MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ------ RESULTS OF OPERATIONS
The specialty insurance lines of business, particularly the aviation and pleasure marine, are volatile from both a rate and claims perspective. As a result, the Registrant's operating results are subject to significant fluctuations from year to year due to the impact of competition on premium pricing, the frequency and severity of claims activity, weather-related catastrophes, and general economic conditions.
The Registrant has and continues to emphasize rate discipline in all lines of its business. The aviation insurance sector, the Registrant's primary line of business, has been engaged in an extremely competitive rate environment for quite some time. There continues to be some improvement of competitive rates in the aviation insurance sector, especially in the areas of higher-valued aircraft hulls and pilots, who are transitioning to larger or more complex aircraft.
The Registrant's Consolidated Statements of Cash Flows on page 49 detail the net cash provided and used by operating, investment, and financing activities. The Registrant's primary sources of operating funds are insurance premiums, commissions, service fees and investment revenues. Primary uses of operating funds are for claim payments to insureds, commissions, and other operating expenses. Operating activities provided $5.8 million, $11.1 million, and $11.8 million of net cash flow in 1996, 1995, and 1994, respectively. Since the level of operating cash flow is principally affected by premium production, paid loss activity, the sale of investment securities, and reinsurance recoveries received, operating cash flow could vary significantly from period to period.
flow for 1995 decreased from that of 1994 primarily because of increased paid claims activity in 1995 and the effect of reinsurance recoverables received in 1994.
At December 31, 1996, the Registrant had $31.6 million in cash and short-term investments. Additionally, $3.3 million of its fixed income portfolio is scheduled to mature in 1997. A further source of short-term liquidity includes a credit facility with a bank. $7.0 million is available under that commitment to address short-term cash needs. The Registrant's investment portfolio is highly liquid, consisting principally of readily marketable securities. In developing its investment strategy, the Registrant establishes a level of cash and highly liquid short- and intermediate-term securities which, combined with expected cash flow, is believed adequate to meet anticipated payment obligations. While short-term liquidity is considered adequate, long-term liquidity will be primarily dependent upon premium production and paid loss activity.
The Registrant has classified its investments as available for sale. While the Registrant has the ability to hold its investments until maturity, these securities may be sold prior to maturity in response to changing market and economic conditions or to maximize after-tax returns.
The Registrant experienced overall favorable development of $1.1 million on net unpaid loss and loss adjustment expenses after deducting reinsurance protections. This compares with favorable development of $1.1 million for 1995 and $2.9 million for 1994. The gross loss reserve development and net loss reserve development can vary significantly, as the level of reinsurance carried on any one risk is dependent upon several factors.
The Registrant's insurance specialty businesses are mostly short-tail in nature, meaning that claims are paid or settled in a relatively short time frame from the time reported. Nonetheless, the nature of the Registrant's principal insurance specialty line, aviation, consists of low frequency, high severity claims, which can result in significant changes in the development of unpaid losses and loss adjustment expenses from period to period. The timing of salvage and subrogation recoveries could likewise affect the loss reserve development.
The Registrant did not experience any significant environmental claim activity during 1996, 1995 or 1994, and currently anticipates that activity in the future should not have a material adverse effect on the overall consolidated financial position of the Registrant.
Gross premiums written for the aviation line were $69.5 million in 1996 compared to $69.1 million in 1995. Included in 1995 gross premiums written, however, were $4 million of non-recurring premiums associated with the January 1995 acquisition of the aviation business from Aviation Underwriting Specialists. Excluding those non-recurring premiums, gross aviation premiums written increased 7% over 1995 due to a combination of rate improvement and unit growth.
Gross premiums written on the non-aviation insurance lines increased 21% over 1995 to $37.5 million. Particularly noteworthy was the lenders single interest production. This particular insurance product, managed by Matterhorn Bank Programs, Inc., a consolidated subsidiary, protects a lender's retail installment portfolio primarily against risk of physical loss of or damage to property securing its installment loans should the borrower fail to maintain the required insurance. Strong new business growth pushed 1996 lenders single interest gross premiums written 38% to $22.9 million as compared to $16.6 million in 1995.
Pleasure marine gross premiums written increased to $4.4 million in 1996 versus $3.5 million in 1995 through improved new business production by the Registrant's independent agency insurer, U.S. Specialty Insurance Company. The Registrant is continuing to develop this product gradually by stressing conservative underwriting guidelines. In addition, the Registrant continues to retain 100% of the pleasure marine risks it writes, with the exception of reinsurance coverage for catastrophic marine losses.
Net premiums written for all lines of business reflect the business retained by the Registrant after its reinsurance arrangements are considered. Net premiums written increased over 1995 primarily because of the growth in the lenders single interest business. 1996 earned premium revenues of $86.2 million increased over 1995's $80.5 million, consistent with the increase in net premiums written.
Net investment income in 1996 was $8.2 million compared to $8.5 million in 1995. The slight decrease is principally attributed to a lower average invested asset base during 1996. The Registrant sold its common equity securities in 1996.
Realized gains on the sale of investments were $3.2 million in 1996 as compared to $600,000 in 1995. The majority of the 1996 gains arose from the Registrant's decision to sell its common equities.
The Registrant sold a subsidiary, National Assurance Underwriters, Inc., during 1996, while retaining all that subsidiary's insurance business. The sale generated a realized gain of $3.3 million.
From a claims perspective, the net loss ratio for 1996 was 73.0% compared to 69.1% in 1995.
Net aviation incurred losses in 1996 increased over 1995, principally due to increased physical damage claims activity on higher-valued aircraft. In addition, earlier in 1996 there was a higher than usual increase in reported small claims activity. Non-aviation losses in 1996 were $22.4 million compared to $19.0 million in 1995 as an increase in lenders single interest insurance claims commensurate with their new business growth was partially offset by improved loss performance by the short-term health programs.
Income tax expense increased in 1996 to $3.7 million as compared to $1.2 million in 1995, mainly as the result of the increased realized investment gains and the realized gain on the sale of National Assurance Underwriters, Inc. Both of these items were fully taxable.
In October 1995, the Financial Accounting Standards Board issued Statement No. 123, "Accounting for Stock-based Compensation." This Statement establishes an alternative fair value-based method of accounting for all employee stock compensation plans in addition to the intrinsic value-based method. The Registrant has elected to continue to use the intrinsic value method as permitted by the Statement. The Registrant has made the necessary disclosures as required by the Statement in its Notes to Consolidated Statements.
Gross premiums written for aviation during 1995 increased by 22% over 1994. That increase resulted principally from the purchase of the aviation business of Aviation Underwriting Specialists (AUS) during the 1995 first quarter. In addition, there was new business growth. While the rate situation in the aviation insurance sector remained competitive, there was some improvement. Market rates continued to rise during 1995, with more significant increases in the areas of high-valued aircraft hulls and with pilots who are transitioning to larger or more complex aircraft.
Registrant plans to continue to build its participation in certain short-term health programs managed by International Group Services (IGS), which it acquired in December of 1994. The Registrant also expects to begin participating late in 1996 on short-term health programs managed by Hinchcliff International (Hinchcliff), a subsidiary acquired in January 1996. IGS and Hinchcliff are third-party administrators and producers of short-term health insurance programs, primarily covering foreign students who temporarily reside in the United States while attending colleges and universities.
Lenders single interest gross premium writings were $16.6 million for 1995 compared to $16.3 million written in 1994. This business principally covers automobile loans and is thereby closely linked to automobile sales, which had a downturn in 1995. Additionally, Matterhorn emphasizes rate discipline and will not write business at what it believes to be an inadequate rate.
Pleasure marine gross premiums written for 1995 were $3.5 million, similar to that of 1994. The Registrant continues to emphasize movement away from coastal exposures, given the frequency of weather-related events over the last several years. The Registrant continues to retain 100% of the pleasure marine business it writes with the exception of reinsurance for catastrophic marine losses.
There were no significant weather-related losses during 1995 or 1994. Additionally, the Registrant did not incur significant losses associated with the "Blizzard of 1996," which occurred shortly after the end of the year.
Commission expense declined to $6.5 million in 1995 compared to $7.2 million in 1994. This decrease is principally attributable to the decline in premiums related to the short-term health plans.
Higher variable interest rates and a slightly higher level of bank borrowings increased interest expense to $4.2 million in 1995 from $3.7 million in 1994.
Income tax expense decreased to $1.2 million in 1995 from $2.7 million in 1994 as pre-tax earnings were predominantly comprised of non-taxable investment income in relation to income from fully taxable sources, such as underwriting and realized investment gains.
Lenders single interest gross premium writings were $16.3 million for 1994, reflecting a 22% increase over that of 1993. Matterhorn's business principally covers automobile loans and is thereby closely linked to automobile sales, which continued to show upward trends in 1994. Additional growth in Matterhorn's business came from the previous acquisition by Matterhorn of KFA, Inc., in Oklahoma.
Net premiums written increased over 1993 because of continued growth in the lenders single interest and short-term health lines and increased retention on the pleasure marine line. Earned premium revenues of $75.5 million increased over 1993's $62.7 million, consistent with the increase in net premiums written.
Net investment income of $8.2 million was under 1993's $9.0 million, principally due to a decline in average invested assets. During the 1993 second half, $15 million of equity securities were sold; the proceeds from those sales were used to repurchase a block of the Registrant's common stock.
Computer products and services revenues generated by The Wheatley Group, Ltd., a consolidated subsidiary, amounted to $9.2 million contrasted to $11.1 million for 1993. The revenue decline is principally attributable to a decrease in hardware equipment sales. Software revenues and services increased from $6.1 million in 1993 to $7.8 million in 1994. Wheatley contributed $1.7 million and $1.4 million to pre-tax operating earnings for 1994 and 1993, respectively.
Commission expense increased to $7.2 million in 1994, as compared to $5.7 million in 1993. This increase is primarily attributable to the increase in assumed reinsurance business, particularly the short-term health programs.
Higher variable interest rates, coupled with a larger average outstanding debt balance on the Registrant's credit facility, increased interest expense to $3.7 million in 1994 from $2.3 million in 1993. Selling, general, and administrative expenses increased a modest 3% reflecting the Registrant's continuing efforts to attain efficient operating cost structures throughout its various business units. The Registrant also incurred approximately $600,000 in non-recurring advisory expenses related to a share repurchase transaction with GEICO in 1993.
The consolidated financial statements and notes to the consolidated financial statements of the Registrant and subsidiaries on pages 45 through 64, and the Independent Auditors' Report on page 65 are incorporated herein.