Our business consists of two lines of business, variable life insurance and annuities, and life and annuity reinsurance. Prior to the acquisition of Scottish Annuity, we provided a variety of insurance administration, accounting and other services to Scottish Annuity.
Under our second reinsurance agreement, we contracted to reinsure up to $400 million of group funding agreement business. This transaction was structured so that reserves would be transferred in four separate $100 million tranches. Additionally, closing each tranch is subject to final approval by both parties. We closed on the two first tranches in July and August. Subsequently, in mutual agreement with the ceding company, we elected to delay taking down the third and fourth tranches. This decision does not reflect the quality of the reinsured business, but rather came as a result of adverse conditions in the overall market that were outside our control and that of the ceding company. As of
December 31, 1999, we have not taken down the third and fourth tranches. As of year end, the business reinsured has perfomed as we had expected and, if market conditions permit, we will consider taking down the final two tranches.
On October 15, 1999 we closed our acquisition of Harbourton. Harbourton provides us with a United States platform to write reinsurance business. Harbourton is licensed in 15 states and the District of Columbia and is an authorized reinsurer in an additional 8 states. Harbourton has approximately $83 million of annuity reinsurance in force as of year end 1999. Subsequent to year end, we have hired 26 reinsurance professionals to expand the reinsurance operations of Harbourton. While we expect to write short duration annuity reinsurance business in Harbourton, the principal focus of new business in Harbourton will be traditional life reinsurance. In addition, we are in the process of changing the name of Harbourton to "Scottish Re (U.S.), Inc.". We expect to have all required regulatory approvals for the name change by the end of the second quarter of 2000.
In the fourth quarter we executed a letter of intent with Lincoln National Life Insurance Company, under which, beginning in February 2000, Scottish Insurance will reinsure a 50% share of the new fixed annuity business written by Lincoln and sold through financial institutions. The business, which is managed by First Penn-Pacific Life Insurance Company, is expected to generate $150 million of reinsurance reserves during 2000. The treaty has subsequently been executed, reinsuring business sold on or after February 15, 2000. However no assurance can be given that these expectations can be achieved.
Effective December 31, 1999 we acquired ownership of Scottish Annuity, which has approximately $250 million of variable annuity business. We had previously provided insurance administration and accounting services to Scottish Annuity under an administration agreement.
Our business consists of two lines of business, variable life insurance and annuity products, and annuity and life reinsuance. Both lines of business are designed to capitalize on our offshore location, which allows us to offer unique product features and competive pricing. During the past year, we entered into several reinsurance agreements and we are pricing and underwriting several more. In addition, the variable products business is beginning to grow more rapidly as we develop relationships with independent insurance brokers.
On October 15, 1999 we completed our acquisition of Harbourton for $25,183,372. On December 31, 1999 we acquired Scottish Annuity for $11,601,464. 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. In addition, we have access to a combined $70 million through available lines and letters of credit, none of which have been utilized to date.
The Financial Accounting Standards Board's Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities", was issued in June 1998 and requires adoption no later than fiscal quarters of fiscal years beginning after June 15, 2000. The new standard establishes accounting and reporting standards for derivative instruments. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted
transaction. We have not yet completed our evaluation of the effect this standard will have on us. We do not currently own any securities that would be subject to this statement.
We will not be successful in our variable life and annuity insurance business if we cannot get clients from referrals by financial advisors, investment managers, private bankers, attorneys and other intermediaries in the United States and elsewhere. Since Scottish Insurance and Scottish Annuity are not licensed or registered to do business in the U.S., these referral sources may not act as our agent, nor can they be compensated by us for any activities in the U.S. As a result, we cannot assure you that we will be able to effectively implement our insurance plans.
We will not be successful in our non-traditional annuity and life reinsurance businesses if we cannot develop business primarily through relationships with reinsurance intermediaries, insurance consultants, members of the actuarial profession and senior insurance company executives.
Our Ability to Develop Our Business Plan is Dependent Upon Maintaining Our Claims-Paying Ability Rating.
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 assigned Scottish Insurance and Harbourton a claims-paying ability rating of "A" and A.M. Best has assigned both companies a 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 Annuities and Life Insurance Could Adversely Affect Our Product Sales
The tax treatment afforded annuity and life insurance products (both variable and non-variable) by United States tax law is in many respects more favorable than the tax treatment of certain other investment alternatives, and is therefore a primary competitive feature of such products. Any material change in the current tax treatment of annuity or life insurance products, including the imposition of a "flat tax" or national sales tax in lieu of the current United States federal income tax structure, could adversely affect the market for variable annuities or life insurance products. In addition, elimination of the federal estate tax has been proposed from time to time. Were the federal estate tax to be eliminated, the sale of life insurance products could be adversely affected.
Scottish Insurance and Scottish Annuity are licensed as unrestricted Class B insurers and are subject to regulation and supervision by the Cayman Islands Monetary Authority. They are not registered or licensed to do business in any jurisdiction in the United States or any other country. Generally, the sale of insurance within a jurisdiction where the insurer is not admitted to do business is prohibited. Under the operating guidelines, Scottish Insurance and Scottish Annuity do not operate in the United States or, to the extent prohibited, in any other country. We can give no assurance that inquiries or challenges to our insurance activities will not be raised in the future. Scottish Insurance's variable life insurance products have customized features that are not typically available from a company subject to those laws. If Scottish Insurance were to become subject to those laws, our business, results of operations and financial condition would likely be materially adversely affected.
Because many jurisdictions do not allow insurance companies to take credit for reinsurance obtained from unlicensed or non-admitted insurers on their statutory financial statements unless appropriate security measures are in place, we anticipate that our reinsurance clients will typically require us to post a letter of credit or provide other collateral through a funds withheld or trust arrangement. If we are unable to obtain a letter of credit facility on commercially acceptable terms or are unable to arrange for such other collateral, our ability to operate our reinsurance business will be severely limited.
Our Products Carry With Them Inherent Insurance Industry Risks And Risks Specific to Our Business Plan.
. the credit risk that the continued ability of a given obligor to make timely payments of principal and interest;
. the risk that we may have to sell assets at a loss to provide for policyholder withdrawals.
In addition, we 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. We can not assure you that we will successfully structure our investments so as to match our anticipated reinsurance liabilities. If our calculations are incorrect, or if we improperly structure our investments to match these liabilities, we could be forced to sell investments before they mature at a significant loss with the result that our assets may not be adequate to meet our needed reserves, which could adversely affect our business, results of operations and financial condition.
We Have Limited 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 limited experience competing with these companies.
As Cayman Islands companies, Scottish Insurance and Scottish Annuity, we operate in a manner so that we are not subject to United States tax, other than withholding tax on certain investment income from United States sources. However, the Internal Revenue Service could contend that we are conducting business in the United States. If the Internal Revenue Service were to prevail in that contention, we would be subject to United States tax at regular corporate rates on taxable income that is effectively connected with United States business plus an additional 30% "branch profits" tax on the income remaining after the regular tax, which could adversely affect our results of operation.
Harbourton is a U.S. licensed insurance company and is therefore subject to United States tax at regular corporate tax rates on taxable income. Any increase in United States taxes on income in Harbourton could adversely affect our results of operation.
Controlled Foreign Corporation Rules. Each "United States shareholder" of a "controlled foreign corporation" who owns shares in the controlled foreign corporation on the last day of its taxable year generally must include in his gross income for United States federal income tax purposes his pro-rata share of the controlled foreign corporation's "subpart F income," even if the subpart F income has not been distributed. For these purposes, any United States person who owns directly or indirectly 10% or more of our ordinary shares will be considered to be a "United States shareholder." In general, a foreign insurance company such as our subsidiary, Scottish Insurance, is treated as a controlled foreign corporation only if such "United States shareholders" collectively own more than 25% of the total combined voting power or total value of our stock for an uninterrupted period of 30 days or more during any year. We believe that, because of the anticipated dispersion of our share ownership among holders and because of the restrictions in our Articles of Association on transfer, issuance or repurchase of our ordinary shares, our shareholders will not be subject to treatment as "United States shareholders" of a controlled foreign corporation. In addition, because under the Articles of Association no single shareholder will be permitted to exercise 10% or more of our total combined voting power, our shareholders should not be viewed as "United States shareholders'" of a controlled foreign corporation for purposes of these rules. There can be no assurance, however, that these rules will not apply to our shareholders.
Our Ability to Pay Dividends Is Dependent on the Success of Our Subsidiaries and Regulatory Constraints.
We are a holding company engaged in the variable insurance and reinsurance business through our wholly owned subsidiaries, Scottish Insurance, Scottish Annuity, and Harbourton. Our principal source of income is dividends paid to us by our subsidiaries. The payment of dividends is at the discretion of our Board of Directors and depends largely on the ability of our subsidiaries to pay dividends to us. Scottish Insurance and Scottish Annuity are subject to Cayman Islands regulatory constraints which also affect their ability to pay dividends to us. Specifically, Scottish Insurance and Scottish Annuity must keep enough capital to support its variable 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 Articles of Association Contain Substantial Limitations on Ownership, Transfers and Voting Rights.
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.
Our Articles of Association and Cayman Islands Confidentiality Laws Have Anti- takeover Effects.