The Company other than Van-Am occupies 40,550 square feet of office space comprising its executive offices at 335 Madison Avenue, New York, New York 10017 pursuant to a sublease expiring August 2000. Van-Am occupies 6,300 square feet of office space at 167 East Main Street, Lexington, Kentucky, pursuant to a lease expiring December 1999.
The following table presents selected historical consolidated financial information derived from the historical consolidated financial statements of the Company as of and for each of the years in the five-year period ended December 31, 1996. This information should be read in conjunction with the historical consolidated financial statements of the Company and the related notes thereto and
The Company's initial capitalization of $113.8 million (net of issuance expenses) when it commenced operations in 1986 was obtained through a private placement in that year of Common Stock to management as well as institutional and other investors. The Company obtained additional capital of $26.5 million in 1988 through the issuance of additional shares, $39.4 million in 1990 through the issuance of additional shares in the merger between Enhance Financial and its partially owned subsidiary, Asset Guaranty, Inc., and $11.8 million in 1992 through the issuance of additional shares in its initial public offering of Common Stock. In 1993, Enhance Financial issued an aggregate $75.0 million principal amount of 6.75% Debentures due 2003 (the "6.75% Debentures"). As of December 31, 1996, the Company's total capitalization was $563.3 million.
The Company's revenues consist primarily of (a) premiums earned on insurance and reinsurance contracts and (b) investment income.
Year Ended December 31, 1996 versus Year Ended December 31, 1995
Net premiums written increased 15.3% to $95.7 million in 1996 from $83.0 million in 1995, consistent with the increase in gross premiums discussed in the preceding paragraphs. The following table shows net premiums written by line of business for the periods presented:
Monoline reinsurance earned premiums increased 21.8% principally due to refundings which contributed $9.9 million (12.8%) of earned premiums in 1996 compared to $5.7 million (9.0%) in 1995. A refunding eliminates the Company's reinsurance exposure to the refunded obligation and as a result, the Company recognizes in current earnings the remaining related deferred premium revenue. Excluding the impact of refundings, premiums earned increased 18.0% over the prior year. The growth in premiums earned also reflects the amortization of the deferred premium revenue balance which has grown to $266.2 million at year-end 1996 from $248.1 million at year-end 1995.
Interest expense of $6.2 million was incurred in 1996 compared to $5.6 million in 1995. The increase reflected the additional borrowings under the Company's line of credit under a bank credit agreement (the "Credit Agreement"). The Company's short term debt increased to $42.6 million at year-end 1996 from $15.0 at year-end 1995.
The Company's effective tax rate was 27.1% for 1996 compared to 25.9% in 1995. The higher 1996 rate reflects the continuing reduction in the percentage of pre-tax income represented by income from tax-exempt assets. This impact has been reduced in part by the Company's strategy of directing a greater proportion of its new cash flow to the purchase of tax-exempt securities in 1996.
Net income for 1996 increased 17.8% to $55.7 million from $47.3 million in 1995. On a per share basis, earnings increased 14.1% to $3.12 in 1996 from $2.73 in 1995. Operating earnings per share, which excludes the impact of capital gains and losses and foreign exchange gains and losses, increased 15.2% to $2.97 in 1996.
The volume of municipal bonds issued in 1995 decreased by 3.3% to $159.0 billion as compared with $164.5 billion in issuance in the prior year. Bonds issued for new money purposes decreased to $112.6 billion in 1995 from the 1994 level of $114.3 billion. The insured portion of new issues rose to 43.0% in 1995 compared with 37.3% in 1994.
Net premiums written increased 2.9% to $83.0 million in 1995 from $80.7 million in 1994, consistent with the increase in gross premiums discussed above. Of the Company's net premiums written in 1995, 47.9%, 16.3% and 35.8% were derived from the reinsurance of municipal bonds, the reinsurance of asset-
backed debt obligations and the Company's specialty activities, respectively, compared to 58.5%, 11.0% and 30.5% in 1994.
