Information for this item is in the section captioned "Five Year Financial Summary" within the 1998 Annual Report.
Certain information enclosed is based on management's estimates, assumptions and projections. Important factors that could cause results to differ materially from those estimated by management include an unexpected increase in competition, unfavorable government regulation, the pricing environment and other industry developments.
The Company's principal functional currency is the U.S. dollar. The changes in line item amounts from year to year as discussed below are all affected by the movement in exchange rates, principally the dollar/sterling average rate which varied from $1.66 for 1998, $1.64 for 1997 and $1.57 for 1996.
(a) Increased writings by Terra Nova Capital to $331.6 million (excluding orphan syndicate business and reinsurance to close premiums) in 1998 from $162.8 million in 1997 due to the Company's increased participation in the Octavian syndicates from 44% in 1997 to approximately 60% in 1998. The major lines of business written by Terra Nova Capital are marine, aviation, motor and UK liability;
Net written premiums increased by 33.7% to $646.2 million in 1998 from $483.5 million in 1997, as a result of the increase in gross written premiums, partially offset by higher reinsurance costs. Net earned premiums increased 30.5%, to $546.9 million in 1998 from $419.1 million in 1997.
Realized Net Capital Gains on Sales of Investments. Realized net capital gains on sales of investments increased $2.7 million to $18.0 million in 1998 from $15.3 million in 1997. Of the gain in 1998, $8.9 million arose from sales of fixed maturities and $9.1 million from sales of equity securities.
Foreign Exchange Losses. Foreign exchange losses of $0.6 million in 1998 and $1.3 million in 1997 arose from foreign currency transactions during the year, together with the translation of foreign currency assets and liabilities into U.S. dollars, the Company's principal functional currency.
Losses and Loss Adjustment Expenses. Losses and LAE increased 27.3%, to $359.6 million in 1998 from $282.5 million in 1997. As a percentage of net earned premiums, losses and LAE decreased 1.6 points, to 65.8% in 1998 from 67.4% in 1997.
The loss and LAE ratio for non-marine property business increased to 66.9% in 1998 from 65.8% in 1997, following the catastrophe activity in the third quarter of 1998 and an increase in losses on the Company's motor business due to the competitive market conditions that exist in this class. The loss associated with Hurricane Georges was approximately $15 million, with Hurricane Mitch adding a further $2 million of losses.
The loss and LAE ratio for non-marine casualty business decreased to 71.8% in 1998 from 74.9% in 1997. This decrease reflects the prior year reserve redundancies on casualty business written by Terra Nova in the period 1986-1993 and profits on the orphan syndicate business written in 1997 and 1998.
Combined Ratios. The Company's combined ratios were 98.8% for 1998 and 98.2% for 1997. This is the net result of a reduction in the loss ratio and an increase in the expense ratio.
Other Expenses. Other expenses increased 5.7%, to $5.6 million in 1998 from $5.3 million in 1997.
Income before Income Tax and Extraordinary Charge. Income before income tax and extraordinary charge increased 11.3% to $101.3 million in 1998 from $91.0 million in 1997. This was due to higher investment income in 1998 and an increase in the net contribution from the managing agent.
Extraordinary Charge. An extraordinary charge of $11.6 million arose during the second quarter as a result of UK Holdings extinguishing all of its $100 million 10.75% Senior Notes due 2005. The charge was net of a $5.2 million income tax benefit.
Net Income. Net income decreased $1.0 million, to $72.4 million in 1998 from $73.4 million in 1997, after the $11.6 million extraordinary charge recognized in the second quarter of 1998.
(a) Increased writings by Terra Nova Capital to $162.8 million (excluding orphan syndicate business and reinsurance to close premiums) in 1997 from $36.8 million in 1996 due to the Company's increased participation in the Octavian syndicates from 11% in 1996 to 44% in 1997;
(c) $17.9 million of premiums in respect of Terra Nova Capital's 11% share of the closure of the 1995 year of account into the 1996 year of account.
