We developed a proprietary management system, the RTW SOLUTION-Registered Trademark-, designed to lower employers' workers' compensation costs and return injured employees to work as soon as possible. We combine our management system with insurance products underwritten by our insurance subsidiary to offer services to customers. We currently provide workers' compensation management services solely to employers insured through our insurance subsidiary. We operated in Minnesota, Wisconsin, South Dakota, Colorado, Missouri, Illinois, Kansas, Michigan, Indiana, Massachusetts, Connecticut, New Hampshire and Rhode Island during 1998.
RTW reported total revenues of $90.2 million in 1998, a 2.1 percent increase over total revenues of $88.3 million reported for 1997. Total revenues in 1998 were significantly reduced by premiums ceded under an excess of loss reinsurance agreement entered into during the fourth quarter of 1998. This agreement was effective for claims occurring on or after July 1, 1998, however the effect of the transaction was recorded entirely in the fourth quarter of 1998. Total revenues were also positively affected by a refund of $2.3 million from the Minnesota Workers' Compensation Reinsurance Association, which was recorded in the first quarter of 1998; a similar refund of $358,000 was recorded in the third quarter of 1997. Excluding the effects of reinsurance and refunds, adjusted total revenues increased 7.5 percent in 1998 versus the reported increase of 2.1 percent. We also reported a net loss of $7.1 million in 1998, compared to net income of $5.8 million reported for 1997, and basic and diluted net loss per share of ($0.59) in 1998 versus basic net income per share of $0.49 and diluted income per share of $0.48 in 1997.
In the following pages, we take a look at the 1998, 1997 and 1996 operating results for items in our Consolidated Statement of Operations and also explain key balance sheet accounts in greater detail.
GROSS PREMIUMS EARNED: Premiums on workers' compensation insurance policies are our largest source of revenue. Premiums earned are the gross premiums earned by us on in force workers' compensation policies, net of the effects of ceded premiums under reinsurance agreements.
Gross premiums earned in 1997 increased 27.6% to $81.4 million from $63.8 million in 1996. This increase resulted, in part, from the 12.8% increase in premiums in force to $78.4 million at December 31, 1997, from $69.5 million at December 31, 1996. Additionally, gross premiums earned increased as we recognized $7.5 million of final audit premiums in 1997 compared to $970,000 recognized in 1996.
- We continue to experience reduced pricing on renewal policies due, in part, to our success in lowering our policyholders' loss experience which then improves their claims history, lowering the premium that they have to pay for insurance.
Under our excess of loss reinsurance policies, we pay reinsurers to limit our per incident exposure and record this cost as a reduction to gross premiums earned. In Minnesota, we are required to purchase excess of loss coverage for Minnesota policies from the Minnesota Workers' Compensation Reinsurance Association (WCRA). Our selected retention levels in Minnesota were $280,000 in 1998, $1.1 million in 1997 and $1.0 million in 1996. In other states, we continued to limit our per incident exposure to $500,000 and purchased this coverage from various reinsurers. Additionally, for claims occurring on or after July 1, 1998, we further limited our per incident exposure by purchasing excess of loss coverage for losses from $25,000 to $280,000 in Minnesota and from $25,000 to $300,000 in other states from a single reinsurer. This agreement was finalized after its effective date. As a result, activity occurring from July 1, 1998 through October 1, 1998 has been recorded on a retroactive basis resulting in the deferral of a gain totaling $2.0 million. Activity occurring on or after October 1, 1998 has been recorded prospectively. This gain will be amortized into income in future years using the effective interest rate inherent in the amounts paid to the reinsurer and the estimated timing and amounts of recoveries from the reinsurer.
- We believe the recent events within the workers' compensation reinsurance market will have no impact on our reinsurance program for 1999.
Investment income and net realized investment gains increased 21.3% to $8.8 million in 1998 from $7.2 million in 1997, due to increased funds available for investment and increased net realized investment gains totaling $1.0 million in 1998 compared to $399,000 realized in 1997. Investment income has been significantly affected by growth of tax-exempt municipal securities included in our portfolio that earn lower pre-tax yields than taxable securities but earn higher comparable yields on a tax adjusted basis. Funds available for investment increased to $126.6 million at December 31, 1998, from $112.3 million at December 31, 1997, due to increased net cash provided by operating activities resulting primarily from (i) the difference in timing between the receipt of premiums and the payment of claim and claim settlement expenses and (ii) net cash provided by investment income. Pre-tax investment yields decreased to 6.0% in 1998 from 6.3% in 1997 due to purchasing tax-exempt municipal securities, which have lower yields on a pre-tax basis offset by portfolio diversification during 1998 and 1997. The investment yield realized in future periods will be affected by yields attained on new investments.
- Increased funds will become available for investment due to increased net cash provided by operating and investment activities. The increase, however, will decrease from levels attained in prior years due to ceded premiums on excess of loss policies for losses in excess of $25,000;
CLAIM AND CLAIM SETTLEMENT EXPENSES: Claim expenses refer to medical and indemnity amounts that we paid or expect to pay to claimants for events that have occurred. The costs of investigating, resolving and processing these claims are referred to as claim settlement expenses. We record these expenses, net of amounts recoverable under reinsurance contracts, to claim and claim settlement expenses in the Consolidated Statements of Operations.
- During 1998, we increased our estimate of the pre-1998 liability for unpaid claim and claim settlement expenses by $11.0 million as a result of unfavorable claims experience for those periods. This increase was $14.1 million more than the $3.1 million reduction that we recorded in 1997. Additionally, we increased our estimate for the 1998 liability for unpaid claim and claim settlement expenses as a result of the 1997 and prior year adjustment. At December 31, 1998, we had gross reserves for unpaid claim and claim settlement expenses of $97.3 million including $53.2 million for 1998 claims and $44.1 million for claims relating to years prior to 1998;
- Average claim cost continued to decrease in 1997 due to realized operating efficiencies and effectiveness and legislative changes in benefits to claimants. These decreases did not keep pace, however, with decreases in pricing.
1999 OUTLOOK: We expect that claim and claim settlement expenses will be affected by the following factors:
- Claim costs will be affected by (i) increases in medical and indemnity costs resulting from inflationary changes, (ii) severity experienced in future periods in our policy holder base, (iii) changes resulting from increases in operating efficiency and effectiveness realized through enhancements to our internal processes and procedures, including changes to our proprietary computer systems, and (iv) legislative changes in estimated loss costs;
- Claim and claim settlement expenses will decrease due to reducing our selected retention level to $25,000 in all our states from $280,000 in Minnesota and $500,000 in our non-Minnesota states. This reduction will result in additional ceding of paid and unpaid claim and claim settlement expenses and significantly reduce claim and claim settlement expenses; and
The ultimate result of the above factors, combined with the change in premium rates, on 1999 claim and claim settlement expenses as a percent of premiums earned is unknown at this time.
Policy acquisition costs increased to $14.0 million in 1998 from $11.7 million in 1997 and $6.3 million in 1996. As a percent of gross premiums earned, policy acquisition costs increased to 15.5% in 1998 from 14.3% in 1997 and 9.9% in 1996. These increases reflect the following:
- There were no ceding commissions in 1998 compared to a cost of $1,000 in 1997 from a benefit of $1.9 million in 1996. We recognized favorable adjustments to our claims experience for accident years 1992 through 1994 resulting in the 1996 benefits realized.
1999 OUTLOOK: We expect that policy acquisition costs as a percent of gross premiums earned will stabilize or remain relatively constant as a percent of gross premiums earned during 1999 due to the following:
Income taxes were a benefit of $4.0 million in 1998 compared to expense of $2.9 million in 1997 and $4.7 million in 1996. As a percent of income (loss) before income taxes, the income tax expense (benefit) was (35.8%) of the loss before income taxes in 1998 compared to 33.1% and 34.5% of income before income taxes in 1997 and 1996 respectively. The income tax expense (benefit) percent in 1998 has been affected by (i) our loss from operations which resulted in a credit against taxes previously paid, (ii) decreased taxable net income from the service organization (RTW) which is subject to both federal and state income taxes, (iii) decreases in the profitability of ACIC, and (iv) the introduction of tax-exempt municipal income beginning in the second quarter of 1998.
We record investments on our balance sheet at fair value, with the corresponding appreciation or depreciation from amortized cost recorded in shareholders' equity, net of taxes. Because value is based on the relationship between the portfolio's stated yields and prevailing market yields at any given time, interest rate fluctuations can have a swift and significant impact on the carrying value of these securities. As a result of the increased holdings in securities classified as available-for-sale, and thus carried at fair value, we expect to encounter larger adjustments in shareholders' equity as market interest rates and other factors change.