Net investment income increased 15.5% to $44.2 million in 1995 from $38.2 million for 1994. This growth resulted primarily from the Company's having invested all of its available cash flow in higher yielding special without lowering the credit quality of the portfolio. The average yields on the Company's investment portfolio, after deducting associated costs, were 6.4% and 6.2% for the years ended December 31, 1995 and 1994, respectively. The increase in investment income further reflects the growth in the Company's investment portfolio from $640 million at year-end 1994 to $749 million at December 31, 1995.
In addition, the Company realized $3.5 million of net capital gains in 1995 compared with net realized capital losses of $5.8 million in 1994, reflecting lower interest rates during the year.
The Company believes that the reserves for losses and LAE, including the case and non-specific reserves, including the case and non-specific reserve, are adequate to cover the ultimate net cost of claims. However, the reserves are necessarily based on estimates, and there can be no assurance that the ultimate liability will not exceed such estimates.
Interest expense of $5.6 million was recorded in 1995 compared to $5.8 million in 1994. The decrease reflected the impact of a reverse interest-rate swap entered into in January 1995 and subsequently terminated in June 1995, from which the Company realized a net interest reduction of $0.7 million, including amortization of gain on termination of the swap. This reduction was offset in part by interest expense of $0.6 million on the additional drawdowns of $12.0 million on the Company's line of credit under the Credit Agreement.
Net income for 1995 increased 78.0% to $47.3 million from $26.6 million in 1994. Earnings per share increased similarly by 83.8% to $2.73 in 1995 from $1.49 for 1994.
As a holding company, Enhance Financial finances the payment of its operating expenses, principal and interest on its debt obligations, dividends, if any, to its shareholders and the repurchase of its common stock primarily from dividends and other payments from the Insurance Subsidiaries, and draws on its line of credit provided under the Credit Agreement.
The Company believes that the operating liquidity needs of the Insurance Subsidiaries can be funded exclusively from their respective operating cash flows. The Company's cash flow from operations consists principally of insurance and reinsurance premiums collected and income earned on invested assets, which in turn is applied to the payment of claims, operating expenses and income taxes. The Company's cash flow from operations was $59.8 million, $66.3 million and $64.7 million for the years 1996, 1995 and 1994, respectively. The Company paid a total of $11.9 million, $7.3 million and $4.9 million in claims in 1996, 1995 and 1994, respectively. Of the claim payments made in 1996, $11.3 million related to reserves established in prior years.
In July 1996, the Company formed C-BASS, a joint venture in which the Company and MGIC each own 48% interests. Under the terms of the joint venture agreement, the Company contributed $15.8 million in cash in 1996 and will contribute an additional $9.4 million (including its 100% interest in LLSI) in 1997. In connection with its joint venture agreement with Singer, the Company makes available to Singer a LIBOR-based secured revolving credit facility, up to a maximum of $17 million, for its use in originating assets for securitization. In addition, the Company provides to Singer a LIBOR-based working capital credit line. At December 31, 1996, $13.7 million and $3.3 million were outstanding under the secured credit facility and the working capital credit line, respectively.
Based on the historical cash flow of the Company, the Company's current financial results and the Company's expectation as to the level of the Company's net premiums written during the next twelve months, the Company believes that cash flow provided by operating activities of the Insurance Subsidiaries over the next year will provide sufficient liquidity for the operations of the Company, as well as funds to Enhance Financial so that Enhance Financial will be able to meet its debt service and other obligations. The ability of Enhance Financial to meet its debt service and other obligations beyond the next twelve months will depend upon the cash flow generated by the operating activities of the Insurance Subsidiaries and the availability to Enhance Financial of sufficient amounts of funds from the Insurance Subsidiaries in the form of dividends or other payments. Beyond the next twelve months, the Company's cash flow to Enhance Financial may be influenced by a variety of factors, including market changes, insurance regulatory changes and changes in general economic conditions. Consequently, although the Company presently anticipates that it will be able to meet all debt service and other obligations over the long term, no assurance can be given as to whether the available net cash provided by the Company's operating activities will provide sufficient liquidity for Enhance Financial to meet all its long-term liquidity needs.
