The Company's principal business activity is to underwrite surety bonds through its wholly owned subsidiary, the Surety Company. The Surety Company wrote its first bond in October 1992. In May 1994, the Surety Company received a Treasury Listing (the "T-Listing") to write federally required bonds anywhere in the United States and its territories. Prior to July 1994, the Surety Company was licensed it write bonds only in the Commonwealth of Pennsylvania. The following table sets forth information, chronologically, with respect to those states in which the Surety Company is presently licensed to write bonds:
State Date of Admission - - ----- ----------------- Pennsylvania September 11, 1992 Delaware July 13, 1994 Maryland October 7, 1994 New Jersey March 31, 1995 Virginia August 17, 1995 District of Columbia September 1, 1995 New York October 19, 1995 Ohio November 28, 1995 Kentucky April 26, 1996 Tennessee September 23, 1996 Indiana September 30, 1996 Connecticut December 1, 1996 Mississippi December 1, 1996 Illinois December 5, 1996 South Carolina February 3, 1997
For the year ended December 31, 1996, claims and claim adjustment expenses incurred were $519,708, or an incurred loss and loss adjustment expense ratio of 8.4%, compared to $369,639, or an incurred loss and loss adjustment expense ratio of 9.7%, for the year ended December 31, 1995. The increase in claim and claim adjustment expenses in 1996 reflects primarily the increase in the Company's business volume.
A limited number of claims have been filed on the Surety Company's bonds. Accordingly, the Surety Company has established case reserves of $634,156, gross of reinsurance, to provide for future claims and claim adjustment expense payments.
For the year ended December 31, 1996, commission expenses were $2,233,048, representing approximately 29% of gross written premiums, compared to $1,338,794, or approximately 29% of gross written premiums, for the year ended December 31, 1995. The increase in commission expenses in 1996 relates primarily to the increase in gross written premiums.
For the years ended December 31, 1996 and 1995, the Company incurred salary and benefits costs of $1,299,702 and $1,013,571, respectively. The increase in salary and benefit costs in 1996 reflects an increase in the number of employees, including additional underwriters and related support personnel, a controller, increased compensation and merit bonuses for these personnel, as well as additional compensation awarded to senior management by the Company's compensation committee.
For the years ended December 31, 1996 and 1995, the Company generated $421,810 and $389,991, respectively, of income from its investments, comprised exclusively of U.S. Government securities. The yield on average invested assets for 1996 and 1995 was 5.6% and 5.9%, respectively. The increase in interest income in 1996 was due to the investment of additional funds generated from the
Company's operations, offset by lower yields. On December 29, 1995, the Company sold all of its U.S. government securities having original maturities of less than one year, and reinvested the proceeds of $4,635,219 in a U.S. government security maturing in November 2000 with an effective yield to maturity of 5.44%.
Net income for the year ended December 31, 1996 was $1,135,370, as compared to $705,125 for the year ended December 31, 1995, an increase of $430,245, or 61%.
Because most of the Surety Company's premiums are generated on construction related bonds, and are associated with jobs primarily in Mid-Atlantic States, the Surety Company's business has been seasonal. Accordingly, operating results have varied from quarter to quarter, with premium levels lowest from November to March. Seasonality is expected to have less of an effect on premium activity as the Surety Company becomes licensed and generates business in states having more temperate climates.
Except for historical information provided in the Management's Discussion and Analysis, statements made throughout this document are forward-looking and contain information about financial results, economic conditions, trends and known uncertainties. The Company cautions the reader that actual results could differ materially from those expected by the Company, depending on the outcome of certain factors (some of which are described with the forward-looking statements) including: 1) adverse loss development for projects bonded by the Company in prior years; 2) heightened competition, particularly price competition, reducing margins; 3) significant changes in interest rates.
