In March 1996, the Company entered into a sublease agreement initially expiring in October 2002 for approximately 40,000 square feet of office space in Greenwich, Connecticut, at which the Company's principal offices are located. Under the sublease, future minimum annual rental charges, exclusive of escalation clauses and maintenance costs and net of rental income, will be approximately $4.3 million. The Company's rental expense, net of sublease income, was approximately $613,000 during 1996 and $54,000 in 1995. Commencing in 1996, approximately 13,000 square feet of the office space was subleased to Risk Capital Corp. for a term expiring in October 2002. Under such arrangement, Risk Capital Corp.'s future minimum annual rental charges, exclusive of escalation clauses and maintenance costs, will be approximately $2.8 million. Risk Capital Corp.'s rental expense for 1996 was $264,000. The Company currently intends to sublease approximately 6,000 square feet of the remaining portion of the office space to another tenant.
Set forth below is certain selected consolidated financial information for the year ended December 31, 1996 and the period from June 23, 1995 (date of inception) to December 31, 1995. This information should be read in conjunction with the accompanying Consolidated Financial Statements of the Company and the Notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations.
Reinsurance treaties that are placed by intermediaries are typically for one year terms with a substantial number that are written or renewed on January 1 each year. Other significant renewal dates include April 1, July 1 and October 1. The January 1, 1997 renewal period was marked by continuing intensified competitive conditions in terms of premium rates and treaty terms and conditions in both the property and casualty segments of the marketplace. These conditions have worsened due to large domestic primary companies retaining more of their business and ceding less premiums to reinsurers. While the Company is initially somewhat disadvantaged compared to many of its competitors, which are larger, have greater resources and longer operating histories than the Company, it believes it has been able to generate attractive opportunities in the marketplace due to its substantial unencumbered capital base, experienced management team and relationship with its equity investment advisor as well as its strategic focus on generating a small number of large reinsurance treaty transactions that may also be integrated with an equity investment in client companies.
At January 1, 1997, the Company had 55 in-force treaties, with approximately $128 million of annualized in-force premiums. Such in-force premiums represent estimated annualized premiums from treaties entered into during 1996 and the January 1, 1997 renewal period that are expected to generate net premiums written during calendar year 1997. All 55 of such treaties are subject to renewal. Without taking into account the possibility that (x) several of the treaties entered into during 1996 that are scheduled to expire during the remainder of 1997 may be renewed and (y) additional new treaties may be bound during 1997, it is estimated that the Company will record approximately $110 million of net premiums written over the twelve month period ending December 31, 1997 from such treaties. Such estimates of in-force premiums and net premiums written at January 1, 1997 do not include the unearned premium portfolios and other non-recurring transactions reflected in the Company's net premiums written for 1996 because such portfolios and transactions will not generate any net premiums written during 1997.
For the year ended December 31, 1996 and for the period June 23, 1995 (date of inception) to December 31, 1995, the Company had consolidated net income of approximately $4.1 million, or $0.24 per share, and $1.0 -24 -
million, or $0.06 per share, respectively. After-tax realized investment gains of $0.8 million, or $0.05 per share, and $0.3 million, or $0.02 per share, were also included in net income for the 1996 and 1995 periods, respectively. Net income for 1996 included a loss of $0.2 million, or $0.01 per share, representing the Company's equity in the net loss of an investee company which is accounted for under the equity method of accounting.
The Company believes that the results of operations for the year ended December 31, 1996 are not necessarily indicative of its future financial results due to a number of factors, including (i) the potential increase in net premiums written indicated by the Company's January 1, 1997 renewal season activity, (ii) the Company's emphasis on targeting casualty business that is longer-tail than its current mix of business and (iii) the Company's investment strategy. Increased premium writings, particularly longer-tail casualty business, can generally be expected to generate higher underwriting losses than the business recorded in 1996 because of the related requirement to establish claims liabilities that are adequate to cover the costs of anticipated future claim payments without taking into account the time value of money.
Approximately $32.9 million, or 45%, of net premiums written resulted from unearned premium portfolios and other non-recurring transactions. This amount includes $11.9 million of specialty premiums written from contracts pursuant to which the Company reinsures a portion of one underlying policy for multiple years. Such premiums will be earned over the multiple periods as the exposures expire.
Approximately 30% of net premiums written was from non-U.S. clients which are Lloyd's Syndicates or are located in the United Kingdom and Continental Europe.
Set forth below is the Company's statutory composite ratio for the year ended December 31, 1996 and the estimated aggregate statutory composite ratio for domestic reinsurers based on data reported by the RAA as of such date:
Claims and claims expenses generally represent the Company's most significant and uncertain costs. Reserves for these expenses are estimates involving actuarial and statistical projections at a given time of what the Company expects the ultimate settlement and administration of claims to cost based on facts and circumstances then known. The reserves are based on estimates of claims and claims expenses incurred and, therefore, the amount ultimately paid may be more or less than such estimates. The inherent uncertainties of estimating claim reserves are exacerbated for reinsurers by the significant periods of time (the "tail") that often elapse between the occurrence of an insured claim, the reporting of the claim to the primary insurer and, ultimately, to the reinsurer, and the primary insurer's payment of that claim and subsequent indemnification by the reinsurer. As a consequence, actual claims and claims expenses paid may deviate, perhaps substantially, from estimates reflected in the Company's reserves reported in its financial statements. The estimation of reserves by new reinsurers, such as the Company, may be less reliable than the reserve estimations of a reinsurer with an established volume of business and claim history. To the extent reserves prove to be inadequate, the Company may have to augment such reserves and incur a charge to earnings. Such a development, while not anticipated, could occur and result in a material charge to earnings or stockholders' equity in future periods. Subject to the foregoing, the Company believes that the reserves for claims and claims expenses are adequate to cover the ultimate cost of claims and claims expense incurred through December 31, 1996.
The Company monitors its earthquake and wind exposures and continuously reevaluates its estimated probable maximum pre-tax loss for such exposures through the use of modeling techniques. The Company generally seeks to limit its probable maximum pre-tax loss to no more than 10% of its statutory surplus for severe catastrophic events that could be expected to occur once in every 100 years and that would result in insurance industry-wide losses ranging from approximately $40.0 to $45.0 billion depending on the catastrophe exposure zone (a "100 Year Event"). This limitation includes combined exposure to underwriting losses, reinstatement costs for retrocessional arrangements which may be in force at the time of the losses resulting from the catastrophic event and losses that the Company may be exposed to as a result of its privately held investments in insurance and insurance-related entities. While the Company believes its risk management techniques are adequate, there can be no assurances that the Company will not suffer pre-tax losses greater than 10% of its statutory surplus from a catastrophic event due to the inherent uncertainties in estimating the frequency and severity of such exposures. In addition, the Company believes that it cannot reasonably estimate its exposure to unrealized investment losses (if any) that may result from the Company's investments in publicly traded securities of insurance and insurance-related entities.
At December 31, 1996, approximately 63% of the Company's invested assets consisted of fixed maturity and short-term investments compared to 83% at December 31, 1995. Net investment income for the year ended December 31, 1996 was approximately $13.2 million compared to $4.6 million for the period June 23, 1995 (date of inception) to December 31, 1995. As discussed above, the amount of investment income from quarter to quarter may vary and could diminish as the Company continues to employ its strategy of investing a substantial portion of its investment portfolio in publicly traded and privately held equity securities, which generally yield less investment income than fixed maturity investments.
Assuming a stable interest rate environment, the Company anticipates such yields to moderately decline as funds invested in short-term securities are allocated into equity securities.
The Company's effective tax rate of 7% for the year ended December 31, 1996 and 7% for the period June 23, 1995 (date of inception) to December 31, 1995 are less than the 35% statutory rate on pre-tax operating income due to tax exempt income and the dividends received deductions. The 1996 and 1995 gross deferred income tax benefits of approximately $1.8 million and $0.2 million, respectively, which are assets considered recoverable from future taxable income, result from temporary differences between financial and taxable income.
A principal component of the Company's investment strategy is investing a significant portion of invested assets in publicly traded and privately held equity securities, primarily issued by insurance and reinsurance -27 -
The Company has not invested in derivative financial instruments such as futures, forward contracts, swaps, or options or other financial instruments with similar characteristics such as interest rate caps or floors and fixed-rate loan commitments.
RCHI is a holding company and has no significant operations or assets other than its ownership of all of the capital stock of Risk Capital Reinsurance, whose primary and predominant business activity is providing reinsurance and other forms of capital to insurance and reinsurance companies and making investments in -28 -
Nebraska insurance laws provide that, without prior approval of the Nebraska Director, Risk Capital Reinsurance cannot pay a dividend or make a distribution (together with other dividends or distributions paid during the preceding 12 months) that exceeds the greater of (i) 10% of statutory surplus as of the preceding December 31 or (ii) statutory net income from operations from the preceding calendar year not including realized capital gains. Net income (exclusive of realized capital gains) not previously distributed or paid as dividends from the preceding two calendar years may be carried forward for dividends and distribution purposes. Any proposed dividend or distribution in excess of such amount is called an "extraordinary" dividend or distribution and may not be paid until either it has been approved, or a 30-day waiting period has passed during which it has not been disapproved, by the Nebraska Director. Notwithstanding the foregoing, Nebraska insurance laws provide that any distribution that is a dividend may be paid by Risk Capital Reinsurance only out of earned surplus arising from its business, which is defined as unassigned funds (surplus) as reported in the statutory financial statement filed by Risk Capital Reinsurance with the Nebraska Insurance Department for the most recent year. In addition, Nebraska insurance laws also provide that any distribution that is a dividend and that is in excess of Risk Capital Reinsurance's unassigned funds, exclusive of any surplus arising from unrealized capital gains or revaluation of assets, will be deemed an "extraordinary" dividend subject to the foregoing requirements. See "Business-- Insurance Regulation--Regulation of Dividends and Other Payments from Insurance Subsidiaries" and Note 10 of the Notes to the Consolidated Financial Statements of the Company.
The effect on net income and earnings per share after applying FASB No. 123's fair valuation method to stock issued under the Company's employee stock purchase plan does not materially differ from the pro forma information set forth above with respect to the Company's employee stock options.
From time to time various regulatory and legislative changes have been proposed in the insurance and reinsurance industry, some of which could have an effect on reinsurers. Among the proposals that have in the past been or are at present being considered are the possible introduction of federal regulation in addition to, or in lieu of, the current system of state regulation of insurers and proposals in various state legislatures (some of which proposals have been enacted) to conform portions of their insurance laws and regulations to various model acts adopted by the NAIC. The Company is unable to predict whether any of these laws and regulations will be adopted, the form in which any such laws and regulations would be adopted, or the effect, if any, these developments would have on the operations and financial condition of the Company. See "Business--Insurance Regulation."