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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1998
Or
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period ___________________ to _____________________
Commission file number: 0-26456
RISK CAPITAL HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
Delaware 06-1424716
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
20 Horseneck Lane
Greenwich, Connecticut 06830
(Address of principal executive offices) (Zip Code)
Registrant's telephone number,
including area code: (203) 862-4300
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(Former name, former address and former fiscal year, if changed since last
report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes |X| No |_|
Indicate the number of shares outstanding of each of the issuer's classes of
common stock.
Class Outstanding at September 30, 1998
----- ---------------------------------
Common Stock, $.01 par value 17,066,283
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RISK CAPITAL HOLDINGS, INC.
INDEX
Page No.
--------
PART I. Financial Information
Item 1 - Consolidated Financial Statements
Review Report of Independent Accountants 1
Consolidated Balance Sheet 2
September 30, 1998 and December 31, 1997
Consolidated Statement of Income and Comprehensive Income 3
For the three and nine month periods ended
September 30, 1998 and 1997
Consolidated Statement of Changes in Stockholders' Equity 4
For the nine month periods ended September 30, 1998
and 1997
Consolidated Statement of Cash Flows 5
For the nine month periods ended September 30, 1998
and 1997
Notes to Consolidated Financial Statements 6
Item 2 - Management's Discussion and Analysis of Financial
Condition And Results of Operations 15
PART II. Other Information
Item 6 - Exhibits and Reports on Form 8-K 24
Signatures 25
Review Report of Independent Accountants
To the Board of Directors and Stockholders of
Risk Capital Holdings, Inc.
We have reviewed the accompanying interim consolidated balance sheet of Risk
Capital Holdings, Inc. and its subsidiary as of September 30, 1998, and the
related consolidated statements of income and comprehensive income, of changes
in stockholders' equity and of cash flows for the period from January 1, 1998 to
September 30, 1998. This financial information is the responsibility of the
Company's management.
We conducted our review in accordance with standards established by the American
Institute of Certified Public Accountants. A review of interim financial
information consists principally of applying analytical procedures to financial
data and making inquiries of persons responsible for financial and accounting
matters. It is substantially less in scope than an audit conducted in accordance
with generally accepted auditing standards, the objective of which is the
expression of an opinion regarding the financial statements taken as a whole.
Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should
be made to the accompanying consolidated financial information for it to be in
conformity with generally accepted accounting principles.
We previously audited, in accordance with generally accepted auditing standards,
the consolidated balance sheet as of December 31, 1997, and the related
consolidated statements of income, of retained earnings, and of cash flows for
the year then ended (not presented herein), and in our report dated January 30,
1998 we expressed an unqualified opinion on those consolidated financial
statements. In our opinion, the information set forth in the accompanying
condensed consolidated balance sheet as of December 31, 1997, is fairly stated
in all material respects in relation to the consolidated balance sheet from
which it has been derived.
PricewaterhouseCoopers LLP
New York, New York
October 23, 1998
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEET
(in thousands, except per share data)
(Unaudited)
September 30, December 31,
1998 1997
-------- ---------
ASSETS
Investments:
Fixed maturities $ 175,502 $ 132,159
(amortized cost: 1998, $173,483; 1997, $129,887)
Publicly traded equity securities 178,788 180,052
(cost: 1998, $134,782; 1997, $116,258)
Privately held securities 143,978 95,336
(cost: 1998, $113,569; 1997, $77,550)
Short-term investments 50,160 89,167
--------- ---------
Total investments 548,428 496,714
--------- ---------
Cash 4,685 9,014
Accrued investment income 3,395 2,781
Premiums receivable 82,957 47,507
Reinsurance recoverable 24,033
Deferred policy acquisition costs 22,698 17,292
Other assets 24,033 7,939
--------- ---------
Total Assets $ 710,229 $ 581,247
========= =========
LIABILITIES
Claims and claims expenses $ 177,262 $ 70,768
Unearned premiums 95,157 74,234
Contingent commissions payable 2,561 682
Reinsurance balances payable 7,162 211
Investment accounts payable 4,745 1,996
Deferred income tax liability 18,834 25,090
Other liabilities 9,381 7,235
--------- ---------
Total Liabilities 315,102 180,216
--------- ---------
STOCKHOLDERS' EQUITY
Preferred stock, $.01 par value:
20,000,000 shares authorized (none issued)
Common stock, $.01 par value:
80,000,000 shares authorized
(1998, 17,080,365; 1997, 17,069,845 shares issued) 171 171
Additional paid-in capital 341,461 341,162
Deferred compensation under stock award plan (1,190) (1,778)
Retained earnings 5,267 7,170
Less treasury stock, at cost (1998, 14,082; 1997,
11,383 shares) (264) (198)
Accumulated other comprehensive income consisting of
unrealized appreciation of investments,
net of income tax 49,682 54,504
--------- ---------
Total Stockholders' Equity 395,127 401,031
--------- ---------
Total Liabilities & Stockholders' Equity $ 710,229 $ 581,247
========= =========
See Notes to Consolidated Financial Statements.
2
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF INCOME AND COMPREHENSIVE INCOME
(in thousands, except share data)
(Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
1998 1997 1998 1997
------------ ------------ ------------ ------------
Premiums and Other Revenues
Net premiums written $ 66,628 $ 34,906 $ 163,572 $ 98,862
Increase in unearned premiums (13,958) (10,251) (20,923) (33,234)
------------ ------------ ------------ ------------
Net premiums earned 52,670 24,655 142,649 65,628
Net investment income 3,995 3,798 11,930 10,774
Net investment gains (losses) (425) 4,062 2,922 3,617
------------ ------------ ------------ ------------
Total revenues 56,240 32,515 157,501 80,019
Expenses
Claims and claims expenses 51,407 18,041 116,891 45,992
Commissions and brokerage 10,640 6,217 33,295 17,740
Other operating expenses 3,935 3,281 12,265 10,188
Foreign exchange (gain) loss (648) 116 (588) 654
------------ ------------ ------------ ------------
Total expenses 65,334 27,655 161,863 74,574
Income Before Income Taxes and Equity
In Net Income (Loss) of Investees (9,094) 4,860 (4,362) 5,445
Federal income taxes:
Current (2,721) 507 1,150 1,182
Deferred (788) 930 (3,642) (7)
------------ ------------ ------------ ------------
Income tax expense (benefit) (3,509) 1,437 (2,492) 1,175
------------ ------------ ------------ ------------
Income Before Equity in Net Income
(Loss) of Investees (5,585) 3,423 (1,870) 4,270
Equity in net income (loss) of
investees (1,046) (168) (33) (473)
------------ ------------ ------------ ------------
Net Income (Loss) (6,631) 3,255 (1,903) 3,797
------------ ------------ ------------ ------------
Other Comprehensive Income (Loss), Net
of Tax
Change in net unrealized appreciation,
(depreciation) of investments, net of tax (13,991) 13,391 (4,822) 38,970
------------ ------------ ------------ ------------
Comprehensive Income (Loss) ($ 20,622) $ 16,646 ($ 6,725) $ 42,767
============ ============ ============ ============
Average shares outstanding
Basic 17,065,739 17,034,977 17,061,975 17,027,778
Diluted 17,845,152 17,494,435 17,825,517 17,046,362
Per Share Data
Net Income (Loss) - Basic ($0.39) $0.19 ($0.11) $0.22
- Diluted ($0.39) $0.19 ($0.11) $0.22
Comprehensive Income (Loss) - Basic ($1.21) $0.98 ($0.39) $2.51
- Diluted ($1.21) $0.95 ($0.39) $2.51
See Notes to Consolidated Financial Statements.
3
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(in thousands)
(Unaudited)
Nine Months Ended
September 30,
1998 1997
--------- ---------
Common Stock
Balance at beginning of year $ 171 $ 170
Issuance of common stock
--------- ---------
Balance at end of period 171 170
--------- ---------
Additional Paid-in Capital
Balance at beginning of year 341,162 340,435
Issuance of common stock 299 280
--------- ---------
Balance at end of period 341,461 340,715
--------- ---------
Deferred Compensation Under Stock Award Plan
Balance at beginning of year (1,778) (2,959)
Restricted common stock issued (221) (280)
Compensation expense recognized 809 1,398
--------- ---------
Balance at end of period (1,190) (1,841)
--------- ---------
Retained Earnings
Balance at beginning of year 7,170 5,131
Net income (loss) (1,903) 3,797
--------- ---------
Balance at end of period 5,267 8,928
--------- ---------
Treasury Stock, At Cost
Balance at beginning of year (198)
Purchase of treasury stock (66) (178)
--------- ---------
Balance at end of period (264) (178)
--------- ---------
Accumulated Other Comprehensive Income Consisting of
Unrealized Appreciation (Depreciation) of
Investments, Net of Income Tax
Balance at beginning of year 54,504 9,436
Change in unrealized appreciation (depreciation) (4,822) 38,970
--------- ---------
Balance at end of period 49,682 48,406
--------- ---------
Total Stockholders' Equity
Balance at beginning of year 401,031 352,213
Issuance of common stock 299 280
Change in deferred compensation 588 1,118
Net income (loss) (1,903) 3,797
Purchase of treasury stock (66) (178)
Change in unrealized appreciation (depreciation)
of investments, net of income tax (4,822) 38,970
--------- ---------
Balance at end of period $ 395,127 $ 396,200
========= =========
See Notes to Consolidated Financial Statements.
4
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands)
(Unaudited)
Nine Months Ended
September 30,
1998 1997
-------- --------
OPERATING ACTIVITIES
Net income (loss) ($ 1,903) $ 3,797
Adjustments to reconcile net income
to net cash provided by operating activities:
Liability for claims and claims expenses 106,494 31,963
Unearned premiums 20,923 33,953
Premiums receivable (35,450) (23,627)
Accrued investment income (614) (555)
Contingent commissions, net (1,094) 3,230
Reinsurance balances, net (17,083) (1,086)
Deferred policy acquisition costs (5,406) (8,482)
Net investment gains (2,922) (3,617)
Deferred income tax asset (3,660) (261)
Other liabilities 2,146 (667)
Other items, net (13,890) (3,966)
--------- ---------
NET CASH PROVIDED BY OPERATING ACTIVITIES 47,541 30,682
--------- ---------
INVESTING ACTIVITIES
Purchases of fixed maturity investments (216,789) (172,367)
Sales of fixed maturity investments 176,925 172,973
Net (purchases)/sales of short-term investments 41,142 (2,830)
Purchases of equity securities (102,057) (55,853)
Sales of equity securities 49,097 30,740
Purchases of furniture and equipment (200) (543)
--------- ---------
NET CASH PROVIDED BY (USED FOR) INVESTING ACTIVITIES (51,882) (27,880)
--------- ---------
FINANCING ACTIVITIES
Common stock issued 299 280
Purchase of treasury stock (66) (178)
Deferred compensation on restricted stock (221) (280)
--------- ---------
NET CASH PROVIDED BY (USED FOR) FINANCING ACTIVITIES 12 (178)
--------- ---------
Increase (decrease) in cash (4,329) 2,624
Cash beginning of year 9,014 1,466
--------- ---------
Cash end of period $ 4,685 $ 4,090
--------- ---------
See Notes to Consolidated Financial Statements.
5
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION
Risk Capital Holdings, Inc. ("RCHI"), incorporated in March 1995 under the laws
of the State of Delaware, is a holding company whose wholly owned subsidiary,
Risk Capital Reinsurance Company ("Risk Capital Reinsurance"), a Nebraska
corporation, was formed to provide, on a global basis, property and casualty
reinsurance and other forms of capital, either on a stand-alone basis, or as
part of integrated capital solutions for insurance companies with capital needs
that cannot be met by reinsurance alone. (RCHI and Risk Capital Reinsurance are
collectively referred to herein as the "Company.") In September 1995, through
its initial public offering, related exercise of the underwriters'
over-allotment option and direct sales of an aggregate of 16,750,625 shares of
RCHI's common stock, par value $.01 per share (the "Common Stock"), at $20 per
share, and the issuance of warrants, RCHI was capitalized with net proceeds of
approximately $335.0 million, of which $328.0 million was contributed to the
statutory capital of Risk Capital Reinsurance.
Class A warrants to purchase an aggregate of 2,531,079 shares of Common Stock
and Class B warrants to purchase an aggregate of 1,920,601 shares of Common
Stock were issued in connection with the direct sales. Class A warrants are
immediately exercisable at $20 per share and expire September 19, 2002. Class B
warrants are exercisable at $20 per share during the seven year period
commencing September 19, 1998, provided that the Common Stock has traded at or
above $30 per share for 20 out of 30 consecutive trading days.
In July 1998, Risk Capital Reinsurance capitalized its wholly owned subsidiary,
Cross River Insurance Company ("Cross River"), with $20 million. Cross River
received its Nebraska insurance license in October 1998 and intends to seek
authorization to operate in most other states as an excess and surplus lines
insurer.
2. GENERAL
The accompanying interim consolidated financial statements have been prepared in
conformity with generally accepted accounting principles and in the opinion of
management, reflect all adjustments necessary (consisting of normal recurring
accruals) for a fair presentation of results for such periods. These
consolidated financial statements should be read in conjunction with the 1997
consolidated financial statements and related notes contained in the Company's
Annual Report on Form 10-K for the fiscal year ended December 31, 1997.
3. COMPREHENSIVE INCOME
In presenting its financial statements, the Company has adopted the reporting of
comprehensive income in a one financial statement approach, consistent with
Statement of Financial Accounting Standards No. 130 of the Financial Accounting
Standards Board ("FASB"). Comprehensive income is comprised of net income and
other comprehensive income, which for the Company consists of the change in net
unrealized appreciation or depreciation of investments, net of tax. In addition,
prior periods have been reclassified to reflect the new accounting standard in
order to make prior results comparable to current reporting.
Comprehensive income for the Company consists of net income (loss) and the
change in unrealized appreciation or depreciation, net of income tax, as
follows:
6
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3. COMPREHENSIVE INCOME (Cont'd)
(In thousands)
Nine Months Ended
September 30,
1998 1997
---------- ------------
Net income (loss) ($ 1,903) $ 3,797
Other comprehensive income, net of tax:
Unrealized appreciation (depreciation) of
investments:
Unrealized holdings gains arising during
period (2,923) 41,321
Less, reclassification adjustment for
net realized (gains) losses included in
net income (1,899) (2,351)
-------- --------
Other comprehensive income (loss) (4,822) 38,970
-------- --------
Comprehensive income (loss) ($ 6,725) $ 42,767
======== ========
4. EARNINGS PER SHARE DATA
Earnings per share are computed in accordance with FASB Statement No. 128
"Earnings Per Share" which was retroactively adopted in the 1997 fourth quarter.
All earnings per share amounts for all periods have been presented and, where
appropriate, restated to conform to the new accounting requirements.
Basic earnings per share excludes dilution and is computed by dividing income
available to common stockholders by the weighted average number of shares of
Common Stock outstanding for the periods. Diluted earnings per share reflect the
potential dilution that could occur if Class A and B warrants and employee stock
options were exercised or converted into Common Stock. Diluted per share amounts
are computed using basic average shares outstanding when a loss occurs since the
inclusion of dilutive securities in dilutive earnings per share would be
anti-dilutive.
The following table sets forth the computation of basic and diluted earnings per
share:
(In thousands, except share data)
Nine Months Ended
September 30,
1998 1997
------------ ------------
Net Income
Basic Earnings Per Share:
Net income (loss) ($1,903) $3,797
Divided by:
Weighted average shares outstanding for
the period 17,061,975 17,027,778
Basic earnings (loss) per share ($0.11) $0.22
Diluted Earnings Per Share:
Net income (loss) ($1,903) $3,797
Divided by:
Weighted average shares outstanding for
the period 17,061,975 17,027,778
Effect of dilutive securities:
Warrants
Employee stock options 18,584
------------ ------------
Total shares 17,061,925 17,046,362
============ ============
Diluted earnings (loss) per share ($0.11) $0.22
7
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. EARNINGS PER SHARE DATA (Cont'd)
(In thousands, except share
data)
Nine Months Ended
September 30,
1998 1997
----------------- ---------------
Comprehensive Income
Basic Earnings Per Share:
Comprehensive income (loss) ($6,725) $42,767
Divided by:
Weighted average shares outstanding for
the period 17,061,975 17,027,778
Basic earnings (loss) per share ($0.39) $2.51
Diluted Earnings Per Share:
Comprehensive income (loss) ($6,725) $42,767
Divided by:
Weighted average shares outstanding for
the period 17,061,975 17,027,778
Effect of dilutive securities:
Warrants
Employee stock options 18,584
------------ ------------
Total shares 17,061,975 17,046,362
============ ============
Diluted earnings (loss) per share ($0.39) $2.51
5. INVESTMENT INFORMATION
The Company classifies all of its publicly traded fixed maturity and equity
securities as "available for sale" and accordingly, they are carried at
estimated fair value. The fair value of publicly traded fixed maturity
securities and publicly traded equity securities is estimated using quoted
market prices or dealer quotes. Short-term investments, which have a maturity of
one year or less at the date of acquisition, are carried at cost, which
approximates fair value.
All of the Company's publicly traded equity securities and privately held
securities were issued by insurance and reinsurance companies or companies
providing services to the insurance industry. At September 30, 1998, the
publicly traded equity portfolio consisted of 17 investments, with estimated
fair values ranging individually from $500,000 to $30.9 million.
Investments in privately held securities, issued by privately and publicly held
companies, may include both equity securities and securities convertible into,
or exercisable for, equity securities (some of which may have fixed maturities).
Privately held securities are subject to trading restrictions or are otherwise
illiquid and do not have readily ascertainable market values. The risk of
investing in such securities is generally greater than the risk of investing in
securities of widely held, publicly traded companies. Lack of a secondary market
and resale restrictions may result in the Company's inability to sell a security
at a price that would otherwise be obtainable if such restrictions did not exist
and may substantially delay the sale of a security which the Company seeks to
sell. Such investments are classified as "available for sale" and carried at
estimated fair value, except for investments in which the Company believes it
has the ability to exercise significant influence (generally defined as
investments in which the Company owns 20% or more of the outstanding voting
common stock of the issuer), which are carried under the equity method of
accounting. Under this method, the Company records its proportionate share of
income or loss for such investments in results of operations.
8
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5. INVESTMENT INFORMATION (Cont'd)
The estimated fair value of investments in privately held securities, other than
those carried under the equity method or those with quoted market values, is
initially equal to the cost of such investments until the investments are
revalued based principally on substantive events or other factors which could
indicate a diminution or appreciation in value, such as an arm's-length third
party transaction justifying an increased valuation or adverse development of a
significant nature requiring a write-down. The Company periodically reviews the
valuation of investments in privately held securities with Marsh & McLennan
Capital, Inc., its equity investment advisor.
Privately held securities consisted of the following:
(In thousands)
September 30, December 31,
1998 1997
------------ ------------
Carried under the equity method:
Arbor Acquisition Corp. (Montgomery &
Collins, Inc.) $ 3,573
The ARC Group, LLC 8,868 $ 10,341
Arx Holding Corp. 2,385 2,425
Capital Protection Insurance Services, LLC 1,223 182
First American Financial Corporation 9,415 6,572
Island Heritage Insurance Company, Ltd. 3,145 3,950
LARC Holdings, Ltd. 25,764 24,496
New Europe Insurance Ventures 622 730
Providers' Assurance Corporation 1,112 3,637
Sunshine State Holding Corporation 1,588 1,424
-------- --------
Sub-total 57,695 53,757
-------- --------
Carried at fair value:
Altus Holdings, Ltd. 6,667
Annuity and Life Re (Holdings), Ltd. 23,692
GuideStar Health Systems, Inc. 1,000 1,000
Peregrine Russell Miller Insurance
Investment Fund of Asia Limited 4,399
Sovereign Risk Insurance Ltd. 246 246
Stockton Holdings Limited 10,000
Terra Nova (Bermuda) Holdings, Ltd. 23,760 23,250
TRG Associates, LLC 4,875 4,875
Venton Holdings, Ltd. 16,043 7,809
-------- --------
Sub-total 86,283 41,579
-------- --------
Total $143,978 $ 95,336
======== ========
During the nine month period ended September 30, 1998, the Company received a
special and a regular distribution from The ARC Group, LLC totaling $2.6 million
and dividend distributions by (i) Terra Nova (Bermuda) Holdings, Ltd. of
$102,000 and (ii) TRG Associates, LLC of $103,000.
At September 30, 1998, the Company had investment commitments relating to its
privately held securities totaling approximately $15.0 million, compared to
$22.6 million at December 31, 1997.
Set forth below is certain information relating to the Company's private
investment activity for the nine month period ended September 30, 1998:
9
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5. INVESTMENT INFORMATION (Cont'd)
Altus Holdings, Ltd.
In March 1998, the Company purchased for $10 million an approximately 28.3%
economic interest (9.9% voting interest) in Altus Holdings, Ltd. ("Altus"), a
new Cayman Islands company formed to provide rent-a-captive and other
underwriting management services for risks of individual corporations and
insurance programs developed by insurance intermediaries. The Company's
investment was funded through two-thirds cash and one-third through a letter of
credit. The balance of the $35 million of initial capital invested in Altus was
contributed by The Trident Partnership, L.P. ("Trident"), EXEL Limited, Marsh &
McLennan Risk Capital Holdings, Ltd. ("MMRCH") and members of Altus' management.
The Company may provide reinsurance capacity for business developed by Altus.
The Company issued a letter of credit in the amount of $5.8 million for
Trident's unfunded investment commitment in Altus for an annual fee of $58,000,
or 100 basis points on the letter of credit amount.
Annuity and Life Re (Holdings), Ltd.
In April 1998, the Company acquired for approximately $20 million a minority
interest in Annuity and Life Re (Holdings), Ltd. ("Annuity and Life Re"), a new
Bermuda-based reinsurance company formed to provide annuity and life
reinsurance. The Company's investment was made concurrently with the
consummation of Annuity and Life Re's initial public offering. The Company
purchased approximately 1.4 million common shares of Annuity and Life Re and
warrants to purchase at an exercise price of $15.00 per share (the initial
public offering price) an additional 100,000 common shares. The aggregate
purchase price paid by the Company was based on a price of $14.10 for a unit
consisting of one common share and certain warrants. The Company owns
approximately 5.6% of the outstanding common shares of Annuity and Life Re
following the exercise of the underwriters' over-allotment option. Annuity and
Life Re's common shares are quoted on The Nasdaq Stock Market's National Market
under the symbol "ALREF." The Company is subject to a one-year lock-up period
and therefore carries this investment at a discount to its current market price
until such restriction expires in April 1999.
Arbor Acquisition Corp. (Montgomery & Collins, Inc.)
In March 1998, the Company purchased for approximately $2.8 million a 34.5%
economic and voting interest in Arbor Acquisition Corp. ("Arbor"), the parent of
Montgomery & Collins, Inc., a Boston-based national surplus lines and wholesale
brokerage firm which operates in 11 cities, in addition to Boston. The
investment was made concurrently with investments by MMRCH and Rufus Williams, a
former partner and director of Johnson & Higgins and former Chief Executive
Officer of Henry Ward Johnson & Company, Johnson & Higgins' excess and surplus
brokerage operation. In the third quarter of 1998, Risk Capital Reinsurance
invested an additional $845,000 in Arbor.
First American Financial Corporation
In June 1998, the Company invested an additional $3.8 million in First American
Financial Corporation ("FAFC"), bringing the total investment to $10 million,
representing an approximately 38% interest. The investment was made in
connection with the purchase by Trident of the remaining approximately 62% of
the outstanding capital stock of FAFC. FAFC is a holding company for First
American Insurance Company ("FAIC"), an insurer located in Kansas City,
Missouri. FAIC is rated A- by A.M. Best and writes commercial and private
passenger automobile liability and automobile physical damage, with emphasis
placed on collateral protection.
10
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5. INVESTMENT INFORMATION (Cont'd)
The equity in net loss of $1.0 million in the Company's 1998 nine-month results
represents its proportionate share of First American Financial Corporation's net
loss, recorded on a quarter lag basis, plus goodwill amortization. The loss
emanated from start-up and related costs resulting from the acquisition by The
Trident Partnership, L.P. of a majority ownership interest in First American.
The Company expects to record a similar loss in the 1998 fourth quarter, and a
loss of approximately $800,000 in 1999.
Providers' Assurance Corporation
In April 1997, the Company acquired a 34.3% economic and voting interest in
Providers' Assurance Corporation ("Providers"), a Nashville, Tennessee-based
underwriting management company with a Bermuda insurance subsidiary, for $4
million. Providers, formed in June 1995, develops and markets workers'
compensation insurance programs through joint operating arrangements with
community-based healthcare providers, and offers other workers'
compensation-related consulting services to the healthcare community. Under the
agreements with Providers, the Company has the right to provide certain
reinsurance on insurance programs developed by Providers during specified time
periods.
In the 1998 second quarter, the Company wrote down its investment in Providers
to its estimated realizable value and recorded a net realized investment loss,
net of tax, of $1.4 million, or $0.08 cents per share.
Stockton Holdings Limited
In June 1998, the Company acquired for $10 million a minority interest in
Stockton Holdings Limited ("Stockton Holdings"), a Cayman Islands insurance
holding company. Stockton Holdings conducts a world-wide reinsurance business
through its wholly owned subsidiary Stockton Reinsurance Limited, a
Bermuda-based reinsurance company writing specialty risks with a focus on finite
products. The Company's investment was made as part of a $173.5 million private
placement by Stockton Holdings.
Venton Holdings, Ltd.
During the 1998 third quarter, the Company entered into an agreement to sell one
of its privately held equity investments, Venton Holdings, Ltd. ("Venton"), to
an independent third party. At September 30, 1998, the Company increased the
carrying value of Venton from $7.8 million to $16 million to reflect the
expected transaction's net realizable value, which transaction closed on October
23, 1998. The Company's cost basis in Venton is $4.4 million. The Company had
previously increased the carrying value in June 1997 by $3.3 million to
partially reflect the purchase price paid by EXEL Limited for its 20% ownership
in Venton. The unrealized appreciation resulting from the Venton transaction
increased book value by thirty-one cents per share during the 1998 third
quarter.
6. RETROCESSION AGREEMENTS
The Company utilizes retrocession agreements for the purpose of limiting its
exposure with respect to multiple claims arising from a single occurrence or
event. The Company also participates in "common account" retrocessional
arrangements for certain treaties. Such arrangements reduce the effect of
individual or aggregate losses to all companies participating on such treaties
including the reinsurer, such as the Company, and the ceding company.
11
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
6. RETROCESSION AGREEMENTS (Cont'd)
Reinsurance recoverables are recorded as assets, predicated on the
retrocessionaires' ability to meet their obligations under the retrocessional
agreements. If the retrocessionaries are unable to satisfy their obligations
under the agreements, the Company would be liable for such defaulted amounts.
The effects of reinsurance on written and earned premiums and claims and claims
expenses are as follows:
(In thousands)
Nine Months Ended
September 30,
1998 1997
-------- --------
Assumed premiums written $178,794 $100,244
Ceded premiums written 15,222 1,382
-------- --------
Net premiums written $163,572 $ 98,862
======== ========
Assumed premiums earned 157,871 66,292
Ceded premiums earned 15,222 664
-------- --------
Net premiums earned $142,649 $ 65,628
======== ========
Assumed claims and claims expenses incurred 140,458 46,345
Ceded claims and claims expenses incurred 23,567 353
-------- --------
Net claims and claims expenses incurred $116,891 $ 45,992
======== ========
At September 30, 1998, the Company's balance sheet reflects reinsurance
recoverable balances as follows:
(In thousands)
September 30, December 31,
1998 1997
-------- --------
Reinsurance recoverable balances:
Unpaid claims and claim expenses $ 24,033
Ceded balances payable (7,162) ($ 211)
-------- --------
Reinsurance balances, net $ 16,871 ($ 211)
======== ========
7. STATUTORY DATA
The statutory capital and surplus of Risk Capital Reinsurance at September 30,
1998 was $361.8 million, compared to $385.0 million at December 31, 1997. The
statutory net loss for the nine month period ended September 30, 1998 was $13.8
million, compared to a net loss of $4.3 million in the prior year period.
12
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8. ACCOUNTING PRONOUNCEMENTS
Derivatives and Hedging
In June 1998, the FASB issued Statement No. 133 "Accounting for Derivative
Instruments and Hedging Activities." This statement requires that all derivative
financial instruments be recognized in the statement of financial position as
either assets or liabilities and measured at fair value.
If a derivative instrument is not designated as a hedging instrument, gains or
losses resulting from changes in fair values of such derivative are required to
be recognized in earnings in the period of the change. If certain conditions are
met, a derivative may be designated as a hedging instrument, in which case the
recording of the changes in fair value will depend on the specific exposure
being hedged. The key criterion for hedge accounting is that the hedging
relationship must be highly effective in achieving offsetting changes on fair
values or cash flows.
This statement is effective for fiscal years beginning after June 15, 1999, with
initial application as of the beginning of the first quarter of the applicable
fiscal year. The provisions of this statement may be applied as early as the
beginning of any fiscal quarter that begins after June 1998. Retroactive
application is prohibited.
The Company will adopt this statement in the first quarter of 2000. Generally
the Company has not invested in derivative financial instruments. However, the
Company's portfolio includes market sensitive instruments, such as
mortgage-backed securities, which are subject to prepayment risk and changes in
market value in connection with changes in interest rates. The Company's
investments in mortgage-backed securities are classified as available for sale
and are not held for trading purposes. Assuming the current investment strategy
at the time of adoption, the Company's presentation of financial information
under the new statement will not be materially different than the current
presentation.
Start-Up Costs
In April 1998, the Accounting Standards Executive Committee issued Statement of
Position ("SOP") 98-5 "Reporting on the Costs of Start-Up Activities." This
statement requires costs of start-up activities, including organization costs,
to be expensed as incurred. Unless another conceptual basis exists under other
generally accepted accounting literature to capitalize the cost of an activity,
costs of start-up activities cannot be capitalized.
Start-up activities are defined broadly as those one-time activities related to
opening a new facility, introducing a new product or service, conducting
business in a new territory, conducting business with a new class of customer or
beneficiary, initiating a new process in an existing facility or commencing some
new operation. Start-up activities also include activities related to organizing
a new entity.
SOP 98-5 is effective for fiscal years beginning after December 15, 1998. The
Company will adopt the new statement in the first quarter of 1999 as a
cumulative effect of a change in accounting principle in accordance with the
provisions of Accounting Principles Board Opinion No. 20.
The Company and its investee companies currently amortize organization and
start-up costs over a three to five year period. The Company is presently
evaluating the impact of adopting this new statement.
13
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8. ACCOUNTING PRONOUNCEMENTS (Cont'd)
Market Risk Sensitive Instruments
The Securities and Exchange Commission ("SEC") has amended rules and forms for
domestic and foreign issuers to clarify and expand existing disclosure
requirements for derivative financial instruments, other financial instruments
and derivative commodity instruments (collectively, "market risk sensitive
instruments"). The amendments require enhanced disclosure of accounting policies
for derivative financial instruments and derivative commodity instruments
(collectively, "derivatives"). In addition, the amendments expand existing
disclosure requirements to include quantitative and qualitative information
about market risk inherent in market risk sensitive instruments, which
disclosure will be subject to safe harbor protection under the new SEC rule.
Under SEC guidance, the new rules will be effective for the Company commencing
with filings with the SEC that include annual financial statements for fiscal
years ending after June 15, 1998. Interim information is not required until
after the first fiscal year end in which the new rules are applicable. The
Company is evaluating qualitatively and quantitatively the market risk on its
market risk sensitive instruments and derivatives for the necessary disclosures
under the new rules.
14
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
General
The Company
Risk Capital Holdings, Inc. ("RCHI") is the holding company for Risk Capital
Reinsurance Company ("Risk Capital Reinsurance"), RCHI's wholly owned subsidiary
which is domiciled in Nebraska. (RCHI and Risk Capital Reinsurance are
collectively referred to herein as the "Company".) RCHI was incorporated in
March 1995 and commenced operations during September 1995 upon completion of its
initial public offering and related exercise of the underwriters' over-allotment
option and direct sales of an aggregate of 16,750,625 shares of RCHI's common
stock, par value $.01 per share, at $20 per share, and the issuance of warrants
(collectively, the "Offerings"). RCHI received aggregate net proceeds from the
Offerings of approximately $335.0 million, of which $328.0 million was
contributed to the capital of Risk Capital Reinsurance. On November 6, 1995,
Risk Capital Reinsurance was licensed under the insurance laws of the State of
Nebraska. In July 1998, Risk Capital Reinsurance capitalized its wholly owned
subsidiary, Cross River Insurance Company ("Cross River") with $20 million.
Cross River received its Nebraska insurance license in October 1998, and intends
to seek authorization to operate in most other states as an excess and surplus
lines insurer.
Recent Industry Performance
Demand for reinsurance is influenced significantly by underwriting results of
primary property and casualty insurers and prevailing general economic and
market conditions, all of which affect liability retention decisions of primary
insurers and reinsurance premium rates. The supply of reinsurance is related
directly to prevailing prices and levels of surplus capacity, which, in turn,
may fluctuate in response to changes in rates of return on investments being
realized in the reinsurance industry. The industry's profitability can also be
affected significantly by volatile and unpredictable developments, including
changes in the propensity of courts to grant larger awards, natural disasters
(such as catastrophic hurricanes, windstorms, earthquakes, floods and fires),
fluctuations in interest rates and other changes in the investment environment
that affect market prices of investments and the income and returns on
investments, and inflationary pressures that may tend to affect the size of
losses experienced by ceding primary insurers.
Reinsurance treaties that are placed by intermediaries are typically for one
year terms with a substantial number that are written or renewed on January 1
each year. Other significant renewal dates include April 1, July 1 and October
1. The renewal periods through October 1, 1998 were marked by continuing
intensified competitive conditions in terms of premium rates and treaty terms
and conditions in both the property and casualty segments of the marketplace.
These conditions have been worsened due to large domestic primary companies
retaining more of their business and ceding less premiums to reinsurers. While
the Company is initially somewhat disadvantaged compared to many of its
competitors, which are larger, have greater resources and longer operating
histories than the Company, it believes it has been able to generate attractive
opportunities in the marketplace due to its substantial unencumbered capital
base, experienced management team, relationship with its equity investment
advisor and strategic focus on generating a small number of large reinsurance
treaty transactions that may also be integrated with an equity investment in
client companies as well as its expansion into the marine and aerospace and
surety and fidelity lines of business commencing late in 1997 and early 1998
respectively.
As of October 1, 1998, the Company had 264 in-force treaties, with approximately
$213 million of estimated annualized net in-force premiums. Such in-force
premiums represent estimated annualized premiums from treaties entered into
during the 1997 and 1998 renewal periods that are expected to generate net
premiums written during calendar year 1998. All of the Company's in-force
treaties will be considered for renewal, although there can be no assurance that
such treaties will be renewed.
15
Results of Operations
The Company had consolidated comprehensive loss for the nine month period ended
September 30, 1998 of $6.7 million, which was comprised of net loss of $1.9
million, and other comprehensive loss of $4.8 million, which consisted of the
change in net unrealized appreciation of investments, net of tax. Net loss for
the nine month period ended September 30, 1998 included net realized investment
gains, net of tax, of approximately $1.9 million, and equity in net loss of
investees of approximately $33,000. These amounts compare with comprehensive
income for the nine month period ended September 30, 1997 of $42.8 million,
which was comprised of net income of $3.8 million and the change in net
unrealized appreciation of investments, net of tax, of $39.0 million. Net income
for the nine month period ended September 30, 1997 included net realized
investment losses, net of tax, of $2.4 million, and equity in net loss of
investees of $473,000.
Following is a table of per share data for the nine months ended September 30,
1998 and 1997 on a net of tax basis:
Nine Months Ended
September 30,
1998 1997
----------- ---------
Basic earnings per share:
Operating income loss (1) ($0.22) $0.11
Net realized investment gains (losses) 0.11 (0.14)
Equity in net income (loss) of investees (0.03)
---------- ----------
Net income (loss) (0.11) 0.22
Change in net unrealized appreciation of investments (0.28) 2.29
---------- ----------
Comprehensive income (loss) ($0.39) $2.51
========== ==========
Average shares outstanding (000's) 17,062 17,028
========== ==========
Diluted earnings per share:
Operating income (loss) (1) ($0.22) $0.11
Net realized investment gains (losses) 0.11 (0.14)
Equity in net income (loss) of investees (0.03)
---------- ----------
Net income (loss) (0.11) 0.22
========== ==========
Comprehensive income (loss) ($0.39) $2.51
========== ==========
Average shares outstanding (000's) 17,062 17,046
========== ==========
(1) Represents net income, excluding realized net investment gains (losses)
and equity in net income (loss) of investees, net of tax.
At September 30, 1998, basic and diluted book value per share were $23.15 and
$22.54, respectively, which compare with basic and diluted book value per share
of $23.51 and $22.79, respectively, at December 31, 1997.
16
Net Premiums Written
Net premiums written for the three and nine month periods ended September 30,
1998 and 1997 were as follows:
(in millions) (in millions)
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------- --------------------
1998 1997 1998 1997
--------- -------- --------- ---------
Property $ 6.2 $ 6.1 $ 25.6 $ 14.1
Casualty 18.9 18.9 50.1 50.8
Multi-line 18.9 6.6 46.5 24.6
Aviation and Space 9.8 18.1
Marine 4.7 1.3 12.0 1.3
Other 7.7 2.0 10.8 8.1
Fidelity and Surety .4 .5
------ ------ ------ ------
Total $ 66.6 $ 34.9 $163.6 $ 98.9
====== ====== ====== ======
For the nine months ended September 30 1998, quota share reinsurance and excess
of loss reinsurance amounted to approximately 82% and 18%, respectively, of the
Company's net premiums written, compared to 90% and 10%, respectively, during
the prior year period. The higher content of excess of loss business is due to
the contributions of the Marine and Aviation and Space books of business. In the
future, the mix of quota share and excess of loss reinsurance will depend on
market conditions and other relevant factors and cannot be predicted with
accuracy.
