ITEM 1. BUSINESS.
(a) General Development of Business.
Gryphon Holdings Inc. ("Gryphon" or the "Company") was incorporated under the laws of the State of Delaware in 1983. The Company is a holding company that operates through its main subsidiary, Gryphon Insurance Group ("GIG"), as a specialty property and casualty underwriting organization. The Company's wholly owned insurance company subsidiaries are Associated International Insurance Company ("Associated") and Calvert Insurance Company ("Calvert"). Associated, a California-domiciled insurance corporation, is an admitted carrier in California and an approved excess and surplus lines insurer in 48 other states. Calvert, a Pennsylvania-domiciled insurance corporation, is admitted in all states, the District of Columbia and Canada and all of its provinces.
The Company has developed expertise in lines of insurance typically not emphasized by standard lines insurers, including architects' and engineers' professional liability ("A&E"), difference in conditions ("DIC") (primarily earthquake coverage), and various other specialty coverages. The Company focuses on providing coverage for small to medium-sized insureds.
The Company employs a disciplined approach to underwriting to achieve an overall underwriting profit, even if it is necessary to limit premium growth at times. The Company emphasizes quality service in all areas of its operations and believes that this approach has enabled the Company to maintain strong relationships with its insurance producers, which are primarily excess and surplus lines brokers and general agents.
In February 1998, the Company agreed to acquire The First Reinsurance Company of Hartford ("FRH") and certain affiliated entities from Dearborn Risk Management, Inc. for a combination of cash and preferred stock valued at $43.6 million, plus certain other performance- driven contingent consideration.
The purchase consideration of $43.6 million consists of $31.9 million of cash and $11.7 million fair value of a new issue of Gryphon perpetual convertible preferred stock. The preferred stock, which will have a face amount of $14.4 million, will be convertible into 643,672 shares of the Company's common stock, reflecting a conversion price of $22.44 per share. No cash dividends will be paid or owed during the first four and one-half years; a cash dividend at the rate of 4.0% of the face amount will be paid thereafter. The preferred shares, which are non-callable for three years, have no sinking fund or mandatory redemption features. In connection with the transaction, Gryphon intends to enter into a $55 million credit facility with a group of financial institutions, the proceeds of which will be used to pay the cash portion of the purchase price and to repay existing bank borrowings.
The GAAP shareholders' equity of FRH at December 31, 1997 was approximately $35 million. Its statutory surplus at that date was approximately $31 million. FRH is currently rated A- (excellent) by A.M. Best.
The transaction, which is subject only to regulatory approvals and other customary conditions, is expected to close during the second quarter of 1998.
Business Plan
Since January 1, 1996, the Company has pursued a business plan that has emphasized a more coordinated and integrated approach to the businesses of its two major underwriting subsidiaries. Through this strategy, the Company has endeavored to better utilize the complementary state licensing of the subsidiaries by making available to all underwriting personnel of the Company the policy issuance capability of either its admitted insurance company subsidiary, Calvert, or its non- admitted subsidiary, Associated. In addition, the Company has attempted to enhance the effectiveness of its smaller subsidiary, Calvert, by making available to it the financial resources of the Company's larger subsidiary, Associated.
In pursuit of these objectives, the Company implemented two significant changes, effective January 1, 1996. On that date, all of the operating-level personnel previously employed by Associated and Calvert became employees of GIG, a new management and service subsidiary. The consolidation into a single company has created a more efficient organization, has facilitated a more uniform approach to underwriting and related operations, with freer access to either issuing company, and has encouraged a single-company culture. Secondly, the Company has put into place a pooling arrangement between Associated and Calvert through which the financial resources of the two subsidiaries are, in effect, combined into one larger and stronger entity. This arrangement has enhanced various operating ratios and facilitated the use of higher net retentions in most lines of business.
Underwriting Strategy
The Company seeks to optimize underwriting profitability regardless of market conditions by providing specialty insurance products to small and medium-sized commercial insureds. Using its expertise in specialty lines of insurance, the Company endeavors to maintain adequate pricing by exercising underwriting discipline, particularly during times of excess underwriting capacity and greater competition among insurers. The principal elements of this strategy are set forth below.
Focus on Specialty Lines. The Company focuses on specialty lines of insurance where the Company expects that its particular expertise in evaluating and pricing risks will give it a competitive advantage. By underwriting a variety of specialty insurance programs, the Company diversifies its risk among lines of insurance.
Underwriting Discipline. The Company seeks to write insurance at prices and terms that it believes will generate overall underwriting profits. In underwriting, the Company typically reviews the type of risk, the attractiveness of the pricing and terms relative to the risk and the Company's aggregate exposure to similar risks.
Opportunistic Approach. The Company changes its mix of business as market conditions change and opportunities arise. The Company generally emphasizes insurance products that have greater potential for underwriting profitability. The Company avoids underwriting a line of business if the line cannot be priced profitably. The Company does not emphasize market share.
Commitment to Service. The Company focuses on providing consistent, high quality service to its insurance producers and insureds in both underwriting and claims handling. The Company believes its producers and insureds benefit from the extensive experience of its underwriting and claims personnel.
Use of Sophisticated Computer Modeling Techniques. In addition to employing standard insurance underwriting techniques, the Company's DIC underwriters utilize the Insurance/Investment Risk Assessment System ("IRAS"), a sophisticated computer model which estimates the probable maximum loss ("PML") from earthquakes of varying frequency and severity, to quantify the risk of and assist in determining the price and terms of coverage. The Company also uses IRAS on an ongoing basis to monitor aggregate earthquake exposure.
Emphasis on Relationships with Producers. The Company utilizes select wholesale producers, including general agents and excess and surplus lines brokers, to distribute its insurance products, expand market reach and provide specialized knowledge of particular coverages, markets and customers. The Company generally seeks to be a substantial underwriter for its producers, in order to enhance the likelihood of receiving the most desirable underwriting opportunities.
(b) Financial Information about Industry Segments.
The Company operates in only one industry segment, the property and casualty insurance industry.
(c) Narrative Description of Business.
Principal Business Lines and Products
The following tables set forth the gross and net premiums written by principal lines of business of the Company for the periods indicated:
Architects' and Engineers' Liability. A&E insurance protects architects, engineers and other design professionals against liability to third parties due to the insured's negligence. A&E policies are written by the Company exclusively as claims-made coverage. A&E policies written by the Company protect insureds for up to $5 million.
The Company generally concentrates on smaller architectural and engineering firms (i.e., those with $10 million or less in annual billings) where the principals actively participate in the operations of the business. Based upon gross premiums written, approximately 50.5% and 49.0% of the A&E insurance was written for firms located in California for the years ended December 31, 1997 and 1996, respectively.
The Company has generated its A&E business exclusively through Risk Administration & Management Company ("RAMCO") for over 10 years. RAMCO has been granted binding authority, subject to A&E underwriting guidelines specified by the Company. The Company may cancel any policy, subject to applicable insurance regulations, if it is inconsistent with such guidelines. All A&E claims are handled by RAMCO with oversight by the Company. The Company conducts semi-annual audits of RAMCO's underwriting files and reviews claims with RAMCO on a quarterly basis.
As compensation for A&E insurance produced by RAMCO, the Company pays RAMCO commissions based upon a percentage of gross A&E premiums written. RAMCO also receives a contingent commission based upon the profitability of A&E insurance policies it produces.
Casualty. The Company specializes in casualty policies which provide coverage above an insured's self-insured retention ("SIR policies"), umbrella and buffer or excess layer casualty coverage, including general liability and products liability coverage. SIR policies have minimum attachment points of $100,000 on automobile liability and $50,000 on general liability. The Company's commercial umbrella coverage is generally written in excess of primary liability insurance coverage provided by other insurance carriers. The Company also writes primary general liability and commercial multi-peril package policies.
Commercial Automobile. The Company underwrites commercial automobile policies for owner-operators and small commercial fleets for local, intermediate and long-haul trucking risks produced through selected general agents. The policies provide liability, physical damage and cargo insurance with liability protection up to $1 million.
Difference in Conditions. Substantially all of the DIC policies written by the Company are for California earthquake coverage. The Company uses IRAS, a computer modeling program, in connection with underwriting DIC coverage to estimate PML from earthquakes of varying severity. IRAS evaluates seismic hazard by matching structural information provided by the Company regarding a particular building, group of exposures or portfolio with the IRAS database, which includes information concerning earthquake severity and frequency, soil composition, and proximity to known faults. Although IRAS is available to other property and casualty insurers, the Company believes that the amount and quality of information input into IRAS by the Company results in more effective utilization of IRAS' capabilities. The Company further believes that its use of IRAS prior to actual risk selection enables the Company to differentiate its pricing and terms with respect to particular risks on DIC coverage.
Other Property. The Company's other property coverage consists primarily of monoline fire and all-risk business packages, inland marine and plate glass insurance written on either a primary or an excess and surplus basis. The Company also writes course-of-construction coverage on engineering projects, and utilities coverage including transmission lines.
Specialty Lines. Other specialty insurance products provided by the Company include liquor liability insurance, animal mortality insurance, special events insurance (for events such as concerts and contests), directors' and officers' liability insurance for "not-for-profit" organizations, fiduciary liability insurance for pension fund trustees, public officials liability and miscellaneous errors and omissions. The Company has expanded its specialty lines business to diversify its risk exposure.
Marketing
The Company writes business through wholesale excess and surplus lines brokers and general agents. The Company believes that close working relationships with these insurance producers are essential to its success. These producers provide specialized knowledge of particular products, markets and customers, and enable the Company to capitalize on underwriting opportunities. The Company seeks to be a substantial underwriter for its producers in order to enhance the likelihood of receiving the most desirable underwriting opportunities.
The Company pays brokers and agents commissions based on the amount of premiums and types of business underwritten. These payments constitute part of the Company's acquisition costs and are included in its underwriting expenses. The Company also pays RAMCO and other general agents contingent commissions based upon the profitability of the policies they produce for the Company.
Gross premiums written in the State of California amounted to approximately 40.9% and 43.7% of the aggregate gross premiums written by the Company for the years ended December 31, 1997 and 1996, respectively. Gross premiums written in any other state did not exceed 10% of gross premiums written during 1997 or 1996.
Management emphasizes quality service in all phases of its operations and believes that this approach has enabled the Company to maintain strong relationships with its producers. To deliver prompt service while ensuring consistent disciplined underwriting, the Company has granted selected general agents the authority to sell and bind insurance coverages in accordance with detailed procedures and limitations established by the Company. The Company promptly reviews coverages bound by these agents, decides whether the insurance is written in accordance with such procedures and limitations and may cancel policies that are not in compliance with such procedures and limitations. Approximately 39.9% and 35.6% of the Company's gross premiums for the years ended December 31, 1997 and 1996, respectively, were produced by general agents with binding authority.
Underwriting
The Company employs a disciplined approach to underwriting to achieve an overall underwriting profit, even if it is necessary to limit premium growth at times.
At December 31, 1997, the Company's thirty-two underwriters had an average of 18 years of underwriting experience. By focusing on specialized classes of insurance, the Company is able to take advantage of its underwriters' experience to underwrite complicated insurance risks on a case-by-case basis. In accepting risks, each underwriter is required to comply with risk parameters, retention limits and rates prescribed by the Company. Compensation of senior underwriters depends in part on the profitability of the lines of business for which they are responsible.
The Company's computer systems are capable of generating specific risk reports, which include a variety of historical data regarding individual risks underwritten by the Company. These reports inform the underwriters of the historical annual premium quoted with respect to the risk, the reported losses and loss adjustment expenses ("LAE") relating to the risk, cumulative underwriting profitability and other relevant information.
The Company's underwriters generally perform a complete underwriting evaluation of applicants and determine premiums and coverage provisions before an insurance quotation is issued. While the Company's business is primarily underwritten in-house (except for A&E coverage, which is underwritten exclusively by RAMCO), the Company has granted selected agents binding authority to underwrite programs for the Company, subject to specific guidelines that have been established by the Company. See "Marketing."
Claims Management and Administration
In accordance with its emphasis on underwriting profitability, the Company has an active approach to claims management that is designed to investigate claims as soon as practicable, manage and anticipate developments and service producing brokers and insureds throughout the process. The Company maintains an experienced claims management staff at each of its major offices, with eleven claims examiners in Woodland Hills, California and seven claims examiners in Hoboken, New Jersey.
Claims in respect of A&E insurance written by the Company are administered by RAMCO under the Company's supervision. Each of the A&E policies written by the Company is on a claims-made basis and includes defense costs within the policy limit. Due to the nature of this line of professional liability coverage, the Company generally has needed to retain counsel for a majority of its A&E claims. When the estimated value of a claim exceeds the Company's attachment level on a particular policy, RAMCO provides the Company with documentation and a caption report, recommends appropriate reserve levels and sends requests for claims payments directly to the Company for processing. The Company reviews each claim that is submitted and makes the payment it believes is appropriate.
Reserves
The Company's loss reserves are estimates of amounts that may be needed in the future to pay losses as well as expenses related to the final adjustment of those losses. Reserves for losses and LAE have been estimated by the Company utilizing its own historical experience as well as that of the industry. These estimates include two components: case reserves and incurred but not reported reserves ("IBNR"). Case reserves are estimates of losses and LAE for reported claims and are established by the Company's claims departments. IBNR reserves, include a provision for losses that have occurred but have not been reported to the Company, are the difference between (i) the sum of case reserves and paid losses and (ii) estimated ultimate incurred losses. Ultimate incurred losses are an estimate of total losses and LAE necessary for the ultimate settlement of all reported claims, including amounts already paid and IBNR claims. The Company engages independent actuarial consultants to perform periodic loss and LAE reserve analyses.
The Company's management believes its loss and LAE reserves are adequate for the ultimate net cost of all losses incurred by the Company. The Company does not discount its reserves. The Company will continue to make additional adjustments to loss and LAE reserve calculations based on additional analyses and information as available. Notwithstanding the foregoing, the Company can give no assurances as to the ultimate adequacy of current reserves for losses or LAE, or that additional development will not occur in the future since the process of establishing and estimating loss and LAE reserves is, by its nature, imprecise.
The following loss and LAE development table illustrates the change over time of reserves established for property-liability losses and LAE at the end of various calendar years. The amounts shown for each year on the top line of the table represent the Company's estimate of its gross liability for future payments of losses and LAE as of the balance sheet date as originally reported. The next line represents the amount of ceded reserves recoverable from reinsurers for losses and LAE for the same period, followed by the net losses and LAE unpaid on the Company's business. The upper half of the table includes re- estimates of the original balance sheet net liability for unpaid losses and LAE at the end of each period following the original report date. The estimates change as more information is known about the frequency and severity patterns of claims for each year. A redundancy (deficiency) exists when the reserve as originally reported is greater (less) than the amount re-estimated at each December 31. The cumulative redundancy (deficiency) depicted in the table for a particular calendar year shows the aggregate change in estimates over the period of years subsequent to the original calendar year. As of December 31, 1997, the cumulative deficiency of $6,793,000 results principally from additional loss and LAE development, related to a pre-1985 book of Casualty business and certain pre-1987 reinsurance- assumed business, both previously discontinued.
In evaluating the information in the table, it should be noted that each column includes the effects of all changes in amounts for prior periods. The table does not present accident year or policy year development data. Conditions and trends that have affected the development of liabilities in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table.
Prior to 1985, the Company wrote casualty insurance coverage at high attachment levels on an excess-of-loss basis. The Company's net retention was generally $50,000 per risk on such coverage. As was customary for the insurance industry at that time, such policies sometimes included exposure to sudden and accidental, as well as cumulative, environmental impairment and asbestos-related risks that involve significant unresolved issues regarding liability, policy coverage and other matters. Given the nature of this business, the pre-1985 casualty book of business has an extremely long tail, creating uncertainty in the estimation of ultimate losses to be paid. The Company generally establishes reserves for such claims if it believes that the attachment level of such policies is likely to be reached.
The Company's reserves also reflect certain facultative and treaty casualty and professional liability reinsurance assumed (written) prior to 1985. The inherent uncertainties in estimating reserves are greater for reinsurance than for primary insurance due to the diversity of the development patterns among different types of reinsurance contracts, the longer period between the occurrence of a claim and the reporting of such claim to the reinsurer, the necessary reliance on ceding companies or reinsurance intermediaries for information regarding reported claims and different reserving practices among ceding companies. A reinsurer's internal data is often supplemented by industry data to provide the basis for reserve analysis. Thus, management's judgments about the applicability of industry data to the Company's reinsurance assumed business add an additional element of uncertainty to the reserving process. The Company no longer writes this business.
The insurance industry experienced a number of reinsurance company failures in the 1980's and certain of the Company's treaty reinsurers relating to the pre-1985 book of casualty business have become insolvent or are financially impaired. The Company has written off or reserved for all debts due from insolvent companies and all receivables for paid losses and LAE and reserves ceded to companies it believes to be financially impaired. The Company remainsliable to its policyholders for the portion reinsured to the extent that any reinsurer does not meet its obligations for reinsurance ceded to it under the reinsurance agreements. Failure of reinsurers to honor their obligations could result in losses to the Company. In addition, as is often the case in the normal course of business, the Company is involved in disputes with reinsurers regarding certain loss recoverables. Although the Company believes that such issues will be resolved in the Company's favor, there can be no assurance that the Company will prevail; an unfavorable resolution could have a material effect on the Company's financial statements.
Since 1985, the Company has changed the type of casualty insurance it writes and the risks it covers and has amended the policy forms it uses to expressly exclude from the coverage any risks directly associated with pollution and asbestos.
Associated revised its casualty coverage to meet the severity of loss requirements of commercial insureds by providing coverage over an SIR together with first layer umbrella and buffer/excess layer policies. The policies generally have minimum SIR's of $50,000 for general liability and $100,000 for commercial automobile. As a result, coverage now attaches at much lower levels and the reporting tail for claims is much shorter than for the pre-1986 book of business. The Company has also developed specialty programs which focus on lower-severity business and, in addition, writes A&E coverage only on a claims-made basis and includes defense costs within A&E policy limits.
The following table provides a reconciliation of beginning and ending loss and LAE reserve balances of the Company for each of the years in the three-year period ended December 31, 1997, as computed in accordance with GAAP.
The following table provides a reconciliation of beginning and ending loss and LAE reserve balances of the Company for each of the years in the three-year period ended December 31, 1997 for environmental impairment and asbestos-related liabilities.
At December 31, 1997, the reserve for unpaid environmental impairment losses and related LAE was approximately $6.8 million, net of reinsurance recoverables deemed probable of collection by the Company of approximately $5.2 million. The range of gross reserves for unpaid environmental impairment losses and LAE is estimated to be $12.0 million to $20.0 million and the range of reserves, net of reinsurance recoverable, for unpaid environmental impairment losses and LAE is estimated to be approximately $6.8 million to $9.5 million.
At December 31, 1997, the reserve for unpaid asbestos- related losses and related LAE was $1.7 million, net of reinsurance recoverables deemed probable of collection by the Company of approximately $2.5 million. The range of gross reserves for unpaid asbestos-related losses and LAE is estimated to be $4.2 million to $9.4 million and the range of reserves, net of reinsurance recoverable, for unpaid asbestos-related losses and LAE is estimated to be approximately $1.7 million to $3.3 million.
At December 31, 1997, reserves for IBNR losses and LAE for environmental impairment and asbestos-related claims, included in the net reserves above, were $3.5 million and $1.4 million, respectively.
The range of reserves, net of reinsurance recoverable, for unpaid environmental impairment and asbestos-related losses and LAE is estimated to be approximately $8.5 million to $12.8 million.
At December 31, 1997 and 1996, the Company had 218 and 232 environmental impairment liability claims, respectively, covering 146 and 154 policyholders, respectively. At December 31, 1997 and 1996, the Company had 72 and 66 asbestos claims, respectively, covering 57 and 53 policyholders, respectively.
The Company disputes coverage on substantially all of its environmental impairment and asbestos-related claims since such underlying policies were generally written with certain coverage exclusions. In a majority of cases, coverage is being determined through judicial interpretation, which can vary from jurisdiction to jurisdiction.
There are significant uncertainties in estimating the amount of the Company's environmental impairment and asbestos- related liabilities resulting from a lack of historical data, long reporting delays, uncertainty as to the number and identity of insureds with potential exposure, and complex, unresolved legal issues regarding policy coverage and the extent and timing of any such contractual liability. Courts have reached different and sometimes inconsistent conclusions as to when a loss occurred and what policies provide coverage, what claims are covered, whether there is an insured obligation to defend, how policy limits are determined, how policy exclusions are applied and interpreted, and whether cleanup costs are includible as insured property damage. These issues are not likely to be resolved in the near future. As a result of these issues, the ultimate number and cost of these claims may generate losses that vary materially from the amounts currently recorded and could have a material adverse effect on the Company's results of operations and financial condition. While management believes the Company's reserves for these coverages are appropriately established, because of the uncertainty of circumstances surrounding many critical factors that affect environmental impairment and asbestos-related liabilities, there can be no assurance that the Company's reserves for and losses from these claims will not increase in the future.
Investments
The Company's investment policy has an overall objective of enhancing after-tax return, through allocations among a range of investment-grade securities having varying tax characteristics, maturities and ratings. The precise allocation varies depending upon investment opportunities, economic conditions and tax considerations. The Company's investment portfolio continues to be professionally managed with emphasis on municipal bonds, U.S. Treasury securities and corporate bonds. As of December 31, 1997, the portfolio had an estimated effective modified duration of approximately 4.8 years.
The Company utilizes outside professional investment managers who currently invest substantially all of the Company's invested assets. The outside investment managers consult frequently with management regarding the Company's tax position and aggregate portfolio characteristics. The Investment Committee of the Company's Board of Directors meets quarterly with management to review and amend investment policy and monitor the performance of the Company's investment managers.
The Company's investment portfolio is subject to several risks, including interest rate and reinvestment risk. Fixed maturity security values generally fluctuate inversely with movements in interest rates. The Company's corporate and municipal bond investments may contain call and sinking fund features which may result in early redemptions and the Company's mortgage-backed securities are subject to prepayment risk. Declines in interest rates could cause early redemptions or prepayments, which would require the Company to reinvest at lower rates.
The Company's securities are classified as available for sale and reported at fair value, with unrealized gains and losses, net of deferred income taxes, included in stockholders' equity.
The following table summarizes the investment results of the Company for the periods indicated.
The following table summarizes the Company's fixed maturity portfolio, excluding short-term investments, by sector as of December 31, 1997.
The following table summarizes the Company's fixed maturity portfolio by rating as of December 31, 1997.
(1) Ratings as assigned by Moody's. Such ratings are generally assigned upon the issuance of the securities, subject to revision on the basis of ongoing evaluations. Bonds rated Aaa by Moody's are judged to be of the best quality and are considered to carry the smallest degree of investment risk.
The following table summarizes the Company's fixed maturity portfolio by years to stated maturity as of December 31, 1997.
At December 31, 1997, investments in Federal National Mortgage Association securities aggregating approximately $11.8 million represented the only investments in any entity in excess of 10% of stockholders' equity other than those investments issued or guaranteed by the U.S. Government.
The Company is subject to state laws and regulations that require diversification of its investment portfolio and limit the amount of investments in certain investment categories. As of December 31, 1997, the Company's investments complied with all such laws and regulations.
Reinsurance
Insurance companies purchase reinsurance to spread risk on individual exposures, protect against catastrophic losses and increase their capacity to write insurance. Reinsurance involves an insurance company transferring, or ceding, all or a portion of its exposure on insurance to a reinsurer. The reinsurer assumes the exposure in return for a portion of the premium received by the insurance company. Reinsurance does not discharge the insurer from its obligations to its insureds. If the reinsurer fails to meet its obligations, the ceding insurer remains liable to pay the insured.
The Company cedes a material amount of its business to reinsurers to spread risk and limit loss per exposure. During 1997, 1996 and 1995, the Company ceded premiums of $45.8 million, $62.3 million and $66.8 million, respectively, which constituted 31.3%, 39.7%, and 42.6% respectively, of gross premiums written in each year. Management seeks to mitigate exposure to adverse reinsurance pricing conditions and its credit risk by maintaining a diversity of reinsurers.
Catastrophe reinsurance protects an insurer from significant aggregate loss exposure arising from a single event such as an earthquake, hurricane, riot, tornado or other extraordinary event. The Company uses IRAS to evaluate its earthquake exposure in connection with purchasing catastrophe reinsurance coverage.
Effective January 1, 1998, The Company maintains a five- layer catastrophe reinsurance program covering its DIC writings. The catastrophe reinsurance program covers 95% of the annual aggregate amount of property claims up to $143 million per occurrence, subject to a retention of $2.5 million per occurrence. The Company limits its net retention to $100,000 per risk for DIC.
Most other exposures, including Casualty, A&E, Specialty Lines, Commercial Auto and certain Other Property risks have been consolidated in a three-layer per-event reinsurance program that provides for indemnity of $24.5 million in excess of a net retention of $500,000 per risk. In addition to per-risk coverage, the program provides casualty clash & contingency and certain non-DIC property catastrophe protection on an occurrence basis, subject to the same net retention. Effective December 31, 1997, the Company also maintains a 50% quota share protection to limit its Commercial Auto exposure to $250,000 per policy.
The Company continually evaluates the credit risk related to its reinsurers and has established a minimum A.M. Best rating of "A-" for its domestic and Bermuda-based reinsurers and also requires at least $50 million of policyholder surplus for all domestic and foreign reinsurers. The Company works with intermediaries to continually monitor the financial condition of its reinsurers, as appropriate. If a reinsurer of the Company were to become insolvent or unable to make payments under the terms of a reinsurance agreement, it could have a material adverse effect on the Company.
Competition
The property and casualty insurance industry is highly competitive. The Company competes with national and smaller regional insurers in each state in which it operates, as well as with monoline specialty insurers. Certain of these competitors are larger and have greater financial resources than the Company. Among other things, competition may take the form of lower prices, broader coverage, greater product flexibility, higher quality services or an insurer's rating by independent rating agencies. The Company competes with admitted insurers, surplus line insurers, new forms of insurance organizations such as risk retention groups, and alternative self-insurance mechanisms.
Increased public and regulatory concerns regarding the financial stability of participants in the insurance industry have resulted in greater emphasis being placed by policyholders upon insurance company ratings and have created some measure of competitive advantage for insurance carriers with higher ratings. Associated's and Calvert's financial strength and claims-paying ability are currently rated "A p (Excellent)" by A.M. Best. Also, A.M. Best has assigned the financial size category of Class VII to both companies under its pooling arrangement. In evaluating a company's financial and operating performance, A.M. Best reviews the company's profitability, leverage and liquidity as well as the company's book of business, the adequacy and soundness of its reinsurance, the quality and estimated market value of its assets, the adequacy of its loss reserves and the experience and competence of the management. The ratings assigned by A.M. Best are based upon factors of concern to policyholders, agents and intermediaries and are not directed toward the protection of investors.
Cyclicality
Historically, the overall financial performance of the property and casualty industry has tended to fluctuate in cyclical market patterns. These cycles can be more pronounced for insurance companies, such as the Company, that underwrite business on a surplus lines basis. During a soft market, heightened competition for premiums not only increases competition among surplus lines insurers, but also encourages admitted insurers to offer coverages for risks generally underwritten by the surplus lines insurers. During a hard market, the constriction of available capital among admitted carriers, combined with the opportunity for increased underwriting profit in their more traditional lines of business, tends to cause admitted carriers to reduce their underwriting of surplus lines coverages. This may increase the overall number of risks submitted to the surplus lines insurers and consequently may enhance the opportunity of surplus lines companies to increase premium volume and improve pricing.
Surplus lines insurance is generally placed by wholesale brokers and general agents who specialize in particular lines of coverage or classes of insureds. These insureds tend to be sophisticated and price-conscious insurance purchasers. As a result, surplus lines insurers may experience increased premium rate competition and volume competition in soft markets.
At present, the property and casualty insurance industry is experiencing a prolonged soft market.
Year 2000 Compliance
Recently, there has been significant public discussion regarding the potential inability of computer programs and systems to adequately store and process data after December 31, 1999, due to the inability of such programs and systems to identify correctly dates subsequent to December 31, 1999.
The Company has completed an assessment of its core financial and operational software systems and believes it will be in compliance with the requirements necessary to avoid the foregoing "Year 2000" problem. The Company will test these systems to confirm their compliance. If for any reason these systems are not in compliance by December 31, 1999, the Year 2000 issue could have a material impact on the Company's ability to meet financial and reporting requirements and to support its insurance operations.
The Company is in the process of initiating discussions with significant suppliers, business partners, customers and other third parties to determine the extent to which the Company may be vulnerable to the failure of these parties to address and correct their own Year 2000 issues. However, there can be no guarantee that the systems of other companies that support the Company's operations will be timely converted or that a failure by these companies to correct their Year 2000 problems would not have a material adverse effect on the Company.
The Company is currently assessing what changes may be appropriate in insurance coverages it currently markets in light of the Year 2000 problem. In this connection, management is consulting with Insurance Services Offices, Inc. ("ISO") and others regarding possible modifications and/or exclusions to policy forms that could be implemented in connection with future insurance policies that will extend coverage beyond December 31, 1999.
The costs incurred to date by the Company in connection with its Year 2000 compliance initiative have been nominal, and the Company currently has no indication that the costs associated with any remaining remedial actions in connection with this matter will be material.
Employees
As of December 31, 1997, the Company employed approximately 141 persons, all in the United States. None of its employees is represented by a labor union, and the Company believes that its employee relations are good.
Regulation and Other Matters
As a general rule, an insurance company must be licensed to transact insurance business in each jurisdiction in which it operates, and almost all significant operations of a licensed insurer are subject to regulatory scrutiny. Licensed insurance companies are generally known as "admitted" insurers. Most states provide a limited exemption from licensing for insurers issuing insurance coverages that generally are not available from admitted insurers. These coverages are referred to as "surplus lines" insurance and these insurers are referred to as surplus lines or "non-admitted" companies.
The Company's admitted insurance businesses are subject to comprehensive, detailed regulation throughout the United States and Canada. Various jurisdictions have established supervisory agencies with broad authority to regulate, among other things, licenses to transact business, premium rates for certain coverages, trade practices, agent licensing, policy forms, cancellation and renewal practices, underwriting and claims practices, reserve adequacy and insurer solvency. Many jurisdictions also regulate investment activities on the basis of quality, distribution and other quantitative criteria. Further, most jurisdictions in the United States require admitted insurance companies to participate in their respective guaranty funds. Insurers admitted to transact business in such jurisdictions are required to cover losses of insolvent insurers and are generally subject to annual assessments of 1% to 2% of direct premiums written in that jurisdiction to pay claims of insolvent insurers. In addition, most jurisdictions compel participation in, and regulate the composition of, various shared and residual market mechanisms under which insurers are induced to provide certain coverages.
Generally, non-admitted insurers are subject to less regulatory scrutiny than admitted companies. The eligibility of the Company to write insurance on a surplus lines basis in most jurisdictions is dependent on its compliance with certain financial standards, including the maintenance of a requisite level of capital and surplus and the establishment of certain statutory deposits. State surplus lines laws typically: (i) require the insurance producer placing the business to show that he or she was unable to place the coverage with admitted insurers; (ii) establish minimum financial requirements for surplus lines insurers operating in the state; and (iii) require the insurance producer to obtain a special surplus lines license. In recent years, many jurisdictions have increased the minimum financial standards applicable to surplus lines eligibility.
State insurance regulators have the discretionary authority, in connection with the licensing of an insurance company, to limit or prohibit writing new business within their jurisdiction when, in the state's judgment, the insurance company is not maintaining adequate statutory surplus or capital. The Company does not currently anticipate that any regulator would limit the amount of new business that Associated or Calvert may write, given their respective current levels of statutory surplus.
Most states have enacted legislation that regulates insurance holding company systems, including acquisitions, dividends, the terms of surplus notes, the terms of affiliate transactions and other related matters. Typically, such statutes require the Company to periodically file information with the state insurance commissioner, including information concerning its capital structure, ownership, financial condition and general business operations. Under the terms of applicable state statutes, any person or entity desiring to purchase a specified percentage (commonly 10% or more) of the Company's outstanding voting securities would be required to obtain prior regulatory approval of the purchase. Further, state insurance statutes typically place limitations on the amount of dividends or other distributions payable by insurance companies, in order to protect their solvency. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources."
The insurance industry has been subject to increased scrutiny. A number of state legislatures have considered or enacted legislative proposals that alter and, in many cases, increase the authority of state agencies to regulate insurance companies and holding company systems. In addition, legislation has been introduced in several of the past sessions of Congress which, if enacted, could result in the federal government assuming some role in the regulation of the insurance industry. Several committees of Congress have made inquiries and conducted hearings as part of a broad study of the regulation of United States insurance companies.
The National Association of Insurance Commissioners (the "NAIC") and insurance regulators continue to re-examine existing laws and regulations and their application to insurance companies. In particular, this re-examination has focused on insurance company investment and solvency issues and, in some instances, has resulted in new interpretations of existing law, the development of new laws and the implementation of non-statutory guidelines. The NAIC has formed groups to study and formulate regulatory proposals on such diverse issues as the use of surplus debentures, accounting for reinsurance transactions, and the adoption of risk-based capital rules. In connection with its accreditation of states and as part of its program to monitor the solvency of insurance companies, the NAIC requires states to adopt model NAIC laws and regulations on specific topics, such as holding company regulations and the definition of extraordinary dividends. The NAIC has adopted a system for assessing the adequacy of statutory capital and surplus for all property and casualty insurers. Based on the NAIC guidelines and computations made by the Company in conformity with such risk-based capital guidelines, Associated and Calvert satisfy the required levels of capital. There can be no assurance, however, that capital requirements applicable to the Company's businesses will not increase in the future.
The NAIC has developed through the years a set of financial relationships or "tests" called the Insurance Regulatory Information System ("IRIS") that are designed for early identification of companies which may require special attention by insurance regulatory authorities. Insurance companies submit data on an annual basis to the NAIC, which in turn analyzes the data. Generally, an insurance company will become subject to regulatory scrutiny if it fails to satisfy NAIC standards for such factors as leverage, profitability, liquidity and loss reserve development. Failure to satisfy these standards may result in action by regulatory authorities to constrain a company's underwriting capacity. No such action has been taken with respect to the Company.
It is not possible to predict the future impact of changing state and federal regulations on the Company's operations.
ITEM 2.
ITEM 2. PROPERTIES.
The Company leases approximately 49,500 square feet of office space, including its corporate headquarters located in New York, New York and underwriting offices located in Woodland Hills, California and Hoboken, New Jersey. The headquarters in New York, which consists of 3,900 square feet, is leased for a term ending in the year 1999. The Woodland Hills office space consists of 30,275 square feet and is leased for a term ending in the year 2008. The Hoboken office space consists of 13,525 square feet and is leased for a term ending in the year 2000. The Company also leases small regional offices in Grand Rapids, Michigan and Denver, Colorado.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS. The Company is subject to litigation and arbitration in the normal course of its business. The Company does not believe that any pending litigation or arbitration to which it is a party, or of which any of its property is the subject, is likely to have a material adverse effect on its consolidated financial position or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Company's Common Stock is traded on the NASDAQ National Market under the symbol "GRYP". The following table reflects the high and low prices for the quarterly periods during the years ended December 31,1997 and 1996, as furnished by the NASDAQ National Market:
1997 1996 High Low High Low First Quarter $15 1/4 $13 $20 1/4 $16 7/8 Second Quarter 15 5/8 13 7/8 19 1/2 14 5/8 Third Quarter 17 3/4 15 1/4 15 1/4 12 Fourth Quarter 17 3/4 15 7/8 16 12 1/2
As of February 10, 1998, there were approximately 44 record holders of the Common Stock, which does not include beneficial owners of shares registered in nominee or street name. The Company has not paid any cash dividends on its Common Stock since its initial public offering (the "Offering") and does not anticipate paying any cash dividends in the foreseeable future. In addition, the Company's term-loan agreement contains a covenant restricting its ability to declare or pay any cash dividends to its shareholders. Because the Company is a holding company and operates through its subsidiaries, its cash flow and consequent ability to pay dividends are dependent upon the earnings of its subsidiaries and the distribution of those earnings to the Company. Also, the ability of the Company's subsidiaries to pay dividends to the Company is subject to certain regulatory restrictions. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-- Liquidity and Capital Resources" and Note 9 of Notes to Consolidated Financial Statements.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.
The following table sets forth selected consolidated financial data of the Company for the periods indicated. The selected consolidated financial data for the five years ended December 31, 1997 set forth below are derived from the audited consolidated financial statements of the Company. The selected statutory data have been derived from the financial statements of Associated and Calvert prepared in accordance with statutory accounting practices ("SAP") and filed with insurance regulatory authorities. The following information should be read in conjunction with the Consolidated Financial Statements and the notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations", included elsewhere herein.
1. Summary of Significant Accounting Policies
The significant accounting policies followed by the Company are summarized below.
Basis of Presentation and Principles of Consolidation
Gryphon Holdings Inc. operates through its main subsidiary, Gryphon Insurance Group Inc., as a specialty property and casualty underwriting organization. The Company's wholly owned insurance company subsidiaries are Associated International Insurance Company ("Associated") and Calvert Insurance Company ("Calvert"), which operate in the property and casualty insurance industry. Associated writes the majority of its property and casualty insurance policies in the State of California. Calvert writes property and casualty insurance policies throughout the United States and Canada.
The accompanying consolidated financial statements have been prepared on the basis of generally accepted accounting principles ("GAAP"), which as to the two insurance subsidiaries differ from the statutory accounting practices ("SAP") prescribed or permitted by regulatory authorities, and include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.
The preparation of the consolidated financial statements in conformity with GAAP requires the use of estimates and assumptions that affect amounts reported in the consolidated financial statements and the accompanying notes. Actual results could differ from such estimates.
Premium Revenues
Direct, assumed and ceded property and liability insurance premiums written are recognized as earned on a pro rata basis over the terms of the policies. Unearned premiums are calculated principally by the application of pro rata fractions and represent the portion of premiums written that is applicable to unexpired terms of policies in force.
Recoverable policy acquisition costs that vary with and are directly related to the production of business, consisting of commissions, premium taxes and other underwriting expenses incurred, net of ceding allowances, are deferred and amortized to income as the related premiums are earned. The Company does not consider anticipated investment income when determining the recoverability of amounts deferred. Amortization of deferred policy acquisition costs amounted to $34.0 million, $30.1 million, and $26.7 million for the years ended December 31, 1997, 1996 and 1995, respectively.
Reinsurance
Assumed reinsurance premiums written, commissions and unpaid losses and loss adjustment expenses are accounted for based principally on the reports received from the ceding insurance companies and in a manner consistent with the terms of the related reinsurance agreements.
To limit its risks, the Company acquires reinsurance coverage with retentions and limits that management believes are appropriate for the circumstances. Reinsurance arrangements effected under quota-share reinsurance contracts and excess-of- loss reinsurance contracts provide for greater diversification of business, allow management to control exposure to potential losses arising from large risks, and provide additional capacity for growth. The accompanying consolidated financial statements reflect premiums earned, losses and loss adjustment expenses ("LAE") and underwriting, acquisition and insurance expenses, net of reinsurance ceded. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies.
Contingent commissions and retrospectively-rated premiums are accounted for on an earned basis and are accrued, in accordance with the terms of the applicable reinsurance agreement, based on the estimated ultimate level of profitability relating to such reinsured business. Accordingly, the profitability of the reinsured business is continually reviewed and as adjustments become necessary, such adjustments are reflected in current operations.
Cash and Cash Equivalents
The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.
Investments
The Company's securities are classified as available for sale and reported at fair value, with unrealized gains and losses, net of deferred income taxes, included in stockholders' equity.
Fair values are based on quoted market prices, when available, or estimates based on market prices for similar securities, when quotes are not available. Short-term investments are carried at cost, which approximates their fair value. Realized gains and losses from sales or liquidations of investments are determined on the basis of the specific identification method and are included in net income. Investment income is recognized when earned. The amortization of premium and accretion of discount for fixed maturity securities are computed utilizing the interest method.
Losses and Loss Adjustment Expenses
The liabilities for unpaid losses and LAE are based on the Company's estimates of the ultimate cost of unpaid losses reported prior to the close of the accounting period, IBNR losses, and the related LAE. These liabilities are estimated by management utilizing methods and procedures which it believes are reasonable and necessarily are subject to the impact of future changes in claim severity and frequency, as well as numerous other factors. Although management believes that the estimated liabilities for losses and LAE are reasonable, because of the extended period of time over which such losses are reported and settled, the subsequent development of these liabilities may not conform to the assumptions inherent in their determination and, accordingly, may vary from the estimated amounts included in the accompanying consolidated financial statements. To the extent that the actual emerging loss experience varies from the assumptions used in the determination of these liabilities, they are adjusted to reflect actual experience. Such adjustments, to the extent they occur, are reported in the period recognized.
The Company's liabilities for unpaid losses and LAE include estimates for certain types of latent exposures, such as environmental impairment and asbestos-related claims, relating to business written prior to 1985 and which are generally difficult to establish with traditional reserving techniques.
The Company wrote policies with environmental impairment and asbestos-related exposures at high attachment levels and obtained reinsurance coverage reducing its net retention to $50,000 per occurrence. Among the complications of reserving for this type of business are a lack of sufficient historical data, long reporting delays, uncertainty as to the number and identity of insureds with potential exposure, and complex, unresolved legal issues regarding policy coverage and the extent and timing of any such contractual liability. Courts have reached different and sometimes inconsistent conclusions as to when a loss occurred and which policies provide coverage, which claims are covered, whether there is an insured obligation to defend, how policy limits are determined, how policy exclusions are applied and interpreted, and whether clean-up costs are includible as insured property damage. These legal issues are not likely to be resolved in the near future.
The establishment of appropriate reserves is an inherently uncertain process, and there can be no assurance that the ultimate liability, particularly with respect to latent exposures such as environmental impairment and asbestos, will not materially exceed the Company's current liability for unpaid loss and loss adjustment expense reserve estimates and have a material adverse effect on its future results of operations and financial condition. Furthermore, due to the inherent uncertainty of estimating such liabilities, particularly with respect to such latent exposures, it has been, and may over time continue to be, necessary to revise such estimated liabilities. However, on the basis of the Company's internal procedures, which analyze, among other things, its experience with similar cases and historical trends such as reserving patterns, loss payments, pending levels of unpaid claims, and product mix, as well as court decisions, economic conditions and public attitudes, management believes that adequate provision has been made for the Company's liabilities for unpaid losses and LAE as of December 31, 1997.
Foreign Currency
Transactions denominated in foreign currencies are translated at the rate of exchange at the transaction date. Revenues and expenses are translated at average exchange rates. Assets and liabilities are translated at the exchange rates in effect at the balance sheet date.
Earnings per Share
In February 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards (SFAS) No. 128, "Earnings Per Share", which the Company implemented in 1997. SFAS No. 128 establishes standards for computing and presenting earnings per share. Primary earnings per share have been replaced by basic earnings per share and calculated by dividing income available to common stockholders by the weighted average number of common shares outstanding during the period. Fully diluted earnings per share have been replaced by diluted earnings per share and calculated by including additional common shares that would have been outstanding if potentially dilutive shares had been issued during the period. Prior period earnings per share were not affected by the adoption of SFAS No. 128.
New Accounting Standards
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income", which requires enterprises to disclose comprehensive income and its components in a prominent position on the face of the financial statement. The Company will implement this statement in 1998. This statement relates to presentation of information and will have no impact on results of operations or financial condition.
In June 1997, the FASB issued SFAS No. 131, "Disclosure about Segments of an Enterprise and Related Information", which will be effective for the Company beginning January 1, 1998. SFAS No. 131 redefines how operating segments are determined and requires disclosure of certain financial and descriptive information about a company's operating segments. This statement relates to presentation of information and will have no impact on results of operations or financial condition. Interim financial information will be required beginning in 1999 (with comparative 1998 information). The Company is currently evaluating the segment information disclosures required by SFAS No. 131.
In December of 1997, the American Institute of Certified Public Accountants issued Statement of Position No. 97-3 "Accounting by Insurance and Other Enterprises for Insurance- related Assessments" ("SOP 97-3"). SOP 97-3 establishes standards for accounting for guaranty-fund and certain other insurance related assessments. SOP 97-3 is effective for fiscal years beginning after December 15, 1998 and requires any impact of adoption to be reported as a change in accounting principle. The adoption of this statement is not expected to have a material effect on the Company's results of operations or financial condition.
2. Investments
The major categories of net investment income are summarized as follows:
The gross realized gains and losses from sales of fixed maturity securities are as follows:
At December 31, 1997 and 1996, the amortized cost and estimated fair values of investments in fixed maturities, by categories of securities, and short-term investments were as follows:
At December 31, 1997, the amortized cost and estimated fair value of fixed maturities, by contractual maturity, are shown below. Expected maturities, which are best estimates, will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without prepayment penalties.
At December 31, 1997, investments in Federal National Mortgage Association securities aggregating $11.8 million represented the only investments in any entity in excess of 10.0% of stockholders' equity other than those investments issued or guaranteed by the U.S. government.
Securities on Deposit
At December 31, 1997 and 1996, securities with a fair value of approximately $19.3 million and $18.6 million, respectively were on deposit with various state or governmental insurance departments in order to comply with statutory insurance laws.
3. Losses and Loss Adjustment Expenses
The following table provides a reconciliation of beginning and ending loss and LAE reserve balances of the Company for each of the years in the three-year period ended December 31, 1997 as computed in accordance with GAAP.
The provision for losses and LAE for claims occurring in prior years shows an unfavorable development of $6.8 million in 1997. The unfavorable development resulted principally from a pre-1985 book of Casualty business and certain pre-1987 reinsurance-assumed business, both previously discontinued.
The following table provides a reconciliation of beginning and ending loss and LAE reserve balances of the Company for each of the years in the three-year period ended December 31, 1997 for environmental impairment and asbestos-related liabilities.
At December 31, 1997, the reserve for unpaid environmental impairment losses and related LAE was approximately $6.8 million, net of reinsurance recoverables deemed probable of collection by the Company of approximately $5.2 million. The range of gross reserves for unpaid environmental impairment losses and LAE is estimated to be $12.0 million to $20.0 million and the range of reserves, net of reinsurance recoverable, for unpaid environmental impairment losses and LAE is estimated to be approximately $6.8 million to $9.5 million.
At December 31, 1997, the reserve for unpaid asbestos- related losses and related LAE was $1.7 million, net of reinsurance recoverables deemed probable of collection by the Company of approximately $2.5 million. The range of gross reserves for unpaid asbestos-related losses and LAE is estimated to be $4.2 million to $9.4 million and the range of reserves, net of reinsurance recoverable, for unpaid asbestos-related losses and LAE is estimated to be approximately $1.7 million to $3.3 million.
There are significant uncertainties in estimating the amount of the Company's environmental impairment and asbestos- related liabilities resulting from a lack of historical data, long reporting delays, uncertainty as to the number and identity of insureds with potential exposure, and complex, unresolved legal issues regarding policy coverage and the extent and timing of any such contractual liability. Courts have reached different and sometimes inconsistent conclusions as to when a loss occurred and what policies provide coverage, what claims are covered, whether there is an insured obligation to defend, how policy limits are determined, how policy exclusions are applied and interpreted, and whether cleanup costs are includible as insured property damage. These issues are not likely to be resolved in the near future. As a result of these issues, the ultimate number and cost of these claims may generate losses that vary materially from the amounts currently recorded and could have a material adverse effect on the Company's results of operations and financial condition. While management believes the Company's reserves for these coverages are appropriately established, because of the uncertainty of circumstances surrounding many critical factors that affect environmental impairment and asbestos-related liabilities, there can be no assurance that the Company's reserves for and losses from these claims will not increase in the future.
4. Reinsurance
Certain premiums and losses are assumed from and ceded to other insurance companies under various reinsurance agreements. The Company cedes a portion of its business through quota share treaties, excess of loss treaties and facultative placements, and generally retains net amounts of risk ranging from $100,000 to $500,000 per risk.
The following table sets forth the significant reinsurance receivables due from reinsurers as of December 31, 1997.
The amount and cost of reinsurance available to companies specializing in property and casualty insurance are subject, in large part, to prevailing market conditions beyond the control of the Company. The Company's ability to provide insurance at competitive premium rates and coverage limits on a continuing basis depends to a significant extent upon its ability to obtain adequate reinsurance in amounts and at rates that will not adversely affect its competitive position.
For the years ended December 31, 1997, 1996 and 1995, amounts relating to assumed and ceded reinsurance premiums written and earned and losses and LAE incurred reflected in the accompanying consolidated statements of income approximated the following:
At December 31, 1997 the Company held letters of credit of approximately $7.7 million securing amounts due from reinsurers.
During 1997, Associated maintained a six-layer property catastrophe reinsurance program which covered 95% of the annual aggregate amount of property claims up to $138.0 million per occurrence, subject to a retention of $2.5 million per occurrence.
Associated limits its net retention to $100,000 per risk for difference in conditions ("DIC"). Until October 1, 1996, Associated retained $250,000 per risk for casualty, architects' and engineers' professional liability, specialty lines, and commercial auto and up to $500,000 per risk for non-DIC property policies. Calvert reinsured various lines of business through quota share treaties, excess of loss treaties and facultative placements which limited Calvert's net retention per risk to a maximum of $200,000 for property and casualty.
Effective October 1, 1996, the Company's reinsurance program was restructured to provide protection for loss events covering property and casualty classes of business, excluding DIC and certain other property business. The program provides for $24.5 million of coverage in excess of a new retention of $500,000 for each and every event. Certain business is covered by a quota share treaty that limits the Company's net retention per risk to a maximum of $250,000.
Reinsurance ceded contracts do not relieve the Company of its obligations to policyholders. The Company remains liable to its policyholders for the portion reinsured to the extent that any reinsurer does not meet its obligations for reinsurance ceded to it under the reinsurance agreements. Failure of reinsurers to honor their obligations could result in losses to the Company. In addition, as is often the case in the normal course of business, the Company is involved in disputes with reinsurers regarding certain loss recoverables. Although the Company believes that such issues will be resolved in the Company's favor, there can be no assurance that the Company will prevail; an unfavorable resolution could have a material effect on the Company's financial statements.
5. Federal Income Taxes
The Company uses an asset and liability approach for financial accounting and reporting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recorded based on the difference between the financial statement and tax bases of assets and liabilities and the tax rates in effect when these temporary differences are expected to reverse. The principal assets and liabilities giving rise to such differences are loss and LAE reserves, unearned premiums, deferred policy acquisition costs, and net unrealized investment gains (losses).
The components of the net deferred income tax asset are as follows:
The Company has not established a valuation reserve because it believes, based on its tax-planning strategies and projected future earnings, that it is likely that the net deferred tax asset will be fully realized.
A reconciliation of income taxes computed at the statutory federal income tax rate to the income tax provision is presented below:
6. Long-Term Debt
In September 1995, the Company purchased 1.5 million shares of its common stock beneficially owned by Willis Corroon Group plc for a purchase price of $25.5 million, including related expenses. The Company financed its purchase through an unsecured term loan from commercial lending institutions. This loan matures in varying amounts through 2002 with interest payable at least quarterly. The term loan interest rate is equivalent to either the bank's prime rate or the London Interbank Offered Rate ("LIBOR") plus 1%, at the discretion of the Company. The term loan agreement contains certain restrictive covenants, including restrictions on the Company's ability to declare or pay any cash dividends to its shareholders. As of December 31, 1997, the weighted average interest rate was 6.89%, and the fair value of the loan approximated the carrying value.
Principal payments due on the term loan are as follows:
Year ending December 31, Principal Amount (Dollars in thousands) 1998 $ 3,625 1999 4,125 2000 4,625 2001 5,000 2002 3,750 Total $21,125
In October 1995, the Company entered into an interest rate swap agreement with a commercial lending institution in order to reduce the impact of interest rate fluctuations on the Company's term loan. The interest rate swap was effected with respect to the first $15.5 million of scheduled principal amortizations of the $25.5 million loan. The impact of the swap was to create an effective fixed rate of 6.97% on the $15.5 million principal amount. As of December 31, 1997, the fair value of the interest rate swap approximated the carrying value.
7. Fair Value of Financial Instruments
The Company follows SFAS No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments." SFAS No. 119 requires disclosure of an estimate of the fair value of financial instruments. The Statement defines the fair value of financial instruments as the amount at which the instruments could be exchanged in a current transaction between willing parties. The following table summarizes the carrying amount and estimated fair value of the Company's financial instruments at December 31, 1997 and 1996.
The following methods and assumptions were used to estimate the fair value of each class of financial instrument:
Investments and cash
The fair values of fixed maturities are based on quoted market prices. The fair value of short-term instruments approximates amortized cost. The fair value of cash and cash equivalents approximates amortized cost.
Long-term debt
The fair value of the Company's long-term debt is estimated based on the quoted market prices for the same or similar issues or on current rates offered to the Company for debt of the same maturities. The fair value includes the effect of the interest rate swap.
8. Commitments and Contingencies
Leases
The Company and its subsidiaries lease certain office facilities and computer equipment. Minimum rental commitments for these leases, exclusive of escalations due to real estate taxes and operating expenses, are as follows:
Year ending December 31, (Dollars in thousands) 1998 $1,163 1999 1,130 2000 964 2001 755 2002 784 Thereafter 4,728 $9,524
Total rent expense for all leases was $1,469,000, $1,310,000 and $959,000 in 1997, 1996 and 1995, respectively.
9. Dividends and Stockholders' Equity
Dividends
Associated, a California domiciled company, and Calvert, a Pennsylvania domiciled company, are required to file with the Department of Insurance of various states an annual convention statement, which is prepared in conformity with accounting practices prescribed or permitted by the respective states. These practices vary from GAAP principally in that policy acquisition costs are charged to expense when incurred, deferred federal income taxes are not recognized, investments are reflected at amortized cost, and nonadmitted assets are excluded from the balance sheet.
Under state insurance laws of Pennsylvania, the maximum amount of dividends which can be paid by Pennsylvania-domiciled insurance companies without prior approval of the Insurance Commissioner is limited to the greater of 10% of surplus as regards policyholders as of the preceding year end or the insurance company's net income for the previous year. Under state insurance laws of California, Associated is permitted to pay as dividends to the Company, after advance notice to the California Insurance Department, an amount equal to the greater of 10% of Associated's policyholders surplus at the end of the preceding year or its statutory net income for the preceding year. Dividends in excess of these amounts require the prior approval of the California Insurance Department. Dividends may be paid only out of earned surplus. As such, at December 31, 1997, the maximum amount of dividends that Associated could pay in 1998 without California Insurance Department approval amounted to approximately $9.0 million and the maximum amount of dividends that Calvert could pay in 1998 without Pennsylvania Insurance Department approval amounted to approximately $2.0 million.
Stockholders' Equity
A reconciliation of the two insurance subsidiaries' net income and stockholders' equity for each of the years in the three years ended December 31, 1997 and as of December 31, 1997 and 1996, as reported to the various regulatory authorities in accordance with SAP, to the related GAAP amounts included in the accompanying consolidated financial statements is as follows:
10. Shareholder Rights Plan
In June 1995, the Board of Directors declared a dividend of one right for each outstanding share of Common Stock. Each right entitles the holder to purchase from the Company a unit consisting of 1/100 of a share of Junior Participating Cumulative Preferred Stock at a price of $50 per unit. Initially, the rights will not be exercisable and will trade with the Common Stock. In the event a person or group acquires 20% or more of the Common Stock, or commences a tender offer for the outstanding shares, the rights become exercisable.
If a person or group acquires 20% or more of the Common Stock, the rights will entitle a holder (other than the acquiring person or group of acquiring persons) to buy shares of Common Stock having a market value of twice the exercise price of the right. If the Company is subsequently involved in a merger or other business combination with a holder of 20% or more of the stock of the Company, the rights will entitle a holder to buy shares of common stock of the acquiring corporation having a market value of twice the exercise price of the right.
The rights may be redeemed by the Company at $.001 per right at any time prior to the acquisition by any person or group of 20% or more of the Company's shares. The rights have no voting power and will expire in June 2005, if not previously redeemed.
11. Property and Equipment
Property and equipment is classified with other assets in the accompanying consolidated balance sheets and is stated at cost, net of accumulated depreciation and amortization. Depreciation is computed using the straight-line method over the estimated useful lives of the related property and equipment and ranges principally from three to seven years.
Property and equipment, included in Other assets in the balance sheet, is comprised of the following:
12. Stock Option and Restricted Stock Plans
The Company's stock option plans provide for granting of stock options to key employees and non-employee directors. Options are granted at a price not less than the market price on the date of grant. Options that have been granted under the plans will become exercisable in four annual installments of 25% each commencing on the second anniversary of the date of grant and will expire ten years from the date of grant.
The Company's restricted stock award plan provides for the granting of up to 100,000 shares of common stock to key employees, subject to restrictions as to continuous employment except in the case of death or normal retirement. Restrictions generally expire over a five-year period from date of grant. Compensation expense is recognized over the restriction period. As of December 31, 1997, 76,500 shares are available for issuance under the plan.
The Financial Accounting Standards Board issued SFAS No. 123, "Accounting for Stock-Based Compensation." SFAS No. 123 provides an option either to continue the Company's current method of accounting for stock-based compensation, or to adopt the fair value method of accounting for stock-based employee compensation plans, which would require the Company to expense the fair value of its stock options at the date of grant over the vesting period.
The Company has continued to elect to follow Accounting Principle Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees", and related interpretations in accounting for its stock option and restricted stock plans. Accordingly, no compensation expense has been recognized for its stock-based compensation plans other than for restricted stock awards. Although the Company elected to continue to follow APB No. 25, it is required to provide additional disclosures including pro forma net income and earnings per share as if the Company adopted the fair value method for recognition purposes in 1995.
A summary of stock option activity as of December 31, 1997, follows:
The following table summarizes outstanding and exercisable options as of December 31, 1997.
The pro forma net income and basic earnings per share determined consistent with SFAS No. 123 is as follows:
Pro forma (1) 1997 1996 1995 Net income $8,583 $5,974 $12,880 Basic earnings per share $1.28 $.90 $1.68
(1) During the initial phase-in period of SFAS No. 123, the effects of applying the standard for either recognizing compensation cost or providing pro forma disclosures are not likely to be representative of the effects on reported net income for future years, based on the fact that options vest over several years and additional awards generally are made each year.
The weighted average fair value of options granted during 1997, 1996 and 1995 were $6.62, $7.64 and $6.29, respectively. The Black-Scholes option-pricing model was used with the following weighted average assumptions: volatility of 22.8%, and risk-free interest rate of 5.99% in 1997; volatility of 24.3%, and risk-free interest rate of 6.81% in 1996; volatility of 24.3%, and risk-free interest rate of 6.18% in 1995. For all periods, a seven-year life is assumed.
13. Employee Benefits and Incentive Bonus Plans
The Company maintains a defined contribution retirement 401(k) & Profit Sharing Plan. Participation in the plan is available to all employees upon their satisfaction of specified eligibility requirements. Under the 401(k) component of the plan, the Company matches, on a dollar-for-dollar basis, each employee's contribution up to 3% of eligible compensation. Under the profit sharing component of the plan, annual contributions may be authorized by the Board of Directors based upon the Company's performance for the relevant year. The Company's costs are charged to income and amounted to $0.5 million in 1997, $0.5 million in 1996 and $0.4 million in 1995.
The Company maintains an annual incentive bonus plan for officers and other key employees. Bonuses are based upon predetermined objectives established by the Compensation Committee. The Company's total incentive bonus plan expense for the years ended December 31, 1997, 1996 and 1995 was $0.4 million, $0.6 million and $1.6 million, respectively.
14. Concentrations of Business
Gross premiums written in the State of California amounted to approximately $59,696,000, $68,663,000 and $76,396,000 in 1997, 1996 and 1995, respectively. In the State of New York, the Company's gross premiums written were $11,190,000, $11,975,000 and $20,141,000 for the years ended December 31, 1997, 1996 and 1995, respectively. Gross premiums written in any other state do not exceed 10% of gross premiums written.
The Company's architects' and engineers' professional liability insurance business is produced by Risk Administration and Management Company ("RAMCO"), an unaffiliated managing general agent. For the years ended December 31, 1997, 1996 and 1995, direct premiums written by RAMCO for the Company amounted to approximately $17,704,000, $17,843,000 and $14,452,000, respectively.
15. Quarterly Financial Information (unaudited)
Quarterly financial information (unaudited) for the year ended December 31, 1997 is presented below:
Quarterly financial information (unaudited) for the year ended December 31, 1996 is presented below: