- -------- (1) See Note 2K of Notes to Consolidated Financial Statements for an explanation of the method used to determine the number of shares used to compute per share amounts. (2) Operating income--under generally accepted accounting principles ("GAAP") Operating income, which excludes realized capital (losses) gains--net of tax, is not separately presented. It is presented here as supplemental information. This should not be considered a better measure than net income calculated in accordance with GAAP. (3) Net of tax. (4) See Note 6 of Notes to Consolidated Financial Statements.
Fee income increased 26% to $80.7 million in 1996 and 18% in 1995 to $64.1 million from $54.2 million in 1994. The growth of Fee income has been primarily due to the growth in the number of Legion Insurance Company and Legion Indemnity Company (together "Legion" or the "Legion Companies") accounts, which totaled 284 at the end of 1996 as compared to 235 in 1995 and 193 in 1994, since most Legion accounts also produce IPC Program fees, Commonwealth Risk Services, Inc. ("CRS") fees and Specialty Brokerage fees. The growth in the number of Legion accounts in each period resulted from the addition of new clients and the retention of a relatively high percentage of existing clients as detailed in Table III. There were 108 new Legion accounts sold in 1996 compared to 80 new accounts sold in 1995 and 66 new accounts sold in 1994. Legion's renewal rate amounted to 75% in 1996 as compared to 80% in 1995 and 84% in 1994. The decline in Legion's renewal rate was caused by the increasing competition from traditional insurance companies in the workers' compensation market.
Pre-tax Profit margins declined slightly each year from 45% in 1994 to 43% in 1995 and to 40% in 1996. These decreases reflect the lower profit margin nature of two companies acquired in 1996, Professional Underwriters Corp. ("PUC") and The Hemisphere Group Limited ("Hemisphere"), decreasing premium rates, along with increases in Operating expenses. Excluding the results of these two acquisitions the Profit margins were 46% in 1994, 45% in 1995 and 43% in 1996.
The components of Fee income by business segment are illustrated in Table IV.
Historically, workers' compensation has been the major line of business written by the Company. Competition for workers' compensation business increased in 1995 and 1996 as a result of generally improved reported workers' compensation results and reform legislation. This was especially true in California. Increased competition reduces the incentive for insureds to enter "Alternative Market" programs such as those offered by the Company. Generally in states other than California which have enacted significant workers' compensation reform, the Company has been able to increase its business. In 1996 the Company added 8 new accounts in
The Company has established provisions for losses as a result of these exposures for certain clients. These provisions, which totaled $4.5 million at December 31, 1996, $4.0 million in 1995 and $3.8 million in 1994, reduced the level of Fee income in each of these years by $.5 million, $.2 million and $1.1 million respectively. The increase in the number of accounts, the increase in the clients' aggregate retentions since 1991, in addition to competitive factors which have limited the amount of collateral that clients are willing to provide, have significantly increased the Company's exposure to such losses.
Premiums earned increased 17% to $56.4 million in 1996 from $48.2 million in 1995 which was in turn a 29% decrease from $68.2 million in 1994. The increase in earned premiums in 1996 and decrease in 1995 is directly related to the volume of large deductible policies issued by the Company. The use of large deductible policies increased when they were introduced by the Company in California for the first time during 1995 but their use decreased in 1996. In connection with large deductible policies the Company writes substantially less premium than on other policies. Increases or decreases in Premiums earned have been offset by similar movements in Total insurance costs. Premiums earned represent the net premiums retained by the Company on which it bears underwriting risk. The Company believes that both the volatility of underwriting profit or loss and the probability of experiencing a severe underwriting loss are less than would ordinarily be expected for a traditional property / casualty insurer, due to the nature of the business written by the Company and the structure of its reinsurance. In the past, the level of Premiums earned has been relatively closely matched by the level of Total insurance costs , resulting in small amounts of underwriting loss as a percentage of Premiums earned. The fact that Premiums earned are generally matched by Total insurance costs means that even a significant fluctuation in Premiums earned will have a relatively insignificant impact on the Company's Net income.
Included in Premiums earned are assigned risk premiums of $7.8 million in 1996 as compared to $11.9 million in 1995 and $15.2 million in 1994. The underwriting losses associated with these assigned risk premiums, together with other charges imposed by certain states on voluntary insurers such as Legion to support involuntary market losses ("residual market loads"), are passed on by Legion to client's accounts.
The Company's principal exposure to underwriting loss exists in relation to the premium associated with the Company's retention of a portion of the specific and aggregate excess risk on each client's account. It is on this retained excess risk that the Company may experience the most significant volatility in underwriting results. The portion of the Company's Premiums earned which relate to this risk was $3.3 million in 1996 as compared to $3.9 million in 1995 and $4.9 million in 1994, representing 6%, 8% and 7% of Premiums earned in 1996, 1995 and 1994. The Company incurred an underwriting loss of $.2 million in 1996, $1.0 million in 1995 and $.7 million in 1994 as a result of the retained risk on its treaties and increases in acquisition expenses. The Company takes 100% of the risk within the first $1.25 million layer of the aggregate excess exposure on its main treaty up to a deductible amount equal to 1.5% of the Company's gross premiums (as defined) and 10% of the risk over a loss ratio of 120%, in the event that the loss ratio for the first layer exceeds 120% the Company takes no share of the risk in the layer $3.75 million excess of $1.25 million per account. The maximum retention for specific excess losses is 10% of $.75 million excess of $.25 million per occurrence. On other treaties the Company has decreased its exposure for excess losses.
