Chartwell leases approximately 53,000 square feet of space for its principal executive offices in Stamford, Connecticut. Chartwell also leases approximately 68,000 square feet of space in London, England for the operations of Archer. INSCORP is located in Jericho, New York, occupying approximately 1,150 square feet of office space.
Management's Discussion and Analysis of Financial Condition and Results of Operations Recent Industry Performance
Inadequate pricing during the latter 1970s and early 1980s led to increased underwriting losses and a decline in underwriting capacity. Reinsurance rates and terms improved substantially during the mid-1980s as primary insurers, which had been adversely affected by the soft market of the previous several years, increased their demand for reinsurance. Reinsurers
The financial information contained in this section for the years ended December 31, 1995 and 1994 represents the results of Chartwell Re, the parent and predecessor company of Chartwell. The financial information for the year ended December 31, 1996 represents the results of Chartwell.
The following table presents the statutory combined ratios of Chartwell, the property and casualty reinsurance industry and the property and casualty insurance industry during the 1992 to 1996 years. The combined ratio is the sum of the loss ratio (incurred losses and loss adjustment expenses divided by net premiums earned) and the underwriting expense ratio (underwriting expenses divided by net premiums written). A combined ratio of over 100% indicates unprofitable underwriting. Although an insurance company's underwriting may be unprofitable, the company may be profitable after including investment income. Due to the implementation of SFAS No. 113, the statutory combined ratio of Chartwell Reinsurance as shown below differs significantly in 1992 from its GAAP combined ratio.
- ---------- (1) Beginning in 1996, the combined ratio includes both Chartwell Reinsurance and INSCORP. On a stand alone basis, Chartwell Reinsurance's loss ratio, expense ratio and combined ratio were 73.2%,32.0% and 105.2%, respectively.
(3) Source: A.M. Best Publication, Best's Aggregates and Averages, Property-Casualty, 1996 Edition. Ratios shown are calculated after dividends to policyholders. Ratios for 1996 are preliminary and are from Best's Review: Property/Casualty, January 1997 Edition.
The following discussion of the financial condition and results of operations of Chartwell should be read in conjunction with the consolidated financial statements and notes thereto of Chartwell included elsewhere herein. The following discussion does not include any information relating to Archer's historical results of operations or INSCORP's historical results of operations prior to December 31, 1995. Archer's results of operations for the period from November 19, 1996 to December 31, 1996 were immaterial to Chartwell and, therefore, have not been included. Piedmont's (and INSCORP's) results of operations for the period from December 13, 1995 to December 31, 1995 were immaterial to Chartwell; Chartwell has accounted for the Merger as though it had occurred on December 31, 1995.
Consolidated Results of Operations Year Ended December 31, 1996 Compared With Year Ended December 31, 1995
December 31, ----------------------- (Dollars in thousands) 1996 1995 ---- ---- Specialty .................................. $100,817 $ 60,529 Global: Domestic ................................ 19,818 21,010 International ........................... 24,120 17,400 -------- -------- Subtotal Global ............................ 43,938 38,410 Regional ................................... 25,967 16,738 Marine & Aviation .......................... 27,780 11,291 -------- -------- Total Reinsurance ........................ 198,502 $126,968 -------- ======== Controlled Source .......................... 58,752 -------- INSCORP Run-off ............................ 6,584 -------- $263,838 ========
increase in gross premiums written. Net premiums earned for the year ended December 31, 1996 were $209.5 million, an increase of $89.2 million or 74% compared to the same period in 1995.
Policy Acquisition Costs. Policy acquisition costs, consisting primarily of commissions paid to ceding companies and brokerage fees paid to intermediaries, less commissions received on business ceded to other reinsurers, were $52.0 million for the year ended December 31, 1996, compared to $28.8 million for the same period in 1995. Policy acquisition costs expressed as a percentage of net earned premiums (the acquisition expense ratio) increased to 24.8% from 23.9% in 1995. The increase is due both to the INSCORP Run-off and to a modestly higher commission structure, as noted above, for proportional business.
Income Before Income Taxes and Extraordinary Item. Net income before income taxes and extraordinary items increased to $31.7 million for the year ended December 31, 1996 compared to $8.9 million for the same period in 1995. The increase resulted primarily from the increase in earned premiums, the favorable results in both loss and loss adjustment expense and in other expenses, and from the increases in net investment income and service and other revenue.
Revenues Year Ended December 31, --------------------------- (Dollars in Thousands) 1995 1994 ---- ---- Gross premiums written ...................... $ 126,968 $ 116,396 ========= ========= Net premiums written ........................ $ 123,314 $ 113,962 ========= ========= Premium earned .............................. $ 120,258 $ 102,698 Net investment income ....................... 19,907 14,726 Net realized capital gains (losses) ......... 3,199 (3,794) Service operations .......................... 1,095 1,679 --------- --------- Total ................... $ 144,459 $ 115,309 ========= =========
Net premiums written for the year ended December 31, 1995 increased 8.2% to $123.3 million compared to $114.0 million for the same period in 1994. Net premiums earned increased 17.1% to $120.3 million from $102.7 million in 1994. The increases in net premiums written and net premiums earned were primarily attributable to the reasons noted above. The lower percentage increase of premiums written compared to premiums earned is attributable to the delayed effect on premiums earned of the higher percentage increase in premiums written experienced in 1994.
Policy Acquisition Costs. Policy acquisition costs, primarily brokerage fees paid to reinsurance intermediaries and commissions paid to ceding companies less commissions received from retrocessionaires, increased 18.5% to $28.8 million for 1995 from $24.3 million for 1994. Expressed as a percentage of net premiums earned, acquisition expenses were relatively unchanged at 23.9% for 1995 and 23.7% for 1994. This increase was primarily due to the decrease in the loss and loss adjustment ratio of 4.2 percentage points for the year ending December 31, 1995, which caused an increase in the contingent commission expense component of policy acquisition costs.
Other Expenses. Other expenses relating to the underwriting operations, which include underwriting and administrative expenses, increased to $9.7 million for 1995 from $9.1 million for 1994. This increase was primarily due to a 7.0% growth in salary expense encompassing both new hires and continuing staff salary requirements and increased bonus expenses. Expressed as a percentage of net premiums earned, other expenses decreased to 8.0% in 1995 from 8.8% for 1994. This decrease was primarily due to the higher growth in net premiums earned compared to a lower increase in overhead expense.
The Company realized net capital gains of $3.2 million in 1995 compared to net capital losses of $3.8 million for the same period in 1994. The 1995 net capital gains were realized principally to reposition certain sectors of the portfolio and to modify the portfolio to improve credit quality without sacrificing yield.
Chartwell is a wholly-owned subsidiary of Chartwell Re and is Chartwell Re's only directly owned subsidiary. As a holding company, Chartwell's assets consist primarily of the stock of its direct and indirect subsidiaries, Chartwell Reinsurance, INSCORP, Archer, and Chartwell Advisers. Chartwell's cash flow, therefore, depends largely on dividends and tax sharing payments from Chartwell Reinsurance. Chartwell Reinsurance's sources of funds consist primarily of net premiums, reinsurance recoveries, investment income and proceeds from sales and redemptions of investments. Funds are applied primarily to payments of claims, operating expenses and income taxes and to the purchase of investments, largely fixed income securities. Cash and short-term investments are maintained for the payment of claims and expenses. Chartwell Reinsurance's ability to pay cash dividends to the Company is restricted by law or subject to approval of the insurance regulatory authority of Minnesota, Chartwell Reinsurance's state of domicile. The Minnesota authority recognizes only statutory accounting practices for the ability of an insurer to pay dividends to its stockholders.
At December 31, 1996, the carrying value of total investments, including cash and cash equivalents, increased by $21.8 million, or 3.1%, to $723.9 million compared to $702.1 million at December 31, 1995. The primary reasons for the increase were (i) a capital contribution from its parent company of $48.5 million, (ii) positive cash flow from operations of $14.7 million and (iii) assets relating to the Archer Acquisition of $9.6 million,
offset by (i) $28.3 million for the retirement of 35% of the Senior Notes plus accrued interest, (ii) the decline in the market value of the investment portfolio of $10.0 million pre-tax and (iii) $16.4 million for the cost of purchasing Archer shares.
At December 31, 1996, 88.8% of Chartwell's total investments (including cash and cash equivalents) consisted of fixed income securities, of which 96.1% were rated "A" or better (or "A-1" for commercial paper) by Moody's. While uncertainties exist regarding interest rates and inflation, Chartwell attempts to minimize such risks and exposures by balancing the duration of reinsurance liabilities with the duration of assets in its investment portfolio. The current market value of Chartwell's fixed maturity investments is not necessarily indicative of their future valuation. Chartwell does not have any investments in real estate or high-yield bonds and does not have any non-income producing fixed income investments. The Company's fixed income securities portfolio at December 31, 1996 was comprised primarily of U.S. Treasury and government agency, mortgage pass-through securities, and corporate and municipal bonds.
Financing activities have also been a source of liquidity for Chartwell, its parent and its subsidiaries. On March 17, 1994, Chartwell Re completed the offering of $75.0 million principal amount of the Senior Notes. Net proceeds of $71.9 million (after transaction expenses) were received by Chartwell Re and were used as follows:
Concurrently with the Senior Notes offering, as part of the 1994 refinancing, (i) all outstanding shares of two series of Chartwell Re's preferred stock were converted to Common Stock, (ii) all outstanding shares of the remaining series of preferred stock were redeemed for a nominal consideration and (iii) the holders of certain warrants issued in connection with Chartwell Re's subordinated debentures referred to above exercised their right to acquire Common Stock and in connection therewith, all the outstanding subordinated debentures were retired.
On May 17, 1995, Chartwell Re terminated an interest rate swap transaction it had entered into in April 1994 with a notional amount of $37.5 million to hedge the 10.25% fixed interest rate on the Senior Notes. The effect on the financial statements of this swap was a reduction of interest expense of $0.3 million for the year ended December 31, 1995 and $0.7 million in 1994.
In connection with the Merger, the Company entered into the Fleet Loan and the Fleet Revolver. At the time of the Merger, the Company borrowed the full amount under the Fleet Loan and used the proceeds to repay in full Piedmont's existing bank debt. The Fleet Loan had a seven year term (subject to two one-year extensions) and required equal annual repayments of principal after the first year. At December 31, 1996, there was no outstanding balance under this bank facility because it was replaced by the New Credit Facilities described below.
In connection with the Acquisition, the Company entered into the New Credit Facilities. The New Credit Facilities provide for (i) a Term A-1 $20.0 million loan, (ii) a Term A-2 $10.0 million loan, (iii) a Term B $22.0 million loan (denominated in Pounds Sterling), and (iv) a $25.0 million revolving credit facility (subsequently increased to $35.0 million).
On November 14, 1996 the Company borrowed the full amount under the Term A-1 loan and used the proceeds to repay the Fleet Loan in full. On November 25, 1996 the Company borrowed the full amount under the Term A-2 loan, $11.6 million under the Term B loan, and $5.1 million under the First Union Revolver to acquire Archer Shares. In addition, on November 29, 1996 the Company accessed an additional $10.3 million under the Term B loan to guarantee certain Loan Notes used to acquire Archer Shares. Subsequently, the Company paid down $1.7 million of the First Union Revolver in order to provide capacity to issue certain letters of credit in connection with the capitalization of Oak Dedicated Limited, a corporate vehicle formed by Chartwell Re to provide capacity to selected syndicates managed by Archer. Letters of credit, denominated in Pounds Sterling, totaling $22.1 million were issued on November 29, 1996 and are currently outstanding. The amounts denominated in Pounds Sterling were converted to U.S.
Under New York law, which is applicable to INSCORP, the maximum ordinary dividend payable in any twelve month period without the approval of the Superintendent may not exceed the lesser of (a) 10% of policyholders surplus as shown on the company's last annual statement or any more recent quarterly statement or (b) the company's adjusted net investment income. Adjusted net investment income is defined as net investment income for the twelve months preceding the declaration of the dividend plus the excess, if any, of net investment income over dividends declared or distributed during the period commencing thirty-six months prior to the declaration or distribution of the current dividend and ending twelve months prior thereto. In any case, New York law permits the payment of an ordinary dividend by an insurer or reinsurer only out of earned surplus. Moreover, notwithstanding the receipt of any dividend from INSCORP, Chartwell Reinsurance may make dividend payments to the Company only to the extent permitted under the Minnesota provisions described above.
For the year ended December 31, 1996, INSCORP fell outside the range of usual IRIS values with respect to the Change in Writings ratio, due to the non-renewal of its reinsurance portfolio, as well as for the Two-Year Overall Operating ratio and the Two-Year Reserve Development to Surplus ratio. The unusual values for these ratios were primarily caused by a $25.0 million strengthening in net reserves for losses incurred but not reported in calendar year 1995 with respect to INSCORP's business written in prior years.
See the Consolidated Financial Statements and Notes thereto and the Schedules on pages through and S-1 through S-7 included in Part IV, Item 14.