Neither AIIG, AIIC or AIG Ltd. owns or leases material properties. Substantially all of the business of AIIG and AIIC is conducted from the offices of USA Risk Group. Since inception, AIG Ltd.'s operations have been minimal. See Note G to the audited financial statements for more detail.
The increase in earned premiums during 1998 is attributable to an adjustment for prior year premiums due from CNA and from continued growth of the AICPA Plan. The one-time adjustment for prior year premiums due from CNA amounted to approximately $1.1 million and was a result of information system errors at CNA. CNA underreported the 1995-96 and 1996-97 treaty-year premiums due AIIG by $528,604 and $616,008, respectively. Subsequent to year-end 1998, these balances were received, including interest, net of ceding commissions due. Growth of the AICPA plan accounts for the remaining increases in 1998 and 1997 premiums. This growth is primarily the result of an increase in the number of insureds under the AICPA Plan and from certain rate increases associated with a "step plan" which was initiated during 1995. Under the step plan, insureds are offered discounted premium rates for favorable loss experience. However, as these insureds experience losses their premiums are "stepped up" accordingly. Because of the use of claims-made policies, as the number of years of coverage provided increases, CNA's (and AIIG's) exposure increases. This additional exposure results in an increase in premiums charged.
Net investment income, including realized capital gains and losses, includes amounts earned on the Company's investment portfolio and cash on deposit. Net investment income decreased by $128,544 or 5% in 1998 to $2,443,995 from $2,572,539 in 1997. Net investment income in 1997 increased by $178,162 or 7% from the $2,394,377 reported in 1996. Net investment income in 1998 includes net realized capital gains of $277,627 as compared to net realized capital gains in 1997 of $305,252, a net decrease of $27,625. Net realized capital gains in 1996 were $1,765. Capital losses are used to offset capital gains of prior and future years and recover related income taxes.
Losses and loss adjustment expenses incurred increased by 1% to $4,797,657 in 1998 from $4,748,833 in 1997. Losses and loss adjustment expense for 1997 increased by 75% from $2,717,884 in 1996. These amounts include favorable development of prior years' estimates of losses and loss adjustment expense of approximately $4,883,000 in 1998, $1,411,000 in 1997 and $2,917,000 in 1996. As adjustments to prior estimates of losses and loss adjustment expenses become known, such adjustments are included in current operations. AIIG's loss ratio, calculated as the ratio of losses and loss adjustment expense to premiums earned, is 68% in 1998, 81% in 1997 and 50% in 1995. The ratio calculated using only losses and loss adjustment expenses incurred for the current year (excluding the effects of favorable development and excluding reductions to retrocession premiums) is 140% in 1998, 120% in 1997, 120% in 1996.
Favorable development on prior year losses is attributable to various economic trends and factors. In a strong economic environment, fewer professional liability claims are likely to occur since fewer companies are experiencing the kind of financial stress or failure that can often lead to such claims. However, AIIG also noted that under the CNA program, loss frequency has increased in recent years while loss severity has remained constant. This increase in loss frequency can be attributed to CNA's implementation of a step plan (also see above discussion of premiums) in 1995 that was designed to attract a large number of new insureds, predominantly smaller firms, to the program. CNA expected loss severity to decrease and offset the effects of increases in loss frequency, but to date this has not occurred. Accordingly, losses are trending upward in
Policy acquisition costs of $1,967,307 were expensed in 1998 as compared to $1,462,733 in 1997, an increase of 35%. Policy acquisition costs expensed in 1997 reflect an increase of 12% from $1,302,327 in 1996. Such costs as a percentage of premiums earned (excluding the effects of reductions to retrocession premiums) are 28% in 1998, 29% in 1997 and 28% in 1996, and result primarily from ceding commissions paid to ceding companies determined contractually pursuant to reinsurance agreements.
The effective tax rate was 23% in 1998, 16% in 1997 and 31% in 1996. These rates differ from the statutory federal rate primarily due to the effects of tax exempt municipal bond income. Gross tax exempt investment income increased by 30% in 1998 to $683,891 from $527,600 in 1997. Gross 1997 tax exempt investment income increased by 110% from $250,913 in 1996.
The Company's operations are conducted through its management company, Vermont Insurance Management, Inc. ("VIM"). VIM has informed the Company that it is using both internal and external resources to identify, correct and test its financial, information and operational systems for Year 2000 compliance. VIM is assessing its internal systems for Year 2000 compliance and has made inquiries of third parties with whom the Company has material relationships to assess the potential impact on the Company's operations if key third parties are not successful in converting their systems in a timely manner. VIM has completed its assessment of its hardware systems and is still in the process of reviewing its software systems, and anticipates that its review of its internal systems will be complete by March 31, 1999. VIM anticipates that any necessary remediation will be completed by June 1999 and that any necessary testing will be completed by September 30, 1999. Based on its review efforts to date, VIM does not anticipate any material disruption to the Company's business from its internal systems. The costs of remediation to its systems will be borne by VIM or its affiliates.
The Company's expectations about the impact of the Year 2000 problem on its business are subject to a number of uncertainties that could cause actual results to differ materially. Such factors include the following: (i) The Company's service providers may not be successful in properly identifying all systems and programs that contain two-digit year codes; (ii) The nature and number of systems which require reprogramming, upgrading or replacement may exceed the service providers' expectations in terms of complexity and scope; (iii) The Company's service providers may not be able to complete all remediation and
testing necessary in a timely manner; (iv) The Company has no control over the ability of third parties to achieve Year 2000 compliance; and (v) The impact of the Year 2000 problem on CNA may be of such magnitude that it may adversely affect the Company's business or eliminate its sole source of insurance business.
As of December 31, 1998, total invested assets amounted to $42,548,658, an increase of $865,079 or 2% from $41,683,579 at December 31, 1997. Cash balances increased from $1,081,736 at December 31, 1997 to $1,450,795 at December 31, 1998, an increase of 34%. The balance of cash and cash equivalents varies depending on the maturities of fixed term investments and on the level of funds invested in money market mutual funds. The ratio of cash and invested assets to total liabilities and stockholders' equity at December 31, 1998 was .88 to 1, compared to a ratio of .90 to 1 at December 31, 1997.
Reinsurance recoveries represent AIIG's estimate of losses to be reimbursed by its reinsurer from future loss payments. AIIG (through AIIC) entered into excess of loss retrocession agreements to limit its retained risk on any one claim underwritten by Coregis Group, Inc. (formerly Crum and Forster Managers Corporation), to $50,000 in 1989 and 1990 and $62,500 in 1991 through mid-1993, subject to specified maximum recoveries for each contract year. Retrocession premiums ceded by AIIG are adjustable within a specified range based on actual experience under each contract. Amounts recoverable from the reinsurers pursuant to retrocession agreements have been estimated using actuarial assumptions consistent with those used in establishing the liability for unpaid losses and loss adjustment expenses. The actuary suggested a decrease in its analysis as of December 31, 1998 which is reflected in the decrease to reinsurance recoveries receivable from $1,039,762 at December 31, 1997 to $875,685 at December 31, 1998, a decrease of $164,077, or 16%.
Reinsurance balances payable represent AIIG's estimate of the premiums due to the Company's reinsurer under the retrocession agreements described above, and amounts currently due for losses and loss adjustment expenses payable. Ultimate loss reserves were adjusted downward by the actuary in 1998, which resulted in a decrease in the portion of reinsurance balances payable due for retrospective premiums. The estimate of reinsurance balances due for retrospective premiums decreased by $131,250, $720,298 and $693,976 during 1998, 1997 and 1996, respectively. Including loss and loss adjustment expenses currently due, reinsurance balances payable increased from $1,984,442 at December 31, 1997 to $2,142,396 at December 31, 1998, an increase of $157,954, or 8%.
Prepaid expenses and other assets amounted to $326,172 at December 31, 1998, an increase of 75% from 1997. This is due to the fact that the Company incurred expenses in researching, studying and preparing for its possible redomestication to Bermuda. At December 31, 1998 expenses totaling $86,798 were capitalized and have been included in other assets.
The Registrant paid its fourteenth consecutive quarterly dividend of $0.65 per share during the fourth quarter of 1998.
Due to regulatory restrictions on the payment of dividends, $19,005,196 of AIIG's separately determined GAAP basis stockholders' equity of $20,848,584 is unavailable for distribution as dividends in 1999 without prior regulatory approval.
The consolidated financial statements include the established liability for unpaid losses and loss adjustment expenses (LAE) of the Company's property/casualty (P/C) insurance operations. The liabilities for losses and loss adjustment expenses are determined utilizing both case-basis evaluations and actuarial projections, which together represent an estimate of the ultimate net cost of all unpaid losses and LAE incurred through December 31 of each year. These estimates are subject to the effect of trends in future claim severity and frequency. The estimates are continually reviewed, and as experience develops and new information becomes known, the liability is adjusted as appropriate. Such adjustments are reflected in current financial reports.
AIIC's actuary has applied four standard methods. The Expected Value Method (EVM) relies on pricing considerations prior to the emergence of any actual experience for a particular report year. The Bornhuetter-Ferguson Method (BFM) blends the expected value estimates from the EVM with the actual emerging experience. The Trended Average Cost Method (TACM) allows separate estimation of the three components of expected losses -- frequency, limited severity, and excess severity -- with the ability to introduce different valuation methods for each of these three components at different points in time. The Loss Development Method (LDM) projects current values of incurred losses to their estimated ultimate level based on historical patterns of how losses have developed as a report year ages.
The valuation has been subject to limited adjustments to reflect uncertainties concerning CNA's underwriting, which is not fully comparable to the more mature Crum & Forster results for earlier years.
The "cumulative redundancy (deficiency)" represents the aggregate change in the estimates over all prior years. For example, the 1994 liability has developed a $11,942,000 redundancy which has been reflected in income in subsequent years as the reserves were reestimated.
Schedules I, III, V, and VI are omitted as they are inapplicable, immaterial, or because the required information may be found in the audited consolidated financial statements and notes thereto.