- ------------------------- (1) 1997 amounts reflect revenues from the Company's sale of its investment in Kingsway Financial Services, Inc. (See Note 1 of the Notes to Consolidated Financial Statements).
The Company, through its subsidiaries, is engaged in the business of underwriting specialty insurance coverages for international trade. This includes U.S. Customs bonds, marine cargo insurance, professional liability insurance, and property and casualty insurance. The Company has a subsidiary in Hong Kong and a branch office in the United Kingdom. Until December 18, 1995, the Company was the sole parent company of Kingsway Financial Services, Inc. ("Kingsway"), an underwriter of automobile, and property and casualty insurance in Canada. On December 18, 1995 Kingsway sold 1.8 million shares of its common stock in an initial public offering. The Company participated in that transaction as a selling shareholder, reducing its equity interest in Kingsway from 100% to 50%. In January, 1996, as a result of the exercise of the underwriters' over allotment option, the Company's equity in Kingsway was reduced to 47.0%. In October, 1996, Kingsway conducted a secondary offering in which the Company participated. As a result of this, the Company's equity in Kingsway was further reduced to 31.5%. In August, 1997 Kingsway conducted another secondary offering in which the Company participated. As a result of this, the Company's equity in Kingsway was reduced to less then 1%. During all of 1996 and 1997 until August 25, 1997 this investment had been accounted for by the equity method.
In order to provide the necessary level of service to independent agents and brokers and to enhance the ability to expand the number of independent producers, the Company opened four regional offices. The immediate impact of these openings was an increase to underwriting costs. The Company believes, however, that the regional offices are a necessary factor to increase premium writings and to provide enhanced customer service.
During the course of 1998 the Company was involved in an extensive review of strategic alternatives. This review included among other things potential acquisitions by the Company, as well as strategic alliances and mergers with other entities. These efforts culminated with the Company entering into an Agreement and Plan of Merger with XL noted in Item 1 of this Statement. Additional information is contained in the Registrant's definitive Proxy Statement for the Special Meeting of Shareholders relating to the Merger. As part of this review the Company incurred costs for financial consulting and legal services which impacted underwriting expenses.
Net investment income was $6.1 million in 1998 as compared to $4.9 million in 1997 and $4.0 million in 1996. The increase in 1998 was attributable to earnings on the cash equivalents portion of the investment portfolio. In August of 1997 the Company sold 4,018,000 of its shares in Kingsway Financial Services. The 1998 results benefited from a full year of investment of the resultant proceeds, as compared to approximately
four months in 1997. Yields in 1998 on the long-term portion of the portfolio were down slightly versus 1997. Net investment income was $4.9 million in 1997 as compared to $4.0 million in 1996, an increase of $900 thousand. The increase is attributable to the increase in the fixed income portion of the investment portfolio and to investment income on the proceeds from the Kingsway sale, offset somewhat by a decline in average yield due to the general decline in interest rates. Realized investment gains in 1998 were $2.1 million as compared to $48.9 million in 1997 and $2.4 million in 1996. In 1997, the Company sold 4,018,000 of its shares in Kingsway giving rise to a gain net of related expenses of $49.4 million. The 1998 and 1996 realized gains include $900 thousand and $2.4 million, respectively, in gains related to sales of Kingsway shares. Also included in the 1998 amount is $1.1 million in gain from the sale of certain IAS subsidiaries.
The following chart depicts loss and loss adjustment expenses ("LAE") by segment.
Other underwriting expenses increased approximately $1.5 million, or 9.0% in 1998 to $17.9 million from $16.4 million in 1997. During 1998 the company was in the process of reviewing strategic alternatives, as described previously herein. Costs associated with this endeavor were approximately $1.25 million. Litigation and investigation costs relating to the departure of certain IAS employees and the resultant litigation were approximately $800 thousand. Costs associated with the development of regional offices were approximately $689 thousand. In addition, as the Company refocused on underwriting, the decision was made to discontinue an agency operation, TRM Insurance Services("TRM"). TRM has been sold effective February 28, 1999. Included in the assets of TRM was the value of an agreement with the former owner to not engage in a similar business nor solicit TRM's customer base for a stated period should this person leave TRM. With the discontinuance of agency operations the contract no longer had a basis for the value. Accordingly, the remaining carrying value of $390 thousand was written off. This charge was included in other underwriting expenses. Offsetting these costs somewhat was a reduction in other underwriting expenses of $805 thousand as a result of the sale of certain IAS subsidiaries. In addition, expense initiatives undertaken during the course of the year have reduced headcount by 9.6% in addition to employee reduction resulting from the sale of IAS subsidiaries. The Company is continuing its expense initiative in the current year. Other underwriting expenses increased $2.3 million or 16.3% in 1997 to $16.4 million from $14.1 million in 1996. Insurance company operations in 1997 showed an increase of $3.2 million. This was due to an increase in insurance company bad debt expense in 1997 over 1996 of $2.0 million as the result of the financial failure of certain producers. The Company generally anticipates such failures when establishing allowances for bad debts. These particular failures were unusual in magnitude and such occurrences in the future are expected to be minimal. Also, salary and related benefits increased $972 thousand due in part to approximately $450 thousand associated with changes in management during 1997. Agency operations expenses decreased approximately $909 thousand. Bad debt expense in the agency operations for 1997 was $504 thousand less than 1996 as collection efforts were enhanced. Salary expense for the agency operations in 1997 was down $261 thousand from 1996 due to staffing changes.
