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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 0-20995
EXSTAR FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
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Delaware 77-0321240
(State of Incorporation) (I.R.S. Employer ID No.)
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2029 Village Lane, Solvang, California 93463-2275
(Address of principal executive offices) (Zip Code)
(805) 688-8013
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.01 par value
(Title of Class)
Indicate by check mark whether the registrant: (1) has filed 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 __
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
amendment to this Form 10-K. ____.
The aggregate market value of the registrant's voting stock held by
non-affiliates of the registrant, based upon the last reported sale price of
the registrant's Common Stock on March 31, 1998.
$4,102,500
The number of shares outstanding of the registrant's Common Stock, par
value $0.01, as of March 31, 1998, was 4,961,500.
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EXSTAR FINANCIAL CORPORATION
INDEX TO EXHIBITS
EXHIBITS
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10.125 Lease dated as of April 3, 1998, by and between Alpine Insurance Company and Rob Rosenberry.
27 Financial Data Schedule
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ITEM 1. BUSINESS
OVERVIEW OF CURRENT BUSINESS OPERATIONS
This 1997 Form 10-K contains certain "forward-looking statements" (within
the meaning of the Private Securities Litigation Reform Act of 1995) that
involve substantial risks and uncertainties. When used in this Form 10-K, the
words "anticipate," "believe," "estimate" and "expect" and similar expressions
as they relate to the "Company" (as hereinafter defined) and its management are
intended to identify such forward-looking statements. A number of important
factors could cause the actual results, performance or achievements of the
Company for 1998 and beyond to differ materially from those expressed in such
forward-looking statements. (See " -- Proposed Future Operations and
Organizational Changes; Relationship with Frontier," " -- Relationship with
TCO" and "Management's Discussion and Analysis of Financial Condition and
Results of Operations" -- Item 7.)
Exstar Financial Corporation ("Exstar" if referring to the parent company,
or the "Company" if referring to Exstar and its direct and indirect
subsidiaries) is a holding company which owns (i) Alpine Insurance Company, an
Illinois property and casualty insurance company ("Alpine"), (ii) WESTCAP
Insurance Services, Inc., a California corporation which produces and
underwrites property and casualty insurance business ("WESTCAP"), and (iii)
Claims Control Corporation, an Illinois corporation which manages insurance
claims ("Claims Control"). Prior to August 1996, the Company was engaged
principally in the "direct" issuance (e.g., issuance of insurance policies
directly to insureds) of casualty insurance on a surplus lines basis. As a
result of events occurring in late 1995 and in 1996, however, including A. M.
Best Company ("Best") rating downgrades and regulatory restrictions, the
Company ceased issuing direct insurance in August 1996. Since then the
Company's business activities have consisted principally of producing surplus
lines casualty insurance business for a group of insurance companies
unaffiliated with the Company, managing claims arising out of such insurance
business and assuming reinsurance from the unaffiliated insurance companies
principally on the business produced for them by the Company. The Company also
is running off the direct insurance Alpine and its former parent company,
Transco Syndicate #1 Ltd. ("Syndicate"), wrote prior to August 1996. The
Syndicate previously was a syndicate member of the Illinois Insurance Exchange,
now renamed INEX Insurance Exchange ("IIE"). In late 1996, the Syndicate's
liabilities and assets (other than the stock of Alpine) were transferred to
Alpine, and it ceased functioning as an insurance company. (See " --
Regulation -- Combination of the Syndicate with Alpine.")
WESTCAP became a subsidiary of Exstar effective October 1, 1997. It was
acquired on that date from Peter J. O'Shaughnessy, the Company's chief
executive officer and principal stockholder, for nominal consideration. Upon
WESTCAP's acquisition by Exstar, WESTCAP entered into Limited Agency Agreements
("Limited Agency Agreements") with three insurance company subsidiaries of
Frontier Insurance Group, Inc., a publicly held Delaware insurance holding
company ("Frontier"). These Frontier insurance companies ("Frontier
Companies") are United Capitol Insurance Company, an Illinois insurance company
with "statutory policyholders' surplus" (statutory policyholders' surplus
generally is net worth determined in accordance with insurance regulatory
accounting requirements) at December 31, 1997 of $60.1 million ("UCIC"),
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Frontier Pacific Insurance Company, a California insurance company with
statutory policyholders' surplus at December 31, 1997, of $31.2 million
("FPIC"), and Frontier Insurance Company, a New York insurance company with
statutory policyholders' surplus at December 31, 1997, of $276.4 million
("FIC"). FIC is licensed to issue admitted insurance coverages in all 50
states and, together, FPIC and UCIC are authorized to issue surplus lines
insurance coverage in all 50 states. Each of the Frontier Companies has an A-
(Excellent) Best rating.
Pursuant to the Limited Agency Agreements, WESTCAP produces insurance
business for the Frontier Companies generally through licensed subproducers
unaffiliated with the Company. For its services under the Limited Agency
Agreements, WESTCAP generally receives an aggregate commission of 27.5% of the
gross written premium collected by it on business placed with the Frontier
Companies. WESTCAP retains approximately 40% of this aggregate commission and
pays the balance of approximately 60% of the aggregate commission to
subproducers of WESTCAP. The Limited Agency Agreements are terminable by
either party upon 90 days' prior written notice to the other party, as of the
end of any calendar quarter. WESTCAP is not currently producing or
underwriting insurance business for any insurer or other entity not affiliated
with the Frontier Companies. The business currently being produced for the
Frontier Companies by WESTCAP is similar to the insurance business previously
produced for the Company by TCO Insurance Services, Inc. ("TCO-IL") before
early 1996, and produced for the Frontier Companies by Transre Insurance
Services ("Transre") and Exstar E&S Insurance Services ("E&S") from June 1996
through September 1997. TCO-IL, Transre and E&S are affiliated with the Company
through the common controlling ownership of Mr. O'Shaughnessy, but are not
subsidiaries of Exstar. Upon termination of the Frontier Companies' prior
contracts with Transre and E&S, the individuals performing services for E&S
became employees of WESTCAP.
Claims Control also became a subsidiary of Exstar effective October 1,
1997. It was acquired on that date for nominal consideration from TCO
Insurance Services, a California corporation indirectly wholly owned by Mr.
O'Shaughnessy ("TCO-CA"). Pursuant to Claim Service Agreements ("Claim Service
Agreements") entered into by Claims Control with the Frontier Companies, Claims
Control handles on behalf of the Frontier Companies claims arising out of (i)
insurance business currently produced through WESTCAP, (ii) since October 1,
1997, insurance business produced directly for the Frontier Companies through
Trinity E&S Insurance Services, Inc., a California corporation which is
majority owned by Mr. O'Shaughnessy and which acts as a general agent
("Trinity"), and (iii) insurance business previously produced for the Frontier
Companies through Transre and E&S. For such claims handling services, the
Frontier Companies compensate Claims Control at an hourly rate calculated on a
cost plus basis with respect to the Claims Control employees performing
services for the Frontier Companies. The Claim Service Agreements have
five-year terms and are terminable prior to the end of the terms by either
party on 60 days' prior notice to the other party. Claims Control also handles
claims under policies directly issued by the Company prior to August 1996.
Claims Control does not currently receive compensation for handling claims from
any insurer or other entity not affiliated with the Frontier Companies or the
Company.
As indicated above, Alpine ceased issuing direct insurance in 1996. In
March 1998,
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because of its reduced statutory policyholders' surplus, risk-based capital and
financial condition generally, Alpine voluntarily withdrew as an authorized
surplus lines insurer in each jurisdiction in which it then remained authorized
(Alpine had previously lost its surplus lines authority to write direct
business in a number of jurisdictions, including California, that had accounted
for most of Alpine's direct premium revenues). As an alternative to issuing
direct insurance, Alpine entered into a casualty quota share reinsurance
agreement with UCIC effective April 1, 1997 ("UCIC Quota Share Arrangement").
Under the UCIC Quota Share Arrangement, UCIC ceded to Alpine, and Alpine
assumed, a 30% quota share portion of the net insurance premium produced for
UCIC by Transre and E&S (after the cost of other reinsurance, which
historically has been approximately 5% of total premium). In June 1997, Alpine
also entered into a reinsurance arrangement with FPIC ("FPIC Quota Share
Arrangement") under which FPIC ceded to Alpine, and Alpine assumed, a 50% quota
share portion of certain Texas alternative workers' compensation-related
premium produced for FPIC by Transre and E&S (the FPIC Quota Share Arrangement
and the UCIC Quota Share Arrangement, as amended and expanded, collectively are
referred to as the "Quota Share Arrangement"). Effective October 1, 1997, the
Quota Share Arrangement was amended (i) to add FIC as a ceding insurer, (ii) to
cover business produced for the Frontier Companies through WESTCAP (Transre and
E&S ceased producing business for the Frontier Companies effective October 1,
1997) and certain additional business not produced through WESTCAP, and (iii)
with respect to lines of business for which Alpine's participation was not
already 50%, to increase the quota share portion of net insurance premium
assumed by Alpine to 50% on policies written on or after October 1, 1997.
Alpine pays the Frontier Companies a ceding commission generally of 30% of the
premium ceded to Alpine in connection with the Quota Share Arrangement.
The term of the Quota Share Arrangement continues through December 31,
1999. It is subject to earlier termination under a variety of circumstances
set forth in the Quota Share Arrangement, including termination of the Limited
Agency Agreements and any failure by Alpine to maintain statutory
policyholders' surplus of at least $10 million continuing for a period of 90
days or more.
Although Alpine's statutory policyholders' surplus at December 31, 1997
was $5.3 million, Alpine has received from Frontier a waiver of the
policyholders' surplus condition. (Alpine's statutory annual statement for
1997 required to be filed with insurance regulatory authorities currently
reflects statutory policyholders' surplus of $6.8 million at December 31, 1997.
The $5.3 million represents Alpine's statutory policyholders' surplus after
elimination of certain subrogation recoverables which Alpine currently expects
will not be included in Alpine's audited statutory policyholders' surplus at
December 31, 1997.) Absent any further significant decline in Alpine's
policyholders' surplus, the Company anticipates the Frontier Companies will not
terminate the Quota Share Arrangement because of the potential sale of Alpine
to Frontier and because of the generally positive relationship the Company has
with Frontier and the profitability of the business the Company produces for
Frontier. (See " -- Proposed Future Operations and Operational Changes;
Relationship with Frontier" and " -- Regulation.")
To satisfy certain regulatory and statutory accounting requirements
applicable to, and the business wishes of, the Frontier Companies, the Quota
Share Arrangement has been structured on
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a "funds held" basis. In this regard, portions of premiums otherwise payable
to Alpine generally may be retained by the Frontier Companies until such times
as underwriting profits on the business, if any, are determined from time to
time by the parties. In March 1998, an understanding was reached between the
Company and the Frontier Companies whereby some of the funds held by the
Frontier Companies would be released to Alpine. Initially $1.0 million was
released to Alpine in March 1998 and an additional $1.0 million was released to
Alpine in April 1998. An additional $1.0 million is expected to be released at
the beginning of May 1998. Management expects (but has no understanding with
Frontier) that the Company may be able to obtain the release of some additional
funds held on an accelerated basis if needed by Alpine. Investment income on
the funds held is periodically paid to Alpine. While the funds held
arrangement does not impact the Company's net income, it does reduce the cash
available to Alpine to satisfy Alpine's current liabilities and obligations
(other than loss and loss adjustment expense and return premium liabilities
relating to the premium assumed by Alpine under the Quota Share Arrangement
which are generally to be satisfied out of the funds held). (See "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Liquidity and Capital Resources" -- Item 7.)
The Company is in the process of negotiating revised reinsurance, limited
agency, claim service and other arrangements with the Frontier Companies in
connection with a potential sale of Alpine to Frontier (see " -- Proposed
Future Operations and Organizational Changes; Relationship with Frontier") and
expects the negotiations will result in long-term agreements with the Frontier
Companies. There can be no assurance, however, that the negotiations will
succeed.
For services rendered in negotiating and securing the Quota Share
Arrangement, Alpine pays a commission to TCO Holdings, Inc., a corporation
wholly owned by Mr. O'Shaughnessy ("TCO Holdings"), generally in the amount of
3.75% of the gross premiums assumed by Alpine pursuant to the Quota Share
Arrangement. Such commission is payable pursuant to a Service Agreement
between Alpine and TCO Holdings effective April 1, 1997 ("Service Agreement").
The commission can be used only to pay off or reduce certain obligations of TCO
Holdings to third parties unaffiliated with the Company. The maximum aggregate
amount of such commission payable by Alpine to TCO Holdings is limited to $4.5
million, and the commission is payable only to the extent Alpine actually
receives cash pursuant to the Quota Share Arrangement. (See " -- Investments.")
Virtually all of the Company's financial transactions, organizational
relationships and business methods (and the changes in such relationships and
methods) since mid-1996 have been subject to the review and approval of the
Illinois Department of Insurance ("Illinois DOI"), the principal regulator of
Alpine, pursuant to an order issued by the Illinois DOI in July 1996 ("Illinois
Order"). The Illinois Order subjects Alpine and its officers, directors and
affiliates to a higher level of regulatory scrutiny than that to which they
would be subject absent the Illinois Order, and that to which most other
insurers are subject. The Company has no understanding with the Illinois DOI
as to how long the Illinois Order will continue in effect or if, when or under
what circumstances and to what extent the current level of oversight may be
modified.
The Company's ability to continue to operate as it currently is operating
depends on
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generating sufficient revenues and cash flows from the Company's risk-bearing
activities, currently consisting of Alpine's operations; the Company's
insurance producing activities, currently consisting of WESTCAP's operations;
and the Company's claims servicing activities, currently consisting of Claims
Control's operations.
In terms of financial resources, Alpine's activities are the most
significant of the Company's current operations. Most of the Company's cash
flow to fund operations derives from Alpine's existing assets, investment
income on such assets and premium assumed pursuant to the Quota Share
Arrangement. Alpine, however, is relatively close to several regulatory
thresholds that, if crossed, could reduce Alpine's role in the Company's
operations. Alpine's statutory policyholders' surplus of $5.3 million at
December 31, 1997, was $300,000 above the minimum statutory policyholders'
surplus required of an Illinois reinsurer, $2.1 million above the mandatory
control level risk-based capital for Alpine and $3.8 million above the minimum
statutory policyholders' surplus required of an Illinois insurer that writes
the lines of insurance reinsured by Alpine. Additionally, Alpine's liquid
assets at December 31, 1997, may have been insufficient (depending on
interpretation of the relevant statutory provision), if the provision had been
applicable on such date, to satisfy a statutory "reserve requirement" adopted
by Illinois in 1997 to be applicable in 1998, and in any event a significant
amount of Alpine's assets are restricted for specific purposes. (See " --
Regulation.")
The Company currently expects risk-bearing activities will continue to be
a significant part of its operations in 1998 and later years. First, the
Company is negotiating a potential sale of Alpine to Frontier, and if the
negotiations are successful, expects to continue the Company's risk-bearing
activities through formation of a Cayman Islands insurance company that would
assume premium from the Frontier Companies pursuant to an arrangement similar
to the Quota Share Arrangement. This would provide the Company continuing
investment income and premium revenue, as well as cash flow, in an insurance
regulatory environment relatively more flexible than the environment in which
Alpine operates. The sale of Alpine also would generate additional cash for the
Company beyond the cash that would be required to be contributed to the Cayman
Islands insurance company. (See " -- Proposed Future Operations and
Organizational Changes; Relationship with Frontier.")
Second, even if the sale of Alpine is not consummated, Alpine met the
minimum regulatory requirements it was required to meet at December 31, 1997,
to continue to operate. Alpine's financial condition and regulatory compliance
position, additionally, will improve if the $6.6 million Schedule P penalty
drops off as expected over time ($2.5 million relating to the 1995 accident
year will drop off in 1998 if the loss ratio for Alpine's 1995 accident year
remains at the level estimated as of December 31, 1997 -- see "-- Losses and
Loss Adjustment Expenses"). Exstar, additionally, currently has the ability to
contribute certain real estate assets with a statutory net asset value of up to
$1.7 million at December 31, 1997, to Alpine if necessary to increase Alpine's
statutory policyholders' surplus. Alpine's statutory policyholders' surplus,
liquidity and financial condition generally also are expected to benefit from
continuation of the Quota Share Arrangement, entered into on April 1, 1997.
Frontier also has been willing to release under the Quota Share Arrangement a
portion of the funds held it otherwise would have been entitled to retain under
the Quota Share Arrangement, $2.0 million of which was released by early April
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1998, and has agreed to release another $1.0 million in early May. Alpine may
have difficulty meeting the "reserve requirement" in 1998 depending on how the
new statutory provision ultimately is interpreted, but believes, based on
discussions with the Illinois DOI, that it may be able to comply sufficiently
with the requirement to avoid any increase in the Illinois DOI's current level
of oversight.
Notwithstanding the foregoing, Alpine's continued operations depend on
continuation of the Quota Share Arrangement, or a replacement arrangement
similarly or more beneficial to Alpine, and Alpine's continuing satisfaction of
applicable regulatory requirements. The Company currently believes, based on
the generally positive relationship the Company has with Frontier and the
profitability of the business the Company has produced and in the future has
the potential to produce for Frontier, that the Quota Share Arrangement will
continue generally on its current terms for the foreseeable future, even if
Alpine is not sold to Frontier.
Alpine's continuing satisfaction of applicable regulatory requirements is
more difficult to predict. As described above, Alpine currently is relatively
close to certain regulatory thresholds that, if crossed, could lead to a
required reduction or cessation of Alpine's activities. This could result from
increased oversight by the Illinois DOI, regulatorily required termination of
some or all of Alpine's current business operations and relationships,
termination of the Quota Share Arrangement by the Frontier Companies and
potentially Alpine's being placed in receivership. While the Company expects
Alpine to be able to avoid crossing such thresholds, the expectations are based
on a number of assumptions, including, among others, assumptions about cash
flows, investment yields, asset values, ultimate loss and loss adjustment
expenses and payout patterns, competition, the Illinois DOI's potential
regulatory responses and Frontier's Best ratings. Because Alpine is relatively
close to certain of the regulatory thresholds, there is little room for adverse
fluctuations in the foregoing assumptions. In this regard, it should be noted
that Alpine's financial condition weakened significantly in 1997, as evidenced
by the drop in Alpine's statutory policyholders' surplus to $5.3 million at
December 31, 1997, from $12.6 million at December 31, 1996, and Alpine's
risk-based capital being at 117% of its authorized control level risk-based
capital at December 31, 1997, compared to 173% of its authorized control level
risk-based capital at December 31, 1996.
Should Alpine's operations be curtailed significantly, or the Company's
risk bearing activities otherwise be limited, the Company would be forced to
rely more on its existing cash and on its WESTCAP and Claims Control activities
to generate revenues and cash flows. A portion of the Company's cash needs
would be able to be met out of Exstar's cash on hand, which was $1.6 million at
December 31, 1997. The balance of the Company's cash needs would be met from
WESTCAP's and Claims Control's revenues from ongoing operations.
Should these efforts prove insufficient, the Company would have to seek
alternative solutions. Among those would be a capital contribution from, joint
venture with, or sale of assets to, Frontier or another insurance operation.
The Company has made no specific plans to achieve any of these solutions,
though the Company has been approached from time to time by insurance
operations seeking to establish relationships with the Company, and believes it
could take advantage of one of these prior approaches or a similar opportunity
relatively quickly. The
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Company believes, though there can be no assurances, that Frontier and
potentially other insurance operations would favor such a capital contribution,
joint venture, sale or similar arrangement because of the Company's
historically profitable underwriting results and its potential ability to
generate similar results in the future.
PROPOSED FUTURE OPERATIONS AND ORGANIZATIONAL CHANGES; RELATIONSHIP WITH
FRONTIER
In April 1996, Alpine's Best rating and the Best rating of its then parent
company, the Syndicate, were downgraded to Cs (Marginal) from an A- (Excellent)
for Alpine and a B+ (Very Good) for the Syndicate. In late 1996, the
Syndicate's operations were combined with those of Alpine, and the Syndicate
ceased functioning as a separate insurer. At December 31, 1997, Alpine's
statutory policyholders' surplus had declined to $5.3 million, compared to
$12.6 million at December 31, 1996, and Alpine's financial condition generally
was weak relative to industry standards. (See " -- Operating Ratios," "
- --Regulation" and " -- Losses and Loss Adjustment Expenses.") Consequently, in
March 1998, Alpine voluntarily withdrew as an authorized surplus lines insurer
in each jurisdiction in which it then remained authorized (Alpine had
previously lost its surplus lines authority to write direct business in a
number of jurisdictions, including California, that had accounted for most of
Alpine's direct premium revenues). Although Alpine's Best rating had slightly
improved (it was increased to C++ (Marginal) in September 1997), management
believed that efforts by Alpine to attract profitable direct business would be
unlikely to succeed unless Alpine were able to attain a Best rating of B+ or
better, increase its statutory policyholders' surplus to in excess of $15
million (the minimum requirement for surplus lines qualification in most
states) and otherwise improve its financial condition. Management doubted that
these could be achieved in the foreseeable future.
In view of Alpine's financial condition and prospects, management
determined to seek to improve the Company's prospects by a transaction which
would include a sale of Alpine to Frontier ("Potential Frontier Deal"). The
Company has reached a general understanding with Frontier as to the general
terms and conditions of the Potential Frontier Deal, and is in the process of
seeking to negotiate binding agreements to accomplish the Potential Frontier
Deal. Management believes, based on progress to date, the Potential Frontier
Deal is likely to be consummated during the second quarter of 1998, but there
can be no assurance that the Potential Frontier Deal will be consummated as
described in this Form 10-K or at all.
As the Potential Frontier Deal currently is contemplated, the initial
purchase price paid by Frontier for Alpine would be $7.0 million, consisting of
the sum of Alpine's statutory policyholders' surplus at December 31, 1997 ($5.3
million) plus the net statutory value of certain real estate (currently
estimated to be $1.7 million) to be contributed to Alpine by Exstar prior to
consummation of the sale. The purchase price is expected to be subject to
after-tax adjustment over time, based principally on annual estimates of the
statutory values of Alpine assets and liabilities transferred in the sale,
until the ultimate values of such assets and liabilities are actually realized
through sale or payment or otherwise agreed by the parties. The principal
adjustments to the purchase price are expected to result from increases or
decreases in ultimate losses and loss adjustment expenses relative to currently
estimated reserves for such losses and loss adjustment expenses under policies
issued or reinsured by Alpine prior to the effective date of the sale,
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reductions in the $6.6 million "Schedule P penalty" currently reflected as a
liability of Alpine in its statutory financial statements as the liability
drops off over time (assuming the drop off is not offset by increases in
reserves for losses and loss adjustment expenses) (see " -- Losses and Loss
Adjustment Expenses"), and reductions in Alpine's current unearned premium
reserve liability as the premium is earned (offset by loss and loss adjustment
expense reserves established with respect to such premium as it is earned). In
addition, as the Potential Frontier Deal is currently contemplated: (i) the
purchase price would be increased by up to approximately $6.5 million of net
operating loss carryforwards transferred to Frontier with Alpine, as and to the
extent Frontier actually recognizes the benefit of such loss carryforwards;
(ii) the purchase price would be payable in cash or a combination of cash and
publicly tradable common stock of Frontier; (iii) one-third of the purchase
price initially would be withheld by Frontier as security for Exstar's
obligation, if any, to return any previously paid portions of the purchase
price to Frontier based on required purchase price adjustments; and (iv) the
withheld portion of the purchase price would be released to Exstar over a two
year period, to the extent warranted based on purchase price adjustments.
The Potential Frontier Deal also currently contemplates that Frontier
would pay Exstar, on a quarterly basis, all investment income earned on the
Alpine assets transferred through the sale, reduced by an amount of investment
income deemed earned by Exstar on the purchase price paid by Frontier
(calculated at an annual rate to be mutually agreed by the parties), and would
give the Company the right, but not the obligation, to acquire certain Alpine
assets from Frontier after the consummation of the sale, at their then current
statutory book values. This acquisition right would relate to certain
preferred stock now held by Alpine and the two office buildings located in
Solvang, California which currently serve as the Company's headquarters. The
purpose of any future election by the Company to acquire the preferred stock
would be to take advantage of certain Exstar tax loss carryforwards, which
would be unavailable to Frontier. The purpose of any future election by the
Company to acquire the two Solvang office buildings would be, in addition to
taking advantage of similar Exstar tax loss carryforwards, to ensure the
Company's ability to continue to operate from the buildings.
Additional terms and conditions of the Potential Frontier Deal currently
would provide that, pursuant to separate agreements to be entered into by the
parties, the Company would (i) at the Company's cost, manage certain assets of
Alpine transferred to Frontier pursuant to the sale (principally mortgages,
real estate and premium receivables) and (ii) handle claims incurred under
policies written or reinsured by Alpine prior to the effective date of the sale
for compensation anticipated to be similar to that currently paid by the
Frontier Companies pursuant to the Claim Service Agreement. As the Potential
Frontier Deal is currently contemplated, the parties also would enter into a
new six-year production agreement (similar to the Limited Agency Agreements)
under which the Company would produce certain insurance business for Frontier
and under which the Frontier Companies would be granted a right of first
refusal on certain business produced by the Company (subject to Frontier's
agreement not to accept directly from the Company's production sources
insurance business similar to that produced by the Company for the Frontier
Companies). It is also contemplated currently that Frontier would give the
Company the right to produce for the Frontier Companies any insurance programs
written by them, provided that other entities have not previously been given
the "exclusive" right to produce
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such programs.
If the Potential Frontier Deal is consummated, the Company expects,
subject to approval by the Illinois DOI, that all debts owed to Alpine by the
Company and any of its affiliates would be cancelled, including all debts owed
to Alpine by Exstar and Claims Control, and all debts owed by subsidiaries of
TCO Holdings, which is wholly owned by Mr. O'Shaughnessy. (TCO Holdings and
its subsidiaries collectively are sometimes hereinafter referred to as "TCO.")
The cancellation of such indebtedness would not have any direct impact on the
Company's financial statements prepared in accordance with generally accepted
accounting principles ("GAAP"). To the extent TCO's indebtedness to Alpine
could be repaid, however, other than through funds directly or indirectly
provided by the Company, that repayment (whether before or after the sale of
Alpine to Frontier) would increase the Company's stockholders' equity. (See "
- -- Relationship with TCO.") Management considers the cancellation of such
indebtedness to be appropriate, however, because management believes TCO will
be unable to repay any significant portion of its debt to Alpine in the
foreseeable future, and because management believes TCO's debt is attributable
in large part to expenses incurred in performing activities which Alpine
otherwise would have had to perform itself. (See "Certain Relationships and
Related Transactions" -- Item 13.)
If the Potential Frontier Deal is consummated as currently contemplated,
individuals employed by Alpine prior to the sale would become employees of
Exstar, WESTCAP or Claims Control following the sale. In addition, the portion
of the Company's salary and overhead expenses previously borne by Alpine would
be reallocated among Exstar and/or its remaining subsidiaries, including the
"Cayman Company" discussed below, following the sale.
In connection with consummation of the sale of Alpine, Exstar would expect
to form a new insurance company subsidiary domiciled in the Cayman Islands
("Cayman Company"), capitalized initially with approximately $3.0 million of
the proceeds paid to Exstar from the sale. As currently contemplated, a
reinsurance agreement similar to the Quota Share Arrangement would be entered
into between the Frontier Companies and the Cayman Company. As such agreement
is currently contemplated, and subject to the Cayman Company's not assuming
more premium than permitted by Cayman Island insurance regulations, the
Frontier Companies generally would cede to the Cayman Company a 50% quota share
of lines of business deemed appropriate by the Company and produced by WESTCAP
for the Frontier Companies. Because of restrictions on the Frontier Companies'
abilities to reduce liabilities in their statutory financial statements with
respect to losses ceded to the Cayman Company, the new reinsurance agreement
likely would be structured on a funds-held basis similar to the Quota Share
Arrangement. It is further contemplated that the new reinsurance agreement
would remain in effect during the term of the new production agreement between
the Company and Frontier, and pursuant to the reinsurance agreement the Cayman
Company would assume Alpine's obligation to make payments to TCO Holdings under
the Service Agreement.
The Company has preliminarily investigated formation of the Cayman
Company, and based on such investigation anticipates the Cayman Company could
be formed and operated as currently contemplated by the Potential Frontier
Deal. The Company has not yet taken any substantial steps to form the Cayman
Company, however, and its formation and operation would
9
<PAGE> 12
be subject to Cayman Islands regulation. There can be, consequently, no
assurance that the Cayman Company can be formed and operated as currently
contemplated.
Consummation of the Potential Frontier Deal would be subject to receipt of
regulatory approvals, including approval of the Illinois DOI. Although, based
on informal discussions with the Illinois DOI, management believes that
necessary regulatory approvals would be obtained, there can be no assurance
that they will be obtained or that the Potential Frontier Deal will be
consummated as contemplated or at all.
Management believes the proposed sale of Alpine, the formation of the
Cayman Company and the other transactions contemplated as the Potential
Frontier Deal would be beneficial to the Company for a number of reasons.
First, the sale of Alpine would be expected to significantly improve the
Company's liquidity. (See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Liquidity and Capital Resources" -- Item
7.)
Second, the sale of Alpine would be expected to allow management to focus
on producing additional profitable business and expanding the Company's
insurance underwriting business. Approximately $3.0 million of the proceeds of
the sale initially would be contributed to the Cayman Company to provide
capital. With a portion of the remaining proceeds, the Company would expect to
seek to expand its production and underwriting capabilities through
acquisitions of books of business, hirings of additional personnel with
expertise in new programs and existing and new lines of business (such as
environmental liability and property coverages), and acquisitions of brokerage
operations. Management expects that most of the business generated through such
acquisitions and new personnel would be placed by WESTCAP with the Frontier
Companies, and, if deemed appropriate by the Company, would be reinsured on a
50% quota share basis by the Cayman Company.
Third, the sale of Alpine would be expected to decrease the amount of
time, resources and attention the Company devotes to insurance regulatory
compliance. As an Illinois domestic insurer, Alpine is subject to substantial
regulatory compliance obligations with respect to, among other things,
financial reporting (including preparing financial statements in accordance
with statutory accounting practices, and arranging for a separate audit of such
statutory financial statements), transactions with affiliates, market conduct,
payments of dividends and state and other insurance regulatory filings. The
Illinois Order has significantly increased the Company's regulatory compliance
burden. Management believes this compliance burden could increase in 1998 as a
consequence of Alpine's reduced statutory policyholders' surplus of $5.3
million at December 31, 1997, down from $12.6 million at December 31, 1996, and
certain regulatory requirements applicable to Illinois domiciled insurance
companies, including laws enacted by Illinois in 1997. (See " -- Operating
Ratios," and " -- Regulation" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations" -- Item 7.) Management expects
the Cayman Company (which as currently contemplated would operate only as a
reinsurer of the Frontier Companies for the foreseeable future) would be
subject to a much reduced insurance regulatory compliance burden compared to
that which Alpine is currently and in 1998 is likely to be subject, and would
be required to produce only GAAP financial statements. Further, because the
Cayman Company would not be pursuing a Best rating, the effort
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<PAGE> 13
management previously has devoted to satisfying Best requirements would be
eliminated.
In October 1997, in conjunction with the Frontier Companies' execution of
new Limited Agency Agreements with WESTCAP and the increase in Alpine's quota
share percentage under the Quota Share Arrangement to 50%, Exstar issued a
warrant to Frontier giving Frontier the right to acquire up to 500,000 shares
of Exstar's Common Stock ("Warrant"). Pursuant to the Warrant, effective on
and after October 1, 1997, Frontier has the right to acquire 100,000 shares of
Common Stock for an exercise price of $3.60 per share (the closing price of
Exstar's publicly traded common stock on October 1, 1997, was $4.00 per share).
Frontier's right to acquire the remaining 400,000 shares represented by the
Warrant vests over time through October 1, 2000. The exercise price for such
remaining shares is based on a formula, the application of which is expected to
result in an exercise price of approximately $4.64 per share. Frontier's rights
under the Warrant expire on December 31, 2003 and are subject to earlier
termination or acceleration under circumstances specified in the Warrant. Also
in conjunction with the foregoing transactions, and effective October 1, 1997,
the Company granted Frontier a limited right of first refusal to acquire a
controlling interest in Exstar. Such right can be exercised by Frontier only
in the event that a single person or entity other than Frontier or Mr.
O'Shaughnessy (or an entity majority owned by either of them) acquires more
than 20% of the outstanding voting stock of Exstar or Alpine.
The Company's future financial condition and prospects are heavily
dependent on the Company maintaining or improving its relationships with
Frontier. WESTCAP generates commission revenues from producing insurance
business on behalf of the Frontier Companies; Claims Control generates a small
but increasing amount of its revenue from handling claims on behalf of the
Frontier Companies; and Alpine generates underwriting revenue, if the
underwriting results are profitable, and investment income from assuming
premiums pursuant to the Quota Share Arrangement with the Frontier Companies.
These relationships with the Frontier Companies also generate most of the
Company's cash flows from operations.
The Company believes, based on the Potential Frontier Deal progress, the
generally positive relationship the Company has with Frontier and the
profitability of the business the Company produces for Frontier, that the
current relationships (or alternative arrangements equally or more beneficial
to the Company) will continue in effect for the reasonably foreseeable future.
There can be no assurance, however, that the Limited Agency Agreements, the
Claim Service Agreements or the Quota Share Arrangement will in fact remain in
effect under their current terms or at all, or that the Potential Frontier Deal
or other alternative arrangements will be consummated, either on terms at least
as favorable to the Company as the current relationships or at all. Should the
Company's relationships with the Frontier Companies be discontinued, or their
terms and conditions be changed in a manner materially adverse to the Company,
the Company could have to seek alternative relationships with other insurance
companies. The Company could experience significant losses under such
circumstances. (See " -- Overview of Current Business Operations.")
RELATIONSHIP WITH TCO
TCO Holdings and its subsidiaries are affiliated with Exstar through
common controlling
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<PAGE> 14
ownership by Mr. O'Shaughnessy, but are not owned, directly or indirectly, by
Exstar. Historically, TCO performed certain underwriting, marketing, claims,
management, investment, administrative and related services for Alpine and the
Syndicate pursuant to separate management agreements with Alpine and the
Syndicate. Such management agreements were terminated during 1996, in
connection with the Company's decision to cease writing direct insurance
business. Following termination of the management agreements, the only
operational subsidiaries of TCO Holdings were Transre (which held a California
surplus lines license and was involved in producing business for UCIC beginning
in June 1996) and Claims Control (which was managing claims for the Company
and, beginning in June 1996, UCIC). From June 1996 through September 1997,
E&S, an entity directly owned by Mr. O'Shaughnessy, acted with Transre in the
production of business for UCIC. Upon cancellation of the Limited Agency
Agreement among Transre, E&S and UCIC effective October 1, 1997 (and
replacement of that Limited Agency Agreement with similar Limited Agency
Agreements between WESTCAP and each of the Frontier Companies) and the transfer
of ownership of Claims Control to Exstar on the same date, the TCO entities and
E&S effectively ceased operations. All remaining employees of TCO and E&S
became employees of the Company.
TCO continues to be indebted to Alpine with respect to insurance premiums
collected and not paid to Alpine. The amount of such indebtedness was $9.2
million at December 31, 1997. Such indebtedness is not reflected as an asset
of the Company in its GAAP financial statements, and does not constitute an
admitted asset of Alpine in Alpine's statutory financial statements. TCO also
has significant additional debts and obligations to third parties, and
currently has a net deficit of approximately $18 million. Management
consequently believes TCO will be unable to repay most of its indebtedness to
the Company and the other creditors of TCO. In connection with the proposed
acquisition of Alpine by Frontier (i) TCO transferred to Alpine (subject to
final regulatory approval that has not yet been obtained), effective as of
October 31, 1997, a $985,000 receivable due to TCO from Claims Control, in
partial satisfaction of TCO's indebtedness to Alpine, and (ii) upon
consummation of the sale and subject to Illinois DOI approval, TCO's remaining
indebtedness to Alpine, as well as the newly transferred Claims Control debt,
would be cancelled. The Claims Control debt does not constitute an admitted
asset of Alpine under statutory accounting practices. Such debt cancellations,
should they occur, are expected to have no direct impact on the Company's GAAP
financial statements. To the extent such TCO Holdings indebtedness could be
repaid, however, other than through funds directly or indirectly provided by
the Company, such repayment (whether before or after the sale of Alpine to
Frontier) would increase the Company's stockholders' equity. (See " --
Relationship with TCO.")
Although TCO is not a direct or indirect subsidiary of Exstar, its income
or loss is included in the Company's consolidated GAAP financial statements in
accordance with a form of equity accounting. The Company's adoption of this
form of accounting in 1995 (applied retroactively) was based on the historical
interdependence and common control of the Company and TCO, including the
Company's exertion of significant influence over the operations of TCO, TCO's
limited financial resources and TCO's need for financial support from the
Company. In accordance with this form of equity accounting, the Company's GAAP
net income and stockholders' equity are directly affected by certain changes in
TCO's income and stockholder's equity (i.e., certain losses and gains of TCO
reduce and increase, respectively, the Company's
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<PAGE> 15
GAAP net income and stockholders' equity). With respect to the Company's
historical GAAP financial statements, the effect of the adoption of this
accounting treatment was to reduce the Company's total stockholders' equity and
net income from that reported in the Company's consolidated financial
statements previously filed with the Securities and Exchange Commission
("SEC").
The historical effect of this accounting treatment, as a result of TCO's
losses or profits, has been as follows: in 1992, a reduction in stockholders'
equity and net income of $2.5 million; in 1993, a reduction in stockholders'
equity and net income of an additional $11.6 million; in 1994, a reduction in
stockholders' equity and net income of an additional $7.1 million; in 1995, an
increase in stockholders' equity and net income of $1.7 million; in 1996, an
increase in stockholders' equity and net income of $1.1 million; and in 1997,
an increase in stockholders' equity and net income of $178,000. At December
31, 1997, the cumulative effect of this accounting treatment was to reduce the
Company's total stockholders' equity by $18.2 million. Under this accounting
method, if TCO were to generate income in the future up to a certain threshold
amount (currently approximately $2.9 million), the Company's GAAP income and
stockholders' equity would increase by the amount of such income recognized by
TCO even without any repayments of amounts owed by TCO to the Company.
Conversely, unless the cumulative amount of TCO's losses since July 1, 1992
falls below the cumulative amount of TCO's indebtedness to the Company incurred
since July 1, 1992, any repayments of debt by TCO to the Company generally
would not increase the Company's GAAP net income or stockholders' equity. (See
Note 11 of Notes to Consolidated Financial Statements.)
Because the Company and TCO are affiliated through common controlling
ownership by Mr. O'Shaughnessy, the transactions and relationships between the
Company and TCO and the Company and Mr. O'Shaughnessy present certain conflicts
of interest. Notwithstanding these potential conflicts of interest, management
believes that the actions and inactions of the Company, while they have in some
cases benefited TCO and Mr. O'Shaughnessy, have been, when taken as a whole, in
the best interests of the Company.
SOURCES OF REVENUE
Historically, the Company has derived virtually all of its revenues from
insurance "risk-bearing" operations (the issuance of insurance policies to
insureds), and investment income earned on premiums received from such
operations. In August 1996, the Company ceased issuing insurance policies
directly to insureds, principally as a result of Best rating downgrades and
regulatory restrictions. In lieu of issuing direct insurance coverage,
effective April 1, 1997, the Company entered into the Quota Share Arrangement
with the Frontier Companies. In March 1998, Alpine voluntarily withdrew as an
authorized surplus lines insurer in each jurisdiction in which it then remained
authorized.
Management has determined that, in view of the Best rating, minimum
policyholders' surplus and other regulatory obstacles faced by the Company, it
is unlikely the Company will be able to write profitable direct business in the
foreseeable future. As a result, management has decided to shift the Company's
business focus from risk-bearing operations to production and
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<PAGE> 16
underwriting of insurance coverage to be issued by other insurers (currently
expected to consist principally of the Frontier Companies), from which
activities the Company will derive commission revenues. Through its role as a
reinsurer under the Quota Share Arrangement, or through a similar reinsurance
arrangement if the Potential Frontier Deal is consummated as currently
contemplated, however, the Company expects to continue to derive some revenues,
including underwriting profits and investment income, from risk-bearing
operations. These revenues will be accompanied by significantly less cash
flow, at least as the current arrangement is structured and the Potential
Frontier Deal is currently contemplated, than the cash flow that would
accompany similar premium volume from direct writing of insurance, if the
Company could write such insurance, because of the funds held provisions of the
Quota Share Arrangement.
The Company has historically operated in a single industry segment,
property and casualty insurance, and within this segment has concentrated on a
limited number of lines of business. During 1996 and 1995, most of the
Company's premium volume derived from the direct writing of specialized
liability coverages, consisting principally of products liability coverages and
general liability coverages for contractors, ocean marine coverages and
architects and engineers coverages. During 1997, most of the Company's premium
volume derived from Alpine's reinsurance of similar coverages written directly
by the Frontier Companies. The Company is exploring the possibility of
expanding its production and reinsurance relationship with the Frontier
Companies to include other niche lines of business.
The following table sets forth the sources of the Company's premium for
the years presented:
<TABLE>
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
1997 1996 1995
AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT
(DOLLARS IN THOUSANDS)
GROSS WRITTEN PREMIUM
Direct written premium:
Specialized liability
Contractors.................. $695 5.4% $8,902 61.9% $32,556 50.6%
Products..................... 407 3.2 2,253 15.7 12,744 19.8
Other........................ 330 2.5 1,951 13.6 8,164 12.7
1,432 11.1 13,106 91.2 53,464 83.1
Ocean marine................. (26) (0.2) 764 5.3 7,408 11.5
Architects and engineers..... 4 0.0 307 2.1 2,409 3.8
Total direct written premium. 1,410 10.9 14,177 98.6 63,281 98.4
Reinsurance assumed:
Specialized liability
Contractors.................. 9,233 71.4 0 0.0 0 0.0
Products..................... 156 1.2 0 0.0 0 0.0
Other........................ 194 1.5 196 1.4 1,006 1.6
9,583 74.1 196 1.4 1,006 1.6
Ocean marine................. 1,669 12.9 0 0.0 0 0.0
Architects and engineers..... 263 2.1 0 0.0 0 0.0
Total reinsurance assumed.... 11,515 89.1 196 1.4 1,006 1.6
Total gross written premium.. $12,925 100.0% $14,373 100.0% $64,287 100.0%
</TABLE>
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<PAGE> 17
Specialized Liability. Specialized liability business accounted for $11.0
million or 85.2%, and $13.3 million or 92.5%, of the Company's gross written
premium for 1997 and 1996, respectively. Of the Company's total 1997
specialized liability gross written premium, 87.0% was assumed by the Company
under the Quota Share Arrangement, with the remainder being attributable to
additional premium from audits and collections under policies written directly
by the Company prior to August 1996. General liability insurance for
contractors accounted for approximately 90.1% and 67.9% of the Company's
specialized liability gross written premium in 1997 and 1996, respectively.
Insureds in this group included general contractors and subcontractors. The
typical risk written or assumed by the Company has been a small contractor,
with annual receipts under $3.0 million. The typical policy has provided
coverage for losses up to $1.0 million and has required a premium payment in
the $20,000-$25,000 range, with a deductible of approximately $5,000. Products
liability insureds have consisted generally of manufacturers,
dealers/distributors and, to a lesser degree, others engaged in a wide variety
of businesses including machinery and equipment, auto/vehicle products and
sporting goods. Other specialized liability business written or assumed by the
Company in 1997 and 1996 included employers liability, premises liability
(O,L&T) for apartments, restaurants and property owners, and some small niche
programs.
Most of the specialized liability insurance directly written or assumed by
the Company was written on an occurrence form (approximately 99% and 94% of all
specialized liability premium in 1997 and 1996, respectively). The balance was
written on a claims-made form (approximately 1% and 6% of all specialized
liability premium in 1997 and 1996, respectively). The Company's specialized
liability policies generally excluded liability for pollution and punitive
damages, had aggregate limits and paid expenses in addition to policy limits.
Ocean Marine. Ocean marine business accounted for $1.6 million or 12.7%,
and $764,000 or 5.3%, of the Company's gross written premium in 1997 and 1996,
respectively. All of the Company's 1997 ocean marine gross written premium was
assumed by the Company under the Quota Share Arrangement. Typical risks
included tugs, barges, crew boats, builders risks and yachts. Both hull and
protection and indemnity coverages were provided, as was cargo coverage in some
instances. The average policy had a premium of approximately $40,500 and an
average deductible of $10,000.
Architects and Engineers Professional Liability. The Company's architects
and engineers professional liability business accounted for approximately
$267,000 or 2.1%, and $307,000 or 2.1%, of the Company's gross written premium
in 1997 and 1996, respectively. Of the Company's total 1997 architects and
engineers gross written premium, 98.5% was assumed by the Company under the
Quota Share Arrangement, with the remainder being attributable to adjustments
under policies written directly by the Company prior to August 1996. The
Company's principal classifications of risks were architects, civil engineers,
HVAC/mechanical engineers, electrical engineers, interior designers and land
surveyors. The typical architects and engineers insured was an architectural
firm with annual billings of approximately $301,000 not engaged in structural
or project design work. The average policy had a premium of approximately
$8,000, an average coverage limit of approximately $500,000 and an average
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<PAGE> 18
deductible of approximately $8,000.
The architects and engineers insurance written or assumed by the Company
was written on a claims-made policy form pursuant to which claims must be made
to the insurer issuing the policy within the time frame permitted by the policy
(generally within the policy period, or any extended discovery period). The
policies have had aggregate limits, included expenses within policy limits and
provided extended discovery periods where required by state insurance laws.
Management believes that competition is increasing in the lines of
business in which the Company historically has operated. This may interfere
with the Company's ability to generate revenues and cash flow through the Quota
Share Arrangement or through the operations of WESTCAP. Many of the Company's
and the Frontier Companies' existing or potential competitors are larger, have
higher Best ratings, have considerably greater financial and other resources
and offer a broader line of insurance products than the Company or the Frontier
Companies.
INVESTMENTS
The Company's investments generally consist of those investments permitted
by the Illinois Insurance Code. Pursuant to an agreement entered into by the
Company in May 1996, Asset Allocation & Management Company, L.L.C. had been
granted investment advisory responsibility over most of the Company's liquid
invested assets. That agreement was terminated in December 1997, and the
Company is currently not under contract with any third party for the management
of, or the provision of advisory services with respect to, its investments.
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<PAGE> 19
The table below shows the classifications of the Company's investments at
December 31, 1997:
<TABLE>
<S> <C> <C> <C>
DECEMBER 31, 1997
MARKET VALUE CARRYING VALUE PERCENT OF TOTAL
(DOLLARS IN THOUSANDS)
Fixed maturities:
U.S. government and government agencies and authorities $9,689 $9,689 29.1%
State municipalities and political subdivisions........ 3,312 3,312 10.0%
All other corporate bonds.............................. 125 125 .4%
Redeemable preferred stock............................. 249 249 .7%
Total fixed maturities................................. 13,375 13,375 40.2%
Equity investments:
Common stock........................................... 557 557 1.7%
Non-redeemable preferred stock......................... 984 984 2.9%
Total equity investments............................... $1,541 1,541 4.6%%
Real estate:
Direct investments..................................... 10,035 30.1%
Mortgage loans......................................... 3,953 11.9%
Total real estate...................................... 13,988 42.0%
Short-term investments................................. 4,384 13.2%
Total investments...................................... $33,288 100.0%
</TABLE>
The fixed maturity assets have an average duration of approximately 3.6
years and an average maturity of approximately 5.4 years. The fixed maturities
subject to call at December 31, 1997, had a market value and carrying value of
$2.9 million.
A substantial amount of the investments shown in the table above are
restricted, principally because they are pledged to secure obligations, or held
in trust under arrangements subject to insurance regulatory control as security
for the payment of claims under policies issued or reinsured by the Company and
certain other obligations. This significantly reduces the Company's ability to
utilize these assets to satisfy other obligations of the Company, and adversely
impacts the Company's liquidity. (See " -- Regulation -- Combination of the
Syndicate with Alpine" and "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Liquidity and Capital Resources" -- Item
7.)
Mortgage Loans. The Company's assets at December 31, 1997, included 13
mortgage loans with a total principal balance outstanding of approximately $4.2
million. The book value of these loans, net of a $182,000 reserve against
losses and $30,000 of deferred loan origination fees, was $4.0 million. The
reserve against losses for mortgage loans is calculated as the difference
between the mortgage loan including accrued interest and the appraised value of
the property securing the loan.
Of the total portfolio at December 31, 1997, $842,000 consisted of five
single-family
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<PAGE> 20
residential construction and permanent loans, $3.3 million consisted of
seven commercial loans, and $40,000 consisted of one residential tract
development loan. The largest of the loans was $1.0 million, the smallest
loan was $37,000 and the average loan was approximately $321,000.
The Company is no longer making or purchasing mortgage loans, except to
facilitate sales of real estate owned or in connection with loan workouts. If
the proposed sale of Alpine is consummated in accordance with the Potential
Frontier Deal, as currently contemplated, all of Alpine's assets, including
mortgage loan assets, are expected to be transferred to Frontier. The Company
would continue to manage such assets, however, pursuant to a contract with
Frontier. In addition, as the Potential Frontier Deal is currently
contemplated, the Company's financial results would continue to be affected by
fluctuations in the values of these assets, because changes in such values
would affect the amount of the purchase price ultimately received by the
Company from the sale of Alpine. Further, as the Potential Frontier Deal is
currently contemplated, the Company would continue to receive income generated
by such mortgage loan assets for a period of time after consummation of the
sale.
Real Estate Owned. The Company had real estate investments totaling $10.0
million at December 31, 1997. This value was net of a reserve for losses of
$1.3 million. The reserve against losses for real estate owned relates to real
estate held for sale and real estate acquired through foreclosure. The reserve
is calculated as the difference between the book value and the "fair value"
(fair value generally is the appraised value, less expected costs of sale) of
the real estate. The properties had combined fair values of approximately
$11.9 million as of December 31, 1997, based on appraisals conducted during the
fourth quarter of 1997. The Company has been attempting to liquidate, in an
orderly fashion, its owned real estate portfolio and has no intention of
acquiring or holding real estate, other than possibly the office buildings
described below, in the future.
Among the Company's properties are two commercial office buildings located
in Solvang, California, which serve as headquarters for the Company and which
were formerly leased to TCO. The buildings had a combined book value of $4.1
million and a combined fair value of $5.6 million at December 31, 1997. The
TCO lease was terminated during 1996 after TCO-IL's revenues dropped and its
employees transferred to the Company. The total rent paid by TCO under the
lease was $228,000 in 1996 and $584,000 in 1995. The Company currently leases
6,000 square feet of space in one of these buildings to the YMCA at an annual
rent of approximately $54,000 (subject to adjustment) under a two-year lease,
which commenced November 1, 1996, and which has three one-year renewal options.
In addition, effective April 3, 1998, the Company entered into a five-year
lease with a physical therapy operation with respect to approximately 4,000
square feet of space in the same building, at an annual rent of approximately
$45,000 (subject to adjustment). Except for amounts it receives under these
leases, the Company is currently bearing all costs associated with the
properties. The Company from time to time has solicited offers to purchase
these buildings, but no such offers on terms acceptable to the Company have
been received. (See "Properties" -- Item 2.)
An additional $374,000 of the $10.0 million total investment in real
estate pertains to interests in a real estate development engaged in developing
a 120-lot residential project in
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<PAGE> 21
Bakersfield, California. The land was initially purchased by the Company in
1989. There were 11 lots remaining with a fair value of $416,000 as of
December 31, 1997.
The Company owns two commercial medical condominium units located in
Solvang, California. As of December 31, 1997, the book value of these units
was $581,000, compared to a $567,000 fair value as of that date.
The Company also owns property acquired for residential development in
1990. One, a 50-acre tract located in Solvang, California, initially consisted
of nine parcels. Homes were built on two of the parcels and, during 1993, one
of the homes and two of the parcels were sold. During 1994, one of the parcels
was sold and, during 1995, the other home was sold. During 1997 one additional
parcel was sold. The book value of the remaining three parcels was $794,000
and the fair value of such parcels was $803,000 at December 31, 1997.
The Company's remaining owned real estate consists of one property
acquired in liquidation of secured real estate loans and held for sale, two
purchased residential properties (one of which was acquired from Mr.
O'Shaughnessy) located in the Santa Ynez Valley, California, held for sale, and
a residential property located in Bermuda Dunes, California. These properties
had a combined book value at December 31, 1997 of $4.2 million and a combined
fair value of $4.4 million as of that date. (See "Certain Relationships and
Related Transactions" -- Item 13.)
If the proposed sale of Alpine is consummated in accordance with the
Potential Frontier Deal, as currently contemplated, all of Alpine's assets,
including real estate assets, would be transferred to Frontier (including the
real estate not owned by Alpine at December 31, 1997, which is expected to be
contributed to Alpine prior to Alpine's sale to Frontier). The Company would
continue to manage such assets, however, pursuant to a contract with Frontier.
In addition, as the Potential Frontier Deal is currently contemplated, the
Company's financial results would continue to be affected by fluctuations in
the values of these assets, because changes in such values would
affect the amount of the purchase price ultimately received by the Company for
the sale of Alpine. Further, as the Potential Frontier Deal is currently
contemplated, the Company for a period of time would continue to receive income
generated from such real estate assets after the consummation of the sale.
If the sale of Alpine is consummated in accordance with the Potential
Frontier Deal as currently contemplated, it is likely that the Company would
enter into a lease with Frontier with respect to the two office buildings
located in Solvang, California, which are currently owned by Alpine and serve
as the Company's headquarters. The terms of any such lease have not yet been
determined. Additionally, in accordance with the Potential Frontier Deal as
currently contemplated, the Company would have the right to repurchase one or
both of the buildings at their most recently determined book values. (See " --
Proposed Future Operations and Organizational Changes; Relationship with
Frontier.")
JBW & Co. Loan. In December 1989, the Syndicate made an investment in the
preferred stock of Concord General Corporation, a privately held insurance
holding company ("Concord"). The preferred stock had an 11.3% dividend rate
and a stated value of $10,000 per share.
19
<PAGE> 22
Subsequent to December 31, 1993, Exstar entered into an agreement to facilitate
the restructuring of Concord, and thereby to enhance the value of certain of
the Company's rights with respect to its investment, by an exchange of
the Syndicate's Concord preferred stock for preferred stock in JBW & Co., Inc.
("JBW & Co."), a Concord affiliate, effective as of December 31, 1993. The JBW
& Co. preferred stock acquired by the Syndicate had the same stated value,
terms and dividends as the Concord preferred stock. The preferred stock was
convertible by the holder into secured debt of JBW & Co. upon the occurrence of
specified events.
In August 1995, the Company exercised its right to convert the JBW & Co.
preferred stock to a promissory note. As a result, the Company then held a
collateralized loan receivable in the principal amount of $12.3 million due
from JBW & Co. ("JBW & Co. Loan"). The JBW & Co. Loan was collateralized by a
pledge by Concord of 81% of the outstanding capital stock of Classic Fire and
Marine Insurance Company ("Classic"), an Indiana insurance company affiliated
with JBW & Co. and Concord. Classic is currently in rehabilitation under the
oversight of the Indiana Department of Insurance.
Simultaneously with the Syndicate's original investment in Concord,
Concord made a similar investment in preferred stock of a predecessor of
Exstar. Such preferred stock was later converted into preferred stock of TCO
Holdings, which preferred stock was to have been convertible, upon the
occurrence of specified events, into debt of TCO Holdings. The aggregate
stated value of the TCO Holdings preferred stock (excluding any accrued
dividends) was approximately $10.8 million at December 31, 1996.
In view of the uncertainty surrounding the Company's ability to realize
value with respect to the JBW & Co. Loan (and the collateral pledged to secure
it), the Company consummated a transaction in December 1997 in which the
Company accepted approximately $2.3 million in proceeds of a mortgage note in
full satisfaction of JBW & Co.'s obligations under the JBW & Co. Loan.
Approvals from various regulatory authorities, including the Illinois DOI, were
sought and obtained in connection with the transaction.
Concurrently with the foregoing transaction, TCO Holdings consummated a
transaction in which the TCO Holdings preferred stock was cancelled and, in
lieu thereof, the holder of the TCO Holdings preferred stock was given a TCO
Holdings promissory note in the principal amount of $2.5 million, with 4
percent annual interest on the principal balance outstanding, payable from
commissions received by TCO Holdings in connection with the Quota Share
Arrangement. (See " -- Overview of Current Business Operations.") Mr.
O'Shaughnessy has guaranteed that the holder of the TCO Holdings promissory
note will receive at least $250,000 each calendar year (commencing with 1998)
on account of the obligation evidenced by the note, and that the note will be
paid in full at maturity. No amount was paid by TCO Holdings under this
promissory note in 1997, although $425,000 became payable in December, and was
paid in 1998. Approvals from various regulatory authorities, including the
Illinois DOI, were sought and obtained in connection with the transaction.
The financial impact of the foregoing transactions on the Company's GAAP
financial statements was an increase in stockholders' equity of approximately
$2.3 million. The transaction
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<PAGE> 23
with JBW & Co. also increased Alpine's statutory policyholders' surplus
by approximately $2.3 million.
Loan to TCO. In December 1993, the Company entered into a formal loan
agreement to loan TCO-IL up to $9.0 million to support TCO-IL's operations
("Loan Agreement.") TCO-IL initially pledged a total of 500,000 shares of
Exstar common stock ("Common Stock") owned by TCO-IL to secure its obligations
under the Loan Agreement. The number of shares pledged was reduced to 160,000
by agreement of the parties prior to year-end 1996 based on TCO-IL's prior
satisfaction of payment obligations under the Loan Agreement. TCO-IL's pledge
of the remaining 160,000 shares was terminated upon TCO-IL's transfer to the
Company of all Exstar Common Stock owned by TCO-IL in April 1997, for
consideration of $0.01 per share (the par value of the Exstar Common Stock).
This stock transfer had no impact on the Company's GAAP net income or
stockholders' equity. (See "Certain Relationships and Related Transactions" --
Item 13.)
Payments by TCO were current through December 31, 1996, leaving a
principal balance of $4.6 million of which $2.2 million was payable to Exstar
and $2.4 million was payable to Alpine. By early 1997, the Company believed,
based on TCO's financial condition and prospects, that TCO did not currently
have, and in the foreseeable future was unlikely to have, the ability to repay
this indebtedness. Accordingly, in an effort to help resolve financial issues
between the Company and TCO and to provide the Company assets of value to the
Company's continuing operations, Exstar accepted from TCO, in April 1997, a
transfer of certain computer systems, furniture, fixtures, properties and
rights of TCO in satisfaction of the $2.2 million of TCO debt owed to the
Company. The systems, furniture and fixtures which were transferred
constituted virtually all of TCO's systems, furniture and fixtures, had a then
current book value of approximately $40,000 and were independently appraised in
October 1996 at a total value of approximately $2.4 million. Pursuant to its
rights under a Master Agreement with TCO entered into in December 1992 in
connection with the Company's initial public offering ("Master Agreement"),
Exstar had a license to use the systems that were transferred to it by TCO. No
final resolution has been reached with respect to the $2.4 million of debt owed
by TCO to Alpine. Any offset or reduction of the TCO debt to Alpine would
require the prior approval of the Illinois DOI. It is anticipated that any
amounts owed by TCO to Alpine would be cancelled, subject to Illinois DOI
approval, upon the consummation of Frontier's acquisition of Alpine. (See " --
Proposed Future Operations and Organizational Changes; Relationship with
Frontier.")
In accordance with the equity accounting treatment retroactively adopted
by the Company in early 1995, TCO-IL's repayment obligations to the Company are
generally not carried as assets of the Company in its GAAP consolidated
financial statements. TCO's payment of the $2.2 million debt to Exstar through
the transfer of assets had no impact on the Company's GAAP net income or
stockholders' equity. TCO realized a gain of $2.1 million on the transfer of
assets to the Company, but in accordance with the form of equity accounting
used by the Company to reflect its relationship with TCO, this gain was not
recognized as a change in TCO's equity that would affect the Company's GAAP net
income and stockholders' equity. Additionally, neither the note receivable nor
any other amount owed by TCO to Alpine is reflected as an admitted asset of
Alpine in its statutory financial statements. (See Note 11 of Notes to
Consolidated Financial Statements.) To the extent all or any portion of such
TCO indebtedness could be repaid,
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<PAGE> 24
however, other than through funds directly or indirectly provided by the
Company, such repayment (whether before or after the sale of Alpine to
Frontier) would increase the Company's stockholders' equity. (See " --
Relationship with TCO.") Management considers the cancellation of such
indebtedness to be appropriate, however, because management believes TCO will
be unable to repay any significant portion of its debt to Alpine in the
foreseeable future, and because management believes TCO's debt is attributable
in large part to expenses incurred in performing activities which Alpine
otherwise would have had to perform itself.
22
<PAGE> 25
Fixed Maturity Investments. The table below sets forth the composition of
the Company's portfolio of fixed maturity investments by rating at December 31,
1997.
<TABLE>
<S> <C> <C> <C>
DECEMBER 31, 1997
RATING* CARRYING VALUE PERCENTAGE OF CUMULATIVE
PORTFOLIO PERCENTAGE
AAA (including U.S. Government obligations) $10,238,000 76.5% 76.5%
AA......................................... 1,323,000 9.9% 86.4%
A-......................................... 100,000 .7% 87.1%
BBB+....................................... 249,000 1.9% 89.0%
Nonrated................................... 1,465,000 11.0% 100.0%
Total...................................... $13,375,000 100.0%
</TABLE>
______________
* Ratings are assigned primarily by Standard & Poor's with remaining ratings
assigned by Moody's and converted to the equivalent Standard & Poor's ratings.
Investment Results. Investment results of the Company for each year in
the three years ended December 31, 1997 are shown in the following table.
<TABLE>
<S> <C> <C> <C>
FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995
(Dollars in thousands)
Cash and cash equivalents and invested assets(1) $53,120 $76,690 $90,838
Net investment income........................... 2,488 4,015 4,897
Average yield on total investments(2)........... 4.7% 5.3% 5.4%
Net realized investment (losses) gains.......... $(248) $(377) $389
</TABLE>
_____________________
(1) Total invested assets on an annual average basis.
(2) Calculated on an annualized basis.
REINSURANCE
The Company expects to retain all risk assumed by it under the Quota Share
Arrangement (the Frontier Companies' liability, not the Company's liability,
would be increased by the unlikely failure of any reinsurance on such
business), and, thus, has not renewed its existing reinsurance agreements or
entered into new agreements with reinsurers with respect to such risks. The
Company continues to have protection, with respect to business previously
written, under reinsurance agreements entered into in prior years.
To limit its exposure on large risks and increase capacity, the Company
historically entered into certain reinsurance transactions that ceded 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 Company would
then be liable for such defaulted amounts. All reinsurance payable to the
Company is due from Underwriters at Lloyd's, London or companies rated at least
A- by Best. At December 31, 1997, the largest single amount recoverable for
paid and unpaid losses was $10.4 million from Signet Star Reinsurance Company,
an insurer with a Best rating of
23
<PAGE> 26
A and $271.1 million of policyholders' surplus at December 31, 1997.
Although the Company does not currently write or reinsure material amounts
of business in the property insurance lines, which are lines that tend to be
most susceptible to catastrophes, the Company does periodically consider the
possibility of its exposure to unusually large or catastrophic events,
including in particular potential exposure for the Company's ocean marine line
(most of the Company's ocean marine insureds are located along the Florida and
Gulf of Mexico coasts). Management believes the likelihood is remote that such
an event would occur and the Company's reinsurers would fail to meet their
obligations with respect to such an event in any material way. With respect to
the overall exposure of the Company's reinsurers to catastrophic risk,
management monitors the financial condition of such reinsurers generally while
relying on rating agencies, including Best, to assess its reinsurers'
vulnerabilities to such risk.
The Company ceased issuing direct insurance coverage in August 1996.
Reinsurance for the Company's specialized liability business has been provided
by seven treaties. The first provides coverage for 1991 and 1992 by Signet
Star Reinsurance Company for losses incurred in excess of $1.0 million per
insured, per loss up to a maximum of $2.0 million per insured, per loss, plus
pro rata loss adjustment expenses. The second provides coverage for 1993, and
the third provides coverage from January through September 1994, for losses
incurred in excess of $1.0 million per insured, per loss up to a maximum of
$2.0 million per insured, per loss, plus pro rata loss adjustment expenses, by
Signet Star Reinsurance Company and Security Reinsurance Company. The fourth
provides coverage from October 1, 1994, through December 31, 1995, for losses
incurred in excess of $500,000 per insured, per loss up to a maximum of $1.0
million per insured, per loss, plus pro rata loss adjustment expenses, by
Signet Star Reinsurance Company and Security Reinsurance Company. The fifth
provides coverage from October 1, 1994, through December 31, 1995, for losses
incurred in excess of $1.0 million per insured, per loss up to a maximum of
$2.0 million per insured, per loss, plus pro rata loss adjustment expenses, by
Signet Star Reinsurance Company and Security Reinsurance Company. The sixth
cedes 50% of the first $500,000 of losses incurred per insured per loss, plus
loss adjustment expenses, for losses occurring under (i) policies issued on or
after April 1, 1995 and (ii) policies issued prior to April 1, 1995, for the
unexpired portion thereof, by Signet Star Reinsurance Company and Reliance
Insurance Company. The seventh provides coverage from January through December
1996 for losses incurred in excess of $1.0 million per insured, per loss up to
a maximum of $2.0 million per insured, per loss, plus pro rata loss adjustment
expenses, by Underwriters Reinsurance Company. In 1997, the Company commuted
the reinsurance treaty with Underwriters Reinsurance Company which previously
provided coverage from January through December 1996 for losses incurred in
excess of $500,000 per insured, per loss up to a maximum of $1.0 million per
insured, per loss, plus pro rata loss adjustment expenses, with no impact on
the Company's GAAP net income or stockholders' equity.
Reinsurance for the Company's architects and engineers professional
liability business has been provided by treaties principally with Underwriters
at Lloyd's, London. Treaties effective January 1, 1988, through December 31,
1993 and for 1995 provide coverage for losses incurred, including loss
adjustment expenses, in excess of $250,000 per insured, per loss up to a
maximum of $2.0 million per insured, per loss. The treaty for 1994 provides
coverage for losses incurred,
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<PAGE> 27
including loss adjustment expenses, in excess of $250,000 per insured, per loss
up to a maximum of $1.0 million per insured, per loss. Reinsurance for the
Company's architects and engineers business in 1996 is provided under the
specialized liability treaty described above with Underwriters Reinsurance
Company.
The Company's ocean marine business has been reinsured through a series of
annual treaties principally provided by Underwriters at Lloyd's, London. The
current series of treaties expired February 28, 1997, and provided coverage for
losses incurred, including loss adjustment expenses, in excess of $250,000 per
insured, per loss, generally up to a maximum of $1.0 million per insured, per
loss, up to a maximum aggregate limit of liability (excluding reinstatements)
of $10.0 million. The expiring treaties were extended to July 1997 to provide
run off coverage up to a maximum of $2.0 million per insured, per loss.
Treaties for prior annual periods provide similar coverages, but with reduced
maximum aggregate limits of liability.
Alpine and, prior to year-end 1996, the Syndicate, provided letters of
credit (which were fully collateralized by cash and cash equivalents, fixed
maturities and short-term investments) in connection with assumed reinsurance
agreements totaling $4,016,000, $7,992,000, and $8,746,000 at December 31,
1997, 1996 and 1995, respectively.
The following table reflects the effects of reinsurance on the Company's
premiums:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Earned premium:
Direct.......... $2,775 $40,058 $64,090
Ceded........... (2,178) (19,282) (25,966)
Assumed......... 6,119 234 1,025
Net............. $6,716 $21,010 $39,149
Written premium:
Direct.......... $1,410 $14,177 $63,281
Ceded........... (1,791) (5,563) (36,102)
Assumed......... 11,515 196 1,006
Net............. $11,134 $8,810 $28,185
</TABLE>
Included in the Company's statements of operations as part of policy
acquisition costs amortized were ceded commission income of $2,725,000,
$6,670,000 and $11,424,000 for the years ended December 31, 1997, 1996 and
1995, respectively.
The following table shows the amount of reinsurance recoverables for
unpaid losses and loss adjustment expenses and for paid losses and loss
adjustment expenses payable by the Company's reinsurers:
YEARS ENDED DECEMBER 31,
1997 1996
25
<PAGE> 28
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Unpaid losses and loss adjustment expenses.............. $13,363 $33,921
Receivables for paid losses and loss adjustment expenses 2,382 1,576
Total................................................... $15,745 $35,497
</TABLE>
The ceding of liability to a reinsurer does not legally discharge the
ceding insurer from its primary liability for the full amount of the policies
on which it obtains reinsurance, and the ceding insurer will be required to pay
the entire loss if the assuming reinsurer fails to meet its obligations under
the reinsurance agreement. The Company has never had a significant reinsurance
recovery problem, and expects that it will be able to collect the reinsurance
receivables due from its reinsurers.
OPERATING RATIOS
The following ratios, which are frequently used in evaluating operating
performance in the insurance industry, are presented on a statutory and GAAP
basis.
Combined Ratios. The combined ratio, which reflects underwriting results
but not investment income, is a traditional measure of underwriting performance
of a property and casualty insurer. A statutory combined ratio of less than
100% generally indicates statutory underwriting profitability while a statutory
combined ratio in excess of 100% generally indicates a statutory underwriting
loss.
The following table reflects, on a statutory basis, the consolidated loss
and loss adjustment expense ratios, expense ratios and combined ratios of
Alpine (including such ratios with respect to business written by the Syndicate
in 1996 and 1995) and the property and casualty insurance industry for the
years ended December 31, 1997, 1996 and 1995, and the other liability industry
group of the property and casualty industry, for the years ended December 31,
1996 and 1995.
<TABLE>
YEARS ENDED DECEMBER 31, CUMULATIVE AVERAGE
1997 1996 1995 1995-97
The Company:
<S> <C> <C> <C> <C>
Loss and loss adjustment expense ratio...... 114.2% 60.0% 39.1% 53.2%
Expense ratio............................... 51.2% 63.3% 49.9% 52.7%
Combined ratio.............................. 165.4% 123.3% 89.0% 105.9%
Property and casualty insurance industry(1):
Loss and loss adjustment expense ratio...... 72.9% 78.4% 78.9% n/a
Expense ratio............................... 27.0% 26.3% 26.1% n/a
Combined ratio(2)........................... 101.6% 105.8% 106.3% n/a
Other liability industry group(1)(3):
Loss and loss adjustment expense ratio...... n/a 96.4% 115.0% n/a
Expense ratio............................... n/a 26.7% 28.1% n/a
Combined ratio(2)........................... n/a 123.5% 143.6% n/a
</TABLE>
_______________________
(1) Source for 1995 and 1996 numbers: Best's Aggregates & Averages, Property
Casualty (1997 edition). Source for 1997 numbers: Bestweek, P/C (March
16, 1998 edition).
26
<PAGE> 29
(2) Industry combined ratios include policyholder dividends and, therefore,
exceed the sum of the loss and loss adjustment expense ratio and the
expense ratio.
(3) Represents commercial lines of casualty insurance (excluding medical
malpractice).
The ratios reflected above with respect to 1996 differ from those that
would be calculated on the basis of information in the 1996 annual statement
(statutory financial statement) of Alpine filed with state insurance
regulatory officials, in that the operating results of the Syndicate were not
combined with those of Alpine in Alpine's 1996 annual statement, even though
the Syndicate's operations were combined with those of Alpine effective
December 31, 1996.
27
<PAGE> 30
The following table reflects, on a GAAP basis, the consolidated loss and loss
adjustment expense ratios, expense ratios and combined ratios of Alpine
(including such ratios with respect to business written by the Syndicate in
1996 and 1995) for the years ended December 31, 1997, 1996, and 1995.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31, CUMULATIVE AVERAGE
1997 1996 1995 1995-1997
<S> <C> <C> <C> <C>
Loss and loss adjustment expense ratio 115.0% 60.4% 40.0% 54.0%
Expense ratio......................... (1.7)% 24.4% 29.8% 24.9%
Combined ratio........................ 113.3% 84.8% 69.8% 78.9%
</TABLE>
The loss and loss adjustment expense ratio is calculated by dividing
incurred losses and loss adjustment expenses (determined on a statutory or GAAP
basis, as the case may be) by earned premium (determined on a statutory or GAAP
basis). The statutory expense ratio is calculated by dividing net incurred
other underwriting expenses by net written premium. The GAAP expense ratio is
calculated by dividing policy acquisition costs amortized by earned premium.
The combined ratio is the sum of the loss and loss adjustment expense ratio
plus the expense ratio on both statutory and GAAP bases.
During 1996, the Company reduced its cumulative reserves for losses and
loss adjustment expenses for all years as of December 31, 1995. (See " --
Losses and Loss Adjustment Expenses.") The reduction in the reserves
(approximately $14.9 million) was effective for 1995 and reduced the Company's
1995 loss and loss adjustment expense ratio. The Company's 1995 statutory
expense ratio was increased by profit sharing expense related to the foregoing
reduction in reserves. The cessation of the Company's writing of direct
business in 1996 (without a corresponding immediate reduction in expenses)
adversely affected both the Company's 1996 and 1997 statutory expense ratios
and combined ratios. During 1997, the Company strengthened its reserves for
losses and loss adjustment expenses by $4.4 million, thereby increasing both
the Company's statutory and GAAP loss and loss adjustment expense ratios. The
Company's 1997 (negative) GAAP expense ratio was the result of earning
additional commission income under certain reinsurance agreements (because of
loss development) which exceeded policy acquisition costs for the year. Absent
this additional income, the Company's 1997 GAAP expense ratio would have been
31.3%.
IRIS Ratios and Risk-Based Capital. The National Association of Insurance
Commissioners ("NAIC") utilizes 12 Insurance Regulatory Information System
("IRIS") ratios and has developed a risk-based capital formula to assist
regulators in evaluating insurer performance and capital adequacy. Alpine
failed certain IRIS ratio tests in 1995, 1996 and 1997, and its statutory
policyholders' surplus fell below regulatorily prescribed early warning levels
of risk-based capital in 1995, 1996 and 1997. (See "-- Regulation -- Insurance
Regulatory Information System Tests" and "-- Regulation -- Risk-Based
Capital.")
28
<PAGE> 31
REGULATION
Exstar's insurance company subsidiary, Alpine, is subject to a substantial
degree of regulation, which generally is designed to protect the interests of
Alpine's policyholders, rather than the Company's shareholders. As an Illinois
property and casualty insurance company, Alpine is subject to the primary
regulatory oversight of the Illinois DOI. If the proposed sale of Alpine is
consummated in accordance with the Potential Frontier Deal as currently
contemplated, management expects the Company's regulatory compliance burden
would decrease substantially, because the proposed Cayman Company would be
subject to a much reduced regulatory compliance obligation compared to that
which Alpine is currently and in 1998 is likely to be subject.
Illinois Order. Alpine is currently subject to the Illinois Order, which
limits Alpine's activities and those of the Company. In May 1996, management
approached the Illinois DOI to discuss Alpine's loss reserves, its financial
condition, its relationship with TCO and TCO's inability to pay to Alpine all
amounts owed. Based on that discussion and issues concerning Alpine's statutory
financial statements and its loss reserves (see "-- Losses and Loss Adjustment
Expenses"), the Illinois DOI commenced an actuarial and financial review of
Alpine. In connection with this review, on July 5, 1996, the Illinois DOI
issued an order directing: (i) that Alpine, including the owners, officers,
directors, and employees of Alpine, shall make no disbursements of any kind,
except for properly authorized insurance claim payments, whether by direct cash
transaction, loan offset, forgiveness of debts, purchase, payment of
compensation, dividends of any kind, or by transfer of securities or assets of
any kind, unless prior to such disbursement Alpine has obtained the written
approval of the Illinois DOI; (ii) that Alpine shall not enter into or agree to
enter into any agreement which commits Alpine to any type of disbursement
subject to the foregoing clause (i) without the prior written approval of the
Illinois DOI; (iii) that Alpine is prohibited from entering into any
transactions with any affiliate as defined under the Illinois Insurance Code
without the prior written approval of the Illinois DOI; and (iv) that Alpine
shall demand immediate payment to Alpine of all Alpine premiums held by any
affiliate. The impact of the Illinois Order has been to subject virtually all
of Alpine's and the Company's transactions, organizational relationships and
business operations to close scrutiny by, and approval requirements of, the
Illinois DOI.
If the sale of Alpine to Frontier is consummated as the Potential Frontier
Deal currently contemplates, management anticipates (though it has no
understandings with the Illinois DOI) that the Illinois Order would be
eliminated. The Company's continuing relationships with the Frontier
Companies, however, may continue to be subject to significant regulatory
oversight by the Illinois DOI and other state insurance regulatory authorities.
Combination of the Syndicate with Alpine. Effective December 31, 1996,
the Syndicate withdrew as a syndicate member of the IIE, and concurrently
transferred all of its assets (other than the stock of Alpine which was owned
by the Syndicate) and liabilities to Alpine and changed its name to Alpine
Holdings, Inc. Alpine Holdings, Inc. continues to exist as the current direct
parent of Alpine, but with no operations. Pursuant to an agreement with the
IIE, certain of the Syndicate's assets transferred to Alpine were placed in
trust as security for the payment of claims
29
<PAGE> 32
of policyholders and other Syndicate obligations, and thus are not readily
available for the satisfaction of other Alpine obligations. Alpine is subject
to certain ongoing reporting and compliance obligations to the IIE with respect
to business formerly conducted by the Syndicate. In addition, $1.0 million of
assets of the Syndicate are now held, and will continue to be held through at
least the end of 1999, by the IIE Guaranty Fund, Inc., an entity which is
intended to provide certain financial protection to policyholders of insolvent
IIE syndicates. Such $1.0 million is included as an asset of the Company in its
GAAP financial statements, and as an asset of Alpine in its statutory financial
statements. Because of unrelated IIE syndicate insolvencies which have occurred
and may occur in the future, the Company's ability to recover in full such $1.0
million may be uncertain. If the sale of Alpine to Frontier is consummated as
currently contemplated, the Company likely will continue to be responsible for
the foregoing reporting and compliance obligations unless an agreement
terminating such obligations can be reached with the IIE.
Dividend Limitations. Alpine is limited in its ability to pay dividends
to shareholders. Alpine is subject to an overall limitation that dividends and
other distributions can be declared and paid only to the extent of earned, as
opposed to contributed, statutory policyholders' surplus. In addition, Alpine
is subject to the provisions of the Illinois Insurance Holding Company Systems
Act, which requires prior notice for the payment of all dividends or other
distributions, and special approval for those which, during any consecutive
12-month period, exceed the greater of (i) 10% of Alpine's statutory
policyholders' surplus as of the immediately preceding year-end or (ii) its
statutory net income for the immediately preceding year. In addition to the
foregoing limitations, the Illinois Order prohibits Alpine from paying any
dividends without the prior approval of the Illinois DOI. Management expects
that such approval would be unlikely to be received, if requested, in the
foreseeable future. Should the Potential Frontier Deal be consummated as
currently contemplated, management expects limitations on the Cayman Company's
ability to pay dividends would likely be less restrictive than those applicable
to Alpine.
Holding Company System Regulation. Because of its indirect ownership of
Alpine, the Company is subject to certain provisions of the Illinois Insurance
Holding Company Systems Act, which governs any direct or indirect changes in
control of Alpine and certain affiliated-party transactions involving Alpine or
its assets. No person may acquire, directly or indirectly, 10% or more of the
outstanding voting securities or otherwise acquire control of Alpine, Alpine
Holdings, Inc. (Alpine's direct holding company parent) or Exstar, unless the
Illinois DOI has approved such acquisition. In this regard, Frontier will be
required to obtain such approval if the Proposed Frontier Deal is to be
consummated as currently contemplated, as it includes the sale to Frontier of
the stock of Alpine. The determination of whether to approve any such
acquisition is based on a variety of factors, including an evaluation of the
acquirer's financial stability, the competence of its management and whether
competition in Illinois would be reduced, none of which management believes
would hinder the Illinois DOI's approval of Frontier's acquisition of Alpine.
In addition, certain material transactions involving Alpine and any affiliate
must be disclosed to the Illinois DOI not less than 30 days prior to the
effective date of the transaction (a transaction can be disapproved by the
Illinois DOI within such 30-day period if it does not meet certain standards).
Transactions requiring such approval include, but are not limited to, sales,
purchases or exchanges of assets, loans and extensions of credit, and
investments. Alpine is also required to file periodic
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<PAGE> 33
and updated statements reflecting the current status of its holding company
system, the existence of any related-party transactions and certain
financial information relating to any person who directly or indirectly
controls (presumed at 10% voting control) Alpine. In addition to the
foregoing, the Illinois Orderrequires approval of the Illinois DOI for most
transactions and commitments involving Alpine and its affiliates. Any similar
restrictions on the proposed Cayman Company with respect to transactions with
affiliates are expected to be less burdensome than those applicable to Alpine.
Insurance Guaranty Funds. As an Illinois property and casualty insurance
company, Alpine is subject to the provisions of the Illinois Insurance Guaranty
Fund Act, which provides for the assessment of member insurance companies based
on the amount of direct written premium in Illinois. The amount and timing of
such assessments are beyond the control of the Company. Although Alpine is no
longer writing direct business, it may be subject to assessments with respect
to direct business written in prior years. The Company is not aware of any
similar potential assessments relating to Cayman Islands insurance companies.
National Association of Insurance Commissioners. In addition to
state-imposed insurance laws and regulations, Alpine is subject to the general
statutory accounting practices and reporting formats established by the NAIC.
The NAIC also promulgates model insurance laws and regulations relating to the
financial and operational regulation of insurance companies. These rules and
regulations generally are not directly applicable to an insurance company until
they are adopted by applicable state legislatures and departments of insurance.
NAIC model laws and regulations have become increasingly important in recent
years, due primarily to the NAIC's Financial Regulatory Standards and
Accreditation Program. Under this program, states which have adopted certain
required model laws and regulations and meet various staffing and other
requirements are "accredited" by the NAIC. Such accreditation is the
cornerstone of an eventual nationwide regulatory network, and there is a
certain degree of political pressure on individual states to become accredited
by the NAIC. Because the adoption of certain model laws and regulations is a
prerequisite to accreditation, the NAIC's initiatives have taken on a greater
level of practical importance in recent years. Illinois has been accredited by
the NAIC, but the maintenance of its accreditation is contingent upon Illinois'
continuing substantial compliance with various NAIC model laws and regulations.
All states have adopted the NAIC's financial reporting form, which is
typically referred to as the NAIC "annual statement." In this regard, the NAIC
has a substantial degree of practical influence and is able to accomplish
certain quasi-legislative initiatives through amendments to the NAIC annual
statement and applicable accounting practices and procedures. For instance,
the NAIC has required all insurance companies to have an annual statutory
financial audit and actuarial certification as to loss and loss adjustment
expense reserves by including such requirements within the annual statement
instructions.
In reporting in accordance with the NAIC annual statement form, insurers
must comply with statutory accounting practices typically described as those
practices "prescribed" or "permitted" by the insurance company's domiciliary
insurance regulator. With respect to Alpine, "prescribed" statutory accounting
practices are those described under Illinois laws and regulations
<PAGE> 34
of the Illinois DOI. "Permitted" statutory accounting practices encompass all
statutory accounting practices not so prescribed and must be approved by the
appropriate regulatory authority. All practices used by the Company are
prescribed. The NAIC has completed a project to codify statutory accounting
practices that is expected to change the definition of what comprises prescribed
statutory accounting practices and that is expected to change the accounting
policies that insurance enterprises use to prepare their financial statements.
If the Potential Frontier Deal is consummated as currently contemplated,
the proposed Cayman Company would not directly be subject to state regulation
or NAIC initiatives, nor would it be required to prepare financial statements
in accordance with statutory accounting practices, whether on the NAIC annual
statement form or otherwise.
Insurance Regulatory Information System Tests. The NAIC also has
developed IRIS ratios which are designed to provide regulators indications of
potential problems of insurance companies. Alpine failed 8 of 12 IRIS ratio
tests for 1995 based on initial 1995 statutory financial statements Alpine
filed with regulatory authorities (based on which a number of such regulatory
authorities took actions restricting Alpine's authority to do business).
Alpine amended its 1995 statutory financial statements to reflect the
overstatement in its loss reserves of approximately $14.9 million (see " --
Losses and Loss Adjustment Expenses") and, based on the amended statements, it
failed 4 IRIS ratio tests for 1995. Alpine failed 2 IRIS ratio tests for 1996
(as a general rule, an insurer may fail up to 3 IRIS ratio tests without
triggering a higher level of NAIC or regulatory scrutiny). Alpine failed 6
IRIS ratio tests for 1997, based on statutory policyholders' surplus of $5.3
million. (Alpine's statutory annual statement for 1997 required to be filed
with insurance regulatory authorities currently reflects statutory
policyholders' surplus of $6.8 million at December 31, 1997, and failure of
only 5 IRIS ratio tests. Alpine's statutory policyholders' surplus was $5.3
million after elimination of certain subrogation recoverables which Alpine
currently expects will not be included in Alpine's audited statutory
policyholders' surplus at December 31, 1997.)
The following table sets forth the NAIC's expected normal values for the
IRIS ratios and Alpine's IRIS ratios for 1997 (using $5.3 million of statutory
policyholders' surplus) and 1996.
IRIS RATIOS
<TABLE>
<CAPTION>
UNUSUAL VALUES EQUAL TO OR ALPINE'S RESULTS
OVER UNDER 1997 1996
RATIO
<S> <C> <C> <C> <C>
Gross premium to surplus....................... 900 243 99
Net premium to surplus......................... 300 210 61
Change in net writings......................... 33 (33) 46* (57)*
Surplus aid to surplus......................... 15 0 2
Two-year overall operating ratio............... 100 101* 90
Investment yield............................... 10 4.5 4.8 3.6*
Change in surplus.............................. 50 (10) (44)* (6)
Liabilities to liquid assets................... 105 149* 99
Agents' balances to surplus.................... 40 0 0
One-year reserve development to surplus........ 20 41* 2
Two-year reserve development to surplus........ 20 56* (44)
Estimated current reserve deficiency to surplus 25 (199) (295)
</TABLE>
32
<PAGE> 35
___________________________
* Indicates results outside the usual range.
The six IRIS tests failed in 1997 were Change in Net Writings, Two-Year
Overall Operating Ratio, Change in Surplus, Liabilities to Liquid Assets,
One-Year Reserve Development to Surplus and Two-Year Reserve Development to
Surplus. The Change in Net Writings failure resulted principally from the
increased assumed premiums in 1997 after the Quota Share Arrangement became
effective on April 1, 1997, compared to the reduced direct premiums in 1996
following the Best rating downgrades of Alpine and the Syndicate early in 1996
and the Company's subsequent decision to cease writing direct insurance in
August 1996. The Two-Year Overall Operating Ratio and the Change in Surplus
failures resulted principally from adverse loss development for the 1992-1994
years that could not be offset by favorable loss development for the 1995-1997
years because of a statutorily imposed liability (Schedule P penalty) of $6.6
million. The Schedule P penalty is a statutory accounting requirement which
generally specifies that an insurer must include as a liability on its
statutory financial statements the difference between (i) losses estimated at a
specified percentage of earned premium (60% in the case of Alpine), and (ii)
the Company's actual expected ultimate losses, generally for the three most
recent years. The Schedule P penalty is not applicable to the Company's GAAP
financial statements. (See " -- Losses and Loss Adjustment Expenses.") The
Liabilities to Liquid Assets failure also resulted principally from the
Schedule P penalty, coupled with real estate's constituting approximately 24%
of Alpine's cash and invested assets. The One-Year and Two-Year Reserve
Development to Surplus failures resulted principally from management's
decision to strengthen loss reserves by $4.4 million during the third and
fourth quarters of 1997.
The two IRIS tests failed in 1996 were Change in Net Writings and
Investment Yield. Alpine's Change in Net Writings failure resulted from a
decrease in premiums written because of the Best rating downgrades, regulatory
restrictions and management's decision to cease writing direct insurance in
August 1996. The Company's insurance company subsidiaries historically failed
the Investment Yield test principally because of their payments to TCO of
portions of their investment income pursuant to the management agreement
previously in force between the Company and TCO.
Because of the Company's proposed sale of Alpine to Frontier in accordance
with the Potential Frontier Deal, Alpine's 1997 IRIS results are not expected
to materially adversely affect the Company's future operations. Even if the
sale is not consummated, however, management expects Alpine's 1997 IRIS ratio
results will not adversely impact Alpine's ability to act as a reinsurer of the
Frontier Companies, principally because the reinsurance funds held by the
Frontier Companies under the Quota Share Arrangement provide reasonably
adequate security for Alpine's potential reinsurance obligations.
Notwithstanding the foregoing, Alpine's 1997 IRIS results and financial
condition generally would adversely impact the Company's prospects should the
Company's reinsurance and production relationships with the Frontier Companies
terminate, and the Company have to seek to resume writing direct insurance or
alternative arrangements with other insurance companies similar to the
arrangements with the Frontier Companies.
Risk-Based Capital. The NAIC has adopted a risk-based capital formula for
property and
33
<PAGE> 36
casualty insurance companies. This formula calculates a minimum level of
capital and surplus which should be maintained by each insurer, based on
underwriting, credit, investment and other business risks inherent in an
individual company's operations. Various states, including Illinois, have
adopted the NAIC's risk-based capital model act applicable to property/casualty
insurers. The model act authorizes certain regulatory actions based on the
ratio of a company's "adjusted capital" (generally the insurer's actual
statutory policyholders' surplus) to its "authorized control level" riskbased
capital. The following table sets forth the different levels of risk-based
capital that may trigger regulatory involvement and the corresponding actions
that may result.
LEVEL TRIGGER CORRECTIVE ACTION
Company Action Level Adjusted capital Submit comprehensive plan
less than 200% of to insurance commissioner
authorized control
level
Regulatory Action Level Adjusted capital In addition to above, insurer is
less than 150% of subject to examination, analysis
authorized control and specific corrective
level action
Authorized Control Level Adjusted capital In addition to both of above,
less than 100% of insurance commissioner may
authorized control place insurer under regulatory
level control
Mandatory Control Level Adjusted capital Insurer must be placed under
less than 70% of regulatory control
authorized control
level
The "comprehensive plan" required at the company action level and
certain other levels must: (i) identify the conditions in the insurer that
contribute to the failure to meet the capital requirements; (ii) contain
proposed corrective actions that the insurer intends to make and that would be
expected to result in compliance with the capital requirements; (iii) provide
certain projections of the insurer's financial results for the current year and
at least the four succeeding years; (iv) identify key assumptions impacting the
insurer's projections and the sensitivity of the projections to the
assumptions; and (v) identify the quality of, and problems associated with, the
insurer's business, including but not limited to its assets, anticipated
business growth and associated surplus strain, extraordinary exposure to risk,
mix of business, and use of reinsurance in each case.
At December 31, 1997, in contrast to actual adjusted capital of $5.3
million: (i) Alpine would have needed adjusted capital of $9.1 to exceed the
company action level of risk-based capital applicable to it; (ii) Alpine would
have needed adjusted capital of $6.8 million to exceed the regulatory action
level of risk-based capital applicable to it; (iii) Alpine needed adjusted
capital of $4.6 million to exceed the authorized control level of risk-based
capital applicable to it; and (iv) Alpine needed adjusted capital of $3.2
million to exceed the mandatory control level of risk-based capital applicable
to it.
Alpine's adjusted capital amounts at December 31, 1997, and December 31,
1996, were approximately 117% and 173%, respectively, of its authorized control
level risk-based capital amounts. (See " -- Overview of Current Business
Operations" and "Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Liquidity and Capital Resources" -- Item 7.)
Because Alpine's December 31, 1996, adjusted capital was less than
34
<PAGE> 37
200% of its authorized control level risk-based capital, Alpine was required to
submit a comprehensive financial plan to the Illinois DOI. The plan
identified, as the principal condition that contributed to Alpine's failure to
meet the company action level of risk-based capital, the amount of Alpine's net
reserves for losses and loss adjustment expense relative to its statutory
policyholders' surplus and contained, as the proposed corrective actions,
principally changes to the Company's operations and organizational structure
already implemented, and consummation of the UCIC Quota Share Arrangement.
Alpine's comprehensive financial plan with respect to the year ended December
31, 1996, was filed with and not objected to by the Illinois DOI.
As Alpine was below the regulatory action level at December 31, 1997, a
similar comprehensive financial plan will be required to be submitted to the
Illinois DOI by April 16, 1998. Management expects such plan to identify the
$6.6 million Schedule P penalty incurred by Alpine in 1997 as one of the
principal causes for Alpine's failure to meet or exceed the company action
level of risk-based capital. Additionally, Alpine's statutory policyholders'
surplus was reduced by an underwriting loss of $6.7 million in 1997 as a result
of a relatively small volume of net premiums earned and $4.4 million of loss
and loss adjustment expense reserve strengthening during the year. (See "--
Losses and Loss Adjustment Expenses.") Management expects the plan to propose,
as principal corrective actions to increase Alpine's risk-based capital above
the company action level, the continuation of Alpine's operations in 1998,
during which Alpine (i) expects to experience an overall reduction in net
reserves for losses and loss adjustment expense outstanding relative to its
statutory policyholders' surplus, (ii) expects to eliminate approximately $2.5
million of the Schedule P penalty as the 1995 accident year becomes excluded
from Alpine's Schedule P calculation, and (iii) expects to receive additional
assets contributed by Exstar consisting principally of some or all of up to
approximately $1.7 million of real estate investments owned directly by Exstar,
if necessary. Consummation of the proposed sale of Alpine and merger of Alpine
with UCIC in accordance with the Potential Frontier Deal as currently
contemplated also are expected to eliminate or reduce Alpine's risk-based
capital obligations and concerns.
State Regulation. During 1996 and 1997, a number of states acted to
restrict or eliminate Alpine's ability to issue direct coverage in such states.
Such states had previously accounted for most of the premium written by the
Company. As a general rule, Alpine's inability to issue direct coverage in a
state does not render it unable to provide reinsurance with respect to risks
located in the state. Insurers assuming risk only from other ceding insurers
(reinsurers) rather than issuing direct insurance are subject to a lesser
degree of regulatory scrutiny and compliance obligations outside their states
of domicile than insurers issuing direct insurance. Through regulation of the
reserves required to be maintained in a ceding insurer's statutory financial
statements and the circumstances in which such reserves may be reduced through
the cession of liabilities to a reinsurer, however, states can indirectly
influence the activities of reinsurers. Due, in part, to such reserve
requirements, the Quota Share Arrangement has been structured on a "funds held"
basis. (See " -- Overview of Current Business Operations.") In addition, it
is possible that Alpine's prior and existing regulatory issues could lead
regulators to place material restrictions on Alpine's ability to act as a
reinsurer of the Frontier Companies under the Quota Share Arrangement or of any
other insurer.
In addition, Illinois law requires that an Illinois insurer may not assume
the types of
35
<PAGE> 38
insurance currently assumed by Alpine under the Quota Share Arrangement if the
assuming Illinois insurer's statutory policyholders' surplus is less than $5.0
million. Alpine's statutory policyholders surplus of $5.3 million as of
December 31, 1997, was only $300,000 above the required minimum. (Alpine's
statutory annual statement for 1997 required to be filed with insurance
regulatory authorities currently reflects statutory policyholders' surplus of
$6.8 million at December 31, 1997. The $5.3 million represents Alpine's
statutory policyholders' surplus after elimination of certain subrogation
recoverables which Alpine currently expects will not be included in Alpine's
audited statutory policyholders' surplus at December 31, 1997.) The Company
expects Alpine's surplus to increase during 1998 as a consequence of profitable
or at least break even operations and elimination of the $2.5 million portion of
the Schedule P penalty relating to accident year 1995; and if necessary, the
Company expects it could contribute assets, including principally real estate
investments owned by Exstar with statutory net asset values of up to
approximately $1.7 million at December 31, 1997, to Alpine. There can be no
guarantee, however, that the 1998 operations will be profitable or break even,
especially if the recent trend (since 1995) of adverse loss development should
continue and result in substantial losses. (See " -- Losses and Loss Adjustment
Expenses.") Should Alpine experience losses which offset the sum of (i) the
reduction in the Schedule P penalty, (ii) the contribution of assets by Exstar
and (iii) profits from operations, if any, Alpine's ability to continue to
operate as a reinsurer could be terminated. In such case, the Company could
experience significant losses. (See " -- Overview of Current Business
Operations" and "Management's Discussion and Analysis of Financial Condition and
Results of Operations" -- Item 7.)