At December 31, 1996, 1995 and 1994, the carrying value of the Company's investments was $797 million, $749 million and $640 million, respectively, on which was earned $48.1 million, $44.2 million and $38.2 million in 1996, 1995 and 1994, respectively, excluding $4.0 million, $3.5 million and $(5.8) million of net realized gains (losses) in 1996, 1995, and 1994, respectively. The increase in investments resulted principally from cash flows from operations generated during the period. As of December 31, 1996, the Company held approximately $33.2 million and $5.4 million in short-term investments and cash and cash equivalents, respectively, to meet liquidity needs.
In 1996, the Company incurred annual debt service on its long and short term borrowings of $6.2 million and will incur similar debt service expense in 1997. In 1996, the Company repaid the then remaining balance of its notes issued in 1991 aggregating $3.4 million.
The Company has no other material commitments for capital or other expenditures within the next twelve months or thereafter.
Consolidated Balance Sheets as of December 31, 1996 and 1995 34
Consolidated Statements of Cash Flows for the Years Ended December 31, 1996, 1995, and 1994 37
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 1996 and 1995, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1996 in conformity with generally accepted accounting principles.
For The Years Ended December 31, 1994, 1995 AND 1996 (In thousands except share amounts)
Enhance Financial Services Group Inc. ("Enhance Financial") is a holding company which was incorporated in the State of New York in December 1985 and commenced operations in November 1986. Business is conducted by Enhance Financial's consolidated subsidiaries: Enhance Reinsurance Company ("Enhance Re"); Asset Guaranty Insurance Company ("Asset Guaranty"); and Van-American Companies, Inc. ("Van-Am", see Note 5). Enhance Re and Asset Guaranty (the "Insurance Subsidiaries") are licensed financial guaranty insurance companies domiciled in the State of New York which principally provide insurance and reinsurance coverage on financial guaranties issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions.
The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles ("GAAP") which, for the Insurance Subsidiaries, differ in certain material respects from the accounting practices prescribed or permitted by regulatory authorities (see Note 3). The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from these estimates. The significant accounting policies of Enhance Financial and its subsidiaries are as follows:
Common stocks are carried at market value. Short-term investments are carried at cost, which approximates market. Unrealized gains and losses net of income taxes on common stocks are reflected in shareholders' equity. Realized gains or losses on sales of investments are determined on the basis of specific identification.
In accordance with SFAS No. 109, "Accounting for Income Taxes", deferred federal income taxes are provided for temporary differences between the tax and financial reporting basis of assets and liabilities that will result in deductible or taxable amounts in future years when the reported amount of the asset or liability is recovered or settled. In the case of the Company, such temporary differences relate principally to premium revenue recognition and deferred acquisition costs.
In 1991, the Company implemented a stock option program for key employees. In 1992, the Company implemented a directors' stock option program for the benefit of directors who are not employees of the Company. Under these programs, awards are granted to eligible employees and directors of the Company in the form of Incentive Stock Options, where they qualify under the Internal Revenue Code, or Non Qualified Stock Options. In October 1995, the Financial Accounting Standards Board adopted SFAS No. 123, "Accounting for Stock-Based Compensation". SFAS No. 123 applies to all stock-based employee compensation plans (except employee stock ownership plans) in which an employer grants shares of its stock or other equity instruments to employees. SFAS No. 123 permits a company to choose for its stock-based compensation plans either the fair value based method of accounting as defined in the statement or the intrinsic value based method of accounting as prescribed by APB Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). The company has elected to continue to apply the accounting requirements under APB 25 and in accordance with SFAS No. 123 has made pro forma disclosures of net income and earnings per share as if the fair value based method of accounting had been applied (see Note 13).
For fully diluted earnings per share, the weighted average number of shares of common stock and common stock equivalents was 18,565,000, 17,949,000 and 17,875,000 for the years ended December 31, 1996, 1995 and 1994, respectively.
At December 31, 1996 the statutory basis policyholders' surplus of Enhance Re and Asset Guaranty, as reported to insurance regulatory authorities, was $225.3 million and $86.7 million, respectively. Statutory net income of Enhance Re and Asset Guaranty was $46.5 million and $8.8 million, respectively, for the year ended December 31, 1996. At December 31, 1995 the statutory basis policyholders' surplus of Enhance Re and Asset Guaranty was $214.2 million and $80.3 million, respectively. Statutory net income of Enhance Re and Asset Guaranty was $39.0 million and $10.5 million, respectively, for the year ended December 31, 1995. Statutory net income of Enhance Re and Asset Guaranty was $21.3 million and $2.0 million, respectively, for the year ended December 31, 1994.
Proceeds from sales of investments in fixed maturities during 1996, 1995 and 1994 were approximately $640 million, $529 million and $478 million, respectively. Gross gains of $7.7 million and gross losses of $3.7 million were realized on those sales in 1996. Gross gains of $10.1 million and gross losses of $6.6 million were realized on those sales in 1995. Gross gains of $5.9 million and gross losses of $11.7 million were realized on those sales in 1994.
The Company owns 360,000 shares of EIC Corporation Ltd. ("EIC"), an insurance holding company which, through its wholly owned insurance subsidiary licensed in Bermuda, insures foreign trade receivables. The Company's investment represented an equity interest of approximately 41% at the date of acquisition and approximately 36.5% at December 31, 1996. The Company's percentage ownership may be reduced from time to time through the participation of additional equity investors. However, in accordance with its purchase agreement the Company's ownership percentage cannot be reduced below 36%. The Company accounts for its investment in EIC in accordance with the equity method of accounting.
In October 1995, the Company converted all the shares of convertible preferred stock of Van-Am into shares of common stock of Van-Am. The Company currently owns 89.1% (85.5% on a fully diluted basis) of the outstanding common stock of Van-Am. Since the accumulated deficit attributable to the minority interest exceeds the minority interest in the equity capital of Van-Am and there is no obligation for the minority interest to make good such losses, the Company has accounted for its investment in Van-Am as a wholly owned subsidiary of the Company
In October 1995, the Company acquired a 50% joint venture interest in Singer Asset Finance Company, L.L.C. ("Singer"), which originates and securitizes various types of special assets such as lottery winnings and similar state obligations. The excess (approximately $3.7 million) of the Company's cost over the fair value of its interest in the net assets of Singer represents goodwill and is being amortized over 20 years. Subsequent to year end, the Company increased its ownership interest in Singer to 87.5% in an all stock transaction.
Year Ended December 31, -------------------------------------- In thousands 1996 1995 1994 ------- ------- ------ Current income taxes $ 9,992 $ 5,447 $3,217 Deferred income taxes 10,694 11,096 2,877 ------- ------- ------ Tax provision $20,686 $16,543 $6,094 ======= ======= ======
The components of the net deferred income tax liability as of December 31, 1996 and 1995 are as follows:
The carrying value of the Company's long-term debt is as follows:
The debentures were issued at par and bear interest at 6.75% payable in March and September each year. The debentures are non-callable and are general unsecured and unsubordinated obligations of Enhance Financial.
The 1991 Notes due 1996 bore interest at 7.0% and were subject to mandatory redemption by Enhance Financial in equal annual installments throughout their term to maturity. The 1991 Note due 2001 bore interest at 8.4% and was subject to mandatory redemption in equal annual installments throughout the final five years of its term until maturity. Interest on the 1991 Notes was payable semi-annually, on June 1 and December 1 of each year. In September 1996, Enhance Financial redeemed the 1991 Notes and, in connection with such redemption, incurred an interest penalty of $96,000.
In 1992, Enhance Financial's board of directors authorized the repurchase of up to 600,000 shares of its common stock and in 1994, increased its authorization to 1,200,000 shares. Enhance Financial purchased 1,600, 404,800 and 471,300 shares of its common stock at an average price of $23.82, $16.63, and $18.33 per share in 1996, 1995, and 1994, respectively. In December 1996, the board of directors canceled its prior authorization and authorized the repurchase of up to 750,000 shares of Enhance Financial's common stock from that date. Subsequent to year end, the Company purchased an additional 32,925 shares at an average price of $36.15 per share.
In February 1996, Swiss Reinsurance Company purchased from Enhance Financial and one of its shareholders, respectively, 600,000 and 400,000 shares of Enhance Financial common stock at a purchase price of $24.48 per share.
The New York Insurance Law requires financial guaranty insurers to maintain a minimum policyholders' surplus of $65 million. When added to the minimum policyholders' surplus of $3.4 million separately required for the other lines of insurance which it is licensed to write, each of the Insurance Subsidiaries is required to have an aggregate minimum policyholders' surplus of $68.4 million.
Under the New York Insurance Law, the Insurance Subsidiaries may declare or distribute dividends only out of earned surplus. The maximum amount of dividends which may be paid by the Insurance Subsidiaries to Enhance Financial without prior approval of the Superintendent of Insurance is subject to restrictions relating to statutory surplus and net investment income as defined by statute. Enhance Re declared and paid a total of $13.3 million in dividends to Enhance Financial for the year ended December 31, 1996. Asset Guaranty has paid no dividends since its inception. At December 31, 1996, the Insurance Subsidiaries had $21.2 million available for dividend distribution.
Under the terms of the Credit Agreement, the maximum amount of dividends which may be paid by Enhance Financial as of December 31, 1996 was $31.2 million.
Fixed maturity securities - The fair values of fixed maturity securities are based on quoted market prices or dealer quotes.
Short-term investments - Fair values of short-term investments are assumed to equal cost.
Deferred premium revenue - The fair value of the Company's deferred premium revenue is based on the estimated cost of entering into a cession of the entire portfolio with third-party reinsurers under
market conditions. This figure was determined by using the statutory basis unearned premiums adjusted for ceding commission based on current market rates.
Loss and loss adjustment reserves - The carrying amount is composed of the present value of the expected cash flows for specifically identified claims combined with a general estimate for non-specific reserves. Therefore, the carrying amount is a reasonable estimate of the fair value of the reserve.
California $ 6.9 $ 6.7 New York 6.2 5.7 Florida 4.2 4.2 Texas 3.1 3.0 Pennsylvania 3.1 3.1 Illinois 2.6 2.5 Other (each less than 4%) 30.5 28.2 --------- --------- Total $ 56.6 $ 53.4 ========= =========
The Company makes available to Singer a LIBOR-based secured revolving credit facility, up to a maximum of $17.0 million, for its use in originating assets for securitization. In addition, the Company provides to Singer a LIBOR-based working capital credit line. At December 31, 1996, $13.7 million and $3.3 million were outstanding under the secured credit facility and working capital credit line, respectively.
1996 1995 1994 ---- ---- ---- Discount rate 7.5% 5.5% 5.5% Expected long-term rate of return on plan assets 8.5% 8.5% 8.5% Rate of increase in future compensation levels 6.0% 6.0% 6.0%
In addition to pension benefits, the Company provides certain health care benefits for retired employees. Substantially all employees of Enhance Financial and the Insurance Subsidiaries may become eligible for these benefits if they reach retirement age while working for the Company.
On January 1, 1996, the Company implemented a 401(k) retirement savings plan covering substantially all employees of the Company. Under this plan, the Company provides a matching contribution of 25% on contributions up to 6% of base salary made by eligible employees to the plan. The Company contributed $110,000 to the plan in 1996.
The Company maintains a stock option program for its key employees. Options issued under the program vest in four equal annual installments commencing approximately one year after the date of grant.
The Company also maintains a directors' option program pursuant to which directors of Enhance Financial or the Insurance Subsidiaries who are not employees of the Company are granted non-qualified stock options. Options under this program vest in two equal annual installments commencing on December 31 next following the date of grant. Options under both plans are exercisable at the option price, being the fair market value at the date of grant. The Board of Directors of Enhance Financial has authorized a maximum of 3,367,950 shares of the Company's common stock to be awarded as options of which
Outstanding at beginning of year 2,415,721 $14.50 - $26.625 Granted - Employees 400,110 $26.875 $34.00 - Directors 26,000 $36.50 Exercised (231,275) $14.50 - $20.25 Expired or canceled (57,446) $16.00 - $23.875 --------- Outstanding at year-end 2,553,110 $14.50 - $36.50 --------- Exercisable at year-end - Employees 1,321,457 $14.50 - $23.875 - Directors 143,333 $17.125 -$26.625 ---------
No shares have been issued under the Company's restricted stock award program since 1989. Total compensation expense of $79,000, $157,000, and $211,000 was recognized related to services rendered in 1996, 1995 and 1994, respectively.
The Company applies the provisions of APB Opinion No.25 "Accounting for Stock Issued to Employees" in accounting for its stock option program. Accordingly, no compensation expense has
been recognized for options granted under its stock option program, and the Company has adopted the disclosure-only provisions of SFAS No.123, "Accounting for Stock-Based Compensation." Had compensation cost for the Company's stock option program been determined based upon the fair value at the grant date for awards under these plans consistent with the methodology prescribed under SFAS No. 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below:
Net income - as reported $55,704 Net income - pro forma $55,046 Primary earnings per share - as reported $ 3.12 Primary earnings per share - pro forma $ 3.08
Dividend Yield 1.1% to 1.5% 1.4% to 2.0% Volatility 20.5% to 30.3% 26.5% to 31.1% Risk-free interest rate 6.2% to 6.8% 5.6% to 7.2% Assumed annual forfeiture rate 3.0% 3.0% Expected life 10 years 10 years
The Company has committed to lease office space under non-cancelable leases which expire in August 1999, December 1999, April 2000 and August 2000. The leases provided for escalations resulting from increased assessments for taxes, utilities and maintenance. Future minimum rental payments on all leases, before any deductions for estimated sublease income, are as follows:
The following are the condensed balance sheets of Enhance Financial as of December 31, 1996 and 1995 and its condensed statements of income and cash flows for the years ended December 31, 1996, 1995 and 1994:
CONDENSED BALANCE SHEETS In thousands December 31, ------------------ 1996 1995 ---- ---- Assets: Investments $ 10,213 $ 3,790 Investment in affiliated companies 563,395 501,713 Other assets 38,386 21,218 -------- -------- $611,994 $526,721 ======== ======== Liabilities and Shareholders' Equity: Long-term debt $ 75,000 $ 78,400 Other liabilities 48,645 24,384 Shareholders' equity 488,349 423,937 -------- -------- $611,994 $526,721 ======== ======== CONDENSED STATEMENTS OF INCOME In thousands Year Ended December 31, -------------------------------- 1996 1995 1994 ---- ---- ----
o In 1996 four primary insurers accounted for 18%, 14%, 10% and 7% of gross premiums written.
o In 1995 four primary insurers accounted for 22%, 18%, 8% and 8% of gross premiums written.
o In 1994 four primary insurers accounted for 23%, 23%, 9% and 7% of gross premiums written.
Balance at January 1, $30,799 $29,337 $ 8,947 Less reinsurance recoverables 1,853 2,620 194 ------- ------- ------- Net balance at January 1, 28,946 26,717 8,753 ------- ------- ------- Net incurred related to: Current year 6,087 3,491 9,921 Prior years 3,097 6,022 12,921 ------- ------- ------- Net incurred 9,184 9,513 22,842 ------- ------- ------- Net paid related to: Current year 587 2,705 3,216 Prior years 11,285 4,579 1,662 ------- ------- ------- Net paid 11,872 7,284 4,878 ------- ------- ------- Net balance at December 31, 26,258 28,946 26,717 Plus reinsurance recoverables 1,823 1,853 2,620 ------- ------- -------
In January 1995, the Company entered into a reverse interest-rate swap transaction with a AAA-rated counterparty based on a notional amount of $50 million over a term equal to the remaining term of Enhance Financial's 6.75% Debentures. Pursuant to the terms of the swap, the Company incurred an obligation to pay interest semi-annually at a variable LIBOR-based interest rate in exchange for interest at a fixed rate of 8.00%. The variable rate was set quarterly in advance. The variable rate for the initial period to the first reset date was 6.1875%.
On June 1, 1995, the Company terminated the swap and realized a gain on termination in the amount of $4.6 million. The gain has been deferred and is being amortized over the original term of the swap.