MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - -------------------------------------------------------------------------------- 7.1 CONSOLIDATED RESULTS - --------------------------------------------------------------------------------
The following discussion provides management's assessment of financial results and material changes in financial position for TIG Holdings, Inc. ("TIG Holdings") and its subsidiaries (collectively "TIG") and presents management's expectations for the near term. The analysis focuses on the performance of TIG's three major operating segments, Reinsurance, Commercial Specialty and Custom Markets, and its investment portfolio, which are discussed at Items 7.2, 7.3, 7.4 and 7.7, respectively. Lines of business that have been de-emphasized ("Other Lines") are discussed at Item 7.5. For a better understanding of this analysis, reference should be made to Item 8 - Financial Statements and Supplementary Data.
TIG Holdings would like to caution readers regarding certain forward-looking statements in the Management's Discussion and Analysis and elsewhere in this Form 10-K (see Item 7.11- Forward-Looking Statements). Key industry terms that appear in the Management's Discussion and Analysis and elsewhere in this document are defined at Item 7.12. Certain reclassifications of prior years' amounts have been made to conform to the 1998 presentation.
Closing of Offices and Termination of Employment of Certain Officers. During 1998, the Company decided to downsize executive offices in New York City, consolidating corporate functions with its corporate headquarters in Irving, Texas. In addition, the Company decided to close its staff counsel offices located throughout the continental United States and outsource supervision of claims litigation previously performed by these offices.
As a result of the closing of the company's executive offices in new York City, the employment of certain executive or senior officers of TIG was terminated. These executive or senior officers included Peter M. Acton, Senior Vice President and General Counsel, and Louis J. Paglia, Senior Vice President and Treasurer. In addition, Edwin G. Pickett, Executive Vice President and Chief Financial Officer of the Company, resigned his position. For the purpose of the severance agreement between TIG and Mr. Pickett, the circumstances of his resignation met the agreement's definition of involuntary termination, thereby entitling Mr. Pickett to all benefits provided by the severance agreement. In addition, Cynthia B. Koenig, Controller of TIG Insurance also left the Company effective January 1, 1999.
Sale of Independent Agents Business Unit. On December 31, 1997, TIG completed the sale of the Independent Agents business unit to Nationwide Mutual Insurance Company ("Nationwide"). This unit produced gross premium written of $247 million, $286 million and $299 million in 1998, 1997 and 1996, respectively. As of December 31, 1997, all Independent Agents business was 100% reinsured by a subsidiary of Nationwide, including outstanding loss and LAE reserves, unearned premium reserves and premium receivables. Under the purchase agreement, Nationwide assumed the risk of loss and LAE reserve development and receivable collectibility. To allow Nationwide's subsidiary time to make appropriate regulatory filings, TIG agreed to write Independent Agents business and cede such business 100% to the Nationwide subsidiary without penalty through December 31, 1999, and thereafter if necessary at an increased cost. In addition, approximately 300 employees of the Independent Agents unit became employees of Nationwide on December 31, 1997. As the sale was principally effected through reinsurance transactions, TIG recognized no capital gain or loss (See Note C to the Consolidated Financial Statements at Item 8).
Highly competitive market conditions in both reinsurance and primary insurance products continued in 1998. Oversupply of capital in the insurance industry has resulted in significant downward pricing pressure, making it increasingly difficult to write business that meets TIG's profitability standards; however, TIG will continue to invest in new business initiatives that meet its focused "program" criteria. Continuing soft market conditions are expected to increase the time required for new business initiatives to achieve targeted profitability.
TIG Re's chairman retired effective February 2, 1998. Michael Wacek, a seasoned insurance executive, was appointed President and Chief Executive Officer of TIG Re in February 1998. The retirement of the former Chairman and the appointment of the new Chief Executive Officer could impact, positively or negatively, existing producer relationships and the availability of new business opportunities.
Soft market conditions have continued to persist during 1998. The decline in the Specialty Property unit primarily reflects $22 million of net premium written associated with two significant programs that were not renewed as part of the re-underwriting initiative noted above. Premiums declined by $33 million within the Traditional Treaty business unit due to the non-renewal or the reduction in participation of several large accounts. During the second quarter of 1998, the Company announced that the management and reporting of the Reverse Flow business unit would be transitioned at natural expiration to the Commercial Specialty operating segment of TIG Insurance.
The 10.4 percentage point decrease in the retention ratio in 1998 as compared to 1997 and the 8.0 percentage point decrease in 1997 compared to 1996 is principally attributable to increased premium ceded under aggregate stop loss reinsurance treaties. Included in the 1998 results, is a change in the premium written recognition for various aggregate stop loss contracts, in response to a request made by the Connecticut Insurance Department during their triennial examination. The impact of this adjustment was an increase to ceded written premiums of $27.2 million with no impact on ceded earned premiums. Other net premium written is reduced by aggregate stop loss reinsurance premium cessions of TIG Re not applicable to a specific line of business (see Item 7.6 - Exposure Management).
TIG Re strengthened reserves for current and prior accident years by $145 million in December 1997 based on actuarial evaluations as of September 30, 1997 (see Item 1.6 - Reserves). The reserve increase was net of $40 million of reinsurance benefit under the 1995 inter-company reinsurance treaty with TIG Insurance. Losses ceded by TIG Re under the 1995 reinsurance treaty are reflected in the operations of TIG Insurance through Other Lines loss and LAE incurred. The $12 million increase in 1997 other underwriting expense over 1996 is principally attributable to start-up costs associated with the Facultative business unit which was formed in late 1996. For 1997, the Facultative unit produced $13 million of earned premium; however, operating expenses increased by $7 million and underwriting loss increased by $5 million in 1997 as compared to 1996.
Commercial Specialty net premium written increased 34% in 1997 compared to 1996. This increase was primarily derived from increases in Workers' Compensation, Primary Casualty and the new Lloyd's Syndicates. The growth in Workers' Compensation was driven by the assumption of an existing book of program business. Growth in Primary Casualty comes from new programs in Construction, Marine and Energy, and Professional lines. The increases noted for Lloyd's Syndicates are due to the acquisition of a majority interest in a Lloyd's managing agency as described at Item 1.3 - Commercial Specialty. Other net premium written represents allocations of corporate aggregate stop loss coverage not applicable to a specific business unit (see Item 7.6 - Exposure Management).
Underwriting Results. The table below presents underwriting results for Commercial Specialty operations:
Premium. Custom Markets provides personal lines and small business insurance products through three main business units: Non-Standard Auto, Alternative Distribution and Small Business. Custom Markets distribution system and marketing strategy are described at Item 1.4 - Custom Markets. The table below presents premium production by major product for Custom Markets operations:
Excluding the 1998 adjustments and expenses, Custom Markets underwriting loss increased by $3 million in 1998 as compared to 1997. The deterioration is primarily due to higher losses in short-tailed property lines in the Small Business unit and in the Alternative Distribution unit in the first six months of the year.
Custom Markets underwriting loss increased by $18 million in 1997 as compared to 1996, principally as a result of program start up costs incurred in the Alternative Distribution unit, which began operations in late 1996 and had an underwriting loss of $14 million for 1997. The remaining increase in underwriting loss resulted from lower profitability for the Hawaii unit in 1997, as the Hawaii unit benefited from favorable loss experience in 1996.
Other Lines principally includes the results of Independent Agents personal lines that were sold in 1997, commercial lines that have been placed in run-off due to failure to meet profitability standards and aggregate stop loss reinsurance activity not related to a specific operating segment. See Item 1.5 for a description of business placed in run-off.
Premium. As discussed at Item 7.1 - Consolidated Results and Note C to the Consolidated Financial Statements at Item 8, TIG's Independent Agents business unit was sold and all business 100% reinsured effective December 31, 1997. As a result, net premium written and earned for the Independent Agents unit will be zero for all periods subsequent to the sale, as will all loss, loss adjustment expenses and underwriting expenses. Excluding the impact of the unearned premium cession upon the sale of the unit and increased allocations of corporate aggregate stop loss reinsurance premium, Independent Agents 1997 premium approximated that of 1996. Excluding the Independent Agents unit, non-renewal of Other Lines business has generally progressed at a faster rate than originally expected by TIG management. The rapid elimination of this business is attributable to pro-active efforts by TIG in assisting producers with placing their business with other insurance carriers. As a result, TIG has in many cases avoided lengthy cancellation notice periods. These efforts will continue in 1999 with gross premium written expected to continue to decline. Net premium written in 1998 is negative due to premium receivable write-offs and retro adjustments on certain policies.
Excluding the 1998 adjustments and expenses, Independent Agents ceding commission and net benefit from aggregate stop loss reinsurance, and the 1997 reserve adjustments, Independent Agents underwriting gain and the net benefit from aggregate stop loss reinsurance and commutation of a reinsurance treaty, Other Lines underwriting loss of $19 million in 1998 compares to an underwriting loss of $13 million in 1997. The deterioration of results is primarily attributable to higher incurred losses in short-tail property lines.
General Reinsurance Program. For primary lines, TIG Insurance purchases reinsurance to allow it to insure larger risks while controlling exposure to larger losses and catastrophes. Each year, the primary reinsurance program is modified based upon changes in business mix, coverage availability and pricing. Reinsurance purchased may include both treaty and facultative coverages. TIG Insurance's ceded reinsurance agreements are generally structured on a treaty basis whereby all risks meeting certain criteria are automatically reinsured. During 1998, TIG Insurance enhanced the decentralized reinsurance purchasing function for all primary operating segments and generated new operating controls. During 1998, TIG Insurance made minor modifications to certain retention levels and entered into some new treaty agreements. Also during 1998, TIG Insurance commuted one aggregate stop loss reinsurance treaty that was not utilized to date.
Excluding corporate aggregate stop loss covers, TIG Re purchases reinsurance (retrocessional cover) and aggregate stop loss coverage separately from TIG Insurance's primary operations. TIG Re purchases property catastrophe coverage and several retrocessional coverages for specific treaties or programs. In 1995, TIG Re purchased aggregate stop loss reinsurance coverage from TIG Insurance, similar to external reinsurance purchased in 1996 and 1997. This inter-company aggregate stop loss contract was commuted during 1998.
Reinsurance recoverable increased by $551 million or 36% in 1998 as compared to 1997. The increase is principally attributable to increases in recoverables under aggregate stop loss reinsurance treaties.
After consideration of reinsurance reinstatement premium, TIG Insurance effectively retained approximately 95% of the first $50 million of the total aggregate catastrophe loss and 5% of losses in excess of $50 million for 1997 and 1996. In 1995, TIG Re entered into a separate catastrophe reinsurance agreement providing $25 million in excess of a $15 million retention for TIG Re's property program through 1997. In addition, TIG Re entered into a catastrophe reinsurance agreement on January 1, 1998, providing $40 million in excess of $10 million retention for non-U.S. or Canadian property losses through 1998.
Losses from coverages other than property insurance may also occur from an event giving rise to catastrophic property losses. For example, an earthquake or explosion could cause workers' compensation losses as well as property losses. TIG has estimated a PML for such an event and coordinates its underwriting guidelines and reinsurance covers to limit its probable maximum loss. It is possible that the PML estimated by TIG may either understate or overstate, perhaps to a significant degree, the possible losses to TIG which could be generated by insured loss events. TIG is working with its Catastrophe Management Committee to refine the analysis of these ancillary exposures and to enhance the Company's ability to mitigate these factors.
Aggregate Stop Loss Reinsurance. Both TIG Insurance and TIG Re purchase aggregate stop loss reinsurance to protect against unanticipated exposures not considered in other reinsurance coverages. In addition, aggregate stop loss coverage can be utilized to cover exposure to large deductibles under other reinsurance treaties, especially catastrophe treaties, and mitigate risk inherent in a changing book of business. TIG's aggregate stop loss reinsurance treaties generally provide excess of loss protection on all business written for losses incurred in excess of a specified loss retention ratio ("attachment point"). Stop loss reinsurance is "umbrella" protection, which is utilized after all other specific reinsurance coverages have been exhausted.
Loss Portfolio Reinsurance. Effective January 1, 1998, the Company entered into a loss portfolio reinsurance agreement on a funds held basis for loss and LAE reserves of $265 million related to certain run-off programs. The gain of $22 million was deferred and will be amortized into income as losses are paid. Amortization of the deferred gain of $8 million was recorded as a reduction of incurred losses in 1998. The contract covers 80% of any adverse loss development incurred in excess of $280 million up to a maximum of $343 million. Any additional future benefit from the contract triggered by adverse loss development will also be deferred and amortized into income as the related losses are paid. Funds held bear interest at 1.7% per quarter beginning April 1, 1998. Related interest on funds held of $10 million was recorded as a reduction of net investment income in 1998.
Investment Mix. Management continues to emphasize a conservative investment strategy by maintaining a portfolio of primarily high-quality, fixed maturity investments. In accordance with SFAS 115, TIG's entire fixed maturity portfolio has been classified as available-for-sale. As a result, all fixed maturity investments are recorded in TIG's financial statements at fair value. Unrealized gains and losses on fixed maturity investments and related hedges are recorded net of tax directly in shareholders' equity. See Note D to the Consolidated Financial Statements at Item 8 for further discussion. Following is a summary of TIG's investment portfolio by type of investment.
Less than 17% of TIG's portfolio consists of mortgage-backed securities ("MBS") as of December 31, 1998. United States federal government and government agency mortgages now represent approximately 69% of TIG's exposure to MBS as of December 31, 1998, offering AAA credit quality. A risk inherent to MBS is prepayment risk related to interest rate volatility. The underlying mortgages may be repaid earlier or later than originally anticipated, depending on the repayment and refinancing activity of the underlying homeowners. Should this occur, TIG would receive paydowns on principal amounts which may have been purchased at a premium or discount, and TIG's investment income would be affected by any adjustments to amortization resulting from the prepayments. TIG's consolidated financial results have not been materially impacted by prepayments of MBS. In addition, interest rate volatility can affect the market value of MBS. Substantially all MBS held in the portfolio can be actively traded in the public market.
Investments in TBA's. TIG routinely enters into commitments to purchase securities on a "To Be Announced" ("TBA") basis for which the interest rate risk remains with TIG until the date of delivery and payment. Delivery and payment of securities purchased on a TBA basis can take place a month or more after the date of the transaction. These securities are subject to market fluctuations during this period and it is the Company's policy to recognize any gains or losses only when they are realized. TIG maintains cash and short-term investments with a fair value exceeding the amount of its TBA purchase commitments. At December 31, 1998, there were no TBA purchase commitments compared to TBA commitments of $24 million with a fair value of $26 million at December 31, 1997.
Unrealized gains. The unrealized gain on investments decreased by $17 million on a pre-tax basis during 1998. The following is a summary of net unrealized gains/losses by type of security:
Investment Quality. The table below shows the rating distribution of TIG's fixed maturity investment portfolio:
The information on credit quality in the preceding table is based upon the higher of the rating assigned to each issue of fixed income securities by either Standard & Poor's Rating Service or Moody's Investor Services, Inc. Where neither Standard & Poor's nor Moody's has assigned a rating to a particular fixed maturity issue, classification is based on 1) ratings available from other recognized rating services, 2) ratings assigned by the National Association of Insurance Commissioner's Securities Valuation Office (the "SVO"), or 3) an internal assessment of the characteristics of the individual security, if no other rating is available.
The SVO assigns bond ratings for most publicly held bonds. The SVO ratings are used by insurers when preparing their annual statutory financial statements. State departments of insurance use the bond rating data when attempting to determine whether an insurer's holdings are sound. Investments must fit within certain regulatory guidelines of an insurer's domiciliary state in order for an insurer to be licensed to do business in that state. The SVO ratings range from "1" to "6", with "1" and "2" being higher quality, "3" being medium grade, and "4" through "6" being lower grade obligations. As of December 31, 1998 and 1997, approximately 93% and 84%, respectively, of TIG's portfolio, measured on a statutory carrying value basis, was invested in securities rated as "1" or "2".
The decrease in negative cash flow in Other Lines for 1998 compared to 1997 is primarily due to the $40 million tax payment made in 1997 (see Item 3 - Legal Proceedings), which did not recur in 1998, offset in part by increased loss payments. Other Lines operations negative cash flow improved slightly in 1997 compared to 1996. This improvement is principally driven by a reduction in paid losses and other operating expenses partially offset by the planned decline in premium writings. In addition, Other Lines operations cash flow for 1997 was reduced by the $40 million tax deposit mentioned above, which was partially offset by $26 million in funds received in commutation of a reinsurance treaty.
Notes Payable. In December 1995, as amended and restated in 1997, TIG Holdings established an unsecured revolving line of credit with maximum borrowings of $250 million. During first quarter 1998, TIG borrowed $70 million against this facility. At December 31, 1998 and 1997, TIG Holdings had no outstanding borrowings under this facility. Interest of $2.5 million was paid in 1998.
Liquidity Restrictions. Certain restrictions exist on the payment of dividends by insurance subsidiaries that may limit TIG Holdings' ability to receive funds from its subsidiaries. Dividends from its insurance subsidiaries represent the principal long-term source of liquidity to TIG Holdings. TIG Holdings received cash dividends of $175 million and $145 million from its insurance subsidiaries in 1998 and 1997, respectively. As of December 31, 1998, $96 million of dividends was available for payment to TIG Holdings from its insurance subsidiaries during 1999 without restriction (see Item 1.7 - Regulation). In December 1997, TIG Holdings contributed $70 million in capital to TIG Insurance, which was paid in early 1998.
As of December 31, 1998, the TIG Holdings Board of Directors authorized stock repurchases of up to 18.75 million shares of TIG Holdings common stock. Under the repurchase plan, repurchases may be made from time to time on the open market at prevailing market prices or in privately negotiated transactions. The first repurchases of stock were made in April 1994. Through December 31, 1998, repurchases of 16.3 million shares of stock have been made at an average cost per share of $28.34, for an aggregate cost of $461 million.
TIG and individual insurance company members of the TIG group have a claims paying rating of "A" from Standard & Poor's Insurance Rating Services ("S&P"). The assigned rating reflects S&P's opinion of the operating insurance company's financial capacity to meet the obligations of its insurance policies in accordance with their terms. The "A" rating assigned to TIG is the sixth highest of ten ratings in the "secure claims paying ability" category.
TIG's State of Readiness. TIG has conducted an extensive review of its core processing computer systems, including computer hardware and software vendors, to identify and address all changes, testing and implementation procedures required to make such systems Year 2000 compliant. The Company has a coordinated process to facilitate the necessary changes, testing and implementation procedures. TIG has completed and implemented all of the required code changes of its Year 2000 system remediation project. TIG expects necessary third party software implementation and testing of its computer systems to be completed by March 31, 1999. TIG will continue testing its internal systems, as well as its internal systems' abilities to operate with the systems of key third parties, during the remainder of 1999.
The potential losses that TIG policyholders may incur which stem from Year 2000 problems will be business risks which are not insurable under standard property and casualty policies. A most reasonably likely worst case scenario would anticipate that it is possible that certain TIG policies may be reformed by judicial decisions to cover Year 2000 losses, which were not contemplated. TIG does not believe that such losses will have a material impact on TIG's financial results. To date, TIG has not incurred any losses relating to Year 2000 claims under its insurance and reinsurance policies.
* changes in interest rates which could impact investment yields, the market value of invested assets and ultimately product pricing
* increased competition (on the basis of price, services, or other factors) which could generally reduce operating margins or result in loss of key producer relationships
* regulatory and legislative changes which could increase the Company's overhead costs, increase federal and state tax assessments, restrict access to profitable markets or force participation in unprofitable markets
* changes in ratings assigned to TIG which could impact demand for the Company's products
* changes in loss payment patterns which could impact cash flow and net investment income
* loss of key management personnel which could impact the development and execution of the Company's business strategy and impact key customer and vendor relationships
Many of these uncertainties and contingencies can affect TIG's actual results and could cause its actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, TIG.
Agent: An insurer's representative authorized to market a Company's policy coverages for a commission.
Bordereaux: A detailed report of reinsurance premiums or reinsurance losses furnished periodically by the reinsured. A loss bordereaux contains a detailed list of claims and claims expenses outstanding and paid by the reinsured during the reporting period and the amount of reinsurance indemnity applicable thereto.
Broker/intermediary: One who negotiates contracts of insurance or reinsurance on behalf of an insured party, receiving a commission from the insurer or reinsurer for placement and other services rendered.
Capacity: The percentage of surplus, or the dollar amount of exposure, that an insurer or reinsurer is willing to place at risk. Capacity may apply to a single risk, a program, a line of business or an entire book of business.
Casualty insurance: Insurance which is primarily concerned with the losses caused by injuries to third persons (i.e., not the policyholder) and the legal liability imposed on the insured resulting therefrom. It includes, but is not limited to, employers' liability, workers' compensation, public liability, automobile liability, personal liability and aviation liability insurance. It excludes certain types of loss that by law or custom are considered as being exclusively within the scope of other types of insurance, such as fire or marine.
Combined ratio: A combination of the underwriting expense ratio, the loss and LAE ratio, and the policyholder dividends ratio, determined in accordance with statutory accounting practices. A combined ratio below 100.0 generally indicates profitable underwriting results. A combined ratio over 100.0 generally indicates unprofitable underwriting results.
Excess of loss: A generic term describing insurance or reinsurance which indemnifies the policyholder against all or a specified portion of losses on underlying insurance policies in excess of a specified dollar amount, called a "layer" or "retention."
Generally accepted accounting principles ("GAAP"): Accounting principles as set forth in opinions of the Accounting Principles Board of the American Institute of Certified Public Accountants and/or in statements of the Financial Accounting Standards Board and/or their respective successors and which are applicable in the circumstances as of the date in question.
Gross premium written: Total premium for direct insurance written and reinsurance assumed during a given period.
Incurred but not reported ("IBNR") reserves: Reserves for estimated losses and LAE which have been incurred but not reported to the insurer (including future developments on losses that are known to the insurer).
Loss development: The emergence of actual loss data as compared to estimates for specific accident years and for specific lines of business.
Loss and LAE reserves: Liabilities established by insurers and reinsurers to reflect the estimated cost of claims payments that the insurer or reinsurer will ultimately be required to pay with respect to insurance or reinsurance it has written. Reserves are established for losses and for LAE, and consist of case reserves and IBNR reserves.
Premium-to-surplus ratio: The ratio of statutory net premium written to statutory surplus.
Primary Insurance: The insurance coverage provided under the primary policy issued by the primary insurer to the primary insured (sometimes called "underlying insurance").
Program business: Tailored products developed for a particular industry segment (i.e., sporting events, trucking) or distribution system (i.e., trade associations, affinity groups). Programs are often developed and controlled by GAs.
Reinsurance: The practice whereby one party, called the reinsurer, in consideration of a premium paid to it agrees to indemnify another party, called the reinsured, for part or all of the liability assumed by the reinsured under a policy or policies of insurance which it has issued. The reinsured may be referred to as the original or primary insurer, the direct writing company, or the ceding company. Reinsurance does not legally discharge the primary insurer from its liability to the insured.
Retention: The amount or portion of risk which an insurer or reinsurer retains for its own account. Losses in excess of the retention level are paid by the reinsurer or retrocessionaire. In pro-rata treaties, the retention may be a percentage of the original policy's limit. In excess of loss reinsurance, the retention is a dollar amount of loss, a loss ratio, or a percentage of loss.
Risk-based capital: A regulatory measurement of statutory capital and surplus to analyze continuation of operations at existing levels, taking into consideration various inherent risks.
Stamp capacity: The syndicate's premium limit for the relevant underwriting year.
Statutory surplus: The excess of admitted assets over total liabilities (including loss reserves), determined in accordance with SAP.
Treaty participation: The portion of risk exposure an insurer or reinsurer accepts under an insurance contract. The insurer or reinsurer with the largest participation is the lead insurer and therefore has the ability to influence the terms of the contract.
Underwriting expense ratio: The ratio of underwriting expenses to net premium written, determined in accordance with statutory accounting practices.
Underwriting expenses: The aggregate of policy acquisition costs, including commissions, and the portion of administrative, general, and other expenses attributable to underwriting operations.
Working layer reinsurance: Reinsurance which absorbs the losses immediately above the reinsured's retention layer. A working layer reinsurer will pay up to a certain dollar amount of losses over the insured's retention, at which point a higher layer reinsurer (or the ceding company) will be liable for additional losses. Working layer reinsurance is also known as low layer excess of loss reinsurance.
Consolidated Statements of Income for each of the three years in the period ended December 31, 1998 ................................59
Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1998.................................62
We have audited the accompanying consolidated balance sheets of TIG Holdings, Inc. and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of income, comprehensive income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1998. Our audits also included the financial statement schedules listed in the Index at Item 14 (a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
TIG Holdings is primarily engaged in the business of property/casualty insurance and reinsurance through its 14 domestic insurance subsidiaries, collectively "TIG" or "the Company". Of direct premium written by TIG in 1998, 21% was written in California, 9% in Florida, 7% in Michigan, 6% in New York, and 5% in Hawaii. No other geographical area, including foreign operations, accounted for more than 5% of direct premium written. A description of each operating segments' principal products follows (see also Note P - Operating Segments).
Custom Markets. Custom Markets' principal products are standard automobile, non-standard automobile, homeowners and small business owner's insurance. Automobile policies cover liability to third parties for bodily injury and property damage and physical damage to the insured's own vehicle resulting from collision or various other causes of loss. Homeowners and small commercial property policies protect against loss of dwellings/buildings and contents arising from a variety of perils, as well as liability arising from ownership or occupancy. Custom Markets' products are distributed through strategic relationships with general agents ("GAs") and other key distribution partners. Net premium written for the Custom Markets operating segment comprised 20%, 13% and 6% of consolidated net premium written for the years ended December 31, 1998, 1997 and 1996, respectively.
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Segment Reporting. Effective January 1, 1998, the Company adopted Financial Accounting Standards Board's ("FASB") Statement of Financial Accounting Standard No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("Statement 131"). Statement 131 superseded FASB Statement No. 14, "Financial Reporting for Segments of a Business Enterprise". Statement 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. Statement 131 also established standards for related disclosures about products and services, geographic areas, and major customers. The adoption of Statement 131 did not affect results of operations or financial position (See Note P - Operating Segments).
Reporting Comprehensive Income. As of January 1, 1998, the Company adopted FASB Statement of Financial Accounting Standard No. 130, "Reporting Comprehensive Income" ("Statement 130"). Statement 130 establishes new rules for the reporting and display of comprehensive income and its components; however, the adoption of this Statement had no impact on the Company's net income or shareholders' equity. Statement 130 requires unrealized gains or losses on the Company's available-for-sale securities and the foreign currency translation adjustments, which prior to adoption were reported separately in shareholders' equity, to be included in other comprehensive income. Prior year financial statements have been presented in conformity with the requirements of Statement 130.
Earnings per Share ("EPS"). In December 1997, the Company adopted FASB Statement of Financial Accounting Standard No. 128, "Earnings Per Share", which established a new calculation of EPS. Prior period amounts have been restated to conform with the new requirements. Basic earnings per share is calculated based upon the weighted average common shares outstanding during the period. In order to calculate EPS, unallocated Employee Stock Ownership Plan ("ESOP") shares and treasury shares are deducted from the outstanding common shares. For diluted EPS, Class A common stock and common stock options (See Note K - Incentive Compensation Plans) increase weighted average shares outstanding to the extent that they are dilutive. To obtain net income attributable to common shareholders for EPS computations, the annual preferred stock dividend is deducted from net income. The following schedule presents the calculation of Basic and Diluted EPS:
Interest on fixed maturity investments is recorded as income when earned and is adjusted for any amortization of purchase premium or accrual of discount. Realized gains and losses on the sale of investments are generally determined on a first-in-first-out basis. Realized losses are recorded when an investment's fair value is below book value and the decline is considered other than temporary.
In June 1998, the Financial Accounting Standards Board issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("Statement 133"), which is required to be adopted in years beginning after June 15, 1999. The Statement permits early adoption as of the beginning of any fiscal quarter after its issuance. The Company expects to adopt the new Statement effective January 1, 2000. The Statement will require the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value will be immediately recognized in earnings. The Company has not yet determined what the effect of Statement 133 will be on the earnings and financial position of the Company.
Recognition of Premium Revenues. Premium, including premium on reinsurance contracts, is earned principally on a pro-rata basis over the terms of the policies, which are generally not more than one year. Unearned premium represents the portion of premium written applicable to the unexpired terms of policies in force.
Premium Deficiency Recognition. A premium deficiency is recognized for an operating segment when the sum of expected claim costs and claim adjustment expenses, expected dividends to policyholders, maintenance costs and unamortized acquisition costs exceeds future earned premiums related to non-cancelable in-force policies and related anticipated investment income. A premium deficiency is first recognized by charging unamortized deferred policy acquisition costs to expense and then accruing a liability for any remaining deficiency.
Restructuring Charges. In February 1996, TIG announced the reorganization of its commercial operations and plans to exit certain lines of business that failed to meet profitability standards. As a result of this reorganization, TIG took the following actions: 1) combined its Specialty Commercial and Workers' Compensation divisions to form a new operating segment called Commercial Specialty; 2) identified field offices for consolidation and closure; 3) identified lines of business for non-renewal or cancellation for which 1995 net premium written was approximately $190 million; 4) formed a run-off division (called "Other Lines") to administer contractually required policy renewals for run-off lines of business, and 5) outsourced to third party service providers or otherwise terminated the responsibilities of approximately 600 employees. The consolidation/closure of field offices was completed by December 31, 1996, although various lease obligations remain at December 31, 1998.
TIG recorded a $100 million accrual in first quarter 1996 for estimated restructuring charges comprised of severance of $17 million, contractual policy obligations of $37 million, office lease termination of $18 million, furniture, equipment and capitalized software write-downs of $12 million, and a reserve for litigation and credit issues related to terminated producers of $16 million. In 1997, TIG re-evaluated the $100 million restructuring charge. Although the total amount of the restructuring charge remained unchanged, the components were revised to the following: severance of $13 million; contractual policy obligations of $43 million; office lease terminations of $16 million; furniture, equipment and capitalized software write-downs of $10 million; and a reserve for litigation and credit issues related to terminated producers of $18 million. Severance costs were less than originally estimated due to the employment of certain TIG associates by third party service providers. The reduction in severance was effectively offset by increased costs for contractual policy obligations associated with outsourcing contracts. The revised estimates for leases, asset write-downs, and producer credit issues reflect minor adjustments to original assumptions based on activity through December 31, 1998. Charges against the restructure accrual of $97 million have been recorded since March 1996 and are comprised of $13 million in severance, $43 million in contractual policy obligations, $13 million in lease termination costs, $10 million in asset write-downs and $18 million related to producer credit issues. At December 31, 1998, TIG's exit plan was substantially complete with the remaining restructure accrual of $3 million projected to be paid out over the next two to three years. Net premium written for 1998, 1997, and 1996 from lines of business placed in run-off as a result of the 1996 restructure was ($1) million, $4 million and $140 million, respectively.
Merger with Fairfax Financial Holdings Limited. On December 3, 1998, the Company announced the proposed merger of FFHL, Inc., a wholly-owned subsidiary of Fairfax Financial Holdings Limited (Fairfax), with TIG Holdings, Inc. Fairfax is a financial services holding company that, through its subsidiaries, is engaged in property, casualty and life insurance and reinsurance, investment management and insurance claim management. The merger will be the culmination of an evaluation of strategic alternatives initiated by the Company's Board of Directors in an effort to determine the course of action that was in the best interest of the Company and its stockholders. Under the merger agreement, Fairfax has agreed to convert each share of common stock of the Company issued and outstanding as of the date that the Certificate of Merger is filed with the State of Delaware into the right to receive $16.50 in cash, without interest. On March 8, 1999, at a Special Meeting of Stockholders of TIG Holdings, Inc., the stockholders are expected to vote on the merger agreement. The obligations of the Company and Fairfax to effect the merger are subject, among other things, to the condition that necessary insurance regulatory approvals shall have been obtained.
Sale of Independent Agents Business Unit. On December 31, 1997, TIG sold the Independent Agents unit of its Retail Division, based in Battle Creek, Michigan, for $65 million in cash to Nationwide Mutual Insurance Company ("Nationwide"). The purchase price was adjusted for the surplus of TIG Countrywide Insurance Company ("CIC"), which was included in the sale, after giving effect to certain transactions. There was no capital gain or loss recognized on the sale. At closing, TIG entered into several reinsurance arrangements with CIC and ceded all outstanding loss and LAE reserves, unearned premium reserves and premium receivables related to the Independent Agents unit at book value. Under the purchase agreement, Nationwide assumed the risk of loss and LAE reserve development and receivable collectibility. To allow CIC and Nationwide time to make appropriate regulatory filings, TIG agreed to continue to write Independent Agents business and cede such business 100% to CIC for two years, or longer, if needed. TIG has also agreed to provide transition assistance services to CIC for the processing of this business for a period of up to two years. Independent Agents gross premium written for the years ended December 31, 1998, 1997 and 1996 totaled $247 million, $286 million and $299 million, respectively. During 1998, TIG recognized $20 million in ceding commission from the Independent Agents book of business.
Less than 17% of TIG's portfolio consists of mortgage-backed securities ("MBS") as of December 31, 1998. United States federal government and government agency mortgages represent approximately 69% of TIG's exposure to MBS as of December 31, 1998, offering AAA credit quality. A risk inherent to MBS is prepayment risk related to interest rate volatility. The underlying mortgages may be repaid earlier or later than originally anticipated, depending on the repayment and refinancing activity of the underlying mortgage holders. Should this occur, TIG would receive paydowns on principal amounts which may have been purchased at a premium or discount, and TIG's investment income would be affected by any adjustments to amortization resulting from the prepayments. TIG's consolidated financial results have not been materially impacted by prepayments of MBS. In addition, interest rate volatility can affect the market value of MBS. Substantially all MBS held in the portfolio can be actively traded in the public market.
In the normal course of business, TIG may choose to hedge some of its interest rate risk with futures contracts and/or interest rate swaps. Alternatively, derivative financial instruments may also be utilized to enhance prospective returns. TIG's interest rate swap arrangements generally provide that one party pays interest at a floating rate in relation to movements in an underlying index, and the other party pays interest at a fixed rate. While TIG is exposed to credit risk in the event of nonperformance by the other party, nonperformance is not anticipated due to the credit rating of the counterparties. There were no interest rate swaps at December 31, 1998, and $14 million notional face amount of interest rate swaps at December 31, 1997. From time to time, TIG sells futures contracts to hedge its interest rate and market exposures on thirty-year U.S. Treasury bonds. Risks arise from movements in the futures contracts' values. Futures contracts are carried at market value, with gains and losses recognized as adjustments to the carrying value of the hedged investment. No futures contract positions were open at December 31, 1998 or 1997. However, positions were opened and closed during 1998, 1997 and prior years. The deferral method has been used to account for these closed futures contracts. Under the deferral method, gains and losses from derivatives are deferred on the balance sheet and recognized in earnings in conjunction with the earnings recognition of the designated items. The deferred loss from futures contracts was $5 million and $4 million at December 31, 1998 and 1997, respectively.
TIG has no material non-income producing investments and has no geographic or other concentrations of investment risk which have not been disclosed. Invested assets of TIG, carried at $836 million and $620 million at December 31, 1998 and 1997, respectively, were either on deposit with government agencies as required by law in various states in which TIG insurance subsidiaries conduct business or were held as collateral for various business transactions. Invested assets of TIG's participation in Lloyd's Syndicates totaling $32 million and $8 million at December 31, 1998 and 1997, respectively, including cash of $11 million and $5 million for each respective period, are held in trust in accordance with Lloyd's of London regulations (see Note N - Commitments and Contingencies).
The estimated market value and amortized cost of the portfolio, by contractual maturity, at December 31, 1998 are presented below. Expected maturities will differ from contractual maturities as certain borrowers have the right to call or prepay obligations.
In 1998, TIG recognized unfavorable prior year loss and LAE reserve development of $25 million, of which unfavorable development of $24 million was attributable to TIG Insurance and $1 million of unfavorable development was attributable to TIG Re. The unfavorable development in TIG Insurance is primarily attributable to $11 million of development in unallocated LAE costs related to the termination of programs in Other Lines, unallocated LAE reserve strengthening of $7 million, and $6 million of unfavorable loss and allocated LAE development. Retroactive reinsurance assumed represents reserves assumed from third parties for insurable events that have already occurred in exchange for cash and/or investment consideration. These reserves relate to new programs in TIG's workers' compensation lines and Lloyd's Syndicates. No additional premiums or return premiums have been accrued as a result of prior years affects.
TIG's reserves include an estimate of TIG's ultimate liability for asbestos-related matters, environmental pollution, toxic tort and other non-sudden and accidental claims for which ultimate values cannot be estimated using traditional reserving techniques. TIG's environmental claims activity is predominately from hazardous waste and pollution-related claims arising from commercial insurance policies. Most of TIG's pollution claims are from small regional operations or local businesses involved with disposing wastes at dump sites or having pollution on their own property due to hazardous material use or leaking underground storage tanks. In connection with the initial public offering of TIG Holdings' common stock ("IPO"), an affiliate of Transamerica agreed to pay 75% of up to $119 million of reserve development and newly incurred claims, up to a maximum reimbursement of $89 million, on policies written prior to January 1, 1993 with respect to certain environmental claims involving paid losses and certain LAE in excess of TIG's environmental loss and LAE reserves at December 31, 1992. At December 31, 1998, the Transamerica affiliate had incurred no liability under this agreement.
TIG reinsures portions of its policy risks with other insurance companies or underwriters and remains liable under these contracts. Reinsurance is used to transfer some policy risks such that the amount of individual claims can be limited to a fixed percentage or amount. Reinsurance is also utilized to limit the amount of claims related to catastrophes. This strategy allows TIG to insure larger risks while controlling exposure to large losses. Reinsurance agreements currently in place are structured on both a treaty basis, where all risks meeting a certain criteria are automatically reinsured, and on a facultative basis, where each policy reinsured is separately negotiated. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. As a part of its overall business strategy, TIG also engages in assumed reinsurance transactions, primarily through TIG Re, a wholly-owned subsidiary.
Reinsurance contracts do not relieve TIG from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to TIG; accordingly, allowances are established for amounts estimated to be ultimately uncollectible. TIG evaluates the financial condition of its reinsurers and monitors concentrations of credit risk arising from similar geographic regions, activities, or economic characteristics of the reinsurers to minimize its exposure to significant losses from reinsurer insolvencies. At December 31, 1998, TIG held collateral related to reinsurance amounts in the form of letters of credit totaling $317 million, trust funds totaling $310 million, and funds held totaling $564 million.
The exercise of stock options granted under the Company's various stock option plans gives rise to compensation which is includable in the taxable income of the applicable employees and deductible by the Company for federal and state income tax purposes. Such compensation results from increases in the fair market value of the Company's common stock subsequent to the date of grant of the applicable exercised stock options. Accordingly, in conformity with Accounting Principles Board Opinion No. 25, such compensation is not recognized as an expense for financial accounting purposes and the related tax benefits are taken directly to Additional Paid-in Capital. Additional Paid-in Capital, which is a component of Common Stock in the accompanying consolidated financial statements, was increased $13 million during 1997 as a result of the exercise of such options. Tax benefits from the exercise of stock options by employees were not material in 1998 and 1996 (see Note K - Incentive Compensation Plans).
Sale - Leaseback. In December 1995, TIG Insurance Company entered into a $50 million credit facility, of which approximately $27 million and $24 million was outstanding as of December 31, 1998 and 1997, respectively. The facility is a direct financing arrangement with a third party related to the sale and leaseback of certain fixed assets, excluding data processing equipment. The net book value of these assets is $23 million at December 31, 1998, and $18 million at December 31, 1997, which includes accumulated depreciation of $24 million and $19 million at December 31, 1998 and 1997, respectively. The initial draw of $22 million against the facility in December 1995 is being amortized over 5 years with interest at 5.9% payable quarterly. Subsequent draws against the facility are amortized over 5 years and interest, based on a fixed or floating rate, is payable quarterly. Interest rates during 1998 ranged from 5.9% to 7.7%. Interest expensed and paid was $1.6 million for 1998 and 1997, and $1.4 million for 1996.
At December 31, 1998, approximate future minimum lease payments under this facility are as follows:
Capital Securities. In January of 1997, TIG Capital Trust I ("TIG Capital" or the "Trust"), a statutory business trust created under Delaware law and a trust subsidiary of TIG Holdings, completed a private offering for $125 million of 8.597% mandatory redeemable capital securities maturing in 2027. TIG Holdings is the initial holder of 100% of the common securities of TIG Capital. Holders of the capital securities of the Trust have a preference under certain circumstances over the holders of common securities of the Trust with respect to cash distributions and amounts payable on liquidation, redemption, or otherwise.
TIG Holdings issued $128.75 million in 8.597% Junior Subordinated Debentures to TIG Capital Trust I (including approximately $3.75 million with respect to the capital contributed to the Trust by TIG Holdings). Included in the restrictive covenants are conditions on the merger of the Company. If the merger of the Company with Fairfax is consummated, management expects these conditions will be met. TIG Holdings guaranteed the payment of distributions and payments on liquidation or redemption of the capital securities but only in each case to the extent of funds held by the Trust. The guarantee does not cover payment of distributions when the Trust does not have sufficient funds to pay such distributions. The net proceeds received by TIG Holdings from the issuance of the debentures were used for general corporate purposes including repurchases of the Company's common stock. Interest expense was $10.7 million and $9.9 million in 1998 and 1997, respectively. Interest paid was $10.7 million and $4.9 million in 1998 and 1997, respectively.
If the merger of the company with Fairfax is consummated (see Note C - Significant Transactions and Events), each share of preferred stock that is issued and outstanding immediately prior to the merger will be converted into the right to receive one share of preferred stock of the entity surviving the merger, with the same terms as the original shares.
The 1996 Long-Term Incentive Plan. The 1996 Long-Term Incentive Plan (the "1996 Plan") provides for awards of stock options, stock appreciation rights, restricted stock grants, restricted stock units and/or performance units. The maximum number of shares of Common Stock for which awards may be granted or paid out under the 1996 Plan is five million shares plus, effective January 1, 2000, the Limitation Amount. The "Limitation Amount" is 1.5% of the total number of issued and outstanding shares of Common Stock as of January 1, 2000, plus, effective each January 1 thereafter through and including January 1, 2006, 1.5% of the total number of issued and outstanding shares of Common Stock as of such January 1. In addition to the shares available for grant as previously mentioned, two million shares of Common Stock will be available solely for the grant of awards to employees in connection with acquisitions of other entities or businesses by the Company. As of December 31, 1998, there were no stock appreciation rights, restricted stock units or performance units outstanding. The 1996 Plan was originally to terminate on the date of the Company's annual meeting of shareholders in 2006; however, if the merger of the Company with Fairfax is consummated, the plan will be terminated. Thereafter, no awards may be granted. Stock options under the 1996 Plan typically have a term of ten years from the date of the grant and vest in equal annual installments over four years. Restricted stock grants typically vest in equal annual installments over three years. The weighted average fair value of restricted stock granted during the year was $31.47.
The 1996 Non-Employee Directors Compensation Program. The 1996 Non-Employee Directors Compensation Program (the "1996 Program") provides for awards of stock options and restricted share units. These awards are not to exceed 200,000 shares. As of December 31, 1998, there were 33,873 restricted share units and stock options representing the right to acquire 67,746 shares of common stock. Each restricted share unit converts into one share of common stock based upon an irrevocable election made by each non-employee director. The 1996 Program was to terminate on the close of business on the date of the Company's annual meeting of shareholders in 1999; however, if the merger of the Company with Fairfax is consummated, the program will be terminated. Restricted share units and stock options granted prior to the date of the annual meeting of shareholders in 1997 will vest in three substantially equal installments on the dates of each annual meeting of shareholders in 1997, 1998 and 1999. Restricted share units and stock options granted on or after the date of the 1997 annual meeting of shareholders but prior to the date of the 1998 annual meeting of shareholders will vest in two equal installments on the dates of each annual meeting of shareholders in 1998 and 1999. Restricted share units and stock options granted on or after the date of the 1998 annual meeting of shareholders but prior to the 1999 annual meeting of shareholders were originally to vest in one installment on the date of the 1999 annual meeting of shareholders. The maximum term of any stock option granted will be ten years from the date of grant.
Total compensation cost recognized in the income statement for stock-based employee compensation awards was $4.6 million, $1.8 million and $1.0 million for 1998, 1997 and 1996, respectively.
TIG Holdings' employee benefit plans (the "Plans") include the Diversified Savings and Profit Sharing Plan and the Employee Stock Ownership Plan. TIG Holdings adopted the ESOP and Profit Sharing Restoration Plans, effective January 1, 1994, and the Diversified Savings Restoration Plan, effective January 1, 1997. TIG Holdings may amend, terminate, or suspend contributions to the Plans at any time as it may deem advisable. TIG Holdings is the administrator of the Plans. Any subsidiary of TIG Holdings participating in the Plans may withdraw at any time with the consent of the TIG Holdings' Board of Directors. The Board of Directors of TIG Holdings has fiduciary responsibilities relating to the interpretation and operation of the Plans.
Diversified Savings and Profit Sharing Plan. As of January 1, 1997, the Diversified Savings Plan and Profit Sharing Plan were combined into the TIG Holdings, Inc. Diversified Savings and Profit Sharing Plan (the "DS&PSP). The DS&PSP is qualified under Section 401 (a) of the Internal Revenue Code ("IRC") and the trust established to hold the assets of the DS&PSP is tax-exempt under Section 501 (a) of the IRC. An employee vests 25% after one year of service, 50% after two years of service and 100% after three years of service. While the assets are maintained in a single trust, the record keeping, contributions and participant qualifications remain as if under two separate plans, the Diversified Savings Plan (the "DSP") and the Profit Sharing Plan (the "PSP").
The DSP is available to all salaried employees. Most employees who elect to participate may contribute up to 12% of their pre-tax salary, plus bonuses, commissions, and overtime pay ("Employee Compensation") for each calendar year. TIG Holdings administers the DSP and will make matching contributions to the DSP in an amount equal to 75% of the participant's contribution up to a maximum of 6% of Employee Compensation. Certain IRC required limitations may be imposed for participants who are treated as "highly compensated employees" for purposes of the IRC. Generally, an employee vests in the matching employer contributions based upon years of service. Employer matching contributions were $3 million for 1998, 1997 and 1996.
The PSP benefits eligible employees of TIG Holdings. Eligible employees are those who either were employed by TIG Holdings on December 31 each year or were employed during the plan year but died prior to the plan year end. Generally, each salaried employee is eligible to participate in the PSP. No employee contributions are permitted to be made to the PSP. The amount of any contribution for any calendar year made by TIG Holdings will be determined at the sole discretion of the TIG Holdings' Board of Directors. For 1998, 1997 and 1996 plan years, TIG contributed on behalf of each participant an amount equal to the sum of (i) two percent of the participant's Employee Compensation, as defined, for the Plan Year and (ii) four percent of the participant's annual Employee Compensation in excess of a determined wage base. In addition, if the merger of the Company with Fairfax is consummated (see Note C - Significant Transactions and Events), the 1% contribution for the ESOP 1998 plan year will be contributed to the PSP in 1999. Contributions were $2 million, $2 million and $1 million for 1998, 1997 and 1996, respectively.
Diversified Savings and Profit Sharing Restoration Plan. Effective January 1, 1997, TIG Holdings adopted the TIG Holdings, Inc. Diversified Savings Restoration Plan and combined it with the existing Profit Sharing Restoration Plan. The TIG Holdings, Inc. Diversified Savings and Profit Sharing Restoration Plan (the "DS&PS Restoration Plan") is an unfunded plan for the purpose of providing deferred compensation for a select group of management or highly compensated employees whose allocations under the qualified DS&PSP are limited by the annual restrictions as determined by the Internal Revenue Code. Highly compensated employees will be eligible for participation immediately upon the date of hire if annual earnings, including bonus in the year paid, exceed a specified threshold. The threshold for each year will be the amount of the cap on compensation that may be taken into account under the qualified plan for that year, or such greater amount as may be determined by the TIG Holdings, Inc. Benefits Committee in its discretion. A Participant vests 25% after one year of service, 50% after two years of service and 100% after three years of service. Participants' accounts are credited for the difference between the dollar amount credited to the participants' account under the qualified DS&PSP and the amount that would have been credited in the absence of the restrictions noted above. Participants' accounts are adjusted for gains, losses and earnings as if invested in the same manner as such associate's account under the qualified DS&PSP. Liabilities due to the participants were approximately $3 million and $2 million as of December 31, 1998 and 1997.
Employee Stock Ownership Plan. Most salaried employees are eligible to participate in the ESOP. Generally, TIG Holdings will contribute, for each calendar year, an amount equal to one percent of Employee Compensation, as defined, on behalf of each participant employed on the last working day of that year or who was employed but died during the year. Employees who were actively employed on April 27, 1993 received an initial allocation of 100 shares of TIG Holdings common stock in which they were immediately fully vested. Effective January 1, 1995, all active associates who did not previously receive the initial allocation of shares in 1993 were eligible for 100 shares of TIG Holdings, Inc. common stock upon attainment of six months of service. These shares were allocated to the associates' accounts as of the last day of the plan year. No employee contributions are permitted to be made to the ESOP. An employee vests 25% after one year of service, 50% after two years of service and 100% after three years of service. In April 1993, the ESOP borrowed $24 million from TIG Holdings to purchase 1,124,754 newly issued shares of common stock. The loan obligation of the ESOP is considered unearned employee compensation, and as such, is recorded as a reduction of TIG Holdings' shareholders' equity. As loan repayments are made by the ESOP, common stock is released to participant accounts. Unearned compensation is amortized based on the number of shares committed to be released and compensation expense is recognized based on the current market price. Dividends paid on unallocated shares are considered as employer contributions. Compensation expense of $2 million was recognized in 1997 and 1996, respectively. At December 31, 1998, 189,330 shares are allocated and 360,752 shares are in suspense. As of December 31, 1998, the market value of unallocated shares was $6 million. As noted below, no annual contribution was made to the ESOP plan for the 1998 plan year. Contributions to the ESOP were $1 million and $2 million for 1997 and 1996. A participant's ESOP account will be distributed in full shares of common stock or cash after termination of service.
If the merger of the Company with Fairfax is consummated, the 1% ESOP 1998 plan year contribution will be made to the PSP in 1999. The 100 shares allocation will be terminated as of December 31, 1998, and a cash distribution outside of the plan will be made to those affected employees in lieu of allocating shares to their accounts. If the merger of the Company with Fairfax is consummated, TIG expects to merge the ESOP plan into the DS&PSP.
Postretirement Benefits Other Than Pensions. TIG participated in Transamerica's defined benefit health care plan that provided postretirement benefits to eligible retirees of Transamerica and affiliates. TIG assumed all liabilities with respect to its retirees and active employees at the date of the IPO. These liabilities are a component of the Company's employee healthcare plan, and as such, no plan assets are specifically identified for this unfunded plan. Contributions for these contributory plans are adjusted annually. Consideration for the adjustments include deductibles and coinsurance. Medical benefits are based on the employee's length of service and age at retirement from the Company.
Litigation. TIG's insurance subsidiaries are routinely engaged in litigation in the normal course of business. As a liability insurer, the Company defends third party claims brought against its insureds. As an insurer, the Company defends against coverage claims. In the opinion of TIG, based upon information available at the date of this report, no individual item of litigation, or group of similar items of litigation (including asbestos-related and environmental pollution matters and the matters referred to below), taken net of reserves established therefor and giving effect to insurance and reinsurance, is likely to result in judgments for amounts material to TIG's consolidated results of operations or financial condition.
On February 12, 1998, a purported class action complaint, naming TIG and two of its executive officers as defendants, was filed in the United States District Court for the Southern District of New York on behalf of persons who purchased TIG common stock during the period from October 21, 1997 to January 30, 1998, when TIG announced its fourth quarter 1997 results. The complaint alleges that TIG violated the federal securities laws by misrepresenting the adequacy of its underwriting and monitoring standards and its loss reserves, and that three of its officers and directors sold shares at prices that were artificially inflated as a result of the alleged misrepresentations. Plaintiffs seek unspecified monetary damages, including punitive damages. Management believes that the lawsuit is without merit, and the Company's position will be vigorously defended.
Regulatory Risk-Based Capital. The states of domicile of TIG's insurance subsidiaries impose minimum risk-based capital requirements on insurance companies which were developed by the National Association of Insurance Commissioners ("NAIC"). The formulas for determining the amount of risk based capital specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of the enterprise's regulatory total adjusted capital, as defined by the NAIC, to its authorized control level risk-based capital, as defined by the NAIC. Enterprises below specific trigger points or ratios are classified within certain levels, each of which requires specified corrective action. The levels and ratios are as follows:
At December 31, 1998, the statutory "risk-based" capital for each TIG insurance subsidiary was such that no action (company or regulatory) would be required. As of December 31, 1998, TIG was required to maintain minimum capital of $656 million to avoid triggering a company action level regulatory event.
Permitted Statutory Accounting Practices. TIG's statutory-basis financial statements are prepared in accordance with accounting practices prescribed or permitted by the domiciliary state insurance department. Currently, "prescribed" statutory accounting practices are interspersed throughout the state insurance law and regulations, the NAIC's "Accounting Practices and Procedures Manual" and a variety of other NAIC publications. "Permitted" statutory accounting practices encompass all accounting practices that are not prescribed; such practices may differ from state to state, may differ from company to company within a state, and may change in the future.
In June 1993, the California Department of Insurance permitted TIG Insurance Company ("TIC"), TIG's lead insurer to record a quasi-reorganization of its statutory capital accounts. This permitted statutory accounting practice differs from prescribed statutory accounting practice. The effect of the quasi-reorganization was to increase the earned surplus of TIC to zero from a negative $285 million and to decrease contributed surplus by the same amount. This transaction significantly increased TIC's future dividend paying capability as insurance companies may only pay dividends from earned surplus.
Management of the Company monitors and evaluates the results of operations based upon the performance of its three major operating segments, Reinsurance, Commercial Specialty and Custom Markets, as well as lines of business that have been de-emphasized (Other Lines). Reinsurance Operations are conducted through TIG Re and include those transactions in which TIG Re agrees to indemnify another insurance company for all or a portion of the insurance risks underwritten by that company under an insurance policy or policies. Commercial Specialty generally provides coverage to business and governmental entities, organizations, associations and individual professionals. Commercial workers' compensation products provide benefits to employees as mandated by state laws for payment of benefits associated with employment related accidents, injuries or illnesses. Custom Markets coverages provide protection to individuals through non-standard automobile physical damage and liability programs, homeowners property lines and small business owners liability programs. Other Lines include both commercial and personal programs that TIG has identified for non-renewal or cancellation.
Management evaluates the financial performance of its operating segments based upon the underwriting gain or loss ("underwriting results") generated by each operating segment. Underwriting results include earned premium less loss and loss adjustment expenses incurred, policy acquisition and other underwriting expenses incurred (which includes commissions, premium related expenses and other acquisition expenses), and policyholder dividends. The accounting policies of the operating segments are the same as those described in the summary of significant accounting policies (See Note B of the Consolidated Financial Statements).
The Company does not maintain separate balance sheet data for each of its operating segments. Accordingly, management does not review and evaluate the financial results of its operating segments based upon balance sheet data.
The following tables present the relevant financial results for the operating segments for each year:
In the first quarter of 1996, an after-tax restructuring charge of $65 million was taken for costs related to management's decision to restructure operations (see Note B - Summary of Significant Accounting Policies). In the fourth quarter of 1997 the Company recognized net unfavorable current and prior year loss and LAE reserve development of $145 million in its Reinsurance Operations (see Note E - Loss and Loss Adjustment Expense Reserves) and sold the Independent Agents unit of its Retail Division (see Note C - Significant Transactions and Events) as a result of which favorable adjustments of policy acquisition and other underwriting expenses totaling $8 million were recorded. In the third quarter of 1998, the Company recognized a net charge of $104 million that included $47 million in exit costs relating to the termination of the MBNA program, $38 million in allowances for uncollectible reinsurance recoverable and premium receivable, $6 million in severance related costs for former employees and $13 million in other operating costs (see Note C - Significant Transactions and Events). In the fourth quarter of 1998, the Company recognized $10 million in severance and related charges in conjunction with several staffing changes initiated at the end of the year.
TIG's State of Readiness. TIG has conducted an extensive review of its core processing computer systems, including computer hardware and software vendors, to identify and address all changes, testing and implementation procedures required to make such systems Year 2000 compliant. The Company has a coordinated process to facilitate the necessary changes, testing and implementation procedures. TIG has completed and implemented all of the required code changes of its Year 2000 system remediation project (the "Y2K Project"). TIG expects necessary third party software implementation and testing of its computer systems to be completed by March 31, 1999. TIG will continue testing its internal systems, as well as its internal systems' abilities to operate with the systems of key third parties, during the remainder of 1999.
TIG has processing or significant business relationship dependencies with third parties including, without limitation, general agents, brokers, third party administrators, banks, general suppliers and facility-related vendors. Determination of any action required is expected to be completed in the second quarter of 1999, and TIG will continue to monitor Year 2000 issues relating to such key third parties during the remainder of 1999. Notwithstanding efforts by TIG to assess the third party's systems, there can be no guarantee that such systems will be Year 2000 compliant.
TIG's Contingency Plans. The Company has a comprehensive contingency plan that addresses alternatives for solving the Year 2000 problem should the Company's adopted process prove inadequate. TIG continues to evaluate and modify the plan as necessary for all of the Company's operations and processes.