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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
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FORM 10-K/A
[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,
1998
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
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to .
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Commission File No. 1-12800
EXECUTIVE RISK INC.
(Exact name of registrant as specified in its charter)
DELAWARE 06-1388171
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
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:
Title of Class Name of Exchange on which registered
COMMON STOCK, $.01 PAR VALUE NEW YORK STOCK EXCHANGE
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
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Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
The aggregate market value on March 17, 1999 of the voting stock held by
non-affiliates of the registrant was approximately $770 million. There were
11,371,947 shares of the registrant's Common Stock, $.01 par value, outstanding
as of March 17, 1999.
DOCUMENTS INCORPORATED BY REFERENCE
None
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NOTE ON FORWARD-LOOKING STATEMENTS: The Private Securities Litigation
Reform Act of 1995 provides a "safe harbor" for forward-looking statements. This
Report may include forward-looking statements, as do other publicly available
Company documents, including reports on Forms 10-Q and any Form 8-K filed with
the Securities and Exchange Commission and other written or oral statements made
by or on behalf of the Company, its officers and employees. When made, such
forward-looking statements reflect the then-current views of the Company or its
management with respect to future events and financial performance. There are
known and unknown risks, uncertainties and other factors that could cause actual
results to differ materially from those contemplated or indicated by such
forward-looking statements. These include, but are not limited to, risks and
uncertainties inherent in or relating to the closing under the Agreement and
Plan of Merger, dated as of February 6, 1999, by and among the Company, The
Chubb Corporation and Excalibur Acquisition Inc., as well as (i) general
economic conditions, including interest rate movements, inflation and cyclical
industry conditions, (ii) governmental and regulatory policies affecting
professional liability, as well as the judicial environment, (iii) the loss
reserving process, (iv) increasing competition in the market segments in which
the Company operates, (v) the conduct of international operations, including
exchange rate fluctuations and foreign regulatory changes, and (vi) the effects
of the Year 2000 issue on Company insureds and the degree to which liability
exposure is affected thereby. 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. Neither the Company nor its management
undertakes any obligation to publicly update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise.
The undersigned registrant hereby amends its Form 10-K, filed with the
Securities Exchange Commission for the year ended December 31, 1998 to amend and
restate in its entirety Item 7, "Management's Discussion and Analysis of
Financial Condition and Results of Operation" and to add Item 13, "Certain
Relationships and Related Transactions."
ITEM 7. 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,
1998 with the corresponding periods for 1997 and 1996. The results of the
Company include the consolidated results of ERMA, Executive Re and Executive
Re's insurance subsidiaries, ERII, ERSIC, ERNV, Quadrant and Executive Risk
(Bermuda) Ltd., a 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., 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, 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
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AXA-UAP Group in exchange for the Company agreeing not to compete for a period
of one year 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. In the third
quarter of 1998, the Company announced the closing of the Sullivan Kelly
brokerage operation and the Paris France office of ERNV. In connection with
these closings, $5.8 million of charges were recorded.
On February 6, 1999 the Company entered into a definitive merger agreement with
The Chubb Corporation ("Chubb"). The agreement provides that ERI stockholders
will receive, upon closing, 1.235 shares of Chubb common stock in exchange for
each share of Company common stock. The consummation of the transaction is
subject to customary closing conditions and the approval of ERI's stockholders
and regulatory approvals. It is anticipated that all approvals will be received
by the end of the second quarter of 1999. Also in the first quarter of 1999, the
Company restructured certain of its reinsurance treaties. The restructured
reinsurance program generally makes greater use of excess of loss reinsurance,
rather than quota share reinsurance, to reduce exposure to loss severity. The
reinsurance restructuring resulted in the non-renewal of several in-force
reinsurance treaties commensurate with the effective dates of the new treaties.
The restructuring of the reinsurance treaties is not expected to have a material
adverse effect on the Company's financial position or results of operations.
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. and Standard & Poor's.
ERII, ERSIC, Quadrant and ERNV's current rating from A.M. Best is "A
(Excellent)", and their current financial strength 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, 1998 AND 1997
Gross premiums written increased by $84.9 million, or 20%, to $516.3 million in
1998 from $431.4 million in 1997. The increase was due to growth in sales in
most of the Company's lines of business, including lawyers professional
liability, miscellaneous professional liability errors and omissions insurance
("E&O") and medical malpractice insurance. These increases were partially offset
by a decrease in domestic and international directors and officers liability
insurance ("D&O"). The level of D&O gross premiums written has been adversely
affected both by continued strong competition in the D&O market and by
conservative underwriting of D&O applicants that appear to the Company to
present relatively greater exposure to the Year 2000 issue. These factors are
likely to affect the level of D&O writings over the next few years.
Ceded premiums increased $63.1 million, or 37%, to $232.6 million in 1998 from
$169.5 million in 1997. The rate of growth in ceded premiums exceeded that of
gross premiums written due to a smaller percentage of the 1998 premium writings
being in D&O compared to 1997. D&O premiums are ceded at a lower rate
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than other products, and, therefore, as the D&O premium shrinks as a percentage
of the total premium, the ceded premiums rise relative to gross premiums
written.
As a result of the foregoing, net premiums written increased $21.8 million, or
8%, to $283.7 million in 1998 from $261.9 million in 1997. Over the same
periods, net premiums earned increased to $254.5 million from $211.2 million.
Net investment income increased by $14.6 million, or 31%, to $61.7 million in
1998 from $47.1 million in 1997. The increase resulted principally from growth
in the Company's investment portfolio, measured on an amortized cost basis, from
$1.0 billion at December 31, 1997 to $1.2 billion at December 31, 1998. The
Company's equity investment balances were $79.2 million and $61.7 million at
December 31, 1998 and 1997, respectively, and the cash and short-term investment
balances were $34.3 million and $88.5 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
cash flows from insurance operations. The nominal portfolio yield of the fixed
maturity portfolio at December 31, 1998 was 5.85%, as compared to 6.07% at
December 31, 1997. The tax-equivalent yields on the fixed maturity portfolio
were 7.41% and 7.58% for these periods, respectively. The decrease in yields at
year-end 1998 as compared to year-end 1997 was due principally to lower
prevailing interest rates. See "Liquidity and Capital Resources." The Company's
net realized capital gains were $6.7 million in 1998 as compared to $3.2 million
in 1997. In 1998, 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 $26.1 million, or 18%, to
$167.9 million in 1998 from $141.8 million in 1997 due to higher premiums earned
partially offset by a slightly lower loss ratio. The Company's loss ratio
decreased to 66.0% in 1998 from 67.1% in 1997. 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 1998 for prior report years by approximately $17.3 million. In
1997, the Company reduced its unpaid loss and LAE reserves for prior report
years by $10.3 million. These reductions produced corresponding increases in the
Company's net income of approximately $11.2 million, or $0.96 per diluted share
in 1998, and approximately $6.7 million, or $0.62 per diluted share in 1997.
MANY OF EXECUTIVE RISK'S UNDERWRITTEN CLASSES OF BUSINESS ARE
CHARACTERIZED BY LOW FREQUENCY OF CLAIMS BUT VERY HIGH SEVERITY, SUCH AS ERRORS
AND OMISSIONS COVERAGE FOR LARGE LAW FIRMS AND PUBLIC COMPANY DIRECTORS AND
OFFICERS LIABILITY. THESE ARE VOLATILE CLASSES OF BUSINESS AND ARE THEREFORE
DIFFICULT TO EVALUATE FROM A LOSS RESERVE PERSPECTIVE. OFTEN, COVERAGE IS EXCESS
OF OTHER INSURANCE COMPANIES' POLICIES, WHICH LENGTHENS THE REPORTING PERIOD AND
FURTHER INCREASES LOSS VARIABILITY AND UNCERTAINTY. CLAIMS ON THIS BUSINESS
OFTEN INVOLVE LITIGATION AND COURT DECISIONS REGARDING THE UNDERLYING MERITS OF
THE CLAIM. BECAUSE OF THE LONG-TAIL NATURE OF EXECUTIVE RISK'S BUSINESS, IT IS
NOT UNUSUAL FOR CLAIMS TO DEVELOP MANY YEARS AFTER THE POLICIES HAVE BEEN
WRITTEN.
