The Company and its subsidiaries own or lease office buildings or office space suitable to conduct their operations. Such owned property is as follows:
(1) Investments and stockholders' equity reflect the adoption of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," as of December 31, 1993. Included in the calculation of common stockholders' equity per share are unrealized investments gains (losses), net of federal income taxes, of $31,075,000, $48,450,000, ($33,973,000) and $36,450,000 as of December 31, 1996, 1995, 1994 and 1993, respectively.
The demand for insurance can be characterized as fairly stable and is influenced primarily by general economic conditions, while the supply of insurance is directly related to available capacity, i.e., the level of policyholders' surplus employed in the industry and the willingness of insurance management to risk that capital. In general, it is believed that the amount of available capacity changes as the perceived rate of return on capital employed fluctuates based on the adequacy of premium rates and available investment returns. The adequacy of premium rates is affected mainly by the severity and frequency of claims which are influenced by many factors including natural disasters, regulatory measures and court decisions that define and expand the extent of coverage and the effects of economic inflation on the amount of compensation due for injuries or losses. In addition, investment rates of return may impact policy rates. These factors can have a significant impact on the ultimate adequacy of premium rates because a property casualty insurance policy is priced before its costs are known, as premiums usually are determined long before claims are reported. Over the past several years a trend of increasing price competition, combined with an increase in the number and size of catastrophic losses, has produced a reduction in underwriting profitability for the Company and the industry.
Pre-tax net investment income increased to $164 million from $137 million earned in 1995. Approximately three-fourths of this increase was due to the inclusion of the
results of MECC. The remainder of this increase was due to the increase in average investable assets generated by cash flow from operations which more than offset the effects of lower yields available in the financial markets (see "Liquidity and Capital Resources").
Realized gains from the sale of fixed income securities result primarily from the Company's strategy of rebalancing the asset and liability duration relationship; realized gains on equity securities arise primarily as a result of a variety of factors which influence the Company's valuation criteria. The majority of the 1996 realized gains resulted form the sale of equity securities, whereas in 1995 the majority of realized gains were from the sale of fixed income securities.
The consolidated combined ratio (on a statutory basis) of the Company's insurance operations decreased to 102.2% in 1996 from 102.5% in 1995 due to an improvement in the consolidated loss ratio which was partially offset by an increase in the consolidated expense ratio. The consolidated loss ratio (losses and loss expenses incurred expressed as a percentage of premiums earned) decreased to 68.7% from 70.7% primarily due to improved losses at certain specialty companies resulting from a change in mix of business partially offset by greater catastrophe losses impacting the regional companies.
Interest expense increased due to the January 1996 issuance of $100 million of long-term debt. In addition, in December 1996, the Company issued $210 million of Company obligated manditorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debt securities (see "Liquidity and Capital Resources").
The Federal income tax provision resulted in an effective tax rate of 22% in 1996 and 21% in 1995. The tax rate is lower than the statutory tax rate of 35% because a substantial portion of investment income is tax-exempt. The increase in the effective tax rate in 1996 is due primarily to a decrease in the percentage of pre-tax income that is tax-exempt.
In December 1995, the Company purchased all the remaining outstanding common stock of Signet Star Holdings. As a result of this acquisition, the minority interest in 1996 was solely related to international operations.
Preferred dividends increased as a result of the December 1995 issuance of Series B Cumulative Redeemable Preferred Stock (see "Liquidity and Capital Resources").
Net Income for 1995 was $50 million, or $2.86 per share, compared with 1994 earnings of $25 million, or $1.44 per share. The 1995 results include after-tax realized
Net investment income increased, on a pre-tax basis, to $137 million from $110 million earned in 1994. The higher level of investment earnings is due primarily to growth in investable assets generated by an increase in cash flow from operations and increased portfolio yields. The pre-tax yield of the portfolio increased as a result of a change in the mix of fixed maturity investments, an increase in the duration of the portfolio and an increase in trading account profits (see "Liquidity and Capital Resources").
The consolidated combined ratio (on a statutory basis) of the Company's insurance operations decreased to 102.5% in 1995 from 105.0% (101.9% before the Northridge Earthquake) in 1994 due to an improvement in the consolidated loss ratio which was partially offset by a slight increase in the expense ratio. The consolidated loss ratio (losses and loss expenses incurred expressed as a percentage of premiums earned) decreased to 70.7% from 73.7%, primarily due to the effect of the Northridge Earthquake, which significantly impacted 1994 results. This improvement was partially offset by an increase in the frequency and severity of losses incurred by our commercial transportation unit.
The Company's subsidiaries are highly liquid, receiving substantial cash from premiums, investment income, management fees and proceeds from sales and maturities of portfolio investments. The principal outflows of cash are payments of claims, taxes, interest and operating expenses. The net cash provided from operating activities (before trading account transactions) was $243.8 million in 1996 and $206.6 million in 1995. The increase in cash flow in 1996 was due primarily to additional cash flow generated by the acquisition of MECC and the increase in premium volume previously discussed.
In January 1994, the Company issued 6 million depository shares each representing a one-sixth interest in a share of 7.375% Series A Cumulative Redeemable Preferred Stock and received net proceeds of approximately $145 million. A portion of the proceeds of this offering were contributed to the start-up insurance subsidiaries to support their growth.
On December 19, 1996, the Company issued $210 million of 8.197%, Company obligated manditorily redeemable preferred securities of a trust holding solely junior subordinated debt securities ("Capital Trust Securities") and utilized $38.4 million of the proceeds to retire the remaining outstanding shares of the Series B Preferred Stock. In addition, during December 1996 and January 1997 the Company utilized $39.2 million of
the proceeds to retire 252,273 shares of the Series A Preferred Stock and placed $115.8 million in a trust which will be used to service the remaining outstanding Series A Preferred Stock. The Company expects the proceeds of the trust will be utilized to redeem the Series A Preferred Stock on January 25, 1999. The balance of the proceeds is available for acquisitions, working capital and other general corporate purposes.
The Company's investment policy with respect to fixed maturity securities is generally to purchase instruments with the expectation of holding them to their maturity. However, active management of the portfolio is considered necessary to maintain an approximate matching of assets and liabilities as well as to adjust the portfolio as changes in financial market conditions alter the assumptions underlying the purchase of certain securities.
The Company files a consolidated Federal income tax return. At December 1996, the Company had a deferred tax liability of $48.6 million, which results primarily from unrealized investment gains and intangible assets, and a deferred tax asset of $44.6 million, which results primarily from the discounting of loss reserves for Federal income tax purposes.
The Company follows the customary industry practice of reinsuring a portion of its exposures, paying to reinsurers a part of the premiums received on the policies it writes. Reinsurance is purchased principally to reduce net liability on individual risks and to protect against catastrophic losses. Although reinsurance does not legally discharge an insurer from its primary liability for the full amount of the policies, it does make the assuming reinsurer liable to the insurer to the extent of the reinsurance ceded. The Company monitors the financial condition of its reinsurers and attempts to place its coverages only with substantial, financially sound carriers. The Company has established reserves for uncollectible reinsurance.
Admiral's retention in 1996 was $175,000 per risk for most classes of business and $5.0 million, per insured, for business written by Monitor Liability Managers. In addition, in 1996 Admiral's Directors and Officer coverage also included additional protection on an aggregate basis. Nautilus generally retained $140,000 per risk in 1996 and Carolina maintained its retention at $300,000 on liability exposures.
In our opinion, the information set forth in the selected financial data for each of the years in the five-year period ended December 31, 1996, appearing on page 22, is fairly presented, in all material respects, in relation to the consolidated financial statements from which it has been derived.
The consolidated financial statements, which include the accounts of W. R. Berkley Corporation and its subsidiaries ("the Company"), have been prepared on the basis of generally accepted accounting principles ("GAAP"). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the revenues and expenses reflected during the reporting period. Actual results could differ from those estimates. All significant intercompany transactions and balances have been eliminated. Reclassifications have been made in the 1995 and 1994 financial statements to conform them to the presentation of the 1996 financial statements.
Insurance premiums written are recognized as earned generally on a pro-rata basis over the contract period. Management fees on insurance services contracts are recorded as earned primarily on a pro-rata basis over the policy period. Commission income is recognized as earned on the effective date of the applicable insurance policies.
Realized gains or losses represent the difference between the cost of securities sold and the proceeds realized upon sale. The cost of securities is adjusted where appropriate to include provision for declines in value which are considered to be other than temporary. The Company uses the specific identification method where possible and the first-in, first-out method in other instances, to determine the cost of securities sold. Realized gains or losses, including any provision for decline in value, are included in the statement of operations.
Reserves for losses and loss expenses are an accumulation of amounts determined on the basis of (1) evaluation of claims for business written directly by the Company; (2) estimates received from other companies for reinsurance assumed; and (3) estimates for losses incurred but not reported (based on Company and industry experience). These estimates are periodically reviewed and, as experience develops and new information becomes known, the reserves are adjusted as necessary. Such adjustments are reflected in results of operations in the period in which they are determined.
A subsidiary of the Company, Midwest Employers Casualty Company ("Midwest") which was acquired in November 1995, discounts its liabilities for excess workers' compensation ("EWC") losses and loss expenses using a "risk-free" rate. Midwest discounts its EWC liabilities because of the long period of time over which it pays losses. The Company believes that utilizing a "risk-free" rate to discount these reserves more closely reflects the economics associated with the excess workers' compensation line of business (see Note 12 of notes to consolidated financial statements).
The Company files a consolidated Federal income tax return. In 1995 and prior years, Signet Star Holdings, Inc. filed its own consolidated Federal income tax return.
In 1996 several acquisitions were completed for an aggregate consideration of approximately $15,955,000. The acquisitions were accounted for as purchases and, accordingly, the results of operations of the acquired companies have been included from the respective dates of acquisition. Proforma results of operations have been omitted as such effects are not significant.
The Proforma consolidated financial data do not purport to represent what the Company's results of operations actually would have been had the acquisitions and related financings occurred on the dates indicated, or to project the Company's results of operations for any future period. The above amounts primarily reflect the effects on results of operations of certain adjustments resulting from the revaluation of assets and liabilities of the purchased companies and from the financing of such acquisitions.
The Federal income tax expense (benefit) consists of (dollars in thousands):
At December 31, 1996 and 1995, the tax effects of differences that give rise to significant portions of the deferred tax asset and deferred tax liability are as follows (dollars in thousands):
The Federal income tax expense (benefit) applicable to realized investment gains (losses) was $2,603,000, $3,664,000 and ($61,000) in 1996, 1995 and 1994, respectively. The Company had a current income tax payable of $6,224,000 and a current income tax receivable of $210,000 at December 31, 1996 and 1995, respectively.
The Company obligated mandatorily redeemable preferred securities of a subsidiary trust holding solely junior subordinated debenture ("Capital Trust Securities") were issued by the W.R. Berkley Capital Trust ("the Trust"). All of the common securities of the Trust are owned by the Company. The trust exists for the exclusive purpose of issuing the Capital Trust Securities and investing the proceeds in a junior subordinated debenture of the Company with similar interest rates, principal amount and maturities. The Capital Trust Securities are guaranteed by the Company as to the payment of distributions and the payment of liquidation of the Capital Trust Securities within certain limits. The Capital Trust Securities have a face value of $210,000,000, mature on December 15, 2045 and require preferential cumulative cash distributions at an annual rate of 8.197%.
The Capital Trust Securities are subject to mandatory redemption in a like amount,(i) in whole but not in part, on the stated maturity date, upon repayment of the junior subordinated debentures, (ii) in whole but not in part, at any time contemporaneously with the optional prepayment of the junior subordinated debentures by the Company upon the occurrence and continuation of a certain event and (iii) in whole or in part, on or after December 15, 2006 and contemporaneously with the optional prepayment by the Company of junior subordinated debentures.
At present, neither the Company nor any of its subsidiaries are engaged in any litigation known to the Company which management believes will have a material adverse effect upon the Company's business. As is common with other insurance companies, the Company's subsidiaries are regularly engaged in the defense of claims arising out of the conduct of the insurance business.
Per share data have been computed based on the weighted average number of common shares outstanding. The assumed dilutive effect of employee stock options was not material. Treasury shares have been excluded from average outstanding shares from the date of acquisition. The number of shares used in the computations was 19,861,000, 17,414,000, and 17,182,000 for 1996, 1995 and 1994, respectively.
The Company adopted the W. R. Berkley Corporation 1992 Stock Option Plan under which 1,750,000 shares of Common Stock were reserved for issuance. Pursuant to the Plan, options may be granted at prices determined by the Board of Directors but not less than 85% of the fair market value on the date of grant. To date, options have been granted with an exercise price equal to the average of the high and low market price on the date of grant.
The following table summarizes option information, including options granted under both the 1992 and prior plans:
Had compensation costs for the Company's 1996 and 1995 grants been determined under the cost recognition alternative of FAS 123, the effect on the Company's net income and net income attributable to common shareholders would have been immaterial.