The Company had approximately $9,248,000 of investments and cash equivalents at December 31, 1996, and approximately $7,442,000 of investments and cash equivalents at December 31, 1995. The Company's anticipated expansion plans will require additional personnel and financial resources. While certain costs are expected to increase due to the changes in infrastructure as discussed above, management believes that the Company and the Surety Company have adequate liquidity to pay all claims and meet all other obligations for the next twelve months, at a minimum.
Consolidated Balance Sheets as of December 31, 1996 and 1995 13
Consolidated Statements of Operations for the years ended December 31, 1996 and 1995 14
Consolidated Statements of Cash Flows for the years ended December 31, 1996 and 1995 16
Claims and claims adjustment expenses 519,708 369,639 Commission expense 2,233,048 1,338,794 Salaries and benefits 1,299,702 1,013,571 Professional fees 144,128 131,715 Other operating expenses 705,188 451,054 --------- ---------
Underwriting income 1,307,391 491,857 Other income (expense) Interest income 421,810 389,991 Interest expense - (4,517) --------- ----------
Year ended December 31, ----------------------- 1996 1995 ------ ------ Operating activities: Net income $1,135,370 $705,125 Adjustments to reconcile net income to net cash Provided by (used in) operating activities: Depreciation and amortization 26,391 17,654 Change in: Premiums receivable (177,448) (26,953) Reinsurance receivable (89,874) (205,037) Subrogation recoverable (212,477) (257,641) Accrued investment income (23,523) 18,188 Unearned premiums 332,698 157,307 Unpaid claims and claim adjustmentexpenses 551,005 406,607 Prepaid reinsurance premiums 39,166 2,088 Reinsurance premium payable 353,834 - Accrued expenses and other liabilities 8,335 196,572 Deferred acquisition costs (122,760) (56,554) Deferred tax asset 81,374 (97,866) Federal income taxes payable (35,119) 65,667 Other, net 99,059 (35,867) -------- -------- Net cash provided by operating activities 1,966,031 889,290 --------- -------- Investing activities: Purchase of equipment (30,710) (43,200) Purchase of investments (3,952,428) (23,472,564) Maturities of investments 2,021,217 23,379,443 ---------- ------------
In October 1995, the Financial Accounting Standards Board issued Statement No. 123 "Accounting for Stock-Based Compensation" (SFAS No. 123). The statement defines a fair value based method of accounting for an employee stock option. Companies may, however, elect to adopt this new accounting rule through a pro forma disclosure option, while continuing to use the intrinsic value based method of accounting prescribed by APB Opinion No. 25, "Accounting for Stock Issued to Employees." Under the disclosure option, companies must make pro forma disclosures of net income and earnings per share, as if the fair value method of accounting below had been applied.
During the fourth quarter of 1995, the FASB issued a guide to implementation of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 required that debt and equity securities be classified into different categories and carried at fair value if they are not classified as held-to-maturity. The guide permitted a one-time opportunity to reclassify securities subject to SFAS No. 115. Consequently, Mountbatten reclassified all of its securities to available-for-sale as of
The Company accounts for its investments in fixed maturity securities in accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 requires that an enterprise classify debt and equity securities into either of these categories as applicable: held-to-maturity, available for sale or trading. SFAS No. 115 also requires that unrealized gains and losses for trading securities be included in earnings, while unrealized gains and losses for available-for-sale securities be excluded from earnings and reported as a separate component of shareholders' equity until realized. At December 31, 1996 and 1995, the Company's investments in fixed maturity securities were classified as available-for-sale.
Prior to the Company reclassifying its securities as available for sale at November 30, 1995, the Company classified its investment in debt securities as held-to-maturity. These securities were carried at amortized cost, which approximated market. Any premium or discount was amortized on a monthly basis as interest was earned.
Acquisition costs which vary with and are primarily related to the production of premiums, primarily commissions, premium taxes, and certain underwriting expenses, are deferred and amortized ratably over the terms of the related insurance contracts, to the extent such costs are deemed to be recoverable. Future underwriting and investment income are considered in determining the recoverability of such acquisition costs. Amortization expense related to deferred policy acquisition cost is included as an adjustment to commission expense, salaries and benefits, and other operating expenses.