A significant factor in evaluating insurance company performance is the combined ratio. The combined ratio is a comparison of claims costs plus other expenses as a percentage of premiums earned.
The year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have time sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations including, among other things, a temporary inability to process transactions, send invoices, calculate earned premiums or engage in similar normal business activities.
external consultants. A project plan has been developed which consists of four phases. These phases include (a) an inventory to identify software applications, technology platforms and interfaces, and business partners, and rating each on their potential business impact; (b) an initial assessment of the approach to be used in determining year 2000 compliance; (c) remediation where non-compliant items are reprogrammed or replaced; and (d) testing and certification of code modifications and new inventory with other associated systems, including date testing and quality assurance testing to ensure functioning in the post-1999 time frame. These phases are overlapping with one another and portions may be done simultaneously.
The Company has initiated a program to inform its customers of the potential impact that year 2000 issues may have on their operations. Should customer operations insured by the Company be unable to adequately perform their services due to circumstances arising from year 2000 issues they may have failed to address, the Company may be adversely impacted. This may include, but not be limited to, such items as inability or failure of customers to remit premiums, and additional incurred claims under various insurance policies issued by the Company. While the Company may seek to limit its exposure to such claims, there is uncertainty as to the acceptance of these limitations by regulators and the legal system. The economic impact of these uncertainties cannot be determined at this time.
plans, and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those anticipated. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, and similar uncertainties.
The Company's effective tax rates for the years 1998, 1997 and 1996 were 37.8%, 38.4% and 20.4% respectively. The effective tax rate differs from the U.S. federal corporate tax rate due to the Company's investments in tax exempt securities, changes in the valuation allowance related to deferred tax assets, and the differential in book and tax bases of assets disposed (including the disposal of Kingsway) (see accompanying Notes to Consolidated Financial Statements).
The capacity of an insurance company to underwrite insurance is based upon maintaining liquidity and capital resources sufficient to pay claims and expenses as they become due. The Company has historically generated adequate capital resources to support its current operations. This position is further enhanced by its investment policy which emphasizes high quality, short to medium term investments. The primary sources of the Company's liquidity are funds generated from insurance premiums, investment income, and proceeds from investment maturities. The principal application of such funds are payments of losses and loss adjustment expenses, investments, reinsurance, and operating expenses.
capital and surplus of Intercargo Insurance Company, finance short term investment and general corporate purposes, including payment of related income taxes of $18.5 million on the gain from sale. Proceeds from the sale of Kingsway common stock in 1996 were used to increase the statutory capital and surplus of IIC and for general corporate purpose.
The Company has discontinued its $15.0 million line of credit in light of its current high level of available funds.
The Company does not have any material commitments for capital expenditures. However, under terms of its Agreement and Plan of Merger with XL Capital, the Company is required to have at least $24 million in cash and cash equivalents at the consummation of the subject merger.
We have audited the accompanying consolidated statements of operations, stockholders' equity, and cash flows of Intercargo Corporation and subsidiaries for the year ended December 31, 1996. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated supplementary financial statement schedules as listed in the accompanying index for 1996. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audit.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and the cash flows of Intercargo Corporation and subsidiaries for the year ended December 31, 1996, in conformity with generally accepted accounting principles. Also, in our opinion, the aforementioned supplementary financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ KPMG LLP Chicago, Illinois February 21, 1997
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS, EXCEPT PER SHARE DATA)
In January 1996, the Company sold 60 thousand shares of its fifty percent investment in Kingsway Financial Services, Inc. ("Kingsway") stock. This reduced the Company's ownership percentage to approximately 47%. In October 1996, the Company participated in a secondary offering of Kingsway stock by selling 250 thousand shares, which along with the new shares issued by Kingsway, reduced its equity interest in Kingsway to approximately 31%.
In August 1997 a two-for-one stock split increased the Company's shares of Kingsway to 4.2 million. The Company then sold 4.0 million shares reducing its ownership interest to less than 1%. Prior to August 1997, the Company recorded its share of Kingsway's operating results as equity in net income of investee.
