The conversion and recapitalization transactions described above are considered to be similar to pooling of interests transactions. The historical cost basis accounting of the predecessor companies has been retained and the Company's financial statements have been presented using pooling of interest basis accounting. The conversion and recapitalization transactions had no impact previously reported net income of the consolidated entities.
The Insurance Subsidiaries have entered into certain Quota Share Reinsurance agreements pursuant to which 75% of Bridgefield and 80% of Bridgefield Casualty's net premiums have been ceded to the respective reinsurers. While such reinsurance agreements will enable the Insurance Subsidiaries to underwrite a larger number of policies than they could otherwise write, the ceding of a percentage of the premiums of such policies to the reinsurer will result in lower premium income to the Company than in prior years. However, the Company will receive a ceding commission related to the Quota Share Reinsurance agreements which will be reflected as a reduction of operating expense. Management does not currently anticipate that the net income of the Company will be adversely effected by such agreements.
Historically, ESIF was not operated for the purpose of accumulating profits, but it retained a portion of its earnings and profits to avoid making assessments against its members. ESIF occasionally during its operating history paid distributions of profits to its members, but it never made an assessment against its members. ESIF's indemnity agreements indemnified the member employers against loss or liability relating to workers' compensation insurance risk.
Prior to the Acquisition, ESIF and SHC were non-affiliated. Although SHC (through its wholly owned subsidiary, SCI) had provided all administrative and management services required to operate ESIF since ESIF's inception in 1978, the two organizations had different financial objectives and reported historical financial results independently. ESIF used a fiscal year ending on March 31, and SHC used a fiscal year ending on December 31. As a result of the Acquisition, SHC became a wholly owned subsidiary of ESIF, and management began to implement an integrated strategic plan. The discussion below in "--Results of Operations" includes SHC from and after the date of the Acquisition.
COMPARISON OF FISCAL YEARS ENDED MARCH 31, 1995, 1996 AND 1997
REVENUE. Revenue was $140.8 million, $140.3 million and $144.8 million for the fiscal years ended March 31, 1995, 1996 and 1997, respectively. Revenue declined by $0.5 million for the fiscal year ended March 31, 1996, primarily due to a decrease in premiums earned of $13.6 million, which was offset by the addition of $7.6 million in administrative fees as a result of the Acquisition and an increase in realized investment gains of $4.4 million. Revenue increased by $4.5 million for the fiscal year ended March 31, 1997 as a result of $33.3 in administrative fees generated by SHC in the 1997 period compared to $7.7 million in administrative fees generated by SHC in the 1996 period (January 16, 1996-March 31, 1996). Set forth below is a discussion of the composition of revenues for the periods indicated.
As discussed in the table below, in the fiscal years ended March 31, 1995, 1996 and 1997, the premium credit programs in the aggregate accounted for approximately $11.4 million, $14.1 million and $16.6 million, respectively, in credits.
Net Investment Income. Net investment income increased from $12.2 million for the fiscal year ended March 31, 1995, to $13.2 million for the fiscal year ended March 31, 1996, and decreased to $12.8 million for the fiscal year ended March 31, 1997. The increase for the fiscal year ended March 31, 1996 was due in part to an increase in yields on ESIF's investment portfolio. The decrease in investment income for the fiscal year ended March 31, 1997 was due in part to a reduction of invested assets and a larger portion of those assets invested in municipal bonds. The investment income generated from the municipal bond portion of the portfolio was $3.6 million for the fiscal year ended March 31, 1995 compared to $3.2 million for the fiscal year ended March 31, 1996. The decrease for the fiscal year ended March 31, 1997 was primarily due to an increase in assets invested in municipal bonds from 32% in 1996 to 38% in 1997.
Realized Investment Gains. Realized investment gains increased from a de minimis amount for the fiscal year ended March 31, 1995 to $4.4 million for the fiscal year ended March 31, 1996. These gains resulted from the sale of certain invested assets to finance the Acquisition. There were $0.7 million of realized investment gains for the fiscal year ended March 31, 1997.
LOSSES AND EXPENSES. ESIF's losses and expenses increased from $110.7 million for the fiscal year ended March 31, 1995 to $140.5 million for the fiscal year ended March 31, 1996 and to $134.1 million for the fiscal year ended March 31, 1997. Set forth below is a breakdown of the total annual expenses.
Losses and Loss Adjustment Expenses. ESIF establishes reserves to cover its estimated liabilities for losses from claims and for loss adjustment (claim settlement) expenses ("LAE"). Such loss reserves are estimates established by management based upon, among other factors: (i) results of actuarial reviews which incorporate ESIF's experience with similar cases, estimates of future claim trends, and historical trends such as recurring loss payment and reporting patterns, claim closures, and product mixes; (ii) facts known to ESIF; and (iii) regulatory requirements. Losses and LAE incurred for the fiscal year ended March 31, 1995 were $69.1 million compared to $94.8 million for the fiscal year ended March 31, 1996 and $65.2 million for the fiscal year ended March 31, 1997.
Interest Expense. For the fiscal year ended March 31, 1995, ESIF had no interest expense. In connection with the Acquisition, SHC borrowed $44.0 million from a commercial
lender, and as a result, interest expense on a consolidated basis for the fiscal years ended March 31, 1996 and 1997 was $0.8 million and $3.5 million, respectively.
NET INCOME. Income from continuing operations was $19.2 million, $0.4 million, and $7.0 million for the fiscal years ended March 31, 1995, 1996 and 1997, respectively. The $18.8 million decrease in income from continuing operations for the fiscal year ended March 31, 1996 resulted from decreased premiums as well as increased losses and LAE. The $6.6 million increase for the fiscal year end March 31, 1997 resulted from the stability of the loss and LAE expenses during that year and the depressed net income for the fiscal year ended March 31, 1996 resulting from adjustments of loss reserves in that year.
Losses from discontinued operations of $0.2 million and $1.2 million were incurred for the years ended March 31, 1996 and 1997, respectively. In addition, an extraordinary charge of $1.5 million was incurred during the year ended March 31, 1997 related to the conversion of ESIF from a group of self-insurance fund to a stock insurance company. After inclusion of these nonrecurring items net income was $19.2 million, $0.2 million, and $4.2 million for the years ended March 31, 1995, 1996 and 1997, respectively.
The Company has historically met its cash requirements and financed its growth principally through cash flows generated from operations. The Insurance Subsidiaries' primary sources of cash flows are premiums earned, investment income and the proceeds from the sale or maturity of invested assets. The Administrative Subsidiaries' primary source of cash flow is service fees generated from ESIF and the Funds. The cash requirements of the Insurance Subsidiaries are primarily for the payment of claims, commissions, reinsurance premiums and management fees to SCI and the purchase of investment securities. The cash requirements of the Administrative Subsidiaries are primarily for the payment of salaries, employees benefits, debt obligations and other operating expenses. Due to the uncertainty regarding settlement of unpaid claims, the liquidity requirements of the Company vary, and the Company has attempted to structure its investment portfolio to take into account the historical payout patterns. See "ITEM 1. BUSINESS--Investment Portfolio." The Company purchases reinsurance to mitigate the effect of catastrophic claims and help stabilize demands on its liquidity. See "ITEM 1. BUSINESS--Reinsurance."
As part of the Acquisition, SHC incurred debt which, at March 31, 1997, consisted of a term loan in the amount of $32.7 million, and no balance was outstanding under the revolving line of credit. Scheduled quarterly payments for the term loan began on September 30, 1996. On the date of the Conversion (May 28, 1997), the Company and First Union National Bank of North Carolina entered into a new credit agreement pursuant to which, upon consummation of the Conversion, the then-existing debt was restructured. Under such new credit facility, the term loan
For the fiscal years ended March 31, 1996 and 1997, net cash provided by operating activities was $10.8 million and $5.7 million, respectively, while net cash used in investing activities was $47.1 million and $1.5 million, respectively. In 1996, the increase in cash used in investing activities was primarily related to the Acquisition and the assumption of debt in connection therewith. In 1997, cash used to reduce debt was $11.3 million. The Company expects to redeem the Series A Preferred Stock from future surpluses in excess of statutorily required capital.
As a self-insurance fund, ESIF recorded for statutory reporting an asset of $47.3 million, $47.4 million and $44.4 million at March 31, 1995, March 31, 1996 and March 31, 1997, respectively, for future investment income determined by discounting loss and loss adjustment expense reserves at a statutorily prescribed rate. Following its conversion to a stock insurance company, Bridgefield is permitted to record discounts only on permanent disability cases. The amount of such discount is estimated at approximately $4.9 million, $4.7 million and $4.4 million at March 31, 1995, March 31, 1996 and March 31, 1997, respectively. ESIF's statutory basis surplus as a self-insurance fund was approximately $21.2 million at March 31, 1997. Following its conversion to a stock insurance company and the related public offering of the Company's Common Stock which resulted in net proceeds contributed to Bridgefield of approximately $48 million, plus $7.1 million of additional statutory capital which resulted from the simultaneous reorganization, Bridgefield's statutory basis surplus as a stock insurance company was approximately $36.2 million at May 31, 1997. Such capital and surplus is considered adequate to satisfy the requirements of the Florida Insurance Code. From time to time, the Company may be required to increase the capital surplus of the Insurance Subsidiaries to remain in compliance with state regulatory requirements. If the Company is unable to generate sufficient capital, either internally or from outside sources, it could be required to reduce its growth. There can be no assurance that capital will continue to be available when needed or, if available, will be on terms acceptable to the Company.
The NAIC has recently adopted risk-based capital standards to establish the capital requirements of an insurance carrier based upon the risks inherent in its operations. The standards, which have become effective in Florida under a bill recently passed by the Florida legislature, 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 various financial factors 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 percentage of total adjusted capital to authorized control level risk-based capital is below certain levels. The Company exceeds such risk-based capitalization levels, as recommended by the NAIC.
The following consolidated financial statements of the Company and the reports of independent auditors thereon are set forth following the Index of Financial Statements on page of this report:
Consolidated Balance Sheets as of March 31, 1996 and 1997 Consolidated Statements of Income for the years ended March 31, 1995, 1996 and 1997 Consolidated Statements of Changes in Equity for the years ended March 31, 1995, 1996 and 1997 Consolidated Statements of Cash Flows for the years ended March 31, 1995, 1996 and 1997 Notes to Consolidated Financial Statements