Recent Industry Performance The property and casualty insurance and reinsurance industry has historically been highly cyclical. Demand for reinsurance is influenced significantly by prevailing market conditions, including the underwriting results of primary insurers. The supply of reinsurance is primarily related to levels of underwriting capacity in the reinsurance industry and the relative cost and terms of reinsurance coverage. The industry's profitability and the cyclical trends in the industry can be affected significantly by volatile and unpredictable developments, including the occurrence of natural disasters, other catastrophic events, competitive pressures on pricing (premium rates), fluctuations in interest rates, other variations in the investment environment, changes in the judicial system regarding tort law, general economic conditions and trends, such as inflationary pressures, that may tend to affect the size of profits and losses experienced by ceding primary insurers and other factors such as changes in tax laws and regulations. Many sectors of the industry are currently in a cyclical downturn and it cannot be predicted if or when market conditions will improve or when other sectors may experience a deterioration in pricing and terms. Commencing in the later part of the 1980s, primary property and casualty insurers began to retain more of their business. This reduction in the amount of business ceded to reinsurers, combined with the growth in reinsurance capacity, resulted in renewed price competition and less attractive pricing for reinsurers. This caused a downturn for the reinsurance industry, resulting in increased underwriting losses which have continued to the present. The following table presents the statutory combined ratios of Chartwell and the property and casualty reinsurance industry during the 1994 to 1998 years. The combined ratio is the sum of the loss ratio (incurred losses and loss adjustment expenses divided by net premiums earned) and the underwriting expense ratio (underwriting expenses divided by net premiums written). A combined ratio of over 100% indicates unprofitable underwriting. Although an insurance company's underwriting may be unprofitable, the company may be profitable after including investment income. Statutory Combined Ratios Year Ended December 31, -----------------------------------------------------------------------
Policy Acquisition Costs. Policy acquisition costs, consisting primarily of commissions paid to ceding companies and agents and brokerage fees paid to intermediaries, less commissions received on business ceded to other reinsurers, were $61.6 million for the year ended December 31, 1998, compared to $72.7 million for the same period in 1997. Policy acquisition costs expressed as a percentage of net earned premiums (the acquisition expense ratio) decreased to 26.8% from 29.6% in 1997. The decrease is primarily due to the effect of the 1998 aggregate excess of loss reinsurance treaty.
Net Underwriting Results. The Company produced an underwriting profit (net premiums earned minus losses, LAE and underwriting expenses) of $8.7 million for the year ended December 31, 1998 as compared to an underwriting loss of $4.3 million for the same period in 1997. The combined ratio computed in accordance with GAAP for the year ended December 31, 1998 decreased to 96.2% from 101.9% for 1997. Although the loss ratio component improved to 58.9% for the year ended December 31, 1998 from 65.5% recorded for the same period in 1997, the expense ratio increased to 37.3% for the year ended December 31, 1998 from 36.4% recorded for the same period in 1997, for the reasons noted above.
Corporate Interest and Amortization. Interest and amortization expenses were $13.5 million for the year ended December 31, 1998 compared to $12.3 million for the same period in 1997. Interest and amortization on the Re Holdings' 10.25% Senior Notes due 2004 (the "Senior Notes") was $5.2 million for the years ended December 31, 1998 and 1997. Interest and amortization on the Company's CI Notes was $2.6 million and $2.5 million for the years ended December 31, 1998 and 1997, respectively. Also included in interest and amortization expense for the years ended December 31, 1998 and 1997 is $4.3 million and $3.4 million, respectively, related to a credit facility with First Union National Bank, N. A. ("First Union") established to fund the acquisition of CMA and replace an existing $20 million credit facility.
Corporate Interest and Amortization. Interest and amortization expenses were $12.3 million for the year ended December 31, 1997 compared to $10.1 million for the same period in 1996. Interest and amortization on the Senior Notes was $5.2 million for the year ended December 31, 1997 and $6.0 million for the comparable period in 1996. Interest and amortization on the Company's CI Notes was $2.5 million and $2.2 million for the years ended December 31, 1997 and 1996, respectively. Also included in interest and amortization expense for the year ended December 31, 1997 is $3.4 million related to a credit facility with First Union established to fund the acquisition of CMA and replace an existing $20 million credit facility.
Income Before Income Taxes and Extraordinary Item. Net income before income taxes and extraordinary items increased to $37.9 million for the year ended December 31, 1997 compared to $32.5 million for the same period in 1996. The increase resulted primarily from the increase in earned premiums, the favorable results in both loss and loss adjustment expense and other expenses, and the contributions from CMA to income from service operations.
Net Income Before Extraordinary Item. Net income before extraordinary item increased to $27.3 million for the year ended December 31, 1997 as compared to $22.9 million for the same period in 1996, and basic earnings per share before extraordinary item increased 12.7% to $2.84 from $2.52 for the year ended December 31, 1996. Diluted earnings per share before extraordinary item increased 10.0% to $2.74 from $2.49.
Also in connection with the acquisition of CMA, Re Holdings entered into a new credit facility with First Union, as agent (the "Credit Facility"). The Credit Facility provides for (i) a Tranche A-1 $20.0 million loan, (ii) a Tranche A-2 $10.0 million loan, (iii) a Tranche B $22.0 million loan (denominated in Pounds Sterling) (Tranche A-1, Tranche A-2 and Tranche B collectively, the "First Union Loans"), and (iv) a $25.0 million revolving credit facility (subsequently increased to $60.0 million) (the "First Union Revolver"). The First Union Loans have six-year terms and the First Union Revolver has a five-year term but may be extended with the consent of the lenders. Tranche A-1 and A-2 require repayment of principal starting in year 3, $6.0 million; year 4, $7.5 million; year 5, $7.5 million and year 6, $9.0 million. Tranche B requires repayment of principal starting in year 3, $4.2 million; year 4, $5.3 million; year 5, $5.3 million and year 6, $6.4 million. Borrowings under the First Union Revolver are available at any time prior to maturity, subject to minimum funding amounts. Both the First Union Loans and the First Union Revolver will bear interest at a rate selected by Re Holdings equal to either (1) the Base Rate (as defined below) or (2) U.S. dollar or Sterling LIBOR plus a margin (the "Margin"), as applicable. The amount of the Margin will depend on the higher of Re Holdings' senior debt rating by Standard & Poor's or Moody's and can range from 0.75% to 1.125%. Based on Re Holdings' current senior debt ratings, the Margin over LIBOR is currently at 1.00%. The U.S. dollar Base Rate is the higher of (1) First Union's prime commercial lending rate or (2) the federal funds rate plus 0.5%. The Sterling Base Rate is the rate per annum announced by Midland Bank plc plus the Margin. Re Holdings will also pay (1) an unused commitment fee equal to 0.25% on the aggregate unused portion of the revolver, (2) utilization fees for the issuance of letters of credit and guarantees of Loan Notes, issued in connection with the acquisition of CMA, at a rate per annum of 0.375% (if secured) or the Margin (if unsecured) plus a 0.075% facing fee, currently totaling 1.075% (if unsecured) on the outstanding amount of potential credit exposure, and (3) certain other fees customary in connection with syndicated loans of this nature. All payments of interest and fees with respect to each of the First Union Loans shall be made in the same currency in which the principal of such loan is required. At December 31, 1998, $20.0 million, $10.0 million and $15.9 million were outstanding under the Tranche A-1, Tranche A-2 and Tranche B loans, respectively. During 1998, the Tranche B loan increased by $1.8 million to fund the redemption of Loan Notes for the same amount, resulting in a balance of $5.5 million used to guarantee the Loan Notes. A $5.0 million line of credit and a total of $53.6 million in letters of credit were extended under the First Union Revolver. All amounts denominated in Pounds Sterling were converted to U.S. dollars at the rate of (pound)1=$1.66, the exchange rate in effect at December 31, 1998. On June 30, 1998, the Company entered into an interest rate swap agreement (the "Swap") for other than trading purposes with First Union to convert a specific portion of the floating rate loans outstanding under the Credit Facility to a fixed rate. The Swap requires the Company to pay First Union interest on a notional amount equivalent to the principal outstanding ((pound)10,280,000 at December 31, 1998) at a fixed annual rate throughout the term of the related debt obligation