On April 30, 1998, IAS transferred to the Roanoke Companies, Inc. ("Roanoke") all of the insurance brokerage agency business of IAS in consideration for cash, convertible preferred stock and a secured installment note totaling approximately $7.9 million. The transaction was effected through the sale of the capital stock of seven subsidiaries of IAS. The purchase price, which is equivalent to approximately one times the commission revenue of the transferred agencies, is subject to adjustment based on commission revenue of the transferred agencies for the 12 month period ending June 30, 1999. The subject commission revenue since the date of sale has been less than anticipated. Market factors may continue to impact this commission revenue. Based on these factors the Company estimates that the initial purchase price may be ultimately reduced by 35% to 40%. Accordingly, $3.0 million of the estimated gain on the sale has been deferred until determination of the final purchase price.
Cash equivalents consist of investments with an original or remaining maturity of three months or less at purchase.
Premiums receivable are stated net of allowances for uncollectible accounts of approximately $1.4 million and $1.0 million at December 31, 1998 and 1997, respectively.
Policy acquisition costs are costs such as commissions and certain other underwriting and agency expenses which vary with and are directly related to the production of business. Such costs are deferred to the extent recoverable from future earned premiums and are amortized ratably over the terms of the related policies. Costs deferred and amortized over the past three years are summarized as follows (in thousands):
Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement bases of assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period in which the change is enacted.
Intangible assets relate to the acquisition of licenses, customer lists, non-compete agreements, and employment agreements and are amortized using the straight-line method over periods not exceeding 20 years.
Insurance premiums are recognized as revenue ratably over the terms of the policies. Unearned premiums are computed on the daily pro rata basis. Prospective reinsurance premiums, losses and loss adjustment expenses are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts.
Basic earnings per share are computed based upon the weighted average number of shares of common stock outstanding each year. Diluted earnings per share are computed based upon the weighted average number of shares of common stock and common stock equivalents (to the extent dilutive) outstanding each year. Common stock equivalents consist of shares issuable under the Company's stock option plan.
Components of accumulated other comprehensive income at December 31, 1998, 1997 and 1996 are as follows (in thousands):
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No. 133"), which is required to be adopted in years beginning after June 15, 1999. SFAS No. 133 permits early adoption as of the beginning of any fiscal quarter after its issuance. The Company expects to adopt the new statement effective January 1, 2000. The Company does not anticipate that the adoption of SFAS No. 133 will have a significant effect on its results of operations or financial position, as it currently does not use derivative instruments.
Amortized cost and estimated fair value for fixed maturities held as of December 31, 1998, summarized by maturity, are as follows (in thousands):
The sources of net investment income are as follows (in thousands):
The majority of the Company's ceded reinsurance is placed with a limited number of reinsurers; however, the Company evaluates the financial condition of its reinsurers and monitors concentrations of credit risk to minimize its exposure to significant losses from insolvencies. A contingent liability exists to the extent that the Company's reinsurers are unable to meet their contractual obligations. Management makes provision for uncollectible reinsurance when warranted and is of the opinion that no additional liability will accrue to the Company with respect to this contingency. The effects of reinsurance on premiums written, premiums earned,
and loss and loss adjustment expenses incurred for the three years ended December 31, 1998, 1997, and 1996, are as follows (in thousands):
The valuation allowance of approximately $617 thousand at December 31, 1998 and 1997 pertains to foreign tax credits. The valuation allowance has been established to reduce the deferred tax asset related to foreign tax credits to the amount that, based upon available evidence, is, in management's judgment, more likely than not to be realized. The foreign tax credit carryforwards begin expiring in the year 2001.
Net operating losses of IAS ($2.4 million and $2.9 million at December 31, 1998 and 1997, respectively) are considered to have arisen in separate return limitation years (SRLY) and under Federal tax law can only be utilized against future taxable income generated by IAS. The Company also has net operating losses of $4.0 million for the year ended December 31, 1998 that will be carried forward and utilized against future taxable income of the Company. The net operating losses of IAS begin expiring in 2004 and the net operating loss of the Company will expire in 2020.
Certain of the Company's reinsurers are affiliated insurance companies. The Company ceded to these affiliates premiums written of $15 thousand, $414 thousand, and $649 thousand in 1998, 1997, and 1996, respectively.
During the month of January 1998, the president of IAS resigned and with several other employees formed Avalon Risk Management, Inc. Avalon's announced purpose is to compete with IAS in the marketing and distribution of transportation related insurance and surety products. The Company has filed suit in the Chancery Division of the Circuit Court of Cook County, Illinois against the ex-president, Avalon and certain of the defecting employees alleging breach of fiduciary duty, theft of confidential information and other unlawful activities, and seeking injunctive relief and damages. The action is pending, and its outcome at this point is not certain.
The Company's insurance subsidiaries are required to file statutory financial statements with insurance regulatory authorities. Accounting principles used to prepare these statutory financial statements differ from financial statements prepared on the basis of generally accepted accounting principles.