The Surety Company requires bond applicants to enter into an indemnity agreement which obligates the insured to reimburse the Surety Company for any claims paid and costs incurred that are related to the bond. Subrogation recoverable represents amounts estimated to be recovered by the Surety Company from bonded principals for claim costs incurred by the Surety Company after a failure of a bonded principal to fulfill a bonded obligation. The Company records subrogation recoverable when a claim is incurred and it is probable that the costs will be recovered. Changes in estimates of subrogation recoverable are credited or charged to income in the period in which they are determined and are included in claims and claim adjustment expenses.
U.S. Treasury instruments with a fair market value of approximately $1,819,000 and $812,000 were held on deposit with various insurance departments as of December 31, 1996 and 1995, respectively.
Furniture and fixtures $41,733 $31,890 Office equipment (primarily computers) 58,212 43,814 Leasehold Improvements 14,900 8,431 ------- ------- 114,845 84,135 Less: accumulated depreciation/amortization (58,007) (31,616) -------- -------- $56,838 $52,519 ======= =======
The Company occupies its office space under operating leases that expire September 30, 1999, if not terminated by either party by delivering written notice 60 days prior to the expiration of the current term. Rent expense for 1996 and 1995 was $58,374 and $43,916, respectively.
As of December 31, 1996, the future minimum rental commitments payable under its operating lease are as follows:
Mountbatten, Inc. files a consolidated income tax return with its wholly-owned subsidiary, the Surety Company, and is a party to a tax sharing agreement with the Surety Company. The Company had a gross deferred tax asset at December 31, 1994, which was offset by a valuation allowance of $112,895. The valuation allowance reflected management's assessment that, based upon available information at that time, there was not sufficient positive evidence to determine that it was more likely than not that the
1996 1995 ---- ---- Deferred tax liabilities: Deferred acquisition costs ($133,772) ($92,034) Subrogation receivable discounting (30,958) (21,918) Other - (6,246) -------- --------- Gross deferred tax liabilities (164,730) (120,198) -------- --------- Deferred tax assets: Loss reserve discounting 30,828 17,466 Net unrealized value, fixed maturities 36,900 - Unearned premium reserve 64,879 42,256 Organizational and startup costs 62,606 108,113 Accrued salaries and benefits - 65,960 Other 1,740 - -------- -------- Gross deferred tax asset 196,953 233,795 -------- -------- Deferred tax asset, net $32,223 $113,597 ======== ========
1996 1995 ---- ---- Current federal tax expense $468,561 $277,068 Deferred federal tax expense 125,270 (104,862) -------- --------- Total federal income tax expense $593,831 $172,206 ======== ========
Tax expense at statutory rate (34%) $587,928 $298,293 Other, net 5,903 (13,192) Valuation allowance - (112,895) -------- --------- Total federal income tax expense $593,831 $172,206 ======== ========
The tax effect of temporary differences which resulted in the deferred tax (benefit) were as follows:
1996 1995 ---- ---- Deferred acquisition costs $ 41,738 $ 19,228 Accrued salaries and benefits 65,960 (65,960) Organizational and startup costs 45,508 45,508 Loss reserve discounting (13,362) (11,872) Subrogation receivable discounting 9,041 13,758 Unearned premium reserve (22,623) (13,502) Professional fees - 21,728 Other (992) (910) Valuation allowance - (112,895) --------- ---------- Deferred tax benefit $125,270 ($104,862) ======== ==========
Note 6 - Unpaid Claims and Claim Expense Reserves and Reinsurance Receivable:
The process by which reserves are established for insured events and related litigation requires reliance upon estimates based on the Surety Company's limited claims experience, supplemented with available industry data. The Surety Company's limited claims experience creates uncertainty with respect to the estimation of loss and loss adjustment expense reserves. As information develops which varies from expected experience, provides additional data or, in some cases, augments data which previously were not considered sufficient in determining reserves, adjustments to reserves may be required. Included in loss reserves at December 31, 1996 and 1995 are case reserves totaling $634,156 and $300,090, respectively, and IBNR reserves of $519,114 and $302,175, respectively.
