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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
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FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND
EXCHANGE ACT OF 1934 [FEE REQUIRED]
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES AND EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
FOR THE TRANSITION PERIOD FROM TO .
COMMISSION FILE NO. 1-12800
EXECUTIVE RISK INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 06-1388171
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
82 HOPMEADOW STREET, SIMSBURY, CT 06070-7683
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (860) 408-2000
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SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
TITLE OF CLASS NAME OF EXCHANGE ON WHICH REGISTERED
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Common Stock, $.01 par value New York Stock Exchange
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No ___
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
The aggregate market value on March 17, 1999 of the voting stock held by
non-affiliates of the registrant was approximately $770 million. There were
11,371,947 shares of the registrant's Common Stock, $.01 par value, outstanding
as of March 17, 1999.
DOCUMENTS INCORPORATED BY REFERENCE
None
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EXECUTIVE RISK INC.
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TABLE OF CONTENTS
PAGE
ITEM NUMBER
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PART I
1. Business.................................................... 1
2. Properties.................................................. 17
3. Legal Proceedings........................................... 18
4. Submission of Matters to a Vote of Security Holders......... 18
PART II
5. Market for the Registrant's Common Stock and Related
Stockholder Matters....................................... 18
6. Selected Financial Data..................................... 19
7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 19
7A. Quantitative and Qualitative Disclosures About Market
Risk...................................................... 27
8. Financial Statements and Supplementary Data................. 28
9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosures................................. 29
PART III
10. Directors and Executive Officers............................ 29
11. Executive Compensation...................................... 31
12. Security Ownership of Certain Beneficial Owners and
Management................................................ 33
13. Certain Relationships and Related Transactions..............
PART IV
14. Exhibits, Financial Statement Schedules and Reports on Form
8-K....................................................... 35
Signatures......................................................... 36
Exhibit Index...................................................... 37
Index to Financial Statements and Schedules........................ 39
NOTE ON FORWARD-LOOKING STATEMENTS: The Private Securities Litigation
Reform Act of 1995 provides a "safe harbor" for forward-looking statements. This
Report may include forward-looking statements, as do other publicly available
Company documents, including reports on Forms 10-Q and any Form 8-K filed with
the Securities and Exchange Commission and other written or oral statements made
by or on behalf of the Company, its officers and employees. When made, such
forward-looking statements reflect the then-current views of the Company or its
management with respect to future events and financial performance. There are
known and unknown risks, uncertainties and other factors that could cause actual
results to differ materially from those contemplated or indicated by such
forward-looking statements. These include, but are not limited to, risks and
uncertainties inherent in or relating to the closing under the Agreement and
Plan of Merger, dated as of February 6, 1999, by and among the Company, The
Chubb Corporation and Excalibur Acquisition Inc., as well as (i) general
economic conditions, including interest rate movements, inflation and cyclical
industry conditions, (ii) governmental and regulatory policies affecting
professional liability, as well as the judicial environment, (iii) the loss
reserving process, (iv) increasing competition in the market segments in which
the Company operates, (v) the conduct of international operations, including
exchange rate fluctuations and foreign regulatory changes, and (vi) the effects
of the Year 2000 issue on Company insureds and the degree to which liability
exposure is affected thereby. The words "believe," "expect," "anticipate,"
"project," and similar expressions identify forward-looking statements. Readers
are cautioned not to place undue reliance on these forward-looking statements,
which speak only as of their dates. Neither the Company nor its management
undertakes any obligation to publicly update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise.
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PART I
ITEM 1. BUSINESS
The Specialty Insurance Industry
General. Executive Risk Inc. ("ERI" or the "Company") is an insurance
holding company incorporated under the laws of Delaware. Through its
subsidiaries, ERI develops, markets and underwrites a wide range of specialty
insurance products, principally executive and professional liability coverages
but also crime, inland marine, medical malpractice and other property-casualty
lines. The Company writes primarily domestic insurance, and conducts business in
all United States jurisdictions. An indirect wholly-owned Dutch subsidiary,
Executive Risk N. V. ("ERNV"), markets certain of the Company's product lines
internationally, principally in the European Community. ERI's core business
lines are directors and officers liability insurance ("D&O") and professional
liability insurance, also known as errors and omissions liability insurance
("E&O"), which includes malpractice for law firms and health care providers. The
Company's insurance subsidiaries also offer a variety of other commercial
property-casualty products, including fidelity bonds and fiduciary liability
insurance to financial institutions and other entities, employment practices
liability insurance for entities and their employees, media liability coverage
to publishing and broadcasting businesses, as well as some ancillary general
liability coverage in connection with program administrator relationships. The
Company also writes personal automobile insurance written through a
California-based program administrator.
The Company has been and remains committed to diversifying its book of
business both within and outside the commercial liability arena. In 1996, for
example, the Company introduced a product for technology maintenance and repair
coverage for hospitals and clinics, as well as health care stop-loss
arrangements for medical professionals and medical malpractice liability
coverage for hospitals and other health care institutions. In 1997, the Company
entered the personal automobile insurance business on a limited basis, through a
California-based program. During 1998, the Company introduced its Fraud and
Abuse Liability Control policy (named the F.A.L.CON(sm) policy), which covers
medical organizations for certain costs associated with regulatory audits for
billing errors. Though the Company anticipates that the sale of domestic D&O and
E&O products will remain the principal sources of Company revenue for the
foreseeable future, it intends to supplement the revenues from such products
with other lines of property-casualty insurance in the United States, as well as
with increased writings of D&O and E&O in the European Community. There can be
no assurance, however, as to whether the Company will in fact enter into any
such new lines of insurance or, if it does, as to the timing thereof.
Both D&O and E&O are designed to protect insureds against lawsuits and
associated legal defense expenses. In connection with D&O coverage of for-profit
corporations, such liabilities can arise from claims by customers, vendors,
competitors and former employees, although the most severe liabilities have
historically arisen from lawsuits by stockholders alleging director or officer
failure to discharge duties to the corporation or violations of federal
securities laws. In the case of not-for-profit organizations, the Company's
coverage is often implicated in employment practices litigation. E&O is most
often sold to professionals, such as law firms, accounting firms, health care
organizations, psychologists, securities brokers, real estate agents and
insurance agents, among others, where the principal sources of potential claims
are dissatisfied clients alleging breaches of professional standards or ethical
violations.
Fiduciary liability coverages are intended primarily to protect those who
invest and administer benefit plan trusts, and fidelity insurance policies (or
crime coverage) insure against losses associated with employee theft and other
types of dishonesty. Employment practices liability insurance, which is
available to cover both the employing organization and its supervisors, insures
against losses associated with employee claims such as sexual harassment,
wrongful termination and discriminatory treatment. Non-standard automobile
insurance is offered to insureds in states, like California, where liability
insurance is required in order to register a vehicle. The Company's
non-liability related offerings are the Systems Rx(sm) policy, a service
contract and cost management product for owners of high-tech diagnostic
equipment and related health care technology, and
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providers' excess, which is a stop-loss policy for doctors enrolled in managed
care organizations that receive revenues for services under capitation, a method
which limits such revenues on a per patient basis.
The D&O Market. Under various state laws, corporations are authorized to
indemnify their directors and officers against legal claims arising in
connection with their work on behalf of the corporation. In order to attract and
retain qualified directors and officers, corporations purchase D&O, which
typically covers the corporate entity, but only to the extent that it
indemnifies officers and directors. D&O policies have traditionally also
contained a provision that covers officers and directors directly, in order to
insure against losses for which the corporation is legally or financially unable
to indemnify. In recent years, many D&O insurers, including the Company, have
begun to offer another form of coverage, so-called "entity coverage," which
protects the corporation for limited classes of legal liability, even when
directors and/or officers are not named as defendants in the claim.
The Company's holding company subsidiary, Executive Re Inc. ("Executive
Re"), was formed in late 1986, largely due to the then-existing shortage of D&O
capacity. Over the past decade, the D&O market has softened significantly, and
there has been continual downward pressure on premiums as competition has become
increasingly robust during the 1990s. Company management believes that a
relatively small number of U.S. insurers, together with Underwriters at Lloyd's,
London ("Lloyd's"), currently dominate the D&O market for larger and
medium-sized domestic corporations. Demand within that market should continue to
be impacted by consolidating sectors, such as financial services and technology,
as well as by statutory, regulatory and case law developments that affect
executive liabilities. The Company has identified opportunities for domestic
growth in D&O demand among non-bank financial institutions, corporations
contemplating initial public offerings, and small, privately-held commercial
entities. The Company also believes that certain foreign countries offer D&O
opportunity, particularly within the European Community, where
shareholder-initiated litigation is a relatively new, but growing, phenomenon
due principally to the increase in the trading of American Depository Receipts
("ADRs") on U.S. exchanges.
Historically, the single largest risk for which corporations purchased D&O
insurance coverage involved shareholder-based suits, either in the form of
derivative actions under state corporation laws or in the form of class actions
for securities fraud under Rule 10b-5 of the Securities and Exchange Commission
("SEC"), promulgated under the Securities Exchange Act of 1934. In December
1995, Congress passed the Private Securities Litigation Reform Act of 1995 (as
amended, the "PSLRA"), which has a number of provisions that affect the ability
of private litigants to prosecute securities fraud suits. That statute was
supplemented in 1998, largely to prevent the circumvention of its policies
through resort to state courts, in lieu of the Federal court system. The
Company's management believes that the effects of the PSLRA on the demand for
D&O and upon the frequency and severity of D&O claims have so far been
negligible, althought it does appear that some provisions of the Act are
effectively lengthening the time that securities class actions are open,
increasing the period from the time a D&O claim is made to the point at which
any payment is made thereunder. In terms of its effect on D&O demand, it may be
many years in the future before the actual impact of this legislation is known.
A number of commentators have identified D&O coverage as a line of
liability insurance that is particularly susceptible to claims made in
connection with the Year 2000 ("Y2K") issue. (See also, "The Year 2000" below.)
Most Americans are now aware of the fact that some computer systems may be
unable to properly recognize and process dates later than December 31, 1999, and
that resulting systems failures could cause losses and liability claims. Since
Y2K losses could in some cases be attributed to management negligence, a number
of analysts believe that the burden of dealing with Y2K-related claims could
fall disproportionately on D&O insurers. Conversely, others believe that Y2K
mismanagement claims will be difficult to prosecute successfully due to the
business judgment rule, a legal principle that protects the corporate
decision-making process. As of the date of this Report, the Company is not aware
of any significant Y2K-related claim under any of its D&O policies, nor does the
Company believe that the market for D&O insurance has been materially affected,
in terms of price or capacity, by the Y2K issue.
The E&O Market. The E&O insurance industry tends to be more fragmented and
regionalized than the D&O industry, since the risks underwritten vary
significantly depending on the nature of the profession and
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the geographic area in which it is practiced. Despite such fragmentation,
however, the E&O business is extremely competitive, and the Company's management
believes that success in E&O is particularly dependent on knowledgeable
underwriting and on well-conceived distribution and claims handling systems.
ERI's subsidiaries offer E&O coverage to a wide variety of professional classes,
with major classes that include: large and medium-size law firms, medium-size
accounting firms, psychologists, insurance agents, securities brokers, property
managers and home inspectors. In addition, E&O products are available to
financial institutions and health care organizations.
The Company
History. The Company's subsidiary, Executive Re, was formed in 1986 by The
Aetna Casualty and Surety Company ("Aetna," now a subsidiary of Travelers
Property Casualty Corp.) and certain other institutional investors to capitalize
on the deficiency of insuring capacity which then existed in the D&O industry.
It commenced operations in 1987. During its first five years, Executive Re
established an underwriting and marketing infrastructure for the provision of
D&O coverage through an insurance facility (the "Facility") with Aetna.
Executive Risk Management Associates ("ERMA"), a Connecticut general partnership
initially owned 30% by Executive Re and 70% by Aetna, was formed to market and
underwrite D&O insurance policies. Executive Risk Indemnity Inc. ("ERII"), a
Delaware insurance company, was acquired to reinsure D&O policies for which
Aetna was the direct insurer. In 1991, Executive Re took steps to expand
domestically into E&O markets on a niche basis, and in 1993, began its overseas
marketing efforts through a joint venture known as UAP Executive Partners
("UPEX"), owned 50% by the Company and 50% by Union des Assurance de
Paris -- Incendie Accidents, a large French insurance company. UPEX was
dissolved as of December 31, 1997, and the Company now utilizes the ERNV
subsidiary for access to the European markets (see below). The Company also
formed a Bermuda-domiciled subsidiary, Executive Risk (Bermuda) Ltd. ("ERBL"),
in 1997 principally to reinsure a portion of its domestic business.
Ownership and Structure. ERI was formed in August 1993 in anticipation of
a reorganization transaction (the "1994 Transaction"), consummated on January 1,
1994. As a result of the 1994 Transaction, ERI now owns Executive Re, and
together the two own 100% of ERMA. The Company is the indirect holding company
of the Executive Re subsidiaries, which now include ERII, as well as ERII's
Connecticut domiciled insurance company subsidiaries, Executive Risk Specialty
Insurance Company ("ERSIC") and Quadrant Indemnity Company ("Quadrant"). ERII,
ERSIC and Quadrant are referred to herein as the "Insurance Subsidiaries."
Further, the 1994 Transaction modified the Facility, permitting the Insurance
Subsidiaries to underwrite D&O insurance directly. With the completion of the
1994 Transaction and ERI's initial public stock offering in March 1994, the
Company became a publicly-owned insurance holding company, with Aetna owning
approximately 4.5 million shares of ERI and an option to purchase 100,000 shares
at a price of $12.00 per share (the "Aetna Option").
In March 1996, the Company entered into a Stock Purchase Agreement (the
"Stock Purchase Agreement") with Aetna and its then-parent, Aetna Life and
Casualty Company ("AL&C"). On March 26, 1996 (the "Repurchase Closing Date"),
the Company purchased back from Aetna approximately 2.5 million shares of ERI
capital stock at a price of $29.875 per share, or approximately $75 million in
the aggregate. For approximately two and a half months following the Repurchase
Closing Date, AL&C continued to own 2,000,000 shares of ERI Common Stock,
representing approximately 22% of the then issued and outstanding amount. In
accordance with the Stock Purchase Agreement, the Company registered for public
sale all of AL&C's remaining shares of ERI. In connection with this secondary
offering, the Company also registered 300,000 newly issued shares. The
underwritten public offering closed on June 7, 1996, on which date the 2,300,000
shares were sold at the price of $34.00 per share. With the completion of such
secondary offering, neither Aetna nor AL&C had any remaining ownership interest
in the Company, other than the Aetna Option. Aetna exercised the Aetna Option in
full on March 22, 1999.
The 1997 Facility Restructuring. Until early 1997, D&O business was
primarily conducted through the Facility, consisting of Aetna, ERII and ERSIC,
each of which acted as an insurer or reinsurer, and ERMA, which acted as the
product developer, marketer and managing underwriter. ERMA underwrote and
issued, on behalf of its affiliates and Aetna, policies of D&O insurance,
financial institution trust department errors and
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omissions insurance ("Trust E&O"), and certain other insurance ("Other Lines";
collectively with D&O and Trust E&O, the "Aetna Lines"), all in accordance with
prescribed underwriting guidelines and within defined liability limits. Under
this arrangement, ERMA had the exclusive right and authority to issue D&O
insurance on behalf of Aetna in North America. On February 13, 1997, the Company
announced a restructuring (the "Restructuring") of its relationship with Aetna.
In connection with the Restructuring, the pre-restructuring agreements were
terminated and replaced with the following agreements: (a) a Restructuring
Agreement, dated February 13, 1997 (the "Restructuring Agreement"), by and among
the Company, and its subsidiaries, Executive Re, ERII, ERSIC and ERMA
(collectively, the "Subsidiaries"), and Aetna and its subsidiary, Aetna Casualty
& Surety Company of Canada; (b) an Agency and Insurance Services Agreement,
dated as of January 1, 1997, between Aetna and ERMA (the "1997 Agency
Agreement"); and (c) a Quota Share Reinsurance Agreement, dated as of January 1,
1997, between Aetna and ERII (the "1997 Reinsurance Agreement"). Pursuant to the
1997 Agency Agreement, ERMA retains the right and authority, on a non-exclusive
basis, to (i) renew on Aetna policies all insurance of Aetna Lines written or
quoted prior to February 13, 1997, and (ii) underwrite and issue new policies of
Aetna D&O in the United States in accordance with existing underwriting
guidelines and specified limitations on limits of liability. The 1997 Agency
Agreement provides that annual gross premium volume written by ERMA with respect
to Aetna Lines must not exceed an aggregate amount equal to the lesser of (x)
10% of the sum of the Company's total direct gross D&O premiums plus the total
direct gross D&O premiums written by ERMA on Aetna policies under the 1997
Agency Agreement and (y) $25 million.
The amount of premium written with respect to Aetna policies during 1997
and 1998 has been immaterial, and the Company currently expects that it will
underwrite and issue Aetna policies aggregating much lower premium volumes than
the maximums permitted under the 1997 Agency Agreement. Unless terminated sooner
in accordance with its terms, the 1997 Agency Agreement will remain in effect
through December 31, 1999.
The Chubb Corporation. On February 8, 1999, the Company announced that it
had entered into an Agreement and Plan of Merger, dated as of February 6, 1999
(the "Merger Agreement"), among the Company, The Chubb Corporation ("Chubb") and
Excalibur Acquisition, Inc. The Merger Agreement calls for the merger of the
Company with Excalibur Acquisition, Inc., a Chubb subsidiary, with the effect
that following the proposed merger the Company would be a wholly-owned
subsidiary of Chubb. The completion of the merger is subject to customary
closing conditions, including a vote of the Company's stockholders and to
approval by insurance regulators in the States of Connecticut and Delaware, and
may be subject to additional state regulatory approvals. It is also subject to
clearance from the Federal Trade Commission under the Hart-Scott-Rodino
Antitrust Improvements Act of 1976. The Company filed a Current Report with the
SEC on Form 8-K, dated February 9, 1999, in which further information concerning
the proposed merger with Chubb is contained. Approval of the proposed merger by
the Company's stockholders will be solicited only by means of a proxy statement
to be mailed to all stockholders.
Markets
Directors & Officers Insurance. ERI's strategy continues to focus on
finding profitable niche opportunities, applying product-development skills and
industry knowledge to specific industry groups and market segments. In addition
to international D&O, which is now underwritten through ERNV, the Company's
domestic insurance subsidiaries market D&O products in the following principal
sectors: Commercial Entities, Financial Institutions, Health Care Entities and
Not-for-Profit Organizations. Based on surveys of the D&O industry conducted by
Watson Wyatt Worldwide, ERI's management believes that the Company is among the
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leading primary D&O writers in the United States. The following table shows the
gross D&O premiums written for each of these sectors for the periods indicated:
GROSS DOMESTIC D&O PREMIUMS WRITTEN
SECTOR YEAR ENDED DECEMBER 31,
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1998 1997 1996
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(IN THOUSANDS)
Commercial Entities................................ $134,994 $140,831 $135,418
Financial Institutions............................. 46,743 55,006 52,579
Health Care Entities............................... 47,868 50,419 36,123
Not-for-Profit Organizations....................... 32,180 28,842 16,714
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Total.................................... $261,785 $275,098 $240,834
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Within each of the principal D&O sectors, ERI has targeted subsectors and
developed specialized expertise, a strategy that management believes has allowed
ERMA and the Insurance Subsidiaries to develop and adapt their insurance
products more knowledgeably and to underwrite submissions and process claims
more professionally than competing companies. Management also believes that such
expertise, together with a strong reputation for prompt service and responsive
claims handling, alleviates some of the pressure to compete on the basis of
price during a "soft market," such as that which has prevailed within the
industry in recent years. (See "Competition.")
The Commercial Entities sector has traditionally focused on publicly owned,
mid-sized companies, but a number of ancillary products have also emerged out of
this sector. ERI has provided secondary layers of insurance (called "excess
insurance") for larger public companies which purchase primary D&O coverage from
other insurers. Excess insurance covers large losses above the policy limit(s)
of the primary insurance and any lower layer excess policies. During 1997, the
Company introduced a new excess insurance product, known as the Flex(sm) policy,
which is designed to be layered above multiple primary policies covering diverse
liability risks. Also, in 1993 the Company began to focus on coverages for small
commercial entities (assets under $100 million), and a product (The Power(sm)
policy) specifically designed for the small, non-public commercial entity was
introduced by the Company in late 1995. Another new commercial product created
during 1997 targets private companies about to engage in an initial public
offering.
Within the Financial Institutions sector, the Company maintains
specializations in several sub-sectors, such as community banks (including small
depository institutions with under $250 million in assets), large depository
institutions, investment advisors, mutual fund companies and broker-dealers. The
underwriting of these D&O products is closely aligned with the underwriting of
professional liability, fiduciary and related coverages for providers of
financial services, all of which are encompassed within a single practice area.
The remaining sectors, Health Care Entities and Not-for-Profit Organizations,
include primarily nonprofit hospitals, managed care organizations ("MCOs") and a
wide variety of social service/charitable organizations (such as foundations,
chambers of commerce, etc.).
Errors & Omissions Insurance. Like D&O, the Company's underwriting for E&O
business is divided along market lines. A major portion of the E&O premium is
generated within the Professional Firms unit, including the Lawyers Professional
Liability ("LPL"), Employed Lawyers Professional Liability ("ELPL" for in-house
counsel), and Accountants Professional Liability ("APL") product lines, and the
Professional Services unit, encompassing a wide array of other professionals
such as insurance agents, real estate professionals and home inspectors.
Additional E&O business is written through the Health Care unit, which offers
medical malpractice for hospitals and E&O for MCOs, and through the Financial
Institutions unit, which offers coverage for investment companies and
professionals. The Professional Firms unit's LPL policies are underwritten by
Company-employed professionals, most of whom have some large law firm
experience. Policies for hospitals and MCOs are underwritten by Company staff at
the Company's headquarters in Connecticut, as well as through the ERMA office in
Pasadena which is devoted to malpractice for hospitals and other health care
institutions. A growing percentage of Company E&O coverage is being written
through outside brokerage firms, known as program administrators, which have
experience and expertise with respect to a specific class of risk and with which
the Company has entered into written contractual agreements.
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Following a research and development program, the Company formed the LPL
underwriting group in 1993. Using only attorney-underwriters, this group
initially underwrote E&O only for large law firms (generally those with at least
35 lawyers) on a primary or excess coverage basis. The LPL unit has evolved to
become a Professional Firms unit, the staff of which also underwrites risks for
medium size law firms as well as medium size accounting firms. The Company
believes that the use of experienced professionals (including lawyers and
accountants as applicable) in the marketing and underwriting process has proven
to be a successful tactic for approaching firms in the target market. A
reinsurance program, involving a number of domestic and international
reinsurance markets, has been in effect for several years, allowing the Company
to market LPL policies up to limits of $50 million each loss and $100 million in
the aggregate. (See "Reinsurance.")
The Company's combined D&O and E&O product for health care entities was
introduced in 1996 in recognition of the evolving liability profile of hospital
and MCO managements. In September 1997, the Company acquired the assets of
Sullivan Kelly & Associates, Inc., Insurance Brokers, a writer of malpractice
coverage for health care entities, for $2.3 million in cash, and infused them
into a California subsidiary, Sullivan Kelly Inc. With its principal offices in
Pasadena, and satellite branches in Dallas and Phoenix, Sullivan Kelly Inc. has
aided the Company's entry into the institutional medical malpractice market.
During the latter part of 1998 the Company closed the brokerage operation of
Sullivan Kelly Inc., leaving the institutional malpractice underwriting
operation which has become ERMA's Pasadena office.
Program administration involves contracting with third party producers who,
with special expertise in a specific class of E&O risk, agree to underwrite and,
in most cases, to issue Insurance Subsidiary policies, all within carefully
defined parameters. Plans to increase the Company's distribution capabilities
through the use of program administrators have been and remain a priority for
the Company, with the anticipation that program administrator relationships
could evolve into a significant distribution methodology for the Company's E&O
products. (See "Marketing.")
International. In December 1997, the Company announced that the UPEX joint
venture, which had been formed in 1993, would terminate as of December 31, 1997.
In connection with the termination, the former joint venture partner has paid to
the Company the amount of $0.7 million, and the Company agreed not to solicit
certain UPEX insureds for a period of one year. The UPEX facility had been
formed to write only D&O in Europe, and during 1997 gross written premiums by
UPEX totaled $21.3 million, in which the Company had a 50% participation.
The Company continues to serve the European market through policies
underwritten and issued by ERNV. The Dutch subsidiary was founded in 1995. In
February 1998, the Company restructured ERNV, through the formation of a
Netherlands insurance holding company, Executive Risk International Holdings BV
("ERBV"), to take ownership of ERNV. ERBV was capitalized in February 1998
through a $6.0 million investment of equity capital and a $34.0 million loan
from Executive Re, which total of $40 million was in turn contributed to ERNV.
In addition, the Company applied for and obtained a group rating for ERNV from
A.M. Best and Company Inc. ("Best's") and Standard & Poor's ("S&P"), thereby
extending to ERNV the benefit of the Insurance Subsidiaries' "A (Excellent)"
Best's rating and "A+" S&P rating. With the new capital and surplus and
above-referenced ratings, the Company believes that ERNV is positioned to
compete for liability insurance business within the European Community. Offices
are now open in London and Rotterdam, the former Paris office having closed in
mid-1998. The re-positioning of ERNV as the Company's outlet in Europe is
intended to confer several long-term strategic benefits, including the ability
to sell E&O, as well as D&O, products which had not been permitted by the UPEX
structure. However, ERNV had 1998 gross written premiums of $8.1 million, down
substantially from the $21 million written through UPEX during 1997. Upon the
closing of the Company's announced merger with Chubb, it is likely that
international business will be conducted through a Chubb subsidiary, rather than
through ERNV.
Marketing
The Company's products are distributed principally through licensed
independent property and casualty brokers, excess and surplus lines brokers and
licensed wholesalers. In all, Company policies are produced
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through several thousand brokers, although a number of national/regional
commercial brokerage houses predominate. In recent years, there have been
several mergers involving large, national insurance firms, and distribution
within certain segments of the Company's business has become more concentrated
as a result of such consolidation. (See footnote 7 to the Company's 1998
financial statements, pages F-1 et. seq.) Nonetheless, no single office of any
broker accounted for a significant portion of the gross premiums written through
ERMA.
Before 1997, the Company serviced domestic brokers only from its Simsbury,
Connecticut headquarters and from a small, healthcare-oriented branch office in
Lisle, Illinois, a suburb of Chicago. Beginning in 1997, however, the Company
commenced its National Sales Office distribution plan, calling for the opening
of small (2-4 person) branch offices. As of early 1999, branch sales offices
existed in Atlanta, Chicago (downtown), Dallas, Houston, New York, Phoenix and
San Francisco. There are no plans to add branch offices in other cities in the
short-term future. Together with ERNV's European offices and the underwriting
offices in Lisle and Pasadena, the Company has substantially increased its local
presence in geographic markets it considers important.
Marketing is conducted in a variety of ways, but is generally targeted at
the agent and broker audience. The Company produces a periodic newsletter which
contains articles of interest to the D&O and E&O industry and which is widely
distributed. Additionally, specific product areas publish newsletters with a
narrower focus which are targeted to insurance issues touching their respective
industries or professions. Advertisements, articles in trade publications,
seminar participations and convention sponsorships are among the other methods
used to market the Company's products. In certain lines of insurance,
arrangements with national industry groups or associations have been useful in
presenting the Company's products to targeted consumer markets. An in-house
Marketing/Communications staff produces (or oversees production of) all of the
Company's public relations materials. Recently, the marketing efforts have
focused on brand identification, seeking to strengthen the most positive
associations with the "Executive Risk" brand. The Company believes that these
efforts have resulted in widespread name recognition of the Company and its
products within target markets.
Beginning in 1995, the Company commenced a strategy to create relationships
with insurance agencies with national or regional books of E&O program business.
Under such a "program administration" relationship, the third party entity
becomes the Company's agent to underwrite and issue policies within guidelines
specified by the Company. Program administrators are typically not authorized to
handle or pay claims (other than certain low severity claims), and in no case
does a program administrator bind reinsurance. The Company conducts due
diligence procedures with respect to potential program administrators prior to
entering into such contractual relationships, and it exercises on-going audit
rights under the program administration agreements. As of the date of this
report, eleven program administration relationships were in effect, most of
which were for E&O products. Additional programs are actively being
investigated.
Underwriting
The Company's general underwriting philosophy stresses two factors: expert
consideration of complex insurance submissions, and profitability over premium
growth. Accordingly, while the Company seeks to be competitive within its
markets, premiums are based primarily upon specific risk exposure, including
loss experience, rather than primarily upon market factors. The table below sets
forth statutory loss ratios and combined ratios for the periods indicated for
the Insurance Subsidiaries and the property/casualty industry.
7
10
The Insurance Subsidiaries' specialty products business is not directly
comparable to the business of the property-casualty industry as a whole.
YEAR ENDED DECEMBER 31,
---------------------------------------------
1998 1997 1996 1995 1994
----- ------ ------ ------ ------
STATUTORY ACCOUNTING
PRACTICES DATA
- -------------------------------------
Insurance Subsidiaries
Loss Ratio......................... 66.0% 67.1% 67.6% 67.4% 67.6%
Combined Ratio..................... 94.9% 95.2% 92.7% 90.7% 97.6%
Industry(1)
Loss Ratio......................... * 72.8% 78.3% 78.9% 81.1%
Combined Ratio(2).................. * 99.9% 105.9% 105.0% 107.2%
- ---------------
* Not available
(1) Source: Best's Aggregates & Averages -- Property-Casualty.
(2) Excludes policyholder dividends.
The Company emphasizes industry specialization within its underwriting
staff, which includes a number of professionals with operational experience from
the industries being underwritten. ERMA's underwriters are under the supervision
of John F. Kearney, who has been with the Company since 1987, and who is
currently Senior Vice President and Chief Underwriting Officer of ERMA and the
Insurance Subsidiaries. In addition to consulting with members of the
underwriting management team, underwriters regularly consult with members of the
Company's actuarial, claims and legal departments, as they analyze various
aspects of a prospective insured's risk profile. Except with respect to the
Company's higher volume, lower risk not-for-profit business (not including
hospitals, where a Company-developed ratings system is utilized), submissions
for D&O policies and for most E&O policies are underwritten on a risk-by-risk
basis. Insurance policies written through program administrators are not
individually underwritten at the Company.
A large portion of the Company's policies have a one-year term, though the
number of multi-year policies has been growing in recent years. One-year terms
offer the insurer the advantage of re-underwriting and repricing a risk, to take
more frequent account of claims or other changes in the exposure. Multi-year
terms are offered in several situations, the most common being "run-off"
insurance coverage which is often purchased to protect the directors and
officers of an acquired corporation during the three to six year period
following a merger or acquisition. Most submissions for renewal of an expiring
policy are re-underwritten and re-priced in accordance with the standard
underwriting practices and procedures, which generally do not distinguish
between new and renewal policies.
In all aspects of its operations, and particularly in the underwriting
process, the Company relies heavily on advanced computer technology, including
both purchased and proprietary software. By utilizing down-loaded and on-line
data from government and commercial resources, sophisticated financial modeling
tasks can be performed. Such utilization of technology provides the Company with
what it believes to be a competitive advantage in information-intensive industry
segments, such as banking and large commercial accounts. For not-for-profit D&O
and E&O business lines, the use of technology focuses primarily on maximizing
efficiencies in submissions handling and response.
Claims
Claims arising under insurance policies underwritten by the Company have
historically been managed by the Company's Claims department, and that remains
true of the large majority of claims. More recently, a relatively small number
of low severity claims in connection with some of the Company's program business
is handled by the program administrator or its third party administrator. The
Company's claims personnel are assigned to handle claims based, in part, on
industry specialization. To assist its staff in claims management, the Company
has developed a comprehensive automated electronic claim file system (the
"Claims Informa-
8
11
tion System") for administering and investigating claims, and calculating and
updating case reserves. When the Company receives notice of a loss or potential
loss, a claims handler is assigned to the claim and a claim file is created in
the Claims Information System. This system electronically attaches a copy of the
policy file to the claim file and can also help determine whether there are
obvious claim issues, such as a claim being made outside the policy period. The
Claims Information System automatically composes certain routine correspondence
to the insured. All outgoing correspondence, reports from monitoring counsel and
other relevant data are entered in the Claims Information System claim file.
The Claims Information System, utilizing staff-entered severity code
information relating to various claim characteristics, helps to ensure
objectivity, and consequently consistency, of claims evaluation. The severity
classification assigned to a particular claim assists in determining the
frequency and manner in which the claim is administered. All significant claims
are reviewed at least quarterly. Claims assigned a high severity code are
monitored more frequently and are typically assigned to outside legal counsel
for review and monitoring. Executive Risk's insurance policies have not
historically contained a "duty to defend" provision requiring that the Company
itself hire the attorneys to defend its insureds. However, as the Company
diversifies its policy offerings, duty to defend types of policies are becoming
an increasingly important part of the Company's product mix. Even where there is
no duty to defend, the Company does in certain instances become closely involved
with defense counsel in evaluating claims and developing litigation management
and settlement strategies. Such involvement may be direct by in-house claims
personnel, or it may be provided by outside monitoring counsel retained by the
Company for more severe exposures. The Company believes that its experience in
resolving claims and its proactive approach to claims management have
contributed to the advantageous resolution of many cases.
Based in part on the claims severity code and other factors developed by
the claims handler (assisted by the Claims Information System), the Claims
department recommends a case reserve for each claim. As more information is
discovered with respect to a claim, the claims handler may recommend an increase
or decrease in case reserves. The Company believes that the claims analysis
permitted by the Claims Information System helps the Company to evaluate claims
and make informed judgments with respect to case reserves promptly. (See
"Reserves.")
Reinsurance
The Company has historically used reinsurance arrangements to limit the
amount of risk retained under policies written or reinsured by the Insurance
Subsidiaries. In general, the Company will more heavily reinsure (i.e., retain
less net risk with respect to) new lines or market segments, until claims and
loss assumptions for the product can be validated. It is expected that, as
product lines become more mature, the Company will retain a greater share of the
loss exposure and the premium.
From 1995 through 1998, with respect to public commercial, financial
institution, healthcare D&O (which comprised the majority of the risks insured
by the Company), ERI purchased excess-of-loss reinsurance coverage which
provided 100% reinsurance protection (subject to aggregate limits and other
restrictions) on losses incurred in excess of $2.5 million up to a limit of $10
million. The Company also purchased a quota share reinsurance treaty for these
lines of business, covering 90% of losses in excess of $10 million up to $35
million, and covering 95% of losses in excess of $35 million up to $50 million
from and after April 1, 1998, subject in both cases to certain limitations. With
respect to the LPL product (which, by its nature, has carried the highest policy
limits offered by the Company -- i.e., $50 million), prior to January 1, 1999,
the Company purchased a combination quota share and excess-of-loss reinsurance
program under which the Company retained more of the risk insured on lower-limit
policies, and ceded more of the risk insured on higher limit policies. Under
this reinsurance program, the Company's exposure on an LPL policy with a maximum
limit of $50 million was slightly less than $5 million.
During the first quarter of 1999, the Company restructured several of its
reinsurance programs. With respect to certain lines of business that generally
carry higher policy limits, such as public commercial, financial institution and
healthcare D&O, the Company purchased excess of loss reinsurance which provides
100% reinsurance protection on losses incurred in excess of $500,000 up to a
limit of $10 million. The
9
12
Company also purchased quota share reinsurance for these lines of business,
covering 90% of losses in excess of $10 million up to $20 million, and covering
95% of losses in excess of $20 million up to $50 million.
With respect to certain other "higher limit" lines of business, such as LPL
and Employment Practices Liability ("EPL"), the Company purchased excess of loss
reinsurance which provides 100% reinsurance protection on losses incurred in
excess of $500,000 up to a limit of $5 million. The Company also purchased a
quota share reinsurance treaty for these lines of business, covering 95% of
losses in excess of $5 million up to $50 million.
The Company did not restructure all of its reinsurance programs. For lines
of business that generally carry smaller limits of liability, such as private
commercial and non-profit D&O, insurance agents and brokers E&O, the Company has
retained existing reinsurance programs that provide 100% reinsurance protection
on losses incurred in excess of: (a) $250,000 for larger miscellaneous
professional liability ("MPL") and insurance agents E&O business, (b) $100,000
for private commercial D&O and smaller MPL and insurance agents E&O business,
and (c) $50,000 for non-profit D&O. With respect to Hospital Professional
Liability, the Company continues to purchase quota share reinsurance covering
80% of losses up to $2 million, and 90% of losses in excess of $2 million up to
$50 million.
Reserves
The Company is liable for losses and loss adjustment expenses ("LAE") under
its insurance policies and reinsurance treaties. Both D&O and E&O policies are
generally written on a "claims made" form. In general, a claims made policy
provides for payment with respect to any claim made against the insured during
the policy period with respect to a covered act. In many cases, several years
may elapse between the reporting of the claim or covered act to the Company and
the Company's payment on a related loss. The Company reflects its liability for
the ultimate payment of incurred losses and LAE by establishing loss and LAE
reserves, which are balance sheet liabilities representing estimates of future
amounts needed to pay claims and related expenses with respect to insured events
that have occurred.
The Company maintains two classes of reserves. When a claim is reported,
the Company establishes an initial case reserve for the estimated amount of the
Company's ultimate losses and LAE. This estimate reflects a judgment, based on
the Company's reserving practices and the experience of the Company's claims
staff, regarding the nature and value of the reported claim. The Company may
periodically adjust the amount of case reserves as additional information
becomes known or partial payments are made. The Company also establishes
incurred but not reported reserves ("IBNR reserves") on an aggregate basis to
provide for future developments on case reserves, as well as for claims reported
to the insured or to the Company but not yet recorded by the Company. IBNR
reserves are established based on the experience of the Company and the
insurance industry generally with respect to the average frequency and severity
of insured events.
Reserves are estimates involving actuarial and statistical projections of
the cost of the ultimate settlement and administration of claims, based on known
facts and circumstances, predictions of future events, estimates of future
trends in claims severity and other variable factors such as inflation and new
concepts of liability. It may be necessary in the future to revise estimated
potential loss exposure, and therefore the Company's loss reserves. During the
claim settlement period, which may be years in duration, additional facts
regarding claims and trends may become known. As the Company becomes aware of
new information, it may refine and adjust its estimates of its ultimate
liability. The revised estimates of ultimate liability may prove to be less than
or greater than the actual settlement or award amount for which the claim is
finally discharged. As a consequence, actual losses and LAE paid may deviate,
perhaps substantially, from estimates reflected in the Company's reserves in its
financial statements.
The Company's Insurance Subsidiaries, like other insurance companies, are
subject to the risk of severe or multiple losses, which could significantly
exceed the maximum loss previously assumed. To the extent reserves prove to be
inadequate after taking into account available reinsurance coverage, the Company
augments its reserves, resulting in a current-year charge to earnings. In
addition, loss reserves may prove to be inadequate in the event that a major
part of the Company's reinsurance coverage was to become uncollectible.
Since 1988, the Company has retained the services of an independent
actuarial consulting firm to provide opinions regarding reserves as required for
state regulatory filings. Although the Company believes that its
10
13
reserves are adequate, there can be no assurance that ultimate loss experience
will not exceed the Company's reserves, which may result in a material adverse
effect on the Company's financial condition and results of operations. The
following table sets forth a reconciliation of beginning and ending reserves for
unpaid losses and LAE, net of reserves for reinsured losses and LAE, for the
years indicated.
YEAR ENDED DECEMBER 31,
---------------------------------
1998 1997 1996
--------- -------- --------
(IN THOUSANDS)
Reserves for losses and LAE at beginning of year, gross... $ 637,929 $457,063 $324,416
Reinsurance recoverable at beginning of year.............. (157,166) (76,916) (33,531)
--------- -------- --------
Reserves for losses and LAE at beginning of year, net..... 480,763 380,147 290,885
Provision for losses and LAE for current year claims...... 185,214 152,042 112,107
Decrease in estimated ultimate losses and LAE for prior
year claims............................................. (17,268) (10,269) (6,772)
--------- -------- --------
Total incurred losses and LAE............................. 167,946 141,773 105,335
Adjustment for foreign exchange loss on unpaid loss and
LAE..................................................... 255 (469) (23)
Loss and LAE payments for claims attributable to:
Current year............................................ 16,705 4,495 2,239
Prior years............................................. 56,292 36,193 13,811
--------- -------- --------
Total payments............................................ 72,997 40,688 16,050
--------- -------- --------
Reserves for losses and LAE at end of year, net........... 575,967 480,673 380,147
Reinsurance recoverable at end of year.................... 290,318 157,166 76,916
--------- -------- --------
Reserves for losses and LAE at end of year, gross.... $ 866,285 $637,929 $457,063
========= ======== ========
As shown above, as a result of 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 1998 for prior
report years by approximately $17.3 million. The Company does not consider
reserve reductions to represent a trend, and there can be no assurance
concerning future adjustments of reserves, positive or negative, for prior
years' claims. The procedures used in determining appropriate reserves at
December 31, 1998 were consistent with prior years' reserving methodologies.
Except for the last seven lines, the following "Development of Reserves"
table presents the development of unpaid loss and LAE reserves, net of
reinsurance, from 1988 through 1998. The last seven lines of the table present
that type of development on a "gross-of-reinsurance" basis for the periods
following the Company's adoption of Statement of Financial Standards No. 113,
"Accounting and Reporting For Reinsurance of Short-Duration and Long-Duration
Contracts," as of January 1, 1993. The top line of the table shows the reserves
for unpaid losses and LAE, net of reinsurance recoverables on unpaid claims, at
the end of each of the indicated years. That net reserve represents the amount
of unpaid losses and LAE for claims arising in the current year and all prior
years that were unpaid at the balance sheet date, including IBNR reserves. The
upper portion of the table also shows the re-estimated amount of the previously
recorded reserves based on experience as of the end of each succeeding year. The
estimate changes as more information becomes known about the frequency and
severity of claims for individual years.
11
14
DEVELOPMENT OF RESERVES
(DOLLARS IN THOUSANDS)
YEAR ENDED DECEMBER 31,
-----------------------------------------------------------------------------------
1988 1989 1990 1991 1992 1993 1994 1995
------- ------- -------- -------- -------- -------- -------- --------
Reserves for losses and
LAE, net............. $43,273 $76,277 $111,987 $157,131 $188,438 $209,098 $245,800 $290,885
Reserves re-estimated
as of end of year:
1 year later....... 42,140 74,787 112,710 156,773 185,391 204,965 240,555 284,113
2 years later...... 38,653 70,708 112,333 153,726 181,258 199,720 233,783 274,017
3 years later...... 23,846 56,919 111,178 149,593 176,013 192,948 223,687 257,010
4 years later...... 10,057 55,764 110,597 144,348 169,241 182,852 206,680
5 years later...... 8,899 55,183 105,352 137,576 159,145 165,845
6 years later...... 8,916 49,938 100,368 127,480 151,152
7 years later...... 8,916 49,236 94,269 120,487
8 years later...... 8,916 47,903 88,776
9 years later...... 7,583 45,228
10 years later..... 4,908
Cumulative redundancy
(deficiency)......... $38,365 $31,049 $ 23,211 $ 36,644 $ 37,286 $ 43,253 $ 39,120 $ 33,875
Cumulative paid as of:
1 year later....... $ 50 $ 1,088 $ 9,491 $ 20,075 $ 25,838 $ 26,909 $ 32,711 $ 13,811
2 years later...... 449 4,815 26,321 44,814 47,270 56,823 42,851 41,484
3 years later...... 1,936 17,977 44,759 61,562 73,100 59,760 63,386 53,941
4 years later...... 2,072 26,483 56,572 78,916 75,751 73,053 73,323
5 years later...... 2,134 31,157 68,277 79,675 88,198 78,437
6 years later...... 4,421 38,435 68,671 84,507 89,297
7 years later...... 4,426 38,477 73,558 84,900
8 years later...... 4,441 38,749 73,919
9 years later...... 4,920 38,761
10 years later..... 4,908
Net reserve --
December 31.......... $209,098 $245,800 $290,885
Reinsurance
recoverables......... 6,053 8,958 33,531
-------- -------- --------
Gross reserve --
December 31.......... $215,151 $254,758 $324,416
======== ======== ========
Net re-estimated
reserve.............. 182,852 223,687 274,017
Re-estimated
reinsurance
recoverables......... 2,035 8,665 32,852
-------- -------- --------
Gross re-estimated
reserve.............. 184,887 232,352 306,869
======== ======== ========
Gross cumulative
redundancy........... $ 30,264 $ 22,406 $ 17,547
======== ======== ========
YEAR ENDED DECEMBER 31,
------------------------------
1996 1997 1998
-------- -------- --------
Reserves for losses and
LAE, net............. $380,147 $480,763 $575,967
Reserves re-estimated
as of end of year:
1 year later....... 369,878 463,963
2 years later...... 352,818
3 years later......
4 years later......
5 years later......
6 years later......
7 years later......
8 years later......
9 years later......
10 years later.....
Cumulative redundancy
(deficiency)......... $ 27,329 $ 16,800
Cumulative paid as of:
1 year later....... $ 36,194 $ 56,292
2 years later...... 60,763
3 years later......
4 years later......
5 years later......
6 years later......
7 years later......
8 years later......
9 years later......
10 years later.....
Net reserve --
December 31.......... $380,147 $480,763 $575,967
Reinsurance
recoverables......... 76,916 157,166 290,318
-------- -------- --------
Gross reserve --
December 31.......... $457,063 $637,929 $866,285
======== ======== ========
Net re-estimated
reserve.............. 369,878 463,963
Re-estimated
reinsurance
recoverables......... 76,136 178,411
-------- --------
Gross re-estimated
reserve.............. 446,014 642,374
======== ========
Gross cumulative
redundancy........... $ 11,049 $ (4,445)
======== ========
In the Company's early years of operation, the Company had little or no
actual loss experience upon which to calculate reserves. As a result, its
reserving methodologies were based largely on industry data. In recent years,
the Company has developed reserves based upon its own loss experience. While the
Company believes it is now better able to estimate future losses and reserves
than in its early years of operations, there can be no assurance that the
Company's reserves will be sufficient to cover ultimate losses.
12
15
Investments
The Company's investment philosophy is to seek optimum total return. This
is done in a manner consistent with what management believes is a generally
conservative investment approach, as evidenced by the portfolio's quality
characteristics, liquidity and diversification. The Company has established
investment guidelines and policies and oversees management of the investment
portfolio through the Finance Committee of the Company's Board of Directors.
Investment policies are approved by its Board of Directors or Finance Committee.
All investments are reviewed periodically by the Finance Committee, and
exceptional investment decisions are submitted for advance approval. In addition
to the specifications in the investment policy statements, all investments of
the Insurance Subsidiaries must meet the applicable state statutory
requirements.
The Company's investment policies specify limitations as to type of
investment and exposure to single issuers. Investments currently consist
principally of U.S. Government and agency securities, corporate and municipal
obligations, mortgage-backed and asset-backed securities, partnership interests,
preferred stocks and common equities (including mutual fund shares). At December
31, 1998, the Company had only one direct investment in a commercial real estate
mortgage, in the amount of $2.9 million, and no investment in equity real estate
other than its headquarters building in Simsbury, Connecticut. Investments in
securities backed by the full faith and credit of the U.S. Government and U.S.
Government agencies may be made without limitation. Additionally, the current
Board of Directors guidelines permit 5% of the Company's invested assets to be
in the form of non-investment grade fixed income securities. At December 31,
1998, approximately 1% of the Company's investment portfolio was allocated to
below investment grade bonds.
The following table summarizes the investment portfolio of the Company, by
asset class, as of December 31, 1998.
DECEMBER 31, 1998
--------------------------------------
FAIR VALUE COST(1) PERCENT(2)
---------- ---------- ----------
(DOLLARS IN THOUSANDS)
U.S. Treasury or agency securities.............. $ 23,155 $ 22,677 1.9%
Municipal securities............................ 733,884 703,712 58.7%
Corporate fixed income securities............... 158,987 157,583 12.7%
Mortgage and other asset backed securities...... 139,933 140,203 11.2%
Foreign government securities................... 16,587 16,085 1.3%
Foreign corporate securities.................... 32,247 31,873 2.6%
Sinking fund preferred stocks................... 31,582 30,611 2.5%
---------- ---------- -----
Total fixed maturities................ 1,136,375 1,102,744 90.9%
Equity securities............................... 79,187 50,103 6.3%
Short-term investments and cash................. 34,312 34,312 2.8%
---------- ---------- -----
Total investments and cash............ $1,249,874 $1,187,159 100.0%
========== ========== =====
- ---------------
(1) Amortized cost for fixed maturities and short-term investments.
(2) Percent of total portfolio, based on fair value.
Except with respect to the 5% allocation approved by the Finance Committee
of the Board of Directors, new investments in publicly-traded fixed income
securities, both short- and long-term, are restricted to issues that maintain a
quality rating equal or equivalent to BBB/Baa or better from S&P or Moody's
Investors Service, downgraded below this rating, the investment is not
necessarily sold immediately but is closely monitored for further deterioration
of credit quality and the need to write down the book value of the investment.
Private placements or other investments with lower ratings or investments not
rated by those agencies are permitted, if approved by the Finance Committee and
reported to the Board of Directors. Cash and publicly-traded fixed income
securities comprised 91.7% (based on fair value) of the total investment
portfolio as of December 31, 1998. At December 31, 1998, approximately 99% of
the Company's publicly-
13
16
traded bond portfolio was rated investment grade. The following table sets forth
the composition of the Company's publicly-traded fixed income securities, by
quality rating, as of December 31, 1998.
RATINGS DECEMBER 31,
(S&P/MOODY'S) 1998(1)
------------- ------------
AAA/Aaa................................................... 44.0%
AA/Aa..................................................... 26.5%
A/A....................................................... 21.3%
Other..................................................... 8.2%
-----
Total............................................. 100.0%
=====
- ---------------
(1) Based on fair value.
The National Association of Insurance Commissioners ("NAIC") has a fixed
income securities rating system that assigns to investment securities certain
ratings, called "NAIC designations," that are used by insurers when preparing
their annual statutory financial statements. The NAIC assigns designations to
publicly-traded and privately-placed securities. Designations assigned by the
NAIC range from 1 to 6, with 1 representing securities of the highest quality.
As of December 31, 1998, over ninety percent (based on amortized cost) of the
Insurance Subsidiaries' fixed income investment portfolio was invested in
securities rated 1 by the NAIC.
The investment portfolio is designed to provide sufficient liquidity to
enable the Company to satisfy its obligations on a timely basis. Although the
investment guidelines permit investments with a maturity range of up to 30
years, the Company generally invests in the five to fifteen year maturity range.
The following table indicates the composition of the Company's fixed maturity
investments, based on fair value, by time to maturity as of December 31, 1998.
TIME TO DECEMBER 31,
MATURITY 1998
-------- ------------
0 - 1 year.................................................. 3.7%
1 - 5 years................................................. 32.4%
5 - 10 years................................................ 37.6%
10 - 15 years............................................... 13.7%
15+ years................................................... 3.2%
Mortgage-backed securities.................................. 9.4%
-----
Total............................................. 100.0%
=====
The investment policies of the Company permit hedging activities to
mitigate losses associated with fluctuations in foreign currency. As of the date
hereof, the Company has no material foreign currency exposure. The Company's
investment in ERNV (see "International") is viewed as long-term and, as such, is
not hedged against fluctuations in the dollar value of the foreign currency.
Such funds are invested primarily in fixed income securities denominated in
pounds sterling. The Company, in conjunction with its asset managers, closely
monitors relevant foreign exchange market levels given their importance to the
investment performance of non-dollar denominated securities. The Company also
maintains, in twelve different European currencies, $5.5 million (as translated
to U.S. dollars) of reserves, which are not hedged against fluctuations in the
value of these currencies. The Company may determine at a future date to engage
in hedging transactions with respect to any foreign currency risk associated
with its international operations, including ERNV.
The Company's assets are invested, subject to the above mentioned statutory
constraints and guidelines, to maximize after-tax investment returns. The
Company attempts to optimize the blend of income from
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17
tax-exempt/taxable securities to achieve maximization of after-tax investment
income. The following table illustrates the breakdown of the portfolio between
taxable and tax-exempt securities as of December 31, 1998.
DECEMBER 31, 1998
--------------------------------
FAIR VALUE PERCENT
---------- -------
(DOLLARS IN MILLIONS)
Tax-exempt securities..................................... $ 732.1 58.6%
Taxable securities........................................ 517.8 41.4
-------- -----
Total........................................... $1,249.9 100.0%
======== =====
The Company's investments are managed by Conning Asset Management, Black
Rock Financial Management and Hyperion Capital Management. In addition, the
Company utilizes the investment management services of Vanguard Group. It is
likely that the Company's investments will be managed by Chubb shortly after the
closing of the merger.
Regulation
General. As insurance companies, ERII, ERSIC and Quadrant are subject to
supervision and regulation in the states in which they transact business. ERBL
and ERNV are regulated by the national insurance authorities in Bermuda and the
Netherlands, respectively, whose principal concern is financial condition. For
the domestic companies, such supervision and regulation, which is designed
primarily for the protection of policyholders and not shareholders, relates to
most aspects of an insurance company's business and includes such matters as
authorized lines of business; underwriting standards; financial condition
standards; licensing of insurers; investment standards; premium levels; policy
provisions; the filing of annual and other financial reports prepared on the
basis of Statutory Accounting Practices; the filing and form of actuarial
reports; the establishment and maintenance of reserves for unearned premiums,
losses and LAE; transactions with affiliates; dividends; changes in control; and
a variety of other financial and nonfinancial matters. Additionally, ERMA and
Sullivan Kelly are subject to supervision and regulation under state insurance
agency laws in the states in which each does business as an insurance agent.
Insurance regulatory authorities have broad administrative powers to regulate
trade practices and in that connection to restrict or rescind licenses to
transact business and to levy fines and monetary penalties against insurers and
insurance agents found to be in violation of applicable laws and regulations.
Licenses. The Company has obtained insurance company licenses for ERII in
all states other than Colorado, where an application is pending, and
Connecticut, where ERSIC is the licensed entity. ERSIC is licensed as an
insurance company in Connecticut, its state of domicile, and is an eligible
surplus lines insurer in all other states and the District of Columbia. Quadrant
is licensed in Connecticut, its state of domicile, and thirty-three additional
states. In a few states, the Company's ability to write insurance is limited to
its core liability lines, and the Company is seeking to expand its authority to
include all property/casualty lines in such states. Future flexibility with
respect to certain new products could be somewhat limited, to the extent that
the Company is unable to secure authorization to write additional lines of
business in these remaining states.
ERMA, Sullivan Kelly and a number of their employees are licensed under the
insurance agency and brokerage regulations of the various states in which their
operations require such licensure. Such regulations have not limited the
Company's ability to write insurance; however, ERMA's and Sullivan Kelly's
ability to do business in the future is subject to their ability to secure and
maintain necessary licenses.
Regulation of Insurance Holding Companies. ERII is incorporated under the
laws of Delaware, and ERSIC and Quadrant are incorporated under the laws of
Connecticut. Delaware and Connecticut, like many other states, have laws
governing insurance holding companies (such as ERI). Under Delaware and
Connecticut law, ERII, ERSIC and Quadrant are each required to register annually
and file certain reports with their respective domiciliary State Insurance
Commissioners. Such reports must include current information concerning the
capital structure, ownership, management, financial condition and general
business operations of the filing subsidiary and must also disclose certain
agreements and transactions between such
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subsidiary and its affiliates, which agreements must satisfy certain standards
specified in the respective insurance laws.
Under Delaware law, no person may acquire control of ERII or a corporation
controlling ERII unless such person has filed a statement containing specified
information with the Insurance Commissioner of the State of Delaware (the
"Delaware Commissioner") and the Delaware Commissioner has approved such
acquisition of control. Under Connecticut law, no person may acquire control of
ERSIC or Quadrant or a corporation controlling either of them unless such person
has filed a statement containing specified information with the Insurance
Commissioner of the State of Connecticut (the "Connecticut Commissioner") and
the Connecticut Commissioner has approved such acquisition of control. Under
both Delaware and Connecticut law, any person acquiring, directly or indirectly,
or holding proxies with respect to, 10% or more of the voting stock of any other
person is presumed to have acquired "control" of such person. Accordingly, any
purchase resulting in the purchaser owning 10% or more of the outstanding Common
Stock of ERI would require prior approval of the Delaware and Connecticut
Commissioners. Such prior approval requirement also would apply to an
acquisition of proxies to vote 10% or more of the outstanding Common Stock of
ERI and, therefore, in a proxy contest could delay or prevent a stockholder from
acquiring such proxies. No assurance can be given as to whether or not the
Company would seek to invoke these laws and regulations in the event of a
contested solicitation of proxies.
Under Delaware and Connecticut law, none of ERII, ERSIC or Quadrant may
enter into certain transactions, including certain reinsurance agreements,
management agreements and service contracts, with members of the ERI insurance
holding company system unless they have notified the applicable State Insurance
Commissioner of their intention to enter into such a transaction and the
applicable State Insurance Commissioner has not disapproved of such transaction
within 30 days of such notice. Among other things, such transactions are subject
to the requirements that their terms be fair and reasonable, that charges or
fees for services performed must be reasonable and that the interests of
policyholders not be adversely affected.
Dividend Restrictions. As an insurance holding company, the Company is
dependent on dividends and other permitted payments from the Insurance
Subsidiaries to pay its cash dividends to stockholders. The ability of ERII,
ERSIC or Quadrant to pay dividends to the Company is subject to Delaware and
Connecticut insurance laws, respectively. See Note 10 of the Notes to
Consolidated Financial Statements, pages F-1 et seq.
Regulatory Examinations. As part of its routine regulatory process, the
Delaware Insurance Department conducts, typically once every three years, an
examination of ERII. The report with respect to the most recent completed
examination of ERII was issued in December 1995, and covered the period January
1990 through December 1993. The report contained no material adverse findings. A
Delaware Insurance Department examination for the four-year period ended
December 31, 1997 commenced in the spring of 1998, is ongoing at the date of
this report and could result in the imposition of a fine or an order to return
premiums to specified insureds. Any such financial consequence is not expected
to be material.
ERSIC was incorporated in October 1991, and Quadrant was incorporated in
April 1998. As part of its routine regulatory process, the Connecticut Insurance
Department conducts at the time of initial licensure and, typically once every
five years thereafter, an examination of insurance companies domiciled in
Connecticut. An examination of ERSIC by the Connecticut Insurance Department
commenced in March 1995 and was completed in October 1995. Such examination
covered the period from ERSIC's incorporation through December 31, 1993. There
were no material adverse findings. A Connecticut Insurance Department
examination of ERSIC for the four-year period ended December 31, 1997 commenced
in the spring of 1998 and is ongoing at the date of this report. In addition, an
initial examination of Quadrant was conducted by the Connecticut Insurance
Department in July 1997 in connection with Quadrant's licensure by Connecticut.
There were no adverse findings.
Insurance regulatory authorities of other states in which the Insurance
Subsidiaries hold insurance company licenses may examine the Insurance
Subsidiaries' market conduct within their jurisdictions, and such authorities
are empowered to impose fines or other sanctions where such examinations reveal
deficiencies. To date, several states have conducted market conduct exams, which
have resulted in no material adverse findings.
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The National Association of Insurance Commissioners. In addition to
state-imposed insurance laws and regulations, the Insurance Subsidiaries are
subject to accounting practices and reporting formats established by the NAIC.
The NAIC also promulgates model insurance laws and regulations relating to
insurance companies and agencies, which may or may not be adopted by state
legislatures or departments of insurance. However, NAIC model laws and
regulations have become increasingly important in recent years, due primarily to
the NAIC's state regulatory accreditation program. Under this program, virtually
all states have adopted certain required model laws and regulations and meet
various staffing and other requirements and are "accredited" by the NAIC.
Because the adoption of certain model laws and regulations is a prerequisite to
accreditation, the NAIC's initiatives have taken on a greater level of practical
importance in recent years.
IRIS Ratios. The NAIC annually calculates 11 financial ratios to assist
state insurance departments in monitoring the financial condition of insurance
companies. Results are compared against a "usual range" of results for each
ratio established by the NAIC. Due primarily to their rate of premium growth,
the Insurance Subsidiaries routinely report one or more IRIS ratios outside the
usual range. In addition, ERII's entry into an intercompany quota share
reinsurance arrangement with Executive Risk (Bermuda) Ltd., a wholly-owned
subsidiary of Executive Re, in 1997 has caused and is likely to cause one or
more loss reserve-based IRIS ratios to be outside the usual range. Management
does not believe that the Insurance Subsidiaries' IRIS ratio results will
adversely affect their ability to write new business.
Capital and Surplus Requirements. The NAIC has developed risk-based
capital ("RBC") formulas to be applied to all insurance companies, which
formulas are used to calculate a minimum required statutory net worth, based on
the underwriting, investment and other business risks inherent in an individual
company's operations. Any insurance company which does not meet threshold RBC
levels ultimately could become subject to increasing levels of regulatory
scrutiny and regulatory action. 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, 1998, the total
adjusted capital (as defined by the NAIC) of ERII, ERSIC and Quadrant was in
excess of all risk-based capital action levels. The insurance laws of Delaware
and Connecticut limit the retained exposure on any one risk to 10% of capital
and surplus.
Competition
The insurance industry is highly competitive. ERI competes with domestic
and foreign insurers and reinsurers, some of which have greater financial,
marketing and management resources than ERI, and it may compete with new market
entrants in the future. The Company believes its major competitors are American
International Group, Inc. and Chubb. (See "The Company -- The Chubb
Corporation".) Other competitors include ACE Limited, Associated Electric & Gas
Insurance Services Limited, CNA Financial Corp., EXEL Limited, Great American
Insurance Company, Gulf Insurance Company, Lloyd's syndicates, PHICO Insurance
Company, Reliance Group Holdings, Inc. and Zurich-American Insurance Company.
Competition is based on many factors, including the perceived financial strength
of the insurer, pricing and other terms and conditions, services provided,
ratings assigned by independent rating organizations (including Best's and S&P),
the speed of claims payment and the reputation and experience of the insurer.
Ultimately, this competition could affect ERI's ability to attract business on
terms having the potential to yield appropriate returns.
Employees
At December 31, 1998 the Company employed approximately 560 full-time
employees. None of the employees is subject to collective bargaining agreements
and the Company knows of no current efforts to implement such agreements. The
Company believes it has a good relationship with its employees.
ITEM 2. PROPERTIES
ERI's executive offices are located in an approximately 250,000 square foot
building owned by the Company in Simsbury, Connecticut. The building consists of
two wings: an older 120,000 square foot, two-
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story office wing, fully occupied, and a newly completed 130,000 square foot,
four-story wing, the first floor of which was partially occupied during the
fourth quarter of 1998. With the new addition, the Company's headquarters
building will be able to accommodate a total of approximately 1,200 employees,
which the Company believes to be sufficient for the foreseeable future.
In addition, the Company leases office space for ERNV in London and
Rotterdam, and for ERMA's satellite domestic operations in Atlanta, Chicago,
Dallas, Houston, Lisle, New York, Pasadena, Phoenix and San Francisco. The
domestic branch offices are generally between 2,000 and 3,000 square feet and
are intended for only a small number of employees, except for Pasadena, where
the leased premises are 15,700 square feet and provide adequate office space for
approximately 40 employees. With the discontinuance of the brokerage operations
of Sullivan Kelly in the third quarter of 1998, the Company is currently seeking
to sublet approximately one-half of the Pasadena office space. The operations of
the Company are supported by local area networks of personal computers. The
local networks are interconnected via telecommunications and provide services
such as electronic mail, desktop faxing, real-time data communications and batch
file transfers.
ITEM 3. LEGAL PROCEEDINGS
The Company is subject to routine legal proceedings in connection with its
general operations and insurance business. The Company does not believe that
these legal proceedings will have a material adverse effect on the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the
fourth quarter of 1998.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
Market Information
The Common Stock, $.01 par value, of Executive Risk Inc. was initially
listed for trading on the New York Stock Exchange ("NYSE") on March 15, 1994
under the symbol "ER". For the periods presented below, the high and low sales
prices of the Registrant's Common Stock on the NYSE were as follows:
THREE MONTHS ENDED
--------------------------------------------------
MARCH 31 JUNE 30 SEPTEMBER 30 DECEMBER 31
-------- ------- ------------ -----------
1998
- -----
High sales price....................... $75.31 $74.63 $72.69 $56.88
Low sales price........................ $65.69 $57.50 $35.88 $40.50
THREE MONTHS ENDED
-----------------------------------------------------
MARCH 31 JUNE 30 SEPTEMBER 30 DECEMBER 31
-------- -------- ------------- ------------
1997
- -----
High sales price...................... $48.75 $56.00 $68.38 $72.00
Low sales price....................... $35.63 $43.38 $49.81 $63.50
THREE MONTHS ENDED
-----------------------------------------------------
MARCH 31 JUNE 30 SEPTEMBER 30 DECEMBER 31
-------- -------- ------------- ------------
1996
- -----
High sales price...................... $33.63 $38.25 $38.50 $42.38
Low sales price....................... $26.13 $29.25 $33.38 $33.88
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Stockholders
There were 221 holders of record of shares of the Company's Common Stock as
of March 1, 1999. Approximately 90% of the Registrant's outstanding shares of
Common Stock were held of record by Cede & Co., for between 2,000 and 3,000
beneficial owners.
Dividends
The Company paid cash dividends of $.02 per share in each quarter of 1998,
1997 and 1996. There is presently no intention to either increase or decrease
the cash dividend on the Company's Common Stock in the foreseeable future.
Future dividends will be dependent upon, among other things, the Company's
earnings, financial condition, capital requirements and general business
conditions.
ITEM 6. SELECTED FINANCIAL DATA
AS OF OR FOR THE
YEARS ENDED DECEMBER 31,
--------------------------------------------------
1998 1997 1996 1995 1994
-------- -------- ------ ------ ------
(IN MILLIONS, EXCEPT PER SHARE AMOUNTS)
REVENUES
Premiums earned............................ $ 254.5 $ 211.2 $155.8 $116.4 $ 95.0
Investment income.......................... 61.7 47.1 32.6 26.7 22.5
Realized investment gains (losses)......... 6.7 3.2 1.0 1.6 (0.5)
Other income............................... 0.3 0.2 0.2 0.1 0.1
-------- -------- ------ ------ ------
Total Revenues................... $ 323.2 $ 261.7 $189.6 $144.8 $117.1
======== ======== ====== ====== ======
COMPONENTS OF NET INCOME
Operating income(1)........................ $ 42.9 $ 34.7 $ 27.4 $ 24.3 $ 19.6
Non-recurring expenses..................... (3.8) (0.3) 0 0 0
Realized investment gains (losses)......... 4.3 2.1 0.7 1.0 (0.3)
-------- -------- ------ ------ ------
Net Income............................... $ 43.4 $ 36.5 $ 28.1 $ 25.3 $ 19.3
======== ======== ====== ====== ======
OPERATING INCOME PER DILUTED COMMON
SHARE(1)................................. $ 3.66 $ 3.25 $ 2.61 $ 2.04 $ 1.72
NET INCOME PER DILUTED COMMON SHARE........ $ 3.71 $ 3.41 $ 2.67 $ 2.12 $ 1.70
CASH DIVIDENDS DECLARED PER COMMON SHARE... $ .08 $ .08 $ .08 $ .08 $ .06
TOTAL ASSETS............................... $1,866.0 $1,485.8 $941.2 $705.9 $516.7
INVESTED ASSETS............................ $1,249.9 $1,085.2 $691.0 $549.9 $431.8
UNPAID CLAIMS.............................. $ 866.3 $ 637.9 $457.1 $324.4 $254.8
LONG-TERM DEBT AND PREFERRED SECURITIES.... $ 200.0 $ 200.0 $ 70.0 $ 25.0 $ 25.0
STOCKHOLDERS' EQUITY....................... $ 330.9 $ 276.2 $144.8 $177.7 $130.9
STOCKHOLDERS' EQUITY PER COMMON SHARE...... $ 29.77 $ 25.48 $15.52 $15.46 $11.38
- ---------------
(1) Excludes costs incurred in connection with the acquisition and closing of
the brokerage operations of Sullivan Kelly Inc. and the closing of the Paris
office of Executive Risk N.V.
ITEM 7. 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.
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GENERAL
Management's discussion and analysis of financial condition and results of
operations compares certain financial results for the year ended December 31,
1998 with the corresponding periods for 1997 and 1996. The results of the
Company include the consolidated results of ERMA, Executive Re and Executive
Re's insurance subsidiaries, ERII, ERSIC, ERNV, Quadrant and Executive Risk
(Bermuda) Ltd., a 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., 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, 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 for a period of one year 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. In the third quarter of 1998, the
Company announced the closing of the Sullivan Kelly brokerage operation and the
Paris France office of ERNV. In connection with these closings, $5.8 million of
charges were recorded.
On February 6, 1999 the Company entered into a definitive merger agreement
with The Chubb Corporation ("Chubb"). The agreement provides that ERI
stockholders will receive, upon closing, 1.235 shares of Chubb common stock in
exchange for each share of Company common stock. The consummation of the
transaction is subject to customary closing conditions and the approval of ERI's
stockholders and regulatory approvals. It is anticipated that all approvals will
be received by the end of the second quarter of 1999. Also in the first quarter
of 1999, the Company restructured certain of its reinsurance treaties. The
restructured reinsurance program generally makes greater use of excess of loss
reinsurance, rather than quota share reinsurance, to reduce exposure to loss
severity. The reinsurance restructuring resulted in the non-renewal of several
in-force reinsurance treaties commensurate with the effective dates of the new
treaties. The restructuring of the reinsurance treaties is not expected to have
a material adverse effect on the Company's financial position or results of
operations.
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. and Standard & Poor's).
ERII, ERSIC, Quadrant and ERNV's current rating from A.M. Best is "A
(Excellent)", and their current financial strength 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, 1998 and 1997
Gross premiums written increased by $84.9 million, or 20%, to $516.3
million in 1998 from $431.4 million in 1997. The increase was due to growth in
sales in most of the Company's lines of business, including lawyers
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professional liability, miscellaneous professional liability errors and
omissions insurance ("E&O") and medical malpractice insurance. These increases
were partially offset by a decrease in domestic and international directors and
officers liability insurance ("D&O"). The level of D&O gross premiums written
has been adversely affected both by continued strong competition in the D&O
market and by conservative underwriting of D&O applicants that appear to the
Company to present relatively greater exposure to the Year 2000 issue. These
factors are likely to affect the level of D&O writings over the next few years.
Ceded premiums increased $63.1 million, or 37%, to $232.6 million in 1998
from $169.5 million in 1997. The rate of growth in ceded premiums exceeded that
of gross premiums written due to a smaller percentage of the 1998 premium
writings being in D&O compared to 1997. D&O premiums are ceded at a lower rate
than other products, and, therefore, as the D&O premium shrinks as a percentage
of the total premium, the ceded premiums rise relative to gross premiums
written.
As a result of the foregoing, net premiums written increased $21.8 million,
or 8%, to $283.7 million in 1998 from $261.9 million in 1997. Over the same
periods, net premiums earned increased to $254.5 million from $211.2 million.
Net investment income increased by $14.6 million, or 31%, to $61.7 million
in 1998 from $47.1 million in 1997. The increase resulted principally from
growth in the Company's investment portfolio, measured on an amortized cost
basis, from $1.0 billion at December 31, 1997 to $1.2 billion at December 31,
1998. The Company's equity investment balances were $79.2 million and $61.7
million at December 31, 1998 and 1997, respectively, and the cash and short-term
investment balances were $34.3 million and $88.5 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 cash flows from insurance operations. The nominal portfolio yield
of the fixed maturity portfolio at December 31, 1998 was 5.85%, as compared to
6.07% at December 31, 1997. The tax-equivalent yields on the fixed maturity
portfolio were 7.41% and 7.58% for these periods, respectively. The decrease in
yields at year-end 1998 as compared to year-end 1997 was due principally to
lower prevailing interest rates. See "Liquidity and Capital Resources." The
Company's net realized capital gains were $6.7 million in 1998 as compared to
$3.2 million in 1997. In 1998, 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 $26.1 million, or 18%,
to $167.9 million in 1998 from $141.8 million in 1997 due to higher premiums
earned partially offset by a slightly lower loss ratio. The Company's loss ratio
decreased to 66.0% in 1998 from 67.1% in 1997. 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 1998 for prior report years by approximately $17.3 million. In
1997, the Company reduced its unpaid loss and LAE reserves for prior report
years by $10.3 million. These reductions produced corresponding increases in the
Company's net income of approximately $11.2 million, or $0.96 per diluted share
in 1998, and approximately $6.7 million, or $0.62 per diluted share in 1997.
There is no assurance that reserve adequacy reevaluations will produce similar
reserve reductions and net income increases in the future.
Policy acquisition costs increased $15.3 million, or 44%, to $50.3 million
in 1998 from $35.0 million in 1997. The Company's ratio of policy acquisition
costs to net premiums earned increased to 19.8% in 1998 from 16.6% in 1997. The
increase in the policy acquisition cost ratio was primarily attributable to
higher commission amounts paid to brokers and increased compensation and related
expenses incurred in hiring additional underwriting staff to support growth in
the Company's business. In addition, the Company incurred $1.9 million of
non-recurring expenses in connection with the dissolution of Sullivan Kelly. The
ratio of policy acquisition costs to premiums earned excluding the non-recurring
expenses associated with Sullivan Kelly for the year ended December 31, 1998 was
19.0%.
General and administrative ("G&A") expenses increased $7.7 million, or 27%,
to $36.3 million in 1998 from $28.6 million in 1997. The increase in G&A costs
was due primarily to increased compensation, benefit
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and related overhead costs associated with the growth in premium volume and
development of new products. In addition, $3.9 million of non-recurring expenses
were incurred in connection with the discontinuance of Sullivan Kelly's
brokerage operations and the closing of the Paris office of ERNV. The ratio of
G&A expenses to net premiums earned increased from 13.5% in 1997 to 14.3% in
1998. Excluding the non-recurring expenses associated with Sullivan Kelly and
ERNV, the ratio of G&A costs to premiums earned decreased by 0.8% to 12.7% for
the year ended December 31, 1998 as compared to full year 1997.
As a result of the changes in the aforementioned ratios, the Company's GAAP
combined ratio increased to 100.0% in 1998 from 97.2% in 1997. Excluding the
non-recurring expenses associated with Sullivan Kelly and ERNV the Company's
GAAP combined ratio for 1998 was 97.7%. 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 $5.4 million in 1998 and $1.8 million in 1997 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 $70 million from January 1, 1997 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. 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 $1.1 million, or 14%, to $9.3 million in 1998
from $8.2 million in 1997. The Company's effective tax rate decreased to 17.6%
in 1998 from 18.3% in 1997. 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 $6.9
million, or 19%, to $43.4 million, or $3.71 per diluted share, in 1998 from
$36.5 million, or $3.41 per diluted share, in 1997. The Company's operating
earnings, calculated as net income before $5.8 million of one-time expenses
associated with the discontinuance of the brokerage operations of Sullivan Kelly
and the closing of the Paris office of ERNV and realized capital gains or
losses, all net of tax, increased $8.1 million, or 23%, to $42.9 million, or
$3.66 per diluted share, in 1998 from $34.8 million, or $3.25 per diluted share,
in 1997.
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 D&O
liability insurance and lawyers professional liability and miscellaneous 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.
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,
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respectively, and the cash and short-term investment balances were $88.5 million
and $24.7 million, respectively, on the same dates.
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 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.
G&A expenses increased $11.5 million, or 68%, to $28.6 million in 1997 from
$17.1 million in 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.
Interest expense of $1.8 million in 1997 and $4.5 million in 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. 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 in 1997
from $6.6 million in 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 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.
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
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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
stockholders.
Cash flows from operating activities were $157.9 million, $181.0 million,
and $169.5 million for 1998, 1997 and 1996, respectively. The decrease in cash
flows in 1998 resulted principally from increased loss payments in 1998
partially offset by increased net premiums received and investment income
received. Rising loss payments are expected of a maturing professional liability
underwriter.
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. Total estimated costs for this project approximate $21.1 million.
During 1998 the Company incurred $12.2 million in costs in connection with this
addition. 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, 1998, 1997
and 1996 was approximately 5.2, 4.6 and 4.6 years, respectively 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 $34.3 million (2.7% of the total
investment portfolio) at December 31, 1998 and $88.5 million (8.2% of the total
investment portfolio) at December 31, 1997. The decrease in the short-term
investment pool was due principally to the fact that approximately $40 million
in senior notes had been held in short-term investments at year-end 1997, which
were contributed to ERNV in February 1998. Cash and publicly traded fixed income
securities constituted 94% of the Company's total investment portfolio at
December 31, 1998.
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 (within
accumulated other comprehensive income) until realized. The market value of the
portfolio was 105% and 104% of amortized cost at December 31, 1998 and December
31, 1997, respectively. At December 31, 1998 and 1997, stockholders' equity was
increased by $21.9 million and $19.5 million, respectively, to record the
Company's fixed maturity investment portfolio at fair value net of tax. At
December 31, 1998, the Company owned no derivative instruments, except for
$139.9 million (fair value) invested in mortgage and asset backed securities,
including $5 million in AAA-rated interest only commercial mortgage-backed
securities.
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 of $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 arranged through Chase, $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.
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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 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.
In each of March, June, September and December of 1998, the Company paid
dividends to common stockholders of record of $0.02 per share. Such Common Stock
dividends totaled $0.9 million. ERII, ERSIC and Quadrant are subject to state
regulatory 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.
THE YEAR 2000 ("Y2K")
The Y2K problem is a worldwide issue facing virtually every organization
that employs technology to achieve its goals, including the Company. The Y2K
problem stems from the use of a two-digit code representing the year in
computer-based systems, which could cause some computers to fail or malfunction
after December 31, 1999. The Company's insurance policies contain date sensitive
data, such as expiration dates, and internal systems rely on such date fields.
Further, the Company's philosophy has long emphasized the use of technology, so
it may be more heavily reliant upon computer systems than some other similarly
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situated insurance companies. If the Company's principal computer systems were
not made Y2K compliant, many of its business operations, including its policy
issuance, premium billing and collections, claims handling, investment and
accounting functions, could be materially adversely affected, with negative
financial consequences and damage to the Company's reputation.
Internal: Management has taken steps to address Y2K as it affects the
Company's own business systems. In addition to assigning senior Information
Services staff resources exclusively to this project, the Company formed a Y2K
Project Office, which includes the Chairman of the Board of Directors as well as
representatives from all principal operations areas. Early in 1998, the Project
Office began monitoring the Company's Y2K compliance project, a five-phase
program incorporating assessment, remediation, testing, business partner
compliance and corporate acceptance. Later during 1998, the Company retained an
independent consultant, which advised and made recommendations as to the
adequacy of planned testing protocols and test schedules. As of the date of this
report, the Company has completed the assessment, remediation and testing phases
of all mission-critical applications. It is on-schedule to complete the
remaining testing, and currently plans to conduct a so-called "end to end" test
of all information systems, by late second quarter or early third quarter 1999.
Additionally, third-party business partners that have material vendor or
customer relationships with the Company have been identified, and each has been
contacted to determine its Y2K readiness. In particular, there are several
insurance brokerage firms that produce a significant share of the Company's
insurance business. An inability on the part of any such firm to process
insurance applications due to a failure of their computer systems could
materially affect the Company's financial results for the period in which such
failure occurred. The Company's Y2K readiness project calls for contingency
planning to identify actions to be taken should the Company's or its business
partners' readiness efforts fail. Such plans are being formalized during the
first half of 1999.
Operating results in 1998 included some expense (less than $1.5 million)
directly or indirectly related to Y2K readiness. Based on the progress of the
Company's Y2K project to date, it is not currently anticipated that there will
be a material impact on operating expense related to Y2K during 1999, nor will
the completion of Y2K efforts result in a meaningful reduction in expense levels
in 1999 or future years.
External: Because a significant portion of the Company's business is
insuring executives of business organizations that rely on computer technology,
business interruptions and other problems related to mismanagement of the Y2K
issue could also affect the Company's claims experience in future years. In July
1998, a national rating agency revised its outlook on the rating of the
Company's senior debt from "stable" to "negative," premised upon the agency's
analysis of the D&O insurance industry's exposure to the Y2K issue. (Such
negative ratings outlook has since been removed in light of the announced
transaction with Chubb.) The Company acknowledges that Y2K entails a significant
risk to the entities it insures. Y2K litigation is likely to cause some negative
development in the Company's loss experience. Due to the general uncertainty
inherent in the Y2K problem, however, the Company is unable to determine at this
time whether such losses will have a material impact on the Company's results of
operations or financial condition. The Company believes that its Y2K specific
underwriting techniques, together with conservative reinsurance practices and
loss reserving, should mitigate the impact of the Y2K problem.
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 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,
1998, 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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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk relates, broadly, to changes in the value of financial
instruments that arise from adverse movements in interest rates, equity prices
and foreign exchange rates. Given that varying degrees of market risk exist in
virtually all financial instruments, the Company has adopted, and its Board of
Directors has approved, comprehensive investment and financial risk management
policies and procedures. These policies and procedures outline the
organization's tolerance for risk, detail permissible strategies and instruments
to manage said financial risks and grant the authority to approve risk reducing
transactions to members of senior management only. The Company is exposed
principally to changes in interest rates that affect the market prices of its
fixed income securities, but also has lesser exposures to changes in equity
prices and foreign currency exchange rates. The Company does not have direct
economic exposure to changes in commodity prices.
INTEREST RATE RISK
The Company could experience economic losses if it was required to
liquidate fixed income securities during periods of rising and/or volatile
interest rates. However, the Company attempts to mitigate its exposure to
adverse interest rate movements through a combination of active portfolio
management, asset/liability duration matching exercises, and by staggering the
maturities of its fixed income investments to assure sufficient liquidity to
meet its obligations and to address reinvestment risk considerations. The
Company's insurance liabilities are generally long tailed in nature, which
generally permits ample time to prepare for their settlement. The Company has in
the past, and may in the future, utilize various financial risk management
tools, such as interest rate swaps, forwards, futures and options to modify its
exposure to changes in interest rates.
EQUITY PRICE RISK
The Company does have exposure to adverse movements in equity prices as a
result of its investment in various equity securities. Lower equity valuations
may result from a broad range of factors including a general slowdown in global
macroeconomic activity that results in declining corporate profits, the
existence of asset classes that offer more attractive relative value that may
initiate broad based rotations out of equity securities, and other various
circumstances that may negatively impact investors desire to own a particular
equity security at any point in time. The Company maintains a relatively modest
allocation to equities which serves to minimize the impact of more expansive
declines in equity market valuations on the financial results of the Company.
The Company's principal means of mitigating its exposure to potentially adverse
movements in the prices of individual equities is achieved through its manner of
investing; namely, by utilizing diversified equity index funds as the anchor of
a strategy that focuses on investing in established, larger capitalization
equity issues that are generally more immune to periodic downturns in equity
prices. The Company has in the past hedged its exposure to price movements
through the use of financial instruments, and it may in the future use
appropriate financial instruments to alter its risk profile as it relates to
changes in equity valuations.
FOREIGN EXCHANGE RISKS
While the Company conducts its activities principally in U.S. Dollars, it
does maintain a small allocation to foreign currency denominated fixed income
securities as a result of its European operations. Foreign exchange risk arises
from the possibility that adverse changes in foreign currency exchange rates
will negatively impact the value of these financial instruments. The Company
generates foreign exchange exposure when it buys or sells fixed income
securities or when it underwrites business that is denominated in a foreign
currency. The Company's international fixed income securities possess relatively
short durations, high quality ratings, and are primarily denominated in British
Pounds and Dutch Guilders, both of which are highly liquid currencies. Part of
this foreign exchange exposure is mitigated by the Company's asset/liability
matching strategy (i.e. denominating asset and liabilities in like currencies).
The exposure created by those fixed income securities which are not explicitly
matched are closely monitored in accordance with the above-mentioned risk
management policies and may, in the future, be further managed through the
utilization of appropriate foreign exchange hedging instruments.
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SENSITIVITY ANALYSIS
The Company regularly conducts various analyses to gauge the financial
impact of changes in interest rates, equity prices, and foreign exchange rates
on its financial condition. The ranges selected in these analyses reflect
management's assessment as being reasonably possible over the succeeding twelve
month period. The magnitude of changes modeled in the accompanying analyses
should, in no manner, be construed as a prediction of future economic events,
but rather, be treated as a simple illustration of the potential impact of such
events on the Company's consolidated financial results.
The sensitivity analysis of interest rate risk assumes an instantaneous
shift in market interest rates in a parallel fashion across the yield curve,
with scenarios of interest rates increasing and decreasing 100 and 200 basis
points from their levels at December 31, 1998, and with all other variables held
constant. A 100 and 200 basis point increase in market interest rates would
result in a pre-tax decrease in the market value of the Company's fixed income
investments of $102.9 million and $160.6 million, respectively. Similarly, a 100
and 200 basis point decrease in market interest rates would result in a pre-tax
increase in the market value of the Company's fixed income investments of $32.2
million and $92.6 million, respectively.
Equity price risk was measured assuming an instantaneous 10% and 25% change
in the Standard and Poor's 500 Index from its level of December 31, 1998, with
all other variables held constant. The Company's equity holdings were assumed to
be perfectly correlated with this index. A 10% and 25% decrease in the index
would result in a $4.8 million and $12.0 million decrease, respectively, in the
market value of the Company's equity investment allocation. Similarly, a 10% and
25% increase in the index would result in a $4.8 million and $12.0 million
increase, respectively, in the market value of the Company's equity investment
allocation.
The sensitivity analysis of foreign exchange risk assumes an instantaneous
10% and 20% change in the foreign currency exchange rates versus the U.S. Dollar
from their levels at December 31, 1998, with all other variables held constant.
A 10% and 20% strengthening of the U.S. Dollar versus the other currencies to
which the Company is exposed, would result in a decrease of $4.2 million and
$8.5 million, respectively, of the Company's foreign currency denominated fixed
income security allocation. Similarly, a 10% and 20% weakening of the U.S.
Dollar versus the other currencies to which the Company is exposed, would result
in an increase of $4.2 million and $8.5 million, respectively, of the Company's
foreign currency denominated fixed income security allocation.
The following table reflects the estimated effects on the market value of
the Company's financial instruments due to an increase in interest rates of 100
basis points, a 10% decline in the S&P 500 index, and a decline of 10% in
foreign exchange rates versus the U.S. Dollar. All of the Company's invested
assets have been categorized as other than trading (available for sale) in
accordance with Statement of Financial Accounting Standards No. 115.
DECEMBER 31, 1998 MARKET VALUE INTEREST RATE RISK CURRENCY RISK EQUITY RISK
- ----------------- ------------ ------------------ ------------- -----------
Fixed maturity securities.... $1,136,375 $(102,859) $(4,228) $ 0
Equity securities............ 48,122 0 0 (4,812)
---------- --------- ------- -------
Total................... $1,184,497 $(102,859) $(4,228) $(4,812)
========== ========= ======= =======
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following consolidated financial statements of Executive Risk Inc. and
its subsidiaries, included on pages F-1 et seq. of this Report on Form 10-K:
-- Consolidated Balance Sheets at December 31, 1998 and 1997.
-- Consolidated Statements of Income for the years ended December 31,
1998, 1997 and 1996.
-- Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1998, 1997 and 1996.
-- Consolidated Statements of Cash Flows for the years ended December
31, 1998, 1997 and 1996.
-- Notes to Consolidated Financial Statements.
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ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES
Not applicable.
PART III
ITEM 10. DIRECTORS AND OFFICERS OF THE REGISTRANT
DIRECTORS AND OFFICERS: Biographical summaries of the persons who are
members of the Board of Directors follow below. Messrs. Deutsch, Kullas and
Sills are also the Company's executive officers. Data with respect to shares of
the Company's Common Stock beneficially owned by each of them, directly or
indirectly, as of March 1, 1999 appears later in this Report.
Gary G. Benanav (53). Mr. Benanav has served as a director of the Company
and of ERII since April 1988 and a director of ERSIC since December 1991. In
December 1997, he became Chairman and Chief Executive Officer of New York Life
International, Inc. and Executive Vice President of New York Life Insurance
Company. Prior to joining New York Life Insurance, Mr. Benanav had served since
October 1996 as Chief Operating Officer of ProHealth Physicians MSO, Inc., a
Farmington, CT medical management services organization. Prior to October 1996
he was Executive Vice President of Aetna Life and Casualty Company ("AL&C") and
head of AL&C's property/casualty lines, positions held since December 1993. From
April 1992 through December 1993, he served as Group Executive responsible for
Aetna Life Insurance and Annuity Company businesses and Aetna International. He
also serves as a director of Barnes Group, Inc., Bristol, CT.
Barbara G. Cohen (46). Ms. Cohen has served as a director of the Company,
ERII and ERSIC since May 1996. Since 1993 Ms. Cohen has been President of Kannon
Consulting, a Chicago-based marketing consulting firm. From 1991 to 1993 she was
a senior partner at Cambridge Group, Inc. and, prior to that, a partner in the
Marketing and Strategy practice of Booz, Allen & Hamilton, Inc.
John G. Crosby (55). Mr. Crosby has served as a director of the Company
since 1987 and as a director of ERII and ERSIC since January 1994. Mr. Crosby is
currently President and Managing Director of the investment banking firm,
Madison Partners, Inc., a position he has held since September 1995. He served
as Managing Director of LSG Advisors ("LSG"), an investment banking firm and a
division of Societe Generale Securities Corp., from May 1993 through August
1995. From 1990 through May 1993, Mr. Crosby served as Managing Director of The
Lodestar Group, predecessor to LSG.
Robert V. Deutsch (39). Mr. Deutsch became a director of the Company in
May 1997. He has served as Executive Vice President, Chief Financial Officer,
Chief Actuary and Treasurer of the Company since April 1996, and as President of
ERII and ERSIC and Executive Vice President of ERMA since May 1997. Prior to
those respective dates, he had served as Senior Vice President, Chief Financial
Officer, Chief Actuary and Treasurer of the respective entities since November
1990.
Patrick A. Gerschel (52). Mr. Gerschel has served as a director of the
Company and of ERII since July 1990 and as a director of ERSIC since December
1991. Mr. Gerschel has served as Chairman of Gerschel & Co., a merchant banking
firm, since 1980 and as Chairman of Residential Company of America since 1996.
He is a director of Protein Polymer Technologies Inc.
Peter Goldberg (62). Mr. Goldberg has served as a director of the Company,
ERII and ERSIC since May 1994. Mr. Goldberg has served as Chairman and a
director of Calco Insurance Brokers & Agents, Inc. since 1993. Since 1993, Mr.
Goldberg also has served as President, Chief Operating Officer and director of
California Casualty Management Company. He is also Chairman of CALCO Insurance
Brokers & Agents, Inc.
Robert H. Kullas (54). Since January 1994, Mr. Kullas has served as a
director of the Company and ERII and ERSIC, and as Chairman of the Partnership
Committee of the Company's underwriting manager, ERMA. Since May 1997, he has
been Chairman of the Company and Co-chairman of ERII and ERSIC. From April 1996
until May 1997 he served as the Vice Chairman and Chief Operating Officer of the
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Company, ERII and ERSIC. From January 1994 until August 1994, his title was
Chairman of the Board of each of the Company, ERII and ERSIC, and from August
1994 through April 1996 he was President and Chief Operating Officer for each of
the Company, ERII and ERSIC. Prior to 1994, Mr. Kullas held various financial
and planning positions in the Life, Financial and Commercial Insurance Divisions
at AL&C, including his last position, from 1991 through 1993, as Vice
President -- Finance and Treasurer.
Michael D. Rice (56). Mr. Rice has served as a director of the Company
since 1986. He has also served as a director of ERII and ERSIC since January
1994. Mr. Rice is Chairman and CEO of Aon Services Group, Inc. Prior to assuming
his current position, he had served as President of Aon Specialty Group, an
insurance brokerage firm, since 1989.
Joseph D. Sargent (69). Mr. Sargent has served as a director of the
Company, ERII and ERSIC since December 1986, February 1987 and December 1991,
respectively. Mr. Sargent has served as Chairman of Bradley, Foster & Sargent,
Inc., a securities firm, since February 1998. From December 1992 through
February 1998, he was Chairman of Connecticut Surety Corporation, an insurance
holding company. Mr. Sargent served as Chairman, and later as Vice Chairman, of
the investment banking firm, Conning & Company, from 1991 to 1995 and as its
Chairman and Chief Executive Officer from 1988 to 1991. Mr. Sargent is a
director of Trenwick Group Inc., E.W. Blanch Holdings, Policy Management Systems
Corporation, Mutual Risk Management Ltd. and MMI Companies, Inc.
Stephen J. Sills (50). Mr. Sills has served as a director of the Company
since December 1986. He has been the President and Chief Executive Officer of
the Company, ERII and ERSIC since May 1997, and from April 1996 until May 1997
served as President and Chief Underwriting Officer. He served as Executive Vice
President and Chief Underwriting Officer from November 1990 until April 1996.
Mr. Sills has been a director of ERII and ERSIC since February 1987 and December
1991, respectively. Mr. Sills also has served as President of ERMA since January
1988.
Irving B. Yoskowitz (53). Mr. Yoskowitz has served as a director of the
Company, ERII and ERSIC since November 1997. He has been a Senior Partner of
Global Technology Partners, LLC., an investment firm, since 1998. Prior to that,
he had served since 1990 as Executive Vice President and General Counsel at
United Technologies Corp. Mr. Yoskowitz is also a director of BBA Group, London,
England, and of Equant, NV, Amsterdam, Netherlands.
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE: John G. Crosby, a
director, filed a late Form 4 for the month of August, 1998. Based solely upon a
review of Forms 3 and 4 and amendments thereto furnished to the Company pursuant
to Rule 16a-3(e) of the SEC during the most recent fiscal year, there were no
other known failures to file a Form 3 or 4 by any person required to file.
30
33
ITEM 11. EXECUTIVE COMPENSATION
SUMMARY COMPENSATION TABLE
The following table summarizes the compensation for services rendered in
all capacities to the Company and its subsidiaries during the past three
completed fiscal years by the Company's Chief Executive Officer and all other
executive officers of the Company (the "executive officers").
LONG TERM COMPENSATION
--------------------------
AWARDS
------------ PAYOUTS
ANNUAL COMPENSATION SECURITIES ----------- ALL OTHER
-------------------------------- UNDERLYING LTIP PAYOUT COMPENSATION
NAME AND PRINCIPAL POSITION YEAR SALARY ($) BONUS ($)(1) OPTIONS (#) ($)(2) ($)(3)
- --------------------------- ---- ---------- ------------ ------------ ----------- ------------
Robert V. Deutsch................... 1998 $301,811 $221,100 68,991(4) $533,156 $ 79,459
Executive V.P., Treasurer, 1997 301,527 270,000 65,000 0 100,418
Chief Financial Officer 1996 292,321 267,800 30,785 0 83,439
and Actuary
Robert H. Kullas.................... 1998 $338,811 $248,600 12,124(4) $533,156 $ 89,654
Chairman 1997 338,527 304,600 40,000 0 81,136
1996 329,321 221,600 16,500 0 66,744
Stephen J. Sills.................... 1998 $371,244 $376,500 162,700(4) $533,156 $102,314
President and Chief 1997 343,944 345,200 100,000 0 120,540
Executive Officer 1996 329,321 301,900 35,547 0 109,158
- ---------------
(1) The 1998 bonuses include payments received in February 1999, related to
incentives which were originally awarded in 1995, subject to the Company's
loss ratio performance for the 1995 report year determined as of December
31, 1998. Such payments were $78,400, $88,500, and $88,500 for,
respectively, Messrs. Deutsch, Kullas and Sills. In addition to the bonus
amounts disclosed above, each executive officer may be entitled to bonus
payments related to loss ratio performance with respect to report years
1996, 1997 and 1998, to be determined as of December 31, 1999, 2000 and
2001, respectively, and paid in February of the following year.
(2) Amounts under this column for 1998 represent the value received in May under
the Company's Performance Share Plan ("PSP"), under which each executive
officer received 8,250 shares of Executive Risk common stock in connection
with the 1995 PSP awards. Such awards were based on the Company's financial
performance for the three-year period from 1995 to 1997 inclusive.
(3) Includes the retirement and matching contributions made by the Company under
its tax-qualified and supplemental defined contribution pension plans.
(4) Includes 38,891 shares, 7,824 shares and 98,400 shares for Messrs. Deutsch,
Kullas and Sills, respectively, relating to restoration options. Rather than
increase an employee's holdings, restoration options are intended to permit
the employee who exercises certain previously granted stock options (the
"Parent Options") to remain in the same economic position as if he or she
had continued to hold the original options unexercised. As such, restoration
options meet the Company's objective of fostering continued outright
ownership of Common Stock by employees, but the receipt thereof does not
result in a net increase in the employee's total equity position. The number
of restoration options granted is equal to the number of owned shares used
to pay the exercise price of the Parent Options, plus the number of shares
withheld to satisfy the optionee's statutory tax withholding obligation.
Restoration options are granted at the grant date fair market value, and
expire on the same expiration date as the Parent Options. Shown below is a
table which sets forth the option-related equity position for each executive
officer.
31
34
NET CHANGES IN EQUITY POSITION
RESULTING FROM EXERCISES OF OPTIONS (a)
NET CHANGE IN
NEW EQUITY POSITION
NET RESTORATION FROM GRANTS OF
OPTIONS SHARES OPTIONS RESTORATION
EXERCISED RECEIVED GRANTED OPTIONS
--------- -------- ----------- ---------------
Robert V. Deutsch.......................... 75,871 36,980 38,891 0
Robert H. Kullas........................... 50,900 13,076 7,824 (30,000)
Stephen J. Sills........................... 184,895 86,495 98,400 0
(a) The "Options Exercised" column sets forth the number of options
exercised by such executive officer during the year. The "Net Shares
Received" column sets forth the number of shares such executive officer
actually received upon exercise of the option after subtracting (i) the
number of shares sold, if any, concurrent with or subsequent to the
exercise and (ii) the number of previously owned shares tendered to pay
the exercise price and withheld to pay statutory taxes on the exercise.
The "New Restoration Options Granted" column sets forth the number of
restoration options granted to the executive, which is an amount equal
to the number of shares tendered and withheld. The "Net Changes in
Equity Position from Grants of Restoration Options" column is the
number of options exercised less the sum of the net shares received and
the number of restoration options granted.
STOCK OPTION GRANTS IN FISCAL 1998
The following table sets forth information relating to the grant of stock
options by the Company during 1998 to its executive officers, Messrs. Deutsch,
Kullas and Sills.
INDIVIDUAL GRANTS
% OF
NUMBER OF SECURITIES TOTAL OPTIONS GRANTED
UNDERLYING OPTIONS GRANTED TO ALL EMPLOYEES IN 1998 EXERCISE
-------------------------------- --------------------------- PRICE(1) EXPIRATION
NAME RESTORATION(3) REGULAR RESTORATION(3) REGULAR ($ PER SHARE) DATE
- ---- ---------------------- ------- ----------------- ------- ------------- ----------
Robert V. Deutsch......... 30,100 4.67 $72.69 7/1/08
26,132 4.05 42.69 6/1/03
5,928 0.92 42.69 3/22/05
6,831 1.06 42.69 3/22/06
------ -----
subtotal.................. 38,891 30,100 6.03 4.67
------ ------ ----- ----
TOTAL..................... 68,991 10.70
======= =====
Robert H. Kullas.......... 4,300 0.67 $72.69 7/01/08
7,824 1.21 42.69 6/01/03
TOTAL..................... 12,124 1.88
======= =====
Stephen J. Sills.......... 64,300 9.97 $72.69 7/01/08
81,387 12.60 42.69 6/01/03
7,904 1.22 42.69 3/22/05
9,109 1.41 42.69 3/22/06
------ -----
subtotal.................. 98,400 64,300 15.23 9.97
------ ------ ===== ----
TOTAL..................... 162,700 25.20
======= =====
GRANT DATE
PRESENT VALUE
NAME ($)(2)
- ---- -------------
Robert V. Deutsch......... $ 740,999
250,967
56,931
65,604
----------
subtotal..................
TOTAL..................... $1,114,501
==========
Robert H. Kullas.......... $ 105,857
75,140
----------
TOTAL..................... $ 180,997
==========
Stephen J. Sills.......... $1,582,931
781,624
75,908
87,481
----------
subtotal..................
TOTAL..................... $2,527,944
==========
- ---------------
(1) The option price of each option granted to an executive officer during 1998
is equal to the fair market value of the Common Stock subject to the option
as of the date of the grant.
(2) Based on the Black-Scholes option pricing model adapted for use in valuing
employee stock options. The actual value, if any, an executive officer
realizes will depend on the excess of the stock price over the
32
35
option exercise price on the date of exercise, so there is no assurance the
value actually realized will be at or near the value estimated by the
Black-Scholes model. The estimated grant date present values disclosed in
this column based on the Black-Scholes model assume a stock price volatility
of .2697, a risk-free rate of return of 5.427%, and estimated future
dividend yield of .156% and expected lives of 5 years for the regular
options and 2.5 years for the restoration options. These assumptions were
developed solely for disclosure, and they do not constitute projections or
representations by the Company as to the actual performance of a the common
stock.
(3) See footnote (4) to the Summary Compensation Table for more information
regarding restoration options.
AGGREGATED STOCK OPTION EXERCISES IN FISCAL 1998 AND FISCAL YEAR-END OPTION
VALUES
The following table shows, for each current executive officer of the
Company, the aggregate number and realized value of stock option exercises
during 1998, as well as the number and values of options held by the named
executive officers as of December 31, 1998. The values of unexercised
in-the-money stock options are included pursuant to SEC rules; there is no
assurance that such values will in fact be realized.
NUMBER OF VALUE OF UNEXERCISED
SHARES VALUE UNEXERCISED OPTIONS AT IN-THE-MONEY OPTIONS AT
ACQUIRED REALIZED 12/31/98 12/31/98(1)
UPON UPON ---------------------------- ----------------------------
NAME EXERCISE EXERCISE EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ---- -------- --------- ----------- ------------- ----------- -------------
(#) ($) (#) (#) ($) ($)
Robert V. Deutsch.... 75,871 2,389,806 180,172 135,019 6,979,637 715,149
Robert H. Kullas..... 50,900 2,570,894 66,595 55,929 2,553,066 334,578
Stephen J. Sills..... 184,895 5,589,781 82,145 257,755 2,716,114 1,444,134
- ---------------
(1) Stock options are classified as in-the-money if the fair market value of the
underlying common stock exceeds the exercise price of the option. The value
of such in-the-money options shown above is the difference between the
exercise or base price and the fair market value of the underlying common
stock as of December 31, 1998. The fair market value of the Common Stock on
December 31, 1998, based on the December 31, 1998 closing price on the New
York Stock Exchange, was $54.94 per share.
DIRECTOR COMPENSATION
The Company maintains a compensation program for members of the Board of
Directors who are not officers or employees of the Company ("Nonemployee
Directors"). Under the program, each Nonemployee Director is entitled to an
annual retainer of $20,000, as well as fees of $2,000 for each meeting of the
Board of Directors attended and $1,000 for each committee meeting attended. In
addition to cash fees, all Nonemployee Directors are eligible for options to
purchase Common Stock ("Performance Options"), depending on the financial
performance of the Company. Performance Options may be granted once each year
and are exercisable at the fair market value on the grant date. During 1998,
Performance Options to purchase 2,016 shares were granted to each Nonemployee
Director at an exercise price of $67.50 per share, the grant date market value.
Officers or employees of the Company who serve on the Board of Directors receive
no additional compensation for their services in that capacity.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth, as of March 1, 1999 (except for certain
institutional ownership, as to which the Company has actual notice of
later-dated information), certain information regarding the beneficial ownership
of the Common Stock by (i) each of the Company's directors and executive
officers and all directors and executive officers of the Company as a group, and
(ii) each person, other than a director, known by the Company to own
beneficially more than 5% of the outstanding shares of Common Stock. "Beneficial
ownership" for these purposes includes stock which any person listed below has
the right to acquire within 60 days. Unless otherwise indicated, each person or
entity named below has sole voting and investment power
33
36
with respect to all shares of Common Stock shown as beneficially owned by such
person or entity, subject to community property laws where applicable and the
information set forth in the footnotes to the table below.
TOTAL
COMMON STOCK STOCK OPTIONS COMMON STOCK PERCENT OF
BENEFICIALLY OWNED EXERCISABLE BENEFICIALLY COMMON
NAME EXCLUDING OPTIONS WITHIN 60 DAYS OWNED STOCK(1)
- ---- ------------------ -------------- ------------ ----------
DIRECTORS AND OFFICERS
Gary G. Benanav(2)................ 9,000 3,518 12,518 *
Barbara G. Cohen.................. 498 1,236 1,734 *
John G. Crosby(3)................. 11,015 1,510 12,525 *
Robert V. Deutsch(4).............. 128,914 11,347 140,261 1.2%
Patrick A. Gerschel(5)............ 729,191 2,621 731,812 6.4%
Peter Goldberg(6)................. 3,791 2,780 6,571 *
Robert H. Kullas.................. 51,778 8,570 60,348 *
Michael D. Rice................... 9,310 1,510 10,820 *
Joseph D. Sargent(7).............. 36,205 2,621 38,826 *
Stephen J. Sills(8)............... 171,828 17,320 189,148 1.7%
Irving B. Yoskowitz............... 1,000 202 1,202 *
All officers and directors as a
group (11 persons)............. 1,152,530 53,235 1,205,765 10.6%
PERSON(S) OWNING MORE THAN 5% OF THE OUTSTANDING COMMON STOCK (OTHER THAN
DIRECTORS OR OFFICERS)
Franklin Resources(9)................................................... 856,210 7.5%
Mellon Bank Corporation(10)............................................. 763,313 6.7%
- ---------------
* Less than one percent.
(1) Percentages based upon 11,356,649 shares of Common Stock outstanding
(12,470,943 issued, less 1,114,294 shares owned by the Company in treasury)
and adjusted in each case by the number of shares each owner has the right
to acquire within the 60 day period ending April 30, 1999.
(2) Includes 942 options owned by Mr. Benanav's children, as to which he
disclaims beneficial ownership.
(3) Includes 1,510 shares of Common Stock issuable upon exercise of options
owned by Mr. Crosby's children as to which he disclaims beneficial
ownership.
(4) Includes 2,200 shares held in gift trusts for Mr. Deutsch's minor children
and 1,500 shares owned by Mr. Deutsch's spouse, as to each of which he
disclaims beneficial ownership.
(5) The address for Mr. Gerschel, who is a 5% stockholder as well as a
director, is: c/o Gerschel & Co., 720 Fifth Avenue, New York, NY 10019.
Share total includes 17,000 shares of Common Stock owned by affiliated
entities.
(6) Excludes 25,000 shares of Common Stock beneficially owned by California
Casualty Indemnity Exchange, with which Mr. Goldberg is affiliated.
(7) Includes 3,500 shares owned by Mr. Sargent's spouse and 5,400 shares owned
by an affiliated trust, as to which Mr. Sargent disclaims beneficial
ownership.
(8) Includes 3,475 shares held in gift trusts for Mr. Sills' minor children as
to which he disclaims beneficial ownership.
34
37
(9) Based upon filing on SEC Schedule 13G, dated January 22, 1999. Nature of
ownership is as follows: sole voting power -- all shares; shared voting
power -- 0 shares; sole dispositive power -- all shares; and shared
dispositive power -- 5,830 shares. The address of this stockholder is as
follows:
Franklin Resources Inc.
777 Mariners Island
San Mateo, CA 94404
(10) Based upon filing on SEC Schedule 13G, dated January 26, 1999. Nature of
ownership is as follows: sole voting power -- 607,117 shares; shared voting
power -- 155,700 shares; sole dispositive power -- 59,613; and shared
dispositive power -- 155,700 shares. The address of this stockholder is as
follows:
Mellon Bank Corporation/Mellon Bank, N.A.
One Mellon Bank Center
Pittsburgh, PA 15258
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K
FINANCIAL STATEMENTS AND SCHEDULES
The Financial Statements and schedules listed in the accompanying Index to
Financial Statements and Schedules are filed as part of this Report.
EXHIBITS
The exhibits listed on the accompanying Index to Exhibits are filed as part
of this Report.
REPORTS ON FORM 8-K
The Company filed no Current Reports on Form 8-K during the quarter ended
December 31, 1998. On February 9, 1999, the Company filed a Current Report on
Form 8-K with respect to its entry into an Agreement and Plan of Merger with The
Chubb Corporation, dated as of February 6, 1999.
35
38
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
EXECUTIVE RISK INC.
(REGISTRANT)
By: /s/ STEPHEN J. SILLS
------------------------------------
STEPHEN J. SILLS,
PRESIDENT AND CHIEF EXECUTIVE
OFFICER
March 25, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
--------- ----- ----
/s/ Gary G. Benanav Director March 25, 1999
- -----------------------------------------------------
GARY G. BENANAV
/s/ Barbara G. Cohen Director March 25, 1999
- -----------------------------------------------------
BARBARA G. COHEN
/s/ John G. Crosby Director March 25, 1999
- -----------------------------------------------------
JOHN G. CROSBY
/s/ Robert V. Deutsch Executive Vice President, March 25, 1999
- ----------------------------------------------------- Treasurer, Chief Financial
ROBERT V. DEUTSCH and Accounting Officer, Chief
Actuary and Director
/s/ Patrick A. Gerschel Director March 25, 1999
- -----------------------------------------------------
PATRICK A. GERSCHEL
/s/ Peter Goldberg Director March 25, 1999
- -----------------------------------------------------
PETER GOLDBERG
/s/ Robert H. Kullas Chairman and Director March 25, 1999
- -----------------------------------------------------
ROBERT H. KULLAS
/s/ Michael D. Rice Director March 25, 1999
- -----------------------------------------------------
MICHAEL D. RICE
/s/ Joseph D. Sargent Director March 25, 1999
- -----------------------------------------------------
JOSEPH D. SARGENT
/s/ Stephen J. Sills President, Chief Executive March 25, 1999
- ----------------------------------------------------- Officer and Director
STEPHEN J. SILLS
/s/ Irving B. Yoskowitz Director March 25, 1999
- -----------------------------------------------------
IRVING B. YOSKOWITZ
36
39
INDEX TO EXHIBITS
EXHIBIT NO.
- -----------
(3) -- Articles of incorporation and bylaws:
3.1 Amended and Restated Certificate of Incorporation of
Executive Risk Inc., incorporated herein by reference to
Exhibit 3.1 to the Registrant's Current Report on Form 8-K,
filed June 5, 1997.
3.2 Restated Bylaws of Executive Risk Inc., incorporated herein
by reference to Exhibit 3.2 to Registrant's Current Report
on Form 8-K, filed June 5, 1997.
(10) -- Material contracts
10.1 Stock Purchase Option between Executive Risk Inc. and The
Aetna Casualty and Surety Company, incorporated herein by
reference to Exhibit 10.3 to the Registration Statement on
Form S-1 (No. 33-70820) of the Company (herein the
"Registration Statement").
10.2 Rights Agreement between Executive Risk Inc. and Mellon
Bank, N.A., as Rights Agent, incorporated herein by
reference to Exhibit 10.19 to the Registration Statement, as
amended and restated, incorporated by reference to Exhibit
4.1 to the Current Report on Form 8-K, filed November 6,
1998.
10.3 Executive Risk Inc. Nonqualified Stock Option Plan, as
amended and restated, incorporated by reference to Exhibit
10.7 to the Annual Report on Form 10-K for the fiscal year
ended December 31, 1996 (the "1996 10-K").
10.4 Executive Risk Inc. Employee Incentive Nonqualified Stock
Option Plan, as amended and restated, incorporated by
reference to Exhibit 10.8 to the 1996 10-K.
10.5 Executive Risk Inc. Incentive Compensation Plan,
incorporated herein by reference to Exhibit 10.19 to the
1994 10-K.
10.6 Executive Risk Inc. Retirement Plan, incorporated herein by
reference to Exhibit 10.27 to the Registration Statement.
10.7 Executive Risk Inc. Nonemployee Directors Stock Option Plan,
as amended and restated, filed herewith.
10.9 Supplemental Pension Agreement by and among the Company,
Aetna Life and Casualty Company and LeRoy A. Vander Putten,
dated as of March 31, 1995, incorporated herein by reference
to Exhibit 10.3 to Quarterly Report on Form 10-Q for the
period ended March 31, 1995.
10.10 Executive Risk Inc. Stock Incentive Plan, incorporated
herein by reference to Exhibit 10.25 to the 1996 10K.
10.11 Executive Risk Inc. Performance Share Plan, incorporated
herein by reference to Exhibit 10.26 to the 1996 10-K.
10.12 Restructuring Agreement, dated as of February 13, 1997, by
and among Executive Risk Inc., Executive Re Inc., Executive
Risk Indemnity Inc., Executive Risk Specialty Insurance
Company, Executive Risk Management Associates, The Aetna
Casualty and Surety Company and Aetna Casualty and Surety of
Canada, incorporated by reference to Exhibit 10.1 to Current
Report on Form 8-K dated February 18, 1997 (the "February
1997 8-K").
37
40
EXHIBIT NO.
- -----------
10.13 Agency and Insurance Services Agreement, dated as of January
1, 1997, by and between The Aetna Casualty and Surety
Company and Executive Risk Management Associates,
incorporated by reference to Exhibit 10.2 to the February
1997 8-K.
10.14 Quota Share Reinsurance Agreement, dated as of January 1,
1997, by and between The Aetna Casualty and Surety Company
and Executive Risk Indemnity Inc., incorporated by reference
to Exhibit 10.3 to the February 1997 8-K.
10.15 Retirement Agreement, dated as of June 1, 1997, between the
Company and LeRoy A. Vander Putten, incorporated by
reference to Exhibit 10.15 of the 1997 Form 10-K.
10.16 Consulting and Non-Competition Agreement, dated as of June
1, 1997, between the Company and LeRoy A. Vander Putten,
incorporated by reference to Exhibit 10.16 of the 1997 Form
10-K.
10.17 Agreement and Plan of Merger, dated as of February 6, 1999,
among Executive Risk Inc., The Chubb Corporation and
Excalibur Acquisition, Inc., incorporated by reference to
Exhibit 99.2 to Current Report on Form 8-K filed February
11, 1999 (the "February 1999 8-K").
10.18 Stock Option Agreement, dated as of February 6, 1999,
between Executive Risk Inc. and The Chubb Corporation,
incorporated by reference to Exhibit 99.3 to the February
1999 8-K.
(21) Subsidiaries of Executive Risk Inc.
(23) Consents of experts and counsel
23.1 Consent of Ernst & Young LLP
38
41
INDEX TO FINANCIAL STATEMENTS AND SCHEDULES
PAGES
-----
Financial Statements of Executive Risk Inc.
Report of Independent Auditors on Financial Statements...... F-1
Consolidated Balance Sheets at December 31, 1998 and 1997... F-2
Consolidated Statements of Income for the years ended F-3
December 31, 1998, 1997 and 1996..........................
Consolidated Statements of Stockholders' Equity for the F-4
years ended December 31, 1998,
1997 and 1996.............................................
Consolidated Statements of Cash Flows for the years ended F-5
December 31, 1998, 1997 and 1996..........................
Notes to Consolidated Financial Statements.................. F-6
Schedule(s)
II Condensed Financial Information of Registrant
-- Balance Sheets........................................... S-1
-- Statements of Income..................................... S-2
-- Statements of Cash Flows................................. S-3
Schedules not listed above have been omitted because they are not applicable or
are not required, or the information required to be set forth therein is
included in the Consolidated Financial Statements or Notes thereto.
39
42
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, 1998 and 1997, and the related
consolidated statements of income, stockholders' equity and cash flows for each
of the three years in the period ended December 31, 1998. Our audits also
included the financial statement schedule listed in the Index at Item 14(a).
These financial statements and schedule are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements and schedule 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 consolidated statements referred to above
present fairly, in all material respects, the consolidated financial position of
Executive Risk Inc. and its subsidiaries at December 31, 1998 and 1997, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 1998, in conformity with generally
accepted accounting principles. Also, in our opinion, the related financial
statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.
ERNST & YOUNG LLP
Stamford, Connecticut
February 6, 1999
F-1
43
EXECUTIVE RISK INC.
CONSOLIDATED BALANCE SHEETS
DECEMBER 31,
------------------------
1998 1997
---------- ----------
(In thousands, except share data)
ASSETS
Fixed maturities available for sale, at fair value
(amortized cost: 1998 -- $1,102,744 and
1997 -- $905,050)...................................... $1,136,375 $ 934,981
Equity securities available for sale, at fair value (cost:
1998 -- $50,103 and 1997 -- $42,787)................... 79,187 61,732
Cash and short-term investments, at cost which
approximates market.................................... 34,312 88,505
---------- ----------
TOTAL CASH AND INVESTED ASSETS.................... 1,249,874 1,085,218
Premiums receivable....................................... 44,256 40,033
Reinsurance recoverables.................................. 302,062 159,918
Accrued investment income................................. 16,479 13,731
Deferred acquisition costs................................ 38,252 34,581
Prepaid reinsurance premiums.............................. 150,266 99,847
Deferred income taxes..................................... 22,336 23,316
Other assets.............................................. 42,514 29,160
---------- ----------
TOTAL ASSETS...................................... $1,866,039 $1,485,804
========== ==========
LIABILITIES
Loss and loss adjustment expenses......................... $ 866,285 $ 637,929
Unearned premiums......................................... 369,532 289,840
Senior notes payable...................................... 75,000 75,000
Ceded balances payable.................................... 54,969 37,165
Accrued expenses and other liabilities.................... 44,330 44,687
---------- ----------
TOTAL LIABILITIES................................. 1,410,116 1,084,621
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......... 125,000 125,000
STOCKHOLDERS' EQUITY
Preferred Stock, $.01 par value; authorized 4,000,000
shares; issued -- 1998 and 1997 -- 0 shares............ -- --
Common Stock, $.01 par value; authorized 52,500,000
shares; issued -- 1998 -- 12,229,622 shares and
1997 -- 11,953,358 shares.............................. 122 120
Additional paid-in capital................................ 178,740 176,234
Accumulated other comprehensive income.................... 40,959 31,288
Retained earnings......................................... 143,658 101,101
Cost of shares in treasury, at cost:
1998 -- 1,114,294 shares and 1997 -- 1,114,421
shares................................................ (32,556) (32,560)
---------- ----------
TOTAL STOCKHOLDERS' EQUITY........................ 330,923 276,183
---------- ----------
TOTAL LIABILITIES, PREFERRED SECURITIES OF
EXECUTIVE RISK CAPITAL TRUST AND STOCKHOLDERS'
EQUITY.......................................... $1,866,039 $1,485,804
========== ==========
The accompanying notes are an integral part of the consolidated financial
statements.
F-2
44
EXECUTIVE RISK INC.
CONSOLIDATED STATEMENTS OF INCOME
YEAR ENDED DECEMBER 31,
-----------------------------------
1998 1997 1996
--------- --------- ---------
(In thousands, except per share data)
REVENUES
Gross premiums written................................ $ 516,318 $ 431,394 $ 332,085
Premiums ceded........................................ (232,604) (169,470) (121,709)
--------- --------- ---------
Net premiums written............................... 283,714 261,924 210,376
Change in unearned premiums........................... (29,252) (50,748) (54,592)
--------- --------- ---------
NET PREMIUMS EARNED................................ 254,462 211,176 155,784
Net investment income................................. 61,711 47,115 32,646
Net realized capital gains............................ 6,654 3,212 1,047
Other income.......................................... 331 144 166
--------- --------- ---------
TOTAL REVENUES................................ 323,158 261,647 189,643
EXPENSES
Loss and loss adjustment expenses..................... 167,946 141,773 105,335
Policy acquisition costs.............................. 50,289 34,978 27,803
General and administrative expenses................... 36,301 28,614 17,255
Interest expense...................................... 5,373 1,783 4,511
Minority interest in Executive Risk Capital Trust..... 10,519 9,819 --
--------- --------- ---------
TOTAL EXPENSES................................ 270,428 216,967 154,904
--------- --------- ---------
INCOME BEFORE INCOME TAXES.................... 52,730 44,680 34,739
INCOME TAX EXPENSE (BENEFIT)
Current............................................... 13,157 12,834 14,201
Deferred.............................................. (3,864) (4,679) (7,567)
--------- --------- ---------
9,293 8,155 6,634
--------- --------- ---------
NET INCOME.................................... $ 43,437 $ 36,525 $ 28,105
========= ========= =========
PER SHARE DATA
Earnings per common share............................... $ 3.95 $ 3.71 $ 2.88
Earnings per common share -- assuming dilution.......... $ 3.71 $ 3.41 $ 2.67
Dividends declared per common share..................... $ 0.08 $ 0.08 $ 0.08
The accompanying notes are an integral part of the consolidated financial
statements.
F-3
45
EXECUTIVE RISK INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEAR ENDED DECEMBER 31,
------------------------------
1998 1997 1996
-------- -------- --------
(In thousands)
COMMON STOCK OUTSTANDING (SHARES):
Balance, beginning of year................................ 10,839 9,325 11,498
Options exercised......................................... 246 364 38
Performance Share Plan awards............................. 30 -- --
Secondary offering........................................ -- 1,150 --
Common Stock repurchase................................... -- -- (2,511)
Treasury shares reissued.................................. -- -- 300
-------- -------- --------
Balance, end of year................................... 11,115 10,839 9,325
-------- -------- --------
COMMON STOCK:
Balance, beginning of year................................ $ 120 $ 104 $ 116
Options exercised......................................... 2 4 --
Secondary offering........................................ -- 12 --
Treasury shares retired................................... -- -- (12)
-------- -------- --------
Balance, end of year................................... 122 120 104
-------- -------- --------
ADDITIONAL PAID-IN CAPITAL:
Balance, beginning of year................................ 176,234 93,651 87,228
Options exercised......................................... 2,976 9,885 730
Directors' options fees granted........................... 30 57 66
Employee stock-based compensation plans................... 1,103 6,154 5,444
Performance Share Plan awards............................. (1,607) -- --
Treasury shares issued.................................... 4 -- --
Secondary offerings, net of related expenses.............. -- 66,487 521
Treasury shares retired................................... -- -- (338)
-------- -------- --------
Balance, end of year................................... 178,740 176,234 93,651
-------- -------- --------
ACCUMULATED OTHER COMPREHENSIVE INCOME:
Balance, beginning of year................................ 31,288 18,196 19,185
Unrealized gains (losses) on investments, net of
reclassification adjustment............................ 8,994 13,387 (774)
Currency translation adjustments.......................... 677 (295) (215)
-------- -------- --------
Balance, end of year................................... 40,959 31,288 18,196
-------- -------- --------
RETAINED EARNINGS:
Balance, beginning of year................................ 101,101 65,384 74,315
Comprehensive Income...................................... 53,108 49,617 27,116
Other Comprehensive Income................................ (9,671) (13,092) 989
Common Stock dividends.................................... (880) (808) (789)
Treasury shares retired................................... -- -- (36,247)
-------- -------- --------
Balance, end of year................................... 143,658 101,101 65,384
-------- -------- --------
COMMON STOCK IN TREASURY:
Balance, beginning of year................................ (32,560) (32,560) (3,119)
Treasury shares issued.................................... 4 -- --
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 retired................................... -- -- 36,597
-------- -------- --------
Balance, end of year................................... (32,556) (32,560) (32,560)
-------- -------- --------
TOTAL STOCKHOLDERS' EQUITY.................................. $330,923 $276,183 $144,775
======== ======== ========
The accompanying notes are an integral part of the consolidated financial
statements.
F-4
46
EXECUTIVE RISK INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31,
-----------------------------------
1998 1997 1996
--------- --------- ---------
(In thousands)
OPERATING ACTIVITIES
Net income.................................................. $ 43,437 $ 36,525 $ 28,105
Adjustments to reconcile net income to net cash provided by
operating activities:
Amortization and depreciation............................. 6,147 2,682 1,729
Deferred income taxes..................................... (3,864) (4,679) (7,567)
Amortization of bond premium.............................. 3,245 1,904 1,019
Net realized gains on investments......................... (6,654) (3,212) (1,047)
Stock based compensation plans............................ 241 6,154 2,428
Amortization of loan arrangement fees..................... -- 910 --
Other..................................................... (7,116) (1,011) (1,838)
Change in:
Premiums receivable, net of ceded balances payable...... 13,581 (2,513) 10,297
Accrued investment income............................... (2,748) (3,605) (717)
Deferred acquisition costs.............................. (3,671) (11,885) (6,452)
Loss and loss adjustment exp., net of reinsurance
recoverables.......................................... 86,212 98,672 88,704
Unearned premiums, net of prepaid reinsurance
premiums.............................................. 29,273 50,733 54,592
Accrued expenses and other liabilities.................. (159) 10,324 221
--------- --------- ---------
NET CASH PROVIDED BY OPERATING ACTIVITIES............... 157,924 180,999 169,474
INVESTING ACTIVITIES
Proceeds from sales of fixed maturities available for
sale...................................................... 546,607 286,742 179,510
Proceeds from sales of equity securities available for
sale...................................................... 4,272 1,389 --
Proceeds from maturities of investment securities........... 68,315 44,181 34,586
Purchase of fixed maturities available for sale............. (804,139) (627,134) (340,648)
Purchase of equity securities available for sale............ (10,296) (10,536) (13,691)
Net capital expenditures.................................... (16,860) (8,092) (2,881)
Acquisition of the assets of Sullivan, Kelly & Associates,
Inc....................................................... -- (2,317) --
--------- --------- ---------
NET CASH USED IN INVESTING ACTIVITIES................... (212,101) (315,767) (143,124)
FINANCING ACTIVITIES
Proceeds from exercise of options........................... 1,047 4,122 423
Cost of repurchase of Common Stock.......................... -- -- (75,025)
Placement fees and other.................................... (183) (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.............................. (880) (808) (789)
--------- --------- ---------
NET CASH (USED IN) PROVIDED BY FINANCING ACTIVITIES..... (16) 198,567 (21,888)
--------- --------- ---------
NET (DECREASE) INCREASE IN CASH AND SHORT-TERM
INVESTMENTS........................................... (54,193) 63,799 4,462
Cash and short-term investments at beginning of year........ 88,505 24,706 20,244
--------- --------- ---------
CASH AND SHORT-TERM INVESTMENTS AT END
OF YEAR............................................... $ 34,312 $ 88,505 $ 24,706
========= ========= =========
The accompanying notes are an integral part of the consolidated financial
statements
F-5
47
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization and Principles of Consolidation: Executive Risk Inc. ("ERI")
is a specialty insurance holding company incorporated under the laws of the
State of Delaware. ERI 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
International Holdings B.V. ("ERBV"). ERII, a Delaware corporation, commenced
insurance operations under the ownership of Executive Re in 1986. ERII owns all
of the outstanding stock of Executive Risk Specialty Insurance Company ("ERSIC")
and Quadrant Indemnity Company ("Quadrant"). ERSIC and Quadrant, both
Connecticut corporations, commenced insurance operations in 1992 and 1997,
respectively. ERI and Executive Re also own 100% of Executive Risk Management
Associates ("ERMA"), a Connecticut general partnership. ERBV owns all of the
outstanding stock of Executive Risk N.V. ("ERNV"), a Dutch insurance company
incorporated in May 1995 in the Netherlands to write professional liability
insurance in the European Community. ER Bermuda, a Bermuda domiciled insurance
company, was incorporated in September 1997 under the laws of Bermuda. 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 the third quarter of 1998, the
Company announced the closing of the Sullivan Kelly brokerage operation and the
Paris, France office of ERNV (Note 5). Consolidated results also include
Executive Risk Capital Trust, a Delaware statutory business trust wholly owned
by ERI. ERI and its subsidiaries are collectively referred to as the "Company".
The Company develops, markets and underwrites a wide variety of specialty
insurance coverages, including policies for directors and officers liability
insurance ("D&O"), professional liability insurance, employment practices
liability insurance, medical institution malpractice insurance 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 underwritten by ERMA and issued by Travelers Property Casualty
Corp. ("Travelers"), formerly known as Travelers/Aetna Property Casualty Corp.,
a stockholder of the Company until March 1996 (Notes 6 and 7). The Company also
writes other lines of business through program administrators. The Company's
products are distributed through licensed independent property and casualty
insurance brokers, excess and surplus lines brokers and licensed wholesale
insurance brokers.
All significant intercompany amounts are eliminated in consolidation.
Certain prior year amounts have been reclassified to conform with the 1998
presentation.
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.
Earnings Per Share: In accordance with Statement of Financial Accounting
Standards ("SFAS") No. 128, "Earnings per Share", ("SFAS No. 128") earnings per
common share are based on the weighted average common shares outstanding during
the period and 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. All earnings per share amounts
for all periods presented and, where appropriate, have been restated to conform
to SFAS No. 128 requirements.
Investments: The Company classifies 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).
F-6
48
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Short-term investments are carried at cost which 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.
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 1996 through 1998 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 (Note 7).
Premium Income and Unearned Premiums: Gross premiums written are
recognized as premiums earned principally on a monthly 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 monthly 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: 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, and include a
provision for unreported claims and related expenses. 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 such 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 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 (Note 12).
Software Costs: During the first quarter of 1998, the Company adopted the
Accounting Standards Executive Committee of the American Institute of Certified
Public Accountants' (AcSEC) Statement of Position 98-1, "Accounting for the
Costs of Computer Software Developed or Obtained for Internal Use" ("SOP 98-1").
SOP 98-1 provides guidance on accounting for the costs of computer software
developed or obtained for internal use and for determining when specific costs
should be capitalized and when they should be expensed. The impact of SOP 98-1
on the Company's results of operations was not significant.
F-7
49
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Statements of Cash Flows: In the accompanying statements of cash flows,
the Company considers all highly liquid investments with an original 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 Based 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.
Future Application of Accounting Standards: In June 1998, the Financial
Accounting Standards Board ("FASB") issued SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities" ("SFAS No. 133"). SFAS No. 133
establishes accounting and reporting standards for derivative instruments and
for hedging activities. SFAS No. 133 requires that an entity recognize all
derivatives as either assets or liabilities in the statement of financial
position and measure those derivatives at fair value. The accounting for the
changes in the fair value of the derivatives depends on the intended use of the
derivative and the resulting designation as prescribed by the provisions of SFAS
No. 133. SFAS No. 133 is effective for all fiscal quarters of fiscal years
beginning after June 15, 1999, with earlier application permitted. The Company
is currently reviewing the provisions of SFAS No. 133 and its anticipated
financial statement impact to the Company.
2. SUBSEQUENT EVENTS
On February 6, 1999, The Chubb Corporation ("Chubb") and ERI entered into a
definitive merger agreement under which Chubb will acquire ERI. The agreement,
which has been approved by the boards of directors of both companies, provides
that ERI shareholders will receive 1.235 shares of Chubb common stock for each
outstanding common share of ERI. The merger agreement contains customary
termination provisions including an option for Chubb to acquire 19.9% of ERI's
shares. The directors of ERI have all agreed to vote their shares in favor of
the merger. The acquisition, which is subject to the satisfaction of customary
closing conditions, including stockholder and regulatory approval, is expected
to close by the end of the second quarter of 1999.
In the first quarter of 1999, the Company restructured certain of its
reinsurance treaties. The restructured reinsurance program generally makes
greater use of excess of loss reinsurance, rather than quota share reinsurance,
to reduce exposures to severity losses. The reinsurance restructuring resulted
in the non-renewal of several in-force reinsurance treaties commensurate with
the effective date of the new reinsurance treaties. The restructuring of the
reinsurance treaties is not expected to have a material adverse effect on the
Company's financial position or results of operations.
On March 22, 1999, Aetna Life and Casualty Company ("AL&C") fully exercised
an option to purchase 100,000 shares of ERI Common Stock at $12.00 per share
(the "Aetna Stock Option").
3. COMPREHENSIVE INCOME
On January 1, 1998, the Company adopted SFAS No. 130, "Reporting
Comprehensive Income" ("SFAS No. 130"). SFAS No. 130 establishes new rules for
the reporting and display of comprehensive income and its components; however,
the adoption of this Statement had no impact on the Company's net income or
stockholders' equity. SFAS No. 130 requires unrealized gains or losses on the
Company's available for sale securities and foreign currency translation
adjustments, which prior to adoption were reported separately in stockholders'
equity, to be included in other comprehensive income. Prior year financial
statements have been reclassified to conform to the requirements of SFAS No.
130.
F-8
50
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The related tax effects allocated to each component of comprehensive income
were as follows:
YEAR ENDED DECEMBER 31, 1998
---------------------------------------
BEFORE-TAX TAX EXPENSE NET-OF-TAX
AMOUNT (BENEFIT) AMOUNT
---------- ----------- ----------
(IN THOUSANDS)
Net income...................................... $52,730 $ 9,293 $43,437
------- ------- -------
Unrealized gains on securities:
Unrealized investment gains on available for
sale securities............................ 16,132 5,646 10,486
Less: Reclassification adjustment for realized
gains included in investment income........ (2,293) (801) (1,492)
------- ------- -------
Net unrealized gains on securities.............. 13,839 4,845 8,994
Foreign currency translation adjustments........ 1,042 365 677
------- ------- -------
Other comprehensive income...................... 14,881 5,210 9,671
------- ------- -------
Comprehensive income............................ $67,611 $14,503 $53,108
======= ======= =======
YEAR ENDED DECEMBER 31, 1997
---------------------------------------
BEFORE-TAX TAX EXPENSE NET-OF-TAX
AMOUNT (BENEFIT) AMOUNT
---------- ----------- ----------
(IN THOUSANDS)
Net income...................................... $44,680 $ 8,155 $36,525
------- ------- -------
Unrealized investment gains on available for
sale securities............................... 20,595 7,208 13,387
Foreign currency translation adjustments........ (453) (158) (295)
------- ------- -------
Other comprehensive income...................... 20,142 7,050 13,092
------- ------- -------
Comprehensive income............................ $64,822 $15,205 $49,617
======= ======= =======
YEAR ENDED DECEMBER 31, 1996
---------------------------------------
BEFORE-TAX TAX EXPENSE NET-OF-TAX
AMOUNT (BENEFIT) AMOUNT
---------- ----------- ----------
(IN THOUSANDS)
Net income...................................... $34,739 $6,634 $28,105
Unrealized investment losses on available for
sale securities............................... (1,191) (417) (774)
Foreign currency translation adjustments........ (331) (116) (215)
------- ------ -------
Other comprehensive income...................... (1,522) (533) (989)
------- ------ -------
Comprehensive income............................ $33,217 $6,101 $27,116
======= ====== =======
The components of accumulated other comprehensive income, net of tax, as of
December 31, 1998 and 1997 were as follows:
DECEMBER 31,
------------------
1998 1997
------- -------
(IN THOUSANDS)
Unrealized investment gains.......................... $40,763 $31,769
Foreign currency translation......................... 196 (481)
------- -------
Accumulated other comprehensive income............... $40,959 $31,288
======= =======
F-9
51
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
4. 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,
--------------------------------------
1998 1997 1996
---------- ---------- ----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Numerator:
Net income................................................ $43,437 $36,525 $28,105
Denominator:
Denominator for earnings per common share -- weighted
average shares......................................... 10,987 9,838 9,759
Effect of dilutive securities:
Employee and director stock options....................... 603 764 701
Stock incentive and performance share plans............... 130 113 56
------- ------- -------
Total dilutive potential common shares...................... 733 877 757
Denominator for earnings per common share -- assuming
dilution.................................................. 11,720 10,715 10,516
Earnings per common share................................... $ 3.95 $ 3.71 $ 2.88
Earnings per common share -- assuming dilution.............. 3.71 3.41 2.67
For additional disclosures regarding the outstanding employee and director
stock options and the stock incentive and performance share plans, see Note 10.
Options to purchase 150,677 shares of Common Stock at per share prices from
$65.06 -- $73.69 were outstanding for a portion of 1998 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.
5. BUSINESS ACQUISITION AND DISPOSITIONS
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, consisting of $0.1 million of fixed assets and $0.7 million for
a non-compete agreement which was being amortized over 3.75 years. The remaining
purchase price of $1.5 million was allocated to goodwill and was being amortized
over a 15-year period. In the third quarter of 1998, the Company announced the
closing of the Sullivan Kelly brokerage operation and the Paris, France office
of ERNV. In connection with these closings, $5.8 million of non-recurring
charges were recorded. These non-recurring charges consisted of $3.4 million
related to non-cash asset impairments, $1.1 million for lease termination costs
and $1.3 million of employee separation and other costs. These charges were
recorded on the consolidated income statement as $1.9 million of policy
acquisition costs and $3.9 million of general and administrative costs. As of
December 31, 1998, $1.4 million of these accrued charges remain unpaid.
6. STOCK REPURCHASE AND OFFERINGS
On March 22, 1996, the Company entered into a Stock Purchase Agreement (the
"Agreement") with AL&C and AL&C's wholly owned subsidiary, Aetna. Pursuant to
the Agreement, on March 26, 1996, the Company repurchased 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 $29.88, 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")
F-10
52
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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 and the Aetna Stock
Option remained under Aetna ownership. Subsequently, in connection with the
acquisition of Aetna by The Travelers Insurance Group Inc., Aetna transferred
ownership of the remaining 2,000,000 shares of 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.
The following table presents consolidated pro forma income statement data
for the year ended December 31, 1996 as adjusted to give pro forma effect to the
stock repurchase of 2,511,300 shares of the Company's capital stock at $29.88
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.
YEAR ENDED
DECEMBER 31,
1996
---------------------
(IN THOUSANDS, EXCEPT
PER SHARE DATA)
Total revenues............................................. $189,483
Net income................................................. 27,482
Weighted average shares outstanding -- assuming dilution... 9,910
Earnings per common share -- assuming dilution............. $ 2.77
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.
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
F-11
53
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
new insurance services agreement among the Company, 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 therefore was
able to compete with the Company on D&O sooner than it otherwise could have.
During 1998, 1997 and 1996, gross premiums written assumed by ERII under the
various agreements with Travelers were approximately $1.0 million, $4.6 million
and $13.8 million, respectively.
The Company, through ERII and ERSIC, 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,
-----------------------------------
1998 1997 1996
--------- --------- ---------
(IN THOUSANDS)
PREMIUMS WRITTEN
Direct........................................ $ 509,076 $ 414,967 $ 305,265
Assumed....................................... 7,242 16,427 26,820
Ceded......................................... (232,604) (169,470) (121,709)
--------- --------- ---------
Net Premiums Written............................ $ 283,714 $ 261,924 $ 210,376
========= ========= =========
PREMIUMS EARNED
Direct........................................ $ 425,549 $ 324,182 $ 195,201
Assumed....................................... 11,226 22,692 48,463
Ceded......................................... (182,313) (135,698) (87,880)
--------- --------- ---------
Net Premiums Earned............................. $ 254,462 $ 211,176 $ 155,784
========= ========= =========
Ceded loss and loss adjustment expenses amounted to $159.5 million, $88.4
million and $48.3 million in 1998, 1997 and 1996, 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.
During 1998, the Company adopted SFAS No. 131, "Disclosures about Segments
of an Enterprise and Related Information." The Company has one reportable
segment as it is organized to develop, market and underwrite specialty insurance
coverages domestically and internationally.
F-12
54
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Gross premiums written, net premiums written and net premiums earned by
major product class are as follows:
YEAR ENDED DECEMBER 31,
--------------------------------
1998 1997 1996
-------- -------- --------
(IN THOUSANDS)
GROSS PREMIUMS WRITTEN
D&O...................................................... $261,785 $275,098 $240,834
Professional Firms E&O................................... 56,583 47,633 36,889
Miscellaneous E&O........................................ 115,047 61,680 34,316
International............................................ 7,897 11,365 11,046
Other.................................................... 75,006 35,618 9,000
-------- -------- --------
Gross Premiums Written..................................... $516,318 $431,394 $322,085
======== ======== ========
NET PREMIUMS WRITTEN
D&O...................................................... $191,238 $213,843 $179,201
Professional Firms E&O................................... 18,293 13,833 15,066
Miscellaneous E&O........................................ 42,309 19,397 9,093
International............................................ 1,315 3,581 3,714
Other.................................................... 30,559 11,270 3,302
-------- -------- --------
Net Premiums Written....................................... $283,714 $261,924 $210,376
======== ======== ========
NET PREMIUMS EARNED
D&O...................................................... $185,501 $173,458 $134,940
Professional Firms E&O................................... 16,278 13,480 9,838
Miscellaneous E&O........................................ 28,969 13,690 6,241
International............................................ 1,883 3,331 3,516
Other.................................................... 21,831 7,217 1,249
-------- -------- --------
Net Premiums Earned........................................ $254,462 $211,176 $155,784
======== ======== ========
Two producing brokerage firms and related affiliates accounted for 18% and
16% of the Company's gross written premiums in 1998. No single office of these
firms accounted for more than 6% of the Company's gross written premiums.
8. CREDIT ARRANGEMENTS
On March 26, 1996, in connection with the repurchase of Common Stock from
Aetna (Note 6), 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, $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 Executive Risk Capital Trust (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
F-13
55
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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 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. 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
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, net of capitalized interest in 1998, totaled $16.0
million, $6.3 million and $3.9 million in 1998, 1997 and 1996, respectively.
F-14
56
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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, 1998 and 1997 were as follows:
AMORTIZED GROSS GROSS
COST UNREALIZED UNREALIZED FAIR
AND COST GAINS LOSSES VALUE
---------- ---------- ---------- ----------
(IN THOUSANDS)
1998
FIXED MATURITIES:
United States Government or agency
securities.............................. $ 22,677 $ 494 $ (16) $ 23,155
Obligations of states and political
subdivisions............................ 703,712 30,620 (448) 733,884
Corporate securities....................... 157,583 3,356 (1,952) 158,987
Mortgage and other asset backed
securities.............................. 140,203 2,090 (2,360) 139,933
Foreign government securities.............. 16,085 502 -- 16,587
Foreign corporate securities............... 31,873 589 (215) 32,247
Sinking fund preferred stocks.............. 30,611 971 -- 31,582
---------- ------- ------- ----------
$1,102,744 $38,622 $(4,991) $1,136,375
---------- ------- ------- ----------
EQUITY SECURITIES.......................... $ 50,103 $32,217 $(3,133) $ 79,187
---------- ------- ------- ----------
$1,152,847 $70,839 $(8,124) $1,215,562
========== ======= ======= ==========
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 government securities.............. 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
========== ======= ======= ==========
Realized capital gains and losses on sales of investments were as follows:
YEAR ENDED DECEMBER 31,
----------------------------
1998 1997 1996
------- ------ -------
(IN THOUSANDS)
FIXED MATURITIES:
Gross realized capital gains................. $ 5,039 $2,573 $ 1,913
Gross realized capital losses................ (1,511) (748) (2,071)
EQUITY SECURITIES:
Gross realized capital gains................. $ 3,411 $1,389 $ 1,205
Gross realized capital losses................ (285) (2) --
The amortized cost and fair value of investments in fixed maturities at
December 31, 1998 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
F-15
57
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
will differ from contractual maturities because borrowers may have the right to
call or prepay obligations with or without call or prepayment penalties.
AMORTIZED FAIR
COST VALUE
---------- ----------
(IN THOUSANDS)
Due in one year or less............................. $ 41,720 $ 41,871
Due after one year through five years............... 355,538 368,468
Due after five years through ten years.............. 408,098 427,591
Due after ten years through fifteen years........... 154,220 156,116
Due after fifteen years............................. 37,002 36,650
Mortgage backed securities.......................... 106,166 105,679
---------- ----------
$1,102,744 $1,136,375
========== ==========
Changes in unrealized gains and losses were as follows:
YEAR ENDED DECEMBER 31,
-----------------------------
1998 1997 1996
------- ------- -------
(IN THOUSANDS)
Fixed maturities.............................. $ 3,700 $11,956 $(5,375)
Equity Securities............................. 10,139 9,060 4,236
Investment Income: The components of net investment income were as
follows:
YEAR ENDED DECEMBER 31,
-----------------------------
1998 1997 1996
------- ------- -------
(IN THOUSANDS)
Fixed maturities
Taxable..................................... $25,244 $17,438 $ 8,672
Tax-exempt.................................. 31,486 24,933 22,400
Equity securities............................. 2,756 2,410 637
Short-term investments........................ 3,877 3,398 1,714
------- ------- -------
63,363 48,179 33,423
Investment expenses........................... 1,652 1,064 777
------- ------- -------
Net investment income......................... $61,711 $47,115 $32,646
======= ======= =======
10. STOCKHOLDERS' EQUITY
Preferred Stock: The Company has 4,000,000 preferred shares authorized at
December 31, 1998 and 1997, with no shares issued or outstanding.
Treasury Shares: Pursuant to the Aetna stock repurchase (Note 6), 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 $29.88 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
F-16
58
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Company's Common Stock at a price determined by the Committee on Directors and
Compensation of the Company's Board of Directors.
The Company has an 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.
Information with respect to the employee stock options was as follows:
1998 1997 1996
--------------------- --------------------- ---------------------
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........................... 1,645,915 $29.11 1,465,294 $13.89 1,292,304 $12.77
Granted........................ 645,486 54.61 546,700 58.30 219,202 20.54
Exercised...................... (386,390) 12.49 (355,179) 11.37 (31,137) 12.53
Forfeited...................... (205,725) 70.50 (10,900) 24.52 (15,075) 17.95
---------- ------ ---------- ------ ---------- ------
Outstanding at end of year....... 1,699,286 $37.57 1,645,915 $29.11 1,465,294 $13.89
Options exercisable at end of
year........................... 717,832 $18.59 984,762 $13.42 1,066,418 $12.26
Shares reserved under option
plans.......................... 2,105,982 -- 2,492,372 -- 2,847,551 --
Weighted average fair value of
options granted during the
year........................... $ 23.28 -- $ 31.22 -- $ 18.92 --
The following table summarizes information about the Company's employee
stock options outstanding at December 31, 1998.
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 - $12.91......................... 111,875 $11.36 4.3 111,875 $11.36
13.77 - 17.63.......................... 486,025 14.05 3.5 482,925 14.02
26.00 - 37.50.......................... 307,600 33.62 7.6 61,623 27.97
40.25 - 54.00.......................... 194,086 43.24 4.5 3,750 40.25
57.81 - 72.81.......................... 599,700 61.72 7.9 57,659 59.47
--------- ------ --- ------- ------
$ 4.88 - $72.81......................... 1,699,286 $37.57 5.9 717,832 $18.59
--------- ------ --- ------- ------
The Company has adopted a Nonemployee Directors Stock 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
ERI Common Stock.
F-17
59
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Information with respect to the Directors Plan options was as follows:
1998 1997 1996
-------------------- -------------------- --------------------
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........................... 79,172 $15.24 82,285 $12.93 83,026 $10.89
Granted........................ 24,986 56.05 6,719 41.00 11,242 24.25
Exercised...................... (30,914) 11.52 (8,551) 11.35 (6,725) 4.89
Forfeited...................... -- -- (1,281) 28.01 (5,258) 15.22
-------- ------ -------- ------ -------- ------
Outstanding at end of year....... 73,244 $30.73 79,172 $15.24 82,285 $12.93
Options exercisable at end of
year........................... 55,149 $23.14 79,172 $15.24 72,176 $11.12
Shares reserved under option
plans.......................... 452,890 -- 483,804 -- 492,355 --
Weighted average fair value of
options granted during the
year........................... $ 27.53 -- $ 29.44 -- $ 18.92 --
The following table summarizes information about the Directors Plan stock
options outstanding at December 31, 1998.
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......................... 7,755 $ 4.92 4.9 7,755 $ 4.92
12.00.................................. 23,620 12.00 4.2 23,620 12.00
13.88 - 36.31.......................... 18,473 27.21 5.7 12,749 23.23
45.69 - 67.50.......................... 23,396 60.97 7.9 11,025 59.69
--------- ------ --- ------ ------
$ 3.32 - $67.50......................... 73,244 $30.73 5.8 55,149 $23.14
--------- ------ --- ------ ------
Certain key employees who hold stock options under the Nonqualified Stock
Option Plan are eligible to receive restoration options for shares of ERI common
stock surrendered in payment of the exercise price and withholding taxes.
Current directors holding stock options under the Directors Plan are eligible to
receive restoration options for shares of ERI common stock surrendered in
payment of the exercise price. Restoration options, which are priced at the fair
market value of ERI common stock at the date of the option exercise, are granted
only if, upon the initial option exercise, the fair market value of ERI common
stock is at least 25% greater than the exercise price for such options.
Stock Incentive and Performance Share Plans: The Company has two long-term
stock-based incentive compensation plans, the Stock Incentive Plan (the "SIP")
and the Performance Share Plan (the "PSP"). 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 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). Under the
PSP, certain key employees designated by the Committee on Directors and
Compensation were eligible to receive awards of "performance share units" which
converted 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, received by
participants in the PSP was dependent upon, among other things, the financial
performance of the Company during the relevant three-year
F-18
60
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
performance period. No awards of performance share units were made under the PSP
after December 31, 1997. The Company will incur expenses through 1999 related to
the remaining accrual for the 1997 performance year. 6,823 and 8,484 share units
were granted in 1998 and 1997, respectively, under the SIP, of which 791 and
1,567 share units, respectively, were subsequently forfeited. 37,000 performance
share units were granted under the PSP in 1997, of which 1,850 performance share
units were subsequently forfeited. The weighted average fair value of share
units granted in 1998 was $72.13 per share unit, and the weighted average fair
value of share units and performance share units granted in 1997 was $47.14 per
share unit. The Company accrued compensation expense, under APB 25, for the
years ended December 31, 1998, 1997 and 1996 of approximately $1.1 million, $6.2
million and $1.8 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 No.
123, "Accounting for Stock-Based Compensation" has 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 1998,
1997 and 1996 was .16%, .14% and .26%, respectively. The weighted average
expected life for 1998, 1997 and 1996 was 7.4 years, 9.8 years and 8.8 years,
respectively. The weighted average volatility for 1998, 1997 and 1996 was .27%,
.28% and .27%, respectively. The weighted average risk-free interest rate for
1998, 1997 and 1996 was 5.30%, 6.25% and 6.36%, 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:
1998 1997 1996
--------- --------- ---------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Net income
As reported....................................... $43,437 $36,525 $28,105
Pro forma......................................... 38,202 36,199 27,040
Earnings per common share
As reported....................................... $ 3.95 $ 3.71 $ 2.88
Pro forma......................................... 3.48 3.68 2.77
Earnings per common share -- assuming dilution
As reported....................................... $ 3.71 $ 3.41 $ 2.67
Pro forma......................................... 3.26 3.38 2.59
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. The
maximum amount of dividends which can be paid by State of Delaware domestic
insurance companies to shareholders is subject to restrictions relating to
statutory capital and surplus, earned surplus, statutory net income and realized
capital gains. Therefore, ERII may not pay, in
F-19
61
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
any 12-month period, "extraordinary" dividends, which are defined as dividends
that exceed the greater of (i) 10% of statutory capital and surplus as of the
prior year-end and (ii) statutory net income less realized capital gains for
such prior year, until thirty days after the Insurance Commissioner of the State
of Delaware (the "Commissioner") has received notice of such dividends and has
either (i) not disapproved such dividends within such thirty day period or (ii)
approved such dividends within such thirty day period. Dividends may be paid by
ERII only out of earned surplus. In addition, ERII must provide notice to the
Commissioner of all dividends and other distributions to shareholders within
five business days after declaration and at least ten days prior to payment. The
maximum amount of dividends which can be paid by State of Connecticut domestic
insurance companies to shareholders is subject to restrictions relating to
surplus as regards policyholders, earned surplus and statutory net income.
Therefore, ERSIC and Quadrant must obtain approval of the Insurance Commissioner
of the State of Connecticut (the "Connecticut Commissioner"), or must give the
Connecticut Commissioner thirty days prior notice and must not have received
notice of the Connecticut Commissioner's disapproval during such period in order
to pay, in any 12-month period, "extraordinary" dividends, which are defined as
dividends that exceed the greater of 10% of surplus as regards policyholders as
of the prior year-end and statutory net income for such prior year. Connecticut
law further provides that (i) ERSIC and Quadrant must report to the Connecticut
Commissioner, for informational purposes, all dividends and other distributions
within five business days after declaration thereof and at least ten days prior
to payment thereof 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.
11. 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 are 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 $2.8 million, $2.4 million and $1.7 million in 1998,
1997 and 1996, respectively. These amounts include contributions in respect of
service in prior years with the Company.
12. 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,
-----------------------------
1998 1997 1996
------- ------- -------
(IN THOUSANDS)
Pre-tax income........................................ $52,730 $44,680 $34,739
------- ------- -------
Application of the federal statutory tax rate (35%)... 18,456 15,638 12,159
Tax effect of:
Tax-exempt interest................................. (9,367) (7,417) (6,676)
State income taxes.................................. 280 736 625
Dividends received and other........................ (76) (802) 526
------- ------- -------
Total income tax provision............................ $ 9,293 $ 8,155 $ 6,634
======= ======= =======
F-20
62
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Significant components of the Company's deferred tax assets and liabilities
are summarized as follows:
DECEMBER 31,
------------------
1998 1997
------- -------
(IN THOUSANDS)
DEFERRED TAX ASSETS:
Loss reserve discounting............................... $39,129 $34,850
Unearned premiums...................................... 15,284 13,297
Other.................................................. 6,069 6,244
------- -------
Total deferred tax assets................................ 60,482 54,391
DEFERRED TAX LIABILITIES:
Deferred acquisition costs............................. 13,363 12,108
Unrealized gains on investments........................ 21,951 17,107
Other.................................................. 2,832 1,860
------- -------
Total deferred tax liabilities........................... 38,146 31,075
------- -------
Net deferred tax assets.................................. $22,336 $23,316
======= =======
Income taxes paid were $8.4 million, $11.5 million and $12.4 million in
1998, 1997 and 1996, respectively.
13. 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,
-------------------------------
1998 1997 1996
--------- -------- --------
(IN THOUSANDS)
Reserves for losses and LAE at beginning of year,
gross............................................. $ 637,929 $457,063 $324,416
Reinsurance recoverable at beginning of year........ (157,166) (76,916) (33,531)
--------- -------- --------
Reserves for losses and LAE at beginning of year,
net............................................... 480,763 380,147 290,885
Provision for losses and LAE for current year
claims............................................ 185,214 152,042 112,107
Decrease in estimated ultimate losses and LAE for
prior year claims................................. (17,268) (10,269) (6,772)
--------- -------- --------
Total incurred losses and LAE....................... 167,946 141,773 105,335
Adjustment for foreign exchange loss on unpaid loss
and LAE........................................... 255 (469) (23)
Loss and LAE payments for claims attributable to:
Current year...................................... 16,705 4,495 2,239
Prior years....................................... 56,292 36,193 13,811
--------- -------- --------
Total payments...................................... 72,997 40,688 16,050
--------- -------- --------
Reserves for losses and LAE at end of year, net..... 575,967 480,763 380,147
Reinsurance recoverable at end of year.............. 290,318 157,166 76,916
--------- -------- --------
Reserves for losses and LAE at end of year, gross... $ 866,285 $637,929 $457,063
========= ======== ========
The decrease in estimated ultimate losses and LAE for prior year claims was
due principally to favorable development on claim reserves for accident years
1993 and prior.
F-21
63
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
14. 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 codified statutory accounting practices,
the result of which will, when adopted by State Insurance Departments,
constitute the only source of "prescribed" statutory accounting practices.
Accordingly, the Codification will 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.
15. RECONCILIATION -- GENERALLY ACCEPTED ACCOUNTING PRINCIPLES BASIS TO
STATUTORY BASIS
The following table reconciles consolidated GAAP basis net income and
stockholders' equity as reported herein 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.
YEAR ENDED DECEMBER 31,
-------------------------------
1998 1997 1996
------- ------- --------
(IN THOUSANDS)
Consolidated GAAP income.................................... $43,437 $36,525 $ 28,105
Eliminate GAAP net (income) loss, of parent, non-insurance
and foreign subsidiaries.................................. (329) 8,690 5,037
------- ------- --------
ERII consolidated GAAP income............................... 43,108 45,215 33,142
------- ------- --------
Add (subtract) GAAP adjustments:
Deferred acquisition costs................................ (4,157) 171 (11,754)
Deferred income tax benefits.............................. (867) 9,735 (6,213)
Change in foreign exchange translation.................... 209 (359) (20)
Other..................................................... 33 33 33
------- ------- --------
ERII consolidated statutory income.......................... $38,326 $54,795 $ 15,188
======= ======= ========
DECEMBER 31,
--------------------------------
1998 1997 1996
-------- -------- --------
Consolidated GAAP stockholders' equity..................... $330,923 $276,183 $144,775
Eliminate GAAP deficit of parent, non-insurance and foreign
subsidiaries............................................. 53,404 56,947 64,843
-------- -------- --------
ERII consolidated GAAP stockholders' equity................ 384,327 333,130 209,618
Add (subtract) GAAP adjustments:
Deferred acquisition costs............................... (33,075) (28,918) (29,090)
Deferred income taxes (benefits)......................... (1,396) (4,885) (22,207)
Adjust invested assets to statutory value................ (32,072) (30,434) (17,753)
Non-admitted assets...................................... (11,119) (2,018) (410)
Other.................................................... (813) (1,312) (1,753)
-------- -------- --------
ERII consolidated statutory capital and surplus............ $305,852 $265,563 $138,405
======== ======== ========
F-22
64
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
16. CONSOLIDATED QUARTERLY DATA (UNAUDITED)
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER YEAR
------- ------- ------- ------- --------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
1998
Net premiums earned..................... $59,785 $64,376 $63,835 $66,466 $254,462
Net investment income................... 15,139 14,811 15,767 15,994 61,711
Income before income taxes.............. 14,620 13,656 9,595 14,859 52,730
Federal and state income tax expense.... 3,141 2,295 1,090 2,767 9,293
Net Income(1)........................... 11,479 11,361 8,505 12,092 43,437
Earnings per common share(1)(2)......... 1.06 1.04 0.77 1.09 3.95
Earnings per common share -- assuming
dilution(1)........................... 0.98 0.97 0.73 1.03 3.71
Common Stock price range(3)
-- High............................... 75 5/16 74 5/8 72 11/16 56 7/8 75 5/16
-- Low................................ 65 11/16 57 1/2 35 7/8 40 1/2 35 7/8
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(2)............ 0.90 0.91 0.91 0.98 3.71
Earnings per common share -- assuming
dilution.............................. 0.83 0.83 0.84 0.91 3.41
Common Stock price range(3)
-- 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
- ---------------
(1) Third quarter results include non-recurring expenses associated with
Sullivan Kelly and the closing of the Paris, France office of ERNV (Note 5).
(2) The sum of the quarters' earnings per share does not equal the year-to-date
amount due to the different weighting of common stock equivalents for the
quarterly and annual earnings per share calculations.
(3) 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 1998,
1997 and 1996. 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.
As of March 1, 1999, the approximate number of common stockholders of
record was 221.
F-23
65
EXECUTIVE RISK INC. (PARENT COMPANY ONLY)
SCHEDULE II -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEETS
DECEMBER 31,
--------------------
1998 1997
-------- --------
(In thousands)
ASSETS
Fixed maturities available for sale....................... $ 68,603 $ 69,243
Equity securities available for sale...................... 8 8
Cash and short-term investments........................... 6,346 49,684
-------- --------
TOTAL CASH AND INVESTED ASSETS.................... 74,957 118,935
Accrued investment income................................. 1,025 1,058
Intercompany receivable................................... 1,250 1,376
Investment in subsidiaries and equity investees........... 455,355 353,587
Deferred income taxes..................................... 5,029 4,963
Other assets.............................................. 7,919 5,942
-------- --------
TOTAL ASSETS...................................... $545,535 $485,861
======== ========
LIABILITIES
Senior notes payable...................................... 75,000 75,000
Debentures payable to Executive Risk Capital Trust........ 128,866 128,866
Accrued expenses and other liabilities.................... 10,746 5,812
-------- --------
TOTAL LIABILITIES................................. 214,612 209,678
STOCKHOLDERS' EQUITY
Common Stock.............................................. 122 120
Additional paid-in capital................................ 178,740 176,234
Accumulated other comprehensive income.................... 40,959 31,288
Retained earnings......................................... 143,658 101,101
Cost of shares in treasury................................ (32,556) (32,560)
-------- --------
TOTAL STOCKHOLDERS' EQUITY........................ 330,923 276,183
-------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY........ $545,535 $485,861
======== ========
S-1
66
EXECUTIVE RISK INC. (PARENT COMPANY ONLY)
SCHEDULE II -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF INCOME
YEAR ENDED DECEMBER 31,
-------------------------------
1998 1997 1996
-------- -------- -------
(In thousands)
REVENUES
Net investment income..................................... $ 5,161 $ 1,162 $ 624
Net realized capital gains................................ -- -- 503
-------- -------- -------
TOTAL REVENUES......................................... 5,161 1,162 1,127
EXPENSES
General and administrative expenses....................... 1,939 2,385 3,460
Long-term incentive compensation.......................... -- -- 187
Interest expense.......................................... 16,234 11,911 4,335
-------- -------- -------
TOTAL EXPENSES......................................... 18,173 14,296 7,982
-------- -------- -------
LOSS BEFORE TAXES AND EARNINGS OF SUBSIDIARIES......... (13,012) (13,134) (6,855)
Federal income tax benefit................................ (3,946) (4,145) (2,543)
-------- -------- -------
LOSS BEFORE EARNINGS OF SUBSIDIARIES................... (9,066) (8,989) (4,312)
Equity in earnings of subsidiaries........................ 52,503 45,514 32,417
-------- -------- -------
NET INCOME............................................. $ 43,437 $ 36,525 $28,105
======== ======== =======
S-2
67
EXECUTIVE RISK INC. (PARENT COMPANY ONLY)
SCHEDULE II -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31,
---------------------------------
1998 1997 1996
-------- --------- --------
(In thousands)
OPERATING ACTIVITIES
Net income.............................................. $ 43,437 $ 36,525 $ 28,105
Adjustments to reconcile net income to net cash provided
by (used in) operating activities:
Amortization of bond premium......................... 550 119 16
Equity in earnings of subsidiaries................... (52,503) (45,514) (32,417)
Net realized gains on investments.................... -- -- (503)
Deferred income taxes................................ (102) (1,662) (1,073)
Amortization of loan arrangement fees................ -- 910 --
Other................................................ (2,499) 877 (635)
Change in:
Accrued investment income.......................... 33 (1,058) 263
Intercompany receivable/payable.................... (2,837) 5,593 6,737
Accrued expenses and other liabilities............. 10,068 9,363 587
-------- --------- --------
NET CASH (USED IN) PROVIDED BY OPERATING
ACTIVITIES.................................... (3,853) 5,153 1,080
INVESTING ACTIVITIES
Purchase of fixed maturities available for sale......... (37,554) (72,448) (1,379)
Proceeds from maturities of fixed maturities held for
sale................................................. 37,750 3,000 17,661
Contribution of capital to Executive Risk International
Holdings B.V. ....................................... (40,000) -- --
Contribution of capital to Executive Risk Indemnity
Inc.................................................. -- (65,000) (10,870)
Contribution of capital to Executive Risk Capital
Trust................................................ -- (3.866) --
Contribution of capital to ER (Bermuda) Ltd. ........... -- (20,000) --
Distributions from subsidiaries......................... 335 303 15,104
-------- --------- --------
NET CASH (USED IN) PROVIDED BY INVESTING
ACTIVITIES.................................... (39,469) (158,011) 20,516
FINANCING ACTIVITIES
Proceeds from exercise of options....................... 1,047 4,122 423
Cost of repurchase of Common Stock...................... -- -- (75,025)
Placement fees and other................................ (183) (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............... -- 128,866 --
Proceeds from over-allotment option exercise............ -- -- 9,675
Dividends paid on Common Stock.......................... (880) (808) (789)
-------- --------- --------
NET CASH (USED IN) PROVIDED BY FINANCING
ACTIVITIES.................................... (16) 202,433 (21,888)
-------- --------- --------
NET (DECREASE) INCREASE IN CASH AND SHORT-TERM
INVESTMENTS................................... (43,338) 49,575 (292)
Cash and short-term investments at beginning of year...... 49,684 109 401
-------- --------- --------
CASH AND SHORT-TERM INVESTMENTS AT END OF
YEAR.......................................... $ 6,346 $ 49,684 $ 109
======== ========= ========
Supplemental Cash Flow Disclosures:
Income taxes (received) paid............................ $ (7,169) $ 325 $ (763)
Interest paid on debt................................... 6,826 6,826 4,131
S-3