The following table presents selected historical consolidated financial information derived from the historical consolidated financial statements of the Company as of and for each of the years in the five-year period ended December 31, 1997. This information should be read in conjunction with the historical consolidated financial statements of the Company and the related notes thereto and
The Company principally engages, through the Insurance Subsidiaries, in the reinsurance of financial guaranties of municipal and asset backed debt obligations issued by monoline financial guaranty insurers. In addition, the Company is engaged in other insurance, reinsurance and non-insurance businesses that utilize the Company's expertise in performing sophisticated analyses of complex, credit-based risks. The Company's other insurance businesses involve the issuance of direct financial guaranties of smaller municipal debt obligations, trade credit reinsurance, financial resposibility bonds and excess-SIPC/excess-ICS and related type bonds. These other insurance businesses are conducted by Van-Am, a Kentucky domiciled insurer, and ERE-Bermuda, a Bermuda domiciled insurer. The Company, through its consolidated subsidiary, Singer and a partially owned affiliate, C-BASS, is also engaged in the origination, purchase, servicing and/or securitization of special assets, including lottery awards, structured settlement payments and sub-performing/non-performing residential mortgages.
The Company's revenues consist primarily of (a) premiums earned on insurance and reinsurance contracts, (b) investment income and (c) the sale of securitized lottery awards and structured settlement payments.
Assignment sales for 1997 were $29.2 million. This revenue results from Singer's operations being consolidated with the Company's, commencing March 21, 1997.
Incurred losses and loss adjustment expenses ("LAE") were $9.8 million in 1997 compared with $9.2 million in 1996. Of these amounts, $8.1 million and $7.3 million were incurred in connection with the Company's credit and surety businesses in 1997 and 1996, respectively. The Company believes that the reserves for losses and LAE, including case and non-specific reserves, are adequate to cover the ultimate net cost of claims. However, the reserves are necessarily based on estimates, and there can be no assurance that the ultimate liability will not exceed or be less than such estimates.
The Company's insurance operating expense ratio for 1997 was 50.3% compared to 49.2% in 1996. Policy acquisition costs, which vary with and are directly related to the generation of new and renewal premiums, totaled $30.0 million and $26.7 million in 1997 and 1996, respectively, representing 35.1% and 34.5% of premiums earned in those respective periods. Other operating expenses increased to $12.2 million in 1997 from $10.5 million in 1996.
Net income for 1997 increased 23.5% to $68.6 million from $55.7 million in 1996. On a per share basis, basic earnings per share increased 18.9% to $3.71 in 1997 from $3.12 in 1996, while diluted earnings per share increased 17.1% to $3.56 in 1997 from $3.04 in 1996. Basic operating earnings per share
The weighted average shares outstanding for 1997 was 18.53 million compared to 17.88 million for 1996.
Net premiums earned grew 23.0% to $77.4 million in 1996 from $62.9 million in 1995. This growth in premiums earned was in large part attributable to increased earnings from the Company's other insurance lines as discussed in the preceding paragraph.
Monoline reinsurance premiums earned increased 21.8% due, in part, to refundings which contributed $9.9 million (12.8%) of premiums earned in 1996 compared to $5.7 million (9.0%) in 1995. A refunding eliminates the Company's reinsurance exposure to the refunded obligation and as a result, the Company recognizes in current earnings the remaining related deferred premium revenue. Excluding the impact of refundings, monoline reinsurance premiums earned increased 18.0% over the prior year. The growth in premiums earned also reflects the amortization of the deferred premium revenue balance which grew to $266.2 million at year-end 1996 from $248.1 million at year-end 1995.
Net investment income increased 7.5% to $47.5 million in 1996 from $44.2 million for 1995 consistent with the growth in invested assets in the period. The average yields on the Company's investment portfolio, after deducting associated costs, were 6.4% for 1996 and 1995. In addition, the Company realized $4.0 million and $3.5 million of net capital gains in 1996 and 1995, respectively. Net investment income is presented after deduction of both external investment management fees and internal costs associated with managing the investment portfolio.