The following loss reserve development table sets forth the change, over time, of reserves established for claim and claim settlement expenses at the end of the last seven years. The following loss reserve development table is cumulative and, therefore, ending balances should not be added since the amount at the end of each calendar year includes activity for both current and prior years (000's):
The following table is derived from the loss reserve development table and summarizes the effect of reserve re-estimates, net of reinsurance, on calendar year operations for the same seven-year period ended December 31, 1998. The total of each column details the amount of reserve re-estimates made in the indicated calendar year and shows the accident years to which the re-estimates are applicable. The amounts in the total accident year column represent the cumulative reserve re-estimates for the indicated accident year (000's):
Our primary sources of cash from operations are premiums collected and investment income. Our investment portfolio is also a source of liquidity, through the sale of readily marketable fixed maturity investments, as well as longer-term investments that have appreciated in value. Our primary cash requirements consist of payments for (i) claim and claim settlement expenses, (ii) policy acquisition costs, (iii) general and administrative expenses, (iv)
capital expenditures, (v) income taxes, and (vi) debt service or principal repayment on our outstanding Senior Notes. We generate positive net cash from operations due, in part, to timing differences between the receipt of premiums and the payment of claim and claim settlement expenses. Cash generated is either invested in short-term cash and cash equivalents or longer-term available-for-sale securities pending future payments for such expenses as indemnity, medical benefits and other operating expenses. Cash and cash equivalents consist primarily of U. S. government securities acquired under repurchase agreements with maturities of 90 days or less, with the remaining balances in cash and a money market fund that invests in short-term government securities.
Our need for additional capital is primarily the result of regulations that require certain ratios of capital to premiums written. In the future, we expect that our need for additional capital will be primarily related to the growth of our insurance subsidiary and the need to maintain appropriate capital to premium ratios as defined by state regulatory bodies. As an alternative to raising additional capital, we believe we could secure quota-share or other additional reinsurance, which would have the effect of reducing the ratio of premiums to capital, and could be used to satisfy state regulatory requirements.
State insurance regulations limit distributions, including dividends, from our insurance subsidiary to us. The maximum amount of dividends that can be paid by ACIC to us in any year is equal to the greater of: (i) 10% of ACIC's statutory surplus as of the end of the previous fiscal year, or (ii) the statutory net gain from operations (not including realized capital gains) of ACIC in its most recent fiscal year. Based on this limitation, the maximum dividend that ACIC could pay to us in 1998, without regulatory approval, is approximately $4.2 million. (See Note 9 of Notes to Consolidated Financial Statements.) ACIC has never paid a dividend to us and we intend to retain capital in the insurance subsidiary.
An increase of 100 basis points in prevailing interest rates would reduce the fair value of our interest rate sensitive instruments by approximately $6.1 million.
The year 2000 is a critical year for computer applications. Historically, many computer programs were written using two digits rather than four to define the appropriate year. As a result, many computer programs that have date sensitive fields may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in system failures or miscalculations causing disruption of operations, including, among other things, a temporary inability to process transactions, send invoices or engage in other critical business activities.
Year 2000 readiness includes addressing information technology systems (computer equipment, computer software, network hardware and software, etc.), non-information technology systems (systems which include embedded technology such as micro-controllers including telephone systems) and issues relating to third parties with whom we have a material relationship (customers and vendors).
THIRD PARTY READINESS: We have taken steps to ensure that our significant customers and vendors are year 2000 compliant through surveys and further information requests. We have received preliminary information from our critical vendors and anticipate follow-up based on information received through mid-1999 until we are comfortable that our vendors are year 2000 compliant.
We are reviewing and updating our year 2000 business contingency plan that will address any year 2000 risks we identify. We expect completion of this plan during the second quarter of 1999.
The National Association of Insurance Commissioners (NAIC) has risk-based capital standards to determine the capital requirements of a property and casualty insurance carrier based upon the risks inherent in its operations. These standards 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 factors to various financial data 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 percent of total adjusted capital to authorized control level risk-based capital is below certain levels. Based upon the risk-based capital standards, our percent of total adjusted capital is substantially in excess of authorized control level risk-based capital.
We have audited the accompanying consolidated balance sheets of RTW, Inc. and subsidiary (the Company) as of December 31, 1998 and 1997, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1998. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company at December 31, 1998 and 1997, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles.
RTW, INC. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1998 AND 1997 (IN THOUSANDS, EXCEPT SHARE DATA)
RTW, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (IN THOUSANDS)
RTW, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
INVESTMENTS - We invest entirely in fixed maturity investments and classify our investments as available-for-sale in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities."
We continually monitor the difference between investment cost and fair value for each of our securities. If any security experienced a decline in value that is determined to be other than temporary, we would reduce the security's carrying value for the decline and record a realized loss in the Consolidated Statements of Operations. No securities were reduced for declines in fair value in 1998 or 1997.
Although these costs arise when we issue a policy, we defer certain costs, principally commissions and state premium taxes, and amortize these costs to expense as premium revenue is recognized.
UNPAID CLAIM AND CLAIM SETTLEMENT EXPENSES - Claim expenses refer to amounts that we paid or expect to pay to claimants for events that have occurred. The costs of investigating, resolving and processing these claims are referred to as claim settlement expenses. We record these expenses, net of amounts recoverable under reinsurance contracts, to "Claim and claim settlement expenses" in the Consolidated Statements of Operations.
PREMIUMS EARNED - Premiums on workers' compensation insurance policies are our largest source of revenue. We record premiums written on an installment basis matching billing to the policyholder and earn premiums on a daily basis over the life of each insurance policy. Premiums earned include an estimate for earned but unbilled audit premiums. We record the excess of premiums billed over premiums earned for each policy as unearned premiums on our balance sheet.
RECLASSIFICATIONS - Certain 1997 and 1996 amounts have been reclassified to conform to the consolidated financial statement presentation in 1998.
STATUTORY DEPOSITS - Included in investments are U.S. government securities on deposit with various regulatory authorities as required by law with a fair value of $2,931,000 and $2,828,000 in 1998 and 1997, respectively.
FIXED MATURITIES BY MATURITY DATE - The following table presents the amortized cost and fair value of investments by contractual maturity in 1998. Actual maturities may differ from those stated as a result of calls and prepayments (000's):
INVESTMENT INCOME - Investment income includes income from the following sources (000's):
NET REALIZED INVESTMENT GAINS - Net realized investment gains includes gross realized investment gains net of gross unrealized investment losses as follows (000's):
We report reinsurance transactions on a "gross" basis on the balance sheet, resulting in reinsurance recoverable amounts on paid and unpaid claim and claim settlement expenses recorded as assets. We estimate amounts recoverable from reinsurers in a manner consistent with the claim liability associated with the reinsured policy.
The reinsurance recoverable on paid claim and claim settlement expenses consists solely of receivables from paid claim and claim settlement expenses at December 31, 1998 and 1997.
Unsecured notes payable of RTW consist of Senior Notes payable with principal maturities and monthly interest due as follows (000's):
We may redeem some or all of the Senior Notes payable on any interest date at the principal amount of the redeemed notes plus accrued interest and a premium of 1%.
SENIOR NOTES PAYABLE - The Senior Notes payable contain various restrictive provisions which require that certain financial ratios, primarily debt coverage and net worth restrictions, be met before incurring additional indebtedness or paying dividends or other distributions to shareholders. At December 31, 1998, we were in compliance with these covenants.
STOCK BASED COMPENSATION - We account for our stock-based compensation plans, the RTW, Inc. 1995 Employee Stock Purchase Plan and Trust (ESPP) and the 1994 Stock Plan, using Accounting Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees," and related Interpretations. Under APB 25, compensation cost for stock options is measured as the excess, if any, of the quoted market price of our stock at the date of the grant over the amount an employee must pay to acquire the stock.
1995 EMPLOYEE STOCK PURCHASE PLAN - The ESPP provides employees the opportunity to purchase shares of our stock at 85% of the fair value based on the lesser of the beginning or ending share price for each plan year as set forth in the plan. In May 1998, the shares reserved for distribution under the plan were increased from 75,000 to 200,000 shares. The ESPP terminates in ten years and will be carried out in phases, each consisting of one year or a period of time approved by the Board of Directors. Any employee completing two weeks of service prior to commencing a phase of the plan may participate. Employees may elect to contribute from $10 to 10% of monthly salary to the plan through payroll withholdings. The following summarizes shares purchased and purchase prices for each phase completed through 1998:
The fourth one-year phase began in April 1998 and expires in April 1999.
1994 STOCK PLAN - The 1994 Stock Plan provides for awards of incentive and non-qualified stock options. In January 1997 the shares reserved for distribution under the plan were increased to 1,500,000. In July 1998, the Board of Directors increased the shares reserved for distribution under the plan to 2,000,000 subject to shareholder approval in May 1999. If shareholder approval is not obtained, option grants will be revoked to the extent they exceed shares currently available under the plan. Option price, option term, vesting provisions and other limits and restrictions are determined at the time of grant by the Board of Directors or, if established, by a separate committee. The exercise price for all options granted was the market price of the common stock at the date of grant.
Each of the qualified options expire ten years from the date of grant, subject to continued employment with us. Each of the non-qualified options expire ten years from the date of grant. Certain of the options are subject to vesting provisions that restrict exercise of the option.
NON-QUALIFIED COMMON STOCK OPTIONS - Certain non-qualified options were issued prior to the onset of the 1994 Stock Plan. These non-qualified options are all exercisable. Non-qualified options granted, exercised and outstanding are as follows:
The pro forma effect on net income (loss) for 1998, 1997 and 1996 is not representative of the pro forma effect on net income (loss) in future years because it does not include pro forma compensation expense related to pre-1995 option grants.
The weighted average fair value of options granted under the ESPP and 1994 Stock Plan during 1998, 1997 and 1996 is estimated at $3.14, $4.06 and $12.11, respectively, on the date of grant using the Black-Scholes option-pricing model with the following assumptions: no dividend yield; volatility of 71.0% in 1998, 76.1% in 1997 and 65.3% in 1996; risk-free interest rates ranging from 4.51% to 7.70%; and an expected life of 1 to 5 years.
401(K) RETIREMENT PLAN - We sponsor a defined contribution retirement plan under Section 401(K) of the Internal Revenue Code for eligible employees. Our contributions to the plan are discretionary and are based on contributions made by employees to the plan. Expense recognized under the plan for 1998, 1997 and 1996 was $140,000, $94,000 and $52,000, respectively.
stock having a market value of two times the purchase price of the right, subject to certain possible adjustments. In addition, if we are acquired in a merger or other business combination transaction, each right will entitle its holder to purchase, at the then current purchase price of the right, that number of common shares of the acquiring company having a market value of two times the purchase price of the right. Following the acquisition of a beneficial ownership of 15% or more of our outstanding common stock by any Acquiring Person and prior to an acquisition by any Acquiring Person of 50% or more of our outstanding common stock, our Board of Directors may exchange the outstanding rights (other than rights owned by such Acquiring Person), in whole or in part, at an exchange ratio of one share of common stock, or one one-hundredth share of Preferred Stock (or equivalent securities) per right, subject to adjustment. We may redeem the rights, in whole, at $.001 per right, at any time prior to an acquisition by any Acquiring Person of 15% or more of our outstanding common stock and prior to the expiration of the rights. The rights expire on April 17, 2007, unless extended or earlier redeemed by us.
We adopted Statement of Financial Accounting Standards No. 130 (SFAS 130), "Reporting Comprehensive Income," effective January 1, 1998. Our comprehensive income includes only unrealized gains and losses on investments classified as available-for-sale. Changes in accumulated other comprehensive income and other comprehensive income (loss) were as follows (000's):
The following tables present unaudited quarterly results of operations for the eight quarters ended December 31, 1998:
Quarterly revenues are affected by (i) premiums in force at the beginning of the quarter, (ii) new policies written in the quarter, (iii) final audit premiums recognized during the quarter and (iv) our policy renewal rate in the quarter. Historically, a majority of new policies written and policy renewals have occurred in the first, second and fourth quarters. Additionally, our quarterly results for 1998 and 1997 were affected by refunds from the Minnesota Workers' Compensation Reinsurance Corporation (included in premiums earned), adjustments to the liability for unpaid claim and claim settlement expenses for prior years and adjustments to reverse liabilities accrued for the Minnesota Insurance Guarantee Association (included in general and administrative expenses) as follows (000's):