DUE TO THE VOLATILITY OF THE BUSINESS THAT MAKES THE EVALUATION OF LOSS
RESERVES DIFFICULT, EXECUTIVE RISK'S PRACTICE HAS BEEN TO USE ESTIMATES IN
ESTABLISHING LOSS RESERVES THAT IT BELIEVES WOULD ENSURE THAT ADEQUATE
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PROVISION FOR ALL LOSSES INCURRED IS MADE IN THE FINANCIAL STATEMENTS. LOSS
RESERVES ARE ESTIMATED USING ACTUARIAL PROJECTIONS OF THE COST OF THE ULTIMATE
SETTLEMENT OF CLAIMS, BASED UPON A LARGE NUMBER OF FACTORS INCLUDING ACTUAL LOSS
FREQUENCY AND SEVERITY, RATE LEVELS, INFLATION AND LOSS COST TRENDS IMPLICIT IN
THE UNDERLYING DATA, EXPECTED LOSS EXPOSURES AND AN EVALUATION OF THE CURRENT
RISK ENVIRONMENT, INCLUDING PREVAILING ECONOMIC, LEGAL AND SOCIAL CONDITIONS. AS
NEW INFORMATION BECOMES AVAILABLE, INCLUDING ACTUAL CLAIM SETTLEMENTS, EXECUTIVE
RISK ADJUSTS ITS LOSS RESERVES AND REFLECTS THE CHANGES IN THE CURRENT PERIOD.
IN RECENT YEARS, EXECUTIVE RISK HAS REDUCED ITS LOSS RESERVE ESTIMATE
FOR PRIOR PERIODS BASED UPON FAVORABLE LOSS EXPERIENCE SINCE THE INITIAL LOSS
RESERVES WERE ESTABLISHED. THESE REDUCTIONS IN LOSS RESERVES WERE A COMBINATION
OF CASE RESERVES RELEASED UPON FINAL SETTLEMENT OF INDIVIDUAL CLAIMS AND A
REDUCTION OF RESERVES FOR LOSSES AND LOSS EXPENSE INCURRED BUT NOT REPORTED
("IBNR"), AS KNOWN CLAIMS IN A PARTICULAR ACCIDENT YEAR WERE CLOSED. THERE IS NO
ASSURANCE THAT LOSS EXPERIENCE IN THE FUTURE WILL RESULT IN SIMILAR FAVORABLE
DEVELOPMENT.
Policy acquisition costs increased $15.3 million, or 44%, to $50.3 million in
1998 from $35.0 million in 1997. The Company's ratio of policy acquisition costs
to net premiums earned increased to 19.8% in 1998 from 16.6% in 1997. The
increase in the policy acquisition cost ratio was primarily attributable to
higher commission amounts paid to brokers and increased compensation and related
expenses incurred in hiring additional underwriting staff to support growth in
the Company's business. In addition, the Company incurred $1.9 million of
non-recurring expenses in connection with the dissolution of Sullivan Kelly. The
ratio of policy acquisition costs to premiums earned excluding the non-recurring
expenses associated with Sullivan Kelly for the year ended December 31, 1998 was
19.0%.
General and administrative ("G&A") expenses increased $7.7 million, or 27%, to
$36.3 million in 1998 from $28.6 million in 1997. 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. In
addition, $3.9 million of non-recurring expenses were incurred in connection
with the discontinuance of Sullivan Kelly's brokerage operations and the closing
of the Paris office of ERNV. The ratio of G&A expenses to net premiums earned
increased from 13.5% in 1997 to 14.3% in 1998. Excluding the non-recurring
expenses associated with Sullivan Kelly and ERNV, the ratio of G&A costs to
premiums earned decreased by 0.8% to 12.7% for the year ended December 31, 1998
as compared to full year 1997.