The Company's Specialty Brokerage business segment provides access to Alternative Risk Transfer insurers and reinsurers in Bermuda and Europe. Specialty Brokerage accounted for 7% of total Fee income in both 1996 and 1995 and 4% in 1994. Specialty Brokerage fees grew by 29% in 1996 and 103% in 1995 to $5.6 million and $4.4 million from $2.1 million in 1994. Renewal rates remained high in this segment at 86% for 1996, 87% for 1995 and 89% for 1994. Profit margins decreased to 37% for 1996 from 40% in 1995 up from 28% in 1994. The decrease in 1996 was primarily as a result of the Company's acquisition of substantially all of the minority interest in one of these businesses. This acquisition lowered the business's profit margin by replacing a charge for minority interest which is not part of the profit margin calculation with a bonus expense which is.
Operating expenses increased 33% to $48.7 million in 1996 from $36.5 million in 1995, which was a 22% increase over the 1994 level of $30.0 million. The primary factors responsible for these increases in Operating expenses were: (a) the increased cost of administering the Legion Companies as highly regulated insurers, as the volume of policies issued increased; (b) increased personnel costs in all areas, caused by an increase in the number of full time employees from 261 in 1994 to 316 in 1995 and 433 in 1996, resulting from the growth of the Company's businesses as well as the impact of the Company's growth in revenues and profits on employee bonus plans; and (c) the acquisitions of HJF International Ltd. in 1995 and PUC in 1996.
Fully diluted earnings per Common Share increased by 17% to $1.91 in 1996 from $1.63 in 1995 which was in turn a 17% increase from the 1994 amount of $1.39.
At December 31, 1996 the market value of the Company's Total marketable investments was $452.4 million, as compared to $431.6 million at December 31, 1995. In accordance with SFAS 115, Investments available for sale are reported at fair market value with unrealized gains and losses included as a separate component of Shareholders' equity. These Investments generally consist of investment grade fixed-income securities which the Company believes are readily marketable and could be liquidated to meet cash requirements, if necessary. Cash flow from operations has historically provided the Company its principal source of liquidity. The Company has continued to produce a positive cash flow with $61.5 million of cash provided from operations during 1996, as compared to $33.5 million in 1995 and $40.1 million in 1994. The increase in operating cash flow in 1996 was due to the decreased use of large deductible policies together with an increase in Program Business, reductions in the amount of taxes paid and increases in funds withheld under certain reinsurance agreements. This positive cash flow was offset by payments made in respect of claims deposit liabilities of $26.1 million in 1996. The Company believes that it will continue to maintain a positive cash flow from operations in the foreseeable future and will be able to meet its liquidity requirements. Excess cash flow from operations has principally been used in each year to increase the Company's investment portfolio. In October 1995 the Company completed a private placement of Zero Coupon Convertible Exchangeable Subordinated Debentures due 2015 with a principal amount at maturity of $324.3 million. The net proceeds from the offering were $112.0 million after expenses. The Debentures carry a yield of 5.25% per annum and are convertible into 10.760 Common Shares of the Company per $1,000 principal amount at maturity or an aggregate of 3,489,400 Common Shares.
The NAIC has adopted a risk-based capital ("RBC") formula to be applied to all property/casualty insurance companies. The formula measures capital and surplus needs based on an insurance company's products and investment portfolio and is to be used as a tool to identify weakly capitalized companies. An insurance company that does not meet the threshold RBC measurement standards could be required to reduce the scope of its operations and ultimately could become subject to statutory receivership proceedings. At December 31, 1996 the Legion Companies met the RBC requirements with a combined required risk-based capital of $32.0 million and an actual adjusted capital of $142.3 million.
Shareholders' equity increased 26% to $208.0 million at December 31, 1996 from $165.5 million at December 31, 1995. This increase was attributable primarily to Net income in 1996, less dividends paid, plus the value of shares issued on the exercise of employee stock options and corporate acquisitions, less the movement in unrealized gains and losses on Investments. The unrealized gain on Investments was $.1 million at December 31, 1996, net of tax compared to $1.2 million a year earlier. This $1.1 million change was a result of the changes in the market for fixed income securities. During 1996 the total number of Common Shares outstanding increased to 19,031,853 from the 1995 level of 18,273,722, as a result of the exercise of employee stock options and the Common Shares issued in connection with corporate acquisitions.
Total assets increased to $1.6 billion at December 31, 1996, a 19% increase from $1.4 billion at December 31, 1995. $576.7 million, or 35.2% of Total assets, in 1996 and $525.2 million, or 38.1%, in 1995 related to Assets held in separate accounts. As detailed in Note 2A to the Consolidated Financial Statements, such assets are principally managed assets attributable to participants in the Company's IPC Programs.