The Company owns several properties in Rock Hill, New York, consisting of a three-story office building in which its executive offices and the insurance operations of Frontier are located and three one-story buildings used for the corporate day care center, a facilities and maintenance building and a building used for off site storage. The Company also owns a two-story office building in Monticello, New York, a motel in Rock Hill and a hanger at a local airport. In addition, the Company has a five unit single story office complex in Charlotte, North Carolina, from which Regency conducts its operations.
(1) In May and September 1996, the Company acquired United Capitol Holding and Regency, respectively.
(4) The presentation of realized capital gains--net of tax per share and operating income (loss) per share is not an alternative to GAAP as an indicator of the Company's performance.
The following table sets forth the Company's net premiums earned by reportable segment for the three years indicated and the dollar amount and percentage of change therein from year to year:
The $78 million or 15.8% increase in net premiums earned during 1999 compared to 1998 was primarily attributable to continued growth in certain core and new programs within the Surety, Specialty Programs and Environmental, Excess and Surplus Lines Divisions. The growth in these divisions was offset by planned decreases in unprofitable programs within the Health Care and Personal and Credit Related Divisions and, to a lesser extent, a decline in business in the Alternative Risk Division due to a discontinued earthquake program and competitive conditions in the excess workers' compensation market.
Net premiums earned for the Surety Division continued to grow in all programs due to geographic expansion and the acquisition of several bond agencies with a 31% increase from approximately $74 million in 1998 to $96 million in 1999. Growth in net premiums earned occurred primarily in the contract and license and permit bond programs, which programs showed increases of approximately $9 million and $5 million, respectively.
The decrease in net premiums earned for the Personal and Credit-Related Division was primarily due to the discontinuance of certain nonstandard auto and collateral protection programs. This decrease amounting to approximately $32 million was partially offset by increases of $7 million for an extended warranty program and $8 million for a mobile homeowner program written through one managing general agent.
Net investment income before realized capital gains and losses increased 5.6% in 1999. The primary reason for the increase was a capital infusion of $60 million on December 31, 1998. This increase was partially offset by increased interest costs related to Zurich N.A., reinsurance agreements.
Since the second quarter of 1998, the Company increased its personnel count by approximately 260 employees, including several members of senior management and the formation of several underwriting units, resulting in increased salary expenses of approximately in 1999 $16 million.
The Company periodically evaluates the recoverability of its intangible assets. During 1999, the Company determined that the undiscounted cash flows related to Western and Regency were not sufficient to support the related goodwill. Accordingly, goodwill for Western and Regency of approximately $13.6 million and $1.5 million, respectively, was charged to operations during 1999.
Underwriting and other expenses include a provision for doubtful accounts during 1999 of approximately $3.8 million. In connection with the reorganization of the administrative structure of its premiums receivable area, the Company changed certain procedures utilized in the analysis of doubtful accounts and increased its aggressiveness in the collection and adjustment of delinquent premium balances. While the changes have resulted in improved cash flow for traditionally delinquent accounts, it also resulted in accelerating the identification, assessment and provision for outstanding balances deemed uncollectible.
During 1999, the Company established a valuation allowance related to its deferred tax asset of approximately $123.6 million. For additional disclosure regarding income taxes, see Note G of the Notes to the Consolidated Financial Statements).
The increase in net premiums earned for the Specialty Programs Division was due to growth in many small programs. Our focus on a variety of small commercial auto related programs introduced in late 1998 generated approximately $2 million of earned premium during the year and the Company's investment in the Ward Agency resulted in an additional $2 million of earned premiums in 1998. Geographic expansion of the title agents program resulted in an additional $5 million in net premiums earned in 1998 over 1997. The remaining increase of approximately $3 million in earned premium is attributable to growth in a number of smaller programs such as a summer camp program and an artisan contractors program, none of which were individually significant.
Amortization of policy acquisition costs as a percentage of net premiums earned increased from 20.6% in 1997 to 23.1% in 1998. This increase was due primarily to the acquisition of Acceleration, which for the 1998 year
incurred approximately $9.1 million of policy acquisition costs. Also contributing to this increase was increased premium volume in the Surety Division where commission rates paid to agents tend to be higher.
The Company limits the extent of its credit risk by purchasing securities backed by stable collateral with enhanced priority in the securitization structure. The credit risk is minimized as the majority of the Company's mortgage-backed portfolio is guaranteed by U.S. government-sponsored entities or are supported in the securitization structure by junior securities resulting in bonds with high investment grade ratings. The portfolio is actively managed to minimize the Company's exposure to prepayment and extension risk. As of December 31, 1999, the Company's asset and mortgage-backed holdings were rated Aa1 and Aaa, respectively, by Moody's.
appreciation. The investments generally contain lock-up provisions which require the Company to hold the investments for a specified time horizon, thus limiting their liquidity.
The Company treats the partnership interests as available for sale and limits recognition of income and capital gains to that which is realized by the individual partnerships. At December 31, 1999, the partnership investments had an unrealized gain of $10.8 million. In addition, the Company had unfunded commitments to limited partnerships of $6.2 million to be funded over the next four years. All partnership investments are consistently reviewed and monitored by internal investment personnel.
The Company is a holding company that historically has funded its cash requirements through sales of its common stock and borrowings. The Company's insurance subsidiaries have not historically been a source of liquidity for the Company and are subject to dividend restrictions as described in Note Q of the Notes to the Consolidated Financial Statements. Currently, the only insurance subsidiary that can pay dividends to the Company without the prior approval of the insurance commissioner of its domicile is Regency. The maximum dividend that Regency can pay without such prior approval is approximately $0.3 million.
Under the revised terms of the credit facility, the Company is subject to certain financial and nonfinancial covenants, some of which restrict its ability to dispose of assets, incur additional indebtedness and require the maintenance of a minimum level of consolidated shareholders' equity. At December 31, 1999, the Company violated certain covenants which were waived by the banks. In addition, due to its significantly weakened financial condition and the expected negative impact on operations resulting from recent rating downgrades, the Company expects to violate certain revised covenants during 2000. The Company has received a waiver of these expected violations through April 30, 2000 and is currently negotiating revised covenants with the banks. Should the Company be unable to obtain waivers of such covenants and be in violation thereof, the banks could elect to accelerate repayment of the amounts outstanding under the credit facility and exercise their rights with respect to the stock and ownership interests pledged as collateral.
The net proceeds of $144.5 million from a common stock offering in 1997, and $166.7 million from the sale of convertible trust originated preferred securities during 1996, provided the principal funding for the strategic acquisitions completed during 1998 and 1999 (see Note C of the Notes to the Consolidated Financial Statements).
Due to the Company's current financial condition it is likely that traditional sources of financing such as the issuance of debt or equity securities may not be available. The Company is currently pursuing the sale of Regency, Western and its Surety Division operations, which, if completed, would provide sufficient funding for its liquidity and capital needs. However, the successful consummation of such sales cannot be assured. Additionally, any significant transactions involving the disposition of insurance subsidiaries or their assets would require the approval of insurance regulators and the Company's creditors.
Ratings assigned by nationally recognized agencies are major factors in the Company's ability to market the products of its insurance subsidiaries to its agents and customers since rating information is broadly disseminated and generally used throughout the industry.
All of the Company's insurance subsidiaries are currently rated B ("Fair") by A.M. Best Company, Inc. ("A.M. Best"), which has advised the Company that the Company's failure to sell additional assets to provide holding company liquidity and/or bolster the capital of Frontier, or a continuation of poor operating performance, may result in further downward ratings adjustments.
In its ongoing effort to improve solvency regulation, the NAIC and individual states have enacted certain laws and financial statement changes. The NAIC has adopted Risk-Based Capital ("RBC") requirements for insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks, such as asset quality, mortality and morbidity, asset and liability matching, benefit and loss reserve adequacy, and other business factors. The RBC formula is used by state insurance regulators as an early warning tool to identify, for the purpose of initiating regulatory action, insurance companies that potentially are inadequately capitalized. In addition, the formula defines minimum capital standards that supplement the current system of low fixed minimum capital and surplus requirements on a state-by-state basis. Regulatory compliance is determined by a ratio of the enterprise's regulatory Total Adjusted Capital, to its Authorized Control Level RBC, as defined by the NAIC. Companies below specific trigger points or ratios are classified
within certain levels, each of which may require specific corrective action depending upon the insurer's state of domicile. The levels and ratios are as follows:
At December 31, 1999, all of the Company's insurance subsidiaries, with the exception of Frontier, met the RBC requirements. Frontier, the Company's largest insurance subsidiary, is domiciled in New York State. The Department utilizes its own methodology for computing capital adequacy and does not follow the NAIC RBC guidelines. However, many of the other states in which Frontier writes business have adopted the NAIC RBC guidelines. In accordance with the NAIC RBC guidelines, at December 31, 1999, Frontier was at the Authorized Control Level. The Authorized Control Level authorizes the commissioner of a state insurance department to take whatever regulatory actions it considers necessary to protect the best interest of the policyholders and creditors of an insurer, which could include placing Frontier under regulatory control (i.e., rehabilitation or liquidation). In addition, failure to meet capital requirements and other requirements which may be imposed by the insurance departments, or further unfavorable operating results in future periods, could expose Frontier to regulatory sanctions that may include restrictions on operations and growth and/or mandatory asset dispositions.
The Company has submitted a Corrective Action Plan to the superintendent of the Department and to many of the other state insurance departments in states for which Frontier writes business. It is uncertain what actions, if any, the insurance departments will take with respect to Frontier. While the Company expects to maintain or improve the current RBC ratio level of its insurance subsidiaries, it cannot predict all events that could cause this ratio to decrease to the point of increased oversight by the Department or by other departments of the states in which the Company's subsidiaries are domiciled.
In addition, state insurance statutes typically place restrictions on the maximum amount of dividends or other distributions that may be made by insurance companies to their shareholders without obtaining prior regulatory approval. Such restrictions are typically related to the insurance companies' statutory capital and surplus. (See Note Q of the Notes to the Consolidated Financial Statements.)
In 1998, the NAIC adopted codified SAP ("Codification"). Codification will change, to some extent, prescribed SAP and may result in changes to the accounting practices that the Company's insurance subsidiaries use to prepare their statutory-basis financial statements. Codification requires adoption by the various states before it becomes the prescribed statutory basis of accounting for insurance companies domesticated within those states. Accordingly, before Codification becomes effective for the Company's insurance subsidiaries, their respective states of domicile must adopt Codification as the prescribed basis of accounting for domestic insurers to report their statutory-basis results to the insurance department. As of December 31, 1999, all of the states of domicile for the Company's insurance subsidiaries had adopted or indicated their intent to adopt Codification, in whole or in part, with an effective date of January 1, 2001. Management has not yet determined the impact of Codification on the statutory surplus of the Company's insurance subsidiaries.
Effective January 1, 1995, the Company entered into a stop loss reinsurance agreement with Zurich Reinsurance (North America), Inc. ("Zurich N.A."), formerly Centre Reinsurance Company of New York for accident years 1995 through 1997. Under the agreement, Zurich N.A. provided reinsurance protection within certain accident year and contract aggregate dollar limits for losses and LAE in excess of a predetermined ratio of these expenses to net premiums earned for a given accident year for all subject business. The loss and LAE ratio above which the reinsurance provides coverage was 66%, 65%, and 64% for accident years 1995 through 1997, respectively. The maximum amount recoverable for an accident year is 175% of the reinsurance premium paid for the accident year, or $162.5 million in the aggregate for the three years. As of December 31, 1998, the Company had exceeded the aggregate limits of the contract. (See Note I of the Notes to the Consolidated Financial Statements.)
The Company, through its subsidiary United Capitol, in the ordinary course of business, writes insurance on accounts which have hazardous, unique or unusual risk characteristics. Since United Capitol's organization in 1986, its liability policies have included an absolute pollution coverage exclusion, except for policies specifically designed and underwritten to cover environmental exposures. In addition, United Capitol's product liability and other primary general liability policies contain exclusions for coverage of claims for bodily injury
The Company believes the suit is without merit, has retained special legal counsel to contest this suit vigorously and believes that the Company's exposure to liability, if any, thereunder would not have a material adverse effect on the Company's financial condition or results of operations.