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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
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FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND
EXCHANGE ACT OF 1934 [FEE REQUIRED]
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES AND EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NO. 1-12800
EXECUTIVE RISK INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
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DELAWARE 06-1388171
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
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82 HOPMEADOW STREET, SIMSBURY, CT 06070-7683
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (860) 408-2000
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SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
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TITLE OF CLASS NAME OF EXCHANGE ON WHICH REGISTERED
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Common Stock, $.01 par value New York Stock Exchange
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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 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. [ X ]
The aggregate market value on March 17, 1998 of the voting stock held by
non-affiliates of the registrant was approximately $730,089,000. There were
10,886,987 shares of the registrant's Common Stock, $.01 par value outstanding,
as of March 17, 1998.
DOCUMENTS INCORPORATED BY REFERENCE
(1) Portions of the 1997 Annual Report to Shareholders, as indicated herein
(Part II).
(2) Proxy Statement involving the election of directors and other matters which
the registrant intends to file with the Commission within 120 days after
December 31, 1997 (Part III).
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EXECUTIVE RISK INC.
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TABLE OF CONTENTS
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PAGE
ITEM NUMBER
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PART I
1. Business.................................................... 1
2. Properties.................................................. 17
3. Legal Proceedings........................................... 17
4. Submission of Matters to a Vote of Security Holders......... 18
PART II
5. Market for the Registrant's Common Stock and Related
Stockholder Matters....................................... 18
6. Selected Financial Data..................................... 18
7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 18
7A. Quantitative and Qualitative Disclosures About Market
Risk...................................................... 19
8. Financial Statements and Supplementary Data................. 19
9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosures................................. 19
PART III
10. Directors and Executive Officers............................ 19
11. Executive Compensation...................................... 19
12. Security Ownership of Certain Beneficial Owners and
Management................................................ 19
13. Certain Relationships and Related Transactions.............. 19
PART IV
14. Exhibits, Financial Statement Schedules and Reports on Form
8-K....................................................... 19
Signatures......................................................... 20
Exhibit Index...................................................... 21
Index to Financial Statements and Schedules........................ 23
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The Private Securities Litigation Reform Act of 1995 provides a "safe
harbor" for forward-looking statements. This Form 10-K, the Company's Annual
Report to Stockholders, any Form 10-Q or any Form 8-K of the Company or any
other written or oral statements made by or on behalf of the Company may include
forward-looking statements which reflect the Company's current views with
respect to future events and financial performance. These forward-looking
statements are subject to uncertainties and other factors that could cause
actual results to differ materially from such statements. These uncertainties
and other factors (which are described in more detail elsewhere in this Form
10-K) include, but are not limited to, uncertainties relating to cyclical
industry conditions, uncertainties relating to governmental and regulatory
policies, the legal environment, the uncertainties of the reserving process, the
competitive environment in which the Company operates, the uncertainties
inherent in international operations, interest rate fluctuations and
uncertainties related to the Company's possible entrance into new insurance
lines and new geographic markets. The words "believe," "expect," "anticipate,"
"project," and similar expressions identify forward-looking statements. Readers
are cautioned not to place undue reliance on these forward-looking statements,
which speak only as of their dates. The Company undertakes no obligation to
publicly update or revise any forward-looking statements, whether as a result of
new information, future events or otherwise.
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PART I
ITEM 1. BUSINESS
The Specialty Insurance Industry
General. Executive Risk Inc. ("ERI" or the "Company") is a specialty
insurance holding company incorporated under the laws of Delaware. Through its
subsidiaries, ERI develops, markets and underwrites specialty insurance
products, principally professional liability coverages but also crime, inland
marine and other property-casualty lines. The Company's business is primarily
domestic, conducted in all United States jurisdictions, with a wholly-owned
Dutch subsidiary, Executive Risk N. V. ("ERNV"), marketing certain of the
Company's product lines internationally, principally in the European Community.
The core business lines are directors and officers liability insurance ("D&O")
and professional liability insurance, also known as errors and omissions
liability insurance ("E&O"), which includes malpractice for law firms and health
care providers. Company subsidiaries also offer fidelity bonds and fiduciary
liability insurance to financial institutions and other entities, employment
practices liability insurance for entities and their employees, media liability
coverage to publishing and broadcasting businesses, as well as some automobile
and general liability coverage in connection with program relationships.
The Company is committed to diversifying its book of business both within
and outside the specialty liability arena. In 1996, the Company introduced a
product for technology maintenance and repair coverage for hospitals and
clinics, as well as health care stop-loss arrangements for medical professionals
and medical malpractice liability coverage for hospitals and other health care
institutions. In the last quarter of 1997, an agreement was entered into with an
unaffiliated California-based underwriting agency which issues, on behalf of a
Company subsidiary, automobile liability insurance on a limited basis in the
"non-standard" market. Though the Company intends that the sale of domestic D&O
and E&O products will remain the principal sources of Company revenue for the
foreseeable future, it is expected that such businesses will be supplemented
with other lines of property-casualty insurance in the United States, as well as
with increased writings of D&O and E&O through ERNV in the European Community.
There can be no assurance, however, as to whether the Company will in fact enter
into any such new lines of insurance or, if it does, as to the timing thereof.
Both D&O and E&O are designed to protect insureds against lawsuits and
associated legal defense expenses. In connection with D&O coverage of for-profit
corporations, such liabilities can arise from claims by customers, vendors,
competitors and former employees, although the most severe liabilities have
historically arisen from lawsuits by stockholders alleging director or officer
failure to discharge duties to the corporation or violations of federal
securities laws. In the case of not-for-profit organizations, the Company's
coverage is often implicated in employment practices litigation. E&O is most
often sold to professionals, such as attorneys, health care providers,
psychologists and insurance agents, among others, where the principal sources of
potential claims are dissatisfied clients alleging breaches of professional
standards or ethical violations.
Fiduciary liability coverages are intended primarily to protect those who
invest and administer benefit plan trusts, and fidelity insurance policies (or
crime coverage) insure against losses associated with employee theft and other
types of dishonesty. Employment practices liability insurance, which is
available to cover both the employing organization and its supervisors, insures
against losses associated with employee claims such as sexual harassment,
wrongful termination and discriminatory treatment. Non-standard automobile
insurance is offered to higher-risk insureds in states, like California, where
liability insurance is required in order to register a vehicle. The Company's
non-liability related products are Systems Rx, a service contract and cost
management product for owners of high-tech diagnostic equipment and related
health care technology, and providers' excess which is a stop-loss policy for
doctors enrolled in managed care organizations that receive revenues for
services under the capitation method, which limits such revenues on a per
patient basis.
The D&O Industry. Under various state laws, corporations are authorized to
indemnify their directors and officers against legal claims arising in
connection with their work on behalf of the corporation. In order to attract and
retain qualified directors and officers, corporations purchase D&O, which
typically covers the corporate entity, but only to the extent that it
indemnifies officers and directors. D&O policies have
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traditionally also contained a provision that covers officers and directors
directly, in order to insure against losses for which the corporation is legally
or financially unable to indemnify. In recent years, many D&O insurers,
including the Company, have begun to offer another form of coverage, so-called
"entity coverage," which protects the corporation for limited classes of legal
liability, even when directors and/or officers are not named as defendants in
the claim.
The demand for D&O insurance grew dramatically in response to increased
activity in corporate mergers and acquisitions during the late 1970's and the
1980's and the attendant increase in shareholder lawsuits. By the mid-1980's, a
number of carriers, having suffered large losses in this line of business, had
reduced their D&O activities or had ceased offering D&O coverage altogether,
resulting in a shortage of capacity or a "hard market" for D&O. The Company's
subsidiary, Executive Re Inc. ("Executive Re"), was formed in late 1986, largely
due to the decrease in D&O capacity. Today, the D&O market has softened
significantly, as competition has become robust during the 1990's. Company
management believes that a relatively small number of U.S. insurers, together
with Underwriters at Lloyd's ("Lloyd's"), currently dominate the D&O market for
larger and medium-sized domestic corporations. Demand within that market should
continue to be impacted by consolidating sectors, such as financial services and
technology, as well as by statutory, regulatory and case law developments that
affect executive liabilities. The Company has identified opportunities for
growth in D&O demand in the domestic not-for-profit sector, as well as among
non-bank financial institutions, corporations contemplating initial public
offerings, small, privately-held commercial entities and in the European
Community, where shareholder-initiated litigation is a relatively new, but
growing, phenomenon due principally to the increase in the trading of American
Depository Receipts ("ADRs") of foreign companies on U.S. exchanges.
Historically, the single largest risk for which corporations purchased D&O
insurance coverage has involved shareholder-based suits, either in the form of
derivative actions under state corporation laws or in the form of class actions
for securities fraud under Rule 10b-5 of the Securities and Exchange Commission
("SEC"), promulgated under the Securities Exchange Act of 1934. In December
1995, Congress passed the Private Securities Litigation Reform Act of 1995,
which has a number of provisions purporting to affect the ability of private
litigants to prosecute securities fraud suits. The Company's management believes
that the effects of this legislation on the demand for D&O and upon the
frequency and severity of D&O claims have so far been negligible. It is likely
to be many years in the future before the actual impact of this legislation on
the D&O industry is known.
E&O Insurance. The E&O insurance industry tends to be more fragmented and
regionalized than the D&O industry, since the risks underwritten vary
significantly depending on the nature of the profession and the geographic area
in which it is practiced. Management believes that success in E&O is
particularly dependent on knowledgeable underwriting and on well-conceived
distribution and claims handling systems. ERI's subsidiaries offer E&O coverage
to a wide variety of professional classes, with major classes that include:
large and medium-size law firms, medium-size accounting firms, psychologists,
insurance agents, property managers, home inspectors, real estate title and
closing professionals and mortgage brokers. In addition, E&O products are
available to financial institutions and health care organizations.
The Company's underwriting for E&O business is divided among the
Professional Firms unit, encompassing the Lawyers' Professional Liability
("LPL") and Accountants' Professional Liability ("APL") product lines, the
Health Care unit, which writes medical malpractice for hospitals and E&O for
managed care organizations ("MCOs"), and the Miscellaneous Professional
Liability ("MPL") unit, which encompasses a wide array of professionals
including insurance agents, real estate professionals and home inspectors. The
Professional Firms unit's LPL and APL policies are underwritten by
Company-employed professionals, most of whom have some large law firm
experience. Policies for hospitals and MCOs are underwritten by Company staff at
the Company's headquarters in Connecticut, as well as through Sullivan Kelly
Inc. ("Sullivan Kelly"), a California-based brokerage and underwriting
management firm acquired in September 1997. Policies issued through the MPL unit
are generally underwritten directly by Company-employed underwriters. However, a
growing percentage of Company E&O coverage is being written through outside
brokerage firms, known as program administrators, which have experience and
expertise with respect to a
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specific class of risk and with which the Company has entered into written
contractual agreements (see "Markets -- Errors and Omissions Insurance").
The Company
History. The Company's subsidiary, Executive Re, was formed in 1986 by The
Aetna Casualty and Surety Company ("Aetna," now a subsidiary of Travelers
Property Casualty Corp.) and certain other institutional investors to capitalize
on the deficiency of insuring capacity which then existed in the D&O industry.
It commenced operations in 1987. During its first five years, Executive Re
established an underwriting and marketing infrastructure for the provision of
D&O coverage through an insurance facility (the "Facility") with Aetna.
Executive Risk Management Associates ("ERMA"), a Connecticut general partnership
initially owned 30% by Executive Re and 70% by Aetna, was formed to market and
underwrite D&O insurance policies. Executive Risk Indemnity Inc. ("ERII"), a
Delaware insurance company, was acquired to reinsure D&O policies for which
Aetna was the direct insurer. In 1991, Executive Re took steps to expand
domestically into E&O markets on a niche basis, and in 1993, began its overseas
marketing efforts through a joint venture, known as UAP Executive Partners
("UPEX"), owned 50% by the Company and 50% by Union de Assurance de
Paris -- Incendie Accidents, a large French insurance company. UPEX was
dissolved as of December 31, 1997, and the Company now utilizes ERNV for access
to the European markets (see below).
Ownership and Structure. The Company was formed in August 1993 in
anticipation of a reorganization transaction (the "1994 Transaction"),
consummated on January 1, 1994. As a result of the 1994 Transaction, ERI now
owns Executive Re, and together the two own 100% of ERMA. The Company is the
indirect holding company of the Executive Re subsidiaries, which now include
ERII, as well as ERII's Connecticut domiciled insurance company subsidiaries,
Executive Risk Specialty Insurance Company ("ERSIC") and Quadrant Indemnity
Company ("Quadrant"). ERII, ERSIC and Quadrant are referred to herein as the
"Insurance Subsidiaries," and Executive Re also owns Executive Risk (Bermuda)
Ltd. ("ER Bermuda"), a Bermuda insurer formed in 1997 primarily to reinsure ERII
business. Further, the 1994 Transaction modified the Facility, permitting the
Insurance Subsidiaries to underwrite D&O insurance directly. With the completion
of the 1994 Transaction and ERI's initial public stock offering in March 1994,
the Company became a publicly-owned insurance holding company, with Aetna owning
approximately 4.5 million shares and an option to purchase 100,000 shares at a
price of $12.00 per share (the "Aetna Option"), or approximately 40% of the
Company's capital stock.
In March 1996, the Company entered into a Stock Purchase Agreement (the
"Stock Purchase Agreement") with Aetna and its then-parent, Aetna Life and
Casualty Company ("AL&C"). On March 26, 1996 (the "Repurchase Closing Date"),
the Company purchased from Aetna approximately 2.5 million shares of capital
stock at a price of $29.875 per share, or approximately $75 million in the
aggregate. For approximately two and a half months following the Repurchase
Closing Date, AL&C continued to own 2,000,000 shares of the Company's Common
Stock, representing approximately 22% of the then issued and outstanding amount.
In accordance with the Stock Purchase Agreement, the Company filed with the SEC
a Form S-3 Registration Statement, under which it registered for public sale all
2,000,000 of AL&C's remaining shares. In connection with this secondary
offering, the Company also registered 300,000 newly issued shares. The
underwritten public offering closed on June 7, 1996, on which date the 2,300,000
shares were sold at the price of $34.00 per share. Upon closure of such
secondary offering, neither Aetna nor AL&C have any ownership interest in the
Company, other than the Aetna Option.
The 1997 Facility Restructuring. Until early 1997, D&O business was
primarily conducted through the Facility, consisting of Aetna, ERII and ERSIC,
each of which acted as an insurer or reinsurer, and ERMA, which acted as the
product developer, marketer and managing underwriter. The Facility had operated
under the terms of a number of related agreements, under which Aetna had
authorized ERMA to underwrite and issue, on behalf of Aetna, policies of D&O
insurance, financial institution trust department errors and omissions insurance
("Trust E&O"), and certain other insurance ("Other Lines"; collectively with D&O
and Trust E&O, the "Aetna Lines"), all in accordance with prescribed
underwriting guidelines and within defined liability limits. Under this
arrangement, ERMA had the exclusive right and authority to issue D&O insurance
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on behalf of Aetna in North America, an exclusivity binding on Aetna, but not
binding on Aetna's new parent, Travelers Property Casualty Corp. Generally,
where Aetna's policies had been issued, Aetna had ceded 50% of gross D&O
liability to ERII on a quota share basis, with other specified percentages
applicable to non-D&O policies. Where an Insurance Subsidiary's policy had been
issued, 12.5% of the gross D&O liability had been ceded to Aetna on a quota
share basis. For each reinsured policy, the reinsuring entity had received
premium from the reinsured entity and had been obligated to pay a ceding
commission to the reinsured entity.
On February 13, 1997, the Company announced a restructuring (the
"Restructuring") of its relationship with Aetna. In connection with the
Restructuring, the Pre-restructuring agreements were terminated and replaced
with the following agreements: (a) a Restructuring Agreement, dated February 13,
1997 (the "Restructuring Agreement") by and among the Company, and its
subsidiaries, Executive Re, ERII, ERSIC and ERMA (collectively, the
"Subsidiaries"), and Aetna and its subsidiary, Aetna Casualty & Surety Company
of Canada; (b) an Agency and Insurance Services Agreement, dated as of January
1, 1997, between Aetna and ERMA (the "1997 Agency Agreement"); and (c) a Quota
Share Reinsurance Agreement, dated as of January 1, 1997, between Aetna and ERII
(the "1997 Reinsurance Agreement"). Pursuant to the 1997 Agency Agreement, ERMA
retains the right and authority, on a non-exclusive basis, to (i) renew on Aetna
paper all policies of Aetna Lines written or quoted prior to February 13, 1997,
and (ii) underwrite and issue new policies of Aetna D&O in the United States in
accordance with existing underwriting guidelines and specified limitations on
limits of liability. The 1997 Agency Agreement provides that annual gross
premium volume written by ERMA with respect to Aetna Lines must not exceed an
aggregate amount equal to the lesser of (x) 10% of the sum of the Company's
total direct gross D&O premiums plus the total direct gross D&O premiums written
by ERMA on Aetna policies under the 1997 Agency Agreement and (y) $25 million.
The Company currently expects that it will underwrite and issue Aetna policies
aggregating lower premium volumes than the maximums permitted under the 1997
Agency Agreement. Unless terminated sooner in accordance with its terms, the
1997 Agency Agreement will remain in effect through December 31, 1999 (subject
to possible extension; see paragraph (e) below).
Prior to January 1, 1997, a 12.5% quota share participation had been ceded
to Aetna in generally all direct D&O business written on ERII and ERSIC
policies. Under the Restructuring Agreement, effective as of January 1, 1997,
Aetna no longer participates in the Company's direct D&O business by way of
reinsurance. During 1996, the Company's direct D&O business totaled
approximately $225 million. Additionally, under prior to January 1, 1997, ERII
had a 50% quota share participation in generally all business written on Aetna's
behalf by ERMA. Pursuant to the Restructuring Agreement, as of January 1, 1997,
ERII has a 100% quota share participation in all Aetna Lines business written by
ERMA on behalf of Aetna. Under the 1997 Reinsurance Agreement, Aetna receives a
ceding commission equal to actual producers' commissions plus 3.5% of gross
written premiums, less return premiums, as an allowance for premium taxes and
other costs and expenses incurred by Aetna in connection with the business
covered under that agreement.
In addition to modifying the agency and reinsurance relationships, the
Restructuring Agreement provided for the following:
(a) Mr. Joseph P. Kiernan, an officer of Aetna, resigned from the
Boards of Directors and Partnership Committee, as the case may be, of the
Company, the Insurance Subsidiaries and ERMA, and Aetna no longer has any
election or nomination rights with respect to the Boards of Directors or
Partnership Committee of the Company and its Subsidiaries;
(b) all restrictions on the Company's premium volume (other than as to
the business written on Aetna policies as described above) and any
remaining Aetna consent requirements for the Company's corporate governance
were terminated;
(c) the Company agreed to secure a portion of Aetna's reinsurance
receivable from ERII by means of providing Aetna with a standby letter of
credit in an amount of not more than $25 million, subject to adjustment in
the event of certain contingencies;
(d) Aetna, on behalf of itself and its subsidiaries and certain
affiliates, agreed that for a period of two years it will not solicit the
Company's (or any Subsidiary's) underwriters for employment; and
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(e) the parties have mutually agreed to meet in 1999 to discuss the
possibility of entering into another agency relationship with respect to
D&O beyond December 31, 1999.
Under the Restructuring, the Company and its Subsidiaries relinquished the
exclusive right to underwrite and issue D&O on Aetna policies as discussed
above. Consequently, competition for D&O may increase due to the Restructuring.
Management is of the opinion that there are benefits to the Company by virtue of
the Restructuring, principally those flowing from the cessation of Aetna's 12.5%
quota share participation in ERII's and ERSIC's direct D&O business, as
described above.
Markets
Directors & Officers Insurance. ERI's strategy continues to focus on
finding profitable niche opportunities, applying product-development skills and
industry knowledge to specific industry groups and market segments. In addition
to international D&O, which is now underwritten through ERNV, the Company's
domestic insurance subsidiaries market D&O products in the following principal
sectors: Commercial Entities, Financial Institutions, Health Care Entities and
Not-for-Profit Organizations. Based on the 1996 survey of the D&O industry
conducted by Watson Wyatt Worldwide, ERI's management believes that the Company
is one of the leading writers of primary D&O in the United States.
The following table shows the gross D&O premiums written for each of these
sectors for the periods indicated:
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GROSS DOMESTIC D&O PREMIUMS WRITTEN
SECTOR YEAR ENDED DECEMBER 31,
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1997 1996 1995
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(IN THOUSANDS)
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Commercial Entities................................ $140,831 $135,418 $ 88,318
Financial Institutions............................. 55,006 52,579 44,347
Health Care Entities............................... 50,419 36,123 20,677
Not-for-Profit Organizations....................... 28,842 16,714 6,149
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Total.................................... $275,098 $240,834 $159,491
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Within each of the principal D&O sectors, ERI has targeted subsectors and
developed specialized expertise, a strategy that management believes has allowed
ERMA and the Insurance Subsidiaries to develop and adapt their insurance
products more knowledgeably and to underwrite submissions and process claims
more professionally than competing companies. Management also believes that such
expertise, together with a strong reputation for prompt service and responsive
claims handling, alleviates some of the pressure to compete on the basis of
price during a "soft market," such as that which has prevailed within the
industry in recent years. (See "Competition.")
The Commercial Entities sector has traditionally focused on publicly owned,
mid-sized companies, but a number of ancillary products have also emerged out of
this sector. ERI has provided secondary layers of insurance (called "excess
insurance") for larger public companies which purchase primary D&O coverage from
other insurers. Excess insurance covers large losses above the policy limit(s)
of the primary insurance and any lower layer excess policies. During 1997, the
Company introduced a new excess insurance product, known as the Flex(sm) policy,
which is designed to be layered above multiple primary policies covering diverse
liability risks in addition to D&O. Also, in 1993 the Company began to focus on
coverages for small commercial entities (assets under $100 million), and a
product (The Power(sm) policy) specifically designed for the small, non-public
commercial entity was introduced by the Company in late 1995. Another new
commercial product created during 1997 targets private companies about to engage
in an initial public offering.
Within the Financial Institutions sector, the Company maintains
specializations in several sub-sectors, such as community banks (including small
depository institutions with under $250 million in assets), large depository
institutions, investment advisors, mutual fund companies and broker-dealers. The
underwriting of these D&O products is closely aligned with the underwriting of
professional liability, fiduciary and related
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coverages for providers of financial services, all of which are encompassed
within the Company's Financial Institutions unit. The remaining sectors, Health
Care Entities and Not-for-Profit Organizations, include primarily nonprofit
hospitals, MCOs and a wide variety of social service/charitable organizations
(such as foundations, chambers of commerce, etc.).
Errors & Omissions Insurance. Underwriting of E&O, other than professional
firms E&O, has historically been performed within the MPL group, which was
formed in 1992 and oversees the Company's basic line of E&O products. Through
the MPL unit, the Company offers E&O products providing up to $5 million in
coverage to a variety of smaller to medium-sized, independent professionals in a
wide variety of service sectors, including the insurance agency, financial
services and real estate sectors. (Negotiations currently in progress with
reinsurers will likely permit the Company to write up to $25 million in MPL
limits by the second quarter of 1998.) During 1996, the Company refocused its
efforts with respect to financial institution E&O products, such as policies for
mutual fund sponsors, financial advisory firms and related financial industry
participants. As noted above, such products are underwritten with Financial
Institutions D&O by the Financial Institutions unit of the Underwriting
Department.
