The selected data presented on page 20 under the captions "Summary of Earnings," "Year End Financial Position" and "Operating Ratios" for, and as of the end of, each of the years in the five year period ended December 31, 1998, are derived from the consolidated financial statements of Amwest Insurance Group, Inc. and subsidiaries, which financial statements have been audited by KPMG LLP, independent certified public accountants. The consolidated financial statements as of December 31, 1998 and 1997 and for each of the years in the three year period ended December 31, 1998 and the report thereon, are included elsewhere in this Annual Report on Form 10-K.
Year ended December 31, 1998 compared to year ended December 31, 1997
Net losses and loss adjustment expenses increased 18% from $34,657,000 in 1997 to $40,831,000 in 1998. This resulted in a slight increase in the loss and loss adjustment expense ratio from 37.6% in 1997 to 38.5% in 1998. The increased loss ratio is primarily attributable to an increase in the loss and loss adjustment expense ratio for the property and casualty division whose loss and loss adjustment expense ratio was 80.6% for the year ended December 31, 1998, compared to 67.8% for the year ended December 31, 1997. Substantially all of this increase is attributable to adverse development of prior year commercial auto and general liability reserves as a result of ongoing reserve analysis performed by the Company. During 1998, the Company completed several organizational changes within the P&C claims and legal departments, partially in response to the noted adverse development of prior year reserved amounts and also to both strengthen the Company's in-house capabilities and streamline the expense structure of settling P&C claims. Management believes that these changes will strengthen the Company's reserving and claims settlement practices. The surety loss and loss adjustment expense ratios remained constant at 28% for 1997 and 1998. The 1998 ratio includes the impact of the excess of loss and the aggregate stop loss reinsurance treaties. During 1998 $4,168,000 was ceded in premiums on these treaties with $4,100,000 ceded in losses. In 1997 $2,987,000 was ceded in premiums with no losses ceded to the reinsurers.
General operating costs decreased as a percentage of net premiums earned from 14% or $12,606,000 in 1997 to 13% or $14,172,000 in 1998. The decrease in the ratio is due to increased efficiency in servicing an increased premium base. The 1998 amounts include a non-recurring $319,000 charge in connection with the disposition and write-off of the Company's New York probate operation.
Interest expense remained relatively flat at $1,966,000 in 1997 compared with $1,917,000 in 1998. At December 31, 1997 and 1998, the collateral balances accrued interest daily at an average rate of 3.7% per annum for both years. Additionally, the average interest rate on the bank indebtedness increased from an average rate of 7.3% during 1997 to an average rate of 7.4% during 1998 due to fluctuations during 1998 in the London Interbank Offered (LIBOR) which is used as the benchmark for the Company's rate on bank indebtedness. The interest rate on the Company's bank indebtedness at December 31, 1998 was 7.1%.
Net investment income and realized investment gains increased 12% from $9,869,000 in 1997 to $11,051,000 in 1998. This increase is primarily due to an increase in realized investment gains from $3,473,000 during 1997 to $4,400,000 during 1998. In addition, net investment income before realized investment gains increased 4% from $6,396,000 to $6,651,000 due to higher average invested balances during 1998.
Income before income taxes increased from $7,435,000 in 1997 to $9,012,000 in 1998 due to the factors outlined above.
The effective tax rate was 26% for 1997 and 30% for 1998. The primary reason for the variance from the corporate income tax rate of 34% is tax-advantaged income received on a portion of the Company's investment portfolio offset by certain non-deductible expenses. Additionally, due to various factors arising during 1997, the Company eliminated its valuation allowance on its deferred tax assets, which further lowered the 1997 effective tax rate.
Net income was $5,498,000 in 1997 and $6,269,000 in 1998 due to the factors outlined above.
Year ended December 31, 1997 compared to year ended December 31, 1996
Policy acquisition costs as a percentage of net premiums earned increased from a ratio of 43.7% of $38,367,000 in 1996 to 49.2% or $45,355,000 in 1997. The increase is primarily attributable to a decline in contingent commissions earned by the Company due to changes in its reinsurance treaties coupled with higher commission rates paid on surety products due to intensified competitive pressures during 1997.
