Area leased Location and description (in square feet) Termination - ------------------------ ---------------- ----------- Bloomington, Minnesota; Headquarters space 41,918 September 1999(1) Brainerd, Minnesota; Minnesota satellite office 2,634 October 2000 Denver, Colorado; Colorado office space 11,244 February 2000 St. Louis, Missouri; Missouri office space 4,725 September 2000 Detroit, Michigan; Michigan office space 5,947 June 2002
The Company's revenues consist of premiums earned and investment income. Premiums earned during a period are the gross premiums earned by the Company on outstanding workers' compensation policies less the amount of any premiums ceded to reinsurers.
claim settlement expenses recognized by the Company may differ from the amount estimated. See Note 4 of Notes to Consolidated Financial Statements. - - Policy acquisition costs consist of agents' commissions, premium taxes, certain state administrative and second injury fund charges based on premiums and underwriting and marketing expenses, offset by any ceding commissions received from Reliance. Ceding commissions consist of provisional ceding commissions paid to the Company by Reliance for adjustments based on actual claim and claim settlement expenses related to premiums ceded in prior years. Under the reinsurance agreement, the Company's ceding commission is adjusted to the extent that actual claim and claim settlement expenses vary from levels specified in the agreement.
- - Gross premiums earned increased 34.2% to $63.8 million in 1996 from $47.5 million in 1995. The increase in gross premiums earned resulted from an increase in the amount of premiums in force as the Company's customer base grew to 2,914 customers at the end of 1996 from 998 customers at the end of 1995. The Company's average annual premium decreased to approximately $24,000 at December 31, 1996 from $52,000 at December 31, 1995 due primarily to increased association business with smaller average individual member premiums written. The Company expects continued growth in gross premiums earned in 1997 fueled by growth in premiums in force in its newer markets including Michigan, Missouri and Colorado. - - Premiums ceded to reinsurers decreased 66.8% to a cost of $697,000 in 1996 from a cost of $2,099,000 in 1995. The decrease in premiums ceded to reinsurers resulted from (i) the increase to approximately $1.0 million in 1996 from $450,000 in 1995 in the Minnesota retention level under the Minnesota Workers' Compensation Reinsurance Association (the "WCRA") excess of loss reinsurance coverage, (ii) reduced rates charged for excess of loss reinsurance in Minnesota during 1996, (iii) the recognition of a benefit of $251,000 in the second quarter of 1996 due to an over-estimate of ceded premiums at December 31, 1995, and (iv) the decrease in ceded premium cost in Colorado and Missouri due to exceeding the minimum premium threshold. Colorado, Missouri and Michigan retention levels remained at $500,000 in 1996. Premiums ceded is expected to decrease in 1997 as a percentage of
- Legislative action reduced estimated loss costs in 1996, 1995 and 1994, ultimately reducing premiums charged for workers' compensation insurance. - From October 1995 through September 1996, the Company attempted to write more customers with credit experience modifiers and experienced increased competition in this customer base (including traditional insurance companies competing in greater numbers for accounts). The Company began repositioning its marketing efforts in the fourth quarter of 1996 to refocus on its traditional debit experience modifier customer base. - The Company continues, as anticipated, to experience reduced pricing on renewal policies due to its success in lowering customers' loss experience which reduces customer experience modifiers and, in some cases, increases competition for the customers' business.
- Gross premiums earned increased 24.7% to $47.5 million in 1995 from $38.1 million in 1994. The increase in gross premiums earned resulted from an increase in the amount of premiums in force as the Company's customer base grew to 998 customers at the end of 1995 from 321 customers at the end of 1994. The Company's average annual premium decreased to approximately $52,000 at December 31, 1995 from $124,000 at December 31, 1994 due primarily to increased association business with smaller average individual member premiums written. - Premiums ceded to reinsurers decreased 81.7% to a cost of $2.1 million in 1995 from a cost of $11.5 million in 1994. The decrease in premiums ceded to reinsurers resulted from (i) terminating the quota-share reinsurance agreement, reducing premiums ceded by $9.3 million, and (ii) the increase in ceded premium cost for excess of loss reinsurance in Colorado and Missouri.
