In March 1996, the Company entered into a sublease agreement initially expiring in October 2002 for approximately 40,000 square feet of office space in Greenwich, Connecticut, at which the Company's offices are located. Future minimum rental charges for the remaining term of the sublease, exclusive of escalation clauses and maintenance costs and net of rental income, will be approximately $2,198,000. The Company's rental expense, net of sublease income, during 1998, 1997 and 1996 was approximately $576,000, $643,000 and $613,000, respectively.
Set forth below is certain selected consolidated financial information for fiscal years 1998, 1997 and 1996, and the period from June 23, 1995 (date of inception) to December 31, 1995. This information should be read in conjunction with the accompanying Consolidated Financial Statements of the Company and the Notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations.
Demand for reinsurance is influenced significantly by underwriting results of primary property and casualty insurers and prevailing general economic and market conditions, all of which affect liability retention decisions of primary insurers and reinsurance premium rates. The supply of reinsurance is directly related to prevailing prices and levels of surplus capacity, which, in turn, may fluctuate in response to changes in rates of return on investments being realized in the reinsurance industry. The 1998 year was a difficult period from both a market and earnings perspective for most insurance markets. The property and casualty insurance and reinsurance segments have experienced an increasingly more difficult and highly competitive operating environment characterized by a soft rate structure and overcapitalization. Other factors that have contributed to the prevailing competitive conditions in the reinsurance industry in recent years include new entrants to the reinsurance market (including certain specialized reinsurance operations) and the presence of certain reinsurance companies which operate within tax-advantaged jurisdictions (e.g., Bermuda, Cayman Islands) that benefit from higher after-tax investment returns. In addition, concerns with respect to the financial security of Lloyd's that had adversely impacted the competitive position of that marketplace have apparently been overcome by actions taken at Lloyd's over the last few years, thereby enhancing its competitive position.
The industry's profitability can also be affected significantly by volatile and unpredictable developments, including changes in the propensity of courts to grant larger awards, natural disasters (such as catastrophic hurricanes, windstorms, earthquakes, floods and fires), fluctuations in interest rates and other changes in the investment environment that affect market prices of investments and the income and returns on investments, and inflationary pressures that may tend to affect the size of losses experienced by ceding primary insurers. The reinsurance industry is highly competitive and dynamic, and market changes may affect, among other things, demand for the Company's products, changes in investment opportunities (and the performance thereof), changes in the products offered by the Company or changes in the Company's business strategy. (See "Cautionary Note Regarding Forward-Looking Statements.")
Reinsurance treaties that are placed by intermediaries are typically for one year terms with a substantial number that are written or renewed on January 1 each year. Other significant renewal dates include April 1, July 1 and October 1. The January 1, 1999 renewal period was marked by continuing intensified competitive conditions in terms of premium rates and treaty terms and conditions in both the property and casualty segments of the marketplace. These conditions have been worsened due to large domestic primary companies retaining more of their business and ceding less premiums to reinsurers. While the Company is initially somewhat disadvantaged compared to many of its competitors, which are larger, have greater resources and longer operating histories than the Company, it believes it has been able to generate attractive opportunities in the marketplace due to its substantial unencumbered capital base, experienced management team, relationship with its equity investment advisor and strategic focus on generating a small number of large reinsurance treaty transactions that may also be integrated with an equity investment in client companies. Commencing in late 1997, in addition to its core business, the Company expanded into specialty
classes of reinsurance business, including marine and aviation and space in 1997, surety and fidelity in 1998, and accident and health in 1999.
At January 1, 1999, the Company had approximately 421 renewable reinsurance treaties that are in- force, with approximately $287.5 million of estimated annualized net premiums written, compared to $172.5 million at January 1, 1998, representing an increase of 67%. Such in-force premiums at January 1, 1999 represent estimated annualized premiums from treaties entered into during 1998 and the January 1, 1999 renewal period that are expected to generate net premiums written during 1999. Such renewable treaties at January 1, 1999 are estimated to generate approximately $225 million of net premiums written over the 12-month period ending December 31, 1999 without taking into account certain factors, including the possibility that (i) several treaties entered into in 1998 that are scheduled to expire during the remainder of 1999 may be renewed and (ii) additional treaties may be bound during 1999.
(In millions) Years Ended December 31, ----------------------------------------- 1998 1997 1996 ------- ------- ------- Assumed premiums written $ 260.5 $ 147.8 $ 73.7 Ceded premiums written 25.8 3.0 1.2 ======= ======= ======= Net premiums written $ 234.7 $ 144.8 $ 72.5 ======= ======= =======
In 1998, the Company's net premiums written increased by 62% from $144.8 million in 1997 to $234.7 million in 1998. The Company's premium growth resulted from continued efforts in the Company's two key strategies, the integration of investment with reinsurance and the diversification into specialty classes of reinsurance.
Approximately 32%, 29% and 5% of net premiums written in 1998, 1997 and 1996, respectively, were generated from companies in which the Company has invested or committed to invest funds. Approximately 32%, 28% and 30% of net premiums written in 1998, 1997 and 1996, respectively, were from non-United States clients, which are Lloyd's syndicates or are located in the United Kingdom, Bermuda and Continental Europe.
While not anticipated, the reduction or loss of business assumed from one or more large clients could have a material adverse effect on the Company's results of operations to the extent not offset by new business.
One traditional means of measuring the underwriting performance of a property/casualty insurer, such as the Company, is the statutory composite ratio. This ratio, which is based upon statutory accounting principles (which differ from generally accepted accounting principles in several respects), reflects underwriting experience, but does not reflect income from investments. A statutory composite ratio under 100% indicates underwriting profitability, while a composite ratio exceeding 100% indicates an underwriting loss.
The Company increased its loss reserves at December 31, 1998 relating to the reinsurance provided by the Company on business produced by the managing underwriting agency based upon reported loss activity and the results of an underwriting audit performed by the Company. The underwriting relationship has been discontinued. All deferred acquisition costs, which approximated $1 million, related to the unearned premium reserve at December 31, 1998 have been written off by the Company.
For a discussion of subsequent losses due to claims and claims expenses related to reinsurance provided by the Company on satellite risks and business produced by the managing underwriting agency, see "--Results of Operations--Subsequent Underwriting Losses" below and Note 14 of the accompanying Notes to the Consolidated Financial Statements of the Company.
The Company's 1997 statutory composite ratio, while essentially unchanged from the 1996 ratio, contained a higher aggregate claims and claims expenses and commissions and brokerage ratio components in 1997, which reflects a business mix with a higher casualty content. Such increase was offset by a lower other operating expenses ratio as the Company continued to leverage its infrastructure with increased premium writings.
In pricing its reinsurance treaties, the Company focuses on many factors, including exposure to claims and commissions and brokerage expenses. Commissions and brokerage expenses are acquisition costs that generally vary by the type of treaty and line of business, and are considered by the Company's underwriting and actuarial staff in evaluating the adequacy of premium writings. In a number of reinsurance treaties, provisional commissions are initially paid and subsequently increased or decreased, subject to a minimum and maximum amount, depending upon the claims and claims expenses experience of the assumed business. The Company records the commission increase or decrease in accordance with contractual terms based on the expected ultimate experience of the contract.
Based on a review of additional claims information and its continuing underwriting and actuarial analysis of the business produced by the managing underwriting agency, the Company expects to record additional after-tax underwriting losses of approximately $18 million in the first quarter of 1999 from claims, claims expenses, commissions and brokerage, net of earned premium, relating to reinsurance on business produced by the managing underwriting agency.
Total estimated ultimate premiums for all business produced on behalf of the Company by the managing underwriting agency, including policies that have expired and policies that will expire in 1999 and 2000, are approximately $26 million, of which $17 million and $13 million, respectively, were recorded as net premiums written and net premiums earned through December 31, 1998. Substantially all of the remaining $9 million and $13 million, respectively, of net premiums written and net premiums earned will be recorded in the first quarter of 1999. The Company has discontinued its underwriting relationship with the managing underwriting agency.
exposed to as a result of its privately held investments in insurance and insurance-related entities. While the Company believes its risk management techniques are adequate, there can be no assurances that the Company will not suffer pre-tax losses greater than 10% of its statutory surplus from a catastrophic event due to the inherent uncertainties in estimating the frequency and severity of such exposures. In addition, the Company believes that it cannot reasonably estimate its exposure to unrealized investment losses (if any) that may result from the Company's investments in publicly traded securities of insurance and insurance-related entities.
With respect to integrated transactions (where the Company combines an equity or equity-like investment in a client company with the purchase by such client of reinsurance from the Company), the Company generally limits its combined underwriting and investment exposure to pre-tax losses on any individual client to no more than 10% of its total statutory surplus, and subjects these commitments to scrutiny by the combined professional staffs of both the Company and MMCI.
During 1998, the Company maintained catastrophe reinsurance protection for its marine and aviation business. For 1999, the Company has reinsurance protection for marine business of $37 million in excess of a $3 million initial retention, and additional co-participations, with the Company retaining a total of approximately $8 million. For 1999, the Company is finalizing reinsurance protection for aviation business in an amount of $65 million in excess of a $1 million initial retention, and additional co-participations, with the Company retaining a total of approximately $5.4 million. Catastrophic reinsurance protection has not been purchased for the Company's earthquake and wind exposures.
A principal component of the Company's investment strategy is investing a significant portion of invested assets in publicly traded and privately held equity securities, primarily issued by insurance and reinsurance companies and companies providing services to the insurance industry. Cash and fixed maturity investments and, if necessary, the sale of marketable equity securities will be used to support shorter-term liquidity requirements.
companies. Lack of a secondary market and resale restrictions may result in an inability by the Company to sell a security at a price that would otherwise be obtainable if such restrictions did not exist and may substantially delay the sale of a security the Company seeks to sell.
At December 31, 1998, approximately 89% of the Company's fixed maturity and short-term investments were rated investment grade by Moody's or Standard & Poor's and had an average quality rating of AA and an average duration of approximately 2.8 years.
At December 31, 1998, the Company is obligated under letters of credit in the aggregate amount of approximately $33.3 million, which secure certain reinsurance obligations and investment commitments in amounts of approximately $24.1 million and $9.2 million, respectively. Securities with a carrying value of approximately $38.3 million have been pledged as collateral for these letters of credit.
The financial instruments included in the following sensitivity analysis consist of all of the Company's cash and invested assets, excluding investments carried under the equity method of accounting.
The Company is exposed to equity price risks on the public and private equity securities included in its investment portfolio. All of the Company's publicly traded equity securities and privately held securities were issued by insurance and reinsurance companies or companies providing services to the insurance industry. The Company typically does not attempt to reduce or eliminate its market exposure on these securities. Investments included in the Company's private portfolio include securities issued by privately held companies and securities issued by public companies that are generally restricted as to resale or are otherwise illiquid and do not have readily ascertainable market values. Investments in privately held securities issued by privately and publicly held companies may include both equity securities and securities convertible into, or exercisable for, equity securities (some of which may have fixed maturities).
The Company's publicly traded and privately held equity securities at December 31, 1998, which are carried at a fair value of $154.7 million and $83.5 million, respectively (including unrealized gains of $44.1 million and $27.1 million), have exposure to price risk. The estimated potential losses in fair value for the Company's publicly traded and privately held equity portfolios resulting from a hypothetical 10% decrease in quoted market prices, dealer quotes or fair value are $15.5 million and $8.4 million, respectively.
The aggregate hypothetical loss generated from an immediate adverse shift in the treasury yield curve of 100 basis points would result in a decrease in total return of 4.4%, which would produce a decrease in market value of $7.7 million on the Company's fixed maturity investment portfolio valued at $174.5 million at December 31, 1998. There would be no material impact on the Company's short-term investments.
RCHI, Risk Capital Reinsurance and Cross River file consolidated federal income tax returns and have entered into a tax sharing agreement (the "Tax Sharing Agreement"), allocating the consolidated income tax liability on a separate return basis. Pursuant to the Tax Sharing Agreement, Risk Capital Reinsurance and Cross River make tax sharing payments to RCHI based on such allocation.
At December 31, 1998, the Company's consolidated stockholders' equity totaled $398 million, or $23.29 per share based on issued and outstanding shares, and $22.75 per share on a diluted basis which includes outstanding dilutive warrants and options. At such date, statutory surplus of Risk Capital Reinsurance was approximately $359 million. Based on data available as of December 31, 1998 from the RAA, Risk Capital Reinsurance is the 12th largest domestic broker market oriented reinsurer as measured by statutory surplus.
Many existing computer programs use only two digits to identify a year in the date field. These programs were designed and developed without considering the impact of the upcoming change in the century. If not corrected, many computer applications could fail or create erroneous results by or at the year 2000. The year 2000 issue affects virtually all companies and organizations.
The Company has not established a contingency plan for noncompliance of its internal systems and operating facilities as the Company does not currently expect any material year 2000 compliance problems with respect to such internal systems and facilities. At this time, the Company is not aware of any material business partners or vendors that will not be year 2000 compliant. If the Company becomes aware of non- compliant business partners or vendors, one option will be to evaluate replacing the non-compliant business partners and vendors. The Company intends to continue to assess and attempt to mitigate its risks in the event these third parities fail to be year 2000 compliant, and will consider appropriate contingency arrangements for such potential noncompliance by such entities. In certain instances, the establishment of a contingency plan is not possible or is cost prohibitive. In these situations, noncompliance by the Company's material business partners or vendors could have a material adverse impact on the Company's financial position and results of operations.
This statement is effective for fiscal years beginning after June 15, 1999, with initial application as of the beginning of the first quarter of the applicable fiscal year.
The Company's portfolio includes market sensitive instruments, such as convertible securities and mortgage-backed securities, which are subject to prepayment risk and changes in market value in connection with changes in interest rates. The Company's investments in mortgage-backed securities are classified as available for sale and are not held for trading purposes. Assuming the current investment strategy at the time of adoption, the Company's presentation of financial information under the new statement will not be materially different than the current presentation.
In April 1998, the Accounting Standards Executive Committee ("AcSEC") issued Statement of Position ("SOP") 98-5 "Reporting on the Costs of Start-Up Activities." This statement requires costs of start-up activities, including organization costs, to be expensed as incurred. Unless another conceptual basis exists under other generally accepted accounting literature to capitalize the cost of an activity, costs of start-up activities cannot be capitalized.
SOP 98-5 is effective for fiscal years beginning after December 15, 1998. The Company will adopt the new statement in the first quarter of 1999 as a cumulative effect of a change in accounting principle in accordance with the provisions of Accounting Principles Board Opinion No. 20.
The Company and its investee companies currently defer and amortize organization and start-up costs over a three to five year period. This change in accounting principle will result in the write-off of previously capitalized start up costs. At December 31, 1998, the Company's unamortized capitalized start-up costs, including its proportionate share of such costs deferred by investee companies, was approximately $0.7 million.
In March 1998, the NAIC adopted the codification of statutory accounting principles project that will generally be applied to all insurance and reinsurance company financial statements filed with insurance regulatory authorities as early as the statutory filings made in 2001. Although the codification is not expected to materially effect many existing statutory accounting practices presently followed by most insurers and reinsurers such as the Company, there are several accounting practices that may be changed. The most significant change would involve accounting for deferred income taxes, which change would require a deferred tax liability to be recorded for unrealized appreciation of invested assets, net of available deferred tax assets, that would result in a reduction to statutory surplus. If such requirement had been in effect in 1998, the statutory surplus of the Company at December 31, 1998 would have been reduced by approximately $6 million, from $359 million to $353 million, due to a net deferred tax liability.