<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE PERIOD ENDED SEPTEMBER 30, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ___________________ TO ___________________.
COMMISSION FILE NUMBER 0-25508
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RTW, INC.
(Exact name of registrant as specified in its charter)
MINNESOTA 41-1440870
------------------------------- -----------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
8500 NORMANDALE LAKE BOULEVARD, SUITE 1400
BLOOMINGTON, MN 55437
(Address of principal executive offices and zip code)
(612)-893-0403
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
----- -----
At October 31, 1998, 11,945,312 shares of Common Stock were outstanding.
<PAGE>
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PART I - FINANCIAL INFORMATION Page
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<S> <C>
Item 1. Consolidated Financial Statements and Notes (Unaudited) 3
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 8
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 20
Item 2. Changes in Securities 20
Item 3. Defaults Upon Senior Securities 20
Item 4. Submission of Matters to a Vote of Security Holders 20
Item 5. Other Information 20
Item 6. Exhibits and Reports on Form 8-K 20
Signatures 22
Exhibits 23
</TABLE>
2
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PART I - FINANCIAL INFORMATION
ITEM 1: CONSOLIDATED FINANCIAL STATEMENTS AND NOTES (UNAUDITED)
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
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<S> <C>
CONSOLIDATED FINANCIAL STATEMENTS
Consolidated Balance Sheets 4
Consolidated Statements of Operations 5
Consolidated Statements of Cash Flows 6
Notes to Consolidated Financial Statements 7
</TABLE>
3
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RTW, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
SEPTEMBER 30, 1998 AND DECEMBER 31, 1997
(In thousands, except share data)
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1998 1997
----------- -------------
(Unaudited)
<S> <C> <C>
ASSETS
Investments available-for-sale, at fair value,
amortized cost of $121,569 and $110,880 $ 125,197 $ 112,294
Cash and cash equivalents 9,985 5,798
Accrued investment income 1,565 1,836
Premiums receivable, less allowance of $378 and $182 6,698 5,763
Reinsurance recoverables 4,936 5,374
Reinsurance receivables 680 743
Deferred policy acquisition costs 1,778 1,559
Furniture and equipment, net 4,695 4,927
Other assets 4,162 3,692
----------- -------------
Total assets $ 159,696 $ 141,986
=========== =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Unpaid claim and claim settlement expenses $ 76,355 $ 61,069
Unearned premiums 16,317 13,580
Accrued expenses and other liabilities 2,463 4,105
Notes payable 4,940 4,875
----------- -------------
Total liabilities 100,075 83,629
Shareholders' equity:
Common Stock, no par value; authorized 25,000,000 shares; issued
and outstanding 11,954,612 shares at September 30, 1998 and
11,841,023 shares at December 31, 1997 29,538 28,976
Retained earnings 27,725 28,489
Unrealized gain on available-for-sale securities, net of tax 2,358 892
----------- -------------
Total shareholders' equity 59,621 58,357
----------- -------------
Total liabilities and shareholders' equity $ 159,696 $ 141,986
=========== =============
</TABLE>
See notes to consolidated financial statements.
4
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RTW, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
THREE AND NINE MONTH PERIODS ENDED SEPTEMBER 30, 1998 AND 1997
(Unaudited; in thousands, except share and per share data)
<TABLE>
<CAPTION>
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
--------------------------- ----------------------------
1998 1997 1998 1997
----------- ----------- ------------ -----------
<S> <C> <C> <C> <C>
Revenues:
Premiums earned $ 21,856 $ 20,423 $ 65,585 $ 59,278
Investment income 1,854 1,759 5,909 4,952
Net realized investment gains 330 147 1,049 131
----------- ----------- ------------ -----------
Total revenues 24,040 22,329 72,543 64,361
EXPENSES:
Claim and claim settlement expenses 17,571 14,250 54,782 40,116
Policy acquisition costs 3,657 2,876 10,247 8,482
General and administrative expenses 3,150 2,329 8,681 8,049
----------- ----------- ------------ -----------
Total expenses 24,378 19,455 73,710 56,647
----------- ----------- ------------ -----------
Income (loss) from operations (338) 2,874 (1,167) 7,714
Interest expense 139 196 417 588
----------- ----------- ------------ -----------
Income (loss) before income taxes (477) 2,678 (1,584) 7,126
Income tax expense (benefit) (339) 973 (820) 2,615
----------- ----------- ------------ -----------
Net income (loss) $ (138) $ 1,705 $ (764) $ 4,511
=========== =========== ============ ===========
Income (loss) per share:
Basic income (loss) per share $ (0.01) $ 0.14 $ (0.06) $ 0.38
=========== =========== ============ ===========
Diluted income (loss) per share $ (0.01) $ 0.14 $ (0.06) $ 0.37
=========== =========== ============ ===========
Weighted average shares outstanding:
Basic shares outstanding 11,955,000 11,841,000 11,921,000 11,830,000
=========== =========== ============ ===========
Diluted shares outstanding 11,955,000 12,076,000 11,921,000 12,085,000
=========== =========== ============ ===========
</TABLE>
See notes to consolidated financial statements.
5
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RTW, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997
(Unaudited, in thousands)
<TABLE>
<CAPTION>
FOR THE NINE MONTHS
ENDED SEPTEMBER 30,
---------------------
1998 1997
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<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Reconciliation of net income (loss) to net cash provided by operating activities:
Net income (loss) $ (764) $ 4,511
Adjustments to reconcile net income (loss) to net cash provided by
operating activities:
Depreciation and amortization 944 780
Deferred income taxes (454) (532)
Net realized investment gains (1,049) (131)
Changes in assets and liabilities:
Amounts due from reinsurers 501 179
Unpaid claim and claim settlement expenses 15,286 8,425
Unearned premiums, net of premiums receivable 1,802 709
Other, net (2,314) 1,222
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Net cash provided by operating activities 13,952 15,163
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturities of available-for-sale securities 2,000 -
Proceeds from sales of available-for-sale securities 61,883 28,148
Purchases of available-for-sale securities (73,563) (41,639)
Purchases of furniture and equipment (647) (1,739)
-------- ---------
Net cash used in investing activities (10,327) (15,230)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from stock options exercised 333 1
Issuance of Common Stock to ESOP - 115
Issuance of Common Stock under ESPP 199 154
Proceeds from sales of Common Stock 30 -
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Net cash provided by financing activities 562 270
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NET INCREASE IN CASH AND CASH EQUIVALENTS 4,187 203
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 5,798 10,410
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CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 9,985 $ 10,613
======== =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest $ 352 $ 501
======== =========
Income taxes $ 480 $ 2,636
======== =========
</TABLE>
See notes to consolidated financial statements.
6
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RTW, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THREE AND NINE MONTH PERIODS ENDED SEPTEMBER 30, 1998 AND 1997
(Unaudited)
NOTE A - BASIS OF PRESENTATION
The accompanying consolidated financial statements have been prepared in
conformity with generally accepted accounting principles applied on a basis
consistent with the financial statements included in the RTW, Inc. 1997
Report on Form 10-K filed with the Securities and Exchange Commission, except
that the consolidated financial statements were prepared in conformity with
the instructions to Form 10-Q for interim financial information and,
accordingly, do not include all of the information and notes required by
generally accepted accounting principles for complete financial statements.
The consolidated financial information included herein, other than the
consolidated balance sheet at December 31, 1997, has been prepared by us
without audit by independent certified public accountants. We derived the
consolidated balance sheet at December 31, 1997 from the audited consolidated
financial statements for the year ended December 31, 1997, but this report
does not include all the disclosures contained therein.