The Company's effective tax rate was 27.1% for 1996 compared to 25.9% in 1995. The higher 1996 rate reflected the continuing reduction in the percentage of pre-tax income represented by income from tax-exempt assets. This impact has been reduced in part by the Company's strategy of directing a greater proportion of its new cash flow to the purchase of tax-exempt securities in 1996.
Enhance Financial is party to the Credit Agreement with major commercial banks providing for borrowing by Enhance Financial of up to $75.0 million to be used for general corporate purposes. The Credit Agreement provides for a revolving credit facility under which individual advances may be converted, at Enhance Financial's discretion, into a four-year term loan. The total outstanding under the Credit Agreement at year-end 1997 was $43.5 million.
The Company believes that the operating liquidity needs of the Insurance Subsidiaries can be funded exclusively from their respective operating cash flows. The Company's cash flow from operations consists principally of insurance and reinsurance premiums collected, income earned on invested assets and sales of assignments, which in turn is applied to the payment of claims, operating expenses and income taxes. The Company's cash flow from operations was $73.5 million, $59.8 million and $66.3 million for the years 1997, 1996 and 1995, respectively. The Company paid a total of $5.0 million, $11.9 million and $7.3 million in claims in 1997, 1996 and 1995, respectively. Of the claim payments made in 1997, $4.3 million related to reserves established in prior years.
In July 1996, the Company formed C-BASS, a joint venture in which the Company and MGIC each own 48% interests. The Company contributed $15.8 million in cash in 1996, $6.8 million in cash in 1997 and is expected to contribute an additional $2.4 million (including its 100% interest in LLSI) in 1998. In addition, in January 1998 the Company guarantied repayment of up to $25 million of the amount outstanding under a $50 million LIBOR-based unsecured revolving credit facility that C-BASS obtained from a major commercial bank. The outstanding principal under the facility currently is due not later than January 29, 1999. As of March 27, 1998, the Company had guaranteed $25 million under this facility. The Company believes there are now more attractive financing alternatives available to C-BASS, which are being pursued actively.
Enhance Financial makes available to Singer a $17 million LIBOR-based secured revolving credit facility and a LIBOR-based working capital credit line for its use in originating assets for securitization. At December 31, 1997, $11.2 million and $5.8 million were outstanding under the secured credit facility and the working capital credit line, respectively. Since all intercompany amounts are eliminated in consolidation, these amounts are included in the borrowings outstanding under the Credit Agreement.
In December 1996, the board of directors terminated the then existing stock repurchase program and authorized the repurchase of up to 750,000 shares of Enhance Financial's common stock from that date. In 1997, Enhance Financial purchased 177,925 shares of its common stock for an aggregate consideration of $7.0 million
Based on the historical cash flow of the Company, the Company's current financial results and the Company's expectation as to the level of the Company's net premiums written during 1998, the Company believes that cash flow provided by operating activities of the Insurance Subsidiaries during 1998 will provide sufficient liquidity for the operations of the Company, as well as funds to Enhance Financial so that Enhance Financial will be able to meet its debt service and other obligations. The ability of Enhance Financial to meet its debt service and other obligations after 1998 will depend upon the cash flow generated by its operating activities and the availability to Enhance Financial of sufficient amounts of funds from those operating activities in the form of dividends or other payments. The Company's cash flow to Enhance Financial after 1998 may be influenced by a variety of factors, including market changes, insurance regulatory changes and changes in general economic conditions. Consequently, although the Company currently anticipates that it will be able to meet all debt service and other obligations over the long term, no assurance can be given that the available net cash provided by the Company's operating activities will provide sufficient liquidity for Enhance Financial to meet all its long-term liquidity needs.
The Company has no other material commitments for capital or other expenditures during 1998 or thereafter.
Consolidated Balance Sheets as of December 31, 1997 and 1996 31
Consolidated Statements of Cash Flows for the Years Ended December 31, 1997, 1996 and 1995 34
We have audited the accompanying consolidated balance sheets of Enhance Financial Services Group Inc. and Subsidiaries (the "Company") as of December 31, 1997 and 1996 and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 1997 and 1996 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles.
