<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
__________
FORM 8-K/A
CURRENT REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
__________
Date of report (Date of earliest event reported) APRIL 1, 1998
--------------------------
ZENITH NATIONAL INSURANCE CORP.
- ------------------------------------------------------------------------------
(Exact Name of Registrant as Specified in its Charter)
DELAWARE 1-9627 95-2702776
- ------------------------------------------------------------------------------
(State or Other Jurisdiction (Commission (IRS Employer
of Incorporation) File Number) Identification No.)
21255 CALIFA STREET, WOODLAND HILLS, CALIFORNIA 91367-5021
- -------------------------------------------------------------------------------
(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code (818) 713-1000
--------------------------
- ------------------------------------------------------------------------------
(Former Name or Former Address, if Changed Since Last Report)
1
<PAGE>
On April 16, 1998, the undersigned Registrant filed a Form 8-K dated April 1,
1998. Registrant hereby amends such Form 8-K to provide clarification and update
Item 2 and provide information under Item 7(a) and 7(b).
The Registrant cautions the reader of the Financial Statements of the Business
Acquired and the unaudited PRO FORMA Financial Statements, as follows:
RISCORP, INC.'S CONSOLIDATED FINANCIAL STATEMENTS. The Consolidated
Financial Statements of RISCORP, Inc. that are set out herein were prepared
by RISCORP, Inc., and audited by its independent accountants, KPMG Peat
Marwick LLP. They represent historical financial information for RISCORP,
Inc. and its consolidated subsidiaries. The Registrant specifically
disclaims any responsibility for the accuracy or completeness of RISCORP,
Inc.'s Consolidated Financial Statements.
The Consolidated Financial Statements of RISCORP are included in order
to comply with the Rules and Regulations under the Securities Exchange
Act of 1934, as amended. Under the Asset Purchase Agreement, certain
assets and liabilities shown in the Consolidated Financial Statements of
RISCORP, Inc. were not, or will not be, included in the acquired assets
and liabilities. As a consequence, the Consolidated Financial Statements
of RISCORP may differ materially from the assets and liabilities
acquired by Zenith Insurance. At the closing, effective April 1, 1998,
Zenith Insurance paid the minimum purchase price of $35 million in cash
and assumed and repaid $15 million of indebtedness of RISCORP, Inc. The
final purchase price will be determined by an audit and a dispute
resolution process, and cannot be determined at this time.
Consequently, the results of operations and the related assets and
liabilities acquired may be materially different from that reported in
RISCORP, Inc.'s Consolidated Financial Statements.
UNAUDITED PRO FORMA COMBINED CONDENSED BALANCE SHEET AND UNAUDITED PRO
FORMA COMBINED CONDENSED STATEMENT OF OPERATIONS. The unaudited pro
forma combined condensed balance sheet estimates the pro forma combined
condensed effect of the acquisition as if the acquisition and the
transactions contemplated in the Asset Purchase Agreement had been
consummated on December 31, 1997. The unaudited pro forma combined
condensed statement of operations estimates the effect of the
acquisition as if such acquisition had occurred on January 1, 1997. The
pro forma data may not be indicative of the results of operations and
financial position of the Registrant, as it may be in the future or as
it might have been had the transactions been consummated on the
respective dates assumed. The information should be read in conjunction
with the historical consolidated financial statements and accompanying
notes of the Registrant previously filed in its Form 10-K for the year
ended December 31, 1997, the Proxy Statement of RISCORP, Inc. dated
March 3, 1998 and the historical consolidated financial statements and
accompanying notes of RISCORP, Inc. for the year ended December 31, 1997
contained herein. The pro forma balance sheet and income statement
includes historical information derived from RISCORP, Inc.'s
Consolidated Financial Statements and to such extent is subject to the
disclaimers and qualifications described above. Since the pro forma
combined condensed statement of operations reflects results of
operations for the year ended December 31, 1997, it does not reflect
results of operations for the more recent periods. Financial information
included in the Form 10-Q of RISCORP, Inc. for the first quarter of 1998
indicates that RISCORP, Inc. experienced a net loss for the first
quarter of 1998.
2
<PAGE>
FORWARD-LOOKING INFORMATION. The Private Securities Litigation Reform Act
of 1995 provides a safe harbor for forward-looking statements if
accompanied by meaningful cautionary statements identifying important
factors that could cause actual results to differ materially from those
discussed. Forward-looking statements include those related to the plans
and objectives of management for future operations, future economic
performance, or projections of revenues, income, earnings per share,
capital expenditures, dividends, capital structure, or other financial
items. Statements containing words such as EXPECT, ANTICIPATE, BELIEVE, or
similar words that are used in Management's Discussion and Analysis of
Consolidated Financial Condition and Results of Operations, in other parts
of Zenith's Annual Report on Form 10-K pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934 for the fiscal year ended December 31,
1997, in other parts of Zenith's 1997 Annual Report to Stockholders or in
other written or oral information conveyed by or on behalf of Zenith are
intended to identify forward-looking statements. Zenith undertakes no
obligation to update such forward-looking statements, which are subject to
a number of risks and uncertainties that could cause actual results to
differ materially from those projected. These risks and uncertainties
include but are not limited to the following: (1) heightened competition,
particularly intense price competition; (2) adverse state and federal
legislation and regulations; (3) changes in interest rates causing a
reduction of investment income; (4) general economic and business
conditions which are less favorable than expected; (5) unanticipated
changes in industry trends; (6) adequacy of loss reserves; (7) catastrophic
events or the occurrence of a significant number of storms and wind and
hail losses; (8) ability to timely and accurately complete the Year 2000
conversion process; (9) impact of any failure of third parties with whom
Zenith does business to be Year 2000 compliant; (10) uncertainties with
respect to the RISCORP acquisition, including the ability to integrate the
businesses of RISCORP and (11) other risks detailed herein and from time to
time in Zenith's other reports and filings with the Securities and Exchange
Commission.
3
<PAGE>
ITEM 2. ACQUISITION OR DISPOSITION OF ASSETS.
Effective April 1, 1998, Zenith Insurance Company, a wholly owned
subsidiary of the Registrant ("Zenith Insurance"), closed its
previously announced transaction with RISCORP, Inc. and certain of its
subsidiaries (collectively, "RISCORP"), pursuant to which Zenith Insurance
has acquired substantially all of the assets and assumed certain
liabilities of RISCORP related to its workers' compensation business,
including RISCORP's existing in-force insurance business. Zenith Insurance
also acquired RISCORP's "First Call (sm)" managed care workers'
compensation system. RISCORP has agreed not to engage in the workers'
compensation or managed care businesses. The assets acquired by Zenith
Insurance consist of investments, receivables, reinsurance recoverables,
property, plant and equipment, office leases, certain trade names and other
assets. Real estate acquired by Zenith Insurance was previously used by
RISCORP for its workers' compensation operations and will be used by Zenith
Insurance for its southeast workers' compensation operations.
The final purchase price will be the difference between the book value of
the assets purchased and the book value of the liabilities assumed by
Zenith Insurance as of April 1, 1998, each determined in accordance with
United States generally accepted accounting principles and actuarial
principles consistently applied. The final purchase price is subject to
audit and a dispute resolution process, and cannot be determined at this
time. At the closing, Zenith Insurance paid the minimum purchase price of
$35 million in cash and assumed and repaid $15 million of indebtedness of
RISCORP, Inc. Zenith Insurance will pay any additional purchase price from
internal funds. Nevertheless, the Registrant anticipates that it may, in
the second or third quarter of 1998, issue debt or other securities, the
net proceeds of which may be contributed to Zenith Insurance to strengthen
its capital.
On June 9, 1998, pursuant to the provisions of the Asset Purchase
Agreement between Zenith Insurance and RISCORP, Zenith Insurance
received a Proposed Business Balance Sheet as of April 1, 1998,
indicating that RISCORP's determination of the final purchase price is
approximately $141 million. This balance sheet is currently being
reviewed by Zenith Insurance. As a result of the dispute resolution
process described above, the final purchase price may materially differ
from $141 million proposed by RISCORP.
As part of the closing, Zenith Insurance entered into Assumption and
Indemnity Reinsurance Agreements with each of the three insurance
subsidiaries of RISCORP, Inc.
4
<PAGE>
ITEM 7. FINANCIAL STATEMENTS, PRO FORMA FINANCIAL INFORMATION AND EXHIBITS.
(a) FINANCIAL STATEMENTS OF BUSINESS ACQUIRED. The following Consolidated
Financial Statements of RISCORP, Inc., together with the independent
auditors' report thereon, are included herein:
(i) Consolidated Balance Sheets as of December 31, 1997 and 1996......F-3
(ii) Consolidated Statements of Income for the years ended
December 31, 1997, 1996 and 1995..................................F-5
(iii) Consolidated Statements of Changes in Shareholders' Equity for
the years ended December 31, 1995, 1996 and 1997..................F-6
(iv) Consolidated Statements of Cash Flows for the years ended
December 31, 1997, 1996 and 1995..................................F-7
(b) PRO FORMA FINANCIAL INFORMATION. The Unaudited PRO FORMA combined
condensed balance sheet for Zenith National Insurance Corp. as of
December 31, 1997 and unaudited pro forma combined condensed statement of
operations for the year ended December 31, 1997 and accompanying notes are
included herein.......................................................F-45
(c) EXHIBITS
Number Exhibit
------ -------
10.1 Asset Purchase Agreement, dated as of June 17, 1997, by and among
Zenith Insurance Company and RISCORP, Inc., RISCORP Management
Services, Inc., RISCORP of Illinois, Inc., Independent
Association Administrators Incorporated, RISCORP Insurance
Services, Inc., RISCORP Managed Care Services, Inc., CompSource,
Inc., RISCORP Real Estate Holdings, Inc., RISCORP Acquisition,
Inc., RISCORP West, Inc., RISCORP of Florida, Inc., RISCORP
Insurance Company, RISCORP Property & Casualty Insurance Company,
RISCORP National Insurance Company, RISCORP Services, Inc.,
RISCORP Staffing Solutions Holding, Inc., RISCORP Staffing
Solutions, Inc. I and RISCORP Staffing Solutions, Inc. II.
(Incorporated herein by reference to Exhibit 10.1 to Zenith's
Current Report on Form 8-K dated June 17, 1997.)
5
<PAGE>
Number Exhibit
------ -------
10.2 First Amendment, entered into June 26, 1997, to the
Asset Purchase Agreement dated as of June 17, 1997, by and
among Zenith Insurance Company and RISCORP, Inc., RISCORP
Management Services, Inc., RISCORP of Illinois, Inc.,
Independent Association Administrators Incorporated, RISCORP
Insurance Services, Inc., RISCORP Managed Care Services,
Inc., CompSource, Inc., RISCORP Real Estate Holdings, Inc.,
RISCORP Acquisition, Inc., RISCORP West, Inc., RISCORP of
Florida, Inc., RISCORP Insurance Company, RISCORP Property &
Casualty Insurance Company, RISCORP National Insurance
Company, RISCORP Services, Inc., RISCORP Staffing Solutions
Holding, Inc., RISCORP Staffing Solutions, Inc. I and
RISCORP Staffing Solutions, Inc. II. (Incorporated herein by
reference to Exhibit 10.2 to Zenith's Current Report on Form
8-K dated April 1, 1998.)
10.3 Second Amendment, entered into July 11, 1997, to the
Asset Purchase Agreement dated as of June 17, 1997, by and
among Zenith Insurance Company and RISCORP, Inc., RISCORP
Management Services, Inc., RISCORP of Illinois, Inc.,
Independent Association Administrators Incorporated, RISCORP
Insurance Services, Inc., RISCORP Managed Care Services,
Inc., CompSource, Inc., RISCORP Real Estate Holdings, Inc.,
RISCORP Acquisition, Inc., RISCORP West, Inc., RISCORP of
Florida, Inc., RISCORP Insurance Company, RISCORP Property &
Casualty Insurance Company, RISCORP National Insurance
Company, RISCORP Services, Inc., RISCORP Staffing Solutions
Holding, Inc., RISCORP Staffing Solutions, Inc. I and
RISCORP Staffing Solutions, Inc. II. (Incorporated herein by
reference to Exhibit 10.3 to Zenith's Current Report on Form
8-K dated April 1, 1998.)
6
<PAGE>
Number Exhibit
------ -------
10.4 Amendment No. 3 entered into March 30, 1998, to the
Asset Purchase Agreement dated as of June 17, 1997, by and
among Zenith Insurance Company and RISCORP, Inc., RISCORP
Management Services, Inc., 1390 Main Street Services, Inc.,
RISCORP of Illinois, Inc., Independent Association
Administrators Incorporated, RISCORP Insurance Services,
Inc., RISCORP Managed Care Services, Inc., CompSource, Inc.,
RISCORP Real Estate Holdings, Inc., RISCORP Acquisition,
Inc., RISCORP West, Inc., RISCORP of Florida, Inc., RISCORP
Insurance Company, RISCORP Property & Casualty Insurance
Company, RISCORP National Insurance Company, RISCORP
Services, Inc., RISCORP Staffing Solutions Holding Company,
RISCORP Staffing Solutions, Inc. I and RISCORP Staffing
Solutions, Inc. II. (Incorporated herein by reference to
Exhibit 10.4 to Zenith's Current Report on Form 8-K dated
April 1, 1998.)
10.5 Assumption and Indemnity Reinsurance Agreement, dated
as of April 1, 1998, by and between Zenith Insurance Company
and RISCORP National Insurance Company. (Incorporated herein
by reference to Exhibit 10.5 to Zenith's Current Report on
Form 8-K dated April 1, 1998.)
10.6 Assumption and Indemnity Reinsurance Agreement, dated
as of April 1, 1998, by and between Zenith Insurance Company
and RISCORP Insurance Company. (Incorporated herein by
reference to Exhibit 10.6 to Zenith's Current Report on
Form 8-K dated April 1, 1998.)
10.7 Assumption and Indemnity Reinsurance Agreement, dated
as of April 1, 1998, by and between Zenith Insurance Company
and RISCORP Property & Casualty Insurance Company.
(Incorporated herein by reference to Exhibit 10.7 to
Zenith's Current Report on Form 8-K dated April 1, 1998.)
23 Consent of KPMG Peat Marwick LLP, dated June 12, 1998.
99 Press Release of Zenith National Insurance Corp. dated April 2,
1998. (Incorporated herein by reference to Exhibit 99 to Zenith's
Current Report on Form 8-K dated April 1, 1998.)
7
<PAGE>
Item 7 (a) Financial Statements of Business Acquired
RISCORP, INC.
Consolidated Financial Statements
for the Year Ended December 31, 1997 and
Independent Auditors' Report
<PAGE>
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders
RISCORP, Inc.:
We have audited the accompanying consolidated balance sheets of RISCORP, Inc.
and subsidiaries as of December 31, 1997 and 1996, and the related
consolidated statements of income, changes in shareholders' equity and cash
flows for each of the years in the three-year period ended December 31, 1997.
These consolidated financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. 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.
As discussed in Note 1(a) to the accompanying consolidated financial
statements, during November 1996, the Company undertook a strategic
initiative to evaluate alternatives to maximize shareholder value. The
initiative has resulted in the pending sale and transfer of certain assets
and non-contingent liabilities of the Company and its subsidiaries. As
requested by the Florida Department of Insurance, cut-through endorsements
and an interim reinsurance agreement have been executed in connection with
the pending sale. The sale is subject to the approval of the shareholders of
the Company. The Company's ability to operate at its present level of
activity may be affected if the pending sale transaction is not completed.
Further, as discussed in Note 19, the Company and its subsidiaries have been
named as defendants in various lawsuits.
F-1
<PAGE>
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of RISCORP,
Inc. and subsidiaries at December 31, 1997 and 1996, and the results of
their operations and their cash flows for each of the years in the three-year
period ended December 31, 1997, in conformity with generally accepted
accounting principles.
KPMG Peat Marwick LLP
Fort Lauderdale, Florida
March 24, 1998
F-2
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1997 AND 1996
(in thousands, except share and per share data)
<TABLE>
<CAPTION>
DECEMBER 31, DECEMBER 31,
1997 1996
----------- ------------
ASSETS
<S> <C> <C>
Investments:
Fixed maturities available for sale, at fair value
(amortized cost $142,876 in 1997 and $226,240 in 1996) $ 145,571 $ 228,802
Fixed maturities available for sale, at fair value
(amortized cost $53,437 in 1997)--restricted 53,820 -
Fixed maturities held to maturity, at amortized cost
(fair value $24,347 in 1997 and $22,892 in 1996) 24,090 22,809
Equity securities, at fair value (cost $3,880 in 1996) - 4,045
----------- ------------
Total investments 223,481 255,656
Cash and cash equivalents 16,858 26,307
Cash and cash equivalents--restricted 13,295 -
Premiums receivable, net 100,183 122,078
Accounts receivable--other 16,720 11,676
Recoverable from Florida Special Disability Trust Fund, net 45,211 49,505
Reinsurance recoverables 184,251 180,698
Prepaid reinsurance premiums 29,982 49,788
Prepaid managed care fees 8,420 31,958
Accrued reinsurance commissions 37,188 20,419
Deferred income taxes 22,120 22,551
Property and equipment, net 26,665 27,505
Goodwill 15,286 22,648
Other assets 9,990 7,653
----------- ------------
Total assets $ 749,650 $ 828,442
----------- ------------
----------- ------------
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
F-3
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1997 AND 1996
(in thousands, except share and per share data)
<TABLE>
<CAPTION>
DECEMBER 31, DECEMBER 31,
1997 1996
------------ ------------
LIABILITIES AND SHAREHOLDERS' EQUITY
<S> <C> <C>
Liabilities:
Losses and loss adjustment expenses $ 437,038 $ 458,239
Unearned premiums 56,324 102,562
Notes payable of parent company 15,000 15,000
Notes payable of subsidiaries 609 1,303
Accounts and notes payable--related party - 1,171
Deposit balances payable 5,512 4,787
Accrued expenses and other liabilities 65,885 74,706
Net assets in excess of cost of business acquired 5,749 11,266
------------ ------------
586,117 669,034
------------ ------------
Class A Common Stock subject to put options - 2,100
------------ ------------
Shareholders' equity:
Class A Common Stock, $.01 par value, 100,000,000 shares
authorized; shares issued and outstanding: 11,855,917 in
1997 and 1996 120 120
Class B Common Stock, $.01 par value, 100,000,000 shares
authorized; shares issued and outstanding: 24,334,443 in
1997 and 1996 243 243
Preferred stock, $.01 par value, 10,000,000 shares authorized;
0 shares issued and outstanding - -
Additional paid-in capital 135,974 137,813
Net unrealized gains on investments 2,002 1,769
Unearned compensation--stock options - (546)
Retained earnings 25,195 17,909
Treasury stock--at cost, 112,582 shares (1) -
------------ ------------
Total shareholders' equity 163,533 157,308
------------ ------------
Total liabilities and shareholders' equity $ 749,650 $ 828,442
------------ ------------
------------ ------------
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
F-4
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
(in thousands, except share and per share data)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------------
1997 1996 1995
---------- ---------- ----------
<S> <C> <C> <C>
Revenues:
Premiums earned $ 179,729 $ 173,557 $ 135,887
Fee and other income 20,369 31,733 22,397
Net realized gains 1,546 105 1,016
Net investment income 16,447 12,194 6,708
---------- ---------- ----------
Total revenues 218,091 217,589 166,008
---------- ---------- ----------
Expenses:
Losses and loss adjustment expenses 104,052 114,093 82,532
Unallocated loss adjustment expenses 19,311 12,916 10,133
Commissions, general and administrative expenses 70,800 65,685 48,244
Interest 1,919 2,795 4,634
Depreciation and amortization 7,423 11,500 1,683
---------- ---------- ----------
Total expenses 203,505 206,989 147,226
---------- ---------- ----------
Income before income taxes 14,586 10,600 18,782
Income taxes 7,300 8,202 5,099
---------- ---------- ----------
Net income $ 7,286 $ 2,398 $ 13,683
---------- ---------- ----------
---------- ---------- ----------
Per share data:
Net income per common share-basic $ 0.20 $ 0.07 $ 0.49
---------- ---------- ----------
---------- ---------- ----------
Net income per common share-diluted $ 0.20 $ 0.07 $ 0.45
---------- ---------- ----------
---------- ---------- ----------
Weighted average common shares outstanding 36,891,864 34,647,986 28,100,234
---------- ---------- ----------
---------- ---------- ----------
Weighted average common shares and common share equivalents
outstanding 37,115,672 36,405,588 30,092,500
---------- ---------- ----------
---------- ---------- ----------
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
F-5
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1995, 1996, AND 1997
(in thousands)
<TABLE>
<CAPTION>
NET
UNREALIZED
CLASS A CLASS B ADDITIONAL GAINS TOTAL
COMMON COMMON PAID-IN (LOSSES) ON UNEARNED RETAINED TREASURY SHAREHOLDERS'
STOCK STOCK CAPITAL INVESTMENTS COMPENSATION EARNINGS STOCK EQUITY
-------- ------- ----------- ----------- ------------ --------- -------- ------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance, January 1, 1995 $ - $ 281 $ 349 $ (560) $ (930) $ 4,755 $ - $ 3,895
Net income - - - - - 13,683 - 13,683
Distributions - - - - - (3,206) - (3,206)
Change in unearned compensation - - - - 715 - - 715
Change in net unrealized gains
on investments - - - 1,070 - - - 1,070
-------- ------- ----------- ----------- ------------ --------- -------- ------------
Balance, December 31, 1995 - 281 349 510 (215) 15,232 - 16,157
Net income - - - - - 2,398 - 2,398
Distributions - - - - - 279 - 279
Issuance of common stock 72 - 125,789 - - - - 125,861
Conversion of common stock 38 (38) - - - - - -
Stock options exercised 2 - 63 - - - - 65
Issuance of common stock for -
acquisitions 8 - 10,891 - - - - 10,899
Change in unearned compensation - - 721 - (331) - - 390
Change in net unrealized gains
on investments - - - 1,259 - - - 1,259
-------- ------- ----------- ----------- ------------ --------- -------- ------------
Balance, December 31, 1996 120 243 137,813 1,769 (546) 17,909 - 157,308
Net income - - - - - 7,286 - 7,286
Purchase of treasury stock - - 1 - - - (1) -
Change in unearned compensation - - (1,840) - 546 - - (1,294)
Change in net unrealized gains on
investments - - - 233 - - - 233
-------- ------- ----------- ----------- ------------ --------- -------- ------------
Balance, December 31, 1997 $ 120 $ 243 $ 135,974 $ 2,002 $ - $ 25,195 $ (1) $ 163,533
-------- ------- ----------- ----------- ------------ --------- -------- ------------
-------- ------- ----------- ----------- ------------ --------- -------- ------------
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
F-6
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
(in thousands)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------------
1997 1996 1995
---------- ----------- ----------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income $ 7,286 $ 2,398 $ 13,683
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization 7,423 11,500 1,683
Loss on disposal of property and equipment 291 294 22
Net amortization (accretion) of discounts on investments 14 174 (82)
Net realized gain on sale of investments (1,545) (140) (1,282)
Change in:
Premiums receivable, net 22,026 (24,275) (23,744)
Accounts receivable--other (5,104) (11,676) -
Recoverable from Florida State Disability
Trust Fund, net 4,295 2,331 (5,920)
Reinsurance recoverables (3,553) (76,971) (58,534)
Prepaid reinsurance premiums 19,807 (27,908) (21,880)
Prepaid managed care fees 23,537 (15,589) (15,068)
Accrued reinsurance commissions (16,770) (12,870) (7,549)
Deferred income taxes 431 (8,448) 106
Other assets (3,249) 21,026 3,110
Losses and loss adjustment expenses (21,502) 106,484 51,827
Unearned premiums (46,280) 30,891 7,315
Accounts payable related party (1,171) 171 1,000
Accounts and notes receivable--related party - 10,754 642
Accrued expenses and other liabilities (8,880) 19,909 7,420
---------- ----------- ----------
Net cash (used in) provided by operating activities (22,944) 28,055 (47,251)
---------- ----------- ----------
Cash flows from investing activities:
Proceeds from:
Sale of fixed maturities--available for sale 110,299 88,900 60,303
Maturities of fixed maturities--available for sale 20,243 6,295 10,209
Sale of equity securities 4,109 732 1,162
Maturities of fixed maturities--held to maturity 1,885 4,400 -
Maturities of equity securities 175 - -
Sale of equipment 158 532 564
Purchase of:
Maryland NARM Fund, net of cash acquired 134 - -
Fixed maturities--available for sale (100,499) (191,153) (23,543)
Property and equipment (4,477) (13,215) (6,393)
Fixed maturities--held to maturity (1,237) (2,452) -
Equity securities (637) (3,952) (341)
RISCORP Insurance Company, net of cash acquired - - 5,885
IAA, net of cash acquired - 282 -
RISC, net of cash acquired - (538) -
</TABLE>
F-7
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
(in thousands)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------------------------
1997 1996 1995
----------- ------------ ------------
<S> <C> <C> <C>
Cash flows from investing activities (CONTINUED):
CompSource and Insura, net of cash acquired - (10,733) -
Purchase of:
Atlas Insurance Company, net of cash acquired - (5,573) -
NARM, net of cash acquired - 2,717 -
Virginia Funds, net of cash acquired - 1,300 -
----------- ---------- -------
Net cash provided by (used in) investing activities 30,153 (122,458) 47,846
----------- ---------- -------
Cash flows from financing activities:
Increase (decrease) in deposit balances payable 725 968 (6,980)
Decrease (increase) in unearned compensation 546 (331) 715
Transfer of cash and cash equivalents to restricted balances (13,295) - -
Purchase of common stock (treasury stock) subject to
put options (2,100) - -
Other, net (1,840) (1,325) -
Principal repayments of notes payable (694) (30,202) (25,215)
Proceeds from notes payable - - 43,692
Shareholder distributions - 279 (3,206)
Proceeds of initial offering of common stock - 127,908 -
Stock options exercised - 65 -
----------- ---------- ------------
Net cash (used in) provided by financing activities (16,658) 97,362 9,006
----------- ---------- ------------
Net (increase) decrease in cash and cash equivalents (9,449) 2,959 9,601
Cash and cash equivalents, beginning of period 26,307 23,348 13,747
----------- ----------- ------------
Cash and cash equivalents, end of period $ 16,858 $ 26,307 $ 23,348
----------- ----------- ------------
----------- ----------- ------------
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest $ 1,928 $ 3,689 $ 3,966
----------- ----------- ------------
----------- ----------- ------------
Income taxes $ 6,566 $ 15,127 $ 4,969
----------- ----------- ------------
----------- ----------- ------------
</TABLE>
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
F-8
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) BACKGROUND
(a) REORGANIZATION
RISCORP, Inc. was formed on February 28, 1996 through the
reorganization and consolidation of several affiliated companies
(collectively, "RISCORP" or the "Company") which were under the common
control of a majority shareholder, who, at that time, was the Chairman of the
Board and Chief Executive Officer of RISCORP (see Note 21). The
reorganization and consolidation qualified as a tax-free reorganization of
commonly controlled entities and was accounted for in a manner similar to a
"pooling of interests." Accordingly, the consolidated financial statements
have been restated to include the results of each of the individual companies
for all the periods presented. All significant intercompany accounts and
transactions have been eliminated in consolidation and the accompanying
consolidated financial statements reflect the above changes to the Company's
capital structure for all periods presented.
On November 9, 1996, at a Special Board of Directors' meeting of
RISCORP, the Board voted to establish a Strategic Alternatives Committee to
evaluate alternatives to maximize shareholder value including, without
limitation, potential acquisitions, joint ventures, mergers, strategic
alliances and the sale of all or part of RISCORP and its subsidiaries. The
actions of the Strategic Alternatives Committee during the period of November
1996 through June 1997 culminated in the June 17, 1997 agreement (as more
fully described in Note 20) for the sale and transfer of certain of RISCORP's
and its subsidiaries' assets and non-contingent liabilities to another
insurer for cash. The pending sale, which is anticipated to take place in
early 1998, requires the filing of a proxy statement with the Securities and
Exchange Commission ("SEC"), the approval of the transaction by RISCORP
shareholders and approval by the Florida and Missouri Departments of
Insurance ("FDOI" and "MDOI", respectively), amongst other conditions.
In addition, the FDOI requested the purchaser to provide an interim
reinsurance agreement and cut-through endorsement ("Agreement") on all
inforce business as of June 17, 1997 and all new and renewed business written
after June 17, 1997. This Agreement only provides coverage for Florida
workers' compensation policyholders and was approved by the FDOI. The
ability of RISCORP Insurance Company ("RIC") and RISCORP Property & Casualty
Insurance Company ("RPC") to operate at their present level of insurance
activity could be affected if the transaction discussed in Note 20 is not
completed and RIC and RPC are unable to replace the reinsurance agreement.
Management believes it could replace this reinsurance agreement under similar
terms.
RISCORP experienced difficulty in completing its 1996 financial
statements in a timely manner. This resulted in RISCORP being delisted by
the stock exchange (NASDAQ) on which its stock was traded on July 2, 1997 and
in adverse publicity in the insurance marketplace. RISCORP filed its 1996
Form 10-K/A on October 28, 1997 and amended the 1996 Form 10-K/A on
February 27, 1998 in response to comments received from the SEC in connection
with the preparation of the Company's proxy statement which was mailed to
shareholders on March 3, 1998. In addition, RISCORP has filed all of its
1997 Form 10-Q's with the SEC. RISCORP has not requested to be reinstated on
the NASDAQ stock exchange.
F-9
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(b) INITIAL PUBLIC OFFERING ("IPO") OF COMMON STOCK
On February 29, 1996, the Company completed an IPO of common stock
with the issuance of 10.935 million shares of Class A Common Stock. Of the
shares offered, 7.2 million were sold by the Company and 3.735 million were
sold by the majority shareholder of the Company. The following table
reflects certain summary information regarding the IPO:
<TABLE>
<CAPTION>
UNDERWRITING
NUMBER PRICE DISCOUNTS AND NET
SHARES SOLD BY OF SHARES TO PUBLIC COMMISSIONS PROCEEDS
-------------- ---------- ----------- ------------- ------------
<S> <C> <C> <C> <C>
RISCORP 7,200,000 $19.00 $ 8,892,000 $127,908,000
Shareholder 3,735,000 $19.00 4,612,725 66,352,275
---------- ------------ ------------
10,935,000 $ 13,504,725 $194,260,275
---------- ------------ ------------
---------- ------------ ------------
</TABLE>
The net proceeds reflected above are before deducting other expenses
of $2.0 million incurred in conjunction with the IPO.
The Company used the proceeds from the IPO to repay outstanding
debt, fund acquisitions, increase the capital and surplus of the Company's
insurance subsidiaries and for general corporate purposes.
The Company did not receive any proceeds from the sale of Class A
Common Stock by the majority shareholder; however, a portion of the majority
shareholders' proceeds was used to repay $9.8 million in outstanding
indebtedness to the Company.
(c) BUSINESS
RISCORP, through its wholly-owned insurance subsidiaries, is
primarily engaged in providing workers' compensation insurance under a
managed care philosophy. RISCORP provides managed care workers' compensation
products and services to clients throughout the Southeast and other select
markets. In addition, RISCORP, through its wholly-owned non-insurance
subsidiaries, provides reinsurance, risk management advisory services and
insurance managerial services.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) BASIS OF PRESENTATION
The accompanying consolidated financial statements have been
presented in accordance with generally accepted accounting principles ("GAAP").
The preparation of financial statements in conformity with GAAP requires the
use of assumptions and estimates in reporting certain assets and liabilities
and related disclosures. Actual results could differ from those estimates.
F-10
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(b) RECOGNITION OF REVENUES
Workers' compensation and employer liability insurance premiums
consist of deposit premiums and installment premiums billed under the terms
of the policy, and estimates of retrospectively-rated premiums based on
experience incurred under these contracts to date. Unbilled installment
premiums and audit premiums are recognized as revenue on the accrual basis.
Premiums are primarily recognized as revenue over the period to which the
premiums relate using the daily pro rata basis with a liability for unearned
premium recorded for the excess of premiums billed over the earned premiums.
Service fee revenue is recorded as a percentage of standard earned
premiums of the underlying insurance policies of the facilities managed, in
accordance with the specific contractual provisions.
Reinsurance premiums are recognized as revenue on a pro rata basis
over the contract term with a liability for unearned premiums established for
the unexpired portion of the contract.
(c) STATE OF FLORIDA SPECIAL DISABILITY TRUST FUND
The State of Florida maintains a Special Disability Trust Fund
("SDTF") for the purpose of providing benefits to workers who have a
pre-existing condition and incur a second or subsequent injury.
The SDTF is financed through annual assessments imposed on workers'
compensation insurers, which is based on a percentage of net workers'
compensation premiums written. The Company submits claims to the SDTF for
recovery of applicable claims paid on behalf of the Company's insureds. The
Company estimates such recoveries based on industry statistics applied to
ultimate projected claims. The amounts reflected as SDTF recoveries in the
accompanying Consolidated Balance Sheets are net of a valuation allowance of
$0 and $8.9 million as of December 31, 1997 and 1996, respectively. The
allowance is determined based upon the actuarially estimated recoverable
amount compared to the estimated recovery actually expected from the SDTF by
RISCORP on reported claims (see Note 6). At December 31, 1997, the
actuarially estimated recoverable amount exceeded the amount of the estimated
recoveries on reported claims to the SDTF.
(d) INVESTMENTS
Fixed maturity investments are securities that mature at a specified
future date more than one year after being issued. Fixed maturity securities
that the Company intends to hold until maturity are classified as "fixed
maturities held to maturity" and are carried at amortized cost. Amortized
cost is based on the purchase price and is adjusted periodically so the
carrying value of the security will equal the face or par value at maturity.
Fixed maturity securities which may be sold prior to maturity due to changes
in interest rates, prepayment risks, liquidity needs, tax planning purposes
or other similar factors, are classified as "available for sale" and are
carried at fair value as determined using values from independent pricing
services.
Equity securities (common and nonredeemable preferred stock) are
carried at fair value. If the current market value of equity securities is
higher than the original cost, the excess is an unrealized gain,
F-11
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
and if lower than the original cost, the difference is an unrealized loss.
The net unrealized gains or losses on equity securities, net of the related
deferred income taxes, are reported as a separate component of shareholders'
equity, along with the net unrealized gains or losses on fixed maturity
securities available for sale.
Realized gains and losses on sales of investments are recognized in
net income on the specific identification basis, as of the trade date.
Impairment losses, if any, resulting from other than temporary declines in
fair value are included in net investment income.
(e) LOSSES AND LOSS ADJUSTMENT EXPENSES
The liability for losses and loss adjustment expenses is based on an
actuarial determination and represents management's best estimate of the
ultimate cost of losses and loss adjustment expenses that are unpaid at year
end including incurred but not reported claims. Although the liabilities are
supported by actuarial projections and other data, such liabilities are
ultimately based on management's reasoned expectations of future events. It
is possible that the expectations associated with these accounts could change
in the near future (i.e., within one year) and that the effect of these
changes could be material to the financial statements. The liability for
losses and loss adjustment expenses is continually reviewed and as
adjustments become necessary, such adjustments are included in current
operations.
Management believes that the liability for losses and loss
adjustment expenses at December 31, 1997 is adequate to cover the ultimate
liability. However, the ultimate settlement of losses and the related loss
adjustment expenses may vary from the amounts in the accompanying financial
statements.
The Company recognizes reinsurance recoveries, estimated recoveries
from the SDTF and subrogation from third parties as reductions to losses
incurred.
(f) REINSURANCE
Premiums and losses ceded under reinsurance contracts in which an
assuming enterprise provides indemnification against loss or liability
relating to an insurance risk are reported as a reduction to premium earned
and losses and loss adjustment expenses, respectively. Amounts recoverable
for ceded losses and loss adjustment expenses and ceded unearned premiums
under reinsurance agreements are recorded as assets on the balance sheet.
Reinsurance contracts that do not transfer risk are accounted for as deposits
in the Consolidated Balance Sheets.
(g) INCOME TAXES
The Company accounts for income taxes in accordance with Financial
Accounting Standards Board Statement of Financial Accounting Standards No.
109, "Accounting for Income Taxes," ("SFAS 109"). Under SFAS 109, deferred tax
assets and liabilities are established for temporary differences between the
financial reporting basis and tax basis of the Company's assets and
liabilities at enacted tax rates expected to be in effect when such amounts
are recovered or settled. Such temporary differences are
F-12
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
principally related to the deferral of policy acquisition costs, tax basis
discount on reserves for unpaid losses and loss adjustment expenses, the
deductibility of unearned premiums, the allowance for uncollectible premiums
receivable and the amortization of goodwill. A valuation allowance is
established to reduce deferred tax assets to an amount that, in the opinion
of management, is more likely than not to be realized.
(h) POLICY ACQUISITION COSTS
The cost of acquiring and renewing business, principally
commissions, premium taxes and other underwriting expenses, is deferred to
the extent recoverable and amortized over the term of the related policies.
Anticipated investment income is considered in the determination of
recoverability. Unearned ceding commissions are reported as a reduction to
deferred policy acquisition costs. For the years ended December 31, 1997,
1996 and 1995, policy acquisition costs deferred totaled $41.0 million, $31.8
million and $48.9 million, respectively. For the years ended December 31,
1997, 1996 and 1995, amortization of deferred policy acquisition costs
totaled $49.2 million, $33.7 million and $46.9 million, respectively.
Deferred policy acquisition costs are included in other assets in the
accompanying Consolidated Balance Sheets. Policy acquisition costs are
included in commissions, general and administrative expenses in the
accompanying Consolidated Statements of Income.
(i) GOODWILL
Costs in excess of net assets acquired, or goodwill, represents the
unamortized excess of cost over underlying net assets of companies acquired.
Goodwill is being amortized on a straight-line basis over periods ranging
from 5 to 15 years. Amortization expense, including impairment losses of
$6.0 million in 1996, for the years ended December 31, 1997, 1996 and 1995
totaled $3.3 million, $7.9 million and $0.3, respectively. Accumulated
amortization for the years ended December 31, 1997 and 1996 was $11.3 million
and $8.0 million, respectively.
The Company periodically reviews its assets subject to Statement No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of," ("SFAS 121") and when events or changes in
circumstances indicate that the carrying amount of an asset may no longer be
fully recoverable, the Company tests the recoverability of the asset
primarily by estimating the future cash flows expected to result from the use
of the asset and its eventual disposition. If the sum of the expected future
cash flows (undiscounted and without interest charges) is less than the
carrying value of the asset, the Company recognizes an impairment loss.
Measurement of an impairment loss is based on the carrying amount and
estimated fair value of the asset.
During 1996, using the criteria contained in SFAS 121, the Company
recognized an impairment loss of $3.2 million and reduced goodwill that was
recorded in 1995 in conjunction with the purchase of RISCORP West, formerly
known as the Self Insurors Service Bureau, Inc. ("SISB"). The Company's
impairment assessment was primarily based upon the closing of former SISB
offices in certain states and the Company's current focus on at-risk
business. The impairment loss was recorded as a component of depreciation and
amortization in the Company's Consolidated Statement of Income for the year
ended December 31, 1996. Remaining unamortized goodwill related to the SISB
purchase was $432,000 and $468,000 at December 31, 1997 and 1996,
respectively.
F-13
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
As more fully described in Note 3, the Company recorded an
impairment loss of $2.8 million in connection with the acquisition of
Independent Association Administrators, Inc. during 1996. The remaining
unamortized goodwill relating to this acquisition was $7.9 million and $8.5
million at December 31, 1997 and 1996, respectively.
Net assets acquired in excess of cost, or "negative" goodwill, is
being amortized on a straight-line basis over 10 years. Income from
amortization of negative goodwill totaled $0.8 million, $0.9 million and $0.8
million for the years ended December 31, 1997, 1996 and 1995, respectively
(see Note 3). Accumulated amortization as of December 31, 1997 and 1996 was
$2.5 million and $1.7 million, respectively.
(j) PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost less accumulated
depreciation. Depreciation is computed using the straight-line method over
the useful lives of the related assets. Property and equipment recorded
under capital lease arrangements are amortized over the shorter of the
asset's useful life or the lease term.
The Company capitalizes incremental internal and external costs
directly related to internally developed software to meet the Company's
needs. These software development projects represent major system
enhancements or replacements of existing operating management information
systems. Capitalization commences when management has committed to funding
the software project and it is probable that upon completion the software
will perform its intended function. Capitalized costs are recorded in
property and equipment and amortized using the straight-line method over
three years. For the years ended December 31, 1997, 1996 and 1995, the
Company capitalized $1.3 million, $1.7 million and $0.3 million,
respectively. Amortization expense of $0.3 million, $.04 million and $0 has
been recorded for the years ended December 31, 1997, 1996 and 1995,
respectively, for internally developed software costs.
(k) INVESTMENT IN JOINT VENTURE
The Company accounts for its 50 percent investment in a joint
venture arrangement on the equity basis of accounting whereby the Company's
recorded investment is adjusted for its proportionate share of earnings or
losses of the joint venture.
(l) CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments purchased with
an original maturity of three months or less to be cash equivalents.
F-14
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(m) BAD DEBT ALLOWANCE
The bad debt allowance is based on the Company's experience with
uncollectible premiums receivable and represents the Company's best estimate
of the ultimate uncollectible amounts incurred through the balance sheet
date. Premiums receivable contained in the accompanying Consolidated Balance
Sheets are shown net of this valuation allowance.
(n) EARNINGS PER SHARE
In February 1997, the Financial Standards Board issued Statement No.
128, "Earnings Per Share," ("SFAS 128"), which is effective for periods ending
after December 15, 1997. SFAS 128 requires the presentation of two earnings
per share ("EPS") calculations, basic EPS and diluted EPS, in the Consolidated
Statements of Income and SFAS 128 requires restatement of all prior period
EPS data that is presented in the accompanying financial statements. All
previously reported earnings per share data for 1996 and 1995 have been
restated to reflect the requirements of SFAS 128. Basic EPS is computed by
dividing net income by the weighted average number of shares outstanding for
the period. Diluted EPS is computed by dividing net income by the weighted
average number of shares outstanding for the period plus the shares for the
dilutive effect of stock options, contingent shares and other common stock
equivalents.
The components of the weighted average shares used in the EPS
calculations are as follows:
<TABLE>
<CAPTION>
1997 1996 1995
---------- ---------- ----------
<S> <C> <C> <C>
Average outstanding shares used for
calculating basic EPS 36,891,864 34,647,986 28,100,234
Effect of stock options 223,808 1,757,602 1,992,266
---------- ---------- ----------
Average outstanding shares used for
calculating diluted EPS 37,115,672 36,405,588 30,092,500
---------- ---------- ----------
---------- ---------- ----------
</TABLE>
(o) STOCK-BASED COMPENSATION
In October 1995, the Financial Accounting Standards Board issued
Statement No. 123, "Accounting for Stock-Based Compensation," ("SFAS 123"),
which is effective for fiscal years beginning after December 15, 1995. SFAS
123 establishes a method of accounting for stock-based compensation that is
based on the fair value of stock options and similar instruments and
encourages, but does not require adoption of that method. The Company has
elected to continue following Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees," for measuring compensation cost.
However, as required by SFAS 123, the Company has disclosed pro forma net
income and earnings per share for the years ended December 31, 1997, 1996 and
1995 as if the provisions of SFAS 123 had been adopted (see Note 12).
F-15
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(p) YEAR 2000
In the fourth quarter of 1997, the Company developed a formal plan
to convert its computer systems to be Year 2000 compliant. The Company's
plan provides for all conversion efforts to be completed by the end of March
1999; however, the portion of the plan relating to the Company's policy issue
and management system will be completed by October 1, 1998, the date of the
first Year 2000 incident. The Year 2000 conversion is necessary primarily as
the result of certain computer programs used by the Company being written
using two digits rather than four digits to define the applicable year. The
total cost of the Year 2000 project is estimated to be less than $1.0 million
and all costs associated with these Year 2000 system changes will be expensed
as the costs are incurred.
(q) CONCENTRATIONS OF RISK
Following is a description of significant risks facing the Company
and its property and casualty insurance subsidiaries and how those risks are
minimized:
LEGAL/REGULATORY RISK is the risk that changes in the legal or
regulatory environment in which an insurer operates can create
additional loss costs or expenses not anticipated by the insurer in
pricing its products. That is, regulatory initiatives designed to
reduce insurer profits or new legal theories may create costs for the
insurer beyond those currently recorded in the financial statements.
The Company attempts to minimize this risk by reviewing legislative
and other regulatory changes and adjusting rates whenever possible.
All of the Company's premiums were derived from products offered to
customers located in the United States. Accordingly, the Company
could be adversely affected by economic downturns, significant
unemployment and other conditions that may occur from time. (See
Notes 1(a), 6, 19 and 21)
CREDIT RISK is the risk that issuers of securities owned by the
Company will default, or other parties, including reinsurers, the
SDTF, agents and insureds who may owe the Company money, will not pay.
The Company minimizes this risk by adhering to a conservative
investment strategy, by placing reinsurance with highly rated
reinsurers and by actively monitoring collections of the SDTF
recoverable and premiums receivable.
INTEREST RATE RISK is the risk that interest rates will change and
cause a decrease in the value of an insurer's investments. The
Company mitigates this risk by attempting to match the maturity
schedule of its assets with the expected payout of its liabilities.
To the extent that liabilities come due more quickly than assets
mature, an insurer would have to sell assets prior to maturity and
recognize potential gains or losses.
(r) RESTRUCTURING CHARGES
In June 1997, the Company implemented a workforce reduction and a
consolidation of the Company's management team, field offices and products.
The reduction in the work force resulted in the termination of 128 employees
of the Company. The Company also announced in June 1997 its intention to
F-16
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
focus solely on its core workers' compensation insurance business and to
close all field offices, except Charlotte and Birmingham, by the end of 1997.
The Company recorded $5.8 million in non-recurring expenses during the
second quarter of 1997 in connection with the workforce reduction and
consolidation of the field offices and products. These non-recurring
expenses consisted primarily of severance expenses of $5.1 million and
occupancy costs of $0.7 million of which $3.2 million and $0.4 million,
respectively, were unpaid as of December 31, 1997. These expenses are
included in commissions, underwriting and administrative expenses in the
December 31, 1997 Consolidated Statements of Income.
(s) PARTICIPATING INSURANCE POLICIES
The Company offers participating insurance policies in connection
with custom plans, flexible retention plans and preferred account dividend
plans. Dividends are approved quarterly by the Board of Directors and are
based upon the actual loss experience of each of the policies. Participating
policies represented approximately 15.8 percent, 16.5 percent and 10.1
percent of written premiums at December 31, 1997, 1996 and 1995,
respectively. The Company paid dividends to participating policyholders of
$8.5 million, $9.2 million and $1.6 million for the years ended December 31,
1997, 1996 and 1995, respectively.
(t) DETERMINATION OF FAIR VALUES OF FINANCIAL STATEMENTS
Management has identified the following financial instruments in the
financial statements: cash and cash equivalents, fixed maturities and equity
securities, receivables and other liabilities. Fair values of fixed
maturities and equity securities are presented in Note 4. For the remaining
instruments, management believes the carrying value approximate fair value
due to the short maturity, terms and fluctuations in market conditions of
those instruments. The estimated fair value amounts have been determined by
the Company, using available market information and appropriate valuation
methodologies. However, considerable judgment is necessarily required in
interpreting market data to develop the estimates of fair value.
Accordingly, the estimates presented herein are not necessarily indicative of
the amounts that the Company could realize in a current market exchange. The
use of different market assumptions and/or estimation methodologies may have
a material effect on the estimated fair value amounts.
(u) ACCOUNTING CHANGES
The Company will adopt the reporting requirements of SFAS 130,
"Reporting Comprehensive Income," and SFAS 131, "Disclosures about Segments of
an Enterprise and Related Information," for the year ended December 31, 1998.
The adoption will have no effect on the Company's financial position or on
its results of operations.
(v) RECLASSIFICATIONS
Certain amounts in the financial statements presented have been
reclassified from amounts previously reported in order to be comparable
between years. These reclassifications have no effect on previously reported
shareholders' equity or net income during the periods involved.
F-17
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(3) ACQUISITIONS AND JOINT VENTURE
ACQUISITIONS
As more fully described below, the Company acquired RIC in 1995, RNIC in
1996, and two workers' compensation management services companies in 1996.
Each of these transactions was accounted for under the purchase method of
accounting under which the aggregate purchase price paid for the entity was
allocated to the assets acquired and liabilities assumed based upon the
estimated fair value of such assets and liabilities at the dates of
acquisition. The excess of the purchase price over the fair value of the net
assets acquired is reflected as costs in excess of net assets acquired and is
being accreted over periods ranging from 5 to 15 years. For acquisitions in
which net assets acquired exceeded the purchase price, a liability for net
assets acquired in excess of costs has been recorded and is being amortized
over 10 years.
Operating results of the acquired entities have been included in the
consolidated financial statements from their date of acquisition. The
following schedule summarizes certain pro forma results of operations for the
years ended December 31, 1996 and 1995, as if the acquisitions took place at
the beginning of the Company's fiscal year preceding the year of acquisition
(in thousands, except per share amounts):
<TABLE>
<CAPTION>
1996 1995
-------- --------
<S> <C> <C>
Total revenues $275,410 $266,412
Income before income taxes 18,503 23,070
Net income 6,860 16,407
Earnings per share 0.19 0.55
</TABLE>
ACQUISITION OF RISCORP INSURANCE COMPANY
Effective January 1, 1995, RIC was acquired by RISCORP of Florida, Inc.,
a wholly-owned subsidiary of the Company. As a result of the acquisition,
RIC's name was changed from Commerce Mutual Insurance Company ("CMIC"). Upon
conversion, 1.5 million shares of $100 par value stock were authorized and
15,000 shares were issued and outstanding. RIC received $25.0 million as a
capital contribution from the Company in the form of $12.0 million cash and
the issuance of $13.0 million of surplus notes to the Company. In
conjunction with the acquisition, RIC, subject to a Plan of Conversion and
Recapitalization and with the approval of CMIC's policyholders and the FDOI,
converted from an assessable mutual insurance company to a stock insurance
company. RIC provides workers' compensation insurance in the State of
Florida.
In exchange for their ownership interest in RIC, former CMIC
policyholders were relieved of all contingent liabilities for future policy
assessments and the risk that recorded liabilities were insufficient to cover
incurred losses. On the acquisition date, the estimated fair value of RIC's
net assets in excess of the purchase price was $8.2 million, which was
recorded as negative goodwill and is being amortized on a straight-line basis
over 10 years.
F-18
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
ACQUISITION OF COMPSOURCE
In March 1996, the Company purchased all of the outstanding stock of
CompSource, Inc. and Insura, Inc. (collectively, "CompSource") in exchange for
$12.1 million in cash and 112,582 shares of the Company's Class A Common
Stock valued at $2.1 million on the date of acquisition. On the acquisition
date, the excess of the purchase price over the fair value of the net assets
acquired was $12.6 million and was recorded as goodwill in the accompanying
Consolidated Balance Sheets. CompSource is a workers' compensation
management services company offering its services in North Carolina.
Pursuant to a stock redemption agreement entered into as part of this
transaction, the former shareholders of CompSource elected to have the
Company repurchase the 112,582 shares at a purchase price of $18.653 per
share on March 8, 1997, and the Company repurchased all 112,582 shares from
the former shareholders for $2.1 million in accordance with the terms of the
redemption agreement.
ACQUISITION OF INDEPENDENT ASSOCIATION ADMINISTRATORS, INC. ("IAA") AND RISK
INSPECTION SERVICES AND CONSULTING, INC. ("RISC")
In September 1996, the Company purchased all of the outstanding stock of
IAA and RISC in exchange for $11.5 million, consisting primarily of 790,336
shares of the Company's Class A Common Stock valued at $10.9 million on the
date of acquisition. IAA and RISC are workers' compensation management
services companies offering services in Alabama. On the acquisition date,
the excess of the purchase price over the fair value of the net assets
acquired was $11.4 million and was recorded as goodwill in the accompanying
Consolidated Balance Sheets.
During the first quarter of 1997, it became evident that the goodwill
recorded at the date of the RISC and IAA acquisition could not be fully
recovered from the profitability of the workers' compensation business that
was currently under contract. Therefore, as of December 31, 1996, $2.8
million of goodwill was written off and is included as amortization expense
in the accompanying Consolidated Statements of Income.
ACQUISITION OF ATLAS
In March 1996, RISCORP of Florida, Inc., a wholly-owned subsidiary of
the Company, acquired 100 percent of the outstanding capital stock of Atlas
Insurance Company ("Atlas") for $5.0 million in cash. As a result of the
acquisition, the name was changed from Atlas to RNIC. RNIC, which primarily
provides workers' compensation insurance, is licensed to do business in 19
states and is authorized to operate on an excess and surplus lines basis in 5
additional states. On the acquisition date, the excess of the purchase price
over the fair value of the net assets acquired was $2.6 million and was
recorded as goodwill in the accompanying Consolidated Balance Sheets.
ASSUMPTION REINSURANCE TRANSACTION
During 1996, RNIC also entered into several assumption reinsurance
transactions that resulted in the acquisition of five self insurance funds
that are discussed in Note 7(b).
F-19
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
JOINT VENTURE ARRANGEMENT
In January 1996, the Company, through its wholly-owned subsidiary,
RISCORP of Illinois, entered into a joint venture arrangement with Health
Care Service Corporation ("HCSC"), a subsidiary of Blue Cross and Blue Shield
of Illinois, to underwrite and sell managed care workers' compensation
insurance in Illinois. The Company and HCSC each hold 50 percent ownership in
the joint venture known as Third Coast Holding Company ("Third Coast"). The
Company contributed the use of its expertise, insurance systems and
intellectual property. The Company's initial investment in Third Coast was
valued at $10.0 million; however, the Company's cost basis in the contributed
property was $0. Third Coast has experienced operating losses since its
inception. As of December 31, 1997 and 1996, the Company's carrying of its
investment in Third Coast was $0.
(4) INVESTMENTS
Investments (including restricted investments) included in the
accompanying Consolidated Balance Sheets as of December 31, 1997 and 1996 are
summarized as follows (in thousands):
<TABLE>
<CAPTION>
COST OR GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED ESTIMATED
COST GAINS LOSSES FAIR VALUE
--------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
December 31, 1997:
Available for sale:
Fixed maturity securities:
Municipal government obligations $ 58,294 $ 718 $ 2 $ 59,010
U.S. government obligations 38,065 1,193 10 39,248
Corporate obligations 88,102 1,119 22 89,199
Mortgage backed securities 1,932 36 - 1,968
Asset backed securities 9,920 49 3 9,966
--------- ---------- ---------- ----------
Total available for sale 196,313 3,115 37 199,391
--------- ---------- ---------- ----------
Held to maturity:
Fixed maturity securities:
U.S. government obligations 18,434 204 9 18,629
Municipal government obligations 4,186 62 - 4,248
Certificates of deposit 1,470 - - 1,470
--------- ---------- ---------- ----------
Total held to maturity 24,090 266 9 24,347
--------- ---------- ---------- ----------
Total investments $ 220,403 $ 3,381 $ 46 $ 223,738
--------- ---------- ---------- ----------
--------- ---------- ---------- ----------
Available for sale:
Unrestricted $ 142,876 $ 2,709 $ 14 $ 145,571
Restricted 53,437 406 23 53,820
--------- ---------- ---------- ----------
$ 196,313 $ 3,115 $ 37 $ 199,391
--------- ---------- ---------- ----------
--------- ---------- ---------- ----------
</TABLE>
F-20
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
<TABLE>
<CAPTION>
COST OR GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED ESTIMATED
COST GAINS LOSSES FAIR VALUE
--------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
December 31, 1996:
Available for sale:
Fixed maturity securities:
Municipal government obligations $ 75,844 $ 559 $ 55 $ 76,348
U.S. government obligations 49,144 983 47 50,080
Corporate obligations 86,726 734 94 87,366
Mortgage backed securities 2,588 25 1 2,612
Asset backed securities 5,501 57 2 5,556
Redeemable preferred stocks 6,437 408 5 6,840
--------- ---------- ---------- ----------
226,240 2,766 204 228,802
--------- ---------- ---------- ----------
Equity securities:
Nonredeemable preferred stocks 1,063 28 9 1,082
Common stocks 2,817 205 59 2,963
--------- ---------- ---------- ----------
3,880 233 68 4,045
--------- ---------- ---------- ----------
Total available for sale 230,120 2,999 272 232,847
--------- ---------- ---------- ----------
Held to maturity:
Fixed maturity securities:
U.S. government obligations 16,355 144 62 16,437
Municipal government obligations 4,204 5 4 4,205
Certificates of deposit 2,250 - - 2,250
--------- ---------- ---------- ----------
Total held to maturity 22,809 149 66 22,892
--------- ---------- ---------- ----------
Total investments $ 252,929 $ 3,148 $ 338 $ 255,739
--------- ---------- ---------- ----------
--------- ---------- ---------- ----------
</TABLE>
The fair value of investments (including restricted investments) at
December 31, 1997 and 1996 was determined using independent pricing services.
The amortized cost and estimated fair value of fixed maturities (including
restricted investments) by contractual maturity, as of December 31, 1997, are as
follows (in thousands):
<TABLE>
<CAPTION>
AVAILABLE FOR SALE HELD TO MATURITY
------------------------ -----------------------
AMORTIZED ESTIMATED AMORTIZED ESTIMATED
COST FAIR VALUE COST FAIR VALUE
--------- ---------- --------- ----------
<S> <C> <C> <C> <C>
Due in one year or less $ 20,197 $ 20,262 $ 4,298 $ 4,310
Due after one year through five years 143,418 143,577 18,137 18,326
Due after five years through ten years 19,353 21,952 1,655 1,711
Due after ten years 1,494 1,666 - -
Mortgage and asset backed securities 11,851 11,934 - -
--------- ---------- --------- ----------
$ 196,313 $ 199,391 $ 24,090 $ 24,347
--------- ---------- --------- ----------
--------- ---------- --------- ----------
</TABLE>
Actual maturities may differ from contractual maturities because certain
borrowers have the right to call or prepay obligations with or without call or
prepayment penalties.
During the years ended December 31, 1997, 1996 and 1995, proceeds from
sales of fixed maturities available for sale totaled $94.3 million, $88.9
million and $60.3 million, respectively. Gross realized gains
F-21
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
and gross realized losses for the years ended December 31, 1997, 1996 and 1995
are summarized in the following table (in thousands) and are recorded in net
investment income in the accompanying Consolidated Statements of Income:
<TABLE>
<CAPTION>
1997 1996 1995
-------- -------- ---------
<S> <C> <C> <C>
Gross realized gains $ 1,770 $ 178 $ 1,395
Gross realized losses (224) (73) (379)
-------- ------ --------
Net realized gains $ 1,546 $ 105 $ 1,016
-------- ------ --------
-------- ------ --------
</TABLE>
The following information summarizes the components of net investment
income for the years ended December 31, 1997, 1996 and 1995 (in thousands):
<TABLE>
<CAPTION>
1997 1996 1995
--------- --------- --------
<S> <C> <C> <C>
Fixed maturities $ 13,815 $ 10,444 $ 5,856
Equity securities 469 547 410
Cash and cash equivalents 2,516 1,700 606
--------- --------- --------
16,800 12,691 6,872
Investment expenses (353) (497) (164)
--------- --------- --------
$ 16,447 $ 12,194 $ 6,708
--------- --------- --------
--------- --------- --------
</TABLE>
While the Company has credit risk in the investment portfolio, no fixed
maturity security had a Standard & Poor's rating of less than BBB at December
31, 1997. The carrying value of securities on deposit with various governmental
agencies was $23.8 million and $18.6 million at December 31, 1997 and 1996,
respectively, and is included in fixed maturities held to maturity in the
accompanying Consolidated Balance Sheets. In addition, as more fully explained
in Note 7, securities with a carrying value of $53.8 million at December 31,
1997 have been pledged or are held in trust in connection with certain
reinsurance transactions.
The Company's investments in excess of 10 percent of shareholders' equity
at December 31, 1997 and 1996, aggregated by issuer and excluding investments
issued or guaranteed by the United States, consisted of the following (in
thousands):
<TABLE>
<CAPTION>
CARRYING VALUE
------------------------
1997 1996
--------- ---------
<S> <C> <C>
Fixed maturities:
State of Florida $ 20,980 $ 23,472
--------- ---------
--------- ---------
</TABLE>
(5) LIABILITY FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
The Company establishes an estimated liability for losses and loss
adjustment expenses with respect to reported claims and claims incurred but not
yet reported as of the end of each accounting period. The Company establishes
its liability based on facts then known, estimates of future claims trends and
other
F-22
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
factors, including the Company's experience with similar cases and
historical Company and industry trends, such as reserving patterns, loss payment
patterns, claim closure and reporting patterns, and product mix.
Activity in the liability for losses and loss adjustment expenses for the
years ended December 31, 1997, 1996 and 1995 is summarized as follows (in
thousands):
<TABLE>
<CAPTION>
1997 1996 1995
---------- ---------- ---------
<S> <C> <C> <C>
Gross reserves for losses and loss adjustment expenses, beginning of period $ 458,239 $ 261,700 $ 12,668
Less reinsurance recoverables 180,698 100,675 7,398
Less SDTF recoverables 49,505 51,836 671
Less prepaid managed care fees 31,958 16,369 -
---------- ---------- ---------
Net balance at January 1 196,078 92,820 4,599
---------- ---------- ---------
Assumed during year from loss portfolio transfers and acquisitions - 88,212 123,854
---------- ---------- ---------
Incurred losses and loss adjustment expenses related to:
Current year 125,764 123,986 87,467
Prior years (2,401) 3,023 5,198
---------- ---------- ---------
Total incurred losses and loss adjustment expenses 123,363 127,009 92,665
---------- ---------- ---------
Paid related to:
Current year 45,646 56,088 33,069
Prior years 74,639 55,875 95,229
---------- ---------- ---------
Total paid 120,285 111,963 128,298
---------- ---------- ---------
Net balance at December 31 199,156 196,078 92,820
Plus reinsurance recoverables 184,251 180,698 100,675
Plus SDTF recoverables 45,211 49,505 51,836
Plus prepaid managed care fees 8,420 31,958 16,369
---------- ---------- ----------
Gross reserves for losses and loss adjustment expenses, at December 31 $ 437,038 $ 458,239 $ 261,700
---------- ---------- ----------
---------- ---------- ----------
</TABLE>
The Company recognizes recoveries from the SDTF and subrogation from third
parties as a reduction of incurred losses. In determining the best estimate of
the effect of these recoveries on the ultimate cost of all unpaid losses and
loss adjustment expenses, the Company utilizes historical and industry
statistics. The estimated amount of recoveries from the SDTF included as a
reduction to the liability for losses and loss adjustment expenses was $45.2
million and $49.5 million at December 31, 1997 and 1996, respectively.
The 1995 activity in the liability for losses and loss adjustment expenses
reflects the acquisition of RIC on January 1, 1995. Adverse development in 1996
occurred due to deterioration in 1993 and prior accident years offset in part by
improved experience for the 1995 accident year. The favorable development in
1997 is discussed in Note 21.
(6) STATE OF FLORIDA SPECIAL DISABILITY TRUST FUND
Florida operates the SDTF that reimburses insurance carriers,
self-insurance funds and self-insured employers in Florida for certain workers'
compensation benefits paid to injured employees. SDTF reimburses claim payments
made to a claimant whose injury merges with, aggravates or accelerates a
pre-existing permanent physical impairment. The SDTF is managed by the State of
Florida and is funded
F-23
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
through assessments against insurers and self-insurers providing workers'
compensation coverage in Florida. RISCORP's pro-rata amount of the SDTF
assessment is based upon its written premiums compared to the total workers'
compensation premiums written by all Florida insurers and self-insurance funds.
Should a carrier stop writing business, it has no obligation for future
assessments. The SDTF's assessment formula has historically yielded sufficient
revenues for annual reimbursement payments and for costs associated with
administering the SDTF. The SDTF has not prefunded its claims liability and no
reserves currently exist. As of September 30, 1996, the SDTF had an actuarial
projected undiscounted liability of $4.0 billion based on a study performed for
the SDTF by independent actuarial consultants. In addition, the SDTF actuarial
study indicated that, at the current assessment rates, the payment of the
existing liability would take numerous years.
Under Florida sunset laws applicable to some state-sponsored funds, the
SDTF would have expired on November 4, 1996 unless affirmative action was taken
by the legislature to continue the SDTF. By action of the legislature, the SDTF
was continued and not scheduled for further review under Florida sunset laws
until the year 2000. However, in early 1997, the Florida legislature passed a
bill substantially changing the SDTF. The SDTF will accept no claims with
accident dates after December 31, 1997. Certain SDTF claims may have to be
refiled for reimbursement and such filing may require a refiling fee.
Additionally, companies accruing SDTF recoveries may be statutorily limited in
the level of recoverables they may be allowed to carry. The bill provides for a
funding mechanism through which companies writing workers' compensation
insurance in Florida will be assessed an annual charge to cover payments made by
the SDTF. The Company believes that even in the event of default by the SDTF,
the existing reimbursements of the SDTF would become general obligations of the
State of Florida.
For the years ended December 31, 1997, 1996 and 1995, SDTF cash recoveries
were $5.9 million, $2.5 million and $0.9 million, respectively. SDTF
assessments were $6.8 million, $11.7 million and $12.9 million for the years
ended December 31, 1997, 1996 and 1995, respectively.
In December 1997, the American Institute of Certified Public Accountants
issued a Statement of Position ("SOP") 97-3, "Accounting by Insurance and Other
Enterprises for Insurance-Related Assessments." This SOP is effective for
financial statements for fiscal years beginning after December 15, 1998. The
SOP provides guidance for determining and measuring a liability for
guaranty-fund and other insurance-related assessments, including second injury
trust funds. Management is currently assessing the impact, if any, of this SOP
on the future financial results of the Company's insurance subsidiaries.
(7) REINSURANCE
(a) GENERAL
The Company is involved in the cession of insurance to certain unaffiliated
insurance and reinsurance companies under specific excess of loss and quota
share reinsurance contracts. Amounts by
F-24
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
which certain financial statement balances have been reduced as a result of
these reinsurance contracts as of and for the years ended December 31, 1997,
1996 and 1995 are as follows (in thousands):
<TABLE>
<CAPTION>
1997 1996 1995
---------- ---------- ----------
<S> <C> <C> <C>
Premiums written $ 143,983 $ 192,528 $ 161,696
Premiums earned 167,274 165,022 139,144
Reserve for losses and loss adjustment expenses 183,150 180,698 100,675
Unearned premiums 25,842 49,788 21,880
</TABLE>
Ceded losses and loss adjustment expenses were $73.9 million, $152.3
million and $78.7 million for the years ended December 31, 1997, 1996 and 1995,
respectively, and are reflected as reductions in the related financial statement
balances.
Effective January 1, 1995, RIC and RPC entered into quota share reinsurance
agreements with American Re-Insurance Company ("AmRe"), whereby RIC and RPC
ceded50 percent of new and renewal premiums written and losses incurred. These
reinsurance agreements provide for the payment of a ceding commission at rates
which vary from 27.5 percent to 60 percent based on the loss ratio of the
business ceded, excluding unallocated loss adjustment expenses. The provisional
ceding commission provided for in the reinsurance agreements was 33 percent.
These reinsurance agreements will remain in force for an unlimited period of
time, but may be terminated by either party at any December 31 after December
31, 1995. The Company and AmRe are parties to a senior subordinated note
agreement in the principal amount of $15.0 million due 2002. Under the terms of
the note agreement, the Company must maintain the quota share treaty or other
comparable reinsurance agreements with AmRe for a minimum period of five years
beginning January 1, 1995 (see Note 21). Ceding commissions earned under the
AmRe reinsurance agreements were $50.0 million, $58.2 million and $48.6 million
for the years ended December 31, 1997, 1996 and 1995, respectively. At December
31, 1997 and 1996, the Company was contingently liable for return ceding
commissions to AmRe of $9.3 million and $21.2 million, respectively.
Effective September 1, 1996, RIC entered into a retrocessional reinsurance
agreement with Chartwell Reinsurance Company, whereby Chartwell Reinsurance
Company retrocedes to the Company 50 percent of workers' compensation business
written by RMS (an affiliate of the Company) as underwriting manager for
Virginia Surety Company, Inc. ("Virginia Surety"). The reinsurance agreement
provides for a profit commission in addition to the 30 percent ceding commission
based on the loss ratio and other expenses incurred under the contract. The
initial profit commission calculation will take place on September 1, 2000.
This agreement terminated on December 31, 1997; however the Company continues to
be responsible for its portion of the losses incurred on policies reinsured
before the termination date.
On April 18, 1997, the Company entered into a trust agreement with
Chartwell Reinsurance Company whereby the Company agreed to maintain in trust
for the benefit of Chartwell Reinsurance Company 102 percent of the Company's
portion of the outstanding loss reserves and unearned premiums. As of December
31, 1997, the market value of the securities in the trust account was $8,645,981
and the required trust account balance, based on the outstanding loss reserves
and unearned premium reserves, was $5,159,689. The balance in this trust
account is generally adjusted on a monthly basis, one month in arrears.
F-25
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Effective January 1, 1996, RPC entered into a quota share reinsurance
agreement with Allstate Insurance Company, Chartwell Reinsurance Company, Signet
Star Reinsurance Company and San Francisco Reinsurance Company, whereby the
Company ceded 90 percent of its inforce, new or renewal gross written premiums
for commercial umbrella coverage for the period January 1, 1996 to December 31,
1996. The maximum limits under this agreement are $5.0 million per insured, per
occurrence. The reinsurance agreement provides for the payment of a ceding
commission of 30 percent of the ceded premiums. This reinsurance agreement will
remain in force for an unlimited period of time, but may be terminated by either
party at December 31, 1996 or any December 31 thereafter. During 1997, Allstate
Insurance Company and San Francisco Reinsurance Company were replaced on this
reinsurance agreement by Scor Reinsurance Company and Hartford Fire Insurance
Company, respectively. All other terms and conditions of the reinsurance
agreement were unchanged. This agreement was terminated at December 31, 1997;
however, the reinsurer continues to be responsible for their portion of all
losses incurred on policies effective before the termination date.
Effective January 1, 1996, RPC entered into a quota share reinsurance
agreement with Allstate Insurance Company, Chartwell Reinsurance Company, Signet
Star Reinsurance Company, San Francisco Reinsurance Company and Great Lakes
American Reinsurance Company, whereby the Company ceded 90 percent of its
inforce, new or renewal gross written premiums for commercial property coverage
for the period January 1, 1996 to December 31, 1996. The limits of coverage
under this agreement are 90 percent of $2.5 million per risk, subject to an
occurrence limitation of not less than $10.0 million nor greater than $15.0
million. The reinsurance agreement provides for the payment of a ceding
commission of 30 percent of ceded premiums. This reinsurance agreement will
remain in force for an unlimited period of time, but may be terminated by either
party at December 31, 1996 or any December 31 thereafter. During 1997, Allstate
Insurance Company and San Francisco Reinsurance Company were replaced on this
reinsurance agreement by Scor Reinsurance Company and Hartford Fire Insurance
Company, respectively. All other terms and conditions of the reinsurance
agreement were unchanged. This agreement was terminated at December 31, 1997;
however, the reinsurer continues to be responsible for their portion of all
losses incurred on policies effective before the termination date.
Effective January 1, 1996, RPC entered into a commercial casualty excess of
loss reinsurance agreement with Allstate Insurance Company, Chartwell
Reinsurance Company, Signet Star Reinsurance Company and San Francisco
Reinsurance Company, whereby the Company ceded 100 percent of all losses
incurred on business inforce, written or renewed during the term of this
agreement, per occurrence, in excess of $250,000 to $1,000,000. The Company is
required to pay 11.5 percent of earned premiums subject to a minimum premium of
$483,000 under the agreement. This reinsurance agreement will remain in force
for an unlimited period of time, but may be terminated by either party at
December 31, 1996 or any December 31 thereafter. During 1997, Allstate
Insurance Company and San Francisco Reinsurance Company were replaced on this
reinsurance agreement by Scor Reinsurance Company and Hartford Fire Insurance
Company, respectively. All other terms and conditions of the reinsurance
agreement were unchanged. This agreement was terminated at December 31, 1997;
however, the reinsurer continues to be responsible for their portion of all
losses incurred on policies effective before the termination date.
F-26
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Effective September 1, 1995, RPC entered into a medical excess of loss
reinsurance agreement with Cologne Life Reinsurance Company, whereby the Company
ceded 100 percent of all losses incurred per insured, per agreement year, in
excess of $150,000 up to $1.0 million. The Company pays $6.79 per certificate
of insurance per month for this coverage. The agreement is continuous, but can
be canceled by either party at September 1, 1996 or any September 1 thereafter.
RIC, RNIC and RPC ceded losses in excess of $500,000 to Continental
Casualty Company ("CNA") under an excess of loss reinsurance treaty effective
January 1, 1997. This treaty contains a corridor deductible of $1,250,000 which
is applicable in the aggregate to claims in the $500,000 excess of $500,000
corridor for the Company. RIC and RPC had a similar contract with CNA effective
January 1, 1996 with a corridor deductible of $1,000,000. While the contract
contains provisions for minimum and deposit premiums, the premiums for 1997
based on earned premiums exceeded the minimum premium provisions specified under
the contract.
RNIC has ceded losses in excess of $500,000 to CNA under three separate
excess of loss reinsurance treaties. These treaties have effective dates of
January 1, June 14, and September 1, 1996 and provide for the payment of
premiums to CNA based on earned premiums. While the contracts contain
provisions for minimum premiums, the premiums for 1996 exceed the minimum
premium provisions specified under these contracts. Each of these treaties with
CNA expired on January 1, 1997.
In connection with the proposed sale to Zenith (as more fully described in
Note 15), RIC and RPC entered into an interim reinsurance agreement and
cut-through endorsement covering all inforce business as of June 17, 1997 and
all new and renewal business written after June 17, 1997 on Florida workers'
compensation policies. In connection with this agreement, Zenith required that
33 percent of the direct written premiums and 33 percent of the initial unearned
premiums subject to this agreement be deposited into a trust account for the
benefit of Zenith. In addition, the agreement requires the Company to pay a fee
to Zenith of 1 percent of subject premiums.
As of December 31, 1997, the market value of the securities in the trust
account was $52,413,270 and the required trust account balance, based on the
direct written premiums for the period June 18, 1997 through December 31, 1997
and the unearned premiums at June 17, 1997, was $51,567,757. The balance in the
trust account is generally adjusted on a monthly basis, one month in arrears.
In addition, the Company incurred fees to Zenith of $1.4 million during 1997
under this agreement.
Effective October 1, 1996, RNIC entered into a quota share reinsurance
agreement with Chartwell Reinsurance Company, Swiss Reinsurance America
Corporation and Trenwick America Reinsurance Corporation (collectively the
"Reinsurers"), whereby the Company ceded 65 percent of its net unearned premiums
as of October 1, 1996 and 65 percent of net written workers' compensation and
employers liability premiums, new or renewal, for the period October 1 to
December 31, 1996. Effective January 1, 1997, RNIC reduced the ceded quota
share amount to 60 percent. The reinsurance agreement provides for the payment
of a ceding commission at rates which vary from 27 percent to 49 percent based
on the loss ratio of the business ceded. The provisional ceding commission
contained in the reinsurance agreement was
F-27
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
33 percent. This reinsurance agreement was terminated at December 31, 1997;
however, the reinsurer continues to be responsible for their portion of all
losses incurred on policies effective before the termination date.
RNIC entered into an agreement with the Insurance Company of New York
("INSCORP") and Chartwell Reinsurance Company, effective January 1, 1997, to
issueassumption of liability endorsements ("ALE") to certain policyholders of
RNIC. This agreement expired on December 31, 1997 and was not renewed. In
connection with this agreement, RNIC was required to provide INSCORP and
Chartwell Reinsurance Company with letters of credit in amounts equal to 29.2
percent of the gross written premiums on all ALE policies plus $1,250,000. The
agreement also required RNIC to pay a fee of .5 percent of gross premiums
subject to a minimum fee of $50 and a maximum fee of $1,000 per ALE.
As of December 31, 1997, based on the gross premiums subject to ALE's, RNIC
provided letters of credit of $3,742,090 under this agreement. These letters of
credit are secured by certificates of deposits and are included in the
accompanying balance sheets under the caption "Cash and short-term
investments--restricted." In addition, RNIC incurred fees of $38,797 during
1997 under this agreement.
RNIC also maintains specific excess of loss coverage on the run off of the
Atlas book of business with Allstate Insurance Company.
The combined reinsurance recoverables and ceded unearned premiums (by
reinsurer) in excess of three percent of shareholders' equity as of December 31,
1997 are detailed below (in thousands):
<TABLE>
<CAPTION>
REINSURANCE CEDED UNEARNED
REINSURER RECOVERABLES PREMIUMS
-------------------------------------------- ------------ --------------
<S> <C> <C>
American Re-Insurance Company $ 89,437 $ 20,995
Continental Casualty Company 42,841 -
TIG Reinsurance Company 9,286 -
Chartwell Reinsurance Company 22,198 2,350
Swiss Reinsurance America Company 11,041 1,175
Trenwick American Reinsurance Company 11,041 1,175
</TABLE>
The unaffiliated reinsurers of each of the Company's insurance subsidiaries
are reinsurance companies with A.M. Best ratings of A- or higher. The Company
actively monitors and evaluates the financial condition of its reinsurers. As a
result, the Company does not believe it has any significant credit risk
associated with unaffiliated reinsurance recoverables. To the extent that the
reinsurers are unable to meet their contractual obligations, the Company is
contingently liable for any losses and loss adjustment expenses ceded.
At December 31, 1997 and 1996, reinsurance recoverables consisted of $184.3
million and $180.7 million of recoverables for unpaid losses and loss adjustment
expenses. At December 31, 1997, $89.4 million of the reinsurance recoverable
balance related to RIC's and RPC's quota share agreement with one
F-28
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
reinsurer. The remaining recoverable balance of $94.9 million reflected
estimated recoveries from 17 unaffiliated reinsurers that provided quota share,
specific and aggregate excess of loss coverage. The previous table includes all
reinsurance recoverables in excess of three percent of shareholders' equity at
December 31, 1997.
(b) ASSUMPTION REINSURANCE TRANSACTIONS
During 1996, RNIC entered into loss portfolio transfer and assumption
reinsurance agreements with National Alliance for Risk Management ("NARM"), a
North Carolina self-insured workers' compensation fund; Occupational Safety
Association of Alabama ("OSAA"), an Alabama self-insured workers' compensation
fund; and three NARM self insurance funds in Virginia ("NARM - Virginia").
Under the terms of the agreements, RNIC assumed 100 percent of the outstanding
loss reserves (including incurred but not reported losses) and the outstanding
unearned premiums as of the respective dates of transfer. RNIC issued
assumption certificates to all affected policyholders.
The following loss portfolio transfers and assumption reinsurance
agreements were entered into by RNIC during 1996 (in thousands):
<TABLE>
<CAPTION>
LOSSES ASSUMED AT UNEARNED PREMIUMS
ENTITY EFFECTIVE DATE DATE OF TRANSFER AT DATE OF TRANSFER
--------------------- ------------------- -------------------- --------------------
<S> <C> <C> <C>
NARM June 14, 1996 $ 34,544 $ 5,209
OSAA September 1, 1996 49,716 -
NARM - Virginia October 1, 1996 3,057 996
--------- --------
Total $ 87,317 $ 6,205
--------- --------
--------- --------
</TABLE>
RISCORP received cash and marketable securities from the ceding companies
of $93.5 million to fund the loss and unearned premium reserves assumed in
connection with these transactions. In addition, OSAA transferred to RNIC $11.0
million in OSAA member deposits and cash of $11.0 million. RNIC refunded the
deposits to the policyholders during 1997 upon completion of final premium
audits for the 1996 policy year.
(8) MANAGED CARE AGREEMENTS
The Company is party to arrangements with both Humana Medical Plans, Inc.
("Humana"), an unaffiliated health maintenance organization ("HMO"), and RISCORP
Health Plans, Inc. ("RHP"), an affiliated HMO, whereby, upon policyholder
election to participate, the Company's medical claim costs are fixed for the
first three years of each claim. On May 1, 1996, the Company terminated its
arrangement with RHP; however, injured individuals are covered for three years
following any accident occurring during policy periods in effect prior to
termination. The Humana arrangement, which commenced July 1, 1995, was renewed
for one additional year at the anniversary date. Under the Humana arrangement,
injured individuals are covered for three years following any accident
occurring within the policy periods. On October 30, 1997, the Company entered
into a loss portfolio transfer agreement with RHP to transfer the liability of
RHP under the managedcare agreement. The remaining liability under the managed
care
F-29
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
agreement was determined by the Company's consulting actuarial firm to be $8.0
million and on November 4, 1997, RHP transferred $8.0 million to the Company in
full satisfaction of RHP's liability under the managed care agreement. The fees
paid to Humana and RHP are recognized as prepaid assets and losses and loss
adjustment expenses in the Consolidated Balance Sheets. Included in losses and
loss adjustment expenses were $6.1 million, $30.6 million and $19.0 million of
such fees for the years ended December 31, 1997, 1996 and 1995, respectively.
To the extent that Humana is unable to meet its contractual obligations
under the agreements, the Company is liable for any unpaid losses and loss
adjustment expenses. At December 31, 1997 and 1996, estimated unpaid losses and
loss adjustment expenses to be covered by Humana were $4.8 million and $17.7
million, respectively.
(9) INCOME TAXES
The components of income taxes for the years ended December 31, 1997, 1996
and 1995 are as follows (in thousands):
<TABLE>
<CAPTION>
1997 1996 1995
-------- --------- --------
<S> <C> <C> <C>
Current:
Federal $ 6,197 $ 17,919 $ 4,042
State 798 2,280 1,037
-------- --------- --------
Total current 6,995 20,199 5,079
-------- --------- --------
Deferred:
Federal 305 (12,126) 219
State - 129 (199)
-------- --------- --------
Total deferred 305 (11,997) 20
-------- --------- --------
Total income taxes $ 7,300 $ 8,202 $ 5,099
-------- --------- --------
-------- --------- --------
</TABLE>
The differences between taxes computed at the federal statutory rate and
recorded income tax expense for the years ended December 31, 1997, 1996 and 1995
are as follows (in thousands):
<TABLE>
<CAPTION>
1997 1996 1995
-------- -------- --------
<S> <C> <C> <C>
Computed "expected" tax expense $ 5,105 $ 3,710 $ 6,574
State taxes in excess of federal benefit 519 1,336 545
Non-taxable income (1,188) (982) (637)
Goodwill and other amortization 801 2,437 (287)
Valuation allowance 412 - -
S corporation earnings - - (984)
Fines and penalties 64 543 -
Amounts related to prior years - 980 -
Other 1,587 178 (112)
-------- -------- --------
Income tax expense $ 7,300 $ 8,202 $ 5,099
-------- -------- --------
-------- -------- --------
</TABLE>
F-30
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
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 as follows (in thousands):
<TABLE>
<CAPTION>
1997 1996
--------- --------
<S> <C> <C>
Deferred tax assets:
Unearned premium $ 2,132 $ 3,688
Discount on reserve for losses and loss adjustment
expenses 14,160 13,149
Accrued settlement costs 4,550 -
Accrued employee benefits 575 709
Bad debts 2,450 5,950
Deferred acquisition costs 422 -
Other 811 1,507
-------- --------
Gross deferred tax assets 25,100 25,003
-------- --------
Deferred tax liabilities:
Deferred acquisition costs - 156
Unrealized gains on investments 1,077 952
Depreciation 645 446
Other 846 898
-------- ---------
Gross deferred tax liabilities 2,568 2,452
-------- ---------
Deferred tax assets before valuation allowance 22,532 22,551
Valuation allowance (412) -
--------- ---------
Net deferred tax asset $ 22,120 $ 22,551
--------- ---------
--------- ---------
</TABLE>
The Company estimated it could realize $22.1 million of its December 31,
1997 net deferred tax asset through the carryback of future tax losses to prior
years or the generation of future taxable income, and it is more likely than not
that the tax benefits of the deferred tax assets will be realized. Accordingly,
a valuation allowance of $0.4 million relating to the December 31, 1997 deferred
taxes has been established. No valuation allowance was necessary at December
31, 1996.
(10) NOTES PAYABLE
Notes payable consist of the following at December 31, 1997 and 1996 (in
thousands):
<TABLE>
<CAPTION>
1997 1996
--------- ---------
<S> <C> <C>
Subordinated notes from quota share reinsurer,
bearing interest at 12%; matures December 31, 2002. $ 15,000 $ 15,000
Note payable from acquisition of subsidiary, with implicit
interest rate of 9.76% computed on the payment
stream; matures November 9, 1998. 330 756
Term loan, implicit interest rate of 12% computed on
the payment stream; matures January 1, 1999. 279 470
Notes payable on five automobiles, bearing interest
at 7%; various maturities throughout 2000. - 77
--------- ---------
$ 15,609 $ 16,303
--------- ---------
--------- ---------
</TABLE>
F-31
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Notes payable at December 31, 1997 are due as follows (in thousands):
<TABLE>
<S> <C>
1998 $ 586
1999 23
2000 -
2001 -
2002 and thereafter 15,000
---------
$ 15,609
---------
---------
</TABLE>
The Company is in compliance with debt covenant requirements under the AmRe
note agreement.
(11) SHAREHOLDERS' EQUITY
The Company has 100 million shares of $.01 par value Class A Common Stock
authorized and 11,855,917 issued and outstanding shares at December 31, 1997 and
1996, respectively. Class B Common Stock, par value $.01, consists of 100
million shares authorized and 24.3 million shares issued and outstanding at
December 31, 1997 and 1996, respectively. Ten million shares of preferred stock
are authorized, but no shares are issued or outstanding. The characteristics of
the Class B Common Stock are identical to those of the Class A Common Stock,
except that each holder of the Class B Common Stock is entitled to 10 votes for
each share held. The Class B Common Stock may be converted into Class A Common
Stock at any time at the election of the holders on a one-for-one basis.
The Company's insurance subsidiaries are limited by statute in their
ability to distribute unassigned surplus without approval of the Commissioner of
Insurance for the state of domicile. Dividends or distributions to shareholders
that are made under these statutes and that do not require the prior approval of
the FDOI or the MDOI are determined based on a combination of an insurer's net
income, realized and unrealized capital gains, percentages of dividends and
distribution of surplus, and the relationship of surplus after the dividend or
distribution is made to the minimum required statutory surplus. The Company did
not declare any shareholder dividends during 1997 and 1996. In December 1997,
RISCORP received a dividend of $2.2 million from RPC. The Company paid
dividends to participating policyholders of $8.6 million, $9.2 million and $1.6
million for the years ended December 31, 1997, 1996 and 1995, respectively. As
of December 31, 1997, the Company's insurance subsidiaries have the ability to
dividend $13.5 million to RISCORP without the prior approval of the FDOI or the
MDOI, consisting of $12.3 million from RPC, $1.2 million from RNIC and $0 from
RIC.
Combined statutory policyholders' surplus as of December 31, 1997 and 1996,
and combined statutory net income for the years ended December 31, 1997 and 1996
for the Company's insurance subsidiaries, were as follows (in thousands):
<TABLE>
<CAPTION>
1997 1996
--------- ---------
<S> <C> <C>
Policyholders' surplus $ 96,280 $ 90,639
Net income 11,042 13,980
</TABLE>
F-32
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
In order to facilitate the regulators' responsibility to monitor insurer
solvency, the National Association of Insurance Commissioners issued a model law
in January 1995 to implement risk-based capital ("RBC") reporting requirements
for property and casualty insurance companies. The model law is designed to
assess capital adequacy and the level of protection that statutory surplus
provides for policyholder obligations. The RBC formula for property and
casualty insurance companies measures four major areas of risk facing property
and casualty insurers: (i) underwriting, which encompasses the risk of adverse
loss development and inadequate pricing; (ii) credit risk, which evaluates the
declines in asset values; (iii) investment risk, which evaluates declines in
asset values; and (iv) off balance sheet risk. Pursuant to the model law,
insurers having less statutory surplus than required by the RBC calculation will
be subject to varying degrees of regulatory action, depending on the level of
capital inadequacy. RPC and RIC are domiciled in the State of Florida which has
yet to adopt the provisions of the RBC model law; however, these insurance
subsidiaries monitor their RBC results in anticipation of future filings. The
Company's third insurance subsidiary, RNIC, is domiciled in the State of
Missouri and RBC information is filed with state regulators. RBC is calculated
on an annual basis. At December 31, 1997, the Company's insurance subsidiaries
had statutory surplus in excess of any action level requirements.
(12) STOCK OPTIONS
In October 1995, the Financial Accounting Standards Board issued Statement
No. 123, "Accounting for Stock-Based Compensation," ("SFAS 123"). SFAS 123
establishes a method of accounting for stock-based compensation that is based on
the fair value of stock options and similar instruments and is effective for
fiscal years beginning after December 15, 1995. The adoption of SFAS 123 is not
required and the Company has elected to continue following Accounting Principles
Board Opinion No. 25, "Accounting for Stock Issued to Employees," for measuring
compensation cost. Had the Company adopted SFAS 123, pro forma net income and
earnings per share for the years ended December 31, 1997, 1996 and 1995 would
have been as follows (in thousands, except per share data):
<TABLE>
<CAPTION>
1997 1996 1995
-------- -------- ---------
<S> <C> <C> <C>
Net income - as reported $ 7,286 $ 2,398 $ 13,683
- pro forma 5,286 1,933 13,506
Net income per
common share-diluted - as reported $ 0.20 $ 0.07 $ 0.45
- pro forma 0.14 0.06 0.45
</TABLE>
In conjunction with the reorganization discussed in Note 1, stock options
of the Company were substituted for options previously granted to certain
officers and employees of the Company's affiliates. Options granted in 1997 are
exercisable for 10 years after the date and the options vest over periods
ranging from immediately to 2 years. In 1996 and 1995, options are exercisable
for 12 years after the date of the grant and the options vest over periods
ranging from two to nine years.
F-33
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
A summary of the status of the Company's Stock Option Plan as of and for
the years ended December 1997, 1996 and 1995 is presented below:
<TABLE>
<CAPTION>
1997 1996 1995
------------------------------ --------------------------- --------------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
OPTIONS SHARES EXERCISE PRICE SHARES EXERCISE PRICE SHARES EXERCISE PRICE
------- ------ -------------- ------ -------------- ------ --------------
<S> <C> <C> <C> <C> <C> <C>
Outstanding,
Beginning of year 3,078,779 $3.67 2,556,557 $3.96 1,854,392 $3.01
Granted 2,533,326 4.43 1,572,538 6.84 702,165 $6.50
Exercised - - (17,999) 3.61 - -
Canceled (3,078,779) 3.67 (1,032,317) 9.22 - -
---------- ----- ---------- ----- --------- -----
Outstanding, end of year 2,533,326 $4.43 3,078,779 $3.67 2,556,557 $3.96
---------- ----- ---------- ----- --------- -----
---------- ----- ---------- ----- --------- -----
Options
exercisable at year end 1,085,711 $6.67 731,849 $2.08 193,657 $0.73
---------- ----- --------- ----- --------- -----
---------- ----- --------- ----- --------- -----
Weighted average fair value of
options granted during the year $1.92 $5.44 $5.67
----- ----- -----
----- ----- -----
</TABLE>
The fair value of each option has been estimated on the date the option was
granted using the Black-Scholes option-pricing model with the following weighted
average assumptions used for grants in 1997, 1996 and 1995, respectively:
dividend yield of 0 percent for all years; expected volatility of 62 percent for
1997 and 60 percent for 1996 and 1995; risk-free interest rate of 5.5 percent
(1997), 8.1 percent (1996) and 6.5 percent (1995); and expected lives of 10
years for 1997 and 12 years for 1996 and 1995. Due to events subsequent to
December 31, 1997 and 1996, the amount shown above for the weighted average fair
value of options granted during 1997 and 1996 may not be indicative of the
current market value of the Company's stock.
The exercise price of options granted were determined to be not less than
the fair market value of the Class A Common Stock on the date the option was
granted, with the exception of options for 387,314 and 2,604 shares made to two
employees at exercise prices of $0.72 and $4.50, respectively, and fair values
of $22.78 and $12.54, respectively. Compensation expense recognized for options
with exercise prices below fair market value totaled $0, $0.3 million and $0.7
million for the years ended December 31, 1997, 1996 and 1995, respectively.
This compensation expense was reversed in the fourth quarter of 1997 following
termination of these options.
The following table summarizes information about stock options outstanding
at December 31, 1997:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------------------------- ------------------------------
RANGE OF NUMBER WEIGHTED AVG NUMBER WEIGHTED
EXERCISE OUTSTANDING REMAINING WEIGHTED AVG EXERCISABLE AVG EXERCISE
PRICES AT 12/31/97 CONTRACTUAL LIFE EXERCISE PRICE AT 12/31/97 PRICE
-------- ------------ ---------------- -------------- ----------- ------------
<S> <C> <C> <C> <C> <C>
$ 2.75 1,447,615 9.4 years $ 2.75 - $ -
$ 5.00 542,855 9.4 years 5.00 542,855 5.00
$ 7.50 361,904 9.4 years 7.50 361,904 7.50
$ 10.00 180,952 9.4 years 10.00 180,952 10.00
--------- --------- ------- --------- -------
2,533,326 9.4 years $ 4.43 1,085,711 $ 6.67
--------- --------- ------- --------- -------
--------- --------- ------- --------- -------
</TABLE>
F-34
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(13) PROPERTY AND EQUIPMENT
Property and equipment consist of the following at December 31, 1997 and
1996 (in thousands):
<TABLE>
<CAPTION>
ESTIMATED
USEFUL LIFE 1997 1996
----------- --------- ---------
<S> <C> <C> <C>
Furniture and equipment 3-7 years $ 16,542 $ 15,984
Building 39 years 8,084 7,846
Leasehold improvements 5-10 years 4,810 4,896
Software 3 years 6,758 5,041
Land 1,200 1,200
--------- ----------
37,394 34,967
Less accumulated depreciation and amortization (10,729) (7,462)
--------- ---------
$ 26,665 $ 27,505
--------- ---------
--------- ---------
</TABLE>
Depreciation and amortization expense related to property and equipment
totaled $4.9 million, $3.6 million and $2.0 million for the years ended December
31, 1997, 1996 and 1995, respectively. Included in these amounts is
amortization expense of $1.4 million, $0.8 million and $0.2 million for the
years ended December 31, 1997, 1996 and 1995, respectively, related to both
purchased and capitalized internally developed software costs.
(14) LEASES
The Company leases space for some of its office facilities under
non-cancelable operating leases expiring through January 2002, with renewal
options available for certain leases. Total rental expense for the years ended
December 31, 1997, 1996 and 1995 was $1.7 million, $1.3 million and $0.9
million, respectively. At December 31, 1997, the Company was obligated under
aggregate minimum annual rentals as follows (in thousands):
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, ANNUAL RENTAL
---------------------- -------------
<S> <C>
1998 $ 950
1999 455
2000 327
2001 182
2002 33
Thereafter -
-----
$ 1,947
--------
--------
</TABLE>
F-35
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(15) EMPLOYEE HEALTH BENEFITS
The Company self-insures its employees' health benefits and has
purchased excess insurance that limits its exposure to $1.1 million in the
aggregate and $50,000 per occurrence. The Company estimates its liability
for unpaid claims based on aggregate limits for health insurance payments
less actual payments made. These estimates are continually reviewed and
adjustments, if any, are reflected in current operations. Included in
accrued expenses at December 31, 1997 and 1996 is a liability for
self-insured health benefits of $0.9 million and $0.4 million, respectively.
Expenses for self-insured health benefits were $3.3 million, $2.6 million and
$1.4 million for the years ended December 31, 1997, 1996 and 1995,
respectively.
There were no employee benefit plans in 1997. Expenses relating to
employee benefit plans were $0.4 million and $0.2 million for the years ended
December 31, 1996 and 1995, respectively.
(16) RELATED PARTY TRANSACTIONS
The Company had accounts receivable of $0.8 million from several
affiliates which are included in accounts and notes receivable-other in the
accompanying Consolidated Balance Sheets at December 31, 1997. Additionally,
the Company had accounts and notes payable of $1.2 million at December 31,
1996 to those same affiliates.
In addition, the Company contracted with affiliated entities for
transportation, facilities management, and custodial and maintenance
services. The Company also leased parking facilities from affiliated
entities. Expenses relating to these services totaled $0.1 million, $1.6
million and $2.5 million for the years ended December 31, 1997, 1996 and
1995, respectively. These expenses are included in commissions, general and
administrative expenses in the accompanying Consolidated Statements of Income.
The Company paid brokerage fees to an affiliated company for the
negotiation and placement of reinsurance under several specific excess of
loss coverages. These fees totaled $0, $0.9 million and $0.8 million for the
years ended December 31, 1997, 1996 and 1995, respectively. The Company
terminated its agreement with the affiliated company during 1997.
The Company provides administrative and support services to three
affiliated companies. Under these arrangements, one of which terminated in
1996, the Company received $0.6 million, $0.8 million and $1.02 million for
the years ended December 31, 1997, 1996 and 1995, respectively. In addition,
the Company performed certain unreimbursed services totaling $1.6 million
during 1995 for one of these affiliates.
As described in Note 8, the Company was party to a managed care
arrangement with RHP, an affiliated HMO, until May 1, 1996. Fees paid to RHP
for the years ended December 31, 1997, 1996 and 1995 totaled $3.7 million,
$17.1 million and $1.5 million, respectively. The managed care arrangement
with RHP was terminated in October 1997 following its sale to Oxford Health
Plans. As more fully described in Note 8, the Company assumed the
outstanding liability for unpaid losses and loss adjustment expenses which
totaled $8.0 million.
F-36
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(17) BAD DEBT ALLOWANCE
The following table summarizes activity in the bad debt allowance
account for premiums receivable for the years ended December 31, 1997, 1996
and 1995 (in thousands):
<TABLE>
<CAPTION>
1997 1996 1995
--------- -------- --------
<S> <C> <C> <C>
Balance at beginning of period $ 17,000 $ 5,899 $ 5
Allowance acquired from acquisitions - 782 7,542
Additions to allowance 4,374 31,424 3,852
Write-offs against allowance (14,374) (21,105) (5,500)
--------- -------- --------
Balance at end of period $ 7,000 $ 17,000 $ 5,899
--------- -------- --------
--------- -------- --------
</TABLE>
Premiums receivable included in the accompanying Consolidated Balance
Sheets as of December 31, 1997 and 1996 are summarized as follows (in
thousands):
<TABLE>
<CAPTION>
1997 1996
--------- ---------
<S> <C> <C>
Commercial accounts including final
premium audit adjustments $ 29,612 $ 42,245
Loss sensitive contracts 68,804 91,594
NCCI pool accounts 6,987 -
Other 1,780 5,239
--------- ---------
107,183 139,078
Less bad debt allowance (7,000) (17,000)
--------- ---------
$ 100,183 $ 122,078
--------- ---------
--------- ---------
</TABLE>
(18) CONCENTRATION IN A SINGLE STATE
Although the Company has expanded its operations into additional states,
70 percent, 74 percent and 93 percent of its revenues for the years ended
December 31, 1997, 1996 and 1995, respectively, were derived from products
and services offered to customers located in Florida. Accordingly, the
Company could be adversely affected by economic downturns, significant
unemployment, and other conditions that may occur from time to time in
Florida, which may not significantly affect its more geographically
diversified competitors.
(19) COMMITMENTS AND CONTINGENCIES
Between November 20, 1996 and January 31, 1997, nine shareholder class
action lawsuits were filed against RISCORP, Inc. and other defendants in the
United States District Court for the Middle District of Florida (the
"Securities Litigation"). In March 1997, the court consolidated these lawsuits
and appointed
F-37
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
co-lead plaintiffs and co-lead counsel. The plaintiffs subsequently filed a
consolidated complaint. The consolidated complaint named as defendants RISCORP,
Inc., three of its executive officers, one non-officer director and three of the
underwriters for RISCORP, Inc.'s initial public offering. The plaintiffs in the
consolidated complaint purport to represent the class of shareholders who
purchased RISCORP, Inc. Class A Common Stock between February 28, 1996 and
November 14, 1996. The consolidated complaint alleges that RISCORP, Inc.'s
Registration Statement and Prospectus of February 28, 1996, as well as
subsequent statements, contained false and misleading statements of material
fact and omissions, in violation of sections 11 and 15 of the Securities Act and
sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 promulgated
thereunder. The consolidated complaint seeks unspecified compensatory damages.
Pursuant to court ordered mediation, counsel for the parties have engaged in
discussions in an effort to resolve the Securities Litigation. On January 14,
1998, counsel for the Company, counsel for William D. Griffin and counsel for
the plaintiffs reached an oral agreement on terms to recommend to their clients
to settle this litigation. The proposed settlement is contingent upon the
following: consummation of the transactions contemplated by the Purchase
Agreement with Zenith, certification of a settlement class, payment by the
Company to the settlement class, disclosure of certain documents, interviews of
individuals to verify information relating to the settlement and a release
against all defendants. Counsel to the parties are in the process of finalizing
the initial settlement documents. The settlement will require preliminary
approval by the court as to the fairness of the terms of the settlement. Notice
to the settlement class and an opportunity to object to the terms of the
settlement and to exclude themselves from the settlement class is also required.
The settlement must receive final court approval after notice to the settlement
class and an opportunity to object or opt out is provided. Not all of the terms
of the settlement have been finalized as of this date. Counsel to the parties
have agreed to recommend to their respective clients a settlement amount of
$21.0 million. The Company estimates that $8.0 million of insurance proceeds
will be available for contribution to the settlement amount, as well as related
costs and expenses. Given the preliminary nature of this settlement and the
various contingencies relating to its consummation, there can be no assurance
that this litigation will ultimately be settled on this basis. The Company
recognized the $21.0 million proposed settlement and the related insurance
proceeds in the accompanying financial statements as of December 31, 1997.
In April 1996, RISCORP Insurance Company and certain officers and directors
were named as defendants in a purported class action suit filed in the United
States District Court for the Southern District of Florida (the "Vero Cricket
Litigation"). In this action, the plaintiffs claimed that the defendants
violated the Racketeer Influenced and Corrupt Organizations Act ("RICO"),
breached fiduciary duties and were negligent in the Company's acquisition
of Commerce Mutual Insurance Company ("CMIC") in 1995. The plaintiffs
sought compensatory and punitive damages and equitable relief and treble
damages for the RICO counts. The named plaintiffs, Vero Cricket Shop, Inc.,
Vero Cricket Shop Too, Inc., and Falls Company of Longboat Key, Inc., claimed
to be former policyholders of CMIC and claimed to represent others similarly
situated.
On December 5, 1997, counsel for the parties reached an agreement to
recommend to their respective clients a settlement of the claims asserted in the
Vero Cricket litigation. Plaintiff's counsel has confirmed that the terms of
the settlement are acceptable to the named plaintiffs. The Company's Board of
Directors has approved the terms of the settlement, and the final settlement
documents are being reviewed by the
F-38
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
parties and counsel. The settlement is contingent upon preliminary approval by
the court as to the fairness of the settlement, certification of a settlement
class, notice to the settlement class, opportunity of the settlement class
members to object and withdraw, no termination by either party and final
approval by the court. Pursuant to the terms of the settlement agreement and
subject to the satisfaction of the contingencies discussed above, RISCORP
Insurance Company will pay to the plaintiffs a settlement amount of $475,000.
The Company estimates that 75 percent of the settlement amount will be covered
by insurance. The Company recognized the $475,000 proposed settlement and the
related insurance proceeds in the accompanying financial statements as of
December 31, 1997.
On September 18, 1997, the United States Attorney's office in Pensacola,
Florida announced that a United States grand jury had indicted RISCORP, Inc.,
RISCORP Management Services, Inc. (a wholly owned, non-regulated subsidiary of
RISCORP, Inc.) and five former officers, including William D. Griffin, Founder
and Chairman of the Board, for various charges stemming from alleged illegal
political campaign contributions. On September 18, 1997, the Board of Directors
approved a guilty plea by RMS to a single count of conspiracy to commit mail
fraud. The guilty plea was entered by RMS and accepted by the court on October
9, 1997. As a result of an agreement negotiated with the United States
Attorney, the court dismissed the indictment against RISCORP, Inc. on the same
day. Mr. Griffin has resigned from the Board of Directors of the Company and
all other positions with the Company. RMS agreed to cease to operate as a third
party administrator effective October 31, 1997. As of December 31, 1996, RMS
recorded $1.0 million for the estimated fines and costs related to this matter.
On February 18, 1998, a second superseding indictment was issued against the
five former officers including Mr. Griffin. Neither the Company nor any of its
subsidiaries were named as defendants in the second indictment. The charges
asserted in the second indictment, like those in the first indictment, stem from
alleged illegal political campaign contributions.
On July 17, 1997, plaintiffs Thomas K. Albrecht and Peter D. Norman filed,
in the Circuit Court of Montgomery County, Alabama, an action against the
Company, Mr. William D. Griffin and several other former officers of the
Company. The suit alleged violations of federal and state securities laws and
breach of contract resulting from the purchase of IAA by the Company in 1996.
The plaintiffs sought compensatory and punitive damages and equitable relief.
On or about December 2, 1997, counsel for the Company and counsel for plaintiffs
negotiated a settlement of this action. Settlement documents have been approved
and executed by all parties. As part of the settlement agreement, the Company
paid $2.0 million to plaintiffs, RISCORP, Inc. advanced $2.3 million to
plaintiffs against an anticipated final distribution to shareholders and
RISCORP, Inc. accelerated a distribution of 790,336 additional shares of Class A
Common Stock to the plaintiffs. Such shares were contemplated under the terms
of the Agreement and Plan of Merger by and among the Company, RISCORP-IAA, Inc.,
IAA, Thomas K. Albrecht and Peter D. Norman, dated as of September 17, 1996.
The Company estimates that $2.0 million of insurance proceeds will be available
to offset the total settlement amount as well as related costs and expenses.
The Company recognized the $2.0 million proposed settlement and the related
insurance proceeds in the accompanying financial statements as of December 31,
1997. As part of the settlement agreement, the plaintiffs agreed to vote all
their shares of Class A Common Stock in favor of the Purchase Agreement and the
transaction contemplated therein. Plaintiffs are record holders of 1,580,672
shares of Class A Common Stock, and, thus, these plaintiffs hold 13 percent of
the outstanding shares of Class A Common Stock.
F-39
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
On August 20, 1997, RISCORP, Inc., the Company, IAA and Peter Norman were
named as defendants in a suit filed in state court in Montgomery, Alabama. The
suit alleges common law fraud, breach of contract and breach of fiduciary duty
resulting from the acquisition of OSAA in 1996. The suit seeks compensatory and
punitive damages and equitable relief. The named plaintiff is OSAA. The
Company intends to vigorously defend this action; however, there can be no
assurance that it will prevail in the litigation. It should be noted that the
frequency of large punitive damage awards bearing little or no relation to
actual damages awarded by juries in jurisdictions in which the Company has
substantial business, particularly in Alabama, continues to increase
universally, creating the potential for unpredictable material adverse judgments
in any given punitive damage suit.
In June 1997, the Company terminated a number of employees in connection
with the workforce reduction. As a result of the workforce reduction, a number
of former employees have initiated proceedings, including arbitration, against
the Company for certain severance benefits. The Company intends to vigorously
defend these suits; however, there can be no assurance that it will prevail in
these proceedings.
On March 13, 1998, RIC and RPC were named as defendants in a purported
class action against the National Council on Compensation Insurance, Inc. and
all insurers selling workers' compensation insurance in the State of Florida
from 1985 to 1998. The suit claims the defendants violated the Sherman
Antitrust Act, RICO, the Florida Antitrust Act and the common law in the
collection of workers' compensation premiums for alleged residual market loads.
The suit seeks compensatory and punitive damages and treble damages for the RICO
counts. The named plaintiff, Bristol Hotel Asset Company, claims to be a
purchaser of Florida workers' compensation insurance and claims to represent
others similarly situated. The Company intends to vigorously defend this
action; however, there can be no assurance it will prevail in the litigation.
The Company, in the normal course of business, is party to various lawsuits
which management believes will not materially affect the financial position of
the Company. Based upon information presently available, and in light of legal
and other defenses available to the Company, contingent liabilities arising from
threatened and pending litigation are not presently considered by management to
be material. However, no assurance can be given, or may be taken that material
adverse judgments will not be rendered against the Company as a result of the
aforementioned matters.
Other than as noted above, no provision had been made in the Company's
financial statements for the above matters at December 31, 1997 and 1996. In
addition, certain of the lawsuits and related legal expenses may be covered
under directors and officers' insurance coverage maintained by the Company.
The Company entered into a contract with the Florida Chamber of Commerce
("the Chamber") in 1993, under which the Company agreed to pay the Chamber $1.0
million annually through 1998 for the Chamber's endorsement of the Company, a
non-compete agreement by the Chamber and certain other restrictive covenants.
The fee incurred for each of the years ended December 31, 1996 and 1997 under
this agreement was $1.0 million. The Company collateralized its obligation
under the agreement with an irrevocable letter of credit and RISCORP secured the
letter of credit with certificates of deposit. The final payment of $1.0
million under this contract was paid in December 1997.
F-40
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
On October 9, 1997, the MDOI completed an examination of the Company's
books and records as of December 31, 1996. The MDOI issued a final report on
the 1996 examination on December 10, 1997. The statutory capital and surplus as
of December 31, 1996 determined by the examiners was $29,345,804 compared to
$31,012,399 reported by RNIC in its 1996 statutory financial statements. The
most significant examination adjustment was the non-admission of an accounts
receivable balance relating to the loss portfolio transfer from OSAA in the
amount of $900,000. This balance was paid in full by OSAA. The remaining
adjustments of $800,000 pertain to items that were either collected or charged
to expense during 1997. These examination adjustments relate to the statutory
financial statements and have no impact on the GAAP financial statements.
During February 1998, the FDOI completed an examination of the statutory
books and records of RIC and RPC as of December 31, 1996. The FDOI has not yet
issued a report; however, based on the February 5, 1998 closing conference with
the FDOI examiners, the resolution of the impact of the matters raised by the
FDOI will not have a material impact on the December 31, 1996 statutory
financial statements of RIC and RPC. However, because the FDOI has not released
the final results of their examination, Management cannot determine the
materiality or dollar amount of adjustments, if any, to the December 31, 1996
statutory financial statements resulting from the FDOI's 1996 examinations of
RIC and RPC. Management believes that any adjustments arising out of the
statutory examinations of RIC and RPC will have no material impact on the
accompanying GAAP financial statements.
The Company historically met its cash requirements and financed its growth
through cash flow generated from operations and borrowings. The Company's
primary sources of cash flow from operations are premiums and investment income,
and its cash requirements consist primarily of payment of losses and loss
adjustment expenses, support of its operating activities including various
reinsurance agreements and managed care programs and services, capital surplus
needs for its insurance subsidiaries, and other general and administrative
expenses.
(20) PROPOSED SALE TO ZENITH INSURANCE COMPANY ("ZENITH")
On June 17, 1997, RISCORP and certain of its subsidiaries entered into an
Asset Purchase Agreement for the sale of substantially all of the assets and the
assumption of certain liabilities of RISCORP and its subsidiaries to Zenith in
exchange for cash. The Asset Purchase Agreement was amended on June 26, 1997
and July 11, 1997. The purchase price for the net assets of RISCORP and its
subsidiaries to be acquired by Zenith is undetermined at this time but will be
based on the GAAP Statement of Transferred Assets and Transferred Liabilities as
of the closing date. The Statement of Transferred Assets and Transferred
Liabilities is required to be prepared by RISCORP and audited by RISCORP's
independent accountants within 70 days from the closing date. It is expected
that this pending transaction will transfer primarily all of the assets,
liabilities and operations of the Company to Zenith, leaving the Company with
the minimum required capital and surplus to maintain its various state licenses
and no continuing insurance operations. RISCORP has scheduled a special meeting
of shareholders to be held on March 26, 1998 for the purpose of voting upon the
proposal to approve and adopt the Asset Purchase Agreement. Assuming the
shareholders approve the Purchase Agreement on March 26, 1998, the parties
expect the transaction to close on April 1, 1998.
F-41
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(21) ADJUSTMENTS MADE IN THE FOURTH QUARTER
As described below, the Company made certain adjustments in the fourth
quarter of 1997 which have been included in the accompanying December 31,
1997 financial statements. The impact of the fourth quarter adjustments
described below was an increase of $0.3 million to 1997 income before income
taxes.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
In the fourth quarter of 1997, the Company completed a detailed review
of the composition of the December 31, 1997 premium receivables balance in
connection with the determination of the allowance for doubtful accounts.
This analysis was the continuation of the analysis performed in connection
with the determination of the 1996 allowance for doubtful accounts discussed
below. As a result of this analysis, an increase of $4.4 million was
recorded in the allowance for doubtful accounts to increase the allowance for
doubtful accounts to $21.4 million.
In addition, the allowance for doubtful accounts was reduced by $14.4
million in the fourth quarter as a result of write-offs of bad debts of $14.4
million. This adjustment had no effect on the accompanying statements of
income.
PROPOSED LITIGATION SETTLEMENTS
As more fully discussed in Note 19, the Company negotiated settlements of
three lawsuits during December 1997 and January 1998. As a result of these
proposed settlements, the Company recognized an expense in the fourth quarter of
$13.1 million, net of estimated insurance proceeds, in the accompanying
financial statements as of December 31, 1997.
INVOLUNTARY POOLS
During 1996, RISCORP expanded its workers' compensation business into
Alabama, Georgia, Kansas, North Carolina, South Carolina and Virginia primarily
as a result of the acquisition of Atlas Insurance Company (see Note 3). The
National Council on Compensation Insurance, Inc. ("NCCI") is the administrator
for the National Workers' Compensation Reinsurance Pool ("POOL") for the above
states.
On January 9, 1998, the NCCI notified RISCORP of its proportionate share of
POOL results through September 30, 1997, and RISCORP recorded the information
received from the NCCI in the fourth quarter of 1997. The impact of recording
the information was an increase of earned premiums of $11.6 million, increases
in loss and loss adjustment expenses of $8.9 million and increases in
commissions, general and administrative expenses of $5.0 million.
FAVORABLE RESERVE DEVELOPMENT
During the fourth quarter of 1997, the Company completed a detailed
analysis of its loss and loss adjustment expense reserves in connection with the
determination of the December 31, 1997 loss and loss
F-42
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
adjustment expense reserves. This analysis, combined with favorable development
experienced in the fourth quarter of 1997, resulted in an overall reduction of
the loss and loss adjustment expense reserves of $12.2 million in the fourth
quarter of 1997.
QUOTA SHARE CEDING COMMISSIONS
The Company recognized $6.3 million of ceding commission income in the
fourth quarter of 1997 primarily resulting from the impact of the decrease in
loss and loss adjustment expense reserves discussed above. Ceding commission
income is recorded as a reduction of commissions, general and administrative
expenses in the accompanying financial statements.
STOCK OPTIONS
In the fourth quarter of 1997, the Company terminated all stock options
previously granted under its stock option plan. As a result of the termination
of the stock options, the Company reversed $1.6 million of compensation expense
that had previously been recorded on the stock options granted by the Company.
As described below, the Company made certain adjustments in the fourth
quarter of 1996 which have been included in the accompanying December 31, 1996
financial statements. The impact of the fourth quarter adjustments described
below was a reduction of $11.5 million to 1996 income before income taxes.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
The Company completed a detailed review of the composition of the December
31, 1996 premium receivables balance in 1997, in connection with the
determination of the allowance for doubtful accounts as of December 31, 1996.
As a result of this analysis, an increase of $7.7 million was recorded in the
allowance for doubtful accounts in the fourth quarter of 1996 to increase the
allowance for doubtful accounts to $17.0 million.
GOODWILL
As more fully discussed in Note 2(i) and Note 3, during the first quarter
of 1997, it became evident that the goodwill recorded at the date of the RISC
and IAA acquisition could not be fully recovered from the profitability of the
workers' compensation business that was currently under contract. The Company
performed an analysis of the carrying value of the goodwill recorded in
connection with this acquisition and recognized an impairment loss of $2.8
million in the fourth quarter of 1996. This impairment loss was recorded as a
component of depreciation and amortization in the Company's Consolidated
Statement of Income for the year ended December 31, 1996. Remaining unamortized
goodwill related to IAA was $8.5 million at December 31, 1996.
F-43
<PAGE>
RISCORP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
LITIGATION EXPENSES
As discussed in Note 19, in the fourth quarter of 1996, the Company
recorded a provision of $1.0 million for payment of fines and other costs
related to the RMS matter. This provision was included in the Company's
Consolidated Statement of Income for the year ended December 31, 1996.
(22) EVENTS (UNAUDITED) SUBSEQUENT TO THE DATE OF THE INDEPENDENT AUDITORS'
REPORT
On March 26, 1998, RISCORP, Inc. held a Special Meeting of Shareholders
for the purpose of voting upon the proposal to approve and adopt the Asset
Purchase Agreement. The shareholders approved the Asset Purchase Agreement on
March 26, 1998, the transaction closed on April 1, 1998 (the "Closing Date")
and, on that date, RISCORP, Inc. and its subsidiaries (collectively,
"RISCORP") ceased substantially all of its former business operations.
On June 8, 1998, RISCORP's representatives, in accordance with the Asset
Purchase Agreement, delivered to Zenith an audited statement of Transferred
Assets and Transferred Liabilities as of the Closing Date (the "Proposed
Business Balance Sheet").
F-44
<PAGE>
UNAUDITED PRO FORMA FINANCIAL INFORMATION
The following unaudited combined condensed pro forma balance sheet estimates
the pro forma effect of the acquisition as if the acquisition and the
transactions contemplated in the Asset Purchase Agreement had been
consummated on December 31, 1997. The following unaudited combined condensed
pro forma statement of operations estimates the pro forma statement of
operations based on the pro forma effects of the acquisition as if such
acquisition had occurred on January 1, 1997. The pro forma adjustments are
described in the following notes and are based upon available information and
certain assumptions that Zenith believes are reasonable. The pro forma data
may not be indicative of the results of operations and financial position of
Zenith, as it may be in the future or as it might have been had the
transactions been consummated on the respective dates assumed. The
information should be read in conjunction with the historical consolidated
financial statements and accompanying notes of Zenith previously filed in
Zenith's Form 10-K for the year ended December 31, 1997, the Proxy Statement
of RISCORP, Inc. dated March 3, 1998 and the historical consolidated
financial statements and accompanying notes of RISCORP, Inc. for the year
ended December 31, 1997 contained herein.
The final purchase price will be the difference between the book value of the
assets purchased and the book value of the liabilities assumed by Zenith
Insurance as of April 1, 1998, each determined in accordance with United States
generally accepted accounting principles and actuarial principles consistently
applied. The final purchase price is subject to audit and a dispute resolution
process, and cannot be determined at this time. Consequently, the final
purchase price may differ materially from the amount of derived purchase price
reflected in the pro forma combined condensed balance sheet presented.
F-45
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
PRO FORMA COMBINED CONDENSED BALANCE SHEET
DECEMBER 31, 1997
(Unaudited)
<TABLE>
<CAPTION>
RISCORP
-----------------------------------------
Assets and
Zenith Liabilities to Pro forma
(In thousands) Historical Historical Adjustments be Purchased Adjustments Zenith
- ----------------------------------------------------------------------------------------------------------------------------------
(a) (b) (c) (b)+(c)=(d) (e) (a)+(d)+(e)
<S> <C> <C> <C> <C> <C> <C>
ASSETS
Cash and investments $892,477 $253,634 $253,634 ($176,629)(2),(3) $969,482
Premiums receivable 72,813 100,183 100,183 172,996
Receivable from reinsurers, state trust
funds, and prepaid reinsurance
premiums 106,067 259,445 259,445 365,512
Intangible assets 7,001 15,286 15,286 (9,802)(3) 12,485
Other assets 173,798 121,102 ($39,782)(1) 81,320 1,744(3) 256,862
-----------------------------------------------------------------------------------------
TOTAL ASSETS $1,252,156 $749,650 ($39,782) $709,868 ($184,687) $1,777,337
-----------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------
LIABILITIES
Unpaid loss and loss adjustment expenses $613,266 $437,038 $437,038 $1,050,304
Unearned premiums 128,469 56,324 56,324 184,793
Senior notes payable 74,474 74,474
Other liabilities 74,081 92,755 ($38,135)(1) 54,620 ($22,801)(2),(3) 105,900
-----------------------------------------------------------------------------------------
TOTAL LIABILITIES INCLUDING
PURCHASED LIABILITIES 890,290 586,117 (38,135) 547,982 (22,801) 1,415,471
DERIVED PURCHASE PRICE 161,886 161,886 (161,886)(4)
-----------------------------------------------------------------------------------------
TOTAL LIABILITIES INCLUDING PURCHASE
PRICE PAYABLE $890,290 $586,117 $123,751 $709,868 ($184,687) $1,415,471
-----------------------------------------------------------------------------------------
STOCKHOLDERS' EQUITY
Common stock $24,681 $364 ($364)(1) $24,681
Additional paid-in capital 264,098 135,974 (135,974)(1) 264,098
Retained earnings 186,268 25,195 (25,195)(1) 186,268
Net unrealized appreciation on investments 9,332 2,001 (2,001)(1) 9,332
-----------------------------------------------------------------------------------------
484,379 163,534 (163,534) 484,379
Less treasury stock at cost (122,513) (1) 1 (1) (122,513)
-----------------------------------------------------------------------------------------
TOTAL STOCKHOLDERS' EQUITY 361,866 163,533 (163,533) 361,866
-----------------------------------------------------------------------------------------
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY $1,252,156 $749,650 ($39,782) $709,868 ($184,687) $1,777,337
-----------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------
F-46
The accompanying notes are an integral part of the pro forma combined condensed financial statements.
</TABLE>
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
PRO FORMA COMBINED CONDENSED STATEMENT OF OPERATIONS
FOR THE YEAR ENDED DECEMBER 31, 1997
(Unaudited)
<TABLE>
<CAPTION>
RISCORP
-----------------------------------------
Revenues
Zenith and Expenses Pro forma
(In thousands) Historical Historical Adjustments Remaining Adjustments Zenith
- ----------------------------------------------------------------------------------------------------------------------------------
(a) (b) (c) (b)+(c)=(d) (e) (a)+(d)+(e)
<S> <C> <C> <C> <C> <C> <C>
CONSOLIDATED REVENUES:
Premiums earned $488,721 $179,729 $179,729 $668,450
Fees and other income 20,369 20,369 ($10,344)(5) 10,025
Net investment income 52,332 16,447 16,447 (9,713)(6) 59,066
Realized gains on investments 14,008 1,546 1,546 (1,546)(7) 14,008
Real estate sales 45,419 45,419
---------------------------------------------------------------------------------------
Total revenues 600,480 218,091 218,091 (21,603) 796,968
EXPENSES:
Loss and loss adjustment expenses incurred 348,165 123,362 123,362 471,527
Policy acquisition costs 92,213 92,213
Other underwriting and operating expenses 67,953 74,924 ($13,000)(10) 61,924 (700)(5) 129,177(11)
Amortization of intangible assets 405 3,300 3,300 (3,026)(8) 679
Real estate construction and operating costs 44,286 44,286
Interest expense 3,980 1,919 1,919 (1,919)(2) 3,980
---------------------------------------------------------------------------------------
Total expenses 557,002 203,505 (13,000) 190,505 (5,645) 741,862
Income before federal income tax expense 43,478 14,586 13,000 27,586 (15,958) 55,106
Federal income tax expense 15,378 7,300 4,598(1) 11,898 (7,783)(9) 19,493
---------------------------------------------------------------------------------------
NET INCOME $28,100 $7,286 $ 8,402 $15,688 ($8,175) $35,613
---------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------
Net income per common share $1.59 $2.01
Net income per common share - assuming dilution $1.57 $1.99
Weighted average common shares outstanding 17,716 17,716
Weighted average common shares outstanding
- assuming dilution 17,886 17,886
F-47
The accompanying notes are an integral part of the pro forma combined condensed financial statements.
</TABLE>
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
NOTES TO PRO FORMA COMBINED CONDENSED FINANCIAL STATEMENTS
DECEMBER 31, 1997
Adjustments to the pro forma combined condensed balance sheet to give effect to
the acquisition as of December 31, 1997 are summarized below.
(1) Represents assets, liabilities and stockholders' equity to be retained
by RISCORP, Inc. in accordance with the purchase agreement including
deferred tax asset, certain prepaid expenses, other receivables, net
litigation accruals, certain payables and others.
(2) Represents payments related to the acquisition, including the derived
purchase price of approximately $161.9 million and the immediate
repayment of $15 million note payable to a quota share reinsurer assumed
from RISCORP.
(3) Represents change in intangible assets as a result of eliminating
RISCORP's goodwill of $15.3 million, net assets in excess of cost of
business acquired of $5.7 million, and $8.6 million of deferred
acquisition cost and offsetting deferred ceding commission of $10.7
million; increasing building property by approximately $2.0 million to
record its estimated fair market value; recording the excess of the cost
over the fair value of the assets and liabilities purchased from RISCORP
of approximately $2.7 million; and direct transaction costs associated
with the acquisition of $2.8 million (reclassified from other assets).
(4) Represents derived purchase price based upon reported assets and
liabilities as of December 31, 1997. Actual purchase price will be
based upon balances at the closing date of April 1, 1998 subject to an
audit and a dispute resolution process with a $35.0 million minimum
purchase price. The actual purchase price may differ materially from
this derived amount presented.
F-48
<PAGE>
ZENITH NATIONAL INSURANCE CORP. AND SUBSIDIARIES
NOTES TO PRO FORMA COMBINED CONDENSED FINANCIAL STATEMENTS
DECEMBER 31, 1997
Adjustments to the pro forma combined condensed statement of operations to
give effect to the acquisition as of January 1, 1997 are summarized below.
(5) Represents non-recurring income and related expense from service fee
agreements terminated by RISCORP prior to closing the Asset Purchase
Agreement.
(6) Represents foregone investment income at 6% per year on the derived
purchase price of approximately $161.9 million.
(7) RISCORP's net realized gains on investments, a non-recurring item, have
been reduced to zero.
(8) RISCORP's historical goodwill amortization is eliminated, and the
amortization of intangible assets of approximately $5.5 million from
purchase accounting for the acquisition using straight-line basis over 20
years is recognized.
(9) Represents the tax effect of adjustments.
(10) Represents a $13.0 million expense recognized in 1997 in connection with
the proposed settlement of RISCORP, Inc.'s securities class action
lawsuit.
(11) Includes RISCORP's significant amount of legal, audit and consulting
fees which are probably non-recurring.
F-49
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
ZENITH NATIONAL INSURANCE CORP.
Dated: June 12, 1998 By: /s/ Fredricka Taubitz
---------------------
Name: Fredricka Taubitz
Title: Executive Vice President and
Chief Financial Officer
<PAGE>
The Board of Directors
RISCORP, Inc.:
We consent to the inclusion of our report dated March 24, 1998, with respect
to the consolidated balance sheets of RISCORP, Inc. and subsidiaries as of
December 31, 1997 and 1996, and the related consolidated statements of
income, stockholders' equity, and cash flows for each of the years in the
three-year period ended December 31, 1997, which report appears in the Form
8-K/A of Zenith National Insurance Corp. dated April 1, 1998.
Our report dated March 24, 1998, contains an explanatory paragraph that
states that RISCORP, Inc. and subsidiaries undertook a strategic initiative
to evaluate alternatives to maximize shareholder value. The initiative has
resulted in the pending sale and transfer of certain assets and
non-contingent liabilities of RISCORP, Inc. and its subsidiaries. As
requested by the Florida Department of Insurance, cut-through endorsements
and an interim reinsurance agreement have been executed in connection with
the pending sale. The sale is subject to the approval of the shareholders of
RISCORP, Inc. The Company's ability to operate at its present level of
activity may be affected if the pending sale transaction is not completed.
Further, RISCORP, Inc. and its subsidiaries have been named as defendants in
various lawsuits. The consolidated financial statements do not include any
adjustments that might result from the outcome of these uncertainties.
/s/ KPMG Peat Marwick LLP
- ----------------------------
Fort Lauderdale, Florida
June 12, 1998
