UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE PERIOD ENDED JUNE 30, 1999
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO .
COMMISSION FILE NUMBER 0-25508
RTW, INC.
(Exact name of registrant as specified in its charter)
MINNESOTA 41-1440870
- --------------------------------- ------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
8500 NORMANDALE LAKE BOULEVARD, SUITE 1400
BLOOMINGTON, MN 55437
(Address of principal executive offices and zip code)
(612)-893-0403
(Registrant's telephone number, including area code)
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 ____
At July 31, 1999, approximately 12,312,000 shares of Common Stock were
outstanding.
TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION PAGE
- ------------------------------ ----
Item 1. Consolidated Financial Statements and Notes (Unaudited) 3
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 8
Item 3. Quantitative and Qualitative Disclosures about Market Risk 20
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 21
Item 2. Changes in Securities 21
Item 3. Defaults Upon Senior Securities 21
Item 4. Submission of Matters to a Vote of Security Holders 21
Item 5. Other Information 21
Item 6. Exhibits and Reports on Form 8-K 21
Signatures 22
Exhibits 23
2
PART I - FINANCIAL INFORMATION
ITEM 1: CONSOLIDATED FINANCIAL STATEMENTS AND NOTES (UNAUDITED)
- -------------------------------------------------------------------------
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE
----
CONSOLIDATED FINANCIAL STATEMENTS
Consolidated Balance Sheets 4
Consolidated Statements of Operations 5
Consolidated Statements of Cash Flows 6
Notes to Consolidated Financial Statements 7
3
RTW, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
JUNE 30, 1999 AND DECEMBER 31, 1998
(In thousands, except share data)
JUNE 30, DECEMBER 31,
1999 1998
------------- -------------
ASSETS (Unaudited)
Investments at fair value, amortized cost of $114,184 and $123,924 $ 112,557 $ 126,631
Cash and cash equivalents 3,412 700
Accrued investment income 1,496 1,761
Premiums receivable, less allowance of $530 and $417 9,484 6,554
Reinsurance recoverables:
On unpaid claim and claim settlement expenses 29,778 19,414
On paid claim and claim settlement expenses 1,311 867
Deferred policy acquisition costs 1,707 1,501
Furniture and equipment, net 4,411 4,565
Other assets 9,843 8,952
------------- -------------
Total assets $ 173,999 $ 170,945
------------- -------------
------------- -------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Unpaid claim and claim settlement expenses $ 99,232 $ 97,269
Unearned premiums 14,874 13,027
Accrued expenses and other liabilities 3,534 5,570
Notes payable 2,481 2,461
------------- -------------
Total liabilities 120,121 118,327
Shareholders' equity:
Common Stock, no par value; authorized 25,000,000 shares; issued and
outstanding 12,312,000 shares at June 30, 1999 and
11,935,000 shares at December 31, 1998 30,808 29,451
Retained earnings 24,128 21,408
Accumulated other comprehensive income (loss) (1,058) 1,759
------------- -------------
Total shareholders' equity 53,878 52,618
------------- -------------
Total liabilities and shareholders' equity $ 173,999 $ 170,945
------------- -------------
------------- -------------
See notes to consolidated financial statements.
4
RTW, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
THREE AND SIX MONTH PERIODS ENDED JUNE 30, 1999 AND 1998
(Unaudited; in thousands, except share and per share data)
FOR THE THREE MONTHS FOR THE SIX MONTHS
ENDED JUNE 30, ENDED JUNE 30,
------------------------------- -------------------------------
1999 1998 1999 1998
REVENUES:
Gross premiums earned $ 21,798 $ 22,241 $ 43,112 $ 43,574
Premiums ceded (4,609) (1,056) (8,769) 155
------------- -------------- ------------- --------------
Premiums earned 17,189 21,185 34,343 43,729
Investment income 1,640 2,018 3,326 4,055
Net realized investment gains 65 716 102 719
------------- -------------- ------------- --------------
Total revenues 18,894 23,919 37,771 48,503
EXPENSES:
Claim and claim settlement expenses 10,448 17,938 21,252 37,211
Policy acquisition costs 3,523 3,310 7,009 6,590
General and administrative expenses 2,931 1,884 5,918 5,531
------------- -------------- ------------- --------------
Total expenses 16,902 23,132 34,179 49,332
------------- -------------- ------------- --------------
Income (loss) from operations 1,992 787 3,592 (829)
Interest expense 69 139 138 278
------------- -------------- ------------- --------------
Income (loss) before income taxes 1,923 648 3,454 (1,107)
Income tax expense (benefit) 436 157 734 (481)
------------- -------------- ------------- --------------
Net income (loss) $ 1,487 $ 491 $ 2,720 $ (626)
------------- -------------- ------------- --------------
------------- -------------- ------------- --------------
Net income (loss) per share:
Basic income (loss) per share $ 0.12 $ 0.04 $ 0.22 $ (0.05)
------------- -------------- ------------- --------------
------------- -------------- ------------- --------------
Diluted income (loss) per share $ 0.12 $ 0.04 $ 0.22 $ (0.05)
------------- -------------- ------------- --------------
------------- -------------- ------------- --------------
Weighted average shares outstanding:
Basic shares outstanding 12,308,000 11,940,000 12,270,000 11,912,000
------------- -------------- ------------- --------------
------------- -------------- ------------- --------------
Diluted shares outstanding 12,363,000 12,249,000 12,350,000 11,912,000
------------- -------------- ------------- --------------
------------- -------------- ------------- --------------
See notes to consolidated financial statements.
5
RTW, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
SIX MONTHS ENDED JUNE 30, 1999 AND 1998
(Unaudited, in thousands)
FOR THE SIX MONTHS
ENDED JUNE 30,
1999 1998
------------- ---------------
Cash flows from operating activities:
Net income (loss) $ 2,720 $ (626)
Adjustments to reconcile net income (loss) to net cash provided by
(used in) operating activities:
Net realized investment gains (102) (719)
Depreciation and amortization 691 626
Deferred income taxes (1,200) (1,069)
Changes in assets and liabilities:
Amounts due from reinsurers (10,808) 463
Unpaid claim and claim settlement expenses 1,963 11,767
Unearned premiums, net of premiums receivable (1,083) 1,372
Other, net (151) (1,830)
------------- -------------
Net cash provided by (used in) operating activities (7,970) 9,984
Cash flows from investing activities:
Proceeds from maturities of securities 915 1,000
Proceeds from sales of securities 16,932 35,655
Purchases of securities (8,047) (51,829)
Purchases of furniture and equipment (475) (529)
------------- -------------
Net cash provided by (used in) investing activities 9,325 (15,703)
Cash flows from financing activities:
Proceeds from stock options exercised 1,252 333
Issuance of common stock under ESPP 105 199
Proceeds from sales of common stock - 30
------------- -------------
Net cash provided by financing activities 1,357 562
------------- -------------
Net increase (decrease) in cash and cash equivalents 2,712 (5,157)
Cash and cash equivalents at beginning of year 700 5,798
------------- -------------
Cash and cash equivalents at end of period $ 3,412 $ 641
------------- -------------
------------- -------------
Supplemental disclosure of cash flow information: Cash paid (received) during
the period for:
Interest $ 183 $ 234
------------- -------------
------------- -------------
Income taxes $ (437) $ 320
------------- -------------
------------- -------------
See notes to consolidated financial statements.
6
RTW, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE AND SIX MONTH PERIODS ENDED JUNE 30, 1999 AND 1998
(Unaudited)
NOTE A - BASIS OF PRESENTATION
The accompanying consolidated financial statements have been prepared in
conformity with generally accepted accounting principles applied on a basis
consistent with the financial statements included in the RTW, Inc. 1998 Report
on Form 10-K filed with the Securities and Exchange Commission, except that the
consolidated financial statements were prepared in conformity with the
instructions to Form 10-Q for interim financial information and, accordingly, do
not include all of the information and notes required by generally accepted
accounting principles for complete financial statements. The consolidated
financial information included herein, other than the consolidated balance sheet
at December 31, 1998, has been prepared by us without audit by independent
certified public accountants. We derived the consolidated balance sheet at
December 31, 1998 from the audited consolidated financial statements for the
year ended December 31, 1998, but this report does not include all the
disclosures contained therein.
The information furnished includes all adjustments and accruals, consisting only
of normal, recurring accrual adjustments, which are, in our opinion, necessary
for a fair statement of results for the interim period. The results of
operations for any interim period are not necessarily indicative of results for
the full year. The unaudited interim consolidated financial statements should be
read in conjunction with the consolidated financial statements and notes thereto
contained in the 1998 Annual Report.
7
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
THE COMPANY - RTW, Inc. (RTW) and its wholly owned insurance subsidiary,
American Compensation Insurance Company (ACIC), provide disability management
services to employers. Collectively, "we," "our" and "us" will refer to these
entities in this "Management's Discussion and Analysis of Financial Condition
and Results of Operations."
We developed a proprietary management system, the RTW SOLUTION-Registered
Trademark-, designed to lower employers' workers' compensation costs and return
injured employees to work as soon as possible. We combine our management system
with insurance products underwritten by our insurance subsidiary to offer
services to customers. We currently provide workers' compensation management
services solely to employers insured through our insurance subsidiary or through
fronted insurance arrangements. We currently operate in Minnesota, Wisconsin,
South Dakota, Colorado, Missouri, Illinois, Kansas, Michigan, Indiana,
Massachusetts, Connecticut, Rhode Island and New Hampshire.
FINANCIAL SUMMARY
This financial summary presents our discussion and analysis of the consolidated
results of operations and financial condition of RTW, Inc. This review should be
read in conjunction with our consolidated financial statements and notes thereto
at June 30, 1999 and December 31, 1998 and the three and six month periods ended
June 30, 1999 and 1998.
The following table provides an overview of our key operating results (000's):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------------- ---------------------------
1999 1998 1999 1998
----------- ----------- ----------- -----------
Gross premiums earned $ 21,798 $ 22,241 $ 43,112 $ 43,574
Total revenues 18,894 23,919 37,771 48,503
Claim and claim settlement expenses 10,448 17,938 21,252 37,211
Net income (loss) 1,487 491 2,720 (626)
RTW reported gross premiums earned of $21.8 million in the second quarter
of 1999 compared to $22.2 million in the second quarter of 1998 and reported
gross premiums earned of $43.1 million for the six months ended June 30, 1999
compared to $43.6 million for the same period in 1998.
Total revenues for the second quarter of 1999 were $18.9 million compared
to $23.9 million for the second quarter of 1998 and total revenues for the six
months ended June 30, 1999 were $37.8 million compared to $48.5 million for the
same period in 1998. Total revenues for the three and six month periods ended
June 30, 1999 were reduced by premiums ceded under reinsurance agreements
entered into during the fourth quarter of 1998 totaling $3.3 million and $6.4
million, respectively. No comparative premiums were ceded during the first and
second quarters of 1998. Additionally, total revenues for the six month period
ended June 30, 1998 include a $2.3 million refund received in the first quarter
of 1998 from the Minnesota Workers' Compensation Reinsurance Association (WCRA).
No comparable refund was received in the first half of 1999. After excluding the
effects of reinsurance and refunds, adjusted total revenues for the three and
six month periods ended June 30, 1999 were $22.1 million and $44.2 million,
respectively, compared to $23.9 million and $46.3 million, respectively, for the
same periods in 1998.
We reported net income of $1.5 million in the second quarter of 1999
compared to net income of $491,000 in the second quarter of 1998 and reported
net income of $2.7 million for the six months ended June 30, 1999 compared to a
net loss of $626,000 for the same period in 1998 due primarily to the following
factors:
- - In the second quarter of 1999, we recorded an estimate of ceded paid
and unpaid claim and claim settlement expenses under our $25,000 to
$300,000 excess of loss reinsurance agreements totaling $5.3 million
resulting in a corresponding reduction in claim and claim settlement
expenses. Combined with
8
$5.4 million recorded in the first quarter of 1999, claim and claim
settlement expenses have been reduced by $10.7 million for the six
months ended June 30, 1999. No such ceding estimates were recorded in
the first or second quarters of 1998 as the agreement was not effective
until July 1998.
- - In the second quarter of 1998, we increased our accrual for the
Minnesota Special Compensation Fund (SCF) by approximately $400,000.
The SCF assesses us to cover the costs of second injuries which are
substantially greater, because of a pre-existing physical impairment,
than what would have resulted from the second injury alone.
Additionally, the 1998 six month results include a $3.0 million
increase in reserves for unpaid claim and claim settlement expenses
recorded in the first quarter of 1998 to reflect adverse development of
prior period claims.
- - We have aggressively targeted policies for non-renewal or
re-underwriting at more favorable rates during 1999 at policy
expiration as the profitability of that business does not meet our
underwriting profit margin standards. For the six months ended June 30,
1999, our aggressive re-underwriting resulted in $4.2 million of
premiums renewed at higher prices as well as $4.8 million in premiums
that were not renewed. We will continue to review business at policy
expiration through the remainder of 1999 and non-renew or re-underwrite
at more favorable rates any business not meeting our standards;
- - Pricing pressure continues to affect premiums in force and decrease
profit margins, especially in Minnesota. The pricing pressure is the
result of (i) increased competition in our markets and (ii) continued
price declines due to legislative benefit changes in recent years; and
- - Inflation continues to affect medical and wage costs.
While we expect to continue to operate in a difficult pricing environment
for the remainder of 1999, we are working to improve profitability in all of our
offices by continuing to aggressively manage expenses, refining our sales and
distribution channels and improving our underwriting, including reviewing policy
profitability at renewal and removing unprofitable accounts.
In the following pages, we take a look at the operating results for the
three and six month periods ended June 30, 1999 and 1998 for items in our
Consolidated Statement of Operations and also explain key balance sheet accounts
in greater detail.
RESULTS OF OPERATIONS
TOTAL REVENUES: Our total revenues include gross premiums earned, premiums
ceded, investment income and realized investment gains.
The following tables summarize the components of revenues and premiums in force
(000's):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------------- ---------------------------
1999 1998 1999 1998
----------- ----------- ----------- -----------
Gross premiums earned $ 21,798 $ 22,241 $ 43,112 $ 43,574
Premiums (ceded) recovered (4,609) (1,056) (8,769) 155
----------- ----------- ----------- -----------
Premiums earned 17,189 21,185 34,343 43,729
Investment income 1,640 2,018 3,326 4,055
Net realized investment gains 65 716 102 719
----------- ----------- ----------- -----------
Total revenues $ 18,894 $ 23,919 $ 37,771 $ 48,503
----------- ----------- ----------- -----------
----------- ----------- ----------- -----------
1999 1998
----------- -----------
Premiums in force, by state office location, at quarter-end:
Minnesota $ 32,800 $ 38,300
Colorado 11,700 13,400
Missouri 16,900 16,200
Michigan 10,700 7,600
Massachusetts 13,800 5,000
----------- -----------
Total premiums in force at quarter-end: $ 85,900 $ 80,500
----------- -----------
----------- -----------
9
GROSS PREMIUMS EARNED: Premiums on workers' compensation insurance policies are
our largest source of revenue. Premiums earned are the gross premiums earned by
us on in force workers' compensation policies, net of the effects of ceded
premiums under reinsurance agreements.
The premium we charge a policyholder is a function of their payroll, industry
and prior workers' compensation claims experience. In underwriting a policy, we
receive policyholder payroll estimates for the ensuing year. We record premiums
written on an installment basis matching billing to the policyholder and earn
premiums on a daily basis over the life of each insurance policy based on the
payroll estimate. We record the excess of premiums billed over premiums earned
for each policy as unearned premiums on our balance sheet. When a policy
expires, we audit employer payrolls for the policy period and adjust the
estimated payroll to its actual value. The result is a "final audit" adjustment
recorded to premiums earned when the adjustment becomes known.
Our premiums in force grew 6.7% to $85.9 million at June 30, 1999 from
$80.5 million at June 30, 1998 due primarily to $12.6 million in growth in our
Michigan, Missouri and Massachusetts markets offset by a $7.2 million decrease
in premiums in force in our other markets including Minnesota which decreased
$5.5 million and Colorado which decreased $1.7 million. We have aggressively
targeted policies for non-renewal or re-underwriting at more favorable rates
during 1999 at policy expiration as the profitability of that business does not
meet our underwriting profit margin standards. For the six months ended June 30,
1999, our aggressive re-underwriting resulted in $4.2 million of premiums
renewed at higher prices as well as $4.8 million in premiums that were not
renewed. We will continue to review business at policy expiration through the
remainder of 1999 and non-renew or re-underwrite at more favorable rates any
business not meeting our standards.
Our gross premiums earned were $21.8 million in the second quarter of 1999
compared to $22.2 million in the second quarter of 1998 and $43.1 million for
the six months ending June 30, 1999 compared to $43.6 million for the same
period in 1998. Gross premiums earned was affected by the 6.7% increase in
premiums in force offset by a decrease in final audit premiums recognized to
$322,000 for the three months ended June 30, 1999 compared to $1.9 million for
the three months ended June 30, 1998 and $1.3 million in final audit premiums
recognized in the first half of 1999 compared to $3.4 million in the first half
of 1998. Final audit premiums recognized during the period include billed final
audit premiums plus (or minus) the change in estimate for premiums on unexpired
and expired unaudited policies.
The premium rate that we charge policyholders per payroll dollar has
declined for several years, however, in the first half of 1999, we have seen
indications that pricing may, in fact, be firming or improving. The historical
decline in rates is due, in part, to the following:
- - Many state legislatures where we provide coverage have reduced benefits
that injured employees are paid, resulting in lower loss costs of
workers' compensation insurance and decreased corresponding premiums
paid by the policyholder;
- - As the loss cost structure of workers' compensation has declined, more
insurance companies have entered or re-entered the workers'
compensation insurance market, resulting in increased competition; and
- - We continue to experience reduced pricing on renewal policies due, in
part, to our success in lowering our policyholders' loss experience
which then improves their claims history, lowering the premium that
they have to pay for insurance. The improvement that we do for our
customers also has the effect of making them more desirable to our
competition, thus increasing price competition on these accounts.
PREMIUMS CEDED: Reinsurance agreements allow us to share certain risks with
other insurance companies. The primary purpose of ceded reinsurance is to
protect us from potential losses in excess of the level we are willing to
accept. Our primary ceded reinsurance is excess of loss coverage that limits our
per incident exposure. We expect the companies to which we have ceded
reinsurance to honor their obligations. In the event that these companies are
unable to honor their obligations to us, we will be required to pay these
obligations ourselves. We are not aware of any developments with respect to any
of our reinsurers that would prevent them from honoring any of their obligations
to us.
Under our excess of loss reinsurance policies, we pay reinsurers to limit
our per incident exposure and record this cost to premiums ceded as a reduction
to gross premiums earned. In Minnesota, we are required to purchase excess of
loss coverage for our Minnesota policies from the Minnesota Workers'
Compensation Reinsurance Association (WCRA). Our selected retention levels in
Minnesota are $290,000 in 1999 and $280,000 in 1998. In other states, we
decreased our per incident exposure to $300,000 in 1999 from $500,000 in 1998
and prior years. We
10
purchased this coverage from various reinsurers in 1998 and limited the coverage
to one insurer in 1999. Additionally, for claims occurring after June 30, 1998,
we further limited our per incident exposure by purchasing excess of loss
coverage for losses from $25,000 to the WCRA selected retention level in
Minnesota and from $25,000 to $300,000 in other states from a single reinsurer.
This agreement was finalized after its effective date and activity occurring
from July 1, 1998 through October 1, 1998 was recorded on a retrospective basis
resulting in the deferral of a gain totaling $2.0 million at December 31, 1998.
Activity occurring on or after October 1, 1998 is recorded prospectively. The
deferred gain is being amortized into income in the current year as well as
future years using the effective interest rate inherent in the amounts paid to
the reinsurer and the estimated timing and amounts of recoveries from the
reinsurer. We amortized $187,000 of the deferred gain into operations as a
reduction of claim and claim settlement expenses in the second quarter of 1999
and $374,000 for the six months ended June 30, 1999.
The following table summarizes the components of premiums ceded (000's):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------------- ---------------------------
1999 1998 1999 1998
----------- ----------- ----------- -----------
Premiums (ceded to) recovered from:
WCRA $ (1,034) $ (782) $ (1,716) $ (1,568)
Non-Minnesota excess of loss policies (3,575) (274) (7,053) (524)
Refund from the WCRA on prior years' activity - - - 2,247
----------- ----------- ----------- -----------
Premiums (ceded) recovered $ (4,609) $ (1,056) $ (8,769) $ 155
----------- ----------- ----------- -----------
----------- ----------- ----------- -----------
Premiums ceded to reinsurers were a cost of $4.6 million in the second
quarter of 1999 compared to a cost of $1.1 million in the second quarter of 1998
and premiums ceded to reinsurers were a cost of $8.8 million for the six month
period ended June 30, 1999 compared to a benefit of $155,000 for the same period
in 1998. This increased cost resulted from (i) premiums ceded under our new
excess of loss reinsurance coverage for losses over $25,000; (ii) increased
effective excess of loss premium rates in Minnesota in 1999 from 1998 due to
premium price changes within that state, (iii) increased excess of loss costs
resulting from increased premiums earned in non-Minnesota states, and (iv) the
recognition of a refund of $2.3 million from the WCRA recorded in the first
quarter of 1998. No comparable refund was received in 1999.
PREMIUMS EARNED OUTLOOK: The outlook for gross premiums earned and premiums
ceded for the remainder of 1999 includes the following factors:
- - We expect that the remaining aggressively targeted business for
non-renewal or re-underwriting during 1999 will put downward pressure
on premiums in force in our Minnesota, Colorado and Missouri markets,
however, we expect continued growth in premiums in force in our
Michigan and Massachusetts markets, as well as new business in our
Minnesota, Colorado and Missouri markets will lead to moderate growth
in gross premiums earned for the remainder of the year; and
- - We expect that premiums ceded for the remainder of 1999 will remain
consistent with the results attained for the three month period ended
June 30, 1999. Premiums ceded may decrease slightly in future quarters
of 1999 as a percent of gross premiums earned as the non-Minnesota
markets, where we pay smaller reinsurance premiums, continue to grow
relative to Minnesota. Premiums ceded (after adjusting for the WCRA
refund) will continue to run much higher in 1999 when compared to 1998
as the new lower level excess of loss policy will be in force during
all of 1999 compared to only being in place during the last six months
of 1998.
INVESTMENT INCOME AND NET REALIZED INVESTMENT GAINS: Our investment income
includes earnings on our investment portfolio. Our net realized investment gains
include gains from sales of available-for-sale securities and are displayed
separately on our Consolidated Statement of Operations. We currently invest
entirely in U.S. domiciled investment grade taxable and tax-exempt fixed
maturity investments and classify our investments as available-for-sale. We
intend to hold our available-for-sale investments to maturity, but may sell
before maturity in response to changes in interest rates, changes in prepayment
risk and changes in funding sources or terms, or to address liquidity needs. Our
primary investment objective is to maintain a diversified, high-quality,
fixed-investment portfolio structured to maximize our after-tax investment
income without taking inappropriate credit
11
risk. For further discussion of investments, see the "Investments" section of
this Management's Discussion and Analysis.
Investment income decreased to $1.6 million in the second quarter of 1999
from $2.0 million in the second quarter of 1998 and decreased to $3.3 million
for the six months ended June 30, 1999 from $4.1 million for the six months
ended June 30, 1998. Investment income decreased due to the growth of tax-exempt
municipal securities included in our portfolio which earn lower pre-tax rates
than taxable securities but are comparable on a tax adjusted basis. We first
began purchasing tax-exempt securities in the second quarter of 1998. Funds
available for investment were $112.6 million at June 30, 1999 compared to $127.9
million at June 30, 1998, due to decreased net cash provided by operating
activities, resulting primarily from (i) the difference in timing between the
receipt of premiums, the payment of premiums ceded under our reinsurance
agreements, the payment of claim and claim settlement expenses and the recovery
of paid claim and claim settlement expenses under our reinsurance programs, and
(ii) net cash provided by investment income. Tax-adjusted investment yields
increased to 6.7% for the six months ended June 30, 1999 from 6.4% for the six
months ended June 30, 1998 due to purchasing tax-exempt municipal securities
beginning in the second quarter of 1998, which have higher yields on a
tax-adjusted basis. The investment yields realized in future periods will be
affected by yields attained on new investments.
Net realized investment gains were $65,000 for the second quarter of 1999
compared to $716,000 in the second quarter of 1998 and net realized investment
gains for the six months ending June 30, 1999 were $102,000 compared to $719,000
for the six months ending June 30, 1998. The reduction in net realized
investment gains in the second quarter of 1999 is mainly due to portfolio
restructuring completed in the second and third quarters of 1998 that resulted
in net realized gains.
INVESTMENT INCOME AND NET REALIZED INVESTMENT GAINS OUTLOOK: Barring significant
changes in interest rates or operational cash flows, we expect that the yield
from our investment portfolio for the remainder of 1999 will be affected by the
following:
- - Funds provided by our operating cash flows and investment cash flows
have historically provided growth in our investment portfolio.
Operating cash flows consist of the excess of premiums collected over
claim and claim settlement expenses offset by payments for reinsurance
premiums as well as other operating expenses paid. Investment cash
flows consist of income on existing investments and proceeds from sales
and maturities of investments. We have historically generated positive
net cash flows from operations due, in part, to timing differences
between the receipt of premiums and the payment of claim and claim
settlement expenses. These net cash flows have decreased significantly
in 1999 as we have focused on closing old claims, paying earlier to
close claims. Combined with relatively flat premiums in force since
December 1998, our cash flow from timing on claims payments has
decreased. Additionally, as we lowered our reinsurance retention levels
to $25,000 in mid-1998, we decreased our current period cash flows as a
result of "pre-funding" quarterly premiums under that agreement. We
expect this reduction in quarterly cash flow will continue until
reimbursements for loss payments to claimants under these contracts
equal disbursements for premium payments;
- - Our recognition of realized gains and losses will depend on the
repositioning of the portfolio, if any, that occurs in 1999 as we
continue to diversify our portfolio from U.S. government securities to
other taxable and tax-exempt fixed maturity securities; and
- - We will continue to include fixed maturity tax-exempt securities in our
investment portfolio to increase after-tax yields. The mix of taxable
and tax-exempt securities in our portfolio may change over time to
accommodate our tax situation. Fixed maturity, tax-exempt securities
may have the effect of reducing investment income recognized and
decrease pre-tax investment yields but are expected to contribute more
to after-tax net income as a result of the favorable treatment
tax-exempt municipal income receives for federal income tax purposes.
TOTAL EXPENSES: Our expenses include claim and claim settlement expenses, policy
acquisition costs, general and administrative expenses, interest expense and
income taxes.
CLAIM AND CLAIM SETTLEMENT EXPENSES: Claim expenses refer to amounts that we
paid or expect to pay to claimants for events that have occurred. The costs of
investigating, resolving and processing these claims are referred to as claim
settlement expenses. We record these expenses, net of amounts recoverable under
reinsurance contracts, to claim and claim settlement expenses in the
Consolidated Statements of Operations.
12
Claim and claim settlement expenses are our largest expense and result in
our largest liability. We establish reserves that reflect our estimates of the
total claim and claim settlement expenses we will ultimately have to pay under
our workers' compensation insurance policies. These include claims that have
been reported but not settled and claims that have been incurred but not yet
reported to us. For further discussion of reserve determination, see the "Unpaid
Claim and Claim Settlement Expenses" section of this Management's Discussion and
Analysis.
Claim and claim settlement expenses decreased to $10.4 million in the
second quarter of 1999 from $17.9 million in the second quarter of 1998 and
decreased to $21.3 million for the six months ended June 30, 1999 from $37.2
million for the six months ended June 30, 1998. As a percent of premiums earned,
claim and claim settlement expenses decreased to 60.8% for the second quarter of
1999 from 84.7% for the second quarter of 1998 and decreased to 61.9% for the
six months ended June 30, 1999 compared to 85.1% for the six months ended June
30, 1998. These changes are due to the following:
- - In the second quarter of 1999, we recorded an estimate of ceded paid
and unpaid claim and claim settlement expenses under our $25,000 to
$300,000 excess of loss reinsurance agreements totaling $5.3 million
resulting in a corresponding reduction in claim and claim settlement
expenses. Combined with $5.4 million recorded in the first quarter of
1999, claim and claim settlement expenses have been reduced by $10.7
million for the six months ended June 30, 1999. No such ceding
estimates were recorded in the first or second quarters of 1998 as the
agreement was not effective until July 1998.
- - In the second quarter of 1998, we increased our accrual for the
Minnesota Special Compensation Fund (SCF) by approximately $400,000.
The SCF assesses us to cover the costs of second injuries which are
substantially greater, because of a pre-existing physical impairment,
than what would have resulted from the second injury alone.
Additionally, the 1998 six month results include a $3.0 million
increase in reserves for unpaid claim and claim settlement expenses
recorded in the first quarter of 1998 to reflect adverse development of
prior period claims;
- - We have aggressively targeted policies for non-renewal or
re-underwriting at more favorable rates during 1999 at policy
expiration as the profitability of that business does not meet our
underwriting profit margin standards. For the six months ended June 30,
1999, our aggressive re-underwriting resulted in $4.2 million of
premiums renewed at higher prices as well as $4.8 million in premiums
that were not renewed. We will continue to review business at policy
expiration through the remainder of 1999 and non-renew or re-underwrite
at more favorable rates any business not meeting our standards;
- - Reduced premiums due to legislative changes in estimated loss costs,
increased competition and improving customer loss experience, have
continued to place upward pressure on claim and claim settlement
expenses as a percentage of premiums earned; and
- - Claim costs continued to receive continued upward pressure in accident
year 1999 as compared to accident year 1998 due to increasing medical
and indemnity costs resulting from inflationary changes. This has been
offset somewhat by the effects of provider agreements that we
negotiated during 1998.
CLAIM AND CLAIM SETTLEMENT EXPENSE OUTLOOK: We expect that claim and claim
settlement expenses will be affected by the following factors:
- - Continued favorable effects of ceding paid and unpaid claim and claim
settlement expenses under our $25,000 to $300,000 excess of loss
reinsurance agreements resulting in a reduction of claim and claim
settlement expenses;.
- - Claim costs will continue to be affected by (i) increases in medical
and indemnity costs resulting from inflationary changes, (ii) severity
experienced in future periods in our policy holder base, (iii) changes
resulting from increases in operating efficiency and effectiveness
realized through enhancements to our internal processes and procedures,
including changes to our proprietary computer systems, and (iv)
legislative changes in estimated loss costs;
- - Continued pricing pressure due to legislative changes in estimated loss
costs, increased competition and improving customer loss experience may
result in reduced premiums, ultimately increasing claim and claim
settlement expense as a percent of premium earned; and
- - Continued application of our claims management technology and methods
to all open claims at June 30, 1999, may benefit future periods. The
ultimate result of the above factors, combined with the change in
13
premium rates, on claim and claim settlement expenses as a percent of
premiums earned for the remainder of 1999 is unknown at this time.
POLICY ACQUISITION COSTS. Policy acquisition costs are costs directly related to
writing an insurance policy and consist of commissions, state premium taxes,
underwriting personnel costs and expenses, sales and marketing costs and other
underwriting expenses, offset by ceding commissions received from our
reinsurers. Ceding commissions are amounts that reinsurers pay to us for placing
reinsurance with them. Ceding commissions represent adjustments based on actual
claim and claim settlement expenses related to premiums ceded in prior years.
Under reinsurance agreements, our ceding commission is adjusted to the extent
that actual claim and claim settlement expenses vary from levels specified in
the agreement.
The following table summarizes policy acquisition costs (000's):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------------- ---------------------------
1999 1998 1999 1998
----------- ----------- ----------- ----------
Commission expense $ 1,793 $ 1,724 $ 3,550 $ 3,415
Premium tax expense 465 448 887 904
Other policy acquisition costs 1,265 1,138 2,572 2,271
----------- ----------- ----------- -----------
Direct policy acquisition costs $ 3,523 $ 3,310 $ 7,009 $ 6,590
----------- ----------- ----------- -----------
----------- ----------- ----------- -----------
Policy acquisition costs increased to $3.5 million in the second quarter of
1999 from $3.3 million in the second quarter of 1998 and increased to $7.0
million for the six months ended June 30, 1999 compared to $6.6 million for the
six months ended June 30, 1998. As a percent of gross premiums earned, policy
acquisition costs increased to 16.2% in the second quarter of 1999 from 14.9% in
the second quarter of 1998 and increased to 16.3% for the six months ended June
30, 1999 compared to 15.1% for the six months ended June 30, 1998. These changes
reflect the following:
- - Commission expense was 8.2% of gross premiums earned in the second
quarter of 1999 compared to 7.8% in the second quarter of 1998 and was
8.2% of gross earned premiums for the six months ended June 30, 1999
versus 7.8% for the six months ended June 30, 1998. Historically, as we
entered new markets, we introduced higher commission rates to attract
business from established agents. These rates have continued into
current policy periods and will have a greater effect on the commission
expense percent as the non-Minnesota states continue to grow relative
to Minnesota. In all of our markets, we believe the commission rates we
pay are marketplace competitive;
- - Premium tax expense increased slightly to 2.1% of gross premiums earned
for the second quarter of 1999 compared to 2.0% for the second quarter
of 1998 and remained consistent at 2.1% of gross premiums earned for
the six months ended June 30, 1999 and 1998; and
- - Other policy acquisition costs increased to 5.8% of gross premiums
earned in the second quarter of 1999 from 5.1% in the second quarter of
1998 and increased to 6.0% of gross premiums earned for the six months
ended June 30, 1999 from 5.2% for the six months ended June 30, 1998,
due to increased personnel and overhead costs associated with improving
our underwriting function and increased personnel costs necessary for
the growth in premiums in force.
POLICY ACQUISITION COST OUTLOOK: We expect that policy acquisition costs as a
percent of gross premiums earned will stabilize or remain relatively constant as
a percent of gross premiums earned during the remainder of 1999 due to the
following:
- - We expect commission expense as a percent of gross premiums earned to
increase slightly during the remainder of 1999 as the non-Minnesota
states continue to grow in size relative to Minnesota;
- - We expect premium tax expense as a percent of gross premiums earned to
remain consistent with the first six months of 1999; and
- - We expect that other policy acquisition costs will be consistent with
the first half of 1999 as a percent of gross premiums earned as we
continue to improve our underwriting skills, increase premiums in force
and generate additional revenues to cover the relatively fixed policy
acquisition costs. We also expect that these costs will be offset on a
limited basis from increases in operating efficiency and effectiveness
during the
14
remainder of 1999 realized through enhancements to our internal
processes and procedures, including changes to our proprietary computer
systems.
GENERAL AND ADMINISTRATIVE EXPENSES: Our general and administrative expenses
include personnel costs, office rent, certain state administrative assessments
based on premiums and other costs and expenses not specific to claim and claim
settlement expenses or policy acquisition costs.
General and administrative expenses increased to $2.9 million in the second
quarter of 1999 from $1.9 million in the second quarter of 1998 and increased to
$5.9 million for the six months ended June 30, 1999 compared to $5.5 million for
the same in 1998. As a percent of gross premiums earned, general and
administrative expenses increased to 13.4% in the second quarter of 1999 from
8.5% in the second quarter of 1998 and increased to 13.7% for the six months
ended June 30, 1999 from 12.7% for the six months ended June 30, 1998. General
and administrative expenses continue to be managed aggressively and reduced
where appropriate. Our general and administrative expenses for the second
quarter of 1998 and six months ended June 30, 1998 include a $1.1 million
benefit resulting from the reversal of a 1997 accrual for assessments by the
Minnesota Insurance Guarantee Association (MIGA), an organization formed to fund
Minnesota claims for insolvent insurance companies. MIGA did not assess its
members in 1998 for workers' compensation claim liabilities arising from current
or prior insolvencies resulting in the accrual reversal. We did not accrue for a
1999 MIGA assessment for the six months ended June 30, 1999 while we accrued
$384,000 in the second quarter of 1998 and $615,000 for the six months ended
June 30, 1998. MIGA did not assess its members in 1998 or 1997 for workers'
compensation claim liabilities arising from current or prior insolvencies and we
do not anticipate any assessment in 1999 payable in 2000.
GENERAL AND ADMINISTRATIVE EXPENSES OUTLOOK: We expect that general and
administrative expenses will be affected by the following:
- - We will continue to aggressively manage all general and administrative
expenses for the remainder of 1999;
- - We have no plans to open additional state offices in 1999 and expect
that growth in premiums in force in Michigan and Massachusetts will
result in additional revenues to cover the fixed costs in those states;
and
- - We expect to realize operational efficiency during 1999 through
enhancements to our internal processes and procedures, including
changes to our internal proprietary computer systems.
INTEREST EXPENSE: We incur interest charges on our Senior Notes. The remaining
Senior Notes outstanding mature in December 1999.
We are paying interest at 9.50% during 1999 and paid interest at rates ranging
from 9.25% to 9.50% during 1998 on the outstanding balance on our Senior Notes.
Interest expense decreased to $69,000 in the second quarter of 1999 from
$139,000 in the second quarter of 1998 and decreased to $138,000 for the six
months ended June 30, 1999 from $278,000 for the same period in 1998 due to
principal payments on the Senior Notes in December 1998.
INTEREST EXPENSE OUTLOOK: Interest expense for the remainder of 1999 is expected
to be consistent with the results attained for the three months ended June 30,
1999. Total interest expense on the Senior Notes is expected to decrease to
$266,000 in 1999 from $546,000 in 1998 as a result of principal payments of $2.5
million made in December 1998.
INCOME TAXES: We incur federal income taxes on our combined service organization
(RTW) operations and insurance (ACIC) operations. We incur state income taxes on
the results of our service organization's operations and incur premium taxes in
lieu of state income taxes for substantially all of our insurance operations. In
certain instances, we may incur state income taxes on our insurance operations.
Additionally, certain provisions of the Internal Revenue Code adversely affect
our taxable income by accelerating recognition of revenues, deferring
recognition of expenses ultimately accelerating the payment of income taxes.
Adjustments to book income generating current tax liabilities include
limitations on the deductibility of unpaid claim and claim settlement expenses,
limitations on the deductibility of unearned premium reserves and limitations on
deductions for bad debt reserves. Additionally, we benefit from the non-taxable
portion of our tax-exempt municipal securities.
Income tax expense was $436,000 for the second quarter of 1999 compared to
income tax expense of $157,000 for the second quarter of 1998 and income tax
expense was $734,000 for the six months ended June 30, 1999
15
compared to an income tax benefit of $481,000 for the six months ended June 30,
1998. As a percent of income (loss) before income taxes, the income tax expense
(benefit) was 22.7% for second quarter of 1999 versus 24.2% for the second
quarter of 1998 and was 21.3% for the six months ended June 30, 1999 compared to
(43.5%) for the cumulative loss for the six months ended June 30, 1998. The
income tax expense (benefit) percent in 1999 has been affected by (i) decreased
taxable net income from the service organization (RTW) which is subject to both
federal and state income taxes, and (ii) the introduction of tax-exempt
municipal income beginning in the second quarter of 1998.
INCOME TAX OUTLOOK: Income tax expense (benefit) will vary based on (i) the
income from operations we recognize for the remainder of 1999, and will (ii)
decrease as a percent of income before taxes relative to the statutory effective
rate as we purchase additional tax-exempt municipal fixed investments for our
investment portfolio or decrease as a percent of income before taxes relative to
the statutory effective rate as we sell existing tax exempt municipal fixed
investments. The ultimate change is unknown at this time.
INVESTMENTS
Our portfolio included taxable and tax-exempt fixed maturity securities at June
30, 1999 as follows:
GROSS UNREALIZED
AMORTIZED MARKET -----------------------
COST VALUE GAIN (LOSS)
----------- ----------- -------- ----------
U.S. government securities $ 15,065 $ 14,981 $ 120 $ (204)
Corporate securities 16,449 16,160 48 (337)
Mortgage- and asset-backed securities 19,487 19,143 31 (375)
Municipal bonds, tax-exempt 63,183 62,273 7 (917)
----------- ----------- -------- ---------
Totals $ 114,184 $ 112,557 $ 206 $ (1,833)
----------- ----------- -------- ---------
----------- ----------- -------- ---------
After several years of purchasing solely U.S. government securities, we engaged
an investment manager in 1997 to diversify our portfolio to other taxable fixed
maturity investments and to maximize our after-tax investment income without
taking inappropriate credit risk. During the second quarter of 1998, we
transferred our portfolio to a new investment manager and further diversified
our portfolio by purchasing investment grade tax-exempt fixed maturity
investments. We manage our fixed maturity portfolio conservatively, investing
only in investment grade (BBB or better rating from Standard and Poor's)
securities of U.S. domiciled issuers. We do not invest in derivative securities.
Funds provided by our operating cash flows and investment cash flows have
historically provided growth in our investment portfolio. Operating cash flows
consist of the excess of premiums collected over claim and claim settlement
expenses offset by payments for reinsurance premiums as well as other operating
expenses paid. Investment cash flows consist of income on existing investments
and proceeds from sales and maturities of investments. We have historically
generated positive net cash flows operations due, in part, to timing differences
between the receipt of premiums and the payment of claim and claim settlement
expenses. These net cash flows have decreased significantly in 1999 as we have
focused on closing old claims, paying earlier to close claims. Combined with
relatively flat premiums in force since December 1998, our cash flow from timing
on claims payments has decreased. Additionally, as we lowered our reinsurance
retention levels to $25,000 in mid-1998, we decreased our current period cash
flows as a result of "pre-funding" quarterly premiums under that agreement. We
expect this reduction in quarterly cash flow will continue until reimbursements
for loss payments to claimants under these contracts equal disbursements for
premium payments. Our investment portfolio decreased 12.0% or $15.3 million to
$112.6 million at June 30, 1999, from $127.9 million at June 30, 1998, as a
result of these factors.
We record investments on our balance sheet at fair value, with the
corresponding appreciation or depreciation from amortized cost recorded in
shareholders' equity, net of taxes in accumulated other comprehensive income.
Because value is based on the relationship between the portfolio's stated yields
and prevailing market yields at any given time, interest rate fluctuations can
have a swift and significant impact on the carrying value of these securities.
As a result of classifying our securities as available-for-sale, and thus
carried at fair value, we expect to encounter larger adjustments in
shareholders' equity as market interest rates and other factors change.
16
UNPAID CLAIM AND CLAIM SETTLEMENT EXPENSES
Our unpaid claim and claim settlement expenses represent established,
undiscounted reserves for the estimated total unpaid cost of claim and claim
settlement expenses, which cover events that occurred through June 30, 1999.
These reserves reflect our estimates of the total costs of claims that were
reported, but not yet paid, and the cost of claims incurred but not yet reported
(IBNR). For reported claims, we establish reserves on a "case" basis. For IBNR
claims, we estimate reserves using established actuarial methods. Both our case
and IBNR reserve estimates reflect such variables as past claims experience,
current claim trends and prevailing social, economic and legal environments. Due
to commencing operations in 1992, we have limited historical data to estimate
our reserves for unpaid claim and claim settlement expenses and accordingly
supplement our experience with external industry data, as adjusted, to reflect
anticipated differences between our results and the industry. We reduce the
unpaid claim and claim settlement expenses for estimated amounts of subrogation.
Based on information currently available, we believe our reserves for
unpaid claim and claim settlement expenses are adequate to cover the ultimate
costs of claim and claim settlement expenses. The ultimate cost of claim and
claim settlement expenses may differ from the established reserves, particularly
when claims may not be settled for many years. Reserves for unpaid claim and
claim settlement expenses and assumptions used in their development are
continually reviewed. We record adjustments to prior estimates of unpaid claim
and claim settlement expenses to operations in the year in which the adjustments
are made.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity refers to our ability to generate sufficient cash flows to meet the
short- and long-term cash requirements of our operations. Capital resources
represent those funds deployed or available to be deployed to support our
business operations.
Our primary sources of cash from operations are premiums collected and
investment income. Our investment portfolio is also a source of liquidity,
through the sale of readily marketable fixed maturity investments, as well as
longer-term investments that have appreciated in value. Our primary cash
requirements consist of payments for (i) reinsurance, (ii) claim and claim
settlement expenses, (iii) policy acquisition costs, (iv) general and
administrative expenses, (v) capital expenditures, (vi) income taxes, and (vii)
debt service or principal repayment on our outstanding Senior Notes. We have
historically generated positive net cash from operations due, in part, to timing
differences between the receipt of premiums and the payment of claim and claim
settlement expenses. As we lowered our reinsurance retention levels to $25,000
in mid-1998, we decreased our current period cash flows as a result of
"pre-funding" quarterly premiums under that agreement. We expect this reduction
in quarterly cash flow will continue until reimbursements for loss payments to
claimants under these contracts equal disbursements for premium payments. Cash
generated is either invested in short-term cash and cash equivalents or longer
term available-for-sale securities pending future payments for such expenses as
indemnity, medical benefits and other operating expenses. Cash and cash
equivalents consist of U.S. government securities acquired under repurchase
agreements, tax-exempt municipal securities and corporate securities all with
maturities of 90 days or less, with the remaining balances in cash and a money
market fund that invests primarily in short-term government securities.
Cash used by operating activities for the six months ended June 30, 1999
was $8.0 million. This is primarily a result of an increase of $10.8 million in
amounts due from reinsurers, a decrease of $2.0 million in accrued liabilities,
a decrease of $1.1 million in unearned premiums, net of premiums receivable, an
increase in our deferred income tax asset of $1.2 million, offset by our net
income of $2.7 million and an increase of $2.0 million in unpaid claim and claim
settlement expenses which are non-cash accruals for future claims. Net cash
provided by investing activities was $9.3 million, primarily the result of $17.0
million in proceeds from sales of securities and maturities of $915,000 of
investments offset by $8.0 million in purchases of securities and $475,000 in
purchases of fixed assets. Net cash provided by financing activities was $1.4
million due to proceeds from the exercise of stock options and purchases of
common stock under the Employee Stock Purchase Plan.
Our need for additional capital is primarily the result of regulations
which require certain ratios of capital to premiums written. In the future, we
expect that our need for additional capital will be primarily related to the
growth of our insurance subsidiary and the need to maintain appropriate capital
to premium ratios as defined by state regulatory bodies. As an alternative to
raising additional capital, we believe we could secure quota-share or other
additional reinsurance which would have the effect of reducing the ratio of
premiums to capital and could be used to satisfy state regulatory requirements.
17
State insurance regulations limit distributions, including dividends, from
our insurance subsidiary to us. The maximum amount of dividends that can be paid
by ACIC to us in any year is equal to the greater of: (i) 10% of ACIC's
statutory surplus as of the end of the previous fiscal year, or (ii) the
statutory net gain from operations (not including realized capital gains) of
ACIC in its most recent fiscal year. Based on this limitation, the maximum
dividend that ACIC could pay to us in 1999, without regulatory approval, is
approximately $4.2 million. ACIC has never paid a dividend to us.
On September 15, 1998, our Board of Directors approved a share repurchase
program authorizing us to repurchase, from time to time, up to $4,000,000 of
RTW, Inc. common stock. We will repurchase the shares on the open market or
through private transactions depending upon market conditions and availability.
Through December 31, 1998 we had repurchased 19,500 shares for approximately
$87,000. No shares have been repurchased in 1999. The repurchased shares will be
used for employee stock option and purchase plans and other corporate purposes.
We believe that cash flow generated by our operations and our cash and
investment balances will be sufficient to fund continuing operations, principal
repayments, stock repurchases and debt service on our outstanding Senior Notes,
including principal repayments of $2.5 million due in December 1999, and capital
expenditures for the next 12 months.
INTEREST RATE RISK
Our fixed maturity investments and notes payable are subject to interest rate
risk. Increases and decreases in prevailing interest rates generally translate
into decreases and increases in the fair value of these instruments. Also, fair
values of interest rate sensitive instruments may be affected by the credit
worthiness of the issuer, prepayment options, relative values of alternative
instruments, the liquidity of the instrument and other general market
conditions. We regularly evaluate interest rate risk in order to evaluate the
appropriateness of our investments.
An increase of 100 basis points in prevailing interest rates would reduce
the fair value of our interest rate sensitive instruments by approximately $5.9
million.
The effect of interest rate risk on potential near-term fair value was
determined based on commonly used models. The models project the impact of
interest rate changes on factors such as duration, prepayments, put options and
call options. Fair value was determined based on the net present value of cash
flows or duration estimates, using a representative set of likely future
interest rate scenarios.
IMPACT OF THE YEAR 2000 ON COMPUTER APPLICATIONS
The year 2000 is a critical year for computer applications. Historically, many
computer programs were written using two digits rather than four to define the
appropriate year. As a result, many computer programs that have date sensitive
fields may recognize a date using "00" as the year 1900 rather than the year
2000. This could result in system failures or miscalculations causing disruption
of operations, including, among other things, a temporary inability to process
transactions, send invoices or engage in other critical business activities.
Year 2000 readiness includes addressing information technology systems
(computer equipment, computer software, network hardware and software, etc.),
non-information technology systems (systems which include embedded technology
such as micro-controllers including telephone systems) and issues relating to
third parties with whom we have a material relationship (customers and vendors).
INFORMATION TECHNOLOGY SYSTEMS: Our insurance subsidiary operations began
in 1992. After using third party software and services for several years, we
developed our own internal computer systems to manage our claims and related
claim settlement expenses (1996) and administer our policy information (1995).
These computer systems are year 2000 compliant. Additionally, during the second
quarter of 1998 we implemented third-party provided general ledger and accounts
payable software, which is year 2000 compliant. Also, we completed an internally
developing a billing and cash receipt system in the second quarter of 1999 which
is year 2000 compliant. These system replacements and software developments are
occurring as a part of our ongoing operations and are not specifically occurring
as a result of the year 2000 issue. We believe our critical computer hardware
and software systems are fully year 2000 compliant and non-critical hardware and
software systems will be compliant through the remainder of 1999. The remaining
cost of any hardware and software changes required to comply with the year 2000,
other than those contemplated as routine upgrades in our operations, are not
expected to have a material adverse effect on our results of operations.
18
NON-INFORMATION TECHNOLOGY SYSTEMS: We have reviewed our operationally
critical non-information technology systems (non-IT systems) which may have
embedded technology that is reliant on the year 2000. We have developed a formal
plan to address any non-IT system year 2000 issues. We believe our critical
non-IT systems are be fully year 2000 compliant. We are currently unable to
determine any further ultimate costs relating to non-information technology
systems.
THIRD PARTY READINESS: We have taken steps to ensure that our significant
customers and vendors are year 2000 compliant through surveys and further
information requests. We have received preliminary information from our critical
vendors and anticipate follow-up based on information received through mid-1999
until we are comfortable that our vendors are year 2000 compliant.
We are reviewing and updating our year 2000 business contingency plan that
will address any year 2000 risks we identify.
NAIC RISK-BASED CAPITAL STANDARDS
The National Association of Insurance Commissioners (NAIC) has risk-based
capital standards to determine the capital requirements of a property and
casualty insurance carrier based upon the risks inherent in its operations.
These standards require the computation of a risk-based capital amount which is
then compared to a carrier's actual total adjusted capital. The computation
involves applying factors to various financial data to address four primary
risks: asset risk, insurance underwriting risk, credit risk and off-balance
sheet risk. These standards provide for regulatory intervention when the percent
of total adjusted capital to authorized control level risk-based capital is
below certain levels. Based upon the risk-based capital standards, our percent
of total adjusted capital is substantially in excess of authorized control level
risk-based capital.
REGULATION
Our insurance subsidiary is subject to substantial regulation by governmental
agencies in the states in which we operate, and will be subject to such
regulation in any state in which we provide workers' compensation products and
services in the future. State regulatory agencies have broad administrative
power with respect to all aspects of our business, including premium rates,
benefit levels, policy forms, dividend payments, capital adequacy and the amount
and type of investments. These regulations are primarily intended to protect
covered employees and policyholders rather than the insurance company. Both the
legislation covering insurance companies and the regulations adopted by state
agencies are subject to change. At June 30, 1999, our insurance subsidiary was
licensed to do business in Minnesota, South Dakota, Wisconsin, Colorado,
Missouri, Illinois, Kansas, Michigan, Indiana, Massachusetts, Connecticut, Rhode
Island, Pennsylvania, Tennessee, Maryland, Arkansas, Iowa and Florida.
In March 1998, the National Association of Insurance Commissioners adopted
the Codification of Statutory Accounting Principles (Codification). The
Codification, which is intended to standardize regulatory accounting and
reporting for the insurance industry, is proposed to be effective January 1,
2001. However, statutory accounting principles will continue to be established
by individual state laws and permitted practices and it is uncertain when, or
if, the state of Minnesota will require adoption of Codification for preparing
statutory financial statements. We have not quantified the effect Codification
may have on our statutory financial statements.
FORWARD LOOKING STATEMENTS
Information included in this Form 10-Q which can be identified by the use of
forward-looking terminology such as "may," "will," "expect," "anticipate,"
"estimate," or "continue" or the negative thereof or other variations thereon or
comparable terminology constitutes forward-looking information. The following
important factors, among others, in some cases have affected and in the future
could affect our actual results and could cause our actual financial performance
to differ materially from that expressed in any forward-looking statement: (i)
our ability to manage both our existing claims and our new claims in an
effective manner, (ii) competition from traditional workers' compensation
insurance carriers, (iii) our ability to further penetrate our existing markets,
(iv) changes in workers' compensation regulation by states, including changes in
mandated benefits or insurance company regulation, (v) our ability to retain our
existing customers at favorable beneficial premium rates when their policies
renew (vi) our ability to successfully introduce new products and services, and
(vii) our ability to ensure that our operations are not adversely affected by
year 2000 compliance including our dependence on outside vendors and customers
and their
19
ability to become year 2000 compliant. This discussion of uncertainties is by no
means exhaustive but is designed to highlight important factors that may impact
our future performance.
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Information with respect to Disclosures about Market Risk is contained in the
Section entitled "Management's Discussion and Analysis of Financial Condition
and Results of Operations - Interest Rate Risk" under Item 2 of this Report of
Form 10-Q and is incorporated herein by reference.
20
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
- -------------------------------
None
ITEM 2. CHANGES IN SECURITIES
- -----------------------------------
None
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
- ---------------------------------------------
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
- -----------------------------------------------------------------
The Company held its Annual Meeting of Shareholders on May 27,
1999 and shareholders voted on and approved the following
proposals:
- - Elected two directors, Carl B. Lehmann and Mark E.
Hegman, to hold office for a term of three years or
until their successors are elected. Shares voted for
each director were as follows:
Carl B. Mark E.
Lehmann Hegman
------- ------
For 9,710,619 9,753,736
Withheld 484,744 441,627
Abstain -- --
Non-votes 2,090,067 2,090,067
The terms of David C. Prosser, J. Alexander
Fjelstad David R. Hubers and Steven M.
Rothschild, directors with unexpiring terms,
continued after the meeting.
- - Amended the RTW, Inc. 1994 Stock Plan to increase the
total number of shares available for issuance under
the plan to 2,000,000 from 1,500,000. Shares voted
were as follows:
For - 9,437,974; Withheld - 747,184; Abstain -
10,205; Non-votes - 2,090,067.
ITEM 5. OTHER INFORMATION
- -------------------------------
None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
- ----------------------------------------------
(a) LISTING OF EXHIBITS
Exhibit 11 - STATEMENT REGARDING COMPUTATION OF BASIC
AND DILUTED NET INCOME PER SHARE
Exhibit 27 - FINANCIAL STATEMENT SCHEDULE
(b) LISTING OF REPORTS ON FORM 8-K
None
21
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.
RTW, INC.
Dated: August 12, 1999 By /s/ Carl B. Lehmann
-----------------------------------------------
Carl B. Lehmann
President, Chief Executive Officer and Director
(Principal Executive Officer)
Dated: August 12, 1999 By /s/ Tim C. Chan
------------------------------------------------
Tim C. Chan
Secretary, Treasurer and Chief Financial Officer
(Principal Financial and Accounting Officer)
22
EXHIBIT INDEX
Exhibit
Number Description Page
------ ---------------------------------------------------------------- ----
11 Statement Regarding Computation of Basic and Diluted Net Income
Per Share 24
27 Financial Statement Schedule 25
23