-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, OqpxsefY8jiKX+P87z5dP7cXXCr4jXFIgi0glqCngILAnJh1PzR3ickiIqMUU/Jq Fm7yzJg0YDisqiGF+256NA== 0000950162-00-000518.txt : 20000510 0000950162-00-000518.hdr.sgml : 20000510 ACCESSION NUMBER: 0000950162-00-000518 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 8 CONFORMED PERIOD OF REPORT: 19991231 FILED AS OF DATE: 20000330 DATE AS OF CHANGE: 20000509 FILER: COMPANY DATA: COMPANY CONFORMED NAME: RISK CAPITAL HOLDINGS INC CENTRAL INDEX KEY: 0000947484 STANDARD INDUSTRIAL CLASSIFICATION: 6331 IRS NUMBER: 061424716 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-26456 FILM NUMBER: 589413 BUSINESS ADDRESS: STREET 1: 20 HORSENECK LANE CITY: GREENWICH STATE: CT ZIP: 06830 BUSINESS PHONE: 2038624300 MAIL ADDRESS: STREET 1: 20 HORSENECK LANE CITY: GREENWICH STATE: CT ZIP: 06830 FORMER COMPANY: FORMER CONFORMED NAME: RISK CAPITAL HOLDINGS INC DATE OF NAME CHANGE: 19950816 FORMER COMPANY: FORMER CONFORMED NAME: RISK CAPITAL RE INC DATE OF NAME CHANGE: 19950703 10-K 1 FORM 10-K ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended December 31, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] For the transition period from to ---------- Commission File No. 0-26456 RISK CAPITAL HOLDINGS, INC. (Exact name of Registrant as specified in its charter) Delaware 06-1424716 - - -------------------------------- -------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 20 Horseneck Lane Greenwich, Connecticut 06830 - - --------------------------------------- -------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (203) 862-4300 Securities registered pursuant to Section 12(b) of the Act: Name of each Exchange Title of Each Class on which Registered ------------------- ------------------- None None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.01 per share Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No_______ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] The aggregate market value of the voting stock held by non-affiliates of the Registrant as of March 27, 2000 was approximately $160,932,207 based on the closing price on the Nasdaq National Market on that date. As of March 27, 2000, there were 12,329,398 shares of the Registrant's Common Stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Parts I and II incorporate by reference our definitive proxy statement for a special meeting of our stockholders relating to the asset sale described in this annual report. Part III incorporates by reference our definitive proxy statement for the 2000 annual meeting of stockholders to be filed with the Securities and Exchange Commission before April 30, 2000. RISK CAPITAL HOLDINGS, INC. TABLE OF CONTENTS Item Page - - ---- ---- Part I 1. Business................................................................... 1 2. Properties................................................................ 25 3. Legal Proceedings......................................................... 25 4. Submission of Matters to a Vote of Security Holders....................... 25 Part II 5. Market for Registrant's Common Equity and Related Stockholder Matters..... 25 6. Selected Financial Data and Unaudited Pro Forma Condensed Consolidated Financial Data....................................................... 27 7. Management's Discussion and Analysis of Financial Condition and Results of Operations............................................ 35 7A.Quantitative and Qualitative Disclosures About Market Risk................ 52 8. Financial Statements and Supplementary Data............................... 52 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure............................................. 52 Part III 10.Directors and Executive Officers of the Registrant........................ 52 11.Executive Compensation.................................................... 52 12.Security Ownership of Certain Beneficial Owners and Management............ 52 13.Certain Relationships and Related Transactions............................ 53 Part IV 14.Exhibits, Financial Statement Schedules and Reports on Form 8-K........... 53 Cautionary Note Regarding Forward-Looking Statements The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements. This Form 10-K, our Annual Report to Stockholders, any proxy statement, any Form 10-Q or any Form 8-K of the company or any other written or oral statements made by or on behalf of the company may include forward-looking statements which reflect our current views with respect to future events and financial performance. All statements other than statements of historical fact included in or incorporated by reference in this report are forward-looking statements. Forward-looking statements can generally be identified by the use of forward-looking terminology such as "may," "will," "expect," "intend," "estimate," "anticipate," "believe" or "continue" or their negative or variations or similar terminology. Forward-looking statements involve our current assessment of risks and uncertainties. Actual events and results may differ materially from those expressed or implied in these statements. Important factors relating to our existing business that could cause actual events or results to differ materially from those indicated in such statements are discussed below and elsewhere in this report and include: o the acceptance in the market of our reinsurance products; o competition from new products (including products that may be offered by the capital markets); o the availability of investments on attractive terms; o competition, including increased competition (both as to underwriting and investment opportunities); o changes in the performance of the insurance sector of the public equity markets or market professionals' views as to such sector; o the amount of underwriting capacity from time to time in the market; o general economic conditions and conditions specific to the reinsurance and investment markets in which we operate; o regulatory changes and conditions; o rating agency policies and practices; o claims development, including as to the frequency or severity of claims and the timing of payments; and o loss of key personnel. In addition to risks and uncertainties related to our existing business, the proposed sale of our reinsurance operations to Folksamerica Reinsurance Company referred to in this report is subject to various risks and uncertainties including the risks that the conditions to closing will not be satisfied and that the costs of the transaction and purchase price and reserve adjustments will be greater than currently expected with resulting effects on our book value. These and other risks relating to the proposed asset sale and our business after the sale are discussed in the "Risk Factors" section of our definitive proxy statement for the special meeting of our stockholders relating to the asset sale. The special meeting proxy statement is filed as an exhibit to this annual report and is incorporated by reference in its entirety. All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with other cautionary statements that are included herein or elsewhere. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise. (ii) PART I ITEM 1. BUSINESS In this document, "we," "us," "our" and the "company" refer to Risk Capital Holdings, Inc. and/or Risk Capital Reinsurance Company, as the context requires. Certain terms used below are defined in the "Glossary of Selected Insurance Terms" appearing on pages 21-24 of this report. The Company We were incorporated in March 1995 under the laws of the State of Delaware and commenced operations in September 1995 upon completion of our initial public offering. Through our wholly owned operating subsidiary, Risk Capital Reinsurance Company ("RCRe"), we provide reinsurance and other forms of capital, either on a stand-alone basis, or as part of integrated solutions for insurance companies with capital needs that cannot be met by reinsurance alone. RCRe is rated "A-" (Excellent) by A.M. Best Company. Following the announcement of the proposed sale of our reinsurance operations to Folksamerica Reinsurance Company (see "--Recent Developments" below), A.M. Best announced on January 18, 2000 that it was placing our A- rating under review. At December 31, 1999, RCRe had statutory surplus of $290.1 million (or $230.1 million after giving pro forma effect to our recent repurchase of 4,755,000 shares of our common stock from XL Capital Ltd.). Based upon data available from the Reinsurance Association of America ("RAA"), RCRe is the 20th largest United States based broker market oriented reinsurer as measured by its statutory surplus of $230 million. Our offices are located at 20 Horseneck Lane, Greenwich, Connecticut 06830, and our telephone number is (203) 862-4300. Recent Developments Folksamerica Transaction As of January 10, 2000, we entered into an agreement with Folksamerica Reinsurance Company and Folksamerica Holding Company (collectively, "Folksamerica") pursuant to which Folksamerica Reinsurance Company will assume RCRe's liabilities under the reinsurance agreements transferred in the asset sale and RCRe will transfer to Folksamerica Reinsurance Company assets in an aggregate amount that is, in book value, equal to the book value of the liabilities assumed. In consideration for the transfer of RCRe's book of business, Folksamerica will pay $20.335 million in cash at the closing, subject to adjustment under the circumstances set forth in the asset purchase agreement. The sale of our reinsurance business to Folksamerica is contingent on approval by our stockholders, obtaining applicable regulatory approvals, the retention of a key employee, obtaining certain third party consents, the absence of a material adverse change in RCRe's business, and other customary closing conditions. Marsh & McLennan Risk Capital Holdings, Ltd. ("MMRCH") and The Trident Partnership, L.P. ("Trident"), which collectively represent approximately 13.3% of the total voting power of our outstanding common stock (after giving effect to the repurchase of 4,755,000 shares on March 2, 2000 from XL Capital, which is discussed below), have agreed to vote in favor of the asset sale. Detailed information regarding the proposed asset sale can be found in the sections of our special meeting proxy statement entitled "Questions and Answers About the Asset Sale," "Risk Factors," "The Asset Sale," "The Asset Purchase Agreement" and "Other Transaction Agreements," which are incorporated by reference. In addition, we have filed the asset sale agreement, the voting agreements and other related agreements as exhibits to this annual report. The above summary of the proposed transaction is qualified by these agreements, which are incorporated by reference. Please also refer to "Unaudited Pro Forma Condensed Consolidated Financial Data" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." 1 XL Transaction On March 2, 2000, we repurchased from XL Capital, then our single largest stockholder, all of the 4,755,000 shares of our common stock held by it. Under the terms of a stock repurchase agreement with XL Capital, we paid $12.45 per share of our common stock, or a total of $59.2 million. The per share repurchase price was determined as the lesser of (1) 85% of the average closing market price of our common stock during the 20 trading days beginning on the third business day following public announcement of the stock repurchase and asset sale (January 21, 2000), which was $14.65, and (2) $15. We paid XL Capital the consideration for the repurchase with: our interest in privately held LARC Holdings, Ltd. (parent of Latin American Reinsurance Company Ltd.), valued at $25 million (which was carried by us at $24 million at December 31, 1999); and all of our interest in Annuity and Life Re (Holdings), Ltd., valued at $25.38 per share and $18.50 per warrant, or $37.8 million in the aggregate (which was carried by us at $38.2 million at December 31, 1999). XL Capital paid us in cash the difference (equal to $3.6 million) between our repurchase price and the value of our interests in LARC Holdings and Annuity and Life Re. The value per share of Annuity and Life Re was determined by taking the average of the closing price of Annuity and Life Re shares for the same period used in determining the repurchase price of our shares. The value of the warrants was determined using a Black Scholes methodology. We have filed the stock repurchase agreement and related voting and disposition agreement as exhibits to this annual report. The above summary of the transaction is qualified by these agreements, which are incorporated by reference. As a result of this transaction, stockholders' equity, which was $346.5 million at December 31, 1999, has been reduced by $59.4 million and the number of outstanding voting shares, which was 17,087,970 at December 31, 1999, was 12,332,970 at March 2, 2000. RCRe's statutory surplus, which was $290.1 million at December 31, 1999, was also reduced by $60 million for the distribution of the stock and warrants in both LARC Holdings and Annuity and Life Re to us based on their statutory carrying values at December 31, 1999. Future Operations After the sale of our reinsurance operations to Folksamerica is completed, the company's objective will be to serve as a vehicle to effect business combinations and ventures, whether by acquiring all or a portion of companies, merger, exchange of stock or otherwise, with one or more operating companies that our board of directors believes will have potential to increase stockholder value. These business combinations and ventures may be with companies that are not in the insurance business. The company may cease to pursue this business objective at any time and may also consider alternatives. Please refer to the section of our special meeting proxy statement entitled "Risk Factors" for a discussion of certain risks relating to our business after the sale of our reinsurance operations to Folksamerica Reinsurance Company. The description of the company's business set forth below provides a discussion of the company's business to date and, accordingly, does not describe what we currently intend to be our business strategy following the asset sale. Reinsurance Underwriting We have sought to take advantage of underwriting opportunities in connection with our equity investment activities and, where appropriate, to provide reinsurance to insurers in which we invest. We have also sought to write "large lines" (i.e., significant portions) on a limited number of traditional and finite risk property and casualty reinsurance treaties with a select number of insurance and reinsurance companies located throughout the world (although our principal focus has been on large United States and European-based insurance and reinsurance companies) and with select Lloyd's syndicates. We have focused our efforts on treaty reinsurance and have sought to establish and cultivate long-term relationships with our reinsureds. In addition, we intend to write conservatively in terms of the company's surplus capacity, which helps enable us to maintain underwriting capacity and flexibility. At December 31, 1999, and after giving pro forma effect to our recent repurchase of 4,755,000 shares of our common stock from XL Capital, RCRe's premium-to-surplus ratio was 1.3x, which represents an increase from our prior intention that RCRe's premium-to-surplus ratio not exceed 1.0x. This increase is due to the reduction in RCRe's surplus 2 resulting from the XL Capital stock repurchase as well as from losses due to our poor underwriting performance. We have agreed to transfer all of our reinsurance business to Folksamerica Reinsurance Company. In reaching the determination to sell our reinsurance business, we considered, among other things, the following factors: o RCRe was incurring losses on its reinsurance business and faced increasing competition, which has been adversely affecting results of operations and financial condition; o RCRe's surplus has decreased, while the surpluses of many of RCRe's competitors have increased; o the amount and volatility of our earnings, resulting from our operating strategy and underwriting performance, severely limits our ability to incur and service substantial indebtedness, which in turn limits our ability to increase RCRe's statutory surplus; and o our depressed stock price, combined with our inability to incur debt as described above or otherwise use RCRe's cash because of RCRe's statutory surplus, rating and operating requirements, have prevented us from making acquisitions, which puts us, like many other small reinsurance companies, at a severe competitive disadvantage in an industry that has been experiencing rapid global consolidation. See "Business--Recent Developments," "Management's Discussion and Analysis of Financial Condition and Results of Operations--Folksamerica Transaction" and Note 14 of the accompanying notes to our consolidated financial statements. We also refer you to the section of our special meeting proxy statement entitled "Reasons for the Asset Sale and the Name Change; Our Board of Directors Recommends the Asset Sale," which is incorporated by reference. Operations Net premiums written for 1999, 1998 and 1997 were as follows: Net Premiums Written (Dollars in millions)
Years Ended December 31, ----------------------------------------------------------------------------------------- 1999 1998 1997 --------------------------- ---------------------------- -------------------------- Amount % Amount % Amount % ----------- ----------- ------------ ----------- ----------- ----------- Property $78.9 25.7% $33.7 14.4% $17.8 12.3% Casualty 64.1 20.9 80.3 34.2 69.7 48.1 Multi-Line 67.7 22.1 62.8 26.8 45.9 31.7 Other 7.6 2.5 16.5 7.0 10.0 6.9 Accident & Health 50.3 16.4 Aviation & Space 18.4 6.0 26.0 11.1 Marine 14.0 4.6 14.4 6.1 1.4 1.0 Surety & Fidelity 5.7 1.8 1.0 0.4 ----------- ----------- ------------ ----------- ----------- ----------- Total $306.7 100.0% $234.7 100.0% $144.8 100.0% =========== =========== ============ =========== =========== ===========
RCRe's assumed and ceded premiums written for the years ended December 31, 1999, 1998 and 1997 were as follows:
(In millions) Years Ended December 31, Years --------------------------------------------------------------------- 1999 1998 1997 ---------------------- ------------------ --------------------- Assumed premiums written $386.8 $260.5 $147.8 Ceded premiums written 80.1 25.8 3.0 ---------------------- ------------------ --------------------- Net premiums written $306.7 $234.7 $144.8 ====================== ================== =====================
3 We expanded our reinsurance business into marine and aviation and space underwriting in 1997, surety and fidelity underwriting in 1998, and accident and health underwriting in 1999. During 1999, we discontinued our aviation and space lines of business. RCRe's net premiums written increased 31% to $306.7 million in 1999 from $234.7 million in 1998 and 62% to $234.7 million in 1998 from $144.8 million in 1997. Premium growth resulted from two key strategies, the integration of investment with reinsurance and the diversification into "specialty" classes of business, which for purposes of this discussion consist of accident and health, aviation and space, marine and surety and fidelity. Approximately 30%, 32% and 29% of net premiums written in 1999, 1998 and 1997, respectively, were generated from companies in which we have invested or committed to invest funds ("integrated transactions"). Approximately 29%, 18% and 1% of net premiums written in 1999, 1998 and 1997, respectively, were produced from specialty classes of business. Specialty classes of business accounted for 65% and 44% of the increase in net premiums written for 1999 and 1998, respectively. Approximately 15%, 32% and 28% of net premiums written in 1999, 1998 and 1997, respectively, were from non-United States clients, which are Lloyd's syndicates or are located in the United Kingdom, Bermuda and Continental Europe. Reinsurance is provided by RCRe both on a quota share and excess of loss basis. In 1999, quota share reinsurance and excess of loss reinsurance amounted to 93% and 7%, respectively, of the Company's net premiums written, compared to (1) 81% and 19%, respectively, during 1998 and (2) 71% and 29%, respectively, during 1997. The mix of quota share and excess of loss reinsurance depends on market conditions and other relevant factors and cannot be predicted with accuracy. Depending on future conditions, prior to the asset sale, we may also write other types of reinsurance. Net premiums written in 1999 include approximately $26 million related to a group of property reinsurance treaties that expired in 1999 covering crop hail business underwritten on behalf of a start-up entity formed by Trident II, L.P. This business was protected by extensive aggregate excess of loss retrocession and generated a profit based upon underwriting results. We do not expect to renew these treaties in 2000. Net premiums written in 1999 for other business was reduced by $10.6 million for the retrocession of a treaty which covers future multiple rocket launches that was recorded in 1996. The reduction of net premiums written resulting from this retrocession increased the commission and operating expense ratio components of the statutory composite ratio by 1.1 percentage points, but had no impact on operating results. Consistent with our strategy of writing a small number of large treaties for our core business, two clients contributed approximately $81.3 million, or 26.5%, of 1999 total net premiums written, with the largest client contributing approximately 13.7% and the second contributing 12.8%. Approximately 70% of the business written from the client that contributed 13.7% and all of the business written from the client that contributed 12.8% are part of an integrated transaction, and such business is subject to renewal at our option for two and four remaining years, respectively. In 1998, three clients contributed approximately $74 million, or 32%, of 1998 total net premiums written, with the largest client contributing approximately 18% and the remaining two contributing 8% and 6%, respectively. In 1997, five clients contributed approximately $68 million, or 45%, of total net premiums written, with the largest client contributing approximately 18% and the remaining four contributing from 5% to 8%. RCRe's ceded premiums increased to $80.1 million in 1999, compared to $25.8 million in 1998 and $3.0 million in 1997. Such ceded premiums primarily relate to RCRe's property, multi-line, marine, aviation and space reinsurance business, for which we seek to reduce RCRe's exposure to large and catastrophic losses. Since the fourth quarter of 1998, we have purchased additional retrocessional protection to reduce RCRe's exposures to both space and aviation risks. Effective July 1, 1999, RCRe also purchased a retrocessional treaty for a one year period covering earthquake, wind and other property catastrophe perils for $10 million in excess of a $15 million retention per occurrence. For a discussion of our in-force business at January 1, 2000, please refer to "Management's Discussion and Analysis of Financial Condition and Results of Operations--General--In-Force Business." 4 Investments Our investment goals have been to support RCRe's reinsurance activities and enhance our long-term profitability. The principal components of our strategy to achieve these goals include: (1) supporting short-term liquidity requirements through cash and fixed income investments and, if necessary, through the sale of marketable equity securities from the company's investment portfolio; (2) investing a significant portion of our assets in publicly traded and privately held equity securities issued by insurance and reinsurance companies and companies providing services to the insurance industry; (3) identifying trends and investment opportunities in the insurance industry that could lead to superior returns; (4) utilizing Marsh & McLennan Capital, Inc. ("MMCI"), an experienced insurance industry advisor, as equity investment advisor; (5) investing in insurers to which RCRe provides reinsurance, where appropriate; and (6) when available, co-investing with Trident, a dedicated insurance industry private equity fund, and an entity to which MMCI also provides equity investment advisory services. We have an investment advisory agreement with MMCI for management of our portfolios of equity securities (including convertible securities) that are publicly traded ("Public Portfolio") and privately held ("Private Portfolio"). The Private Portfolio includes equity securities which do not have a readily ascertainable market or are subject to certain trading restrictions. Effective July 1, 1999, we amended our investment advisory agreement with MMCI, which governs the management of our portfolios of equity securities (including convertible securities) that are publicly traded and privately held. Pursuant to the amended agreement, which has a term of four years (subject to renewal), MMCI provides us with investment management and advisory services with respect to investments in the Private Portfolio whose value exceeds (i) $10 million during the first year of the term, (ii) $15 million during the second year of the term, and (iii) $20 million during the third and fourth years of the term. Under the agreement, we pay MMCI an annual fee equal to (x) 20% (previously 7.5%) of cumulative net realized gains including dividends, interest and other distributions, received on the Private Portfolio over (y) cumulative compensation previously paid in prior years on cumulative net realized gains (as defined in the agreement) on the Private Portfolio managed by MMCI, but we will not pay MMCI a management fee (previously 1.5% per annum of the quarterly carrying value of the Private Portfolio). With respect to the management of our Public Portfolio, we pay MMCI a fee equal to 0.50% of the first $50 million under MMCI's management and 0.35% of all amounts in excess of $50 million, subject to a minimum fee of $250,000 per annum (previously 0.35% for the entire Public Portfolio). In connection with the amendments to our agreement with MMCI, we will receive from MMCI $1.25 million per annum during the initial four-year term, subject to certain conditions. The initial agreement provided for a minimum aggregate cash fee to MMCI of $500,000 per annum through December 31, 1997. Fees incurred under the agreements during fiscal years 1999, 1998 and 1997 were approximately $1.5 million, $2.7 million and $1.3 million, respectively. In addition, in 1999, 1998 and 1997, unrealized appreciation in the Private Portfolio is net of accrued fees of approximately $256,000, $2.2 million and $1.4 million, respectively. In May 1999, we transferred the management of the fixed income and short-term cash portfolios from The Putnam Advisory Company, Inc. ("Putnam") to Alliance Capital. Previously, we had an investment advisory agreement with Putnam, an affiliate of MMCI, for the management of our fixed income securities and short-term cash portfolios through April 1999. For the fixed income securities portfolio, we paid to Putnam a fee equal to the sum of 0.35% per annum of the first $50 million of the market value of the portfolio, 0.30% per annum on the next $50.0 million, 0.20% per annum on the next $100 million and 0.15% per annum of the market value of assets that exceeded $200 million. For the short-term cash portfolio, we paid a fee equal to 0.15% per annum of the total monthly average market value. Fees incurred under the Putnam agreement for the period in 1999, 1998 and 1997 were approximately $173,000, $461,000 and $493,000, respectively. MMCI serves as investment manager to Trident and, accordingly, certain restrictions exist with respect to MMCI's ability to make investment recommendations to us with respect to investments which would be suitable for both Trident and us. Under the Trident partnership agreement, until the earlier of May 6, 2000 or the date on which at least 75% of the aggregate capital of Trident has been drawn, neither MMCI nor any of its 5 affiliates may organize, or invest in, any new or existing risk assumption entity unless Trident is first offered a reasonable opportunity to invest in such entity. These restrictions may also apply to us. This limitation, however, does not apply to investments in any such new entity where the total invested capital of such entity does not exceed $10,000,000. Pursuant to the Trident partnership agreement, where Trident has elected to make part, but not all, of the full investment otherwise available to it, we may not be offered the opportunity to participate in such investment unless Trident first offers at least all Trident partners with capital commitments of at least $50,000,000 the right to participate in such additional investment on a pro rata basis. Pursuant to the terms of our equity advisory agreement, MMCI has agreed that it will not invest in such opportunities, and will not offer any such opportunities to its affiliates, without first offering us an opportunity to make such investments. Fixed income investments are used to provide shorter-term liquidity and current returns. The fixed income securities portfolio generally is invested in high quality, liquid securities, including securities issued by United States government agencies and United States government guaranteed securities. In addition, we allocated in early 1998 approximately $35,000,000 for investment in a diversified portfolio of high yielding below investment grade fixed maturity investments managed by Miller Anderson & Sherrerd, LLP, a subsidiary of Morgan Stanley & Co. Such amount was taken from funds that were previously allocated for investing in short-term securities. Miller Anderson manages the portfolio subject to investment guidelines established by the Investment/Finance Committee of our board of directors. At December 31, 1999, our high yield portfolio included approximately $37.6 million of such securities. Since a significant portion of our investment portfolio is currently comprised of equity securities issued by insurance and reinsurance companies and companies providing services to the insurance industry, the portfolio lacks industry diversification and is particularly subject to the performance of the insurance industry. Such performance will affect the market prices of a significant portion of our investment portfolio and the income and return on such investments, all of which could negatively affect our underwriting capacity. As our current investment strategy is to invest a significant portion of its investment portfolio in equity securities, our investment income in any fiscal period may be smaller, as a percentage of investments, and less predictable than other competitor reinsurance companies, which tend to invest primarily in fixed income investments. Net realized and unrealized gains (or losses) on investments may have a greater effect on our results of operations or stockholders' equity at the end of any fiscal period than on those of our competitor reinsurance companies. After the sale of our reinsurance operations to Folksamerica is completed, the company's objective will be to serve as a vehicle to effect business combinations and ventures, whether by acquiring all or a portion of companies, merger, exchange of stock or otherwise, with one or more operating companies that our board of directors believes will have potential to increase stockholder value. These business combinations and ventures may be with companies that are not in the insurance business. We refer you to the section of our special meeting proxy statement entitled "Risk Factors," which is incorporated by reference, for a discussion of certain risks relating to our business after the sale of our reinsurance operations to Folksamerica Reinsurance Company. Operations At December 31, 1999, cash and invested assets totaled approximately $585.9 million, consisting of $82.2 million of cash and short-term investments, $261.1 million of publicly traded fixed maturity investments, $158.6 million of publicly traded equity securities and $84.0 million of privately held securities. The components of net investment income for the years ended December 31, 1999, 1998 and 1997 are summarized in a table found in Note 3 under the caption "Investment Information" of the accompanying notes to our consolidated financial statements. 6 Our investments on a consolidated basis at December 31, 1999, 1998 and 1997 consisted of the following:
(Dollars in thousands) December 31, --------------------------------------------------------------------------------------------------- 1999 1998 1997 ------------------------------ ------------------------------- ------------------------------ Estimated Estimated Estimated Fair Value Percent Fair Value Percent Fair Value Percent ---------- ------- ---------- ------- ---------- ------- Cash and short-term $ 82,242 14% $120,846 20% $ 98,181 19% -------- -- -------- -- -------- -- Fixed maturities: U.S. government and government agencies 41,095 7 39,283 6 44,135 9 Municipal bonds 52,245 9 45,273 8 37,637 7 Corporate bonds 136,838 23 56,256 10 19,323 4 Mortgage and asset- backed securities 27,298 5 33,532 6 30,487 6 Foreign governments 3,591 1 196 - 577 - ----- - --- -- --- -- Sub-total, fixed maturities 261,067 45 174,540 30 132,159 26 Equity securities: Publicly traded 158,631 27 154,678 27 180,052 36 Privately held 83,969 14 137,091 23 95,336 19 ------ -- ------- -- ------ -- Sub-total, equity securities 242,600 41 291,769 50 275,388 55 ------- -- ------- -- ------- -- Total $585,909 100% $587,155 100% $505,728 100% ======== === ======== === ======== ===
Our current investment guidelines restrict the portion of our fixed maturities portfolio that can be held in lower quality securities. At December 31, 1999, 88% of the fixed maturity and short-term investments were rated investment grade by Moody's Investors Service, Inc. or Standard & Poor's Corporation and had an average quality rating of AA and an average duration of approximately 3.7 years. Contractual maturities of our consolidated fixed maturity securities are shown below. Expected maturities, which are our best estimates, will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. (In thousands) December 31, 1999 ----------------- Estimated Amortized Fair Value Cost ---------- ---- Available for sale: Due in one year or less $10,210 $10,237 Due after one year through five years 68,182 69,956 Due after five years through 10 years 78,461 82,282 Due after 10 years 76,916 79,446 ------ ------ Sub-total 233,769 241,921 Mortgage and asset-backed securities 27,298 28,424 ------ ------ Total $261,067 $270,345 ======== ======== At December 31, 1999, our investment portfolio included $158.6 million of publicly traded equity securities and 12 investments in privately held securities totaling $84.0 million, with additional investment portfolio commitments in an aggregate amount of $23.2 million. At this date, all of our equity investments were in securities issued by insurance and reinsurance companies or companies providing services to the insurance industry. 7 Please refer to Note 3 under the caption "Investment Information" of the accompanying Notes to our consolidated financial statements for information regarding our publicly traded and privately held securities and their carrying values, and commitments made by us relating to our privately held securities. We have not invested in derivative financial instruments such as futures, forward contracts, swaps, or options or other financial instruments with similar characteristics such as interest rate caps or floors and fixed-rate loan commitments. Our portfolio includes market sensitive instruments, such as mortgage-backed securities, which are subject to prepayment risk and changes in market value in connection with changes in interest rates. Our investments in mortgage-backed securities are classified as available for sale and are not held for trading purposes. These investments amounted to approximately $27.3 million, or 4.7% of cash and invested assets at December 31, 1999, $33.5 million, or 6% of cash and invested assets at December 31, 1998, and $30.5 million, or 6% of cash and invested assets at December 31, 1997. Marketing RCRe has obtained substantially all of its reinsurance business through intermediaries representing the cedent in negotiations for the purchase of reinsurance. The process of effecting a brokered reinsurance placement typically begins when a cedent enlists the aid of an intermediary in structuring a reinsurance program. Often the intermediary will consult with one or more lead reinsurers as to the pricing and contract terms of the reinsurance protection being sought. Once the cedent has approved the terms quoted by the lead reinsurer, the intermediary offers participation to qualified reinsurers until the program is fully subscribed to by reinsurers on terms agreed upon by all parties. By working through intermediaries to originate business, we have avoided maintaining a substantial sales organization. In addition, we believe that submissions from the intermediary market are more numerous and diverse, including certain targeted specialty coverages, than would be available through a salaried sales organization and that we are able to exercise greater selectivity than would be possible in dealing directly with cedents. RCRe pays commissions to intermediaries based on negotiated percentages of the premiums it writes. Direct writers of reinsurance typically incur higher fixed costs that are included in their underwriting expenses. Reinsurers using intermediaries can lower these costs during a downturn in the market by writing less business and incurring lower brokerage costs. Intermediaries do not generally have the authority to bind RCRe with respect to reinsurance agreements nor does RCRe generally commit in advance to accept any portion of the business that intermediaries submit to it. Reinsurance business from any cedent, whether new or renewal, is generally subject to acceptance by RCRe. In 1999, (1) affiliates of Marsh & McLennan, including Balis & Co., Inc., Guy Carpenter & Company, Inc., Carpenter Bowring Ltd. and Cecar & Jutheau, S.A. (collectively, "Marsh Affiliates"), (2) the Aon Group and (3) E.W. Blanch Company accounted for approximately 33.1%, 17.4% and 5.7%, respectively, of RCRe's assumed net premiums written. In 1998, (1) Marsh Affiliates, (2) Aon and (3) E.W. Blanch accounted for approximately 43.2%, 16.5% and 10.9%, respectively, of RCRe's assumed net premiums written. In 1997, (1) Marsh Affiliates, (2) Aon and (3) E.W. Blanch accounted for approximately 47.3%, 19.1%, and 9.3%, respectively, of RCRe's assumed net premiums written. Loss of all or a substantial portion of the business provided by any of these intermediaries could have a short-term material adverse effect on the business and operations of RCRe. We do not believe that the loss of such business would have a long-term material adverse effect due to RCRe's competitive position within the broker reinsurance market and the availability of business from other intermediaries. The terms relating to RCRe's intermediary arrangements with Marsh Affiliates have been negotiated on an arm's-length basis. In addition to investment opportunities arising from the activities of MMCI as our equity investment advisor, we are provided with investment opportunities by reinsurance brokers and traditional financing sources, including investment banking firms, venture capital firms and other banking and financing sources, both acting as principal investors and intermediaries. Underwriting opportunities may arise from such sources in connection with our investment activities as part of integrated transactions. Retrocessional Arrangements Reinsurance companies enter into retrocessional arrangements for many of the same reasons primary insurers seek reinsurance, including reducing the effect of individual or aggregate losses and increasing 8 premium writing and risk capacity without requiring additional capital. Retrocessional arrangements do not relieve RCRe from its obligations to the insurers and reinsurers from which it assumes business. The failure of retrocessionaires to honor their obligations could result in losses to RCRe. RCRe utilizes retrocession agreements for the purpose of limiting its exposure with respect to multiple claims arising from a single occurrence or event. RCRe also participates in "common account" retrocessional arrangements for certain reinsurance treaties, which are arrangements whereby the ceding company purchases a cover for the benefit of the ceding company and the reinsurers on the reinsurance treaty. Common account retrocessional arrangements reduce the effect of individual or aggregate losses to all participating companies with respect to a reinsurance treaty, including the cedent. All retrocessionaires must conform to RCRe's standards and must be specifically approved by RCRe's Security Committee, which consists of four members of senior management, including the President. Business may not be conducted with retrocessionaires that are not approved by the Security Committee. For additional information on our retrocessional arrangements and risk management policies, please refer to "Management's Discussion and Analysis of Financial Condition and Results of Operations--Results of Operations--Net Premiums Written," "--Aviation Business" and "--Risk Retention" and Note 7 of the accompanying notes to our consolidated financial statements. We continue to evaluate RCRe's retrocessional requirements periodically in relation to many factors, including its surplus, gross line capacity and changing market conditions. Claims Administration Claims are managed by our professional claims staff whose responsibilities include the review of initial loss reports, creation of claim files, determination of whether further investigation is required, establishment and adjustment of case reserves and payment of claims. In addition, our claims staff conducts comprehensive claims audits of both specific claims and overall claims procedures at the offices of selected ceding companies. In certain instances, as part of a comprehensive risk evaluation process, a claims audit may be performed prior to assuming reinsurance business or entering into an investment transaction. Reserves for Unpaid Claims and Claims Expenses As a reinsurance company, RCRe is required to establish and maintain reserves to cover its estimated ultimate liability for unpaid claims and claims expenses with respect to reported and unreported claims incurred as of the end of each accounting period (net of estimated related salvage and subrogation claims and retrocession recoverables (if any) of RCRe). These reserves are estimates involving actuarial and statistical projections at a given time of what RCRe expects the ultimate settlement and administration of claims to cost based on facts and circumstances then known, predictions of future events, estimates of future trends in claims severity and other variable factors such as inflation and new concepts of liability. For certain types of claims, it may over time be necessary to revise estimated potential loss exposure and therefore RCRe's unpaid claims and claims expense reserves. The inherent uncertainties of estimating claims and claims expense reserves are exacerbated for reinsurers by the significant periods of time (the "tail") that often elapse between the occurrence of an insured claim, the reporting of the claim to the primary insurer and ultimately to the reinsurer, and the primary insurer's payment of that claim and subsequent indemnification by the reinsurer. As a consequence, actual claims and claims expenses paid may deviate, perhaps substantially, from estimates reflected in RCRe's reserves in its financial statements. The estimation of reserves by new reinsurers, such as RCRe, may be less reliable than the reserve estimations of a reinsurer with an established volume of business and loss history. To the extent reserves prove to be inadequate, RCRe may have to augment such reserves and incur a charge to earnings. Such a development could result in a material charge to earnings or stockholders' equity in future periods. When a claim is reported to an insurance company that cedes business to RCRe, its claims personnel establish a "case reserve" for the estimated amount of the ultimate payment. The estimate reflects the informed judgment of such personnel based on general insurance reserving practices and on the experience and knowledge of such personnel regarding the nature and value of the specific type of claim. RCRe, in turn, typically establishes a case reserve when it receives a notice of a claim from the ceding company. Such reserves are based on an independent evaluation by RCRe, taking into consideration coverage, liability, severity of injury or damage, jurisdiction, RCRe's assessment of the ceding company's ability to evaluate and handle the 9 claim and the amount of reserves recommended by the ceding company. Case reserves are adjusted periodically by RCRe based on subsequent developments and audits of ceding companies. In accordance with industry practice, RCRe maintains incurred but not reported ("IBNR") reserves. These reserves are established to provide for future case reserves and loss payments on incurred claims which have not yet been reported to an insurer or reinsurer. In calculating its IBNR reserves, RCRe uses generally accepted actuarial reserving techniques that take into account quantitative loss experience data, together, where appropriate, with qualitative factors. IBNR reserves are based on loss experience of RCRe and the industry, and are grouped both by class of business and by accident year. IBNR reserves are also adjusted to take into account certain factors such as changes in the volume of business written, reinsurance contract terms and conditions, the mix of business, claims processing and inflation that can be expected to affect RCRe's liability for losses over time. The reconciliation of claims and claims expense reserves for the years ended December 31, 1999, 1998 and 1997 is as follows:
(In thousands) Years Ended December 31, ----------------------------------------------------------- 1999 1998 1997 ---- ---- ---- At beginning of year: Gross claims and claims expense reserves $216,657 $70,768 $20,770 Reinsurance recoverables 30,468 _____ 522 ------ ------- Net claims and claims expense reserves 186,189 70,768 20,248 Net claims and claims expenses incurred relating to: Current year $275,455 178,957 73,385 Prior year 30,386 (2,832) 22 ------ ------- ------- Total 305,841 176,125 73,407 Net paid claims and claims expenses incurred relating to: Current year 95,367 41,910 13,649 Prior year 88,034 18,794 9,238 ------ ------ ------- Total 183,401 60,704 22,887 At end of year: Net claims and claims expense reserves current year 308,629 186,189 70,768 Reinsurance recoverables 55,925 30,468 _____ ------ ------ Gross claims and claims expense reserves $364,554 $216,657 $70,768 -------- -------- -------
RCRe believes that its exposure, if any, to environmental impairment liability and asbestos-related claims is minimal since it did not write business prior to 1996. RCRe does not currently discount its reserves to reflect the present value of claims that may eventually be paid. Subject to the foregoing, we believe that the reserves for claims and claims expenses are adequate to cover the ultimate cost of claims and claims expenses incurred through December 31, 1999. The estimates will be continuously reviewed and as adjustments to these reserves become necessary, these adjustments will be reflected in current operations. Estimates of prior accident year claims were increased by approximately $30 million in 1999. A substantial portion of this amount resulted from (1) our review of additional claims information and our continuing underwriting and actuarial analysis of the business produced by a certain managing underwriting agency, (2) notification of additional satellite losses received in 1999 pertaining to 1998, (3) aviation losses, principally the 1998 Swiss Air crash, and (4) property losses reported on several international treaties that are in run-off. Estimates of prior accident year claims were reduced by approximately $2.8 million in 1998 primarily due to favorable claims development in the property and multi-line classes of business. The following table represents the development of generally accepted accounting principles ("GAAP") balance sheet reserves for 1996 through 1999. The top line of the table shows the reserves, net of reinsurance recoverables, at the balance sheet date for each of the indicated years. This represents the estimated amounts of net claims and claims expenses arising in all prior years that are unpaid at the balance sheet date, including IBNR. The table also shows the reestimated amount of the previously recorded reserve based on experience as of the end of each succeeding year. The estimate changes as more information becomes known about the frequency and severity of claims for individual years. The "cumulative redundancy (deficiency)" represents the aggregate change in the estimates over all prior years. The table also shows the cumulative amounts paid as of successive years with respect to that reserve liability. The lower portion of the table represents the claim development of the gross balance sheet reserves for 1996 through 1999. With respect to the information in the table below, it should be noted that each amount includes the effects of all changes in amounts for prior periods. This table does not present accident or policy year development data. Conditions and trends that have affected development of the liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future reserve development based on the following table. For additional information on RCRe's reserving and retrocessional activities, please refer to "Management's Discussion and Analysis of Financial Condition and Results of Operations--Results of Operations--Risk Retention," "Business--Retrocessional Arrangements" and Notes 6 and 7 of the accompanying notes to our consolidated financial statements. Development of GAAP Reserves Cumulative Redundancy (Deficiency) (in millions)
Years Ended December 31, ----------------------------------------------------------- 1996 1997 1998 1999 ---------- ----------- ------------- ----------- Reserves for unpaid claims and claims adjustment expenses, net of reinsurance recoverables $20 $71 $186 $309 Paid (cumulative) as of: One year later 9 19 88 Two years later 10 33 Three years later 12 Reserve reestimated as of: One year later 20 68 216 Two years later 19 65 Three years later 18 Cumulative redundancy (deficiency) $2 $6 ($30) ========== =========== ============= Percentage 10.0% 8.5% (16.1)% Gross reserve for claims and claims expenses $20 $71 $216 $365 Reinsurance recoverable 0 0 (30) (56) ---------- ----------- --------- --------- Net reserve for claims and claims expenses $20 $71 $186 $309 ---------- ----------- --------- --------- Gross reestimated reserve $18 $65 $246 Reestimated reinsurance recoverable 0 0 (30) ---------- ------------ --------- Net reestimated reserve $18 $65 $216 Gross reestimated redundancy (deficiency) $2 $6 ($30) ---------- ----------- ---------
Overview of the Reinsurance Industry Reinsurance is a form of insurance in which a reinsurer indemnifies a primary insurer against part or all of the liability assumed by the primary insurer under one or more insurance policies. Reinsurance is a contractual 11 agreement whereby an insurer or reinsurer (ceding company) remits a portion of the premium it receives to a reinsurer (assuming company) as payment for the assuming company's agreement to indemnify the ceding company for a portion of the risk. Reinsurance provides insurers with several benefits which include the following: reduction in net liability on individual risks, protection against catastrophic losses and assistance in maintaining acceptable regulatory ratios and additional underwriting capacity in that the primary insurer can accept larger risks and can expand the book of business it writes at a faster rate than would be possible without a corresponding increase in its capital and surplus position. Reinsurance does not legally discharge the ceding company from its liability with respect to its obligation to the insured. There are two principal types of reinsurance: treaty reinsurance and facultative reinsurance. Treaty reinsurance is a contractual arrangement, usually renewable annually, between a primary insurer and a reinsurer under which the primary insurer must cede and the reinsurer must assume a specified portion of a type or category of risks. Facultative reinsurance is the reinsurance of individual risks. Rather than agreeing to reinsure all or a portion of a class of risk, the reinsurer separately rates and underwrites each risk. In the underwriting of treaty reinsurance, the reinsurer need not separately evaluate each of the individual risks assumed, as it must in the underwriting of facultative reinsurance, and in general depends on the original underwriting decisions made by the reinsured. Both facultative and treaty reinsurance can be written on both an excess of loss and a quota share basis. In quota share reinsurance, the reinsurer assumes from the reinsured a percentage specified in the treaty of each risk in the reinsured class of risk. Premiums that the reinsured pays to the reinsurer are proportional to the portion of the risk that the reinsurer assumes, and the reinsurer generally pays the reinsured a ceding commission to reimburse the reinsured for the expenses incurred in obtaining the business (e.g., commissions, premium taxes, assessments and miscellaneous administrative expenses). The ceding commission may also contain a profit component. In quota share reinsurance, the reinsurer may receive the benefit of common account reinsurance and, therefore, the reinsurer will have credit risk with respect to the underlying reinsurers providing such common account reinsurance. In excess of loss treaty reinsurance, the reinsurer indemnifies the reinsured for a portion of the losses on underlying policies which exceed a specified loss retention amount up to an amount per loss specified in the treaty. Premiums that the reinsured pays to the reinsurer for excess of loss coverage are not directly proportional to the premiums that the reinsured receives because the reinsurer does not assume a proportionate risk. The reinsurer generally does not pay any commission to the reinsured in connection with excess of loss reinsurance. Excess of loss treaty reinsurance can, in turn, be written on a per risk or catastrophe basis. Per risk excess of loss reinsurance protects the reinsured against a loss resulting from a single risk or location. Catastrophe excess of loss reinsurance protects a reinsured from an accumulation or large number of related losses resulting from a variety of risks which may occur in a given catastrophe and hence is a highly volatile business. Excess of loss reinsurance is often written in layers, with one reinsurer taking the risk from the primary insurer's retention layer up to a specified amount, at which point another reinsurer assumes the excess liability or the excess liability reverts back to the primary insurer. The reinsurer taking on the risk just above the primary insurer's retention layer is said to write "working" or "low layer" excess of loss reinsurance. A loss that reaches just beyond the primary insurer's retention layer will create a loss for the lower layer reinsurer, but not for the reinsurers on higher layers. Losses incurred in low layer reinsurance tend to be more predictable than those in high layers due to the greater availability of actuarial data. Since facultative reinsurance, unlike treaty reinsurance, usually involves the assumption of selected, individual risks and is sold in separate transactions, facultative reinsurance typically generates higher profit margins than treaty business. However, the reinsurer's losses may be higher for facultative business because the reinsurer may assume a higher potential liability and because the risks involved may be more volatile. In addition, underwriting expenses and, in particular, personnel costs, are higher on facultative business because each risk is individually underwritten and administered. Facultative reinsurance is normally purchased by insurance companies for individual risks not covered by their reinsurance treaties, for excess losses on risks covered by their reinsurance treaties, and for unusual risks. The demand for facultative reinsurance is typically inversely related to the supply of treaty reinsurance. Reinsurers may also purchase reinsurance, known as retrocessional reinsurance, to cover their own risk exposure. Reinsurance companies enter into retrocessional agreements for reasons similar to those that cause ceding companies to purchase reinsurance. 12 The reinsurance market has two basic segments: reinsurers which primarily obtain their business directly from insurers and other reinsurers ("direct writers"), and those which, like RCRe, primarily obtain business through reinsurance intermediaries or brokers. Please see "Management's Discussion and Analysis of Financial Condition and Results of Operations--General--Recent Industry Performance." Competition The property and casualty reinsurance business is highly competitive. Competition is based on many factors, including the perceived overall financial strength of the reinsurer, premiums charged, contract terms and conditions, services offered, ratings assigned by independent rating agencies, speed of claims payment and reputation and experience. In pursuing our investment strategy, we have also competed with venture capitalists, buyout funds, merchant banking firms, investment banking firms and other banking and financing sources for investment opportunities in publicly traded and privately held equity securities. Competition is based on many factors, including the ability to identify trends and investment opportunities that could lead to superior returns, financial and personnel resources of the investor, the ability to negotiate investment terms effectively, and the ability of the investor to provide expertise and advice to companies targeted for investment. We compete in the United States and international reinsurance markets and, in the United States markets, we compete with both United States and internationally domiciled reinsurers. Our competitors include independent reinsurance companies, subsidiaries or affiliates of established worldwide insurance companies, reinsurance departments of certain primary insurance companies and domestic and international underwriting syndicates, many of which have substantially greater financial resources than we do. Competitors include direct writers and those that, like RCRe, write primarily through reinsurance intermediaries. Significant competitors of RCRe in the direct market include American Re-Insurance Company, Employers Reinsurance Corporation, General Reinsurance Corporation and Swiss Reinsurance Company. Significant competitors of RCRe in the intermediary/broker market include Everest Reinsurance Company, GE Capital Reinsurance Company, Gerling Global Reinsurance Corporation of America, NAC Reinsurance Company, Odyssey Reinsurance Corporation, PartnerRe Ltd., PMA Reinsurance Corporation, The St. Paul Companies, Inc., Transatlantic Reinsurance Company, Trenwick America Reinsurance Corporation, Underwriters Reinsurance Company and Zurich Re North America. In addition, we compete with Lloyd's syndicates and certain companies operating in the London reinsurance market. We also face competition from other market participants that determine to devote greater amounts of capital to the types of business written by us. We may also compete with new market entrants, including possibly other companies organized by (or that may, in the future, be organized by) certain of our initial investors, including MMRCH and Trident, their affiliates or entities that they advise or in which such initial investors, their affiliates or entities in which they advise, have (or may, in the future, have) significant investments. In addition, affiliates of MMCI engage in activities in support of their ongoing business strategies, which activities may compete with our activities. We believe that the reinsurance industry is consolidating, and the largest reinsurers are writing a larger proportion of total industry premiums as ceding companies place increasing importance on size and financial strength in the selection of reinsurers. Please see "Management's Discussion and Analysis of Financial Condition and Results of Operations--General--Recent Industry Performance." We have been unable to make acquisitions because of (1) our depressed stock price, (2) our inability to use RCRe's cash due to RCRe's statutory surplus, rating and operating requirements and (3) our inability to incur debt due to the amount and volatility of our earnings. This has put us, like many other small reinsurance companies, at a severe competitive disadvantage in the rapidly consolidating reinsurance industry. We have also been facing increasing competition, which has been adversely affecting our results of operations and financial condition. These are some of the factors that led us to the proposed sale of our reinsurance operations to Folksamerica. We refer you to the section of our special meeting proxy statement entitled "Reasons for the Asset Sale and the Name Change; Our Board of Directors Recommends the Asset Sale," which is incorporated by reference. Insurance ratings are used by insurers and reinsurance intermediaries as an important means of assessing the financial strength and quality of reinsurers. In addition, a ceding company's own rating may be adversely 13 affected by the lack of a rating of its reinsurer. A.M. Best is generally considered to be a significant rating agency with respect to the evaluation of insurance and reinsurance companies. A.M. Best's ratings reflect their independent opinion of the financial strength, operating performance and market profile of an insurer relative to standards established by A.M. Best, and are not a warranty of an insurer's current or future ability to meet its obligations to policyholders. In May 1999, A.M. Best Company revised its rating of RCRe from A (Excellent) to A- (Excellent). While several factors were identified, the rating action principally reflected the poor underwriting results reported by RCRe in late 1998 and the first quarter of 1999 on its satellite book of business and the business produced by a certain managing underwriting agency. Following the announcement of the proposed sale of our reinsurance operations to Folksamerica Reinsurance Company, A.M. Best announced on January 18, 2000 that it was placing our rating under review. The ratings actions taken by A.M. Best have decreased RCRe's ability to compete in the reinsurance markets in which it operates. See "Business--Recent Developments," "Management's Discussion and Analysis of Financial Condition and Results of Operations--General--Folksamerica Transaction" and Note 14 of the accompanying notes to our consolidated financial statements. Insurance Regulation General The terms and conditions of reinsurance agreements generally are not subject to regulation by any governmental authority with respect to rates or policy terms. This contrasts with primary insurance policies and agreements, the rates and terms of which generally are closely regulated by state insurance regulators. As a practical matter, however, the rates charged by primary insurers do have an effect on the rates that can be charged by reinsurers. State Regulation RCRe, in common with other insurers, is subject to extensive governmental regulation and supervision in the various states and jurisdictions in which it transacts business. The laws and regulations of the State of Nebraska, the domicile of RCRe, have the most significant impact on its operations. This regulation and supervision is designed to protect policyholders rather than investors and relates to, among other things, the standards of solvency which must be met and maintained, the nature of and limitations on investments, restrictions on the size of risk which may be insured under a single policy, and reserves and provisions for unearned premiums, losses and other purposes. Some states are considering legislative proposals which would authorize the establishment of an interstate compact concerning various aspects of insurer insolvency proceedings, including interstate governance of receiverships and guaranty funds. As of March 2000, such legislation had been adopted by three states, including Illinois, Michigan and Nebraska. Insurance departments also conduct periodic examinations of the affairs of insurance companies and require the filing of annual and other reports relating to the financial condition of companies and other matters. The Nebraska Insurance Department completed an examination of RCRe's records, accounts and business affairs for the period October 1995 through December 31, 1997 and issued its final report for the examination on March 15, 1999, which report included no material findings. Prior to this examination, RCRe had not been examined by the Nebraska Insurance Department other than in connection with the receipt of its insurance license in November 1995. Credit for Reinsurance A primary insurer ordinarily will enter into a reinsurance agreement only if it can obtain credit for the reinsurance ceded on its statutory financial statements. In general, credit for reinsurance is allowed in the following circumstances: (1) if the reinsurer is licensed in the state in which the primary insurer is domiciled or, in some instances, in certain states in which the primary insurer is licensed; (2) if the reinsurer is an "accredited" or otherwise approved reinsurer in the state in which the primary insurer is domiciled or, in some instances, in certain states in which the primary insurer is licensed; (3) in some instances, if the reinsurer (a) is domiciled in a state that is deemed to have substantially similar credit for reinsurance standards as the state in which the primary insurer is domiciled and (b) meets certain financial requirements; or (4) if none of the above apply, to the extent that the reinsurance obligations of the reinsurer are collateralized appropriately, typically 14 through the posting of a letter of credit for the benefit of the primary insurer or the deposit of assets into a trust fund established for the benefit of the primary insurer. Therefore, as a result of the requirements relating to the provision of credit for reinsurance, RCRe is indirectly subject to certain regulatory requirements imposed by jurisdictions in which ceding companies are licensed. As of March 27, 2000, RCRe is licensed or is an accredited or otherwise approved reinsurer in 44 states as follows: Alabama, Alaska, Arkansas, Connecticut, Delaware, District of Columbia, Florida, Georgia, Hawaii, Idaho, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maryland, Michigan, Minnesota, Mississippi, Missouri, Montana, Nebraska (state of domicile), Nevada, New Hampshire, New Jersey, New Mexico, New York, North Carolina, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, South Carolina, South Dakota, Tennessee, Texas, Utah, Vermont, Virginia, West Virginia, Wisconsin and Wyoming. RCRe also holds a Certificate of Authority from the United States Treasury Department for surety business. In addition, RCRe is an authorized reinsurer in the Argentine Republic and Colombia, South America. Investment Limitations The Nebraska insurance laws contain rules governing the types and amounts of investments that are permissible for Nebraska-domiciled insurers, including RCRe. These rules are designed to ensure the safety and liquidity of an insurer's investment portfolio. Investments in excess of statutory guidelines do not constitute "admitted assets" (i.e., assets permitted by the Nebraska insurance laws to be included in a domestic insurer's statutory financial statements), unless special approval is obtained from the Nebraska Director of Insurance (the "Nebraska Director"). Non-admitted assets do not count for the purposes of various financial ratios and tests, including those governing solvency and the ability to write premiums. An insurer may hold an investment authorized under more than one provision of the Nebraska insurance laws under the provision of its choice (except as otherwise expressly provided by law). Subject to the "basket" clause described below, the maximum amount of an insurer's authorized investments in preferred stock and common stock of insurance companies for calculation of admitted assets in Nebraska is the lesser of (1) the amount by which admitted assets exceed required capital and liabilities or (2) 50% of policyholders surplus. Based on RCRe's statutory or policyholders surplus of $230.1 million following our recent repurchase of stock from XL Capital described above under "Business--Recent Developments," such amounts for RCRe were $225.1 million and $115.0 million, respectively. Stock of insurance companies is valued for these purposes at cost. Unrealized appreciation of such securities does not count for the purpose of determining the percentage of certain admitted assets attributable to insurance stock investments. While there is a concentration restriction which precludes investment of more than 5% of the insurer's admitted assets in any one issuer, this restriction does not apply to investments in common and preferred stock of other insurers whose senior debt obligations have received a designation of 1 or 2 from the Securities Valuation Office (the "SVO") of the National Association of Insurance Commissioners (the "NAIC"). Designations assigned by the SVO range from class 1 to class 6, with class 1 as the highest quality rating. Generally, SVO designations of 1 and 2 are comparable to investment grade ratings by Moody's and Standard & Poor's, and SVO designations of 3 to 6 are comparable to below investment grade ratings by such rating organizations. Other concentration restrictions preclude investment of more than 3%, 2%, 1% or 1/2% of an insurer's admitted assets in any one person whose senior debt obligations have received a designation of 3, 4, 5 or 6, respectively, from the SVO. In addition, an insurer's investments in debt obligations having a 4, 5 or 6 designation from the SVO may not exceed 4%, 2% or 1%, respectively, of RCRe's admitted assets. Aggregate investments in obligations having any combination of 3, 4, 5 and 6 designations from the SVO may not exceed, in the aggregate, 15% of the insurer's admitted assets. An insurer's investments in equity interests of business entities (e.g., corporations, partnerships, limited liability companies and partnerships, trusts, joint ventures, etc., including insurance companies) that are created or existing under the laws of the United States or Canada (or any state or province thereof) are also authorized under the Nebraska insurance laws, provided that, in the case of an investment in a business entity other than an insurance company, (1) the insurer may not generally invest in more than 10% of the total equity interests of such entity and (2) the investment will be subject to the concentration restrictions described above. In the case 15 of an investment in a business entity that is a corporation, such entity must also meet certain requirements regarding retained earnings and dividend payment history. Authorized foreign investments by an insurer in foreign jurisdictions whose sovereign debt has a designation of 1, 2 or 3 from the SVO may not exceed, in the aggregate, 15% of the insurer's admitted assets. Investments may not be made in foreign jurisdictions whose sovereign debt has a designation of 4, 5 or 6 from the SVO. In addition, authorized foreign investments denominated in foreign currencies may not exceed, in the aggregate, 5% of the insurer's admitted assets. Authorized foreign investments must also have a minimum designation of 1 or 2 from the SVO (or corresponding investment grade rating from any rating organization recognized by the SVO, including Moody's and Standard & Poor's), and must be aggregated with investments of the same kinds and classes made under the Nebraska insurance laws (except for the "basket" clause) for purposes of determining compliance with the limitations contained in other sections. Notwithstanding the foregoing or any other limitations under the Nebraska insurance laws, there is a "basket" clause under which investments "not otherwise authorized" are permitted up to a maximum of the greater of (1) the lesser of (a) 25% of the amount by which admitted assets exceed total liabilities, excluding capital, or (b) 5% of admitted assets (investments authorized under this subsection of the "basket" clause may not include obligations with SVO designations of 3, 4, 5 or 6), or (2) that portion of policyholders surplus which is in excess of 50% of the insurer's annual net written premiums. Derivative instruments otherwise authorized under the Nebraska insurance laws may not be authorized under the "basket" clause. Based on RCRe's statutory surplus of $230.1 million following our recent repurchase of stock from XL Capital described above under "Business--Recent Developments," the "basket" clause would have allowed RCRe to make investments not otherwise authorized under the Nebraska insurance laws up to a maximum amount of $76.6 million. The Nebraska insurance laws provide that the Nebraska Director may waive any of the legal investment limitations upon application by an insurer. The Nebraska Director is required to consider the following factors in determining whether to approve or disapprove any such application: (1) the credit risk quality of the proposed investment; (2) the liquidity of the proposed investment and of the insurer's entire investment portfolio; (3) the extent of the diversification of the insurer's investment portfolio; (4) the yield of the proposed investment; (5) the reasonableness of the insurer's policyholders surplus in relation to the insurer's outstanding liabilities and financial needs; and (6) any other relevant considerations. From time to time, it may be necessary for the Company to seek waivers from the Nebraska Director of the legal investment limitations imposed by the Nebraska insurance laws; no assurances can be given that such waivers can be obtained. States in which RCRe is or may become licensed or authorized may also seek to impose their legal investment laws on RCRe. Such laws vary from state to state and may not permit investments that are permitted under Nebraska law. To the extent that any state disallows an investment that is permitted under Nebraska law, RCRe's statutory surplus reflected in its statutory financial statements filed in such state would be reduced by the amount of such disallowance. Holding Company Acts State insurance holding company statutes provide a regulatory apparatus which is designed to protect the financial condition of domestic insurers operating within a holding company system. All holding company statutes require disclosure and, in some instances, prior approval of significant transactions between the domestic insurer and an affiliate. Such transactions typically include sales, purchases, exchanges, loans and extensions of credit, and investments between an insurance company and its affiliates, involving in the aggregate certain percentages of a company's admitted assets or policyholders surplus, or dividends that exceed certain percentages of the company's surplus or income. The Nebraska insurance laws and the insurance laws of other states generally regard an issuer as an "affiliate" of one of its investors if it is controlled by, or is under common control with, the investor. Generally, "control" means the possession of the power to direct or cause the direction of the management and policies of the issuer, whether through the ownership of voting securities, by contract or otherwise. Control is generally presumed to exist if the investor, directly or indirectly, owns or controls 10% or more of the voting securities of the issuer. The Nebraska insurance laws and the insurance laws of other states generally allow investors to rebut this presumption by filing a "disclaimer" that sets forth the bases for disclaiming affiliation. In certain states, such as Nebraska, a disclaimer is deemed effective once filed unless it is specifically disallowed by the 16 respective insurance department (after the parties in interest have been provided notice and an opportunity to be heard). In other states, a disclaimer must be specifically approved by the relevant insurance department. In cases where RCRe may be presumed to "control," and therefore deemed an affiliate of, an insurer under applicable holding company statutes, RCRe intends to continue to file disclaimers with respect to such insurer unless prevented by the surrounding circumstances. Typically, the holding company statutes also require each of the insurance subsidiaries periodically to file information with state insurance regulatory authorities, including information concerning capital structure, ownership, financial condition and general business operations. Under the terms of applicable state statutes, any person or entity desiring to acquire control of a domestic insurer is required first to obtain approval of the applicable state insurance regulator. Liquidation of Insurers The liquidation of insurance companies, including reinsurers, is generally conducted pursuant to state insurance law. In the event of the liquidation of RCRe, such liquidation would be conducted by the Nebraska Director as the domestic receiver of the properties, assets and business of RCRe. Liquidators located in other states (known as ancillary liquidators) in which RCRe conducts business may have jurisdiction over assets or properties located in such states under certain circumstances. Under Nebraska law, all creditors of RCRe, including but not limited to reinsureds under its reinsurance agreements, would be entitled to payment of their allowed claims in full from the assets of RCRe before we, as a stockholder of RCRe, would be entitled to receive any distribution therefrom. Regulation of Dividends and Other Payments from Insurance Subsidiaries As an insurance holding company, we are largely dependent on dividends and other permitted payments from RCRe to meet our obligations. The ability of RCRe to pay dividends or make other distributions is subject to insurance regulatory limitations of Nebraska, the state in which RCRe is domiciled. The Nebraska insurance laws provide that dividends or other distributions, together with other dividends or distributions paid during the preceding 12 months, may not exceed the greater of (i) 10% of statutory surplus as of the preceding December 31 or (ii) statutory net income from operations for the preceding calendar year not including realized capital gains. Net income (exclusive of realized capital gains) not previously distributed or paid as dividends from the preceding two calendar years may be carried forward for dividend and distribution purposes. Any proposed dividend or distribution in excess of such amount is called an "extraordinary" dividend or distribution and may not be paid until either it has been approved, or a 30-day waiting period has passed during which it has not been disapproved, by the Nebraska Director. Notwithstanding the foregoing, the Nebraska insurance laws provide that any distribution that is a dividend may be paid by RCRe only out of earned surplus arising from its business, which is defined as unassigned funds (surplus) as reported in the statutory financial statement filed by RCRe with the Nebraska Insurance Department for the most recent year, including any surplus arising from unrealized capital gains or revaluations of assets. Any distribution that is a dividend and that is in excess of RCRe's unassigned funds, exclusive of any surplus arising from unrealized capital gains or revaluation of assets, will be deemed an "extraordinary" dividend subject to the foregoing requirements. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources" and Notes 10 and 14 of the accompanying Notes to our consolidated financial statements. The Nebraska insurance laws also require that the statutory surplus of RCRe following any dividend or distribution be reasonable in relation to its outstanding liabilities and adequate to its financial needs. The Nebraska Director is required to apply certain factors in determining the adequacy of an insurer's surplus, including, among other things, the size of the insurer, the extent to which the insurer's business is diversified, the number and size of risks insured by each line of business, the extent of geographical dispersion of insured risks and the reinsurance program, and characteristics of the investment portfolio. In addition, the Nebraska insurance laws require that each insurer give notice to the Nebraska Director of all dividends and other distributions within five business days following declaration thereof and that any such dividend or other distribution may not be paid within 10 business days of the notice unless for good cause shown the Nebraska Director has approved such payment within the such notice period. Insurance Regulatory Information System Ratios The NAIC's Insurance Regulatory Information System ("IRIS") was developed by a committee of state insurance regulators and is intended primarily to assist state insurance departments in executing their statutory 17 mandates to oversee the financial condition of insurance companies operating in their respective states. IRIS identifies 11 industry ratios and specifies "usual values" for each ratio. Departure from the usual values of the ratios can lead to inquiries from individual state insurance commissioners as to certain aspects of an insurer's business. For the year ended December 31, 1999, RCRe's results were within the usual values for eight of the 11 ratios. The "investment yield" ratio was outside the usual value primarily due to our investment strategy of investing a significant portion of our investment portfolio in equity securities, which generally yield less current investment income than fixed maturity investments. The "two year operating ratio" was outside the usual value due to the combined impact of RCRe's "investment yield" ratio (described above) and the 1999 and 1998 statutory combined ratios of 129.2% and 116.4%, respectively, which reflect poor underwriting performance. RCRe's two year statutory combined ratio was adversely affected by underwriting results from RCRe's aviation and space lines of business and casualty and multi-line reinsurance provided by RCRe on insurance business produced by a certain managing underwriting agency. We have discontinued our aviation and space lines of business. We have also discontinued our underwriting relationship with the managing underwriting agency and the business and operations of the managing underwriting agency are in run-off. For a related discussion, please refer to "Management's Discussion and Analysis of Financial Condition and Results of Operations--Results of Operations," --Operating Costs and Expenses," "--Managing Underwriting Agency," "--Space and Aviation Business," "--Space Business" and "--Aviation Business." The "change in surplus" ratio was outside the usual range due to RCRe's operating results and the reduction in RCRe's unrealized appreciation on invested assets. Accreditation The NAIC has instituted its Financial Regulatory Accreditation Standards Program ("FRASP") in response to federal initiatives to regulate the business of insurance. FRASP provides a set of standards designed to establish effective state regulation of the financial condition of insurance companies. Under FRASP, a state must adopt certain laws and regulations, institute required regulatory practices and procedures, and have adequate personnel to enforce such items in order to become an "accredited" state. If a state is not accredited, accredited states are not able to accept certain financial examination reports of insurers prepared solely by the regulatory agency in such unaccredited state. The State of Nebraska is accredited under FRASP; however, there can be no assurance that it or any other state will remain accredited. Risk-Based Capital Requirements In order to enhance the regulation of insurer solvency, the NAIC adopted in December 1993 a formula and model law to implement risk-based capital requirements for property and casualty insurance companies. Effective January 1, 1994, Nebraska adopted risk-based capital legislation for property and casualty companies which is similar to the NAIC risk-based capital requirements. These risk-based capital requirements are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholder obligations. The risk-based capital model for property and casualty insurance companies measures three major areas of risk facing property and casualty insurers: (1) underwriting, which encompasses the risk of adverse loss developments and inadequate pricing; (2) declines in asset values arising from credit risk; and (3) declines in asset values arising from investment risks. Insurers having less statutory surplus than required by the risk-based capital calculation will be subject to varying degrees of regulatory action, depending on the level of capital inadequacy. Equity investments in common stock typically are valued at 85% of their market value under the risk-based capital guidelines. For equity investments in an insurance company affiliate, the risk-based capital requirement for the equity securities of such affiliate would generally be RCRe's proportionate share of the affiliate's risk-based capital requirement. For a discussion of "affiliate" status under the insurance laws, see "Business--Insurance Regulation--Holding Company Acts." RCRe's surplus (as calculated for statutory annual statement purposes) is well above the risk-based capital thresholds that would require either company or regulatory action. Regulation of Certain Reinsurance Intermediaries Certain states, including Nebraska, have adopted legislation or regulation that, in effect, places additional requirements upon insurance and reinsurance intermediaries and brokers when, on behalf of an insured, they place business with an insurance or reinsurance company that is affiliated with such intermediary or broker. While we believe that there is no such affiliation between RCRe and reinsurance intermediaries that may be affiliated with Marsh & McLennan Companies, Inc., no assurances can be given that other persons (including 18 such intermediaries) may not take a contrary position. While we believe that compliance with such regulations would not be burdensome upon an intermediary or broker, no assurances can be given as to whether a broker or intermediary would decide to place or continue to place business with RCRe if such regulations were viewed to be applicable. Federal Regulation Although state regulation is the dominant form of regulation for insurance and reinsurance business, the federal government has shown increasing concern over the adequacy of state regulation. It is not possible to predict the future impact of any potential federal regulations or other possible laws or regulations on RCRe's capital and operations, and such laws or regulations could materially adversely affect its business. Legislative and Regulatory Proposals From time to time various regulatory and legislative changes have been proposed in the insurance and reinsurance industry, some of which could have an effect on reinsurers. Among the proposals that have in the past been or are at present being considered are the possible introduction of federal regulation in addition to, or in lieu of, the current system of state regulation of insurers. In addition, there are a variety of proposals being considered by various state legislatures (some of which proposals have been enacted). We are unable to predict whether any of these laws and regulations will be adopted, the form in which any such laws and regulations would be adopted, or the effect, if any, these developments would have on our operations and financial condition. Senior Management The Company's senior management team consists of: Name Age Position ---- --- -------- Mark D. Mosca 46 President, Chief Executive Officer and Director Robert Clements 67 Chairman and Director Peter A. Appel 38 Executive Vice President, Chief Operating Officer, General Counsel and Secretary Paul J. Malvasio 53 Managing Director, Chief Financial Officer and Treasurer - - ------------- Mark D. Mosca was elected as President and a Director of the company in June 1995 and as Chief Executive Officer of the company in March 1998, and President, Chief Executive Officer and Director of RCRe in August 1995, and has served as acting Chief Underwriting Officer of RCRe since March 1999. Prior to June 1995, he was Senior Vice President and Chief Underwriting Officer of Zurich Reinsurance Centre Holdings, Inc. since the completion of its initial public offering in May 1993. Prior thereto, Mr. Mosca served as a Vice President of NAC Re Corporation ("NAC Re"), where he was manager of the Treaty Division since February 1986. From 1975 to 1986, Mr. Mosca was employed by General Reinsurance Corporation where he was a Vice President. Mr. Mosca holds an A.B. degree from Harvard University. Robert Clements was elected as Chairman and Director of the company at the time of our formation in March 1995 and Chairman and Director of RCRe in September 1995. He is currently an advisor to MMCI with whom he served as Chairman and Chief Executive Officer from January 1994 to March 1996. Prior thereto, he served as President of Marsh & McLennan Companies, Inc. since 1992, having been Vice Chairman during 1991. He was Chairman of J&H Marsh & McLennan, Incorporated (formerly Marsh & McLennan, Incorporated), a subsidiary of Marsh & McLennan Companies, Inc., from 1988 until March 1992. He joined Marsh & McLennan, Ltd., a Canadian subsidiary of Marsh & McLennan Companies, Inc., in 1959. Mr. Clements is a director of Marsh & McLennan Companies, Inc., XL Capital, Annuity and Life Re (Holdings), Ltd., Stockton Reinsurance Limited and Hiscox plc. He is Chairman of the Board of Trustees of The College of Insurance and a member of Rand Corp. President's Council. Peter A. Appel has been Executive Vice President, Chief Operating Officer and a Director of both the company and RCRe since November 1999, and General Counsel and Secretary of the company and RCRe since November 1995. Mr. Appel previously served as a Managing Director of the company and RCRe from November 1995 to November 1999. From September 1987 to November 1995, Mr. Appel practiced law with 19 the New York firm of Willkie Farr & Gallagher, where he was a partner from January 1995. He holds an A.B. degree from Colgate University and a law degree from Harvard University. Paul J. Malvasio has been a Managing Director, Chief Financial Officer and Treasurer of both the company and RCRe since September 1995 and a Director of RCRe since November 1995. Prior to that time, he was Senior Vice President and Chief Financial Officer of NAC Re since January 1986. From 1967 to 1986, Mr. Malvasio was employed by the public accounting firm of Coopers & Lybrand, where he was an audit partner from October 1979. Mr. Malvasio is a certified public accountant and holds a B.B.A. degree in Accounting from St. Francis College. Employees At March 27, 2000, we employed a total of 29 full-time employees. Our employees are not represented by a labor union and we believe that our employee relations are good. 20 GLOSSARY OF SELECTED INSURANCE TERMS Admitted assets.............................Assets permitted by state law to be included as "assets" in an insurance company's annual statement. Annual Statement ........................... A report that an insurance company must file annually with the state insurance commissioner in its domiciliary state and each other state in which it does business. The statement shows the current status of reserves, expenses, assets, total liabilities and investment portfolio. Assume ..................................... To take from an insurer or reinsurer (a ceding company) all or part of a risk underwritten by such person, along with the related premiums, losses and expenses. Attachment point ............................The amount of loss (per occurrence or in the aggregate, as the case may be) above which excess of loss coverage becomes operative. Broker market reinsurer A reinsurer that markets and sells reinsurance through brokers rather than through its own employees. Case reserves ...............................Loss reserves established with respect to individual reported claims. Casualty insurance ..........................Insurance which is primarily concerned with the losses caused by injuries to third persons (in other words, persons other than the policyholder) and the legal liability imposed on the insured resulting therefrom. Catastrophe reinsurance .....................A form of excess of loss reinsurance that, subject to a specified limit, indemnifies the ceding company for the amount of loss in excess of a specified retention with respect to an accumulation of losses resulting from a catastrophic event. The actual reinsurance document is called a "catastrophe cover." Cede; Cedent; Ceding company ................When a party reinsures all or part of its risks with another, it "cedes" business and is referred to as the "cedent" or "ceding company." Common account reinsurance ..................Arrangements whereby the ceding company enters the reinsurance market and purchases a cover for the benefit of the ceding company and the reinsurers on the reinsurance treaty. A pro rata portion of the costs of this protection is deducted from the ceded premium. Credit enhancement ..........................Use of financial guaranty to upgrade the quality of a security through the use of an insurance policy or letter of credit or other means. Direct underwriter; Direct writer ...........An insurer or reinsurer that markets and sells insurance directly to its insureds or reinsureds without the assistance of brokers. Excess of loss reinsurance ..................A generic term describing reinsurance that indemnifies the reinsured against all or a specified portion of losses on underlying insurance policies in excess of a specified amount, which is called a "level" or "retention." Also known as non-proportional reinsurance. Excess of loss reinsurance is written in layers. A reinsurer or group of reinsurers accepts a band of coverage up to a specified amount. The total coverage purchased by the cedent is referred to as a "program" and will typically be placed with predetermined reinsurers in prenegotiated layers. Any liability exceeding the outer limit of the program reverts to the ceding company, which also bears the credit risk of a reinsurer's insolvency. Facultative reinsurance .....................The reinsurance of all or a portion of the insurance provided by a single policy. Each policy reinsured is separately negotiated. 21 Finite risk reinsurance .....................Similar to traditional reinsurance with the exception that there is a finite risk to the reinsurer with respect to minimum and maximum exposure in relation to the premium to be received. Gross premiums written ......................Total premiums for insurance and reinsurance assumed during a given period. Incurred but not reported ("IBNR") ..........Reserves for estimated losses that have been incurred by insureds and reinsureds but not yet reported to the insurer or reinsurer, including unknown future developments on losses which are known to the insurer or reinsurer. In-force premiums ...........................The total of estimated annualized premiums of all policies in force as of a certain date which would be anticipated to generate net premiums written during the annual period being considered. Intermediary/broker .........................One who negotiates contracts of insurance between an insured and a primary insurer on behalf of the insured and/or contracts of reinsurance between a primary insurer or other reinsured and a reinsurer on behalf of the primary insurer or reinsured, in each case receiving a commission for placement and other services rendered. Lloyd's syndicate ...........................Underwriting members of Lloyd's (which can be individual "names" and/or dedicated corporate members) that group together annually to form a syndicate to underwrite insurance coverage. Each syndicate is managed by a Lloyd's-approved managing agent, which appoints one or more active or named underwriters who have the authority to bind the syndicate to contracts of insurance, pay claims and effect recoveries. Net premiums written ........................Gross premiums written for a given period less premiums ceded to retrocessionaires during such period. Primary insurer .............................An insurance company that contracts with the insured to provide insurance coverage. Such insurer may then cede a portion of its business to reinsurers. Probable maximum loss .......................Under RCRe's current guidelines, probable maximum loss is the anticipated maximum exposure to an event of a magnitude such that it would be expected to occur once in 100 years. Quota share or proportional reinsurance .................................A generic term describing all forms of reinsurance in which the reinsurer shares a proportional part of the original premiums and losses of the reinsured. (Also known as pro rata reinsurance or participating reinsurance.) In proportional reinsurance, the reinsurer generally pays the ceding company a ceding commission. The ceding commission generally is based on the ceding company's cost of acquiring the business being reinsured (including commissions, premium taxes, assessments and miscellaneous administrative expenses) and also may include a profit factor. Generally, the reinsurer gets the benefit of common account reinsurance. RAA .........................................Reinsurance Association of America, a trade association of medium and large property and casualty reinsurers doing business in the United States. The RAA provides statistical data concerning the markets, which voluntarily provide such information to the RAA. Reinsurance .................................An arrangement in which an insurance company, the reinsurer, agrees to indemnify another insurance or reinsurance company, the ceding company, against all or a portion of the insurance or reinsurance risks 22 underwritten by the ceding company under one or more policies. Reinsurance can provide a ceding company with several benefits, including a reduction in net liability on individual risks and catastrophe protection from large or multiple losses. Reinsurance also provides a ceding company with additional underwriting capacity by permitting it to accept larger risks and write more business than would be possible without a concomitant increase in capital and surplus, and facilitates the maintenance of acceptable financial ratios by the ceding company. Reinsurance does not legally discharge the ceding company from its liability with respect to its obligations to the insured. Reserves ....................................Liabilities established by insurers and reinsurers to reflect the estimated costs of claims payments and the related expenses that the insurer or reinsurer will ultimately be required to pay in respect of insurance or reinsurance it has written. Reserves are established for losses and for unpaid claims and claims expenses and for unearned premiums. Loss reserves consist of case reserves and IBNR reserves. For reinsurers, unpaid claims and claims expense reserves are generally not significant because substantially all of the unpaid claims and claims expenses associated with particular claims are incurred by the primary insurer and reported to reinsurers as losses. Unearned premium reserves constitute the portion of premiums paid in advance for insurance or reinsurance that has not yet been provided. Retention ...................................The amount or portion of risk that an insurer retains for its own account. Losses in excess of the retention level are paid by the reinsurer. In proportional treaties, the retention may be a percentage of the original policy's limit. In excess of loss business, the retention is a dollar amount of loss, a loss ratio or a percentage. Retrocession ................................A transaction whereby a reinsurer cedes to another reinsurer (the "retrocessionaire") all or part of the reinsurance that the first reinsurer has assumed. Retrocessions do not legally discharge the ceding reinsurer from its liability with respect to its obligations to the reinsured. Reinsurance companies cede risks to retrocessionaires for reasons similar to those that cause primary insurers to purchase reinsurance: to reduce net liability on individual risks, to protect against catastrophic losses, to stabilize financial ratios and to obtain additional underwriting capacity. Statutory accounting principles ("SAP") ..................................The rules and procedures prescribed or permitted by United States state insurance regulatory authorities including the NAIC, which govern the preparation of financial statements. Such rules and procedures generally reflect a liquidating, rather than going concern, concept of accounting. Statutory composite ratio ...................Provides an overall indication of underwriting profitability. The ratio is the sum of: the ratio of commissions and other underwriting expenses to premiums written, and the ratio of claims and claims expenses to premiums earned. A statutory composite ratio under 100% indicates underwriting profitability, while a composite ratio exceeding 100% indicates an underwriting loss. Statutory surplus ...........................The excess of admitted assets over total liabilities (including loss reserves), determined in accordance with SAP. 23 Tail.........................................The period of time that elapses between the writing of the applicable insurance policy or the loss event (or the insurer's knowledge of the loss event) and the payment in respect thereof. Treaties ....................................The reinsurance of a specified type or category of risks defined in a reinsurance agreement (a "treaty") between an insurer and a reinsurer or between a reinsurer and a retrocessionaire. In treaty reinsurance, the cedent is typically obligated to offer, and the reinsurer or retrocessionaire is obligated to accept, a specified portion of a type or category of risks insured by the ceding company as set forth in the governing contract. Treaty reinsurance may provide for proportional or non-proportional reinsurance. Underwriting ................................The insurer's or reinsurer's process of reviewing applications submitted for insurance coverage, deciding whether to accept all or part of the coverage requested and determining the applicable premiums. Underwriting capacity .......................The maximum amount that an insurance company can underwrite. The limit is generally determined by the company's policyholders or statutory surplus, which depends, among other things, on the insurer's admitted assets. Reinsurance serves to increase a company's capacity by reducing its exposure from particular risks. 24 ITEM 2. PROPERTIES In March 1996, we entered into a sublease agreement expiring in October 2002 for approximately 40,000 square feet of office space in Greenwich, Connecticut, where our offices are located. Future minimum rental charges for the remaining term of the sublease, exclusive of escalation clauses and maintenance costs and net of rental income, will be approximately $1,994,000. Our rental expense, net of sublease income, during 1999, 1998 and 1997 was approximately $576,000, 576,000 and $643,000, respectively. Commencing in 1996, we subleased approximately 13,000 square feet of the office space to MMCI for a term expiring in October 2002. Future minimum rental income under the remaining term of the sublease, exclusive of escalation clauses and maintenance costs, will be approximately $1,218,000. Rental income for 1999, 1998 and 1997 was $430,000 for each year. MMCI also reimbursed the company approximately $60,000 $100,000 and $574,000 in 1999, 1998 and 1997, respectively, for MMCI's pro rata share of improvement and maintenance costs under the sublease. In addition, commencing in 1997, we subleased approximately 6,000 square feet of the office space to another tenant for a term expiring in October 2002. Rental income for 1999, 1998 and 1997 was $225,000, $225,000 and $117,000, of which $89,000, $89,000 and $44,000, respectively, was paid to MMCI as its pro rata share of such income. Effective March 31, 2000, the sublease with this tenant will be terminated, and MMCI will assume the 6,000 square feet of space and will be responsible for the costs associated with the space. ITEM 3. LEGAL PROCEEDINGS The company is subject to litigation and arbitration in the ordinary course of its business. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. There were no matters submitted to a vote of security holders during the fourth quarter of 1999. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Market Information Shares of our common stock are traded on the Nasdaq National Market under the symbol "RCHI." For the periods presented below, the high and low sales prices and closing prices for our common stock as reported on the Nasdaq National Market were as follows:
Three Months Ended ----------------------------------------------------------------------------- December 31, September 30, June 30, March 31, 1999 1999 1999 1999 ---- ----- ---- ---- High................................ $15.69 $16.00 $17.38 $22.63 Low................................. 11.00 13.00 13.50 12.00 Close............................... 12.63 15.63 13.50 15.13 Three Months Ended ----------------------------------------------------------------------------- December 31, September 30, June 30, March 31, 1998 1998 1998 1998 ---- ---- ---- ---- High................................ $23.75 $25.50 $25.50 $24.00 Low................................. 18.81 19.00 22.75 19.75 Close............................... 21.75 22.00 24.94 24.00
25 On March 27, 2000, the high and low sales prices and the closing price for our common stock as reported on the Nasdaq National Market were $16.13, $15.19 and $15.50, respectively. Holders As of March 27, 2000, there were approximately 47 holders of record of our common stock and approximately 1,600 beneficial holders of our common stock. Dividends We have not declared any dividends since our formation in 1995. Any determination to pay dividends in the future will be at the discretion of our board of directors and will be dependent upon our results of operations, financial condition, capital requirements, contractual restrictions and other factors deemed relevant by our board of directors. Our board currently does not intend to declare dividends or make any other distributions. The payment of any dividends will be dependent upon the ability of RCRe to provide funds to us. For a description of the restrictions on the ability of RCRe to pay dividends or make distributions to us, please refer to "Business(Insurance Regulation--Regulation of Dividends and Other Payments from Insurance Subsidiaries," "Management's Discussion and Analysis of Financial Condition and Results of Operations(Liquidity and Capital Resources" and Note 10 of the accompanying notes to our consolidated financial statements. Our board intends to make a determination regarding repurchases of our shares after the consummation of the sale of our reinsurance operations to Folksamerica Reinsurance Company, but no decision has yet been made as to whether any such repurchases will be made or the amount, timing or method of any such repurchases, which will depend on future circumstances. 26 ITEM 6. SELECTED FINANCIAL DATA Our and RCRe's selected consolidated historical financial data for the years ended December 31, 1999, 1998, 1997, 1996 and for the period from June 23, 1995 (date of inception) to December 31, 1995 should be read in conjunction with our audited consolidated financial statements and the related notes and unaudited pro forma condensed consolidated financial data contained elsewhere in this report.
Period from June 23, 1995 Years Ended December 31, to --------------------------------------------------------------- December 31, -------------- 1999 1998 1997 1996 1995 ---- ---- ---- ---- ---- (Dollars in thousands, except share data) Statement of Operations Data Net premiums earned............... $311,368 $206,194 $107,372 $35,761 Net investment income............. 20,173 15,687 14,360 13,151 $4,578 Net realized investment gains (losses)....................... 17,227 25,252 (760) 1,259 397 Total revenues.................... 348,768 247,133 120,972 50,171 4,975 Net income (loss)................. (32,436) 3,091 2,039 4,112 1,019 Comprehensive income (loss)....... ($52,286) ($4,375) $47,107 $9,817 $4,750 Average shares outstanding Basic.......................... 17,086,732 17,065,165 17,032,601 16,981,724 16,747,084 Diluted........................ 17,086,808 17,718,223 17,085,788 16,983,909 16,990,425 Per Share Data Net income (loss) Basic........................ ($1.90) $0.18 $0.12 $0.24 $0.06 Diluted...................... ($1.90) $0.17 $0.12 $0.24 $0.06 Comprehensive Income (loss) Basic....................... ($3.06) ($0.26) $2.77 $0.58 $0.28 Diluted..................... ($3.06) ($0.26) $2.76 $0.58 $0.28 Cash dividends per share.......... N/A N/A N/A N/A N/A
December 31, -------------------------------------------------------------------------------- 1999 1998 1997 1996 1995 -------------------------------------------------------------------------------- (Dollars in thousands, except share data) Balance Sheet Data Cash and invested assets.......... $585,909 $587,155 $505,728 $392,940 $347,327 Total assets...................... 864,359 757,830 581,247 432,486 350,986 Stockholders' equity.............. 346,514 398,002 401,031 352,213 340,215 Sharses outstanding Basic.......................... 17,087,970 17,087,438 17,058,462 17,031,246 16,941,125 Diluted........................ 17,087,970 17,497,904 17,601,608 17,065,406 16,941,125 Book value per share Basic.......................... $20.28 $23.29 $23.51 $20.68 $20.08 Diluted........................ $20.28 $22.75 $22.79 $20.64 $20.08
27 UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL DATA The following unaudited pro forma balance sheet as of December 31, 1999 reflects our historical accounts as of that date, adjusted to give pro forma effect to the sale of our reinsurance business to Folksamerica, which is subject to stockholder approval, and our repurchase of 4,755,000 shares, or 27.8%, of our outstanding common stock from XL Capital, which repurchase was completed on March 2, 2000, as if those transactions had occurred on December 31, 1999. The following unaudited pro forma statement of income and comprehensive income for the year ended December 31, 1999 reflects our historical accounts for that period, adjusted to give pro forma effect to the asset sale and the XL Capital stock repurchase as if those transactions had occurred on January 1, 1999. The pro forma financial data and accompanying notes should be read in conjunction with the description of the asset sale and XL Capital stock repurchase contained in this report and our audited consolidated financial statements and related notes also included in this report as well as the description included in our special meeting proxy statement. We believe that the assumptions used in the following statements, which are set forth in the accompanying notes, provide a reasonable basis on which to present the pro forma financial data. The pro forma financial data is provided for informational purposes only and should not be construed to be indicative of our financial condition or results of operations had the asset sale and XL Capital stock repurchase been consummated on the dates assumed and are not intended to project our financial condition on any future date or results of operations for any future period. 28 Risk Capital Holdings, Inc. and Subsidiaries Pro Forma Condensed Consolidated Balance Sheet December 31, 1999 (Dollars in thousands, except per share data)
Pro Forma Adjustments --------------------- XL Folksamerica Historical Transaction(1) Transaction(4) Pro Forma ---------- -------------- -------------- --------- Assets Investments: Fixed maturities and short-term investments $333,852 ($245,545)(5) $88,307 (10) Publicly traded equity securities 158,631 ($38,169)(2) 120,462 Privately held securities 83,969 (24,040)(2) 59,929 --------- ----------------- --------------- ------- Total investments 576,452 (62,209) (245,545) 268,698 Cash 9,457 3,647 (2) 1,335 (8) 14,439 Accrued investment income 4,527 4,527 Premiums receivable 119,320 (119,320)(5) Reinsurance recoverable 73,122 (73,122)(5) Deferred policy acquisition costs 23,585 (23,585)(6) Deferred income tax asset 7,834 127 (2) (5,352)(7) 2,609 Other assets 50,062 (36,975)(5) 13,087 --------- ----------------- -------------- -------- Total Assets 864,359 ($58,435) ($502,564) $303,360 ========= ================= ============== ======== Liabilities Claims and claims expenses $364,554 ($364,554)(5) Unearned premiums 108,743 (108,743)(5) Reinsurance balances payable 14,666 (14,666)(5) Other liabilities 29,882 $1,000 (2) (24,541)(5) $6,341 --------- ------ -- ------------- ------ Total Liabilities 517,845 1,000 (512,504) 6,341 ======== ========= ============= ====== Stockholders' Equity Common stock, $.01 par value: 171 171 Additional paid-in capital 342,034 342,034 Deferred compensation under stock award plan (317) (317) Retained earnings (deficit) (22,175) 10,959 (3) 6,080 (9) (5,136) Less treasury stock, at cost (387) (59,200)(1) (59,587) Accumulated other comprehensive income consisting of unrealized appreciation of investments, net of income tax 27,188 (11,194)(3) 3,860 (9) 19,854 --------- ------- --- -------- ------ Total Stockholders' Equity 346,514 (59,435)(2) 9,940 (9) 297,019 --------- ------- --- --------- ------ Total Liabilities and Stockholders' Equity $864,359 ($58,435) ($502,564) $303,360 ========= ======== ========= ======== Shares outstanding - basic 17,087,970 (4,755,000)(1) -- 12,332,970 ========= ========== == ========== Basic book value per share $20.28 $24.08 ====== ======
30 Notes to Pro Forma Balance Sheet 1. Reflects our repurchase from XL Capital of all of the 4,755,000 shares of our common stock held by it for $59,200,000, or $12.45 per share, which represents 85% of our average closing market price of our common stock for the twenty day trading period between January 21, 2000 and February 17, 2000 in exchange for the following: (i) our interest in LARC Holdings, Ltd., valued at $25 million, and (ii) our interest in Annuity and Life Re (Holdings), Ltd. valued at $37,847,000, consisting of 1,418,440 common shares at $25.38 per share, which represents the average closing market price of Annuity and Life Re (Holdings), Ltd. common shares for the twenty day trading period between January 21, 2000 and February 17, 2000, and 100,000 warrants at $18.50 per warrant based on a Black-Scholes option valuation model, and We received cash from XL Capital of $3,647,000, which is the excess of the value of the securities described in (i) and (ii) above over the purchase price of our common stock repurchased from XL Capital. 2. The decrease in book value resulting from the XL Capital stock repurchase is calculated as follows (in thousands): Repurchase of 4,755,000 shares of our outstanding common stock at $12.45 per share, recorded as a reduction to stockholders' equity as treasury stock, plus $59,200 Net loss on the disposition of securities and transaction costs as follows:
(In thousands) ---------------------------------------------------------- Annuity and Life Re LARC (Holdings) Ltd. Holdings, Ltd Total ------------- ----------------- ----- Consideration received, consisting of cash of $3,647,000 and our common stock valued at $59,200,000 $25,000 $37,847 $62,847 Carrying values at December 31, 1999 24,040 38,169 62,209 Pre-tax gain (loss) before transaction costs $960 ($322) 638 ======= ====== ======== Transaction costs 1,000 -------- Pre-tax loss (362) Tax benefit (127) Net loss (235) -------- Net decrease in book value $59,435 ==========
30 3. The gain recorded in retained earnings of $10,959,000 represents the realized gain that will be recorded for the $11,194,000 of net unrealized appreciation, net of tax, recorded at December 31, 1999 for LARC Holdings, Ltd. and Annuity and Life Re (Holdings), Ltd. and the net loss of $235,000, which is discussed in note 2 above. 4. Reflects the asset sale, pursuant to which Folksamerica Reinsurance Company will assume RCRe's liabilities under the reinsurance agreements transferred to it and RCRe will transfer to Folksamerica Reinsurance Company assets in an aggregate amount that is, in GAAP book value (as set forth on our estimated closing date balance sheet), equal to the GAAP book value (as set forth on our estimated closing date balance sheet) of the liabilities assumed. In consideration for the transfer of RCRe's book of business, Folksamerica will pay $20.335 million in cash at the closing, subject to adjustment under the circumstances described in our special meeting proxy statement under the heading "The Asset Purchase Agreement--Purchase Price." 5. Represents securities and insurance assets and insurance liabilities to be transferred to Folksamerica based on December 31, 1999 financial statement amounts. At the closing of the asset sale, RCRe and Folksamerica Reinsurance Company will enter into a transfer and assumption agreement, under which Folksamerica Reinsurance Company will assume RCRe's rights and obligations under the reinsurance agreements being transferred in the asset sale. Following the closing of the asset sale, Folksamerica Reinsurance Company will notify the reinsureds under those of such agreements that are in-force that it has assumed RCRe's obligations and that, unless the reinsureds object to such assumption, RCRe will be released from its obligations to those reinsureds. The pro forma accounting for this transaction assumes that none of RCRe's reinsureds will object to such assumption and, accordingly, the gross liabilities for its reinsurance business will be removed from the accounts of RCRe for statutory accounting and GAAP accounting purposes. RCRe will continue to record gross liabilities in its accounts for reinsureds that object to the release of RCRe from its obligations to such reinsureds. In such instances, an offsetting accounts receivable amount from Folksamerica Reinsurance Company would be recorded as an asset equal to such gross liabilities. 6. Elimination of deferred policy acquisition costs related to the liability for unearned premiums transferred to Folksamerica. 7. Net reduction in deferred income tax asset as follows (in thousands): Reduction in net deferred tax asset for elimination of temporary differences between financial statements and income tax return amounts resulting from the Folksamerica transaction $13,957 Less, estimated tax benefit resulting from the transaction 8,605 Net reduction in deferred tax asset $ 5,352 ======== 31 8. Represents cash payment received from Folksamerica at the closing of the asset sale of $20.335 million less estimated related transaction costs of $19 million, which include investment banking, legal and accounting fees, severance costs, tax reimbursement to Folksamerica and costs to purchase additional reinsurance protection for Folksamerica. 9. The book value gain resulting from the Folksamerica transaction is calculated as follows (in thousands):
Consideration received, consisting of the following: Total liabilities transferred $512,504 Cash premium received 20,335 -------- 532,839 -------- Assets transferred 474,962 Amortization of deferred policy acquisition costs 23,585 Transaction costs 19,000 ------- 517,547 ------- Pre-tax gain 15,292 Tax expense 5,352 ------ Net transaction gain 9,940 Realized loss, net of tax for securities transferred at market value (3,860) ------ Net income 6,080 Change in net unrealized appreciation of investments, net of tax 3,860 ----- Comprehensive income and net book gain $9,940 ======
The pro forma accounting for this transaction assumes that none of RCRe's reinsureds will object to the release of RCRe under the transfer and assumption agreement and, accordingly, the gross liabilities for such business are removed from the accounts of RCRe for statutory and GAAP accounting purposes (see note 5 above). RCRe will continue to record gross liabilities in its accounts for reinsureds that object to the release of RCRe from its obligations to such reinsureds. This would result in a portion of the pre-tax gain on the transaction being deferred and amortized into income as the gross liabilities are extinguished. 10. Includes $20 million of fixed income securities deposited in an escrow account for a five year period primarily to reimburse Folksamerica for claims and claim expenses exceeding reserves recorded by RCRe as of the closing date resulting from business produced on behalf of RCRe by a certain managing underwriting agency. At December 31, 1999, such reserves approximated $38.3 million, which were recorded based on RCRe's actuarially determined best estimate for such business. We could record a loss to the extent that such reserves turn out to be deficient, due to our reimbursement of Folksamerica for such deficiency to the extent of the escrowed funds. Amounts in escrow may also be released to Folksamerica to satisfy its indemnification claims against us relating to undisclosed liabilities, RCRe's reinsurance agreements and the managing underwriting agency referred to above. Under the asset purchase agreement, we may be required to deposit an additional amount of up to $5 million into a supplemental escrow account a short time following the closing of the asset sale. The above unaudited pro forma condensed consolidated balance sheet has been prepared assuming that such supplemental escrow account will not be required. 32 Risk Capital Holdings, Inc. and Subsidiaries Pro Forma Condensed Consolidated Statement of Income and Comprehensive Income For the Year Ended December 31, 1999 (Dollars in thousands, except per share data)
Pro Forma Adjustments --------------------- XL Folksamerica Historical Transaction(1) Transaction(2) Pro Forma ---------- -------------- -------------- --------- Revenues Net premiums written $306,726 ($306,726) -- (Increase) decrease in unearned premiums 4,642 (4,642) -- ------- --------- -------- Net premiums earned 311,368 (311,368) -- Net investment income 20,173 $145 (10,253) $10,065 Net realized investment gains and losses 17,227 1,350 1,192 19,769 Total revenues 348,768 1,495 (320,429) 29,834 ------- ----- -------- ------ Operating Costs and Expenses Claims and claims expenses 305,841 (305,841) Commissions and brokerage 80,540 (80,540) Other operating expenses 14,816 (10,666) 4,150 (198) 198 ------- ------- --- Total operating costs and expenses 400,999 -- (396,849) 4,150 Income (Loss) Income before income taxes, equity in net income of investees and cumulative effect of accounting change (52,231) 1,495 76,420 25,684 Federal income taxes expense (benefit) (19,557) 571 27,171 8,185 ------- ----- ------ ----- Income before equity in net income of investees and cumulative effect of accounting change (32,674) 924 49,249 17,499 Equity in net income of investees 621 114 735 ------ --- ----- ------ Income (loss) before cumulative effect of accounting change (32,053) 1,038 9,249 18,234 ------- ----- ----- ------ Cumulative effect of accounting change (383) 99 (284) ------- ----- ----- ------ Net income (loss) (32,436) 1,137 49,249 17,950 Other Comprehensive Income (Loss), Net of Tax Change in net unrealized appreciation of investments, net of tax (19,850) (1,914) 4,553 (17,211) Comprehensive Income (Loss) ($52,286) ($777) $53,802 $739 ======== ===== ======= ==== Average shares outstanding Basic 17,086,732 (4,755,000) -- 12,331,732 Diluted 17,086,808 (4,755,000) -- 12,331,808 Per Share Data Net Income (Loss) - Basic $1.46 ($1.90 - Diluted $1.46 ($1.90) Comprehensive Income (Loss) - Basic $0.06 ($3.06) - - - Diluted $0.06 ($3.06)
33 Notes to Pro Forma Statement of Income and Comprehensive Income 1. Represents all revenue and expense and other comprehensive income items recorded during 1999 for LARC Holdings, Ltd. and Annuity and Life Re (Holdings), Ltd., which were disposed of in the XL Capital stock repurchase. 2. Represents all revenue and expense and other comprehensive income items recorded during 1999 related to the sale of our reinsurance business to Folksamerica Reinsurance Company. Net investment income, net realized investment gains (losses) and unrealized appreciation (depreciation) of investments have been allocated based on the proportion of the average amount of fixed maturities and short term investments related to the business that will be transferred to the average total fixed maturities and short term investments in 1999. All other revenue and expense items were allocated based on specific identification. 34 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. General The Company We are the holding company for RCRe, our wholly owned subsidiary which is domiciled in Nebraska. We were incorporated in March 1995 and commenced operations in September 1995 upon completion of our initial public offering. We received aggregate net proceeds from the offering of approximately $335 million, of which $328 million was contributed to the capital of RCRe. On November 6, 1995, RCRe was licensed under the insurance laws of the State of Nebraska and is currently licensed or accredited as a reinsurer in 44 states. As of December 31, 1999, the statutory surplus of RCRe was approximately $290 million. In July 1998, RCRe capitalized its wholly owned subsidiary, Cross River, with $20 million. Cross River received its Nebraska insurance license in October 1998, and is currently authorized to write insurance on an excess and surplus lines basis in 22 additional states. Folksamerica Transaction As of January 10, 2000, we entered into an agreement with Folksamerica Reinsurance Company and Folksamerica Holding Company (collectively, "Folksamerica") pursuant to which Folksamerica Reinsurance Company will assume RCRe's liabilities under the reinsurance agreements transferred in the asset sale and RCRe will transfer to Folksamerica Reinsurance Company assets in an aggregate amount that is, in book value, equal to the book value of the liabilities assumed. In consideration for the transfer of RCRe's book of business, Folksamerica will pay $20.335 million in cash at the closing, subject to adjustment under the circumstances set forth in the asset purchase agreement. Under the terms of the agreement, we will place $20 million in escrow for a period of five years. These funds will be primarily used to reimburse Folksamerica to the extent that the loss reserves (which were $38.7 million at December 31, 1999) relating to business produced on behalf of RCRe by a certain managing underwriting agency are deficient as measured at the end of such five year period. To the extent that such loss reserves are redundant, all of the escrowed funds will be returned to us and Folksamerica will pay us an amount equal to such redundancy. We will be responsible for certain tax costs incurred by Folksamerica in the transaction, as well as our own transaction and severance costs, and certain reinsurance costs incurred for the benefit of Folksamerica. An additional amount of up to $5 million may be placed in escrow for a period of five years to the extent that RCRe's reserves at closing are less by at least a specified amount than those estimated by its independent actuaries. In connection with either escrow arrangement, we will record a loss in an amount equal to any probable deficiency in the related reserve that may become known during or at the end of the five year period. The sale of our reinsurance business to Folksamerica is contingent on approval by our stockholders, obtaining applicable regulatory approvals, the retention of a key employee, obtaining certain third party consents, the absence of a material adverse change in RCRe's business, and other customary closing conditions. Marsh & McLennan Risk Capital Holdings, Ltd. and The Trident Partnership, L.P., which collectively represent approximately 13.3% of the total voting power of our outstanding common stock (after giving effect to the repurchase of 4,755,000 shares on March 2, 2000 from XL Capital, which is discussed below), have agreed to vote in favor of the asset sale. Please see the sections of our special meeting proxy statement entitled "Questions and Answers About the Asset Sale," "Risk Factors," "The Asset Sale," "The Asset Purchase Agreement" and "Other Transaction Agreements," which are incorporated by reference. In addition, we have filed the asset sale agreement, the voting agreements and other related agreements as exhibits to this annual report. The above summary of the proposed transaction is qualified by these agreements, which are incorporated by reference. Please also refer to "Unaudited Pro Forma Condensed Consolidated Financial Data." 35 The GAAP book value of the assets and liabilities to be transferred to Folksamerica recorded in the accompanying financial statements at December 31, 1999 are as follows: (In Millions) Fixed maturities and short-term investments $245.6 Premiums receivable 119.3 Reinsurance recoverable 73.1 Deferred policy acquisition costs 23.6 Deferred income tax asset 13.9 Other insurance assets 37.0 ------ Total Assets $512.5 ------ Reserve for claims and claims expenses $364.6 Net unearned premium reserve 108.7 Reinsurance premiums payable 14.7 Other insurance liabilities 24.5 ------ Total Liabilities $512.5 ------ Net book value of assets and liabilities to be transferred -- ======= The actual GAAP book value of the assets and liabilities transferred to Folksamerica will be determined as of the closing date of the asset sale, and will differ from that set forth above. At the closing of the asset sale, RCRe and Folksamerica will enter into a transfer and assumption agreement, under which Folksamerica will assume RCRe's rights and obligations under the reinsurance agreements being transferred in the asset sale. Following regulatory approval of these agreements, the reinsureds under such agreements that are in-force will be notified that Folksamerica has assumed RCRe's obligations and that, unless the reinsureds object to the assumption, RCRe will be released from its obligations to those reinsureds. Assuming that none of the reinsureds object to the assumption, the gross liabilities for such business will be removed from the accounts of RCRe for statutory accounting and GAAP accounting purposes. RCRe will continue to record gross liabilities in its accounts for reinsureds that object to the release of RCRe from its obligations to such reinsureds. In such instances, an offsetting accounts receivable amount from Folksamerica would be recorded as an asset equal to such gross liabilities. This would also result in a portion of any pre-tax gain on the asset sale being deferred and amortized into income as gross liabilities are extinguished. XL Transaction On March 2, 2000, we repurchased from XL Capital, then our single largest stockholder, all of the 4,755,000 shares of our common stock held by it. Under the terms of a stock repurchase agreement with XL Capital, we paid $12.45 per share of our common stock, or a total of $59.2 million. The per share repurchase price was determined as the lesser of (1) 85% of the average closing market price of our common stock during the 20 trading days beginning on the third business day following public announcement of the stock repurchase and asset sale (January 21, 2000), which was $14.65, and (2) $15. We paid XL Capital the consideration for the repurchase with: our interest in privately held LARC Holdings, Ltd. (parent of Latin American Reinsurance Company Ltd.), valued at $25 million (which was carried by us at $24 million at December 31, 1999); and all of our interest in Annuity and Life Re (Holdings), Ltd., valued at $25.38 per share and $18.50 per warrant, or $37.8 million in the aggregate (which was carried by us at $38.2 million at December 31, 1999). XL Capital paid us in cash the difference (equal to $3.6 million) between our repurchase price and the value of our interests in LARC Holdings and Annuity and Life Re. The value per share of Annuity and Life Re was determined by taking the average of the closing price of Annuity and Life Re shares for the same period used in determining the repurchase price of our shares. The value of the warrants was determined using a Black Scholes methodology. We have filed the stock repurchase agreement and related voting and disposition agreement as exhibits to this annual report. The above summary of the transaction is qualified by these agreements, which are incorporated by reference. As a result of this transaction, stockholders' equity, which was $346.5 million at December 31, 1999, has been reduced by $59.4 million and the number of outstanding voting shares, which was 17,087,970 at December 31, 1999, was 12,332,970 at March 2, 2000. RCRe's statutory surplus, which was $290 million at December 31, 1999, was also reduced by $60 million for the distribution of the stock and warrants in both LARC Holdings, Ltd. and Annuity and Life Re Holdings, Ltd., to us, based on their statutory carrying values at December 31, 1999. RCRe Distribution Upon payment of a contemplated distribution from RCRe to us that would occur after the completion of the asset sale, our assets would consist of fixed maturity and short term investments, publicly traded equity securities and privately held securities, and our remaining $19 million investment commitment to Trident II, L.P. would remain in place. We would also continue to own all of the outstanding capital stock of RCRe and Cross River, each with statutory surplus of approximately $20 million (or any greater amount the Nebraska Insurance Department requires RCRe to retain in the event there are any objections from reinsureds to the release of RCRe from further liability pursuant to the transfer and assumption agreement). See "--Liquidity and Capital Resources" below for a discussion of the regulatory issues relating to distributions by RCRe. Future Operations Following the sale of our reinsurance business to Folksamerica, our intended strategy is to pursue business combinations and ventures with operating businesses. Our success will depend almost entirely on the operations, financial condition and management of the companies with which we may merge or which we may acquire in whole or in part. We have not yet identified specific business opportunities. Accordingly, the financial and operational risks that we may encounter in the future cannot be specified. See the section of our special meeting proxy statement entitled "Risk Factors--Risks Relating to Our Business After the Asset Sale," which is incorporated by reference. Recent Industry Performance Demand for reinsurance is influenced significantly by underwriting results of primary property and casualty insurers and prevailing general economic and market conditions, all of which affect liability retention decisions of primary insurers and reinsurance premium rates. The supply of reinsurance is directly related to prevailing prices and levels of surplus capacity, which, in turn, may fluctuate in response to changes in rates of return on investments being realized in the reinsurance industry. The last three years have been difficult periods from both a market and earnings perspective for most insurance markets. The property and casualty insurance and reinsurance segments have experienced an increasingly more difficult and highly competitive operating environment characterized by a soft rate structure and overcapitalization. Other factors that have contributed to the prevailing competitive conditions in the reinsurance industry in recent years include new entrants to the reinsurance market (including certain specialized reinsurance operations) and the presence of certain reinsurance companies which operate within tax-advantaged jurisdictions (e.g., Bermuda, Cayman Islands) that benefit from higher after-tax investment returns. In addition, concerns with respect to the financial security of Lloyd's that had adversely impacted the competitive position of that marketplace have apparently been overcome by actions taken at Lloyd's over the last few years, thereby enhancing its competitive position. The industry's profitability can also be affected significantly by volatile and unpredictable developments, including changes in the propensity of courts to grant larger awards, natural disasters (such as catastrophic hurricanes, windstorms, earthquakes, floods and fires), fluctuations in interest rates and other changes in the investment environment that affect market prices of investments and the income and returns on investments, and inflationary pressures that may tend to affect the size of losses experienced by ceding primary insurers. The reinsurance industry is highly competitive and dynamic, and market changes may affect, among other things, demand for our products, changes in investment opportunities (and the performance thereof), changes in the products offered by us or changes in our business strategy. Reinsurance treaties that are placed by intermediaries are typically for one year terms with a substantial number that are written or renewed on January 1 each year. Other significant renewal dates include April 1, July 1 and October 1. The January 1, 2000 renewal period was marked by continuing intensified competitive conditions in terms of premium rates and treaty terms and conditions in both the property and casualty segments of the marketplace. These conditions have been worsened due to large domestic primary companies retaining more of their business and ceding less premiums to reinsurers. Commencing in late 1997, in addition to our core business, we expanded into specialty classes of reinsurance business, including marine and aviation and space in 1997, surety and fidelity in 1998, and accident and health in 1999. In 1999, we discontinued our aviation and space lines of business. In-Force Business At January 1, 2000, RCRe had approximately 330 renewable in-force reinsurance treaties (such renewal is subject to negotiation and evaluation during the renewal period), with approximately $249.1 million of estimated annualized net premiums written, compared to $287.5 million at January 1, 1999 and $172.5 million at January 1, 1998, representing a decline of 13% and an increase of 67% over the prior year, respectively. Such in-force premiums at January 1, 2000 represent estimated annualized premiums from treaties entered into during 1999 and the January 1, 2000 renewal period that are expected to generate net premiums written during 2000. Such treaties at January 1, 2000 are estimated to generate approximately $210.6 million of net premiums written over the 12-month period ending December 31, 2000 without taking into account certain factors, including the possibilities that (i) several treaties entered into in 1999 that are scheduled to expire during the remainder of 2000 may be renewed and (ii) additional treaties may be bound during 2000. The decline in in-force business of 13% in 1999 compared to 1998 is due to several factors which include (i) discontinuing aviation and space business in 1999; (ii) non-renewals in other classes of business, due to (a) our adherence to underwriting standards in competitive market conditions and (b) the effect on cedents of our poor underwriting performance, coupled with a decline in RCRe's A.M. Best rating from A to A-. Such decline was partially offset by increased in-force premiums in Accident & Health business where significant underwriting capacity has exited the market since 1998, and we believe reinsurance pricing improvements have occurred in 1999 and 2000. Results of Operations We had consolidated comprehensive losses of $52.3 million and $4.4 million for the years ended December 31, 1999 and 1998, respectively, and consolidated comprehensive income of $47.1 million for the year ended December 31, 1997. Our comprehensive income or loss is composed of net income and the change in unrealized appreciation of investments. Net loss for the year ended December 31, 1999 was $32.4 million and net income for the years ended December 31, 1998 and 1997 was $3.1 million and $2.0 million, respectively. After-tax realized investment gains (losses) of $11.2 million, $16.4 million and ($0.5 million) were also included in net income for 1999, 1998 and 1997, respectively. Net income for the years ended December 31, 1999, 1998 and 1997 included income (losses) of $0.7 million, ($1.1 million), and ($0.2 million), respectively, representing our equity in the net income (loss) of investee companies accounted for under the equity method of accounting. Net loss for the year ended December 31, 1999 also included a loss of $383,000 from a cumulative effect of an accounting change for start-up costs. 38 Following is a table of per share data for the years ended December 31, 1999, 1998 and 1997 on an after-tax basis:
Years Ended December 31, ---------------------------------------------------- 1999 1998 1997 ---- ---- ---- Basic earnings per share: Underwriting loss ($3.42) ($1.39) ($0.45) Net investment income 0.85 0.68 0.61 Net realized investment gains (losses) 0.66 0.96 (0.03) Equity in net income (loss) of investees 0.03 (0.07) (0.01) Cumulative effect of accounting change (0.02) ------- ------- ------- Net income (1.90) 0.18 0.12 Change in net unrealized appreciation of investments (1.16) (0.44) 2.65 Comprehensive income (loss) ($3.06) ($0.26) $2.77 ====== ====== ===== Average Shares Outstanding (000's) 17,087 17,065 17,033 ====== ====== ====== Diluted earnings per share: Underwriting loss ($3.42) ($1.35) ($0.45) Net investment income 0.85 0.65 0.61 Net realized investment gains (losses) 0.66 0.93 (0.03) Equity in net income (loss) of investees 0.03 (0.06) (0.01) Cumulative effect of accounting change (0.02) ------- ------ ------- Net income ($1.90) $0.17 $0.12 ====== ===== ===== Comprehensive income (loss) ($3.06) ($0.26) $2.76 ====== ====== ===== Average shares outstanding (000's) 17,087 17,718 17,086 ==== ====== ====== ====== Book Value Per Share, December 31: Basic $20.28 $23.29 $23.51 Diluted $20.28 $22.75 $22.79 Shares outstanding (000's) Basic 17,088 17,087 17,058 Diluted 17,088 17,498 17,602
39 Net Premiums Written Net premiums written for the years ended December 31, 1999, 1998 and 1997 were as follows: (In millions) Percent Years Ended December 31, Change ------------------------ ------ 1999 1998 1997 1998/1999 ---- ---- ---- --------- Property $78.9 $33.7 $17.8 134% Casualty 64.1 80.3 69.7 (20%) Multi-line 67.7 62.8 45.9 8% Other 7.6 16.5 10.0 (54%) Accident & Health 50.3 Aviation & Space 18.4 26.0 (29%) Marine 14.0 14.4 1.4 (3%) Surety & Fidelity 5.7 1.0 470% ----- ----- ------ ----- Total $306.7 $234.7 $144.8 31% ====== ====== ====== == Set forth below are RCRe's assumed and ceded premiums written for the years ended December 31, 1999, 1998 and 1997: (In millions) Years Ended December 31, ------------------------ 1999 1998 1997 ---- ---- ---- Assumed premiums written $386.8 $260.5 $147.8 Ceded premiums written 80.1 25.8 3.0 Net premiums written $306.7 $234.7 $144.8 RCRe's net premiums written increased 31% to $306.7 million in 1999 from $234.7 million in 1998 and 62% to $234.7 million in 1998 from $144.8 million in 1997. Premium growth resulted from two key strategies, the integration of investment with reinsurance and the diversification into "specialty" classes of business, which for purposes of this discussion consist of Accident & Health, Aviation and Space, Marine and Surety & Fidelity. Approximately 30%, 32% and 29% of net premiums written in 1999, 1998 and 1997, respectively, were generated from companies in which we have invested or committed to invest funds ("integrated transactions"). Approximately 29%, 18% and 1% of net premiums written in 1999, 1998 and 1997, respectively, was produced from specialty classes of business. Specialty classes of business accounted for 65% and 44% of the increase in net premiums written for 1999 and 1998, respectively. Approximately 15%, 32% and 28% of net premiums written in 1999, 1998 and 1997, respectively, were from non-United States clients, which are Lloyd's syndicates or are located in the United Kingdom, Bermuda and Continental Europe. Net premiums written in 1999 includes approximately $26 million related to a group of property reinsurance treaties that expired in 1999 covering crop hail business underwritten on behalf of a start-up entity formed by Trident II, L.P. This business was protected by extensive aggregate excess of loss retrocession and generated a profit based upon underwriting results. We do not expect to renew these treaties in 2000. Net premiums written in 1999 for other business was reduced by $10.6 million for the retrocession of a treaty which covers future multiple rocket launches that was recorded in 1996. The reduction of net premiums written resulting from this retrocession increased the commission and operating expense ratio components of the statutory composite ratio by 1.1 percentage points, but had no impact on operating results. Consistent with our strategy of writing a small number of large treaties for our core business, two clients contributed approximately $81.3 million or 26.5% of 1999 total net premiums written, with the largest client contributing approximately 13.7% and the second contributing 12.8%. Approximately 70% of the business 40 written from the client that contributed 13.7% and all of the business written from the client that contributed 12.8% are part of an integrated transaction, and such business is subject to renewal at our option for two and four remaining years, respectively. In 1998, three clients contributed approximately $74 million, or 32%, of 1998 total net premiums written, with the largest client contributing approximately 18% and the remaining two contributing 8% and 6%, respectively. In 1997, five clients contributed approximately $68 million, or 45%, of total net premiums written, with the largest client contributing approximately 18% and the remaining four contributing from 5% to 8%. RCRe's ceded premiums increased to $80.1 million in 1999, compared to $25.8 million in 1998 and $3.0 million in 1997. Such ceded premiums primarily relate to RCRe's property, multi-line, marine, aviation and space reinsurance business, for which we seek to reduce RCRe's exposure to large and catastrophic losses. Since the fourth quarter of 1998, we have purchased additional retrocessional protection to reduce RCRe's exposures to both space and aviation risks. Effective July 1, 1999, RCRe also purchased a retrocessional treaty for a one year period covering earthquake, wind and other property catastrophe perils for $10 million in excess of a $15 million retention per occurrence. See "(Results of Operations(Aviation Business" and "(Risk Retention," "Business(Retrocessional Arrangements" and Note 7 of the accompanying notes to our consolidated financial statements. While not anticipated, prior to the asset sale, the reduction or loss of business assumed from one or more large clients could have a material adverse effect on our results of operations to the extent not offset by new business. Operating Costs and Expenses One traditional method of measuring the underwriting performance of a property/casualty insurer, such as RCRe, is the statutory combined ratio. This ratio, which is based upon statutory accounting principles (which differ from generally accepted accounting principles in several respects), reflects underwriting experience, but does not reflect income from investments. A statutory combined ratio under 100% indicates underwriting profitability, while a combined ratio exceeding 100% indicates an underwriting loss. Set forth below are RCRe's statutory combined ratios for the years ended December 31, 1999, 1998 and 1997 and the estimated aggregate statutory combined ratios for domestic reinsurers and domestic broker market reinsurers based on data reported by the Reinsurance Association of America ("RAA") as of such dates: Years Ended December 31, ----------------------------------- 1999 1998 1997 ---- ---- ---- Claims and claims expenses 98.2% 85.4% 68.4% Commissions and brokerage 26.3% 24.2% 28.8% ---- ---- ---- 124.5% 109.6% 97.2% Other operating expenses 4.7% 6.8% 9.1% ----- ------ ----- Statutory combined ratio 129.2% 116.4% 106.3% ===== ===== ===== Domestic reinsurer aggregate Statutory combined ratios 113.8% 104.4% 102.3% ===== ===== ===== After-tax underwriting losses for the years indicated were as follows (dollars in millions): Years Ended December 31, ----------------------------------- 1999 1998 1997 ---- ---- ---- After-tax underwriting loss Amount $ 58.4 $ 23.0 $ 7.7 Per Share (Basic) $ 3.42 $ 1.39 $ 0.45 Statutory combined ratio after-tax underwriting results for 1999 and 1998 reflect very poor underwriting performance in competitive market conditions. 41 RCRe's 1999 and 1998 statutory combined ratios were adversely affected by underwriting results from the sources identified below, which added 16 points and 9 points to the combined ratios (excluding operating expenses), respectively (dollars in millions): 1999 Year Underwriting Impact ----------------------------- Managing Underwriting Space & Agency Aviation Total ------ -------- ----- Net premiums written $ 2.1 $ 18.4 $ 20.5 Earned premiums $ 6.4 $ 13.8 $ 20.2 After-tax underwriting loss Amount $ 16.5 $ 19.7 $ 36.2 Per Share (Basic) $ 0.96 $ 1.15 $ 2.11 Combined Ratio Effect (in percentage points) 7.7 8.3 16.0 1998 Year Underwriting Impact -------------------------------------- Managing Underwriting Space & Agency Aviation Total ------ -------- ----- Net premiums written $ 16.3 $ 26.0 $ 42.3 Earned premiums $ 12.5 $ 21.3 $ 33.8 After-tax underwriting loss Amount $ 6.5 $ 7.8 $ 14.3 Per Share (Basic) $ 0.38 $ 0.46 $ 0.84 Combined Ratio Effect (in 4.1 4.9 9.0 percentage points) Managing Underwriting Agency As identified above, during 1999 and 1998, we recorded after-tax underwriting losses of $16.5 million, or $0.96 per share, and $6.5 million, or $0.38 cents per share, respectively, from reinsurance on casualty and multi-line business produced by the managing underwriting agency. We also recorded related after-tax investment losses of $1.3 million, or $0.07 per share, and $862,000, or $0.03 per share, in net realized investment losses in 1999 and 1998, respectively. We have discontinued our underwriting relationship with the managing underwriting agency. The business and operations of the managing underwriting agency are in run-off. The total estimated ultimate net premiums written and earned by RCRe on all business produced by the managing underwriting agency recorded from inception in late 1997 through December 31, 1999 are approximately $19.3 million and $19.1 million, respectively, resulting in an inception to date after-tax underwriting loss of $22.4 million. Net reserves for claims and claims expenses for this business approximated $38.7 million at December 31, 1999. See "--Folksamerica Transaction" for a discussion of a $20 million escrow fund relating to such reserves in connection with the sale of our reinsurance business to Folksamerica. Space & Aviation Business As identified above, during 1999 and 1998, RCRe recorded after-tax underwriting losses of $19.7 million, or $1.15 per share, and $7.8 million, or $0.46 per share, respectively, for its space and aviation lines of business. During 1999, RCRe discontinued both lines of business. 42 Space Business The total estimated ultimate net premiums written and earned by RCRe for space business from inception in 1998 through December 31, 1999 are $17.6 million each, resulting in an inception to date after-tax underwriting loss of $13.1 million. Net reserves for claims and claims expenses for space business approximated $2.4 million at December 31, 1999. At December 31, 1999, all satellite treaties have expired except for one treaty covering future multiple rocket launches which was 100% retroceded in 1999. Aviation Business The total estimated ultimate net premiums written and earned by RCRe for aviation business from inception in 1998 through December 31, 1999 are $26.8 million and $17.5 million, respectively, resulting in an inception to date after-tax underwriting loss of $14.3 million. Net reserves for aviation business approximated $26 million at December 31, 1999. Included in the 1999 after-tax underwriting loss for aviation business are incurred losses for the 1998 Swiss Air and Korean Air crashes and certain 1999 crashes, including the Egypt Air, American Airlines, Korean Air and China Air crashes. The additional loss recorded in 1999 for the Swiss Air crash was based on a reallocation of the $642 million expected industry loss between the plane manufacturer and Swiss Air. This reallocation adversely affected RCRe's gross loss. The gross loss associated with the Swiss Air crash reported as of December 31, 1998 had exhausted RCRe's retrocessional protections applicable to this occurrence. Therefore, none of such additional loss reported was ceded to retrocessionaires. To the extent that either the expected industry loss increases or additional loss is allocated to the plane manufacturer, RCRe could record additional losses. For example, if the expected industry loss increases by approximately $100 million, and assuming additional loss reallocations such that one-third of the industry loss is allocated to the plane manufacturer, RCRe would record additional aggregate loss (net of additional reinstatement premiums) of approximately $2.7 million after-tax. However, we cannot be certain of the ultimate industry loss or the final allocation of liability between the plane manufacturer and Swiss Air, and there can be no assurances that the ultimate industry loss will not be larger or that the plane manufacturer will not be allocated a greater proportion of the industry loss. With respect to all other reinsured crashes which occurred through December 31, 1999, we currently believe that RCRe's gross loss will not exhaust RCRe's reinsurance protections (although RCRe's net loss could increase within these protections based on the ultimate industry loss, the ultimate allocation of losses between the plane manufacturers and the airlines and other factors). For the year ended December 31, 1999, aviation assumed gross premiums earned, retroceded premiums earned, and net earned premiums were $43.7 million, $32.5 million and $11.2 million, respectively. While RCRe discontinued writing aviation business in 1999, RCRe currently has a number of assumed treaties that will continue to expose it to significant risk of aviation losses through 2001. Current estimates for gross aviation premiums that will be earned beyond 1999 aggregate approximately $20.5 million. Retrocessional premium charges to be recorded for retrocessional treaties presently in-force that expire during 2000 total approximately $15.4 million. Such retrocessional premium costs do not include additional retrocessional premium amounts that will be purchased to provide Folksamerica with additional retrocessional protection in connection with the sale of our reinsurance business to Folksamerica. Following the Egypt Air crash in October 1999, RCRe exhausted its initial layer of retrocessional protection for 1999 aviation exposures. Since October 1999, RCRe's initial retention as well as its total retention for aviation exposures are contingent on the size of insured industry losses, which could materially impact the recoveries under such retrocessions and therefore the net loss to us. Based on information currently available to us, we believe that RCRe's maximum exposures (net of retrocessional recoveries and reinstatement premiums) for future commercial airline losses vary depending on (i) the size of insured industry losses, (ii) the declining gross loss exposures as current in-force business expires, and (iii) the application of retrocessional protections which expire throughout 2000. Based on such current information, set forth below is our estimate of after-tax losses for RCRe's maximum exposures for the size industry loss and the time period presented (in millions): $700 to Industry Loss: $50 $100 $200 $300 $500 $1,500 --- ---- ---- ---- ---- ------ Year 2000 From/To: January 1 March 31 $1.5 $4.1 $3.4 $1.2 N/A $1.0 April 1 June 30 $1.5 $4.1 $6.5 $4.3 $2.4 $8.3 July 1 September 30 $1.3 $3.1 $6.5 $7.5 $5.8 $8.7 October 1 December 31 $1.6 $3.7 $3.6 $5.1 $6.2 $8.7 Year 2001 $1.6 $3.7 $5.3 $5.5 $5.5 $7.8 We are presently evaluating the impact of recent commercial airline crashes that occurred in 2000, including the Alaska Air crash. Other Underwriting Loss Activity Except for multi-line business, all other classes of business also contributed to the 1999 underwriting loss, with the largest contribution from property business. The after-tax underwriting loss for property business approximated $4.9 million which included after-tax losses of $4.3 million for two large catastrophes in 1999 (Rouge steel plant in Dearborn, Michigan and French storm losses). The 1998 underwriting loss included an after-tax underwriting loss of $3.3 million for a property loss on a finite risk treaty. 1999 Prior Year Development Estimates of prior accident year claims were increased by approximately $30 million in 1999 which added 10.2 points to the 1999 combined ratio. A substantial portion of this amount stemmed from (i) our review of additional claims information and our continuing underwriting and actuarial analysis of the business produced by the managing underwriting agency, (ii) notification of additional satellite losses received in 1999 pertaining to 1998, (iii) aviation losses, principally the previously discussed 1998 Swiss Air crash, and (iv) property losses reported on several international treaties that are in run-off. Estimates of prior accident year claims were reduced by approximately $2.8 million in 1998 primarily due to favorable claim development in the property and multi-line classes of business. Claims and claims expenses generally represent our most significant and uncertain costs. Reserves for these expenses are estimates involving actuarial and statistical projections at a given time of what we expect the ultimate settlement and administration of claims to cost based on facts and circumstances then known. The reserves are based on estimates of claims and claims expenses incurred and, therefore, the amount ultimately paid may be more or less than such estimates. The inherent uncertainties of estimating claim reserves are exacerbated for reinsurers by the significant periods of time (the "tail") that often elapse between the occurrence of an insured loss, the reporting of the loss to the primary insurer and, ultimately, to the reinsurer, and the primary insurer's payment of that loss and subsequent indemnification by the reinsurer. As a consequence, actual claims and claims expenses paid may deviate, perhaps materially, from estimates reflected in our reserves reported in our financial statements. The estimation of reserves by new reinsurers, such as us, may be less reliable than the reserve estimations of a reinsurer with an established volume of business and claims history. To the extent reserves prove to be inadequate, we may have to augment such reserves and incur a charge to earnings. 44 Acquisition Costs In pricing RCRe's reinsurance treaties, we focus on many factors, including exposure to claims and commissions and brokerage expenses. Commissions and brokerage expenses are acquisition costs that generally vary by the type of treaty and line of business, and are considered by our underwriting and actuarial staff in evaluating the adequacy of premium writings. In a number of reinsurance treaties, provisional commissions are initially paid and subsequently increased or decreased, subject to a minimum and maximum amount, depending upon the claims and claims expenses experience of the assumed business. We record the commission increase or decrease in accordance with contractual terms based on the expected ultimate experience of the contract. The claims and commissions and brokerage ratios reflect our business mix. Other Operating Expenses Other operating expenses were $14.8 million in 1999, compared to $16.5 million and $13.5 million for the years ended December 31, 1998 and 1997, respectively. For 1999, the statutory operating expense ratio declined to 4.7%, compared with 6.8% for 1998 and 9.1% in 1997. The decline in our operating expense ratio was due to a decrease in other operating expenses and an increase in our net premiums written from the comparable prior year period. In addition, commencing in 1999, we allocated certain compensation and other operating expenses related to investment activities in the amount of $2.1 million to net investment income based on internal time studies. Such allocations were not made in prior periods. Due to such allocations, the 1999 statutory operating expense ratio improved by approximately one point and net investment income was reduced by approximately $0.08 per share, with no overall effect on operating results. On a pro-forma basis, the statutory operating expense ratios for 1998 and 1997 would have been 5.8% and 7.6%, respectively. Foreign Exchange Pre-tax foreign exchange gains and losses are recorded separately from statutory underwriting results and are therefore excluded from the statutory composite ratio. Unhedged monetary assets and liabilities are translated at the exchange rate in effect at the balance sheet date, with the resulting foreign exchange gains or losses recognized in income. For the years ended December 31, 1999, 1998 and 1997, pretax foreign exchange gains and (losses) were $198,000, $443,000 and ($682,000), respectively. Such future gains or losses may be affected by changes in foreign exchange rates which are unpredictable and could be material. For additional discussion, see "--Market Sensitive Instruments and Risk Management" below. Risk Retention Given RCRe's current level of surplus, under its current underwriting guidelines, the maximum net retention on any one claim for a given property or casualty treaty risk is generally $10 million. We monitor RCRe's earthquake and wind exposures and continuously reevaluate its estimated probable maximum pre-tax loss for such exposures through the use of modeling techniques. We generally seek to limit RCRe's probable maximum pre-tax net loss to no more than 10% of its statutory surplus for severe catastrophic events such as hurricanes and earthquakes that could be expected to occur once in every 100 years. This limitation includes combined exposure to underwriting losses, reinstatement costs for retrocessional arrangements which may be in force at the time of the losses resulting from the catastrophic event, and losses that RCRe may be exposed to as a result of its privately held investments in insurance and insurance-related entities. While we believe RCRe's risk management techniques are adequate, we cannot assure you that RCRe will not suffer pre-tax losses greater than 10% of its statutory surplus from a catastrophic event due to the inherent uncertainties in estimating the frequency and severity of such exposures. In addition, we believe that we cannot reasonably estimate RCRe's exposure to unrealized investment losses (if any) that may result from RCRe's investments in publicly traded securities of insurance and insurance-related entities. With respect to integrated solutions (where we combine an equity, equity-like or debt investment in a client company with the purchase by such client of reinsurance from RCRe), we generally limit RCRe's combined underwriting and investment exposure to pre-tax losses on any individual client to no more than 10% of RCRe's total statutory surplus. 45 We continue to evaluate RCRe's potential catastrophe exposure, including both gross loss estimates and the impact of available reinsurance protection. While we believe our management of catastrophe exposures and underwriting guidelines are adequate, an extremely large catastrophic event, multiple catastrophic events or other unforeseen events could have a material adverse effect on our financial condition and results of operations. Net Investment Income At December 31, 1999, approximately 59% of our invested assets consisted of fixed maturity and short-term investments, compared to 48% at December 31, 1998. Net investment income was approximately $20.2 million in 1999, compared to $15.7 million and $14.4 million in 1998 and 1997, respectively. Such amounts for 1999, 1998 and 1997 are net of investment expenses of $5.5 million, $3.6 million and $2.2 million, respectively. The investment expense amounts include investment advisory fees of $2.0 million, $3.3 million and $1.8 million, respectively. The 1999 net investment income is also net of $1.1 million for the payment of interest expense in connection with the settlement of satellite losses. Our investment yields at amortized cost were as follows for the periods set forth below: Years Ended December 31, --------------------------------------------- 1999 1998 1997 ---- ---- ---- Investment yields: Pre-tax 3.6% 3.4% 3.7% Net of tax 2.7% 2.5% 2.7% Our investment yields are reflective of a significant allocation of the total investment portfolio in equity securities, which yield less current income than fixed maturity investments. At December 31, 1999 and 1998, investments in public and private equity securities approximated 41% and 49%, respectively, of total cash and invested assets. Additionally, such investment yields exclude our equity in the net income or loss of private equity investments accounted for under the equity method. Net Realized Gains (Losses) on Investments Our source of net realized investment gains (losses) were as follows:
In thousands Years Ended December 31, --------------------------------- 1999 1998 1997 ---- ---- ---- Net realized investment gain (losses) Fixed maturity securities ($1,776) $1,472 $275 Publicly traded equity securities 16,798 16,582 3,878 Privately held securities 2,205 7,198 (4,913) ------- ------- ------ Sub-total 17,227 25,252 (760) Income tax expense (benefit) 6,029 8,838 (266) ------- ------- ---- Net realized investment gains (losses), net of $11,198 $16,414 ($494) ======= ======= ===== tax
Income Taxes Our 1999 income tax benefit, 1998 effective tax rate of 5% and the 1997 income tax benefit are less than the 35% statutory rate on pre-tax operating income due primarily to tax exempt income and the dividends received deductions. The 1999, 1998 and 1997 gross deferred income tax benefits of approximately $10.5 million, $7.3 million and $2.1 million, respectively, which are assets considered recoverable from future taxable income, resulted from temporary differences between financial and taxable income. 46 The net deferred income tax asset at December 31, 1999 was $7.8 million. We periodically evaluate the need for a valuation allowance for any portion of the deferred tax asset that our management believes will not be realized based on current and future operating performance and available tax planning strategies. While we believe that a valuation allowance is not necessary at December 31, 1999, continued future comprehensive losses or future decisions with respect to business strategy following the sale of our reinsurance business may result in the establishment of a valuation allowance in future financial statements. We have a net operating loss carryforward which expires in 2019, for which we have established a deferred income tax asset of $7.3 million at December 31, 1999. The repurchase of our common stock held by XL Capital resulted in a 27.8% change in ownership by 5% shareholders. If, in the ensuing three years, there is more than a 22.2% additional change in ownership by 5% shareholders, an "ownership change" will have taken place for federal income tax purposes. If such ownership change occurs, the amount of loss carryforwards that can be used in any subsequent year may be severely limited and could be eliminated in certain circumstances. See the section of our special meeting proxy statement entitled "Risk Factors--The financing of our business plan may cause us to forfeit certain tax benefits," which is incorporated by reference. Investments A principal component of our investment strategy is investing a significant portion of RCRe's invested assets in publicly traded and privately held equity securities, primarily issued by insurance and reinsurance companies and companies providing services to the insurance industry. Cash and fixed maturity investments and, if necessary, the sale of marketable equity securities will be used to support shorter-term liquidity requirements. As a significant portion of RCRe's investment portfolio consists of equity securities issued by insurance and reinsurance companies and companies providing services to the insurance industry, the equity portfolio lacks industry diversification and will be particularly subject to the performance of the insurance industry. Unlike fixed income securities, equity securities such as common stocks, including the equity securities in which RCRe has invested, generally are not and will not be rated by any nationally recognized rating service. The values of equity securities generally are more dependent on the financial condition of the issuer and less dependent on fluctuations in interest rates than are the values of fixed income securities. The market value of equity securities generally is regarded as more volatile than the market value of fixed income securities. The effects of such volatility on RCRe's equity portfolio could be exacerbated to the extent that such portfolio is concentrated in the insurance industry and in relatively few issuers. From December 31, 1999 to March 24, 2000, the market value of our public equity portfolio has decreased by approximately $28 million due to general stock market volatility, market decline in the property and casualty insurance sector and the poor operating performance of several of our investee companies. For additional discussion, see "--Market Sensitive Instruments and Risk Management" below. As our investment strategy is to invest a significant portion of RCRe's investment portfolio in equity securities, our investment income in any fiscal period may be smaller, as a percentage of investments, and less predictable than that of other insurance and/or reinsurance companies, and net realized and unrealized gains (losses) on investments may have a greater effect on our results of operations or stockholders' equity at the end of any fiscal period than would be the case for other insurance and/or reinsurance companies. Since the realization of gains and losses on equity investments is not generally predictable, such gains and losses have differed and will differ significantly from period to period. Variability and declines in our results of operations could be further exacerbated by private equity investments in start-up companies which are accounted for under the equity method. Such start-up companies may be expected initially to generate operating losses. Investments included in RCRe's private portfolio include securities issued by privately held companies and by publicly traded companies that are generally restricted as to resale or are otherwise illiquid and do not have readily ascertainable market values. The risk of investing in such securities is generally greater than the risk of investing in securities of widely held, publicly traded companies. Lack of a secondary market and resale restrictions may result in an inability by us to sell a security at a price that would otherwise be obtainable if such restrictions did not exist and may substantially delay the sale of a security we seek to sell. At December 31, 1999, cash and invested assets totaled approximately $585.9 million, consisting of $82.2 million of cash and short-term investments, $261.1 million of publicly traded fixed maturity investments, 47 $158.6 million of publicly traded equity securities, and $83.9 million of privately held securities. Included in privately held securities are investments totaling $42.6 million which are accounted for under the equity method. At December 31, 1999, RCRe's private equity portfolio consisted of 12 investments, with additional investment portfolio commitments in an aggregate amount of approximately $23.2 million. In 1999, we completed one integrated transaction with an existing client of RCRe, a follow-on investment in an existing investee and one additional investment commitment. In addition, we divested four of RCRe's investments. (See note 3 under the caption "Investment Information" of the accompanying notes to our audited consolidated financial statements.) In October 1998, we provided $5 million in financing on a fully secured basis to a managing general agency, and received a related reinsurance commitment expected to generate an aggregate of $90 million of reinsurance premiums over three years pursuant to terms and conditions that we believe are more favorable than those available in the open market. On March 6, 2000, we extended a loan in an aggregate principal amount of $3.5 million to American Independent Insurance Holding Company ("AIHC"), one of our investee companies. The loan is secured by a second priority pledge of the capital stock of AIHC and assets of AIHC, and matures on September 6, 2001 (which date may be extended to March 6, 2002 upon the occurrence of certain events). The net proceeds of the loan were contributed to the surplus of AIHC's subsidiary, American Independent Insurance Company. In connection with the loan, we were issued warrants (in addition to the warrants issued to us in connection with a prior loan to AIHC) granting us the right to acquire equity in AIHC. See note 3 under the caption "Investment Information" of the accompanying notes to our audited consolidated financial statements for certain information regarding RCRe's publicly traded and privately held securities and their carrying values, and commitments made by RCRe relating to its privately held securities. At December 31, 1999, approximately 88% of RCRe's fixed maturity and short-term investments were rated investment grade by Moody's or Standard & Poor's and had an average quality rating of AA and an average duration of approximately 3.7 years. At December 31, 1999, RCRe is obligated under letters of credit in the aggregate amount of approximately $9.7 million, which secure certain reinsurance obligations. Securities with a carrying value of approximately $11.2 million have been pledged as collateral for these letters of credit. RCRe has not invested in derivative financial instruments such as futures, forward contracts, swaps, or options or other financial instruments with similar characteristics such as interest rate caps or floors and fixed-rate loan commitments. RCRe's portfolio includes market sensitive instruments, such as mortgage-backed securities, which are subject to prepayment risk and changes in market value in connection with changes in interest rates. RCRe's investments in mortgage-backed securities, which amounted to approximately $27.3 million at December 31, 1999, or 4.7% of cash and invested assets, are classified as available for sale and are not held for trading purposes. Market Sensitive Instruments and Risk Management In accordance with the SEC's Financial Reporting Release No. 48, the following analysis presents hypothetical losses in cash flows, earnings and fair values of market sensitive instruments which are held by RCRe as of December 31, 1999 and are sensitive to changes in interest rates, foreign exchange rates and equity security prices. This risk management discussion and the estimated amounts generated from the following sensitivity analysis represent forward-looking statements of market risk assuming certain adverse market conditions occur. Actual results in the future may differ materially from these projected results due to actual developments in the global financial markets. The analysis methods used by us to assess and mitigate risk should not be considered projections of future events of losses. Market risk represents the risk of changes in the fair value of a financial instrument and is comprised of several components, including liquidity, basis and price risks. The focus of the SEC's market risk rules is on price risk. For purposes of specific risk analysis, we employ sensitivity analysis to determine the effects that market risk exposures could have on the future earnings, fair values or cash flows of RCRe's financial instruments. 48 The financial instruments included in the following sensitivity analysis consist of all of our cash and invested assets, excluding investments carried under the equity method of accounting. Equity Price Risk We are exposed to equity price risks on the public and private equity securities included in RCRe's investment portfolio. All of RCRe's publicly traded equity securities and privately held securities were issued by insurance and reinsurance companies or companies providing services to the insurance industry. We typically do not attempt to reduce or eliminate RCRe's market exposure on these securities. Investments included in RCRe's private portfolio include securities issued by privately held companies and securities issued by public companies that are generally restricted as to resale or are otherwise illiquid and do not have readily ascertainable market values. Investments in privately held securities issued by privately and publicly held companies may include both equity securities and securities convertible into, or exercisable for, equity securities (some of which may have fixed maturities). RCRe's publicly traded and privately held equity securities at December 31, 1999, which are carried at a fair value of $158.6 million and $84.0 million, respectively, have exposure to price risk. The estimated potential losses in fair value for RCRe's publicly traded and privately held equity portfolios resulting from a hypothetical 10% decrease in quoted market prices, dealer quotes or fair value are $15.9 million and $8.4 million, respectively. Interest Rate Risk The aggregate hypothetical loss generated from an immediate adverse shift in the treasury yield curve of 100 basis points would result in a decrease in total return of 4.1%, which would produce a decrease in market value of $10.6 million on RCRe's fixed maturity investment portfolio valued at $261.1 million at December 31, 1999. There would be no material impact on RCRe's short-term investments. Foreign Currency Exchange Rate Risk We have foreign currency risk on both reinsurance balances receivable and reinsurance balances payable, including claims and claims expenses. We do not currently utilize derivative instruments to manage our exposure to foreign currency movements. At December 31, 1999, the substantial majority of the Company's net receivable/payable position was denominated in United States dollars. At such date, the largest foreign currency exposure related to liabilities denominated in British Pounds Sterling. We had a net liability balance in Sterling of approximately $2.6 million. A 10% increase in the Sterling/United States dollar exchange rate would have resulted in a loss to us of $268,000. Given our limited amount of net asset or liability balances in other foreign currencies, any currency movement of 10% would not produce a material loss for purposes of this discussion. Liquidity and Capital Resources We are a holding company and currently have no significant operations or assets other than our ownership of the capital stock of RCRe. We rely on cash dividends and distributions from RCRe to make payments, including for any operating expenses that we may incur and for any dividends or stock repurchases as our board of directors may determine. Our board currently does not intend to declare dividends or make any other distributions. However, our board intends to make a determination regarding stock repurchases following the consummation of the asset sale. See "Market for Registrant's Common Equity and Related Stockholder Matters(Dividends" and the sections included in our special meeting proxy statement entitled "Risk Factors-- We currently do not anticipate paying dividends, but may consider share repurchases" and "Dividend and Stock Repurchase Policy." RCRe's ability to pay dividends or make distributions to us is dependent upon its ability to achieve satisfactory underwriting and investment results and to meet regulatory standards of the State of Nebraska, as described below. There are presently no contractual restrictions on RCRe's payment of dividends or the making of distributions to us. We intend to cause RCRe to make an extraordinary distribution to us following the asset sale. See "--General--RCRe Distribution." Nebraska insurance laws provide that, without prior approval of the Nebraska Director, RCRe cannot pay a dividend or make a distribution (together with other dividends or distributions paid during the preceding 12 months) that exceeds the greater of (i) 10% of statutory surplus as of the preceding December 31 or 49 (ii) statutory net income from operations from the preceding calendar year not including realized capital gains. Net income (exclusive of realized capital gains) not previously distributed or paid as dividends from the preceding two calendar years may be carried forward for dividends and distribution purposes. Any proposed dividend or distribution in excess of such amount is called an "extraordinary" dividend or distribution and may not be paid until either it has been approved, or a 30-day waiting period has passed during which it has not been disapproved, by the Nebraska Director. Notwithstanding the foregoing, Nebraska insurance laws provide that any distribution that is a dividend may be paid by RCRe only out of earned surplus arising from its business, which is defined as unassigned funds (surplus) as reported in the statutory financial statement filed by RCRe with the Nebraska Insurance Department for the most recent year, including any surplus arising from unrealized capital gains or revaluations of assets. Any distribution that is a dividend and that is in excess of RCRe's unassigned funds, exclusive of any surplus arising from unrealized capital gains or revaluation of assets, will be deemed an "extraordinary" dividend subject to the foregoing requirements. Due to the distribution that was required to be made in connection with the XL Capital stock repurchase, we may not declare any other distribution for twelve months from the closing date of the stock repurchase unless such subsequent distribution is approved by the Nebraska Director. See "Business--Insurance Regulation" and note 10 to our audited consolidated financial statements included in this report for further details regarding statutory restrictions on distributions by RCRe. We, RCRe and Cross River file consolidated federal income tax returns and have entered into a tax sharing agreement (the "Tax Sharing Agreement"), allocating the consolidated income tax liability on a separate return basis. Pursuant to the Tax Sharing Agreement, RCRe and Cross River make tax sharing payments to us based on such allocation. Net cash flow from operating activities for the years ended December 31, 1999, 1998 and 1997 was approximately $7.5 million, $68.5 million and $49.0 million, respectively, consisting principally of premiums received, investment income (excluding net realized investment gains), offset by operating costs and expenses. The primary sources of liquidity for Risk Capital Reinsurance are net cash flow from operating activities, principally premiums received, the receipt of dividends and interest on investments and proceeds from the sale or maturity of investments. RCRe's cash flow is also affected by claims payments, some of which have been large. For example, we experienced negative cash flow from operations of approximately $25 million in the 1999 fourth quarter as a result of significant paid loss activity. Such situations could reoccur as our book of business matures, claims are settled and if we continue to experience poor underwriting performance. Therefore, our cash flow could fluctuate significantly from period to period. RCRe does not currently have any material commitments for any capital expenditures over the next 12 months. We expect that our financing and operational needs for the foreseeable future will be met by our balance of cash and short-term investments, as well as by funds generated from operations. Following the sale of the reinsurance operations to Folksamerica, our objective will be to pursue business combinations and ventures with operating businesses. We have not yet identified any specific business opportunities. Accordingly, we may need to secure additional financing to carry out our business plan. We cannot assure you that we will be successful in the implementation of our current or future business strategy. See the section of our special meeting proxy statement entitled "Risk Factors--Risks Relating to Our Business After the Asset Sale," which is incorporated by reference. At December 31, 1999, our consolidated stockholders' equity totaled $346.5 million, or $20.28 per share based on issued and outstanding shares, and $20.28 per share on a diluted basis which includes outstanding dilutive warrants and options. At such date, statutory surplus of RCRe was approximately $290 million. As a result of the XL Capital stock repurchase, stockholders' equity has been reduced by $59.4 million and book value per share has increased to $23.27 per share on a fully diluted basis. RCRe's statutory surplus was also reduced by $60 million to $230 million due to the sale to XL Capital of the stock and warrants in LARC Holdings, Ltd. and Annuity and Life Re Holdings, Ltd., based on their statutory carrying values at December 31, 1999. Based on data from the RAA, after giving effect to the XL Capital stock repurchase, RCRe was the 20th largest domestic broker market oriented reinsurer as measured by its $230 million of statutory surplus. 50 Accounting Pronouncements Derivatives and Hedging In June 1998, the Financial Accounting Standards Board issued Statement No. 133 "Accounting for Derivative Instruments and Hedging Activities." This statement requires that all derivative financial instruments be recognized in the statement of financial position as either assets or liabilities and measured at fair value. If a derivative instrument is not designated as a hedging instrument, gains or losses resulting from changes in fair values of such derivative are required to be recognized in earnings in the period of the change. If certain conditions are met, a derivative may be designated as a hedging instrument, in which case the recording of the changes in fair value will depend on the specific exposure being hedged. The key criterion for hedge accounting is that the hedging relationship must be highly effective in achieving offsetting changes on fair values or cash flows. This statement is effective for fiscal years beginning after June 15, 2000, with initial application as of the beginning of the first quarter of the applicable fiscal year. We will adopt this statement in the first quarter of 2001. Historically, we have not invested in derivative financial instruments. However, derivatives may be embedded in other financial instruments, such as convertible securities and prepayment options in mortgages. If the embedded derivative meets certain criteria, it must be bifurcated from the host contract and separately accounted for consistent with other derivatives. RCRe's portfolio includes market sensitive instruments, such as convertible securities and mortgage-backed securities, which are subject to prepayment risk and changes in market value in connection with changes in interest rates. Our investments in mortgage-backed securities are classified as available for sale and are not held for trading purposes. Assuming the current investment strategy at the time of adoption, our presentation of financial information under the new statement will not be materially different than the current presentation. Start-Up Costs Effective January 1, 1999, we changed our method of accounting for start-up costs in accordance with the Accounting Standards Executive Committee's Statement of Position ("SOP") 98-5 "Reporting on the Costs of Start-Up Activities." This statement requires costs of start-up activities, including organization costs, to be expensed as incurred. The change in accounting principle resulted in the write-off of the start-up costs capitalized as of January 1, 1999 for us and RCRe's investee companies carried under the equity method of accounting. The cumulative effect of the write-off, which totals $383,000, after-tax, or $0.02 per share, has been expensed and is included in the 1999 net loss. (See note 2 of the accompanying notes to our audited consolidated financial statements.) Insurance Regulation RCRe, in common with other insurers, is subject to extensive governmental regulation and supervision in the various states and jurisdictions in which it transacts business. The laws and regulations of the State of Nebraska, the domicile of RCRe, have the most significant impact on its operations. From time to time various regulatory and legislative changes have been proposed in the insurance and reinsurance industry, some of which could have an effect on reinsurers. Among the proposals that have in the past been, or are at present being considered, are (i) the possible introduction of federal regulation in addition to, or in lieu of, the current system of state regulation of insurers and (ii) proposals in various state legislatures (some of which proposals have been enacted) to conform portions of their insurance laws and regulations to various model acts adopted by the NAIC. We are unable to predict whether any of such laws and regulations will be adopted, the form in which any such laws and regulations would be adopted, or the effect, if any, these developments would have on our operations and financial condition. See "Business--Insurance Regulation." In March 1998, the NAIC adopted the codification of statutory accounting principles project that will generally be applied to all insurance and reinsurance company financial statements filed with insurance regulatory authorities as early as the statutory filings made in 2001. Although the codification is not expected to materially affect many existing statutory accounting practices presently followed by most insurers and 51 reinsurers such as RCRe, there are several accounting practices that may be changed. The most significant change would involve accounting for deferred income taxes, which change would require a deferred tax liability to be recorded for unrealized appreciation of invested assets, net of available deferred tax assets, that would result in a reduction to statutory surplus. If such requirement had been in effect in 1999, the statutory surplus of RCRe at December 31, 1999 would have remained at $290 million. Effects of Inflation The effects of inflation on us are implicitly considered in pricing and estimating reserves for unpaid claims and claims expenses. The actual effects of inflation on our results cannot be accurately known until claims are ultimately settled. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Please refer to the information appearing above under the subheading "Market Sensitive Instruments and Risk Management" included as part of the "Management's Discussion and Analysis of Financial Condition and Results of Operations," which information is incorporated by reference. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See our consolidated financial statements and notes thereto and required financial statement schedules on pages F-1 through F-43 and S-1 through S-7 below. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item is incorporated by reference from the information to be included in our definitive proxy statement for our annual meeting of stockholders to be held in 2000, which we intend to file with the SEC before April 30, 2000, under the following headings: "Election of Directors--Directors and Executive Officers--Nominees," "--Continuing Directors and Executive Officers" and "Election of Directors--Security Ownership of Certain Beneficial Owners and Management--Section 16(a) Beneficial Ownership Reporting Compliance." ITEM 11. EXECUTIVE COMPENSATION The information required by this item is incorporated by reference form the information to be included in the annual meeting proxy statement under the headings "Election of Directors--Directors and Executive Officers--Compensation of Directors," "Election of Directors--Executive Compensation" and "--Performance Graph." ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is incorporated by reference from the information to be included in the annual meeting proxy statement under the heading "Election of Directors--Security Ownership of Certain Beneficial Owners and Management." 52 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by this item is incorporated by reference from the information to be included in the annual meeting proxy statement under the headings "Election of Directors--Executive Compensation--Compensation Committee Interlocks and Insider Participation" and "Election of Directors--Certain Relationships and Related Transactions." PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. Financial Statements and Schedules Financial statements and schedules listed in the accompanying index to our financial statements and schedules on page F-1 are filed as part of this report, and are included in Item 8. Exhibits The exhibits listed in the accompanying exhibit index are filed as part of this report. These exhibits include, without limitation, certain management contracts and compensatory plans as described therein. Reports on Form 8-K No reports on Form 8-K were filed by us during the fourth quarter of 1999. We did file Forms 8-K on (1) January 18, 2000 (reporting the proposed sale of our reinsurance operations to Folksamerica Reinsurance Company and the XL stock repurchase) and (2) March 2, 2000 (reporting the closing of the XL stock repurchase). 53 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. RISK CAPITAL HOLDINGS, INC. (Registrant) By: /s/ Mark D. Mosca Name: Mark D. Mosca Title: President and Chief Executive Officer March 29, 2000 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date /s/ Mark D. Mosca President and Chief Executive Officer March 21, 2000 ------------------------------- (Principal Executive Officer) and Mark D. Mosca Director /s/ Robert Clements Chairman and Director March 22, 2000 ------------------------------- Robert Clements /s/ Peter A. Appel Executive Vice President, Chief March 21, 2000 ------------------------------- Operating Officer, General Counsel and Peter A. Appel Director /s/ Paul J. Malvasio Managing Director, Chief Financial March 21, 2000 ------------------------------- Officer and Treasurer (Principal Paul J. Malvasio Financial Officer and Principal Accounting Officer) /s/ Michael P. Esposito, Jr. Director March 27, 2000 ------------------------------- Michael P. Esposito, Jr. /s/ Lewis L. Glucksman Director March 27, 2000 ------------------------------- Lewis L. Glucksman /s/ Ian R. Heap Director March 22, 2000 ------------------------------- Ian R. Heap /s/ Thomas V. A. Kelsey Director March 27, 2000 ------------------------------- Thomas V. A. Kelsey /s/ Robert F. Works Director March 23, 2000 ------------------------------- Robert F. Works /s/ Philip L. Wroughton Director March 27, 2000 ------------------------------- Philip L. Wroughton
54 - - ---------------- * By Paul J. Malvasio, as attorney-in-fact and agent, pursuant to a power of attorney, a copy of which has been filed with the Securities and Exchange Commission as Exhibit 24 to this report. /s/ Paul J. Malvasio ------------------------- Paul J. Malvasio Attorney-in-Fact 55 INDEX TO FINANCIAL STATEMENTS AND SCHEDULES Pages Risk Capital Holdings, Inc. and Subsidiaries Report of Independent Accountants on Financial Statements .............................................. F-2 Consolidated Balance Sheet at December 31, 1999 and 1998 .................................................... F-3 Consolidated Statement of Income and Comprehensive Income for the years ended December 31, 1999, 1998 and 1997 .................................................... F-4 Consolidated Statement of Changes in Stockholders' Equity for the years ended December 31, 1999, 1998 and 1997 .................................................... F-5 Consolidated Statement of Cash Flows for the years ended December 31, 1999, 1998 and 1997 .................. F-6 Notes to Consolidated Financial Statements .............. F-7 - F-43 Schedules Report of Independent Accountants on Financial Statement Schedules S-1 I. Summary of Investments Other Than Investments in Related Parties at December 31, 1999 ............... S-2 II. Condensed Financial Information of Registrant ...... S-3 - S-5 III. Supplementary Insurance Information for the years ended December 31, 1999, 1998 and 1997 ............. S-6 IV. Reinsurance for the years ended December 31, 1999, 1998 and 1997 ...................................... S-7 Schedules other than those listed above are omitted for the reason that they are not applicable. F-1 Report of Independent Accountants To the Board of Directors and Stockholders of Risk Capital Holdings, Inc. In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of income and comprehensive income, of changes in stockholders' equity and of cash flows present fairly, in all material respects, the financial position of Risk Capital Holdings, Inc. and its subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. /s/ PricewaterhouseCoopers, LLP New York, New York February 1, 2000, except as to Note 14, which is as of March 2, 2000 F-2
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (Dollars in thousands) December 31, ---------------------------------- 1999 1998 ------------- ---------------- Assets Investments: Fixed maturities (amortized cost: 1999, $270,345; 1998, $173,379) $261,067 $174,540 Publicly traded equity securities (cost: 1999, $105,747; 1998, $110,598) 158,631 154,678 Privately held securities (cost: 1999, $85,748; 1998, $109,966) 83,969 137,091 Short-term investments 72,785 108,809 ------------- ---------------- Total investments 576,452 575,118 Cash 9,457 12,037 Accrued investment income 4,527 2,632 Premiums receivable 119,320 88,610 Reinsurance recoverable 73,122 30,575 Deferred policy acquisition costs 23,585 23,515 Investment accounts receivable 3,928 Federal income tax recoverable 8,758 Deferred income tax asset 7,834 Other insurance assets 36,975 16,832 Other assets 4,329 4,583 ------------- ---------------- Total Assets $864,359 $757,830 ============= ================ Liabilities Claims and claims expenses $364,554 $216,657 Unearned premiums 108,743 102,775 Reinsurance premiums payable 14,666 5,396 Investment accounts payable 3,981 Federal income tax payable 2,229 Deferred income tax liability 13,182 Other insurance liabilities 24,541 9,525 Other liabilities 5,341 6,083 ------------- ---------------- Total Liabilities 517,845 359,828 ------------- ---------------- Commitments (See Note 5) Stockholders' Equity Preferred stock, $.01 par value: 20,000,000 shares authorized (none issued) Common stock, $.01 par value: 80,000,000 shares authorized (issued: 1999, 17,109,736; 1998, 17,102,503) 171 171 Additional paid-in capital 342,034 341,878 Deferred compensation under stock award plan (317) (1,062) Retained earnings (deficit) (22,175) 10,261 Accumulated other comprehensive income consisting of unrealized appreciation of investments, net of income tax 27,188 47,038 Less treasury stock, at cost (1999, 21,766; 1998, 15,065) (387) (284) ------------- ---------------- Total Stockholders' Equity 346,514 398,002 ------------- Total Liabilities and Stockholders' Equity $864,359 $757,830 ============= ================
See Notes to Consolidated Financial Statements F-3
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF INCOME AND COMPREHENSIVE INCOME (In thousands, except per share data) Years Ended December 31, 1999 1998 1997 -------------- --------------- ----------------- Revenues Net premiums written $306,726 $234,735 $144,834 (Increase) decrease in unearned premiums 4,642 (28,541) (37,462) -------------- -------------- ----------------- Net premiums earned 311,368 206,194 107,372 Net investment income 20,173 15,687 14,360 Net realized investment gains (losses) 17,227 25,252 (760) -------------- -------------- ----------------- Total revenues 348,768 247,133 120,972 -------------- -------------- ----------------- Operating Costs and Expenses Claims and claims expenses 305,841 176,125 73,407 Commissions and brokerage 80,540 50,537 31,467 Other operating expenses 14,816 16,452 13,523 Foreign exchange (gain) loss (198) (443) 682 -------------- -------------- ----------------- Total operating costs and expenses 400,999 242,671 119,079 -------------- -------------- ----------------- Income (Loss) Income (loss) before income taxes, equity in net income (loss) of investees and cumulative effect of accounting change (52,231) 4,462 1,893 -------------- -------------- ----------------- Federal income taxes: Current (9,021) 7,512 1,761 Deferred (10,536) (7,277) (2,099) -------------- -------------- ----------------- Income tax expense (benefit) (19,557) 235 (338) -------------- -------------- ----------------- Income (loss) before equity in net income (loss) of investees and cumulative effect of accounting change (32,674) 4,227 2,231 Equity in net income (loss) of investees 621 (1,136) (192) -------------- -------------- ----------------- Income (loss) before cumulative effect of accounting change (32,053) 3,091 2,039 Cumulative effect of accounting change (383) -------------- -------------- ----------------- Net income (loss) (32,436) 3,091 2,039 -------------- -------------- ----------------- Other Comprehensive Income (Loss), Net of Tax Change in net unrealized appreciation of investments, net of tax (19,850) (7,466) 45,068 -------------- -------------- ----------------- Comprehensive Income (Loss) ($52,286) ($4,375) $47,107 ============== ============== ================= Average shares outstanding Basic 17,086,732 17,065,165 17,032,601 Diluted 17,086,808 17,718,223 17,085,788 Per Share Data Net Income (Loss) - Basic ($1.90) $0.18 $0.12 - Diluted ($1.90) $0.17 $0.12 Comprehensive Income (Loss) - Basic ($3.06) ($0.26) $2.77 - Diluted ($3.06) ($0.26) $2.76
See Notes to Consolidated Financial Statements F-4
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (In thousands) Years Ended December 31, 1999 1998 1997 --------------- ---------------- ---------------- Common Stock Balance at beginning of year $171 $171 $170 Issuance of common stock Restricted common stock issued 1 --------------- --------------- ---------------- Balance at end of year 171 171 171 Additional Paid-in Capital Balance at beginning of year 341,878 341,162 340,435 Issuance of common stock 156 716 727 --------------- --------------- ---------------- Balance at end of year 342,034 341,878 341,162 --------------- --------------- ---------------- Deferred Compensation Under Stock Award Plan Balance at beginning of year (1,062) (1,778) (2,959) Restricted common stock (issued) cancelled 117 (296) (506) Compensation expense recognized 628 1,012 1,687 --------------- --------------- ---------------- Balance at end of year (317) (1,062) (1,778) --------------- --------------- ---------------- Retained Earnings (Deficit) Balance at beginning of year 10,261 7,170 5,131 Net income (loss) (32,436) 3,091 2,039 --------------- --------------- ---------------- Balance at end of year (22,175) 10,261 7,170 --------------- --------------- ---------------- Treasury Stock, At Cost Balance at beginning of year (284) (198) Purchase of treasury stock (103) (86) (198) --------------- --------------- ---------------- Balance at end of year (387) (284) (198) --------------- --------------- ---------------- Accumulated Other Comprehensive Income Consisting of Unrealized Appreciation of Investments, Net of Income Tax Balance at beginning of year 47,038 54,504 9,436 Change in unrealized appreciation (19,850) (7,466) 45,068 --------------- --------------- ---------------- Balance at end of year 27,188 47,038 54,504 --------------- --------------- ---------------- Total Stockholders' Equity Balance at beginning of year 398,002 401,031 352,213 Issuance of common stock 156 716 728 Change in deferred compensation 745 716 1,181 Net income (loss) (32,436) 3,091 2,039 Purchase of treasury stock (103) (86) (198) Change in unrealized appreciation of investments, net of income tax (19,850) (7,466) 45,068 --------------- --------------- ---------------- Balance at end of year $346,514 $398,002 $401,031 =============== =============== ================
See Notes to Consolidated Financial Statements F-5
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (In thousands) Years Ended December 31, 1999 1998 1997 --------------- --------------- ---------------- Operating Activities Net income (loss) ($32,436) $3,091 $2,039 Adjustments to reconcile net income to net cash Provided by (used for) operating activities: Liability for claims and claims expenses, net 147,897 145,889 49,998 Unearned premiums (4,642) 28,541 36,886 Premiums receivable (30,710) (41,103) (23,838) Accrued investment income (1,895) 149 (630) Reinsurance recoverable (31,938) (31,087) 1,098 Reinsurance balances payable 9,270 5,185 (325) Deferred policy acquisition costs (70) (6,223) (10,274) Net realized investment (gains)/losses (17,227) (25,252) 760 Deferred income tax asset (10,327) (7,889) (2,202) Other liabilities 11,695 9,920 (78) Other items, net (32,071) (12,715) (4,396) --------------- --------------- ---------------- Net Cash Provided By Operating Activities 7,546 68,506 49,038 --------------- --------------- ---------------- Investing Activities Purchases of fixed maturity investments (374,862) (295,912) (239,395) Sales of fixed maturity investments 270,325 254,716 241,035 Net sales (purchases) of short-term investments 41,898 (16,924) 20,390 Purchases of equity securities (39,364) (110,321) (95,738) Sales of equity securities 92,045 102,876 33,104 Purchases of furniture, equipment and leasehold improvements (338) (252) (910) --------------- --------------- ---------------- Net Cash Used For Investing Activities (10,296) (65,817) (41,514) --------------- --------------- ---------------- Financing Activities Common stock issued 156 716 728 Purchase of treasury shares (103) (86) (198) Deferred compensation on restricted stock 117 (296) (506) --------------- --------------- ---------------- Net Cash Provided By Financing Activities 170 334 24 --------------- --------------- ---------------- Increase in cash (2,580) 3,023 7,548 Cash beginning of year 12,037 9,014 1,466 --------------- --------------- ---------------- Cash end of year $9,457 $12,037 $9,014 =============== =============== ================
See Notes to Consolidated Financial Statements F-6 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Formation, Capitalization and Business Risk Capital Holdings, Inc. ("RCHI"), incorporated in March 1995 under the laws of the State of Delaware, is a holding company whose wholly owned subsidiary, Risk Capital Reinsurance Company ("Risk Capital Reinsurance"), a Nebraska corporation, was formed to provide, on a global basis, property and casualty reinsurance and other forms of capital, either on a stand-alone basis or as part of integrated capital solutions for insurance companies with capital needs that cannot be met by reinsurance alone. RCHI and Risk Capital Reinsurance are collectively referred to herein as the "Company". In September 1995, through its initial public offering, related exercise of the underwriters' over-allotment option and direct sales of 16,750,625 shares of RCHI's common stock, par value $.01 per share (the "Common Stock"), at $20 per share, and the issuance of warrants, RCHI was capitalized with net proceeds of approximately $335.0 million, of which $328.0 million was contributed to the statutory capital of Risk Capital Reinsurance. In July 1998, Risk Capital Reinsurance capitalized its wholly owned subsidiary, Cross River Insurance Company ("Cross River"), with $20 million. Cross River received its Nebraska license in October 1998, and is currently authorized to write insurance on an excess and surplus lines basis in 22 additional states. Class A warrants to purchase an aggregate of 2,531,079 shares of Common Stock and Class B warrants to purchase an aggregate of 1,920,601 shares of Common Stock were issued in connection with the direct sales. Class A warrants are immediately exercisable at $20 per share and expire September 19, 2002. Class B warrants are exercisable at $20 per share during the seven year period commencing September 19, 1998, provided that the Common Stock has traded at or above $30 per share for 20 out of 30 consecutive trading days. The Company generally seeks to write a small number of large reinsurance treaty transactions that may also be integrated with an equity investment in client companies. Such reinsurance may include traditional and finite risk property and casualty reinsurance treaty coverages, including excess of loss reinsurance and quota share or proportional reinsurance. The Company also writes treaty reinsurance for ocean marine, aviation and space, fidelity and surety, and accident and health risks. In 1999, the Company discontinued its aviation and space lines of business. The Company's investment strategy is focused on the insurance industry. A principal component of this strategy is investing a significant portion of invested assets in publicly traded and privately held equity securities issued by insurance and reinsurance companies and companies providing services to the insurance industry. The Company obtains substantially all of its reinsurance through intermediaries which represent the cedent in negotiations for the purchase of reinsurance. In addition to investment opportunities arising from the activities of Marsh & McLennan Capital, Inc. ("MMCI"), as the Company's equity investment advisor, the Company is provided with investment opportunities by reinsurance brokers and traditional financing sources, including investment banking firms, venture capital firms and other banking and financing sources, both acting as principal investors and intermediaries. Underwriting opportunities may arise from such sources in connection with the Company's investment activities as part of integrated transactions. See Note 14 - Subsequent Events for information on the agreement entered into by the Company to sell its reinsurance business to Folksamerica Reinsurance Company ("Folksamerica") and the repurchase from XL Capital Ltd. ("XL") of all of the 4,755,000 shares of the Common Stock held by XL. F-7 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies Basis of Presentation The consolidated financial statements have been prepared in conformity with generally accepted accounting principles ("GAAP") and include the accounts of RCHI, Risk Capital Reinsurance and Cross River. All intercompany transactions and balances have been eliminated in consolidation. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Premium Revenues and Related Expenses Premiums are recognized as income on a pro rata basis over the terms of the related reinsurance contracts. These amounts are based on reports received from ceding companies, supplemented by the Company's own estimates of premiums for which ceding company reports have not been received. Unearned premium reserves represent the portion of premiums written that relates to the unexpired terms of contracts in force. Certain of the Company's contracts include provisions that adjust premiums based upon the experience under the contracts. Premiums written and earned as well as related acquisition expenses under these contracts are recorded based upon the expected ultimate experience under these contracts. Acquisition costs, which vary with and are primarily related to the acquisition of policies, consisting principally of commissions and brokerage expenses incurred at the time a contract is issued, are deferred and amortized over the period in which the related premiums are earned. Deferred acquisition costs are limited to their estimated realizable value based on the related unearned premiums and take into account anticipated claims and claims expenses, based on historical and current experience, and anticipated investment income. Investments The Company classifies all of its publicly traded fixed maturity and equity securities as "available for sale" and, accordingly, they are carried at estimated fair value. The fair value of publicly traded fixed maturity securities and publicly traded equity securities is estimated using quoted market prices or dealer quotes. Short-term investments, which have a maturity of one year or less at the date of acquisition, are carried at cost, which approximates fair value. Investments in privately held securities, issued by privately and publicly held companies, may include both equity securities and securities convertible into, or exercisable for, equity securities (some of which may have fixed maturities) and debt securities. Privately held securities are subject to trading restrictions or are otherwise illiquid and do not have readily ascertainable market values. The risk of investing in such securities is generally greater than the risk of investing in securities of widely held, publicly traded companies. Lack of a secondary market and resale restrictions may result in the Company's inability to sell a security at a price that would otherwise be obtainable if such restrictions did not exist and may substantially delay the sale of a security which the Company seeks to sell. Such investments are classified as "available for sale" and carried at estimated fair value, except for investments in which the Company believes it has the ability to exercise significant influence (generally defined as investments in which the Company owns 20% or more of the outstanding voting common stock of the issuer), which are carried under the equity method of accounting. Under this method, the Company initially records an investment at cost, and then records its proportionate share of comprehensive income or loss for such investment after the date of acquisition. F-8 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies (continued) The estimated fair value of investments in privately held securities, other than those carried under the equity method, is initially equal to the cost of such investments until the investments are revalued based principally on substantive events or other factors which could indicate a diminution or appreciation in value, such as an arm's-length third party transaction justifying an increased valuation or adverse development of a significant nature requiring a write down. The Company periodically reviews the valuation of investments in privately held securities with MMCI, its equity investment advisor. Realized investment gains or losses on the sale of investments are determined by the first-in first-out method and recorded in net income. Unrealized appreciation or depreciation of securities which are carried at fair value is excluded from net income and recorded as a separate component of stockholders' equity, net of applicable deferred income tax. Net investment income, consisting of dividends and interest, net of investment expenses, is recognized when earned. The amortization of premium and accretion of discount for fixed maturity investments is computed utilizing the interest method. Anticipated prepayments and expected maturities are used in applying the interest method for certain investments such as mortgage and other asset-backed securities. When actual prepayments differ significantly from anticipated prepayments, the effective yield is recalculated to reflect actual payments to date and anticipated future payments. The net investment in the security is adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the security. Such adjustments, if any, are included in net investment income. Claims and Claims Expenses The reserve for claims and claims expenses consists of unpaid reported claims and claims expenses and estimates for claims incurred but not reported. These reserves are based on reports received from ceding companies, supplemented by the Company's estimates of reserves for which ceding company reports have not been received, and the Company's own historical experience. To the extent that the Company's own historical experience is inadequate for estimating reserves, such estimates will be determined based upon industry experience and management's judgment. The ultimate liability may vary from such estimates, and any adjustments to such estimates are reflected in income in the period in which they become known. Reserves are recorded without consideration of potential salvage or subrogation recoveries which are estimated to be immaterial. Such recoveries, when realized, are reflected as a reduction of claims incurred. Foreign Exchange The United States dollar is the functional currency for the Company's foreign business. Gains and losses on the translation into United States dollars of amounts denominated in foreign currencies are included in net income. Foreign currency revenue and expenses are translated at average exchange rates during the year. Assets and liabilities denominated in foreign currencies are translated at the rate of exchange in effect at the balance sheet date. Income Taxes The Company utilizes the liability method of accounting for income taxes. Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and amounts used for income tax purposes. A valuation allowance is recorded using the "more-likely-than-not" criteria when some or all of a deferred tax asset may not be realized. F-9 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies (continued) Comprehensive Income In presenting its financial statements, the Company has adopted the reporting of comprehensive income in a one financial statement approach, consistent with Statement of Financial Accounting Standards ("SFAS") No. 130. Comprehensive income as shown below is comprised of net income and other comprehensive income, which for the Company consists of the change in net unrealized appreciation or depreciation of investments, net of tax.
(In thousands, except per share data) Years Ended December 31, 1999 1998 1997 ------------ ----------- ------------- Net income (loss) ($32,436) $3,091 $2,039 Other comprehensive income net of tax: Unrealized appreciation (depreciation) of investments: Unrealized holdings gains (losses) arising during period (8,652) 8,948 44,574 Less, reclassification adjustment for net realized (gains) losses included in net income (11,198) (16,414) 494 ------------ ----------- -------------- Other comprehensive income (loss) (19,850) (7,466) 45,068 ------------ ----------- -------------- Comprehensive income (loss) ($52,286) ($4,375) $47,107 ============ =========== ============== Comprehensive income (loss) per share: Basic ($3.06) ($0.26) $2.77 ============ =========== ============== Diluted ($3.06) ($0.26) $2.76 ============ =========== ==============
Earnings Per Share Data Earnings per share are computed in accordance with SFAS No. 128, "Earnings per share" (see Note 12 for the Company's earnings per share computations). Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted average number of shares of Common Stock outstanding for the periods. Diluted earnings per share reflect the potential dilution that could occur if Class A and B warrants and employee stock options were exercised for Common Stock. Segment Information In June 1997, the Financial Accounting Standards Board ("FASB"), issued SFAS No. 131 "Disclosure About Segments of an Enterprise and Related Information". This Statement establishes standards for the way that public business enterprises report information about operating segments in annual and interim financial reports issued to stockholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. Operating segments are defined as components of an enterprise for which separate financial information is available that is evaluated regularly by the chief operating decision maker for purposes of deciding how to allocate resources and in assessing performance. Generally, financial information is required to be reported on the basis for which it is used internally for evaluating segment performance and determining how to allocate resources to segments. F-10 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies (continued) The Company operates in one reportable business segment, of providing property casualty reinsurance and other forms of capital to insurance and reinsurance companies and making investments in insurance and insurance related entities on a global basis. This segment includes the results of Risk Capital Reinsurance and Cross River, and consists primarily of the premiums, claims and claims expenses, other operating expenses and investment results. The Company's adoption of SFAS No. 131 did not have a material impact on the Company's financial statements or the accompanying notes. See Note 11 for information concerning the Company's business. See Note 14 - Subsequent Events for information on the agreement entered into by the Company to sell its reinsurance business. Market Risk Sensitive Instruments The Securities and Exchange Commission ("SEC") issued Financial Reporting Release No. 48 which included amended rules requiring domestic and foreign issuers to clarify and expand existing disclosure for derivative financial instruments, other financial instruments and derivative commodity instruments (collectively, "market risk sensitive instruments"). The amendments require enhanced disclosure of accounting policies for derivative financial instruments and derivative commodity instruments (collectively, "derivatives"). In addition, the amendments expand existing disclosure requirements to include quantitative and qualitative information about market risk inherent in market risk sensitive instruments, which disclosure will be subject to safe harbor protection under the SEC rule (see the accompanying Management's Discussion and Analysis of Financial Condition and Results of Operations). These amendments are designed to provide additional information about market risk sensitive instruments which investors can use to better understand and evaluate market risk exposures of registrants, including the Company. Employee Stock Options The Company follows Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees" ("APB No. 25") and related interpretations in accounting for its employee stock options because the alternative fair value accounting provided for under FASB Statement No. 123 "Accounting for Stock-Based Compensation" ("FASB No. 123") requires use of option valuation models that were not developed for use in valuing employee stock options (see Note 8). Under APB No. 25, no compensation expense is recognized by the Company because the exercise prices of the Company's employee stock options equal the market prices of the underlying stock on the date of grant. In addition, under APB No. 25, the Company does not recognize compensation expense for stock issued to employees under its stock purchase plan. Goodwill In connection with its acquisitions of privately held equity securities recorded under the equity method of accounting, the Company amortizes goodwill on a straight line basis for periods from 5 years to 25 years. Goodwill at December 31, 1999 and 1998 was $8,931,000 and $10,638,000, respectively. Amortization of goodwill included in equity in net loss of investees in 1999, 1998 and 1997, was $400,000, $1,000,000 and $248,000, respectively. F-11 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies (continued) Furniture, Equipment and Leasehold Improvements The costs of furniture and equipment are charged against income over their estimated service lives. Leasehold improvements are amortized over the term of the office lease. Depreciation and amortization are computed on the straight-line method. Maintenance and repairs are charged to expense as incurred. Furniture, equipment and leasehold improvements, net of accumulated depreciation and amortization at December 31, 1999 and 1998 recorded in other assets was $2,479,000 and $2,858,000, respectively. Reclassifications The Company has reclassified the presentation of certain prior year information to conform to the current presentation. New Accounting Pronouncements Derivatives and Hedging In June 1998, the FASB issued Statement No. 133 "Accounting for Derivative Instruments and Hedging Activities." This statement requires that all derivative financial instruments be recognized in the statement of financial position as either assets or liabilities and measured at fair value. If a derivative instrument is not designated as a hedging instrument, gains or losses resulting from changes in fair values of such derivative are required to be recognized in earnings in the period of the change. If certain conditions are met, a derivative may be designated as a hedging instrument, in which case the recording of the changes in fair value will depend on the specific exposure being hedged. The key criterion for hedge accounting is that the hedging relationship must be highly effective in achieving offsetting changes on fair values or cash flows. This Statement is effective for fiscal years beginning after June 15, 2000, with initial application as of the beginning of the first quarter of the applicable fiscal year. The Company will adopt this Statement in the first quarter of 2001. Generally, the Company has not invested in derivative financial instruments. However, derivatives may be embedded in other financial instruments, such as convertible securities and prepayment options in mortgages. If the embedded derivative meets certain criteria, it must be bifurcated from the host contract and separately accounted for consistent with other derivatives. The Company's portfolio includes market sensitive instruments, such as convertible securities and mortgage-backed securities, which are subject to prepayment risk and changes in market value in connection with changes in interest rates. The Company's investments in mortgage-backed securities are classified as available for sale and are not held for trading purposes. Assuming the current investment strategy at the time of adoption, the Company's presentation of financial information under the new Statement will not be materially different than the current presentation. Start-Up Costs Effective January 1, 1999, the Company changed its method of accounting for start-up costs in accordance with the Accounting Standards Executive Committee's Statement of Position ("SOP") 98-5 "Reporting on the Costs of Start-Up Activities." This statement requires costs of start-up activities, including organization costs, to be expensed as incurred. F-12 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Summary of Significant Accounting Policies (continued) Start-up activities are defined broadly as those one-time activities related to opening a new facility, introducing a new product or service, conducting business in a new territory, conducting business with a new class of customer or beneficiary, initiating a new process in an existing facility or commencing some new operation. Start-up activities also include activities related to organizing a new entity. The change in accounting principle resulted in the write-off of the start-up costs capitalized as of January 1, 1999 for the Company and its investee companies carried under the equity method of accounting. The cumulative effect of the write-off, which totals $383,000, after-tax, or $0.02 per share, has been expensed and is included in the 1999 net loss. 3. Investment Information Net Investment Income The components of net investment income were derived from the following sources:
(In thousands) Years Ended December 31, -------------------------------------------------------------- 1999 1998 1997 ------------------ ------------------ ------------------ Fixed maturity securities $14,924 $10,500 $7,105 Publicly traded equity securities 4,019 4,022 3,272 Privately held equity securities 1,007 426 157 Short-term investments 5,677 4,386 6,039 ------------------ ------------------ ------------------ Gross investment income 25,627 19,334 16,573 Investment expenses 5,454 3,647 2,213 ------------------ ------------------ ------------------ Net investment income $20,173 $15,687 $14,360 ================== ================== ==================
Realized and Unrealized Investment Gains (Losses) Net realized investment gains (losses) were as follows:
(In thousands) Years Ended December 31, ----------------------------------------------- 1999 1998 1997 ------------- -------------- ------------ Fixed maturity securities ($1,776) $1,472 $275 Publicly traded equity securities 16,798 16,582 3,878 Privately held securities 2,205 7,198 (4,913) ------------- -------------- ------------ Sub-total 17,227 25,252 (760) ------------- -------------- ------------ Income tax expense (benefit) 6,029 8,838 (266) ------------- -------------- ------------ Net realized investment gains (losses), net of tax $11,198 $16,414 ($494) ============= ============== ============
F-13 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Investment Information (continued) The following tables reconcile estimated fair value and carrying value to the amortized cost of fixed maturity and equity securities:
(In thousands) December 31, 1999 -------------------------------------------------------------------- Estimated Fair Value and Gross Gross Carrying Unrealized Unrealized Amortized Value Gains (Losses) Cost -------------- ---------------- ---------------- ----------------- Fixed maturities: U.S. government and government agencies $41,095 $3 ($1,673) $42,765 Municipal bonds 52,245 136 (308) 52,417 Mortgage and asset backed securities 27,298 3 (1,129) 28,424 Corporate bonds 136,838 484 (6,694) 143,048 Foreign governments 3,591 (100) 3,691 -------------- --------------- ---------------- ----------------- Sub-total fixed maturities 261,067 626 (9,904) 270,345 Equity securities: Publicly traded 158,631 66,724 (13,840) 105,747 Privately held 83,969 (1,779) 85,748 -------------- --------------- ---------------- ----------------- Sub-total equity securities 242,600 66,724 (15,619) 191,495 -------------- --------------- ---------------- ----------------- Total $503,667 $67,350 ($25,523) $461,840 ============== =============== ================ ================= (In thousands) December 31, 1998 ------------------------------------------------------------------ Estimated Fair Value Gross Gross & Carrying Unrealized Unrealized Amortized Value Gains (Losses) Cost ---------------- --------------- ---------------- --------------- Fixed maturities: U.S. government and government agencies $39,283 $606 ($60) $38,737 Municipal bonds 45,273 1,193 (11) 44,091 Mortgage and asset backed securities 33,532 397 (46) 33,181 Corporate bonds 56,256 962 (1,882) 57,176 Foreign governments 196 2 194 ---------------- --------------- --------------- --------------- Sub-total fixed maturities 174,540 3,160 (1,999) 173,379 Equity securities: Publicly traded 154,678 51,093 (7,013) 110,598 Privately held 137,091 27,125 109,966 ---------------- --------------- --------------- --------------- Sub-total equity securities 291,769 78,218 (7,013) 220,564 ---------------- --------------- --------------- --------------- Total $466,309 $81,378 ($9,012) $393,943 ================ =============== =============== ===============
At December 31, 1999, all of the Company's equity investments were in securities issued by insurance and reinsurance companies or companies providing services to the insurance industry. F-14 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Investment Information (continued) At December 31, 1999, the publicly traded equity portfolio consisted of the following investments:
(In thousands) December 31, 1999 ----------------------------------------------------------- Estimated Fair Value and Net Unrealized Carrying Value Gain (Loss) Cost ------------------ ---------------- ---------------- Common Stocks: ACE Limited $5,397 ($2,745) $8,142 Annuity and Life Re (Holdings) Ltd. (includes 100,000 warrants) (1) 38,169 18,169 20,000 Arthur J. Gallagher 19,425 9,231 10,194 XL Capital Ltd. 13,488 4,612 8,876 E.W. Blanch Holdings, Inc. 21,866 14,545 7,321 Farm Family Holdings, Inc. 3,802 819 2,983 IPC Holdings, Ltd. 7,988 (7,005) 14,993 Limit PLC 2,394 (492) 2,886 Meadowbrook Insurance Group 1,200 (1,882) 3,082 Partner Re, Ltd. 3,698 (1,263) 4,961 Renaissance Re 2,044 334 1,710 Terra Nova Holdings 26,572 18,096 8,476 WR Berkley Corp. 2,088 (453) 2,541 Preferred Stock: St. Paul Companies, 6% Convertible Preferred 10,500 918 9,582 ------------------ ---------------- ---------------- Total $158,631 $52,884 $105,747 ================== ================ ================
(1) See Note 14 - Subsequent Events for information on the disposition of the Company's interest in Annuity and Life Re (Holdings) Ltd. in connection with the Company's repurchase from XL of all of the 4,755,000 shares of the Common Stock held by XL. F-15 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Investment Information (continued) Privately held securities consisted of the following:
(In thousands) Percentage December 31, ----------------------------------- Ownership 1999 1998 --------------- --------------- --------------- Carried under the equity method: The ARC Group, LLC 27.0% $8,687 $9,448 Arx Holding Corp. 35.2% 2,654 2,400 Capital Protection Insurance Services, LLC 250 First American Financial Corporation 9,805 Island Heritage Insurance Company, Ltd. 33.0% 4,356 3,101 LARC Holdings, Ltd. (1) 23.9% 24,039 25,349 New Europe Insurance Ventures 14.6% 819 1,083 Sunshine State Holding Corporation 21.5% 1,885 1,688 --------------- --------------- Sub-total 42,440 53,124 --------------- --------------- Carried at fair value: Altus Holdings, Ltd. 28% 19,173 6,667 American Independent Holding Company 4,250 Annuity and Life Re (Holdings) Ltd. (2) 5.6% 34,243 Arbor Acquisition Corp. (Montgomery & Collins, 500 Inc.) GuideStar Health Systems, Inc. 2.6% 500 1,000 Sorrento Holdings, Inc. 1,517 5,113 Sovereign Risk Insurance Ltd. 246 Stockton Holdings Limited 1.7% 10,000 10,000 Terra Nova (Bermuda) Holdings, Ltd. (2) 21,323 TRG Associates, LLC 4,875 Trident II, L.P. 2.0% 6,089 --------------- --------------- Sub-total 41,529 83,967 --------------- --------------- Total $83,969 $137,091 =============== ===============
(1) See Note 14 - Subsequent Events for information on the disposition of the Company's interest in LARC Holdings, Ltd. in connection with the Company's repurchase from XL of all of the 4,755,000 shares of the Common Stock held by XL. (2) As of June 2, 1999, the Company reclassified the above privately held securities as publicly traded equity securities. Pursuant to the existing investment advisory agreement, the Company incurred a fee of $2.5 million payable to MMCI upon the reclassification of such securities. In addition, the Company had investment commitments relating to its privately held securities in the amounts of $23.2 million and $10.4 million at December 31, 1999 and 1998, respectively. The outstanding commitments at December 31, 1999 included $19 million committed to Trident II, L.P., a newly formed investment fund established by MMCI dedicated to making private equity and equity related investments in the global insurance, reinsurance and related industries. F-16 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Investment Information (continued) Set forth below is certain information relating to each of the Company's investments and investment commitments in privately held securities at December 31, 1999. Investments Carried Under The Equity Method: The ARC Group, LLC In July 1997, the Company completed its acquisition, effective May 1997, of a 27.0% economic and voting interest in The ARC Group, LLC ("ARC"), a Long Island-based wholesaler of specialty insurance, for approximately $9.5 million. ARC, founded in 1986, is an independent wholesale insurance broker and managing general agent specializing in the placement of professional liability insurance, primarily directors and officers liability coverage. The Company is a co-investor with Marsh & McLennan Risk Capital Holdings, Ltd. ("MMRCH"), MMCI's parent, and ARC's founders, who continue to have managerial control over the daily operations. The Company records its equity in the operating results of ARC on a two-month lag basis. Cumulative distributions received from ARC of $4.7 million have been recorded as reductions to the carrying value of the investment. For the years ended 1999 and 1998 and for the period recorded in 1997, the Company's equity in net income, net of goodwill amortization and net of tax, was $827,000, or $0.05 per share, $1.0 million, or $0.06 per share, and $561,000, or $0.03 per share, respectively. Arx Holding Corp. In December 1997, the Company acquired a 35.2% economic and voting interest in Arx Holding Corp. ("ARX"), a Florida-based company, for $2,425,000. ARX, through its recently formed wholly owned subsidiary American Strategic Insurance Corp., underwrites homeowners policies in the State of Florida produced in the open market, and may also seek to offer other lines of insurance in Florida and other states. The Company provides reinsurance for ARX. A subsidiary of XL is a co-investor in ARX and also provides reinsurance for ARX. The Company's net premiums written and net premiums earned from business developed by ARX were $8.2 million and $5.6 million, respectively, in 1999 and $2.8 million and $1.1 million, respectively, in 1998. The Company records its equity in the operating results of ARX on a quarter-lag basis. For the years ended 1999 and 1998, the Company's equity in net income (loss), net of goodwill amortization and net of tax, was $282,000 and ($63,000), respectively. Capital Protection Insurance Services, LLC In May 1997, the Company acquired a 51% economic interest (49% voting interest) in Capital Protection Insurance Services, LLC ("CPI"), a newly formed managing underwriting agency headquartered in New York City offering specialty risk and alternative market insurance solutions. The Company co-invested with CPI's founders. The Company also provided reinsurance capacity for the business CPI developed. Net premiums written and net premiums earned recorded by the Company from casualty and multi-line business developed by CPI were $2.1 million and $6.4 million in 1999, $16.3 million and $12.3 million in 1998 and $857,399 and $178,527, in 1997, respectively. F-17 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Investment Information (continued) At December 31, 1998, the Company recorded a realized loss of $862,000 by reducing the carrying value of its investment in CPI to $250,000. During 1999, the Company wrote off its remaining investment carrying value in CPI and recorded an after-tax realized investment loss of $1.3 million, which represents actual and estimated costs associated with terminating leases and divesting physical assets, and other costs to run-off the business of this managing underwriting agency. First American Financial Corporation In February 1997, the Company acquired a 35.5% voting and economic interest in First American Financial Corporation ("First American") for $6.5 million. First American, a Missouri-based company, through its wholly owned subsidiaries including First American Insurance Company, underwrites specialty vehicle property and casualty insurance coverages with emphasis placed on collateral protection. In May 1999, Altus Holdings Ltd. ("Altus") agreed to acquire First American in a share exchange, which closed in July 1999 upon receipt of regulatory approval. During the 1999 second quarter, the Company reclassified its investment in First American from the equity method of accounting to an investment accounted for at fair value and the carrying value of First American was adjusted to $9.3 million in order to reflect the transaction value resulting from the acquisition by Altus. The Company recorded an after-tax realized loss of $0.7 million from the transaction. The Company's total investment in First American (excluding repaid demand loans) was $10.4 million. For the period recorded in 1999 and the year ended 1998, the Company's equity in net loss, net of goodwill amortization and net of tax, was $320,000, or $0.02 per share, and $1.3 million, or $0.08 per share, respectively. For the period recorded in 1997, the Company's equity in the net income, net of goodwill amortization and net of tax, was $32,036. The Company's net premiums written and net premiums earned from business developed by First American was $0.9 million each in 1999. Island Heritage Insurance Company, Ltd. In April 1996, the Company acquired a 33% economic interest (9.75% voting interest) in Island Heritage Insurance Company, Ltd. ("Island Heritage"), a Cayman Islands insurer, for an aggregate purchase price of $4.5 million, which was funded through $1.7 million in cash and a trust account in an amount equal to $2.8 million. Island Heritage commenced operations in May 1996 as an insurer which writes high value personal and commercial property insurance in the Caribbean. Certain directors of the Company and other investors invested in the securities of Island Heritage at the same per share price as that paid by the Company. In February 1999, the Company made an additional investment in Island Heritage in the amount of approximately $1.0 million. The investment in Island Heritage is recorded under the equity method of accounting since the Company believes it has the ability to exercise significant influence over the operating and financial policies of Island Heritage due to the Company's participation on the Board of Directors and through certain consent rights attaching to the Company's holdings of non-voting shares. F-18 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Investment Information (continued) The Company records its equity in the operating results of Island Heritage on a quarter-lag basis. For the year ended 1999, the Company's equity in net income, net of tax, was $153,400, or $0.01 per share. For years ended 1998 and 1997, the Company's equity in net loss, net of tax, was $551,850, or $0.03 per share, and $195,922, or $0.01 per share, respectively. LARC Holdings, Ltd. In November 1997, the Company acquired shares and warrants representing a 23.9% economic interest (9.9% voting interest) in LARC Holdings, Ltd. ("LARC"), a newly formed holding company located in Bermuda, for $24.5 million. LARC, through its newly-formed wholly owned Bermuda subsidiary, Latin American Reinsurance Company, Ltd. ("LARe"), provides multi-line reinsurance to the Latin American reinsurance market, emphasizing short-tail, multi-peril property reinsurance and, to a limited extent, casualty, marine, aviation and other lines of reinsurance. LARe may also seek to enter other reinsurance niches on both a treaty and facultative basis. The Company co-invested with a subsidiary of XL, which holds a majority interest in LARC, and the founders of LARC. The investment in LARC is recorded under the equity method of accounting since the Company believes it has the ability to exercise significant influence over the operating and financial policies of LARC due to the Company's participation on the Board of Directors and through certain consent rights attaching to the Company's holdings of non-voting shares. The Company records its equity in the operating results of LARC on a quarter-lag basis. For the year ended 1999, the Company's equity in net loss, net of goodwill amortization and net of tax, was $113,750; for the year ended 1998 the Company's equity in net income, net of goodwill amortization and net of tax was $531,700; and for the period recorded in 1997, the Company's equity in net loss, net of tax, was $18,936. See Note 14 - Subsequent Events for information on the disposition of the Company's interest in LARC in connection with the Company's repurchase from XL of all of the 4,755,000 shares of the Common Stock held by XL. New Europe Insurance Ventures In March 1997, the Company, through a wholly owned special purpose subsidiary, committed to pay $5 million over the long term to fund its partnership interest, currently at 14.6%, in New Europe Insurance Ventures ("NEIV"), a Scottish limited partnership that targets private equity investments in insurance and insurance-related companies in Eastern Europe. The Company records its participation in this partnership under the equity method of accounting and applies the specialized accounting practices for investment companies. Unrealized gains and losses on private equity investments, consisting mostly of foreign exchange fluctuations, are recorded in the income statement when such investments are revalued into United States dollars each quarter. The $820,000 investment balance at December 31, 1999 is composed of five investments in Eastern Europe in insurance related companies. The unfunded commitment remaining at December 31, 1999 was approximately $3.2 million. F-19 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Investment Information (continued) The Company records its equity in the operating results of NEIV on a quarter-lag basis. For the years ended 1999, 1998 and for the period recorded in 1997, the Company's equity in net loss, net of tax, was $345,150, $141,700 and $54,532, respectively. Sunshine State Holding Corporation In December 1997, the Company acquired a 21.5% economic and voting interest in Sunshine State Holding Corporation ("Sunshine State"), a newly formed Florida-based company, for $1.4 million. Sunshine State and its subsidiaries, which includes Sunshine State Insurance Company, a Florida domiciled insurer, underwrite homeowners policies in the State of Florida obtained from the Florida Residential Property and Casualty Joint Underwriting Association in accordance with the Market Challenge Program of the Florida Department of Insurance. Sunshine State also insures homeowners policies produced through the open market and offers other lines of insurance in Florida and other states. In connection with the investment, the Company provides reinsurance for Sunshine State. A subsidiary of XL invested in Sunshine State and will also provide reinsurance for Sunshine State during specified periods. The Company records its equity in the operating results of Sunshine State on a quarter-lag basis. The Company's net premiums written and net premiums earned from business developed by Sunshine State were $6.6 million and $5.6 million, respectively, in 1999 and $3.9 million and $4.5 million, respectively, in 1998. For the years ended 1999 and 1998, the Company's equity in net income, net of tax, was $179,000, or $0.01 per share, and $171,600, or $0.01 per share. Investments Carried at Fair Value: Altus Holdings, Ltd. In March 1998, the Company purchased for $10 million an approximately 28.6% economic interest (9.9% voting interest) in Altus, a new Cayman Islands company formed to provide rent-a-captive and other underwriting management services for risks of individual corporations and insurance programs developed by insurance intermediaries. The Company's investment was funded two-thirds in cash and one-third through a letter of credit. The balance of the $35 million of initial capital invested in Altus was contributed by The Trident Partnership, L.P. ("Trident"), XL, MMRCH and members of Altus' management. The Company may provide reinsurance capacity for business developed by Altus. The Company issued a letter of credit in the amount of $5.8 million for Trident's unfunded investment commitment in Altus for an annual fee of $58,000, or 100 basis points on the letter of credit amount. In May 1999, Altus acquired First American in a share exchange, which closed in July 1999 upon receipt of regulatory approval. During the 1999 second quarter, the Company reclassified its investment in First American from the equity method of accounting to an investment accounted for at fair value. At June 30, 1999, the carrying value of First American was adjusted to $9.3 million, in order to reflect the transaction value resulting from the acquisition by Altus resulting in the Company recording an after-tax realized loss of $0.7 million. In July 1999, the Company and Trident funded their investment commitments to Altus (previously secured by letters of credit) of $3.3 million and $5.8 million, respectively, and XL redeemed its shares in Altus at their original costs. After Altus' acquisition of First American, such additional funding and the XL redemption, the Company's economic ownership in Altus decreased from 28.6% to 28% (9.9% voting interest). F-20 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Investment Information (continued) American Independent Insurance Holding Company In February 1999, the Company loaned $5 million to American Independent Insurance Holding Company ("AIHC"). The promissory note, secured by the stock of AIHC, matures in January 2003, and will accrue interest at rates per annum expected to approximate 6%, depending on the investment returns on proceeds of the loan which are invested by AIHC on the Company's behalf. Principal and interest repayments are subject to prior approval by the Pennsylvania Department of Insurance. In consideration for the loan, the Company received Class A warrants to purchase shares of common stock of AIHC, constituting approximately 4% of AIHC's outstanding common stock on a fully-diluted basis. Interest income recorded in 1999 was $148,000. At December 31, 1999, the Company recorded a pre-tax unrealized loss of $750,000, which reflects a market value discount of 15% based on a comparison of the AIHC note to bonds with similar characteristics. In connection with this investment and the Company's prior $3.6 million loan commitment to AIHC (which commitment expired on December 31, 1998), the Company has the option to write an aggregate amount of premiums of at least approximately $375 million over the next seven to eight year period, subject to the amount of business written by AIIC. From inception through December 31, 1999, premiums written by the Company under these arrangements with AIHC and its insurance subsidiary, American Independent Insurance Company ("AIIC"), totaled $107.2 million. No assurances can be given that any such additional premiums will be written by the Company. The Company's net premiums written and net premiums earned from business developed by AIIC were $39.2 million and $43.7 million, respectively, in 1999, $42 million and $36 million, respectively, in 1998, and $25.9 million and $15.2 million, respectively, in 1997. Annuity and Life Re (Holdings), Ltd. In April 1998, the Company acquired for approximately $20 million a minority interest in Annuity and Life Re (Holdings), Ltd. ("Annuity and Life Re"), a new Bermuda-based reinsurance company formed to provide annuity and life reinsurance. The Company coinvested with XL concurrently with the consummation of Annuity and Life Re's initial public offering. The Company purchased approximately 1.4 million common shares of Annuity and Life Re and warrants to purchase at an exercise price of $15.00 per share (the initial public offering price) an additional 100,000 common shares. The aggregate purchase price paid by the Company was based on a price of $14.10 for a unit consisting of one common share and certain warrants. The Company owns approximately 5.6% of the outstanding common shares of Annuity and Life Re following the exercise of the underwriters' over-allotment option. Annuity and Life Re's common shares are quoted on The Nasdaq Stock Market's National Market ("NASDAQ") under the symbol "ALRE." At December 31, 1998, the Company recorded its investment in Annuity and Life Re common stock and warrants at the closing price reported by NASDAQ on such date less a discount for trading restrictions. In June 1999, the Company reclassified its investment in Annuity and Life Re to a publicly traded equity security. See Note 14 - Subsequent Events for information on the disposition of the Company's interest in Annuity and Life Re in connection with the Company's repurchase from XL of all of the 4,755,000 shares of Common Stock held by XL. F-21 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Investment Information (continued) Arbor Acquisition Corp. (Montgomery & Collins, Inc.) In March 1998, the Company purchased for approximately $2.8 million a 34.5% economic and voting interest in Arbor Acquisition Corp. ("Arbor"), the parent of Montgomery & Collins, Inc. a Boston-based national surplus lines and wholesale brokerage firm which operates in 11 cities, in addition to Boston. The investment was made concurrently with investments by MMRCH. In September 1998, the Company invested an additional $845,000 in Arbor, increasing the Company's ownership interest to approximately 37.3%. For the period recorded in 1998, the Company's equity in net loss, net of goodwill amortization and net of tax, was $506,000 or $0.03 per share. In addition, in December 1998, the Company recorded a realized loss of $2.4 million by reducing the carrying value of its investment in Arbor to $500,000 and reclassified this investment from the equity method of accounting to an investment carried at fair value. At June 30, 1999, the Company increased the carrying value of its investment in Arbor from $500,000 to approximately $3.0 million based on the expected net realizable value resulting from the sale of the business and run-off of the operations. The sale of the business occurred in two transactions that closed in June and July 1999. It is expected that the wind-up of the remaining operations will be substantially completed by July 2000. GuideStar Health Systems, Inc. In December 1997, the Company acquired a 2.6% economic and voting interest in GuideStar Health Systems, Inc. ("GuideStar"), an Alabama-based managed care organization, for $1 million. Founded in late 1995, GuideStar provides comprehensive managed care services to employers and individuals through strategic alliances with selected insurance companies and health care providers. GuideStar develops health care provider networks, and provides claims processing, customer relations and comprehensive utilization management services. In September 1999, the Company reduced the carrying value of GuideStar by 50% to $500,000 and realized an after tax loss of $325,000. Sorrento Holdings, Inc. In October 1998, the Company purchased for $5 million 5,000 shares of Class C Cumulative Redeemable Preferred Stock (the "Preferred C Shares") of Sorrento Holdings, Inc. ("Sorrento"). The Preferred C Shares accrue interest at the rate of 6% per annum and are subject to mandatory redemptions through December 31, 2000. Sorrento's obligation to redeem the Preferred C Shares is secured by an irrevocable letter of credit. For the year ended December 31, 1999, the Company received $3.7 million from Sorrento for the redemption of 3,483 shares of preferred stock of Sorrento, which redemption amount included a payment of $1,000 per share and dividends of approximately $233,000. Sorrento was formed by Clarendon National Insurance Company ("Clarendon") and the Arrowhead Group ("Arrowhead"), a managing agency. Sorrento intends to form a wholly owned subsidiary, Sorrento Insurance Company, to underwrite automobile liability and physical damage policies produced by Arrowhead. In connection with the issuance of the Preferred C Shares, the Company is providing reinsurance to Clarendon in respect of automobile physical damage policies and may provide reinsurance on other business produced by Arrowhead. F-22 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Investment Information (continued) The Company's net premiums written and net premiums earned from business developed by Arrowhead were $30 million and $22.5 million, respectively, in 1999. Sovereign Risk Insurance Ltd. In July 1997, the Company acquired a 9.0% voting and economic interest in Sovereign Risk Insurance Ltd. ("Sovereign Risk"), a newly formed Bermuda-based managing general agency, for $237,500. Sovereign Risk provides underwriting services for political risk insurance coverages for the Company, ACE Insurance Company, Ltd. and a subsidiary of XL, who are also co-investors in Sovereign Risk. In June 1999, the Company sold its investment in Sovereign Risk to ACE Limited and XL and recorded an after-tax net realized gain of $103,000. The Company retained an option to provide certain reinsurance on business produced by Sovereign Risk for a five-year period. The Company's net premiums written and net premiums earned from business developed by Sovereign Risk were $2.9 million and $2.4 million, respectively, in 1999, $1,397,000 and $887,000, respectively, in 1998 and $175,000 and $51,130, respectively, in 1997. Stockton Holdings Limited In June 1998, the Company acquired for $10 million a 1.7% interest in Stockton Holdings Limited ("Stockton Holdings"), a Cayman Islands insurance holding company. Stockton Holdings conducts a world-wide reinsurance business through its wholly owned subsidiary Stockton Reinsurance Limited, a Bermuda-based reinsurance company writing specialty risks with a focus on finite products. The Company's investment was made as part of a private placement by Stockton Holdings. During 1999, the Company received a dividend distribution of $157,000. Terra Nova (Bermuda) Holdings, Ltd. In October 1995, the Company acquired a 3.6% voting and economic interest in Terra Nova (Bermuda) Holdings, Ltd. ("Terra Nova") for $8.9 million. Terra Nova, based in Bermuda, is a holding company for two principal operating insurance companies located in Bermuda and London that write property and casualty reinsurance. In April 1996, Terra Nova completed the initial public offering of its common stock, which is traded on the New York Stock Exchange ("NYSE") under the symbol "TNA." In December 1998, the Company sold 41,000 shares of Terra Nova and recorded a realized gain of approximately $800,000, reducing the Company's voting and economic interest to 3.5%. Dividend income recorded in 1999, 1998 and 1997 received from Terra Nova was $213,000, $213,000 and $157,000, respectively. In June 1999, the Company reclassified its investment in Terra Nova to a publicly traded equity security. TRG Associates, LLC In October 1997, the Company acquired an 8.8% economic interest (7.7% voting interest) in TRG Associates, LLC ("LLC"), a new limited liability company formed for the purpose of holding all of the Class 1 common stock of TRG Holding Corporation ("TRG Holdings"), for $4,875,000. TRG Holdings acquired all of the common stock of The Resolution Group, Inc. ("TRG") in exchange for $150 million in cash (funded by $50 million from the LLC and $100 million of debt incurred by TRG Holdings) and $462 million face amount of the Class 2 common stock of TRG Holdings. F-23 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Investment Information (continued) TRG, located in Chicago, was formed to manage and pay off claims liabilities on policies that insurance subsidiaries of Talegen Holdings, Inc., a subsidiary of Xerox Corporation, had written prior to 1993. In August 1999, the Company recorded an after-tax net realized gain of $2.2 million upon completion of the sale of this investment to Fairfax Financial Holdings Limited. Trident II, L.P. On June 4, 1999, the Company committed to invest $25 million as a limited partner of Trident II, L.P. ("Trident II"), a partnership managed by MMCI. Trident II will make private equity and equity related investments in the global insurance, reinsurance and related industries. The fund will target investments in existing companies that are in need of growth capital or are under performing as well as in newly formed companies. The Company's Chairman is one of four Senior Principals of MMCI who manage Trident II. The term of Trident II expires in 2009. However, the term may be extended for up to a maximum of three one-year periods at the discretion of MMCI to permit orderly dissolution. During the first six years of the fund, the Company will pay an annual management fee, payable semi-annually in advance, equal to 1.5% of the Company's aggregate $25.0 million commitment as well as a percentage of cumulative net gains on invested funds. After such six year period, the annual management fee will be 1.5% of the aggregate funded commitments. For the period ended December 31, 1999, the Company funded its 1.96% share, or $6.1 million, of investments made by Trident II in various entities. Fees and expenses of $250,000 were paid in 1999 to MMCI relating to its management of Trident II. Fixed Maturities Contractual maturities of fixed maturity securities at December 31, 1999 are shown below. Expected maturities, which are management's best estimates, will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
(In thousands) December 31, 1999 --------------------------------------- Estimated Fair Amortized Value Cost ---------------- --------------- Available for sale: Due in one year or less $10,210 $10,237 Due after one year through five years 68,182 69,956 Due after five years through 10 years 78,461 82,282 Due after 10 years 76,916 79,446 ---------------- --------------- Sub-total 233,769 241,921 Mortgage and asset-backed securities 27,298 28,424 ---------------- --------------- Total $261,067 $270,345 ================ =============== As of December 31, 1999, the weighted average contractual and expected maturities of the fixed maturity investments, based on fair value, were 12.6 years and 8.1 years, respectively.
F-24 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Investment Information (continued) Proceeds from the sale of fixed maturity securities during 1999, 1998 and 1997 were approximately $270 million, $255 million and $241 million, respectively. Gross gains of $1,522,000, $2,242,000 and $858,000 were realized on those sales during 1999, 1998 and 1997, respectively. Gross losses of $3,298,000, $770,000 and $583,000 were realized during 1999, 1998 and 1997, respectively. Approximately 86% of fixed maturity investments held by the Company at December 31, 1999 were considered investment grade by Standard & Poor's Corporation or Moody's Investors Service, Inc. There are no investments in any entity in excess of 10% of the Company's stockholders' equity at December 31, 1999 other than investments issued or guaranteed by the United States government or its agencies and the Company's investment in Annuity and Life Re. Securities Pledged and on Deposit Securities with a carrying value of approximately $11.1 million have been pledged as collateral for letters of credit obtained in connection with certain reinsurance obligations of the Company (see Note 5). At December 31, 1999, securities with a face amount of $5.8 million were on deposit with the Insurance Department of the State of Nebraska and other states in order to comply with insurance laws. 4. Agreements with Related Parties Investment Advisory Agreements The Company has an investment advisory agreement with MMCI for management of the Company's portfolios of equity securities (including convertible securities) that are publicly traded ("Public Portfolio") and privately held ("Private Portfolio"). The Private Portfolio includes equity securities which at the time of acquisition do not have a readily ascertainable market or are subject to certain trading restrictions. MMCI is also an investment advisor to Trident, a dedicated insurance industry private equity fund organized by MMCI and three other sponsors. MMCI's direct parent, MMRCH, owns 1,395,625 shares, or approximately 8.2% of the outstanding Common Stock, and Class A warrants and Class B warrants to purchase 905,397 and 1,770,601 shares of Common Stock, respectively. At December 31, 1999, Trident owns 250,000 shares, or approximately 1.5%, of the outstanding Common Stock, and Class A warrants to purchase 1,386,079 shares of Common Stock. Effective July 1, 1999, the Company amended its investment advisory agreement with MMCI, which governs the management of the Company's portfolios of equity securities (including convertible securities) that are publicly traded and privately held. Pursuant to the amended agreement, which has a term of four years (subject to renewal), MMCI provides the Company with investment management and advisory services with respect to investments in the Private Portfolio whose value exceeds (i) $10 million during the first year of the term, (ii) $15 million during the second year of the term, and (iii) $20 million during the third and fourth years of the term. Under such amendments, the Company pays MMCI an annual fee equal to (x) 20% (previously 7.5%) of cumulative net realized gains including dividends, interest and other distributions, received on the Private Portfolio over (y) cumulative compensation previously paid in prior years on cumulative net realized gains (as defined in the agreement) on the Private Portfolio managed by MMCI, but the Company will not pay MMCI a management fee (previously 1.5% per annum of the quarterly carrying value of the Private Portfolio). With respect to the management of the Company's Public Portfolio, the Company pays MMCI a fee equal to 0.50% of the first $50 million under MMCI's management and 0.35% of all amounts in excess of $50 million (subject to a minimum fee of $250,000 per annum). F-25 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. Agreements with Related Parties (continued) In connection with the amendments to the Company's agreement with MMCI, RCHI will receive from MMCI $1.25 million per annum during the initial four-year term, subject to certain conditions. The initial agreement provided for a minimum aggregate cash fee to MMCI of $500,000 per annum through December 31, 1997. Fees incurred under the agreements during fiscal years 1999, 1998 and 1997 were approximately $1.5 million, $2.7 million and $1.3 million, respectively. In addition, in 1999, 1998 and 1997, unrealized appreciation in the Private Portfolio is net of accrued fees of approximately $256,000, $2.2 million and $1.4 million, respectively. In May 1999, the Company transferred the management of the fixed income and short term cash portfolios from The Putnam Advisory Company, Inc. ("Putnam") to Alliance Capital. The Company had an investment advisory agreement with Putnam, an affiliate of MMCI, for the management of the Company's fixed income securities and short term cash portfolios through April 1999. For the fixed income securities portfolio, the Company paid to Putnam a fee equal to the sum of 0.35% per annum of the first $50 million of the market value of the portfolio, 0.30% per annum on the next $50.0 million, 0.20% per annum on the next $100 million and 0.15% per annum of the market value of assets that exceeds $200 million. For the short term cash portfolio, the Company paid a fee equal to 0.15% per annum of the total monthly average market value. Fees incurred under the Putnam agreement for the period in 1999, 1998 and 1997 were approximately $173,000, $461,000 and $493,000, respectively. Reinsurance Treaties In addition to business assumed from insurance companies where the Company has a private equity investment as described in Note 3, the Company also assumed premiums written and premiums earned of $5.2 million and $5.3 million, respectively, in 1999, $3.3 million and $3.4 million, respectively, in 1998 and $5.5 million and $2.5 million, respectively, in 1997 from XL, which owned 4,755,000 shares prior to the stock repurchase described in Note 14, or approximately 27.8% of the outstanding Common Stock, and premiums written and premiums earned of $17.4 million and $17.3 million, respectively, in 1999, $18.5 million and $20.7 million, respectively, in 1998 and $12.3 million and $6.8 million, respectively, in 1997 from majority-owned insurance companies of Trident. Other Agreements Commencing in 1996, MMCI subleased office space from the Company for a term expiring in October 2002. Future minimum rental income, exclusive of escalation clauses and maintenance costs, under the remaining term of the sublease will be approximately $1,218,000. Rental income for 1999, 1998 and 1997 was $430,000 in each year. In addition in 1999, 1998 and 1997, MMCI reimbursed the Company approximately $1,000, $11,000 and $530,000 (net of $59,000, $89,000 and $44,000 for certain sublease income allocated to MMCI) for their pro-rata share of improvement and maintenance costs under the sublease. During 1999, the Company committed to invest $25 million as a limited partner in Trident II, a partnership managed by MMCI. See Note 3. F-26 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 5. Commitments Lease Agreement The Company has a sublease agreement for office facilities for a term expiring in October 2002. Future minimum rental charges under the remaining term of the sublease, exclusive of escalation clauses and maintenance costs and net of rental income, are as follows: (In thousands) ---------------------- 2000 $681 2001 716 2002 597 ------------------- $1,994 =================== During 1999, 1998 and 1997, rental expense, net of income from subleases, was approximately $576,000, $576,000 and $643,000, respectively. Letters of Credit At December 31, 1999, the Company is obligated under letters of credit in an aggregate amount of approximately $9.7 million, which secure certain of the Company's reinsurance obligations. Severance Arrangements The Company has a program for all employees that provides for certain severance payments, immediate vesting of restricted stock grants and option awards and continuation of benefits in the event of termination of employment resulting from a change in control. The extent of such payments depends on the position of the employee. See Note 14 - Subsequent Events for information on the agreement entered into by the Company to sell its reinsurance business to Folksamerica, which constitutes a change in control for purposes of the Company's employee benefit plans and agreements. Employment Agreements The Company has employment agreements with its executive officers. One of these agreements has a five-year term initially expiring in September 2000, and the remaining agreements may be terminated upon notice by either party. These agreements provide for compensation in the form of base salary, annual bonus, stock-based awards under the 1995 and 1999 Stock Plans (as hereinafter defined), participation in the Company's employee benefit programs and the reimbursement of certain expenses. Under one of the agreements, the Company guaranteed loans in the amount of $500,000 made to an executive by a financial institution to fund such executive's purchase of 25,000 shares of Common Stock and related tax liability under such stock's vesting provisions. In connection with such guarantee, the Company is entitled to customary subrogation rights. F-27 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. Claims and Claims Expenses The reconciliation of claims and claims expense reserves is as follows:
(In thousands) December 31, 1999 1998 1997 ------------ ------------ ------------ At beginning of year: Gross claims and claims expense reserves $216,657 $70,768 $20,770 Reinsurance recoverables 30,468 522 ------------ ------------ ------------ Net claims and claims expense reserves 186,189 70,768 20,248 Net claims and claims expenses incurred relating to: Current year 275,455 178,957 73,385 Prior year 30,386 (2,832) 22 ------------ ------------ ------------ Total 305,841 176,125 73,407 Net paid claims and claims expenses incurred relating to: Current year 95,367 41,910 13,649 Prior year 88,034 18,794 9,238 ------------ ------------ ------------ Total 183,401 60,704 22,887 At end of year: Net claims and claims expense reserves current year 308,629 186,189 70,768 Reinsurance recoverables 55,925 30,468 - ------------ ------------ ------------ Gross claims and claims expense reserves $364,554 $216,657 $70,768 ============ ============ ============
The Company believes that its exposure, if any, to environmental impairment liability and asbestos-related claims is minimal since no business has been written for periods prior to 1996. Subject to the following, the Company believes that the reserves for claims and claims expenses are adequate to cover the ultimate cost of claims and claims expenses incurred through December 31, 1999. The reserves are based on estimates of claims and claims expenses incurred and, therefore, the amount ultimately paid may be more or less than such estimates. The inherent uncertainties of estimating claims and claims expense reserves are exacerbated for reinsurers by the significant periods of time (the "tail") that often elapse between the occurrence of an insured claim, the reporting of the claim to the primary insurer and, ultimately, to the reinsurer, and the primary insurer's payment of that claim and subsequent indemnification by the reinsurer. As a consequence, actual claims and claims expenses paid may deviate, perhaps materially, from estimates reflected in the Company's reserves reported in its financial statements. The estimation of reserves by new reinsurers, such as the Company, may be less reliable than the reserve estimations of a reinsurer with an established volume of business and claims history. To the extent reserves prove to be inadequate, the Company may have to augment such reserves and incur a charge to earnings. Such a development could occur and result in a material charge to earnings or stockholders equity in future periods. Estimates of prior accident year claims were increased by approximately $30 million in 1999. A substantial portion of this amount resulted from (i) the Company's review of additional claims information and its continuing underwriting and actuarial analysis of the business produced by a certain managing underwriting agency, (ii) notification of additional satellite losses received in 1999 pertaining to 1998, (iii) aviation losses, principally the 1998 Swiss Air crash, and (iv) property losses reported on several international treaties that are in run-off. Estimates of prior accident year claims were reduced by approximately $2.8 million in 1998 primarily due to favorable claim development in the property and multi-line classes of business. F-28 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. Retrocession Agreements The Company utilizes retrocession agreements for the purpose of limiting its exposure with respect to multiple claims arising from a single occurrence or event. The Company also participates in "common account" retrocessional arrangements for certain treaties. Such arrangements reduce the effect of individual or aggregate losses to all companies participating on such treaties including the reinsurer, such as the Company, and the ceding company. Reinsurance recoverables are recorded as assets, predicated on the retrocessionaires' ability to meet their obligations under the retrocessional agreements. If the retrocessionaires are unable to satisfy their obligations under the agreements, the Company would be liable for such defaulted amounts. The effects of reinsurance on written and earned premiums and claims and claims expenses are as follows:
(In thousands) Years Ended December 31, ----------------------------------------------------------- 1999 1998 1997 ---------------- ---------------- ----------------- Assumed premiums written $386,848 $260,566 $147,878 Ceded premiums written 80,122 25,831 3,044 ---------------- ---------------- ----------------- Net premiums written $306,726 $234,735 $144,834 ================ ================ ================= Assumed premiums earned $380,880 $232,025 $110,992 Ceded premiums earned 69,512 25,831 3,620 ---------------- ---------------- ----------------- Net premiums earned $311,368 $206,194 $107,372 ================ ================ ================= Assumed claims and claims expenses incurred $348,979 $210,006 $73,407 Ceded claims and claims expenses incurred 43,138 33,881 ---------------- ---------------- ----------------- Net claims and claims expenses incurred $305,841 $176,125 $73,407 ================ ================ =================
At December 31, 1999, the Company's balance sheet reflects reinsurance recoverable and reinsurance premiums payable balances as follows:
(In thousands) December 31, December 31, 1999 1998 -------------------- -------------------- Reinsurance recoverable balances: Unpaid claims and claim expenses $55,925 $30,468 Paid amounts 6,588 107 Unearned premiums 10,609 -------------------- -------------------- Total $73,122 $30,575 ==================== ==================== Reinsurance premiums payable $14,666 $5,396 ==================== ====================
F-29 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Employee Benefits and Compensation Arrangements 1995 Long Term Incentive and Share Award Plan In September 1995, the Company adopted the 1995 Long Term Incentive and Share Award Plan (the "1995 Stock Plan"), which is administered by the Compensation Committee of the Board of Directors. The Company may grant, subject to certain restrictions, stock options, stock appreciation rights, restricted shares, restricted share units payable in shares of Common Stock or cash, stock awards in lieu of cash awards, and other stock-based awards to eligible employees of the Company. Awards relating to not more than 1,700,000 shares of Common Stock may be made over the five-year term of the 1995 Stock Plan. In April 1999, the Company adopted the 1999 Long Term Incentive and Share Award Plan (the "1999 Stock Plan"). The 1999 Stock Plan, like its predecessor, is intended to provide incentives to attract, retain and motivate employees and Directors in order to achieve the Company's long term growth and profitability objectives. The 1999 Stock Plan provides for the grant to eligible employees and Directors of stock options, stock appreciation rights, restricted shares, restricted share units payable in shares of Common Stock or cash, stock awards in lieu of cash awards, dividend equivalents and other stock based awards. The 1999 Stock Plan also provides the Non-Employee Directors with the opportunity to receive the annual Board retainer fee in shares of Common Stock. An aggregate of 900,000 shares of Common Stock has been reserved for issuance under the 1999 Stock Plan (of which no more than 300,000 of such shares may be issued pursuant to grants of restricted shares, restricted share units, performance shares and performance units), subject to anti-dilution adjustments in the event of certain changes in the Company's capital structure. Shares issued pursuant to the 1999 Stock Plan will be either authorized but unissued shares or treasury shares. Restricted Stock During 1999, 1998 and 1997, the Company granted an aggregate of 2,500, 15,700, 24,000 shares, respectively, of restricted stock under the 1995 Stock Plan. Grants of restricted stock generally vest at a rate of 20% per year over five years commencing on the first anniversary of the date of grant. The Company records a deferred expense equal to the market value of the shares at the date of grant which is amortized and charged to income over the vesting period. The deferred expense was ($117,000), $296,000 and $506,000, and the amortization of the deferred expense was $628,000, $1,012,000, and $1,687,000, for 1999, 1998 and 1997, respectively. Upon the closing of the sale of the Company's reinsurance business to Folksamerica, all unvested restricted stock and all unvested stock options will immediately become vested. See Note 14 - Subsequent Events. F-30 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Employee Benefits and Compensation Arrangements (continued) Stock Options The Company issues incentive stock options and/or non-qualified stock options at fair market values at the grant dates to officers and non-employee Directors. Options to officers generally vest and become exercisable at a rate of 20% per year over five years from the date of grant. Incentive stock options expire ten years after the grant date and non-qualified stock options expire seven years after vesting. Initial options granted to non-employee Directors vest and become exercisable in three equal installments, commencing on the date of grant and annually thereafter. Annual options granted to non-employee Directors in office on January 1 of each year vest on the first anniversary of the date the option is granted. Upon the closing of the sale of the Company's reinsurance business to Folksamerica, all unvested restricted stock and all unvested stock options will immediately become vested. See Note 14 - Subsequent Events. Information relating to the Company's stock options is set forth below:
Years Ended December 31, --------------------------------------------------------- 1999 1998 1997 ---------------- ---------------- ---------------- Number of options Outstanding, beginning of year 1,347,075 960,650 628,950 Granted 18,800 410,825 371,700 Canceled (84,519) (20,580) (39,500) Exercised - (3,820) (500) Outstanding, end of year 1,281,356 1,347,075 960,650 Exercisable, end of year 683,388 358,884 178,611 Average exercise price Granted $17.25 $22.47 $22.86 Canceled $21.81 $20.97 $17.63 Exercised - $19.24 $17.63 Outstanding, end of year $20.90 $21.00 $20.38 Exercisable, end of year $20.45 $19.85 $19.32
Exercise prices for options outstanding at December 31, 1999 ranged from $12.94 to $24.94. The weighted average remaining contractual life of these options is approximately 7.3 years. Employee Stock Purchase Plan Effective December 1, 1995, the Company established a tax-qualified employee stock purchase plan (the "Purchase Plan"). An aggregate of 120,000 shares of Common Stock have been reserved for issuance under the Purchase Plan. Eligible employees may elect to participate in an annual offering period under the Purchase Plan by authorizing after-tax payroll deductions of up to 20% (in whole percentages) of their eligible compensation for the purchase of shares of Common Stock at 85% of the lesser of the market value per share of the Common Stock at the beginning or end of the annual offering period, subject to certain restrictions. During 1999, 1998 and 1997, employees purchased approximately 8,509, 18,638 and 14,100 shares, respectively, of Common Stock under the Purchase Plan. F-31 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Employee Benefits and Compensation Arrangements (continued) Pro Forma Information Pro forma information regarding net income and earnings per share is required by FASB Statement No. 123. Such information has been determined for the Company as if the Company has accounted for its employee stock options under the fair value method of this Statement. The fair value for the Company's employee stock options has been estimated at the date of grant using a Black-Scholes option valuation model, with the following weighted-average assumptions for options issued in 1999, 1998 and 1997, respectively: (i) dividend yield: 0.0%; (ii) volatility factor: 25.0%; (iii) average expected option life of six years for all years; and (iv) risk free interest rates of 6.5%, 4.9%, and 5.8% respectively. The weighted-average fair value of options granted for the years ended December 31, 1999, 1998 and 1997 was $123,000, $3.3 million and $3.2 million, respectively. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models, such as the Black-Scholes model, require the input of highly subjective assumptions (particularly with respect to the Company, which has a limited stock-trading history), including expected stock price volatility. As the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, the Company believes that the existing option valuation models, such as the Black-Scholes model, may not necessarily provide a reliable single measure of the fair value of employee stock options. For purposes of the required pro forma information, the estimated fair value of employee stock options is amortized to expense over the options' vesting period. The Company's pro forma information regarding net income and earnings per share follows:
(In thousands, except per share data) Years Ended December 31, 1999 1998 1997 ---------------- ---------------- ---------------- Net income (loss), as reported ($32,436) $3,091 $2,039 Pro forma net income (loss) ($34,094) $1,633 $994 Earnings (loss) per share as reported: Basic ($1.90) $0.18 $0.12 Diluted ($1.90) $0.17 $0.12 Pro forma earnings (loss) per share: Basic ($2.00) $0.10 $0.06 Diluted ($2.00) $0.09 $0.06
The effects of applying FASB 123 as shown in the pro forma disclosures may not be representative of the effects on reported net income for future years. The effect on net income and earnings per share after applying FASB Statement No. 123's fair valuation method to stock issued to employees under the Purchase Plan does not materially differ from the pro forma information set forth above with respect to the Company's employee stock options. F-32 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Employee Benefits and Compensation Arrangements (continued) Retirement Plans Effective as of January 1, 1996, the Company adopted a tax-qualified, non-contributory defined contribution money purchase pension plan (the "Pension Plan") under which the Company contributes for each eligible employee an amount equal to the sum of (i) 5% in 1999 and 4% in 1998 and 1997 of eligible compensation up to the taxable wage base (as such term is defined in the Pension Plan; for 1999, 1998 and 1997, amounts were set at $72,600, $68,400 and $65,400, respectively) and (ii) 10% in 1999 and 8% in 1998 and 1997 of eligible compensation in excess of the taxable wage base (up to the applicable compensation limit (the "compensation limit") imposed by Section 401(a)(17) of the Internal Revenue Code of 1986, as amended (the "Code"), which for 1999, 1998 and 1997 was $160,000. Substantially all employees of the Company are eligible for participation in the Pension Plan. In 1999, 1998 and 1997, the Company expensed $344,000, $215,000 and $168,000, respectively, related to the Pension Plan. Effective as of January 1, 1996, the Company adopted a tax-qualified, employee savings plan (the "Savings Plan"). Pursuant to Section 401(k) of the Code, eligible employees of the Company are able to make deferral contributions of up to 15% of their eligible compensation, subject to limitations under applicable law. The Company matches 100% of the first 3% of eligible compensation deferred by employees and 50% of the next 3% of eligible compensation so deferred. Substantially all employees of the Company are eligible for participation in the Savings Plan. In 1999, 1998 and 1997, the Company expensed $192,000, $165,000 and $123,000, respectively, related to the Savings Plan. Effective as of January 1, 1996, the Company adopted a supplemental, non-qualified executive savings and retirement plan (the "Supplemental Plan") under which the Company contributes 10% of eligible compensation in excess of the compensation limit for eligible officers of the Company. Participants may also defer certain amounts of eligible base compensation and bonus. Under the Supplemental Plan, the Company matches 100% of the first 3% of eligible base compensation in excess of the compensation limit that is deferred by participants under the Supplemental Plan, and provides a 50% matching contribution for the next 3% of such excess eligible compensation so deferred. In 1999, 1998 and 1997, the Company expensed $96,000, $85,000 and $74,000, respectively, related to the Supplemental Plan. 9. Income Taxes RCHI, Risk Capital Reinsurance and Cross River file a consolidated federal income tax return and have a tax sharing agreement (the "Tax Sharing Agreement"), allocating the consolidated income tax liability on a separate return basis. Pursuant to the Tax Sharing Agreement, Risk Capital Reinsurance and Cross River make tax sharing payments to RCHI based on such allocation. The provision for federal income taxes has been determined on the basis of a consolidated tax return consisting of RCHI, Risk Capital Reinsurance and Cross River. F-33 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. Income Taxes (continued) An analysis of the Company's effective tax rate for the years ended December 31, 1999, 1998 and 1997 is as follows:
(In thousands) Years Ended December 31, 1999 1998 1997 --------------- ------------ -------------- Income tax (benefit) computed on pre-tax income ($18,281) $1,562 $663 Reduction/increase in income tax (benefit) resulting from: Tax-exempt investment income (733) (582) (524) Dividend received deduction (958) (896) (650) Restricted stock 140 Other 275 151 173 --------------- ------------ -------------- Income tax expense (benefit) on pre-tax income ($19,557) $235 ($338) =============== ============ ==============
The Company's current federal tax expense (benefit) for 1999, 1998 and 1997 was based on regular taxable income. Actual federal income taxes paid in 1999, 1998 and 1997 were $1.9 million, $5.3 million and $1.4 million, respectively. The amount paid in 1999 was the final installment related to the 1998 tax return. The net deferred income tax asset reflects temporary differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes, net of a valuation allowance for any portion of the deferred tax asset that management believes will not be realized. Significant components of the Company's deferred income tax assets and liabilities as of December 31, 1999 and 1998 were:
(In thousands) December 31, 1999 1998 ---------------- ----------------- Deferred income tax assets: Net claim reserve discount $15,639 $10,176 Net operating loss 7,334 Net unearned premium reserve 6,573 7,194 Compensation liabilities 372 622 Equity in net loss of investees, net 7 2,328 Other 165 56 ---------------- ----------------- Total deferred tax assets 30,090 20,376 ---------------- ----------------- Deferred income tax liabilities: Deferred policy acquisition cost (8,255) (8,230) Unrealized appreciation of investments (14,001) (25,328) ---------------- ----------------- Total deferred tax liabilities (22,256) (33,558) ---------------- ---------------- Net deferred income tax asset (liability) $7,834 ($13,182) ================ =================
The net deferred income tax asset at December 31, 1999 was $7.8 million. The Company periodically evaluates the need for a valuation allowance for any portion of the deferred tax asset that management believes will not be realized based on current and future operating performance and available tax planning strategies. While the Company believes that a valuation allowance is not necessary at December 31, 1999, continued future comprehensive losses or future decisions with respect to business strategy following the sale of the Company's reinsurance business may result in the establishment of a valuation allowance in future financial statements. F-34 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. Income Taxes (continued) The Company has a net operating loss carryforward which expires in 2019, for which it has established a deferred income tax asset of $7.3 million at December 31, 1999. The repurchase of the Company's Common Stock held by XL resulted in a 27.8% change in ownership by 5% shareholders. If, in the ensuing three years, there is more than 22.2% additional change in ownership by 5% shareholders, an "ownership change" will have taken place for federal income tax purposes. If such ownership change occurs, the amount of loss carryforwards that can be used in any subsequent year may be severely limited and could be eliminated in certain circumstances. 10. Statutory Information The Insurance Department of the State of Nebraska issued to Risk Capital Reinsurance its domiciliary insurance license on November 6, 1995. Statutory net income and surplus of Risk Capital Reinsurance, as reported to insurance regulatory authorities, differ in certain respects from the amounts prepared in accordance with GAAP. The following tables reconcile statutory net loss and surplus of Risk Capital Reinsurance to consolidated GAAP net income (loss) and stockholders' equity:
(In thousands) Years Ended December 31, 1999 1998 1997 ---------------- ---------------- ----------------- Net Income (Loss): Risk Capital Reinsurance Statutory net loss ($44,561) ($11,973) ($5,649) GAAP adjustments: Privately held investments 1,179 2,623 (4,601) Deferred acquisition costs 70 6,223 10,273 Deferred income taxes 10,536 7,277 2,099 Equity in net income (loss) of investees 621 (1,136) (192) Cumulative effect of accounting change (370) -------------- --------------- ---------------- GAAP net income (loss) (32,525) 3,014 1,930 RCHI (parent company only) operations 89 77 109 -------------- --------------- ---------------- Consolidated GAAP net income (loss) ($32,436) $3,091 $2,039 ============== =============== ================
(In thousands) December 31, 1999 1998 --------------- -------------- Stockholders' Equity: Statutory surplus $290,082 $358,702 Deferred acquisition costs 23,585 23,515 Unrealized appreciation (depreciation) (6,320) 298 Deferred income tax asset (liability), net 7,818 (13,164) Privately held investments--non-admitted assets 13,695 11,080 Other non-admitted assets 3,693 4,190 Other 244 500 --------------- -------------- Investment in Risk Capital Reinsurance, GAAP 332,797 385,121 RCHI (parent company only): Other net assets 13,717 12,881 --------------- -------------- Consolidated stockholders' equity, GAAP $346,514 $398,002 =============== ==============
F-35 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. Statutory Information (continued) RCHI is a holding company and has no significant operations or assets other than its ownership of all of the capital stock of Risk Capital Reinsurance. RCHI will rely on cash dividends and distributions from Risk Capital Reinsurance to pay any cash dividends to, or repurchase any shares from, stockholders of RCHI and to pay any operating expenses that RCHI may incur. The payment of dividends or the repurchase of shares by RCHI will be dependent upon the ability of Risk Capital Reinsurance to provide funds to RCHI. The ability of Risk Capital Reinsurance to pay dividends or make distributions to RCHI is dependent upon Risk Capital Reinsurance's ability to achieve satisfactory underwriting and investment results and to meet certain regulatory standards of the State of Nebraska. There are presently no contractual restrictions on the payment of dividends or the making of distributions by Risk Capital Reinsurance to RCHI. Nebraska insurance laws provide that, without prior approval of the Nebraska Director of Insurance ("Nebraska Director"), Risk Capital Reinsurance cannot pay a dividend or make a distribution (together with other dividends or distributions paid during the preceding 12 months) that exceeds the greater of (i) 10% of statutory surplus as of the preceding December 31 ($290.1 million as of December 31, 1999) or (ii) statutory net income from operations from the preceding calendar year not including after tax realized capital gains ($54.3 million loss for 1999). Net income (exclusive of realized capital gains) not previously distributed or paid as dividends from the preceding two calendar years may be carried forward for dividend and distribution purposes. Any proposed dividend or distribution in excess of such amount is called an "extraordinary" dividend or distribution and may not be paid until either it has been approved, or a 30-day waiting period has passed during which it has not been disapproved, by the Nebraska Director. Notwithstanding the foregoing, Nebraska insurance laws provide that any distribution that is a dividend may only be paid out of earned surplus arising from its business, which is defined as unassigned funds (surplus) as reported in the statutory statement for the most recent years, including any surplus arising from unrealized capital gains or revaluations of assets ($38 million deficit as of December 31, 1999). Any distribution that is a dividend and that is in excess of Risk Capital Reinsurance's unassigned funds, exclusive of any surplus arising from unrealized capital gains or revaluation of assets ($78.5 million deficit as of December 31, 1999), will be deemed an "extraordinary" dividend subject to the foregoing requirements. Therefore, Risk Capital Reinsurance cannot make a distribution that is a dividend without the prior approval of the Nebraska Director during 2000. Nebraska insurance laws also require that the statutory surplus of Risk Capital Reinsurance following any dividend or distribution be reasonable in relation to its outstanding liabilities and adequate to its financial needs. In addition, Nebraska insurance laws require that each insurer give notice to the Nebraska Director of all dividends and other distributions within five business days following declaration thereof and that any such dividend or other distribution may not be paid within 10 business days of such notice (the "Notice Period") unless for good cause shown the Nebraska Director has approved such payment within the Notice Period. See Note 14 - Subsequent Events for information on distributions from Risk Capital Reinsurance to RCHI which will reduce the GAAP book value and the statutory surplus of Risk Capital Reinsurance. In light of such distributions, and as required by the above statutory provisions, Risk Capital Reinsurance may not declare any other distribution for a period of 12 months following the stock repurchase described in Note 14 unless such subsequent distribution is approved by the Nebraska Department. F-36 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. Business Information As discussed in Note 2, the Company provides property casualty reinsurance to insurance and reinsurance companies and other forms of capital and makes investments in insurance and insurance-related entities on a global basis. The Company operates from one domestic location in Greenwich, Connecticut. During 1999, one client contributed $42.1 million, or 13.7%, of net premiums written and $33.8 million, or 13.5%, of net premiums earned, and a second client contributed $39.2 million, or 12.8%, of net premiums written and $43.7, or 14%, of net premiums earned. For 1998, that second client company contributed approximately $42 million, or 18%, of net premiums written and $36.6 million, or 17.8%, of net premiums earned. For 1997, such client company contributed $25.9 million, or 18%, of net premiums written, and $15.1 million, or 14%, of net premiums earned. The following lists individual broker business greater than 10% of the 1999 year's net premiums written with comparative amounts for the years ended 1998 and 1997, respectively:
Net Premiums Written 1999 1998 1997 ------------------- --------------------- --------------------- Balis & Co., Inc. (1) 15.0% 23.7% 22.7% Guy Carpenter & Co. (1) 10.7% 11.3% 11.0% Aon Group 17.4% 16.5% 19.1% ------------------ -------------------- -------------------- Total 43.1% 51.5% 52.8% ================== ==================== ====================
(1) In addition, approximately 7.4%, 8.2%, and 13.6% of net premiums written in 1999, 1998 and 1997, respectively, were produced by other brokers who are affiliated with Marsh & McLennan Companies, Inc. Net premiums written and earned recorded from client companies which are Lloyd's syndicates or are located in the United Kingdom, Bermuda and Continental Europe (some which are denominated in United States dollars) were:
1999 1998 1997 ---------------------------- --------------------------- --------------------------- Net Premiums Net Premiums Net Premiums Written Earned Written Earned Written Earned ------------- ------------ ------------- ----------- ------------ ----------- Non U.S. Premiums $46.9 $58.0 $76.1 $65.9 $40.1 $25.8 % of Total 15.3% 18.6% 32.4% 32.0% 27.7% 24.0%
F-37 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. Earnings Per Share The following table sets forth the computation of basic and diluted earnings per share:
(In thousands, except share data) Years Ended December 31, 1999 1998 1997 ----------------- --------------- ---------------- Basic Earnings Per Share: Net income (loss) ($32,436) $3,091 $2,039 Divided by: Weighted average shares outstanding for the period 17,086,732 17,065,165 17,032,601 ================ ============== =============== Basic earnings (loss) per share ($1.90) $0.18 $0.12 ================ ============== =============== Diluted Earnings Per Share: Net income (loss) ($32,436) $3,091 $2,039 Divided by: Weighted average shares outstanding for the period 17,086,732 17,065,165 17,032,601 Effect of dilutive securities: Warrants 581,327 24,836 Employee stock options 76 71,731 28,351 ---------------- -------------- --------------- Total shares 17,086,808 17,718,223 17,085,788 ================ ============== =============== Diluted earnings (loss) per share ($1.90) $0.17 $0.12 ================ ============== ===============
Certain employee stock options to purchase 1,273,856, 22,750, and 448,250 shares of Common Stock at per share prices averaging $20.93, $23.61 and $22.62 were outstanding as of December 31, 1999, 1998, and 1997, respectively. These options were not included in the computation of diluted earnings per share because the options' average exercise prices were greater than the average market prices of the Common Stock of $15.40, $23.00 and $20.11 for the years ended December 31, 1999, 1998 and 1997. In addition, warrants to purchase 4,451,680 shares of Common Stock at $20 per share were outstanding as of December 31, 1999, 1998 and 1997 but were not included in the computation of diluted earnings per share for the year ended December 31, 1999 because the warrants' exercise price of $20.00 per share was greater than the average market price of the Common Stock for such year. See Note 14 - Subsequent Events. F-38 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 13. Quarterly Financial Information The following is a summary of unaudited quarterly financial data, restated where applicable, to conform to FASB Statement No. 128:
(In thousands, except per share data) Quarter Quarter Quarter Quarter Ended Ended Ended Ended December 31, September 30, June 30, March 31, 1999 1999 1999 1999 ------------------- ------------------- --------------- --------------- Income Statement Data: Net premiums written $74,023 $76,749 $91,517 $64,437 Net premiums earned 80,995 80,463 86,988 62,922 Net investment income 4,908 5,965 4,817 4,483 Net realized investment gains (losses) (10,243) 5,236 23,386 (1,152) Operating expenses 106,468 98,583 91,629 104,319 Equity in net income (loss) of 188 400 196 (163) investees Net income (loss) (19,591) (3,737) 15,883 (24,991) Comprehensive income (loss) ($15,021) ($10,494) $8,720 ($35,491) Statutory Combined Ratio: 132.6% 120.4% 106.3% 167.0% Per Share Data: Net income (loss) Basic ($1.15) ($0.22) $0.93 ($1.46) Diluted ($1.15) ($0.22) $0.93 ($1.46) Comprehensive income (loss) Basic ($0.88) ($0.61) $0.51 ($2.08) Diluted ($0.88) ($0.61) $0.51 ($2.08) Stockholders' equity per share Basic $20.28 $21.15 $21.75 $21.23 Diluted $20.28 $21.15 $21.75 $21.23 Common Stock Prices: High $15.69 $16.00 $17.38 $22.63 Low $11.00 $13.00 $13.50 $12.00 Close $12.63 $15.63 $13.50 $15.13
F-39 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 13. Quarterly Financial Information (continued)
(In thousands, except per share data) Quarter Quarter Quarter Quarter Ended Ended Ended Ended December 31, September 30, June 30, March 31, 1998 1998 1998 1998 ----------------- ------------------ ---------------- ---------------- Income Statement Data: Net premiums written $71,163 $66,628 $52,536 $44,408 Net premiums earned 63,545 52,670 48,477 41,502 Net investment income 3,757 3,995 4,331 3,604 Net realized investment gains (losses) 25,606 (425) 2,870 477 Operating expenses 80,808 (65,334) 51,756 44,773 Equity in net income (loss) of investees (1,103) (1,046) 257 756 Net income (loss) 4,994 (6,631) 3,159 1,569 Comprehensive income (loss) $2,350 ($20,622) ($2,871) $16,768 Statutory Combined Ratio: 124.4% 123.8% 107.8% 105.9% Per Share Data: Net income (loss) Basic $0.29 ($0.39) $0.19 $0.09 Diluted $0.29 ($0.39) $0.18 $0.09 Comprehensive income (loss) Basic $0.14 ($1.21) ($0.17) $0.98 Diluted $0.14 ($1.21) ($0.17) $0.95 Stockholders' equity per share Basic $23.29 $23.15 $24.35 $24.50 Diluted $22.75 $22.54 $23.01 $23.36 Common Stock Prices: High $23.75 $25.50 $25.50 $24.00 Low $18.81 $19.00 $22.75 $19.75 Close $21.75 $22.00 $24.94 $24.00
F-40 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 14. Subsequent Events Folksamerica Transaction On January 18, 2000, the Company entered into an agreement with Folksamerica Reinsurance Company ("Folksamerica") pursuant to which Folksamerica will acquire substantially all of the reinsurance operations of the Company's wholly owned subsidiary Risk Capital Reinsurance, for a cash purchase price equal to the GAAP book value of the assets and liabilities to be transferred to Folksamerica plus $20.335 million, payable at closing. Under the terms of the agreement, the Company will place $20 million in escrow for a period of five years. These funds will be primarily used to reimburse Folksamerica to the extent that the loss reserves relating to business produced on behalf of Risk Capital Reinsurance by CPI, a managing underwriting agency, are deficient as measured at the end of such five-year period. Such reserves were $38.7 million at December 31, 1999. To the extent that such loss reserves are redundant, all of the escrowed funds will be returned to the Company and Folksamerica will pay the Company an amount equal to such redundancy. Amounts in the escrow may also be released to Folksamerica to satisfy its indemnification claims against the Company relating to undisclosed liabilities, the Company's reinsurance and retrocession treaties, and CPI and the business produced by it. The Company will be responsible for certain tax costs incurred by Folksamerica in the transaction, as well as its own transaction and severance costs, and certain reinsurance costs incurred for the benefit of Folksamerica. An additional amount of up to $5 million may be placed in escrow for a period of five years to the extent that the Company's reserves at closing are less by at least a specified amount than those estimated by Risk Capital Reinsurance's independent actuaries. In connection with either escrow arrangement, the Company will record a loss amount equal to any probable deficiency in the related reserves that may become known during or at the end of the five year period. The sale of the Company's reinsurance business to Folksamerica is contingent on obtaining applicable regulatory approvals, approval by the Company's stockholders, expiration of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act, the retention of a key employee, obtaining certain third party consents, the absence of a material adverse change in Risk Capital Reinsurance's business, and other customary closing conditions. MMRCH and Trident, which collectively represent approximately 13.3% of the 12,329,494 outstanding voting shares of RCHI on March 2, 2000, have agreed to vote in favor of the transaction. XL gave Folksamerica a similar proxy, but that proxy terminated upon the consummation of the repurchase of XL's interest in RCHI described below. F-41 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 14. Subsequent Events (continued) The GAAP book value of the assets and liabilities to be transferred to Folksamerica recorded in the accompanying financial statements at December 31, 1999 are as follows: (In millions) Fixed maturities and short-term investments $245.6 Premiums receivable 119.3 Reinsurance recoverable 73.1 Deferred policy acquisition costs 23.6 Deferred income tax asset 13.9 Other insurance assets 37.0 ----------------- Total Assets $512.5 ----------------- Reserve for claims and claims expenses $364.6 Net unearned premium reserve 108.7 Reinsurance premium 14.7 Other insurance liabilities 24.5 ----------------- Total Liabilities $512.5 ----------------- Net book value of assets and liabilities to be transferred - ================= The actual GAAP book value of the assets and liabilities transferred to Folksamerica will be determined as of the closing date of the asset sale, and will differ from that set forth above. At the closing of the asset sale, Risk Capital Reinsurance and Folksamerica will enter into a transfer and assumption agreement, under which Folksamerica will assume Risk Capital Reinsurance's rights and obligations under the reinsurance agreements being transferred in the asset sale. Following regulatory approval of the agreement, the reinsureds under such agreements will be notified that Folksamerica has assumed Risk Capital Reinsurance's obligations and that, unless the reinsureds object to the assumption, Risk Capital Reinsurance will be released from its obligations to those reinsureds. Assuming that none of the reinsureds object to the assumption, the gross liabilities for such business will be removed from the accounts of Risk Capital Reinsurance for statutory accounting and GAAP accounting purposes. Risk Capital Reinsurance will continue to record gross liabilities in its accounts for reinsureds that object to the release of Risk Capital Reinsurance from its obligations to such reinsureds. In such instances, an offsetting accounts receivable amount from Folksamerica would be recorded as an asset equal to such gross liabilities. This would also result in a portion of any pre-tax gain on the transaction being deferred and amortized into income as the gross liabilities are extinguished. F-42 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 14. Subsequent Events (continued) XL Transaction On March 2, 2000, RCHI repurchased from XL all of the 4,755,000 shares of Common Stock held by XL constituting in the aggregate 27.8% and 20.8% of its Common Stock on a basic basis and diluted basis (assuming all dilutive securities are vested, exercised and converted into common stock, which consist of 4,451,680 warrants exercisable at $20.00 per share and 1,281,356 stock options exercisable at an average price of $20.90 per share), respectively. Under the terms of the stock repurchase agreement with XL, RCHI paid to XL a purchase price of $12.45 per share, for a total of $59.2 million. The per share repurchase price was determined as the lesser of (i) 85% of the average closing market price of the Common Stock during the twenty-day trading period beginning January 21, 2000, which was $14.65, and (ii) $15.00. The consideration paid to XL for the repurchase consisted of (i) its interest in privately held LARC Holdings, Ltd. (parent of Latin American Reinsurance Company), valued at $25 million (which interest was carried by the Company at $24 million at December 31, 1999), and (ii) all of the shares and warrants held by RCHI in Annuity and Life Re (Holdings), Ltd., valued at $25.38 per share and $18.50 per warrant, or $37.8 million in the aggregate (which interest was carried by the Company at $38.2 million at December 31, 1999). XL paid RCHI in cash the $3.6 million difference between the repurchase price and the value of its interests in LARC Holdings and Annuity and Life Re. The value per share of Annuity and Life Re was determined by taking the average of the closing prices of Annuity and Life Re shares for the same twenty-day period used in determining the repurchase price of RCHI's shares. As a result of the repurchase, stockholder's equity of RCHI, which was $346.5 million at December 31, 1999, has been reduced by $59.4 million to 287.1 million, and outstanding voting shares, which were 17,087,970 at December 31, 1999, have been reduced to 12,332,970. Risk Capital Reinsurance's stockholder's equity and statutory surplus, which were $332.8 million and $290.1 million, respectively, at December 31, 1999 were reduced by $62 million and $60 million, respectively, following the distribution of the shares and warrants in LARC Holdings, Ltd. and Annuity and Life Re (Holdings), Ltd. to RCHI based on their GAAP and statutory carrying values, respectively, at December 31, 1999. Risk Capital Reinsurance Distribution Upon payment of a contemplated distribution from Risk Capital Reinsurance to the Company that would occur after the transfer of Risk Capital Reinsurance's reinsurance-related assets and liabilities to Folksamerica (which distribution is subject to regulatory approval), the assets of the Company would consist of fixed maturity and short term investments, publicly traded equity securities, and privately held securities and the Company's remaining $19 million investment commitment to Trident II would remain in place. The Company would also continue to own all of the outstanding capital stock of Risk Capital Reinsurance and Cross River, each anticipated to have statutory surplus of approximately $20 million or any greater amount the Nebraska Insurance Department requires them to retain in light of any objections from reinsureds under the transferred reinsurance agreements. F-43 Report of Independent Accountants on Financial Statement Schedules To the Board of Directors and Stockholders of Risk Capital Holdings, Inc. Our audit of the consolidated financial statements referred to in our report dated February 1, 2000, except as to Note 14, which is as of March 2, 2000 appearing on Page F-2 of this Annual Report on Form 10-K also included an audit of the financial statement schedules listed on Page F-1. In our opinion, these financial statement schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ PricewaterhouseCoopers, LLP New York, New York February 1, 2000, except as to Note 14, which is as of March 2, 2000 S-1 SCHEDULE I RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES
SUMMARY OF INVESTMENTS OTHER THAN INVESTMENTS IN RELATED PARTIES (In thousands) December 31, 1999 -------------------------------------------------------- Amount at Which Shown in Amortized Fair the Balance Cost Value Sheet -------------- ----------------- ---------------- Type of Investment: FIXED MATURITY SECURITIES U.S. government and government agencies And authorities $42,765 $41,095 $41,095 Foreign governments 3,691 3,591 3,591 Mortgage and asset-backed securities 28,424 27,298 27,298 States, municipalities and political subdivisions 52,417 52,245 52,245 Corporate bonds 143,048 136,838 136,838 -------------- ----------------- ---------------- Total Fixed Maturities 270,345 261,067 261,067 EQUITY SECURITIES Publicly traded 105,747 158,631 158,631 Privately held 85,748 83,969 83,969 -------------- ----------------- ---------------- Total Equity Securities 191,495 242,600 242,600 SHORT-TERM INVESTMENTS 72,785 72,785 72,785 -------------- ----------------- ---------------- Total Investments $534,625 $576,452 $576,452 ============== ================= ================
S-2 SCHEDULE II
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEET (Parent Company Only) (Dollars in thousands) December 31, ----------------------------------- 1999 1998 --------------- --------------- Assets Investment in wholly owned subsidiary $332,797 $385,121 Fixed maturities (amortized cost: 1999, $6,002; 1998, $8,007) 5,974 8,057 Short-term investments 3,252 1,149 Cash 4,313 3,415 Other assets 271 411 ---------------- --------------- Total Assets $346,607 $398,153 ================ =============== Liabilities Accounts payable and other liabilities 93 151 Stockholders' Equity Preferred stock, $0.01 par value: 20,000,000 shares authorized (none issued) Common stock, $0.01 par value: 80,000,000 shares authorized (issued: 1999, 17,109,736; 1998, 17,102,503) 171 171 Additional paid-in capital 342,034 341,878 Accumulated other comprehensive income consisting of unrealized appreciation of investments, net of income tax 27,188 47,038 Deferred compensation under stock award plan (317) (1,062) Retained earnings (deficit) (22,175) 10,261 Less treasury stock at cost (1999, 21,766; 1998, 15,065) (387) (284) Total Stockholders' Equity 346,514 398,002 ---------------- --------------- Total Liabilities and Stockholders' Equity $346,607 $398,153 ================ ===============
S-3 SCHEDULE II
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT (continued) Statement of Income (Parent Company Only) (Dollars In thousands) Years Ended December 31, 1999 1998 1997 -------------- ------------ -------------- Revenues Net investment income $641 $631 $524 Operating Costs and Expenses Operating expenses 485 513 357 -------------- ------------ -------------- Income before income tax expense 156 118 167 Income tax expense 55 41 58 -------------- ------------ -------------- Net income before equity in net income (loss) of wholly owned subsidiary and cumulative effect of accounting change 101 77 109 Equity in net income (loss) of wholly owned subsidiary (32,525) 3,014 1,930 Cumulative effect of accounting change (12) -------------- ------------ -------------- Net income (loss) (32,436) 3,091 2,039 Other Comprehensive Income (Loss), Net of Tax Change in net unrealized depreciation, of investments, net of tax (51) 12 21 -------------- ------------ -------------- Comprehensive Income (Loss) ($32,487) $3,103 $2,060 ============== ============ ==============
S-4 SCHEDULE II
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES CONDENSED FINANCIAL INFORMATION OF REGISTRANT (continued) Statement of Cash Flows (Parent Company Only) (In thousands) Years Ended December 31, 1999 1998 1997 ------------ ------------ ------------ Operating Activities Net income from operations $89 $77 $109 Adjustments to reconcile net income to net cash Used for operating activities: Net change in other assets and liabilities 137 225 (650) ------------ ------------ ------------ Net Cash Provided By (Used For) Operating Activities 226 302 (541) Investing Activities: Purchases of fixed maturities (3,000) (4,999) (11,014) Sales of fixed maturities 5,000 4,000 4,000 Net change in short-term investments (2,036) 1,005 4,697 ------------ ------------ ------------ Net Cash Provided By (Used For) Investing Activities (36) 6 (2,317) Financing Provided By Activities: Common stock issued 156 716 727 Purchase of treasury shares (103) (86) (197) Common stock issued to Directors (90) Deferred compensation on restricted stock awarded 117 (296) (506) Amortization of deferred compensation collected 628 1,302 3,367 ------------ ------------ ------------ Net Cash Provided By Financing Activities 708 1,636 3,391 Increase in cash 898 1,944 533 Cash at beginning of period 3,415 1,471 938 ------------ ------------ ------------ Cash at end of period $4,313 $3,415 $1,471 ============ ============ ============
S-5 SCHEDULE SCHEDULE III
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION (In thousands) Future Policy Benefits, Deferred Losses, Policy Claims and Net Acquisition Claims Unearned Premium Investment Costs Expenses Premiums Revenue Income -------------- -------------- -------------- -------------- -------------- December 31, 1999 Property-Casualty $23,585 $277,271 $98,133 $261,029 $20,173 Accident and Health 31,358 50,339 -------------- -------------- -------------- -------------- -------------- Total $23,585 $308,629 $98,133 $311,368 $20,173 ============== ============== ============== ============== ============== December 31, 1998 Property-Casualty $23,515 $186,189 $102,775 $206,194 $15,687 Accident and Health -------------- -------------- -------------- -------------- -------------- Total $23,515 $186,189 $102,775 $206,194 $15,687 ============== ============== ============== ============== ============== December 31, 1997 Property-Casualty $17,292 $70,768 $74,234 $107,372 $14,360 Accident and Health -------------- -------------- -------------- -------------- -------------- Total $17,292 $70,768 $74,234 $107,372 $14,360 ============== ============== ============== ============== ============== S-6 RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION (In thousands) Benefits, Amortization Claims, of Deferred Losses and Policy Other Settlement Acquisition Operating Premiums Expenses Costs Expenses Written -------------- ---------------- -------------- -------------- December 31, 1999 Property-Casualty $267,622 $64,279 $14,816 $256,388 Accident and Health 38,219 16,261 50,338 -------------- ---------------- -------------- -------------- Total $305,841 $80,540 $14,816 $306,726 ============== ================ ============== ============== December 31, 1998 Property-Casualty $176,125 $50,537 $16,452 $234,735 Accident and Health -------------- ---------------- -------------- -------------- Total $176,125 $50,537 $16,452 $234,735 ============== ================ ============== ============== December 31, 1997 Property-Casualty $73,407 $31,467 $13,523 $144,834 Accident and Health -------------- ---------------- -------------- -------------- Total $73,407 $31,467 $13,523 $144,834 ============== ================ ============== ==============
SCHEDULE IV
RISK CAPITAL HOLDINGS, INC. AND SUBSIDIARIES REINSURANCE (In thousands) Assumed Percentage Ceded to From of Amount Gross Other Others Net Assumed to Amount Companies Companies Amount Net ----------- -------------- -------------- -------------- ---------------- December 31, 1999 Premiums Written: Property and Casualty $80,122 $336,510 $256,388 131.3% Accident and Health 50,338 50,338 100.0% ----------- -------------- -------------- -------------- ---------------- Total $80,122 $386,848 $306,726 126.1% =========== ============== ============== ============== ================ December 31, 1998 Premiums Written: Property and Casualty $25,831 $260,566 $234,735 111.0% Accident and Health ----------- -------------- -------------- -------------- ---------------- Total $25,831 $260,566 $234,735 111.0% =========== ============== ============== ============== ================ December 31, 1997 Premiums Written: Property and Casualty $3,044 $147,878 $144,834 102.1% Accident and Health ----------- -------------- -------------- -------------- ---------------- Total $3,044 $147,878 $144,834 102.1% =========== ============== ============== ============== ================
S-7 EXHIBIT INDEX Exhibit Number Description - - ------ ----------- 3.1 Amended and Restated Certificate of Incorporation of Risk Capital Holdings, Inc. ("RCHI")1(a) 3.2 Amended and Restated Bylaws of RCHI(b) 4.1 Specimen Common Stock Certificate(a) 4.2.1 Class A Common Stock Purchase Warrants issued to Marsh & McLennan Risk Capital Holdings, Ltd. ("MMRCH") on September 19, 19952(b) and September 28, 19953(c) 4.2.2 Class A Common Stock Purchase Warrants issued to The Trident Partnership, L.P. ("Trident") on September 19, 1995(b) and September 28, 1995(c) 4.2.3 Class A Common Stock Purchase Warrants issued to Taracay Investors ("Taracay") on September 19, 1995(b) and September 28, 1995(c) 4.3 Class B Common Stock Purchase Warrants issued to MMRCH on September 19, 1995(b) and September 28, 1995(c) 10.1.1 Employment Agreement, between RCHI and Mark D. Mosca(b)+ 10.1.2 Employment Agreement, between RCHI and Peter A. Appel(b)+ 10.1.3 Employment Agreement, between RCHI and Bonnie L. Boccitto(b)+ 10.1.4 Employment Agreement, between RCHI and Paul J. Malvasio(b)+ 10.2 Amended and Restated Subscription Agreement, between RCHI and Trident(b) 10.3 Amended and Restated Subscription Agreement, between RCHI and MMRCH(b) 10.4 Amended and Restated Subscription Agreement, between RCHI and Taracay(b) 10.5 Purchase Agreement, between RCHI and X.L. Insurance Company, Ltd.(b) E-1 Exhibit Number Description - - ------ ----------- 10.6.1 Investment Advisory Agreement, between RCHI and Marsh & McLennan Capital, Inc. ("MMCI")(b) 10.6.2 Investment Advisory Agreement, between Risk Capital Reinsurance Company ("RCRe") and MMCI(b) 10.6.3 Investment Advisory Agreement among, RCHI, RCRe and Alliance Capital Management L.P.(i) 10.7 Management Agreement, among RCHI, RCRe and The Putnam Advisory Company, Inc.(b) 10.8.1 Sublease Agreement, dated as of March 18, 1996, between RCRe and Coca-Cola Bottling Company of New York, Inc. ("Coca-Cola")(b) 10.8.2 Sublease Amendment Agreement and Consent, dated as of November 11, 1997, between RCRe and Coca-Cola(d) 10.8.3 Sub-Sublease Agreement, dated as of March 18, 1996, between RCRe and MMCI(e) 10.8.4 Sub-Sublease Agreement, dated as of April 30, 1997, between RCRe and Bank of Ireland Asset Management (US) Limited ("BOI"), as amended(e) 10.8.5 Sub-Sublease Termination Agreement, effective March 31, 2000, between RCRe and BOI (filed herewith) 10.9.1 Tax Sharing Agreement, between RCHI and RCRe (amended)(d) 10.9.2 Addition of Cross River Insurance Company to Tax Sharing Agreement(g) 10.10.1 RCHI 1999 Long Term Incentive and Share Award Plan(f)+ 10.10.2 RCHI 1995 Long Term Incentive and Share Award Plan (the "1995 Stock Plan")(b)4+ 10.10.3 First Amendment to the 1995 Stock Plan(c)5+ 10.10.4 Restricted Stock Agreements--Executive Officers(h)+ 10.10.5 Stock Option Agreements--Executive Officers--1995 and 1996 grants(h) and 1997 and 1998 grants(g)+ 10.10.6 Stock Option Agreements--Chairman--1996 grant,(h) 1997 grant(d) and 1998 grant(g) 10.10.7 Stock Option Agreements--Non-Employee Directors--initial grants(g) (and filed herewith) E-2 Exhibit Number Description - - ------ ----------- 10.10.8 Stock Option Agreements--Non-Employee Directors--1996 and 1997 annual grants,(c) 1998 annual grants,(d) 1999 annual grants (g) and 2000 annual grants (filed herewith) 10.11.1 Change in Control Agreement (as amended)--President(i)+ 10.11.2 Change in Control Agreements (as amended)--Managing Directors(i)+ 10.11.3 Form of Change in Control Agreements (as amended)--Senior Vice Presidents(i)+ 10.11.4 Change in Control Severance Plan (as amended)(i)+ 10.12 RCHI 1995 Employee Stock Purchase Plan(j)+ 10.13.1 RCRe Money Purchase Pension Plan (the "Pension Plan")(b)+ 10.13.2 Amendment and Restatement of the Adoption Agreement relating to the Pension Plan(c)+ 10.13.3 Amendment to the Adoption Agreement relating to the Pension Plan(g)+ 10.14.1 RCRe Employee Savings Plan (the "Savings Plan")(b)+ 10.14.2 Amendment and Restatement of the Adoption Agreement relating to the Savings Plan(c)+ 10.14.3 Amendment to the Adoption Agreement relating to the Savings Plan(g)+ 10.15.1 RCRe Executive Supplemental Non-Qualified Savings and Retirement Plan (the "Supplemental Plan") and related Trust Agreement(b)+ 10.15.2 Amendment No. 1 to the Adoption Agreement relating to the Supplemental Plan(c)+ 10.15.3 Amendment No. 2 to the Adoption Agreement relating to the Supplemental Plan(g)+ 10.16 Asset Purchase Agreement, dated as of January 10, 2000, amount RCHI, Folksamerica Holding Company, Inc. ("FHC") and Folksamerica Reinsurance Company ("FRC")(k) 10.17 Voting Agreement, dated as of January 10, 2000, among MMRCH, RCHI and FHC(k) 10.18 Voting Agreement, dated as of January 10, 2000, among Trident, RCHI and FHC(k) 10.19 Voting Agreement, dated as of January 10, 2000, among XL Capital Ltd ("XL"), Garrison Investments Inc. ("GI"), RCHI and FHC(k) 10.20 Form of Transfer and Assumption Agreement between RCRe and FRC(k) 10.21 Form of Balance Sheet of Assumed Business(k) 10.22 Form of Escrow Agreement among RCRe, FHC, FRC and the Escrow Agent(k) 10.23 Form of Supplemental Escrow Agreement among, RCRe, FHC, FRC and the Escrow Agent(k) 10.24 Stock Repurchase Agreement, dated January 17, 2000, among RCHI, RCRe, XL and GI(k) 10.25 Form of Voting and Disposition Agreement, among RCHI, RCRe, XL and GI(k) 21 Subsidiaries of Registrant(g) 23 Consent of PricewaterhouseCoopers LLP (filed herewith) 24 Power of Attorney (filed herewith) 27 Financial Data Schedule (filed herewith) E-3 Exhibit Number Description - - ------ ----------- 99.1 Definitive proxy statement for a special meeting of stockholders, filed with the SEC on March 16, 2000 (excluding audited financial statements and annexes thereto) - - -------- 1(a) Filed as an exhibit to Amendment No. 3 to our Registration Statement on Form S-1 (No. 33-94184), as filed with the Securities and Exchange Commission (the "SEC") on August 11, 1995, and incorporated by reference. 2(b) Filed as an exhibit to our Annual Report on Form 10-K for the year ended December 31, 1995, as filed with the SEC on March 30, 1996, and incorporated by reference. 3(c) Filed as an exhibit to our Annual Report on Form 10-K for the year ended December 31, 1996, as filed with the SEC on March 31, 1997, and incorporated by reference. (d) Filed as an exhibit to our Annual Report on Form 10-K for the year ended December 31, 1997, as filed with the SEC on March 27, 1998, and incorporated by reference. (e) Filed as an exhibit to our Report on Form 10-Q for the period ended June 30, 1998, as filed with the SEC on August 14, 1998, and incorporated by reference. (f) Filed as an exhibit to our Definitive Proxy Statement filed with the SEC on April 14, 1999, and incorporated by reference. (g) Filed as an exhibit to our Annual Report on Form 10-K for the year ended December 31, 1998, as filed with the SEC on March 30, 1999, and incorporated by reference. 4(h) Filed as an exhibit to our Report on Form 10-Q for the period ended June 30, 1997, as filed with the SEC on August 14, 1997, and incorporated by reference. (i) Filed as an exhibit to our Report on Form 10-Q for the period ended June 30, 1999, as filed with the SEC on August 12, 1999, and incorporated by reference. (j) Filed as an exhibit to our Registration Statement on Form S-8 (No. 33-99974), as filed with the SEC on December 4, 1995, and incorporated by reference. (k) Filed as an exhibit to our Report on Form 8-K filed with the SEC on January 18, 2000, and incorporated by reference. + A management contract or compensatory plan or arrangement required to be filed pursuant to Item 14(c) of Form 10-K. EX-10.8.5 2 SUB-SUBLEASE TERMINATION AGREEMENT Exhibit 10.8.5 SUB-SUBLEASE TERMINATION AGREEMENT THIS SUB-SUBLEASE TERMINATION AGREEMENT (the "Agreement"), dated as of November 8, 1999, by and between RISK CAPITAL REINSURANCE COMPANY ("Sub-Sublandlord"), having an address at 20 Horseneck Lane, Greenwich, Connecticut 06830, and BANK OF IRELAND ASSET MANAGEMENT (U.S.) LIMITED ("Sub-Subtenant"), having an address at 20 Horseneck Lane, Greenwich, Connecticut 06830. W I T N E S S E T H: WHEREAS, by Sub-Sublease Agreement dated as of April 30, 1997 (the "Sub-Sublease"), Sub-Sublandlord, as sub-sublessor, sub-subleased to Sub-Subtenant, as sub-sublessee, certain premises, constituting approximately 6,431 rentable square feet as more particularly described therein (the "BOI Space"), located in that building commonly known as 20 Horseneck Lane, Greenwich, Connecticut (the "Building"); and WHEREAS, pursuant to discussions between the parties, Sub-Sublandlord desires to recapture, and Sub-Subtenant desires to relocate from, the BOI Space prior to the expiration of the Sub-Sublease; and WHEREAS, effective as of the Termination Date (as hereinafter defined), Sub-Sublandlord and Sub-Subtenant desire to terminate the Sub-Sublease and to end the term thereby demised (the "Term"), and to release each other from their respective obligations thereafter accruing under the Sub-Sublease, all in accordance with the terms hereof. NOW, THEREFORE, in consideration of the mutual covenants contained herein, and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, Sub-Sublandlord and Sub-Subtenant hereby agree as follows, notwithstanding anything to the contrary contained in the Sub-Sublease: 1. General Definitions. Capitalized terms used but not separately defined in this Agreement shall have their respective meanings used in the Sub-Sublease. 2. Termination Date; Adjustment; Holdover. The "Termination Date" herein shall mean midnight on March 31, 2000, except as such Termination Date is adjusted as hereinafter provided. Sub-Subtenant shall have a single option, to be exercised upon at least forty-five (45) days prior written notice to Sub-Sublandlord, to adjust the Termination Date to a later date specified in such notice; provided, however, in no event shall such adjusted Termination Date be a date which is greater than fifteen (15) days after such original Termination Date. Notwithstanding anything to the contrary contained in this Agreement, to the extent such Termination Date is so adjusted, the term "Termination Date" as used herein shall mean such adjusted Termination Date. If Sub-Subtenant retains possession of the BOI Space beyond the Termination Date without Sub-Sublandlord's prior written consent, such holdover shall not operate to extend or renew Sub-Subtenant's tenancy, which shall continue only as a tenancy at sufferance, upon the same terms and conditions then applicable under the Sub-Sublease, except that the Minimum Rent payable by Sub-Subtenant shall be at a rate equal to 150% of the rate then payable under the Sub-Sublease, prorated on a per diem basis for the duration of such holdover. 3. Sub-Sublease Termination. Sub-Sublandlord and Sub-Subtenant hereby agree that the Sub-Sublease shall terminate and the Term shall expire as of the Termination Date, with the same force and effect as if the Term were, by the provisions of the Sub-Sublease, fixed to expire on said Termination Date, except to the extent of any unperformed obligations theretofore accruing under the Sublease, as hereinafter provided. 4. Release; Survival. As of the Termination Date, Sub-Sublandlord and Sub-Subtenant, respectively, shall be released and discharged from their respective Sub-Sublease obligations which accrue on and after the Termination Date. Any unperformed Sub-Sublease obligations of either party with respect to the BOI Space accruing up to the Termination Date shall survive the Termination Date, however. 5. Surrender. On or before the Termination Date, Sub-Subtenant shall surrender the BOI Space to Sub-Sublandlord in the condition required under the Sub-Sublease (i.e., in reasonably good order and repair, reasonable wear and tear and damage by casualty, excepted). Any holdover by Sub-Subtenant without Sub-Sublandlord's prior written consent shall be subject to the holdover premium set forth in Section 2 hereof. 6. Adjustments. As of the Termination Date, the following items shall be adjusted and apportioned between Sub-Sublandlord and Sub-Subtenant: (a) any due and unpaid, or prepaid, Minimum Rent payable pursuant to the Sub-Sublease; (b) increases in Operating Expenses payable pursuant to the Sub- Sublease; (c) increases in Taxes payable pursuant to the Sub-Sublease; (d) electrical service charges payable pursuant to the Sub-Sublease; and (e) any other Additional Rent then due and payable under the Sub-Sublease. In the event any of the statements or information necessary to compute the foregoing adjustments and apportionments have not been, or reasonably cannot be, determined as of the Termination Date, then the parties' respective obligations therefor shall be adjusted as soon as is reasonably possible after, and in any event shall survive, the Termination Date. 7. Security Deposit. Within thirty (30) days after the Termination Date, provided Sub-Subtenant is not in default of its obligations under the Sub-Sublease, Sub-Sublandlord shall return to Sub-Subtenant, the original draft of Sub-Subtenant's $37,514.16 Letter of Credit, which Letter of Credit was provided to Sub-Sublandlord as security for Sub-Subtenant's obligations under the Sub-Sublease. Sub-Sublandlord's obligations under this Section 7 shall survive the Termination Date. 2 8. No Brokerage. Sub-Sublandlord and Sub-Subtenant each hereby represent to the other that it has not dealt with any broker(s) in connection with this Agreement. Sub-Sublandlord and Sub-Subtenant hereby agree to indemnify, defend and hold the other harmless from and against any and all claims, costs, damages or liabilities (including, without limitation, reasonable attorneys' fees and costs) for any commissions or other compensation asserted by any broker(s) caused by the indemnifying party's breach of its representation made in the immediately preceding sentence. Said indemnities shall survive the Termination Date. 9. [Reserved] 10. Miscellaneous. Each party shall be responsible for their respective costs and expenses incurred in connection with the negotiation, documentation, review and execution of this Agreement. As amended hereby, the Sub-Sublease shall continue in full force and effect, the parties hereby ratifying and confirming the Sub-Sublease, as amended by this Agreement. In the event of any conflicts or inconsistencies between the terms of the Sub-Sublease, and the terms of the Sub-Sublease (as amended by this Agreement), the terms of the Sub-Sublease (as amended by this Agreement) shall govern and control in each instance. The Sub-Sublease, as amended hereby, shall not be modified or altered except by written agreement signed by Sub-Sublandlord and Sub-Subtenant. This Agreement shall bind and enure to the benefit of Sub-Sublandlord and Sub-Subtenant, and their respective successors and assigns. Notwithstanding anything to the contrary contained in this Agreement, this Agreement shall not be binding on Sub-Sublandlord or Sub-Subtenant, however, unless and until Sub-Sublandlord and Sub-Subtenant, respectively, shall have executed and delivered final counterparts of this Agreement to the other. This Agreement may be executed in individual counterparts, which counterparts, when so executed and delivered, shall be deemed one and the same counterpart. This Agreement may also be executed and transmitted via facsimile machine, provided the parties deliver original, signed Agreement counterparts (or the relevant, original signature pages) to each other within ten (10) days of such facsimile transmission. 3 IN WITNESS WHEREOF, the parties hereto have duly executed this Agreement as of the date first set forth above. SUB-SUBLANDLORD: RISK CAPITAL REINSURANCE COMPANY By: /s/ Louis T. Petrillo ------------------------------------------- Name: Louis T. Petrillo Title: Vice President and Associate General Counsel, Duly authorized and empowered SUB-SUBTENANT: BANK OF IRELAND ASSET MANAGEMENT (U.S.) LIMITED By: /s/ Rosemary Mahon ------------------------------------------- Name: Rosemary Mahon Title: Senior Vice President, Duly authorized and empowered 4 STATE OF CONNECTICUT ) ) ss. GREENWICH COUNTY OF FAIRFIELD ) On this 18th day of November, 1999, personally appeared, RISK CAPITAL REINSURANCE COMPANY, by Louis T. Petrillo, its Vice President and Associate General Counsel, hereunto duly authorized, who acknowledged that he/she signed, sealed and delivered the above and foregoing instrument as his/her free act and deed, and the free act and deed of said corporation, for the purposes therein stated, before me. /s/ Lisa M. Morrissey ------------------------------------ Notary Public Commissioner of the Superior Court My Commission Expires: May 31, 2003 STATE OF CONNECTICUT ) ) ss. GREENWICH COUNTY OF FAIRFIELD ) On this 5th day of November, 1999, personally appeared, BANK OF IRELAND ASSET MANAGEMENT (U.S.) LIMITED, by Rosemary Mahon, its Senior Vice President, hereunto duly authorized, who acknowledged that he/she signed, sealed and delivered the above and foregoing instrument as his/her free act and deed, and the free act and deed of said corporation, for the purposes therein stated, before me. /s/ Cathy R. Graves ------------------------------------ Notary Public Commissioner of the Superior Court My Commission Expires: July 31, 2001 5 EX-10.10.7 3 DIRECTOR OPTION AGREEMENT Exhibit 10.10.7 RISK CAPITAL HOLDINGS, INC. Director Option Agreement FOR GOOD AND VALUABLE CONSIDERATION, receipt of which is hereby acknowledged, Risk Capital Holdings, Inc. (the "Company"), a Delaware corporation, hereby grants to Robert Works, a director of the Company on the date hereof (the "Option Holder"), the option to purchase common stock, $.01 par value per share, of the Company ("Shares"), upon the following terms: WHEREAS, the following terms reflect the Company's 1995 Long Term Incentive and Share Award Plan, as amended by the First Amendment thereto (the "Plan"); (a) Grant. The Option Holder is hereby granted an option (the "Option") to purchase 300 Shares (the "Option Shares") pursuant to the Plan, the terms of which are incorporated herein by reference. The Option is granted as of May 26, 1999 (the "Date of Grant") and such grant is subject to the terms and conditions herein and the terms and conditions of the applicable provisions of the Plan. Such Option shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code of 1986, as amended. (b) Status of Option Shares. The Option Shares shall upon issue rank equally in all respects with the other Shares. (c) Option Price. The purchase price for the Option Shares shall be, except as herein provided, $16.00 per Option Share, hereinafter sometimes referred to as the "Option Price," payable immediately in full upon the exercise of the Option. (d) Term of Option. The Option may be exercised only during the period (the "Option Period") commencing in accordance with paragraph (f) below and shall continue until May 26, 2009; thereafter the Option Holder shall cease to have any rights in respect thereof. The right to exercise the Option may be subject to sooner termination as provided in paragraph (j) below. (e) No Rights of Shareholder. The Option Holder shall not, by virtue hereof, be entitled to any rights of a shareholder in the Company, either at law or in equity. (f) Exercisability. The Option shall become exercisable in three equal installments commencing on the Date of Grant and thereafter on the first and second anniversary thereof, subject to paragraph (j) below; provided that such Option, to the extent not already exercisable in full, shall become immediately and fully exercisable (1) to the extent provided in paragraph (j) below and (2) upon a Change in Control. Subject to paragraph (j) below, the Option may be exercised at any time or from time to time during the Option Period in regard to all or any portion of the Option which is then exercisable, as may be adjusted pursuant to paragraph (g) below. "Change in Control" means and shall be deemed to have occurred if: a. any person (within the meaning of the Securities Exchange Act of 1934, as amended (the "Exchange Act")), other than a Permitted Person or Initial Investor, is or becomes the "beneficial owner" (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of Voting Securities representing 35% or more of the total voting power of all the then outstanding Voting Securities; or b. any Initial Investor is or becomes the "beneficial owner" (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of Voting Securities representing 50% or more of the total voting power of all the then outstanding Voting Securities; or c. the individuals who, as of the Date of Grant, constitute the Board of Directors of the Company (the "Board") together with those who become directors subsequent to such date and whose recommendation, election or nomination for election to the Board was approved by a vote of at least a majority of the directors then still in office who either were directors as of such date or whose recommendation, election or nomination for election was previously so approved, cease for any reason to constitute a majority of the members of the Board; or d. the required stockholders of the Company approve a merger, consolidation, recapitalization, liquidation, sale or disposition by the Company of all or substantially all of the Company's assets, or reorganization of the Company (provided that all material regulatory approvals have been obtained), or consummation of any such transaction, other than any such transaction which would (x) result in at least 60% of the total voting power represented by the voting securities of the surviving entity outstanding immediately after such transaction being beneficially owned by the former stockholders of the Company and (y) not otherwise be deemed a Change in Control under subparagraphs a, b, c or e of this paragraph (f); or e. the Board adopts a resolution to the effect that, for purposes hereof, a Change in Control has occurred. (i) "Initial Investors" means (A) X.L. Insurance Company, Ltd.; (B) The Trident Partnership, L.P.; (C) Marsh & McLennan Risk Capital Holdings, Ltd.; or (D) any majority-owned subsidiary or parent (or equivalent in the case of a non-corporate entity) of the foregoing. (ii) "Permitted Persons" means (A) the Company; (B) any Related Party; or (C) any group (as defined in Rule 13d-3 under the Exchange Act) comprised of any or all of the foregoing. (iii)"Related Party" means (A) a majority-owned subsidiary of the Company; (B) a trustee or other fiduciary holding securities under an employee benefit plan of the Company or any majority-owned subsidiary of the Company; or (C) a corporation owned directly or indirectly by the stockholders of the Company in substantially the same proportion as their ownership of Voting Securities. (iv) "Voting Security" means any security of the Company which carries the right to vote generally in the election of directors. (g) Adjustments for Recapitalization and Dividends. In the event that, prior to the expiration of the Option, any dividend in Shares, recapitalization, Share split, reverse split, reorganization, merger, consolidation, spin-off, combination, repurchase, or share exchange, or other such change affects the Shares such that they are increased or decreased or changed into or exchanged for a different number or kind of shares, other securities of the Company or of another corporation or other -2- consideration, then in order to maintain the proportionate interest of the Option Holder and preserve the value of the Option, (i) there shall automatically be substituted for each Share subject to the unexercised Option the number and kind of shares, other securities or other consideration into which each outstanding Share shall be changed or for which each such Share shall be exchanged, and (ii) the exercise price shall be increased or decreased proportionately so that the aggregate purchase price for the Shares subject to the unexercised Option shall remain the same as immediately prior to such event. (h) Transferability. The Option may not be assigned or otherwise transferred, disposed of or encumbered by the Option Holder, other than by will or by the laws of descent and distribution. During the lifetime of the Option Holder, the Option shall be exercisable only by the Option Holder or by his or her guardian or legal representative. Notwithstanding the foregoing, the Option may be transferred by the Option Holder to members of his or her "immediate family" or to a trust established for the exclusive benefit of solely one or more members of the Option Holder's "immediate family." Any Option held by the transferee will continue to be subject to the same terms and conditions that were applicable to the Option immediately prior to the transfer, except that the Option will be transferable by the transferee only by will or the laws of descent and distribution. For purposes hereof, "immediate family" means the Option Holder's children, stepchildren, grandchildren, parents, stepparents, grandparents, spouse, siblings (including half brothers and sisters), in-laws, and relationships arising because of legal adoption. (i) Exercise of Option. In order to exercise the Option, the Option Holder shall submit to the Company an instrument in writing signed by the Option Holder, specifying the number of Option Shares in respect of which the Option is being exercised, accompanied by payment of the Option Price for the Option Shares for which the Option is being exercised in cash or Shares already owned by the Option Holder (provided that the Option Holder has owned such Shares for a minimum period of six months) and having a total Fair Market Value (as defined below) equal to the exercise price, or in a combination of cash and such Shares. Option Shares will be issued accordingly by the Company within 15 business days, and a share certificate dispatched to the Option Holder within 30 days. The Company shall not be required to issue fractional Shares upon the exercise of the Option. If any fractional interest in a Share would be deliverable upon the exercise of the Option in whole or in part but for the provisions of this paragraph, the Company, in lieu of delivering any such fractional share therefor, shall pay a cash adjustment therefor in an amount equal to their Fair Market Value (or if any Shares are not publicly traded, an amount equal to the book value per share at the end of the most recent fiscal quarter) multiplied by the fraction of the fractional share which would otherwise have been issued hereunder. Anything to the contrary herein notwithstanding, the Company shall not be obligated to issue any Option Shares hereunder if the issuance of such Option Shares would violate the provision of any applicable law, in which event the Company shall, as soon as practicable, take whatever action it reasonably can so that such Option Shares may be issued without resulting in such violations of law. For purposes hereof, Fair Market Value shall mean the mean between the high and low selling prices per Share on the immediately preceding date (or, if the Shares were not traded on that day, the next preceding day that the Shares were traded) on the principal exchange on which the Shares are traded, as such prices are officially quoted on such exchange. (j) Termination of Service. In the event the Option Holder ceases to be a director of the Company (i) due to retirement after attainment of age 65 or (ii) due to death or disability, the Option, to the extent not already exercisable in full, shall become immediately and fully exercisable at the time of such termination of service, and the Option may be exercised at any time during the Option Period. Subject to paragraph (f) above, if the Option Holder ceases to be a director of the Company for any other reason, the portion of the Option which is not then exercisable shall be cancelled on the date service -3- terminates, and the portion of the Option which is then exercisable may be exercised at any time within six months after the date of such termination, but not later than termination of the Option Period. (k) Obligations as to Capital. The Company agrees that it will at all times maintain authorized and unissued share capital sufficient to fulfill all of its obligations under the Option. (l) Transfer of Shares. The Option, the Option Shares, or any interest in either, may be sold, assigned, pledged, hypothecated, encumbered, or transferred or disposed of in any other manner, in whole or in part, only in compliance with the terms, conditions and restrictions as set forth in the governing instruments of the Company, applicable United States federal and state securities laws and the terms and conditions hereof. Each certificate for Option Shares issued upon exercise of the Option, unless at the time of exercise such Option Shares are registered under the Securities Act of 1933, as amended, shall bear the following legend or such other legend as the Company deems appropriate: "The securities evidenced hereby have not been registered under the Securities Act of 1933, as amended (the `Act'), and may not be offered, sold or otherwise transferred except (i) in compliance with the provisions of any applicable state securities or `Blue Sky' laws and (ii) (A) pursuant to an effective registration under the Act, (B) in compliance with Rule 144 under the Act, (C) inside the United States to a Qualified Institutional Buyer in compliance with Rule 144A under the Act, (D) outside the United States in compliance with Rule 904 of Regulation S under the Act or (E) inside the United States to an institutional `accredited investor' as defined in Rule 501(a)(1), (2), (3) or (7) under the Act in a transaction which, in the opinion of counsel reasonably satisfactory to the Company, qualifies as an exempt transaction under the Act and the rules and regulations promulgated thereunder." Any certificate issued at any time in exchange or substitution for any certificate bearing such legend or such other legend deemed appropriate by the Company shall also bear such legend unless, in the opinion of counsel for the Company, the securities represented thereby need no longer be subject to the restrictions set forth therein. The provisions of this paragraph (l) shall be binding upon all subsequent holders of certificates bearing the above legend and all subsequent holders of the Option, if any. (m) Expenses of Issuance of Option Shares. The issuance of stock certificates upon the exercise of the Option in whole or in part, shall be without charge to the Option Holder. The Company shall pay, and indemnify the Option Holder from and against any issuance, stamp or documentary taxes (other than transfer taxes) or charges imposed by any governmental body, agency or official (other than income taxes) by reason of the exercise of the Option in whole or in part or the resulting issuance of the Option Shares. (n) Withholding. The Option Holder agrees to make appropriate arrangements with the Company for satisfaction of any applicable tax withholding requirements, or similar requirements, arising out of the Option. (o) References. References herein to rights and obligations of the Option Holder shall apply, where appropriate, to the Option Holder's legal representative or estate without regard to whether specific reference to such legal representative or estate is contained in a particular provision of this Option. -4- (p) Settlement of Disputes. Any dispute between the parties arising from or relating to the terms of this Option shall be resolved by arbitration held in the State of Connecticut in accordance with the rules of the American Arbitration Association. All costs associated with any arbitration, including all legal expenses, for both parties shall be borne by the Company. (q) No Mitigation. To the extent that the vesting of the Option is accelerated upon a Change in Control or upon a termination of service as provided herein, neither the Option, nor any Option Shares nor any interest in either, shall be reduced by any compensation received by the Option Holder in connection with any other employment. (r) Notices. Any notice required or permitted to be given under this agreement shall be in writing and shall be deemed to have been given when delivered personally or by courier, or sent by certified or registered mail, postage prepaid, return receipt requested, duly addressed to the party concerned at the address indicated below or to such changed address as such party may subsequently by similar process give notice of: If to the Company: Risk Capital Holdings, Inc. 20 Horseneck Lane Greenwich, CT 06830 Attn: Secretary If to the Option Holder: [Insert address of Option Holder] (s) Governing Law. This agreement shall be governed by and construed in accordance with the laws of the State of New York, without giving effect to principles of conflict of laws. (t) Entire Agreement. This agreement constitutes the entire agreement among the parties relating to the subject matter hereof, and any previous agreement or understanding among the parties with respect thereto is superseded by this agreement. (u) Counterparts. This agreement may be executed in two counterparts, each of which shall constitute one and the same instrument. -5- IN WITNESS WHEREOF, the undersigned have duly executed this agreement as of the Date of Grant. RISK CAPITAL HOLDINGS, INC. By: /s/ Peter A. Appel ---------------------------------------- Peter A. Appel Managing Director, General Counsel and Secretary /s/ Robert Works ---------------------------------------- Robert Works -6- EX-10.10.8 4 STOCK OPTION AGREEMENTS Exhibit 10.10.8 STOCK OPTION AGREEMENTS -- NON-EMPLOYEE DIRECTORS (2000 ANNUAL GRANTS) Each of the non-employee directors of Risk Capital Holdings, Inc. ("RCHI") listed below has entered into Stock Option Agreements with RCHI that are substantially identical in all material respects to the agreement, dated as of January 1, 2000, between RCHI and Michael P. Esposito, Jr., a copy of which is included as part of this Exhibit 10.10.8. Robert Clements Lewis L. Glucksman Ian R. Heap Thomas V. A. Kelsey Robert F. Works Philip L. Wroughton * * * * RISK CAPITAL HOLDINGS, INC. Director Option Agreement FOR GOOD AND VALUABLE CONSIDERATION, receipt of which is hereby acknowledged, Risk Capital Holdings, Inc. (the "Company"), a Delaware corporation, hereby grants to Michael P. Esposito, Jr., a director of the Company on the date hereof (the "Option Holder"), the option to purchase common stock, $.01 par value per share, of the Company ("Shares"), upon the following terms: WHEREAS, the following terms reflect the Company's 1999 Long Term Incentive and Share Award Plan (the "Plan"); Grant. The Option Holder is hereby granted an option (the "Option") to purchase 1,500 Shares (the "Option Shares") pursuant to the Plan, the terms of which are incorporated herein by reference. The Option is granted as of January 1, 2000 (the "Date of Grant") and such grant is subject to the terms and conditions herein and the terms and conditions of the applicable provisions of the Plan. Such Option shall not be treated as an incentive stock option under Section 422 of the Internal Revenue Code of 1986, as amended. Status of Option Shares. The Option Shares shall upon issue rank equally in all respects with the other Shares. Option Price. The purchase price for the Option Shares shall be, except as herein provided, $12.657 per Option Share, hereinafter sometimes referred to as the "Option Price," payable immediately in full upon the exercise of the Option. Term of Option. The Option may be exercised only during the period (the "Option Period") commencing in accordance with paragraph (f) below and shall continue until January 1, 2010; thereafter the Option Holder shall cease to have any rights in respect thereof. The right to exercise the Option may be subject to sooner termination as provided in paragraph (j) below. No Rights of Shareholder. The Option Holder shall not, by virtue hereof, be entitled to any rights of a shareholder in the Company, either at law or in equity. Exercisability. The Option shall become exercisable on January 1, 2001, subject to paragraph (j) below; provided that such Option, to the extent not already exercisable in full, shall become immediately and fully exercisable (1) to the extent provided in paragraph (j) below and (2) upon a Change in Control. Subject to paragraph (j) below, the Option may be exercised at any time or from time to time during the Option Period in regard to all or any portion of the Option which is then exercisable, as may be adjusted pursuant to paragraph (g) below. "Change in Control" means and shall be deemed to have occurred if: a. any person (within the meaning of the Securities Exchange Act of 1934, as amended (the "Exchange Act")), other than a Permitted Person or Initial Investor, is or becomes the "beneficial owner" (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of Voting Securities representing 35% or more of the total voting power of all the then outstanding Voting Securities; or b. any Initial Investor is or becomes the "beneficial owner" (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of Voting Securities representing 50% or more of the total voting power of all the then outstanding Voting Securities; or c. the individuals who, as of the Date of Grant, constitute the Board of Directors of the Company (the "Board") together with those who become directors subsequent to such date and whose recommendation, election or nomination for election to the Board was approved by a vote of at least a majority of the directors then still in office who either were directors as of such date or whose recommendation, election or nomination for election was previously so approved, cease for any reason to constitute a majority of the members of the Board; or d. the required stockholders of the Company approve a merger, consolidation, recapitalization, liquidation, sale or disposition by the Company of all or substantially all of the Company's assets, or reorganization of the Company (provided that all material regulatory approvals have been obtained), or consummation of any such transaction, other than any such transaction which would (x) result in at least 60% of the total voting power represented by the voting securities of the surviving entity outstanding immediately after such transaction being beneficially owned by the former stockholders of the Company and (y) not otherwise be deemed a Change in Control under subparagraphs a, b, c or e of this paragraph (f); or e. the Board adopts a resolution to the effect that, for purposes hereof, a Change in Control has occurred. (i) "Initial Investors" means (A) X.L. Insurance Company, Ltd.; (B) The Trident Partnership, L.P.; (C) Marsh & McLennan Risk Capital Holdings, Ltd.; or (D) any majority-owned subsidiary or parent (or equivalent in the case of a non-corporate entity) of the foregoing. (ii) "Permitted Persons" means (A) the Company; (B) any Related Party; or (C) any group (as defined in Rule 13d-3 under the Exchange Act) comprised of any or all of the foregoing. (iii) "Related Party" means (A) a majority-owned subsidiary of the Company; (B) a trustee or other fiduciary holding securities under an employee benefit plan of the Company or any majority-owned subsidiary of the Company; or (C) a corporation owned directly or indirectly by the stockholders of the Company in substantially the same proportion as their ownership of Voting Securities. (iv) "Voting Security" means any security of the Company which carries the right to vote generally in the election of directors. Adjustments for Recapitalization and Dividends. In the event that, prior to the expiration of the Option, any dividend in Shares, recapitalization, Share split, reverse split, reorganization, merger, consolidation, spin-off, combination, repurchase, or share exchange, or other such change affects the Shares such that they are increased or decreased or changed into or exchanged for -2- a different number or kind of shares, other securities of the Company or of another corporation or other consideration, then in order to maintain the proportionate interest of the Option Holder and preserve the value of the Option, (i) there shall automatically be substituted for each Share subject to the unexercised Option the number and kind of shares, other securities or other consideration into which each outstanding Share shall be changed or for which each such Share shall be exchanged, and (ii) the exercise price shall be increased or decreased proportionately so that the aggregate purchase price for the Shares subject to the unexercised Option shall remain the same as immediately prior to such event. Transferability. The Option may not be assigned or otherwise transferred, disposed of or encumbered by the Option Holder, other than by will or by the laws of descent and distribution. During the lifetime of the Option Holder, the Option shall be exercisable only by the Option Holder or by his or her guardian or legal representative. Notwithstanding the foregoing, the Option may be transferred by the Option Holder to members of his or her "immediate family" or to a trust established for the exclusive benefit of solely one or more members of the Option Holder's "immediate family." Any Option held by the transferee will continue to be subject to the same terms and conditions that were applicable to the Option immediately prior to the transfer, except that the Option will be transferable by the transferee only by will or the laws of descent and distribution. For purposes hereof, "immediate family" means the Option Holder's children, stepchildren, grandchildren, parents, stepparents, grandparents, spouse, siblings (including half brothers and sisters), in-laws, and relationships arising because of legal adoption. Exercise of Option. In order to exercise the Option, the Option Holder shall submit to the Company an instrument in writing signed by the Option Holder, specifying the number of Option Shares in respect of which the Option is being exercised, accompanied by payment of the Option Price for the Option Shares for which the Option is being exercised in cash or Shares already owned by the Option Holder (provided that the Option Holder has owned such Shares for a minimum period of six months) and having a total Fair Market Value (as defined below) equal to the exercise price, or in a combination of cash and such Shares. Option Shares will be issued accordingly by the Company within 15 business days, and a share certificate dispatched to the Option Holder within 30 days. The Company shall not be required to issue fractional Shares upon the exercise of the Option. If any fractional interest in a Share would be deliverable upon the exercise of the Option in whole or in part but for the provisions of this paragraph, the Company, in lieu of delivering any such fractional share therefor, shall pay a cash adjustment therefor in an amount equal to their Fair Market Value (or if any Shares are not publicly traded, an amount equal to the book value per share at the end of the most recent fiscal quarter) multiplied by the fraction of the fractional share which would otherwise have been issued hereunder. Anything to the contrary herein notwithstanding, the Company shall not be obligated to issue any Option Shares hereunder if the issuance of such Option Shares would violate the provision of any applicable law, in which event the Company shall, as soon as practicable, take whatever action it reasonably can so that such Option Shares may be issued without resulting in such violations of law. For purposes hereof, Fair Market Value shall mean the mean between the high and low selling prices per Share on the immediately preceding date (or, if the Shares were not traded on that day, the next preceding day that the Shares were traded) on the principal exchange on which the Shares are traded, as such prices are officially quoted on such exchange. Termination of Service. In the event the Option Holder ceases to be a director of the Company (i) due to retirement after attainment of age 65 or (ii) due to death or disability, the Option, to the extent not already exercisable in full, shall become immediately and fully exercisable at the time of such termination of service, and the Option may be exercised at any time during the Option Period. -3- Subject to paragraph (f) above, if the Option Holder ceases to be a director of the Company for any other reason, the portion of the Option which is not then exercisable shall be cancelled on the date service terminates, and the portion of the Option which is then exercisable may be exercised at any time within six months after the date of such termination, but not later than termination of the Option Period. Obligations as to Capital. The Company agrees that it will at all times maintain authorized and unissued share capital sufficient to fulfill all of its obligations under the Option. Transfer of Shares. The Option, the Option Shares, or any interest in either, may be sold, assigned, pledged, hypothecated, encumbered, or transferred or disposed of in any other manner, in whole or in part, only in compliance with the terms, conditions and restrictions as set forth in the governing instruments of the Company, applicable United States federal and state securities laws and the terms and conditions hereof. Each certificate for Option Shares issued upon exercise of the Option, unless at the time of exercise such Option Shares are registered under the Securities Act of 1933, as amended, shall bear the following legend or such other legend as the Company deems appropriate: "The securities evidenced hereby have not been registered under the Securities Act of 1933, as amended (the `Act'), and may not be offered, sold or otherwise transferred except (i) in compliance with the provisions of any applicable state securities or `Blue Sky' laws and (ii) (A) pursuant to an effective registration under the Act, (B) in compliance with Rule 144 under the Act, (C) inside the United States to a Qualified Institutional Buyer in compliance with Rule 144A under the Act, (D) outside the United States in compliance with Rule 904 of Regulation S under the Act or (E) inside the United States to an institutional `accredited investor' as defined in Rule 501(a)(1), (2), (3) or (7) under the Act in a transaction which, in the opinion of counsel reasonably satisfactory to the Company, qualifies as an exempt transaction under the Act and the rules and regulations promulgated thereunder." Any certificate issued at any time in exchange or substitution for any certificate bearing such legend or such other legend deemed appropriate by the Company shall also bear such legend unless, in the opinion of counsel for the Company, the securities represented thereby need no longer be subject to the restrictions set forth therein. The provisions of this paragraph (l) shall be binding upon all subsequent holders of certificates bearing the above legend and all subsequent holders of the Option, if any. Expenses of Issuance of Option Shares. The issuance of stock certificates upon the exercise of the Option in whole or in part, shall be without charge to the Option Holder. The Company shall pay, and indemnify the Option Holder from and against any issuance, stamp or documentary taxes (other than transfer taxes) or charges imposed by any governmental body, agency or official (other than income taxes) by reason of the exercise of the Option in whole or in part or the resulting issuance of the Option Shares. Withholding. The Option Holder agrees to make appropriate arrangements with the Company for satisfaction of any applicable tax withholding requirements, or similar requirements, arising out of the Option. (o) References. References herein to rights and obligations of the Option Holder shall apply, where appropriate, to the Option Holder's legal representative or estate without regard to -4- whether specific reference to such legal representative or estate is contained in a particular provision of this Option. (p) Settlement of Disputes. Any dispute between the parties arising from or relating to the terms of this Option shall be resolved by arbitration held in the State of Connecticut in accordance with the rules of the American Arbitration Association. All costs associated with any arbitration, including all legal expenses, for both parties shall be borne by the Company. (q) No Mitigation. To the extent that the vesting of the Option is accelerated upon a Change in Control or upon a termination of service as provided herein, neither the Option, nor any Option Shares nor any interest in either, shall be reduced by any compensation received by the Option Holder in connection with any other employment. (r) Notices. Any notice required or permitted to be given under this agreement shall be in writing and shall be deemed to have been given when delivered personally or by courier, or sent by certified or registered mail, postage prepaid, return receipt requested, duly addressed to the party concerned at the address indicated below or to such changed address as such party may subsequently by similar process give notice of: If to the Company: Risk Capital Holdings, Inc. 20 Horseneck Lane Greenwich, CT 06830 Attn: Secretary If to the Option Holder: [Insert address of Option Holder] (s) Governing Law. This agreement shall be governed by and construed in accordance with the laws of the State of New York, without giving effect to principles of conflict of laws. (t) Entire Agreement. This agreement constitutes the entire agreement among the parties relating to the subject matter hereof, and any previous agreement or understanding among the parties with respect thereto is superseded by this agreement. (u) Counterparts. This agreement may be executed in two counterparts, each of which shall constitute one and the same instrument. -5- IN WITNESS WHEREOF, the undersigned have duly executed this agreement as of the Date of Grant. RISK CAPITAL HOLDINGS, INC. By: /s/ Peter A. Appel ------------------------------------ Peter A. Appel Managing Director, General Counsel and Secretary /s/ Michael P. Esposito, Jr. ------------------------------------ Michael P. Esposito, Jr. -6- EX-23 5 CONSENT OF INDEPENDENT ACCOUNTANTS [Letterhead of PricewaterhouseCoopers LLP] Consent of Independent Accountants We hereby consent to the incorporation by reference in the Registration Statement on Form S-3 (Registration No. 33-34499) and Registration Statement on Form S-8 (Registration No. 33-99974) of Risk Capital Holdings, Inc. of our report dated February 1, 2000 appearing on page F-2 of the Company's Annual Report on Form 10-K for the year ended December 31, 1999. We also consent to the incorporation by reference of our report on the Financial Statement Schedules, also dated February 1, 2000, which appears on page S-1 of the Company's Annual Report on Form 10-K for the year ended December 31, 1999. We also consent to the reference to us under the heading "Experts" in such Registration Statement. /s/ PricewaterhouseCoopers LLP New York, New York March 27, 2000 EX-24 6 POWER OF ATTORNEY Exhibit 24 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Mark D. Mosca, Paul J. Malvasio and Peter A. Appel, and each of them, with full power to act without the other, his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report of Risk Capital Holdings, Inc. on Form 10-K for the fiscal year ended December 31, 1999, including one or more amendments to such Form 10-K, which amendments may make such changes as such person deems appropriate, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or their or his substitutes or substitute, may lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has executed this Power-of-Attorney on the date set opposite his respective name.
Signature Title Date - - --------- ----- ---- /s/ Mark D. Mosca President and Chief Executive March 27, 2000 --------------------------------- Officer and Director (Principal Mark D. Mosca Executive Officer) /s/ Robert Clements Chairman and Director March 27, 2000 --------------------------------- Robert Clements /s/ Peter A. Appel Executive Vice President, Chief March 27, 2000 --------------------------------- Operating Officer, General Counsel, Peter A. Appel Secretary and Director /s/ Paul J. Malvasio Managing Director, Chief Financial March 27, 2000 --------------------------------- Officer and Treasurer (Principal Paul J. Malvasio Financial Officer and Principal Accounting Officer) /s/ Michael P. Esposito, Jr. Director March 27, 2000 --------------------------------- Michael P. Esposito, Jr. /s/ Lewis L. Glucksman Director March 27, 2000 --------------------------------- Lewis L. Glucksman /s/ Ian R. Heap Director March 27, 2000 --------------------------------- Ian R. Heap /s/ Thomas V. A. Kelsey Director March 27, 2000 --------------------------------- Thomas V. A. Kelsey /s/ Robert F. Works Director March 27, 2000 --------------------------------- Robert F. Works /s/ Philip L. Wroughton Director March 27, 2000 --------------------------------- Philip L. Wroughton
EX-27 7 FINANCIAL DATA SCHEDULE
7 RISK CAPITAL HOLDINGS, INC. Article 7 of Regulation S-X Insurance Companies Twelve month period ended December 31, 1999 (Dollars in thousands, except per share amounts) THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED BALANCE SHEET OF RISK CAPITAL HOLDINGS, INC. AND ITS SUBSIDIARY AT DECEMBER 31, 1999, AND THE RELATED STATEMENT OF INCOME, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 12-MOS DEC-31-1999 JAN-01-1999 DEC-31-1999 261,067 0 0 242,600 0 0 576,452 9,457 73,122 23,585 864,359 364,554 108,743 0 0 0 0 0 171 346,343 864,359 311,368 20,173 17,227 0 305,841 80,540 14,618 (52,231) (19,557) (32,436) 0 0 0 (32,436) (1.90) (1.90) 186,189 275,456 30,385 95,369 88,033 308,628 30,385
EX-99.1 8 DEFINITIVE PROXY STATEMENT SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 SCHEDULE 14A INFORMATION PROXY STATEMENT PURSUANT TO SECTION 14(a) OF THE SECURITIES EXCHANGE ACT OF 1934 Filed by the Registrant [X] Filed by a Party other than the Registrant [ ] Check the appropriate box: [ ] Preliminary proxy statement [ ] Confidential, for Use of the Commission Only (as permitted by Rule 14a-6(e)(2)) [X] Definitive proxy statement [ ] Definitive Additional Materials [ ] Soliciting Material Pursuant to ss. 240.14a-11(c) or ss. 240.14a-12 RISK CAPITAL HOLDINGS, INC. - - -------------------------------------------------------------------------------- (Name of Registrant as Specified in Its Charter) Not Applicable - - -------------------------------------------------------------------------------- (Name of Person(s) Filing Proxy Statement, if other than the Registrant) Payment of Filing Fee (Check the appropriate box): [ ] No fee required. [X] Fee computed on table below per Exchange Act Rules 14(a)-6(i)(1) and 0-11. 1) Title of each class of securities to which transaction applies: 2) Aggregate number of securities to which transaction applies: 3) Per unit price or other underlying value of transaction computed pursuant to Exchange Act Rule 0-11 (set forth the amount on which the filing fee is calculated and state how it was determined): $20,335,000.00 (based on the purchase price in the transaction) 4) Proposed maximum aggregate value of transaction: $20,335,000.00 5) Total fee paid: $4,067.00 [X] Fee paid previously with preliminary materials. [ ] Check box if any part of the fee is offset as provided by Exchange Act Rule 0-11(a)(2) and identify the filing for which the offsetting fee was paid previously. Identify the previous filing by registration statement number, or the Form or Schedule and the date of its filing. 1) Amount Previously Paid: 2) Form, Schedule or Registration Statement No.: 3) Filing Party: 4) Date Filed: [LETTERHEAD OF RISK CAPITAL HOLDINGS, INC.] March 15, 2000 Dear Stockholder: I am pleased to invite you to a special meeting of stockholders of Risk Capital Holdings, Inc. on April 17, 2000 at 1:00 p.m. (local time), at our offices, located at 20 Horseneck Lane, Greenwich, Connecticut 06830. At this important meeting, you will be asked to approve the sale of our reinsurance business through the transfer of the reinsurance assets and liabilities of our operating subsidiary, Risk Capital Reinsurance Company, to Folksamerica Reinsurance Company, and effective with the consummation of the asset sale, to change the name of the company from "Risk Capital Holdings, Inc." to "Arch Capital Group Ltd." Our board of directors, taking into consideration the recommendation of a special committee and the opinion of our financial advisor Donaldson, Lufkin & Jenrette Securities Corporation, has unanimously determined that the asset sale is in the best interests of our company. Accordingly, our board of directors recommends that you vote FOR the asset sale. This proposal requires the approval of the majority of our outstanding shares. YOUR VOTE IS VERY IMPORTANT. The accompanying notice and proxy statement contain details concerning this proposal. Whether or not you plan to attend the meeting, please sign and return your proxy card in the enclosed envelope to ensure that your shares will be represented and voted. If you do attend the meeting, you may choose to withdraw your proxy and vote your shares in person. I appreciate your support in this important event. Sincerely, [Signature Logo] ROBERT CLEMENTS Chairman of the Board This proxy statement is first being mailed to stockholders on or about March 15, 2000. RISK CAPITAL HOLDINGS, INC. NOTICE OF SPECIAL MEETING OF STOCKHOLDERS Time: 1:00 p.m. (local time) Date: April 17, 2000 Place: Risk Capital Holdings, Inc. 20 Horseneck Lane Greenwich, Connecticut 06830 Purpose: o To consider and vote upon a proposal to approve the sale of our reinsurance business through the transfer of the reinsurance assets and liabilities of our operating subsidiary, Risk Capital Reinsurance Company, to Folksamerica Reinsurance Company, pursuant to the Asset Purchase Agreement dated as of January 10, 2000 among Risk Capital Holdings, Inc., Risk Capital Reinsurance Company, Folksamerica Holding Company, Inc. and Folksamerica Reinsurance Company and, effective with the consummation of the asset sale, to amend our certificate of incorporation to change the name of the company from "Risk Capital Holdings, Inc." to "Arch Capital Group Ltd." o Conduct other business if properly raised. Only stockholders of record on March 14, 2000 may vote at the meeting. Your vote is very important. Please complete, sign, date and return your proxy card in the enclosed envelope promptly. [Signature Logo] PETER A. APPEL Executive Vice President, Chief Operating Officer, General Counsel and Secretary Greenwich, Connecticut March 15, 2000 TABLE OF CONTENTS Page SUMMARY TERM SHEET.............................................................1 SUMMARY FINANCIAL DATA.........................................................6 QUESTIONS AND ANSWERS ABOUT THE ASSET SALE.....................................8 RISK FACTORS..................................................................10 THE STOCKHOLDERS' MEETING.....................................................18 Time and Place.........................................................18 Proposal...............................................................18 Record Date; Voting at the Stockholders' Meeting.......................18 Quorum; Vote Required for Approval.....................................18 Voting and Revocation of Proxies.......................................19 Solicitation of Proxies................................................19 Other Matters..........................................................19 THE ASSET SALE................................................................20 Background of the Asset Sale...........................................20 Reasons for the Asset Sale and the Name Change; Our Board of Directors Recommends the Asset Sale...............................23 Donaldson, Lufkin & Jenrette Has Delivered a Fairness Opinion Relating to the Asset Sale...................................25 Certain Stockholders Have Agreed to Vote for the Asset Sale............30 Management Changes.....................................................30 Accounting Treatment of the Asset Sale.................................30 Material Federal Income Tax Consequences of the Asset Sale.............30 Regulatory Matters.....................................................31 == THE ASSET PURCHASE AGREEMENT..................................................32 Purchase Price.........................................................32 Tax Sharing Arrangement................................................32 Related Costs..........................................................33 Our Representations and Warranties.....................................33 Folksamerica's Representations and Warranties..........................34 Principal Covenants....................................................35 Employee Matters.......................................................36 Conditions to Closing..................................................36 Indemnification........................................................37 Termination............................................................37 Survival...............................................................38 OTHER TRANSACTION AGREEMENTS..................................................40 Transfer and Assumption Agreement......................................40 Escrow Agreement.......................................................40 Supplemental Escrow Agreement..........................................41 XL STOCK REPURCHASE...........................................................43 -i- Page SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT................44 INTERESTS OF CERTAIN PERSONS IN MATTERS TO BE ACTED UPON......................48 Payments to Executive Officers and Chairman of the Board...............48 Vesting of Options and Restricted Shares...............................48 Ownership of Warrants..................................................49 DIVIDEND AND STOCK REPURCHASE POLICY..........................................50 SELECTED HISTORICAL FINANCIAL DATA............................................51 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS..............................................52 UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL DATA.....................71 INDEPENDENT ACCOUNTANTS.......................................................78 WHERE YOU CAN FIND MORE INFORMATION...........................................78 INDEX TO FINANCIAL STATEMENTS AND SCHEDULES..................................F-1 Annexes Asset Purchase Agreement.....................................................A-1 Voting Agreements............................................................B-1 Form of Transfer and Assumption Agreement....................................C-1 Form of Escrow Agreement.....................................................D-1 Form of Supplemental Escrow Agreement........................................E-1 Opinion of Donaldson, Lufkin & Jenrette Securities Corporation...............F-1 -ii- SUMMARY TERM SHEET This summary term sheet highlights selected information from this document and may not contain all of the information that is important to you. To understand the asset sale fully and for a more complete description of the legal terms of the asset sale, you should read carefully this entire proxy statement and the other documents to which we have referred you. See "Where You Can Find More Information" on page 78 of this proxy statement. In this document, "we," "us," "our" and the "company" refer to Risk Capital Holdings, Inc. and "you" refers to Risk Capital Holdings, Inc.'s stockholders. The Parties to the Asset Sale Risk Capital Holdings, Inc........... Since incorporation in 1995, we Risk Capital Reinsurance Company have, through our wholly owned Risk 20 Horseneck Lane Capital Reinsurance Company Greenwich, Connecticut 06830 operating subsidiary, Risk Capital (203) 862-4300 Reinsurance Company ("RCRe"), 20 Horseneck Lane integrated solutions for insurance provided reinsurance and other forms of capital, either on a companies with (203) 862-4300 stand-alone Greenwich, Connecticut 06830 basis, or as part of capital needs that cannot be met by reinsurance alone. RCRe is rated "A-" (Excellent) by A.M. Best Company. On January 18, 2000, A.M. Best announced that it was placing our A- rating under review. At December 31, 1999, RCRe had statutory surplus of $290.1 million (or $230.1 million after giving pro forma effect to our recent repurchase of 4,755,000 shares of our common stock from XL Capital Ltd). You can find more information about us in the documents that are incorporated by reference in this proxy statement. See "Where You Can Find More Information." Folksamerica Holding Company, Inc.... Folksamerica Reinsurance Company, Folksamerica Reinsurance Company an indirect wholly owned subsidiary One Liberty Plaza of White Mountains Insurance Group, New York, New York 10006 Ltd., is a multi-line broker-market (212) 312-2500 reinsurance company which provides reinsurance to insurers of property and casualty risks in Caribbean. Folksamerica Reinsurance the United States, Canada, Latin America and the Company is rated "A" (Excellent) by A.M. Best Company. At December 31, 1999, Folksamerica Reinsurance Company had statutory surplus of approximately $338.5 million. Folksamerica Reinsurance Company is wholly owned by Folksamerica Holding Company, Inc. In this proxy statement, we refer to Folksamerica Reinsurance Company and Folksamerica Holding Company collectively as "Folksamerica." The Stockholders' Meeting Time and Place....................... The stockholders' meeting will be held at 1:00 p.m. (local time) on April 17, 2000 at our offices, located at 20 Horseneck Lane, Greenwich, Connecticut 06830. -1- Proposal............................. At the meeting, you will consider and vote upon the proposal to approve the sale of our reinsurance business to Folksamerica and, effective with the consummation of the asset sale, to amend our certificate of incorporation to change our name from "Risk Capital Holdings, Inc." to "Arch Capital Group Ltd." See "The Stockholders' Meeting-- Proposal." Voting and Revocation of Proxies..... All stockholders of record as of March 14, 2000 are entitled to vote at the meeting. Even if you plan to attend the meeting, please sign and return your proxy card. The affirmative vote of a majority of our outstanding shares is necessary to approve the proposal, so a failure to send in a signed proxy card or vote in person at the meeting will have the effect of a vote against the proposal. See "The Stockholders' Meeting-- Quorum; Vote Required for Approval." Any proxy may be revoked by the person giving it at any time before it is voted. Proxies may be revoked by either filing with us a written notice of revocation bearing a later date than the date of the proxy or a later-dated proxy relating to the same shares, or attending the stockholders' meeting and voting in person. See "The Stockholders' Meeting-- Voting and Revocation of Proxies." See "Risk Factors" for a discussion of some considerations you should take into account before deciding how to vote. Your vote is very important. Please sign, date and return the proxy card as soon as possible. Board Recommendation...................... Our board of directors recommends that you vote FOR the asset sale and the name change. The board's recommendation is based in part on the recommendation of a special committee of the board and an opinion of Donaldson Lufkin & Jenrette that, as of the date of that opinion, the consideration to be received by us in the asset sale is fair to us from a financial point of view. See "The Asset Sale-- Reasons for the Asset Sale and the Name Change; Our Board of Directors Recommends the Asset Sale" and "The Asset Sale-- Donaldson Lufkin & Jenrette Has Delivered a Fairness Opinion Relating to the Asset Sale." The fairness opinion is attached to this proxy statement as Annex F. Voting Agreements......................... Marsh & McLennan Risk Capital Holdings, Ltd. and The Trident Partnership, L.P., which together control 13.3% of the total voting power of our stock, have signed voting agreements granting Folksamerica proxies to vote their -2- shares in favor of the asset sale. See "The Asset Sale-- Certain Stockholders Have Agreed to Vote For the Asset Sale." The Asset Sale........................... Folksamerica Reinsurance Company will assume RCRe's liabilities under the reinsurance agreements transferred to it in the asset sale and RCRe will transfer to Folksamerica Reinsurance Company assets in an aggregate amount that is, in book value, equal to the book value of the liabilities assumed. In consideration for the transfer of RCRe's book of business, Folksamerica will pay $20.335 million in cash at the closing, subject to adjustment under the circumstances set forth in the asset purchase agreement. Our costs and expenses related to the transaction are estimated to be $19 million. See "The Asset Purchase Agreement." Escrow Agreement........................ At closing, we will deposit $20 million of the purchase price into a five-year escrow to reimburse Folksamerica for losses relating to business produced on behalf of RCRe by a certain managing underwriting agency. Depending on whether the reserves related to that business turn out to have been deficient or redundant as of the closing, following the fifth anniversary of the closing, we may be entitled to none, a portion or all of the escrowed funds. If those reserves turn out to have been redundant, we will also be entitled to receive from Folksamerica the amount of the redundancy. The funds in this escrow will also be available to indemnify Folksamerica for its losses, if any, due to breaches of certain of our representations and warranties. See "Other Transaction Agreements-- Escrow Agreement." Supplemental Escrow Agreement........... We may be required to deposit an additional amount of up to $5 million in a supplemental five-year escrow if our reserves as of the closing (other than reserves covered by the escrow described above) are more than one-half percent (0.5%) less than our independent actuary's estimate. If the supplemental escrow is required, depending on whether those reserves turn out to have been deficient or redundant, following the fifth anniversary of the closing, the escrow agent may release to us none, a portion or all of the escrowed funds. See "Other Transaction Agreements-- Supplemental Escrow Agreement." No Payment to Stockholders.............. The asset sale does not involve any merger, consolidation or liquidation; therefore, no payment of cash or securities will be made to stockholders. Delaware law does not provide for dissenters' rights in -3- the context of an asset sale. No Solicitation......................... We agreed not to solicit an acquisition proposal from a third party. We also agreed not to take part in any discussions regarding an unsolicited acquisition proposal unless our board determines, based on the written advice of an investment bank, that the acquisition proposal is a superior proposal and determines, based on the advice of counsel, that it is obligated to take part in such discussions to comply with its fiduciary duties. If there is such a superior proposal, we may terminate the asset purchase agreement two business days after giving notice to Folksamerica that we are prepared to accept the proposal. See "The Asset Purchase Agreement-- No Solicitation." Conditions to Closing................... The asset purchase agreement contains conditions to closing, including the receipt of regulatory approval, the retention of a key employee, third party consents and stockholder approval and the absence of a material adverse change since the date of the asset purchase agreement. See "The Asset Purchase Agreement-- Conditions to Closing." Termination............................. The asset purchase agreement may be terminated: o if the parties mutually agree to terminate it; o if the closing has not occurred prior to July 31, 2000; o by the non-breaching party, if (subject to materiality exceptions) any of the representations, warranties or covenants is breached and not cured; o by Folksamerica, if we violate the "no solicitation" covenant; o by us, if there is a superior proposal; or o if our stockholders vote against approval of the asset purchase agreement. See "The Asset Purchase Agreement-- Termination." Termination Fee......................... If we terminate the asset purchase agreement in the event of a superior proposal, we will be required to pay to Folksamerica a termination fee of $1.5 million two days after the day we terminate the asset purchase agreement. -4- If, as a result of direct solicitation by a third party, our stockholders do not approve the asset purchase agreement and thereafter we or Folksamerica terminate the asset purchase agreement due to the failure of our stockholders to approve it or because the closing has not occurred prior to July 31, 2000, we must pay the $1.5 million termination fee to Folksamerica if we enter into or consummate an acquisition proposal with the third party that solicited our stockholders within 12 months of the day we terminate the asset purchase agreement. See "The Asset Purchase Agreement-- Termination Fee." Accounting Treatment.................... The asset sale will be reflected on our consolidated balance sheet as a sale of certain of our assets and the transfer of certain of our liabilities. See "The Asset Sale-- Accounting Treatment of the Asset Sale." Tax Consequences........................ The asset sale will not result in any federal income tax consequences to you, but the asset sale will be a taxable transaction to RCRe for federal income tax purposes. See "The Asset Sale-- Material Federal Income Tax Consequences of the Asset Sale." Regulatory Matters...................... The Nebraska Insurance Department has approved the asset sale. The asset purchase agreement requires that the approval of the insurance departments of New York and Florida be obtained before the asset sale can be consummated. We have been granted early termination of the waiting period requirement under federal antitrust law . See "The Asset Sale-- Regulatory Matters." Interest of Officers and Directors in... Our executive officers and the the Asset Sale chairman of our board will be entitled to receive payments following the asset sale. See "Interests of Certain Persons in Matters to Be Acted Upon -- Payments to Executive Officers and Chairman of the Board." Upon stockholder and regulatory approval of the asset sale, all unvested stock options and shares of restricted stock held by our executive officers and members of our board will immediately vest. See "Interests of Certain Persons in Matters to Be Acted Upon -- Vesting of Options and Restricted Shares." The chairman of our board and two of our stockholders own, and will continue to own after the asset sale is completed, warrants to purchase shares of our common stock. See "Interests of Certain Persons in Matters to Be Acted Upon -- Ownership of Warrants." -5- SUMMARY FINANCIAL DATA The following tables reflect selected unaudited pro forma condensed consolidated financial data for the year ended December 31, 1999 compared to our and RCRe's consolidated historical data for the years ended December 31, 1999, 1998 and 1997. The selected unaudited pro forma condensed consolidated financial data have been derived from the unaudited pro forma condensed consolidated financial information included elsewhere in this proxy statement. The unaudited pro forma income statement and per share data reflect our historical accounts for the year ended December 31, 1999, adjusted to give pro forma effect to the proposed sale of our reinsurance business to Folksamerica and the stock repurchase from XL Capital as if such transactions had occurred on January 1, 1999. The unaudited pro forma balance sheet data reflect our historical accounts as of December 31, 1999, adjusted to give pro forma effect to the asset sale and stock repurchase as if those transactions had occurred on December 31, 1999. The unaudited pro forma data are presented for illustrative purposes only and are not indicative of the results of operations or financial position that would have occurred if the transactions had been completed on the assumed dates, nor are they necessarily indicative of our future operating results or financial position. Our selected consolidated historical data set forth below are derived from our audited consolidated financial statements and should be read in conjunction with the consolidated financial statements and the related notes contained elsewhere in this proxy statement.
Years Ended December 31, -------------------------------------------------------------------- Pro forma Historical ----------- ----------------------------------------------------- 1999 1999 1998 1997 ----------- ---------------- --------------- ------------- (Dollars in thousands, except per share data) Statement of Operations Data Net premiums earned -- $311,368 $206,194 $107,372 Total revenues $29,834 348,768 247,133 120,972 Net income (loss) 17,950 (32,436) 3,091 2,039 Comprehensive income (loss) 739 (52,286) (4,375) 47,107 Per Share Data Net income (loss) - basic $1.46 ($1.90) $0.18 $0.12 - diluted $1.46 ($1.90) $0.17 $0.12 Comprehensive income (loss) - basic $0.06 ($3.06) ($0.26) $2.77 - diluted $0.06 ($3.06) ($0.26) $2.76 Average shares outstanding - basic 12,331,732 17,086,732 17,065,165 17,032,601 - diluted 12,331,808 17,086,808 17,718,223 17,085,788 Cash dividends per share N/A N/A N/A N/A -6- Years Ended December 31, -------------------------------------------------------------------- Pro forma Historical ----------- ----------------------------------------------------- 1999 1999 1998 1997 ----------- ---------------- --------------- ------------- (Dollars in thousands, except per share data) Balance Sheet Data Cash and invested assets $283,137 $585,909 $587,155 $505,728 Total assets 303,360 864,359 757,830 581,247 Stockholders' equity 297,019 346,514 398,002 401,031 Book value per share - basic $24.08 $20.28 $23.29 $23.51 - diluted $24.08 $20.28 $22.75 $22.79 Shares outstanding - basic 12,332,970 17,087,970 17,087,438 17,058,462 - diluted 12,332,970 17,087,970 17,497,904 17,601,608
-7- QUESTIONS AND ANSWERS ABOUT THE ASSET SALE Q: What is being sold in the asset sale? A: We are selling our reinsurance business through the transfer of the reinsurance assets and liabilities of our operating subsidiary, Risk Capital Reinsurance Company ("RCRe"), to Folksamerica Reinsurance Company for a purchase price of $20.335 million. Q: Will the company pay any dividends after the asset sale is completed? A: We have no current intention to pay dividends or make any other distribution to stockholders. Q: Will the company be repurchasing shares? A: Our board intends to reach a determination regarding repurchases of our shares after consummation of the asset sale, but no decision has yet been made as to whether any such repurchases will be made or the amount, timing or method of any such repurchases, which will depend on future circumstances. Q: Will I continue to be able to sell my shares? A: The asset sale will not affect stockholders' rights to sell or otherwise transfer shares. Q: Why is the transaction structured as a sale of the company's reinsurance business rather than a sale of the entire company? A: Our shares have been, for some time, trading at a significant discount to book value. We believe that this transaction should result in greater value realization than would a sale of the entire company, although we cannot predict the overall market impact of the asset sale or any other transaction on the trading price of our shares. We also believe that this structure best reflects the intent of the parties and provides for future flexibility. Q: What will be the book value of the company's remaining assets? A: As of December 31, 1999, our book value was $346.5 million, or $20.28 per share. As of that date, assuming that the proposed asset sale to Folksamerica and our repurchase of 4,755,000 shares from XL Capital Ltd, described in this proxy statement, had occurred on that date, our book value would have been $297.0 million, or $24.08 per share. Please read the section entitled "Unaudited Pro Forma Condensed Consolidated Financial Data" in this proxy statement for details regarding the assumptions underlying these calculations. On January 14, 2000, the trading day before we announced the asset sale, the closing price of our common stock as reported on the Nasdaq National Market was $14.875. On March 13, 2000, the closing sale price per share for our common stock as reported on the Nasdaq National Market was $14.875. -8- Q: What will the company do after the asset sale is completed? A: The company's objective will be to serve as a vehicle to effect business combinations and ventures, whether by acquiring all or a portion of companies, merger, exchange of stock or otherwise, with one or more operating companies that the board believes will have potential to increase stockholder value. These business combinations and ventures may be with companies that are not in the insurance business. The company may cease to pursue this business objective at any time and may also consider alternatives. In addition, as discussed above, our board intends to reach a determination regarding repurchases of our shares. Q: Will the company retain its insurance licenses? A: We have no current intention to cause our insurance subsidiaries, RCRe and Cross River Insurance Company, to relinquish or dispose of their insurance licenses. Q: Does the board have an alternative strategic plan in the event the stockholders do not approve the asset sale? A: At this time, the board does not have a specific alternative strategic plan. Q: Will I be able to vote separately on the change in the nature of the company's business? A: No. Stockholders will not have an opportunity to vote separately on the change in the nature of the business of the company. Consequently, a vote in favor of the approval of the asset sale and name change will in effect constitute a vote in favor of changing the nature of the business of the company as determined by our board of directors. Q: When do you expect the asset sale to be completed? A: We are working toward completing the asset sale as quickly as possible. In addition to stockholder approval, we must satisfy certain other conditions to closing, as described in this proxy statement in "The Asset Purchase Agreement -- Conditions to Closing." We currently expect to complete the asset sale in the second quarter of 2000. Q: What should I do now? A: After you have carefully reviewed this document, you should mail your completed, dated and signed proxy card in the provided prepaid envelope as soon as possible so that your shares will be voted at the stockholders' meeting. -9- RISK FACTORS In deciding whether to approve the proposal, stockholders should consider the following risk factors, as well as the other information in this document. Cautionary note regarding forward-looking statements The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements. All statements other than statements of historical fact included in or incorporated by reference in this proxy statement are forward-looking statements. Forward-looking statements can generally be identified by the use of forward-looking terminology such as "may," "will," "expect," "intend," "estimate," "anticipate," "believe" or "continue" or their negative or variations or similar terminology. Forward-looking statements involve our current assessment of risks and uncertainties. Actual events and results may differ materially from those expressed or implied in these statements. Important factors relating to our existing business that could cause actual events or results to differ materially from those indicated in such statements are discussed below and elsewhere in this proxy statement and include: o the acceptance in the market of our reinsurance products; o competition from new products (including products that may be offered by the capital markets); o the availability of investments on attractive terms; o competition, including increased competition (both as to underwriting and investment opportunities); o changes in the performance of the insurance sector of the public equity markets or market professionals' views as to such sector; o the amount of underwriting capacity from time to time in the market; o general economic conditions and conditions specific to the reinsurance and investment markets in which we operate; o regulatory changes and conditions; o rating agency policies and practices; and o claims development, including as to the frequency or severity of claims and the timing of payments. In addition to risks and uncertainties related to our existing business, the transactions described in this proxy statement are subject to various risks and uncertainties including the risks that the conditions to closing will not be satisfied and that the costs of the transaction and purchase price and reserve adjustments will be greater than currently expected with resulting effects on our book value. Forward-looking statements relating to the transaction that is the subject of this proxy statement are discussed below and elsewhere in this proxy statement and include: o the purchase price to be paid by Folksamerica; -10- o the tax consequences of the asset sale; o RCRe's reserves for its book of business; o our future business operations and strategy; o potential stock repurchases; RCRe's payment of special distributions to us following the asset sale; o transaction costs incurred in connection with the asset sale and the XL Capital stock repurchase; o our book value and the trading price of our common stock after the asset sale and the XL Capital stock repurchase; o amount of premiums expected to be generated in 2000 from in-force treaties; o our estimate of after-tax losses relating to RCRe's maximum aviation exposures; and o our management of catastrophe exposures. All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise. Risks Relating to the Asset Sale The ultimate purchase price to be paid by Folksamerica in the asset sale may be less than $20.335 million. Folksamerica Reinsurance Company will assume RCRe's reinsurance liabilities and RCRe will transfer to Folksamerica Reinsurance Company assets in an aggregate amount that is, in GAAP book value (as set forth on our estimated closing date balance sheet), equal to the GAAP book value (as set forth on our estimated closing date balance sheet) of the liabilities assumed. In consideration for the transfer of RCRe's book of business, Folksamerica will pay $20.335 million in cash at the closing, subject to adjustment under the circumstances described below. Following the closing, the closing date balance sheet will be audited by our independent public accountants. Folksamerica is permitted to dispute the closing date balance sheet (other than the component of the balance sheet that relates to our loss reserves). Any dispute will be referred to neutral experts mutually acceptable to us and Folksamerica for final resolution. In the event that we overestimated the net value of the assumed business, we will be required to pay to Folksamerica a post-closing purchase price adjustment. Conversely, if we underestimated the net value of the assumed business, Folksamerica will be required to pay us a post-closing purchase price adjustment. We have agreed to indemnify Folksamerica in connection with the asset sale. See "--We may be liable to Folksamerica for breaches of representations and warranties" and "The Asset Purchase Agreement -- Indemnification." At the closing, $20 million of the purchase price will be delivered into escrow. The final disposition of this $20 million will generally be determined five years after closing of the asset sale and will depend on whether our closing date loss reserves relating to business produced on behalf of RCRe by a certain managing underwriting agency turns out to have been redundant or deficient. In the event that there is no deficiency, all -11- of the amounts then in escrow will be released to us and, in addition, Folksamerica will pay us in cash the amount of any redundancy. In the event that there is a deficiency of less than $20 million, the amount of the deficiency will be released from the escrow to Folksamerica and the remainder will be released to us. In the event that the deficiency is more than $20 million, all of the amounts then in escrow will be released to Folksamerica, but Folksamerica will have no further recourse to us. Moreover, amounts in this escrow may be released to Folksamerica to satisfy its indemnification claims against us under the asset purchase agreement relating to undisclosed liabilities, RCRe's reinsurance and retrocession treaties, accounts receivable and the managing underwriting agency referred to above or the business produced by it. We may be required to deposit an additional amount of up to $5 million in a supplemental escrow for five years in the event that our closing date loss reserves (other than reserves covered by the escrow described above) are less by more than one-half percent (0.5%) than those estimated by our independent actuary. This supplemental escrow will be governed by terms substantially similar to the escrow described above, except that (1) if those reserves turn out to have been redundant, the full escrow fund will be released to us, but Folksamerica will have no obligation to make payments to us and (2) this escrow will not be available to satisfy indemnification claims. In connection with either escrow arrangement, we will record a loss in an amount equal to any probable deficiency in the related reserve that may become known during or at the end of the five year period. Under the Internal Revenue Code, a purchaser of insurance assets may become liable for a "bargain purchase price tax" if, in a transaction, the tax basis of the assets it is purchasing is more than the tax basis of the liabilities it is assuming plus the purchase price it is paying (including transaction costs). We have agreed to grant Folksamerica a credit against the purchase price for a portion of this potential tax by the following method: To the extent it is determined that the tax basis of the assets being transferred exceeds the sum of o the tax basis of the liabilities being transferred, o the final purchase price, and o Folksamerica's transaction costs relating to the asset sale, we will give Folksamerica a credit against the purchase price equal to: o if the excess is $15 million or less, then the lesser of (1) 17.5% of the excess and (2) $2 million; and o if the excess is more than $15 million, then the sum of (1) $2 million plus (2) 35% of the excess. Under the asset purchase agreement, we have agreed to retain the liabilities relating to our severance plans and agreements, as well as to pay to Folksamerica at closing the amount by which the cost of reinsurance protection on our aviation line of business exceeds the net premiums we earn on that business after December 31, 1999. Furthermore, as described above, we are liable for a portion of Folksamerica's bargain purchase price tax liability and our own transaction costs. We estimate that these costs will be approximately $19 million in the aggregate, which amount will effectively reduce the purchase price we will retain. These costs are reflected in the pro forma book value amounts set forth under "Unaudited Pro Forma Condensed Consolidated Financial Data." -12- Folksamerica may be unable to make payments that they may become obligated to make to us. As described above, following the closing, Folksamerica will be required to make payments to reinsureds under RCRe's reinsurance agreements transferred in the asset sale and to indemnify us for losses arising out of or relating to those agreements. The asset purchase agreement provides that if our closing date loss reserves (other than reserves covered by the $20 million escrow) are found to be redundant as of the fifth anniversary of the closing, Folksamerica will pay us the amount of that redundancy up to $2 million. In addition, as described above, Folksamerica may be required to make certain purchase price adjustment payments to us under the asset purchase agreement and pay to us the amount of any loss reserve redundancy under the $20 million escrow agreement, some of which may be payable more than five years after the closing. Therefore, we remain exposed to Folksamerica's creditworthiness and ability under applicable regulatory requirements to make payments to us. Folksamerica may refuse or be unable to make all the payments it may be required to make to us. We may be liable to Folksamerica for breaches of representations and warranties. Under the asset purchase agreement, we have made extensive representations and warranties about us and the assumed business. Representations and warranties are required to be reaffirmed as of the closing, and our inability to reaffirm them will (if, in the case of representations and warranties that are not already qualified by materiality, it would result in a material adverse effect) entitle Folksamerica to terminate the agreement. Our representations and warranties relating to the following matters will survive for one year following the closing and, if breached, could result in liability to us: o incorporation and authority to enter into the transaction; o property and assets necessary to operate the assumed business remaining in our company or our affiliates and outstanding intercompany obligations relating to the assumed business; o compliance with instruments, including our certificate of incorporation and bylaws, and other agreements to which we are party; o absence of undisclosed liabilities; o title and rating of all of our fixed income investments being transferred to Folksamerica; o our transactions that combine capital investments with reinsurance ("Integrated Solutions") for which we had obligations as of September 30, 1999; o absence of a material adverse change since September 30, 1999 relating to the assumed business; o absence of adjustments to case reserves since September 30, 1999, except in the ordinary course consistent with past practice; o actuarial reports of the company for periods ending on or after December 31, 1995; o reinsurance and retrocession agreements being transferred in the asset sale; o accounts receivable; o non-competition covenants; o agents through whom RCRe sells insurance; and -13- o broker's or finder's fees. In addition, representations and warranties relating to tax matters will survive until the expiration of the applicable statute of limitations. We retain our tax and employee benefit liabilities and other liabilities not being assumed by Folksamerica, including all liabilities not arising under RCRe's reinsurance agreements transferred to Folksamerica Reinsurance Company. All of the reinsurance agreements transferred to Folksamerica Reinsurance Company are listed in a schedule to the asset purchase agreement. RCRe may retain exposure on the reinsurance agreements that are being transferred to Folksamerica Reinsurance Company. Under the transfer and assumption agreement to be entered into at the closing, Folksamerica Reinsurance Company will assume RCRe's obligations under the reinsurance agreements being transferred in the asset sale. Following the closing, Folksamerica Reinsurance Company will notify the reinsureds under the in-force reinsurance agreements that it has assumed RCRe's obligations and that, unless the reinsureds object to the assumption, RCRe will be released from its obligations to those reinsureds. However, RCRe will continue to be liable under those reinsurance agreements if the reinsureds object to the release of RCRe from its obligations or the notice is found not to be an effective release by the reinsureds. Folksamerica has agreed to indemnify us for any losses arising out of the reinsurance agreements transferred to Folksamerica Reinsurance Company in the asset sale. However, in the event that Folksamerica refuses or is unable to perform its obligations to us, RCRe may incur losses relating to the reinsurance agreements transferred in the asset sale. Risks Relating to Our Business After the Asset Sale We may have no operating history in our new line of business. Following the asset sale, the company's objective will be to serve as a vehicle to effect business combinations and ventures, whether by acquiring all or a portion of companies, merger, exchange of stock or otherwise, with one or more operating companies that the board believes will have potential to increase stockholder value. These business combinations and ventures may be with companies that are not in the insurance business. The company may cease to pursue this business objective at any time and may also consider alternatives. We may have had no operating history in our new line of business, although members of our board of directors have broad business experience. Accordingly, there can be no assurance that our future operations will generate cash flows or operating or net income, and our prospects must therefore be considered in light of the risks, expenses, problems and delays inherent in acquiring and/or establishing a new business. We and our stockholders may suffer a substantial loss should the new business plan prove to be unsuccessful. Our success will depend almost entirely on the operations, financial condition and management of the companies in which we may acquire interests or with which we may merge. Further, these ventures may involve financial and operational risks. Financial risks include the possible incurrence of indebtedness by us in order to effect the acquisitions and the consequent need to service that indebtedness. Operational risks include the possibility that a venture does not ultimately provide the benefits we had originally anticipated while we continue to incur operating and other expenses. In addition, if we make a strategic investment by acquiring a minority interest in a company, we may lack elements of control over the operations and strategy of the business in which we invested. We cannot assure you that we will be successful in identifying new operating businesses, completing and financing business combination or venture transactions on favorable terms, or operating our new business successfully. In implementing our strategy, we will attempt to minimize the risk of unexpected liabilities and contingencies associated with our new operating businesses through planning, investigation and negotiation, but unexpected liabilities and contingencies may nevertheless accompany such transactions. -14- We cannot specify the exact nature of the business risks we may encounter in the future. We have not identified the business opportunities and businesses in which we will attempt to obtain an interest. We therefore cannot describe the specific risks presented by such businesses. To the extent that we effect a business combination with or invest in a financially unstable company or an entity in its early stage of development or growth (including entities without established records of revenues or income), we will become subject to numerous risks inherent in the business and operations of financially unstable and early stage or potential emerging growth companies. In addition, to the extent that we effect a business combination with an entity in an industry characterized by a high level of risk, we will become subject to the unascertainable risks of that industry. An extremely high level of risk frequently characterizes industries which experience rapid growth. Although we will endeavor to evaluate the risks inherent in a particular new operating business or industry, we cannot assure you that we will properly ascertain or assess all such risks. Such new operating business may involve an unproven product, technology or marketing strategy, the ultimate success of which cannot be assured. The new operating businesses may be in competition with larger, more established firms that have competitive advantages over us. Our investment in a business opportunity may be highly illiquid and could result in a total loss to us if the opportunity is unsuccessful. We may need to secure additional financing to carry out our business plan. We may be required to raise cash to consummate a business combination, to provide funds for an additional infusion of capital into a new operating business or to fund any share repurchases we may make. The amount and nature of any borrowings by us will depend on numerous considerations, including our capital requirements, our perceived ability to meet debt service on any such borrowings and the then prevailing conditions in the financial markets, as well as general economic conditions. If we are able to raise additional funds through the incurrence of debt, and we do so, we would likely become subject to restrictive financial covenants. Additionally, to the extent that debt financing ultimately proves to be available, any borrowings may subject us to various risks and restrictions traditionally associated with indebtedness, including the risks of interest rate fluctuations and insufficiency of cash flow to service that indebtedness. If additional funds are raised through the issuance of equity securities, the percentage ownership of our then current stockholders would be diluted, our earnings and book value per share could be diluted and, if such equity securities take the form of preferred stock, the holders of such preferred stock may have rights, preferences or privileges senior to those of holders of common stock. We are not currently in discussions, nor have we had any discussions, with respect to obtaining any debt or equity financing. We cannot assure you that we will be able to raise equity capital, obtain capital lease or bank financing or incur other indebtedness to fund any business combination or the working capital and other capital requirements of a new operating business on terms deemed by us to be commercially acceptable and in our best interests. We may incur significant costs to avoid investment company status and may suffer other adverse consequences if deemed to be an investment company. We may incur significant costs to avoid investment company status and may suffer other adverse consequences if deemed to be an investment company under the Investment Company Act of 1940. Some equity investments in other businesses made by us to date and in the future constitute or may constitute investment securities under the Investment Company Act. A company may be deemed to be an investment company if it owns investment securities with a value exceeding 40% of its total assets, subject to certain exclusions. Investment companies are subject to registration under, and compliance with, the Investment Company Act unless an exclusion applies. If we were deemed to be an investment company and could not rely on an exclusion, unless we complied with the registration and other extensive requirements of the Investment Company Act, we would be prohibited from engaging in business or issuing our securities as we have in the past and might be subject to civil and criminal penalties for noncompliance. In addition, in such case, certain of our contracts might be voidable, and a court-appointed receiver could take control of us and liquidate our business. -15- Our investment securities currently comprise more than 40% of our assets. We currently rely on an exclusion under the Investment Company Act for insurance companies. Immediately following the asset sale, when we will not have an operating business, we will need to rely on one or more other exclusions from regulation under the Investment Company Act. If at any time we could not rely on an exclusion, we would attempt to reduce our investment securities as a percentage of our total assets. This reduction can be attempted in a number of ways, including the disposition of investment securities and the acquisition of assets that do not constitute investment securities. These sales may be at depressed prices and we may never realize the anticipated benefits from, or may incur losses on, these investments. We may not be able to sell some investments because of contractual or legal restrictions or our inability to locate a buyer. Moreover, we may incur tax liabilities when we sell assets. We may also be unable to purchase additional investment securities that may be important to our future operating strategy. We may not be able to identify and acquire suitable assets that do not constitute investment securities on acceptable terms. Our ability to attract and retain key personnel may be limited. Our future success depends on our ability to attract and retain key management and other personnel with expertise required in connection with the acquisition and/or growth and development of a new business. See "The Asset Sale--Management Changes." We cannot assure you that we will be successful in attracting and retaining such executives and personnel. Inability to attract and retain qualified personnel and the loss of services of key personnel could have a material adverse effect on our ability to acquire and/or enter new businesses and on our results of operations. We will face intense competition as we seek to complete acquisitions and other business combinations. We will be a small participant in the market of seeking mergers with and acquisitions of all or a portion of other entities. We expect to encounter intense competition from other entities having business objectives similar to ours. Many of these entities are well-established and have extensive experience in identifying and effecting business combinations directly or through affiliates. Many of these competitors possess greater financial, technical, human and other resources than ours and we cannot assure you that we will have the ability to compete successfully. Our financial resources will be limited in comparison to those of many of our competitors. We cannot assure you that we will be able to achieve our stated business objectives. The financing of our business plan may cause us to forfeit certain tax benefits. We expect that our remaining net loss carry-forwards will remain available for use by us following the asset sale. In general, under Internal Revenue Code Section 382, a change in control occurs when the major stockholders of a corporation with net operating losses increase their ownership of its stock (including through the exercise of warrants and stock repurchases) by more than 50 percentage points within a three-year period ending on the day of any ownership shift. If such a change in control occurs, the utilization of the remaining net loss carry-forwards would be limited and possibly lost. In general, the amount of this limitation is determined by taking the value of the stock of the corporation multiplied by a "long-term tax-exempt rate." The long-term tax-exempt rate is adjusted monthly by the Internal Revenue Service. We cannot predict the degree of fluctuation in the long-term tax-exempt rate, but the rate for March 2000 is 5.84%. To finance a business combination, we may have to raise equity from persons or entities not presently our stockholders, which could result in a change in control. We cannot assure you that we (or any company successor) will be able to receive benefits from any net loss carry-forwards. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Results of Operations--Income Taxes." As a general rule, federal and state tax laws and regulations have a significant impact upon the structuring of business combinations. We will evaluate the possible tax consequences of any prospective business combination and will endeavor to structure the business combination so as to achieve a favorable tax treatment to us and our stockholders. We cannot assure you, however, that the Internal Revenue Service or other tax -16- authorities will ultimately assent to our proposed tax treatment of a consummated business combination. To the extent the IRS or other tax authorities ultimately prevail in recharacterizing the tax treatment of a business combination, there may be adverse tax consequences to us, the new operating business and our stockholders. The public market for our common stock may become limited. There can be no assurance that an active trading market for our common stock will continue. Historically, the market prices for securities of non-operating companies in the business of seeking mergers and acquisitions have been highly volatile. The market price of our common stock could be subject to significant fluctuations in response to various factors and events, including the liquidity of the market for our common stock, announcements of potential business combinations and changes in the industry or industries which we may enter, as well as general economic and market conditions. We expect to continue to file and be current in our Securities Exchange Act reports as we pursue our business objectives. Accordingly, we anticipate that our common stock will continue to be quoted on the Nasdaq National Market. We may issue new equity in order to help attain our new business plan. Generally, the board of directors has the power to issue new equity (to the extent of authorized shares) without stockholder approval, except that stockholder approval may be required under applicable law or Nasdaq National Market rules for certain transactions. We may issue new equity to raise additional capital in connection with a business combination or venture transaction with an operating business. Any additional issuance by us would have the effect of diluting the percentage ownership of our stockholders, could have the effect of diluting our earnings and our book value per share, could result in stockholders of another company obtaining a controlling interest in us, and could result in the adverse tax consequences described above. We have no current arrangement, agreement or understanding with respect to the sale or issuance of any new equity. We currently do not anticipate paying dividends, but may consider share repurchases. Any determination to pay dividends in the future will be at the discretion of our board of directors and will be dependent upon our results of operations, financial condition, capital requirements, contractual restrictions and other factors deemed relevant by our board of directors. Our board of directors currently does not intend to declare dividends or make any other distributions. Our board intends to make a determination regarding repurchases of our shares after the consummation of the asset sale, but no decision has yet been made as to whether any such repurchases will be made or the amount, timing or method of any such repurchases, which will depend on future circumstances. -17- THE STOCKHOLDERS' MEETING We are furnishing this proxy statement to holders of our common stock in connection with the solicitation of proxies by our board of directors at the stockholders' meeting, and at any adjournments and postponements of the meeting. Time and Place The stockholders' meeting will be held on April 17, 2000 at 1:00 p.m. (local time) at our offices, located at 20 Horseneck Lane, Greenwich, Connecticut 06830. Proposal At the stockholders' meeting, our stockholders will consider and vote on the proposal to approve the sale of substantially all of the reinsurance business of our operating subsidiary Risk Capital Reinsurance Company to Folksamerica Reinsurance Company pursuant to the Asset Purchase Agreement dated as of January 10, 2000 among Risk Capital Holdings, Inc., Risk Capital Reinsurance Company, Folksamerica Holding Company, Inc. and Folksamerica Reinsurance Company and, effective with the consummation of the asset sale, to amend our certificate of incorporation to change the name of the company from "Risk Capital Holdings, Inc." to "Arch Capital Group Ltd." Stockholders will not have an opportunity to vote separately on the change in the nature of the business of the company. Consequently, a vote in favor of the approval of the asset sale and name change will in effect constitute a vote in favor of changing the nature of the business of the company as determined by our board of directors. Record Date; Voting at the Stockholders' Meeting The board of directors has fixed the close of business on March 14, 2000 as the record date for determination of the stockholders entitled to notice of and to vote at the stockholders' meeting and any and all postponements or adjournments of the stockholders' meeting. On the record date, there were approximately 12,329,424 shares of common stock outstanding and entitled to vote, which were held by 47 holders of record and approximately 1,600 beneficial holders. Each holder of record of common stock on the record date is entitled to cast one vote per share. A stockholder may vote in person or by a properly executed proxy on each proposal put forth at the stockholders' meeting. Quorum; Vote Required for Approval The presence in person or by properly executed proxy of a majority of our common stock outstanding and entitled to vote at the stockholders' meeting is necessary to constitute a quorum. If a quorum is not present, the stockholders' meeting may be adjourned from time to time until a quorum is obtained. The approval of the proposal requires the affirmative vote of the holders of a majority of our common stock outstanding and entitled to vote. Our officers and directors will be present at the stockholders' meeting and available to respond to questions. Our independent accountants are expected to be present at the stockholders' meeting, will have the opportunity to make a statement if they desire to do so and are expected to be available to respond to appropriate questions. Under applicable rules, brokers that hold shares in street name for customers are precluded from exercising their voting discretion on those shares. Signed proxies held by brokers without instructions are referred to as "broker non-votes." While broker non-votes will be counted for purposes of determining whether there is -18- a quorum at the stockholders' meeting, absent specific instructions from the beneficial owner of the shares, brokers are not empowered to vote these shares. Since the affirmative vote of a majority of the common stock outstanding and entitled to vote is required to approve the proposal, a broker non-vote or the failure to vote in person or by proxy will have the effect of a vote against the proposal. Voting and Revocation of Proxies All stockholders should complete, sign and return the enclosed form of proxy. All shares of common stock represented at the stockholders' meeting by properly executed proxies received before or at the stockholders' meeting, unless those proxies have been revoked, will be voted at the stockholders' meeting, including any postponement or adjournment of the stockholders' meeting. If no instructions are indicated on a properly executed proxy, the proxies will be deemed to be FOR approval of the proposal. Any proxy given pursuant to this solicitation may be revoked by the person giving it at any time before it is voted. Proxies may be revoked by either o filing, including by facsimile, with the Secretary of Risk Capital Holdings, Inc., before the vote at the stockholders' meeting is taken, a written notice of revocation bearing a later date than the date of the proxy or a later-dated proxy relating to the same shares, or o attending the stockholders' meeting and voting in person. In order to vote in person at the stockholders' meeting, stockholders must attend the stockholders' meeting and cast their vote in accordance with the voting procedures established for the stockholders' meeting. Attendance at a stockholders' meeting will not in and of itself constitute a revocation of a proxy. Any written notice of revocation or subsequent proxy must be sent so as to be delivered at or before the taking of the vote at the stockholders' meeting to Risk Capital Holdings, Inc., 20 Horseneck Lane, Greenwich, Connecticut 06830, Facsimile: (203) 861-4508, Attention: Secretary. Solicitation of Proxies Proxies are being solicited by and on behalf of the board of directors. We have retained MacKenzie Partners, Inc. to aid in the solicitation of proxies and to verify records related to the solicitations. We will pay MacKenzie Partners, Inc. approximately $4,500 plus expense reimbursement for its services. Brokerage houses, nominees, fiduciaries and other custodians will be requested to forward solicitation materials to beneficial owners and will be reimbursed for their reasonable expenses incurred in so doing. We may request by telephone, facsimile, mail, electronic mail or other means of communication the return of the proxy cards. Other Matters As of the date of this proxy statement, our board of directors knows of no matters that will be presented for consideration at the special meeting, other than as described in this proxy statement. If any other matters shall properly come before the special meeting or any adjournments or postponements of the special meeting and shall be voted on, the enclosed proxies will be deemed to confer discretionary authority on the individuals named as proxies therein to vote the shares represented by such proxies as to any of those matters. The persons named as proxies intend to vote or not vote in accordance with the recommendation of our board of directors and management. -19- THE ASSET SALE Background of the Asset Sale Our board has continually monitored and reviewed the insurance industry and general economic conditions, as well as the company's position in those environments, with the objective of enhancing stockholder value. Our shares have been, for some time, trading at a significant discount to book value. Recognizing the need to have a comprehensive and thorough review of strategic alternatives available to us, the board retained Donaldson, Lufkin & Jenrette in March 1999. Its role would include identifying potential acquirors and transactions, assisting us in the negotiation of the financial aspects of any proposed transaction and rendering an opinion regarding the fairness to us from a financial point of view of the consideration to be received in a transaction. Donaldson, Lufkin & Jenrette's compensation arrangements, set forth in letter agreements in May and November of 1999, are described under "--Donaldson, Lufkin & Jenrette Has Delivered a Fairness Opinion Relating to the Asset Sale." On April 15, 1999, the board established a strategic alternative evaluation committee, consisting of Robert Clements, Stephen Friedman, Lewis L. Glucksman and Mark D. Mosca. The strategic alternative evaluation committee was directed to evaluate possible business combinations and other strategic alternatives for the purpose of presenting possible opportunities to the board. In consultation with representatives of Donaldson, Lufkin & Jenrette, we reviewed the various structuring possibilities for a transaction. After consideration, we decided to pursue a sale of our reinsurance operations rather than a business combination or a sale of the entire company. In April 1999, Company X advised Donaldson, Lufkin & Jenrette that it was interested in exploring a transaction for the purchase of RCRe's business for consideration to consist of cash and shares of Company X common stock. On April 8, 1999, we and Company X executed a confidentiality agreement and formally began conducting due diligence on each other's businesses. On May 11, 1999, our board met to discuss the transaction with Company X and also identified certain other prospective business partners that could provide us with additional opportunities to increase stockholder value. We and Company X began to negotiate the terms of a transaction. On May 27, 1999, the board, with its legal advisors present, met to discuss the potential transaction with Company X and to designate a special committee consisting of Thomas V.A. Kelsey, Mr. Glucksman and Robert F. Works to evaluate and make recommendations to the full board with respect to a potential transaction with Company X. We and Company X could not reach agreement, however, and the discussions ended. After discussions with Company X ended, we, in consultation with representatives of Donaldson, Lufkin & Jenrette, determined that a sale exploration process offered the best means of finding a purchaser that would offer the most value for our reinsurance business. This sale exploration process included identifying potential buyers, evaluating their preliminary interest and conducting due diligence sessions. Representatives of Donaldson, Lufkin & Jenrette conducted an extensive process to identify and solicit potential buyers of our reinsurance business. They contacted a total of 18 additional parties, 12 of whom received a confidential information memorandum regarding our company and its business, and several of whom conducted due diligence. The confidential information memorandum indicated that, although we preferred a transaction involving the sale of our reinsurance business, we were willing to consider any form of transaction that we believed would be in the best interests of our stockholders. Together with representatives of Donaldson, Lufkin & Jenrette, we engaged in preliminary discussions regarding a transaction with several parties who indicated interest. In each case other than with Folksamerica, the discussions were terminated at an early stage. In early June 1999, Folksamerica expressed an interest in acquiring RCRe's business. On June 11, 1999, Folksamerica sent us a non-binding letter expressing its interest in acquiring RCRe or RCRe's insurance business (as well as its financial ability to do so) and its desire to conduct due diligence on RCRe. On June 15, -20- 1999, Folksamerica executed a confidentiality agreement and formally began to conduct due diligence. We began negotiating with representatives of Folksamerica regarding the terms of a possible transaction. Our legal advisors and representatives of Donaldson, Lufkin & Jenrette, as well as the legal and financial advisors of Folksamerica, participated in some of these negotiations. On September 14, 1999, the board designated a special committee consisting of Mr. Kelsey, Mr. Glucksman and Mr. Works to evaluate a transaction with Folksamerica and make a recommendation to the full board. On October 25, 1999, we entered into a letter agreement with Folksamerica whereby it agreed to conduct additional analysis to confirm its interest in a possible acquisition of RCRe's reinsurance business in accordance with the terms set forth on a preliminary term sheet. The letter stated that by November 1, 1999, Folksamerica aimed to confirm its interest in continuing to pursue the proposed transaction pursuant to the terms set forth on the preliminary term sheet. If confirmation was provided on that date consistent with the terms of the preliminary term sheet, we agreed to either (1) provide Folksamerica with an exclusivity period commencing at that time and continuing until November 15, 1999 to complete negotiation of a transaction or (2) reimburse Folksamerica for 50% of the costs incurred by it between October 25, 1999 and November 1, 1999 during its analysis of RCRe. On October 28, 1999, the special committee met with members of management and representatives of Donaldson, Lufkin & Jenrette to review the negotiations with Folksamerica. Representatives of Donaldson, Lufkin & Jenrette reported that the sale exploration process culminated in one proposal (from Folksamerica) that would result in an acquisition of our reinsurance business at a price potentially at or above book value, and further indicated the asset sale to Folksamerica was attractive for a number of reasons, including among others, the potential premium to book value represented by the proposal, market factors and the alternatives available to us. The special committee authorized management to discuss the Folksamerica proposal to determine whether a definitive agreement could be entered into and requested Donaldson, Lufkin & Jenrette to prepare a detailed financial analysis of the proposed transaction. On November 10, 1999, counsel to Folksamerica provided us with an initial draft of a purchase agreement. On November 11, 1999, the special committee met with management and representatives of Donaldson, Lufkin & Jenrette. Management updated the board as to the negotiations of the Folksamerica transaction and stated that the asset sale was the best alternative for the company. After detailed discussion of the proposed transaction and future business opportunities available to the company, the special committee requested Donaldson, Lufkin & Jenrette to present its full financial analysis of the asset sale at the next board meeting and to address the fairness of the consideration. On November 12, 1999, the special committee met, with management, counsel to the special committee, counsel to the company and representatives of Donaldson, Lufkin & Jenrette present, to further discuss the asset sale to Folksamerica. Management summarized the negotiations and present terms of the Folksamerica transaction, and Donaldson, Lufkin & Jenrette stated that, based on the draft documentation, the consideration to be received by us in the proposed asset sale is fair to us from a financial point of view. On November 12, 1999, the board of directors met, with its legal and financial advisors present, to consider the Folksamerica transaction in the context of other potential opportunities. The special committee discussed its meetings and other work to date, the focus of which was the proposed asset sale to Folksamerica and alternative transactions with other parties, and then requested Donaldson, Lufkin & Jenrette to present to the board its analysis of the Folksamerica transaction as reflected in the draft documentation. Donaldson, Lufkin & Jenrette presented its financial analysis of the asset sale to Folksamerica and reiterated its oral opinion that, -21- based on the draft documentation, the consideration to be received by us in the asset sale is fair to us from a financial point of view. Members of the board discussed Donaldson, Lufkin & Jenrette's presentation with representatives of Donaldson, Lufkin & Jenrette and management. Management indicated that it believed the asset sale to Folksamerica was the best alternative available to the company at the time. The special committee recommended the Folksamerica transaction to the entire board as it was presently being discussed, subject to acceptable final definitive documentation being completed and receipt of an acceptable fairness opinion from Donaldson, Lufkin & Jenrette. The board unanimously resolved that the special committee be delegated the authority to respond to and approve changes made to the terms of the transaction in the course of negotiating final documentation with Folksamerica, unless those changes represented a substantial departure from the transaction terms outlined to the board. Following that action, the board unanimously determined that the asset sale was expedient and in the best interests of our company and approved the transaction, subject to acceptable final documentation and the receipt of an acceptable fairness opinion from Donaldson, Lufkin & Jenrette. Over the next two months, our management, together with our counsel and representatives of Donaldson, Lufkin & Jenrette, negotiated the terms of the asset sale within the parameters of the transaction approved by the board on November 12, 1999. Our legal advisors and representatives of Donaldson, Lufkin & Jenrette, as well as the legal and financial advisors of Folksamerica, were involved in many of these negotiations. The special committee and its counsel were kept apprised of the negotiations and received drafts of the transaction documents. In mid-December 1999, during a hiatus in the discussions with Folksamerica, management had preliminary discussions with Company Y. On December 18, 1999, our counsel delivered to Company Y a draft asset purchase agreement that, if negotiations with Folksamerica ended, could serve as the basis for a possible transaction. Discussions with Company Y were suspended in light of the recommencement and advanced state of negotiations with Folksamerica, whose proposal was considered to be more advantageous. During the process of negotiating the asset sale with Folksamerica, management learned of XL Capital's interest in having us repurchase our shares held by them with the consideration for such repurchase to include our interest in LARC Holdings, Ltd. and Annuity and Life Re (Holdings), Ltd. The board referred the matter to the special committee. Negotiations followed, including as to the repurchase price, which was agreed to be the lesser of (1) 85% of the average closing market price of our common stock during the 20 trading days beginning on the third business day following public announcement of the stock repurchase and the asset sale (January 21, 2000) and (2) $15. Management discussed with the special committee the stock repurchase from XL Capital at its November 11, 1999 meeting. At that meeting, the special committee requested Donaldson, Lufkin & Jenrette to prepare a financial analysis of the XL Capital stock repurchase at the next board meeting. At the November 12, 1999 meeting of the special committee, management presented the terms of the XL Capital stock repurchase to the special committee. Representatives of Donaldson, Lufkin & Jenrette discussed their views of the proposed XL Capital stock repurchase with the special committee, including the positive impact that the transaction would have on the company's book value per share. Representatives of Donaldson, Lufkin & Jenrette indicated that they believed that they would be prepared to render a fairness opinion to the board with respect to the XL Capital stock repurchase, subject to review of definitive documentation and transaction terms. On November 12, 1999, the special committee determined that the XL Capital stock repurchase is fair to and in the best interests of us and our stockholders other than XL Capital and recommended that the board approve the stock repurchase, subject to acceptable final definitive documentation being completed and receipt of an acceptable fairness opinion from Donaldson, Lufkin & Jenrette. At the November 12, 1999 meeting of the board, management presented the terms of the XL Capital stock repurchase and Donaldson, Lufkin & Jenrette presented its financial analysis of the stock repurchase. The board discussed the impact of the stock repurchase in light of Donaldson, Lufkin & Jenrette's presentation. Following that, the board (with Michael P. Esposito, Jr., Ian R. Heap and Mr. Clements, who are also directors of XL Capital, abstaining) determined that the XL Capital stock repurchase is fair to and in the best interests of our stockholders other than XL Capital and approved -22- the stock repurchase, subject to acceptable final definitive documentation being completed and receipt of an acceptable fairness opinion from Donaldson, Lufkin & Jenrette. On December 13, 1999, the special committee met, with its and the Company's legal and financial advisors present, to receive an update from management as to the negotiations for the asset sale and the XL Capital stock repurchase. Management advised the special committee of the progress of the negotiation of the documentation for the transactions. Representatives of Donaldson, Lufkin & Jenrette presented their full financial analysis of both the asset sale and XL Capital stock repurchase. In connection with that presentation, Donaldson, Lufkin & Jenrette delivered its oral opinions that (1) the consideration to be received by us in the asset sale is fair to us from a financial point of view and (2) the consideration to be received by us in the XL Capital stock repurchase is fair to us and our stockholders other than XL Capital from a financial point of view. The special committee then confirmed its recommendations of the proposed transactions and directed management to seek to conclude negotiations with respect to both transactions. On January 17, 2000, we reached definitive agreement with Folksamerica as to the terms of the asset sale and executed the asset purchase agreement. Three of our stockholders, XL Capital, Marsh & McLennan Risk Capital, Ltd. and The Trident Partnership, L.P., executed voting agreements in which they granted Folksamerica Holding Company proxies to vote their shares in favor of the asset sale. Since we repurchased the shares held by XL Capital, those shares will not be voted at the stockholder meeting and will not be counted for purposes of determining the total number of shares entitled to vote. Donaldson, Lufkin & Jenrette delivered to the board a written opinion that, as of the date we executed that asset purchase agreement, the consideration to be received by us in the asset sale was fair to us from a financial point of view. On the same date, we executed the stock repurchase agreement with XL Capital. Donaldson, Lufkin & Jenrette delivered to the board an opinion that, as of the date we executed the stock repurchase agreement, the consideration to be received by us in the stock repurchase was fair to us and our stockholders, other than XL Capital, from a financial point of view. Reasons for the Asset Sale and the Name Change; Our Board of Directors Recommends the Asset Sale As described above under "Background of the Asset Sale," the decision of the board to approve the asset sale was the result of an extensive sale exploration and negotiation process which included the substantial involvement of our legal and financial advisors. Among the factors that the board considered in such determination were: o RCRe was incurring losses on its reinsurance business and faced increasing competition, which was adversely affecting results of operations and financial condition; o RCRe's surplus has decreased, while the surpluses of many of RCRe's competitors have increased; o we are unable to make expenditures to repurchase our shares while still operating as a reinsurance business because of RCRe's statutory surplus, rating and operating requirements; o the amount and volatility of our earnings, resulting from our operating strategy and underwriting performance, severely limits our ability to incur and service substantial indebtedness, which in turn limits our ability to increase RCRe's statutory surplus; o our depressed stock price, combined with our inability to incur debt or otherwise use RCRe's cash, as described above, have prevented us from making acquisitions, which puts us, like many other small reinsurance companies, at a severe competitive disadvantage in an industry that has been experiencing rapid global consolidation; -23- o the board considered the prospects of the company absent a transaction such as the asset sale and determined that stockholder value would likely continue to be diminished if strategic steps were not taken; o our shares have been trading at a significant discount to book value, and the board determined that the structure of the transaction with Folksamerica, which will result in the removal of reinsurance liabilities and uncertainties from our business, presented the best opportunity for our shares to trade closer to their book value; o a number of parties had been contacted (including 19 by Donaldson, Lufkin & Jenrette) regarding a possible transaction with us, and discussions and due diligence sessions were held with several of those parties, but other than with Folksamerica, none of the discussions with those parties resulted in an agreement; o the asset sale to Folksamerica was the only proposed transaction or structure that would result in our stockholders potentially realizing value at or above the book value of the company; o the asset purchase agreement is a result of extensive arm's-length negotiations and its terms reflect such negotiations; o the board's financial advisor, Donaldson, Lufkin & Jenrette, determined that the consideration to be received by us in the transaction is fair to us from a financial point of view; o the special committee recommended that the board approve the asset sale; and o the various matters described in "Interests of Certain Persons in Matters to Be Acted Upon" do not outweigh or materially detract from the benefits of the asset sale to us. The board also took into account the following negative aspects of the asset sale: o the asset sale does not provide liquidity for our stockholders and creates uncertainty as to our future prospects; o the asset purchase agreement limits our ability to consider other proposals that could be more attractive and, if it is not consummated, may require us to, under certain circumstances, pay to Folksamerica a termination fee of $1.5 million; o the purchase price could be significantly less than $20.335 million (see "Risk Factors -- The ultimate purchase price to be paid by Folksamerica in the asset sale may be less than $20.335 million"); o the asset sale is subject to state regulatory approvals, including the approval of the insurance departments of Nebraska (which has been obtained), New York and Florida; and while we believe those approvals will be obtained, delays could prevent the timely completion of the asset sale and result in additional expenditures by us; o the consummation of the asset sale is subject to other conditions, including, among others, third party consents, the retention of a key employee and the absence of a material adverse change in the assumed business; and o the uncertainty as to the company's future plans and the uncertainties and unquantifiable risks of entering into any new business ventures in which we have not been previously engaged. -24- After taking into account, among others, the factors set forth above, the board unanimously determined that the asset sale is expedient and for the best interests of the company and approved the asset sale. In view of the variety of factors considered in connection with its evaluation of the asset sale, the board did not find it practicable to, and did not, quantify or otherwise assign relative strengths to specific factors considered in reaching its determination. Under the asset purchase agreement, we agreed to cease the use of the name "Risk Capital Reinsurance Company" or any similar name following the closing. In light of that covenant, the board has proposed to change the name of our company from "Risk Capital Holdings, Inc." to "Arch Capital Group Ltd." THE BOARD OF DIRECTORS RECOMMENDS THAT YOU VOTE FOR THE ASSET SALE AND THE NAME CHANGE. Donaldson, Lufkin & Jenrette Has Delivered a Fairness Opinion Relating to the Asset Sale We and RCRe requested Donaldson, Lufkin & Jenrette Securities Corporation, as financial advisor to us and RCRe, to render an opinion to the board of directors of each of us and RCRe regarding the fairness from a financial point of view to us and RCRe of the consideration to be received by RCRe in the transaction. For purposes of its opinion, Donaldson, Lufkin & Jenrette defined the consideration (or total value) receivable to be $15.0 million (which reflects the purchase price of $20.335 million less the portion of that purchase price that represents severance obligations to be reimbursed by Folksamerica to us) plus the amount of GAAP book value of RCRe to be retained by RCRe. For purposes of its analysis, based on information provided by us and RCRe to Donaldson, Lufkin & Jenrette, Donaldson, Lufkin & Jenrette assumed the amount of GAAP book value of RCRe to be $347.9 million. In addition, Donaldson, Lufkin & Jenrette assumed that the total value received was a range which included results reflecting receipt of none of the escrowed funds in five years or all of the escrowed funds in five years. This analysis resulted in a range of total value of $342.9 million to $362.9 million, which included the $20.335 million payment to be made to RCRe, reduced to reflect the portion of that payment that represents our severance obligations to be reimbursed by Folksamerica, and the GAAP book value of RCRe. On December 13, 1999, Donaldson, Lufkin & Jenrette expressed its oral opinion to the special committee, acting on behalf of our full board, that, as of that date, and based on and subject to the assumptions, limitations and qualifications set forth in the written opinion, the consideration receivable by RCRe in the proposed transaction was fair to us and RCRe from a financial point of view. Donaldson, Lufkin & Jenrette subsequently confirmed its December 13, 1999 oral opinion in writing on January 17, 2000. The full text of the January 17, 2000 Donaldson, Lufkin & Jenrette opinion is attached as Annex F. We urge you to read the opinion carefully and in its entirety for the procedures followed, assumptions made, other matters considered and limits of the review by Donaldson, Lufkin & Jenrette in connection with its opinion. Donaldson, Lufkin & Jenrette prepared its oral and written opinion for our board of directors and the board of RCRe. The opinions addressed only the fairness from a financial point of view of the consideration receivable by RCRe to us and RCRe as of their respective dates. Donaldson, Lufkin & Jenrette necessarily based its opinion on economic, market, financial and other conditions as they existed on the dates of its opinion and on the information made available to it as of those dates. Although subsequent developments may affect the assumptions, analyses or conclusions of the opinion, Donaldson, Lufkin & Jenrette does not have any obligation to update, revise or reaffirm its opinion. The opinion is not a recommendation to any stockholder as to how such stockholder should vote on the transaction. The opinion does not address the relative merits of the -25- transaction compared to other business strategies considered by our board of directors or the board of directors' decision to proceed with the transaction. In arriving at its January 17, 2000 opinion, Donaldson, Lufkin & Jenrette: o reviewed the execution copy of the asset purchase agreement and the disclosure schedule and all exhibits thereto; o reviewed financial and other information that was publicly available or furnished to it by us, including information provided during discussions with the management; o reviewed earnings projections of RCRe for the period beginning January 1, 1999 and ending December 31, 2000 prepared by the management; o compared our financial and securities data with data of various other companies whose securities are traded in public markets; o reviewed the historical share prices and trading volumes of our common stock; o reviewed prices paid in other relevant business combinations of property-casualty insurance companies; and o conducted such other financial studies, analyses and investigations as Donaldson, Lufkin & Jenrette deemed appropriate for purposes of the opinion. Donaldson, Lufkin & Jenrette reviewed substantially identical information in arriving at its December 13, 1999 opinion. In rendering its oral and written opinion, Donaldson, Lufkin & Jenrette relied upon and assumed the accuracy and completeness of all of the financial and other information that was available to it from public sources, that was provided to it by us or our representatives, or that it otherwise reviewed. Management believes that the financial projections it provided to Donaldson, Lufkin & Jenrette are based on reasonable assumptions. Donaldson, Lufkin & Jenrette did not make any independent evaluation of any assets or liabilities or make any independent verification of any of the information that it reviewed. -26- The following is a summary of the presentation that Donaldson, Lufkin & Jenrette made to the special committee at its December 13, 1999 meeting in connection with rendering its December 13, 1999 fairness opinion. The chart below summarizes the ranges of implied equity values based on Donaldson, Lufkin & Jenrette's analyses and compares these ranges with the total value receivable by RCRe. For a detailed description of each of Donaldson, Lufkin & Jenrette's analyses, see the discussion of the individual analyses below: [EXPLANATORY CHART] 1. Analysis of Consideration Receivable Based on Selected Publicly Traded Property-Casualty Insurance Companies. Donaldson, Lufkin & Jenrette compared the consideration receivable by RCRe to the range of equity values of RCRe implied by the relative valuation multiples of the following publicly traded property-casualty insurance companies: o Ace Limited o PXRE Group Ltd. o Everest Reinsurance Holdings, Inc. o Renaissance Re Holdings, Ltd. o IPC Holdings, Ltd. o Transatlantic Holdings, Inc. o LaSalle Re Holdings Ltd. o Trenwick Group Inc. o PartnerRe Ltd. o XL Capital Ltd Donaldson, Lufkin & Jenrette analyzed the equity value of each of these selected companies using trading valuations as of December 10, 1999, measured as a multiple of September 30, 1999 book value per share. Based on this analysis, Donaldson, Lufkin & Jenrette developed the following range of valuation multiples reflecting Donaldson, Lufkin & Jenrette's judgment as to the business mix and trading levels of such companies: 0.60x - 1.10x for September 30, 1999 book value per share In determining the range of equity values for RCRe, Donaldson, Lufkin & Jenrette applied the preceding valuation multiple to RCRe's shareholder's equity at September 30, 1999. The analysis resulted in a range of implied equity values for RCRe of $208.7 million to $382.7 million. The range of consideration receivable -27- by RCRe is within the resulting implied range of equity values of RCRe, valuing the $20 million escrow at full and zero value. 2. Analysis of Consideration Receivable Based on Acquisitions of Property-Casualty Insurance Companies. Donaldson, Lufkin & Jenrette compared the consideration receivable by RCRe to the range of values of RCRe implied by the relative purchase price multiples generated from 15 acquisitions of property-casualty insurance companies that have occurred since August 7, 1995. These 15 selected acquisitions are: o Swiss Reinsurance acquisition of Underwriters Re Group Inc. o Markel Corporation acquisition of Terra Nova (Bermuda) Holdings Ltd. o Trenwick Group, Inc. acquisition of Chartwell Re Corporation o ACE Limited acquisition of Capital Re Corporation o ACE Limited acquisition of CAT Limited o XL Capital Ltd acquisition of NAC Re Corp. o Gerling-Kozern Allegemeine Versicherungs AG acquisition of Constitution Re o Fund American Enterprises Holdings, Inc. acquisition of Folksamerica Holding Company, Inc. o XL Capital Ltd acquisition of Mid Ocean Limited o Fairfax Financial Holdings Limited acquisition of Sphere Drake Holdings Limited o XL Capital Ltd acquisition of GCR Holdings Ltd o PXRE Corporation acquisition of Transnational Re Corporation o General Re Corporation acquisition of National Re Corporation o ACE Limited acquisition of Tempest Reinsurance Company Limited o Chartwell Re Corporation acquisition of Piedmont Management Company, Inc. Donaldson, Lufkin & Jenrette analyzed the equity value of each of the acquired companies, measured as a multiple of book value per share for the most recent quarter. Based on this analysis, Donaldson, Lufkin & Jenrette developed the following range of acquisition multiples reflecting Donaldson, Lufkin & Jenrette's judgment as to the business mix of such property-casualty insurance companies involved in such acquisitions: 0.90x - 1.30x book value per share Donaldson, Lufkin & Jenrette then applied this acquisition multiple to RCRe's stockholders' equity to determine the range of implied equity values of RCRe. The analysis resulted in a range of implied values for RCRe of $313.1 million to $452.3 million. The range of consideration receivable by RCRe is within this range of implied values, valuing the $20 million escrow at full and zero value. 3. Analysis of pro forma financial effect of the transaction on our stockholders' equity. Donaldson, Lufkin & Jenrette calculated our pro forma stockholders' equity per share using the range of consideration receivable. The analysis resulted in the following range of stockholders' equity per share: -28- Stockholders' Equity Per Share -------------------------------- Basic Fully Diluted --------- ---------------- As of September 30, 1999 $21.15 $20.91 Assumes we receive no escrowed funds $21.20 $20.95 Accretion 0.2% 0.2% Assumes we receive all escrowed funds $21.96 $21.52 Accretion 3.8% 2.9% The summary set forth above is not a complete description of the analyses performed by Donaldson, Lufkin & Jenrette but summarizes the material elements of its presentation to the special committee on December 13, 1999 in connection with preparation of its December 13, 1999 opinion. Donaldson, Lufkin & Jenrette performed substantially identical analyses in connection with its January 17, 2000 opinion. When Donaldson, Lufkin & Jenrette prepares a fairness opinion it must determine the most appropriate and relevant methods of financial analysis and apply these methods to the particular circumstances. Donaldson, Lufkin & Jenrette conducted each of the analyses in order to provide a different perspective on the transaction and to add to the total mix of information available. In reaching its conclusion, Donaldson, Lufkin & Jenrette considered the results of the analyses in light of each other and ultimately reached its opinion based on the results of all analyses taken as a whole. Donaldson, Lufkin & Jenrette did not place particular reliance or weight on any individual analysis. Accordingly, Donaldson, Lufkin & Jenrette has indicated to our board of directors and RCRe's board of directors that it believes that its analyses must be considered as a whole and that selecting portions of its analyses and the factors considered by it, without considering all analyses and factors, could create an incomplete view of the evaluation process underlying its opinion. The results of Donaldson, Lufkin & Jenrette's analyses are not necessarily indicative of actual values or future results, which may be significantly more or less favorable than suggested by such analyses. Pursuant to letter agreements in May and November of 1999, we: o have paid to Donaldson, Lufkin & Jenrette a retainer fee of $100,000; o upon completion of the transaction, will pay to Donaldson, Lufkin & Jenrette an additional $1,150,000, which includes a $500,000 fairness opinion fee in connection with the January 17, 2000 opinion. In addition, we have agreed to pay Donaldson, Lufkin & Jenrette a fee of $250,000 in connection with its January 17, 2000 opinion, should the transaction with Folksamerica not be consummated, and to reimburse Donaldson, Lufkin & Jenrette from time to time for all out-of-pocket expenses, including the reasonable fees and expenses of counsel, that it incurs in connection with its engagement and to indemnify Donaldson, Lufkin & Jenrette and related persons against specified liabilities in connection with its engagement, including liabilities under U.S. federal securities laws. Separately, Donaldson, Lufkin & Jenrette entered into an agreement with us dated November 22, 1999 in connection with the stock repurchase from XL Capital. We have paid Donaldson, Lufkin & Jenrette a fee of $500,000 relating to the delivery of the fairness opinion related to the stock repurchase from XL Capital. Donaldson, Lufkin & Jenrette and we negotiated the terms of the fee arrangements, and our board of directors was aware of the arrangements. Donaldson, Lufkin & Jenrette believes that the terms of the arrangements are customary for transactions of this nature. -29- As part of its investment banking business, Donaldson, Lufkin & Jenrette regularly engages in the valuation of businesses and securities in connection with mergers, acquisitions, underwritings, sales and distributions of listed and unlisted securities, private placements and valuations for corporate and other purposes. In the ordinary course of its business, Donaldson, Lufkin & Jenrette or its affiliates may at any time hold long or short positions, and may trade or otherwise effect transactions, for its own account or for the accounts of customers, in our equity or debt securities. Donaldson, Lufkin & Jenrette has performed investment banking and other services for Folksamerica and XL Capital and their affiliates in the past and has received compensation for its services. Certain Stockholders Have Agreed to Vote for the Asset Sale Marsh & McLennan Risk Capital Holdings, Ltd. and The Trident Partnership, L.P., which together control 13.3% of the total voting power of our stock, have given Folksamerica their proxies to vote their shares in favor of the asset sale at the stockholders' meeting. The proxies were given to Folksamerica pursuant to voting agreements dated as of the same date as the asset purchase agreement. The proxies expire on July 31, 2000 and will terminate if either the asset purchase agreement or the voting agreements are terminated. The voting agreements are included in this proxy statement as Annexes B1 and B2. XL Capital gave Folksamerica a similar proxy, but that proxy terminated upon the consummation of the XL Capital stock repurchase. Management Changes It is contemplated that after the consummation of the asset sale, when our company will no longer have reinsurance operations, our board of directors will remain in place, Robert Clements will continue as chairman of the board and the executive officers of our company will be Peter A. Appel and others to be identified. Accounting Treatment of the Asset Sale The asset sale will be reflected on our consolidated balance sheet as a sale of certain of our assets and the transfer of certain of our liabilities. Upon consummation of the asset sale, we will recognize either a gain or a loss equal to the final purchase price (net of transaction costs) plus the liabilities assumed by Folksamerica, less the carrying value of the assets sold to Folksamerica. Material Federal Income Tax Consequences of the Asset Sale The asset sale will not result in any federal income tax consequences to you. The asset sale will be a taxable transaction for RCRe for federal income tax purposes. However, it is not expected that the asset sale will result in material federal, state, local or foreign income tax liability, if any. We have agreed to reimburse Folksamerica for a portion of the tax liability it may incur as a result of the asset sale. See "The Asset Purchase Agreement--Tax Sharing Arrangement." -30- Regulatory Matters Insurance Regulatory Law The asset sale, as contemplated by the transfer and assumption agreement in the form attached as Annex C to this proxy statement, was approved by the Nebraska Insurance Department on February 11, 2000. The transfer and assumption agreement approved by the Nebraska Insurance Department provides for Folksamerica Reinsurance Company to notify the reinsureds under RCRe's in-force treaties about the transaction and to give them 30 days to object to the release of RCRe from further liability under those treaties. RCRe intends to apply to the Nebraska Insurance Department for permission to distribute to us all of RCRe's remaining assets other than statutory surplus of $20 million required for RCRe to maintain its insurance licenses and authorizations in the states in which it is currently licensed or authorized. While the permission of the Nebraska Insurance Department will generally be required for any distribution by RCRe, RCRe expects that it will be permitted to make such distribution subject to any greater amount that it may be required by the Nebraska Insurance Department to retain in the event there are any objections from reinsureds to the release of RCRe from further liability pursuant to the transfer and assumption agreement. See footnote 10 to our audited consolidated financial statements included in this proxy statement for further details regarding statutory restrictions on distributions by RCRe. The Florida Department of Insurance ("FDOI") has been notified of the proposed transaction. In connection with RCRe's license in Florida, RCRe is required to obtain approval from the FDOI if there is a material change in its plan of operations in Florida. The FDOI approval relates to RCRe's Florida certificate of authority, and the FDOI may take action against RCRe's certificate of authority if it does not obtain the required approval. The approval of the FDOI is a condition to the consummation of the asset sale. The New York Insurance Department has also been notified of the proposed transaction. The approval of the New York Insurance Department is a condition to the consummation of the asset sale. Antitrust Law The Hart-Scott-Rodino Antitrust Improvements Act of 1976 and the related rules and regulations prohibit us from consummating the asset sale until we and Folksamerica have notified and furnished information to the United States Federal Trade Commission and the Antitrust Division of the United States Department of Justice and the specified waiting period requirements under the Act expire or terminate. On February 22, 2000, in connection with the asset sale, we and Folksamerica each filed with the FTC and the Antitrust Division a Notification and Report Form under the Hart-Scott-Rodino Act. On March 3, 2000, the FTC granted early termination of the review period under the Hart-Scott-Rodino Act. -31- THE ASSET PURCHASE AGREEMENT The following is a description of the more significant terms of the asset purchase agreement. We urge you to read carefully the entire asset purchase agreement, which we have included in this proxy statement as Annex A. Purchase Price Folksamerica Reinsurance Company will assume RCRe's liabilities under the reinsurance agreements transferred to it in the asset sale and RCRe will transfer to Folksamerica Reinsurance Company assets in an aggregate amount that is, in GAAP book value (as set forth on our estimated closing date balance sheet), equal to the GAAP book value (as set forth on our estimated closing date balance sheet) of the liabilities assumed. The decrease in our net GAAP book value due to increases after September 30, 1999 in our loss reserves relating to certain of our Swiss Air liabilities will be disregarded for purposes of the closing date balance sheet up to an aggregate of $5 million, net of tax effects. In consideration for the transfer of RCRe's book of business, Folksamerica will pay $20.335 million in cash at the closing, subject to adjustment under the circumstances described below. Following the closing, the closing date balance sheet will be audited by our independent public accountants. Folksamerica is permitted to dispute the closing date balance sheet (other than the component of the balance sheet that relates to our loss reserves). Any dispute will be referred to neutral experts mutually acceptable to us and Folksamerica for final resolution. In the event that we overestimated the net value of the assumed business, we will be required to pay to Folksamerica a post-closing purchase price adjustment. Conversely, if we underestimated the net value of the assumed business, Folksamerica will be required to pay us a post-closing purchase price adjustment. Folksamerica will designate independent experts to determine the sum of the loss reserves relating to the assumed business (other than that portion of the assumed business covered by the $20 million escrow described in "Other Transaction Agreements--Escrow Agreement") as of the fifth anniversary of the closing date plus the losses paid under those reinsurance agreements. If our reserves for those agreements as of the closing date exceeds that sum, then Folksamerica will be required to pay us in cash that excess up to $2 million. If we dispute the calculation of this amount by those experts, the dispute will be referred to neutral experts mutually acceptable to us and Folksamerica for final resolution. We may be required to deposit an additional amount of up to $5 million in a supplemental escrow for five years in the event that our closing date loss reserves (other than reserves covered by the $20 million escrow) are less by more than one-half percent (0.5%) than those estimated by our independent actuary. This supplemental escrow will be governed by the supplemental escrow agreement described in "Other Transaction Agreements--Supplemental Escrow Agreement." Tax Sharing Arrangement Under the Internal Revenue Code, a purchaser of insurance assets may become liable for a "bargain purchase price tax" if, in a transaction, the tax basis of the assets it is purchasing is more than the tax basis of the liabilities it is assuming plus the purchase price (including transaction costs) it is paying. We have agreed to grant Folksamerica a credit against the purchase price for a portion of this potential tax by the following method: To the extent it is determined that the tax basis of the assets being transferred exceeds the sum of o the tax basis of the liabilities being transferred, -32- o the final purchase price, and o Folksamerica's transaction costs relating to the asset sale, we will give Folksamerica a credit against the purchase price equal to o if the excess is $15 million or less, then the lesser of (1) 17.5% of the excess and (2) $2 million; and o if the excess is more than $15 million, then the sum of (1) $2 million plus (2) 35% of the excess. Related Costs Under the asset purchase agreement, we have agreed to retain the liabilities relating to our severance plans and agreements, as well as to pay to Folksamerica at closing the amount by which the cost of reinsurance protection on our aviation line of business exceeds the net premiums we earn on that business after December 31, 1999. Furthermore, as described above, we are liable for a portion of Folksamerica's bargain purchase price tax liability and our own transaction costs. We estimate that these costs will be approximately $19 million in the aggregate, which amount will effectively reduce the purchase price we will retain. These costs are reflected in the pro forma book value amounts set forth under "Unaudited Condensed Consolidated Pro Forma Financial Data." Our Representations and Warranties The asset purchase agreement contains representations and warranties by us, including as to o incorporation and authority to enter into the transaction; o property and assets necessary to operate the assumed business remaining in our company or our affiliates and outstanding intercompany obligations relating to the assumed business; o no defaults under any judgments relating to the assumed business; o compliance with instruments, including the certificate of incorporation and bylaws, and other agreements to which we are party; o receipt of the necessary governmental approvals; o accuracy of our SEC filings and statutory financial statements filed with state insurance departments and the pro forma September 30, 1999 balance sheet of the assumed business; o absence of undisclosed liabilities; o title to and rating of all of our fixed income investments being transferred to Folksamerica; o the Integrated Solutions for which we had obligations as of September 30, 1999; o absence of a material adverse change since September 30, 1999 relating to the assumed business; o the operation of the assumed business in the ordinary course of business; -33- o absence of adjustments to case reserves since September 30, 1999, except in the ordinary course consistent with past practice; o actuarial reports of the company for periods ending on or after December 31, 1995; o accuracy of the information in this proxy statement; o judgments; o pending or threatened litigation; o compliance with laws; o licenses and permits; o ownership of and rights to use intellectual property; o title to property; o reinsurance and retrocession agreements being transferred in the asset sale; o accounts receivable; o compliance with and validity of contracts and instruments other than the reinsurance agreements, including noncompetition agreements; o employee benefit matters; o tax matters; o agents through whom RCRe sells insurance products; o year 2000 issue; and o broker's or finder's fees. Folksamerica's Representations and Warranties The asset purchase agreement contains representations and warranties by Folksamerica, including as to o incorporation and authority to enter into the transaction; o compliance with instruments, including the certificate of incorporation and bylaws, and other agreements to which Folksamerica is a party; o pending or threatened litigation; o receipt of the necessary governmental approvals; o accuracy of statutory financial statements filed with state insurance departments; o financial ability of Folksamerica to complete the transaction; -34- o accuracy of information in this proxy statement supplied by Folksamerica; and o broker's or finder's fees. Principal Covenants Conduct of Business Before the Closing We have agreed that, until closing, subject to certain exceptions, we will conduct the assumed business in the ordinary course and in the same manner as conducted prior to the date of the asset purchase agreement and will use our commercially reasonable efforts to maintain intact our existing business organization and will not take any actions out of the ordinary course of business, without the prior consent of Folksamerica. No Solicitation We have agreed not to solicit, encourage or take part in any discussions regarding an acquisition proposal. An acquisition proposal means an offer from a party other than Folksamerica to purchase 15% or more of the company. We are, however, allowed to engage in discussions and provide information to third parties if o the acquisition proposal is a "superior proposal," meaning that, based on the written advice of a financial advisor of nationally recognized reputation, our board of directors has determined that it is more favorable to you than the asset purchase agreement; and o in response to a superior proposal, our board of directors determines, based on advice of our counsel, that it is necessary to do so in order to comply with its fiduciary duties. We also agreed that the board will not withdraw its recommendation to you to vote for the approval of the asset sale and not approve, recommend to you or propose any acquisition proposal or enter into any agreement relating to an acquisition proposal. However, in the event of an unsolicited superior proposal, our board of directors is permitted, two business days after we give notice to Folksamerica specifying the material terms of the superior proposal and that we are prepared to accept it, to o terminate the asset purchase agreement; o enter into an agreement relating to the superior proposal; and o withdraw its recommendation of the asset purchase agreement and recommend to you the superior proposal. Termination Fee If we terminate the asset purchase agreement in the event of a superior proposal, we will be required to pay to Folksamerica a termination fee of $1.5 million two days after the day we terminate. If, as a result of direct solicitation by a third party, our stockholders do not approve the asset purchase agreement and thereafter we or Folksamerica terminate the asset purchase agreement due to the failure of our stockholders to approve it or because the closing has not occurred prior to July 31, 2000, we must pay the $1.5 million termination fee to Folksamerica if we enter into or consummate an acquisition proposal with the third party that solicited our stockholders within 12 months of the day we terminate. -35- Aviation Business We have agreed to pay to Folksamerica at closing the amount by which the cost of reinsurance protection on our aviation line of business exceeds the net premiums we earn on that business after December 31, 1999. Employee Matters We have agreed to retain all of the liabilities under our benefit and employment arrangements, and we will make a payment in the aggregate amount of $665,000 at the closing to four of our employees who will become employees of Folksamerica following the closing. We have agreed to offer to retain all of our employees (other than our senior executives and the four employees mentioned in the prior sentence) involved in the operation of the assumed business for a period of up to 60 days following the closing. These employees will work at the direction of Folksamerica and the cost of their employment will be reimbursed to us by Folksamerica, except for those employees whose services Folksamerica determines it does not require, whom we may redeploy or terminate. If terminated, employees will be eligible for severance payments. Conditions to Closing Mutual Conditions The obligation of us and Folksamerica to consummate the asset sale is subject to the conditions set forth in the asset purchase agreement, including the following: o the representations and warranties must be true and the covenants must be complied with where such inaccuracy or noncompliance would have a material adverse effect (except for those representations and warranties that are already qualified by materiality, which must be true); o no court or government body shall have issued an order restraining the closing of the asset purchase agreement; o all necessary governmental approvals must have been obtained; o all third party consents must have been obtained, including those approving: o the transfer of the software licenses to our SICS Reinsurance System to Folksamerica; o the transfer of our letters of credit and/or the assets underlying them to Folksamerica; and o the transfer to Folksamerica of our reinsurance rights granted in connection with four of our Integrated Solutions investments; o expiration of the waiting period under the Hart-Scott-Rodino Act; o the receipt of legal opinions; and o the approval of the asset sale by our stockholders. -36- Additional Conditions to the Obligation of Folksamerica The following are additional conditions to Folksamerica's obligations to close the asset sale: o there being no material adverse change in the assumed business since the date of the asset purchase agreement; o Joanne DeBlasis, our accident and health underwriter, shall be in RCRe's employ at the closing; o we shall have purchased additional coverage for our aviation line of business and aggregate excess reinsurance on behalf of Folksamerica (the cost of which aggregate excess reinsurance will be reimbursed to us by Folksamerica); and o we shall have amended our broad-based severance plans to require that only employees who remain working at our Greenwich, Connecticut offices for a period of up to sixty days after closing to assist Folksamerica in the transition (or whose employment is involuntarily terminated by the company during that 60-day period) will be entitled to receive severance payments. Indemnification We and Folksamerica have agreed to indemnify each other for breaches of some representations, warranties and covenants contained in the asset purchase agreement. Indemnification obligations, except for representations about our authority, investments, reinsurance and retrocession agreements, accounts receivable, agents and broker's fees, are subject to a $500,000 deductible. Our liability to Folksamerica due to our breaches of representations and warranties regarding the transferred reinsurance and retrocession agreements and accounts receivable is limited to amounts then available under the escrow agreement. A $5 million aggregate limitation applies to the parties' indemnification obligations with respect to the assumed business (including those involving representations and warranties related to undisclosed liabilities, which are to be satisfied solely out of amounts then available under the escrow agreement). There is no limit on our indemnification obligations with respect to losses Folksamerica may incur from liabilities not assumed by it in the asset sale, which liabilities include any liabilities (other than liabilities under reinsurance agreements) arising out of or related to the managing underwriting agency referred to in "Other Transaction Agreements -- Escrow Agreement." Termination The asset purchase agreement may be terminated: o by mutual consent of us and Folksamerica; o by either us or Folksamerica, if the closing has not occurred prior July 31, 2000, but this option is not available to a party whose failure to fulfill its obligations prevented the closing; o by Folksamerica, if we have breached or not complied with any representation, warranty or covenant in the asset purchase agreement, if such breach or failure would give rise to a failure of a condition and we are not capable of curing it; o by Folksamerica, if we breach our obligations under the "no solicitation" provisions of the asset purchase agreement; o by us, if Folksamerica has breached or not complied with any representation, warranty or covenant in the asset purchase agreement, if such breach or failure would give rise to failure of a condition and Folksamerica is not capable of curing it; -37- o by us, in the event of a superior proposal; o by us or Folksamerica, if our stockholders have voted against approval of the asset purchase agreement; and o by Folksamerica, if the loss reserves recorded by us as of December 31, 1999 relating to the reinsurance agreements other than those produced by a certain managing underwriting agency were more than 5% less than our independent actuary's estimate of those reserves and we failed to increase those reserves so that they were no longer more than 5% less than our independent actuary's estimate within 10 business days of the delivery of our actuary's report (this termination provision was not triggered). Survival Our representations and warranties relating to the following matters will survive for one year following the closing and, if breached, may result in liability to us: o incorporation and authority to enter into the transaction; o property and assets necessary to operate the assumed business remaining in our company or our affiliates and outstanding intercompany obligations relating to the assumed business; o compliance with instruments, including the certificate of incorporation and bylaws, and other agreements to which we are party; o absence of undisclosed liabilities; o title and rating of all of our fixed income investments being transferred to Folksamerica; o the Integrated Solutions for which we had obligations as of September 30, 1999; o absence of a material adverse change since September 30, 1999 relating to the assumed business; o absence of adjustments to case reserves since September 30, 1999, except in the ordinary course consistent with past practice; o actuarial reports of the company for periods ending on or after December 31, 1995; o reinsurance and retrocession agreements being transferred in the asset sale; o accounts receivable; o non-competition covenants; o agents through whom RCRe sells insurance; and o broker's or finder's fees. In addition, representations and warranties relating to tax matters will survive until the expiration of the applicable statute of limitations. We retain our tax and employee benefit liabilities and other liabilities not being assumed by Folksamerica, including all liabilities not arising under RCRe's reinsurance agreements transferred to Folksamerica Reinsurance Company and all liabilities (other than liabilities under reinsurance agreements) -38- arising out of or relating to the managing underwriting agency referred to in "Other Transaction Agreements -- Escrow Agreements." All of the reinsurance agreements transferred to Folksamerica Reinsurance Company are listed in a schedule to the asset purchase agreement. Folksamerica's representations and warranties relating to incorporation and authority to enter into the transaction; compliance with instruments, including its certificate of incorporation and bylaws, and other agreements to which they are party; and broker's or finders' fees will also survive for one year following the closing. -39- OTHER TRANSACTION AGREEMENTS Transfer and Assumption Agreement The following is a brief summary of the transfer and assumption agreement. The form of transfer and assumption agreement is included in this proxy statement as Annex C and we urge you to read the entire agreement. RCRe and Folksamerica Reinsurance Company will enter into the transfer and assumption agreement at the closing of the asset sale, under which Folksamerica Reinsurance Company will assume RCRe's rights and obligations under the reinsurance agreements being transferred in the asset sale. Following the closing, Folksamerica Reinsurance Company will notify the reinsureds under the in-force reinsurance agreements that it has assumed RCRe's obligations and that, unless the reinsureds object to the assumption, RCRe will be released from its obligations to those reinsureds. However, RCRe will continue to be liable under those reinsurance agreements if the reinsureds object to the release of RCRe from its obligations or such release is found not to be enforceable against the reinsureds. Folksamerica has agreed to indemnify us for any losses arising out of the reinsurance agreements transferred to Folksamerica Reinsurance Company in the asset sale. Escrow Agreement The following is a brief summary of the escrow agreement. The form of escrow agreement is included in this proxy statement as Annex D and we urge you to read the entire agreement. The escrow agreement may be modified before closing to reflect certain changes requested by the escrow agent and agreed to by us and Folksamerica. At closing, $20 million of the purchase price will be delivered into a five-year escrow account established under an escrow agreement to be entered into among RCRe, Folksamerica Holding Company, Inc., Folksamerica Reinsurance Company and an escrow agent (which is expected to be Citibank, N.A.). Those escrowed funds will primarily be used to reimburse Folksamerica for losses it may incur under reinsurance agreements produced on our behalf by a certain managing underwriting agency. Amounts in this escrow may be released to Folksamerica to satisfy its indemnification claims against us relating to undisclosed liabilities, our reinsurance and retrocession agreements, accounts receivable and the managing underwriting agency referred to above or the business produced by it. Our liability for indemnification claims relating to our reinsurance and retrocession agreements and accounts receivable are limited to amounts then in the escrow account and, with respect to claims for undisclosed liabilities, is also subject to the aggregate $5 million dollar limitation on indemnification described in "The Asset Purchase Agreement--Indemnification." Claims against us for indemnification relating to the managing underwriting agency referred to above (other than liabilities under reinsurance agreements) are not subject to any limitation. Distributions from the Escrow Account The escrow agent may invest the escrowed funds only in investment grade tax-exempt fixed income securities. The "escrowed funds" means, at any time: o the amount we originally deposit in the escrow account, plus o interest earned on that amount, minus o any distribution made from the escrowed funds under the terms of the escrow agreement. The escrow agreement provides that the escrow agent will release funds to us to reimburse us for any tax liability that we incur as a result of interest on the escrowed funds, to the extent we actually pay those taxes. -40- In the first calendar quarter in which the losses paid under the reinsurance agreements exceed the loss reserves established by us as of the closing for losses relating to business written on behalf of RCRe by a certain managing underwriting agency, Folksamerica will notify us. That notice will be accompanied by a report of independent accountants designated by Folksamerica showing the calculation of the losses paid in respect of that business. We may dispute that calculation and refer the matter to a neutral accounting firm. Upon resolution, if it is determined that the paid losses do in fact exceed the closing date reserves, then the escrow agent will release funds equal to that excess to Folksamerica. After the initial release of escrowed funds, Folksamerica may deliver reports of additional paid losses to the escrow agent and the escrow agent will release funds in an amount equal to those losses to Folksamerica. Within ninety (90) days of the fifth anniversary of the closing of the asset sale, Folksamerica will deliver to us o a report of independent accountants designated by it showing the calculation of all losses paid on the business covered by the escrow in the five-year period; o a report of an independent actuary designated by it showing the calculation of the loss reserves for the business covered by the escrow as of the fifth anniversary of the closing; and o a report of the independent accountants designated by it showing the difference of the reserves relating to the business covered by the escrow as of the closing over the sum of the related paid losses and those reserves as of the fifth anniversary of the closing. If the difference is positive, that means those reserves as of the closing were redundant, and if the difference is negative, that means those reserves as of the closing were deficient. In the event that those reserves turn out to have been redundant, all of the amounts then in escrow will be released to us and, in addition, Folksamerica will pay us in cash the amount by which those reserves were redundant. In the event that those reserves turn out to have been deficient by less than $20 million, the amount by which those reserves were deficient will be released from the escrow to Folksamerica and the remainder will be released to us. In the event that those reserves were deficient by more than $20 million, all of the amounts then in escrow will be released to Folksamerica. In that case, Folksamerica will have no further recourse to us, except that we will be required to deliver to Folksamerica all or a part of the distributions of escrowed funds made to us to satisfy our tax liabilities. In each case, the party receiving a payment will also be entitled to receive interest with respect to that amount. Supplemental Escrow Agreement Under the circumstances described below, we may be required to enter into the supplemental escrow agreement. The following is a brief summary of the supplemental escrow agreement. The form of supplemental escrow agreement is attached to this proxy statement as Annex E and we urge you to read the entire agreement. The supplemental escrow agreement may be modified before closing to reflect certain changes requested by the escrow agent and agreed to by us and Folksamerica. We may be required to deposit an additional amount of up to $5 million into a five-year supplemental escrow under a supplemental escrow agreement that would be entered into among RCRe, Folksamerica Holding Company, Inc., Folksamerica Reinsurance Company and an escrow agent (which is expected to be Citibank, N.A.), in the event that our closing date loss reserves (other than reserves covered by the escrow agreement described above) are less by more than one-half percent (0.5%) than those estimated by our independent actuary. This supplemental escrow will be governed by terms substantially similar to the escrow described above, except that (1) if those reserves turn out to have been redundant, the full escrow fund will be released to us but Folksamerica will have no obligation to make payments to us and (2) this escrow will not be available to satisfy indemnification claims. -41- XL STOCK REPURCHASE On March 2, 2000, we repurchased from XL Capital, then our single largest stockholder, all of the 4,755,000 shares of our common stock held by it. Set forth below is a brief summary of the terms of the stock repurchase agreement. We filed the stock repurchase agreement and the related voting disposition agreement with the SEC as exhibits to our Current Report on Form 8-K on January 18, 2000. Those agreements are incorporated in this proxy statement by reference, and we encourage you to read them carefully. Under the terms of the stock repurchase agreement, we purchased from XL Capital all of the 4,755,000 shares of our company held by it for a purchase price of $12.45 per share, or a total of $59,200,000. The per share repurchase price was determined as the lesser of (1) 85% of the average closing market price of our common stock during the 20 trading days beginning on the third business day following public announcement of the stock repurchase and asset sale (January 21, 2000), which was $14.65, and (2) $15. We paid XL Capital the consideration for the repurchase with: o our interest in privately held LARC Holdings, Ltd. (parent of Latin American Reinsurance Company Ltd.), valued at $25 million; and o all of our interest in Annuity and Life Re (Holdings), Ltd., valued at $25.38 per share and $18.50 per warrant, or $37,847,000 in the aggregate. XL Capital paid us in cash the difference (equal to $3,647,000) between our repurchase price and the value of our interests in LARC Holdings and Annuity and Life Re. The value per share of Annuity and Life Re was determined by taking the average of the closing price of Annuity and Life Re shares for the same period used in determining the repurchase price of our shares. Prior to this transaction, XL Capital owned 75% of LARC Holdings, and we owned 25% of LARC Holdings, exclusive of options held by management of LARC Holdings. In addition, XL Capital and we each owned approximately 5 1/2% of the outstanding shares of Annuity and Life Re. Several directors of XL Capital are also directors of Annuity and Life Re. The stock repurchase from XL Capital did not require stockholder approval. Effective as of the closing of the stock repurchase, Ian R. Heap and Michael P. Esposito, Jr. have continued to serve on our board, but not as XL Capital's designees. -42- SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth information available to us as of March 2, 2000 with respect to the ownership of our common stock by (i) each person known to us to be the beneficial owner of more than 5% of our outstanding shares, (ii) each director of the company, (iii) each executive officer of the company and (iv) all of our directors and executive officers as a group. Except as otherwise indicated, each person named below has sole investment and voting power with respect to the securities shown.
Number of Shares Rule 13d-3 Name and Address Beneficially Percentage Fully-Diluted of Beneficial Owner Owned(l) Ownership(l) Percentage(2) - - --------------------------------------------------- ---------------- ------------- ------------- Marsh & McLennan Risk Capital Holdings, Ltd. (3)............................ 2,301,022 17.4% 22.6% 1166 Avenue of the Americas New York, New York 10036 Merrill Lynch & Co., Inc. (4)...................... 2,033,900 16.5 11.3 World Financial Center, North Tower 250 Vesey Street New York, New York 10381 The Trident Partnership, L.P. (5).................. 1,636,079 11.9 9.1 Craig Appin House 8 Wesley Street Hamilton, HM11, Bermuda EQSF Advisers, Inc. and M.J. Whitman Advisers, Inc. (6)........................................... 1,132,975 9.2 6.3 767 Third Avenue New York, New York 10017 Franklin Resources, Inc. (7)....................... 1,064,100 8.6 5.9 777 Mariners Island Boulevard San Mateo, California 94404 Beck, Mack & Oliver LLC (8)........................ 992,700 8.1 5.5 330 Madison Avenue New York, New York 10017 Steinberg Asset Management Co., Inc. (9)...................................... 894,154 7.3 5.0 12 East 49th Street New York, New York 10017 Crabbe Huson Group, Inc. (10)...................... 809,887 6.6 4.5 121 SW Morrison, Suite 1400 Portland, Oregon 97204 Mark D. Mosca (11)................................. 307,574 2.5 2.5 Robert Clements (12)............................... 232,292 1.9 2.5 Peter A. Appel (13)................................ 102,834 * 1.1 Paul J. Malvasio (14).............................. 96,651 * * Michael P. Esposito, Jr. (15)...................... 7,804 * * -43- Number of Shares Rule 13d-3 Name and Address Beneficially Percentage Fully-Diluted of Beneficial Owner Owned(l) Ownership(l) Percentage(2) - - --------------------------------------------------- ---------------- ------------- ------------- Lewis L. Glucksman (15)............................ 3,804 * * Ian R. Heap (15)................................... 5,300 * * Thomas V. A. Kelsey (15)........................... 6,554 * * Robert F. Works (15)............................... 2,104 * * Philip L. Wroughton (15)........................... 2,800 * * All directors and executive officers (11 persons).................................. 767,717 6.1% 7.3% - - ---------------
* Denotes beneficial ownership of less than 1.0%. (1) Pursuant to Rule 13d-3 promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), amounts shown under "Number of Shares Beneficially Owned" and "Rule 13d-3 Percentage Ownership" include shares of common stock that may be acquired by a person within 60 days of the date of this proxy statement. Therefore, "Rule 13d-3 Percentage Ownership" has been computed based on (1) 12,329,494 shares of common stock actually outstanding as of March 2, 2000 and (2) shares of common stock that may be acquired within 60 days of the date of this proxy statement upon the exercise of options and warrants held by the person whose Rule 13d-3 Percentage Ownership is being computed, excluding those options and restricted shares that would vest upon stockholder and regulatory approval of the asset sale, as described in "Interests of Certain Persons in Matters to be Acted Upon--Vesting of Options and Restricted Shares." (2) Amounts shown under "Fully-Diluted Percentage," in the above table have been computed based on 12,329,494 shares of common stock actually outstanding as of March 2, 2000 and shares of common stock that may be acquired upon the exercise of all outstanding options and warrants (whether or not such options and warrants are exercisable within 60 days). As of March 2, 2000, there were an aggregate of 5,713,781 shares of common stock issuable under outstanding warrants and options as follows: (1) Class A Warrants to purchase an aggregate of 2,531,079 shares of common stock (the "Class A Warrants"), (2) Class B Warrants to purchase an aggregate of 1,920,601 shares of common stock (the "Class B Warrants") and (3) options to purchase an aggregate of 1,262,201 shares of common stock. The Class A Warrants are immediately exercisable at $20 per share and expire on September 19, 2002. The Class B Warrants are exercisable at $20 per share at any time after our common stock has traded at or above $30 per share for 20 out of 30 consecutive trading days and expire on September 19, 2005. (3) Amounts include (1) 1,395,625 shares of common stock owned directly by MMRCH and (2) 905,397 shares issuable upon the exercise of Class A Warrants held by MMRCH. "Fully-Diluted Percentage" also reflects 1,770,601 shares of common stock issuable upon the exercise of Class B Warrants held by MMRCH, which warrants may become exercisable within 60 days of the date of this proxy statement. Based upon a Schedule 13D, dated November 7, 1996, filed with the SEC by Marsh & McLennan Companies, Inc. (4) Based upon a Schedule 13G dated January 26, 2000, filed with the SEC jointly by Merrill Lynch & Co., Inc., a parent holding company, and Merrill Lynch Global Allocation Fund, Inc. ("MLGAF"), a registered investment company. In the Schedule 13G, Merrill Lynch & Co. reported that it has shared voting power and shared dispositive power with respect to 2,033,900 shares of common stock and MLGAF re- -44- ported that it has shared voting power and shared dispositive power with respect to 1,947,500 shares of common stock. (5) Amounts include (1) 250,000 shares of common stock owned directly by The Trident Partnership, L.P. ("Trident") and (2) 1,386,079 shares of common stock issuable upon the exercise of Class A Warrants held by Trident. Based upon a Schedule 13D, dated March 27, 1998, filed with the SEC by Trident. (6) Based upon a Schedule 13G dated February 14, 2000, filed with the SEC jointly by EQSF Advisers, Inc. ("EQSF") and M.J. Whitman Advisers, Inc. ("MJWA"), each an investment advisor, and Martin J. Whitman. In the Schedule 13G, EQSF reported that it has sole voting power and sole dispositive power with respect to 473,400 shares of common stock and MJWA reported that it has sole voting power and sole dispositive power with respect to 659,575 shares of common stock. (7) Based upon a Schedule 13G dated January 31, 2000, filed with the SEC by Franklin Resources, Inc. and certain of its affiliates (collectively, "FRI"). In the Schedule 13G, FRI reported that it has sole voting power and sole dispositive power with respect to 1,064,100 shares of common stock beneficially owned by one or more managed accounts which are advised by investment advisory subsidiaries of FRI. (8) Based upon a Schedule 13G dated January 22, 1999, filed with the SEC by Beck, Mack & Oliver LLC ("Beck"), an investment advisor. In the Schedule 13G, Beck reported that it has shared dispositive power with respect to 992,700 shares of common stock beneficially owned by its clients. (9) Based on Schedule 13G dated February 10, 2000, filed with the SEC jointly by Steinberg Asset Management Co., Inc., an investment adviser ("SAMC"), and Michael A. Steinberg & Co., Inc., a broker-dealer. In the Schedule 13G, SAMC reported that it has sole voting power with respect to 554,200 shares of common stock and sole dispositive power with respect to 891,654 shares of common stock, and Steinberg & Co. reported that it has sole dispositive power with respect to 2,500 shares of common stock. (10) Based upon a Schedule 13G dated February 3, 2000, filed with the SEC by the Crabbe Huson Group, Inc. ("CHG"), an investment advisor. In the Schedule 13G, CHG reported that it has shared voting power with respect to 774,287 shares of common stock and shared dispositive power with respect to 809,887 shares of common stock beneficially owned by its clients. (11) Amounts include (1) 141,071 shares of Common Stock owned directly by Mr. Mosca (20,000 of such shares are subject to vesting) and (2) 166,503 shares of Common Stock subject to immediately exercisable options. "Fully-Diluted Percentage" also includes 145,897 shares of common stock subject to stock options that may become exercisable within 60 days of the date of this proxy statement. See "Interests of Certain Persons in Matters to be Acted Upon -- Vesting of Options and Restricted Shares." (12) Amounts include (1) 24,304 shares of common stock owned directly by Mr. Clements, (2) Class A Warrants to purchase 80,000 shares of common stock, (3) 33,385 shares of Common Stock subject to immediately exercisable options and (4) 55,000 shares of common stock and Class A Warrants to purchase 39,603 shares of common stock beneficially owned by Taracay Investors, a general partnership ("Taracay"), the general partners of which consist of Mr. Clements and members of his family. Mr. Clements is the managing partner of Taracay. "Fully-Diluted Percentage," also includes (1) 73,740 shares of common stock subject to stock options (see "Interests of Certain Persons in Matters to be Acted Upon -- Vesting of Options and Restricted Shares") and (2) 150,000 shares of common stock issuable upon the exercise of Class B Warrants, which options and Class B Warrants may become exercisable within 60 days of the date of this proxy statement. -45- (13) Amounts include (1) 31,171 shares of common stock owned directly by Mr. Appel (5,000 of such shares are subject to vesting) and (2) 71,663 shares subject to immediately exercisable options. "Fully-Diluted Percentage" also includes 94,137 shares of common stock subject to stock options that may become exercisable within 60 days of the date of this proxy statement. See "Interests of Certain Persons in Matters to be Acted Upon -- Vesting of Options and Restricted Shares." (14) Amounts include (1) 29,988 shares of common stock owned directly by Mr. Malvasio (5,000 of such shares are subject to vesting) and (2) 66,663 shares subject to immediately exercisable options. "Fully-Diluted Percentage" also includes 74,137 shares of common stock subject to stock options that may become exercisable within 60 days of the date of this proxy statement. See "Interests of Certain Persons in Matters to be Acted Upon -- Vesting of Options and Restricted Shares." (15) Amounts include 1,800 shares (in the case of Messrs. Kelsey and Works, 1,550 and 100 shares, respectively) of common stock subject to immediately exercisable options. "Fully-Diluted Percentage" also includes 1,500 shares (in the case of Mr. Works, 1,700 shares) of common stock subject to stock options that may become exercisable within 60 days of the date of this proxy statement. See "Interests of Certain Persons in Matters to be Acted Upon -- Vesting of Options and Restricted Shares." -46- INTERESTS OF CERTAIN PERSONS IN MATTERS TO BE ACTED UPON Payments to Executive Officers and Chairman of the Board The asset sale will constitute a change in control for purposes of our benefit and employment arrangements. The following payments, which will be made to our executive officers upon closing of the asset sale, are estimated to be: Mark D. Mosca, $2,716,714; Peter A. Appel, $1,476,563; and Paul J. Malvasio, $1,220,625. These amounts are equal to a specified multiple of the sum of such executive officer's annual base salary and target annual bonus (or, in the case of Mr. Mosca, a notional target amount equal to 100% of his annual base salary). The specified multiple is 2.99 for Mr. Mosca and 2.25 for Messrs. Appel and Malvasio. In addition, a prorated portion of such executive officer's target annual bonus (or, in the case of Mr. Mosca, a prorated portion of a notional target amount equal to 100% of his annual base salary) will be paid to the executive officers at the closing of the asset sale. Each executive officer will also be entitled to continuance of his insurance benefits. Robert Clements, chairman of the board, will receive a special bonus of up to $500,000 upon the consummation of the asset sale. Vesting of Options and Restricted Shares Our executive officers and members of our board of directors currently hold unvested stock options and shares of restricted stock as set forth below, all of which will immediately vest upon stockholder and regulatory approval of the asset sale: Unvested Stock Options Exercise Price -------------- -------------- Mark D. Mosca 20,000 $ 20.00 29,600 17.63 43,258 23.00 53,039 22.44 Peter A. Appel 5,000 21.00 15,800 17.63 23,098 23.00 50,239 22.44 Paul J. Malvasio 5,000 20.00 15,800 17.63 23,098 23.00 30,239 22.44 Robert Clements 32,460 23.00 39,780 22.44 1,500 12.66 Michael P. Esposito, Jr. 1,500 12.66 Lewis L. Glucksman 1,500 12.66 Ian R. Heap 1,500 12.66 Thomas V.A. Kelsey 1,500 12.66 -47- Unvested Stock Options Exercise Price -------------- -------------- Robert F. Works 200 16.00 1,500 12.66 Philip L. Wroughton 1,500 12.66 Shares of Restricted Stock -------------------------- Mark D. Mosca 20,000 Peter A. Appel 5,000 Paul J. Malvasio 5,000 Ownership of Warrants There are outstanding, and will continue to be outstanding after the asset sale, Class A Warrants to purchase an aggregate of 2,531,079 shares of our common stock and Class B Warrants to purchase an aggregate of 1,920,601 shares of our common stock. The Class A Warrants are immediately exercisable at $20 per share and expire on September 19, 2002. The Class B Warrants are exercisable at $20 per share at any time after our common stock has traded at or above $30 per share for 20 out of 30 consecutive trading days and expire on September 19, 2005. Holders of Class A Warrants include Marsh & McLennan Risk Capital Holdings, Ltd., The Trident Partnership, L.P. and Robert Clements, the chairman of our board, members of his family and a family partnership. Holders of Class B Warrants include Marsh & McLennan Risk Capital Holdings, Ltd., Mr. Clements and members of his family. Please see footnotes 2, 3, 5 and 12 to the table in the section entitled "Security Ownership of Certain Beneficial Owners and Management" in the preceding pages of this proxy statement for details on the ownership of the Class A Warrants and the Class B Warrants. -48- DIVIDEND AND STOCK REPURCHASE POLICY Any determination to pay dividends in the future will be at the discretion of our board of directors and will be dependent upon our results of operations, financial condition, capital requirements, contractual restrictions and other factors deemed relevant by our board of directors. Our board of directors currently does not intend to declare dividends or make any other distributions. Our board intends to make a determination regarding repurchases of our shares after the consummation of the asset sale, but no decision has yet been made as to whether any such repurchases will be made or the amount, timing or method of any such repurchases, which will depend on future circumstances. -49- SELECTED HISTORICAL FINANCIAL DATA Our and RCRe's selected consolidated historical financial data for the years ended December 31, 1999, 1998, 1997, 1996 and for the period from June 23, 1995 (date of inception) to December 31, 1995 should be read in conjunction with our audited consolidated financial statements and the related notes contained elsewhere in this proxy statement.
Period from June 23, 1995 to Years Ended December 31, December 31, ----------------------------------------------------------- ------------- 1999 1998 1997 1996 1995 ----------- ---------- --------- --------- ------------- (Dollars in thousands, except share data) Statement of Operations Data Net premiums earned....................... $311,368 $206,194 $107,372 $35,761 Net investment income..................... 20,173 15,687 14,360 13,151 $4,578 Net realized investment gains (losses)............................... 17,227 25,252 (760) 1,259 397 Total revenues............................ 348,768 247,133 120,972 50,171 4,975 Net income (loss)......................... (32,436) 3,091 2,039 4,112 1,019 Comprehensive income (loss)............... ($52,286) ($4,375) $47,107 $9,817 $4,750 Average shares outstanding Basic.................................. 17,086,732 17,065,165 17,032,601 16,981,724 16,747,084 Diluted................................ 17,086,808 17,718,223 17,085,788 16,983,909 16,990,425 Per Share Data Net income (loss) Basic................................ ($1.90) $0.18 $0.12 $0.24 $0.06 Diluted.............................. ($1.90) $0.17 $0.12 $0.24 $0.06 Comprehensive Income (loss) Basic.................................. ($3.06) ($0.26) $2.77 $0.58 $0.28 Diluted ............................... ($3.06) ($0.26) $2.76 $0.58 $0.28 December 31, ---------------------------------------------------------------------------- 1999 1998 1997 1996 1995 ------------ ---------- ----------- ----------- ------------ (Dollars in thousands, except share data) Balance Sheet Data Cash and invested assets.................. $585,909 $587,155 $505,728 $392,940 $347,327 Total assets.............................. 864,359 757,830 581,247 432,486 350,986 Stockholders' equity...................... 346,514 398,002 401,031 352,213 340,215 Shares outstanding Basic.................................. 17,087,970 17,087,438 17,058,462 17,031,246 16,941,125 Diluted................................ 17,087,970 17,497,904 17,601,608 17,065,406 16,941,125 Book value per share Basic.................................. $20.28 $23.29 $23.51 $20.68 $20.08 Diluted................................ $20.28 $22.75 $22.79 $20.64 $20.08 Cash dividends per share.................. N/A N/A N/A N/A N/A
-50- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General The Company We are the holding company for Risk Capital Reinsurance ("RCRe"), our wholly owned subsidiary which is domiciled in Nebraska. We were incorporated in March 1995 and commenced operations in September 1995 upon completion of our initial public offering. We received aggregate net proceeds from the offering of approximately $335 million, of which $328 million was contributed to the capital of RCRe. On November 6, 1995, RCRe was licensed under the insurance laws of the State of Nebraska and is currently licensed or accredited as a reinsurer in 44 states. As of December 31, 1999, the statutory surplus of RCRe was approximately $290 million. In July 1998, RCRe capitalized its wholly owned subsidiary, Cross River Insurance Company ("Cross River"), with $20 million. Cross River received its Nebraska insurance license in October 1998, and is currently authorized to write insurance on an excess and surplus lines basis in 22 additional states. Folksamerica Transaction As of January 10, 2000, we entered into an agreement with Folksamerica Reinsurance Company and Folksamerica Holding Company (collectively, "Folksamerica") pursuant to which Folksamerica Reinsurance Company will assume RCRe's liabilities under the reinsurance agreements transferred in the asset sale and RCRe will transfer to Folksamerica Reinsurance Company assets in an aggregate amount that is, in book value, equal to the book value of the liabilities assumed. In consideration for the transfer of RCRe's book of business, Folksamerica will pay $20.335 million in cash at the closing, subject to adjustment under the circumstances set forth in the asset purchase agreement. Under the terms of the agreement, we will place $20 million in escrow for a period of five years. These funds will be primarily used to reimburse Folksamerica to the extent that the loss reserves (which were $38.7 million at December 31, 1999) relating to business produced on behalf of RCRe by a certain managing underwriting agency are deficient as measured at the end of such five year period. To the extent that such loss reserves are redundant, all of the escrowed funds will be returned to us and Folksamerica will pay us an amount equal to such redundancy. We will be responsible for certain tax costs incurred by Folksamerica in the transaction, as well as our own transaction and severance costs, and certain reinsurance costs incurred for the benefit of Folksamerica. An additional amount of up to $5 million may be placed in escrow for a period of five years to the extent that RCRe's reserves at closing are less by at least a specified amount than those estimated by its independent actuaries. In connection with either escrow arrangement, we will record a loss in an amount equal to any probable deficiency in the related reserve that may become known during or at the end of the five year period. See "The Asset Purchase Agreement" and "Other Transaction Agreements" for a detailed description of the asset purchase agreement and escrow agreements. The sale of our reinsurance business to Folksamerica is contingent on approval by our stockholders, expiration of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act, the retention of a key employee, obtaining certain third party consents, the absence of a material adverse change in RCRe's business, and other customary closing conditions. Marsh & McLennan Risk Capital Holdings, Ltd. and The Trident Partnership, L.P., which collectively represent approximately 13.3% of the total voting power of our outstanding common stock (after giving effect to the repurchase of 4,755,000 shares on March 2, 2000 from XL Capital, which is discussed below), have agreed to vote in favor of the asset sale. -51- The GAAP book value of the assets and liabilities to be transferred to Folksamerica recorded in the accompanying financial statements at December 31, 1999 are as follows: (In Millions) Fixed maturities and short-term investments $245.6 Premiums receivable 119.3 Reinsurance recoverable 73.1 Deferred policy acquisition costs 23.6 Deferred income tax asset 13.9 Other insurance assets 37.0 ------------- Total Assets $512.5 ------------- Reserve for claims and claims expenses $364.6 Net unearned premium reserve 108.7 Reinsurance premiums payable 14.7 Other insurance liabilities 24.5 ------------- Total Liabilities $512.5 ------------- Net book value of assets and liabilities to be transferred -- ============= The actual GAAP book value of the assets and liabilities transferred to Folksamerica will be determined as of the closing date of the asset sale, and will differ from that set forth above. At the closing of the asset sale, RCRe and Folksamerica will enter into a transfer and assumption agreement, under which Folksamerica will assume RCRe's rights and obligations under the reinsurance agreements being transferred in the asset sale. Following regulatory approval of these agreements, the reinsureds under such agreements that are in-force will be notified that Folksamerica has assumed RCRe's obligations and that, unless the reinsureds object to the assumption, RCRe will be released from its obligations to those reinsureds. Assuming that none of the reinsureds object to the assumption, the gross liabilities for such business will be removed from the accounts of RCRe for statutory accounting and GAAP accounting purposes. RCRe will continue to record gross liabilities in its accounts for reinsureds that object to the release of RCRe from its obligations to such reinsureds. In such instances, an offsetting accounts receivable amount from Folksamerica would be recorded as an asset equal to such gross liabilities. This would also result in a portion of any pre-tax gain on the asset sale being deferred and amortized into income as gross liabilities are extinguished. XL Transaction On March 2, 2000, we repurchased from XL Capital, then our single largest stockholder, all of the 4,755,000 shares of our common stock held by it. Under the terms of a stock repurchase agreement with XL Capital, we paid $12.45 per share of our common stock, or a total of $59.2 million. The per share repurchase price was determined as the lesser of (1) 85% of the average closing market price of our common stock during the 20 trading days beginning on the third business day following public announcement of the stock repurchase and asset sale (January 21, 2000), which was $14.65, and (2) $15. We paid XL Capital the consideration for the repurchase with: our interest in privately held LARC Holdings, Ltd. (parent of Latin American Reinsurance Company Ltd.), valued at $25 million (which was carried by us at $24 million at December 31, 1999); and all of our interest in Annuity and Life Re (Holdings), Ltd., valued at $25.38 per share and $18.50 per warrant, or $37.8 million in the aggregate (which was carried by us at $38.2 million at December 31, 1999). XL Capital paid us in cash the difference (equal to $3.6 million) between our repurchase price and the value of our interests -52- in LARC Holdings and Annuity and Life Re. The value per share of Annuity and Life Re was determined by taking the average of the closing price of Annuity and Life Re shares for the same period used in determining the repurchase price of our shares. The value of the warrants was determined using a Black Scholes methodology. As a result of this transaction, stockholders' equity, which was $346.5 million at December 31, 1999, has been reduced by $59.4 million and the number of outstanding voting shares, which was 17,087,970 at December 31, 1999, was 12,332,970 at March 2, 2000. RCRe's statutory surplus, which was $290 million at December 31, 1999, was also reduced by $60 million for the distribution of the stock and warrants in both LARC Holdings, Ltd. and Annuity and Life Re Holdings, Ltd., to us, based on their statutory carrying values at December 31, 1999. RCRe Distribution Upon payment of a contemplated distribution from RCRe to us that would occur after the completion of the asset sale, our assets would consist of fixed maturity and short term investments, publicly traded equity securities and privately held securities, and our remaining $19 million investment commitment to Trident II, L.P. would remain in place. We would also continue to own all of the outstanding capital stock of RCRe and Cross River, each with statutory surplus of approximately $20 million (or any greater amount the Nebraska Insurance Department requires RCRe to retain in the event there are any objections from reinsureds to the release of RCRe from further liability pursuant to the transfer and assumption agreement). See "--Liquidity and Capital Resources" below for a discussion of the regulatory issues relating to distributions by RCRe. Future Operations Following the sale of our reinsurance business to Folksamerica, our intended strategy is to pursue business combinations and ventures with operating businesses. Our success will depend almost entirely on the operations, financial condition and management of the companies with which we may merge or which we may acquire in whole or in part. We have not yet identified specific business opportunities. Accordingly, the financial and operational risks that we may encounter in the future cannot be specified. See "Risk Factors--Risks Relating to Our Business After the Asset Sale." Recent Industry Performance Demand for reinsurance is influenced significantly by underwriting results of primary property and casualty insurers and prevailing general economic and market conditions, all of which affect liability retention decisions of primary insurers and reinsurance premium rates. The supply of reinsurance is directly related to prevailing prices and levels of surplus capacity, which, in turn, may fluctuate in response to changes in rates of return on investments being realized in the reinsurance industry. The last three years have been difficult periods from both a market and earnings perspective for most insurance markets. The property and casualty insurance and reinsurance segments have experienced an increasingly more difficult and highly competitive operating environment characterized by a soft rate structure and overcapitalization. Other factors that have contributed to the prevailing competitive conditions in the reinsurance industry in recent years include new entrants to the reinsurance market (including certain specialized reinsurance operations) and the presence of certain reinsurance companies which operate within tax-advantaged jurisdictions (e.g., Bermuda, Cayman Islands) that benefit from higher after-tax investment returns. In addition, concerns with respect to the financial security of Lloyd's that had adversely impacted the competitive position of that marketplace have apparently been overcome by actions taken at Lloyd's over the last few years, thereby enhancing its competitive position. The industry's profitability can also be affected significantly by volatile and unpredictable developments, including changes in the propensity of courts to grant larger awards, natural disasters (such as cata- -53- strophic hurricanes, windstorms, earthquakes, floods and fires), fluctuations in interest rates and other changes in the investment environment that affect market prices of investments and the income and returns on investments, and inflationary pressures that may tend to affect the size of losses experienced by ceding primary insurers. The reinsurance industry is highly competitive and dynamic, and market changes may affect, among other things, demand for our products, changes in investment opportunities (and the performance thereof), changes in the products offered by us or changes in our business strategy. Reinsurance treaties that are placed by intermediaries are typically for one year terms with a substantial number that are written or renewed on January 1 each year. Other significant renewal dates include April 1, July 1 and October 1. The January 1, 2000 renewal period was marked by continuing intensified competitive conditions in terms of premium rates and treaty terms and conditions in both the property and casualty segments of the marketplace. These conditions have been worsened due to large domestic primary companies retaining more of their business and ceding less premiums to reinsurers. Commencing in late 1997, in addition to our core business, we expanded into specialty classes of reinsurance business, including marine and aviation and space in 1997, surety and fidelity in 1998, and accident and health in 1999. In 1999, we discontinued our aviation and space lines of business. In-Force Business At January 1, 2000, RCRe had approximately 330 renewable in-force reinsurance treaties (such renewal is subject to negotiation and evaluation during the renewal period), with approximately $249.1 million of estimated annualized net premiums written, compared to $287.5 million at January 1, 1999 and $172.5 million at January 1, 1998, representing a decline of 13% and an increase of 67% over the prior year, respectively. Such in-force premiums at January 1, 2000 represent estimated annualized premiums from treaties entered into during 1999 and the January 1, 2000 renewal period that are expected to generate net premiums written during 2000. Such treaties at January 1, 2000 are estimated to generate approximately $210.6 million of net premiums written over the 12-month period ending December 31, 2000 without taking into account certain factors, including the possibilities that (i) several treaties entered into in 1999 that are scheduled to expire during the remainder of 2000 may be renewed and (ii) additional treaties may be bound during 2000. The decline in in-force business of 13% in 1999 compared to 1998 is due to several factors which include (i) discontinuing aviation and space business in 1999; (ii) non-renewals in other classes of business, due to (a) our adherence to underwriting standards in competitive market conditions and (b) the effect on cedents of our poor underwriting performance, coupled with a decline in RCRe's A.M. Best rating from A to A-. Such declines were partially offset by increased in-force premiums in Accident & Health business where significant underwriting capacity has exited the market since 1998, and we believe reinsurance pricing improvements have occurred in 1999 and 2000. Results of Operations We had consolidated comprehensive losses of $52.3 million and $4.4 million for the years ended December 31, 1999 and 1998, respectively, and consolidated comprehensive income of $47.1 million for the year ended December 31, 1997. Our comprehensive income or loss is composed of net income and the change in unrealized appreciation of investments. Net loss for the year ended December 31, 1999 was $32.4 million and net income for the years ended December 31, 1998 and 1997 was $3.1 million and $2.0 million, respectively. After-tax realized investment gains (losses) of $11.2 million, $16.4 million and ($0.5 million) were also included in net income for 1999, 1998 and 1997, respectively. Net income for the years ended December 31, 1999, 1998 and 1997 included income (losses) of $0.7 million, ($1.1 million), and ($0.2 million), respectively, representing our equity in the net income (loss) of investee companies accounted for under the equity method of accounting. Net loss for the year ended December 31, 1999 also included a loss of $383,000 from a cumulative effect of an accounting change for start-up costs. -54- Following is a table of per share data for the years ended December 31, 1999, 1998 and 1997 on an after-tax basis:
Years Ended December 31, ---------------------------------------------------- 1999 1998 1997 ------------ ------------ -------------- Basic earnings per share: Underwriting loss ($3.42) ($1.39) ($0.45) Net investment income 0.85 0.68 0.61 Net realized investment gains (losses) 0.66 0.96 (0.03) Equity in net income (loss) of investees 0.03 (0.07) (0.01) Cumulative effect of accounting change (0.02) ------------ ----------- --------- Net income (1.90) 0.18 0.12 Change in net unrealized appreciation of investments (1.16) (0.44) 2.65 ------------ ----------- --------- Comprehensive income (loss) ($3.06) ($0.26) $2.77 ============ =========== ========= Average Shares Outstanding (000's) 17,087 17,065 17,033 ============ =========== ========= Diluted earnings per share: Underwriting loss ($3.42) ($1.35) ($0.45) Net investment income 0.85 0.65 0.61 Net realized investment gains (losses) 0.66 0.93 (0.03) Equity in net income (loss) of investees 0.03 (0.06) (0.01) Cumulative effect of accounting change (0.02) ------------ ----------- --------- Net income ($1.90) $0.17 $0.12 ============ =========== ========= Comprehensive income (loss) ($3.06) ($0.26) $2.76 ============ =========== ========= Average shares outstanding (000's) 17,087 17,718 17,086 ============ =========== ========= Book Value Per Share, December 31: Basic $20.28 $23.29 $23.51 Diluted $20.28 $22.75 $22.79 Shares outstanding (000's) Basic 17,088 17,087 17,058 Diluted 17,088 17,498 17,602
-55- Net Premiums Written Net premiums written for the years ended December 31, 1999, 1998 and 1997 were as follows:
(In millions) Percent Years Ended December 31, Change 1999 1998 1997 1998/1999 ---------- ----------- ------------ ---------- Property $78.9 $33.7 $17.8 134% Casualty 64.1 80.3 69.7 (20%) Multi-line 67.7 62.8 45.9 8% Other 7.6 16.5 10.0 (54%) Accident & Health 50.3 Aviation & Space 18.4 26.0 (29%) Marine 14.0 14.4 1.4 (3%) Surety & Fidelity 5.7 1.0 470% ----------- ----------- ----------- ---------- Total $306.7 $234.7 $144.8 31% =========== =========== =========== ==========
Set forth below are RCRe's assumed and ceded premiums written for the years ended December 31, 1999, 1998 and 1997:
(In millions) Years Ended December 31, ---------------------------------------------- 1999 1998 1997 ------------ ------------- ------------ Assumed premiums written $386.8 $260.5 $147.8 Ceded premiums written 80.1 25.8 3.0 ------------ ------------- ------------ Net premiums written $306.7 $234.7 $144.8 ============ ============= ============
RCRe's net premiums written increased 31% to $306.7 million in 1999 from $234.7 million in 1998 and 62% to $234.7 million in 1998 from $144.8 million in 1997. Premium growth resulted from two key strategies, the integration of investment with reinsurance and the diversification into "specialty" classes of business, which for purposes of this discussion consist of Accident & Health, Aviation and Space, Marine and Surety & Fidelity. Approximately 30%, 32% and 29% of net premiums written in 1999, 1998 and 1997, respectively, were generated from companies in which we have invested or committed to invest funds ("integrated transactions"). Approximately 29%, 18% and 1% of net premiums written in 1999, 1998 and 1997, respectively, was produced from specialty classes of business. Specialty classes of business accounted for 65% and 44% of the increase in net premiums written for 1999 and 1998, respectively. Approximately 15%, 32% and 28% of net premiums written in 1999, 1998 and 1997, respectively, were from non-United States clients, which are Lloyd's syndicates or are located in the United Kingdom, Bermuda and Continental Europe. Net premiums written in 1999 includes approximately $26 million related to a group of property reinsurance treaties that expired in 1999 covering crop hail business underwritten on behalf of a start-up entity formed by Trident II, L.P. This business was protected by extensive aggregate excess of loss retrocession and generated a profit based upon underwriting results. We do not expect to renew these treaties in 2000. Net premiums written in 1999 for other business was reduced by $10.6 million for the retrocession of a treaty which covers future multiple rocket launches that was recorded in 1996. The reduction of net premiums -56- written resulting from this retrocession increased the commission and operating expense ratio components of the statutory composite ratio by 1.1 percentage points, but had no impact on operating results. Consistent with our strategy of writing a small number of large treaties for our core business, two clients contributed approximately $81.3 million or 26.5% of 1999 total net premiums written, with the largest client contributing approximately 13.7% and the second contributing 12.8%. Approximately 70% of the business written from the client that contributed 13.7% and all of the business written from the client that contributed 12.8% are part of an integrated transaction, and such business is subject to renewal at our option for two and four remaining years, respectively. In 1998, three clients contributed approximately $74 million, or 32%, of 1998 total net premiums written, with the largest client contributing approximately 18% and the remaining two contributing 8% and 6%, respectively. In 1997, five clients contributed approximately $68 million, or 45%, of total net premiums written, with the largest client contributing approximately 18% and the remaining four contributing from 5% to 8%. RCRe's ceded premiums increased to $80.1 million in 1999, compared to $25.8 million in 1998 and $4.2 million in 1997. Such ceded premiums primarily relate to RCRe's property, multi-line, marine, aviation and space reinsurance business, for which we seek to reduce RCRe's exposure to large and catastrophic losses. Since the fourth quarter of 1998, we have purchased additional retrocessional protection to reduce RCRe's exposures to both space and aviation risks. Effective July 1, 1999, RCRe also purchased a retrocessional treaty for a one year period covering earthquake, wind and other property catastrophe perils for $10 million in excess of a $15 million retention per occurrence. While not anticipated, the reduction or loss of business assumed from one or more large clients could have a material adverse effect on our results of operations to the extent not offset by new business. Operating Costs and Expenses One traditional method of measuring the underwriting performance of a property/casualty insurer, such as RCRe, is the statutory combined ratio. This ratio, which is based upon statutory accounting principles (which differ from generally accepted accounting principles in several respects), reflects underwriting experience, but does not reflect income from investments. A statutory combined ratio under 100% indicates underwriting profitability, while a combined ratio exceeding 100% indicates an underwriting loss. Set forth below are RCRe's statutory combined ratios for the years ended December 31, 1999, 1998 and 1997 and the estimated aggregate statutory combined ratios for domestic reinsurers and domestic broker market reinsurers based on data reported by the Reinsurance Association of America ("RAA") as of such dates:
Years Ended December 31, 1999 1998 1997 Claims and claims expenses 98.2% 85.4% 68.4% Commissions and brokerage 26.3% 24.2% 28.8% ----- ----- ----- 124.5% 109.6% 97.2% Other operating expenses 4.7% 6.8% 9.1% ----- ----- ----- Statutory combined ratio 129.2% 116.4% 106.3% ===== ===== ===== Domestic reinsurer aggregate Statutory combined ratios 109.6%(1) 104.4% 102.3% ===== ===== =====
(1) Estimated based on RAA data published at September 30, 1999. -57- After-tax underwriting losses for the years indicated were as follows (dollars in millions):
Years Ended December 31, --------------------------------------------------- 1999 1998 1997 ----------- ------------ ------------ After-tax underwriting loss Amount $ 58.4 $ 23.0 $ 7.7 Per Share (Basic) $ 3.42 $ 1.39 $ 0.45
Statutory combined ratio after-tax underwriting results for 1999 and 1998 reflect very poor underwriting performance in competitive market conditions. RCRe's 1999 and 1998 statutory combined ratios were adversely affected by underwriting results from the sources identified below, which added 16 points and 9 points to the combined ratios (excluding operating expenses), respectively (dollars in millions):
1999 Year Underwriting Impact ----------------------------------------------------- Managing Underwriting Space & Agency Aviation Total Net premiums written $ 2.1 $ 18.4 $ 20.5 Earned premiums $ 6.4 $ 13.8 $ 20.2 After-tax underwriting loss Amount $ 16.5 $ 19.7 $ 36.2 Per Share (Basic) $ 0.96 $ 1.15 $ 2.11 Combined Ratio Effect (in percentage points) 7.7 8.3 16.0
1998 Year Underwriting Impact ----------------------------------------------------- Managing Underwriting Space & Agency Aviation Total Net premiums written $ 16.3 $ 26.0 $ 42.3 Earned premiums $ 12.5 $21.3 $ 33.8 After-tax underwriting loss Amount $ 6.5 $ 7.8 $ 14.3 Per Share (Basic) $ 0.38 $ 0.46 $ 0.84 Combined Ratio Effect (in percentage points) 4.1 4.9 9.0
Managing Underwriting Agency As identified above, during 1999 and 1998, we recorded after-tax underwriting losses of $16.5 million, or $0.96 per share, and $6.5 million, or $0.38 cents per share, respectively, from reinsurance on casualty and multi-line business produced by the managing underwriting agency. We also recorded related after-tax investment losses of $1.3 million, or $0.07 per share, and $862,000, or $0.03 per share, in net realized investment losses in 1999 and 1998, respectively. We have discontinued our underwriting relationship with the managing underwriting agency. The business and operations of the managing underwriting agency are in run-off. The total estimated ultimate net premiums written and earned by RCRe on all business produced by the managing underwriting agency recorded from inception in late 1997 through December 31, 1999 are approximately $19.3 million and $19.1 million, respectively, resulting in an inception to date after-tax underwriting -58- loss of $22.4 million. Net reserves for claims and claim expenses for this business approximated $38.7 million at December 31, 1999. See "-- Folksamerica Transaction" for a discussion of a $20 million escrow fund relating to such reserves in connection with the sale of our reinsurance business to Folksamerica. Space & Aviation Business As identified above, during 1999 and 1998, RCRe recorded after-tax underwriting losses of $19.7 million, or $1.15 per share and $7.8 million, or $0.46 per share, respectively, for its space and aviation lines of business. During 1999, RCRe discontinued both lines of business. Space Business The total estimated ultimate net premiums written and earned by RCRe for space business from inception in 1998 through December 31, 1999 are $17.6 million each, resulting in an inception to date after-tax underwriting loss of $13.1 million. Net reserves for claims and claim expenses for space business approximated $2.4 million at December 31, 1999. At December 31, 1999, all satellite treaties have expired except for one treaty covering future multiple rocket launches which was 100% retroceded in 1999. Aviation Business The total estimated ultimate net premiums written and earned by RCRe for aviation business from inception in 1998 through December 31, 1999 are $26.8 million and $17.5 million, respectively, resulting in an inception to date after-tax underwriting loss of $14.3 million. Net reserves for aviation business approximated $26 million at December 31, 1999. Included in the 1999 after-tax underwriting loss for aviation business are incurred losses for the 1998 Swiss Air and Korean Air crashes and certain 1999 crashes, including the Egypt Air, American Airlines, Korean Air and China Air crashes. The additional loss recorded in 1999 for the Swiss Air crash was based on a reallocation of the $642 million expected industry loss between the plane manufacturer and Swiss Air. This reallocation adversely affected RCRe's gross loss. The gross loss associated with the Swiss Air crash reported as of December 31, 1998 had exhausted RCRe's retrocessional protections applicable to this occurrence. Therefore, none of such additional loss reported was ceded to retrocessionaires. To the extent that either the expected industry loss increases or additional loss is allocated to the plane manufacturer, RCRe could record additional losses. For example, if the expected industry loss increases by approximately $100 million, and assuming additional loss reallocations such that one-third of the industry loss is allocated to the plane manufacturer, RCRe would record additional aggregate loss (net of additional reinstatement premiums) of approximately $2.7 million after-tax. However, we cannot be certain of the ultimate industry loss or the final allocation of liability between the plane manufacturer and Swiss Air, and there can be no assurances that the ultimate industry loss will not be larger or that the plane manufacturer will not be allocated a greater proportion of the industry loss. With respect to all other reinsured crashes which occurred through December 31, 1999, we currently believe that RCRe's gross loss will not exhaust RCRe's reinsurance protections (although RCRe's net loss could increase within these protections based on the ultimate industry loss, the ultimate allocation of losses between the plane manufacturers and the airlines and other factors). For the year ended December 31, 1999, aviation assumed gross premiums earned, retroceded premiums earned, and net earned premiums were $43.7 million, $32.5 million and $11.2 million, respectively. While RCRe discontinued writing aviation business in 1999, RCRe currently has a number of assumed treaties that will continue to expose it to significant risk of aviation losses through 2001. Current estimates for gross aviation premiums that will be earned beyond 1999 aggregate approximately $20.5 million. Retrocessional premium charges to be recorded for retrocessional treaties presently in-force that expire during 2000 total -59- approximately $15.4 million. Such retrocessional premium costs do not include additional retrocessional premium amounts that will be purchased to provide Folksamerica with additional retrocessional protection in connection with the sale of our reinsurance business to Folksamerica. Following the Egypt Air crash in October 1999, RCRe exhausted its initial layer of retrocessional protection for 1999 aviation exposures. Since October 1999, RCRe's initial retention as well as its total retention for aviation exposures are contingent on the size of insured industry losses, which could materially impact the recoveries under such retrocessions and therefore the net loss to us. Based on information currently available to us, we believe that RCRe's maximum exposures (net of retrocessional recoveries and reinstatement premiums) for future commercial airline losses vary depending on (i) the size of insured industry losses, (ii) the declining gross loss exposures as current in-force business expires, and (iii) the application of retrocessional protections which expire throughout 2000. Based on such current information, set forth below is our estimate of after-tax losses for RCRe's maximum exposures for the size industry loss and the time period presented (in millions):
$700 to Industry Loss: $50 $100 $200 $300 $500 $1,500 ------------- ------ ------- -------- -------- -------- ------- Year 2000 From/To: January 1 March 31 $1.5 $4.1 $3.4 $1.2 N/A $1.0 April 1 June 30 $1.5 $4.1 $6.5 $4.3 $2.4 $8.3 July 1 September 30 $1.3 $3.1 $6.5 $7.5 $5.8 $8.7 October 1 December 31 $1.6 $3.7 $3.6 $5.1 $6.2 $8.7 Year 2001 $1.6 $3.7 $5.3 $5.5 $5.5 $7.8
We are presently evaluating the impact of recent commercial airline crashes that occurred in 2000, including the Alaska Air crash. Other Underwriting Loss Activity Except for multi-line business, all other classes of business also contributed to the 1999 underwriting loss, with the largest contribution from property business. The after-tax underwriting loss for property business approximated $4.9 million which included after-tax losses of $4.3 million for two large catastrophes in 1999 (Rouge steel plant in Dearborn, Michigan and French storm losses). The 1998 underwriting loss included an after-tax underwriting loss of $3.3 million for a property loss on a finite risk treaty. 1999 Prior Year Development Estimates of prior accident year claims were increased by approximately $30 million in 1999 which added 10.2 points to the 1999 combined ratio. A substantial portion of this amount stemmed from (i) our review of additional claims information and our continuing underwriting and actuarial analysis of the business produced by the managing underwriting agency, (ii) notification of additional satellite losses received in 1999 -60- pertaining to 1998, (iii) aviation losses, principally the previously discussed 1998 Swiss Air crash, and (iv) property losses reported on several international treaties that are in run-off. Estimates of prior accident year claims were reduced by approximately $2.8 million in 1998 primarily due to favorable claim development in the property and multi-line classes of business. Claims and claims expenses generally represent our most significant and uncertain costs. Reserves for these expenses are estimates involving actuarial and statistical projections at a given time of what we expect the ultimate settlement and administration of claims to cost based on facts and circumstances then known. The reserves are based on estimates of claims and claims expenses incurred and, therefore, the amount ultimately paid may be more or less than such estimates. The inherent uncertainties of estimating claim reserves are exacerbated for reinsurers by the significant periods of time (the "tail") that often elapse between the occurrence of an insured loss, the reporting of the loss to the primary insurer and, ultimately, to the reinsurer, and the primary insurer's payment of that loss and subsequent indemnification by the reinsurer. As a consequence, actual claims and claims expenses paid may deviate, perhaps materially, from estimates reflected in our reserves reported in our financial statements. The estimation of reserves by new reinsurers, such as us, may be less reliable than the reserve estimations of a reinsurer with an established volume of business and claims history. To the extent reserves prove to be inadequate, we may have to augment such reserves and incur a charge to earnings. Acquisition Costs In pricing RCRe's reinsurance treaties, we focus on many factors, including exposure to claims and commissions and brokerage expenses. Commissions and brokerage expenses are acquisition costs that generally vary by the type of treaty and line of business, and are considered by our underwriting and actuarial staff in evaluating the adequacy of premium writings. In a number of reinsurance treaties, provisional commissions are initially paid and subsequently increased or decreased, subject to a minimum and maximum amount, depending upon the claims and claims expenses experience of the assumed business. We record the commission increase or decrease in accordance with contractual terms based on the expected ultimate experience of the contract. The claims and commissions and brokerage ratios reflect our business mix. Other Operating Expenses Other operating expenses were $14.8 million in 1999, compared to $16.5 million and $13.5 million for the years ended December 31, 1998 and 1997, respectively. For 1999, the statutory operating expense ratio declined to 4.7%, compared with 6.8% for 1998 and 9.1% in 1997. The decline in our operating expense ratio was due to a decrease in other operating expenses and an increase in our net premiums written from the comparable prior year period. In addition, commencing in 1999, we allocated certain compensation and other operating expenses related to investment activities in the amount of $2.1 million to net investment income based on internal time studies. Such allocations were not made in prior periods. Due to such allocations, the 1999 statutory operating expense ratio improved by approximately one point and net investment income was reduced by approximately $0.08 per share, with no overall effect on operating results. On a pro-forma basis, the statutory operating expense ratios for 1998 and 1997 would have been 5.8% and 7.6%, respectively. Foreign Exchange Pre-tax foreign exchange gains and losses are recorded separately from statutory underwriting results and are therefore excluded from the statutory composite ratio. Unhedged monetary assets and liabilities are translated at the exchange rate in effect at the balance sheet date, with the resulting foreign exchange gains or losses recognized in income. For the years ended December 31, 1999, 1998 and 1997, pretax foreign exchange gains and (losses) were $198,000, $443,000 and ($682,000), respectively. Such future gains or losses may be -61- affected by changes in foreign exchange rates which are unpredictable and could be material. For additional discussion, see "--Market Sensitive Instruments and Risk Management" below. Risk Retention Given RCRe's current level of surplus, under its current underwriting guidelines, the maximum net retention on any one claim for a given property or casualty treaty risk is generally $10 million. We monitor RCRe's earthquake and wind exposures and continuously reevaluate its estimated probable maximum pre-tax loss for such exposures through the use of modeling techniques. We generally seek to limit RCRe's probable maximum pre-tax net loss to no more than 10% of its statutory surplus for severe catastrophic events such as hurricanes and earthquakes that could be expected to occur once in every 100 years. This limitation includes combined exposure to underwriting losses, reinstatement costs for retrocessional arrangements which may be in force at the time of the losses resulting from the catastrophic event, and losses that RCRe may be exposed to as a result of its privately held investments in insurance and insurance-related entities. While we believe RCRe's risk management techniques are adequate, we cannot assure you that RCRe will not suffer pre-tax losses greater than 10% of its statutory surplus from a catastrophic event due to the inherent uncertainties in estimating the frequency and severity of such exposures. In addition, we believe that we cannot reasonably estimate RCRe's exposure to unrealized investment losses (if any) that may result from RCRe's investments in publicly traded securities of insurance and insurance-related entities. With respect to integrated solutions (where we combine an equity, equity-like or debt investment in a client company with the purchase by such client of reinsurance from RCRe), we generally limit RCRe's combined underwriting and investment exposure to pre-tax losses on any individual client to no more than 10% of RCRe's total statutory surplus. We continue to evaluate RCRe's potential catastrophe exposure, including both gross loss estimates and the impact of available reinsurance protection. While we believe our management of catastrophe exposures and underwriting guidelines are adequate, an extremely large catastrophic event, multiple catastrophic events or other unforeseen events could have a material adverse effect on our financial condition and results of operations. Net Investment Income At December 31, 1999, approximately 59% of our invested assets consisted of fixed maturity and short-term investments, compared to 48% at December 31, 1998. Net investment income was approximately $20.2 million in 1999, compared to $15.7 million and $14.4 million in 1998 and 1997, respectively. Such amounts for 1999, 1998 and 1997 are net of investment expenses of $5.5 million, $3.6 million and $2.2 million, respectively. The investment expense amounts include investment advisory fees of $2.0 million, $3.3 million and $1.8 million, respectively. The 1999 net investment income is also net of $1.1 million for the payment of interest expense in connection with the settlement of satellite losses. Our investment yields at amortized cost were as follows for the periods set forth below: Years Ended December 31, 1999 1998 1997 ----------- ------------ ------------ Investment yields: Pre-tax 3.6% 3.4% 3.7% Net of tax 2.7% 2.5% 2.7% Our investment yields are reflective of a significant allocation of the total investment portfolio in equity securities, which yield less current income than fixed maturity investments. At December 31, 1999 and 1998, -62- investments in public and private equity securities approximated 41% and 49%, respectively, of total cash and invested assets. Additionally, such investment yields exclude our equity in the net income or loss of private equity investments accounted for under the equity method. Net Realized Gains (Losses) on Investments Our sources of net realized investment gains (losses) were as follows:
In thousands Years Ended December 31, -------------------------------------- 1999 1998 1997 --------- ---------- -------- Net realized investment gain (losses) Fixed maturity securities ($1,776) $1,472 $275 Publicly traded equity securities 16,798 16,582 3,878 Privately held securities 2,205 7,198 (4,913) ------- ------- ------ Sub-total 17,227 25,252 (760) Income tax expense (benefit) 6,029 8,838 (266) ------- ------- ------ Net realized investment gains (losses), net of tax $11,198 $16,414 ($494) ======= ======= ======
Income Taxes Our 1999 income tax benefit, 1998 effective tax rate of 5% and the 1997 income tax benefit are less than the 35% statutory rate on pre-tax operating income due primarily to tax exempt income and the dividends received deductions. The 1999, 1998 and 1997 gross deferred income tax benefits of approximately $10.5 million, $7.3 million and $2.1 million, respectively, which are assets considered recoverable from future taxable income, resulted from temporary differences between financial and taxable income. The net deferred income tax asset at December 31, 1999 was $7.8 million. We periodically evaluate the need for a valuation allowance for any portion of the deferred tax asset that our management believes will not be realized based on current and future operating performance and available tax planning strategies. While we believe that a valuation allowance is not necessary at December 31, 1999, continued future comprehensive losses or future decisions with respect to business strategy following the sale of our reinsurance business may result in the establishment of a valuation allowance in future financial statements. We have a net operating loss carryforward which expires in 2019, for which we have established a deferred income tax asset of $7.3 million at December 31, 1999. The repurchase of our common stock held by XL Capital resulted in a 27.8% change in ownership by 5% shareholders. If, in the ensuing three years, there is more than a 22.2% additional change in ownership by 5% shareholders, an "ownership change" will have taken place for federal income tax purposes. If such ownership change occurs, the amount of loss carryforwards that can be used in any subsequent year may be severely limited and could be eliminated in certain circumstances. See "Risk Factors -- The financing of our business plan may cause us to forfeit certain tax benefits." Investments A principal component of our investment strategy is investing a significant portion of RCRe's invested assets in publicly traded and privately held equity securities, primarily issued by insurance and reinsurance companies and companies providing services to the insurance industry. Cash and fixed maturity investments and, if necessary, the sale of marketable equity securities will be used to support shorter-term liquidity requirements. -63- As a significant portion of RCRe's investment portfolio consists of equity securities issued by insurance and reinsurance companies and companies providing services to the insurance industry, the equity portfolio lacks industry diversification and will be particularly subject to the performance of the insurance industry. Unlike fixed income securities, equity securities such as common stocks, including the equity securities in which RCRe has invested, generally are not and will not be rated by any nationally recognized rating service. The values of equity securities generally are more dependent on the financial condition of the issuer and less dependent on fluctuations in interest rates than are the values of fixed income securities. The market value of equity securities generally is regarded as more volatile than the market value of fixed income securities. The effects of such volatility on RCRe's equity portfolio could be exacerbated to the extent that such portfolio is concentrated in the insurance industry and in relatively few issuers. Since December 31, 1999, the market value of our public equity portfolio has decreased by approximately $25 million due to general stock market volatility, market decline in the property and casualty insurance sector and the poor operating performance of several of our investee companies. For additional discussion, see "--Market Sensitive Instruments and Risk Management" below. As our investment strategy is to invest a significant portion of RCRe's investment portfolio in equity securities, our investment income in any fiscal period may be smaller, as a percentage of investments, and less predictable than that of other insurance and/or reinsurance companies, and net realized and unrealized gains (losses) on investments may have a greater effect on our results of operations or stockholders' equity at the end of any fiscal period than would be the case for other insurance and/or reinsurance companies. Since the realization of gains and losses on equity investments is not generally predictable, such gains and losses have differed and will differ significantly from period to period. Variability and declines in our results of operations could be further exacerbated by private equity investments in start-up companies which are accounted for under the equity method. Such start-up companies may be expected initially to generate operating losses. Investments included in RCRe's private portfolio include securities issued by privately held companies and by publicly traded companies that are generally restricted as to resale or are otherwise illiquid and do not have readily ascertainable market values. The risk of investing in such securities is generally greater than the risk of investing in securities of widely held, publicly traded companies. Lack of a secondary market and resale restrictions may result in an inability by us to sell a security at a price that would otherwise be obtainable if such restrictions did not exist and may substantially delay the sale of a security we seek to sell. At December 31, 1999, cash and invested assets totaled approximately $585.9 million, consisting of $82.2 million of cash and short-term investments, $261.1 million of publicly traded fixed maturity investments, $158.6 million of publicly traded equity securities, and $83.9 million of privately held securities. Included in privately held securities are investments totaling $42.6 million which are accounted for under the equity method. At December 31, 1999, RCRe's private equity portfolio consisted of 12 investments, with additional investment portfolio commitments in an aggregate amount of approximately $23.2 million. In 1999, we completed one integrated transaction with an existing client of RCRe, a follow-on investment in an existing investee and one additional investment commitment. In addition, we divested four of RCRe's investments. (See note 3 under the caption "Investment Information" of the accompanying notes to our audited consolidated financial statements.) In October 1998, we provided $5 million in financing on a fully secured basis to a managing general agency, and received a related reinsurance commitment expected to generate an aggregate of $90 million of reinsurance premiums over three years pursuant to terms and conditions that we believe are more favorable than those available in the open market. -64- On March 6, 2000, we extended a loan in an aggregate principal amount of $3.5 million to American Independent Insurance Holding Company ("AIHC"), one of our investee companies. The loan is fully secured with the capital stock of AIHC and matures on September 6, 2001 (which date may be extended to March 6, 2002 upon the occurrence of certain events). The net proceeds of the loan were contributed to the surplus of AIHC's subsidiary, American Independent Insurance Company. In connection with the loan, we were issued warrants (in addition to the warrants issued to us in connection with a prior loan to AIHC) granting us the right to purchase equity in AIHC. See note 3 under the caption "Investment Information" of the accompanying notes to our audited consolidated financial statements for certain information regarding RCRe's publicly traded and privately held securities and their carrying values, and commitments made by RCRe relating to its privately held securities. At December 31, 1999, approximately 88% of RCRe's fixed maturity and short-term investments were rated investment grade by Moody's or Standard & Poor's and had an average quality rating of AA and an average duration of approximately 3.7 years. At December 31, 1999, RCRe is obligated under letters of credit in the aggregate amount of approximately $9.7 million, which secure certain reinsurance obligations. Securities with a carrying value of approximately $11.2 million have been pledged as collateral for these letters of credit. RCRe has not invested in derivative financial instruments such as futures, forward contracts, swaps, or options or other financial instruments with similar characteristics such as interest rate caps or floors and fixed-rate loan commitments. RCRe's portfolio includes market sensitive instruments, such as mortgage-backed securities, which are subject to prepayment risk and changes in market value in connection with changes in interest rates. RCRe's investments in mortgage-backed securities, which amounted to approximately $27.3 million at December 31, 1999, or 4.7% of cash and invested assets, are classified as available for sale and are not held for trading purposes. Market Sensitive Instruments and Risk Management In accordance with the SEC's Financial Reporting Release No. 48, the following analysis presents hypothetical losses in cash flows, earnings and fair values of market sensitive instruments which are held by RCRe as of December 31, 1999 and are sensitive to changes in interest rates, foreign exchange rates and equity security prices. This risk management discussion and the estimated amounts generated from the following sensitivity analysis represent forward-looking statements of market risk assuming certain adverse market conditions occur. Actual results in the future may differ materially from these projected results due to actual developments in the global financial markets. The analysis methods used by us to assess and mitigate risk should not be considered projections of future events of losses. Market risk represents the risk of changes in the fair value of a financial instrument and is comprised of several components, including liquidity, basis and price risks. The focus of the SEC's market risk rules is on price risk. For purposes of specific risk analysis, we employ sensitivity analysis to determine the effects that market risk exposures could have on the future earnings, fair values or cash flows of RCRe's financial instruments. The financial instruments included in the following sensitivity analysis consist of all of our cash and invested assets, excluding investments carried under the equity method of accounting. Equity Price Risk We are exposed to equity price risks on the public and private equity securities included in RCRe's investment portfolio. All of RCRe's publicly traded equity securities and privately held securities were issued by -65- insurance and reinsurance companies or companies providing services to the insurance industry. We typically do not attempt to reduce or eliminate RCRe's market exposure on these securities. Investments included in RCRe's private portfolio include securities issued by privately held companies and securities issued by public companies that are generally restricted as to resale or are otherwise illiquid and do not have readily ascertainable market values. Investments in privately held securities issued by privately and publicly held companies may include both equity securities and securities convertible into, or exercisable for, equity securities (some of which may have fixed maturities). RCRe's publicly traded and privately held equity securities at December 31, 1999, which are carried at a fair value of $158.6 million and $84.0 million, respectively, have exposure to price risk. The estimated potential losses in fair value for RCRe's publicly traded and privately held equity portfolios resulting from a hypothetical 10% decrease in quoted market prices, dealer quotes or fair value are $15.9 million and $8.4 million, respectively. Interest Rate Risk The aggregate hypothetical loss generated from an immediate adverse shift in the treasury yield curve of 100 basis points would result in a decrease in total return of 4.1%, which would produce a decrease in market value of $10.6 million on RCRe's fixed maturity investment portfolio valued at $261.1 million at December 31, 1999. There would be no material impact on RCRe's short-term investments. Foreign Currency Exchange Rate Risk We have foreign currency risk on both reinsurance balances receivable and reinsurance balances payable, including claims and claims expenses. We do not currently utilize derivative instruments to manage our exposure to foreign currency movements. At December 31, 1999, the substantial majority of the Company's net receivable/payable position was denominated in United States dollars. At such date, the largest foreign currency exposure related to liabilities denominated in British Pounds Sterling. We had a net liability balance in Sterling of approximately $2.6 million. A 10% increase in the Sterling/United States dollar exchange rate would have resulted in a loss to us of $268,000. Given our limited amount of net asset or liability balances in other foreign currencies, any currency movement of 10% would not produce a material loss for purposes of this discussion. Liquidity and Capital Resources We are a holding company and currently have no significant operations or assets other than our ownership of the capital stock of RCRe. We rely on cash dividends and distributions from RCRe to make payments, including for any operating expenses that we may incur and for any dividends or stock repurchases as our board of directors may determine. Our board currently does not intend to declare dividends or make any other distributions. However, our board intends to make a determination regarding stock repurchases following the consummation of the asset sale. See "Risk Factors -- We do not currently anticipate paying dividends, but may consider share repurchases" and "Dividend and Stock Repurchase Policy" elsewhere in this proxy statement. RCRe's ability to pay dividends or make distributions to us is dependent upon its ability to achieve satisfactory underwriting and investment results and to meet regulatory standards of the State of Nebraska, as described below. There are presently no contractual restrictions on RCRe's payment of dividends or the making of distributions to us. We intend to cause RCRe to make an extraordinary dividend to us following the asset sale. See "-- General -- RCRe Distribution." Nebraska insurance laws provide that, without prior approval of the Nebraska Director of Insurance ("Nebraska Director"), RCRe cannot pay a dividend or make a distribution (together with other dividends or distributions paid during the preceding 12 months) that exceeds the greater of (i) 10% of statutory surplus as of the preceding December 31 or (ii) statutory net income from operations from the preceding calendar year not -66- including after tax realized capital gains. Net income (exclusive of realized capital gains) not previously distributed or paid as dividends from the preceding two calendar years may be carried forward for dividend and distribution purposes. Any proposed dividend or distribution in excess of such amount is called an "extraordinary" dividend or distribution and may not be paid until either it has been approved, or a 30-day waiting period has passed during which it has not been disapproved, by the Nebraska Director. Notwithstanding the foregoing, Nebraska insurance laws provide that any distribution that is a dividend may only be paid out of earned surplus arising from the business of the insurer, which is defined as unassigned funds (surplus) as reported in the statutory statement for the most recent year, including any surplus arising from unrealized capital gains or revaluations of assets. Any distribution that is a dividend and that is in excess of RCRe's unassigned funds, exclusive of any surplus arising from unrealized capital gains or revaluation of assets, will be deemed an "extraordinary" dividend subject to the foregoing requirements. Due to the distribution that was made in connection with the XL Capital stock repurchase, we may not declare any other distribution for twelve months from the closing date of the stock repurchase without the prior approval of the Nebraska Director. See footnote 10 to our audited consolidated financial statements included in this proxy statement for further details regarding statutory restrictions on distributions by RCRe. We, RCRe and Cross River file consolidated federal income tax returns and have entered into a tax sharing agreement (the "Tax Sharing Agreement"), allocating the consolidated income tax liability on a separate return basis. Pursuant to the Tax Sharing Agreement, RCRe and Cross River make tax sharing payments to us based on such allocation. Net cash flow from operating activities for the years ended December 31, 1999, 1998 and 1997 was approximately $7.5 million, $68.5 million and $49.0 million, respectively, consisting principally of premiums received, investment income (excluding net realized investment gains), offset by operating costs and expenses. The primary sources of liquidity for Risk Capital Reinsurance are net cash flow from operating activities, principally premiums received, the receipt of dividends and interest on investments and proceeds from the sale or maturity of investments. RCRe's cash flow is also affected by claims payments, some of which have been large. For example, we experienced negative cash flow from operations of approximately $25 million in the 1999 fourth quarter as a result of significant paid loss activity. Such situations could reoccur as our book of business matures, claims are settled and if we continue to experience poor underwriting performance. Therefore, our cash flow could fluctuate significantly from period to period. RCRe does not currently have any material commitments for any capital expenditures over the next 12 months. We expect that our financing and operational needs for the foreseeable future will be met by our balance of cash and short-term investments, as well as by funds generated from operations. Following the sale of the reinsurance operations to Folksamerica, our objective will be to pursue business combinations and ventures with operating businesses. We have not yet identified any specific business opportunities. Accordingly, we may need to secure additional financing to carry out our business plan. We cannot assure you that we will be successful in the implementation of our current or future business strategy. See "Risk Factors--Risks Relating to Our Business After the Asset Sale." At December 31, 1999, our consolidated stockholders' equity totaled $346.5 million, or $20.28 per share based on issued and outstanding shares, and $20.28 per share on a diluted basis which includes outstanding dilutive warrants and options. At such date, statutory surplus of RCRe was approximately $290 million. As a result of the XL Capital stock repurchase, stockholders' equity has been reduced by $59.4 million and book value per share has increased to $23.27 per share on a fully diluted basis. RCRe's statutory surplus was also reduced by $60 million to $230 million due to the sale to XL Capital of the stock and warrants in LARC Holdings, Ltd. and Annuity and Life Re Holdings, Ltd., based on their statutory carrying values at December 31, 1999. Based on data from the RAA, after giving effect to the XL Capital stock repurchase, RCRe was the 20th largest domestic broker market oriented reinsurer as measured by its $230 million of statutory surplus. -67- Accounting Pronouncements Derivatives and Hedging In June 1998, the Financial Accounting Standards Board issued Statement No. 133 "Accounting for Derivative Instruments and Hedging Activities." This statement requires that all derivative financial instruments be recognized in the statement of financial position as either assets or liabilities and measured at fair value. If a derivative instrument is not designated as a hedging instrument, gains or losses resulting from changes in fair values of such derivative are required to be recognized in earnings in the period of the change. If certain conditions are met, a derivative may be designated as a hedging instrument, in which case the recording of the changes in fair value will depend on the specific exposure being hedged. The key criterion for hedge accounting is that the hedging relationship must be highly effective in achieving offsetting changes on fair values or cash flows. This statement is effective for fiscal years beginning after June 15, 2000, with initial application as of the beginning of the first quarter of the applicable fiscal year. We will adopt this statement in the first quarter of 2001. Historically, we have not invested in derivative financial instruments. However, derivatives may be embedded in other financial instruments, such as convertible securities and prepayment options in mortgages. If the embedded derivative meets certain criteria, it must be bifurcated from the host contract and separately accounted for consistent with other derivatives. RCRe's portfolio includes market sensitive instruments, such as convertible securities and mortgage-backed securities, which are subject to prepayment risk and changes in market value in connection with changes in interest rates. Our investments in mortgage-backed securities are classified as available for sale and are not held for trading purposes. Assuming the current investment strategy at the time of adoption, our presentation of financial information under the new statement will not be materially different than the current presentation. Start-Up Costs Effective January 1, 1999, we changed our method of accounting for start-up costs in accordance with the Accounting Standards Executive Committee's Statement of Position ("SOP") 98-5 "Reporting on the Costs of Start-Up Activities." This statement requires costs of start-up activities, including organization costs, to be expensed as incurred. The change in accounting principle resulted in the write-off of the start-up costs capitalized as of January 1, 1999 for us and RCRe's investee companies carried under the equity method of accounting. The cumulative effect of the write-off, which totals $383,000, after-tax, or $0.02 per share, has been expensed and is included in the 1999 net loss. (See note 2 of the accompanying notes to our audited consolidated financial statements.) Insurance Regulation RCRe, in common with other insurers, is subject to extensive governmental regulation and supervision in the various states and jurisdictions in which it transacts business. The laws and regulations of the State of Nebraska, the domicile of RCRe, have the most significant impact on its operations. From time to time various regulatory and legislative changes have been proposed in the insurance and reinsurance industry, some of which could have an effect on reinsurers. Among the proposals that have in the past been, or are at present being considered, are (i) the possible introduction of federal regulation in addition to, or in lieu of, the current system of state regulation of insurers and (ii) proposals in various state legislatures (some of which proposals have been enacted) to conform portions of their insurance laws and regulations to various model acts adopted by the NAIC. We are unable to predict whether any of such laws and regulations -68- will be adopted, the form in which any such laws and regulations would be adopted, or the effect, if any, these developments would have on our operations and financial condition. In March 1998, the NAIC adopted the codification of statutory accounting principles project that will generally be applied to all insurance and reinsurance company financial statements filed with insurance regulatory authorities as early as the statutory filings made in 2001. Although the codification is not expected to materially affect many existing statutory accounting practices presently followed by most insurers and reinsurers such as RCRe, there are several accounting practices that may be changed. The most significant change would involve accounting for deferred income taxes, which change would require a deferred tax liability to be recorded for unrealized appreciation of invested assets, net of available deferred tax assets, that would result in a reduction to statutory surplus. If such requirement had been in effect in 1999, the statutory surplus of RCRe at December 31, 1999 would have remained at $290 million. Effects of Inflation The effects of inflation on us are implicitly considered in pricing and estimating reserves for unpaid claims and claims expenses. The actual effects of inflation on our results cannot be accurately known until claims are ultimately settled. -69- UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL DATA The following unaudited pro forma balance sheet as of December 31, 1999 reflects our historical accounts as of that date, adjusted to give pro forma effect to the sale of our reinsurance business to Folksamerica, which is subject to stockholder approval, and our repurchase of 4,755,000 shares, or 27.8%, of our outstanding common stock from XL Capital, which repurchase was completed on March 2, 2000, as if those transactions had occurred on December 31, 1999. The following unaudited pro forma statement of income and comprehensive income for the year ended December 31, 1999 reflects our historical accounts for that period, adjusted to give pro forma effect to the asset sale and the XL Capital stock repurchase as if those transactions had occurred on January 1, 1999. The pro forma financial data and accompanying notes should be read in conjunction with the description of the asset sale and XL Capital stock repurchase contained in this proxy statement and our audited consolidated financial statements and related notes also included in this proxy statement. We believe that the assumptions used in the following statements, which are set forth in the accompanying notes, provide a reasonable basis on which to present the pro forma financial data. The pro forma financial data is provided for informational purposes only and should not be construed to be indicative of our financial condition or results of operations had the asset sale and XL Capital stock repurchase been consummated on the dates assumed and are not intended to project our financial condition on any future date or results of operations for any future period. -70-
Risk Capital Holdings, Inc. and Subsidiaries Pro Forma Condensed Consolidated Balance Sheet December 31, 1999 (Dollars in thousands, except per share data) Pro Forma Adjustments ---------------------------------- XL Folksamerica Historical Transaction(1) Transaction(4) Pro Forma ---------------- -------------- --------------- ------------- Assets Investments: Fixed maturities and short-term investments $333,852 ($245,545)(5) $88,307 (10) Publicly traded equity securities 158,631 ($38,169)(2) 120,462 Privately held securities 83,969 (24,040)(2) 59,929 ------------ ------------ -------------- --------------- Total investments 576,452 (62,209) (245,545) 268,698 Cash 9,457 3,647 (2) 1,335 (8) 14,439 Accrued investment income 4,527 4,527 Premiums receivable 119,320 (119,320)(5) Reinsurance recoverable 73,122 (73,122)(5) Deferred policy acquisition costs 23,585 (23,585)(6) Deferred income tax asset 7,834 127 (2) (5,352)(7) 2,609 Other assets 50,062 (36,975)(5) 13,087 ------------ ------------ ------------- ------------- Total Assets 864,359 ($58,435) ($502,564) $303,360 ============ ============ ============= ============= Liabilities Claims and claims expenses $364,554 ($364,554)(5) Unearned premiums 108,743 (108,743)(5) Reinsurance balances payable 14,666 (14,666)(5) Other liabilities 29,882 $1,000 (2) (24,541)(5) $6,341 ------------ ------------ ------------- ------------- Total Liabilities 517,845 1,000 (512,504) 6,341 ------------ ------------ ------------- ------------- Stockholders' Equity Common stock, $.01 par value: 171 171 Additional paid-in capital 342,034 342,034 Deferred compensation under stock award plan (317) (317) Retained earnings (deficit) (22,175) 10,959 (3) 6,080 (9) (5,136) Less treasury stock, at cost (387) (59,200)(1) (59,587) Accumulated other comprehensive income consisting of unrealized appreciation of investments, net of income tax 27,188 (11,194)(3) 3,860 (9) 19,854 ------------ ------------ ------------- ------------- Total Stockholders' Equity 346,514 (59,435)(2) 9,940 (9) 297,019 ------------ ------------ ------------- ------------- Total Liabilities and Stockholders' Equity $864,359 ($58,435) ($502,564) $303,360 ============ ============ ============= ============= Shares outstanding - basic 17,087,970 (4,755,000)(1) -- 12,332,970 ============ ============ ============= ============= Basic book value per share $20.28 $24.08 ============ =============
-71- Notes to Pro Forma Balance Sheet 1. Reflects our repurchase from XL Capital of all of the 4,755,000 shares of our common stock held by it for $59,200,000, or $12.45 per share, which represents 85% of our average closing market price of our common stock for the twenty day trading period between January 21, 2000 and February 17, 2000 in exchange for the following: (i) our interest in LARC Holdings, Ltd., valued at $25 million, and (ii) our interest in Annuity and Life Re (Holdings), Ltd. valued at $37,847,000, consisting of 1,418,440 common shares at $25.38 per share, which represents the average closing market price of Annuity and Life Re (Holdings), Ltd. common shares for the twenty day trading period between January 21, 2000 and February 17, 2000, and 100,000 warrants at $18.50 per warrant based on a Black-Scholes option valuation model, and We received cash from XL Capital of $3,647,000, which is the excess of the value of the securities described in (i) and (ii) above over the purchase price of our common stock repurchased from XL Capital. 2. The decrease in book value resulting from the XL Capital stock repurchase is calculated as follows (in thousands):
Repurchase of 4,755,000 shares of our outstanding common stock at $12.45 per share, recorded as a reduction to stockholders' equity as treasury stock, plus $59,200
Net loss on the disposition of securities and transaction costs as follows:
(in thousands) Annuity and LARC Life Re Holdings, Ltd. (Holdings) Ltd. Total ------------------ ---------------- ----------- Consideration received, consisting of cash of $3,647,000 and our common stock valued at $59,200,000 $25,000 $37,847 $62,847 Carrying values at December 31, 1999 24,040 38,169 62,209 ------------------ ---------------- ----------- Pre-tax gain (loss) before transaction costs $960 ($322) 638 ================== ================ Transaction costs 1,000 =========== Pre-tax loss (362) Tax benefit (127) ----------- Net loss (235) ----------- Net decrease in book value $59,435 ===========
3. The gain recorded in retained earnings of $10,959,000 represents the realized gain that will be recorded for the $11,194,000 of net unrealized appreciation, net of tax, recorded at December 31, 1999 for LARC Holdings, Ltd. and Annuity and Life Re (Holdings), Ltd. and the net loss of $235,000, which is discussed in note 2 above. 4. Reflects the asset sale, pursuant to which Folksamerica Reinsurance Company will assume RCRe's liabilities under the reinsurance agreements transferred to it and RCRe will transfer to Folksamerica Reinsurance Company assets in an aggregate amount that is, in GAAP book value (as set forth on our estimated closing date balance sheet), equal to the GAAP book value (as set forth on our estimated clos- -72- ing date balance sheet) of the liabilities assumed. In consideration for the transfer of RCRe's book of business, Folksamerica will pay $20.335 million in cash at the closing, subject to adjustment under the circumstances described in "The Asset Purchase Agreement--Purchase Price". 5. Represents securities and insurance assets and insurance liabilities to be transferred to Folksamerica based on December 31, 1999 financial statement amounts. At the closing of the asset sale, RCRe and Folksamerica Reinsurance Company will enter into a transfer and assumption agreement, under which Folksamerica Reinsurance Company will assume RCRe's rights and obligations under the reinsurance agreements being transferred in the asset sale. Following the closing of the asset sale, Folksamerica Reinsurance Company will notify the reinsureds under those of such agreements that are in-force that it has assumed RCRe's obligations and that, unless the reinsureds object to such assumption, RCRe will be released from its obligations to those reinsureds. The pro forma accounting for this transaction assumes that none of RCRe's reinsureds will object to such assumption and, accordingly, the gross liabilities for its reinsurance business will be removed from the accounts of RCRe for statutory accounting and GAAP accounting purposes. RCRe will continue to record gross liabilities in its accounts for reinsureds that object to the release of RCRe from its obligations to such reinsureds. In such instances, an offsetting accounts receivable amount from Folksamerica Reinsurance Company would be recorded as an asset equal to such gross liabilities. 6. Elimination of deferred policy acquisition costs related to the liability for unearned premiums transferred to Folksamerica. 7. Net reduction in deferred income tax asset as follows (in thousands):
Reduction in net deferred tax asset for elimination of temporary differences between financial statements and income tax return amounts resulting from the Folksamerica transaction $13,957 Less, estimated tax benefit resulting from the transaction 8,605 ------- Net reduction in deferred tax asset $ 5,352 =======
8. Represents cash payment received from Folksamerica at the closing of the asset sale of $20.335 million less estimated related transaction costs of $19 million, which include investment banking, legal and accounting fees, severance costs, tax reimbursement to Folksamerica and costs to purchase additional reinsurance protection for Folksamerica. -73- 9. The book value gain resulting from the Folksamerica transaction is calculated as follows (in thousands):
Consideration received, consisting of the following: Total liabilities transferred $512,504 Cash premium received 20,335 ------ 532,839 ------- Assets transferred 474,962 Amortization of deferred policy acquisition costs 23,585 Transaction costs 19,000 ------ 517,547 ------- Pre-tax gain 15,292 Tax expense 5,352 ----- Net transaction gain 9,940 Realized loss, net of tax for securities transferred at market value (3,860) ------ Net income 6,080 Change in net unrealized appreciation of investments, net of tax 3,860 ----- Comprehensive income and net book gain $9,940 ======
The pro forma accounting for this transaction assumes that none of RCRe's reinsureds will object to the release of RCRe under the transfer and assumption agreement and, accordingly, the gross liabilities for such business are removed from the accounts of RCRe for statutory and GAAP accounting purposes (see note 5 above). RCRe will continue to record gross liabilities in its accounts for reinsureds that object to the release of RCRe from its obligations to such reinsureds. This would result in a portion of the pre-tax gain on the transaction being deferred and amortized into income as the gross liabilities are extinguished. 10. Includes $20 million of fixed income securities deposited in an escrow account for a five year period primarily to reimburse Folksamerica for claims and claim expenses exceeding reserves recorded by RCRe as of the closing date resulting from business produced on behalf of RCRe by a certain managing underwriting agency. At December 31, 1999, such reserves approximated $38.3 million, which were recorded based on RCRe's actuarially determined best estimate for such business. We could record a loss to the extent that such reserves turn out to be deficient, due to our reimbursement of Folksamerica for such deficiency to the extent of the escrowed funds. Amounts in escrow may also be released to Folksamerica to satisfy its indemnification claims against us relating to undisclosed liabilities, RCRe's reinsurance agreements and the managing underwriting agency referred to above. Under the asset purchase agreement, we may be required to deposit an additional amount of up to $5 million into a supplemental escrow account a short time following the closing of the asset sale. The above unaudited pro forma condensed consolidated balance sheet has been prepared assuming that such supplemental escrow account will not be required. -74- Risk Capital Holdings, Inc. and Subsidiaries Pro Forma Condensed Consolidated Statement of Income and Comprehensive Income For the Year Ended December 31, 1999 (Dollars in thousands, except per share data)
Pro Forma Adjustments --------------------------------- XL Folksamerica Historical Transaction(1) Transaction(2) Pro Forma ------------ -------------- ------------- ----------- Revenues Net premiums written $306,726 ($306,726) -- (Increase) decrease in unearned premiums 4,642 (4,642) -- ---------- -------------- ------------- ----------- Net premiums earned 311,368 (311,368) -- Net investment income 20,173 145 (10,253) 10,065 Net realized investment gains and losses 17,227 1,350 1,192 19,769 ---------- -------------- ------------- ----------- Total revenues 348,768 1,495 (320,429) 29,834 Operating Costs and Expenses Claims and claims expenses 305,841 (305,841) Commissions and brokerage 80,540 (80,540) Other operating expenses 14,816 (10,666) 4,150 Foreign exchange (gain) (198) 198 ---------- -------------- ------------- ----------- Total operating costs and expenses 400,999 -- 396,849 4,150 Income (Loss) Income before income taxes, equity in net income of investees and cumulative effect of accounting change (52,231) 1,495 76,420 25,684 Federal income taxes expense (benefit) (19,557) 571 27,171 8,185 ---------- -------------- ------------- ----------- Income before equity in net income of investees and cumulative effect of accounting change (32,674) 924 49,249 17,499 Equity in net income of investees 621 114 735 ---------- -------------- ------------- ----------- Income (loss) before cumulative effect of accounting change (32,053) 1,038 49,249 18,234 ---------- -------------- ------------- ----------- Cumulative effect of accounting change (383) 99 (284) ---------- -------------- ------------- ----------- Net income (loss) (32,436) 1,137 49,249 17,950 Other Comprehensive Income (Loss), Net of Tax Change in net unrealized appreciation of investments, net of tax (19,850) (1,914) 4,553 (17,211) ---------- -------------- ------------- ----------- Comprehensive Income (Loss) ($52,286) ($777) $53,802 $739 ========== ============== ============= =========== Average shares outstanding Basic 17,086,732 (4,755,000) -- 12,331,732 Diluted 17,086,808 (4,755,000) -- 12,331,808 Per Share Data Net Income (Loss) - Basic ($1.90) $1.46 - Diluted ($1.90) $1.46 Comprehensive Income (Loss) Basic ($3.06) $0.06 Diluted ($3.06) $0.06
-75- Notes to Pro Forma Statement of Income and Comprehensive Income 1) Represents all revenue and expense and other comprehensive income items recorded during 1999 for LARC Holdings, Ltd. and Annuity and Life Re (Holdings), Ltd., which were disposed of in the XL Capital stock repurchase. 2) Represents all revenue and expense and other comprehensive income items recorded during 1999 related to the sale of our reinsurance business to Folksamerica Reinsurance Company. Net investment income, net realized investment gains (losses) and unrealized appreciation (depreciation) of investments have been allocated based on the proportion of the average amount of fixed maturities and short term investments related to the business that will be transferred to the average total fixed maturities and short term investments in 1999. All other revenue and expense items were allocated based on specific identification. -76- INDEPENDENT ACCOUNTANTS Our consolidated financial statements as of December 31, 1999 and 1998 and for each of the three years in the period ended December 31, 1999 included in this proxy statement have been audited by PricewaterhouseCoopers LLP, independent accountants, as stated in their report appearing in this proxy statement. WHERE YOU CAN FIND MORE INFORMATION As required by law, we file reports, proxy statements and other information with the SEC (SEC file number: 0-26456). These reports, proxy statements and other information contain additional information about us. You can inspect and copy these materials at the SEC's Public Reference Room at 450 Fifth Street, N.W., Judiciary Plaza, Washington, D.C. 20549. You can obtain information about the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet web site that contains reports, proxy and information statements and other information regarding companies that file electronically with the SEC. The SEC's internet address is http://www.sec.gov. You can also inspect these materials at the offices of the Nasdaq Stock Market, 1735 K Street, N.W. Washington, D.C. 20006. The SEC allows us to "incorporate by reference" information into this proxy statement, which means that we can disclose important information by referring you to another document filed separately with the SEC. Information incorporated by reference is considered part of this proxy statement, except to the extent that the information is superseded by information in this proxy statement. This proxy statement incorporates by reference the information contained in our Annual Report on Form 10-K for the year ended December 31, 1998, our proxy statement for our annual meeting of stockholders held on May 11, 1999, our Quarterly Reports on Form 10-Q for the quarters ended March 31, 1999, June 30, 1999 and September 30, 1999 and our Current Reports on Form 8-K dated January 18, 2000 and March 2, 2000. We also incorporate by reference the information contained in all other documents that we file with the SEC after the date of this proxy statement and before the special meeting. The information contained in any of these documents will be considered part of this proxy statement from the date these documents are filed. Any statement contained in this proxy statement or in a document incorporated or deemed to be incorporated by reference herein shall be deemed to be modified or superseded for purposes of this proxy statement to the extent that a statement contained herein or in any other subsequently filed document which also is or is deemed to be incorporated by reference herein modifies or supersedes such statement. Any statement so modified or superseded shall not be deemed, except as so modified or superseded, to constitute a part of this proxy statement. If you are one of our stockholders and would like to receive a copy of any document incorporated by reference into this proxy statement (which will not include any of the exhibits to the document other than those exhibits that are themselves specifically incorporated by reference into this proxy statement), you should call or write to Risk Capital Holdings, Inc., 20 Horseneck Lane, Greenwich, Connecticut 06830, Attention: Secretary (telephone (203) 862-4300). We will provide these documents to our stockholders, without charge, by first class mail within one business day of the day we receive a request. In order to ensure timely delivery of the documents prior to the special meeting, you should make any such request not later than April 4, 2000. -77- You should rely only on the information contained in (or incorporated by reference into) this proxy statement. We have not authorized anyone to give any information different from the information contained in (or incorporated by reference into) this proxy statement. This proxy statement is dated March 15, 2000. You should not assume that the information contained in this proxy statement is accurate as of any later date, and the mailing of this proxy statement to stockholders shall not mean otherwise. By Order of the Board of Directors, [Signature Logo] PETER A. APPEL Executive Vice President, Chief Operating Officer, General Counsel and Secretary -78- -----END PRIVACY-ENHANCED MESSAGE-----