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Exhibit 17(b)(4)
Financial Institutions Insurance Group, Ltd.
Due Diligence Review
Executive Summary
Draft Report
Prepared For
Castle Harlan, Inc.
AM-RE CONSULTANTS, INC.
February 28, 1996
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Table of Contents
Page
Introduction 1
Summary of Findings 2
Review of Operations
- -Financial 3
- -Actuarial 5
- -Underwriting 6
- -Claims 7
Conditions and Limitations 9
Exhibits
- -Summary Exhibit for Reserve Analysis A
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Introduction
Am-Re Consultants, Inc. (ARCI) was retained by Castle Harlan, Inc. (Castle
Harlan) to perform a due diligence review of Financial Institutions Insurance
Group Ltd. (FIIG) and its insurance company subsidiary, The First Reinsurance
Company of Hartford (First Re) in connection with the possible investment in
FIIG by Castle Harlan.
Our review was performed over a four day period by a team of six ARCI
consultants with general management, marketing/underwriting, claims, actuarial
and financial expertise. The first two days of the review were spent on-site
at FIIG's home office in Chicago, Illinois. The on-site review involved
collecting data, interviewing management and staff, and reviewing a sampling of
claim and underwriting files. During the following two days, further financial
and actuarial analyses were performed off-site.
This Executive Summary presents an overview of our findings and can be
supplemented by a full detailed report if requested.
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Summary of Findings
First Re is a specialty carrier writing non-medical professional liability
coverages on a claims-made basis. The company operates in a very competitive
environment and has a philosophy to write relatively low limits (up to $5
million) in various programs within the D&O and E&O marketplace.
First Re is dependent on Aon for a number of services including policy fronting
in some states by Virginia Surety
The internal control of the financial reporting area needs strengthening
Gross loss and loss adjustment expense (LAE) reserves are projected to be $6.2
million (19.2%) redundant
The quality of FIIG's reinsurance program is acceptable
The overall underwriting effort appears strong and well-controlled
First Re's claims are well managed by two Aon affiliates
The company limits its writings of risk types that present higher than average
exposures e.g., computer hardware manufacturers and distributors
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Review of Operations
Financial
FIIG is currently dependent on Aon for a number of services. The ability to
move away from this dependency in the long run is dependent on obtaining
additional state licenses and developing stand alone claims handling and
systems capabilities
Senior financial management is very hands on
The internal control environment needs strengthening
- -- Little, if any, oversight or peer review outside the two primary financial
team members
- -- Financial decisions and reporting often not adequately checked
- -- A small operation in two locations which may be slightly understaffed
The quality of the overall reinsurance program appears acceptable with
reinsurance recoverables as of 12/31/95 of $5.6 million gross
- -- Many small balances from many reinsurers
- -- The largest balance of $1.2 million with Walbrook (a company in liquidation)
was commuted in 1996 at full value
- -- Balance of $1.0 million is fully collateralized with Anglo American is
expected to be commuted in 1996
- -- Approximately $0.6 million recoverable from Lloyd's (uncollateralized),
which we rate as weak, pending resolution of its current problems
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Review of Operations (con't.)
Financial (con't.)
First Re received an unfavorable triennial examination report from Connecticut
as of December 31, 1993 primarily because of financial reporting issues
- -- It appears most items in the report have been addressed as of 12/31/95
- -- The examination may cause delays in additional state licensing in the near
term
Deductible receivables are not monitored pro-actively in the financial area but
appear to be managed appropriately on an individual claim basis
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Review of Operations (con't.)
Actuarial
Total gross loss and LAE reserves are projected to be $6.2 million (19.2%)
redundant as of December 31, 1995. The components of the estimated redundancy
are:
- -- Loss and allocated loss adjustment expense (ALAE) reserves for the run-off
Financial Institutions D&O and Fidelity books: $4.6 million
- -- Loss and ALAE reserves for the Oakley book: $1.3 million
- -- Unallocated loss adjustment expense (ULAE) reserves: ($0.2) million
- -- Reserves for all other run-off books were not independently projected by
ARCI.
We reviewed the Coopers & Lybrand actuarial analysis as of December 31, 1995
and relied upon their results which showed a redundancy of $0.4 million
The ARCI analysis employed traditional actuarial methodologies including
incurred loss projection, Bornhuetter-Ferguson, and loss ratio selection
techniques. Differences from C&L and Liscord, Ward, and Roy analyses were
primarily the result of selecting different loss development tail factors and
loss ratios for the various programs
The current year combined underwriting ratio is projected to be 121% broken
down by -- 78% gross loss + LAE ratio -- 43% expense ratio
Despite the indicated overall redundancy, we have concern about data integrity.
In particular they had considerable difficulty balancing raw data with that
shown in the actuarial reports and the annual statement.
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Review of Operations (con't.)
Underwriting
The overall underwriting effort appears strong and well-controlled
Staff is knowledgeable and experienced and have a good working relationship
with claims staff
The underwriting process appears to be well managed
- -- Good development and use of risk and exposure information
- -- Use a variety of specialized applications and questionnaires which are keyed
to risk types
- -- Strong financial analysis (D&O book) using a variety of sources (e.g. Dow
Jones, 10K/10Q, annual reports)
- -- Excellent file documentation
FIIG writes a variety of risk types:
- -- Small to medium size firms for lawyers, architects/engineers
- -- Corporate D&O for firms less than $200 million in assets
- -- Computer hardware manufacturers and distributors are acceptable but present
higher than average exposures
- -- Some business could be deemed "distressed" due to size and loss experience;
however risk selection is sound
- -- Will write prior "acts" and "tail" coverage
Market is very competitive for A&E, D&O, Lawyers
- -- Pricing modifications are aggressive reflecting competitive market, however,
pricing modifications are documented in the files (keyed to risk exposures,
conditions, and characteristics)
- -- Major competitors include Aetna, AIG, CNA, Coregis, DPIC, ERMA
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Review of Operations (con't.)
Claims
The claims reviewed at Aon are well handled
- -- The files are well documented often containing detailed summaries analyzing
coverage, liability and damages
- -- Coverage issues are recognized and separate coverage counsel engaged to
avoid potential "conflicts"
- -- Deductibles are generally paid directly by the insured who must provide
verification of same before any payment is made over the deductible
- -- Aon is cost conscious and only retains counsel as necessary
- -- A concerted effort is made to involve other coverages if at all possible
- -- They have developed a list of very competent attorneys specializing in D&O
and E&O claims.
Each Aon affiliate has qualified staff with manageable case loads
The policies are written on a "claims made" basis and most were policies of
indemnification
- -- Reimbursement of defense costs is predicated on coverage for the loss
- -- Expense is part of loss
- -- Specific exclusions are tailored to known situations revealed during the
underwriting/production process
- -- Extensive exclusions in the D&O/Corporate Reimbursement coverages leave
only a narrow window for potential coverage
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Review of Operations (con't.)
Claims (con't.)
D&O coverage for computer manufacturers with limits of $5,000,000 is an area
of concern:
- -- Possibility of "class actions" arising out of
- -- Product failure
- -- Obsolescence
- -- Alleged inadequate research and development
- -- Falling stock prices following IPO's
Class action litigation usually involves significant legal expense even if the
merits are lacking
Although we generally agreed with Aon's reserves there were some exceptions
due to:
- -- Over-reliance on the strength of coverage positions resulting in optimistic
reserving with stair-stepping following adverse developments
- -- Difficulty in measuring damages in failure to disclose/insider trading cases
A systemized process to track the erosion of aggregate limits does not
presently exist.
- -- Aon acknowledges the need and is in the process of putting in a new system
(FUSION D) which will reportedly track per claim and aggregate limit erosion
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Conditions and Limitations
This report was prepared for the internal use of the management of Castle
Harlan. Further distribution or use is expressly prohibited without the prior
written consent of ARCI.
ARCI has prepared this report in conformity with its intended utilization by a
person(s) technically competent in the areas addressed and for the stated
purposes only. Judgments as to the conclusions, recommendations, methods and
data contained in this report should be made only after studying the report in
its entirety. Furthermore, members of the ARCI staff are available to explain
and/or amplify any matter presented herein, and it is assumed that the user of
this report will seek such explanation and/or amplification as to any matter in
question.
This report is not a recommendation to invest in or not to invest in FIIG nor
is it an evaluation of any proposed investment pricing thereof. For our
analysis, ARCI relied upon the accuracy of data and information provided by
FIIG in connection with this assignment. ARCI has made no independent analysis
of completeness of such data and information for the purposes of this report.
Loss and ALAE reserve estimates are subject to potential errors of estimation
since the ultimate liability for claims is subject to the outcome of events yet
to occur, e.g., jury decisions and attitudes of claimants with respect to
settlements. Thus no assurance can be given as to the adequacy of the
projected reserve levels.
Our projection of future claim payment and emergence was based on FIIG's
historical experience, supplemented by industry data and other qualitative
information where appropriate. It is possible that this historical data will
not be a prediction of future emergence for FIIG. We have not anticipated any
extraordinary changes to the legal, social and economic environment which might
affect the cost and frequency of claims.
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Conditions and Limitations (con't.)
We have employed techniques and assumptions that we believe are appropriate,
and we believe the conclusions presented herein are reasonable, given the
information currently available. However, it should be recognized that future
loss emergence will likely deviate, perhaps substantially, from our estimates.
Because the above procedures do not constitute an examination made in
accordance with generally accepted auditing standards, we do not express an
opinion on any of the financial statements or accounts of FIIG. Had we
performed additional procedures or had we made an examination of FIIG's
financial statements in accordance with generally accepted auditing standards,
other matters might have come to our attention that would have been reported to
you.
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Exhibit A
First Reinsurance Company of Hartford
Summary of December 31, 1995 Gross Loss and LAE Reserves (000's)
ARCI First Re Redundancy/ As Percent
Estimate Carried (Deficiency) of Carried
Russell Re
Hugo 1,445 * 794 (651) -82.0%
Storm 90A 528 * 255 (273) -107.1%
Property 1,776 * 2,216 440 19.9%
Casualty 508 * 713 205 28.8%
Total 4,257 3,978 (279) -7.0%
ALAS 2,302 2,765 463 16.7%
Financial
D&O 817 2,889 2,072 71.7%
Bonds 4,644 7,171 2,527 35.2%
Total 5,461 10,060 4,599 45.7%
Other Re 2,516 * 2,739 223 8.1%
Oakley 10,433 11,782 1,349 11.4%
ULAE 957 766 (191) -24.9%
Grand Total 25,926 32,090 6,164 19.2%
*Not independently projected by ARCI, relying on Coopers' 12/31/95 report.
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Exhibit A
First Reinsurance Company of Hartford
Summary of December 31, 1995 Gross Loss and LAE Reserves (000's)
ARCI First Re Redundancy/ As Percent
Estimate Carried (Deficiency) of Carried
Russell Re
Hugo 1,445 * 794 (651) -82.0%
Storm 90A 528 * 255 (273) -107.1%
Property 1,776 * 2,216 440 19.9%
Casualty 508 * 713 205 28.8%
Total 4,257 3,978 (279) -7.0%
ALAS 2,302 * 2,765 463 16.7%
Financial
D&O 817 2,889 2,072 71.7%
Bonds 4,644 7,171 2,527 35.2%
Total 5,461 10,060 4,599 45.7%
Other Re 2,516 * 2,739 223 8.1%
Oakley 9,595 11,422 1,827 16.0%
ULAE 916 766 (150) -19.6%
Grand Total 25,047 31,730 6,683 21.1%
C&L 25,047 31,791 6,744
Sch P 25,047 32,456 7,409
*Not independently projected by ARCI, relying on Coopers' 12/31/95 report.