Consolidated Net Income increased by 29% to $47.8 million in 1997 from $37.0 million in 1996 which was in turn a 23% increase over the $30.2 million earned in 1995. The increase in 1997 earnings was primarily attributable to the growth experienced in the Program Business segment which benefited from the acquisition of Small Business Underwriters ("SBU") as well as the expansion of Professional Underwriters Corporation ("PUC") into New York State. 1996 earnings growth was also a result of the growth in the Program Business segment, as well as the acquisitions of The Hemisphere Group Limited ("Hemisphere") and PUC.
Program Business, the fastest growing segment of the Company's business, involves replacing traditional insurers as the conduit between producers of specialty books of business and reinsurers wishing to write that business. Program Business accounted for 45% of total Fee income for 1997 compared to 24% in 1996 and 11% in 1995. This growth has resulted from the continued expansion of this business as a result of reinsurers' increased appetite for premium volume in this soft market, and the acquisition of SBU on February 1, 1997. Fees earned on individual Program accounts are more likely to grow compared to Corporate accounts, because new policy holders are constantly being added in each program, also they have a higher retention rate than Corporate accounts due to the complexity of Program accounts. Pre-tax margins in this segment were 41% for 1997 compared to 38% in 1996 and 48% in 1995. The decrease in margins in 1996 was due to the acquisition of PUC which has lower margins due to the labor intensive nature of its services.
Financial Services, the Company's newest business segment, is being built on the 1996 acquisition of Hemisphere which provides administrative services to offshore mutual funds and other companies. The Financial Services segment also includes the Company's newly launched family of proprietary mutual funds and MRM Life. MRM Life was recently incorporated to issue variable insurance products in Bermuda. This segment
Premiums earned increased by 49% in 1997, and 17% in 1996, these increases are directly attributable to the shift in business from the Corporate Risk Management segment to the Program Business segment and the strong growth within this segment. Program Business usually involves higher premiums than business derived from the Corporate Risk Management segment. Premiums earned represent the net premiums retained by the Company on which it bears underwriting risk. The Company believes that both the volatility of underwriting profit or loss and the probability of experiencing a severe underwriting loss are less than would ordinarily be expected for a traditional property/casualty insurer, due to the nature of the business written by the Company and the structure of its reinsurance. In the past, the level of Premiums earned has been closely matched by the level of Total insurance costs resulting in small amounts of underwriting loss as a percentage of Premiums earned. The fact that Premiums earned are generally matched by Total insurance costs means that even a significant fluctuation in Premiums earned will have a relatively insignificant impact on the Company's Net income.
The Company's principal exposure to underwriting loss exists in relation to the premium associated with the Company's retention of a portion of the specific and aggregate excess risk on each client's account. It is on this retained excess risk that the Company may experience the most significant volatility in underwriting results. The portion of the Company's Premiums earned which relate to this risk was $3.9 million in 1997 as compared to $3.3 million in 1996 and $3.9 million in 1995, representing 3%, 6% and 8% of Premiums earned in 1997,
Gross investment income increased by $2.2 million or 8% to $29.7 million in 1997 from $27.5 million in 1996 and $20.3 million in 1995 as a result of increases in gross invested assets. Net investment income after adjusting for investment income which is payable to others increased by 17% to $26.3 million in 1997 from $22.5 million in 1996 and $16.2 million in 1995. Net invested assets increased $11 million or 3% to $398 million in 1997 from $387 million in 1996 and $345 million in 1995. The yield on these assets increased to 6.7% from 6.1% in 1996 and 6.3% in 1995. The Company's investment income is produced through the investment of its capital funds, long term debt, other funds held representing amounts due others and reserves held by the Company for unearned premiums and unpaid losses. The Company carries $42.4 million at December 31, 1997 and $45.7 million at December 31, 1996 on its Consolidated Balance Sheets as Claims deposit liabilities. These liabilities relate to loss obligations which, under SFAS 113, are not classified as insurance. Investment income on these funds of $2.5 million in 1997, $4.0 million in 1996 and $3.5 million in 1995, is credited directly to the Claims deposit liability account.
The primary factors responsible for the increases in Operating expenses were: (a) the increased cost of administering the Company's highly regulated policy-issuing subsidiaries, as the volume of policies issued increased; (b) increased personnel costs in all areas, caused by an increase in the number of full time employees from 433 in 1996 to 617 in 1997, resulting from the growth of the Company's businesses as well as the impact of the Company's growth in revenues and profits on employee bonus plans; and (c) the acquisitions of SBU and Hugo Trust as well as the expansion of PUC into New York State.
The charges for Income taxes represent effective tax rates of 18.1%, 17.9% and 22.3% respectively. The reduced tax rates experienced since 1995 are primarily due to increased earnings outside of the United States and the tax benefit derived from the exercise of employee stock options. These factors plus the Company's investment in tax-exempt municipal securities, offset by state income taxes, are the major causes of the difference between the expected federal income tax rate in the United States of 35% plus state income taxes and the Company's effective rates in each year. The Legion Companies, as insurance companies in the United States, are subject to income tax on an accelerated basis and, as a result, a deferred tax benefit was carried on the Consolidated Balance Sheets of $4.6 million in 1997 and $3.4 million in 1996.
Cash flow from operations has historically provided the Company its principal source of liquidity. The Company has continued to produce a positive cash flow with $55.2 million of cash provided from operations during 1997, as compared to $61.5 million in 1996 and $33.5 million in 1995.
A widely accepted factor used by regulators and rating agencies in evaluating insurance companies is the ratio of net premiums written to policyholders' surplus which is an indication of the degree to which an insurer is leveraged. Because of the low level of net premiums written, they have produced a relatively low ratio on this basis of approximately 0.4:1 in 1997, 0.3:1 in 1996 and 0.5:1 in 1995 and should continue to produce relatively low ratios in the future. The accepted industry standard for this ratio is below 3:1. Due to the nature of the Company's operations, a more appropriate indication of leverage is the ratio of gross premium written to policyholders' surplus, which amounted to 3.0:1 in 1997, 2.4:1 in 1996 and 2.6:1 in 1995. The National Association of Insurance Commissioners ("NAIC") has established that an "unusual value" for this ratio would be 9:1 or higher. The Company has adopted a policy that this ratio should not exceed 4:1.
The NAIC has adopted a risk-based capital ("RBC") formula to be applied to all property/casualty insurance companies. The formula measures capital and surplus needs based on an insurance company's products and investment portfolio and is to be used as a tool to identify weakly capitalized companies. An insurance company that does not meet the threshold RBC measurement standards could be required to reduce the scope of its operations and ultimately could become subject to statutory receivership proceedings. At December 31, 1997 the Company's policy-issuing subsidiaries met the RBC requirements with a combined required risk-based capital of $45.6 million and an actual adjusted capital of $196.8 million.
Total assets increased to $2.1 billion at December 31, 1997, a 31% increase from $1.6 billion at December 31, 1996. $625.2 million, or 29% of Total assets, in 1997 and $576.7 million, or 35%, in 1996 related to Assets held in separate accounts. As detailed in Note 2A to the Consolidated Financial Statements, such assets are principally managed assets attributable to participants in the Company's IPC Programs.
The Company is modifying all software that is not Year 2000 compliant.
The Company's consolidated financial statements for the years ended December 31, 1997, 1996 and 1995 are filed herewith in response to Item 14.