INVESTMENT INCOME. Investment income increased to $5.7 million in 1996 from $4.0 million in 1995, due to increased funds available for investment and increased yields on amounts invested. Funds available for investment increased to $89.8 million at December 31, 1996 from $68.5 million at December 31, 1995, due to increased net cash provided by operating activities. Investment yields increased to 6.2% in 1996 from 6.1% in 1995 due to higher interest rates on U.S. Treasury Securities purchased in 1996 from rates on U.S. Treasury Securities purchased in prior years. The investment yield realized in future periods will be affected by yields attained on new investments. The Company expects that the investment yield will be consistent with the yield attained during 1996.
of performance but the results of these changes may not be fully effective until the second half of 1997. - During the fourth quarter, the Company experienced the four largest claims in its history, incurring approximately $2.0 million with respect to these claims, three of which were Minnesota and one of which was Missouri. - Average claim cost decreased in 1996 from 1995 due to efficiencies within the Company and legislative changes in benefits to claimants. The effects of legislative changes in benefits, as estimated by various state regulatory agencies, for periods the Company operated, by state, including known future periods, are as follows:
Increase (decrease) in estimated loss costs ------------------------------------------- 1997 1996 1995 1994 ------- ------- ------ ---- Minnesota (14.8%) (15.6%) (5.6%) 1.3% Colorado (1.5%) (8.6%) (9.6%) N/A
- During 1996, the Company reduced its estimate of the pre-1996 liability for unpaid claim and claim settlement expenses by $8.1 million as a result of favorable claims experience for those periods, which resulted in an $8.1 million reduction in 1996 claim and claim settlement expenses. The Company believes that continued application of its claims management technology and methods to all open claims at December 31, 1996 will benefit future periods. The magnitude of that benefit, if any, can not be quantified. At December 31, 1996, the Company had net reserves for unpaid claim and claim settlement expenses of $49.3 million including $33.2 million for 1996 claims and $16.1 million for years prior to 1996.
The Company believes that, in the current environment (reduced premiums due to legislative changes in estimated costs of losses, increased competition in credit modifier customers written from October 1995 through September 1996, decreasing customer loss experience and decreasing average claim costs), it may continue to experience upward pressure on claim and claim settlement expenses as a percentage of premiums earned.
Policy acquisition costs increased to $6.3 million in 1996 from $2.7 million in 1995 and a benefit of $172,000 in 1994 for the following reasons:
GENERAL AND ADMINISTRATIVE EXPENSES. The Company's general and administrative expenses increased to $8.5 million in 1996 from $6.1 million in 1995 and $3.9 million in 1994. This increase reflects:
- additional personnel costs for new employees, - higher compensation for existing employees, - expenses incurred for growth in Minnesota and Colorado, - startup expenses incurred for expansion in Missouri and Michigan, and - increased fees for professional services.
INTEREST EXPENSE. Interest expense decreased to $1.1 million in 1996 from $1.3 million in 1995 and 1994 due to principal payments on the Series 1991A and 1991B Notes in December 1996, 1995 and 1994 and payment on the Senior Notes in December 1996 and 1995. The Series 1991A and 1991B Notes were paid in full in 1996. Interest expense on the Senior Notes is anticipated to be $777,000 in 1997 as a result of principal payments made in December 1996.
FIRST SECOND THIRD FOURTH QUARTER QUARTER QUARTER QUARTER -------- -------- -------- -------- 1996 (IN THOUSANDS, EXCEPT PER SHARE DATA) Premiums in force: Minnesota $ 46,800 $ 51,100 $ 52,900 $ 52,400 Colorado 8,700 9,600 10,600 12,000 Missouri 600 1,500 3,000 4,700 Michigan - - - 400 -------- -------- -------- -------- Premiums in force at period end $ 56,100 $ 62,200 $ 66,500 $ 69,500 -------- -------- -------- -------- -------- -------- -------- -------- Gross premiums earned $ 14,040 $ 15,242 $ 17,161 $ 17,312 -------- -------- -------- -------- -------- -------- -------- -------- Premiums earned $ 13,764 $ 15,344 $ 16,914 $ 17,036 -------- -------- -------- -------- -------- -------- -------- -------- Total revenues $ 15,052 $ 16,722 $ 18,379 $ 18,572
Claim and claim settlement expenses 7,858 8,503 10,025 12,694 Policy acquisition costs 1,420 1,877 2,132 898 General and administrative expenses 1,844 2,108 1,815 2,743 -------- -------- -------- -------- Income from operations $ 3,930 $ 4,234 $ 4,407 $ 2,237 -------- -------- -------- -------- -------- -------- -------- -------- Net income $ 2,283 $ 2,481 $ 2,582 $ 1,636 -------- -------- -------- -------- -------- -------- -------- -------- Net income per common and common share equivalent $ 0.19 $ 0.20 $ 0.21 $ 0.13 -------- -------- -------- -------- -------- -------- -------- -------- Premiums in force: Minnesota $ 42,600 $ 44,600 $ 44,700 $ 47,700 Colorado 800 1,300 1,600 4,000 -------- -------- -------- -------- Premiums in force at period end $ 43,400 $ 45,900 $ 46,300 $ 51,700 -------- -------- -------- -------- -------- -------- -------- -------- Gross premiums earned $ 10,653 $ 12,272 $ 12,163 $ 12,419 -------- -------- -------- -------- -------- -------- -------- -------- Premiums earned $ 10,308 $ 11,847 $ 11,652 $ 11,601 -------- -------- -------- -------- -------- -------- -------- --------
The Company's premiums in force have increased in each of the last eight quarters. Quarterly revenues are affected by (i) premiums in force at the beginning of the quarter, (ii) new policies written in a quarter and (iii) the Company's policy renewal rate in each quarter. Historically, a majority of new policies written and policy renewals
have occurred in the first, second and fourth quarters. In addition, the Company's quarterly results for 1996 and 1995 were affected favorably by adjustments to the liability for unpaid claim and claim settlement expenses and ceding commissions relating to those years and prior years as follows:
The Company establishes reserves to cover its estimated liability for claim and claim settlement expenses with respect to reported claims and claims incurred but not yet reported as of the end of each accounting period. The Company establishes its reserves based on facts then known, estimates of future trends in claims severity and other factors, including the Company's experience with similar cases and historical trends such as reserving patterns, loss payments and pending levels of unpaid claims. See Note 1 of Notes to Consolidated Financial Statements.
The following table sets forth reserves on a gross (before reinsurance) basis:
The following table sets forth reserves on a net (after reinsurance) basis :
The Company's investments increased to $89.8 million at December 31, 1996 from $68.5 million at December 31, 1995, primarily from cash provided by operating activities. Of the Company's investments at December 31, 1996, $54.0 million were classified as held-to-maturity and valued at amortized cost, while $35.9 million were classified as available-for-sale and valued at fair value. All of the Company's investment securities at December 31, 1996 were U. S. Treasury and Agency Securities. Of the held-to-maturity securities, $44.3 million had remaining maturities of one to five years and $9.7 million had maturities of five to ten years (see Note 2 of Notes to Consolidated Financial Statements). The Company's current investment policy is to invest only in U.S. Treasury and Agency Securities, and it does not invest in derivative securities. Historically, changes in market interest rates have caused fluctuations in the fair value of securities. During 1996, the Company invested solely in available-for-sale securities and intends to continue this investment strategy for the foreseeable future. Additionally, the Company intends to broaden its investment policy during 1997 to increase investment income consistent with prudent risk. As a result of the increased holdings in securities classified as available-for-sale, and thus carried at fair value, the Company expects increased volatility in shareholders' equity as market interest rates and other factors change.
The Company's need for additional capital is primarily the result of regulations which require certain ratios of capital to premiums written. In order for ACIC to begin operations, the Company had to raise capital and contribute it to ACIC. As ACIC grew, additional capital was required to support the higher premium levels. As a result, the Company raised approximately $27.0 million in April 1995 through an initial public offering and $9.2 million in January 1994 through the issuance of Senior Notes and contributed $18.0 million in 1995 and $9.0 million in 1994 to ACIC. In the future, the Company expects that its need for additional capital will be primarily related to the growth of ACIC and the need to maintain appropriate capital to premium ratios as defined by state regulatory
bodies. As an alternative to raising additional capital, the Company believes it could secure quota-share or other reinsurance which would have the effect of reducing the ratio of premiums to capital and could be used to satisfy state regulatory requirements. The Company entered into its reinsurance agreements with Reliance during 1992, 1993 and 1994 for that purpose.
The Company believes that cash flow generated by its operations and its cash and investment balances will be sufficient to fund continuing operations, principal repayments and debt service on its outstanding Senior Notes and capital expenditures for the next 12 months.
The National Association of Insurance Commissioners ("NAIC") has recently adopted risk-based capital standards to determine the capital requirements of a property and casualty insurance carrier based upon the risks inherent in its operations. Such standards require the computation of a risk-based capital amount which is then compared to a carrier's actual total adjusted capital. The computation involves applying factors to various financial data to address four primary risks: asset risk, insurance underwriting risk, credit risk and off- balance sheet risk. These standards provide for regulatory intervention when the percent of total adjusted capital to authorized control level risk-based capital is below certain levels. Based upon the risk-based capital standards, the Company's percent of total adjusted capital is substantially in excess of authorized control level risk-based capital.
The Company's insurance subsidiary is subject to substantial regulation by the governmental agencies in the states in which it operates, and will be subject to such regulation in any state in which it provides workers' compensation products and services in the future. State regulatory agencies have broad administrative power with respect to all aspects of the business of the Company and its insurance subsidiary, including premium rates, benefit levels, policy forms, dividend payments, capital adequacy and the amount and type of investments. These regulations are primarily intended to protect covered employees and policyholders rather than the insurance company. Both the legislation covering insurance companies and the regulations adopted by state agencies are subject to change. The Company's insurance subsidiary is currently licensed to do business in Minnesota, Colorado, Missouri, Michigan, Massachusetts, Pennsylvania and Illinois.
The NAIC is in the process of codifying statutory accounting principles. The ultimate completion date and impact of this project on current statutory policies and practices is unknown.
RTW, INC. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1996 AND 1995 (IN THOUSANDS, EXCEPT SHARE DATA)
Unpaid claim and claim settlement expenses $ 49,256 $ 37,138 Unearned premiums 13,308 9,606 Accrued expenses and other liabilities 3,117 4,051 Notes payable 6,739 8,891 --------- --------- Total liabilities 72,420 59,686
Shareholders' equity: Common Stock, no par value; authorized 25,000,000 shares; issued and outstanding 11,807,576 and 11,709,199 shares 28,610 27,606 Retained earnings 22,690 13,708 Unrealized appreciation on securities available-for-sale 11 124 --------- --------- Total shareholders' equity 51,311 41,438 --------- ---------
1996 1995 1994 --------- --------- --------- Revenues: Premiums earned $ 63,058 $ 45,408 $ 26,614 Investment income 5,667 4,025 1,627 --------- --------- --------- Total revenues 68,725 49,433 28,241
Expenses: Claim and claim settlement expenses 39,080 28,062 16,603 Policy acquisition costs 6,327 2,689 (172) General and administrative expenses 8,510 6,113 3,931 --------- --------- --------- Total expenses 53,917 36,864 20,362 --------- --------- --------- Income from operations 14,808 12,569 7,879
Net income per common and common share equivalent $ 0.73 $ 0.64 $ 0.49 --------- --------- --------- --------- --------- ---------
Weighted average common and common share equivalents outstanding 12,256,833 11,087,831 8,516,895 ---------- ---------- --------- ---------- ---------- ---------
RTW, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 (IN THOUSANDS)
ORGANIZATION - In 1992, RTW, Inc. (the "Company") through its wholly-owned subsidiary, American Compensation Insurance Company ("ACIC"), began providing workers' compensation insurance coverage to benefit from the Company's ability to reduce workers' compensation costs and to provide more control over its insureds' workers' compensation programs. ACIC is domiciled in Minnesota and licensed in Minnesota, Colorado, Missouri, Michigan, Pennsylvania, Illinois and Massachusetts. The Company wrote business primarily in Minnesota, Colorado and Missouri during 1996.
In January 1994, the Company raised $9,169,000 (net of underwriting discounts and other offering expenses totaling $831,000) through a $10,000,000 Senior Note. The Company contributed $9,000,000 of the net proceeds of the offering to ACIC to support expansion of its business in Minnesota.
No provision is made for temporary declines in fair values of the held-to- maturity debt securities as the Company does not expect to realize any significant losses. If, however, an impairment that is other than temporary occurs in a security, the Company would write the security down to the new value.
DEPRECIATION - Furniture and equipment is depreciated over the estimated useful lives of the assets (five to ten years) by the straight-line method of depreciation. Accumulated depreciation at December 31, 1996 and 1995 was $1,366,000 and $788,000, respectively.
DEBT ISSUE COSTS - Debt issue costs associated with the Senior Notes payable are reported as a reduction in notes payable. These costs are being amortized over the terms of the Senior Notes.
There were no significant investment expenses associated with the above investment income.
The Company's held-to-maturity and available-for-sale debt securities are all U.S. Treasury Securities. The amortized cost and fair values of U.S. Treasury Securities at December 31 are as follows (000's):
The amortized cost and fair value of U.S. Treasury Securities at December 31, 1996 by contractual maturities, are as follows (000's):
1996 1995 -------- -------- Quota-share reinsurance for 1992 to 1994 through a single insurer $ 1,673 $ 4,812 Excess of loss reinsurance through various reinsurers 4,510 3,500 -------- -------- Reinsurance receivable $ 6,183 $ 8,312 -------- -------- -------- --------
WRITTEN EARNED -------- --------- Year Ended December 31, 1996: Direct $ 67,457 $ 63,755 Ceded (697) (697) -------- --------- Net premiums $ 66,760 $ 63,058 -------- --------- -------- --------- Year Ended December 31, 1995: Direct $ 50,070 $ 47,507 Ceded (2,099) (2,099) -------- --------- Net premiums $ 47,971 $ 45,408 -------- --------- -------- --------- Year Ended December 31, 1994: Direct $ 39,892 $ 38,099 Ceded (11,895) (11,485) -------- --------- Net premiums $ 27,997 $ 26,614 -------- --------- -------- ---------
1996 1995 -------- --------- Premiums payable to reinsurer $ - $ (262) Reinsurance recoverable from paid claim and claim settlement expenses 75 615 Ceding commission receivable 2,480 1,216 -------- --------- Reinsurance premiums receivable, net $ 2,555 $ 1,569 -------- --------- -------- ---------
The ceding commission earned, which will be based upon final settlement of claim and claim settlement expenses, will range between 10% and 48% during accident years 1994 and 1993 and 15% and 25% during accident year 1992. Ceding commissions earned of $1,871,000, $1,733,000, and $2,978,000 for fiscal years 1996, 1995 and 1994, respectively, are reported as a reduction in policy acquisition costs on the consolidated statements of income.
In 1994, as a result of changes in estimates of unpaid claim and claim settlement expenses in prior years, the provision for claim and claim settlement expenses (and net of reinsurance recoveries of $9,235,000 in 1994) increased by $98,000 in 1994 because of higher than anticipated losses on workers' compensation cases for that year.
Unsecured notes payable consist of the following at December 31 (000's):
SENIOR NOTES PAYABLE - The Senior Notes payable contain various restrictive provisions which require that certain financial ratios, primarily debt coverage and net worth restrictions, be met before the incurrence of additional indebtedness or the payment of dividends or other distributions to shareholders. At December 31, 1996, the Company was in compliance with these covenants.
1996 1995 1994 --------- -------- -------- Current: Federal $ 5,165 $ 4,787 $ 3,281 State 342 501 177 --------- -------- -------- Total current 5,507 5,288 3,458 Deferred: Federal (650) (949) (1,070) State (117) (113) (10) --------- -------- -------- Total deferred (767) (1,062) (1,080) --------- -------- -------- Income tax expense $ 4,740 $ 4,226 $ 2,378 --------- -------- -------- --------- -------- --------
1996 1995 1994 --------- -------- -------- Federal income tax at statutory rate $ 4,803 $ 3,949 $ 2,301 Increase (reduction) in income taxes resulting from: State income taxes, net of federal income tax benefit 126 310 109 Other (189) (33) (32) --------- -------- -------- Total $ 4,740 $ 4,226 $ 2,378 --------- -------- -------- --------- -------- --------
The effect of temporary differences that gave rise to net deferred tax asset balances, included within other assets at December 31, were as follows (000's):
1996 1995 -------- -------- Unpaid claim and claim settlement expenses $ 2,731 $ 1,859 Unearned premiums 1,001 698 Other 124 95 -------- -------- Deferred tax assets 3,856 2,652
The options granted, exercised, terminated and outstanding under the 1994 Stock Plan as of and for the years ended December 31, 1994, 1995 and 1996 are as follows:
Each of the options expire ten years from the date of grant, subject to continued employment with the Company. Certain of these options are subject to vesting provisions which restrict exercise of the option.
Net income per common and common share equivalent: As reported $ 0.73 $ 0.64 Pro forma $ 0.71 $ 0.63
The pro forma effect on net income for 1996 and 1995 is not representative of the pro forma effect on net income in future years because it does not take into consideration pro forma compensation expense related to grants prior to 1995.
The weighted average fair value of options granted under the ESPP and 1994 Stock Plan during 1996 and 1995 is estimated at $12.36 and $5.29, respectively, on the date of grant using the Black-Scholes option-pricing model with the following assumptions: no dividend yield; volatility of 65.3%; risk-free interest rates ranging from 5.41% to 7.70%; and an expected life of 1 to 5 years.
Balance, December 31, 1994 413,903 0.53 - 2.00 2.00 Exercised (1,403) 0.53 0.53 --------- ------------- -----
Exercisable, December 31, 1996 363,500 $2.00 $2.00 --------- ------------- ----- --------- ------------- -----
Weighted average remaining contractual life for outstanding and exercisable shares 7 years --------- ---------
Each of the non-qualified options expires ten years from the date of grant subject to early termination when the optionee leaves the Company's employment.
EMPLOYEE STOCK OWNERSHIP PLAN - The RTW, Inc. Employee Stock Ownership Plan and Trust (the "ESOP") was adopted by the Board of Directors of the Company during 1993. Any individual who had attained age 21 and was employed on May 1, 1993 became a participant in the ESOP on its effective date, May 1, 1993. All other employees are eligible for participation under the ESOP as of the first day of the calendar quarter following completion of 1,000 hours of service during 12 consecutive months at the Company and attainment of age 21. Company contributions to the plan are discretionary. Contributions may be made in cash or shares of the Company's Common Stock.
In December 1994, the Company made a contribution of 23,490 shares of the Company's Common Stock to the ESOP at an estimated fair value of $6.53 per share. In January 1996, the Company contributed 12,196 shares to the plan for fiscal 1995 at a fair value of $19.33 per share. Compensation expense recognized under the plan for 1996, 1995 and 1994 was $116,000, $236,000 and $153,000, respectively.
The ability of the Company to pay cash dividends to shareholders may be dependent upon the amount of dividends received from its insurance subsidiary, ACIC. ACIC's ability to pay dividends is restricted by law or subject to approval of the insurance regulatory authorities of Minnesota.
Under Minnesota insurance law regulating the payment of dividends by ACIC, dividends must be paid solely from the adjusted earned surplus of ACIC. Adjusted earned surplus is defined as earned surplus, as determined in accordance with statutory accounting practices (unassigned funds), less 25% of the amount of such earned surplus which is attributable to unrealized capital gains. Further, pursuant to Minnesota legal requirements, dividend payments from ACIC to the Company are limited in any year to 10% of statutory capital and surplus at the prior year end. In addition, any dividends paid which, when combined with other dividends paid within the previous 12 month period, exceed the greater of 10% of statutory capital and surplus at the prior year end or 100% of ACIC's statutory net gain from operations (not including realized capital gains) for the preceding year, require the prior consent of the Minnesota Department of Commerce (the "MDC"). For 1997, dividends in excess of $3,954,000 would require prior consent of the MDC.
OPERATING LEASES - The Company conducts its operations in leased office facilities under various operating lease agreements. The agreements provide for monthly base lease payments plus contingent rentals based on an allocable portion of certain operating expenses incurred by the lessor.
Future minimum (base) rental payments required under the leases, as of December 31, 1996, are as follows for the year ending December 31 (000's):
The selected quarterly financial data is included in the Sub-Section entitled "Quarterly Results" contained in the Section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Part II, Item 7 of this Report.