General operating costs decreased as a percentage of net premiums earned from 14.5% or $12,698,000 in 1996 to 13.7% or $12,606,000 in 1997. The decrease in the actual amount of general operating costs is primarily attributable to decreased home office occupancy costs due to the consolidation of the El Segundo and Woodland Hills home offices locations in Calabasas, California during May and June of 1997.
Interest expense decreased 11% from $2,217,000 in 1996 to $1,966,000 in 1997 primarily due to a decrease in funds held as collateral during 1997. At December 31, 1996 and 1997, the collateral balances accrued interest daily at an average rate of 3.8% and 3.7% per annum, respectively. Additionally, the average interest rate on the bank indebtedness decreased from an average rate of 7.8% during 1996 to an average rate of 7.3% during 1997 due to fluctuations during 1997 in the London Interbank Offered Rate (LIBOR) which is used as the benchmark for the Company's rate on bank indebtedness. This decrease was partially offset by an increase in the outstanding debt of $2,000,000 in June 1997. The interest rate on the company's bank indebtedness at December 31, 1997 was 7.52%
Net investment income and realized investment gains increased 10% from $9,008,000 in 1996 to $9,869,000 in 1997. This increase is primarily due to an increase in realized investment gains from $2,201,000 during 1996 to $3,473,000 in 1997. This increase was partially offset by a slight decrease in average annual yield on investments from 5.2% in 1996 to 5.1% in 1997.
Lease termination costs of $1,300,000 were incurred in 1996 in connection with the signing of a definitive agreement to terminate the Company's lease at its corporate headquarters prior to its scheduled termination in August 1998. The Company moved to a new facility in Calabasas, California at significantly reduced rental rates in June of 1997.
The effective rate of the tax benefit was 46.8% for the year ended December 31, 1996. The effective tax rate for 1997 is 26.1%. The primary reason for the variance from the corporate income tax rate of 34% is tax- advantaged income received on a portion of the Company's investment portfolio. Additionally, due to various factors arising during 1997, the Company eliminated its valuation allowance on its deferred tax assets.
As of December 31, 1998, the Company had total cash and cash equivalents and investments of $131,071,000. Included in these amounts is an aggregate of $30,542,000 in funds held which are shown as a liability on the Company's consolidated balance sheet. As of December 31, 1998, the Company's investment balances were comprised of $107,227,000 in fixed maturities held at market, $10,572,000 in common equity securities, $4,265,000 in preferred equity securities, $4,375,000 in other invested assets and $2,201,000 in short-term investments.
In addition, funds held increased from $23,116,000 at December 31, 1997 to $30,542,000 at December 31, 1998. The Company reflects in its consolidated financial statements only funds received as collateral on which net earnings inure to the benefit of the Company. The increase in this amount is primarily attributed to deposits attributable to the "Safety Association" which the Company acquired during 1998. The amount of cash collateral can also be impacted by the timing and payment of claims activity related to draws on irrevocable letters of credit and certificates of deposit.
The Company generated $1,396,000, used $1,539,000 and used $697,000 in cash from operating activities in the fiscal years ended December 31, 1996, 1997 and 1998, respectively. The Company generated $8,691,000, generated $3,835,000 and used $7,526,000 in cash for investing activities for the fiscal years ended December 31, 1996, 1997 and 1998, respectively. The Company used $8,885,000, used $4,924,000 and generated $6,847,000 in cash from financing activities for the fiscal years ended December 31, 1996, 1997 and 1998, respectively. The cash used for investing activities in 1998 was funded principally by financing activities.
The main objective in managing the investment portfolios of the Company is to maximize total investment returns while minimizing credit risks, in order to provide maximum support to the insurance underwriting operations. Investment strategies are developed based on many factors including expected underwriting results, tax position, regulatory requirements, fluctuations in interest rates and consideration of other market risks. Investment decisions are primarily managed by the Company's investment advisors based on guidelines established by management and approved by the board of directors.
Market risk represents the potential for loss due to adverse changes in the fair value of financial instruments. The market risks related to financial instruments of the Company primarily relate to the investment portfolio, which exposes the Company to risks related to interest rates and, to a lesser extent, credit quality, prepayment and equity prices.
Interest rate risk is the price sensitivity of a fixed income security to changes in interest rates. Since most of the Company's property and casualty business is short-tailed in nature, the Company has established duration guidelines to be commensurate with our liabilities. Our guidelines have established duration of the portfolio to be between 2-5 years.
Prepayment risk refers to the changes in prepayment patterns related to decreases and increases in interest rates than can either shorten or lengthen the expected timing of the principal repayments and thus the average life and the effective yield of a security. Such risk exists primarily within the portfolio of mortgage-backed securities.
The Company and its third party vendors are highly reliant on the use of computers and embedded technology for the conduct of its business. Accordingly the Company has, for several years, been in the process of analyzing, and to the extent necessary either replacing non-year 2000 (Y2K) compliant systems or fixing non-compliant Y2K systems in order to make them Y2K compliant.
The Company's state of readiness with respect to each of these categories is as follows:
The Company has five significant corporate wide applications which include Oracle financials, the system providing electronic interface between Oracle financials and the Company's bank, fixed asset accounting, payroll, reinsurance and corporate e-mail. The Company has completed its assessment of these systems and believes that all of these systems other than the reinsurance system are Y2K compliant. This conclusion is based on either certifications received from the third party vendor(s) supplying the system or testing performed by the Company for internally developed or modified systems. As stated the only currently deployed corporate system which the Company believes to be non-Y2K compliant is the reinsurance system. The Company is currently analyzing whether to replace the system with a different Y2K compliant product or modify the current system to make it Y2K compliant. Currently the Company estimates that the current version would require one person month to make this system compliant.
The Company has fourteen surety specific systems which vary in their significance from critical (such as the surety production system commonly known as ABS) to non-critical applications which only affect a small portion of the surety business (such as several retail bail production systems). The Company has completed its assessment of its fourteen surety specific systems and believes that all of the mission critical surety specific systems are Y2K compliant other than the Company's probate production system, cash collateral system and one bail system. This conclusion is based on either certifications received from the third party vendor(s) supplying the system or testing performed by the Company for internally developed or modified systems. The Company is currently in the process of modifying its ABS system in order for it to be used for probate production and is proceeding with completing system changes for the cash collateral and bail systems. The Company expects that these modifications will be completed during the second quarter of 1999, and will be implemented immediately thereafter.
In addition to the above systems where the Company is primarily responsible for assessing, analyzing and implementing Y2K compliant systems, the Company may also be affected by any of the agents, brokers, suppliers, financial institutions or others with whom the Company does business who may be materially affected by Y2K problems and thus indirectly affect the Company. Where appropriate, the Company has inquired as to the state of readiness with respect to these third parties, but the Company has not performed any independent Y2K testing of these systems as the Company does not believe that such independent testing would be cost justified.
The Company has analyzed the risks associated with the year 2000 issues and concluded that the biggest risk which the Company can have a reasonable influence toward preventing is the lack of Y2K compliance by the commercial lines property and casualty production system. The commercial lines represent approximately $20,000,000 of written premiums for the Company and the lack of a Y2K compliant system for this business could have a significant adverse impact on the Company's results.
The Company has also reviewed the underwriting risks associated with its insureds for both the property and casualty and surety products and believes that the major risk with respect to Y2K non-compliance relates to the surety product. Should Y2K problems affect the ability of the Company's principals to complete projects and pay subcontractors on a timely basis it could have a material adverse affect on the Company's surety loss ratio. Further, should Y2K problems affect the ability of obligees to pay for work performed on bonded projects, liquidity issues for principals could also impact the Company's surety loss ratio. The Company is unable to estimate the affect such risks will have on the Company's financial results.
Certain statements contained in this Form 10-K regard matters which are not historical facts and are forward looking statements. Because such forward looking statements include risks and uncertainties, actual results may differ materially from those expressed in or implied by such forward looking statements. Factors that could cause actual results to differ materially include, but are not limited to: A decline in demand for surety bonds or specialty property and casualty insurance, the ineffectiveness of programs initiated and changes made by management, a deterioration in results of any of the Company's product lines, or a general economic decline. The Company undertakes no obligation to release publicly the results of any revisions to these forward looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.