Approximately 32% of net premiums written in the first nine months of 1998 was
from non-United States clients, compared to 29% in the first nine months of
1997. Approximately 32% of net premiums written in the first nine months of 1998
were generated from companies in which the Company has invested or committed to
invest funds. New business activity during the first nine months of 1998
reflects contributions of (i) the Company's three new specialty underwriting
units of Marine, Aviation and Space, and Fidelity and Surety and (ii) the
Company's integrated investment strategy.
Set forth below is the Company's statutory composite ratios for the nine month
periods ended September 30, 1998 and 1997:
Nine Months Ended
---------------------------------
As Excluding As 1997
Reported Aviation Reported Year
1998 1998 1997 Actual
-------- --------- -------- --------
Claims and claims expenses 81.9% 70.7% 70.1% 68.4%
Commissions and brokerage 23.7% 25.4% 26.5% 28.8%
----- ----- ----- -----
105.6% 96.1% 96.6% 97.2%
Operating expense 7.2% 8.1% 10.0% 9.1%
----- ----- ----- -----
Combined ratio 112.8% 104.2% 106.6% 106.3%
===== ===== ===== =====
The 1998 ratio as reported includes claims expenses and net reinstatement
premiums from the Company's Aviation and Space business, which was impacted
during the third quarter by the Swiss Air catastrophe and a series of satellite
losses. The Aviation and Space business increased the overall statutory
composite ratio for the 1998 third quarter, which was 123.8%, by 28.9 percentage
points. The Aviation and Space business increased the overall statutory
composite ratio for the 1998 nine month period by 8.6 points, which contributed
$26 million to the Company's pre-tax underwriting loss for the nine month period
ended September 30, 1998.
17
In pricing its reinsurance treaties, the Company focuses on many factors,
including exposure to claims and commissions and brokerage expenses. Commissions
and brokerage expenses are acquisition costs that generally vary by the type of
treaty and line of business, and are considered by the Company's underwriting
and actuarial staff in evaluating the adequacy of premium writings. The claims
and commissions and brokerage ratios reflect the Company's business mix.
Other operating expenses increased to $11.7 million for the first nine months of
1998, compared to $10.8 million for the 1997 prior year period. Assuming the
successful execution of the Company's business strategy, the Company expects
other operating expenses to grow commensurate with growing operations, but
expects other operating expenses to continue to decline moderately as a
percentage of net premiums written because increases in premium writings are
generally expected to exceed the growth in such expenses.
Pre-tax foreign exchange gains and losses were approximately $588,000 and
$654,000 for the nine months ended September 30, 1998 and 1997, respectively.
Such gains and losses are principally related to assets and premiums receivable
of approximately $5.8 million denominated in European Currency Units, which is
recorded separately from statutory underwriting results and therefore excluded
from the statutory composite ratio. Unhedged monetary assets and liabilities are
translated at the exchange rate in effect at the balance sheet date, with the
resulting foreign exchange gains or losses recognized in income. Such future
gains or losses are unpredictable, and could be material.
Investment Results
At September 30, 1998, approximately 41% of the Company's invested assets
consisted of fixed maturity and short-term investments, compared to 44% at the
end of 1997. Net investment income for the first nine months of 1998 was
approximately $11.9 million, compared to $10.8 million for the prior year
period.
The Company's pre-tax and net of tax investment yields in the first nine months
of 1998 were 3.6% and 2.7%, respectively, compared to 3.7% and 2.7%,
respectively, for the same prior year period. Assuming a stable interest rate
environment, the Company anticipates the 1998 yields to moderately decline as
funds invested in short-term securities are allocated into equity securities.
The amount of investment income from quarter to quarter could vary and diminish
as the Company continues to employ its strategy of investing a substantial
portion of its investment portfolio in publicly traded and privately held equity
securities of insurance companies which generally yield less current investment
income than fixed maturity investments. Unrealized appreciation or depreciation
of such investments to the extent that it occurs is recorded in a separate
component of stockholders' equity, net of related deferred income taxes. Gains
or losses are recorded in net income to the extent investments are sold, but the
recognition of such gains and losses is unpredictable and not indicative of
future operating results.
For the nine months ended September 30, 1998, the Company's equity in net loss
of investee companies was $33,000. This compares to equity in net loss of
investee companies of $473,000 in the prior year period.
Equity in net loss of investee companies for the 1998 third quarter was $1.0
million, which reflected losses from Hurricane Georges in the Caribbean that
impacted an investee company and losses from start-up and related costs
resulting from an acquisition by The Trident Partnership, L.P. of a majority
ownership interest in another investee company.
Income Taxes
The Company's effective tax rates for the first nine months of 1998 and 1997
were less than the 35% statutory rate on pre-tax operating income due to tax
exempt income and dividends received deductions. The gross deferred income tax
benefits for the first nine months of 1998 and 1997 of approximately $3.6
million and $261,000, respectively, which are assets considered recoverable from
future taxable income, resulted principally from temporary differences between
financial and taxable income. Temporary differences include, among other things,
charges for restricted stock grants which are not deductible for income tax
purposes until vested (vesting of existing restricted stock grants will occur
over a five-year period), as well as charges for a portion of unearned premiums
and claims reserves and equity in net income (loss) of investees.
18
Investments
A principal component of the Company's investment strategy is investing a
significant portion of invested assets in publicly traded and privately held
equity securities, primarily issued by insurance and reinsurance companies and
companies providing services to the insurance industry. Cash and fixed maturity
investments and, if necessary, the sale of publicly traded equity securities
will be used to support shorter-term liquidity requirements.
As a significant portion of the Company's investment portfolio will generally
consist of equity securities issued by insurance and reinsurance companies and
companies providing services to the insurance industry, the equity portfolio
lacks industry diversification and will be particularly subject to the
cyclicallity of the insurance industry. Unlike fixed income securities, equity
securities such as common stocks, including the equity securities in which the
Company may invest, generally are not and will not be rated by any nationally
recognized rating service. The values of equity securities generally are more
dependent on the financial condition of the issuer and less dependent on
fluctuations in interest rates than are the values of fixed income securities.
The market value of equity securities generally is regarded as more volatile
than the market value of fixed income securities. The effects of such volatility
on the Company's equity portfolio could be exacerbated to the extent that such
portfolio is concentrated in the insurance industry and in relatively few
issuers.
As the Company's investment strategy is to invest a significant portion of its
investment portfolio in equity securities, its investment income in any fiscal
period may be smaller, as a percentage of investments, and less predictable than
that of other insurance and/or reinsurance companies, and net realized and
unrealized gains (losses) on investments may have a greater effect on the
Company's results of operations or stockholders' equity at the end of any fiscal
period than other insurance and/or reinsurance companies. Because the
realization of gains and losses on equity investments is not generally
predictable, such gains and losses may differ significantly from period to
period. Variability and declines in the Company's results of operations could be
further exacerbated by private equity investments in start-up companies, which
are accounted for under the equity method. Such start-up companies may be
expected initially to generate operating losses.
Investments that are or will be included in the Company's private portfolio
include securities issued by privately held companies and securities issued by
public companies that are generally restricted as to resale or are otherwise
illiquid and do not have readily ascertainable market values. The risk of
investing in such securities is generally greater than the risk of investing in
securities of widely held, publicly traded companies. Lack of a secondary market
and resale restrictions may result in the Company's inability to sell a security
at a price that would otherwise be obtainable if such restrictions did not exist
and may substantially delay the sale of a security the Company seeks to sell.