Enhance Financial Services Group Inc. ("Enhance Financial", and together with its consolidated subsidiaries, the "Company") is a holding company which was incorporated in the State of New York in December 1985 and commenced operations in November 1986. The Company principally engages, through its wholly-owned, New York-domiciled insurance subsidiaries Enhance Reinsurance Company ("Enhance Re") and Asset Guaranty Insurance Company ("Asset Guaranty") (together, the "Insurance Subsidiaries") in the reinsurance of financial guaranties of municipal and asset backed debt obligations issued by monoline financial guaranty insurers. In addition, the Company is engaged in other insurance, reinsurance and non-insurance businesses that utilize the Company's expertise in performing sophisticated analyses of complex, credit-based risks.
The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles ("GAAP") which, for the Insurance Subsidiaries, differ in certain material respects from the accounting practices prescribed or permitted by regulatory authorities (see Note 3). The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. The significant accounting policies of Enhance Financial and its subsidiaries are as follows:
The accompanying financial statements include the accounts of Enhance Financial, the Insurance Subsidiaries, Singer, Van-Am and EnRe Bermuda (collectively the "Company"). All significant intercompany accounts and transactions have been eliminated. Investments in immaterial wholly owned subsidiaries and in investments in which the Company owns from 20% to 50% of those companies are accounted for in accordance with the equity method of accounting (see Note 5).
Common stocks are carried at fair value. Short-term investments are carried at cost, which approximates market. Unrealized gains and losses, net of taxes, on common stocks are reflected in shareholders' equity. Realized gains or losses on sales of investments are determined on the basis of specific identification.
The Company uses derivative financial instruments for hedging purposes as part of its overall risk management strategy. Gains and losses on the derivative financial instruments that qualify as accounting hedges are deferred until the underlying hedged asset is sold, at which time the gain or loss on the related hedge is recognized in income.
The following summarizes the effect of reinsurance on premiums written and earned:
In the event that any or all of the reinsurers were unable to meet their obligations, the Insurance Subsidiaries would be liable for such defaulted amounts.
Deferred policy acquisition costs comprise those expenses that vary with and are primarily related to the production of insurance premiums, including: commissions paid on reinsurance assumed, salaries and related costs of underwriting and marketing personnel, rating agency fees, premium taxes and certain other underwriting expenses, offset by ceding commission income on premiums ceded to reinsurers. Acquisition costs are deferred and amortized over the period in which the related premiums are earned. Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed or be less than recoverable amounts.
Reserves for losses and LAE are established based on the Company's best estimate of specific and non-specific losses, including expenses associated with settlement of such losses, on its insured and reinsured obligations. The Company records a provision for losses and related LAE when reported by primary insurers or when, in the Company's opinion, an insured risk is in default or a default is probable and the amount of the loss is reasonably estimable. In the case of obligations with fixed periodic payments, the provision for losses and LAE represents the present value of the Company's ultimate expected losses, adjusted for estimated recoveries under salvage or subrogation rights. The estimates for losses and LAE are periodically evaluated by the Company, and changes in estimates are reflected in income currently. The Company believes that the reserves are adequate to cover the ultimate cost of all claims net of reinsurance recoveries. However, the reserves are necessarily based on estimates, and there can be no assurance that the ultimate liability will not exceed such estimates.
The Internal Revenue Code permits municipal bond insurance companies to deduct from taxable income, subject to certain limitations, the amounts added to the statutory mandatory contingency reserve during the year. The deduction taken is allowed only to the extent that U.S. Treasury non-interest-bearing tax and loss bonds are purchased at their par value prior to the original due date of the Company's consolidated Federal tax return and held in an amount equal to the tax benefit attributable to such deductions. The amounts deducted must be included in taxable income when the contingency reserve is released, at which time the Company may redeem the tax and loss bonds to satisfy the additional tax liability. The purchases of tax and loss bonds are recorded as payments of federal income taxes and are not reflected in the Company's current tax provision.
Certain of the prior years' amounts have been reclassified to conform to the current year presentation.
The consolidated financial statements are prepared on the basis of generally accepted accounting principles ("GAAP") which, for the Insurance Subsidiaries, differ in certain material respects from accounting practices prescribed or permitted by insurance regulatory authorities. The significant differences result from statutory accounting practices which treat premiums earned, policy acquisition costs, deferred income taxes, investments in fixed maturities and loss reserves differently.
Under the New York Insurance Law, the Insurance Subsidiaries may declare or distribute dividends only out of earned surplus. The maximum amount of dividends which may be paid by the Insurance Subsidiaries to Enhance Financial without prior approval of the Superintendent of Insurance is subject to restrictions relating to statutory surplus and net investment income as defined by statute. Enhance Re and Asset Guaranty declared and paid a total of $22.0 million and $2.0 million, respectively, in dividends to Enhance Financial for the year ended December 31, 1997. At December 31, 1997, the Insurance Subsidiaries had an additional $14.4 million available for dividend distribution.
The New York Insurance Law establishes single risk limits applicable to all obligations issued by a single entity and backed by a single revenue source. Under the limit applicable to municipal bonds, the insured average annual debt service for a single risk, net of reinsurance and collateral, may not exceed 10% of the sum of the insurer's policyholders' surplus and contingency reserves. In addition, insured principal of municipal bonds attributable to any single risk, net of reinsurance and collateral, is limited to 75% of the insurer's policyholders' surplus and contingency reserves. Additional single risk limits, which generally are more restrictive than the municipal bond single risk limit, are also specified for several other categories of insured obligations.
The following is a summary of the Company's investments in fixed maturities at December 31, 1997 and 1996:
Gross Gross In thousands Amortized Unrealized Unrealized Fair 1977 Cost Gains Losses Value --------- --------- ---------- -------- HELD TO MATURITY
Private placements $ 105,125 $ - $ - $105,125 Municipal obligations 96,959 8,877 105,836 Corporate securities 5,832 324 6,156 U.S. Government obligations 2,520 126 2,646 --------- -------- -------- -------- Total held to maturity $ 210,436 $ 9,327 $ $219,763 ========= ======== ======== ========
Fixed maturities $50,258 $46,102 $42,188 Short-term investments and cash equivalents 1,872 3,184 4,131 Other 572 188 261 ------- ------- ------- Total investment income 52,702 49,474 46,580 Less investment expenses 2,084 2,012 2,421 ------- ------- ------- Net investment income $50,618 $47,462 $44,159 ======= ======= =======
Under agreements with its primaries and in accordance with statutory requirements, the Insurance Subsidiaries maintain funds (fixed maturities and cash equivalents) in trust accounts principally for the benefit of reinsured companies and for the protection of policyholders in states in which the Insurance Subsidiaries are not licensed. The Company maintains full control over the management of assets held in trust accounts. The carrying amount of such restricted balances amounted to approximately $286 million and $212 million at December 31, 1997 and December 31, 1996, respectively.
In 1997, as part of the recapitalization of Van-Am, the Company contributed $2.0 million to Van-Am. The Company owns a controlling equity interest in the outstanding stock of Van Am and accounts for its investment on a consolidated basis.
In 1996, the Company and MGIC Investment Corporation formed a joint venture C-BASS, which evaluates, purchases, services and securitizes sub-performing and non-performing residential mortgages. At December 31, 1997, the Company had contributed $22.6 million of its required initial capital contribution of $24 million to the C-BASS joint venture. The Company owns a 48% interest in C-BASS, which is being accounted for on the equity basis of accounting. As part of its commitment to capitalize C-BASS, the Company will contribute the entire interest in LLSI to the joint venture. Since Enhance Financial's current 100% ownership interest in LLSI is temporary, the Company has also accounted for this investment on the equity basis of accounting.
Current income taxes $10,311 $ 9,992 $ 5,447 Deferred income taxes 14,839 10,694 11,096 ------- ------- ------- Tax provision $25,150 $20,686 $16,543 ======= ======= =======
In thousands DECEMBER 31, 1997 DECEMBER 31, 1996 ------------------- --------------------- ASSETS LIABILITIES ASSETS LIABILITIES ------ ---------- ------ -----------
Debentures, due 2003 $ 75,000 $ 75,000 Short term credit facility 43,500 42,500 --------- --------- Total $ 118,500 $ 117,500 ========= =========
Enhance Financial has pledged shares of Enhance Re common stock representing 46.8% of such class outstanding to secure equally and ratably the indebtedness outstanding under the Credit Agreement and that outstanding under the indenture dated as of March 5, 1993 (the "Indenture") governing the debenture. The pledge of shares to secure the latter indebtedness was required under the terms of the Indenture as a result of the increase in outstanding borrowings under the Credit Agreement to a level exceeding $30 million. Additionally, the Credit Agreement prohibits the Company from incurring additional indebtedness to the extent the resulting total would exceed 25% of the Company's total capitalization as defined and includes certain convenants, none of which significantly restricts the Company's operating activities or dividend-paying ability.
In December 1996, the board of directors terminated the then existing repurchase program and authorized the repurchase of up to 750,000 shares of its common stock from that date. Enhance Financial purchased 177,925, 1,600 and 404,800 shares of its common stock at an average price of $39.46, $23.82 and $16.63 per share in 1997, 1996, and 1995, respectively.
In 1997, Enhance Financial entered into a forward purchase agreement regarding 128,197 shares of its common stock at a forward purchase price of $42.50 per share. The agreement settles quarterly on a net basis in shares of Enhance Financial stock or in cash at Enhance Financial's election. To the extent that the market price of Enhance Financial common stock on a settlement date is higher (lower) than the forward purchase price, the net differential is received (paid) by Enhance Financial. During 1997, settlements resulted in Enhance Financial receiving 75,000 shares, which were recorded as treasury shares.
In 1996, Swiss Reinsurance Company ("Swiss Re") acquired from Enhance Financial and one of its shareholders, respectively, 600,000 and 400,000 shares of Enhance Financial common stock at a purchase price of $24.48 per share. In 1997, Swiss Re acquired an additional 700,000 shares of Enhance Financial common stock in the open market.
Under the terms of the Credit Agreement, the maximum amount of dividends which may be paid by Enhance Financial as of December 31, 1997 was $35.1 million.
FIXED MATURITY SECURITIES - The fair values of fixed maturity securities are based on quoted market prices or dealer quotes. For private placements, fair value approximates amortized cost.
OTHER INVESTED ASSETS - The fair values of the Company's other invested assets are based on the net present value, discounted at market rates, of the future cash flows purchased.
LONG-TERM DEBT - The fair value is estimated based on the quoted market prices for the same or similar issue or on the current rates offered to the Company for debt of the same remaining maturities.
The Company's potential liability in the event of nonperformance by the issuer of the insured obligation is represented by its proportionate share of the aggregate outstanding principal and interest payable ("insurance in force") on such insured obligation. At December 31, 1997, the Company's aggregate insurance in force was $64.4 billion. The Company's insured portfolio as of December 31, 1997 was broadly diversified by geographic and bond market sector with no single credit representing more than 1.4% of the Company's net insurance in force.
STATE OF ISSUE In billions December 31, 1997 1996 ---- ----
The actuarially computed net pension cost for 1997, 1996, and 1995 using the projected unit credit actuarial method of attribution includes the following components:
In thousands YEARS ENDED DECEMBER 31, 1997 1996 1995 ------- ------- ------- Accumulated benefits obligation, including vested benefits of $4,666, $4,457 and $4,879 $(5,025) $(4,635) $(5,809) ------- ------- ------- Projected benefit obligation $(8,131) $(6,475) $(8,824) Plan assets at fair value 4,726 4,437 5,053 ------- ------- ------- Projected benefit obligation in excess of plan assets (3,405) (2,038) (3,771) ------- ------- ------- Unrecognized prior service cost 961 1,014 1,067 Unrecognized transition net asset 14 16 17 Unrecognized net (gain)loss (2,266) (2,717) 189 ------- ------- ------- Accrued pension cost $(4,696) $(3,725) $(2,498) ======= ======= =======
1997 1996 1995 ---- ---- ---- Discount rate 7.0% 7.5% 5.5% Expected long-term rate of return on plan assets 8.5% 8.5% 8.5% Rate of increase in future compensation levels 6.0% 6.0% 6.0%
The net post-retirement benefit cost for 1997, 1996, and 1995 was $127,000, $118,000, and $105,000, respectively, and includes service cost, interest cost and amortization of the transition obligation.
In January 1996, the Company implemented a 401(k) retirement savings plan covering substantially all employees of the Company. Under this plan, the Company provides a matching contribution of 25% on contributions up to 6% of base salary made to the plan by eligible employees. The Company's matching contribution was $106,000 and $98,000 in 1997 and 1996, respectively.
The Company maintains a stock option program for its key employees. Options issued under the program vest in four equal annual installments commencing one year after the date of grant. The Company also maintains a directors' option program pursuant to which directors of Enhance Financial and the Insurance Subsidiaries who are not employees of the Company are granted non-qualified stock options.
Options under this program vest in two equal annual installments commencing on December 31 next following the date of grant. All options are exercisable at the option price, being the fair value of the stock at the date of grant. The board of directors of Enhance Financial has authorized a maximum of 4,850,000 shares of Enhance Financial common stock to be awarded as options of which 3,938,500 options for shares (net of expirations and cancellations) had been awarded as of December 31, 1997. Information regarding activity in the option programs follows:
Outstanding at beginning of year 2,415,721 $14.50 - $26.625 Granted - Employees 400,110 $26.875 - $34.00 - Directors 26,000 $36.50 Exercised (231,275) $14.50 - $20.25 Expired or canceled (57,446) $16.00 - $23.875 ---------- Outstanding at year-end 2,553,110 $14.50 - $36.50 ---------- Exercisable at year-end - Employees 1,321,457 $14.50 - $23.875 - Directors 143,333 $17.125 - $26.625
Net income - as reported $68,806 $55,704 - pro forma $67,475 $55,046 Basic earnings per share - as reported $3.71 $3.12 - pro forma $3.64 $3.08 Diluted earnings per share - as reported $3.56 $3.04 - pro forma $3.49 $3.00
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. The weighted average grant date fair value of option grants were $24.02, $10.88 and $7.27 in 1997, 1996 and 1995, respectively. The following assumptions were used for option grants awarded in 1997, 1996 and 1995:
The Company has committed to lease office space under non-cancelable leases which expire in August 1999, December 1999, April 2000, August 2000 and August 2005. The leases provided for escalations resulting from increased assessments for taxes, utilities and maintenance. Future minimum rental payments on all leases, before any deductions for estimated sublease income, are as follows:
CONDENSED BALANCE SHEETS In thousands December 31, 1997 1996 --------- --------- ASSETS Investments $ 12,706 $ 10,213 Investment in affiliated companies 658,609 563,395 Other assets 46,161 38,386 --------- --------- $ 717,476 $ 611,994 ========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY: Long-term debt $ 75,000 $ 75,000 Other liabilities 61,083 48,645 Shareholders' equity 581,393 488,349 --------- --------- $ 717,476 $ 611,994 ========= =========
In thousands Years Ended December 31, 1997 1996 1995 -------- -------- --------
- In 1996 four primary insurers accounted for 19%, 13%, 10% and 7% of gross premiums written.
This customer concentration results from the small number of primary insurance companies which are licensed to write financial guaranty insurance.
Net incurred related to: Current year 6,002 6,087 3,491 Prior years 3,753 3,097 6,022 ------- ------- ------- Net incurred 9,755 9,184 9,513 ------- ------- ------- Net paid related to: Current year 720 587 2,705 Prior years 4,306 11,285 4,579 ------- ------- ------- Net paid 5,026 11,872 7,284 ------- ------- -------
Revenues from external customers $ 88,966 $ 30,152 $ 119,118 Interest revenue 50,618 - 50,618 Interest expense 5,881 1,436 7,317 Equity in income of affiliates 1,075 7,703 8,778 Income tax expense 19,270 5,664 24,934 Operating income - pre-allocation 57,884 10,519 68,403 Operating income - post-allocation 60,029 8,374 68,403 Identifiable assets 1,049,596 97,913 1,147,509
The following are reconciliations of reportable segment revenues and profit to Enhance Financial's consolidated totals: