SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q\A
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1994
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 1-5686
The Continental Corporation
(Exact name of registrant as specified in its charter)
New York 13-2610607
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
180 Maiden Lane, New York, New York 10038
(Address of principal executive offices)
(Zip Code)
(212) 440-3000
(Registrant's telephone number, including area code)
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
The number of shares outstanding of each of the issuer's classes of
common stock as of February 10, 1995 is as follows:
55,487,419 shares of Common Stock
Page 1 of Pages
AMENDMENT TO APPLICATION OR REPORT
filed pursuant to Section 12, 13, or 15(d) of the
Securities Exchange Act of 1934
THE CONTINENTAL CORPORATION
The undersigned registrant hereby amends the following items, financial
statements, exhibits or other portions of its Quarterly Report on Form 10-Q
for the fiscal quarter ended September 30, 1994 as set forth in the pages
attached hereto:
Part 1 - Financial Information
Item 1 - Financial Statements
Item 2 - Management's Discussion and Analysis of Financial Condition
and Results of Operations
THE CONTINENTAL CORPORATION
INDEX
Part I- Financial Information
Item 1 - Financial Statements:
Consolidated Statements of Income - Three and
Nine Months Ended September 30, 1994 and 1993
Consolidated Balance Sheets -
September 30, 1994 and December 31, 1993
Consolidated Statements of Cash Flows -
Nine Months Ended September 30, 1994 and 1993
Notes to Consolidated Financial Statements
Item 2 - Management's Discussion and Analysis of Financial
Condition and Results of Operations
Signature
THE CONTINENTAL CORPORATION
Part I - Financial Information
Item 1 - Financial Statements
CONSOLIDATED STATEMENTS OF INCOME
(millions, except share and per share amounts)
Three Months Ended Nine Months Ended
September 30, September 30,
1994 1993 1994 1993
Revenues:
Premiums $1,080.0 $1,175.3 $3,348.9 $3,306.6
Net Investment Income 121.8 128.2 373.0 399.8
Realized Capital Gains
(Losses), Net (4.0) 30.7 21.4 114.2
Other Revenues 25.8 21.3 72.2 72.0
Total Revenues 1,223.6 1,355.5 3,815.5 3,892.6
Expenses:
Losses and Loss Expenses 1,340.4 920.8 3,209.7 2,567.1
Insurance Operating Expenses 353.6 352.5 1,097.9 1,038.3
Other Expenses 74.5 25.6 140.5 92.3
Interest on Corporate Borrowings 9.6 8.8 27.9 38.2
Total Expenses 1,778.1 1,307.7 4,476.0 3,735.9
Income (Loss) from Continuing
Operations before Income Taxes
(Benefits) (554.5) 47.8 (660.5) 156.7
Income Taxes (Benefits):
Current 6.7 9.9 (11.9) 29.8
Deferred (242.3) (6.5) (245.7) (4.2)
Total Income Taxes
(Benefits) (235.6) 3.4 (257.6) 25.6
Income (Loss) from Continuing
Operations (318.9) 44.4 (402.9) 131.1
Income from Discontinued
Operations, Net of Income
Taxes 39.5 0.6 39.5 8.3
Income (Loss) before Net
Cumulative Effect of Changes
in Accounting Principles (279.4) 45.0 (363.4) 139.4
Net Cumulative Effect of Changes
in Accounting Principles - - - 1.6
Net Income (Loss) $(279.4) $45.0 $(363.4) $141.0
Net Income (Loss) Available
to Common Shareholders $(279.4) $44.2 $(363.5) $138.6
See Notes to Consolidated Financial Statements.
THE CONTINENTAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME, CONTINUED
(millions, except share and per share amounts)
Three Months Ended Nine Months Ended
September 30, September 30,
1994 1993 1994 1993
Per Common Share:
Income (Loss) from Continuing
Operations $(5.75) $0.79 $(7.27) $2.34
Income from Discontinued
Operations, Net of Income
Taxes $ 0.71 $0.01 $ 0.71 $0.15
Net Cumulative Effect of Changes
in Accounting Principles - - - $0.03
Net Income (Loss) $(5.04) $0.80 $(6.56) $2.52
Dividends Declared - $0.25 $ 0.50 $0.75
Weighted Average Shares of
Common Stock Outstanding 55,466,002 55,314,017 55,424,896 55,139,893
See Notes to Consolidated Financial Statements.
THE CONTINENTAL CORPORATION
CONSOLIDATED BALANCE SHEETS
(millions, except par values)
September 30, December 31,
1994 1993
Assets:
Investments:
Fixed Maturities Available-for-Sale
at Fair Value (Amortized Cost:
1994-$6,292.3; 1993-$6,615.9) $ 6,068.5 $ 6,916.4
Equity Securities Available-for-Sale
at Fair Value (Cost: 1994-$575.4;
1993-$600.0) 728.9 759.1
Other Long-Term Investments at Fair Value
(Cost: 1994-$609.9; 1993-$387.9) 616.7 395.9
Other Short-Term Investments 364.5 1,071.0
Total Investments 7,778.6 9,142.4
Cash and Cash Equivalents 92.2 58.5
Premiums Receivable 1,516.2 1,021.0
Accrued Interest and Dividends 112.1 160.7
Reinsurance Receivables 3,247.6 3,152.9
Prepaid Reinsurance Premiums 497.7 321.5
Reinsurance Recoverable 327.8 329.0
Deferred Policy Acquisition Costs 476.3 494.0
Property and Equipment, Net 450.1 463.5
Deferred Tax Asset 449.4 41.7
Other Assets 863.8 870.6
Net Assets of Discontinued Operations 69.6 84.6
Total Assets $15,881.4 $16,140.4
Liabilities:
Outstanding Losses and Loss Expenses $ 9,686.3 $ 9,068.7
Unearned Premiums 2,514.0 2,409.7
Short-Term Debt 190.7 229.1
Long-Term Debt 777.7 774.4
Accounts Payable and Accrued Expenses 109.9 107.9
Accrued Employee Benefits 306.5 308.3
Other Liabilities 920.8 1,059.2
Total Liabilities 14,505.9 13,957.3
Commitments and Contingencies - -
Shareholders' Equity:
Preferred Stock - $4 par value 0.3 0.3
Common Stock - $1 par value 65.7 65.7
Paid-in Capital 613.2 613.2
Retained Earnings 1,220.8 1,612.5
Net Unrealized Appreciation
(Depreciation) of Investments (89.3) 322.1
Cumulative Foreign Currency Translation
Adjustment (69.8) (61.1)
Common Stock in Treasury at Cost (365.4) (369.6)
Total Shareholders' Equity 1,375.5 2,183.1
Total Liabilities, Commitments and
Contingencies and Shareholders'
Equity $15,881.4 $16,140.4
See Notes to Consolidated Financial Statements.
THE CONTINENTAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(millions)
Nine Months Ended
September 30,
1994 1993
Cash Flows From Operating Activities:
Income (Loss) from Continuing Operations $ (402.9) $ 131.1
Adjustments to Reconcile Income (Loss)
from Continuing
Operations to Net Cash Provided from
(Used in)
Continuing Operating Activities:
Realized Capital Gains (21.4) (114.2)
Outstanding Losses and Loss Expenses 617.6 (66.3)
Unearned Premiums 104.3 169.4
Premiums Receivable (495.2) (752.8)
Reinsurance Recoverable 1.2 95.2
Prepaid Reinsurance Premiums (176.2) (32.5)
Reinsurance Receivables (94.7) 94.6
Deferred Tax Asset (245.7) (4.2)
Depreciation and Amortization 38.1 28.5
Other-Net (69.2) 58.7
Net Cash Used in Continuing Operating
Activities (744.1) (392.5)
Net Cash Provided from Discontinuing
Operating Activities 27.0 106.2
(717.1) (286.3)
Cash Flows From Investing Activities:
Net Purchase of Property and Equipment (24.7) (31.0)
Cost of Investments Purchased (3,635.8) (5,045.3)
Proceeds from Investments Sold 3,460.0 4,927.2
Proceeds from Investments Matured 529.6 590.9
Net (Increase) Decrease in Long-Term
Investments (222.0) 153.6
Net Decrease (Increase) in Short-Term
Investments 706.5 (66.3)
Net Cash Provided from Investing Activities 813.6 529.1
Cash Flows From Financing Activities:
Proceeds from Treasury Shares Sold 4.2 8.2
Dividends to Shareholders (28.4) (44.6)
Issuance of Long-Term Debt - 150.0
Decrease in Short-Term Debt (38.4) (52.4)
Retirement of Debt - (281.7)
Other Increase in Long-Term Debt (0.2) (3.8)
Net Cash Used in Financing Activities (62.8) (224.3)
Net Increase in Cash and Cash Equivalents 33.7 18.5
Cash and Cash Equivalents at Beginning of
Year 58.5 111.5
Cash and Cash Equivalents at End of Period $ 92.2 $ 130.0
See Notes to Consolidated Financial Statements.
THE CONTINENTAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1: Basis of Presentation
The consolidated financial statements include The Continental Corporation and
its majority-owned subsidiaries (collectively, "Continental"). These
financial statements have been prepared in conformity with generally accepted
accounting principles and are unaudited. These interim statements
necessarily rely heavily on estimates. In the opinion of management, all
material adjustments have been made. All adjustments recorded in Continental's
interim statements are of a normal recurring nature except for the third
quarter charges to establish, for the first time, loss and loss expense
reserves for incurred but not reported asbestos-related, other toxic tort and
environmental pollution claims, the related reinsurance receivables
charge on environmental IBNR, and the first and third quarter restructuring
charges. Certain reclassifications have been made to the
prior years' financial information to conform to the 1994 presentation
Note 2: Investments
Fixed maturities available-for-sale consist of bonds and preferred stocks,
presented at fair value, that management may not hold until maturity. Equity
securities available-for-sale are comprised of common stocks and
nonredeemable preferred stocks which are reported at fair value.
Other investments are comprised of money market instruments, mortgages
receivable and certificates of deposit, which are reported at amortized cost;
notes receivable, time deposits, federal funds sold and securities purchased
under resale agreements, which are reported at cost; venture capital
investments, which are reported at lower of cost or market; investments in
minority affiliates, which are reported under the equity method of
accounting; and investment in limited partnerships, which are reported at
fair value. These other investments are classified as short term if their
original maturity date is within one year of the balance sheet date. All
investment transactions are recorded on the settlement date.
Realized capital gains and losses on the sales of investments are included as
a component of revenues, based upon the specific identification method.
Provisions for impairments of investments that are considered other than
temporary are reported as realized capital losses. Unrealized gains and
losses on investments reported at fair value, net of related deferred taxes,
are reflected in shareholders' equity.
At September 30, 1994, Continental did not invest in the securities of any
issuer, except securities issued/backed by U.S. or Canadian government
agencies, in excess of 10% of total shareholders' equity.
Note 3: Reinsurance
In the ordinary course of business, Continental cedes business to other
insurers and reinsurers. Purchasing reinsurance enables Continental to limit
its exposure to catastrophic events and other concentrations of risk.
However, purchasing reinsurance does not relieve Continental of its
obligations to its insureds. Continental reviews the creditworthiness of its
reinsurers on an ongoing basis. To minimize potential problems,
Continental's policy is to purchase reinsurance only from carriers who meet
its credit quality standards. It has also taken and is continuing to take
steps to settle existing reinsurance arrangements with reinsurers who do not
meet its credit quality standards. Continental does not believe that there
is a significant solvency risk concerning its reinsurance claims. In
addition, Continental regularly evaluates the adequacy of its reserves for
uncollectible reinsurance. Continental believes that it makes adequate
provisions for the ultimate collectibility of its reinsurance claims and
therefore believes the collection of these net recoveries to be probable.
Continental has in place various reinsurance arrangements with respect to its
current operations. These arrangements are subject to retentions, coverage
limits and other policy terms. Some of the principal treaty arrangements
which are presently in effect are an excess of loss treaty reducing
Continental's liability on individual property losses, a blanket casualty
program reducing Continental's liability on third party liability losses, a
clash casualty program reducing Continental's liability on multiple
insured/single event losses, and a property catastrophe program, with a net
retention of $50 million in both 1994 and 1993, reducing its liability from
a catastrophic event. Continental also uses individual risk facultative and
other facultative agreements to further reduce its liabilities.
Effective July 1, 1994, Continental entered into a quota share agreement
(i.e., the Quota Share Cession) to reinsure a portion of its domestic
personal lines business with a major U.S. reinsurer. From July 1, 1994
through December 31, 1995, Continental's quota share participation is 50% of
the covered lines. Continental expects to cede premiums related to this
agreement of approximately $300 million per year, through December 31, 1995.
This arrangement will help Continental lower its premium-to-surplus ratio and
further reduce its exposure to catastrophes subject to the agreement's
catastrophe coverage limits.
Note 4: Changes in Accounting Principles
The net cumulative effect of changes in accounting principles is comprised
of the following:
(millions, except per common share amounts) Nine Months Ended
September 30, 1994
Net Cumulative Effect of the Change in
Accounting for Postemployment Benefits $ (3)
Net Cumulative Effect of the Change in
Accounting for Retrospectively Rated
Reinsurance Contracts 5
Net Cumulative Effect of Changes in
Accounting Principles $ 2
Per Common Share:
Net Cumulative Effect of the Change in
Accounting for Postemployment Benefits $ (0.06)
Net Cumulative Effect of the Change in
Accounting for Retrospectively Rated
Reinsurance Contracts 0.09
Net Cumulative Effect of Changes in
Accounting Principles $ 0.03
Effective January 1, 1993, Continental adopted Statement of Financial
Accounting Standards (SFAS No. 112), "Employers' Accounting for Post-
employment Benefits", Emerging Issues Task Force Issue No. 93-6,
"Accounting for Multiple-Year Retrospectively Rated Contracts By Ceding
and Assuming Enterprises" and SFAS No. 113, "Accounting and Reporting for
Reinsurance of Short-Duration and Long-Duration Contracts".
In addition, effective December 31, 1993, Continental adopted SFAS No. 115,
"Accounting for Certain Investments in Debt and Equity Securities", which
did not change the way Continental accounts for investments or have a
material impact on its 1993 financial results.
Note 5: Restructuring Charges
In March 1994, Continental's senior management approved a definite plan to
re-engineer the operations of Continental's Agency & Brokerage division
(including home office, field claims and underwriting), selected operations
of Continental's Special Operations division, particularly its multinational
unit, and several corporate staff divisions, including Human Resources,
Corporate Claims, Actuarial, Finance, and Legal. The locations identified
for re-engineering are Cranbury, New Jersey; New York, New York; Duluth,
Georgia; Chicago, Illinois; Dallas, Texas; Glens Falls, New York; Overland
Park, Kansas; Rancho Cordova, California; Columbus, Ohio; York, Pennsylvania
and certain overseas locations. These re-engineering efforts are expected to
involve a net elimination of 680 positions (approximately 1,200 terminations,
net of new hires and transfers), from a total company workforce of 12,255 at
year end 1993, within one year from approval of the plan, as well as achieve
business-related expense savings. Substantially all of the identified
employees have been notified that their positions have been eliminated.
The re-engineering efforts also include vacating leased space at 27 locations.
As of September 30, 1994, 15 of these locations have been vacated; the
lease vacating program is expected to be completed by the end of 1994.
Continental has also implemented additional cost saving measures in several
employee benefit programs. Included in the re-engineering plan are severance
packages for all affected employees as well as extended benefits and outplace-
ment counseling for many of them. Underwriting results for the first nine
months of 1994 included a $45 million restructuring charge, including $29
million in expected severance and related benefits and $16 million in expected
lease vacations and other associated costs.
In June 1994, Continental announced additional steps with a goal to improve
its profitability. As part of this goal and to further reduce its operating
expenses, Continental reconsidered its staffing needs and developed another
plan, in the third quarter of 1994, that would result in a further net reduc-
tion of approximately 1,100 positions, (in addition to the terminations of
approximately 1,200 from the March plan). Underwriting results for the third
quarter include a $14 million charge for the additional staff reductions,
which includes the cost for expected severance and related benefits. As of
September 30, 1994, substantially all identified employees have been notified
that their positions have been eliminated.
Note 6: Income Taxes (Benefits)
The provision for income taxes (benefits) from continuing operations was as
follows:
Nine Months Ended
(millions) September 30,
1994 1993
Current Tax Expenses (Benefit):
U.S. Federal $ (14) $ 26
State and Local 1 1
Foreign 1 3
Total Current Expenses (Benefit) (12) 30
Deferred Tax Expenses (Benefit):
U.S. Federal (243) (5)
Foreign (3) 1
Total Deferred Expenses (Benefit) (246) (4)
Total Income Taxes (Benefit) $ (258) $ 26
In the first nine months of 1994, there was no reduction in current income
taxes through the utilization of tax net operating loss carryforwards and tax
credit carryforwards. In the first nine months of 1993, a reduction in
current income taxes of $6 million was recognized through the utilization of
$3 million of tax net operating loss carryforwards and $3 million of tax
credit carryforwards.
Unused domestic net operating loss carryforwards at September 30, 1994,
available for use in future years on a tax return basis, amount to $692
million for regular tax and $431 million for AMT and expire at various
stages through the year 2009.
Continental also has a foreign tax credit, general business credit and AMT
credit carryforwards of $31 million, $15 million and $10 million, respective-
ly; the foreign tax and general business credits expire at various stages
through the year 2000.
Set forth below are the significant differences between the U.S. federal
income tax rate and the effective tax rates as reflected in the accompanying
Consolidated Statements of Income:
Nine Months Ended
September 30,
(millions, except percentages)
1994 1993
% of % of
Pretax Pretax
Amount Income Amount Income
Income (Loss) from Continuing
Operations Before Income Taxes (Benefits) $(660) $ 157
Statutory Federal Corporate Tax (Benefit) (231) (35)% 55 35%
Increases (Reductions) in
Taxes Resulting from:
Tax-Exempt Interest (15) (2) (17) (11)
Dividends Received Deduction (4) (1) (4) (2)
Foreign Income at Higher Rates (5) (1) (1) (1)
Change in Valuation Allowance - - (7) (4)
Other (3) - - -
Total Income Taxes (Benefit) $(258) (39)% $26 17%
The tax effects of temporary differences that give rise to significant por-
tions of the deferred tax assets and deferred tax liabilities at December 31,
1993 and September 30, 1994, and the provision for deferred income taxes under
SFAS #109 "Accounting for Income Taxes" for the nine months ended September
30, 1994 and 1993 are presented on pages 11 and 12.
The net deferred tax asset, before considering deferred taxes (benefits)
on unrealized appreciation (depreciation) of investments, increased by
$242 million at September 30, 1994. The increase was caused predominately by
an increase in tax net operating loss (NOL's) carryforwards; loss reserve
discounting caused by a $400 million first time charge for environmental
incurred but not reported losses and loss expenses; and a $164 million
charge for reinsurance receivables and other assets.
In light of significant re-engineering of operations in the third quarter of
1994 and the expected results such actions will have on increasing future
taxable income, management believes it is more likely than not that a sig-
nificant portion of the deferred tax asset will be realized against future
taxable income.
The valuation allowance for deferred tax assets was $136 million at December
31, 1993. The net change in the valuation allowance for deferred tax assets
was an increase of $32 million, resulting in a $168 million valuation allow-
ance at September 30, 1994. The $32 million increase in the valuation allow-
ance resulted from an increase in the deferred tax assets attributable to un-
realized depreciation in the securities portfolio.
Deferred Tax (Expense) Benefit
Statement
(millions) Balance of Shareholders' Balance
December 31, Income Equity September 30,
1993 1994
Deferred Tax Assets:
Unearned Premium Reserve $ 127 $ (6) - $ 121
Loss Reserve Discounting 245 32 - 277
Adoption of SFAS No. 106 70 - - 70
Net Operating Loss Carry
forward - 165 - 165
Tax Credit Carryforwards 73 (15) - 58
Real Estate Basis Differences 47 (2) - 45
Allowance for Bad Debts 16 5 - 21
Capital Leases 15 - - 15
Provision for Early Retirement 15 - - 15
Unrealized Depreciation of
investments - - 32 32
Other Items 28 14 - 42
Total Gross Deferred Tax
Assets 636 193 32 861
Valuation Allowance (136) - (32) (168)
Net Deferred Tax Assets 500 193 - 693
Deferred Tax Liabilities:
Deferred Acquisition Costs 154 (7) - 147
Accrual for Retrospectively
Rated Premiums 13 (11) - 2
Audit Premiums 43 - - 43
Installment Receivables 18 - - 18
Unrealized Appreciation of
Investments 165 (4) (161) -
Other Items 65 (31) - 34
Total Gross Deferred
Tax Liabilities 458 (53) (161) 244
Deferred Tax Asset, Net $ 42 $ 246 $ 161 $ 449
Deferred Tax (Expense) Benefit
Statement
(millions) Balance of Shareholders' Balance
December 31, Income Equity September 30,
1994 1993
Deferred Tax Assets:
Unearned Premium Reserve $ 112 $ 11 - $ 123
Loss Reserve Discounting 269 69 - 338
Adoption of SFAS No. 106 68 2 - 70
Net Operating Loss Carryforward - - - -
Tax Attribute Carryforwards 76 (6) - 70
Real Estate Basis Differences 50 - - 50
Allowance for Bad Debts 22 2 - 24
Capital Leases 15 - - 15
Provision for Early Retirement 14 - - 14
Other Items 35 (9) - 26
Total Gross Deferred Tax
Assets 661 69 - 730
Valuation Allowance (159) 4 - (155)
Net Deferred Tax Assets 502 73 - 575
Deferred Tax Liabilities:
Deferred Acquisition Costs 140 14 - 154
Accrual for Retrospectively
Rated Premiums 13 - - 13
Audit Premiums 42 1 - 43
Discounted Reserves for
Workers' Compensation - 25 - 25
Installment Receivables 15 - - 15
Unrealized Appreciation of
Investments 101 5 71 177
Other Items 92 24 - 116
Total Gross Deferred
Tax Liabilities 403 69 71 543
Deferred Tax Asset, Net $ 99 $ 4 $ (71) $ 32
Note 7: Long-Term Debt
In March 1993, Continental sold $150 million of a total of $350 million of
Notes (which provided $147 million of a total $346 million in cash, net of
offering and underwriting costs) outstanding under its shelf registration of
up to $400 million of debt securities with the Securities and Exchange Com-
mission. During 1993, Continental used $282 million of the net proceeds from
these sales to retire its outstanding 9 3/8% Notes due July 1, 1993 and $50
million of net proceeds from these sales to reduce corporate short-term bor-
rowings. Continental intends to raise additional capital of approximately
$100 million, through the issuance of either preferred stock or notes; but
does not currently contemplate incurring other borrowings other than for the
purpose of reducing amounts outstanding under its revolving credit facility
described below.
In December 1993, Continental entered into a revolving credit facility, pro-
viding for borrowings of up to $150 million from a syndicate of banks. During
the third quarter, Continental extended the maturity of its revolving credit
facility from December 30, 1994 to December 31, 1995. In addition, the revol-
ving credit facility has been increased by $60 million and provides for bor-
rowings of up to $210 million. Funds borrowed from the facility may be used
for general corporate purposes, but Continental has used and intends to use
the facility as an alternative to traditional sources of short-term borrow-
ings. At September 30, 1994, Continental had a $128 million balance outstand-
ing through the facility. As of October 31, 1994, that balance increased to
a $205 million balance outstanding through the facility; the proceeds of these
borrowings were used to repay other short-term borrowings.
Note 8: Preferred Stock
The Series A and Series B preferred stocks are convertible into common stock
at the rate of 2.2 shares of common stock for each share of preferred stock.
The number of common shares reserved for conversion of these preferred stocks
is 117,847.
Note 9: Employee Stock Options and Performance Awards
Continental has a Long-Term Incentive Plan under which it grants performance
awards and issues stock options to key employees. Nine million shares of
common stock, the maximum number of shares which may be issued under the Plan,
have been reserved for issuance. Continental has granted both incentive stock
options and nonqualified stock options under the Plan. No stock option has
been granted with an exercise price below the market price of Continental's
common stock at the time of grant.
Performance awards are payable in either cash or shares of Continental's
common stock in amounts based on Continental's performance for four-year award
cycles determined by the Compensation Committee of the Board of Directors. As
of September 30, 1994, 715,032 of such shares were reserved for possible pay-
ment of such awards.
The stock options are accounted for as common stock equivalents and are used
in computing earnings per share. Options for 4,395,593 shares (at a weighted
average exercise price of $29.70 per share) were outstanding, of which
3,667,518 were then exercisable. During the nine months ended September 30,
1994, no options were exercised.
Note 10: Discontinued Operations
In 1994, Continental recognized an additional after tax gain of $4 million
related to the sale of its premium financing operations as a result of final
tax elections made for 1993. In addition, Continental reduced various tax
liabilities related to previously discontinued operations and realized $36
million in additional income. The reduction in the various tax liabilities
is a direct result of a recent review of Continental's tax position and the
development of the discontinued operations over the last two years. In Dec-
ember 1993, Continental completed the sale of its premium financing opera-
tions, AFCO Credit Corporation, AFCO Acceptance Corporation and their Canadian
affiliate CAFO Inc., to Mellon Bank Corporation. Continental had realized a
$36 million gain from this sale, net of income taxes. The 1993 results and
net assets of these premium financing operations, which were previously re-
ported in the Corporate & Other Operations segment, have been classified as
discontinued in the accompanying Consolidated Financial Statements. Also
included in discontinued operations are the traditional assumed reinsurance
and marine reinsurance businesses, as well as the indigenous international and
international marine insurance businesses which were discontinued in 1992.
Continental has sold all of its discontinued entities intended for sale and
will run-off the remaining reserves of these discontinued insurance oper-
ations. The financial statements reflect the operating results and balance
sheet items of the discontinued operations separately from continuing oper-
ations. Operating results of the discontinued operations were as follows:
Insurance Operations Three Months Ended Nine Months Ended
September 30, September 30,
(millions) 1994 1993 1994 1993
Total Revenues $ 20 $ 47 $ 53 $ 332
Total Expenses 20 50 53 335
Income (loss) before Income Taxes - (3) - (3)
Income Taxes (Benefits) (36) - (36) -
Income (Loss) from
Discontinued Insurance Operations $ 36 $ (3) $ 36 $ (3)
Premium Financing Operations Three Months Ended Nine Months Ended
September 30, September 30,
(millions) 1994 1993 1994 1993
Total Revenues - $ 26 - $ 76
Total Expenses - 21 - 61
Income before Income Taxes - 5 - 15
Income Taxes - 1 - 4
Gain on Disposal of Discontinued
Premium Financing Operations,
Net of Income Taxes 4 - 4 -
Income from Discontinued
Premium Financing Operations $ 4 $ 4 $ 4 $ 11
Net assets of discontinued insurance operations at September 30, 1994 and Dec-
ember 31, 1993 were as follows:
Insurance Operations
September 30, December 31,
(millions) 1994 1993
Assets
Cash and Investments $1,074 $1,167
Other Assets 595 528
1,669 1,695
Liabilities
Outstanding Losses and Loss Expenses 1,274 1,346
Unearned Premiums 2 3
Other Liabilities 323 261
1,599 1,610
Net Assets $ 70 $ 85
Note 11: Asbestos-Related, Other Toxic Tort and Environmental Pollution Claims
Prior to the third quarter of 1994, Continental did not establish reserves for
incurred but not reported asbestos-related, other toxic tort and environmental
pollution claims (Environmental IBNR) because the existence of significant
uncertainties, (including difficulties in determining the frequency and severity
of potential claims and in predicting the outcome of judicial decisions, as case
law evolves regarding liability exposure, insurance coverage and interpretation
of policy language), and the absence of standard techniques to measure exposure
did not allow ultimate liabilities to be reasonably estimated in accordance with
accepted actuarial standards.
While Continental continues to believe that it is not possible to reasonably
estimate ultimate liabilities for unreported environmental claims, it has
concluded that different measurement techniques, based on industry averages,
for estimating a reserve for unreported environmental claims have been
sufficiently developed, and accepted in the industry, to permit Continental to
determine a reasonable gross estimate for Environmental IBNR. However, due to
the continuing level of uncertainty involved with environmental exposures,
Continental may incur future charges for incurred but not reported
environmental claims which may be material to Continental's financial position,
results of operations or liquidity.
Included in Continental's liability for outstanding losses and loss expenses
are gross undiscounted reserves of $790 million for asbestos-related, other
toxic tort and environmental pollution claims. At September 30, 1994
the gross undiscounted reported environmental reserves for losses and loss
expenses (Environmental Claims) were $310 million ($268 million at September
30, 1993) and a gross undiscounted environmental reserve of $480 million
was established for losses and loss expenses for Environmental IBNR
($0 at September 30, 1993). The $310 million represents Continental's current
best estimate for reported Environmental Claims. The $480 million represents
Continental's best estimate for its unreported Environmental Claims, using a
measurement technique believed to be reasonable, based upon information
currently available. However, it is not possible at this time to estimate the
amount of additional liability related to the unreported Environmental Claims
that is at least reasonably possible to exist.
Included in Continental's reinsurance asset are amounts due for reported
Environmental Claims of $139 million at September 30, 1994 ($120 million at
September 30, 1993). A reinsurance asset of $80 million was recorded in
conjunction with the establishment of the Environmental IBNR, but was fully
reserved for as not recoverable due to the degree of uncertainty in the
collectibility of such amounts.
The technique utilized by Continental involves measuring total net reserves for
reported Environmental Claims and Environmental IBNR in terms of the number of
years such reserves could fund the net annual payments for these claims. Such
technique is consistent with that utilized by an insurance rating agency and
by the actuarial profession in some of its discussion papers for its
preliminary work with respect to such liabilities. At the end of 1992, the
industry was at a net environmental reserve to net environmental paid ratio
("Survival Ratio") of six times such paid losses, which had been increasing
and was expected to continue to increase further. Continental's net
environmental claims reserves would comprise approximately nine times its
historical average net paid losses and loss expenses for these claims.
Net losses and loss expenses include charges for reported Environmental Claims
and Environmental IBNR of $556 million and $31 million for the first nine
months of 1994 and 1993, respectively. The increase is primarily related to
the establishment of the Environmental IBNR.
Most of Continental's environmental pollution claims result from general
liability policies written prior to 1986. Certain provisions of these
policies have been subject to wide-ranging challenges by policyholders and/or
differing interpretations by courts in various jurisdictions, with inconsistent
conclusions as to the applicability of coverage for environmental pollution
claims. Asbestos-related claims have generally arisen out of product liability
coverage provided by Continental under general liability policies written prior
to 1983. Thereafter, asbestos-related product exclusions were included in
general liability policies. Other toxic tort claims have also generally arisen
out of product coverage under general liability policies. These claims involve
a variety of allegations of bodily injury arising from exposure over a
period of time to products alleged to be harmful or toxic.
Note 12: Planned Sales of Subsidiaries
In third quarter 1994, the Continental entered into a definitive agreement to
sell Continental Canada, a major property and casualty insurer in Canada, to
Fairfax Financial Holdings Limited, a Canadian financial services company.
Under the terms of the agreement, the Corporation would receive (expressed in
Canadian dollars) $130 million in cash, debt securities of Fairfax Financial
with a face value of $25 million and a contingent payment of up to $10 mil-
lion based on the performance of Continental Canada during the five years
following the sale. The approximate U.S. dollar equivalents at the exchange
rate on October 31, 1994 are $97 million, $19 million and $7 million, respec-
tively. The proposed sale is subject to satisfaction of closing conditions
under the agreement, including regulatory approvals. Continental does not ex-
pect the sale of Continental Canada as proposed to have a significant impact
on its financial position, results of operations or liquidity.
In October 1994, Continental entered into an agreement in principle to sell
its Casualty Insurance unit to Fremont General Corporation for $250 million
in cash. Casualty Insurance, based in Chicago, is the leading writer of wor-
kers' compensation insurance in Illinois. The unit also has facilities oper-
ating in Wisconsin, Indiana, Michigan and California. In 1993, Casualty wrote
$362 million in premiums, overwhelmingly in the Midwest. The proposed trans-
action is subject to completion of a definitive agreement, regulatory approvals,
and satisfaction of other closing conditions under the agreement. Continen-
tal expects to recognize a gain on the sale of this operation but does not
expect the sale to have a significant impact on its financial position or
liquidity.
Also in October 1994, Continental entered into an agreement with Insurance
Partners, L.P., and related parties to sell the operations of Continental
Asset Management (CAM) for about $35 million in notes. Under the terms of
this agreement, Continental has an option to purchase a 20% interest in these
operations. The proposed transaction is subject to satisfaction of closing
conditions, including financing and applicable regulatory approvals.
Continental Asset Management is an investment advisory firm which manages
Continental's investment portfolio and provides investment management services
for outside clients, including property/casualty insurance companies. The
agreement contemplates that Continental will continue to receive investment
advisory services from CAM. The purchase price will be subject to adjustments
under circumstances relating to the loss, if any, of unaffiliated clients
prior to the consummation of the purchase and to a shortfall, if any, in
fees by Continental's affiliates over a 7 year period following the con-
summation of the purchase. Due to the conditions of sale, Continental will
not immediately recognize any gain from this transaction.
Note 13: Subsequent Event - Planned Capital Infusion
In order to bolster insurance operating capital and to maintain the financial
strength and claims paying ability ratings of its domestic insurance subsidiar-
ies, Continental has entered into a definitive agreement to sell preferred
stock with an aggregate liquidation preference of $200 million to Insurance
Partners, L.P. The agreement provides that Insurance Partners, L.P., will
acquire for $200 million in cash two series of cumulative preferred stock
issues, each series paying an annual cash dividend of 9.75%. In addition,
Insurance Partners, L.P., will receive an option to acquire $125 million in
liquidation preference of a separate series of 9.75% non-convertible preferred
stock. Of the $200 million, about $165 million will be for a series of con-
vertible preferred stock, convertible into approximately 19.9% of Continen-
tal's currently outstanding common shares, at a conversion price of $15.00
per share. The balance, about $35 million, will be for a series of noncon-
vertible preferred stock redeemable under certain circumstances
at a price which would include a redemption premium for any increase in the
per share price of Continental's common stock over a strike price of $15.00.
The two preferred issues will mature in 15 years, but may be redeemed by Con-
tinental after seven years under certain circumstances. The option and its
underlying preferred stock will be redeemable under certain circumstances at
a price which would include a redemption premium for any increase in the per
share price of the common stock over a strike price of $17.00.
At the time of their issuance, for financial statement reporting, these se-
curities will be presented separately from shareholder's equity and to the
$200 million of proceeds received will be allocated to the preferred stock
issues and the option based on the relative fair value of the securities
issued, net of related transaction fees. Any difference between the recorded
amount and liquidation value will be accreted using the interest method
through a charge to retained earnings. In addition, changes in the redemption
premium will also be adjusted through retained earnings generally when the
fair value of the common shares exceeds the strike prices. The amounts of
the preferred dividends, periodic accretion and changes for the recognition
of the redemption charges will reduce income applicable to common shareholders
in the calculation of earnings per share.
The terms of the preferred stock provide that Continental will continue to not
pay dividends on its common stock for an additional period of three years from
the time the preferred stock is sold and would after three years be subject
to limitations in payment of such dividends if any Continental preferred stock
is not rated at least BBB- by Standard & Poor's Insurance Rating Services and
Baa3 by Moody's Investor Services.
The agreement also provides that, following the investment by Insurance Part-
ners, Continental will further strengthen its capital base by raising $100
million, at Continental's option, in non-convertible preferred stock or debt.
Following the anticipated purchase of the preferred stock, Insurance Partners
will be entitled to nominate up to four directors to serve on Continental's
board.
In addition, Richard M. Haverland has been elected Vice Chairman and a
Director of The Continental Corporation's Board. Upon completion of the
planned transaction, Mr. Haverland will become Chairman and Chief Executive
Officer, succeeding John P. Mascotte, who will resign.
The proposed transaction is subject to satisfaction of closing conditions
under the agreement, including regulatory approvals. If the agreement is ter-
minated by Continental in order to enter into an agreement for a merger or
similar transaction, Insurance Partners would be paid a termination fee rep-
resenting the higher of $17.5 million or 1.875% of the aggregate value of the
other transaction and expenses incurred in connection with this transaction.
Item 2 - Management's Discussion and Analysis of Financial
Condition and Results of Operations
Business Operations: Continental's principal business is
property and casualty insurance. These Insurance Operations are
comprised of three segments: Agency & Brokerage Commercial,
Agency & Brokerage Personal and Specialized Commercial. The
results of Continental's non-insurance operations, including
investment management, claims adjusting and risk management, are
reported in the Corporate & Other Operations segment. Insurance
Operations generated 98% of consolidated revenues for the first
nine months of 1994, including 88% from premiums earned and 10%
from investment activities (net investment income and realized
capital gains). In 1993, Continental sold its premium financing
operations, the results of which were reported as discontinued.
Results of Operations - First nine months 1994 compared with
first nine months 1993.
Summary: The net result for the first nine months of 1994
included a $403 million loss from continuing operations and $40
million of income from discontinued operations. The loss from
continuing operations included the following: a $400 million
charge to establish, for the first time, loss and loss expense
reserves for incurred but not reported asbestos-related, other
toxic tort and environmental pollution claims ("Environmental
IBNR") (see "Asbestos-Related, Other Toxic Tort and Environmental
Pollution Claims") and a $164 million charge for reinsurance
receivables and other assets partially offset by $34 million of
returned reinsurance premiums and a $258 million tax benefit
resulting from the first nine months of 1994 pretax loss and an
increase in Continental's effective tax rate (see "Results of
Operations - Income Taxes"). The $164 million charge for
reinsurance receivables and other assets included an $80 million
charge for a provision for future uncollectible reinsurance
receivables on Environmental IBNR (the "Reinsurance Receivables
Charge") (see "Asbestos-Related, Other Toxic Tort and
Environmental Pollution Claims"), a $31 million charge for an
additional provision for uncollectible premiums receivable (the
"Premiums Receivable Charge"), and a $53 million provision for
other assets. The Premiums Receivable Charge was a result of a
review of premiums receivable completed in the third quarter of 1994,
which included an assessment of the effects of declining books of
business subject to premium accrual. The charge for other assets includes
a $27 million write-off of unreconciled intercompany balances, as a result of
an investigation completed in the third quarter, a $17
million charge for reinsurance balances related to the Canadian
subsidiary being sold which were deemed unrecoverable and a $9
million write-down of goodwill associated with a group
put up for sale. The loss from continuing operations for the first
nine months of 1994 also included a $45 million first quarter
charge (the "Restructuring Charge") to restructure the field
claims operations and several corporate staff units (see
"Restructuring Charge") and a $14 million third quarter charge
(the "Additional Staff Reduction Charge") for additional staff
reductions (see "Additional Improvements"). The income from
discontinued operations for the first nine months of 1994
consisted of a $36 million reduction of various tax liabilities
for operations discontinued in 1992 and a $4 million additional
after tax gain from the sale in 1993 of the premium financing
operations (see "Other Developments - Discontinued Operations").
The net result for the first nine months of 1993 included $131
million of income from continuing operations, $8 million of
income from discontinued operations and a $2 million benefit from
the cumulative effect of changes in accounting principles.
Insurance Operations: Insurance Operations had a loss before
income taxes for the first nine months of 1994 of $573 million,
$761 million worse than the first nine months of 1993.
Underwriting results for the first nine months of 1994 were down
$660 million and investment results were down $101 million,
including an $88 million decrease in realized capital gains and a
$13 million decrease in net investment income.
The $660 million decrease in underwriting results was primarily
due to the charge to establish Environmental IBNR; the
Reinsurance Receivables Charge; the Premiums Receivable Charge;
the Insurance Operations' $17 million share of the provision for
other assets; increases in weather-related losses not officially
designated as catastrophic and in large losses; the Restructuring
Charge ($26 million in loss expenses and $19 million in insurance
operating expenses); the Additional Staff Reduction Charge ($2
million in loss expenses and $12 million in insurance operating
expenses); and a $45 million increase in net reported
environmental losses and loss expenses partially offset by a $34
million increase in returned reinsurance premiums. Premiums
earned increased $42 million, primarily due to the increase in
returned reinsurance premiums and increases in certain non-
package standard commercial and specialty lines (resulting from
both price increases and acceptance of new risk) partially offset
by the cession of $110 million of domestic personal lines
business under a quota share agreement (the "Quota Share
Cession") (see "Reinsurance") and the Premiums Receivable Charge.
Losses and loss expenses increased $643 million, primarily due to
the charge to establish Environmental IBNR, the Reinsurance
Receivables Charge, increases in non-catastrophe weather-related
losses and large losses, the Restructuring Charge, the increase
in net reported environmental losses and loss expenses and
inflation in loss costs, partially offset by a $77 million Quota
Share Cession and a decrease in the amount of risk accepted.
Insurance operating expenses increased $59 million, primarily due
to the Restructuring Charge, the provision for other assets, the
Additional Staff Reduction Charge, and a $24 million decrease in
servicing carrier income (which is recorded as a reduction in
commission expenses), partially offset by a $42 million decrease
in commission expenses (a $75 million ceding commission resulting
from the Quota Share Cession less related deferred acquisition costs).
Underwriting results for the first nine months of 1994 included
pretax catastrophe losses of $139 million, compared with $135
million for the first nine months of 1993. Catastrophe losses
for the first nine months of 1994 included $43 million from
January snow and ice storms and $30 million from the California
earthquake; catastrophe losses for the first nine months of 1993
included $44 million from the East Coast blizzard.
The insurance segments' premiums earned and underwriting results
for the first nine months of 1994 and 1993 were as follows:
(millions)
Premiums Earned Underwriting Results
INSURANCE SEGMENT* 1994 1993 1994 1993
Agency & Brokerage Commercial $1,683 $1,595 $(595) $(169)
Agency & Brokerage Personal 550 647 (68) (52)
Specialized Commercial 1,116 1,065 (296) (78)
Total Insurance Operations $3,349 $3,307 $(959) $(299)
* Distinct investment portfolios are not maintained for
individual insurance segments; accordingly, Insurance Operations'
investment results are explained in aggregate below.
The Agency & Brokerage Commercial segment's underwriting results
for the first nine months of 1994 were $426 million worse than
the first nine months of 1993, primarily due to the segment's
$224 million share of the charge to establish Environmental IBNR;
its $45 million share of the Reinsurance Receivables Charge; the
Premiums Receivable Charge; increases in non-catastrophe weather-
related losses and large losses; its $29 million share of the
Restructuring Charge ($17 million in loss expenses and $12
million in insurance operating expenses); its $11 million share
of the provision for other assets; its $9 million share of the
Additional Staff Reduction Charge ($1 million in loss expenses
and $8 million in insurance operating expenses); and a $35
million increase in net reported environmental losses and loss
expenses; partially offset by a $34 million increase in returned
reinsurance premiums. Premiums earned increased $88 million,
primarily due to increases in certain non-package standard
commercial lines and the increase in returned reinsurance
premiums partially offset by the Premiums Receivable Charge.
Losses and loss expenses increased $450 million, primarily due to
the charge to establish Environmental IBNR; the Reinsurance
Receivables Charge; increases in non-catastrophe weather-related
losses and large losses; the Restructuring Charge; the increase
in net reported environmental losses and loss expenses; and
inflation in loss costs. Insurance operating expenses increased
$64 million, primarily due to the Restructuring Charge, the
Additional Staff Reduction Charge, the provision for other assets
and a $24 million decrease in servicing carrier income.
The Agency & Brokerage Personal segment's underwriting results
for the first nine months of 1994 were $16 million worse than the
first nine months of 1993, primarily due to a $16 million
increase in catastrophe losses, the segment's $13 million share
of the Restructuring Charge ($9 million in loss expenses and $4
million in insurance operating expenses), its $6 million share of
the provision for other assets and its $5 million share of the
Additional Staff Reduction Charge ($1 million in loss expenses
and $4 million in insurance operating expenses) partially offset
by better loss experience and a decrease in relative underwriting
expenses. Premiums earned decreased $97 million, primarily due to
the Quota Share Cession and a decrease in the amount of risk
accepted partially offset by price increases. Losses and loss
expenses decreased $57 million, primarily due to the Quota Share
Cession and the decrease in the amount of risk accepted partially
offset by the increase in catastrophe losses, an increase in non-
catastrophe weather-related losses, the Restructuring Charge and
inflation in loss costs. Insurance operating expenses decreased
$24 million, primarily due to a $42 million decrease in
commission expense resulting from the Quota Share Cession
partially offset by the Restructuring Charge, the Additional
Staff Reduction Charge and the provision for other assets.
The Specialized Commercial segment's underwriting results for the
first nine months of 1994 were $218 million worse than the first
nine months of 1993, primarily due to the segment's $176 million
share of the charge to establish Environmental IBNR, its $35
million share of the Reinsurance Receivables Charge and a $10
million increase in net reported environmental losses and loss
expenses, partially offset by a $13 million decrease in
catastrophe losses. Premiums earned increased $51 million, primarily due to
both price increases and acceptance of new risk in certain lines.
Premiums earned increased $51 million in domestic marine, $46
million in specialty casualty, $33 million in workers'
compensation in selected markets, and $19 million in aviation.
These increases were partially offset by a $77 million decrease
in customized financial coverages and a $24 million decrease in
multinational business. Losses and loss expenses increased $250
million, despite the decrease in catastrophe losses, primarily
due to the charge to establish Environmental IBNR; the
Reinsurance Receivables Charge; the increase in the amount of
risk accepted; the increase in net reported environmental losses
and loss expenses; and inflation in loss costs. Insurance
operating expenses increased $19 million, primarily due to an
increase in business written.
Net investment income for Insurance Operations for the first nine
months of 1994 was $363 million, down $13 million from the first
nine months of 1993, primarily due to the reinvestment of
proceeds from sales, redemptions and maturities of fixed income
securities into lower yielding intermediate-term securities.
Fixed income securities include short-term investments, fixed
maturities investments and nonredeemable preferred stock and
comprise 83% of Continental's investments.
Realized capital gains for Insurance Operations for the first
nine months of 1994 were $24 million, compared with $112 million
for the first nine months of 1993. Sales of securities in the
fixed income portfolio produced net realized capital losses of $7
million, compared with gains of $76 million in the first nine
months of 1993. Sales of securities in the common stock portfolio
produced $31 million of net realized capital gains, compared with
gains of $36 million in the first nine months of 1993.
Corporate & Other Operations: Corporate & Other Operations had a
loss before income taxes for the first nine months of 1994 of
$88 million, $56 million worse than the first nine months of
1993. This decrease is primarily due to Corporate & Other
Operations' $36 million share of the provision for other assets,
a $19 million decrease in investment results (a $14 million
decrease in net investment income and a $5 million decrease in
realized capital gains) and higher corporate operating expenses
partially offset by a $10 million decrease in corporate interest
expense.
Income Taxes: In the first nine months of 1994, Continental
recorded federal and foreign income tax benefits of $257 million
and $2 million, respectively, and state and other income tax
expenses of $1 million. In the first nine months of 1993
Continental recorded federal, foreign, and state and other income
tax expenses of $21 million, $4 million, and $1 million,
respectively. The income tax benefits for the first nine months
of 1994 reflect the recognition of a deferred tax asset for the
period's operating loss.
This recognition of a deferred tax asset for the period's
operating losses gives rise to a change in the Corporation's
overall effective tax rate. In the first nine months of 1994,
Continental recorded an overall effective tax rate of 39%
compared with 17% for the first nine months of 1993. The
increase in the effective income tax rate is primarily due to the
recognition of a deferred tax asset based upon management's
estimate of increased future taxable income as discussed below.
Under Statement of Financial Accounting Standards (SFAS) No. 109
"Accounting for Income Taxes", deferred tax assets are initially
recognized for net operating losses (NOLs), credits and
differences between the financial statement carrying amounts and
tax basis of assets and liabilities that will result in future
deductible amounts; a valuation allowance is then established to
reduce that deferred tax asset, if it is more likely than not
that the related tax benefits will not be realized from future
taxable income after considering tax planning. In establishing
a valuation allowance, all available evidence, both positive and
negative, must be considered. A valuation allowance is provided
when it is more likely than not that some portion of the deferred
tax asset will not be realized and then only for that portion.
Management believes that future taxable income will be sufficient
to validate a significant portion of the deferred tax asset.
Management anticipates that increases in future taxable income
will arise primarily as a result of the completion of a re-engineering
of its operations. These actions involve the
following changes: (a) a reduction in volume of the business
most prone to catastrophes, (b) the 1992 discontinuance of the
traditional assumed reinsurance and marine reinsurance
businesses, as well as indigenous international and international
marine insurance businesses, (c) a reduction in staff and a
concomitant $120 million reduction in expenses, (d) the estimated
reduction in potential future charges resulting from the third
quarter reserve adjustments, (e) anticipated income from the $300
million planned for capital infusion, and (f) the disposition of
various subsidiaries at a substantial taxable gain.
Taking these actions into account, management has estimated that
future taxable income will be sufficient to support a
significant portion of the deferred tax asset. Because of
uncertainties inherent in estimating the sufficiency of future
taxable income, management concluded that a valuation allowance
in the range of 20-25% of the net deferred tax asset after
excluding unrealized depreciation is appropriate.
Discontinued Operations: In the first nine months of 1994,
discontinued operations had income, net of income taxes, of $40
million, including a $36 million reduction of various tax
liabilities on the books of operations discontinued in 1992 and a
$4 million additional after tax gain from the sale of the premium
financing operations. In the first nine months of 1993,
discontinued operations had income, net of income taxes, from
discontinued premium financing operations of $8 million.
Results of Operations - Third quarter 1994 compared with third
quarter 1993.
Summary: The net result for third quarter 1994 included a $319
million loss from continuing operations and $40 million of income
from discontinued operations. Net income for third quarter 1993
included $44 million of income from continuing operations and $1
million of income from discontinued operations.
Insurance Operations: Insurance Operations had a third quarter
1994 loss before income taxes of $499 million, $556 million worse
than third quarter 1993. Third quarter 1994 underwriting results
were down $516 million and investment results were down $40
million, including a $34 million decrease in net realized capital
gains and a $6 million decrease in net investment income.
The $516 million decrease in underwriting results was primarily
due to the $400 million charge to establish Environmental IBNR,
the $80 million Reinsurance Receivables Charge, the $31 million
Premiums Receivable Charge, the Insurance Operations' $17 million
share of the provision for other assets, the $14 million
Additional Staff Reduction Charge ($2 million in loss expenses
and $12 million in insurance operating expenses) and a $25
million increase in net reported environmental losses and loss
expenses partially offset by a $6 million decrease in catastrophe
losses and a $25 million increase in returned reinsurance
premiums. Premiums earned decreased $95 million, primarily due
to a $110 million Quota Share Cession and a decrease in the
amount of risk accepted partially offset by the increase in
returned reinsurance premiums. Losses and loss expenses increased
$421 million, primarily due to the charge to establish
Environmental IBNR, the Reinsurance Receivables Charge, the
increase in net reported environmental losses and loss expenses
and inflation in loss costs partially offset by a $77 million
Quota Share Cession, the decrease in catastrophe losses and the
decrease in the amount of risk accepted. Insurance operating
expenses remained flat with the prior year's third quarter.
Third quarter 1994 underwriting results included pretax
catastrophe losses of $22 million, compared with $28 million in
third quarter 1993.
The insurance segments' third quarter premiums earned and
underwriting results were as follows:
(millions)
Premiums Earned Underwriting Results
INSURANCE SEGMENT* 1994 1993 1994 1993
Agency & Brokerage Commercial $ 590 $ 566 $ (371) $ (46)
Agency & Brokerage Personal 112 227 (9) (17)
Specialized Commercial 378 382 (234) (35)
Total Insurance Operations $1,080 $1,175 $ (614) $ (98)
*Distinct investment portfolios are not maintained for individual
insurance segments; accordingly, Insurance Operations' investment
results are explained in aggregate below.
The Agency & Brokerage Commercial segment's third quarter 1994
underwriting results were $325 million worse than third quarter
1993, primarily due to the segment's $224 million share of the
charge to establish Environmental IBNR, its $45 million share of
the Reinsurance Receivables Charge, the Premiums Receivable
Charge, its $11 million share of the provision for other assets,
its $9 million share of the Additional Staff Reduction Charge ($1
million in loss expenses and $8 million in insurance operating
expenses), a $16 million increase in net reported
environmental losses and loss expenses and inflation in loss costs
partially offset by a $24 million increase in returned
reinsurance premiums and a $9 million decrease in catastrophe
losses. Premiums earned increased $24 million, primarily due to
the increase in returned reinsurance premiums and an increase in
certain non-package standard commercial lines
partially offset by the Premiums Receivable Charge. Losses and
loss expenses increased $315 million, primarily due to the charge
to establish Environmental IBNR, the Reinsurance Receivables
Charge, the increase in net reported environmental losses and
loss expenses, worse loss experience and inflation in loss costs
partially offset by the decrease in catastrophe losses and a
decrease in the amount of risk accepted. Insurance operating
expenses increased $34 million, primarily due to the Additional
Staff Reduction Charge, the provision for other assets and an
increase in relative underwriting expenses.
The Agency & Brokerage Personal segment's third quarter 1994
underwriting results were $8 million better than third quarter
1993, primarily due to better loss experience and a decrease in
relative underwriting expenses partially offset by an $11 million
increase in catastrophe losses, the segment's $6 million share of
the provision for other assets and its $5 million share of the
Additional Staff Reduction Charge ($1 million in loss expenses
and $4 million in insurance operating expenses). Premiums earned
decreased $115 million, primarily due to the Quota Share Cession.
Losses and loss expenses decreased $82 million, primarily due to
the Quota Share Cession and a decrease in the amount of risk
accepted partially offset by an $11 million increase in
catastrophe losses and inflation in loss costs. Insurance
operating expenses decreased $41 million, primarily due to a $42
million decrease in commission expense resulting from the Quota
Share Cession and a decrease in relative underwriting expenses
partially offset by the Additional Staff Reduction Charge and the
provision for other assets.
The Specialized Commercial segment's third quarter 1994
underwriting results were $199 million worse than third quarter
1993, primarily due to the segment's $176 million share of the
charge to establish Environmental IBNR, its $35 million share of
the Reinsurance Receivables Charge and a $9 million increase in
net reported environmental losses and loss expenses partially
offset by an $8 million decrease in catastrophe losses. Premiums
earned decreased $4 million, primarily due to a $29 million
decrease in customized financial coverages and an $11 million
charge related to reinsurance disputes partially offset by
increases in certain lines ($14 million in domestic marine, $10
million in specialty casualty, $8 million in aviation and $5
million in workers' compensation in selected markets) due to both
price increases and acceptance of new risks.
Losses and loss expenses increased $188 million primarily due to
the charge to establish Environmental IBNR, the Reinsurance
Receivables Charge, the increase in net reported environmental
losses and loss expenses and inflation in loss costs partially
offset by the decrease in catastrophe losses and better loss
experience in certain lines. Insurance operating expenses
increased $7 million primarily due an increase in relative
underwriting expenses.
Third quarter 1994 net investment income for Insurance Operations
was $119 million, down $6 million from third quarter 1993,
primarily due to the reinvestment of proceeds from sales,
redemptions and maturities of fixed income securities into lower
yielding intermediate-term securities.
Third quarter 1994 realized capital losses for Insurance
Operations were $4 million compared with realized capital gains
of $30 million in third quarter 1993. Sales of securities in the
fixed income portfolio produced $10 million of net realized
capital losses, compared with gains of $21 million in third
quarter 1993. Sales of appreciated securities in the common stock
portfolio produced $6 million of net realized capital gains,
compared with $9 million in third quarter 1993.
Corporate & Other Operations: Corporate & Other Operations had a
third quarter 1994 loss before income taxes of $56 million, $47
million worse than third quarter 1993. This decrease is
primarily due to Corporate & Other Operations' $36 million share
of the provision for other assets and an increase in corporate
operating expenses.
Income Taxes: In third quarter 1994, Continental recorded
federal and foreign income tax benefits of $235 million and $1
million, respectively, and no state and other income tax expense
or benefit. In third quarter 1993, Continental recorded federal
income tax expense of $3 million and no foreign or state and
other income tax expenses or benefits. The decrease in the
federal income tax expense reflects third quarter 1994's
operating losses.
The federal tax benefit for third quarter 1994 is primarily due
to a $240 million increase in the deferred tax asset recognized,
which resulted in an effective tax rate of 43% in the third
quarter 1994. This compares with effective tax rates of 22% and
21% for the first three and first six months of 1994,
respectively (see "Results of Operations - First Nine Months 1994
compared with First Nine Months 1993 - Income Taxes").
Discontinued Operations: In third quarter 1994, discontinued
operations had income, net of income taxes, of $40 million,
including a $36 million reduction of various tax liabilities on
the books of operations discontinued in 1992 and a $4 million
additional after tax gain from the sale in 1993 of the premium financing
operations. In third quarter 1993, discontinued premium
financing operations had income, net of income taxes, of $1 million.
Other Developments
Planned Capital Infusion: In order to bolster insurance
operating capital and to maintain the financial strength and
claims paying ability ratings of its domestic insurance
subsidiaries (see "Rating Agencies"), Continental has entered
into a definitive agreement to sell preferred stock with an
aggregate liquidation preference of $200 million to Insurance
Partners, L.P. The agreement provides that Insurance Partners,
L.P., will acquire for $200 million in cash two series of
cumulative preferred stock issues, each series paying an annual
cash dividend of 9.75% (approximately $20 million). In addition,
Insurance Partners, L.P., will receive an option to acquire $125
million in liquidation preference of a separate series of 9.75%
non-convertible preferred stock. Of the $200 million, about $165
million will be for a series of convertible preferred stock,
convertible into approximately 19.9% of Continental's currently
outstanding common shares, at a conversion price of $15.00 per
share. The balance, about $35 million, will be for a series of
nonconvertible preferred stock redeemable under
certain circumstances at a price which would include a redemption
premium for any increase in the per share price of the common
stock over a strike price of $15.00. The two preferred issues
will mature in 15 years, but may be redeemed by Continental after
seven years under certain circumstances. The option and its
underlying preferred stock will be redeemable under certain
circumstances at a price which would include a redemption premium
for any increase in the per share price of the common stock over
a strike price of $17.00.
At the time of their issuance, for financial statement reporting,
these redeemable securities will be presented separately from
shareholder's equity and the $200 million of proceeds received will
be allocated to the preferred stock issued and to the option based
on the relative fair value of the securities issued, net of
related transaction fees. Any difference between the recorded
amount and liquidation value will be accreted using the interest
method through a charge to retained earnings. In addition,
changes in the redemption premium will also be adjusted through
retained earnings generally when the fair value of the common
shares exceeds the strike prices. The amounts of the preferred
dividends, periodic accretion and changes for the recognition of
the redemption charges will reduce income applicable to common
shareholders in the calculation of earnings per share.
The terms of the preferred stock provide that Continental will
continue to not pay dividends on its common stock for an
additional period of three years from the time the preferred
stock is sold and would after three years be subject to
limitations in payment of such dividends if any Continental
preferred stock is not rated at least BBB- by Standard & Poor's
Insurance Rating Services and Baa3 by Moody's Investor Services
(see "Liquidity").
The agreement also provides that, following the investment by
Insurance Partners, Continental will further strengthen its
capital base by raising $100 million, at Continental's option, in
non-convertible preferred stock or debt.
Following the anticipated purchase of the preferred stock,
Insurance Partners will be entitled to nominate up to four
directors to serve on Continental's board.
In addition, Richard M. Haverland has been elected Vice Chairman
and a Director of The Continental Corporation's Board. Upon
completion of the planned transaction, Mr. Haverland will become
Chairman and Chief Executive Officer, succeeding John P.
Mascotte, who will resign.
The proposed transaction is subject to satisfaction of closing
conditions under the agreement, including regulatory approvals.
If the agreement is terminated by Continental in order to enter
into an agreement for a merger or similar transaction, Insurance
Partners would be paid a termination fee representing the higher
of $17.5 million or 1.875% of the aggregate value of the other
transaction and expenses incurred in connection with this transaction.
Economic Issues: Price levels in the property and casualty
insurance markets are cyclical and materially affect
Continental's underwriting results. Continental is reunderwriting
its existing book of business to focus on those areas in which
management believes Continental can achieve an underwriting
profit. The slowdown in Continental's premium growth from 1993
reflects actions taken in 1994 to significantly curtail business
for which management believes prices are inadequate relative to
loss costs. Premiums, net income and cash flow will depend on the
degree to which these efforts are successful.
Inflation generally increases the cost of losses covered by
insurance contracts. However, the effect of inflation varies by
line of business. Since the overall rate of inflation has been
relatively constant and historically normal in recent years, such
effects have been less significant than in previous years, except
in medical care costs. The medical cost inflation rate, while now
generally decreasing in anticipation of enactment of a
comprehensive health care reform program, is still higher than
the overall inflation rate. Lines of insurance involving medical
care costs, such as automobile, workers' compensation and medical
malpractice, comprised 38% of Continental's premiums earned for
the first nine months of 1994. The method used by Continental to
estimate individual case reserves and reserves for unreported
claims implicitly considers the effect of inflation in the
projection of ultimate costs.
Asbestos-Related, Other Toxic Tort and Environmental Pollution Claims:
Prior to the third quarter of 1994, Continental did not establish reserves for
incurred but not reported asbestos-related, other toxic tort and environmental
pollution claims (Environmental IBNR) because the existence of significant
uncertainties, (including difficulties in determining the frequency and severity
of potential claims and in predicting the outcome of judicial decisions, as case
law evolves regarding liability exposure, insurance coverage and interpretation
of policy language), and the absence of standard techniques to measure exposure
did not allow ultimate liabilities to be reasonably estimated in accordance with
accepted actuarial standards.
While Continental continues to believe that it is not possible to reasonably
estimate ultimate liabilities for unreported environmental claims, it has
concluded that different measurement techniques, based on industry averages,
for estimating a reserve for unreported environmental claims have been
sufficiently developed, and accepted in the industry, to permit Continental to
determine a reasonable gross estimate for Environmental IBNR. However, due to
the continuing level of uncertainty involved with environmental exposures,
Continental may incur future charges for incurred but not reported
environmental claims which may be material to Continental's financial position,
results of operations or liquidity.
Included in Continental's liability for outstanding losses and loss expenses
are gross undiscounted reserves of $790 million for asbestos-related, other
toxic tort and environmental pollution claims. At September 30, 1994
the gross undiscounted reported environmental reserves for losses and loss
expenses (Environmental Claims) were $310 million ($268 million at September
30, 1993) and a gross undiscounted environmental reserve of $480 million
was established for losses and loss expenses for Environmental IBNR
($0 at September 30, 1993). The $310 million represents Continental's current
best estimate for reported Environmental Claims. The $480 million represents
Continental's best estimate for its unreported Environmental Claims, using a
measurement technique believed to be reasonable, based upon information
currently available. However, it is not possible at this time to estimate the
amount of additional liability related to the unreported Environmental Claims
that is at least reasonably possible to exist.
Included in Continental's reinsurance asset are amounts due for reported
Environmental Claims of $139 million at September 30, 1994 ($120 million at
September 30, 1993). A reinsurance asset of $80 million was recorded in
conjunction with the establishment of the Environmental IBNR, but was fully
reserved for as not recoverable due to the degree of uncertainty in the
collectibility of such amounts.
The technique utilized by Continental involves measuring total net reserves for
reported Environmental Claims and Environmental IBNR in terms of the number of
years such reserves could fund the net annual payments for these claims. Such
technique is consistent with that utilized by an insurance rating agency and
by the actuarial profession in some of its discussion papers for its
preliminary work with respect to such liabilities. At the end of 1992, the
industry was at a net environmental reserve to net environmental paid ratio
("Survival Ratio") of six times such paid losses, which had been increasing
and was expected to continue to increase further. Continental's net
environmental claims reserves would comprise approximately nine times its
historical average net paid losses and loss expenses for these claims.
Net losses and loss expenses include charges for reported Environmental Claims
and Environmental IBNR of $556 million and $31 million for the first nine
months of 1994 and 1993, respectively. The increase is primarily related to
the establishment of the Environmental IBNR.
Most of Continental's environmental pollution claims result from general
liability policies written prior to 1986. Certain provisions of these
policies have been subject to wide-ranging challenges by policyholders and/or
differing interpretations by courts in various jurisdictions, with inconsistent
conclusions as to the applicability of coverage for environmental pollution
claims. Asbestos-related claims have generally arisen out of product liability
coverage provided by Continental under general liability policies written prior
to 1983. Thereafter, asbestos-related product exclusions were included in
general liability policies. Other toxic tort claims have also generally arisen
out of product coverage under general liability policies. These claims involve
a variety of allegations of bodily injury arising from exposure over a
period of time to products alleged to be harmful or toxic.
Restructuring Charge: In March 1994, Continental's senior
management approved a definite plan to re-engineer the operations
of Continental's Agency & Brokerage division (including home
office, field claims and underwriting), selected operations of
Continental's Special Operations division, particularly its
multinational unit, and several corporate staff divisions,
including Human Resources, Corporate Claims, Actuarial, Finance,
and Legal. The locations identified for re-engineering are
Cranbury, New Jersey; New York, New York; Duluth, Georgia;
Chicago, Illinois; Dallas, Texas; Glens Falls, New York; Overland
Park, Kansas; Rancho Cordova, California; Columbus, Ohio; York,
Pennsylvania and certain overseas locations. These re-engineering
efforts are expected to involve a net elimination of 680
positions (approximately 1,200 terminations, net of new hires and
transfers), from a total company workforce of 12,255 at year end
1993, within one year from approval of the plan, as well as
achieve business-related expense savings. Substantially all of
the identified employees have been notified that their positions
have been eliminated. The re-engineering efforts also include
vacating leased space at 27 locations. As of September 30, 1994,
15 of these locations have been vacated; the lease vacating
program is expected to be completed by the end of 1994.
Continental has also implemented additional cost saving measures
in several employee benefit programs. Included in the re-
engineering plan are severance packages for all affected
employees as well as extended benefits and outplacement
counseling for many of them. Underwriting results for the first
nine months of 1994 included a $45 million restructuring charge,
including $29 million in expected severance and related benefits
and $16 million in expected lease vacations and other associated costs.
Through the third quarter 1994, Continental paid $10 million in
expenses ($8 million in severance and related benefits, and $2
million in lease vacations and other associated costs)
associated with its planned restructuring, which reduced its
outstanding liability at September 30, 1994 to $35 million.
Additional Improvements: In June 1994, Continental announced
additional steps with a goal to improve its profitability and
strengthen the capital base of its domestic insurance
subsidiaries. To improve its profitability, Continental began to
curtail its property writings, especially in catastrophe-prone
areas (see "Economic Issues"). Also, to further reduce its
operating expenses, Continental reconsidered its staffing needs
and developed another plan in the third quarter of 1994 that
would result in a further net reduction of approximately 1,100
positions (in addition to the terminations of approximately 1,200
from the March plan). Underwriting results for the third quarter
include the $14 million Additional Staff Reduction Charge, which
include the cost for expected severance and related benefits. As
of September 30, 1994, no payments were made relating to this
charge. In addition, substantially all identified employees have
been notified that their positions have been eliminated.
Management believes that its previously announced re-engineering
actions (see "Restructuring Charge") together with this
elimination of another 1,100 positions will create annual pretax
savings of about $120 million compared with its reported 1993 expenses.
To strengthen the capital base of its domestic insurance
subsidiaries, during the second and third quarters of 1994, The
Continental Corporation redeployed $275 million of capital to
its domestic insurance operations. This redeployment represents
essentially all of its currently available surplus from
operations other than its domestic insurance operations. In
addition, Continental has arranged the Quota Share Cession to
lower its premium-to-surplus ratio and further reduce its
exposure to catastrophes (see "Reinsurance"). Continental will
conduct its regular annual in-depth review of its core (non-
environmental) reserves at year-end. This review could result in
substantial additional reserve strengthening.
Planned Sales of Subsidiaries: In third quarter 1994, the
Continental entered into a definitive agreement to sell
Continental Canada, a major property and casualty insurer in
Canada, to Fairfax Financial Holdings Limited, a Canadian
financial services company. Under the terms of the agreement,
the Corporation would receive (expressed in Canadian dollars)
$130 million in cash, debt securities of Fairfax Financial with a
face value of $25 million and a contingent payment of up to $10
million based on the performance of Continental Canada during the
five years following the sale. The approximate U.S. dollar
equivalents at the exchange rate on October 31, 1994 are $97
million, $19 million and $7 million, respectively. The proposed
sale is subject to satisfaction of closing conditions under the
agreement, including regulatory approvals. Continental does not
expect the sale of Continental Canada as proposed to have a
significant impact on its financial position, results of
operations or liquidity.
In October 1994, Continental entered into an agreement in
principle to sell its Casualty Insurance unit to Fremont General
Corporation for $250 million in cash. Casualty Insurance, based
in Chicago, is the leading writer of workers' compensation
insurance in Illinois. The unit also has facilities operating in
Wisconsin, Indiana, Michigan and California. In 1993, Casualty
wrote $362 million in premiums, overwhelmingly in the Midwest.
The proposed transaction is subject to completion of a definitive
agreement, regulatory approvals, and satisfaction of other
closing conditions under the agreement. Continental expects to
recognize a gain on the sale of this operation but does not
expect the sale to have a significant impact on its financial
position or liquidity.
Also in October 1994, Continental entered into an agreement with
Insurance Partners, L.P., and related parties to sell the
operations of Continental Asset Management (CAM) for about $35
million in notes. Under the terms of this agreement, Continental
has an option to purchase a 20% interest in these operations.
The proposed transaction is subject to satisfaction of closing
conditions, including financing and applicable regulatory
approvals. Continental Asset Management is an investment
advisory firm which manages Continental's investment portfolio
and provides investment management services for outside clients,
including property/casualty insurance companies. The agreement
contemplates that Continental will continue to receive advisory
services from CAM. The purchase price will be subject to
adjustments under circumstances relating to the loss, if any, of
unaffiliated clients prior to the consummation of the purchase
and to a shortfall, if any, in fees by Continental's affiliates
over a 7 year period following the consummation of the purchase.
Due to the conditions of sale, Continental will not immediately
recognize any gain from this transaction.
Discontinued Operations: In 1994, Continental recognized an
additional after tax gain of $4 million related to the sale of
its premium financing operations as a result of final tax
elections made for 1993. In addition, Continental reduced various
tax liabilities related to previously discontinued operations and
realized $36 million in additional income. The reduction in the
various tax liabilities is a direct result of a recent review of
Continental's tax position (see "Results of Operations - Income
Taxes") and the development of the discontinued operations over
the last two years. In December 1993, Continental completed the
sale of its premium financing operations, AFCO Credit
Corporation, AFCO Acceptance Corporation and their Canadian
affiliate CAFO Inc., to Mellon Bank Corporation. Continental
realized a $36 million gain from this sale, net of income taxes.
The 1993 results and net assets of these premium financing
operations, which were previously reported in the Corporate &
Other Operations segment, have been classified as discontinued in
the accompanying Consolidated Financial Statements.
New Accounting Pronouncements: Effective January 1, 1993,
Continental adopted SFAS No. 112, "Employers' Accounting for
Postemployment Benefits," Emerging Issues Task Force issue No.
93-6, "Accounting for Multiple-Year Retrospectively Rated
Contracts by Ceding and Assuming Enterprises," and SFAS No. 113,
"Accounting and Reporting for Reinsurance of Short-Duration and
Long-Duration Contracts". The cumulative change to Continental's
results for the first nine months of 1993 from these adoptions
was a net benefit of $2 million.
In addition, effective December 31, 1993, Continental adopted
SFAS No. 115, "Accounting for Certain Investments in Debt and
Equity Securities," which did not change the way Continental
accounts for investments or have a material impact on its 1993
financial results.
Financial Resources and Liquidity
Cash Flow Analysis: Operating activities for the first nine
months of 1994 used $717 million in cash and cash equivalents,
whereas operating activities for the first nine months of 1993
used cash and cash equivalents of $286 million. The principal
causes for the increase in cash used by operations were a $242
million increase in losses and loss expenses paid, the repayment
of $188 million of obligations under reverse repurchase and
dollar reverse repurchase agreements and a $56 million increase
in underwriting expenses paid. These increases were partially
offset by a $91 million increase in premiums collected and a $12
million increase in investment income received. In addition,
discontinued operations provided $27 million in cash for
continuing operations in the first nine months of 1994 whereas it
provided $106 million in the first nine months of 1993. The
decrease represents cash proceeds received from sales of
discontinued operations in 1993.
Investing activities for the first nine months of 1994 provided
$814 million in cash and cash equivalents, whereas investing
activities for the first nine months of 1993 provided $529
million in cash and cash equivalents. Increases in investments
are reported as uses of cash and cash equivalents, and proceeds
from sales, redemptions and maturities of investments are
reported as provisions of cash and cash equivalents. The
increase in cash provided by investing activities is primarily
due to higher 1994 net sales of securities as a result of
increased cash used by operating activities.
Financing activities for the first nine months of 1994 used $63
million in cash and cash equivalents, whereas financing
activities for the first nine months of 1993 used $224 million in
cash and cash equivalents. Increases in borrowings are reported
as provisions of cash and cash equivalents, while decreases in
borrowings and payments of dividends are reported as uses of cash
and cash equivalents. The decrease in cash used by financing
activities is primarily due to a $282 million retirement of debt
in the first nine months of 1993, $14 million reduction in short-
term debt partially offset by the issuance of $150 million of
Notes in the first nine months of 1993 and a $17 million decrease
in dividends paid to shareholders.
As a result of the operating, investing and financing activities
described above, cash and cash equivalents provided by operations
increased $15 million from the first nine months of 1993.
Liquidity: To meet its cash obligations, including claims
payments, operating expenses, interest and principal payments on
debt, declared shareholder dividends and taxes, Continental holds
cash reserves, short-term money market instruments and other
fixed income securities with maturities of less than one year.
In March 1993, Continental sold $150 million of a total of $350
million of Notes (which provided $147 million of a total of $346
million in cash, net of offering and underwriting costs)
outstanding under its shelf registration of up to $400 million of
debt securities with the Securities and Exchange Commission.
During 1993, Continental used $282 million of the net proceeds
from these sales to retire its outstanding 9 3/8% Notes due July
1, 1993 and $50 million of net proceeds from these sales to
reduce corporate short-term borrowings. Continental intends to
raise additional capital of approximately $100 million, through
the issuance of either preferred stock or notes; but does not
currently contemplate incurring other borrowings other than for
the purpose of reducing amounts outstanding under its revolving
credit facility described below.
During the first nine months of 1994, Continental's domestic
insurance subsidiaries paid it $58 million in dividends. Each of
the states in which one or more of these subsidiaries are
domiciled have enacted a formula which governs the maximum amount
of dividends that they may pay without prior regulatory approval.
These formulas, which are substantially similar, limit such
dividends based on such factors as policyholder surplus, net
income, net investment income, and/or unassigned surplus. Under
the restrictions currently in effect, the maximum amount
available for payment of dividends to Continental by its domestic
insurance subsidiaries during the year ending December 31, 1994
without regulatory approval is estimated to be $129 million, in
addition to the $58 million paid during the first nine months of
1994. Continental anticipates that dividends from its domestic
insurance subsidiaries will enable it to meet its near term
obligations for interest and principal payments on debt,
anticipated preferred stock dividends, corporate expenses and
taxes . To the extent that its insurance subsidiaries do not
generate amounts available for distribution sufficient to meet
Continental's cash requirements without regulatory approval,
Continental would seek approval for additional distributions. In
August 1994, Continental's Board of Directors, citing the need to
further strengthen the Corporation's capital base, eliminated the
quarterly cash dividend of $.25 per share on the Corporation's
common stock. The preferred stock issuable to Insurance Partners
will prohibit payment of common stock dividends for three years
and restricts common stock dividends thereafter under certain
circumstance (see "Planned Capital Infusion").
Continental anticipates using cash flows from operations to pay
for the remaining charges associated with its planned
restructuring and additional improvements ($49 million). Based on
its restructuring program, the remaining costs should be paid
over the fourth quarter of 1994 with any residual amount to be
paid in first quarter 1995.
During the third quarter, Continental extended the maturity of
its revolving credit facility from December 30, 1994 to December
31, 1995. In addition, the revolving credit facility has been
increased by $60 million and provides for borrowings of up to
$210 million from a syndicate of banks. Funds borrowed through
the facility may be used for general corporate purposes, but
Continental has used and intends to use the facility primarily as
an alternative to traditional sources of short-term borrowings.
At September 30, 1994, Continental had a $128 million balance
outstanding through the facility. As of October 31, 1994, that
balance increased to $205 million outstanding through the
facility; the proceeds of these borrowings were used to repay
other short-term borrowings. Under the revolving credit
agreement, Continental is required, among other things, to
maintain a modified debt to capital (debt plus shareholders'
equity minus net unrealized appreciation (depreciation) of
investments) ratio of 40% and a minimum level of statutory
surplus for its domestic insurance subsidiaries of $1,465
million. As at September 30, 1994 (the most recent date for
compliance computations), Continental maintained a debt to
capital ratio of approximately 39.9% and statutory surplus for
such subsidiaries of $1,480 million.
Investments: Fixed maturities available-for-sale consist of
certain bonds and redeemable preferred stocks that management may
not hold until maturity and which have an average Standard &
Poor's rating of AA (or its Moody's equivalent). Continental's
fixed maturities available-for-sale had a balance sheet fair
value of $6,068 million at September 30, 1994 (compared with a
fair value of $6,291 million at September 30, 1993) and included
mortgage-backed securities with a fair value of $1,337 million
and an amortized cost of $1,400 million at September 30, 1994
(compared with a fair value of $1,235 million and an amortized
cost of $1,226 million at September 30, 1993). Continental's
mortgage-backed securities have an average Standard & Poor's
rating of AAA (or its Moody's equivalent) and an average life of
9 years. Continental has an insignificant investment in
collateralized mortgage obligations which put the return of
principal at risk if interest rates or prepayment patterns
fluctuate.
At September 30, 1994, Continental's bond portfolio classified by
Moody's rating was as follows:
Percentage of
Moody's Rating Bond Portfolio
Aaa 53.2%
Aa 20.2
A 15.5
Baa 6.8
Below Baa 4.3
100.0%
At September 30, 1994, the fixed maturities portfolio included an
immaterial amount of securities, the fair value of which is
expected to be lower than their carrying value for more than a
temporary period; such investments have been recorded in the
accompanying Consolidated Balance Sheets at their net realizable
value.
Continental also maintains an equity securities portfolio, the
fair value of which was $729 million at September 30, 1994. At
September 30, 1994, Continental also had a $110 million
investment in privately placed direct mortgages, which are
included in the balance sheet caption "Other Long-Term Investments."
Unrealized appreciation on investments decreased $531 million,
before income taxes, from December 31, 1993. Unrealized
appreciation on fixed maturities decreased $524 million.
Unrealized appreciation on common stocks increased $2 million,
while unrealized appreciation on nonredeemable preferred stocks
decreased $8 million. Unrealized appreciation on other long-term
investments decreased $1 million. In addition, unrealized
appreciation on investments held by discontinued operations
decreased $49 million, before income taxes, from December 31, 1993.
In October, Continental sold a significant portion of its
appreciated equity securities and recognized $92 million of
realized capital gains. At October 31, 1994, Continental equity
securities had a fair value of $424 million, which represents a
$305 million decrease from the fair value at September 30, 1994.
Continental holds a small amount of derivative financial
investments for the purposes of enhancing income and total return
and/or hedging long-term investments. At September 30, 1994 the
total notional value of these investments amounted to $478
million and include financial future contracts, interest rate
swap agreements, swaptions, financial options and foreign
currency forward contracts. Continental does not expect to
recognize material gains or losses related to these investments.
Continental's book value per share at September 30, 1994 was
$24.75, compared with $39.40 at December 31, 1993, reflecting a
$7.42 per share decline in the unrealized appreciation of
investments (primarily due to the rise in interest rates during
the first nine months of 1994), the $6.56 per share loss for the
first nine months of 1994, a $0.16 per share worsening of the
foreign currency translation adjustment and a $0.50 per share
shareholder dividend payment.
Rating Agencies: In June, 1994, A.M. Best Company affirmed the
financial strength rating of Continental's domestic insurance
subsidiaries as "A-" (Excellent), A.M. Best Company's fourth highest
of six secure financial strength ratings, but placed the rating under
review with developing implications, pending further evaluation
of the companies capital preservation efforts, restructuring
plans and future business plans. In October 1994, as a result of
Continental's recent capital preservation efforts (see "Planned
Capital Infusion", "Restructuring Charge", "Additional
Improvements", and "Planned Sale of Subsidiaries"), and its
capital raising efforts (see "Planned Capital Infusion"), A.M.
Best Company completed the announced review of the rating and
affirmed the financial strength rating of the domestic insurance
subsidiaries as "A-" (Excellent). Management believes that
failure to maintain this rating would have a material adverse
effect on its results of operations and financial condition.
In September and October 1994, Moody's Investor Services ("Moody's"), an
independent rating agency, lowered the claims paying ability
rating of the Corporation's principal insurance subsidiaries from
A2 (Good), Moody's sixth highest of ten investment grade ratings,
to A3 (Good), Moody's seventh highest rating, and then from
A3 to Baa1 (Adequate), Moody's eighth highest rating, and
the Corporation's senior debt rating from Baa1 to Baa2,
Moody's ninth highest rating, and then from Baa2 to Baa3, Moody's
lowest investment grade rating. Also in October 1994, Standard & Poor's
Insurance Rating Services("S&P"), another independent rating agency,
lowered the claims paying ability rating of the Corporation's
principal insurance subsidiaries from AA-(Excellent), S&P's fourth
highest of ten investment grade ratings, to A- (Good), S&P's seventh highest
rating, and the Corporation's senior debt rating from A- to BBB-, S&P's lowest
investment grade rating. These downgrades are expected to cause an increase
in Continental's borrowing costs which is not expected to be significant.
Reinsurance: In the ordinary course of business, Continental
cedes business to other insurers and reinsurers. Purchasing
reinsurance enables Continental to limit its exposure to
catastrophic events and other concentrations of risk. However,
purchasing reinsurance does not relieve Continental of its
obligations to its insureds. Continental reviews the
creditworthiness of its reinsurers on an ongoing basis. To
minimize potential problems, Continental's policy is to purchase
reinsurance only from carriers who meet its credit quality
standards. It has also taken and is continuing to take steps to
settle existing reinsurance arrangements with reinsurers who do
not meet its credit quality standards. Continental does not
believe that there is a significant solvency risk concerning its
reinsurance claims. In addition, Continental regularly evaluates
the adequacy of its reserves for uncollectible reinsurance.
Continental believes that it makes adequate provisions for the
ultimate collectibility of its reinsurance claims and therefore
believes the collection of these net recoveries to be probable.
Continental has in place various reinsurance arrangements with
respect to its current operations. These arrangements are subject
to retentions, coverage limits and other policy terms. Some of
the principal treaty arrangements which are presently in effect
are an excess of loss treaty reducing Continental's liability on
individual property losses, a blanket casualty program reducing
Continental's liability on third party liability losses, a clash
casualty program reducing Continental's liability on multiple
insured/single event losses, and a property catastrophe program,
with a net retention of $50 million in both 1994 and 1993,
reducing its liability from a catastrophic event. Continental
also uses individual risk facultative and other facultative
agreements to further reduce its liabilities.
Effective July 1, 1994, Continental entered into a quota share
agreement (i.e., the Quota Share Cession) to reinsure a portion
of its domestic personal lines business with a major U.S.
reinsurer. From July 1, 1994 through December 31, 1995,
Continental's quota share participation is 50% of the covered
lines. Continental expects to cede premiums related to this
agreement of approximately $300 million per year, through
December 31, 1995. This arrangement will help Continental lower
its premium-to-surplus ratio and further reduce its exposure to
catastrophes subject to the agreement's catastrophe coverage limits.
Sale of Premiums Receivable: In December, 1993, Continental sold
$513 million of premiums receivables balances. This sale
accelerated the cash flow from the sold receivables, increasing
cash provided by operations in 1993, but reducing cash by $487
million for the first nine months of 1994, when this portion of
the receivables would have been collected. As a result, the
balance sheet caption "Premiums Receivable" at September 30, 1994
is lower by $26 million than it otherwise would have been. In
the event that the receivables are not collected, Continental's
credit risk is limited to the amount that the purchasers of such
receivables hold as a deposit ($15 million at September 30, 1994).
SIGNATURE
Pursuant to the requirements 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.
The Continental Corporation
(Registrant)
Dated: February 22, 1995 By s\Heath Fitzsimmons
Heath Fitzsimmons
Senior Vice President and
Chief Financial Officer
Mr. Fitzsimmons has signed this Report on behalf of the Registrant in
his capacity as a duly authorized officer and as the Chief
Financial Officer of the Registrant.