Following a research and development program, the Company formed the LPL
underwriting group in 1993. Using only attorney-underwriters, this group
initially underwrote E&O only for large law firms (generally those with at least
35 lawyers) on a primary or excess coverage basis. The LPL unit has evolved to
become a Professional Firms unit, the staff of which underwrites risks for
medium size law firms as well as medium size accounting firms. The Company
believes that the use of experienced professionals (including lawyers and
accountants as applicable) in the marketing and underwriting process has proven
to be a successful tactic for approaching firms in the target market. Beginning
in January 1996, a reinsurance program, involving a number of domestic and
international reinsurance markets, became effective, and the Company began to
market LPL policies up to limits of $50 million each loss and $100 million in
the aggregate. (See "Reinsurance.")
The Company's combined D&O and E&O product for health care entities was
introduced in 1996 in recognition of the evolving liability profile of hospital
and MCO managements. In September 1997, the assets of Sullivan Kelly &
Associates, Inc., Insurance Brokers ("SKA"), a writer of malpractice coverage
for health care entities, became available through a bankruptcy, and the Company
acquired such assets for $2.3 million in cash. With principal offices in
Pasadena, and satellite branches in Dallas and Phoenix, this acquisition is
expected by management to help leverage the Company's position as a leading
provider of insurance products to the hospital and health care industry. A new
subsidiary of Executive Re, Sullivan Kelly, was formed to acquire the assets of
SKA and conduct the institutional medical malpractice business, which involves
placing Insurance Subsidiary and third party insurance policies.
Program administration involves contracting with third party producers who,
with special expertise in a specific class of risk, agree to underwrite and, in
most cases, to issue Insurance Subsidiary policies, all within carefully defined
parameters. The Company plans to increase its distribution capabilities through
the use of program administrators. Program administration arrangements could
become a bigger part of the distribution methodology in the coming year. (See
"Marketing.")
International. In December 1997, the Company announced that the UPEX joint
venture, which had been formed in 1993, would terminate as of December 31, 1997.
In connection with the termination, the former joint venture partner has paid to
the Company the amount of $0.7 million in exchange for an agreement by the
Company not to solicit a list of UPEX insureds for a period of one year. The
UPEX facility had been formed to write only D&O in Europe, and during 1997 gross
written premiums by UPEX totaled $21.3 million, in which the Company had a 50%
participation.
The Company plans to continue to serve the European market through policies
underwritten and issued by ERNV. The Dutch subsidiary was founded in 1995,
primarily to participate in a Netherlands-based D&O pool, which participation
ended on December 31, 1996. In February 1998, the Company restructured ERNV,
through the formation of a Netherlands insurance holding company, Executive Risk
International Holdings BV ("ERBV"), to take ownership of ERNV. ERBV was
capitalized in February 1998 through a $6.0 million investment of equity capital
and a $34.0 million loan from Executive Re, which total of $40 million was in
turn
6
<PAGE> 9
contributed to ERNV as equity capital. In addition, the Company applied for and
obtained a group rating for ERNV from A.M. Best and Company Inc. ("Best's"),
thereby extending to it the benefit of the Insurance Subsidiaries' "A
(Excellent)" Best's rating.
With the new capital and surplus and above-referenced Best's rating, the
Company believes that ERNV is positioned to compete for liability insurance
business within the European Community. Offices have been opened in London,
Paris and Rotterdam, and executive and underwriting personnel have been hired.
The re-positioning of ERNV as the Company's outlet in Europe confers several
long-term strategic benefits, including the ability to sell E&O, as well as D&O,
products which was not permitted by the UPEX structure. However, it is not
anticipated that gross written premiums for ERNV in 1998 will equal those
underwritten through UPEX during 1997.
Marketing
The Company's products are distributed principally through licensed
independent property and casualty brokers, excess and surplus lines brokers and
licensed wholesalers. In all, Company policies are produced through several
thousand brokers. In recent years, there have been several mergers involving
large, national insurance firms, and distribution within certain segments of the
Company's business has become more concentrated as a result of such
consolidation. Nonetheless, no single office of any broker or organization
accounted for a material portion of the gross premiums written through ERMA, and
the Company was not dependent on any one broker. Until recently, the Company
serviced domestic brokers only from its Simsbury, Connecticut headquarters and
from a small, health care oriented branch office in metropolitan Chicago.
Beginning in the fourth quarter of 1997, however, the Company has commenced a
new distribution plan, with the opening of small branch offices in New York,
Atlanta, Dallas and San Francisco. Plans for additional offices, including
near-term plans for an additional presence in Chicago, are proceeding. Together
with ERNV's European offices and the offices of Sullivan Kelly, the Company is
substantially increasing its local presence in important regional markets.
Improvements to the Company's product distribution system are regularly under
review to ensure optimal relations with producers and insureds across the
country.
Marketing is conducted in a variety of ways, but is generally targeted at
the agent and broker audience. The Company produces a periodic newsletter which
contains articles of interest to the D&O and E&O industry and which is widely
distributed. Additionally, specific product areas publish newsletters with a
narrower focus which are targeted to insurance issues touching their respective
industries or professions. Advertisements, articles in trade publications,
seminar participations and convention sponsorships are among the other methods
used to market the Company's products. In certain lines, arrangements with
national industry groups or associations have been useful in presenting the
Company's products to target markets. An in-house marketing and communications
staff produces (or oversees production of) all of the Company's public relations
materials. The Company believes that these efforts have resulted in widespread
name recognition of the Company and its products within target markets.
Beginning in 1995, the Company commenced a strategy to create relationships
with insurance agencies with national or regional books of E&O program business.
Under such a "program administration" relationship, the third party entity
becomes the Company's agent to underwrite and issue policies within guidelines
specified by the Company. Program administrators are not authorized to handle or
pay claims or bind reinsurance. The Company conducts due diligence procedures
with respect to potential program administrators prior to entering such
contractual relationships, and it exercises on-going audit rights under the
program administration agreements. As of year-end 1997, seven program
administration relationships were in effect, most of which were for E&O
products. Additional programs are actively being investigated.
Underwriting
The Company's general underwriting philosophy stresses two factors: expert
consideration of complex insurance submissions, and profitability over premium
growth. Accordingly, while the Company seeks to be competitive within its
markets, premiums are based primarily upon specific risk exposure, including
loss experience, rather than primarily upon market factors. The table below sets
forth statutory loss ratios and
7
<PAGE> 10
combined ratios for the periods indicated for the Insurance Subsidiaries and the
property/casualty industry. The Insurance Subsidiaries' specialty products
business is not directly comparable to the business of the property/casualty
industry as a whole.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------------
1997 1996 1995 1994 1993
---- ----- ----- ----- -----
<S> <C> <C> <C> <C> <C>
STATUTORY ACCOUNTING
PRACTICES DATA
- --------------------------------------------
Insurance Subsidiaries
Loss Ratio................................ 67.1% 67.6% 67.4% 67.6% 67.6%
Combined Ratio............................ 95.2 92.7 90.7 97.6 102.1
Industry(1)
Loss Ratio................................ * 78.3 78.9 81.1 79.5
Combined Ratio(2)......................... * 105.9 105.0 107.2 105.7
</TABLE>
- ---------------
* Not available
(1) Source: Best's Aggregates & Averages -- Property-Casualty.
(2) Excludes policyholder dividends.
The Company emphasizes industry specialization within its underwriting
staff, which includes a number of professionals with operational experience from
the industries being underwritten. ERMA's staff of approximately 190
underwriters (at February 28, 1998) are under the supervision of John F.
Kearney. Mr. Kearney has been with the Company since 1987, and is currently
Senior Vice President and Chief Underwriting Officer of ERMA and the Insurance
Subsidiaries. In addition to consulting with members of the underwriting
management team, underwriters regularly consult with members of the Company's
actuarial, claims and legal departments, as they analyze various aspects of a
prospective insured's risk profile. Except with respect to the Company's higher
volume, lower risk not-for-profit business (not including hospitals, where a
Company-developed ratings system is utilized), submissions for D&O and E&O
insurance are underwritten on a risk-by-risk basis.
A large portion of the Company's policies have a one-year term, though the
number of multi-year policies has been growing in recent years. One-year terms
offer the insurer the advantage of re-underwriting and repricing a risk, to take
more frequent account of claims or other changes in the exposure. Multi-year
terms are offered in several situations. The most typical multi-year term is
three years, although for "run-off" insurance coverage, which is often purchased
to protect the directors and officers of an acquired corporation, the policy
will usually be written for the three to six year period following a merger or
acquisition. Most submissions for renewal of an expiring policy are
re-underwritten and re-priced in accordance with the standard underwriting
practices and procedures, which generally do not distinguish between new and
renewal policies.
In all aspects of its operations, and particularly in the underwriting
process, the Company relies heavily on advanced computer technology, including
both purchased and proprietary software. By utilizing down-loaded and on-line
data from government and commercial resources, sophisticated financial modeling
tasks can be performed. Such utilization of technology provides the Company with
what it believes to be a competitive advantage in information-intensive industry
segments, such as banking and large commercial accounts. For not-for-profit D&O
and certain E&O business lines, the use of technology focuses primarily on
maximizing efficiencies in submissions handling and response.
Claims
Claims arising under insurance policies underwritten by the Company are
managed by the Company's Claims department. Because of the nature of the
Company's policies and the persons covered by D&O insurance, claims tend to be
reported soon after the occurrence of a loss or an event representing a
potential loss. Claims personnel are assigned to handle claims based, in part,
on industry specialization. To assist its staff
8
<PAGE> 11
in claims management, the Company has developed a comprehensive automated
electronic claim file system (the "Claims Information System") for administering
and investigating claims, and calculating and updating case reserves. When the
Company receives notice of a loss or potential loss, a claims handler is
assigned to the claim and a claim file is created in the Claims Information
System. This system electronically attaches a copy of the policy file to the
claim file and can also help determine whether there are obvious claim issues,
such as a claim being made outside the policy period. The Claims Information
System automatically composes certain routine correspondence to the insured. All
outgoing correspondence, reports from monitoring counsel and other relevant data
are entered in the Claims Information System claim file.
In reviewing the claim, the Claims Information System, utilizing
staff-entered severity code information relating to various claim
characteristics, helps to ensure objectivity, and consequently consistency, of
claims evaluation. The severity classification assigned to a particular claim
assists in determining the frequency and manner in which the claim is
administered. All significant claims are reviewed at least quarterly. Claims
assigned a high severity code are monitored more frequently and typically
assigned to outside legal counsel for review and monitoring. The Company's
insurance policies have not generally contained a "duty to defend" provision
requiring it to hire attorneys to defend its insureds, although duty to defend
types of policies are becoming an increasingly important part of the Company's
product mix. Even where there is no duty to defend, however, the Company does in
certain instances become closely involved with defense counsel in evaluating
claims and developing litigation management and settlement strategies. The
Company believes that its experience in resolving claims and its proactive
approach to claims management has contributed to the advantageous resolution of
many cases.
Based in part on the claims severity code and other factors developed by
the claims handler (assisted by the Claims Information System), the Claims
department recommends a case reserve for each claim. As more information is
discovered with respect to a claim, the claims handler may recommend an increase
or decrease in case reserves. The Company believes that the claims analysis
permitted by the Claims Information System helps the Company to evaluate claims
and make informed judgments with respect to case reserves promptly. (See
"Reserves.")
Reinsurance
The Insurance Subsidiaries utilize a pooling arrangement to obtain the
benefits of risk diversification. The pooling arrangement also permits the
Insurance Subsidiaries to obtain a pooled rating from Best's and S&P. The
pooling is achieved through interaffiliated reinsurance agreements. ER Bermuda
also provides internal reinsurance to ERII.
The Company has historically used external reinsurance arrangements to
limit the amount of risk retained under policies written or reinsured by the
Insurance Subsidiaries. In general, the Company will more heavily reinsure
(i.e., retain less net risk with respect to) new lines or market segments, until
claims and loss assumptions for the product can be validated. As product lines
become more mature, reinsurance arrangements will evolve toward the Company
retaining a greater share of the loss exposure and the premium.
With respect to D&O, which comprises the majority the risks insured by the
Company, ERI purchased excess-of-loss reinsurance coverage in 1995, 1996 and
1997, which provided 100% reinsurance protection (subject to aggregate limits
and other restrictions) on losses incurred in excess of $2.5 million up to a
limit of $10 million. The treaty was renewed effective January 1, 1998 under
substantially the same terms and conditions as applied in 1997. The Insurance
Subsidiaries have also entered into a D&O quota share reinsurance treaty, with
various reinsurers, covering 90% of losses in excess of $10 million up to (i)
$25 million through February 28, 1997 and (ii) $35 million from and after March
1, 1997, subject in both cases to certain limitations.
By the nature of its market, the LPL product has historically carried the
highest policy limits offered by the Company, i.e., $50 million. This line is
reinsured, through a number of domestic and international markets, in a
combination quota share and excess of loss reinsurance program whereby the
Company retains more of the risk insured on lower limit policies and cedes more
of the risk insured on higher limit policies. The
9
<PAGE> 12
LPL reinsurance program limits the Company's exposure to slightly under $5
million on a policy with a maximum limit of $50 million.
Since the Company, in its role as ceding insurer, remains responsible for
policy claims without regard to the extent the reinsurer does or does not pay
such claims, reinsurers are carefully selected, taking into consideration the
financial stability of a potential reinsurer and its service and claims paying
history. While the Company endeavors to diversify its reinsurance relationships
and to reinsure with financially sound reinsurers, there can be no assurance
that the Company will not experience difficulties in the future in recovering
under these arrangements should one or more of its reinsurers experience
financial difficulties.
The Company's reinsurance programs include material exposure to Lloyd's,
which is a collection of investors (known as "Names") who group together
annually to form syndicates. Lloyd's syndicates have experienced substantial
underwriting losses and decreases in underwriting capacity in the past, and they
underwent a restructuring of liabilities during 1996. The long-term success or
failure of such restructuring could affect Lloyd's syndicates' ability to meet
their reinsurance obligations. The Company, together with its reinsurance
brokers, performs a periodic security analysis of its Lloyd's exposure, and
management believes that the syndicates supporting the Company's reinsurance
programs are financially stable.
For the year ended December 31, 1997, the Company's total ceded premiums
were approximately $169.5 million, of which approximately $57.3 million were
ceded to Lloyd's syndicates. To date, the Company has experienced no reinsurance
recoverable defaults. The availability and cost of reinsurance arrangements are
subject to prevailing market conditions, which are beyond the Company's control.
As a result of these or other factors, the Company may in the future choose to
revise further its reinsurance practices to increase, decrease or eliminate
entirely the amount of risk it cedes to reinsurers.
Primarily due to expense considerations and in light of past experience,
the Company does not purchase "clash" reinsurance protection. Clash coverage
protects the ceding insurer in situations where there are multiple losses --
either in a single line of business or multiple lines of business -- arising out
of a single event.
Reserves
The Company is liable for losses and loss adjustment expenses ("LAE") under
its insurance policies and reinsurance treaties. Both D&O and E&O policies are
generally written on a "claims made" form. In general, a claims made policy
provides for payment with respect to any claim made against the insured during
the policy period with respect to a covered act. In many cases, several years
may elapse between the reporting of the claim or covered act to the Company and
the Company's payment on a related loss. The Company reflects its liability for
the ultimate payment of incurred losses and LAE by establishing loss and LAE
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.
The Company maintains two classes of reserves. When a claim is reported,
the Company establishes an initial case reserve for the estimated amount of the
Company's ultimate losses and LAE. This estimate reflects a judgment, based on
the Company's reserving practices and the experience of the Company's claims
staff, regarding the nature and value of the reported claim. The Company may
periodically adjust the amount of case reserves as additional information
becomes known or partial payments are made. The Company also establishes
incurred but not reported reserves ("IBNR reserves") on an aggregate basis to
provide for future developments on case reserves, as well as for claims reported
to the insured or to the Company but not yet recorded by the Company. IBNR
reserves are established based on the experience of the Company and the
insurance industry generally with respect to the average frequency and severity
of insured events.
Reserves are estimates involving actuarial and statistical projections of
the cost of the ultimate settlement and administration of claims, based on known
facts and circumstances, predictions of future events, estimates of future
trends in claims severity and other variable factors such as inflation and new
concepts of liability. It may be necessary in the future to revise estimated
potential loss exposure, and therefore the Company's loss reserves. During the
claim settlement period, which may be years in duration, additional facts
regarding claims and trends may become known. As the Company becomes aware of
new information, it may refine and adjust its estimates of its ultimate
liability. The revised estimates of ultimate liability may prove to be less than
or greater than the actual settlement or award amount for which the claim is
finally discharged. As a
10
<PAGE> 13
consequence, actual losses and LAE paid may deviate, perhaps substantially, from
estimates reflected in the Company's reserves in its financial statements.
The Company's Insurance Subsidiaries, like other insurance companies, are
subject to the risk of severe or multiple losses, which could significantly
exceed the maximum loss previously assumed. To the extent reserves prove to be
inadequate after taking into account available reinsurance coverage, the Company
augments its reserves, resulting in a current-year charge to earnings. In
addition, loss reserves may prove to be inadequate in the event that a major
part of the Company's reinsurance coverage was to become uncollectible. See
"Reinsurance."
Since 1988, the Company has retained the services of an independent
actuarial consulting firm to provide opinions regarding reserves as required for
state regulatory filings. The Company intends to retain such services in the
future. Although the Company believes that its reserves are adequate, there can
be no assurance that ultimate loss experience will not exceed the Company's
reserves, which may result in a material adverse effect on the Company's
financial condition and results of operations. The following table sets forth a
reconciliation of beginning and ending reserves for unpaid losses and LAE, net
of reserves for reinsured losses and LAE for the years indicated.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------
1997 1996 1995
-------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
Reserves for losses and LAE at beginning of period,
gross.................................................... $457,063 $324,416 $254,758
Reinsurance recoverable at beginning of period............. (76,916) (33,531) (8,958)
-------- -------- --------
Reserves for losses and LAE at beginning of period, net.... 380,147 290,885 245,800
Provision for losses and LAE for current year claims....... 152,042 112,107 83,775
Decrease in estimated ultimate losses and LAE for prior
year claims.............................................. (10,269) (6,772) (5,245)
-------- -------- --------
Total incurred losses and LAE.............................. 141,773 105,335 78,530
Adjustment for foreign exchange loss on unpaid loss and
LAE...................................................... (469) (23) 58
Loss and LAE payments for claims attributable to:
Current year............................................. 4,495 2,239 792
Prior years.............................................. 36,193 13,811 32,711
-------- -------- --------
Total payments............................................. 40,688 16,050 33,503
-------- -------- --------
Reserves for losses and LAE at end of period, net.......... 480,763 380,147 290,885
Reinsurance recoverable at end of period................... 157,166 76,916 33,531
-------- -------- --------
Reserves for losses and LAE at end of period, gross... $637,929 $457,063 $324,416
======== ======== ========
</TABLE>
As shown above, as a result of the Company's normal reserving review, which
includes a reevaluation of the adequacy of reserve levels for prior-years'
claims, the Company reduced its unpaid loss and LAE reserves in 1997 for prior
report years by approximately $10.3 million. The Company does not consider
reserve reductions to represent a trend, and there can be no assurance
concerning future adjustments of reserves, positive or negative, for
prior-years' claims. The procedures used in determining appropriate reserves at
December 31, 1997 were consistent with prior-years' reserving methodologies.
Except for the last seven lines, the following "Development of Reserves"
table presents the development of unpaid loss and LAE reserves, net of
reinsurance, from 1988 through 1997. The last seven lines of the table present
that type of development on a "gross-of-reinsurance" basis for the periods
following the Company's adoption of Statement of Financial Standards No. 113,
"Accounting and Reporting For Reinsurance of Short-Duration and Long-Duration
Contracts," as of January 1, 1993. The top line of the table shows the reserves
for unpaid losses and LAE, net of reinsurance recoverables on unpaid claims, at
the end of each of the indicated years. That net reserve represents the amount
of unpaid losses and LAE for claims arising in the current year and all prior
years that were unpaid at the balance sheet date, including IBNR reserves. The
upper portion of the table also shows the re-estimated amount of the previously
recorded reserves based on experience as of the end of each succeeding year. The
estimate changes as more information becomes known about the frequency and
severity of claims for individual years.
11
<PAGE> 14
DEVELOPMENT OF RESERVES
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------------------------------------------------
1988 1989 1990 1991 1992 1993 1994
------- ------- -------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C> <C>
Reserves for losses and LAE,
net........................... $43,273 $76,277 $111,987 $157,131 $188,438 $209,098 $245,800
Reserves re-estimated as of
end of year:
1 year later................ 42,140 74,787 112,710 156,773 185,391 204,965 240,555
2 years later............... 38,653 70,708 112,333 153,726 181,258 199,720 233,783
3 years later............... 23,846 56,919 111,178 149,593 176,013 192,948 223,687
4 years later............... 10,057 55,764 110,597 144,348 169,241 182,852
5 years later............... 8,899 55,183 105,352 137,576 159,145
6 years later............... 8,916 49,938 100,368 127,480
7 years later............... 8,916 49,236 94,269
8 years later............... 8,916 47,903
9 years later............... 7,583
Cumulative redundancy
(deficiency).................. 35,690 28,374 17,718 29,651 29,293 26,246 22,113
Cumulative paid as of:
1 year later................ $ 50 $ 1,088 $ 9,491 $ 20,075 $ 25,838 $ 26,909 $ 32,711
2 years later............... 449 4,815 26,321 44,814 47,270 56,823 42,851
3 years later............... 1,936 17,977 44,759 61,562 73,100 59,760 63,386
4 years later............... 2,072 26,483 56,572 78,916 75,751 73,053
5 years later............... 2,134 31,157 68,277 79,675 88,198
6 years later............... 4,421 38,435 68,671 84,507
7 years later............... 4,426 38,477 73,558
8 years later............... 4,441 38,749
9 years later............... 4,920
Net reserve -- December 31...... $209,098 $245,800
Reinsurance recoverables........ 6,053 8,958
-------- --------
Gross reserve -- December 31.... $215,151 $254,758
======== ========
Net re-estimated reserve........ 182,852 223,687
Re-estimated reinsurance
recoverables.................. 2,339 9,006
-------- --------
Gross re-estimated reserve...... $185,191 $232,693
======== ========
Gross cumulative redundancy..... $ 29,960 $ 22,065
======== ========
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------
1995 1996 1997
-------- -------- --------
<S> <C> <C> <C>
Reserves for losses and LAE,
net........................... $290,885 $380,147 $480,763
Reserves re-estimated as of
end of year:
1 year later................ 284,113 369,878
2 years later............... 274,017
3 years later...............
4 years later...............
5 years later...............
6 years later...............
7 years later...............
8 years later...............
9 years later...............
Cumulative redundancy
(deficiency).................. 16,868 10,269
Cumulative paid as of:
1 year later................ $ 13,811 $ 36,194
2 years later............... 41,484
3 years later...............
4 years later...............
5 years later...............
6 years later...............
7 years later...............
8 years later...............
9 years later...............
Net reserve -- December 31...... $290,885 $380,147 $480,763
Reinsurance recoverables........ 33,531 76,916 157,166
-------- -------- --------
Gross reserve -- December 31.... $324,416 $457,063 $637,929
======== ======== ========
Net re-estimated reserve........ 274,017 369,878
Re-estimated reinsurance
recoverables.................. 33,536 76,984
-------- --------
Gross re-estimated reserve...... $307,553 $446,862
======== ========
Gross cumulative redundancy..... $ 16,863 $ 10,201
======== ========
</TABLE>
In the Company's early years of operation, the Company had little or no
actual loss experience upon which to calculate reserves. As a result, its
reserving methodologies were based largely on industry data. In recent years,
the Company has developed reserves based upon its own loss experience. While the
Company believes it is now better able to estimate future losses and reserves
than in its early years of operations, there can be no assurance that the
Company's reserves will be sufficient to cover ultimate losses.
