(a) Includes the interim period income statement and ending balance sheet of Folksamerica which was acquired during 1998.
(b) Restated as a result of White Mountains' acquisition of Folksamerica during 1998. See Note 3.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
White Mountains reported net income of $121.0 million for the year ended December 31, 1999, which compares to net income of $78.5 million and $39.3 million for 1998 and 1997, respectively. Net income for 1999, 1998 and 1997 includes after tax gains from sales of investment securities of $45.2 million, $46.1 million and $63.4 million, respectively. Net income for 1999 includes after tax gains of $53.8 million from the Valley Group Sale and $11.6 million from the Mortgage Banking Sale.
Book value plus deferred credit per Share was $120.23 at December 31, 1999, which compares to $115.11 at December 31, 1998. At December 31, 1999 and 1998, White Mountains had $100.6 million and $37.1 million of after tax unamortized deferred credit, respectively, which will be amortized to income over the next four years. During 1998 White Mountains recorded a deferred credit of $39.8 million resulting from its acquisition of Folksamerica. During 1999 White Mountains added a $62.0 million deferred credit resulting from its acquisition of the CIG companies and a $14.2 million deferred credit resulting from a write-down of its investment in FSA.
Folksamerica contributed $44.9 million to net income during 1999 versus $10.0 million and $5.2 million during 1998 and 1997, respectively. Folksamerica's contribution for 1998 included $5.6 million of pretax earnings ($4.5 million after tax) recorded as earnings from unconsolidated insurance affiliates. Folksamerica's entire contribution for 1997 was recorded as earnings from unconsolidated insurance affiliates.
During 1999 Folksamerica acquired USF Re Insurance Co. ("USF Re") from The Centris Group Inc. for total consideration of $92.5 million. The purchase consideration included the issuance of a $20.8 million, five-year note by Folksamerica (which can be reduced by adverse loss development at USF Re post acquisition).
Folksamerica's 1999 combined ratio of 122.5% included approximately $20.1 million in pretax losses associated with USF Re's loss reserves, $4.0 million of pretax property catastrophe losses and higher than anticipated asbestos and environmental losses. These significant 1999 adverse loss developments resulted primarily from business acquired through Folksamerica's prior acquisitions (mainly USF Re). However, Folksamerica's 1999 combined ratio does not reflect the offsetting bargain purchase benefits of such acquisitions which are recorded at its parent. For 1999, Folksamerica's holding company recorded $20.3 million of after tax income resulting from the favorable purchase structures of such acquisitions which were designed to mitigate Folksamerica's adverse loss development. These benefits for 1999 included a $14.0 million after tax reduction in the USF Re seller note and $6.3 million of after tax deferred credit amortization. The effects of such favorable purchase structures, which are not included in Folksamerica's combined ratio, would serve to reduce the 1999 combined ratio by approximately 13 points to 110%.
As previously mentioned, Folksamerica underwrites each reinsurance contract anticipating an element of underwriting profit. The anticipated degree of underwriting profit varies by contract and is based on a variety of factors which can include some degree of float. Despite this expectation on an individual contract basis, Folksamerica's reported results for the years ended December 31, 1999, 1998 and 1997 included overall underwriting losses due to the following: (i) actual results on some accounts or classes have produced higher than anticipated loss costs (considering the highly competitive market conditions, there has been insufficient margin in profitable accounts to absorb higher loss costs produced by other accounts); (ii) higher than anticipated property catastrophe losses, particularly during 1999 and 1998; and (iii) continued strengthening of reserve portfolios relating to acquired companies. However, as previously mentioned, Folksamerica has various protections into its prior acquisition structures at its holding company which are designed to mitigate such losses.
The following table presents the subsequent development of the year-end reinsurance losses for the ten-year period from 1989 to 1999. Section I of the table shows the estimated liabilities that were recorded at the end of each of the indicated years for all current and prior year unpaid losses and loss adjustment expenses ("lae"). Section II shows the re-estimate of the liabilities made in each succeeding year. Section III shows the cumulative liabilities paid of such previously recorded liabilities. Section IV shows the cumulative deficiency representing the aggregate change in the liability from the original balance sheet dates:
The table above has been prepared in accordance with prescribed instructions, however, management believes that this information is not indicative of Folksamerica's actual loss development history for the following reasons: (i) with respect to 1992 through 1999, the information is presented prior to considering the benefit of significant amounts of ceded reinsurance recovered (and recoverable) from Folksamerica's reinsurers; (ii) the information includes the complete loss development history for companies acquired by Folksamerica for all periods presented, including periods prior to Folksamerica's acquisition of such companies; and (iii) the structure of each of Folksamerica's acquisitions has provided effective economic protections to offset potential post-acquisition loss development. The form of these protections has included deferred and adjustable purchase consideration and favorable purchase prices. In consideration of such factors, the table presented below is management's attempt to adjust the deficiencies presented above for the most recent five years:
On June 17, 1999, the Company completed the Valley Group Sale and recorded a pretax gain of $88.1 million, $53.8 million after tax on the transaction. The Company recorded net income from Valley Group for the 1999 period through the date of sale of $3.6 million which primarily represented realized investment gains. For the years ended December 31,1998 and 1997, VGI contributed $5.0 million and $7.2 million, respectively, to net income.
Net realized gains on investments and the total net investment return from White Mountains' investment activities (excluding net unrealized investment holding gains and losses from White Mountains' investments in unconsolidated insurance affiliates) are shown below:
(a) Excludes a $15.8 million realized gain on sale of the USF Re shell company
Compensation and benefits totalled $67.8 million for 1999 versus $51.5 million for 1998 and $45.5 million for 1997. The increase in compensation and benefits from 1998 to 1999 is due to both the inclusion of Folksamerica in the Company's consolidated results for the entire 1999 period and expenses incurred in connection with the Redomestication. See "Liquidity and Capital Resources". The increase in compensation and benefits from 1997 to 1998 is primarily due to the initial inclusion of $7.1 million of Folksamerica's compensation and benefits during 1998.
Interest expense totalled $14.7 million during 1999 versus $13.7 million for 1998 and $10.6 million for 1997. The increase in interest expense from 1998 to 1999 primarily reflects higher average indebtedness levels due to indebtedness outstanding at Folksamerica for the entire 1999 period. The increase in interest expense from 1997 to 1998 primarily reflects the inclusion of $1.4 million of Folksamerica's interest expense for 1998 and an increase in average indebtedness under White Mountains' credit facility associated with its 1998 acquisition of Folksamerica and its 1998 increase in its investment in MSA.
in the event of net losses incurred by such companies. Additionally, prior to the Redomestication, the Company filed a consolidated United States income tax return with its subsidiaries. The Onshore Companies must continue to file United States tax returns but may no longer do so on a group-wide consolidated basis. As a result, the aggregate United States income tax liability of the Onshore Companies may be higher than it otherwise would have been if part of a consolidated tax return. These factors may serve to increase or decrease White Mountains' effective tax rate for 1999 and beyond, depending on the events and circumstances occurring during such periods.
White Mountains recorded a deferred tax asset of $52.5 million (relating primarily to various operating items) and a deferred tax liability of $37.5 million (relating primarily to net unrealized investment holding gains) on its balance sheet as of December 31, 1999. White Mountains recorded a net deferred tax liability of $13.4 million on its balance sheet as of December 31, 1998. The 1998 net deferred tax liability consisted of $103.3 million of deferred tax assets (relating primarily to various operating items) and $116.7 million of deferred tax liabilities (relating primarily to net unrealized investment holding gains).
The Company has a revolving credit agreement whereby it may borrow up to $35.0 million
During 1999 the Company issued a total of 1,137,495 common shares to its Chairman and its key employees in satisfaction of the Chairman's warrant exercise and various employee benefit plan obligations. In order to entice the Chairman to exercise his Warrants early, the Company paid Mr. Byrne $6.0 million to compensate him for the estimated interest cost of borrowing the strike price and the amounts required to prematurely pay his income taxes.
During 1999 White Mountains exercised FSA Options pursuant to which it acquired 666,667 shares of FSA Common Stock at a strike price of $23.50 per share. Also during 1999, White Mountains exercised FSA Options pursuant to which it acquired 1,893,940 shares of FSA Common Stock at a strike price of $26.40 per share in accordance with the redemption of the MediaOne preferred stock.
On March 14, 2000, White Mountains entered into a definitive agreement to sell its indirect,
wholly-owned subsidiary, White Mountains Holdings, Inc. (which controls a substantial amount of its holdings of FSA Common Stock and the FSA Preferred Stock) as well as all its other holdings of FSA Common Stock, to Dexia S.A. ("Dexia") for total cash proceeds of $620.4 million. The transaction will occur only in connection with Dexia's pending merger with FSA in which all holders of FSA Common Stock will receive $76.00 cash per share. The merger agreement between FSA and Dexia is subject to, among other matters, regulatory approvals and the satisfaction of the conditions contained in Dexia's merger agreement with FSA, including the approval of FSA shareholders. The transaction, if approved, is expected to close mid-year 2000.
Under the insurance laws of New York an insurer is restricted with respect to the amount of dividends it may pay without prior approval by state regulatory authorities. Accordingly, there is no assurance that dividends may be paid by Folksamerica in the future.
As part of the Folksamerica acquisition in 1998, White Mountains agreed to repay or refinance Folksamerica's $55.6 million of outstanding long-term indebtedness during February 1999. On February 24, 1999, White Mountains repayed and replaced its former facility with a revolving credit agreement whereby it may borrow up to $100.0 million (which was subsequently increased to $120.0 million during 1999) at market interest rates. The new credit agreement contains certain customary covenants and conditions. At December 31, 1999, Folksamerica was in compliance with all covenants under the facility and had $100.0 million of borrowings outstanding under the agreement.
On January 10, 2000, Folksamerica announced that it had signed a definitive agreement to acquire substantially all the reinsurance operations of Risk Capital Reinsurance Company ("RCRe"), a wholly-owned subsidiary of Risk Capital Holdings, Inc., for consideration of $20.3 million. The transaction is subject to regulatory approvals.
Folksamerica operates a branch office in Toronto, Canada to service its Canadian customers and a portion of BICC's premiums are denominated in a foreign currencies. Net unrealized foreign currency translation gains and losses associated with Folksamerica and BICC are reported, after tax, as a net amount in a separate component of shareholders' equity. Changes in the values of these operations due to currency fluctuations, after tax, are reported on the income statement as a component of other comprehensive net income. At December 31, 1999 and 1998, Folksamerica's and BICC's net assets denominated in foreign currency represented approximately one percent of the Company's shareholders' equity, therefore, any significant change in foreign currency rates would not have a material impact on White Mountains' financial position.
The table below summarizes White Mountains' equity price risks as of December 31, 1999 and shows the effects of a hypothetical 20% increase and a 20% decrease in market prices as of that date.