of 6.85% and for First Union to pay the Company interest equal to the three month LIBOR interest rate determined at the commencement of each calendar quarter. The Swap terminates on December 31, 2002. The weighted average LIBOR rate payable by First Union in 1998 under the Swap was 7.62%. The notional amount set forth in the Swap does not represent an amount exchanged by the Company and First Union, and thus is not a measure of exposure of the Company. Since First Union is not required to collateralize its obligations under the Swap, the Company is exposed to loss if First Union were to default on its obligations under the Swap. The Company does not believe that any reasonably likely change in interest rates would cause the Swap to have a material adverse effect on the financial position, the results of operations or cash flows of the Company. The Swap was reviewed with and approved by the Company's Board of Directors. Upon consummation of the Piedmont Merger, Chartwell became the successor to Piedmont under the CI Notes. The CI Notes were issued in an aggregate principal amount of $1 million, which principal amount will accrue interest at a rate of 8% per annum, compounded annually. Such interest will not be payable until maturity or earlier redemption of the CI Notes. In addition, the CI Notes will entitle the holders thereof to receive at maturity, in proportion to the principal amount of the CI Notes held by them, an aggregate of from $10 million up to $55 million in contingent interest. Settlement of the CI Notes may be made by payment of cash or, under certain specified conditions, by delivery of shares of the Company's common stock. The CI Notes mature on June 30, 2006. Chartwell and its subsidiaries may incur additional indebtedness in the future, subject to the limitations contained in the Senior Notes indenture, the agreements governing the Credit Facility and the CI Notes indenture.
The agreements governing the Senior Notes, the CI Notes and the Credit Facility significantly restrict the ability of Re Holdings to make dividend and other payments to Chartwell. Further, dividend payments by Chartwell Reinsurance and INSCORP are subject to limits under the laws of the States of Minnesota and New York, respectively. Under the applicable provisions of the insurance holding company laws of the State of Minnesota, Chartwell Reinsurance may, upon five days notice to the Commissioner of Insurance of the State of Minnesota ("the Commissioner") following the declaration of dividends to stockholders, and upon at least ten days notice to the Commissioner prior to dividend payments, pay dividends without the approval of the Commissioner, unless such dividends, together with other dividends paid within the preceding twelve months, exceed the greater of (i) 10% of Chartwell Reinsurance's policyholders' surplus as of the end of the prior calendar year or (ii) Chartwell Reinsurance's statutory net income, excluding realized capital gains, for the prior calendar year. Any dividend in excess of the amount determined pursuant to the foregoing formula would be characterized as an "extraordinary dividend" requiring the prior approval of the Commissioner. In any case, the maximum amount of dividends Chartwell Reinsurance may pay is limited to its earned surplus, also known as unassigned funds. As of December 31, 1998, Chartwell Reinsurance reported unassigned funds, as defined, in the amount of $103.8 million. Up to $30.3 million is available under the foregoing formula for the payment of dividends by Chartwell Reinsurance without regulatory approval in 1999. On November 25, 1997, Chartwell Reinsurance paid a $3.0 million dividend to Re Holdings and on February 24, 1999, Chartwell Reinsurance paid a $5.5 million dividend to Re Holdings. Chartwell Reinsurance paid no dividends in 1996 or 1998. Under New York law, which is applicable to INSCORP, the maximum ordinary dividend payable in any twelve month period without the approval of the Superintendent may not exceed the lesser of (a) 10% of policyholders surplus as shown on the company's last annual statement or any more recent quarterly statement or (b) the company's adjusted net investment income. Adjusted net investment income is defined as net investment income for the twelve months preceding the declaration of the dividend plus the excess, if any, of net investment income over dividends declared or distributed during the period commencing thirty-six months prior to