An insurer's eligibility to write direct insurance on a surplus lines
basis in most jurisdictions is dependent on its compliance with certain
financial standards, including the maintenance of a requisite level of capital
and statutory surplus and the establishment of certain statutory deposits. To
maintain its license as an Illinois domestic property and casualty insurer,
Alpine must maintain statutory policyholders' surplus of at least $1.5 million.
In recent years, many jurisdictions, including those in which Alpine has
conducted most of its insurance business, have increased the minimum financial
standards for surplus lines eligibility, including adoption of the NAIC's model
surplus lines act which, among other things, establishes a minimum statutory
policyholders' surplus requirement of $15.0 million. This minimum requirement
would preclude Alpine from acting as a surplus lines insurer in these
jurisdictions but not preclude it from acting as a reinsurer. As a result of
Alpine's diminished statutory policyholders' surplus level ($5.3 million at
December 31, 1997), risk-based capital results and Best rating, as well as the
proposed sale of Alpine to Frontier and merger with UCIC in accordance with the
Potential Frontier Deal (which would render the continuation of Alpine's
surplus lines authorizations unnecessary), effective March 1, 1998, Alpine
voluntarily withdrew as an authorized surplus lines insurer in every
jurisdiction in which it then remained authorized.
In certain states where insurers such as Alpine are not authorized to
conduct insurance business, such insurers may not be permitted to file certain
pleadings in court until they have posted bonds with the courts. Alpine has
been faced with this requirement in two states, but has to date suffered little
material adverse impact. If the requirement were to be enforced more broadly
against Alpine, it could significantly increase Alpine's costs with respect to
coverage lawsuits and other litigation matters, and, thus, adversely affect the
Company. It also could materially adversely impact Alpine's liquidity. (See "--
Management's Discussion and Analysis of Financial Condition and Results of
Operations" -- Item 7.)
36
<PAGE> 39
If the sale of Alpine to Frontier is accomplished in accordance with the
Potential Frontier Deal as currently contemplated, the Cayman Company would be
subject to Cayman Islands regulation, but would not be directly subject to
state regulation in the U.S. Management expects this would significantly
reduce the Company's insurance regulatory compliance burden.
Reserve Requirement. During 1997, Illinois enacted a statute governing
investments, in general, and requiring, beginning with Alpine's statutory
financial statements to be filed with respect to the quarter ending March 31,
1998, that Alpine maintain (i) the sum of cash and other specified assets, in
excess of (ii) the sum of Alpine's discounted loss and loss adjustment expense
reserves and reserves for
<PAGE> 40
unearned premiums ("reserve requirement"). The Illinois DOI has not yet
adopted regulations or other official guidelines interpreting the reserve
requirement. Alpine may have difficulty meeting the reserve requirement in
1998, depending on how the new statutory provision ultimately is interpreted,
but believes, based on discussions with the Illinois DOI, that it may be able
to comply sufficiently with the requirement to avoid any increase in the
Illinois DOI's current level of oversight. Should Alpine fail to satisfy the
reserve requirement under such an interpretation, the Illinois DOI could
require action by Alpine to rectify the failure, and if Alpine ultimately were
to fail to comply, could seek to cause Alpine to cease operations.
LOSSES AND LOSS ADJUSTMENT EXPENSES
The Company is directly liable for loss and loss adjustment expense
payments under the terms of insurance policies that it has written and pursuant
to reinsurance agreements under which it has assumed insurance business. For
the Company's occurrence policies and occurrence policies reinsured by the
Company, a number of years normally will elapse between the occurrence of an
insured loss, the reporting of the loss to the Company and the Company's
payment of that loss. For the Company's claims made policies and claims made
policies reinsured by the Company, the occurrence of the loss must be reported
during the policy period or any extended reporting period, though losses may
not be paid out for a number of years. The Company reflects its liability for
the ultimate payment of all incurred losses and loss adjustment expenses by
establishing loss and loss adjustment expense reserves, which are balance sheet
liabilities representing estimates of future amounts needed to pay claims and
related expenses with respect to insured events that have occurred.
When a claim involving a probable loss is reported, the Company
establishes a case reserve for the estimated amount of the Company's ultimate
loss and loss adjustment expense payments. The estimate reflects an informed
judgment based on established reserving practices and the experience and
knowledge of claims personnel regarding the nature and value of the claim as
well as the estimated expense of settling the claim, including legal and other
fees, and general expenses of administering the claims adjustment process.
Management also establishes reserves on an aggregate basis to provide for
losses incurred but not reported ("IBNR reserves"), as well as future
development on losses reported to the Company. The amount of an insurer's
incurred losses in a given period is determined by adding losses and loss
adjustment expenses paid during the period to case loss and loss adjustment
expense reserves and IBNR reserves (collectively, "loss reserves") at the end
of the period, then subtracting loss reserves existing at the beginning of
37
<PAGE> 41
the period.
As part of the reserving process, historical data is reviewed, and
consideration is given to the anticipated effect of various factors, including
known and anticipated legal developments, inflation and economic conditions and
collectibility of deductibles. Reserve amounts are necessarily based on
management's estimates, and as other data become available and are reviewed,
these estimates and judgments are revised, resulting in increases or decreases
to existing reserves. To verify the adequacy of its reserves, the Company
engages independent actuarial consultants to perform periodic case and ultimate
loss reserve analyses.
Estimates for ultimate loss reserves are inherently difficult to determine
because they are attempts to quantify future results based on current trends and
incomplete information. The effort to predict the Company's ultimate losses
and loss adjustment expense has been made more difficult because the Company's
recent business includes a substantial amount of insurance written for
subcontractors and general contractors, most of which are located in
California. California law relating to contractors has changed significantly
over the last several years as a consequence of California legal decisions and
newly enacted legislation. The Company, additionally, significantly modified
its policy forms and underwriting standards relating to its contractor business
in each of 1996, 1995 and 1994. Because of the foregoing, the assumptions made
and the trends used by the Company in estimating its reserves for losses and
loss adjustment expenses have been relatively untested by time and actual
development of reserves.
In February 1996, the Company's independent actuaries arrived at a
determination that the Syndicate and Alpine had experienced substantial adverse
loss development during 1995. This adverse loss development was in addition to
adverse loss development during each of 1994 and 1993. In order to evaluate
the loss data on which the actuarial determinations were based, the Company
hired an independent claims specialist in February 1996 to conduct a review of
its "case" loss reserves (reserves relating to specific claims). Based on the
claims specialist's review of the Company's claim files, the Company determined
that its case loss reserves were substantially overstated. Alpine and the
Syndicate were unable to provide data concerning the reserve overstatements in
final form to the actuaries in time for such data to be considered in the
actuaries' certification of Alpine's and the Syndicate's 1995 loss reserves for
their unaudited 1995 statutory financial statements. Consequently, the
statutory financial statements which incorporated the overstated loss reserves
were provided to Best and state regulatory authorities. The overstatement of
loss reserves contributed to the adverse financial results reported by Alpine
and the Syndicate, the Best ratings downgrades and the actions taken against
the Company by state regulatory authorities.
After discussions with the Illinois DOI in early 1996, the Company hired
another independent actuarial firm to review and recertify the Company's loss
reserves as of December 31, 1995. The recertification was completed in August
1996 and accepted by the Illinois DOI, following its commissioning of an
additional independent actuarial review confirming the Company's review, in
December 1996. Based upon the recertifications, the Company had an
overstatement, or redundancy, of approximately $14.9 million in its loss
reserves in its initially filed unaudited December 31, 1995 statutory
statements. In September 1996, Alpine filed
38
<PAGE> 42
amended statutory statements eliminating substantially all of the redundancy.
Because Alpine also non-admitted a substantial amount of assets in 1995
(principally receivables from TCO), the net effect on Alpine's statutory
policyholders' surplus was a reduction of approximately $5.0 million.
As a consequence of the independent reviews of the Company's case loss
reserves in 1996, the Company adopted what management believes is a less
conservative reserving approach than had previously been employed. Reserve
development since then generally has consisted of increases in ultimate
estimated losses and loss adjustment expenses annually, compared to a trend
prior to 1995 of relatively higher initially estimated losses and loss
adjustment expenses followed by annual decreases from the initial estimates.
During 1997, Alpine incurred a Schedule P penalty of $6.6 million. The
Schedule P penalty resulted from a statutory accounting requirement that an
insurer such as Alpine include, as a liability, the difference between (i)
losses estimated at a specified level (60% in the case of Alpine) and (ii) the
insurer's actual expected ultimate losses, generally for the three most recent
years. The Schedule P penalty affects Alpine's statutory accounting results
only; it does not affect the Company's GAAP operating results or stockholders'
equity. It is anticipated that Alpine will be permitted to eliminate a
significant portion (approximately $2.5 million) of such Schedule P penalty
during 1998, thereby increasing Alpine's statutory policyholders' surplus by an
equal amount.
The following table sets forth a reconciliation of beginning and ending
loss reserves net of reinsurance. Consistent with the Company's adoption of
Statement of Financial Accounting Standards No. 113, Accounting and Reporting
for Reinsurance of Short-Duration and Long-Duration Contracts, the reserves are
presented in the financial statements on a gross basis with reinsurance
recoverable-unpaid losses and loss adjustment expenses presented as assets.
The Company does not discount its loss reserves.
39
<PAGE> 43
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1997 1996 1995
NET NET NET
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Reserves for losses and loss adjustment
expenses at beginning of year................ $53,006 $68,820 $81,197
Incurred losses and loss adjustment
expenses:
Provision for insured events of the current
year......................................... 3,299 12,971 23,545
Increase (decrease) in provision for
insured events of prior years................ 4,424 (282) (7,874)
Total incurred losses and loss adjustment
expenses..................................... 7,723 12,689 15,671
Payments:
Losses and loss adjustment expenses
attributable to insured events of the current
year......................................... 217 1,842 2,496
Losses and loss adjustment expenses
attributable to insured events of prior years 30,462 26,661 25,552
Total payments............................... 30,679 28,503 28,048
Reserves for losses and loss adjustment
expenses at end of year $30,050 $53,006 $68,820
</TABLE>
The above table reflects an increase in ultimate losses and loss
adjustment expenses for insured events of prior years of $4.4 million. This is
a consequence of actual losses incurred and paid during 1997 for such years
trending slightly higher than previously estimated. Management believes this
may result from the less conservative reserving approach adopted by the Company
following the reserve reviews conducted by the Company in 1996.
The following table sets forth a reconciliation from the Company's GAAP
basis reserves to its reserves calculated in accordance with statutory
accounting practices.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1997 1996
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Gross unpaid losses and loss adjustment expenses--GAAP........................ $43,413 $86,927
Reinsurance recoverable-unpaid losses and loss adjustment expense--GAAP....... 13,363 33,921
Net reserves for losses and loss adjustment expenses at end of year--GAAP..... 30,050 53,006
Other......................................................................... (43) 93
Net reserves for losses and loss adjustment expenses at end of year--Statutory $30,007 $53,099
</TABLE>
The following table presents the development of unpaid loss and loss
adjustment expense reserves net of reinsurance from 1988 through 1997 for the
Company. The top line of the table shows the estimated reserves for unpaid
losses and loss adjustment expenses net of reinsurance at the balance sheet
date for each of the indicated years. These figures represent the estimated
amount of unpaid losses and loss adjustment expenses for claims arising in all
prior years that
40
<PAGE> 44
were unpaid at the balance sheet date, including losses that had been incurred
but not yet reported. The second line of the table, "Subsequent commutations
and other adjustments not affecting development," represents reductions of
the reserve credits as a result of commutations of reinsurance treaties
subsequent to the year ended in each column and additions to reserves as a
result of acquisition of another IIE syndicate in 1989. These adjustments do
not affect development as payments made against these reserves are classified in
the appropriate year. The table also shows the re-estimated amounts of the
previously recorded reserves based on experience as of the end of each
succeeding year. The estimates change as more information becomes known about
the frequency and severity of claims for individual years.
41
<PAGE> 45
The following table presents loss reserves net of reinsurance with
supplemental gross data.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1997 1996 1995 1994 1993 1992 1991 1990 1989 1988
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Net reserves for losses
and loss settlement
expenses, as stated......... $30,050 $53,006 $68,820 $81,197 $68,167 $65,297 $69,757 $79,106 $63,932 $41,271
Subsequent commutations
and other adjustments not
affecting development....... 0 0 0 0 0 562 2,706 6,577 16,163 30,507
Adjusted reserves........... 30,050 53,006 68,820 81,197 68,167 65,859 72,463 85,683 80,095 71,778
Paid (cumulative) as of
1 year later................ 30,543 26,809 16,647 17,396 21,180 16,940 22,778 18,559 9,621
2 years later............... 54,620 39,128 26,779 34,330 35,773 38,407 36,542 23,876
3 years later............... 60,739 40,676 39,910 45,133 54,364 49,448 37,742
4 years later............... 51,106 47,072 53,072 62,293 59,895 47,429
5 years later............... 51,120 58,719 69,064 63,266 54,808
6 years later............... 60,831 72,247 68,468 57,659
7 years later............... 73,951 70,774 61,203
8 years later............... 71,517 62,283
9 years later............... 62,589
Net reserves re-estimated
as of end of year...........
1 year later................ 57,430 68,538 73,222 68,959 64,167 70,830 82,144 79,236 66,628
2 years later............... 74,317 71,030 58,984 64,068 70,827 81,111 78,243 67,825
3 years later............... 78,327 58,422 54,087 66,790 78,024 79,666 66,879
4 years later............... 62,868 52,151 63,548 78,383 73,062 66,212
5 years later............... 53,165 62,590 76,440 73,315 63,922
6 years later............... 62,029 75,324 72,638 63,627
7 years later............... 74,299 71,832 62,869
8 years later............... 70,769 62,250
9 years later............... 61,595
Net cumulative (deficiency)
redundancy
Dollars..................... (4,424) (5,497) 2,870 5,299 12,694 10,434 11,384 9,326 10,183
Percentage.................. (8.35)% (7.99)% 3.53% 7.77% 19.27% 14.40% 13.29% 11.64% 14.19%
Gross liability-end of year 43,413 86,927 91,984 88,276 70,938 73,586
Reinsurance recoverable..... 13,363 33,921 23,164 7,079 2,771 8,289
Net liability-end of year... 30,050 53,006 68,820 81,197 68,167 65,297
Gross re-estimated
Liability-latest............ 75,167 89,685 85,296 68,476 58,347
Reclassification 17,893
Adjusted gross re-estimated
Liability - Latest 93,060 89,685 85,296 68,476 58,347
Re-estimated
Recoverable-latest.......... 17,737 15,368 6,969 5,608 5,182
Reclassification 17,893
Adjusted re-estimated
recoverable - Latest 35,630 15,368 6,969 5,608 5,182
Net re-estimated
Liability-latest............ 57,430 74,317 78,327 62,868 53,165
Gross cumulative redundancy.
Dollars..................... (6,133) 2,299 2,980 2,462 15,239
Percentage.................. (7.06)% 2.50% 3.38% 3.47% 20.71%
</TABLE>
A reclassification of $17.9 million was made to adjust the Company's
financial statements to conform the accounting treatment for reinsurance
commutations to the current NAIC accounting practices. This reclassification
served to reduce both gross and ceded reserves by the same amount. The
reclassification was made between gross reserves and ceded reserves and had
42
<PAGE> 46
no effect on net reserves and also had no effect on the Company's GAAP net
income or stockholders' equity.
The cumulative redundancy or deficiency represents the aggregate change in
the loss reserve estimates over all prior years. The table presents a run-off
of balance sheet reserves rather than accident or policy year loss development.
Therefore, each amount in the table includes the effects of changes in loss
reserves for all prior years. The table generally indicates that through 1994,
on both gross and net bases, the Company's reserves for losses and loss
adjustment expenses have been subsequently adjusted downward from the reserves
initially established. The trend since then has been reversed. Management
believes, as described above in this section, that this reversal is principally
a consequence of the Company's review of its reserving practices in 1996, and
the consequent modification of those practices to make them in management's
opinion less conservative.
EMPLOYEES
Prior to January 1995, the Company had no compensated employees; employees
of TCO performed all underwriting, claims and other services for the Company
pursuant to management agreements between the Company and TCO. (See " --
Relationship with TCO.") Effective January 1, 1995, certain officers of TCO
and Alpine, and certain individuals providing administrative and support
services to such officers, became fully or partially compensated employees of
Exstar. Following the downgrading of the Company's Best ratings in 1996, the
Company and TCO significantly reduced their staff and expenses, and most of the
remaining employees of TCO (other than Claims Control employees) became
employees of Alpine. Consequently, the Company became directly responsible for
the payment of all salaries and benefits related to such employees. The claims
handling staff, however, became employees of Claims Control, then a TCO
Holdings subsidiary, on January 1, 1996. Effective October 1, 1997, Claims
Control and WESTCAP became subsidiaries of Exstar, and WESTCAP began performing
the activities for the Frontier Companies previously performed by Transre and
E&S. As a result, all remaining persons previously employed by TCO became
direct employees of the Company and TCO had no remaining employees on such
date.
In December 1997, the Company's senior casualty underwriter terminated his
employment with the Company, and another casualty underwriter departed in
February 1998. The Company, in January 1998, hired a new senior casualty
underwriter, who formerly had been employed by TCO and has over 25 years of
casualty underwriting experience. The Company is currently seeking to hire
additional casualty underwriters, as well as underwriters with expertise in
other areas, such as environmental liability and property coverage.
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<PAGE> 47
ITEM 2. PROPERTIES.
The Company generally owns real property only for investment or sale. The
Company's principal real estate investments consist of two office buildings
with a combined book value of approximately $4.1 million. These office
buildings serve as the Company's headquarters, and are located at 2028 Village
Lane (25,000 square feet) and 2029 Village Lane (13,000 square feet), Solvang,
California. The Company currently leases 6,000 square feet of space in one of
these buildings to the YMCA at an annual rent of approximately $54,000 (subject
to adjustment) under a two-year lease which commenced November 1, 1996, and
which has three one-year renewal options. In addition, effective April 3,
1998, the Company entered into a five-year lease with a physical therapy
operation with respect to approximately 4,000 square feet of space in one of
the buildings, at an annual rent of $45,000 (subject to adjustment). The
Company from time to time has solicited offers to purchase the office buildings
and would be willing to sell the properties to a buyer with whom the Company
would enter into a sale-leaseback arrangement if appropriate terms could be
agreed upon. At the present time, the Company has not identified such a
purchaser.
If the Potential Frontier Deal is consummated under the terms currently
contemplated, all of Alpine's assets, including the two office buildings, would
be transferred to Frontier. The Company would continue to manage the office
buildings, however, pursuant to a contract with Frontier. Further, it is
likely that the Company would enter into a lease with Frontier with respect to
the two office buildings. The terms of any such lease have not yet been
determined. Additionally, under the terms of the Potential Frontier Deal as
currently contemplated, the Company would have the right to repurchase one or
both of the buildings at their most recently determined book values. (See
"Business -- Proposed Future Operations and Organizational Changes;
Relationship with Frontier" -- Item 1.)
TCO previously leased office space in Chicago, Illinois. In August 1996,
TCO defaulted in its obligations under the lease, but continued to occupy the
premises. Exstar may have been deemed to be a guarantor of TCO's obligations
or otherwise may have been deemed to be obligated under the lease. The Company
is currently in the process of negotiating a new lease with respect to a
portion of the premises leased by TCO, and a settlement of all obligations
under the existing lease. Based on such negotiations, management expects that,
retroactive to August 1, 1997, WESTCAP would enter into a new five year lease
with respect to approximately 7,800 square feet of the 16,400 square feet
previously occupied by TCO, at a rental rate of $13.50 per square foot per year
(as compared to approximately $38 per square foot per year under the TCO
lease). It is anticipated that such lease would be terminable by the landlord
at any time two years or more following its execution, on six months' prior
written notice to WESTCAP, in the event Exstar's stockholders' equity were
below $12 million at the time notice of termination were given. It is further
anticipated that, in settlement of all obligations under the prior lease with
TCO, Exstar would issue 150,000 shares of its Common Stock to the landlord, and
that the landlord would have the right to put such stock back to Exstar at a
per share price of $7.50 at any time on or after July 31, 1999. (Effective
April 1, 1997, TCO had transferred all 536,000 shares of Exstar common stock
owned by it to Exstar for consideration of $0.01 per share.) As of December 31,
1997, the Company had accrued liabilities for the lease obligations on the
basis that the lease continued in effect in accordance with its original terms.
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<PAGE> 48
ITEM 3. LEGAL PROCEEDINGS
In July 1995, the Company filed a lawsuit against its former independent
auditors, Coopers & Lybrand, L.L.P. ("C&L"), for damages arising out of advice
and services rendered to the Company by C&L relating to the GAAP accounting
treatment of loans made by the Company to TCO and the JBW & Co. preferred
stock, as well as the withdrawal of C&L's unqualified audit opinion with
respect to the Company's 1993 consolidated GAAP financial statements. (See
"Business -- Investments -- JBW & Co. Loan" and "Business -- Investments --
Loan to TCO" -- Item 1.) The loans to TCO and the JBW & Co. preferred stock
were the subject of certain changes in GAAP accounting adopted by the Company
in early 1995. In January 1997, Exstar and C&L entered into a settlement
agreement relating to this lawsuit. After the payment of legal fees and other
fees and costs associated with the lawsuit and settlement, the Company's 1997
pre-tax income and stockholders' equity increased by approximately $3 million
as a result of this settlement agreement.
In October 1994, as a result of the resignation of C&L and the withdrawal
of their opinion covering the 1993 financial statements, the SEC notified the
Company that it had opened an informal inquiry with respect to Exstar. The SEC
requested Exstar's voluntary cooperation and requested various information
which Exstar provided. In September 1995, the SEC requested that the Company
produce additional documents and that the Company's then Chief Financial
Officer provide testimony. The Company's then Chief Financial Officer provided
such testimony in November 1995 and February 1996. The Company has not
received any additional requests from the SEC.
Exstar's insurance subsidiaries and various of the TCO entities are
subject to routine legal proceedings in connection with their property and
casualty insurance businesses. Neither Exstar nor any of its subsidiaries nor
any of the TCO entities is currently involved in any pending or threatened
legal proceedings which reasonably could be expected to have a material adverse
impact on the Company's financial condition or Consolidated Statement of
Operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Annual Meeting of the stockholders of the Company was held on
September 16, 1997. At the meeting, the stockholders voted in favor of the
re-election of Steven C. Shinn and David W. Fleming as Class II directors of
the Company. At the meeting, 4,422,653 shares were voted in favor of the
re-election of Mr. Shinn and Mr. Fleming, and 9,625 votes were withheld.
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<PAGE> 49
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Exstar's Common Stock had been traded on the Nasdaq National Market
("NNM") under the symbol EXTR from the date of the Company's initial public
offering on December 18, 1992. On October 12, 1994, the Nasdaq Stock Market,
Inc. ("Nasdaq") amended Exstar's symbol to EXTRE as a result of the withdrawal
of C&L's audit report covering the Company's 1993 consolidated financial
statements (which caused the Company to be in technical non-compliance with
Nasdaq requirements). The symbol reverted to EXTR after the filing of the 1994
Form 10-K and certain related reports with Nasdaq. However, the symbol was
again amended to EXTRE on April 16, 1996, due to the Company's failure to file
its 1995 Form 10-K on April 15, 1996. The Company's Common Stock was delisted
from the NNM on July 18, 1996 for failure to meet certain of the maintenance
criteria required for continued listing on the NNM, including: (i) the
Company's failure to timely file its 1995 Form 10-K; (ii) the Company's failure
to maintain on its board of directors two independent directors (the Company
had only one independent director at that time); and (iii) the minimum bid
price for the Common Stock being below $1.00 for a substantial period of time.
The Company filed its Form 10-K for the year ending December 31, 1996 in April
1997, and appointed a second independent director to its board of directors in
August 1997. The Company's stock has not been re-listed on the NNM, however,
because its stock price has not exceeded certain threshold levels required for
NNM listing.
Exstar's Common Stock continues to be publicly traded in the "over the
counter" market. If the Company can satisfy the requirements for NNM listing
or listing on the Nasdaq "small cap" market, management plans to seek relisting
of the Common Stock on either such market during 1998.
The Company from time to time considers the possibility of issuing
additional shares of Exstar Common Stock in private placements, public
offerings and other transactions. The Company, additionally, is considering
whether to seek to register shares of Exstar Common Stock (i) owned by Mr.
O'Shaughnessy to facilitate the sale or pledging of such Common Stock; (ii) to
be issued by the Company sold to Company employees and others who hold options
to acquire shares of Exstar Common Stock from the Company; (iii) to be issued
and sold to Frontier in accordance with the Warrant issued to Frontier in the
fourth quarter of 1997; (iv) to be issued and transferred to the owner of the
office building at 311 South Wacker Drive, Chicago, Illinois, in connection
with a potential settlement of alleged obligations of the Company under the
lease relating to such building; and (v) to be issued and sold to others in
connection with acquisitions of their operations. Finally, the Company
believes members of its management and Frontier may purchase shares of Exstar
Common Stock which are currently outstanding, in addition to any Exstar Common
Stock currently owned by them.
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<PAGE> 50
The following table sets forth for the periods indicated the range of high
and low closing sale prices for the Common Stock.
<TABLE>
<CAPTION>
HIGH LOW
<S> <C> <C>
First Quarter 1995. 5.00 2.75
Second Quarter 1995 5.125 2.50
Third Quarter 1995. 3.50 2.50
Fourth Quarter 1995 3.00 0.875
First Quarter 1996. 2.25 1.03
Second Quarter 1996 1.25 0.50
Third Quarter 1996. 1.00 0.625
Fourth Quarter 1996 0.25 0.15
First Quarter 1997. 1.18 0.19
Second Quarter 1997 4.25 1.25
Third Quarter 1997. 4.25 2.75
Fourth Quarter 1997 4.25 3.00
</TABLE>
On March 31, 1998 the last reported sale price for the Common Stock was
$2.50 per share. As of March 31, 1998, there were 48 holders of record of the
Exstar Common Stock, and to the Company's knowledge there were in excess of 400
beneficial owners of the Exstar Common Stock.
Exstar has never declared or paid any cash dividends on its Common Stock
and does not anticipate paying any cash dividends in the foreseeable future.
(See "Business -- Regulation -- Dividend Limitations" -- Item 1 and Note 3 of
Notes to Consolidated Financial Statements.)
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data presented below under the
captions "Operating data" and "Balance sheet data" for the years ended December
31, 1997, 1996, 1995, 1994 and 1993 have been derived from the audited
consolidated financial statements of the Company and its subsidiaries. The
statutory operating data are based on statutory accounting practices and were
derived from statutory financial data of the Syndicate and Alpine. The
statutory operating data for the year ended December 31, 1996, differ from data
which would be derived from the 1996 annual statement of Alpine filed with
state insurance regulatory officials in that the operating results of the
Syndicate were not combined with those of Alpine in its 1996 annual statement,
even though the Syndicate's operations were combined with those of Alpine
effective December 31, 1996. These data should be read in conjunction with the
consolidated financial statements, related notes and other financial
information included elsewhere in this 1997 Form 10-K.
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<PAGE> 51
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1997 1996 1995 1994 1993
<S> <C> <C> <C> <C> <C>
Operating data: (DOLLARS IN THOUSANDS EXCEPT FOR PER SHARE DATA)
Gross written premiums............................. $12,925 $14,373 $64,287 $60,910 $47,740
Net written premiums............................... 11,134 8,810 28,185 53,532 48,739
Net premiums earned................................ 6,716 21,010 39,149 52,513 34,037
Net losses incurred................................ (170) 7,737 6,400 25,086 15,709
Net loss adjustment expenses incurred.............. 7,893 4,952 9,271 7,764 5,368
Other underwriting expenses........................ (117) 6,405 16,897 17,164 10,124
Reinsurance expense................................ 0 0 0 124 3,613
Net commission income.............................. 272 0 0 0 0
Net investment income.............................. 2,488 4,015 4,897 3,933 3,552
Net realized investment (losses) gains............. (248) (377) 389 (41) (970)
Other income....................................... 3,479 142 385 1,339 1,675
Interest expense................................... 197 220 212 152 225
Other expenses..................................... 6,036 7,252 6,239 3,068 2,257
Net (loss) income before provision
for income taxes, minority interest
and equity in income (losses) of affiliates........ (1,132) (1,776) 5,801 4,386 998
Provision for income taxes......................... 510 (1,715) 5,057 1,781 362
Minority interest.................................. 0 0 (157) (94) (88)
Equity in (income) losses of affiliates............ (16) (1,561) (3,829) 5,173 10,746
Net (loss) income.................................. (1,626) 1,500 4,730 (2,474) (10,022)
Net (loss) income per share(1).................... $(0.32) $0.27 $0.86 $(0.45) $(1.83)
Balance sheet data(2):
Cash and cash equivalents and invested assets...... $41,701 $64,539 $88,841 $92,834 $79,784
Total assets....................................... 76,794 108,154 142,628 142,203 119,255
Insurance liabilities.............................. 50,065 89,398 125,246 122,777 101,184
Long-term debt, less current portion............... 1,057 1,078 1,484 0 0
Total stockholders' equity......................... 13,515 12,526 11,195 5,252 9,490
Net book value per share........................... $2.72 $2.28 $2.04 $0.96 $1.73
Statutory operating data(3):
Net underwriting (loss) gain....................... $(6,655) $2,826 $9,752 $(421) $(2,378)
Policyholders' surplus(4).......................... 5,276 12,596 (7,017) 21,097 20,352
Loss and loss adjustment expense ratio............. 114.2% 60.0% 39.1% 64.6% 73.4%
Expense ratio...................................... 51.2% 63.3% 49.9% 31.7% 26.5%
Combined ratio..................................... 165.4% 123.3% 89.0% 96.3% 99.9%
GAAP operating ratios:
Loss and loss adjustment expense ratio............. 115.0% 60.4% 40.0% 62.6% 61.9%
Expense ratio...................................... (1.7)% 24.4% 29.8% 30.1% 28.3%
Combined ratio..................................... 113.3% 84.8% 69.8% 92.7% 90.2%
</TABLE>
- ----------------------------
(1) Shares used in the calculation for 1997 were 5,096,000 shares
outstanding; for 1996, 1995 and 1994, 5,498,000 shares outstanding; for
1993, 5,490,000 shares outstanding.
(2) Information is shown as of the end of each year presented.
(3) In addition to usual differences between statutory accounting practices
and GAAP, until December 31, 1996 a significant portion of profit sharing
expense was allocated as a reduction to investment income for statutory
accounting practices.
(4) Policyholders' surplus is reflected as of the end of each year presented
on a consolidated basis after the elimination of the Syndicate's prior
investment in Alpine. If the Syndicate's investments had not been subject
to certain concentration limits under the IIE regulations, policyholders'
surplus on a consolidated basis as of December 31, 1995 would have been
$6,038,000.
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<PAGE> 52
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
The Company's operations and business underwent fundamental changes during
1997 and 1996, and additional changes are anticipated in 1998. (See "Business
- -- Overview of Current Business Operations," and "Business -- Proposed Future
Operations and Organizational Changes; Relationship with Frontier" --Item 1.)
Because of these changes, differences in the Company's results of operations
between 1997 and 1996, and between 1996 and 1995, are not necessarily
indicative of trends or likely results of operations for 1998 or future years.
The Company's 1997 Form 10-K contains certain "forward-looking statements"
(within the meaning of the Private Securities Litigation Reform Act of 1995)
that involve substantial risks and uncertainties. When used in this 1997 Form
10-K, the words "anticipate," "believe," "estimate" and "expect" and similar
expressions as they relate to the Company and its management are intended to
identify such forward-looking statements. A number of important factors could
cause the actual results, performance or achievements of the Company for 1998
and beyond to differ materially from those expressed in such forward-looking
statements. These factors include, without limitation, the potential sale of
Alpine and other transactions relating thereto, the discontinuation or a
material adverse change in the terms and conditions of the Quota Share
Arrangement or the potential replacement reinsurance agreement with the Cayman
Company, a material increase in competition, material changes to the Frontier
Companies' financial conditions or regulatory authorities and material adverse
changes in the Illinois DOI's oversight of Alpine. In light of the Company's
current financial and insurance regulatory circumstances, relatively small
changes from the expected results, performance and achievements of the Company
could materially adversely impact the Company's financial condition and
prospects as anticipated in this 1997 Form 10-K.
The Company's ability to continue to operate as it currently is operating
depends on generating sufficient revenues and cash flows from the Company's
risk-bearing activities, currently consisting of Alpine's operations; the
Company's insurance producing activities, currently consisting of WESTCAP's
operations; and the Company's claims servicing activities, currently
consisting of Claims Control's operations.
In terms of financial resources, Alpine's activities are the most
significant of the Company's current operations. Most of the Company's cash
flow to fund operations derives from Alpine's existing assets, investment
income on such assets and premium assumed pursuant to the Quota Share
Arrangement. Alpine, however, is relatively close to several regulatory
thresholds that, if crossed, could reduce Alpine's role in the Company's
operations. Alpine's statutory policyholders' surplus of $5.3 million at
December 31, 1997, was $300,000 above the minimum statutory policyholders'
surplus required of an Illinois reinsurer, $2.1 million above the mandatory
control level risk-based capital for Alpine and $3.8 million above
the minimum statutory policyholders' surplus required of an Illinois insurer
that writes the lines of insurance reinsured by Alpine. Additionally, Alpine's
liquid assets at December 31, 1997, may have been insufficient (depending on
interpretation of the relevant statutory provision), if the provision had been
applicable on such date, to satisfy a statutory "reserve requirement" adopted
by Illinois in
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<PAGE> 53
1997 to be applicable in 1998, and in any event a significant amount of Alpine's
assets are restricted for specific purposes. (See " Business -- Regulation" --
Item 1.)
The Company currently expects risk-bearing activities will continue to be
a significant part of its operations in 1998 and later years. First, the
Company is negotiating a potential sale of Alpine to Frontier, and if the
negotiations are successful, expects to continue the Company's risk-bearing
activities through formation of a Cayman Islands insurance company that would
assume premium from the Frontier Companies pursuant to an arrangement similar
to the Quota Share Arrangement. This would provide the Company continuing
investment income and premium revenue, as well as cash flow, in an insurance
regulatory environment relatively more flexible than the environment in which
Alpine operates. The sale of Alpine also would generate additional cash for the
Company beyond the cash that would be required to be contributed to the Cayman
Islands insurance company. (See " Business -- Proposed Future Operations and
Organizational Changes; Relationship with Frontier" -- Item 1)
Second, even if the sale of Alpine is not consummated, Alpine met the
minimum regulatory requirements it was required to meet at December 31, 1997,
to continue to operate. Alpine's financial condition and regulatory compliance
position, additionally, will improve if the $6.6 million Schedule P penalty
drops off as expected over time ($2.5 million relating to the 1995 accident
year will drop off in 1998 if the loss ratio for Alpine's 1995 accident year
remains at the level estimated as of December 31, 1997 -- see "-- Losses and
Loss Adjustment Expenses"). Exstar, additionally, currently has the ability to
contribute certain real estate assets with a statutory net asset value of up to
$1.7 million at December 31, 1997, to Alpine if necessary to increase Alpine's
statutory policyholders' surplus. Alpine's statutory policyholders' surplus,
liquidity and financial condition generally also are expected to benefit from
continuation of the Quota Share Arrangement, entered into on April 1, 1997.
Frontier also has been willing to release under the Quota Share Arrangement a
portion of the funds held it otherwise would have been entitled to retain under
the Quota Share Arrangement, $2.0 million of which was released by early April
1998, and has agreed to release another $1.0 million in early May. Alpine may
have difficulty meeting the "reserve requirement" in 1998, depending on how the
new statutory provision ultimately is interpreted, but believes, based on
discussions with the Illinois DOI, that it may be able to comply sufficiently
with the requirement to avoid any increase in the Illinois DOI's current level
of oversight.
Notwithstanding the foregoing, Alpine's continued operations depend on
continuation of the Quota Share Arrangement, or a replacement arrangement
similarly or more beneficial to Alpine, and Alpine's continuing satisfaction of
applicable regulatory requirements. The Company currently believes, based on
the generally positive relationship the Company has with Frontier and the
profitability of the business the Company has produced and in the future has
the potential to produce for Frontier, that the Quota Share Arrangement will
continue generally on its current terms for the foreseeable future, even if
Alpine is not sold to Frontier.
Alpine's continuing satisfaction of applicable regulatory requirements is
more difficult to predict. As described above, Alpine currently is relatively
close to certain regulatory thresholds that, if crossed, could lead to a
required reduction or cessation of Alpine's activities. This could
50
<PAGE> 54
result from increased oversight by the Illinois DOI, regulatorily required
termination of some or all of Alpine's current business operations and
relationships, termination of the Quota Share Arrangement by the Frontier
Companies and potentially Alpine's being placed in receivership. While the
Company expects Alpine to be able to avoid crossing such thresholds, the
expectations are based on a number of assumptions, including, among others,
assumptions about cash flows, investment yields, asset values, ultimate loss and
loss adjustment expenses and payout patterns, competition, the Illinois DOI's
potential regulatory responses and Frontier's Best ratings. Because Alpine is
relatively close to certain of the regulatory thresholds, there is little room
for adverse fluctuations in the foregoing assumptions. In this regard, it should
be noted that Alpine's financial condition weakened significantly in 1997, as
evidenced by the drop in Alpine's statutory policyholders' surplus to $5.3
million at December 31, 1997, from $12.6 million at December 31, 1996, and
Alpine's risk-based capital being at 117% of its authorized control level
risk-based capital at December 31, 1997, compared to 173% of its authorized
control level risk-based capital at December 31, 1996.
Should Alpine's operations be curtailed significantly, or the Company's
risk bearing activities otherwise be limited, the Company would be forced to
rely more on its existing cash and on its WESTCAP and Claims Control activities
to generate revenues and cash flows. A portion of the Company's cash needs
would be able to be met out of Exstar's cash on hand, which was $1.6 million at
December 31, 1997. The balance of the Company's cash needs would be met from
WESTCAP's and Claims Control's revenues from ongoing operations.
Should these efforts prove insufficient, the Company would have to seek
alternative solutions. Among those would be a capital contribution from, joint
venture with, or sale of assets to, Frontier or another insurance operation.
The Company has made no specific plans to achieve any of these solutions,
though the Company has been approached from time to time by insurance
operations seeking to establish relationships with the Company, and believes it
could take advantage of one of these prior approaches or a similar opportunity
relatively quickly. The Company believes, though there can be no assurances,
that Frontier and potentially other insurance operations would favor such a
capital contribution, joint venture, sale or similar arrangement because of the
Company's historically profitable underwriting results and its potential
ability to generate similar results in the future.
The Company's future financial condition and prospects are heavily
dependent on the Company's maintaining or improving its relationships with
Frontier. WESTCAP generates commission revenues from producing insurance
business on behalf of the Frontier Companies; Claims Control generates a small
but increasing amount of the revenue from handling claims on behalf of the
Frontier Companies; and Alpine generates underwriting revenue, if the
underwriting results are profitable, and investment income from assuming
premiums pursuant to the Quota Share Arrangement. These relationships also
generate most of the Company's cash flows from operations.
The Company believes based on the Potential Frontier Deal progress, the
generally positive relationship the Company has with Frontier and the
profitability of the business the Company produces for Frontier, that the
current relationships or alternative arrangements equally
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<PAGE> 55
or more beneficial to the Company will continue in effect for the reasonably
foreseeable future. There can be no assurance, however, that the Limited
Agency Agreements, the Claim Service Agreements or the Quota Share Arrangement
will in fact remain in effect under their current terms or at all, or that
the Potential Frontier Deal or other alternative arrangements will be
consummated, either on terms at least as favorable to the Company as the
current relationships or at all. Should the Company's relationships with the
Frontier Companies be discontinued, or their terms and conditions be changed in
a manner materially adverse to the Company, the Company could experience
significant losses.
The Company's principal sources of revenue historically have been net
premiums earned (net premiums are the balances remaining after deducting from
gross written premiums amounts paid for unaffiliated reinsurance, and they are
generally earned ratably over the policy periods) on insurance policies issued
by the Company's insurance company subsidiaries, income derived from the
Company's invested assets and miscellaneous other income. The Company's
principal costs historically have consisted of reserves for loss and loss
adjustment expenses (reserves for such loss and loss adjustment expenses, which
initially are estimated based on a combination of the Company's historical data
and industry averages, are reflected as expense in the periods in which they
are initially estimated and as the estimates are revised the revisions are
reflected as adjustments to expense in the periods in which the adjustments are
made), commissions and other amounts paid by the Company's insurance company
subsidiaries in connection with its producing and underwriting insurance
policies issued by the Company's insurance company subsidiaries, and
miscellaneous other expenses.
The Company's net income historically derived from the difference between
these net revenues and net expenses, after adjustment for taxes and minority
interests. In addition, due to the Company's adoption of a form of equity
accounting in 1995 (applied retroactively), the Company's net income also has
included its equity in gains and losses of its affiliates. (See "Business --
Relationship with TCO" -- Item 1 and Note 11 of Notes to Consolidated Financial
Statements.)
The Company, because of Best rating downgrades, regulatory restrictions
and other matters affecting its insurance company subsidiaries (see "Business
- -- Overview of Current Business Operations" -- Item 1), ceased issuing direct
insurance in August 1996. This directly resulted in a sharp decline in the
Company's earned premium revenue during the second half of 1996, and the first
half of 1997. The Company, however, began earning premium revenue through the
Quota Share Arrangement effective April 1, 1997. The portion assumed by the
Company initially was 30% of the net premium accruing to UCIC on such business,
including premiums unearned as of April 1, 1997 (approximately $13.6 million)
and premiums on policies issued after such date. Effective October 1, 1997,
the Quota Share Arrangement was amended generally and among other things to
increase the quota share portion of net premium assumed by Alpine to 50% on
policies underwritten by WESTCAP and certain policies underwritten by Trinity
on or after October 1, 1997. The Company also earned investment income on the
funds held by the Frontier Companies under the Quota Share Arrangement.
Because most of the premium funds are being held by the Frontier Companies,
however, the Quota Share Arrangement does not benefit the Company's cash flow
to the same extent it benefits the Company's net income
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<PAGE> 56
(assuming the Quota Share Arrangement underwriting results are as profitable
as or more profitable than the Company's underwriting results historically
were).
The Company reduced its underwriting expenses during 1996 by terminating
its insurance company subsidiaries' management agreements with TCO, thereby
terminating the Company's obligation to pay commissions and profit-sharing
amounts to TCO, and such expenses were virtually eliminated for a time following
the Company's decision to cease issuing new and renewal insurance policies in
August 1996. However, the Company incurs significant underwriting expenses
under the Quota Share Arrangement. Of the net premium assumed by Alpine, Alpine
(i) generally allows UCIC to retain 30% as a ceding commission and (ii)
generally pays approximately 3.75% to TCO Holdings as an override commission.
Additionally, effective August 1, 1996, the Company began assuming a substantial
amount of personnel costs and operating expenses previously borne by TCO. These
expenses, which previously would have been included in the Company's
underwriting expenses, have been included in the Company's other expenses since
August 1, 1996. Until September 30, 1997, these expenses were offset in part by
reimbursements from Transre and E&S. (See -- "Business - Overview of Current
Business Operations" -- Item 1.)
Management has determined that, in view of the obstacles faced by the
Company, it is unlikely that the Company will be able to write profitable
direct business in the foreseeable future. As a result, management has decided
to shift the Company's business focus from risk-bearing operations (i.e. the
issuance of insurance policies) to the production and underwriting of insurance
coverage to be issued by other insurers (principally the Frontier Companies),
from which activities the Company will derive increased commission revenues.
Through its role as a reinsurer under the Quota Share Arrangement, or a similar
reinsurance arrangement with the Cayman Company if the sale of Alpine to
Frontier is consummated, however, the Company expects to continue to derive
significant portions of its revenues, including underwriting profits and
investment income, from risk-bearing operations.
Because of the numerous uncertainties facing the Company and the Company's
likelihood of experiencing substantial further changes in its operations and
business during 1998 (see "Overview of Current Business Operations" and
"Proposed Future Operations and Organizational Changes; Relationship with
Frontier" -- Item 1), management has made no effort to anticipate the Company's
results in the following discussion beyond the end of 1998.
1997 TO 1996
Gross written premiums were $12.9 million for 1997, a decrease of 10.1%
from $14.4 million in 1996. The Company ceased writing direct insurance in
August 1996. Of the gross written premiums for 1997, 89.1% were premiums
assumed by Alpine as a reinsurer of the Frontier Companies pursuant to the
Quota Share Arrangement which became effective April 1, 1997, and the balance
representing audit and other premiums relating to run off of the direct
insurance written by the Company through August 1996.
Management expects gross written premiums to increase in 1998 because (i)
the portion
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of net insurance premium assumed by Alpine in connection with the Quota Share
Arrangement, which increased from 30% to 50% effective October 1, 1997, or any
similar replacement reinsurance arrangement with the Cayman Company, is expected
to be 50% for all of 1998 and (ii) the Company anticipates hiring additional
underwriting staff, making acquisitions and obtaining authority from Frontier to
produce certain program business, all of which should enable the Company to
expand into additional lines of business and generate additional premiums
during 1998. The Company anticipates this increase to be offset to some extent
by reduced business in the Company's traditional lines of business as a
consequence of increased competition.
Net premiums earned, consisting of premiums earned less premiums ceded
(generally earned ratably over individual policy periods), were $6.7 million in
1997, a 68.0% decrease from $21.0 million in 1996. The decrease directly
resulted from the decrease in gross written premiums, particularly during the
period between August 1996, when the Company ceased writing direct insurance,
and April 1997, when the Quota Share Arrangement incepted. Net premiums earned
are expected to increase during 1998 as a consequence of the expected increase
in written premiums, but at a slower rate because the premiums are earned over
individual policy periods.
Net commission income for 1997 was $272,000 compared to no commission
income in 1996 and prior years. This represented commission income earned by
WESTCAP on insurance business produced for the Frontier Companies following
WESTCAP's acquisition by Exstar on October 1, 1997, net of commissions due to
WESTCAP's subproducers (generally earned ratably over the corresponding
individual policy periods). Net commission income is expected to increase in
1998 because (i) WESTCAP will be owned by the Company for the full year and
(ii) the commissions should increase proportionately with the anticipated
increase in premiums. Net commission income also may increase
disproportionately faster than the anticipated increase in premiums if the
Company is successful in acquiring brokerage operations, some of which could
produce business for entities other than the Frontier Companies, or writing
lines of business for the Frontier Companies that are not reinsured by the
Company.
Net investment income for 1997 was $2.5 million, a decrease of $1.5
million, or 37.9% from $4.0 million in 1996. The decrease between the periods
was caused principally by a 30.7% decrease in average investable assets from
$76.4 million in 1996 to $53.1 million in 1997, resulting from the Company's
need to make loss and expense payments and pay other expenses, and a decline in
the average yield on investable assets to 4.7% in 1997 from 5.3% in 1996.
Management generally anticipates a continued reduction in investment income in
1998 as a consequence of (i) loss payments and expenses reducing the Company's
investable assets more quickly than investable assets increase under the Quota
Share Arrangement or any similar replacement reinsurance arrangement with the
Cayman Company, and (ii) expected relatively steady investment yields.
Other income was $3.5 million for 1997, compared to $100,000 for 1996.
The other income in 1997, reflecting proceeds less certain related expenses,
was principally a consequence of a one-time settlement of a lawsuit against the
Company's former independent auditors. Management expects minimal other income
for the foreseeable future.
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Net loss and loss adjustment expense incurred during 1997 totaled $7.7
million, down 39.1% from $12.7 million in 1996. Net loss and loss adjustment
expenses as a portion of net premiums earned was 115.0% in 1997 compared to
60.4% in 1996. The decrease in net loss and loss adjustment expense incurred
between the periods resulted principally from the decrease in net premiums
earned. The increase in net loss and loss adjustment expense as a portion of
net premiums earned was the result of reserve strengthening in the amount of
$4.4 million for 1994 and prior underwriting years. Management expects the
Company's loss ratio on insurance assumed by Alpine pursuant to the Quota Share
Arrangement or any similar replacement reinsurance arrangement will be
substantially lower than the Company's historical loss ratios as a consequence
of higher pricing in 1996 and 1997 and more restrictive policy forms used in
underwriting the insurance assumed from the Frontier Companies, though
continuing competition in 1998 is expected to result in gradually reduced
pricing on the business assumed by the Company from the Frontier Companies.
Other underwriting expenses historically have consisted of (i) policy
acquisition costs, which equaled a fixed percentage of gross written premiums
less reinsurance commissions, plus (ii) the allocated portion of profit sharing
payments to TCO. Following termination of the management agreements between
the Company's insurance company subsidiaries and TCO in 1996, the fees and
commissions that otherwise would have been paid by the Company to TCO were
eliminated.
The Company's other underwriting expenses for 1997 were a negative
$100,000, compared to $6.4 million in 1996. The decrease in other underwriting
expenses between periods was principally attributable to (i) the Company's
earning in 1997 additional commission income under certain reinsurance
agreements because of loss development on the direct business written by the
Company, (ii) the decrease in net premiums and (iii) reduced net expenses
resulting from termination of the management agreements with TCO. Absent the
additional reinsurance commission income, the ratio of the Company's other
underwriting expenses to net premiums earned would have been 31.3% in 1997
compared to 30.5% in 1996. Management anticipates the ratio of other
underwriting expenses to premiums earned for 1998 will be about the same as or
somewhat in excess of the 1997 ratio, because of the approximately 33-34%
aggregate commissions payable by the Company in connection with the Quota Share
Arrangement or any similar replacement reinsurance arrangement.
Interest expense in 1997 was $200,000, unchanged from 1996. Interest
expense in 1998 is expected to continue at approximately the same or at a
slightly reduced level. The level could be significantly reduced in 1998 after
the sale of Alpine is consummated, if at all, as most of the Company's
indebtedness would be transferred as part of the sale. (Continued payments on
such indebtedness, however, would ultimately reduce the purchase price paid by
Frontier for Alpine.)
Other expenses, consisting of professional fees, personnel costs and other
costs, were $6.1 million in 1997, compared to $7.3 million in 1996. The
decrease was principally due to a 56% reduction in legal and professional
expenses, partially offset by an increase in personnel and general
administrative costs resulting from Alpine's assuming a portion of those costs
previously
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<PAGE> 59
borne by TCO. The Company anticipates an increase in other expenses during
1998 as a consequence of incurring operating expenses for WESTCAP and Claims
Control following their acquisitions effective October 1, 1997. This increase
could be potentially offset in part by settlement of the 311 South Wacker,
Chicago, Illinois office lease which could result in reduced rent expense.
Income tax expense was $510,000 in 1997 compared to a benefit of $1.7
million in 1996. Because of the numerous uncertainties facing the Company,
management decided to increase the valuation allowance against the Company's
deferred tax asset in 1997 by $4.4 million, compared to a reduction in the
allowance of $1.3 million in 1996. Partially offsetting this increase was a
benefit of $3.4 million from the settlement of the JBW & Co. loan and a tax
benefit of $385,000 in 1997 resulting from a taxable loss for the current year.
Management anticipates no significant income tax expense from the potential
sale of Alpine to Frontier because of significant capital loss carryforwards.
However, the sale, if it is consummated in accordance with the Potential
Frontier Deal as currently contemplated, would transfer to Frontier $6.5 million
of operating loss carryforwards which otherwise would have been available to
offset income taxes on the Company's operating income (the Company expects
ultimately to recoup certain tax benefits recognized by Frontier from the
acquisition of Alpine, as and to the extent actually realized by Frontier). If
the sale of Alpine is not consummated, and absent other changes in
circumstances, management anticipates no income tax expense in 1998.
Equity in income or losses of affiliates, included in the Company's
results due to the Company's adoption of a form of equity accounting in 1995,
generally reflects TCO's net income or loss for the period after certain
adjustments. Equity in income of affiliates was minimal for 1997 compared to
$1.6 million for 1996. The smaller amount in 1997 reflects the significantly
reduced revenues generated by TCO after Exstar's insurance company subsidiaries
ceased issuing direct insurance in August 1996 and the management agreements
with TCO were terminated. The Company anticipates that equity in income or
losses of affiliates during 1998 will continue at a low level, as TCO is in
complete run-off and consequently is expected to have virtually no revenues or
expenses relating to operations. The Company believes, however, that
additional equity in income of affiliates could be generated if TCO is
successful in settling certain of its existing liabilities (other than
liabilities to the Company) at less than their book values including TCO's
obligations under the lease relating to office facilities at 311 South Wacker,
Chicago, Illinois, which could generate income to the Company of as much as
$525,000.
Net (loss) income per share -- basic and diluted was a loss of $0.32 for
1997, compared to income of $0.27 for 1996. The decrease was principally the
result of (i) the $4.4 million loss and loss adjustment expense reserve
strengthening (ii) the $1.5 million reduction in equity in income of affiliates
and (iii) the $4.4 million increase in the valuation allowance against the
deferred tax asset, offset to a large degree by (iv) the $3.4 million tax
benefit from the settlement of the JBW & Co. loan and (v) the $3.5 million of
other income generated principally by the settlement of the lawsuit against the
Company's former independent auditors compared to the impact of the same items
for 1996.
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<PAGE> 60
1996 TO 1995
Gross written premiums were $14.4 million for 1996, a decrease of 77.6%
from $64.3 million in 1995. This decrease was due to the Best ratings
downgrades of the Company's insurance company subsidiaries in January and April
1996, and the losses of their authorizations to conduct surplus lines business
in key states, including California, beginning early in the year. (See
"Business -- Overview of Current Business Operations" "Business -- Regulation"
- -- Item 1). These developments progressively constricted the Company's ability
to write direct insurance policies during the first half of 1996, and led the
Company to cease writing direct insurance policies in August 1996.
Net premiums earned were $21.0 million in 1996, a 46.3% decrease from
$39.1 million in 1995. The decrease directly resulted from the decrease in
gross written premiums, though the percentage decrease in net premiums earned
between the periods was lower because premiums continued to be earned on
previously written insurance after the Company ceased issuing direct insurance
in August 1996.
Net loss and loss adjustment expense incurred during 1996 totaled $12.7
million, down 19.0% from $15.7 million in 1995. Net loss and loss adjustment
expense as a portion of net premiums earned was 60.4% in 1996 compared to 40.0%
in 1995. The decrease in net loss and loss adjustment expense incurred between
the periods resulted principally from the decrease in net premiums earned. The
decrease was relatively smaller than the decrease in net premiums earned
between the periods, however, because of the approximately $14.9 million
reduction in loss and loss adjustment expense reserves at the end of 1995,
which included reductions relating to net premiums earned in prior years.
Other underwriting expenses for 1996 were $6.4 million, a decrease of
62.1% from $16.9 million in 1995. The ratio of the Company's other
underwriting expenses to net premiums earned was 30.5% in 1996 compared to
43.2% in 1995. The decrease in other underwriting expenses between the periods
was principally attributable to reduced net expenses resulting from termination
of the management agreements with TCO, the Company's earning in 1996 additional
commission income under certain reinsurance agreements because of favorable
loss development and the Company's payment in 1995 of profit sharing of
approximately $3.7 million relating to the approximately $14.9 million
reduction in loss and loss adjustment expense reserves at the end of 1995.
Net investment income for 1996 was $4.0 million, a decrease of $900,000,
or 18.0%, from $4.9 million in 1995. The decrease between the periods was
caused principally by a 15.8% decrease in average investable assets from $90.8
million in 1995 to $76.4 million in 1996 and a decline in the average yield on
investable assets to 5.3% in 1996 from 5.4% in 1995.
Net realized investment (losses) gains for 1996 were a loss of $400,000
versus a gain of $400,000 in 1995. The net loss in 1996 was the result of
losses on the sale of an equity security and certain real estate investments,
as well as net increases in real estate valuation reserves. The Company
realized net investment gains of over $700,000 in 1995 on its fixed maturities
portfolio
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as it benefited from declining interest rates while liquidating certain assets.
Other income declined in 1996 to $100,000 from $400,000 in 1995. Other
income consists primarily of contingent commission income from and interest
earned on funds on deposit with an unaffiliated insurance company which have
been assigned to the Company by TCO. The decline in other income in 1996 was
due to a reduction in the amount of business placed by TCO over the last
several years with the unaffiliated insurance company and a disagreement
between TCO and the unaffiliated insurance company as to the amounts due to TCO
and assigned to the Company. Additionally, the amount of funds on deposit was
significantly reduced in 1996 compared to 1995.
Interest expense in 1996 was approximately $200,000, unchanged from 1995.
Other expenses were $7.3 million in 1996 compared to $6.3 million in 1995.
This increase was principally due to (i) Exstar's incurring additional legal
expenses for the lawsuit against the Company's former auditors (see "Legal
Proceedings" -- Item 3), (ii) increases in legal, audit, actuarial and other
fees (including approximately $500,000 of IIE withdrawal fees) in connection
with the Illinois DOI's review of Alpine, withdrawal of the Syndicate from the
IIE and reorganization of the Company's business and operations during 1996, and
(iii) Alpine's assuming a portion of the personnel, general and administrative
costs previously borne by TCO.
Income tax benefit was $1.7 million in 1996 compared to an expense of $5.1
million in 1995, principally because of the Company's substantially higher 1995
taxable net income resulting from the $14.9 million reduction in loss reserves
in 1995. The Company had a net pre-tax loss (before minority interest and
equity in gains of affiliates) of $1.8 million in 1996 compared to $5.8 million
of pre-tax net income (before minority interest and equity in gains of
affiliates) in 1995. The difference also resulted from application of a $6.6
million valuation reserve against the Company's deferred tax asset in 1995,
compared to a $1.3 million reduction in the reserve in 1996.
Equity in income (losses) of affiliates was $1.6 million in 1996 compared
to $3.8 million in 1995. The smaller amount in 1996 reflects a reduction in
TCO's revenues for 1996 following the Best rating downgrades and regulatory
restrictions affecting the Company's insurance company subsidiaries, and the
terminations of the management agreements between the Syndicate and TCO and
Alpine and TCO. It also reflects reduced profit sharing of $1.3 million paid
to TCO-IL in 1996 compared to the $5.2 million paid to TCO-IL in 1995. The
difference between the $1.3 million payment to TCO-IL in 1996 and the $5.2
million payment in 1995 is principally attributable to reductions in net loss
and loss adjustment expenses incurred, due, in significant part, to the $14.9
million reduction in the Company's loss reserves at December 31, 1995.
Net income per common share was $0.27 in 1996 compared to $0.86 in 1995.
This reflects, overall, the decline in the Company's revenues following the
Best rating downgrades and the regulatory restrictions affecting the Company's
insurance company subsidiaries beginning in early 1996, compared to the
substantial revenues realized from ongoing operations and the income resulting
from the $14.9 million reduction in loss reserves in 1995. The impact of these
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items would have been greater if it had not been offset by an overall swing of
$7.7 million in deferred tax expense.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 1997, cash and investments totaled $41.7 million, compared
to $64.5 million at December 31, 1996. At December 31, 1997, the Company had
$24.0 million in cash and investments pledged as collateral for letters of
credit related to reinsurance, held in trust for the benefit of the Frontier
Companies, on deposit with the various states in which it has done business, on
deposit in the IIE Guaranty Fund, Inc. and held in trust for the benefit of the
Syndicate's policyholders and otherwise to satisfy the Syndicate's obligations.
This $24.0 million amount represented 57.6% of the Company's total cash and
investments at December 31, 1997. Funds held in trust for the benefit of the
Syndicate's policyholders may be used by the Company to satisfy claims of the
policyholders and other obligations of the Syndicate.
The foregoing $24.0 million included the following at December 31, 1997:
(i) $11.0 million of fixed maturities (ii) $100,000 of cash and cash
equivalents and (iii) $800,000 of short term investments which were required to
be maintained as collateral for letters of credit and to satisfy insurance
regulatory requirements. Also included in the $24.0 million was $10.2 million
comprised of cash and various types of investments held in trust for the
benefit of the Syndicate's policyholders and $2.0 million of cash and cash
equivalents held in trust for the benefit of the Frontier Companies. (See
"Business -- Regulation -- Combination of the Syndicate with Alpine" -- Item 1
and Note 4 of Notes to Consolidated Financial Statements.)
Because substantial portions of Alpine's assets are restricted for
specific purposes, they may not be available to satisfy other obligations of
Alpine. This greatly reduces Alpine's liquidity and, in the event cash is
required to meet current liabilities beyond those currently projected by
management (e.g., as a consequence of increased or more rapid payouts of losses
or expenses), could lead to significant losses. (See "Business -- Overview of
Current Business Operations" -- Item 1 and " -- Results of Operations.")
At December 31, 1997, $14.0 million, or 18.2% of the Company's total
assets, consisted of real estate mortgages and real estate investments. This
compared to $16.7 million of such investments, comprising 15.5% of the
Company's total assets at December 31, 1996. The Company's intent is to
transfer such assets to Frontier if the sale of Alpine is consummated, in
accordance with the Potential Frontier Deal as currently contemplated, and if
not to reduce the real estate mortgages and real estate owned investments in an
aggressive but orderly manner. (See "Business -- Investments" -- Item 1.)
The decrease in cash and invested assets at December 31, 1997, compared to
December 31, 1996, resulted from cash applied to operations. Cash applied to
operations during 1997 was $22.6 million compared to $24.2 million for 1996,
and $14.3 million for 1995. The continued high level of cash applied to
operations in 1997 resulted principally from a continuing high level of
payments of loss and loss adjustment expenses, and continued low premium
revenues as a consequence of the Best rating downgrades, regulatory issues
affecting the Syndicate and Alpine
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and the Company's decision to cease writing direct insurance in August 1996.
(See "Business" -- Item 1.)
In order to fund the cash applied to operations during 1997 and 1996, the
Company liquidated investments at more accelerated rates than historically had
been necessary. Net cash inflow from investing activities was $30.6 million in
1997 compared to $21.0 million in 1996 and cash applied to investing activities
of $6.2 million in 1995.
The total debt obligation of the Company as of December 31, 1997 was $1.1
million. Of this amount, $100,000 is due during 1998. This debt obligation
will be transferred to Frontier if the sale of Alpine is consummated in
accordance with the Potential Frontier Deal as currently contemplated, but the
payments likely will remain indirectly as obligations of the Company.
Exstar, as a parent company, has historically relied on advances and tax
agreement payments from its subsidiaries to fund its cash requirements.
Exstar's cash was depleted during 1996 to pay for the suit against C&L, but as
a consequence of Exstar's settling the suit in January 1997, Exstar received
net cash, after related expenses not paid during 1996, of approximately $3
million. (See "Legal Proceedings" -- Item 3.) Management anticipates Exstar
will receive small, if any, dividends from its subsidiaries for 1998, but that
Exstar's cash needs, as a parent company, may be satisfied during the year out
of its own resources. Exstar does not plan to pay cash dividends in the
foreseeable future.
The Company currently does not anticipate that it will issue direct
insurance in the foreseeable future. Additionally, under the Quota Share
Arrangement or any similar replacement reinsurance arrangement, including such
an arrangement involving the Cayman Company, most of the premiums ultimately
due to Alpine may be withheld by the Frontier Companies, reducing Alpine's cash
available to satisfy current obligations. In March 1998, however, an
understanding was reached between the Company and the Frontier Companies
whereby some of the funds held by the Frontier Companies would be released to
Alpine. Initially $1.0 million was released to Alpine in March 1998 and an
additional $1.0 million was released to Alpine in April 1998. An additional
$1.0 million is expected to be released at the beginning of May 1998, assuming
the Potential Frontier Deal has not been consummated by such time. Management
expects (but has no understanding with Frontier) that if the sale of Alpine
should not be consummated, the Company may be able to obtain the accelerated
release of some additional funds held over time. Investment income on the
funds held by the Frontier Companies, although relatively insignificant, is
being and will continue to be paid to Alpine. Should the Company not be able
to obtain the release of additional funds held, or be obligated to replenish
the funds previously released during 1998, the Company's liquidity would be
adversely affected.
Management anticipates that during 1998 the need to continue to liquidate
investments as the Company's principal source of cash to fund its operations
will be significantly diminished as a consequence of anticipated reduced net
loss and loss adjustment expenses. Management believes that cash from (i) the
release of funds held by the Frontier Companies, (ii) liquidation of real
estate mortgages and real estate owned investments, (iii) reinsurance
recoveries, (iv) investment income, (v) net premium collections and deductible
and subrogation recoveries and (vi) reductions
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in the amounts of restricted cash and investments generally will be sufficient
to fund payment of loss and loss adjustment expenses and other expenses. Cash
received by the Company upon consummation of the sale of Alpine, should it
occur, in accordance with the Potential Frontier Deal as currently contemplated,
also would be available for obligations of the Company. Such sale,
additionally, would terminate the Company's obligation to fund with cash
Alpine's payment of losses.
The Company's future financial condition and prospects are heavily
dependent on the Company's maintaining or improving its relationships with
Frontier. Should the Company's relationships with the Frontier Companies be
discontinued, or their terms and conditions be changed in a manner materially
adverse to the Company, the Company experience significant losses. (See
"Business -- Proposed Future Operations and Organizational Changes;
Relationship with Frontier" -- Item 1 and " -- Results of Operations.")
As of December 31, 1997, the Company had no off-balance sheet obligations
or capital commitments that were not reflected in the Company's financial
statements.
Alpine's adjusted capital amounts at December 31, 1997, and December 31,
1996, were approximately 117% and 173%, respectively, of its authorized control
level risk-based capital amounts. (See "Business -- Regulation" -- Item 1.)
Because Alpine's December 31, 1996 adjusted capital was less than 200% of its
authorized control level risk-based capital, Alpine was required to submit a
comprehensive financial plan to the Illinois DOI. The plan identified, as the
principal condition that contributed to Alpine's failure to meet the company
action level of risk-based capital, the amount of Alpine's net reserves for
losses and loss adjustment expense relative to its statutory policyholders'
surplus and contained, as the proposed corrective actions, principally changes
to the Company's operations and organizational structure already implemented and
consummation of the Quota Share Arrangement with UCIC.
Alpine's comprehensive financial plan with respect to the year ended
December 31, 1996 was filed with and not objected to by the Illinois DOI. As
Alpine was below the regulatory action level at December 31, 1997, a similar
comprehensive financial plan will be required to be submitted to the Illinois
DOI by April 16, 1998. Management expects such plan to identify the $6.6
million Schedule P penalty incurred by Alpine in 1997 as one of the principal
causes for Alpine's failure to meet or exceed the company action level of
risk-based capital. Additionally, Alpine's statutory policyholders' surplus
was reduced by an underwriting loss of $6.7 million in 1997 as a result of a
relatively small volume of net premiums earned and $4.4 million of loss and
loss adjustment expense reserve strengthening during the year. (See "Business
- - Losses and Loss Adjustment Expenses" - Item 1.) Management expects the plan
to propose, as principal corrective actions to increase Alpine's risk-based
capital above the company action level, the continuation of Alpine's operations
in 1998, during which Alpine (i) expects to experience an overall reduction in
net reserves for losses and loss adjustment expense outstanding relative to its
statutory policyholders' surplus, (ii) expects to eliminate approximately $2.5
million of the Schedule P penalty as the 1995 accident year becomes excluded
from Alpine's Schedule P calculation, and (iii) expects to receive additional
assets contributed by Exstar consisting principally of some or all of
approximately $1.7 million of real estate investments owned directly by Exstar,
if necessary. Consummation of the proposed sale of Alpine and merger
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of Alpine with UCIC in accordance with the Potential Frontier Deal as currently
contemplated also are expected to eliminate or reduce Alpine's risk-based
capital obligations and concerns.
Over the last several years, the Company has been converting its computer
systems to be Year 2000 compliant. The Year 2000 problem results from computer
programs using two rather than four digits to define the applicable year (e.g.,
in many programs, each of 1900 and 2000 are defined by the digits "00"). The
Company expects its conversion efforts to be completed by the end of 1999, and
expects no material adverse impact internally from the Year 2000 problem.
Management has made no effort, however, to attempt to estimate the impact on
the Company of third parties' efforts to become, or lack of success in
becoming, Year 2000 compliant. All of the insurance assumed by the Company is
expected to exclude losses arising out of the Year 2000 problem. The Company
has made no effort to track the cost of the Year 2000 conversion as the
conversion is being accomplished in conjunction with routine upgrades of the
Company's underwriting, claims and accounting systems.
INFLATION
The Company believes the premium pricing levels established by the
Frontier Companies and thus the pricing levels on the premiums assumed by the
Company generally take into account inflationary pressures. The Company
believes the Frontier Companies, for competitive reasons, are limited in the
extent to which they can increase premiums to account for anticipated
inflation, and actual inflation may be greater than anticipated. In either
event, the Company believes the Frontier Companies, and thus the Company, rather
than the insureds, may have to absorb inflation costs.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Not applicable.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Information in response to this item is incorporated by reference from
Item 14.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
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PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information with respect to each of
the directors and executive officers of the Company as of March 31, 1998:
<TABLE>
<CAPTION>
NAME AGE POSITION WITH COMPANY
<S> <C> <C>
Peter J. O'Shaughnessy 56 Chief Executive Officer, Chairman of the Board and a Director
Steven C. Shinn 50 President and a Director
David W. Fleming 63 Director
Frank A. Johnson 63 Director
Mark Rosenberg 47 Senior Vice President and Chief Financial Officer
</TABLE>
Mr. O'Shaughnessy has served as the Chief Executive Officer and Chairman
of the Board of the Company (or its predecessor organizations) since its
formation in 1988, and served as its President from 1988 to September 1993.
Mr. O'Shaughnessy has been Chairman of the Board of Alpine since 1988 and was
an Executive Vice President of Alpine from 1986 to June 1993. He has been a
director and President of WESTCAP since October 1996. He has served as a
director of Claims Control since December 1986, has been its Chief Executive
Officer since March 1994, and was its President from December 1988 through
February 1994. Mr. O'Shaughnessy has served as Chairman of the Board of the
Syndicate and was President of the Syndicate from 1985 to June 1993. He has
been Chairman of the Board and Chief Executive Officer of TCO-CA, a subsidiary
of TCO Holdings, since 1977 and was President of TCO-CA and its predecessors
from 1977 to September 1993. He has also been a director of TCO-IL since 1987.
From 1986 to December 1993, Mr. O'Shaughnessy was a member of the Board of
Trustees of the IIE, and a member, as well as chairman, of a number of
committees of the IIE Board.
Mr. Shinn has served as President of the Company since September 1993. He
served as an Executive Vice President of the Company (or its predecessor
organizations) from its formation in 1988 until September 1993. Mr. Shinn has
been a director of the Company (or its predecessor corporations) since its
formation in 1988. Mr. Shinn has been a director of Alpine since 1987. Mr.
Shinn was an executive officer of Alpine from 1987 to June 1993 and has been
its President since September 1996. He has been a director and Executive Vice
President of WESTCAP since October 1996. He has served as a director of Claims
Control since September 1988, and was an Executive Vice President of Claims
Control from December 1988 through February 1994 and its President from March
1994 through March 1997. Mr. Shinn was also an executive officer of the
Syndicate from 1987 to June 1993 and served as its President from September
1996 through December 1996. Mr. Shinn has been an executive officer and
director of TCO-CA since 1987, and was an executive officer and director of
TCO-IL from 1987 to June 1993. Mr. Shinn has served as a director of Advanced
Hardware Architectures, Inc., a designer of computer chips located in Pullman,
Washington, since 1989.
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Mr. Fleming has been counsel to the international law firm of Latham &
Watkins since 1992. From 1960 to 1992, he was a senior partner at the law firm
of Fleming and Ingalls in the San Fernando Valley region. Mr. Fleming is
a member of the California Transportation Commission and chairs the Public
Transportation Committee of the Commission. He has been President of the Los
Angeles City Board of Fire Commissioners since 1993 and Chairman of Valley
Presbyterian Hospital since 1988. He has been a director of Valley Industry and
Commerce Association ("VICA") for 27 years and served as VICA's Chairman from
1988 to 1990.
Mr. Johnson is the President of RSA Soil Products, a wholesale distributor
of soil products, which he founded in 1954. He is also the president of Sutter
Enterprises, a trucking company, a position he has held since its formation in
1969.
Mr. Rosenberg has served as Chief Financial Officer and Senior Vice
President of the Company since January 1, 1997. From 1988 to 1997, he served
as Controller and Reinsurance Manager of TCO-CA. Mr. Rosenberg has been a
director of Alpine since September 1996. Since October 1996, he has served as
the Chief Financial Officer of WESTCAP. Mr. Rosenberg has also been a director
and the Chief Financial Officer of Claims Control since May 1996.
Section 16(a) of the Securities Exchange Act of 1934 ("1934 Act"), as
amended, requires the Company's executive officers, directors and persons who
own greater than ten percent of a registered class of the Company's equity
securities ("Reporting Persons") to file reports of ownership and changes in
ownership with the SEC and any exchange on which the Company's securities may
be listed. Reporting Persons are required by SEC regulations to furnish the
Company with copies of all Section 16(a) forms they file. Based solely on a
review of the forms it has received and on written representations from certain
Reporting Persons that no such forms were required for them, the Company
believes that during the year ended December 31, 1996, the Reporting Persons
complied with all filing requirements applicable to them, except as described
below.
In 1997, Mr. Rosenberg inadvertently failed to timely file a report on
Form 3 with respect to his appointment as Chief Financial Officer and stock
options received by him. The Form 3, which was required to be filed by January
11, 1997, was filed February 12, 1998.
ITEM 11. EXECUTIVE COMPENSATION
From the date of the Company's initial public offering through the end of
December 1994, neither the Company nor any of its subsidiaries had any
compensated employees. During that period, employees of TCO (including
individuals who were executive officers of the Company) performed all
administrative, management, underwriting, finance, claims, investment and other
services for the Company and its subsidiaries pursuant to the Master Agreement
and the management agreements between TCO-IL and the Company. As a result of
certain GAAP accounting changes adopted by the Company in early 1995, however,
the Company elected to provide the information required by Item 402 of
Regulation S-K with respect to compensation received by its executive officers
from TCO for the years ending December 31, 1994 and
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thereafter.
Effective January 1, 1995, the Company's executive officers became direct
employees of the Company, and, as such, began to receive compensation directly
from the Company. Each such individual continued to hold the offices and
directorships he previously held with TCO, and certain of such individuals
continued to receive salaries from TCO until August 1, 1996.
Effective August 1, 1996, portions of the compensation paid to the
Company's executive officers were allocated to and reimbursed to the Company by
Transre and E&S. The Company directly paid such amounts solely for
administrative convenience. The amounts paid by Transre and E&S were not in
any way related to the Company's results or the time devoted, or services
provided, to the Company. Accordingly, such amounts reimbursed by Transre and
E&S are not reflected in the body of the Summary Compensation Table below,
although they are reflected in the notes thereto.
Effective September 30, 1997, Transre and E&S ceased operations, and
operations previously performed by them began to be performed by WESTCAP, a
subsidiary of Exstar, effective as of October 1, 1997. Accordingly, effective
as of October 1, 1997, all allocations and reimbursements of compensation
between the Company and Transre and E&S ceased.
SUMMARY COMPENSATION
The following table provides information concerning the annual and other
compensation for services in all capacities to the Company and TCO (but not for
services to Transre or E&S) of those persons who were at December 31, 1997 the
Chief Executive Officer of the Company, and executive officers of the Company
whose total salary and bonus paid by the Company and TCO exceeded $100,000 in
1997 (collectively, the "Named Officers").
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SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG TERM
COMPENSATION
ANNUAL COMPENSATION AWARDS
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS OTHER SECURITIES ALL OTHER
($) ($) ANNUAL UNDERLYING COMPENSATION
COMPENSATION OPTIONS ($)
($) (#)
<S> <C> <C> <C> <C> <C> <C>
Peter J. O'Shaughnessy, 1997 $270,645 (1) -- -- 50,000 --
Chairman of the Board, 1996 665,462 (2) -- 33,532 (3) -- --
Chief Executive Officer 1995 1,314,052 (4) -- 79,569 (5) -- --
Steven C. Shinn, President 1997 247,374 (6) 38,800(7) -- 146,350 --
1996 207,310 (8) -- -- -- --
1995 237,522 -- -- -- --
Richard G. Kersten,
Senior Vice President, 1997 121,198 (9) 20,480(10) -- -- --
General Counsel and 1996 129,945 (11) -- -- -- --
Secretary 1995 156,625 (12) -- -- -- --
</TABLE>
_________________________
(1) Excludes $219,294 paid by the Company in 1997 but reimbursed to the
Company by Transre and E&S.
(2) Includes $37,505 paid by TCO. The TCO companies are not subsidiaries of
the Company and are directly or indirectly wholly owned by Mr.
O'Shaughnessy. Excludes $123,175 paid by the Company in 1996 but
reimbursed to the Company by Transre and E&S.
(3) This amount is attributable to various services and benefits provided to
Mr. O'Shaughnessy by TCO ($23,818) and by the Company ($9,714).
(4) Includes $592,347 paid by TCO.
(5) This amount is attributable to various services and benefits provided to
Mr. O'Shaughnessy by TCO ($37,569) and by the Company ($42,000).
(6) Excludes $49,159 paid by the Company in 1997 but reimbursed to the
Company by Transre and E&S. Includes $33,421 paid by TCO in settlement of
obligations under Mr. Shinn's Employment Agreement.
(7) Excludes $9,700 paid by the Company in 1997 but reimbursed to the Company
by Transre and E&S.
(8) Excludes $20,740 paid by the Company in 1996 but reimbursed to the
Company by Transre and E&S.
(9) Excludes $29,771 paid by the Company in 1997 but reimbursed to the
Company by Transre and E&S.
(10) Excludes $5,120 paid by the Company in 1997 but reimbursed to the Company
by Transre and E&S.
(11) Includes $81,817 paid by TCO. Excludes $12,032 paid by the Company in
1996 but reimbursed to the Company by Transre and E&S.
(12) Paid by TCO.
Mr. Kersten's employment with the Company terminated effective in January
1998.
ISSUANCE OF EXSTAR STOCK OPTIONS; AGGREGATED OPTION EXERCISES AND YEAR-END 1997
OPTION VALUES
Prior to April 1, 1997, 274,781 shares of Exstar Common Stock owned by TCO
were the subject of options issued by TCO to TCO employees, Company employees
and others. The exercise price of such options was $2.73 per share, and
options for all but 916 of the shares were scheduled to be fully vested by July
1, 1997. In connection with the Company's hiring and
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continuing employment of the former employees of TCO, effective April 1, 1997,
all such TCO options were terminated, and all shares of Exstar Common Stock
owned by TCO were transferred to Exstar. Effective April 1, 1997, Exstar
agreed to issue incentive stock options for up to approximately 400,000
shares of Exstar Common Stock to employees of the Company and its affiliates,
including options with respect to 215,682 shares to replace options previously
issued by TCO and options with respect to 175,102 additional shares. The
vesting periods for these options generally run through at least January 1,
1999, and the exercise prices for these options are $1.40 per share. In
addition, Exstar agreed to issue non-qualifying stock options for 61,848 shares
of Exstar Common Stock to persons not employed by the Company or its affiliates
to replace vested options previously issued by TCO. All such non-qualifying
stock options are immediately exercisable and have exercise prices of $1.40 per
share.
OPTION GRANTS IN 1997
The following table provides information on grants of stock options in
1997 to the Named Officers. No stock appreciation rights were granted to the
Named Officers during 1997.
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS
NUMBER OF
SECURITIES PERCENT OF TOTAL POTENTIAL REALIZABLE
UNDERLYING OPTIONS OPTIONS GRANTED TO VALUE AT ASSUMED ANNUAL RATES
GRANTED EMPLOYEES IN FISCAL EXERCISE OR BASE OF STOCK PRICE APPRECIATION
NAME (1) YEAR PRICE ($/SH) EXPIRATION DATE FOR OPTION TERM (2)
- ----
5% ($) 10% ($)
<S> <C> <C> <C> <C> <C> <C>
Peter J. O'Shaughnessy 50,000 100% 1.40 3/31/02 10,000 38,500
Steven C. Shinn....... 146,350 100% 1.40 3/31/07 116,000 293,000
Richard G. Kersten.... 27,488 100% 1.40 3/31/07 22,000 55,000
</TABLE>
(1) All options were granted pursuant to the Company's 1992 Stock Incentive
Plan and are subject to the terms of such plan. Prior to April 1, 1997,
TCO (which is owned by Mr. O'Shaughnessy) owned 536,000 shares of Exstar
Common Stock; and Messrs. Shinn and Kersten had options to acquire 126,350
shares and 27,488 shares, respectively, of Exstar Common Stock from TCO,
at exercise prices of $2.73 per share, two-thirds of which were vested and
one-third of which were scheduled to vest July 1, 1997. In connection
with the Company's hiring and continuing employment of the former
employees of TCO, effective April 1, 1997 (i) all such TCO options were
terminated, (ii) all shares of Exstar Common Stock owned by TCO were
transferred to Exstar for nominal consideration and (iii) Exstar agreed to
issue incentive stock options, vesting one-third on July 1, 1997,
one-third on January 1, 1998 and one-third on January 1, 1999, for up to
approximately 400,000 shares of Exstar Common Stock to employees of the
Company and its affiliates, including options to replace options
previously issued by TCO. All options were granted at an exercise price
equal to 110% of the fair market value of the Company's Common Stock on
the date of grant as determined by the Compensation Committee of the Board
of Directors of the Company.
(2) In accordance with the rules of the SEC, shown are the hypothetical gains
or "option spreads" that would exist for the respective options. These
gains are based on assumed rates of annual compounded stock price
appreciation of 5% and 10% from the date the option was granted over the
full option terms of 5 years in the case of Mr. O'Shaughnessy and 10 years
in the cases of Messrs. Shinn and Kersten. The 5% and 10% assumed rates
of appreciation are mandated by the rules of the SEC and do not represent
the Company's estimate or projection for future increases in the price of
its Common Stock.
The following table provides information on unexercised options held by
the Named
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Officers at December 31, 1997, all of which were granted in 1997 under the
Exstar 1992 Stock Incentive Plan. No options or stock appreciation rights were
exercised by the Named Officers in 1997.
YEAR-END 1997 OPTION VALUES
<TABLE>
<CAPTION>
NUMBERS OF SHARES VALUE OF
UNDERLYING UNEXERCISED UNEXERCISED IN-THE-MONEY
OPTIONS AT 12/31/97 OPTIONS AT 12/31/97 (1)
(#) ($)
NAME EXERCISABLE/UNEXERCISABLE EXERCISABLE/UNEXERCISABLE
<S> <C> <C>
Peter J. O'Shaughnessy 16,667 / 33,333 30,834 / 61,668
Steven C. Shinn 48,783 / 97,567 90,256 / 180,512
Richard G. Kersten 9,163 / 18,325 16,952 / 33,903
</TABLE>
(1) Values are calculated as the closing price of Exstar Common Stock on
December 31, 1997, or $3.25 per share, less the exercise price of $1.40 per
share.
EMPLOYMENT AND CONSULTING AGREEMENTS
In 1994, TCO-CA entered into an employment agreement with Mr. Shinn which
initially had a term ending August 31, 1996 (the "Employment Agreement").
Pursuant to the Employment Agreement, Mr. Shinn agreed to serve as President of
both TCO-CA and the Company. The agreement provided for two consecutive
two-year extensions at the option of TCO or Mr. Shinn. In August 1997, TCO-CA
and Mr. Shinn entered into an agreement terminating their respective rights and
obligations under the Employment Agreement. In connection with such
settlement, Mr. Shinn entered into a Consulting Agreement with TCO-CA, under
which Mr. Shinn agreed to perform certain consulting services for TCO-CA, in
return for annual consideration to Mr. Shinn of approximately $13,000 per year
from 1998 through 2007, payable only through offsets against debts owed to
TCO-CA by Mr. Shinn (totaling approximately $90,000).
DIRECTOR COMPENSATION
Non-management directors receive $15,000 per year paid in quarterly
installments of $3,750, and $1,000 per day for each day they attend a board
meeting or a committee meeting. The Company paid its non-management directors
$24,000 under this arrangement in 1997. Non-employee directors are also
eligible to receive options under the Exstar Financial Corporation 1995
Directors Stock Option Plan; no options have been granted under this plan. The
Company currently has two non-employee directors.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth, as of March 31, 1998, certain information
with respect to the beneficial ownership of Exstar Common Stock by (i) each
person known by the Company to own beneficially more than five percent of the
outstanding shares of Common Stock, (ii) each director and nominee, and (iii)
all Company executive officers, directors and nominees as a group.
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<TABLE>
<CAPTION>
NUMBER OF SHARES
NAME AND ADDRESS BENEFICIALLY OWNED(1) PERCENT OF OWNERSHIP
<C> <C> <C>
Peter J. O'Shaughnessy
42-510 Caracas Place
Bermuda Dunes, CA 92201 3,027,758 (2) 61.0%
Mochel Family Limited
Partnership (3) P.O. Box 2526
Avon, CO 81620 270,500 5.4%
Steven C. Shinn
705 Mesa Drive
Solvang, CA 93463 169,267 (4) 3.4%
David W. Fleming
c/o Latham & Watkins
10 Universal City Plaza
Suite 2570
Universal City, CA 91608-1002 10,000 *
Mark Rosenberg
3590 Cerrito Street
Santa Ynez, CA 93460 12,730 (5) *
All executive officers,
Directors and nominees as
a group (4 persons) 3,219,755 64.8%
</TABLE>
___________________________
(1) Unless otherwise indicated below, the persons in the above table have
sole voting and investment power with respect to all shares shown as
beneficially owned by them.
(2) Includes 33,333 shares issuable upon the exercise of vested options.
(3) Based on a Form 13D filed by the Mochel Family Limited Partnership on May
21, 1997.
(4) Includes 97,567 shares issuable upon the exercise of vested options.
(5) Represents shares issuable upon the exercise of vested options.
* Less than 1%.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
During July 1995, the Company acquired from Mr. O'Shaughnessy eight
parcels of land ranging in size from 20 to 28 acres for which the off-site
improvements had been completed. The property was acquired subject to a first
trust deed to an unrelated financial institution in the amount of $595,000.
Also during July 1995, the Company acquired from Mr. O'Shaughnessy an
eight-acre residential property with a house and other improvements. This
property was acquired subject to existing liabilities of $1,126,000 and
$644,000 to unrelated financial institutions, secured by first and second trust
deeds, respectively. The purchase prices, as approved by the disinterested
members of the Company's board of directors, were equal to Mr. O'Shaughnessy's
costs in the properties, which were $1,114,000 in the case of the eight parcels
(compared to an appraised value as of the date of transfer of $1,045,000) and
$2,125,000 in the case of the residential property (compared to an appraised
value as of the date of transfer of $2.8 million). If
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the properties are sold for less than the Company's costs, Mr. O'Shaughnessy
has agreed to reimburse the Company for the differences. If the properties are
sold at amounts less than their appraised values as of the dates they
were acquired by the Company but more than their costs, any excess of proceeds
(less costs to carry and sell the properties) over their costs will be paid to
Mr. O'Shaughnessy. If the properties are sold for more than their appraised
values as of the dates they were acquired by the Company, the excess over
appraised values will be shared between the Company and Mr.
O'Shaughnessy. During 1996, the Company sold six of the eight parcels for net
proceeds of $623,000. During 1997, the Company sold the remaining two parcels
for net proceeds of $204,000. As of December 31, 1997, Mr. O'Shaughnessy would
have had a liability to the Company of $392,000 (Company's costs of $1,219,000
less sale proceeds of $827,000) based on the sale of the eight parcels. The
Company's costs exceeded the fair value of the remaining eight-acre residential
property by $326,000 as of December 31, 1997. At December 31, 1997, the
appraised value of the eight-acre residential property was $2.5 million and its
fair value was $2.3 million. As of December 31, 1997, Mr. O'Shaughnessy would
have had an estimated liability to the Company of approximately $718,000 based
on the foregoing arrangements, though his ultimate liability, if any, will not
be determined or payable until the eight-acre residential property has been
sold. The property is included in real estate held for sale. Under the terms
of the Potential Frontier Deal as currently contemplated, it is anticipated
that the eight-acre residential property would be contributed to Alpine in
connection with the sale of Alpine to Frontier. Neither such contribution nor
the sale of Alpine would trigger Mr. O'Shaughnessy's payment obligation. Mr.
O'Shaughnessy's ultimate liability, if any, would not be determined until the
property is sold by Frontier. The Company has no understanding with Mr.
O'Shaughnessy as to how and when any such liability would be paid to the
Company upon Frontier's sale of the property, or whether any compromise will be
agreed to in connection with any such liability. Any payment by Mr.
O'Shaughnessy would increase the Company's stockholders' equity and net income.
Effective in July 1996, the Company leased a residential property included
in real estate held for sale to Mr. O'Shaughnessy, which lease was terminated
effective September 30, 1997. Rental income from Mr. O'Shaughnessy on this
property included in the income statement for the year ended December 31, 1997
was approximately $28,000, which amount was paid in cash by Mr. O'Shaughnessy.
Effective October 1, 1997, the Company leased a different residential
property included in real estate held for investment to Mr. O'Shaughnessy.
Such lease is for a one-year initial term, at a monthly rental rate of $1,500.
An independent broker's price opinion was sought and obtained by the Company
with respect to the adequacy of this rental rate. No income relating to this
lease was included in the income statement for the year ended December 31, 1997
and no rent was actually paid in 1997, as the independent broker's opinion had
not been obtained by December 31, 1997. The full $9,000 rental amount due to
the Company for the period from October 1, 1997 through March 31, 1998 was paid
in cash in the first quarter of 1998.
During 1997, TCO-CA and TCO-IL made loans to Mr. O'Shaughnessy in the
aggregate amounts of $25,000 and $147,325, respectively, none of which was
repaid in 1997. In accordance with the Company's current GAAP accounting
methods, the Company's stockholders'
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No understanding has been reached with Mr. O'Shaughnessy as to how and when
such indebtedness would be paid, or whether any compromise will be agreed to in
connection with such indebtedness. Any principal payments up to approximately
$2.5 million in the aggregate would increase the Company's stockholders' equity
and net income. The accrual or payment of interest on the indebtedness has no
impact on the Company's stockholders' equity or net income.
Mr. O'Shaughnessy is the indirect owner of TCO-IL, an entity that is
indebted to Alpine in the amount of approximately $9.2 million. This
receivable is not reflected as an admitted asset of Alpine in its statutory
financial statements or as an asset of the Company in its GAAP financial
statements. In connection with a proposed sale by the Company of the stock of
Alpine to a third party, subject to approval by the Illinois DOI such
indebtedness of TCO-IL to Alpine is anticipated to be cancelled.
In April 1997, Exstar acquired certain farm equipment used to maintain
real property owned by the Company from Mr. O'Shaughnessy for $29,280. The
price of the equipment (tractors, gardening tools, etc.) was determined using
fair market values obtained from an implement dealer for used equipment.
Mr. O'Shaughnessy directly owns all of the issued and outstanding stock of
E&S. From June 1996 through September 1997, E&S received commissions on
insurance business placed with the Frontier Companies, generally at the rate of
27.5% of the gross premiums collected for such insurance. Approximately a 30%
quota share portion of such insurance business was ceded by the Frontier
Companies to Alpine. The aggregate amount of commissions received by E&S
during 1997 on such business (net of commissions paid to subproducers) was $1.2
million. E&S agreed to pay a portion of E&S's net profits earned in connection
with this arrangement to the Company, in partial satisfaction of debts owed to
the Company by TCO-IL. Because E&S did not have any net profits in 1997, no
such profits were paid to the Company in 1997.
Also in June 1996, Claims Control began handling claims on behalf of the
Frontier Companies with respect to insurance produced through E&S. Until
October 1, 1997, when its stock was transferred to Exstar, Claims Control was
wholly owned by TCO-CA (which is indirectly owned by Mr. O'Shaughnessy).
Claims Control is reimbursed by Alpine for the salary and benefit costs related
to Claims Control's employees, as well as Claims Control's general and
administrative costs. Such cost reimbursement for the period from January 1,
1997 through September 30, 1997 was approximately $787,000. In partial
satisfaction of TCO-IL's liabilities to the Company, Claims Control agreed to
assign to the Company all revenues received by Claims Control from the Frontier
Companies (less any payments made by the Frontier Companies with respect to
Claims Control costs not initially borne by Alpine). The amount so assigned by
Claims Control to the Company for the period from January 1, 1997 through
September 30, 1997 was approximately $62,000.
On April 1, 1997, TCO Holdings entered into a Service Agreement with
Alpine under
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which TCO Holdings agreed to assist Alpine in the negotiation and
placement of a quota share reinsurance agreement with the Frontier Companies.
For such services, Alpine agreed to pay TCO Holdings 3.75% of the gross
premiums received by Alpine pursuant to the quota share agreement, subject to a
maximum aggregate payment to TCO Holdings of $4.5 million.
In October 1997, Mr. O'Shaughnessy transferred all of the stock of WESTCAP
to Exstar for consideration of $1,000. Also in October 1997, TCO-CA, an entity
indirectly wholly owned by Mr. O'Shaughnessy, transferred all of the stock of
Claims Control to Exstar for consideration of $1,000. (Management believes
that the values of WESTCAP and Claims Control to the Company substantially
exceed the amounts paid to Mr. O'Shaughnessy and TCO-CA.)
On April 1, 1997, TCO-IL, an entity indirectly wholly owned by Mr.
O'Shaughnessy, transferred to the Company 536,000 shares of Exstar Common Stock
(all of the Exstar Common Stock owned by it) for consideration of $0.01 per
share, or $5,360 in the aggregate. The per share market value of Exstar's
Common Stock on that date was $1.25 and thus, the aggregate market value of the
Common Stock transferred to Exstar was $670,000 on that date. At December 31,
1997, the per share market value of Exstar's Common Stock was $3.25; thus, the
aggregate December 31, 1997 market value of the shares previously transferred
was $1,742,000.
The Master Agreement sets forth a number of rights and responsibilities
between the Company and TCO and covers, among other things, the circumstances
under which Exstar has the option to acquire certain TCO operations. Under the
terms of the Master Agreement, Exstar has the option to acquire these
operations in the event that, among other things, TCO-IL becomes insolvent or
unable to continue operations. The purchase price, based on formulas defined
in the Master Agreement, is to be equal to the sum of a multiple of the
operations' then book value, plus a multiple of the operations' then revenues
unrelated to the Company, net of certain expenses. Management believes the
Company's right to acquire the TCO operations has been triggered, but has not
elected to exercise such right.
Since the end of 1995, the Company believes it has had a number of rights
and remedies it could potentially assert against or with respect to TCO under
the Master Agreement, the management agreements, the Loan Agreement and a lease
between the Syndicate and TCO-CA. Among other things, the Company (i) could
have asserted its right to acquire TCO or TCO's operations or otherwise
asserted its remedies under the Master Agreement, (ii) could have, because
TCO's financial condition apparently breached certain financial covenants of
the Loan Agreement, asserted its right to accelerate TCO's loan payments or
otherwise asserted its remedies under the Loan Agreement, and (iii) could have
asserted its rights under the lease to require that TCO-CA continue as lessee
or pay damages. Additionally, TCO failed to pay the Syndicate and Alpine $9.2
million of agents' balances due in accordance with the terms and conditions of
the management agreements. As a result, the Company could have sought to
assert its remedies, including retaining ownership of TCO's renewals, under the
management agreements.
The Company determined not to assert the foregoing or other rights it
could have asserted under the Master Agreement, the management agreements, the
Loan Agreement, the lease or
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otherwise. In lieu thereof, the Company agreed to termination of the management
agreements, subject to a final determination of obligations and liabilities
between the Company and TCO, and to the termination of the lease. The
management agreement between Alpine and TCO was terminated effective July 31,
1996. The management agreement between TCO and the Syndicate was terminated
effective December 31, 1996 (except with respect to the profit sharing provision
which was terminated effective September 30, 1996). Pursuant to the management
agreements, the Company paid TCO $5,582,000 in 1996 and $24,672,000 in 1995.
Additionally, in lieu thereof, the Company agreed to allow certain assets
of TCO to be used by Transre, Claims Control and E&S. The assets were used to
produce insurance and handle claims for UCIC, which agreed, effective April 1,
1997, to cede to Alpine as a reinsurer a portion of such insurance. (See
"Business -- Overview of Current Business Operations" -- Item 1.) The transfer
to the Company of the stock of WESTCAP and Claims Control, and the transfer to
the Company of the 536,000 shares of Exstar Common Stock owned by TCO, all for
nominal consideration, were consummated in recognition of the Company's rights
and TCO's obligations under the Master Agreement.
The Company has consented to TCO's, Claims Control's and E&S's use of
certain of TCO's assets and cash flows, that the Company otherwise might have
attempted to claim for itself, to satisfy obligations to third parties,
including tax obligations, obligations to an unaffiliated insurance company,
obligations owed to the holder of the TCO Holdings preferred stock (see Notes
12 and 16 of the Notes to Consolidated Financial Statements), and obligations
under an office lease to which TCO was subject. Mr. O'Shaughnessy may have
contingent liability with respect to certain of these TCO obligations, and,
consequently, may benefit from their satisfaction through the use of such
assets and cash flows.
During each of 1995 and 1996, in consideration of TCO's meeting its
repayment obligations under the Loan Agreement, Exstar released 170,000 of the
shares of Exstar Common Stock then pledged to secure TCO's obligations under
the Loan Agreement. As of December 31, 1996, 160,000 shares of Exstar Common
Stock owned by TCO were still pledged under the Loan Agreement. Such shares
were released in April 1997 upon the transfer by TCO to Exstar of the 536,000
shares of Exstar Common Stock owned by TCO.
During 1987, the Syndicate and Alpine issued a policy to provide stop-loss
coverage on business written by an unaffiliated insurer and produced by TCO.
As consideration, the Syndicate and Alpine were entitled to 2.5% of the
unaffiliated insurer's written premium on the business. Total written premium
subject to the stop-loss coverage was $0, $345,000 and $1,320,000 in 1997,
1996, and 1995, respectively. Both the Syndicate and Alpine furnished the
unaffiliated insurer with letters of credit fully collateralized by fixed
maturity investments, certificates of deposit and other short-term investments
in the amount of $4,523,000 as of December 31, 1997, and $7,900,000 as of
December 31, 1996 and 1995, respectively to provide security for their and
TCO's performance in connection with this arrangement. Since July 1, 1992, as
consideration for the letters of credit provided by the Syndicate and Alpine,
Exstar has been entitled to receive the interest earned on funds on deposit
with and certain contingent amounts potentially due from the unaffiliated
insurance company. As additional consideration, TCO has assigned to Exstar any
73
<PAGE> 77
contingent amounts from the unaffiliated insurance company up to $1,000,000 per
year, under which arrangement Exstar received no amounts in 1997 or 1996.
The Company owns two office buildings in Solvang, California. The Company,
until June 1996, leased the two office buildings to TCO. The rental income from
TCO included in the statements of operations for the years ended December 31,
1996 and 1995 was $228,000 and $584,000, respectively.
In connection with the Quota Share Arrangement, Alpine has agreed to pay
the Frontier Companies a ceding commission generally of 30% of the premium
assumed by Alpine. This ceding commission is to compensate the Frontier
Companies for expenses incurred by them generally in obtaining the insurance
which is subject to the Quota Share Arrangement. The Frontier Companies paid
Transre and E&S a fee of 27.5% of the premium produced by them pursuant to the
Limited Agency Agreement prior to October 1, 1997. The ceding commission paid
by Alpine, consequently, may have indirectly benefited Transre and E&S, as well
as the employees of Alpine whose compensation was paid in part by
reimbursements to Alpine from Transre and E&S.
The Syndicate and Alpine derived premiums on insurance produced for them
by Trinity, which was formerly a subsidiary of TCO Holdings and is now majority
owned directly by Mr. O'Shaughnessy. The gross premiums derived by the
Syndicate and Alpine from Trinity were $27,000, $1,575,000 and $5,726,000 in
1997, 1996, and 1995, respectively. As a subproducer of WESTCAP, Trinity
received commissions of approximately $210,000 from WESTCAP in 1997. Steven
Shinn, President of the Company, owns five percent of Trinity's outstanding
stock.
During 1991, the Company made construction loans to Trinity for
construction of a new office building. The outstanding loan balances at
December 31, 1997 and 1996, were $1,084,000 and $1,096,000, respectively.
On April 1, 1997, the Company issued to Mr. O'Shaughnessy options to
acquire 50,000 shares of Exstar Common Stock at an exercise price of $1.40 per
share. The closing price of the Company's Common Stock on that date was $1.25
per share. Subject to certain restrictions, options representing 33,333 shares
were exercisable as of January 1, 1998, and options representing the remaining
16,667 shares become exercisable January 1, 1999. Also on April 1, 1997, the
Company issued to Mr. Shinn options to acquire 146,350 shares of Exstar Common
Stock at an exercise price of $1.40 per share. Subject to certain
restrictions, options representing 97,567 shares were exercisable as of January
1, 1998, and options representing the remaining 48,783 shares become
exercisable January 1, 1999. These options were issued generally in
replacement of options to acquire Exstar Common Stock previously issued to Mr.
Shinn by TCO. The Company also issued to Mark Rosenberg, the Company's Chief
Financial Officer, options to acquire 19,000 shares of Exstar Common Stock at
an exercise price of $1.40 per share. Subject to certain restrictions, options
representing 12,667 shares were exercisable as of January 1, 1998 and options
representing the remaining 6,333 shares become exercisable January 1, 1999.
These options were issued generally in replacement of options to acquire Exstar
Common Stock previously issued to Mr. Rosenberg by TCO.
74
<PAGE> 78
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) 1. The following financial statements of the Company and the related
report of independent public accountants are filed as part of this
Form 10-K:
Independent Auditors' Report
Consolidated Balance Sheets as of December 31, 1997 and 1996
Consolidated Statements of Operations for the years ended
December 31, 1997, 1996 and 1995
Consolidated Statements of Changes in 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. The following financial statement schedules of the Company
and the related report of independent public accountants are filed
as part of this Form 10-K:
Schedule II -- Condensed Financial Information of Registrant
(Parent Only)
Schedule IV -- Reinsurance
Schedule VI -- Supplemental Information Concerning
Property--Casualty Insurance Operations
All other financial schedules are omitted because such schedules
are not required or the information required has been presented in
the aforementioned financial statements.
3. The following exhibits are filed with this Report or
incorporated by reference as set forth below.
<TABLE>
<CAPTION>
EXHIBIT
NUMBER
- -----------
<S> <C>
*2.1 Plan and Agreement of Merger, executed on October 20, 1992.
*3.1 Restated Certificate of Incorporation of Registrant.
*3.2 Bylaws of Registrant.
*4.1 Specimen stock certificate representing the Common Stock.
*10.1 Exstar Financial Corporation 1992 Stock Incentive Plan.
*10.2 TCO Insurance Services 1992 Stock Incentive Plan, effective July 1, 1992.
*10.6 Master Agreement between TCO Insurance Services, Inc. and Registrant.
*10.7 Loan and Security Agreement, dated as of December 30, 1988, by and
between Registrant, Peter J. O'Shaughnessy and Boulevard Bank National
Association.
</TABLE>
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<PAGE> 79
<TABLE>
<CAPTION>
EXHIBIT
NUMBER
- -----------
<S> <C>
*10.8 Agreement and Amendment of Loan and Security Agreement, Term Note and
Related Loan Documents, dated as of September 30, 1989, by and
between Boulevard Bank National Association, Registrant and Peter J.
O'Shaughnessy.
*10.9 Second Amendment of Loan and Security Agreement and Waiver Agreement,
dated as of September 30, 1991, by and between Boulevard Bank National
Association, Registrant and Peter J. O'Shaughnessy.
*10.10 Letter Agreement, dated September 14, 1992, by and between Boulevard Bank
National Association, Registrant and Peter J. O'Shaughnessy, regarding
restructuring of loans.
*10.11 Interests and Liabilities Contract to Property and Casualty Stop Loss
Reinsurance Agreement between United National Insurance Company, Diamond
State Insurance Company, and Hallmark Insurance Company, Inc., and
Transco Syndicate #1 Ltd., The Erie Syndicate, Inc., and IMI Insurance
Company.
*10.12 Amendment, effective April 1, 1987, to Property and Casualty Stop Loss
Reinsurance Agreement between United National Insurance Company, Diamond
State Insurance Company, and Hallmark Insurance Company, Inc. and Transco
Syndicate #1 Ltd., The Erie Syndicate, Inc., and IMI Insurance Company.
*10.15 Excess of Loss Reinsurance Cover Note, effective January 1, 1992, issued
by Carvill America, Inc. to Alpine Insurance Company.
*10.16 Marine Excess of Loss Reinsurance Cover Notes, effective February 1,
1992, issued by Intere Intermediaries, Inc. to Transco Syndicate #1 Ltd.
and/or Alpine Insurance Company.
*10.17 Stock Purchase Agreement, dated as of October 30, 1989, by and among
Registrant and all of the stockholders of The Erie Syndicate, Inc.
*10.18 Stock Purchase Agreement, dated as of December 28, 1989, by and among
Jeffery W. Beresford-Wood, Concord General Corporation, First Horizon
Insurance Company, Peter J. O'Shaughnessy, Registrant and Transco
Syndicate #1 Ltd.
*10.19 Amendment No. 1, dated as of June 22, 1990, to the Stock Purchase
Agreement dated as of December 28, 1989, by and among Jeffery W.
Beresford-Wood, Concord General Corporation, First Horizon Insurance
Company, Peter J. O'Shaughnessy, Registrant and Transco Syndicate #1 Ltd.
*10.20 Amendment No. 2, dated as of December 3, 1990, to the Stock Purchase
Agreement dated as of December 28, 1989, by and among Jeffery W.
Beresford-Wood, Concord General Corporation, First Horizon Insurance
Company, Peter J. O'Shaughnessy, Registrant and Transco Syndicate #1 Ltd.
*10.21 Amendment No. 3, dated as of April 22, 1991, to the Stock Purchase
Agreement dated as of December 28, 1989, by and among Jeffery W.
Beresford-Wood, Concord General Corporation, First Horizon Insurance
Company, Peter J. O'Shaughnessy, Registrant and Transco Syndicate #1,
Ltd.
*10.22 Letter Agreement, dated August 26, 1992, between Registrant and Concord
General Corporation, regarding certain transactions in connection with
the Registrant's Company's public offering.
*10.23 Tax Allocation Agreement, dated January 1, 1988, by and among Registrant
and each of its then affiliates.
</TABLE>
76
<PAGE> 80
<TABLE>
<CAPTION>
EXHIBIT
NUMBER
- -----------
<S> <C>
*10.24 Supplemental Tax Agreement between Registrant and TCO Insurance Services,
Inc.
**10.25 Endorsement No. 3 Commuting Casualty Excess of Loss Reinsurance
Agreement, effective January 1, 1991, issued by Alexander Reinsurance
Intermediaries, Inc. to Transco Syndicate #1 Ltd. and/or Alpine Insurance
Company.
**10.26 Casualty Excess of Loss Cover Note, effective January 1, 1993, issued by
Alexander Reinsurance Intermediaries, Inc. to Transco Syndicate #1 Ltd.
and/or Alpine Insurance Company.
**10.27 Semi-Automatic Facultative Casualty Excess of Loss Cover Note, effective
January 1, 1993, issued by Alexander Reinsurance Intermediaries, Inc. to
Transco Syndicate #1 and/or Alpine Insurance Company.
**10.28 Casualty Excess of Loss Cover Note, effective January 1, 1991, issued by
Alexander Reinsurance Intermediaries, Inc. to Transco Syndicate #1 Ltd.
and/or Alpine Insurance Company.
**10.29 Automatic Facultative Casualty Excess of Loss Cover Note, effective
January 1, 1991, issued by Alexander Reinsurance Intermediaries, Inc. to
Transco Syndicate #1 and/or Alpine Insurance Company.
***10.30 Management and Underwriting Agency Agreement between Transco Syndicate
#1, Ltd. and TCO Insurance Services, Inc. dated June 29, 1993.
***10.31 Management Agreement between Alpine Insurance Company and TCO Insurance
Services, Inc. dated June 29, 1993.
***10.32 Servicing Agreement between TCO Insurance Services, Inc. and TCO
Insurance Services dated July 1, 1993.
***10.33 Servicing Agreement between TCO Insurance Services, Inc. and TCO
Insurance Services dated July 1, 1993.
#10.34 Management and Servicing Agreement between Alpine Insurance Company and
TCO Insurance Services, Inc. dated as of December 31, 1993.
#10.35 Agreement between Transco Syndicate #1 Ltd. and United National Insurance
Company, Diamond State Insurance Company and Hallmark Insurance Company,
Inc. dated January 21, 1994.
#10.36 Commercial Real Property Lease by and between Transco Syndicate #1 Ltd.
and TCO Insurance Services dated January 1, 1994.
#10.37 Casualty Excess of Loss Cover Note, effective January 1, 1991, issued by
Alexander Reinsurance Intermediaries, Inc. to Transco Syndicate #1 Ltd.
and/or Alpine Insurance Company.
#10.38 Casualty Excess of Loss Cover Note, effective January 1, 1992, issued by
Alexander Reinsurance Intermediaries, Inc. to Transco Syndicate #1 Ltd.
and/or Alpine Insurance Company.
#10.39 Casualty Excess of Loss Cover Note, effective January 1, 1993, issued by
Alexander Reinsurance Intermediaries, Inc. to Transco Syndicate #1 Ltd.
and/or Alpine Insurance Company.
#10.40 Semi-Automatic Facultative Casualty Excess of Loss Agreement effective
January 1, 1994, issued by Alexander Reinsurance Intermediaries, Inc. to
Transco Syndicate #1 Ltd. and/or Alpine Insurance Company.
</TABLE>
77
<PAGE> 81
<TABLE>
<CAPTION>
EXHIBIT
NUMBER
- -----------
<S> <C>
#10.41 Marine Excess of Loss Cover Notes, effective February 1, 1993, issued by
Intere Intermediaries, Inc. to Transco Syndicate #1 Ltd. and/or Alpine
Insurance Company and/or Affiliated Companies of TCO Insurance Services,
Inc.
#10.42 Loan Agreement among TCO Insurance Services, Inc., TCO Insurance
Services, Exstar Financial Corporation, Transco Syndicate #1 Ltd. and
Alpine Insurance Company dated as of December 30, 1993.
#10.43 First Amended and Restated Loan Agreement among TCO Insurance Services,
Inc., TCO Insurance Services, Registrant, Transco Syndicate #1 Ltd. and
Alpine Insurance Company dated March 25, 1994.
#10.44 Guaranty of JBW & Co., Inc. to Registrant, Alpine Insurance Company and
Transco Syndicate #1 Ltd. dated December 30, 1993.
#10.45 Security Agreement between Registrant, Alpine Insurance Company and
Transco Syndicate #1 Ltd. and JBW & Co., Inc. dated December 30, 1993.
#10.46 Guaranty of Jeffery W. Beresford-Wood to Registrant, Alpine Insurance
Company and Transco Syndicate #1 Ltd. dated December 30, 1993.
#10.47 Indemnification Agreement between Peter J. O'Shaughnessy, Jeffery W.
Beresford-Wood and JBW & Co., Inc. dated December 30, 1993.
#10.48 Revolving Credit Note in the amount of $1,494,380 issued by TCO Insurance
Services, Inc. to Registrant dated December 30, 1993.
#10.49 Revolving Credit Note in the amount of $5,005,620 issued by TCO Insurance
Services, Inc. to Transco Syndicate #1 Ltd. dated December 30, 1993.
#10.50 Secured Debt Conversion Agreement between Transco Syndicate #1 Ltd.,
Concord General Corporation and JBW & Co., Inc. dated December 31, 1993.
#10.51 Exchange Agreement between Concord General Corporation and Transco
Syndicate #1 Ltd. dated March 25, 1994.
#10.52 Backup Pledge Agreement among TCO Insurance Services, Inc., Exstar
Financial Corporation, Transco Syndicate #1 Ltd. and Alpine Insurance
Company dated as of December 30, 1993.
##10.53 Letter Agreement between Scudder, Stevens & Clark, Inc. and Exstar
Financial Corporation dated as of March 1, 1994.
###10.54 Revolving Credit Note in the amount of $1,400,000 issued by TCO Insurance
Services, Inc. to Alpine Insurance Company dated May 1, 1994.
###10.55 Reformed First Amended and Restated Loan Agreement effective December 30,
1993, by and among TCO Insurance Services, Inc., TCO Insurance Services,
Exstar Financial Corporation, Transco Syndicate #1 Ltd., and Alpine
Insurance Company dated June 30, 1994.
###10.56 Letter Agreement between Alpine Insurance Company and TCO Insurance
Services, Inc. re: Management and Servicing Agreement of December 31,
1993, Financial Investment Management Fee dated July 1, 1994.
$10.57 Lease of 311 South Wacker Drive, Suite 500, Chicago, Illinois, effective
August 8, 1990, between Wacker Drive Limited Partnership and TCO
Insurance Services.
$10.58 First Amendment to Lease, effective September 1, 1993, between Wacker
Drive Limited Partnership and TCO Insurance Services, Inc.
</TABLE>
78
<PAGE> 82
<TABLE>
<CAPTION>
EXHIBIT
NUMBER
- -----------
<S> <C>
$10.59 Executive Employment Agreement, effective September 1, 1994, between TCO
Insurance Services and Steven C. Shinn.
$10.60 Multiple Advance Note of April 1, 1992, in the principal face amount of
$4,500,000 between TCO Insurance Services, Inc. as beneficiary and Peter
J. O'Shaughnessy as debtor.
$10.61 Revolving Credit Note in the amount of $1,400,000 issued by TCO Insurance
Services, Inc. to the Company dated December 4, 1994.
$10.62 Revolving Credit Note in the amount of $1,500,000 issued by TCO Insurance
Services, Inc. to the Company dated December 21, 1994.
$10.63 Casualty Quota Share Reinsurance Agreement, effective July 1, 1994,
between Alpine Insurance Company and Transco Syndicate #1 Ltd.
$10.64 Casualty Excess of Loss Cover Note, effective January 1, 1994, issued by
Carvill America to Alpine Insurance Company.
$10.65 Memorandum of Reinsurance, effective May 1, 1993, issued by Sedgwick
Payne Co. to Alpine Insurance Company.
$10.66 Semi-Automatic Facultative Casualty Excess of Loss Cover Note, effective
January 1, 1994, issued by Alexander Reinsurance Intermediaries, Inc. to
Transco Syndicate #1 Ltd. and/or Alpine Insurance Company.
$10.67 Endorsement No. 2 to the Reinsurance Cover Note No. CH0323-94, effective
September 30, 1994, issued by Alexander Reinsurance Intermediaries, Inc.
to Transco Syndicate #1 Ltd. and/or Alpine Insurance Company.
$10.68 Semi-Automatic Facultative Casualty First Excess of Loss Cover Note,
effective October 1, 1994, issued by Alexander Reinsurance
Intermediaries, Inc. to Transco Syndicate #1 Ltd. and/or Alpine Insurance
Company.
$10.69 Semi-Automatic Facultative Casualty Second Excess of Loss Cover Note,
effective October 1, 1994, issued by Alexander Reinsurance
Intermediaries, Inc. to Transco Syndicate #1 Ltd. and/or Alpine Insurance
Company.
$10.70 Letter of TCO Insurance Services, Inc. to Alpine Insurance Company of
September 29, 1994, re: Management and Servicing Agreement of December
31, 1993, Financial Investment Management Fee.
$$10.71a Amendment No. 1 to Reformed First Amended and Restated Loan Agreement
effective January 1, 1995, by and among TCO Insurance Services, Inc., TCO
Insurance Services, Exstar Financial Corporation, Transco Syndicate #1,
Ltd. And Alpine Insurance Company dated January 1, 1995. (Originally
filed as Exhibit Number 10.71.)
$$10.72a Waiver number One Pursuant to Section 10.3 of Loan Agreement of June 30,
1994, dated March 22, 1995. (Originally filed as Exhibit Number 10.72.)
$$10.73a Casualty Excess of Loss Reinsurance Confirmation, effective May 1, 1994,
issued by E.W. Blanch Co., Inc. to Alpine Insurance Company. (Originally
filed as Exhibit Number 10.73.)
$$10.74a Casualty Excess of Loss Reinsurance Confirmation, effective May 1, 1995,
issued by E.W. Blanch Co., Inc. to Alpine Insurance Company. (Originally
filed as Exhibit Number 10.74.)
$$10.75a Ocean Marine Cover Notes Nos. MA950269, A952031, MA950406, MA950475,
</TABLE>
79
<PAGE> 83
<TABLE>
<CAPTION>
EXHIBIT
NUMBER
- -----------
<S> <C>
MA950271 and MA950270 effective February 1, 995, issued by Intere
Intermediaries, Inc. to Alpine Insurance Company and/or Transco Syndicate
#1 Ltd. (Originally filed as Exhibit Number 10.75.)
$$10.76a Note Secured by Deed of Trust dated April 17, 1995, in the principal
amount of $231,000 between TCO Insurance Services, Inc. as beneficiary
and Peter J. O'Shaughnessy as debtor. (Originally filed as Exhibit
10.76.)
$$$10.77a Architects & Engineers Reinsurance Cover Note No. 95/0640/IL, effective
January 1, 1995, issued by Carvill America to Alpine Insurance Company.
(Originally filed as Exhibit 10.77.)
$$$10.78a Commutation Agreement and Release between Transco Syndicate #1, Ltd.,
Alpine Insurance Company and Re Capital Reinsurance Corporation,
effective April 15, 1995. (Originally filed as Exhibit Number 10.78.)
$$$10.79a Casualty Quota Share Cover Note No. CH 0333-95, effective April 1, 1995,
issued by Alexander Reinsurance Intermediaries, Inc. to Transco Syndicate
#1, Ltd., Alpine Insurance Company and/or their affiliates. (Originally
filed as Exhibit Number 10.79.)
$$$10.80a Amendment No. 1 to Security Agreement between Exstar Financial
Corporation, Alpine Insurance Company, Transco Syndicate #1 Ltd. And JBW
& Co., Inc. (Originally filed as Exhibit Number 10.80.)
$$$10.81a Settlement Agreement and Mutual Release dated January 9, 1995, between
Exstar Financial Corporation and Thomas J. Gassen. (Originally filed as
Exhibit Number 10.81.)
$$$10.82a Promissory Note in the amount of $45,000 by Thomas J. Gassen to Exstar
Financial Corporation dated January 2, 1995. (Originally filed as Exhibit
Number 10.82.)
+10.83a Reinsurance Intermediary Manager Agreement between Alpine Insurance
Company and Camelback Reinsurance Underwriters, Inc. dated as of January
1, 1996. (Originally filed as Exhibit Number 10.83.)
+10.84a Ocean Marine Cover Note No. MA952045 effective June 1, 1995, issued by
Intere Intermediaries, Inc. to Transco Syndicate #1 Ltd. And/or Alpine
Insurance Company. (Exhibit Number 10.84.)
+10.85a Form of Agreement between TCO Insurance Services, Inc. and Majority
Shareholder for the Sale and Purchase of Real Property dated June 30,
1995. (Originally filed as Exhibit Number 10.85.)
+10.86a Form of Agreement between Transco Syndicate #1 Ltd. and Majority
Shareholder for the Sale and Purchase of Real Property dated July 1,
1995. (Originally filed as Exhibit Number 10.86.)
+10.87a Form of Agreement between Exstar Financial Corporation and Majority
Shareholder for the Sale and Purchase of Real Property dated July 1,
1995. (Originally filed as Exhibit Number 10.87.)
++10.71 Upper Layer Employers Excess Indemnity Cover Note No. 94-200 effective
August 1, 1994, issued by Combined Intermediaries of America, Inc. to
Transco Syndicate, Inc. and Alpine Insurance Company.
++10.72 Upper Layer Employers Excess Indemnity Cover Note No. 94-201 effective
August 1, 1994, issued by Combined Intermediaries of America, Inc. to
Transco Syndicate, Inc. and Alpine Insurance Company.
</TABLE>
80
<PAGE> 84
<TABLE>
<CAPTION>
EXHIBIT
NUMBER
- -----------
<S> <C>
++10.73 Primary Employers Indemnity Cover Note No. 94-202 effective August 1,
1994, issued by Combined Intermediaries of America, Inc. to Transco
Syndicate, Inc. and Alpine Insurance Company.
++10.74 Reinsurance Confirmation of Casualty Excess of Loss Reinsurance Agreement
effective May 1, 1995 between Alpine Insurance Company, TCO Insurance
Services, Inc. and Trinity MGA Insurance Services, Inc.
++10.75 Reinsurance Cover Note No. 95/0640/IL effective January 1, 1995 issued by
Carvill America to Alpine Insurance Company.
++10.76 Commutation Agreement and Release between Transco Syndicate #1, Ltd.,
Alpine Insurance Company and ReCapital Reinsurance Corporation effective
April 15, 1995.
++10.77 Secured Promissory Note dated December 31, 1995 by JBW & Co., Inc.,
Concord General Corporation and Jeffery Beresford-Wood.
++10.78 Pledge Agreement dated December 31, 1995 by and between Transco Syndicate
#1 Ltd. and JBW & Co., Inc., Concord General Corporation and Jeffery W.
Beresford-Wood.
++10.79 First Excess of Loss Cover Note No. SF961000 effective January 1, 1996
issued by Intere Intermediaries to Alpine Insurance Company and Transco
Syndicate #1.
++10.80 Second Casualty Excess of Loss Cover Note No. SF961001 effective January
1, 1996 issued by Intere Intermediaries to Alpine Insurance Company,
Transco Syndicate #1.
++10.81 Endorsement No. 1 to Marine Account Excess of Loss Reinsurance Cover Note
(Treaty No. MA960269) issued by Minet Re North America to Transco
Syndicate No. 1 and/or Alpine Insurance Co. effective March 1, 1996.
++10.82 Endorsement No. 1 to Marine Account Excess of Loss Reinsurance Cover Note
(Treaty No. MA960270) issued by Minet Re North America to Transco
Syndicate No. 1 and/or Alpine Insurance Co. effective March 1, 1996.
++10.83 Endorsement No. 1 to Marine Account Excess of Loss Reinsurance Cover Note
(Treaty No. MA960406) issued by Minet Re North America to Transco
Syndicate No. 1 and/or Alpine Insurance Co. effective March 1, 1996.
++10.84 Endorsement No. 1 to Marine Account Excess of Loss Reinsurance Cover Note
(Treaty No. MA960475) issued by Minet Re North America to Transco
Syndicate No. 1 and/or Alpine Insurance Co. effective March 1, 1996.
++10.85 Endorsement No. 2 to Marine Excess of Loss Reinsurance Cover Note (Treaty
No. MA962045) issued by Minet Re North America, Inc. to Transco Syndicate
No. 1 and/or Alpine Insurance Co. effective March 1, 1996.
++10.86 Marine Excess of Loss Reinsurance Cover Note No. MA962045 issued by Minet
Re North America, Inc. to Transco Syndicate #1 Ltd. and/or Alpine
Insurance Company effective March 1, 1996.
++10.87 Marine Excess of Loss Reinsurance Cover Note No. MA960475 issued by Minet
Re North America, Inc. to Transco Syndicate #1 Ltd. and/or Alpine
Insurance Company effective March 1, 1996.
++10.88 Marine Excess of Loss Reinsurance Cover Note No. MA960406 issued by Minet
Re North America, Inc. to Transco Syndicate #1 Ltd. and/or Alpine
Insurance Company effective March 1, 1996.
++10.89 Marine Excess of Loss Reinsurance Cover Note No. MA960269 issued by Minet
Re
</TABLE>
811
<PAGE> 85
<TABLE>
<CAPTION>
EXHIBIT
NUMBER
- -----------
<S> <C>
North America, Inc. to Transco Syndicate #1 Ltd. and/or Alpine
Insurance Company effective March 1, 1996.
++10.90 Marine Excess of Loss Reinsurance Cover Note No. MA960270 issued by Minet
Re North America, Inc. to Transco Syndicate #1 Ltd. and/or Alpine
Insurance Company effective March 1, 1996.
++10.91 Casualty Quota Share Cover Note No. CH 0333-95 issued by Alexander
Reinsurance Intermediaries, Inc. to Transco Syndicate #1, Ltd., Alpine
Insurance Company effective April 1, 1995.
++10.92 Investment Advisory Agreement dated May 21, 1996 by and between Asset
Allocation & Management Company, L.L.C. and Alpine Insurance Company.
++10.93 Claim Service Agreement dated June 15, 1996 by and between Claims Control
Corporation and United Capitol Insurance Company.
++10.94 Termination Endorsement effective July 1, 1996 to Management and
Servicing Agreement, as amended and with an original effective date of
December 31, 1993 between Alpine Insurance Company and TCO Insurance
Services, Inc.
++10.95 Termination Endorsement effective December 31, 1996 to Management and
Servicing Agreement, as amended and with an original effective date of
July 1, 1993 between Transco Syndicate #1, Ltd. and TCO Insurance
Services, Inc.
++10.96 Lease dated September 18, 1996 by and between Transco Syndicate #1 Ltd.
and Channel Islands YMCA.
++10.97 Limited Agency Agreement by and between Olympic Underwriting Managers,
Inc., Transre Insurance Services and Exstar E&S Insurance Services
effective June 24, 1996.
++10.98 Consulting Agreement between Alpine Insurance Company and Craig Rice
dated October 10, 1996.
++10.99 Withdrawal Agreement effective December 31, 1996 between Illinois
Insurance Exchange, Illinois Insurance Exchange Immediate Access Security
Association, Illinois Insurance Exchange Guaranty Fund, Inc., Transco
Syndicate #1 Ltd. and Alpine Insurance Company.
++10.100 Commutation Agreement and Release between Alpine Insurance Company and
Transco Syndicate #1 Ltd. effective December 31, 1996.
++10.101 Assignment and Assumption Agreement between Alpine Insurance Company and
Transco Syndicate #1 Ltd. dated December 31, 1996.
++10.102 Trust Agreement dated January 9, 1997 between Alpine Insurance Company
and LaSalle National Bank.
++10.103 Casualty Quota Share Slip between United Capitol Insurance Company and
Alpine Insurance Company dated March 27, 1997.
+++10.104 Board of Directors Resolution Dated June 30, 1997.
+++10.105 Commutation and Release Agreement between Alpine Insurance
Company/Transco Syndicate #1 Ltd. And Underwriters Reinsurance Company
effective as of April 1, 1997.
+++10.106 Cover Note Number 964788 Addendum dated March 7, 1997, to Transco
Syndicate No. 1 &/Or Alpine Insurance Company Marine Account Excess of
Loss Reinsurance
</TABLE>
83
<PAGE> 86
<TABLE>
<CAPTION>
EXHIBIT
NUMBER
- -----------
<S> <C>
+++10.107 Cover Note Number 964789 Addendum dated March 7, 1997, to Transco
Syndicate No. 1 &/Or Alpine Insurance Company Marine Account Excess
of Loss Reinsurance
+++10.108 Assignment of Receivable dated March 31, 1997, between TCO Insurance
Services, Inc. and Exstar Financial Corporation.
+++10.109 Assignment of Receivable dated March 31, 1997, between TCO Insurance
Services, Inc. and Alpine Insurance Company.
&10.110 Claim Service Agreement dated as of July 1, 1997 between Claims Control
Corporation and Frontier Pacific Insurance Company.
&10.111 Limited Agency Agreement dated as of June 23, 1996 between Frontier
Pacific Insurance Company and Transre Insurance Services and Exstar E&S
Insurance Services.
&10.112 Consulting Agreement dated August 6, 1997 between TCO Insurance Services
and Steven C. Shinn.
&10.113 Amendment No. 1 to Settlement Agreement dated June 2, 1997, between
Central National Insurance Company and Transre Insurance Services and TCO
Holdings, Inc.
&10.114 JBW Restructuring Agreement dated as of June 30, 1997, between Concord
General Corporation, JBW & Co., Inc., Classic Fire and Marine Insurance
Company and Alpine Insurance Company and TCO Holdings, Inc.
&10.115 Amendment to Note Secured by Deed of Trust dated as of December 5, 1996,
by Par Mee Development, Inc., and Concord General Corporation.
&10.116 Note Secured by Deed of Trust in the amount of $3,500,000 dated October
19, 1994 by Par Mee Development, Inc.
&10.117 Assignment of Deed of Trust dated October 27, 1994 by American Canyon
Partners.
&10.118 Escrow Agreement by and among Concord General Corporation, JBW & Co.,
Inc., Classic Fire & Marine Insurance Company, Alpine Insurance Company,
TCO Holdings, Inc., and Katten Muchin & Zavis.
&10.119 Restructuring Agreement dated as of June 30, 1997, between Mark Boozell,
Director of Insurance of the State of Illinois, as liquidator of Geneva
Assurance Syndicate, Inc. and TCO Holdings, Inc.
&10.120 Form of Promissory Note in the amount of $2,500,000 dated June 30, 1997
by TCO Holdings, Inc. to Geneva Assurance Syndicate, Inc.
&10.121 Form of Assignment and Payment Direction dated June 30, 1997 by TCO
Holdings, Inc. to Geneva Assurance Syndicate, Inc., and Alpine Insurance
Company.
&10.122 Service Agreement between TCO Holdings, Inc. and Alpine Insurance Company.
&10.123 Agreement dated as of October 1, 1997 between Exstar Financial
Corporation and Frontier Insurance Group, Inc.
&10.124 Warrant of Exstar Financial Corporation to Frontier Insurance Group, Inc.
10.125 Lease dated as of April 3, 1998, by and between Alpine Insurance Company
and Rob Rosenberry.
</TABLE>
84
<PAGE> 87
<TABLE>
<CAPTION>
EXHIBIT
NUMBER
- -----------
<S> <C>
+16.1 Letter re Change in Certifying Accountant, dated September 22, 1994, of
Coopers & Lybrand L.L.P., filed with the Securities and Exchange
Commission as an exhibit to the Company's Form 8-K, dated September 27,
1994.
27 Financial Data Schedule
</TABLE>
____________________
* Previously filed with the SEC as an Exhibit to the Company's Registration
Statement on Form S-1, as amended, File No. 33-54320 and incorporated
herein by reference.
** Previously filed with the SEC as an Exhibit to the Company's Annual
Report on Form 10-K, for the fiscal year ended December 31, 1992.
*** Previously filed with the SEC as an Exhibit to the Company's Quarterly
Report on Form 10-Q for the fiscal quarter ended June 30, 1993.
# Previously filed with the SEC as an Exhibit to the Company's Annual Report
on Form 10-K for the fiscal year ended December 31, 1993.
## Previously filed with the SEC as an Exhibit to the Company's Quarterly
Report on Form 10-Q for the fiscal quarter ended March 31, 1994.
### Previously filed with the SEC as an Exhibit to the Company's Quarterly
Report on Form 10-Q for the fiscal quarter ended June 30, 1994.
$ Previously filed with the SEC as an Exhibit to the Company's Annual Report
on Form 10-K for the fiscal year ended December 31, 1994.
$$ Previously filed with the SEC as an Exhibit to the Company's Quarterly
Report on Form 10-Q for the fiscal quarter ended March 31, 1995.
$$$ Previously filed with the SEC as an Exhibit to the Company's Quarterly
Report on Form 10-Q for the fiscal quarter ended June 30, 1995.
+ Previously filed with the SEC as an Exhibit to the Company's Quarterly
Report on Form 10-Q for the fiscal quarter ended September 30, 1995.
++ Previously filed with the SEC as an Exhibit to the Company's Annual Report
on Form 10-K for the fiscal year ended December 31, 1996
+++ Previously filed with the SEC as an Exhibit to the Company's Quarterly
Report on Form 10-Q for the fiscal quarter ended June 30, 1997.
& Previously filed with the SEC as an Exhibit to the Company's Quarterly
Report on Form 10-Q for the fiscal quarter ended September 30, 1997.
(b) Reports filed on Form 8-K:
No reports on Form 8-K were filed with the SEC during 1995, 1996 or 1997.
84
<PAGE> 88
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Company has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, on the 14th day of
April, 1998.
EXSTAR FINANCIAL CORPORATION
By: /s/ Steven C. Shinn
------------------------
Steven C. Shinn
President and a Director
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 indicated on the 14th day of April, 1998.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
- --------- ----- ----
<S> <C> <C>
Chief Executive Officer,
Chairman of the Board,
and a Director
/s/ Peter J. O'Shaughnessy (Principal Executive April 14, 1998
- -------------------------- Officer)
Peter J. O'Shaughnessy
/s/ Steven C. Shinn April 14, 1998
- ------------------- President and a Director
Steven C. Shinn
Principal Financial
/s/ Mark Rosenberg Officer and Principal April 14, 1998
- ------------------ Accounting Officer
Mark Rosenberg
/s/ David W. Fleming April 14, 1998
- -------------------- Director
David W. Fleming
/s/ Frank A. Johnson April 14, 1998
- -------------------- Director
Frank A. Johnson
</TABLE>
85
<PAGE> 89
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
<S> <C>
Independent Auditors' Report F-2
Consolidated Balance Sheets as of December 31, 1997 and 1996 F-3
Consolidated Statements of Operations
for the years ended December 31, 1997, 1996 and 1995 F-5
Consolidated Statements of Changes in Stockholders' Equity
for the years ended December 31, 1997, 1996 and 1995 F-6
Consolidated Statements of Cash Flows for the years ended
December 31, 1997, 1996 and 1995 F-7
Notes to Consolidated Financial Statements F-9
Financial Statement Schedules
Schedule II - Condensed Financial Information of Registrant (Parent Only) S-1
Schedule IV - Reinsurance S-5
Schedule VI - Supplemental Information Concerning Property--Casualty Insurance Operations S-6
</TABLE>
<PAGE> 90
INDEPENDENT AUDITORS' REPORT
The Board of Directors
Exstar Financial Corporation:
We have audited the consolidated financial statements of Exstar Financial
Corporation and subsidiaries as listed in the accompanying index. In
connection with our audits of the consolidated financial statements, we also
have audited the financial statement schedules as listed in the accompanying
index. These consolidated financial statements and financial statement
schedules are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements and financial statement schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
As more fully described in notes 1 and 16, virtually all of the Company's
transactions, organizational relationships and business methods are subject to
close scrutiny by, and prior approval of, the State of Illinois Department of
Insurance (Illinois DOI) pursuant to an order issued by the Illinois DOI in
response to its concern regarding the financial condition of Alpine Insurance
Company, the Company's principal operating subsidiary.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Exstar Financial
Corporation and subsidiaries as of December 31, 1997 and 1996, and the results
of their operations and their cash flows for each of the years in the
three-year period ended December 31, 1997, in conformity with generally
accepted accounting principles. Also in our opinion, the related financial
statement schedules, when considered in relation to the basic consolidated
financial statements taken as a whole, present fairly, in all material
respects, the information set forth therein.
(signed) KPMG PEAT MARWICK LLP
Los Angeles, California
April 3, 1998, except as to Note 16 which is as of April 14, 1998
F-2
<PAGE> 91
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS
<TABLE>
<CAPTION>
DECEMBER 31,
1997 1996
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Investments (including restricted investments - see Note 4):
Fixed maturities available for sale:
Bonds, at market
(amortized cost--1997, $13,125; 1996, $39,080).............. $13,126 $38,547
Redeemable preferred stocks, at market
(amortized cost--1997, $250; 1996, $250).................... 249 253
Equity securities available for sale:
Preferred stocks, at market
(cost--1997, $1,000; 1996, $1,000).......................... 984 1,156
Common stocks, at market
(cost--1997, $250; 1996, $250).............................. 557 375
Mortgage loans--unaffiliated................................ 3,057 4,225
Mortgage loans--affiliated.................................. 896 908
Real estate held for investment............................. 4,555 4,728
Real estate held for sale................................... 5,241 6,391
Real estate acquired through foreclosure.................... 239 493
Short-term investments...................................... 4,384 4,944
Total investments........................................... 33,288 62,020
Cash and cash equivalents--restricted....................... 4,925 1,129
Cash and cash equivalents--unrestricted..................... 3,488 1,390
Accounts receivable......................................... 4,415 2,443
Funds held by reinsured companies........................... 7,438 0
Reinsurance recoverable:
Paid loss and loss adjustment expenses...................... 2,382 1,576
Unpaid loss and loss adjustment expenses.................... 13,363 33,921
Prepaid reinsurance premiums................................ 0 386
Accrued investment income................................... 527 822
Deferred acquisition costs.................................. 1,657 307
Property and equipment, net................................. 400 324
Deferred income taxes....................................... 0 1,700
Other assets................................................ 4,911 2,136
Total assets................................................ $76,794 $108,154
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
F-3
<PAGE> 92
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
LIABILITIES AND STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
DECEMBER 31,
1997 1996
(DOLLARS IN
THOUSANDS, EXCEPT PER
SHARE DATA)
Policy liabilities and accruals:
<S> <C> <C>
Unpaid losses and loss adjustment expenses.......................... $43,413 $86,927
Unearned premiums................................................... 5,396 1,365
Reinsurance balances payable........................................ 1,256 1,106
Total policy liabilities and accruals............................... 50,065 89,398
Premiums payable.................................................... 5,620 0
Notes payable....................................................... 1,130 1,588
Current income taxes................................................ 66 375
Accumulated equity in losses of affiliates.......................... 2,926 3,020
Other liabilities................................................... 3,472 1,247
Total liabilities................................................... 63,279 95,628
Stockholders' equity:
Common stock, $.01 par value, 30,000,000 shares authorized;
5,497,500 shares issued; 5,497,500 shares outstanding in 1997 and
1996................................................................ 55 55
Paid in capital..................................................... 16,812 26,865
Net unrealized investment gains (losses)............................ 291 (68)
Collateral loan--contra equity...................................... 0 (12,314)
Retained deficit.................................................... (3,638) (2,012)
Treasury shares at cost (536,000 shares in 1997; 0 in 1996)......... (5) 0
Net stockholders' equity............................................ 13,515 12,526
Total liabilities and stockholders' equity.......................... $76,794 $108,154
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
F-4
<PAGE> 93
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
Revenue:
<S> <C> <C> <C>
Premiums earned......................................................... $8,894 $40,292 $65,115
Premiums ceded.......................................................... (2,178) (19,282) (25,966)
Net premiums earned..................................................... 6,716 21,010 39,149
Net commission income--unaffiliated..................................... 272 0 0
Net investment income--unaffiliated..................................... 2,424 3,722 4,313
Net investment income--affiliated....................................... 64 293 584
Net realized investment (losses) gains.................................. (248) (377) 389
Other income............................................................ 3,479 142 385
Total revenue........................................................... 12,707 24,790 44,820
Losses and expenses:
Loss and loss adjustment expenses....................................... (7,863) 24,258 32,423
Reinsurance ceded....................................................... 15,586 (11,569) (16,752)
Net loss and loss adjustment expenses................................... 7,723 12,689 15,671
Policy acquisition costs amortized...................................... (117) 5,119 11,655
Profit sharing--affiliated.............................................. 0 1,286 5,242
Interest expense........................................................ 197 220 212
Other expenses.......................................................... 6,036 7,252 6,239
Total expenses.......................................................... 13,839 26,566 39,019
(Loss) income before Federal income taxes, minority interest and
equity in income of affiliates.......................................... (1,132) (1,776) 5,801
Federal income taxes:
Current................................................................. (1,010) (275) (1,211)
Deferred................................................................ 1,520 (1,440) 6,268
Net Federal income tax expense (benefit)................................ 510 (1,715) 5,057
Minority interest....................................................... 0 0 157
Equity in income of affiliates.......................................... 16 1,561 3,829
Net (loss) income....................................................... $(1,626) $1,500 $4,730
Net (loss) income per share--basic and diluted.......................... $(0.32) $0.27 $0.86
Shares used in computation of net (loss) income per share (in thousands) 5,096 5,498 5,498
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
F-5
<PAGE> 94
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
COMMON PAID IN NET COLLATERAL PREFERRED STOCK RETAINED TREASURY NET
STOCK CAPITAL UNREALIZED LOAN- INVESTMENT CONTRA (DEFICIT) SHARES AT STOCK-HOLDERS'
INVESTMENT CONTRA EQUITY EARNINGS COST EQUITY
GAINS EQUITY
(LOSSES)
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1994. $55 $26,865 $(2,426) $0 $(11,000) $(8,242) $0 $5,252
Conversion of preferred stock
plus cumulative dividends to
collateral loan.............. (12,314) 11,000 (1,314)
Change in net unrealized
investment gains (losses):...
Fixed maturities............. 3,207 3,207
Equity securities............ 411 411
Deferred tax expense......... (1,091) (1,091)
Net income................... 4,730 4,730
Balance at December 31, 1995. 55 26,865 101 (12,314) 0 (3,512) 0 11,195
Change in net unrealized
investment gains (losses):
Fixed maturities............. (764) (764)
Equity securities............ 335 335
Deferred tax benefit......... 260 260
Net income................... 1,500 1,500
Balance at December 31, 1996. 55 26,865 (68) (12,314) 0 (2,012) 0 12,526
Settlement of collateral loan (10,053) 12,314 2,261
Change in net unrealized
investment gains (losses):
Fixed maturities............. 529 529
Equity securities............ 10 10
Deferred tax expense......... (180) (180)
Purchase of 536,000 shares
of common stock.............. (5) (5)
Net loss..................... (1,626) (1,626)
Balance at December 31, 1997. $55 $16,812 $291 $0 $0 $(3,638) $(5) $13,512
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
F-6
<PAGE> 95
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995
(DOLLARS IN THOUSANDS)
Increase (decrease) in unrestricted cash and cash equivalents:
<S> <C> <C> <C>
Cash flows applied to operating activities:
Premiums received.................................................. $7,549 $8,378 $28,778
Investment income received--unaffiliated........................... 2,985 4,320 4,339
Investment income received--affiliated............................. 176 449 713
Commission income received--unaffiliated........................... 985 0 0
Losses and loss adjustment expenses paid........................... (30,679) (28,502) (28,049)
Interest paid...................................................... (197) (220) (134)
Policy acquisition and other expenses paid--unaffiliated........... (6,818) (6,392) (2,715)
Policy acquisition and other expenses paid--affiliated............. 0 (2,199) (16,531)
Taxes recovered (paid)--unaffiliated............................... 701 500 (766)
Other.............................................................. 2,673 (520) 111
Net cash applied to operating activities........................... (22,625) (24,186) (14,254)
Cash flows provided by (applied to) investing activities:..........
Purchase of fixed maturities....................................... 0 (12,789) (63,199)
Purchase of property, equipment and real estate.................... (343) (29) (4,440)
Sale of fixed maturities........................................... 21,966 21,081 53,497
Maturity and calls of fixed maturities............................. 3,628 2,379 8,762
Sale of equity securities.......................................... 0 255 10
Short-term investments, net........................................ 560 7,707 (7,103)
Sale of property, equipment and real estate........................ 1,372 2,255 4,936
Mortgage loans funded--unaffiliated................................ (208) (524) (100)
Repayments of mortgage loans--unaffiliated......................... 3,590 691 1,042
Repayments of mortgage loans--affiliated........................... 11 9 368
Net cash provided by (applied to) investing activities............. 30,576 21,035 (6,227)
Cash flows (applied to) provided by financing activities:
Issuance of notes payable.......................................... 412 0 2,593
Repayment of notes payable......................................... (870) (758) (411)
Transfers (to) from affiliates..................................... (83) 1,866 3,550
Other.............................................................. (1,516) (494) 696
Transfers (to) from restricted cash and cash equivalents........... (3,796) (101) 933
Net cash (applied to) provided by financing activities............. (5,853) 513 7,361
Net increase (decrease) in unrestricted cash and cash equivalents.. 2,098 (2,638) (13,120)
Unrestricted cash and cash equivalents at beginning of period...... 1,390 4,028 17,148
Unrestricted cash and cash equivalents at end of period............ $3,488 $1,390 $4,028
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
F-7
<PAGE> 96
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS - (CONTINUED)
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Reconciliation of net (loss) income to net cash applied to
operating activities:
Cash flows applied to operating activities:
Net (loss) income......................................... $(1,626) $1,500 $4,730
Net realized investment losses (gains).................... 248 377 (389)
Non-cash charges (credits) included in net income:
Amortization and depreciation............................. 748 690 737
Deferred federal income taxes............................. 1,520 (1,440) 6,268
Equity in income of affiliates............................ (16) (1,561) (3,829)
Change in:
Deferred acquisition costs................................ (1,350) 4,206 2,818
Funds held by reinsured companies......................... (7,438) 0 0
Accounts receivable....................................... (2,778) 3,779 1,375
Accrued investment income................................. 295 377 (189)
Prepaid expenses.......................................... (167) 260 (80)
Unpaid loss and loss adjustment expenses.................. (22,956) (15,814) (12,377)
Reinsurance balances, net................................. 592 8,848 (10,546)
Premiums payable.......................................... 5,620 0 0
Accrued expenses.......................................... 248 286 189
Unearned premium.......................................... 4,031 (25,919) (828)
Federal income taxes payable.............................. (309) 225 (1,977)
Deferred commission income................................ 713 0 0
Minority interest......................................... 0 0 (156)
Net cash applied to operating activities.................. $(22,625) $(24,186) $(14,254)
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
F-8
<PAGE> 97
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1 -- BUSINESS AND ORGANIZATION
Exstar Financial Corporation ("Exstar" if referring to the parent company,
or the "Company" if referring to Exstar and its direct and indirect
subsidiaries) is a holding company which owns Alpine Insurance Company, an
Illinois property and casualty insurance company ("Alpine"), WESTCAP Insurance
Services, Inc., a California corporation which produces and underwrites
property and casualty insurance business ("WESTCAP"), and Claims Control
Corporation, an Illinois corporation which manages insurance claims ("CCC.")
