SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------------
FORM 10-Q
----------------------
(X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTER ENDED MARCH 31, 1999
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES AND EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ____TO____
------------------------------------------------------
CAPITAL RE CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
------------------------------------------------------
DELAWARE 1-10995 52-1567009
(STATE OR OTHER JURISDICTION (COMMISSION FILE NUMBER) (IRS EMPLOYER
OF INCORPORATION OR IDENTIFICATION NUMBER)
ORGANIZATION)
1325 AVENUE OF THE AMERICAS
18TH FLOOR
NEW YORK, NEW YORK 10019
(212) 974-0100
(NAME, ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE,
OF REGISTRANT'S PRINCIPAL EXECUTIVE OFFICES)
INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED
TO BE FILED BY SECTIONS 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 (REGISTRANT BECAME SUBJECT TO THE
FILING REQUIREMENTS ON APRIL 8, 1992.)
AS OF MAY 14, 1999 THERE WERE 32,045,119 OUTSTANDING SHARES OF COMMON STOCK, PAR
VALUE $.01 PER SHARE, OF THE REGISTRANT.
<PAGE>
<TABLE>
CAPITAL RE CORPORATION AND SUBSIDIARIES
INDEX
<S> <C>
PART I FINANCIAL INFORMATION PAGE
ITEM 1. FINANCIAL STATEMENTS (UNAUDITED) CAPITAL RE CORPORATION
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS -MARCH 31, 1999 (UNAUDITED) AND
DECEMBER 31, 1998 3
CONSOLIDATED STATEMENTS OF INCOME - THREE MONTHS
ENDED MARCH 31, 1999 (UNAUDITED) AND MARCH 31, 1998
(UNAUDITED) 4
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME - THREE MONTHS
ENDED MARCH 31, 1999 (UNAUDITED) AND MARCH 31, 1998
(UNAUDITED) 5
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY - THREE MONTHS
ENDED MARCH 31, 1999 (UNAUDITED) 6
CONSOLIDATED STATEMENTS OF CASH FLOWS - THREE MONTHS ENDED
MARCH 31, 1999 (UNAUDITED) AND MARCH 31, 1998 (UNAUDITED) 7
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 8-12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS 13-29
PART II OTHER INFORMATION
ITEM 3 EXHIBITS AND REPORTS ON FORM 8-K 30-32
SIGNATURES 33
</TABLE>
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<TABLE>
<CAPTION>
CAPITAL RE CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
(Dollars in thousands except per share amounts)
March 31, December 31,
1999 1998
(Unaudited)
------------- -------------
<S> <C> <C>
Assets
Fixed maturity securities available for sale, at market
(amortized cost: $1,062,432 in 1999 and $1,026,684 in 1998) $1,099,143 $1,086,891
Short-term investments, at cost, which approximates market 91,813 88,147
------------- -------------
Total Investments 1,190,956 1,175,038
Cash 18,619 9,893
Accrued investment income 14,920 15,371
Deferred acquisition costs 149,967 135,029
Prepaid reinsurance premiums 47,901 49,603
Reinsurance recoverable on ceded losses 3,334 3,292
Funds held under reinsurance agreements 6,011 5,033
Premiums receivable, net 5,499 16,997
Amounts receivable on ceded annuity reserves 53,869 53,869
Investment in affiliates 16,870 15,080
Net assets of discontinued operations 5,260 11,695
Other assets 16,260 17,873
------------- -------------
Total Assets $1,529,466 $1,508,773
============= =============
Liabilities
Deferred premium revenue $408,401 $405,866
Reserve for losses and loss adjustment expenses 93,583 87,960
Annuity benefit reserves 53,869 53,869
Accident and health reserves 18,165 17,843
Profit commission liability 61,009 57,389
Deferred federal income taxes payable 79,484 79,237
Bank note payable 25,000 25,000
Long-term debt 74,866 74,856
Other liabilities 24,769 20,927
------------- -------------
Total Liabilities $839,146 $822,947
------------- -------------
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 and outstanding in 1999 and 1998 --- ---
Common stock - $.01 par value per share; 75,000,000 shares
authorized, 32,045,119 and 31,929,119 shares issued and
outstanding in 1999 and 1998, respectively 325 324
Additional paid-in capital 228,831 227,280
Retained earnings 367,348 355,693
Treasury stock; 428,000 and 428,000 shares in 1999 and 1998, respectively (4,891) (4,891)
Other Comprehensive Income
Net unrealized gain on fixed maturities securities available for sale,
net of reclassification adjustment 23,863 32,520
Net unrealized loss on foreign exchange translation (156) (100)
------------- -------------
Accumulated Other Comprehensive Income 23,707 32,420
------------- -------------
Total Stockholders' Equity 615,320 610,826
------------- -------------
Total Liabilities, Preferred Securities of Capital Re LLC and
Stockholders' Equity $1,529,466 $1,508,773
============= =============
See Accompanying Notes to Unaudited Consolidated Financial Statements
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
CAPITAL RE CORPORATION AND SUBSIDIARIES
Consolidated Statements of Income
(Dollars in thousands except per share amounts)
Three Months Ended
March 31,
(Unaudited)
-------------------------
1999 1998
-------------------------
<S> <C> <C>
Revenues:
Orgination premiums written $58,455 $62,127
Canceled Reinsurance 9,567 0
-------------------------
Gross premiums written $48,888 $62,127
Ceded premiums 2,064 1,081
-------------------------
Net premiums written 46,824 61,046
Increase in deferred premium revenue (4,236) (17,315)
-------------------------
Net premiums earned 42,588 43,731
Net investment income 17,164 15,865
Net realized gain 408 1,180
Fee income 95 180
Other income 10 164
Equity income in affiliate 1,490 32
-------------------------
Total Revenues 61,755 61,152
-------------------------
Expenses:
Loss and loss adjustment expenses 12,793 9,986
Acquisition costs 27,268 18,871
Increase in deferred acquisition costs (14,938) (5,352)
Profit commission expense 3,757 2,873
Other operating expenses 3,298 3,973
Interest expense 1,845 1,879
Foreign exchange loss/(gain) 489 (341)
Minority interest in Capital Re LLC 1,434 1,434
-------------------------
Total Expenses 35,946 33,323
-------------------------
Income before provision for federal income taxes 25,809 27,829
Provision for federal income taxes
Current 1,577 4,092
Deferred 4,853 3,461
-------------------------
Total provision for federal income taxes 6,430 7,553
-------------------------
Net Income from continuing operations $19,379 $20,276
Discontinued operations:
Income from operations 0 (480)
Loss on disposal (6,443) 0
-------------------------
Loss from discontinued operations, net of tax (6,443) (480)
Net Income $12,936 $19,796
=========================
Net Income from Continuing Operations
Per Common Share:
Basic $0.61 $0.64
Diluted $0.60 $0.62
Net Income Per Common Share:
Basic $0.40 $0.62
Diluted $0.40 $0.60
Weighted Average Number of Shares Outstanding
Basic 32,009 31,834
Diluted 32,343 32,745
Cash dividends per common share $0.04 $0.04
See Accompanying Notes to Unaudited Consolidated Financial Statements
</TABLE>
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<TABLE>
<CAPTION>
CAPITAL RE CORPORATION AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income
(Dollars in thousands)
Three Months Ended
March 31,
(Unaudited)
-------------------------------
1999 1998
-------------------------------
<S> <C> <C>
Net Income $12,936 $19,796
Other Comprehensive Income, net of tax:
Unrealized holding losses arising during period (8,249) (1,411)
Reclassification adjustment for gains included in net income (408) (1,180)
-------------------------------
Change in net unrealized gain on fixed maturities securities
