Our principal and executive offices are located in Houston, Texas, in an approximately 51,000 square foot building owned by Houston Casualty Company. Houston Casualty Company also owns a 77,000 square foot building adjacent to its home office building. We also maintain offices in over 20 locations elsewhere in the United States and England. The majority of these additional locations are in leased facilities.
(1) Certain amounts in the 2000, 1999, 1998 and 1997 selected consolidated financial data have been reclassified to conform to the 2001 presentation. Such reclassifications had no effect on our net earnings, shareholders' equity, or cash flows.
We primarily receive our revenue from earned premium derived from our insurance company operations, management fees generated by our underwriting agency operations, commission income produced by our intermediary operations, investment income from all of our operations and capital and other operating income. Our core underwriting activities involve providing life, accident and health; aviation; marine, energy and property; and other specialty lines of insurance and reinsurance, each of which is marketed by our insurance companies and our underwriting agencies either directly to customers or through a network of independent or affiliated agents and brokers.
During the past several years, we have substantially increased our shareholders' equity through the issuance of equity securities and through our retaining of earnings, thereby enabling us to increase the underwriting capacity of our insurance companies. With this additional equity, we increased underwriting activity across many of our core lines of business, emphasizing lines of business and individual opportunities with the most favorable underwriting characteristics at a particular point in the insurance cycle. As an insurer, we also purchase reinsurance for each of our lines of business. We purchase different types of reinsurance in amounts we consider appropriate for each of our lines of business based upon market conditions and the level of risk we wish to retain.
Our intermediaries are fee based, non-risk bearing and place reinsurance for our insurance companies and underwriting agencies and for other non-affiliated insurance companies and risk taking entities, as well as insurance on behalf of medium and large corporate clients.
- to increase the management fees and commission income components of our total revenue, which we believed were a more predictable and stable source of revenue than the potential underwriting gain from insurance company operations during periods of overly competitive pricing.
YEAR ENDED DECEMBER 31, 2001 VERSUS YEAR ENDED DECEMBER 31, 2000
Our book value per share was $12.40 as of December 31, 2001, up substantially from $10.29 as of December 31, 2000.
Loss and loss adjustment expense increased to $267.4 million for 2001 compared to $198.5 million in 2000 substantially due to losses and expenses arising from the September 11 loss and the charge related to lines of business being exited. The net loss ratio in accordance with generally accepted accounting principles was 78.0% (62.3% excluding the September 11 loss and the charge related to lines of business being exited) for 2001 compared to 74.2% in 2000. The medical stop-loss line of business continues to have significantly improved underwriting results. The gross loss ratio in accordance with generally accepted accounting principles was 105.5% (77.6% excluding the September 11, Petrobras and Total losses and the charge related to lines of business being exited) in 2001 compared to 79.4% for 2000. The Petrobras and Total claims were substantially reinsured and did not have a material effect on our net loss ratio or net earnings. The combined ratio in accordance with generally accepted accounting principles was 103.7% (87.1% excluding the September 11 loss and the charge related to lines of business being exited) in 2001 compared to 95.2% for 2000.
Policy acquisition costs, which are net of ceding commissions on reinsurance ceded, increased somewhat to $27.9 million during 2001 compared to 2000. During 2001, our insurance companies charged higher policy issuance fees on certain lines of business which are recorded as a reduction in acquisition costs. This reduction in costs is offset by the increase in policy acquisition costs resulting from higher earned premium and part of the charge from lines of business being exited.
Management fees decreased to $61.8 million for 2001 compared to $96.1 million in 2000. Much of the decrease is the result of our consolidation of the operations of three of our underwriting agencies into the
operations of our insurance companies effective January 1, 2001. Additional decreases are due to lines of business either sold or exited and increased retentions of our insurance companies. Net earnings of our underwriting agencies decreased to $17.2 million for 2001 from $21.4 million in 2000 for the same reasons. We expect management fees (before eliminations) and net earnings of our underwriting agency segment to grow in 2002 due to organic growth and recent acquisitions.
Commission income was $43.4 million for 2001 compared to $49.9 million in 2000. Commission income decreased due to general market conditions and less ceded reinsurance being placed on behalf of our insurance companies as they increased their retentions. Net earnings of our intermediaries decreased to $8.7 million for 2001 compared to $11.2 million in 2000. The decrease in net earnings was partly caused by our acquisition of The Schanen Consulting Group, LLC who was not subject to income taxes during 2000 prior to our ownership, but reflected in our historical results due to pooling-of-interest accounting and less commission income as a result of the mix of business, which had a lower gross margin during the current year, somewhat offset by a lower effective tax rate.
The decrease in other operating revenue to $17.4 million for 2001 from $25.5 million in 2000 results principally from the disposition or closure of certain non-core operations. During 2001, we recorded gains of $8.2 million from the sale of other operating investments compared to $5.7 million for 2000. The increase in gains was somewhat offset by loss of revenue included in the 2000 period related to operations that have since been closed or disposed of. Net earnings of other operations were $7.1 million in 2001 up from $6.0 million in 2000 for the same reasons. Period to period comparisons may vary substantially depending on other operating investments, or dispositions of such investments, in any given period. As of December 31, 2001, all operating entities included in this segment had been sold or closed so revenue is expected to decrease substantially in 2002.
YEAR ENDED DECEMBER 31, 2000 VERSUS YEAR ENDED DECEMBER 31, 1999
Our total revenue increased 37% to $473.6 million in 2000 compared to 1999. This revenue increase resulted from the higher retention of premium underwritten by our insurance companies, particularly in the medical stop-loss line of business, and increased investment income.
of $4.3 million in 1999. Our net realized investment gains from the disposition of fixed income securities were $203,000 in 2000, compared to losses of $164,000 in 1999.
Our compensation expense increased to $83.1 million during 2000 from $79.2 million in 1999. This increase reflects a normal progressional increase due to business growth plus the increase due to The Centris Group, Inc. acquisition, offset by the savings resulting from the 1999 fourth quarter restructuring and the sale of non-core subsidiaries. Other than the restructuring expenses discussed below, other operating expenses increased to $52.5 million from $47.7 million for similar reasons. Included in other operating expense are restructuring expenses of $761,000 in 2000 and $5.5 million in 1999. Currency conversion losses amounted to $330,000 in 2000, compared to gains of $442,000 in 1999.
Our net earnings in 2000 increased 109% to $55.5 million or $1.07 per diluted share from $26.6 million or $0.52 per diluted share in 1999. These increases result principally from improved underwriting results, an increase in investment income and the effects of the provision for reinsurance and a larger restructuring expense recorded during 1999. In 2000, we incurred a $2.0 million after-tax charge for a change in accounting principles to conform our agency and intermediary revenue recognition principles to those required by the guidance in Securities and Exchange Commission's Staff Accounting Bulletin Number 101 entitled "Revenue Recognition in Financial Statements". The change was not material to earnings before cumulative effect of accounting change for 2000.
Gross written premium generated by our insurance companies increased 70% to $967.5 million in 2000 compared to 1999 due to new business, rate increases, increased participation by our insurance companies in the business underwritten by our underwriting agencies and the acquisition of The Centris Group, Inc. Net written premium generated by our insurance companies in 2000 increased 103% to $283.8 million compared to 1999, as our insurance companies have increased retentions in many of their lines of business as underwriting results showed improvement. Net earned premium increased 89% to $267.6 million during 2000 for the same reasons.
Net earnings of our insurance companies increased to $24.2 million in 2000 from a loss of $10.7 million in 1999, primarily as a result of improved underwriting results, the effect of the provision for reinsurance recorded in 1999 and the increase in investment income.
Management fees generated by our underwriting agencies increased 6% to $96.1 million in 2000 compared to 1999. This increase resulted primarily from the increased premium volume in the medical stop-loss line of business, which was due to rate increases and The Centris Group, Inc. acquisition. The increase in management fees was disproportionate to the increase in premium as a result of higher policy issuance fees and increased retentions by our insurance companies which reduced management fees earned by our underwriting agencies. These reductions are offset by an equal reduction in net policy acquisition costs of our insurance companies. Net earnings of our underwriting agencies increased 25% to $21.4 million in 2000 from $17.2 million in 1999 due to increased revenue, a smaller restructuring charge in 2000 than in 1999 and higher pretax margins primarily as a result of the successful integration of The Centris Group, Inc. acquisition.
Other operating revenue decreased to $25.5 million during 2000 from $28.5 million for the same period in 1999. Net earnings of our other operations decreased to $6.0 million in 2000 from $7.6 million in 1999. Revenue and earnings can vary considerably from period to period depending on investment or disposition activity.
The net loss of the corporate segment was $4.7 million in 2000 compared to a net loss of $2.3 million in 1999. This resulted from the increase of interest expense not allocated to the operating segments during 2000 as well as costs of the closing of some operations of a company acquired in late 1999.
As of December 31, 1999, we had also accrued a restructuring liability related to our acquisition of The Centris Group, Inc. Changes in the accrual between December 31, 1999 and December 31, 2000 are shown in the table below (in thousands):
The adjustments in 2000 were recorded as management decided to take additional steps to integrate parts of The Centris Group, Inc. operations. As of December 31, 2001, all amounts have been paid except for a $0.3 million lease obligation.
The following is a summary of our contractual cash payment obligations as of December 31, 2001 (in thousands):
Property and casualty insurance companies domiciled in the State of Texas are limited in the payment of dividends to their shareholders in any twelve-month period, without the prior written consent of the Commissioner of Insurance, to the greater of statutory net income for the prior calendar year or 10% of its statutory policyholders' surplus as of the prior year end. Dividends may only be paid out of statutory unassigned surplus funds. During 2002, Houston Casualty Company's ordinary dividend capacity will be approximately $28.5 million and U.S. Specialty Insurance Company's ordinary dividend capacity will be zero.
As of December 31, 2001, we had a net deferred tax asset of $16.5 million compared to $6.7 million as of December 31, 2000. Due to our history of consistent earnings, expectations for future earnings and taxable income in carry back years, we expect to be able to fully realize the benefit of our net deferred tax asset.
We have a reserve of $5.2 million as of December 31, 2001 for potential collectibility issues related to reinsurance recoverables and associated expenses. The adverse economic environment in the worldwide insurance industry and the terrorist attacks on September 11 have placed great pressure on reinsurers and the results of their operations. Ultimately, these conditions could affect reinsurers' solvency. Historically, there have been insolvencies following a period of competitive pricing in the industry, such as the marketplace has experienced for the last several years. While we believe that the reserve is adequate based on currently available information, conditions may change or additional information might be obtained that would affect our estimate of the adequacy of the level of the reserve and which may result in a future change in the reserve. We continually review our financial exposure to the reinsurance market and continue to take actions to mitigate our position.
In this regard, as of December 31, 2001, our insurance companies had initiated litigation or arbitration proceedings against five reinsurers and were involved in one arbitration proceeding initiated by a reinsurer. These proceedings primarily concern the collection of amounts owing under reinsurance agreements. As of such date, our insurance companies had an aggregate amount of $15.3 million which had not been paid to us under the disputed agreements and we estimate that there could be an additional $31.2 million of incurred losses and loss expenses under the subject agreements. In addition, because our insurance companies, principally Houston Casualty Company, participated in facilities which were managed by one of our underwriting agencies, they are indirectly involved in any reinsurance disputes which affect the applicable facilities. As of December 31, 2001, Houston Casualty Company's allocated portion of aggregate amounts which had not been reimbursed to the applicable facilities under the disputed agreements was $4.8 million and we estimate that there could be an additional $4.0 million of incurred losses and loss expenses under the subject agreements allocated to Houston Casualty Company. Houston Casualty Company has no net exposure on disputed amounts due to the non-affiliated companies who also participated in the applicable facilities.
Subsequent to the terrorist attacks on September 11, 2001, where possible, we canceled all terrorist coverage, to the extent we could, under the terms of existing in-force policies, primarily in the property and energy lines of business. All new and renewal policies are written with an appropriate terrorist exclusion except for lines of business, such as aviation, where reinsurance for acts of terrorism is available at an economic cost or where we feel comfortable with the net exposure.
A significant portion of our revenue is related to healthcare insurance and reinsurance products that are subject to the effects of the underlying inflation of healthcare costs. Such inflation in the costs of healthcare tends to generate increases in premiums for medical stop-loss coverage, resulting in greater revenue, but also higher claim payments. Inflation may have a negative impact on insurance and reinsurance operations by causing higher claim settlements than may originally have been estimated without an immediate increase in premiums to a level necessary to maintain profit margins. We do not specifically provide for inflation when setting underwriting terms and claim reserves, although we do consider trends. We continually review claim reserves to assess their adequacy and make necessary adjustments. Also, the market value of our investments vary depending on economic and market conditions and interest rates. Any significant increase in interest rates could have a material adverse effect on the market value of our investments. In addition, the interest rate payable under our $200.0 million bank loan fluctuates with that of the market. Any significant increase in interest rates could have a material adverse effect on our earnings, depending on the amount borrowed on our bank facility.
We underwrite risks which are denominated in a number of foreign currencies. As a result, we have receivables and payables in foreign currencies and we establish and maintain loss reserves with respect to our insurance policies in their respective currencies. Our net earnings could be impacted by exchange rate fluctuations affecting these balances. Our principal area of exposure is with respect to fluctuations in the exchange rate between the major European currencies and the U.S. Dollar. We constantly monitor the balance between our receivables and payables and loss reserves to mitigate the potential exposure should an imbalance be expected to exist for other than a short period of time. For the year ended December 31, 2001, our gain from currency conversion was $0.3 million compared to a loss of $0.3 million in 2000 and a gain of $0.4 million in 1999.
On a limited basis, we enter into foreign currency forward contracts as a hedge against foreign currency fluctuations. RML has revenue streams in U.S. Dollars and Canadian Dollars but incurs expenses in British Pound Sterling ("GBP"). To mitigate the foreign exchange risk, we have entered into foreign currency forward contracts expiring at staggered times through December, 2002. As of December 31, 2001, we had forward contracts to sell US $6.0 million for GBP at an average rate of GBP 1.00 equals US $1.43. The foreign currency forward contracts are used to convert currency at a known rate in an amount which either approximates or is less than average monthly expenses. Thus, the effect of these transactions is to limit the
We constantly review the collectibility of the reinsurance recoverables of our insurance companies and record a reserve for uncollectible reinsurance. Our estimates utilized to calculate the reserve are subject to change and this could affect the level of the reserve required.
- significant changes in the strategy for our overall business; and
SFAS No. 142 entitled "Goodwill and Other Intangible Assets" was also issued in June, 2001, in concert with SFAS No. 141. SFAS No. 142 becomes effective for us on January 1, 2002. SFAS No. 142 requires goodwill to be tested for impairment at a level referred to as a reporting unit, which could be either our reportable segments or one level lower than our reportable segments. SFAS No. 142 requires us to perform the first goodwill impairment test on all reporting units within six months of adoption. The first step is to compare the fair value with the book value of a reporting unit. If the fair value of a reporting unit is less than its book value, the second step will be to calculate the impairment loss, if any. We will recognize any impairment loss from the initial adoption of SFAS No. 142 as a change in accounting principle. After the initial adoption, goodwill of a reporting unit will be tested for impairment on an annual basis and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. SFAS No. 142 is not expected to have a material effect on our financial position or cash flows, but it will impact our results of operations. Based upon our preliminary review of the impact of SFAS No. 142 to determine the effect, if any, of the initial goodwill impairment testing, we do not believe that we will have to record an impairment charge. However, we are still in the process of completing the valuations, so our tentative conclusion could change.
SFAS No. 144 entitled "Accounting for the Impairment or Disposal of Long-Lived Assets" was issued in August, 2001 and will become effective for us on January 1, 2002. SFAS No. 144 resolves implementation issues being experienced under previously existing accounting literature but does not change previous requirements to (a) recognize an impairment loss if the carrying amount for an asset is not recoverable from its undiscounted cash flows, and (b) measure the impairment loss as the difference between carrying amount and fair value of the asset. SFAS No. 144 also retains the basic provisions of discontinued operations found in previous accounting literature but broadens the separate income statement presentation of discontinued operations from a reporting segment to a component of the entity which has clearly distinguishable operations and cash flows. We do not expect the adoption of SFAS No. 144 to have a material effect on our financial position, results of operations or cash flows.
On January 1, 1999, certain member countries of the European Union irrevocably fixed the conversion rates between their national currencies and a common currency, the Euro, which became the common legal currency of those countries on that date. The participating countries' former national currencies continued to serve as legal tender and as denominations of the Euro until January 1, 2002. The conversion to the Euro is scheduled to be completed on July 1, 2002, when the national currencies will cease to exist. The introduction of the Euro has not had a material effect on our business, financial condition or results of operations.