Prior to August 1996, the Company was engaged principally in the issuance of
specialty lines insurance policies on a surplus lines basis directly to
insureds.
The Company historically conducted its insurance business through its two
insurance company subsidiaries--Alpine and Transco Syndicate #1 Ltd.
("Syndicate"), a former member of the Illinois Insurance Exchange, now renamed
INEX Insurance Exchange ("IIE"), and the direct parent company of Alpine.
Effective December 31, 1996, the assets (other than the stock of Alpine) and
liabilities of the Syndicate were transferred to Alpine. The Syndicate then
withdrew as a syndicate member of the IIE and changed its name to Alpine
Holdings, Inc.
As a result of events occurring since the end of 1995, including A.M. Best
Company ("Best") ratings downgrades and regulatory restrictions relating to
Exstar's subsidiaries, the Company ceased issuing direct insurance in August
1996. Effective March 1, 1998, Alpine voluntarily withdrew as an authorized
surplus lines insurer in every jurisdiction in which it was then authorized.
The Company's current business activities consist of acting as a reinsurer with
respect to insurance policies placed by WESTCAP with subsidiaries of Frontier
Insurance Group, Inc. ("Frontier"), an unaffiliated group of insurance
companies; handling claims under policies and reinsurance contracts previously
issued by the Company as well as providing such services to Frontier through
CCC; and related management, investment, reporting and accounting functions.
WESTCAP became a subsidiary of Exstar effective October 1, 1997. It was
acquired on that date from the Company's majority stockholder for nominal
consideration. CCC also became a subsidiary of Exstar effective October 1,
1997. It was acquired on that date from a company controlled by the Company's
majority stockholder for nominal consideration. The Company's financial
statements include the results of operations of these subsidiaries since their
dates of acquisition.
TCO Holdings, Inc. ("TCO Holdings"), a Delaware corporation, and its
current and former subsidiaries (collectively referred to as "TCO") are owned
by Exstar's majority stockholder. TCO Holdings' significant wholly owned
subsidiaries include: (i) TCO Insurance Services, Inc. ("TCO-IL"), an Illinois
corporation that historically performed certain marketing, underwriting,
claims, management, investment and general administrative functions for the
Company pursuant to management agreements with the Syndicate and Alpine and a
master agreement with the Company; (ii) TCO Insurance Services ("TCO-CA"), a
California corporation which historically performed certain administrative
services for TCO-IL pursuant to a servicing agreement; (iii) Transre Insurance
Services ("Transre"), a licensed California surplus lines broker, and, (iv)
CCC, until September 30, 1997.
Since July 1996, virtually all of the Company's transactions,
organizational relationships and business methods (and the changes in such
relationships and methods) have been subject to the close scrutiny by, and
prior approval of, the State of Illinois Department of Insurance ("Illinois
DOI"), the principal regulator of Alpine, pursuant to an order issued by the
Illinois DOI ("Illinois Order"). The Illinois Order directs: (i) that Alpine,
including the owners, officers, directors, and employees of Alpine, shall make
no disbursements of any kind, except for properly authorized insurance claim
payments, whether by direct cash transaction, loan offset, forgiveness of
debts, purchase, payment of compensation, dividends of any kind, or by transfer
of securities or assets of any kind, unless prior to such disbursement Alpine
has obtained the written approval of the Illinois DOI; (ii) that Alpine shall
not enter into or agree to enter into any agreement which commits Alpine to any
type of
F-9
<PAGE> 98
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
disbursement subject to the foregoing clause (i) without the prior written
approval of the Illinois DOI; (iii) that Alpine is prohibited from entering into
any transactions with any affiliate as defined under the Illinois Insurance Code
without the prior written approval of the Illinois DOI; and (iv) that Alpine
shall demand immediate payment to Alpine of all Alpine premiums held by
any affiliate. The Illinois Order subjects Alpine and its officers, directors
and affiliates to a higher level of regulatory scrutiny than that to which it
has previously been subject and to which most other insurers are subject. No
understanding has been reached with the Illinois DOI as to if, when or under
what circumstances and to what extent the current level of oversight may be
modified. For further discussion regarding the Company's current operating
activities and financial condition, see Note 16.
2 -- SIGNIFICANT ACCOUNTING POLICIES
The consolidated financial statements include the financial statements of
Exstar, its subsidiaries, and its real estate joint ventures in which it had a
controlling financial interest. All significant inter-company accounts and
transactions have been eliminated. These statements have been prepared on a
generally accepted accounting principles ("GAAP") basis.
Cash and Cash Equivalents: Cash equivalents consist principally of
investments in certificates of deposit, U.S. Treasury instruments, and
commercial paper with a maturity of three months or less at the time of
acquisition.
Investments: The Company's fixed maturity and equity securities are
classified as available for sale. Accordingly, such securities are carried at
market value, with unrealized gains and losses, net of applicable income taxes,
reported as a separate component of stockholders' equity..
The Company's carrying values for investments in the available-for-sale
category are reduced to the estimated realizable value if declines in market
value are deemed other than temporary. Such reductions in carrying value are
recognized as realized losses and charged to income. Premiums and discounts on
fixed maturity securities are amortized over the lives of the securities as
adjustments to yield using the effective interest method.
Mortgage loans are carried at the aggregate of unpaid balances net of
unamortized loan origination fees and allowance for loan losses. Loan
origination fees in excess of the actual costs of originating the loans are
amortized over the lives of the loans.
Real estate held for sale is carried at the lower of cost or fair value.
Real estate held for investment generates investment income and is carried at
cost less accumulated depreciation. Real estate acquired through foreclosure
is recorded at fair value at the date of foreclosure and subsequently adjusted
through a valuation allowance for any decrease in fair value.
Short-term investments, consisting primarily of U.S. Treasury obligations
and commercial paper with maturities of less than one year but more than three
months, are carried at cost which approximates market value.
Realized investment gains and losses are included in income based upon
specific identification of the investments sold. Investment income is recorded
when earned.
Reserves for impaired investments, including mortgage loans and real
estate, are charged to earnings as realized losses when the declines in value
of the investments below carrying values or declines in value of the underlying
collateral are considered to be other than temporary.
Fair Value of Financial Instruments: The fair values of financial
instruments presented in the applicable notes to the financial statements are
estimates of the fair values at the specific point in time using available
market information and appropriate valuation methodologies. These estimates
are subjective and involve significant
F-10
<PAGE> 99
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
judgment in the interpretation of current market information. Therefore, the
fair value estimates are not necessarily indicative of the amount the Company
might receive in actual market transactions.
Premium Revenue Recognition: Premiums written and assumed, net of
reinsurance premiums ceded, are recognized as income over the policy periods on
a pro-rata basis as the coverages are provided. Accordingly, the unearned
premium reserve represents the portion of premiums written and assumed that is
applicable to the unexpired terms of policies in force.
Commission Revenue Recognition: Commission income generated on insurance
policies placed by the Company is recognized over the underlying policy periods
on a pro-rata basis as the coverages are provided.
Reinsurance Ceded: Reinsurance recoverable represents the estimated
portion of unpaid losses and loss adjustment expenses that will be recovered
from reinsurers. Prepaid reinsurance represents the portion of premiums ceded
to reinsurers applicable to the unexpired terms of the reinsurance contracts.
Any change in the estimated recoverable is charged to income in the period of
the change.
Deferred Acquisition Costs: Acquisition costs, consisting principally of
commission expense net of commission income earned from ceding reinsurance, are
deferred and amortized over the period in which the related premiums are
earned. Commission expense, until December 31, 1996, was to the benefit of
TCO, an affiliate. Commission income earned from ceding business to other
insurance carriers generally is not specified in treaties with the reinsurers
but is assumed based on the Company's policy issuance costs. Deferred
acquisition costs are reviewed for recoverability from future income, including
investment income, and those costs which are deemed not recoverable are
expensed in the year in which the determination is made. No such costs have
been deemed unrecoverable during the years ended December 31, 1997, 1996 and
1995.
Unpaid Losses and Loss Adjustment Expenses: The liability for unpaid
losses and loss adjustment expenses represents case basis estimates of reported
losses and loss adjustment expenses and estimates based on past experience of
unreported losses and loss adjustment expenses. Management believes that the
reserves for unpaid losses and loss adjustment expenses at December 31, 1997
are adequate to cover the net cost of losses and loss adjustment expenses
incurred to date; however, the liability is by necessity based on estimates,
and accordingly, there can be no assurance that the ultimate liability will not
differ from such estimates.
Depreciation and Amortization: Depreciation of property and equipment and
real estate held for investment is computed primarily on the straight-line
method over the estimated useful lives of the assets, as follows:
<TABLE>
<CAPTION>
Estimated useful
life (years)
<S> <C>
Buildings.............. 30
Equipment.............. 5 to 8
Furniture and fixtures. 5 to 8
Leasehold improvements. 3 to 10
Computer software costs 5
</TABLE>
Expenditures for improvements are capitalized. Upon sale or retirement,
the cost and related accumulated depreciation and amortization are removed from
the accounts and the resulting gain or loss, if any, is reflected in income.
Expenditures for maintenance and repairs are charged to expense as incurred.
F-11
<PAGE> 100
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Intangible Assets: Acquisition costs in excess of the fair value of the
net assets acquired are amortized on a straight-line basis over 10 years.
Other intangible assets, including covenant not to compete agreements, are
amortized on a straight-line basis over the terms of the agreements.
Equity in Gains or Losses of Affiliates: Although TCO is not a direct or
indirect subsidiary of Exstar, its income or loss is included in the Company's
consolidated GAAP financial statements in accordance with a form of equity
accounting adopted in 1995 (applied retroactively). See Note 11.
Income Taxes: Deferred income taxes are recognized for the differences
between the tax bases of assets and liabilities and their financial reporting
amounts at each year-end based on enacted tax laws and statutory tax rates
applicable to the years in which the differences are expected to affect taxable
income. Valuation allowances are established when necessary to reduce deferred
tax assets to the amount expected to be realized.
Stock Options: Prior to January 1, 1996, the Company accounted for its
stock option plan in accordance with the provisions of Accounting Principles
Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, and
related interpretations. As such, compensation expense would be recorded on the
date of grant only if the current market price of the underlying stock exceeded
the exercise price. On January 1, 1996, the company adopted Statement of
Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based
Compensation, which permits entities to recognize as expense over the vesting
periods, the fair value of all stock-based awards on the date of grant.
Alternatively, SFAS No. 123 also allows entities to continue to apply the
provisions of APB Opinion No. 25 and provide pro forma net income and pro forma
earnings per share disclosures for employee stock option grants made in 1995
and future years as if the fair value based method defined in SFAS No. 123 had
been applied. The Company has elected to continue to apply the provisions of
APB Opinion No. 25 and provide the pro forma disclosure provisions of SFAS No.
123.
Net (Loss) Income per Share: Effective December 31, 1997, the Company
adopted Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings
Per Share." SPAS No. 128 requires dual presentation of basic and diluted net
income per share on the face of the income statement for all entities with
complex capital structures. Basic net (loss) income per share is determined by
dividing net (loss) income by the weighted-average number of common shares
outstanding, while diluted net (loss) income per share is determined by
dividing the weighted-average of common shares outstanding adjusted for the
dilutive effect of common stock equivalents. Total options and warrants were
952,632, 0, and 0 shares in 1997, 1996 and 1995, respectively. The Company's
common stock equivalents are stock options and warrants which had no dilutive
effect on net (loss) income per share. The weighted average shares used to
calculate basic net (loss) income per share were 5,096,000, 5,498,000 and
5,498,000 for the years ended December 31, 1997, 1996 and 1995 respectively.
The change in the number of outstanding shares in 1997 was the result of the
transfer to the Company, on April 1, 1997, of 536,000 shares of the Company's
common stock.
Recently Issued Accounting Standards: Statement of Financial Accounting
Standards No. 130 (SFAS No. 130), "Reporting Comprehensive Income," and
Statement of Financial Accounting Standards No. 131 (SFAS No. 131),
"Disclosures about Segments of an Enterprise and Related Information," were
issued in June 1997 and are effective for fiscal years beginning after December
15, 1997. SFAS No. 130 establishes standards for the reporting and display of
comprehensive income, which includes net income and changes in equity except
those resulting from investments by, or distributions to stockholders. SFAS
No. 131 establishes standards for disclosures related to business operating
segments. The Company is currently evaluating the impact that these statements
will have on the consolidated financial statements.
Use of Estimates: Management has made a number of estimates and
assumptions relating to the reporting of assets and liabilities and the
disclosure of contingent assets and liabilities to prepare these consolidated
financial statements in conformity with GAAP. Actual results could differ from
those estimates. As further discussed in the notes, significant estimates and
assumptions affect unpaid losses and loss adjustment expenses and the related
reinsurance recoverables, allowances for real estate and mortgage loans,
other-than-temporary declines in values
F-12
<PAGE> 101
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
for fixed maturities, the valuation allowance for deferred income taxes and
the calculation of fair value disclosures for certain financial instruments.
Reclassifications: Certain reclassifications have been made to the 1996
and 1995 balances, without affecting net income, to conform them to the 1997
classifications.
3 -- STATUTORY INFORMATION
Statutory Accounting Practices: Alpine is required to file statutory
financial statements with state insurance regulatory authorities. Accounting
practices used to prepare these statutory financial statements differ from
GAAP. The principal differences between statutory and GAAP accounting
practices are: (i) acquisition costs, such as commissions, reinsurance
commissions, premium taxes and other items, are charged or credited to current
operations as incurred, whereas related premium income is taken into earnings
on a pro-rata basis over the period covered by the policies; (ii) certain
assets, designated as "non-admitted assets" (principally premiums and other
receivables 90 days past due) are charged off against statutory policyholders'
surplus; (iii) certain reinsurance balances are netted for statutory accounting
practices while they are shown separately for GAAP reporting; (iv) 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; (v) a provision for statutory liabilities
with respect to unearned premiums and losses reinsured with unauthorized
reinsurers, to the extent funds are not held, is charged directly against
policyholders' surplus; and (vi) statutorily required loss reserves, in excess
of amounts considered adequate by the Company, are provided and are charged
directly to policyholders' surplus. Statutory accounting practices are
"prescribed" or "permitted" by the Illinois DOI. "Prescribed" statutory
accounting practices include a variety of publications of the National
Association of Insurance Commissioners as well as state laws, regulations and
general administrative rules. "Permitted" statutory accounting practices
encompass all statutory accounting practices not so prescribed; such practices
differ from state to state, may differ from company to company within a state
and may change in the future. The NAIC has completed a project to codify
statutory accounting practices that is expected to change the definition of
what comprises prescribed statutory accounting practices and that is expected
to change the accounting policies that insurance enterprises use to prepare
their financial statements. Alpine has not yet determined the impact, if any,
on its statutory financial statements from application of the newly codified
accounting practices.
The surplus as regards policyholders of Alpine determined in accordance
with statutory accounting practices as of December 31, 1997 and 1996 was
$5,276,000 and $12,596,000, respectively. Alpine's statutory annual statement
for 1997 required to be filed with insurance regulatory authorities currently
reflects surplus as regards policyholders of $$6,822,000 at December 31, 1997.
The $5,276,000 represents Alpine's surplus as regards policyholders after
elimination of certain subrogation recoverables which Alpine currently expects
will not be included in Alpine's audited surplus as regards policyholders at
December 31, 1997. The net (loss) income of Alpine determined in accordance
with statutory accounting practices for the years ended December 31, 1997,
1996, and 1995 was $(14,622,000), $4,899,000 and $3,666,000, respectively. In
1997 Alpine settled a collateral loan which had been carried as a nonadmitted
asset of $12,314,000 for cash in the amount of $2,261,000. In accordance with
statutory accounting practices, Alpine reported the settlement as a realized
investment loss of $10,053,000 in its Statement of Income and an increase to
statutory policyholders' surplus of $12,314,000 in it capital and surplus
account. The realized investment loss was a principal cause of Alpine's
statutory net loss for the year ended December 31, 1997. See Note 12 for
discussion of the impact on the Company's GAAP financial statements.
Effective December 31, 1996, the assets and liabilities of the Syndicate
were transferred to Alpine. The surplus as regards policyholders of the
Syndicate immediately prior to the transfer (including the stock of Alpine)
would have been $4,698,000, had the Syndicate's investments not been subject to
certain concentration limits under
F-13
<PAGE> 102
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
the IIE regulations. The net income of the Syndicate determined in
accordance with statutory accounting practices for the year ended December 31,
1996 and 1995 was $34,000 and $5,552,000, respectively.
The NAIC has adopted a risk-based capital formula for property and
casualty insurance companies. This formula calculates a minimum level of
capital and surplus which should be maintained by each insurer, based on
underwriting, credit, investment and other business risks inherent in an
individual company's operations. Various states, including Illinois, have
adopted the NAIC's risk-based capital model act applicable to property/casualty
insurers. The model act authorizes certain regulatory actions based on the
ratio of a company's "adjusted capital" (generally the insurer's actual
policyholders' surplus) to its "authorized control level" risk-based capital.
The following table sets forth the different levels of risk-based capital
that may trigger regulatory involvement and the corresponding actions that may
result.
<TABLE>
<CAPTION>
LEVEL TRIGGER CORRECTIVE ACTION
<S> <C> <C>
Company Action Level Adjusted capital Submit
less than 200% of comprehensive plan
authorized control to insurance
level commissioner
Regulatory Action Level Adjusted capital In addition to
less than 150% of above, insurer is
authorized control subject to
level examination,
analysis and
specific corrective
action
Authorized Control Level Adjusted capital In addition to both
less than 100% of of above, insurance
authorized control commissioner may
level place insurer under
regulatory control
Mandatory Control Level Adjusted capital Insurer must be
less than 70% of placed under
authorized control regulatory control
level
</TABLE>
The "comprehensive plan" required at the company action level and
certain other levels must: (i) identify the conditions in the insurer that
contribute to the failure to meet the capital requirements; (ii) contain
proposed corrective actions that the insurer intends to make and that would be
expected to result in compliance with capital requirements; (iii) provide
certain projections of the insurer's financial results for the current year and
at least the four succeeding years; (iv) identify key assumptions impacting the
insurer's projections and the sensitivity of the projections to the
assumptions; and (v) identify the quality of, and problems associated with, the
insurer's business, including but not limited to its assets, anticipated
business growth and associated surplus strain, extraordinary exposure to risk,
mix of business, and use of reinsurance in each case.
At December 31, 1997, compared to actual adjusted capital of $5,276,000:
(i) Alpine would have needed adjusted capital of $9,114,000 to exceed the
company action level of risk-based capital applicable to it; (ii) Alpine would
have needed adjusted capital of $6,835,000 to exceed the regulatory action
level of risk-based capital applicable to it; (iii) Alpine needed adjusted
capital of $4,557,000 to exceed the authorized control level of risk-based
capital applicable to it; and (iv) Alpine needed adjusted capital of $3,190,000
to exceed the mandatory control level of risk-based capital applicable to it.
Alpine's adjusted capital amounts at December 31, 1997 and 1996 were
approximately 117% and 173%, respectively, of its authorized control level
risk-based capital amounts. Because Alpine's December 31, 1996 adjusted
capital was less than 200% of its authorized control level risk-based capital,
Alpine submitted a comprehensive plan to the Illinois DOI. The plan was filed
with and not objected to by the Illinois DOI. As Alpine was below the
regulatory action level at December 31, 1997, a similar comprehensive plan will
be required to be submitted to the Illinois DOI in April 1998 with respect to
Alpine's risk-based capital results at December 31, 1997. Management expects
such plan to identify the $6,554,000 Schedule P penalty incurred by Alpine in
1997 as
F-14
<PAGE> 103
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
one of the principal causes for Alpine's failure to meet or exceed the company
action level of risk-based capital. Additionally, Alpine's surplus as regards
policyholders was reduced by an underwriting loss of $6,655,000 in 1997 as a
result of a relatively small volume of net premiums earned and $4,424,000 of
loss and loss adjustment expense reserve strengthening during the year. The
plan is expected to propose, as principal corrective actions to increase
Alpine's risk-based capital above the company action level, the continuation of
Alpine's operations in 1998, during which Alpine (i) expects to experience an
overall reduction in net reserves for losses and loss adjustment expense
outstanding relative to its policyholders' surplus, (ii) expects to eliminate
approximately $2,532,000 of the Schedule P penalty as the 1995 accident year
becomes excluded from Alpine's Schedule P calculation, and (iii) expects to
receive additional assets contributed by Exstar consisting principally of some
or all of up to approximately $1,731,000 of real estate investments owned
directly by Exstar, if necessary. Consummation of the proposed sale of Alpine
to Frontier also is expected to eliminate or reduce Alpine's risk-based capital
obligations and concerns.
Minimum Surplus as Regards Policyholders: Illinois law requires that an
Illinois insurer may not assume the types of insurance currently assumed by
Alpine under the Quota Share Arrangement if the assuming Illinois insurer's
policyholders' surplus is less than $5,000,000. Alpine's statutory
policyholders surplus of $5,276,000 as of December 31, 1997, was only $276,000
above the required minimum. (Alpine's statutory annual statement for 1997
required to be filed with insurance regulatory authorities currently reflects
statutory policyholders' surplus of $6,822,000 at December 31, 1997. The
$5,276,000 represents Alpine's statutory policyholders' surplus after
elimination of certain subrogation recoverables which Alpine currently expects
will not be included in Alpine's audited statutory policyholders' surplus at
December 31, 1997.) The Company expects Alpine's surplus to increase during
1998 as a consequence of profitable or at least break even operations and
elimination of the $2,532,000 portion of the Schedule P penalty relating to
accident year 1995; and if necessary, the Company expects it could contribute
assets, including principally real estate investments owned by Exstar with
statutory net asset values of up to approximately $1,731,000 at December 31,
1997, to Alpine. If Alpine experiences losses which offset the sum of (i) the
reduction in the Schedule P penalty, (ii) the contribution of assets by Exstar
and (iii) profits from operations, if any, Alpine's ability to continue to
operate as a reinsurer could be terminated. In such case, the Company could
experience significant losses.
To maintain its license as an Illinois domestic property and casualty
insurer, Alpine must maintain statutory policyholders' surplus of at least $1.5
million. In recent years, many jurisdictions, including those in which Alpine
has conducted most of its insurance business, have increased the minimum
financial standards for surplus lines eligibility including adoption of the
NAIC's model surplus lines act which, among other things, establishes a minimum
statutory policyholders' surplus requirement of $15.0 million. This minimum
requirement would preclude Alpine from acting as a surplus lines insurer in
these jurisdictions but not preclude it from acting as a reinsurer.
Reserve Requirement: During 1997, Illinois enacted a statute governing
investments, in general, and requiring, beginning with Alpine's statutory
financial statements to be filed with respect to the quarter ending March 31,
1998, that Alpine maintain (i) the sum of cash and other specified assets in
excess of (ii) the sum of Alpine's discounted loss and loss adjustment expense
reserves and reserves for unearned premiums ("reserve requirement"). The
Illinois DOI has not yet adopted regulations or other official guidelines
interpreting the reserve requirement. Alpine may have difficulty meeting the
reserve requirement in 1998, depending on how the new statutory provision
ultimately is interpreted, but believes, based on discussions with the Illinois
DOI, that it may be able to comply sufficiently with the requirement to avoid
any increase in the Illinois DOI's current level of oversight. Should Alpine
fail to satisfy the reserve requirement under such an interpretation, the
Illinois DOI could require action by Alpine to rectify the failure, and if
Alpine ultimately fails to comply, could seek to cause Alpine to cease
operations.
Dividend Restrictions: Alpine is limited in its ability to pay dividends
to its shareholder. Alpine is subject to an overall limitation that dividends
and other distributions can be declared and paid only to the extent of earned,
as opposed to contributed, policyholders' surplus as determined under statutory
accounting practices. In addition,
F-15
<PAGE> 104
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Alpine is subject to the provisions of the Illinois Insurance Holding Company
Systems Act, which requires prior notice for the payment of all dividends or
other distributions, and special approval for those which, during any
consecutive 12-month period, exceed the greater of (i) 10% of Alpine's
policyholders' surplus as determined under statutory accounting practices as of
the immediately preceding year-end or (ii) its statutory net income as
determined under statutory accounting practices for the immediately preceding
year. Alpine is unable to pay a dividend in 1998 without the prior approval of
the Illinois DOI, as Alpine has no earned surplus and is prohibited from
declaring dividends by the Illinois DOI without prior approval, pursuant to the
Illinois Order. See Note 1.
4 -- RESTRICTED ASSETS
The Company has cash and investments on deposit with the various states in
which it does business, pledged as collateral for letters of credit related to
reinsurance and claim defense, on deposit in the IIE Guaranty Fund, held in
trust for the benefit of the Syndicate's policyholders and held in trust on
business placed by WESTCAP for unaffiliated insurance companies. At December
31, 1997, the restricted assets comprised:
<TABLE>
<CAPTION>
COLLATERAL FOR HELD IN TRUST ON DEPOSIT IN
PREMIUMS HELD IN LETTERS OF FOR SYNDICATE GUARANTY ON DEPOSIT
TRUST CREDIT POLICYHOLDERS FUND WITH STATES TOTAL
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Fixed maturities......... $0 $4,922 $0 $1,076 $4,958 $10,956
Equity securities........ 0 0 984 0 0 984
Mortgage loans........... 0 0 2,036 0 0 2,036
Real estate.............. 0 0 3,600 0 0 3,600
Cash and cash equivalents 1,962 0 2,876 47 40 4,925
Short-term investments... 0 772 742 0 0 1,514
TOTAL.................... $1,962 $5,694 $10,238 $1,123 $4,998 $24,015
</TABLE>
Effective December 31, 1996, in connection with the Syndicate's withdrawal
from the IIE, and the transfer of all of the Syndicate's assets (other than the
stock of Alpine) and liabilities to Alpine, and pursuant to an agreement with
the IIE, certain of the Syndicate's assets transferred to Alpine were placed in
trust as security for the payment of claims of policyholders and other
obligations of the Syndicate. In accordance with the withdrawal agreement with
the IIE, Alpine is obligated to maintain a certain amount of its assets in the
IIE Guaranty Fund, Inc. for the protection of IIE insureds. The funding
requirement of the IIE Guaranty Fund, Inc. is $1,000,000. At December 31,
1997, Alpine maintained a conforming balance of $1,123,000.
Because substantial portions of Alpine's assets are restricted for
specific purposes, they may not be available to satisfy other obligations of
Alpine. This greatly reduces Alpine's liquidity, and in the event cash is
required to meet current liabilities beyond those currently projected by
management (e.g., as a consequence of increased or more rapid payouts of losses
or expenses), could lead to significant losses.
The Company is attempting to obtain release of funds on deposit with
states, since it ceased issuing direct insurance in August, 1996, and has
recovered $400,000 in 1998.
F-16
<PAGE> 105
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5 -- INVESTMENTS
Investments as of December 31, 1997 and 1996, are summarized in the
following table. Certain of the Company's investments are restricted -- See
Note 4.:
<TABLE>
<CAPTION>
GROSS
GROSS UNREALIZED UNREALIZED FAIR CARRYING
COST (1) GAINS LOSSES VALUE (2) VALUE
(DOLLARS IN THOUSANDS)
1997:
<S> <C> <C> <C> <C> <C>
Fixed maturities:
U.S. Treasury securities and
obligations of U.S. Government
corporations and agencies............. $7,593 $7 $16 $7,584 $7,584
Obligations of states, municipalities
and political subdivisions............ 3,297 26 11 3,312 3,312
Other bonds........................... 124 1 0 125 125
Loan-backed securities................ 2,111 3 9 2,105 2,105
Redeemable preferred stock............ 250 0 1 249 249
Total fixed maturities................ 13,375 37 37 13,375 13,375
Equity securities:
Industrial, miscellaneous and all
other................................. 250 307 0 557 557
Non-redeemable preferred stock........ 1,000 0 16 984 984
Total equity securities............... 1,250 $307 $16 1,541 1,541
Mortgage loans on real estate:
Unaffiliated.......................... 3,057 3,122 3,057
Affiliated............................ 896 913 896
Total mortgage loans on real
estate................................ 3,953 4,035 3,953
Real estate:
Held for investment................... 4,555 6,073 4,555
Held for sale (3)..................... 5,241 5,516 5,241
Acquired through foreclosure.......... 239 250 239
Total real estate..................... 10,035 11,839 10,035
Short-term investments................ 4,384 4,384 4,384
Total investments..................... $32,997 $35,174 $33,288
</TABLE>
F-17
<PAGE> 106
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
GROSS
GROSS UNREALIZED UNREALIZED FAIR CARRYING
COST (1) GAINS LOSSES VALUE (2) VALUE
(DOLLARS IN THOUSANDS)
1996:
<S> <C> <C> <C> <C> <C>
Fixed maturities:
U.S. Treasury securities and
obligations of U.S. Government
corporations and agencies............. $17,902 $6 $153 $17,755 $17,755
Obligations of states, municipalities
and political subdivisions............ 7,015 12 146 6,881 6,881
Other bonds........................... 124 0 1 123 123
Loan-backed securities................ 14,039 22 273 13,788 13,788
Redeemable preferred stock............ 250 3 0 253 253
Total fixed maturities................ 39,330 43 573 38,800 38,800
Equity securities:
Common stocks.........................
Industrial, miscellaneous and all
other................................. 250 125 0 375 375
Non-redeemable preferred stock........ 1,000 156 0 1,156 1,156
Total equity securities............... 1,250 $281 $0 1,531 1,531
Mortgage loans on real estate:
Unaffiliated.......................... 4,225 4,214 4,225
Affiliated............................ 908 890 908
Total mortgage loans on real
estate................................ 5,133 5,104 5,133
Real estate:
Held for investment................... 4,728 6,165 4,728
Held for sale (3)..................... 6,391 6,829 6,391
Acquired through foreclosure.......... 493 500 493
Total real estate..................... 11,612 13,494 11,612
Short-term investments................ 4,944 4,944 4,944
Total investments..................... $62,269 $63,873 $62,020
</TABLE>
___________________
(1) Original cost of equity securities; original cost of fixed maturities
reduced for repayments and adjusted for amortization of premiums and
accrual of discounts; cost adjusted for amortization and accretion of
loan-backed securities adjusted for principal paydowns and changes in
expected maturities; principal balance outstanding reduced for valuation
allowances for mortgage loans on real estate; original cost reduced for
depreciation for real estate held for investment; lower of original cost
or fair value for real estate held for sale; and fair value at date of
foreclosure adjusted for any subsequent decline in value, if any, for real
estate acquired through foreclosure.
F-18
<PAGE> 107
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(2) The following methods and assumptions were used to estimate the fair
value of each class of financial instruments for which it is practicable
to estimate the value:
Fixed maturities--For bonds, loan-backed securities and redeemable
preferred stocks fair value equals quoted market price.
Equity securities--For non-redeemable preferred and common stocks fair
value equals quoted market price, if available. If quoted market value is
not available, fair value is estimated using quoted market prices for
similar securities.
Mortgage loans--The fair value is estimated by discounting future cash
flows using current interest rates at which similar loans would be made
to borrowers with similar credit ratings for the same maturities.
Real estate--The fair value of real estate is based on the appraised
value as determined by an independent appraiser reduced for the estimated
cost to sell. The appraisal process involves estimates which are
subjective. The actual sales price in a market transaction may vary from
the appraised value.
Short-term investments--For short-term investments, the carrying amount
is a reasonable estimate of the fair value. No fair values were Company
determined.
(3) Real estate held for sale includes property acquired from the majority
stockholder. See Note 15.
THE SCHEDULE OF MATURITIES AT DECEMBER 31, 1997, IS AS FOLLOWS:
<TABLE>
<CAPTION>
AMORTIZED COST ESTIMATED FAIR VALUE
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Due in one year or less............... $350 $349
Due after one year through five years. 7,592 7,584
Due after five years through ten years 545 549
Due after ten years................... 2,777 2,788
Loan-backed securities................ 2,111 2,105
Total................................. $13,375 $13,375
</TABLE>
MORTGAGE LOANS ON REAL ESTATE-UNAFFILIATED COMPRISED:
<TABLE>
<CAPTION>
1997 1996
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Residential................... $842 $1,234
Commercial.................... 2,205 3,024
Construction.................. 40 0
3,087 4,258
Deferred loan origination fees (30) (33)
$3,057 $4,225
</TABLE>
At December 31, 1997 and 1996, commitments to fund mortgage loans totaled
$6,000 and $69,000, respectively.
The rate of interest charged on mortgage loans ranged from 7.25% to 9.75%
during 1997 and 1996 and the loans had original terms from 1 to 30 years.
F- 19
<PAGE> 108
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MORTGAGE LOANS ON REAL ESTATE--AFFILIATED COMPRISED:
<TABLE>
<CAPTION>
1997 1996
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Commercial............... $1,084 $1,096
Allowance for loan losses (188) (188)
$896 $908
</TABLE>
REAL ESTATE HELD FOR INVESTMENT COMPRISED:
<TABLE>
<CAPTION>
1997 1996
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Commercial real estate.. $6,336 $6,336
Residential real estate. 457 457
Accumulated depreciation (2,238) (2,065)
$4,555 $4,728
</TABLE>
REAL ESTATE HELD FOR SALE COMPRISED:
<TABLE>
<CAPTION>
1997 1996
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Commercial real estate............. $649 $927
Residential real estate............ 3,899 3,899
Residential real estate development 1,926 3,414
6,474 8,240
Accumulated depreciation........... (10) 0
Real estate valuation allowance.... (1,223) (1,849)
$5,241 $6,391
</TABLE>
REAL ESTATE ACQUIRED THROUGH FORECLOSURE COMPRISED:
<TABLE>
<CAPTION>
1997 1996
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Residential real estate development $355 $665
Real estate valuation allowance.... (116) (172)
$239 $493
</TABLE>
Real estate held for sale and real estate acquired through foreclosure
amounting to $3,692,000 was non-income producing at December 31, 1997. An
eight acre improved residential property held for sale at December 31, 1997 was
purchased from Exstar's majority stockholder. See Note 15.
F-20
<PAGE> 109
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
INVESTMENTS OTHER THAN U.S. GOVERNMENT SECURITIES HAVING A CARRYING VALUE
IN EXCESS OF 10% OF STOCKHOLDERS' EQUITY AT DECEMBER 31, 1997, COMPRISED:
<TABLE>
<CAPTION>
CARRYING VALUE
(DOLLARS IN THOUSANDS)
<S> <C>
Fixed maturities available for sale - bonds
Gardena, CA -- Financing Agency Revenue......... 1,450
Real estate--held for investment
Office building--Solvang, California............ 2,689
Office building--Solvang, California............ 1,410
Real estate--held for sale
Single family residence--Santa Ynez, California. 2,125
Single family residence--Santa Ynez, California. 1,370
Short term investments
LaSalle National Corporation commercial paper... 2,876
</TABLE>
NET INVESTMENT INCOME--UNAFFILIATED COMPRISED:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Fixed maturities:...................
Bonds............................... $1,499 $2,639 $2,686
Redeemable preferred stocks......... 14 53 267
Mortgage loans...................... 324 382 361
Real estate held for investment..... 54 9 69
Real estate held for sale........... 54 55 37
Cash and short-term investments..... 708 817 1,325
2,653 3,955 4,745
Investment expense.................. (229) (233) (432)
Net investment income-unaffiliated.. $2,424 $3,722 $4,313
</TABLE>
NET INVESTMENT INCOME--AFFILIATED COMPRISED:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Mortgage loans................... $89 $69 $114
Real estate held for investment.. 59 323 584
Real estate held for sale........ 28 61 42
176 453 740
Investment expense............... (112) (160) (156)
Net investment income--affiliated $64 $293 $584
</TABLE>
F-21
<PAGE> 110
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NET REALIZED INVESTMENT GAINS (LOSSES) COMPRISED:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995
GROSS GROSS NET NET NET
REALIZED REALIZED REALIZED REALIZED REALIZED
GAINS LOSSES GAINS GAINS GAINS
(LOSSES) (LOSSES) (LOSSES)
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Fixed maturities:
Bonds....................... $33 $(196) $(163) $91 $764
Redeemable preferred stock.. 0 0 0 15 (22)
33 (196) (163) 106 742
Equity securities:
Preferred stock............. 0 0 0 0 0
Common stock................ 0 0 0 (166) (212)
0 0 0 (166) (212)
Mortgage loans:............. 0 (63) (63) (64) 105
Real estate:
Held for investment......... 0 0 0 (16) 292
Held for sale............... 75 (71) 4 (229) (506)
Acquired through foreclosure 0 (26) (26) (8) (32)
75 (97) (22) (253) (246)
Total....................... $108 $(356) $(248) $(377) $389
</TABLE>
Gross realized gains on sale of fixed maturities were $33,000, $126,000
and $968,000 for the years ended December 31, 1997, 1996 and 1995,
respectively. Gross realized losses on sale of fixed maturities were $196,000,
$35,000 and $226,000 for the years ended December 31, 1997, 1996 and 1995,
respectively. Gross realized gains on sale of equity securities were $0 for
the years ended December 31, 1997, 1996 and 1995, respectively. Gross realized
losses on sale of equity securities were $0, $166,000, and $212,000 for the
years ended December 31, 1997, 1996 and 1995, respectively.
F-22
<PAGE> 111
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SUMMARY OF VALUATION ACCOUNT ACTIVITY:
<TABLE>
<CAPTION>
REAL ESTATE REAL ESTATE MORTGAGE
HELD FOR ACQUIRED THROUGH LOANS ON
SALE FORECLOSURE REAL ESTATE
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Balance at December 31, 1995....................... $1,875 $140 $119
Increases in reserves charged to costs and expenses 330 32 69
Disposal of properties............................. (356) 0 0
Balance at December 31, 1996....................... 1,849 172 188
Disposal of properties............................. (626) (56) 0
Balance at December 31, 1997....................... $1,223 $116 $188
</TABLE>
6 -- INVESTMENT IN JOINT VENTURES AND MINORITY INTEREST
Exstar has invested in residential real estate under development through
various partnerships. The partnerships are included in the consolidated
financial statements, which results in a minority interest for the unaffiliated
partners' interests. The partnerships were liquidated in 1996. The amounts
included in net realized investment losses from the joint ventures comprise:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Proceeds from sales.............................. $0 $0 $2,139
Cost of sales and other costs.................... 0 0 2,186
Net realized investment losses from joint venture $0 $0 $(47)
</TABLE>
7 -- SIGNIFICANT GROUP CONCENTRATIONS OF RISK
Mortgage Loans. The Company has mortgage loans on property located
principally in central California. Residential and commercial loans constituted
$4,131,000 and $5,354,000 of the portfolio at December 31, 1997 and 1996,
respectively. Construction loans constituted $40,000 and $0 of the portfolio
at December 31, 1997 and 1996, respectively. While it is Exstar's policy to
limit loans to 80% of appraised value at origination, and management believes
that except for geographic concentration there is no concentration of borrowers
in a single economic sector, realization of the full loan value in the event of
default by the borrower is substantially contingent on the real estate market.
F-23
<PAGE> 112
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Real Estate Investments. The Company had investments in real estate
totaling $10,035,000 and $11,612,000 as of December 31, 1997 and 1996,
respectively. The real estate is located principally in Central California.
Realization of the carrying value is dependent on the real estate market.
Premiums and Commissions. As of December 31, 1997, the Company's sole
source of premium and commission income is Frontier.
8 -- LIABILITY FOR UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES
The liability for unpaid losses and loss adjustment expenses is based upon
the accumulation of individual case estimates for losses reported prior to the
close of the accounting period plus estimates, based on experience and industry
data, for unreported losses and loss adjustment expenses.
There is a high level of uncertainty inherent in the evaluation of the
required loss and loss adjustment expense reserves for the Company. The
long-tailed nature of other liability claims exacerbates that uncertainty.
Management has selected target loss and loss expense ratios that it believes
are reasonable and reflective of anticipated ultimate experience. The ultimate
costs of claims are dependent upon future events, the outcomes of which are
affected by many factors. Company claim reserving procedures and settlement
philosophy, current and perceived social and economic inflation, current and
future court rulings and jury attitudes, improvements in medical technology,
and many other economic, scientific, legal, political, and social factors all
can have significant effects on the ultimate cost of claims. Changes in
Company operations and management philosophy also may cause actual developments
to vary from the past. Since the emergence and disposition of claims are
subject to uncertainties, the net amounts that will ultimately be paid to
settle the liability may vary from the estimated amounts provided for in the
accompanying consolidated financial statements. Any adjustments to reserves
are reflected in the operating results of the periods in which they are made.
Estimates for ultimate loss reserves are inherently difficult to
determine, because they are attempts to quantify future results based on
current trends. The effort to predict the Company's ultimate losses and loss
adjustment expense has been made more difficult because the Company's recent
business includes a substantial amount of insurance written for subcontractors
and general contractors, most of which are located in California. California
law relating to contractors has changed significantly over the last several
years as a consequence of California legal decisions and newly enacted
legislation. The Company, additionally, significantly modified its policy
forms and underwriting standards relating to its contractor business in each of
1996 and 1995. Because of the foregoing, the assumptions made and the trends
used by the Company in estimating its reserves for losses and loss adjustment
expenses have been relatively untested by time and actual development of
reserves.
F-24
<PAGE> 113
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Activity in the liability for unpaid losses and loss adjustment expenses
comprised:
<TABLE>
<CAPTION>
1997 1996 1995
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Balance at January 1........ $86,927 $91,984 $88,276
Less reinsurance recoverable 33,921 23,164 7,079
Net balance at January 1.... 53,006 68,820 81,197
Incurred related to:
Current year................ 3,299 12,971 23,545
Prior years................. 4,424 (282) (8,253)
Provision for commutations.. 0 0 379
Total incurred.............. 7,723 12,689 15,671
Paid related to:
Current year................ 217 1,842 2,496
Prior years................. 30,462 26,661 25,552
Total paid.................. 30,679 28,503 28,048
Net balance at December 31.. 30,050 53,006 68,820
Plus reinsurance recoverable 13,363 33,921 23,164
Balance at December 31...... $43,413 $86,927 $91,984
</TABLE>
The favorable development on prior years in 1995 relates to the Company's
determination that its case loss reserves were substantially overstated,
stemming principally from three reserving practices: (i) claims examiners'
establishing initial case reserves at levels higher than justified by the
information received by the Company with respect to claims, (ii) claims
examiners' establishing case reserves without taking into account deductibles
(e.g., a claim may have a likely ultimate loss amount of $15,000, but the claim
may relate to a policy with a $5,000 deductible payable by the insured, in
which case the appropriate reserve, generally, would be $10,000, assuming the
deductible is collectible) and (iii) claims examiners' not timely reducing case
reserves following receipt of favorable information with respect to claims.
The adverse development of $4,424,000 on prior years in 1997 is a
consequence of actual losses incurred and paid during 1997 for such years
trending slightly higher than previously estimated.
F-25
<PAGE> 114
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
9 -- NOTES PAYABLE
<TABLE>
<CAPTION>
1997 1996
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Notes collateralized by real property:
Note payable due October 1, 2017, with principal and interest due monthly at
(six month secondary market CD plus 2.75%) 8.5% at December 31, 1997,
collateralized by real property with a fair value of $2,500,000 as of
December 31, 1997(1)........................................................ $1,079 $1,098
Note payable with interest due monthly at (prime rate plus 2.75%) 11.0% at
December 31, 1996, principal due in monthly installments of $3,333, a
principal installment of $100,000 due March 31, 1997, and the balance due
September 30, 1997 (1)...................................................... 0 490
Installment note due 10-31-98 for acquisition of computer software.......... 51 0
Total....................................................................... $1,130 $1,588
</TABLE>
(1) These notes were assumed in connection with transactions with Exstar's
majority stockholder. See Note 15.
The carrying values of the notes payable approximate their fair values at
December 31, 1997 and 1996.
These notes payable mature as follows:
<TABLE>
<CAPTION>
FOR THE YEAR ENDING
DECEMBER 31,
(DOLLARS IN THOUSANDS)
<S> <C>
1998...... $73
1999...... 24
2000...... 26
2001...... 28
2002...... 30
Thereafter 949
Total..... $1,130
</TABLE>
F-26
<PAGE> 115
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
10 -- FEDERAL INCOME TAXES
The Company's effective tax rate differs from the statutory federal income
tax rate for the following reasons:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Book (loss) income before federal income tax, minority
interest and equity in losses of affiliates.................. $(1,132) $(1,776) $5,801
Tax at statutory federal income tax rate..................... (385) (604) 1,972
Increase (decrease) resulting from:
Dividends received deduction and tax exempt interest......... (4) (16) (303)
Amortization of cost in excess of net assets acquired........ 38 38 38
Reclassifications reflected in equity in losses of affiliates 0 172 708
Prior year provision to return difference.................... 0 0 (1,361)
Accounts receivable write-off................................ 0 0 (2,898)
Other........................................................ (54) (50) 296
Increase (decrease) in valuation allowance.................. 915 (1,255) 6,605
Total federal income tax expense (benefit)................... $510 $(1,715) $5,057
</TABLE>
The deferred federal income tax asset (net of a valuation allowance) and
liability have been netted to reflect the tax impact of temporary differences.
The components of the net deferred federal income tax asset are as follows:
<TABLE>
<CAPTION>
1997 1996
(DOLLARS IN THOUSANDS)
ASSETS:
<S> <C> <C>
Capital loss carryforward................................................. $3,127 $0
Differences between financial and tax basis of assets..................... 475 748
Discounting of unpaid losses and loss adjustment expenses for tax purposes 2,093 4,142
Nondeductible portion of unearned premium................................. 367 67
Unrealized investment losses-fixed maturities............................. 0 180
Alternative minimum tax credit carryforward............................... 391 259
Net operating loss carryforward........................................... 4,125 2,231
Income reported in different periods for financial reporting purposes and
tax purposes, net......................................................... 10 16
Gross deferred tax asset before valuation allowance....................... 10,588 7,643
Valuation allowance....................................................... (9,973) (5,619)
Total deferred federal income tax asset................................... 615 2,024
LIABILITIES:
Deferred acquisition costs................................................ 563 104
Income reported in different periods for financial reporting purposes and
tax purposes.............................................................. 52 220
Total deferred federal income tax liabilities............................. 615 324
Net deferred federal income tax asset..................................... $0 $1,700
</TABLE>
F-27
<PAGE> 116
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company is required to establish a valuation allowance for any portion
of the deferred tax asset thatmanagement believes will not be realized.
Consideration must be given to those items of taxable income available to offset
the future deductible amounts represented in the deferred asset. The sources of
taxable income available include amounts from the reversal of temporary
differences, and the balance through future taxable income. At December 31,
1997, it is the opinion of management that it is more likely than not that the
Company will not generate sufficient ordinary taxable income to offset the
future ordinary deductibles and, therefore, a valuation reserve is required for
the ordinary income portion of the asset. It is also the opinion of management
that it is more likely than not that the Company will not generate sufficient
capital gain income to offset future capital loss deductibles associated with
equity securities and, therefore, a valuation allowance has been established for
the capital gain asset.
In view of the unfavorable events which had occurred (including Best
rating downgrades and regulatory uncertainties), management believed that the
future revenues of the Company were sufficiently uncertain as to require an
increase in the valuation allowance against its deferred federal income tax
asset for the year ended December 31, 1995. Accordingly, the valuation
allowance was increased by $6.6 million for the year ended December 31, 1995.
Based on events occurring in 1996, including the reorganization of the
Company's operations and the relationship with UCIC (including the reinsurance
arrangement), management reassessed the future revenues of the Company, and
decreased the valuation allowance by $1.3 million at December 31, 1996.
In evaluating its deferred tax asset at December 31, 1997, management
considered market conditions in the industry segments in which it competes and
certain other transactions contemplated by the Company. The competition in the
excess and surplus lines markets continued to increase in 1997 with many
companies writing lines of business similar to those of the Company.
Accordingly, while having the full capacity to produce business through its
relationship with Frontier, written premiums have been less than projected at
December 31, 1996. Additionally the Company is contemplating a transaction
that will likely change the ownership of Alpine. This transaction, if
completed, would negate the Company's ability to directly control Alpine's
operating results going forward. Accordingly, at December 31, 1997, management
again believed that the future revenues of the Company were sufficiently
uncertain as to require an increase in the valuation allowance in the amount of
$4.4 million. Of the increase in the valuation allowance, $915,000 was
applicable to current operations and $3.4 million was applicable to the
settlement of the JBW & Co. loan and was offset against paid in capital.
11 -- EQUITY ACCOUNTING
To provide TCO with funding needed to support its operations, the Company
entered into a loan agreement with TCO-IL in December 1993, under which the
Company agreed to loan TCO-IL up to $9.0 million ("Loan Agreement"). In
addition, funding was provided by certain unpaid balances due to Alpine with
respect to insurance premiums collected by TCO.
During 1994, the Company re-evaluated the appropriate accounting treatment
for such loans under GAAP. The Company determined that any increase or
decrease in TCO's stockholder's equity after June 30, 1992 (other than
decreases in equity resulting from depreciation of assets that would not be
replaced by TCO)--adjusted for (i) any intercompany gains or losses, including
gains on sale of Exstar shares owned by TCO to independent parties which were
reclassified to paid in capital, (ii) the reclassification of dividends
received and accrued on the JBW & Co. preferred stock (see also Note 12), and
(iii) the reclassification of the interest paid by TCO under the Loan
Agreement--should be treated as an increase or decrease, respectively, in the
net income of the Company in the period in which such increase or decrease in
stockholder's equity was recorded by TCO. This determination was based on the
historical interdependence and common control of the Company and TCO, including
the Company's exertion of significant influence over the operations of TCO,
TCO's limited financial resources and TCO's
F-28
<PAGE> 117
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
historical and anticipated continuing need for financial support from the
Company.
In particular, under this accounting treatment, the Company's net income
in any period generally is reduced by (i) if cumulative decreases in TCO's
stockholder's equity since July 1, 1992, are greater than cumulative amounts
due from TCO to the Company since July 1, 1992, any decrease in TCO's
stockholder's equity in the period (other than decreases in equity resulting
from depreciation on assets that will not be replaced by TCO), adjusted as
described above, or (ii) if cumulative amounts due from TCO to the Company since
July 1, 1992 are greater than cumulative decreases in TCO's stockholder's equity
since July 1, 1992, any increase in amounts due from TCO to the Company during
the period (including increases in amounts due under the Loan Agreement and
other amounts due to the Company from TCO). Conversely, in the event that TCO's
revenues exceed its costs in any such period, the Company's net income in that
period generally is increased by the amount of TCO's profits in such period
(excluding any gains from the sale by TCO of assets that will not be replaced by
TCO), provided that the aggregate increase in the Company's net income as a
result of profits of TCO may not exceed the aggregate amount of losses
previously recognized by the Company as a result of TCO's operations. To the
extent the Company receives cash from TCO-IL in the form of interest and/or
principal payments on TCO's indebtedness to the Company, the Company's cash flow
will be benefited, but such payments will affect the Company's net income only
to the extent they represent TCO's profits in the period such payments are
received.
The following sets forth the financial position and results of operations
of TCO Holdings, Inc. and its subsidiaries:
<TABLE>
<CAPTION>
DECEMBER 31
1997 1996
(DOLLARS IN THOUSANDS)
ASSETS:
<S> <C> <C>
Cash and investments........................................................ $465 $4,489
Accounts receivable......................................................... 264 4,915
Property and equipment...................................................... 0 119
Other assets................................................................ 770 914
Total assets................................................................ 1,499 10,437
LIABILITIES:
Premiums payable............................................................ 11,318 19,304
Notes payable - affiliated.................................................. 2,404 4,581
Notes payable - unaffiliated................................................ 2,518 0
Due to affiliates........................................................... 1,020 718
Net unearned commission income.............................................. 0 659
Other liabilities........................................................... 2,029 3,328
Total liabilities........................................................... 19,289 28,590
PREFERRED STOCK:
Series A 11.3% cumulative redeemable, nonvoting, stated value $10,000
per share, 3,500 shares authorized; Issued and outstanding - 0 in 1997;
1,075 in 1996............................................................... 0 12,035
STOCKHOLDER'S EQUITY:
Stockholder's accumulated deficiency........................................ (17,790) (30,188)
Total liabilities, preferred stock, and stockholder's accumulated deficiency $1,499 $10,437
</TABLE>
F-29
<PAGE> 118
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995
(DOLLARS IN THOUSANDS)
REVENUES:
<S> <C> <C> <C>
Net commissions earned - affiliated................ $874 $6,647 $14,473
Other revenues..................................... 983 1,166 2,106
Total revenues..................................... 1,857 7,813 16,579
EXPENSES:
Personnel costs.................................... 128 2,751 8,105
Office and selling expenses........................ (19) 1,116 3,007
Depreciation....................................... 77 84 929
Interest........................................... 298 647 1,246
Other expenses..................................... 607 1,498 1,031
Total expenses..................................... 1,091 6,096 14,318
Income before Federal income taxes, minority
interest, and equity in income of affiliates....... 766 1,717 2,261
Net affiliated gains............................... 1,361 0 0
Federal income tax expense......................... 0 25 26
Minority interest.................................. (21) 0 (39)
Equity in income of affiliates..................... 0 85 0
Net income......................................... 2,106 1,777 2,196
Beginning stockholder's accumulated deficiency..... 30,188 30,900 32,011
Cancellation of preferred stock -- see Note 12..... (9,535) 0 0
Net income......................................... (2,106) (1,777) (2,196)
Net affiliated gains............................... (1,324) 342 0
Dividends paid..................................... 0 0 1,215
Increase (decrease) in subscription note receivable 567 723 (130)
Net change......................................... (12,398) (712) (1,111)
Ending stockholder's accumulated deficiency........ $17,790 $30,188 $30,900
</TABLE>
Commission income, net of related commissions paid to brokers, was earned
ratably over the periods of the underlying policies. Loans to TCO Holdings'
stockholder in the amounts $5,998,000, $5,432,000 and $4,708,000 as of December
31, 1997, 1996 and 1995, respectively, have been added to the stockholder's
accumulated deficiency similar to the treatment of an unpaid capital
subscription note receivable. All other accounting policies are consistent
with those of the Company.
F-30
<PAGE> 119
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following sets forth the computation of the equity in income of
affiliates included in the Statement of Operations:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Increase in net equity of TCO Holdings and
subsidiaries.............................. $(12,398) $(712) $(1,111)
Asset adjustments:
Cancellation of preferred stock........... 9,535 0 0
Net affiliated gains (losses)............. 2,685 (342) 0
Depreciation.............................. 0 0 (637)
(178) (1,054) (1,748)
Reclassifications:
Interest on advances...................... (179) (507) (838)
Reinsurance commissions--affiliated....... 425 0 0
Extraordinary items--affiliated........... (84) 0 0
Dividend on preferred stock--contra equity 0 0 (1,243)
Equity in income of affiliates............ $(16) $(1,561) $(3,829)
</TABLE>
Accumulated equity in losses of affiliates comprises:
<TABLE>
<CAPTION>
DECEMBER 31,
1997 1996
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Cumulative adjusted losses................................... $18,185 $18,363
Amounts advanced by and other amounts due to the Company from
TCO Holdings, Inc. and its subsidiaries...................... 15,259 15,343
Accumulated equity in losses of affiliates................... $2,926 $3,020
</TABLE>
12 -- COLLATERAL LOAN - CONTRA EQUITY
In December 1989 and February 1990, the Syndicate made separate
investments totaling $15 million in the preferred stock of Concord General
Corporation ("Concord"), a privately held insurance holding company located in
Concord, California. Simultaneously with the issuance of the Concord preferred
stock, a subsidiary of Concord made a similar investment of $15 million in the
preferred stock of a predecessor of Exstar which then owned the Syndicate ("Old
Exstar"). The Concord preferred stock and the Old Exstar preferred stock had
similar rights, preferences and dividend rates. In 1991, $4 million of the
Concord preferred stock held by the Syndicate was redeemed, and $4.25 million
of the Old Exstar preferred stock held by the Concord affiliate was redeemed.
As part of the restructuring of the Company's holding company in
connection with the Company's initial public offering in December 1992
("Company IPO"), the Concord affiliate agreed to exchange its remaining Old
Exstar preferred stock for similar preferred stock issued by TCO Holdings.
Subsequently, effective in December 1993, the Company entered into an agreement
exchanging the Concord preferred stock for preferred stock of JBW & Co., Inc.,
a Concord affiliate ("JBW & Co."). The JBW & Co. preferred stock had the same
stated value, rights, preferences and dividend rate as the previous Concord
preferred stock, and additionally the Syndicate obtained the
F- 31
<PAGE> 120
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
right to convert the JBW & Co. preferred stock into secured debt.
During 1994, the Company determined that, due to the economic
interdependence of the Company and Concord attributable to the outstanding
preferred stock held by each organization, Old Exstar's use of the proceeds of
the preferred stock and the ongoing relationships among Exstar, TCO, Concord
and JBW & Co., the preferred stock transactions were more in the nature of
capital transactions than investment transactions. Therefore, the Company
determined that it should change the accounting treatment for the JBW & Co.
preferred stock. Specifically, the Company established a "contra-equity"
account in the amount of the stated value of the JBW & Co. preferred stock,
accounting for it in a manner similar to the accounting for an unpaid capital
subscription note receivable, thereby reducing the Company's stockholders'
equity by the full $11 million stated value of the preferred stock. Although
the dividends received on the preferred stock have been reclassified in the
income statement to equity in gains and losses of affiliates, the
reclassification of the preferred stock has had no effect on net income.
Effective December 31, 1995, the Company converted the JBW & Co. preferred
stock to a promissory note which, however, did not change the investment's
contra-equity treatment. As a result, the Company held a collateralized loan
receivable in the principal amount of $12.3 million due from JBW & Co. ("JBW &
Co. Loan"). The JBW & Co. Loan was collateralized by a pledge by Concord of
81% of the outstanding capital stock of Classic Fire and Marine Insurance
Company ("Classic"), an Indiana insurance company affiliated with JBW & Co. and
Concord.
In view of uncertainty surrounding the Company's ability to realize value
with respect to the JBW & Co. Loan and the collateral pledged to secure it, the
Company consummated a transaction in December 1997 in which the Company
accepted approximately $2.3 million in proceeds of a mortgage note in full
satisfaction of the JBW & Co. Loan.
Concurrently with the foregoing transaction, TCO Holdings consummated a
transaction in which the TCO Holdings preferred stock was cancelled and, in
lieu thereof, the holder of the TCO Holdings preferred stock was given a TCO
Holdings promissory note in the principal amount of $2.5 million, with four
percent annual interest on the principal balance outstanding, payable solely
from commissions received by TCO Holdings in connection with the Quota Share
Arrangement. See Note 15.
In effect, the above transactions eliminated the economic interdependence
of Concord and the Company. Therefore, the Company's stockholders' equity was
increased in 1997 in the amount of $2.3 million.
13 -- REINSURANCE
To limit its exposure on large risks and increase capacity, the Company
historically entered into certain reinsurance transactions that ceded 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 Company would
then be liable for such defaulted amounts. All reinsurance payable to the
Company is due from Underwriters at Lloyd's, London or companies rated at least
A- by Best. At December 31, 1997 and 1996 the largest single amount
recoverable for paid and unpaid losses was $10.4 million and $24.4 million,
respectively, from Signet Star Reinsurance Company, an insurer with a Best
rating of A at December 31, 1997.
Although the Company does not write material amounts of business in the
property insurance lines, which are lines that tend to be most susceptible to
catastrophes, the Company does periodically consider the possibility of its
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EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
exposure to unusually large or catastrophic events. Management believes the
likelihood to be remote that such an event would occur and the Company's
reinsurers would fail to meet their obligations with respect to such an event
in any material way. With respect to the overall exposure of the Company's
reinsurers to catastrophic risk, management monitors the financial condition of
such reinsurers generally while relying on rating agencies, including Best, to
assess its reinsurers' vulnerabilities to such risk.
Reinsurance for the Company's specialized liability business has been
provided by seven treaties. The first provides coverage for 1991 and 1992 by
Signet Star Reinsurance Company for losses incurred in excess of $1.0 million
per insured, per loss up to a maximum of $2.0 million per insured, per loss,
plus pro rata loss adjustment expenses. The second provides coverage for 1993,
and the third provides coverage from January through September 1994, for losses
incurred in excess of $1.0 million per insured, per loss up to a maximum of
$2.0 million per insured, per loss, plus pro rata loss adjustment expenses, by
Signet Star Reinsurance Company and Security Reinsurance Company. The fourth
provides coverage from October 1, 1994, through December 31, 1995, for losses
incurred in excess of $500,000 per insured, per loss up to a maximum of $1.0
million per insured, per loss, plus pro rata loss adjustment expenses, by
Signet Star Reinsurance Company and Security Reinsurance Company. The fifth
provides coverage from October 1, 1994, through December 31, 1995, for losses
incurred in excess of $1.0 million per insured, per loss up to a maximum of
$2.0 million per insured, per loss, plus pro rata loss adjustment expenses, by
Signet Star Reinsurance Company and Security Reinsurance Company. The sixth
cedes 50% of the first $500,000 of losses incurred per insured per loss, plus
loss adjustment expenses, for losses occurring under (i) policies issued on or
after April 1, 1995 and (ii) policies issued prior to April 1, 1995, for the
unexpired portion thereof, by Signet Star Reinsurance Company and Reliance
Insurance Company. The seventh provides coverage from January through December
1996 for losses incurred in excess of $1.0 million per insured, per loss up to
a maximum of $2.0 million per insured, per loss, plus pro rata loss adjustment
expenses, by Underwriters Reinsurance Company. In 1997, the Company commuted
the reinsurance treaty with Underwriters Reinsurance Company which previously
provided coverage from January through December 1996 for losses incurred in
excess of $500,000 per insured, per loss up to a maximum of $1.0 million per
insured, per loss, plus pro rata loss adjustment expenses, with no impact on
the Company's GAAP net income or stockholders' equity.
Reinsurance for the Company's architects and engineers professional
liability business through 1995 is provided by treaties principally with
Underwriters at Lloyd's, London. Treaties effective January 1, 1988, through
December 31, 1993 and for 1995 provide coverage for losses incurred, including
loss adjustment expenses, in excess of $250,000 per insured, per loss up to a
maximum of $2.0 million per insured, per loss. The treaty for 1994 provides
coverage for losses incurred, including loss adjustment expenses, in excess of
$250,000 per insured, per loss up to a maximum of $1.0 million per insured, per
loss.
The Company's ocean marine business is reinsured through a series of
annual treaties principally provided by Underwriters at Lloyd's, London. The
current series of treaties expired February 28, 1997, and provided coverage for
losses incurred, including loss adjustment expenses, in excess of $250,000 per
insured, per loss, generally up to a maximum of $1.0 million per insured, per
loss, up to a maximum aggregate limit of liability (excluding reinstatements)
of $10.0 million. The expiring treaties were extended to July, 1997 to provide
run off coverage up to a maximum of $2.0 million per insured, per loss.
Treaties for prior annual periods provide similar coverages, but with reduced
maximum aggregate limits of liability.
Alpine provided letters of credit, which are fully collateralized by cash
and cash equivalents, fixed maturities and short-term investments, in
connection with assumed reinsurance agreements totaling $4,016,000 and
$7,992,000 at December 31, 1997 and 1996, respectively. The amount of the
collateral is required by the grantor
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EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
of the letters of credit to be greater than the amounts of such letters of
credit. The following table reflects the effects of reinsurance on the
Company's premiums:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995
(DOLLARS IN THOUSANDS)
Earned premium:
<S> <C> <C> <C>
Direct.......... $2,775 $40,058 $64,090
Ceded........... (2,178) (19,282) (25,966)
Assumed......... 6,119 234 1,025
Net............. $6,716 $21,010 $39,149
Written premium:
Direct.......... $1,410 $14,177 $63,281
Ceded........... (1,791) (5,563) (36,102)
Assumed......... 11,515 196 1,006
Net............. $11,134 $8,810 $28,185
</TABLE>
Included in Statements of Operations as part of policy acquisition costs
amortized was ceded commission income of $2,725,000, $6,670,000, and
$11,424,000 for the years ended December 31, 1997, 1996 and 1995, respectively.
14 -- COMMON STOCK AND STOCK OPTIONS
The weighted average number of shares outstanding for net income per share
was 5,096,000, 5,498,000 and 5,498,000 for December 31, 1997, 1996 and 1995,
respectively.
Exstar has adopted a stock incentive plan to enable officers, directors,
key employees and independent contractors of Exstar, its subsidiaries and its
affiliates to participate in Exstar's future and enable Exstar to attract and
retain these persons by offering them a proprietary interest in Exstar. The
plan provides for the issuance of up to 400,000 shares pursuant to the grant or
exercise of stock options, stock appreciation rights, restricted stock,
deferred stock, or combinations thereof. No stock appreciation rights,
restricted stock or deferred stock were outstanding at December 31, 1997.
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EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following is a summary of the calculation of basic and diluted net
(loss) income per share:
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31
1997 1996
<S> <C> <C>
Net (loss) income $(1,626,000) $1,500,000
Basic net (loss) income per share:
Weighted average shares outstanding 5,096,000 5,498,000
Basic net (loss) income per share $(0.32) $0.27
Diluted net (loss) income per share:
Weighted average shares outstanding 5,096,000 5,498,000
Effect of dilutive stock options 0 0
5,096,000 5,498,000
Diluted net (loss) income per share $(0.32) $0.27
</TABLE>
Exstar had granted no options as of December 31, 1996. In conjunction
with TCO's transfer to Exstar of 536,000 shares of Exstar common stock in the
first quarter of 1997, Exstar issued options for 452,632 shares of Exstar
common stock, of which options for 390,784 shares were issued pursuant to the
plan, to former TCO employees that had become employees of the Company and CCC
and certain other individuals. The exercise price for these options is $1.40
per share and the vesting periods generally run through January 1, 1999. At
December 31, 1997, options for 192,109 shares were exercisable but not yet
exercised.
At December 31, 1997, there was outstanding a warrant to purchase 500,000
shares of common stock, 100,000 shares at $3.60 per share and 400,000 shares at
an exercise price of $4.64 per share, expiring on December 31, 2003. No
portion of the warrant was exercised as of December 31, 1997.
The per share weighted average fair value of stock options granted during
1997 was $0.81 on the date of grant using an option-pricing model with the
following assumptions:
<TABLE>
<S> <C>
Expected divided yield. 0%
Expected life in years. 7
Risk-free interest rate 5.0%
Volatility............. 63.7%
</TABLE>
The Company applies APB Opinion No. 25 in accounting for its Plan and,
accordingly, no compensation cost has been recognized for its stock options in
the financial statements. Had the Company determined compensation cost based
on the fair value at the grant date for its stock options under SFAS No. 123,
the Company's net income would have been reduced to the pro forma amounts
indicated below:
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EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
FOR THE YEAR ENDED DECEMBER
31, 1997
(Dollars in thousands, except
per share amounts)
Net loss
<S> <C>
As reported............. (1,626)
Pro forma............... (1,732)
Net loss per share basic
As reported............. (0.32)
Pro forma............... (0.34)
</TABLE>
15 -- RELATED PARTIES
The following are in addition to other transactions described elsewhere in
the Notes.
In June 1995, TCO acquired from its sole stockholder a five acre parcel of
real estate in satisfaction of amounts advanced to the stockholder during the
second quarter of 1995. The purchase price, $285,000, was equal to the
seller's basis in the property. The appraised value of the parcel as of the
date of transfer was $325,000.
During July 1995, the Company acquired from its majority stockholder eight
parcels ranging in size from 20 to 28 acres for which the off-site improvements
had been completed. The property was acquired subject to a first trust deed to
an unrelated financial institution in the amount of $595,000. Also during July
1995, the Company acquired from the majority stockholder an eight acre
residential property with a house and other improvements. This property was
acquired subject to existing indebtedness of $1,126,000 and $644,000 to
unrelated financial institutions, secured by first and second trust deeds,
respectively. The purchase prices, as approved by the disinterested members of
the Company's board of directors, were equal to the stockholder's costs in the
properties, which were $1,114,000 in the case of the eight parcels (compared to
an appraised value as of the date of transfer of $1,045,000) and $2,125,000 in
the case of the residential property (compared to an appraised value as of the
date of transfer of $2.8 million). If the properties are sold for less than
the Company's costs, the stockholder has agreed to reimburse the Company for
the differences. If the properties are sold at amounts less than their
appraised values as of the dates they were acquired by the Company but more
than their costs, any excess of proceeds (less costs to carry and sell the
properties) over their costs will be paid to the stockholder. If the
properties are sold for more than their appraised values as of the dates they
were acquired by the Company, the excess over appraised values will be shared
between the Company and the stockholder. During 1996, the Company sold six of
the eight parcels for net proceeds of $623,000. During 1997, the Company sold
the remaining two parcels for net proceeds of $204,000. As of December 31,
1997, the majority stockholder would have had a liability to the Company of
$392,000 (Company's costs of $$1,219,000 less sales proceeds of $827,000) based
on the sale of the eight parcels. The Company's costs exceed the fair value of
the remaining eight acre residential property by $326,000 as of December 31,
1997. At December 31, 1997 the appraised value of the eight acre residential
property was $2.5 million and its fair value was $2.3 million. As of December
31, 1997, the majority stockholder would have had an estimated liability to the
Company of approximately $718,000 based on the foregoing arrangements, though
his ultimate liability, if any, will not be determined or payable until the
eight acre residential property has been sold. The property is included in real
estate held for sale. Effective July 1995 the Company leased the eight-acre
residential property to the majority stockholder, which lease was terminated
effective June 30, 1996. Rental income with respect to the eight-acre
residential property from the majority stockholder included in the income
statements for the years ended December 31, 1996 and 1995 was $42,000 in each
year. The rent for 1996 was settled through accruing an amount due from TCO,
and TCO's adding the accrued amount to the majority
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EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
stockholder's loan. The 1995 rent was treated as income to the majority
stockholder with the Company recording compensation expense offset by rental
income. Effective July 1996, the Company leased a different residential
property included in real estate held for sale to the majority stockholder,
which lease was terminated effective September 30, 1997. Rental income from
the majority stockholder on this property included in the income statement for
the year ended December 31, 1997 and 1996 was approximately $28,000 and $19,000,
respectively, which amount was paid in cash by the majority stockholder.
Effective October 1, 1997, the Company leased a different residential property
included in real estate held for investment to the majority stockholder. No
rental income was included in the income statement for the year ended December
31, 1997, as the lease amount (subsequently agreed at $1,500 per month) had not
been determined by December 31, 1997.
During 1997, TCO-CA and TCO-IL made loans to the Company's majority
stockholder in the aggregate amounts of $25,000 and $147,325, respectively,
none of which was repaid in 1997. In accordance with the Company's current GAAP
accounting methods, the Company's stockholders' equity and net income were
reduced by the amount of such loans. Including loans made in 1997, the
outstanding amount of the Company's majority stockholder indebtedness to TCO at
December 31, 1997 was approximately $6.0 million (including approximately
$970,000 in accrued interest).
In April 1997, Exstar acquired certain farm equipment used to maintain
real property owned by the Company from the Company's majority stockholder for
$29,000. The price of the equipment was determined using fair market values
obtained from an independent dealer.
The Company's majority stockholder directly owns all of the issued and
outstanding stock of Exstar E&S Insurance Services, a company affiliated with
Exstar through the majority stockholder's common control but which is not a
subsidiary of Exstar. From June 1996 through September 1997, E&S received
commissions on insurance business placed with Frontier. Approximately a 30%
quota share portion of such insurance business was ceded by Frontier to Alpine.
The aggregate amount of commissions received by E&S during 1997 on such
business (net of commissions paid to subproducers) was $1.2 million. E&S
agreed to pay a portion of E&S's net profits earned in connection with this
arrangement to the Company, in partial satisfaction of debts owed to the
Company by TCO-IL. Because E&S did not have any net profits in 1997, no such
profits were paid to the Company in 1997.
In June 1996, CCC began handling claims on behalf of Frontier with respect
to insurance produced through E&S. Until October 1, 1997, when its stock was
transferred to Exstar, CCC was wholly owned by TCO-CA (which is indirectly
owned by the Company's majority stockholder). CCC is reimbursed by Alpine for
the salary and benefit costs related to CCC's employees, as well as CCC's
general and administrative costs. Such cost reimbursement for the period from
January 1, 1997 through September 30, 1997 was approximately $787,000. In
partial satisfaction of TCO-IL's liabilities to the Company, CCC agreed to
assign to the Company all revenues received by CCC from Frontier (less any
payments made by Frontier with respect to CCC costs not initially borne by
Alpine). The amount so assigned by CCC to the Company for the period from
January 1, 1997 through September 30, 1997 was approximately $62,000.
On April 1, 1997, TCO Holdings entered into a Service Agreement with
Alpine under which TCO Holdings agreed to assist Alpine in the negotiation and
placement of a quota share reinsurance agreement with Frontier. For such
services, Alpine agreed to pay TCO Holdings 3.75% of the gross premiums
received by Alpine pursuant to the quota share agreement, subject to a maximum
aggregate payment to TCO Holdings of $4.5 million.
On April 1, 1997, TCO-IL, an entity indirectly wholly owned by the
Company's majority stockholder, transferred to the Company 536,000 shares of
Exstar common stock for consideration of $0.01 per share, or $5,360 in the
aggregate. The per share market value of Exstar's common stock on that date was
$1.25, and thus, the
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EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
aggregate market value of the common stock transferred to Exstar was $670,000
on that date.
During each of 1995 and 1996, in consideration of TCO's meeting certain
loan repayment obligations to the Company, Exstar released 170,000 of the
shares of Exstar common stock then pledged to secure such obligations. As of
December 31, 1996, 160,000 shares of Exstar common stock owned by TCO were
still pledged to secure such obligations. Such shares were released in April
1997 upon the transfer by TCO to Exstar of the 536,000 shares of Exstar common
stock owned by TCO.
Pursuant to the respective management agreements between the Syndicate and
TCO and Alpine and TCO, commissions and fees, including profit sharing,
credited by the Syndicate and Alpine to TCO totaled $5,582,000 and $24,672,000
in 1996 and 1995, respectively. The management agreements were terminated in
1996.
In connection with terminating the management agreements between Alpine
and TCO and the Syndicate and TCO, most of the remaining TCO employees (other
than CCC employees) became employees of Alpine. Consequently, the Company
became directly responsible for the payment of all salaries and benefits
related to such employees. The claims handling staff became employees of CCC
effective January 1, 1996. CCC was reimbursed by Alpine for the salary and
benefit costs related to such employees. Effective October 1, 1997, CCC was
purchased by Exstar for a nominal sum.
In addition to performing services directly for the Company, during 1996
and part of 1997 the majority of the Company's employees were performing
services for Transre and E&S, in connection with a Limited Agency Agreement
("Limited Agency Agreement") with Frontier. In accordance with a plan filed by
Alpine with and approved by the Illinois DOI in connection with its review of
Alpine, the salaries and benefit costs associated with these employees, as well
as general and administrative costs (including rent, utilities, insurance costs
and licensing fees), were allocated among Alpine, Transre and E&S. The
allocations were based on management's estimates of the relative amounts of
employee time and Company resources devoted to the operations. The total
amount reimbursed by Transre and E&S to the Company during 1997 and 1996 was
$2.3 and $1.0 million respectively. During 1997, the related business was
placed by WESTCAP, which was acquired by Exstar from the majority shareholder
effective October 1, 1997 for a nominal sum.
The Company has agreed to allow certain assets of TCO, that the Company
otherwise might have claimed for itself, to be used by Transre, CCC and E&S to
produce insurance and handle claims for Frontier. The Company also has
consented to TCO's, CCC's and E&S' use of certain of TCO's assets and cash
flows, that the Company otherwise might have attempted to claim for itself, to
satisfy obligations to third parties, including tax obligations, obligations to
unaffiliated insurance companies (see Notes 12 and 16) and obligations under an
office lease to which TCO is subject. Exstar's majority stockholder may have
contingent liability with respect to certain of these obligations, and
consequently may benefit from their satisfaction through the use of such assets
and cash flows.
During 1987, the Syndicate and Alpine issued a policy to provide stop-loss
coverage on business written by an unaffiliated insurer and produced by TCO.
As consideration, the Syndicate and Alpine are entitled to 2.5% of the
unaffiliated insurer's written premium on the business. Total written premium
subject to the stop-loss coverage was $0 and $345,000 in 1997 and 1996,
respectively. Both the Syndicate and Alpine have furnished the unaffiliated
insurer with letters of credit fully collateralized by fixed maturity
investments, certificates of deposit and other short-term investments in the
amount of $4.5 million as of December 31, 1997 ($7.9 million as of December
1996 and 1995) to provide security for their and TCO's performance in
connection with this arrangement. Since July 1, 1992, as consideration for the
letters of credit provided by the Syndicate and Alpine, Exstar has been
entitled to receive the interest earned on funds on deposit with the
unaffiliated insurance
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EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
company. As additional consideration, TCO has assigned to Exstar any contingent
amounts from the unaffiliated insurance company up to $1,000,000 per year,
under which arrangement Exstar received no amounts in 1997 or 1996.
The Company owns two office buildings in Solvang, California. The
Company, until June 1996, leased the two office buildings to TCO. The rental
income from TCO included in the statements of operations for the years ended
December 31, 1996 and 1995 was $228,000 and $584,000, respectively.
Effective June 1996, Transre and E&S entered into a Limited Agency
Agreement with an underwriting manager which is a wholly-owned subsidiary of
Frontier, pursuant to which Transre and E&S, until September 30, 1997, produced
for Frontier business of the type previously produced for the Company by TCO.
The same business has been placed by WESTCAP, since October 1, 1997. In lieu
of issuing direct insurance, effective April 1, 1997, Alpine entered
into a casualty quota share reinsurance agreement with Frontier pursuant to
which Alpine assumes a portion of the business placed with Frontier by WESTCAP
(and until September 30, 1997, by Transre and E&S.)
In connection with the Quota Share Arrangement, Alpine has agreed to pay
Frontier a ceding commission generally of 30% of the premium assumed by Alpine.
This ceding commission is to compensate Frontier for expenses incurred by
Frontier generally in obtaining the insurance which is subject to the Quota
Share Arrangement. Frontier pays WESTCAP (previously Transre and E&S) generally
a fee of 27.5% of the premium produced by them pursuant to the Limited Agency
Agreement. Also in connection with the Quota Share Arrangement, Alpine entered
into a Service Agreement with TCO Holdings under which Alpine agreed to pay TCO
Holdings for reinsurance services 3.75% of the gross premiums received by
Alpine pursuant to the Quota Share Arrangement, subject to a maximum aggregate
amount of $4.5 million. As of December 31, 1997, $425,000 was payable by
Alpine to TCO Holdings pursuant to this Service Agreement. No payments were
made in 1997.
The Syndicate entered into an underwriting management agreement with
Camelback Reinsurance Underwriters, Inc. ("Camelback"), to assume premiums on
various treaties for which Camelback was the underwriting manager. Camelback,
an Arizona corporation majority owned by TCO Holdings (until Camelback's
dissolution on April 1, 1997), was a reinsurance underwriting manager from
which the Company historically assumed business. The Syndicate's total
premiums assumed pursuant to those treaties were $147,000 and $1,150,000 in
1996 and 1995, respectively.
The Syndicate and Alpine derived premiums on insurance produced for them
by Trinity E&S Insurance Services ("Trinity"). Trinity, a California
corporation which was formerly a subsidiary of TCO Holdings and is now majority
owned directly by the majority stockholder and five percent owned by the
president of the Company, is a surplus lines brokerage company which
historically produced business for the Company. The gross premiums derived by
the Syndicate and Alpine from Trinity were $27,000, $1,575,000 and $5,726,000
in 1997, 1996 and 1995, respectively. As a subproducer of WESTCAP, Trinity also
received commissions of $210,000 from WESTCAP in 1997.
On April 1, 1997, the Company issued to the Company's majority stockholder
options to acquire 50,000 shares of Exstar common stock at an exercise price of
$1.40 per share. The closing price of the Company's common stock on that date
was $1.25 per share. Subject to certain restrictions, options representing
33,333 shares were exercisable as of January 1, 1998, and options representing
the remaining 16,667 shares are due to become exercisable January 1, 1999. Also
on April 1, 1997, the Company issued to the Company's president options to
acquire 146,350 shares of Exstar common stock at an exercise price of $1.40 per
share. Subject to certain restrictions, options representing 97,567 shares were
exercisable as of January 1, 1998, and options representing the remaining
48,783 shares become exercisable January 1, 1999. Also on April 1, 1997, the
Company issued to the Company's chief financial officer options to acquire
19,000 shares of Exstar common stock at an exercise price of $1.40 per share.
Subject to certain restrictions, options representing 12,667 shares were
exercisable as of January 1,
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EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1998 and options representing the remaining 6,333 shares are due to become
exercisable January 1, 1999.
During 1991, the Company made construction loans to Trinity for
construction of a new office building. The outstanding loan balances at
December 31, 1997 and 1996, were $1,084,000 and $1,096,000, respectively.
16 -- CONTINGENCIES AND COMMITMENTS
TCO has incurred significant losses over the past several years in the
performance of services on behalf of the Company, and has had to rely on the
Company for the funding of a significant portion of these losses. As a result,
TCO is currently indebted to the Company for $15.3 million (including $2.4
million due to the Company pursuant to the Loan Agreement and $9.2 million due
to Alpine as certain unpaid balances with respect to insurance premiums unpaid
by TCO), and has significant additional debts and obligations to unrelated
third parties. TCO currently has a negative net worth of approximately $18
million. Management, consequently, believes that TCO will be unable to repay
the majority of this indebtedness to the Company or the other creditors of TCO.
The foregoing amounts due from TCO are not reflected as assets of the Company
at December 31, 1997, and the nonpayment of such amounts would have no impact
on the Company's future net income or stockholders' equity.
The Company's ability to continue to operate as it currently is operating
depends on generating sufficient revenues and cash flows from the Company's
risk-bearing activities, currently consisting of Alpine's operations; the
Company's insurance producing activities, currently consisting of WESTCAP's
operations; and the Company's claims servicing activities, currently consisting
of Claims Control's operations.
In terms of financial resources, Alpine's activities are the most
significant of the Company's current operations. Most of the Company's cash
flow to fund operations derives from Alpine's existing assets, investment
income on such assets and premium assumed pursuant to the Quota Share
Arrangement. Alpine, however, is relatively close to several regulatory
thresholds that, if crossed, could reduce Alpine's role in the Company's
operations. Alpine's statutory policyholders' surplus of $5.3 million at
December 31, 1997, was $300,000 above the minimum statutory policyholders'
surplus required of an Illinois reinsurer, $2.1 million above the mandatory
control level risk-based capital for Alpine and $3.8 million above the minimum
statutory policyholders' surplus required of an Illinois insurer that
writes the lines of insurance reinsured by Alpine. Additionally, Alpine's
liquid assets at December 31, 1997, may have been insufficient (depending on
interpretation of the relevant statutory provision), if the provision had been
applicable on such date, to satisfy a statutory "reserve requirement" adopted
by Illinois in 1997 to be applicable in 1998, and in any event a significant
amount of Alpine's assets are restricted for specific purposes. See Notes 3
and 4.
The Company currently expects risk-bearing activities will continue to be
a significant part of its operations in 1998 and later years. First, the
Company is negotiating a potential sale of Alpine to Frontier, and if the
negotiations are successful, expects to continue the Company's risk-bearing
activities through formation of a Cayman Islands insurance company that would
assume premium from Frontier pursuant to an arrangement similar to the Quota
Share Arrangement. This would provide the Company continuing investment income
and premium revenue, as well as cash flow, in an insurance regulatory
environment relatively more flexible than the environment in which Alpine
operates. The sale of Alpine also would generate additional cash for the
Company beyond the cash that would be required to be contributed to the Cayman
Islands insurance company.
Second, even if the sale of Alpine is not consummated, Alpine met the
minimum regulatory requirements it was required to meet at December 31, 1997,
to continue to operate. Alpine's financial condition and regulatory compliance
position, additionally, will improve if the $6.6 million Schedule P penalty
drops off as expected over
F-40
<PAGE> 129
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
time ($2.5 million relating to the 1995 accident year will drop off in 1998 if
the loss ratio for Alpine's 1995 accident year remains at the level estimated as
of December 31, 1997). Exstar, additionally, currently has the ability to
contribute certain real estate assets with a statutory net asset value of up to
approximately $1.7 million at December 31, 1997, to Alpine if necessary to
increase Alpine's policyholders' surplus. Alpine's policyholders' surplus,
liquidity and financial condition generally also are expected to benefit from
continuation of the Quota Share Arrangement, entered into on April 1, 1997.
Frontier also has been willing to release under the Quota Share Arrangement a
portion of the funds held it otherwise would have been entitled to retain under
the Quota Share Arrangement, consisting of $2.0 million by early April 1998, and
has agreed to release another $1.0 million in early May. Alpine may have
difficulty meeting the "reserve requirement" in 1998, depending on how the new
statutory provision ultimately is interpreted, but believes, based on
discussions with the Illinois DOI, that it may be able to comply sufficiently
with the requirement to avoid any increase in the Illinois DOI's current level
of oversight.
Notwithstanding the foregoing, Alpine's continued operations depend on
continuation of the Quota Share Arrangement, or a replacement arrangement
similarly or more beneficial to Alpine, and Alpine's continuing satisfaction of
applicable regulatory requirements. The Company currently believes, based on
the generally positive relationship the Company has with Frontier, that the
Quota Share Arrangement will continue generally on its current terms for the
foreseeable future, even if Alpine is not sold to Frontier.
Alpine's continuing satisfaction of applicable regulatory requirements is
more difficult to predict. As described above, Alpine currently is relatively
close to certain regulatory thresholds that, if crossed, could lead to a
required reduction or cessation of Alpine's activities. This could result from
increased oversight by the Illinois DOI, regulatorily required termination of
some or all of Alpine's current business operations and relationships,
termination of the Quota Share Arrangement by Frontier and potentially Alpine's
being placed in receivership. While the Company expects Alpine to be able to
avoid crossing such thresholds, the expectations are based on a number of
assumptions, including, among others, assumptions about cash flows, investment
yields, asset values, ultimate loss and loss adjustment expenses and payout
patterns, competition, the Illinois DOI's potential regulatory responses and
Frontier's Best ratings. Because Alpine is relatively close to certain of the
regulatory thresholds, there is little room for adverse fluctuations in the
foregoing assumptions. In this regard, it should be noted that Alpine's
financial condition weakened significantly in 1997, as evidenced by the drop in
Alpine's statutory policyholders' surplus to $5.3 million at December 31, 1997,
from $12.6 million at December 31, 1996, and Alpine's risk-based capital being
at 117% of its authorized control level risk-based capital at December 31,
1997, compared to 173% of its authorized control level risk-based capital at
December 31, 1996.
Should Alpine's operations be curtailed significantly, or the Company's
risk bearing activities otherwise be limited, the Company would be forced to
rely more on its existing cash and on its WESTCAP and Claims Control activities
to generate revenues and cash flows. A portion of the Company's cash needs
would be able to be met out of Exstar's cash on hand, which was $1.6 million at
December 31, 1997. The balance of the Company's cash needs would be met from
WESTCAP's and Claims Control's revenues from ongoing operations.
TCO previously leased office space in Chicago, Illinois. In August 1996,
TCO defaulted on its obligations under the lease, but continued to occupy the
premises. The Company is currently in the process of negotiating a new lease
with respect to a portion of the premises leased by TCO, and a settlement of
all obligations under the existing lease. Based on such negotiations, the
Company expects that, retroactive to August 1, 1997, WESTCAP will enter into a
new five year lease with respect to approximately 7,800 square feet of the
16,400 square feet previously occupied by TCO, at a rental rate of $13.50 per
square foot per year (as compared to approximately $38.00 per square foot per
year under the TCO lease). It is anticipated that such lease will be
terminable by the landlord at any time two years or more following its
execution, on six months' prior written notice to WESTCAP,
F-41
<PAGE> 130
EXSTAR FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
in the event Exstar's stockholders' equity is below $12 million at the time
notice of termination is given. It is further anticipated that, in
settlement of all obligations under the prior lease with TCO, Exstar will issue
150,000 shares of its common stock to the landlord, and that the landlord will
have the right to put such stock back to Exstar at a per share price of $7.50 at
any time on or after July 31, 1999. As of December 31, 1997, the Company had
accrued liabilities for the lease obligations on the basis that the lease
continued in effect in accordance with its original terms.
Exstar's insurance subsidiaries are involved in various pending or
threatened legal proceedings arising from the normal course of the insurance
business. In some instances, these proceedings include claims for relief in
unspecified amounts in addition to amounts for alleged extra-contractual
liability or requests for equitable relief. Management believes these
proceedings ultimately will be resolved without materially affecting the
consolidated financial position of the Company.
F-42
<PAGE> 131
SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
EXSTAR FINANCIAL CORPORATION (PARENT ONLY)
CONDENSED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31,
1997 1996
(DOLLARS IN THOUSANDS,
EXCEPT PER SHARE DATA)
<S> <C> <C>
ASSETS:
Investments:
Mortgage loans............................................... $268 $335
Real estate held for sale.................................... 3,074 3,898
Cash and cash equivalents--unrestricted...................... 1,647 95
Total investments............................................ 4,989 4,328
Investment in and advances to subsidiaries................... 14,737 11,655
Other assets................................................. 790 2,214
Total assets................................................. $20,516 $18,197
LIABILITIES AND STOCKHOLDERS' EQUITY:
Liabilities:
Current income taxes and other liabilities................... $938 $1,063
Notes payable................................................ 1,130 1,588
Accumulated equity in losses of affiliates................... 4,933 3,020
Total liabilities............................................ 7,001 5,671
Stockholders' equity:
Common stock, $.01 par value, 30,000,000 shares authorized;
5,497,500 shares issued; 5,497,500 shares outstanding in 1997
and 1996..................................................... 55 55
Paid in capital.............................................. 16,812 26,865
Net unrealized investment gains (losses)..................... 291 (68)
Preferred stock investment--contra equity.................... 0 (12,314)
Retained deficit............................................. (3,638) (2,012)
Treasury shares at cost (536,000 shares in 1997; 0 in 1996).. (5) 0
Total equity................................................. 13,515 12,526
Total liabilities and stockholders' equity................... $20,516 $18,197
</TABLE>
S-1
<PAGE> 132
SCHEDULE II (CONTINUED)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
EXSTAR FINANCIAL CORPORATION (PARENT ONLY)
CONDENSED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995
(DOLLARS IN THOUSANDS,
EXCEPT PER SHARE DATA)
Revenue:
<S> <C> <C> <C>
Net investment income--unaffiliated........... $110 $12 $16
Net investment income--affiliated............. 92 333 451
Net realized investment (losses) gains........ (43) (526) 272
Other income.................................. 3,376 143 317
Total revenue (loss).......................... 3,535 (38) 1,056
Expenses:
Other expenses................................ 1,518 3,202 4,233
Interest expense.............................. 135 123 131
Total expenses................................ 1,653 3,325 4,364
Income (loss) before federal income taxes,
equity in net income of subsidiaries and
equity in net income of affiliates............ 1,882 (3,363) (3,308)
Federal income tax expense (benefit).......... 510 (1,715) 5,057
Equity in net (loss) income of subsidiaries... (3,014) 1,587 9,266
Equity in net income of affiliates............ 16 1,561 3,829
Net (loss) income............................. $(1,626) $1,500 $4,730
Net (loss) income per share--basic and diluted $(0.32) $0.27 $0.86
Shares used in computation of net income
per common share (in thousands)............... 5,096 5,498 5,498
</TABLE>
S-2
<PAGE> 133
SCHEDULE II (CONTINUED)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT ONLY)
EXSTAR FINANCIAL CORPORATION (PARENT ONLY)
CONDENSED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995
(Dollars in thousands)
<S> <C> <C> <C>
Increase (Decrease) in Unrestricted Cash and Cash Equivalents:
Cash flows provided by (applied to) operating activities:
Investment income received--affiliated........................... $216 $324 $548
Other income..................................................... 3,376 143 317
Interest paid.................................................... (135) (123) (131)
Other expenses paid.............................................. (1,234) (2,696) (3,863)
Taxes recovered (paid)........................................... 701 500 (500)
Net cash provided by (applied to) operating activities........... 2,924 (1,852) (3,629)
Cash flows provided by (applied to) investing activities:
Purchase of property, equipment and real estate.................. (367) (18) (2,243)
Sale of property, equipment and real estate...................... 824 0 0
Mortgage loans funded--affiliated................................ 0 (265) (2)
Repayments of mortgage loans..................................... 107 0 0
Net cash provided by (applied to) investing activities........... 564 (283) (2,245)
Cash flows (applied to) provided by financing activities
Issuance of notes payable........................................ 0 0 2,011
Repayment of notes payable....................................... (457) (430) 0
Transfers (to) from affiliates.................................. (1,412) 2,563 2,999
Other............................................................ (67) 97 (69)
Net cash (applied to) provided by financing activities........... (1,936) 2,230 4,941
Net increase (decrease) in unrestricted cash and cash equivalents 1,552 95 (933)
Unrestricted cash and cash equivalents at beginning of year...... 95 0 933
Unrestricted cash and cash equivalents at end of year............ $1,647 $95 $0
</TABLE>
S-3
<PAGE> 134
SCHEDULE II (CONTINUED)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
EXSTAR FINANCIAL CORPORATION (PARENT ONLY)
CONDENSED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
1997 1996 1995
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
Reconciliation of Net (Loss) Income to Net Cash Provided
by (Applied to) Operating Activities:
Cash Flows provided by (applied to) operating activities:
Net (loss) income........................................ $(1,626) $1,500 $4,730
Net realized investment losses (gains)................... 43 526 (272)
Non-cash charges (credits) included in net income:
Amortization and depreciation............................ 208 122 123
Equity in net loss (income) of subsidiaries.............. 4,534 (3,027) (2,732)
Equity in net income of affiliates....................... (16) (1,561) (3,829)
Change in:
Accrued investment income--affiliated.................... 14 (21) 81
Prepaid expenses......................................... (106) 278 (84)
Accrued expenses......................................... 182 106 331
Federal income taxes payable............................. (309) 225 (1,977)
Net cash provided by (applied to) operating activities... $2,924 $(1,852) $(3,629)
</TABLE>
S-4
<PAGE> 135
SCHEDULE IV
EXSTAR FINANCIAL CORPORATION
REINSURANCE
FOR THE YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
Column A Column B Column C Column D Column E Column E
Gross amount Ceded to Assumed from other Net amount Percentage of
other companies companies amount assumed to
net
1997
- ----
<S> <C> <C> <C> <C> <C>
Accident and
Health insurance 360 284 66 142 46.5%
Property and 2,415 1,894 6,053 6,574 92.1%
Liability insurance
Total Premiums 2,775 2,178 6,119 6,716 91.1%
1996
- ----
Accident and
Health insurance 2,171 1,722 449 0%
Property and 37,887 17,560 234 20,561 1.1%
Liability insurance
Total Premiums 40,058 19,282 234 21,010 1.1%
1995
- ----
Accident and
Health insurance 2,472 2,015 457 0%
Property and 61,618 23,951 1,025 38,692 2.6%
Liability insurance
Total Premiums 64,090 25,966 1,025 39,149 2.6%
</TABLE>
S-5
<PAGE> 136
SCHEDULE VI
EXSTAR FINANCIAL CORPORATION
SUPPLEMENTAL INFORMATION
CONCERNING PROPERTY--CASUALTY INSURANCE OPERATIONS
AS OF AND FOR THE YEARS ENDED DECEMBER 31, 1997, 1996, AND 1995
(DOLLARS IN THOUSANDS)
<TABLE>
COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F COLUMN G
Net Reserve for
Unpaid Claims and Discount Net Net
Affirmations with Deferred Policy Claim Adjustment if any Deducted in Net Unearned Earned Investment
Registrant Acquisition Costs Expenses Column C Premiums Premiums Income
Consolidated
property casualty
Entities
<S> <C> <C> <C> <C> <C>
Dec. 31, 1997 1,657 30,050 0 5,396 6,716 2,488
Dec. 31, 1996 307 53,006 0 979 21,010 4,015
Dec. 31, 1995 4,513 68,820 0 13,178 39,149 4,897
</TABLE>
<TABLE>
<CAPTION>
COLUMN H COLUMN I COLUMN J COLUMN K
Claims and Claim
Adjustment Expenses
Incurred Related to
(1) (2) Amortization of Net Paid Claims and
Current Prior Deferred Policy Claim Adjustment
Year Years Acquisition Costs Expenses Net Premiums Written
<S> <C> <C> <C> <C>
3,299 4,424 (117) 30,679 11,134
12,971 (282) 5,119 28,502 8,810
23,545 (7,874) 11,655 28,049 28,185
</TABLE>
S-6
<PAGE> 1
[TYPE] EX-10
[DESCRIPTION] Exhibit 10.125 -
LEASE
This Lease is made and entered into as of the 3rd day of April, 1998, by
and between ALPINE INSURANCE COMPANY, an Illinois corporation, hereinafter
referred to as "Landlord," and ROB ROSENBERRY, hereinafter referred to as
"Tenant." For and in consideration of the rental and of the covenants and
agreements hereinafter set forth to be kept and performed by the Tenant,
Landlord hereby leases to Tenant and Tenant hereby leases from Landlord the
premises herein described for the term, at the rental and subject to and upon
all of the terms, covenants and agreements hereinafter set forth.
1. DESCRIPTION OF PREMISES:
Landlord hereby leases to Tenant and Tenant hereby leases from Landlord,
upon the terms and conditions herein set forth, 3,507 square feet of office
space and 532 square feet of designated hallway and restroom areas of the
commercial building known as 2028 Village Lane, City of Solvang, County of Santa
Barbara, State of California (hereinafter "the Premises"). Tenant's Premises of
Landlord's building is outlined on a floor plan of the building which is
attached hereto as Exhibit "A" and incorporated herein. The Premises are
comprised of both the office space and the hallway and restroom areas leased to
Tenant. Notwithstanding that fact, Tenant shall not have exclusive use of the
portion of the Premises comprised of hallway and restroom areas.
2. TERM:
The term of this Lease shall be for five (5) years and four (4) weeks
commencing on April 3, 1998 and ending on May 1, 2003. As used in this Lease,
the "Lease Term" shall mean the term of this Lease as specified in this
paragraph and any extensions thereof agreed to by Landlord and Tenant. Tenant
shall have access to the Premises, without charge of rent, to install equipment
and complete modifications approved by Landlord, commencing on April 3, 1998.
3. RENT:
Tenant agrees to pay to Landlord as rent in lawful money of the United
States without deduction or offset at such place or places as may be designated
from time to time by the Landlord the following:
A. Rent. Tenant agrees to pay Landlord as rent without abatement,
offset or deduction, the sum of Three Thousand Seven Hundred Seventy-Three
Dollars ($3,773.00) in advance, beginning on May 1, 1998, and Three Thousand
Seven Hundred Seventy-Three Dollars ($3,773.00) on the first day of each and
every succeeding calendar month through the first year of the Lease Term.
B. Annual Rent Adjustment. The rent shall be adjusted each year on May
1, 1999, May 1, 2000, May 1, 2001, and May 1, 2002 by increasing the rent in the
amount of the lesser of (a) five percent (5%) of the rent applicable for the
previous year or (b) the change, if any, from the Base Month specified below in
the Consumer Price Index of the Bureau of Labor Statistics of the U.S.
Department of Labor for All Urban Consumers, Los Angeles-Long Beach-Anaheim
<PAGE> 2
Area, all items (1982-1984=100), hereinafter referred to as the "CPI." The rent
based on the CPI shall be calculated as follows: the rent for the twelve (12)
months immediately preceding the adjustment date shall be multiplied by a
fraction, the numerator of which is the CPI of the calender months two months
prior to the adjustment date and the denominator of which is the CPI of the
first month of the least year immediately preceding the adjustment date. In no
event shall any such new monthly rent be less than the rent payable for the
month immediately preceding the rent adjustment.
C. Additional Rent. All sums required to be paid by Tenant under
this Lease other than or in addition to the Base Rent provided for above shall
be considered additional rent under this Lease and shall be paid on or before
the day on which it is due.
D. Late Charge. Payment of rent shall be in lawful money of the United
States, without offset or deduction. Rent for any period during the term hereof
which is for less than one (1) full calendar month shall be prorated based upon
the actual number of days of said month. Payment of rent shall be made to
Landlord at its address stated herein or to such other persons or place as
Landlord may from time to time designate in writing. Acceptance of a payment
which is less than the amount then due shall not be a waiver of Landlord's
rights to the balance of such rent, regardless of the Landlord's endorsement of
any checks so stated. Acceptance of any late charge by Landlord shall in no
event constitute a waiver of Tenant's default with respect to such overdue
amount, nor prevent the exercise of any of the other rights and remedies granted
to Landlord under this Lease or under the laws of the State of California.
(i) A service charge equal to ten percent (10%) of the total
outstanding balance will be added to all amounts which Tenant is required to
pay under this Lease which have not been received in Landlord's accounting
office on or before the tenth (10th) day after the due date.
4. INTENTIONALLY OMITTED.
5. SECURITY DEPOSIT:
Concurrently with Tenant's execution of this Lease, Tenant shall deposit
with Landlord as a security deposit the sum of One Thousand Dollars ($1,000.00).
Said sum shall be held by Landlord as a security deposit for the faithful
performance by Tenant of all the terms, covenants, and conditions of this Lease.
If Tenant defaults with respect to any provisions of this Lease, including but
not limited to this provision relating to the payment of rent, Landlord may (but
shall not be required to) use, apply or retain all or any part of the security
deposit for the payment of any amount due and payable under this Lease, for the
payment of any other amount which Landlord may spend by reason of Tenant's
default or to compensate Landlord for any other loss or damage which Landlord
may suffer by reason of Tenant's default. If any portion of the security deposit
is so used or applied, Tenant shall, within ten (10) days after written demand
therefor, deposit cash with Landlord in an amount sufficient to restore the
security deposit to its original amount, and Tenant's failure to restore the
security deposit shall be a material breach of this Lease. Landlord shall not be
required to keep the security deposit separate from its general funds, and
Tenant shall not be entitled to interest on such deposit. Provided that Tenant
is not in default hereunder, upon the expiration of the Lease term and after
Tenant has vacated the Premises, Landlord shall return the security deposit,
less any sums Landlord is entitled to keep, to Tenant (or at Landlord's option,
to the last assignee of Tenant's interest hereunder). In the event of
termination of Landlord's interest in this Lease, Landlord shall transfer said
deposit to Landlord's successor in interest whereupon Tenant agrees to release
Landlord from liability for the return of such deposit or the accounting
<PAGE> 3
therefor.
6. TAXES:
A. Personal Property Taxes. Tenant shall pay, prior to delinquency,
all taxes assessed against and levied upon fixtures, furnishings, equipment and
all other personal property of Tenant contained in the Premises, and when
possible, Tenant shall cause said fixtures, furnishings, equipment and other
personal property to be assessed and billed separately from the real property
of Landlord. In the event any or all of Tenant's fixtures, furnishings,
equipment and other personal property are assessed and taxed with Landlord's
real property, then Tenant shall pay to Landlord its share of such taxes, as
additional rent, in accordance with the provisions of Paragraph 3. For the
purpose of determining said amount, figures supplied by the County Assessor as
to the amount so assessed shall be conclusive. Tenant shall comply with the
provisions of any law, ordinance or rule of taxing authorities which requires
Tenant to file a report of Tenant's property located in the Premises.
B. Real Property Taxes. Tenant shall pay all (100%) of the real
property taxes (as hereinafter defined) levied or assessed against the office
space (3,507 sq. ft.) portion of the Premises and fifty percent (50%) of real
property taxes levied or assessed against the hallway and restroom area portion
of the Premises during the term of this Lease. Tenant's allocated portion of
such real property taxes shall be fifteen percent (15%) of the total real
estate taxes required to be paid with respect to the 2028 Village Lane
commercial property (which has a total square footage of 25,769).
For the purpose of this Lease, "real property taxes" means and
includes without limitation all taxes, assessments (including, but not limited
to, assessments for public improvements or benefits), taxes based on vehicles
utilizing parking areas, taxes based or measured by the rent paid, payable or
received under this Lease, taxes on the value of the Premises, environmental
surcharges, and all other governmental impositions and charges of every kind and
nature whatsoever, whether or not customary or within the contemplation of the
parties hereto and regardless of whether the same shall be extraordinary or
ordinary, general or special, unforeseen or foreseen, or similar or dissimilar
to any of the foregoing which, at any time during the Lease term, shall be
applicable to, assessed, levied or imposed upon the Premises or become due and
payable and a lien or charge upon the Premises or any part thereof, under or by
virtue of any present or future laws, statutes, ordinances, regulations, or
other requirements of any governmental authority whatsoever. The term
"environmental surcharges" shall mean and include any and all expenses, taxes,
charges or penalties imposed by the Federal Department of Energy, the Federal
Environmental Protection Agency, the Federal Clean Air Act, or any regulations
promulgated thereunder or any other local, state of federal governmental agency
or entity now or hereafter vested with the power to impose taxes, assessments or
other types of surcharges as a means of controlling or abating environmental
pollution or the use of energy. The term "real property taxes" shall not include
any federal, state or local income, estate or inheritance tax imposed on Tenant.
7. USE OF PREMISES:
A. Use. The Premises shall be used and occupied by Tenant solely for
Tenant's physical therapy business and related uses, and for no other purpose
without the prior written consent of Landlord. Tenant covenants and agrees that
it will continuously and uninterruptedly, from and after taking possession of
the Premises, operate and conduct on the Premises only those uses which it is
permitted to operate under the provisions of this Lease.
B. Suitability. Tenant acknowledges that neither Landlord nor
<PAGE> 4
Landlord's agents have made any representation or warranty with respect to the
Premises or the building or the real property or with respect to the
suitability of the same for Tenant's uses, including without limitation and
except as provided in Paragraph 24 below, any representation concerning the
number or identity of other tenants or prospective tenants in the building, nor
has Landlord agreed to undertake any modification, alteration or improvement to
the Premises except as provided in this Lease. The taking of possession of the
Premises by Tenant shall conclusively establish that the Premises and building
were at such time in good order, condition and repair and that Landlord's work
with respect to the Premises has been completed.
C. Prohibited Uses; Compliance with Laws.
(i) Tenant shall not do or permit anything to be done in or about
the Premises nor bring or keep anything which will in any way increase the
existing rate of or otherwise affect any fire or other insurance covering the
Premises or the building, or any of its contents, whether the insurance is
maintained by Landlord, Tenant or other tenants, or cause a cancellation of any
such insurance policy. Tenant shall not sell or permit to be kept, used or sold
in or about the Premises any articles which may be prohibited by a standard form
of fire insurance policy. In the event any costs of any such insurance are
increased as a result of Tenant's failure to comply with the provisions of this
Lease, Tenant shall pay to Landlord, as additional rent, said increased costs,
plus interest from the date of expenditure, at the highest rate then permitted
under California law, within ten (10) days after Landlord gives Tenant written
notice of said increase.
(ii) Tenant shall not (a) do or permit anything to be done in or
about the Premises which will in any way obstruct or interfere with the rights
of other tenants or occupants of this building; (b) use or allow the use of the
Premises for any unlawful or objectionable purpose; (c) cause, maintain or
permit any nuisance in, or about the Premises or the building; (d) commit or
suffer to be committed any waste in or upon the Premises; (e) place or operate,
or permit to be placed or operated, electronic games or amusement devices on the
Premises or (f) perform or carry on any practice which may cause damage or
deface the Premises or any part of the building.
(iii) Tenant shall not use the Premises or permit anything to be
done in or about the Premises which will in any way conflict with any law,
statute, ordinance or governmental rule or regulation or requirement of duly
constituted public authorities now in force or which may hereafter be enacted or
promulgated. Tenant shall, at its sole cost and expense, promptly comply with
all permit and licensing ordinances and regulations applicable to Tenant's use
of the Premises and with all other laws, statutes, ordinances and governmental
rules, regulations or requirements now in force or which may hereafter be in
force and with the requirements of any fire rating bureau or other similar body
relating to or affecting the condition, use or occupancy of the Premises. The
judgment of any court of competent jurisdiction or the admission of Tenant in
any action against Tenant, whether Landlord be a party thereto or not, that
Tenant has violated any law, statute, ordinance or governmental rule, regulation
or requirement, shall be conclusive of that fact as between Landlord and Tenant.
(iv) In the event that prior to the commencement of the Lease
Term Tenant is unable to obtain the appropriate licenses, permits, zoning
variances, or any other governmental approvals to utilize the property for its
intended uses under this Lease, Tenant, at its option, may immediately
terminate this Lease without penalty.
8. UTILITIES:
<PAGE> 5
A. Monthly Charge. If utilities to the Premises are separately
metered, all charges therefor will be paid directly by Tenant, as additional
rent, on or before their due date. Tenant shall bear the cost of installation
of any meters necessary for the separate metering of the Premises. If not
separately metered, Tenant agrees to pay Landlord, as additional rent for all
gas, electricity, water, and normal trash removal supplied to the Premises by
Landlord, an amount to be agreed upon once it is determined that any of these
utilities cannot be separately metered. Tenant shall pay, prior to delinquency,
all charges (including all taxes thereon) for telephone and janitorial services
and any other utilities not specifically otherwise provided for herein,
materials, and services supplied to the Premises during the Lease Term and
shall hold Landlord harmless from any liability therefrom. Landlord shall not be
liable for any damages which may result from any failure or interruption of any
utility service being furnished to the Premises unless such failure is caused
by Landlord, and no such failure or interruption shall entitle Tenant to
terminate this Lease or to any abatement of rent unless such failure or
interruption extends for more than 4[initialed SB] (four) consecutive days in
which case the rent shall be abated during the period of the interruption.
B. Provision for Cost of Living Utility Increase. The monthly charge
for utilities that cannot be separately metered, if any, in an amount to be
agreed upon as provided for by Subparagraph A of this Paragraph 8 shall be
adjusted annually commencing the first month of the second year of the Lease
Term hereof, and annually thereafter each year Tenant occupies the Premises in
the same manner as the rent is to be adjusted based on the CPI under Paragraph
3.B. above. In no event will the adjusted charge be less than the charge prior
to the adjustment date.
If the Index shall no longer be published, then appropriate reference
figures shall be derived from any successor or comparable index mutually agreed
by the parties to be authoritative, and if the parties are unable to agree,
then the substituted Index shall be selected by the then presiding Judge of the
Superior Court for the County of Santa Barbara, California, upon the
application of either party. In any event, the base used by any new Index or as
revised on the existing Index base shall be reconciled to the 1982-84 Index.
9. COMMON AREA OPERATION:
A. Common Area Definition and Use. The term "common area" as used
herein shall mean all areas and facilities in the building and on the real
property, including, without limitation, driveways, sidewalks, landscaped
areas, and service areas. Landlord hereby grants to Tenant, its subtenants,
licensees, invitees, customers and employees, the nonexclusive right to use the
common area in common with Landlord, other tenants and their respective
subtenants, licensees, invitees, customers, and employees, subject to the
provisions of this Lease and to such rules and regulations pertaining to the
use of the common area as Landlord shall make from time to time. Landlord
expressly reserves the right to alter any part of the common area at its sole
discretion
B. Maintenance. Landlord shall operate, manage and maintain the
common area in a reasonably commercial condition. The manner in which the
common area shall be maintained and the expenditures thereof shall be at the
sole discretion of Landlord.
C. Parking Areas. Tenant shall have twenty-one (21) parking spaces
located on Landlord's real property as set forth in Exhibit "B" attached hereto
and made a part hereof. Such designated parking spaces shall be the sole
parking spaces on Landlord's real property to be used by Tenant, his employees,
patients, clients, invitees, and guests. Landlord reserves the right to
<PAGE> 6
promulgate such reasonable rules and regulations relating to the use of the
parking areas as Landlord may deem appropriate for the best interest of the
tenants of the building. Landlord shall have the right to temporarily close all
or any portion of the parking area for purposes of normal maintenance and
repairs. The parking area shall not be used for any purpose other than the
parking of motor vehicles during business hours and the ingress and egress of
pedestrians and motor vehicles. No overnight parking use of vehicles shall be
made by Tenant.
10. MAINTENANCE AND REPAIRS:
A. Landlord's Obligations. Subject to the provisions of Paragraph 16,
Landlord, at its sole cost and expense, shall maintain, in a good state of
repair, the surface and structural parts of the roof, exterior walls (excluding
the interior of all walls and the exterior and interior of all windows, doors,
plate glass and show cases), all sewer, water, electric, gas lines and other
utility lines of any nature which lie under, within the walls, in the ceiling,
or on the roof of the Premises (excluding any such lines which have been
installed by Tenant), and foundations of the Premises and building; provided
however that in the event any maintenance and repairs are made necessary by the
wrongful act or omission of Tenant or his employees, agents, clients or
invitees, or in the event maintenance and/or repair costs are incurred or
increased principally as a result of any extraordinary or unusual use to which
Tenant puts the Premises, including Tenant's installation and maintenance of a
swimming pool, Tenant shall pay to Landlord within ten (10) days after written
demand, as additional rent, the actual cost of such maintenance and repairs
plus interest from the date of expenditure at the highest rate then permitted
under California law. Landlord shall have no obligation to make repairs under
this Paragraph until a reasonable time after Tenant has notified Landlord in
writing of the need for such repairs and/or maintenance.
B. Tenant's Obligations. Except as otherwise provided in this Lease,
Tenant, at Tenant's sole cost and expense, shall maintain the Premises and
appurtenances and every part thereof (excepting only those items which Landlord
is specifically obligated to maintain or repair pursuant to Paragraphs 9.A. and
10.A.) in good order, condition and repair including without limitation, all
interior walls, partitions and floors, floor coverings, interior surfaces of
the ceilings, doors, windows, plate glass, show cases, all electrical,
plumbing and lighting systems and equipment, including all heating,
refrigeration and evaporative cooling equipment, and any fixtures, signs and
equipment installed by or at the expense of Tenant, including specifically any
swimming pool installed by Tenant.
Tenant shall maintain and repair the heating, ventilation and air
conditioning systems and equipment that service the Premises, but shall
coordinate any such maintenance and repair with Landlord (with ultimate control
thereof being within Landlord's sole discretion).
Should Tenant fail to make repairs required by Tenant hereunder within
five (5) days after notice is given by Landlord (but within one (1) day with
respect to the swimming pool), Landlord, in addition to all other remedies
available hereunder or by law and without waiving any alternative remedies, may
make the repairs, and in that event, Tenant shall reimburse Landlord, as
additional rent, for the cost of such maintenance or repairs, plus interest at
the highest rate then permitted by California law, within ten (10) days after
written demand by Landlord.
11. ALTERATIONS:
A. Alterations by Tenant. Tenant shall not make, or suffer to be made,
<PAGE> 7
any alterations, improvements or additions (collectively "alterations"), in, on,
about or to the Premises or any part thereof, without the prior written consent
of Landlord and without a valid building permit issued by the appropriate
governmental authority. As a condition to giving such consent, Landlord may
impose such requirements as Landlord in its sole discretion deems necessary,
including without limitation requirements that (i) Tenant agree to remove any
such alterations at the termination of this Lease, and to restore the Premises
to their prior condition; (ii) Tenant secure a completion and lien indemnity
bond satisfactory to Landlord for said work; (iii) Tenant secure and maintain in
place throughout the Lease Term a performance bond satisfactory to Landlord for
the removal of the swimming pool and the restoration of the Premises at the end
of the Lease Term or earlier termination of the Lease; and (iv) Landlord may
approve the contractor for such alterations and limit the times during which the
alteration work may be done. Unless Landlord requires that Tenant remove any
such alteration, the alteration, except movable furniture and trade fixtures not
affixed to the Premises, shall become the property of Landlord upon installation
and shall remain upon and be surrendered with the Premises at the termination of
this Lease.
The bond required by clause (iii) of this Paragraph A will provide
that (a) in no event shall the aggregate liability of the surety for any and all
claims exceed Twelve Thousand Dollars ($12,000.00); and (b) the bond may be
cancelled by the surety as to subsequent liability at any time by giving sixty
(60) days written notice to Landlord during which sixty (60) day period Landlord
may make a demand under the bond, and upon expiration of such sixty (60) day
period shall receive the proceeds of the bond, if Tenant fails to remove the
swimming pool and restore the Premises prior to the expiration of such sixty
(60) day period.
Tenant shall not permit any mechanic's or materialmen's liens to be
placed on the Premises and shall indemnify, defend and hold Landlord harmless
against any liens, claims, demands, encumbrances or judgments relating to any
labor or services performed or materials furnished for such alternations to the
Premises.
Tenant shall also give Landlord written notice five (5) days prior to
commencement of services or receipt of material for such alterations and shall
permit Landlord to post a notice of nonresponsibility in accordance with the
statutory requirement of California Civil Code Section 3095 or any amendment
thereof.
B. Tenant's Personal Property. Subject to the requirements of
Paragraph 21 hereof, Tenant may install in the Premises such trade fixtures,
signs and equipment as Tenant deems desirable. All articles of personal property
and all business and trade fixtures, machinery and equipment, furniture and
movable partitions owned or installed by Tenant in or on the Premises shall be
and remain the property of Tenant, and may be removed by Tenant at any time
during the Lease term provided Tenant is not in default hereunder, and provided
further that Tenant shall repair damage caused by such installation, use or
removal. If Tenant fails to remove all of its effects from the Premises upon
termination of this Lease, Landlord may, at its option, remove the same in any
manner that Landlord shall choose, and store said effects without liability to
Tenant for loss thereof. Tenant agrees to pay Landlord within ten (10) days
after written demand, as additional rent, any and all expenses incurred in such
removal, including court costs and attorney's fees and storage charges on such
effects for any length of time that the same shall be in Landlord's possession,
plus interest from the date of expenditure at the highest rate then permitted by
California law. Landlord may, at its option and without notice, sell any or all
of said effects, at private sale and without legal process, for such price as
Landlord may obtain and apply the proceeds of such sale to (i) any amount due
<PAGE> 8
under this Lease from Tenant to Landlord and (ii) the expense incident to the
removal and sale of said effects.
12. LANDLORD'S ENTRY:
Tenant shall allow Landlord or Landlord's agents, representatives,
employees or contractors, to enter upon the Premises at reasonable times to
inspect the Premises, to perform required maintenance and repair, to make such
additions or alterations to the Premises as Landlord deems necessary or
desirable, and to show the Premises to prospective purchasers or tenants and
post "for sale" and "for lease" signs. Landlord may, in connection with any such
alterations, additions, or repairs, erect scaffolding, post relevant notices,
and place movable equipment without any obligation to reduce Tenant's rent for
the Premises during such period, provided that Tenant's entrance to the Premises
shall not be blocked thereby and that the authorized uses of the Premises by
Tenant shall not be interfered with unreasonably. Tenant hereby waives any claim
for damages for any injury or inconvenience to or interference with Tenant's
authorized uses of the Premises by, any loss of occupancy or quiet enjoyment of
the Premises, and any other loss occasioned thereby. For each of the aforesaid
purposes, Landlord shall have the right to use any and all means which Landlord
may deem proper to open said doors in any emergency in order to obtain entry to
the Premises, and any entry to the Premises by Landlord shall not under any
circumstances to construed or deemed to be a forcible or unlawful entry into, or
detainer of, the Premises, or an eviction of Tenant from the Premises or any
portion thereof.
13. LIENS:
Tenant shall keep the Premises and the building free from any liens
arising out of work performed, materials furnished, or obligations incurred by
Tenant and shall indemnify, hold harmless and defend Landlord from any claims,
liens, attachments, encumbrances and litigation arising out of any work
performed or materials furnished by or at the direction of Tenant relating to
the Premises. In the event that Tenant shall not, within twenty (20) days
following the imposition of any such lien, cause such lien to be released of
record by payment or posting of a proper bond, Landlord shall have, in addition
to all other remedies provided herein and by law, the right but not the
obligation to cause the same to be released by such means as it shall deem
proper, including payment of the claim giving rise to such lien or filing of a
bond in favor of any lien claimant. All such claims paid by Landlord and all
expenses incurred by it in connection therewith, including attorney's fees and
costs, shall be payable to Landlord by Tenant as additional rent, with ten (10)
days after written demand, with interest from the date of expenditures at the
highest rate then permitted by California law. Landlord shall have the right at
all times to post and keep posted on the Premises any notices of
nonresponsibility or other notices permitted or required by law, or which
Landlord shall deem proper, for the protection of Landlord and the Premises from
mechanics' and materialmen's liens.
14. INDEMNITY:
Tenant shall indemnify, defend and hold Landlord harmless from and against
any and all claims (i) arising out of Tenant's use of the Premises or the
common area or the conduct of his business; (ii) arising out of any activity,
work, or thing done, permitted or suffered to be done by Tenant or any of
his patients, clients, invitees, agents, contractors or employees in or about
the Premises or the common area; (iii) arising from any breach or default in the
performance of any obligation on Tenant's part to be performed under the terms
of this Lease; (iv) arising from any act or negligence of Tenant, or any of his
patients, clients, invitees, agents, contractors, or employees; or (v) arising
out of Tenant's sharing the Premises with any other tenants, sublessee or
partners.
<PAGE> 9
Tenant shall further indemnify and hold Landlord harmless from and against
any and all costs, attorneys' fees, expenses and liabilities incurred in
connection with such claim or any action or proceeding brought thereon. In case
any action or proceeding is brought against Landlord by reason of any such
claim, Tenant upon notice from Landlord shall defend the same at Tenant's
expense by counsel reasonably satisfactory to Landlord. Tenant shall not be
liable for damage or injury occasioned by the sole negligence or willful
misconduct of Landlord and its designated agents or employees, unless the same
are covered by insurance Tenant is required to provide.
15. INSURANCE:
A. Liability Insurance. Tenant shall, at Tenant's sole cost and
expense, but for the mutual benefit of Landlord and Tenant, maintain throughout
the Lease term comprehensive public liability insurance against claims for
personal injury, death or property damage occurring in or about the Premises,
including, without limitation, sidewalks directly adjacent to the Premises and
such other areas as Tenant, his patients, clients, agents, employees,
contractors, and invitees shall have the right to use pursuant to this Lease.
Such insurance shall have a combined single limit of not less than $1,000,000
for liability coverage and $50,000 for property damage coverage and shall name
Landlord (and such other persons or entities as Landlord may designate) as an
additional insured. Such insurance shall also insure performance of the
indemnity agreement contained in Paragraph 14. of this Lease. Such liability
insurance shall be primary and not contributing to any insurance available to
Landlord, and Landlord's insurance (if any) shall be in excess thereto. Tenant
shall deliver to Landlord prior to commencement of the Lease Term a copy of
Tenant's insurance policy and a Certificate of Insurance designating Landlord as
an additional insured.
B. Fire and Extended Coverage: Landlord shall maintain during the
Lease term, fire, extended coverage, special extended insurance, including
vandalism and malicious mischief coverage, earthquake and "difference in
conditions" insurance, in an amount equal to the full replacement cost of the
building, exclusive of Tenant's fixtures, furnishings, equipment and other
personal property. Tenant shall have no interest in or any right to the
proceeds of any insurance procured by Landlord on the building, the Premises or
the real property.
C. Form of the Policies. The policies required by Paragraph 15.A.
shall be in a form reasonably satisfactory to Landlord, with an A.M. Best "A"
rated or better insurer and a certificate as to such insurance shall be
delivered to Landlord. Tenant shall have the right to provide the insurance
coverage that it is obligated to provide in a blanket policy; provided such
blanket policy expressly affords coverage to the Premises and to Tenant and
Landlord as required by this Lease. Tenant shall obtain a written obligation on
the part of any insurance company providing such insurance to notify Landlord
in writing of any delinquency in premium payments and, at least ten (10) days
prior thereto, of any cancellation of any such policy. Tenant agrees that if
Tenant does not take out such insurance or keep the same in full force and
effect, Landlord may take out the necessary insurance and pay the premiums
therefor, and Tenant shall repay to Landlord, as additional rent and within
ten (10) days after written demand, the amount so paid plus interest from the
date of expenditure at the highest rate then permitted by California law.
D. Waiver of Subrogation. Landlord and Tenant each hereby waive any
and all rights of recovery against the other or against the officers,
employees, agents and representatives of the other, on account of loss or damage
occasioned to such waiving party or its property or the property of others
under its control to the extent that such loss or damage is insured against
under any fire
<PAGE> 10
and extended coverage insurance policy which either may have in force at the
time of such loss or damage.
E. Plate Glass Insurance. Tenant, at his sole cost, shall be
responsible for the maintenance, repair, and replacement of all plate glass in
or enclosing the Premises and shall procure insurance on such plate glass.
16. EMINENT DOMAIN:
In the event the leased Premises or any part thereof be appropriated or
taken under the power of eminent domain, this Lease shall terminate as to the
part taken as of the date of taking actual possession thereof. Any award shall
be paid and belong to Landlord except any award for the taking of or damage to
the fixtures and equipment of Tenant. Landlord shall be entitled to the entire
award for the real property, including Tenant's leasehold interest therein.
Tenant shall be entitled to any award to which it is otherwise entitled which
shall not reduce the award to Landlord.
In the event the portion of the leased Premises remaining after such
taking is not reasonably adequate for the operation of the business of Tenant,
Tenant may, at his option, terminate this Lease as of the date of the taking of
actual possession by the condemning authority by giving written notice thereof
to Landlord with ten (10) days after such taking of possession. In the event
Tenant may not or does not terminate this Lease as hereinbefore provided, then
the minimum rent payable under the terms of this Lease shall be reduced from and
after the date of taking of possession in the proportion that the floor area
taken bears to the floor area of the leased Premises immediately prior to such
taking.
17. ASSIGNMENT AND SUBLETTING:
Landlord's Consent Required. Tenant shall not assign all or any part
of its interest in this Lease, sublet all or any part of the Premises, transfer
any interest of Tenant therein or permit any use of the Premises by another
party (any and all such acts being collectively referred to herein as a
"transfer") without the prior written consent of Landlord, and any attempt to do
so without such consent being first had and obtained shall be wholly void and
shall constitute a breach of this Lease. Landlord shall not unreasonably
withhold its consent to a transfer provided that the provisions of this
Paragraph 17 are met.
18. DEFAULT, REMEDIES:
A. Tenant's Default. The occurrence of any one or more of the
following events shall constitute a material default and breach of this Lease
by Tenant:
(1) The abandonment or vacation of the Premises by Tenant;
(2) The failure by Tenant to make any payment of Rent or
additional rent, or of any other sum required to be paid by Tenant hereunder,
as and when due;
(3) The failure by Tenant to observe or perform any of the
covenants, conditions or provisions of this Lease to be observed or performed
by Tenant other than the payment of money, if such failure is not cured within
ten(10) days after written notice thereof from Landlord to Tenant; provided,
however, that if the nature of Tenant's default is such that more than ten (10)
days are reasonably required for its cure, then Tenant shall not be deemed to
be in default if Tenant commences such cure within the ten (10) day period and
<PAGE> 11
thereafter diligently prosecutes such cure to completion;
(4) The failure of Tenant to remove the swimming pool on or
before the end of the Lease Term or earlier termination of the Lease or during
the sixty (60) day period following Landlord's receipt of the notice from the
issuer of the performance bond required under Paragraph 11.A(iii) hereof that
such bond will be cancelled, without further notice from Landlord; and
(5) The making by Tenant of any general assignment for the
benefit of creditors, the filing by or against Tenant of a petition to have
Tenant adjudged a bankrupt or of a petition for reorganization or arrangement
under any law relating to bankruptcy (unless, in the case of a petition filed
against Tenant, the same is dismissed within sixty (60) days; the appointment
of a trustee or receiver to take possession of substantially all of
Tenant's assets located at the Premises or of Tenant's interest in this Lease,
where possession is not restored to Tenant within thirty (30) days; or the
attachment, execution or other judicial seizure of substantially all of
Tenant's assets located at the Premises or of Tenant's interest in this Lease,
where such seizure is not discharged within thirty (30) days.
B. Remedies. In the event of any material default or breach of this
Lease by Tenant, Landlord's obligations under this Lease shall be suspended and
Landlord may at any time thereafter, without limiting Landlord in the exercise
of any other right or remedy at law or equity which Landlord may have (all
remedies provided herein being non-exclusive and cumulative), do any one or
more of the following:
(1) Maintain this Lease in full force and effect and recover the
rent, additional rent and/or other monetary charges as they become due, without
terminating Tenant's right to possession irrespective of whether Tenant shall
have abandoned the Premises. If Landlord elects not to terminate the Lease,
Landlord shall have the right to attempt to relet the Premises at such rent and
upon such conditions, and for such a term, as Landlord deems appropriate in its
sole discretion and to do all acts necessary with regard thereto, without being
deemed to have elected to terminate the Lease, re-entering the Premises to make
repairs or to maintain or modify the Premises, and removing all persons and
property from the Premises; such property may be removed and stored in a public
warehouse or elsewhere at the cost of and for the account of Tenant. Reletting
may be for a period shorter or longer than the remaining term of this Lease,
and for more or less rent, but Landlord shall have no obligation to relet at
less than prevailing market rental rates. If reletting occurs, this Lease shall
terminate automatically when the new tenant takes possession of the Premises and
commences rent payment. Notwithstanding that Landlord fails to elect to
terminate the Lease initially, Landlord at any time thereafter may elect to
terminate the Lease by virtue of any previous uncured default by Tenant. In the
event of any such termination, Landlord shall be entitled to recover from Tenant
all damage incurred by Landlord by reason of Tenant's default, as well as all
costs of reletting including commissions, attorneys' fees, restoration or
remodeling costs, and all other consequential damages.
(2) Terminate Tenant's right to possession by any lawful means,
in which case this Lease shall terminate and Tenant shall immediately surrender
possession of the Premises to Landlord. In such event Landlord shall be entitled
to recover from Tenant all damages incurred by Landlord by reason of Tenant's
default including, without limitation, the following: (a) the worth, at the time
of award, of any unpaid rent which had been earned at the time of such
termination; (b) the worth, at the time of award, of the amount by which the
unpaid rent which would have been earned after termination until the time of
award exceeds the amount of such rental loss that Tenant proves could have been
reasonably avoided; plus (c) the worth, at the time of award, of the amount by
<PAGE> 12
which the unpaid rent for the balance of the term after the time of award
exceeds the amount of such rental loss that Tenant proves could have been
reasonably avoided; plus (d) any other amount, and court costs, necessary to
compensate Landlord for all the detriment proximately caused by Tenant's default
or which in the ordinary course of things would be likely to result therefrom
(including, without limiting the generality of the foregoing, the amount of any
commissions and/or finder's fee for a replacement tenant). The term "rent" as
used in this Paragraph shall be deemed to be and to mean all rent, additional
rent and other monetary sums required to be paid by Tenant pursuant to this
Lease.
(3) Proceed to cure the default at Tenant's sole cost and
expense, without waiving or releasing Tenant from any obligation of Tenant. If
at any time Landlord pays any sum or incurs any expense as a result of or in
connection with curing any default of Tenant, all sums so paid by Landlord and
all costs incurred by Landlord in performing such act (including any
administrative fees provided for herein and attorneys' fees), together with
interest thereon at the legal rate from the date of such payment by Landlord,
shall be paid by Tenant to Landlord immediately upon demand.
C. Landlord's Default. Landlord shall not be deemed to be in default
in the performance of any obligation under this Lease unless and until it has
failed to perform such obligation within thirty (30) days after receipt of
written notice by Tenant to Landlord specifying such failure; provided, however,
that if the nature of Landlord's default is such that more than thirty (30)
days are required for its cure, then Landlord shall not be deemed to be in
default if it commences such cure within the thirty (30) day period and
thereafter diligently prosecutes such cure to completion. Tenant agrees to give
any Mortgagee a copy, by registered mail, of any notice of default served upon
Landlord, provided that prior to such notice Tenant has been notified in writing
(by way of Notice of Assignment of Rents and Leases, or otherwise), of the
address of such Mortgagee.
Tenant further agrees that if Landlord shall have failed to cure such default
within the time provided for in this Lease, then any such Mortgagee shall
have an additional forty-five (45) days within which to cure such default on the
part of the Landlord or if such default cannot be cured within that time, then
such additional time as may be necessary if within that forty-five (45) days the
Mortgagee has commenced and is pursuing the remedies necessary to cure such
default (including but not limited to commencement of foreclosure proceedings,
if necessary to effect such cure).
19. ATTORNEY'S FEES; COSTS OF SUIT:
If either Tenant or Landlord brings any action for any relief against the
other, declaratory or otherwise, arising out of this Lease, including any suit
by Landlord for the recovery of rent or possession of the Premises, the losing
party shall pay to the successful party a reasonable sum for attorney's fees
which shall be deemed to have accrued on the commencement of such action and
shall be paid whether or not such action is prosecuted to judgment.
20. SURRENDER OF PREMISES:
On expiration of the Lease Term, or on sooner termination of the Lease,
Tenant shall surrender the Premises to Landlord in the same condition as
received, ordinary wear and tear excepted, and shall remove from the Premises
all of tenant's personal property and trade fixtures and such alterations,
additions and improvements as Landlord has indicated to Tenant must be removed
or restored, as the case may be. If the Premises are not so surrendered, Tenant
shall indemnify, defend and hold Landlord harmless from and against loss or
<PAGE> 13
liability resulting from Tenant's delay, including without limitation any
claims made by any succeeding Tenant or losses to Landlord for lost rental
opportunities. Termination of this Lease shall not release Tenant from the
payment of any obligation or sum that accrued prior to said termination. The
voluntary or other surrender of this Lease by Tenant, or a mutual cancellation
thereof, shall not work a merger, and shall, at the option of the Landlord,
terminate all or any existing subleases or subtenancies, or may, at the option
of Landlord, operate as an assignment to it of any or all such subleases or
subtenancies.
21. SIGNS; USE OF BUILDING NAME:
Tenant shall not inscribe, paint, affix, place or permit to be placed any
new projecting sign, marquee, awning, advertisement, sign, notice of placard on
the exterior or roof of the Premises or upon or about the entrance doors,
windows, sidewalks or areas adjacent to the Premises without Landlord's prior
written consent, except that Tenant shall be allowed to place on the exterior of
the Premises a new sign which has been approved by the City of Solvang or
allowed by the sign ordinance of the City of Solvang, provided, however, the
location of such sign shall be mutually agreed upon between Landlord and Tenant.
Landlord reserves the right, in Landlord's sole discretion, to place and locate
on the roof, exterior sidewalls and rear wall of the Premises or any portion of
the building which is not leased to Tenant, such notices, signs, marquees and
advertisements as Landlord may deem appropriate in the operation of Landlord's
affairs. Landlord shall fully cooperate with Tenant and/or any appropriate
governmental authorities in securing necessary and reasonable signage for
Tenant's use of the Premises and Landlord shall not arbitrarily, unreasonably or
untimely withhold consent to signage consistent with Tenant's needs and
Landlord's development of the land.
22. RIGHTS RESERVED BY LANDLORD:
In addition and without limiting all other rights granted hereunder,
Landlord specifically reserves the right from time to time except as otherwise
expressly set forth in this Lease, (i) to make changes to, eliminate or add to
the building, the common area and other improvements located in or about the
Premises, and (ii) to effect any other tenancies in the building and grant
anyone the exclusive right to conduct any particular business or enterprise,
other than Tenant's business as of the commencement date, in the building or on
the real property, except that no removal of Tenant's designated parking
spaces, if any, shall be allowed. Landlord reserves the right however to
relocate Tenant's designated parking spaces in its discretion.
23. RIGHT OF FIRST REFUSAL:
Tenant shall have the right of first refusal to lease the remaining office
space in the vicinity of the Premises (approximately 1,100 sq. ft. of
additional space). The space subject to the first right of refusal is shown on
Exhibit A hereto as the cross-hatched area. In the event that Landlord
determines, in its sole discretion, to offer the adjacent office space for
rent or lease, Landlord will so advise Tenant in writing. Tenant will thereafter
have twenty (20) days in which to notify Landlord of its election to exercise
its right of first refusal, in which event the adjacent space will be included
in the Premises for all purposes under this Lease at the market rate then
prevailing as determined by Landlord in good faith.
24. RESTRICTIVE COVENANT:
Landlord covenants that it will not rent office space in the building of
which the Premises is a part to a person, entity or group for use for physical
<PAGE> 14
therapy or occupational therapy. Landlord retains the right to lease such space
to any other type of medical or commercial business in its sole discretion.
25. DAMAGE OR DESTRUCTION:
If the Premises are damaged or destroyed by a risk covered under any fire
and extended coverage insurance policy issued in favor of Landlord, this Lease
shall continue in full force and effect, except that Tenant shall be entitled to
an equitable reduction of rent, commencing with the date of damage and
continuing through completion of repairs by Landlord, such reduction to be based
upon the extent to which the damage and/or restoration efforts materially
interfere with the Tenant's business in the Premises.
If the Premises or the Building are damaged by a risk not covered by such
insurance, then Landlord shall have the option either to repair or restore such
damage, this Lease continuing in full force and effect, but the rent to be
equitably reduced as hereinabove provided, or to give notice to Tenant at any
time within ninety (90) days after such damage terminating this Lease as of a
date to be specified in such notice, which date shall not be less then sixty
(60) days after giving such notice. If such notice is given, this Lease shall
expire and any interest of Tenant in the Premises shall terminate on the date
specified in such notice and the rent, reduced by an equitable reduction based
upon the extent, if any, to which such damage materially interfered with
Tenant's business in the Premises, shall be paid to the date of such
termination, provided that if such uninsured damage is due to the act or
omission of Tenant or Tenant's agents, employees, contractors, licensees or
invitees, Tenant shall not be entitled to any reduction in rent.
If in Landlord's judgment, Landlord determines not to repair or restore
the Premises, notwithstanding the availability of insurance proceeds for that
purpose, Landlord shall so notify Tenant and this Lease shall be terminated
effective as of the date of the damage.
26. GENERAL PROVISIONS:
A. Captions; Exhibits, Defined Terms.
(i) The captions of the sections and paragraphs of this Lease are
for convenience only and shall not be deemed to be relevant in resolving any
questions of interpretation or construction of any section of this Lease.
(ii) Exhibits attached hereto, and addendums and schedules
initialed by the parties, are deemed by attachment to constitute part of this
Lease and are incorporated herein.
(iii) The words "Landlord" and "Tenant" as used herein shall
include the plural as well as the singular. Words used in neuter gender include
the masculine and feminine and words in the masculine and feminine gender
include the neuter. The term "Landlord" shall mean only the owner or owners at
the time in question of the fee title or of the tenant's interest in a ground
lease covering the Premises.
B. Entire Agreement. This instrument, along with any exhibits and
attachments hereto, constitutes the entire agreement between Landlord and
Tenant relative to the Premises and their agreement to lease the Premises, and
this Lease, the exhibits and attachments may be altered, amended or revoked only
by
<PAGE> 15
an instrument in writing signed by both Landlord and Tenant. Landlord and
Tenant agree hereby that all prior or contemporaneous oral agreements between
and among themselves and their agents or representatives relative to the leasing
of the Premises are merged in or revoked by this Lease.
C. Severability. If any term or provision of this Lease is, to any
extent, determined by a court of competent jurisdiction to be invalid or
unenforceable, the remainder of this Lease shall not be affected thereby, and
each term and provision of this Lease shall be valid and be enforceable to the
fullest extent permitted by law; provided, however, that if Tenant's obligation
to pay the rent (or other sums required to be paid by Tenant hereunder) is
determined to be invalid or unenforceable, then this Lease at the option of
Landlord shall terminate.
D. Time; Joint and Several Liability. Time is of the essence of this
Lease and each and every provision hereof, except as to the conditions relating
to the delivery of possession of the Premises to Tenant. All the terms,
covenants and conditions contained in this Lease to be performed by either
party shall be deemed to be material, and all rights and remedies of the parties
shall be cumulative and nonexclusive of any other remedy at law or in equity.
E. Binding Effect; Choice of Law. The parties hereto agree that all
provisions hereof are to be construed as both covenants and conditions as
though the words importing such covenants and conditions were used in each
separate paragraph hereof. Subject to any provisions hereof restricting
assignment or subletting by Tenant and subject to Paragraph 16, all of the
provisions hereof shall bind and inure to the benefit of the parties hereto and
their respective heirs, legal representatives, successors and assigns; provided,
however, that the obligations contained in this Lease to be performed by
Landlord shall be binding on Landlord's successors and assigns only during their
respective periods of ownership. This Lease shall be governed by the laws of the
State of California.
F. Waiver. No covenant, term or condition or the breach thereof shall
be deemed waived, except by written consent of the party against whom the
waiver is claimed, and any waiver of the breach of any covenant, term or
condition shall not be deemed to be a waiver of any preceding or succeeding
breach of the same or any other covenant, term or condition. Acceptance by
Landlord of any performance by Tenant after the time the same shall have become
due shall not constitute a waiver by Landlord of the breach or default or any
covenant, term or condition unless otherwise expressly agreed to in writing by
Landlord.
G. Interest on Past Due Obligations. Except as expressly herein
provided, any amount due to Landlord not paid when due shall bear interest from
the date due at the highest rate then permitted under California law. Payment
on such interest shall not excuse or cure any default by Tenant under this
Lease.
H. Notices. All notices or demands of any kind required or desired
to be given by Landlord or Tenant hereunder shall be in writing and shall be
deemed delivered upon personal delivery or forty-eight (48) hours after
depositing the notice or demand in the United States mail, certified, or
registered postage prepaid, addressed to Landlord or Tenant at the respective
addresses set forth as follows:
To LANDLORD:
ALPINE INSURANCE COMPANY
an Illinois corporation
P.O. Box 350
2029 Village Lane
Solvang, CA 93463
<PAGE> 16
To TENANT:
ROB ROSENBERRY
2028 Village Lane
Solvang, CA 93463
I. Corporate Authority - Warranty. If Tenant is a corporation, each
individual executing this Lease on behalf of said corporation represents or
warrants that he is duly authorized to execute and deliver this Lease on behalf
of said corporation in accordance with a duly adopted resolution of the board
of directors of said corporation or in accordance with the bylaws of said
corporation, and that this Lease is binding upon said corporation in accordance
with its terms. If Tenant is a corporation, Tenant shall, within thirty (30)
days after execution of this Lease, deliver to Landlord a certified copy of a
resolution of the board of directors of said corporation authorizing or
ratifying the execution of this Lease. Tenant shall execute any warranty of
lease that is requested/required by Landlord.
J. Contaminants. Tenant warrants that it shall not make any use of the
Premises which may cause contamination of the soil, sub-soil or ground water.
Tenant shall not keep, or cause to be kept in, on or around the Premises any
substance controlled by any government or quasi-governmental regulatory agency
unless Tenant stores and handles said substance in strict compliance with any
and all applicable laws, rules and regulations. Tenant will remove said
substances in the legally prescribed manner when Tenant's occupancy is
terminated. Tenant shall not do, bring or keep anything in, on or around the
Premises which will cause a cancellation of any insurance covering the
Premises.
K. Execution and Delivery of Lease. Tenant's signature on this
Lease constitutes an offer which shall not be deemed accepted by Landlord until
Landlord has executed this Lease and delivered an executed copy to Tenant.
L. General Interpretation. The terms of this Lease have been
negotiated by the parties hereto and the language used in this Lease shall be
deemed to be the language chosen by the parties hereto to express their mutual
intent. This Lease shall be construed without regard to any presumption or rule
requiring construction against the party causing such instrument of any portion
thereof to be drafted, or in favor of the party receiving a particular benefit
under the Lease. No rule of strict construction will be applied against any
person.
M. Quiet Enjoyment. Landlord covenants and agrees with Tenant that
upon Tenant's payment of rent and other monetary sums due under this Lease and
performance of its covenants and conditions under this Lease, Tenant shall and
may peacefully and quietly have, hold and enjoy the Premises for the Lease
Term, subject however to the terms of this Lease.
<PAGE> 17
IN WITNESS WHEREOF, Landlord and Tenant have executed this Lease with the
respective dates shown below:
LANDLORD: TENANT:
ALPINE INSURANCE COMPANY,
an Illinois corporation /S/ Robert A. Rosenberry
--------------------------------------
By: /S/ Sharon S. Bannister ROB ROSENBERRY
-----------------------
Title: AVP Admin Services Dated: 4/3, 1998.
-----------------------
Dated: 4/3, 1998.
<PAGE> 18
EXHIBIT "A"
Diagram for 2028 Village Lane, Santa Barbara County, Solvang, California
labeled "GROUND FLOOR PLAN" showing Tenant's Premises of Landlord's building
outlined.
<PAGE> 19
EXHIBIT "B"
Unlabeled diagram of parking structure at 2028 Village Lane, Santa Barbara
County, Solvang, California indicating designated parking spaces to be used by
Tenant, his employees, patients, clients, invitees and guests.
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