The following selected financial data should be read in conjunction with the Consolidated Financial Statements, including the related notes, and "Management's Discussion and Analysis of Financial Condition and Results of Operations."
: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
We are an insurance holding company, and our principal asset is ownership of Scottish Insurance. We were formed on May 12, 1998, and Scottish Insurance was formed on June 3, 1998, under the laws of the Cayman Islands. We commenced our insurance operations on November 30, 1998, immediately following our initial public offering. Consequently, we have a very short operating history in 1998, and we are still in the start up phase of our operations.
Our operating earnings of $450,557 or $0.13 per share were driven by revenues from our investment portfolio and insurance administration fees. The expenses incurred include nonrecurring startup costs. Since we are in a start- up phase, the revenues and expenses set forth above should not be used to project future periods.
Our investment portfolio is managed by three professional investment managers, Pacific Investment Management Company, Prudential Investment Corporation and Gen Re - New England Asset Management, Inc. Our investment guidelines are designed to diversify the portfolio to maximize investment income while minimizing risk. At December 31, 1998, the portfolio had an average quality rating of AA+, an average duration of 3.67 years and an average book yield of 5.50%. We anticipate that the average yield will go up in 1999 when the proceeds are fully deployed. At year-end our investment mangers were still in the process of deploying the proceeds from the stock offering. A realized loss of $14,236 and net unrealized depreciation of $853,146 was recognized on investments during the period.
At December 31, 1998, total capitalization was $252,060,179. We currently have no material commitments for capital expenditures and do not anticipate incurring material indebtedness other than letters of credit, which may be required in the ordinary course of our planned reinsurance business.
We expect that our cash and investments, together with cash generated from our businesses, will provide sufficient sources of liquidity and capital to meet our needs for the next several years.
When used, the words "may," "will," "expect," "anticipate," "continue," "estimate," "project," "plan," "intend" and similar expressions identify forward-looking statements regarding among other things: (i) our business and growth plans; (ii) our relationship with third-party service providers and clients; (iii) trends in the insurance and reinsurance industries; (iv) government regulations; (v) trends that may affect our financial condition or results of operations; and (vi) the declaration and payment of dividends. Potential investors are cautioned that any forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties. Actual results may differ materially from those included within the forward- looking statements as a result of various factors. Factors that could cause or contribute to such differences include, but are not limited to, those described below and under the heading "Management's Discussion and Analysis of Financial Condition and Plan of Operations" and elsewhere in this Form 10-K.
We will not be successful in our fixed annuity and other reinsurance businesses if we cannot develop business primarily through our executive officers' relationships with international insurance brokers, insurance consultants, members of the actuarial profession and senior insurance company executives.
Our business plan for our reinsurance activities provides that one of our principle targets is reinsuring blocks of in-force fixed annuities issued by insurers that are no longer actively writing
Annuities in the accumulation phase are subject to surrender risk. Although we will take this into account when negotiating prices, we cannot assure you that we will succeed in negotiating prices that actually take into account such risk. Nor can we assure you that, as these fixed annuities or similar contracts are surrendered, terminate or expire, we will have enough reinsurance business to sustain our growth or that there will be enough reinsurance business in our target market to replace these fixed annuities or similar contracts.
Potential purchasers of insurance policies, insurers, reinsurers and insurance and reinsurance intermediaries use insurance ratings to assess the financial strength and quality of insurers and reinsurers. In addition, an unfavorable rating or the lack of a rating will adversely affect a company purchasing reinsurance. Although Duff & Phelps has given us a claims-paying ability rating of "A" and A.M. Best has given us Best Rating of "A-" (Excellent), we cannot assure you that we will be able to maintain these ratings. If we are unable to maintain these ratings, we cannot assure you that we will be able to obtain similar claims-paying ability ratings from other major rating agencies.
Changes in U.S. Tax Laws With Respect To Variable Life Insurance Could Adversely Affect Our Product Sales.
The favorable tax treatment for variable life insurance products in the United States compared to certain other investment alternatives is the reason for the variable life insurance market. Any material change in this tax treatment, including the imposition of a "flat tax" or a national sales tax in lieu of the current federal income tax structure in the United States, would adversely affect the market for variable life insurance products.
Past legislative proposals would have limited the ability of policyholders to change private independent money managers without triggering adverse tax consequences. If any of these proposals were enacted into law, they could adversely affect our variable life insurance business.
In the past, federal and state governments have proposed to regulate foreign insurers more than currently regulated. While none of these proposals has been adopted, we cannot assure you that federal or state legislation will not be enacted subjecting our business to supervision and regulation in the United States.
Our Reinsurance Business Could Be Adversely Affected By Uncertainties of Letters of Credit or Other Collateral Amounts.
reinsurance will be available on commercially acceptable terms or that the reinsurers will perform under their reinsurance agreements.
Universal life insurance and similar policies sensitive to interest rates provide life insurance with adjustable rates of return based on applicable interest rates in effect from time to time. As a result, the risks with respect to reinsuring those kinds of policies may also include investment risks similar to those for fixed annuities. In addition, like annuities, life insurance policies and variable annuities are subject to surrender risk.
In addition, under our investment guidelines, we can invest up to 15% of our investment portfolio in below investment grade fixed income securities. While any investment carries some risk, the risks of investing in lower-rated securities are greater than the risks of investing in investment grade securities.
In addition, if we enter into a coinsurance transaction, we will seek to invest the assets transferred to us to match our anticipated reinsurance liabilities. We expect to invest these assets in fixed income and, to a lesser extent, equity securities. We may invest in foreign denominated securities to manage currency risk if the coinsurance transaction involves foreign currency. We may also enter into interest rate swaps and other hedging transactions in an effort to manage interest rate risks.
Our functional currency is the United States dollar. However, because a portion of our planned business, including premiums, may be in currencies other than United States dollars and because we may maintain a small portion of our investment portfolio in investments denominated in currencies other than United States dollars, we may have losses if we do not properly manage or otherwise hedge, our currency risks.
We Have No Experience Competing With Established Companies in the Life Insurance and Reinsurance Industry.
The life insurance and reinsurance industries are highly competitive and most of the companies in these industries are significantly larger, have operating histories and have access to significantly greater financial and other resources than we do. We have no experience competing with these companies.
Passive Foreign Investment Company Risks. You will have adverse United States federal income tax consequences if we are deemed a "passive foreign investment company." In general, a foreign corporation is a passive foreign investment company if 75% or more of its income constitutes "passive income" or 50% or more of its assets produces passive income. "Passive income" generally includes interest, dividends and other investment income. However, "passive income" does not include income "derived in the active conduct of an insurance business by a corporation which is predominantly engaged in an insurance business." This exception is intended to ensure that income derived by a bona fide insurance company is not treated as passive income, except to the extent this income is attributable to financial reserves in excess of the reasonable needs of the insurance business. Because we intend to continue to be in the insurance business and do not intend to have financial reserves in excess of the reasonable needs of our insurance business, we do not expect to be a "passive foreign investment company." We can give no assurance, however, that the IRS or a court will agree in this view.
Our Ability to Pay Dividends Is Dependent on the Success of Our Subsidiary and Regulatory Constraints.
dividends paid to us by Scottish Insurance. The payment of dividends is at the discretion of our Board of Directors and depends largely on the ability of Scottish Insurance to pay dividends to us. Scottish Insurance is subject to Cayman Islands regulatory constraints which also affect its ability to pay dividends to us. Specifically, Scottish Insurance must keep enough capital to support its variable life insurance and reinsurance businesses and comply with restrictions under Cayman Islands insurance corporate law. Accordingly, there is no assurance that dividends will be declared or paid in the future.
Our directors will not decline to register any transfer of our shares executed on the Nasdaq National Market. However, if any transfer results in the transferee (or any group) beneficially owning, directly or indirectly, 10% or more of any class of shares or causes our directors to have reason to believe that a transfer may expose us, any subsidiary or shareholder thereof or any person insured or reinsured or proposing to be insured or reinsured to adverse tax or regulatory treatment in any jurisdiction, under our Articles of Association, the directors have the power to deliver a notice to the transferee demanding that the transferee surrender to an agent, designated by the directors, certificates representing the shares and any dividends or distributions that the transferee has received as a result of owning the shares. A transferee who has resold the shares before receiving this notice will be required to transfer to the agent the proceeds of the sale, to the extent such proceeds exceed the amount that the transferee paid for such shares, together with any dividends or distributions that the transferee received from us. As soon as practicable after receiving the shares and any dividends or distributions that the transferee received, the agent will use its best efforts to sell the shares and any non-cash dividends or distributions to the extent tradeable as market securities in an arm's-length transaction on the Nasdaq National Market. After applying the proceeds from such sale toward reimbursing the transferee for the price paid for such shares, the agent will pay any remaining proceeds and any cash dividends and distributions to organizations described in Section 501(c)(3) of the Code that the directors designate. The proceeds of any such sale by the agent or the surrender of dividends
or distributions will not inure to our benefit or the agent's benefit, but the amounts may be used to reimburse expenses incurred by the agent in performing its duties.