The Company and its subsidiaries operate out of leased premises the most significant of which are in Philadelphia and Bermuda.
- -------- (1) See Note 2 I 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) See Note 6 of Notes to Consolidated Financial Statements. (3) All prior period results have been restated to reflect the pooling of interests following the acquisition of CompFirst, Inc. and International Advisory Services Group of Companies.
Consolidated Net Income increased by 31% to $63.6 million in 1998 from $48.7 million in 1997 which was in turn a 29% increase over the $37.8 million earned in 1996. The increase in 1998 earnings was primarily attributable to the growth experienced in the Program Business and Financial Services segments. 1997 earnings growth was also a result of the growth in the Program Business segment, as well as the acquisition of Small Business Underwriters ("SBU") and the expansion of Professional Underwriters Corporation into New York State.
All prior period results have been restated to reflect a pooling of interests following the acquisitions of CompFirst, Inc. and International Advisory Services Group of Companies.
The growth of Fee income and Premiums earned over the past three years has been primarily due to the strong growth in Program Business and Financial Services which have compensated for the decline in Corporate Risk Management business.
Overall, pre-tax profit margins on Fee income continue to remain steady at 37% in 1998 compared to 38% in 1997 and 37% in 1996.
Program Business, the fastest growing segment of the Company's business, involves replacing traditional insurers as the conduit between producers of specialty books of business and reinsurers wishing to write that business. Program Business accounted for 55% of total Fees for 1998 compared to 43% in 1997 and 24% in 1996. This growth has resulted from the continued expansion of this business as a result of reinsurers increased appetite for premium volume in the current soft market and the acquisition of SBU on February 1, 1997. Fees earned on individual Program accounts are more likely to grow compared to Corporate accounts because new policy holders can potentially be added in each program, also Program Business has historically had a higher retention rate than Corporate Risk Management. Pre-tax margins in this segment were 40% for 1998 compared to 39% in 1997 and 34% in 1996.
Corporate Risk Management, the Company's original business segment, involves providing services to businesses and associations seeking to insure a portion of their risk in a loss sensitive Alternative Market structure. This segment, which accounted for 29% of total Fee income for 1998 compared to 42% in 1997 and 62% in 1996, has been the most affected by the extremely soft insurance market cycle for commercial risks Corporate Risk Management fees decreased in 1997 for the first time due to these soft market conditions. The number of Corporate Risk Management accounts decreased in 1998 to 118 from 154 in 1997 which was in turn down from 180 in 1996. Profit margins increased, despite the difficult market, to 45% in 1998 compared to 41% in 1997 and 40% in 1996.
Historically, workers' compensation has been the major line of business written by the Company in both its Corporate Risk Management and Program Business segments. Competition for workers' compensation business has increased in recent years, as a result of generally improved reported underwriting results and workers' compensation reform legislation. The resulting under pricing of workers' compensation risks by traditional insurers reduces the incentive for insureds to enter "Alternative Market" vehicles such as those offered by the Company in its Corporate Risk Management segment.
and 129 in 1997, to 195 in 1998 as well as relatively high renewal rates of 80% in 1996, 93% in 1997 and 80% in 1998. Profit margins decreased from 20% in 1996 and 26% in 1997 to 4% in 1998. Margins in the Financial Services segment were adversely affected due to a revised Executive Incentive Plan implemented at Hemisphere in 1998. The effect of this revised Executive Incentive Plan will continue through 2000. Excluding the effect of the revised Executive Incentive Plan, the profit margins in this segment would have been 18% for the year ended December 31, 1998.
The Company has established provisions for losses as a result of these exposures for certain clients and reinsurers. These provisions, which totaled $6.5 million at December 31, 1998, $5.6 million in 1997 and $4.5 million in 1996, reduced the level of Fee income in each year by $.9 million, $1.1 million and $.5 million, respectively. The increase in the number of accounts and their inherent growth in premium volume, the increase in the clients' aggregate retentions since 1991, the amounts recoverable from reinsurers, which amounted to $1,286 million at December 31, 1998 and $787 million at December 31, 1997, 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. The Company evaluates the financial condition of its clients, brokers and reinsurers to minimize its exposure to losses from insolvencies.
Included in Premiums earned are assigned risk premiums of $2.5 million in 1998 as compared to $8.4 million in 1997 and $7.8 million in 1996. 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 clients' accounts.
treaties. 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.
increased; (b) increased personnel costs in all areas, caused by an increase in the number of full time employees from 515 in 1996 to 700 in 1997 to 886 in 1998, 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 SBU, Hugo Trust, Avreco, Capital Management and the Hemisphere expansion to Boston and Ireland.
The charges for Income taxes represent effective tax rates of 17.6%, 17.9% and 11.8% in 1996 through 1998, respectively. The reduced tax rate in 1998 is primarily due to increased earnings outside of the United States. This, plus the Company's investment in tax-exempt municipal securities, offset by state income taxes and foreign taxes, are the major causes of the difference between the expected federal income tax rate in the United States of 35% plus state income taxes and the Company's effective rates in each year. The Legion Companies, as insurance companies in the United States, are subject to income tax on an accelerated basis and, as a result, a deferred tax benefit was carried on the Consolidated Balance Sheets of $1.5 million in 1998 and $4.6 million in 1997.
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.
At the end of 1998 and 1997, 56% and 69% of the Company's Total marketable investments were held by the Company's policy-issuing subsidiaries in the United States. These companies are restricted by regulation in the amount of dividends they can pay without prior regulatory approval to $23.6 million in 1999 (based on 1998 results) and will continue to face these restrictions in the future. During 1998 they paid a dividend of $12 million. They are also required to maintain certain deposits with or supply letters of credit to regulatory authorities which totaled $152 million at December 31, 1998 ($60 million of deposits and $92 million of letters of credit) as compared to $135 million at December 31, 1997 ($51 million of deposits and $84 million of letters of credit).
The National Association of Insurance Commissioners ("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, 1998 the Company's policy- issuing subsidiaries met the RBC requirements with a combined required risk- based capital of $78.5 million and an actual adjusted capital of $225.5 million.
Shareholders' equity increased 30% to $342 million at December 31, 1998 from $263 million at December 31, 1997. This increase was attributable to Net income in 1998, less dividends paid, plus the value of shares issued on the exercise of employee stock options, the conversion of redeemable common shares and debenture conversions. During 1998 the total number of Common Shares outstanding increased to 41,146,830 from the 1997 level of 38,820,704, mainly as a result of the exercise of employee stock options, conversion of redeemable common shares and debenture conversions.
Total assets increased to $3.0 billion at December 31, 1998, a 40% increase from $2.2 billion at December 31, 1997. $722.3 million, or 24% of Total assets in 1998 and $649.2 million, or 30%, in 1997 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. Total assets also increased due to the increase in Reinsurance receivables from $630.7 million in 1997 to $1,079.6 million in 1998, this increase, which is largely offset by corresponding increases in the Reserve for losses and loss expenses and Accounts payable, is due to the greater amount of reinsurance utilized in connection with the Company's Program Business segment.
The Company does not believe its operations have been materially affected by inflation. The potential adverse impacts of inflation include: (a) a decline in the market value of the Company's fixed maturity investment portfolio; (b) an increase in the ultimate cost of settling claims which remain unresolved for a significant period of time; and (c) an increase in the Company's Operating expenses. However, the Company generally holds its fixed maturity investments to maturity and currently believes that an acceptable amount is included in the yield to compensate the Company for the risk of inflation. In addition, any increase from inflation in the ultimate cost of settling unpaid claims will be borne by the Company's clients and offset by investment income earned for the benefit of the client during the period that the claim is outstanding. Finally, the increase in Operating expenses resulting from inflation should generally be matched by similar inflationary increases in the client's premium and the Company's fee income, which includes a fee based upon a percentage of the client's premium.
fixed rate instruments held. The Company is also exposed to credit spread risk resulting from possible changes in the issuer's credit rating. To manage its exposure to interest rate risk the Company attempts to select investments with characteristics that match the characteristics of the related insurance and contract holder liabilities. Additionally, the Company generally only invests in higher-grade interest bearing instruments.
The table below provides information about the Company's available for sale investments that are sensitive to changes in interest rates at December 31, 1998. The table presents expected cash flows and related weighted-average interest rates by expected maturity dates. Separate account assets and liabilities are not included in this analysis as gains and losses related to these accounts generally accrue to the program holders.
The Company began assessing the impact of the Year 2000 issue on its computer hardware and software systems in 1997. Certain systems have been identified for replacement before year-end 1999 due to normal business requirements. The replacement systems will be assessed for Year 2000-related problems. Remediation is expected to continue through the end of the 1999 third quarter at a cost that is not expected to be material to the Company. Currently, management has inventoried and is conducting a review of all such systems. As of December 31, 1998, the Company's historical Year 2000 remediation costs have not been material. The Company's lack of legacy systems is fortunate, most of its applications are PC databases, some networked but most from a programming stand point, easily corrected. As of this disclosure date, management has not identified any hardware or software computer system within the Company with a significant Year 2000 compliance problem that is expected to have a materially adverse effect on the Company's financial condition or results of operations. As the Company regularly updates its hardware and software, the pure additional cost for Year 2000 compliance should not be material.
The Company has acquired all of the outstanding shares of CompFirst, Inc. ("CompFirst"), a Georgia-based managing general agent, specializing in workers' compensation and excess medical stop loss. CompFirst places special emphasis on managed care and provides extensive managed care services in addition to producing and underwriting business.
During the third quarter of 1998, the Company, through its subsidiary Professional Underwriters Corporation, acquired all of the assets and goodwill of Avreco Corp. ("Avreco"). Avreco is a specialty brokerage operation based in Chicago. Its principal lines of business are Medical Malpractice, Excess Property and Professional Liability. This acquisition will assist in the development of the takeout Company's business in these specialty markets.
In connection with the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 (the "1995 Act"), the Company sets forth below cautionary statements identifying important factors that could
cause the Company's actual results to differ materially from those which might be projected, forecasted, or estimated or otherwise implied in the Company's forward-looking statements, as defined in the 1995 Act, made by or on behalf of the Company in press releases, written statements or documents filed with the Securities and Exchange Commission, or in its communications and discussions with investors and analysts in the normal course of business through meetings, telephone calls and conference calls. Such statements may include, but are not limited to, projections of Fee income, Premiums earned, Net investment income, Other income, Losses and loss expenses incurred, Acquisition costs, Operating expenses, Other expenses, earnings (including earnings per share), cash flows, plans for future operations, Shareholders' equity, financing needs, capital plans, dividends, plans relating to products or services of the Company, and estimates concerning the effects of litigation or other disputes, as well as assumptions for any of the foregoing and are generally expressed with words such as "believes", "estimates", "expects", "anticipates", "could have", "may have", and similar expressions.
The Company's consolidated financial statements for the years ended December 31, 1998, 1997 and 1996 are filed herewith in response to Item 14.