(a) During 1996, 1995 and 1994, gross gains of $5,904,000, $11,570,000 and $5,601,000, respectively, and gross losses of $4,054,000, $3,751,000 and $8,177,000, respectively, were realized.
(b) The provision for decline in value of investments is $3,485,000, $3,333,000 and $7,172,000 as of December 31, 1996, 1995 and 1994, respectively. The 1996 increase is due to additional writedowns, the decrease in 1995 and 1994 resulted from the sale of securities.
(a) The primary focus of the trading account is merger and municipal fixed income arbitrage. Merger arbitrage is the business of investing in the securities of publicly held companies which are the targets in announced tender offers and mergers. Merger arbitrage differs from other types of investments in its focus on transactions and events believed likely to bring about a change in value over a relatively short time period (usually four months or less). The Company believes that this makes merger arbitrage investments less vulnerable to changes in general financial market conditions. Potential changes in market conditions are also mitigated by the implementation of short sales.
Due to the nature of Excess Workers Compensation ("EWC") business and the long period of time over which losses are paid in this line of business, the Company discounts the liability for losses and loss expenses established for the excess workers' compensation line of business. Discounting liabilities for losses and loss expenses gives recognition to the time value of money set aside to pay claims in the future and is intended to appropriately match losses and loss expense to income earned on investment securities supporting the liabilities. The expected losses and loss expense payout pattern subject to discounting was derived from Midwest's loss payout experience and is supplemented with data compiled from insurance companies writing workers' compensation on an excess-of-loss basis. The expected payout pattern has a very long duration because it reflects the nature of losses which generally penetrate self-insured retention limits contained in excess workers' compensation policies. The Company has limited the payout duration to 30 years in order to introduce an additional level of conservatism into the discounting process. The liabilities for losses and loss expenses have been discounted using "risk-free" discount rates determined by reference to the U.S. Treasury yield curve weighted for the EWC premium volume to reflect the seasonality of the anticipated duration of losses associated with such coverages. The average discount rate for accident years 1996 and 1995 and prior is 5.90% and 5.80%, respectively. The aggregate net discount, after reflecting the effects of ceded reinsurance, is $172,415,000 and $152,235,000 at December 31, 1996 and 1995, respectively. For Statutory purposes, Midwest uses a discount rate of 3.0% as permitted by the Department of Insurance of the State of Ohio.
The Company's net reserves for losses and loss adjustment expenses relating to pollution and environmental claims were $35.2 million and $30.8 million at December 31, 1996 and 1995, respectively. The Company's gross reserves for losses and loss adjustment expenses relating to pollution and environmental claims were $71.9 million and $59.4 million at December 31, 1996 and 1995, respectively. Net incurred losses and loss expenses for reported pollution and environmental claims were approximately $6.9 million, $8.0 million and $5.6 million in 1996, 1995 and 1994, respectively. Net paid losses and loss expenses has averaged approximately $3 million for each of the last three years. The estimation of these liabilities is subject to significantly greater than normal variation and uncertainty because it is difficult to make a reasonable actuarial estimate of these liabilities due to the absence of a generally accepted actuarial methodology for these exposures and the potential affect of significant unresolved legal matters, including coverage issues as well as the cost of litigating the legal issues. Additionally, the determination of ultimate damages and the final allocation of such damages to financially responsible parties is highly uncertain.
The Company's insurance subsidiaries are restricted by law as to the amount of dividends they may pay without the approval of regulatory authorities. During 1997, the maximum amount of dividends which can be paid without such approval is approximately $69,235,000.
At December 31, 1996 and 1995, bonds with a market value of $139,497,000 and $137,579,000 were on deposit with various state Insurance Departments as required by state laws.
The Company's operations are presently conducted through five basic segments: regional property casualty insurance; reinsurance; specialty lines of insurance; alternative markets operations; and international. Summary financial information about the Company's operating segments is presented in the following table. Income before income taxes by segment consists of revenues less expenses related to the respective segment's operations. These amounts include realized gains (losses) where applicable. Intersegment revenues consist primarily of dividends, interest on intercompany debt and fees paid by subsidiaries for portfolio management and other services to the Company. Identifiable assets by segment are those assets used in the operation of each segment.
The estimated fair value of investments is based on quoted market prices as of the respective reporting dates. The fair value of the long-term debt is based on rates available for borrowings similar to the Company's outstanding debt as of the respective reporting dates.