If the Potential Frontier Deal is consummated under the terms currently contemplated, all of Alpine's assets, including the two office buildings, would be transferred to Frontier. The Company would continue to manage the office buildings, however, pursuant to a contract with Frontier. Further, it is likely that the Company would enter into a lease with Frontier with respect to the two office buildings. The terms of any such lease have not yet been determined. Additionally, under the terms of the Potential Frontier Deal as currently contemplated, the Company would have the right to repurchase one or both of the buildings at their most recently determined book values. (See "Business -- Proposed Future Operations and Organizational Changes; Relationship with Frontier" -- Item 1.)
The selected consolidated financial data presented below under the captions "Operating data" and "Balance sheet data" for the years ended December 31, 1997, 1996, 1995, 1994 and 1993 have been derived from the audited consolidated financial statements of the Company and its subsidiaries. The statutory operating data are based on statutory accounting practices and were derived from statutory financial data of the Syndicate and Alpine. The statutory operating data for the year ended December 31, 1996, differ from data which would be derived from the 1996 annual statement of Alpine filed with state insurance regulatory officials in that the operating results of the Syndicate were not combined with those of Alpine in its 1996 annual statement, even though the Syndicate's operations were combined with those of Alpine effective December 31, 1996. These data should be read in conjunction with the consolidated financial statements, related notes and other financial information included elsewhere in this 1997 Form 10-K.
- ---------------------------- (1) Shares used in the calculation for 1997 were 5,096,000 shares outstanding; for 1996, 1995 and 1994, 5,498,000 shares outstanding; for 1993, 5,490,000 shares outstanding. (2) Information is shown as of the end of each year presented. (3) In addition to usual differences between statutory accounting practices and GAAP, until December 31, 1996 a significant portion of profit sharing expense was allocated as a reduction to investment income for statutory accounting practices. (4) Policyholders' surplus is reflected as of the end of each year presented on a consolidated basis after the elimination of the Syndicate's prior investment in Alpine. If the Syndicate's investments had not been subject to certain concentration limits under the IIE regulations, policyholders' surplus on a consolidated basis as of December 31, 1995 would have been $6,038,000.
The Company's operations and business underwent fundamental changes during 1997 and 1996, and additional changes are anticipated in 1998. (See "Business - -- Overview of Current Business Operations," and "Business -- Proposed Future Operations and Organizational Changes; Relationship with Frontier" --Item 1.) Because of these changes, differences in the Company's results of operations between 1997 and 1996, and between 1996 and 1995, are not necessarily indicative of trends or likely results of operations for 1998 or future years. The Company's 1997 Form 10-K contains certain "forward-looking statements" (within the meaning of the Private Securities Litigation Reform Act of 1995) that involve substantial risks and uncertainties. When used in this 1997 Form 10-K, the words "anticipate," "believe," "estimate" and "expect" and similar expressions as they relate to the Company and its management are intended to identify such forward-looking statements. A number of important factors could cause the actual results, performance or achievements of the Company for 1998 and beyond to differ materially from those expressed in such forward-looking statements. These factors include, without limitation, the potential sale of Alpine and other transactions relating thereto, the discontinuation or a material adverse change in the terms and conditions of the Quota Share Arrangement or the potential replacement reinsurance agreement with the Cayman Company, a material increase in competition, material changes to the Frontier Companies' financial conditions or regulatory authorities and material adverse changes in the Illinois DOI's oversight of Alpine. In light of the Company's current financial and insurance regulatory circumstances, relatively small changes from the expected results, performance and achievements of the Company could materially adversely impact the Company's financial condition and prospects as anticipated in this 1997 Form 10-K.
In terms of financial resources, Alpine's activities are the most significant of the Company's current operations. Most of the Company's cash flow to fund operations derives from Alpine's existing assets, investment income on such assets and premium assumed pursuant to the Quota Share Arrangement. Alpine, however, is relatively close to several regulatory thresholds that, if crossed, could reduce Alpine's role in the Company's operations. Alpine's statutory policyholders' surplus of $5.3 million at December 31, 1997, was $300,000 above the minimum statutory policyholders' surplus required of an Illinois reinsurer, $2.1 million above the mandatory control level risk-based capital for Alpine and $3.8 million above the minimum statutory policyholders' surplus required of an Illinois insurer that writes the lines of insurance reinsured by Alpine. Additionally, Alpine's liquid assets at December 31, 1997, may have been insufficient (depending on interpretation of the relevant statutory provision), if the provision had been applicable on such date, to satisfy a statutory "reserve requirement" adopted by Illinois in
1997 to be applicable in 1998, and in any event a significant amount of Alpine's assets are restricted for specific purposes. (See " Business -- Regulation" -- Item 1.)
The Company currently expects risk-bearing activities will continue to be a significant part of its operations in 1998 and later years. First, the Company is negotiating a potential sale of Alpine to Frontier, and if the negotiations are successful, expects to continue the Company's risk-bearing activities through formation of a Cayman Islands insurance company that would assume premium from the Frontier Companies pursuant to an arrangement similar to the Quota Share Arrangement. This would provide the Company continuing investment income and premium revenue, as well as cash flow, in an insurance regulatory environment relatively more flexible than the environment in which Alpine operates. The sale of Alpine also would generate additional cash for the Company beyond the cash that would be required to be contributed to the Cayman Islands insurance company. (See " Business -- Proposed Future Operations and Organizational Changes; Relationship with Frontier" -- Item 1)
Notwithstanding the foregoing, Alpine's continued operations depend on continuation of the Quota Share Arrangement, or a replacement arrangement similarly or more beneficial to Alpine, and Alpine's continuing satisfaction of applicable regulatory requirements. The Company currently believes, based on the generally positive relationship the Company has with Frontier and the profitability of the business the Company has produced and in the future has the potential to produce for Frontier, that the Quota Share Arrangement will continue generally on its current terms for the foreseeable future, even if Alpine is not sold to Frontier.
Alpine's continuing satisfaction of applicable regulatory requirements is more difficult to predict. As described above, Alpine currently is relatively close to certain regulatory thresholds that, if crossed, could lead to a required reduction or cessation of Alpine's activities. This could
Should these efforts prove insufficient, the Company would have to seek alternative solutions. Among those would be a capital contribution from, joint venture with, or sale of assets to, Frontier or another insurance operation. The Company has made no specific plans to achieve any of these solutions, though the Company has been approached from time to time by insurance operations seeking to establish relationships with the Company, and believes it could take advantage of one of these prior approaches or a similar opportunity relatively quickly. The Company believes, though there can be no assurances, that Frontier and potentially other insurance operations would favor such a capital contribution, joint venture, sale or similar arrangement because of the Company's historically profitable underwriting results and its potential ability to generate similar results in the future.
The Company's future financial condition and prospects are heavily dependent on the Company's maintaining or improving its relationships with Frontier. WESTCAP generates commission revenues from producing insurance business on behalf of the Frontier Companies; Claims Control generates a small but increasing amount of the revenue from handling claims on behalf of the Frontier Companies; and Alpine generates underwriting revenue, if the underwriting results are profitable, and investment income from assuming premiums pursuant to the Quota Share Arrangement. These relationships also generate most of the Company's cash flows from operations.
The Company's net income historically derived from the difference between these net revenues and net expenses, after adjustment for taxes and minority interests. In addition, due to the Company's adoption of a form of equity accounting in 1995 (applied retroactively), the Company's net income also has included its equity in gains and losses of its affiliates. (See "Business -- Relationship with TCO" -- Item 1 and Note 11 of Notes to Consolidated Financial Statements.)
The Company, because of Best rating downgrades, regulatory restrictions and other matters affecting its insurance company subsidiaries (see "Business - -- Overview of Current Business Operations" -- Item 1), ceased issuing direct insurance in August 1996. This directly resulted in a sharp decline in the Company's earned premium revenue during the second half of 1996, and the first half of 1997. The Company, however, began earning premium revenue through the Quota Share Arrangement effective April 1, 1997. The portion assumed by the Company initially was 30% of the net premium accruing to UCIC on such business, including premiums unearned as of April 1, 1997 (approximately $13.6 million) and premiums on policies issued after such date. Effective October 1, 1997, the Quota Share Arrangement was amended generally and among other things to increase the quota share portion of net premium assumed by Alpine to 50% on policies underwritten by WESTCAP and certain policies underwritten by Trinity on or after October 1, 1997. The Company also earned investment income on the funds held by the Frontier Companies under the Quota Share Arrangement. Because most of the premium funds are being held by the Frontier Companies, however, the Quota Share Arrangement does not benefit the Company's cash flow to the same extent it benefits the Company's net income
(assuming the Quota Share Arrangement underwriting results are as profitable as or more profitable than the Company's underwriting results historically were).
Management has determined that, in view of the obstacles faced by the Company, it is unlikely that the Company will be able to write profitable direct business in the foreseeable future. As a result, management has decided to shift the Company's business focus from risk-bearing operations (i.e. the issuance of insurance policies) to the production and underwriting of insurance coverage to be issued by other insurers (principally the Frontier Companies), from which activities the Company will derive increased commission revenues. Through its role as a reinsurer under the Quota Share Arrangement, or a similar reinsurance arrangement with the Cayman Company if the sale of Alpine to Frontier is consummated, however, the Company expects to continue to derive significant portions of its revenues, including underwriting profits and investment income, from risk-bearing operations.
Because of the numerous uncertainties facing the Company and the Company's likelihood of experiencing substantial further changes in its operations and business during 1998 (see "Overview of Current Business Operations" and "Proposed Future Operations and Organizational Changes; Relationship with Frontier" -- Item 1), management has made no effort to anticipate the Company's results in the following discussion beyond the end of 1998.
Gross written premiums were $12.9 million for 1997, a decrease of 10.1% from $14.4 million in 1996. The Company ceased writing direct insurance in August 1996. Of the gross written premiums for 1997, 89.1% were premiums assumed by Alpine as a reinsurer of the Frontier Companies pursuant to the Quota Share Arrangement which became effective April 1, 1997, and the balance representing audit and other premiums relating to run off of the direct insurance written by the Company through August 1996.
Management expects gross written premiums to increase in 1998 because (i) the portion
of net insurance premium assumed by Alpine in connection with the Quota Share Arrangement, which increased from 30% to 50% effective October 1, 1997, or any similar replacement reinsurance arrangement with the Cayman Company, is expected to be 50% for all of 1998 and (ii) the Company anticipates hiring additional underwriting staff, making acquisitions and obtaining authority from Frontier to produce certain program business, all of which should enable the Company to expand into additional lines of business and generate additional premiums during 1998. The Company anticipates this increase to be offset to some extent by reduced business in the Company's traditional lines of business as a consequence of increased competition.
Net loss and loss adjustment expense incurred during 1997 totaled $7.7 million, down 39.1% from $12.7 million in 1996. Net loss and loss adjustment expenses as a portion of net premiums earned was 115.0% in 1997 compared to 60.4% in 1996. The decrease in net loss and loss adjustment expense incurred between the periods resulted principally from the decrease in net premiums earned. The increase in net loss and loss adjustment expense as a portion of net premiums earned was the result of reserve strengthening in the amount of $4.4 million for 1994 and prior underwriting years. Management expects the Company's loss ratio on insurance assumed by Alpine pursuant to the Quota Share Arrangement or any similar replacement reinsurance arrangement will be substantially lower than the Company's historical loss ratios as a consequence of higher pricing in 1996 and 1997 and more restrictive policy forms used in underwriting the insurance assumed from the Frontier Companies, though continuing competition in 1998 is expected to result in gradually reduced pricing on the business assumed by the Company from the Frontier Companies.
Other underwriting expenses historically have consisted of (i) policy acquisition costs, which equaled a fixed percentage of gross written premiums less reinsurance commissions, plus (ii) the allocated portion of profit sharing payments to TCO. Following termination of the management agreements between the Company's insurance company subsidiaries and TCO in 1996, the fees and commissions that otherwise would have been paid by the Company to TCO were eliminated.
The Company's other underwriting expenses for 1997 were a negative $100,000, compared to $6.4 million in 1996. The decrease in other underwriting expenses between periods was principally attributable to (i) the Company's earning in 1997 additional commission income under certain reinsurance agreements because of loss development on the direct business written by the Company, (ii) the decrease in net premiums and (iii) reduced net expenses resulting from termination of the management agreements with TCO. Absent the additional reinsurance commission income, the ratio of the Company's other underwriting expenses to net premiums earned would have been 31.3% in 1997 compared to 30.5% in 1996. Management anticipates the ratio of other underwriting expenses to premiums earned for 1998 will be about the same as or somewhat in excess of the 1997 ratio, because of the approximately 33-34% aggregate commissions payable by the Company in connection with the Quota Share Arrangement or any similar replacement reinsurance arrangement.
Interest expense in 1997 was $200,000, unchanged from 1996. Interest expense in 1998 is expected to continue at approximately the same or at a slightly reduced level. The level could be significantly reduced in 1998 after the sale of Alpine is consummated, if at all, as most of the Company's indebtedness would be transferred as part of the sale. (Continued payments on such indebtedness, however, would ultimately reduce the purchase price paid by Frontier for Alpine.)
Other expenses, consisting of professional fees, personnel costs and other costs, were $6.1 million in 1997, compared to $7.3 million in 1996. The decrease was principally due to a 56% reduction in legal and professional expenses, partially offset by an increase in personnel and general administrative costs resulting from Alpine's assuming a portion of those costs previously
Net (loss) income per share -- basic and diluted was a loss of $0.32 for 1997, compared to income of $0.27 for 1996. The decrease was principally the result of (i) the $4.4 million loss and loss adjustment expense reserve strengthening (ii) the $1.5 million reduction in equity in income of affiliates and (iii) the $4.4 million increase in the valuation allowance against the deferred tax asset, offset to a large degree by (iv) the $3.4 million tax benefit from the settlement of the JBW & Co. loan and (v) the $3.5 million of other income generated principally by the settlement of the lawsuit against the Company's former independent auditors compared to the impact of the same items for 1996.
Gross written premiums were $14.4 million for 1996, a decrease of 77.6% from $64.3 million in 1995. This decrease was due to the Best ratings downgrades of the Company's insurance company subsidiaries in January and April 1996, and the losses of their authorizations to conduct surplus lines business in key states, including California, beginning early in the year. (See "Business -- Overview of Current Business Operations" "Business -- Regulation" - -- Item 1). These developments progressively constricted the Company's ability to write direct insurance policies during the first half of 1996, and led the Company to cease writing direct insurance policies in August 1996.
Net investment income for 1996 was $4.0 million, a decrease of $900,000, or 18.0%, from $4.9 million in 1995. The decrease between the periods was caused principally by a 15.8% decrease in average investable assets from $90.8 million in 1995 to $76.4 million in 1996 and a decline in the average yield on investable assets to 5.3% in 1996 from 5.4% in 1995.
Net realized investment (losses) gains for 1996 were a loss of $400,000 versus a gain of $400,000 in 1995. The net loss in 1996 was the result of losses on the sale of an equity security and certain real estate investments, as well as net increases in real estate valuation reserves. The Company realized net investment gains of over $700,000 in 1995 on its fixed maturities portfolio
as it benefited from declining interest rates while liquidating certain assets.
Income tax benefit was $1.7 million in 1996 compared to an expense of $5.1 million in 1995, principally because of the Company's substantially higher 1995 taxable net income resulting from the $14.9 million reduction in loss reserves in 1995. The Company had a net pre-tax loss (before minority interest and equity in gains of affiliates) of $1.8 million in 1996 compared to $5.8 million of pre-tax net income (before minority interest and equity in gains of affiliates) in 1995. The difference also resulted from application of a $6.6 million valuation reserve against the Company's deferred tax asset in 1995, compared to a $1.3 million reduction in the reserve in 1996.
Net income per common share was $0.27 in 1996 compared to $0.86 in 1995. This reflects, overall, the decline in the Company's revenues following the Best rating downgrades and the regulatory restrictions affecting the Company's insurance company subsidiaries beginning in early 1996, compared to the substantial revenues realized from ongoing operations and the income resulting from the $14.9 million reduction in loss reserves in 1995. The impact of these
items would have been greater if it had not been offset by an overall swing of $7.7 million in deferred tax expense.
At December 31, 1997, cash and investments totaled $41.7 million, compared to $64.5 million at December 31, 1996. At December 31, 1997, the Company had $24.0 million in cash and investments pledged as collateral for letters of credit related to reinsurance, held in trust for the benefit of the Frontier Companies, on deposit with the various states in which it has done business, on deposit in the IIE Guaranty Fund, Inc. and held in trust for the benefit of the Syndicate's policyholders and otherwise to satisfy the Syndicate's obligations. This $24.0 million amount represented 57.6% of the Company's total cash and investments at December 31, 1997. Funds held in trust for the benefit of the Syndicate's policyholders may be used by the Company to satisfy claims of the policyholders and other obligations of the Syndicate.
Because substantial portions of Alpine's assets are restricted for specific purposes, they may not be available to satisfy other obligations of Alpine. This greatly reduces Alpine's liquidity and, in the event cash is required to meet current liabilities beyond those currently projected by management (e.g., as a consequence of increased or more rapid payouts of losses or expenses), could lead to significant losses. (See "Business -- Overview of Current Business Operations" -- Item 1 and " -- Results of Operations.")
The total debt obligation of the Company as of December 31, 1997 was $1.1 million. Of this amount, $100,000 is due during 1998. This debt obligation will be transferred to Frontier if the sale of Alpine is consummated in accordance with the Potential Frontier Deal as currently contemplated, but the payments likely will remain indirectly as obligations of the Company.
Management anticipates that during 1998 the need to continue to liquidate investments as the Company's principal source of cash to fund its operations will be significantly diminished as a consequence of anticipated reduced net loss and loss adjustment expenses. Management believes that cash from (i) the release of funds held by the Frontier Companies, (ii) liquidation of real estate mortgages and real estate owned investments, (iii) reinsurance recoveries, (iv) investment income, (v) net premium collections and deductible and subrogation recoveries and (vi) reductions
of Alpine with UCIC in accordance with the Potential Frontier Deal as currently contemplated also are expected to eliminate or reduce Alpine's risk-based capital obligations and concerns.