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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 March 31, 1999
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 incorporation or (I.R.S. Employer
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
---------------------------------------------------------------
(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 MARCH 31, 1999
----- -----------------------------
Common Stock, $.01 par value 17,086,266
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RISK CAPITAL HOLDINGS, INC.
INDEX
Page
No.
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PART I. FINANCIAL INFORMATION
ITEM 1 - CONSOLIDATED FINANCIAL STATEMENTS
Review Report of Independent Accountants 1
Consolidated Balance Sheet 2
March 31, 1999 and December 31, 1998
Consolidated Statement of Income and Comprehensive Income 3
For the three month periods ended March 31, 1999 and 1998
Consolidated Statement of Changes in Stockholders' Equity 4
For the three month periods ended March 31, 1999 and 1998
Consolidated Statement of Cash Flows 5
For the three month periods ended March 31, 1999 and 1998
Notes to Consolidated Financial Statements 6
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS 16
ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 25
PART II. OTHER INFORMATION
ITEM 1 - LEGAL PROCEEDINGS 26
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K 26
Signatures 27
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 subsidiaries as of March 31, 1999 and 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,
1999 to March 31, 1999. 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, 1998, and the related
consolidated statements of income and comprehensive income, of changes in
stockholders' equity, and of cash flows for the year then ended (not presented
herein), and in our report dated January 29, 1999, except as to Note 14, which
is as of March 25, 1999, 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, 1998,
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
April 23, 1999
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEET
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
MARCH 31, DECEMBER 31,
1999 1998
--------- ---------
ASSETS
Investments:
Fixed maturities $ 178,168 $ 174,540
(amortized cost: 1999, $179,084; 1998, $173,379)
Publicly traded equity securities 154,829 154,678
(cost: 1999, $118,199; 1998, $110,598)
Privately held securities 134,615 137,091
(cost: 1999, $114,117; 1998, $109,966)
Short-term investments 114,637 108,809
--------- ---------
Total investments 582,249 575,118
--------- ---------
Cash 4,025 12,037
Accrued investment income 3,411 2,632
Premiums receivable 103,822 88,610
Reinsurance recoverable 45,681 31,087
Deferred policy acquisition costs 25,351 23,515
Other assets 28,193 24,831
--------- ---------
Total Assets $ 792,732 $ 757,830
========= =========
LIABILITIES
Claims and claims expenses $ 282,014 $ 216,657
Unearned premiums 114,899 102,775
Reinsurance balances payable 19,112 5,396
Investment accounts payable 2,765 3,981
Deferred income tax liability 13,182
Other liabilities 11,225 17,837
--------- ---------
Total Liabilities 430,015 359,828
--------- ---------
STOCKHOLDERS' EQUITY
Preferred stock, $.01 par value:
20,000,000 shares authorized (none issued)
Common stock, $.01 par value:
80,000,000 shares authorized
(issued: 1999, 17,102,503; 1998, 17,102,503) 171 171
Additional paid-in capital 341,878 341,878
Deferred compensation under stock award plan (831) (1,062)
Retained earnings (Deficit) (14,730) 10,261
Less treasury stock, at cost (1999, 16,237; 1998, 15,065 shares) (309) (284)
Accumulated other comprehensive income consisting of unrealized
appreciation of investments, net of income tax 36,538 47,038
--------- ---------
Total Stockholders' Equity 362,717 398,002
--------- ---------
Total Liabilities & Stockholders' Equity $ 792,732 $ 757,830
========= =========
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
MARCH 31,
1999 1998
------------ ------------
PREMIUMS AND OTHER REVENUES
Net premiums written $ 64,437 $ 44,408
Increase in unearned premiums (1,515) (2,906)
------------ ------------
Net premiums earned 62,922 41,502
Net investment income 4,483 3,604
Net investment gains (losses) (1,152) 477
------------ ------------
TOTAL REVENUES 66,253 45,583
EXPENSES
Claims and claims expenses 80,732 30,253
Commissions and brokerage 19,538 9,931
Other operating expenses 3,661 4,479
Foreign exchange (gain) loss 388 110
------------ ------------
TOTAL EXPENSES 104,319 44,773
INCOME (LOSS) BEFORE INCOME TAXES, EQUITY IN NET INCOME (LOSS)
OF INVESTEES AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE (38,066) 810
Federal income taxes:
Current (6,000) 1,563
Deferred (7,621) (1,566)
------------ ------------
Income tax expense (benefit) (13,621) (3)
------------ ------------
INCOME (LOSS) BEFORE EQUITY IN NET INCOME (LOSS) OF INVESTEES
AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE (24,445) 813
Equity in net income (loss) of investees (163) 756
------------ ------------
INCOME (LOSS) BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE (24,608) 1,569
Cumulative effect of accounting change (383)
------------ ------------
NET INCOME (LOSS) (24,991) 1,569
------------ ------------
OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX
Change in net unrealized appreciation of investments, net of tax (10,500) 15,199
------------ ------------
COMPREHENSIVE INCOME (LOSS) $ (35,491) $ 16,768
============ ============
AVERAGE SHARES OUTSTANDING
Basic 17,086,601 17,058,444
Diluted 17,102,353 17,683,439
PER SHARE DATA
Net Income (Loss) - Basic $ (1.46) $ 0.09
- Diluted $ (1.46) $ 0.09
Comprehensive Income (Loss) - Basic $ (2.08) $ 0.98
- Diluted $ (2.08) $ 0.95
See Notes to Consolidated Financial Statements.
3
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(IN THOUSANDS)
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
1999 1998
--------- ---------
COMMON STOCK
Balance at beginning of year $ 171 $ 171
Issuance of common stock
--------- ---------
Balance at end of period $ 171 171
--------- ---------
ADDITIONAL PAID-IN CAPITAL
Balance at beginning of year 341,878 341,162
Issuance of common stock 164
--------- ---------
Balance at end of period 341,878 341,326
--------- ---------
DEFERRED COMPENSATION UNDER STOCK AWARD PLAN
Balance at beginning of year (1,062) (1,778)
Restricted common stock issued (133)
Compensation expense recognized 231 277
--------- ---------
Balance at end of period (831) (1,634)
--------- ---------
RETAINED EARNINGS (DEFICIT)
Balance at beginning of year 10,261 7,170
Net income (loss) (24,991) 1,569
--------- ---------
Balance at end of period (14,730) 8,739
--------- ---------
TREASURY STOCK, AT COST
Balance at beginning of year (284) (198)
Purchase of treasury stock (25) (16)
--------- ---------
Balance at end of period (309) (214)
--------- ---------
ACCUMULATED OTHER COMPREHENSIVE INCOME CONSISTING OF
UNREALIZED APPRECIATION OF INVESTMENTS, NET OF INCOME TAX
Balance at beginning of year 47,038 54,504
Change in unrealized appreciation (10,500) 15,199
--------- ---------
Balance at end of period 36,538 69,703
--------- ---------
TOTAL STOCKHOLDERS' EQUITY
Balance at beginning of year 398,002 401,031
Issuance of common stock 164
Change in deferred compensation 231 144
Net income (loss) (24,991) 1,569
Purchase of treasury stock (25) (16)
Change in unrealized appreciation
of investments, net of income tax (10,500) 15,199
--------- ---------
Balance at end of period $ 362,717 $ 418,091
========= =========
See Notes to Consolidated Financial Statements.
4
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
1999 1998
-------- --------
OPERATING ACTIVITIES
Net income (loss) $(24,991) $ 1,569
Adjustments to reconcile net income
to net cash provided by operating activities:
Liability for claims and claims expenses 65,357 29,382
Unearned premiums 12,124 2,906
Premiums receivable (15,212) (6,469)
Accrued investment income (779) (600)
Reinsurance recoverable (14,594) 1,376
Reinsurance balances payable 13,716 (4,900)
Deferred policy acquisition costs (1,836) (438)
Net investment (gains)/losses 1,152 (477)
Deferred income tax asset (7,728) (1,159)
Other liabilities (6,612) (2,010)
Other items, net (6,543) (6,615)
-------- --------
NET CASH PROVIDED BY OPERATING ACTIVITIES 14,054 12,565
-------- --------
INVESTING ACTIVITIES
Purchases of fixed maturity investments (63,727) (90,051)
Sales of fixed maturity investments 52,165 52,295
Net (purchases)/sales of short-term investments (2,711) 22,463
Purchases of equity securities (16,321) (11,762)
Sales of equity securities 8,714 9,574
Purchases of furniture and equipment (161) (122)
-------- --------
NET CASH PROVIDED BY (USED FOR) INVESTING ACTIVITIES (22,041) (17,603)
-------- --------
FINANCING ACTIVITIES
Common stock issued 164
Purchase of treasury stock (25) (16)
Deferred compensation on restricted stock (133)
-------- --------
NET CASH PROVIDED BY (USED FOR) FINANCING ACTIVITIES (25) 15
-------- --------
Increase (decrease) in cash (8,012) (5,023)
Cash beginning of year 12,037 9,014
-------- --------
Cash end of period $ 4,025 $ 3,991
======== ========
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. 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.
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.
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 1998
consolidated financial statements and related notes contained in the Company's
Annual Report on Form 10-K for the fiscal year ended December 31, 1998.
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.
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)
THREE MONTHS ENDED
MARCH 31,
1999 1998
-------- --------
Net income (loss) $(24,991) $ 1,569
Other comprehensive income, net of tax:
Unrealized appreciation (depreciation) of investments:
Unrealized holdings gains arising during period (11,249) 15,509
Less, reclassification adjustment for net realized (gains)
losses included in net income 749 (310)
-------- --------
Other comprehensive income (loss) (10,500) 15,199
======== ========
Comprehensive income (loss) $(35,491) $ 16,768
======== ========
4. EARNINGS PER SHARE DATA
Earnings per share are computed in accordance with FASB Statement No. 128
"Earnings Per Share."
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)
THREE MONTHS ENDED
MARCH 31,
1999 1998
------------ ------------
NET INCOME
BASIC EARNINGS PER SHARE:
Net income (loss) $ (24,991) $ 1,569
Divided by:
Weighted average shares outstanding for the period 17,086,601 17,058,444
Basic earnings (loss) per share $ (1.46) $ 0.09
DILUTED EARNINGS PER SHARE:
Net income (loss) $ (24,991) $ 1,569
Divided by:
Weighted average shares outstanding for the period 17,086,601 17,058,444
Effect of dilutive securities:
Warrants 556,095
Employee stock options 15,752 68,900
------------ ------------
Total shares 17,102,353 17,683,439
============ ============
Diluted earnings (loss) per share $ (1.46) $ 0.09
7
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4. EARNINGS PER SHARE DATA (CONT'D)
(IN THOUSANDS, EXCEPT SHARE DATA)
THREE MONTHS ENDED
MARCH 31,
1999 1998
------------ ------------
COMPREHENSIVE INCOME
BASIC EARNINGS PER SHARE:
Comprehensive income (loss) $ (35,491) $ 16,768
Divided by:
Weighted average shares outstanding for the period 17,086,601 17,058,444
Basic earnings (loss) per share $ (2.08) $ 0.98
DILUTED EARNINGS PER SHARE:
Comprehensive income (loss) $ (35,491) $ 16,768
Divided by:
Weighted average shares outstanding for the period 17,086,601 17,058,444
Effect of dilutive securities:
Warrants 556,095
Employee stock options 15,752 68,900
------------ ------------
Total shares 17,102,353 17,683,439
============ ============
Diluted earnings (loss) per share $ (2.08) $ 0.95
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 March 31, 1999, the publicly
traded equity portfolio consisted of 15 investments, with estimated fair values
ranging individually from $1.0 million to $28.1 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)
MARCH 31, DECEMBER 31,
1999 1998
-------- --------
CARRIED UNDER THE EQUITY METHOD:
The ARC Group, LLC $ 8,478 $ 9,448
Arx Holding Corp. 2,479 2,400
Capital Protection Insurance Services, LLC 250
First American Financial Corporation 11,091 9,805
Island Heritage Insurance Company, Ltd. 4,008 3,101
LARC Holdings, Ltd. 24,601 25,349
New Europe Insurance Ventures 922 1,083
Sunshine State Holding Corporation 1,729 1,688
-------- --------
Sub-total 53,308 53,124
-------- --------
CARRIED AT FAIR VALUE:
Altus Holdings, Ltd. 6,667 6,667
American Independent Holding Company 5,000
Annuity and Life Re (Holdings), Ltd. 30,635 34,243
Arbor Acquisition Corp. (Montgomery & Collins, Inc.) 500 500
GuideStar Health Systems, Inc. 1,000 1,000
Sovereign Risk Insurance Ltd. 237 246
Sorrento Holdings, Inc. 3,836 5,113
Stockton Holdings Limited 10,000 10,000
Terra Nova (Bermuda) Holdings, Ltd. 18,557 21,323
TRG Associates, LLC 4,875 4,875
-------- --------
Sub-total 81,307 83,967
-------- --------
Total $134,615 $137,091
======== ========
During the quarter ended March 31, 1999, the Company received (i) a distribution
from The ARC Group, LLC totaling $1.2 million and (ii) dividend distributions
from Terra Nova (Bermuda) Holdings, Ltd. of $53,000 and TRG Associates, LLC of
$487,500.
9
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5. INVESTMENT INFORMATION (CONT'D)
The Company also received $1,376,000 from Sorrento Holdings, Inc. ("Sorrento")
for the redemption of 1,273 shares of preferred stock of Sorrento, which
redemption amount was comprised of a payment of $1,000 per share and interest
income of approximately $103,000.
At March 31, 1999, the Company had investment commitments relating to its
privately held securities totaling approximately $10.3 million, compared to
$10.4 million at December 31, 1998.
Set forth below is certain information relating to the Company's private
investment activity for the three month period ended March 31, 1999:
AMERICAN INDEPENDENT INSURANCE HOLDING COMPANY
In February 1999, the Company loaned $5 million to American Independent
Insurance Holding Company ("AIHC"). The secured promissory note matures in
January 2003, and will accrue interest at rates per annum expected to
approximate 6%, depending on the investment returns on proceeds of the loan
which are invested by AIHC on the Company's behalf. Principal and interest
repayments are subject to prior approval by the Pennsylvania Department of
Insurance. In consideration for the loan, the Company received Class A warrants
to purchase shares of common stock of AIHC, constituting approximately 4% of
AIHC's outstanding common stock on a fully-diluted basis.
In connection with this investment and the Company's prior $3.6 million loan
commitment to AIHC (which commitment expired on December 31, 1998), the Company
will have the option to write an aggregate amount of premiums of at least
approximately $300 million over the next seven to eight year period, in
addition to the $78.5 million of premiums ceded to the Company through
March 31, 1999. No assurances can be given that any such additional premiums
will be written by the Company.
CAPITAL PROTECTION INSURANCE SERVICES, LLC
In the 1999 first quarter, the Company wrote off its investment in Capital
Protection Insurance Services, LLC ("CPI") by recording an after-tax realized
investment loss of $650,000, which represents an estimate of costs associated
with terminating leases and divesting physical assets, and other costs to
run-off the business of this managing underwriting agency.
FIRST AMERICAN FINANCIAL CORPORATION
In March 1999, the Company loaned to First American Financial Corporation $1.6
million in the form of a demand note.
ISLAND HERITAGE
In February 1999, the Company made an additional investment in Island Heritage
in the amount of $1.0 million.
10
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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.
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 effect of reinsurance on written and earned premiums and claims and claims
expenses are as follows:
(IN THOUSANDS)
THREE MONTHS ENDED
MARCH 31,
1999 1998
------- -------
Assumed premiums written $89,484 $48,154
Ceded premiums written 25,047 3,746
------- -------
Net premiums written $64,437 $44,408
======= =======
Assumed premiums earned $77,360 $45,248
Ceded premiums earned 14,438 3,746
------- -------
Net premiums earned $62,922 $41,502
======= =======
Assumed claims and claims expenses incurred $83,672 $34,903
Ceded claims and claims expenses incurred 2,940 4,650
------- -------
Net claims and claims expenses incurred $80,732 $30,253
======= =======
At March 31, 1999, the Company's balance sheet reflects reinsurance recoverable
balances as follows:
(IN THOUSANDS)
MARCH 31, DECEMBER 31,
1999 1998
-------- --------
Reinsurance recoverable balances:
Unpaid claims and claim expenses $ 35,072 $ 31,087
Unearned premiums 10,609
-------- --------
Total $ 45,681 $ 31,087
======== ========
Ceded balances payable $(19,112) $ (5,396)
======== ========
11
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
7. STATUTORY DATA
The following table reconciles statutory net loss and surplus of Risk Capital
Reinsurance Company to consolidated GAAP net income (loss) and stockholders
equity:
(IN THOUSANDS)
THREE MONTHS ENDED
MARCH 31,
1999 1998
--------- ---------
NET INCOME (LOSS):
Risk Capital Reinsurance
Statutory net loss $ (32,721) $ (5,780)
GAAP adjustments:
Dividend income (1,215)
Deferred acquisition costs 1,835 440
Realized loss 4,601
Deferred income taxes 7,621 1,566
Equity in net income (loss) of investees (163) 756
Cumulative effect of accounting change (371)
--------- ---------
GAAP net income (loss) (25,014) 1,583
RCHI (parent company only) operations 23 (14)
--------- ---------
Consolidated GAAP net income (loss) $ (24,991) $ 1,569
========= =========
(IN THOUSANDS)
MARCH 31, DECEMBER 31,
1999 1998
--------- ---------
STOCKHOLDERS' EQUITY:
Statutory surplus $ 308,651 $ 358,702
Deferred acquisition costs 25,351 23,515
Unrealized appreciation 4,155 4,579
Deferred income tax liability, net (13,164)
Deferred income tax asset, net 212
Non-admitted assets 11,089 11,489
Other 160
--------- ---------
Investment in Risk Capital Reinsurance, GAAP 349,618 385,121
RCHI (parent company only):
Other net assets 13,100 12,881
--------- ---------
Consolidated stockholders' equity, GAAP $ 362,717 $ 398,002
========= =========
12
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
8. INCOME TAXES
RCHI, Risk Capital Reinsurance and Cross River file a consolidated federal
income tax return and have 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.
The provision for federal income taxes has been determined on the basis of a
consolidated tax return consisting of RCHI, Risk Capital Reinsurance and Cross
River.
An analysis of the Company's effective tax rate for the three months ended March
31, 1999 and 1998 is as follows:
(IN THOUSANDS)
THREE MONTHS ENDED
MARCH 31,
1999 1998
-------- --------
Income taxes (benefit) computed on pre-tax
income $(13,323) $ 284
Reduction in income taxes resulting from:
Tax-exempt investment income (165) (136)
Dividend received deduction (237) (207)
Other 104 56
-------- --------
Income tax expense (benefit) on pre-tax income $(13,621) $ (3)
======== ========
The Company's current federal tax expense (benefit) for the three months ended
March 31, 1999 and 1998 was based on regular taxable income.
The net deferred income tax asset reflects temporary differences between the
carrying amounts of assets and liabilities for financial reporting and income
tax purposes, net of a valuation allowance for any portion of the deferred tax
asset that management believes will not be realized. Significant components of
the Company's deferred income tax assets and liabilities as of March 31, 1999
and December 31, 1998 were as follows:
(IN THOUSANDS)
MARCH 31, DECEMBER 31,
1999 1998
-------- --------
Deferred income tax assets:
Net claim reserve discount $ 13,654 $ 10,176
Net unearned premium reserve 7,300 7,194
Compensation liabilities 594 622
Foreign currency 219 84
Equity in net loss of investees, net 2,594 2,328
Net operating loss carryforward 4,394
-------- --------
Total deferred tax assets 28,755 20,404
-------- --------
Deferred income tax liabilities:
Deferred policy acquisition cost (8,872) (8,230)
Unrealized appreciation of investments (19,675) (25,328)
Other (8) (28)
-------- --------
Total deferred tax liabilities 28,555 (33,586)
-------- --------
Net deferred income tax asset $ 200 $(13,182)
======== ========
13
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. 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
Effective January 1, 1999, the Company changed its method of accounting for
start-up costs in accordance with the Accounting Standards Executive Committee's
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.
The change in accounting principle resulted in the write-off of the start-up
costs capitalized as of January 1, 1999 for the Company and its investee
companies carried under the equity method of accounting. The cumulative effect
of the write-off, which totals $383,000, after-tax, or $0.02 per share, has been
expensed and is included in the 1999 first quarter net loss. The effect of the
change on the net loss in the first quarter of 1999 was not material.
14
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9. ACCOUNTING PRONOUNCEMENTS (CONT'D)
MARKET RISK SENSITIVE INSTRUMENTS
The Securities and Exchange Commission ("SEC") issued Financial Reporting
Release ("FRR") No. 48 which included amended rules requiring domestic and
foreign issuers to clarify and expand existing disclosure 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 (see "Management's Discussion and Analysis of
Financial Condition and Results of Operations" included elsewhere in this Form
10-Q). These amendments are designed to provide additional information about
market risk sensitive instruments which investors can use to better understand
and evaluate market risk exposures of registrants, including the Company. There
have been no material changes in market risk exposures that affect the
quantitative and qualitative disclosures presented as of the year ended December
31, 1998.
15
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 directly
related 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 1998 year was a difficult period from
both a market and earnings perspective for most insurance markets. The property
and casualty insurance and reinsurance segments have experienced an increasingly
more difficult and highly competitive operating environment characterized by a
soft rate structure and overcapitalization. Other factors that have contributed
to the prevailing competitive conditions in the reinsurance industry in recent
years include new entrants to the reinsurance market (including certain
specialized reinsurance operations) and the presence of certain reinsurance
companies which operate within tax-advantaged jurisdictions (e.g., Bermuda,
Cayman Islands) that benefit from higher after-tax investment returns. In
addition, concerns with respect to the financial security of Lloyd's that had
adversely impacted the competitive position of that marketplace have apparently
been overcome by actions taken at Lloyd's over the last few years, thereby
enhancing its competitive position.
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. The reinsurance industry is highly competitive and dynamic,
and market changes may affect, among other things, demand for the Company's
products, changes in investment opportunities (and the performance thereof),
changes in the products offered by the Company or changes in the Company's
business strategy. (See "Cautionary Note Regarding Forward-Looking Statements.")
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 April 1, 1999 renewal period was 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
16
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. Commencing in late 1997, in addition to its core business, the
Company expanded into specialty classes of reinsurance business, including
marine and aviation and space in 1997, surety and fidelity in 1998, and accident
and health in 1999.
IN-FORCE BUSINESS
At April 1, 1999, the Company had approximately 421 renewable reinsurance
treaties that are in-force, with approximately $275.4 million of estimated
annualized net in-force premiums. Such in-force premiums at April 1, 1999
represent estimated annualized premiums from treaties entered into during 1998
and the 1999 renewal periods that are expected to generate net premiums written
during 1999. 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.
RESULTS OF OPERATIONS
The Company had consolidated comprehensive loss for the three month period ended
March 31, 1999 of $35.5 million, which was composed of a net loss of $25.0
million and other comprehensive loss of $10.5 million, consisting of the change
in after-tax unrealized appreciation of investments. The net loss for the three
month period ended March 31, 1999 included after-tax realized investment losses
of approximately $749,000, equity in net loss of investees of approximately
$163,000 and a loss of $383,000 from the cumulative effect of an accounting
change. These amounts compare with comprehensive income for the three month
period ended March 31, 1998 of $16.8 million, which was composed of net income
of $1.6 million and the change in after-tax unrealized appreciation of
investments of $15.2 million. Net income for the three month period ended March
31, 1998 included after-tax realized investment gains of $310,000 and equity in
net income of investees of $756,000.
Following is a table of per share data for the three months ended March 31, 1999
and 1998 on an after-tax basis:
THREE MONTHS ENDED
MARCH 31,
1999 1998
---------- ----------
BASIC EARNINGS PER SHARE:
Underwriting loss $ (1.58) $ (0.12)
Net investment income 0.19 0.15
Net realized investment gains (losses) (0.04) 0.02
Equity in net income (loss) of investees (0.01) 0.04
Cumulative effect of accounting change (0.02)
---------- ----------
Net income (loss) (1.46) 0.09
Change in net unrealized appreciation of investments (0.62) 0.89
========== ==========
Comprehensive income (loss) $ (2.08) $ 0.98
========== ==========
Average shares outstanding (000's) 17,087 17,058
========== ==========
DILUTED EARNINGS PER SHARE:
Underwriting loss $ (1.58) $ (0.12)
Net investment income 0.19 0.15
Net realized investment gains (losses) (0.04) 0.02
Equity in net income (loss) of investees (0.01) 0.04
Cumulative effect of accounting change (0.02)
---------- ----------
Net income (loss) $ (1.46) $ 0.09
========== ==========
Comprehensive income (loss) $ (2.08) $ 0.95
========== ==========
Average shares outstanding (000's) 17,102 17,683
========== ==========
At March 31, 1999, basic and diluted book value per share was $21.23, which
compare with basic and diluted book value per share of $23.29 and $22.75,
respectively, at December 31, 1998.
17
NET PREMIUMS WRITTEN
Net premiums written for the three month periods ended March 31, 1999 and 1998
were as follows:
(IN THOUSANDS)
THREE MONTHS ENDED MARCH 31,
---------------------------------------- PERCENT
CORE BUSINESS 1999 1998 CHANGE
------------------ ------------------ --------------------
Property $12,245 $11,601 5.6%
Casualty 19,850 10,158 95.4
Multi-line 17,455 11,543 51.2
Other (4,592) 3,015 N/M
------------------ ------------------ --------------------
Sub-total Core Business 44,958 36,317 23.8%
------------------ ------------------ --------------------
SPECIALTY BUSINESS
Accident & Health 8,068
Aviation & Space 5,642 2,491 126.5
Marine 3,965 5,600 (29.0)
Surety & Fidelity 1,804
------------------ ------------------ --------------------
Sub-total Specialty Business 19,471 8,091 140.7
------------------ ------------------ --------------------
Total $64,437 $44,408 45.1%
================== ================== ====================
Net premiums written for the 1999 first quarter were $64.4 million, representing
a 45% increase from the $44.4 million of net premiums written for the 1998 first
quarter. The Company's premium growth resulted from continued efforts in two key
strategies, the integration of investment with reinsurance and the
diversification into specialty classes of reinsurance. Approximately $19
million, or 30%, of net premiums written for the 1999 first quarter was produced
from specialty lines of business, which accounted for approximately 57% of the
increase in net premiums written for the 1999 first quarter compared to the 1998
first quarter. In addition, approximately 50% of net premiums written for the
1999 first quarter were generated from treaties integrated with a private
investment transaction, compared to 25% for the 1998 first quarter and 32% for
all of 1998.
Net premiums written for the 1999 first quarter for other business was reduced
by $10.6 million for the retrocession of a treaty which covered multiple future
rocket launches. The reduction of net premiums written resulting from this
retrocession increased the commission and operating expense ratio components of
the statutory composite ratio by 4.7 points, but had no impact on operating
results.
Approximately 7.5% of net premiums written in the first three months of 1999 was
from non-United States clients, compared to 28.9% in the first three months of
1998.
Set forth below are the Company's statutory composite ratios for the three month
periods ended March 31, 1999 and 1998:
THREE MONTHS ENDED
MARCH 31,
-----------------------
1999 1998
------ ------
Claims and claims expenses 128.3% 72.9%
Commissions and brokerage 33.2% 23.3%
Other operating expenses 5.5% 9.7%
------ ------
Statutory composite ratio 167.0% 105.9%
====== ======
18
The Company's statutory combined ratio for the 1999 first quarter was 167.0%,
compared with the 1998 first quarter ratio of 105.9%. The 1999 ratio was
adversely affected by underwriting results from the sources identified below,
which added 59.1 points to the combined ratio (dollars in millions):
NET AFTER-TAX PER
PREMIUMS EARNED UNDERWRITING SHARE COMPOSITE
SOURCES OF BUSINESS: WRITTEN PREMIUMS LOSS LOSS EFFECT (1)
- ------------------- ------------ ------------ --------------- ---------- ------------
Managing underwriting agency $5.9 $3.3 $15.4 $0.90 34.4%
Satellite business 1.5 1.5 4.4 0.26 9.6
Aviation 4.2 1.8 3.8 0.22 7.5
Property .7 .7 1.6 0.09 3.2
------------ ------------ --------------- ---------- ------------
12.3 7.3 25.2 1.47 54.7
4.4
------------ ------------ --------------- ---------- ------------
All items $12.3 $7.3 $25.2 $1.47 59.1%
============ ============ =============== ========== ============
(1) The composite effect of each item separately is as shown above and adds to
54.7%. When such items are aggregated together and excluded from
underwriting results, the impact is 59.1% because of the exclusion of the
related written and earned premiums.
As identified above, during the 1999 first quarter, the Company recorded an
after-tax underwriting loss of $15.4 million, or $0.90 per share, from
reinsurance on business produced by the managing underwriting agency, and a
related after-tax investment loss of $650,000, or $0.04 per share, recorded in
net realized investment losses. Such amounts compare to the preliminary
after-tax loss estimate previously disclosed on March 18, 1999 of $18 million,
or $1.07 per share. Included in the reserve for claims and claims expenses is an
undiscounted premium deficiency reserve of $8.2 million relating to the $7
million unearned premium reserve for this business as of March 31, 1999.
The total estimated ultimate net premiums written for all business produced on
behalf of the Company by the managing underwriting agency recorded through March
31, 1999 is approximately $23 million. The Company has discontinued its
underwriting relationship with the managing underwriting agency.
As identified above, during the 1999 first quarter, the Company recorded an
after-tax underwriting loss of $4.4 million, or $0.26 per share, for satellite
business, which includes after-tax satellite losses of $4 million, or $0.24 per
share, previously disclosed on March 18, 1999. In order to mitigate the impact
of possible future loss activity, in the fourth quarter of 1998, the Company
commenced the process of re-underwriting and reducing its satellite business and
seeking additional retrocessional protection. At March 31, 1999, the Company
currently estimates that it had net exposure of approximately $23 million to
satellite losses (net of reinstatement premiums and retrocessions) for expired
treaties and treaties expiring during 1999.
During the 1999 first quarter, the Company recorded additional after-tax
underwriting losses of $3.8 million, or $0.22 per share, for aviation business,
principally from the 1998 Swiss Air and Korean Air crashes. The additional loss
recorded for the Swiss Air crash was based on a reallocation of the $642 million
expected industry loss between the plane manufacturer and Swiss Air. This
reallocation adversely affected the Company's gross loss. The gross loss
associated with the Swiss Air crash reported as of December 31, 1998 had
exhausted the Company's retrocessional protections applicable to this
occurrence. Therefore, none of such additional loss reported during the 1999
first quarter was ceded to retrocessionaires. To the extent that the expected
industry loss increases, the Company could record additional losses. For
example, if the expected industry loss increases by $100 million, and assuming
no further loss reallocations that would increase the loss to the plane
manufacturer, the Company could record additional loss of approximately $1.7
million. However, the ultimate allocation of liability between the plane
manufacturer and Swiss Air cannot be known at present and may not be
determinable for years. With respect to the Korean Air crash, the Company
currently believes that there is no reasonable scenario in which the Company's
reinsurance protections would be exhausted as a result of this event.
19
The Company also incurred an after-tax underwriting loss of $1.6 million, or
$0.09 per share, on a property treaty resulting from an explosion and fire in
the Rouge Steel Plant, in Dearborn, Michigan in February 1999.
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.
For the 1999 first quarter, the statutory operating expense ratio improved to
5.5%, compared with 9.7% for the 1998 prior year, which improvement resulted
from the increase in net premiums written from the prior year period. In the
1999 first quarter, the Company allocated certain compensation and other
expenses of $0.6 million to net investment income based on internal time
studies. Such allocations were not made in prior periods. Due to such
allocations, the 1999 statutory operating expense ratio improved by
approximately 1 point and net investment income was reduced by approximately
$0.02 per share, with no overall effect on operating results. On a pro-forma
basis, the 1998 first quarter statutory operating expense ratio would have been
8.4%.
Pre-tax foreign exchange gains and losses are recorded separately from statutory
underwriting results and are 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. For the three months ended March 31, 1999
and 1998, pre-tax foreign exchange losses were $388,000 and $110,000,
respectively. Such future gains or losses are unpredictable, and could be
material.
INVESTMENT RESULTS
At March 31, 1999, approximately 50% of the Company's invested assets consisted
of fixed maturity and short-term investments, compared to 48% at the end of
1998. Net investment income for the first three months of 1999 was approximately
$4.5 million, compared to $3.6 million for the prior year period.
The Company's pre-tax and net of tax investment yields in the first three months
of 1999 were 3.4% and 2.5%, respectively, compared to 3.4% and 2.4%,
respectively, for the same prior year period. Assuming a stable interest rate
environment, the Company anticipates the 1999 yields to moderately increase as
funds invested in short-term securities are allocated into fixed maturity
investments.
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 three months ended March 31, 1999, the Company's equity in net loss of
investee companies was $163,000. This compares to equity in net income of
investee companies of $756,000 in the prior year period.
20
INCOME TAXES
The net deferred income tax benefits for the first three months of 1999 and 1998
of approximately $7.6 million and $1.6 million, 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. The net operating loss incurred in the three months
ended March 31, 1999 generated a deferred tax asset of approximately $4.4
million, which is anticipated to be utilized against future taxable income. See
note 8 under the caption "Income Taxes" of the accompanying Notes to the
Consolidated Financial Statements.
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 marketable 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
will lack industry diversification and will be particularly subject to the
performance 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. (For additional discussion, see "--Market Sensitive Instruments and
Risk Management.")
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. Since 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 publicly traded
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 an inability by the Company 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 March 31, 1999, cash and invested assets totaled approximately $586.3
million, consisting of $118.6 million of cash and short-term investments, $178.2
million of publicly traded fixed maturity investments, $154.8 million of
publicly traded equity securities and $134.6 million of privately held
securities. Included in privately held securities are investments totaling $53.3
million which are carried under the equity method.
During the first three months of 1999, the Company completed three equity
transactions. See Note 5 under the caption "Investment Information" of the
accompanying Notes to the Consolidated Financial Statements. The private equity
portfolio includes 17 investments, totaling approximately $134.6 million of
invested capital at March 31, 1999.
21
Approximately 89% 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 2.7 years.
See Note 5 under the caption "Investment Information" of the accompanying Notes
to the Consolidated Financial Statements for certain information regarding the
Company's privately held securities and their carrying values. During the
remainder of 1999 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 March 31, 1999, the publicly traded equity portfolio consisted of investments
in 15 publicly traded domestic insurers, reinsurers or companies providing
services to the insurance industry. The estimated fair values of such
investments ranged individually from $1 million to $28.1 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 $31.6 million at March 31, 1999, or 5.4% of cash and invested
assets, are classified as available for sale and are not held for trading
purposes.
MARKET SENSITIVE INSTRUMENTS AND RISK MANAGEMENT
In accordance with the SEC's Financial Reporting Release No. 48, the Company
performed a sensitivity analysis to determine the effects that market risk
exposures could have on the future earnings, fair values or cash flows of the
Company's financial instruments as of December 31, 1998. (See "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
included in the Company's 1998 Annual Report on Form 10-K). Market risk
represents the risk of changes in the fair value of a financial instrument and
is comprised of several components, including liquidity, basis and price risks.
At March 31, 1999, there have been no material changes in market risk exposures
that affect the quantitative and qualitative disclosures presented as of
December 31, 1998.
RATINGS
A.M. Best Company ("A.M. Best") revised its rating of Risk Capital Reinsurance
Company from A (Excellent) to A- (Excellent). While several factors were
identified, the rating action principally reflects the poor underwriting results
reported by the Company in late 1998 and the first quarter of 1999 on its
satellite book of business and the business produced by the managing
underwriting agency.
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.
22
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.
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 three months ended March 31,
1999 was $14.1 million, compared with $12.6 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 March 31, 1999, the Company's consolidated stockholders' equity totaled
$362.7 million, or $21.23 per share. At such date, statutory surplus of Risk
Capital Reinsurance was approximately $308.6 million. Based on data available as
of December 31, 1998 from the Reinsurance Association of America, Risk Capital
Reinsurance is the twelfth largest domestic broker market oriented reinsurer as
measured by statutory surplus.
23
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.
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 9 of the
accompanying notes to the Consolidated Financial Statements of the Company.)
Effective January 1, 1999, the Company changed its method of accounting for
start-up costs in accordance with the Accounting Standards Executive Committee's
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. The change in accounting
principle resulted in the write-off of the start-up costs capitalized as of
January 1, 1999 for the Company and its investee companies carried under the
equity method of accounting. The cumulative effect of the write-off, which
totals $383,000, after-tax, or $0.02 per share, has been expensed and is
included in the 1999 first quarter net loss. The effect of the change on the net
loss of the first quarter of 1999 was not material. (See Note 9 of the
accompanying notes to the Consolidated Financial Statements of the Company.)
THE 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 substantially completed its testing and implementation of
compliant components for its internal business systems and operating facilities.
The Company's significant internal systems and facilities have been deemed
compliant, and the Company is currently in the remediation and testing phases to
ensure that its remaining 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 total cost of this internal compliance effort will not
have a material adverse effect on the Company's financial position or results of
operations.
24
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 continuing to
survey 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 financial
position or results of operations from the possible failure of these entities to
be year 2000 compliant is not determinable.
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 internal
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 non-compliant business partners or vendors, one option
will be to evaluate replacing the non-compliant business partners and vendors.
The Company intends to continue to assess and attempt to mitigate its risks in
the event these third parties 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 operations.
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. Due to a significant number of variables associated with the
extent and severity of the year 2000 problem, the Company's potential
underwriting exposure to year 2000 losses cannot be determined at this time.
These variables include, but are not limited to, actual pervasiveness and
severity of year 2000 system flaws, the magnitude of the amount of costs and
expenses directly attributable to year 2000 failures, the portion of such amount
(if any) that constitutes insurable losses, and the extent of governmental
intervention. The Company's underwriting staff has considered the risks with
respect to the year 2000 problem that might be associated with underwriting
their various lines of business, and have developed internal guidelines intended
to minimize these risks. The Company seeks to minimize its potential year 2000
underwriting exposures by (i) assisting clients in the evaluation of their
potential year 2000 underwriting exposures, (ii) performing underwriting
evaluations of its clients' potential year 2000 exposure, (iii) structuring
contract language to mitigate potential exposure where appropriate and (iv)
recommending technical support as appropriate. However, the Company cannot be
certain that these steps will adequately minimize its year 2000 underwriting
exposures. Given the possible extent and severity of the year 2000 problem, the
Company may incur a significant amount of year 2000 related losses, and such
losses may have a material adverse impact on the Company's financial condition
or results of operations.
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
Except for the historical information and discussions contained herein,
statements included in this Report 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
25
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.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Reference is made to the information appearing above under the subheading
"Market Sensitive Instruments and Risk Management" under the caption
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," which information is hereby incorporated by reference.
26
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is subject to litigation and arbitration in the ordinary
course of its business.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
Exhibit No. Description
----------- -----------
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 March 31, 1999.
Omitted from this Part II are items which are inapplicable or to
which the answer is negative for the period covered.
27
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: MAY 14, 1999 MARK D. MOSCA
PRESIDENT AND CHIEF EXECUTIVE OFFICER
/s/ Paul J. Malvasio
-----------------------------------------
DATE: MAY 14, 1999 PAUL J. MALVASIO
CHIEF FINANCIAL OFFICER
28
EXHIBIT INDEX
Exhibit No. Description
----------- -----------
15 Accountants' Awareness Letter and Limitation of
Liability (regarding unaudited interim financial
information)
27 Financial Data Schedule