the declaration or distribution of the current dividend and ending twelve months prior thereto. In any case, New York law permits the payment of an ordinary dividend by an insurer or reinsurer only out of earned surplus. Moreover, notwithstanding the receipt of any dividend from INSCORP, Chartwell Reinsurance may make dividend payments to Re Holdings only to the extent permitted under the Minnesota provisions described above. In addition to the foregoing limitation, the New York Insurance Department, as is its practice in any change of control situation, required Chartwell to commit to preclude the acquired New York-domiciled insurer, INSCORP, from paying any dividends for two years after the Piedmont Merger without prior regulatory approval. The foregoing restriction expired on December 13, 1997. INSCORP paid no dividends in 1997 or 1998. The maximum dividend permitted by law is not indicative of an insurer's actual ability to pay dividends, which may be constrained by business and regulatory considerations, such as the impact of dividends on surplus, which could affect an insurer's ratings or competitive position, the amount of premiums that can be written and the ability to pay future dividends. Furthermore, beyond the limits described in the preceding paragraph, the Commissioner and Superintendent have discretion to limit the payment of dividends by insurance companies domiciled in Minnesota and New York, respectively. Management believes that current levels of cash flow from operations and assets held at the holding company level provide the Company with sufficient liquidity to meet its operating needs in the short term (over the next 12 months). Management expects Chartwell to be able to continue to meet its operating needs after the next 12 months from internally generated funds. Since the ability of Chartwell to meet its obligations in the long term (beyond such 12-month period) is dependent upon such factors as market changes, insurance regulatory changes and economic conditions, no assurance can be given that the available net cash flow will be sufficient to meet its operating needs. The Company expects that, in order to repay the principal amount of the Senior Notes on maturity or otherwise, it will be required to seek additional financing or engage in asset sales or similar transactions, and would be required to take similar actions in order to repay the CI Notes on maturity or otherwise, in the event it chose or was required to settle the CI Notes in cash rather than common stock. There can be no assurance that sufficient funds for any of the foregoing purposes would be available to the Company at such time.
Equity Price Risk: The carrying values of investments subject to equity price risks are based on quoted market prices or management's estimates of fair value as of the balance sheet date. Market prices are subject to fluctuation and, consequently, the amount realized in the subsequent sale of an investment may significantly differ from the reported market value. Fluctuation in the market price of a security may result from perceived changes in the underlying economic characteristics of the investee, the relative price of alternative investments and general market conditions. Furthermore, amounts realized in the sale of a particular security may be affected by the relative quantity of the security being sold. Chartwell's common equity portfolio of $36.4 million primarily consists of long term strategic minority positions in illiquid equity securities of managing general agents of Controlled Source Insurance. A 10% immediate decrease in the market prices of all equity securities held by Chartwell at December 31, 1998, would result in an approximate 1.2% decrease in Chartwell's stockholders' equity.
The above analyses do not take into account any correlation among foreign currency exchange rates, or any correlation among various markets (i.e., the fixed income markets and foreign exchange and equity markets). Chartwell's actual experience may differ from the results noted above due to the correlation assumptions utilized, or if events occur that were not included in the methodology, such as significant liquidity or market events. The selection of the amount of increases or decreases in currency exchange rates, interest rates and equity values in the above analyses should not be construed as a prediction of future market events, but rather, to illustrate the potential impact of such an event.
Year 2000 Compliance The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. The Company's computer equipment, software and devices with imbedded technology that are time sensitive may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions or engage in other normal business activities. The consequences to the Company of such failures could include business interruption, lost revenue or illiquidity. The magnitude of the financial impact of such potential failures on the Company is not known at this time. The Company believes that it has identified all significant computer hardware and software applications and devices with imbedded time sensitive technology that are employed by the Company in its operations that will require modification to ensure Year 2000 Compliance. The Company is using both internal and external resources to test all significant computer systems and applications and to make the modifications necessary for Year 2000 Compliance. The testing and modification process, which is proceeding on schedule, is 95% complete and is expected to be fully completed by June 30, 1999. The testing and modification process has not materially interfered with the Company's Information Technology operations or the operations of the Company . In addition, the Company has contacted all of its significant business partners and service vendors to determine their Year 2000 Compliance readiness, as well as the extent to which the Company is vulnerable to any third party Year 2000 issues. However, there can be no guarantee that the systems of other companies on which the Company's systems rely will become Year 2000 compliant in a timely manner, or that the failure by a third party to become Year 2000 compliant would not have a material adverse effect on the Company. The Company is revising its existing disaster recovery contingency plans to address issues specific to the Year 2000 problem. These revisions are expected to be completed by June 30, 1999. Such plans are intended to enable the Company to continue to operate by performing certain processes manually, changing vendors and repairing or replacing existing systems, where feasible. The total cost to the Company to test and modify all systems to be Year 2000 compliant has not been, and is not expected to be, material to its financial position or results of operations in any given year. To date, the Company has budgeted $50,000 to accomplish its Year 2000 testing and remediation goals and approximately 50% of the amount budgeted has been expended. Expenditures to fund Year 2000 testing and modification have to date and will continue to be funded from operating cash flows. The anticipated completion dates for Year 2000 compliance and the Company's contingency plans and the cost estimates for the completion of the Company's Year 2000 compliance program are based on management's best estimates utilizing current data regarding available resources, coordination with third parties and other relevant factors and information about systems conversion. However, there can be no assurance that these estimates will be achieved, and actual results could differ from the current plan. In addition, the Company may also have material exposure in its property and casualty operations to claims related to the Year 2000 issue. It is not yet possible to determine whether such claims might be made against insurance or reinsurance contracts in which the Company participates or if such claims will be held to have merit. Readers are cautioned that forward-looking statements contained in this description of the Company's treatment of the Year 2000 issue should be read in conjunction with the Company's disclosures under the heading "Cautionary Note Regarding Forward-Looking Statements" below.
Disclosures About Segments of an Enterprise and Related Information Footnotes - SFAS No. 131 In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information Footnotes," which became effective for the Company beginning January 1, 1998. SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. The adoption of SFAS No. 131 had no impact on the Company's financial position or results of operations. Prior year segment information has been reclassified to conform to the SFAS No. 131 requirements.
Reporting Comprehensive Income - SFAS No. 130 In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income," which became effective for the Company beginning January 1, 1998. SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains and losses) in a full set of general-purpose financial statements. This Statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. It does not require a specific format for that financial statement but requires that an enterprise display an amount representing total comprehensive income for the period in that financial statement. The adoption of SFAS No. 130 had no impact on the Company's financial position or results of operations. Prior year financial statements have been reclassified to conform to the SFAS No. 130 requirements.
Regulatory Accounting Practices In March 1998, the National Association of Insurance Commissioners adopted the Codification of Statutory Accounting Principles ("Codification"). The Codification, which is intended to standardize regulatory accounting and reporting for the insurance industry, is proposed to be effective January 1, 2001. However, statutory accounting principles will continue to be established by individual state laws and permitted practices and it is uncertain when, or if, the states of Minnesota, New York and North Dakota will require adoption of Codification for the preparation of statutory financial statements. The Company has not finalized the quantification of the effects of Codification on its statutory financial statements.
i. the impact of changing market conditions on the Company's business strategy; ii. the effects of increased competition on pricing, coverage terms, retention of customers and ability to attract new customers; iii. greater severity or frequency of the types of large or catastrophic losses which the Company's subsidiaries insure or reinsure; iv. faster or more adverse loss development experience than that on which the Company's underwriting, reserving and investment practices are based; v. changes in the Company's retrocessional arrangements; vi. developments in global financial markets which could adversely affect the performance of the Company's investment portfolio; vii. litigation, regulatory or tax developments that could adversely affect the Company's business; viii. risks associated with the introduction of new products and services; and ix. the impact of mergers and acquisitions.