The information furnished includes all adjustments and accruals, consisting
only of normal, recurring accrual adjustments, which are, in our opinion,
necessary for a fair statement of results for the interim period. The results
of operations for any interim period are not necessarily indicative of
results for the full year. The unaudited interim consolidated financial
statements should be read in conjunction with the consolidated financial
statements and notes thereto contained in the 1997 Annual Report.
NOTE B - SHARE REPURCHASE PROGRAM
On September 15, 1998, we announced that our Board of Directors approved a
share repurchase program authorizing us to repurchase, from time to time, up
to $4,000,000 of RTW, Inc. common stock. We will repurchase the shares on
the open market or through private transactions depending upon market
conditions and availability. Through October 31, 1998 we had repurchased
9,300 shares for approximately $41,000. The repurchased shares will be used
for employee stock option and purchase plans and other corporate purposes.
NOTE C - RECENTLY ISSUED ACCOUNTING STANDARDS
Effective January 1, 1998, we adopted Statement of Financial Accounting
Standards No. 130 (SFAS 130), Reporting Comprehensive Income, and Statement
of Financial Accounting Standards No. 131 (SFAS 131), Disclosures About
Segments of an Enterprise and Related Information. SFAS 130 requires that
all items recognized under accounting standards as components of
comprehensive income be reported in a financial statement that is displayed
with the same prominence as other financial statements. SFAS 130 also
requires that an entity classify items of other comprehensive income by their
nature in a financial statement. Items contained in other comprehensive
income for us include unrealized gains and losses on investments classified
as available-for-sale. Our total comprehensive income includes unrealized
gains on all investments at September 30, 1998 due to reclassifying
held-to-maturity securities to available-for-sale in December 1997 compared
to including only unrealized gains on available-for-sale securities at
September 30, 1997. Total comprehensive income was as follows (000's):
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- -------------------
1998 1997 1998 1997
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<S> <C> <C> <C> <C>
Net income (loss) $ (138) $ 1,705 $ (764) $ 4,511
Other comprehensive income 1,597 410 1,467 435
------- ------- ------- -------
Total comprehensive income $ 1,459 $ 2,115 $ 703 $ 4,946
======= ======= ======= =======
</TABLE>
SFAS 131 requires certain disclosures about segments of an enterprise and has
no impact on our Consolidated Financial Statements.
7
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ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
THE COMPANY - RTW, Inc. (RTW) and its wholly owned insurance subsidiary,
American Compensation Insurance Company (ACIC), provide disability management
services to employers. Collectively, "we," "our" and "us" will refer to
these entities in this "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
We developed a proprietary management system, the RTW SOLUTION-Registered
Trademark-, designed to lower employers' workers' compensation costs and
return injured employees to work as soon as possible. We combine our
management system with insurance products underwritten by our insurance
subsidiary to offer services to customers. We currently provide workers'
compensation management services solely to employers insured through our
insurance subsidiary or through fronted insurance arrangements. We currently
operate in Minnesota, Colorado, Missouri, Illinois, Kansas, Michigan,
Indiana, Massachusetts, Connecticut, Wisconsin, Rhode Island and New
Hampshire.
The following analysis of the consolidated results of operations and
financial condition of RTW and ACIC, should be read in conjunction with our
consolidated financial statements and notes thereto at September 30, 1998 and
December 31, 1997 and the three and nine month periods ended September 30,
1998 and 1997.
SUMMARY OPERATING RESULTS - The following table provides an overview of our
key operating results (000's):
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- ------------------
1998 1997 1998 1997
------- ------- ------- -------
<S> <C> <C> <C> <C>
Total revenues $24,040 $22,329 72,543 64,361
Net income (loss) (138) 1,705 (764) 4,511
1998 1997
------- -------
Premiums in force at September 30 $84,400 $75,500
</TABLE>
Our premiums in force grew 11.8% to $84.4 million at September 30, 1998
from $75.5 million at September 30, 1997 due primarily to $16.1 million in
growth in our newer markets including Missouri, Michigan and Massachusetts
and $200,000 growth in Colorado offset by a $7.4 million decrease in premiums
in force in Minnesota.
Revenues for the three and nine month periods ended September 30, 1998
include net realized investment gains of $330,000 and $1.0 million,
respectively compared to net realized investment gains of $147,000 and
$131,000 recorded for the three and nine month periods ended September 30,
1997. Additionally, total revenues for the nine months ended September 30,
1998 include a $2.2 million refund received from the Minnesota Workers'
Compensation Reinsurance Association (WCRA) recorded in the first quarter of
1998 compared to refunds totaling $358,000 recorded in the third quarter of
1997. The $8.9 million growth in premiums in force, combined with the refund
received from the WCRA in the first quarter of 1998, gains recognized in 1998
compared to 1997 and increased earnings on our investment portfolio, offset
by the refund received from the WCRA recorded in the third quarter of 1997,
resulted in an increase in revenues of 7.6% to $24.0 million for the third
quarter of 1998 from $22.3 million for the third quarter of 1997 and an
increase of 12.7% to $72.5 million for the nine months ended September 30,
1998 from $64.4 million for the nine months ended September 30, 1997.
We recognized a net loss of $138,000 in the third quarter of 1998 compared
to net income of $1.7 million in the third quarter of 1997 and a $764,000 net
loss for the nine months ended September 30, 1998 compared to net income of
$4.5 million for the nine months ended September 30, 1997 due primarily to
the following factors:
- The Minnesota Insurance Guarantee Association, an organization formed
to fund Minnesota claims for insolvent insurance companies, did not
assess its members in 1998 for workers' compensation claim liabilities
arising from current or prior insolvencies. As a result, we reversed
the $1.1 million pre-tax
8
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accrual recorded in 1997 and recognized a corresponding reduction
in general and administrative expenses during second quarter of
1998. A similar reversal totaling $842,000 was also recorded in
the third quarter of 1997.
- Claim and claim settlement expenses increased as a percent of premiums
earned due to inflationary increases in medical and wage costs,
compounded by pricing decreases. The 1998 nine month results include a
$3.0 million reserve increase recorded in the first quarter of 1998 to
reflect adverse development of prior period claims and a $400,000
increase in the Minnesota Special Compensation Fund (SCF) accrual for
periods prior to March 31, 1998 resulting from an increased assessment
declared during the second quarter of 1998. The SCF assesses us to
cover the costs of second injuries which, because of a preexisting
physical impairment, are substantially greater than what would have
resulted from the second injury alone. The 1997 three and nine month
results benefited from favorable reserve adjustments totaling $850,000
and $2.4 million, respectively. Combined with pricing pressure, our
loss ratio has increased;
- Pricing pressure continues to affect premiums in force and decrease
profit margins in all markets. The pricing pressure is the result of
(i) increased competition in our markets and (ii) continued price
declines due to legislative benefit changes in 1997 and prior years;
- Operating costs, including personnel costs and other operating
expenses allocated to claim and claim settlement expenses, policy
acquisition costs and general and administrative expenses, have
increased when compared to the first nine months of 1997 due to (i)
increased premiums in force, (ii) increased fixed costs resulting from
opening the Michigan office in late 1996 and the Massachusetts office
in the second quarter of 1997, (iii) higher compensation for existing
employees, and (iv) increased fees for professional services. Actions
to reduce personnel costs were initiated in the first quarter of 1998
to bring these expenses more in line with revenues. Other expenses
continue to be managed aggressively and reduced where appropriate; and
- Decreased effective income tax rates resulting from the decrease in
income and the purchase of tax-advantaged municipal securities which
generated tax-exempt income in the second and third quarters of 1998.
While we expect to continue to operate in a difficult pricing environment for
the remainder of 1998, we are working to improve profitability in all of our
offices by continuing to aggressively manage expenses, refining our sales and
distribution channels and improving our underwriting, including reviewing policy
profitability at renewal and removing unprofitable accounts.
TOTAL REVENUES: Our total revenues include premiums earned and investment
income.
PREMIUMS EARNED - Premiums on workers' compensation insurance policies are
our largest source of revenue. Premiums earned are the gross premiums
earned by us on in force workers' compensation policies, net of the effects
of ceded premiums under reinsurance agreements.
Reinsurance agreements allow us to share certain risks with other
insurance companies. The primary purpose of ceded reinsurance is to
protect us from potential losses in excess of the level we are willing to
accept. Our primary ceded reinsurance is excess of loss coverage that
limits our per incident exposure. We expect the companies to which we have
ceded reinsurance to honor their obligations. In the event that these
companies are unable to honor their obligations to us, we will be required
to pay these obligations ourselves. We are not aware of any developments
with respect to any of our reinsurers that would prevent them from honoring
any of their obligations to us.
INVESTMENT INCOME - Our investment income includes earnings on our
investment portfolio.
NET REALIZED INVESTMENT GAINS - Our net realized investment gains include
gains and losses from sales of available-for-sale securities.
TOTAL EXPENSES: Our expenses include claim and claim settlement expenses,
policy acquisition costs, general and administrative expenses, interest expense
and income taxes.
CLAIM AND CLAIM SETTLEMENT EXPENSES - Claim expenses refer to amounts that
we paid or expect to pay to claimants for events that have occurred. The
costs of investigating, resolving and processing these claims are
9
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referred to as claim settlement expenses. We record these expenses, net
of amounts recoverable under reinsurance contracts, to claim and claim
settlement expenses in the Consolidated Statements of Operations.
POLICY ACQUISITION COSTS - Policy acquisition costs are costs directly
related to writing an insurance policy and consist of commissions, state
premium taxes, underwriting personnel costs and expenses, sales and
marketing costs and other underwriting expenses, offset by ceding
commissions received from our reinsurers. Ceding commissions are amounts
that reinsurers pay to us for placing reinsurance with them. Ceding
commissions represent adjustments based on actual claim and claim
settlement expenses related to premiums ceded in prior years. Under
reinsurance agreements, our ceding commission is adjusted to the extent
that actual claim and claim settlement expenses vary from levels specified
in the agreement.
GENERAL AND ADMINISTRATIVE EXPENSES - Our general and administrative
expenses include personnel costs, office rent, certain state administrative
assessments based on premiums and other costs and expenses not specific to
claim and claim settlement expenses or policy acquisition costs.
INTEREST EXPENSE - We incur interest charges on our Senior Notes. The
remaining Senior Notes outstanding mature in 1998 and 1999.
INCOME TAXES - We incur federal income taxes on our combined service
organization (RTW) operations and insurance (ACIC) operations. We incur
state income taxes on the results of our service organization's operations
and incur premium taxes in lieu of state income taxes for substantially all
of our insurance operations. In certain instances, we may incur state
income taxes on our insurance operations. Additionally, certain provisions
of the Internal Revenue Code adversely affect our taxable income by
accelerating recognition of revenues, deferring recognition of expenses
ultimately accelerating the payment of income taxes. Adjustments to book
income generating current tax liabilities include limitations on the
deductibility of unpaid claim and claim settlement expenses, limitations on
the deductibility of unearned premium reserves and limitations on
deductions for bad debt reserves.
In the following pages, we take a look at the results for the three and nine
month periods ended September 30, 1998 and 1997 in these areas and also explain
key balance sheet accounts in greater detail.
RESULTS OF OPERATIONS
The following tables summarize the components of revenues and premiums in force
(000's):
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- --------------------
1998 1997 1998 1997
------- ------- ------- -------
<S> <C> <C> <C> <C>
Gross premiums earned $22,885 $20,279 $66,459 $59,401
Premiums (ceded) recovered (1,029) 144 (874) (123)
------- ------- ------- -------
Premiums earned 21,856 20,423 65,585 59,278
Investment income 1,854 1,759 5,909 4,952
Net realized investment gains (losses):
Gains 871 178 1,594 210
Losses (541) (31) (545) (79)
------- ------- ------- -------
Net realized investment gains 330 147 1,049 131
------- ------- ------- -------
Total revenues $24,040 $22,329 $72,543 $64,361
======= ======= ======= =======
<CAPTION>
1998 1997
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Premiums in force, by state office location, at quarter-end:
Minnesota $ 38,500 $45,900
Colorado 13,200 13,000
Missouri 16,700 12,600
Michigan 9,100 3,100
Massachusetts 6,900 900
-------- -------
Total premiums in force September 30: $ 84,400 $75,500
======== =======
</TABLE>
10
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GROSS PREMIUMS EARNED: The premium we charge a policyholder is a function of
their payroll, industry and prior workers' compensation claims experience. In
underwriting a policy, we receive policyholder payroll estimates for the ensuing
year. We record premiums written on an installment basis matching billing to the
policyholder and earn premiums on a daily basis over the life of each insurance
policy based on the payroll estimate. We record the excess of premiums billed
over premiums earned for each policy as unearned premiums on our balance sheet.
When a policy expires, we audit employer payrolls for the policy period and
adjust the estimated payroll to its actual value. The result is a "final audit"
adjustment recorded to premiums earned when the adjustment becomes known.
Our gross premiums earned increased 12.9% to $22.9 million for the third
quarter of 1998 from $20.3 million for the third quarter of 1997 and increased
11.9% to $66.5 million for the nine months ended September 30, 1998 from $59.4
million for the nine months ended September 30, 1997. These increases resulted,
in part, from the 11.8% increase in premiums in force to $84.4 million at
September 30, 1998, from $75.5 million at September 30, 1997. Included in this
11.8% increase is a $7.4 million decrease in Minnesota premiums in force.
Additionally, gross premiums earned included $1.5 million of final audit
premiums recognized in the third quarter of 1998 and $4.9 million recognized for
the nine months ended September 30, 1998 compared to $1.8 million recognized in
the third quarter of 1997 and $4.8 million recognized for the nine months ended
September 30, 1997. Final audit premiums recognized during the period include
billed final audit premiums plus (or minus) the change in estimate for premiums
on unexpired and expired unaudited policies.
Underlying these increases in gross premiums earned is another trend. The
premium rate that we charge policyholders per payroll dollar has declined for
several years. This is the result, in part, of the following:
- Many state legislatures where we provide coverage have reduced
benefits that injured employees are paid, resulting in lower loss
costs of workers' compensation insurance and decreased corresponding
premiums to the policyholder;
- As the loss cost structure of workers' compensation has declined, more
insurance companies have entered or re-entered the workers'
compensation insurance market, resulting in increased competition; and
- We continue to experience reduced pricing on renewal policies due, in
part, to our success in lowering our policyholders' loss experience
which then improves their claims history, lowering the premium that
they have to pay for insurance. The improvement that we do for our
customers also has the effect of making them more desirable to our
competition, thus increasing price competition on these accounts.
PREMIUMS CEDED: We pay reinsurers, under excess of loss reinsurance policies,
to limit our per incident exposure and record this cost as a reduction of gross
premiums earned. We are required to purchase excess of loss coverage for
Minnesota policies from the Minnesota Workers' Compensation Reinsurance
Association (WCRA). Our selected retention level in Minnesota is $280,000 for
1998 and was approximately $1.1 million in 1997. In other states, we have chosen
to limit our per incident exposure to $500,000 and purchased this coverage from
various reinsurers.
The following table summarizes the components of premiums ceded (000's):
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- -----------------
1998 1997 1998 1997
------- ----- ------- -----
<S> <C> <C> <C> <C>
Premiums (ceded to) recovered from:
WCRA $ (706) $ - $(2,274) $
Non-Minnesota excess of loss policies (323) (214) (847) (481)
Refund from the WCRA on prior years' activity - 358 2,247 358
------- ----- ------- -----
Premiums (ceded) recovered $(1,029) $ 144 $ (874) $(123)
======= ===== ======= =====
</TABLE>
Premiums ceded to reinsurers were a cost of $1.0 million in the third quarter
of 1998 compared to a benefit of $144,000 in the third quarter of 1997. This
increased cost resulted from (i) reducing our selected Minnesota excess of loss
reinsurance coverage levels to $280,000 in 1998 from $1.1 million in 1997; (ii)
increased excess of loss premium rates in Minnesota in 1998 from 1997, (iii)
increased excess of loss costs resulting from increased premiums earned in
non-Minnesota states, and (iv) the recognition of a refund of $358,000 from the
WCRA in the third quarter of 1997. Premiums ceded to reinsurers was a cost of
$874,000 for the nine months ended September 30, 1998 versus a cost of $123,000
for the nine months ended September 30, 1997. The increase in premiums ceded
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for the nine months ended September 30, 1998 compared to the same period for
1997 resulted from increased excess of loss cost in Minnesota in 1998 from
1997 (as discussed in (i) and (ii) above) and increased excess of loss cost
resulting from increased premiums earned in non-Minnesota states for the nine
months ended September 30, 1998. This increase was offset by recognizing a
$2.2 million refund received from the WCRA in the first quarter of 1998 as a
reduction of premiums ceded.
PREMIUMS EARNED OUTLOOK: The outlook for gross premiums earned and premiums
ceded for the remainder of 1998 includes the following factors:
- We expect continued growth in premiums in force in our non-Minnesota
markets and stabilizing in force premium in Minnesota which will lead
to growth in gross premiums earned for the remainder of the year;
- We expect continued downward pressure on the amount we charge for our
products and services; and
- After adjusting for the effects of the 1998 and 1997 refunds received
from the WCRA totaling $2.2 million and $358,000, respectively, we
expect that premiums ceded for the remainder of 1998 will remain
consistent with the results attained for the nine months ended
September 30, 1998. Premiums ceded may decrease slightly in future
quarters of 1998 as a percent of gross premiums earned as the
non-Minnesota markets, where we pay smaller reinsurance premiums,
continue to grow relative to Minnesota. Premiums ceded (after
adjusting for the WCRA refund) will continue to run much higher in
1998 when compared to 1997 due to the 6.8% policy premium we are
paying for increased excess of loss coverage in Minnesota compared to
the premium-free rate received in 1997.
INVESTMENT INCOME AND NET REALIZED INVESTMENT GAINS: We currently invest
entirely in taxable and tax-exempt fixed maturity investments and classify our
investments as available-for-sale. We intend to hold our available-for-sale
investments to maturity, but may sell before maturity in response to changes in
interest rates, changes in prepayment risk and changes in funding sources or
terms, or to address liquidity needs. Our primary investment objective is to
maintain a diversified, high-quality, fixed-investment portfolio structured to
maximize our after-tax investment income without taking inappropriate credit
risk. For further discussion of investments, see the "Investments" section of
this Management's Discussion and Analysis.
Investment income increased 5.4% to $1.9 million in the third quarter of 1998
from $1.8 million in the third quarter of 1997 and increased 19.3% to $5.9
million for the nine months ended September 30, 1998 from $5.0 million for the
nine months ended September 30, 1997. Investment income increased for these
periods due to increased funds available for investment but has been
significantly affected by growth of tax-exempt municipal securities included in
our portfolio which earn lower pre-tax rates than taxable securities but are
comparable on a tax adjusted basis. Funds available for investment increased to
$125.2 million at September 30, 1998, from $104.0 million at September 30, 1997,
due to increased net cash provided by operating activities, resulting primarily
from (i) the difference in timing between the receipt of premiums and the
payment of claim and claim settlement expenses and (ii) net cash provided by
investment income. Pre-tax investment yields decreased to 6.1% for the nine
months ended September 30, 1998 from 6.2% for the nine months ended September
30, 1997 due to purchasing tax-exempt municipal securities, which have lower
yields on a pre-tax basis, during the second and third quarters of 1998 offset
by portfolio diversification which began in the second quarter of 1997. The
investment yields realized in future periods will be affected by yields attained
on new investments and will decrease, on a pre-tax basis, due to the purchase of
tax-exempt municipal securities.
Net realized investment gains increased to $330,000 in the third quarter of
1998 from $147,000 in the third quarter of 1997 and increased to $1.0 million
for the nine months ended September 30, 1998 versus $131,000 for the nine months
ended September 30, 1997. The increase in net realized investment gains in the
third quarter of 1998 is the result of repositioning U.S. government securities
previously classified as held-to-maturity and transferred to available-for-sale
in December 1997, to higher after-tax yielding securities, including tax-exempt
municipal securities and corporate securities. These net realized investment
gains include losses realized on the sale of certain corporate securities.
INVESTMENT INCOME AND NET REALIZED INVESTMENT GAINS OUTLOOK: In December 1997,
we reclassified our entire held-to-maturity portfolio, invested in U.S.
government securities to available-for-sale investments. We reclassified these
securities to enable us to more actively manage our investment yield and overall
portfolio risk. The held-to-maturity portfolio had a net unrealized gain of
approximately $900,000 at December 31, 1997, while the total portfolio net
unrealized gain at September 30, 1998, was $3.6 million. Barring significant
changes in interest rates or operational
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<PAGE>
cash flows, we expect that the yield from our investment portfolio for the
remainder of 1998 will be affected by the following:
- Our investment portfolio will increase as funds become available for
investment from net cash provided by current year operating and
investing activities;
- Our recognition of realized gains and losses will depend on the
repositioning of the portfolio that occurs for the remainder of the
year as we continue to diversify the previously classified
held-to-maturity securities from U.S. government securities to other
taxable and tax-exempt fixed maturity securities; and
- We further diversified our investment portfolio in the third quarter
of 1998 increasing our fixed maturity tax-exempt securities to $62.9
million (fair value) from $48.1 million at June 30, 1998 to increase
after-tax yields. Fixed maturity, tax-exempt securities will reduce
investment income recognized and decrease pre-tax investment yields
but are expected to contribute more to after-tax net income as a
result of the favorable treatment tax-exempt municipal income receives
for federal income tax purposes.
CLAIM AND CLAIM SETTLEMENT EXPENSES: Claim and claim settlement expenses are
our largest expense and result in our largest liability. We establish reserves
that reflect our estimates of the total claim and claim settlement expenses we
will ultimately have to pay under our workers' compensation insurance policies.
These include claims that have been reported but not settled and claims that
have been incurred but not yet reported to us. For further discussion of reserve
determination, see the "Unpaid Claim and Claim Settlement Expenses" section of
this Management's Discussion and Analysis.