available for sale (8,657) (2,591)
Change in foreign exchange translation (56) 184
-------------------------------
Other Comprehensive Income (8,713) (2,407)
-------------------------------
Comprehensive Income $4,223 $17,389
===============================
See Accompanying Notes to Unaudited Consolidated Financial Statements
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
CAPITAL RE CORPORATION AND SUBSIDIARIES
Consolidated Statement of Stockholders' Equity
(Dollars in thousands except share amounts)
(Unaudited)
Additional
Common Paid-In Retained
Stock Capital Earnings
--------------------------------------------------
<S> <C> <C> <C>
Balance, January 1, 1999 $324 $227,280 $355,693
Net Income - - 12,936
Exercise of stock options, including tax benefit (116,000 shares) 1 1,551 -
Fixed maturities securities available for sale adjustments - - -
Foreign exhange translation - - -
Dividend ($.04 per common share) - - (1,281)
--------------------------------------------------
Balance, March 31, 1999 $325 $228,831 $367,348
==================================================
Accumulated
Other Total
Treasury Comprehensive Stockholders'
Stock Income Equity
----------------------------------------------
<S> <C> <C> <C>
Balance, January 1, 1999 ($4,891) $32,420 $610,826
Net Income - - 12,936
Exercise of stock options, including tax benefit (116,000 shares) - - 1,552
Fixed maturities securities available for sale adjustments - (8,657) (8,657)
Foreign exhange translation - (56) (56)
Dividend ($.04 per common share) - - (1,281)
----------------------------------------------
Balance, March 31, 1999 ($4,891) $23,707 $615,320
==============================================
See Accompanying Notes to Unaudited Consolidated Financial Statements.
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
CAPITAL RE CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(Dollars in thousands)
Three Months Ended
March 31,
(Unaudited)
----------------------------
1999 1998
----------------------------
<S> <C> <C>
Operating Activities:
Net income $12,936 $19,794
Adjustments to reconcile net income to
net cash provided by operating activities:
Amortization of bond discount on long-term debt 9 9
Net amortization of security premiums (351) (631)
Provision for deferred federal income taxes 4,909 3,461
Acquisition costs deferred (27,268) (18,871)
Amortization of deferred acquisition costs 12,329 13,519
Equity Income in affiliates (1,490) (32)
Change in accrued investment income 451 60
Change in premiums receivable, net 10,285 (1,819)
Change in deferred premium revenue, net 4,237 17,315
Change in outstanding loss reserves, net 5,582 4,622
Net realized gain on investments (408) (1,180)
Change in ceded balances payable 1,213 267
Other 8,694 7,644
---------- -----------
Net Cash Provided by Operating Activities 31,129 44,159
Investing Activities:
Securities available-for-sale:
Purchases - fixed maturities (242,674) (175,964)
Sales-fixed maturites 217,854 130,293
Maturities (purchases) of short-term
investments, net (3,658) 1,760
Investment in Affiliate (300) -
Discontinued Operations, net 6,443 244
Other investing activities (339) (175)
---------- -----------
Net Cash Used in Investing Activities (22,673) (43,842)
Financing Activities:
Net proceeds from exercise of stock options 1,551 284
Dividends paid (1,281) (1,273)
---------- -----------
Net Cash Used by Financing Activities 270 (989)
(Decrease) Increase in Cash 8,726 (673)
Cash at Beginning of Period 9,893 14,103
---------- -----------
Cash at End of Period $18,619 $13,430
========== ===========
See Accompanying Notes to Unaudited Consolidated Financial Statements.
</TABLE>
<PAGE>
CAPITAL RE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
MARCH 31, 1999
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements and footnotes have
been prepared in accordance with the instructions to Form 10-Q and the
preparation of unaudited interim financial statements under the Rules and
Regulations of the Securities and Exchange Commission and do not include all the
information and disclosures required by generally accepted accounting
principles. These statements should be read in conjunction with the audited
consolidated financial statements of Capital Re Corporation and Subsidiaries
(the "Corporation") included in the Corporation's 1998 Annual Report on Form
10-K. The accompanying unaudited consolidated financial statements include all
adjustments, consisting only of normal recurring adjustments, necessary to
present fairly the Corporation's financial position and results of operations.
The results of operations for the three months ended March 31, 1999 may not be
indicative of the results that may be expected for the year ending December 31,
1999.
As of January 1, 1998, the Company adopted Statement of Financial Accounting
Standard 130, "Reporting Comprehensive Income" ("FAS 130"). Statement 130
establishes new rules for the reporting and display of comprehensive income and
its components; however, the adoption of this Statement had no impact on the
Corporation income or shareholders' equity. FAS 130 requires unrealized gains or
losses on the Corporation's available-for-sale securities and foreign currency
translation adjustments, which prior to adoption were reported separately in
shareholders' equity to be included in other comprehensive income. Prior year
financial statements have been reclassified to conform to the requirements of
Statement 130. For the three months March 31, 1999 and 1998, total comprehensive
income amounted to $4.2 million and $17.4 million, respectively.
On June 30, 1998, the Corporation completed a two for one stock split of its
outstanding common shares. Prior period financial results have been restated to
reflect the stock split. Additionally, beginning in the third quarter of 1998,
the Company's investment in Lloyd's which was previously consolidated, is
reflected as a discontinued operation based on the Company's intention to pursue
its divestiture. The Company has recorded a loss on disposal of $6.4 million
based on current estimates. All prior period results have been restated for
comparative purposes.
2. REINSURANCE
Ceded earned premium for both the three months ended March 31, 1999 and 1998
were $3.8 million. Ceded losses for the same periods were $42,000 and $0.4
million, respectively.
3. INCOME TAXES
The effective tax rate for the three months ended March 31, 1999 and 1998 is
lower than the federal corporate tax rate on ordinary income of 35% due
principally to the effect of tax-exempt interest income. No income taxes were
paid as of March 31, 1999 and $1.0 million of income taxes were paid as of March
31, 1998.
4. SEGMENT REPORTING
The Corporation provides reinsurance to primary insurers in various specialty
insurance markets. For segment reporting purposes, the Corporation's reinsurance
lines of business are organized into four discrete segments - municipal
financial guaranty, nonmunicipal financial guaranty, each of which include
credit default swap transactions, mortgage guaranty and trade credit. Two
additional lines, financial solutions and title reinsurance are combined into
"Other" for segment reporting purposes. Operating procedures and corporate
resources are tailored to the business and regulatory needs of each line of
business or segment as necessary. In cases where practical, the same procedures
and or resources may be utilized for more than one line of business.
Financial guaranty insurance of municipal and nonmunicipal debt obligations, is
a form of credit enhancement which, as a specialized class of surety, provides
for the unconditional and irrevocable guarantee of the obligor's scheduled
payment of principal and interest on investment grade municipal and
non-municipal debt obligations. The premiums related to municipal bond
reinsurance are generally paid in full at the time of policy issuance, credited
to a deferred premium account and then recognized as revenues over the life of
the reinsured obligation. As a result, only a small portion of annual premium
revenue is derived from premiums written in any one year. Given the zero
expected loss underwriting standard, this multi-year revenue translates into an
annuity of earned premiums, which is itself supplemented by the investment
income derived from the deferred premiums account. Non-municipal financial
guaranty premiums are generally paid in installments over the life of the
underlying obligation, also providing an annuity of earned premiums.
Mortgage guaranty insurance is a specialized class of credit insurance,
providing protection to mortgage lenders against default by borrowers on low
down-payment residential mortgage loans. For the Corporation's proportional
mortgage guaranty business, reinsurance premiums are paid on a monthly basis and
fully recognized when written. A certain level of losses is expected in this
business. For the non-proportional mortgage guaranty business, premiums are
generally paid in full at contract inception and earned over the life, usually
ten years. Generally, losses are not expected in this non-proportional mortgage
guaranty business. Credit insurance protects suppliers of goods and services
from the risk of non-payment by their customers. Some level of losses are also
expected in this business. This business is centered on blending participation
in excess of loss reinsurance programs with traditional proportional treaty
lines. These contracts are generally of a one year duration and premiums are
typically received in installments throughout the coverage period.
For purposes of financial planning, resource allocation and performance
evaluation, segments are measured based on net underwriting profits and other
income directly attributable to the segments. For segment reporting purposes,
investment income, net realized gains/losses, operating expenses (i.e.,
salaries, rent, etc.), interest expense and income taxes are allocated to the
segments. The mortgage segment includes equity income from an investment in a
subsidiary engaged in mortgage related products. Management does not allocate
assets to the Corporation's segments. Rather, assets are managed as a
consolidated pool.
For marketing purposes, the Corporation aggregates its reinsurance lines of
business into two divisions, Financial Guaranty and Financial Risks. The
municipal and non-municipal lines including credit default swaps, are combined
to represent Financial Guaranty while the Financial Risks division includes
mortgage, credit, title and financial solutions.
The following tables summarize the operating results of the Corporation's
segments:
<TABLE>
<CAPTION>
Three Months Ended March 31, 1999
Reportable Segments
---------------------------------------------------------------------
Municipal Non Mortgage Credit Other Consolidated
Municipal
---------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Origination Written Premiums $20,432 $12,269 $12,128 $9,060 $4,566 $58,455
Canceled Reinsurance 0 9,567 0 0 0 9,567
---------------------------------------------------------------------
Gross Written Premiums 20,432 2,702 12,128 9,060 4,566 48,888
Net Premiums Written 19,411 1,769 12,128 8,950 4,566 46,824
Net Premiums Earned 9,607 6,616 12,786 9,048 4,531 42,588
Net Underwriting Profit and Other
Segment Related Income $4,479 $4,224 $4,880 $1,297 $1,391 $16,271
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
Three Months Ended March 31, 1998
Reportable Segments
---------------------------------------------------------------------
Municipal Non Mortgage Credit Other Consolidated
Municipal
---------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Origination Written Premiums $22,219 $5,994 $20,197 $8,455 $5,262 $62,127
Canceled Reinsurance 0 0 0 0 0 0
---------------------------------------------------------------------
Gross Written Premiums 22,219 5,994 20,197 8,455 5,262 62,127
Net Premiums Written 21,267 5,994 20,120 8,403 5,262 61,046
Net Premiums Earned 9,371 3,921 17,953 7,166 5,320 43,731
Net Underwriting Profit and Other
Segment Related Income $6,957 $2,268 $6,959 $1,932 $1,372 $19,488
</TABLE>
THREE MONTHS ENDED
MARCH 31,
RECONCILIATION TO CONSOLIDATED RESULTS 1999 1998
-------------------------------
Net Segment Income $16,271 $19,488
Investment Income and Net Realized
Gains 17,572 17,045
Other Income 1,595 376
Operating Expense, net (6,350) (5,767)
Interest Expense & Minority Int in Subs (3,279) (3,313)
-------------------------------
Consolidated Income Before Taxes $25,809 $27,829
-------------------------------
5. OTHER
Interest paid for the three months ended March 31, 1999 and 1998 was $.04
million.
<PAGE>
6. SUBSEQUENT EVENTS
In February 1999, ACE Bermuda Insurance Ltd., a subsidiary of ACE Limited,
agreed to invest $75 million in the Company through a purchase of common stock.
The proceeds will be used to augment the surplus of the Company's operating
subsidiaries. Under the stock purchase agreement, as amended, the purchase price
is $16.95. The closing under the purchase agreement is expected to occur prior
to the end of the second quarter of 1999. Closing is contingent on customary
conditions as well as certain regulatory approvals.
On April 28, 1999 Standard & Poor's affirmed the double-A financial strength
ratings of Capital Mortgage Reinsurance Co., and KRE Reinsurance Ltd. and the
single-A plus financial strength rating of Capital Credit Reinsurance Co. In
addition, S&P raised Capital Title Reinsurance Co.'s financial strength rating
to double-A from double-A minus.
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
Capital Re Company (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 has two
principal divisions: financial guaranty and financial risks. The financial
guaranty division is composed of municipal and non-municipal financial guaranty
reinsurance and credit default swaps. The financial risks division is composed
of mortgage guaranty reinsurance, trade credit reinsurance, title reinsurance
and financial solutions. In both of its principal areas of business, 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). The Company believes that its future growth
will be generated through application of its core credit expertise to new
products and markets in its two existing divisions.
The Company participates in its business lines through five wholly-owned
insurance subsidiaries and two joint venture vehicles. Its wholly-owned
subsidiaries are: Capital Reinsurance Company ("Capital Reinsurance"), Capital
Credit Reinsurance Company Ltd. ("Capital Credit"), Capital Mortgage Reinsurance
Company ("Capital Mortgage"), KRE Reinsurance Ltd. ("KRE"), and Capital Title
Reinsurance Company ("Capital Title"). The Company owns a fifty percent economic
interest in ACE Capital Re Ltd. ("ACRE"), a non-consolidated, Bermuda based
joint venture vehicle. The Company's joint venture partner in ACRE is Bermuda
based ACE Bermuda Insurance, Ltd. ("ACE Bermuda"). The Company also owns a fifty
percent interest in Lenders Residential Asset Company LLC (formerly, Lenders
Mortgage Alliance Company LLC) ("LRAC"), a non-consolidated Delaware limited
liability company.
The Company's financial guaranty division conducts its business primarily
through Capital Reinsurance and KRE. 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. Capital Reinsurance
applies a "zero expected loss" standard to its underwriting process, which 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 reinsurance and credit default swap
portfolios. At the same time, consistent with its "zero expected loss"
underwriting policies, Capital Reinsurance has pursued the reinsurance of
investment grade non-municipal debt obligations and directed 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. In addition,
Capital Reinsurance sells municipal and non-municipal credit risk protection on
a facultative basis to a wide variety of counterparties through credit default
swap transactions. Credit default swaps are underwritten in accordance with the
same "zero expected loss" standard that applies to Capital Reinsurance's
municipal and non-municipal financial guaranty business. KRE, a Bermuda based
insurer, also assumes financial guaranty risk, both as a retrocessionaire of
Capital Reinsurance and directly from certain primary financial guaranty
insurers.
The Company's financial risks division conducts its business primarily through
Capital Mortgage, Capital Credit, Capital Title, KRE, ACRE and LRAC. Capital
Mortgage is 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. In order to
optimize capital utilization, the business plan of Capital Mortgage includes the
reinsurance of mortgage guaranty insurance business by KRE, both as a
retrocessionaire of Capital Mortgage and directly from primary mortgage guaranty
insurers.
The Company writes trade credit reinsurance in the U.S. and Europe through
Capital Credit. Trade credit insurance protects those who sell goods and
services on credit terms against default by the purchaser on its payment
obligations. Trade credit reinsurance is a logical extension of the Company's
underwriting focus, relying on 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. Portfolio losses will also be
expected to occur regularly in the Company's trade credit reinsurance business.
Capital Title is a New York domiciled, monoline insurance company formed in 1996
to provide title reinsurance. 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. 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. KRE provides retrocessional support to Capital Title.
The Company's financial solutions business is written through KRE and ACRE. The
financial solutions business is focused on providing highly structured solutions
to problems of financial and risk management through reinsurance, including
credit enhancement, excess of loss and surplus management covers. The principle
target market is life, accident and health insurers and reinsurers, although
specialty property and casualty markets also provide opportunities. The
underwriting process places significant emphasis on actuarial analysis.
Transactions are underwritten to be risk remote or finite, standards that are
compatible with the Company's "zero expected loss" financial guaranty
underwriting standard. Losses can be expected to occur in the Company's existing
and future financial solutions portfolio.
LRAC provides 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. In addition, by providing direct access to
lenders, it generates markets for the sale of the Company's other products.
The Company also owns RGB Underwriting Agencies Ltd. ("RGB"), a Lloyd's of
London ("Lloyd's") managing agency which presently manages four syndicates
operating in the Lloyd's insurance market, and CRC Capital Ltd. ("CRC Capital"),
a corporate name at Lloyd's, which provides underwriting capacity to the
syndicates managed by RGB. The Company has commenced a plan of divestiture of
its Lloyd's operations. Accordingly, commencing in 1998, the Company began
reflecting its participation in Lloyd's as a discontinued operation. All 1999
and prior year figures presented herein reflect Lloyd's as a discontinued
operation.
The Capital Re corporate group also includes Capital Re Solutions Incorporated
(formerly, Capital Re Management Company), 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. Capital Re Financial Products
Company, a newly formed Delaware business Company, and Capital Risk Assurance
Company ("Capital Risk"), a newly formed Maryland surety insurer, intend to
commence business in 1999.
RESULTS OF OPERATIONS
THREE MONTHS ENDED MARCH 31, 1999 VERSUS THREE MONTHS ENDED MARCH 31, 1998
Net income from continuing operations for the three months ended March 31, 1999
decreased 4.4% to $19.4 million from $20.3 million for the same period of 1998.
On a per share basis, basic and diluted net income from continuing operations
decreased to $0.61 and $0.60, respectively, for the three months ended March 31,
1999 from $0.64 and $0.62, respectively, for the same period of 1998.
Net income including losses from discontinued operations for the three months
ended March 31, 1999 decreased to $12.9 million from $19.8 million for the same
period of the prior year. On a per share basis, both basic and diluted net
income including loss from discontinued operations decreased to $0.40 for the
three months ended March 31, 1999 from $0.62 and $0.60, respectively, for the
same period of 1998, or 35.5% and 33.3%, respectively. The decrease in net
income in the first quarter of 1999 was primarily due to a $6.4 million charge
to discontinued operations, net of tax, representing an expected loss on the
ultimate disposition of the Company's Lloyd's operations.
Net operating income from continuing operations (net income from continuing
operations excluding realized gains and losses and foreign exchange gains and
losses) increased 1.0% to $19.4 million for the three months ended March 31,
1999 from $19.3 million for the same period of 1998. On a per share basis, basic
and diluted net operating income from continuing operations was $0.61 and $0.60,
respectively, for the three months ended March 31, 1999 and $0.61 and $0.59,
respectively, for the same period of 1998.
Origination premiums written (i.e., gross premiums written before canceled
reinsurance) decreased 5.8% to $58.5 million for the three months ended March
31, 1999 from $62.1 million for the same period of 1998. Non-municipal
origination premiums written increased to $12.3 million for the three months
ended March 31, 1999 from $6.0 million for the three months ended March 31, 1998
due to a significant increase in premiums written in the credit default swaps
sector of that business. A credit default swap is a transaction whereby one
counterparty pays a periodic fee in fixed basis points on a notional amount in
return for a contingent payment by the other counterparty in the event one or
more defined credit events occurs with respect to one or more third party
reference securities or loans. A credit event is generally defined as a failure
to pay, bankruptcy, cross acceleration (generally accompanied by a failure to
pay), repudiation, restructuring, or similar nonpayment event. Credit default
swap premium grew to $3.8 million for the year ended March 31, 1999 from $0.6
million in the prior year. Mortgage guaranty reinsurance premium decreased to
$12.1 million in the first quarter of 1999 compared to $20.2 million in the
first quarter of 1998 due to an increase in mortgage prepayments caused by lower
interest rates as well as the Company's shift from assuming quota share mortgage
guaranty reinsurance business toward assuming structured excess of loss mortgage
guaranty reinsurance business.
The following table shows origination premiums written by line of business
for the three months ended March 31, 1999 and March 31,1998.
ORIGINATION PREMIUMS WRITTEN
THREE MONTHS ENDED
MARCH 31,
1999 1998
(dollars in millions)
FINANCIAL GUARANTY DIVISION:
MUNICIPAL $20.5 $22.2
NON-MUNICIPAL 12.3 6.0
FINANCIAL RISKS DIVISION:
MORTGAGE 12.1 20.2
CREDIT 9.1 8.5
FINANCIAL SOLUTIONS 2.7 4.1
TITLE 1.8 1.1
--- ---
TOTAL ORIGINATION
PREMIUMS WRITTEN $58.5 $62.1
Net premiums written decreased by 23.3% to $46.8 million for the three months
ended March 31, 1999 from $61.0 million for the same period of 1998. The
decrease is primarily attributable to $9.6 million in canceled reinsurance
resulting from the cancelation of a large non-municipal financial guaranty
transaction. (See discussion of canceled reinsurance in Liquidity and Capital
Resources.) The following table shows net premiums written by line of business
for the three months ended March 31, 1999 and March 31, 1998.
<PAGE>
NET PREMIUMS WRITTEN
THREE MONTHS ENDED
MARCH 31,
1999 1998
(dollars in millions)
FINANCIAL GUARANTY DIVISION:
MUNICIPAL $19.4 $21.3
NON-MUNICIPAL 1.8 6.0
FINANCIAL RISKS DIVISION:
MORTGAGE 12.1 20.1
CREDIT 9.0 8.4
FINANCIAL SOLUTIONS 2.7 4.1
TITLE 1.8 1.1
--- ---
TOTAL NET
PREMIUMS WRITTEN $46.8 $61.0
For the three months ended March 31, 1999, net premiums earned decreased 2.5% to
$42.6 million from $43.7 million for the comparable 1998 period. For the three
months ended March 31, 1999, net refunded earned premium decreased to $3.3
million from $3.6 million for the comparable period of 1998. Excluding the
effects of net refunded municipal earned premium, net premiums earned decreased
to $39.3 million for the three months ended March 31, 1999 from $40.1 million
for the three months ended March 31, 1998. A refunding extinguishes the
Company's reinsurance liability for the refunded obligation and the Company then
recognizes revenue equal to the remaining related deferred premium revenue. The
decrease in net premiums earned is the result of the decrease in mortgage
premiums earned to $12.8 million in the first quarter of 1999 from $17.9 million
in the first quarter of 1998. This decrease was expected due to the shift of
business written to structured excess of loss mortgage guaranty as explained
above. However, net premiums earned from credit default swaps increased to $3.8
million for the three months ended March 31, 1999 from $0.6 million in the prior
year. For both the three months ended March 31, 1999 and 1998, ceded earned
premium was $3.8 million. The following table shows net premiums earned by line
of business for the three months ended March 31, 1999 and March 31, 1998.
NET PREMIUMS EARNED
THREE MONTHS ENDED
MARCH 31,
1999 1998
(dollars in millions)
FINANCIAL GUARANTY DIVISION:
MUNICIPAL $9.6 $9.4
NON-MUNICIPAL 6.6 3.9
FINANCIAL RISKS DIVISION:
MORTGAGE 12.8 17.9
CREDIT 9.1 7.2
FINANCIAL SOLUTIONS 2.7 4.1
TITLE 1.8 1.2
--- ---
TOTAL NET
PREMIUMS EARNED $42.6 $43.7
For the three months ended March 31, 1999, net investment income increased 8.2%
to $17.2 million from $15.9 million for the comparable period of 1998. 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 March 31, 1999. The Company recognized net
realized gains of $0.4 million for the three months ended March 31, 1999
compared to $1.2 million for the same period of 1998.
Loss and loss adjustment expenses increased to $12.8 million from $10.0 million
for the three months ended March 31, 1999 and 1998, respectively. The increase
in losses accrued for the three months ended March 31, 1999 was primarily
attributable to expected loss development in the trade credit line of business,
accretion related to the present value of outstanding reserves for Commercial
Financial Services ("CFS") and Allegheny Health Education and Research
Foundation ("Allegheny") as well as the establishment of a $1.0 million
non-specific loss reserve for the financial guaranty reinsurance lines. The
present value of expected losses for CFS and Allegheny was originally
established in 1998; however, quarterly accretion will be recorded on each loss.
The non-specific reserve was established in response to the recent increase in
loss activity and will be evaluated on a quarterly basis and correlated to
management's overall assessment of its outstanding credit exposures. Ceded
losses for the three months ended March 31, 1999 and 1998 were $42,000 and $0.4
million, respectively. The loss ratio was 30.0% for the three months ended March
31, 1999 compared to 22.8% for the same period of the prior year.
Total expenses, including loss and loss adjustment expenses, increased 7.8% to
$35.9 million for the three months ended March 31, 1999 from $33.3 million for
the same period of 1998. This increase was primarily attributable to the
increase in losses noted above. The expense ratios for the three months ended
March 31, 1999 and 1998 were 45.5% and 46.6%, respectively. The combined ratio,
excluding expenses associated with non-insurance operations, increased to 75.5%
for the three months ended March 31, 1999 from 69.4% for the comparable 1998
period. This increase is a result of the Company's mix of business, which is
producing more business from lines with relatively higher combined ratios than
that of the financial guaranty reinsurance business. In addition, acquisition
costs increased to $27.3 million for three months ended March 31, 1999 from
$18.9 million for the same period last year. This increase was in response to
Capital Reinsurance's downgrade by Moody's Investor's Service, Inc. as explained
below. The downgrade increased the contractual ceding commission on certain
reinsurance contracts by approximately $10.8 million. These commissions were
deferred and will be amortized as the related premium is earned.
For the three months ended March 31, 1999, the total federal tax provision
decreased to $6.4 million from $7.6 million for the same period of 1998. In
addition, the effective tax rate decreased to 24.9% for the three months ended
March 31, 1999 from 27.1% for the same period of 1998. The decrease in the
Company's effective tax rate was due to the increased tax deduction in ceding
commission expense as explained above.
LIQUIDITY AND CAPITAL RESOURCES
The Company 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 1999 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, 1998, or
approximately $32.3 million. For the three months ended March 31, 1999, Capital
Reinsurance paid no dividends to the Company.
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. As of March 31, 1999, Capital
Credit had paid no dividends to the Company.
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 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 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 for Capital Credit
described in the preceding paragraph. To date, Capital Mortgage and KRE have not
declared nor paid any dividends. The maximum dividend payable by Capital
Mortgage during 1999 is $0 since its earned surplus was ($9.2) million as of
December 31, 1998.
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. As of December 31, 1998, Capital Title's maximum
amount payable as a dividend during 1999 is approximately $3.6 million. As of
March 31, 1999 Capital Title has paid no dividends.
In January 1994, the Company 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 Company 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 Company. The Company 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.
In June 1997, Capital Reinsurance invested approximately $10.9 million for a
minority ownership interest in CGA. CGA was formed to provide financial guaranty
insurance ("Policies") of structured securities, including commercial real
estate and asset backed transactions. CGA's initial capitalization consisted of
$150.5 million of paid-in capital and $60 million of committed capital. The
Company's investment consists of an aggregate of $10.0 million in B Preferred
Stock and Common Stock of CGA and $1.0 million in A Preferred Stock. In
connection with its investment in the B Preferred Stock, Capital Reinsurance has
a commitment to invest an additional $7.5 million (the "Capital Commitments") in
CGA to the extent that such investment would be necessary in order for CGA's
operating subsidiary, Commercial Guaranty Assurance, Ltd. ("CG Assurance") to
maintain its triple-A rating from Duff & Phelps Credit Rating Company ("D&P").
Additionally, KRE has a $20 million outstanding excess of loss reinsurance
agreement with CG Assurance which responds when CG Assurance's credit losses
under Policies reach certain catastrophic levels (including Policies issued in
favor of the funding banks described below). Also in June 1997, Capital
Reinsurance invested $0.1 million in St. George Holdings Ltd. ("St. George"). In
response to market value declines in the insured portfolios of CGA and the
resulting potential stress on its triple A rating from Duff & Phelps, the
Corporation performed an analysis to determine the appropriate valuation of its
investment in CGA for the 1998 year-end reporting period. The Corporation
determined the investment in CGA had suffered a permanent impairment as defined
under the guidelines of Generally Accepted Accounting Principles ("GAAP"). Based
on its analysis the Corporation recorded a $7.5 million write-down.
As part of its business plan, through its operating subsidiaries (the "St.
George Investment Subsidiaries"), St. George purchases investment grade,
asset-backed securities to be held to maturity, selectively resold, or
repackaged with CG Assurance Policies and then resold (the "Managed
Portfolios"). The securities purchases are funded by bank loans advanced to the
St. George Investment Subsidiaries. CG Assurance issues Policies to secure
repayment to the funding banks. Under certain of the bank loan agreements, the
St. George Investment Subsidiaries are required to provide additional collateral
to the extent the market values of the Managed Portfolios fall below certain
thresholds. Failure to satisfy the collateral requirements may result in the
liquidation of the Managed Portfolios and, to the extent that proceeds from
liquidation are insufficient to repay the bank loans, the St. George Investment
Subsidiaries must pay any shortfall. If the St. George Investment Subsidiaries
cannot pay the amount then due, CG Assurance is obligated to pay such amounts
under its Policies issued in favor of the funding banks.
Due to unprecedented market conditions relating to credit spreads during the
third and fourth quarters of 1998, the market values of the Managed Portfolios
declined. As of September 30, 1998, the market values of the Managed Portfolios
with collateral threshold triggers were not then below the collateral threshold
triggers. Subsequent to September 30, market values further declined through
mid-October and, as of October 18, 1998, CG Assurance's management prepared an
estimate of market values of the Managed Portfolios, which indicated that if
such market values were validated at the October 30, 1998 valuation date
provided for in the bank loan agreements, substantial collateral would be
required in the case of the Managed Portfolios subject to the collateral
threshold triggers. As a result, certain institutional investors in CGA provided
credit enhancements on various securities in the Managed Portfolios in the
aggregate principal amount of $382 million. Of that aggregate amount, Capital
Reinsurance credit enhanced $74.6 million of investment-grade asset-backed
securities. Capital Reinsurance also credit enhanced the two other institutional
investors that provided credit enhancement on the securities in the Managed
Portfolios. Capital Reinsurance was paid a market rate premium for providing the
reinsurance support. Market values of the Managed Portfolios have improved since
October and, currently, the market values of the Managed Portfolios are above
the relevant collateral threshold triggers. Because market values of the Managed
Portfolios have improved since October of 1998 and CG Assurance's triple-A
rating was affirmed by D&P, the above mentioned transaction was canceled in
March 1999. See discussion of canceled reinsurance under "Results of
Operations."
For the three months ended March 31, 1999, common dividends were declared and
paid in the amount of $1.3 million or $0.04 per share.
Cash flows from operations for the three months ended March 31, 1999 and 1998,
consisting of reinsurance premiums collected net of expenses, investment income
and income taxes, were $37.6 million and $44.4 million, respectively. The
Company believes that current levels of cash flow from operations provide the
Company with sufficient liquidity to meet its operating needs. The Company'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 March 31, 1999, cash and investments were approximately $1.21 billion, an
increase of $24.6 million, or 2.1%, from $1.18 billion at December 31, 1998. In
managing its investment portfolio, the Company places a high priority on quality
and liquidity. As of March 31, 1999, the entire investment portfolio was
invested in highly rated fixed income securities.
At March 31, 1999, approximately $218.0 million, or 18.0%, of the Company's
investment portfolio was composed of mortgage-backed securities ("MBS"). Of the
MBS portfolio, approximately $184.1 million, or 84.4%, is backed by agencies or
entities sponsored by the U.S. government as to the full amount of principal and
interest. As of March 31, 1999, 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 March 31, 1999, $3.6 million, or approximately 1.7%, 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, $214.4 million, or 98.3%, 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 March 31, 1999, 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.
Capital Reinsurance is party to a credit facility with Deutsche Bank AG (the "DB
Credit Facility") pursuant to which Deutsche Bank AG provides up to $100.0
million specifically designed to provide rating agency qualified capital to
further support Capital Reinsurance's claims-paying resources. This agreement
expires January 27, 2006. The Company has not borrowed under the DB Credit
Facility.
In addition, on August 20, 1996, the Company 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 Company utilized $16 million of the Chase
Facility for purposes of paying subordinated notes that came due. Interest on
the bank note issued under the Chase Facility is payable quarterly based upon
the Company's chosen interest rate option under the terms of the Chase Facility.
In November 1996, the Company utilized the remaining $9 million of the Chase
Facility for purposes of acquiring RGB.
On March 10, 1999, Moody's Investors Service, Inc. ("Moody's") announced that it
had downgraded the financial strength rating of Capital Reinsurance to Aa2 from
Aaa. This action ended a review process that began on November 5, 1998. Moody's
cited increased competition in the monoline financial guaranty reinsurance
industry, an increased risk profile in business assumed and rising operating
leverage as reasons for the downgrade. Under certain of its reinsurance
agreements with two of its financial guaranty ceding companies, Capital
Reinsurance has agreed to increase the ceding commission payable under such
agreements as a result of the rating action by Moody's. The increase will apply
to in-force and future business ceded by those companies. The Company accrued
$10.8 million in additional ceding commission in the first quarter of 1999
related to the in-force business subject to this agreement. The commission will
be amortized as the related reinsurance premium is earned. The reinsurance
agreements with the two ceding companies also give those companies an option to
reassume business previously ceded to Capital Reinsurance upon certain adverse
rating actions; however, those options to fully reassume will not be triggered
by Capital Reinsurance's March 10th downgrade.
Additionally, one of the ceding companies may reassume a minor portion of its
previously ceded business based on this rating action alone; however, that
company has not indicated that it will exercise the option.
On December 16, 1998, Standard & Poor's ("S&P") affirmed the triple A financial
strength rating of Capital Reinsurance. In addition, on April 28, 1999 S&P
affirmed the financial strength ratings of Capital Mortgage (double "A"), KRE
(double "A") and Capital Credit (single "A" plus). S&P also upgraded the
financial strength rating of Capital Title from double "A" minus to double "A".
In February 1999, ACE Bermuda Insurance Ltd., a subsidiary of ACE Limited,
agreed to invest $75 million in the Company through a purchase of common stock.
The proceeds will be used to augment the surplus of the Company's operating
subsidiaries. Under the stock purchase agreement, as amended, the purchase price
is $16.95. The closing under the purchase agreement is expected to occur prior
to the end of the second quarter of 1999. Closing is contingent on customary
conditions as well as certain regulatory approvals.
MARKET RISK
The main objectives in managing the investment portfolios of the Company and its
operating subsidiaries are to maximize after-tax investment income and total
investment returns while minimizing credit risks in order to provide maximum
support to the reinsurance underwriting operations. Investment strategies are
developed based on many factors including underwriting results and the Company's
resulting tax position, regulatory requirements, fluctuations in interest rates
and consideration of other market risks. Investment decisions are managed by
outside investment professionals under discretionary investment management
agreements and based on guidelines established by management and approved by the
board of directors.
Market risk represents the potential for loss due to adverse changes in the fair
value of financial instruments. The market risks related to financial
instruments of the Company and its operating subsidiaries primarily relate to
the investment portfolio, which exposes the Company to risks related to interest
rates and, to a lesser extent, credit quality and prepayment. Analytical tools
and monitoring systems are in place to assess each of these elements of market
risk.
Interest rate risk is the price sensitivity of a fixed income security to
changes in interest rates. Management views these potential changes in price
within the overall context of asset and liability management. Wherever possible,
the duration of asset and liability portfolios are matched. However, the
duration of most of the asset portfolio is managed according to the level of
expected return and volatility deemed tolerable by management. The duration of
the liability portfolio does not lend itself to active duration management due
to the low frequency, high severity losses in a majority of the Company's
reinsured businesses. Other factors are considered in determining the duration
of the asset portfolio, which the Company believes mitigates the overall effect
of interest risk for the Company.
The following table provides information about the Company's fixed maturity
investments at March 31, 1999 that are sensitive to changes in interest rates.
The table presents cash flows of principal amounts and related weighted average
interest rates by expected maturity dates. The cash flows are based on the
earlier of the call date or the maturity date or, for mortgage-backed
securities, expected payment patterns. Actual cash flows could differ from the
expected amounts.
<TABLE>
<CAPTION>
LONG-TERM FIXED MATURITIES
EXPECTED CASH FLOWS OF PRINCIPAL AMOUNTS
(DOLLARS IN MILLIONS)
Amortized Market
1999 2000 2001 2002 2003 Thereafter Cost Value
---- ---- ---- ---- ---- ---------- ---- -----
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Tax-exempt $0.2 $1.8 $4.1 $6.3 $18.3 $464.8 $495.5 $529.1
Average Interest Rate 7.9% 5.7% 7.5% 7.3% 7.2% 5.7% -- --
Taxable-other than mortgage-backed 12.2 23.4 47.4 45.0 24.1 198.7 350.8 352.0
securities
Average Interest Rate 6.7% 6.9% 7.7% 6.6% 6.3% 5.5% -- --
Mortgage-backed securities 21.9 26.2 23.6 20.5 20.5 103.4 216.1 218.0
Average Interest Rate 7.0% 7.0% 6.9% 6.9% 6.9% 6.8% -- --
---- ---- ---- ---- ---- ----
Total $34.3 $51.4 $75.1 $71.8 $62.9 $766.9 $1,062.4 $1,099.1
----- ----- ----- ----- ----- ------ -------- --------
</TABLE>
The Company and its operating subsidiaries have consistently invested in high
quality marketable securities. As a result, the Company believes that it has
minimal credit quality risk. Taxable bonds in the Company's domestic portfolio
consist of U.S. Treasury, government agency, mortgage-backed and corporate
securities. At March 31, 1999, approximately 18.1% of taxable bonds were issued
by the U.S. Treasury or U.S. government agencies and approximately 70.0% were
rated AA or better by Moody's or S&P. Of the tax exempt bonds, approximately
99.0% were rated AA or better with more than 91.0% rated AAA. Less than 1.1% of
the Company's bond portfolio was below investment grade at March 31, 1999. At
March 31, 1999, both taxable and tax exempt bonds had a weighted average
maturity of approximately 8.4 years.
The Company's taxable bond portfolio includes mortgage-backed securities, which
comprised 38.3% of the portfolio at March 31, 1999. Prepayment risk refers to
the changes in prepayment patterns that can either shorten or lengthen the
expected timing of the principal repayments and thus the average life and the
effective yield of a security. Such risk exists primarily within the Company's
portfolio of mortgage-backed securities. The Company invests primarily in those
classes of mortgage-backed securities that are less subject to prepayment risk.
All of the above risks are monitored on an ongoing basis. A combination of
in-house systems and proprietary models and externally licensed software are
used to analyze individual securities as well as each portfolio. These tools
provide management with information to assist them in the evaluation of the
market risks of the portfolio.
THE YEAR 2000
The Company is actively pursuing its Year 2000 analysis and preparation. The
Year 2000 issue involves potential complications related to computer systems,
machinery and electronics that contain computer code, whether in software or
embedded within microchips, that recognize years in two digit code, e.g. "98"
for the year 1998. Software or microchips that recognize the Year 2000 as "00"
or any year thereafter in its two digit equivalent, threatens date sensitive
calculations by potentially misapplying the date (e.g. "00" could be applied as
1900 rather than 2000). Any coding that causes a date recognition error of this
sort is commonly referred to as a Year 2000 bug.
STATE OF READINESS
The Company has assembled a team consisting of officers and employees of the
finance and information systems departments to oversee the Company's readiness
for the Year 2000. The group has already completed the first phase of its
analysis in which a comprehensive list of all the Company's own information
technology systems and general technology was prepared. Additionally, the
Company's clients and vendors were reviewed and a listing was prepared of those
with information systems or other technology upon which the Company may rely and
those which may be affected by the Year 2000 bug. The Company has made inquiries
as to Year 2000 readiness with these clients and vendors and has received
responses from a majority of them. It is currently evaluating these responses.
However, all of the Company's ceding companies that have thus far responded
report that they expected to be Year 2000 compliant by mid 1999. The Company is
now performing testing and remediation, as necessary, on its information
technology systems, its general systems and any other technology that may be
affected by the Year 2000 bug. This process is not yet complete, but is expected
to be completed by mid-1999.
The following is a summary of the Company's internal readiness status:
o IN-HOUSE APPLICATIONS: All key in-house applications have been
tested and are Year 2000 compliant.
o ACCOUNTING SOFTWARE: Vendors for the major accounting software
packages used by the Company have stated that the software
versions the Company uses are Year 2000 compliant.
o ADMINISTRATION/HUMAN RESOURCES; OPERATING SYSTEM SOFTWARE;
NETWORK/LAN UTILITIES; DESKTOP HARDWARE: Ninety-five percent of
these applications are Year 2000 compliant.
o GENERAL OFFICE SERVICES: These systems will all be upgraded by
mid-1999.
The Company has not had to defer any of its expected information technology or
other technology installations, updates or enhancements in order to accommodate
its Year 2000 review and remediation work.
COSTS
Due to the youthfulness of the Company's information technology and other
systems, testing and remediation have been fairly uncomplicated. Moreover, none
of the Company's technology is mainframe computer based. Mainframes
traditionally use older coding methodologies and, thus, are more likely to be
double digit dated coded. No external consultants have been retained. Internal
information technology personnel have overseen and implemented the testing and
remediation of the systems and technology. The amount of additional time
allocable to employees' efforts has been nominal. All system upgrade costs
incurred would have been incurred by the Company as part of routine software
upgrades and all patches have been provided without any material cost to the
Company. The Company does not expect any material additional costs and expects
that, including the cost allocation of internal personnel, the overall testing
and remediation will be less than $50,000 as originally anticipated. The costs
are being funded through operating cash flows and will be expensed as incurred.
THE RISK OF THE COMPANY'S YEAR 2000 ISSUES
A Year 2000 bug issue may manifest itself as (i) a failure of the Company's
software, systems and general technology, (ii) a failure of a client's or
vendor's software or systems which would impact the Company, and (iii) insurance
claims against the Company due to Year 2000 issues. Management believes that the
likelihood that a failure of the Company's software and systems would have a
material effect on the business of the Company is minimal. The information
technology and other systems are not critical to the carrying-on of the
Company's business. Additionally, all critical accounting, financial reporting
and human resources functions can be maintained on a manual basis for a period
of time without materially impeding the operations of the Company. Similarly, a
failure of clients and vendors to properly provide data or services will also
not materially affect the Company's ability to continue its operations. Such a
failure would likely be temporary and could be compensated for in the short-term
by using manual alternatives to tracking business with our clients or vendors.
Reinsurance losses pose the most reasonably likely worst case scenario for the
Company arising out of Year 2000 bugs. The issue would originate with a default
on debt service obligations of bond issuers due to the issuer's own Year 2000
bug difficulties. In the event of such a default, the Company's clients, the
ceding companies, will be required to make debt service payments on behalf of
the defaulting issuers. The Company will have to make prompt payment to its
clients for its agreed upon portion of such losses. Such defaults by bond
issuers would generally be of a technical nature, arising out of temporary
inabilities to process payments or calculate payment amounts. Additionally, the
defaulted debt service obligations would generally not require our clients, the
ceding insurers, to make debt service payments on behalf of the issuers for a
prolonged period. Once issuers or payment agents have cured any errors, they
would resume debt service payment and reimburse the insurers for all payments
made. Hence, the reasonable worst case scenario for the Company under such
circumstances would involve liquidity pressure which should ease quickly. There
is no way to quantify the potential exposure under this scenario as there has
never been any event similar to the Year 2000. Consequently, it is difficult to
make assumptions based on the Company's business. However, as the Company's
operating units affected by such an occurrence already meet the rating agency
stress test requirements designed to simulate depression-era conditions, the
Company believes it can withstand temporary defaults of that magnitude based on
the Year 2000 bug.
CONTINGENCY PLANS
The Company does not have a prescribed contingency plan relative to Year 2000
bug issues. The Company does not predict that a failure of its information
technology systems will materially affect daily operations or have an immediate
impact on the Company's ability to conduct business. All internal financial
reporting of the Company may be conducted by hand. As for any failure of a bond
issuer that has been reinsured by the Company, the Company expects to handle
such matters in the ordinary course of business. As the Company is a reinsurer,
payments are requested in bulk by the Company's ceding insurers, and payment of
reinsurance proceeds would be made in bulk. The Company is not required to make
payment to individual bond obligees. Ultimately, all recovery efforts in the
event of any Year 2000 bug related event can either be handled internally, or
would require the intervention of hardware, software or other technology
vendors. The Company maintains a list of the appropriate contacts at such
vendors in the event such a need arises.
<PAGE>
PART II - OTHER INFORMATION
ITEM 3 - EXHIBITS AND REPORTS ON FORM 8-K
(A) THE FOLLOWING IS ANNEXED AS AN EXHIBIT:
EXHIBIT
NUMBER DESCRIPTION
------- -----------
11 STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS (UNAUDITED)
(B) REPORTS ON FORM 8-K: NONE
<PAGE>
INDEX TO EXHIBITS
EXHIBIT
NUMBER DESCRIPTION PAGE
- -------- ------------ ----
11 STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS (UNAUDITED) 32
<PAGE>
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THE
REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE
UNDERSIGNED THEREUNTO DULY AUTHORIZED.
CAPITAL RE CORPORATION
DATE: MAY 14, 1999 BY /S/ DAVID A. BUZEN
------------------
DAVID A. BUZEN
EXECUTIVE VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER
DATE: MAY 14, 1999 BY /S/ ALAN S. ROSEMAN
-------------------
ALAN S. ROSEMAN
EXECUTIVE VICE PRESIDENT,
GENERAL COUNSEL AND SECRETARY
<TABLE>
<CAPTION>
CAPITAL RE CORPORATION AND SUBSIDIARIES
Exhibit 11 Statement Re: Computation of Per Share Earnings
(Dollars in thousands except per share amounts)
Three Months Ended
March 31,
--------------------------------
1999 1998
--------------------------------
<S> <C> <C>
Net Income from Continuing Operations 19,379 20,276
Net Income 12,936 19,796
Basic weighted average shares outstanding during the period 32,009 31,834
Potentially dilutive employee stock options 334 911
--------------------------------
Diluted weighted average shares outstanding during the period 32,343 32,745
================================
Basic earnings per common share from continuing operations $0.61 $0.64
================================
Diluted earnings per common share from continuing operations $0.60 $0.62
================================
Basic earnings per common share $0.40 $0.62
================================
Diluted earnings per common share $0.40 $0.60
================================
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 7
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-mos
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> MAR-31-1999
<DEBT-HELD-FOR-SALE> 1,190,956
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 0
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 1,190,956
<CASH> 18,619
<RECOVER-REINSURE> 3,334
<DEFERRED-ACQUISITION> 149,967
<TOTAL-ASSETS> 1,473,621
<POLICY-LOSSES> 93,583
<UNEARNED-PREMIUMS> 408,401
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 99,866
75,000
0
<COMMON> 325
<OTHER-SE> 614,995
<TOTAL-LIABILITY-AND-EQUITY> 1,529,466
46,824
<INVESTMENT-INCOME> 17,164
<INVESTMENT-GAINS> 408
<OTHER-INCOME> 1,595
<BENEFITS> 12,793
<UNDERWRITING-AMORTIZATION> 12,330
<UNDERWRITING-OTHER> 3,298
<INCOME-PRETAX> 25,809
<INCOME-TAX> 6,430
<INCOME-CONTINUING> 19,379
<DISCONTINUED> (6,443)
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 12,936
<EPS-PRIMARY> 0.40
<EPS-DILUTED> 0.40
<RESERVE-OPEN> 84,553
<PROVISION-CURRENT> 2,478
<PROVISION-PRIOR> 7,732
<PAYMENTS-CURRENT> 5
<PAYMENTS-PRIOR> 4,035
<RESERVE-CLOSE> 90,723
<CUMULATIVE-DEFICIENCY> 0<F1>
<FN>
Not Applicable for mortgage guaranty and specialty reinsurer
</FN>
</TABLE>
