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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 For the Fiscal Year Ended December 31, 1999
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
For the transition period from to
----------
Commission File No. 0-26456
RISK CAPITAL HOLDINGS, INC.
(Exact name of Registrant as specified in its charter)
Delaware 06-1424716
- - -------------------------------- --------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
20 Horseneck Lane
Greenwich, Connecticut 06830
- - --------------------------------------- --------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (203) 862-4300
Securities registered pursuant to Section 12(b) of the Act:
Name of each Exchange
Title of Each Class on which Registered
------------------- -------------------
None None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.01 per share
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No_______
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
The aggregate market value of the voting stock held by non-affiliates of
the Registrant as of March 27, 2000 was approximately $160,932,207 based on the
closing price on the Nasdaq National Market on that date.
As of March 27, 2000, there were 12,329,398 shares of the Registrant's
Common Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Parts I and II incorporate by reference our definitive proxy statement for
a special meeting of our stockholders relating to the asset sale described in
this annual report. Part III incorporates by reference our definitive proxy
statement for the 2000 annual meeting of stockholders to be filed with the
Securities and Exchange Commission before April 30, 2000.
RISK CAPITAL HOLDINGS, INC.
TABLE OF CONTENTS
Item Page
- - ---- ----
Part I
1. Business................................................................... 1
2. Properties................................................................ 25
3. Legal Proceedings......................................................... 25
4. Submission of Matters to a Vote of Security Holders....................... 25
Part II
5. Market for Registrant's Common Equity and Related Stockholder Matters..... 25
6. Selected Financial Data and Unaudited Pro Forma Condensed Consolidated
Financial Data....................................................... 27
7. Management's Discussion and Analysis of Financial Condition
and Results of Operations............................................ 35
7A.Quantitative and Qualitative Disclosures About Market Risk................ 52
8. Financial Statements and Supplementary Data............................... 52
9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure............................................. 52
Part III
10.Directors and Executive Officers of the Registrant........................ 52
11.Executive Compensation.................................................... 52
12.Security Ownership of Certain Beneficial Owners and Management............ 52
13.Certain Relationships and Related Transactions............................ 53
Part IV
14.Exhibits, Financial Statement Schedules and Reports on Form 8-K........... 53
Cautionary Note Regarding Forward-Looking Statements
The Private Securities Litigation Reform Act of 1995 provides a "safe
harbor" for forward-looking statements. This Form 10-K, our Annual Report to
Stockholders, any proxy statement, any Form 10-Q or any Form 8-K of the company
or any other written or oral statements made by or on behalf of the company may
include forward-looking statements which reflect our current views with respect
to future events and financial performance. All statements other than statements
of historical fact included in or incorporated by reference in this report are
forward-looking statements. Forward-looking statements can generally be
identified by the use of forward-looking terminology such as "may," "will,"
"expect," "intend," "estimate," "anticipate," "believe" or "continue" or their
negative or variations or similar terminology.
Forward-looking statements involve our current assessment of risks and
uncertainties. Actual events and results may differ materially from those
expressed or implied in these statements. Important factors relating to our
existing business that could cause actual events or results to differ materially
from those indicated in such statements are discussed below and elsewhere in
this report and include:
o the acceptance in the market of our reinsurance products;
o competition from new products (including products that may be offered
by the capital markets);
o the availability of investments on attractive terms;
o competition, including increased competition (both as to underwriting
and investment opportunities);
o changes in the performance of the insurance sector of the public
equity markets or market professionals' views as to such sector;
o the amount of underwriting capacity from time to time in the market;
o general economic conditions and conditions specific to the reinsurance
and investment markets in which we operate;
o regulatory changes and conditions;
o rating agency policies and practices;
o claims development, including as to the frequency or severity of
claims and the timing of payments; and
o loss of key personnel.
In addition to risks and uncertainties related to our existing business, the
proposed sale of our reinsurance operations to Folksamerica Reinsurance Company
referred to in this report is subject to various risks and uncertainties
including the risks that the conditions to closing will not be satisfied and
that the costs of the transaction and purchase price and reserve adjustments
will be greater than currently expected with resulting effects on our book
value. These and other risks relating to the proposed asset sale and our
business after the sale are discussed in the "Risk Factors" section of our
definitive proxy statement for the special meeting of our stockholders relating
to the asset sale. The special meeting proxy statement is filed as an exhibit to
this annual report and is incorporated by reference in its entirety.
All subsequent written and oral forward-looking statements attributable to
us or persons acting on our behalf are expressly qualified in their entirety by
these cautionary statements. The foregoing review of important factors should
not be construed as exhaustive and should be read in conjunction with other
cautionary statements that are included herein or elsewhere. We undertake no
obligation to publicly update or revise any forward-looking statement, whether
as a result of new information, future events or otherwise.
(ii)
PART I
ITEM 1. BUSINESS
In this document, "we," "us," "our" and the "company" refer to Risk Capital
Holdings, Inc. and/or Risk Capital Reinsurance Company, as the context requires.
Certain terms used below are defined in the "Glossary of Selected Insurance
Terms" appearing on pages 21-24 of this report.
The Company
We were incorporated in March 1995 under the laws of the State of Delaware
and commenced operations in September 1995 upon completion of our initial public
offering. Through our wholly owned operating subsidiary, Risk Capital
Reinsurance Company ("RCRe"), we provide reinsurance and other forms of capital,
either on a stand-alone basis, or as part of integrated solutions for insurance
companies with capital needs that cannot be met by reinsurance alone. RCRe is
rated "A-" (Excellent) by A.M. Best Company. Following the announcement of the
proposed sale of our reinsurance operations to Folksamerica Reinsurance Company
(see "--Recent Developments" below), A.M. Best announced on January 18, 2000
that it was placing our A- rating under review. At December 31, 1999, RCRe had
statutory surplus of $290.1 million (or $230.1 million after giving pro forma
effect to our recent repurchase of 4,755,000 shares of our common stock from XL
Capital Ltd.). Based upon data available from the Reinsurance Association of
America ("RAA"), RCRe is the 20th largest United States based broker market
oriented reinsurer as measured by its statutory surplus of $230 million.
Our offices are located at 20 Horseneck Lane, Greenwich, Connecticut 06830,
and our telephone number is (203) 862-4300.
Recent Developments
Folksamerica Transaction
As of January 10, 2000, we entered into an agreement with Folksamerica
Reinsurance Company and Folksamerica Holding Company (collectively,
"Folksamerica") pursuant to which Folksamerica Reinsurance Company will assume
RCRe's liabilities under the reinsurance agreements transferred in the asset
sale and RCRe will transfer to Folksamerica Reinsurance Company assets in an
aggregate amount that is, in book value, equal to the book value of the
liabilities assumed. In consideration for the transfer of RCRe's book of
business, Folksamerica will pay $20.335 million in cash at the closing, subject
to adjustment under the circumstances set forth in the asset purchase agreement.
The sale of our reinsurance business to Folksamerica is contingent on
approval by our stockholders, obtaining applicable regulatory approvals, the
retention of a key employee, obtaining certain third party consents, the absence
of a material adverse change in RCRe's business, and other customary closing
conditions. Marsh & McLennan Risk Capital Holdings, Ltd. ("MMRCH") and The
Trident Partnership, L.P. ("Trident"), which collectively represent
approximately 13.3% of the total voting power of our outstanding common stock
(after giving effect to the repurchase of 4,755,000 shares on March 2, 2000 from
XL Capital, which is discussed below), have agreed to vote in favor of the asset
sale.
Detailed information regarding the proposed asset sale can be found in the
sections of our special meeting proxy statement entitled "Questions and Answers
About the Asset Sale," "Risk Factors," "The Asset Sale," "The Asset Purchase
Agreement" and "Other Transaction Agreements," which are incorporated by
reference. In addition, we have filed the asset sale agreement, the voting
agreements and other related agreements as exhibits to this annual report. The
above summary of the proposed transaction is qualified by these agreements,
which are incorporated by reference. Please also refer to "Unaudited Pro Forma
Condensed Consolidated Financial Data" and "Management's Discussion and Analysis
of Financial Condition and Results of Operations."
1
XL Transaction
On March 2, 2000, we repurchased from XL Capital, then our single largest
stockholder, all of the 4,755,000 shares of our common stock held by it. Under
the terms of a stock repurchase agreement with XL Capital, we paid $12.45 per
share of our common stock, or a total of $59.2 million. The per share repurchase
price was determined as the lesser of (1) 85% of the average closing market
price of our common stock during the 20 trading days beginning on the third
business day following public announcement of the stock repurchase and asset
sale (January 21, 2000), which was $14.65, and (2) $15. We paid XL Capital the
consideration for the repurchase with: our interest in privately held LARC
Holdings, Ltd. (parent of Latin American Reinsurance Company Ltd.), valued at
$25 million (which was carried by us at $24 million at December 31, 1999); and
all of our interest in Annuity and Life Re (Holdings), Ltd., valued at $25.38
per share and $18.50 per warrant, or $37.8 million in the aggregate (which was
carried by us at $38.2 million at December 31, 1999). XL Capital paid us in cash
the difference (equal to $3.6 million) between our repurchase price and the
value of our interests in LARC Holdings and Annuity and Life Re. The value per
share of Annuity and Life Re was determined by taking the average of the closing
price of Annuity and Life Re shares for the same period used in determining the
repurchase price of our shares. The value of the warrants was determined using a
Black Scholes methodology. We have filed the stock repurchase agreement and
related voting and disposition agreement as exhibits to this annual report. The
above summary of the transaction is qualified by these agreements, which are
incorporated by reference.
As a result of this transaction, stockholders' equity, which was $346.5
million at December 31, 1999, has been reduced by $59.4 million and the number
of outstanding voting shares, which was 17,087,970 at December 31, 1999, was
12,332,970 at March 2, 2000.
RCRe's statutory surplus, which was $290.1 million at December 31, 1999,
was also reduced by $60 million for the distribution of the stock and warrants
in both LARC Holdings and Annuity and Life Re to us based on their statutory
carrying values at December 31, 1999.
Future Operations
After the sale of our reinsurance operations to Folksamerica is completed,
the company's objective will be to serve as a vehicle to effect business
combinations and ventures, whether by acquiring all or a portion of companies,
merger, exchange of stock or otherwise, with one or more operating companies
that our board of directors believes will have potential to increase stockholder
value. These business combinations and ventures may be with companies that are
not in the insurance business. The company may cease to pursue this business
objective at any time and may also consider alternatives. Please refer to the
section of our special meeting proxy statement entitled "Risk Factors" for a
discussion of certain risks relating to our business after the sale of our
reinsurance operations to Folksamerica Reinsurance Company.
The description of the company's business set forth below provides a
discussion of the company's business to date and, accordingly, does not describe
what we currently intend to be our business strategy following the asset sale.
Reinsurance Underwriting
We have sought to take advantage of underwriting opportunities in
connection with our equity investment activities and, where appropriate, to
provide reinsurance to insurers in which we invest.
We have also sought to write "large lines" (i.e., significant portions) on
a limited number of traditional and finite risk property and casualty
reinsurance treaties with a select number of insurance and reinsurance companies
located throughout the world (although our principal focus has been on large
United States and European-based insurance and reinsurance companies) and with
select Lloyd's syndicates.
We have focused our efforts on treaty reinsurance and have sought to establish
and cultivate long-term relationships with our reinsureds. In addition, we
intend to write conservatively in terms of the company's surplus capacity, which
helps enable us to maintain underwriting capacity and flexibility. At December
31, 1999, and after giving pro forma effect to our recent repurchase of
4,755,000 shares of our common stock from XL Capital, RCRe's premium-to-surplus
ratio was 1.3x, which represents an increase from our prior intention that
RCRe's premium-to-surplus ratio not exceed 1.0x. This increase is due to the
reduction in RCRe's surplus
2
resulting from the XL Capital stock repurchase as
well as from losses due to our poor underwriting performance.
We have agreed to transfer all of our reinsurance business to Folksamerica
Reinsurance Company. In reaching the determination to sell our reinsurance
business, we considered, among other things, the following factors:
o RCRe was incurring losses on its reinsurance business and faced
increasing competition, which has been adversely affecting results of
operations and financial condition;
o RCRe's surplus has decreased, while the surpluses of many of RCRe's
competitors have increased;
o the amount and volatility of our earnings, resulting from our
operating strategy and underwriting performance, severely limits our
ability to incur and service substantial indebtedness, which in turn
limits our ability to increase RCRe's statutory surplus; and
o our depressed stock price, combined with our inability to incur debt
as described above or otherwise use RCRe's cash because of RCRe's
statutory surplus, rating and operating requirements, have prevented
us from making acquisitions, which puts us, like many other small
reinsurance companies, at a severe competitive disadvantage in an
industry that has been experiencing rapid global consolidation.
See "Business--Recent Developments," "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Folksamerica Transaction" and
Note 14 of the accompanying notes to our consolidated financial statements. We
also refer you to the section of our special meeting proxy statement entitled
"Reasons for the Asset Sale and the Name Change; Our Board of Directors
Recommends the Asset Sale," which is incorporated by reference.
Operations
Net premiums written for 1999, 1998 and 1997 were as follows:
Net Premiums Written
(Dollars in millions)
Years Ended December 31,
-----------------------------------------------------------------------------------------
1999 1998 1997
--------------------------- ---------------------------- --------------------------
Amount % Amount % Amount %
----------- ----------- ------------ ----------- ----------- -----------
Property $78.9 25.7% $33.7 14.4% $17.8 12.3%
Casualty 64.1 20.9 80.3 34.2 69.7 48.1
Multi-Line 67.7 22.1 62.8 26.8 45.9 31.7
Other 7.6 2.5 16.5 7.0 10.0 6.9
Accident & Health 50.3 16.4
Aviation & Space 18.4 6.0 26.0 11.1
Marine 14.0 4.6 14.4 6.1 1.4 1.0
Surety & Fidelity 5.7 1.8 1.0 0.4
----------- ----------- ------------ ----------- ----------- -----------
Total $306.7 100.0% $234.7 100.0% $144.8 100.0%
=========== =========== ============ =========== =========== ===========
RCRe's assumed and ceded premiums written for the years ended December 31,
1999, 1998 and 1997 were as follows:
(In millions)
Years Ended December 31, Years
---------------------------------------------------------------------
1999 1998 1997
---------------------- ------------------ ---------------------
Assumed premiums written $386.8 $260.5 $147.8
Ceded premiums written 80.1 25.8 3.0
---------------------- ------------------ ---------------------
Net premiums written $306.7 $234.7 $144.8
====================== ================== =====================
3
We expanded our reinsurance business into marine and aviation and space
underwriting in 1997, surety and fidelity underwriting in 1998, and accident and
health underwriting in 1999. During 1999, we discontinued our aviation and space
lines of business.
RCRe's net premiums written increased 31% to $306.7 million in 1999 from
$234.7 million in 1998 and 62% to $234.7 million in 1998 from $144.8 million in
1997. Premium growth resulted from two key strategies, the integration of
investment with reinsurance and the diversification into "specialty" classes of
business, which for purposes of this discussion consist of accident and health,
aviation and space, marine and surety and fidelity.
Approximately 30%, 32% and 29% of net premiums written in 1999, 1998 and
1997, respectively, were generated from companies in which we have invested or
committed to invest funds ("integrated transactions").
Approximately 29%, 18% and 1% of net premiums written in 1999, 1998 and
1997, respectively, were produced from specialty classes of business. Specialty
classes of business accounted for 65% and 44% of the increase in net premiums
written for 1999 and 1998, respectively.
Approximately 15%, 32% and 28% of net premiums written in 1999, 1998 and
1997, respectively, were from non-United States clients, which are Lloyd's
syndicates or are located in the United Kingdom, Bermuda and Continental Europe.
Reinsurance is provided by RCRe both on a quota share and excess of loss
basis. In 1999, quota share reinsurance and excess of loss reinsurance amounted
to 93% and 7%, respectively, of the Company's net premiums written, compared to
(1) 81% and 19%, respectively, during 1998 and (2) 71% and 29%, respectively,
during 1997. The mix of quota share and excess of loss reinsurance depends on
market conditions and other relevant factors and cannot be predicted with
accuracy. Depending on future conditions, prior to the asset sale, we may also
write other types of reinsurance.
Net premiums written in 1999 include approximately $26 million related to a
group of property reinsurance treaties that expired in 1999 covering crop hail
business underwritten on behalf of a start-up entity formed by Trident II, L.P.
This business was protected by extensive aggregate excess of loss retrocession
and generated a profit based upon underwriting results. We do not expect to
renew these treaties in 2000.
Net premiums written in 1999 for other business was reduced by $10.6
million for the retrocession of a treaty which covers future multiple rocket
launches that was recorded in 1996. The reduction of net premiums written
resulting from this retrocession increased the commission and operating expense
ratio components of the statutory composite ratio by 1.1 percentage points, but
had no impact on operating results.
Consistent with our strategy of writing a small number of large treaties
for our core business, two clients contributed approximately $81.3 million, or
26.5%, of 1999 total net premiums written, with the largest client contributing
approximately 13.7% and the second contributing 12.8%. Approximately 70% of the
business written from the client that contributed 13.7% and all of the business
written from the client that contributed 12.8% are part of an integrated
transaction, and such business is subject to renewal at our option for two and
four remaining years, respectively.
In 1998, three clients contributed approximately $74 million, or 32%, of
1998 total net premiums written, with the largest client contributing
approximately 18% and the remaining two contributing 8% and 6%, respectively. In
1997, five clients contributed approximately $68 million, or 45%, of total net
premiums written, with the largest client contributing approximately 18% and the
remaining four contributing from 5% to 8%.
RCRe's ceded premiums increased to $80.1 million in 1999, compared to $25.8
million in 1998 and $3.0 million in 1997. Such ceded premiums primarily relate
to RCRe's property, multi-line, marine, aviation and space reinsurance business,
for which we seek to reduce RCRe's exposure to large and catastrophic losses.
Since the fourth quarter of 1998, we have purchased additional retrocessional
protection to reduce RCRe's exposures to both space and aviation risks.
Effective July 1, 1999, RCRe also purchased a retrocessional treaty for a one
year period covering earthquake, wind and other property catastrophe perils for
$10 million in excess of a $15 million retention per occurrence.
For a discussion of our in-force business at January 1, 2000, please refer
to "Management's Discussion and Analysis of Financial Condition and Results of
Operations--General--In-Force Business."
4
Investments
Our investment goals have been to support RCRe's reinsurance activities and
enhance our long-term profitability. The principal components of our strategy to
achieve these goals include: (1) supporting short-term liquidity requirements
through cash and fixed income investments and, if necessary, through the sale of
marketable equity securities from the company's investment portfolio; (2)
investing a significant portion of our assets in publicly traded and privately
held equity securities issued by insurance and reinsurance companies and
companies providing services to the insurance industry; (3) identifying trends
and investment opportunities in the insurance industry that could lead to
superior returns; (4) utilizing Marsh & McLennan Capital, Inc. ("MMCI"), an
experienced insurance industry advisor, as equity investment advisor; (5)
investing in insurers to which RCRe provides reinsurance, where appropriate; and
(6) when available, co-investing with Trident, a dedicated insurance industry
private equity fund, and an entity to which MMCI also provides equity investment
advisory services.
We have an investment advisory agreement with MMCI for management of our
portfolios of equity securities (including convertible securities) that are
publicly traded ("Public Portfolio") and privately held ("Private Portfolio").
The Private Portfolio includes equity securities which do not have a readily
ascertainable market or are subject to certain trading restrictions.
Effective July 1, 1999, we amended our investment advisory agreement with
MMCI, which governs the management of our portfolios of equity securities
(including convertible securities) that are publicly traded and privately held.
Pursuant to the amended agreement, which has a term of four years (subject
to renewal), MMCI provides us with investment management and advisory services
with respect to investments in the Private Portfolio whose value exceeds (i) $10
million during the first year of the term, (ii) $15 million during the second
year of the term, and (iii) $20 million during the third and fourth years of the
term. Under the agreement, we pay MMCI an annual fee equal to (x) 20%
(previously 7.5%) of cumulative net realized gains including dividends, interest
and other distributions, received on the Private Portfolio over (y) cumulative
compensation previously paid in prior years on cumulative net realized gains (as
defined in the agreement) on the Private Portfolio managed by MMCI, but we will
not pay MMCI a management fee (previously 1.5% per annum of the quarterly
carrying value of the Private Portfolio). With respect to the management of our
Public Portfolio, we pay MMCI a fee equal to 0.50% of the first $50 million
under MMCI's management and 0.35% of all amounts in excess of $50 million,
subject to a minimum fee of $250,000 per annum (previously 0.35% for the entire
Public Portfolio).
In connection with the amendments to our agreement with MMCI, we will
receive from MMCI $1.25 million per annum during the initial four-year term,
subject to certain conditions. The initial agreement provided for a minimum
aggregate cash fee to MMCI of $500,000 per annum through December 31, 1997. Fees
incurred under the agreements during fiscal years 1999, 1998 and 1997 were
approximately $1.5 million, $2.7 million and $1.3 million, respectively. In
addition, in 1999, 1998 and 1997, unrealized appreciation in the Private
Portfolio is net of accrued fees of approximately $256,000, $2.2 million and
$1.4 million, respectively.
In May 1999, we transferred the management of the fixed income and
short-term cash portfolios from The Putnam Advisory Company, Inc. ("Putnam") to
Alliance Capital. Previously, we had an investment advisory agreement with
Putnam, an affiliate of MMCI, for the management of our fixed income securities
and short-term cash portfolios through April 1999. For the fixed income
securities portfolio, we paid to Putnam a fee equal to the sum of 0.35% per
annum of the first $50 million of the market value of the portfolio, 0.30% per
annum on the next $50.0 million, 0.20% per annum on the next $100 million and
0.15% per annum of the market value of assets that exceeded $200 million. For
the short-term cash portfolio, we paid a fee equal to 0.15% per annum of the
total monthly average market value. Fees incurred under the Putnam agreement for
the period in 1999, 1998 and 1997 were approximately $173,000, $461,000 and
$493,000, respectively.
MMCI serves as investment manager to Trident and, accordingly, certain
restrictions exist with respect to MMCI's ability to make investment
recommendations to us with respect to investments which would be suitable for
both Trident and us. Under the Trident partnership agreement, until the earlier
of May 6, 2000 or the date on which at least 75% of the aggregate capital of
Trident has been drawn, neither MMCI nor any of its
5
affiliates may organize, or invest in, any new or existing risk assumption
entity unless Trident is first offered a reasonable opportunity to invest in
such entity. These restrictions may also apply to us. This limitation, however,
does not apply to investments in any such new entity where the total invested
capital of such entity does not exceed $10,000,000.
Pursuant to the Trident partnership agreement, where Trident has elected to
make part, but not all, of the full investment otherwise available to it, we may
not be offered the opportunity to participate in such investment unless Trident
first offers at least all Trident partners with capital commitments of at least
$50,000,000 the right to participate in such additional investment on a pro rata
basis. Pursuant to the terms of our equity advisory agreement, MMCI has agreed
that it will not invest in such opportunities, and will not offer any such
opportunities to its affiliates, without first offering us an opportunity to
make such investments.
Fixed income investments are used to provide shorter-term liquidity and
current returns. The fixed income securities portfolio generally is invested in
high quality, liquid securities, including securities issued by United States
government agencies and United States government guaranteed securities.
In addition, we allocated in early 1998 approximately $35,000,000 for
investment in a diversified portfolio of high yielding below investment grade
fixed maturity investments managed by Miller Anderson & Sherrerd, LLP, a
subsidiary of Morgan Stanley & Co. Such amount was taken from funds that were
previously allocated for investing in short-term securities. Miller Anderson
manages the portfolio subject to investment guidelines established by the
Investment/Finance Committee of our board of directors. At December 31, 1999,
our high yield portfolio included approximately $37.6 million of such
securities.
Since a significant portion of our investment portfolio is currently
comprised of equity securities issued by insurance and reinsurance companies and
companies providing services to the insurance industry, the portfolio lacks
industry diversification and is particularly subject to the performance of the
insurance industry. Such performance will affect the market prices of a
significant portion of our investment portfolio and the income and return on
such investments, all of which could negatively affect our underwriting
capacity. As our current investment strategy is to invest a significant portion
of its investment portfolio in equity securities, our investment income in any
fiscal period may be smaller, as a percentage of investments, and less
predictable than other competitor reinsurance companies, which tend to invest
primarily in fixed income investments. Net realized and unrealized gains (or
losses) on investments may have a greater effect on our results of operations or
stockholders' equity at the end of any fiscal period than on those of our
competitor reinsurance companies.
After the sale of our reinsurance operations to Folksamerica is completed,
the company's objective will be to serve as a vehicle to effect business
combinations and ventures, whether by acquiring all or a portion of companies,
merger, exchange of stock or otherwise, with one or more operating companies
that our board of directors believes will have potential to increase stockholder
value. These business combinations and ventures may be with companies that are
not in the insurance business. We refer you to the section of our special
meeting proxy statement entitled "Risk Factors," which is incorporated by
reference, for a discussion of certain risks relating to our business after the
sale of our reinsurance operations to Folksamerica Reinsurance Company.
Operations
At December 31, 1999, cash and invested assets totaled approximately $585.9
million, consisting of $82.2 million of cash and short-term investments, $261.1
million of publicly traded fixed maturity investments, $158.6 million of
publicly traded equity securities and $84.0 million of privately held
securities.
The components of net investment income for the years ended December 31,
1999, 1998 and 1997 are summarized in a table found in Note 3 under the caption
"Investment Information" of the accompanying notes to our consolidated financial
statements.
6
Our investments on a consolidated basis at December 31, 1999, 1998 and 1997
consisted of the following:
(Dollars in thousands)
December 31,
---------------------------------------------------------------------------------------------------
1999 1998 1997
------------------------------ ------------------------------- ------------------------------
Estimated Estimated Estimated
Fair Value Percent Fair Value Percent Fair Value Percent
---------- ------- ---------- ------- ---------- -------
Cash and short-term $ 82,242 14% $120,846 20% $ 98,181 19%
-------- -- -------- -- -------- --
Fixed maturities:
U.S. government and
government agencies 41,095 7 39,283 6 44,135 9
Municipal bonds 52,245 9 45,273 8 37,637 7
Corporate bonds 136,838 23 56,256 10 19,323 4
Mortgage and asset-
backed securities 27,298 5 33,532 6 30,487 6
Foreign governments 3,591 1 196 - 577 -
----- - --- -- --- --
Sub-total, fixed
maturities 261,067 45 174,540 30 132,159 26
Equity securities:
Publicly traded 158,631 27 154,678 27 180,052 36
Privately held 83,969 14 137,091 23 95,336 19
------ -- ------- -- ------ --
Sub-total, equity
securities 242,600 41 291,769 50 275,388 55
------- -- ------- -- ------- --
Total $585,909 100% $587,155 100% $505,728 100%
======== === ======== === ======== ===
Our current investment guidelines restrict the portion of our fixed
maturities portfolio that can be held in lower quality securities. At December
31, 1999, 88% of the fixed maturity and short-term investments were rated
investment grade by Moody's Investors Service, Inc. or Standard & Poor's
Corporation and had an average quality rating of AA and an average duration of
approximately 3.7 years.
Contractual maturities of our consolidated fixed maturity securities are
shown below. Expected maturities, which are our best estimates, will differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties.
(In thousands)
December 31, 1999
-----------------
Estimated Amortized
Fair Value Cost
---------- ----
Available for sale:
Due in one year or less $10,210 $10,237
Due after one year through five years 68,182 69,956
Due after five years through 10 years 78,461 82,282
Due after 10 years 76,916 79,446
------ ------
Sub-total 233,769 241,921
Mortgage and asset-backed securities 27,298 28,424
------ ------
Total $261,067 $270,345
======== ========
At December 31, 1999, our investment portfolio included $158.6 million of
publicly traded equity securities and 12 investments in privately held
securities totaling $84.0 million, with additional investment portfolio
commitments in an aggregate amount of $23.2 million. At this date, all of our
equity investments were in securities issued by insurance and reinsurance
companies or companies providing services to the insurance industry.
7
Please refer to Note 3 under the caption "Investment Information" of the
accompanying Notes to our consolidated financial statements for information
regarding our publicly traded and privately held securities and their carrying
values, and commitments made by us relating to our privately held securities.
We have not invested in derivative financial instruments such as futures,
forward contracts, swaps, or options or other financial instruments with similar
characteristics such as interest rate caps or floors and fixed-rate loan
commitments. Our portfolio includes market sensitive instruments, such as
mortgage-backed securities, which are subject to prepayment risk and changes in
market value in connection with changes in interest rates. Our investments in
mortgage-backed securities are classified as available for sale and are not held
for trading purposes. These investments amounted to approximately $27.3 million,
or 4.7% of cash and invested assets at December 31, 1999, $33.5 million, or 6%
of cash and invested assets at December 31, 1998, and $30.5 million, or 6% of
cash and invested assets at December 31, 1997.
Marketing
RCRe has obtained substantially all of its reinsurance business through
intermediaries representing the cedent in negotiations for the purchase of
reinsurance. The process of effecting a brokered reinsurance placement typically
begins when a cedent enlists the aid of an intermediary in structuring a
reinsurance program. Often the intermediary will consult with one or more lead
reinsurers as to the pricing and contract terms of the reinsurance protection
being sought. Once the cedent has approved the terms quoted by the lead
reinsurer, the intermediary offers participation to qualified reinsurers until
the program is fully subscribed to by reinsurers on terms agreed upon by all
parties.
By working through intermediaries to originate business, we have avoided
maintaining a substantial sales organization. In addition, we believe that
submissions from the intermediary market are more numerous and diverse,
including certain targeted specialty coverages, than would be available through
a salaried sales organization and that we are able to exercise greater
selectivity than would be possible in dealing directly with cedents.
RCRe pays commissions to intermediaries based on negotiated percentages of
the premiums it writes. Direct writers of reinsurance typically incur higher
fixed costs that are included in their underwriting expenses. Reinsurers using
intermediaries can lower these costs during a downturn in the market by writing
less business and incurring lower brokerage costs. Intermediaries do not
generally have the authority to bind RCRe with respect to reinsurance agreements
nor does RCRe generally commit in advance to accept any portion of the business
that intermediaries submit to it. Reinsurance business from any cedent, whether
new or renewal, is generally subject to acceptance by RCRe.
In 1999, (1) affiliates of Marsh & McLennan, including Balis & Co., Inc.,
Guy Carpenter & Company, Inc., Carpenter Bowring Ltd. and Cecar & Jutheau, S.A.
(collectively, "Marsh Affiliates"), (2) the Aon Group and (3) E.W. Blanch
Company accounted for approximately 33.1%, 17.4% and 5.7%, respectively, of
RCRe's assumed net premiums written. In 1998, (1) Marsh Affiliates, (2) Aon and
(3) E.W. Blanch accounted for approximately 43.2%, 16.5% and 10.9%,
respectively, of RCRe's assumed net premiums written. In 1997, (1) Marsh
Affiliates, (2) Aon and (3) E.W. Blanch accounted for approximately 47.3%,
19.1%, and 9.3%, respectively, of RCRe's assumed net premiums written. Loss of
all or a substantial portion of the business provided by any of these
intermediaries could have a short-term material adverse effect on the business
and operations of RCRe. We do not believe that the loss of such business would
have a long-term material adverse effect due to RCRe's competitive position
within the broker reinsurance market and the availability of business from other
intermediaries. The terms relating to RCRe's intermediary arrangements with
Marsh Affiliates have been negotiated on an arm's-length basis.
In addition to investment opportunities arising from the activities of MMCI
as our equity investment advisor, we are provided with investment opportunities
by reinsurance brokers and traditional financing sources, including investment
banking firms, venture capital firms and other banking and financing sources,
both acting as principal investors and intermediaries. Underwriting
opportunities may arise from such sources in connection with our investment
activities as part of integrated transactions.
Retrocessional Arrangements
Reinsurance companies enter into retrocessional arrangements for many of
the same reasons primary insurers seek reinsurance, including reducing the
effect of individual or aggregate losses and increasing
8
premium writing and risk capacity without requiring additional capital.
Retrocessional arrangements do not relieve RCRe from its obligations to the
insurers and reinsurers from which it assumes business. The failure of
retrocessionaires to honor their obligations could result in losses to RCRe.
RCRe utilizes retrocession agreements for the purpose of limiting its
exposure with respect to multiple claims arising from a single occurrence or
event. RCRe also participates in "common account" retrocessional arrangements
for certain reinsurance treaties, which are arrangements whereby the ceding
company purchases a cover for the benefit of the ceding company and the
reinsurers on the reinsurance treaty. Common account retrocessional arrangements
reduce the effect of individual or aggregate losses to all participating
companies with respect to a reinsurance treaty, including the cedent.
All retrocessionaires must conform to RCRe's standards and must be
specifically approved by RCRe's Security Committee, which consists of four
members of senior management, including the President. Business may not be
conducted with retrocessionaires that are not approved by the Security
Committee.
For additional information on our retrocessional arrangements and risk
management policies, please refer to "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Results of Operations--Net
Premiums Written," "--Aviation Business" and "--Risk Retention" and Note 7 of
the accompanying notes to our consolidated financial statements.
We continue to evaluate RCRe's retrocessional requirements periodically in
relation to many factors, including its surplus, gross line capacity and
changing market conditions.
Claims Administration
Claims are managed by our professional claims staff whose responsibilities
include the review of initial loss reports, creation of claim files,
determination of whether further investigation is required, establishment and
adjustment of case reserves and payment of claims. In addition, our claims staff
conducts comprehensive claims audits of both specific claims and overall claims
procedures at the offices of selected ceding companies. In certain instances, as
part of a comprehensive risk evaluation process, a claims audit may be performed
prior to assuming reinsurance business or entering into an investment
transaction.
Reserves for Unpaid Claims and Claims Expenses
As a reinsurance company, RCRe is required to establish and maintain
reserves to cover its estimated ultimate liability for unpaid claims and claims
expenses with respect to reported and unreported claims incurred as of the end
of each accounting period (net of estimated related salvage and subrogation
claims and retrocession recoverables (if any) of RCRe). These reserves are
estimates involving actuarial and statistical projections at a given time of
what RCRe expects the ultimate settlement and administration of claims to cost
based on facts and circumstances then known, predictions of future events,
estimates of future trends in claims severity and other variable factors such as
inflation and new concepts of liability. For certain types of claims, it may
over time be necessary to revise estimated potential loss exposure and therefore
RCRe's unpaid claims and claims expense reserves. The inherent uncertainties of
estimating claims and claims expense reserves are exacerbated for reinsurers by
the significant periods of time (the "tail") that often elapse between the
occurrence of an insured claim, the reporting of the claim to the primary
insurer and ultimately to the reinsurer, and the primary insurer's payment of
that claim and subsequent indemnification by the reinsurer. As a consequence,
actual claims and claims expenses paid may deviate, perhaps substantially, from
estimates reflected in RCRe's reserves in its financial statements. The
estimation of reserves by new reinsurers, such as RCRe, may be less reliable
than the reserve estimations of a reinsurer with an established volume of
business and loss history. To the extent reserves prove to be inadequate, RCRe
may have to augment such reserves and incur a charge to earnings. Such a
development could result in a material charge to earnings or stockholders'
equity in future periods.
When a claim is reported to an insurance company that cedes business to
RCRe, its claims personnel establish a "case reserve" for the estimated amount
of the ultimate payment. The estimate reflects the informed judgment of such
personnel based on general insurance reserving practices and on the experience
and knowledge of such personnel regarding the nature and value of the specific
type of claim. RCRe, in turn, typically establishes a case reserve when it
receives a notice of a claim from the ceding company. Such reserves are based on
an independent evaluation by RCRe, taking into consideration coverage,
liability, severity of injury or damage, jurisdiction, RCRe's assessment of the
ceding company's ability to evaluate and handle the
9
claim and the amount of reserves recommended by the ceding company. Case
reserves are adjusted periodically by RCRe based on subsequent developments and
audits of ceding companies.
In accordance with industry practice, RCRe maintains incurred but not
reported ("IBNR") reserves. These reserves are established to provide for future
case reserves and loss payments on incurred claims which have not yet been
reported to an insurer or reinsurer. In calculating its IBNR reserves, RCRe uses
generally accepted actuarial reserving techniques that take into account
quantitative loss experience data, together, where appropriate, with qualitative
factors. IBNR reserves are based on loss experience of RCRe and the industry,
and are grouped both by class of business and by accident year. IBNR reserves
are also adjusted to take into account certain factors such as changes in the
volume of business written, reinsurance contract terms and conditions, the mix
of business, claims processing and inflation that can be expected to affect
RCRe's liability for losses over time.
The reconciliation of claims and claims expense reserves for the years
ended December 31, 1999, 1998 and 1997 is as follows:
(In thousands)
Years Ended
December 31,
-----------------------------------------------------------
1999 1998 1997
---- ---- ----
At beginning of year:
Gross claims and claims expense reserves $216,657 $70,768 $20,770
Reinsurance recoverables 30,468 _____ 522
------ -------
Net claims and claims expense reserves 186,189 70,768 20,248
Net claims and claims expenses incurred relating to:
Current year $275,455 178,957 73,385
Prior year 30,386 (2,832) 22
------ ------- -------
Total 305,841 176,125 73,407
Net paid claims and claims expenses incurred relating to:
Current year 95,367 41,910 13,649
Prior year 88,034 18,794 9,238
------ ------ -------
Total 183,401 60,704 22,887
At end of year:
Net claims and claims expense reserves current year 308,629 186,189 70,768
Reinsurance recoverables 55,925 30,468 _____
------ ------
Gross claims and claims expense reserves $364,554 $216,657 $70,768
-------- -------- -------
RCRe believes that its exposure, if any, to environmental impairment
liability and asbestos-related claims is minimal since it did not write business
prior to 1996.
RCRe does not currently discount its reserves to reflect the present value
of claims that may eventually be paid.
Subject to the foregoing, we believe that the reserves for claims and
claims expenses are adequate to cover the ultimate cost of claims and claims
expenses incurred through December 31, 1999. The estimates will be continuously
reviewed and as adjustments to these reserves become necessary, these
adjustments will be reflected in current operations.
Estimates of prior accident year claims were increased by approximately $30
million in 1999. A substantial portion of this amount resulted from (1) our
review of additional claims information and our continuing underwriting and
actuarial analysis of the business produced by a certain managing underwriting
agency, (2) notification of additional satellite losses received in 1999
pertaining to 1998, (3) aviation losses, principally the 1998 Swiss Air crash,
and (4) property losses reported on several international treaties that are in
run-off.
Estimates of prior accident year claims were reduced by approximately $2.8
million in 1998 primarily due to favorable claims development in the property
and multi-line classes of business.
The following table represents the development of generally accepted
accounting principles ("GAAP") balance sheet reserves for 1996 through 1999. The
top line of the table shows the reserves, net of reinsurance
recoverables, at the balance sheet date for each of the indicated years. This
represents the estimated amounts of net claims and claims expenses arising in
all prior years that are unpaid at the balance sheet date, including IBNR. The
table also shows the reestimated amount of the previously recorded reserve based
on experience as of the end of each succeeding year. The estimate changes as
more information becomes known about the frequency and severity of claims for
individual years. The "cumulative redundancy (deficiency)" represents the
aggregate change in the estimates over all prior years. The table also shows the
cumulative amounts paid as of successive years with respect to that reserve
liability. The lower portion of the table represents the claim development of
the gross balance sheet reserves for 1996 through 1999.
With respect to the information in the table below, it should be noted that
each amount includes the effects of all changes in amounts for prior periods.
This table does not present accident or policy year development data. Conditions
and trends that have affected development of the liability in the past may not
necessarily occur in the future. Accordingly, it may not be appropriate to
extrapolate future reserve development based on the following table. For
additional information on RCRe's reserving and retrocessional activities, please
refer to "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Results of Operations--Risk Retention,"
"Business--Retrocessional Arrangements" and Notes 6 and 7 of the accompanying
notes to our consolidated financial statements.
Development of GAAP Reserves
Cumulative Redundancy (Deficiency)
(in millions)
Years Ended December 31,
-----------------------------------------------------------
1996 1997 1998 1999
---------- ----------- ------------- -----------
Reserves for unpaid claims and claims adjustment
expenses, net of reinsurance recoverables $20 $71 $186 $309
Paid (cumulative) as of:
One year later 9 19 88
Two years later 10 33
Three years later 12
Reserve reestimated as of:
One year later 20 68 216
Two years later 19 65
Three years later 18
Cumulative redundancy (deficiency) $2 $6 ($30)
========== =========== =============
Percentage 10.0% 8.5% (16.1)%
Gross reserve for claims and claims expenses $20 $71 $216 $365
Reinsurance recoverable 0 0 (30) (56)
---------- ----------- --------- ---------
Net reserve for claims and claims expenses $20 $71 $186 $309
---------- ----------- --------- ---------
Gross reestimated reserve $18 $65 $246
Reestimated reinsurance recoverable 0 0 (30)
---------- ------------ ---------
Net reestimated reserve $18 $65 $216
Gross reestimated redundancy (deficiency) $2 $6 ($30)
---------- ----------- ---------
Overview of the Reinsurance Industry
Reinsurance is a form of insurance in which a reinsurer indemnifies a
primary insurer against part or all of the liability assumed by the primary
insurer under one or more insurance policies. Reinsurance is a contractual
11
agreement whereby an insurer or reinsurer (ceding company) remits a portion of
the premium it receives to a reinsurer (assuming company) as payment for the
assuming company's agreement to indemnify the ceding company for a portion of
the risk. Reinsurance provides insurers with several benefits which include the
following: reduction in net liability on individual risks, protection against
catastrophic losses and assistance in maintaining acceptable regulatory ratios
and additional underwriting capacity in that the primary insurer can accept
larger risks and can expand the book of business it writes at a faster rate than
would be possible without a corresponding increase in its capital and surplus
position. Reinsurance does not legally discharge the ceding company from its
liability with respect to its obligation to the insured.
There are two principal types of reinsurance: treaty reinsurance and
facultative reinsurance. Treaty reinsurance is a contractual arrangement,
usually renewable annually, between a primary insurer and a reinsurer under
which the primary insurer must cede and the reinsurer must assume a specified
portion of a type or category of risks. Facultative reinsurance is the
reinsurance of individual risks. Rather than agreeing to reinsure all or a
portion of a class of risk, the reinsurer separately rates and underwrites each
risk. In the underwriting of treaty reinsurance, the reinsurer need not
separately evaluate each of the individual risks assumed, as it must in the
underwriting of facultative reinsurance, and in general depends on the original
underwriting decisions made by the reinsured.
Both facultative and treaty reinsurance can be written on both an excess of
loss and a quota share basis. In quota share reinsurance, the reinsurer assumes
from the reinsured a percentage specified in the treaty of each risk in the
reinsured class of risk. Premiums that the reinsured pays to the reinsurer are
proportional to the portion of the risk that the reinsurer assumes, and the
reinsurer generally pays the reinsured a ceding commission to reimburse the
reinsured for the expenses incurred in obtaining the business (e.g.,
commissions, premium taxes, assessments and miscellaneous administrative
expenses). The ceding commission may also contain a profit component. In quota
share reinsurance, the reinsurer may receive the benefit of common account
reinsurance and, therefore, the reinsurer will have credit risk with respect to
the underlying reinsurers providing such common account reinsurance. In excess
of loss treaty reinsurance, the reinsurer indemnifies the reinsured for a
portion of the losses on underlying policies which exceed a specified loss
retention amount up to an amount per loss specified in the treaty. Premiums that
the reinsured pays to the reinsurer for excess of loss coverage are not directly
proportional to the premiums that the reinsured receives because the reinsurer
does not assume a proportionate risk. The reinsurer generally does not pay any
commission to the reinsured in connection with excess of loss reinsurance.
Excess of loss treaty reinsurance can, in turn, be written on a per risk or
catastrophe basis. Per risk excess of loss reinsurance protects the reinsured
against a loss resulting from a single risk or location. Catastrophe excess of
loss reinsurance protects a reinsured from an accumulation or large number of
related losses resulting from a variety of risks which may occur in a given
catastrophe and hence is a highly volatile business.
Excess of loss reinsurance is often written in layers, with one reinsurer
taking the risk from the primary insurer's retention layer up to a specified
amount, at which point another reinsurer assumes the excess liability or the
excess liability reverts back to the primary insurer. The reinsurer taking on
the risk just above the primary insurer's retention layer is said to write
"working" or "low layer" excess of loss reinsurance. A loss that reaches just
beyond the primary insurer's retention layer will create a loss for the lower
layer reinsurer, but not for the reinsurers on higher layers. Losses incurred in
low layer reinsurance tend to be more predictable than those in high layers due
to the greater availability of actuarial data.
Since facultative reinsurance, unlike treaty reinsurance, usually involves
the assumption of selected, individual risks and is sold in separate
transactions, facultative reinsurance typically generates higher profit margins
than treaty business. However, the reinsurer's losses may be higher for
facultative business because the reinsurer may assume a higher potential
liability and because the risks involved may be more volatile. In addition,
underwriting expenses and, in particular, personnel costs, are higher on
facultative business because each risk is individually underwritten and
administered. Facultative reinsurance is normally purchased by insurance
companies for individual risks not covered by their reinsurance treaties, for
excess losses on risks covered by their reinsurance treaties, and for unusual
risks. The demand for facultative reinsurance is typically inversely related to
the supply of treaty reinsurance.
Reinsurers may also purchase reinsurance, known as retrocessional
reinsurance, to cover their own risk exposure. Reinsurance companies enter into
retrocessional agreements for reasons similar to those that cause ceding
companies to purchase reinsurance.
12
The reinsurance market has two basic segments: reinsurers which primarily
obtain their business directly from insurers and other reinsurers ("direct
writers"), and those which, like RCRe, primarily obtain business through
reinsurance intermediaries or brokers.
Please see "Management's Discussion and Analysis of Financial Condition and
Results of Operations--General--Recent Industry Performance."
Competition
The property and casualty reinsurance business is highly competitive.
Competition is based on many factors, including the perceived overall financial
strength of the reinsurer, premiums charged, contract terms and conditions,
services offered, ratings assigned by independent rating agencies, speed of
claims payment and reputation and experience. In pursuing our investment
strategy, we have also competed with venture capitalists, buyout funds, merchant
banking firms, investment banking firms and other banking and financing sources
for investment opportunities in publicly traded and privately held equity
securities. Competition is based on many factors, including the ability to
identify trends and investment opportunities that could lead to superior
returns, financial and personnel resources of the investor, the ability to
negotiate investment terms effectively, and the ability of the investor to
provide expertise and advice to companies targeted for investment.
We compete in the United States and international reinsurance markets and,
in the United States markets, we compete with both United States and
internationally domiciled reinsurers. Our competitors include independent
reinsurance companies, subsidiaries or affiliates of established worldwide
insurance companies, reinsurance departments of certain primary insurance
companies and domestic and international underwriting syndicates, many of which
have substantially greater financial resources than we do. Competitors include
direct writers and those that, like RCRe, write primarily through reinsurance
intermediaries.
Significant competitors of RCRe in the direct market include American
Re-Insurance Company, Employers Reinsurance Corporation, General Reinsurance
Corporation and Swiss Reinsurance Company. Significant competitors of RCRe in
the intermediary/broker market include Everest Reinsurance Company, GE Capital
Reinsurance Company, Gerling Global Reinsurance Corporation of America, NAC
Reinsurance Company, Odyssey Reinsurance Corporation, PartnerRe Ltd., PMA
Reinsurance Corporation, The St. Paul Companies, Inc., Transatlantic Reinsurance
Company, Trenwick America Reinsurance Corporation, Underwriters Reinsurance
Company and Zurich Re North America. In addition, we compete with Lloyd's
syndicates and certain companies operating in the London reinsurance market.
We also face competition from other market participants that determine to
devote greater amounts of capital to the types of business written by us. We may
also compete with new market entrants, including possibly other companies
organized by (or that may, in the future, be organized by) certain of our
initial investors, including MMRCH and Trident, their affiliates or entities
that they advise or in which such initial investors, their affiliates or
entities in which they advise, have (or may, in the future, have) significant
investments. In addition, affiliates of MMCI engage in activities in support of
their ongoing business strategies, which activities may compete with our
activities.
We believe that the reinsurance industry is consolidating, and the largest
reinsurers are writing a larger proportion of total industry premiums as ceding
companies place increasing importance on size and financial strength in the
selection of reinsurers. Please see "Management's Discussion and Analysis of
Financial Condition and Results of Operations--General--Recent Industry
Performance."
We have been unable to make acquisitions because of (1) our depressed stock
price, (2) our inability to use RCRe's cash due to RCRe's statutory surplus,
rating and operating requirements and (3) our inability to incur debt due to the
amount and volatility of our earnings. This has put us, like many other small
reinsurance companies, at a severe competitive disadvantage in the rapidly
consolidating reinsurance industry. We have also been facing increasing
competition, which has been adversely affecting our results of operations and
financial condition. These are some of the factors that led us to the proposed
sale of our reinsurance operations to Folksamerica. We refer you to the section
of our special meeting proxy statement entitled "Reasons for the Asset Sale and
the Name Change; Our Board of Directors Recommends the Asset Sale," which is
incorporated by reference.
Insurance ratings are used by insurers and reinsurance intermediaries as an
important means of assessing the financial strength and quality of reinsurers.
In addition, a ceding company's own rating may be adversely
13
affected by the lack of a rating of its reinsurer. A.M. Best is generally
considered to be a significant rating agency with respect to the evaluation of
insurance and reinsurance companies. A.M. Best's ratings reflect their
independent opinion of the financial strength, operating performance and market
profile of an insurer relative to standards established by A.M. Best, and are
not a warranty of an insurer's current or future ability to meet its obligations
to policyholders. In May 1999, A.M. Best Company revised its rating of RCRe from
A (Excellent) to A- (Excellent). While several factors were identified, the
rating action principally reflected the poor underwriting results reported by
RCRe in late 1998 and the first quarter of 1999 on its satellite book of
business and the business produced by a certain managing underwriting agency.
Following the announcement of the proposed sale of our reinsurance operations to
Folksamerica Reinsurance Company, A.M. Best announced on January 18, 2000 that
it was placing our rating under review. The ratings actions taken by A.M. Best
have decreased RCRe's ability to compete in the reinsurance markets in which it
operates. See "Business--Recent Developments," "Management's Discussion and
Analysis of Financial Condition and Results of Operations--General--Folksamerica
Transaction" and Note 14 of the accompanying notes to our consolidated financial
statements.
Insurance Regulation
General
The terms and conditions of reinsurance agreements generally are not
subject to regulation by any governmental authority with respect to rates or
policy terms. This contrasts with primary insurance policies and agreements, the
rates and terms of which generally are closely regulated by state insurance
regulators. As a practical matter, however, the rates charged by primary
insurers do have an effect on the rates that can be charged by reinsurers.
State Regulation
RCRe, in common with other insurers, is subject to extensive governmental
regulation and supervision in the various states and jurisdictions in which it
transacts business. The laws and regulations of the State of Nebraska, the
domicile of RCRe, have the most significant impact on its operations. This
regulation and supervision is designed to protect policyholders rather than
investors and relates to, among other things, the standards of solvency which
must be met and maintained, the nature of and limitations on investments,
restrictions on the size of risk which may be insured under a single policy, and
reserves and provisions for unearned premiums, losses and other purposes.
Some states are considering legislative proposals which would authorize the
establishment of an interstate compact concerning various aspects of insurer
insolvency proceedings, including interstate governance of receiverships and
guaranty funds. As of March 2000, such legislation had been adopted by three
states, including Illinois, Michigan and Nebraska.
Insurance departments also conduct periodic examinations of the affairs of
insurance companies and require the filing of annual and other reports relating
to the financial condition of companies and other matters. The Nebraska
Insurance Department completed an examination of RCRe's records, accounts and
business affairs for the period October 1995 through December 31, 1997 and
issued its final report for the examination on March 15, 1999, which report
included no material findings. Prior to this examination, RCRe had not been
examined by the Nebraska Insurance Department other than in connection with the
receipt of its insurance license in November 1995.
Credit for Reinsurance
A primary insurer ordinarily will enter into a reinsurance agreement only
if it can obtain credit for the reinsurance ceded on its statutory financial
statements. In general, credit for reinsurance is allowed in the following
circumstances: (1) if the reinsurer is licensed in the state in which the
primary insurer is domiciled or, in some instances, in certain states in which
the primary insurer is licensed; (2) if the reinsurer is an "accredited" or
otherwise approved reinsurer in the state in which the primary insurer is
domiciled or, in some instances, in certain states in which the primary insurer
is licensed; (3) in some instances, if the reinsurer (a) is domiciled in a state
that is deemed to have substantially similar credit for reinsurance standards as
the state in which the primary insurer is domiciled and (b) meets certain
financial requirements; or (4) if none of the above apply, to the extent that
the reinsurance obligations of the reinsurer are collateralized appropriately,
typically
14
through the posting of a letter of credit for the benefit of the primary insurer
or the deposit of assets into a trust fund established for the benefit of the
primary insurer. Therefore, as a result of the requirements relating to the
provision of credit for reinsurance, RCRe is indirectly subject to certain
regulatory requirements imposed by jurisdictions in which ceding companies are
licensed.
As of March 27, 2000, RCRe is licensed or is an accredited or otherwise
approved reinsurer in 44 states as follows: Alabama, Alaska, Arkansas,
Connecticut, Delaware, District of Columbia, Florida, Georgia, Hawaii, Idaho,
Illinois, Indiana, Iowa, Kentucky, Louisiana, Maryland, Michigan, Minnesota,
Mississippi, Missouri, Montana, Nebraska (state of domicile), Nevada, New
Hampshire, New Jersey, New Mexico, New York, North Carolina, North Dakota, Ohio,
Oklahoma, Oregon, Pennsylvania, Rhode Island, South Carolina, South Dakota,
Tennessee, Texas, Utah, Vermont, Virginia, West Virginia, Wisconsin and Wyoming.
RCRe also holds a Certificate of Authority from the United States Treasury
Department for surety business. In addition, RCRe is an authorized reinsurer in
the Argentine Republic and Colombia, South America.
Investment Limitations
The Nebraska insurance laws contain rules governing the types and amounts
of investments that are permissible for Nebraska-domiciled insurers, including
RCRe. These rules are designed to ensure the safety and liquidity of an
insurer's investment portfolio. Investments in excess of statutory guidelines do
not constitute "admitted assets" (i.e., assets permitted by the Nebraska
insurance laws to be included in a domestic insurer's statutory financial
statements), unless special approval is obtained from the Nebraska Director of
Insurance (the "Nebraska Director"). Non-admitted assets do not count for the
purposes of various financial ratios and tests, including those governing
solvency and the ability to write premiums. An insurer may hold an investment
authorized under more than one provision of the Nebraska insurance laws under
the provision of its choice (except as otherwise expressly provided by law).
Subject to the "basket" clause described below, the maximum amount of an
insurer's authorized investments in preferred stock and common stock of
insurance companies for calculation of admitted assets in Nebraska is the lesser
of (1) the amount by which admitted assets exceed required capital and
liabilities or (2) 50% of policyholders surplus. Based on RCRe's statutory or
policyholders surplus of $230.1 million following our recent repurchase of stock
from XL Capital described above under "Business--Recent Developments," such
amounts for RCRe were $225.1 million and $115.0 million, respectively. Stock of
insurance companies is valued for these purposes at cost. Unrealized
appreciation of such securities does not count for the purpose of determining
the percentage of certain admitted assets attributable to insurance stock
investments.
While there is a concentration restriction which precludes investment of
more than 5% of the insurer's admitted assets in any one issuer, this
restriction does not apply to investments in common and preferred stock of other
insurers whose senior debt obligations have received a designation of 1 or 2
from the Securities Valuation Office (the "SVO") of the National Association of
Insurance Commissioners (the "NAIC"). Designations assigned by the SVO range
from class 1 to class 6, with class 1 as the highest quality rating. Generally,
SVO designations of 1 and 2 are comparable to investment grade ratings by
Moody's and Standard & Poor's, and SVO designations of 3 to 6 are comparable to
below investment grade ratings by such rating organizations.
Other concentration restrictions preclude investment of more than 3%, 2%,
1% or 1/2% of an insurer's admitted assets in any one person whose senior debt
obligations have received a designation of 3, 4, 5 or 6, respectively, from the
SVO. In addition, an insurer's investments in debt obligations having a 4, 5 or
6 designation from the SVO may not exceed 4%, 2% or 1%, respectively, of RCRe's
admitted assets. Aggregate investments in obligations having any combination of
3, 4, 5 and 6 designations from the SVO may not exceed, in the aggregate, 15% of
the insurer's admitted assets.
An insurer's investments in equity interests of business entities (e.g.,
corporations, partnerships, limited liability companies and partnerships,
trusts, joint ventures, etc., including insurance companies) that are created or
existing under the laws of the United States or Canada (or any state or province
thereof) are also authorized under the Nebraska insurance laws, provided that,
in the case of an investment in a business entity other than an insurance
company, (1) the insurer may not generally invest in more than 10% of the total
equity interests of such entity and (2) the investment will be subject to the
concentration restrictions described above. In the case
15
of an investment in a business entity that is a corporation, such entity must
also meet certain requirements regarding retained earnings and dividend payment
history.
Authorized foreign investments by an insurer in foreign jurisdictions whose
sovereign debt has a designation of 1, 2 or 3 from the SVO may not exceed, in
the aggregate, 15% of the insurer's admitted assets. Investments may not be made
in foreign jurisdictions whose sovereign debt has a designation of 4, 5 or 6
from the SVO. In addition, authorized foreign investments denominated in foreign
currencies may not exceed, in the aggregate, 5% of the insurer's admitted
assets. Authorized foreign investments must also have a minimum designation of 1
or 2 from the SVO (or corresponding investment grade rating from any rating
organization recognized by the SVO, including Moody's and Standard & Poor's),
and must be aggregated with investments of the same kinds and classes made under
the Nebraska insurance laws (except for the "basket" clause) for purposes of
determining compliance with the limitations contained in other sections.
Notwithstanding the foregoing or any other limitations under the Nebraska
insurance laws, there is a "basket" clause under which investments "not
otherwise authorized" are permitted up to a maximum of the greater of (1) the
lesser of (a) 25% of the amount by which admitted assets exceed total
liabilities, excluding capital, or (b) 5% of admitted assets (investments
authorized under this subsection of the "basket" clause may not include
obligations with SVO designations of 3, 4, 5 or 6), or (2) that portion of
policyholders surplus which is in excess of 50% of the insurer's annual net
written premiums. Derivative instruments otherwise authorized under the Nebraska
insurance laws may not be authorized under the "basket" clause. Based on RCRe's
statutory surplus of $230.1 million following our recent repurchase of stock
from XL Capital described above under "Business--Recent Developments," the
"basket" clause would have allowed RCRe to make investments not otherwise
authorized under the Nebraska insurance laws up to a maximum amount of $76.6
million.
The Nebraska insurance laws provide that the Nebraska Director may waive
any of the legal investment limitations upon application by an insurer. The
Nebraska Director is required to consider the following factors in determining
whether to approve or disapprove any such application: (1) the credit risk
quality of the proposed investment; (2) the liquidity of the proposed investment
and of the insurer's entire investment portfolio; (3) the extent of the
diversification of the insurer's investment portfolio; (4) the yield of the
proposed investment; (5) the reasonableness of the insurer's policyholders
surplus in relation to the insurer's outstanding liabilities and financial
needs; and (6) any other relevant considerations. From time to time, it may be
necessary for the Company to seek waivers from the Nebraska Director of the
legal investment limitations imposed by the Nebraska insurance laws; no
assurances can be given that such waivers can be obtained.
States in which RCRe is or may become licensed or authorized may also seek
to impose their legal investment laws on RCRe. Such laws vary from state to
state and may not permit investments that are permitted under Nebraska law. To
the extent that any state disallows an investment that is permitted under
Nebraska law, RCRe's statutory surplus reflected in its statutory financial
statements filed in such state would be reduced by the amount of such
disallowance.
Holding Company Acts
State insurance holding company statutes provide a regulatory apparatus
which is designed to protect the financial condition of domestic insurers
operating within a holding company system. All holding company statutes require
disclosure and, in some instances, prior approval of significant transactions
between the domestic insurer and an affiliate. Such transactions typically
include sales, purchases, exchanges, loans and extensions of credit, and
investments between an insurance company and its affiliates, involving in the
aggregate certain percentages of a company's admitted assets or policyholders
surplus, or dividends that exceed certain percentages of the company's surplus
or income.
The Nebraska insurance laws and the insurance laws of other states
generally regard an issuer as an "affiliate" of one of its investors if it is
controlled by, or is under common control with, the investor. Generally,
"control" means the possession of the power to direct or cause the direction of
the management and policies of the issuer, whether through the ownership of
voting securities, by contract or otherwise. Control is generally presumed to
exist if the investor, directly or indirectly, owns or controls 10% or more of
the voting securities of the issuer. The Nebraska insurance laws and the
insurance laws of other states generally allow investors to rebut this
presumption by filing a "disclaimer" that sets forth the bases for disclaiming
affiliation. In certain states, such as Nebraska, a disclaimer is deemed
effective once filed unless it is specifically disallowed by the
16
respective insurance department (after the parties in interest have been
provided notice and an opportunity to be heard). In other states, a disclaimer
must be specifically approved by the relevant insurance department. In cases
where RCRe may be presumed to "control," and therefore deemed an affiliate of,
an insurer under applicable holding company statutes, RCRe intends to continue
to file disclaimers with respect to such insurer unless prevented by the
surrounding circumstances.
Typically, the holding company statutes also require each of the insurance
subsidiaries periodically to file information with state insurance regulatory
authorities, including information concerning capital structure, ownership,
financial condition and general business operations. Under the terms of
applicable state statutes, any person or entity desiring to acquire control of a
domestic insurer is required first to obtain approval of the applicable state
insurance regulator.
Liquidation of Insurers
The liquidation of insurance companies, including reinsurers, is generally
conducted pursuant to state insurance law. In the event of the liquidation of
RCRe, such liquidation would be conducted by the Nebraska Director as the
domestic receiver of the properties, assets and business of RCRe. Liquidators
located in other states (known as ancillary liquidators) in which RCRe conducts
business may have jurisdiction over assets or properties located in such states
under certain circumstances. Under Nebraska law, all creditors of RCRe,
including but not limited to reinsureds under its reinsurance agreements, would
be entitled to payment of their allowed claims in full from the assets of RCRe
before we, as a stockholder of RCRe, would be entitled to receive any
distribution therefrom.
Regulation of Dividends and Other Payments from Insurance Subsidiaries
As an insurance holding company, we are largely dependent on dividends and
other permitted payments from RCRe to meet our obligations. The ability of RCRe
to pay dividends or make other distributions is subject to insurance regulatory
limitations of Nebraska, the state in which RCRe is domiciled. The Nebraska
insurance laws provide that dividends or other distributions, together with
other dividends or distributions paid during the preceding 12 months, may not
exceed the greater of (i) 10% of statutory surplus as of the preceding December
31 or (ii) statutory net income from operations for the preceding calendar year
not including realized capital gains. Net income (exclusive of realized capital
gains) not previously distributed or paid as dividends from the preceding two
calendar years may be carried forward for dividend and distribution purposes.
Any proposed dividend or distribution in excess of such amount is called an
"extraordinary" dividend or distribution and may not be paid until either it has
been approved, or a 30-day waiting period has passed during which it has not
been disapproved, by the Nebraska Director. Notwithstanding the foregoing, the
Nebraska insurance laws provide that any distribution that is a dividend may be
paid by RCRe only out of earned surplus arising from its business, which is
defined as unassigned funds (surplus) as reported in the statutory financial
statement filed by RCRe with the Nebraska Insurance Department for the most
recent year, including any surplus arising from unrealized capital gains or
revaluations of assets. Any distribution that is a dividend and that is in
excess of RCRe's unassigned funds, exclusive of any surplus arising from
unrealized capital gains or revaluation of assets, will be deemed an
"extraordinary" dividend subject to the foregoing requirements. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Liquidity and Capital Resources" and Notes 10 and 14 of the
accompanying Notes to our consolidated financial statements.
The Nebraska insurance laws also require that the statutory surplus of RCRe
following any dividend or distribution be reasonable in relation to its
outstanding liabilities and adequate to its financial needs. The Nebraska
Director is required to apply certain factors in determining the adequacy of an
insurer's surplus, including, among other things, the size of the insurer, the
extent to which the insurer's business is diversified, the number and size of
risks insured by each line of business, the extent of geographical dispersion of
insured risks and the reinsurance program, and characteristics of the investment
portfolio. In addition, the Nebraska insurance laws require that each insurer
give notice to the Nebraska Director of all dividends and other distributions
within five business days following declaration thereof and that any such
dividend or other distribution may not be paid within 10 business days of the
notice unless for good cause shown the Nebraska Director has approved such
payment within the such notice period.
Insurance Regulatory Information System Ratios
The NAIC's Insurance Regulatory Information System ("IRIS") was developed
by a committee of state insurance regulators and is intended primarily to assist
state insurance departments in executing their statutory
17
mandates to oversee the financial condition of insurance companies operating in
their respective states. IRIS identifies 11 industry ratios and specifies "usual
values" for each ratio. Departure from the usual values of the ratios can lead
to inquiries from individual state insurance commissioners as to certain aspects
of an insurer's business. For the year ended December 31, 1999, RCRe's results
were within the usual values for eight of the 11 ratios. The "investment yield"
ratio was outside the usual value primarily due to our investment strategy of
investing a significant portion of our investment portfolio in equity
securities, which generally yield less current investment income than fixed
maturity investments. The "two year operating ratio" was outside the usual value
due to the combined impact of RCRe's "investment yield" ratio (described above)
and the 1999 and 1998 statutory combined ratios of 129.2% and 116.4%,
respectively, which reflect poor underwriting performance. RCRe's two year
statutory combined ratio was adversely affected by underwriting results from
RCRe's aviation and space lines of business and casualty and multi-line
reinsurance provided by RCRe on insurance business produced by a certain
managing underwriting agency. We have discontinued our aviation and space lines
of business. We have also discontinued our underwriting relationship with the
managing underwriting agency and the business and operations of the managing
underwriting agency are in run-off. For a related discussion, please refer to
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Results of Operations," --Operating Costs and Expenses," "--Managing
Underwriting Agency," "--Space and Aviation Business," "--Space Business" and
"--Aviation Business." The "change in surplus" ratio was outside the usual range
due to RCRe's operating results and the reduction in RCRe's unrealized
appreciation on invested assets.
Accreditation
The NAIC has instituted its Financial Regulatory Accreditation Standards
Program ("FRASP") in response to federal initiatives to regulate the business of
insurance. FRASP provides a set of standards designed to establish effective
state regulation of the financial condition of insurance companies. Under FRASP,
a state must adopt certain laws and regulations, institute required regulatory
practices and procedures, and have adequate personnel to enforce such items in
order to become an "accredited" state. If a state is not accredited, accredited
states are not able to accept certain financial examination reports of insurers
prepared solely by the regulatory agency in such unaccredited state. The State
of Nebraska is accredited under FRASP; however, there can be no assurance that
it or any other state will remain accredited.
Risk-Based Capital Requirements
In order to enhance the regulation of insurer solvency, the NAIC adopted in
December 1993 a formula and model law to implement risk-based capital
requirements for property and casualty insurance companies. Effective January 1,
1994, Nebraska adopted risk-based capital legislation for property and casualty
companies which is similar to the NAIC risk-based capital requirements. These
risk-based capital requirements are designed to assess capital adequacy and to
raise the level of protection that statutory surplus provides for policyholder
obligations. The risk-based capital model for property and casualty insurance
companies measures three major areas of risk facing property and casualty
insurers: (1) underwriting, which encompasses the risk of adverse loss
developments and inadequate pricing; (2) declines in asset values arising from
credit risk; and (3) declines in asset values arising from investment risks.
Insurers having less statutory surplus than required by the risk-based capital
calculation will be subject to varying degrees of regulatory action, depending
on the level of capital inadequacy. Equity investments in common stock typically
are valued at 85% of their market value under the risk-based capital guidelines.
For equity investments in an insurance company affiliate, the risk-based capital
requirement for the equity securities of such affiliate would generally be
RCRe's proportionate share of the affiliate's risk-based capital requirement.
For a discussion of "affiliate" status under the insurance laws, see
"Business--Insurance Regulation--Holding Company Acts."
RCRe's surplus (as calculated for statutory annual statement purposes) is
well above the risk-based capital thresholds that would require either company
or regulatory action.
Regulation of Certain Reinsurance Intermediaries
Certain states, including Nebraska, have adopted legislation or regulation
that, in effect, places additional requirements upon insurance and reinsurance
intermediaries and brokers when, on behalf of an insured, they place business
with an insurance or reinsurance company that is affiliated with such
intermediary or broker. While we believe that there is no such affiliation
between RCRe and reinsurance intermediaries that may be affiliated with Marsh &
McLennan Companies, Inc., no assurances can be given that other persons
(including
18
such intermediaries) may not take a contrary position. While we believe that
compliance with such regulations would not be burdensome upon an intermediary or
broker, no assurances can be given as to whether a broker or intermediary would
decide to place or continue to place business with RCRe if such regulations were
viewed to be applicable.
Federal Regulation
Although state regulation is the dominant form of regulation for insurance
and reinsurance business, the federal government has shown increasing concern
over the adequacy of state regulation. It is not possible to predict the future
impact of any potential federal regulations or other possible laws or
regulations on RCRe's capital and operations, and such laws or regulations could
materially adversely affect its business.
Legislative and Regulatory Proposals
From time to time various regulatory and legislative changes have been
proposed in the insurance and reinsurance industry, some of which could have an
effect on reinsurers. Among the proposals that have in the past been or are at
present being considered are the possible introduction of federal regulation in
addition to, or in lieu of, the current system of state regulation of insurers.
In addition, there are a variety of proposals being considered by various state
legislatures (some of which proposals have been enacted). We are unable to
predict whether any of these laws and regulations will be adopted, the form in
which any such laws and regulations would be adopted, or the effect, if any,
these developments would have on our operations and financial condition.
Senior Management
The Company's senior management team consists of:
Name Age Position
---- --- --------
Mark D. Mosca 46 President, Chief Executive Officer and Director
Robert Clements 67 Chairman and Director
Peter A. Appel 38 Executive Vice President, Chief Operating Officer,
General Counsel and Secretary
Paul J. Malvasio 53 Managing Director, Chief Financial Officer and
Treasurer
- - -------------
Mark D. Mosca was elected as President and a Director of the company in
June 1995 and as Chief Executive Officer of the company in March 1998, and
President, Chief Executive Officer and Director of RCRe in August 1995, and has
served as acting Chief Underwriting Officer of RCRe since March 1999. Prior to
June 1995, he was Senior Vice President and Chief Underwriting Officer of Zurich
Reinsurance Centre Holdings, Inc. since the completion of its initial public
offering in May 1993. Prior thereto, Mr. Mosca served as a Vice President of NAC
Re Corporation ("NAC Re"), where he was manager of the Treaty Division since
February 1986. From 1975 to 1986, Mr. Mosca was employed by General Reinsurance
Corporation where he was a Vice President. Mr. Mosca holds an A.B. degree from
Harvard University.
Robert Clements was elected as Chairman and Director of the company at the
time of our formation in March 1995 and Chairman and Director of RCRe in
September 1995. He is currently an advisor to MMCI with whom he served as
Chairman and Chief Executive Officer from January 1994 to March 1996. Prior
thereto, he served as President of Marsh & McLennan Companies, Inc. since 1992,
having been Vice Chairman during 1991. He was Chairman of J&H Marsh & McLennan,
Incorporated (formerly Marsh & McLennan, Incorporated), a subsidiary of Marsh &
McLennan Companies, Inc., from 1988 until March 1992. He joined Marsh &
McLennan, Ltd., a Canadian subsidiary of Marsh & McLennan Companies, Inc., in
1959. Mr. Clements is a director of Marsh & McLennan Companies, Inc., XL
Capital, Annuity and Life Re (Holdings), Ltd., Stockton Reinsurance Limited and
Hiscox plc. He is Chairman of the Board of Trustees of The College of Insurance
and a member of Rand Corp. President's Council.
Peter A. Appel has been Executive Vice President, Chief Operating Officer
and a Director of both the company and RCRe since November 1999, and General
Counsel and Secretary of the company and RCRe since November 1995. Mr. Appel
previously served as a Managing Director of the company and RCRe from November
1995 to November 1999. From September 1987 to November 1995, Mr. Appel practiced
law with
19
the New York firm of Willkie Farr & Gallagher, where he was a partner from
January 1995. He holds an A.B. degree from Colgate University and a law degree
from Harvard University.
Paul J. Malvasio has been a Managing Director, Chief Financial Officer and
Treasurer of both the company and RCRe since September 1995 and a Director of
RCRe since November 1995. Prior to that time, he was Senior Vice President and
Chief Financial Officer of NAC Re since January 1986. From 1967 to 1986, Mr.
Malvasio was employed by the public accounting firm of Coopers & Lybrand, where
he was an audit partner from October 1979. Mr. Malvasio is a certified public
accountant and holds a B.B.A. degree in Accounting from St. Francis College.
Employees
At March 27, 2000, we employed a total of 29 full-time employees. Our
employees are not represented by a labor union and we believe that our employee
relations are good.
20
GLOSSARY OF SELECTED INSURANCE TERMS
Admitted assets.............................Assets permitted by state law to be
included as "assets" in an insurance
company's annual statement.
Annual Statement ........................... A report that an insurance company
must file annually with the state
insurance commissioner in its
domiciliary state and each other
state in which it does business.
The statement shows the current
status of reserves, expenses,
assets, total liabilities and
investment portfolio.
Assume ..................................... To take from an insurer or
reinsurer (a ceding company) all or
part of a risk underwritten by such
person, along with the related
premiums, losses and expenses.
Attachment point ............................The amount of loss (per occurrence
or in the aggregate, as the case
may be) above which excess of loss
coverage becomes operative.
Broker market reinsurer A reinsurer that markets and sells
reinsurance through brokers rather
than through its own employees.
Case reserves ...............................Loss reserves established with
respect to individual reported
claims.
Casualty insurance ..........................Insurance which is primarily
concerned with the losses caused by
injuries to third persons (in other
words, persons other than the
policyholder) and the legal
liability imposed on the insured
resulting therefrom.
Catastrophe reinsurance .....................A form of excess of loss
reinsurance that, subject to a
specified limit, indemnifies the
ceding company for the amount of
loss in excess of a specified
retention with respect to an
accumulation of losses resulting
from a catastrophic event. The
actual reinsurance document is
called a "catastrophe cover."
Cede; Cedent; Ceding company ................When a party reinsures all or part
of its risks with another, it
"cedes" business and is referred to
as the "cedent" or "ceding
company."
Common account reinsurance ..................Arrangements whereby the ceding
company enters the reinsurance
market and purchases a cover for
the benefit of the ceding company
and the reinsurers on the
reinsurance treaty. A pro rata
portion of the costs of this
protection is deducted from the
ceded premium.
Credit enhancement ..........................Use of financial guaranty to
upgrade the quality of a security
through the use of an insurance
policy or letter of credit or other
means.
Direct underwriter; Direct writer ...........An insurer or reinsurer that
markets and sells insurance
directly to its insureds or
reinsureds without the assistance
of brokers.
Excess of loss reinsurance ..................A generic term describing
reinsurance that indemnifies the
reinsured against all or a
specified portion of losses on
underlying insurance policies in
excess of a specified amount, which
is called a "level" or "retention."
Also known as non-proportional
reinsurance. Excess of loss
reinsurance is written in layers. A
reinsurer or group of reinsurers
accepts a band of coverage up to a
specified amount. The total
coverage purchased by the cedent is
referred to as a "program" and will
typically be placed with
predetermined reinsurers in
prenegotiated layers. Any liability
exceeding the outer limit of the
program reverts to the ceding
company, which also bears the
credit risk of a reinsurer's
insolvency.
Facultative reinsurance .....................The reinsurance of all or a portion
of the insurance provided by a
single policy. Each policy
reinsured is separately negotiated.
21
Finite risk reinsurance .....................Similar to traditional reinsurance
with the exception that there is a
finite risk to the reinsurer with
respect to minimum and maximum
exposure in relation to the premium
to be received.
Gross premiums written ......................Total premiums for insurance and
reinsurance assumed during a given
period.
Incurred but not reported ("IBNR") ..........Reserves for estimated losses that
have been incurred by insureds and
reinsureds but not yet reported to
the insurer or reinsurer, including
unknown future developments on
losses which are known to the
insurer or reinsurer.
In-force premiums ...........................The total of estimated annualized
premiums of all policies in force
as of a certain date which would be
anticipated to generate net
premiums written during the annual
period being considered.
Intermediary/broker .........................One who negotiates contracts of
insurance between an insured and a
primary insurer on behalf of the
insured and/or contracts of
reinsurance between a primary
insurer or other reinsured and a
reinsurer on behalf of the primary
insurer or reinsured, in each case
receiving a commission for
placement and other services
rendered.
Lloyd's syndicate ...........................Underwriting members of Lloyd's
(which can be individual "names"
and/or dedicated corporate members)
that group together annually to
form a syndicate to underwrite
insurance coverage. Each syndicate
is managed by a Lloyd's-approved
managing agent, which appoints one
or more active or named
underwriters who have the authority
to bind the syndicate to contracts
of insurance, pay claims and effect
recoveries.
Net premiums written ........................Gross premiums written for a given
period less premiums ceded to
retrocessionaires during such
period.
Primary insurer .............................An insurance company that contracts
with the insured to provide
insurance coverage. Such insurer
may then cede a portion of its
business to reinsurers.
Probable maximum loss .......................Under RCRe's current guidelines,
probable maximum loss is the
anticipated maximum exposure to an
event of a magnitude such that it
would be expected to occur once in
100 years.
Quota share or proportional
reinsurance .................................A generic term describing all forms
of reinsurance in which the
reinsurer shares a proportional
part of the original premiums and
losses of the reinsured. (Also
known as pro rata reinsurance or
participating reinsurance.) In
proportional reinsurance, the
reinsurer generally pays the ceding
company a ceding commission. The
ceding commission generally is
based on the ceding company's cost
of acquiring the business being
reinsured (including commissions,
premium taxes, assessments and
miscellaneous administrative
expenses) and also may include a
profit factor. Generally, the
reinsurer gets the benefit of
common account reinsurance.
RAA .........................................Reinsurance Association of America,
a trade association of medium and
large property and casualty
reinsurers doing business in the
United States. The RAA provides
statistical data concerning the
markets, which voluntarily provide
such information to the RAA.
Reinsurance .................................An arrangement in which an
insurance company, the reinsurer,
agrees to indemnify another
insurance or reinsurance company,
the ceding company, against all or
a portion of the insurance or
reinsurance risks
22
underwritten by the ceding company
under one or more policies.
Reinsurance can provide a ceding
company with several benefits,
including a reduction in net
liability on individual risks and
catastrophe protection from large
or multiple losses. Reinsurance
also provides a ceding company with
additional underwriting capacity by
permitting it to accept larger
risks and write more business than
would be possible without a
concomitant increase in capital and
surplus, and facilitates the
maintenance of acceptable financial
ratios by the ceding company.
Reinsurance does not legally
discharge the ceding company from
its liability with respect to its
obligations to the insured.
Reserves ....................................Liabilities established by insurers
and reinsurers to reflect the
estimated costs of claims payments
and the related expenses that the
insurer or reinsurer will
ultimately be required to pay in
respect of insurance or reinsurance
it has written. Reserves are
established for losses and for
unpaid claims and claims expenses
and for unearned premiums. Loss
reserves consist of case reserves
and IBNR reserves. For reinsurers,
unpaid claims and claims expense
reserves are generally not
significant because substantially
all of the unpaid claims and claims
expenses associated with particular
claims are incurred by the primary
insurer and reported to reinsurers
as losses. Unearned premium
reserves constitute the portion of
premiums paid in advance for
insurance or reinsurance that has
not yet been provided.
Retention ...................................The amount or portion of risk that
an insurer retains for its own
account. Losses in excess of the
retention level are paid by the
reinsurer. In proportional
treaties, the retention may be a
percentage of the original policy's
limit. In excess of loss business,
the retention is a dollar amount of
loss, a loss ratio or a percentage.
Retrocession ................................A transaction whereby a reinsurer
cedes to another reinsurer (the
"retrocessionaire") all or part of
the reinsurance that the first
reinsurer has assumed.
Retrocessions do not legally
discharge the ceding reinsurer from
its liability with respect to its
obligations to the reinsured.
Reinsurance companies cede risks to
retrocessionaires for reasons
similar to those that cause primary
insurers to purchase reinsurance:
to reduce net liability on
individual risks, to protect
against catastrophic losses, to
stabilize financial ratios and to
obtain additional underwriting
capacity.
Statutory accounting principles
("SAP") ..................................The rules and procedures prescribed
or permitted by United States state
insurance regulatory authorities
including the NAIC, which govern
the preparation of financial
statements. Such rules and
procedures generally reflect a
liquidating, rather than going
concern, concept of accounting.
Statutory composite ratio ...................Provides an overall indication of
underwriting profitability. The
ratio is the sum of: the ratio of
commissions and other underwriting
expenses to premiums written, and
the ratio of claims and claims
expenses to premiums earned. A
statutory composite ratio under
100% indicates underwriting
profitability, while a composite
ratio exceeding 100% indicates an
underwriting loss.
Statutory surplus ...........................The excess of admitted assets over
total liabilities (including loss
reserves), determined in accordance
with SAP.
23
Tail.........................................The period of time that elapses
between the writing of the
applicable insurance policy or the
loss event (or the insurer's
knowledge of the loss event) and
the payment in respect thereof.
Treaties ....................................The reinsurance of a specified type
or category of risks defined in a
reinsurance agreement (a "treaty")
between an insurer and a reinsurer
or between a reinsurer and a
retrocessionaire. In treaty
reinsurance, the cedent is
typically obligated to offer, and
the reinsurer or retrocessionaire
is obligated to accept, a specified
portion of a type or category of
risks insured by the ceding company
as set forth in the governing
contract. Treaty reinsurance may
provide for proportional or
non-proportional reinsurance.
Underwriting ................................The insurer's or reinsurer's
process of reviewing applications
submitted for insurance coverage,
deciding whether to accept all or
part of the coverage requested and
determining the applicable
premiums.
Underwriting capacity .......................The maximum amount that an
insurance company can underwrite.
The limit is generally determined
by the company's policyholders or
statutory surplus, which depends,
among other things, on the
insurer's admitted assets.
Reinsurance serves to increase a
company's capacity by reducing its
exposure from particular risks.
24
ITEM 2. PROPERTIES
In March 1996, we entered into a sublease agreement expiring in October
2002 for approximately 40,000 square feet of office space in Greenwich,
Connecticut, where our offices are located. Future minimum rental charges for
the remaining term of the sublease, exclusive of escalation clauses and
maintenance costs and net of rental income, will be approximately $1,994,000.
Our rental expense, net of sublease income, during 1999, 1998 and 1997 was
approximately $576,000, 576,000 and $643,000, respectively.
Commencing in 1996, we subleased approximately 13,000 square feet of the
office space to MMCI for a term expiring in October 2002. Future minimum rental
income under the remaining term of the sublease, exclusive of escalation clauses
and maintenance costs, will be approximately $1,218,000. Rental income for 1999,
1998 and 1997 was $430,000 for each year. MMCI also reimbursed the company
approximately $60,000 $100,000 and $574,000 in 1999, 1998 and 1997,
respectively, for MMCI's pro rata share of improvement and maintenance costs
under the sublease. In addition, commencing in 1997, we subleased approximately
6,000 square feet of the office space to another tenant for a term expiring in
October 2002. Rental income for 1999, 1998 and 1997 was $225,000, $225,000 and
$117,000, of which $89,000, $89,000 and $44,000, respectively, was paid to MMCI
as its pro rata share of such income. Effective March 31, 2000, the sublease
with this tenant will be terminated, and MMCI will assume the 6,000 square feet
of space and will be responsible for the costs associated with the space.
ITEM 3. LEGAL PROCEEDINGS
The company is subject to litigation and arbitration in the ordinary course
of its business.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
There were no matters submitted to a vote of security holders during the
fourth quarter of 1999.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Market Information
Shares of our common stock are traded on the Nasdaq National Market under
the symbol "RCHI." For the periods presented below, the high and low sales
prices and closing prices for our common stock as reported on the Nasdaq
National Market were as follows:
Three Months Ended
-----------------------------------------------------------------------------
December 31, September 30, June 30, March 31,
1999 1999 1999 1999
---- ----- ---- ----
High................................ $15.69 $16.00 $17.38 $22.63
Low................................. 11.00 13.00 13.50 12.00
Close............................... 12.63 15.63 13.50 15.13
Three Months Ended
-----------------------------------------------------------------------------
December 31, September 30, June 30, March 31,
1998 1998 1998 1998
---- ---- ---- ----
High................................ $23.75 $25.50 $25.50 $24.00
Low................................. 18.81 19.00 22.75 19.75
Close............................... 21.75 22.00 24.94 24.00
25
On March 27, 2000, the high and low sales prices and the closing price for
our common stock as reported on the Nasdaq National Market were $16.13, $15.19
and $15.50, respectively.
Holders
As of March 27, 2000, there were approximately 47 holders of record of our
common stock and approximately 1,600 beneficial holders of our common stock.
Dividends
We have not declared any dividends since our formation in 1995. Any
determination to pay dividends in the future will be at the discretion of our
board of directors and will be dependent upon our results of operations,
financial condition, capital requirements, contractual restrictions and other
factors deemed relevant by our board of directors. Our board currently does not
intend to declare dividends or make any other distributions. The payment of any
dividends will be dependent upon the ability of RCRe to provide funds to us. For
a description of the restrictions on the ability of RCRe to pay dividends or
make distributions to us, please refer to "Business(Insurance
Regulation--Regulation of Dividends and Other Payments from Insurance
Subsidiaries," "Management's Discussion and Analysis of Financial Condition and
Results of Operations(Liquidity and Capital Resources" and Note 10 of the
accompanying notes to our consolidated financial statements.
Our board intends to make a determination regarding repurchases of our
shares after the consummation of the sale of our reinsurance operations to
Folksamerica Reinsurance Company, but no decision has yet been made as to
whether any such repurchases will be made or the amount, timing or method of any
such repurchases, which will depend on future circumstances.
26
ITEM 6. SELECTED FINANCIAL DATA
Our and RCRe's selected consolidated historical financial data for the
years ended December 31, 1999, 1998, 1997, 1996 and for the period from June 23,
1995 (date of inception) to December 31, 1995 should be read in conjunction with
our audited consolidated financial statements and the related notes and
unaudited pro forma condensed consolidated financial data contained elsewhere in
this report.
Period from
June 23, 1995
Years Ended December 31, to
--------------------------------------------------------------- December 31,
--------------
1999 1998 1997 1996 1995
---- ---- ---- ---- ----
(Dollars in thousands, except share data)
Statement of Operations Data
Net premiums earned............... $311,368 $206,194 $107,372 $35,761
Net investment income............. 20,173 15,687 14,360 13,151 $4,578
Net realized investment gains
(losses)....................... 17,227 25,252 (760) 1,259 397
Total revenues.................... 348,768 247,133 120,972 50,171 4,975
Net income (loss)................. (32,436) 3,091 2,039 4,112 1,019
Comprehensive income (loss)....... ($52,286) ($4,375) $47,107 $9,817 $4,750
Average shares outstanding
Basic.......................... 17,086,732 17,065,165 17,032,601 16,981,724 16,747,084
Diluted........................ 17,086,808 17,718,223 17,085,788 16,983,909 16,990,425
Per Share Data
Net income (loss)
Basic........................ ($1.90) $0.18 $0.12 $0.24 $0.06
Diluted...................... ($1.90) $0.17 $0.12 $0.24 $0.06
Comprehensive Income
(loss)
Basic....................... ($3.06) ($0.26) $2.77 $0.58 $0.28
Diluted..................... ($3.06) ($0.26) $2.76 $0.58 $0.28
Cash dividends per share.......... N/A N/A N/A N/A N/A
December 31,
--------------------------------------------------------------------------------
1999 1998 1997 1996 1995
--------------------------------------------------------------------------------
(Dollars in thousands, except share data)
Balance Sheet Data
Cash and invested assets.......... $585,909 $587,155 $505,728 $392,940 $347,327
Total assets...................... 864,359 757,830 581,247 432,486 350,986
Stockholders' equity.............. 346,514 398,002 401,031 352,213 340,215
Sharses outstanding
Basic.......................... 17,087,970 17,087,438 17,058,462 17,031,246 16,941,125
Diluted........................ 17,087,970 17,497,904 17,601,608 17,065,406 16,941,125
Book value per share
Basic.......................... $20.28 $23.29 $23.51 $20.68 $20.08
Diluted........................ $20.28 $22.75 $22.79 $20.64 $20.08
27
UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL DATA
The following unaudited pro forma balance sheet as of December 31, 1999
reflects our historical accounts as of that date, adjusted to give pro forma
effect to the sale of our reinsurance business to Folksamerica, which is subject
to stockholder approval, and our repurchase of 4,755,000 shares, or 27.8%, of
our outstanding common stock from XL Capital, which repurchase was completed on
March 2, 2000, as if those transactions had occurred on December 31, 1999.
The following unaudited pro forma statement of income and comprehensive
income for the year ended December 31, 1999 reflects our historical accounts for
that period, adjusted to give pro forma effect to the asset sale and the XL
Capital stock repurchase as if those transactions had occurred on January 1,
1999.
The pro forma financial data and accompanying notes should be read in
conjunction with the description of the asset sale and XL Capital stock
repurchase contained in this report and our audited consolidated financial
statements and related notes also included in this report as well as the
description included in our special meeting proxy statement. We believe that the
assumptions used in the following statements, which are set forth in the
accompanying notes, provide a reasonable basis on which to present the pro forma
financial data. The pro forma financial data is provided for informational
purposes only and should not be construed to be indicative of our financial
condition or results of operations had the asset sale and XL Capital stock
repurchase been consummated on the dates assumed and are not intended to project
our financial condition on any future date or results of operations for any
future period.
28
Risk Capital Holdings, Inc. and Subsidiaries
Pro Forma Condensed Consolidated Balance Sheet
December 31, 1999
(Dollars in thousands, except per share data)
Pro Forma Adjustments
---------------------
XL Folksamerica
Historical Transaction(1) Transaction(4) Pro Forma
---------- -------------- -------------- ---------
Assets
Investments:
Fixed maturities and short-term
investments $333,852 ($245,545)(5) $88,307 (10)
Publicly traded equity securities 158,631 ($38,169)(2) 120,462
Privately held securities 83,969 (24,040)(2) 59,929
--------- ----------------- --------------- -------
Total investments 576,452 (62,209) (245,545) 268,698
Cash 9,457 3,647 (2) 1,335 (8) 14,439
Accrued investment income 4,527 4,527
Premiums receivable 119,320 (119,320)(5)
Reinsurance recoverable 73,122 (73,122)(5)
Deferred policy acquisition costs 23,585 (23,585)(6)
Deferred income tax asset 7,834 127 (2) (5,352)(7) 2,609
Other assets 50,062 (36,975)(5) 13,087
--------- ----------------- -------------- --------
Total Assets 864,359 ($58,435) ($502,564) $303,360
========= ================= ============== ========
Liabilities
Claims and claims expenses $364,554 ($364,554)(5)
Unearned premiums 108,743 (108,743)(5)
Reinsurance balances payable 14,666 (14,666)(5)
Other liabilities 29,882 $1,000 (2) (24,541)(5) $6,341
--------- ------ -- ------------- ------
Total Liabilities 517,845 1,000 (512,504) 6,341
======== ========= ============= ======
Stockholders' Equity
Common stock, $.01 par value: 171 171
Additional paid-in capital 342,034 342,034
Deferred compensation under stock award plan
(317)
(317)
Retained earnings (deficit) (22,175) 10,959 (3) 6,080 (9) (5,136)
Less treasury stock, at cost (387) (59,200)(1) (59,587)
Accumulated other comprehensive income
consisting of unrealized appreciation of
investments, net of income tax 27,188 (11,194)(3) 3,860 (9) 19,854
--------- ------- --- -------- ------
Total Stockholders' Equity 346,514 (59,435)(2) 9,940 (9) 297,019
--------- ------- --- --------- ------
Total Liabilities and
Stockholders' Equity $864,359 ($58,435) ($502,564) $303,360
========= ======== ========= ========
Shares outstanding - basic 17,087,970 (4,755,000)(1) -- 12,332,970
========= ========== == ==========
Basic book value per share $20.28 $24.08
====== ======
30
Notes to Pro Forma Balance Sheet
1. Reflects our repurchase from XL Capital of all of the 4,755,000 shares
of our common stock held by it for $59,200,000, or $12.45 per share,
which represents 85% of our average closing market price of our common
stock for the twenty day trading period between January 21, 2000 and
February 17, 2000 in exchange for the following:
(i) our interest in LARC Holdings, Ltd., valued at $25 million, and
(ii) our interest in Annuity and Life Re (Holdings), Ltd. valued at
$37,847,000, consisting of 1,418,440 common shares at $25.38 per
share, which represents the average closing market price of
Annuity and Life Re (Holdings), Ltd. common shares for the twenty
day trading period between January 21, 2000 and February 17,
2000, and 100,000 warrants at $18.50 per warrant based on a
Black-Scholes option valuation model, and
We received cash from XL Capital of $3,647,000, which is the excess of the value
of the securities described in (i) and (ii) above over the purchase price of our
common stock repurchased from XL Capital.
2. The decrease in book value resulting from the XL Capital stock
repurchase is calculated as follows (in thousands):
Repurchase of 4,755,000 shares of our outstanding common stock at
$12.45 per share, recorded as a reduction to stockholders' equity as
treasury stock, plus $59,200
Net loss on the disposition of securities and transaction costs as follows:
(In thousands)
----------------------------------------------------------
Annuity and
Life Re
LARC (Holdings) Ltd.
Holdings, Ltd Total
------------- ----------------- -----
Consideration received, consisting of cash of $3,647,000
and our common stock valued at $59,200,000 $25,000 $37,847 $62,847
Carrying values at December 31, 1999 24,040 38,169 62,209
Pre-tax gain (loss) before transaction costs $960 ($322) 638
======= ====== ========
Transaction costs 1,000
--------
Pre-tax loss (362)
Tax benefit (127)
Net loss (235)
--------
Net decrease in book value $59,435
==========
30
3. The gain recorded in retained earnings of $10,959,000 represents the
realized gain that will be recorded for the $11,194,000 of net
unrealized appreciation, net of tax, recorded at December 31, 1999 for
LARC Holdings, Ltd. and Annuity and Life Re (Holdings), Ltd. and the
net loss of $235,000, which is discussed in note 2 above.
4. Reflects the asset sale, pursuant to which Folksamerica Reinsurance
Company will assume RCRe's liabilities under the reinsurance agreements
transferred to it and RCRe will transfer to Folksamerica Reinsurance
Company assets in an aggregate amount that is, in GAAP book value (as
set forth on our estimated closing date balance sheet), equal to the
GAAP book value (as set forth on our estimated closing date balance
sheet) of the liabilities assumed. In consideration for the transfer of
RCRe's book of business, Folksamerica will pay $20.335 million in cash
at the closing, subject to adjustment under the circumstances described
in our special meeting proxy statement under the heading "The Asset
Purchase Agreement--Purchase Price."
5. Represents securities and insurance assets and insurance liabilities to
be transferred to Folksamerica based on December 31, 1999 financial
statement amounts.
At the closing of the asset sale, RCRe and Folksamerica Reinsurance
Company will enter into a transfer and assumption agreement, under
which Folksamerica Reinsurance Company will assume RCRe's rights and
obligations under the reinsurance agreements being transferred in the
asset sale. Following the closing of the asset sale, Folksamerica
Reinsurance Company will notify the reinsureds under those of such
agreements that are in-force that it has assumed RCRe's obligations and
that, unless the reinsureds object to such assumption, RCRe will be
released from its obligations to those reinsureds. The pro forma
accounting for this transaction assumes that none of RCRe's reinsureds
will object to such assumption and, accordingly, the gross liabilities
for its reinsurance business will be removed from the accounts of RCRe
for statutory accounting and GAAP accounting purposes.
RCRe will continue to record gross liabilities in its accounts for
reinsureds that object to the release of RCRe from its obligations to
such reinsureds. In such instances, an offsetting accounts receivable
amount from Folksamerica Reinsurance Company would be recorded as an
asset equal to such gross liabilities.
6. Elimination of deferred policy acquisition costs related to the
liability for unearned premiums transferred to Folksamerica.
7. Net reduction in deferred income tax asset as follows (in thousands):
Reduction in net deferred tax asset for elimination of temporary
differences between financial statements and income tax return amounts
resulting from the Folksamerica transaction $13,957
Less, estimated tax benefit resulting from the transaction 8,605
Net reduction in deferred tax asset $ 5,352
========
31
8. Represents cash payment received from Folksamerica at the closing of
the asset sale of $20.335 million less estimated related transaction
costs of $19 million, which include investment banking, legal and
accounting fees, severance costs, tax reimbursement to Folksamerica and
costs to purchase additional reinsurance protection for Folksamerica.
9. The book value gain resulting from the Folksamerica transaction is
calculated as follows (in thousands):
Consideration received, consisting of the following:
Total liabilities transferred $512,504
Cash premium received 20,335
--------
532,839
--------
Assets transferred 474,962
Amortization of deferred policy acquisition costs 23,585
Transaction costs 19,000
-------
517,547
-------
Pre-tax gain 15,292
Tax expense 5,352
------
Net transaction gain 9,940
Realized loss, net of tax for securities transferred at market value
(3,860)
------
Net income 6,080
Change in net unrealized appreciation of investments, net of tax 3,860
-----
Comprehensive income and net book gain $9,940
======
The pro forma accounting for this transaction assumes that none of
RCRe's reinsureds will object to the release of RCRe under the transfer
and assumption agreement and, accordingly, the gross liabilities for
such business are removed from the accounts of RCRe for statutory and
GAAP accounting purposes (see note 5 above). RCRe will continue to
record gross liabilities in its accounts for reinsureds that object to
the release of RCRe from its obligations to such reinsureds. This would
result in a portion of the pre-tax gain on the transaction being
deferred and amortized into income as the gross liabilities are
extinguished.
10. Includes $20 million of fixed income securities deposited in an escrow
account for a five year period primarily to reimburse Folksamerica for
claims and claim expenses exceeding reserves recorded by RCRe as of the
closing date resulting from business produced on behalf of RCRe by a
certain managing underwriting agency. At December 31, 1999, such
reserves approximated $38.3 million, which were recorded based on
RCRe's actuarially determined best estimate for such business. We could
record a loss to the extent that such reserves turn out to be
deficient, due to our reimbursement of Folksamerica for such deficiency
to the extent of the escrowed funds. Amounts in escrow may also be
released to Folksamerica to satisfy its indemnification claims against
us relating to undisclosed liabilities, RCRe's reinsurance agreements
and the managing underwriting agency referred to above. Under the asset
purchase agreement, we may be required to deposit an additional amount
of up to $5 million into a supplemental escrow account a short time
following the closing of the asset sale. The above unaudited pro forma
condensed consolidated balance sheet has been prepared assuming that
such supplemental escrow account will not be required.
32
Risk Capital Holdings, Inc. and Subsidiaries
Pro Forma Condensed Consolidated Statement of Income and Comprehensive Income
For the Year Ended December 31, 1999
(Dollars in thousands, except per share data)
Pro Forma Adjustments
---------------------
XL Folksamerica
Historical Transaction(1) Transaction(2) Pro Forma
---------- -------------- -------------- ---------
Revenues
Net premiums written $306,726 ($306,726) --
(Increase) decrease in unearned premiums 4,642 (4,642) --
------- --------- --------
Net premiums earned 311,368 (311,368) --
Net investment income 20,173 $145 (10,253) $10,065
Net realized investment gains and losses 17,227 1,350 1,192 19,769
Total revenues 348,768 1,495 (320,429) 29,834
------- ----- -------- ------
Operating Costs and Expenses
Claims and claims expenses 305,841 (305,841)
Commissions and brokerage 80,540 (80,540)
Other operating expenses 14,816 (10,666) 4,150
(198) 198
------- ------- ---
Total operating costs and expenses 400,999 -- (396,849) 4,150
Income (Loss)
Income before income taxes, equity in net
income of investees and cumulative effect of
accounting change (52,231) 1,495 76,420 25,684
Federal income taxes expense (benefit) (19,557) 571 27,171 8,185
------- ----- ------ -----
Income before equity in net income of
investees and cumulative effect of accounting
change (32,674) 924 49,249 17,499
Equity in net income of investees 621 114 735
------ --- ----- ------
Income (loss) before cumulative effect of
accounting change (32,053) 1,038 9,249 18,234
------- ----- ----- ------
Cumulative effect of accounting change (383) 99 (284)
------- ----- ----- ------
Net income (loss) (32,436) 1,137 49,249 17,950
Other Comprehensive Income (Loss), Net of Tax
Change in net unrealized appreciation of
investments, net of tax (19,850) (1,914) 4,553 (17,211)
Comprehensive Income (Loss) ($52,286) ($777) $53,802 $739
======== ===== ======= ====
Average shares outstanding
Basic 17,086,732 (4,755,000) -- 12,331,732
Diluted 17,086,808 (4,755,000) -- 12,331,808
Per Share Data
Net Income (Loss) - Basic $1.46
($1.90
- Diluted $1.46
($1.90)
Comprehensive Income (Loss) - Basic $0.06
($3.06)
- - - Diluted $0.06
($3.06)
33
Notes to Pro Forma Statement of Income and Comprehensive Income
1. Represents all revenue and expense and other comprehensive income items
recorded during 1999 for LARC Holdings, Ltd. and Annuity and Life Re
(Holdings), Ltd., which were disposed of in the XL Capital stock
repurchase.
2. Represents all revenue and expense and other comprehensive income items
recorded during 1999 related to the sale of our reinsurance business to
Folksamerica Reinsurance Company. Net investment income, net realized
investment gains (losses) and unrealized appreciation (depreciation) of
investments have been allocated based on the proportion of the average
amount of fixed maturities and short term investments related to the
business that will be transferred to the average total fixed maturities and
short term investments in 1999.
All other revenue and expense items were allocated based on specific
identification.
34
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
General
The Company
We are the holding company for RCRe, our wholly owned subsidiary which is
domiciled in Nebraska. We were incorporated in March 1995 and commenced
operations in September 1995 upon completion of our initial public offering. We
received aggregate net proceeds from the offering of approximately $335 million,
of which $328 million was contributed to the capital of RCRe. On November 6,
1995, RCRe was licensed under the insurance laws of the State of Nebraska and is
currently licensed or accredited as a reinsurer in 44 states. As of December 31,
1999, the statutory surplus of RCRe was approximately $290 million. In July
1998, RCRe capitalized its wholly owned subsidiary, Cross River, with $20
million. Cross River received its Nebraska insurance license in October 1998,
and is currently authorized to write insurance on an excess and surplus lines
basis in 22 additional states.
Folksamerica Transaction
As of January 10, 2000, we entered into an agreement with Folksamerica
Reinsurance Company and Folksamerica Holding Company (collectively,
"Folksamerica") pursuant to which Folksamerica Reinsurance Company will assume
RCRe's liabilities under the reinsurance agreements transferred in the asset
sale and RCRe will transfer to Folksamerica Reinsurance Company assets in an
aggregate amount that is, in book value, equal to the book value of the
liabilities assumed. In consideration for the transfer of RCRe's book of
business, Folksamerica will pay $20.335 million in cash at the closing, subject
to adjustment under the circumstances set forth in the asset purchase agreement.
Under the terms of the agreement, we will place $20 million in escrow for a
period of five years. These funds will be primarily used to reimburse
Folksamerica to the extent that the loss reserves (which were $38.7 million at
December 31, 1999) relating to business produced on behalf of RCRe by a certain
managing underwriting agency are deficient as measured at the end of such five
year period. To the extent that such loss reserves are redundant, all of the
escrowed funds will be returned to us and Folksamerica will pay us an amount
equal to such redundancy. We will be responsible for certain tax costs incurred
by Folksamerica in the transaction, as well as our own transaction and severance
costs, and certain reinsurance costs incurred for the benefit of Folksamerica.
An additional amount of up to $5 million may be placed in escrow for a period of
five years to the extent that RCRe's reserves at closing are less by at least a
specified amount than those estimated by its independent actuaries. In
connection with either escrow arrangement, we will record a loss in an amount
equal to any probable deficiency in the related reserve that may become known
during or at the end of the five year period.
The sale of our reinsurance business to Folksamerica is contingent on
approval by our stockholders, obtaining applicable regulatory approvals, the
retention of a key employee, obtaining certain third party consents, the absence
of a material adverse change in RCRe's business, and other customary closing
conditions. Marsh & McLennan Risk Capital Holdings, Ltd. and The Trident
Partnership, L.P., which collectively represent approximately 13.3% of the total
voting power of our outstanding common stock (after giving effect to the
repurchase of 4,755,000 shares on March 2, 2000 from XL Capital, which is
discussed below), have agreed to vote in favor of the asset sale.
Please see the sections of our special meeting proxy statement entitled
"Questions and Answers About the Asset Sale," "Risk Factors," "The Asset Sale,"
"The Asset Purchase Agreement" and "Other Transaction Agreements," which are
incorporated by reference. In addition, we have filed the asset sale agreement,
the voting agreements and other related agreements as exhibits to this annual
report. The above summary of the proposed transaction is qualified by these
agreements, which are incorporated by reference. Please also refer to "Unaudited
Pro Forma Condensed Consolidated Financial Data."
35
The GAAP book value of the assets and liabilities to be transferred to
Folksamerica recorded in the accompanying financial statements at December 31,
1999 are as follows:
(In Millions)
Fixed maturities and short-term investments $245.6
Premiums receivable 119.3
Reinsurance recoverable 73.1
Deferred policy acquisition costs 23.6
Deferred income tax asset 13.9
Other insurance assets 37.0
------
Total Assets $512.5
------
Reserve for claims and claims expenses $364.6
Net unearned premium reserve 108.7
Reinsurance premiums payable 14.7
Other insurance liabilities 24.5
------
Total Liabilities $512.5
------
Net book value of assets and liabilities to be transferred --
=======
The actual GAAP book value of the assets and liabilities transferred to
Folksamerica will be determined as of the closing date of the asset sale, and
will differ from that set forth above.
At the closing of the asset sale, RCRe and Folksamerica will enter into a
transfer and assumption agreement, under which Folksamerica will assume RCRe's
rights and obligations under the reinsurance agreements being transferred in the
asset sale. Following regulatory approval of these agreements, the reinsureds
under such agreements that are in-force will be notified that Folksamerica has
assumed RCRe's obligations and that, unless the reinsureds object to the
assumption, RCRe will be released from its obligations to those reinsureds.
Assuming that none of the reinsureds object to the assumption, the gross
liabilities for such business will be removed from the accounts of RCRe for
statutory accounting and GAAP accounting purposes.
RCRe will continue to record gross liabilities in its accounts for
reinsureds that object to the release of RCRe from its obligations to such
reinsureds. In such instances, an offsetting accounts receivable amount from
Folksamerica would be recorded as an asset equal to such gross liabilities. This
would also result in a portion of any pre-tax gain on the asset sale being
deferred and amortized into income as gross liabilities are extinguished.
XL Transaction
On March 2, 2000, we repurchased from XL Capital, then our single largest
stockholder, all of the 4,755,000 shares of our common stock held by it. Under
the terms of a stock repurchase agreement with XL Capital, we paid $12.45 per
share of our common stock, or a total of $59.2 million. The per share repurchase
price was determined as the lesser of (1) 85% of the average closing market
price of our common stock during the 20 trading days beginning on the third
business day following public announcement of the stock repurchase and asset
sale (January 21, 2000), which was $14.65, and (2) $15. We paid XL Capital the
consideration for the repurchase with: our interest in privately held LARC
Holdings, Ltd. (parent of Latin American Reinsurance Company Ltd.), valued at
$25 million (which was carried by us at $24 million at December 31, 1999); and
all of our interest in Annuity and Life Re (Holdings), Ltd., valued at $25.38
per share and $18.50 per warrant, or $37.8 million in the aggregate (which was
carried by us at $38.2 million at December 31, 1999). XL Capital paid us in cash
the difference (equal to $3.6 million) between our repurchase price and the
value of our interests in LARC Holdings and Annuity and Life Re. The value per
share of Annuity and Life Re was determined by taking the average of the closing
price of Annuity and Life Re shares for the same period used in determining the
repurchase price of our shares. The value of the warrants was determined using a
Black Scholes
methodology. We have filed the stock repurchase agreement and related voting and
disposition agreement as exhibits to this annual report. The above summary of
the transaction is qualified by these agreements, which are incorporated by
reference.
As a result of this transaction, stockholders' equity, which was $346.5
million at December 31, 1999, has been reduced by $59.4 million and the number
of outstanding voting shares, which was 17,087,970 at December 31, 1999, was
12,332,970 at March 2, 2000.
RCRe's statutory surplus, which was $290 million at December 31, 1999, was
also reduced by $60 million for the distribution of the stock and warrants in
both LARC Holdings, Ltd. and Annuity and Life Re Holdings, Ltd., to us, based on
their statutory carrying values at December 31, 1999.
RCRe Distribution
Upon payment of a contemplated distribution from RCRe to us that would
occur after the completion of the asset sale, our assets would consist of fixed
maturity and short term investments, publicly traded equity securities and
privately held securities, and our remaining $19 million investment commitment
to Trident II, L.P. would remain in place. We would also continue to own all of
the outstanding capital stock of RCRe and Cross River, each with statutory
surplus of approximately $20 million (or any greater amount the Nebraska
Insurance Department requires RCRe to retain in the event there are any
objections from reinsureds to the release of RCRe from further liability
pursuant to the transfer and assumption agreement). See "--Liquidity and Capital
Resources" below for a discussion of the regulatory issues relating to
distributions by RCRe.
Future Operations
Following the sale of our reinsurance business to Folksamerica, our
intended strategy is to pursue business combinations and ventures with operating
businesses. Our success will depend almost entirely on the operations, financial
condition and management of the companies with which we may merge or which we
may acquire in whole or in part. We have not yet identified specific business
opportunities. Accordingly, the financial and operational risks that we may
encounter in the future cannot be specified. See the section of our special
meeting proxy statement entitled "Risk Factors--Risks Relating to Our Business
After the Asset Sale," which is incorporated by reference.
Recent Industry Performance
Demand for reinsurance is influenced significantly by underwriting results
of primary property and casualty insurers and prevailing general economic and
market conditions, all of which affect liability retention decisions of primary
insurers and reinsurance premium rates. The supply of reinsurance is directly
related to prevailing prices and levels of surplus capacity, which, in turn, may
fluctuate in response to changes in rates of return on investments being
realized in the reinsurance industry. The last three years have been difficult
periods from both a market and earnings perspective for most insurance markets.
The property and casualty insurance and reinsurance segments have experienced an
increasingly more difficult and highly competitive operating environment
characterized by a soft rate structure and overcapitalization. Other factors
that have contributed to the prevailing competitive conditions in the
reinsurance industry in recent years include new entrants to the reinsurance
market (including certain specialized reinsurance operations) and the presence
of certain reinsurance companies which operate within tax-advantaged
jurisdictions (e.g., Bermuda, Cayman Islands) that benefit from higher after-tax
investment returns. In addition, concerns with respect to the financial security
of Lloyd's that had adversely impacted the competitive position of that
marketplace have apparently been overcome by actions taken at Lloyd's over the
last few years, thereby enhancing its competitive position.
The industry's profitability can also be affected significantly by volatile
and unpredictable developments, including changes in the propensity of courts to
grant larger awards, natural disasters (such as catastrophic hurricanes,
windstorms, earthquakes, floods and fires), fluctuations in interest rates and
other changes in the investment environment that affect market prices of
investments and the income and returns on investments, and inflationary
pressures that may tend to affect the size of losses experienced by ceding
primary insurers. The reinsurance industry is highly competitive and dynamic,
and market changes may affect, among other things, demand for our products,
changes in investment opportunities (and the performance thereof), changes in
the products offered by us or changes in our business strategy.
Reinsurance treaties that are placed by intermediaries are typically for
one year terms with a substantial number that are written or renewed on January
1 each year. Other significant renewal dates include April 1, July 1 and October
1. The January 1, 2000 renewal period was marked by continuing intensified
competitive conditions in terms of premium rates and treaty terms and conditions
in both the property and casualty segments of the marketplace. These conditions
have been worsened due to large domestic primary companies retaining more of
their business and ceding less premiums to reinsurers. Commencing in late 1997,
in addition to our core business, we expanded into specialty classes of
reinsurance business, including marine and aviation and space in 1997, surety
and fidelity in 1998, and accident and health in 1999. In 1999, we discontinued
our aviation and space lines of business.
In-Force Business
At January 1, 2000, RCRe had approximately 330 renewable in-force
reinsurance treaties (such renewal is subject to negotiation and evaluation
during the renewal period), with approximately $249.1 million of estimated
annualized net premiums written, compared to $287.5 million at January 1, 1999
and $172.5 million at January 1, 1998, representing a decline of 13% and an
increase of 67% over the prior year, respectively. Such in-force premiums at
January 1, 2000 represent estimated annualized premiums from treaties entered
into during 1999 and the January 1, 2000 renewal period that are expected to
generate net premiums written during 2000. Such treaties at January 1, 2000 are
estimated to generate approximately $210.6 million of net premiums written over
the 12-month period ending December 31, 2000 without taking into account certain
factors, including the possibilities that (i) several treaties entered into in
1999 that are scheduled to expire during the remainder of 2000 may be renewed
and (ii) additional treaties may be bound during 2000.
The decline in in-force business of 13% in 1999 compared to 1998 is due to
several factors which include (i) discontinuing aviation and space business in
1999; (ii) non-renewals in other classes of business, due to (a) our adherence
to underwriting standards in competitive market conditions and (b) the effect on
cedents of our poor underwriting performance, coupled with a decline in RCRe's
A.M. Best rating from A to A-. Such decline was partially offset by increased
in-force premiums in Accident & Health business where significant underwriting
capacity has exited the market since 1998, and we believe reinsurance pricing
improvements have occurred in 1999 and 2000.
Results of Operations
We had consolidated comprehensive losses of $52.3 million and $4.4 million
for the years ended December 31, 1999 and 1998, respectively, and consolidated
comprehensive income of $47.1 million for the year ended December 31, 1997. Our
comprehensive income or loss is composed of net income and the change in
unrealized appreciation of investments. Net loss for the year ended December 31,
1999 was $32.4 million and net income for the years ended December 31, 1998 and
1997 was $3.1 million and $2.0 million, respectively. After-tax realized
investment gains (losses) of $11.2 million, $16.4 million and ($0.5 million)
were also included in net income for 1999, 1998 and 1997, respectively. Net
income for the years ended December 31, 1999, 1998 and 1997 included income
(losses) of $0.7 million, ($1.1 million), and ($0.2 million), respectively,
representing our equity in the net income (loss) of investee companies accounted
for under the equity method of accounting. Net loss for the year ended December
31, 1999 also included a loss of $383,000 from a cumulative effect of an
accounting change for start-up costs.
38
Following is a table of per share data for the years ended December 31, 1999,
1998 and 1997 on an after-tax basis:
Years Ended December 31,
----------------------------------------------------
1999 1998 1997
---- ---- ----
Basic earnings per share:
Underwriting loss ($3.42) ($1.39) ($0.45)
Net investment income 0.85 0.68 0.61
Net realized investment gains (losses) 0.66 0.96 (0.03)
Equity in net income (loss) of investees 0.03 (0.07) (0.01)
Cumulative effect of accounting change (0.02)
------- ------- -------
Net income (1.90) 0.18 0.12
Change in net unrealized appreciation of investments (1.16) (0.44) 2.65
Comprehensive income (loss) ($3.06) ($0.26) $2.77
====== ====== =====
Average Shares Outstanding (000's) 17,087 17,065 17,033
====== ====== ======
Diluted earnings per share:
Underwriting loss ($3.42) ($1.35) ($0.45)
Net investment income 0.85 0.65 0.61
Net realized investment gains (losses) 0.66 0.93 (0.03)
Equity in net income (loss) of investees 0.03 (0.06) (0.01)
Cumulative effect of accounting change
(0.02)
------- ------ -------
Net income ($1.90) $0.17 $0.12
====== ===== =====
Comprehensive income (loss) ($3.06) ($0.26) $2.76
====== ====== =====
Average shares outstanding (000's) 17,087 17,718 17,086
==== ====== ====== ======
Book Value Per Share, December 31:
Basic $20.28 $23.29 $23.51
Diluted $20.28 $22.75 $22.79
Shares outstanding (000's)
Basic 17,088 17,087 17,058
Diluted 17,088 17,498 17,602
39
Net Premiums Written
Net premiums written for the years ended December 31, 1999, 1998 and 1997
were as follows:
(In millions) Percent
Years Ended December 31, Change
------------------------ ------
1999 1998 1997 1998/1999
---- ---- ---- ---------
Property $78.9 $33.7 $17.8 134%
Casualty 64.1 80.3 69.7 (20%)
Multi-line 67.7 62.8 45.9 8%
Other 7.6 16.5 10.0 (54%)
Accident & Health 50.3
Aviation & Space 18.4 26.0 (29%)
Marine 14.0 14.4 1.4 (3%)
Surety & Fidelity 5.7 1.0 470%
----- ----- ------ -----
Total $306.7 $234.7 $144.8 31%
====== ====== ====== ==
Set forth below are RCRe's assumed and ceded premiums written for the years
ended December 31, 1999, 1998 and 1997:
(In millions)
Years Ended December 31,
------------------------
1999 1998 1997
---- ---- ----
Assumed premiums written $386.8 $260.5 $147.8
Ceded premiums written 80.1 25.8 3.0
Net premiums written $306.7 $234.7 $144.8
RCRe's net premiums written increased 31% to $306.7 million in 1999 from
$234.7 million in 1998 and 62% to $234.7 million in 1998 from $144.8 million in
1997. Premium growth resulted from two key strategies, the integration of
investment with reinsurance and the diversification into "specialty" classes of
business, which for purposes of this discussion consist of Accident & Health,
Aviation and Space, Marine and Surety & Fidelity.
Approximately 30%, 32% and 29% of net premiums written in 1999, 1998 and
1997, respectively, were generated from companies in which we have invested or
committed to invest funds ("integrated transactions").
Approximately 29%, 18% and 1% of net premiums written in 1999, 1998 and
1997, respectively, was produced from specialty classes of business. Specialty
classes of business accounted for 65% and 44% of the increase in net premiums
written for 1999 and 1998, respectively.
Approximately 15%, 32% and 28% of net premiums written in 1999, 1998 and
1997, respectively, were from non-United States clients, which are Lloyd's
syndicates or are located in the United Kingdom, Bermuda and Continental Europe.
Net premiums written in 1999 includes approximately $26 million related to
a group of property reinsurance treaties that expired in 1999 covering crop hail
business underwritten on behalf of a start-up entity formed by Trident II, L.P.
This business was protected by extensive aggregate excess of loss retrocession
and generated a profit based upon underwriting results. We do not expect to
renew these treaties in 2000.
Net premiums written in 1999 for other business was reduced by $10.6
million for the retrocession of a treaty which covers future multiple rocket
launches that was recorded in 1996. The reduction of net premiums written
resulting from this retrocession increased the commission and operating expense
ratio components of the statutory composite ratio by 1.1 percentage points, but
had no impact on operating results.
Consistent with our strategy of writing a small number of large treaties
for our core business, two clients contributed approximately $81.3 million or
26.5% of 1999 total net premiums written, with the largest client contributing
approximately 13.7% and the second contributing 12.8%. Approximately 70% of the
business
40
written from the client that contributed 13.7% and all of the business written
from the client that contributed 12.8% are part of an integrated transaction,
and such business is subject to renewal at our option for two and four remaining
years, respectively.
In 1998, three clients contributed approximately $74 million, or 32%, of
1998 total net premiums written, with the largest client contributing
approximately 18% and the remaining two contributing 8% and 6%, respectively. In
1997, five clients contributed approximately $68 million, or 45%, of total net
premiums written, with the largest client contributing approximately 18% and the
remaining four contributing from 5% to 8%.
RCRe's ceded premiums increased to $80.1 million in 1999, compared to $25.8
million in 1998 and $3.0 million in 1997. Such ceded premiums primarily relate
to RCRe's property, multi-line, marine, aviation and space reinsurance business,
for which we seek to reduce RCRe's exposure to large and catastrophic losses.
Since the fourth quarter of 1998, we have purchased additional retrocessional
protection to reduce RCRe's exposures to both space and aviation risks.
Effective July 1, 1999, RCRe also purchased a retrocessional treaty for a one
year period covering earthquake, wind and other property catastrophe perils for
$10 million in excess of a $15 million retention per occurrence. See "(Results
of Operations(Aviation Business" and "(Risk Retention," "Business(Retrocessional
Arrangements" and Note 7 of the accompanying notes to our consolidated financial
statements.
While not anticipated, prior to the asset sale, the reduction or loss of
business assumed from one or more large clients could have a material adverse
effect on our results of operations to the extent not offset by new business.
Operating Costs and Expenses
One traditional method of measuring the underwriting performance of a
property/casualty insurer, such as RCRe, is the statutory combined ratio. This
ratio, which is based upon statutory accounting principles (which differ from
generally accepted accounting principles in several respects), reflects
underwriting experience, but does not reflect income from investments. A
statutory combined ratio under 100% indicates underwriting profitability, while
a combined ratio exceeding 100% indicates an underwriting loss.
Set forth below are RCRe's statutory combined ratios for the years ended
December 31, 1999, 1998 and 1997 and the estimated aggregate statutory combined
ratios for domestic reinsurers and domestic broker market reinsurers based on
data reported by the Reinsurance Association of America ("RAA") as of such
dates:
Years Ended December 31,
-----------------------------------
1999 1998 1997
---- ---- ----
Claims and claims expenses 98.2% 85.4% 68.4%
Commissions and brokerage 26.3% 24.2% 28.8%
---- ---- ----
124.5% 109.6% 97.2%
Other operating expenses 4.7% 6.8% 9.1%
----- ------ -----
Statutory combined ratio 129.2% 116.4% 106.3%
===== ===== =====
Domestic reinsurer aggregate
Statutory combined ratios 113.8% 104.4% 102.3%
===== ===== =====
After-tax underwriting losses for the years indicated were as follows
(dollars in millions):
Years Ended December 31,
-----------------------------------
1999 1998 1997
---- ---- ----
After-tax underwriting loss
Amount $ 58.4 $ 23.0 $ 7.7
Per Share (Basic) $ 3.42 $ 1.39 $ 0.45
Statutory combined ratio after-tax underwriting results for 1999 and 1998
reflect very poor underwriting performance in competitive market conditions.
41
RCRe's 1999 and 1998 statutory combined ratios were adversely affected by
underwriting results from the sources identified below, which added 16 points
and 9 points to the combined ratios (excluding operating expenses), respectively
(dollars in millions):
1999 Year Underwriting Impact
-----------------------------
Managing
Underwriting Space &
Agency Aviation Total
------ -------- -----
Net premiums written $ 2.1 $ 18.4 $ 20.5
Earned premiums $ 6.4 $ 13.8 $ 20.2
After-tax underwriting loss
Amount $ 16.5 $ 19.7 $ 36.2
Per Share (Basic) $ 0.96 $ 1.15 $ 2.11
Combined Ratio Effect (in
percentage points) 7.7 8.3 16.0
1998 Year Underwriting Impact
--------------------------------------
Managing
Underwriting Space &
Agency Aviation Total
------ -------- -----
Net premiums written $ 16.3 $ 26.0 $ 42.3
Earned premiums $ 12.5 $ 21.3 $ 33.8
After-tax underwriting loss
Amount $ 6.5 $ 7.8 $ 14.3
Per Share (Basic) $ 0.38 $ 0.46 $ 0.84
Combined Ratio Effect (in
4.1 4.9 9.0
percentage points)
Managing Underwriting Agency
As identified above, during 1999 and 1998, we recorded after-tax
underwriting losses of $16.5 million, or $0.96 per share, and $6.5 million, or
$0.38 cents per share, respectively, from reinsurance on casualty and multi-line
business produced by the managing underwriting agency. We also recorded related
after-tax investment losses of $1.3 million, or $0.07 per share, and $862,000,
or $0.03 per share, in net realized investment losses in 1999 and 1998,
respectively. We have discontinued our underwriting relationship with the
managing underwriting agency. The business and operations of the managing
underwriting agency are in run-off.
The total estimated ultimate net premiums written and earned by RCRe on all
business produced by the managing underwriting agency recorded from inception in
late 1997 through December 31, 1999 are approximately $19.3 million and $19.1
million, respectively, resulting in an inception to date after-tax underwriting
loss of $22.4 million. Net reserves for claims and claims expenses for this
business approximated $38.7 million at December 31, 1999. See "--Folksamerica
Transaction" for a discussion of a $20 million escrow fund relating to such
reserves in connection with the sale of our reinsurance business to
Folksamerica.
Space & Aviation Business
As identified above, during 1999 and 1998, RCRe recorded after-tax
underwriting losses of $19.7 million, or $1.15 per share, and $7.8 million, or
$0.46 per share, respectively, for its space and aviation lines of business.
During 1999, RCRe discontinued both lines of business.
42
Space Business
The total estimated ultimate net premiums written and earned by RCRe for
space business from inception in 1998 through December 31, 1999 are $17.6
million each, resulting in an inception to date after-tax underwriting loss of
$13.1 million. Net reserves for claims and claims expenses for space business
approximated $2.4 million at December 31, 1999.
At December 31, 1999, all satellite treaties have expired except for one
treaty covering future multiple rocket launches which was 100% retroceded in
1999.
Aviation Business
The total estimated ultimate net premiums written and earned by RCRe for
aviation business from inception in 1998 through December 31, 1999 are $26.8
million and $17.5 million, respectively, resulting in an inception to date
after-tax underwriting loss of $14.3 million. Net reserves for aviation business
approximated $26 million at December 31, 1999.
Included in the 1999 after-tax underwriting loss for aviation business are
incurred losses for the 1998 Swiss Air and Korean Air crashes and certain 1999
crashes, including the Egypt Air, American Airlines, Korean Air and China Air
crashes. The additional loss recorded in 1999 for the Swiss Air crash was based
on a reallocation of the $642 million expected industry loss between the plane
manufacturer and Swiss Air. This reallocation adversely affected RCRe's gross
loss. The gross loss associated with the Swiss Air crash reported as of December
31, 1998 had exhausted RCRe's retrocessional protections applicable to this
occurrence. Therefore, none of such additional loss reported was ceded to
retrocessionaires. To the extent that either the expected industry loss
increases or additional loss is allocated to the plane manufacturer, RCRe could
record additional losses. For example, if the expected industry loss increases
by approximately $100 million, and assuming additional loss reallocations such
that one-third of the industry loss is allocated to the plane manufacturer, RCRe
would record additional aggregate loss (net of additional reinstatement
premiums) of approximately $2.7 million after-tax. However, we cannot be certain
of the ultimate industry loss or the final allocation of liability between the
plane manufacturer and Swiss Air, and there can be no assurances that the
ultimate industry loss will not be larger or that the plane manufacturer will
not be allocated a greater proportion of the industry loss. With respect to all
other reinsured crashes which occurred through December 31, 1999, we currently
believe that RCRe's gross loss will not exhaust RCRe's reinsurance protections
(although RCRe's net loss could increase within these protections based on the
ultimate industry loss, the ultimate allocation of losses between the plane
manufacturers and the airlines and other factors).
For the year ended December 31, 1999, aviation assumed gross premiums
earned, retroceded premiums earned, and net earned premiums were $43.7 million,
$32.5 million and $11.2 million, respectively. While RCRe discontinued writing
aviation business in 1999, RCRe currently has a number of assumed treaties that
will continue to expose it to significant risk of aviation losses through 2001.
Current estimates for gross aviation premiums that will be earned beyond 1999
aggregate approximately $20.5 million. Retrocessional premium charges to be
recorded for retrocessional treaties presently in-force that expire during 2000
total approximately $15.4 million. Such retrocessional premium costs do not
include additional retrocessional premium amounts that will be purchased to
provide Folksamerica with additional retrocessional protection in connection
with the sale of our reinsurance business to Folksamerica.
Following the Egypt Air crash in October 1999, RCRe exhausted its initial
layer of retrocessional protection for 1999 aviation exposures. Since October
1999, RCRe's initial retention as well as its total retention for aviation
exposures are contingent on the size of insured industry losses, which could
materially impact the recoveries under such retrocessions and therefore the net
loss to us. Based on information currently available to us, we believe that
RCRe's maximum exposures (net of retrocessional recoveries and reinstatement
premiums) for future commercial airline losses vary depending on (i) the size of
insured industry losses, (ii) the declining gross loss exposures as current
in-force business expires, and (iii) the application of retrocessional
protections which expire throughout 2000. Based on such current information, set
forth below is our estimate of after-tax losses for RCRe's maximum exposures for
the size industry loss and the time period presented (in millions):
$700
to
Industry Loss: $50 $100 $200 $300 $500 $1,500
--- ---- ---- ---- ---- ------
Year 2000
From/To:
January 1
March 31 $1.5 $4.1 $3.4 $1.2 N/A $1.0
April 1
June 30 $1.5 $4.1 $6.5 $4.3 $2.4 $8.3
July 1
September 30 $1.3 $3.1 $6.5 $7.5 $5.8 $8.7
October 1
December 31 $1.6 $3.7 $3.6 $5.1 $6.2 $8.7
Year 2001 $1.6 $3.7 $5.3 $5.5 $5.5 $7.8
We are presently evaluating the impact of recent commercial airline crashes
that occurred in 2000, including the Alaska Air crash.
Other Underwriting Loss Activity
Except for multi-line business, all other classes of business also
contributed to the 1999 underwriting loss, with the largest contribution from
property business. The after-tax underwriting loss for property business
approximated $4.9 million which included after-tax losses of $4.3 million for
two large catastrophes in 1999 (Rouge steel plant in Dearborn, Michigan and
French storm losses).
The 1998 underwriting loss included an after-tax underwriting loss of $3.3
million for a property loss on a finite risk treaty.
1999 Prior Year Development
Estimates of prior accident year claims were increased by approximately $30
million in 1999 which added 10.2 points to the 1999 combined ratio. A
substantial portion of this amount stemmed from (i) our review of additional
claims information and our continuing underwriting and actuarial analysis of the
business produced by the managing underwriting agency, (ii) notification of
additional satellite losses received in 1999 pertaining to 1998, (iii) aviation
losses, principally the previously discussed 1998 Swiss Air crash, and (iv)
property losses reported on several international treaties that are in run-off.
Estimates of prior accident year claims were reduced by approximately $2.8
million in 1998 primarily due to favorable claim development in the property and
multi-line classes of business.
Claims and claims expenses generally represent our most significant and
uncertain costs. Reserves for these expenses are estimates involving actuarial
and statistical projections at a given time of what we expect the ultimate
settlement and administration of claims to cost based on facts and circumstances
then known. The reserves are based on estimates of claims and claims expenses
incurred and, therefore, the amount ultimately paid may be more or less than
such estimates. The inherent uncertainties of estimating claim reserves are
exacerbated for reinsurers by the significant periods of time (the "tail") that
often elapse between the occurrence of an insured loss, the reporting of the
loss to the primary insurer and, ultimately, to the reinsurer, and the primary
insurer's payment of that loss and subsequent indemnification by the reinsurer.
As a consequence, actual claims and claims expenses paid may deviate, perhaps
materially, from estimates reflected in our reserves reported in our financial
statements. The estimation of reserves by new reinsurers, such as us, may be
less reliable than the reserve estimations of a reinsurer with an established
volume of business and claims history. To the extent reserves prove to be
inadequate, we may have to augment such reserves and incur a charge to earnings.
44
Acquisition Costs
In pricing RCRe's reinsurance treaties, we focus on many factors, including
exposure to claims and commissions and brokerage expenses. Commissions and
brokerage expenses are acquisition costs that generally vary by the type of
treaty and line of business, and are considered by our underwriting and
actuarial staff in evaluating the adequacy of premium writings. In a number of
reinsurance treaties, provisional commissions are initially paid and
subsequently increased or decreased, subject to a minimum and maximum amount,
depending upon the claims and claims expenses experience of the assumed
business. We record the commission increase or decrease in accordance with
contractual terms based on the expected ultimate experience of the contract. The
claims and commissions and brokerage ratios reflect our business mix.
Other Operating Expenses
Other operating expenses were $14.8 million in 1999, compared to $16.5
million and $13.5 million for the years ended December 31, 1998 and 1997,
respectively.
For 1999, the statutory operating expense ratio declined to 4.7%, compared
with 6.8% for 1998 and 9.1% in 1997. The decline in our operating expense ratio
was due to a decrease in other operating expenses and an increase in our net
premiums written from the comparable prior year period. In addition, commencing
in 1999, we allocated certain compensation and other operating expenses related
to investment activities in the amount of $2.1 million to net investment income
based on internal time studies. Such allocations were not made in prior periods.
Due to such allocations, the 1999 statutory operating expense ratio improved by
approximately one point and net investment income was reduced by approximately
$0.08 per share, with no overall effect on operating results. On a pro-forma
basis, the statutory operating expense ratios for 1998 and 1997 would have been
5.8% and 7.6%, respectively.
Foreign Exchange
Pre-tax foreign exchange gains and losses are recorded separately from
statutory underwriting results and are therefore excluded from the statutory
composite ratio. Unhedged monetary assets and liabilities are translated at the
exchange rate in effect at the balance sheet date, with the resulting foreign
exchange gains or losses recognized in income. For the years ended December 31,
1999, 1998 and 1997, pretax foreign exchange gains and (losses) were $198,000,
$443,000 and ($682,000), respectively. Such future gains or losses may be
affected by changes in foreign exchange rates which are unpredictable and could
be material. For additional discussion, see "--Market Sensitive Instruments and
Risk Management" below.
Risk Retention
Given RCRe's current level of surplus, under its current underwriting
guidelines, the maximum net retention on any one claim for a given property or
casualty treaty risk is generally $10 million.
We monitor RCRe's earthquake and wind exposures and continuously reevaluate
its estimated probable maximum pre-tax loss for such exposures through the use
of modeling techniques. We generally seek to limit RCRe's probable maximum
pre-tax net loss to no more than 10% of its statutory surplus for severe
catastrophic events such as hurricanes and earthquakes that could be expected to
occur once in every 100 years. This limitation includes combined exposure to
underwriting losses, reinstatement costs for retrocessional arrangements which
may be in force at the time of the losses resulting from the catastrophic event,
and losses that RCRe may be exposed to as a result of its privately held
investments in insurance and insurance-related entities. While we believe RCRe's
risk management techniques are adequate, we cannot assure you that RCRe will not
suffer pre-tax losses greater than 10% of its statutory surplus from a
catastrophic event due to the inherent uncertainties in estimating the frequency
and severity of such exposures. In addition, we believe that we cannot
reasonably estimate RCRe's exposure to unrealized investment losses (if any)
that may result from RCRe's investments in publicly traded securities of
insurance and insurance-related entities.
With respect to integrated solutions (where we combine an equity,
equity-like or debt investment in a client company with the purchase by such
client of reinsurance from RCRe), we generally limit RCRe's combined
underwriting and investment exposure to pre-tax losses on any individual client
to no more than 10% of RCRe's total statutory surplus.
45
We continue to evaluate RCRe's potential catastrophe exposure, including
both gross loss estimates and the impact of available reinsurance protection.
While we believe our management of catastrophe exposures and underwriting
guidelines are adequate, an extremely large catastrophic event, multiple
catastrophic events or other unforeseen events could have a material adverse
effect on our financial condition and results of operations.
Net Investment Income
At December 31, 1999, approximately 59% of our invested assets consisted of
fixed maturity and short-term investments, compared to 48% at December 31, 1998.
Net investment income was approximately $20.2 million in 1999, compared to $15.7
million and $14.4 million in 1998 and 1997, respectively. Such amounts for 1999,
1998 and 1997 are net of investment expenses of $5.5 million, $3.6 million and
$2.2 million, respectively. The investment expense amounts include investment
advisory fees of $2.0 million, $3.3 million and $1.8 million, respectively. The
1999 net investment income is also net of $1.1 million for the payment of
interest expense in connection with the settlement of satellite losses.
Our investment yields at amortized cost were as follows for the periods set
forth below:
Years Ended December 31,
---------------------------------------------
1999 1998 1997
---- ---- ----
Investment yields:
Pre-tax 3.6% 3.4% 3.7%
Net of tax 2.7% 2.5% 2.7%
Our investment yields are reflective of a significant allocation of the
total investment portfolio in equity securities, which yield less current income
than fixed maturity investments. At December 31, 1999 and 1998, investments in
public and private equity securities approximated 41% and 49%, respectively, of
total cash and invested assets. Additionally, such investment yields exclude our
equity in the net income or loss of private equity investments accounted for
under the equity method.
Net Realized Gains (Losses) on Investments
Our source of net realized investment gains (losses) were as follows:
In thousands
Years Ended December 31,
---------------------------------
1999 1998 1997
---- ---- ----
Net realized investment gain (losses)
Fixed maturity securities ($1,776) $1,472 $275
Publicly traded equity securities 16,798 16,582 3,878
Privately held securities 2,205 7,198 (4,913)
------- ------- ------
Sub-total 17,227 25,252 (760)
Income tax expense (benefit) 6,029 8,838 (266)
------- ------- ----
Net realized investment gains (losses), net of $11,198 $16,414 ($494)
======= ======= =====
tax
Income Taxes
Our 1999 income tax benefit, 1998 effective tax rate of 5% and the 1997
income tax benefit are less than the 35% statutory rate on pre-tax operating
income due primarily to tax exempt income and the dividends received deductions.
The 1999, 1998 and 1997 gross deferred income tax benefits of approximately
$10.5 million, $7.3 million and $2.1 million, respectively, which are assets
considered recoverable from future taxable income, resulted from temporary
differences between financial and taxable income.
46
The net deferred income tax asset at December 31, 1999 was $7.8 million. We
periodically evaluate the need for a valuation allowance for any portion of the
deferred tax asset that our management believes will not be realized based on
current and future operating performance and available tax planning strategies.
While we believe that a valuation allowance is not necessary at December
31, 1999, continued future comprehensive losses or future decisions with respect
to business strategy following the sale of our reinsurance business may result
in the establishment of a valuation allowance in future financial statements.
We have a net operating loss carryforward which expires in 2019, for which
we have established a deferred income tax asset of $7.3 million at December 31,
1999. The repurchase of our common stock held by XL Capital resulted in a 27.8%
change in ownership by 5% shareholders. If, in the ensuing three years, there is
more than a 22.2% additional change in ownership by 5% shareholders, an
"ownership change" will have taken place for federal income tax purposes. If
such ownership change occurs, the amount of loss carryforwards that can be used
in any subsequent year may be severely limited and could be eliminated in
certain circumstances. See the section of our special meeting proxy statement
entitled "Risk Factors--The financing of our business plan may cause us to
forfeit certain tax benefits," which is incorporated by reference.
Investments
A principal component of our investment strategy is investing a significant
portion of RCRe's invested assets in publicly traded and privately held equity
securities, primarily issued by insurance and reinsurance companies and
companies providing services to the insurance industry. Cash and fixed maturity
investments and, if necessary, the sale of marketable equity securities will be
used to support shorter-term liquidity requirements.
As a significant portion of RCRe's investment portfolio consists of equity
securities issued by insurance and reinsurance companies and companies providing
services to the insurance industry, the equity portfolio lacks industry
diversification and will be particularly subject to the performance of the
insurance industry. Unlike fixed income securities, equity securities such as
common stocks, including the equity securities in which RCRe has invested,
generally are not and will not be rated by any nationally recognized rating
service. The values of equity securities generally are more dependent on the
financial condition of the issuer and less dependent on fluctuations in interest
rates than are the values of fixed income securities. The market value of equity
securities generally is regarded as more volatile than the market value of fixed
income securities. The effects of such volatility on RCRe's equity portfolio
could be exacerbated to the extent that such portfolio is concentrated in the
insurance industry and in relatively few issuers. From December 31, 1999 to
March 24, 2000, the market value of our public equity portfolio has decreased by
approximately $28 million due to general stock market volatility, market decline
in the property and casualty insurance sector and the poor operating performance
of several of our investee companies. For additional discussion, see "--Market
Sensitive Instruments and Risk Management" below.
As our investment strategy is to invest a significant portion of RCRe's
investment portfolio in equity securities, our investment income in any fiscal
period may be smaller, as a percentage of investments, and less predictable than
that of other insurance and/or reinsurance companies, and net realized and
unrealized gains (losses) on investments may have a greater effect on our
results of operations or stockholders' equity at the end of any fiscal period
than would be the case for other insurance and/or reinsurance companies. Since
the realization of gains and losses on equity investments is not generally
predictable, such gains and losses have differed and will differ significantly
from period to period. Variability and declines in our results of operations
could be further exacerbated by private equity investments in start-up companies
which are accounted for under the equity method. Such start-up companies may be
expected initially to generate operating losses.
Investments included in RCRe's private portfolio include securities issued
by privately held companies and by publicly traded companies that are generally
restricted as to resale or are otherwise illiquid and do not have readily
ascertainable market values. The risk of investing in such securities is
generally greater than the risk of investing in securities of widely held,
publicly traded companies. Lack of a secondary market and resale restrictions
may result in an inability by us to sell a security at a price that would
otherwise be obtainable if such restrictions did not exist and may substantially
delay the sale of a security we seek to sell.
At December 31, 1999, cash and invested assets totaled approximately $585.9
million, consisting of $82.2 million of cash and short-term investments, $261.1
million of publicly traded fixed maturity investments,
47
$158.6 million of publicly traded equity securities, and $83.9 million of
privately held securities. Included in privately held securities are investments
totaling $42.6 million which are accounted for under the equity method.
At December 31, 1999, RCRe's private equity portfolio consisted of 12
investments, with additional investment portfolio commitments in an aggregate
amount of approximately $23.2 million.
In 1999, we completed one integrated transaction with an existing client of
RCRe, a follow-on investment in an existing investee and one additional
investment commitment. In addition, we divested four of RCRe's investments. (See
note 3 under the caption "Investment Information" of the accompanying notes to
our audited consolidated financial statements.)
In October 1998, we provided $5 million in financing on a fully secured
basis to a managing general agency, and received a related reinsurance
commitment expected to generate an aggregate of $90 million of reinsurance
premiums over three years pursuant to terms and conditions that we believe are
more favorable than those available in the open market.
On March 6, 2000, we extended a loan in an aggregate principal amount of
$3.5 million to American Independent Insurance Holding Company ("AIHC"), one of
our investee companies. The loan is secured by a second priority pledge of the
capital stock of AIHC and assets of AIHC, and matures on September 6, 2001
(which date may be extended to March 6, 2002 upon the occurrence of certain
events). The net proceeds of the loan were contributed to the surplus of AIHC's
subsidiary, American Independent Insurance Company. In connection with the loan,
we were issued warrants (in addition to the warrants issued to us in connection
with a prior loan to AIHC) granting us the right to acquire equity in AIHC.
See note 3 under the caption "Investment Information" of the accompanying
notes to our audited consolidated financial statements for certain information
regarding RCRe's publicly traded and privately held securities and their
carrying values, and commitments made by RCRe relating to its privately held
securities.
At December 31, 1999, approximately 88% of RCRe's fixed maturity and
short-term investments were rated investment grade by Moody's or Standard &
Poor's and had an average quality rating of AA and an average duration of
approximately 3.7 years.
At December 31, 1999, RCRe is obligated under letters of credit in the
aggregate amount of approximately $9.7 million, which secure certain reinsurance
obligations. Securities with a carrying value of approximately $11.2 million
have been pledged as collateral for these letters of credit.
RCRe has not invested in derivative financial instruments such as futures,
forward contracts, swaps, or options or other financial instruments with similar
characteristics such as interest rate caps or floors and fixed-rate loan
commitments. RCRe's portfolio includes market sensitive instruments, such as
mortgage-backed securities, which are subject to prepayment risk and changes in
market value in connection with changes in interest rates. RCRe's investments in
mortgage-backed securities, which amounted to approximately $27.3 million at
December 31, 1999, or 4.7% of cash and invested assets, are classified as
available for sale and are not held for trading purposes.
Market Sensitive Instruments and Risk Management
In accordance with the SEC's Financial Reporting Release No. 48, the
following analysis presents hypothetical losses in cash flows, earnings and fair
values of market sensitive instruments which are held by RCRe as of December 31,
1999 and are sensitive to changes in interest rates, foreign exchange rates and
equity security prices. This risk management discussion and the estimated
amounts generated from the following sensitivity analysis represent
forward-looking statements of market risk assuming certain adverse market
conditions occur. Actual results in the future may differ materially from these
projected results due to actual developments in the global financial markets.
The analysis methods used by us to assess and mitigate risk should not be
considered projections of future events of losses.
Market risk represents the risk of changes in the fair value of a financial
instrument and is comprised of several components, including liquidity, basis
and price risks. The focus of the SEC's market risk rules is on price risk. For
purposes of specific risk analysis, we employ sensitivity analysis to determine
the effects that market risk exposures could have on the future earnings, fair
values or cash flows of RCRe's financial instruments.
48
The financial instruments included in the following sensitivity analysis
consist of all of our cash and invested assets, excluding investments carried
under the equity method of accounting.
Equity Price Risk
We are exposed to equity price risks on the public and private equity
securities included in RCRe's investment portfolio. All of RCRe's publicly
traded equity securities and privately held securities were issued by insurance
and reinsurance companies or companies providing services to the insurance
industry. We typically do not attempt to reduce or eliminate RCRe's market
exposure on these securities. Investments included in RCRe's private portfolio
include securities issued by privately held companies and securities issued by
public companies that are generally restricted as to resale or are otherwise
illiquid and do not have readily ascertainable market values. Investments in
privately held securities issued by privately and publicly held companies may
include both equity securities and securities convertible into, or exercisable
for, equity securities (some of which may have fixed maturities).
RCRe's publicly traded and privately held equity securities at December 31,
1999, which are carried at a fair value of $158.6 million and $84.0 million,
respectively, have exposure to price risk. The estimated potential losses in
fair value for RCRe's publicly traded and privately held equity portfolios
resulting from a hypothetical 10% decrease in quoted market prices, dealer
quotes or fair value are $15.9 million and $8.4 million, respectively.
Interest Rate Risk
The aggregate hypothetical loss generated from an immediate adverse shift
in the treasury yield curve of 100 basis points would result in a decrease in
total return of 4.1%, which would produce a decrease in market value of $10.6
million on RCRe's fixed maturity investment portfolio valued at $261.1 million
at December 31, 1999. There would be no material impact on RCRe's short-term
investments.
Foreign Currency Exchange Rate Risk
We have foreign currency risk on both reinsurance balances receivable and
reinsurance balances payable, including claims and claims expenses. We do not
currently utilize derivative instruments to manage our exposure to foreign
currency movements. At December 31, 1999, the substantial majority of the
Company's net receivable/payable position was denominated in United States
dollars. At such date, the largest foreign currency exposure related to
liabilities denominated in British Pounds Sterling. We had a net liability
balance in Sterling of approximately $2.6 million. A 10% increase in the
Sterling/United States dollar exchange rate would have resulted in a loss to us
of $268,000. Given our limited amount of net asset or liability balances in
other foreign currencies, any currency movement of 10% would not produce a
material loss for purposes of this discussion.
Liquidity and Capital Resources
We are a holding company and currently have no significant operations or
assets other than our ownership of the capital stock of RCRe. We rely on cash
dividends and distributions from RCRe to make payments, including for any
operating expenses that we may incur and for any dividends or stock repurchases
as our board of directors may determine. Our board currently does not intend to
declare dividends or make any other distributions. However, our board intends to
make a determination regarding stock repurchases following the consummation of
the asset sale. See "Market for Registrant's Common Equity and Related
Stockholder Matters(Dividends" and the sections included in our special meeting
proxy statement entitled "Risk Factors-- We currently do not anticipate paying
dividends, but may consider share repurchases" and "Dividend and Stock
Repurchase Policy." RCRe's ability to pay dividends or make distributions to us
is dependent upon its ability to achieve satisfactory underwriting and
investment results and to meet regulatory standards of the State of Nebraska, as
described below. There are presently no contractual restrictions on RCRe's
payment of dividends or the making of distributions to us. We intend to cause
RCRe to make an extraordinary distribution to us following the asset sale. See
"--General--RCRe Distribution."
Nebraska insurance laws provide that, without prior approval of the
Nebraska Director, RCRe cannot pay a dividend or make a distribution (together
with other dividends or distributions paid during the preceding 12 months) that
exceeds the greater of (i) 10% of statutory surplus as of the preceding December
31 or
49
(ii) statutory net income from operations from the preceding calendar year not
including realized capital gains. Net income (exclusive of realized capital
gains) not previously distributed or paid as dividends from the preceding two
calendar years may be carried forward for dividends and distribution purposes.
Any proposed dividend or distribution in excess of such amount is called an
"extraordinary" dividend or distribution and may not be paid until either it has
been approved, or a 30-day waiting period has passed during which it has not
been disapproved, by the Nebraska Director. Notwithstanding the foregoing,
Nebraska insurance laws provide that any distribution that is a dividend may be
paid by RCRe only out of earned surplus arising from its business, which is
defined as unassigned funds (surplus) as reported in the statutory financial
statement filed by RCRe with the Nebraska Insurance Department for the most
recent year, including any surplus arising from unrealized capital gains or
revaluations of assets. Any distribution that is a dividend and that is in
excess of RCRe's unassigned funds, exclusive of any surplus arising from
unrealized capital gains or revaluation of assets, will be deemed an
"extraordinary" dividend subject to the foregoing requirements. Due to the
distribution that was required to be made in connection with the XL Capital
stock repurchase, we may not declare any other distribution for twelve months
from the closing date of the stock repurchase unless such subsequent
distribution is approved by the Nebraska Director. See "Business--Insurance
Regulation" and note 10 to our audited consolidated financial statements
included in this report for further details regarding statutory restrictions on
distributions by RCRe.
We, RCRe and Cross River file consolidated federal income tax returns and
have entered into a tax sharing agreement (the "Tax Sharing Agreement"),
allocating the consolidated income tax liability on a separate return basis.
Pursuant to the Tax Sharing Agreement, RCRe and Cross River make tax sharing
payments to us based on such allocation.
Net cash flow from operating activities for the years ended December 31,
1999, 1998 and 1997 was approximately $7.5 million, $68.5 million and $49.0
million, respectively, consisting principally of premiums received, investment
income (excluding net realized investment gains), offset by operating costs and
expenses. The primary sources of liquidity for Risk Capital Reinsurance are net
cash flow from operating activities, principally premiums received, the receipt
of dividends and interest on investments and proceeds from the sale or maturity
of investments. RCRe's cash flow is also affected by claims payments, some of
which have been large. For example, we experienced negative cash flow from
operations of approximately $25 million in the 1999 fourth quarter as a result
of significant paid loss activity. Such situations could reoccur as our book of
business matures, claims are settled and if we continue to experience poor
underwriting performance. Therefore, our cash flow could fluctuate significantly
from period to period.
RCRe does not currently have any material commitments for any capital
expenditures over the next 12 months. We expect that our financing and
operational needs for the foreseeable future will be met by our balance of cash
and short-term investments, as well as by funds generated from operations.
Following the sale of the reinsurance operations to Folksamerica, our objective
will be to pursue business combinations and ventures with operating businesses.
We have not yet identified any specific business opportunities. Accordingly, we
may need to secure additional financing to carry out our business plan. We
cannot assure you that we will be successful in the implementation of our
current or future business strategy. See the section of our special meeting
proxy statement entitled "Risk Factors--Risks Relating to Our Business After the
Asset Sale," which is incorporated by reference.
At December 31, 1999, our consolidated stockholders' equity totaled $346.5
million, or $20.28 per share based on issued and outstanding shares, and $20.28
per share on a diluted basis which includes outstanding dilutive warrants and
options. At such date, statutory surplus of RCRe was approximately $290 million.
As a result of the XL Capital stock repurchase, stockholders' equity has been
reduced by $59.4 million and book value per share has increased to $23.27 per
share on a fully diluted basis. RCRe's statutory surplus was also reduced by $60
million to $230 million due to the sale to XL Capital of the stock and warrants
in LARC Holdings, Ltd. and Annuity and Life Re Holdings, Ltd., based on their
statutory carrying values at December 31, 1999. Based on data from the RAA,
after giving effect to the XL Capital stock repurchase, RCRe was the 20th
largest domestic broker market oriented reinsurer as measured by its $230
million of statutory surplus.
50
Accounting Pronouncements
Derivatives and Hedging
In June 1998, the Financial Accounting Standards Board issued Statement No.
133 "Accounting for Derivative Instruments and Hedging Activities." This
statement requires that all derivative financial instruments be recognized in
the statement of financial position as either assets or liabilities and measured
at fair value.
If a derivative instrument is not designated as a hedging instrument, gains
or losses resulting from changes in fair values of such derivative are required
to be recognized in earnings in the period of the change. If certain conditions
are met, a derivative may be designated as a hedging instrument, in which case
the recording of the changes in fair value will depend on the specific exposure
being hedged. The key criterion for hedge accounting is that the hedging
relationship must be highly effective in achieving offsetting changes on fair
values or cash flows.
This statement is effective for fiscal years beginning after June 15, 2000,
with initial application as of the beginning of the first quarter of the
applicable fiscal year.
We will adopt this statement in the first quarter of 2001. Historically, we
have not invested in derivative financial instruments. However, derivatives may
be embedded in other financial instruments, such as convertible securities and
prepayment options in mortgages. If the embedded derivative meets certain
criteria, it must be bifurcated from the host contract and separately accounted
for consistent with other derivatives.
RCRe's portfolio includes market sensitive instruments, such as convertible
securities and mortgage-backed securities, which are subject to prepayment risk
and changes in market value in connection with changes in interest rates. Our
investments in mortgage-backed securities are classified as available for sale
and are not held for trading purposes. Assuming the current investment strategy
at the time of adoption, our presentation of financial information under the new
statement will not be materially different than the current presentation.
Start-Up Costs
Effective January 1, 1999, we changed our method of accounting for start-up
costs in accordance with the Accounting Standards Executive Committee's
Statement of Position ("SOP") 98-5 "Reporting on the Costs of Start-Up
Activities." This statement requires costs of start-up activities, including
organization costs, to be expensed as incurred. The change in accounting
principle resulted in the write-off of the start-up costs capitalized as of
January 1, 1999 for us and RCRe's investee companies carried under the equity
method of accounting. The cumulative effect of the write-off, which totals
$383,000, after-tax, or $0.02 per share, has been expensed and is included in
the 1999 net loss. (See note 2 of the accompanying notes to our audited
consolidated financial statements.)
Insurance Regulation
RCRe, in common with other insurers, is subject to extensive governmental
regulation and supervision in the various states and jurisdictions in which it
transacts business. The laws and regulations of the State of Nebraska, the
domicile of RCRe, have the most significant impact on its operations.
From time to time various regulatory and legislative changes have been
proposed in the insurance and reinsurance industry, some of which could have an
effect on reinsurers. Among the proposals that have in the past been, or are at
present being considered, are (i) the possible introduction of federal
regulation in addition to, or in lieu of, the current system of state regulation
of insurers and (ii) proposals in various state legislatures (some of which
proposals have been enacted) to conform portions of their insurance laws and
regulations to various model acts adopted by the NAIC. We are unable to predict
whether any of such laws and regulations will be adopted, the form in which any
such laws and regulations would be adopted, or the effect, if any, these
developments would have on our operations and financial condition. See
"Business--Insurance Regulation."
In March 1998, the NAIC adopted the codification of statutory accounting
principles project that will generally be applied to all insurance and
reinsurance company financial statements filed with insurance regulatory
authorities as early as the statutory filings made in 2001. Although the
codification is not expected to materially affect many existing statutory
accounting practices presently followed by most insurers and
51
reinsurers such as RCRe, there are several accounting practices that may be
changed. The most significant change would involve accounting for deferred
income taxes, which change would require a deferred tax liability to be recorded
for unrealized appreciation of invested assets, net of available deferred tax
assets, that would result in a reduction to statutory surplus. If such
requirement had been in effect in 1999, the statutory surplus of RCRe at
December 31, 1999 would have remained at $290 million.
Effects of Inflation
The effects of inflation on us are implicitly considered in pricing and
estimating reserves for unpaid claims and claims expenses. The actual effects of
inflation on our results cannot be accurately known until claims are ultimately
settled.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Please refer to the information appearing above under the subheading
"Market Sensitive Instruments and Risk Management" included as part of the
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," which information is incorporated by reference.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See our consolidated financial statements and notes thereto and required
financial statement schedules on pages F-1 through F-43 and S-1 through S-7
below.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item is incorporated by reference from the
information to be included in our definitive proxy statement for our annual
meeting of stockholders to be held in 2000, which we intend to file with the SEC
before April 30, 2000, under the following headings: "Election of
Directors--Directors and Executive Officers--Nominees," "--Continuing Directors
and Executive Officers" and "Election of Directors--Security Ownership of
Certain Beneficial Owners and Management--Section 16(a) Beneficial Ownership
Reporting Compliance."
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference form the
information to be included in the annual meeting proxy statement under the
headings "Election of Directors--Directors and Executive Officers--Compensation
of Directors," "Election of Directors--Executive Compensation" and
"--Performance Graph."
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated by reference from the
information to be included in the annual meeting proxy statement under the
heading "Election of Directors--Security Ownership of Certain Beneficial Owners
and Management."
52
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this item is incorporated by reference from the
information to be included in the annual meeting proxy statement under the
headings "Election of Directors--Executive Compensation--Compensation Committee
Interlocks and Insider Participation" and "Election of Directors--Certain
Relationships and Related Transactions."
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
Financial Statements and Schedules
Financial statements and schedules listed in the accompanying index to our
financial statements and schedules on page F-1 are filed as part of this report,
and are included in Item 8.
Exhibits
The exhibits listed in the accompanying exhibit index are filed as part of
this report. These exhibits include, without limitation, certain management
contracts and compensatory plans as described therein.
Reports on Form 8-K
No reports on Form 8-K were filed by us during the fourth quarter of 1999.
We did file Forms 8-K on (1) January 18, 2000 (reporting the proposed sale of
our reinsurance operations to Folksamerica Reinsurance Company and the XL stock
repurchase) and (2) March 2, 2000 (reporting the closing of the XL stock
repurchase).
53
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
RISK CAPITAL HOLDINGS, INC.
(Registrant)
By: /s/ Mark D. Mosca
Name: Mark D. Mosca
Title: President and Chief
Executive Officer
March 29, 2000
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.
Signature Title Date
/s/ Mark D. Mosca President and Chief Executive Officer March 21, 2000
------------------------------- (Principal Executive Officer) and
Mark D. Mosca Director
/s/ Robert Clements Chairman and Director March 22, 2000
-------------------------------
Robert Clements
/s/ Peter A. Appel Executive Vice President, Chief March 21, 2000
------------------------------- Operating Officer, General Counsel and
Peter A. Appel Director
/s/ Paul J. Malvasio Managing Director, Chief Financial March 21, 2000
------------------------------- Officer and Treasurer (Principal
Paul J. Malvasio Financial Officer and Principal
Accounting Officer)
/s/ Michael P. Esposito, Jr. Director March 27, 2000
-------------------------------
Michael P. Esposito, Jr.
/s/ Lewis L. Glucksman Director March 27, 2000
-------------------------------
Lewis L. Glucksman
/s/ Ian R. Heap Director March 22, 2000
-------------------------------
Ian R. Heap
/s/ Thomas V. A. Kelsey Director March 27, 2000
-------------------------------
Thomas V. A. Kelsey
/s/ Robert F. Works Director March 23, 2000
-------------------------------
Robert F. Works
/s/ Philip L. Wroughton Director March 27, 2000
-------------------------------
Philip L. Wroughton
54
- - ----------------
* By Paul J. Malvasio, as attorney-in-fact and agent, pursuant to a power of
attorney, a copy of which has been filed with the Securities and Exchange
Commission as Exhibit 24 to this report.
/s/ Paul J. Malvasio
-------------------------
Paul J. Malvasio
Attorney-in-Fact
55
INDEX TO FINANCIAL STATEMENTS AND SCHEDULES
Pages
Risk Capital Holdings, Inc. and Subsidiaries
Report of Independent Accountants on Financial
Statements .............................................. F-2
Consolidated Balance Sheet at December 31, 1999 and
1998 .................................................... F-3
Consolidated Statement of Income and Comprehensive
Income for the years ended December 31, 1999, 1998 and
1997 .................................................... F-4
Consolidated Statement of Changes in Stockholders'
Equity for the years ended December 31, 1999, 1998 and
1997 .................................................... F-5
Consolidated Statement of Cash Flows for the years
ended December 31, 1999, 1998 and 1997 .................. F-6
Notes to Consolidated Financial Statements .............. F-7 - F-43
Schedules
Report of Independent Accountants on Financial Statement
Schedules S-1
I. Summary of Investments Other Than Investments in
Related Parties at December 31, 1999 ............... S-2
II. Condensed Financial Information of Registrant ...... S-3 - S-5
III. Supplementary Insurance Information for the years
ended December 31, 1999, 1998 and 1997 ............. S-6
IV. Reinsurance for the years ended December 31, 1999,
1998 and 1997 ...................................... S-7
Schedules other than those listed above are omitted for the reason that they
are not applicable.
F-1
Report of Independent Accountants
To the Board of Directors and Stockholders of
Risk Capital Holdings, Inc.
In our opinion, the accompanying consolidated balance sheet and the related
consolidated statements of income and comprehensive income, of changes in
stockholders' equity and of cash flows present fairly, in all material respects,
the financial position of Risk Capital Holdings, Inc. and its subsidiaries at
December 31, 1999 and 1998, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 1999, in
conformity with accounting principles generally accepted in the United States.
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. We conducted our audits of these statements in accordance with
auditing standards generally accepted in the United States, which require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for the opinion expressed above.
/s/ PricewaterhouseCoopers, LLP
New York, New York
February 1, 2000, except as to Note 14, which is as of
March 2, 2000
F-2
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in thousands)
December 31,
----------------------------------
1999 1998
------------- ----------------
Assets
Investments:
Fixed maturities (amortized cost: 1999, $270,345; 1998, $173,379) $261,067 $174,540
Publicly traded equity securities (cost: 1999, $105,747; 1998, $110,598) 158,631 154,678
Privately held securities (cost: 1999, $85,748; 1998, $109,966) 83,969 137,091
Short-term investments 72,785 108,809
------------- ----------------
Total investments 576,452 575,118
Cash 9,457 12,037
Accrued investment income 4,527 2,632
Premiums receivable 119,320 88,610
Reinsurance recoverable 73,122 30,575
Deferred policy acquisition costs 23,585 23,515
Investment accounts receivable 3,928
Federal income tax recoverable 8,758
Deferred income tax asset 7,834
Other insurance assets 36,975 16,832
Other assets 4,329 4,583
------------- ----------------
Total Assets $864,359 $757,830
============= ================
Liabilities
Claims and claims expenses $364,554 $216,657
Unearned premiums 108,743 102,775
Reinsurance premiums payable 14,666 5,396
Investment accounts payable 3,981
Federal income tax payable 2,229
Deferred income tax liability 13,182
Other insurance liabilities 24,541 9,525
Other liabilities 5,341 6,083
------------- ----------------
Total Liabilities 517,845 359,828
------------- ----------------
Commitments (See Note 5)
Stockholders' Equity Preferred stock, $.01 par value:
20,000,000 shares authorized (none issued)
Common stock, $.01 par value:
80,000,000 shares authorized
(issued: 1999, 17,109,736; 1998, 17,102,503) 171 171
Additional paid-in capital 342,034 341,878
Deferred compensation under stock award plan (317) (1,062)
Retained earnings (deficit) (22,175) 10,261
Accumulated other comprehensive income consisting of unrealized appreciation of
investments, net of income tax 27,188 47,038
Less treasury stock, at cost (1999, 21,766; 1998, 15,065) (387) (284)
------------- ----------------
Total Stockholders' Equity 346,514 398,002
-------------
Total Liabilities and Stockholders' Equity $864,359 $757,830
============= ================
See Notes to Consolidated Financial Statements
F-3
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF INCOME AND COMPREHENSIVE INCOME
(In thousands, except per share data)
Years Ended December 31,
1999 1998 1997
-------------- --------------- -----------------
Revenues
Net premiums written $306,726 $234,735 $144,834
(Increase) decrease in unearned premiums 4,642 (28,541) (37,462)
-------------- -------------- -----------------
Net premiums earned 311,368 206,194 107,372
Net investment income 20,173 15,687 14,360
Net realized investment gains (losses) 17,227 25,252 (760)
-------------- -------------- -----------------
Total revenues 348,768 247,133 120,972
-------------- -------------- -----------------
Operating Costs and Expenses
Claims and claims expenses 305,841 176,125 73,407
Commissions and brokerage 80,540 50,537 31,467
Other operating expenses 14,816 16,452 13,523
Foreign exchange (gain) loss (198) (443) 682
-------------- -------------- -----------------
Total operating costs and expenses 400,999 242,671 119,079
-------------- -------------- -----------------
Income (Loss)
Income (loss) before income taxes, equity in net income (loss)
of investees and cumulative effect of accounting change (52,231) 4,462 1,893
-------------- -------------- -----------------
Federal income taxes:
Current (9,021) 7,512 1,761
Deferred (10,536) (7,277) (2,099)
-------------- -------------- -----------------
Income tax expense (benefit) (19,557) 235 (338)
-------------- -------------- -----------------
Income (loss) before equity in net income (loss) of investees
and cumulative effect of accounting change (32,674) 4,227 2,231
Equity in net income (loss) of investees 621 (1,136) (192)
-------------- -------------- -----------------
Income (loss) before cumulative effect of accounting change (32,053) 3,091 2,039
Cumulative effect of accounting change (383)
-------------- -------------- -----------------
Net income (loss) (32,436) 3,091 2,039
-------------- -------------- -----------------
Other Comprehensive Income (Loss), Net of Tax
Change in net unrealized appreciation of investments, net of tax (19,850) (7,466) 45,068
-------------- -------------- -----------------
Comprehensive Income (Loss) ($52,286) ($4,375) $47,107
============== ============== =================
Average shares outstanding
Basic 17,086,732 17,065,165 17,032,601
Diluted 17,086,808 17,718,223 17,085,788
Per Share Data
Net Income (Loss) - Basic ($1.90) $0.18 $0.12
- Diluted ($1.90) $0.17 $0.12
Comprehensive Income (Loss) - Basic ($3.06) ($0.26) $2.77
- Diluted ($3.06) ($0.26) $2.76
See Notes to Consolidated Financial Statements
F-4
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(In thousands)
Years Ended December 31,
1999 1998 1997
--------------- ---------------- ----------------
Common Stock
Balance at beginning of year $171 $171 $170
Issuance of common stock
Restricted common stock issued 1
--------------- --------------- ----------------
Balance at end of year 171 171 171
Additional Paid-in Capital
Balance at beginning of year 341,878 341,162 340,435
Issuance of common stock 156 716 727
--------------- --------------- ----------------
Balance at end of year 342,034 341,878 341,162
--------------- --------------- ----------------
Deferred Compensation Under Stock Award Plan
Balance at beginning of year (1,062) (1,778) (2,959)
Restricted common stock (issued) cancelled 117 (296) (506)
Compensation expense recognized 628 1,012 1,687
--------------- --------------- ----------------
Balance at end of year (317) (1,062) (1,778)
--------------- --------------- ----------------
Retained Earnings (Deficit)
Balance at beginning of year 10,261 7,170 5,131
Net income (loss) (32,436) 3,091 2,039
--------------- --------------- ----------------
Balance at end of year (22,175) 10,261 7,170
--------------- --------------- ----------------
Treasury Stock, At Cost
Balance at beginning of year (284) (198)
Purchase of treasury stock (103) (86) (198)
--------------- --------------- ----------------
Balance at end of year (387) (284) (198)
--------------- --------------- ----------------
Accumulated Other Comprehensive Income Consisting
of Unrealized
Appreciation of Investments, Net of Income Tax
Balance at beginning of year 47,038 54,504 9,436
Change in unrealized appreciation (19,850) (7,466) 45,068
--------------- --------------- ----------------
Balance at end of year 27,188 47,038 54,504
--------------- --------------- ----------------
Total Stockholders' Equity
Balance at beginning of year 398,002 401,031 352,213
Issuance of common stock 156 716 728
Change in deferred compensation 745 716 1,181
Net income (loss) (32,436) 3,091 2,039
Purchase of treasury stock (103) (86) (198)
Change in unrealized appreciation of investments,
net of income tax
(19,850) (7,466) 45,068
--------------- --------------- ----------------
Balance at end of year $346,514 $398,002 $401,031
=============== =============== ================
See Notes to Consolidated Financial Statements
F-5
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(In thousands)
Years Ended December 31,
1999 1998 1997
--------------- --------------- ----------------
Operating Activities
Net income (loss) ($32,436) $3,091 $2,039
Adjustments to reconcile net income to net cash
Provided by (used for) operating activities:
Liability for claims and claims expenses, net 147,897 145,889 49,998
Unearned premiums (4,642) 28,541 36,886
Premiums receivable (30,710) (41,103) (23,838)
Accrued investment income (1,895) 149 (630)
Reinsurance recoverable (31,938) (31,087) 1,098
Reinsurance balances payable 9,270 5,185 (325)
Deferred policy acquisition costs (70) (6,223) (10,274)
Net realized investment (gains)/losses (17,227) (25,252) 760
Deferred income tax asset (10,327) (7,889) (2,202)
Other liabilities 11,695 9,920 (78)
Other items, net (32,071) (12,715) (4,396)
--------------- --------------- ----------------
Net Cash Provided By Operating Activities 7,546 68,506 49,038
--------------- --------------- ----------------
Investing Activities
Purchases of fixed maturity investments (374,862) (295,912) (239,395)
Sales of fixed maturity investments 270,325 254,716 241,035
Net sales (purchases) of short-term investments 41,898 (16,924) 20,390
Purchases of equity securities (39,364) (110,321) (95,738)
Sales of equity securities 92,045 102,876 33,104
Purchases of furniture, equipment and leasehold improvements (338) (252) (910)
--------------- --------------- ----------------
Net Cash Used For Investing Activities (10,296) (65,817) (41,514)
--------------- --------------- ----------------
Financing Activities
Common stock issued 156 716 728
Purchase of treasury shares (103) (86) (198)
Deferred compensation on restricted stock 117 (296) (506)
--------------- --------------- ----------------
Net Cash Provided By Financing Activities 170 334 24
--------------- --------------- ----------------
Increase in cash (2,580) 3,023 7,548
Cash beginning of year 12,037 9,014 1,466
--------------- --------------- ----------------
Cash end of year $9,457 $12,037 $9,014
=============== =============== ================
See Notes to Consolidated Financial Statements
F-6
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Formation, Capitalization and Business
Risk Capital Holdings, Inc. ("RCHI"), incorporated in March 1995 under the
laws of the State of Delaware, is a holding company whose wholly owned
subsidiary, Risk Capital Reinsurance Company ("Risk Capital Reinsurance"), a
Nebraska corporation, was formed to provide, on a global basis, property and
casualty reinsurance and other forms of capital, either on a stand-alone basis
or as part of integrated capital solutions for insurance companies with capital
needs that cannot be met by reinsurance alone. RCHI and Risk Capital Reinsurance
are collectively referred to herein as the "Company". In September 1995, through
its initial public offering, related exercise of the underwriters'
over-allotment option and direct sales of 16,750,625 shares of RCHI's common
stock, par value $.01 per share (the "Common Stock"), at $20 per share, and the
issuance of warrants, RCHI was capitalized with net proceeds of approximately
$335.0 million, of which $328.0 million was contributed to the statutory capital
of Risk Capital Reinsurance. In July 1998, Risk Capital Reinsurance capitalized
its wholly owned subsidiary, Cross River Insurance Company ("Cross River"), with
$20 million. Cross River received its Nebraska license in October 1998, and is
currently authorized to write insurance on an excess and surplus lines basis in
22 additional states.
Class A warrants to purchase an aggregate of 2,531,079 shares of Common
Stock and Class B warrants to purchase an aggregate of 1,920,601 shares of
Common Stock were issued in connection with the direct sales. Class A warrants
are immediately exercisable at $20 per share and expire September 19, 2002.
Class B warrants are exercisable at $20 per share during the seven year period
commencing September 19, 1998, provided that the Common Stock has traded at or
above $30 per share for 20 out of 30 consecutive trading days.
The Company generally seeks to write a small number of large reinsurance
treaty transactions that may also be integrated with an equity investment in
client companies. Such reinsurance may include traditional and finite risk
property and casualty reinsurance treaty coverages, including excess of loss
reinsurance and quota share or proportional reinsurance. The Company also writes
treaty reinsurance for ocean marine, aviation and space, fidelity and surety,
and accident and health risks. In 1999, the Company discontinued its aviation
and space lines of business. The Company's investment strategy is focused on the
insurance industry. A principal component of this strategy is investing a
significant portion of invested assets in publicly traded and privately held
equity securities issued by insurance and reinsurance companies and companies
providing services to the insurance industry.
The Company obtains substantially all of its reinsurance through
intermediaries which represent the cedent in negotiations for the purchase of
reinsurance. In addition to investment opportunities arising from the activities
of Marsh & McLennan Capital, Inc. ("MMCI"), as the Company's equity investment
advisor, the Company is provided with investment opportunities by reinsurance
brokers and traditional financing sources, including investment banking firms,
venture capital firms and other banking and financing sources, both acting as
principal investors and intermediaries. Underwriting opportunities may arise
from such sources in connection with the Company's investment activities as part
of integrated transactions.
See Note 14 - Subsequent Events for information on the agreement entered
into by the Company to sell its reinsurance business to Folksamerica Reinsurance
Company ("Folksamerica") and the repurchase from XL Capital Ltd. ("XL") of all
of the 4,755,000 shares of the Common Stock held by XL.
F-7
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. Summary of Significant Accounting Policies
Basis of Presentation
The consolidated financial statements have been prepared in conformity with
generally accepted accounting principles ("GAAP") and include the accounts of
RCHI, Risk Capital Reinsurance and Cross River. All intercompany transactions
and balances have been eliminated in consolidation. The preparation of financial
statements in conformity with GAAP requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Premium Revenues and Related Expenses
Premiums are recognized as income on a pro rata basis over the terms of the
related reinsurance contracts. These amounts are based on reports received from
ceding companies, supplemented by the Company's own estimates of premiums for
which ceding company reports have not been received. Unearned premium reserves
represent the portion of premiums written that relates to the unexpired terms of
contracts in force. Certain of the Company's contracts include provisions that
adjust premiums based upon the experience under the contracts. Premiums written
and earned as well as related acquisition expenses under these contracts are
recorded based upon the expected ultimate experience under these contracts.
Acquisition costs, which vary with and are primarily related to the
acquisition of policies, consisting principally of commissions and brokerage
expenses incurred at the time a contract is issued, are deferred and amortized
over the period in which the related premiums are earned. Deferred acquisition
costs are limited to their estimated realizable value based on the related
unearned premiums and take into account anticipated claims and claims expenses,
based on historical and current experience, and anticipated investment income.
Investments
The Company classifies all of its publicly traded fixed maturity and equity
securities as "available for sale" and, accordingly, they are carried at
estimated fair value. The fair value of publicly traded fixed maturity
securities and publicly traded equity securities is estimated using quoted
market prices or dealer quotes. Short-term investments, which have a maturity of
one year or less at the date of acquisition, are carried at cost, which
approximates fair value.
Investments in privately held securities, issued by privately and publicly
held companies, may include both equity securities and securities convertible
into, or exercisable for, equity securities (some of which may have fixed
maturities) and debt securities. Privately held securities are subject to
trading restrictions or are otherwise illiquid and do not have readily
ascertainable market values. The risk of investing in such securities is
generally greater than the risk of investing in securities of widely held,
publicly traded companies. Lack of a secondary market and resale restrictions
may result in the Company's inability to sell a security at a price that would
otherwise be obtainable if such restrictions did not exist and may substantially
delay the sale of a security which the Company seeks to sell. Such investments
are classified as "available for sale" and carried at estimated fair value,
except for investments in which the Company believes it has the ability to
exercise significant influence (generally defined as investments in which the
Company owns 20% or more of the outstanding voting common stock of the issuer),
which are carried under the equity method of accounting. Under this method, the
Company initially records an investment at cost, and then records its
proportionate share of comprehensive income or loss for such investment after
the date of acquisition.
F-8
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. Summary of Significant Accounting Policies (continued)
The estimated fair value of investments in privately held securities, other
than those carried under the equity method, is initially equal to the cost of
such investments until the investments are revalued based principally on
substantive events or other factors which could indicate a diminution or
appreciation in value, such as an arm's-length third party transaction
justifying an increased valuation or adverse development of a significant nature
requiring a write down. The Company periodically reviews the valuation of
investments in privately held securities with MMCI, its equity investment
advisor.
Realized investment gains or losses on the sale of investments are
determined by the first-in first-out method and recorded in net income.
Unrealized appreciation or depreciation of securities which are carried at fair
value is excluded from net income and recorded as a separate component of
stockholders' equity, net of applicable deferred income tax.
Net investment income, consisting of dividends and interest, net of
investment expenses, is recognized when earned. The amortization of premium and
accretion of discount for fixed maturity investments is computed utilizing the
interest method. Anticipated prepayments and expected maturities are used in
applying the interest method for certain investments such as mortgage and other
asset-backed securities. When actual prepayments differ significantly from
anticipated prepayments, the effective yield is recalculated to reflect actual
payments to date and anticipated future payments. The net investment in the
security is adjusted to the amount that would have existed had the new effective
yield been applied since the acquisition of the security. Such adjustments, if
any, are included in net investment income.
Claims and Claims Expenses
The reserve for claims and claims expenses consists of unpaid reported
claims and claims expenses and estimates for claims incurred but not reported.
These reserves are based on reports received from ceding companies, supplemented
by the Company's estimates of reserves for which ceding company reports have not
been received, and the Company's own historical experience. To the extent that
the Company's own historical experience is inadequate for estimating reserves,
such estimates will be determined based upon industry experience and
management's judgment. The ultimate liability may vary from such estimates, and
any adjustments to such estimates are reflected in income in the period in which
they become known. Reserves are recorded without consideration of potential
salvage or subrogation recoveries which are estimated to be immaterial. Such
recoveries, when realized, are reflected as a reduction of claims incurred.
Foreign Exchange
The United States dollar is the functional currency for the Company's
foreign business. Gains and losses on the translation into United States dollars
of amounts denominated in foreign currencies are included in net income. Foreign
currency revenue and expenses are translated at average exchange rates during
the year. Assets and liabilities denominated in foreign currencies are
translated at the rate of exchange in effect at the balance sheet date.
Income Taxes
The Company utilizes the liability method of accounting for income taxes.
Deferred income taxes reflect the net tax effect of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and amounts used for income tax purposes. A valuation allowance is
recorded using the "more-likely-than-not" criteria when some or all of a
deferred tax asset may not be realized.
F-9
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. Summary of Significant Accounting Policies (continued)
Comprehensive Income
In presenting its financial statements, the Company has adopted the
reporting of comprehensive income in a one financial statement approach,
consistent with Statement of Financial Accounting Standards ("SFAS") No. 130.
Comprehensive income as shown below is comprised of net income and other
comprehensive income, which for the Company consists of the change in net
unrealized appreciation or depreciation of investments, net of tax.
(In thousands, except per share data)
Years Ended December 31,
1999 1998 1997
------------ ----------- -------------
Net income (loss) ($32,436) $3,091 $2,039
Other comprehensive income net of tax:
Unrealized appreciation (depreciation) of investments:
Unrealized holdings gains (losses) arising during period (8,652) 8,948 44,574
Less, reclassification adjustment for net realized (gains)
losses included in net income (11,198) (16,414) 494
------------ ----------- --------------
Other comprehensive income (loss) (19,850) (7,466) 45,068
------------ ----------- --------------
Comprehensive income (loss) ($52,286) ($4,375) $47,107
============ =========== ==============
Comprehensive income (loss) per share:
Basic ($3.06) ($0.26) $2.77
============ =========== ==============
Diluted ($3.06) ($0.26) $2.76
============ =========== ==============
Earnings Per Share Data
Earnings per share are computed in accordance with SFAS No. 128, "Earnings
per share" (see Note 12 for the Company's earnings per share computations).
Basic earnings per share excludes dilution and is computed by dividing income
available to common stockholders by the weighted average number of shares of
Common Stock outstanding for the periods. Diluted earnings per share reflect the
potential dilution that could occur if Class A and B warrants and employee stock
options were exercised for Common Stock.
Segment Information
In June 1997, the Financial Accounting Standards Board ("FASB"), issued
SFAS No. 131 "Disclosure About Segments of an Enterprise and Related
Information". This Statement establishes standards for the way that public
business enterprises report information about operating segments in annual and
interim financial reports issued to stockholders. It also establishes standards
for related disclosures about products and services, geographic areas and major
customers.
Operating segments are defined as components of an enterprise for which
separate financial information is available that is evaluated regularly by the
chief operating decision maker for purposes of deciding how to allocate
resources and in assessing performance. Generally, financial information is
required to be reported on the basis for which it is used internally for
evaluating segment performance and determining how to allocate resources to
segments.
F-10
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. Summary of Significant Accounting Policies (continued)
The Company operates in one reportable business segment, of providing
property casualty reinsurance and other forms of capital to insurance and
reinsurance companies and making investments in insurance and insurance related
entities on a global basis. This segment includes the results of Risk Capital
Reinsurance and Cross River, and consists primarily of the premiums, claims and
claims expenses, other operating expenses and investment results. The Company's
adoption of SFAS No. 131 did not have a material impact on the Company's
financial statements or the accompanying notes. See Note 11 for information
concerning the Company's business.
See Note 14 - Subsequent Events for information on the agreement entered
into by the Company to sell its reinsurance business.
Market Risk Sensitive Instruments
The Securities and Exchange Commission ("SEC") issued Financial Reporting
Release No. 48 which included amended rules requiring domestic and foreign
issuers to clarify and expand existing disclosure for derivative financial
instruments, other financial instruments and derivative commodity instruments
(collectively, "market risk sensitive instruments"). The amendments require
enhanced disclosure of accounting policies for derivative financial instruments
and derivative commodity instruments (collectively, "derivatives"). In addition,
the amendments expand existing disclosure requirements to include quantitative
and qualitative information about market risk inherent in market risk sensitive
instruments, which disclosure will be subject to safe harbor protection under
the SEC rule (see the accompanying Management's Discussion and Analysis of
Financial Condition and Results of Operations). These amendments are designed to
provide additional information about market risk sensitive instruments which
investors can use to better understand and evaluate market risk exposures of
registrants, including the Company.
Employee Stock Options
The Company follows Accounting Principles Board Opinion No. 25 "Accounting
for Stock Issued to Employees" ("APB No. 25") and related interpretations in
accounting for its employee stock options because the alternative fair value
accounting provided for under FASB Statement No. 123 "Accounting for Stock-Based
Compensation" ("FASB No. 123") requires use of option valuation models that were
not developed for use in valuing employee stock options (see Note 8).
Under APB No. 25, no compensation expense is recognized by the Company
because the exercise prices of the Company's employee stock options equal the
market prices of the underlying stock on the date of grant. In addition, under
APB No. 25, the Company does not recognize compensation expense for stock issued
to employees under its stock purchase plan.
Goodwill
In connection with its acquisitions of privately held equity securities
recorded under the equity method of accounting, the Company amortizes goodwill
on a straight line basis for periods from 5 years to 25 years. Goodwill at
December 31, 1999 and 1998 was $8,931,000 and $10,638,000, respectively.
Amortization of goodwill included in equity in net loss of investees in 1999,
1998 and 1997, was $400,000, $1,000,000 and $248,000, respectively.
F-11
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. Summary of Significant Accounting Policies (continued)
Furniture, Equipment and Leasehold Improvements
The costs of furniture and equipment are charged against income over their
estimated service lives. Leasehold improvements are amortized over the term of
the office lease. Depreciation and amortization are computed on the
straight-line method. Maintenance and repairs are charged to expense as
incurred.
Furniture, equipment and leasehold improvements, net of accumulated
depreciation and amortization at December 31, 1999 and 1998 recorded in other
assets was $2,479,000 and $2,858,000, respectively.
Reclassifications
The Company has reclassified the presentation of certain prior year
information to conform to the current presentation.
New Accounting Pronouncements
Derivatives and Hedging
In June 1998, the FASB issued Statement No. 133 "Accounting for Derivative
Instruments and Hedging Activities." This statement requires that all derivative
financial instruments be recognized in the statement of financial position as
either assets or liabilities and measured at fair value.
If a derivative instrument is not designated as a hedging instrument, gains
or losses resulting from changes in fair values of such derivative are required
to be recognized in earnings in the period of the change. If certain conditions
are met, a derivative may be designated as a hedging instrument, in which case
the recording of the changes in fair value will depend on the specific exposure
being hedged. The key criterion for hedge accounting is that the hedging
relationship must be highly effective in achieving offsetting changes on fair
values or cash flows.
This Statement is effective for fiscal years beginning after June 15, 2000,
with initial application as of the beginning of the first quarter of the
applicable fiscal year.
The Company will adopt this Statement in the first quarter of 2001.
Generally, the Company has not invested in derivative financial instruments.
However, derivatives may be embedded in other financial instruments, such as
convertible securities and prepayment options in mortgages. If the embedded
derivative meets certain criteria, it must be bifurcated from the host contract
and separately accounted for consistent with other derivatives.
The Company's portfolio includes market sensitive instruments, such as
convertible securities and mortgage-backed securities, which are subject to
prepayment risk and changes in market value in connection with changes in
interest rates. The Company's investments in mortgage-backed securities are
classified as available for sale and are not held for trading purposes. Assuming
the current investment strategy at the time of adoption, the Company's
presentation of financial information under the new Statement will not be
materially different than the current presentation.
Start-Up Costs
Effective January 1, 1999, the Company changed its method of accounting for
start-up costs in accordance with the Accounting Standards Executive Committee's
Statement of Position ("SOP") 98-5 "Reporting on the Costs of Start-Up
Activities." This statement requires costs of start-up activities, including
organization costs, to be expensed as incurred.
F-12
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2. Summary of Significant Accounting Policies (continued)
Start-up activities are defined broadly as those one-time activities
related to opening a new facility, introducing a new product or service,
conducting business in a new territory, conducting business with a new class of
customer or beneficiary, initiating a new process in an existing facility or
commencing some new operation. Start-up activities also include activities
related to organizing a new entity.
The change in accounting principle resulted in the write-off of the
start-up costs capitalized as of January 1, 1999 for the Company and its
investee companies carried under the equity method of accounting.
The cumulative effect of the write-off, which totals $383,000, after-tax,
or $0.02 per share, has been expensed and is included in the 1999 net loss.
3. Investment Information
Net Investment Income
The components of net investment income were derived from the following
sources:
(In thousands)
Years Ended December 31,
--------------------------------------------------------------
1999 1998 1997
------------------ ------------------ ------------------
Fixed maturity securities $14,924 $10,500 $7,105
Publicly traded equity securities 4,019 4,022 3,272
Privately held equity securities 1,007 426 157
Short-term investments 5,677 4,386 6,039
------------------ ------------------ ------------------
Gross investment income 25,627 19,334 16,573
Investment expenses 5,454 3,647 2,213
------------------ ------------------ ------------------
Net investment income $20,173 $15,687 $14,360
================== ================== ==================
Realized and Unrealized Investment Gains (Losses)
Net realized investment gains (losses) were as follows:
(In thousands)
Years Ended December 31,
-----------------------------------------------
1999 1998 1997
------------- -------------- ------------
Fixed maturity securities ($1,776) $1,472 $275
Publicly traded equity securities 16,798 16,582 3,878
Privately held securities 2,205 7,198 (4,913)
------------- -------------- ------------
Sub-total 17,227 25,252 (760)
------------- -------------- ------------
Income tax expense (benefit) 6,029 8,838 (266)
-------------
-------------- ------------
Net realized investment gains (losses), net of tax $11,198 $16,414 ($494)
============= ============== ============
F-13
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. Investment Information (continued)
The following tables reconcile estimated fair value and carrying value to
the amortized cost of fixed maturity and equity securities:
(In thousands)
December 31, 1999
--------------------------------------------------------------------
Estimated
Fair Value
and Gross Gross
Carrying Unrealized Unrealized Amortized
Value Gains (Losses) Cost
-------------- ---------------- ---------------- -----------------
Fixed maturities:
U.S. government and government agencies $41,095 $3 ($1,673) $42,765
Municipal bonds 52,245 136 (308) 52,417
Mortgage and asset backed securities 27,298 3 (1,129) 28,424
Corporate bonds 136,838 484 (6,694) 143,048
Foreign governments 3,591 (100) 3,691
-------------- --------------- ---------------- -----------------
Sub-total fixed maturities 261,067 626 (9,904) 270,345
Equity securities:
Publicly traded 158,631 66,724 (13,840) 105,747
Privately held 83,969 (1,779) 85,748
-------------- --------------- ---------------- -----------------
Sub-total equity securities 242,600 66,724 (15,619) 191,495
-------------- --------------- ---------------- -----------------
Total $503,667 $67,350 ($25,523) $461,840
============== =============== ================ =================
(In thousands)
December 31, 1998
------------------------------------------------------------------
Estimated
Fair Value Gross Gross
& Carrying Unrealized Unrealized Amortized
Value Gains (Losses) Cost
---------------- --------------- ---------------- ---------------
Fixed maturities:
U.S. government and government agencies $39,283 $606 ($60) $38,737
Municipal bonds 45,273 1,193 (11) 44,091
Mortgage and asset backed securities 33,532 397 (46) 33,181
Corporate bonds 56,256 962 (1,882) 57,176
Foreign governments 196 2 194
---------------- --------------- --------------- ---------------
Sub-total fixed maturities 174,540 3,160 (1,999) 173,379
Equity securities:
Publicly traded 154,678 51,093 (7,013) 110,598
Privately held 137,091 27,125 109,966
---------------- --------------- --------------- ---------------
Sub-total equity securities 291,769 78,218 (7,013) 220,564
---------------- --------------- --------------- ---------------
Total $466,309 $81,378 ($9,012) $393,943
================ =============== =============== ===============
At December 31, 1999, all of the Company's equity investments were in
securities issued by insurance and reinsurance companies or companies providing
services to the insurance industry.
F-14
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. Investment Information (continued)
At December 31, 1999, the publicly traded equity portfolio consisted of the
following investments:
(In thousands)
December 31, 1999
-----------------------------------------------------------
Estimated Fair
Value and Net Unrealized
Carrying Value Gain (Loss)
Cost
------------------ ---------------- ----------------
Common Stocks:
ACE Limited $5,397 ($2,745) $8,142
Annuity and Life Re (Holdings) Ltd.
(includes 100,000 warrants) (1) 38,169 18,169 20,000
Arthur J. Gallagher 19,425 9,231 10,194
XL Capital Ltd. 13,488 4,612 8,876
E.W. Blanch Holdings, Inc. 21,866 14,545 7,321
Farm Family Holdings, Inc. 3,802 819 2,983
IPC Holdings, Ltd. 7,988 (7,005) 14,993
Limit PLC 2,394 (492) 2,886
Meadowbrook Insurance Group 1,200 (1,882) 3,082
Partner Re, Ltd. 3,698 (1,263) 4,961
Renaissance Re 2,044 334 1,710
Terra Nova Holdings 26,572 18,096 8,476
WR Berkley Corp. 2,088 (453) 2,541
Preferred Stock:
St. Paul Companies, 6% Convertible Preferred 10,500 918 9,582
------------------ ---------------- ----------------
Total $158,631 $52,884 $105,747
================== ================ ================
(1) See Note 14 - Subsequent Events for information on the disposition of the
Company's interest in Annuity and Life Re (Holdings) Ltd. in connection
with the Company's repurchase from XL of all of the 4,755,000 shares of the
Common Stock held by XL.
F-15
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. Investment Information (continued)
Privately held securities consisted of the following:
(In thousands)
Percentage December 31,
-----------------------------------
Ownership 1999 1998
--------------- --------------- ---------------
Carried under the equity method:
The ARC Group, LLC 27.0% $8,687 $9,448
Arx Holding Corp. 35.2% 2,654 2,400
Capital Protection Insurance Services, LLC 250
First American Financial Corporation 9,805
Island Heritage Insurance Company, Ltd. 33.0% 4,356 3,101
LARC Holdings, Ltd. (1) 23.9% 24,039 25,349
New Europe Insurance Ventures 14.6% 819 1,083
Sunshine State Holding Corporation 21.5% 1,885 1,688
--------------- ---------------
Sub-total 42,440 53,124
--------------- ---------------
Carried at fair value:
Altus Holdings, Ltd. 28% 19,173 6,667
American Independent Holding Company 4,250
Annuity and Life Re (Holdings) Ltd. (2) 5.6% 34,243
Arbor Acquisition Corp. (Montgomery & Collins, 500
Inc.)
GuideStar Health Systems, Inc. 2.6% 500 1,000
Sorrento Holdings, Inc. 1,517 5,113
Sovereign Risk Insurance Ltd. 246
Stockton Holdings Limited 1.7% 10,000 10,000
Terra Nova (Bermuda) Holdings, Ltd. (2) 21,323
TRG Associates, LLC 4,875
Trident II, L.P. 2.0% 6,089
--------------- ---------------
Sub-total 41,529 83,967
--------------- ---------------
Total $83,969 $137,091
=============== ===============
(1) See Note 14 - Subsequent Events for information on the disposition of the
Company's interest in LARC Holdings, Ltd. in connection with the Company's
repurchase from XL of all of the 4,755,000 shares of the Common Stock held
by XL.
(2) As of June 2, 1999, the Company reclassified the above privately held
securities as publicly traded equity securities. Pursuant to the existing
investment advisory agreement, the Company incurred a fee of $2.5 million
payable to MMCI upon the reclassification of such securities.
In addition, the Company had investment commitments relating to its
privately held securities in the amounts of $23.2 million and $10.4 million at
December 31, 1999 and 1998, respectively.
The outstanding commitments at December 31, 1999 included $19 million
committed to Trident II, L.P., a newly formed investment fund established by
MMCI dedicated to making private equity and equity related investments in the
global insurance, reinsurance and related industries.
F-16
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. Investment Information (continued)
Set forth below is certain information relating to each of the Company's
investments and investment commitments in privately held securities at December
31, 1999.
Investments Carried Under The Equity Method:
The ARC Group, LLC
In July 1997, the Company completed its acquisition, effective May 1997, of
a 27.0% economic and voting interest in The ARC Group, LLC ("ARC"), a Long
Island-based wholesaler of specialty insurance, for approximately $9.5 million.
ARC, founded in 1986, is an independent wholesale insurance broker and managing
general agent specializing in the placement of professional liability insurance,
primarily directors and officers liability coverage. The Company is a
co-investor with Marsh & McLennan Risk Capital Holdings, Ltd. ("MMRCH"), MMCI's
parent, and ARC's founders, who continue to have managerial control over the
daily operations.
The Company records its equity in the operating results of ARC on a
two-month lag basis.
Cumulative distributions received from ARC of $4.7 million have been
recorded as reductions to the carrying value of the investment.
For the years ended 1999 and 1998 and for the period recorded in 1997, the
Company's equity in net income, net of goodwill amortization and net of tax, was
$827,000, or $0.05 per share, $1.0 million, or $0.06 per share, and $561,000, or
$0.03 per share, respectively.
Arx Holding Corp.
In December 1997, the Company acquired a 35.2% economic and voting interest
in Arx Holding Corp. ("ARX"), a Florida-based company, for $2,425,000. ARX,
through its recently formed wholly owned subsidiary American Strategic Insurance
Corp., underwrites homeowners policies in the State of Florida produced in the
open market, and may also seek to offer other lines of insurance in Florida and
other states.
The Company provides reinsurance for ARX. A subsidiary of XL is a
co-investor in ARX and also provides reinsurance for ARX.
The Company's net premiums written and net premiums earned from business
developed by ARX were $8.2 million and $5.6 million, respectively, in 1999 and
$2.8 million and $1.1 million, respectively, in 1998.
The Company records its equity in the operating results of ARX on a
quarter-lag basis.
For the years ended 1999 and 1998, the Company's equity in net income
(loss), net of goodwill amortization and net of tax, was $282,000 and ($63,000),
respectively.
Capital Protection Insurance Services, LLC
In May 1997, the Company acquired a 51% economic interest (49% voting
interest) in Capital Protection Insurance Services, LLC ("CPI"), a newly formed
managing underwriting agency headquartered in New York City offering specialty
risk and alternative market insurance solutions. The Company co-invested with
CPI's founders.
The Company also provided reinsurance capacity for the business CPI
developed. Net premiums written and net premiums earned recorded by the Company
from casualty and multi-line business developed by CPI were $2.1 million and
$6.4 million in 1999, $16.3 million and $12.3 million in 1998 and $857,399 and
$178,527, in 1997, respectively.
F-17
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. Investment Information (continued)
At December 31, 1998, the Company recorded a realized loss of $862,000 by
reducing the carrying value of its investment in CPI to $250,000.
During 1999, the Company wrote off its remaining investment carrying value
in CPI and recorded an after-tax realized investment loss of $1.3 million, which
represents actual and estimated costs associated with terminating leases and
divesting physical assets, and other costs to run-off the business of this
managing underwriting agency.
First American Financial Corporation
In February 1997, the Company acquired a 35.5% voting and economic interest
in First American Financial Corporation ("First American") for $6.5 million.
First American, a Missouri-based company, through its wholly owned subsidiaries
including First American Insurance Company, underwrites specialty vehicle
property and casualty insurance coverages with emphasis placed on collateral
protection.
In May 1999, Altus Holdings Ltd. ("Altus") agreed to acquire First American
in a share exchange, which closed in July 1999 upon receipt of regulatory
approval. During the 1999 second quarter, the Company reclassified its
investment in First American from the equity method of accounting to an
investment accounted for at fair value and the carrying value of First American
was adjusted to $9.3 million in order to reflect the transaction value resulting
from the acquisition by Altus. The Company recorded an after-tax realized loss
of $0.7 million from the transaction. The Company's total investment in First
American (excluding repaid demand loans) was $10.4 million.
For the period recorded in 1999 and the year ended 1998, the Company's
equity in net loss, net of goodwill amortization and net of tax, was $320,000,
or $0.02 per share, and $1.3 million, or $0.08 per share, respectively. For the
period recorded in 1997, the Company's equity in the net income, net of goodwill
amortization and net of tax, was $32,036.
The Company's net premiums written and net premiums earned from business
developed by First American was $0.9 million each in 1999.
Island Heritage Insurance Company, Ltd.
In April 1996, the Company acquired a 33% economic interest (9.75% voting
interest) in Island Heritage Insurance Company, Ltd. ("Island Heritage"), a
Cayman Islands insurer, for an aggregate purchase price of $4.5 million, which
was funded through $1.7 million in cash and a trust account in an amount equal
to $2.8 million. Island Heritage commenced operations in May 1996 as an insurer
which writes high value personal and commercial property insurance in the
Caribbean. Certain directors of the Company and other investors invested in the
securities of Island Heritage at the same per share price as that paid by the
Company.
In February 1999, the Company made an additional investment in Island
Heritage in the amount of approximately $1.0 million.
The investment in Island Heritage is recorded under the equity method of
accounting since the Company believes it has the ability to exercise significant
influence over the operating and financial policies of Island Heritage due to
the Company's participation on the Board of Directors and through certain
consent rights attaching to the Company's holdings of non-voting shares.
F-18
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. Investment Information (continued)
The Company records its equity in the operating results of Island Heritage
on a quarter-lag basis. For the year ended 1999, the Company's equity in net
income, net of tax, was $153,400, or $0.01 per share. For years ended 1998 and
1997, the Company's equity in net loss, net of tax, was $551,850, or $0.03 per
share, and $195,922, or $0.01 per share, respectively.
LARC Holdings, Ltd.
In November 1997, the Company acquired shares and warrants representing a
23.9% economic interest (9.9% voting interest) in LARC Holdings, Ltd. ("LARC"),
a newly formed holding company located in Bermuda, for $24.5 million. LARC,
through its newly-formed wholly owned Bermuda subsidiary, Latin American
Reinsurance Company, Ltd. ("LARe"), provides multi-line reinsurance to the Latin
American reinsurance market, emphasizing short-tail, multi-peril property
reinsurance and, to a limited extent, casualty, marine, aviation and other lines
of reinsurance. LARe may also seek to enter other reinsurance niches on both a
treaty and facultative basis.
The Company co-invested with a subsidiary of XL, which holds a majority
interest in LARC, and the founders of LARC.
The investment in LARC is recorded under the equity method of accounting
since the Company believes it has the ability to exercise significant influence
over the operating and financial policies of LARC due to the Company's
participation on the Board of Directors and through certain consent rights
attaching to the Company's holdings of non-voting shares.
The Company records its equity in the operating results of LARC on a
quarter-lag basis.
For the year ended 1999, the Company's equity in net loss, net of goodwill
amortization and net of tax, was $113,750; for the year ended 1998 the Company's
equity in net income, net of goodwill amortization and net of tax was $531,700;
and for the period recorded in 1997, the Company's equity in net loss, net of
tax, was $18,936.
See Note 14 - Subsequent Events for information on the disposition of the
Company's interest in LARC in connection with the Company's repurchase from XL
of all of the 4,755,000 shares of the Common Stock held by XL.
New Europe Insurance Ventures
In March 1997, the Company, through a wholly owned special purpose
subsidiary, committed to pay $5 million over the long term to fund its
partnership interest, currently at 14.6%, in New Europe Insurance Ventures
("NEIV"), a Scottish limited partnership that targets private equity investments
in insurance and insurance-related companies in Eastern Europe.
The Company records its participation in this partnership under the equity
method of accounting and applies the specialized accounting practices for
investment companies. Unrealized gains and losses on private equity investments,
consisting mostly of foreign exchange fluctuations, are recorded in the income
statement when such investments are revalued into United States dollars each
quarter.
The $820,000 investment balance at December 31, 1999 is composed of five
investments in Eastern Europe in insurance related companies.
The unfunded commitment remaining at December 31, 1999 was approximately
$3.2 million.
F-19
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. Investment Information (continued)
The Company records its equity in the operating results of NEIV on a
quarter-lag basis. For the years ended 1999, 1998 and for the period recorded in
1997, the Company's equity in net loss, net of tax, was $345,150, $141,700 and
$54,532, respectively.
Sunshine State Holding Corporation
In December 1997, the Company acquired a 21.5% economic and voting interest
in Sunshine State Holding Corporation ("Sunshine State"), a newly formed
Florida-based company, for $1.4 million.
Sunshine State and its subsidiaries, which includes Sunshine State
Insurance Company, a Florida domiciled insurer, underwrite homeowners policies
in the State of Florida obtained from the Florida Residential Property and
Casualty Joint Underwriting Association in accordance with the Market Challenge
Program of the Florida Department of Insurance. Sunshine State also insures
homeowners policies produced through the open market and offers other lines of
insurance in Florida and other states. In connection with the investment, the
Company provides reinsurance for Sunshine State. A subsidiary of XL invested in
Sunshine State and will also provide reinsurance for Sunshine State during
specified periods.
The Company records its equity in the operating results of Sunshine State
on a quarter-lag basis.
The Company's net premiums written and net premiums earned from business
developed by Sunshine State were $6.6 million and $5.6 million, respectively, in
1999 and $3.9 million and $4.5 million, respectively, in 1998.
For the years ended 1999 and 1998, the Company's equity in net income, net
of tax, was $179,000, or $0.01 per share, and $171,600, or $0.01 per share.
Investments Carried at Fair Value:
Altus Holdings, Ltd.
In March 1998, the Company purchased for $10 million an approximately 28.6%
economic interest (9.9% voting interest) in Altus, a new Cayman Islands company
formed to provide rent-a-captive and other underwriting management services for
risks of individual corporations and insurance programs developed by insurance
intermediaries. The Company's investment was funded two-thirds in cash and
one-third through a letter of credit. The balance of the $35 million of initial
capital invested in Altus was contributed by The Trident Partnership, L.P.
("Trident"), XL, MMRCH and members of Altus' management. The Company may provide
reinsurance capacity for business developed by Altus. The Company issued a
letter of credit in the amount of $5.8 million for Trident's unfunded investment
commitment in Altus for an annual fee of $58,000, or 100 basis points on the
letter of credit amount.
In May 1999, Altus acquired First American in a share exchange, which
closed in July 1999 upon receipt of regulatory approval.
During the 1999 second quarter, the Company reclassified its investment in
First American from the equity method of accounting to an investment accounted
for at fair value. At June 30, 1999, the carrying value of First American was
adjusted to $9.3 million, in order to reflect the transaction value resulting
from the acquisition by Altus resulting in the Company recording an after-tax
realized loss of $0.7 million.
In July 1999, the Company and Trident funded their investment commitments
to Altus (previously secured by letters of credit) of $3.3 million and $5.8
million, respectively, and XL redeemed its shares in Altus at their original
costs. After Altus' acquisition of First American, such additional funding and
the XL redemption, the Company's economic ownership in Altus decreased from
28.6% to 28% (9.9% voting interest).
F-20
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. Investment Information (continued)
American Independent Insurance Holding Company
In February 1999, the Company loaned $5 million to American Independent
Insurance Holding Company ("AIHC"). The promissory note, secured by the stock of
AIHC, matures in January 2003, and will accrue interest at rates per annum
expected to approximate 6%, depending on the investment returns on proceeds of
the loan which are invested by AIHC on the Company's behalf. Principal and
interest repayments are subject to prior approval by the Pennsylvania Department
of Insurance. In consideration for the loan, the Company received Class A
warrants to purchase shares of common stock of AIHC, constituting approximately
4% of AIHC's outstanding common stock on a fully-diluted basis. Interest income
recorded in 1999 was $148,000. At December 31, 1999, the Company recorded a
pre-tax unrealized loss of $750,000, which reflects a market value discount of
15% based on a comparison of the AIHC note to bonds with similar
characteristics.
In connection with this investment and the Company's prior $3.6 million
loan commitment to AIHC (which commitment expired on December 31, 1998), the
Company has the option to write an aggregate amount of premiums of at least
approximately $375 million over the next seven to eight year period, subject to
the amount of business written by AIIC. From inception through December 31,
1999, premiums written by the Company under these arrangements with AIHC and its
insurance subsidiary, American Independent Insurance Company ("AIIC"), totaled
$107.2 million. No assurances can be given that any such additional premiums
will be written by the Company. The Company's net premiums written and net
premiums earned from business developed by AIIC were $39.2 million and $43.7
million, respectively, in 1999, $42 million and $36 million, respectively, in
1998, and $25.9 million and $15.2 million, respectively, in 1997.
Annuity and Life Re (Holdings), Ltd.
In April 1998, the Company acquired for approximately $20 million a
minority interest in Annuity and Life Re (Holdings), Ltd. ("Annuity and Life
Re"), a new Bermuda-based reinsurance company formed to provide annuity and life
reinsurance. The Company coinvested with XL concurrently with the consummation
of Annuity and Life Re's initial public offering. The Company purchased
approximately 1.4 million common shares of Annuity and Life Re and warrants to
purchase at an exercise price of $15.00 per share (the initial public offering
price) an additional 100,000 common shares. The aggregate purchase price paid by
the Company was based on a price of $14.10 for a unit consisting of one common
share and certain warrants. The Company owns approximately 5.6% of the
outstanding common shares of Annuity and Life Re following the exercise of the
underwriters' over-allotment option. Annuity and Life Re's common shares are
quoted on The Nasdaq Stock Market's National Market ("NASDAQ") under the symbol
"ALRE."
At December 31, 1998, the Company recorded its investment in Annuity and
Life Re common stock and warrants at the closing price reported by NASDAQ on
such date less a discount for trading restrictions.
In June 1999, the Company reclassified its investment in Annuity and Life
Re to a publicly traded equity security.
See Note 14 - Subsequent Events for information on the disposition of the
Company's interest in Annuity and Life Re in connection with the Company's
repurchase from XL of all of the 4,755,000 shares of Common Stock held by XL.
F-21
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. Investment Information (continued)
Arbor Acquisition Corp. (Montgomery & Collins, Inc.)
In March 1998, the Company purchased for approximately $2.8 million a 34.5%
economic and voting interest in Arbor Acquisition Corp. ("Arbor"), the parent of
Montgomery & Collins, Inc. a Boston-based national surplus lines and wholesale
brokerage firm which operates in 11 cities, in addition to Boston. The
investment was made concurrently with investments by MMRCH.
In September 1998, the Company invested an additional $845,000 in Arbor,
increasing the Company's ownership interest to approximately 37.3%.
For the period recorded in 1998, the Company's equity in net loss, net of
goodwill amortization and net of tax, was $506,000 or $0.03 per share. In
addition, in December 1998, the Company recorded a realized loss of $2.4 million
by reducing the carrying value of its investment in Arbor to $500,000 and
reclassified this investment from the equity method of accounting to an
investment carried at fair value.
At June 30, 1999, the Company increased the carrying value of its
investment in Arbor from $500,000 to approximately $3.0 million based on the
expected net realizable value resulting from the sale of the business and
run-off of the operations.
The sale of the business occurred in two transactions that closed in June
and July 1999. It is expected that the wind-up of the remaining operations will
be substantially completed by July 2000.
GuideStar Health Systems, Inc.
In December 1997, the Company acquired a 2.6% economic and voting interest
in GuideStar Health Systems, Inc. ("GuideStar"), an Alabama-based managed care
organization, for $1 million.
Founded in late 1995, GuideStar provides comprehensive managed care
services to employers and individuals through strategic alliances with selected
insurance companies and health care providers. GuideStar develops health care
provider networks, and provides claims processing, customer relations and
comprehensive utilization management services.
In September 1999, the Company reduced the carrying value of GuideStar by
50% to $500,000 and realized an after tax loss of $325,000.
Sorrento Holdings, Inc.
In October 1998, the Company purchased for $5 million 5,000 shares of Class
C Cumulative Redeemable Preferred Stock (the "Preferred C Shares") of Sorrento
Holdings, Inc. ("Sorrento"). The Preferred C Shares accrue interest at the rate
of 6% per annum and are subject to mandatory redemptions through December 31,
2000. Sorrento's obligation to redeem the Preferred C Shares is secured by an
irrevocable letter of credit.
For the year ended December 31, 1999, the Company received $3.7 million
from Sorrento for the redemption of 3,483 shares of preferred stock of Sorrento,
which redemption amount included a payment of $1,000 per share and dividends of
approximately $233,000.
Sorrento was formed by Clarendon National Insurance Company ("Clarendon")
and the Arrowhead Group ("Arrowhead"), a managing agency. Sorrento intends to
form a wholly owned subsidiary, Sorrento Insurance Company, to underwrite
automobile liability and physical damage policies produced by Arrowhead. In
connection with the issuance of the Preferred C Shares, the Company is providing
reinsurance to Clarendon in respect of automobile physical damage policies and
may provide reinsurance on other business produced by Arrowhead.
F-22
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. Investment Information (continued)
The Company's net premiums written and net premiums earned from business
developed by Arrowhead were $30 million and $22.5 million, respectively, in
1999.
Sovereign Risk Insurance Ltd.
In July 1997, the Company acquired a 9.0% voting and economic interest in
Sovereign Risk Insurance Ltd. ("Sovereign Risk"), a newly formed Bermuda-based
managing general agency, for $237,500.
Sovereign Risk provides underwriting services for political risk insurance
coverages for the Company, ACE Insurance Company, Ltd. and a subsidiary of XL,
who are also co-investors in Sovereign Risk.
In June 1999, the Company sold its investment in Sovereign Risk to ACE
Limited and XL and recorded an after-tax net realized gain of $103,000. The
Company retained an option to provide certain reinsurance on business produced
by Sovereign Risk for a five-year period.
The Company's net premiums written and net premiums earned from business
developed by Sovereign Risk were $2.9 million and $2.4 million, respectively, in
1999, $1,397,000 and $887,000, respectively, in 1998 and $175,000 and $51,130,
respectively, in 1997.
Stockton Holdings Limited
In June 1998, the Company acquired for $10 million a 1.7% interest in
Stockton Holdings Limited ("Stockton Holdings"), a Cayman Islands insurance
holding company. Stockton Holdings conducts a world-wide reinsurance business
through its wholly owned subsidiary Stockton Reinsurance Limited, a
Bermuda-based reinsurance company writing specialty risks with a focus on finite
products. The Company's investment was made as part of a private placement by
Stockton Holdings.
During 1999, the Company received a dividend distribution of $157,000.
Terra Nova (Bermuda) Holdings, Ltd.
In October 1995, the Company acquired a 3.6% voting and economic interest
in Terra Nova (Bermuda) Holdings, Ltd. ("Terra Nova") for $8.9 million.
Terra Nova, based in Bermuda, is a holding company for two principal
operating insurance companies located in Bermuda and London that write property
and casualty reinsurance. In April 1996, Terra Nova completed the initial public
offering of its common stock, which is traded on the New York Stock Exchange
("NYSE") under the symbol "TNA."
In December 1998, the Company sold 41,000 shares of Terra Nova and recorded
a realized gain of approximately $800,000, reducing the Company's voting and
economic interest to 3.5%.
Dividend income recorded in 1999, 1998 and 1997 received from Terra Nova
was $213,000, $213,000 and $157,000, respectively.
In June 1999, the Company reclassified its investment in Terra Nova to a
publicly traded equity security.
TRG Associates, LLC
In October 1997, the Company acquired an 8.8% economic interest (7.7%
voting interest) in TRG Associates, LLC ("LLC"), a new limited liability company
formed for the purpose of holding all of the Class 1 common stock of TRG Holding
Corporation ("TRG Holdings"), for $4,875,000. TRG Holdings acquired all of the
common stock of The Resolution Group, Inc. ("TRG") in exchange for $150 million
in cash (funded by $50 million from the LLC and $100 million of debt incurred by
TRG Holdings) and $462 million face amount of the Class 2 common stock of TRG
Holdings.
F-23
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. Investment Information (continued)
TRG, located in Chicago, was formed to manage and pay off claims
liabilities on policies that insurance subsidiaries of Talegen Holdings, Inc., a
subsidiary of Xerox Corporation, had written prior to 1993.
In August 1999, the Company recorded an after-tax net realized gain of $2.2
million upon completion of the sale of this investment to Fairfax Financial
Holdings Limited.
Trident II, L.P.
On June 4, 1999, the Company committed to invest $25 million as a limited
partner of Trident II, L.P. ("Trident II"), a partnership managed by MMCI.
Trident II will make private equity and equity related investments in the global
insurance, reinsurance and related industries. The fund will target investments
in existing companies that are in need of growth capital or are under performing
as well as in newly formed companies. The Company's Chairman is one of four
Senior Principals of MMCI who manage Trident II.
The term of Trident II expires in 2009. However, the term may be extended
for up to a maximum of three one-year periods at the discretion of MMCI to
permit orderly dissolution.
During the first six years of the fund, the Company will pay an annual
management fee, payable semi-annually in advance, equal to 1.5% of the Company's
aggregate $25.0 million commitment as well as a percentage of cumulative net
gains on invested funds. After such six year period, the annual management fee
will be 1.5% of the aggregate funded commitments.
For the period ended December 31, 1999, the Company funded its 1.96% share,
or $6.1 million, of investments made by Trident II in various entities. Fees and
expenses of $250,000 were paid in 1999 to MMCI relating to its management of
Trident II.
Fixed Maturities
Contractual maturities of fixed maturity securities at December 31, 1999
are shown below. Expected maturities, which are management's best estimates,
will differ from contractual maturities because borrowers may have the right to
call or prepay obligations with or without call or prepayment penalties.
(In thousands)
December 31, 1999
---------------------------------------
Estimated
Fair Amortized
Value Cost
---------------- ---------------
Available for sale:
Due in one year or less $10,210 $10,237
Due after one year through five years 68,182 69,956
Due after five years through 10 years 78,461 82,282
Due after 10 years 76,916 79,446
---------------- ---------------
Sub-total 233,769 241,921
Mortgage and asset-backed securities 27,298 28,424
---------------- ---------------
Total $261,067 $270,345
================ ===============
As of December 31, 1999, the weighted average contractual and expected
maturities of the fixed maturity investments, based on fair value, were
12.6 years and 8.1 years, respectively.
F-24
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. Investment Information (continued)
Proceeds from the sale of fixed maturity securities during 1999, 1998 and
1997 were approximately $270 million, $255 million and $241 million,
respectively. Gross gains of $1,522,000, $2,242,000 and $858,000 were realized
on those sales during 1999, 1998 and 1997, respectively. Gross losses of
$3,298,000, $770,000 and $583,000 were realized during 1999, 1998 and 1997,
respectively.
Approximately 86% of fixed maturity investments held by the Company at
December 31, 1999 were considered investment grade by Standard & Poor's
Corporation or Moody's Investors Service, Inc.
There are no investments in any entity in excess of 10% of the Company's
stockholders' equity at December 31, 1999 other than investments issued or
guaranteed by the United States government or its agencies and the Company's
investment in Annuity and Life Re.
Securities Pledged and on Deposit
Securities with a carrying value of approximately $11.1 million have been
pledged as collateral for letters of credit obtained in connection with certain
reinsurance obligations of the Company (see Note 5).
At December 31, 1999, securities with a face amount of $5.8 million were on
deposit with the Insurance Department of the State of Nebraska and other states
in order to comply with insurance laws.
4. Agreements with Related Parties
Investment Advisory Agreements
The Company has an investment advisory agreement with MMCI for management
of the Company's portfolios of equity securities (including convertible
securities) that are publicly traded ("Public Portfolio") and privately held
("Private Portfolio"). The Private Portfolio includes equity securities which at
the time of acquisition do not have a readily ascertainable market or are
subject to certain trading restrictions. MMCI is also an investment advisor to
Trident, a dedicated insurance industry private equity fund organized by MMCI
and three other sponsors. MMCI's direct parent, MMRCH, owns 1,395,625 shares, or
approximately 8.2% of the outstanding Common Stock, and Class A warrants and
Class B warrants to purchase 905,397 and 1,770,601 shares of Common Stock,
respectively. At December 31, 1999, Trident owns 250,000 shares, or
approximately 1.5%, of the outstanding Common Stock, and Class A warrants to
purchase 1,386,079 shares of Common Stock.
Effective July 1, 1999, the Company amended its investment advisory
agreement with MMCI, which governs the management of the Company's portfolios of
equity securities (including convertible securities) that are publicly traded
and privately held.
Pursuant to the amended agreement, which has a term of four years (subject
to renewal), MMCI provides the Company with investment management and advisory
services with respect to investments in the Private Portfolio whose value
exceeds (i) $10 million during the first year of the term, (ii) $15 million
during the second year of the term, and (iii) $20 million during the third and
fourth years of the term. Under such amendments, the Company pays MMCI an annual
fee equal to (x) 20% (previously 7.5%) of cumulative net realized gains
including dividends, interest and other distributions, received on the Private
Portfolio over (y) cumulative compensation previously paid in prior years on
cumulative net realized gains (as defined in the agreement) on the Private
Portfolio managed by MMCI, but the Company will not pay MMCI a management fee
(previously 1.5% per annum of the quarterly carrying value of the Private
Portfolio). With respect to the management of the Company's Public Portfolio,
the Company pays MMCI a fee equal to 0.50% of the first $50 million under MMCI's
management and 0.35% of all amounts in excess of $50 million (subject to a
minimum fee of $250,000 per annum).
F-25
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. Agreements with Related Parties (continued)
In connection with the amendments to the Company's agreement with MMCI,
RCHI will receive from MMCI $1.25 million per annum during the initial four-year
term, subject to certain conditions. The initial agreement provided for a
minimum aggregate cash fee to MMCI of $500,000 per annum through December 31,
1997. Fees incurred under the agreements during fiscal years 1999, 1998 and 1997
were approximately $1.5 million, $2.7 million and $1.3 million, respectively. In
addition, in 1999, 1998 and 1997, unrealized appreciation in the Private
Portfolio is net of accrued fees of approximately $256,000, $2.2 million and
$1.4 million, respectively.
In May 1999, the Company transferred the management of the fixed income and
short term cash portfolios from The Putnam Advisory Company, Inc. ("Putnam") to
Alliance Capital. The Company had an investment advisory agreement with Putnam,
an affiliate of MMCI, for the management of the Company's fixed income
securities and short term cash portfolios through April 1999. For the fixed
income securities portfolio, the Company paid to Putnam a fee equal to the sum
of 0.35% per annum of the first $50 million of the market value of the
portfolio, 0.30% per annum on the next $50.0 million, 0.20% per annum on the
next $100 million and 0.15% per annum of the market value of assets that exceeds
$200 million. For the short term cash portfolio, the Company paid a fee equal to
0.15% per annum of the total monthly average market value. Fees incurred under
the Putnam agreement for the period in 1999, 1998 and 1997 were approximately
$173,000, $461,000 and $493,000, respectively.
Reinsurance Treaties
In addition to business assumed from insurance companies where the Company
has a private equity investment as described in Note 3, the Company also assumed
premiums written and premiums earned of $5.2 million and $5.3 million,
respectively, in 1999, $3.3 million and $3.4 million, respectively, in 1998 and
$5.5 million and $2.5 million, respectively, in 1997 from XL, which owned
4,755,000 shares prior to the stock repurchase described in Note 14, or
approximately 27.8% of the outstanding Common Stock, and premiums written and
premiums earned of $17.4 million and $17.3 million, respectively, in 1999, $18.5
million and $20.7 million, respectively, in 1998 and $12.3 million and $6.8
million, respectively, in 1997 from majority-owned insurance companies of
Trident.
Other Agreements
Commencing in 1996, MMCI subleased office space from the Company for a term
expiring in October 2002. Future minimum rental income, exclusive of escalation
clauses and maintenance costs, under the remaining term of the sublease will be
approximately $1,218,000. Rental income for 1999, 1998 and 1997 was $430,000 in
each year.
In addition in 1999, 1998 and 1997, MMCI reimbursed the Company
approximately $1,000, $11,000 and $530,000 (net of $59,000, $89,000 and $44,000
for certain sublease income allocated to MMCI) for their pro-rata share of
improvement and maintenance costs under the sublease.
During 1999, the Company committed to invest $25 million as a limited
partner in Trident II, a partnership managed by MMCI. See Note 3.
F-26
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5. Commitments
Lease Agreement
The Company has a sublease agreement for office facilities for a term
expiring in October 2002. Future minimum rental charges under the remaining term
of the sublease, exclusive of escalation clauses and maintenance costs and net
of rental income, are as follows:
(In thousands)
----------------------
2000 $681
2001 716
2002 597
-------------------
$1,994
===================
During 1999, 1998 and 1997, rental expense, net of income from subleases,
was approximately $576,000, $576,000 and $643,000, respectively.
Letters of Credit
At December 31, 1999, the Company is obligated under letters of credit in
an aggregate amount of approximately $9.7 million, which secure certain of the
Company's reinsurance obligations.
Severance Arrangements
The Company has a program for all employees that provides for certain
severance payments, immediate vesting of restricted stock grants and option
awards and continuation of benefits in the event of termination of employment
resulting from a change in control. The extent of such payments depends on the
position of the employee. See Note 14 - Subsequent Events for information on the
agreement entered into by the Company to sell its reinsurance business to
Folksamerica, which constitutes a change in control for purposes of the
Company's employee benefit plans and agreements.
Employment Agreements
The Company has employment agreements with its executive officers. One of
these agreements has a five-year term initially expiring in September 2000, and
the remaining agreements may be terminated upon notice by either party. These
agreements provide for compensation in the form of base salary, annual bonus,
stock-based awards under the 1995 and 1999 Stock Plans (as hereinafter defined),
participation in the Company's employee benefit programs and the reimbursement
of certain expenses. Under one of the agreements, the Company guaranteed loans
in the amount of $500,000 made to an executive by a financial institution to
fund such executive's purchase of 25,000 shares of Common Stock and related tax
liability under such stock's vesting provisions. In connection with such
guarantee, the Company is entitled to customary subrogation rights.
F-27
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
6. Claims and Claims Expenses
The reconciliation of claims and claims expense reserves is as follows:
(In thousands)
December 31,
1999 1998 1997
------------ ------------ ------------
At beginning of year:
Gross claims and claims expense reserves $216,657 $70,768 $20,770
Reinsurance recoverables 30,468 522
------------ ------------ ------------
Net claims and claims expense reserves 186,189 70,768 20,248
Net claims and claims expenses incurred relating to:
Current year 275,455 178,957 73,385
Prior year 30,386 (2,832) 22
------------ ------------ ------------
Total 305,841 176,125 73,407
Net paid claims and claims expenses incurred relating to:
Current year 95,367 41,910 13,649
Prior year 88,034 18,794 9,238
------------ ------------ ------------
Total 183,401 60,704 22,887
At end of year:
Net claims and claims expense reserves current year 308,629 186,189 70,768
Reinsurance recoverables 55,925 30,468 -
------------ ------------ ------------
Gross claims and claims expense reserves $364,554 $216,657 $70,768
============ ============ ============
The Company believes that its exposure, if any, to environmental impairment
liability and asbestos-related claims is minimal since no business has been
written for periods prior to 1996.
Subject to the following, the Company believes that the reserves for claims
and claims expenses are adequate to cover the ultimate cost of claims and claims
expenses incurred through December 31, 1999. The reserves are based on estimates
of claims and claims expenses incurred and, therefore, the amount ultimately
paid may be more or less than such estimates. The inherent uncertainties of
estimating claims and claims expense reserves are exacerbated for reinsurers by
the significant periods of time (the "tail") that often elapse between the
occurrence of an insured claim, the reporting of the claim to the primary
insurer and, ultimately, to the reinsurer, and the primary insurer's payment of
that claim and subsequent indemnification by the reinsurer. As a consequence,
actual claims and claims expenses paid may deviate, perhaps materially, from
estimates reflected in the Company's reserves reported in its financial
statements. The estimation of reserves by new reinsurers, such as the Company,
may be less reliable than the reserve estimations of a reinsurer with an
established volume of business and claims history. To the extent reserves prove
to be inadequate, the Company may have to augment such reserves and incur a
charge to earnings. Such a development could occur and result in a material
charge to earnings or stockholders equity in future periods.
Estimates of prior accident year claims were increased by approximately $30
million in 1999. A substantial portion of this amount resulted from (i) the
Company's review of additional claims information and its continuing
underwriting and actuarial analysis of the business produced by a certain
managing underwriting agency, (ii) notification of additional satellite losses
received in 1999 pertaining to 1998, (iii) aviation losses, principally the 1998
Swiss Air crash, and (iv) property losses reported on several international
treaties that are in run-off.
Estimates of prior accident year claims were reduced by approximately $2.8
million in 1998 primarily due to favorable claim development in the property and
multi-line classes of business.
F-28
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
7. Retrocession Agreements
The Company utilizes retrocession agreements for the purpose of limiting
its exposure with respect to multiple claims arising from a single occurrence or
event. The Company also participates in "common account" retrocessional
arrangements for certain treaties. Such arrangements reduce the effect of
individual or aggregate losses to all companies participating on such treaties
including the reinsurer, such as the Company, and the ceding company.
Reinsurance recoverables are recorded as assets, predicated on the
retrocessionaires' ability to meet their obligations under the retrocessional
agreements. If the retrocessionaires are unable to satisfy their obligations
under the agreements, the Company would be liable for such defaulted amounts.
The effects of reinsurance on written and earned premiums and claims and
claims expenses are as follows:
(In thousands)
Years Ended December 31,
-----------------------------------------------------------
1999 1998 1997
---------------- ---------------- -----------------
Assumed premiums written $386,848 $260,566 $147,878
Ceded premiums written 80,122 25,831 3,044
----------------
---------------- -----------------
Net premiums written $306,726 $234,735 $144,834
================ ================ =================
Assumed premiums earned $380,880 $232,025 $110,992
Ceded premiums earned 69,512 25,831 3,620
---------------- ---------------- -----------------
Net premiums earned $311,368 $206,194 $107,372
================ ================ =================
Assumed claims and claims expenses incurred $348,979 $210,006 $73,407
Ceded claims and claims expenses incurred 43,138 33,881
---------------- ---------------- -----------------
Net claims and claims expenses incurred $305,841 $176,125 $73,407
================ ================ =================
At December 31, 1999, the Company's balance sheet reflects reinsurance
recoverable and reinsurance premiums payable balances as follows:
(In thousands)
December 31, December 31,
1999 1998
-------------------- --------------------
Reinsurance recoverable balances:
Unpaid claims and claim expenses $55,925 $30,468
Paid amounts 6,588 107
Unearned premiums 10,609
-------------------- --------------------
Total $73,122 $30,575
==================== ====================
Reinsurance premiums payable $14,666 $5,396
==================== ====================
F-29
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8. Employee Benefits and Compensation Arrangements
1995 Long Term Incentive and Share Award Plan
In September 1995, the Company adopted the 1995 Long Term Incentive and
Share Award Plan (the "1995 Stock Plan"), which is administered by the
Compensation Committee of the Board of Directors. The Company may grant, subject
to certain restrictions, stock options, stock appreciation rights, restricted
shares, restricted share units payable in shares of Common Stock or cash, stock
awards in lieu of cash awards, and other stock-based awards to eligible
employees of the Company. Awards relating to not more than 1,700,000 shares of
Common Stock may be made over the five-year term of the 1995 Stock Plan.
In April 1999, the Company adopted the 1999 Long Term Incentive and Share
Award Plan (the "1999 Stock Plan"). The 1999 Stock Plan, like its predecessor,
is intended to provide incentives to attract, retain and motivate employees and
Directors in order to achieve the Company's long term growth and profitability
objectives. The 1999 Stock Plan provides for the grant to eligible employees and
Directors of stock options, stock appreciation rights, restricted shares,
restricted share units payable in shares of Common Stock or cash, stock awards
in lieu of cash awards, dividend equivalents and other stock based awards. The
1999 Stock Plan also provides the Non-Employee Directors with the opportunity to
receive the annual Board retainer fee in shares of Common Stock. An aggregate of
900,000 shares of Common Stock has been reserved for issuance under the 1999
Stock Plan (of which no more than 300,000 of such shares may be issued pursuant
to grants of restricted shares, restricted share units, performance shares and
performance units), subject to anti-dilution adjustments in the event of certain
changes in the Company's capital structure. Shares issued pursuant to the 1999
Stock Plan will be either authorized but unissued shares or treasury shares.
Restricted Stock
During 1999, 1998 and 1997, the Company granted an aggregate of 2,500,
15,700, 24,000 shares, respectively, of restricted stock under the 1995 Stock
Plan. Grants of restricted stock generally vest at a rate of 20% per year over
five years commencing on the first anniversary of the date of grant. The Company
records a deferred expense equal to the market value of the shares at the date
of grant which is amortized and charged to income over the vesting period. The
deferred expense was ($117,000), $296,000 and $506,000, and the amortization of
the deferred expense was $628,000, $1,012,000, and $1,687,000, for 1999, 1998
and 1997, respectively. Upon the closing of the sale of the Company's
reinsurance business to Folksamerica, all unvested restricted stock and all
unvested stock options will immediately become vested. See Note 14 - Subsequent
Events.
F-30
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8. Employee Benefits and Compensation Arrangements (continued)
Stock Options
The Company issues incentive stock options and/or non-qualified stock
options at fair market values at the grant dates to officers and non-employee
Directors. Options to officers generally vest and become exercisable at a rate
of 20% per year over five years from the date of grant. Incentive stock options
expire ten years after the grant date and non-qualified stock options expire
seven years after vesting. Initial options granted to non-employee Directors
vest and become exercisable in three equal installments, commencing on the date
of grant and annually thereafter. Annual options granted to non-employee
Directors in office on January 1 of each year vest on the first anniversary of
the date the option is granted. Upon the closing of the sale of the Company's
reinsurance business to Folksamerica, all unvested restricted stock and all
unvested stock options will immediately become vested. See Note 14 - Subsequent
Events.
Information relating to the Company's stock options is set forth below:
Years Ended December 31,
---------------------------------------------------------
1999 1998 1997
---------------- ---------------- ----------------
Number of options
Outstanding, beginning of year 1,347,075 960,650 628,950
Granted 18,800 410,825 371,700
Canceled (84,519) (20,580) (39,500)
Exercised - (3,820) (500)
Outstanding, end of year 1,281,356 1,347,075 960,650
Exercisable, end of year 683,388 358,884 178,611
Average exercise price
Granted $17.25 $22.47 $22.86
Canceled $21.81 $20.97 $17.63
Exercised - $19.24 $17.63
Outstanding, end of year $20.90 $21.00 $20.38
Exercisable, end of year $20.45 $19.85 $19.32
Exercise prices for options outstanding at December 31, 1999 ranged from
$12.94 to $24.94. The weighted average remaining contractual life of these
options is approximately 7.3 years.
Employee Stock Purchase Plan
Effective December 1, 1995, the Company established a tax-qualified
employee stock purchase plan (the "Purchase Plan"). An aggregate of 120,000
shares of Common Stock have been reserved for issuance under the Purchase Plan.
Eligible employees may elect to participate in an annual offering period under
the Purchase Plan by authorizing after-tax payroll deductions of up to 20% (in
whole percentages) of their eligible compensation for the purchase of shares of
Common Stock at 85% of the lesser of the market value per share of the Common
Stock at the beginning or end of the annual offering period, subject to certain
restrictions. During 1999, 1998 and 1997, employees purchased approximately
8,509, 18,638 and 14,100 shares, respectively, of Common Stock under the
Purchase Plan.
F-31
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8. Employee Benefits and Compensation Arrangements (continued)
Pro Forma Information
Pro forma information regarding net income and earnings per share is
required by FASB Statement No. 123. Such information has been determined for the
Company as if the Company has accounted for its employee stock options under the
fair value method of this Statement. The fair value for the Company's employee
stock options has been estimated at the date of grant using a Black-Scholes
option valuation model, with the following weighted-average assumptions for
options issued in 1999, 1998 and 1997, respectively: (i) dividend yield: 0.0%;
(ii) volatility factor: 25.0%; (iii) average expected option life of six years
for all years; and (iv) risk free interest rates of 6.5%, 4.9%, and 5.8%
respectively. The weighted-average fair value of options granted for the years
ended December 31, 1999, 1998 and 1997 was $123,000, $3.3 million and $3.2
million, respectively.
The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options that have no vesting restrictions
and are fully transferable. In addition, option valuation models, such as the
Black-Scholes model, require the input of highly subjective assumptions
(particularly with respect to the Company, which has a limited stock-trading
history), including expected stock price volatility. As the Company's employee
stock options have characteristics significantly different from those of traded
options, and because changes in the subjective input assumptions can materially
affect the fair value estimate, the Company believes that the existing option
valuation models, such as the Black-Scholes model, may not necessarily provide a
reliable single measure of the fair value of employee stock options.
For purposes of the required pro forma information, the estimated fair
value of employee stock options is amortized to expense over the options'
vesting period. The Company's pro forma information regarding net income and
earnings per share follows:
(In thousands, except per share data)
Years Ended December 31,
1999 1998 1997
---------------- ---------------- ----------------
Net income (loss), as reported ($32,436) $3,091 $2,039
Pro forma net income (loss) ($34,094) $1,633 $994
Earnings (loss) per share as reported:
Basic ($1.90) $0.18 $0.12
Diluted ($1.90) $0.17 $0.12
Pro forma earnings (loss) per share:
Basic ($2.00) $0.10 $0.06
Diluted ($2.00) $0.09 $0.06
The effects of applying FASB 123 as shown in the pro forma disclosures may
not be representative of the effects on reported net income for future years.
The effect on net income and earnings per share after applying FASB
Statement No. 123's fair valuation method to stock issued to employees under the
Purchase Plan does not materially differ from the pro forma information set
forth above with respect to the Company's employee stock options.
F-32
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8. Employee Benefits and Compensation Arrangements (continued)
Retirement Plans
Effective as of January 1, 1996, the Company adopted a tax-qualified,
non-contributory defined contribution money purchase pension plan (the "Pension
Plan") under which the Company contributes for each eligible employee an amount
equal to the sum of (i) 5% in 1999 and 4% in 1998 and 1997 of eligible
compensation up to the taxable wage base (as such term is defined in the Pension
Plan; for 1999, 1998 and 1997, amounts were set at $72,600, $68,400 and $65,400,
respectively) and (ii) 10% in 1999 and 8% in 1998 and 1997 of eligible
compensation in excess of the taxable wage base (up to the applicable
compensation limit (the "compensation limit") imposed by Section 401(a)(17) of
the Internal Revenue Code of 1986, as amended (the "Code"), which for 1999, 1998
and 1997 was $160,000. Substantially all employees of the Company are eligible
for participation in the Pension Plan. In 1999, 1998 and 1997, the Company
expensed $344,000, $215,000 and $168,000, respectively, related to the Pension
Plan.
Effective as of January 1, 1996, the Company adopted a tax-qualified,
employee savings plan (the "Savings Plan"). Pursuant to Section 401(k) of the
Code, eligible employees of the Company are able to make deferral contributions
of up to 15% of their eligible compensation, subject to limitations under
applicable law. The Company matches 100% of the first 3% of eligible
compensation deferred by employees and 50% of the next 3% of eligible
compensation so deferred. Substantially all employees of the Company are
eligible for participation in the Savings Plan. In 1999, 1998 and 1997, the
Company expensed $192,000, $165,000 and $123,000, respectively, related to the
Savings Plan.
Effective as of January 1, 1996, the Company adopted a supplemental,
non-qualified executive savings and retirement plan (the "Supplemental Plan")
under which the Company contributes 10% of eligible compensation in excess of
the compensation limit for eligible officers of the Company. Participants may
also defer certain amounts of eligible base compensation and bonus. Under the
Supplemental Plan, the Company matches 100% of the first 3% of eligible base
compensation in excess of the compensation limit that is deferred by
participants under the Supplemental Plan, and provides a 50% matching
contribution for the next 3% of such excess eligible compensation so deferred.
In 1999, 1998 and 1997, the Company expensed $96,000, $85,000 and $74,000,
respectively, related to the Supplemental Plan.
9. Income Taxes
RCHI, Risk Capital Reinsurance and Cross River file a consolidated federal
income tax return and have a tax sharing agreement (the "Tax Sharing
Agreement"), allocating the consolidated income tax liability on a separate
return basis. Pursuant to the Tax Sharing Agreement, Risk Capital Reinsurance
and Cross River make tax sharing payments to RCHI based on such allocation.
The provision for federal income taxes has been determined on the basis of
a consolidated tax return consisting of RCHI, Risk Capital Reinsurance and Cross
River.
F-33
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. Income Taxes (continued)
An analysis of the Company's effective tax rate for the years ended
December 31, 1999, 1998 and 1997 is as follows:
(In thousands)
Years Ended December 31,
1999 1998 1997
--------------- ------------ --------------
Income tax (benefit) computed on pre-tax income ($18,281) $1,562 $663
Reduction/increase in income tax (benefit) resulting from:
Tax-exempt investment income (733) (582) (524)
Dividend received deduction (958) (896) (650)
Restricted stock 140
Other 275 151 173
--------------- ------------ --------------
Income tax expense (benefit) on pre-tax income ($19,557) $235 ($338)
=============== ============ ==============
The Company's current federal tax expense (benefit) for 1999, 1998 and 1997
was based on regular taxable income. Actual federal income taxes paid in 1999,
1998 and 1997 were $1.9 million, $5.3 million and $1.4 million, respectively.
The amount paid in 1999 was the final installment related to the 1998 tax
return.
The net deferred income tax asset reflects temporary differences between
the carrying amounts of assets and liabilities for financial reporting and
income tax purposes, net of a valuation allowance for any portion of the
deferred tax asset that management believes will not be realized. Significant
components of the Company's deferred income tax assets and liabilities as of
December 31, 1999 and 1998 were:
(In thousands)
December 31,
1999 1998
---------------- -----------------
Deferred income tax assets:
Net claim reserve discount $15,639 $10,176
Net operating loss 7,334
Net unearned premium reserve 6,573 7,194
Compensation liabilities 372 622
Equity in net loss of investees, net 7 2,328
Other 165 56
---------------- -----------------
Total deferred tax assets 30,090 20,376
---------------- -----------------
Deferred income tax liabilities:
Deferred policy acquisition cost (8,255) (8,230)
Unrealized appreciation of investments (14,001) (25,328)
---------------- -----------------
Total deferred tax liabilities (22,256) (33,558)
---------------- ----------------
Net deferred income tax asset (liability) $7,834 ($13,182)
================ =================
The net deferred income tax asset at December 31, 1999 was $7.8 million.
The Company periodically evaluates the need for a valuation allowance for any
portion of the deferred tax asset that management believes will not be realized
based on current and future operating performance and available tax planning
strategies.
While the Company believes that a valuation allowance is not necessary at
December 31, 1999, continued future comprehensive losses or future decisions
with respect to business strategy following the sale of the Company's
reinsurance business may result in the establishment of a valuation allowance in
future financial statements.
F-34
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. Income Taxes (continued)
The Company has a net operating loss carryforward which expires in 2019,
for which it has established a deferred income tax asset of $7.3 million at
December 31, 1999. The repurchase of the Company's Common Stock held by XL
resulted in a 27.8% change in ownership by 5% shareholders. If, in the ensuing
three years, there is more than 22.2% additional change in ownership by 5%
shareholders, an "ownership change" will have taken place for federal income tax
purposes. If such ownership change occurs, the amount of loss carryforwards that
can be used in any subsequent year may be severely limited and could be
eliminated in certain circumstances.
10. Statutory Information
The Insurance Department of the State of Nebraska issued to Risk Capital
Reinsurance its domiciliary insurance license on November 6, 1995. Statutory net
income and surplus of Risk Capital Reinsurance, as reported to insurance
regulatory authorities, differ in certain respects from the amounts prepared in
accordance with GAAP. The following tables reconcile statutory net loss and
surplus of Risk Capital Reinsurance to consolidated GAAP net income (loss) and
stockholders' equity:
(In thousands)
Years Ended December 31,
1999 1998 1997
---------------- ---------------- -----------------
Net Income (Loss):
Risk Capital Reinsurance
Statutory net loss ($44,561) ($11,973) ($5,649)
GAAP adjustments:
Privately held investments 1,179 2,623 (4,601)
Deferred acquisition costs 70 6,223 10,273
Deferred income taxes 10,536 7,277 2,099
Equity in net income (loss) of investees 621 (1,136) (192)
Cumulative effect of accounting change (370)
-------------- --------------- ----------------
GAAP net income (loss) (32,525) 3,014 1,930
RCHI (parent company only) operations 89 77 109
-------------- --------------- ----------------
Consolidated GAAP net income (loss) ($32,436) $3,091 $2,039
============== =============== ================
(In thousands)
December 31,
1999 1998
--------------- --------------
Stockholders' Equity:
Statutory surplus $290,082 $358,702
Deferred acquisition costs 23,585 23,515
Unrealized appreciation (depreciation) (6,320) 298
Deferred income tax asset (liability), net 7,818 (13,164)
Privately held investments--non-admitted assets 13,695 11,080
Other non-admitted assets 3,693 4,190
Other 244 500
--------------- --------------
Investment in Risk Capital Reinsurance, GAAP 332,797 385,121
RCHI (parent company only):
Other net assets 13,717 12,881
--------------- --------------
Consolidated stockholders' equity, GAAP $346,514 $398,002
=============== ==============
F-35
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10. Statutory Information (continued)
RCHI is a holding company and has no significant operations or assets other
than its ownership of all of the capital stock of Risk Capital Reinsurance. RCHI
will rely on cash dividends and distributions from Risk Capital Reinsurance to
pay any cash dividends to, or repurchase any shares from, stockholders of RCHI
and to pay any operating expenses that RCHI may incur. The payment of dividends
or the repurchase of shares by RCHI will be dependent upon the ability of Risk
Capital Reinsurance to provide funds to RCHI. The ability of Risk Capital
Reinsurance to pay dividends or make distributions to RCHI is dependent upon
Risk Capital Reinsurance's ability to achieve satisfactory underwriting and
investment results and to meet certain regulatory standards of the State of
Nebraska. There are presently no contractual restrictions on the payment of
dividends or the making of distributions by Risk Capital Reinsurance to RCHI.
Nebraska insurance laws provide that, without prior approval of the
Nebraska Director of Insurance ("Nebraska Director"), Risk Capital Reinsurance
cannot pay a dividend or make a distribution (together with other dividends or
distributions paid during the preceding 12 months) that exceeds the greater of
(i) 10% of statutory surplus as of the preceding December 31 ($290.1 million as
of December 31, 1999) or (ii) statutory net income from operations from the
preceding calendar year not including after tax realized capital gains ($54.3
million loss for 1999). Net income (exclusive of realized capital gains) not
previously distributed or paid as dividends from the preceding two calendar
years may be carried forward for dividend and distribution purposes. Any
proposed dividend or distribution in excess of such amount is called an
"extraordinary" dividend or distribution and may not be paid until either it has
been approved, or a 30-day waiting period has passed during which it has not
been disapproved, by the Nebraska Director. Notwithstanding the foregoing,
Nebraska insurance laws provide that any distribution that is a dividend may
only be paid out of earned surplus arising from its business, which is defined
as unassigned funds (surplus) as reported in the statutory statement for the
most recent years, including any surplus arising from unrealized capital gains
or revaluations of assets ($38 million deficit as of December 31, 1999). Any
distribution that is a dividend and that is in excess of Risk Capital
Reinsurance's unassigned funds, exclusive of any surplus arising from unrealized
capital gains or revaluation of assets ($78.5 million deficit as of December 31,
1999), will be deemed an "extraordinary" dividend subject to the foregoing
requirements. Therefore, Risk Capital Reinsurance cannot make a distribution
that is a dividend without the prior approval of the Nebraska Director during
2000.
Nebraska insurance laws also require that the statutory surplus of Risk
Capital Reinsurance following any dividend or distribution be reasonable in
relation to its outstanding liabilities and adequate to its financial needs. In
addition, Nebraska insurance laws require that each insurer give notice to the
Nebraska Director of all dividends and other distributions within five business
days following declaration thereof and that any such dividend or other
distribution may not be paid within 10 business days of such notice (the "Notice
Period") unless for good cause shown the Nebraska Director has approved such
payment within the Notice Period.
See Note 14 - Subsequent Events for information on distributions from Risk
Capital Reinsurance to RCHI which will reduce the GAAP book value and the
statutory surplus of Risk Capital Reinsurance. In light of such distributions,
and as required by the above statutory provisions, Risk Capital Reinsurance may
not declare any other distribution for a period of 12 months following the stock
repurchase described in Note 14 unless such subsequent distribution is approved
by the Nebraska Department.
F-36
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
11. Business Information
As discussed in Note 2, the Company provides property casualty reinsurance
to insurance and reinsurance companies and other forms of capital and makes
investments in insurance and insurance-related entities on a global basis. The
Company operates from one domestic location in Greenwich, Connecticut.
During 1999, one client contributed $42.1 million, or 13.7%, of net
premiums written and $33.8 million, or 13.5%, of net premiums earned, and a
second client contributed $39.2 million, or 12.8%, of net premiums written and
$43.7, or 14%, of net premiums earned. For 1998, that second client company
contributed approximately $42 million, or 18%, of net premiums written and $36.6
million, or 17.8%, of net premiums earned. For 1997, such client company
contributed $25.9 million, or 18%, of net premiums written, and $15.1 million,
or 14%, of net premiums earned.
The following lists individual broker business greater than 10% of the 1999
year's net premiums written with comparative amounts for the years ended 1998
and 1997, respectively:
Net Premiums Written
1999 1998 1997
------------------- --------------------- ---------------------
Balis & Co., Inc. (1) 15.0% 23.7% 22.7%
Guy Carpenter & Co. (1) 10.7% 11.3% 11.0%
Aon Group 17.4% 16.5% 19.1%
------------------ -------------------- --------------------
Total 43.1% 51.5% 52.8%
================== ==================== ====================
(1) In addition, approximately 7.4%, 8.2%, and 13.6% of net premiums written in
1999, 1998 and 1997, respectively, were produced by other brokers who are
affiliated with Marsh & McLennan Companies, Inc.
Net premiums written and earned recorded from client companies which are
Lloyd's syndicates or are located in the United Kingdom, Bermuda and Continental
Europe (some which are denominated in United States dollars) were:
1999 1998 1997
---------------------------- --------------------------- ---------------------------
Net Premiums Net Premiums Net Premiums
Written Earned Written Earned Written Earned
------------- ------------ ------------- ----------- ------------ -----------
Non U.S. Premiums $46.9 $58.0 $76.1 $65.9 $40.1 $25.8
% of Total 15.3% 18.6% 32.4% 32.0% 27.7% 24.0%
F-37
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
12. Earnings Per Share
The following table sets forth the computation of basic and diluted
earnings per share:
(In thousands, except share data)
Years Ended December 31,
1999 1998 1997
----------------- --------------- ----------------
Basic Earnings Per Share:
Net income (loss) ($32,436) $3,091 $2,039
Divided by:
Weighted average shares outstanding for the period 17,086,732 17,065,165 17,032,601
================ ============== ===============
Basic earnings (loss) per share ($1.90) $0.18 $0.12
================ ============== ===============
Diluted Earnings Per Share:
Net income (loss) ($32,436) $3,091 $2,039
Divided by:
Weighted average shares outstanding for the period 17,086,732 17,065,165 17,032,601
Effect of dilutive securities:
Warrants 581,327 24,836
Employee stock options 76 71,731 28,351
---------------- -------------- ---------------
Total shares 17,086,808 17,718,223 17,085,788
================ ============== ===============
Diluted earnings (loss) per share ($1.90) $0.17 $0.12
================ ============== ===============
Certain employee stock options to purchase 1,273,856, 22,750, and 448,250
shares of Common Stock at per share prices averaging $20.93, $23.61 and $22.62
were outstanding as of December 31, 1999, 1998, and 1997, respectively. These
options were not included in the computation of diluted earnings per share
because the options' average exercise prices were greater than the average
market prices of the Common Stock of $15.40, $23.00 and $20.11 for the years
ended December 31, 1999, 1998 and 1997. In addition, warrants to purchase
4,451,680 shares of Common Stock at $20 per share were outstanding as of
December 31, 1999, 1998 and 1997 but were not included in the computation of
diluted earnings per share for the year ended December 31, 1999 because the
warrants' exercise price of $20.00 per share was greater than the average market
price of the Common Stock for such year. See Note 14 - Subsequent Events.
F-38
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. Quarterly Financial Information
The following is a summary of unaudited quarterly financial data, restated
where applicable, to conform to FASB Statement No. 128:
(In thousands, except per share data)
Quarter Quarter Quarter Quarter
Ended Ended Ended Ended
December 31, September 30, June 30, March 31,
1999 1999 1999 1999
------------------- ------------------- --------------- ---------------
Income Statement Data:
Net premiums written $74,023 $76,749 $91,517 $64,437
Net premiums earned 80,995 80,463 86,988 62,922
Net investment income 4,908 5,965 4,817 4,483
Net realized investment gains
(losses) (10,243) 5,236 23,386 (1,152)
Operating expenses 106,468 98,583 91,629 104,319
Equity in net income (loss) of 188 400 196 (163)
investees
Net income (loss) (19,591) (3,737) 15,883 (24,991)
Comprehensive income (loss) ($15,021) ($10,494) $8,720 ($35,491)
Statutory Combined Ratio: 132.6% 120.4% 106.3% 167.0%
Per Share Data:
Net income (loss)
Basic ($1.15) ($0.22) $0.93 ($1.46)
Diluted ($1.15) ($0.22) $0.93 ($1.46)
Comprehensive income (loss)
Basic ($0.88) ($0.61) $0.51 ($2.08)
Diluted ($0.88) ($0.61) $0.51 ($2.08)
Stockholders' equity per share
Basic $20.28 $21.15 $21.75 $21.23
Diluted $20.28 $21.15 $21.75 $21.23
Common Stock Prices:
High $15.69 $16.00 $17.38 $22.63
Low $11.00 $13.00 $13.50 $12.00
Close $12.63 $15.63 $13.50 $15.13
F-39
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
13. Quarterly Financial Information (continued)
(In thousands, except per share data)
Quarter Quarter Quarter Quarter
Ended Ended Ended Ended
December 31, September 30, June 30, March 31,
1998 1998 1998 1998
----------------- ------------------ ---------------- ----------------
Income Statement Data:
Net premiums written $71,163 $66,628 $52,536 $44,408
Net premiums earned 63,545 52,670 48,477 41,502
Net investment income 3,757 3,995 4,331 3,604
Net realized investment gains (losses)
25,606 (425) 2,870 477
Operating expenses 80,808 (65,334) 51,756 44,773
Equity in net income (loss) of
investees (1,103) (1,046) 257 756
Net income (loss) 4,994 (6,631) 3,159 1,569
Comprehensive income (loss) $2,350 ($20,622) ($2,871) $16,768
Statutory Combined Ratio: 124.4% 123.8% 107.8% 105.9%
Per Share Data:
Net income (loss)
Basic $0.29 ($0.39) $0.19 $0.09
Diluted $0.29 ($0.39) $0.18 $0.09
Comprehensive income (loss)
Basic $0.14 ($1.21) ($0.17) $0.98
Diluted $0.14 ($1.21) ($0.17) $0.95
Stockholders' equity per share
Basic $23.29 $23.15 $24.35 $24.50
Diluted $22.75 $22.54 $23.01 $23.36
Common Stock Prices:
High $23.75 $25.50 $25.50 $24.00
Low $18.81 $19.00 $22.75 $19.75
Close $21.75 $22.00 $24.94 $24.00
F-40
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
14. Subsequent Events
Folksamerica Transaction
On January 18, 2000, the Company entered into an agreement with
Folksamerica Reinsurance Company ("Folksamerica") pursuant to which Folksamerica
will acquire substantially all of the reinsurance operations of the Company's
wholly owned subsidiary Risk Capital Reinsurance, for a cash purchase price
equal to the GAAP book value of the assets and liabilities to be transferred to
Folksamerica plus $20.335 million, payable at closing.
Under the terms of the agreement, the Company will place $20 million in
escrow for a period of five years. These funds will be primarily used to
reimburse Folksamerica to the extent that the loss reserves relating to business
produced on behalf of Risk Capital Reinsurance by CPI, a managing underwriting
agency, are deficient as measured at the end of such five-year period. Such
reserves were $38.7 million at December 31, 1999. To the extent that such loss
reserves are redundant, all of the escrowed funds will be returned to the
Company and Folksamerica will pay the Company an amount equal to such
redundancy. Amounts in the escrow may also be released to Folksamerica to
satisfy its indemnification claims against the Company relating to undisclosed
liabilities, the Company's reinsurance and retrocession treaties, and CPI and
the business produced by it. The Company will be responsible for certain tax
costs incurred by Folksamerica in the transaction, as well as its own
transaction and severance costs, and certain reinsurance costs incurred for the
benefit of Folksamerica. An additional amount of up to $5 million may be placed
in escrow for a period of five years to the extent that the Company's reserves
at closing are less by at least a specified amount than those estimated by Risk
Capital Reinsurance's independent actuaries. In connection with either escrow
arrangement, the Company will record a loss amount equal to any probable
deficiency in the related reserves that may become known during or at the end of
the five year period.
The sale of the Company's reinsurance business to Folksamerica is
contingent on obtaining applicable regulatory approvals, approval by the
Company's stockholders, expiration of the applicable waiting period under the
Hart-Scott-Rodino Antitrust Improvements Act, the retention of a key employee,
obtaining certain third party consents, the absence of a material adverse change
in Risk Capital Reinsurance's business, and other customary closing conditions.
MMRCH and Trident, which collectively represent approximately 13.3% of the
12,329,494 outstanding voting shares of RCHI on March 2, 2000, have agreed to
vote in favor of the transaction. XL gave Folksamerica a similar proxy, but that
proxy terminated upon the consummation of the repurchase of XL's interest in
RCHI described below.
F-41
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
14. Subsequent Events (continued)
The GAAP book value of the assets and liabilities to be transferred to
Folksamerica recorded in the accompanying financial statements at December 31,
1999 are as follows:
(In millions)
Fixed maturities and short-term investments $245.6
Premiums receivable 119.3
Reinsurance recoverable 73.1
Deferred policy acquisition costs 23.6
Deferred income tax asset 13.9
Other insurance assets 37.0
-----------------
Total Assets $512.5
-----------------
Reserve for claims and claims expenses $364.6
Net unearned premium reserve 108.7
Reinsurance premium 14.7
Other insurance liabilities 24.5
-----------------
Total Liabilities $512.5
-----------------
Net book value of assets and liabilities
to be transferred -
=================
The actual GAAP book value of the assets and liabilities transferred to
Folksamerica will be determined as of the closing date of the asset sale, and
will differ from that set forth above.
At the closing of the asset sale, Risk Capital Reinsurance and Folksamerica
will enter into a transfer and assumption agreement, under which Folksamerica
will assume Risk Capital Reinsurance's rights and obligations under the
reinsurance agreements being transferred in the asset sale. Following regulatory
approval of the agreement, the reinsureds under such agreements will be notified
that Folksamerica has assumed Risk Capital Reinsurance's obligations and that,
unless the reinsureds object to the assumption, Risk Capital Reinsurance will be
released from its obligations to those reinsureds. Assuming that none of the
reinsureds object to the assumption, the gross liabilities for such business
will be removed from the accounts of Risk Capital Reinsurance for statutory
accounting and GAAP accounting purposes.
Risk Capital Reinsurance will continue to record gross liabilities in its
accounts for reinsureds that object to the release of Risk Capital Reinsurance
from its obligations to such reinsureds. In such instances, an offsetting
accounts receivable amount from Folksamerica would be recorded as an asset equal
to such gross liabilities. This would also result in a portion of any pre-tax
gain on the transaction being deferred and amortized into income as the gross
liabilities are extinguished.
F-42
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
14. Subsequent Events (continued)
XL Transaction
On March 2, 2000, RCHI repurchased from XL all of the 4,755,000 shares of
Common Stock held by XL constituting in the aggregate 27.8% and 20.8% of its
Common Stock on a basic basis and diluted basis (assuming all dilutive
securities are vested, exercised and converted into common stock, which consist
of 4,451,680 warrants exercisable at $20.00 per share and 1,281,356 stock
options exercisable at an average price of $20.90 per share), respectively.
Under the terms of the stock repurchase agreement with XL, RCHI paid to XL a
purchase price of $12.45 per share, for a total of $59.2 million. The per share
repurchase price was determined as the lesser of (i) 85% of the average closing
market price of the Common Stock during the twenty-day trading period beginning
January 21, 2000, which was $14.65, and (ii) $15.00. The consideration paid to
XL for the repurchase consisted of (i) its interest in privately held LARC
Holdings, Ltd. (parent of Latin American Reinsurance Company), valued at $25
million (which interest was carried by the Company at $24 million at December
31, 1999), and (ii) all of the shares and warrants held by RCHI in Annuity and
Life Re (Holdings), Ltd., valued at $25.38 per share and $18.50 per warrant, or
$37.8 million in the aggregate (which interest was carried by the Company at
$38.2 million at December 31, 1999). XL paid RCHI in cash the $3.6 million
difference between the repurchase price and the value of its interests in LARC
Holdings and Annuity and Life Re. The value per share of Annuity and Life Re was
determined by taking the average of the closing prices of Annuity and Life Re
shares for the same twenty-day period used in determining the repurchase price
of RCHI's shares.
As a result of the repurchase, stockholder's equity of RCHI, which was
$346.5 million at December 31, 1999, has been reduced by $59.4 million to 287.1
million, and outstanding voting shares, which were 17,087,970 at December 31,
1999, have been reduced to 12,332,970.
Risk Capital Reinsurance's stockholder's equity and statutory surplus,
which were $332.8 million and $290.1 million, respectively, at December 31, 1999
were reduced by $62 million and $60 million, respectively, following the
distribution of the shares and warrants in LARC Holdings, Ltd. and Annuity and
Life Re (Holdings), Ltd. to RCHI based on their GAAP and statutory carrying
values, respectively, at December 31, 1999.
Risk Capital Reinsurance Distribution
Upon payment of a contemplated distribution from Risk Capital Reinsurance
to the Company that would occur after the transfer of Risk Capital Reinsurance's
reinsurance-related assets and liabilities to Folksamerica (which distribution
is subject to regulatory approval), the assets of the Company would consist of
fixed maturity and short term investments, publicly traded equity securities,
and privately held securities and the Company's remaining $19 million investment
commitment to Trident II would remain in place. The Company would also continue
to own all of the outstanding capital stock of Risk Capital Reinsurance and
Cross River, each anticipated to have statutory surplus of approximately $20
million or any greater amount the Nebraska Insurance Department requires them to
retain in light of any objections from reinsureds under the transferred
reinsurance agreements.
F-43
Report of Independent Accountants on
Financial Statement Schedules
To the Board of Directors and Stockholders of
Risk Capital Holdings, Inc.
Our audit of the consolidated financial statements referred to in our report
dated February 1, 2000, except as to Note 14, which is as of March 2, 2000
appearing on Page F-2 of this Annual Report on Form 10-K also included an audit
of the financial statement schedules listed on Page F-1. In our opinion, these
financial statement schedules present fairly, in all material respects, the
information set forth therein when read in conjunction with the related
consolidated financial statements.
/s/ PricewaterhouseCoopers, LLP
New York, New York
February 1, 2000, except as to Note 14, which is as of
March 2, 2000
S-1
SCHEDULE I
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
SUMMARY OF INVESTMENTS
OTHER THAN INVESTMENTS IN RELATED PARTIES
(In thousands)
December 31, 1999
--------------------------------------------------------
Amount
at Which
Shown in
Amortized Fair the Balance
Cost Value Sheet
-------------- ----------------- ----------------
Type of Investment:
FIXED MATURITY SECURITIES
U.S. government and government agencies
And authorities $42,765 $41,095 $41,095
Foreign governments 3,691 3,591 3,591
Mortgage and asset-backed securities 28,424 27,298 27,298
States, municipalities and political subdivisions 52,417 52,245 52,245
Corporate bonds 143,048 136,838 136,838
-------------- ----------------- ----------------
Total Fixed Maturities 270,345 261,067 261,067
EQUITY SECURITIES
Publicly traded 105,747 158,631 158,631
Privately held 85,748 83,969 83,969
-------------- ----------------- ----------------
Total Equity Securities 191,495 242,600 242,600
SHORT-TERM INVESTMENTS 72,785 72,785 72,785
-------------- ----------------- ----------------
Total Investments $534,625 $576,452 $576,452
============== ================= ================
S-2
SCHEDULE II
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEET
(Parent Company Only)
(Dollars in thousands)
December 31,
-----------------------------------
1999 1998
--------------- ---------------
Assets
Investment in wholly owned subsidiary $332,797 $385,121
Fixed maturities (amortized cost: 1999, $6,002; 1998, $8,007) 5,974 8,057
Short-term investments 3,252 1,149
Cash 4,313 3,415
Other assets 271 411
---------------- ---------------
Total Assets $346,607 $398,153
================ ===============
Liabilities
Accounts payable and other liabilities 93 151
Stockholders' Equity
Preferred stock, $0.01 par value:
20,000,000 shares authorized (none issued)
Common stock, $0.01 par value:
80,000,000 shares authorized
(issued: 1999, 17,109,736; 1998, 17,102,503) 171 171
Additional paid-in capital 342,034 341,878
Accumulated other comprehensive income consisting of unrealized
appreciation of investments, net of income tax 27,188 47,038
Deferred compensation under stock award plan (317) (1,062)
Retained earnings (deficit) (22,175) 10,261
Less treasury stock at cost (1999, 21,766; 1998, 15,065) (387) (284)
Total Stockholders' Equity 346,514 398,002
---------------- ---------------
Total Liabilities and Stockholders' Equity $346,607 $398,153
================ ===============
S-3
SCHEDULE II
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (continued)
Statement of Income
(Parent Company Only)
(Dollars In thousands)
Years Ended December 31,
1999 1998 1997
-------------- ------------ --------------
Revenues
Net investment income $641 $631 $524
Operating Costs and Expenses
Operating expenses 485 513 357
-------------- ------------ --------------
Income before income tax expense 156 118 167
Income tax expense 55 41 58
-------------- ------------ --------------
Net income before equity in net income (loss) of wholly
owned subsidiary and cumulative effect of accounting change 101 77 109
Equity in net income (loss) of wholly owned subsidiary (32,525) 3,014 1,930
Cumulative effect of accounting change (12)
-------------- ------------ --------------
Net income (loss) (32,436) 3,091 2,039
Other Comprehensive Income (Loss), Net of Tax
Change in net unrealized depreciation, of investments, net of tax (51) 12 21
-------------- ------------ --------------
Comprehensive Income (Loss) ($32,487) $3,103 $2,060
============== ============ ==============
S-4
SCHEDULE II
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (continued)
Statement of Cash Flows
(Parent Company Only)
(In thousands)
Years Ended December 31,
1999 1998 1997
------------ ------------ ------------
Operating Activities
Net income from operations $89 $77 $109
Adjustments to reconcile net income to net cash
Used for operating activities:
Net change in other assets and liabilities 137 225 (650)
------------ ------------ ------------
Net Cash Provided By (Used For) Operating Activities 226 302 (541)
Investing Activities:
Purchases of fixed maturities (3,000) (4,999) (11,014)
Sales of fixed maturities 5,000 4,000 4,000
Net change in short-term investments (2,036) 1,005 4,697
------------ ------------ ------------
Net Cash Provided By (Used For) Investing Activities (36) 6 (2,317)
Financing Provided By Activities:
Common stock issued 156 716 727
Purchase of treasury shares (103) (86) (197)
Common stock issued to Directors (90)
Deferred compensation on restricted stock awarded 117 (296) (506)
Amortization of deferred compensation collected 628 1,302 3,367
------------ ------------ ------------
Net Cash Provided By Financing Activities 708 1,636 3,391
Increase in cash 898 1,944 533
Cash at beginning of period 3,415 1,471 938
------------ ------------ ------------
Cash at end of period $4,313 $3,415 $1,471
============ ============ ============
S-5
SCHEDULE
SCHEDULE III
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
SUPPLEMENTARY INSURANCE INFORMATION
(In thousands)
Future
Policy
Benefits,
Deferred Losses,
Policy Claims and Net
Acquisition Claims Unearned Premium Investment
Costs Expenses Premiums Revenue Income
-------------- -------------- -------------- -------------- --------------
December 31, 1999
Property-Casualty $23,585 $277,271 $98,133 $261,029 $20,173
Accident and Health 31,358 50,339
-------------- -------------- -------------- -------------- --------------
Total $23,585 $308,629 $98,133 $311,368 $20,173
============== ============== ============== ============== ==============
December 31, 1998
Property-Casualty $23,515 $186,189 $102,775 $206,194 $15,687
Accident and Health
-------------- -------------- -------------- -------------- --------------
Total $23,515 $186,189 $102,775 $206,194 $15,687
============== ============== ============== ============== ==============
December 31, 1997
Property-Casualty $17,292 $70,768 $74,234 $107,372 $14,360
Accident and Health
-------------- -------------- -------------- -------------- --------------
Total $17,292 $70,768 $74,234 $107,372 $14,360
============== ============== ============== ============== ==============
S-6
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
SUPPLEMENTARY INSURANCE INFORMATION
(In thousands)
Benefits, Amortization
Claims, of Deferred
Losses and Policy Other
Settlement Acquisition Operating Premiums
Expenses Costs Expenses Written
-------------- ---------------- -------------- --------------
December 31, 1999
Property-Casualty $267,622 $64,279 $14,816 $256,388
Accident and Health 38,219 16,261 50,338
-------------- ---------------- -------------- --------------
Total $305,841 $80,540 $14,816 $306,726
============== ================ ============== ==============
December 31, 1998
Property-Casualty $176,125 $50,537 $16,452 $234,735
Accident and Health
-------------- ---------------- -------------- --------------
Total $176,125 $50,537 $16,452 $234,735
============== ================ ============== ==============
December 31, 1997
Property-Casualty $73,407 $31,467 $13,523 $144,834
Accident and Health
-------------- ---------------- -------------- --------------
Total $73,407 $31,467 $13,523 $144,834
============== ================ ============== ==============
SCHEDULE IV
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
REINSURANCE
(In thousands)
Assumed Percentage
Ceded to From of Amount
Gross Other Others Net Assumed to
Amount Companies Companies Amount Net
----------- -------------- -------------- -------------- ----------------
December 31, 1999
Premiums Written:
Property and Casualty $80,122 $336,510 $256,388 131.3%
Accident and Health 50,338 50,338 100.0%
----------- -------------- -------------- -------------- ----------------
Total $80,122 $386,848 $306,726 126.1%
=========== ============== ============== ============== ================
December 31, 1998
Premiums Written:
Property and Casualty $25,831 $260,566 $234,735 111.0%
Accident and Health
----------- -------------- -------------- -------------- ----------------
Total $25,831 $260,566 $234,735 111.0%
=========== ============== ============== ============== ================
December 31, 1997
Premiums Written:
Property and Casualty $3,044 $147,878 $144,834 102.1%
Accident and Health
----------- -------------- -------------- -------------- ----------------
Total $3,044 $147,878 $144,834 102.1%
=========== ============== ============== ============== ================
S-7
EXHIBIT INDEX
Exhibit
Number Description
- - ------ -----------
3.1 Amended and Restated Certificate of Incorporation of Risk Capital Holdings,
Inc. ("RCHI")1(a)
3.2 Amended and Restated Bylaws of RCHI(b)
4.1 Specimen Common Stock Certificate(a)
4.2.1 Class A Common Stock Purchase Warrants issued to Marsh & McLennan Risk
Capital Holdings, Ltd. ("MMRCH") on September 19, 19952(b) and September
28, 19953(c)
4.2.2 Class A Common Stock Purchase Warrants issued to The Trident Partnership,
L.P. ("Trident") on September 19, 1995(b) and September 28, 1995(c)
4.2.3 Class A Common Stock Purchase Warrants issued to Taracay Investors
("Taracay") on September 19, 1995(b) and September 28, 1995(c)
4.3 Class B Common Stock Purchase Warrants issued to MMRCH on September 19,
1995(b) and September 28, 1995(c)
10.1.1 Employment Agreement, between RCHI and Mark D. Mosca(b)+
10.1.2 Employment Agreement, between RCHI and Peter A. Appel(b)+
10.1.3 Employment Agreement, between RCHI and Bonnie L. Boccitto(b)+
10.1.4 Employment Agreement, between RCHI and Paul J. Malvasio(b)+
10.2 Amended and Restated Subscription Agreement, between RCHI and Trident(b)
10.3 Amended and Restated Subscription Agreement, between RCHI and MMRCH(b)
10.4 Amended and Restated Subscription Agreement, between RCHI and Taracay(b)
10.5 Purchase Agreement, between RCHI and X.L. Insurance Company, Ltd.(b)
E-1
Exhibit
Number Description
- - ------ -----------
10.6.1 Investment Advisory Agreement, between RCHI and Marsh & McLennan
Capital, Inc. ("MMCI")(b)
10.6.2 Investment Advisory Agreement, between Risk Capital Reinsurance Company
("RCRe") and MMCI(b)
10.6.3 Investment Advisory Agreement among, RCHI, RCRe and Alliance Capital
Management L.P.(i)
10.7 Management Agreement, among RCHI, RCRe and The Putnam Advisory Company,
Inc.(b) 10.8.1 Sublease Agreement, dated as of March 18, 1996, between
RCRe and Coca-Cola Bottling Company of New York, Inc. ("Coca-Cola")(b)
10.8.2 Sublease Amendment Agreement and Consent, dated as of November 11, 1997,
between RCRe and Coca-Cola(d)
10.8.3 Sub-Sublease Agreement, dated as of March 18, 1996, between RCRe and
MMCI(e)
10.8.4 Sub-Sublease Agreement, dated as of April 30, 1997, between RCRe and
Bank of Ireland Asset Management (US) Limited ("BOI"), as amended(e)
10.8.5 Sub-Sublease Termination Agreement, effective March 31, 2000, between
RCRe and BOI (filed herewith)
10.9.1 Tax Sharing Agreement, between RCHI and RCRe (amended)(d)
10.9.2 Addition of Cross River Insurance Company to Tax Sharing Agreement(g)
10.10.1 RCHI 1999 Long Term Incentive and Share Award Plan(f)+
10.10.2 RCHI 1995 Long Term Incentive and Share Award Plan (the "1995 Stock
Plan")(b)4+
10.10.3 First Amendment to the 1995 Stock Plan(c)5+
10.10.4 Restricted Stock Agreements--Executive Officers(h)+
10.10.5 Stock Option Agreements--Executive Officers--1995 and 1996 grants(h) and
1997 and 1998 grants(g)+
10.10.6 Stock Option Agreements--Chairman--1996 grant,(h) 1997 grant(d) and 1998
grant(g)
10.10.7 Stock Option Agreements--Non-Employee Directors--initial grants(g) (and
filed herewith)
E-2
Exhibit
Number Description
- - ------ -----------
10.10.8 Stock Option Agreements--Non-Employee Directors--1996 and 1997 annual
grants,(c) 1998 annual grants,(d) 1999 annual grants (g) and 2000 annual
grants (filed herewith)
10.11.1 Change in Control Agreement (as amended)--President(i)+
10.11.2 Change in Control Agreements (as amended)--Managing Directors(i)+
10.11.3 Form of Change in Control Agreements (as amended)--Senior Vice
Presidents(i)+
10.11.4 Change in Control Severance Plan (as amended)(i)+
10.12 RCHI 1995 Employee Stock Purchase Plan(j)+
10.13.1 RCRe Money Purchase Pension Plan (the "Pension Plan")(b)+
10.13.2 Amendment and Restatement of the Adoption Agreement relating to the
Pension Plan(c)+
10.13.3 Amendment to the Adoption Agreement relating to the Pension Plan(g)+
10.14.1 RCRe Employee Savings Plan (the "Savings Plan")(b)+
10.14.2 Amendment and Restatement of the Adoption Agreement relating to the
Savings Plan(c)+
10.14.3 Amendment to the Adoption Agreement relating to the Savings Plan(g)+
10.15.1 RCRe Executive Supplemental Non-Qualified Savings and Retirement Plan
(the "Supplemental Plan") and related Trust Agreement(b)+
10.15.2 Amendment No. 1 to the Adoption Agreement relating to the Supplemental
Plan(c)+
10.15.3 Amendment No. 2 to the Adoption Agreement relating to the Supplemental
Plan(g)+
10.16 Asset Purchase Agreement, dated as of January 10, 2000, amount RCHI,
Folksamerica Holding Company, Inc. ("FHC") and Folksamerica Reinsurance
Company ("FRC")(k)
10.17 Voting Agreement, dated as of January 10, 2000, among MMRCH, RCHI and
FHC(k)
10.18 Voting Agreement, dated as of January 10, 2000, among Trident, RCHI and
FHC(k)
10.19 Voting Agreement, dated as of January 10, 2000, among XL Capital Ltd
("XL"), Garrison Investments Inc. ("GI"), RCHI and FHC(k)
10.20 Form of Transfer and Assumption Agreement between RCRe and FRC(k)
10.21 Form of Balance Sheet of Assumed Business(k)
10.22 Form of Escrow Agreement among RCRe, FHC, FRC and the Escrow Agent(k)
10.23 Form of Supplemental Escrow Agreement among, RCRe, FHC, FRC and the
Escrow Agent(k)
10.24 Stock Repurchase Agreement, dated January 17, 2000, among RCHI, RCRe, XL
and GI(k)
10.25 Form of Voting and Disposition Agreement, among RCHI, RCRe, XL and GI(k)
21 Subsidiaries of Registrant(g)
23 Consent of PricewaterhouseCoopers LLP (filed herewith)
24 Power of Attorney (filed herewith)
27 Financial Data Schedule (filed herewith)
E-3
Exhibit
Number Description
- - ------ -----------
99.1 Definitive proxy statement for a special meeting of stockholders, filed
with the SEC on March 16, 2000 (excluding audited financial statements
and annexes thereto)
- - --------
1(a) Filed as an exhibit to Amendment No. 3 to our Registration
Statement on Form S-1 (No. 33-94184), as filed with the
Securities and Exchange Commission (the "SEC") on August
11, 1995, and incorporated by reference.
2(b) Filed as an exhibit to our Annual Report on Form 10-K for
the year ended December 31, 1995, as filed with the SEC on
March 30, 1996, and incorporated by reference.
3(c) Filed as an exhibit to our Annual Report on Form 10-K for
the year ended December 31, 1996, as filed with the SEC on
March 31, 1997, and incorporated by reference.
(d) Filed as an exhibit to our Annual Report on Form 10-K for
the year ended December 31, 1997, as filed with the SEC on
March 27, 1998, and incorporated by reference.
(e) Filed as an exhibit to our Report on Form 10-Q for the
period ended June 30, 1998, as filed with the SEC on
August 14, 1998, and incorporated by reference.
(f) Filed as an exhibit to our Definitive Proxy Statement
filed with the SEC on April 14, 1999, and incorporated by
reference.
(g) Filed as an exhibit to our Annual Report on Form 10-K for
the year ended December 31, 1998, as filed with the SEC on
March 30, 1999, and incorporated by reference.
4(h) Filed as an exhibit to our Report on Form 10-Q for the
period ended June 30, 1997, as filed with the SEC on
August 14, 1997, and incorporated by reference.
(i) Filed as an exhibit to our Report on Form 10-Q for the
period ended June 30, 1999, as filed with the SEC on
August 12, 1999, and incorporated by reference.
(j) Filed as an exhibit to our Registration Statement on Form
S-8 (No. 33-99974), as filed with the SEC on December 4,
1995, and incorporated by reference.
(k) Filed as an exhibit to our Report on Form 8-K filed with
the SEC on January 18, 2000, and incorporated by
reference.
+ A management contract or compensatory plan or arrangement
required to be filed pursuant to Item 14(c) of Form 10-K.