income components of the Company's total revenue, which management believes to be a more predictable and more stable source of revenue than the potential underwriting gain from insurance company operations. Secondly, an effort to insulate the Company from a decline in its net earnings growth rate as insurance premium rates become more competitive in the lines of business in which the Company specializes in and the Company becomes more selective in its underwriting approach, resulting in reduced earned premium. Thirdly, to provide a future source of premium revenue to the Company's insurance company subsidiaries.
The following table sets forth the relationships of certain income statement items as a percent of total revenue for the three years ended December 31, 1998:
Net investment income increased 6% to $29.3 million in 1998 from $27.6 million in 1997 reflecting a slightly higher level of investment assets. In 1998, the Company also utilized a substantial amount of its non-insurance company subsidiary cash flow to reduce debt and therefore interest expense, limiting the amount of cash subject to short-term investment. Management expects to follow this strategy in 1999, which, together with expected lower interest rates will produce investment income comparable to 1998.
Other operating income increased from $15.2 million in 1997 to $22.3 million in 1998, principally as a result of a $4.0 million pre-tax gain on the sale of one of the Company's subsidiaries whose operations were not material to those of the Company. Additionally, revenue of a service company subsidiary increased $2.0 million in 1998.
AIC, acquired in June, 1997, recorded a $10.0 million increase in loss and LAE reserves during December, 1997, predominantly relating to 1995 and 1996 claims incurred prior to the Company's acquisition of AIC. This increase in reserves was made to bring AIC's reserving practices consistent with the more conservative method used by the Company's other insurance company operations. Management
Loss and LAE decreased $5.2 million in 1998, to $91.3 million, reflecting the reduction in risk retention, despite the catastrophe loss in 1998 from the Hurricanes Georges and Mitch. Excluding the effects of the catastrophe loss in 1998 and AIC's reserve strengthening in 1997, loss and LAE decreased $692,000 and the Company's GAAP loss ratio increased to 60.0% in 1998 from 53.2% in 1997. Including these effects, the Company's GAAP loss ratio increased to 63.8% for 1998 from 59.4% in 1997. Both increases reflect the higher incurred losses and LAE on substantially lower earned premium in 1998 when compared to 1997. Additionally, the increased loss ratios reflect a general deterioration in pricing in 1998 coupled with a higher frequency of attritional losses. The Company's insurance company subsidiaries statutory combined ratio was 82.9% for 1998 compared to 78.8% for 1997. The Company's combined ratio remains significantly better than the industry average.
During 1998, the Company had net loss and LAE redundancy of $14.6 million relating to prior year losses compared to a redundancy of $3.8 million in 1997. During 1998, the Company had gross loss and LAE deficiency of $33.5 million compared to a deficiency of $23.2 million in 1997. The gross deficiency results from the development of several large claims on individual policies which were either reported late or reserves were increased as subsequent information became available. However, as most of these policies were substantially reinsured, there is no material effect to the Company's net earnings. The redundancies in the net reserves result from the Company's and its actuaries' continued review of its loss reserves and the reduction of such reserves as losses are finally settled and claims exposures are reduced. The Company continues to believe it has materially provided for all net incurred losses.
Compensation expense increased $4.6 million or 9% in 1998 to $56.1 million due to the increase in personnel resulting from acquisitions completed during 1998, along with an increase in management personnel to oversee the operations of the rapidly expanding group.
Net earnings increased 45% to $72.3 million in 1998, from $49.8 million in 1997. Diluted earnings per share increased 44% to $1.48in 1998 from $1.03 in 1997.
Total revenue increased to $280.3 million in 1997 from $270.8 million in 1996. GWP increased to $346.4 million in 1997 from $337.3 million in 1996, due primarily to increased aviation and accident and health premium offset by decreased property and marine premium. NWP for 1997 decreased to $142.9 million from $183.0 million in 1996, due to an increase in the amount of ceded reinsurance. Net earned premium decreased to $162.6 million in 1997 compared to $170.1 million in 1996 reflecting the reduction in NWP and the reduced retentions of the Company.
increased 13% to $24.2 million from $21.5 million in 1996, reflecting internal growth. Net investment income increased 17% to $27.6 million in 1997 from $23.6 million in 1996 reflecting a higher level of investment assets.
Net realized investment losses from sales of equity securities were $154,000 during 1997, compared to gains of $8.3 million in 1996. During 1996, the Company systematically liquidated the majority of its equity portfolio. Net realized investment losses from disposition of fixed income securities were $174,000 during 1997, compared to gains of $29,000 in 1996.
Loss and LAE decreased $18.0 million in 1997, to $96.5 million, reflecting the increased use of reinsurance, despite the $10.0 million reserve strengthening charge taken by AIC. During 1997, the Company had net loss and LAE redundancy of $3.8 million relating to prior year losses compared to a redundancy of $4.9 million in 1996. During 1997, the Company had gross loss and LAE deficiency of $23.2 million compared to a deficiency of $42.5 million in 1996. The gross deficiency comes from two primary sources. Firstly, the development of several large claims on individual policies which were either reported late or reserves were increased as subsequent information became available; however, as most of these policies were substantially reinsured, there is no material effect to the Company's net earnings. Secondly, is the run-off of the retrocessional excess of loss business which the Company underwrote between 1988 and 1991. This development, $1.6 million in 1997 compared to $11.3 million in 1996, is primarily due to the delay in reporting of catastrophe losses by the London insurance market, coupled with the unprecedented number of catastrophes during the period in which the Company underwrote this business. This business is also substantially reinsured, thereby not having a material effect on the Company's net earnings.
The Company receives substantial cash from premiums, reinsurance recoverables, management fees and commission income and, to a lesser extent, investment income, and proceeds from sales and redemptions of investment assets. The principal cash outflows are for the payment of claims and LAE, payment of premiums to reinsurers, purchase of investments, debt service, policy acquisition costs, operating expenses, income and other taxes and dividends.
On March 8, 1999, the Company entered into a Loan Agreement (the "Facility") with a group of banks. The Facility includes a $150.0 million Revolving Loan Facility and $100.0 million Short Term Revolving Loan Facility. Borrowing under the Facility may be made from time to time by the Company for general corporate purposes through the Short Term Revolving Loan Facility until its expiration on March 7, 2000 and through the Revolving Loan Facility until its expiration on February 28, 2002. Outstanding loans under the Facility bear interest at agreed upon rates. The Facility is collateralized in part by the pledge of the stock of HC, AIC, and USSIC and by the pledge of stock and guaranties entered into by the Company's principal underwriting agency and intermediary subsidiaries. The Facility agreement contains certain restrictive covenants, including, without limitation, minimum net worth requirements for the Company and certain subsidiaries, restrictions on certain extraordinary corporate actions, notice requirements for certain material occurrences, and required maintenance of specified financial ratios. Management believes that the restrictive covenants and other obligations of the Company which are contained in the Facility agreement are typical for financing arrangements comparable to the Facility. The initial funding available under the Facility was used, among other things, to refinance existing indebtedness of the Company including all outstanding indebtedness under the Company's $120.0 million revolving credit facility entered into as of December 30, 1997, which has been terminated.
As of March 13, 1999, total debt outstanding under the Facility was $176.0 million with $150.0 million due under the $150.0 million Revolving Loan Facility and $26.0 million due under the $100.0 million Short
Term Revolving Loan Facility. The increase in debt subsequent to December 31, 1998 resulted from the funding of the purchase price of acquisitions.
The Company maintains a substantial level of cash and liquid short-term investments which are used to meet anticipated payment obligations. As of December 31, 1998, the Company had cash and short-term investments of approximately $145.1 million. The Company's consolidated investment portfolio of $525.6 million as of December 31, 1998 (of which $129.1 million is short-term investments), is available to provide additional liquidity and cash for operations.
Property and casualty insurance companies domiciled in the State of Texas are limited in the payment of dividends to their shareholders in any 12 month period, without the prior written consent of the Commissioner of Insurance, to the greater of statutory net income or 10% of statutory policyholders' surplus. HC paid no dividends to HCC in 1998. During 1999, HC's ordinary dividend capacity will be approximately $38.2 million.
Under the laws of the State of Maryland, AIC may only pay dividends out of statutory earned surplus. The maximum amount of dividends that AIC may pay without prior regulatory approval in any 12 month period is the greater of its statutory net income (under certain conditions) or 10% of its statutory policyholders' surplus. The maximum amount at December 31, 1998 was $10.5 million.
The overall increase in activities at the insurance company subsidiaries resulted in increases in gross loss reserves, gross unearned premiums, deferred policy acquisition costs and deferred ceding commissions since December 31, 1997. The Company continues to collect its receivables and recoverables generally in the ordinary course and has not incurred and does not expect to incur any significant liquidity difficulties as a result of the substantial growth in gross amounts due. The Company limits any liquidity exposure it may have by holding funds, letters of credit or other security such that net balances due to it are significantly less than the gross balances shown in the consolidated balance sheet.
As of December 31, 1998, each of the domestic insurance company subsidiaries' total adjusted capital is significantly in excess of the NAIC authorized control level risk-based capital.
Industry and regulatory guidelines suggest that a property and casualty insurer's annual statutory GWP should not exceed 900% of its statutory policyholders' surplus and NWP should not exceed 300% of its statutory policyholders' surplus. The Company's insurance company subsidiaries maintain a premium to surplus ratio significantly lower than such guidelines, and for the year ended December 31, 1998, their annual statutory GWP was 135.6% of their statutory policyholders' surplus and their NWP was 33.4% of their statutory policyholders' surplus.
The Company's operations, like those of other property and casualty insurers, are susceptible to the effects of inflation, as premiums are established before the ultimate amounts of loss and LAE are known. Although management considers the potential effects of inflation when setting premium rates, for competitive reasons, such premiums may not adequately compensate the Company for the effects of inflation. However, as the majority of the Company's business is comprised of lines which have short lead times between the occurrence of an insured event, reporting of the claims to the Company and the final settlement of the claims, the effects of inflation are minimized.
The Company adopted Statement of Financial Accounting Standards (SFAS") No. 130 entitled "Reporting Comprehensive Income" in 1998. This statement required that all components of comprehensive income be reported in a full set of financial statements and that the amount of total comprehensive income be reported. Other comprehensive income includes gains and losses that are excluded from net income, but are added to or deducted from net earnings in order to calculate comprehensive income. Unrealized investment gains and losses of investments and net unrealized gains and losses on foreign currency translation are examples of such items.
Company has utilized derivatives or hedging strategies only infrequently in the past and in immaterial amounts, although it may do so more frequently in the future as it expands its foreign operations. The Company is not a party to any derivatives or hedging activities at December 31, 1998. The effect of the Statement as well as the timing of its adoption are currently being reviewed by management.
In November, 1998, AcSEC issued SOP 98-7, "Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk." The SOP provides guidance as to the use of deposit accounting for insurance and reinsurance contracts that do not transfer insurance risk. This SOP is effective for financial statements for fiscal years beginning after June 15, 1999. The Company does not expect the adoption of this SOP to have a material effect on the Company's financial position, results of operations or shareholders' equity.
The Company is currently involved in discussion with important suppliers, business partners, customers and other third parties to determine the extent to which the Company may be vulnerable to the failure of these parties to identify and correct their own Year 2000 issues. Based upon information received from these third parties, management does not believe that the Company has any significant Year 2000 exposures related to its third party relationships.
The Company is utilizing and will continue to utilize both internal and external resources to evaluate and mitigate its Year 2000 exposures in advance of respective critical dates. Further, in the ongoing acquisition of technology and business equipment, the Company generally requires that its vendors certify the Year 2000 compliance of acquired products. The Company relies upon such certifications.
During the two years ended December 31, 1998, the Company expensed $546,000 with respect to Year 2000 compliance and capitalized $6 million with respect to new software purchases and installations which are Year 2000 compliant. The total estimated remaining cost of modification of existing software and new Year 2000 compliant systems is $1.5 million which includes $1.2 million attributable to the planned purchase and implementation of new systems. The cost of this new software is being capitalized. The remaining estimated cost of $230,000 will be expensed as incurred over the next twelve months. The Company does not track internal costs with respect to the expenses related to Year 2000 remediation. The level of expense anticipated in connection with the Year 2000 issues is not expected to have a material effect on the Company's results of operations. The costs of the Company's Year 2000 compliance efforts are expected to be funded out of operating cash flow, which is sufficient to provide funding. To date, no material information technology projects of the Company have been delayed as a result of the Company's Year 2000 compliance efforts.
On January 1, 1999, certain member countries of the European Union irrevocably fixed the conversion rates between their national currencies and a common currency, the "Euro", which became their common legal currency on that date. The participating countries' former national currencies will continue to serve as legal tender and denominations of the Euro between January 1, 1999 and January 1, 2002. The
conversion to the Euro is scheduled to be completed on July 1, 2002, when the national currencies will cease to exist. The Company does not expect the introduction of the Euro to have a material effect on the Company's business, software plans, financial condition or results of operations.