(2) Book value per share is calculated by dividing the sum of shares outstanding plus contractually issuable shares into total shareholders' equity.
(3) Certain amounts in the 1998, 1997, 1996 and 1995 selected consolidated financial data have been reclassified to conform to the 1999 presentation. Such reclassifications had no effect on the Company's net earnings, shareholders' equity, or cash flows.
The Company's primary sources of revenue are earned premium and investment income derived from its insurance company operations, management fees generated from its underwriting agency operations, commission income produced by its intermediary operations and other operating income. The Company's core underwriting activities involve providing accident and health reinsurance, aviation, marine, offshore energy, property, workers' compensation, group health and medical stop-loss insurance, marketed directly by the Company and produced by independent agents.
The Company has substantially increased its shareholders' equity through the issuance of equity securities and earnings, thereby enabling it to increase the underwriting capacity of its insurance company subsidiaries. The Company has utilized this additional equity by increasing underwriting activity across many of its core lines of business, emphasizing lines of business and individual opportunities with the most favorable underwriting characteristics at a particular point in time. In each line of business, as an insurer, the Company also cedes premium through the purchase of reinsurance in types and amounts appropriate to the line of business, market conditions and the Company's desired net risk retention profile.
The Company's intermediary operations also place insurance and reinsurance for the Company's insurance company and underwriting agency operations and other non-affiliated insurance companies and risk taking entities, as well as on behalf of medium to large corporate clients.
Since 1996, the Company has focused its acquisition activities on expanding its underwriting agency and intermediary operations for three principal reasons. The first reason is an attempt to increase the
Operations whose revenue are included in other operating income consist of insurance related service operations which may support the Company's operations as well as service unaffiliated customers. Additionally, this revenue includes revenue from strategic operational investments and gains and losses from their disposition. The Company may make such strategic investments from time to time, generally in businesses that complement the Company's operations.
The following table sets forth certain premium revenue information for the three years ended December 31, 1999 (dollars in thousands):
The following table sets forth the relationships of certain income statement items as a percent of total revenue for the three years ended December 31, 1999:
Net investment income increased 5% to $30.9 million in 1999 from $29.3 million in 1998, reflecting a slightly higher level of investment assets and increased interest rates earned on short-term investments. During 2000, the Company will utilize its available cash flow to reduce its debt but, nevertheless, it is anticipated that net investment income will continue to grow.
Compensation expense increased to $77.5 million in 1999, from $56.1 million in 1998. This increase reflects a normal progressional increase due to business growth as well as the effect of acquisitions. Other operating expenses increased $11.1 million to $47.2 million during the same period for similar reasons. Currency conversion gains amounted to $442,000 in 1999, compared to gains of $219,000 in 1998.
The Company's book value per share was $9.29 as of December 31, 1999, up from $9.12 as of December 31, 1998.
Loss and LAE increased to $109.7 million in 1999, from $91.3 million in 1998, and the GAAP net loss ratio increased to 77.6% in 1999, from 63.8% in 1998. The GAAP gross loss ratio was 116.8% in 1999 compared to 109.2% in 1998. The deterioration is primarily from poor results in the aviation, property and medical stop-loss lines of business. The Company has taken steps to reduce these gross loss ratios, primarily by increasing premium rates and more selective risk selection. The statutory net combined ratio was 129.9% (104.1% excluding the effects of the provision for reinsurance) in 1999 compared to 82.9% in 1998.
During 1999, the Company had net loss and LAE deficiency of $4.6 million relating to prior year losses compared to a redundancy of $14.6 million in 1998. During 1999, the Company had gross loss and LAE deficiency of $90.0 million compared to a deficiency of $33.5 million in 1998. The gross deficiency results from the development of large claims on individual policies which were either reported late or reserves were increased as subsequent information became available. However, as these policies were substantially reinsured, there is no material effect to the Company's net earnings. The deficiencies and redundancies in the net reserves result from the Company's and its actuaries' continued review of its loss reserves and the increase or reduction of such reserves as losses are finally settled and claims exposures are reduced. The Company continues to believe it has materially provided for all material net incurred losses.
In 1999, the insurance company subsidiaries recorded a $43.5 million provision for reinsurance to reflect an estimated $29.5 million pre-tax loss for the insolvency of one of the subsidiaries' reinsurers and an estimated $14.0 million pre-tax loss, the majority of which represents the discount on ceded reserves, related to the commutation of all liabilities with another reinsurer. This commutation, made at the Company's request, was finalized and settled in February, 2000. In connection with the commutation, the subsidiaries received cash and other amounts totaling $56.5 million. Additionally, as of December 31, 1999 the Company has a reserve of $5.5 million which management believes is sufficient to absorb any potential losses related to its reinsurance recoverables. However, the adverse economic environment in the worldwide insurance industry has placed great pressure on reinsurers and the results of their operations and these conditions could, ultimately, affect reinsurers' solvency. Historically, there have been insolvencies following a period of competitive pricing in the industry, such as the marketplace has experienced for the last several years. Therefore, while management believes that the reserve is adequate based upon current available information, conditions may change or additional information might be obtained that would affect management's estimate of the adequacy of the level of the reserve and which may result in a future increase or decrease in the reserve. Management continually reviews the Company's financial exposure to the reinsurance market and will continue to take actions to protect shareholders' equity.
Net earnings of the insurance companies decreased to a loss of $10.7 million in 1999, from a profit of $33.8 million in 1998, as a result of the provision for reinsurance, the effect of restructuring and the higher net loss ratio.
Generally, underwriting profitability has deteriorated as the extremely competitive market conditions continue to affect current results. These results will probably continue to deteriorate even as there is a transition to a harder market but, eventually, should become profitable as rates increase and underwriting becomes more selective.
Management fees increased 23% to $90.7 million in 1999, from $74.0 million in 1998. Premium underwritten on behalf of affiliated and unaffiliated insurance companies increased to $848.1 million in 1999, an increase of 20% from $706.2 million in 1998. Both increases resulted from acquisitions and internal growth of existing operations. Management fees and premium underwritten are expected to continue to increase in 2000 as a result of the Centris acquisition and increased premium.
Commission income increased 42% to $54.6 million in 1999, from $38.4 million in 1998, primarily as a result of the acquisition of RML, effective January 1, 1999. Net earnings of the intermediaries decreased to $13.6 million in 1999 from $16.9 million in 1998. The increase in net earnings generated by RML was offset by fewer large brokerage transactions in 1999 and other reductions, including a $551,000 (net of income tax) restructuring expense in 1999.
In connection with the Centris acquisition, a plan was formulated, approved and implemented prior to December 31, 1999 to eliminate Centris' corporate staff, combine the Centris medical stop-loss operations with those of HCCB and combine certain Centris and HCCB production and underwriting facilities. In accordance with the plan, certain Centris employees were terminated with severance benefits to be paid in accordance with Centris' employment contracts for executives or the HCC severance plan for Centris employees who did not have employment contracts. These severance obligations were accrued as of the acquisition date, included in the purchase price allocation and will not be included in expense in the Company's statements of earnings. Additionally, accruals of $848,000 were made at that date for future
It is expected that the significant portion of the severance accruals will be paid prior to April 30, 2000, in accordance with the contractual terms of the severance agreements. Management is still evaluating what additional actions, if any, are necessary to finalize the integration of the Centris operations. Any additional accruals will be recorded as an adjustment to the purchase price allocation.
The Company recorded a restructuring charge and associated expenses of $5.5 million during the fourth quarter of 1999. Since its initial public offering in 1992, the Company has completed more than fifteen acquisitions for a total value exceeding $750.0 million. During that time, total employees have grown from less than 100 to more than 1,000. As a result of this rapid growth, management believes certain operating inefficiencies occurred. At the beginning of the fourth quarter of 1999, management made a review of its operations and determined that they could be made more efficient, principally by reducing the employee count in certain of its operations. Management believes that this restructuring will strengthen the Company's corporate and management structure and enhance future earnings by improving operating efficiency and therefore profitability. The savings, principally in compensation expense, from the restructuring is estimated to be approximately $10.0 million to $12.0 million in the year 2000 and annually thereafter. The terminations that generated the compensation savings took place in the fourth quarter.
A total of 92 employees were terminated in the fourth quarter as a result of the Company's restructuring which affected all segments. The Company accrued severance payments for 27 of these terminated employees at December 31, 1999, substantially all of which was paid in January, 2000. The restructuring charge also includes accruals of $911,000 related to future lease costs of office space made redundant as a result of the restructuring plan and a write down of $647,000 principally of leasehold improvements and other assets related to the redundant space. The following table provides a detailed analysis of the charge:
operating income as a result of internal growth and acquisitions. The decrease in insurance company net earned premium offsets these increases.
Net investment income increased 6% to $29.3 million in 1998 from $27.6 million in 1997 reflecting a slightly higher level of investment assets. In 1998, the Company also utilized a substantial amount of its non-insurance company subsidiary cash flow to reduce debt and therefore interest expense, limiting the amount of cash subject to short-term investment.
Income tax expense was $35.2 million in 1998, compared to $23.3 million in 1997. The Company's effective tax rate was 32.8% in 1998 compared to 31.9% in 1997. As net income from the underwriting agency and intermediary operations grow, the Company's effective tax rate increases due to state income taxes and the mitigation of the effect of tax exempt municipal bond income on the combined effective tax rate.
Net earnings increased 45% to $72.3 million in 1998, from $49.8 million in 1997. Diluted earnings per share increased 44% to $1.48 in 1998 from $1.03 in 1997.
GWP increased 44% to $498.3 million in 1998 from $346.4 million in 1997, due primarily to increased aviation, property, medical stop-loss and accident and health reinsurance premium. NWP for 1998 decreased to $121.9 million from $142.9 million in 1997, due to an increase in the amount of ceded reinsurance. Net earned premium decreased to $143.1 million in 1998 compared to $162.6 million in 1997 reflecting the reduction in NWP and the reduced retentions of the Company.
AIC, acquired in June, 1997, recorded a $10.0 million increase in loss and LAE reserves during December, 1997, predominantly relating to 1995 and 1996 claims incurred prior to the Company's acquisition of AIC. This increase in reserves was made to bring AIC's reserving practices consistent with the more conservative method used by the Company's other insurance company operations. Management expects the increase in AIC's loss reserves to be adequate to cover any subsequent adverse development of AIC's prior losses.
Net earnings of the insurance companies decreased to $33.8 million in 1998 from $40.6 million in 1997, as a result of a general deterioration in underwriting results.
Management fees in 1998 increased 45% to $74.0 million from $51.0 million in 1997. Premium underwritten on behalf of affiliated and unaffiliated insurance companies increased to $706.2 million in 1998, an increase of 49% from $473.4 million in 1997. Both increases resulted from acquisitions and internal growth.
Net earnings of the underwriting agencies increased 46% to $19.4 million in 1998 from $13.3 million in 1997 due to acquisitions and internal growth.
Commission income increased to $38.4 million in 1998 from $24.2 million in 1997 an increase of 59%. Net earnings of the intermediaries increased 139% to $16.9 million in 1998 from $7.1 million in 1997. The increases result from internal growth and a number of large brokerage transactions.
Other operating income increased 46% to $22.3 million in 1998, from $15.2 million in 1997, principally as a result of a $4.0 million pre-tax gain on the sale of one of the Company's subsidiaries whose operations were not material to those of the Company. Additionally, revenue of a service company subsidiary increased $2.0 million in 1998. Net earnings from other operations increased for the same reasons.
The Company receives substantial cash from premiums, reinsurance recoverables, and management fee and commission income and, to a lesser extent, investment income, and proceeds from sales and redemptions of investment assets. The principal cash outflows are for the payment of claims and LAE,
payment of premiums to reinsurers, purchase of investments, debt service, policy acquisition costs, operating expenses, income and other taxes and dividends.
Property and casualty insurance companies domiciled in the State of Texas are limited in the payment of dividends to their shareholders in any 12 month period, without the prior written consent of the Commissioner of Insurance, to the greater of statutory net income or 10% of statutory policyholders' surplus. HC and USSIC paid no dividends in 1999. During 2000, HC and USSIC's ordinary dividend capacity is approximately $25.0 million and $10.4 million, respectively.
As of December 31, 1999, the Company had a net deferred tax asset of $18.3 million compared to $3.4 million as of December 31, 1998. Due to the Company's history of consistent earnings and expectations for the future, it is more likely than not that the Company will be able to realize the benefit of its deferred tax asset.
The overall increase in activities at the insurance company subsidiaries and the acquisition of Centris in late December, 1999 resulted in increases in gross loss reserves, life and annuity policy benefits, gross unearned premiums and deferred policy acquisition costs since 1997. Related amounts of reinsurance recoverables, ceded life and policy benefits, ceded unearned premium and deferred ceding commissions also increased. The Company continues to collect its receivables and recoverables generally in the ordinary course of business and has not incurred and does not expect to incur any significant liquidity difficulties as a result of the substantial growth in gross amounts due. The Company limits its liquidity exposure by holding funds, letters of credit or other security such that net balances due to it are significantly less than the gross balances shown in the consolidated balance sheets.
As of December 31, 1999, each of the domestic insurance company subsidiaries' total adjusted capital is significantly in excess of the NAIC authorized control level risk-based capital.
provision for inflation is made, although trends are considered when setting underwriting terms and claim reserves. Claim reserves are subject to a continuing review process to assess their adequacy and are adjusted as deemed appropriate. In addition, the market value of the investments held by the Company varies depending on economic and market conditions and interest rates, which are highly sensitive to the policies of governmental and regulatory authorities. Any significant increase in interest rates could therefore have a material adverse effect on the market value of the Company's investments. In addition, the Company's $300.0 million Facility's interest rate floats with that of the market. Any significant increase in interest rates could have a material adverse effect on earnings.
The Company underwrites risks which are denominated in a number of foreign currencies. It establishes and maintains loss reserves with respect to these policies in their respective currencies. These reserves are subject to exchange rate fluctuations which can have an effect on the Company's net earnings. The Company's principal area of exposure is with respect to fluctuation in the exchange rate between the major European currencies and the United States Dollar. For the years ended December 31, 1999, 1998 and 1997, the gain (loss) from currency conversion was $442,000, $219,000 and ($884,000), respectively.
On a very limited basis in the past, the Company has entered into foreign currency forward contracts as a hedge against foreign currency fluctuations. RML, purchased by the Company during January, 1999, has a revenue stream in US Dollars but incurs expenses in GBP. To mitigate the foreign exchange risk, the Company entered into foreign currency forward contracts expiring at staggered times through December 2000. As of December 31, 1999, the Company had forward contracts to sell US $12.0 million for GBP at an average rate of 1.00 GBP equals US$1.60. The foreign currency forward contracts are used to convert currency at a known rate in an amount which approximates average monthly expenses. Thus, the effect of these transactions is to limit the foreign currency exchange risk of the recurring monthly expenses. In the future, the Company may continue to limit its exposure to currency fluctuations through the use of foreign currency forward contracts. The Company utilizes these foreign currency forward contracts strictly as a hedge against existing exposure to foreign currency fluctuations rather than a form of speculative or trading investment.
connection with the Year 2000 issues associated with its own systems did not have a material effect on the Company's results of operations. No additional costs are anticipated.
On January 1, 1999, certain member countries of the European Union irrevocably fixed the conversion rates between their national currencies and a common currency, the "Euro", which became their common legal currency on that date. The participating countries' former national currencies will continue to serve as legal tender and denominations of the Euro between January 1, 1999 and January 1, 2002. The conversion to the Euro is scheduled to be completed on July 1, 2002, when the national currencies will cease to exist. The Company does not expect the introduction of the Euro to have a material effect on the Company's business, software plans, financial condition or results of operations.