Capital Re Corporation, Capital Reinsurance, Capital Mortgage, Capital Title and Capital Re Management Corporation maintain offices at 1325 Avenue of the Americas, New York, New York 10019. The office comprises the entire 18th floor of the building, approximately 23,000 square feet of space. The companies began occupying these offices in April 1993. Prior to that, Capital Re and Capital Reinsurance maintained offices at 787 Seventh Avenue, New York, New York. The offices at 787 Seventh Avenue were sublet to a third party upon the move to 1325 Avenue of the Americas. RGB currently leases one floor of office space at 2 Minster Court, Mincing Lane, London, England, and one floor of office space as well as basement space at Marlon House, Mincing Lane, London, England.
Gross premiums written increased 69.1% to $219.5 million for the year ended December 31, 1997 from $129.8 million for the same period of 1996. Gross premiums written increased across all product lines. This increase was primarily due to the consolidation of the Lloyd's premiums written from CRC. In addition, in 1997 the Company added a financial reinsurance line of business. This line consists of structured financial transactions involving the reinsurance of annuity and accident and health reserves. These reserves are recorded on the balance sheet as a liability and are offset by assets of equal value. The following table shows gross premiums written by line of business for the years ended December 31, 1997 and December 31, 1996.
Net premiums written increased by 95.2% to $205.4 million for the year ended December 31, 1997 from $105.2 million for the same period in 1996. This increase is commensurate with the increase in gross premiums written explained above as well as the recording of a large ceded premium installment on a municipal portfolio paid in the fourth quarter of 1996. The following table shows net premiums written by line of business for the years ended December 31, 1997 and December 31, 1996.
Total expenses, including loss and loss adjustment expenses, increased 52.1% to $105.4 million for the year ended December 31, 1997 from $69.3 million in the same period of 1996. This increase was primarily attributable to commissions associated with the increased level of premiums written and normal loss development from the mortgage and credit lines of business. In addition, the
increase in expenses was attributable to operating and loss expenses associated with the consolidation, for accounting purposes, of the Company's Lloyd's operations with the Company's reinsurance operations. Furthermore, the combined ratio, excluding expenses associated with non-insurance operations, increased to 66.7% for the year ended December 31, 1997 from 60.7% for the comparable 1996 period. This increase is an expected result of the Corporation's diversification strategy, which is producing more business from lines with relatively higher combined ratios than that of the financial guaranty reinsurance business.
For the year ended December 31, 1997, the total federal tax provision increased to $26.2 million from $20.6 million for the same period in 1996. In addition, the effective tax rate increased slightly to 27.3% for the year ended December 31, 1997 from 26.7% in the same period of 1996.
Net premiums written increased by 17.5% to $105.2 million for the year ended December 31, 1996 from $89.5 million for the same period in 1995. This increase is commensurate with the increase in gross premiums written explained above. The following table shows net premiums written by line of business for the year ended December 31, 1996 and December 31, 1995.
For the year ended December 31, 1996, net investment income increased 10.5% to $51.6 million from $46.7 million for the comparable period in 1995. Growth in investment income was primarily attributable to a larger investment portfolio caused by (i) an increase in invested assets from positive operating cash flows during the year ended December 31, 1996 and (ii) a public offering in the first quarter of 1996 of the Corporation's common stock which generated $25.9 million in net proceeds to the Corporation. In addition, the Corporation recognized net realized gains of $1.5 million for the year ended December 31, 1996 compared to net realized gains of $0.1 million for same period in 1995.
Total expenses, including loss and loss adjustment expenses, increased 48.7% to $69.6 million for the year ended December 31, 1996 from $46.8 million in the same period of 1995. This increase was primarily attributable to commissions associated with the increased level of premiums assumed, normal loss development from the mortgage and credit lines of business and increased net profit commissions payable under certain of the Corporation's reinsurance contracts. In addition, the combined ratio increased to 61.7% for the year ended December 31, 1996 from 56.8% for the comparable 1995 period. This increase is an expected result of the Corporation's diversification strategy, which is producing more business from lines with relatively higher combined ratios than that of the financial guaranty reinsurance business.
For the year ended December 31, 1996, the total tax provision increased to $20.5 million from $14.6 million for the same period in 1995. In addition, the effective tax rate increased to 26.7% in the third quarter of 1996 from 24.2% in the same period of 1995. This increase occurred in response to the Corporation's strategy of using a greater proportion of new cash flow to purchase taxable securities during 1996.
The Corporation relies on dividends from Capital Reinsurance to fund its payment of dividends on its capital stock and interest on its outstanding debt. The major sources of liquidity for Capital Reinsurance are funds generated from reinsurance premiums, net investment income and maturing investments. Capital Reinsurance is domiciled in the State of Maryland, and, under Maryland insurance law, the amount of the surplus of Capital Reinsurance available for distribution as dividends is subject to certain statutory restrictions. The amount available for distribution from Capital Reinsurance during 1998 with notice to, but without prior approval of, the Maryland Insurance Commissioner is limited to 10% of Capital Reinsurance's policyholders' surplus as of December 31, 1997, or approximately $34.6 million. For the year ended December 31, 1997, Capital Reinsurance paid $8.0 million in dividends to the Corporation.
Capital Mortgage is subject to the dividend restrictions imposed under New York insurance law. Accordingly, dividends may only be declared and distributed out of earned surplus (as defined under New York insurance law). Additionally, no dividend may be declared or distributed by Capital Mortgage in an amount which, together with all dividends declared or distributed by Capital Mortgage, as the case may be, during the preceding twelve months, exceeds the lesser of 10% of such company's surplus to policyholders as shown by its last Annual Statutory Statement on file with the New York insurance department, or 100% of adjusted net investment income (as defined under New York insurance law) during such period, unless, upon prior application, the New York Superintendent of Insurance approves a greater dividend distribution based upon his finding that Capital Mortgage, as the case may be, will retain sufficient surplus to support its obligations and writings. KRE's dividends and distributions to its sole shareholder, Capital Mortgage, are governed by Bermuda law, and are subject to the same restrictions as those described in the preceding paragraph for Capital Credit. To date, Capital Mortgage and KRE have
In January 1994, the Corporation formed and capitalized, through the purchase of common shares, Capital Re LLC. Capital Re LLC exists solely for the purpose of issuing preferred and common shares and lending the proceeds of such issuance to the Corporation to fund its business operations. In January 1994, Capital Re LLC issued $75.0 million of company obligated mandatorily redeemable preferred securities, the proceeds of which were loaned to the Corporation. The Corporation has, among other undertakings, unconditionally guaranteed all legally declared and unpaid dividends of Capital Re LLC. The company obligated mandatorily redeemable preferred securities were issued at $25 par value per share and pay monthly dividends at a rate of 7.65% per annum. Also in January 1994, Capital Reinsurance and Capital Credit invested an aggregate of $120.0 million to capitalize Capital Mortgage. Of the total original contribution of $120.0 million, Capital Reinsurance invested $94.8 million and Capital Credit invested $25.2 million.
In June 1997, Capital Reinsurance invested approximately $10.9 million in CGA Group Ltd. ("CGA"). CGA was formed to provide financial guaranty insurance of structured securities, including commercial real estate and asset backed transactions. Capital Reinsurance also has a commitment to invest an additional $7.5 million in CGA to the extent that it would be necessary to maintain a triple-A rating from Duff & Phelps for CGA's operating subsidiary, Commercial Guaranty Assurance, Ltd. Also, Capital Reinsurance invested $0.1 million in St. George Holdings Ltd. ("St. George"). Through its operating subsidiary, St. George Investments Ltd., St. George will purchase securities to be held to maturity, selectively resold, or repackaged with CGA insurance and then resold.
In December 1997, the Corporation's Board of Directors authorized an increase of the quarterly common stock dividend rate to $0.08 per share, or $0.32 annually. For the year ended December 31, 1997, common dividends were declared and paid in the amount of $4.6 million or $0.29 per share.
On January 22, 1998, the Corporation extended its existing agreement with Deutsche Bank AG for the provision of a $25.0 million liquidity facility (the "DB Liquidity Facility") which is available for general corporate purposes. The DB Liquidity Facility was extended for one year and is scheduled to expire on January 22, 1999. Capital Reinsurance also renewed an agreement on January 27, 1998 with Deutsche Bank AG for a credit facility (the "DB Credit Facility") of up to $75.0 million specifically designed to provide rating agency qualified capital to further support Capital Reinsurance's claims-paying resources. This agreement expires January 27, 2005. The Corporation has not borrowed under either the DB Liquidity Facility or the DB Credit Facility.
We have audited the accompanying consolidated balance sheets of Capital Re Corporation and Subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits.
two syndicates, one marine and the other nonmarine. Effective January 1, 1998, CIDR's nonmarine syndicate was merged with the nonmarine syndicate of RGB. CRC Capital will participate on the syndicates acquired in the CIDR transaction beginning with the 1998 year of account. The results of RGB, CIDR and CRC Capital are consolidated in the Corporation's financial statements. The goodwill associated with these acquisitions will be amortized over 20 years.
The 1996 and 1995 financial statements have been reclassified to conform with the 1997 presentation.
Investments in Securities: The Corporation accounts for its investments in fixed maturity securities in accordance with FASB Statement No. 115 ("SFAS 115"), "Accounting for Certain Investments in Debt and Equity Securities". Management determines the appropriate classification of securities at the time of purchase. At December 31, 1997 and 1996 investments in fixed maturity securities were designated as available-for-sale.
Premium Revenue Recognition: All premiums are earned over the terms of the risks covered under the Corporation's insurance and reinsurance contracts. Generally, premiums are received either in full at contract inception or in installments over the life of the covered risk. Financial guaranty premiums are typically received entirely at contract inception. For purposes of earnings recognition, premiums are allocated to each year in the term of the guaranty and are earned pro-rata over the period of risk. Receipts of installment premiums for financial guaranty and all other lines of business are generally earned on monthly pro-rata basis over the installment period.
Contingent Commissions: Under the terms of certain of the Corporation's reinsurance contracts, the Corporation is obligated to pay the ceding company a contingent commission based upon a specified percentage of the net underwriting profits. As of December 31, 1997 and 1996, the Corporation's liability for the present value of expected future payments is shown on the balance sheet under the caption "Profit commission liability."
For the years ended 1997, 1996 and 1995, and in order to arrive at the number of weighted average diluted shares outstanding of 16,253, 15,946, and 14,914, employee stock option awards in the amount of 380, 290 and 126 were added to weighted average common shares outstanding for basic earnings per share of 15,873, 15,656, and 14,788, respectively. All figures are reported in thousands.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income," which is effective for fiscal years beginning after December 15, 1997. SFAS No. 130 establishes standards for the reporting item, termed comprehensive income, which will combine net income and certain items that directly effect stockholders' equity, such as net unrealized gain/loss on fixed maturity securities available for sale and foreign currency translation adjustments. This statement will have no impact on the financial condition or results of operations of the Corporation.
In June 1997, the FASB also issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information", which is effective for fiscal years beginning after December 15, 1997. SFAS No. 131 establishes new standards for defining how operating segments are determined and requires more comprehensive disclosures about the Corporation's reportable operating segments. The Corporation believes that SFAS No. 131 will require expanded financial and descriptive disclosure about the Corporation's operating lines of business, however, the Corporation, has not yet determined the impact of this statement on the Corporation's financial statement disclosure.
The financial statements are prepared on the basis of GAAP, which differs in certain respects from accounting practices prescribed or permitted by the Maryland Insurance Administration and the Insurance Department of the State of New York (the insurance departments in the states of domicile of Capital Reinsurance and Capital Mortgage and Capital Title, respectively), as well as the statutory requirements of the Minister of Finance of the Island of Bermuda (place of domicile of Capital Credit and KRE). Statutory accounting practices for the Corporation's insurance subsidiaries differ from GAAP as follows:
Acquisition costs are charged to current operations as incurred rather than as related premiums are earned;
A contingency reserve is computed on the basis of statutory requirements regardless of when loss contingencies actually exist;
A title statutory premium reserve is established based upon assumed exposure regardless of when loss contingencies actually exist;
Investments in fixed maturity securities are reported at amortized cost or market value based on the National Association of Insurance Commissioners ("NAIC") rating; under GAAP, these fixed maturity investments are carried in accordance with SFAS 115 (see Note 2).
The following is a reconciliation of the Corporation's consolidated GAAP net income and stockholders' equity to the corresponding consolidated statutory amounts for its insurance subsidiaries:
Financial Guaranty: At December 31, 1997, the Corporation's reinsured financial guaranty portfolio included the reinsured portfolios of Capital Reinsurance, Capital Credit and KRE, net of eliminations and was broadly diversified by bond type, geographic location and maturity schedule, with no single risk representing more than 2.4% of the Corporation's net par in force. The Corporation limits its exposure to losses from reinsured financial guarantees by underwriting primarily investment grade obligations and retroceding a portion of its risks to other insurance companies.
The reinsured portfolio contained exposures in each of the 50 states. Net par in force at December 31, 1997, by state, was as follows:
During the fourth quarter of 1997, fiscal and economic turmoil spread through several Asian countries causing some Asian currencies to experience significant devaluation and subjecting certain corporations, financial institutions and sovereigns to pronounced fiscal stress. Included in the Corporation's financial guaranty net par in force is $770.7 million related to the Asian region. While the Corporation has reinsured exposures in this region, 83% of the net par relates to Japan, China and Hong Kong which are countries that remain investment grade despite the downturn. The remaining exposure is to Korea, Indonesia, Thailand, Philippines and Malaysia and is principally in the form of sovereign debt. As of December 31, 1997, the Corporation did not expect to incur any losses related to the Asian economic downturn and as a result no loss reserve had been recorded.
Mortgage Guaranty: At December 31, 1997, the Corporation's net mortgage guaranty insurance in force (representing the current principal balance of all mortgage loans that are currently reinsured) and direct primary net risk in force was approximately $10.7 billion and $3.2 billion, respectively. California represents the Corporation's largest U.S. risk concentration at approximately 22%, however, its total U.S. distribution of mortgage guaranty risk in force parallels that of the U.S. primary mortgage insurance industry.
The Debentures include certain covenants, none of which significantly restrict the Corporation's operating activities or dividend paying ability. During 1996, the Corporation entered into a $25.0 million credit facility with Chase Manhattan Bank, expiring August 20, 1998. The facility is renewable each year at the option of the Corporation. Interest on the facility is payable semi-annually at a rate equal to the then London Interbank offered rate plus 40 basis points.
The Corporation and its subsidiaries file a consolidated federal income tax return. The Corporation's effective federal corporate tax rate for 1997, 1996 and 1995 was 27.3%, 26.7% and 24.2%, respectively.
Income taxes paid during 1997, 1996 and 1995 were approximately $18.9 million, $7.9 million and $8.7 million, respectively.
To limit its exposure on assumed risks, the Corporation enters into certain proportional and nonproportional retrocessional agreements that cede a portion of risks underwritten to other insurance companies. In the event that any or all of the reinsurers were unable to meet their obligations, the Corporation would be liable for such defaulted amounts.
For the years ended December 31, 1997, 1996 and 1995, ceded earned premiums were $29.8 million, $14.7 million and $8.0 million, respectively. Ceded losses for the same periods were $5.4 million, $6.5 million and $2.6 million, respectively.
During 1995, Capital Mortgage entered into an assumption agreement whereby it provides excess of loss reinsurance on an existing portfolio of mortgage pool insurance. In connection with this assumed transaction, Capital Mortgage is required to cede a portion of the risks, thereby reducing its total net retention. Total ceded premiums under the contract were approximately $21.0 million. Total expected assumed premiums of $56.0 million are payable in seven annual installments of $8.0 million. As of December 31, 1997, the Corporation has received three of the seven installments. Contingent commissions will be payable on the assumed reinsurance and receivable on the ceded reinsurance, dependent upon the level of losses incurred under the contract.
The fair value for fixed maturity securities shown in Note 6 is based on quoted market prices.
The fair value of the Corporation's $75.0 million of outstanding Debentures is determined based on the projected cash flows discounted by the sum of the seven- year U.S. treasury yield at December 31, 1997 and the appropriate credit spread for similar debt instruments. At December 31, 1997, the fair value of the Corporation's Debentures was estimated to be $78.2 million.
The fair value of the Corporation's $75.0 million Company obligated mandatorily redeemable preferred securities of Capital Re LLC at December 31, 1997 was $75.6 million based on the closing price per share on the New York Stock Exchange at that date.
Under New York Insurance Law, as a mortgage guaranty insurance corporation, Capital Mortgage may not pay dividends except from earned surplus as defined by New York Insurance Law. Capital Mortgage is further restricted from paying dividends to the extent that any dividend paid to shareholders which, together with all dividends declared or distributed by it during the preceding twelve months, exceeds the lesser of 10% of its surplus to policyholders as shown by its last statement on file with the superintendent, or 100% of adjusted net investment income during such period unless specifically allowed by the superintendent. To date, Capital Mortgage has not declared or paid any dividends. The maximum dividend payable by Capital Mortgage during 1998 is $0 since its earned surplus was ($0.4) million as of December 31, 1997.
Capital Title is subject to the New York Insurance Law laws and regulations governing title insurers. Accordingly, dividends may only be declared and distributed out of earned surplus as defined under New York Insurance Law and only if such dividends do not reduce the company's surplus to less than 50% of its outstanding capital shares, i.e., the value of its outstanding common equity. Additionally, no dividend may be declared or distributed in an amount which, together with all dividends declared or distributed by the company during the preceding twelve months, exceeds 10% of the company's outstanding capital shares, unless, after deducting such dividends, it has a surplus at least equal to 50% of its statutory reinsurance reserve or a surplus at least equal to $250,000, whichever is greater. During 1997, Capital Title paid a dividend in the amount of $1.1 million to its immediate parent, KRE. As of December 31, 1997, Capital Title's maximum amount payable as a dividend during 1998 is approximately $1.3 million.
At December 31, 1997, future minimum rental payments under the terms of the Corporation's noncancellable operating leases for office space are $1.4 million for the year 1998, $1.5 million for each of the years 1999, 2000, 2001 and 2002, and $8.9 million in the aggregate thereafter. These future minimum rental payments total $16.3 million. These payments are subject to escalations in building operating costs and real estate taxes. Total rent expense amounted to approximately $0.9 million in each of the years 1997, 1996 and 1995.
In June 1997, the Corporation invested approximately $10.9 million in CGA Group Ltd ("CGA"), a Bermuda domiciled insurance company formed to provide financial guaranty insurance of structured securities, including commercial real estate and asset-backed transactions. Its insurance company subsidiary, Commercial Guaranty Assurance, Ltd is rated triple A by Duff & Phelps Credit Rating Co. ("Duff & Phelps"). The Corporation's investment was in the form of the purchase of common and preferred shares. As part of the Corporation's agreement to invest in CGA, it has also committed to invest an additional $7.5 million in the form of the purchase of common shares in the event that maintenance of Commercial Guaranty Assurance Ltd.'s triple A rating from Duff & Phelps make such action necessary.
In January 1994, the Corporation formed and capitalized Capital Re LLC, a limited liability company organized under the laws of the Turks and Caicos Islands. Additionally, in January 1994, Capital Re LLC issued $75,000,000, 7.65% of cumulative monthly income preferred shares, the proceeds of which were loaned to the Corporation. The preferred shares were issued at $25 par value per share and are shown on the balance sheet under the caption "Company obligated mandatorily redeemable preferred securities of Capital Re LLC." The Corporation guarantees the payment of the monthly dividend as well as any amounts upon liquidation or redemption which cannot occur prior to January 31, 1999, at the Corporation's discretion. Capital Re LLC exists solely for the purpose of issuing preferred and common shares and lending the proceeds to the Corporation to fund its business operations. The total amount paid to preferred shareholders for each of the years ended 1997, 1996 and 1995 was approximately $5.7 million and is shown on the income statement under the caption "Minority interest in Capital Re LLC."
Prior to its initial public offering, the Corporation had a stock incentive plan wherein eligible employees were granted shares of restricted common stock. Shares awarded under the Plan amounted to 696,000 at December 31, 1991. For these awards, the difference between the price paid by the employees and the market value of the award at the date of grant, if any, was recorded as deferred compensation and was amortized ratably over the four-year vesting period. Upon completion of the initial public offering in 1992, these shares became vested and all restrictions lapsed.
Pro forma information regarding net income and earnings per share is required by Statement 123, and has been determined as if the Corporation had accounted for its employee stock options under the fair value method of that statement. The fair value for these options was estimated at the date of grant using a Black- Scholes option pricing model with the following weighted-average assumptions for 1997, 1996 and 1995, respectively: risk-free interest rates of 6.33%, 5.42% and 7.36%; dividend yields of 0.67%, 0.80% and 0.88%; volatility factors of the expected market price of the Corporation's common stock of 23.37, 19.10 and 29.94; and an expected life of the options of 7 years.
A summary of the Corporation's stock option activity, and related information for the years ended December 31 follows:
Exercise prices for options outstanding as of December 31, 1997 ranged from $19.50 to $56.75. The weighted-average remaining contractual life of those options is approximately 8.0 years.
In 1996, the Corporation adopted a performance share plan for the benefit of senior executives of the Corporation. The plan is intended to align senior management with the interest of the shareholders. To achieve this objective, the plan ties awards granted under the plan with earning per share growth and with total shareholder return and share price. These shares will be awarded at December 31, 1999. The Corporation recognized $3.0 million and $1.0 million in deferred compensation expense for the years ended December 31, 1997 and 1996, respectively.
The Corporation maintains a savings incentive plan which is qualified under Section 401 of the Internal Revenue Code. The savings incentive plan is available to all full-time employees with a minimum of six months of service. Eligible participants may contribute 9% of their base salary subject to a maximum of $10,000 for 1997. Contributions are matched by the Corporation at a rate of 100%, up to 7% of the participants' contribution subject to certain limitations and vest at a rate of 25% per year starting with the second year of service. The Corporation contributed approximately $0.3 million in each of the years 1997 and 1996 and $0.2 million in 1995.