Reconciliations of combined net income (loss) and statutory capital and surplus as determined using statutory accounting principles to the amounts included in the accompanying financial statements are as follows (in thousands):
The statutory capital and surplus of the Company's U.S. insurance subsidiary is sufficient to satisfy current regulatory requirements. Dividend payments to the Company from its insurance subsidiary are restricted by insurance laws as to the amount that may be paid without prior approval of insurance regulatory authorities. Under the insurance regulations of Illinois, IIC's state of domicile, ordinary dividends are limited to the greater of (i) 10% of statutory surplus or (ii) statutory net income, as defined, for the prior twelve
month period. The estimated dividend distribution which can be made to the Company by its subsidiary in 1999 based on these regulatory guidelines is approximately $3.3 million.
The Company's U.S. insurance subsidiary, IIC, is required to file annual statements with insurance regulatory authorities which are prepared on an accounting basis prescribed or permitted by such authorities. Prescribed statutory accounting practices include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners ("NAIC"). Permitted statutory accounting practices encompass all accounting practices that are not prescribed; such practices differ from state to state, may differ from company to company within a state, and may change in the future. IIC does not currently use permitted statutory accounting practices in its statutory financial statements. Furthermore, the NAIC has completed a project to codify statutory accounting practices ("Codification"), the result of which will constitute the only source of "prescribed" statutory accounting practices after December 31, 2000. Upon adoption by the State of Illinois, Codification will change the definition of what comprises prescribed versus permitted statutory accounting practices, and will result in changes to the accounting policies that insurance enterprises use to prepare their statutory financial statements.
(9) UNAUDITED INTERIM FINANCIAL INFORMATION (IN THOUSANDS, EXCEPT PER SHARE DATA)
During the fourth quarter of 1998 the Company increased its loss reserves by $4.2 million on a pre-tax basis for emerging development on marine, other property and casualty, and professional liability lines of business. The Company incurred $1.0 million of pre-tax expenses related to the merger agreement with a subsidiary of XL Capital Ltd. The Company also increased its bad debt reserves by $761 thousand and wrote off certain intangible assets of $390 thousand related to its agency business. The Company realized a pre-tax gain of $504 thousand on sales of Kingsway shares.
On July 28, 1987, the Company's stockholders approved the Company's 1987 Non-Qualified and Incentive Stock Option Plan ("Option Plan"). The Option Plan has been extended through May 15, 2007. A total of 600 thousand shares of common stock have been authorized for issuance under the Option Plan.
5.5 percent and 6.2 percent; expected volatility of 40 percent, 43 percent and 38 percent; and expected lives of 2.5 years, 4.5 years and 4.5 years.
For the purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting periods. The Company's pro forma information is as follows (in thousands, except per share data):
Options outstanding and options exercisable at December 31, 1998 are as follows:
The Company has obligations under long-term operating leases for its office premises in the United States, Hong Kong, and the United Kingdom. The future minimum lease payments are as follows (in thousands):
Included in other underwriting expenses is rental expense of $1.4 million, $1.7 million, and $1.5 million for 1998, 1997, and 1996, respectively.
The Company paid interest of $0, $489 thousand and $768 thousand in 1998, 1997 and 1996, respectively.
Supplemental duty deposits are security deposits held by IAS until the insured bond principal (Depositor) has settled duty charges imposed by U.S. Customs. Under the terms of the agreement with the Depositor, the Depositor is not entitled to a refund of its deposit until it has provided competent written legal evidence that the conditions of each and every bond connected with the deposit have been fully satisfied.
Loss and loss adjustment expense reserves are based on long-range projections which are subject to uncertainty. Uncertainty regarding reserves of a given accident year is gradually reduced as new information emerges each succeeding year, allowing more reliable reevaluations of such reserves. While management believes that reserves as of December 31, 1998 are adequate, uncertainties in the reserving process could cause such reserves to develop favorably or unfavorably as new or additional information emerges. Any adjustments to reserves are reflected in the operating results of the periods in which they are made. Movements in reserves which are small relative to the amount of such reserves could significantly impact future reported earnings of the Company.
Activity related to unpaid loss and loss adjustment expenses (LAE) follows (in thousands):
The estimated fair values of the Company's financial instruments at December 31, 1998 are as follows (in thousands):
The net assets of the Company's foreign operations are translated into U.S. dollars using exchange rates in effect at each year end. An analysis of the foreign currency translation adjustment included in other comprehensive income is as follows (amounts in thousands):
Kingsway is a property and casualty insurance holding company based in Canada which primarily writes and assumes commercial and other automobile insurance considered to be non-standard, and other specialty insurance for commercial properties through its 100% owned subsidiaries, Kingsway General Insurance Company and York Fire & Casualty Insurance Company.
The following presents summary financial data for Kingsway for the year ended December 31, 1996 (in thousands).