The Company's principal and executive offices are located in Houston, Texas, in an approximately 54,000 square foot building owned by HC. LDG's principal facility is leased office space in Wakefield, Massachusetts consisting of approximately 34,000 square feet, which lease terminates on October 31, 2001. AIC's principal facility is an approximately 40,000 square foot office building owned by an AVEMCO subsidiary and located in Frederick, Maryland. AMIG's principal facility is leased office space in Dallas, Texas consisting of approximately 36,000 square feet, which lease terminates on August 31, 2002. The Company owns a 48,200 square foot office building and storage complex in St. Peters, Missouri. The Company also maintains sales and administration offices or other facilities in over 30 locations elsewhere in the United States and in England, Turkey and China. The majority of these additional locations are in leased facilities.
On November 27, 1996, the Company acquired 100% of the outstanding shares of NASRA, on April 30, 1997, the Company acquired 100% of the outstanding shares of Interworld Corporation and on August 8, 1997, the Company acquired all of the outstanding shares of Southern and Aviation Claims Administrators, Inc. These combinations have been accounted for as poolings-of-interests. However, the Company's consolidated financial statements have not been restated due to immateriality.
(3) These amounts have been adjusted to reflect the effects of the three-for-two stock split payable as a 50% stock dividend to shareholders of record March 15, 1994, and the five-for-two stock split payable as a 150% stock dividend to shareholders of record April 30, 1996.
(4) Book value per share is calculated by dividing shares outstanding into total shareholders' equity. Net tangible book value per share uses total shareholders' equity less goodwill as the numerator.
The Company's insurance agency operations underwrite and service domestic general aviation, medical stop-loss, lenders single interest, occupational accident, and accident and health insurance and reinsurance business. They also place reinsurance for the Company's insurance company operations and other non-affiliated insurance companies.
The following table sets forth certain premium revenue information for the three years ended December 31, 1997 (dollars in thousands):
(1) Reinsurance assumed includes all reinsurance business written, including facultative reinsurance.
YEAR ENDED DECEMBER 31, 1997 VERSUS YEAR ENDED DECEMBER 31, 1996
reduction in NWP and the reduced retentions of the Company. The Company expects GWP to increase during 1998 primarily due to internal growth as the Company's managing general agency subsidiaries transfer business from non-affiliated insurance companies to the Company's insurance company operations. However, NWP and net earned premium will be unchanged as the Company does not intend to increase its retentions at this time.
Net realized investment losses from sales of equity securities were $155,000 during 1997, compared to gains of $8.3 million in 1996. During 1996, the Company systematically liquidated the majority of its equity portfolio. Net realized investment losses from disposition of fixed income securities were $174,000 during 1997, compared to gains of $29,000 in 1996. During 1996, AVEMCO consummated the sale of National Assurance Underwriters, Inc., which was a subsidiary of AVEMCO prior to the pooling-of-interests combination with the Company. This sale generated an after tax gain of $2.2 million or $0.05 per share.
AIC, acquired in June, 1997, recorded a $10.0 million increase in loss and LAE reserves during December, 1997, predominately relating to 1995 and 1996 claims incurred prior to the Company's acquisition of AIC. This increase in reserves was made to bring AIC's reserving practices consistent with the more conservative method used by the Company's other insurance company operations. The Company expects the increase in loss reserves to be adequate to cover any subsequent adverse development of AIC's prior losses.
Loss and LAE decreased $18.0 million in 1997, to $96.5 million, reflecting the increased use of reinsurance, despite the $10.0 million reserve strengthening charge taken by AIC. During 1997, the Company had net loss and LAE redundancy of $3.8 million relating to prior year losses compared to a redundancy of $4.9 million in 1996. During 1997, the Company had gross loss and LAE deficiency of $23.2 million compared to a deficiency of $42.5 million in 1996. The gross deficiency comes from two primary sources. Firstly, the development of several large claims on individual policies which were either reported late or reserves were increased as subsequent information became available, however, as most of these policies were substantially reinsured, there is no material effect to the Company's net earnings. Secondly, is the run-off of the retrocessional excess of loss business which the Company underwrote between 1988 and 1991. This development, $1.6 million in 1997 compared to $11.3 million in 1996, is primarily due to the delay in reporting of catastrophe losses by the London insurance market, coupled with the unprecedented number of catastrophes during the period in which the Company underwrote this business. This business is also substantially reinsured, thereby not having a material effect on the Company's net earnings. The Company continues to believe it has materially provided for all net incurred losses.
Compensation expense increased $7.5 million or 20% in 1997, to $44.6 million due to the increase in personnel resulting from acquisitions completed during 1997, along with an increase in management personnel hired to oversee the integration of the Company's many acquisitions.
Other operating expense increased 20% to $31.0 million in 1997. These expenses reflect increased expenditures required to meet the overall growth in business and from acquisitions. Currency conversion losses amounted to $884,000 in 1997, compared to losses of $181,000 in 1996.
employees immediately prior to the merger. The amounts incurred during 1997 were due to the combinations with AVEMCO, Interworld and Southern.
Income tax expense was $23.3 million in 1997, compared to $9.9 million in 1996. The 1996 amount included a deferred tax benefit of $9.6 million which was recorded in connection with the compensatory stock grant to certain key LDG employees. The compensation expense was a non-cash item; however, $9.6 million of actual cash tax savings will be recognized beginning from the grant date. Most of the other merger expenses are not deductible for income tax purposes. Also, as an S Corporation, LDG was exempt from Federal income taxes through May 21, 1996. Had LDG been subject to Federal income tax during the period January 1, 1996 to May 21, 1996, additional income tax expense of $2.3 million would have been recorded in 1996.
Net earnings increased 29% to $49.8 million in 1997 from $38.5 million in 1996. Diluted earnings per share increased 23% to $1.07 in 1997 from $0.87 in 1996.
YEAR ENDED DECEMBER 31, 1996 VERSUS YEAR ENDED DECEMBER 31, 1995
Total revenue during 1996 increased 16% to $270.4 million from $234.0 million in 1995. 1996 GWP decreased to $337.3 million from $339.1 million in 1995, while NWP increased from $184.3 million in 1995 to $188.3 million in 1996. The decrease in written premium was a result of the planned exit from the offshore energy business as a result of increased competition that has driven rates below acceptable levels, as well as the softening in marine rates and, more recently, property rates. Net earned premium in 1996 increased from $159.6 million to $175.3 million, reflecting the large increase in written premium during 1995.
Management fee and commission income in 1996 increased 20% to $51.4 million from $42.8 million in 1995, reflecting internal growth. Net investment income increased 8% to $23.6 million in 1996 from $21.7 million in 1995 reflecting a higher level of investment assets.
Company's net earnings. Secondly, is the run-off of the retrocessional excess of loss business which the Company underwrote between 1988 and 1991. This development, $11.3 million in 1996 compared to $9.8 million in 1995, is due to the delay in reporting of catastrophe losses by the London insurance market, coupled with the unprecedented number of catastrophes during the period in which the Company underwrote this business. This business is also substantially reinsured, thereby not having a material effect on the Company's net earnings. The Company continues to believe it has materially provided for all net incurred losses.
Interest expense during 1996 decreased 23% to $5.0 million from $6.5 million during 1995 due to the reduced level of indebtedness as a portion of the proceeds of a June, 1995, public offering of Common Stock which was used to retire debt.
The Company's insurance company subsidiaries' statutory combined ratio was 83.6% for 1996 compared to 84.5% in 1995. The Company's combined ratio remains significantly better than the industry average.
HCC completed an initial public offering of 1,437,500 shares of Common Stock during October, 1992 and secondary public offerings of 1,254,200 shares of Common Stock in September, 1993 and 2,012,500 shares of Common Stock in June, 1995. The offerings significantly improved the capital resources of the Company. The net proceeds of the offerings have been used to reduce the Company's indebtedness and to contribute capital to its insurance company subsidiaries. HC now has more than $233.0 million in policyholders' surplus. This additional capital enables HC to write significantly more premium and to have sufficient financial size and strength to operate in the current insurance industry environment.
The Company receives substantial cash from premiums and reinsurance recoverables, and, to a lesser extent, investment income, proceeds from sales and redemptions of investment assets and management fee and commission income. The principal cash outflows are for the payment of claims and LAE, payment of premiums to reinsurers, purchase of investments, debt service, policy acquisition costs, operating expenses, income and other taxes and dividends.
The Company maintains a substantial level of cash and liquid short-term investments which are used to meet anticipated payment obligations. As of December 31, 1997, the Company had cash and short-term investments of approximately $112.6 million. The Company's consolidated investment portfolio of $523.3 million as of December 31, 1997 (of which $105.3 million is short-term investments), is available to provide additional liquidity and cash for operations.
The Company's 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 LAE are known. Although management considers the potential effects of inflation when setting premium rates for competitive reasons, such premiums may not adequately compensate the Company for the effects of inflation. However, as the majority of the Company's business is comprised of lines which have short lead times
A significant portion of the Company's revenue is related to healthcare insurance and reinsurance products which are subject to the effects of the underlying inflation of medical 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. No express provision for inflation is made, although trends are considered when setting underwriting terms and claim reserves. Claim reserves are subject to a continuing review process to assess their adequacy and are adjusted as deemed appropriate. In addition, the market value of the investments held by the Company varies depending on economic and market conditions and interest rates, which are highly sensitive to the policies of governmental and regulatory authorities. Any significant increase in interest rates could therefore have a material adverse effect on the market value of the Company's investments.
In June, 1997, the Financial Accounting Standards Board issued SFAS No. 130 "Reporting Comprehensive Income" and SFAS No. 131 "Disclosures about Segments of an Enterprise and Related Information". Both statements are effective for fiscal years beginning after December 15, 1997. These SFAS's require that additional information be included in a complete set of financial statements, but will have no effect on the Company's net earnings, shareholders' equity or cash flows. The Company does not expect to change its definition of segments when SFAS No. 131 is adopted.
software and in connection with planned conversions to new software, the Year 2000 issue will be mitigated. The Company has implemented a plan to mitigate its Year 2000 exposure, including the identification, selection and implementation of a new Year 2000 compliant software system at an insurance company subsidiary. Management believes that the plan is progressing such that Year 2000 exposures will be mitigated prior to any critical date and by October, 1998 with respect to the insurance company subsidiary where the Company's major Year 2000 risk exists.
The Company is utilizing and will continue to utilize both internal and external resources to reprogram or replace its computer systems such that the reprogrammed or new systems will cause the Company to be Year 2000 compliant in advance of respective critical dates. The total estimated remaining cost of modification of existing software and new Year 2000 compliant systems is $4,600,000 which includes, $4,400,000 attributable to the planned purchase and implementation of new systems, principally to replace the above mentioned insurance company subsidiary's system. The cost of this new software will be capitalized. The remaining estimated cost of $200,000 will be expensed as incurred over the next two years. The level of expense is not expected to have a material effect on results of operations. The cost of modification of existing systems to become Year 2000 compliant and of the new Year 2000 compliant software is to be funded out of operating cash flow, which is sufficient to provide the funding. The cost estimates are management's best estimates based upon assumed future events which could change.
In 1997, the Company expensed $11,000 with respect to Year 2000 compliance and capitalized $550,000 with respect to new Year 2000 compliant software purchases and installations. The Company does not believe that it has significant Year 2000 exposure with respect to its vendors and the Company's software vendor subsidiary's products are Year 2000 compliant.