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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1997 Commission file number 1-10995
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Capital Re Corporation
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(Exact name of registrant as specified in its charter)
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<CAPTION>
<S> <C>
Delaware 52-1567009
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(State or other jurisdiction of incorporation (I.R.S. Employer Identification No.)
or organization)
1325 Avenue of the Americas, New York, N.Y. 10019
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: 212-974-0100
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Securities registered pursuant to Section 12(b) of the Act:
Common Stock, $.01 par value, and
Capital Re LLC 7.65% Cumulative
Monthly Income Preferred Shares, Series A
(guaranteed by Capital Re Corporation) New York Stock Exchange, Inc.
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(Title of Class) (Name of each exchange on which registered)
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Securities registered pursuant to Section 12(g) of the Act:
None
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(Title of Class)
Indicate by check mark whether registrant (1) has filled all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
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Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendments to
this Form 10-K. [ ]
The approximate aggregate market value of the voting and non-voting common
equity held by non-affiliates of the registrant as of March 24, 1998
was $1,038,743,264. The number of shares of Common Stock outstanding as of
March 24, 1998 was 15,919,437.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's 1998 definitive Proxy Statement for the annual
shareholders meeting to be held May 20, 1998 are incorporated by reference into
Part III hereof.
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PART I
ITEM 1. BUSINESS.
A. GENERAL:
(1) Company Overview and Business Strategy -
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Capital Re Corporation (the "Company" or "Capital Re") is an insurance holding
company for a group of reinsurance companies that provide value-added
reinsurance products in several specialty insurance markets. The Company
provides reinsurance to insurers in four principal areas of specialization:
financial guaranty insurance, mortgage guaranty insurance, trade credit
insurance and title insurance. Together, the Company's financial guaranty and
mortgage guaranty reinsurance lines of business contributed 93% of 1997
consolidated net operating income. The Company will continue to diversify
through product development in its core financial reinsurance lines, expansion
into complementary financial and credit-based areas of insurance and
reinsurance, and the provision of related financial products and services.
The Company provides reinsurance products through five wholly-owned insurance
subsidiaries: Capital Reinsurance Company ("Capital Reinsurance"), Capital
Mortgage Reinsurance Company ("Capital Mortgage"), KRE Reinsurance Ltd.
(formerly, Capital Mortgage Reinsurance Company (Bermuda) Ltd.) ("KRE"),
Capital Credit Reinsurance Company Ltd. ("Capital Credit") and Capital Title
Reinsurance Company ("Capital Title"). In all of its principal areas of
specialization, the Company seeks to provide innovative reinsurance solutions to
satisfy the diverse risk and financial management demands of its primary
clients. Theses solutions often take the form of complex reinsurance
arrangements that provide value other than pure risk management (i.e., financial
statement benefit, regulatory relief and rating agency qualified capital).
Capital Reinsurance is a professional reinsurance company dedicated to serving
the U.S. domestic and international financial guaranty insurance markets and has
established itself as a leading specialty reinsurer (by market share) of
financial guaranties of investment grade debt obligations, principally municipal
debt obligations. Capital Reinsurance's focus on the municipal bond reinsurance
business recognizes the fact that historically municipal bond insurance has been
a proven revenue source in the financial guaranty insurance market which, when
managed properly, can provide predictable revenues from (i) an associated
deferred premium revenue account, (ii) installment premiums from business
already originated and (iii) interest income on the Company's investment
portfolio. In the municipal bond insurance market, Capital Reinsurance has
sought to assume business with what it believes is a lower risk profile and
higher than average pricing for the municipal bond insurance industry. At the
same time, consistent with its "zero loss" underwriting policies, Capital
Reinsurance has pursued the reinsurance of investment grade non-municipal debt
obligations and directing its capacity to the reinsurance of financial
guaranties of asset-backed securities. In the case of both municipal bond
reinsurance and the reinsurance of non-municipal debt obligations, Capital
Reinsurance has emphasized facultative reinsurance, which Capital Reinsurance
believes better permits it to maintain portfolio diversification, pricing
discipline and conformity to its underwriting policies, because through
facultative reinsurance the reinsurer may exercise control over risks assumed as
they are accepted only on a risk-by-risk basis.
The claims-paying ability of Capital Reinsurance is rated AAA by Standard and
Poor's Corporation ("S&P"), Moody's Investors Service, Inc. ("Moody's") and
Fitch IBCA ("Fitch"). In January 1998, Moody's placed the claims-paying ability
rating of Capital Reinsurance on credit review for possible downgrade. See
"Business--Ratings." Capital Reinsurance's underwriting process is premised on a
general policy of reinsuring only those obligations that are investment grade on
the date reinsured and where there is no expectation of loss on the risk
reinsured. Nevertheless, losses can be expected to occur in Capital
Reinsurance's existing and future reinsured portfolio.
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The successful establishment of Capital Reinsurance as a leading financial
guaranty reinsurer, together with the creation of a quality reinsurance
portfolio that provides a substantial base of recurring revenues, have given the
Company a foundation to facilitate its strategy of expansion into complementary
financial reinsurance business lines. The first stage in the execution of that
strategy was the Company's expansion into mortgage guaranty reinsurance through
the organization and capitalization of Capital Mortgage, which commenced
operations in February 1994. Capital Mortgage has become a leading reinsurer of
mortgage guaranty insurance. Capital Mortgage's strategy is based on the
development of creative reinsurance programs targeted to the individual capital,
risk and portfolio management demands of the primary mortgage guaranty insurers.
Mortgage guaranty reinsurance is underwritten with the expectation that losses
will occur regularly. The claims-paying ability of Capital Mortgage is rated AA
by S&P.
In order to optimize capital utilization, the business plan of Capital Mortgage
includes the assumption of financial guaranty insurance business by its
subsidiary, KRE, both as a retrocessionaire of Capital Reinsurance and directly
from the U.S. primary financial guaranty insurers, as well as the reinsurance of
mortgage guaranty insurance business by KRE, both as a retrocessionaire of
Capital Mortgage and directly from the primary mortgage guaranty insurers. KRE
also provides retrocessional support to Capital Title and Capital Credit. KRE is
rated AA by S&P.
In 1994, the Company identified an opportunity to further expand into trade
credit reinsurance in the U.S. and Europe through Capital Credit. Trade credit
reinsurance is a logical extension of the Company's underwriting focus, relying
on trade credit analysis and portfolio diversification techniques similar to
those employed in financial guaranty and mortgage guaranty reinsurance. Capital
Credit's strategy is to build a limited portfolio of trade credit reinsurance
business from the leading European and U.S. primary trade credit insurers, which
outperforms the overall market by combining quota share and structured excess of
loss participations. Beginning in 1995, Capital Credit expanded into several
specialty reinsurance lines, including international bonding and political risk,
which complement its trade credit reinsurance line. Specialty insurance and
reinsurance can cover a wide variety of products. In view of this, Capital
Credit's underwriting of specialty reinsurance is designed to develop
relationships with insurance and reinsurance underwriters who are recognized
leaders in their respective markets, who have a history of producing
consistently profitable underwriting results for themselves and their
reinsurers, and who are willing to share underwriting information freely.
Capital Credit structures its participations in specialty reinsurance to
minimize risk by limiting its line size, carefully monitoring potential
aggregations and emphasizing non-proportional contracts. Portfolio losses will
also occur regularly in the trade credit reinsurance line of the Company's
business. In 1997, Capital Credit received an A+ claims-paying rating from S&P.
In early 1996, the Company entered the title reinsurance business through a
newly formed, New York domiciled, monoline insurance company, Capital Title.
Opportunities in the field of title reinsurance have arisen due to rapid
consolidation among title insurers, an increased focus in the title insurance
industry on relatively high margin commercial business, and increased scrutiny
of title insurers' capital adequacy from financial institutions, rating agencies
and the National Association of Insurance Commissioners. Prior to the formation
of Capital Title, there were no dedicated title reinsurers, and only intra-
industry facultative reinsurance was available to support large commercial title
insurance policies. Capital Title provides coverages designed to aid title
insurers in meeting capital adequacy concerns and to achieve desired claims-
paying ability ratings from nationally recognized rating agencies. Capital Title
derives business from relationships with primary title insurers, financial
institutions active in commercial real estate lending and professionals involved
in the real estate industry. Capital Title offers excess of loss and quota share
reinsurance products on both a treaty and facultative basis. Capital Title is
rated AA- by S&P and Duff & Phelps Credit Rating Co. ("Duff & Phelps"). Title
reinsurance is underwritten without the expectation of any significant loss;
however, losses can be expected to occur in Capital Title's existing and future
reinsured portfolio.
For the year ended December 31, 1997, financial guaranty reinsurance accounted
for 32.5% of net premiums written, mortgage guaranty reinsurance accounted for
34.3% of net premiums written, trade credit and related
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specialty reinsurance accounted for 11.2% of net premiums written and title
reinsurance accounted for 2.0% of net premiums written.
In order to access the global market for specialty reinsurance and provide the
Company with accretive earnings opportunities, in November 1996 the Company,
through a newly formed United Kingdom holding company, Capital Re (UK) Holdings,
acquired 100% of the issued shares of Tower Street Holdings Limited (now known
as RGB Holdings, Ltd.), the holding company for RGB Underwriting Agencies Ltd.
("RGB"), a Lloyd's managing agency. RGB presently manages five syndicates
operating in the Lloyd's of London insurance market. In connection with this
acquisition, the Company established a corporate name at Lloyd's, CRC Capital
Ltd. ("CRC Capital"), to provide underwriting capacity to the managed syndicates
commencing with the 1997 year of account. In November 1997, the Company, through
RGB Holdings, Ltd., acquired 100% of the issued shares of C.I. de Rougemont
Group Limited, the holding company for C.I. de Rougemont Ltd. ("CIDER"). CIDER
is a managing agency which presently manages two syndicates operating in the
Lloyd's of London insurance market. For the year ended December 31, 1997, 20.0%
of the Company's net premiums written were attributed to the Company's
investment in Lloyd's.
In December 1996, the Company entered into a joint venture with GCR Holdings
Limited ("GCR") to form a Bermuda based insurer, Capital Global Underwriters
Limited ("CGUL"), which will specialize in financial lines reinsurance. In April
1997, GCR was acquired by EXEL Limited ("EXEL"). In March 1998, EXEL sold its
share of CGUL to Bermuda based ACE Limited, and CGUL was renamed ACE Capital Re
Ltd.
In October 1997, the Company acquired a fifty percent interest in a newly-formed
limited liability company, Lenders Mortgage Alliance Company LLC ("LMAC"). LMAC
will provide marketing and consulting services to mortgage lenders with regard
to the origination and closing of residential mortgages and the sale of such
mortgages into the capital markets.
The Capital Re corporate group also includes Capital Re Management Corporation,
a New York reinsurance intermediary, ACE Capital Re Managers Ltd., a Bermuda
based management company, and Capital Re LLC, a Turks & Caicos Islands finance
subsidiary organized in 1993 to issue $75 million of Company guaranteed
mandatorily redeemable preferred stock, the proceeds of which were loaned to
Capital Re.
Set forth below is a chart showing the subsidiaries and affiliates of Capital
Re:
[CHART SHOWING SUBSIDIARIES AND AFFILIATES APPEARS HERE]
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At December 31, 1997, 82.0% of the Company's investment portfolio consisted
exclusively of fixed income securities rated AAA or A-1+ by S&P or Aaa or P-1 by
Moody's, or issues by the U.S. Government or its agencies or instrumentalities.
Overall portfolio weighted average quality is AA+. In managing its investment
portfolio, the Company places a high priority on credit and liquidity. The
Company employs a modified total return investment strategy, and investment
guidelines are established and approved by the Investment Committee of the
Company's Board of Directors. The investment guidelines permit investments in
investment grade and limited amounts of non-investment grade fixed income
securities, including non-dollar denominated bonds, emerging market debt and
other financial instruments. See "Business--Investments."
In 1997, the Company's Board of Directors adopted a Strategic Investment Policy,
the objective of which is to create a portfolio of investments in businesses
related to the Company's core financial lines reinsurance business in order to
optimize the production of insurance and reinsurance opportunities. The policy
permits aggregate expenditures of up to $50 million in connection with such
strategic investments and establishes a maximum ownership interest in any one
entity equal to 50% of the total equity capital of such entity, with a target
ownership interest of 10% to 20%. Further, the policy establishes expected
after-tax return targets of 15% on the overall strategic investment portfolio
and 13% to 17% on each strategic investment.
In accordance with the Strategic Investment Policy, in 1997 the Company made a
common and preferred equity investment in CGA Group, Ltd. ("CGA Group"), a
Bermuda holding company which owns Commercial Guaranty Assurance, Ltd. ("CGA
Ltd."), a Bermuda insurance company, and CGA Investment Management, Inc.
("CGAIM"), a Delaware corporation. CGA Ltd. will focus on providing financial
guaranty insurance of commercial real estate securities, including commercial
mortgage backed securities. CGA Ltd. will also provide financial guaranty
insurance of other financial obligations, primarily asset-backed securities, by
targeting market segments and originating structures which are outside of the
traditional markets of the major AAA/Aaa rated financial guaranty insurers.
(2) Financial Guaranty Reinsurance -
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(a) Overview of Financial Guaranty Insurance Market -
Financial guaranty insurance is a type of credit enhancement in the form of a
surety or insurance which is regulated under the insurance laws of various
jurisdictions. The insurance provides an unconditional and irrevocable guaranty
which indemnifies the insured against nonpayment of principal and interest when
due by an obligor on an insured debt obligation. The two largest nationally
recognized rating agencies, S&P and Moody's, assign the claims-paying ability
rating of a financial guaranty insurance company to the obligations insured by
that company. Because all of the major U.S. primary financial guaranty
insurance companies have AAA claims-paying ratings from these rating agencies,
bonds insured by those companies are rated AAA.
Both issuers of and investors in financial instruments may benefit from
financial guaranty insurance. Issuers benefit because the insurance may have the
effect of lowering an issuer's cost of borrowing in the public and private debt
markets. The borrowing costs are lowered to the extent that the insurance
premium is less than the value of the difference between the yield on the AAA
insured obligation and the yield on the obligation if sold on the basis of its
uninsured credit rating. Financial guaranty insurance also increases the
marketability of obligations issued by infrequent or unknown issuers. Investors
benefit from increased liquidity in the secondary market, reduced exposure to
price volatility caused by changes in the credit quality of the underlying
insured issue, and added protection against loss in the event of the obligor's
default on its obligation. Upon nonpayment by an obligor, the financial guaranty
insurance company is obligated to pay the principal of and interest on the
insured obligation in accordance with the original payment schedule as if no
default had occurred.
The majority of financial guaranty insurance premiums are paid in full at policy
inception, although on certain financial guaranties, such as guaranties of most
non-municipal obligations, premiums are paid on an installment
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basis and typically earned in the period paid. Financial guaranty premiums are
non-refundable and those paid in full are earned over the term of the related
insured obligation. Because most obligations insured by the financial guaranty
insurers have long maturities, the portion of premiums earned on a policy in any
year represents a relatively small percentage of initial premium received. This
methodology generates a predictable contribution to revenues over time that is
relatively independent of new business written in any given year. Premium rates
are generally calculated as a percentage of the principal amount of the insured
obligation or the principal and interest scheduled to come due during the stated
term of the insured obligation. A number of factors are considered in the
setting of premium rates including the type of credit obligation, collateral
security, maturity and rating agency capital charge.
The financial guaranty insurance market consists of two main product sectors:
municipal bond insurance and insurance of non-municipal debt obligations.
Municipal bond insurance provides credit enhancement of debt obligations issued
by or on behalf of states or their political subdivisions (counties, cities,
towns and villages, utility districts, public universities and hospitals, public
housing and transportation authorities) and other public and quasi-public
entities (including non-U.S. sovereigns and subdivisions thereof). Insurance
provided to the municipal bond market has been and continues to be the major
source of revenue for the financial guaranty insurance industry.
The volume of long-term municipal debt issuances and municipal bond insurance
has increased significantly since 1983. In 1985, pending federal tax legislation
relating to municipal bonds prompted an unusual rise in total long-term new
issue municipal bond volume. The market for new issues returned to more normal
volumes in 1987 and grew steadily through 1991. In 1992 and 1993, historically
low interest rates prompted a dramatic increase in new issue volume, in part
arising from the refinancing of refunding activity. This increase ended in 1994
as rising interest rates and other market uncertainties developed throughout the
year. Growth in new issue volume regained some momentum in 1995 through 1997 as
market conditions improved in a lower interest rate environment. Furthermore,
insurance penetration has reached a historic high, edging toward 50% by 1997.
The table below sets forth the volume of long-term municipal bonds and the
volume of insured long-term municipal bonds issued over the period from 1988
through 1997.
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NEW TOTAL NEW INSURED NEW INSURED VOLUME
YEAR VOLUME VOLUME AS A PERCENT OF NEW
(IN BILLIONS) (IN BILLIONS) TOTAL VOLUME
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1988 117.3 27.1 23.1
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1989 125.0 31.1 24.9
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1990 127.8 33.5 26.2
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1991 172.4 51.9 30.1
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1992 234.6 80.8 34.4
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1993 291.9 108.0 37.0
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1994 164.6 61.4 37.3
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1995 160.3 68.5 42.7
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1996 184.4 85.2 46.2
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1997 221.4 107.8 48.7
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Source: Figures for 1988-1997 are based upon data provided by The Bond
Buyer, February 6, 1998. Amounts under the New Insured Volume column
include only the insured portion of an issue. Amounts under the New Total
Volume and New Insured Volume columns represent gross principal amounts
issued or insured, as the case may be, during such year.
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The primary financial guaranty insurers also insure municipal bond investment
vehicles, such as unit investment trusts and mutual funds, and outstanding
municipal bonds trading in the secondary market.
The non-municipal financial guaranty insurance market is newer and more diverse
than the municipal bond insurance market. The types of securities supported by
guaranties of non-municipal debt obligations include various asset-backed
securities, including consumer and trade receivable-backed securities and
commercial and residential mortgage-backed securities, corporate bonds and
mutual funds. Although this market has been slower to develop than the municipal
market, demand for this type of insurance is being stimulated by innovations in
both domestic and foreign capital markets coupled with increasing investor and
issuer awareness of the value provided by financial guaranties.
As of December 31, 1997 there were five AAA rated primary U.S. financial
guaranty insurance companies active in the business, the first four of which
dominate the insured market: Municipal Bond Investors Assurance Company
("MBIA"), AMBAC Indemnity Company ("AMBAC"), Financial Guaranty Insurance
Company ("FGIC"), Financial Security Assurance Inc. ("FSA") and Capital
Markets Assurance Company ("CapMAC"). In 1997, MBIA entered into a definitive
agreement for the purchase of CapMAC. It is anticipated that the purchase will
be consummated in 1998. Additionally, in late 1997, AMBAC acquired Connie Lee
Insurance Company, a formerly independent U.S. financial guaranty insurer. In
1997, ACA Financial Guaranty Corporation ("ACA") commenced operations. ACA is a
single A rated financial guaranty insurer focusing on the insurance of
marginally investment grade and non-investment grade municipal and non-municipal
securities. Also, Asia Ltd., a Singapore based financial guaranty insurer, is
active in guarantying non-municipal securities in the Asian markets. Further,
CGA Ltd., a Bermuda based financial guaranty insurer which commenced operations
in June 1997, provides financial guaranty insurance of structured securities,
including commercial real estate and asset-backed securities.
(b) Financial Guaranty Reinsurance Market -
Reinsurance is a transaction whereby the reinsurer agrees to indemnify the
primary insurance company against part or all of the loss which the latter may
sustain under a policy which it has issued. The reinsurer may also assume
reinsurance from other reinsurers ("retrocessions"). In the event of loss, the
reinsured generally remains liable on its obligation to indemnify the insured.
The two major kinds of reinsurance are treaty and facultative. Treaty
reinsurance requires the reinsured to cede and the reinsurer to assume specific
classes of risk underwritten by the ceding company over a period of time,
typically one year. Facultative reinsurance is the reinsurance of part or all of
one or more reinsurance policies which is subject to separate negotiation for
each cession. It offers the option of accepting or rejecting individual
submissions by a ceding company as distinguished from the obligation to accept
specified classes of risk as a treaty reinsurer. Ceding companies generally will
seek facultative agreements when treaty terms preclude the cession or inclusion
of a particular risk, when the capacity of the treaty program is insufficient
for a given risk (for instance, when policy limits are in excess of the treaty
limits) or when special coverage is needed to comply with regulatory or other
capacity restrictions.
Reinsurance is written on a proportional or non-proportional basis. Proportional
reinsurance includes: (i) quota share reinsurance, whereby the assumed risk is a
fixed percentage of the reinsured's risk, (ii) surplus share reinsurance,
whereby the percentage of risk assumed is a multiple of the reinsured's net
retention up to a stated maximum, and (iii) variable quota share reinsurance,
whereby the percentage of assumed risk increases with the risk size to a stated
maximum. There are many possible variations of these three types of proportional
reinsurance. Non-proportional reinsurance includes: (i) risk assumption per risk
and per occurrence in excess of a reinsured's retention, subject to a specified
limit, and (ii) stop loss or aggregate excess of loss reinsurance, whereby the
reinsurer assumes an aggregate loss incurred over a specific time period (for
specific risks) above the reinsured's retention of loss incurred, up to a stated
maximum.
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The purposes of reinsurance in the financial guaranty industry are to (i)
increase the insurance capacity of the reinsured, (ii) assist the reinsured in
meeting applicable regulatory and rating agency requirements, (iii) augment the
reinsured's financial strength, and (iv) manage the reinsured's risk exposure.
State insurance laws and regulations, as well as the rating agencies, impose
minimum capital requirements on financial guaranty companies, limiting the
aggregate amount of insurance which may be written and the maximum size of any
single risk which may be insured. Reinsurance allows the reinsured to increase
its capacity to write new business by effectively reducing the reinsured's gross
liability on an aggregate and single risk basis. Furthermore, primary insurers
manage the risk of their insured portfolios based on internal underwriting
criteria and portfolio management guidelines. Reinsurance is instrumental in
achieving those portfolio risk management goals. There are currently two
domestic reinsurance companies, Capital Reinsurance and Enhance Reinsurance
Company, specializing in the reinsurance of financial guaranties. Several non-
U.S. multiline insurers and a small number of domestic multiline insurers also
participate in this reinsurance market. Based upon the 1997 annual statutory
statements filed by each of the U.S. primary financial guaranty insurers, the
Company believes that the Company and its principal competitor assumed most of
the reinsurance ceded by the U.S. primary financial guaranty insurers in 1997.
The size and growth of the financial guaranty reinsurance market is dependent on
(i) the size of the primary insurance market, (ii) the percentage of aggregate
risk that the primary insurers cede to the reinsurers, (iii) regulatory, rating
agency and other external risk retention limitations imposed on the primary
insurers and (iv) the price and availability of substitute AAA rated capital
facilities.
(c) Credit Default Swap Market -
Credit default swaps are transactions whereby one party, in consideration of a
fixed payment, agrees to make a specified payment to another party upon the
occurrence of one or more specified credit events with respect to a reference
entity. The Company, through Capital Reinsurance, entered the credit default
swap business in early 1996. Although structured as financial derivatives,
credit default swaps are functionally equivalent to financial guaranty
insurance, and Capital Reinsurance underwrites and manages this business in
tandem with, and in accordance with the same policies and procedures as, its
financial guaranty business.
(3) Mortgage Guaranty Reinsurance -
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The purposes of reinsurance in the mortgage guaranty insurance industry are to
(i) increase the insurance capacity of the reinsured, (ii) assist the reinsured
in meeting applicable regulatory and rating agency requirements, (iii) augment
the reinsured's financial strength and (iv) manage the reinsured's risk
exposure.
Mortgage guaranty insurance is a specialized class of credit insurance,
providing protection to mortgage lending institutions against the default of
borrowers on mortgage loans which at the time of the advance had a loan-to-value
("LTV") ratio in excess of 80%. The market for mortgage guaranty insurance is
competitively shared by three sectors: governmental agencies, principally the
Federal Housing Administration ("FHA") and the Veterans Administration
("VA"), private mortgage guaranty insurers, and the lending institutions which
choose to self-insure against the risk of loss on high LTV mortgage loans.
The private mortgage insurance industry, comprised of only monoline insurance
companies, as required by law, provides two basic types of coverage: primary
insurance, which protects lenders against default on individual residential
mortgage loans by covering losses on such loans to a stated coverage percentage;
and pool insurance, which protects lenders against aggregate default levels in
an underlying pool of individual mortgages by covering the full amount of loss
(less the proceeds from any primary insurance coverage that may be in place) on
individual residential mortgage loans in such pool of loans, with an aggregate
limit usually expressed as a percentage of the initial loan balances of the pool
of loans. Primary insurance also facilitates the sale of high LTV mortgage loans
in the secondary mortgage market, principally to the Federal Home Loan Mortgage
Corporation and Federal National
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Mortgage Association, while pool insurance is often used to provide credit
support for mortgage-backed securities and other secondary mortgage market
transactions. There are eight private mortgage guaranty insurers writing new
business: General Electric Mortgage Insurance Company ("GEMICO"); Mortgage
Guaranty Insurance Company; PMI Mortgage Insurance Co. ("PMI"); United
Guaranty Residential Insurance Company; Commonwealth Mortgage Assurance Company
("CMAC"); Republic Mortgage Insurance Company; Amerin Guaranty Corporation;
and Triad Mortgage Insurance Company.
Mortgage guaranty insurers do not underwrite risk to a zero loss underwriting
standard as in the financial guaranty insurance industry; rather, they
underwrite with a view to target loss ratios ranging from 45% to 60%. A critical
factor to successfully underwriting this class of business is the ability to
consistently control the quality and diversity of insurance in-force, avoiding
catastrophic losses from regional depressions and declines in residential real
estate prices, by effective geographic and product dispersion.
Except for the Company, the external reinsurance capacity for the industry is
provided almost exclusively by European multiline insurers and reinsurers, who
offer modest amounts of traditional reinsurance products. Mortgage guaranty
insurers have traditionally relied upon proportional reinsurance for their risk
management needs. Recently, the need to profitably utilize invested capital and
the need to manage risk have become equally important and the trend has shifted
away from proportional reinsurance products. In addition to external reinsurance
support, primary mortgage insurers have developed a system of risk sharing
relationships with their own affiliates and other companies in the industry.
The profitable nature of the mortgage guaranty business over the last several
years has caused primary mortgage insurers to be reluctant to cede business to
reinsurers. Low loss ratios, higher premiums and streamlined operations have
allowed mortgage insurers to bolster capital thereby diminishing the need for
reinsurance support. In addition, during 1997 certain banks received approval
from the Comptroller of the Currency to establish operating subsidiaries, known
as reinsurance captives, to reinsure a portion of the mortgage insurance on
loans originated or purchased by the bank or its lending affiliates. The
mortgage insurers, however, continue to rely on non-captive reinsurance due to a
combination of factors including regulations imposing more stringent limits on
exposure to risk, increased pressure to optimize financial results and the
strengthening of rating agency constraints on allocation of risk. The Company,
which through Capital Mortgage is the only dedicated mortgage guaranty
reinsurer, has been able to capitalize on these factors by providing
sophisticated mortgage reinsurance products in addition to the quota share
reinsurance products historically offered.
Rating agencies currently impose more stringent requirements on risk-to-capital
ratios for mortgage guaranty insurers than the 25:1 ratio imposed by applicable
law. Generally, S&P and Moody's require that AA rated mortgage guaranty insurers
operate at a risk-to-capital ratio of less than 20:1. The maintenance or
improvement of high quality (AA or better) claims-paying ratings directly
influences an insurer's ability to compete in the market and access capital
resources to support its book of business.
(4) Title Reinsurance -
-----------------
Title insurance is currently written by seven national and dozens of regional
companies throughout the United States, all of which are required by statute to
be monoline insurers. Title insurance essentially provides the acquirer or the
mortgagor of real property with two forms of coverage. The first assures that
the search and examination of the real estate records upon which the acquirer or
mortgagor is relying for good and clean title was properly performed. In
insuring that a process was in fact properly done and recorded, the title
insurer is providing risk exclusion. The second form of coverage assures that
all previously existing mortgages and liens will be paid off from the proceeds
of the sale or refinancing of the property. In insuring that the existing
mortgages and liens are extinguished, the title insurer is providing risk
assumption.
9
<PAGE>
Capital Title was formed to take advantage of the strategic opportunities
presented by the recent trends in the title insurance business discussed above.
Specifically, reinsurance needs are becoming more complex as primary insurers
strive to react to the trends detailed above by diversifying reinsurance
recoverable risk, optimizing financial results and maintaining high quality
claims paying ability ratings. Risk syndication and access to larger,
independent pools of capital to support ever increasing industry exposure is an
important issue as the industry begins to compete in a rated environment. To
address the concerns of rating agencies and the resulting capital adequacy and
profitability issues, title insurers are adjusting their business practices,
especially with regard to commercial transactions. Rating agencies, lenders, and
regulators are increasingly concerned with the level of risk being taken by
insurer's on large commercial transactions. Single-risk limits on the order of
20% to 30% of policyholders surplus have been, and are likely to continue to be,
imposed on insurers. Accordingly, third party reinsurance, such as that provided
by Capital Title, to build single risk capacity and as an overall capital
substitute, has become important.
Capital Title applies its financial, reinsurance, rating agency, underwriting
and legal expertise to provide reinsurance solutions tailored to the particular
rating agency, financial, regulatory and risk management needs of each primary
title insurer. Capital Title represents an independent source of capacity in an
industry which has historically relied on a closed system of reinsurance
capacity provided by the industry's primary insurers. Capital Title offers
several specific products to the title insurance industry, all of which are
derived from two basic reinsurance product types, excess of loss and quota
share.
(5) Trade Credit and Specialty Reinsurance -
--------------------------------------
Trade credit insurance protects sellers of goods and services from the risk of
non-payment of trade receivables and is a large, well-established specialty
insurance product, particularly in Western Europe. Policyholders are generally
covered for short-term exposures (generally less than 180 days and averaging 60-
90 days) to insolvency or payment defaults by domestic and/or foreign buyers.
Some export credit policies also cover political events which can disrupt either
the flow of goods and services or payment for goods and services. Specialist
underwriters dominate the market, using sophisticated information management
systems to provide rapid approval of policy requests while maintaining
underwriting controls. Credit insurance relies on credit analysis and portfolio
diversification techniques similar to those employed in financial guaranty and
mortgage guaranty insurance. Results are heavily dependent upon macroeconomic
conditions, with typical loss ratios of 30-50% during healthy economies and
rising to 80-100% during recessions.
The trade credit reinsurance market is led by traditional multi-line players,
principally Munich Re and Swiss Re, who have been able to maintain their
dominant market position in part through their ownership interests in many of
the leading primary companies. Capital Credit has attempted to identify areas of
opportunity where its specialty focus provides some advantage over the
traditional players. Revenue targets have been set conservatively with the
intention of selectively choosing participations. The product mix combines quota
share and structured excess participations that are geared to produce results
that outperform the overall credit insurance market.
Although trade credit reinsurance represents the bulk of its portfolio, Capital
Credit also provides reinsurance in several other related specialty areas,
including international bonding and political risk reinsurance.
(6) Overview of Lloyd's of London Insurance Market -
----------------------------------------------
Lloyd's is a long established insurance marketplace where many varied forms of
insurance are sold by syndicates, which, until 1994, were annual joint ventures
of participating capital providers known as "Names." Participation as a Name on
a syndicate carries with it unlimited liability for the Name's share of any
insurance losses incurred by the syndicate (each Name participating severally).
In 1994, the rules relating to membership in Lloyd's were changed to allow
limited liability corporate capital vehicles to enter the Lloyd's marketplace as
capital providers.
10
<PAGE>
Typically, Lloyd's syndicates now comprise a mixture of limited and unlimited
liability capital combining in the annual joint venture.
Several of the underwriting years of the late 1980's and early 1990's were
particularly unprofitable for many of the syndicates operating at Lloyd's. This
proved to be financially disastrous for some of the Names on the affected
syndicates due to the unlimited liability of their participation. In August
1996, Lloyd's implemented its "Reconstruction and Renewal" proposals which
involved a new company, Equitas, being authorized to reinsure the liabilities of
the 1992 and prior years of account of most of the syndicates at Lloyd's. The
funding to give effect to these proposals came from a variety of sources
including the premiums on the liabilities assumed by Equitas as well as a series
of levies charged to entities that had historically provided services to the
Lloyd's insurance market (including managing agencies and insurance brokers).
Participation in selective syndicates in the Lloyd's insurance market provides
the Company with new lines of business in the life, marine and non-marine
markets as well as the opportunity to diversify its insurance risk profile
through markets to which it would otherwise not have access. This syndicate
participation is through a dedicated corporate capital vehicle, CRC Capital,
thus limiting the liability of the Company. RGB and CIDER provide accounting,
reporting and ancillary insurance services to the syndicates managed by them and
on which the Company participates.
For the 1997 year of account, the Company committed approximately (Pounds)20
million of capital, in the form of a letter of credit, to two syndicates managed
by RGB, which supported approximately (Pounds)40 million of underwriting
capacity, and, for the 1998 year of account, the Company has committed
approximately (Pounds)44 million of capital, in the form of a letter of credit,
to three syndicates managed by RGB and CIDER, which supports up to approximately
(Pounds)88 million of underwriting capacity.
11
<PAGE>
B. BUSINESS OF CAPITAL RE:
(1) Insurance in Force -
------------------
The information below is presented on a consolidated basis for Capital
Reinsurance, Capital Mortgage (including KRE), Capital Credit, Capital Title and
the Lloyd's operations, unless expressly indicated otherwise. The information
includes estimates derived from the accounting and statistical records of
Capital Reinsurance, Capital Mortgage (including KRE), Capital Credit, Capital
Title and the Lloyd's operations. Capital Title was not in operation before
February 1996 and is not included in the information reported below for years
prior to 1996. The Company's Lloyd's operations were not acquired until
November 1996 and are not included for years prior to 1997. Capital
Reinsurance's credit default swap income and exposure is included as part of
financial guaranty premium and exposure.
The table below sets forth gross and net premiums written and net premiums
earned by line of business.
PREMIUMS BY LINE OF BUSINESS
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
1997 1996 1995
--------------------------------------------------------
<S> <C> <C> <C>
Gross Premiums Written:
- ------------------------------------------------------------------------------------------------------
Municipal $ 52,778 $ 48,411 $ 44,201
- ------------------------------------------------------------------------------------------------------
Mortgage 70,752 53,683 39,111
- ------------------------------------------------------------------------------------------------------
Non-Municipal 16,674 10,902 17,244
- ------------------------------------------------------------------------------------------------------
Credit and Specialty 25,714 15,070 7,043
- ------------------------------------------------------------------------------------------------------
Title 4,024 1,752 0
- ------------------------------------------------------------------------------------------------------
Lloyd's 49,580 0 0
- ------------------------------------------------------------------------------------------------------
Total Gross Premiums Written 219,522 $129,818 $107,599
- ------------------------------------------------------------------------------------------------------
<CAPTION>
<S> <C> <C> <C>
Net Premiums Written:
- ------------------------------------------------------------------------------------------------------
Municipal $ 50,157 $ 36,707 $ 38,120
- ------------------------------------------------------------------------------------------------------
Mortgage 70,480 40,936 27,584
- ------------------------------------------------------------------------------------------------------
Non-Municipal 16,599 10,902 17,244
- ------------------------------------------------------------------------------------------------------
Credit and Specialty 23,015 14,891 6,560
- ------------------------------------------------------------------------------------------------------
Title 4,024 1,752 0
- ------------------------------------------------------------------------------------------------------
Lloyd's 41,085 0 0
- ------------------------------------------------------------------------------------------------------
Total Net Premiums Written $205,360 $105,188 $ 89,508
- ------------------------------------------------------------------------------------------------------
<CAPTION>
<S> <C> <C> <C>
Net Premiums Earned:
- ------------------------------------------------------------------------------------------------------
Municipal $ 29,748 $ 27,540 $ 25,633
- ------------------------------------------------------------------------------------------------------
Mortgage 53,246 43,882 22,072
- ------------------------------------------------------------------------------------------------------
Non-Municipal 11,402 7,199 6,433
- ------------------------------------------------------------------------------------------------------
Credit and Specialty 17,266 12,239 5,959
- ------------------------------------------------------------------------------------------------------
Title 3,628 1,576 0
- ------------------------------------------------------------------------------------------------------
Lloyd's 18,374 0 0
- ------------------------------------------------------------------------------------------------------
Total Net Premiums Earned $133,664 $ 92,436 $ 60,097
- ------------------------------------------------------------------------------------------------------
</TABLE>
12
<PAGE>
The following charts sets forth certain information regarding gross premiums
written on insurance ceded to the Company by its largest ceding company clients
in each material line of business in 1997, 1996, and 1995.
GROSS PREMIUMS WRITTEN BY PRIMARY FINANCIAL GUARANTY INSURER
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
1997 1996 1995
----------------------------------------------------------------------------------------------------------
PRIMARY GROSS PERCENT GROSS PERCENT GROSS PERCENT
INSURER PREMIUMS OF TOTAL PREMIUMS OF TOTAL PREMIUMS OF TOTAL
WRITTEN WRITTEN WRITTEN
- --------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
AMBAC $ 4,797 7 % $ 8,766 15 % $12,995 21%
- --------------------------------------------------------------------------------------------------------------------------
CapMAC 6,945 10 6,092 10 3,725 6
- --------------------------------------------------------------------------------------------------------------------------
FGIC 15,559 22 15,388 26 7,040 11
- --------------------------------------------------------------------------------------------------------------------------
FSA 19,518 28 8,590 14 15,968 26
- --------------------------------------------------------------------------------------------------------------------------
MBIA 21,118 30 19,589 33 19,474 32
- --------------------------------------------------------------------------------------------------------------------------
Other 1,515 3 888 2 2,243 4
- --------------------------------------------------------------------------------------------------------------------------
Total $69,452 100 % $59,313 100 % $61,445 100 %
- --------------------------------------------------------------------------------------------------------------------------
</TABLE>
GROSS PREMIUMS WRITTEN BY PRIMARY MORTGAGE GUARANTY INSURER
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
1997 1996 1995
----------------------------------------------------------------------------------------------------------
PRIMARY GROSS PERCENT GROSS PERCENT GROSS PERCENT
INSURER PREMIUMS OF TOTAL PREMIUMS OF TOTAL PREMIUMS OF TOTAL
WRITTEN WRITTEN WRITTEN
- --------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
PMI $15,176 21 % $13,897 26 % $11,304 29%
- --------------------------------------------------------------------------------------------------------------------------
CMAC 26,879 38 20,553 38 12,432 32
- --------------------------------------------------------------------------------------------------------------------------
GEMICO 9,908 14 7,686 14 8,000 20
- --------------------------------------------------------------------------------------------------------------------------
General 4,173 6 4,490 8 4,511 12
Accident (U.K.)
- --------------------------------------------------------------------------------------------------------------------------
Other 14,616 21 7,057 14 2,864 7
- --------------------------------------------------------------------------------------------------------------------------
Total $70,752 100 % $53,683 100 % $39,111 100 %
- --------------------------------------------------------------------------------------------------------------------------
</TABLE>
GROSS PREMIUMS WRITTEN BY PRIMARY TITLE INSURER
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
1997 1996
--------------------------------------------------------------------------------------------
PRIMARY GROSS PERCENT GROSS PERCENT
INSURER PREMIUMS OF TOTAL PREMIUMS OF TOTAL
WRITTEN WRITTEN
- ------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Commonwealth $1,243 31 % 536 31 %
- ------------------------------------------------------------------------------------------------------------
United General 1,600 40 1,061 61
- ------------------------------------------------------------------------------------------------------------
Other 1,181 29 155 8
- ------------------------------------------------------------------------------------------------------------
Total $4,024 100 % $1,752 100 %
- ------------------------------------------------------------------------------------------------------------
</TABLE>
13
<PAGE>
GROSS PREMIUMS WRITTEN BY PRIMARY CREDIT INSURER
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
1997 1996 1995
----------------------------------------------------------------------------------------------------------
Primary GROSS PERCENT GROSS PERCENT GROSS PERCENT
INSURER PREMIUMS OF TOTAL PREMIUMS OF TOTAL PREMIUMS OF TOTAL
WRITTEN WRITTEN WRITTEN
- --------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
AIU $ 5,903 23 % $ 4,176 28 % $1,695 24 %
- --------------------------------------------------------------------------------------------------------------------------
HERMES 2,989 12 3,513 23 1,263 18
- --------------------------------------------------------------------------------------------------------------------------
Munich Re 1,031 4 581 4 259 4
- --------------------------------------------------------------------------------------------------------------------------
NCM 4,358 17 3,838 26 2,977 42
- --------------------------------------------------------------------------------------------------------------------------
Trade Indemnity 2,667 10 501 3 0 0
- --------------------------------------------------------------------------------------------------------------------------
Other 8,766 34 2,461 16 849 12
- --------------------------------------------------------------------------------------------------------------------------
Total $25,714 100 % $15,070 100 % $7,043 100 %
- --------------------------------------------------------------------------------------------------------------------------
</TABLE>
The following table sets forth the Company's gross premiums written, net
premiums written and net premiums earned relating to its reinsured U.S. and non-
U.S. risks for each of the three years ended December 31, 1997, 1996 and 1995.
U.S. AND NON-U.S. PREMIUMS WRITTEN AND EARNED
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
U.S. % NON-U.S. %
U.S. NON-U.S. TOTAL TOTAL TOTAL
- ----------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
YEAR ENDED DECEMBER 31, 1997
- ----------------------------------------------------------------------------------------------------------------
Gross Premiums Written $145,925 $73,597 $219,522 66.5% 33.5%
- ----------------------------------------------------------------------------------------------------------------
Net Premiums Written 140,309 65,051 205,360 68.3 31.7
- ----------------------------------------------------------------------------------------------------------------
Net Premiums Earned 101,249 32,415 133,664 75.8 24.2
- ----------------------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 1996
- ----------------------------------------------------------------------------------------------------------------
Gross Premiums Written $108,869 $20,949 $129,818 83.9% 16.1%
- ----------------------------------------------------------------------------------------------------------------
Net Premiums Written 84,239 20,949 105,188 80.1 19.9
- ----------------------------------------------------------------------------------------------------------------
Net Premiums Earned 77,666 14,770 92,436 84.0 16.0
- ----------------------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 1995
- ----------------------------------------------------------------------------------------------------------------
Gross Premiums Written $ 94,270 $13,329 $107,599 87.6% 12.4%
- ----------------------------------------------------------------------------------------------------------------
Net Premiums Written 76,739 12,769 89,508 85.7 14.3
- ----------------------------------------------------------------------------------------------------------------
Net Premiums Earned 53,373 6,724 60,097 88.8 11.2
- ----------------------------------------------------------------------------------------------------------------
</TABLE>
14
<PAGE>
(2) Detail on Financial Guaranty Insurance in Force -
-----------------------------------------------
The following table shows the Company's ten largest financial guaranty single
risk exposures by consolidated net par in force as of December 31, 1997.
Collectively, these ten exposures accounted for 16.0% (consolidated net par) of
the Company's reinsured financial guaranty portfolio.
TEN LARGEST FINANCIAL GUARANTY SINGLE RISK EXPOSURES
NET PAR IN FORCE
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
Credit (1) As of December 31, 1997
- ----------------------------------------------------------------------------------------------------------------
<S> <C>
Massachusetts State GO & Bay Transportation Bonds $1,079,445
- ----------------------------------------------------------------------------------------------------------------
California General Obligation Bonds 982,258
- ----------------------------------------------------------------------------------------------------------------
New Jersey Transportation Trust Fund Authority 820,674
- ----------------------------------------------------------------------------------------------------------------
New York City General Obligation Bonds 771,356
- ----------------------------------------------------------------------------------------------------------------
Washington Public Power Supply System 667,251
- ----------------------------------------------------------------------------------------------------------------
New York State General Obligation Bonds 625,884
- ----------------------------------------------------------------------------------------------------------------
New York City Municipal Water Finance Authority 610,496
- ----------------------------------------------------------------------------------------------------------------
Denver Colorado Airport System Revenue Bonds 560,692
- ----------------------------------------------------------------------------------------------------------------
Pennsylvania State General Obligation Bonds 528,000
- ----------------------------------------------------------------------------------------------------------------
Los Angeles County California Metro Transportation 526,754
- ----------------------------------------------------------------------------------------------------------------
</TABLE>
(1) All subject to non proportional Excess of Loss ("EOL") retrocessional
program and/or Annual Debt Service ("ADS") retrocessional program. See
"Business of Capital Re--Retrocessional Arrangements, Soft Capital
Facilities and Intercompany Capital Supports."
Although the Company generally does not write financial guaranty reinsurance on
obligations that are non-investment grade at the time reinsured, the credit
ratings of certain obligations may be reduced after the date such obligations
are reinsured. The Company monitors its exposure to non-investment grade
obligations and in this regard relies in part on information provided by its
ceding companies, particularly with respect to certain municipal treaty
business. The Company is familiar on an ongoing basis with the criteria used by
S&P and Moody's for determining the investment grade status of the various
credit sectors reinsured by the Company. These criteria are specific to, and
vary considerably depending on, the line of business and type of credit
reinsured. In certain cases, the Company and/or its cedants may obtain access to
information on individual credits indicating that those credits no longer
conform to the rating agencies' investment grade criteria, even through the
rating agencies may not have yet reviewed those credits to determine their
investment grade status. In such cases, the Company and/or its cedants may
determine that certain individual credits are below investment grade quality.
Based upon these procedures, the Company believes that approximately 1.1% of the
reinsured financial guaranty portfolio (based on net par amount) or
approximately $488.6 million, was rated below investment grade (i.e., not rated
at least BBB- or Baa3 by either S&P or Moody's, or, if not rated, determined to
be below investment grade in the opinion of the ceding company or the Company)
at December 31, 1997.
Capital Reinsurance has developed several non-proportional retrocessional
programs which supplement its financial guaranty single risk capacity for a
number of selected large volume issuers of municipal bonds. In some cases, these
arrangements are effected on an excess of loss basis and involve the retention
by Capital Reinsurance of a first loss exposure (liability for all losses
related to a particular risk up to a stated dollar amount). Under these
arrangements, Capital Reinsurance's potential annual payment liability (the
annual amount of claims payments which Capital Reinsurance is obligated to pay)
related to an issue default during the period of such first loss exposure may be
several times Capital Reinsurance's net average annual debt service exposure to
such reinsured issue.
15
<PAGE>
The financial guaranty reinsured portfolio of the Company contained exposures in
each of the fifty states, the District of Columbia, Puerto Rico and several
foreign countries. The following table sets forth the distribution of
consolidated net book of business by state as of December 31, 1997.
DISTRIBUTION OF FINANCIAL GUARANTY NET BOOK OF BUSINESS BY STATE
AS OF DECEMBER 31, 1997
(DOLLARS IN THOUSANDS)
[PIE CHART APPEARS HERE]
Total: $44,800,912
------------------
California 10.75%
New York 10.26%
Florida 6.03%
Texas 5.17%
Penn. 4.35%
NJ 3.99%
Mass. 3.74%
Ill. 3.70%
Washington 2.40%
Ohio 2.13%
Others 47.48%
(3) Exposure under Credit Default Swaps -
-----------------------------------
As of December 31, 1997, the Company had approximately $1.8 billion of nominal
exposure as a counterparty to credit default swap agreements. This exposure is
included in the information provided in "Business of Capital Re -- Insurance In
Force."
(4) Marketing -
---------
The majority of the Company's business is derived from relationships it has
established and maintains with the major U.S. primary financial guaranty,
mortgage guaranty and title insurers. European trade credit insurers, U.S.
title insurers, United Kingdom mortgage guaranty insurers and Australian
mortgage guaranty insurers also provide a significant portion of the Company's
business. These relationships provide business opportunities for the Company on
both a treaty and facultative basis.
The Company's international retrocessional relationships enable it to access
international sources of reinsurance. These relationships link the Company's
technical expertise in financial guaranty and related reinsurance risk
underwriting with the market knowledge and capital strength of the Company's
international retrocessionaires. See "Business of Capital Re -- Retrocessional
Arrangements, Soft Capital Facilities and Intercompany Capital Supports."
Substantially all of the Company's reinsurance business to date has been derived
from reinsurance products written directly with insurers and not through
intermediaries. However, the Company does use reinsurance brokers to
16
<PAGE>
access certain reinsurance opportunities, especially in the credit line of
business. For the year ended December 31, 1997, intermediaries and brokers had
accounted for 15.6% of U.S. gross premiums written and 41.97% of non-U.S. gross
premiums written. The Company's relationships with these brokers do not commit
or obligate the Company to accept business submitted by them. All applications
for reinsurance from both new and existing ceding companies are subject to
review and acceptance by the Company in accordance with the Company's
underwriting guidelines. Brokers are compensated based on a percentage of
premium, which varies from transaction to transaction. Certain U.S. domestic
mortgage guaranty, non-municipal and other special risk reinsurance
opportunities may also be produced by reinsurance intermediaries and brokers.
Capital Mortgage and KRE derive their mortgage guaranty reinsurance business
principally through direct relationships with primary mortgage guaranty
insurance companies. Reinsurance intermediaries and brokers are used in
accessing reinsurance opportunities in the United Kingdom and the international
market. Capital Credit has developed credit reinsurance business opportunities
principally through reinsurance brokers and intermediaries. Capital Title has
developed all of its business opportunities through direct contacts with primary
title insurers.
(5) Underwriting Guidelines, Policies and Procedures -
------------------------------------------------
(a) Financial Guaranty Reinsurance -
The underwriting process for the Company's financial guaranty insurance business
is premised on the Company's policy of reinsuring investment grade obligations.
Capital Reinsurance underwrites risks on a "zero loss" basis, meaning that
each reinsured policy obligation has been evaluated by Capital Reinsurance under
a standard of no loss expectation. However, losses in Capital Reinsurance's
reinsured portfolio can be expected to occur, and there can be no assurance that
these losses will not have a material adverse effect on financial condition and
results of operations. See "Business of Capital Re--Losses and Reserves." In
addition, Capital Reinsurance's ongoing review of its portfolio does not involve
any commitment by rating agencies or ceding companies to provide credit rating
information on each assumed obligation.
Capital Reinsurance has organized its underwriting procedures to provide for
multiple levels of credit review and analysis. Facultative submissions, which
form the majority of Capital Reinsurance's business, are initially reviewed by
one of Capital Reinsurance's underwriting analysts who performs a detailed
evaluation of each individual submission to assure compliance with Capital
Reinsurance's underwriting guidelines and rating agency and regulatory criteria.
The analyst's recommendation is presented to one of Capital Reinsurance's
Underwriting Committees for consideration. There are separate committees for
municipal, non-municipal and non-U.S. financial guaranty risks. The Company's
Chief Underwriting Officer must approve the decision of the Underwriting
Committee before the risk is written by Capital Reinsurance. The Board of
Directors of the Company also reviews underwriting policy and trends on a
quarterly basis.
Capital Reinsurance has established treaty reinsurance relationships with most
of the U.S. primary financial guaranty insurance companies. Ceding insurers must
be financially strong. Generally, each ceding company must also adhere to the
underwriting standard of no loss expectation on financial guaranty insurance.
Prior to initiating any treaty relationship, and on an annual basis thereafter,
Capital Reinsurance conducts a review of the ceding company. Capital Reinsurance
evaluates the ceding company's capital position, in-force book of business,
reserves, cash flow, profitability and financial strength. The ceding company's
underwriting process is analyzed to determine compliance with established credit
guidelines and legal documentation requirements. Management of each ceding
company is reviewed in the areas of credit control, monitoring and surveillance
practices, claims administration and remedial management. After Capital
Reinsurance completes its ceding company review, a report is prepared and
presented to Capital Reinsurance's senior management. All new treaty
relationships must be approved by the appropriate Underwriting Committee and the
Chief Underwriting Officer before the treaty is accepted by Capital Reinsurance.
Treaty results and compliance are reviewed by Capital Reinsurance on quarterly
and annual bases.
17
<PAGE>
Capital Reinsurance also conducts its own due diligence and credit surveillance
of underlying credits in accordance with internally developed and maintained
standards. Capital Reinsurance's Chief Underwriting Officer formulates Capital
Reinsurance's underwriting policy and is responsible for its administration. The
Board of Directors of Capital Reinsurance regularly reviews Capital
Reinsurance's underwriting policy.
The underwriting staff is also responsible for the ongoing monitoring and review
of ceding company underwriting practices and financial results. The annual
underwriting reviews of the ceding companies described above measure adherence
to the ceding company's own underwriting standards and monitor the relationship
of pricing to risk on business being reinsured by Capital Reinsurance. The
reviews are also used to monitor pricing by product line, bond type and risk
classification in an effort to allocate capital effectively to specific
portfolios and product areas that are considered to have a greater potential for
profitability.
Capital Reinsurance's ongoing credit management of its reinsured portfolio is
overseen by the Chief Underwriting Officer and the underwriting staff. The
underwriting analysts recommend appropriate bond and credit sector
representations and distributions. Capital Reinsurance's single and aggregate
risk underwriting policies, while complying with regulatory and rating agency
requirements, reflect Capital Reinsurance's capital resources, liquidity
capabilities and retrocessional programs. Portfolio diversification is monitored
regularly to improve the balance of geographic distribution, credit quality,
bond type and maturity.
(b) Mortgage Guaranty Reinsurance -
Unlike the "zero loss" standard applied in financial guaranty insurance
underwriting, mortgage guaranty insurance is underwritten with the expectation
of loss. Under normal economic conditions and in a stable interest rate
environment, loss ratios in this line of business are generally in the 15% to
40% range and are associated with frictional unemployment, divorce and other
social factors. By avoiding geographic concentrations and employing prudent
underwriting, mortgage insurers are better able to manage their risk.
Capital Mortgage has established underwriting standards, procedures and closely
monitored controls. A senior Mortgage Underwriting Committee, comprised of three
voting members, including the Chief Underwriting Officer, must approve each
underwriting submission. Submissions are made through preparation of a
comprehensive underwriting report, which is derived from (i) extensive meetings
with senior management and staff of the ceding company, (ii) underwriting,
actuarial and financial analysis of detailed information including historic
mortgage performance, portfolio composition, origination procedures, quality
control, loss mitigation and claims management, and (iii) reinsurance structure
and profitability analysis.
Generally, ceding companies must demonstrate their capability to monitor
economic trends in markets in which they are providing insurance and to exercise
underwriting discipline. Capital Mortgage seeks to identify insurers having the
capability to prospectively analyze economic trends in various markets based on
local and regional market factors, political developments and global resource
factors, such as energy prices. The ceding company is required to maintain
analytical personnel dedicated to reviewing trends in local residential property
markets. Capital Mortgage closely examines analytical methods by which the
ceding company follows pricing adequacy and loss development patterns of its
insurance in force. Ceding company loss mitigation and claims management
procedures are evaluated and analyzed. The ceding company must demonstrate an
adequate investigative capability, engaging in a systematic review of early
payment defaults to detect fraud or potential defects in underwriting systems.
Capital Mortgage's underwriting staff reviews all reinsurance in force and
recommends portfolio balancing targets (e.g., amount of risk in force by region,
underwriting year, ceding company, loan type). On-site reviews of all ceding
companies are conducted on at least an annual basis, encompassing a review of
overall company organization, financial performance, developments in sales and
marketing, underwriting systems and operations, actuarial services and claims
management. Underwriting department analysts are charged with following rating
18
<PAGE>
agency reviews and industry developments, including a detailed review of semi-
annual portfolio reports submitted by each ceding company to the rating
agencies.
(c) Trade Credit and Specialty Products Reinsurance -
Credit sales expose the seller to numerous risks ranging from the ability and
willingness of the buyer to make payments according to agreed terms to political
events which could disrupt the relationship between the seller and the buyer.
Credit insurance is available in a variety of forms, and in varying degrees of
comprehensiveness, to cover many of the potential risks encountered by the
seller of goods and services. There are two broad areas of risk assumed in
credit insurance and, consequently, reinsurance: commercial risks, including
bankruptcy of the buyer and political risks, which can interfere with the
fulfillment of an otherwise valid contract. Credit insurance underwriters
manage risk by modifying the terms of coverage, by diversifying exposures to
control aggregations of risks to particular buyers, industries, or territories,
and by developing sophisticated databases of credit and political information.
The Company also writes a limited portfolio of other specialty lines. The
Company performs extensive diligence of prospective ceding companies to identify
those expected to produce superior underwriting results, structures its
reinsurance participation to eliminate unacceptable risks and actively monitors
exposures to identify any deterioration in risk profile and control aggregation
across participations.
(d) Title Reinsurance -
Similar to the "zero loss" standard applied in financial guaranty insurance
underwriting, title reinsurance is underwritten without the expectation of any
significant loss. Capital Title's underwriting decisions are, in major part,
based on the underwriting audits of its ceding companies, focusing on (i)
underwriting policies, guidelines and procedures and the experience and quality
of underwriting personnel, including knowledge of localized issues and quality
control, (ii) financial performance and stability, reserve adequacy and
liquidity, (iii) claims handling procedures and personnel and loss management
techniques and procedures, with particular emphasis on salvage, (iv) record
keeping and title plant to ensure that all are well maintained and up to date,
(v) agent and branch office review procedures, and (vi) trust fund and escrow
account procedures. Preference is given to those companies whose overall
policies, procedures and personnel exhibit a strong commitment to quality
underwriting and loss management.
Capital Title automatically accepts for reinsurance all policies which fall
within the parameters of its various treaties. However, policies which contain
certain enumerated types of extraordinary risks will have to be submitted on a
special acceptance basis and separately underwritten by Capital Title's
underwriting staff. Such extraordinary risks may include insured interests
created by, under or concerning bankruptcy or state insolvency laws, federal or
state securities laws, mineral interests, Indian lands, wet lands, tide lands,
and mechanic's lien issues.
In designing and recommending various excess of loss reinsurance strategies,
Capital Title pays particular attention to each ceding company's loss
experience, including frequency, severity and type of loss, at various policy
sizes and levels of business. In conjunction therewith, salvage practices and
procedures are considered.
Capital Title is also called upon to provide facultative reinsurance capacity to
the industry, particularly on larger commercial transactions and securitized
pools of real estate. Capital Title maintains an underwriting staff experienced
in handling these types of transactions and familiar with the particular risks
attendant thereto.
(6) Retrocessional Arrangements, Soft Capital Facilities and Intercompany
---------------------------------------------------------------------
Capital Supports -
----------------
The Company's business strategy places emphasis on the development of
retrocessional relationships which provide the Company with a higher level of
reinsurance risk capacity and serve as a means of accessing additional
reinsurance opportunities. The Company's retrocessional strategy emphasizes
building single-risk capacity and risk management. The Company retroceded 6.5%
or $14.2 million of its gross premiums written in 1997, 19.0% or
19
<PAGE>
$24.6 million of its gross premiums written in 1996 and 16.8% or $18.1 million
of its gross premiums written in 1995.
In 1992, Capital Reinsurance entered into a portfolio first loss and excess of
loss reinsurance agreement with Centre Reinsurance Company of New York, a AA
rated reinsurer. The agreement, which covered the entire reinsured portfolio of
Capital Reinsurance, provided protection against currently unforeseen losses
which, should they occur, would, in the absence of the reinsurance cover,
require a significantly greater loss reserve in the year of occurrence. The
cover also provided Capital Reinsurance with catastrophic loss protection.
Capital Credit entered into a similar cover in 1992 with AXA Re Finance S.A.
("AXA Re"). Under these arrangements, as of December 31, 1997, Capital
Reinsurance has ceded $19.5 million in premium and Capital Credit has ceded
$4.25 million in premium.
On January 31, 1994, Capital Reinsurance entered into an agreement with Deutsche
Bank AG for a credit facility of up to $75 million specifically designed to
provide rating agency qualified capital to further support the claims-paying
resources of Capital Reinsurance. The agreement expires on January 27, 2005.
As part of its original capital structure, in 1994 Capital Mortgage purchased
$30 million of portfolio excess of loss reinsurance. Additionally, in 1994
Capital Reinsurance established a $100 million portfolio excess of loss
reinsurance arrangement. Capital Credit's claims-paying resources are further
supported through a portfolio aggregate excess of loss reinsurance agreement
with Capital Reinsurance.
The Company creates specialized retrocessional structures for establishing large
financial guaranty single risk capacity, which the Company believes improve its
competitive position with the primary financial guaranty insurance market. The
Company believes that its ability to offer the primary financial guaranty market
reinsurance capacity for the largest insurable debt issues is a significant
marketing benefit, which allows it to access additional reinsurance
opportunities. The Company's retrocessional treaty programs are its EOL Program
and ADS Program. The EOL Program was a structured, non-proportional
retrocessional treaty which (i) produced single risk capacity for the largest
issuers of insurable municipal bonds, (ii) allowed international
retrocessionaires to participate at a variety of risk levels, (iii) improved
transactional profitability for the Company and (iv) complied with the Company's
external risk limitations. The EOL Program was active through the end of 1991,
and currently no new business is being ceded to it. The ADS Program is a
proportional treaty covering annual payment obligations of the Company on issues
reinsured under the EOL Program. The ADS Program was effective as of January 1,
1992.
Capital Reinsurance ceded to Capital Credit $3.1 million, $0 million and $1.3
million in premiums, and $.8 billion, $0 billion and $1.1 billion in par
amounts, for the years ended December 31, 1997, 1996 and 1995, respectively.
Capital Credit interacts with Capital Reinsurance and Capital Mortgage as a
captive retrocessionaire for reinsurance opportunities which might otherwise be
constrained in the context of Capital Reinsurance's rating agency and regulatory
limitations. To further support Capital Credit's credit reinsurance business,
Capital Credit entered into a reinsurance agreement with Capital Reinsurance
under which Capital Reinsurance provides $25 million in aggregate excess
coverage. Further, to support Capital Credit's A+ rating, Capital Re has
issued a $50 million guaranty of Capital Credit's liabilities.
KRE also provides retrocessional capacity to Capital Reinsurance, Capital
Mortgage, Capital Credit and Capital Title. For the year ended December 31,
1997, Capital Reinsurance retroceded to KRE $2.0 million of premiums.
Approximately $85 million of per policy coverage is provided to Capital Title by
KRE pursuant to a Per Policy Excess of Loss Retrocession Agreement. Under this
agreement, KRE covers an amount of loss paid by Capital Title arising from each
of its policies equal to $90 million minus Capital Title's retention under the
agreement. Capital Title's retention under the agreement is equal to the
greater of: (i) $5 million, and (ii) 20% of Capital Title's policyholder's
surplus. $25 million of additional coverage is provided by KRE to Capital Title
pursuant to the Excess of Loss Retrocession Agreement. Under this agreement,
KRE covers up to $25 million of loss paid by
20
<PAGE>
Capital Title arising from its policies in excess of the lesser of: (i) 100% of
Capital Title's net written premium, and (ii) the amount by which Capital
Title's statutory capital exceeds $25 million. Capital Reinsurance has
guaranteed payment of all of KRE's title reinsurance obligations to the extent
KRE is unable to satisfy those obligations.
Capital Re and Capital Credit are parties to a Capital Support Agreement
pursuant to which Capital Re has agreed to maintain the net worth of Capital
Credit (exclusive of its investment in Capital Mortgage) at $10 million.
Also, Capital Mortgage and KRE are parties to a Capital Support Agreement
pursuant to which Capital Mortgage has agreed, subject to certain limitations,
to maintain the net worth of KRE at $15 million and KRE has agreed to maintain
the net worth of Capital Mortgage at $25 million. In addition, Capital
Reinsurance and KRE are parties to a Guaranty Agreement pursuant to which
Capital Reinsurance has guaranteed all of KRE's obligations arising under all
reinsurance contracts issued or assumed by KRE covering business other than
business classified by KRE as mortgage guaranty reinsurance, credit reinsurance
and financial guaranty reinsurance, to the extent such obligations are
associated with the first $18 million of premium per calendar year written by
KRE with respect to such business.
(7) Competition -
-----------
(a) Financial Guaranty Reinsurance -
Capital Reinsurance competes directly with one U.S. financial guaranty
reinsurer, Enhance Reinsurance Company, and indirectly with various
international multiline reinsurers and insurers. Based upon the 1997 annual
statutory statements filed by each of the primary U.S. financial guaranty
insurers, the Company believes that the Company and its principal competitor
assumed most of the reinsurance ceded by the primary U.S. financial guaranty
insurers in 1997.
U.S. multiline insurance companies generally do not provide reinsurance to the
financial guaranty insurance industry. Although applicable state insurance
regulations have mandated a specialized form for the transaction of primary
financial guaranty insurance, multiline insurers may participate as reinsurers.
However, the Company believes, based upon its own experience, that almost all
U.S. multiline insurers have declined to participate in this market primarily
because of their lack of the special expertise and underwriting skills necessary
for this line of reinsurance.
Numerous non-U.S. insurers participate in financial guaranty reinsurance
treaties. Competition from international multiline reinsurance companies is best
understood in the context of the financial guaranty reinsurance market in
general. Cooperative channels of reinsurance capacity have developed throughout
the reinsurance market in order to spread financial guaranty risk across a broad
spectrum of insurers. As a result, international companies which may compete
with Capital Reinsurance are frequently Capital Reinsurance's retrocessionaires
and ceding companies. As the global market evolves, this interaction may become
more pronounced.
Competition in the financial guaranty reinsurance business is based upon many
factors, including overall financial strength, pricing, service and evaluation
of claims-paying ability by the major rating agencies, including S&P. S&P will
grant credit against a primary company's capital requirements and single risk
limits for reinsurance ceded, provided the reinsurer meets S&P claims-paying
ability standards. The primary company receives a 100% credit for reinsurance
ceded subject to the reinsurer's maintenance of a AAA claims-paying rating from
S&P. A 70% credit is assigned if the reinsurer is rated AA and 30% if the
reinsurer is rated A.
Capital Reinsurance also faces competition indirectly from other AAA rated
financial institutions which provide capital substitutes to the primary
financial guaranty insurance companies. Several international commercial banks
have developed credit facilities and letter of credit products that qualify as
rating agency capital and therefore
21
<PAGE>
provide primary insurers with increased insurance capacity for rating agency
purposes. However, these banking facilities cannot provide regulatory capital or
credit against liabilities. Further, the current lack of substantial AAA bank
credit has reduced banks as a competitive force in the reinsurance market.
Competition is also a function of the ease with which primary insurers can raise
capital in the private or public equity markets. Increased primary capital
increases the ability of insurers to retain risk and the need for reinsurance in
general is diminished. The Company believes that primary insurers have recently
increased their primary capital base and that increased competition from foreign
insurers is occurring. AXA Group Cie., one of France's largest insurers,
established a subsidiary in 1995, AXA Re, in an effort to compete more
effectively with AAA rated U.S. financial guaranty reinsurers. In 1998, RAM Re,
a Bermuda domiciled financial guaranty reinsurance company, commenced
operations. RAM Re is rated AAA by S&P and Aa3 by Moody's.
(b) Mortgage Guaranty Reinsurance -
Capital Mortgage is not aware of any other U.S. professional reinsurer which
specializes in mortgage guaranty reinsurance. Several U.S. multiline reinsurers
offer capacity to the mortgage guaranty market but their participation has been
limited. In addition, during 1997 certain banks received approval from the
Comptroller of the Currency to establish operating subsidiaries to reinsure a
portion of the mortgage insurance on loans originated or purchased by the bank
or its lending affiliates. Substantially all of the external reinsurance
capacity for the mortgage guaranty insurance industry is provided by European
multiline insurers and reinsurers, who offer modest amounts of traditional
reinsurance products. Capital Mortgage believes that those reinsurance providers
typically lack the orientation and flexibility to address the current risk
management, capital and financial problems of the mortgage guaranty insurance
industry.
Like financial guaranty reinsurance, competition is also a function of the ease
with which primary insurers can raise capital in the private or public equity
markets. Increased primary capital increases the ability of insurers to retain
risk and reduces the need for reinsurance in general.
(c) Trade Credit and Specialty Products Reinsurance -
The trade credit reinsurance market is led by traditional multiline players,
principally Munich Re and Swiss Re, which have been able to maintain their
dominant market position in part through their ownership interests in many of
the leading primary companies. In addition to the market leaders, there are a
large number of mainly European and U.S. reinsurers that compete for the
business. Reciprocal reinsurance arrangements between primary companies are
widespread, thus adding to the degree of competition in the industry.
The reinsurance market for specialty products is very competitive and dominated
by large multiline reinsurance companies, both domestic and foreign.
(d) Title Reinsurance -
Capital Title is the only U.S. professional reinsurer which specializes in
third-party title reinsurance. To date, substantially all title reinsurance has
been provided by the large title insurance companies, except for some minor
excess coverage. The global reinsurance market has not been tapped to any
significant extent by title insurers.
(e) Lloyd's Operations-
There is significant competition in all classes of business transacted by the
syndicates managed by RGB and CIDER emanating from a number of different markets
worldwide. Depending upon the class of business, competition comes from the
London market, other Lloyd's syndicates, Institute of London Underwriters
companies, and major international insurers and reinsurers. With respect to
international risks, competition also comes from domestic insurers in the
country of origin of the insured.
22
<PAGE>
(8) Ratings -
-------
(a) Financial Guaranty Reinsurance -
Maintenance of an S&P and Moody's AAA rating is very important for the business
of Capital Reinsurance, particularly in the area of financial guaranty
reinsurance, because S&P will permit a AAA rated ceding company 100% credit for
a cession only if the reinsurer is also AAA rated. The claims-paying ability of
Capital Reinsurance has been rated AAA by S&P and Moody's. The major rating
agencies have developed and published rating guidelines for rating financial
guaranty reinsurers. These criteria follow the standards used to evaluate the
claims-paying ability of primary monoline financial guaranty insurers. The
claims-paying ratings assigned by S&P and Moody's are based upon factors
relevant to policyholders and are not directed towards the protection of
investors in Capital Re. In January 1998, Moody's placed the claims-paying
ability rating of Capital Reinsurance on credit review for possible downgrade.
The Company's successful diversification strategy has prompted Moody's to focus
on the interrelationships between AAA rated Capital Reinsurance and the
Company's other operating subsidiaries. The Company believes that Moody's
review is a natural by-product of the Company's strategic direction to continue
its growth through diversification. In March 1998, Capital Reinsurance received
a AAA claims-paying rating from Fitch.
The claims-paying rating criteria used by S&P and Moody's focus on the following
factors: capital resources, financial strength; demonstrated management
expertise in financial guaranty and traditional reinsurance, credit analysis,
systems development, marketing, capital markets and investment operations; and a
minimum policyholders' surplus comparable to primary company requirements, with
capital sufficient to meet projected growth as well as access to such additional
capital as may be necessary to continue to meet standards for capital adequacy.
S&P has published standards as to capital charges and single risk categories to
which Capital Reinsurance and other AAA rated financial guaranty insurers and
reinsurers must adhere in order to maintain their highest ratings. These
standards weight numerous factors to types of obligations which are
significantly more complex than an insurance-in-force-to-capital ratio. In
addition, capital adequacy is tested against an economic model that simulates a
growth period followed by an economic depression which assumes no new business
is written.
The Company's ability to compete with other AAA rated financial guarantors, and
its results of operations and financial condition, may be materially adversely
affected by any reduction in the claims-paying rating of Capital Reinsurance.
Under several treaties to which Capital Reinsurance is a party, the ceding
companies may recapture business previously ceded to Capital Reinsurance in the
event of a specified rating downgrade of Capital Reinsurance, which could result
in a material adverse effect on the Company's deferred premium revenue and its
recognition of future income from that reserve.
(b) Mortgage Guaranty Reinsurance -
Capital Mortgage's mortgage guaranty reinsurance business plan is premised on a
claims-paying rating of at least AA. S&P has rated the claims-paying ability of
both Capital Mortgage and KRE AA. Although the rating agencies have not
published explicit rules regarding rating agency credit for reinsurance in the
mortgage guaranty insurance area, in practice, they provide 100% credit to a AA
rated ceding company for reinsurance to AA rated reinsurers. Reinsurance to
lesser rated reinsurers is substantially discounted.
A reinsurer's financial ability to pay claims is the standard of value to its
primary insurance market. The general standard of creditworthiness in the
mortgage guaranty industry is AA. Certain national mortgage lenders and a large
segment of the mortgage securitization market, including the Federal National
Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage
Corporation ("Freddie Mac"), generally will not purchase mortgages or
mortgage-backed securities unless the private mortgage insurance on the
mortgages has been issued
23
<PAGE>
by an insurer with a claims-paying ability rating of at least AA- from S&P or
Fitch or at least Aa3 from Moody's. As a result, all of the eight U.S. primary
mortgage guaranty insurers have claims-paying ratings of at least AA and
generally seek similarly rated reinsurance security. Ratings of at least AA
provide the ceding companies with confidence that the reinsurer has the
financial strength to meet its policy obligations.
(c) Title Reinsurance -
Capital Title is rated AA- by S&P and Duff & Phelps. Although the rating
agencies have not published explicit rules regarding rating agency credit for
reinsurance in the title insurance area, in practice, the primary title insurers
receive 100% credit for cessions to Capital Title. Title insurers are only
beginning to obtain claims-paying ability ratings; the general standard of
creditworthiness that seems to be developing in the title insurance
industry is A.
(d) Other Ratings -
In 1997, Capital Credit received an A+ claims-paying rating from S&P. The
Company's senior debt is rated A by S&P and Aa3 by Moody's, and the MIPS issued
by the Company's finance subsidiary, Capital Re LLC, are rated A- by S&P and A1
by Moody's. In January 1998, Moody's placed the Company's senior debt rating
and the rating of the MIPS under credit review for possible downgrade.
Capital Reinsurance, Capital Mortgage, KRE and Capital Title have not received
ratings from A.M. Best Company, Inc. ("A.M. Best"), a major rating agency
covering the insurance industry. A.M. Best rates insurance companies annually
and provides statistical reports on their financial condition and history.
However, A.M. Best has not rated financial guaranty insurers and reinsurers.
Because the claims-paying ability ratings discussed above from S&P, Moody's and
Duff & Phelps are generally considered far more important than A.M. Best ratings
in the markets in which those companies compete, the Company believes the
absence of an A.M. Best rating has no impact on the Company's business or on its
competitive position.
(9) NAIC-IRIS Ratios -
----------------
The National Association of Insurance Commissioners' Insurance Regulatory
Information System ("IRIS") was developed by a committee of state insurance
regulators and is primarily intended to assist state insurance departments in
executing their statutory mandates to oversee the financial condition of
insurance companies operating in their respective states. IRIS identifies
eleven industry ratios and specifies "usual values" for each ratio. Departure
from the usual values on four or more of the ratios could lead to inquiries from
individual state insurance commissioners as to certain aspects of a company's
business.
For the year ended December 31, 1997, Capital Reinsurance had no unusual values.
The IRIS ratios for Capital Mortgage for the year ended December 31, 1997
have not yet been received.
(10) Losses and Reserves -
-------------------
In the financial guaranty line of business, case basis loss reserves are
required to be established under generally accepted accounting principles
("GAAP") and statutory accounting practices ("SAP") when a payment default
on an insured obligation is probable and the amount of the probable loss can be
reasonably estimated. Moreover, under its various reinsurance treaties and
facultative agreements, Capital Reinsurance is obligated to establish and
maintain SAP case basis loss reserves. Under GAAP, the amount of the case basis
loss reserve is calculated as the
24
<PAGE>
present value of the losses expected to be incurred through the full term of the
obligation, including loss adjustment expenses, net of anticipated salvage and
subrogation. Under current Maryland insurance law, case basis loss reserves may
not be discounted under SAP.
In the mortgage guaranty reinsurance line, the Company's reserves are a function
of the reserving methodologies of the primary insurance companies from which
mortgage guaranty risk is assumed. A significant period of time may elapse
between the occurrence of the borrower's default on mortgage payments (the event
a potential future claim), the reporting of such default to the primary
insurance company, the primary company's notification of loss to the reinsurer
and the eventual payment of the claim related to the default. To recognize the
liability for unpaid mortgage guaranty losses related to defaulted mortgages,
primary mortgage guaranty insurers establish loss reserves in respect of such
defaults based upon the claim rate and estimated average claim amount. Included
in these loss reserves are loss adjustment expense ("LAE") and Incurred But Not
Reported Reserves. These reserves are estimates and there can be no assurance
that they will prove adequate to cover ultimate loss developments on the
reported defaults. The reserving process is premised on the assumption that
historical experience relating to mortgage defaults, adjusted for the
anticipated effect of current economic conditions and projected future economic
trends, provides a reasonable basis for estimating future events. However,
estimation of loss reserves is a difficult process, especially in light of the
rapidly changing economic conditions that have affected certain regions of the
United States. Additionally, economic conditions that have affected the
development of the loss reserves in the past may not necessarily affect
development patterns in the future.
For the trade credit reinsurance business, loss reserves are established
according to management's loss expectations which are based on historical loss
development patterns experienced by the ceding companies on similar business as
well as management's view of current macroeconomic conditions in the countries
in which the policies apply.
For the specialty reinsurance business, loss reserves are established according
to management's loss expectations which are based on historical loss development
patterns experienced by the ceding companies on similar business.
For the title reinsurance business, case basis loss reserves are required to be
established under GAAP and SAP when a loss under a reinsured title policy is
probable and the amount of the probable loss can be reasonably estimated.
In the Lloyd's business, case basis loss reserves are established for all known
losses. Notice of a claim is given by the cedant to its broker who in turn
provides notice to the lead underwriter and, once the claim has been agreed by
the lead underwriter, it in turn provides notice of such claim to the Lloyd's
claims notification system, which is common to all syndicates operating at
Lloyd's.
For developed underwriting years, a provision for ultimate losses is made by
applying statistical projection techniques to incurred losses. For undeveloped
years, Bornhuetter-Ferguson techniques are applied based on a weighting of
incurred and expected loss ratios to estimate ultimate losses. Ultimate premiums
are also estimated by the same methods. Reserves for incurred but not reported
("IBNR") losses are calculated as the earned portion of ultimate premiums
applied to ultimate losses less paid losses and case reserves.
For paid losses and case reserves, the reinsurance recoverables are calculated
by applying reinsurance to those specific losses. Reinsurance recoverables are
provided against IBNR losses based on techniques similar to those used to
calculate ultimate losses for undeveloped years.
The Chief Financial Officer of the Company is responsible for determining the
appropriate timing and amount of loss reserves after consultation with the
Company's Chief Executive Officer and Chief Underwriting Officer. In making his
determination, the Chief Financial Officer will also confer with the ceding
company which originally insured the obligation. The Company may, in its
discretion, establish a loss reserve independent of the originating ceding
company.
25
<PAGE>
As of December 31, 1997, the Company had established a net $30.7 million in GAAP
case basis loss and LAE reserves (of which $18.3 million is classified as
incurred but not reported reserves in the Company's statutory financial
statements). The Company believes its loss and LAE reserves are adequate. The
following table sets forth for the periods indicated certain information
regarding the Company's loss experience.
YEAR ENDED DECEMBER 31
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
1997 1996 1995
- --------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
GAAP Net Premiums Earned $133,664 $92,436 $60,097
- --------------------------------------------------------------------------------------------------------------
Net Reserve for Unpaid Losses and LAE at 18,069 10,259 7,702
Beginning of Period (including foreign currency
revaluation)
- --------------------------------------------------------------------------------------------------------------
Incurred Losses and LAE 27,357 9,483 2,637
- --------------------------------------------------------------------------------------------------------------
Paid (Recovered) Losses and LAE 14,472 1,969 94
- --------------------------------------------------------------------------------------------------------------
Unrealized Foreign Currency Loss on Reserve (299) 296 14
Revaluation
- --------------------------------------------------------------------------------------------------------------
Net Reserve for Unpaid Losses and LAE at 30,655 18,069 $10,259
End of Period (including foreign currency
revaluation)(1)
- --------------------------------------------------------------------------------------------------------------
Ratio of Losses Incurred and LAE to GAAP 20.5% 10.3% 4.4%
Net Premiums Earned
- --------------------------------------------------------------------------------------------------------------
</TABLE>
(1) Net of reinsurance recoverable on ceded losses of (in thousands) $7,245,
$1,833 and $2,524 for the years ended December 31, 1997, 1996 and 1995,
respectively.
(11) Investments -
-------------
In managing its investment portfolio, the Company places a high priority on
credit quality and liquidity. Investment policy is set by the Board of Directors
and specific investments are managed by two outside advisers: Lazard Freres
Asset Management, Inc. and Goldman Sachs Asset Management (the "Advisers"). The
Advisers act as investment managers of the Company's portfolio under contracts
terminable on 30 days' notice. Performance of the Advisers and the fees
associated with these arrangements have been and will continue to be
periodically reviewed by the Board of Directors of the Company. All investments
made by the Advisers for the Company are in accordance with the general
requirements and guidelines for investments established by the Board of
Directors and Investment Committee thereof, including guidelines relating to
average maturities, duration and quality, in accordance with applicable law. All
investments in municipal bonds and certain asset backed securities are subject
to prior approval by the Capital Reinsurance underwriting department. The
Company's current investment policy permits the purchase of both investment
grade and non-investment grade fixed income securities, provided that non-
investment grade fixed income securities may be rated no lower than "B" at the
time of purchase. Further, total investment in non-investment grade fixed
income securities may not exceed 3% of the aggregate portfolio.
At December 31, 1997, 82.0% of the Company's investment portfolio consisted
exclusively of fixed income securities rated AAA or A-1+ by S&P or Aaa or P-1 by
Moody's, or issues by the U.S. Government or its agencies or instrumentalities.
Overall weighted average credit quality is AA+.
A strategic change to the Company's investment guidelines approved by the Board
of Directors in 1997 allows tactical purchases of high yield/emerging market
debt securities at the discretion of the Advisers and within the constraints
established by the Board of Directors. The overall portfolio performance,
however, remains benchmarked to composite domestic benchmarks. No assurance can
be given that the Company's strategy of
26
<PAGE>
diversification will prove successful, or that losses will not be incurred in
excess of those realized under the prior investment strategy.
AGGREGATE INVESTMENT PORTFOLIO BY MATURITY
AS OF DECEMBER 31
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
1997 1996 1995
--------------------------------------------------------------------------------------------------------
CARRYING PERCENTAGE CARRYING PERCENTAGE CARRYING PERCENTAGE
VALUE OF TOTAL VALUE OF TOTAL VALUE OF TOTAL
MATURITY OF INVESTMENT INVESTMENT INVESTMENT
INVESTMENTS PORTFOLIO PORTFOLIO PORTFOLIO
- -----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Due in One Year or $ 87,757 8.7% $ 76,606 8.5% $ 96,837 12.6%
Less
- -----------------------------------------------------------------------------------------------------------------------------
Due After One Year 112,001 11.1% 117,503 13.0% 70,365 9.1%
Through Five Years
- -----------------------------------------------------------------------------------------------------------------------------
Due After Five Years 128,094 12.6% 74,723 8.3% 47,177 6.1%
Through Ten Years
- -----------------------------------------------------------------------------------------------------------------------------
Due After Ten Years 683,239 67.6% 632,270 70.2% 557,388 72.2%
- -----------------------------------------------------------------------------------------------------------------------------
Total Investment $1,011,091 100% $901,102 100% $771,767 100.0%
Portfolio
- -----------------------------------------------------------------------------------------------------------------------------
</TABLE>
AGGREGATE INVESTMENT PORTFOLIO AND YIELD BY TYPE OF SECURITY
AS OF DECEMBER 31, 1997
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
CARRYING ESTIMATED WEIGHTED
VALUE FAIR AVERAGE YIELD
INVESTMENT CATEGORY VALUE TO MATURITY(1)
- -----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Long-Term Investments:
- -----------------------------------------------------------------------------------------------------------
Municipal Obligations $ 487,696 $ 487,696 6.13%
- -----------------------------------------------------------------------------------------------------------
Corporate Securities 115,212 115,212 7.06%
- -----------------------------------------------------------------------------------------------------------
U.S. Government and Agency Obligations 90,053 90,053 6.28%
- -----------------------------------------------------------------------------------------------------------
Mortgage-Backed Securities 155,443 155,443 7.10%
- -----------------------------------------------------------------------------------------------------------
Emerging Markets 18,501 18,501 7.47%
- -----------------------------------------------------------------------------------------------------------
Other Asset-Backed Securities 65,518 65,518 6.52%
- -----------------------------------------------------------------------------------------------------------
Total Long Term Investments 932,423 932,423 6.49%
- -----------------------------------------------------------------------------------------------------------
Short-Term Investments 78,668 78,668 5.24%
Total Investment Portfolio $1,011,091 $1,011,091 6.38%
- -----------------------------------------------------------------------------------------------------------
</TABLE>
(1) Represents yield to maturity on long-term investments and current yield on
short-term investments. All percentages are stated on a pre-tax basis, based
on contractual maturity periods. Expected maturities will differ from
contractual maturities because borrowers may have the right to call or
prepay obligations with or without call or prepayment penalties.
At December 31, 1997, approximately $155.4 million or 15.4% of the Company's
investment portfolio was comprised of mortgage-backed securities ("MBS"). Of the
MBS portfolio, approximately $132.7 million or 85.4%
27
<PAGE>
was backed by agencies or entities sponsored by the U.S. government as to the
full amount of principal and interest. As of December 31, 1997, the entire MBS
portfolio was invested in triple A rated securities.
Prepayment risk is an inherent risk of holding MBS. However, the degree of
prepayment risk is particular to the type of MBS held. The Company limits its
exposure to prepayments by purchasing less volatile types of MBS. As of
December 31, 1997, $3.7 million or approximately 2.4% of the MBS portfolio was
invested in collateralized mortgage obligations ("CMOs") which are characterized
as planned amortization class CMOs ("PACs"). PACs are securities whose cash
flows are designed to remain constant over a variety of mortgage prepayment
environments. Other classes in the CMO security are structured to accept the
volatility of mortgage prepayment changes, thereby insulating the PAC class. Of
the remaining MBS portfolio, $151.7 million, or 97.6%, was invested in mortgage-
backed pass-throughs or sequential CMOs. Pass-throughs are securities in which
the monthly cash flows of principal and interest (both scheduled and
prepayments) generated by the underlying mortgages are distributed on a pro-rata
basis to the holders of securities. A sequential MBS is structured to divide the
CMO security into sequentially ordered classes. Receipt of principal payments
within classes is contingent on the retirement of all previously paying classes.
Generally, interest payments are made currently on all classes. While these
securities are more sensitive to prepayment risk than PACs, they are not
considered highly volatile securities. While the Company may consider investing
in any tranche of a sequential MBS, the individual security's characteristics
(duration, relative value, underlying collateral, etc.) along with aggregate
portfolio risk management determine which tranche of sequential MBS will be
purchased. At December 31, 1997, the Company had no securities such as interest
only securities, principal only securities, or MBS purchased at a substantial
premium to par that have the potential for loss of a significant portion of the
original investment due to changes in the prepayment rate of the underlying
loans supporting the security.
(12) Banking Facilities -
------------------
On January 22, 1998, the Company extended its arrangements with Deutsche Bank AG
for the provision of a $25 million liquidity facility which is available for
general corporate purposes. The Company has not borrowed any funds under this
facility.
(13) Data Processing -
---------------
The Company believes that its data processing system is adequate to support its
current needs and that such system has the capacity to support a greater volume
of reinsurance business.
The Company uses microcomputers on a Novell and UNIX network. The network has
four fileservers which provide for disk duplexing and complete data and
application redundancy. System applications files and databases are backed up to
tape daily. Backup tapes are shipped to an off-site storage facility weekly and
on-site backup is stored in a fire-proof safe outside the data center. For a
discussion of Year 2000 issues, see "Management's Discussion and Analysis of
Financial Condition and Results of Operations" in Part II hereof.
(14) Employees -
---------
As of December 31, 1997, the Company employed 150 persons, of whom 53 were in
administration, legal, finance and management, 72 were in underwriting and
technical support, 14 in management information services and 11 in direct
marketing. None of these employees is covered by collective bargaining
agreements. The Company believes that its employee relations are excellent.
28
<PAGE>
(15) Executive Officers -
--------------------
The executive officers of the Company and their present ages and positions with
the Company are set forth below.
<TABLE>
<CAPTION>
Name Age Position and Term of Office
- ----------------------------- ----------------- -------------------------------------------------------
<S> <C> <C>
Michael E. Satz 49 Chairman of the Board, President and Chief Executive
Officer (Officer since 1987)
Jerome F. Jurschak 50 Executive Vice President and Chief Underwriting
Officer (Officer since 1988)
David A. Buzen 38 Executive Vice President and Chief Financial Officer
(Officer since 1988)
Alan S. Roseman 41 Senior Vice President, General Counsel and Secretary
(Officer since 1989)
Laurence C.D. Donnelly 39 Executive Vice President (Officer since 1988)
Joseph W. Swain III 45 Executive Vice President (effective February 1998,
Officer since 1988)
</TABLE>
(16) Regulatory Status of Insurance Subsidiaries -
-------------------------------------------
Capital Reinsurance is licensed as a surety, property and casualty insurer
(including mortgage guaranty insurance) in the State of Maryland and is licensed
or authorized to transact insurance business in the States of New York,
Michigan, Florida and California and is an approved or accredited reinsurer in
the States of Alaska, Colorado, Illinois, North Carolina, Pennsylvania, Texas
and Wisconsin and in the Islands of Bermuda. Under its New York license,
Capital Reinsurance is authorized to write surety insurance and to reinsure
risks of every kind or description permitted by its charter (including financial
guaranty risks). Notwithstanding the breadth of its New York license, Capital
Reinsurance has committed to the New York Insurance Department that it will act
in the United States only as a reinsurer and intends to reinsure only financial
guaranty and related special risks consistent with its business strategy as a
specialty reinsurer.
Capital Mortgage is licensed as a mortgage guaranty insurer in the State of New
York and is thereby authorized to transact solely the business of mortgage
guaranty insurance. Capital Mortgage is an approved or accredited reinsurer in
the States of Arizona, Illinois, North Carolina, Pennsylvania and Wisconsin.
Capital Title is licensed as a title insurer in the State of New York and is
thereby authorized to transact solely the business of title insurance. Capital
Title is also licensed or authorized to transact title insurance business in the
States of Michigan and Texas. Capital Title is an approved or accredited
reinsurer in the States of Connecticut, Florida, Louisiana, Maryland, North
Carolina, South Carolina and Virginia.
Capital Reinsurance is subject to the insurance laws and regulations of the
State of Maryland and Capital Mortgage and Capital Title are subject to the
insurance laws of the State of New York. Additionally, Capital Reinsurance,
Capital Mortgage and Capital Title are subject to the laws of the other
jurisdictions in which they are, or may be, licensed to transact business. In
general, such insurance laws and regulations are primarily for the protection of
the policyholders of these companies, i.e., their ceding insurers, and
ultimately the policyholders of those ceding insurers.
29
<PAGE>
These laws and regulations, as well as the level of supervisory authority that
may be exercised by the various state insurance departments, vary by
jurisdiction, but generally require reinsurance companies to maintain minimum
standards of business conduct and solvency, including the satisfaction of
minimum capital requirements, and certain financial tests, the maintenance of
deposits of securities with state insurance departments for the benefit of
ceding insurers and the filing of certain reports with regulatory authorities.
Capital Reinsurance, Capital Mortgage and Capital Title are required to file
quarterly and annual SAP financial statements in each jurisdiction where they
are licensed and with the National Association of Insurance Commissioners, and
are subject to certain risk limits and other statutory restrictions concerning
the types and quality of, and limitations on, investments.
The operations and accounts of Capital Reinsurance, Capital Mortgage and Capital
Title are subject to periodic examination by the insurance departments of the
jurisdictions in which they are licensed, authorized or accredited. The Maryland
Insurance Administration, the regulatory authority of the domiciliary
jurisdiction of Capital Reinsurance, conducts a triennial examination of
insurance companies domiciled in Maryland. During 1997, the Maryland Insurance
Administration completed its field work in connection with a triennial
examination of Capital Reinsurance for the period from January 1, 1994 though
December 31, 1996. The report on the examination has not yet been issued. The
New York Insurance Department, the regulatory authority of the domiciliary
jurisdiction of Capital Mortgage, conducts a triennial examination of insurance
companies domiciled in New York. During 1997, the New York Insurance Department
completed its field work in connection with a triennial examination of Capital
Mortgage for the period from January 1, 1994 though December 31, 1996. The
report on the examination has not yet been issued. The New York Insurance
Department, the regulatory authority of the domiciliary jurisdiction of Capital
Title, will conduct examinations of Capital Title on a periodic basis.
Although the rates and policy terms of primary insurance agreements are
generally closely regulated by state insurance departments, the terms and
conditions of reinsurance agreements generally are not subject to regulation by
any regulatory authority with respect to rates or policy terms. However, as a
practical matter, the rates charged by the primary insurers have an effect on
the rates that can be charged by reinsurers and, with respect to reinsurance of
financial guaranty, mortgage guaranty and title primary insurers licensed in the
States of California, Florida and New York, certain terms must often be included
in the reinsurance agreement in order for such primary insurer to receive credit
for the reinsurance on its statutory financial statements.
Capital Credit and KRE are insurance companies registered and licensed as
general insurers under the laws of the Islands of Bermuda. Each is subject to
the Insurance Act of 1978, as amended, of the Islands of Bermuda. It is the
policy of the government of Bermuda that the insurance industry be essentially
self-regulating and the Insurance Act is drawn to require certification by the
appropriate officers and professionals of each company of compliance with the
applicable statutory standards. Capital Credit and KRE are required under the
Act to prepare annual statutory financial statements and file a statutory
financial return, including a declaration of compliance with the statutory
ratios (premium to statutory surplus ratio, five-year operating ratio and change
in statutory surplus ratio) and a general business solvency certificate
demonstrating compliance with the Insurance Act's minimum solvency ratio.
The Company and certain of its UK subsidiaries are subject to the regulatory
jurisdiction of the Council of Lloyd's (the "Council") as a result of the
acquisition by the Company of RGB and CIDER and the establishment of CRC
Capital. Unlike other financial markets in the UK, Lloyd's is not currently
subject to direct UK government regulation through the UK Financial Services Act
1986 but, instead, is self regulating by virtue of the Lloyd's Act 1971-1982
through bye-laws, regulations and codes of conduct made by the Council, which
governs the market. Under the Council there are two boards, the Market Board
and the Regulatory Board. The former is led by working members of the Council
and is responsible for strategy and the provision of services such as premium
and claims handling, accounting and policy signing. The Regulatory Board is
responsible for the regulation of the market, compliance and the protection of
policyholders. There are no provisions in the Lloyd's Acts, the bye-laws or the
regulations which provide for any liabilities of CRC Capital, RGB or CIDER to be
met by the Company. In addition, a managing agency is required to comply with
various capital and solvency requirements and to submit to
30
<PAGE>
regular monitoring and compliance procedures. CRC Capital, as a corporate member
of Lloyd's, is required to commit an amount broadly equal to 50 percent of its
underwriting capacity on the syndicates to support its underwriting on those
syndicates. For the 1997 year of account, the Company committed approximately
(Pounds)20 million of capital, in the form of a letter of credit, to two
syndicates managed by RGB, which supported approximately (Pounds)40 million of
underwriting capacity, and, for the 1998 year of account, the Company has
committed approximately (Pounds)44 million of capital, in the form of a letter
of credit, to three syndicates managed by RGB and CIDER, which supports up to
approximately (Pounds)88 million of underwriting capacity.
In 1997, the UK Government announced reforms for the regulation of the domestic
financial services industry by proposing amendments to the Financial Services
Act 1986. The proposed changes involved the consolidation of all self-regulating
investment organizations and the Securities and Investments Board into a single
statutory regulator, the Financial Services Authority (the "FSA"). The UK
Government has announced that Lloyd's will be brought within the new structure
and made subject to FSA oversight.
(17) Insurance Holding Company Regulations -
-------------------------------------
The Company, Capital Reinsurance, Capital Mortgage and Capital Title are subject
to regulation under the insurance holding company statutes of Maryland, the
domiciliary state of Capital Reinsurance, New York, the domiciliary state of
Capital Mortgage and Capital Title, and of other jurisdictions in which they
are, or may be, licensed. The insurance holding company laws and regulations
vary from jurisdiction to jurisdiction, but generally require an insurance
holding company, such as the Company, and insurers and reinsurers that are
subsidiaries of insurance holding companies, to register with the applicable
state regulatory authorities and to file with those authorities certain reports
describing, among other information, their capital structure, ownership,
financial condition, certain inter-company transactions and general business
operations. The insurance holding company statutes also require prior
regulatory agency approval or, in certain circumstances, prior notice of certain
material inter-company transfers of assets and certain transactions between
insurance companies, their parent companies and affiliates. The insurance
holding company statutes impose standards on certain transactions between
affiliated companies within the holding company structure, which include, among
other requirements, that all transactions be fair and reasonable and have terms
no less favorable than terms that would result from transactions between parties
negotiating at arm's length and that those exceeding specified limits receive
prior regulatory approval.
(18) Maryland and New York Insurance Acquisitions Disclosure and Control Acts;
-------------------------------------------------------------------------
Lloyd's "Controller" Regulations -
--------------------------------
Under the Maryland Insurance Code and New York Insurance Laws, unless certain
filings are made with the Insurance Commissioner, no person may acquire any
voting security, or security convertible into a voting security, of an insurance
holding company, such as the Company, which controls a Maryland or New York
insurance company, as applicable, such as Capital Reinsurance, Capital Mortgage
or Capital Title, or merge with such holding company, if, as a result of such
transaction, such person would "control" such insurance holding company. Under
current law, the transaction may not proceed without prior approval or exemption
by the Insurance Commissioner unless following the required provision of certain
information to the Insurance Commissioner, the Insurance Commissioner
affirmatively approves the acquisition within a specified time period.
"Control" is presumed to exist if a person, directly or indirectly, owns or
controls 10% or more of the voting securities of another person. This
presumption may be rebutted by establishing by a preponderance of evidence that
control does not exist in fact.
Under the Lloyd's regulations, the approval of the Council must be obtained
before any person can be a "controller" of a Lloyd's corporate member or of a
managing agency. The Company has been approved as a "controller." Lloyd's
imposes an absolute prohibition on any company being a 10% controller of a
corporate member without first notifying Lloyd's and receiving their consent.
This prohibition is qualified in respect of becoming a 20%, 33%, 50% or majority
controller in that the corporate member must do all that lies within its powers
to comply
31
<PAGE>
with Lloyd's requirements. In these latter circumstances, this essentially means
that notice must have been given to the Council that the relevant threshold will
be exceeded and the Council has not objected. Persons seeking to become
controllers may be required to deliver a declaration and undertaking to Lloyd's,
in the form prescribed by Lloyd's, unless Lloyd's exempts such person from this
requirement. As a "controller," the company is required to give certain
undertakings, directed principally towards ensuring that there is no direct
interference in the conduct of the business of the managing agency.
Under English law, if any person that holds or subsequently becomes the holder
of more than 5 percent of the Company's stock also owns any interest in a
Lloyd's broker or is a partner or a director of a Lloyd's broker, that Lloyd's
broker risks losing its Lloyd's license. For these purposes "Lloyd's broker"
includes the holding company of a corporate Lloyd's broker, any company which
controls (a test based on one-third voting rights or control of the board) such
a Lloyd's broker or its holding company or, if the Lloyd's broker is a
partnership, any person who controls (on a similar test) such a Lloyd's broker
or one of its partners.
(19) Restrictions on Dividends -
-------------------------
(a) Maryland Law:
The principal source of cash for the payment of debt service and dividends by
the Company is the receipt of dividends from Capital Reinsurance. Under current
Maryland insurance law, as it applies to Capital Reinsurance, any proposed
payment of a dividend or distribution in excess of certain amounts is called an
"extraordinary dividend." "Extraordinary dividends" must be reported to, and
approved by, the Maryland Commissioner prior to payment. An "extraordinary
dividend" is defined to be any dividend or distribution to stockholders, such as
the Company, which together with dividends paid during the preceding twelve
months exceeds 10% of an insurance company's policyholders' surplus at the
preceding December 31. Further, an insurer may not pay any dividend or make any
distribution to its shareholders, such as the Company, unless the insurer
notifies the Commissioner of the proposed payment within five business days
following declaration and at least ten days before payment. The Commissioner
may declare that such dividend not be paid if he finds that the insurer's
policyholders surplus would be inadequate after payment of the dividend or could
lead the insurer to a hazardous financial condition. Based on the Maryland
restrictions, at December 31, 1997, the maximum amount available during 1998,
with notice to, but without prior approval of the Maryland Insurance
Administration, for payment of dividends by Capital Reinsurance to the Company
which would not be characterized as "extraordinary dividends" is approximately
$34.6 million.
(b) New York Law:
Capital Mortgage is subject to the dividend restrictions imposed under sections
4105 and 6502(b)(2) of the New York Insurance Law. Those sections provide that
dividends may only be declared and distributed out of earned surplus.
Additionally, no dividend may be declared or distributed in an amount which,
together with all dividends declared or distributed by the company during the
preceding twelve months, exceeds the lesser of 10% of the company's surplus to
policyholders as shown by its last Annual Statutory Statement on file with the
New York Department, or 100% of adjusted net investment income during such
period, unless, upon prior application therefor, the superintendent approves a
greater dividend distribution based upon his finding that the company will
retain sufficient surplus to support its obligations and writings. "Earned
surplus" is defined as the portion of the company's surplus that represents the
net earnings, gains or profits, after deduction of all losses, that have not
been distributed to shareholders as dividends or transferred to stated capital
or capital surplus or contingency reserves or applied to other purposes
permitted by law but does not include unrealized appreciation of assets.
"Adjusted net investment income" is defined as net investment income for the
twelve months immediately preceding the declaration of the dividend increased by
the excess, if any, of net investment income over dividends declared or
distributed during the period commencing thirty-six months before the
declaration of the current dividend and ending twelve months prior thereto.
32
<PAGE>
Capital Title is subject to the dividend restrictions imposed under sections
4105 and 6407 of the New York Insurance Law. Those sections provide that
dividends may only be declared and distributed out of earned surplus and only if
such dividends do not reduce the company's surplus to less than 50% of its
outstanding capital shares, i.e., the value of its outstanding common equity.
Additionally, no dividend may be declared or distributed in an amount which,
together with all dividends declared or distributed by the company during the
preceding twelve months, exceeds 10% of the company's outstanding capital
shares, unless, after deducting such dividends, it has a surplus at least equal
to 50% of its statutory reinsurance reserve or a surplus at least equal to
$250,000, whichever is greater. "Earned surplus" is defined as the portion of
the company's surplus that is not attributable to contributions to surplus made
in the preceding five years or to appreciation in the value of the company's
investments not sold or otherwise disposed of.
(c) Bermuda Law:
Capital Credit and KRE have never declared nor paid dividends. Under Bermuda
Law and the Bye-Laws of Capital Credit and KRE, dividends may be paid out of
their profits (defined as accumulated realized profits less accumulated realized
losses). Distributions to shareholders may also be paid out of their surplus
limited by the requirements that they must at all times (i) maintain the minimum
share capital required under Bermuda Law, and (ii) have relevant assets in an
amount equal to or greater than 75% of relevant liabilities, all as defined
under Bermuda Law.
(20) Credit for Reinsurance -
----------------------
Through the "credit for reinsurance" mechanism, Capital Re's insurance
subsidiaries are indirectly subject to the effects of regulatory requirements
imposed by jurisdictions in which ceding primary insurers are licensed. In
general, a ceding insurer will ordinarily enter into reinsurance agreements only
if the ceding insurer can obtain credit for reinsurance on its statutory
financial statements. Credit is allowed when the reinsurer is licensed,
authorized or accredited in a jurisdiction where the ceding company is domiciled
or, in some cases, licensed. In addition, many jurisdictions allow credit for
reinsurance ceded to a reinsurer that is licensed in another jurisdiction and
which meets certain financial requirements, provided, in some instances, that
the jurisdiction has substantially similar reinsurance credit law requirements.
Alternatively, most jurisdictions permit a ceding insurer to take credit for
reinsurance on its statutory financial statements if the reinsurer is not
licensed, accredited or authorized if the reinsurer provides security against
the reserves ceded in the form of a letter of credit, funds withheld or through
a trust fund mechanism. Capital Reinsurance is licensed or meets the financial
requirements in each of the jurisdictions in which the primary U.S. financial
guaranty insurers are domiciled. Capital Mortgage is licensed or meets the
financial requirements in each of the jurisdictions in which the primary private
U.S. mortgage guaranty insurers are domiciled. Capital Title is licensed or
meets the financial requirements in each of the jurisdictions in which it has
ceding companies and that impose such requirements.
(21) SAP Reserves -
------------
(a) Financial Guaranty Contingency Reserve -
Capital Reinsurance maintains the contingency reserves which the Company
believes are required by the New York, California and Florida insurance laws to
provide credit for reinsurance to ceding financial guaranty insurers licensed in
New York, California and Florida. Under those laws, all financial guaranty
insurers, or their reinsurers, are required to maintain a contingency reserve to
protect policyholders against the impact of excessive losses occurring during
adverse economic cycles.
Under the New York Insurance Law, for financial guaranty policies written on and
after July 1, 1989, contributions are required to be made to the contingency
reserve equal to the greater of 50% of premiums written for the relevant
33
<PAGE>
category of insurance or a percentage of the principal guaranteed, varying from
0.55% to 2.50%, depending upon the type of obligation. Contributions to the
contingency reserve are required to be made as follows: (a) for municipal bonds,
special revenue bonds and substantially equivalent obligations, by quarterly
payments equal to one-eightieth of the total reserve required over a 20 year
period; (b) for all other obligations, by quarterly payments equal to one-
sixtieth of the total reserve required over a 15 year period. Contributions may
be discontinued if the required total contingency reserve for all categories of
obligations has been reached. The contingency reserves must be maintained for
the period specified above, except that withdrawals by the insurer may be
permitted, with the prior written approval of or written notice to the
Superintendent of Insurance, under specified circumstances in the event that the
actual incurred loss experience exceeds certain thresholds or if the reserve
accumulated is deemed excessive in relation to the insurer's outstanding insured
obligations.
As of December 31, 1997, 1996 and 1995, the contingency reserve recorded on
Capital Reinsurance's statutory financial statements was $103.9 million, $87.4
million and $71.4 million, respectively.
(b) Mortgage Guaranty Contingency Reserve:
Under the New York Insurance Law, Capital Mortgage is required to establish a
contingency reserve in an amount equal to 50% of earned premiums. Contributions
to the contingency reserve made during each calendar year must be maintained for
a period of one hundred and twenty months, except that withdrawals may be made
by the insurer with the prior approval of the Superintendent of Insurance in any
year in which the actual incurred losses exceed 35% of corresponding earned
premiums.
(c) Title Reinsurance Reserve:
Under the New York Insurance Law, Capital Title is required to establish a
reinsurance reserve in an amount equal to one-eightieth of one percent of the
exposure assumed by it. Capital Title may release from the reinsurance reserve
five percent of the amount added to the reinsurance reserve during each year
following the year in which the sum was added.
(22) Single and Aggregate Risk Limitations -
-------------------------------------
(a) Financial Guaranty Business -
The New York Insurance Law limits the single and aggregate risks that a
financial guaranty insurer may insure on a net basis. Capital Reinsurance
complies with the single and aggregate risk limits of the New York Insurance Law
for financial guaranty insurers. For example, the New York Insurance Law limits
the insured average annual debt service on insured municipal bonds, special
revenue bonds and substantially equivalent obligations with respect to a single
entity and backed by a single revenue source (net of qualifying collateral and
reinsurance) to not more than 10% of the sum of the insurer's policyholders'
surplus and contingency reserves. In addition, insured principal of municipal
bonds attributable to any single risk, net of qualifying collateral and
reinsurance, is limited to not more than 75% of the sum of the insurer's
policyholders' surplus and contingency reserves. Single risk limits, which
generally are more restrictive than the municipal bond single risk limit, are
also specified for several other categories of insured obligations. The New York
Insurance Law also limits the aggregate insured outstanding principal and
interest of guaranteed obligations, net of qualifying collateral and
reinsurance, to certain multiples of the insurer's policyholders' surplus and
contingency reserve. Aggregate risk limits vary for different categories of
insured obligations.
34
<PAGE>
(b) Mortgage Guaranty Business:
Capital Mortgage is subject to the various limitations and requirements of the
New York Insurance Law governing mortgage guaranty insurance. For example, the
aggregate risk (i.e., total liability under its aggregate insurance and
reinsurance policies) that a mortgage guaranty insurer may insure on a net basis
cannot exceed twenty-five times its policyholders' surplus. The regulations
promulgated under the New York Insurance Laws also contain detailed limitations
on the conduct of mortgage pool insurance business by a New York licensed
mortgage guaranty insurer.
(c) Title Business:
Capital Title is subject to the various limitations and requirements of the New
York Insurance Law governing title insurance. For example, Capital Title may
not assume any single risk in excess of the sum of its capital, policyholders'
surplus, statutory premium reserves and voluntary reserves.
ITEM 2. PROPERTIES.
Capital Re Corporation, Capital Reinsurance, Capital Mortgage, Capital Title and
Capital Re Management Corporation maintain offices at 1325 Avenue of the
Americas, New York, New York 10019. The office comprises the entire 18th floor
of the building, approximately 23,000 square feet of space. The companies began
occupying these offices in April 1993. Prior to that, Capital Re and Capital
Reinsurance maintained offices at 787 Seventh Avenue, New York, New York. The
offices at 787 Seventh Avenue were sublet to a third party upon the move to 1325
Avenue of the Americas. RGB currently leases one floor of office space at 2
Minster Court, Mincing Lane, London, England, and one floor of office space as
well as basement space at Marlon House, Mincing Lane, London, England.
ITEM 3. LEGAL PROCEEDINGS.
There are no material lawsuits pending, or to the knowledge of the Company
threatened, to which the Company or any of its subsidiaries is a party or of
which any of their properties is the subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Not applicable.
35
<PAGE>
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Registrant's common stock trades on the New York Stock Exchange under the
symbol "KRE." The high and low sales prices for, and the cash dividends
declared on, the Registrant's common stock for each quarter within the two most
recent fiscal years is as follows:
<TABLE>
<CAPTION>
Quarter Dividends
Paid Per Share
- ---------------------------------------------------------------------
High Low
- -------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
1997
1st Quarter $0.07 $47.38 $41.25
2nd Quarter $0.07 $54.25 $39.00
3rd Quarter $0.07 $61.00 $50.06
4th Quarter $0.08 $62.88 $55.94
- -------------------------------------------------------------------------------------------------------
1996
1st Quarter $0.06 $36.00 $28.88
2nd Quarter $0.06 $38.00 $32.63
3rd Quarter $0.06 $39.38 $33.25
4th Quarter $0.07 $46.63 $38.38
- -------------------------------------------------------------------------------------------------------
</TABLE>
Information concerning restrictions on the payment of dividends is set forth in
Item 1 above, under the caption "Business of Capital Re - Restrictions on
Dividends."
As of March 24, 1998, there were 36 stockholders of record of the Company's
Common Stock.
ITEM 6. SELECTED FINANCIAL DATA.
36
<PAGE>
Capital Re Corporation and Subsidiaries
Selected Financial Data
<TABLE>
<CAPTION>
Year Ended December 31,
------------------------------------------------------------------------------------
(Dollars in thousands except per share amounts) 1997 1996 1995 1994 1993
- ------------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
SUMMARY OF OPERATIONS
Gross Premiums Written $219,522 $129,818 $107,599 $94,851 $85,367
Net Premiums Written 205,360 105,188 89,508 82,795 73,946
Net Premiums Earned 133,664 92,436 60,097 58,850 44,936
Net Investment Income 56,616 51,558 46,654 40,113 32,131
Net Realized Gains 8,037 1,471 53 1,780 881
Total Revenues 201,723 146,416 107,085 101,462 79,477
Net Income 70,052 56,524 45,527 39,806 36,354
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET
Investment Portfolio 1,011,091 901,102 771,767 638,751 552,405
Total Assets 1,387,954 1,156,401 981,885 810,040 711,633
Net Deferred Premium Revenue 337,192 265,070 252,318 222,907 198,960
Long-term Debt 74,819 74,782 74,744 90,706 90,668
Company Obligated Mandatorily Redeemable
Preferred Securities of Capital Re LLC 75,000 75,000 75,000 75,000 --
Stockholders' Equity 568,943 489,346 411,943 325,514 323,832
- ------------------------------------------------------------------------------------------------------------------------------------
PER SHARE DATA
Basic Earnings Per Share 4.41 3.61 3.08 2.69 2.43
Diluted Earnings Per Share 4.31 3.54 3.05 2.67 2.42
Cash Dividends Per Share 0.29 0.25 0.21 0.20 0.20
Book Value Per Share 35.75 30.86 27.82 22.02 21.66
- ------------------------------------------------------------------------------------------------------------------------------------
STATUTORY SURPLUS AND RESERVES
Unearned Premium Reserve 358,399 307,236 278,980 242,574 218,095
Contingency Reserve 162,250 123,363 89,685 63,591 43,459
Policyholders' Surplus 435,118 443,451 412,884 401,743 304,222
Total Policyholders' Surplus
and Reserves 955,767 874,050 781,549 707,908 565,776
- ------------------------------------------------------------------------------------------------------------------------------------
</TABLE>
37
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
Capital Re Corporation (the "Corporation") was incorporated in the State of
Delaware in December 1991, and is the successor by merger to a Maryland
corporation incorporated in 1986. The Corporation is an insurance holding
company and has six wholly owned operating subsidiaries. Capital Reinsurance
Company ("Capital Reinsurance"), domiciled in the State of Maryland, commenced
operations in January 1988. Capital Reinsurance is engaged in the business of
financial guaranty reinsurance, primarily the reinsurance of municipal and non-
municipal bond insurance obligations. Capital Mortgage Reinsurance Company
("Capital Mortgage"), a New York domiciled company, commenced operations in
February 1994. Capital Mortgage reinsures only residential mortgage guaranty
insurance obligations. KRE Reinsurance Ltd. (formerly Capital Mortgage
Reinsurance Company (Bermuda) Ltd.) ("KRE"), a Bermuda domiciled company,
commenced operations in March 1994. KRE is engaged in the business of
reinsuring financial guaranty, mortgage guaranty, financial insurance, trade
credit and other specialty lines of insurance, both as a direct reinsurer of
third party primary insurers and as a retrocessionaire of Capital Reinsurance,
Capital Mortgage, Capital Credit Reinsurance Company Ltd. ("Capital Credit") and
Capital Title Reinsurance Company ("Capital Title"). Capital Credit, also a
Bermuda domiciled insurance company, commenced operations in February 1990.
Capital Credit reinsures trade credit, political risk, and other specialty
insurance lines concentrated in Western Europe and the United States and is a
retrocessionaire of Capital Reinsurance and Capital Mortgage. Capital Title, a
New York domiciled insurance company, commenced operations in March 1996.
Capital Title is engaged in the business of reinsuring title insurance policies.
In November 1996, the Corporation acquired, through its newly formed United
Kingdom holding company, Capital Re (UK) Holdings, 100% of the issued shares of
Tower Street Holdings Limited (now known as RGB Holdings, Ltd.), the holding
company for RGB Underwriting Agencies Ltd. ("RGB"). RGB is a managing agency
and presently manages five syndicates operating in the Lloyd's of London
("Lloyd's") insurance market. In connection with this acquisition, the
Corporation established a corporate name at Lloyd's, CRC Capital, Ltd. ("CRC"),
to support underwriting on certain of the managed syndicates. CRC participates
in a non-marine and a life syndicate. In November 1997, RGB Holdings, Ltd.
acquired 100% of C.I. de Rougemont Group Limited, the ultimate holding company
for C.I. de Rougemont & Co. Ltd. ("CIDR"), another Lloyd's managing agency.
CIDR manages two syndicates, one marine and the other non-marine. Effective
January 1, 1998, the CIDR non-marine syndicate was merged with the non-marine
syndicate of RGB. CRC will participate in the business of the newly acquired
managed syndicates beginning in 1998. At December 31, 1997 and 1996, the
results of RGB, CIDR and CRC are consolidated in the Corporation's financial
statements.
In December 1996, the Corporation entered into a joint venture with Global
Capital Reinsurance Limited ("GCR"), to form a Bermuda based insurer, Capital
Global Underwriters Limited
38
<PAGE>
("CGUL"), which specializes in financial lines reinsurance. In April 1997, GCR
was acquired by EXEL Limited ("EXCEL"). In March 1998, EXEL sold its share of
CGUL to Bermuda based ACE Limited and CGUL was renamed ACE Capital Re Ltd. The
Corporation, through its subsidiary, KRE, owns a fifty-percent interest in ACE
Capital Re Ltd. and controls 9.9% of its voting stock. The Corporation accounts
for its investment in ACE Capital Re Ltd. under the equity method.
RESULTS OF OPERATIONS
YEAR ENDED DECEMBER 31, 1997 VERSUS YEAR ENDED DECEMBER 31, 1996
Net income for the year ended December 31, 1997 increased 24.1% to $70.1 million
from $56.5 million for the same period of 1996. The Company adopted Statement
of Financial Standards No. 128, "Earnings per Share" ("FAS 128"), as of December
31, 1997. FAS 128 requires the calculation and presentation on the face of the
income statement of basic earnings per share and, if applicable, diluted
earnings per share. Basic earnings per share is calculated based on the
weighted average common shares outstanding. All potentially dilutive securities
such as stock options and convertible securities are excluded from the basic
earnings per share calculation. In calculating diluted earnings per share, the
number of shares is increased to include all potentially dilutive securities,
including stock options and convertible securities. On a per share basis, basic
and diluted net income increased to $4.41 and $4.31, respectively, for the year
ended December 31, 1997 from $3.61 and $3.54, respectively, for the same period
of 1996, or 22.2% and 21.8%, respectively. In addition, net operating income
(net income excluding realized gains and losses) increased 17.6% to $65.1
million for the year ended December 31, 1997 from $55.3 million for the same
period in 1996. On a per share basis, basic and diluted net operating income
increased to $4.10 and $4.00, respectively, for the year ended December 31,
1997 from $3.53 and $3.47, respectively, for the same period of 1996, or 16.1%
and 15.3%, respectively. Growth in net premiums earned to $133.7 million from
$92.4 million, or 44.7%, was the principal cause of the increase in net income.
Growth in net premiums earned is a result of the Corporation's Lloyd's
participation through CRC as well as growth in the financial guaranty, mortgage,
trade credit and other specialty reinsurance lines of business.
Gross premiums written increased 69.1% to $219.5 million for the year ended
December 31, 1997 from $129.8 million for the same period of 1996. Gross
premiums written increased across all product lines. This increase was primarily
due to the consolidation of the Lloyd's premiums written from CRC. In addition,
in 1997 the Company added a financial reinsurance line of business. This line
consists of structured financial transactions involving the reinsurance of
annuity and accident and health reserves. These reserves are recorded on the
balance sheet as a liability and are offset by assets of equal value. The
following table shows gross premiums written by line of business for the years
ended December 31, 1997 and December 31, 1996.
39
<PAGE>
<TABLE>
<CAPTION>
GROSS PREMIUMS WRITTEN
YEAR ENDED
DECEMBER 31,
1997 1996
------ ------
(dollars in millions)
<S> <C> <C>
MUNICIPAL $ 52.8 $ 48.3
NON-MUNICIPAL 16.7 10.9
FINANCIAL LINES 2.7 0.0
MORTGAGE 70.7 53.7
TITLE 4.0 1.8
CREDIT AND SPECIALTY 23.0 15.1
Lloyd's 49.6 0.0
------ ------
$219.5 $129.8
</TABLE>
Net premiums written increased by 95.2% to $205.4 million for the year ended
December 31, 1997 from $105.2 million for the same period in 1996. This increase
is commensurate with the increase in gross premiums written explained above as
well as the recording of a large ceded premium installment on a municipal
portfolio paid in the fourth quarter of 1996. The following table shows net
premiums written by line of business for the years ended December 31, 1997 and
December 31, 1996.
<TABLE>
<CAPTION>
NET PREMIUMS WRITTEN
YEAR ENDED
DECEMBER 31,
1997 1996
------ ------
(dollars in millions)
<S> <C> <C>
MUNICIPAL $ 50.2 $ 36.7
NON-MUNICIPAL 16.6 10.9
FINANCIAL LINES 0.1 0.0
MORTGAGE 70.5 40.9
TITLE 4.0 1.8
CREDIT AND SPECIALTY 22.9 14.9
LLOYD'S 41.1 0.0
------ ------
$205.4 $105.2
</TABLE>
For the year ended December 31, 1997, net premiums earned increased 44.7% to
$133.7 million from $92.4 million for the comparable 1996 period. This increase
was primarily due to growth in net premiums earned across all product lines of
business as well as the addition of the Lloyd's line
40
<PAGE>
of business. For the year ended December 31, 1997, net refunded earned premium
decreased to $4.8 from $5.8 million for the comparable period in 1996. Excluding
the effects of net refunded earned premium, net premiums earned increased 48.8%
to $128.9 million for the year ended December 31, 1997 from $86.6 million for
the year ended December 31, 1996. A refunding extinguishes the Corporation's
reinsurance liability for the refunded obligation and the Corporation then
recognizes revenue equal to the remaining related deferred premium revenue. For
the years ended December 31, 1997 and 1996, ceded earned premium was $21.2
million and $14.7 million, respectively. The following table shows net premiums
earned by line of business for the years ended December 31, 1997 and December
31, 1996.
<TABLE>
<CAPTION>
NET PREMIUMS EARNED
YEAR ENDED
DECEMBER 31,
1997 1996
------ ------
(dollars in millions)
<S> <C> <C>
MUNICIPAL $ 29.8 $27.5
NON-MUNICIPAL 11.4 7.2
FINANCIAL LINES 0.1 0.0
MORTGAGE 53.2 43.9
TITLE 3.6 1.6
CREDIT AND SPECIALTY 17.2 12.2
LLOYD'S 18.4 0.0
------ -----
$133.7 $92.4
</TABLE>
For the year ended December 31, 1997, net investment income increased 9.7% to
$56.6 million from $51.6 million for the comparable period in 1996. Growth in
investment income was primarily attributable to a larger investment portfolio
caused by an increase in invested assets from positive operating cash flows
during the twelve months ended December 31, 1997. In addition, the Corporation
recognized net realized gains of $8.0 million for the year ended December 31,
1997 compared to $1.5 million for same period in 1996.
Loss and loss adjustment expenses increased to $27.4 million from $9.5 million
for the years ended December 31, 1997 and 1996, respectively. Losses recorded
for the year ended December 31, 1997 were primarily attributable to the expected
loss recognition associated with the addition of the Lloyd's line of business as
well as normal loss development in the mortgage guaranty and credit reinsurance
lines of business. Ceded losses for the years ended December 31, 1997 and 1996
were $8.8 million and $6.5 million, respectively.
Total expenses, including loss and loss adjustment expenses, increased 52.1% to
$105.4 million for the year ended December 31, 1997 from $69.3 million in the
same period of 1996. This increase was primarily attributable to commissions
associated with the increased level of premiums written and normal loss
development from the mortgage and credit lines of business. In addition, the
41
<PAGE>
increase in expenses was attributable to operating and loss expenses associated
with the consolidation, for accounting purposes, of the Company's Lloyd's
operations with the Company's reinsurance operations. Furthermore, the
combined ratio, excluding expenses associated with non-insurance operations,
increased to 66.7% for the year ended December 31, 1997 from 60.7% for the
comparable 1996 period. This increase is an expected result of the
Corporation's diversification strategy, which is producing more business from
lines with relatively higher combined ratios than that of the financial
guaranty reinsurance business.
For the year ended December 31, 1997, the total federal tax provision increased
to $26.2 million from $20.6 million for the same period in 1996. In addition,
the effective tax rate increased slightly to 27.3% for the year ended December
31, 1997 from 26.7% in the same period of 1996.
YEAR ENDED DECEMBER 31, 1996 VERSUS YEAR ENDED DECEMBER 31, 1995
Net income for the year ended December 31, 1996 increased 24.2% to $56.5 million
from $45.5 million for the same period of 1995. On a per share basis, basic and
diluted net income increased to $3.61 and $3.54, respectively, for the year
ended December 31, 1996 from $3.08 and $3.05, respectively, for the same period
of 1996, or 17.2% and 16.1%, respectively. In addition, net operating income
(net income excluding realized gains and losses) increased 21.3% to $55.3
million for the year ended December 31, 1996 from $45.6 million for the same
period in 1995. On a per share basis, basic and diluted net operating income
increased to $3.53 and $3.47, respectively, for the year ended December 31, 1996
from $3.09 and $3.06, respectively, for the same period of 1995, or 14.2% and
13.4%, respectively. Growth in net premiums earned to $92.4 million from $60.1
million, or 53.7%, was the principal cause of the increase in net income. Growth
in net premiums earned is a result of the Corporation's successful
diversification into the mortgage, trade credit and other specialty reinsurance
lines of business.
Gross premiums written increased 20.6% to $129.8 million for the year ended
December 31, 1996 from $107.6 million for the same period of 1995. This increase
was primarily due to growth in the mortgage guaranty, trade credit and other
specialty lines of business. In addition, Capital Title established its first
reinsurance relationships in 1996, which contributed $1.8 million in premiums
written for the year ended December 31, 1996. Non-municipal premiums written
decreased to $10.9 for the year ended December 31, 1996 million from $17.2
million for the same period in 1995 because of the positive impact on gross
premiums written in the fourth quarter of 1995 of several large reinsurance
transactions, which had upfront premium payments. The following table shows
gross written premiums by line of business for the year ended December 31, 1996
and December 31, 1995.
42
<PAGE>
<TABLE>
<CAPTION>
GROSS PREMIUMS WRITTEN
YEAR ENDED
DECEMBER 31,
1996 1995
------ -----
(dollars in millions)
<S> <C> <C>
MUNICIPAL $ 48.3 $ 44.2
NON-MUNICIPAL 10.9 17.2
MORTGAGE 53.7 39.1
TITLE 1.8 0.0
CREDIT AND SPECIALTY 15.1 7.1
------ ------
$129.8 $107.6
</TABLE>
Net premiums written increased by 17.5% to $105.2 million for the year ended
December 31, 1996 from $89.5 million for the same period in 1995. This increase
is commensurate with the increase in gross premiums written explained above. The
following table shows net premiums written by line of business for the year
ended December 31, 1996 and December 31, 1995.
<TABLE>
<CAPTION>
NET PREMIUMS WRITTEN
YEAR ENDED
DECEMBER 31,
1996 1995
------ -----
(dollars in millions)
<S> <C> <C>
MUNICIPAL $ 36.7 $38.1
NON-MUNICIPAL 10.9 17.2
MORTGAGE 40.9 27.6
TITLE 1.8 0.0
CREDIT AND SPECIALTY 14.9 6.6
------ -----
$105.2 $89.5
</TABLE>
For the year ended December 31, 1996, net premiums earned increased 53.7% to
$92.4 million from $60.1 million for the comparable 1995 period. This increase
was primarily due to growth in net premiums earned in the mortgage, credit and
specialty reinsurance lines of business. For the year ended December 31, 1996,
net refunded earned premium increased to $5.8 from $0.8 million for the
comparable period in 1995. Excluding the effects of net refunded earned premium,
net premiums earned increased 46.2% to $86.7 million for the year ended December
31, 1996 from $59.3 million for the year ended December 31, 1995. A refunding
extinguishes the Corporation's reinsurance liability for the refunded obligation
and the Corporation then recognizes revenue equal to the remaining related
deferred premium revenue. For the years ended December 31, 1996 and 1995, ceded
earned premium was $14.7 million and $8.0 million, respectively.
43
<PAGE>
The following table shows net premiums earned by line of business for the years
ended December 31, 1996 and December 31, 1995.
<TABLE>
<CAPTION>
NET PREMIUMS EARNED
YEAR ENDED
DECEMBER 31,
1996 1995
------ -----
(dollars in millions)
<S> <C> <C>
MUNICIPAL $27.5 $25.6
NON-MUNICIPAL 7.2 6.4
MORTGAGE 43.9 22.1
TITLE 1.6 0.0
CREDIT AND SPECIALTY 12.2 6.0
----- -----
$92.4 $60.1
</TABLE>
For the year ended December 31, 1996, net investment income increased 10.5% to
$51.6 million from $46.7 million for the comparable period in 1995. Growth in
investment income was primarily attributable to a larger investment portfolio
caused by (i) an increase in invested assets from positive operating cash flows
during the year ended December 31, 1996 and (ii) a public offering in the first
quarter of 1996 of the Corporation's common stock which generated $25.9 million
in net proceeds to the Corporation. In addition, the Corporation recognized net
realized gains of $1.5 million for the year ended December 31, 1996 compared to
net realized gains of $0.1 million for same period in 1995.
Loss and loss adjustment expenses increased to $9.5 million from $2.6 million
for the year ended December 31, 1996 and 1995, respectively. Losses recorded in
the year ended December 31, 1996 were primarily attributable to normal loss
development in the mortgage guaranty and credit reinsurance lines of business
which constitute an increasing portion of the Corporation's assumed book of
business. Ceded losses for the year ended December 31, 1996 and 1995 were $6.5
million and $2.6 million, respectively.
Total expenses, including loss and loss adjustment expenses, increased 48.7% to
$69.6 million for the year ended December 31, 1996 from $46.8 million in the
same period of 1995. This increase was primarily attributable to commissions
associated with the increased level of premiums assumed, normal loss development
from the mortgage and credit lines of business and increased net profit
commissions payable under certain of the Corporation's reinsurance contracts.
In addition, the combined ratio increased to 61.7% for the year ended December
31, 1996 from 56.8% for the comparable 1995 period. This increase is an
expected result of the Corporation's diversification strategy, which is
producing more business from lines with relatively higher combined ratios than
that of the financial guaranty reinsurance business.
44
<PAGE>
For the year ended December 31, 1996, the total tax provision increased to $20.5
million from $14.6 million for the same period in 1995. In addition, the
effective tax rate increased to 26.7% in the third quarter of 1996 from 24.2% in
the same period of 1995. This increase occurred in response to the
Corporation's strategy of using a greater proportion of new cash flow to
purchase taxable securities during 1996.
LIQUIDITY AND CAPITAL RESOURCES
The Corporation relies on dividends from Capital Reinsurance to fund its payment
of dividends on its capital stock and interest on its outstanding debt. The
major sources of liquidity for Capital Reinsurance are funds generated from
reinsurance premiums, net investment income and maturing investments. Capital
Reinsurance is domiciled in the State of Maryland, and, under Maryland insurance
law, the amount of the surplus of Capital Reinsurance available for distribution
as dividends is subject to certain statutory restrictions. The amount available
for distribution from Capital Reinsurance during 1998 with notice to, but
without prior approval of, the Maryland Insurance Commissioner is limited to 10%
of Capital Reinsurance's policyholders' surplus as of December 31, 1997, or
approximately $34.6 million. For the year ended December 31, 1997, Capital
Reinsurance paid $8.0 million in dividends to the Corporation.
Credit Re Corporation, a wholly owned subsidiary of the Corporation, relies on
dividends from its wholly owned subsidiary, Capital Credit, for funds to be
provided to the Corporation. Capital Credit's major sources of liquidity are
funds generated from reinsurance premiums, net investment income and maturing
investments. Capital Credit is a Bermuda domiciled insurer whose distributions
are governed by Bermuda law. Under Bermuda law and the by-laws of Capital
Credit, dividends may be paid out of the profits of the company (defined as
accumulated realized profits less accumulated realized losses). Distributions
to shareholders may also be paid out of Capital Credit's surplus limited by
requirements that such company must at all times (i) maintain the minimum share
capital required under Bermuda law, and (ii) have relevant assets in an amount
equal to or greater than 75% of relevant liabilities, all as defined under
Bermuda law. Since its organization, Capital Credit has not declared nor paid
any dividends.
Capital Mortgage is subject to the dividend restrictions imposed under New York
insurance law. Accordingly, dividends may only be declared and distributed out
of earned surplus (as defined under New York insurance law). Additionally, no
dividend may be declared or distributed by Capital Mortgage in an amount which,
together with all dividends declared or distributed by Capital Mortgage, as the
case may be, during the preceding twelve months, exceeds the lesser of 10% of
such company's surplus to policyholders as shown by its last Annual Statutory
Statement on file with the New York insurance department, or 100% of adjusted
net investment income (as defined under New York insurance law) during such
period, unless, upon prior application, the New York Superintendent of Insurance
approves a greater dividend distribution based upon his finding that Capital
Mortgage, as the case may be, will retain sufficient surplus to support its
obligations and writings. KRE's dividends and distributions to its sole
shareholder, Capital Mortgage, are governed by Bermuda law, and are subject to
the same restrictions as those described in the preceding paragraph for Capital
Credit. To date, Capital Mortgage and KRE have
45
<PAGE>
not declared nor paid any dividends. The maximum dividend payable by Capital
Mortgage during 1998 is $0 since its earned surplus was ($0.4) million as of
December 31, 1997.
Capital Title is subject to the New York insurance laws and regulations
governing title insurers. Accordingly, dividends may only be declared and
distributed out of earned surplus as defined under New York insurance law and
only if such dividends do not reduce the company's surplus to less than 50% of
its outstanding capital shares, i.e., the value of its outstanding common
equity. Additionally, no dividend may be declared or distributed in an amount
which, together with all dividends declared or distributed by the company during
the preceding twelve months, exceeds 10% of the company's outstanding capital
shares, unless, after deducting such dividends, it has a surplus at least equal
to 50% of its statutory reinsurance reserve or a surplus at least equal to
$250,000, whichever is greater. During 1997, Capital Title paid a dividend in
the amount of $1.1 million to its immediate parent, KRE. As of December 31,
1997, Capital Title's maximum amount payable as a dividend during 1998 is
approximately $1.3 million.
In January 1994, the Corporation formed and capitalized, through the purchase of
common shares, Capital Re LLC. Capital Re LLC exists solely for the purpose of
issuing preferred and common shares and lending the proceeds of such issuance to
the Corporation to fund its business operations. In January 1994, Capital Re LLC
issued $75.0 million of company obligated mandatorily redeemable preferred
securities, the proceeds of which were loaned to the Corporation. The
Corporation has, among other undertakings, unconditionally guaranteed all
legally declared and unpaid dividends of Capital Re LLC. The company obligated
mandatorily redeemable preferred securities were issued at $25 par value per
share and pay monthly dividends at a rate of 7.65% per annum. Also in January
1994, Capital Reinsurance and Capital Credit invested an aggregate of $120.0
million to capitalize Capital Mortgage. Of the total original contribution of
$120.0 million, Capital Reinsurance invested $94.8 million and Capital Credit
invested $25.2 million.
On February 12, 1996, the Corporation completed a public offering of
approximately 3.5 million shares of common stock. Of the 3.5 million shares, an
institutional shareholder sold 2.6 million shares and the Corporation sold
853,120 shares in the public offering generating net proceeds to the Corporation
of approximately $25.9 million of which $21.5 million was used to complete the
$25 million capitalization of Capital Title. The remaining $4.4 million was used
for Corporation expenses associated with the public offering and general
corporate purposes. The Corporation received no proceeds from the institutional
shareholder's sale of shares.
In June 1997, Capital Reinsurance invested approximately $10.9 million in CGA
Group Ltd. ("CGA"). CGA was formed to provide financial guaranty insurance of
structured securities, including commercial real estate and asset backed
transactions. Capital Reinsurance also has a commitment to invest an additional
$7.5 million in CGA to the extent that it would be necessary to maintain a
triple-A rating from Duff & Phelps for CGA's operating subsidiary, Commercial
Guaranty Assurance, Ltd. Also, Capital Reinsurance invested $0.1 million in St.
George Holdings Ltd. ("St. George"). Through its operating subsidiary, St.
George Investments Ltd., St. George will purchase securities to be held to
maturity, selectively resold, or repackaged with CGA insurance and then resold.
46
<PAGE>
In December 1997, the Corporation's Board of Directors authorized an increase of
the quarterly common stock dividend rate to $0.08 per share, or $0.32 annually.
For the year ended December 31, 1997, common dividends were declared and paid in
the amount of $4.6 million or $0.29 per share.
Cash flows from operations for the year ended December 31, 1997 and 1996,
consisting of reinsurance premiums collected net of expenses, investment income
and income taxes, were $143.5 million and $95.9 million, respectively. The
Corporation believes that current levels of cash flow from operations provide
the Corporation with sufficient liquidity to meet its operating needs. The
Corporation's non-operating cash outflows are primarily dedicated to (i) fixed-
income investment activity, (ii) the payment of dividends on its common shares,
(iii) payments of interest on long-term debt and (iv) the payment of its loan
obligations to Capital Re LLC.
At December 31, 1997, cash and investments approximated $1.03 billion, an
increase of $113.6 million, or 12.4%, from $916.4 million at December 31, 1996.
In managing its investment portfolio, the Corporation places a high priority on
quality and liquidity. As of December 31, 1997, the entire investment portfolio
was invested in highly rated fixed income securities.
At December 31, 1997, approximately $155.4 million, or 15.4%, of the
Corporation's investment portfolio was comprised of mortgage-backed securities
("MBS"). Of the MBS portfolio, approximately $132.7, million or 85.4%, is backed
by agencies or entities sponsored by the U.S. government as to the full amount
of principal and interest. As of December 31, 1997, the entire MBS portfolio was
invested in triple A rated securities.
Prepayment risk is an inherent risk of holding MBS. However, the degree of
prepayment risk is particular to the type of MBS held. The Corporation limits
its exposure to prepayments by purchasing less volatile types of MBS. As of
December 31, 1997, $3.7 million, or approximately 2.4%, of the MBS portfolio was
invested in collateralized mortgage obligations ("CMOs") which are characterized
as planned amortization class CMOs ("PACs"). PACs are securities whose cash
flows are designed to remain constant over a variety of mortgage prepayment
environments. Other classes in the CMO security are structured to accept the
volatility of mortgage prepayment changes, thereby insulating the PAC class. Of
the remaining MBS portfolio, $151.7 million, or 97.6%, was invested in mortgage-
backed pass-throughs or sequential CMOs. Pass-throughs are securities in which
the monthly cash flows of principal and interest (both scheduled and
prepayments) generated by the underlying mortgages are distributed on a pro-rata
basis to the holders of securities. A sequential MBS is structured to divide the
CMO security into sequentially ordered classes. Receipt of principal payments
within classes is contingent on the retirement of all previously paying classes.
Generally, interest payments are made currently on all classes. While these
securities are more sensitive to prepayment risk than PACs, they are not
considered highly volatile securities. While the Corporation may consider
investing in any tranche of a sequential MBS, the individual security's
characteristics (duration, relative value, underlying collateral, etc.) along
with aggregate portfolio risk management determine which tranche of sequential
MBS will be purchased. At December 31, 1997, the Corporation had no securities
such as interest only
47
<PAGE>
securities, principal only securities, or MBS purchased at a substantial premium
to par that have the potential for loss of a significant portion of the original
investment due to changes in the prepayment rate of the underlying loans
supporting the security.
On January 22, 1998, the Corporation extended its existing agreement with
Deutsche Bank AG for the provision of a $25.0 million liquidity facility (the
"DB Liquidity Facility") which is available for general corporate purposes. The
DB Liquidity Facility was extended for one year and is scheduled to expire on
January 22, 1999. Capital Reinsurance also renewed an agreement on January 27,
1998 with Deutsche Bank AG for a credit facility (the "DB Credit Facility") of
up to $75.0 million specifically designed to provide rating agency qualified
capital to further support Capital Reinsurance's claims-paying resources. This
agreement expires January 27, 2005. The Corporation has not borrowed under
either the DB Liquidity Facility or the DB Credit Facility.
In addition, on August 20, 1996, the Corporation entered into a credit agreement
with Chase Manhattan Bank for the provision of a $25.0 million credit facility
(the "Chase Facility") which is available for general corporate purposes.
Furthermore, on August 26, 1996, the Corporation utilized $16 million of the
Chase Facility for purposes of paying subordinated notes which came due.
Interest on the bank note issued under the Chase Facility is payable quarterly
based upon the Corporation's chosen interest rate option under the terms of the
Chase Facility. In November 1996, the Corporation utilized the remaining $9
million of the Chase Facility for purposes of acquiring RGB.
The Corporation is addressing the Year 2000 issue. The Company has initiated a
plan to review its internal computer systems. It also has initiated discussions
with its significant clients and other entities to ensure that those parties
have appropriate plans to correct Year 2000 issues where their systems interface
with the Corporation's systems or otherwise impact its operations. While the
Corporation believes its planning efforts are adequate to address its Year 2000
concerns, there can be no guarantee that the systems of other companies on which
the Corporation's systems and operations rely will be converted on a timely
basis. In conclusion, the Corporation does not expect that there will be any
major Year 2000 impact to its computer systems, nor does it expect that the cost
of the Year 2000 initiative will be material.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Not applicable.
48
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Audited Consolidated Financial Statements
Capital Re Corporation and Subsidiaries
Year ended December 31, 1997
with Report of Independent Auditors
49
<PAGE>
Capital Re Corporation and Subsidiaries
Audited Consolidated Financial Statements
Year ended December 31, 1997
CONTENTS
<TABLE>
<CAPTION>
<S> <C>
Report of Independent Auditors............................................. 51
Consolidated Balance Sheets................................................ 52
Consolidated Statements of Income.......................................... 54
Consolidated Statements of Stockholders' Equity............................ 55
Consolidated Statements of Cash Flows...................................... 56
Notes to Consolidated Financial Statements................................. 57
</TABLE>
50
<PAGE>
Report of Independent Auditors
Board of Directors and Stockholders
Capital Re Corporation
We have audited the accompanying consolidated balance sheets of Capital Re
Corporation 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 three years in the period ended December 31, 1997. These financial
statements are the responsibility of the Corporation's management. Our
responsibility is to express an opinion on these 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.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Capital Re
Corporation and Subsidiaries at December 31, 1997 and 1996 and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1997, in conformity with generally accepted
accounting principles.
/s/ Ernst & Young LLP
January 27, 1998
51
<PAGE>
Capital Re Corporation and Subsidiaries
Consolidated Balance Sheets
<TABLE>
<CAPTION>
DECEMBER 31
1997 1996
------------------------------------
(Dollars in Thousands Except Share
Amounts)
<S> <C> <C>
ASSETS
Fixed maturity securities available for sale, at market
(amortized cost: $887,205 in 1997 and $800,137 in 1996) $ 932,423 $ 825,678
Short-term investments, at cost, which approximates market 78,668 75,424
------------------------------------
Total investments 1,011,091 901,102
Cash 18,878 15,285
Accrued investment income 13,761 12,287
Deferred acquisition costs 135,332 111,364
Prepaid reinsurance premiums 64,953 72,034
Reinsurance recoverable on ceded losses 7,245 1,833
Funds held under reinsurance contracts 3,926 3,861
Premiums receivable 27,567 5,794
Amounts receivable on ceded annuity reserves 58,635
Property and equipment, at cost (net of accumulated depreciation
and amortization of $4,576 in 1997 and $1,502 in 1996) 2,738 2,291
Goodwill 12,677 13,567
Investment in affiliates 21,858 10,000
Other assets 9,293 6,983
------------------------------------
Total assets $1,387,954 $1,156,401
====================================
</TABLE>
See accompanying notes to consolidated financial statements.
52
<PAGE>
<TABLE>
<CAPTION>
DECEMBER 31
1997 1996
-------------------------------------
(Dollars in Thousands Except
Share Amounts)
<S> <C> <C>
LIABILITIES
Deferred premium revenue $ 402,145 $ 337,104
Reserve for losses and loss adjustment expenses 37,900 19,902
Profit commission liability 30,457 13,329
Ceded balances payable 2,153 50
Annuity benefit reserves 58,635 -
Accident and health reserves 16,367 -
Bank note payable 25,000 25,000
Long-term debt 74,819 74,782
Deferred federal income taxes payable 72,879 58,474
Other liabilities 23,656 20,665
Liability for securities purchases - 42,749
-------------------------------------
Total liabilities 744,011 592,055
-------------------------------------
Company obligated mandatorily redeemable preferred securities
of Capital Re LLC 75,000 75,000
Stockholders' equity:
Preferred stock--$.01 par value per share:
25,000,000 shares authorized; no shares issued or
outstanding - -
Common stock--$.01 par value per share:
75,000,000 shares authorized; and 15,913,437 and 15,856,762
shares issued and outstanding in 1997 and 1996 161 160
Additional paid-in capital 225,160 222,525
Retained earnings 319,253 253,807
Treasury stock; 214,000 and 189,700 shares in 1997 and 1996,
respectively (4,891) (3,870)
Net unrealized gain on fixed maturity securities available
for sale 29,392 16,602
Net unrealized (loss) gain on foreign currency translation (132) 122
-------------------------------------
Total stockholders' equity 568,943 489,346
-------------------------------------
Total liabilities, preferred securities of Capital Re LLC and
stockholders' equity $1,387,954 $1,156,401
=====================================
</TABLE>
53
<PAGE>
Capital Re Corporation and Subsidiaries
Consolidated Statements of Income
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
1997 1996 1995
-----------------------------------------------------------
(Dollars in Thousands Except Per Share Amounts)
<S> <C> <C> <C>
REVENUES
Gross written premiums $219,522 $129,818 $107,599
Ceded premiums (14,162) (24,630) (18,091)
-----------------------------------------------------------
Net written premiums 205,360 105,188 89,508
Increase in deferred premium revenue (71,696) (12,752) (29,411)
-----------------------------------------------------------
Earned premiums 133,664 92,436 60,097
Net investment income 56,616 51,558 46,654
Net realized gains 8,037 1,471 53
Other income 2,548 951 281
Equity income in affiliates 858 - -
-----------------------------------------------------------
Total revenues 201,723 146,416 107,085
-----------------------------------------------------------
EXPENSES
Losses and loss adjustment expenses 27,357 9,483 2,637
Acquisition costs 66,714 39,725 32,607
Increase in deferred acquisition costs (23,827) (9,011) (11,705)
Profit commission expense 5,111 6,008 902
Other operating expenses 15,890 10,796 9,710
Amortization of goodwill 669 - -
Foreign exchange losses (gains) 378 (377) 228
Interest expense 7,399 6,895 6,893
Minority interest in Capital Re LLC 5,738 5,738 5,738
-----------------------------------------------------------
Total expenses 105,429 69,257 47,010
-----------------------------------------------------------
Income before provision for federal income taxes 96,294 77,159 60,075
Provision for federal income taxes:
Current 17,782 9,146 9,175
Deferred 8,460 11,489 5,373
-----------------------------------------------------------
Total provision for federal income taxes 26,242 20,635 14,548
-----------------------------------------------------------
Net income $ 70,052 $ 56,524 $ 45,527
===========================================================
PER SHARE DATA
Basic earnings per share:
Weighted average common shares outstanding 15,873 15,656 14,788
Net income per share of common stock $4.41 $3.61 $3.08
Diluted earnings per share:
Weighted average common shares outstanding 16,253 15,946 14,914
Net income per share of common stock $4.31 $3.54 $3.05
Cash dividend per common share $0.29 $0.25 $0.21
</TABLE>
See accompanying notes to consolidated financial statements.
54
<PAGE>
Capital Re Corporation and Subsidiaries
Consolidated Statements of Stockholders' Equity
<TABLE>
<CAPTION>
ADDITIONAL
PREFERRED COMMON PAID-IN RETAINED
STOCK STOCK CAPITAL EARNINGS
----------------------------------------------------
(Dollars in Thousands Except Per Share Amounts)
<S> <C> <C> <C> <C>
Balance, December 31, 1994 $ -- $150 $191,214 $158,806
Issuance of common stock (22,575 shares) -- -- 440 --
Net income -- -- -- 45,527
Fixed maturity securities available for sale,
net of tax ($15,241) -- -- -- --
Foreign currency translation adjustments -- -- -- --
Dividend ($.21 per common share) -- -- -- (3,105)
----------------------------------------------------
Balance, December 31, 1995 -- 150 191,654 201,228
----------------------------------------------------
Net income -- -- -- 56,524
Issuance of common stock (853,120 shares) -- 8 25,485 --
Exercise of stock options, including tax
benefit (198,587 shares) -- 2 5,386 --
Purchase of treasury stock, at cost (7,000
shares) -- -- -- --
Fixed maturity securities available for sale,
net of tax ($3,202) -- -- -- --
Foreign currency translation adjustments -- -- -- --
Dividend ($.25 per common share) -- -- -- (3,945)
----------------------------------------------------
Balance December 31, 1996 -- 160 222,525 253,807
----------------------------------------------------
Net income -- -- -- 70,052
Exercise of stock options, including tax
benefit (80,975 shares) -- 1 2,635 --
Purchase of treasury stock, at cost (24,300
shares) -- -- -- --
Fixed maturity securities available for sale,
net of tax ($6,887) -- -- -- --
Foreign currency translation adjustments -- -- -- --
Dividend ($.29 per common share) -- -- -- (4,606)
----------------------------------------------------
Balance December 31, 1997 $ -- $161 $225,160 $319,253
====================================================
<CAPTION>
NET UNREALIZED
GAIN (LOSS) ON NET UNREALIZED
FIXED MATURITY (LOSS) GAIN ON
SECURITIES FOREIGN TOTAL
TREASURY AVAILABLE CURRENCY STOCKHOLDERS'
STOCK FOR SALE TRANSLATION EQUITY
-----------------------------------------------------------------
(Dollars in Thousands Except Per Share Amounts)
<S> <C> <C> <C> <C>
Balance, December 31, 1994 $(3,638) $(20,998) $ (20) $325,514
Issuance of common stock (22,575 shares) -- -- -- 440
Net income -- -- -- 45,527
Fixed maturity securities available for sale,
net of tax ($15,241) -- 43,547 -- 43,547
Foreign currency translation adjustments -- -- 20 20
Dividend ($.21 per common share) -- -- -- (3,105)
-----------------------------------------------------------------
Balance, December 31, 1995 (3,638) 22,549 -- 411,943
-----------------------------------------------------------------
Net income -- -- -- 56,524
Issuance of common stock (853,120 shares) -- -- -- 25,493
Exercise of stock options, including tax
benefit (198,587 shares) -- -- -- 5,388
Purchase of treasury stock, at cost (7,000 (232) -- -- (232)
shares)
Fixed maturity securities available for sale,
net of tax ($3,202) -- (5,947) -- (5,947)
Foreign currency translation adjustments -- -- 122 122
Dividend ($.25 per common share) -- -- -- (3,945)
-----------------------------------------------------------------
Balance December 31, 1996 (3,870) 16,602 122 489,346
-----------------------------------------------------------------
Net income -- -- -- 70,052
Exercise of stock options, including tax
benefit (80,975 shares) -- -- -- 2,636
Purchase of treasury stock, at cost (24,300 (1,021) -- -- (1,021)
shares)
Fixed maturity securities available for sale,
net of tax ($6,887) -- 12,790 -- 12,790
Foreign currency translation adjustments -- -- (254) (254)
Dividend ($.29 per common share) -- -- -- (4,606)
-----------------------------------------------------------------
Balance December 31, 1997 $(4,891) $ 29,392 $(132) $568,943
=================================================================
</TABLE>
See accompanying notes to consolidated financial statements.
55
<PAGE>
Capital Re Corporation and Subsidiaries
Consolidated Statements of Cash Flows
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
1997 1996 1995
--------------------------------------------------------------
(Dollars in Thousands)
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net income $ 70,052 $ 56,524 $ 45,527
Adjustments to reconcile net income to net cash
provided by operating activities:
Net amortization of investment security discounts 348 293 1,573
Provision for deferred federal income taxes 7,518 11,489 5,351
Acquisition costs deferred (65,589) (39,725) (32,607)
Amortization of deferred acquisition costs 41,620 30,714 20,902
Equity income in affiliates (858) - -
Change in accrued investment income (1,474) (2,806) 462
Change in premiums receivable (21,773) 2,467 (13,864)
Change in deferred premium revenue, net 72,122 12,752 29,411
Change in reserve for losses and loss adjustment
expenses, net 12,587 7,810 2,557
Net realized gains on investments (8,037) (1,471) (53)
Change in ceded balances payable 2,103 (7,950) 8,000
Change in accident and health reserves 16,367 - -
Other 18,465 25,833 6,425
--------------------------------------------------------------
Net cash provided by operating activities 143,451 95,930 73,684
--------------------------------------------------------------
INVESTING ACTIVITIES
Fixed maturity securities available-for-sale:
Purchases (1,868,917) (741,415) (226,955)
Sales 1,789,418 589,143 165,775
Maturities - 6,280 7,100
Fixed maturity securities held-to-maturity:
Purchases - - -
Maturities - - 6,028
Purchases of short-term investments, net (3,243) 8,686 (21,649)
Investment in affiliates (11,000) (25,791) (304)
Other investing activities (43,125) 42,211 -
--------------------------------------------------------------
Net cash used in investing activities (136,867) (120,886) (70,005)
--------------------------------------------------------------
FINANCING ACTIVITIES
Net proceeds from sale of stock - 25,493 440
Net proceeds from exercise of stock options 2,636 5,388 -
Net proceeds from issuance of notes payable - 9,000 -
Purchase of treasury stock, at cost (1,021) (232) -
Dividends paid (4,606) (3,945) (3,105)
--------------------------------------------------------------
Net cash (used in) provided by financing activities (2,991) 35,704 (2,665)
--------------------------------------------------------------
Increase in cash 3,593 10,748 1,014
Cash at beginning of year 15,285 4,537 3,523
--------------------------------------------------------------
Cash at end of year $ 18,878 $ 15,285 $ 4,537
==============================================================
</TABLE>
See accompanying notes to consolidated financial statements.
56
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 1997
1. BUSINESS AND ORGANIZATION
Capital Re Corporation (the "Corporation") was incorporated in the State of
Delaware in December 1991, and is the successor by merger to a Maryland
corporation incorporated in 1986. The Corporation is an insurance holding
company and has as operating subsidiaries six wholly-owned operating
subsidiaries. Capital Reinsurance Company ("Capital Reinsurance"), domiciled in
the state of Maryland, commenced operations in January 1988. Capital Reinsurance
is engaged in the business of financial guaranty reinsurance, primarily the
reinsurance of municipal and nonmunicipal bond obligations. Capital Mortgage
Reinsurance Company ("Capital Mortgage"), a New York domiciled company,
commenced operations in February 1994. Capital Mortgage reinsures only
residential mortgage guaranty insurance obligations originating principally in
the United States and the United Kingdom. KRE Reinsurance, Ltd. (formerly
Capital Mortgage Reinsurance Company (Bermuda) Ltd.) ("KRE"), a Bermuda
domiciled company, commenced operations in March 1994. KRE is engaged in the
business of reinsuring financial guaranty, mortgage guaranty, financial
insurance, trade credit and other specialty lines of insurance policies both as
a direct reinsurer of third party primary insurers and as a retrocessionaire of
Capital Reinsurance, Capital Mortgage, Capital Credit Reinsurance Company, Ltd.
("Capital Credit") and Capital Title Reinsurance Company ("Capital Title").
Capital Credit, also a Bermuda domiciled insurance company, commenced operations
in February 1990. Capital Credit reinsures trade credit and other specialty
insurance lines from primary insurers whose business is concentrated in Western
Europe and the United States. Capital Credit is also a retrocessionaire of
Capital Reinsurance and Capital Mortgage. Capital Title, a New York domiciled
insurance company, commenced operations in March 1996. Capital Title is engaged
in the business of reinsuring title insurance policies.
In November 1996, the Corporation, through its newly formed United Kingdom
holding company, Capital Re (UK) Holdings, acquired 100% of the issued shares of
Tower Street Holdings Limited (now known as RGB Holdings, Ltd.), the holding
company for RGB Underwriting Agencies Ltd. ("RGB"). RGB is a Lloyd's managing
agency and presently manages five syndicates operating in the Lloyd's of London
insurance market. In connection with this acquisition, the Corporation
established a corporate name ("CRC Capital, Ltd.") at Lloyd's to support
underwriting on certain of the managed syndicates beginning with the 1997 year
of account. CRC participates in a nonmarine and life syndicate. In November
1997, RGB Holdings acquired 100% of C.I. de Rougemont Group Limited, the holding
company for C.I. de Rougemont and Co. Ltd. ("CIDR"), another Lloyd's managing
agency. CIDR manages
57
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
1. BUSINESS AND ORGANIZATION (CONTINUED)
two syndicates, one marine and the other nonmarine. Effective January 1, 1998,
CIDR's nonmarine syndicate was merged with the nonmarine syndicate of RGB. CRC
Capital will participate on the syndicates acquired in the CIDR transaction
beginning with the 1998 year of account. The results of RGB, CIDR and CRC
Capital are consolidated in the Corporation's financial statements. The goodwill
associated with these acquisitions will be amortized over 20 years.
In December 1996, the Corporation entered into a joint venture with Global
Capital Reinsurance Limited, ("GCR") to form a Bermuda based insurer, Capital
Global Underwriters Limited ("CGUL"), which specializes in financial lines
reinsurance. In April 1997, GCR was acquired by EXEL Limited ("EXEL"). In March
1998 sold its share of CGUL to Bermuda based ACE Limited, and CGUL was renamed
ACE Capital Re Ltd. The Corporation, through its subsidiary, KRE, owns a 50%
interest in ACE Capital Re Ltd. and controls 9.9% of its voting stock. The
Corporation accounts for its investment in ACE Capital Re Ltd. under the equity
method.
2. SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The accompanying consolidated financial statements include the accounts and
operations of the Corporation and its wholly-owned subsidiaries. All significant
intercompany accounts and transactions have been eliminated.
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
The 1996 and 1995 financial statements have been reclassified to conform with
the 1997 presentation.
58
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Significant accounting policies are as follows:
Investments in Securities: The Corporation accounts for its investments in
fixed maturity securities in accordance with FASB Statement No. 115 ("SFAS
115"), "Accounting for Certain Investments in Debt and Equity Securities".
Management determines the appropriate classification of securities at the time
of purchase. At December 31, 1997 and 1996 investments in fixed maturity
securities were designated as available-for-sale.
The Corporation invests in mortgage-backed securities, including
collateralized mortgage obligations. The Corporation recognizes income for
these securities using a constant effective yield based on anticipated
prepayments and the estimated economic life of the securities. When actual
prepayments differ significantly from anticipated prepayments, the effective
yield is recalculated to reflect actual payments to date and anticipated
future payments. The net investment in the security is adjusted to the amount
that would have existed had the new effective yield been applied since the
acquisition of the security. That adjustment is included in net investment
income. Short-term investments are carried at cost, which approximates market
value. Realized gains and losses on sale or maturity of investments and
declines in value judged to be other-than-temporary are determined by specific
identification and included in net realized gains.
The amortized cost of fixed maturity securities is adjusted for amortization
of premiums and accretion of discounts. That amortization or accretion is
included in net investment income.
Premium Revenue Recognition: All premiums are earned over the terms of the
risks covered under the Corporation's insurance and reinsurance contracts.
Generally, premiums are received either in full at contract inception or in
installments over the life of the covered risk. Financial guaranty premiums
are typically received entirely at contract inception. For purposes of
earnings recognition, premiums are allocated to each year in the term of the
guaranty and are earned pro-rata over the period of risk. Receipts of
installment premiums for financial guaranty and all other lines of business
are generally earned on monthly pro-rata basis over the installment period.
59
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Deferred Acquisition Costs: Acquisition costs include only those expenses that
relate to, and vary with, premium production, including commissions, brokerage
and costs of underwriting and marketing personnel. Acquisition costs are
deferred and amortized over the period in which the related premiums are
earned. Ceding commission income on premiums ceded to other reinsurers reduces
acquisition costs. Anticipated losses, loss adjustment expenses and the
remaining costs of servicing the reinsured issues are considered in
determining the recoverability of acquisition costs.
Losses and Loss Adjustment Expenses: The liability for loss and loss
adjustment expenses is determined according to management's loss expectations
which are based on historical loss development patterns as well as reports and
individual case estimates received from ceding companies where applicable. An
estimate is also provided for losses and loss adjustment expenses for incurred
but not reported losses for the mortgage guaranty, trade credit and specialty,
and Lloyd's lines of business. Incurred but not reported losses are not
estimated for the financial guaranty and title reinsurance lines of business
since they are underwritten to a zero loss standard. Financial guaranty loss
and loss adjustment expenses were discounted using an average rate of 6.4% in
1997 and 6.0% in 1996.
Contingent Commissions: Under the terms of certain of the Corporation's
reinsurance contracts, the Corporation is obligated to pay the ceding company
a contingent commission based upon a specified percentage of the net
underwriting profits. As of December 31, 1997 and 1996, the Corporation's
liability for the present value of expected future payments is shown on the
balance sheet under the caption "Profit commission liability."
Stock Based Compensation: The Corporation grants stock options to certain
employees for a fixed number of shares to employees with an exercise price
equal to the fair value of the shares at the date of grant. The Corporation
accounts for stock option grants in accordance with APB Opinion No. 25,
"Accounting for Stock Issued to Employees," and, accordingly, recognizes no
compensation expense for the stock option grants.
60
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
2. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Income Taxes: In accordance with FASB Statement No. 109, "Accounting for
Income Taxes," deferred federal income taxes are provided on the temporary
difference between the tax basis of an asset or liability and its reported
amount in the financial statements that will result in deductible or taxable
amounts in future years when the reported amount of the asset or liability is
recovered or settled. Such temporary differences relate principally to premium
revenue recognition, deferred acquisition costs, and contingency reserve. The
Internal Revenue Code permits companies writing financial guaranty insurance
and mortgage guaranty insurance to deduct from taxable income amounts added to
the statutory contingency reserve, subject to certain limitations. The amounts
deducted must be included in taxable income in the tenth or twentieth year
following the year of deduction dependent on the type of business, or in the
event that incurred losses exceed certain statutorily established levels and
the contingency reserve is released to cover such excess losses. However, the
tax benefits obtained from such deductions must be invested in noninterest-
bearing U.S. Government tax and loss bonds. The Corporation records purchases
of tax and loss bonds as payments of federal income taxes.
Earnings Per Share: In February 1997, the Financial Accounting Standards Board
issued Statement of Financial Accounting Standard No. 128, Earnings Per Share
("SFAS 128"), effective for years ending after December 15, 1997. SFAS 128
requires the calculation and presentation on the income statement of "basic"
earnings per share and "diluted" earnings per share. Basic earnings per share
is calculated based on the weighted average common shares outstanding. All
potentially dilutive securities such as stock options are excluded from the
basic earnings per share calculation. In calculating diluted earnings per
share, the number of shares outstanding is increased to include all
potentially dilutive securities. The Corporation adopted SFAS 128 in 1997 and
has restated earnings per share for each of the years ending December 31, 1996
and 1995. Basic and diluted net income per share of common stock are computed
by dividing net income by the applicable weighted average number of shares of
common stock outstanding during each year.
For the years ended 1997, 1996 and 1995, and in order to arrive at the number
of weighted average diluted shares outstanding of 16,253, 15,946, and 14,914,
employee stock option awards in the amount of 380, 290 and 126 were added to
weighted average common shares outstanding for basic earnings per share of
15,873, 15,656, and 14,788, respectively. All figures are reported in
thousands.
61
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
3. ACCOUNTING DEVELOPMENTS
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income,"
which is effective for fiscal years beginning after December 15, 1997. SFAS No.
130 establishes standards for the reporting item, termed comprehensive income,
which will combine net income and certain items that directly effect
stockholders' equity, such as net unrealized gain/loss on fixed maturity
securities available for sale and foreign currency translation adjustments. This
statement will have no impact on the financial condition or results of
operations of the Corporation.
In June 1997, the FASB also issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information", which is effective for fiscal years
beginning after December 15, 1997. SFAS No. 131 establishes new standards for
defining how operating segments are determined and requires more comprehensive
disclosures about the Corporation's reportable operating segments. The
Corporation believes that SFAS No. 131 will require expanded financial and
descriptive disclosure about the Corporation's operating lines of business,
however, the Corporation, has not yet determined the impact of this statement on
the Corporation's financial statement disclosure.
4. STATUTORY ACCOUNTING PRACTICES
The financial statements are prepared on the basis of GAAP, which differs in
certain respects from accounting practices prescribed or permitted by the
Maryland Insurance Administration and the Insurance Department of the State of
New York (the insurance departments in the states of domicile of Capital
Reinsurance and Capital Mortgage and Capital Title, respectively), as well as
the statutory requirements of the Minister of Finance of the Island of Bermuda
(place of domicile of Capital Credit and KRE). Statutory accounting practices
for the Corporation's insurance subsidiaries differ from GAAP as follows:
Acquisition costs are charged to current operations as incurred rather than as
related premiums are earned;
A contingency reserve is computed on the basis of statutory requirements
regardless of when loss contingencies actually exist;
A title statutory premium reserve is established based upon assumed exposure
regardless of when loss contingencies actually exist;
62
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
4. STATUTORY ACCOUNTING PRACTICES (CONTINUED)
Federal income taxes are only provided on taxable income for which income
taxes are currently payable, while under GAAP, deferred income taxes are
provided with respect to temporary differences;
Purchases of tax and loss bonds are reflected as admitted assets, while under
GAAP they are recorded as federal income tax payments;
Financial guaranty premiums are earned in direct proportion to the payment of
debt service rather than pro-rata over the period of risk;
Investments in fixed maturity securities are reported at amortized cost or
market value based on the National Association of Insurance Commissioners
("NAIC") rating; under GAAP, these fixed maturity investments are carried in
accordance with SFAS 115 (see Note 2).
Certain assets designated as "nonadmitted assets" are charged directly to
statutory capital and surplus, but are reflected as assets under GAAP.
Holding company guarantees (approved by Bermuda's Minister of Finance) issued
for the benefit of Capital Credit and KRE under which the holding company is
obligated under certain circumstances to invest additional capital in each
company are admitted assets and included as part of statutory capital and
surplus at December 31, 1996. During 1997, such guarantees were allowed to
lapse and are not intended to be renewed in the near term. Accordingly, they
are not included as part of statutory capital and surplus at December 31,
1997.
63
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
4. STATUTORY ACCOUNTING PRACTICES (CONTINUED)
The following is a reconciliation of the Corporation's consolidated GAAP net
income and stockholders' equity to the corresponding consolidated statutory
amounts for its insurance subsidiaries:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
1997 1996 1995
-----------------------------------------------------
(Dollars in Thousands)
<S> <C> <C> <C>
Consolidated GAAP net income $ 70,052 $ 56,524 $ 45,527
Premium revenue recognition (1,199) (14,851) (6,995)
Deferred acquisition costs (23,827) (9,011) (11,705)
Deferral of income taxes 8,460 11,489 5,373
Tax and loss bonds 1,581 4,848 4,116
Interest expense and minority interest in
Capital Re LLC 13,137 12,633 12,631
Other, including noninsurance subsidiaries (5,886) (4,091) (3,160)
-----------------------------------------------------
Consolidated statutory net income $ 62,318 $ 57,541 $ 45,787
=====================================================
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31
1997 1996
-----------------------------------
(Dollars in Thousands)
<S> <C> <C>
GAAP stockholders' equity $ 568,943 $ 489,346
Premium revenue recognition (44,345) (42,166)
Deferred acquisition costs (127,637) (111,364)
Unrealized (gain) loss on fixed maturity
securities available-for-sale (45,218) (25,541)
Deferral of income taxes 72,879 58,474
Tax and loss bonds 18,737 17,157
Contingency reserve (162,250) (123,363)
Long-term debt and Company obligated
mandatorily redeemable preferred securities
of Capital Re LLC 174,819 174,782
Parental guarantee - 30,000
Goodwill (12,677) (13,567)
Other, including noninsurance subsidiaries (8,133) (10,307)
-----------------------------------
Consolidated statutory policyholders' surplus $ 435,118 $ 443,451
===================================
</TABLE>
64
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
5. INSURANCE IN FORCE--FINANCIAL GUARANTY AND MORTGAGE GUARANTY
Financial Guaranty: At December 31, 1997, the Corporation's reinsured financial
guaranty portfolio included the reinsured portfolios of Capital Reinsurance,
Capital Credit and KRE, net of eliminations and was broadly diversified by bond
type, geographic location and maturity schedule, with no single risk
representing more than 2.4% of the Corporation's net par in force. The
Corporation limits its exposure to losses from reinsured financial guarantees by
underwriting primarily investment grade obligations and retroceding a portion of
its risks to other insurance companies.
Net financial guaranty par in force was approximately $44.8 billion at December
31, 1997. The composition at December 31, 1997, by type of issue and the range
of final maturities, was as follows:
<TABLE>
<CAPTION>
RANGE OF FINAL
Type of Issue NET PAR IN FORCE MATURITIES
- ---------------------------------------------------------------------------------------------
(Dollars in Billions)
<S> <C> <C>
Tax-backed $14.2 1-40 years
Utility 12.4 1-40 years
Nonmunicipal 7.2 1-35 years
Special revenue 5.2 1-40 years
Health care 5.0 1-40 years
Housing 0.8 1-40 years
----------------------
$44.8
======================
</TABLE>
The reinsured portfolio contained exposures in each of the 50 states. Net par in
force at December 31, 1997, by state, was as follows:
<TABLE>
<CAPTION>
STATE Net Par in Force
- --------------------------------------------------------------------------
(Dollars in Billions)
<S> <C>
California $ 4.8
New York 4.6
Florida 2.7
Texas 2.3
Pennsylvania 1.9
New Jersey 1.8
Massachusetts 1.7
Illinois 1.7
Washington 1.1
Ohio 0.9
Others (each less than 2%) 21.3
------------------------
$44.8
========================
</TABLE>
65
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
5. INSURANCE IN FORCE--FINANCIAL GUARANTY AND MORTGAGE GUARANTY (CONTINUED)
As part of its financial guaranty business, the Corporation participates in
credit default swap transactions whereby a counterparty pays a periodic fee,
typically expressed in fixed basis points on a notional amount in return for a
contingent payment by the Corporation in the event of default of one or more
third party reference securities. A default is typically defined as bankruptcy,
insolvency or failure to meet payment obligations when due, accompanied by
significant price deterioration in a reference security. The total notional
amount of credit default swaps outstanding at December 31, 1997 and included in
the Corporation's financial guaranty exposure above was $1.8 billion.
During the fourth quarter of 1997, fiscal and economic turmoil spread through
several Asian countries causing some Asian currencies to experience significant
devaluation and subjecting certain corporations, financial institutions and
sovereigns to pronounced fiscal stress. Included in the Corporation's financial
guaranty net par in force is $770.7 million related to the Asian region. While
the Corporation has reinsured exposures in this region, 83% of the net par
relates to Japan, China and Hong Kong which are countries that remain investment
grade despite the downturn. The remaining exposure is to Korea, Indonesia,
Thailand, Philippines and Malaysia and is principally in the form of sovereign
debt. As of December 31, 1997, the Corporation did not expect to incur any
losses related to the Asian economic downturn and as a result no loss reserve
had been recorded.
As stated in Note 1, the principal business of Capital Reinsurance is the
reinsurance of financial guaranties. In connection with this business, the
claims-paying ability of Capital Reinsurance is rated triple-A by Standard &
Poors ("S&P"), Moody's Investor Service ("Moody's") and Fitch IBCA. The rating
agencies have developed and published rating guidelines for rating financial
guaranty reinsurers. These criteria follow the standards used to evaluate the
claims-paying ability of primary monoline financial guaranty insurers. In
January 1998, Moody's placed the claims-paying ability rating of Capital
Reinsurance on review for a possible downgrade. Moody's took this action in
light of the company's diversification into nonfinancial guaranty businesses.
While this action does not impact the Corporation's 1997 financial statements,
under several reinsurance treaties to which Capital Reinsurance is a party, the
ceding companies may recapture business previously ceded to Capital Reinsurance
in the event of a specified rating downgrade. Should Moody's rating review
result in a downgrade of Capital Reinsurance's claims paying rating to double-A,
the Corporation does not expect that any previously ceded business to Capital
Reinsurance will be recaptured.
66
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
5. INSURANCE IN FORCE--FINANCIAL GUARANTY AND MORTGAGE GUARANTY (CONTINUED)
Mortgage Guaranty: At December 31, 1997, the Corporation's net mortgage guaranty
insurance in force (representing the current principal balance of all mortgage
loans that are currently reinsured) and direct primary net risk in force was
approximately $10.7 billion and $3.2 billion, respectively. California
represents the Corporation's largest U.S. risk concentration at approximately
22%, however, its total U.S. distribution of mortgage guaranty risk in force
parallels that of the U.S. primary mortgage insurance industry.
6. INVESTMENTS IN SECURITIES
The following summarizes the Corporation's aggregate investment portfolio at
December 31, 1997:
<TABLE>
<CAPTION>
GROSS GROSS
UNREALIZED UNREALIZED ESTIMATED
AMORTIZED COST GAINS LOSSES FAIR VALUE
----------------------------------------------------------------
(Dollars in Thousands)
<S> <C> <C> <C> <C>
Fixed maturity securities
available-for-sale:
U.S. Treasury securities and
obligations of U.S. government
agencies $ 85,977 $ 4,089 $ (13) $ 90,053
Obligations of states and
political subdivisions 453,326 34,370 - 487,696
Corporate securities 112,595 2,759 (142) 115,212
Mortgage-backed securities 152,720 2,758 (35) 155,443
Asset-backed 64,050 1,477 (9) 65,518
Emerging markets 18,537 160 (196) 18,501
----------------------------------------------------------------
Total available-for-sale 887,205 45,613 (395) 932,423
Short-term investments 78,668 - - 78,668
----------------------------------------------------------------
Total investments $965,873 $45,613 $(395) $1,011,091
================================================================
</TABLE>
67
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
6. INVESTMENTS IN SECURITIES (CONTINUED)
The following summarizes the Corporation's aggregate investment portfolio at
December 31, 1996:
<TABLE>
<CAPTION>
GROSS GROSS
UNREALIZED UNREALIZED ESTIMATED
AMORTIZED COST GAINS LOSSES FAIR VALUE
-----------------------------------------------------------------
(Dollars in Thousands)
<S> <C> <C> <C> <C>
Fixed maturity securities
available-for-sale:
U.S. Treasury securities and
obligations of U.S. government
agencies $ 75,960 $ 1,525 $ (428) $ 77,057
Obligations of states and
political subdivisions 398,006 21,058 (98) 418,966
Corporate securities 115,013 751 (231) 115,533
Mortgage-backed securities 197,928 3,147 (313) 200,762
Emerging markets 13,230 136 (6) 13,360
-----------------------------------------------------------------
Total available-for-sale 800,137 26,617 (1,076) 825,678
-----------------------------------------------------------------
Short-term investments 75,424 75,424
Total investments $875,561 $26,617 $(1,076) $901,102
=================================================================
</TABLE>
The amortized cost and estimated fair value of fixed maturity securities
available-for-sale at December 31, 1997, by contractual maturity are shown
below. Expected maturities will differ from contractual maturities because
borrowers may have the right to call or prepay obligations with or without call
or prepayment penalties.
<TABLE>
<CAPTION>
AMORTIZED COST FAIR VALUE
--------------------------------------
(Dollars in Thousands)
<S> <C> <C>
Maturity:
Due in 1998-2002 $120,221 $121,349
Due in 2003-2007 112,900 115,981
Due after 2007 501,364 539,651
Mortgage-backed securities 152,720 155,442
--------------------------------------
Total $887,205 $932,423
======================================
</TABLE>
68
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
6. INVESTMENTS IN SECURITIES (CONTINUED)
In 1997, the Corporation realized gross gains and losses of $12.4 million and
($4.4) million, respectively. In 1996, the Corporation realized gross gains and
losses of $8.5 million and ($7.0) million, respectively. In 1995, the
Corporation realized gross gains and losses of $3.5 million and ($3.4) million,
respectively. Included in gross losses in 1995 were ($2.6) million for other
than temporary declines in value.
Approximately 15.4% of the Corporation's total investment portfolio of $1.0
billion at December 31, 1997 is comprised of mortgage-backed securities ("MBS"),
including collateralized mortgage obligations. Of the securities in the MBS
portfolio, approximately 85.4% are backed by agencies or entities sponsored by
the U.S. government. As of December 31, 1997, the weighted average credit
quality of the Corporation's entire investment portfolio was AA+.
Net investment income is derived from the following sources:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
1997 1996 1995
--------------------------------------------------
(Dollars in Thousands)
<S> <C> <C> <C>
Income from fixed maturity securities $51,187 $46,207 $42,730
Income from short-term investments 6,952 6,351 4,406
--------------------------------------------------
Total investment income 58,139 52,558 47,136
Less investment expenses (1,523) (1,000) (482)
--------------------------------------------------
Net investment income $56,616 $51,558 $46,654
==================================================
</TABLE>
Under agreements with its cedants and in accordance with statutory requirements,
certain of the Corporation's subsidiaries maintain fixed maturity securities in
trust accounts for the benefit of reinsured companies and for the protection of
policyholders in states in which they are not licensed. The carrying amount of
such restricted balances amounted to approximately $87.3 million and $31.9
million at December 31, 1997 and 1996, respectively. Additionally, at December
31, 1997 and 1996, $4.1 million and $3.7 million, respectively, was on deposit
with state insurance departments to satisfy regulatory requirements.
69
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
7. RESERVES FOR UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES
The following table provides a reconciliation of the beginning and ending
reserve balances for unpaid losses and loss adjustment expenses ("LAE").
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
1997 1996 1995
---------------------------------------------------
(Dollars in Thousands)
<S> <C> <C> <C>
Reserve for losses and LAE, net of related
reinsurance recoverables, at beginning of year $17,759 $10,245 $ 7,702
Add:
Provision for unpaid losses and LAE for claims
occurring in the current year, net of
reinsurance 25,508 8,370 1,660
Increase in estimated losses and LAE for claims
occurring in prior years, net of reinsurance 1,849 1,113 977
---------------------------------------------------
Incurred losses during the current year, net of
reinsurance 27,357 9,483 2,637
---------------------------------------------------
Deduct:
Losses and LAE payments (net of recoverables)
for claims occurring in the current year 4,574 10 (474)
Losses and LAE payments (net of recoverables)
for claims occurring in the prior year 9,898 1,959 568
---------------------------------------------------
14,472 1,969 94
---------------------------------------------------
Reserve for unpaid losses and LAE, net of
related reinsurance recoverables, at end of year 30,644 17,759 10,245
Unrealized foreign exchange loss on reserve
revaluation 11 310 14
Reinsurance recoverables on unpaid losses and
LAE, at end of year 7,245 1,833 2,524
---------------------------------------------------
Reserve for unpaid losses and LAE, gross of
reinsurance recoverables on unpaid losses at
end of year $37,900 $19,902 $12,783
===================================================
</TABLE>
70
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
7. RESERVES FOR UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES (CONTINUED)
Incurred losses in 1997 were principally from the Corporation's Lloyd's
insurance operations as well as the mortgage guaranty and trade credit and
specialty reinsurance lines of business. During 1996, incurred losses were
principally from the mortgage guaranty and trade credit and specialty
reinsurance lines of business. Incurred losses in 1995 were caused primarily by
increases in reserves estimated for mortgage guaranty losses. The increases for
1997, 1996 and 1995 are consistent with the expected loss development patterns
for the respective lines of business.
8. DEBT AND LIQUIDITY FACILITY
Debt consists of:
<TABLE>
<CAPTION>
DECEMBER 31
1997 1996
------------------------------
(Dollars in Thousands)
<S> <C> <C>
7.75% debentures due 2002, net of unamortized
discount of $0.2 million in 1997 and $0.2 million
in 1996 ("Debentures") $74,819 $74,782
Bank note payable 25,000 25,000
------------------------------
Total $99,819 $99,782
==============================
</TABLE>
The Debentures include certain covenants, none of which significantly restrict
the Corporation's operating activities or dividend paying ability. During 1996,
the Corporation entered into a $25.0 million credit facility with Chase
Manhattan Bank, expiring August 20, 1998. The facility is renewable each year at
the option of the Corporation. Interest on the facility is payable semi-annually
at a rate equal to the then London Interbank offered rate plus 40 basis points.
On January 22, 1998, the Corporation renewed an agreement with Deutsche Bank AG
for the provision of a $25.0 million liquidity facility which will be available
for general corporate purposes expiring January 22, 1999. Capital Reinsurance
also renewed an agreement on January 27, 1998 with Deutsche Bank AG for a credit
facility of up to $75.0 million specifically designed to provide rating agency
qualified capital to further support Capital Reinsurance's claims-paying
resources. This agreement expires January 27, 2005.
71
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
8. DEBT AND LIQUIDITY FACILITY (CONTINUED)
During 1997, 1996 and 1995, the Corporation paid total interest of approximately
$7.4 million, $6.9 million and $6.9 million, respectively.
9. INCOME TAXES
The Corporation and its subsidiaries file a consolidated federal income tax
return. The Corporation's effective federal corporate tax rate for 1997, 1996
and 1995 was 27.3%, 26.7% and 24.2%, respectively.
A reconciliation from the tax provision calculated at the federal statutory rate
of 35% in 1997, 1996 and 1995, to the total tax is as follows:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
1997 1996 1995
-----------------------------------------------------
(Dollars in Thousands)
<S> <C> <C> <C>
Tax provision at statutory rate $33,703 $27,006 $21,026
Tax-exempt interest (7,751) (6,710) (5,940)
Other 290 339 (538)
-----------------------------------------------------
Total federal income tax provisions $26,242 $20,635 $14,548
=====================================================
</TABLE>
The liability for deferred federal income taxes reflects the tax effect of the
following temporary differences:
<TABLE>
<CAPTION>
DECEMBER 31
1997 1996
-----------------------------------
(Dollars in Thousands)
<S> <C> <C>
Deferral of acquisition costs $ 44,673 $ 39,033
Contingency reserve 33,437 30,670
Deferred premium revenue 1,517 3,198
Unrealized gain on fixed maturity securities
available-for-sale 15,826 8,940
Deferred compensation (1,397)
Other (1,223) 430
-----------------------------------
Effects of temporary differences 92,833 82,271
Credit for alternative minimum tax carryforwards (1,217) (6,640)
Tax and loss bonds (18,737) (17,157)
-----------------------------------
Liability for deferred federal income taxes $ 72,879 $ 58,474
===================================
</TABLE>
72
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
9. INCOME TAXES (CONTINUED)
Income taxes paid during 1997, 1996 and 1995 were approximately $18.9 million,
$7.9 million and $8.7 million, respectively.
10. REINSURANCE CEDED
To limit its exposure on assumed risks, the Corporation enters into certain
proportional and nonproportional retrocessional agreements that cede a portion
of risks underwritten to other insurance companies. In the event that any or all
of the reinsurers were unable to meet their obligations, the Corporation would
be liable for such defaulted amounts.
For the years ended December 31, 1997, 1996 and 1995, ceded earned premiums were
$29.8 million, $14.7 million and $8.0 million, respectively. Ceded losses for
the same periods were $5.4 million, $6.5 million and $2.6 million, respectively.
During 1993, Capital Reinsurance entered into a multi-year nonproportional
reinsurance contract which provides for aggregate loss protection of $80.0
million in exchange for $19.5 million of premium. Additional premiums may become
payable dependent upon the level of losses incurred. During 1993, Capital Credit
entered into similar multi-year reinsurance contracts which provide for
aggregate loss protection of $34.0 million in exchange for $4.25 million in
premiums. Additional premiums may also become payable dependent upon the level
of losses incurred.
During 1994, Capital Reinsurance entered into a portfolio excess of loss
reinsurance contract which provides $100.0 million aggregate loss protection on
specified municipal obligations in excess of $82.0 million of losses. Capital
Mortgage entered into a similar portfolio excess of loss reinsurance contract
which provides $30.0 million aggregate loss protection in excess of a specified
loss ratio covering all reinsured obligations. Premiums due on both contracts
are not dependent upon the level of losses incurred.
73
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
10. REINSURANCE CEDED (CONTINUED)
During 1995, Capital Mortgage entered into an assumption agreement whereby it
provides excess of loss reinsurance on an existing portfolio of mortgage pool
insurance. In connection with this assumed transaction, Capital Mortgage is
required to cede a portion of the risks, thereby reducing its total net
retention. Total ceded premiums under the contract were approximately $21.0
million. Total expected assumed premiums of $56.0 million are payable in seven
annual installments of $8.0 million. As of December 31, 1997, the Corporation
has received three of the seven installments. Contingent commissions will be
payable on the assumed reinsurance and receivable on the ceded reinsurance,
dependent upon the level of losses incurred under the contract.
11. FAIR VALUES OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used by the Corporation in estimating
its fair value disclosure for financial instruments. These determinations were
made based on available market information and appropriate valuation
methodologies. Considerable judgment is required to interpret market data to
develop the estimates and therefore, they may not necessarily be indicative of
the amount the Corporation could realize in a current market exchange.
CASH AND SHORT-TERM INVESTMENTS
The carrying amount reported in the balance sheet for these instruments
approximates fair value.
FIXED MATURITY SECURITIES
The fair value for fixed maturity securities shown in Note 6 is based on quoted
market prices.
74
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
11. FAIR VALUES OF FINANCIAL INSTRUMENTS (CONTINUED)
DEFERRED PREMIUM REVENUE
The fair value of the Corporation's deferred premium revenue is based on
entering into a cession of the entire portfolio with third party reinsurers
under market conditions. This figure was determined by using the statutory basis
unearned premium reserve, net of deferred acquisition costs, and the present
value of the estimated future cash flow stream from installment premiums. At
December 31, 1997, the fair value of the Corporation's net deferred premium
revenue was estimated to be $311.9 million.
RESERVE FOR LOSSES AND LOSS ADJUSTMENT EXPENSES, NET OF REINSURANCE
RECOVERABLE ON CEDED LOSSES
For financial guaranty losses, the carrying amount is composed of the present
value of the expected cash flows for case basis claims and therefore represents
the best estimate of fair value. The short-term nature of losses from the
remaining lines of business indicate that the carrying value represents the best
estimate of fair value. Accordingly, for all lines, the carrying amount is
deemed the best estimate of fair value as of December 31, 1997.
DEBT
The fair value of the Corporation's $75.0 million of outstanding Debentures is
determined based on the projected cash flows discounted by the sum of the seven-
year U.S. treasury yield at December 31, 1997 and the appropriate credit spread
for similar debt instruments. At December 31, 1997, the fair value of the
Corporation's Debentures was estimated to be $78.2 million.
The carrying amount of the Corporation's bank note payable of $25.0 million
approximates fair value due to its floating interest rate provision.
PREFERRED SECURITIES OF CAPITAL RE LLC
The fair value of the Corporation's $75.0 million Company obligated mandatorily
redeemable preferred securities of Capital Re LLC at December 31, 1997 was $75.6
million based on the closing price per share on the New York Stock Exchange at
that date.
75
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
12. DIVIDENDS
Under Maryland's insurance law, the amount of surplus available for distribution
as dividends is subject to certain statutory provisions, which generally
prohibit the payment of dividends in any twelve-month period without prior
approval of the Maryland Commissioner of Insurance in an amount exceeding 10% of
policyholder's surplus at the preceding December 31. The amount available for
distribution from Capital Reinsurance during 1998 with notice to, but without
prior approval of, the Maryland Commissioner of Insurance under the Maryland
insurance law is approximately $34.6 million. During 1997, Capital Reinsurance
paid dividends in the amount of $8.0 million to the Corporation.
Credit Re Corporation, Capital Credit's holding company has never paid a
dividend to the Corporation. Were it to pay dividends to the Corporation, it
would rely on dividends from its wholly-owned subsidiary, Capital Credit.
Capital Credit's and KRE's dividend distributions are governed by Bermuda law.
Under Bermuda law and the By-Laws of Capital Credit and KRE, dividends may be
paid out of the profits of Capital Credit and KRE (defined as accumulated
realized profits less accumulated realized losses). Distributions to
shareholders may also be paid out of Capital Credit's and KRE's surplus limited
by requirements that Capital Credit and KRE must at all times (i) maintain the
minimum share capital required under Bermuda law and (ii) have relevant assets
in an amount equal to or greater than 75% of relevant liabilities, all as
defined under Bermuda law. Since their organization, Capital Credit and KRE have
not declared or paid any dividends.
Under New York Insurance Law, as a mortgage guaranty insurance corporation,
Capital Mortgage may not pay dividends except from earned surplus as defined by
New York Insurance Law. Capital Mortgage is further restricted from paying
dividends to the extent that any dividend paid to shareholders which, together
with all dividends declared or distributed by it during the preceding twelve
months, exceeds the lesser of 10% of its surplus to policyholders as shown by
its last statement on file with the superintendent, or 100% of adjusted net
investment income during such period unless specifically allowed by the
superintendent. To date, Capital Mortgage has not declared or paid any
dividends. The maximum dividend payable by Capital Mortgage during 1998 is $0
since its earned surplus was ($0.4) million as of December 31, 1997.
76
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
12. DIVIDENDS (CONTINUED)
Capital Title is subject to the New York Insurance Law laws and regulations
governing title insurers. Accordingly, dividends may only be declared and
distributed out of earned surplus as defined under New York Insurance Law and
only if such dividends do not reduce the company's surplus to less than 50% of
its outstanding capital shares, i.e., the value of its outstanding common
equity. Additionally, no dividend may be declared or distributed in an amount
which, together with all dividends declared or distributed by the company during
the preceding twelve months, exceeds 10% of the company's outstanding capital
shares, unless, after deducting such dividends, it has a surplus at least equal
to 50% of its statutory reinsurance reserve or a surplus at least equal to
$250,000, whichever is greater. During 1997, Capital Title paid a dividend in
the amount of $1.1 million to its immediate parent, KRE. As of December 31,
1997, Capital Title's maximum amount payable as a dividend during 1998 is
approximately $1.3 million.
13. COMMITMENTS
At December 31, 1997, future minimum rental payments under the terms of the
Corporation's noncancellable operating leases for office space are $1.4 million
for the year 1998, $1.5 million for each of the years 1999, 2000, 2001 and 2002,
and $8.9 million in the aggregate thereafter. These future minimum rental
payments total $16.3 million. These payments are subject to escalations in
building operating costs and real estate taxes. Total rent expense amounted to
approximately $0.9 million in each of the years 1997, 1996 and 1995.
In June 1997, the Corporation invested approximately $10.9 million in CGA Group
Ltd ("CGA"), a Bermuda domiciled insurance company formed to provide financial
guaranty insurance of structured securities, including commercial real estate
and asset-backed transactions. Its insurance company subsidiary, Commercial
Guaranty Assurance, Ltd is rated triple A by Duff & Phelps Credit Rating Co.
("Duff & Phelps"). The Corporation's investment was in the form of the purchase
of common and preferred shares. As part of the Corporation's agreement to invest
in CGA, it has also committed to invest an additional $7.5 million in the form
of the purchase of common shares in the event that maintenance of Commercial
Guaranty Assurance Ltd.'s triple A rating from Duff & Phelps make such action
necessary.
77
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
13. COMMITMENTS (CONTINUED)
The Corporation participates in the Lloyd's of London insurance market through
its corporate name, CRC Capital Ltd. At the Corporation's direction, a letter of
credit has been provided to Lloyd's in satisfaction of CRC Capital's capital
requirement. All corporate capital providers are required by Lloyd's to post
funds at Lloyd's equal to a fixed percentage of the amount of committed
insurance capacity. For the year ended December 31, 1997, the total amount of
insurance capacity committed by CRC Capital was British Pound Sterling 39.7
million, and CRC Capital's Funds at Lloyd's requirement was 50% of that amount
and was supported by a letter of credit for British Pound Sterling 19.9 million.
For the 1998 year, the Corporation increased its insurance capacity commitment
to British Pound Sterling 88.2 million which is supported by a letter of credit
of British Pound Sterling 44.1 million.
14. CAPITAL RE LLC
In January 1994, the Corporation formed and capitalized Capital Re LLC, a
limited liability company organized under the laws of the Turks and Caicos
Islands. Additionally, in January 1994, Capital Re LLC issued $75,000,000, 7.65%
of cumulative monthly income preferred shares, the proceeds of which were loaned
to the Corporation. The preferred shares were issued at $25 par value per share
and are shown on the balance sheet under the caption "Company obligated
mandatorily redeemable preferred securities of Capital Re LLC." The Corporation
guarantees the payment of the monthly dividend as well as any amounts upon
liquidation or redemption which cannot occur prior to January 31, 1999, at the
Corporation's discretion. Capital Re LLC exists solely for the purpose of
issuing preferred and common shares and lending the proceeds to the Corporation
to fund its business operations. The total amount paid to preferred shareholders
for each of the years ended 1997, 1996 and 1995 was approximately $5.7 million
and is shown on the income statement under the caption "Minority interest in
Capital Re LLC."
15. COMPENSATION PLANS
Prior to its initial public offering, the Corporation had a stock incentive plan
wherein eligible employees were granted shares of restricted common stock.
Shares awarded under the Plan amounted to 696,000 at December 31, 1991. For
these awards, the difference between the price paid by the employees and the
market value of the award at the date of grant, if any, was recorded as deferred
compensation and was amortized ratably over the four-year vesting period. Upon
completion of the initial public offering in 1992, these shares became vested
and all restrictions lapsed.
78
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
15. COMPENSATION PLANS (CONTINUED)
To enable recipients of awards under the stock incentive plan to meet tax
obligations which may have resulted from such awards, the Corporation agreed to
make loans to recipients, payable upon ultimate disposition of their shares or
three years after their termination of employment. As of December 31, 1997 and
1996, total loans outstanding under all officer loan programs were approximately
$1.64 million and $1.74 million, respectively, at the end of the year, and are
included under the caption "Other assets."
On April 15, 1992, the Corporation adopted the 1992 Stock Option Plan (the "1992
Option Plan"). The 1992 Option Plan enables key employees to benefit from
appreciation in the price of the common stock of the Corporation. The 1992
Option Plan provides for grants of incentive stock options ("ISO"), which are
intended to qualify under Section 422 of the Internal Revenue Code and of
options which are intended not to so qualify ("NQSO"). Under the 1992 Option
Plan, options may be granted at a price not less than 100% of the fair market
value as determined on the date granted. ISO's and NQSO's awarded, vest in four
equal yearly installments commencing one year after the date of grant. Once
vested, options may be exercised at any time and expire ten years from the date
of grant. According to the terms of the 1992 Option Plan, the aggregate number
of shares subject to option awards may not exceed 1,450,000. All option awards
have been granted under the 1992 Option Plan as of December 31, 1997. During
1997, the Corporation adopted the 1997 Stock Option Plan ("1997 Plan"). The
terms of the 1997 Plan are similar to those of the 1992 Option Plan, however,
the number of shares subject to option award shall not exceed 1,000,000.
In 1993, the Corporation also adopted a stock option plan (the "Director's
Plan") for the benefit of its outside directors. The terms of the plan are
similar to those of the employee plan except that options become fully vested at
the time of grant. According to the terms of the Director's Plan, the aggregate
number of shares subject to option award shall not exceed 30,000.
The Corporation has elected to follow Accounting Principles Board Opinion No. 25
"Accounting for Stock Issued to Employees" (APB 25) and related interpretations
in accounting for its employee stock options because, as discussed below, the
alternative fair value accounting provided for under FASB Statement No. 123,
"Accounting for Stock-Based Compensation," requires use of option valuation
models that were not developed for use in valuing employee stock options. Under
APB 25, because the exercise price of the Corporation's employee stock options
equals the market price of the underlying stock on the date of grant, no
compensation expense is recognized.
79
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
15. COMPENSATION PLANS (CONTINUED)
Pro forma information regarding net income and earnings per share is required by
Statement 123, and has been determined as if the Corporation had accounted for
its employee stock options under the fair value method of that statement. The
fair value for these options was estimated at the date of grant using a Black-
Scholes option pricing model with the following weighted-average assumptions for
1997, 1996 and 1995, respectively: risk-free interest rates of 6.33%, 5.42% and
7.36%; dividend yields of 0.67%, 0.80% and 0.88%; volatility factors of the
expected market price of the Corporation's common stock of 23.37, 19.10 and
29.94; and an expected life of the options of 7 years.
The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions including the expected stock price volatility. Because
the Corporation's employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options.
For purposes of pro forma disclosures, the estimated fair value of the options
is amortized to expense over the options' expected lives. The Corporation's pro
forma information follows (in thousands, except for per share information):
<TABLE>
<CAPTION>
1997 1996 1995
--------------------------------------------
<S> <C> <C> <C>
Pro forma net income $69,052 $56,030 $45,273
Pro forma basic earnings per common share $ 4.35 $ 3.58 $ 3.06
Pro forma diluted earnings per common share $ 4.31 $ 3.54 $ 3.03
</TABLE>
80
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
15. COMPENSATION PLANS (CONTINUED)
A summary of the Corporation's stock option activity, and related information
for the years ended December 31 follows:
<TABLE>
<CAPTION>
1997 1996 1995
-------------------------------- ------------------------------- ---------------------------
WEIGHTED- WEIGHTED- WEIGHTED-
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE
---------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Outstanding, beginning of year 968,600 $24.01 908,000 $20.77 $686,400 $19.56
Granted 302,500 43.39 277,500 31.49 248,400 23.99
Exercised (80,975) 21.98 (205,587) 19.69 (22,575) 19.51
Forfeited (8,550) 29.04 (11,313) 26.50 (4,225) 19.62
Outstanding, end of year 1,181,575 $29.07 968,600 $24.01 908,000 $20.77
=============================================================================================
Exercisable, end of year 520,975 $21.96 422,447 $20.25 395,150 $19.63
=============================================================================================
</TABLE>
<TABLE>
<CAPTION>
1997 1996 1995
------------------------------------------------
<S> <C> <C> <C>
Weighted-average fair value of
options granted during the year $16.99 $10.42 $11.03
</TABLE>
Exercise prices for options outstanding as of December 31, 1997 ranged from
$19.50 to $56.75. The weighted-average remaining contractual life of those
options is approximately 8.0 years.
In 1996, the Corporation adopted a performance share plan for the benefit of
senior executives of the Corporation. The plan is intended to align senior
management with the interest of the shareholders. To achieve this objective,
the plan ties awards granted under the plan with earning per share growth and
with total shareholder return and share price. These shares will be awarded at
December 31, 1999. The Corporation recognized $3.0 million and $1.0 million in
deferred compensation expense for the years ended December 31, 1997 and 1996,
respectively.
81
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
15. COMPENSATION PLANS (CONTINUED)
The Corporation maintains a savings incentive plan which is qualified under
Section 401 of the Internal Revenue Code. The savings incentive plan is
available to all full-time employees with a minimum of six months of service.
Eligible participants may contribute 9% of their base salary subject to a
maximum of $10,000 for 1997. Contributions are matched by the Corporation at a
rate of 100%, up to 7% of the participants' contribution subject to certain
limitations and vest at a rate of 25% per year starting with the second year of
service. The Corporation contributed approximately $0.3 million in each of the
years 1997 and 1996 and $0.2 million in 1995.
The Corporation also maintains a profit sharing plan which is available to all
full-time employees with a minimum of six months of service. Annual
contributions to the plan are at the discretion of the Board of Directors. The
plan contains a qualified portion and a nonqualified portion. Total expense
incurred under the plan amounted to approximately $0.3 million in 1997, 1996 and
1995.
The Corporation does not provide health care or life insurance benefits to
retirees.
16. MAJOR CUSTOMERS
The Corporation derives the majority of its gross written premiums from a small
number of primary insurers. The primary insurers which accounted for 10% or more
of gross written premiums are as follows:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
1996 1995
---------------------------------
PRIMARY INSURER
<S> <C> <C>
CMAC 15.9% 11.5%
MBIA 14.9 17.8
FGIC 11.9 *
PMI 10.7 10.5
AMBAC * 12.1
FSA * 14.9
</TABLE>
*Less than 10%
82
<PAGE>
Capital Re Corporation and Subsidiaries
Notes to Consolidated Financial Statements (continued)
16. MAJOR CUSTOMERS (CONTINUED)
During 1997, one customer, CMAC, provided 12.3% of the Corporation's total gross
written premium. All other clients provided less than 10% during 1997. Customer
concentration occurring in 1996 and 1995 resulted from the fact that a larger
portion of the Corporation's total gross written premiums came from the
financial guaranty and mortgage guaranty reinsurance lines of business. This is
due to the small number of primary insurance companies writing primary financial
guaranty and mortgage guaranty insurance. As the Corporation continues to
diversify its businesses, client concentration should decrease.
17. QUARTERLY FINANCIAL SUMMARY (UNAUDITED)*
<TABLE>
<CAPTION>
1ST 2ND 3RD 4TH
QUARTER QUARTER QUARTER QUARTER YEAR
-----------------------------------------------------------------------
(Dollars in Thousands Except Per Share Amounts)
1997
<S> <C> <C> <C> <C> <C>
Gross written premiums $64,525 $60,431 $48,206 $46,360 $219,522
Net written premiums 56,270 58,971 44,616 45,503 205,360
Earned premiums 30,549 31,874 36,085 35,155 133,663
Net investment income and net realized gains 16,600 13,799 16,918 17,336 64,653
Income before provision for federal income 23,878 23,056 24,807 24,551 96,293
tax
Net income 17,136 16,108 18,257 18,550 70,051
Basic net income per common share $ 1.08 $ 1.02 $ 1.16 $ 1.17 $ 4.41
Diluted net income per share $ 1.06 $ 0.99 $ 1.12 $ 1.14 $ 4.31
1996
Gross written premiums $34,255 $30,957 $43,220 $21,386 $129,818
Net written premiums 18,060 26,902 40,500 19,726 105,188
Earned premiums 20,104 22,322 22,005 28,005 92,436
Net investment income and net realized gains 12,191 11,781 12,781 16,276 53,029
Income before provision for federal income 17,193 18,207 18,808 22,951 77,159
tax
Net income 12,767 13,285 13,955 16,517 56,524
Basic net income per common share $ 0.84 $ 0.85 $ 0.88 $ 1.04 $ 3.61
Diluted net income per share $ 0.83 $ 0.83 $ 0.87 $ 1.02 $ 3.54
1995
Gross written premiums $24,189 $21,202 $23,977 $38,231 $107,599
Net written premiums 21,748 19,302 20,789 27,669 89,508
Earned premiums 13,929 16,584 13,322 16,262 60,097
Net investment income and net realized gains 11,530 11,493 11,546 12,138 46,707
Income before provision for federal income 14,350 15,004 15,099 15,622 60,075
tax
Net income 11,077 11,262 11,353 11,833 45,527
Basic net income per common share $ 0.75 $ 0.76 $ 0.77 $ 0.80 $ 3.08
Diluted net income per share $ 0.75 $ 0.76 $ 0.76 $ 0.79 $ 3.05
</TABLE>
* Numbers may not add due to rounding.
83
<PAGE>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information concerning directors set forth under "Election of Directors" in
the Company's 1998 Proxy Statement is incorporated herein by reference.
Information concerning executive officers is set forth under PART I, Item 1
"BUSINESS OF CAPITAL RE: Executive Officers" in this report.
ITEM 11. EXECUTIVE COMPENSATION.
The information concerning compensation of the Company's executive officers set
forth in the Company's 1998 Proxy Statement is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information concerning security ownership of certain beneficial owners and
management set forth in the Company's 1998 Proxy Statement is incorporated
herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information concerning certain relationships and related transactions set
forth in the Company's 1998 Proxy Statement is incorporated herein by reference.
84
<PAGE>
PART IV
ITEM 14.
(a) Financial Statements, Financial Statement Schedules and Exhibits.
1. Financial Statements
--------------------
The following consolidated financial statements of the Company are filed as
part of this Report in Item 8:
CAPITAL RE CORPORATION AND SUBSIDIARIES
Report of Independent Auditors
Consolidated Balance Sheets at December 31, 1997 and 1996
Consolidated Statements of Income For the Years Ended December 31, 1997,
1996 and 1995
Consolidated Statements of Stockholders' Equity for the Years Ended
December 31, 1997, 1996 and 1995
Consolidated Statements of Cash Flows for the Years Ended December 31,
1997, 1996 and 1995
Notes to Consolidated Financial Statements
2. Financial Statement Schedules
-----------------------------
The following Financial Statement Schedules are filed as part of this
Report:
Schedule Title
-------- -----
II Condensed Financial Information of Registrant
IV Reinsurance
The report of the Registrant's independent auditors with respect to the
above listed financial statement schedules is set forth in Exhibit 23.01 of
this Report.
All other schedules are omitted because they are either inapplicable or the
required information is presented in the consolidated financial statements
of the Company or the notes thereto.
3. Exhibits
--------
The following are annexed as exhibits to this Report:
Exhibit No. Exhibit
----------- -------
3.01 Certificate of Incorporation of the Company, dated
December 3, 1991, 1992 (Filed as exhibit 3.01 to the
Company's Registration Statement on Form S-1 (Reg. No.
33-45286) and incorporated herein by reference)
3.02 By-laws of the Company (Filed as exhibit 3.02 to the
Company's Registration Statement on Form S-1 (Reg. No.
33-45286) and incorporated herein by reference)
3.03 Certificate of Ownership and Merger of Capital Re
Delaware Corporation and Capital Re Corporation (Filed
as exhibit 3.03 to the Company's Registration
85
<PAGE>
Statement on Form S-1 (Reg. No. 33-45286) and
incorporated herein by reference)
4.01 Specimen Stock Certificate representing shares of Common
Stock (Filed as exhibit 4.01 to the Company's
Registration Statement on Form S-1 (Reg. No. 33-45286)
and incorporated herein by reference)
4.02 Form of Indenture between the Company and Morgan
Guaranty Trust Company of New York, as Trustee including
form of specimen Debenture (Filed as exhibit 4.01 to the
Company's Registration Statement on Form S-1 (Reg. No.
33-53618) and incorporated herein by reference)
4.03 Form of Subordinated Promissory Notes (Filed as Exhibits
10.01 -10.03 to the Company's Quarterly Report on Form
10-Q for the quarter ended September 30, 1993 (Comm.
File No. 1-10995) and incorporated herein by reference)
4.04 Form of Payment and Guarantee Agreement between Capital
Re LLC and the Company (Filed as exhibit 4.1 to the
Company's Registration Statement on Form S-3 (Reg. No.
33-72090) and incorporated herein by reference)
4.05 Form of the Declaration of Terms of Capital Re LLC 7.65%
Cumulative Monthly Income Preferred Shares, Series A
(Filed as exhibit 4.2 to the Company's Registration
Statement on Form S-3 (Reg. No. 33-72090) and
incorporated herein by reference)
4.06 Form of Liability Assumption Agreement between Capital
Re LLC and Capital Re Corporation (Filed as exhibit 99.2
to the Company's Registration Statement on Form S-3
(Reg. No. 33-72090) and incorporated herein by
reference)
4.07 Form of Loan Agreement between Capital Re LLC and
Capital Re Corporation (Filed as exhibit 99.1 to the
Company's Registration Statement on Form S-3 (Reg. No.
33-72090) and incorporated herein by reference)
4.08 $25 Million Credit Facility between the Company, Various
Banks and Deutsche Bank AG, as Agent (Filed as Exhibit
4.08 to the Company's Annual Report on Form 10-K for the
fiscal year ended December 31, 1994 (Comm. File
No. 1-10995) and incorporated herein by reference)
4.09 $75 Million Credit Facility between Capital Reinsurance,
Various Banks and Deutsche Bank AG, as Agent (Filed as
Exhibit 4.09 to the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1994 (Comm. File
No. 1-10995) and incorporated herein by reference)
4.10 $25 Million Credit Facility between the Company, Various
Banks and The Chase Manhattan Bank, as Agent, dated
August 20, 1996 (Filed as Exhibit 4.10 to the Company's
Annual Report on Form 10-K for the fiscal year ended
December 31, 1996 (Comm. File No. 1-10995) and
incorporated herein by reference).
4.11 Amendment dated January 27, 1998 to $75 Million Credit
Facility between Capital Reinsurance, Various Banks and
Deutsche Bank AG, as Agent
86
<PAGE>
9.01 Stockholders' Agreement dated as of January 17, 1992 by
and among the Registrant, its institutional stockholders
and certain of its management stockholders (Filed as
exhibit 9.01 to the Company's Registration Statement on
Form S-1 (Reg. No. 33-53618) and incorporated herein by
reference)
9.02 First Amendment to Capital Re Corporation 1992
Stockholders Agreement dated December 28, 1992 (Filed as
exhibit 9.03 to the Company's Annual Report on From 10-K
for the fiscal year ended December 31, 1992 and
incorporated herein by reference)
9.03 Modification of Credit Re Corporation Stockholders
Agreement dated August 20, 1993 (Filed as Exhibit 10.31
to the Company's Annual Report on Form 10-K for the
fiscal year ended December 31, 1993 (Comm. File No. 1-
10995) and incorporated herein by reference) *
10.01 Capital Re Corporation 1988 Stock Incentive Plan, as
amended (the "1988 Plan") (Filed as exhibit 10.04 to the
Company's Registration Statement on Form S-1 (Reg. No.
33-45286) and incorporated herein by reference)
10.02 Form of 1988 Stock Incentive Plan Agreement (Filed as
exhibit 10.05 to the Company's Registration Statement on
Form S-1 (Reg. No. 33-45286) and incorporated herein by
reference)
10.03 Forms of Tax Equalization Loan Agreements related to
1988 Plan (Filed as exhibit 10.06 to the Company's
Registration Statement on Form S-1 (Reg. No. 33-45286)
and incorporated herein by reference)
10.04 Form of Indemnity Agreement related to 1988 Plan (Filed
as exhibit 10.07 to the Company's Registration Statement
on Form S-1 (Reg. No. 33-45286) and incorporated herein
by reference)
10.05 1992 Stock Option Plan and related form of Non-Qualified
Stock Option Agreement (Filed as exhibit 10.11 to the
Company's Registration Statement on Form S-1 (Reg. No.
33-45286) and incorporated herein by reference)
10.06 Lease Agreement for the Company's principal office
between Capital Reinsurance Company and 1325 Limited
Partnership (Filed as Exhibit 10.29 to the Company's
Annual Report on Form 10-K for the fiscal year ended
December 31, 1992 (Comm. File No. 1-10995) and
incorporated herein by reference) *
10.07 Capital Re Corporation Directors' Stock Option Plan
(Filed as Exhibit 10.26 to the Company's Annual Report
on Form 10-K for the fiscal year ended December 31, 1993
(Comm. File No. 1-10995) and incorporated herein by
reference) *
10.08 Capital Re Corporation Deferred Compensation Plan.
(Filed as Exhibit 10.37 to the Company's Annual Report
on Form 10-K for the fiscal year ended December 31, 1995
(Comm. File No. 1-10995) and incorporated herein by
reference)
87
<PAGE>
10.09 Capital Re Corporation Non-Qualified Profit Sharing
Plan. (Filed as Exhibit 10.38 to the Company's Annual
Report on Form 10-K for the fiscal year ended December
31, 1995 (Comm. File No. 1-10995) and incorporated
herein by reference)
10.10 Capital Re Corporation Performance Share Plan (Filed as
Exhibit 10.39 to the Company's Annual Report on Form 10-
K for the fiscal year ended December 31, 1996 (Comm.
File No. 1-10995) and incorporated herein by reference).
10.11 1997 Employee Stock Option Plan (Filed as Appendix A to
the Company's definitive proxy statement for the 1997
annual meeting of the Company's shareholders and
incorporated herein by reference)
10.12 Annual Incentive Plan for Covered Executive Officers
(Filed as Appendix C to the Company's definitive proxy
statement for the 1997 annual meeting of the Company's
shareholders and incorporated herein by reference)
11.01 Statement Re: Computation of Per Share Earnings
21.01 Subsidiaries of Registrant
23.01 Consent of Ernst & Young LLP, Independent Auditors
24.01 Power of Attorney of the Board of Directors
27.01 Financial Data Schedule as of December 31, 1997
__________
* Confidential treatment was afforded, or has been requested, for certain
portions of these agreements
(b) Reports on Form 8-K
None.
88
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.
Dated: March 30, 1998 CAPITAL RE CORPORATION
(Registrant)
By: /s/ Alan S. Roseman
-------------------------------------
Name: Alan S. Roseman
Title: Senior Vice President,
General Counsel and Secretary
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
Name Title Date
- ---- ----- ----
<S> <C> <C>
Michael E. Satz* Chairman of the Board, March 30, 1998
Chief Executive Officer and
President (Principal Executive
Officer)
David A. Buzen* Executive Vice President and March 30, 1998
Chief Financial Officer
(Principal Financial and
Accounting Officer)
Harrison Conrad* Director March 30, 1998
Richard L. Huber* Director March 30, 1998
Steven D. Kesler* Director March 30, 1998
Steven Newman* Director March 30, 1998
Philip Robinson* Director March 30, 1998
Edwin Russell* Director March 30, 1998
Michael E. Satz* Director March 30, 1998
Dan R. Skowronski* Director March 30, 1998
Barbara Stewart* Director March 30, 1998
Jeffrey F. Stuermer* Director March 30, 1998
</TABLE>
- --------------------------
*Alan S. Roseman, by signing his name hereto, does hereby sign this Annual
Report on Form 10-K on behalf of each of the Directors and Officers of the
Company named above pursuant to powers of attorney duly executed by such
Directors and Officers and filed with the Securities and Exchange Commission as
an exhibit to this report.
By: /s/ Alan S. Roseman
------------------------------------
Alan S. Roseman, Attorney-in-fact
89
<PAGE>
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
Capital Re Corporation
December 31, 1997
(Dollars in thousands)
<TABLE>
<CAPTION>
CONDENSED BALANCE SHEETS AS OF AS OF
- ------------------------ DECEMBER 31, DECEMBER 31,
ASSETS 1997 1996
- ------ ------------ ------------
<S> <C> <C>
Investment in affiliates $756,345 $669,721
Other assets 1,541 9,080
-------- --------
Total Assets $757,886 $678,801
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
- ------------------------------------
Long-term debt $ 74,819 $ 74,781
Subordinated notes payable 0 0
Bank note payable 25,000 25,000
Intercompany balance with affiliates 89,124 89,673
Stockholders' Equity 568,943 489,347
-------- --------
Total Liabilities and Stockholders' Equity $757,886 $678,801
======== ========
<CAPTION>
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
CONDENSED STATEMENTS OF INCOME 1997 1996 1995
- ------------------------------ ------------ ------------ ------------
<S> <C> <C> <C>
Revenues $ 241 $ 183 $ 217
Expenses 17,033 14,354 13,867
-------- -------- --------
Total Operating (Loss) (16,792) (14,171) (13,650)
Equity in net income of affiliates 81,116 66,086 54,132
-------- -------- --------
Income before income tax (benefit) 64,324 51,915 40,482
Income tax (benefit) (5,728) (4,610) (5,045)
-------- -------- --------
Net Income $ 70,052 $ 56,525 $ 45,527
======== ======== ========
</TABLE>
See accompanying notes to Condensed Financial Statements
90
<PAGE>
<TABLE>
<CAPTION>
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
CONDENSED STATEMENTS OF CASH FLOWS 1996 1995 1994
- ---------------------------------- --------------------- --------------------- ---------------------
<S> <C> <C> <C>
OPERATING ACTIVITIES
- --------------------
Net Income $ 70,052 $ 56,525 $ 45,527
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Equity in net income of affiliates (81,116) (66,086) (54,132)
Dividends received from subsidiary 8,000 17,500 13,856
Other 7,617 (9,056) 3,147
-------- -------- --------
Net cash provided by/ (used in) operating activities 4,553 (1,117) 8,398
INVESTING ACTIVITIES
- --------------------
Investment in affiliates 0 (33,800) (6,000)
Maturities (purchases) of short-term investments, net 0 0 0
-------- -------- --------
Net cash used in investing activities 0 (33,800) (6,000)
FINANCING ACTIVITIES
- --------------------
Proceeds from issuance of stock 2,636 30,882 440
Net proceeds from issuance of bank note payable 0 9,000 0
Proceeds from intercompany loan 0 0 0
Dividends paid to stockholders' (4,606) (3,945) (3,105)
Purchase of treasury stock, at cost (1,021) (232) 0
-------- -------- --------
Net cash provided by/ (used in) financing activities (2,991) 35,705 (2,665)
(Decrease)/ Increase in cash 1,562 788 (267)
Cash at beginning of year 950 162 429
-------- -------- --------
Cash at end year $ 2,512 $ 950 $ 162
======== ======== ========
</TABLE>
See accompanying notes to Condensed Financial Statements
91
<PAGE>
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT - CONTINUED
CAPITAL RE CORPORATION
DECEMBER 31, 1997
NOTES TO CONDENSED FINANCIAL STATEMENTS
The accompanying condensed financial statements should be read in conjunction
with the consolidated financial statements and notes thereto of Capital Re
Corporation and Subsidiaries.
The long-term debt of $74.8 million is senior unsecured debentures. See Note 8
to the consolidated financial statements of Capital Re Corporation and
Subsidiaries for a description of Capital Re Corporation's debt.
Of the $89.1 million intercompany balance with subsidiary, $94.9 million is a
loan between the Corporation and its subsidiary, Capital Re LLC, a limited life
company organized under the laws of the Turks and Caicos Islands. The $94.9
million loan consists of $75.0 million of proceeds received from the issuance of
Company obligated mandatorily redeemable preferred securities of Capital Re LLC
as well as the Corporation's $19.9 million common stock investment in Capital Re
LLC. See Note 14 to the consolidated financial statements of Capital Re
Corporation and Subsidiaries for an explanation of the loan. Also, $5.8 million
is a loan between the Corporation and its subsidiary, Capital Re (UK) Holdings,
whereby the Corporation loaned Capital Re (UK) Holdings $5.8 million to
facilitate the purchase of RGB Holdings Ltd.
92
<PAGE>
CAPITAL RE CORPORATION
SCHEDULE IV - REINSURANCE
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
Premiums Percentage
Property Ceded to Assumed of Amount
and Gross Other from Other Net Assumed to
Liability Amount Companies Companies Amount Net
- --------- ------ --------- ---------- -------- ----------
<S> <C> <C> <C> <C> <C>
1997 $0 $14,162 $219,522 $205,360 106.9%
1996 $0 $24,630 $129,818 $105,188 123.4%
1995 $0 $18,091 $107,599 $89,508 120.2%
</TABLE>
93
<PAGE>
Exhibit 4.11
JANUARY 1998 AMENDMENT TO THE CREDIT AGREEMENT
----------------------------------------------
JANUARY 1998 AMENDMENT TO THE CREDIT AGREEMENT (this "Amendment"), dated as of
January 27, 1998, among Capital Reinsurance Company (the "Borrower"), various
banks (the "Banks") and Deutsche Bank AG, New York Branch, as agent (the
"Agent"). All capitalized terms defined in the hereinafter defined Credit
Agreement shall have the same meaning when used herein unless otherwise defined
herein.
W I T N E S S E T H:
- - - - - - - - - -
WHEREAS, the Borrower, the Banks and the Agent entered into a Credit
Agreement, dated as of January 27, 1994 (as amended to date, the "Credit
Agreement");
WHEREAS, the parties hereto wish to amend the Credit Agreement as herein
provided;
NOW, THEREFORE, in consideration of the premises and the mutual covenants
herein contained, the parties hereto hereby agree as follows:
1. Amendments to the Credit Agreement. (a) The definition of "Loss Threshold
----------------------------------
Incurrence Date" in Section 1.01 of the Credit Agreement is hereby amended in
its entirety to the following:
"Loss Threshold Incurrence Date" shall mean the date on which the Borrower has
Cumulative Losses during the relevant Commitment Period equal to the greater
of (i) $210 million and (ii) 4.75% of the Average Annual Debt Service on the
Covered Portfolio as of such date.
(b) Section 1.01 of the Credit Agreement is hereby amended by addition of the
following terms in proper alphabetical order:
"Average Annual Debt Service" as of a specified date with respect to an
Insured Obligation shall mean the applicable Retained Percentage times the sum
of (i) the aggregate outstanding principal amount of such Insured Obligation
and (ii) the aggregate amount of interest thereafter required to be paid on
such Insured Obligation (giving effect to all mandatory sinking fund
<PAGE>
payments or other regularly scheduled required redemptions, prepayments or
other retirement of principal), divided by the number of whole and fractional
years from the date of determination to the latest maturity date of such
Insured Obligation, and as of a specified date with respect to the Covered
Portfolio shall mean the sum of the Annual Average Debt Service as of such date
of all Insured Obligations contained in the Covered Portfolio. In the event
that an Insured Obligation bears interest at a variable rate, the interest
thereon for purposes of the determination of Average Annual Debt Service shall
be calculated at the rate employed by the Borrower to compute average annual
debt service with respect to such Insured Obligation in accordance with its
customary business practices.
"Retained Percentage" of an Insured Obligation shall mean the percentage of
risk assumed by the Borrower under Insurance Contracts with respect thereto
minus the percentage of aggregate risk with respect to such Insurance Contracts
that has been ceded by the Borrower to other Persons pursuant to a reinsurance
agreement (whether facultative or treaty) or a similar arrangement.
(c) The first sentence of Section 3.04 of the Credit Agreement is hereby
amended in its entirety to read as follows:
The expiration of the Commitments of the Banks shall be January 27, 2005 (the
"Expiry Date"); provided, however, that before (but not earlier than 120 days
nor later than 45 days before) each anniversary of the Effective Date, the
Borrower may make a written request (an "Extension Request") to the Agent at
its Notice Office and each of the Banks that the Expiry Date be extended by one
calendar year.
(d) The third sentence of Section 3.04 of the Credit Agreement is hereby
amended in its entirety to read as follows:
If, after the Agent's receipt of the Extension Request but prior to the
anniversary of the Effective Date next occurring thereafter, any Bank agrees to
the extension of the Expiry Date requested thereby in writing by so indicating
on counterparts of the Extension Request and delivering such counterparts to
the Agent and the Borrower, "Expiry Date" as to such Bank shall mean the
-2-
<PAGE>
January 27 occurring in the calendar year next succeeding the Expiry Date then
in effect, provided that (i) any failure by the Agent or a Bank to so notify
the Borrower shall be deemed to be a disapproval by such Bank of the Borrower's
Extension Request and (ii) the portion of the Commitment representing the
Commitment of any Bank not so agreeing shall terminate on the Expiry Date as
then in effect.
2. Representations and Warranties. In order to induce the Banks and the
------------------------------
Agent to enter into this Amendment, the Borrower hereby represents and warrants
that:
(a) no Default or Event of Default exists or will exist as of the date hereof
and after giving effect to this Amendment; and
(b) as of the date hereof, after giving effect to this Amendment, all
representations, warranties and agreements of the Borrower contained in the
Credit Agreement will be true and correct in all material respects.
3. GOVERNING LAW. THIS AMENDMENT AND THE RIGHTS AND OBLIGATIONS OF THE
-------------
PARTIES HEREUNDER SHALL BE CONSTRUED IN ACCORDANCE WITH AND BE GOVERNED BY THE
LAW OF THE STATE OF NEW YORK, WITHOUT REGARD TO THE CHOICE OF LAW PROVISIONS
THEREOF.
4. Agreement Not Otherwise Amended. This Amendment is limited precisely as
-------------------------------
written and shall not be deemed to be an amendment, consent, waiver or
modification of any other term or condition of the Credit Agreement or any of
the instruments or agreements referred to therein, or prejudice any right or
rights which the Banks, the Agent or any of them now have or may have in the
future under or in connection with the Credit Agreement or any of the
instruments or agreements referred to therein. Except as expressly modified
hereby, the terms and provisions of the Credit Agreement shall continue in full
force and effect. Whenever the Credit Agreement is referred to in the Credit
Agreement or any of the instruments, agreements or other documents or papers
executed and delivered in connection therewith, it shall be deemed to be a
reference to the Credit Agreement as modified hereby.
5. Counterparts. This Amendment may be executed in two or more counterparts,
------------
each of which shall be deemed an
-3-
<PAGE>
original, but all of which together shall constitute one and the same
instrument.
IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be duly
executed and delivered by their respective duly authorized officers as of the
date first above written.
CAPITAL REINSURANCE COMPANY
By
---------------------------
Title:
DEUTSCHE BANK AG, NEW YORK
BRANCH, Individually and as
Agent
By
---------------------------
Title:
By
---------------------------
Title:
Each of the participants named
below hereby acknowledges
and consents to the execution,
delivery and effectiveness
of this Amendment.
THE CHASE MANHATTAN BANK
By
---------------------------
Title:
-4-
<PAGE>
KREDIETBANK, N.V.
By
---------------------------
Title:
By
---------------------------
Title:
WESTDEUTSCHE LANDESBANK GIROZENTRALE,
NEW YORK BRANCH
By
---------------------------
Title:
By
---------------------------
Title:
-5-
<PAGE>
Exhibit 11.01
CAPITAL RE CORPORATION AND SUBSIDIARIES
EXHIBIT 11 STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS
(Amounts in thousands except per share amounts)
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------------------
1997 1996 1995
-----------------------------------
<S> <C> <C> <C>
Net Income $70,052 $56,524 $45,527
Basic weighted average
common shares outstanding 15,873 15,656 14,788
Potentially dilutive employee
stock options 380 290 126
-----------------------------------
Diluted weighted average
common shares outstanding 16,253 15,946 14,914
===================================
Basic earnings per share $ 4.41 $ 3.61 $ 3.08
===================================
Diluted earnings per share $ 4.31 $ 3.54 $ 3.05
===================================
</TABLE>
<PAGE>
SUBSIDIARIES OF REGISTRANT
Capital Re Corporation, a Delaware insurance holding company;
Credit Re Corporation, a Maryland corporation;
Capital Re LLC, a Turks and Caicos limited life company;
Capital Reinsurance Company, a Maryland domiciled insurance company;
Capital Credit Reinsurance Company Ltd., a Bermuda domiciled insurance company;
Capital Mortgage Reinsurance Company, a New York domiciled insurance company;
Capital Title Reinsurance Company, a New York domiciled insurance company;
KRE Reinsurance Ltd., a Bermuda domiciled insurance company
Capital Re Management Corporation, a New York reinsurance intermediary
Capital Re (UK) Holdings
CRC Capital, Ltd., a corporation established under the Laws of England
RGB Holdings, Ltd., a corporation established under the Laws of England
RGB Underwriting Services, Ltd., a corporation established under the Laws of
England
RGB Underwriting Agencies, Ltd., a corporation established under the Laws of
England
C.I. de Rougemont Group Ltd., a corporation established under the Laws of
England
C.I. de Rougemont & Co. Ltd., a corporation established under the Laws of
England
ACE Capital Re Managers Ltd., a Bermuda domiciled managing general agency
ACE Capital Re Ltd., a Bermuda domiciled insurance company
Lenders Mortgage Alliance Company LLC, a Delaware Limited Liability Company
<PAGE>
Exhibit 23.01
CONSENT OF INDEPENDENT AUDITORS
Our report dated Janaury 27, 1998 on this Annual Report (Form 10-K) of Capital
Re Corporation is included in Item 8.
Our audits also included the financial statement schedules of Capital Re
Corporation listed in Item 14(a). These schedules are the responsibility of the
Corporation's management. Our responsibility is to express an opinion based on
our audits. In our opinion, the financial statement schedules referred to
above, when considered in relation to the basic financial statements taken as a
whole, present fairly in all material respects the information set forth
therein.
We consent to the incorporation by reference in the Registration Statement
(Form S-8 No. 33-47723) pertaining to the Capital Re Corporation 1992 Stock
Option Plan, in Registration Statement (Form S-8 No. 33-73122) pertaining to the
Capital Re Corporation Directors' Stock Option Plan and in the Registration
Statement (Form S-8 No. 333-37353) pertaining to the Capital Re Corporation 1997
Employee Stock Option Plan, the Capital Re Corporation Performance Share Plan
and the Capital Re Corporation Annual Incentive Plan for Covered Executive
Officers of our report dated January 27, 1998, with respect to the consolidated
financial statements, and our report included in the preceding paragraph with
respect to the financial statement schedules included in this Annual Report
(Form 10-K) of Capital Re Corporation.
/s/ Ernst & Young LLP
New York, New York
March 25, 1998
<PAGE>
Exhibit 25.01
CAPITAL RE CORPORATION
POWER OF ATTORNEY
-----------------
KNOW ALL MEN BY THESE PRESENTS, that each of the Officers and Directors of
Capital Re Corporation, 1325 Avenue of the Americas, New York, New York 10019
whose signature appears below constitutes and appoints Michael E. Satz and Alan
S. Roseman, and each of them individually, as his true and lawful attorneys-in-
fact and agents as of March 31, 1998, with full power of substitution and
resubstitution, for him and his name, place and stead in any and all capacities,
to sign the Annual Report on Form 10-K of Capital Re Corporation and any and all
amendments to such Annual Report, and to file the same, with all exhibits
thereto, and other documents in connection therewith, with the Securities and
Exchange Commission pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934, as amended, granting unto said attorney's-in-fact and agents, full
power and authority to perform each and every act and thing requisite and
necessary to be done in and about the premises, as fully to all intents and
purposes as he might or could do in person, hereby ratifying and confirming all
that said attorneys-in-fact and agents, or their substitutes, may lawfully do or
cause to be done by virtue thereof.
/s/ Michael E. Satz
- ------------------------ President, Chief Executive February 25, 1998
Michael E. Satz Officer and Chairman of the Board
/s/ David A. Buzen
- ------------------------ Executive Vice President February 25, 1998
David A. Buzen and Chief Financial Officer
/s/ Edwin Russell
- ------------------------ Director February 25, 1998
Edwin Russell
/s/ Jeffery F. Stuermer
- ------------------------ Director February 25, 1998
Jeffery F. Stuermer
/s/ Dan Skowronski
- ------------------------ Director February 25, 1998
Dan Skowronski
/s/ Steven H. Newman
- ------------------------ Director February 25, 1998
Steven H. Newman
/s/ Steven D. Kesler
- ------------------------ Director February 25, 1998
Steven D. Kesler
/s/ Richard L. Huber
- ------------------------ Director February 25, 1998
Richard L. Huber
/s/ Philip Robinson
- ------------------------ Director February 25, 1998
Philip Robinson
/s/ Harrison Conrad
- ------------------------ Director February 25, 1998
Harrison Conrad
/s/ Barbara Stewart
- ------------------------ Director February 25, 1998
Barbara Stewart
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 7
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-END> DEC-31-1997
<DEBT-HELD-FOR-SALE> 1,011,091
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 0
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 1,011,091
<CASH> 18,878
<RECOVER-REINSURE> 1,116,816
<DEFERRED-ACQUISITION> 135,332
<TOTAL-ASSETS> 1,387,954
<POLICY-LOSSES> 37,900
<UNEARNED-PREMIUMS> 402,145
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 99,819
75,000
0
<COMMON> 160
<OTHER-SE> 568,783
<TOTAL-LIABILITY-AND-EQUITY> 1,387,954
133,664
<INVESTMENT-INCOME> 56,616
<INVESTMENT-GAINS> 8,037
<OTHER-INCOME> 2,548
<BENEFITS> 27,357
<UNDERWRITING-AMORTIZATION> 42,887
<UNDERWRITING-OTHER> 15,890
<INCOME-PRETAX> 96,294
<INCOME-TAX> 26,242
<INCOME-CONTINUING> 70,052
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 70,052
<EPS-PRIMARY> 4.41
<EPS-DILUTED> 4.31
<RESERVE-OPEN> 17,759
<PROVISION-CURRENT> 25,508
<PROVISION-PRIOR> 1,849
<PAYMENTS-CURRENT> 4,574
<PAYMENTS-PRIOR> 9,898
<RESERVE-CLOSE> 30,644
<CUMULATIVE-DEFICIENCY> 0<F1>
<FN>
<F1>Not applicable for mortgage guaranty and specialty reinsurer.
</FN>
</TABLE>