Losses and Loss Adjustment Expenses. Losses and LAE increased 58.5%, to $282.5 million in 1997 from $178.3 million in 1996. As a percentage of net earned premiums, losses and LAE increased 3.4 points, to 67.4% in 1997 from 64.0% in 1996. The loss and LAE ratio for non-marine property business increased to
Acquisition Costs. Acquisition costs, which consisted of commission expenses and other underwriting expenses, increased 40.1% to $115.4 million in 1997 from $82.4 million in 1996. Acquisition costs as a percentage of net earned premiums decreased to 27.5% in 1997 from 29.6% in 1996. The decrease was largely a result of the earned premiums from the orphan syndicate and RITC business written during 1997, which have very low acquisition costs; excluding this business, acquisition costs would have been 31.3% of earned premiums.
Net Interest Expense. Net interest expense in 1997 related to interest on the $100 million 10.75% Senior Notes issued on June 30, 1995 and interest on the $75 million 7.2% Senior Notes issued on August 26, 1997. The net interest expense in 1996 related to interest on the $100 million 10.75% Senior Notes.
The principal sources of funds for the Company's subsidiaries consist of net premiums, investment income and proceeds from sales and redemption of investments. The funds are used to pay claims and operating expenses and to buy investments, largely fixed income securities.
Total investments and cash were $1,575.0 million at December 31, 1998. At December 31, 1998, 91.8%, 5.6% and 2.6% of total investments and cash were held in fixed maturities, common stocks and cash and cash equivalents, respectively. At December 31, 1998, approximately 91% of the Company's fixed income investments were rated "A" or better by Moody's or S&P. The Company's investment portfolio earned interest and dividend income, net of investment management fees, of 6.1% and 6.2% in 1998 and 1997, respectively. The Company had realized investment gains of $18.0 million and $15.3 million in 1998 and 1997, respectively.
On April 29, 1998, Moody's Investor Services raised its debt rating on UK Holdings' Senior Notes to "Baa1" from "Baa3". This rating increase reflects the improved strength of UK Holdings' financial position.
On May 28, 1998, the Company filed a Form 8-K concerning the issue of $100 million 7.0% Senior Notes due 2008, fully and unconditionally guaranteed by Bermuda Holdings.
On October 12, 1998, the Company announced that Terra Nova Capital's participation in the Lloyd's Capacity Auctions for the 1999 underwriting year resulted in the acquisition of $102.4 million ((Pounds)64.0 million) of new capacity.
The eleven participating EMU countries adopted the euro as their national currency on January 1, 1999. The European Central Bank (ECB) established a fixed conversion rate between each participant's existing currency and the euro as from that date. The euro is now traded on foreign currency exchanges and fluctuates in value against currencies of non-participating countries. It can be used for non-cash transactions throughout the three year transition period which ends on December 31, 2001. On January 1, 2002, the ECB will begin to issue bills and coins denominated in euro for use in cash transactions.
The Company identified relevant issues and established a strategy to deal with each phase of the euro's implementation. The Company has the requisite capability to process and account for current transactions in the euro, and, as needs are identified, will modify its information technology and other systems in response to changed or expanded exposures to euro transactions.
The competitive impact of the euro is not expected to be significant because less than 10% of the Company's business is conducted within EMU member states. Management believes that the costs of modifying information systems software will not be material to the Company's results, operations, financial condition or liquidity. Accordingly, such costs are expensed as incurred.
The Year 2000 issue arises from the fact that many computers and computer programs use two digits rather than four to represent the year portion of a date. The faulty interpretation or the misinterpretation of these two digits could result in system failure or miscalculation causing disruption to business processes.
The Year 2000 date change problem is widely recognized as the biggest single issue to have faced the information technology ("IT") industry. Its impact is likely to extend into all areas of business and commerce. Accordingly, the Company is addressing Year 2000 as both an IT issue and a business issue. The Company has established a Year 2000 Project team composed of representatives from all IT and business areas in order to ensure a co-ordinated approach. The Project team reports directly to senior management who, in turn, report regularly to the Board of Directors on the status of the Company's Year 2000 compliance.
The assessment phase for the IT section of the Project consisted of an inventory and high level analysis of all hardware, software and embedded systems. ("Embedded systems" include "non-IT items" such as facsimile machines, elevators and telephones.) As a result of the assessment phase, the Company identified five business critical systems. All five were deemed compliant by December 31, 1998, following completion of testing and implementation work.
