Westbrook currently sub-leases 1,600 square feet at 1062 Barnes Road, Wallingford, Connecticut. The sub-lease extends until October 14, 1998 and provides for annual lease payments of $21,300.
Pinnacle leases 7,808 square feet at 116 Wedgewood Drive, Carrollton, Georgia. The lease extends until December 31, 1998 and provides for annual lease payments of $99,000.
Merchant Bakers leases 1,780 square feet at 1400 Old Country Road, Westbury, New York. The lease extends until January 31, 1998 and provides for annual lease payments of $49,082, which space has been fully sub-leased through the end of the lease. In addition, Merchant Bakers leases 21,800 square feet at 116 John Street, New York, New York. The lease extends until October 31, 2004 and provides for annual lease payments of $190,750.
(1) Primarily book rollover fees and, for years prior to 1994, management fees which totaled $158,000, $315,000, $914,000 and $30,000 for 1995, 1994, 1993 and 1992 respectively.
(2) 1992 is based upon 4,050,000 shares as adjusted for the Company's 1993 recapitalization. 1996 reflects dividends on the Preferred Stock.
The increase in the loss ratio is predominantly due to: 1) the impact of the 1996 winter storms; 2) a reassessment of current and prior accident year anticipated loss experience following an increase in the volume of reported claims falling below the companies' attachment points; and 3) decreased reinsurance profit sharing income resulting from the impact of increased loss ratios.
The winter storms of 1995-1996 produced significant catastrophic losses for the property and casualty industry. Particularly affected were insurers like Home State and Home Mutual, with significant concentrations of insured risks in the Northeast. The impact of the storms on the Company was greater due to the recent pooling agreement entered into with Home Mutual effective January 1, 1996. Storm related losses suffered by the Company and Home Mutual combined were estimated to be approximately $6 million.
In the remainder of 1996, the Company continued to reassess its current and prior year loss experience. As part of this review, in the fourth quarter of 1996, the Company undertook a comprehensive review of its case reserves. In addition to addressing loss reserving and growth issues, the Company also strengthened senior management and supervisory personnel in claims administration, as well as employing an internal actuary to assist with loss reserving estimates and pricing of risks. As part of the reassessment of the Company's loss experience, management made significant additional reserve increases in the fourth quarter of 1996, leading to a 1996 loss ratio of 113% and total adverse development of $23 million on 1995 and prior accident years.
The Company is also looking to make changes in its reinsurance program going forward. In this regard, quota share reinsurance, rather than excess of loss reinsurance, will be the most effective means to provide the Company with reinsurance protection.
On April 10, 1997, the Company announced a downgrade by A.M. Best in the rating of each of its National Pool and New York Pool to "C". Such downgrade relates primarily to the Company's 1996 net loss from operations of approximately $20.5 million. Additional factors considered in the rating action included historical rapid growth, loss reserve development, diminished capital strength and dependency on surplus relief reinsurance arrangements.
Net investment income increased from $3.5 million in 1995 to $4.6 million in 1996. The increase in net investment income was primarily a result of an increase in invested assets which was partially offset by a decrease in investment yield from 5.8% in 1995 to 5.5% in 1996. Cash and invested assets were $103.4 million as of December 31, 1996 compared to $88.3 million as of December 31, 1995.
Income from the Company's financial services subsidiaries increased from $3.0 million in 1995 to $3.7 million in 1996. The financial services group is comprised of Aspen Intermediaries ("Aspen"), which provides reinsurance brokerage services; Tower Hill, Inc. ("Tower Hill"), which provides premium finance services; and HSIM L.L.C. ("HSIM") which provides certain administrative services to the Company. Aspen's reinsurance brokerage fee revenue increased to $2.1 million in 1996 from $1.6 million in 1995. Tower Hill received $1.5 million in premium financing income in 1996 compared to $604,000 in 1995. HSIM earned $775,000 in management fees from Home Mutual in 1995 compared to no such fees in 1996 as a result of the operating losses during 1996 at Home Mutual.
Other income decreased from $315,000 in 1995 to $135,000 in 1996. Other income in 1996 consisted primarily of insurance premium installment fees, offset by premium receivable write-offs whereas in 1995, other income consisted primarily of book rollover fees and insurance premium installment fees.
The Company incurred a pre-tax loss of $35.1 million during 1996. Primarily as a result of net operating loss carrybacks, the Company recorded a $6.1 million current tax benefit. In addition, net operating loss carryforwards generated deferred tax benefits of $8.3 million. During 1995, the Company reported a tax expense of $2.0 million or a 26% effective tax rate.
The Company has aggressively used reinsurance in order to achieve its growth objectives. Management has negotiated reinsurance treaties that enable the Company to leverage its resources in order to write additional risks while maintaining premium to surplus ratios recommended by regulatory authorities and rating agencies. Although a majority of the profits on the ceded premium is retained by reinsurers, the Company receives ceding commissions and profit sharing revenues which provide a means of participating in the profitability of the reinsurance programs. The Company continually evaluates the opportunity to retain a greater portion of ceded premium to reduce reinsurance costs and/or further enhance profitability. As a result, the Company has made certain changes in the combined reinsurance program during 1995 for 1996, moving certain classes of liability insurance business from excess of loss to quota share agreements. The historical loss ratio and/or policy limits for these classes make quota share reinsurance, rather than excess of loss reinsurance, the most effective means to provide the Company with reinsurance protection.
The Company had $269,000 of net realized gains in 1995 compared to $99,000 of net realized losses from the sale of securities in 1994. The realized net gains in 1995 were derived primarily from the sale of the Company's investments classified as available for sale and several bonds being called before scheduled maturity while the net realized losses in 1994 resulted from the sale of selected fixed maturity securities in the first quarter.
Income from Home State Financial Services, Inc. and its subsidiaries, consisting primarily of reinsurance brokerage fees, financing revenue and management fees increased $900,000 or 43% from $2.1 million in 1994 to $3.0 million in the comparable period of 1995. In 1995, the financial services group was comprised of Aspen Intermediaries, Inc., which provides reinsurance brokerage services; Tower Hill, Inc., which provides premium finance services; and Home State Insurance Management, Inc., which provides certain administrative services. Aspen received reinsurance brokerage fees of $1.6 million in 1995 as compared to $1.1 million in the comparable period of 1994. Home State Insurance Management received $775,000 in management fees from Home Mutual in 1995 as compared to $1 million in the comparable period of 1994 and Tower Hill received $604,000 in financing income in 1995 and none in 1994. In 1996, the business of Home State Insurance Management was restructured as a limited liability company.
Other income, consisting primarily of book rollover fees, decreased from $452,000 in 1994 to $315,000 in 1995. Book rollover fees were $315,000 in 1994 and $158,000 in 1995.
Insurance losses and loss adjustment expenses increased $26.6 million or 117% from $22.7 million in 1994 to $49.3 million in 1995 (of which $13.2 million represents Merchant Bakers), primarily as a result of an increase in volume and risks assumed under premiums in force and adverse development in prior year reserves with respect to the commercial auto lines of business in New York and New Jersey. Consequently, the GAAP loss ratio increased to 76% in 1995 compared to 67% in 1994, as management is continuing to strengthen loss reserves.
The GAAP expense ratio decreased to 17% in 1995 from 21% in 1994. The Company has experienced an increase in its overall operating expenses in 1995 as compared to 1994 largely to support the addition of $43.6 million of gross written premium in the Company's markets for personal and commercial automobile business. Favorable comparison of 1995 results to 1994 reflect the positive benefits of producing incremental premium growth by leveraging the Company's existing cost structure, as well as efficiencies derived from investments in technology made during the 1994 and 1995 fiscal years.
Other expenses in 1995 and 1994 include the operating expenses of the financial services group and the parent company.
In October of 1996, the Company raised $10,000,000 in additional capital through the sale of 10,000 shares of its Series A Cumulative Voting Preferred Stock (the "Preferred Stock") to Swiss Reinsurance America Corporation and Reliance Insurance Company. Swiss Re and Reliance each purchased $5,000,000 of the Preferred Stock. Proceeds of the sale were used to increase the capital and surplus of Merchant Bakers. The Company, Swiss Re and Reliance have also entered into agreements for the Company's subsidiaries to purchase reinsurance at commercially reasonable and actuarially sound rates and for Swiss Re and Reliance to provide certain management and consulting services to the Company.
Each share of Preferred Stock is entitled to one vote along with the Company's common stock and carries a dividend rate of 7.5%. The Company may call the Preferred Stock for redemption at any time after the fourth anniversary of the closing. The Preferred Stock must be redeemed at $1,000 per share plus any accumulated dividends in five equal tranches at the 10th through 14th anniversaries of the closing. In addition, the Preferred Stock is subject to redemption upon the occurrence of specified redemption events. Each share of Preferred Stock carries with it detachable Series A Warrants ("Warrants") to purchase 140 shares of the Company's common stock for $9.50 per share at any time until October 4, 2003. If all of the Warrants issued in connection with the $10,000,000 of Preferred Stock issued were to be exercised, the common stock purchased would represent 19.8% of the Company's issued and outstanding common stock as of December 31, 1996.
The Company generated positive cash flow from operations in 1996 of $4.2 million which was invested in high quality investment grade securities. The Company has a policy of investing a portion of its cash in short-term and highly liquid investments for the payment of pending claims and expenses. The Company believes that its liquid assets plus its cash flow from operations will be adequate to meet foreseeable cash requirements. During 1996, the Company conducted a thorough review of its business plans and primary insurance operations. As a result, the Company has re-evaluated its methodologies for case basis reserving and is aggressively managing its claims handling procedures. The change in claims management may accelerate the cash needed to settle claims, which management believes will be sufficiently met with existing cash and investment assets.
As a holding company, the principal source of the parent company's cash available for payment of dividends is dividends received from its insurance subsidiaries. State regulatory requirements limit the amount of annual dividends these companies can pay to the holding company without obtaining prior insurance department approval. The maximum amount distributable is limited to the greater of (i) 10% of statutory surplus as of the end of the preceding year or (ii) net investment income for the preceding year, with larger dividends payable only upon prior regulatory approval. Accordingly, the maximum dividend which may be paid to the Company by its insurance subsidiaries without prior approval at December 31, 1996 is approximately $4.6 million.
Inflation may have an impact on property and casualty insurers because premium rates are established before the amount of losses and loss expenses are known. The Company attempts to anticipate increases from inflation in establishing rates, subject to competitive and regulatory limitations.
The Company considers inflation when estimating liabilities for losses and loss adjustment expenses. The liabilities for losses and loss adjustment expenses are management's estimates of the ultimate net costs of underlying claims and expenses and are not discounted for the time value of money. In times of high inflation, the normally higher yields on investment income may partially offset potentially higher claims and expenses.
In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, "Earning per Share" (SFAS 128"). For the years ended December 31, 1996, 1995 and 1994 the Company has followed the standards established under APB No. 15 for computing and presenting earnings per share ("EPS"). SFAS 128 establishes standards for computing and presenting EPS and applies to entities with publicly held common stock or potential common stock. SFAS 128 replaces primary EPS, as defined in APB No. 15, with basic EPS. Additionally, SFAS 128 requires dual presentation of basic and diluted EPS on the face of the statement of operations for all entities with complex capital structures. SFAS also requires certain disclosures including: 1) a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation; 2) the effect given to preferred dividends in arriving at income available to common shareholders and; 3) securities that could potentially dilute basic EPS in the future that were not included in the computation of diluted EPS because to do so would have been anti-dilutive for the period(s) presented.
The Company has calculated basic and diluted EPS, as defined in SFAS 128 and interpreted by the Company based on information currently available, and has determined that such amounts do not differ materially from primary EPS, which is reflected in the Company's statement of operations, for the years presented.
(1) Uncertainty regarding the adequacy of reserves for loss adjustment expenses, the establishment of which involve an inherent degree of uncertainty and may be impacted by numerous factors; (2) Factors affecting the property and casualty insurance industry generally including periods of intense price competition, the size and frequency of claims, escalating damage awards, natural disasters, changes in statutes, regulations and court decisions and regulatory constraints, which can cause fluctuations in underwriting results and net income; (3) The geographic concentration of a disproportionate amount of the Company's business, which could result in unusually severe storms or other natural disasters or adverse economic conditions in such geographic areas having an adverse impact on the Company; (4) Adverse effects resulting from the recent downgrading or any future downgrades in the ratings assigned by A.M. Best to the National Pool, the New York Pool or one of the Company's subsidiaries, which could adversely effect the Company's competitive position; (5) Capital and surplus levels may constrain the Company's ability to maintain or increase the volume of premiums it writes, result in regulatory scrutiny and/or require the Company to cede a greater portion of premiums written to reinsurers, which could reduce profitability; (6) State laws and regulations applicable to insurance holding companies, such as the Company, which, among other things, limit the payment of dividends by insurance subsidiaries; (7) The unavailability of reinsurance on favorable terms, a reinsurer's insolvency or inability to make payments under a reinsurance treaty or lower than estimated reinsurance recoveries on unpaid losses; (8) Changes in subrogation recovery rates; (9) Loss of significant independent agencies producing business for the Company; (10) Increases in interest rates, which cause a reduction in the market value of the Company's interest rate sensitive investments, including, but not limited to, its fixed income investment portfolio; (11) Decreases in interest rates causing a reduction of income earned on new cash flow from operations and the reinvestment of the proceeds from sales, calls or maturities of existing investments; (12) Changes in the demand for the financial services offered by the Company; and (13) Adverse results in litigation matters.