The Company obtains reinsurance coverage primarily through excess-of-loss treaty reinsurance. Under excess-of- loss reinsurance treaties, the reinsurer assumes losses above specified amounts as stipulated in the reinsurance contract for an agreed-upon premium. The agreed-upon premium may vary within predetermined ranges based upon the level of losses experienced by the reinsurer. AEIC's maximum net retention is $200,000 for liability loss and $150,000 for hull loss in the Aviation Division subject to reinsurance deductible amounts, $250,000 per occurrence in the P & C Division and $75,000 per occurrence in the Marine Division.
In the fourth quarter of 1996 the Company announced a proposal to the holders of common stock to approve a securities purchase agreement dated as of November 5, 1996. The shareholders approved the agreement on December 31, 1996. The securities purchase agreement included, among other things, the sale and issuance for $35 million of 350,000 shares of the Company's Series D Preferred Stock, the issuance of up
Case and IBNR reserves do not represent an exact calculation of liability but, rather, are estimates involving actuarial and statistical projections at a given time to reflect the Company's expectations of the ultimate costs of administration and settlement of claims. Such estimates are based on facts and circumstances then known, predictions of future events, estimates of future trends in claims reporting frequency and severity and other variable factors. As a consequence, although the Company believes that its reserves at December 31, 1996, are adequate to meet its future obligations under existing policies, actual losses may deviate, perhaps substantially, from reserves reflected in the Company's consolidated financial statements. There are a number of factors that could cause losses to deviate from estimates. Such factors could include assumptions proving incorrect regarding the positive effect of changes in underwriting and claims handling improvements on future trends in claims reporting, frequency and severity of losses, and increases in claims settlement costs due to higher inflation or new theories of liability. To the extent reserves prove inadequate, the Company would have to increase reserves and incur a charge to earnings in the period in which the reserves are increased, which could have a material adverse effect on the financial position and results of operations the Company for such period.
As a result of the effect of the 1996 loss on statutory policyholders' surplus of AEIC, in March 1997, A.M. Best Company lowered its rating of AEIC to "D." This reduction could have a material adverse impact on AEIC's ability to generate premium income. The loss in policyholders' surplus also restricts the amount of premium income that AEIC can write. Consequently, the Company and Zurich Reinsurance Centre, an affiliate of Zurich Insurance Group, are implementing an expanded underwriting agreement to make available A.M. Best "A" rated policies for all of American Eagle's general aviation product lines. Additional regulatory filings to provide this coverage are in progress. The Company expects that these factors will increase the amount of business that the Company assumes from other companies that provide the "A" rated policies, and it will substantially reduce the amount of business the Company directly writes for its own account in the future. The Company has also engaged Credit Suisse First Boston to pursue alternatives including, among other things, sale of the Company or assets of the Company, a rights offering to stockholders, a sale of securities and other alternatives to increase underwriting capacity.
which was partially offset by a 1.8% increase produced by the Marine Division. The Aviation Division's gross premiums produced decreased 15.1% to $108.7 million in 1996 from $128.1 million in 1995. This decline was due to a decrease in policies in force resulting from underwriting actions taken by the Company in its commercial aviation book of business and from business lost due to its decline in credit rating. Gross premiums produced by the P&C Division decreased 28.3% to $35.9 million in 1996 from $50.1 million in 1995. This decrease results from a decision to discontinue the auto dealer program in the fourth quarter of 1995 and the transportation program in the fourth quarter of 1996, offset by growth in the artisan program. On March 22, 1997 the Company announced that its principal subsidiary, American Eagle Insurance Company, had entered into a letter of intent to sell its artisan program and complete its strategic plan for a complete withdrawal from the specialty property and casualty lines of business. The sale, subject to definite documentation, approvals of the boards of directors, regulatory approvals and licenses, and other customary conditions would result in an immaterial gain. The Marine Division's gross premiums produced increased 100.0% to $6.6 million in 1996 from $3.3 million in 1995 as a result of more policies in force.
The gross premiums assumed from other companies increased 103.2% to $12.6 million in 1996 from $6.2 million in 1995 as a result of the increase in the amount of gross premiums produced for other companies.
Gross premiums written decreased 17.1% to $142.8 million in 1996 from $172.2 million in 1995 primarily as a result of the factors noted in the three preceding paragraphs.
Net premiums written decreased 20.5% to $96.2 million in 1996 from $121.0 million in 1995 as a result of the matters described above.
Earned premiums, net of reinsurance, increased 4.7% to $107.2 million in 1996 from $102.4 million in 1995. Of this increase, 8.6% was related to the Aviation Division and 2.8% to the Marine Division, which was offset by a 6.7% decrease in the P&C Division. The reasons for the changes in the components of gross premiums produced resulted in the increase.
Investment income, net of related expenses, decreased 18.2% to $4.5 million in 1996 from $5.5 million in 1995. Average invested assets decreased 15.4% to $84.9 million in 1996 from $100.3 million in 1995. The decrease in average invested assets was a result of cash flow used by operations, which resulted primarily from reductions in unearned premiums and decreases in other policy liabilities. The yield for the year increased to 5.6% from 5.5% in 1995.
Realized investment gains (losses), net, were $(0.1) million in 1996 compared to $0.5 million in 1995.
Interest expense increased 10.0% to $1.1 million in 1996 from $1.0 million in 1995 due to an increase of $2.0 million in the outstanding note payable for most of 1996. As of December 1996, the note payable balance was fully paid.
Loss before income tax benefit was $44.4 million in 1996 compared to $20.4 million in 1995 as a result of the factors described above.
The income tax benefit in 1995 resulted from the Company's ability to carryback losses to prior years and recover previously paid taxes. In accordance with the requirements of SFAS No. 109, the Company did
not record an income tax benefit relating to the net operating loss carryforward generated in 1996. At December 31, 1996 the Company had a net operating loss carryforward of approximately $45.0 million available to offset future income. During 1996, the Company underwent a change in ownership for purposes of Section 382 of the Internal Revenue Code of 1986. As a result, the Company's net operating loss carryforward will be limited to approximately $1.9 million per year through 2011. At the current statutory tax rate of 34%, the Company has an unrecorded income tax benefit of approximately $14.1 million.
The Company recorded a net loss of $44.4 million in 1996 compared to a net loss of $13.1 million in 1995.
Approximately $8.9 million of the special charge resulted from additional case reserves and related costs for three segments of the Aviation Division in which certain classes of coverage were discontinued. Approximately $.7 million of the special charge resulted from additional case reserves and related costs for the discontinued auto dealer program of the P&C Division. The remainder of the special charge, approximately $11.0 million, resulted from an increase in IBNR and unearned premium reserves, which included reserves for the discontinued lines and classes of business. Of the increase in IBNR and unearned premium reserves, $7.1 million was attributed to the Aviation Division, and $3.9 million to the P&C Division.
Case and IBNR reserves do not represent an exact calculation of liability but, rather, are estimates involving actuarial and statistical projections at a given time to reflect the Company's expectations of the ultimate costs of administration and settlement of claims. Such estimates are based on facts and circumstances then known, predictions of future events, estimates of future trends in claims reporting frequency and severity and other variable factors. As a consequence, although the Company believes that its reserves at December 31, 1995, were adequate to meet its future obligations under existing policies, actual losses may deviate, perhaps substantially, from reserves reflected in the Company's consolidated financial statements. There are a number of factors that could cause losses to deviate from estimates. Such factors could include assumptions proving incorrect regarding the positive effect of recent changes in underwriting and claims-handling improvements on future trends in claims reporting, frequency and severity, and increases in claims settlement costs due to higher inflation or new theories of liability. To the extent reserves prove inadequate, the Company would have to increase reserves and incur a charge to earnings in the period in which the reserves are increased, which could have a material adverse effect on the financial position and results of operations of the Company for such period.
As a result of the effect of the special charge on the statutory policyholders' surplus and operating results of AEIC, A.M. Best Company lowered its rating of AEIC by one level to "B++ (Very Good)." American Eagle does not believe this rating change will have a material affect on its underwriting profitability. This is forward-looking information, and actual results could differ materially. Some insureds and agents require their insurance carriers to maintain a Best's rating of at least "A-." Through various current agreements, American Eagle has authority to offer policies issued by an insurance carrier with an "A" level rating to general aviation accounts, such as municipal and governmental accounts in the airport liability and commercial general aviation lines of business. American Eagle reinsures and services these policies. These agreements are limited in scope, have an annual term, and are subject to regulatory requirements. American Eagle expects to renew or replace these agreements on acceptable terms on a timely basis, but no assurance of this can be given.
Gross premiums produced for other companies is comprised of premiums written for other companies which are assumed by the Company and those premiums written for other companies for higher coverage limits which are retained by the other companies. Such amounts increased 1.5% to $15.6 million in 1995 from $15.3 million in 1994 as a result of an increase in underwriting airport risks in the Aviation Division. Due to the size of coverage limits involved in airport liability policies, more of these risks are retained by the other companies.
The gross premiums assumed from other companies decreased 14.2% to $6.2 million in 1995 from $7.3 million in 1994 as a result of more of the gross premiums produced for other companies being retained by such companies.
Earned premiums, net of reinsurance, increased 23.8% to $102.4 million in 1995 from $82.7 million in 1994. Of this increase, 17.5% was related to the Aviation Division, 5.1% to the P&C Division, and 1.2% to the Marine Division. The reasons for the changes in the components of gross premiums produced resulted in the increase.
Realized investment gains, net, were $0.5 million in 1995 compared to an immaterial realized investment loss in 1994.
Losses and loss adjustment expenses, net of reinsurance, were 88.8% (59.9% excluding special charge) of earned premiums, net of reinsurance in 1995 as compared to 63.7% in 1994. The ratio of losses and loss adjustment expenses to earned premiums, net of reinsurance, is referred to as the loss ratio. The Aviation Division loss ratio increased to 92.2% (58.2% excluding the special charge) in 1995 from 57.7% in 1994, and the P&C Division loss ratio increased to 82.6% (62.6% excluding the special charge) in 1995 from 73.9% in 1994. The Marine Division loss ratio was 80.0% in 1995. The Aviation Division loss ratio, excluding the special charge, was within normal operating ranges in both 1995 and 1994. The increase in the Aviation Division loss ratio in 1995 is primarily attributed to the adverse results in the three classes of coverages, which were discontinued in 1995, and a higher-than-expected number of severe liability losses in the 1994 and prior accident years. The P&C Division loss ratio increased due to the continued adverse results of the auto dealer program and a longer than anticipated development period for the other liability coverages line of business.
Policy acquisition and other underwriting expenses were 36.4% of earned premiums, net of reinsurance in 1995 and 28.6% of earned premiums, net of reinsurance, in 1994. The ratio of policy acquisition and other underwriting expenses, computed on a GAAP basis, to earned premiums, net of reinsurance, is referred to as the expense ratio. The increase in the expense ratio in 1995 compared to 1994 was due to an increase in ceded premiums and growth in policy acquisition and other underwriting expense levels in 1995. Policy acquisition and other underwriting expense levels in the P&C Division grew partially as
a result of increased commission expenses due to changes in the local and intermediate haul transportation program's method of distribution.
Interest expense increased 23.4% to $1.0 million in 1995 from $0.8 million in 1994 due to an increase of $2.0 million in the outstanding note payable. As of December 1995, the outstanding note payable balance was $11.3 million.
Income (loss) before income tax provision (benefit) was a loss of $20.4 million in 1995 as compared to income of $10.5 million in 1994 as a result of the factors described above.
AEIC's sources of funds are premiums collected, reinsurance recoveries, investment income and proceeds from sales and maturities of investments. Funds are applied primarily to the payments of claims and expenses and to the purchase of investments. Premiums are typically received in advance of related claim payments. Because AEIC has $53.6 million of cash and cash equivalents, short-term investments and U.S. Treasury securities, and $35.5 million of other fixed income, investment-grade securities at December 31, 1996, the Company believes that AEIC will have adequate liquidity to meet all of its cash needs for the next twelve months.
The Company's cash flow used in operations was $36.0 million in 1996. Cash flow provided by operations was $4.0 million in 1995, and cash flow used in operations was $4.1 million in 1994. Cash flow used in operations resulted primarily from a reduction in unearned premiums of $19.5 million, as a result of a decline in gross premiums written and the resultant decline in net premiums written and a decrease of $20.0 million in other policy liabilities. Other policy liabilities decreased as a result of decreases in claims drafts payable and ceded reinsurance payable. Cash flow provided by operations in 1995 resulted primarily from settlement of balances with reinsurers, as well as positive cash flow from increases in written premiums and premium collections. Cash flow used by operations in 1994 resulted primarily from an increase in reinsurance recoverable, as well as reinsurers' accelerating the payment for premiums due them in the 1994 reinsurance renewal. Cash proceeds from the sales and maturities of fixed income securities and sales of equity securities were $41.6 million in 1996, $166.3 million in 1995, and $84.2 million in 1994.
In December 1996, the Company issued 350,000 shares of Series D Preferred Stock for a total purchase price of $35 million, before expenses. Of the proceeds, the Company used $13.3 million to fully repay and cancel its bank credit facility, and $17.0 million was contributed to the capital and surplus of AEIC. The Series D Preferred Stock has an interest rate of 9%, payable quarterly. At the option of the Company, during the first five years, the quarterly dividend can be paid in additional shares of Series D Preferred Stock.
The Company's fixed income securities are segregated into two categories at December 31, 1996. Fixed-income securities expected to be held to maturity are carried at amortized cost; the carrying value of such securities was $23.5 million, and the market value was $23.3 million, both at December 31, 1996. The remaining fixed-income securities are available for sale and were carried at a market value of $29.2 million at December 31, 1996.
The Company plans to spend up to $1.0 million on capital expenditures in 1997 primarily for computer hardware and software, which will be funded out of operating cash flow. The Company has no plans for other material capital expenditures in 1997.
AMERICAN EAGLE GROUP, INC. AND SUBSIDIARIES - INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
We have audited the accompanying consolidated balance sheets of American Eagle Group, Inc. (a Delaware corporation) and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
CONSOLIDATEDBALANCE SHEETS - DECEMBER 31, 1996 AND 1995 (In Thousands Except Share Data)
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 (In Thousands Except Share Data)
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 (In Thousands)
The Company is currently reviewing and developing capital and strategic alternatives, including the sale of the Company or assets of the Company, a rights offering to stockholders, a sale of securities and other alternatives to increase underwriting capacity. In addition, as a result of the decline in rating, the Company and Zurich Reinsurance Centre, Inc. ("ZRC") are implementing an expanded underwriting agreement to make available A.M. Best "A" rated paper for all of AEIC's general aviation product lines. ZRC, which leads the Company's general aviation reinsurance program, is in the process of providing "A" rated policies through various of its affiliated companies. Additional regulatory filings to provide this coverage are in progress.
In March 1997, the Company entered into a letter of intent to sell its Artisan line of business. The 1996 gross premiums produced for this line were approximately $21.0 million. The Company expects to recognize an immaterial gain on the transaction. Closing of the transaction is subject to regulatory approvals and other customary conditions.
The consolidated financial statements include the accounts of the Company prepared in conformity with generally accepted accounting principles, which differ in some respects from those followed in reports to insurance regulatory authorities. All intercompany balances and transactions have been eliminated in consolidation. The term insurance operations refers to the activities of AEIC and its wholly owned insurance subsidiary American Meridian Insurance Company Limited ("AMIC"). The term agency operations refers to the activities of Aviation Office of America ("AOA").
Insurance premiums are earned on a pro rata basis, net of reinsurance premiums, over the terms of the respective policies. Unearned premiums represent the portion of net premiums written applicable to the unexpired portion of the coverage period.
Costs of acquiring business for the insurance operations which vary with and are directly related to the production of such business are deferred and amortized ratably over the related policy period (generally one year). Policy acquisition costs include commissions, brokerage fees and certain other policy issuance expenses. Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed recoverable amounts after considering anticipated investment income.
Expenditures for significant improvements or betterments are capitalized. Maintenance and repair costs are expensed as incurred. Depreciation is provided on a straight-line basis over the estimated useful lives of the assets (four to ten years).
The excess of cost over the fair market value of net assets acquired of AEIC and AOA is being amortized on a straight- line basis over 25 years. Intangible assets, net of accumulated amortization, of $4,969 and $5,309 at December 31, 1996 and 1995, respectively, were recorded as a component of Other Assets. Accumulated amortization totaled approximately $3,603 and $3,254 at December 31, 1996 and 1995, respectively.
The Company follows the provisions of SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 requires an asset and liability approach for financial accounting and reporting for income taxes.
Net income (loss) per common share has been computed by dividing income (loss), after deducting preferred stock dividends, by the weighted average number of common shares and equivalent shares outstanding each year.
The Company includes as cash equivalents in the statements of cash flows, temporary cash investments which generally have original maturities of 90 days or less.
In the ordinary course of business, AEIC and AMIC purchase reinsurance for the purpose of limiting their retained loss exposure and maintaining required statutory surplus amounts.
The Company makes quarterly deposits for reinsurance contracts in the normal course of business. At December 31, 1996 and 1995, the Company had entered into reinsurance contracts with future deposits totaling $17,550 and $ 32,064, respectively. These deposits are generally payable in the first nine months of the subsequent year.
Changes in deferred policy acquisition costs for the years ended December 31, 1996, 1995 and 1994, are summarized below:
Changes in reserves for losses and loss adjustment expenses are summarized as follows:
There are no investments in fixed income securities that have been non-income producing for the years ended December 31, 1996, 1995 and 1994. Investment expenses include advisory fees paid to unrelated parties.
Following is an analysis of the change in the unrealized appreciation (depreciation) of investment securities available for sale, which is reported as a component of stockholders' equity:
The amortized cost and estimated fair values of investments in fixed income and equity securities at December 31, 1996 and 1995, are as follows:
The amortized cost and estimated fair value of fixed income securities at December 31, 1996, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Total interest expense for the years ended December 31, 1996, 1995 and 1994 was approximately $1,132, $987 and $800, respectively.
The components of and changes in the net deferred tax asset (liability) during the years ended December 31, 1996 and 1995, were as follows:
No income, profit or capital gain taxes are levied in Bermuda and, accordingly, no provision or benefit for such taxes has been recorded by AMIC. In the event such taxes are levied, AMIC has an agreement with the Bermuda government exempting it from all such taxes until March 2016.
Generally accepted accounting principles ("GAAP") differ in certain respects from accounting practices prescribed or permitted by the domiciliary insurance regulatory authorities of the State of Texas and Bermuda. AEIC and AMIC are required to report to certain regulatory agencies on the basis of Statutory Accounting Practices ("SAP"). The principal differences between SAP and GAAP are as follows:
o Under SAP, federal income taxes are only provided on taxable income for which income taxes are currently payable, while under GAAP, deferred income taxes are provided with respect to temporary differences;
The unaudited statutory capital and surplus of AMIC as of December 31, 1996 and 1995, was $4,031 and $3,761, respectively. Unaudited statutory net income of AMIC for the years ended December 31, 1996, 1995 and 1994, was $92, $1,143 and $313, respectively.
The Series D Preferred Stock has an annual, cumulative dividend of 9% payable quarterly. At the option of the Company, dividends during the first five years may be paid either in cash or in shares of the Series D Preferred Stock.
The common stock of the Company is issuable in either of two classes, Common Stock or Nonvoting Common Stock. Other than the voting rights, the two classes are identical in every respect. As of December 31, 1996 and 1995, 7,047,098 and 7,044,698 shares of Common Stock were outstanding, respectively. As of December 31, 1996, no shares of Nonvoting Common Stock were outstanding. At December 31, 1995, 6,000 shares of Nonvoting Common Stock were outstanding, all of which were converted to Common Stock in January 1996. The Company declared cash dividends of $0.08, $0.13 and $0.09 per common share in 1996, 1995 and 1994, respectively.
At December 31, 1996, the Company has 1,229,550 common shares reserved for stock options. Option activity is as follows:
In February 1994, the board of directors approved the 1994 Employee Restricted Stock Plan ("Restricted Stock Plan"). Under the Restricted Stock Plan, all employees on the date of closing of the initial public offering received a grant of 100 shares of Common Stock, subject to forfeiture upon termination of
The Company may make annual profit sharing contributions for all employees eligible to participate in the Savings Plan. The amount of the contribution is within the discretion of the Board of Directors. Profit sharing contributions are allocated among participants in proportion to their compensation. Participants vest in profit sharing contributions on a graduated vesting schedule over three years. The Company's profit sharing contributions to the Savings Plan totaled $100, $140 and $175 for the years ended December 31, 1996, 1995 and 1994, respectively.
SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," requires the Company to disclose the estimated fair value of its financial instrument assets and liabilities. Approximately 33% of the Company's assets and 0% of its liabilities are considered financial instruments as defined in Statement No. 107.
Estimated fair values have been determined using an estimation methodology suitable for each category of financial instruments. The estimation methodologies used, estimated fair values, and recorded book balances at December 31, 1996 and 1995, were as follows:
The Company is required to indemnify officers and directors for liability and defense costs associated with litigation which might arise in connection with the fulfillment of their responsibilities to the Company.
AMERICAN EAGLE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The fourth quarter of 1996 includes a charge to operations of approximately $30.0 million relating primarily to reserve additions (including incurred-but-not-reported losses) and reinsurance costs.