Activity in the reserve for unpaid claims and claim adjustment expenses for the years ended December 31, 1996 and 1995 were as follows:
Gross Reserves - January 1 $ 602,265 $ 195,658 Less subrogation recoverable 393,999 136,358 Less reinsurance receivable 75,838 - ---------- --------- Net reserve- January 1 132,428 59,300 ---------- ---------
Note 6 - Unpaid Claims and Claim Expense Reserves and Reinsurance Receivable (continued)
The note payable of $170,000, due to a commercial bank, was repaid in April 1995.
Prior to November 1995, the reinsurance program required that the Company not write any bond exceeding $3,000,000 or bonds on the same work program in favor of the principal exceeding $4,500,000 in the aggregate. Under this program, the maximum bond duration could not exceed 24 months.
Subject to these restrictions, dividends may be paid as determined by the Board of Directors.
In February 1995, the Company granted incentive stock options to selected individuals to purchase 19,000 shares of common stock at an exercise price of $5.00 per share. These options vest over a four-year period and are exercisable for a ten-year period after the date of grant. In September 1995, 2,000 of these incentive stock options were canceled.
In February 1995, the Company granted non-qualified stock options to selected individuals to purchase 8,000 shares of common stock at an exercise price of $5.00 per share. These options vest immediately, and are exercisable for a ten-year period after the date of grant. In June 1995, 4,000 of these non-qualified stock options were canceled.
In April 1995, the Company granted non-qualified and incentive stock options to a selected individual to purchase 10,000 and 30,000 shares, respectively, of common stock at an exercise price of $5.25 per share. The non-qualified stock option vested immediately, and is exercisable for a ten-year period after the date of the grant. The incentive stock option vests over a five-year period, and is exercisable for a ten-year period after the date of the grant.
On November 3, 1995, the Company adopted the Equity Incentive Plan for Key Employees and the non-qualified Equity Incentive Plan for Outside Directors whereby key employees and outside directors may be granted options to purchase shares of the Company's common stock at a price not less than the fair market value of such shares, as determined by the Company's Board of Directors, at the date on which the options are granted. The options are exercisable during the period selected by the Board of Directors, but no earlier than six months after the date of grant and no later than ten years from the date of grant. A total of 250,000 and 50,000 shares of common stock were reserved for issuance under the Key Employees and Outside Directors Plans, respectively.
As of December 31, 1996, reserved shares for stock options granted under all plans totaled approximately 665,000.
In January 1996, the Company granted incentive stock options to selected individuals to purchase 63,750 and 20,000 shares of common stock at an exercise price of $5.25 and $5.78 per share, respectively. These options all vest over a five-year period, and are exercisable for a ten-year and five-year period, respectively, after the date of the grant. 250 and 500 of these incentive stock options were cancelled in September and December 1995, respectively.
In January 1996, the Company granted non-qualified stock options to selected individuals to purchase 35,000 shares of common stock at an exercise price of $5.25 per share. These options vest immediately, and are exercisable for a ten-year period after the date of grant.
In December 1996, the Company granted non-qualified stock options to selected individuals to purchase 64,000 shares of common stock at an exercise price of $8 per share. These options vest immediately, and are exercisable for a ten-year period after the date of grant.
The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-based Compensation." Accordingly, under SFAS No. 123, no compensation expense has been recognized for the stock option plans. Had compensation cost been determined based on the fair value at the grant date for awards in 1996 and 1995 consistent with the accounting provision of SFAS No. 123, where the fair value of the stock option grants are recognized on a straight line basis over the vesting period of the grant, the Company's net earnings and earnings per share would have been reduced to the pro forma amounts indicated below:
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for the respective year of grant: