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 $2.8 million. The Company's rental expense, net of sublease income, during 1997 and 1996 was approximately $643,000 and $613,000, respectively.
Commencing in 1996, the Company subleased approximately 13,000 square feet of the office space to Risk Capital Corp. for a term expiring in October 2002. Future minimum rental income under the remaining term of the sublease, exclusive of escalation clauses and maintenance costs, will be approximately $2.1 million. Rental income for 1997 and 1996 was $430,000 and $264,000, respectively. Risk Capital Corp. also reimbursed the Company approximately $574,000 in 1997 for Risk Capital Corp.'s pro rata share of improvement and maintenance costs under the sublease. In addition, commencing in 1997, the Company subleased approximately 6,000 square feet of the office space to another tenant for a term expiring in October 2002. Future minimum rental income under the remaining term of the sublease, exclusive of escalation clauses and maintenance costs, will be approximately $689,000. Rental income for 1997 was $117,000, of which $44,000 was paid to Risk Capital Corp. as its pro rata share of such income.
Set forth below is certain selected consolidated financial information for fiscal years 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.
Balance Sheet Data Total assets ................... $581,247 $432,486 $350,986 Total stockholders' equity ..... 401,031 352,213 340,215 Shares outstanding Basic ...................... 17,058,462 17,031,246 16,941,125 Diluted .................... 17,601,608 17,065,406 Book value per share Basic ...................... $23.51 $20.68 $20.08 Diluted .................... 22.79 20.64
RCHI is the holding company for Risk Capital Reinsurance, its wholly owned subsidiary which is domiciled in Nebraska. RCHI was incorporated in March 1995 and commenced operations during September 1995 upon completion of the Offerings. RCHI received aggregate net proceeds from the Offerings of approximately $335.0 million, of which $328.0 million was contributed to the capital of Risk Capital Reinsurance. On November 6, 1995, Risk Capital Reinsurance was licensed under the insurance laws of the State of Nebraska. As of December 31, 1997, the statutory surplus of Risk Capital Reinsurance was approximately $385 million.
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 related directly 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. Perceived surplus capacity has led to pressure on pricing and other terms, which pressure is expected to continue in 1998. 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, 1998 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 as well as its expansion into the marine and aerospace lines of business commencing late in 1997.
Consistent with the Company's strategy of writing a small number of large treaties for its core business, five clients contributed approximately $68 million, or 45%, of the Company's 1997 net premiums written, with the largest client contributing approximately 18% and the remaining four clients each contributing an amount ranging from 5% to 8%. One client that contributed 8% of 1997 net premiums written is expected to retain most of the business it previously ceded to the Company. 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.
The Company's 1997 statutory composite ratio, while essentially unchanged from the 1996 ratio, contains a higher aggregate claims and claims expenses and commissions and brokerage ratio component 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 continues to leverage its infrastructure with increased premium writings. There was no significant favorable or unfavorable claims development from 1996.
Other operating expenses increased to $14.2 million in 1997, compared to $11.3 million for the year ended December 31, 1996 and $3.9 million for the period June 23, 1995 (date of inception) to December 31, 1995. Assuming the successful execution of the Company's business strategy, the Company expects other operating expenses to grow commensurate with maturing operations, but expects other operating expenses to
decline moderately as a percentage of net premiums written because increases in premium writings are generally expected to exceed the growth in such expenses.
The Company monitors its earthquake and wind exposures and continuously reevaluates its estimated probable maximum pre-tax loss for such exposures through the use of modeling techniques. The Company generally seeks to limit its probable maximum pre-tax loss to no more than 10% of its statutory surplus for severe catastrophic events that could be expected to occur once in every 100 years. This limitation includes combined exposure to underwriting losses, reinstatement costs for retrocessional arrangements which may be in force at the time of the losses resulting from the catastrophic event, and losses that the Company may be 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 Risk Capital Corp.
At December 31, 1997, approximately 45% of the Company's invested assets consisted of fixed maturity and short-term investments, compared to 63% at December 31, 1996. Net investment income was approximately $14.4 million in 1997, compared to $13.2 million in 1996 and $4.6 million for the period June 23, 1995 (date of inception) to December 31, 1995. The amount of investment income from quarter to quarter may vary and could diminish as the Company continues to employ its strategy of investing a substantial portion of its investment portfolio in publicly traded and privately held equity securities, which generally yield less current investment income than fixed maturity investments.
Years Ended December 31, June 23, 1995 -------------------------- (date of inception) to 1997 1996 December 31, 1995 ------------ ------------- ---------------------- Investment yields: Pre-tax............ 3.7% 3.8% 4.8% Net of tax......... 2.7% 2.8% 3.5%
Assuming a stable interest rate environment, the Company anticipates such yields to slightly decline as funds invested in short-term securities continue to be allocated into investments in equity securities, which yield less current income than fixed maturity investments. Additionally, such investment yields exclude the Company's equity in the net income or loss of private equity investments accounted for under the equity method.
The Company's 1997 income tax benefit and effective tax rates of 7% for the year ended December 31, 1996 and 7% for the period June 23, 1995 (date of inception) to December 31, 1995 are less than the 35% statutory rate on pre-tax operating income due to tax exempt income and the dividends received deductions. The 1997, 1996 and 1995 gross deferred income tax benefits of approximately $2.1 million, $1.8 million and $0.2 million, respectively, which are assets considered recoverable from future taxable income, result from temporary differences between financial and taxable income.
As the Company's investment strategy is to invest a significant portion of its investment portfolio in equity securities, its investment income in any fiscal period may be smaller, as a percentage of investments, and less predictable than that of other insurance and/or reinsurance companies, and net realized and unrealized gains (losses) on investments may have a greater effect on the Company's results of operations or stockholders' equity at the end of any fiscal period than other insurance and/or reinsurance companies. Because the realization of gains and losses on equity investments is not generally predictable, such gains and losses may differ significantly from period to period. Variability and declines in the Company's results of operations could be further exacerbated by private equity investments in start-up companies, which are accounted for under the equity method. Such start-up companies may be expected initially to generate operating losses.
Investments that are or will be included in the Company's private portfolio include securities issued by privately held companies and by publicly traded companies that are generally restricted as to resale or are otherwise illiquid and do not have readily ascertainable market values. The risk of investing in such securities is generally greater than the risk of investing in securities of widely held, publicly traded 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, 1997, cash and invested assets totaled approximately $505.7 million, consisting of $98.2 million of cash and short-term investments, $132.2 million of publicly traded fixed maturity investments, $180.1 million of publicly traded equity securities and $95.3 million of privately held securities. Included in privately held securities are investments totaling $53.8 million which are accounted for under the equity method.
RCHI and Risk Capital Reinsurance 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 makes tax sharing payments to RCHI based on such allocation.
Effective in the 1998 first quarter, the Company will adopt the provisions of FASB Statement No. 130 "Reporting Comprehensive Income." This statement establishes standards for reporting and displaying comprehensive income and its components in a full set of general purpose financial statements. Comprehensive income for the Company consists of net income and changes in unrealized appreciation or depreciation, net of tax. Reclassification of financial statements of earlier periods for comparative purposes is required. (See Note 13 of the accompanying Notes to the Consolidated Financial Statements of the Company.)
The Company is evaluating the applicability of FASB Statement No. 131 "Disclosure About Segments of an Enterprise and Related Information" to its Consolidated Financial Statements, which statement will be effective in the first quarter of 1998. This statement establishes standards for the way that public business enterprises report information about operating segments in annual and interim financial reports to stockholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. (See Note 13 of the accompanying Notes to the Consolidated Financial Statements of the Company.)
The Company elected in 1996 to continue to account for its stock-based compensation under Accounting Principles Board Opinion ("APB") No. 25 "Accounting for Stock Issued to Employees" and related interpretations under APB No. 25. The Company does not recognize any compensation expense for its grants of employee stock options because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant. In addition, under APB No. 25, the Company does not recognize compensation expense for stock issued to employees under its stock purchase plan. The alternative to APB No. 25 is FASB No. 123 "Accounting for Stock-Based Compensation," which requires fair value accounting for stock-based compensation.
The Company is presently assessing its information systems to ensure that they are capable of processing information for the year 2000 and beyond. Based on information currently available, the cost of this internal effort, while not quantified, is not expected to have a material adverse effect on the Company's results of operations. However, due to the interdependent nature of computer systems, the Company may be adversely impacted depending upon whether other entities not affiliated with the Company (e.g., vendors and business partners) address this issue successfully. Where practicable, the Company intends to assess and attempt to mitigate its risks in the event that these entities fail to be year 2000 compliant. The effect, if any, on the Company's results of operations from the possible failure of these entities to be year 2000 compliant is not determinable.
From time to time various regulatory and legislative changes have been proposed in the insurance and reinsurance industry, some of which could have an effect on reinsurers. Among the proposals that have in the past been, or are at present being considered, are (i) the possible introduction of federal regulation in addition to, or in lieu of, the current system of state regulation of insurers and (ii) proposals in various state legislatures (some of which proposals have been enacted) to conform portions of their insurance laws and regulations to various model acts adopted by the NAIC. The Company is unable to predict whether any of these laws and regulations will be adopted, the form in which any such laws and regulations would be adopted, or the effect, if any, these developments would have on the operations and financial condition of the Company. See "Business--Insurance Regulation."