The Octavian syndicates are also represented on the underwriting committee. However, the senior underwriters on the Octavian syndicates have adopted a different approach from that of their colleagues at Terra Nova, reflecting the different regulatory environment in which they operate. The syndicate underwriters have analyzed the Year 2000 exposure on each class of business that they write. They have then drawn up a course of action for dealing with the exposure, using the results of their analysis. The regulatory department at Lloyd's requests detailed Year 2000 returns from each syndicate. This is to assist the Corporation of Lloyd's in determining whether or not each syndicate is taking appropriate action to address the issue.
It is difficult to estimate the degree of completeness of the underwriting section of the Project, just as it is difficult to estimate the frequency and severity of Year 2000 related claims, notifications and associated costs. However, management believes that reliance on the combined experience of the Company's underwriters who contribute to the ongoing assessment will enable the Company to make prudent judgments about exposures and to react accordingly.
The Third Parties section of the Year 2000 Project includes the process of identifying critical suppliers, customers and trading partners who deal directly with the Company and ascertaining their plans and progress in addressing Year 2000 issues. The Company receives the majority of its underwriting data from bureaus, most notably, the London Processing Centre and Lloyd's. Market testing has been performed to insure continuous and reliable connectivity to, and the ongoing provision of effective services from, these organizations and has been successfully completed.
Material trading partners at all business levels have been contacted and asked to respond with an assessment of the Year 2000 compliance status of their own businesses. The target for completion of this work was December 31, 1998. However, approximately sixty-eight percent of the responses were still outstanding at that date. These responses will be pursued during 1999. The replies from trading partners will be taken into account as the contingency plan is developed which covers critical business areas considered to be at risk in the event of the failure of third parties to provide effective ongoing essential services and supplies.
From an IT perspective, the Year 2000 risks have been reduced significantly by bringing business critical systems into compliance and should not restrict the ability of the Company to trade through the Year 2000. The Company's reliance on compliance adequacy of outside suppliers and trading partners can only be addressed through questionnaires and compliance statements. Even with apparently thorough third parties' responses, the Company cannot guarantee their Year 2000 readiness. The inability of such parties to complete their Year 2000 resolution process could materially affect the Company.
Bermuda Holdings maintains an internal control structure designed to provide reasonable assurance that assets are safeguarded from loss or unauthorized use, that transactions are recorded in accordance with management's direction and that the financial records are reliable for the purposes of preparing financial statements and maintaining accountability of assets. The management of Bermuda Holdings applied the concept of reasonable assurance by weighing the cost of an internal control structure against the benefits to be derived. The internal control structure is supported by the careful selection, training and development of qualified personnel, an appropriate division of responsibilities and the dissemination of written policies and procedures throughout Bermuda Holdings. The internal control structure is continually reviewed and evaluated by qualified personnel and periodically assessed by PricewaterhouseCoopers, independent accountants, to the extent required under generally accepted auditing standards in connection with their annual audit of Bermuda Holdings' financial statements.
The Company is a specialty property, casualty, marine and aviation insurance and reinsurance company. It operates in the London market through its London based subsidiary, Terra Nova, in the Continental European Market through its French subsidiary, Corifrance, in the Bermuda market through its Bermuda based subsidiary, Terra Nova (Bermuda) and in the Lloyd's market through its London based subsidiary, Terra Nova Capital. Writings originate worldwide. It writes most insurance and reinsurance business through brokers authorized to place business at Lloyd's. It also writes through non-Lloyd's brokers and with individual ceding companies. The broker is regarded as the agent of the insured or reinsured in placing the business. The Company also owns the business and assets of Octavian, a Lloyd's managing agent, consisting of the rights to manage eight Lloyd's syndicates (the "Octavian syndicates").
The accompanying consolidated financial statements have been prepared on the basis of United States generally accepted accounting principles ("GAAP"). All material intercompany transactions and balances have been eliminated.
(d) Deferred acquisition costs: Acquisition costs, which represent net commission and other expenses incurred in producing business, are deferred and amortized over the period in which the related premiums are earned. Deferred acquisition costs are limited to the amounts estimated as recoverable from the applicable unearned premiums and the related expected investment income, after giving effect to anticipated losses, loss adjustment expenses and expenses necessary to maintain the contracts in force.
(g) Foreign currency translation: The U.S. dollar is the reporting currency and principal functional currency, as most of the policies written are denominated in U.S. dollars. Revenues and expenses in non-U.S. dollar currencies are translated at the average rates of exchange. Monetary assets and liabilities are translated at the rate of exchange in effect at the close of the period. Non-monetary assets and liabilities, primarily deferred revenue and expenses, are translated at historical rates of exchange. Gains or losses resulting from non-U.S. dollar transactions are included in net income. Certain other net translation adjustments are shown as a separate item of shareholders' equity.
(h) Accrued premium income: Accrued premium income represents the difference between the estimated cumulative ultimate gross written premiums and cumulative billed premiums.
(j) Losses and loss adjustment expenses: Losses and loss adjustment expenses are charged to income as incurred. The reserve for unpaid losses and loss adjustment expenses represents estimates for reported losses, including provisions for losses incurred but not reported ("IBNR"). The adequacy of these estimates is assessed by reference to projections of the ultimate losses for each accident year. The methods of determining such estimates and establishing reserves are reviewed continually and updated. Resulting adjustments are reflected in current operations.
(l) Risks and uncertainties: Information about risks and uncertainties existing at the balance sheet date related to the following areas are included in Notes 1, 3, 4, 10, 11, 12, 13, 14 and 17:
(o) Reclassifications: Certain prior year amounts have been reclassified to conform with the current year presentation.
In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No.133 "Accounting for Derivative Instruments and Hedging Activities". SFAS No.133 is effective for fiscal years beginning after June 15, 1999, and will require all derivatives to be recognized in the statement of financial position as either assets or liabilities, measured at fair value. In addition, all hedging relationships must be designated, reassessed and documented under the provisions of SFAS No.133. The Company does not expect SFAS No.133 to have a significant impact on its financial reporting.
(a) Deposits: Securities with a carrying value of $103,731,433 and $74,832,873 at December 31, 1998 and 1997, respectively, were held in trust for the benefit of the Company's U.S. cedents and to facilitate the Company's accreditation as an alien reinsurer by certain States.
1997, respectively. The Company has deposited cash and investments with a carrying value of $158,018,677 and $175,213,503 at December 31, 1998 and 1997, respectively, as collateral against these amounts.
(c) Investment gains and losses: The realized net capital gains and changes in net unrealized appreciation or depreciation of investments are summarized below:
Realized net capital gains on sale of fixed maturities for the years ended December 31, 1998, 1997 and 1996, included gross capital gains of $9,420,000, $9,600,000 and $6,802,000, and gross capital losses of $566,000, $4,258,000 and $5,293,000, respectively.
Proceeds from sales of investments in equity securities during 1998, 1997 and 1996, respectively, were $140,564,000, $215,732,000 and $163,173,000. Realized net capital gains on sale of equity securities for the years ended December 31, 1998, 1997 and 1996, included gross capital gains of $24,567,000, $29,613,000 and $22,512,000, and gross capital losses of $15,458,000, $19,622,000 and $12,271,000, respectively.
Net unrealized appreciation of equities (before income tax) at December 31, 1998, of the Company included gross unrealized appreciation of $38,551,000 and gross unrealized depreciation of $7,453,000. Net unrealized appreciation of equities at December 31, 1997, of the Company included gross unrealized appreciation of $38,111,000 and gross unrealized depreciation of $3,658,000.
Not Rated securities consist mainly of securities issued by municipalities in countries other than the U.S. or the U.K. and are generally considered by management to be at least the equivalent in quality of AA rated investments.
(f) At December 31, 1998, the estimated fair value of the following investments exceeded 10% of shareholders' equity:
(g) Equities available for sale: At December 31, 1998, the cost and estimated fair value of investments in common stocks were as follows:
(a) The U.K. corporation tax rate applicable to ordinary income was 33% for 1996. The tax rate was reduced to 31% from 33% on April 1, 1997. The corporation tax rate in France was 41.67% for 1997 and 1998. The difference between the actual tax expense and the "expected" amount calculated by applying the U.K. corporation tax rate is explained as follows:
(c) Deferred tax liabilities and assets are provided for expected future tax consequences of events that have been recognized in the consolidated financial statements or tax returns. The measurement of current and deferred tax liabilities and assets is based on the difference between the financial statements and tax bases of assets and liabilities using enacted rates in effect for the years in which the differences are expected to reverse. Measurement of a deferred tax asset, if any, is subject to the expectation of future realization. The components of net deferred tax liabilities of the Company as at December 31, 1998 and 1997, were as follows:
The total cost of the Company's defined contribution plans for the year was $2,351,000.
