ITEM 1. BUSINESS
THE COMPANY
Mutual Risk Management Ltd. (the "Company") is a Bermuda company incorporated in 1977. The Company's principal business is the provision of risk management services to clients seeking an alternative to traditional commercial insurance for certain of their risk exposures. Risk management involves a process of analyzing loss exposures and developing risk financing methods to reduce exposure to loss and to control associated costs. The use of such loss financing methods in place of traditional insurance has become known as the alternative market and involves clients participating in a significant amount of their loss exposure and transferring only the unpredictable excess risk to insurers. The benefits of such alternative market techniques typically include lower and more stable costs, greater control over the client's risk management program and an increase in the emphasis within the client's organization on loss prevention and loss control.
The Company's insurance business can be divided into three segments:
Program Business: The fastest growing of the Company's business segments, involves the Company replacing traditional insurers as the conduit between producers of specialty books of business and reinsurers wishing to write that business. The Company provides a wide range of services for a fee and the underwriting profit is shared between the producer and the reinsurers.
Corporate Risk Management: The Company's original business segment, involves providing services to businesses and associations seeking to insure a portion of their risk in a loss sensitive alternative market structure.
Specialty Brokerage: This business segment provides access to Alternative Risk Transfer insurers and reinsurers in Bermuda and Europe. The two components of this segment are MRM Hancock Limited, which provides access to London and European reinsurers, and Park International Limited which brokers to the Bermuda market.
In addition to its insurance industry services, in 1996 the Company entered the financial services business through its acquisition of The Hemisphere Group Limited ("Hemisphere"). Hemisphere, which is based in Bermuda, provides administrative and other services to offshore mutual funds and other companies.
FORWARD-LOOKING STATEMENTS
This Report may contain certain forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934, as amended, and is subject to the safe-harbor created by such sections. Such forward-looking statements may concern the Company's operations, economic performance and financial condition, including in particular its acquisitions and their integration into the Company's existing operations. Such statements may involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, the following: general economic and business conditions; changes in customer preferences; competition; changes in technology; the integration of acquisitions; changes in business strategy; the indebtedness of the Company; quality of management, business abilities and judgment of the Company's personnel; the availability, terms and deployment of capital; and various other factors referenced in this Report. Such forward-looking statements may be made as of the date of this Report, and the Company assumes no obligation to update such forward-looking statements or to update the reasons why actual results could differ from those projected in such forward-looking statements.
INSURANCE SERVICES
The Company's principal source of profits is fees received for the various insurance and other services provided to clients in connection with the Company's programs. The structure of the Company's programs places most of the underwriting risk with the Company's client. For regulatory and other reasons, however, the Company is required to assume a limited amount of risk. The Company seeks to limit this risk to the minimum level feasible. This approach to risk distinguishes the Company from typical property/casualty companies which assume significant levels of underwriting risk as part of their business. The Company does not seek to earn income from underwriting risk, but rather from fees for services provided. The Company markets its services exclusively to retail insurance brokers and consultants representing clients. The services offered to clients in connection with the Company's products typically include the following:
. Design and implementation of a risk financing program.
. Issuance of an insurance policy by one of the Company's wholly-owned, licensed insurance companies, Legion Insurance Company ("Legion"), Legion Indemnity Ltd. ("Legion Indemnity") and Villanova Insurance Company ("Villanova"). In December 1997, A.M. Best Company extended the Legion Insurance Group rating of "A" (excellent) to include Villanova.
. Use of the Company's Insurance Profit Center Program or IPC Program as the vehicle within which to fund a chosen portion of the client's risk or, alternatively, the management by the Company of the client's captive insurance company.
. Brokering to unaffiliated reinsurers the excess risk which the client chooses not to fund and in some cases arranging for insurers, other than Legion, to issue the original insurance policy.
. Coordinating the purchase, on behalf of the client, of loss prevention, loss control and claims administration services from unaffiliated providers.
The Company's major product is the IPC Program. This program allows the client to retain a significant portion of its own loss exposure without the administrative costs and capital commitment necessary to establish and operate its own captive insurance company. The actual amount of underwriting profit and investment income produced by the client's IPC Program is returned to the client, creating a direct incentive for it to engage in loss prevention and loss control in order to reduce the overall cost of financing its loss exposures. The fastest growing segment of the Company's business is its Program Business, in which third-parties other than the insured, typically the broker and re-insurers, finance a portion of the insured's risk and participate in any underwriting profit or loss. For a discussion of the Company's Corporate Risk Management and Program Business segments, see "Management's Discussion and Analysis of Financial Condition and Results of Operations".
Lines of Business
The Company's programs can be utilized by clients for many lines of insurance. In 1997, approximately 57% of the Company's fee income was derived from workers' compensation insurance. During the 1980's and through 1993, workers' compensation presented many employers with substantial problems due to cost increases and the limited availability of commercial coverage in certain states. Workers' compensation costs accelerated rapidly due to (a) the general level of medical cost inflation, since medical costs generally amount to 40% or more of all workers' compensation costs; (b) an increase in the number of workers' compensation claims which resulted in litigation; (c) a broadening of injuries which are considered to be work-related; and (d) an increase in state mandated benefit levels. Since 1993 workers' compensation reforms have been occurring in a number of states, most notably in California, which have addressed many of these issues in the last five years. A number of markets have seen a significant decline in premium rates due to new capacity entering the market subsequent to these reforms. These lower premium rates reduce the fees that the Company earns on its programs as its fees are based on premiums. Notwithstanding the changes in the market, workers' compensation continues to be suitable for the alternative market because many states set rates or enforce minimum rate laws which prohibit the commercial insurance market from offering premium discounts to insureds with favorable loss experience. This
causes such clients to seek an alternative method of funding their workers' compensation exposure which rewards their status as a preferred risk. In addition, workers' compensation involves relatively frequent, predictable levels of loss which are the type favored by clients for alternative market insurance programs.
In addition to workers' compensation, the Company's programs have been utilized for other casualty insurance lines such as medical malpractice, general liability, commercial auto liability and auto physical damage.
At December 31, 1997, the Company had a total of 617 employees.
Marketing -- CRS
The Company's wholly owned subsidiary Commonwealth Risk Services ("CRS") markets the Company's services in the United States, Canada and Europe to insurance brokers and consultants representing clients. CRS also designs risk financing programs for potential clients in conjunction with their insurance brokers and consultants. Through offices in Philadelphia, California and London, CRS markets these services using direct mail, advertising, seminars and trade and industry conventions.
CRS seeks to become actively involved with the insurance broker in the presentation of the Company's services to potential clients and maintains a direct relationship with the client after the sale. CRS assists brokers in the design and implementation of risk financing programs, although the extent of this involvement depends on the size, experience and resources of the particular broker. Members of the CRS staff frequently provide supporting promotional materials and assist in the preparation of financial analyses comparing the net present value, after-tax cost of an IPC Program with alternative approaches. Representatives of CRS seek to be present at meetings with potential clients to explain how the IPC Program works, including how reinsurance is handled, how funds are invested, and how underwriting profits and investment income are returned.
The Insurance Profit Center Program
In 1980 the Company developed a program which provides clients with a facility for managing their insurance exposures. This type of structure is frequently referred to as a "rent-a-captive" although the facility has many significant differences from a captive. The facility was designed to provide certain of the benefits available through captive insurance companies without the administrative cost and capital commitment necessary to establish and operate a captive insurance company. Since the IPC Program involves a retention of risk by the client, it encourages the implementation of risk management and risk reduction programs to lower the losses incurred.
The IPC Program is appropriate for corporations and associations which generate $.75 million or more in annual premiums. Typically clients which use an IPC Program are profitable and have adequate working capital but generate insufficient premium to consider or are otherwise unsuitable for a wholly- owned captive. During 1997, the Company significantly increased the number of agency IPC Programs in which an insurance agent or broker, rather than the insured, becomes the preferred shareholder and participates in the profit or loss on the program. These types of programs are referred to as "Program Business".
Return on the program is a function of the loss experience of the insured. The principal benefits of the IPC Program to the client are:
. A reduction of the net present value, after-tax cost of financing the client's risks.
. A lower commitment of funds than would be necessary to capitalize and maintain a captive insurance company.
. Access to commercial reinsurance markets for the client's excess risk.
. Program structure that is customized, flexible and relatively easily implemented.
The Company operates the IPC Program from offices in Bermuda. The Bermuda office is involved in designing, negotiating and administering IPC Programs and reviews each prospective client, negotiates the shareholder's agreement with the client and the reinsurance agreement with Legion or other policy- issuing company. One of the Company's foreign insurance companies (the "IPC Companies") receives and invests premiums, administers policy claims, establishes reserves, provides quarterly financial reports to clients and, ultimately, returns the underwriting profit and investment income to the client as preferred share dividends.
The funds of each IPC Program are invested by a subsidiary, Mutual Finance Ltd. The assets are invested using the services of professional investment advisors.
Neither Legion nor the IPC Companies underwrite risk in the traditional sense. Rather, their function is to ensure that substantially all of the underwriting risk of the client is either retained by the client in the IPC Program (or its captive insurance company) or transferred to unaffiliated reinsurers. In the event that the IPC Company sustains an underwriting loss on a program which exceeds that program's investment income, the IPC Company recovers this loss from the client. Since the client has generally collateralized the Company for at least the difference between the funds available in that client's IPC Program and the level of currently expected losses by cash or a letter of credit, the Company should not be affected by the bankruptcy of a client. In the event, however, that the IPC Company is unable to recover the full amount of its loss from the cash collateral or the letter of credit, the IPC Company would seek to recover from the client pursuant to the indemnity provisions of the shareholder's agreement. As of December 31, 1997 the Company maintained a provision of $5.6 million, against losses which may occur on programs where it may be forced to rely solely on the clients indemnity. See "Management's Discussion and Analysis of Financial Condition and Results of Operations".
In addition to programs for corporate clients, the Company also offers an association IPC Program which allows smaller insureds collectively to take advantage of the financial benefits available to larger corporate insureds individually.
Program Design and Policy Issuance
The Company acquired Professional Underwriters Corp. ("PUC") on January 1, 1996. PUC specializes in placing and managing Program Business which is a growing segment of the Company's product line in which third parties other than the insured, typically the broker and reinsurer, finance the insured risk and participate in any underwriting profit or loss. PUC operates as an underwriting manager and policy services provider for "Program Business", and through its Prowriter division, manages "Alternative Market" insurance programs. PUC's revenues for 1997 were $8.1 million.
In January 1997, the Company acquired all of the assets and certain of the liabilities of The McDonough Insurance Agency of Manasquan, New Jersey. The acquired business, which will operate under the "Small Business Underwriters" or "SBU" name, acts as an underwriting manager of workers' compensation insurance programs for small commercial insured accounts produced by a large number of independent agencies. The major states in which SBU has programs are Massachusetts, New Jersey and Georgia. It has recently commenced programs for insureds in New York, Pennsylvania, Delaware, Alabama, South Carolina and Florida. SBU's revenues for the year ended December 31, 1997 were $5.4 million.
THE LEGION COMPANIES
Legion is domiciled in Pennsylvania and is admitted in 50 states of the United States, the District of Columbia and Puerto Rico. Legion Indemnity is domiciled in Illinois, is an admitted insurer in Illinois, and an authorized surplus lines insurer in 42 states, the District of Columbia, Guam and the Virgin Islands. Villanova Insurance Company is domiciled in Pennsylvania and is admitted in 37 states. (Legion, Legion Indemnity and Villanova are collectively referred to herein as "Legion" or the "Legion Companies"). In the Company's corporate risk management business segment, one of the Legion Companies issues an insurance policy to the client, which either fulfills a legal requirement that the client have a policy from a licensed insurer or satisfies a
business need the client may have for such an admitted policy. The client and Legion determine the level of exposure the client wishes to retain and Legion transfers the specific excess risk and the aggregate excess risk beyond that retention to unaffiliated reinsurers. Legion then reinsures the client's chosen retention to one of the IPC Companies or to the client's captive insurance company. In certain cases Legion may issue a large deductible type policy in which the client pays claims up to its chosen retention directly. Payments within the deductible are covered by a deductible reimbursement policy issued by one of the IPC Companies. In either type of policy Legion retains only a relatively small portion of the risk on each program for its own account.
In Program Business, Legion replaces traditional insurers as the conduit between producers of specialty books of business and reinsurers wishing to write that business. In this line of business, the reinsurer replaces the insured as the risk-bearing entity. As with the corporate risk management line of business, Legion negotiates the reinsurance, and performs certain administrative services in connection with the program. Program Business differs from the corporate risk management line of business in that policy underwriting, issuance and premium collection are usually provided by the general agent, rather than Legion.
Legion analyzes each program prior to inception, arranges for quota share or specific and aggregate excess reinsurance coverage through its reinsurance treaties, collects the premium from the client, prepares accounting cessions for the reinsurers, audits the final premium, supervises the independent claims adjuster, collects claim reimbursements from reinsurers, and performs certain other related services for each account.
For its Corporate Risk Management business, Legion has established several reinsurance treaties to transfer the specific and aggregate excess risk above the client's retention. The client's retention is negotiated separately for each program and reflects the amount of risk the client wishes to retain on a program on both a specific and aggregate loss occurrence basis. For its Program Business, Legion has established several reinsurance treaties, both on a quota share and a specific and aggregate excess of loss occurrence basis. Legion currently places substantially all of the reinsurance in both lines of business with unaffiliated commercial reinsurers whose ratings from A.M. Best Company are A- or higher. At December 31, 1997, the largest reinsurance recoverables from unaffiliated commercial reinsurers were $129.0 million from Transatlantic Reinsurance Co., a participant on several layers of specific and aggregate reinsurance with respect to the Company's program business and substantially all of the Company's American Psychiatric Association program, $40.6 million from First Excess and Reinsurance Corp., and $40.2 million from Scor Reinsurance Company which are both reinsurers on several current treaties. Transatlantic is rated "A++", First Excess is rated "A-" and Scor is rated "A+" by A.M. Best Company. During the period from January, 1988 to October 1991 one of Legion's aggregate reinsurers was Mutual Benefit Life Insurance Company ("Mutual Benefit"). In July, 1991 Mutual Benefit was placed in rehabilitation by the Insurance Department of the State of New Jersey. The proposed plan of rehabilitation for Mutual Benefit would make no distribution to Mutual Benefit's reinsureds such as Legion. At December 31, 1996, Legion wrote off its recoverable from Mutual Benefit of $.9 million and reduced its provision for uncollectable reinsurance by an equivalent amount. For a discussion of current reinsurance arrangements, see "Management's Discussion and Analysis of Financial Condition and Results of Operations".
Through its reinsurance arrangements, Legion places significant amounts of reinsurance with a variety of unaffiliated reinsurance companies. In order to maintain an acceptable level of net written premium for regulatory purposes, Legion seeks to develop a level of net written premium which will not involve a significant degree of underwriting risk. In most Legion programs, Legion retains liability for a specified amount of losses equal to at least 10% of gross written premium. The level of losses retained by Legion are set at a level such that no significant underwriting profit or loss should occur.
In order to take regulatory credit for reinsurance ceded to one of the IPC Companies or to a captive insurance company, Legion must receive a letter of credit for the amount of the insurance reserves ceded, since such companies are not licensed reinsurers in any state of the United States. The letter of credit must be issued or confirmed by a bank which is a member of the U.S. Federal Reserve System. At December 31, 1997, the Legion Companies had $288 million of such letters of credit, of which $265 million was supplied by the IPC Companies. Legion, Legion Indemnity and Villanova are also subject to other regulation by the insurance departments of Pennsylvania and Illinois and other states where they are licensed. See "Regulatory Considerations."
As of December 31, 1997 the Legion Companies had 343 accounts, they wrote gross statutory premiums of $596.6 million during 1997 and had statutory capital of $200.2 million at December 31, 1997. See "Management's Discussion and Analysis of Financial Conditions and Results of Operations".
SPECIALTY BROKERAGE
In 1991, the Company acquired a 51% interest in a newly-formed London reinsurance brokerage firm, MRM Hancock Limited ("MRM Hancock"). MRM Hancock specializes in the placement of reinsurance for captive insurance companies in the London market, including Lloyds of London. The remaining 49% of MRM Hancock was owned by management of MRM Hancock and General International Ltd., a Bermuda insurance subsidiary of General Motors Corporation. During 1996, the Company acquired the minority interests in MRM Hancock and it is now a wholly owned subsidiary.
In July 1992, the Company acquired 100% of Park International Limited, a Bermuda broker specializing in placing coverage with Bermuda-based excess liability and corporate officers and directors liability carriers.
FINANCIAL SERVICES
In July 1996, the Company acquired The Hemisphere Group Limited ("Hemisphere"), a Bermuda financial services company. Hemisphere, which has been in business since 1980, has three active subsidiary operations in Bermuda providing company management, corporate secretarial, fund administration and trust management services. It also has a wholly-owned Cayman Islands subsidiary. With a total staff of 97 Hemisphere had approximately 129 mutual fund clients as of December 31, 1997. In addition Hemisphere administers investment holding companies, trading companies and trusts. Hemisphere has formed a network of professional relationships in the major financial centers of the world and these are the source for significant ongoing referrals of business. During 1997, Hemisphere expanded its trust operations by the acquisition of Hugo Trust Company ("Hugo") based in Jersey in the Channel Islands. Hugo will provide a base to develop European based trust business. Hugo had revenues of $.6 million in 1997.
In January 1997, the Company incorporated MRM Life Ltd. in Bermuda to provide life insurance and related products, including annuities and variable annuities. The Company began marketing these products in the fourth quarter of 1997.
COMPETITION
The Company's insurance services compete with self-insurance plans, captive insurance companies managed by others and a variety of risk financing insurance policies. The Company believes that the IPC Program is the largest independent alternative market facility that is not affiliated with either a major retail insurance broker or a major insurance company. However, the Company faces significant competition in marketing the IPC Program from other risk management programs offered by U.S. insurance companies, from captive insurance companies for large insureds, and from rent-a-captives organized by large insurance companies and brokers.
The primary basis for competition among these alternative risk management vehicles varies with the financial and insurance needs and resources of each potential insurance buyer. The principal factors that are considered include an analysis of the net present-value, after-tax cost of financing the buyer's expected level of losses, the amount of premium and collateral required, the attachment point of excess coverage provided in the event losses exceed expected levels as well as cash flow and tax planning considerations and the expected quality and consistency of the services to be provided. The Company believes that for insureds with financial characteristics and loss experience lending themselves to an IPC Program, the IPC Companies compete effectively with other risk financing alternatives.
In the present soft insurance market, characterized by excess capital and competitive pricing, it is generally easier for the Company to structure programs because of the availability and pricing of reinsurance, but more
difficult to attract potential participants and sell programs because of competition. In a hard market, such as that experienced during 1985-1987, it is more difficult to structure programs due to the high price and unavailability of reinsurance, but the Company experiences less competition in attracting clients and selling programs.
REGULATORY CONSIDERATIONS
The Bermuda-based IPC Companies, Mutual Indemnity Ltd., Mutual Indemnity (Bermuda) Ltd. and Mutual Indemnity (US) Ltd., are subject to regulation under the Bermuda Companies Act 1981 and, as insurers, under the Bermuda Insurance Act 1978 (as amended by the Insurance Amendment Act 1995) and the Regulations promulgated thereunder and are required, amongst other things, to meet and maintain certain standards of solvency, to file periodic reports in accordance with Bermuda statutory accounting rules, to produce annual audited financial statements and to maintain a minimum level of statutory capital and surplus. In general, the regulation of insurers in Bermuda relies heavily upon the auditors, directors and managers of the Bermuda insurer, each of which must certify that the insurer meets the solvency and capital requirements of the Bermuda Insurance Act 1978. Mutual Indemnity (Barbados) Ltd. and Mutual Indemnity (Dublin) Ltd. are subject to similar regulation in Barbados and Ireland, respectively.
The Legion Companies are subject to regulation and supervision by the insurance regulatory authorities of the various states in which they conduct business. Such regulation is intended primarily for the benefit of policyholders. Legion Insurance is admitted in 50 states, the District of Columbia and Puerto Rico, and is subject to regulation in each jurisdiction. Legion Indemnity is admitted in Illinois, and is authorized in 42 states, the District of Columbia, Guam and the Virgin Islands, as a surplus lines insurer. Legion Indemnity is regulated in Illinois, but is generally not subject to regulation in those states where it acts as a surplus lines insurer. Villanova is admitted in 37 states and is subject to regulation in each jurisdiction. State insurance departments have broad regulatory, supervisory and administrative powers. These powers relate primarily to the standards of solvency which must be met and maintained; the licensing of insurers and their agents; the approval of rates and forms and policies used; the nature of, and limitations on, insurers' investments; the form and content of periodic and other reports required to be filed; and the establishment of reserves required to be maintained for unearned premiums, losses and loss expenses or other purposes.
The Legion Companies are also subject to state laws regulating insurance holding companies. Under these laws, state insurance departments may examine Legion at any time, require disclosure of material transactions by the holding company and require prior approval of certain "extraordinary" transactions, such as dividends from the insurance subsidiary to the holding company, or purchases of certain amounts of the insurance subsidiary's capital stock. These laws also generally require approval of changes of control which are usually triggered by the direct or indirect acquisition of 10% or more of the insurer.
Most states require all admitted insurance companies to participate in their respective guaranty funds, which cover certain claims against insolvent insurers. Solvent insurers licensed in such states are required to cover the losses paid on behalf of insolvent insurers by the guaranty funds and are generally subject to annual assessments in that state by the guaranty fund to cover such losses. Certain states also require licensed insurance companies to participate in assigned risk plans which provide coverage for workers' compensation, automobile insurance and other lines for insureds which, for various reasons, cannot otherwise obtain insurance in the open market. This participation may take the form of reinsuring a portion of a pool of such policies, or the direct issuance of policies to insureds. Generally, Legion participates as a pool reinsurer, or assigns to other companies the direct policy issuance obligations. The calculation of an insurer's participation in such plans is usually based on the amount of premium for that type of coverage that was written by the insurer on a voluntary basis in a prior year. Assigned risk pools tend to produce losses, which result in assessments to insurers writing the same lines on a voluntary basis. Legion also pays a fee to carriers assuming Legion's direct policy issuance obligations. For each program Legion writes, Legion estimates the amount of assigned risk and guaranty fund assessments that Legion will incur as a result of having written that program. If that estimate proves to be inadequate, Legion is entitled under its reinsurance agreements with the IPC Companies to recover from the reinsurer the amount of such assessments in excess of the estimate. The IPC Companies then are entitled under the terms of the shareholders agreement to recover this excess from the client. However, the IPC Companies are generally only able to collateralize this obligation up to the amount of the estimated assessments.
The National Association of Insurance Commissioners ("NAIC") has established the Insurance Regulatory Information System ("IRIS") to assist state insurance departments in their regulation and oversight of insurance companies domiciled or operating in their respective states. IRIS established a set of twelve financial ratios and specifies "unusual values" for each ratio. Companies reporting four or more unusual values on the IRIS ratios may expect inquiries from individual state insurance commissioners concerning specific aspects of the insurer's financial position. As of December 31, 1997, Legion Insurance Company had four unusual values. Three of the unusual values, "change in net writings", "estimated current reserve deficiency" and "surplus aid to surplus" are related to the substantial growth in premium related to its Program Business and the related loss retentions. The fourth unusual value "agent's balances to surplus" is also related to premium growth on program business and also reflects lags in premium collection that are consistent with the nature of Program Business. Legion Indemnity had no unusual values. Villanova Insurance Company had one unusual value, "change in surplus", due entirely to the change in ownership during 1997 and the resultant change in surplus.
The NAIC has also adopted a Risk Based Capital for Insurers Model Act (the "Risk Based Capital Model Act"). The Risk Based Capital Model Act sets forth a risk based capital formula for property and casualty insurers. The formula measures minimum capital and surplus needs based on the risk characteristics of the company's products and investment portfolio. The formula is part of each company's annual financial statement filings, and is to be used as a tool to identify weakly capitalized companies. In those states having enacted the Risk Based Capital Model Act, companies having capital and surplus greater than the minimum required by the formula, but less than a specified multiple of the minimum may be subject to additional regulatory scrutiny from domiciliary state insurance departments. To date, nearly all states have adopted this model act. At December 31, 1997 Legion's combined risk-based capital was $196.8 million and the threshold requiring the least regulatory involvement was $45.6 million. Therefore, Legion's capital exceeds all requirements of the Risk Based Capital Model Act.
In reaction to increasing rates for and decreasing availability of workers' compensation insurance starting in the early 1990's, many states began to enact reforms designed to reduce the cost of workers' compensation insurance, principally through a reduction in benefits or an increase in efficiencies in the system. In California, a reform package was enacted in 1993 providing, in part, a reduction of premium rates, an increase in the standard necessary to prove "stress"-related work injuries, group-self insurance for employers and the repeal of the minimum rate law effective January 1, 1995. In Florida, the assigned risk plan was abolished, and replaced by a joint underwriting authority. Other states have enacted or are considering similar reforms. Workers' compensation reform, to the extent it reduces premiums and introduces relative stability in the traditional workers' compensation market, may reduce the appeal of alternative market products such as those offered by the Company. This is apparent in California where workers' compensation rates have declined by more than 50% since mid-1993 while benefit levels actually increased. This will inevitably lead to significant losses for those traditional carriers who are writing this business. A number of these carriers have recently filed for significant rate increases. However, because of open rating in California, actual rates charged by carriers may vary significantly from filed base rates due to extensive use of credits.
Legion is permitted to pay dividends only from statutory earned surplus. Subject to this limitation, the maximum amount of dividends that it is able to pay in any twelve-month period will be the greater of statutory net income in the preceding year or 10% of statutory surplus. Based on 1997 results, the maximum dividend Legion will be permitted to pay in 1998 is $21.9 million.
LOSSES AND LOSS RESERVES
The Company establishes reserves for losses and loss adjustment expenses related to claims which have been reported on the basis of the evaluations of independent claims adjusters under the supervision of Legion's claims staff. In addition, reserves are established for losses which have occurred but have not yet been reported and for adverse development of reserves on reported losses by the Company on a quarterly basis. The estimate of claims arising for accidents which have not yet been reported is based upon the Company's and the insurance industry's experience together with statistical information with respect to the probable number and nature of such claims.
Gross loss reserves of $95.0 million and $88.5 million at December 31, 1997 and 1996 have been discounted by $28.1 million and $23.3 million, respectively, assuming interest rates of 6% for medical malpractice reserves and 4% for excess workers' compensation reserves based on the recommended rate under Pennsylvania law. These reserves are also discounted in the Company's regulatory filings. In 1993 the Company adopted SFAS 113 and reclassified substantially all of its net retained medical malpractice reserves as claims deposit liabilities. On a net basis, therefore, the only discounted reserves are those relating to the Company's share of the excess reinsurance coverage provided in connection with each Legion program. After reinsurance, the net effect of this discounting was to increase net income after tax for 1997 and 1996 by $.1 million and $.2 million, respectively. This discounting reduced net loss reserves on the Consolidated Balance Sheets by $3.7 million and $3.5 million at December 31, 1997 and 1996, respectively.
Subsequent to 1989, loss development has been generally favorable. The deficiencies in earlier years primarily relate to the loss development on the Company's share of the aggregate excess coverage provided in connection with each Legion program. Estimation of reserves for losses and loss adjustment expenses on such aggregate excess coverage is more difficult than on primary insurance coverage because coverage does not attach until the underlying aggregate retention is exhausted. Commencing in 1990, the Company (a) reduced its net retention on this coverage; (b) generally increased its minimum attachment points; and (c) increased pricing so as to reduce the underwriting loss on this business in the future.
The following table sets forth a reconciliation of beginning and ending reserves for losses and loss adjustment expenses:
- -------- (1) Other reserves represent reinsurance contracts which are being run-off and which were written in subsidiaries other than Legion, plus reserves for other run-off business.
The previous table presents a reconciliation of reserves in accordance with generally accepted accounting principles ("GAAP"). The following table reconciles the difference between the Legion portion of these reserves and those contained in regulatory filings made by Legion in accordance with statutory accounting practices ("SAP").
RECONCILIATION OF SAP AND GAAP RESERVES
The following table presents the development of the Company's ongoing net reserves for 1988 through 1997. The top line of the table shows the estimated reserve for unpaid losses and loss adjustment expenses recorded at the balance sheet date for each of the indicated years. This amount represents the estimated amount of losses and loss adjustment expenses for claims that are unpaid at the balance sheet date, including losses that have been incurred but not yet reported to the Company. The table also shows the re-estimated amount of the previously recorded reserve based on experience as of the end of each succeeding year. The estimate changes as more information becomes known about the frequency and severity of claims for individual years. The "Cumulative redundancy (deficiency)" represents the aggregate change in the estimates over all prior years. It should be noted that the following table presents a "run- off" of balance sheet reserves, rather than accident or policy year loss development. Therefore, each amount in the table includes the effects of changes in reserves for all prior years.
ANALYSIS OF LOSS AND LOSS EXPENSE DEVELOPMENT (NET OF REINSURANCE RECOVERABLE)
- ------- (1) Medical malpractice reserves have been discounted at 8% in 1988, 8.25% in 1989 and 1990, and 6% in 1991, 1992, 1993, 1994, 1995, 1996 and 1997. (2) The re-classification of reserves to claims deposit liabilities is a result of the adoption of SFAS 113. (3) Other reserves represent reinsurance contracts which are being run-off and which were written in subsidiaries other than Legion, plus reserves for other run-off business.
INVESTMENTS AND INVESTMENT RESULTS
For a complete description of the Company's Investments and investment results See Note 5 to Consolidated Financial Statements.
ITEM 2.
ITEM 2. PROPERTIES
The Company and its subsidiaries operate out of leased premises the most significant of which are in Philadelphia and Bermuda.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is a party to various lawsuits generally arising in the normal course of its business. The Company does not believe that the eventual outcome of any such suits will have a material effect on the Company's financial condition.
The United States Internal Revenue Service (the "IRS") has commenced an examination of the Company's calculation of "Related Party Insurance Income" ("RPII") for 1993 and 1994. The Company calculates RPII on behalf of certain of its clients participating in its Insurance Profit Center Program in order to provide those clients with information used in preparing their United States income tax returns. The Company believes that its calculation of RPII was materially correct in both years. In addition, any adjustment made by the IRS would affect the Company's clients and not the Company directly.
As a part of this examination the IRS has questioned whether certain clients of the Insurance Profit Center Program properly deducted all or a portion of the premium paid in connection with their program. In general, the IRS has challenged the deductibility of premiums paid to captive insurance companies in a series of rulings and cases since 1977. The Company believes that the particular fact situations of each of its Insurance Profit Center clients are sufficiently diverse such that no general determination can be made with respect to the appropriate tax treatment of the premium paid by participants in the Company's programs. To the Company's knowledge, none of the small number of clients reviewed by the IRS, has received notices of any significant adjustment to their tax liability.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO SECURITY HOLDERS
Not applicable.
EXECUTIVE OFFICERS
All Executive Officers are appointed by the Company's Board of Directors and serve until the next annual general meeting of the shareholders or until their successors are appointed.
PART II
ITEM 5.
ITEM 5. MARKET FOR COMMON SHARES
The Company's Common Shares have been listed on the New York Stock Exchange under the symbol MM since June 25, 1991. The Common Shares were listed in connection with the Company's initial public offering completed in July 1991. There were 377 holders of record of the Company's Common Shares as of February 27, 1998.
The following table sets forth the high and low closing sale prices for the Shares during 1996 and 1997 for the calendar quarters indicated as reported by the New York Stock Exchange Composite Tape.
The last reported sale price of the Common Shares on the New York Stock Exchange Composite Tape on March 20, 1998 was $34 5/16.
During 1997 and 1996 the Company paid dividends of $.19 and $.16 per Common Share respectively. Dividends are paid quarterly.
The Company's ability to pay dividends is restricted due to certain insurance regulations. See "Management's Discussion and Analysis of Financial Conditions and Results of Operations" and Note 11 to Consolidated Financial Statements.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
- -------- (1) See Note 2 I of Notes to Consolidated Financial Statements for an explanation of the method used to determine the number of shares used to compute per share amounts. (2) Operating income--under generally accepted accounting principles ("GAAP") Operating income, which excludes realized capital (losses) gains--net of tax, is not separately presented. It is presented here as supplemental information. This should not be considered a better measure than net income calculated in accordance with GAAP. (3) Net of tax. (4) See Note 6 of Notes to Consolidated Financial Statements.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
Consolidated Net Income increased by 29% to $47.8 million in 1997 from $37.0 million in 1996 which was in turn a 23% increase over the $30.2 million earned in 1995. The increase in 1997 earnings was primarily attributable to the growth experienced in the Program Business segment which benefited from the acquisition of Small Business Underwriters ("SBU") as well as the expansion of Professional Underwriters Corporation ("PUC") into New York State. 1996 earnings growth was also a result of the growth in the Program Business segment, as well as the acquisitions of The Hemisphere Group Limited ("Hemisphere") and PUC.
Set forth in Table I is an analysis of the components of the Company's revenues for each of the last three years. Revenue is not considered to be the best measure of the Company's performance since it includes Premiums earned which historically have been closely matched by Total insurance costs and should not have a significant impact on Net income. Excluding Premiums earned, revenues increased in 1997 by 29% over 1996 which increased 28% over 1995.
TABLE I--REVENUES
The growth of Fee income has been primarily due to the strong growth in Program Business which more than compensated for the decline in Corporate Risk Management business.
Overall, pre-tax profit margins on Fee income continue to remain steady at 41% in 1997 compared to 40% in 1996 and 43% in 1995.
SEGMENT ANALYSIS
The components of Fee income by business segment are illustrated in Table II.
TABLE II--FEE INCOME BY BUSINESS SEGMENT
PROGRAM BUSINESS
Program Business, the fastest growing segment of the Company's business, involves replacing traditional insurers as the conduit between producers of specialty books of business and reinsurers wishing to write that business. Program Business accounted for 45% of total Fee income for 1997 compared to 24% in 1996 and 11% in 1995. This growth has resulted from the continued expansion of this business as a result of reinsurers' increased appetite for premium volume in this soft market, and the acquisition of SBU on February 1, 1997. Fees earned on individual Program accounts are more likely to grow compared to Corporate accounts, because new policy holders are constantly being added in each program, also they have a higher retention rate than Corporate accounts due to the complexity of Program accounts. Pre-tax margins in this segment were 41% for 1997 compared to 38% in 1996 and 48% in 1995. The decrease in margins in 1996 was due to the acquisition of PUC which has lower margins due to the labor intensive nature of its services.
CORPORATE RISK MANAGEMENT
Corporate Risk Management, the Company's original business segment, involves providing services to businesses and associations seeking to insure a portion of their risk in a loss sensitive Alternative Market structure. This segment, which accounted for 40% of total Fee income for 1997 compared to 61% in 1996 and 75% in 1995, has been the most affected by the extremely soft insurance market cycle for commercial risks. Corporate Risk Management fees decreased in 1997 for the first time due to these soft market conditions. The number of Corporate Risk Management accounts decreased in 1997 to 154 from 180 in 1996 which was in turn down from 194 in 1995. Profit margins remained consistent, despite the difficult market, at 44% in 1997 compared to 43% in 1996 and 45% in 1995.
Historically, workers' compensation has been the major line of business written by the Company in both its Corporate Risk and Program Business segments. Competition for workers' compensation business has increased in recent years, as a result of generally improved reported underwriting results and workers' compensation reform legislation. The resulting under-pricing of workers' compensation risks by traditional insurers reduces the incentive for insureds to enter "Alternative Market" vehicles such as those offered by the Company in its Corporate Risk Management segment. Despite these competitive forces, the Company was successful in increasing its business in most states as a result of the attractiveness of Program Business in this soft reinsurance market. In 1997 the Company added 25 new Program and Corporate Risk accounts in California compared to 8 in 1996 and 6 in 1995, while increasing the renewal rate to 85% from 77% in 1996 and 74% in 1995. There were 48 California based accounts at the end of 1997 compared to 27 in 1996 and 25 in 1995. The Company continued to strive to diversify its business to reduce its reliance on the workers' compensation market and was successful in doing so. As a percentage of Total Fee income, workers' compensation accounts decreased from over 80% at December 31, 1994 to 57% at December 31, 1997 as a result of the Company writing accounts which comprise other lines of coverage such as commercial auto liability, auto physical damage and other liability coverages as well as the expansion of the Company's Financial Services segment.
SPECIALTY BROKERAGE
The Company's Specialty Brokerage business segment provides access to Alternative Risk Transfer insurers and reinsurers in Bermuda and Europe. Despite declines in premium on new and renewal policies, fees in this segment continued to grow. Renewal rates remained high at 85% for 1997 compared to 86% for 1996 and 87% for 1995. Profit margins decreased slightly to 35% from 37% in 1996 and 40% in 1995.
FINANCIAL SERVICES
Financial Services, the Company's newest business segment, is being built on the 1996 acquisition of Hemisphere which provides administrative services to offshore mutual funds and other companies. The Financial Services segment also includes the Company's newly launched family of proprietary mutual funds and MRM Life. MRM Life was recently incorporated to issue variable insurance products in Bermuda. This segment
accounted for 8% of total Fee income for both 1997 and 1996 up from 7% in 1995. Fees from Financial Services increased primarily as a result of an increase in the number of mutual funds under management from 60 in 1995 and 85 in 1996, to 129 in 1997 as well as relatively high renewal rates of 98% in 1995, 80% in 1996 and 93% in 1997. Profit margins improved from 14% in 1995 and 20% in 1996 to 26% in 1997. Margins in the Financial Services segment are expected to decline slightly in 1998 due to start up costs being incurred in connection with the MRM mutual funds and MRM Life and on account of a revised Executive Incentive Plan being implemented at Hemisphere.
UNDERWRITING
The Company generally requires each Corporate Risk Management client to indemnify it against an underwriting loss and the client normally provides collateral for at least the difference between the funds available in that client's account and the level of expected losses as actuarially determined by the Company, although in certain circumstances the collateral level is below the level of expected losses. The Company faces a credit exposure in the event that losses exceed their expected level and the client is unable or unwilling to honor its indemnity to the Company. The Company also faces credit exposure on both Program and Corporate Risk Business if its clients or brokers fail to pay the premium due and through failure of reinsurers to honor their obligations.
The Company has established provisions for losses as a result of these exposures for certain clients and reinsurers. These provisions, which totaled $5.6 million at December 31, 1997, $4.5 million in 1996 and $4.0 million in 1995, reduced the level of Fee income in each year by $1.1 million, $.5 million and $.2 million respectively. The increase in the number of accounts and their inherent growth in premium volume, the increase in the clients' aggregate retentions since 1991, the amounts recoverable from reinsurers which amounted to $787 million at December 31, 1997 and $424 million at December 31, 1996, in addition to competitive factors which have limited the amount of collateral that clients are willing to provide, have significantly increased the Company's exposure to such losses. The Company evaluates the financial condition of its clients, brokers and reinsurers to minimize its exposure to losses from insolvencies.
Premiums earned increased by 49% in 1997, and 17% in 1996, these increases are directly attributable to the shift in business from the Corporate Risk Management segment to the Program Business segment and the strong growth within this segment. Program Business usually involves higher premiums than business derived from the Corporate Risk Management segment. Premiums earned represent the net premiums retained by the Company on which it bears underwriting risk. The Company believes that both the volatility of underwriting profit or loss and the probability of experiencing a severe underwriting loss are less than would ordinarily be expected for a traditional property/casualty insurer, due to the nature of the business written by the Company and the structure of its reinsurance. In the past, the level of Premiums earned has been closely matched by the level of Total insurance costs resulting in small amounts of underwriting loss as a percentage of Premiums earned. The fact that Premiums earned are generally matched by Total insurance costs means that even a significant fluctuation in Premiums earned will have a relatively insignificant impact on the Company's Net income.
Included in Premiums earned are assigned risk premiums of $8.4 million in 1997 as compared to $7.8 million in 1996 and $11.9 million in 1995. The underwriting losses associated with these assigned risk premiums, together with other charges imposed by certain states on voluntary insurers such as Legion to support involuntary market losses ("residual market loads") are passed on by Legion to clients.
The Company's principal exposure to underwriting loss exists in relation to the premium associated with the Company's retention of a portion of the specific and aggregate excess risk on each client's account. It is on this retained excess risk that the Company may experience the most significant volatility in underwriting results. The portion of the Company's Premiums earned which relate to this risk was $3.9 million in 1997 as compared to $3.3 million in 1996 and $3.9 million in 1995, representing 3%, 6% and 8% of Premiums earned in 1997,
1996 and 1995 respectively. The Company incurred an underwriting loss of $1.5 million in 1997, $.2 million in 1996 and $1.0 million in 1995 as a result of the retained risk on its treaties and increases in acquisition expenses. The Company takes 100% of the risk within the first $1.25 million layer of the aggregate excess exposure on its main treaty up to a deductible amount equal to 1.5% of the Company's gross premiums (as defined) and 10% of the risk over a loss ratio of 120%, in the event that the loss ratio for the first layer exceeds 120% the Company takes no share of the risk in the layer $3.75 million excess of $1.25 million per account. The maximum retention for specific excess losses is 10% of $.75 million excess of $.25 million per occurrence. On other treaties the Company has decreased its exposure for excess losses.
INVESTMENT INCOME
Gross investment income increased by $2.2 million or 8% to $29.7 million in 1997 from $27.5 million in 1996 and $20.3 million in 1995 as a result of increases in gross invested assets. Net investment income after adjusting for investment income which is payable to others increased by 17% to $26.3 million in 1997 from $22.5 million in 1996 and $16.2 million in 1995. Net invested assets increased $11 million or 3% to $398 million in 1997 from $387 million in 1996 and $345 million in 1995. The yield on these assets increased to 6.7% from 6.1% in 1996 and 6.3% in 1995. The Company's investment income is produced through the investment of its capital funds, long term debt, other funds held representing amounts due others and reserves held by the Company for unearned premiums and unpaid losses. The Company carries $42.4 million at December 31, 1997 and $45.7 million at December 31, 1996 on its Consolidated Balance Sheets as Claims deposit liabilities. These liabilities relate to loss obligations which, under SFAS 113, are not classified as insurance. Investment income on these funds of $2.5 million in 1997, $4.0 million in 1996 and $3.5 million in 1995, is credited directly to the Claims deposit liability account.
The breakdown of expenses for each of 1997, 1996 and 1995 is set forth in Table III.
TABLE III--EXPENSES
The increases in Total insurance costs were the direct result of the increases in Premiums earned during these periods. Losses incurred increased as a direct result of the decreased use of large deductible policies, and the increase in Program Business. The Company discounts its specific and aggregate workers' compensation reserves using a 4% rate recommended under Pennsylvania law where Legion Insurance is domiciled. The net effect of this discounting was to increase Net income after tax for the years ended December 31, 1997, 1996 and 1995 by $.1 million, $.2 million and $.3 million respectively. Discounting also reduced net loss reserves by $3.7 million, $3.5 million and $3.3 million at December 31, 1997, 1996 and 1995. The 48% increase in Acquisition costs from 1996 to 1997 is a direct result of the 49% increase in premiums earned. The 3% decrease from 1995 to 1996 is attributable to: (a) the fact that Acquisition costs in all years include significant expenses associated with the involuntary workers' compensation business the Company is required to assume and over which it has no control. Such expenses have no net financial impact on the Company as they are recharged to clients. These expenses decreased in 1996 and (b) Acquisition costs on large deductible policies are higher in relation to the
associated premium than under a traditional guaranteed cost policy. The volume of deductible programs written by the Company decreased in 1996.
The primary factors responsible for the increases in Operating expenses were: (a) the increased cost of administering the Company's highly regulated policy-issuing subsidiaries, as the volume of policies issued increased; (b) increased personnel costs in all areas, caused by an increase in the number of full time employees from 433 in 1996 to 617 in 1997, resulting from the growth of the Company's businesses as well as the impact of the Company's growth in revenues and profits on employee bonus plans; and (c) the acquisitions of SBU and Hugo Trust as well as the expansion of PUC into New York State.
The charges for Income taxes represent effective tax rates of 18.1%, 17.9% and 22.3% respectively. The reduced tax rates experienced since 1995 are primarily due to increased earnings outside of the United States and the tax benefit derived from the exercise of employee stock options. These factors plus the Company's investment in tax-exempt municipal securities, offset by state income taxes, are the major causes of the difference between the expected federal income tax rate in the United States of 35% plus state income taxes and the Company's effective rates in each year. The Legion Companies, as insurance companies in the United States, are subject to income tax on an accelerated basis and, as a result, a deferred tax benefit was carried on the Consolidated Balance Sheets of $4.6 million in 1997 and $3.4 million in 1996.
LIQUIDITY AND CAPITAL RESOURCES
INVESTMENTS
At December 31, 1997 the market value of the Company's Total marketable investments was $474 million, as compared to $452 million at December 31, 1996. In accordance with SFAS 115, Investments available for sale are reported at fair market value with unrealized gains and losses included as a separate component of Shareholders' equity. These Investments generally consist of investment grade fixed-income securities which the Company believes are readily marketable and could be liquidated to meet cash requirements, if necessary.
CASH FLOW
Cash flow from operations has historically provided the Company its principal source of liquidity. The Company has continued to produce a positive cash flow with $55.2 million of cash provided from operations during 1997, as compared to $61.5 million in 1996 and $33.5 million in 1995.
The Company believes that it will continue to maintain a positive cash flow from operations in the foreseeable future and will be able to meet its liquidity requirements. Excess cash flow from operations has principally been used in each year to increase the Company's investment portfolio. In October 1995 the Company completed a private placement of Zero Coupon Convertible Exchangeable Subordinated Debentures due 2015 with a principal amount at maturity of $324 million. The net proceeds from the offering were $112 million after expenses. The Debentures carry a yield of 5.25% per annum and are convertible into 21.52 Common Shares of the Company per $1,000 principle amount at maturity or an aggregate of 6,978,800 Common Shares.
INSURANCE OPERATIONS
At the end of 1997 and 1996, 70% and 68% respectively, of the Company's Total marketable investments were held by the Company's policy-issuing subsidiaries in the United States. These companies are restricted by regulation in the amount of dividends they can pay without prior regulatory approval to $21.9 million in 1998 (based on 1997 results) and will continue to face these restrictions in the future. During 1997 they paid a dividend of $2 million. They are also required to maintain certain deposits with or supply letters of credit to regulatory authorities which totaled $135 million at December 31, 1997 ($51 million of deposits and $84 million of letters of credit) as compared to $126 million at December 31, 1996 ($44 million of deposits and $82 million of letters of credit).
A widely accepted factor used by regulators and rating agencies in evaluating insurance companies is the ratio of net premiums written to policyholders' surplus which is an indication of the degree to which an insurer is leveraged. Because of the low level of net premiums written, they have produced a relatively low ratio on this basis of approximately 0.4:1 in 1997, 0.3:1 in 1996 and 0.5:1 in 1995 and should continue to produce relatively low ratios in the future. The accepted industry standard for this ratio is below 3:1. Due to the nature of the Company's operations, a more appropriate indication of leverage is the ratio of gross premium written to policyholders' surplus, which amounted to 3.0:1 in 1997, 2.4:1 in 1996 and 2.6:1 in 1995. The National Association of Insurance Commissioners ("NAIC") has established that an "unusual value" for this ratio would be 9:1 or higher. The Company has adopted a policy that this ratio should not exceed 4:1.
The NAIC has adopted a risk-based capital ("RBC") formula to be applied to all property/casualty insurance companies. The formula measures capital and surplus needs based on an insurance company's products and investment portfolio and is to be used as a tool to identify weakly capitalized companies. An insurance company that does not meet the threshold RBC measurement standards could be required to reduce the scope of its operations and ultimately could become subject to statutory receivership proceedings. At December 31, 1997 the Company's policy-issuing subsidiaries met the RBC requirements with a combined required risk-based capital of $45.6 million and an actual adjusted capital of $196.8 million.
SHAREHOLDERS' EQUITY
Shareholders' equity increased 25% to $260 million at December 31, 1997 from $208 million at December 31, 1996. This increase was attributable primarily to Net income in 1997, less dividends paid, plus the value of shares issued on the exercise of employee stock options and the movement in unrealized gains and losses on Investments. The unrealized gain on Investments was $4.0 million at December 31, 1997, net of tax compared to $.1 million a year earlier. This $3.9 million change was a result of the changes in the market for fixed income securities. During 1997 the total number of Common Shares outstanding increased to 38,814,051 from the 1996 level of 38,063,706, mainly as a result of the exercise of employee stock options.
TOTAL ASSETS
Total assets increased to $2.1 billion at December 31, 1997, a 31% increase from $1.6 billion at December 31, 1996. $625.2 million, or 29% of Total assets, in 1997 and $576.7 million, or 35%, in 1996 related to Assets held in separate accounts. As detailed in Note 2A to the Consolidated Financial Statements, such assets are principally managed assets attributable to participants in the Company's IPC Programs.
INFLATION
The Company does not believe its operations have been materially affected by inflation. The potential adverse impacts of inflation include: (a) a decline in the market value of the Company's fixed maturity investment portfolio; (b) an increase in the ultimate cost of settling claims which remain unresolved for a significant period of time; and (c) an increase in the Company's Operating expenses. However, the Company generally holds its fixed maturity investments to maturity and currently believes that an acceptable amount is included in the yield to compensate the Company for the risk of inflation. In addition, any increase from inflation in the ultimate cost of settling unpaid claims will be borne by the Company's clients and offset by investment income earned for the benefit of the client during the period that the claim is outstanding. Finally, the increase in Operating expenses resulting from inflation should generally be matched by similar inflationary increases in the client's premium and therefore the Company's fee income which includes a fee based upon a percentage of the client's premium.
IMPACT OF YEAR 2000
The Company is modifying all software that is not Year 2000 compliant.
The Company is utilizing both internal and external resources to program or replace and test the software for Year 2000 modifications. The Company anticipates that this exercise will be completed during 1998 and will not be a material cost, due to the fact that most systems are relatively new and were Year 2000 compliant when purchased.
RECENT ACCOUNTING PRONOUNCEMENTS
The Financial Accounting Standards Board has recently issued SFAS 130, "Reporting Comprehensive Income" and SFAS 131, "Disclosures about Segments of an Enterprise and Related Information". Both statements are effective for periods beginning after December 15, 1997. The Company is currently considering the effects of these statements on its financial statement presentation and disclosures.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Company's consolidated financial statements for the years ended December 31, 1997, 1996 and 1995 are filed herewith in response to Item 14.
ITEM 9.
ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. MANAGEMENT
See Part I for information relating to Company's executive officers.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
ITEM 13.
ITEM 13. CERTAIN TRANSACTIONS
Pursuant to General Instructions G(3) of Form 10-K, Items 10 to 13, inclusive, have not been restated or answered since the Company intends to file within 120 days after the close of its fiscal year with the Securities and Exchange Commission a definitive proxy statement pursuant to Regulation 14A under the Securities Exchange Act of 1934 and the information contained therein is hereby incorporated by reference. The information included in such proxy statement pursuant to the requirements of Sections 402(k) and (l) of Regulation S-K is not incorporated by reference herein.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8K
A. EXHIBITS
- -------- (1) Incorporated by reference to Form S-1 Registration Statement (No. 33- 40152) of Mutual Risk Management Ltd. declared effective June 25, 1991. (2) Incorporated by reference to the 1991 Annual Report on Form 10-K of Mutual Risk Management Ltd. (3) This exhibit is a management contract or compensatory plan or arrangement. (4) Incorporated by reference to Form 10-Q of Mutual Risk Management Ltd. for the period ended June 30, 1996. (5) Incorporated by reference to 1995 Annual Report on Form 10-K of Mutual Risk Management Ltd. (6) Incorporated by reference to 1996 Annual Report on Form 10-K of Mutual Risk Management Ltd.
B. FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
All other schedules required by Article 7 of Regulation S-X are not required under the related instructions, are inapplicable or are included elsewhere in this filing, and therefore have been omitted.
C. REPORTS ON FORM 8-K
None
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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, in Hamilton, Bermuda, on March 18, 1998.
MUTUAL RISK MANAGEMENT LTD.
By: /s/ Robert A. Mulderig ----------------------------------- Robert A. Mulderig Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
/s/ Robert A. Mulderig Chairman and Chief Executive - ----------------------------- Officer (Principal Executive March 18, 1998 Robert A. Mulderig Officer)
/s/ John Kessock, Jr. President, Director and - ----------------------------- Authorized U.S. March 18, 1998 John Kessock, Jr. Representative
/s/ Richard G. Turner Executive Vice President and - ----------------------------- Director March 18, 1998
Richard G. Turner
/s/ Glenn R. Partridge Executive Vice President and - ----------------------------- Director March 18, 1998
Glenn R. Partridge
/s/ James C. Kelly Senior Vice President and - ----------------------------- Chief Financial Officer March 18, 1998 James C. Kelly (Principal Financial and Accounting Officer)
/s/ Roger E. Dailey Director - ----------------------------- March 18, 1998
Roger E. Dailey
/s/ David J. Doyle Director
March 18, 1998 - ----------------------------- David J. Doyle
/s/ Arthur E. Engel Director
March 18, 1998 - ----------------------------- Arthur E. Engel
/s/ Allan W. Fulkerson Director
March 18, 1998 - ----------------------------- Allan W. Fulkerson
/s/ William F. Galtney, Jr. Director
March 18, 1998 - ----------------------------- William F. Galtney, Jr.
/s/ Beverly H. Patrick Director
March 18, 1998 - ----------------------------- Beverly H. Patrick
/s/ Jerry S. Rosenbloom Director
March 18, 1998 - ----------------------------- Jerry S. Rosenbloom
/s/ Norman L. Rosenthal Director
March 18, 1998 - ----------------------------- Norman L. Rosenthal
/s/ Joseph D. Sargent Director
March 18, 1998 - ----------------------------- Joseph D. Sargent
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
See Accompanying Notes to Consolidated Financial Statements
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
- -------- (1) Prior periods per share calculations have been restated to reflect the four-for-three stock split to holders of record at May 31, 1996, and the two-for-one stock split to holders of record at September 26, 1997.
See Accompanying Notes to Consolidated Financial Statements
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
- -------- (1) Dividend per share amounts were $.04 for 1997 and $.06 for 1996 and 1995. (2) Dividend per share amounts were $.19, $.16 and $.13 for 1997, 1996 and 1995 respectively (prior periods restated for stock splits). (3) Effective May 31, 1996 the Company effected a four-for-three stock split recorded in the form of a stock dividend. 4,438,974 Common Shares were issued in respect of this split. Prior periods have been restated. (4) Effective September 26, 1997 the Company effected a two-for-one stock split recorded in the form of a stock dividend. 18,741,121 Common Shares were issued in respect of this split. Prior periods have been restated.
See Accompanying Notes to Consolidated Financial Statements
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
See Accompanying Notes to Consolidated Financial Statements
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1997
1. GENERAL
Mutual Risk Management Ltd. (the "Company") was incorporated under the laws of Bermuda in 1977. The Company is a holding company engaged, through its subsidiaries, in providing risk management and financial services in the United States, Bermuda, Barbados, the Cayman Islands and Europe. The "IPC Companies", offer the IPC Program, an alternative risk facility for insureds. The Company also provides administrative, accounting and reinsurance services for unaffiliated captive insurers. Legion Insurance Company, a Pennsylvania insurance company, Legion Indemnity Company, an Illinois excess and surplus lines insurance company and Villanova Insurance Company, a Massachusetts insurance company (together "Legion" or the "Legion Companies") act as policy- issuing companies on many of the IPC Programs reinsuring a portion of the liability and premium to one of the IPC Companies. MRM Financial Services Ltd provides financial services to offshore mutual funds and other companies. Other subsidiaries provide specialty brokerage, proprietary loss control services and underwriting management.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
These Consolidated Financial Statements have been prepared in accordance with generally accepted accounting principles prevailing in the United States ("GAAP") and are presented in United States Dollars.
A. CONSOLIDATION
(i) General
The Consolidated Financial Statements include the accounts of the Company and all of its subsidiaries. All significant intercompany transactions and balances have been eliminated on consolidation. Management is required to make estimates that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Actual results may differ from those estimates.
(ii) Assets Held in and Liabilities Related to Separate Accounts
A substantial majority of the assets and liabilities of the IPC Companies represents assets under management and related liabilities of the IPC Programs. Under these programs, the program holders, through their ownership of preferred shares in the IPC Companies, assume investment and underwriting risk and the IPC Company receives a fee for managing the program. Accordingly, the Company treats the Premium written in connection with these programs, whether written directly or assumed as reinsurance, as Premiums ceded to the separate accounts of the IPC Companies and does not include such amounts in the Company's Premiums earned on the Consolidated Statements of Income. This Premium ceded amounted to $277.4 million in 1997 (1996--$195.2 million; 1995-- $152.8 million). The related assets and liabilities are shown separately on the Consolidated Balance Sheets as "Assets held in and Liabilities related to separate accounts". Included in these assets are cash and marketable investments of $390.7 million at December 31, 1997 (1996--$378.1 million) and other assets of $212.5 million (1996--$188.1 million). Consolidated assets and liabilities of the IPC Companies which accrue to the Company are included on a line-by-line basis in the Consolidated Financial Statements.
B. INVESTMENTS
Investments are comprised of bonds, redeemable preferred shares and mutual funds. All Investments are classified as available for sale in accordance with SFAS 115 and are reported at fair market value with unrealized gains and losses included as a separate component of Shareholders' Equity, net of tax.
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DECEMBER 31, 1997
Realized gains and losses on the sale of Investments are recognized in Net income using the specific identification basis. Investments which incur a decline in value, which is other than temporary, are written down to fair value as a new cost basis with the amount of the write down included in Net income. Investment income is accrued as earned and includes amortization of premium and discount relative to bonds acquired at amounts other than their par value.
C. REVENUE RECOGNITION
(i) Policy issuing fees earned are recorded as the premium is written and earned over the applicable policy period. The unearned portion is included in Prepaid fees on the Consolidated Balance Sheets.
(ii) Underwriting fees of the IPC Companies are earned as premiums are reported or over the applicable policy period. The unearned portion of such fees is included in Prepaid fees on the Consolidated Balance Sheets.
(iii) Investment fees earned by the IPC Companies are accrued on a daily basis.
(iv) Commissions and brokerage fees are recorded and earned as premiums are billed.
(v) Premiums written and assumed are recorded on an accruals basis. Premiums earned are calculated on a pro-rata basis over the terms of the applicable underlying insurance policies with the unearned portion deferred on the Consolidated Balance Sheets as Reserve for unearned premiums. Reinsurance premiums ceded are similarly pro-rated with the prepaid portion recorded as an asset in the Consolidated Balance Sheets. Premiums written which are related to the separate accounts of the IPC Companies are included in Premiums ceded (see Note 2A(ii)).
(vi) Net investment income is included after deducting various items as detailed in Note 5C.
(vii) Realized capital (losses) gains include gains and losses on the sale of investments available for sale, other investments and fixed assets (see Note 5B(ii)).
D. LOSSES AND LOSS EXPENSES INCURRED
Losses and related loss adjustment expenses are charged to income as they are incurred and are net of losses recovered and recoverable of $521.9 million in 1997 (1996--$203.9 million; 1995--$239.5 million). Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Included in loss reserves are gross loss reserves of $95.0 million and $88.5 million at December 31, 1997 and 1996 which have been discounted by $28.1 million and $23.3 million respectively, assuming interest rates of approximately 6% for medical malpractice reserves and 4% for specific and aggregate workers' compensation reserves. These reserves are also discounted for regulatory filings. After reinsurance, the net effect of this discounting was to increase Net income by $.1 million, $.2 million and $.3 million in 1997, 1996 and 1995 respectively. Discounting also reduced net loss reserves by $3.7 million and $3.5 million at December 31, 1997 and 1996 respectively.
Reserves are established for losses and loss adjustment expenses relating to claims which have been reported on the basis of evaluations of independent claims adjusters under the supervision of the Company's claims staff. In addition, reserves are established, in consultation with the Company's independent actuaries, for losses which have occurred but have not yet been reported to the Company and for adverse development of reserves on reported losses. Reinsurance receivables are shown separately on the Consolidated Balance Sheets. Management
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DECEMBER 31, 1997
believes that the resulting estimate of the liability for losses and loss adjustment expenses at December 31, 1997 and 1996 is adequate to cover the ultimate net cost of losses and loss expenses incurred, however, such liability is necessarily an estimate and no representation can be made that the ultimate liability will not exceed such estimate.
E. CLAIMS DEPOSIT LIABILITIES
The Company records certain programs that do not meet the conditions for reinsurance accounting as Claims deposit liabilities on the Consolidated Balance Sheets.
F. INCOME TAXES
The Company records its income tax liability and deferred tax asset in accordance with SFAS 109. In accordance with this statement, the Company records deferred income taxes which reflect the net tax effect of the temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.
G. DEPRECIATION AND AMORTIZATION
Depreciation of furniture and equipment is provided on a straight-line basis over their estimated useful lives ranging from 2 to 10 years. Amortization of leasehold improvements is computed on a straight-line basis over the terms of the leases. Accumulated depreciation at December 31, 1997 amounted to $12.4 million (1996--$8.6 million). Goodwill related to the acquisition of subsidiaries is amortized on a straight-line basis over 25 to 40 years, is evaluated periodically for any impairment in value and is included in Other expenses on the Consolidated Statements of Income. Accumulated amortization at December 31, 1997 amounted to $2.9 million (1996--$1.8 million).
H. DEFERRED EXPENSES
Deferred expenses which consist primarily of policy acquisition costs are deferred and charged to income on a pro-rata basis over the periods of the related policies.
I. EARNINGS PER COMMON SHARE
In 1997, the Financial Accounting Standards Board issued SFAS 128, Earnings per Share. SFAS 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods have been presented, and where appropriate, restated to conform to SFAS 128 (see Note 13). All earnings per share, for all periods presented, have been restated to reflect the four-for- three stock split effective May 31, 1996 and the two-for-one stock split effective September 26, 1997 (see Note 11).
J. CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash on hand, money market instruments and other debt issues purchased with an original maturity of ninety days or less.
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DECEMBER 31, 1997
K. ZERO COUPON CONVERTIBLE EXCHANGEABLE SUBORDINATED DEBENTURES
The Debentures are recorded at original issue price plus accrued original issue discount. The current amortization of the original issue discount is included in Interest expense on the Consolidated Statements of Income.
L. STOCK-BASED COMPENSATION
The Company applies APB Opinion 25 and related Interpretations in accounting for its stock option plans and, accordingly, does not recognize compensation cost as all options are issued with an exercise price equal to the market price of the stock on the date of issue. Note 12 contains a summary of the pro-forma effects to reported Net income and earnings per share for 1997, 1996 and 1995 had the Company elected to recognize compensation cost based on the fair value of the options granted at grant date as prescribed by SFAS 123.
3. REINSURANCE AND CLIENT INDEMNIFICATION
A. Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company and allowances are established for amounts deemed uncollectible. The Company evaluates the financial condition of its reinsurers to minimize its exposure to losses from reinsurer insolvencies.
B. At December 31, 1997, Losses recoverable and Prepaid reinsurance of $786.7 million (1996--$423.9 million) had been ceded to reinsurers other than the IPC Companies. $761.6 million of this amount (1996--$404.8 million) has been ceded to reinsurers licensed in the United States which are not required to provide letters of credit or other collateral to secure their obligations. One such U.S. reinsurer accounted for $144.6 million (1996--$105.1 million). The remaining $25.1 million of reinsurance ceded (1996--$19.1 million) was ceded to reinsurers not licensed in the United States, including $10.9 million ceded to companies managed by the Company (1996--$10.8 million). These non- U.S. reinsurers have provided collateral security to the Company in the form of letters of credit and cash at December 31, 1997 of $31.3 million (1996-- $31.8 million). Letters of credit held by the Company are issued by and/or confirmed by member banks of the U.S. Federal Reserve. The Company regularly reviews the credit exposure which it has to each bank, together with that bank's financial position and requires replacement of the collateral security in cases where the exposure to the bank exceeds acceptable levels. The Company's largest exposure to an individual bank amounted to $10.3 million at December 31, 1997 (1996--$12.1 million). The IPC Companies have a $290 million Letter of Credit facility pursuant to which letters of credit are issued on their behalf to the Legion Companies and certain other US insurance companies. This facility is fully collateralized by incoming letters of credit and funds on deposit. The facility is guaranteed by the Company. At December 31, 1997 a reserve for uncollectible reinsurance of $.6 million was outstanding.
C. The Company's Reserve for unearned premiums and Reserve for losses and loss expenses exclude reserves related to Premiums ceded to the IPC Companies, where the program holders assume the underwriting risk relating to such premium (see Note 2A(ii)). These reserves are included in Liabilities related to separate accounts and amounted to $468.3 million at December 31, 1997 (1996--$425.2 million). Clients of the Company's IPC Program generally agree, as part of a Shareholder Agreement, to indemnify the Company against certain underwriting losses on the IPC Program. Clients generally provide letters of credit or cash deposits as collateral for this indemnification, either in the full amount of the potential net loss or to the level of expected losses as projected by the Company. These contractual indemnifications from clients, whether fully or partially secured, amounted to approximately $102.2 million at December 31, 1997 (1996--$97.9 million) of which $38.1 million (1996--$27.6 million) is uncollateralized. The uncollateralized amounts will vary based on the
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DECEMBER 31, 1997
underwriting results of the IPC Programs. Management reviews its collateral security position at the inception and renewal of each IPC Program in order to minimize the risk of loss. In order for the Company to sustain a loss on the portion of such indemnity agreement secured by a letter of credit, the Company would have to be unable to collect from both the client and the bank issuing the letter of credit. The Company has a credit exposure in the event that losses exceed their expected level and the client is unable or unwilling to honor its indemnity to the Company or fails to pay the premium due. For these reasons the Company has established provisions for losses on certain of these programs. These provisions, which totalled $5.6 million at December 31, 1997 (1996--$4.5 million), reduced the level of Risk management fees by $1.1 million, $.5 million and $.2 million for the years ending December 31, 1997, 1996 and 1995 respectively.
D. Premiums earned are the result of the following:
4. RESERVE FOR LOSSES AND LOSS EXPENSES
The following table sets forth a reconciliation of beginning and ending reserves for losses and loss expenses.
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DECEMBER 31, 1997
5. INVESTMENTS
A. Cash and cash equivalents include amounts invested in commercial paper at December 31, 1997 of $23.4 million (1996--$13.6 million). Substantially all of the remaining amount is invested in money market or interest-bearing bank accounts.
B. (i) All Investments are held as available for sale. The amortized cost and fair market value are as follows:
- -------- (1) The Company invests in Mutual Funds with fair market values of $84 million which are administered by MRM Financial Services Ltd., a wholly-owned subsidiary of the Company.
The Company does not have any investment in a single corporate security which exceeds 1.3% of total bonds at December 31, 1997 (1996--1.0%).
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DECEMBER 31, 1997
The following unrealized gains and losses on available for sale securities have been recorded as a component of Shareholders' equity:
The following table sets forth certain information regarding the investment ratings of the Company's Bond and Redeemable Preferred Share portfolio.
- -------- (1) Ratings as assigned by Standard & Poor's Corporation.
The maturity distribution of Investments in Bonds and Redeemable Preferred Shares is as follows:
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DECEMBER 31, 1997
(ii) Realized gains and losses:
C. Details of investment income by major categories are presented below:
Net investment income is reported after deducting investment income earned on assets related to Claims deposit liabilities. Contract expense represents investment income where the Company has contracted to pay this income to the insured. Investment expenses consisting of investment advisory fees and custodian charges have been deducted from Net investment income.
D. Legion is required by certain states in which it operates to maintain special deposits or provide letters of credit. This obligation amounted to $135.3 million at December 31, 1997 (1996--$126.0 million) and included deposits of $51.3 million (1996--$43.8 million) and letters of credit of $84.0 million (1996--$82.2 million).
6. ZERO COUPON CONVERTIBLE EXCHANGEABLE SUBORDINATED DEBENTURES
On October 30, 1995, the Company issued $324.3 million principal amount of Zero Coupon Convertible Exchangeable Subordinated Debentures ("Debentures") with an aggregate issue price of $115.0 million. The issue price of each Debenture was $354.71 and there will be no periodic payments of interest. The Debentures will mature on October 30, 2015 at $1,000 per Debenture representing a yield to maturity of 5.25% (computed on a semi-annual bond equivalent basis). The Debentures are subordinated to all existing and future senior indebtedness of the Company.
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DECEMBER 31, 1997
Each Debenture is convertible at the option of the holder at any time on or prior to maturity, unless previously redeemed or otherwise purchased by the Company, into Common Shares of the Company at a conversion rate of 21.52 shares per Debenture or an aggregate of 6,978,800 Common Shares. The Debentures may be purchased by the Company, at the option of the holder, as of October 30, 2000, October 30, 2005 and October 30, 2010, at the issue price plus accrued original issue discount. The Company, at its option, may elect to pay such purchase price on any particular purchase date in cash or Common Shares, or any combination thereof. After October 30, 2000, each Debenture is redeemable in cash at the option of the Company for an amount equal to the issue price plus accrued original issue discount.
Prior to October 30, 2000 the Debentures will be purchased for cash by the Company, at the option of the holder, in the event of a Fundamental Change (as defined). In addition, the Company will have the right, under certain circumstances, to require the holders to exchange the Debentures for Guaranteed Zero Coupon Exchangeable Subordinated Debentures due 2015 of Mutual Group Ltd. (the "Exchangeable Debentures"), to be guaranteed on a subordinated basis by the Company. The Exchangeable Debentures will be exchangeable for the Company's Common Shares and will otherwise have terms and conditions substantially identical to the Debentures.
7. DERIVATIVE FINANCIAL INSTRUMENTS
The Company has had only limited involvement with derivative financial instruments and does not use them for trading or speculative purposes. They are utilized to manage interest rate risk. Interest rate swaps are utilized to reduce the potential impact of increases in interest rates on the market value of the fixed income portfolio. At December 31, 1996 and 1997, the Company had no interest rate swaps outstanding.
8. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair value of specific classes of financial instruments. The carrying values of all other financial instruments, as defined by SFAS 107, approximate their fair values due to their short term nature.
Investments:............. The fair market value of Investments is calculated using quoted market prices.
Claims deposit The fair value of Claims deposit liabilities is liabilities:............. calculated by discounting the actuarially determined ultimate loss payouts at a rate of 6%.
Loans receivable:........ See Note 10B.
Debentures:.............. The fair value of the Debentures is calculated using discounted cash flow analyses based on current borrowing rates for similar types of borrowing arrangements.
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DECEMBER 31, 1997
Assets held in separate (a) Within Assets held in separate accounts are accounts:................ cash and marketable investments with a carrying value and fair value of $390.7 million (1996: $378.1 million). Fair value is calculated using quoted market prices (see Note 2A(ii)).
(b) Within the $212.5 million of other assets (1996: $188.1 million) $61.4 million (1996: $73.2 million) are financial instruments. The fair market value of other assets approximates carrying value due to the short term nature of these items (see Note 2A(ii)).
9. INCOME TAXES
The Company is incorporated under the laws of Bermuda and, under current Bermuda law, is not obligated to pay any taxes in Bermuda based upon income or capital gains. The Company has received an undertaking from the Minister of Finance in Bermuda pursuant to the provisions of the Exempted Undertakings Tax Protection Act, 1966, which exempts the Company and its shareholders, other than shareholders ordinarily resident in Bermuda, from any Bermuda taxes computed on profits, income or any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance tax, at least until the year 2016. The Company does not consider itself to be engaged in a trade or business in the United States and accordingly does not expect to be subject to direct United States income taxation. The United States subsidiaries of the Company file a consolidated U.S. federal income tax return. Mutual Indemnity (U.S.) Ltd. and Premium Securities Ltd., Bermuda subsidiaries of the Company, have made irrevocable elections to be taxed as domestic United States corporations. Income tax expense consists of:
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DECEMBER 31, 1997
The effective total tax rate differed from the statutory U.S. federal tax rate for the following reasons:
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1997 and 1996 are presented below:
The movement in deferred tax benefit of $1.2 million for the year ended December 31, 1997 consists of a $2.8 million credit attributable to income for the year and a $1.6 million charge attributable to unrealized gains on investments.
10. REDEEMABLE PREFERRED AND COMMON SHARES
A. Series B Non-Voting Redeemable Preferred Shares--Authorized and issued 2,951,835, par value $1.00 per share. These shares were issued to one of the IPC Companies as the holder of record for the benefit of the IPC Program participants and are entitled to fixed, cumulative, preferential, semi-annual dividends calculated at the six month LIBOR rate based on the redemption price of $2.95 million. The Series B Non-Voting Redeemable Preferred Shares were redeemed for their $1.00 par value or $2.95 million in 1997. The average effective annual interest rate on these shares was 5.0% in 1997 (1996--5.6%; 1995--6.4%).
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DECEMBER 31, 1997
B. Common Shares Subject to Redemption--Issued 937,168 at $1.75 per share. These shares were issued to four executive officers of the Company. The Company has the right to reacquire these shares if the employees default on the loans used for the purchase. The employees have the right to require the Company to repurchase the shares upon a change of control of the Company, as defined. Two subsidiaries of the Company made loans to these executive officers during the third quarter of 1990 for the purchase of the Common Shares Subject to Redemption. These loans are for a period of eight years and bore interest at 7.7% per annum to September 17, 1994, 5.7% to September 17, 1995, 5.4% to September 17, 1996, 5.3% to September 17, 1997 and currently 5.1%. Interest received by the Company on these loans is credited to Redeemable Common Shares on the Consolidated Balance Sheets. The loans are repayable in four equal annual installments commencing September 1995. One loan of $.1 million was repaid on February 1, 1992 and additional amounts totalling $.4 million were repaid during each of 1995, 1996 and 1997. The fair value of these loans estimated using discounted cash flow analyses at 8.5% is $.4 million.
11. SHAREHOLDERS' EQUITY AND RESTRICTIONS
A. In September 1997 the company announced a two-for-one stock split of its Common Shares. In connection with this split the Company issued an additional 18,741,121 Common Shares and 468,584 Common Shares subject to redemption.
B. In May 1996 the Company announced a four-for-three stock split of its Common Shares. In connection with this split the Company issued an additional 4,438,974 Common Shares and 117,146 Common Shares subject to redemption.
C. The Company's ability to pay dividends is subject to certain restrictions including the following:
(i) The Company is subject to a 30% U.S. withholding tax on any dividends received from its U.S. subsidiaries and certain of the IPC Companies.
(ii) The Company's ability to cause the Legion Companies to pay a dividend is limited by insurance regulation to an annual amount equal to the greater of 10% of the Legion Companies' statutory surplus as regards policyholders or the Legion Companies' statutory income for the preceding year. The maximum dividend the Legion Companies will be permitted to pay under this restriction in 1998 is $21.9 million based upon 1997 results (1997--$21.2 million based on 1996 results). The Legion Companies' net assets which were restricted by the above were $208.4 million at December 31, 1997 (1996--$157.2 million). Loans and advances by the Legion Companies to the Company or any other subsidiary would require the prior approval of the Pennsylvania insurance department and possibly other states in which they are licensed.
D. At December 31, 1997 the Legion Companies' combined risk-based capital was $196.8 million (1996--$142.3 million). Under the risk-based capital tests, the threshold requiring the least regulatory involvement was $45.6 million.
E. Net income and policyholders' surplus of the Legion Companies, as filed with regulatory authorities on the basis of statutory accounting practices, are as follows:
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DECEMBER 31, 1997
12. STOCK OPTIONS
Employees have been granted options to purchase Common Shares under the Company's Long Term Incentive Plan. In each case, the option price equals the fair market value of the Common Shares on the day of the grant and an option's maximum term is five to ten years. Options granted vest ratably over a four year period.
In accordance with the provisions of SFAS 123, the Company applies APB Opinion 25 and related Interpretations in accounting for its stock option plans and, accordingly, does not recognize compensation cost. If the Company had elected to recognize compensation cost based on the fair value of the options granted at grant date as prescribed by SFAS 123, net income and earnings per share would have been reduced to the pro forma amounts indicated in the table below:
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:
The weighted average fair value of options granted during 1997 is $7.83 per share (1996--$4.10 per share, 1995--$4.00 per share).
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DECEMBER 31, 1997
The pro forma effect on net income for 1997, 1996 and 1995 is not representative of the pro forma effect on net income in future years because it does not take into consideration pro forma compensation expense related to grants made prior to 1995. Options issued and outstanding under the plan are as follows:
SUMMARY OF OPTIONS OUTSTANDING AT DECEMBER 31, 1997
All options vest 25% annually commencing one year after issuance, except for 770,000 of the options issued in 1996 at a grant price of $15, which were issued to executives of the Company. These options are for 10 years and 75% have vesting schedules tied to the conversion of the Zero Coupon Convertible Exchangeable Subordinated Debentures (see Note 6) and other performance benchmarks.
Options have been granted to each of eight outside directors. All options are for five years and become exercisable six months after issuance.
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DECEMBER 31, 1997
Total options granted to directors are as follows:
13. EARNINGS PER COMMON SHARE
The following table sets forth the computation of basic and diluted earnings per common share.
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DECEMBER 31, 1997
14. SEGMENT INFORMATION
Selected information by business segment is summarized in the chart below.
LINE OF BUSINESS FINANCIAL INFORMATION
- -------- (1) Fee income from two clients accounted for 2% and 2% of total Fee income in 1997 (1996--3% and 2%; 1995--4% and 4%). No other client accounted for over 10% of Risk management fees during these periods. Premiums earned from two clients accounted for 5% and 4% of total Premiums earned during 1997 (1996--5% and 4%; 1995--4% and 3%).
The subsidiaries' accounting records do not capture information by reporting segment sufficient to determine identifiable assets by such reporting segments.
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DECEMBER 31, 1997
15. FOREIGN SALES AND OPERATIONS
The Company's non-U.S. operations include Bermuda, Barbados, the Cayman Islands and Europe.
FINANCIAL INFORMATION RELATING TO GEOGRAPHIC AREAS
- -------- (1) Includes Assets held in separate accounts of $625.2 million, $576.7 million and $525.2 million for 1997, 1996 and 1995 respectively.
16. ACQUISITIONS
During 1997 the Company acquired several new businesses for a total of $19.6 million (1996--$28.6 million). The excess of the purchase price over net assets acquired was $18.7 million (1996--$6.3 million). The pro forma effect on the Company's revenue, net income and earnings per share is not material.
17. RELATED PARTY TRANSACTIONS
A. $.9 million (1996--$.6 million; 1995--$.8 million) of fee income and $4.2 million (1996--$2.9 million; 1995--$(.6) million) of premiums were earned from a certain IPC Program participant associated with a director and shareholder of the Company.
B. A number of subsidiaries of the Company have written business involving subsidiaries of The Galtney Group, Inc. ("GGI") of which a director of the Company is the principal shareholder. During 1997 the Company paid fees of $4.3 million on such business to GGI (1996--$3.5 million; 1995--$2.1 million) and received $Nil in fees from GGI (1996--$Nil; 1995--$Nil). During 1995 the Company sold its holding of GGI shares for $1.3 million, realizing a gain of $.4 million.
C. The Company and its subsidiaries provide administrative and accounting services to a number of unaffiliated insurance and reinsurance companies. Certain officers, directors and employees of the Company serve as officers and directors of these companies, generally without remuneration.
MUTUAL RISK MANAGEMENT LTD. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
DECEMBER 31, 1997
D. Two subsidiaries of the Company made loans to four executive officers in 1990 for the purchase of Common Shares (see Note 10B).
E. In connection with the Company's acquisition of The Hemisphere Group Limited ("Hemisphere") in July 1996, the Company acquired a 40% interest in the Hemisphere Trust Company Limited ("Hemisphere Trust"), a Bermuda "local" trust company, which had formerly been a wholly owned subsidiary of Hemisphere. As a "local" Bermuda company, at least 60% of the shares of Hemisphere Trust must be owned by Bermudians. In compliance with this requirement, Mr. Robert A. Mulderig, Chairman and CEO of the Company, acquired 60% of Hemisphere Trust for $.2 million at the time of the Company's acquisition of Hemisphere. The amount of the purchase price was equal to 60% of the book value of Hemisphere Trust on the date of acquisition.
The Company and Mr. Mulderig have entered into a Shareholders' Agreement relating to Hemisphere Trust which provides, amongst other things, that (i) the Company has the option, subject to regulatory approval to acquire Mr. Mulderig's interest in Hemisphere Trust at Mr. Mulderig's cost, plus interest at 6% per annum; (ii) the Company has a pre-emptive right, also subject to regulatory approval, over the shares held by Mr. Mulderig and (iii) no dividends or other distributions can be made by Hemisphere Trust without the prior consent of the Company.
18. QUARTERLY FINANCIAL DATA--(UNAUDITED)
- -------- (1) The 1996 and first three quarters of 1997 earnings per share amounts have been restated to comply with SFAS 128 (see Note 2I). (2) Prior periods per share calculations have been restated to reflect the four-for-three stock split to holders of record at May 31, 1996 and the two-for-one stock split to holders of record at September 26, 1997.
INDEPENDENT AUDITORS' REPORT
[LOGO] ERNST & YOUNG
To the Board of Directors and Shareholders Mutual Risk Management Ltd.
We have audited the accompanying consolidated balance sheets of Mutual Risk Management Ltd. and subsidiaries as of December 31, 1997 and 1996 and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Mutual Risk Management Ltd. and subsidiaries at December 31, 1997 and 1996 and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1997 in conformity with accounting principles generally accepted in the United States.
/s/ Ernst & Young
Hamilton, Bermuda February 17, 1998
SCHEDULE II
MUTUAL RISK MANAGEMENT LTD. CONDENSED FINANCIAL INFORMATION OF REGISTRANT PARENT COMPANY ONLY BALANCE SHEETS
See Notes to Consolidated Financial Statements.
S-1
SCHEDULE II
MUTUAL RISK MANAGEMENT LTD. CONDENSED FINANCIAL INFORMATION OF REGISTRANT PARENT COMPANY ONLY INCOME STATEMENTS
See Notes to Consolidated Financial Statements
S-2
SCHEDULE II
MUTUAL RISK MANAGEMENT LTD.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT PARENT COMPANY ONLY STATEMENTS OF CASH FLOWS
See Notes to Consolidated Financial Statements.
S-3
SCHEDULE VI
MUTUAL RISK MANAGEMENT LTD.
SUPPLEMENTARY INSURANCE INFORMATION (U.S. DOLLARS IN THOUSANDS)
- ---- (1) Medical malpractice reserves have been discounted at 6% in 1997, 1996 and 1995. Workers' compensation reserves have been discounted at 4% in 1997, 1996 and 1995.
S-4