Our principal executive offices are located in Calabasas, California and are subject to a lease that expires in 2000. We have 46 other office leases across the United States. Lease expiration dates range from 1999 to 2005.
SELECTED FINANCIAL DATA (AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
- ------------------------------ (1) The information for the year ended December 31, 1997 includes the financial data of SPCC for the period beginning April 1, 1997.
(5) These ratios are for continuing operations. The claim and claim adjustment expense ratio is calculated by dividing the claim and claim adjustment expenses by net premiums earned. The expense ratio is calculated by dividing the sum of commissions (net of reinsurance ceding commissions), policyholder dividends, and general and administrative expenses by net premiums earned. The combined ratio is the sum of the claim and claim adjustment expense ratio and the expense ratio.
(6) Claim and claim adjustment expense ratio for 1998 is calculated by dividing the sum of the net claim and claim adjustment expenses and reinsurance recovery on loss reserve guarantee by net premiums earned.
The following discussion and analysis provides information that management believes to be relevant for an understanding of our consolidated results of operations and financial condition. The discussion should be read in conjunction with the consolidated financial statements and the notes thereto.
For the year ended December 31, 1998, we recorded a net loss of $13.6 million after preferred securities' dividends and accretion, discontinued operations, and extraordinary items, as compared to a net loss of $5.1 million for the year ended December 31, 1997. Net loss per share for the year ended December 31, 1998 was $2.01 (diluted) versus net loss per share of $0.74 (diluted) in 1997. During 1997, we recorded a $2.5 million extraordinary loss as the result of retirement of debt; no such charges were recorded in 1998. Further, during 1998, we recorded $7.4 million in dividend expense and accretion on preferred securities, as compared to $3.0 million in 1997.
During 1997, we completed three significant transactions. First, in April 1997 we acquired Pac Rim Holding Corporation, the parent of SPCC, for a purchase price of $42.0 million and completed the related senior bank debt financing of $44.0 million and private offering of our common stock for $18.0 million. Second, in June 1997 we terminated a financing transaction with a related party reinsurer, which transferred $110.5 million in receivables from the related party reinsurer in exchange for the cancellation of $94.9 million of long-term debt. Third, the issuance of $105.0 million in Trust Preferred Securities by one of our subsidiaries, was completed December 3, 1997. SNIG's income before preferred securities' dividends and accretion, discontinued operations and extraordinary items was $0.5 million in 1997, as compared to $3.6 million in 1996. This $3.1 million decrease was primarily the result of a $15.7 million loss on the termination of a financing transaction with a related party reinsurer. The $15.7 million charge was offset in part by a $4.9 million increase in investment income before taxes in 1997 and a $5.9 million pre-tax reduction in the accrual for policyholder dividends in 1996. The increase of $4.9 million in net investment income was primarily due to increases of $92.7 million and $93.1 million in assets available for investment that resulted, respectively, from the acquisition of SPCC and the November 1996 financing transaction with The Chase Manhattan Bank ("Chase"). See "--Liquidity and Capital Resources."
Net claim and claim adjustment expenses increased $152.9 million or 169.0% to $243.3 million for the year ended December 31, 1998 as compared to $90.4 million for the year ended December 31, 1997. The increase in claim and claim adjustment expense is due to $175.0 million in claim and claim adjustment expenses related to the Loss Reserves Guarantee and a $28.0 million loss associated with the Pac Rim book of business. These increases are partially offset by a $50.1 million decrease in claim and claim adjustment expenses primarily due to an increase in ceded claim and claim adjustment expense related to the Quota-Share Arrangement. The net claim and claim adjustment expense ratio increased to 279.4% for the year ended December 31, 1998, as compared to 64.2% for the year ended December 31, 1997. The increase in the claim and claim adjustment expense ratio is due to $175.0 million in claim and claim adjustment expenses related to the Loss Reserves Guarantee which has no associated premium. Excluding the $175.0 million in claim and claim adjustment expenses related to the Loss Reserves Guarantee, the claim and claim adjustment expense ratio was 78.5% for the year ended December 31, 1998. This 78.5% claim and claim adjustment expense ratio represents a 14.3 percentage point increase over the same period
in 1997. This increase is due to adverse development on net claim and claim adjustment expense liabilities of prior years.
Policyholder dividend expense was $1.2 million for the year ended December 31, 1998, as compared to no such expense in the same period in 1997. The $1.2 million increase in policyholder dividend expense was comprised of $1.0 million from BIG insurance subsidiaries and $0.2 million of accrual relating to policies written in Arizona in fiscal year 1998 for SNIC and SPCC.
We recorded an underwriting loss, excluding the loss on the termination of a financing transaction with a related party reinsurer, from continuing operations of $20.6 million for the year ended December 31, 1998, versus an underwriting profit of $12.8 million for the same period in 1997. The decrease in underwriting profit from continuing operations was primarily the result of losses associated with the Pac Rim book of business.
Net investment income, excluding realized investment gains, increased $1.8 million or 13.9% to $14.4 million for the year ended December 31, 1998 compared to the same period in 1997. The increase in investment income was due to an increase in assets available for investment of approximately $773.6 million that resulted from the purchase of BIG.
In June 1997, we recorded a $15.7 million charge related to the termination of a financing transaction with a related party reinsurer. The termination of the financing transaction transferred $110.5 million in receivables from the reinsurer in exchange for the cancellation of $94.9 million in indebtedness to a lender. No such charges were incurred during 1998.
YEAR ENDED DECEMBER 31, 1997 AS COMPARED TO YEAR ENDED DECEMBER 31, 1996
Gross premiums written for the years ended December 31, 1997 and 1996 were $159.4 million and $99.3 million, respectively. This increase in gross premiums written represents an increase of $60.1 million or 60.5% for the 1997 policy year as compared to the 1996 policy year. Substantially all of this increase can be attributed to business written related to SPCC. Net premiums written increased $49.2 million or 56.1% to $136.9 million for the year ended December 31, 1997, as compared to the year ended December 31, 1996. This increase reflects the increase in gross premiums written. Net premiums earned increased $52.3 million or 59.0% to $140.9 million for the year ended December 31, 1997, as compared to the year ended December 31, 1996.
Interest expense decreased 15.8% to $6.3 million for the year ended December 31, 1997, as compared to the year ended December 31, 1996. The decline in interest expense is due primarily to the elimination of funds withheld balance.
In June 1997, we recorded a $15.7 million charge related to the termination of a financing transaction with a related party reinsurer. The termination of the financing transaction transferred $110.5 million in receivables from a related party reinsurer in exchange for the cancellation of $94.9 million in indebtedness to Chase. No such charges were incurred in the 1996 period.
Liquidity is a measure of an entity's ability to secure sufficient cash to meet its contractual obligations and operating needs. Our cash inflows are generated from cash collected from policies sold, investment income generated from our existing portfolio, and sales and maturities of investments. Our cash outflows consist primarily of payments for policyholders' claims, operating expenses and debt service. For our insurance operations, we must have available cash and liquid assets to meet obligations to our policyholders and claimants in accordance with contractual obligations in addition to meeting ordinary operating costs. Absent adverse material changes in the workers' compensation insurance market, we believe our present cash resources will be sufficient to meet our needs for the foreseeable future.
During the year ended December 31, 1998, we used $149.8 million of cash in our operations versus $52.4 million cash used in the year ended December 31, 1997. This $97.4 million increase in cash used was due to $43.9 million in ceded premiums paid related to the Quota-Share Arrangement, an increase of $27.6 million in funds held by reinsured primarily related to the loss portfolio transfer from BICO, and an increase of $8.4 million of interest paid associated with the $105.0 million in Trust Preferred Securities. Another factor contributing to our continued negative cash flow is the impact of our premium inforce being significantly higher historically versus our current level and higher than expected payments of claim and claim adjustment expense in the 1995 and 1996 accident years. We anticipate that we will continue to experience the negative cash flow from operations until the claims related to the historically higher premium base have been paid out. In addition, the reduction in net written premium arising as a result of the Quota-Share Arrangement will increase negative cash flow substantially. In any event, we believe that we have adequate short-term investments and readily marketable investment grade securities to cover both claim payments and expenses. At December 31, 1998, we had total cash and cash equivalents, and investments of $867.4 million and had 99.8% of our investment portfolio invested in cash, cash equivalents, and fixed maturities. In addition, 92.7% of our fixed-income portfolio had ratings of "AA" or equivalent or better and 100% had ratings of "BBB" or equivalent or better.
The equity financing was obtained pursuant to (a) the sale of 1,902,233 shares of our common stock for $31.9 million, in connection with the exercise of subscription rights ("Rights") to purchase common stock distributed to existing stockholders (other than IP Delaware and IP Bermuda) and warrant holders (the "Rights Offering"), (b) the sale of 620,610 shares of common stock for $10.4 million, all paid in the form of promissory notes in favor of SNIG, in connection with the Rights Offering to holders of SNIG's stock options and restricted common stock (the "Employee Participation"), and (c) the private placement (the "IP Stock Issuance") pursuant to the Stock Purchase Agreement (as defined below) of (i) 5,276,960 shares of common stock for $88.4 million to IP II, (ii) 2,949,594 shares of common stock for $49.4 million to IP Delaware and (iii) 1,196,588 shares of common stock for $20.0 million to IP Bermuda. All of the shares were sold at $16.75 per share. Employees purchasing common stock in the Employee Participation included William L. Gentz and J. Chris Seaman, who are directors and executive officers of Superior National. Prior to the consummation of the acquisition of BIG, IP Delaware and IP Bermuda beneficially owned approximately 23% and 13%, respectively, of the then outstanding shares of common stock. IP II owned no shares of common stock prior to the consummation of the acquisition of BIG. Robert A. Spass, Steven B. Gruber and Bradley E. Cooper, directors of Superior National, own certain direct and indirect limited partnership interests some of the limited partnerships that are the direct or indirect general partners of IP Delaware and IP Bermuda. Messrs. Gruber and Spass are officers of the ultimate general partners of IP Delaware and IP Bermuda and Messrs. Spass and Cooper are officers of Capital Z Partners, Ltd. ("Cap Z"), the ultimate general partner of IP II. Certain members of SNIG's management are investors in an investment fund that is a limited partner of IP II.
We have a reverse purchase facility with a national securities brokerage firm that allows us to engage in up to $20.0 million in reverse purchase transactions secured by either U.S. Treasury instruments, U.S. Agency debt, or corporate debt. This arrangement provides us with additional short-term liquidity. Reverse purchase transactions may be rolled from one period to the next, at which time the transaction is repriced. This type of financing allows a great deal of flexibility to manage short-term investments, avoiding unnecessary realization of losses to satisfy short-term cash needs. Further, this method of financing is less expensive than bank debt. As of December 31, 1998, we had no obligation outstanding under this facility.
We are party to several leases principally associated with our home and branch office space, as well as our fixed assets. These leases contain provisions for scheduled lease charges and escalations in base rent over the lease term. Our minimum lease commitment with respect to these leases in 1999 is approximately $21.9 million. These leases expire from 2000 to 2003.
The effect of inflation on our revenues and net income during the years ended December 31, 1998, 1997, and 1996 was not significant.
As of December 31, 1998, Superior National had available $204.0 million in NOLs to offset taxable income recognized by us in periods after December 31, 1998. For federal income tax purposes, these NOLs will expire in material amounts beginning in the year 2006. Because our sale of our common stock to fund the acquisition of BIG caused us to undergo an "ownership change" under Section 382 of the Internal Revenue Code, we will be able to use only a maximum of approximately $8.0 million per year of our NOLs, together with additional amounts to offset "built-in gains." Built-in gains are unrealized gains related to appreciated property, including investments, that we own. Limitations imposed by Section 382 may cause the availability of our NOLs to be deferred, causing us to incur tax obligations when we otherwise would not, or may allow some portions of the NOLs to expire before we can use them to reduce our tax obligations. Our tax obligation affects our cash position and therefore affects our ability to make payments on our long-term debt as it becomes due.
Information technology is an integral part of our business. We also recognize the critical nature and technological challenges of the Year 2000 issue. The Year 2000 issue results from computer programs and computer hardware that utilize only two digits to identify a year in the date field, rather than four digits.
We believe that we have identified substantially all of our IT systems that require modification in order to become Year 2000 compliant. Most of our IT systems, which are developed in-house, have been modified for Year 2000 compliance. These systems include underwriting, policy administration, claims administration and data warehouse decision support systems, which are accessed through a Pentium processor-based personal computer network. See "Business--Information Services." Software purchased from vendors (for example, e-mail software, accounting software and other non-insurance applications) in most cases has been upgraded to be Year 2000 compliant. In certain instances we have received certifications of Year 2000 compliance from the developers of the software manufacturers used by us. We have begun testing these modified, upgraded and certified systems.
We have performed significant testing of our modified, in-house developed systems in order to confirm expected Year 2000 compliance. Significant testing of these systems will continue and will be completed by the end of the second quarter of 1999. In addition, we have contacted a large number of our business partners, including medical providers, third party administrators and financial business partners, to obtain information regarding the progress on their Year 2000 remediation. We have not been informed by any significant business partners that they will not be Year 2000 compliant in a timely manner. However, there can be no assurance that significant Year 2000 related issues will not ultimately arise with our business partners.
We are utilizing primarily internal resources to meet our Year 2000 goals. The cost of Year 2000 related efforts were approximately $250,000 for the year ended 1998. Remediation costs are expected to total about $250,000 during 1999. Due to the complexities of estimating the cost of modifying all IT and non-IT systems to become Year 2000 compliant, and the difficulties in assessing our vendors' and business partners' abilities to become Year 2000 compliant, estimates are likely to change.
We expect that by the end of 1999, all critical systems, in-house or vendor-obtained, that are not Year 2000 compliant will be corrected or replaced. However, there can be no assurance that all of our systems or those of our business partners will be Year 2000 compliant, that the costs to be Year 2000 compliant will not exceed our current expectations, or that the failure of our systems or those of our business partners to be Year 2000 compliant will not have a material and adverse effect on our business. See "Business--Risk Factors--Our operations could be adversely affected if we are not Year 2000 compliant or if we are required to pay claims on policies related to Year 2000 losses."
In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 133 is effective for fiscal years beginning after June 15, 1999 and establishes standards for the reporting for derivative instruments. It requires changes in the fair value of a derivative instrument and the changes in fair value of assets or liabilities hedged by that instrument to be included in income. To the extent that the hedge transaction is effective, income is equally offset by both investments. Currently the changes in fair value of derivative instruments and hedged items are reported in net unrealized gain (loss)