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EXHIBIT 13 to Executive Risk Inc. Annual Report on Form 10-K
Management's Discussion and Analysis of Financial Condition and Results of
Operations Financial Statements and Notes
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
The following discussion should be read in conjunction with the Consolidated
Financial Statements of the Company and related notes thereto.
GENERAL
Management's discussion and analysis of financial condition and results of
operations compares certain financial results for the year ended December 31,
1997 with the corresponding periods for 1996 and 1995. The results of Executive
Risk Inc. (the "Company" or "ERI") include the consolidated results of Executive
Risk Management Associates ("ERMA"), Executive Re Inc. ("Executive Re") and
Executive Re's insurance subsidiaries, Executive Risk Indemnity Inc. ("ERII"),
Executive Risk Specialty Insurance Company ("ERSIC"), Executive Risk N.V.
("ERNV"), Quadrant Indemnity Company ("Quadrant"), a newly formed Connecticut
insurance company owned by ERII, and Executive Risk (Bermuda) Ltd., a newly
formed Bermuda insurance company owned by Executive Re. In addition, the
Company's results include Executive Risk Capital Trust (the "Trust"), a Delaware
statutory business trust, Sullivan Kelly Inc. ("Sullivan Kelly"), a California
corporation formed in September 1997 to acquire the assets of Sullivan, Kelly &
Associates, Inc., Insurance Brokers, a California underwriting agency and
insurance broker, and a 50% interest in UAP Executive Partners ("UPEX"), a
French underwriting agency which was a joint venture between the Company and
Union des Assurances de Paris - Incendie Accidents ("UAP"), a subsidiary of
AXA-UAP Group. The joint venture agreement between the Company and UAP was
terminated on December 31, 1997. In conjunction with such termination, the
Company transferred its 50% interest in UPEX to AXA-UAP Group and in exchange
received a cash payment in the amount of $1.1 million. The Company also received
$0.7 million from AXA-UAP Group in exchange for the Company agreeing not to
compete with AXA-UAP Group on certain policies underwritten by UPEX and in force
on December 31, 1997. No realized gain or loss resulted from this termination.
The Company does not believe that the termination of the UPEX joint venture
agreement, including the non-compete agreement, will have a material adverse
impact on the Company's business or financial condition.
The Company's financial position and results of operations are subject to
fluctuations due to a variety of factors. Abnormally high severity or frequency
of claims in any period could have a material adverse effect on the Company.
Also, reevaluations of the Company's loss reserves could result in an increase
or decrease in reserves and a corresponding adjustment to earnings.
Additionally, the insurance industry is highly competitive. The Company competes
with domestic and foreign insurers and reinsurers, some of which have greater
financial, marketing and management resources than the Company, and it may
compete with new market entrants in the future. Competition is based on many
factors, including the perceived market strength of the insurer, pricing and
other terms and conditions, services provided, the speed of claims payment, the
reputation and experience of the insurer, and ratings assigned by independent
rating organizations (including A.M. Best Company, Inc. ("A.M. Best") and
Standard & Poor's ("S&P")). ERII, ERSIC, Quadrant and ERNV's current rating from
A.M. Best is "A (Excellent)". ERII, ERSIC and Quadrant's current claims-paying
ability rating from S&P is "A+". These ratings are based upon factors of concern
to policyholders, including financial condition and solvency, and are not
directed to the protection of investors.
RESULTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1997 AND 1996
Gross premiums written increased by $99.3 million, or 30%, to $431.4 million in
1997 from $332.1 million in 1996. The increase was due to growth in sales in all
of the Company's existing lines of business, including domestic directors and
officers ("D&O") liability insurance and lawyers professional liability and
miscellaneous professional liability errors and omissions ("E&O") insurance.
Ceded premiums increased $47.8 million, or 39%, to $169.5 million in 1997 from
$121.7 million in 1996. The rate of growth in ceded premiums exceeded that of
gross premiums written due to increased cessions on E&O and certain D&O products
partially offset by a reduction in direct D&O cessions to Travelers Property
Casualty Corporation ("Travelers") (formerly known as Travelers/Aetna Property
Casualty Company). In connection with the acquisition of The Aetna Casualty &
Surety Company ("Aetna") by The Travelers Insurance Group Inc., all reinsurance
treaties previously with Aetna were assumed by Travelers. Pursuant to a
restructuring of the Company's relationship with Travelers entered into on
February 13, 1997 and effective January 1, 1997, Travelers is no longer a 12.5%
quota share reinsurer of the Company's direct D&O business.
As a result of the foregoing, net premiums written increased $51.5 million, or
25%, to $261.9 million in 1997 from $210.4 million in 1996. Over the same
periods, net premiums earned increased to $211.2 million from $155.8 million.
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Net investment income increased by $14.5 million, or 44%, to $47.1 million in
1997 from $32.6 million in 1996. The increase resulted principally from growth
in the Company's investment portfolio, measured on an amortized cost basis, from
$663.1 million at December 31, 1996 to $1.0 billion at December 31, 1997. The
Company's equity investment balances were $61.7 million and $37.7 million at
December 31, 1997 and 1996, respectively, and the cash and short-term investment
balances were $88.5 million and $24.7 million, respectively, on the same dates.
The Company manages its portfolio on a total return basis, and, as such, its
investments in equity securities are made for their perceived superior return
potential over the long term. Growth in invested assets resulted primarily from
proceeds received from the issuance of capital securities, common stock and
senior notes as well as cash flows from insurance operations. The nominal
portfolio yield of the fixed maturity portfolio at December 31, 1997 was 6.07%,
as compared to 6.18% at December 31, 1996. The tax-equivalent yields on the
fixed maturity portfolio were 7.58% and 8.00% for these periods, respectively.
See "Liquidity and Capital Resources." The Company's net realized capital gains
were $3.2 million in 1997 as compared to $1.0 million in 1996. In 1997, net
capital gains were realized principally from the sale of fixed maturity
investments, equity mutual fund distributions and certain equity limited
partnership investments.
Loss and loss adjustment expenses ("LAE") increased $36.5 million, or 35%, to
$141.8 million in 1997 from $105.3 million in 1996 due to higher premiums earned
partially offset by a slightly lower loss ratio. The Company's loss ratio
decreased to 67.1% in 1997 from 67.6% in 1996. In connection with the Company's
normal reserving review, which includes a reevaluation of the adequacy of
reserve levels for prior years' claims, the Company reduced its unpaid loss and
LAE reserves in 1997 for prior report years by approximately $10.3 million. In
1996, the Company reduced its unpaid loss and LAE reserves for prior report
years by $6.8 million. These reductions produced corresponding increases in the
Company's net income of approximately $6.7 million, or $0.62 per diluted share,
in 1997 and $4.4 million, or $0.42 per diluted share, in 1996. There is no
assurance that reserve adequacy reevaluations will produce similar reserve
reductions and net income increases in the future.
Policy acquisition costs increased $7.2 million, or 26%, to $35.0 million in
1997 from $27.8 million in 1996. The Company's ratio of policy acquisition costs
to net premiums earned declined to 16.6% in 1997 from 17.8% in 1996. The
decrease in the policy acquisition cost ratio was primarily attributable to
higher ceding commissions earned on the Company's reinsurance programs.
General and administrative ("G&A") expenses increased $11.5 million, or 68%, to
$28.6 million for the year ended December 31, 1997 from $17.1 million for the
year ended December 31, 1996. The increase in G&A costs was due primarily to
increased compensation, benefit and related overhead costs associated with the
growth in premium volume and development of new products. The ratio of G&A
expenses to net premiums earned increased from 11.0% in 1996 to 13.5% in 1997.
As a result of the changes in the aforementioned ratios, the Company's GAAP
combined ratio increased to 97.2% in 1997 from 96.4% in 1996. A combined ratio
below 100% indicates profitable underwriting prior to the consideration of
investment income, capital gains and interest expense. A company with a combined
ratio exceeding 100% can still be profitable due to such factors as investment
income and realized capital gains.
Interest expense of $1.8 million for the year ended December 31, 1997 and $4.5
million for the year ended December 31, 1996 was attributable principally to the
outstanding balances under the Company's senior notes payable and bank credit
agreement. The outstanding balances under the Company's bank credit agreement
were $25 million from January 1, 1996 to March 26, 1996 and $70 million from
March 26, 1996 to February 5, 1997. On February 5, 1997, the Company repaid the
$70 million outstanding under the term loan portion of a senior credit facility
(the "Senior Credit Facility") arranged through The Chase Manhattan Bank
("Chase"). On December 12, 1997, the Company sold $75 million aggregate amount
of 7.125% senior notes payable. In addition, interest expense in 1997 includes
$0.9 million of loan arrangement fees paid to Chase in 1996 which were fully
amortized in connection with the repayment of amounts outstanding under the
Senior Credit Facility. See "Liquidity and Capital Resources" and Note 8 of
Notes to Consolidated Financial Statements of the Company. Minority interest in
the Trust is attributable to distributions payable on the securities of the
Trust. See "Liquidity and Capital Resources."
Income tax expense increased $1.6 million, or 23%, to $8.2 million for the year
ended December 31, 1997 from $6.6 million for the year ended December 31, 1996.
The Company's effective tax rate decreased to 18.3% in 1997 from 19.1% in 1996.
The decrease in the effective tax rate was due principally to growth in
tax-exempt investment income outpacing the increase in pre-tax income.
As a result of the factors described above, net income increased $8.4 million,
or 30%, to $36.5 million, or $3.41 per diluted share, in 1997 from $28.1
million, or $2.67 per diluted share, in 1996. The Company's operating earnings,
calculated as net
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income before $0.3 million of one-time expenses associated with the acquisition
of the assets of Sullivan, Kelly & Associates, Inc., Insurance Brokers and
realized capital gains or losses, all net of tax, increased $7.4 million, or
27%, to $34.8 million, or $3.25 per diluted share, in 1997 from $27.4 million,
or $2.61 per diluted share, in 1996.
YEARS ENDED DECEMBER 31, 1996 AND 1995
Gross premiums written increased by $121.5 million, or 58%, to $332.1 million in
1996 from $210.6 million in 1995. The increase was partially due to growth in
sales in all of the Company's key lines of business, including domestic and
international D&O liability insurance and lawyers professional liability and
miscellaneous professional liability E&O insurance. Also contributing to the
rise in gross premiums written was the Company's issuance of ERII and ERSIC D&O
policies, rather than Aetna (now known as Travelers) policies, to both new and
renewing insureds. Converting an insured to ERII or ERSIC from Aetna resulted in
the Company receiving 100% of the gross premiums written (and ceding 12.5% to
Aetna) as compared to receiving 50% when reinsuring Aetna's risks. In 1996,
$226.3 million of gross D&O premiums written were issued on ERII and ERSIC
policies as compared to $99.0 million in 1995. Ceded premiums increased $56.2
million, or 86%, to $121.7 million in 1996 from $65.5 million in 1995. The rise
in ceded premiums was due principally to an increase in direct premium volume, a
portion of which was ceded to reinsurers under the Company's various D&O and E&O
treaties.
As a result of the foregoing, net premiums written increased $65.3 million, or
45%, to $210.4 million in 1996 from $145.1 million in 1995. Over the same
periods, net premiums earned increased to $155.8 million from $116.4 million.
Net investment income increased by $5.9 million, or 22%, to $32.6 million in
1996 from $26.7 million in 1995. This increase resulted principally from growth
in the Company's investment portfolio, measured on an amortized cost basis, from
$520.9 million at December 31, 1995 to $663.1 million at December 31, 1996, as
well as a slight increase in nominal investment yields. The Company's equity
investment balances were $45.9 million and $26.1 million at December 31, 1996
and 1995, respectively, and the cash and short-term investment balances were
$24.7 million and $20.2 million, respectively, on the same dates. The nominal
portfolio yield of the fixed maturity portfolio at December 31, 1996 was 6.18%,
as compared to 6.09% at December 31, 1995. The tax-equivalent yields on the
fixed maturity portfolio were 8.00% and 8.25% for these periods, respectively.
See "Liquidity and Capital Resources." The Company's net realized capital gains
were $1.0 million in 1996, as compared to $1.6 million in 1995. In 1996, capital
gains were realized from the sale of fixed maturities to provide available cash
for the repurchase of Common Stock and Class B Common Stock from Aetna. In
addition, capital gains were realized from equity mutual fund distributions and
certain equity limited partnership investments. Partially offsetting the gains
were net realized capital losses from fixed maturities sold at a loss and
replaced with higher yielding securities.
Loss and LAE increased $26.8 million, or 34%, to $105.3 million in 1996 from
$78.5 million in 1995 due to higher premiums earned. The Company's loss ratio
increased slightly to 67.6% in 1996 from 67.4% in 1995. In connection with the
Company's normal reserving review, which includes a reevaluation of the adequacy
of reserve levels for prior years' claims, the Company reduced its unpaid loss
and LAE reserves in 1996 for prior report years by approximately $6.8 million.
In 1995, the Company reduced its unpaid loss and LAE reserves for prior report
years by approximately $5.2 million. These reductions produced corresponding
increases in the Company's net income of approximately $4.4 million, or $0.42
per share, in 1996 and $3.4 million, or $0.28 per share, in 1995. Policy
acquisition costs increased $5.9 million, or 27%, to $27.8 million in 1996 from
$21.9 million in 1995. The Company's ratio of policy acquisition costs to net
premiums earned declined to 17.8% in 1996 from 18.8% in 1995. The decrease in
the acquisition cost ratio was primarily due to savings achieved by paying less
in override commissions to Aetna as a result of successfully converting insureds
from Aetna policies to ERII and ERSIC policies. Under the Amended and Restated
Agency and Insurance Services Agreement among Aetna, the Company and ERMA, ERMA
paid Aetna an override commission equal to 3% of gross written premiums with
respect to Aetna D&O policies issued by ERMA through June 30, 1996. Pursuant to
this agreement, effective with respect to business written on or after July 1,
1996, ERMA was no longer required to pay an override commission to Aetna. G&A
expenses increased $6.4 million, or 59%, to $17.1 million for the year ended
December 31, 1996, as compared to $10.7 million for the year ended December 31,
1995. The increase in G&A costs was due primarily to increased compensation,
benefit and related overhead costs associated with new employees hired to
support the growth in premium volume. The ratio of G&A costs to net premiums
earned increased to 11.0% in 1996 from 9.3% in 1995. As a result of the changes
in the aforementioned ratios, the Company's GAAP combined ratio increased to
96.4% in 1996 from 95.5% in 1995.
Long-term incentive compensation in 1996 and 1995 of $0.2 million and $1.5
million, respectively, consisted of non-cash charges to earnings for the value
of the stock option element of the IPO Stock Compensation Plan
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(the "IPO Plan"). See Note 10 of Notes to Consolidated Financial Statements of
the Company for a further discussion of the IPO Plan.
Interest expense was incurred principally on the outstanding balances under the
Company's bank credit agreement. Higher outstanding debt balances in 1996
resulted in an increase in interest expense to $4.5 million in 1996 as compared
to $2.0 million in 1995. The outstanding balances were $25 million for 1995, $25
million from January 1, 1996 through March 26, 1996 and $70 million from March
26, 1996 to December 31, 1996. See "Liquidity and Capital Resources" and Note 8
of Notes to Consolidated Financial Statements of the Company.
Income tax expense increased $1.7 million, or 37%, to $6.6 million for the year
ended December 31, 1996, as compared to $4.9 million for the year ended December
31, 1995. The Company's effective tax rate increased to 19.1% in 1996 from 16.1%
in 1995. The increase in the effective tax rate was due in part to growth in
pre-tax income outpacing the increase in tax-exempt investment income and an
increase in the Company's state tax liability. As a result of the factors
described above, net income increased $2.8 million, or 11%, to $28.1 million, or
$2.67 per diluted share, in 1996 from $25.3 million, or $2.12 per diluted share,
in 1995. The Company's operating earnings increased $3.1 million, or 13%, to
$27.4 million, or $2.61 per diluted share, in 1996 from $24.3 million, or $2.04
per diluted share, in 1995.
LIQUIDITY AND CAPITAL RESOURCES
ERI is a holding company, the principal asset of which is equity in its
subsidiaries. ERI's cash flows depend primarily on dividends and other payments
from its subsidiaries. ERI's sources of funds consist primarily of premiums
received by the insurance subsidiaries, income received on investments and
proceeds from the sales and redemptions of investments. Funds are used primarily
to pay claims and operating expenses, to purchase investments, to pay interest
and principal under the terms of the Company's indebtedness for borrowed money
and to pay dividends to Common Stock holders.
Cash flows from operating activities were $181.0 million, $169.5 million and
$86.0 million for 1997, 1996 and 1995, respectively. The modest increase in cash
flows in 1997 resulted principally from increased net premiums received and
investment income received partially offset by higher losses and G&A expenses
paid as well as a $9.5 million return of funds held under a funds withheld
arrangement. Rising loss payments are expected of a maturing professional
liability underwriter. The primary components of the cash flow increase in 1996
over 1995 were increased net premiums received coupled with lower than
anticipated loss payments.
The Company believes that it has sufficient liquidity to meet its anticipated
insurance obligations as well as its operating and capital expenditure needs.
Such capital expenditure needs include the costs of an addition to the
Company-owned office headquarters building in Simsbury, Connecticut. Site
improvements have begun and bids have been accepted on the first $4 million of
the total estimated cost of $20 million. The project is targeted for completion
in 1999.
The Company's investment strategy emphasizes quality, liquidity and
diversification. With respect to liquidity, the Company considers liability
durations, specifically loss reserves, when determining investment maturities.
In addition, maturities have been staggered to produce a pre-planned pattern of
cash flows for purposes of loss payments and reinvestment opportunities. Average
investment duration of the fixed maturity portfolio at December 31, 1997, 1996
and 1995 was approximately 4.6 years as compared to an expected loss reserve
duration of 5.0 to 5.5 years for such dates. The Company's short-term investment
pool was $88.5 million (8.2% of the total investment portfolio) at December 31,
1997 and $24.7 million (3.6% of the total investment portfolio) at December 31,
1996. The increase in the short-term investment pool was due principally to the
addition to that pool of that portion of the net proceeds received from a senior
notes offering completed on December 12, 1997, as discussed below, which has
been designated for increasing the capitalization of ERNV. Cash and publicly
traded fixed income securities constituted 88% of the Company's total investment
portfolio at December 31, 1997.
The Company's entire investment portfolio is classified as available for sale,
and is reported at fair value, with the resulting unrealized gains or losses
included as a separate component of stockholders' equity until realized. The
market value of the portfolio was 103% of amortized cost at December 31, 1997
and December 31, 1996. At December 31, 1997 and 1996, stockholders' equity was
increased by $19.5 million and $11.9 million, respectively, to record the
Company's fixed maturity investment portfolio at fair value. At December 31,
1997, the Company owned no derivative instruments, except for $121.5 million
(fair value) invested in mortgage and asset backed securities. On March 22,
1996, ERI entered into a Stock Purchase Agreement (the "Agreement") with Aetna
Life and Casualty Company ("AL&C") and AL&C's wholly owned subsidiary, Aetna.
Pursuant to the Agreement, on March 26, 1996, the Company purchased 1,286,300
shares of Common Stock and 1,225,000 shares of Class B Common Stock from Aetna
at a per share price of $29.875, or approximately $75 million in the aggregate.
In connection with the Agreement, the Company secured the $70 million Senior
Credit Facility arranged through Chase. The proceeds of the loan were utilized
as follows: $38 million to
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partially finance the repurchase of Common Stock and Class B Common Stock from
Aetna, $25 million to refinance the Company's previously existing debt and $7
million for general corporate purposes. In addition, the Company obtained
through Chase a $25 million revolving credit facility. The Company has no plans
to draw funds under the revolving credit facility.
The Agreement also contained provisions requiring the Company to file a
registration statement with respect to the remaining 2,000,000 shares of Common
Stock under AL&C ownership and AL&C was obligated to sell all of these shares in
an underwritten secondary offering. The secondary offering was completed on June
7, 1996. In conjunction with the secondary offering, the Company granted to the
underwriters an option to purchase an additional 300,000 shares of Common Stock,
at $34.00 per share less underwriting discounts and commissions of $1.75 per
share, to cover over-allotments. This over-allotment option was exercised in
full, and the Company received $9.7 million in net proceeds which were used for
general corporate purposes. The 300,000 shares of Common Stock covered by the
over-allotment option were issued from shares held in treasury. On May 10, 1996,
the Board of Directors approved a resolution to retire the 1,225,000 shares of
Class B Common Stock in treasury acquired in the Aetna stock repurchase. At its
May 1997 Annual Meeting, the Company's stockholders approved an Amended and
Restated Certificate of Incorporation which eliminated all Class B Common Stock.
On January 24, 1997, the Company formed the Trust, the common securities of
which are wholly owned by the Company. On February 5, 1997, the Trust sold
125,000 8.675% Series A Capital Securities (liquidation amount, $1,000 per
Capital Security) to certain qualified institutional buyers pursuant to SEC Rule
144A. The Trust used the $125 million of proceeds received from the sale of the
Series A Capital Securities and the $3.9 million received from the sale to the
Company of the common securities of the Trust to purchase $128.9 million
aggregate principal amount of 8.675% Series A Junior Subordinated Deferrable
Interest Debentures of the Company due February 1, 2027 (the "Series A
Debentures"). The Company utilized the $123.5 million of net proceeds as
follows: $70 million to repay the amount outstanding under the term loan portion
of the Senior Credit Facility, $45 million to make a surplus contribution to
ERII and $8.5 million for general corporate purposes. On May 29, 1997, all of
the Series A Capital Securities were exchanged for Series B Capital Securities
(the "Capital Securities"). In addition, $125 million aggregate principal amount
of the Series A Debentures were exchanged for a like aggregate principal amount
of 8.675% Series B Junior Subordinated Deferrable Interest Debentures of the
Company due February 1, 2027 (the "Series B Debentures" and together with the
remaining $3.9 million aggregate principal amount of the outstanding Series A
Debentures are hereinafter referred to as the "Debentures"). The terms of the
Capital Securities are identical in all material respects to the terms of the
Series A Capital Securities, except that the Capital Securities have been
registered under the Securities Act of 1933 and are not subject to the $100,000
minimum liquidation amount transfer restriction and certain other transfer
restrictions applicable to the Series A Capital Securities. The sole assets of
the Trust are the Debentures.
Holders of the Capital Securities are entitled to receive cumulative cash
distributions, accumulating from the date of original issuance and payable
semi-annually in arrears on February 1 and August 1 of each year at an annual
rate of 8.675%. Interest on the Debentures, and hence distributions on the
Capital Securities, may be deferred by the Company to the extent set forth in
the applicable instrument. The Capital Securities are subject to mandatory
redemption on February 1, 2027, upon repayment of the Series B Debentures, at a
redemption price equal to the principal amount of, plus accrued but unpaid
interest on, the Series B Debentures. The Capital Securities are also subject to
mandatory redemption in certain other specified circumstances at a redemption
price that may or may not include a make-whole premium. The Company's
obligations under the Series B Debentures, the related indenture and trust
agreement and the guarantee issued for the benefit of the holders of the Capital
Securities, taken together, constitute a full, irrevocable and unconditional
guarantee by the Company of the Capital Securities.
On September 12, 1997, the Company completed an underwritten public offering of
1,000,000 shares of its Common Stock at $62.25 per share less underwriting
discounts and commissions of $3.05 per share. In connection with this secondary
offering, the Company granted to the underwriters an option to purchase an
additional 150,000 shares of its Common Stock to cover over-allotments. Such
over-allotment option was exercised in full. The Company received $67.8 million
in net proceeds which have been used to make surplus contributions to ERII and
Executive Risk (Bermuda) Ltd. in order to support existing business lines and to
finance entry into new business lines, and for general corporate purposes.
On December 12, 1997, the Company issued $75 million aggregate principal amount
of unsecured 7.125% senior notes (the "Senior Notes") maturing on December 15,
2007. Interest on the Senior Notes is payable semi-annually in arrears on June
15 and December 15, commencing on June 15, 1998. The Senior Notes may not be
redeemed prior to maturity and are not subject to any sinking fund. The Company
used the $74.2 million of net proceeds of the issue to make surplus
contributions to current insurance company subsidiaries of the Company in order
to support existing business lines and to finance entry into new business lines,
and for general corporate purposes.
In each of March, June, September and December of 1997, the Company paid
dividends to Common Stock holders of record of $0.02 per share. Such Common
Stock dividends totaled $0.8 million. ERII, ERSIC and Quadrant are subject to
state regulatory
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restrictions that limit the amount of dividends payable by these companies.
Subject to certain net income carryforward provisions, ERII must obtain approval
of the Insurance Commissioner of the State of Delaware in order to pay, in any
12-month period, dividends that exceed the greater of 10% of surplus as regards
policyholders as of the preceding December 31 and statutory net income less
realized capital gains for the preceding calendar year. Dividends may be paid by
ERII only out of earned surplus. ERSIC and Quadrant must obtain approval of the
Insurance Commissioner of the State of Connecticut in order to pay, in any
12-month period, dividends that exceed the greater of 10% of surplus with
respect to policyholders as of the preceding December 31 and statutory net
income for the preceding calendar year. In addition, ERSIC and Quadrant may not
pay any dividend or distribution in excess of the amount of its earned surplus,
as reflected in its most recent statutory annual statement on file with the
Connecticut Insurance Commissioner, without such Commissioner's approval. ERII,
ERSIC and Quadrant are all required to provide notice to the Insurance
Commissioners of the States of Delaware and Connecticut, as applicable, of all
dividends to shareholders. Additionally, both Delaware and Connecticut law
require that the statutory surplus of ERII, ERSIC or Quadrant, as applicable,
following any dividend or distribution be reasonable in relation to its
outstanding liabilities and adequate for its financial needs.
YEAR 2000 ISSUES
Many computer systems have date-sensitive programs that may not properly
recognize the year 2000, which could result in operational disruptions and
errors (the "Year 2000" issue). The Company's exposure to the Year 2000 issue is
mitigated by the fact that it does not rely on mainframe computers, but instead
has a client-server infrastructure in which no component is more than eight
years old. Having completed its internal assessment of the modifications
necessary in order that the Company become Year 2000 compliant, management
currently expects to complete the Year 2000 compliance project during the first
quarter of 1999. Based upon information currently available and upon a number of
assumptions of future events, including the continued availability of manpower
resources and other factors believed to be reliable, management estimates that
the total cost for internal Year 2000 compliance will not exceed $0.5 million
and will not materially affect the Company's results of operations.
Additionally, during 1997 the Company instituted procedures to communicate with
significant vendors to determine the extent to which the Company is vulnerable
to those third parties' Year 2000 issues. These communications are ongoing and
there can be no assurance that such third parties' failure to become Year 2000
compliant in a timely fashion would not have a material adverse effect on the
Company.
Lastly, the Year 2000 issue has liability implications for the directors and
officers of entities insured by the Company. The Company has adopted an
underwriting strategy to assess insureds' understanding of the Year 2000
exposures, as well as to evaluate the action steps that the insureds are
implementing. Such underwriting techniques should mitigate, but cannot
eliminate, the risk to the Company of increases in claims and losses related to
the Year 2000 issue. There can be no assurance that any such Year 2000-related
claims and losses will not have a material adverse effect on the Company's
results of operations.
OTHER
Delaware, the state of domicile of ERII, and Connecticut, the state of domicile
of ERSIC and Quadrant, impose minimum risk-based capital requirements on all
insurance companies that were developed by the National Association of Insurance
Commissioners ("NAIC"). The formulas for determining the amount of risk-based
capital specify various weighting factors that are applied to financial balances
or various levels of activity based on the perceived degree of risk. Regulatory
compliance is determined by a ratio of the insurance company's regulatory total
adjusted capital to its authorized control level risk-based capital, both as
defined by the NAIC. At December 31, 1997, the total adjusted capital (as
defined by the NAIC) of ERII, ERSIC and Quadrant was in excess of the risk-based
capital standards.
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FINANCIAL REPORTING RESPONSIBILITY
The management of Executive Risk Inc. has primary responsibility for the
integrity and accuracy of the financial information presented in this annual
report and for making certain that such information presents fairly the
financial position and operating results of the Company. The consolidated
financial statements included herein were prepared in conformity with generally
accepted accounting principles. All financial information presented within this
annual report is consistent with these financial statements or, when
appropriate, with the statutory financial statements of Executive Risk Indemnity
Inc., Executive Risk Specialty Insurance Company and Quadrant Indemnity Company
as reported to the state insurance regulatory authorities.
The accounting systems and related controls are designed to provide
reasonable assurance that the Company's financial records are reliable for the
preparation of financial statements and that the Company's assets are
safeguarded against loss.
Ernst & Young LLP, the Company's independent auditors, have audited
the consolidated financial statements of the Company, and their report is
included herein. Such audits were conducted in accordance with generally
accepted auditing standards and included reviews of internal controls to the
extent required by those standards.
The Audit Committee of the Board of Directors is comprised of certain
directors who are neither employees nor officers of the Company. The Audit
Committee meets periodically with the independent auditors and management to
approve the scope and timing of the independent audit and to discuss other
auditing and financial reporting matters. The independent auditors have direct
access to, and meet privately with, the Audit Committee.
9
REPORT OF INDEPENDENT AUDITORS
To the Stockholders and Board of Directors
Executive Risk Inc.
We have audited the accompanying consolidated balance sheets of Executive Risk
Inc. and its subsidiaries as of December 31, 1997 and 1996, and the related
consolidated statements of income, stockholders' equity, and cash flows for each
of the three years in the period ended December 31, 1997. 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. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. 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 consolidated financial position of Executive Risk
Inc. and its subsidiaries at December 31, 1997 and 1996, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1997, in conformity with generally accepted
accounting principles.
/s/ Ernst & Young LLP
Stamford, Connecticut
February 3, 1998
10
Consolidated Balance Sheets
December 31,
(In thousands, except share data) 1997 1996
Assets
Fixed maturities available for sale, at fair value
(amortized cost: 1997 - $905,050 and 1996 - $610,589) $ 934,981 $ 628,564
Equity securities available for sale, at fair value
(cost: 1997 - $42,787 and 1996 - $27,820) 61,732 37,705
Cash and short-term investments, at cost
which approximates market 88,505 24,706
---------------------------
Total Cash and Invested Assets 1,085,218 690,975
Premiums receivable 40,033 26,757
Reinsurance recoverables 159,918 77,724
Accrued investment income 13,731 10,126
Investment in UPEX -- 1,087
Deferred acquisition costs 34,581 22,696
Prepaid reinsurance premiums 99,847 66,088
Deferred income taxes 23,316 26,269
Other assets 29,160 19,525
---------------------------
Total Assets $ 1,485,804 $ 941,247
Liabilities
Loss and loss adjustment expenses $ 637,929 $ 457,063
Unearned premiums 289,840 205,348
Note payable to bank -- 70,000
Senior notes payable 75,000 --
Ceded balances payable 37,165 26,402
Accrued expenses and other liabilities 44,687 37,659
---------------------------
Total Liabilities 1,084,621 796,472
Preferred Securities of Executive Risk Capital Trust Company obligated
mandatorily redeemable preferred securities of subsidiary, Executive Risk
Capital Trust, holding solely $125,000,000 aggregate principal amount of
8.675% Series B Junior Subordinated Deferrable Interest Debentures of the
Company due February 1, 2027 and $3,866,000 aggregate principal amount of
8.675% Series A Junior Subordinated Deferrable Interest Debentures of the
Company due February 1, 2027 125,000 --
---------------------------
Stockholders' Equity
Preferred Stock, $.01 par value; authorized - 4,000,000 shares;
issued - 1997 and 1996 - 0 shares -- --
Common Stock, $.01 par value; authorized - 52,500,000 shares;
issued - 1997 - 11,953,358 shares and 1996 - 10,439,628 shares 120 104
Additional paid-in capital 176,234 93,651
Unrealized gains on investments, net of tax 31,769 18,382
Currency translation adjustments (481) (186)
Retained earnings 101,101 65,384
Cost of shares in treasury, at cost: 1997 and 1996 - 1,114,421 shares (32,560) (32,560)
---------------------------
Total Stockholders' Equity 276,183 144,775
---------------------------
Total Liabilities, Preferred Securities of Executive Risk
Capital Trust and Stockholders' Equity $ 1,485,804 $ 941,247
---------------------------
The accompanying notes are an integral part of the consolidated financial
statements.
11
CONSOLIDATED STATEMENTS OF INCOME
Year Ended December 31,
(In thousands, except per share data) 1997 1996 1995
Revenues
Gross premiums written $ 431,394 $ 332,085 $ 210,640
Premiums ceded (169,470) (121,709) (65,519)
-----------------------------------------
Net premiums written 261,924 210,376 145,121
Change in unearned premiums (50,748) (54,592) (28,687)
-----------------------------------------
Net Premiums Earned 211,176 155,784 116,434
Net investment income 47,115 32,646 26,706
Net realized capital gains 3,212 1,047 1,588
Other income 144 166 83
-----------------------------------------
Total Revenues 261,647 189,643 144,811
Expenses
Loss and loss adjustment expenses 141,773 105,335 78,530
Policy acquisition costs 34,978 27,803 21,931
General and administrative expenses 28,614 17,068 10,730
Long-term incentive compensation -- 187 1,458
Interest expense 1,783 4,511 2,022
Minority interest in Executive Risk Capital Trust 9,819 -- --
-----------------------------------------
Total Expenses 216,967 154,904 114,671
Income Before Income Taxes 44,680 34,739 30,140
Income Tax Expense (Benefit)
Current 12,834 14,201 9,890
Deferred (4,679) (7,567) (5,036)
-----------------------------------------
8,155 6,634 4,854
-----------------------------------------
Net Income $ 36,525 $ 28,105 $ 25,286
Per Share Data
Earnings per common share $ 3.71 $ 2.88 $ 2.20
Earnings per common share - assuming dilution 3.41 2.67 2.12
Dividends declared per common share 0.08 0.08 0.08
The accompanying notes are an integral part of the consolidated financial
statements.
12
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Year Ended December 31,
(In thousands) 1997 1996 1995
Common Stock Outstanding (Shares):
Balance, beginning of year 9,325 11,498 11,495
Options exercised 364 38 132
Secondary offering 1,150 -- --
Common Stock repurchase -- (2,511) --
Treasury shares reissued -- 300 --
Treasury shares repurchased -- -- (129)
-----------------------------------------
Balance, end of year 10,839 9,325 11,498
Common Stock:
Balance, beginning of year $ 104 $ 116 $ 115
Options exercised 4 -- 1
Secondary offering 12 -- --
Treasury shares retired -- (12) --
-----------------------------------------
Balance, end of year 120 104 116
Additional Paid-In Capital:
Balance, beginning of year 93,651 87,228 84,725
Options exercised 9,885 730 2,418
Directors' options fees granted 57 66 85
Secondary offerings, net of related expenses 66,487 521 --
Employee stock-based compensation plans 6,154 5,444 --
Treasury shares retired -- (338) --
-----------------------------------------
Balance, end of year 176,234 93,651 87,228
Unrealized Gains (Losses) on Investments:
Balance, beginning of year 18,382 19,156 (3,958)
Unrealized gains (losses) on investments 13,387 (774) 23,114
-----------------------------------------
Balance, end of year 31,769 18,382 19,156
Currency Translation Adjustments:
Balance, beginning of year (186) 29 24
Currency translation adjustments (295) (215) 5
-----------------------------------------
Balance, end of year (481) (186) 29
Retained Earnings:
Balance, beginning of year 65,384 74,315 49,948
Net income 36,525 28,105 25,286
Common Stock dividends (808) (789) (919)
Treasury shares retired -- (36,247) --
-----------------------------------------
Balance, end of year 101,101 65,384 74,315
Common Stock in Treasury:
Balance, beginning of year (32,560) (3,119) 0
Common Stock repurchase -- (38,428) --
Class B Common Stock repurchase -- (36,597) --
Secondary offering over-allotment option exercised -- 8,962 --
Treasury shares reissued -- 25 --
Treasury shares repurchased -- -- (3,119)
Treasury shares retired -- 36,597 --
-----------------------------------------
Balance, end of year (32,560) (32,560) (3,119)
Total Stockholders' Equity $ 276,183 $ 144,775 $ 177,725
The accompanying notes are an integral part of the consolidated financial
statements.
13
CONSOLIDATED STATEMENT OF CASH FLOWS
Year Ended December 31,
(In thousands) 1997 1996 1995
Operating Activities
Net income $ 36,525 $ 28,105 $ 25,286
Adjustments to reconcile net income to net cash
provided by operating activities:
Amortization and depreciation 2,682 1,729 935
Share of income of UPEX (144) (166) (83)
Deferred income taxes (4,679) (7,567) (5,036)
Amortization of bond premium 1,904 1,019 1,541
Net realized gains on investments (3,212) (1,047) (1,588)
Stock based compensation plans 6,154 2,428 2,023
Amortization of loan arrangement fees 910 -- --
Other (867) (1,672) (2,477)
Change in:
Premiums receivable, net of ceded balances payable (2,513) 10,297 (289)
Accrued investment income (3,605) (717) (1,544)
Deferred acquisition costs (11,885) (6,452) (5,384)
Loss and loss adjustment expenses, net of
reinsurance recoverables 98,672 88,704 44,841
Unearned premiums, net of prepaid reinsurance
premiums 50,733 54,592 28,687
Accrued expenses and other liabilities 10,324 221 (924)
-----------------------------------------
Net Cash Provided by Operating Activities 180,999 169,474 85,988
Investing Activities
Proceeds from sales of fixed maturities available for sale 286,742 179,510 79,323
Proceeds from sales of equity securities available for sale 1,389 -- 10,278
Proceeds from maturities of investment securities 44,181 34,586 32,113
Purchase of fixed maturities available for sale (627,134) (340,648) (199,298)
Purchase of equity securities available for sale (10,536) (13,691) (4,861)
Net capital expenditures (8,092) (2,881) (4,069)
Acquisition of the assets of Sullivan, Kelly & Associates, Inc. (2,317) -- --
-----------------------------------------
Net Cash Used in Investing Activities (315,767) (143,124) (86,514)
Financing Activities
Proceeds from exercise of options 4,122 423 241
Cost of repurchase of Common Stock -- (75,025) (3,119)
Placement fees and other (2,827) (1,172) --
Repayment of note payable to bank (70,000) (25,000) --
Note payable to bank -- 70,000 --
Proceeds from issuance of Senior Notes Payable 75,000 -- --
Proceeds from issuance of Common Stock 68,080 -- --
Proceeds from Capital Securities offering 125,000 -- --
Proceeds from over-allotment option exercise -- 9,675 --
Dividends paid on Common Stock (808) (789) (919)
-----------------------------------------
Net Cash Provided by (Used in) Financing Activities 198,567 (21,888) (3,797)
-----------------------------------------
Net Increase (Decrease) in Cash and Short-Term Investments 63,799 4,462 (4,323)
Cash and short-term investments at beginning of period 24,706 20,244 24,567
Cash and Short-Term Investments at End of Period $ 88,505 $ 24,706 $ 20,244
The accompanying notes are an integral part of the consolidated financial
statements.
14
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997
1. ORGANIZATION AND PRINCIPLES OF CONSOLIDATION
Executive Risk Inc. (the "Company" or "ERI") was formed under the laws of the
State of Delaware. As of December 31, 1997, the Company owns all of the
outstanding stock of Executive Re Inc. ("Executive Re"), and Executive Re owns
all of the outstanding stock of Executive Risk Indemnity Inc. ("ERII"),
Executive Risk (Bermuda) Ltd. ("ER Bermuda"), Sullivan Kelly Inc. ("Sullivan
Kelly") and Executive Risk N.V. ("ERNV"). ERII owns all of the outstanding stock
of Executive Risk Specialty Insurance Company ("ERSIC") and Quadrant Indemnity
Company ("Quadrant"). In addition, the Company and Executive Re own 100% of
Executive Risk Management Associates ("ERMA"), a Connecticut general
partnership. ERII, a Delaware corporation, commenced insurance operations under
the ownership of Executive Re in 1986. ERSIC and Quadrant, both Connecticut
corporations, commenced insurance operations in 1992 and 1997, respectively.
ERNV, a Dutch insurance company, was incorporated in May 1995 in the Netherlands
to participate in professional liability insurance opportunities. ER Bermuda, a
newly formed Bermuda insurance company, was incorporated in September 1997.
Sullivan Kelly, a California corporation, was formed in September 1997 to
acquire the assets of Sullivan, Kelly & Associates, Inc., Insurance Brokers, a
California underwriting agency and insurance broker. In addition, the Company's
results include Executive Risk Capital Trust (the "Trust"), a Delaware statutory
business trust.
The Company is a specialty insurance holding company that, through its
subsidiaries, develops, markets and underwrites professional liability
insurance, including directors and officers liability insurance ("D&O") and
errors and omissions liability insurance ("E&O") for lawyers and other
professionals. Through ERII, ERSIC and Quadrant, the Company writes, on a direct
basis, D&O and E&O throughout the United States, and reinsures D&O and certain
ancillary lines of insurance written by Travelers Property Casualty Corporation
("Travelers"), formerly known as Travelers/Aetna Property Casualty Company, a
stockholder of the Company until March 1996 (Note 5). The Company's products are
distributed through licensed independent property and casualty brokers, excess
and surplus lines brokers and licensed wholesalers.
The 1997 consolidated financial statements include the Company,
Executive Re, ERII, ERSIC, Quadrant, ER Bermuda, Sullivan Kelly, ERMA, ERNV and
the Trust. The 1996 and 1995 consolidated financial statements include the
Company, Executive Re, ERII, ERSIC, ERMA and ERNV. All references made herein to
the Company include ERI and all of its subsidiaries unless otherwise noted. All
significant intercompany amounts are eliminated in consolidation. Certain prior
year amounts have been reclassified to conform with the 1997 presentation.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation: The accompanying consolidated financial statements have
been prepared in conformity with generally accepted accounting principles
("GAAP"), some of which require the use of management's estimates. Actual
results could differ from those estimates.
New Accounting Standards: In June 1997, the Financial Accounting Standards Board
("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 130,
"Reporting Comprehensive Income" ("SFAS 130") and SFAS No. 131, "Disclosures
about Segments of an Enterprise and Related Information" ("SFAS 131"). SFAS 130
establishes standards for the reporting and display of comprehensive income and
its components in a full set of general-purpose financial statements; however,
adoption in 1998 will have no impact on the Company's net income or
stockholders' equity. Comprehensive income is defined as the change in equity
during the financial reporting period of a business enterprise resulting from
non-owner sources. SFAS 131 establishes standards for the reporting of operating
segment information in both annual financial reports and interim financial
reports issued to shareholders. Operating segments are components of an entity
for which separate financial information is available and is evaluated regularly
by the entity's chief operating management. Both statements are effective for
fiscal years beginning after December 15, 1997 and are not anticipated to have a
material impact on the Company.
Earnings Per Share: In February 1997, the FASB issued SFAS No. 128,
"Earnings per Share" ("SFAS 128"). SFAS 128 replaced the calculation of primary
and fully diluted earnings per share with basic (or earnings per common share)
and diluted earnings per share (or earnings per common share - assuming
dilution). Unlike primary earnings per share, earnings per common share excludes
any dilutive effects of options, warrants and convertible securities. Earnings
per common share assuming dilution is very similar to the previously reported
fully diluted earnings per share. All earnings per share amounts for all periods
are presented and, where appropriate, have been restated to conform to SFAS 128
requirements. Earnings per
15
common share are based on the weighted average common shares outstanding during
the period. Earnings per common share - assuming dilution includes the effect of
all dilutive securities, which include potential common shares. Potential common
shares are securities, such as options and warrants, that do not have a current
right to participate in earnings but could do so in the future by virtue of
option or conversion rights.
Investments: The Company has classified its entire portfolio of fixed
maturities and equity securities as available for sale and reports such
investments at fair value. Fair values are determined by quoted market prices
when available or, in the case of private placements, are estimated by
discounting expected future cash flows using a market rate on fixed maturities
with similar terms and credit worthiness (Note 9). The Company's classification
of its portfolio as available for sale provides the Company with the flexibility
to adjust its portfolio as needed in response to changes in operating, tax and
regulatory conditions.
Short-term investments are carried at cost that approximates market.
The amortized cost of fixed maturities is adjusted for amortization of premiums
and accretion of discounts to maturity which are included in investment income.
Unrealized gains and losses resulting from changes in fair values of fixed
maturities and equity securities are reflected in stockholders' equity, net of
applicable deferred income taxes.
Realized capital gains and losses are reported in revenues and are determined
based on the specific identification of the investments sold.
Investment in UPEX: The Company's 50% interest in UAP Executive
Partners ("UPEX"), a French underwriting agency which was a joint venture
between the Company and Union des Assurances de Paris - Incendie-Accidents
("UAP"), a subsidiary of AXA-UAP Group, was reported using the equity method of
accounting. Financial results were reported to the Company in French francs. The
Company's share of income and losses was calculated using the average exchange
rate in effect during the period. Resulting translation gains and losses were
reported as a separate component of stockholders' equity. The joint venture
agreement between the Company and UAP was terminated on December 31, 1997, and
the Company sold its 50% interest in UPEX to AXA-UAP Group on that date. No
realized gain or loss resulted from this termination.
Consolidation of ERMA Results: As the majority of ERMA's activities
relate to the marketing and underwriting of insurance policies, a substantial
portion of the revenues ERMA received from Travelers (or from The Aetna Casualty
and Surety Company ("Aetna"), prior to its acquisition by Travelers) for
underwriting and management services during the years 1995 through 1997 offset
the Company's policy acquisition costs. The remaining portion of the revenues
received from Travelers related to the general and administrative ("G&A") costs
of running the business, and were therefore offset against the Company's G&A
expenses.
Premium Income and Unearned Premiums: Gross premiums written are
recognized as premiums earned principally on a pro rata basis over the in-force
period of the policies. Ceded reinsurance premiums are charged against premiums
earned on the same basis. Unearned premiums and prepaid reinsurance premiums
represent the portions of premiums written and ceded applicable to the unexpired
terms of the related policies.
Deferred Acquisition Costs: Deferred acquisition costs, consisting
primarily of commissions net of allowances on ceded reinsurance and the portion
of ERMA's expenses relating to the acquisition of premiums, are deferred and
amortized on a pro rata basis over the period that the related premiums are
earned. Deferred acquisition costs are limited to their estimated realizable
value based on the related unearned premiums and take into account anticipated
claims and claim expenses, based on historical and current experience and
anticipated investment income.
Loss and Loss Adjustment Expense Reserves: As substantially all of the
Company's business is written on a claims-made form of coverage, the reserves
for loss and loss adjustment expenses represent the estimated liability on
outstanding claims, based on an evaluation of reported claims. Although
considerable variability is inherent in such estimates, management believes that
the recorded reserves for loss and loss adjustment expenses are adequate in the
aggregate to cover the ultimate resolution of reported claims. These estimates
are continually reviewed and any required adjustments are reflected in current
operations.
Reinsurance Recoverables: In the normal course of business, the Company
seeks to manage its exposure to potential losses arising from risks it writes or
assumes by reinsuring certain levels of risk with various reinsurers (Note 7).
Amounts
16
recoverable from reinsurers are estimated in a manner consistent with the loss
and loss adjustment expense reserves associated with the outstanding claims.
Income Taxes: Income taxes are accounted for using the liability
method. Using this method, deferred tax assets and liabilities are determined
based on differences between the financial reporting and tax basis of assets and
liabilities and are measured using the enacted tax rates and laws that will be
in effect when the differences are expected to reverse.
Statements of Cash Flows: In the accompanying statements of cash flows,
the Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents. Cash and cash equivalents
are classified as cash and short-term investments in the accompanying balance
sheets. Stock Compensation: The Company applies Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and
related interpretations in accounting for its stock-based compensation plans.
Under APB 25, compensation expense for stock option and award plans is
recognized as the difference between the fair value of the stock at the date of
grant less the amount, if any, the employee or director is required to pay.
3. EARNINGS PER SHARE
The following table sets forth the computation of earnings per common share and
earnings per common share - assuming dilution:
Year Ended December 31,
(In thousands, except per share data) 1997 1996 1995
Numerator:
Net income $36,525 $28,105 $25,286
Denominator:
Denominator for earnings per common share -
weighted average shares 9,838 9,759 11,491
Effect of dilutive securities:
Employee and director stock options 764 701 418
Stock incentive and performance share plans 113 56 --
---------------------------------
Total dilutive potential common shares 877 757 418
Denominator for earnings per common share
- assuming dilution 10,715 10,516 11,909
Earnings per common share $ 3.71 $ 2.88 $ 2.20
Earnings per common share - assuming dilution 3.41 2.67 2.12
For additional disclosures regarding the outstanding employee and director stock
options and the stock incentive and performance share plans, see Note 10 -
Stockholders' Equity.
Options to purchase 91,200 shares of Common Stock at $67.375 per share were
outstanding for a portion of 1997 but were not included in the computation of
earnings per common share - assuming dilution because the options' exercise
price was greater than the average market price of the common shares, and
therefore, the effect would be antidilutive.
4. ACQUISITION OF BUSINESS
On September 12, 1997, the Company formed Sullivan Kelly to acquire the assets
of Sullivan, Kelly & Associates, Inc. Insurance Brokers, a California
underwriting agency and insurance broker of malpractice insurance for medical
institutions. The Company accounted for the acquisition as a purchase and the
results of Sullivan Kelly are included in the accompanying financial statements
beginning with the date of acquisition. Based upon an assessment of the fair
value of the assets acquired at the date of acquisition, the Company paid $2.3
million in cash for $0.1 million of fixed assets and $0.7 million for a
non-compete agreement which is being amortized over 3.75 years. The remaining
purchase price of $1.5 million was allocated to goodwill and is being amortized
over a 15-year period.
5. STOCK REPURCHASE AND OFFERINGS
On March 22, 1996, the Company entered into a Stock Purchase Agreement (the
"Agreement") with Aetna Life and Casualty Company ("AL&C") and AL&C's wholly
owned subsidiary, Aetna. Prior to the closing of the Agreement, Aetna owned
4,511,300 shares of the Company's capital stock, consisting of (i) 3,286,300
shares of Common Stock and (ii) all
17
1,225,000 shares of Class B Common Stock. Through this investment and an option
to purchase 100,000 shares of Common Stock at $12.00 per share (the "Aetna Stock
Option"), Aetna controlled approximately 40% of the Company's capital stock.
Pursuant to the Agreement, on March 26, 1996, the Company purchased 1,286,300
shares of Common Stock and 1,225,000 shares of Class B Common Stock from Aetna
at a per share price of $29.875, or approximately $75 million in the aggregate.
In connection with the Agreement, the Company secured a $70 million senior
credit facility (the "Senior Credit Facility") arranged through The Chase
Manhattan Bank ("Chase") (Note 8). Upon the closing of the Agreement, 2,000,000
shares of Common Stock, representing approximately 22% of the Company's issued
and outstanding Common Stock, remained under Aetna ownership. Subsequently, in
connection with the acquisition of Aetna by The Travelers Insurance Group Inc.,
Aetna transferred ownership of the remaining Common Stock and the Aetna Stock
Option to AL&C.
The Agreement also contained provisions requiring the Company to file a
registration statement with respect to the remaining 2,000,000 shares of Common
Stock under AL&C ownership and AL&C was obligated to sell all of these shares in
an underwritten secondary offering. The secondary offering was completed on June
7, 1996. In conjunction with this secondary offering, the Company granted to the
underwriters an option to purchase an additional 300,000 shares of Common Stock,
at $34.00 per share less underwriting discounts and commissions of $1.75 per
share, to cover over-allotments. This over-allotment option was exercised in
full, and the Company received $9.7 million in net proceeds. The proceeds were
used for general corporate purposes.
On September 12, 1997, the Company completed an underwritten public
offering of 1,000,000 shares of its Common Stock at $62.25 per share less
underwriting discounts and commissions of $3.05 per share. In connection with
this secondary offering, the Company granted to the underwriters an option to
purchase an additional 150,000 shares of its Common Stock to cover
over-allotments. Such over-allotment option was exercised in full. The Company
received $67.8 million in net proceeds which have been used to make surplus
contributions to ERII and ER Bermuda in order to support existing business lines
and to finance entry into new business lines, and for general corporate
purposes.
6. PRO FORMA FINANCIAL DATA
The following table presents consolidated pro forma income statement data for
the years ended December 31, 1996 and 1995, as adjusted to give pro forma effect
to the stock repurchase of 2,511,300 shares of the Company's capital stock at
$29.875 per share and the exercise of the 300,000 share over-allotment option in
the June 7, 1996 secondary offering, at $32.25 per share, as if they had
occurred on January 1, 1996 and 1995, respectively.
Year Ended December 31,
(In thousands, except per share data) 1996 1995
Total revenues $189,483 $143,639
Net income 27,482 22,187
Weighted average shares outstanding - assuming dilution 9,910 9,698
Earnings per common share - assuming dilution $ 2.77 $ 2.29
7. UNDERWRITING AND REINSURANCE
On January 1, 1995, the Company, ERMA and Aetna entered into an amended
and restated insurance services agreement. Under this agreement, ERMA was
appointed as Aetna's underwriting manager and received a commission in 1996 and
1995 of 24% of the portion of premiums written reported by ERMA to Aetna. The
Company paid a commission to ERMA equal to ERMA's costs of producing business
for the Company. Additionally, ERMA paid an override to Aetna of 3% of gross
premiums written with respect to Aetna D&O policies issued through ERMA.
As the Company met certain financial tests, the 3% override was
discontinued on July 1, 1996. The business underwritten by ERMA on behalf of
Aetna generally was reinsured 50% by ERII through December 31, 1996. ERII paid a
ceding commission of 3% of premiums reinsured for premium taxes plus ERII's
share of certain costs of ERMA related to this business.
On February 13, 1997, the Company, ERMA and Travelers agreed to
terminate the amended and restated insurance services agreement effective
December 31, 1996, following the acquisition of Aetna by the Travelers Insurance
Group Inc. ERMA's obligations for policies effective prior to January 1, 1997
remain the same until all such policies expire and all liabilities with respect
to such policies have been settled. Under a new insurance services agreement
between the Company,
18
ERMA and Travelers, ERMA receives a commission equal to its costs to produce the
business for Travelers policies effective on or after January 1, 1997. The total
business underwritten by ERMA on Travelers policies is subject to limitations as
stipulated in the agreement. ERII generally assumes 100% of these risks and pays
Travelers a ceding commission equal to 3.5% of premiums reinsured for premium
taxes plus other costs and expenses related to this business.
ERII had entered into several quota share reinsurance treaties with
Aetna prior to its acquisition by Travelers. Under the largest reinsurance
treaty, ERII assumed 50% of the risk associated with the first $20 million of
coverage provided by each D&O policy underwritten by ERMA and issued by Aetna
through December 31, 1996. Effective January 1, 1997, ERII assumes 100% of the
risk associated with each D&O policy underwritten by ERMA and issued by
Travelers. These policies generally have limits of up to $20 million. Under the
other reinsurance treaties, ERII assumes a portion of the risk associated with
up to $10 million of coverage provided by various D&O and ancillary line
coverages underwritten by ERMA and issued by Travelers.
Pursuant to the agreement entered into on February 13, 1997 by the
Company and Travelers, the Company released Travelers from its obligation to
issue D&O exclusively through ERMA until December 31, 1999, and Travelers may
therefore compete with the Company on D&O sooner than it otherwise could have.
During 1997, 1996 and 1995, gross premiums written assumed by ERII under the
various agreements with Travelers were approximately $4.6 million, $13.8 million
and $60.5 million, respectively.
UPEX underwrote, on behalf of UAP, policies providing D&O coverage up
to a maximum policy limit of $25 million, subject to certain foreign currency
adjustments, of which the Company generally assumed a 50% participation in 1997,
1996 and 1995. This arrangement ended on December 31, 1997 pursuant to the
termination of the joint venture agreement between the Company and UAP (Note 2).
The Company, through ERII, ERSIC and Quadrant, cedes reinsurance to
manage its exposure to potential losses arising from risks it assumes or writes.
Entering into such reinsurance arrangements does not discharge the Company's
obligation to pay policy claims on the reinsured business. The ceding insurer
remains responsible for policy claims without regard to the extent the reinsurer
pays such claims.
The components of the Company's premiums written and earned were as
follows:
Year Ended December 31,
(In thousands) 1997 1996 1995
Premiums Written
Direct $ 414,967 $ 305,265 $ 134,312
Assumed 16,427 26,820 76,328
Ceded (169,470) (121,709) (65,519)
-----------------------------------------
Net Premiums Written $ 261,924 $ 210,376 $ 145,121
-----------------------------------------
Premiums Earned
Direct $ 324,182 $ 195,201 $ 71,071
Assumed 22,692 48,463 91,604
Ceded (135,698) (87,880) (46,241)
Net Premiums Earned $ 211,176 $ 155,784 $ 116,434
Ceded loss and loss adjustment expenses amounted to $88.4 million, $48.3 million
and $25.1 million in 1997, 1996 and 1995, respectively.
A portion of the Company's ceded reinsurance is placed with Lloyd's syndicates.
To date, the Company has not experienced any reinsurance recoverable defaults.
Further, Lloyd's syndicates have established trust funds securing their
obligations to U.S.
cedants.
8. CREDIT ARRANGEMENTS
On March 26, 1996, in connection with the repurchase of Common Stock
from Aetna (Note 5), the Company borrowed $70 million under the terms of the
Senior Credit Facility arranged through Chase. The proceeds of the loan were
utilized as follows: $38 million to partially finance the repurchase of Common
Stock and Class B Common Stock from Aetna,
19
$25 million to refinance the Company's previously existing debt and $7 million
for general corporate purposes. In addition, the Company has obtained through
Chase a $25 million revolving credit facility. The Company has no current plans
to draw funds under the revolving credit facility.
The terms of the revolving credit facility require, among other things,
that the Company maintain certain defined minimum consolidated net worth and
combined statutory surplus levels, and certain debt leverage and
premiums-to-surplus level ratios and place restrictions on the incurrence of
additional debt, the sale of assets, the making of acquisitions and the
incurrence of liens.
On January 24, 1997, the Company formed the Trust, the common
securities of which are wholly owned by the Company. On February 5, 1997, the
Trust sold 125,000 8.675% Series A Capital Securities (liquidation amount,
$1,000 per Capital Security) to certain qualified institutional buyers pursuant
to SEC Rule 144A. The Trust used the $125 million of proceeds received from the
sale of the Series A Capital Securities and the $3.9 million received from the
sale to the Company of the common securities of the Trust to purchase $128.9
million aggregate principal amount of 8.675% Series A Junior Subordinated
Deferrable Interest Debentures of the Company due February 1, 2027 (the "Series
A Debentures"). The Company utilized the $123.5 million of net proceeds as
follows: $70 million to repay the amount outstanding under the term loan portion
of the Senior Credit Facility, $45 million to make a surplus contribution to
ERII and $8.5 million for general corporate purposes. On May 29, 1997, all of
the Series A Capital Securities were exchanged for Series B Capital Securities
(the "Capital Securities"). In addition, $125 million aggregate principal amount
of the Series A Debentures were exchanged for a like aggregate principal amount
of 8.675% Series B Junior Subordinated Deferrable Interest Debentures of the
Company due February 1, 2027 (the "Series B Debentures" and together with the
remaining $3.9 million aggregate principal amount of the outstanding Series A
Debentures are hereinafter referred to as the "Debentures"). The terms of the
Capital Securities are identical in all material respects to the terms of the
Series A Capital Securities, except that the Capital Securities have been
registered under the Securities Act of 1933 and will not be subject to the
$100,000 minimum liquidation amount transfer restriction and certain other
transfer restrictions applicable to the Series A Capital Securities. The sole
assets of the Trust are the Debentures.
Holders of the Capital Securities will be entitled to receive
cumulative cash distributions, accumulating from the date of original issuance
and payable semi-annually in arrears on February 1 and August 1 of each year at
an annual rate of 8.675%. Interest on the Debentures, and hence distributions on
the Capital Securities, may be deferred by the Company to the extent set forth
in the applicable instrument. The Capital Securities are subject to mandatory
redemption on February 1, 2027, upon repayment of the Series B Debentures, at a
redemption price equal to the principal amount of, plus accrued but unpaid
interest on, the Series B Debentures. The Capital Securities are also subject to
mandatory redemption in certain other specified circumstances at a redemption
price that may or may not include a make-whole premium. The Company's
obligations under the Series B Debentures, the related indenture and trust
agreement and the guarantee issued for the benefit of the holders of the Capital
Securities, taken together, constitute a full, irrevocable and unconditional
guarantee by the Company of the Capital Securities.
On December 12, 1997, the Company issued $75 million aggregate
principal amount of unsecured 7.125% senior notes (the "Senior Notes") maturing
on December 15, 2007. Interest on the Senior Notes is payable semi-annually in
arrears, on June 15 and December 15, commencing on June 15, 1998. The Senior
Notes may not be redeemed prior to maturity and are not subject to any sinking
fund. The Company has used the $74.2 million of net proceeds of the issue to
make surplus contributions to current insurance company subsidiaries of the
Company in order to support existing business lines and to finance entry into
new business lines, and for general corporate purposes.
The carrying value of the Capital Securities and the Senior Notes
approximates their fair market value. Interest paid on debt totaled $6.3
million, $3.9 million and $1.8 million in 1997, 1996 and 1995, respectively.
20
9. INVESTMENT INFORMATION
Fixed Maturities and Equity Securities: The amortized cost, cost and
fair value of investments in fixed maturities and equity securities as of
December 31, 1997 and 1996 were as follows:
Amortized Gross Gross
Cost Unrealized Unrealized Fair
(In thousands) and Cost Gains Losses Value
1997
Fixed Maturities:
United States Government
or agency securities $ 50,237 $ 391 ($ 7) $ 50,621
Obligations of states and
political subdivisions 532,839 24,514 -- 557,353
Corporate securities 178,382 2,752 (733) 180,401
Mortgage and other asset backed securities 119,203 2,469 (152) 121,520
Foreign governments 1,297 13 -- 1,310
Sinking fund preferred stocks 23,092 684 -- 23,776
$905,050 $ 30,823 ($ 892) $ 934,981
-------------------------------------------------------
Equity securities $ 42,787 $ 18,945 -- $ 61,732
-------------------------------------------------------
$947,837 $ 49,768 ($ 892) $996,713
-------------------------------------------------------
1996
Fixed Maturities:
United States Government
or agency securities $ 24,621 $ 178 ($ 65) $ 24,734
Obligations of states and
political subdivisions 424,012 15,403 (134) 439,281
Corporate securities 91,528 1,463 (136) 92,855
Mortgage and other asset backed securities 60,911 1,168 (124) 61,955
Foreign governments 1,517 50 -- 1,567
Sinking fund preferred stocks 8,000 172 -- 8,172
$610,589 $ 18,434 ($ 459) $ 628,564
-------------------------------------------------------
Equity securities $ 27,820 $ 9,899 ($ 14) $ 37,705
-------------------------------------------------------
$638,409 $ 28,333 ($ 473) $ 666,269
-------------------------------------------------------
Realized capital gains and losses on sales of investments were as follows:
Year Ended December 31,
(In thousands) 1997 1996 1995
Fixed Maturities:
Gross realized capital gains $ 2,573 $ 1,913 $ 175
Gross realized capital losses (748) (2,071) (1,649)
Equity Securities:
Gross realized capital gains $ 1,389 $ 1,205 $ 3,062
Gross realized capital losses (2) -- --
The amortized cost and fair value of investments in fixed maturities at December
31, 1997 are shown as follows by effective maturity dates except that for
mortgage and other asset backed securities, maturities are calculated using
expected maturity dates, which are based on historic cash flow patterns.
Effective maturities will differ from contractual maturities because borrowers
may have the right to call or prepay obligations with or without call or
prepayment penalties.
21
Amortized Fair
(In thousands) Cost Value
Due in one year or less $ 73,364 $ 73,835
Due after one year through five years 302,799 310,034
Due after five years through ten years 464,016 484,321
Due after ten years 64,871 66,791
-------------------------
$905,050 $934,981
Changes in unrealized gains and losses were as follows:
Year Ended December 31,
(In thousands) 1997 1996 1995
Fixed maturities $11,956 ($5,375) $27,369
Equity Securities 9,060 4,236 6,320
Investment Income: The components of net investment income were as follows:
Year Ended December 31,
(In thousands) 1997 1996 1995
Fixed maturities
Taxable $17,438 $ 8,672 $ 5,052
Tax-exempt 24,933 22,400 20,242
Equity securities 2,410 637 868
Short-term investments 3,398 1,714 1,132
---------------------------------------
48,179 33,423 27,294
Investment expenses 1,064 777 588
---------------------------------------
Net investment income $47,115 $32,646 $26,706
10. STOCKHOLDERS' EQUITY
Preferred Stock: The Company has 4,000,000 preferred shares authorized
at December 31, 1997 and 1996, with no shares issued or outstanding.
Treasury Shares: Pursuant to the Aetna stock repurchase (Note 5), all
1,225,000 shares of Class B Common Stock and 1,286,300 shares of Common Stock
were repurchased at a per share price of $29.875 and held in treasury during the
first quarter of 1996. In connection with the June 7, 1996 secondary offering,
the 300,000 shares of Common Stock covered by the underwriters' over-allotment
option were issued (at a net per share price of $32.25) from shares held in
treasury. On May 10, 1996, the Board of Directors approved a resolution to
retire all 1,225,000 shares of Class B Common Stock held in treasury. In May
1997, the Articles of Incorporation were amended so that the Company no longer
has Class B Common Stock as an authorized class.
Stock Option Plans: The Company has a Nonqualified Stock Option Plan
and an Employee Incentive Nonqualified Stock Option Plan whereby key employees
may be granted options to purchase shares of the Company's Common Stock at a
price determined by the Committee on Directors and Compensation of the Company's
Board of Directors.
In November 1990, the Company adopted the IPO Stock Compensation Plan
(the "IPO Plan") under which Share Units were granted to certain key employees.
On the date of the closing of the Company's March 1994 initial public offering,
the Share Units were converted into the right to receive 161,905 stock options
to purchase Common Stock at an exercise price equal to 30% of the average
closing price of the Common Stock for the 30-day period immediately preceding
that date. Options representing one-half of the total award were granted on
March 22, 1995 to those specified employees employed by the Company on that
date. The other half were granted on March 22, 1996 to those specified employees
still employed by the Company on that date.
22
Information with respect to the employee stock options was as follows:
1997 1996 1995
Weighted Weighted Weighted
Average Average Average
Number of Exercise Number of Exercise Number of Exercise
Options Price Options Price Options Price
------- ----- ------- ----- ------- -----
Outstanding at
beginning of year 1,465,294 $ 13.89 1,292,304 $ 12.77 1,329,350 $ 13.33
Granted 546,700 58.30 219,202 20.54 101,104 7.42
Exercised (355,179) 11.37 (31,137) 12.53 (131,312) 14.29
Forfeited (10,900) 24.52 (15,075) 17.95 (6,838) 13.44
Outstanding at
end of year 1,645,915 $ 29.11 1,465,294 $ 13.89 1,292,304 $ 12.77
Options exercisable at
end of year 984,762 $ 13.42 1,066,418 $ 12.26 768,042 $ 12.20
Shares reserved under
option plans 2,492,372 -- 2,847,551 -- 2,878,688 --
Weighted average fair
value of options granted
during the year $ 31.22 -- $ 18.92 -- $ 12.52 --
In connection with the majority of options exercised in 1995, promissory notes
were issued in favor of the Company. Such notes were repaid in full in the first
quarter of 1997.
The following table summarizes information about the Company's employee stock
options outstanding at December 31, 1997.
Options Outstanding Options Exercisable
Average
Weighted Remaining Weighted
Range of Number of Average Contractual Number of Average
Exercise Prices Options Price Life (Years) Options Price
$ 4.88 - $10.00 90,476 $ 6.92 7.7 90,476 $ 6.92
12.00 - 20.00 886,988 13.61 5.4 863,100 13.60
26.00 - 53.75 156,250 30.13 8.4 31,186 27.46
57.81 - 67.38 512,200 59.57 9.7 -- --
--------- -------
$ 4.88 - $67.38 1,645,914 $29.11 7.2 984,762 $13.42
The Company has adopted a Nonemployee Directors Option Plan (the
"Directors Plan") to provide its nonemployee directors with stock-based
incentive compensation. The Directors Plan is intended to relate director
compensation to the financial performance of the Company and the market value of
the Common Stock.
23
Information with respect to the Directors Plan options was as follows:
1997 1996 1995
Weighted Weighted Weighted
Average Average Average
Number of Exercise Number of Exercise Number of Exercise
Options Price Options Price Options Price
Outstanding
at beginning
of year 82,285 $12.93 83,026 $10.89 59,798 $ 9.48
Granted 6,719 41.00 11,242 24.25 24,148 14.43
Exercised (8,551) 11.35 (6,725) 4.89 (920) 12.00
Forfeited (1,281) 28.01 (5,258) 15.22 -- --
-------- -------- -------
Outstanding at
end of year 79,172 $15.24 82,285 $12.93 83,026 $10.89
Options
exercisable at
end of year 79,172 $15.24 72,176 $11.12 58,878 $ 9.44
Shares reserved
under option
plan 483,804 -- 492,355 -- 499,080 --
Weighted
average fair
value of options
granted during
the year $ 29.44 $ 18.92 $10.02
The following table summarizes information about the Directors Plan stock
options outstanding at December 31, 1997.
Options Outstanding Options Exercisable
Average
Weighted Remaining Weighted
Range of Number of Average Contractual Number of Average
Exercise Prices Options Price Life (Years) Options Price
$ 3.32 - $11.51 18,235 $ 4.94 6.9 18,235 $ 4.94
$ 12.00 35,780 12.00 6.1 35,780 12.00
$13.89 - 50.25 25,157 27.30 8.2 25,157 27.30
------ ------
$ 3.32 - $50.25 79,172 $15.24 6.9 79,172 $15.24
In connection with the aforementioned employee and director stock option plans,
the Company accrued compensation expense, under APB 25, for the years ended
December 31, 1997, 1996 and 1995, of approximately $0.1 million, $0.7 million
and $1.5 million, respectively.
Stock Incentive and Performance Share Plans: In November 1995, the
Board of Directors approved two long-term stock-based incentive compensation
plans, the Stock Incentive Plan (the "SIP") and the Performance Share Plan (the
"PSP"), together referred to herein as the "1995 Plans." The SIP became
effective as of January 1, 1996 and the PSP as of January 1, 1995.
The Company has reserved 250,000 shares of Common Stock for issuance
under the SIP and 1,000,000 shares of Common Stock for issuance under the PSP,
subject to the restrictions set forth in each of the respective 1995 Plans, and
to the approval of the Committee on Directors and Compensation of the Board of
Directors. Under the SIP, employees are eligible to be granted stock "units,"
bearing a relationship to their respective cash bonuses under the Company's
Incentive Compensation Plan, which convert into shares of Common Stock upon
completion of the applicable vesting period (generally three years). Virtually
all employees are eligible to receive awards under the SIP with respect to any
fiscal year, other than those employees receiving awards under the PSP with
respect to that year. Under the PSP, certain key employees designated by the
Committee on Directors and Compensation are eligible to receive awards of
"performance share units" which convert into Common Stock and/or cash, as
determined by the Committee on Directors and Compensation, upon completion of
the performance period to which such awards relate. The amount of Common Stock
and/or cash, if any, to be received by participants in the PSP is
24
dependent upon, among other things, the financial performance of the Company
during the relevant three-year performance period. 8,484 and 8,525 share units
were granted in 1997 and 1996, respectively, under the SIP, of which 374 and 915
share units, respectively, were subsequently forfeited. 37,000 and 83,050
performance share units were granted under the PSP in 1997 and 1996,
respectively, of which 1,150 and 7,850 performance share units, respectively,
were subsequently forfeited. The weighted average fair value of the share units
and performance share units granted during 1997 and 1996 was $47.14 and $30.48
per share unit, respectively. The Company accrued compensation expense, under
APB 25, for the years ended December 31, 1997, 1996 and 1995 of approximately
$6.2 million, $1.8 million and $0.6 million, respectively, in connection with
the SIP and PSP.
Supplemental and Pro Forma Disclosures: The following pro forma
information regarding net income and earnings per share, required by SFAS 123,
"Accounting for Stock-Based Compensation" have been determined as if the Company
had accounted for its stock-based compensation plans under the fair value
methods described in that statement. The fair value of options and other awards
granted under the Company's stock-based compensation plans was estimated at the
date of grant using a Black-Scholes option pricing model. The Black-Scholes
option pricing model was developed for use in estimating the fair value of
traded options that have no vesting restrictions and are fully transferable. In
addition, option pricing models require the input of highly subjective
assumptions including the expected dividend yield, the expected life of the
options, the expected price volatility and the risk-free interest rate.
The weighted average dividend yield for stock option grants during
1997, 1996 and 1995 was .14%, .26% and .47%, respectively. The weighted average
expected life for 1997, 1996 and 1995 was 9.8 years, 8.8 years and 9.3 years,
respectively. The weighted average volatility for 1997, 1996 and 1995 was .28%,
.27% and .28%, respectively. The weighted average risk-free interest rate for
1997, 1996 and 1995 was 6.25%, 6.36% and 7.10%, respectively.
For purposes of pro forma disclosures, the estimated fair value of the
options and stock awards is amortized to expense over the options' and awards'
vesting period and does not include grants prior to January 1, 1995. As such,
the pro forma net income and earnings per share are not indicative of future
years. The Company's pro forma information was as follows:
(In thousands, except per share data) 1997 1996 1995
Net income As reported $36,525 $28,105 $25,286
Pro forma 36,199 27,040 25,665
Earnings per common
share As reported $3.71 $2.88 $2.20
Pro forma 3.68 2.77 2.23
Earnings per common
share - assuming dilution As reported $3.41 $2.67 $2.12
Pro forma 3.38 2.59 2.15
Rights Plan: The Company has adopted a Shareholder Rights Plan (the
"Rights Plan"). When exercisable, each Right entitles the registered holder to
purchase from ERI one share of Common Stock at a price of $60.32 per share,
subject to adjustment. The Rights Plan has certain anti-takeover effects. The
Rights will cause substantial dilution to a person or group that attempts to
acquire the Company on terms not approved by the Board of Directors.
Retained Earnings: ERII, ERSIC and Quadrant are subject to state
regulatory restrictions that limit the maximum amount of dividends payable.
Subject to certain net income carryforward provisions as described below, ERII
must obtain approval of the Insurance Commissioner of the State of Delaware in
order to pay, in any 12-month period, "extraordinary" dividends which are
defined as those in excess of the greater of 10% of surplus as regards
policyholders as of the prior year-end and statutory net income less realized
capital gains for such prior year. Dividends may be paid by ERII only out of
earned surplus. In addition, ERII must provide notice to the Insurance
Commissioner of the State of Delaware of all dividends and other distributions
to shareholders within five business days after declaration and at least ten
days prior to payment. ERSIC and Quadrant must obtain approval of the Insurance
Commissioner of the State of Connecticut in order to pay, in any 12-month
period, "extraordinary" dividends which are defined as those in excess of the
greater of 10% of surplus as regards policyholders as of the prior year-end and
statutory net income for such prior year. The Connecticut law further provides
that (i) ERSIC and Quadrant must report to the Connecticut Commissioner, for
informational purposes, all dividends and other distributions to shareholders
within five business days after the declaration thereof and at least ten days
prior to payment and (ii) ERSIC and Quadrant may not pay any dividend or
distribution in excess of its earned surplus, as reflected in its most recent
statutory annual statement on file with the Connecticut Commissioner, without
such Commissioner's approval. Under
25
applicable insurance law, the retained exposure of ERII, ERSIC and Quadrant on
any one risk cannot exceed 10% of its statutory capital and surplus.
11. RELATED PARTIES
A substantial portion of the investments of the Company have been
managed by Conning Asset Management (previously Conning & Company), a former
stockholder of the Company. The related agreement associated with this service
stipulates annual fees based on the aggregate invested assets of the Company.
The management contract with Conning Asset Management expires in June 1998. The
aggregate payments by the Company under this agreement were approximately $0.5
million in 1997, $0.6 million in 1996 and $0.5 million in 1995.
12. RETIREMENT PLANS
The Company maintains a defined contribution retirement plan (the
"Plan") covering substantially all employees. Under the Plan, the Company
contributes 4% of total compensation up to the social security wage base.
Thereafter, the Company contributes 8% of the total compensation that exceeds
this wage base. In addition, employee contributions of up to 10% (8% as of
January 1, 1998) of each such employee's total compensation to the Plan is
matched by the Company at a rate determined by the Company's average return on
equity for the preceding three years. The Company also maintains the Benefit
Equalization Plan (the "BEP"), a supplemental, nonqualified defined contribution
plan. The BEP covers certain officers of the Company for the portion of
retirement contributions, as determined by the provisions of the Plan, which
exceed IRS limitations on contributions and eligible compensation. Amounts
contributed by the Company to these retirement plans were $2.4 million, $1.7
million and $1.3 million in 1997, 1996 and 1995, respectively. These amounts
include contributions in respect of service in prior years with the Company.
During 1996, the Company entered into a Supplemental Pension Agreement
(the "SPA") with its former Chief Executive Officer ("CEO") and AL&C which
replaced a 1988 retirement arrangement among the parties, under which the
Company had previously accrued an unfunded, non-tax qualified defined benefit.
Under the SPA and the former CEO's Employment Agreement, (i) the former CEO
participated in the Plan and the BEP, to the same extent as other Company
employees and (ii) the Company has an obligation to make premium payments on a
life insurance policy in the initial amount of $1 million owned by an
irrevocable trust established by the former CEO, a so-called "split-dollar"
arrangement.
On May 30, 1997, the Company's former CEO (and Chairman) retired as an
officer and director. The Company's obligation to make additional contributions
to the Plan and the BEP, on behalf of the former CEO, ended with his retirement.
The Company's obligation to make premium payments on the life insurance policy,
as described above, continues.
13. INCOME TAXES
The provision for income taxes varies from the amount that would be computed
using the federal statutory income tax rate as follows:
Year Ended December 31,
(In thousands) 1997 1996 1995
Pre-tax income $ 44,680 $ 34,739 $ 30,140
Application of the federal statutory
tax rate (35%) 15,638 12,159 10,549
Tax effect of:
Tax-exempt interest (7,417) (6,676) (6,059)
State income taxes 736 625 10
Dividends received and other (802) 526 354
------------------------------------------
Total income tax provision $ 8,155 $ 6,634 $ 4,854
26
Significant components of the Company's deferred tax assets and liabilities are
summarized as follows:
December 31,
(In thousands) 1997 1996 1995
Deferred tax assets:
Loss reserve discounting $34,850 $30,871 $24,178
Unearned premiums 13,297 9,462 5,750
Other 6,244 4,518 4,544
-------------------------------------
Total deferred tax assets 54,391 44,851 34,472
Deferred tax liabilities:
Deferred acquisition costs 12,108 7,707 5,510
Unrealized gains on investments 17,107 9,475 9,842
Other 1,860 1,400 783
-------------------------------------
Total deferred tax liabilities 31,075 18,582 16,135
-------------------------------------
Net deferred tax assets $23,316 $26,269 $18,337
Income taxes paid were $11.5 million, $12.4 million and $10.6 million in 1997,
1996 and 1995, respectively.
27
14. UNPAID LOSS AND LOSS ADJUSTMENT EXPENSES
The following table sets forth the activity in unpaid loss and loss adjustment
expenses ("LAE"), net of reserves for reinsured loss and LAE, for the years
indicated.
Year Ended December 31,
(In thousands) 1997 1996 1995
Reserves for losses and LAE at beginning of period, gross $ 457,063 $ 324,416 $ 254,758
Reinsurance recoverable at beginning of period (76,916) (33,531) (8,958)
Reserves for losses and LAE at beginning of period, net 380,147 290,885 245,800
Provision for losses and LAE for current year claims 152,042 112,107 83,775
Decrease in estimated ultimate losses
and LAE for prior year claims (10,269) (6,772) (5,245)
---------------------------------------------
Total incurred losses and LAE 141,773 105,335 78,530
Adjustment for foreign exchange loss
on unpaid loss and LAE (469) (23) 58
Loss and LAE payments for claims attributable to:
Current year 4,495 2,239 792
Prior years 36,193 13,811 32,711
---------------------------------------------
Total payments 40,688 16,050 33,503
---------------------------------------------
Reserves for losses and LAE at end of period, net 480,763 380,147 290,885
Reinsurance recoverable at end of period 157,166 76,916 33,531
---------------------------------------------
Reserves for losses and LAE at end of period, gross $ 637,929 $ 457,063 $ 324,416
The decrease in estimated ultimate losses and LAE for prior year claims was due
principally to favorable development on known claims.
15. PRESCRIBED OR PERMITTED STATUTORY PRACTICES
ERII, which is domiciled in Delaware, and ERSIC and Quadrant, which are
domiciled in Connecticut, prepare their statutory financial statements in
accordance with accounting principles and practices prescribed or permitted by
their respective state insurance departments. Prescribed statutory accounting
practices include state laws, regulations and general administrative rules, as
well as a variety of publications of the National Association of Insurance
Commissioners ("NAIC"). Permitted statutory accounting practices encompass all
accounting practices that are not prescribed; such practices differ from state
to state, may differ from company to company within a state and may change in
the future. Furthermore, the NAIC has a project to codify statutory accounting
practices, the result of which is expected to constitute the only source of
"prescribed" statutory accounting practices. Accordingly, that project will
likely change the definitions of what comprises prescribed versus permitted
statutory accounting practices and may result in changes to the accounting
policies that insurance companies use to prepare their statutory financial
statements. ERII, ERSIC and Quadrant follow prescribed accounting practices in
preparing their statutory financial statements, in all material respects.
16. RECONCILIATION - GENERALLY ACCEPTED ACCOUNTING PRINCIPLES BASIS TO STATUTORY
BASIS
The following table reconciles consolidated net income and stockholders' equity
as reported herein on the basis of GAAP with ERII's consolidated statutory basis
income and consolidated statutory basis capital and surplus. ERII's consolidated
results include those of its wholly owned subsidiaries, ERSIC and Quadrant.
28
Year Ended December 31,
(In thousands) 1997 1996 1995
Consolidated GAAP income $ 36,525 $ 28,105 $ 25,286
Eliminate parent company loss 8,690 5,037 2,183
ERII consolidated GAAP income 45,215 33,142 27,469
Add (subtract) GAAP adjustments:
Deferred acquisition costs 171 (11,754) (3,221)
Deferred income tax benefits 9,735 (6,213) (4,348)
Change in foreign exchange translation (359) (20) 56
Other 33 33 (32)
---------------------------------------------
ERII consolidated statutory income $ 54,795 $ 15,188 $ 19,924
December 31,
1997 1996 1995
Consolidated GAAP stockholders' equity $ 276,183 $ 144,775 $ 177,725
Eliminate parent company deficit 56,947 64,843 663
---------------------------------------------
ERII consolidated GAAP stockholders' equity 333,130 209,618 178,388
Add (subtract) GAAP adjustments:
Deferred acquisition costs (28,918) (29,090) (17,336)
Deferred income tax benefits (4,885) (22,207) (16,109)
Adjust invested assets to statutory value (30,434) (17,753) (21,824)
Other (3,330) (2,163) (1,654)
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ERII consolidated statutory capital and surplus $ 265,563 $ 138,405 $ 121,465
17. CONSOLIDATED QUARTERLY DATA (UNAUDITED)
First Second Third Fourth
(In thousands, except per share data) Quarter Quarter Quarter Quarter Year
1997
Net premiums earned $46,229 $50,206 $54,787 $59,954 $211,176
Net investment income 10,105 11,255 11,682 14,073 47,115
Income before income taxes 10,100 10,758 10,525 13,297 44,680
Federal and state income tax expense 1,686 2,190 1,610 2,669 8,155
Net Income 8,414 8,568 8,915 10,628 36,525
Earnings per common share -
assuming dilution (1) 0.83 0.83 0.84 0.91 3.41
Common Stock price range (2)
- High 48 3/4 56 68 3/8 72 72
- Low 35 5/8 43 3/8 49 13/16 63 1/2 35 5/8
1996
Net premiums earned $33,913 $36,425 $41,066 $44,380 $155,784
Net investment income 7,375 7,450 8,389 9,432 32,646
Income before income taxes 8,763 6,722 8,103 11,151 34,739
Federal and state income tax expense 1,538 1,162 1,359 2,575 6,634
Net Income 7,225 5,560 6,744 8,576 28,105
Earnings per common share -
assuming dilution (1)(3) 0.60 0.57 0.67 0.85 2.67
Common Stock price range (2)
- High 33 5/8 38 1/4 38 1/2 42 3/8 42 3/8
- Low 26 1/8 29 1/4 33 3/8 33 7/8 26 1/8
(1) The 1996 and the first three quarters of 1997 earnings per common share
amounts have been restated to comply with the provisions of SFAS 128.
(2) The stock price range is based on high and low sales prices reported by
Bloomberg. The Company paid quarterly dividends of $0.02 per share in 1997, 1996
and 1995. The Company currently intends to continue paying regular cash
dividends on a quarterly basis. See Notes 8 and 10 for information on potential
restrictions on the payment of future dividends.
(3) The sum of the quarters' earnings per share does not equal the year-to-date
per share amount. As of February 23, 1998, the approximate number of common
shareholders of record was 95.