At September 30, 1998, cash and invested assets totaled approximately $553.1
million, consisting of $54.8 million of cash and short-term investments, $175.5
million of publicly traded fixed maturity investments, $178.8 million of
publicly traded equity securities and $144.0 million of privately held
securities. Included in privately held securities are investments totaling $57.7
million which are accounted for under the equity method.
During the first nine months of 1998, the Company completed four private
investments, bringing the private equity portfolio to 18 investments, totaling
approximately $144.0 million of invested capital at September 30, 1998. The
Company also allocated approximately $30 million to its high grade taxable
portfolio (which amount included approximately $20 million invested in high
grade taxable securities through Cross River following its capitalization by
Risk Capital Reinsurance in July 1998) and $10 million to its tax exempt core
fixed income portfolio, each managed by The Putnam Advisory Company, Inc. In
addition, the Company allocated $35 million to a high yield fixed income
portfolio managed by Miller Anderson & Sherrerd, LLP ("MAS"), a subsidiary of
Morgan Stanley & Co. The objective of such portfolio is to earn a superior total
return consistent with reasonable risk through investing primarily in below
investment grade fixed income securities.
19
Approximately 86% of fixed maturity and short-term investments were rated
investment grade by Moody's Investors Service, Inc. or Standard & Poor's
Corporation and have an average duration of approximately 3.6 years.
See Note 5 under the caption "Investment Information" of the accompanying Notes
to Consolidated Financial Statements for certain information regarding the
Company's privately held securities and their carrying values. During the
remainder of 1998 and over the long-term, the Company intends to continue to
maintain a substantial portion of its investments in publicly traded and
privately held equity securities.
At September 30, 1998, the publicly traded equity portfolio consisted of
investments in 17 publicly traded domestic insurers, reinsurers or companies
providing services to the insurance industry. The estimated fair values of such
investments ranged individually from $500,000 to $30.9 million.
The Company has not invested in derivative financial instruments such as
futures, forward contracts, swaps, or options or other financial instruments
with similar characteristics such as interest rate caps or floors and fixed-rate
loan commitments. The Company's portfolio includes market sensitive instruments,
such as mortgage-backed securities, which are subject to prepayment risk and
changes in market value in connection with changes in interest rates. The
Company's investments in mortgage-backed securities, which amounted to
approximately $42.4 million at September 30, 1998, or 7.7% of cash and invested
assets, are classified as available for sale and are not held for trading
purposes.
Ratings
The Company has been assigned an initial rating of "A" (Excellent) by A. M. Best
Company ("A.M. Best"). This rating is assigned by A.M. Best to companies which
A.M. Best considers to have, on balance, excellent financial strength, operating
performance and market profile when compared to established standards and a
strong ability to meet their ongoing obligations to policyholders.
The objective of A.M. Best's rating system is to provide an overall opinion of
an insurance company's ability to meet its obligations to policyholders. A.M.
Best's ratings reflect their independent opinion of the financial strength,
operating performance and market profile of an insurer relative to standards
established by A. M. Best. A.M. Best's ratings are not a warranty of an
insurer's current or future ability to meet its obligations to policyholders,
nor are they a recommendation of a specific policy form, contract, rate or claim
practice.
Liquidity and Capital Resources
RCHI is a holding company and has no significant operations or assets other than
its ownership of all of the capital stock of Risk Capital Reinsurance, whose
primary and predominant business activity is providing reinsurance and other
forms of capital to insurance and reinsurance companies and making investments
in insurance-related companies. RCHI will rely on cash dividends and
distributions from Risk Capital Reinsurance to pay any cash dividends to
stockholders of RCHI and to pay any operating expense that RCHI may incur. The
payment of dividends by RCHI will be dependent upon the ability of Risk Capital
Reinsurance to provide funds to RCHI. The ability of Risk Capital Reinsurance to
pay dividends or make distributions to RCHI is dependent upon its ability to
achieve satisfactory underwriting and investment results and to meet certain
regulatory standards of the State of Nebraska. There are presently no
contractual restrictions on the payment of dividends or the making of
distributions by Risk Capital Reinsurance to RCHI.
Nebraska insurance laws provide that, without prior approval of the Nebraska
Director of Insurance (the "Nebraska Director"), Risk Capital Reinsurance cannot
pay a dividend or make a distribution (together with other dividends or
distributions paid during the preceding 12 months) that exceeds the greater of
(i) 10% of statutory surplus as of the preceding December 31 or (ii) statutory
net income from operations from the preceding calendar year not including
realized capital gains. Net income (exclusive of realized capital gains) not
previously distributed or paid as dividends from the preceding two calendar
years may be carried forward for dividends and distribution purposes. Any
proposed dividend or distribution in excess of such amount is called an
"extraordinary" dividend or distribution and may not be paid until either it has
been approved, or a 30-day waiting period has passed during which it has not
been disapproved, by the Nebraska Director.
20
Notwithstanding the foregoing, Nebraska insurance laws provide that any
distribution that is a dividend may be paid by Risk Capital Reinsurance only out
of earned surplus arising from its business, which is defined as unassigned
funds (surplus) as reported in the statutory financial statement filed by Risk
Capital Reinsurance with the Nebraska Insurance Department for the most recent
year. In addition, Nebraska insurance laws also provide that any distribution
that is a dividend and that is in excess of Risk Capital Reinsurance's
unassigned funds, exclusive of any surplus arising from unrealized capital gains
or revaluation of assets, will be deemed an "extraordinary" dividend subject to
the foregoing requirements.
RCHI, Risk Capital Reinsurance and Cross River file consolidated federal income
tax returns, and have entered into a tax sharing agreement (the "Tax Sharing
Agreement"), allocating the consolidated income tax liability on a separate
return basis. Pursuant to the Tax Sharing Agreement, Risk Capital Reinsurance
and Cross River make tax sharing payments to RCHI based on such allocation.
Net cash flow from operating activities for the nine months ended September 30,
1998 was $47.5 million, compared with $30.7 million for the prior year period.
The primary sources of liquidity for Risk Capital Reinsurance are net cash flow
from operating activities, principally premiums received, the receipt of
dividends and interest on investments and proceeds from the sale or maturity of
investments. The Company's cash flow is also affected by claims payments, some
of which could be large. Therefore, the Company's cash flow could fluctuate
significantly from period to period.
The Company does not currently have any material commitments for any capital
expenditures over the next 12 months other than in connection with the further
development of the Company's infrastructure. The Company expects that its
financing and operational needs for the foreseeable future will be met by the
Company's balance of cash and short-term investments, as well as by funds
generated from operations. However, no assurance can be given that the Company
will be successful in the implementation of its business strategy.
At September 30, 1998, the Company's consolidated stockholders' equity totaled
$395.1 million, or $23.15 per share. At such date, statutory surplus of Risk
Capital Reinsurance was approximately $361.8 million. Based on data available as
of June 30, 1998 from the Reinsurance Association of America, Risk Capital
Reinsurance is the twelfth largest domestic broker market oriented reinsurer as
measured by statutory surplus.
In March 1998, the National Association of Insurance Commissioners adopted the
codification of statutory accounting principles project that will generally be
applied to all insurance and reinsurance company financial statements filed with
insurance regulatory authorities as early as the 2001 statutory filings.
Although the codification is not expected to materially affect many existing
statutory accounting practices presently followed by most insurers and
reinsurers such as the Company, there are several accounting practices that will
be changed. The most significant change involves accounting for deferred income
taxes, which change would require a deferred tax liability to be recorded for
unrealized appreciation of invested assets, net of available deferred tax
assets, that would result in a reduction to statutory surplus. If this
requirement had been in effect in 1998, the statutory surplus of the Company
would have been reduced by approximately $9.8 million for a net deferred tax
liability, from $361.8 million to $352.0 million at September 30, 1998.
Accounting Pronouncements
In June 1998, the FASB issued Statement No. 133 "Accounting for Derivative
Instruments and Hedging Activities." This statement is effective for fiscal
years beginning after June 15, 1999, with initial application as of the
beginning of the first quarter of the applicable fiscal year. The provisions of
this statement may be applied as early as the beginning of any fiscal quarter
that begins after June 1998. Retroactive application is prohibited. The Company
will adopt this statement in the first quarter of 2000. (See Note 8 of the
accompanying notes to the Consolidated Financial Statements of the Company.)
21
In April 1998, the Accounting Standards Executive Committee issued Statement of
Position ("SOP") 98-5 "Reporting on the Costs of Start-Up Activities." This
statement requires costs of start-up activities, including organization costs,
to be expensed as incurred. SOP 98-5 is effective for fiscal years beginning
after December 15, 1998. Initial application of SOP 98-5 should be as of the
beginning of the fiscal year in which the SOP is first adopted. The Company will
apply the provisions of SOP 98-5 in the first quarter of 1999. The Company and
its investee companies currently amortize organization and start-up costs over a
three to five year period. (See Note 8 of the accompanying notes to the
Consolidated Financial Statements of the Company.)
The Securities and Exchange Commission ("SEC") has amended rules and forms for
domestic and foreign issuers to clarify and expand existing disclosure
requirements for derivative financial instruments, other financial instruments
and derivative commodity instruments (collectively, "market risk sensitive
instruments"). The amendments require enhanced disclosure of accounting policies
for derivative financial instruments and derivative commodity instruments
(collectively "derivatives"). In addition, the amendments expand existing
disclosure requirements to include quantitative and qualitative information
about market risk inherent in market risk sensitive instruments, which
disclosure will be subject to safe harbor protection under the new SEC rule.
Under SEC guidance, the new rules will be effective for the Company commencing
with filings with the SEC that include annual financial statements for fiscal
years ending after June 15, 1998. Interim information is not required until
after the first fiscal year end in which the new rules are applicable. (See Note
8 of the accompanying notes to the Consolidated Financial Statements of the
Company.)
Year 2000 Issues
Many existing computer programs use only two digits to identify a year in the
date field. These programs were designed and developed without considering the
impact of the upcoming change in the century. If not corrected, many computer
applications could fail or create erroneous results by or at the year 2000. The
year 2000 issue affects virtually all companies and organizations.
The Company has instituted a comprehensive year 2000 compliance plan designed to
help avoid unexpected interruption in conducting its business. The Company's
year 2000 initiative includes the following strategic steps:
o Inventory of business systems and operating facilities;
o Assessment of potential year 2000 problems;
o Repair/replacement of non-compliant systems and facilities;
o Testing of systems and facilities; and
o Implementation of year 2000 compliant systems and facilities.
The Company has completed the assessment phase for its business systems and
operating facilities, and is currently in the remediation and testing phases to
ensure that the Company's systems and facilities are capable of processing
information for the year 2000 and beyond. The Company does not currently
anticipate any material year 2000 compliance problems with respect to its
internal business systems and operating facilities. Based on information
currently available, the cost of this internal compliance effort, while not
quantified, is not expected to have a material adverse effect on the Company's
financial position and results of operations.
However, due to the interdependent nature of systems and facilities, the Company
may be adversely impacted depending upon whether its business partners and
vendors address this issue successfully. Therefore, the Company is surveying its
key business partners and vendors in an attempt to determine their respective
level of year 2000 compliance. As part of this initiative, the Company is
evaluating the year 2000 exposures to insurers included in the Company's
investment portfolio. The effect, if any, on the Company's results of operations
from the possible failure of these entities to be year 2000 compliant is not
determinable.
22
The Company has not established a contingency plan for noncompliance of its
internal systems and operating facilities as the Company does not currently
expect any material year 2000 compliance problems with respect to such systems
and facilities. At this time, the Company is not aware of any material business
partners or vendors that will not be year 2000 compliant. If the Company becomes
aware of noncompliant business partners or vendors, one option will be to
evaluate replacing the noncompliant business partners and vendors. The Company
intends to continue to assess and attempt to mitigate its risks in the event
these third parities fail to be year 2000 compliant, and will consider
appropriate contingency arrangements for such potential noncompliance by such
entities. In certain instances, the establishment of a contingency plan is not
possible or is cost prohibitive. In these situations, noncompliance by the
Company's material business partners or vendors could have a material adverse
impact on the Company's financial position and results of operation.
In addition, property and casualty reinsurance companies, like the Company, may
have underwriting exposure related to the year 2000. The year 2000 issue is a
risk for some of the Company's reinsureds and is therefore considered during the
underwriting process similar to any other risk to which the Company's clients
may be exposed. While the Company continues to review these potential exposures,
the Company is unable to determine at this time whether the adverse impact, if
any, in connection with these exposures would be material to the Company.
Cautionary Note Regarding Forward-Looking Statements
Except for the historical information and discussions contained herein,
statements included in this release may constitute "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995. Such
forward-looking statements address matters that involve risks, uncertainties and
other factors that could cause actual results or performance to differ
materially from those indicated in such statements. The Company believes that
these factors include, but are not limited to, acceptance in the market of the
Company's reinsurance products; competition from new products (including
products that may be offered by the capital markets); the availability of
investments on attractive terms; competition, including increased competition
(both as to underwriting and investment opportunities); changes in the
performance of the insurance sector of the public equity markets or market
professionals' views as to such sector; the amount of underwriting capacity from
time to time in the market; general economic conditions and conditions specific
to the reinsurance and investment markets in which the Company operates;
regulatory changes and conditions; rating agency policies and practices; claims
development, including as to the frequency or severity of claims and the timing
of payments; and loss of key personnel. Changes in any of the foregoing may
affect the Company's ability to realize its business strategy or may result in
changes in the Company's business strategy. The foregoing review of important
factors should not be construed as exhaustive and should be read in conjunction
with other cautionary statements that are included herein or elsewhere in the
Company's filings with the SEC. The Company undertakes no obligation to publicly
update or revise any forward-looking statement, whether as a result of new
information, future events or otherwise.
23
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits.
Exhibit No. Description
----------- -----------
10.1 Stock Option Agreements - Executive Officers (1997 Grant)
10.2.1 Change in Control Agreement -President
10.2.2 Change in Control Agreements - Managing Directors
15 Accountants' Awareness Letter and Limitation of Liability
(regarding unaudited interim financial information)
27 Financial Data Schedule
(b) Reports on Form 8-K.
There were no reports filed on Form 8-K for the three month period ended
September 30, 1998.
Omitted from this Part II are items which are inapplicable or to which
the answer is negative for the period covered.
24
SIGNATURES
================================================================================
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
RISK CAPITAL HOLDINGS, INC.
-------------------------------------
(Registrant)
/s/ Mark D. Mosca
-------------------------------------
Date: November 11, 1998 MARK D. MOSCA
President and Chief Executive
Officer
/s/ Paul J. Malvasio
-------------------------------------
Date: November 11, 1998 PAUL J. MALVASIO
Chief Financial Officer
25
EXHIBIT INDEX
Exhibit No. Description
- ----------- -----------
10.1 Stock Option Agreements - Executive Officers (1997 Grant)
10.2.1 Change in Control Agreement - President
10.2.2 Change in Control Agreements - Managing Directors
15 Accountants' Awareness Letter and Limitation of Liability
(regarding unaudited interim financial information)
27 Financial Data Schedule