Our principal and executive offices are located in Houston, Texas, in an approximately 51,000 square foot building owned by Houston Casualty. Houston Casualty also owns a 77,000 square foot building adjacent to its home office building. We also maintain offices in over 30 locations elsewhere in the United States and England. The majority of these additional locations are in leased facilities.
(1) Certain amounts in the 1999, 1998, 1997, and 1996 selected consolidated financial data have been reclassified to conform to the 2000 presentation. Such reclassifications had no effect on the Company's net earnings, shareholders' equity, or cash flows.
During the past several years, we have substantially increased our shareholders' equity through the issuance of equity securities and through our retained 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.
Other operating income is generated through our insurance services operations, which support our own operations as well as provide services for other clients. Additionally, other operating income may include the equity in the earnings of a company in which we invest, dividends or gains or losses from the disposition of these investments.
- 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;
- to insulate our Company from a decline in our revenue growth rate as insurance premium rates became more competitive in our specialty lines of business and we became more selective in our underwriting, resulting in reduced earned premium;
During December, 1999, we acquired all of the outstanding shares of The Centris Group, Inc. in a transaction accounted for using the purchase method of accounting. Therefore, the results of operations and cash flows of Centris are included in the condensed consolidated statements of earnings and cash flows for the twelve months ended December 31, 2000, but are not included in the condensed consolidated statement of earnings and cash flows for the twelve months ended December 31, 1999 and earlier periods.
Centris was the parent corporation of a group of insurance companies and underwriting agencies principally operating in the medical stop-loss line of business. Centris' primary insurance company subsidiary was the entity now known as HCC Life Insurance Company. Following the acquisition, HCC Life's operations were relocated to Houston, and it became a subsidiary of Houston Casualty. Centris' medical stop-loss underwriting agency operations have been combined with HCC Benefits' operations. Since the date of the acquisition, the premium rates for medical stop-loss have increased substantially and the loss ratio has greatly improved for the 2000 business underwritten by the combined operations. In connection with the integration of Centris' operations with our own, we took a restructuring charge, which was accrued at the date of acquisition.
From 1992 through 1999, our employee count had grown from less than 100 to more than 1,000. In the fourth quarter of 1999, we determined, based upon a review of our operations, that our operating efficiency and profitability could be enhanced principally by reducing the employee count in certain operations. We therefore implemented a restructuring plan which resulted in the termination of 92 of our employees during 1999. This restructuring resulted in a decreased level of operating expenses in 2000 for the operating entities affected.
Year Ended December 31, 2000 Versus Year Ended December 31, 1999
Our compensation expense increased to $78.4 million during 2000 from $77.5 million in 1999. This increase reflects a normal progressional increase due to business growth plus the increase due to the Centris 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 $51.8 million from $47.2 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 income tax expense was $35.9 million in 2000 compared to $12.3 million in 1999. Our effective tax rate was 40% in the 2000 period compared to 33% in 1999. Most of the increase in the effective tax rate was due to non-deductible goodwill amortization relating to the Centris acquisition, a shift of fixed income investments to taxable instruments from tax exempt instruments and increased underwriting agency income which is subject to state income taxes.
Our net earnings in 2000 increased 113% to $53.4 million or $1.06 per diluted share from $25.1 million or $0.51 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 SEC 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 Centris. 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. We expect net premium increases to continue in 2001.
Loss and loss adjustment expense incurred by our insurance companies increased to $198.5 million in 2000 from $109.7 million in 1999. The increase in net loss and loss adjustment expense is due to the higher level of net retained premium, net of the effect of improved underwriting results. The GAAP net loss ratio decreased to 74.2% in 2000 from 77.6% in 1999. In 2000, we also recorded a $4.4 million increase in reserves for discontinued lines of business acquired with our 1999 acquisition of Centris. This increase represents 1.6% of the 2000 net loss ratio. The GAAP gross loss ratio decreased to 79.4% in 2000 from 116.5% in 1999. The general improvement in our loss ratios result from the effects of increased premium rates in certain lines of business, reduced writings in other unprofitable lines of business and a general improvement in market conditions, particularly in the domestic aviation and medical stop-loss lines of business. The statutory net combined ratio of our insurance companies was 98.1% for 2000 compared to 129.9% (104.1% excluding effects of the provision for reinsurance) in 1999.
During 2000, we had net loss and LAE redundancy of $9.6 million relating to prior year losses compared to a deficiency of $4.6 million in 1999 and we had gross loss and LAE redundancy of $1.9 million compared to a deficiency of $90.0 million in 1999. The 1999 gross deficiency results from two principal conditions. The first is the development of large claims on individual policies which were either reported late or for which reserves were increased as subsequent information became available. However, as these policies were substantially reinsured, there was no material effect to our net earnings. Secondly, during 1999 in connection with the insolvency of one of our reinsurers and with the commutation, finalized subsequent to year end, of all liabilities with another, we re-evaluated all loss reserves and incurred but not reported loss reserves related to business placed with these reinsurers to determine the ultimate losses we
Policy acquisition costs, which are net of commissions on ceded reinsurance, increased to $23.7 million during 2000 from $8.2 million for 1999. This increase in costs results from higher retained premium and the resulting reduced ceding commissions.
In January 2001, we acquired all of the outstanding shares of Schanen Consulting for 996,805 shares of our common stock. This transaction will be recorded using the pooling-of-interests method of accounting. Schanen Consulting's operations have been consolidated with those of HCC Employee Benefits, our specialty retail employee benefits agency.
As of December 31, 1999, we accrued a restructuring liability of $4.0 million related to our ongoing operations. As of December 31, 2000, all restructuring costs had been paid or adjusted with the exception of a remaining liability of $105,000. During 2000, we determined that one of the leased offices scheduled to be closed would be retained. Therefore, we reversed $789,000 (included as a credit in other operating expenses in the consolidated financial statements) of the restructuring expense recorded during the fourth quarter of 1999, of which $514,000 was the reversal of the accrual for future lease payments and $275,000 was the reversal of the write-off of certain assets.
As of December 31, 1999, we had also accrued a restructuring liability related to our acquisition of Centris. Changes in the accrual between December 31, 1999 and December 31, 2000 are shown in the table below:
The adjustments in 2000 were recorded as management decided to take additional steps to integrate parts of the Centris operations.
During the fourth quarter of 2000, we also recorded a restructuring charge and associated expenses of $1.5 million. A total of 26 employees were or will be terminated as a result of our restructuring of certain underwriting agency operations and their integration into our insurance company operations. The charges affected both segments and consisted of $557,000 accrued severance pay to be paid at various times throughout 2001 and $992,000 for the write down or write off of various impaired assets, primarily redundant computer software.
We recorded a restructuring charge and associated expenses of $5.5 million during the fourth quarter of 1999. Since our initial public offering in 1992, we have completed more than fifteen acquisitions. During that time, total employees had grown from less than 100 to more than 1,000. As a result of this rapid growth, we believe certain operating inefficiencies occurred. At the beginning of the fourth quarter of 1999, we made a review of our operations and determined that they could be made more efficient, principally by reducing the employee count in certain operations. We believe that this restructuring will strengthen our corporate and management structure and enhance future earnings by improving operating efficiency and therefore profitability. The charge included severance pay of $3.8 million for 92 employees, $1.0 million related to lease costs of office space made redundant as a result of the restructuring plan and an asset write down of $647,000, principally of leasehold improvements, and other assets related to the redundant space.
Our interest expense was $13.0 million for 1999, an increase of $6.9 million from 1998. The increase is a result of increased debt outstanding as a result of funding for acquisitions.
Our income tax expense was $12.3 million in 1999 compared to $35.2 million in 1998. The decrease was due to the reduction in earnings before income tax. Our effective tax rate for both years was approximately the same.
Our book value per share was $9.29 as of December 31, 1999, up from $9.12 as of December 31, 1998.
Net earnings of our insurance companies decreased to a loss of $10.7 million in 1999, from a profit of $33.8 million in 1998, as a result of the provision for reinsurance, the effect of restructuring and the higher net loss ratio.
Net earnings of our underwriting agencies decreased to $17.2 million in 1999, from $19.4 million in 1998. Acquisitions made during 1998 and 1999 had not yet had a positive impact on net earnings due to licensing and other regulatory requirements, which were still in process.
Commission income generated by our intermediaries increased 42% to $54.6 million in 1999, from $38.4 million in 1998, primarily as a result of the January 1, 1999 acquisition of Rattner Mackenzie. Net earnings of the intermediaries decreased to $13.6 million in 1999 from $16.9 million in 1998. The increase in net earnings generated by Rattner Mackenzie was offset by fewer large brokerage transactions in 1999 and other reductions, including a $902,000 (net of income tax) restructuring expense in 1999.
We receive substantial cash from premiums, reinsurance recoverables, and management fee and commission income and, to a lesser extent, investment income, and proceeds from sales and redemptions of investments and other assets. Our principal cash outflows are for the payment of claims and loss adjustment expenses, payment of premiums to reinsurers, purchase of investments, debt service, and repayment policy acquisition costs, operating expenses, income and other taxes and dividends. Variations in operating cash flows can occur due to timing differences in either the payment of claims and the collection of related recoverables or the collection of receivables and the payment of related payable amounts. We limit our liquidity exposure by holding funds, letters of credit and other security such that net balances due to us are less than the gross balances shown in our condensed consolidated balance sheets.
We maintain a substantial level of cash and liquid short-term investments which are used to meet anticipated payment obligations. Our consolidated cash and investment portfolio increased $116.5 million, or 19% since December 31, 1999, and totaled $724.3 million as of December 31, 2000, of which $277.0 million was cash and short-term investments. The increase in investments resulted from increased
operating cash flows and from the collection of a commutation receivable. Total assets increased slightly to $2.7 billion as of December 31, 2000.
Our investment portfolio includes a high percentage of liquid investments and generates a significant amount of investment income, which serves as a source of cash flow. The average tax equivalent yield on investments was 7.3% in 2000, compared to 7.2% in 1999. The weighted average duration of the portfolio was four years as of December 31, 2000. Over 99% of our fixed income securities were rated A or better by Standard & Poor's. The value of our portfolio of fixed income securities is inversely correlated to changes in market interest rates. In addition, some of our fixed income securities have call or prepayment options. This could subject us to reinvestment risk should interest rates fall or issuers call their securities and we reinvest the proceeds at lower interest rates. We mitigate this risk by investing in securities with varied maturity dates, so that only a portion of our portfolio will mature at any point in time.
During March 2001, we sold 6.9 million shares of our common stock in a public offering at a price of $23.35 per share. Net proceeds from the offering amounted to approximately $152.8 million after deducting underwriting discounts and commissions and estimated offering expenses. Most of the proceeds, $152.5 million, were used to pay down our bank facility.
no dividends during 2000. During 2001, Avemco Insurance will have an ordinary dividend capacity of approximately $18.2 million.
We continue to collect our receivables and recoverables generally in the ordinary course of business and we have not incurred and do not expect to incur any significant liquidity difficulties as a result of the substantial growth in gross amounts due. However, during 2000, a number of reinsurers have delayed or suspended the payment of amounts recoverable under certain reinsurance contracts to which we are a party. Such delays have affected, though not materially to date, the investment income of our insurance companies, but not to any extent their liquidity. We limit our liquidity exposure by holding funds, letters of credit or other security such that net balances due are significantly less than the gross balances shown in our consolidated balance sheets. In addition, a number of reinsurers have claimed they are not liable for payment to us and, in one or more cases, have sought arbitration of these matters. We believe these claims are without merit and expect to collect the full amount recoverable. We are currently in negotiations with most of these parties. If such negotiations do not result in a satisfactory resolution of the matters in question, we will seek a judicial or arbitral determination of these matters.
As of December 31, 2000, each of our domestic insurance companies' total adjusted capital was significantly in excess of the authorized control level risk-based capital level prescribed by the National Association of Insurance Commissioners.
Our operations, like those of other property and casualty insurers, are susceptible to the effects of inflation, as premiums are established before the ultimate amounts of loss and loss adjustment expense are known. Although we consider the potential effects of inflation when setting premium rates, for competitive reasons, such premiums may not fully offset the effects of inflation. However, because the majority of our
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 $300.0 million bank loan floats 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. For the year ended December 31, 2000, our loss from currency conversion was $(330,000) compared to gains of $442,000 in 1999 and $219,000 in 1998.
On a limited basis, we enter into foreign currency forward contracts as a hedge against foreign currency fluctuations. Rattner Mackenzie has revenue streams in U.S. Dollars and Canadian Dollars ("CAD") but its expenses are paid in British Pound Sterling ("GBP"). To mitigate our foreign exchange risk, we entered into foreign currency forward contracts expiring at staggered times through December 31, 2001. As of December 31, 2000 we had forward contracts to sell U.S. $7.5 million for GBP at an average rate of 1.00 GBP equals U.S. $1.50 and to sell CAD $600,000 for GBP at an average exchange rate of 1.00 GBP equals CAD $2.18. This compares with December 31,1999 when we had forward contracts to sell U.S. $12.0 million for GBP at an average rate of 1.00 GBP equals U.S. $1.60. The foreign currency forward contracts are used to convert currency at a known rate in an amount which approximates average monthly expenses. This permits us to limit the foreign currency exchange risk of the recurring monthly expenses. In the future, we may continue to limit our exposure to currency fluctuations through the use of foreign currency forward contracts. We utilize these foreign currency forward contracts strictly as a hedge against existing exposure to foreign currency fluctuations rather than as a form of speculation or trading investment.
In addition, the Financial Accounting Standards Board has recently announced that it proposes to change the accounting for certain acquisitions and goodwill. This pronouncement, if finally adopted, could affect the way we account for and the structure of future acquisitions. Final rules implementing the announced standards are not expected until the second quarter of 2001 and no date has been established for adopting the final standards.
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 will continue 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. We do not expect the introduction of the Euro to have a material effect on our business, financial condition or results of operations.