As a result of the changes in the aforementioned ratios, the Company's GAAP
combined ratio increased to 100.0% in 1998 from 97.2% in 1997. Excluding the
non-recurring expenses associated with Sullivan Kelly and ERNV the Company's
GAAP combined ratio for 1998 was 97.7%. 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 $5.4 million in 1998 and $1.8 million in 1997 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 $70 million from January 1, 1997 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
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payable. 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 $1.1 million, or 14%, to $9.3 million in 1998 from
$8.2 million in 1997. The Company's effective tax rate decreased to 17.6% in
1998 from 18.3% in 1997. 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 $6.9 million,
or 19%, to $43.4 million, or $3.71 per diluted share, in 1998 from $36.5
million, or $3.41 per diluted share, in 1997. The Company's operating earnings,
calculated as net income before $5.8 million of one-time expenses associated
with the discontinuance of the brokerage operations of Sullivan Kelly and the
closing of the Paris office of ERNV and realized capital gains or losses, all
net of tax, increased $8.1 million, or 23%, to $42.9 million, or $3.66 per
diluted share, in 1998 from $34.8 million, or $3.25 per diluted share, in 1997.
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 D&O liability insurance
and lawyers professional liability and miscellaneous 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.
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 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 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
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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.
G&A expenses increased $11.5 million, or 68%, to $28.6 million in 1997 from
$17.1 million in 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.
Interest expense of $1.8 million in 1997 and $4.5 million in 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. 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 in 1997 from
$6.6 million in 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 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.
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 stockholders.
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Cash flows from operating activities were $157.9 million, $181.0 million, and
$169.5 million for 1998, 1997 and 1996, respectively. The decrease in cash flows
in 1998 resulted principally from increased loss payments in 1998 partially
offset by increased net premiums received and investment income received. Rising
loss payments are expected of a maturing professional liability underwriter.
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. Total
estimated costs for this project approximate $21.1 million. During 1998 the
Company incurred $12.2 million in costs in connection with this addition. 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, 1998, 1997
and 1996 was approximately 5.2, 4.6 and 4.6 years, respectively 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 $34.3 million (2.7% of the total
investment portfolio) at December 31, 1998 and $88.5 million (8.2% of the total
investment portfolio) at December 31, 1997. The decrease in the short-term
investment pool was due principally to the fact that approximately $40 million
in senior notes had been held in short-term investments at year-end 1997, which
were contributed to ERNV in February 1998. Cash and publicly traded fixed income
securities constituted 94% of the Company's total investment portfolio at
December 31, 1998.
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 (within accumulated
other comprehensive income) until realized. The market value of the portfolio
was 105% and 104% of amortized cost at December 31, 1998 and December 31, 1997,
respectively. At December 31, 1998 and 1997, stockholders' equity was increased
by $21.9 million and $19.5 million, respectively, to record the Company's fixed
maturity investment portfolio at fair value net of tax. At December 31, 1998,
the Company owned no derivative instruments, except for $139.9 million (fair
value) invested in mortgage and asset backed securities, including $5 million in
AAA-rated interest only commercial mortgage-backed securities.
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 of $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 arranged through Chase, $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
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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 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.
In each of March, June, September and December of 1998, the Company paid
dividends to common stockholders of record of $0.02 per share. Such Common Stock
dividends totaled $0.9 million. ERII, ERSIC and Quadrant are subject to state
regulatory 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.
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THE YEAR 2000 ("Y2K")
The Y2K problem is a worldwide issue facing virtually every organization that
employs technology to achieve its goals, including the Company. The Y2K problem
stems from the use of a two-digit code representing the year in computer-based
systems, which could cause some computers to fail or malfunction after December
31, 1999. The Company's insurance policies contain date sensitive data, such as
expiration dates, and internal systems rely on such date fields. Further, the
Company's philosophy has long emphasized the use of technology, so it may be
more heavily reliant upon computer systems than some other similarly situated
insurance companies. If the Company's principal computer systems were not made
Y2K compliant, many of its business operations, including its policy issuance,
premium billing and collections, claims handling, investment and accounting
functions, could be materially adversely affected, with negative financial
consequences and damage to the Company's reputation.
Internal: Management has taken steps to address Y2K as it affects the Company's
own business systems. In addition to assigning senior Information Services staff
resources exclusively to this project, the Company formed a Y2K Project Office,
which includes the Chairman of the Board of Directors as well as representatives
from all principal operations areas. Early in 1998, the Project Office began
monitoring the Company's Y2K compliance project, a five-phase program
incorporating assessment, remediation, testing, business partner compliance and
corporate acceptance. Later during 1998, the Company retained an independent
consultant, which advised and made recommendations as to the adequacy of planned
testing protocols and test schedules. As of the date of this report, the Company
has completed the assessment, remediation and testing phases of all
mission-critical applications. It is on-schedule to complete the remaining
testing, and currently plans to conduct a so-called "end to end" test of all
information systems, by late second quarter or early third quarter 1999.
Additionally, third-party business partners that have material vendor or
customer relationships with the Company have been identified, and each has been
contacted to determine its Y2K readiness. In particular, there are several
insurance brokerage firms that produce a significant share of the Company's
insurance business. An inability on the part of any such firm to process
insurance applications due to a failure of their computer systems could
materially affect the Company's financial results for the period in which such
failure occurred. The Company's Y2K readiness project calls for contingency
planning to identify actions to be taken should the Company's or its business
partners' readiness efforts fail. Such plans are being formalized during the
first half of 1999.
Operating results in 1998 included some expense (less than $1.5 million)
directly or indirectly related to Y2K readiness. Based on the progress of the
Company's Y2K project to date, it is not currently anticipated that there will
be a material impact on operating expense related to Y2K during 1999, nor will
the completion of Y2K efforts result in a meaningful reduction in expense levels
in 1999 or future years.
External: Because a significant portion of the Company's business is insuring
executives of business organizations that rely on computer technology, business
interruptions and other problems related to mismanagement of the Y2K issue could
also affect the Company's claims experience in future years. In July 1998, a
national rating agency revised its outlook on the rating of the Company's senior
debt from "stable" to "negative," premised upon the agency's analysis of the D&O
insurance industry's exposure to the Y2K issue. (Such negative ratings outlook
has since been removed in light of the announced transaction with Chubb.) The
Company acknowledges that Y2K entails a significant risk to the entities it
insures. Y2K litigation is likely to cause some negative development in the
Company's loss experience. Due to the general uncertainty inherent in the Y2K
problem, however, the Company is unable to determine at this time whether such
losses will have a material impact on the Company's results of operations or
financial condition. THE COMPANY BELIEVES THAT ITS Y2K SPECIFIC UNDERWRITING
TECHNIQUES, TOGETHER WITH CONSERVATIVE REINSURANCE PRACTICES, SHOULD MITIGATE
THE IMPACT OF THE Y2K PROBLEM.
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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 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,
1998, the total adjusted capital (as defined by the NAIC) of ERII, ERSIC and
Quadrant was in excess of the risk-based capital standards.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
ON DECEMBER 21, 1998, A SUBSIDIARY OF THE COMPANY INVESTED $2.85 MILLION IN THE
SECURED INDEBTEDNESS OF A LIMITED PARTNERSHIP THAT OWNS AND IS DEVELOPING A
COMMERCIAL OFFICE BUILDING IN WESTON, FLORIDA. MR. PATRICK A. GERSCHEL, A
DIRECTOR OF THE COMPANY, OWNS ALL OF THE STOCK OF THE GENERAL PARTNER, AND IS A
LIMITED PARTNER, IN THIS LIMITED PARTNERSHIP. THE COMPANY BELIEVES THE TERMS OF
THE INVESTMENT ARE NO LESS FAVORABLE THAN COULD BE OBTAINED FROM AN UNAFFILIATED
PARTY.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this amendment to its report on Form
10-K to be signed on its behalf by the undersigned, thereunto duly authorized.
EXECUTIVE RISK INC.
(Registrant)
Principal Financial and
Accounting Officer
Robert V. Deutsch Executive Vice President May 28, 1999
- ------------------- and Chief Financial Officer
(Robert V. Deutsch)
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