The "A" ordinary shares and "B" ordinary shares rank pari passu in right to receive dividends.
The assumptions made in calculating the pro forma amounts above were: risk free rate of return, 5.05%; volatility, 0.37; dividend yield, 0.47%; and expected life, 4 years.
At December 31, 1998, the outstanding Option Shares under the Stock Option Plan had exercise prices between $5.80 and $25.75 and a weighted-average remaining contractual life of 6.8 years.
Options outstanding and options exercisable at December 31, 1998, are summarized as follows:
At December 31, 1998, the 214,158 options outstanding under the Octavian Stock Option Plan all had exercise prices of $nil and a weighted-average remaining contractual life of 7.54 years.
Management believes that its reserves for losses and loss adjustment expenses are adequate. Significant delays occur in notifying certain claims and a large measure of experience and judgment is involved in assessing outstanding liabilities, the ultimate cost of which cannot be known with certainty at the balance sheet date. The reserve for unpaid losses and loss adjustment expenses is determined on the basis of information currently available. However, it is inherent in the nature of the business written that the ultimate liabilities may vary as a result of subsequent development.
Movement in unpaid losses and loss adjustment expenses for the years ended December 31, 1998, 1997 and 1996, is summarized in the table below. Incurred claims relating to prior years are offset by decreases to prior year net written and net earned premiums less related acquisition costs of $9,757,000, $4,800,000 and $3,550,000 for 1998, 1997 and 1996, respectively. When these revisions to prior written and earned premiums are considered, the Company experienced net prior year improvements of $15,207,000 in 1998, $5,596,000 in 1997 and deterioration of $950,000 in 1996.
Asbestos-Related Losses and Loss Adjustment Expenses Incurred and Reserves Outstanding (net of reinsurance)
An extraordinary charge of $11.6 million arose during the second quarter as a result of UK Holdings extinguishing all of its $100 million 10.75% Senior Notes due 2005 (the "Senior Notes"). The charge was net of a $5.2 million income tax benefit.
In 1992, Terra Nova's directors decided to cease writing aviation business ("Aviation"). Since the acquisition of Terra Nova by the Company in 1994, any charges or credits resulting from changes in estimates are recorded in continuing operations of the Company.
The Company's operations are conducted through four segments: Marine & Aviation, Non-Marine, Agency and the Corporate operations. The Marine & Aviation and Non-Marine segments earn income from insurance and reinsurance business written worldwide. The Agency segment comprises the operations of Octavian (see Note 1). The Corporate segment holds the assets, principally investments not allocable to the insurance underwriting and agency operations.
The Company's reportable segments are strategic business units that offer different products and services, other than the Corporate segment, which runs the Company's non-insurance related activities.
Substantially all the revenues are drawn from business within the London Market. Additional operations are conducted in Belgium, Bermuda, Canada and France. No further geographic information is provided since it is impracticable to do so.
(a) Terra Nova files an annual audited return with the Financial Services Authority (the "FSA"), as previously with H.M. Treasury (the "Treasury"), in the U.K. The regulations require U.K. insurance companies to comply with prescribed minimum solvency margins. Terra Nova's unaudited required minimum solvency margin and unaudited solvency margin at December 31, 1998, were $24,479,000 and $239,053,000, respectively. Terra Nova's unaudited and estimated Treasury Return policyholders' surplus and unaudited net income for the year ended December 31, 1998, and the audited Treasury Return policyholders' surplus and net income as reported in the annual returns to the Treasury for the years ended December 31, 1997 and 1996, are as follows:
Terra Nova's ability to pay dividends is limited by a Notice of Requirements issued by a predecessor of the FSA which requires Terra Nova to give 14 days' advance notice to the FSA of its intention to declare and pay a dividend. In addition, Terra Nova must comply with the Companies Act 1985 which provides that dividends may only be paid out of distributable profits.
Terra Nova (Bermuda)'s statutory capital and surplus and minimum required statutory capital and surplus at December 31, 1998, 1997 and 1996, respectively, were: