SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 8-K/A
Current Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
March 15, 2001
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Date of Report (Date of earliest event reported)
Arch Capital Group Ltd.
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(Exact name of registrant as specified in its charter)
Bermuda 0-26456 N/A
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(State or other (Commission File Number) (I.R.S. Employer
jurisdiction of Identification No.)
incorporation or
organization)
20 Horseneck Lane, Greenwich, Connecticut 06830
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code:
(203) 862-4300
Not Applicable
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(Former name or former address, if changed since last report)
ITEM 2. ACQUISITION OR DISPOSITION OF ASSETS
On February 28, 2001, Arch Capital Group Ltd., a Bermuda corporation
("ACGL"), acquired all of the capital stock of American Independent Insurance
Holding Company ("AIHC"), a Pennsylvania corporation. Prior to this date, AIHC
was one of ACGL's investee companies.
The acquisition was made pursuant to the terms and subject to the
conditions set forth in a certain reorganization agreement (the "Reorganization
Agreement"), dated as of December 31, 2000, by and among AIHC, Lewis Small,
Richard Small Voting Trust, David Wilstein, Leonard Wilstein, Denise Wilstein,
Gary Wilstein, Ronald Wilstein, BCI Holdings, Inc., American Independent Company
Voting Trust (together with Lewis Small, Richard Small Voting Trust, David
Wilstein, Leonard Wilstein, Denise Wilstein, Gary Wilstein, Ronald Wilstein and
BCI Holdings, Inc., (the "Selling Stockholders"), TDH Capital Partners, a
Delaware business trust ("TDHCP"), TDH III, L.P., a Delaware limited partnership
("TDH III" and, together with TDHCP, "TDH"), and ACGL, the execution version of
which is set forth as an exhibit hereto.
As more fully described in the Reorganization Agreement, ACGL purchased a
portion of the common shares of AIHC held by the Selling Stockholders for $1.25
million. The remainder of the outstanding common shares of AIHC were redeemed by
ACGL in exchange for the right to receive a distribution with respect to any
proceeds received as a result of the final adjudication or settlement of certain
lawsuits to which AIHC, as a plaintiff, is currently involved (the "Lawsuits").
TDH also returned certain warrants to purchase AIHC common shares for
cancellation and forgave the obligations owing to it under certain notes issued
by AIHC in an aggregate principal amount of $4.0 million in exchange for the
right to receive a distribution with respect to any proceeds received as a
result of the final adjudication or settlement of the Lawsuits. Immediately
after the foregoing transactions, ACGL contributed notes issued by AIHC in an
aggregate principal amount of $8.5 million to the capital of AIHC and returned
certain warrants to purchase AIHC common shares for cancellation.
Immediately after the closing of the transaction, ACGL made a capital
contribution to AIHC which, in turn, made a capital contribution to its
operating insurance company subsidiary, American Independent Insurance Company
("AIIC") in the amount of $11.0 million.
In addition, pursuant to a letter agreement dated as of December 28,
2000, between Folksamerica Reinsurance Company ("Folksamerica"), ACGL and
AIHC, Folksamerica agreed to release AIIC from the reinsurance commitments
transferred to Folksamerica under the letter dated as of February 16, 2000
from Arch Reinsurance Company to AIIC at a cost to AIIC of $1.5 million.
1
ITEM 7. FINANCIAL STATEMENTS AND OTHER EXHIBITS
(a) FINANCIAL STATEMENTS OF BUSINESS ACQUIRED.
Audited Consolidated Financial Statements of AIHC:
Independent Auditors' Report
Consolidated Balance Sheets - December 31, 2000, 1999 and 1998
Consolidated Statements of Operations and Comprehensive Loss - For the
Years Ended December 31, 2000, 1999 and 1998
Consolidated Statements of Changes in Stockholders' Deficit - For the
Years Ended December 31, 2000, 1999 and 1998
Consolidated Statements of Cash Flows - For the Years Ended
December 31, 2000, 1999 and 1998
Notes to the Consolidated Financial Statements - For the Years Ended
December 31, 2000, 1999 and 1998
(b) PRO FORMA FINANCIAL INFORMATION.
Unaudited Pro Forma Condensed Combined Financial Statements of ACGL and AIHC:
Unaudited Pro Forma Condensed Combined Statement of Financial Condition -
December 31, 2000
Unaudited Pro Forma Condensed Combined Statement of Income - For the Year
Ended December 31, 2000
Notes to Unaudited Pro Forma Condensed Combined Financial Statements
(c) EXHIBITS.
10.1.Reorganization Agreement, dated as of December 31, 2000, by and among
AIHC, the Selling Stockholders, TDH and ACGL (filed as an exhibit to
our Report on Form 8-K, as filed with the SEC on March 15, 2001, and
incorporated by reference).
23 Consent of Independent Public Accountants.
99.1.Press Release, dated January 3, 2001.
99.2.Press Release, dated February 28, 2001.
2
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, the registrant has duly caused this report to be signed on its behalf
by the undersigned thereunto duly authorized.
ARCH CAPITAL GROUP LTD.
Date: May 14, 2001 By: /s/ Debra M. O'Connor
----------------------
Debra M. O'Connor
Senior Vice President, Controller
and Treasurer
3
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS
Page
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Audited Consolidated Financial Statements of AIHC:
Independent Auditors' Report 5
Consolidated Balance Sheets - December 31, 2000, 1999 and 1998 6
Consolidated Statements of Operations and Comprehensive Loss - For the Years Ended December 31, 2000,
1999 and 1998 7
Consolidated Statements of Changes in Stockholders' Deficit - For the Years Ended December 31, 2000,
1999 and 1998 8
Consolidated Statements of Cash Flows - For the Years Ended December 31, 2000, 1999 and 1998 9
Notes to the Consolidated Financial Statements - For the Years Ended December 31, 2000, 1999 and 1998 10-26
Pro Forma Financial Information:
Unaudited Pro Forma Condensed Combined Financial Statements of ACGL and AIHC:
Unaudited Pro Forma Condensed Combined Statement of Financial Condition - December 31, 2000 28
Unaudited Pro Forma Condensed Combined Statement of Income - For the Year Ended December 31, 2000 30
Notes to the Unaudited Pro Forma Condensed Combined Financial Statements 32-33
4
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
American Independent Insurance
Holding Company and Subsidiaries
Plymouth Meeting, Pennsylvania
We have audited the accompanying consolidated balance sheets of American
Independent Insurance Holding Company and Subsidiaries as of December 31,
2000, 1999, and 1998, and the related consolidated statements of operations
and comprehensive loss, changes in stockholders' deficit and cash flows for
the years then ended. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on
these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards in the United States of America. Those standards require that we
plan and perform the audits to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of American Independent
Insurance Holding Company and Subsidiaries, as of December 31, 2000, 1999,
and 1998, and the results of its operations and its cash flows for the years
then ended, in conformity with accounting principles generally accepted in
the United States of America.
/s/ Saslow Lufkin & Buggy, LLP
May 11, 2001
Hartford, Connecticut
5
AMERICAN INDEPENDENT INSURANCE HOLDING COMPANY AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2000, 1999, AND 1998
ASSETS
2000 1999 1998
---- ---- ----
Investments:
Fixed maturities at market (cost, $7,654,160,
$9,421,391, and $2,961,125 at 2000, 1999,
and 1998, respectively) $ 7,465,712 $ 9,163,398 $ 2,995,018
Equity securities at market (cost $224,403 and
$175,000 at 2000 and 1999, respectively) 208,658 155,313 -
Short term investments at cost 6,318,930 4,206,199 2,464,938
Real estate at amortized cost (net of accumulated
depreciation of $143,731) - - 3,343,466
------------------- ------------------- -------------------
Total investments 13,993,300 13,524,910 8,803,422
Cash 1,101,137 452,138 5,034,582
Premiums receivable 36,000,618 21,369,015 21,267,547
Reinsurance recoverable 41,084,648 27,990,249 23,440,305
Prepaid insurance 28,984,955 18,597,325 18,467,885
Property and equipment, net 1,382,457 1,192,448 1,325,462
Deferred acquisition costs, net 1,975,539 1,344,954 1,290,606
Prepaids and other assets 601,195 1,669,122 1,543,313
------------------- ------------------- -------------------
Total assets $ 125,123,849 $ 86,140,161 $ 81,173,122
=================== =================== ===================
LIABILITIES AND STOCKHOLDERS' DEFICIT
Unpaid losses and loss adjustment expenses $ 53,315,368 $ 34,595,738 $ 29,909,439
Unearned premiums 38,542,916 24,966,457 24,922,526
Ceded premiums payable 29,953,577 18,199,045 19,644,280
Subordinated debt 13,842,500 10,202,500 3,124,337
Accounts payable and accrued expenses 3,303,623 2,031,609 1,739,711
Cash overdraft 1,802,069 408,503 -
Premium and other taxes payable 1,371,787 1,013,166 1,068,523
Mortgage payable - - 1,879,712
Long term debt - 992,000 -
Other liabilities 206,488 122,641 184,872
------------------- ------------------- -------------------
Total liabilities 142,338,328 92,531,659 82,473,400
Commitments and contingencies (see notes 13 and 14)
Stockholders' deficit:
Common stock, $1 par value, 100,000 shares
authorized, 7,441 shares issued and outstanding 7,441 7,441 7,441
Paid in capital 5,512,862 5,512,862 5,512,862
Accumulated deficit (22,486,671) (11,634,121) (6,854,473)
Accumulated other comprehensive (loss) income (248,111) (277,680) 33,892
------------------- ------------------- -------------------
Total stockholders' deficit (17,214,479) (6,391,498) (1,300,278)
------------------- ------------------- -------------------
Total liabilities and stockholders' deficit $ 125,123,849 $ 86,140,161 $ 81,173,122
=================== =================== ===================
The accompanying notes are an integral part of these financial statements.
6
AMERICAN INDEPENDENT INSURANCE HOLDING COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
FOR THE YEARS ENDED DECEMBER 31, 2000, 1999, AND 1998
2000 1999 1998
---- ---- ----
Revenues:
Premiums earned $ 64,068,184 $ 51,387,758 $ 45,898,498
Ceded premiums earned (48,147,064) (38,404,373) (33,694,557)
------------------- ------------------- -------------------
Net earned premiums 15,921,120 12,983,385 12,203,941
Investment income (net of expenses) 882,585 411,937 599,694
Net realized investment (losses) gains (32,942) 4,315 2,081
Billing fees 7,722,297 4,350,384 4,130,931
------------------- ------------------- -------------------
Total revenues 24,493,060 17,750,021 16,936,647
Expenses:
Losses and loss adjustment expenses 22,161,984 14,707,312 13,261,173
Amortization of policy acquisition costs 3,103,371 2,485,045 1,375,931
Lapsed policy write-off 1,100,000 - -
Other operating expenses 7,794,834 4,741,150 1,262,594
Interest expense 1,048,903 571,889 428,724
------------------- ------------------- -------------------
Total expenses 35,209,092 22,505,396 16,328,422
Net (loss) income before income taxes (10,716,032) (4,755,375) 608,225
Income tax expense 136,518 24,273 84,630
------------------- ------------------- -------------------
Net (loss) income (10,852,550) (4,779,648) 523,595
Other comprehensive income (loss):
Unrealized holding (loss) gain arising during period (3,373) (307,257) 31,083
Add: reclassification adjustment for losses (gains)
included in net income 32,942 (4,315) (2,081)
------------------- ------------------- -------------------
Other comprehensive income (loss) 29,569 (311,572) 29,002
------------------- ------------------- -------------------
Comprehensive (loss) income $ (10,822,981) $ (5,091,220) $ 552,597
=================== =================== ===================
The accompanying notes are an integral part of these financial statements.
7
AMERICAN INDEPENDENT INSURANCE HOLDING COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' DEFICIT
FOR THE YEARS ENDED DECEMBER 31, 2000, 1999, AND 1998
Accumulated
Common Stock Other
------------------ Paid-in Comprehensive Accumulated
Shares Amount Capital Income (Loss) Deficit Total
-------- -------- ------------- ------------------ ------------------- ----------------
Balance at
January 1, 1998 7,441 $ 7,441 $ 5,512,862 $ 4,890 $ (7,378,068) $ (1,852,875)
Other comprehensive income - - - 29,002 - 29,002
Net income - - - - 523,595 523,595
-------- -------- ------------- ------------------ ------------------ -------------------
Balance at
December 31, 1998 7,441 7,441 5,512,862 33,892 (6,854,473) (1,300,278)
Other comprehensive loss - - - (311,572) - (311,572)
Net loss - - - - (4,779,648) (4,779,648)
-------- -------- ------------- ------------------ ------------------ -------------------
Balance at
December 31, 1999 7,441 7,441 5,512,862 (277,680) (11,634,121) (6,391,498)
Other comprehensive income - - - 29,569 - 29,569
Net loss - - - - (10,852,550) (10,852,550)
-------- -------- ------------- ------------------ ------------------ -------------------
Balance at
December 31, 2000 7,441 $ 7,441 $ 5,512,862 $ (248,111) $ (22,486,671) $ (17,214,479)
======== ======== ============= ================== ================== ===================
The accompanying notes are an integral part of these financial statements.
8
AMERICAN INDEPENDENT INSURANCE HOLDING COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2000, 1999, AND 1998
2000 1999 1998
---- ---- ----
Cash flows from operating activities:
Net (loss) income $ (10,852,550) $ (4,779,648) $ 523,595
Adjustments to reconcile net (loss) income to
net cash used in operating activities:
Depreciation and amortization 612,686 647,293 509,396
Debt discount amortization 140,000 140,000 140,000
Accretion of fixed maturities (19,455) (8,107) (4,343)
Net realized investment losses (gains) 32,942 (4,315) (2,081)
Changes in assets and liabilities:
Premiums receivable (14,631,603) (101,468) (7,727,344)
Reinsurance recoverable (13,094,399) (4,549,944) (9,161,853)
Prepaid reinsurance (10,387,630) (129,440) (6,125,824)
Deferred acquisition costs (630,585) (54,348) (1,519,448)
Prepaids and other assets 1,067,927 (125,809) (948,547)
Unpaid losses and loss adjustment expenses 18,719,630 4,686,299 6,934,083
Unearned premiums 13,576,459 43,931 7,666,194
Ceded premiums payable 11,754,532 (1,445,235) 8,854,987
Accounts payable and accrued expenses 1,272,014 291,898 82,239
Cash overdraft 1,393,566 408,503 -
Premium and other taxes payable 358,621 (55,357) 596,495
Other liabilities 83,847 (62,231) 124,358
----------------- ------------------ -------------------
Net cash used in operating activities (603,998) (5,097,978) (58,093)
----------------- ------------------ -------------------
Cash flows from investing activities:
Purchases of available for sale investments (49,403) (8,565,448) (1,684,242)
Proceeds from available for sale investments sold 1,210,254 1,692,605 583,220
Proceeds from maturities of investments 499,572 250,000 -
Net (purchases) proceeds of short term investments (2,112,730) (1,741,261) 811,792
Net proceeds from real estate investment - 1,463,754 27,251
Additions to property and equipment (802,696) (514,279) (806,218)
----------------- ------------------ -------------------
Net cash used in investing activities (1,255,003) (7,414,629) (1,068,197)
----------------- ------------------ -------------------
Cash flows from financing activities:
Proceeds from subordinated debt 3,500,000 7,000,000 -
Repayments of subordinated debt - (61,837) (241,042)
Proceeds from long-term debt - 2,000,000 -
Repayments of long-term debt (992,000) (1,008,000) -
----------------- ------------------ -------------------
Net cash provided by (used in) financing activities 2,508,000 7,930,163 (241,042)
----------------- ------------------ -------------------
Net increase (decrease) in cash 648,999 (4,582,444) (1,367,332)
Cash, beginning at year 452,138 5,034,582 6,401,914
----------------- ------------------ -------------------
Cash, end of year $ 1,101,137 $ 452,138 $ 5,034,582
================= ================== ===================
Supplemental disclosure:
Cash paid during the year for interest $ 679,234 $ 169,070 $ 16,326
================= ================== ===================
Cash paid during the year for taxes $ 28,644 $ 97,915 $ 150,218
================= ================== ===================
The accompanying notes are an integral part of these financial statements.
9
AMERICAN INDEPENDENT INSURANCE HOLDING COMPANY AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2000, 1999, AND 1998
NOTE 1 - GENERAL
NATURE OF OPERATIONS - American Independent Insurance Holding Company ("AIHC"
or the "Company") is a specialty property and casualty insurance holding
company that markets and underwrites nonstandard personal automobile
insurance through its subsidiaries. The Company provides personal automobile
liability and personal automobile physical damage (comprehensive and
collision) lines of insurance, primarily in the Philadelphia, PA metropolitan
area and in 1999 and 2000, began writing business in Maryland and Delaware.
SUBSEQUENT EVENT - On February 28, 2001, the Company entered into a
reorganization transaction in which Arch Capital Group Ltd. ("Arch")
acquired a portion of the outstanding shares of the Company for $1.25
million. The remaining outstanding shares of the Company were redeemed in
exchange for the right of the sellers to receive a portion of the proceeds
resulting from the adjudication or settlement of certain lawsuits the
Company, as plaintiff, has previously filed against certain defendants
("Lawsuit Net Proceeds"). Immediately after the acquisition of the Company by
Arch, $8.5 million of debt that was issued to subsidiaries of Arch by the
Company was converted to capital and certain notes (the "TDH notes") in the
aggregate amount of $4 million plus accrued interest was forgiven. In
consideration for the forgiveness, TDH will be entitled to receive a portion
of the Lawsuit Net Proceeds as described above. Subsequent to the
transaction, Arch also made a capital contribution to the Company in the
amount of $11.0 million. On February 28, 2001, all securities convertible
into Capital Stock of AIHC were permanently cancelled and retired and the
stock option plan was terminated in its entirety. The effect of the
aforementioned transaction was to reduce the Company's debt obligations by
approximately $12.5 million and to increase surplus by approximately $23.5
million as of February 28, 2001.
In connection with loans that were made by subsidiaries of Arch to the
Company, Arch Reinsurance Company (formerly known as Risk Capital Reinsurance
Company and referred to herein as "Arch Re"), a subsidiary of Arch, obtained
the rights to provide reinsurance to AIIC for specified periods. On May 5,
2000, Arch sold Arch Re's reinsurance operations to Folksamerica and
transferred these reinsurance rights to Folksamerica. Upon the consummation
of the reorganization, Folksamerica released the Company from these
reinsurance commitments at a cost to AIIC of $1.5 million.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION - The accompanying consolidated financial statements
include the accounts of the Company and its subsidiaries: American Independent
Insurance Company ("AIIC"), American Independent Services Company, Inc.
("AISC"), and C&L Insurance Agency, Inc. ("C&L"). All of the subsidiaries are
wholly owned. All significant inter-company accounts and transactions are
eliminated in consolidation.
BASIS OF PRESENTATION - The accompanying financial statements have been prepared
in conformity with generally accepted accounting principles that differ from
statutory accounting practices prescribed or permitted for insurance companies
by regulatory agencies.
GOING CONCERN - The accompanying financial statements have been prepared on a
going concern basis, which contemplates the realization of assets and
satisfaction of liabilities in the normal course of business.
10
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The Company has experienced recurring operating losses and has an accumulated
deficit of approximately $17,000,000 at December 31, 2000. As discussed in Note
1, on February 28, 2001, the Company entered into a reorganization transaction
in which Arch acquired all of the then outstanding shares of the Company for
$1.25 million. As a result of this transaction the surplus of the Company was
increased by approximately $23.5 million on February 28, 2001.
USE OF ESTIMATES - The preparation of financial statements in conformity with
generally accepted accounting principles require management to make estimates
and assumptions that affect the reported amounts of assets, liabilities,
revenues and expenses, at and during the reported period, along with the
disclosure of contingent assets and liabilities at the date of the financial
statements. Actual results may differ from these estimates.
INVESTMENTS - The Company accounts for investments in accordance with Statement
of Financial Accounting Standards No. 115 (FAS 115), "ACCOUNTING FOR CERTAIN
INVESTMENTS IN DEBT AND EQUITY SECURITIES." The Company's management determines
the appropriate classification of its investments in debt and equity securities
at the time of purchase and reevaluates such determinations at each balance
sheet date. At December 31, 2000, 1999, and 1998, all of the Company's
investments are classified as available for sale and are carried at fair value.
Unrealized gains and losses relating to available for sale securities are
reported as a separate component of stockholders' deficit as accumulated other
comprehensive income (loss). Realized investment gains and losses are determined
on a specific identification basis. The amortized costs of fixed maturities are
adjusted for amortization of premiums and accretion of discounts. Such
amortization and accretion are included in interest income.
The fair values of investments are measured using quoted market prices or dealer
quotations, when available. When quoted market prices are not available, fair
value is measured using quoted market prices for similar securities.
Investment securities are exposed to various risks such as interest rate, market
and credit risk. Market values of securities fluctuate based on the magnitude of
changing market conditions, and significant changes in market conditions could
materially affect portfolio value in the near term. Short-term investments
consist primarily of money market accounts and are reported at cost, which
approximates market.
The investment in real estate consists of rental property that is reported at
cost less allowance for depreciation. In the opinion of management, there is no
present indication of diminished value in the reported amount.
POLICY ACQUISITION COSTS - Policy acquisition costs include agents' commissions,
premium taxes, and other general and administrative costs incurred in connection
with writing business. These costs are deferred and amortized over the period in
which the related premiums are earned. The Company does not consider anticipated
investment income in determining the recoverability of these costs. There is no
indication that these costs will not be fully recoverable in the near term.
Reinsurance commissions represent a recovery of acquisition costs and are netted
against policy acquisition costs.
11
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
PROPERTY AND EQUIPMENT - Property and equipment are recorded at cost and
depreciated on a straight-line basis over the flowing estimated useful lives of
the related assets; computer software - 5 years, computer equipment - 5 years,
furniture and office equipment - 3 to 5 years, vehicles - 4 years.
UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES - The liability for unpaid losses and
loss adjustment expenses includes case basis estimates of reported losses, plus
amounts for incurred but not reported losses (IBNR) calculated based upon loss
projections utilizing company historical and industry data. The liability for
losses has been established on the basis of actuarial assumptions and management
judgments. The liability for loss adjustment expenses is generally determined as
a percentage of the liability for losses based on an average ratio of paid
adjustment expense to paid losses by classes of business. In establishing the
liability for losses and loss adjustment expenses, AIIC utilizes the findings of
an independent consulting actuary. Management believes that its aggregate
liability for unpaid losses and loss adjustment expenses at year-end represents
its best estimate, based upon the available data, of the amount necessary to
cover the ultimate cost of losses; and claims to date.
Projections of future ultimate losses and loss expenses are inherently uncertain
because of the random nature of claims occurrences and the dependency on future
contingent events, which are affected by economic, legal, political and social
factors. Because of these uncertainties, it is not presently possible to
determine whether actual loss experience will conform to the assumptions used in
estimating the liability. As a result, the actual liability may be significantly
in excess of or less than the amount indicated in the financial statements. As
adjustments to those estimates become necessary such adjustments are reflected
in current operations.
REVENUE RECOGNITION - Premiums are recognized as revenue on a pro rata basis
over the policy term. The portion of premiums that will be earned in the future
is deferred and reported as unearned premiums. A significant portion of premiums
that are written by the Company lapse as the insured fails to make the required
installment payments. Generally, premiums are collected in advance of providing
risk coverage, minimizing the Company's exposure to credit risk. When policies
lapse the Company writes off the written premium and the applicable unearned
premium. Service revenues are recorded as cash is received.
REINSURANCE - In the normal course of business, the Company seeks to reduce
losses by reinsuring certain levels of risk with reinsurers. Amounts recoverable
from reinsurers are estimated in a manner consistent with the reinsurance
contracts. Reinsurance commissions are recognized as income on a pro rata basis
over the period of risk. The portion of such commissions that will be earned in
the future is deferred and reported as commission, net of related policy
acquisition costs.
INCOME TAXES - The Company accounts for income taxes in accordance with
Statement of Financial Accounting Standards 109 (SFAS 109), "ACCOUNTING FOR
INCOME TAXES". SFAS 109 is an asset and liability method, which requires the
recognition of deferred tax liabilities and assets for the expected future tax
consequences of temporary differences between the tax and financial reporting
bases of certain assets and liabilities. Such differences are related
principally to deferred policy acquisition costs, unearned premiums, and the
discounting of reserves. Valuation allowances are established, when necessary,
to reduce deferred tax assets to the amount expected to be realized.
12
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
FAIR VALUES OF FINANCIAL INSTRUMENTS - The Company values financial instruments
as required by Statement of Financial Accounting Standards No. 107, "DISCLOSURE
ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS." The carrying amount of cash,
premiums receivable, other assets, accounts payable and other liabilities
approximate fair value.
CONCENTRATIONS OF CREDIT RISK - The Company and its subsidiaries maintain cash
balances at several banks, which are insured by the Federal Deposit Insurance
Corporation (FDIC) up to $100,000. On occasion during the normal course of
business, balances are maintained above the FDIC insurance limit.
The Company maintains short-term investment balances in money market accounts
that are insured by the Securities Investor Protection Corporation (SIPC) up to
$500,000. Balances for these accounts are maintained in excess of the SIPC
insurance limit.
Insurance is written by the Company primarily throughout the Commonwealth of
Pennsylvania. The Company performs ongoing credit and risk evaluations of its
brokers, insured and reinsureds.
EMPLOYEE STOCK OPTIONS - The Company accounts for employee stock options in
accordance with Financial Accounting Standards Board ("FASB") Statement 123,
"ACCOUNTING FOR STOCK-BASED COMPENSATION". This statement permits companies to
recognize related compensation expense by either the fair value method
prescribed by FASB Statement 123, or the intrinsic value approach as prescribed
by Accounting Principles Board ("APB") Opinion No. 25 for options granted after
December 31, 1995. The Company has elected to use the measurement principles
prescribed by APB Opinion No. 25 for all employee stock options.
COMPREHENSIVE INCOME - The Company accounts for comprehensive income in
accordance with Financial Accounting Standards Board Statement 130, "REPORTING
COMPREHENSIVE INCOME." Comprehensive income is a measurement of certain changes
in stockholders' deficit that result from transactions and other economic events
other than transactions with members. For the Company, these consist of changes
in unrealized gains and losses on the investment portfolio, which are used to
adjust net income to arrive at comprehensive income. The cumulative amount of
these changes is reported in the balance sheets within accumulated other
comprehensive income.
13
NOTE 3 - INVESTMENTS
Fixed maturities and equities classified as available for sale and carried at
fair value as of December 31, 2000, 1999 and 1998 are as follows:
December 31, 2000 Gross Gross
- ---------------------------------------- Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------------------- -------------- ----------------- -------------------
U.S. Treasury and government agencies $2,978,698 $77,800 ($2,000) $3,056,498
Corporate bonds 4,675,462 5,130 (271,378) 4,409,214
--------------------- -------------- ----------------- -------------------
Total fixed maturities $7,654,160 $82,930 ($273,378) $7,465,712
===================== ============== ================= ===================
Preferred stocks $175,000 $1,000 ($3,000) $173,000
Common stocks 49,403 1,421 (15,166) 35,658
--------------------- -------------- ----------------- -------------------
Total equity securities $224,403 $2,421 ($18,166) $208,658
===================== ============== ================= ===================
December 31, 1999 Gross Gross
- ---------------------------------------- Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------------------- -------------- ----------------- -------------------
U.S. Treasury and government agencies $3,016,068 $11,511 ($48,327) $2,979,252
Corporate bonds 6,405,323 - (221,177) 6,184,146
--------------------- -------------- ----------------- -------------------
Total fixed maturities $9,421,391 $11,511 ($269,504) $9,163,398
===================== ============== ================= ===================
Preferred stock $175,000 $563 ($20,250) $155,313
--------------------- -------------- ----------------- -------------------
Total equity securities $175,000 $563 ($20,250) $155,313
===================== ============== ================= ===================
December 31, 1999 Gross Gross
- ---------------------------------------- Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------------------- -------------- ----------------- -------------------
U.S. Treasury and government agencies $2,457,721 $34,160 ($151) $2,491,730
State and political subdivisions 4,011 77 - 4,088
Corporate bonds 499,393 - (193) 499,200
--------------------- -------------- ----------------- -------------------
Total fixed maturities $2,961,125 $34,237 ($344) $2,995,018
===================== ============== ================= ===================
14
NOTE 3 - INVESTMENTS (CONTINUED)
The cost and fair value of fixed maturities are shown by contractual maturity as
of December 31, 2000. Expected maturities will differ from contractual
maturities because borrowers may have the right to call or prepay obligations
with or without call or prepayment penalties.
Amortized Fair
Cost Value
----------------- ----------------
Due to mature:
One year or less $1,000,000 $998,000
After one year through five years 5,997,516 5,740,858
After five years through ten years 239,507 240,204
After ten years 417,137 486,650
----------------- ----------------
Total fixed maturities $7,654,160 $7,465,712
================= ================
Certain investments with a carrying value of $554,044, $349,694 and $599,167
have been deposited with various state regulatory agencies as required by law at
December 31, 2000, 1999, and 1998, respectively.
Net investment income comprised of accretion and amortization, interest,
dividends, rental income and related expenses for the years ended December 31,
is as follows:
2000 1999 1998
---------------- --------------- ---------------
Fixed maturity investments $873,887 $217,249 $181,897
Short term investments 83,902 96,398 102,583
Real estate - 233,997 393,593
Cash 52,478 182,666 334,057
---------------- --------------- ---------------
Investment Income 1,010,267 730,310 1,012,130
Less expenses (127,682) (318,373) (412,436)
---------------- --------------- ---------------
Net investment income $882,585 $411,937 $599,694
================ =============== ===============
Proceeds from sales and repayments of securities amounted to $1,709,826,
$1,942,605 and $583,220 in 2000, 1999 and 1998, respectively. Gross gains of $0,
$4,315, and $2,081 and gross losses of $32,942, $0 and $0 were realized on those
sales during 2000, 1999 and 1998, respectively.
15
NOTE 4 - RESTRICTED ASSETS
The following assets were held in Trust under various Securities Purchase
Agreements, as further described in Note 8 and can only be utilized to pay
claims of AIIC's policyholders and not for any other purpose. The Company pays
interest income on the collateral accounts to holder of the note.
2000 1999 1998
---------------- --------------- ---------------
Short term investments $5,539,287 $2,158,509 $ -
Fixed maturity investments 4,765,932 4,831,279 -
---------------- --------------- ---------------
$10,305,219 $6,989,788 $ -
================ =============== ===============
NOTE 5 - PROPERTY AND EQUIPMENT
Property and equipment consisted of the following at December 31:
2000 1999 1998
---------------- --------------- ---------------
Computer equipment $3,060,569 $2,427,486 $2,691,267
Furniture and office equipment 220,878 217,249 298,355
Vehicles 185,538 145,152 145,152
Leasehold improvements 19,890 19,980 -
---------------- --------------- ---------------
3,486,875 2,809,867 3,134,774
Less accumulated depreciation and amortization (2,104,418) (1,617,419) (1,809,312)
---------------- --------------- ---------------
$1,382,457 $1,192,448 $1,325,462
================ =============== ===============
Depreciation and amortization expenses for the years ended December 31, 2000,
1999, and 1998, were $612,686, $647,293, and $509,396, respectively.
NOTE 6 - INSURANCE ACTIVITY
The Company writes nonstandard personal auto liability insurance and in August
1999, began writing auto bodily injury and property damage including uninsured
and underinsured motorists liability. The Company has reinsured a substantial
part of these risks on a quota share basis.
In fiscal years 2000, 1999, and 1998, the Company had a 70% quota share
reinsurance agreement for the auto liability program with Arch Re. As discussed
in Note 1, Arch sold Arch Re's reinsurance operations to Folksamerica and
transferred these reinsurance agreements to Folksamerica. In fiscal years 2000
and 1999, the Company entered into a 90% quota share agreement for the auto
bodily injury and auto physical damage with Arch Re. Both agreements provide a
28% provisional ceding commission which is adjusted based upon the actual loss
ratio in a given accident year. As discussed in Note 1, the Company entered into
a reorganization transaction in which Arch acquired all of the then outstanding
shares of the Company for $1.25 million.
16
NOTE 6 - INSURANCE ACTIVITY (CONTINUED)
For fiscal years 2000, 1999 and 1998, the Company obtained an excess of loss
reinsurance agreement with Transatlantic Reinsurance (Transatlantic) for auto
liability whereby Transatlantic is liable for losses in excess of $1,000,000
each loss occurrence and $1,000,000 to any one occurrence. For fiscal years 2000
and 1999, the Company obtained an excess of loss reinsurance agreement with Scor
Reinsurance Company (Scor) for the auto bodily injury and auto physical damage.
For bodily injury, uninsured and underinsured motorists, Scor is liable for
$15,000 per person or $30,000 per occurrence with a limit of liability of
$85,000 per person and $270,000 per occurrence. In addition, extra contractual
obligations and excess policy limits coverage of 90% of $250,000 is provided.
For property damage liability, Scor is liable for $5,000 ultimate net loss each
and every occurrence with a limit of $45,000 ultimate net loss for each and
every occurrence.
The Company had maintained reinsurance agreements covering policies effective in
1994 and 1995, which were unilaterally terminated in 1995. Reinsurance
agreements for policies effective 1991, 1992 and 1993 were commuted by the
Company's prior management. It is current management's opinion that these
commutations are voidable as they were not completed in an arms' length manner
and resulted in significant losses to the Company. The Company is seeking
recovery of these losses. The Company has not anticipated and accrued for any
recoveries that may be due back to the Company.
Reinsurance contracts do not relieve the Company from its obligations to
policyholders. Additionally, failure of reinsurers to honor their obligations
could result in significant losses to the Company. The majority of the Company's
reinsurance recoverable is from one reinsurer and accordingly, the Company
continually evaluates the reinsurers financial condition. There can be no
assurance that reinsurance will continue to be available to the Company to the
same extent, and at the same cost, as it has in the past. The Company may choose
in the future to reevaluate the use of reinsurance to increase or decrease the
amounts of risk it cedes to reinsurers. Certain reinsurance treaties require the
Company to make deposits into trust accounts to secure the Company's obligations
under treaties.
Premiums written and related reinsurance amounts for the years ended December
31, are as follows:
Premiums Written Premiums Earned
------------------------------------------------ ----------------------------------------------------
2000 1999 1998 2000 1999 1998
--------------- ---------------- --------------- ---------------- ---------------- ------------------
Direct premiums $77,644,643 $51,431,689 $53,564,692 $64,068,184 $51,387,758 $45,898,498
Premiums ceded (58,534,694) (38,533,813) (39,820,381) (48,147,064) (38,404,373) (33,694,557)
--------------- ---------------- --------------- ---------------- ---------------- ------------------
Net premiums $19,109,949 $12,897,876 $13,744,311 $15,921,120 $12,983,385 $12,203,941
=============== ================ =============== ================ ================ ==================
17
NOTE 6 - INSURANCE ACTIVITY (CONTINUED)
A reconciliation of changes in unpaid losses and loss adjustment expenses for
the years ended December 31, 2000, 1999, and 1998, are summarized as follows (in
thousands):
2000 1999 1998
------------------ ------------------- -----------------
Balance at January 1 $34,596 $29,909 $22,975
Less: reinsurance recoverables (22,963) (19,340) (13,393)
------------------ ------------------- -----------------
11,633 10,569 9,582
Incurred related to
Current year 17,722 12,033 11,026
Prior years 4,440 2,674 2,235
------------------ ------------------- -----------------
Total incurred 22,162 14,707 13,261
Paid related to
Current year (8,496) (6,386) (5,368)
Prior years (6,426) (7,257) (6,906)
------------------ ------------------- -----------------
Total paid (14,922) (13,643) (12,274)
Net balance December 31 18,873 11,633 10,569
Add: reinsurance recoverables 34,442 22,963 19,340
------------------ ------------------- -----------------
Balance, December 31 $53,315 $34,596 $29,909
================== =================== =================
During 2000 the Company determined that based upon historical experience,
changes in underlying actuarial assumptions related to loss development were
appropriate. Accordingly, the Company strengthened its reserves for 2000 and all
prior years by approximately $5.4 million.
NOTE 7 - REAL ESTATE AND MORTGAGE PAYABLE
As of December 31, 1998, the Company had a mortgage payable outstanding in the
amount of $1,879,712 collateralized by investment real estate located in Los
Angeles, CA. The Company was relieved from liability under the mortgage as a
result of the sale of the real estate during the year ended December 31, 1999.
18
NOTE 8 - DEBT
2000 1999 1998
------------------ ------------------- -----------------
$3,500,000 senior subordinated note with Arch- $3,500,000 $ - $ -
U.S. dated March 6, 2000
$2,000,000 senior subordinated note with TDH 2,000,000 2,000,000 -
dated February 24, 1999
$5,000,000 senior subordinated note with Arch Re 5,000,000 5,000,000 -
dated February 24, 1999
$2,000,000 senior subordinated note with TDH 1,842,500 1,702,500 1,562,500
dated February 20, 1997
$1,500,000 surplus notes payable to a former 1,500,000 1,500,000 1,500,000
employee dated December 31, 1993
$500,000 convertible notes - - 38,665
$300,000 note payable - - 23,172
------------------ ------------------- -----------------
Total $13,842,500 $10,202,500 $3,124,337
================== =================== =================
On March 6, 2000, the Company issued a $3,500,000 senior subordinated note to
Arch Capital Group (U.S.) Inc., a subsidiary of Arch ("Arch-U.S."), in
connection with a securities purchase agreement. The note carries an interest
rate of 9% per year and is due, in full, on September 6, 2001. The note can be
prepaid without penalty.
On February 24, 1999, the Company issued $2,000,000 and $5,000,000 senior
subordinated notes to TDH Holdings and Arch Re, respectively, in connection with
a securities purchase agreement. The notes carry an interest rate of 9% per year
and are due, in full, on January 7, 2003. The notes can be prepaid without
penalty.
The notes issued to Arch-U.S. and Arch Re were subsequently transferred to Arch
in December 2000.
On February 20, 1997, the Company obtained a $2,000,000 senior subordinated note
from TDH. The note bears a rate of interest of 12%, compounded quarterly and is
due in full in February 2002. Debt discount of $700,000 is being recognized as
interest expense over the life of the note.
All of the senior subordinated note agreements provide for the loan proceeds to
be contributed to the capital of AIIC in the form of a surplus note, held in
trust under collateral accounts and utilized solely to pay claims of AIIC's
policyholders and not for any other purpose (exclusive of the February 20, 1997
TDH debt which did not require assets to be held in a collateral account). The
agreements provide for the holders to receive as collateral in the respective
surplus note of AIIC as well as all of the outstanding capital stock of the
company and it's subsidiaries and all tangible and intangible assets.
As discussed in Note 1, on February 28, 2001, the notes issued to Arch-U.S.,
Arch Re and TDH were contributed to capital or cancelled, as applicable, in
connection with the reorganization.
On December 31, 1993, the Company obtained a surplus note from a former employee
for $1,500,000. This note has no stated interest or repayment terms except in
the event of bankruptcy or liquidation of the
19
NOTE 8 - DEBT (CONTINUED)
company, the note will be fully payable.
The $500,000 convertible notes payable to stockholders and other related parties
are payable at $20,000 per month plus interest at a rate of 10%. The debt was
convertible in full for common stock of the Company at $1,746 per share and is
subordinate to all other debt. The obligation was paid in full in 1999.
In connection with a stock purchase agreement dated February 29, 1996, the
stockholders loaned $300,000 to the Company. The obligation required monthly
payments of $10,000 plus interest at the prime rate plus 2% adjusted annually at
December 31. The obligation was paid in full in 1999.
On February 24, 1999, the Company obtained a $2,000,000 term loan from Prime
Bank and bears interest at the prime rate plus 1.25%. The company had pledged as
collateral all of the capital stock of the Company and it's subsidiaries along
with a $7,000,000 surplus note from AIIC to AIIHC. The agreement contained
certain restrictive covenants regarding the maintenance of minimum tangible net
worth and liquid assets. At December 31, 1999 the Company was in violation of
these covenants, which could have resulted in the obligation being due and
payable immediately, however the bank did not demand repayment and the
obligation continued to be paid in accordance with its original terms. The loan
provided for monthly principal payments of $112,000 and was paid in full on
August 2000.
Aggregate annual maturities of subordinated debt for each of the next five years
as of December 31, 2000 are as follows:
2001 $3,500,000
2002 1,842,500
2003 7,000,000
2004 -
2005 1,500,000
-----------------
$13,842,500
=================
NOTE 9 - INCOME TAXES
The Company files a consolidated federal income tax return with its subsidiaries
and due to operating losses the Company does not have a current federal
liability for 2000, 1999 and 1998. The Company and its subsidiaries file
separate state income tax returns which resulted in current state tax
liabilities of $136,518, $24,273 and $84,630 for the years ending December 31,
2000, 1999 and 1998, respectively. The insurance subsidiary is not subject to
state income taxes.
20
NOTE 9 - INCOME TAXES (CONTINUED)
Significant components of the Company's deferred tax assets and liabilities are
as follows:
2000 1999 1998
------------------ ------------------- -----------------
Deferred tax assets
Net operating loss carryforwards $6,962,562 $4,022,152 $2,263,064
Capital loss carryover 88,852 88,852 88,852
LARC Receivable 238,456 238,456 238,456
Unearned premiums adjustments 649,941 433,101 438,916
Difference between book and tax reserves 195,023 169,378 243,861
Unrealized loss on investments 84,358 94,411 -
------------------ ------------------- -----------------
8,219,192 5,046,350 3,273,149
Valuation allowance (7,547,508) (4,589,065) (2,822,820)
------------------ ------------------- -----------------
Total deferred tax assets 671,684 457,285 450,329
Deferred tax liabilities
Unrealized gain on investments -- -- (11,523)
Net policy acquisition costs (671,684) (457,285) (438,806)
------------------ ------------------- -----------------
Total deferred tax liabilities (671,684) (457,285) (450,329)
------------------ ------------------- -----------------
Net deferred tax asset (liability) $ - $ - $ -
================== =================== =================
At December 2000, 1999, and 1998, the Company had net operating loss
carryforwards totaling approximately $20,500,000, $12,000,000, and $6,700,000,
respectively. These net operating losses expire at various times from 2008 to
2015. Additionally, utilization of these losses, if available, will depend on
generation of sufficient taxable income prior to the expiration of the net
operating loss carryforwards. Due to the acquisition of the Company as described
in Note 1, the utilization of the net operating losses will be limited to
approximately $60,000 per year due to the change in ownership. The primary
difference between the Company's effective tax rate and statutory rate for 2000,
1999, and 1998 was attributed to the establishment of valuation reserves on the
net deferred tax asset.
NOTE 10 - EMPLOYEE BENEFIT PLANS
PROFIT-SHARING RETIREMENT AND SAVINGS PLAN - The Company sponsors a
profit-sharing retirement and savings plan under Section 401(k) of the Internal
Revenue Code covering all eligible employees. Under the plan, employees make
voluntary contributions up to statutory maximum amounts, and the Company may
make discretionary contributions based on a percentage of eligible compensation.
No discretionary contributions were made in 2000, 1999 and 1998.
STOCK OPTION PLAN - The Company has a Stock Option Plan (the "Plan"), which
permits the granting of options to purchase up to 992.22 shares of common stock
at a price per share no less than 100% of fair market value of the common stock
on the date the option is granted. The options vest over periods not to
21
NOTE 10 - EMPLOYEE BENEFIT PLANS (CONTINUED)
exceed three years. The plan provides for the granting of incentive stock
options qualified under Section 422 of the Internal Revenue Code, as well as
nonqualified stock options for employees and directors.
No option may have a term longer than 10 years. Options under the plan are
non-transferable except in the event of death and are only exercisable by the
holder while employed by the Company. In connection with the reorganization as
discussed in Note 1, the Plan was terminated effective February 28, 2001.
The following table contains information on stock options for options granted
from the Plan:
Number Exercise Weighted-
of Price Range average
Shares Per Share Price
----------- ------------------- ---------------
Options outstanding at December 31, 1998, 1999, 2000 896 $756 to $1,344 $1,018
=========== =================== ===============
Shares exercisable at December 31, 1998 464 $756 to $1,344 $1,093
=========== =================== ===============
Shares exercisable at December 31, 1999 896 $756 to $1,344 $1,018
=========== =================== ===============
Shares exercisable at December 31, 2000 896 $756 to $1,344 $1,018
=========== =================== ===============
Options available for future grant under the Plan 96 - -
=========== =================== ===============
Ranges Total
-------------------------- -------------------
Range of exercise prices $756 $1,344 $756 to $1,344
Outstanding options:
Number outstanding 496 400 896
Weighted average remaining years contractual life (years) 5.1 6 5.5
Weighted average exercise price $756 $1,344 $1,019
=========== =========== ===================
Exercisable options:
Number outstanding at December 31, 1998 198 266 464
Weighted average exercise price $756 $1,344 $1,093
================ ============== =============
Number outstanding at December 31, 1999 496 400 896
Weighted average exercise price $756 $1,344 $1,018
================ ============== =============
Number outstanding at December 31, 2000 496 400 896
Weighted average exercise price $756 $1,344 $1,018
================ ============== =============
22
NOTE 11 - STOCK WARRANTS
In connection with the issuance of the subordinated note to TDH III L.P.
("TDH"), dated February 20, 1997 and discussed in Note 8, the Company issued
three warrants to purchase a total of 2,729 shares of common stock. The A-1
warrant to purchase 1,489 shares of common stock at a price of $.01 per share is
exercisable immediately, was valued at $700,000 and has been recorded as
original issue discount and paid-in-capital. This discount is being amortized
over the life of the loan (five years) and amounted to $140,000 during the years
ended December 31, 2000, 1999, and 1998, respectively. This warrant contains
certain repurchase provisions that entitle the Company to repurchase the
warrant, or if the warrant has been exercised, the shares issued in connection
with the warrant, at a repurchase price that will fluctuate based on the date of
repurchase. The repurchase price has been tied by formula to a floating rate of
return between 38% and 30% on the $2,000,000 subordinated note. The repurchase
provision may be exercised from February 21, 1998 to August 21, 2002, only after
repayment in full of the subordinated note and all interest accrued thereon.
The A-2 warrant granted to TDH enables TDH to purchase 496 shares of common
stock upon their advancing $666,667 to the Company. The A-2 warrant will be
deemed to be exercised by virtue of the extinguishment of the note evidencing
the above obligation and may be exercised at any time after TDH advances the
funds and continuing until February 21, 2004.
The third warrant associated with the subordinated note, the B warrant, entitles
TDH to purchase 744 shares of common stock at any time prior to February 21,
2005 with the occurrence of certain events at an exercise price of $.01 per
share. These triggering events include, but are not limited to: a) an initial
public offering by the Company of its common stock; b) a consolidation or merger
of the Company with another entity; c) a change of control of 33% or more of the
issued and outstanding shares of the Company; d) a sale of assets or operations
which generated more than 33% of the Company's revenues during the preceding
fiscal year; or e) a transaction in which the Company sells assets for a
purchase price equal to or greater than 33% of the Company's assets as indicated
by the Company's most recent financial statements prior to such transaction.
In connection with the securities purchase agreement dated February 24, 1999
with Arch Re and TDH as discussed in Note 8, the Company issued Class A warrants
to purchase 490.65 and 297.45 shares of common stock at a price of $0 per share.
The warrants are exercisable immediately. The warrants contain certain
provisions that allow for changes to the exercise rate based upon changes in the
Company's capital stock. Due to the financial condition of the Company at the
date of issuance no value was assigned to the warrants.
In connection with the securities purchase agreement dated March 6, 2000 with
Arch-U.S. as discussed in Note 8, the Company issued Class C warrants to
purchase 645.52 shares of common stock at a price of $0 per share. The warrants
are exercisable immediately. The warrants contain certain provisions that allow
for changes to the exercise rate based upon changes in the Company's capital
stock. Due to the financial condition of the Company at the date of issuance no
value was assigned to the warrants.
With the reorganization of the Company as discussed in Note 1, on February 28,
2001, all stock warrants were permanently cancelled.
23
NOTE 11 - STOCK WARRANTS (CONTINUED)
The following table summarizes information concerning the warrants described
above as of December 31, 2000, 1999, and 1998:
Number Exercise Weighted-
of Price Range average
Shares Per Share Price
------------ -------------------- ---------------
Warrants Balance at December 31, 1997 3,354.1 $.01 to 1,344 $198.77
Warrants issued - February 24, 1999 788.1 .00 .00
Warrants issued - March 6, 2000 645.5 .00 .00
Warrants canceled (625.1) 0.1 0.1
Warrants exercised - - -
Warrants outstanding at December 31, 2000 4,162.60 $.00 to 1,344 $160.15
============ ==================== ===============
Warrants exercisable - December 31, 1998 1,489.0 $.00 to 0.1 $.01
============ ==================== ===============
Warrants exercisable - December 31, 1999 2,277.1 $.00 to 0.1 $.01
============ ==================== ===============
Warrants exercisable - December 31, 2000 2,922.6 $.00 to 0.1 $.01
============ ==================== ===============
NOTE 12 - RELATED PARTY TRANSACTIONS
The Company's real estate investment was managed by a company owned by certain
stockholders (the "S/H group"). The management fee was 5% of gross rental income
which amounted to approximately $11,700 and $19,680 in 1999 and 1998,
respectively. An agreement between the Company and the S/H group entitled the
S/H group to repurchase the property at book value. As disclosed in Note 7, the
S/H group repurchased the building during the year ended December 31, 1999.
NOTE 13 - COMMITMENTS
Concurrent with the TDH note agreement effective February 20, 1997, (see Note
8), the Company and its subsidiaries entered into a Securities Purchase
Agreement ("Arch Re Agreement") with Arch Re, the Company's primary reinsurer.
The Arch Re Agreement provided for a credit facility of $3,595,000 to AISC to be
used to pay losses and loss adjustment expenses for accident years prior to
January 1, 1996. The agreement provided that Arch Re has the right to purchase
notes from AISC for the entire commitment amount. The notes obligated AIHC to
issue to Arch Re warrants to purchase 625.1 shares of common stock at a price of
$.01 per share. The warrant was to be issued upon the draw down by the Company
of funds under the agreement however, no amounts were borrowed and no warrants
were issued under this agreement, which terminated on December 31, 1998. The
termination of this commitment was part of an agreement dated February 24, 1999.
As a condition to the agreement, the Company established a Trust in the initial
amount of $5,200,000 during 1997, which was released in 1998 when the agreement
terminated.
24
NOTE 13 - COMMITMENTS (CONTINUED)
The Company leases its home office under an operating lease that expires July
2002. Minimum monthly lease payments are approximately $22,000 with an
escalation clause equal to the CPI not to exceed 3%.
Aggregate annual lease payments for each of the next five years as of December
31, 2000 are as follows:
2001 $320,700
2002 187,050
-----------------
$507,750
=================
The total rental expense was $436,515, $347,133, and $288,641 for the years
ended December 31, 2000, 1999, and 1998, respectively.
The Company has entered into employment contracts with its Chairman and
President both expiring in 2002. The agreements provide for minimum annual base
compensation aggregating $570,000 and also include provisions for bonus
compensation. The agreements also provide for other benefits, including
Company-paid life insurance and expense allowances. The agreement with the
Chairman was terminated on February 28, 2001.
NOTE 14 - CONTINGENCIES
The Company is named as defendant in various lawsuits generally relating to its
insurance operations. Legal actions generally arise from claims made under
insurance policies issued by the subsidiaries. These actions were considered by
the Company in establishing its loss and loss adjustment expense reserves. The
Company believes that the ultimate disposition of these and other pending
lawsuits will not materially impact the Company's financial position, cash
flows, or results of operations.
The Company is the plaintiff in various state and federal suits against
various parties, one of which is a former director and officer of the
Company. The state suit has been settled and the Company will not retain the
majority of the proceeds. The federal suit is currently scheduled for trial
in the fall of 2001. The former director/officer has filed a counterclaim in
the amount of $3.8 million of which $1.5 million is due to him under surplus
note agreements. (See Note 8). The Company believes that the payment of any
amount under the counterclaim is unlikely.
The Pennsylvania Property and Casualty Insurance Guarantee Association ("PIGA")
assesses solvent insurance companies for insurance companies under regulatory
supervision to cover losses to policyholders of insolvent or rehabilitated
companies. PIGA assesses its members on a pro rata basis and bills such
assessments deemed necessary by its Board of Directors. Although the Company is
not able to reasonably estimate the potential effect of any future assessments,
such amounts charged against operations historically have not been material. The
Company records these assessments in accordance with Statement of Position No
97-3 "ACCOUNTING BY INSURANCE & OTHER ENTERPRISES FOR INSURANCE-RELATED
ASSESSMENTS".
25
NOTE 15 - STATUTORY INFORMATION
As a holding company, the principal source of the Company's cash available for
debt service and payment of dividends (other than through the use of borrowed
funds or employment of other assets) is dividends received from AIIC and AISC.
Under Pennsylvania Insurance Law, AIIC may only pay dividends out of unassigned
funds (surplus) or, otherwise, upon the approval (or failure to disapprove
within 30 days written notice) of the Pennsylvania Insurance Commissioner. As of
December 31, 2000, 1999, and 1998, AIIC had a deficit of unassigned (surplus)
approximating, $0, $15,000,000, and $10,000,000, respectively. Additionally,
prior to the reorganization on February 28, 2001 (see Note 1), dividends must be
approved by TDH and Arch under the terms of their respective securities purchase
agreements. These restrictions are not expected to significantly affect the
Company's ability to meet its foreseeable cash requirements.
The Company's insurance subsidiary, as part of its regulatory filings is
required to disclose its risk-based capital ("RBC") requirements. The National
Association of Insurance Commissioners ("NAIC") develops the RBC program to
enable regulators to take appropriate and timely regulatory actions with respect
to insurers that show sign of weak or deteriorated financial condition. RBC is
a series of dynamic surplus-related formulas that contain a variety of factors
that are applied to financial balances based on a degree of certain risks, such
as asset, credit and underwriting risks. The Company's statutory capital and
surplus exceeded the NAIC's mandatory control level risk based capital at
December 31, 2000, 1999, and 1998.
At December 31, 2000, 1999, and 1998, statutory capital approximated $6,000,000,
$7,000,000, and $9,000,000, respectively. For the years ended December 31, 2000,
1999 and 1998, statutory net (loss) income approximated $(10,000,000),
$(5,000,000) and $140,000, respectively.
For the purposes of determining statutory capital and surplus, and corresponding
risk-based capital, the Pennsylvania Insurance Department has permitted certain
accounting practices in the preparation of AIIC's statutory financial
statements. These permitted practices include: a) the recognition of the
reorganization transaction as described in Note 1 as of December 31, 2000 in
which the Company transferred $11,200,907 from surplus notes to contributed
surplus; recognized as a receivable and as an addition to surplus of $9,500,000
($2,600,000 in the form of a surplus note and $6,900,000 as additional capital)
of future capital contributions; and reclassified all of AIIC's unassigned funds
(surplus) to gross paid in and contributed surplus, b) the recognition of a
receivable and additional surplus for surplus notes to be contributed by AIHC of
$3,500,000 and $7,000,000 in 1999 and 1998; c) the recognition of $1,145,000 of
amounts due from AISC in 1998 that was in excess of 90 days old. These practices
resulted in increases to statutory surplus of $9,500,000, $3,500,000, and
$8,145,000 at December 31, 2000, 1999, and 1998, respectively.
In addition, the Commonwealth of Pennsylvania Insurance Laws require the
maintenance of minimum capital for insurance companies domiciled therein. At
December 31, 2000, 1999, and 1998, AIIC's minimum statutory capital exceeded the
statutory requirement of $850,000.
The NAIC has recently adopted a codified set of statutory accounting practices
(the codification). The codification has been adopted by the Commonwealth of
Pennsylvania and was effective on January 1, 2001. The Company has reported the
effect of adoption will be a net increase in surplus of approximately $600,000,
primarily as a result of the recording of a deferred tax asset.
26
UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL STATEMENTS OF
ARCH CAPITAL GROUP LTD. AND
AMERICAN INDEPENDENT INSURANCE HOLDING COMPANY
The following unaudited pro forma condensed combined information as of and
for the twelve months ended December 31, 2000 is based on the historical
financial statements of American Independent Insurance Holding Company ("AIHC")
included elsewhere in this Form 8-K and the historical financial statements of
Arch Capital Group Ltd. ("ACGL") included in its Annual Report on Form 10-K for
the year ended December 31, 2000. The pro forma financial information gives
effect to the transactions consummated by the Reorganization Agreement.
The pro forma statement of income was prepared assuming the transaction
was effected as of January 1, 2000, and the pro forma statement of financial
condition was prepared assuming the transaction was effected on December 31,
2000. The purchase price allocation (given effect to in the pro forma
financial statements) is preliminary because additional information is
necessary to complete the actual purchase price allocation. The unaudited pro
forma financial information should be read in conjunction with the related
Notes thereto and the historical financial statements of AIHC, included
herein, and the historical financial statements of ACGL.
AIHC operating results for the year ended December 31, 2000 included the
impact of a change in the underlying actuarial assumptions related to loss
development along with a number of non-recurring expense items. The pro forma
information does not purport to be indicative of the results of operations that
would have occurred had the transaction been consummated on the assumed dates,
nor is the information intended to be a projection for any future period.
27
ARCH CAPITAL GROUP LTD.
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF FINANCIAL CONDITION
DECEMBER 31, 2000
(IN THOUSANDS)
PRO FORMA
---------------------------------------
ACGL AIHC ADJUSTMENTS COMBINED
------------- ------------- ---------------- --------------
ASSETS
Investments:
Fixed maturities $38,475 $7,466 $45,941
Publicly traded equity securities 51,322 208 51,530
Privately held securities 59,437 ($7,350) b 52,087
Securities held in escrow 20,970 20,970
Short-term investments 97,387 6,319 103,706
------------- ------------- ---------------- --------------
Total investments 267,591 13,993 (7,350) 274,234
------------- ------------- ---------------- --------------
Cash 11,481 1,101 (1,742) a,f,g 10,840
Accrued investment income 1,432 240 1,672
Goodwill 6,111 15,477 a 21,588
Investment accounts receivable 993 993
Deferred income tax asset 8,192 8,192
Premiums receivable 36,001 36,001
Reinsurance recoverable 70,070 70,070
Other assets 3,126 3,719 (1,500) c 5,345
------------- ------------- ---------------- --------------
TOTAL ASSETS $298,926 $125,124 $4,885 $428,935
============= ============= ================ ==============
LIABILITIES
Reserve for contingent loss of escrowed assets $15,000 $15,000
Claims and claims expenses $53,315 53,315
Unearned premiums 38,543 38,543
Reinsurance balances payable 29,954 29,954
Other insurance liabilities 1,372 1,372
Subordinated debt 13,843 ($12,342) b,e 1,501
Other liabilities 8,608 5,311 (1,137) e 12,782
------------- ------------- ---------------- --------------
TOTAL LIABILITIES 23,608 142,338 (13,479) 152,467
------------- ------------- ---------------- --------------
a,b,c,
Shareholders' Equity 275,318 (17,214) 18,364 e,f,g 276,468
------------- ------------- ---------------- --------------
Total Liabilities & Shareholders' Equity $298,926 $125,124 $4,885 $428,935
============= ============= ================ ==============
The accompanying notes are an integral part of
the unaudited pro forma combined financial statements.
28
ARCH CAPITAL GROUP LTD.
UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL STATEMENTS
SUMMARY OF PRO FORMA ADJUSTMENTS - STATEMENT OF FINANCIAL CONDITION
BALANCE SHEET ACCOUNT NOTE ADJUSTMENT December 31, 2000
- ------------------------------------- ---------- --------------------------------------------- -------------------
(in thousands)
Contribution to capital - ACGL note
Privately held securities b receivable from AIHC ($7,350)
Cash a Payment of purchase price (1,543)
f Net proceeds from Lawsuits to AIHC 169
g Stock redemption of Selling Shareholders (368)
Goodwill a Excess purchase price 15,477
Other assets c Payment of Folksamerica release (1,500)
-------------------
Effect on Total Assets $4,885
===================
Contribution to capital - AIHC note payable
Subordinated debt b to ACGL (8,500)
e Debt forgiveness - AIHC note payable to TDH (3,842)
Interest forgiveness of AIHC note payable
Other liabilities e to TDH (1,137)
-------------------
Effect on Total Liabilities (13,479)
Shareholders' equity a Excess purchase price 15,477
a Payment of purchase price (1,543)
Contribution to capital - ACGL note receivable
b from AIHC 1,150
c Payment of Folksamerica release (1,500)
Retained earnings - forgiveness of AIHC
e note payable and interest payable to TDH 4,979
f Net proceeds from Lawsuits to AIHC 169
g Stock redemption of Selling Shareholders (368)
-------------------
Effect on Shareholders' Equity 18,364
Effect on Total Liabilities
-------------------
and Shareholders' Equity $4,885
===================
29
ARCH CAPITAL GROUP LTD.
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF INCOME
FOR THE YEAR ENDED DECEMBER 31, 2000
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
PRO FORMA
-------------------------------------
ACGL AIHC ADJUSTMENTS COMBINED
-------------- ------------ --------------- -------------
REVENUES
Net premiums written ($10,604) $19,984 $9,380
(Increase) decrease in unearned premiums 98,134 (4,063) 94,071
-------------- ------------ --------------- -------------
Net premiums earned 87,530 15,921 103,451
Net investment income 15,923 883 $220 b,e 17,026
Gain on sale of reinsurance operations 2,191 2,191
Net realized investment gains 16,872 (33) 16,839
Other revenue 7,722 9,642
-------------- ------------ --------------- -------------
Total revenues 122,516 24,493 220 147,229
-------------- ------------ --------------- -------------
OPERATING COSTS AND EXPENSES
Claims and claims expenses 76,263 22,162 98,425
Commissions and brokerage 26,756 4,203 30,959
Reserve for contingent loss of escrowed assets 15,000 15,000
Other operating expenses 7,953 8,844 1,032 a 17,829
Foreign exchange (gain) loss 1,159 1,159
-------------- ------------ --------------- -------------
Total operating costs and expenses 127,131 35,209 1,032 163,372
-------------- ------------ --------------- -------------
Income (Loss) Before Income Taxes and Equity in
Net Income (Loss) of Investees (4,615) (10,716) (812) (16,143)
-------------- ------------ --------------- -------------
Income taxes:
Current 137 137
Deferred 5,425 0 d 5,425
-------------- ------------ --------------- -------------
Income tax expense (benefit) 5,425 137 0 5,562
-------------- ------------ --------------- -------------
Income (Loss) Before Equity in Net Income
of Investees (10,040) (10,853) (812) (21,705)
Equity in net income of investees 1,299 1,299
-------------- ------------ --------------- -------------
Net Income (Loss) ($8,741) ($10,853) ($812) ($20,406)
============== ============ =============== =============
AVERAGE SHARES OUTSTANDING
Basic 13,198,075 13,198,075
Diluted 13,198,075 13,198,075
PER SHARE DATA
Net Income (Loss) - Basic ($0.66) ($1.55)
Net Income (Loss) - Diluted ($0.66) ($1.55)
30
ARCH CAPITAL GROUP LTD.
UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL STATEMENTS
SUMMARY OF PRO FORMA ADJUSTMENTS - STATEMENT OF INCOME
Year Ended
December 31,
INCOME STATEMENT ITEM NOTE ADJUSTMENT 2000
- ------------------------------------ --------- ------------------------------------------------------ -----------------
(in thousands)
Net investment income b Interest income on ACGL note receivable from AIHC ($471)
b Interest expense on AIHC's note payable to ACGL 471
e Interest expense on AIHC's note payable to TDH 220
Other operating expenses a Amortization of goodwill (1,032)
Provision for income taxes d Tax effect of pro forma adjustments (77)
d Valuation allowance on pro forma adjustments 77
-----------------
Effect on Net Income (Loss) ($812)
=================
31
ARCH CAPITAL GROUP LTD.
NOTES TO THE UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL STATEMENTS
The pro forma financial statements include the historical results of ACGL and
AIHC. The following pro forma adjustments, which are necessary to reflect the
acquisition of AIHC, are included:
(a) The acquisition of AIHC has been accounted for as a business
combination using the purchase method. The purchase price for this
acquisition is the sum of consideration paid and the transaction costs
incurred by ACGL. Under the purchase method of accounting for business
combinations, the purchase price is allocated to the assets and
liabilities based on their relative fair value with the excess of the
acquisition costs over the fair value of the net assets recorded as
the excess of cost over the book value acquired. The fair values of
reserves for claims and claims expenses and related reinsurance
recoverable for AIHC's subsidiary, American Independent Insurance
Company ("AIIC"), were estimated based on the present value of the
expected underlying cash flows of the reserves and reinsurance
recoverables, and include a risk factor and a profit margin.
Preliminary analyses have been performed in order to identify
intangible assets and to allocate purchase price to identifiable
assets with the excess of purchase price over net tangible and
intangible assets recorded as goodwill, which will be amortized over
15 years. The following table summarizes the calculation and
allocation of purchase price:
PURCHASE PRICE (000'S): AIHC
---------------
Consideration paid or payable $1,250
Transaction costs 293
---------------
Total Purchase Price $1,543
===============
PURCHASE PRICE ALLOCATION (000'S):
Fair value of acquired net assets $(13,934)
Identified intangibles 0
Deferred taxes 0
Goodwill 15,477
---------------
Total Allocation of Purchase Price $1,543
===============
(b) Pro forma adjustments have been included to eliminate ACGL's note
receivable from AIHC ($7.35 million), restoration of a previously
recorded estimated market value discount on the note receivable
($1.15 million) and related net investment income ($0.5 million)
along with the corresponding AIHC note payable to ACGL and related
interest expense.
(c) In connection with the loans ACGL previously made to AIHC, ACGL had
obtained rights to provide reinsurance to AIIC for specific periods.
These rights were subsequently transferred to Folksamerica. In
connection with ACGL's acquisition of AIHC, Folksamerica released AIIC
from these rights to provide reinsurance at a cost of $1.5 million to
AIIC.
(d) The pro forma adjustments have been tax effected at an estimated
effective tax rate of 35% on all items except goodwill, which is not
deductible for tax purposes. At December 31, 2000, AIHC carried a full
valuation allowance against its deferred tax asset related to its net
operating loss carryforwards. A full valuation allowance has been
applied against the pro forma adjustment amount, resulting in no
additional income tax expense reflected in the pro forma results.
(e) TDH $4.0 million note payable forgiven at closing in return for a
portion of the proceeds from the Lawsuits ($0.2 million) along with
forgiveness of accrued interest on the note payable in the amount
32
of $1.1 million. The related interest expense in 2000 has been
eliminated as a pro forma adjustment.
(f) Proceeds from the Lawsuits, net of expenses, were distributed to the
Selling Shareholders and TDH according to agreed-upon percentages.
After these distributions, AIHC retained a small portion of the
proceeds.
(g) AIHC redeemed the outstanding stock held by the Selling Shareholders
in return for a portion of the proceeds from the Lawsuits ($0.4
million).
33