Investments
The Company's investment philosophy is to seek optimum total return. This
is done in a manner consistent with what management believes is a generally
conservative investment approach, as evidenced by the portfolio's quality
characteristics, liquidity and diversification. The Company has established
investment guidelines and policies and oversees management of the investment
portfolio through the Finance Committee of the Company's Board of Directors.
Investment policies are approved by its Board of Directors or Finance Committee.
All investments are reviewed periodically by the Finance Committee, and
exceptional investment decisions are submitted for advance approval. In addition
to the specifications in the investment policy statements, all investments of
the Insurance Subsidiaries must meet the applicable state statutory
requirements.
12
<PAGE> 15
The Company's investment policies specify limitations as to type of
investment and exposure to single issuers. Investments currently consist
principally of U.S. Government and Agency securities, corporate and municipal
obligations, mortgage-backed and asset-backed securities, partnership interests,
preferred stocks and common equities (including mutual fund shares). At December
31, 1997, the Company had no direct investments in mortgages or equity real
estate, other than its headquarters building in Simsbury, Connecticut.
Investments in securities backed by the full faith and credit of the U.S.
Government and U.S. Government agencies may be made without limitation.
Additionally, the current Board of Directors guidelines permit 5% of the
Company's invested assets to be in the form of non-investment grade fixed income
securities. At December 31, approximately 2% of the Company's investment
portfolio was allocated to below investment grade bonds.
The following table summarizes the investment portfolio of the Company, by
asset class, as of December 31, 1997.
<TABLE>
<CAPTION>
DECEMBER 31, 1997
--------------------------------------
FAIR VALUE COST(1) PERCENT(2)
---------- ---------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
U.S. Treasury or agency securities.............. $ 50,621 $ 50,237 4.7%
Municipal securities............................ 557,353 532,839 51.4%
Corporate fixed income securities............... 180,401 178,382 16.6%
Mortgage and other asset backed securities...... 121,520 119,203 11.2%
Foreign government securities................... 1,310 1,297 0.1%
Sinking fund preferred stocks................... 23,776 23,092 2.2%
---------- ---------- -----
Total fixed maturities................ 934,981 905,050 86.2%
Equity securities............................... 61,732 42,787 5.7%
Short-term investments and cash................. 88,505 88,505 8.1%
---------- ---------- -----
Total investments and cash............ $1,085,218 $1,036,342 100.0%
========== ========== =====
</TABLE>
- ---------------
(1) Amortized cost for fixed maturities and short-term investments.
(2) Percent of total portfolio, based on fair value.
Except with respect to the 5% allocation approved by the Board of
Directors, new investments in publicly-traded fixed income securities, both
short- and long-term, are restricted to issues that maintain a quality rating
equal or equivalent to BBB/Baa or better from Standard & Poor's ("S&P") or
Moody's Investors Service, Inc. ("Moody's"). Should an investment in the
portfolio be downgraded below this rating, the investment is not necessarily
sold immediately but is closely monitored for further deterioration of credit
quality and the need to write down the book value of the investment. Private
placements or other investments with lower ratings or investments not rated by
those agencies are permitted, if approved by the Finance Committee and reported
to the Board of Directors. Cash and publicly-traded fixed income securities
comprised 88.3% (based on fair value) of the total investment portfolio as of
December 31, 1997. At December 31, 1997, approximately 98% of the Company's
publicly-traded bond portfolio was rated investment grade. The following table
sets forth the composition of the Company's publicly-traded fixed income
securities, by quality rating, as of December 31, 1997.
<TABLE>
<CAPTION>
RATINGS DECEMBER 31,
(S&P/MOODY'S) 1997(1)
------------- ------------
<S> <C>
AAA/Aaa................................................... 50.6%
AA/Aa..................................................... 21.6
A/A....................................................... 17.6
Other..................................................... 10.2
-----
Total............................................. 100.0%
=====
</TABLE>
- ---------------
(1) Based on fair value.
13
<PAGE> 16
The National Association of Insurance Commissioners ("NAIC") has a fixed
income securities rating system that assigns to investment securities certain
ratings, called "NAIC designations," that are used by insurers when preparing
their annual statutory financial statements. The NAIC assigns designations to
publicly-traded and privately-placed securities. Designations assigned by the
NAIC range from 1 to 6, with 1 representing securities of the highest quality.
As of December 31, 1997, 90.8% (based on amortized cost) of the Insurance
Subsidiaries' fixed income investment portfolio was invested in securities rated
1 by the NAIC.
The investment portfolio is designed to provide sufficient liquidity to
enable the Company to satisfy its obligations on a timely basis. Although the
investment guidelines permit investments with a maturity range of up to 30
years, the Company generally invests in the five to fifteen year maturity range.
The following table indicates the composition of the Company's fixed maturity
investments, based on fair value, by time to maturity as of December 31, 1997.
<TABLE>
<CAPTION>
TIME TO DECEMBER 31,
MATURITY 1997
-------- ------------
<S> <C>
0 - 1 year.............................................. 7.9%
1 - 5 years............................................. 33.2
5 - 10 years............................................ 51.8
10+ years............................................... 7.1
-----
Total......................................... 100.0%
=====
</TABLE>
The investment policies of the Company permit hedging activities to
mitigate losses associated with fluctuations in foreign currency. At this point,
the Company has no material foreign currency exposure. The Company's initial
investment of 3 million Dutch guilders in ERNV (see "International") is viewed
as a long-term capital commitment and, as such, is not hedged against
fluctuations in the dollar value of the foreign currency. On February 24, 1998
the Company invested an additional $40 million in ERNV. These funds were
subsequently converted and invested in fixed income securities denominated in
pounds sterling. The Company, in conjunction with its asset managers, closely
monitors relevant foreign exchange market levels given their importance to the
investment performance of non-dollar denominated securities. The Company also
maintains, in twelve different European currencies, $4.2 million (as translated
to U.S. dollars) of loss reserves, which are not hedged against fluctuations in
the value of these currencies. The Company may determine at a future date to
engage in hedging transactions with respect to any foreign currency risk
associated with its international operations, including ERNV.
The Company's assets are invested, subject to the above mentioned statutory
constraints and guidelines, to maximize after-tax investment returns. The
Company attempts to optimize the blend of income from tax-exempt/taxable
securities to achieve maximization of after-tax investment income. The following
table illustrates the breakdown of the portfolio between taxable and tax-exempt
securities as of December 31, 1997.
<TABLE>
<CAPTION>
DECEMBER 31, 1997
--------------------------------
FAIR VALUE PERCENT
---------- -------
(DOLLARS IN MILLIONS)
<S> <C> <C>
Tax-exempt securities..................................... $ 555.6 51.2%
Taxable securities........................................ 529.6 48.8
-------- -----
Total........................................... $1,085.2 100.0%
======== =====
</TABLE>
The Company's investments are managed by Conning Asset Management, Black
Rock Financial Management and Hyperion Capital Management. In addition, the
Company utilizes the investment management services of Vanguard Group.
Regulation
General. As insurance companies, ERII, ERSIC and Quadrant are subject to
supervision and regulation in the states in which they transact business. Such
supervision and regulation, which is designed primarily for the protection of
policyholders and not shareholders, relates to most aspects of an insurance
14
<PAGE> 17
company's business and includes such matters as authorized lines of business;
underwriting standards; financial condition standards; licensing of insurers;
investment standards; premium levels; policy provisions; the filing of annual
and other financial reports prepared on the basis of Statutory Accounting
Practices; the filing and form of actuarial reports; the establishment and
maintenance of reserves for unearned premiums, losses and LAE; transactions with
affiliates; dividends; changes in control; and a variety of other financial and
nonfinancial matters. Additionally, each of ERMA and Sullivan Kelly is subject
to supervision and regulation under state insurance agency laws in the states in
which it does business as an insurance agent. Insurance regulatory authorities
have broad administrative powers to regulate trade practices and in that
connection to restrict or rescind licenses to transact business and to levy
fines and monetary penalties against insurers and insurance agents found to be
in violation of applicable laws and regulations.
Licenses. The Company has obtained insurance company licenses for ERII in
all states other than Colorado, where the application is pending, and
Connecticut, where ERSIC is the licensed entity. ERSIC is licensed as an
insurance company in Connecticut, its state of domicile, and is an eligible
surplus lines insurer in all other states and the District of Columbia. Quadrant
is licensed in Connecticut, its state of domicile, and in the District of
Columbia, with applications pending in numerous additional states. In a small
number of states, the Company's ability to write insurance is limited to its
core liability lines, and the Company is seeking to expand its authority to
include all property/casualty lines in such states. Future flexibility with
respect to certain new products could be limited to the extent that the Company
is unable to secure additional authorized lines of business in these remaining
states.
ERMA, Sullivan Kelly and a number of their employees are licensed under the
insurance agency and brokerage regulations of the various states in which their
operations require such licensure. Such regulations have not limited the
Company's ability to write insurance; however, ERMA's and Sullivan Kelly's
ability to do business in the future is subject to their ability to secure
necessary licenses.
Regulation of Insurance Holding Companies. ERII is incorporated under the
laws of Delaware, and ERSIC and Quadrant are incorporated under the laws of
Connecticut. Delaware and Connecticut, like many other states, have laws
governing insurance holding companies (such as ERI). Under Delaware and
Connecticut law, ERII, ERSIC and Quadrant are each required to register annually
and file certain reports with their respective domiciliary State Insurance
Commissioners. Such reports must include current information concerning the
capital structure, ownership, management, financial condition and general
business operations of the filing subsidiary and must also disclose certain
agreements and transactions between such subsidiary and its affiliates, which
agreements must satisfy certain standards specified in the respective insurance
laws.
Under Delaware law, no person may acquire control of ERII or a corporation
controlling ERII unless such person has filed a statement containing specified
information with the Insurance Commissioner of the State of Delaware (the
"Delaware Commissioner") and the Delaware Commissioner has approved such
acquisition of control. Under Connecticut law, no person may acquire control of
ERSIC or Quadrant or a corporation controlling either of them unless such person
has filed a statement containing specified information with the Insurance
Commissioner of the State of Connecticut (the "Connecticut Commissioner") and
the Connecticut Commissioner has approved such acquisition of control. Under
both Delaware and Connecticut law, any person acquiring, directly or indirectly,
or holding proxies with respect to, 10% or more of the voting stock of any other
person is presumed to have acquired "control" of such person. Accordingly, any
purchase resulting in the purchaser owning 10% or more of the outstanding Common
Stock of ERI would require prior approval of the Delaware and Connecticut
Commissioners. Such prior approval requirement also would apply to an
acquisition of proxies to vote 10% or more of the outstanding Common Stock of
ERI and, therefore, in a proxy contest could delay or prevent a stockholder from
acquiring such proxies. No assurance can be given as to whether or not the
Company would seek to invoke these laws and regulations in the event of a
contested solicitation of proxies.
Under Delaware and Connecticut law, neither ERII, ERSIC nor Quadrant may
enter into certain transactions, including certain reinsurance agreements,
management agreements and service contracts, with members of their insurance
holding company system unless they have notified the applicable State Insurance
15
<PAGE> 18
Commissioner of their intention to enter into such a transaction and the
applicable State Insurance Commissioner has not disapproved of such transaction
within 30 days of such notice. Among other things, such transactions are subject
to the requirements that their terms be fair and reasonable, that charges or
fees for services performed must be reasonable and that the interests of
policyholders not be adversely affected.
Dividend Restrictions. As an insurance holding company, the Company is
dependent on dividends and other permitted payments from the Insurance
Subsidiaries to pay its cash dividends to stockholders, as well as interest and
principal on debt instruments. The ability of ERII, ERSIC or Quadrant to pay
dividends to the Company is subject to Delaware and Connecticut insurance laws,
respectively. See Note 10 of the Notes to Consolidated Financial Statements in
the Company's 1997 Annual Report to Stockholders.
Regulatory Examinations. As part of its routine regulatory process, the
Delaware Insurance Department conducts, typically once every three years, an
examination of ERII. The report with respect to the most recent completed
examination of ERII was issued in December 1995, and covered the period January
1990 through December 1993. The report contained no material adverse findings.
Another triennial examination is scheduled to commence on during the second
quarter of 1998.
ERSIC was incorporated in October 1991, and Quadrant was incorporated in
April 1998. As part of its routine regulatory process, the Connecticut Insurance
Department conducts at the point of initial licensure and, typically once every
five years thereafter, an examination of insurance companies domiciled in
Connecticut. An examination of ERSIC by the Connecticut Insurance Department
commenced in March 1995 and was completed in October 1995. Such examination
covered the period from ERSIC's incorporation through December 31, 1993. There
were no material adverse findings. In addition, an initial examination of
Quadrant was conducted by the Connecticut Insurance Department in July 1997 in
connection with Quadrant's licensure by Connecticut. There were no adverse
findings.
Insurance regulatory authorities of other states in which the Insurance
Subsidiaries hold insurance company licenses may examine the Insurance
Subsidiaries' market conduct within their jurisdictions, and such authorities
are empowered to impose fines or other sanctions where such examinations reveal
deficiencies. To date, only California has completed a market conduct exam. That
exam in 1996 resulted in no material adverse findings. Examiners from the State
of Connecticut conducted a market conduct exam in 1997, but the results thereof
are not yet available. As of the date of this Report, the State of Missouri is
conducting a market conduct examination. Management believes that these
examinations are all in the ordinary course and should not result in material
adverse findings.
The National Association of Insurance Commissioners. In addition to
state-imposed insurance laws and regulations, the Insurance Subsidiaries are
subject to accounting practices and reporting formats established by the NAIC.
The NAIC also promulgates model insurance laws and regulations relating to
insurance companies, which may or may not be adopted by state legislatures or
departments of insurance. However, NAIC model laws and regulations have become
increasingly important in recent years, due primarily to the NAIC's state
regulatory accreditation program. Under this program, virtually all states have
adopted certain required model laws and regulations and meet various staffing
and other requirements and are "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.
IRIS Ratios. The NAIC annually calculates 11 financial ratios to assist
state insurance departments in monitoring the financial condition of insurance
companies. Results are compared against a "usual range" of results for each
ratio, established by the NAIC. Due primarily to their rate of premium growth,
the Insurance Subsidiaries routinely report one or more IRIS ratios outside the
usual range. In addition, it is likely that ERII's entry into an intercompany
quota share reinsurance arrangement with ER Bermuda may cause one or more loss
reserve-based IRIS ratios to be outside the usual range. Management does not
believe that the Insurance Subsidiaries' IRIS ratio results will adversely
affect their ability to write new business.
Capital and Surplus Requirements. The NAIC has developed risk-based
capital ("RBC") formulas to be applied to all insurance companies, which
formulas are used to calculate a minimum required statutory net worth, based on
the underwriting, investment and other business risks inherent in an individual
company's
16
<PAGE> 19
operations. Any insurance company which does not meet threshold RBC levels
ultimately could become subject to increasing levels of regulatory scrutiny and
regulatory action. Implementation of these requirements was required for the
first time in regulatory filings covering fiscal 1994. The formulas for
determining the amount of risk-based capital specify various weighting factors
that are applied to financial balances or various levels of activity based on
the perceived degree of risk. Regulatory compliance is determined by a ratio of
the insurance company's regulatory total adjusted capital to its authorized
control level risk-based capital, both as defined by the NAIC. At December 31,
1997, the total adjusted capital (as defined by the NAIC) of ERII, ERSIC and
Quadrant was in excess of all risk-based capital action levels. The insurance
laws of Delaware and Connecticut limit the retained exposure on any one risk to
10% of capital and surplus. The insurance laws of the Netherlands and Bermuda
impose capital requirements for ERNV and ER Bermuda, respectively, and may limit
these subsidiaries' ability to pay dividends.
Competition
The insurance industry is highly competitive. ERI competes with domestic
and foreign insurers and reinsurers, some of which have greater financial,
marketing and management resources than ERI, and it may compete with new market
entrants in the future. The Company believes its major competitors are American
International Group, Inc. and The Chubb Corporation, who the Company believes
are dominant competitors in the industry. Other competitors include ACE Limited,
Associated Electric & Gas Insurance Services Limited, CNA Financial Corp., EXEL
Limited, Great American Insurance Company, Gulf Insurance Company, Lloyd's
syndicates, PHICO Insurance Company, Reliance Group Holdings, Inc. and Zurich-
American Insurance Company. Competition is based on many factors, including the
perceived financial strength of the insurer, pricing and other terms and
conditions, services provided, ratings assigned by independent rating
organizations (including Best's and S&P), the speed of claims payment and the
reputation and experience of the insurer. Ultimately, this competition could
affect ERI's ability to attract business on terms having the potential to yield
appropriate returns.
Employees
At December 31, 1997 the Company employed approximately 480 full-time
employees. None of the employees is subject to collective bargaining agreements
and the Company knows of no current efforts to implement such agreements. The
Company believes it has a good relationship with its employees.
ITEM 2. PROPERTIES
ERI's executive offices occupy an approximately 120,000 square foot,
two-story office building that the Company owns in Simsbury, Connecticut. The
Company believes that the premises provide adequately for its near-term space
requirements in Connecticut. A four-story 130,000 square foot addition to this
headquarters building is currently under construction to provide for the
long-term needs of the Company. With the new addition, which is expected to cost
approximately $20 million and to be completed in 1999, the Company's
headquarters building will be able to accommodate a total of approximately 1,200
employees.
In addition, the Company leases office space for ERNV in London, Paris and
Rotterdam, and for satellite domestic operations in Atlanta, Chicago, Dallas,
New York, Pasadena, Phoenix and San Francisco. Except for Pasadena, where the
leased premises are 15,700 square feet and provide adequate office space for
approximately 40 employees, the domestic branch offices are generally less than
1,000 square feet and are intended for only two or three employees. The
operations of the Company are supported by local area networks of personal
computers. The local networks are interconnected via telecommunications and
provide services such as electronic mail, desktop faxing, real-time data
communications and batch file transfers.
ITEM 3. LEGAL PROCEEDINGS
The Company is subject to routine legal proceedings in connection with its
general operations and insurance business. The Company does not believe that
these legal proceedings will have a material adverse effect on the Company.
17
<PAGE> 20
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the
fourth quarter of 1997.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
Market Information
The Common Stock, $.01 par value, of Executive Risk Inc. was initially
listed for trading on the New York Stock Exchange ("NYSE") on March 15, 1994
under the symbol "ER". For the periods presented below, the high and low sales
prices of the Registrant's Common Stock on the NYSE were as follows:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
--------------------------------------------------
MARCH 31 JUNE 30 SEPTEMBER 30 DECEMBER 31
-------- ------- ------------ -----------
<S> <C> <C> <C> <C>
1997
- -----
High sales price...................... $48.750 $56.000 $68.375 $72.000
Low sales price....................... $35.625 $43.375 $49.813 $63.500
</TABLE>
<TABLE>
<CAPTION>
THREE MONTHS ENDED
-----------------------------------------------------
MARCH 31 JUNE 30 SEPTEMBER 30 DECEMBER 31
-------- -------- ------------- ------------
<S> <C> <C> <C> <C>
1996
- -----
High sales price..................... $33.625 $38.250 $38.500 $42.375
Low sales price...................... $26.125 $29.250 $33.375 $33.875
</TABLE>
<TABLE>
<CAPTION>
THREE MONTHS ENDED
-----------------------------------------------------
MARCH 31 JUNE 30 SEPTEMBER 30 DECEMBER 31
-------- -------- ------------- ------------
<S> <C> <C> <C> <C>
1995
- -----
High sales price..................... $17.125 $19.000 $23.875 $29.000
Low sales price...................... $13.625 $16.625 $18.375 $22.000
</TABLE>
Stockholders
There were 95 holders of record of shares of the Company's Common Stock as
of March 1, 1998. Approximately 90% of the Registrant's outstanding shares of
Common Stock were held of record by Cede & Co., for an unknown number of
beneficial owners.
Dividends
The Company paid cash dividends of $.02 per share in each quarter of 1997,
1996 and 1995. There is presently no intention to either increase or decrease
the cash dividend on the Company's Common Stock in the foreseeable future.
Future dividends will be dependent upon, among other things, the Company's
earnings, financial condition, capital requirements and general business
conditions.
ITEM 6. SELECTED FINANCIAL DATA
Financial Highlights on the inside front cover of the Company's 1997 Annual
Report to Shareholders is incorporated herein by reference.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Management's Discussion and Analysis of Financial Condition and Results of
Operations on pages 24 through 30 of the 1997 Annual Report to Stockholders is
incorporated herein by reference. See Exhibit 13 hereto.
18
<PAGE> 21
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable to the Company at this time.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following consolidated financial statements of Executive Risk Inc. and
its subsidiaries, included on pages 35 through 52 of the Company's 1997 Annual
Report to Stockholders (see Exhibit 13), are incorporated herein by reference:
-- Consolidated Balance Sheets at December 31, 1997 and 1996.
-- Consolidated Statements of Income for the years ended December 31,
1997, 1996 and 1995.
-- Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1997, 1996 and 1995.
-- Consolidated Statements of Cash Flows for the years ended December
31, 1997, 1996 and 1995.
-- Notes to Consolidated Financial Statements.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES
Not applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
Information concerning the Company's directors and executive officers is
incorporated herein by reference to the caption "Item 1. Election of Directors"
in the definitive Proxy Statement involving the election of directors and other
matters (the "Proxy Statement") which the Company intends to file with the
Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934
not later than 120 days after December 31, 1997.
ITEM 11. EXECUTIVE COMPENSATION
Incorporated herein by reference to the caption "Executive Compensation" in
the Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Incorporated by reference to the caption "Beneficial Ownership of Stock" in
the Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Incorporated by reference to the captions "Certain Relationships and
Related Transactions" in the Proxy Statement.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
Financial Statements and Schedules
The Financial Statements and schedules listed in the accompanying Index to
Financial Statements and Schedules are filed as part of this Report.
Exhibits
The exhibits listed on the accompanying Index to Exhibits are filed as part
of this report.
Reports on Form 8-K
The Company filed no Current Reports on Form 8-K during the quarter ended
December 31, 1997.
19
<PAGE> 22
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON
ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.
EXECUTIVE RISK INC.
(REGISTRANT)
By: /s/ STEPHEN J. SILLS
------------------------------------
STEPHEN J. SILLS,
PRESIDENT AND CHIEF EXECUTIVE
OFFICER
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS
REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE
REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED:
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<C> <S> <C>
/s/ Gary G. Benanav Director March 25, 1998
- -----------------------------------------------------
GARY G. BENANAV
/s/ Barbara G. Cohen Director March 25, 1998
- -----------------------------------------------------
BARBARA G. COHEN
/s/ John G. Crosby Director March 25, 1998
- -----------------------------------------------------
JOHN G. CROSBY
/s/ Robert V. Deutsch Executive Vice President, March 25, 1998
- ----------------------------------------------------- Treasurer, Chief Financial
ROBERT V. DEUTSCH and Accounting Officer, Chief
Actuary and Director
/s/ Patrick A. Gerschel Director March 25, 1998
- -----------------------------------------------------
PATRICK A. GERSCHEL
/s/ Peter Goldberg Director March 25, 1998
- -----------------------------------------------------
PETER GOLDBERG
/s/ Robert H. Kullas Chairman and Director March 25, 1998
- -----------------------------------------------------
ROBERT H. KULLAS
/s/ Michael D. Rice Director March 25, 1998
- -----------------------------------------------------
MICHAEL D. RICE
/s/ Joseph D. Sargent Director March 25, 1998
- -----------------------------------------------------
JOSEPH D. SARGENT
/s/ Stephen J. Sills President, Chief Executive March 25, 1998
- ----------------------------------------------------- Officer and Director
STEPHEN J. SILLS
/s/ Irving B. Yoskowitz Director March 25, 1998
- -----------------------------------------------------
IRVING B. YOSKOWITZ
</TABLE>
20
<PAGE> 23
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT NO.
- -----------
<C> <S> <C>
(3) -- Articles of incorporation and bylaws:
3.1 Amended and Restated Certificate of Incorporation of
Executive Risk Inc., incorporated herein by reference to
Exhibit 3.1 to the Registrant's Current Report on Form 8-K,
filed June 5, 1997.
3.2 Restated Bylaws of Executive Risk Inc., incorporated herein
by reference to Exhibit 3.2 to Registrant's Current Report
on Form 8-K, filed June 5, 1997.
(10) -- Material contracts
10.1 Stock Purchase Option between Executive Risk Inc. and The
Aetna Casualty and Surety Company, incorporated herein by
reference to Exhibit 10.3 to the Registration Statement on
Form S-1 (No. 33-70820) of the Company (herein the
"Registration Statement").
10.2 Rights Agreement between Executive Risk Inc. and Mellon
Bank, N.A., as Rights Agent, incorporated herein by
reference to Exhibit 10.19 to the Registration Statement.
10.3 Executive Risk Inc. Nonqualified Stock Option Plan, as
amended and restated, incorporated by reference to Exhibit
10.7 to the Annual Report on Form 10-K for the fiscal year
ended December 31, 1996 (the "1996 10-K").
10.4 Executive Risk Inc. Employee Incentive Nonqualified Stock
Option Plan, as amended and restated, incorporated by
reference to Exhibit 10.8 to the 1996 10-K.
10.5 Executive Risk Inc. Incentive Compensation Plan,
incorporated herein by reference to Exhibit 10.19 to the
1994 10-K.
10.6 Executive Risk Inc. Retirement Plan, incorporated herein by
reference to Exhibit 10.27 to the Registration Statement.
10.7 Executive Risk Inc. Nonemployee Directors Stock Option Plan,
as amended and restated, filed herewith.
10.9 Supplemental Pension Agreement by and among the Company,
Aetna Life and Casualty Company and LeRoy A. Vander Putten,
dated as of March 31, 1995, incorporated herein by reference
to Exhibit 10.3 to Quarterly Report on Form 10-Q for the
period ended March 31, 1995.
10.10 Executive Risk Inc. Stock Incentive Plan, incorporated
herein by reference to Exhibit 10.25 to the 1996 10-K.
10.11 Executive Risk Inc. Performance Share Plan, incorporated
herein by reference to Exhibit 10.26 to the 1996 10-K.
10.12 Restructuring Agreement, dated as of February 13, 1997, by
and among Executive Risk Inc., Executive Re Inc., Executive
Risk Indemnity Inc., Executive Risk Specialty Insurance
Company, Executive Risk Management Associates, The Aetna
Casualty and Surety Company and Aetna Casualty and Surety of
Canada, incorporated by reference to Exhibit 10.1 to Current
Report on Form 8-K dated February 18, 1997 (the "February
1997 8-K").
10.13 Agency and Insurance Services Agreement, dated as of January
1, 1997, by and between The Aetna Casualty and Surety
Company and Executive Risk Management Associates,
incorporated by reference to Exhibit 10.2 to the February
1997 8-K.
</TABLE>
21
<PAGE> 24
<TABLE>
<CAPTION>
EXHIBIT NO.
- -----------
<C> <S> <C>
10.14 Quota Share Reinsurance Agreement, dated as of January 1,
1997, by and between The Aetna Casualty and Surety Company
and Executive Risk Indemnity Inc., incorporated by reference
to Exhibit 10.3 to the February 1997 8-K.
10.15 Retirement Agreement, dated as of June 1, 1997, between the
Company and LeRoy A. Vander Putten, filed herewith.
10.16 Consulting and Non-Competition Agreement, dated as of June
1, 1997, between the Company and LeRoy A. Vander Putten,
filed herewith.
Executive Risk Inc. 1997 Annual Report to Stockholders; except for
(13) those portions thereof which are expressly incorporated by
reference in the Annual Report on Form 10-K for the year ended
December 31, 1997, the Report to Stockholders is furnished for the
information of the Securities and Exchange Commission only and is
not to be deemed "filed" as part of this Annual Report on Form
10-K.
(21) Subsidiaries of Executive Risk Inc.
(23) Consents of experts and counsel
23.1 Consent of Ernst & Young LLP
23.2 Consent of Ernst & Young LLP
</TABLE>
22
<PAGE> 25
INDEX TO FINANCIAL STATEMENTS AND SCHEDULES
<TABLE>
<CAPTION>
PAGES
-----
<S> <C> <C>
Financial Statements of Executive Risk Inc.
Report of Independent Auditors on Financial Statements...... *
Consolidated Balance Sheets at December 31, 1997 and 1996... *
Consolidated Statements of Income for the years ended *
December 31, 1997, 1996 and 1995..........................
Consolidated Statements of Stockholders' Equity for the *
years ended December 31, 1997, 1996 and 1995..............
Consolidated Statements of Cash Flows for the years ended *
December 31, 1997, 1996 and 1995..........................
Notes to Consolidated Financial Statements.................. *
Schedule(s)
II Condensed Financial Information of Registrant
-- Balance Sheets........................................... S-1
-- Statements of Income..................................... S-2
-- Statements of Cash Flows................................. S-3
</TABLE>
Schedules not listed above have been omitted because they are not applicable or
are not required, or the information required to be set forth therein is
included in the Consolidated Financial Statements or Notes thereto.
- ---------------
* Incorporated by reference to the Executive Risk Inc. 1997 Annual Report to
Stockholders; see Exhibit 13 to this Annual Report on Form 10-K.
23
<PAGE> 26
EXECUTIVE RISK INC. (PARENT COMPANY ONLY)
SCHEDULE II -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1997 1996
-------- --------
<S> <C> <C>
(In thousands)
ASSETS
Fixed maturities available for sale....................... $ 69,243 $ --
Equity securities available for sale...................... 8 --
Cash and short-term investments........................... 49,684 109
-------- --------
TOTAL CASH AND INVESTED ASSETS.................... 118,935 109
Accrued investment income................................. 1,058 --
Intercompany receivable................................... 1,376 815
Investment in subsidiaries and equity investees........... 353,587 206,366
Deferred income taxes..................................... 4,963 3,275
Other assets.............................................. 5,942 6,413
-------- --------
TOTAL ASSETS...................................... $485,861 $216,978
======== ========
LIABILITIES
Senior notes payable...................................... 75,000 --
Note payable to bank...................................... -- 70,000
Debentures payable to Executive Risk Capital Trust........ 128,866 --
Accrued expenses and other liabilities.................... 5,812 2,203
-------- --------
TOTAL LIABILITIES................................. 209,678 72,203
STOCKHOLDERS' EQUITY
Common Stock.............................................. 120 104
Additional paid-in capital................................ 176,234 93,651
Unrealized gain on investments, net of tax................ 31,769 18,382
Currency translation adjustments.......................... (481) (186)
Retained earnings......................................... 101,101 65,384
Cost of shares in treasury................................ (32,560) (32,560)
-------- --------
TOTAL STOCKHOLDERS' EQUITY........................ 276,183 144,775
-------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY........ $485,861 $216,978
======== ========
</TABLE>
S-1
<PAGE> 27
EXECUTIVE RISK INC. (PARENT COMPANY ONLY)
SCHEDULE II -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF INCOME
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------------
1997 1996 1995
------- ------- -------
<S> <C> <C> <C>
(In thousands)
REVENUES
Net investment income..................................... $ 1,162 $ 624 $ 779
Net realized capital gains................................ -- 503 --
------- ------- -------
TOTAL REVENUES......................................... 1,162 1,127 779
EXPENSES
General and administrative expenses....................... 2,385 3,460 2,321
Long-term incentive compensation.......................... -- 187 1,458
Interest expense.......................................... 11,911 4,335 1,893
------- ------- -------
TOTAL EXPENSES......................................... 14,296 7,982 5,672
------- ------- -------
LOSS BEFORE TAXES AND EARNINGS OF SUBSIDIARIES......... (13,134) (6,855) (4,893)
Federal income tax benefit................................ (4,145) (2,543) (2,100)
------- ------- -------
LOSS BEFORE EARNINGS OF SUBSIDIARIES................... (8,989) (4,312) (2,793)
Equity in earnings of subsidiaries........................ 45,514 32,417 28,079
------- ------- -------
NET INCOME............................................. $36,525 $28,105 $25,286
======= ======= =======
</TABLE>
S-2
<PAGE> 28
EXECUTIVE RISK INC. (PARENT COMPANY ONLY)
SCHEDULE II -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------
1997 1996 1995
-------- -------- --------
<S> <C> <C> <C>
(In thousands)
OPERATING ACTIVITIES
Net income............................................... $ 36,525 $ 28,105 $ 25,286
Adjustments to reconcile net income to net cash provided
by (used in) operating activities:
Amortization of bond premium.......................... 119 16 36
Equity used in earnings of subsidiaries............... (45,514) (32,417) (28,079)
Net realized gains on investments -- (503) --
Deferred income taxes................................. (1,662) (1,073) (622)
Amortization of loan arrangement fees................. 910 -- --
Other................................................. 877 (635) (1,450)
Change in:
Accrued investment income........................... (1,058) 263 (146)
Intercompany receivable/payable..................... 5,593 6,737 3,099
Accrued expenses and other liabilities.............. 9,363 587 1,476
-------- -------- --------
Net Cash Provided by (Used in) Operating
Activities..................................... 5,153 1,080 (400)
INVESTING ACTIVITIES
Purchase of fixed maturities available for sale.......... (72,448) (1,379) (10,481)
Proceeds from sales of fixed maturities held for sale.... 3,000 17,661 --
Contribution of capital to Executive Risk Indemnity
Inc................................................... (65,000) (10,870) --
Contribution of capital to Executive Risk Capital
Trust................................................. (3,866) -- --
Contribution of capital to ER (Bermuda) Ltd.............. (20,000) -- --
Distributions from subsidiaries.......................... 303 15,104 14,387
-------- -------- --------
Net Cash (Used in) Provided by Investing
Activities..................................... (158,011) 20,516 3,906
FINANCING ACTIVITIES
Proceeds from exercise of options........................ 4,122 423 241
Cost of repurchase of Common Stock....................... -- (75,025) (3,119)
Placement fees and other................................. (2,827) (1,172) --
Repayment of note payable to bank........................ (70,000) (25,000) --
Note payable to bank..................................... -- 70,000 --
Proceeds from issuance of Senior Notes Payable........... 75,000 -- --
Proceeds from issuance of Common Stock................... 68,080 -- --
Proceeds from Capital Securities offering................ 128,866 -- --
Proceeds from over-allotment option exercise............. -- 9,675 --
Dividends paid on Common Stock........................... (808) (789) (919)
-------- -------- --------
Net Cash Provided by (Used in) Financing Activities........ 202,433 (21,888) (3,797)
-------- -------- --------
Net Increase (Decrease) in Cash and Short-Term
Investments.................................... 49,575 (292) (291)
Cash and short-term investments at beginning of period..... 109 401 692
-------- -------- --------
Cash and Short-Term Investments at End of
Period......................................... $ 49,684 $ 109 $ 401
======== ======== ========
Supplemental Cash Flow Disclosures:
Income taxes paid (received)............................. $ 325 $ (763) $ 70
Interest paid on debt.................................... 6,826 4,131 1,888
</TABLE>
S-3
<PAGE> 1
EXHIBIT 10.15
RETIREMENT AGREEMENT
RETIREMENT AGREEMENT (the "Retirement Agreement"), dated as of June
1, 1997, among EXECUTIVE RISK INC., a Delaware corporation (the "Company"), and
LEROY A. VANDER PUTTEN (the "Executive").
WHEREAS, the Executive is employed as Chairman and Chief Executive
Officer of the Company;
WHEREAS, effective as of May 30, 1997 (the "Retirement Date"), the
Executive's employment with the Company has terminated;
WHEREAS, the parties wish to provide for their mutual rights and
obligations arising from such retirement;
WHEREAS, the parties have entered into a Consulting and
Non-Competition Agreement, dated as of the date hereof (the "Consulting and
Non-Competition Agreement"), pursuant to which the Executive has agreed to
perform consulting services for the Company, upon request, following the
Retirement Date and the Company has agreed to compensate the Executive;
NOW, THEREFORE, in consideration of the mutual promises and
agreements set forth herein and in the Consulting and Non-Competition
Agreement, and other good and valuable consideration, the receipt of which are
hereby acknowledged, the Company and the Executive hereby agree as follows:
1. Incentive Compensation. The Executive shall receive a bonus with
respect to the Company's performance during the 1997 calendar year equal to
5/12 of the amount of the Award he would have received had he been designated
as a Participant under the Executive Risk Inc. Incentive Compensation Plan
(Pool A) (the "Pool A Plan") for the 1997 Plan Year and had he been actively
employed by the Company for the entire 1997 Plan Year. Solely for purposes of
calculating such bonus, the Salary of the Executive shall be deemed to be
$352,0000 and the respective percentages of Salary which will apply if the
Threshold, Target or Maximum objectives for all Key Performance Variables under
the Pool A Plan are met exactly for the 1997 Plan Year are as follows:
<PAGE> 2
Threshold 40%
Target 80%
Maximum 120%
Except as provided herein, all provisions regarding the calculation,
payment and timing of payment of the bonus payable pursuant to this Section 1
shall be determined as if such bonus were payable as an Award under the Pool A
Plan (including, without limitation, the provisions of Paragraph III(f)(3) of
the Pool A Plan pursuant to which the portion of the Award for Plan Year 1997
allocable to the Report Year Loss Ratio shall be paid in 2001).
The Executive shall be entitled to receive payments with respect to the
portion of Awards for Plan Years 1994, 1995 and 1996 allocable to Report Year
Loss Ratio as provided in the Pool A Plan.
All capitalized terms used in this Section 1 which are not otherwise
defined herein shall have the respective meanings ascribed to such terms under
the Pool A Plan.
Section 2. Performance Share Plan. For purposes of determining the number
of Performance Share Units to which the Executive is entitled under the
Executive Risk Inc. Performance Share Plan (the "PSP") with respect to the
1995-1997 and 1996-1998 Performance Periods, the Executive's retirement from the
Company shall be deemed to have occurred on August 31, 1999. Except as provided
herein, all provisions regarding the calculation and payment of such Performance
Share Units shall be made pursuant to the PSP. All capitalized terms used in
this Section 2 which are not otherwise defined herein shall have the respective
meanings ascribed to such terms under the PSP.
Section 3. Stock Options. The stock options currently held by the Executive
shall be governed by the terms of the respective stock option agreements and
stock option plans pursuant to which such options were granted; provided,
however, that, notwithstanding anything to the contrary in the stock option
agreement pursuant to which the Executive was granted options to purchase 16,500
shares of the Company's Common Stock on March 13, 1996 (the "1996 Options"),
vesting of the 1996 Options shall be as follows: options to purchase 4,125
shares became vested on March 13, 1997, options to purchase 4,125 shares will
vest on March 13, 1998, options to purchase 4,125 shares will vest on March 13,
1999 and options to purchase 4,125 shares shall be forfeited.
Section 4. Office. Through May 31, 1998, the Company shall provide the
Executive with the use of an office and shared secretarial services at the
Company's headquarters
2
<PAGE> 3
or, at the Company's discretion, at a location within 15 miles of downtown
Hartford, Connecticut.
Section 5. Medical Benefits. Through their respective 65th birthdays,
the Executive and his spouse shall be entitled to continued coverage under the
Company's medical plan. The Executive shall reimburse the Company for the cost
of providing such benefits based on the amount the Company charges from time to
time for comparable coverage to former employees who are entitled to
continuation coverage pursuant to Section 4980B of the Internal Revenue Code
("COBRA"). The continuation coverage provided pursuant to this Section 5 shall
satisfy all of the Company's COBRA obligations to the Executive.
Section 6. Other Rights and Benefits. Except as specifically provided
herein, this Retirement Agreement shall have no effect on the rights of the
Executive to payments or other benefits due to the Executive pursuant to (i)
clauses B and C (relating to supplemental pension benefits and split dollar life
insurance, respectively) of Appendix A to the Employment Agreement between the
Executive and the Company dated March 31, 1995, or (ii) the terms of any
employee benefit plan, fringe benefit policy or payroll practice of the Company,
including, without limitation, rights in respect of coverage under welfare
benefit plans for periods through the Retirement Date and reimbursement for any
reasonable business expenses incurred through the Retirement Date in accordance
with Company policy.
Section 7. Conditions of Benefits. The Company shall provide to the
Executive the rights, payments and benefits set forth herein as consideration
for and contingent upon the Executive's continued compliance with the
restrictive covenants set forth in Section 4 of the Consulting and
Non-Competition Agreement.
Section 8. Miscellaneous.
A. Complete Agreement. This Retirement Agreement, together with
the rights and benefits provided to the Executive as described in Section 6
hereof, constitutes the entire agreement between the parties and cancels and
supersedes all other agreements and understandings, whether written or oral,
between the parties which may have related to the subject matter contained in
this Retirement Agreement.
B. Modification; Amendment; Waiver. No modification, amendment
or waiver of any provisions of this Retirement Agreement shall be effective
unless approved in writing by both parties. The failure at any time to enforce
any of the provisions of this Retirement Agreement shall in no way be construed
as a waiver of such provisions and shall not affect the right of either party
thereafter to enforce
3
<PAGE> 4
each and every provision hereof in accordance with its terms.
C. Governing Law; Jurisdiction. This Retirement Agreement and
performance under it, and all proceedings that may ensue from its breach, shall
be construed in accordance with and under the laws of the State of Connecticut,
and the parties submit to the jurisdiction of the courts of the State of
Connecticut for purposes of any actions or proceedings that may be required to
enforce this Retirement Agreement.
D. Severability. Whenever possible, each provision of this
Retirement Agreement shall be interpreted in such manner as to be effective and
valid under applicable law, but if any provision of this Retirement Agreement
shall be held to be prohibited by or invalid under applicable law, such
provision shall be ineffective only to the extent of such prohibition or
invalidity, without invalidating the remainder of such provision or the
remaining provisions of this Retirement Agreement.
E. Assignment. The rights and obligations of the parties under
this Retirement Agreement shall be binding upon and inure to the benefit of
their respective successors, assigns, executors, administrators and heirs;
provided, however, that neither the Company nor the Executive may assign any
duties under this Retirement Agreement without the prior written consent of the
other.
F. Notices. All notices and other communications under this
Retirement Agreement shall be in writing and shall be given in person or by
telefax or first class mail, certified or registered with return receipt
requested, and shall be deemed to have been duly given when delivered
personally or three days after mailing or one day after transmission of a
confirmed telefax, as the case may be, to the respective persons named below:
If to the Company: Chairman
Executive Risk Inc.
82 Hopmeadow Street
Post Office Box 2002
Simsbury, Connecticut 06070-
7683
Telefax: 860-408-2502
If to the Executive: LeRoy A. Vander Putten
1076 Main Street
South Windsor, Connecticut
06074
Telefax: 860-528-4374
IN WITNESS WHEREOF, the parties have executed this
4
<PAGE> 5
Retirement Agreement as of the day and year first above written.
COMPANY: Executive Risk Inc.
By /s/ Robert H. Kullas
-----------------------
Its Chairman
----------------------
EXECUTIVE: /s/ LeRoy A. Vander Putten
--------------------------
LeRoy A. Vander Putten
5
<PAGE> 1
EXHIBIT 10.16
CONSULTING AND NON-COMPETITION AGREEMENT
THIS CONSULTING AND NON-COMPETITION AGREEMENT (the "Agreement") dated as of
June 1, 1997, by and between EXECUTIVE RISK INC., a Delaware corporation (the
"Company"), and LeRoy A. Vander Putten ("Vander Putten").
WHEREAS, the Company and Vander Putten have entered into a Retirement
Agreement, dated as of the date hereof (the "Retirement Agreement"), pursuant
to which the parties have made mutual promises and agreements in connection
with Vander Putten's retirement from the Company;
WHEREAS, the Company desires to have Vander Putten available upon request
to assist in the Company's operations, and Vander Putten desires to remain
available to provide such consulting services to the Company;
NOW, THEREFORE, in consideration of the premises and the mutual covenants
and agreements contained herein and in the Retirement Agreement, the parties
hereby covenant and agree as follows:
1. Engagement. Vander Putten shall be available upon request to advise and
counsel management and/or the Board of Directors of the Company at such times
as the Chief Executive Officer, Chairman and/or the Board of Directors of the
Company and Vander Putten may reasonably agree, by telephone, letter or in
person, wherever Vander Putten may be.
During the time that Vander Putten is performing services for the Company
under this Agreement, and for all purposes hereunder, the status of Vander
Putten shall be that of an independent contractor of the Company and Vander
Putten shall not have the benefits, rights and privileges ordinarily accorded
to an employee of the Company.
2. Term. The period of engagement of Vander Putten hereunder shall
commence on June 1, 1997 and shall terminate on August 31, 1999. During the
term of this Agreement as provided herein, Vander Putten may engage in any
business and perform any service for his own account, provided that such
business or service shall not violate any provision of this Agreement.
3. Expenses. During the term of this Agreement, Vander Putten may be
required to incur business expenses in connection with the performance of his
duties hereunder. All such business expenses must be previously authorized by
the Company in writing, and the Company shall reimburse Vander
<PAGE> 2
Putten for all such expenses that are reasonable and are appropriately
documented in accordance with the Company's policies.
4. Noncompetition; Nondisclosure; Nonsolicitation. Vander Putten
hereby agrees that from the date hereof through August 31, 1999 he shall not:
i) engage or participate, directly or indirectly, as an officer,
director, employee, partner or consultant with primary responsibility for
activities in the fields of directors and officers or errors and omissions
liability insurance or reinsurance in the United States of America (a
"Competing Activity"), or in any business which is, or as a result of Vander
Putten's engagement or participation would become, a Competing Activity;
ii) divulge, furnish, or make accessible to anyone (other than in
the ordinary course of his provision of consulting services pursuant to the
Consulting Agreement) any knowledge or information (x) with respect to
confidential or secret business plans, new products, policy forms,
insurance-related technology or other proprietary information of the Company
or any of its Subsidiaries, or (y) with respect to any confidential or
secret development or research work of the Company or any of its
Subsidiaries which, if disclosed, would have a material adverse effect upon
the business or operations of the Company and its Subsidiaries taken as a
whole;
iii) solicit or recruit any officer or employee of the Company or
any of its Subsidiaries to join any other company to engage in a Competing
Activity, or solicit or recruit a substantial number of employees to work
with any company with whom Vander Putten is associated if the departure of
the solicited or recruited employees from the Company or any of its
Subsidiaries would materially harm the Company and its Subsidiaries taken as
a whole; or
iv) engage in or participate in, directly or indirectly, any
business conducted under a name that shall be the same as or similar to the
name of, or any trade name used by, the Company or any of its Subsidiaries.
Vander Putten acknowledges that irreparable damage would result to
the Company if the provisions of this Section 4 are not specifically enforced,
and agrees that the Company shall be entitled to any appropriate legal,
equitable or other remedy, including injunctive relief, in respect of any
failure to comply with the provisions of this Section 4.
2
<PAGE> 3
For purposes of this Section 4, the term "Subsidiary" shall mean (i)
a corporation of which shares of stock having ordinary voting power (other than
stock having such power only by reason of the happening of a contingency) to
elect 50% or more of the board of directors or other managers of such
corporation are at the time owned, directly or indirectly, through one or more
intermediaries, by the Company, or (ii) in the case of unincorporated entities,
any such entity with respect to which the Company has the power, directly or
indirectly, to designate 50% or more of the individuals exercising functions
similar to a board of directors.
5. Fees. Vander Putten shall be entitled to receive from the Company a
fee at the rate of $300,000 per annum, payable in arrears not less frequently
than monthly for the term of this Agreement or until his date of death should
he die during such term.
6. Miscellaneous.
A. Complete Agreement. This Agreement constitutes the entire
agreement between the parties and cancels and supersedes all other agreements
and understandings, whether written or oral, between the parties and between
the Company and Vander Putten which may have related to the subject matter
contained in this Agreement, it being expressly understood that this Agreement
does not cancel or supersede any provision of the Retirement Agreement.
B. Modification; Amendment; Waiver. No modification, amendment
or waiver of any provisions of this Agreement shall be effective unless
approved in writing by both parties. The failure at any time to enforce any of
the provisions of this Agreement shall in no way be construed as a waiver of
such provisions and shall not affect the right of either party thereafter to
enforce each and every provision hereof in accordance with its terms.
C. Governing Law; Jurisdiction. This Agreement and performance
under it, and all proceedings that may ensue from its breach, shall be
construed in accordance with and under the laws of the State of Connecticut,
and the parties submit to the jurisdiction of the courts of the State of
Connecticut for purposes of any actions or proceedings that may be required to
enforce this Agreement.
D. Severability. Whenever possible, each provision of this
Agreement shall be interpreted in such manner as to be effective and valid
under applicable law, but if any provision of this Agreement shall be held to
be prohibited by or invalid under applicable law, such provision
3
<PAGE> 4
shall be ineffective only to the extent of such prohibition or invalidity,
without invalidating the remainder of such provision or the remaining
provisions of this Agreement.
E. Assignment. The rights and obligations of the parties under
this Agreement shall be binding upon and inure to the benefit of their
respective successors, assigns, executors, administrators and heirs; provided,
however, that neither the Company nor Vander Putten may assign any duties under
this Agreement without the prior written consent of the other.
F. Notices. All notices and other communications under this
Agreement shall be in writing and shall be given in person or by telefax or
first class mail, certified or registered with return receipt requested, and
shall be deemed to have been duly given when delivered personally or three days
after mailing or one day after transmission of a confirmed telefax, as the case
may be, to the respective persons named below:
If to the Company: Chairman
Executive Risk Inc.
82 Hopmeadow Street
Post Office Box 2002
Simsbury, Connecticut 06070-7683
Telefax: 860-408-2502
If to Vander Putten: LeRoy A. Vander Putten
1076 Main Street
South Windsor, Connecticut 06074
Telefax: 860-528-4374
IN WITNESS WHEREOF, the parties have executed this Agreement as of
the day and year first above written.
Executive Risk Inc.
By /s/ Robert H. Kullas
Its Chairman
/s/ LeRoy A. Vander Putten
--------------------------
LeRoy A. Vander Putten
4
<PAGE> 1
EXHIBIT 13 to Executive Risk Inc. Annual Report on Form 10-K
Management's Discussion and Analysis of Financial Condition and Results of
Operations Financial Statements and Notes
<PAGE> 2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
The following discussion should be read in conjunction with the Consolidated
Financial Statements of the Company and related notes thereto.
GENERAL
Management's discussion and analysis of financial condition and results of
operations compares certain financial results for the year ended December 31,
1997 with the corresponding periods for 1996 and 1995. The results of Executive
Risk Inc. (the "Company" or "ERI") include the consolidated results of Executive
Risk Management Associates ("ERMA"), Executive Re Inc. ("Executive Re") and
Executive Re's insurance subsidiaries, Executive Risk Indemnity Inc. ("ERII"),
Executive Risk Specialty Insurance Company ("ERSIC"), Executive Risk N.V.
("ERNV"), Quadrant Indemnity Company ("Quadrant"), a newly formed Connecticut
insurance company owned by ERII, and Executive Risk (Bermuda) Ltd., a newly
formed Bermuda insurance company owned by Executive Re. In addition, the
Company's results include Executive Risk Capital Trust (the "Trust"), a Delaware
statutory business trust, Sullivan Kelly Inc. ("Sullivan Kelly"), a California
corporation formed in September 1997 to acquire the assets of Sullivan, Kelly &
Associates, Inc., Insurance Brokers, a California underwriting agency and
insurance broker, and a 50% interest in UAP Executive Partners ("UPEX"), a
French underwriting agency which was a joint venture between the Company and
Union des Assurances de Paris - Incendie Accidents ("UAP"), a subsidiary of
AXA-UAP Group. The joint venture agreement between the Company and UAP was
terminated on December 31, 1997. In conjunction with such termination, the
Company transferred its 50% interest in UPEX to AXA-UAP Group and in exchange
received a cash payment in the amount of $1.1 million. The Company also received
$0.7 million from AXA-UAP Group in exchange for the Company agreeing not to
compete with AXA-UAP Group on certain policies underwritten by UPEX and in force
on December 31, 1997. No realized gain or loss resulted from this termination.
The Company does not believe that the termination of the UPEX joint venture
agreement, including the non-compete agreement, will have a material adverse
impact on the Company's business or financial condition.
The Company's financial position and results of operations are subject to
fluctuations due to a variety of factors. Abnormally high severity or frequency
of claims in any period could have a material adverse effect on the Company.
Also, reevaluations of the Company's loss reserves could result in an increase
or decrease in reserves and a corresponding adjustment to earnings.
Additionally, the insurance industry is highly competitive. The Company competes
with domestic and foreign insurers and reinsurers, some of which have greater
financial, marketing and management resources than the Company, and it may
compete with new market entrants in the future. Competition is based on many
factors, including the perceived market strength of the insurer, pricing and
other terms and conditions, services provided, the speed of claims payment, the
reputation and experience of the insurer, and ratings assigned by independent
rating organizations (including A.M. Best Company, Inc. ("A.M. Best") and
Standard & Poor's ("S&P")). ERII, ERSIC, Quadrant and ERNV's current rating from
A.M. Best is "A (Excellent)". ERII, ERSIC and Quadrant's current claims-paying
ability rating from S&P is "A+". These ratings are based upon factors of concern
to policyholders, including financial condition and solvency, and are not
directed to the protection of investors.
RESULTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1997 AND 1996
Gross premiums written increased by $99.3 million, or 30%, to $431.4 million in
1997 from $332.1 million in 1996. The increase was due to growth in sales in all
of the Company's existing lines of business, including domestic directors and
officers ("D&O") liability insurance and lawyers professional liability and
miscellaneous professional liability errors and omissions ("E&O") insurance.
Ceded premiums increased $47.8 million, or 39%, to $169.5 million in 1997 from
$121.7 million in 1996. The rate of growth in ceded premiums exceeded that of
gross premiums written due to increased cessions on E&O and certain D&O products
partially offset by a reduction in direct D&O cessions to Travelers Property
Casualty Corporation ("Travelers") (formerly known as Travelers/Aetna Property
Casualty Company). In connection with the acquisition of The Aetna Casualty &
Surety Company ("Aetna") by The Travelers Insurance Group Inc., all reinsurance
treaties previously with Aetna were assumed by Travelers. Pursuant to a
restructuring of the Company's relationship with Travelers entered into on
February 13, 1997 and effective January 1, 1997, Travelers is no longer a 12.5%
quota share reinsurer of the Company's direct D&O business.
As a result of the foregoing, net premiums written increased $51.5 million, or
25%, to $261.9 million in 1997 from $210.4 million in 1996. Over the same
periods, net premiums earned increased to $211.2 million from $155.8 million.
<PAGE> 3
Net investment income increased by $14.5 million, or 44%, to $47.1 million in
1997 from $32.6 million in 1996. The increase resulted principally from growth
in the Company's investment portfolio, measured on an amortized cost basis, from
$663.1 million at December 31, 1996 to $1.0 billion at December 31, 1997. The
Company's equity investment balances were $61.7 million and $37.7 million at
December 31, 1997 and 1996, respectively, and the cash and short-term investment
balances were $88.5 million and $24.7 million, respectively, on the same dates.
The Company manages its portfolio on a total return basis, and, as such, its
investments in equity securities are made for their perceived superior return
potential over the long term. Growth in invested assets resulted primarily from
proceeds received from the issuance of capital securities, common stock and
senior notes as well as cash flows from insurance operations. The nominal
portfolio yield of the fixed maturity portfolio at December 31, 1997 was 6.07%,
as compared to 6.18% at December 31, 1996. The tax-equivalent yields on the
fixed maturity portfolio were 7.58% and 8.00% for these periods, respectively.
See "Liquidity and Capital Resources." The Company's net realized capital gains
were $3.2 million in 1997 as compared to $1.0 million in 1996. In 1997, net
capital gains were realized principally from the sale of fixed maturity
investments, equity mutual fund distributions and certain equity limited
partnership investments.
Loss and loss adjustment expenses ("LAE") increased $36.5 million, or 35%, to
$141.8 million in 1997 from $105.3 million in 1996 due to higher premiums earned
partially offset by a slightly lower loss ratio. The Company's loss ratio
decreased to 67.1% in 1997 from 67.6% in 1996. In connection with the Company's
normal reserving review, which includes a reevaluation of the adequacy of
reserve levels for prior years' claims, the Company reduced its unpaid loss and
LAE reserves in 1997 for prior report years by approximately $10.3 million. In
1996, the Company reduced its unpaid loss and LAE reserves for prior report
years by $6.8 million. These reductions produced corresponding increases in the
Company's net income of approximately $6.7 million, or $0.62 per diluted share,
in 1997 and $4.4 million, or $0.42 per diluted share, in 1996. There is no
assurance that reserve adequacy reevaluations will produce similar reserve
reductions and net income increases in the future.
Policy acquisition costs increased $7.2 million, or 26%, to $35.0 million in
1997 from $27.8 million in 1996. The Company's ratio of policy acquisition costs
to net premiums earned declined to 16.6% in 1997 from 17.8% in 1996. The
decrease in the policy acquisition cost ratio was primarily attributable to
higher ceding commissions earned on the Company's reinsurance programs.
General and administrative ("G&A") expenses increased $11.5 million, or 68%, to
$28.6 million for the year ended December 31, 1997 from $17.1 million for the
year ended December 31, 1996. The increase in G&A costs was due primarily to
increased compensation, benefit and related overhead costs associated with the
growth in premium volume and development of new products. The ratio of G&A
expenses to net premiums earned increased from 11.0% in 1996 to 13.5% in 1997.
As a result of the changes in the aforementioned ratios, the Company's GAAP
combined ratio increased to 97.2% in 1997 from 96.4% in 1996. A combined ratio
below 100% indicates profitable underwriting prior to the consideration of
investment income, capital gains and interest expense. A company with a combined
ratio exceeding 100% can still be profitable due to such factors as investment
income and realized capital gains.
Interest expense of $1.8 million for the year ended December 31, 1997 and $4.5
million for the year ended December 31, 1996 was attributable principally to the
outstanding balances under the Company's senior notes payable and bank credit
agreement. The outstanding balances under the Company's bank credit agreement
were $25 million from January 1, 1996 to March 26, 1996 and $70 million from
March 26, 1996 to February 5, 1997. On February 5, 1997, the Company repaid the
$70 million outstanding under the term loan portion of a senior credit facility
(the "Senior Credit Facility") arranged through The Chase Manhattan Bank
("Chase"). On December 12, 1997, the Company sold $75 million aggregate amount
of 7.125% senior notes payable. In addition, interest expense in 1997 includes
$0.9 million of loan arrangement fees paid to Chase in 1996 which were fully
amortized in connection with the repayment of amounts outstanding under the
Senior Credit Facility. See "Liquidity and Capital Resources" and Note 8 of
Notes to Consolidated Financial Statements of the Company. Minority interest in
the Trust is attributable to distributions payable on the securities of the
Trust. See "Liquidity and Capital Resources."
Income tax expense increased $1.6 million, or 23%, to $8.2 million for the year
ended December 31, 1997 from $6.6 million for the year ended December 31, 1996.
The Company's effective tax rate decreased to 18.3% in 1997 from 19.1% in 1996.
The decrease in the effective tax rate was due principally to growth in
tax-exempt investment income outpacing the increase in pre-tax income.
As a result of the factors described above, net income increased $8.4 million,
or 30%, to $36.5 million, or $3.41 per diluted share, in 1997 from $28.1
million, or $2.67 per diluted share, in 1996. The Company's operating earnings,
calculated as net
<PAGE> 4
income before $0.3 million of one-time expenses associated with the acquisition
of the assets of Sullivan, Kelly & Associates, Inc., Insurance Brokers and
realized capital gains or losses, all net of tax, increased $7.4 million, or
27%, to $34.8 million, or $3.25 per diluted share, in 1997 from $27.4 million,
or $2.61 per diluted share, in 1996.
YEARS ENDED DECEMBER 31, 1996 AND 1995
Gross premiums written increased by $121.5 million, or 58%, to $332.1 million in
1996 from $210.6 million in 1995. The increase was partially due to growth in
sales in all of the Company's key lines of business, including domestic and
international D&O liability insurance and lawyers professional liability and
miscellaneous professional liability E&O insurance. Also contributing to the
rise in gross premiums written was the Company's issuance of ERII and ERSIC D&O
policies, rather than Aetna (now known as Travelers) policies, to both new and
renewing insureds. Converting an insured to ERII or ERSIC from Aetna resulted in
the Company receiving 100% of the gross premiums written (and ceding 12.5% to
Aetna) as compared to receiving 50% when reinsuring Aetna's risks. In 1996,
$226.3 million of gross D&O premiums written were issued on ERII and ERSIC
policies as compared to $99.0 million in 1995. Ceded premiums increased $56.2
million, or 86%, to $121.7 million in 1996 from $65.5 million in 1995. The rise
in ceded premiums was due principally to an increase in direct premium volume, a
portion of which was ceded to reinsurers under the Company's various D&O and E&O
treaties.
As a result of the foregoing, net premiums written increased $65.3 million, or
45%, to $210.4 million in 1996 from $145.1 million in 1995. Over the same
periods, net premiums earned increased to $155.8 million from $116.4 million.
Net investment income increased by $5.9 million, or 22%, to $32.6 million in
1996 from $26.7 million in 1995. This increase resulted principally from growth
in the Company's investment portfolio, measured on an amortized cost basis, from
$520.9 million at December 31, 1995 to $663.1 million at December 31, 1996, as
well as a slight increase in nominal investment yields. The Company's equity
investment balances were $45.9 million and $26.1 million at December 31, 1996
and 1995, respectively, and the cash and short-term investment balances were
$24.7 million and $20.2 million, respectively, on the same dates. The nominal
portfolio yield of the fixed maturity portfolio at December 31, 1996 was 6.18%,
as compared to 6.09% at December 31, 1995. The tax-equivalent yields on the
fixed maturity portfolio were 8.00% and 8.25% for these periods, respectively.
See "Liquidity and Capital Resources." The Company's net realized capital gains
were $1.0 million in 1996, as compared to $1.6 million in 1995. In 1996, capital
gains were realized from the sale of fixed maturities to provide available cash
for the repurchase of Common Stock and Class B Common Stock from Aetna. In
addition, capital gains were realized from equity mutual fund distributions and
certain equity limited partnership investments. Partially offsetting the gains
were net realized capital losses from fixed maturities sold at a loss and
replaced with higher yielding securities.
Loss and LAE increased $26.8 million, or 34%, to $105.3 million in 1996 from
$78.5 million in 1995 due to higher premiums earned. The Company's loss ratio
increased slightly to 67.6% in 1996 from 67.4% in 1995. In connection with the
Company's normal reserving review, which includes a reevaluation of the adequacy
of reserve levels for prior years' claims, the Company reduced its unpaid loss
and LAE reserves in 1996 for prior report years by approximately $6.8 million.
In 1995, the Company reduced its unpaid loss and LAE reserves for prior report
years by approximately $5.2 million. These reductions produced corresponding
increases in the Company's net income of approximately $4.4 million, or $0.42
per share, in 1996 and $3.4 million, or $0.28 per share, in 1995. Policy
acquisition costs increased $5.9 million, or 27%, to $27.8 million in 1996 from
$21.9 million in 1995. The Company's ratio of policy acquisition costs to net
premiums earned declined to 17.8% in 1996 from 18.8% in 1995. The decrease in
the acquisition cost ratio was primarily due to savings achieved by paying less
in override commissions to Aetna as a result of successfully converting insureds
from Aetna policies to ERII and ERSIC policies. Under the Amended and Restated
Agency and Insurance Services Agreement among Aetna, the Company and ERMA, ERMA
paid Aetna an override commission equal to 3% of gross written premiums with
respect to Aetna D&O policies issued by ERMA through June 30, 1996. Pursuant to
this agreement, effective with respect to business written on or after July 1,
1996, ERMA was no longer required to pay an override commission to Aetna. G&A
expenses increased $6.4 million, or 59%, to $17.1 million for the year ended
December 31, 1996, as compared to $10.7 million for the year ended December 31,
1995. The increase in G&A costs was due primarily to increased compensation,
benefit and related overhead costs associated with new employees hired to
support the growth in premium volume. The ratio of G&A costs to net premiums
earned increased to 11.0% in 1996 from 9.3% in 1995. As a result of the changes
in the aforementioned ratios, the Company's GAAP combined ratio increased to
96.4% in 1996 from 95.5% in 1995.
Long-term incentive compensation in 1996 and 1995 of $0.2 million and $1.5
million, respectively, consisted of non-cash charges to earnings for the value
of the stock option element of the IPO Stock Compensation Plan
<PAGE> 5
(the "IPO Plan"). See Note 10 of Notes to Consolidated Financial Statements of
the Company for a further discussion of the IPO Plan.
Interest expense was incurred principally on the outstanding balances under the
Company's bank credit agreement. Higher outstanding debt balances in 1996
resulted in an increase in interest expense to $4.5 million in 1996 as compared
to $2.0 million in 1995. The outstanding balances were $25 million for 1995, $25
million from January 1, 1996 through March 26, 1996 and $70 million from March
26, 1996 to December 31, 1996. See "Liquidity and Capital Resources" and Note 8
of Notes to Consolidated Financial Statements of the Company.
Income tax expense increased $1.7 million, or 37%, to $6.6 million for the year
ended December 31, 1996, as compared to $4.9 million for the year ended December
31, 1995. The Company's effective tax rate increased to 19.1% in 1996 from 16.1%
in 1995. The increase in the effective tax rate was due in part to growth in
pre-tax income outpacing the increase in tax-exempt investment income and an
increase in the Company's state tax liability. As a result of the factors
described above, net income increased $2.8 million, or 11%, to $28.1 million, or
$2.67 per diluted share, in 1996 from $25.3 million, or $2.12 per diluted share,
in 1995. The Company's operating earnings increased $3.1 million, or 13%, to
$27.4 million, or $2.61 per diluted share, in 1996 from $24.3 million, or $2.04
per diluted share, in 1995.
LIQUIDITY AND CAPITAL RESOURCES
ERI is a holding company, the principal asset of which is equity in its
subsidiaries. ERI's cash flows depend primarily on dividends and other payments
from its subsidiaries. ERI's sources of funds consist primarily of premiums
received by the insurance subsidiaries, income received on investments and
proceeds from the sales and redemptions of investments. Funds are used primarily
to pay claims and operating expenses, to purchase investments, to pay interest
and principal under the terms of the Company's indebtedness for borrowed money
and to pay dividends to Common Stock holders.
Cash flows from operating activities were $181.0 million, $169.5 million and
$86.0 million for 1997, 1996 and 1995, respectively. The modest increase in cash
flows in 1997 resulted principally from increased net premiums received and
investment income received partially offset by higher losses and G&A expenses
paid as well as a $9.5 million return of funds held under a funds withheld
arrangement. Rising loss payments are expected of a maturing professional
liability underwriter. The primary components of the cash flow increase in 1996
over 1995 were increased net premiums received coupled with lower than
anticipated loss payments.
The Company believes that it has sufficient liquidity to meet its anticipated
insurance obligations as well as its operating and capital expenditure needs.
Such capital expenditure needs include the costs of an addition to the
Company-owned office headquarters building in Simsbury, Connecticut. Site
improvements have begun and bids have been accepted on the first $4 million of
the total estimated cost of $20 million. The project is targeted for completion
in 1999.
The Company's investment strategy emphasizes quality, liquidity and
diversification. With respect to liquidity, the Company considers liability
durations, specifically loss reserves, when determining investment maturities.
In addition, maturities have been staggered to produce a pre-planned pattern of
cash flows for purposes of loss payments and reinvestment opportunities. Average
investment duration of the fixed maturity portfolio at December 31, 1997, 1996
and 1995 was approximately 4.6 years as compared to an expected loss reserve
duration of 5.0 to 5.5 years for such dates. The Company's short-term investment
pool was $88.5 million (8.2% of the total investment portfolio) at December 31,
1997 and $24.7 million (3.6% of the total investment portfolio) at December 31,
1996. The increase in the short-term investment pool was due principally to the
addition to that pool of that portion of the net proceeds received from a senior
notes offering completed on December 12, 1997, as discussed below, which has
been designated for increasing the capitalization of ERNV. Cash and publicly
traded fixed income securities constituted 88% of the Company's total investment
portfolio at December 31, 1997.
The Company's entire investment portfolio is classified as available for sale,
and is reported at fair value, with the resulting unrealized gains or losses
included as a separate component of stockholders' equity until realized. The
market value of the portfolio was 103% of amortized cost at December 31, 1997
and December 31, 1996. At December 31, 1997 and 1996, stockholders' equity was
increased by $19.5 million and $11.9 million, respectively, to record the
Company's fixed maturity investment portfolio at fair value. At December 31,
1997, the Company owned no derivative instruments, except for $121.5 million
(fair value) invested in mortgage and asset backed securities. On March 22,
1996, ERI entered into a Stock Purchase Agreement (the "Agreement") with Aetna
Life and Casualty Company ("AL&C") and AL&C's wholly owned subsidiary, Aetna.
Pursuant to the Agreement, on March 26, 1996, the Company purchased 1,286,300
shares of Common Stock and 1,225,000 shares of Class B Common Stock from Aetna
at a per share price of $29.875, or approximately $75 million in the aggregate.
In connection with the Agreement, the Company secured the $70 million Senior
Credit Facility arranged through Chase. The proceeds of the loan were utilized
as follows: $38 million to
<PAGE> 6
partially finance the repurchase of Common Stock and Class B Common Stock from
Aetna, $25 million to refinance the Company's previously existing debt and $7
million for general corporate purposes. In addition, the Company obtained
through Chase a $25 million revolving credit facility. The Company has no plans
to draw funds under the revolving credit facility.
The Agreement also contained provisions requiring the Company to file a
registration statement with respect to the remaining 2,000,000 shares of Common
Stock under AL&C ownership and AL&C was obligated to sell all of these shares in
an underwritten secondary offering. The secondary offering was completed on June
7, 1996. In conjunction with the secondary offering, the Company granted to the
underwriters an option to purchase an additional 300,000 shares of Common Stock,
at $34.00 per share less underwriting discounts and commissions of $1.75 per
share, to cover over-allotments. This over-allotment option was exercised in
full, and the Company received $9.7 million in net proceeds which were used for
general corporate purposes. The 300,000 shares of Common Stock covered by the
over-allotment option were issued from shares held in treasury. On May 10, 1996,
the Board of Directors approved a resolution to retire the 1,225,000 shares of
Class B Common Stock in treasury acquired in the Aetna stock repurchase. At its
May 1997 Annual Meeting, the Company's stockholders approved an Amended and
Restated Certificate of Incorporation which eliminated all Class B Common Stock.
On January 24, 1997, the Company formed the Trust, the common securities of
which are wholly owned by the Company. On February 5, 1997, the Trust sold
125,000 8.675% Series A Capital Securities (liquidation amount, $1,000 per
Capital Security) to certain qualified institutional buyers pursuant to SEC Rule
144A. The Trust used the $125 million of proceeds received from the sale of the
Series A Capital Securities and the $3.9 million received from the sale to the
Company of the common securities of the Trust to purchase $128.9 million
aggregate principal amount of 8.675% Series A Junior Subordinated Deferrable
Interest Debentures of the Company due February 1, 2027 (the "Series A
Debentures"). The Company utilized the $123.5 million of net proceeds as
follows: $70 million to repay the amount outstanding under the term loan portion
of the Senior Credit Facility, $45 million to make a surplus contribution to
ERII and $8.5 million for general corporate purposes. On May 29, 1997, all of
the Series A Capital Securities were exchanged for Series B Capital Securities
(the "Capital Securities"). In addition, $125 million aggregate principal amount
of the Series A Debentures were exchanged for a like aggregate principal amount
of 8.675% Series B Junior Subordinated Deferrable Interest Debentures of the
Company due February 1, 2027 (the "Series B Debentures" and together with the
remaining $3.9 million aggregate principal amount of the outstanding Series A
Debentures are hereinafter referred to as the "Debentures"). The terms of the
Capital Securities are identical in all material respects to the terms of the
Series A Capital Securities, except that the Capital Securities have been
registered under the Securities Act of 1933 and are not subject to the $100,000
minimum liquidation amount transfer restriction and certain other transfer
restrictions applicable to the Series A Capital Securities. The sole assets of
the Trust are the Debentures.
Holders of the Capital Securities are entitled to receive cumulative cash
distributions, accumulating from the date of original issuance and payable
semi-annually in arrears on February 1 and August 1 of each year at an annual
rate of 8.675%. Interest on the Debentures, and hence distributions on the
Capital Securities, may be deferred by the Company to the extent set forth in
the applicable instrument. The Capital Securities are subject to mandatory
redemption on February 1, 2027, upon repayment of the Series B Debentures, at a
redemption price equal to the principal amount of, plus accrued but unpaid
interest on, the Series B Debentures. The Capital Securities are also subject to
mandatory redemption in certain other specified circumstances at a redemption
price that may or may not include a make-whole premium. The Company's
obligations under the Series B Debentures, the related indenture and trust
agreement and the guarantee issued for the benefit of the holders of the Capital
Securities, taken together, constitute a full, irrevocable and unconditional
guarantee by the Company of the Capital Securities.
On September 12, 1997, the Company completed an underwritten public offering of
1,000,000 shares of its Common Stock at $62.25 per share less underwriting
discounts and commissions of $3.05 per share. In connection with this secondary
offering, the Company granted to the underwriters an option to purchase an
additional 150,000 shares of its Common Stock to cover over-allotments. Such
over-allotment option was exercised in full. The Company received $67.8 million
in net proceeds which have been used to make surplus contributions to ERII and
Executive Risk (Bermuda) Ltd. in order to support existing business lines and to
finance entry into new business lines, and for general corporate purposes.
On December 12, 1997, the Company issued $75 million aggregate principal amount
of unsecured 7.125% senior notes (the "Senior Notes") maturing on December 15,
2007. Interest on the Senior Notes is payable semi-annually in arrears on June
15 and December 15, commencing on June 15, 1998. The Senior Notes may not be
redeemed prior to maturity and are not subject to any sinking fund. The Company
used the $74.2 million of net proceeds of the issue to make surplus
contributions to current insurance company subsidiaries of the Company in order
to support existing business lines and to finance entry into new business lines,
and for general corporate purposes.
In each of March, June, September and December of 1997, the Company paid
dividends to Common Stock holders of record of $0.02 per share. Such Common
Stock dividends totaled $0.8 million. ERII, ERSIC and Quadrant are subject to
state regulatory
<PAGE> 7
restrictions that limit the amount of dividends payable by these companies.
Subject to certain net income carryforward provisions, ERII must obtain approval
of the Insurance Commissioner of the State of Delaware in order to pay, in any
12-month period, dividends that exceed the greater of 10% of surplus as regards
policyholders as of the preceding December 31 and statutory net income less
realized capital gains for the preceding calendar year. Dividends may be paid by
ERII only out of earned surplus. ERSIC and Quadrant must obtain approval of the
Insurance Commissioner of the State of Connecticut in order to pay, in any
12-month period, dividends that exceed the greater of 10% of surplus with
respect to policyholders as of the preceding December 31 and statutory net
income for the preceding calendar year. In addition, ERSIC and Quadrant may not
pay any dividend or distribution in excess of the amount of its earned surplus,
as reflected in its most recent statutory annual statement on file with the
Connecticut Insurance Commissioner, without such Commissioner's approval. ERII,
ERSIC and Quadrant are all required to provide notice to the Insurance
Commissioners of the States of Delaware and Connecticut, as applicable, of all
dividends to shareholders. Additionally, both Delaware and Connecticut law
require that the statutory surplus of ERII, ERSIC or Quadrant, as applicable,
following any dividend or distribution be reasonable in relation to its
outstanding liabilities and adequate for its financial needs.
YEAR 2000 ISSUES
Many computer systems have date-sensitive programs that may not properly
recognize the year 2000, which could result in operational disruptions and
errors (the "Year 2000" issue). The Company's exposure to the Year 2000 issue is
mitigated by the fact that it does not rely on mainframe computers, but instead
has a client-server infrastructure in which no component is more than eight
years old. Having completed its internal assessment of the modifications
necessary in order that the Company become Year 2000 compliant, management
currently expects to complete the Year 2000 compliance project during the first
quarter of 1999. Based upon information currently available and upon a number of
assumptions of future events, including the continued availability of manpower
resources and other factors believed to be reliable, management estimates that
the total cost for internal Year 2000 compliance will not exceed $0.5 million
and will not materially affect the Company's results of operations.
Additionally, during 1997 the Company instituted procedures to communicate with
significant vendors to determine the extent to which the Company is vulnerable
to those third parties' Year 2000 issues. These communications are ongoing and
there can be no assurance that such third parties' failure to become Year 2000
compliant in a timely fashion would not have a material adverse effect on the
Company.
Lastly, the Year 2000 issue has liability implications for the directors and
officers of entities insured by the Company. The Company has adopted an
underwriting strategy to assess insureds' understanding of the Year 2000
exposures, as well as to evaluate the action steps that the insureds are
implementing. Such underwriting techniques should mitigate, but cannot
eliminate, the risk to the Company of increases in claims and losses related to
the Year 2000 issue. There can be no assurance that any such Year 2000-related
claims and losses will not have a material adverse effect on the Company's
results of operations.
OTHER
Delaware, the state of domicile of ERII, and Connecticut, the state of domicile
of ERSIC and Quadrant, impose minimum risk-based capital requirements on all
insurance companies that were developed by the National Association of Insurance
Commissioners ("NAIC"). The formulas for determining the amount of risk-based
capital specify various weighting factors that are applied to financial balances
or various levels of activity based on the perceived degree of risk. Regulatory
compliance is determined by a ratio of the insurance company's regulatory total
adjusted capital to its authorized control level risk-based capital, both as
defined by the NAIC. At December 31, 1997, the total adjusted capital (as
defined by the NAIC) of ERII, ERSIC and Quadrant was in excess of the risk-based
capital standards.
<PAGE> 8
FINANCIAL REPORTING RESPONSIBILITY
The management of Executive Risk Inc. has primary responsibility for the
integrity and accuracy of the financial information presented in this annual
report and for making certain that such information presents fairly the
financial position and operating results of the Company. The consolidated
financial statements included herein were prepared in conformity with generally
accepted accounting principles. All financial information presented within this
annual report is consistent with these financial statements or, when
appropriate, with the statutory financial statements of Executive Risk Indemnity
Inc., Executive Risk Specialty Insurance Company and Quadrant Indemnity Company
as reported to the state insurance regulatory authorities.
The accounting systems and related controls are designed to provide
reasonable assurance that the Company's financial records are reliable for the
preparation of financial statements and that the Company's assets are
safeguarded against loss.
Ernst & Young LLP, the Company's independent auditors, have audited
the consolidated financial statements of the Company, and their report is
included herein. Such audits were conducted in accordance with generally
accepted auditing standards and included reviews of internal controls to the
extent required by those standards.
The Audit Committee of the Board of Directors is comprised of certain
directors who are neither employees nor officers of the Company. The Audit
Committee meets periodically with the independent auditors and management to
approve the scope and timing of the independent audit and to discuss other
auditing and financial reporting matters. The independent auditors have direct
access to, and meet privately with, the Audit Committee.
<PAGE> 9
REPORT OF INDEPENDENT AUDITORS
To the Stockholders and Board of Directors
Executive Risk Inc.
We have audited the accompanying consolidated balance sheets of Executive Risk
Inc. and its subsidiaries as of December 31, 1997 and 1996, and the related
consolidated statements of income, stockholders' equity, and cash flows for each
of the three years in the period ended December 31, 1997. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Executive Risk
Inc. and its subsidiaries at December 31, 1997 and 1996, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1997, in conformity with generally accepted
accounting principles.
/s/ Ernst & Young LLP
Stamford, Connecticut
February 3, 1998
<PAGE> 10
Consolidated Balance Sheets
<TABLE>
<CAPTION>
December 31,
(In thousands, except share data) 1997 1996
<S> <C> <C>
Assets
Fixed maturities available for sale, at fair value
(amortized cost: 1997 - $905,050 and 1996 - $610,589) $ 934,981 $ 628,564
Equity securities available for sale, at fair value
(cost: 1997 - $42,787 and 1996 - $27,820) 61,732 37,705
Cash and short-term investments, at cost
which approximates market 88,505 24,706
---------------------------
Total Cash and Invested Assets 1,085,218 690,975
Premiums receivable 40,033 26,757
Reinsurance recoverables 159,918 77,724
Accrued investment income 13,731 10,126
Investment in UPEX -- 1,087
Deferred acquisition costs 34,581 22,696
Prepaid reinsurance premiums 99,847 66,088
Deferred income taxes 23,316 26,269
Other assets 29,160 19,525
---------------------------
Total Assets $ 1,485,804 $ 941,247
Liabilities
Loss and loss adjustment expenses $ 637,929 $ 457,063
Unearned premiums 289,840 205,348
Note payable to bank -- 70,000
Senior notes payable 75,000 --
Ceded balances payable 37,165 26,402
Accrued expenses and other liabilities 44,687 37,659
---------------------------
Total Liabilities 1,084,621 796,472
Preferred Securities of Executive Risk Capital Trust Company obligated
mandatorily redeemable preferred securities of subsidiary, Executive Risk
Capital Trust, holding solely $125,000,000 aggregate principal amount of
8.675% Series B Junior Subordinated Deferrable Interest Debentures of the
Company due February 1, 2027 and $3,866,000 aggregate principal amount of
8.675% Series A Junior Subordinated Deferrable Interest Debentures of the
Company due February 1, 2027 125,000 --
---------------------------
Stockholders' Equity
Preferred Stock, $.01 par value; authorized - 4,000,000 shares;
issued - 1997 and 1996 - 0 shares -- --
Common Stock, $.01 par value; authorized - 52,500,000 shares;
issued - 1997 - 11,953,358 shares and 1996 - 10,439,628 shares 120 104
Additional paid-in capital 176,234 93,651
Unrealized gains on investments, net of tax 31,769 18,382
Currency translation adjustments (481) (186)
Retained earnings 101,101 65,384
Cost of shares in treasury, at cost: 1997 and 1996 - 1,114,421 shares (32,560) (32,560)
---------------------------
Total Stockholders' Equity 276,183 144,775
---------------------------
Total Liabilities, Preferred Securities of Executive Risk
Capital Trust and Stockholders' Equity $ 1,485,804 $ 941,247
---------------------------
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
<PAGE> 11
CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
Year Ended December 31,
(In thousands, except per share data) 1997 1996 1995
<S> <C> <C> <C>
Revenues
Gross premiums written $ 431,394 $ 332,085 $ 210,640
Premiums ceded (169,470) (121,709) (65,519)
-----------------------------------------
Net premiums written 261,924 210,376 145,121
Change in unearned premiums (50,748) (54,592) (28,687)
-----------------------------------------
Net Premiums Earned 211,176 155,784 116,434
Net investment income 47,115 32,646 26,706
Net realized capital gains 3,212 1,047 1,588
Other income 144 166 83
-----------------------------------------
Total Revenues 261,647 189,643 144,811
Expenses
Loss and loss adjustment expenses 141,773 105,335 78,530
Policy acquisition costs 34,978 27,803 21,931
General and administrative expenses 28,614 17,068 10,730
Long-term incentive compensation -- 187 1,458
Interest expense 1,783 4,511 2,022
Minority interest in Executive Risk Capital Trust 9,819 -- --
-----------------------------------------
Total Expenses 216,967 154,904 114,671
Income Before Income Taxes 44,680 34,739 30,140
Income Tax Expense (Benefit)
Current 12,834 14,201 9,890
Deferred (4,679) (7,567) (5,036)
-----------------------------------------
8,155 6,634 4,854
-----------------------------------------
Net Income $ 36,525 $ 28,105 $ 25,286
Per Share Data
Earnings per common share $ 3.71 $ 2.88 $ 2.20
Earnings per common share - assuming dilution 3.41 2.67 2.12
Dividends declared per common share 0.08 0.08 0.08
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
<PAGE> 12
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
Year Ended December 31,
(In thousands) 1997 1996 1995
<S> <C> <C> <C>
Common Stock Outstanding (Shares):
Balance, beginning of year 9,325 11,498 11,495
Options exercised 364 38 132
Secondary offering 1,150 -- --
Common Stock repurchase -- (2,511) --
Treasury shares reissued -- 300 --
Treasury shares repurchased -- -- (129)
-----------------------------------------
Balance, end of year 10,839 9,325 11,498
Common Stock:
Balance, beginning of year $ 104 $ 116 $ 115
Options exercised 4 -- 1
Secondary offering 12 -- --
Treasury shares retired -- (12) --
-----------------------------------------
Balance, end of year 120 104 116
Additional Paid-In Capital:
Balance, beginning of year 93,651 87,228 84,725
Options exercised 9,885 730 2,418
Directors' options fees granted 57 66 85
Secondary offerings, net of related expenses 66,487 521 --
Employee stock-based compensation plans 6,154 5,444 --
Treasury shares retired -- (338) --
-----------------------------------------
Balance, end of year 176,234 93,651 87,228
Unrealized Gains (Losses) on Investments:
Balance, beginning of year 18,382 19,156 (3,958)
Unrealized gains (losses) on investments 13,387 (774) 23,114
-----------------------------------------
Balance, end of year 31,769 18,382 19,156
Currency Translation Adjustments:
Balance, beginning of year (186) 29 24
Currency translation adjustments (295) (215) 5
-----------------------------------------
Balance, end of year (481) (186) 29
Retained Earnings:
Balance, beginning of year 65,384 74,315 49,948
Net income 36,525 28,105 25,286
Common Stock dividends (808) (789) (919)
Treasury shares retired -- (36,247) --
-----------------------------------------
Balance, end of year 101,101 65,384 74,315
Common Stock in Treasury:
Balance, beginning of year (32,560) (3,119) 0
Common Stock repurchase -- (38,428) --
Class B Common Stock repurchase -- (36,597) --
Secondary offering over-allotment option exercised -- 8,962 --
Treasury shares reissued -- 25 --
Treasury shares repurchased -- -- (3,119)
Treasury shares retired -- 36,597 --
-----------------------------------------
Balance, end of year (32,560) (32,560) (3,119)
Total Stockholders' Equity $ 276,183 $ 144,775 $ 177,725
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
<PAGE> 13
CONSOLIDATED STATEMENT OF CASH FLOWS
<TABLE>
<CAPTION>
Year Ended December 31,
(In thousands) 1997 1996 1995
<S> <C> <C> <C>
Operating Activities
Net income $ 36,525 $ 28,105 $ 25,286
Adjustments to reconcile net income to net cash
provided by operating activities:
Amortization and depreciation 2,682 1,729 935
Share of income of UPEX (144) (166) (83)
Deferred income taxes (4,679) (7,567) (5,036)
Amortization of bond premium 1,904 1,019 1,541
Net realized gains on investments (3,212) (1,047) (1,588)
Stock based compensation plans 6,154 2,428 2,023
Amortization of loan arrangement fees 910 -- --
Other (867) (1,672) (2,477)
Change in:
Premiums receivable, net of ceded balances payable (2,513) 10,297 (289)
Accrued investment income (3,605) (717) (1,544)
Deferred acquisition costs (11,885) (6,452) (5,384)
Loss and loss adjustment expenses, net of
reinsurance recoverables 98,672 88,704 44,841
Unearned premiums, net of prepaid reinsurance
premiums 50,733 54,592 28,687
Accrued expenses and other liabilities 10,324 221 (924)
-----------------------------------------
Net Cash Provided by Operating Activities 180,999 169,474 85,988
Investing Activities
Proceeds from sales of fixed maturities available for sale 286,742 179,510 79,323
Proceeds from sales of equity securities available for sale 1,389 -- 10,278
Proceeds from maturities of investment securities 44,181 34,586 32,113
Purchase of fixed maturities available for sale (627,134) (340,648) (199,298)
Purchase of equity securities available for sale (10,536) (13,691) (4,861)
Net capital expenditures (8,092) (2,881) (4,069)
Acquisition of the assets of Sullivan, Kelly & Associates, Inc. (2,317) -- --
-----------------------------------------
Net Cash Used in Investing Activities (315,767) (143,124) (86,514)
Financing Activities
Proceeds from exercise of options 4,122 423 241
Cost of repurchase of Common Stock -- (75,025) (3,119)
Placement fees and other (2,827) (1,172) --
Repayment of note payable to bank (70,000) (25,000) --
Note payable to bank -- 70,000 --
Proceeds from issuance of Senior Notes Payable 75,000 -- --
Proceeds from issuance of Common Stock 68,080 -- --
Proceeds from Capital Securities offering 125,000 -- --
Proceeds from over-allotment option exercise -- 9,675 --
Dividends paid on Common Stock (808) (789) (919)
-----------------------------------------
Net Cash Provided by (Used in) Financing Activities 198,567 (21,888) (3,797)
-----------------------------------------
Net Increase (Decrease) in Cash and Short-Term Investments 63,799 4,462 (4,323)
Cash and short-term investments at beginning of period 24,706 20,244 24,567
Cash and Short-Term Investments at End of Period $ 88,505 $ 24,706 $ 20,244
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
<PAGE> 14
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997
1. ORGANIZATION AND PRINCIPLES OF CONSOLIDATION
Executive Risk Inc. (the "Company" or "ERI") was formed under the laws of the
State of Delaware. As of December 31, 1997, the Company owns all of the
outstanding stock of Executive Re Inc. ("Executive Re"), and Executive Re owns
all of the outstanding stock of Executive Risk Indemnity Inc. ("ERII"),
Executive Risk (Bermuda) Ltd. ("ER Bermuda"), Sullivan Kelly Inc. ("Sullivan
Kelly") and Executive Risk N.V. ("ERNV"). ERII owns all of the outstanding stock
of Executive Risk Specialty Insurance Company ("ERSIC") and Quadrant Indemnity
Company ("Quadrant"). In addition, the Company and Executive Re own 100% of
Executive Risk Management Associates ("ERMA"), a Connecticut general
partnership. ERII, a Delaware corporation, commenced insurance operations under
the ownership of Executive Re in 1986. ERSIC and Quadrant, both Connecticut
corporations, commenced insurance operations in 1992 and 1997, respectively.
ERNV, a Dutch insurance company, was incorporated in May 1995 in the Netherlands
to participate in professional liability insurance opportunities. ER Bermuda, a
newly formed Bermuda insurance company, was incorporated in September 1997.
Sullivan Kelly, a California corporation, was formed in September 1997 to
acquire the assets of Sullivan, Kelly & Associates, Inc., Insurance Brokers, a
California underwriting agency and insurance broker. In addition, the Company's
results include Executive Risk Capital Trust (the "Trust"), a Delaware statutory
business trust.
The Company is a specialty insurance holding company that, through its
subsidiaries, develops, markets and underwrites professional liability
insurance, including directors and officers liability insurance ("D&O") and
errors and omissions liability insurance ("E&O") for lawyers and other
professionals. Through ERII, ERSIC and Quadrant, the Company writes, on a direct
basis, D&O and E&O throughout the United States, and reinsures D&O and certain
ancillary lines of insurance written by Travelers Property Casualty Corporation
("Travelers"), formerly known as Travelers/Aetna Property Casualty Company, a
stockholder of the Company until March 1996 (Note 5). The Company's products are
distributed through licensed independent property and casualty brokers, excess
and surplus lines brokers and licensed wholesalers.
The 1997 consolidated financial statements include the Company,
Executive Re, ERII, ERSIC, Quadrant, ER Bermuda, Sullivan Kelly, ERMA, ERNV and
the Trust. The 1996 and 1995 consolidated financial statements include the
Company, Executive Re, ERII, ERSIC, ERMA and ERNV. All references made herein to
the Company include ERI and all of its subsidiaries unless otherwise noted. All
significant intercompany amounts are eliminated in consolidation. Certain prior
year amounts have been reclassified to conform with the 1997 presentation.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation: The accompanying consolidated financial statements have
been prepared in conformity with generally accepted accounting principles
("GAAP"), some of which require the use of management's estimates. Actual
results could differ from those estimates.
New Accounting Standards: In June 1997, the Financial Accounting Standards Board
("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 130,
"Reporting Comprehensive Income" ("SFAS 130") and SFAS No. 131, "Disclosures
about Segments of an Enterprise and Related Information" ("SFAS 131"). SFAS 130
establishes standards for the reporting and display of comprehensive income and
its components in a full set of general-purpose financial statements; however,
adoption in 1998 will have no impact on the Company's net income or
stockholders' equity. Comprehensive income is defined as the change in equity
during the financial reporting period of a business enterprise resulting from
non-owner sources. SFAS 131 establishes standards for the reporting of operating
segment information in both annual financial reports and interim financial
reports issued to shareholders. Operating segments are components of an entity
for which separate financial information is available and is evaluated regularly
by the entity's chief operating management. Both statements are effective for
fiscal years beginning after December 15, 1997 and are not anticipated to have a
material impact on the Company.
Earnings Per Share: In February 1997, the FASB issued SFAS No. 128,
"Earnings per Share" ("SFAS 128"). SFAS 128 replaced the calculation of primary
and fully diluted earnings per share with basic (or earnings per common share)
and diluted earnings per share (or earnings per common share - assuming
dilution). Unlike primary earnings per share, earnings per common share excludes
any dilutive effects of options, warrants and convertible securities. Earnings
per common share assuming dilution is very similar to the previously reported
fully diluted earnings per share. All earnings per share amounts for all periods
are presented and, where appropriate, have been restated to conform to SFAS 128
requirements. Earnings per
<PAGE> 15
common share are based on the weighted average common shares outstanding during
the period. Earnings per common share - assuming dilution includes the effect of
all dilutive securities, which include potential common shares. Potential common
shares are securities, such as options and warrants, that do not have a current
right to participate in earnings but could do so in the future by virtue of
option or conversion rights.
Investments: The Company has classified its entire portfolio of fixed
maturities and equity securities as available for sale and reports such
investments at fair value. Fair values are determined by quoted market prices
when available or, in the case of private placements, are estimated by
discounting expected future cash flows using a market rate on fixed maturities
with similar terms and credit worthiness (Note 9). The Company's classification
of its portfolio as available for sale provides the Company with the flexibility
to adjust its portfolio as needed in response to changes in operating, tax and
regulatory conditions.
Short-term investments are carried at cost that approximates market.
The amortized cost of fixed maturities is adjusted for amortization of premiums
and accretion of discounts to maturity which are included in investment income.
Unrealized gains and losses resulting from changes in fair values of fixed
maturities and equity securities are reflected in stockholders' equity, net of
applicable deferred income taxes.
Realized capital gains and losses are reported in revenues and are determined
based on the specific identification of the investments sold.
Investment in UPEX: The Company's 50% interest in UAP Executive
Partners ("UPEX"), a French underwriting agency which was a joint venture
between the Company and Union des Assurances de Paris - Incendie-Accidents
("UAP"), a subsidiary of AXA-UAP Group, was reported using the equity method of
accounting. Financial results were reported to the Company in French francs. The
Company's share of income and losses was calculated using the average exchange
rate in effect during the period. Resulting translation gains and losses were
reported as a separate component of stockholders' equity. The joint venture
agreement between the Company and UAP was terminated on December 31, 1997, and
the Company sold its 50% interest in UPEX to AXA-UAP Group on that date. No
realized gain or loss resulted from this termination.
Consolidation of ERMA Results: As the majority of ERMA's activities
relate to the marketing and underwriting of insurance policies, a substantial
portion of the revenues ERMA received from Travelers (or from The Aetna Casualty
and Surety Company ("Aetna"), prior to its acquisition by Travelers) for
underwriting and management services during the years 1995 through 1997 offset
the Company's policy acquisition costs. The remaining portion of the revenues
received from Travelers related to the general and administrative ("G&A") costs
of running the business, and were therefore offset against the Company's G&A
expenses.
Premium Income and Unearned Premiums: Gross premiums written are
recognized as premiums earned principally on a pro rata basis over the in-force
period of the policies. Ceded reinsurance premiums are charged against premiums
earned on the same basis. Unearned premiums and prepaid reinsurance premiums
represent the portions of premiums written and ceded applicable to the unexpired
terms of the related policies.
Deferred Acquisition Costs: Deferred acquisition costs, consisting
primarily of commissions net of allowances on ceded reinsurance and the portion
of ERMA's expenses relating to the acquisition of premiums, are deferred and
amortized on a pro rata basis over the period that the related premiums are
earned. Deferred acquisition costs are limited to their estimated realizable
value based on the related unearned premiums and take into account anticipated
claims and claim expenses, based on historical and current experience and
anticipated investment income.
Loss and Loss Adjustment Expense Reserves: As substantially all of the
Company's business is written on a claims-made form of coverage, the reserves
for loss and loss adjustment expenses represent the estimated liability on
outstanding claims, based on an evaluation of reported claims. Although
considerable variability is inherent in such estimates, management believes that
the recorded reserves for loss and loss adjustment expenses are adequate in the
aggregate to cover the ultimate resolution of reported claims. These estimates
are continually reviewed and any required adjustments are reflected in current
operations.
Reinsurance Recoverables: In the normal course of business, the Company
seeks to manage its exposure to potential losses arising from risks it writes or
assumes by reinsuring certain levels of risk with various reinsurers (Note 7).
Amounts
<PAGE> 16
recoverable from reinsurers are estimated in a manner consistent with the loss
and loss adjustment expense reserves associated with the outstanding claims.
Income Taxes: Income taxes are accounted for using the liability
method. Using this method, deferred tax assets and liabilities are determined
based on differences between the financial reporting and tax basis of assets and
liabilities and are measured using the enacted tax rates and laws that will be
in effect when the differences are expected to reverse.
Statements of Cash Flows: In the accompanying statements of cash flows,
the Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents. Cash and cash equivalents
are classified as cash and short-term investments in the accompanying balance
sheets. Stock Compensation: The Company applies Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and
related interpretations in accounting for its stock-based compensation plans.
Under APB 25, compensation expense for stock option and award plans is
recognized as the difference between the fair value of the stock at the date of
grant less the amount, if any, the employee or director is required to pay.
3. EARNINGS PER SHARE
The following table sets forth the computation of earnings per common share and
earnings per common share - assuming dilution:
<TABLE>
<CAPTION>
Year Ended December 31,
(In thousands, except per share data) 1997 1996 1995
<S> <C> <C> <C>
Numerator:
Net income $36,525 $28,105 $25,286
Denominator:
Denominator for earnings per common share -
weighted average shares 9,838 9,759 11,491
Effect of dilutive securities:
Employee and director stock options 764 701 418
Stock incentive and performance share plans 113 56 --
---------------------------------
Total dilutive potential common shares 877 757 418
Denominator for earnings per common share
- assuming dilution 10,715 10,516 11,909
Earnings per common share $ 3.71 $ 2.88 $ 2.20
Earnings per common share - assuming dilution 3.41 2.67 2.12
</TABLE>
For additional disclosures regarding the outstanding employee and director stock
options and the stock incentive and performance share plans, see Note 10 -
Stockholders' Equity.
Options to purchase 91,200 shares of Common Stock at $67.375 per share were
outstanding for a portion of 1997 but were not included in the computation of
earnings per common share - assuming dilution because the options' exercise
price was greater than the average market price of the common shares, and
therefore, the effect would be antidilutive.
4. ACQUISITION OF BUSINESS
On September 12, 1997, the Company formed Sullivan Kelly to acquire the assets
of Sullivan, Kelly & Associates, Inc. Insurance Brokers, a California
underwriting agency and insurance broker of malpractice insurance for medical
institutions. The Company accounted for the acquisition as a purchase and the
results of Sullivan Kelly are included in the accompanying financial statements
beginning with the date of acquisition. Based upon an assessment of the fair
value of the assets acquired at the date of acquisition, the Company paid $2.3
million in cash for $0.1 million of fixed assets and $0.7 million for a
non-compete agreement which is being amortized over 3.75 years. The remaining
purchase price of $1.5 million was allocated to goodwill and is being amortized
over a 15-year period.
5. STOCK REPURCHASE AND OFFERINGS
On March 22, 1996, the Company entered into a Stock Purchase Agreement (the
"Agreement") with Aetna Life and Casualty Company ("AL&C") and AL&C's wholly
owned subsidiary, Aetna. Prior to the closing of the Agreement, Aetna owned
4,511,300 shares of the Company's capital stock, consisting of (i) 3,286,300
shares of Common Stock and (ii) all
<PAGE> 17
1,225,000 shares of Class B Common Stock. Through this investment and an option
to purchase 100,000 shares of Common Stock at $12.00 per share (the "Aetna Stock
Option"), Aetna controlled approximately 40% of the Company's capital stock.
Pursuant to the Agreement, on March 26, 1996, the Company purchased 1,286,300
shares of Common Stock and 1,225,000 shares of Class B Common Stock from Aetna
at a per share price of $29.875, or approximately $75 million in the aggregate.
In connection with the Agreement, the Company secured a $70 million senior
credit facility (the "Senior Credit Facility") arranged through The Chase
Manhattan Bank ("Chase") (Note 8). Upon the closing of the Agreement, 2,000,000
shares of Common Stock, representing approximately 22% of the Company's issued
and outstanding Common Stock, remained under Aetna ownership. Subsequently, in
connection with the acquisition of Aetna by The Travelers Insurance Group Inc.,
Aetna transferred ownership of the remaining Common Stock and the Aetna Stock
Option to AL&C.
The Agreement also contained provisions requiring the Company to file a
registration statement with respect to the remaining 2,000,000 shares of Common
Stock under AL&C ownership and AL&C was obligated to sell all of these shares in
an underwritten secondary offering. The secondary offering was completed on June
7, 1996. In conjunction with this secondary offering, the Company granted to the
underwriters an option to purchase an additional 300,000 shares of Common Stock,
at $34.00 per share less underwriting discounts and commissions of $1.75 per
share, to cover over-allotments. This over-allotment option was exercised in
full, and the Company received $9.7 million in net proceeds. The proceeds were
used for general corporate purposes.
On September 12, 1997, the Company completed an underwritten public
offering of 1,000,000 shares of its Common Stock at $62.25 per share less
underwriting discounts and commissions of $3.05 per share. In connection with
this secondary offering, the Company granted to the underwriters an option to
purchase an additional 150,000 shares of its Common Stock to cover
over-allotments. Such over-allotment option was exercised in full. The Company
received $67.8 million in net proceeds which have been used to make surplus
contributions to ERII and ER Bermuda in order to support existing business lines
and to finance entry into new business lines, and for general corporate
purposes.
6. PRO FORMA FINANCIAL DATA
The following table presents consolidated pro forma income statement data for
the years ended December 31, 1996 and 1995, as adjusted to give pro forma effect
to the stock repurchase of 2,511,300 shares of the Company's capital stock at
$29.875 per share and the exercise of the 300,000 share over-allotment option in
the June 7, 1996 secondary offering, at $32.25 per share, as if they had
occurred on January 1, 1996 and 1995, respectively.
<TABLE>
<CAPTION>
Year Ended December 31,
(In thousands, except per share data) 1996 1995
<S> <C> <C>
Total revenues $189,483 $143,639
Net income 27,482 22,187
Weighted average shares outstanding - assuming dilution 9,910 9,698
Earnings per common share - assuming dilution $ 2.77 $ 2.29
</TABLE>
7. UNDERWRITING AND REINSURANCE
On January 1, 1995, the Company, ERMA and Aetna entered into an amended
and restated insurance services agreement. Under this agreement, ERMA was
appointed as Aetna's underwriting manager and received a commission in 1996 and
1995 of 24% of the portion of premiums written reported by ERMA to Aetna. The
Company paid a commission to ERMA equal to ERMA's costs of producing business
for the Company. Additionally, ERMA paid an override to Aetna of 3% of gross
premiums written with respect to Aetna D&O policies issued through ERMA.
As the Company met certain financial tests, the 3% override was
discontinued on July 1, 1996. The business underwritten by ERMA on behalf of
Aetna generally was reinsured 50% by ERII through December 31, 1996. ERII paid a
ceding commission of 3% of premiums reinsured for premium taxes plus ERII's
share of certain costs of ERMA related to this business.
On February 13, 1997, the Company, ERMA and Travelers agreed to
terminate the amended and restated insurance services agreement effective
December 31, 1996, following the acquisition of Aetna by the Travelers Insurance
Group Inc. ERMA's obligations for policies effective prior to January 1, 1997
remain the same until all such policies expire and all liabilities with respect
to such policies have been settled. Under a new insurance services agreement
between the Company,
<PAGE> 18
ERMA and Travelers, ERMA receives a commission equal to its costs to produce the
business for Travelers policies effective on or after January 1, 1997. The total
business underwritten by ERMA on Travelers policies is subject to limitations as
stipulated in the agreement. ERII generally assumes 100% of these risks and pays
Travelers a ceding commission equal to 3.5% of premiums reinsured for premium
taxes plus other costs and expenses related to this business.
ERII had entered into several quota share reinsurance treaties with
Aetna prior to its acquisition by Travelers. Under the largest reinsurance
treaty, ERII assumed 50% of the risk associated with the first $20 million of
coverage provided by each D&O policy underwritten by ERMA and issued by Aetna
through December 31, 1996. Effective January 1, 1997, ERII assumes 100% of the
risk associated with each D&O policy underwritten by ERMA and issued by
Travelers. These policies generally have limits of up to $20 million. Under the
other reinsurance treaties, ERII assumes a portion of the risk associated with
up to $10 million of coverage provided by various D&O and ancillary line
coverages underwritten by ERMA and issued by Travelers.
Pursuant to the agreement entered into on February 13, 1997 by the
Company and Travelers, the Company released Travelers from its obligation to
issue D&O exclusively through ERMA until December 31, 1999, and Travelers may
therefore compete with the Company on D&O sooner than it otherwise could have.
During 1997, 1996 and 1995, gross premiums written assumed by ERII under the
various agreements with Travelers were approximately $4.6 million, $13.8 million
and $60.5 million, respectively.
UPEX underwrote, on behalf of UAP, policies providing D&O coverage up
to a maximum policy limit of $25 million, subject to certain foreign currency
adjustments, of which the Company generally assumed a 50% participation in 1997,
1996 and 1995. This arrangement ended on December 31, 1997 pursuant to the
termination of the joint venture agreement between the Company and UAP (Note 2).
The Company, through ERII, ERSIC and Quadrant, cedes reinsurance to
manage its exposure to potential losses arising from risks it assumes or writes.
Entering into such reinsurance arrangements does not discharge the Company's
obligation to pay policy claims on the reinsured business. The ceding insurer
remains responsible for policy claims without regard to the extent the reinsurer
pays such claims.
The components of the Company's premiums written and earned were as
follows:
<TABLE>
<CAPTION>
Year Ended December 31,
(In thousands) 1997 1996 1995
<S> <C> <C> <C>
Premiums Written
Direct $ 414,967 $ 305,265 $ 134,312
Assumed 16,427 26,820 76,328
Ceded (169,470) (121,709) (65,519)
-----------------------------------------
Net Premiums Written $ 261,924 $ 210,376 $ 145,121
-----------------------------------------
Premiums Earned
Direct $ 324,182 $ 195,201 $ 71,071
Assumed 22,692 48,463 91,604
Ceded (135,698) (87,880) (46,241)
Net Premiums Earned $ 211,176 $ 155,784 $ 116,434
</TABLE>
Ceded loss and loss adjustment expenses amounted to $88.4 million, $48.3 million
and $25.1 million in 1997, 1996 and 1995, respectively.
A portion of the Company's ceded reinsurance is placed with Lloyd's syndicates.
To date, the Company has not experienced any reinsurance recoverable defaults.
Further, Lloyd's syndicates have established trust funds securing their
obligations to U.S.
cedants.
8. CREDIT ARRANGEMENTS
On March 26, 1996, in connection with the repurchase of Common Stock
from Aetna (Note 5), the Company borrowed $70 million under the terms of the
Senior Credit Facility arranged through Chase. The proceeds of the loan were
utilized as follows: $38 million to partially finance the repurchase of Common
Stock and Class B Common Stock from Aetna,
<PAGE> 19
$25 million to refinance the Company's previously existing debt and $7 million
for general corporate purposes. In addition, the Company has obtained through
Chase a $25 million revolving credit facility. The Company has no current plans
to draw funds under the revolving credit facility.
The terms of the revolving credit facility require, among other things,
that the Company maintain certain defined minimum consolidated net worth and
combined statutory surplus levels, and certain debt leverage and
premiums-to-surplus level ratios and place restrictions on the incurrence of
additional debt, the sale of assets, the making of acquisitions and the
incurrence of liens.
On January 24, 1997, the Company formed the Trust, the common
securities of which are wholly owned by the Company. On February 5, 1997, the
Trust sold 125,000 8.675% Series A Capital Securities (liquidation amount,
$1,000 per Capital Security) to certain qualified institutional buyers pursuant
to SEC Rule 144A. The Trust used the $125 million of proceeds received from the
sale of the Series A Capital Securities and the $3.9 million received from the
sale to the Company of the common securities of the Trust to purchase $128.9
million aggregate principal amount of 8.675% Series A Junior Subordinated
Deferrable Interest Debentures of the Company due February 1, 2027 (the "Series
A Debentures"). The Company utilized the $123.5 million of net proceeds as
follows: $70 million to repay the amount outstanding under the term loan portion
of the Senior Credit Facility, $45 million to make a surplus contribution to
ERII and $8.5 million for general corporate purposes. On May 29, 1997, all of
the Series A Capital Securities were exchanged for Series B Capital Securities
(the "Capital Securities"). In addition, $125 million aggregate principal amount
of the Series A Debentures were exchanged for a like aggregate principal amount
of 8.675% Series B Junior Subordinated Deferrable Interest Debentures of the
Company due February 1, 2027 (the "Series B Debentures" and together with the
remaining $3.9 million aggregate principal amount of the outstanding Series A
Debentures are hereinafter referred to as the "Debentures"). The terms of the
Capital Securities are identical in all material respects to the terms of the
Series A Capital Securities, except that the Capital Securities have been
registered under the Securities Act of 1933 and will not be subject to the
$100,000 minimum liquidation amount transfer restriction and certain other
transfer restrictions applicable to the Series A Capital Securities. The sole
assets of the Trust are the Debentures.
Holders of the Capital Securities will be entitled to receive
cumulative cash distributions, accumulating from the date of original issuance
and payable semi-annually in arrears on February 1 and August 1 of each year at
an annual rate of 8.675%. Interest on the Debentures, and hence distributions on
the Capital Securities, may be deferred by the Company to the extent set forth
in the applicable instrument. The Capital Securities are subject to mandatory
redemption on February 1, 2027, upon repayment of the Series B Debentures, at a
redemption price equal to the principal amount of, plus accrued but unpaid
interest on, the Series B Debentures. The Capital Securities are also subject to
mandatory redemption in certain other specified circumstances at a redemption
price that may or may not include a make-whole premium. The Company's
obligations under the Series B Debentures, the related indenture and trust
agreement and the guarantee issued for the benefit of the holders of the Capital
Securities, taken together, constitute a full, irrevocable and unconditional
guarantee by the Company of the Capital Securities.
On December 12, 1997, the Company issued $75 million aggregate
principal amount of unsecured 7.125% senior notes (the "Senior Notes") maturing
on December 15, 2007. Interest on the Senior Notes is payable semi-annually in
arrears, on June 15 and December 15, commencing on June 15, 1998. The Senior
Notes may not be redeemed prior to maturity and are not subject to any sinking
fund. The Company has used the $74.2 million of net proceeds of the issue to
make surplus contributions to current insurance company subsidiaries of the
Company in order to support existing business lines and to finance entry into
new business lines, and for general corporate purposes.
The carrying value of the Capital Securities and the Senior Notes
approximates their fair market value. Interest paid on debt totaled $6.3
million, $3.9 million and $1.8 million in 1997, 1996 and 1995, respectively.
<PAGE> 20
9. INVESTMENT INFORMATION
Fixed Maturities and Equity Securities: The amortized cost, cost and
fair value of investments in fixed maturities and equity securities as of
December 31, 1997 and 1996 were as follows:
<TABLE>
<CAPTION>
Amortized Gross Gross
Cost Unrealized Unrealized Fair
(In thousands) and Cost Gains Losses Value
1997
<S> <C> <C> <C> <C>
Fixed Maturities:
United States Government
or agency securities $ 50,237 $ 391 ($ 7) $ 50,621
Obligations of states and
political subdivisions 532,839 24,514 -- 557,353
Corporate securities 178,382 2,752 (733) 180,401
Mortgage and other asset backed securities 119,203 2,469 (152) 121,520
Foreign governments 1,297 13 -- 1,310
Sinking fund preferred stocks 23,092 684 -- 23,776
$905,050 $ 30,823 ($ 892) $ 934,981
-------------------------------------------------------
Equity securities $ 42,787 $ 18,945 -- $ 61,732
-------------------------------------------------------
$947,837 $ 49,768 ($ 892) $996,713
-------------------------------------------------------
1996
Fixed Maturities:
United States Government
or agency securities $ 24,621 $ 178 ($ 65) $ 24,734
Obligations of states and
political subdivisions 424,012 15,403 (134) 439,281
Corporate securities 91,528 1,463 (136) 92,855
Mortgage and other asset backed securities 60,911 1,168 (124) 61,955
Foreign governments 1,517 50 -- 1,567
Sinking fund preferred stocks 8,000 172 -- 8,172
$610,589 $ 18,434 ($ 459) $ 628,564
-------------------------------------------------------
Equity securities $ 27,820 $ 9,899 ($ 14) $ 37,705
-------------------------------------------------------
$638,409 $ 28,333 ($ 473) $ 666,269
-------------------------------------------------------
</TABLE>
Realized capital gains and losses on sales of investments were as follows:
<TABLE>
<CAPTION>
Year Ended December 31,
(In thousands) 1997 1996 1995
<S> <C> <C> <C>
Fixed Maturities:
Gross realized capital gains $ 2,573 $ 1,913 $ 175
Gross realized capital losses (748) (2,071) (1,649)
Equity Securities:
Gross realized capital gains $ 1,389 $ 1,205 $ 3,062
Gross realized capital losses (2) -- --
</TABLE>
The amortized cost and fair value of investments in fixed maturities at December
31, 1997 are shown as follows by effective maturity dates except that for
mortgage and other asset backed securities, maturities are calculated using
expected maturity dates, which are based on historic cash flow patterns.
Effective maturities will differ from contractual maturities because borrowers
may have the right to call or prepay obligations with or without call or
prepayment penalties.
<PAGE> 21
<TABLE>
<CAPTION>
Amortized Fair
(In thousands) Cost Value
<S> <C> <C>
Due in one year or less $ 73,364 $ 73,835
Due after one year through five years 302,799 310,034
Due after five years through ten years 464,016 484,321
Due after ten years 64,871 66,791
-------------------------
$905,050 $934,981
</TABLE>
Changes in unrealized gains and losses were as follows:
<TABLE>
<CAPTION>
Year Ended December 31,
(In thousands) 1997 1996 1995
<S> <C> <C> <C>
Fixed maturities $11,956 ($5,375) $27,369
Equity Securities 9,060 4,236 6,320
</TABLE>
Investment Income: The components of net investment income were as follows:
<TABLE>
<CAPTION>
Year Ended December 31,
(In thousands) 1997 1996 1995
<S> <C> <C> <C>
Fixed maturities
Taxable $17,438 $ 8,672 $ 5,052
Tax-exempt 24,933 22,400 20,242
Equity securities 2,410 637 868
Short-term investments 3,398 1,714 1,132
---------------------------------------
48,179 33,423 27,294
Investment expenses 1,064 777 588
---------------------------------------
Net investment income $47,115 $32,646 $26,706
</TABLE>
10. STOCKHOLDERS' EQUITY
Preferred Stock: The Company has 4,000,000 preferred shares authorized
at December 31, 1997 and 1996, with no shares issued or outstanding.
Treasury Shares: Pursuant to the Aetna stock repurchase (Note 5), all
1,225,000 shares of Class B Common Stock and 1,286,300 shares of Common Stock
were repurchased at a per share price of $29.875 and held in treasury during the
first quarter of 1996. In connection with the June 7, 1996 secondary offering,
the 300,000 shares of Common Stock covered by the underwriters' over-allotment
option were issued (at a net per share price of $32.25) from shares held in
treasury. On May 10, 1996, the Board of Directors approved a resolution to
retire all 1,225,000 shares of Class B Common Stock held in treasury. In May
1997, the Articles of Incorporation were amended so that the Company no longer
has Class B Common Stock as an authorized class.
Stock Option Plans: The Company has a Nonqualified Stock Option Plan
and an Employee Incentive Nonqualified Stock Option Plan whereby key employees
may be granted options to purchase shares of the Company's Common Stock at a
price determined by the Committee on Directors and Compensation of the Company's
Board of Directors.
In November 1990, the Company adopted the IPO Stock Compensation Plan
(the "IPO Plan") under which Share Units were granted to certain key employees.
On the date of the closing of the Company's March 1994 initial public offering,
the Share Units were converted into the right to receive 161,905 stock options
to purchase Common Stock at an exercise price equal to 30% of the average
closing price of the Common Stock for the 30-day period immediately preceding
that date. Options representing one-half of the total award were granted on
March 22, 1995 to those specified employees employed by the Company on that
date. The other half were granted on March 22, 1996 to those specified employees
still employed by the Company on that date.
<PAGE> 22
Information with respect to the employee stock options was as follows:
<TABLE>
<CAPTION>
1997 1996 1995
Weighted Weighted Weighted
Average Average Average
Number of Exercise Number of Exercise Number of Exercise
Options Price Options Price Options Price
------- ----- ------- ----- ------- -----
<S> <C> <C> <C> <C> <C> <C>
Outstanding at
beginning of year 1,465,294 $ 13.89 1,292,304 $ 12.77 1,329,350 $ 13.33
Granted 546,700 58.30 219,202 20.54 101,104 7.42
Exercised (355,179) 11.37 (31,137) 12.53 (131,312) 14.29
Forfeited (10,900) 24.52 (15,075) 17.95 (6,838) 13.44
Outstanding at
end of year 1,645,915 $ 29.11 1,465,294 $ 13.89 1,292,304 $ 12.77
Options exercisable at
end of year 984,762 $ 13.42 1,066,418 $ 12.26 768,042 $ 12.20
Shares reserved under
option plans 2,492,372 -- 2,847,551 -- 2,878,688 --
Weighted average fair
value of options granted
during the year $ 31.22 -- $ 18.92 -- $ 12.52 --
</TABLE>
In connection with the majority of options exercised in 1995, promissory notes
were issued in favor of the Company. Such notes were repaid in full in the first
quarter of 1997.
The following table summarizes information about the Company's employee stock
options outstanding at December 31, 1997.
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
Average
Weighted Remaining Weighted
Range of Number of Average Contractual Number of Average
Exercise Prices Options Price Life (Years) Options Price
<S> <C> <C> <C> <C> <C> <C>
$ 4.88 - $10.00 90,476 $ 6.92 7.7 90,476 $ 6.92
12.00 - 20.00 886,988 13.61 5.4 863,100 13.60
26.00 - 53.75 156,250 30.13 8.4 31,186 27.46
57.81 - 67.38 512,200 59.57 9.7 -- --
--------- -------
$ 4.88 - $67.38 1,645,914 $29.11 7.2 984,762 $13.42
</TABLE>
The Company has adopted a Nonemployee Directors Option Plan (the
"Directors Plan") to provide its nonemployee directors with stock-based
incentive compensation. The Directors Plan is intended to relate director
compensation to the financial performance of the Company and the market value of
the Common Stock.
<PAGE> 23
Information with respect to the Directors Plan options was as follows:
<TABLE>
<CAPTION>
1997 1996 1995
Weighted Weighted Weighted
Average Average Average
Number of Exercise Number of Exercise Number of Exercise
Options Price Options Price Options Price
<S> <C> <C> <C> <C> <C> <C>
Outstanding
at beginning
of year 82,285 $12.93 83,026 $10.89 59,798 $ 9.48
Granted 6,719 41.00 11,242 24.25 24,148 14.43
Exercised (8,551) 11.35 (6,725) 4.89 (920) 12.00
Forfeited (1,281) 28.01 (5,258) 15.22 -- --
-------- -------- -------
Outstanding at
end of year 79,172 $15.24 82,285 $12.93 83,026 $10.89
Options
exercisable at
end of year 79,172 $15.24 72,176 $11.12 58,878 $ 9.44
Shares reserved
under option
plan 483,804 -- 492,355 -- 499,080 --
Weighted
average fair
value of options
granted during
the year $ 29.44 $ 18.92 $10.02
</TABLE>
The following table summarizes information about the Directors Plan stock
options outstanding at December 31, 1997.
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
Average
Weighted Remaining Weighted
Range of Number of Average Contractual Number of Average
Exercise Prices Options Price Life (Years) Options Price
<S> <C> <C> <C> <C> <C> <C>
$ 3.32 - $11.51 18,235 $ 4.94 6.9 18,235 $ 4.94
$ 12.00 35,780 12.00 6.1 35,780 12.00
$13.89 - 50.25 25,157 27.30 8.2 25,157 27.30
------ ------
$ 3.32 - $50.25 79,172 $15.24 6.9 79,172 $15.24
</TABLE>
In connection with the aforementioned employee and director stock option plans,
the Company accrued compensation expense, under APB 25, for the years ended
December 31, 1997, 1996 and 1995, of approximately $0.1 million, $0.7 million
and $1.5 million, respectively.
Stock Incentive and Performance Share Plans: In November 1995, the
Board of Directors approved two long-term stock-based incentive compensation
plans, the Stock Incentive Plan (the "SIP") and the Performance Share Plan (the
"PSP"), together referred to herein as the "1995 Plans." The SIP became
effective as of January 1, 1996 and the PSP as of January 1, 1995.
The Company has reserved 250,000 shares of Common Stock for issuance
under the SIP and 1,000,000 shares of Common Stock for issuance under the PSP,
subject to the restrictions set forth in each of the respective 1995 Plans, and
to the approval of the Committee on Directors and Compensation of the Board of
Directors. Under the SIP, employees are eligible to be granted stock "units,"
bearing a relationship to their respective cash bonuses under the Company's
Incentive Compensation Plan, which convert into shares of Common Stock upon
completion of the applicable vesting period (generally three years). Virtually
all employees are eligible to receive awards under the SIP with respect to any
fiscal year, other than those employees receiving awards under the PSP with
respect to that year. Under the PSP, certain key employees designated by the
Committee on Directors and Compensation are eligible to receive awards of
"performance share units" which convert into Common Stock and/or cash, as
determined by the Committee on Directors and Compensation, upon completion of
the performance period to which such awards relate. The amount of Common Stock
and/or cash, if any, to be received by participants in the PSP is
<PAGE> 24
dependent upon, among other things, the financial performance of the Company
during the relevant three-year performance period. 8,484 and 8,525 share units
were granted in 1997 and 1996, respectively, under the SIP, of which 374 and 915
share units, respectively, were subsequently forfeited. 37,000 and 83,050
performance share units were granted under the PSP in 1997 and 1996,
respectively, of which 1,150 and 7,850 performance share units, respectively,
were subsequently forfeited. The weighted average fair value of the share units
and performance share units granted during 1997 and 1996 was $47.14 and $30.48
per share unit, respectively. The Company accrued compensation expense, under
APB 25, for the years ended December 31, 1997, 1996 and 1995 of approximately
$6.2 million, $1.8 million and $0.6 million, respectively, in connection with
the SIP and PSP.
Supplemental and Pro Forma Disclosures: The following pro forma
information regarding net income and earnings per share, required by SFAS 123,
"Accounting for Stock-Based Compensation" have been determined as if the Company
had accounted for its stock-based compensation plans under the fair value
methods described in that statement. The fair value of options and other awards
granted under the Company's stock-based compensation plans was estimated at the
date of grant using a Black-Scholes option pricing model. The Black-Scholes
option pricing model was developed for use in estimating the fair value of
traded options that have no vesting restrictions and are fully transferable. In
addition, option pricing models require the input of highly subjective
assumptions including the expected dividend yield, the expected life of the
options, the expected price volatility and the risk-free interest rate.
The weighted average dividend yield for stock option grants during
1997, 1996 and 1995 was .14%, .26% and .47%, respectively. The weighted average
expected life for 1997, 1996 and 1995 was 9.8 years, 8.8 years and 9.3 years,
respectively. The weighted average volatility for 1997, 1996 and 1995 was .28%,
.27% and .28%, respectively. The weighted average risk-free interest rate for
1997, 1996 and 1995 was 6.25%, 6.36% and 7.10%, respectively.
For purposes of pro forma disclosures, the estimated fair value of the
options and stock awards is amortized to expense over the options' and awards'
vesting period and does not include grants prior to January 1, 1995. As such,
the pro forma net income and earnings per share are not indicative of future
years. The Company's pro forma information was as follows:
<TABLE>
<CAPTION>
(In thousands, except per share data) 1997 1996 1995
<S> <C> <C> <C> <C>
Net income As reported $36,525 $28,105 $25,286
Pro forma 36,199 27,040 25,665
Earnings per common
share As reported $3.71 $2.88 $2.20
Pro forma 3.68 2.77 2.23
Earnings per common
share - assuming dilution As reported $3.41 $2.67 $2.12
Pro forma 3.38 2.59 2.15
</TABLE>
Rights Plan: The Company has adopted a Shareholder Rights Plan (the
"Rights Plan"). When exercisable, each Right entitles the registered holder to
purchase from ERI one share of Common Stock at a price of $60.32 per share,
subject to adjustment. The Rights Plan has certain anti-takeover effects. The
Rights will cause substantial dilution to a person or group that attempts to
acquire the Company on terms not approved by the Board of Directors.
Retained Earnings: ERII, ERSIC and Quadrant are subject to state
regulatory restrictions that limit the maximum amount of dividends payable.
Subject to certain net income carryforward provisions as described below, ERII
must obtain approval of the Insurance Commissioner of the State of Delaware in
order to pay, in any 12-month period, "extraordinary" dividends which are
defined as those in excess of the greater of 10% of surplus as regards
policyholders as of the prior year-end and statutory net income less realized
capital gains for such prior year. Dividends may be paid by ERII only out of
earned surplus. In addition, ERII must provide notice to the Insurance
Commissioner of the State of Delaware of all dividends and other distributions
to shareholders within five business days after declaration and at least ten
days prior to payment. ERSIC and Quadrant must obtain approval of the Insurance
Commissioner of the State of Connecticut in order to pay, in any 12-month
period, "extraordinary" dividends which are defined as those in excess of the
greater of 10% of surplus as regards policyholders as of the prior year-end and
statutory net income for such prior year. The Connecticut law further provides
that (i) ERSIC and Quadrant must report to the Connecticut Commissioner, for
informational purposes, all dividends and other distributions to shareholders
within five business days after the declaration thereof and at least ten days
prior to payment and (ii) ERSIC and Quadrant may not pay any dividend or
distribution in excess of its earned surplus, as reflected in its most recent
statutory annual statement on file with the Connecticut Commissioner, without
such Commissioner's approval. Under
<PAGE> 25
applicable insurance law, the retained exposure of ERII, ERSIC and Quadrant on
any one risk cannot exceed 10% of its statutory capital and surplus.
11. RELATED PARTIES
A substantial portion of the investments of the Company have been
managed by Conning Asset Management (previously Conning & Company), a former
stockholder of the Company. The related agreement associated with this service
stipulates annual fees based on the aggregate invested assets of the Company.
The management contract with Conning Asset Management expires in June 1998. The
aggregate payments by the Company under this agreement were approximately $0.5
million in 1997, $0.6 million in 1996 and $0.5 million in 1995.
12. RETIREMENT PLANS
The Company maintains a defined contribution retirement plan (the
"Plan") covering substantially all employees. Under the Plan, the Company
contributes 4% of total compensation up to the social security wage base.
Thereafter, the Company contributes 8% of the total compensation that exceeds
this wage base. In addition, employee contributions of up to 10% (8% as of
January 1, 1998) of each such employee's total compensation to the Plan is
matched by the Company at a rate determined by the Company's average return on
equity for the preceding three years. The Company also maintains the Benefit
Equalization Plan (the "BEP"), a supplemental, nonqualified defined contribution
plan. The BEP covers certain officers of the Company for the portion of
retirement contributions, as determined by the provisions of the Plan, which
exceed IRS limitations on contributions and eligible compensation. Amounts
contributed by the Company to these retirement plans were $2.4 million, $1.7
million and $1.3 million in 1997, 1996 and 1995, respectively. These amounts
include contributions in respect of service in prior years with the Company.
During 1996, the Company entered into a Supplemental Pension Agreement
(the "SPA") with its former Chief Executive Officer ("CEO") and AL&C which
replaced a 1988 retirement arrangement among the parties, under which the
Company had previously accrued an unfunded, non-tax qualified defined benefit.
Under the SPA and the former CEO's Employment Agreement, (i) the former CEO
participated in the Plan and the BEP, to the same extent as other Company
employees and (ii) the Company has an obligation to make premium payments on a
life insurance policy in the initial amount of $1 million owned by an
irrevocable trust established by the former CEO, a so-called "split-dollar"
arrangement.
On May 30, 1997, the Company's former CEO (and Chairman) retired as an
officer and director. The Company's obligation to make additional contributions
to the Plan and the BEP, on behalf of the former CEO, ended with his retirement.
The Company's obligation to make premium payments on the life insurance policy,
as described above, continues.
13. INCOME TAXES
The provision for income taxes varies from the amount that would be computed
using the federal statutory income tax rate as follows:
<TABLE>
<CAPTION>
Year Ended December 31,
(In thousands) 1997 1996 1995
<S> <C> <C> <C>
Pre-tax income $ 44,680 $ 34,739 $ 30,140
Application of the federal statutory
tax rate (35%) 15,638 12,159 10,549
Tax effect of:
Tax-exempt interest (7,417) (6,676) (6,059)
State income taxes 736 625 10
Dividends received and other (802) 526 354
------------------------------------------
Total income tax provision $ 8,155 $ 6,634 $ 4,854
</TABLE>
<PAGE> 26
Significant components of the Company's deferred tax assets and liabilities are
summarized as follows:
<TABLE>
<CAPTION>
December 31,
(In thousands) 1997 1996 1995
<S> <C> <C> <C>
Deferred tax assets:
Loss reserve discounting $34,850 $30,871 $24,178
Unearned premiums 13,297 9,462 5,750
Other 6,244 4,518 4,544
-------------------------------------
Total deferred tax assets 54,391 44,851 34,472
Deferred tax liabilities:
Deferred acquisition costs 12,108 7,707 5,510
Unrealized gains on investments 17,107 9,475 9,842
Other 1,860 1,400 783
-------------------------------------
Total deferred tax liabilities 31,075 18,582 16,135
-------------------------------------
Net deferred tax assets $23,316 $26,269 $18,337
</TABLE>
Income taxes paid were $11.5 million, $12.4 million and $10.6 million in 1997,
1996 and 1995, respectively.
<PAGE> 27
14. UNPAID LOSS AND LOSS ADJUSTMENT EXPENSES
The following table sets forth the activity in unpaid loss and loss adjustment
expenses ("LAE"), net of reserves for reinsured loss and LAE, for the years
indicated.
<TABLE>
<CAPTION>
Year Ended December 31,
(In thousands) 1997 1996 1995
<S> <C> <C> <C>
Reserves for losses and LAE at beginning of period, gross $ 457,063 $ 324,416 $ 254,758
Reinsurance recoverable at beginning of period (76,916) (33,531) (8,958)
Reserves for losses and LAE at beginning of period, net 380,147 290,885 245,800
Provision for losses and LAE for current year claims 152,042 112,107 83,775
Decrease in estimated ultimate losses
and LAE for prior year claims (10,269) (6,772) (5,245)
---------------------------------------------
Total incurred losses and LAE 141,773 105,335 78,530
Adjustment for foreign exchange loss
on unpaid loss and LAE (469) (23) 58
Loss and LAE payments for claims attributable to:
Current year 4,495 2,239 792
Prior years 36,193 13,811 32,711
---------------------------------------------
Total payments 40,688 16,050 33,503
---------------------------------------------
Reserves for losses and LAE at end of period, net 480,763 380,147 290,885
Reinsurance recoverable at end of period 157,166 76,916 33,531
---------------------------------------------
Reserves for losses and LAE at end of period, gross $ 637,929 $ 457,063 $ 324,416
</TABLE>
The decrease in estimated ultimate losses and LAE for prior year claims was due
principally to favorable development on known claims.
15. PRESCRIBED OR PERMITTED STATUTORY PRACTICES
ERII, which is domiciled in Delaware, and ERSIC and Quadrant, which are
domiciled in Connecticut, prepare their statutory financial statements in
accordance with accounting principles and practices prescribed or permitted by
their respective state insurance departments. Prescribed statutory accounting
practices include state laws, regulations and general administrative rules, as
well as a variety of publications of the National Association of Insurance
Commissioners ("NAIC"). Permitted statutory accounting practices encompass all
accounting practices that are not prescribed; such practices differ from state
to state, may differ from company to company within a state and may change in
the future. Furthermore, the NAIC has a project to codify statutory accounting
practices, the result of which is expected to constitute the only source of
"prescribed" statutory accounting practices. Accordingly, that project will
likely change the definitions of what comprises prescribed versus permitted
statutory accounting practices and may result in changes to the accounting
policies that insurance companies use to prepare their statutory financial
statements. ERII, ERSIC and Quadrant follow prescribed accounting practices in
preparing their statutory financial statements, in all material respects.
16. RECONCILIATION - GENERALLY ACCEPTED ACCOUNTING PRINCIPLES BASIS TO STATUTORY
BASIS
The following table reconciles consolidated net income and stockholders' equity
as reported herein on the basis of GAAP with ERII's consolidated statutory basis
income and consolidated statutory basis capital and surplus. ERII's consolidated
results include those of its wholly owned subsidiaries, ERSIC and Quadrant.
<PAGE> 28
<TABLE>
<CAPTION>
Year Ended December 31,
(In thousands) 1997 1996 1995
<S> <C> <C> <C>
Consolidated GAAP income $ 36,525 $ 28,105 $ 25,286
Eliminate parent company loss 8,690 5,037 2,183
ERII consolidated GAAP income 45,215 33,142 27,469
Add (subtract) GAAP adjustments:
Deferred acquisition costs 171 (11,754) (3,221)
Deferred income tax benefits 9,735 (6,213) (4,348)
Change in foreign exchange translation (359) (20) 56
Other 33 33 (32)
---------------------------------------------
ERII consolidated statutory income $ 54,795 $ 15,188 $ 19,924
December 31,
1997 1996 1995
Consolidated GAAP stockholders' equity $ 276,183 $ 144,775 $ 177,725
Eliminate parent company deficit 56,947 64,843 663
---------------------------------------------
ERII consolidated GAAP stockholders' equity 333,130 209,618 178,388
Add (subtract) GAAP adjustments:
Deferred acquisition costs (28,918) (29,090) (17,336)
Deferred income tax benefits (4,885) (22,207) (16,109)
Adjust invested assets to statutory value (30,434) (17,753) (21,824)
Other (3,330) (2,163) (1,654)
---------------------------------------------
ERII consolidated statutory capital and surplus $ 265,563 $ 138,405 $ 121,465
</TABLE>
17. CONSOLIDATED QUARTERLY DATA (UNAUDITED)
<TABLE>
<CAPTION>
First Second Third Fourth
(In thousands, except per share data) Quarter Quarter Quarter Quarter Year
<S> <C> <C> <C> <C> <C>
1997
Net premiums earned $46,229 $50,206 $54,787 $59,954 $211,176
Net investment income 10,105 11,255 11,682 14,073 47,115
Income before income taxes 10,100 10,758 10,525 13,297 44,680
Federal and state income tax expense 1,686 2,190 1,610 2,669 8,155
Net Income 8,414 8,568 8,915 10,628 36,525
Earnings per common share -
assuming dilution (1) 0.83 0.83 0.84 0.91 3.41
Common Stock price range (2)
- High 48 3/4 56 68 3/8 72 72
- Low 35 5/8 43 3/8 49 13/16 63 1/2 35 5/8
1996
Net premiums earned $33,913 $36,425 $41,066 $44,380 $155,784
Net investment income 7,375 7,450 8,389 9,432 32,646
Income before income taxes 8,763 6,722 8,103 11,151 34,739
Federal and state income tax expense 1,538 1,162 1,359 2,575 6,634
Net Income 7,225 5,560 6,744 8,576 28,105
Earnings per common share -
assuming dilution (1)(3) 0.60 0.57 0.67 0.85 2.67
Common Stock price range (2)
- High 33 5/8 38 1/4 38 1/2 42 3/8 42 3/8
- Low 26 1/8 29 1/4 33 3/8 33 7/8 26 1/8
</TABLE>
(1) The 1996 and the first three quarters of 1997 earnings per common share
amounts have been restated to comply with the provisions of SFAS 128.
(2) The stock price range is based on high and low sales prices reported by
Bloomberg. The Company paid quarterly dividends of $0.02 per share in 1997, 1996
and 1995. The Company currently intends to continue paying regular cash
dividends on a quarterly basis. See Notes 8 and 10 for information on potential
restrictions on the payment of future dividends.
(3) The sum of the quarters' earnings per share does not equal the year-to-date
per share amount. As of February 23, 1998, the approximate number of common
shareholders of record was 95.
<PAGE> 1
EXHIBIT 21
SUBSIDIARIES OF EXECUTIVE RISK INC.
<TABLE>
<CAPTION>
CHARTERING PERCENT
NAME OF SUBSIDIARY JURISDICTION OWNED
- ------------------ ------------ -------
<S> <C> <C>
Executive Risk Inc. Subsidiaries
--------------------------------
Executive Risk Management Associates* Connecticut 70%
(underwriting and claims agency)
Executive Risk Capital Trust Delaware 100%
Executive Re Inc. Delaware 100%
(middle-level holding company)
Executive Re Inc. Subsidiaries
------------------------------
- Executive Risk Management Associates* Connecticut 30%
- Executive Risk Netherlands 100%
International Holdings BV
(mid-level holding co.)
Executive Risk I.H. BV subsidiary
---------------------------------
- Executive Risk N.V. Netherlands 100%
(Netherlands insurer)
- Executive Risk (Bermuda) Ltd. Bermuda 100%
(Bermuda insurer)
- Sullivan Kelly Inc. California 100%
(underwriting manager)
Sullivan Kelly Inc. subsidiary
------------------------------
- Sullivan Kelly of Arizona, Inc. Arizona 100%
- Executive Risk Indemnity Inc. Delaware 100%
(admitted insurance company)
Executive Risk Indemnity Inc. subsidiaries
------------------------------------------
- Executive Risk Specialty Connecticut 100%
Insurance Company
(surplus lines company)
</TABLE>
<PAGE> 2
-Quadrant Indemnity Company Connecticut 100%
(admitted insurance company)
-Talcott Services Corporation Connecticut 100%
-Executive Risk Limited United Kingdom 100%
- ---------------------------------------
*Connecticut general partnership.
ALL SUBSIDIARIES HAVE A PRINCIPAL U.S. MAILING ADDRESS OF:
82 HOPMEADOW STREET
SIMSBURY, CONNECTICUT 06070
<PAGE> 1
Exhibit 23.1
CONSENT OF INDEPENDENT AUDITORS
We consent to the incorporation by reference in this Annual Report (Form
10-K) of Executive Risk Inc. of our report dated February 3, 1998, included in
the 1997 Annual Report to Shareholders of Executive Risk Inc.
Our audits also included the financial statement schedule of Executive Risk
Inc. listed in Item 14. This schedule is the responsibility of the Company's
management. Our responsibility is to express an opinion based on our audits. In
our opinion, the financial statement schedule referred to above, when considered
in relation to the basic financial statements taken as a whole, presents fairly
in all material respects the information set forth therein.
/s/ ERNST & YOUNG LLP
Stamford, Connecticut
March 25, 1998
<PAGE> 1
Exhibit 23.2
CONSENT OF INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statement
(Form S-8 No. 33-78414) pertaining to the Executive Risk Inc. Nonqualified Stock
Option Plan, Executive Risk Inc. Employee Incentive Nonqualified Stock Option
Plan, Executive Risk, Inc. IPO Stock Compensation Plan, Executive Risk Inc.
Nonemployee Directors Stock Option Plan, and Option Agreements for Outside
Directors of Executive Re Inc. of our report dated February 3, 1998 with respect
to the consolidated financial statements and schedule of Executive Risk Inc. and
subsidiaries included and/or incorporated by reference in the Annual Report
(Form 10-K) for the year ended December 31, 1997.
/s/ ERNST & YOUNG LLP
Stamford, Connecticut
March 25, 1998
<TABLE> <S> <C>
<ARTICLE> 7
<LEGEND>
This schedule contains summary financial information extracted from the
Company's 1997 10-K and is qualified in its entirety by reference to such
financial statements.
</LEGEND>
<MULTIPLIER> 1,000
<CURRENCY> U.S. DOLLARS
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
<EXCHANGE-RATE> 1
<DEBT-HELD-FOR-SALE> 934,981
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 61,732
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 996,713
<CASH> 88,505
<RECOVER-REINSURE> 2,751
<DEFERRED-ACQUISITION> 34,581
<TOTAL-ASSETS> 1,485,804
<POLICY-LOSSES> 637,929
<UNEARNED-PREMIUMS> 289,840
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 75,000
125,000
0
<COMMON> 120
<OTHER-SE> 276,063
<TOTAL-LIABILITY-AND-EQUITY> 1,485,804
211,176
<INVESTMENT-INCOME> 47,115
<INVESTMENT-GAINS> 3,212
<OTHER-INCOME> 144
<BENEFITS> 141,773
<UNDERWRITING-AMORTIZATION> 34,978
<UNDERWRITING-OTHER> 40,216
<INCOME-PRETAX> 44,680
<INCOME-TAX> 8,155
<INCOME-CONTINUING> 36,525
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 36,525
<EPS-PRIMARY> 3.71
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