Claim and claim settlement expenses increased to $17.6 million in the third
quarter of 1998 from $14.3 million in the third quarter of 1997 and increased to
$54.8 million for the nine months ended September 30, 1998 from $40.1 million
for the nine months ended September 30, 1997. As a percent of gross premiums
earned, claim and claim settlement expenses increased to 76.8% for the third
quarter of 1998 from 70.3% for the third quarter of 1997 and increased to 82.4%
for the nine months ended September 30, 1998 from 67.5% for the nine months
ended September 30, 1997. These changes are due to the following:
- We recorded reserve estimate changes in the three and nine month
results of 1998 and 1997 as follows:
- We increased our estimate of the pre-1998 liability for unpaid
claim and claim settlement expenses by $3.0 million in the first
quarter of 1998 as a result of unfavorable claims experience for
those periods.
- We increased our accrual for the Minnesota Special Compensation
Fund in the second quarter of 1998 by approximately $400,000 for
periods prior to March 31, 1998 resulting from an increased rate
of assessment declared during the second quarter of 1998.
- We reduced our estimate of the pre-1997 liability for unpaid
claim and claim settlement expenses by $850,000 in the third
quarter of 1997 as a result of favorable claims experience for
those periods and when combined with the reduction of $850,000 in
the second quarter of 1997 and $675,000 recorded in the first
quarter of 1997, totaled $2.4 million for the nine months ended
September 30, 1997.
After adjusting for these estimate changes, claim and claim settlement
expenses increased as a percent of gross premiums earned to 78.9% for
the third quarter of 1998 from 69.3% for the third quarter of 1997
and increased to 77.6% for the nine months ended September 30, 1998
from 70.0% for the nine months ended September 30, 1997;
- Reduced premiums due to legislative changes in estimated loss costs,
increased competition and improving customer loss experience, have
resulted in an increase in claim and claim settlement expenses as a
percentage of gross premiums earned;
- Claim costs increased in accident year 1998 as compared to accident
year 1997 due to increasing medical and indemnity costs resulting from
inflationary changes and increased severity; and
- Gross premiums earned increased to $22.8 million in the third quarter
of 1998 from $20.3 million in the third quarter of 1997 and increased
to $66.5 million for the nine months ended September 30, 1998 from
$59.4 million for the nine months ended September 30, 1997 resulting
in increased claim and claim settlement expenses as we provided
coverage for more employers.
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CLAIM AND CLAIM SETTLEMENT EXPENSE OUTLOOK: We expect that claim and claim
settlement expenses will be affected by the following factors:
- During the third quarter, we identified an adverse change in the
development of Minnesota open claims for 1997 and prior years. We
are continuing the process of reviewing Minnesota and
non-Minnesota reserve development for years prior to 1998. We
expect to complete this review in the fourth quarter. Based on
information currently available, we do not expect the impact, if
any, to be material to liquidity, capital resources, or financial
position; the impact however, if any, may be material to the
results of operations. We continue to aggressively manage our
prior year open claims.
- Claim costs will be affected by (i) increases in medical and indemnity
costs resulting from inflationary changes, (ii) severity experienced
in future periods in our policy holder base, (iii) changes resulting
from increases in operating efficiency and effectiveness realized
through enhancements to our internal processes and procedures,
including changes to our proprietary computer systems, and (iv)
legislative changes in estimated loss costs;
- Continued pricing pressure due to legislative changes in estimated
loss costs, increased competition and improving customer loss
experience may result in reduced premiums, ultimately increasing claim
and claim settlement expense as a percent of gross premium earned; and
- Continued application of our claims management technology and methods
to all open claims at September 30, 1998, may benefit future periods.
The ultimate effect cannot be quantified at this time.
The ultimate result of the above factors, combined with the change in premium
rates, on claim and claim settlement expenses as a percent of gross premiums
earned for the remainder of 1998 is unknown at this time.
POLICY ACQUISITION COSTS. The following table summarizes policy acquisition
costs (000's):
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- -------------------
1998 1997 1998 1997
------- ------- ------- -------
<S> <C> <C> <C> <C>
Commission expense $ 1,881 $ 1,585 $ 5,296 $ 4,714
Premium tax expense 465 412 1,369 1,217
Other policy acquisition costs 1,311 879 3,582 2,551
------- ------- ------- -------
Direct policy acquisition costs $ 3,657 $ 2,876 $10,247 $ 8,482
======= ======= ======= =======
</TABLE>
Policy acquisition costs increased to $3.7 million in the third quarter of 1998
from $2.9 million in the third quarter of 1997 and increased to $10.2 million
for the nine months ended September 30, 1998 from $8.5 million for the nine
months ended September 30, 1997. As a percent of gross premiums earned, policy
acquisition costs increased to 16.0% in the third quarter of 1998 from 14.2% in
the third quarter of 1997 and increased to 15.4% for the nine months ended
September 30, 1998 from 14.3% for the nine months ended September 30, 1997.
These changes reflect the following:
- Commission expense was 8.2% of gross premiums earned in the third
quarter of 1998 compared to 7.8% in the third quarter of 1997 and was
8.0% of gross earned premiums for the nine months ended September 30,
1998 versus 7.9% for the nine months ended September 30, 1997.
Historically, as we entered new markets, we introduced higher
commission rates to attract business from established agents. These
rates have continued into current policy periods and will have a
greater affect on the commission expense percent as the non-Minnesota
states continue to grow relative to Minnesota. In all of our markets,
we believe the commission rates we pay are marketplace competitive;
- Premium tax expense remained consistent at 2.0% of gross premiums
earned for the third quarters of 1998 and 1997 and was stable at 2.1%
and 2.0% of gross premiums earned for the nine months ended September
30, 1998 and 1997, respectively. Premium tax expense for the nine
month period is running slightly higher than our historical rate of
2.0% due to accrual adjustments in the first quarter of 1998 and
higher premium tax rates paid for premiums earned in Colorado; and
- Other policy acquisition costs increased to 5.7% of gross premiums
earned in the third quarter of 1998 from 4.3% in the third quarter of
1997 and increased to 5.4% of gross premiums earned for the nine
months ended September 30, 1998 from 4.3% for the nine months ended
September 30, 1997, due to
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<PAGE>
increased personnel and overhead costs associated with improving
our underwriting function and increased personnel costs necessary
for the growth in premiums in force.
POLICY ACQUISITION COST OUTLOOK: We expect that policy acquisition costs as a
percent of gross premiums earned will stabilize or remain relatively constant as
a percent of gross premiums earned during the remainder of 1998 due to the
following:
- We expect commission expense as a percent of gross premiums earned to
increase slightly during the remainder of 1998 as the non-Minnesota
states continue to grow in size relative to Minnesota;
- We expect premium tax expense as a percent of gross premiums earned to
remain consistent with the first nine months of 1998; and
- We expect that other policy acquisition costs will be consistent with
the third quarter of 1998 as a percent of gross premiums earned as we
continue to improve our underwriting skills, increase premiums in
force and generate additional revenues to cover the relatively fixed
policy acquisition costs. We also expect that these costs will be
offset on a limited basis from increases in operating efficiency and
effectiveness during the remainder of 1998 realized through
enhancements to our internal processes and procedures, including
changes to our proprietary computer systems.
GENERAL AND ADMINISTRATIVE EXPENSES: Our general and administrative expenses
for the third quarters of 1998 and 1997 and the nine month periods ended
September 30, 1998 and 1997 include benefits of $1.1 million recorded in the
second quarter of 1998 and $842,000 recorded in the third quarter of 1997,
resulting from the reversal of 1997 and 1996 accruals for assessments by the
Minnesota Insurance Guarantee Association (MIGA), an organization formed to fund
Minnesota claims for insolvent insurance companies. MIGA did not assess its
members in 1998 or 1997 for workers' compensation claim liabilities arising from
current or prior insolvencies resulting in the accrual reversals. After
adjusting for the accrual reversals, our general and administrative expenses
were stable at $3.2 million in the third quarters of 1998 and 1997 and increased
to $9.8 million for the nine months ended September 30, 1998 from $8.9 million
for the nine months ended September 30, 1997. As a percent of gross premiums
earned, after adjusting for the MIGA reversals, general and administrative
expenses decreased to 13.8% in the third quarter of 1998 from 15.6% in the third
quarter of 1997 and decreased to 14.7% for the nine months ended September 30,
1998 from 15.0% for the nine months ended September 30, 1997. These changes
reflect:
- Expenses incurred for expansion in Michigan and Massachusetts, not
initially offset by revenues from premiums in force in those states;
- Additional personnel costs for new employees resulting from the growth
in premiums in force;
- Higher compensation for existing employees; and
- General and administrative expenses continue to improve as a percent
of premiums earned, compared to the third quarter of 1997, after
adjusting for MIGA accrual reversals and one time charges. Actions to
reduce personnel costs were initiated in the first quarter of 1998 to
bring operating expenses more in line with revenues. Other expenses
continue to be managed aggressively and reduced where appropriate.
GENERAL AND ADMINISTRATIVE EXPENSES OUTLOOK: We expect that general and
administrative expenses will be affected by the following:
- We will continue to aggressively manage general and administrative
expenses, specifically legal and consulting expenses to decrease
relative costs during the remainder of 1998 and 1999;
- We have no plans to open additional state offices in 1998 or 1999 and
expect that growth in premiums in force in Michigan and Massachusetts
will result in additional revenues to cover the fixed costs in those
states;
- We expect to increase operational efficiency during 1998 and 1999
through enhancements to our internal processes and procedures,
including changes to our internal proprietary computer systems; and
- We have limited our salary increases.
INTEREST EXPENSE: We are paying interest at rates ranging from 9.25% to 9.50%
during 1998 and paid interest at rates ranging from 9.00% to 9.50% during 1997
on the outstanding balance on our Senior Notes.
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<PAGE>
Interest expense decreased to $139,000 in the third quarter of 1998 from
$196,000 in the third quarter of 1997 and decreased to $417,000 for the nine
months ended September 30, 1998 from $588,000 for the nine months ended
September 30, 1997 due to principal payments on the Senior Notes in December
1997.
INTEREST EXPENSE OUTLOOK: Interest expense for the remainder of 1998 is
expected to be consistent with the results attained for the nine months ended
September 30, 1998. Total interest expense on the Senior Notes is expected to
decrease to $546,000 in 1998 from $777,000 in 1997 as a result of principal
payments of $2.0 million made in December 1997.
INCOME TAXES: Income taxes were a benefit of $339,000 for the third quarter of
1998 compared to income tax expense of $973,000 for the third quarter of 1997
and were a benefit of $820,000 for the nine months ended September 30, 1998
compared to income tax expense of $2.6 million for the nine months ended
September 30, 1997. As a percent of income (loss) before income taxes, the
income tax expense (benefit) was (71.1%) for third quarter of 1998 versus 36.3%
for the third quarter of 1997 and was (51.8%) of the cumulative loss for the
nine months ended September 30, 1998 compared to 36.7% of net income for the
nine months ended September 30, 1997. The income tax expense (benefit) percent
in 1998 has been affected by (i) our loss from operations which resulted in a
credit against taxes previously paid, (ii) decreased taxable net income from the
service organization (RTW) which is subject to both federal and state income
taxes, (iii) decreases in the profitability of ACIC, and (iv) the introduction
of tax-exempt municipal income beginning in the second quarter of 1998.
INCOME TAX OUTLOOK: Income tax expense (benefit) will vary based on (i) the
income (loss) from operations we recognize for the remainder of 1998, and will
(ii) decrease as a percent of income (loss) before taxes relative to the
statutory effective rate as we purchase additional tax-exempt municipal fixed
investments for our investment portfolio. The ultimate change is unknown at this
time.
INVESTMENTS
Our portfolio included taxable and tax-exempt fixed maturity securities at
September 30, 1998 as follows:
<TABLE>
<CAPTION>
GROSS UNREALIZED
MARKET ----------------
COST VALUE GAIN (LOSS)
-------- -------- ------ ------
<S> <C> <C> <C> <C>
U.S. government securities $ 14,955 $ 15,529 575 $(1)
Corporate securities 25,437 26,466 1,030 (1)
Mortgage- and asset-backed securities 19,911 20,294 383 -
Municipal bonds, tax-exempt 61,266 62,908 1642 -
-------- -------- ------ ------
Totals $121,569 $125,197 $3,630 $(2)
======== ======== ====== ======
</TABLE>
After several years of purchasing solely U.S. government securities, we engaged
an investment manager in the second quarter of 1997 to diversify our portfolio
to other taxable fixed maturity investments and to maximize our after-tax
investment income without taking inappropriate credit risk. During the second
quarter of 1998, we transferred our portfolio to a new investment manager and
further diversified our portfolio to include investment grade tax-exempt fixed
maturity investments. We manage our fixed maturity portfolio conservatively,
investing only in investment grade (BBB or better rating from Standard and
Poor's) securities of U.S. domiciled issuers. We do not invest in derivative
securities. Additionally, in December 1997, we reclassified our entire
held-to-maturity portfolio, invested in U.S. government securities with a
historical cost, net of amortization, of $53.8 million and a fair value of $54.7
million, to available-for-sale investments. We reclassified these securities to
enable us to more actively manage our investment yield and overall portfolio
risk.
Funds provided by our operating cash flows and investment cash flows are the
source of growth in our investment portfolio. Operating cash flows consist of
the excess of premiums collected over claim and claim settlement expenses and
other operating expenses paid. Investment cash flows consist of income on
existing investments and proceeds from sales and maturities of investments. Our
investment portfolio grew 20.4% or $21.2 million to $125.2 million at September
30, 1998, from $104.0 million at September 30, 1997, as a result of these
factors. We invest solely in available-for-sale securities and intend to
continue this investment strategy for the foreseeable future.
We record investments on our balance sheet at fair value, with the
corresponding appreciation or depreciation from amortized cost recorded in
shareholders' equity, net of taxes. Because value is based on the relationship
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<PAGE>
between the portfolio's stated yields and prevailing market yields at any given
time, interest rate fluctuations can have a swift and significant impact on the
carrying value of these securities. As a result of the increased holdings in
securities classified as available-for-sale, and thus carried at fair value, we
expect to encounter larger adjustments in shareholders' equity as market
interest rates and other factors change.
UNPAID CLAIM AND CLAIM SETTLEMENT EXPENSES
Our unpaid claim and claim settlement expenses represent established,
undiscounted reserves for the estimated total unpaid cost of claim and claim
settlement expenses, which cover events that occurred through September 30,
1998. These reserves reflect our estimates of the total costs of claims that
were reported, but not yet paid, and the cost of claims incurred but not yet
reported (IBNR). For reported claims, we establish reserves on a "case" basis.
For IBNR claims, we estimate reserves using established actuarial methods. Both
our case and IBNR reserve estimates reflect such variables as past claims
experience, current claim trends and prevailing social, economic and legal
environments. Due to commencing operations in 1992, we have limited historical
data to estimate our reserves for unpaid claim and claim settlement expenses and
accordingly supplement our experience with external industry data, as adjusted,
to reflect anticipated differences between our results and the industry. We
reduce the unpaid claim and claim settlement expenses for estimated amounts of
subrogation.
Based on information currently available, we believe our reserves for
unpaid claim and claim settlement expenses are adequate to cover the ultimate
costs of claim and claim settlement expenses. The ultimate cost of claim and
claim settlement expenses may differ from the established reserves,
particularly when claims may not be settled for many years. Reserves for
unpaid claim and claim settlement expenses and assumptions used in their
development are continually reviewed. We record adjustments to prior
estimates of unpaid claim and claim settlement expenses to operations in the
year in which the adjustments are made.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity refers to our ability to generate sufficient cash flows to meet the
short- and long-term cash requirements of our operations. Capital resources
represent those funds deployed or available to be deployed to support our
business operations.
Our primary sources of cash from operations are premiums collected and
investment income. Our investment portfolio is also a source of liquidity,
through the sale of readily marketable fixed maturity investments, as well as
longer-term investments that have appreciated in value. Our primary cash
requirements consist of payments for (i) claim and claim settlement expenses,
(ii) policy acquisition costs, (iii) general and administrative expenses, (iv)
capital expenditures, (v) income taxes, and (vi) debt service or principal
repayment on our outstanding Senior Notes. We generate positive net cash from
operations due, in part, to timing differences between the receipt of premiums
and the payment of claim and claim settlement expenses. Cash generated is either
invested in short-term cash and cash equivalents or longer term
available-for-sale securities pending future payments for such expenses as
indemnity, medical benefits and other operating expenses. Cash and cash
equivalents consist of U.S. government securities acquired under repurchase
agreements, tax-exempt municipal securities and corporate securities all with
maturities of 90 days or less, with the remaining balances in cash and a money
market fund that invests primarily in short-term government securities.
Cash provided by operating activities for the nine months ended September 30,
1998 was $14.0 million. This is primarily a result of an increase of $15.3
million in unpaid claim and claim settlement expenses which are non-cash
accruals for future claims, an increase of $1.8 million in unearned premiums,
net of premiums receivable and depreciation and amortization of $944,000, offset
by our net loss of $764,000, an increase in deferred tax assets of $454,000 and
net realized investment gains of $1.0 million. Net cash used by investing
activities was $10.3 million, primarily the result of $73.6 million in purchases
of available-for-sale securities offset by $61.9 million in proceeds from sales
of available-for-sale securities and maturities of $2.0 million of
available-for-sale investments. Net cash provided by financing activities was
$562,000, primarily due to proceeds from the exercise of stock options totaling
$333,000.
Our need for additional capital is primarily the result of regulations which
require certain ratios of capital to premiums written. In the future, we expect
that our need for additional capital will be primarily related to the growth of
our insurance subsidiary and the need to maintain appropriate capital to premium
ratios as defined by state regulatory bodies. As an alternative to raising
additional capital, we believe we could secure quota-share or other reinsurance
which would have the effect of reducing the ratio of premiums to capital and
could be used to satisfy state regulatory requirements.
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<PAGE>
State insurance regulations limit distributions, including dividends, from
our insurance subsidiary to us. The maximum amount of dividends that can be paid
by ACIC to us in any year is equal to the greater of: (i) 10% of ACIC's
statutory surplus as of the end of the previous fiscal year, or (ii) the
statutory net gain from operations (not including realized capital gains) of
ACIC in its most recent fiscal year. Based on this limitation, the maximum
dividend that ACIC could pay to us in 1998, without regulatory approval, is
approximately $4.5 million. ACIC may be subject to more restrictive limitations
on dividends as we enter additional states. ACIC has never paid a dividend to
us.
We believe that cash flow generated by our operations and our cash and
investment balances will be sufficient to fund continuing operations, principal
repayments, stock repurchases and debt service on our outstanding Senior Notes,
including principal repayments of $2.5 million due in December 1998, and capital
expenditures for the next 12 months.
IMPACT OF THE YEAR 2000 ON COMPUTER APPLICATIONS
The year 2000 is a critical year for computer applications. Historically,
many computer programs were written using two digits rather than four to
define the appropriate year. As a result, many computer programs that have
date sensitive fields may recognize a date using "00" as the year 1900 rather
than the year 2000. This could result in system failures or miscalculations
causing disruption of operations, including, among other things, a temporary
inability to process transactions, send invoices or engage in other critical
business activities.
Year 2000 readiness includes addressing information technology systems
(computer equipment, computer software, network hardware and software, etc.),
non-information technology systems (systems which include embedded technology
such as microcontrollers including telephone systems) and issues relating to
third parties with whom we have a material relationship (customers and
vendors).
INFORMATION TECHNOLOGY SYSTEMS: Our insurance subsidiary operations began
in 1992. Since 1992, we developed our own internal computer systems to
manage our claims and related claim settlement expenses and administer our
policy information. These computer systems are year 2000 compliant.
Additionally, during the second quarter of 1998 we implemented third-party
provided, general ledger and accounts payable software which is year 2000
compliant. Also, we are in the process of internally developing a billing
and cash receipt system to be completed by the first quarter of 1999 which
will be year 2000 compliant. These system replacements and software
developments are occurring as a part of our ongoing operations and are not
specifically occurring as a result of the year 2000 issue. We anticipate that
our critical computer hardware and software systems will be fully year 2000
compliant in early 1999 and non-critical hardware and software systems are
compliant during the second quarter of 1999. The cost of any hardware and
software changes required to comply with the year 2000, other than those
contemplated as routine upgrades in our operations, are not expected to have
a material adverse effect on our results of operations.
NON-INFORMATION TECHNOLOGY SYSTEMS: We are in the process of reviewing
our operationally critical non-information technology systems (non-IT
systems) which may have embedded technology that is reliant on the year 2000.
We are in the assessment stage of this process which we expect to complete
early in the fourth quarter of 1998 and will develop a formal plan to address
any non-IT system year 2000 issues in the fourth quarter of 1998. We expect
that our non-IT systems will be fully year 2000 compliant by the end of the
second quarter of 1999. We are currently unable to determine the ultimate
costs relating to non-information technology systems.
THIRD PARTY READINESS: We are taking steps to ensure that our significant
customers and vendors are year 2000 compliant through surveys and further
information requests. We expect to have received preliminary information from
our critical vendors by the third quarter of 1998 and anticipate follow-up based
on information received through mid-1999 until we are comfortable that our
vendors are year 2000 compliant.
We have not yet established a year 2000 contingency plan. After completing
the assessment stages for the non-IT systems and third party readiness, we will
to determine our year 2000 areas of risk and will develop a contingency plan.
NAIC RISK-BASED CAPITAL STANDARDS
The National Association of Insurance Commissioners (NAIC) has risk-based
capital standards to determine the capital requirements of a property and
casualty insurance carrier based upon the risks inherent in its operations.
These standards require the computation of a risk-based capital amount which is
then compared to a carrier's actual
18
<PAGE>
total adjusted capital. The computation involves applying factors to various
financial data to address four primary risks: asset risk, insurance
underwriting risk, credit risk and off-balance sheet risk. These standards
provide for regulatory intervention when the percent of total adjusted
capital to authorized control level risk-based capital is below certain
levels. Based upon the risk-based capital standards, our percent of total
adjusted capital is substantially in excess of authorized control level
risk-based capital.
REGULATION
Our insurance subsidiary is subject to substantial regulation by governmental
agencies in the states in which we operate, and will be subject to such
regulation in any state in which we provide workers' compensation products and
services in the future. State regulatory agencies have broad administrative
power with respect to all aspects of our business, including premium rates,
benefit levels, policy forms, dividend payments, capital adequacy and the amount
and type of investments. These regulations are primarily intended to protect
covered employees and policyholders rather than the insurance company. Both the
legislation covering insurance companies and the regulations adopted by state
agencies are subject to change. At December 31, 1997, our insurance subsidiary
was licensed to do business in Minnesota, Colorado, Missouri, Michigan,
Massachusetts, Pennsylvania, Illinois, Kansas, Connecticut, South Dakota,
Tennessee and Wisconsin. We received Indiana, Iowa, Rhode Island, Maryland and
Florida licenses so far in 1998.
The codification of the statutory accounting principles is complete and has
been adopted by the NAIC. Implementation is expected in 2001and the impact of
this project on current statutory policies and practices is unknown.
RECENTLY ISSUED ACCOUNTING STANDARDS
In February 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 132, "Employers' Disclosures about Pensions
and Other Post-retirement Benefits." This Statement revises employers'
disclosures about pension and other post-retirement benefit plans. It does not
change the measurement or recognition of those plans. This Statement
standardizes the disclosure requirements for pensions and other post-retirement
benefits to the extent practicable, requires additional information on changes
in the benefit obligations and fair values of plan assets that will facilitate
financial analysis, and eliminates certain disclosures. Restatement of
disclosures for earlier periods is required. This Statement is effective for
financial statements for fiscal years beginning after December 15, 1997. We do
not expect this standard to have an impact on our Consolidated Financial
Statements.
In March 1998, the American Institute of Certified Public Accountants issued
Statement of Opinion ("SOP") 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use." This SOP provides guidance on
accounting for the costs of computer software developed or obtained for internal
use. This SOP requires that entities capitalize certain internal-use software
costs once certain criteria are met. Currently, we expense the costs of
developing or obtaining internal-use software as incurred. We are currently
evaluating SOP 98-1, but do not expect it to have a material impact on our
Consolidated Financial Statements. This SOP is effective for financial
statements for fiscal years beginning after December 15, 1998. Earlier
application is encouraged in fiscal years for which annual financial statements
have not been issued.
FORWARD LOOKING STATEMENTS
Information included in this Form 10-Q which can be identified by the use of
forward-looking terminology such as "may," "will," "expect," "anticipate,"
"estimate," or "continue" or the negative thereof or other variations thereon or
comparable terminology constitutes forward-looking information. The following
important factors, among others, in some cases have affected and in the future
could affect our actual results and could cause our actual financial performance
to differ materially from that expressed in any forward-looking statement: (i)
our ability to manage both our existing claims and our new claims in an
effective manner, (ii) competition from traditional workers' compensation
insurance carriers, (iii) our ability to further penetrate our existing markets,
(iv) changes in workers' compensation regulation by states, including changes in
mandated benefits or insurance company regulation, (v) our ability to retain our
existing customers at favorable beneficial premium rates when their policies
renew (vi) our ability to expand into new states and attract customers in those
states, (vii) our ability to successfully introduce new products and services,
and (viii) our ability to ensure that our operations are not adversely affected
by year 2000
19
<PAGE>
compliance including our dependence on outside vendors and customers and
their ability to become year 2000 compliant.
20
<PAGE>
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
None
ITEM 2. CHANGES IN SECURITIES
None
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) LISTING OF EXHIBITS
Exhibit 11 - STATEMENT REGARDING COMPUTATION OF BASIC AND
DILUTED INCOME (LOSS) PER SHARE
Exhibit 27 - FINANCIAL STATEMENT SCHEDULE
(b) LISTING OF REPORTS ON FORM 8-K
None
21
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
RTW, INC.
Dated: November 12, 1998 By: /s/ Carl B. Lehmann
-----------------------------------------------
Carl B. Lehmann
President, Chief Executive Officer and Director
(Principal Executive Officer)
Dated: November 12, 1998 By: /s/ Tim C. Chan
-----------------------------------------------
Tim C. Chan
Secretary, Treasurer and Chief Financial Officer
(Principal Financial and Accounting Officer)
22
<PAGE>
EXHIBIT INDEX
Exhibit
Number Description Page
------- ----------------------------------------------------- ----
11 Statement Regarding Computation of Basic and Diluted
Income (Loss) Per Share 24
27 Financial Statement Schedule 25
23
<PAGE>
EXHIBIT 11
RTW, INC. AND SUBSIDIARY
STATEMENT REGARDING COMPUTATION OF BASIC AND DILUTED LOSS PER SHARE
<TABLE>
<CAPTION>
FOR THE THREE MONTHS ENDED FOR THE NINE
---------------------------------------- MONTHS ENDED
MARCH 31, JUNE 30, SEPT. 30, SEPTEMBER 30,
1998 1998 1998 1998
---------- ---------- ---------- ------------
<S> <C> <C> <C> <C>
BASIC WEIGHTED AVERAGE SHARES OUTSTANDING 11,868,375 11,940,413 11,954,612 11,921,133
STOCK OPTIONS
Options at $25.00 - - - -
Options at $19.33 - - - -
Options at $16.67 - - - -
Options at $12.50 - - - -
Options at $10.75 - - - -
Options at $ 8.67 - - - -
Options at $ 7.13 - 658 - -
Options at $ 7.00 - 21,376 - -
Options at $ 6.75 - 88,665 - -
Options at $ 5.81 - - - -
Options at $ 4.75 - - - -
Options at $ 2.67 - 29,219 - -
Options at $ 2.00 - 168,972 - -
---------- ---------- ---------- ----------
DILUTED WEIGHTED AVERAGE SHARES OUTSTANDING 11,868,375 12,249,303 11,954,612 11,921,133
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
NET INCOME (LOSS) ($000'S) $(1,117) $491 $(138) $(764)
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
NET INCOME (LOSS) PER SHARE:
BASIC INCOME (LOSS) PER SHARE $(0.09) $0.04 $(0.01) $(0.06)
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
DILUTED INCOME (LOSS) PER SHARE $(0.09) $0.04 $(0.01) $(0.06)
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
</TABLE>
24
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 7
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<DEBT-HELD-FOR-SALE> 125,197
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 0
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 125,197
<CASH> 9,985
<RECOVER-REINSURE> 4,936
<DEFERRED-ACQUISITION> 1,778
<TOTAL-ASSETS> 159,696
<POLICY-LOSSES> 76,355
<UNEARNED-PREMIUMS> 16,317
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 4,940
0
0
<COMMON> 29,538
<OTHER-SE> 30,083
<TOTAL-LIABILITY-AND-EQUITY> 159,696
21,856
<INVESTMENT-INCOME> 1,854
<INVESTMENT-GAINS> 330
<OTHER-INCOME> 0
<BENEFITS> 17,571
<UNDERWRITING-AMORTIZATION> 3,657
<UNDERWRITING-OTHER> 3,150
<INCOME-PRETAX> (477)
<INCOME-TAX> (339)
<INCOME-CONTINUING> (138)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (138)
<EPS-PRIMARY> (0.01)
<EPS-DILUTED> (0.01)
<RESERVE-OPEN> 0
<PROVISION-CURRENT> 0
<PROVISION-PRIOR> 0
<PAYMENTS-CURRENT> 0
<PAYMENTS-PRIOR> 0
<RESERVE-CLOSE> 0
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
