-----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, HkhcSRCQ8zoqSS+c2VCMCxIsvkcR1VSpJXOwA0rLcXj5GrI9FsHsDJi2J1YG1mAD wwbiunWq/1gkGzsd/4B52A== 0000950123-99-002845.txt : 19990402 0000950123-99-002845.hdr.sgml : 19990402 ACCESSION NUMBER: 0000950123-99-002845 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990331 FILER: COMPANY DATA: COMPANY CONFORMED NAME: ESG RE LTD CENTRAL INDEX KEY: 0001049624 STANDARD INDUSTRIAL CLASSIFICATION: LIFE INSURANCE [6311] IRS NUMBER: 000000000 FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-23481 FILM NUMBER: 99581413 BUSINESS ADDRESS: STREET 1: SKANDIA INTERNATIONAL HOUSE STREET 2: 16 CHURCH STREET, HAMILTON CITY: BERMUDA STATE: D0 BUSINESS PHONE: 4412952185 MAIL ADDRESS: STREET 1: SKANDIA INTERNATIONAL HOUSE STREET 2: 16 CHURCH STREET CITY: BERMUDA 10-K405 1 FORM 10-K405 1 - -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1998 Commission file number 000-23481 ESG RE LIMITED (Exact name of Registrant as specified in its charter) Bermuda Not Applicable (State or other jurisdiction of (I.R.S. Employer Identification No.) ncorporation of organization) 16 Church Street Hamilton HM11, Bermuda (Address of executive offices, zip code) (441) 295-2185 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of each class Common Shares, $1.00 par value Name of each exchange on which registered Nasdaq National Market Securities registered pursuant to Section 12(g) of the Act: 3,000,000 Common Shares 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. |X| The aggregate market value of the voting stock held by non-affiliates of the Registrant, as of March 22, 1999, was $197,124,329.63 based on the closing price of $16.375 on that date. The number of the Registrant's common shares (par value $1.00 per share) outstanding as of March 22, 1999, was 13,923,799. Documents Incorporated by Reference: Certain portions of the Annual Report to Shareholders for 1998 (the "Annual Report") are incorporated by reference in Parts II and IV of this Form 10-K. Certain portions of the Definitive Proxy Statement in connection with the 1999 Annual General Meeting of Shareholders (the "Proxy Statement") which will be filed with the Securities and Exchange Commission not later than 120 days after the Registrant's fiscal year ended December 31, 1998, are incorporated by reference in Part III of this Form 10-K. 2 PART I. Unless the context requires otherwise, references herein to the "Company" or "ESG Re" include the Company's subsidiaries through which the Company operates. All references to the Company prior to the closing of its initial public offering on December 12, 1997, are to the Company's reinsurance management business, which was conducted through its subsidiary, European Specialty Group Holding AG ("ESG Germany") and its subsidiaries (together with ESG Germany, "ES Management"). ITEM 1. BUSINESS General ESG Re Limited (the "Company" or "ESG Re") was formed on August 21, 1997, under the laws of Bermuda. The Company, through its wholly owned direct and indirect subsidiaries, European Specialty Reinsurance (Bermuda) Limited ("ES Bermuda"), European Specialty Reinsurance (Ireland) Limited ("ES Ireland") and European Specialty Ruckversicherung AG ("ES Germany"), is a specialty reinsurer providing innovative risk solutions and capacity on a global basis in the fields of accident, health, life and special risk reinsurance to insurers and selected reinsurers. On December 12, 1997, the Company raised gross proceeds of $257 million in a private placement and initial public offering (the "Offerings"). The net proceeds from the Offerings of the Company's common shares in December 1997 provided the capitalization for the Company to assume reinsurance risks. In June 1998, the Company incorporated Accent Insurance Company Ltd. ("Accent") in Ireland, enabling it to offer its products on a pan-European basis directly to its insured parties. In the former Soviet State of Georgia, ESG Re has helped to establish the first locally-managed insurance company to be run along Western business standards, supplying a range of innovative products and services, extensive management and training support, technical expertise and capital funding. The Company has also established operations in the Latin American market and has increased its presence in the London, North American, and Asian markets. The Company has increased its investment in SportSecure GmbH, a reinsurance intermediary specializing in sports and entertainment risks, giving the Company a majority ownership interest and securing a leadership position in the Special Risk market. The Company distinguishes itself by offering "intelligent reinsurance" products and services for particular underwriting problems including actuarial support, product design, and, in the field of medical expense reinsurance, loss prevention and disease management. ESG Re believes that "intelligent reinsurance" products combined with management's experience, extensive relationships, market reputation, underwriting skills, and a strong balance sheet will produce a solid book of business characterized by high stability, above average performance, broad product and global diversity and strong growth opportunities. Market Growth The Company believes that it is well positioned to benefit from market growth developments because of its reputation as a recognized lead underwriter, risk-oriented approach and far-ranging and well-established relationship network. ESG Re believes that its reinsurance markets are currently experiencing significant growth as a result of: (i) the worldwide trend of transferring social security and national health responsibility to the private sector; (ii) increasing insurance demand accompanying economic growth in emerging markets in Eastern Europe, Asia and Latin America; (iii) the deregulation of certain European markets as a consequence of new trade directives from the European Union enabling the introduction of new products; (iv) increasing individual morbidity and decreasing mortality within large demographic segments of the population; and (v) increased capacity requirements for the insurance of major global sports and entertainment events. 2 3 Business Strategy The Company's strategy places an emphasis on underwriting profitability rather than market share. The Company intends to achieve its growth objectives through the following strategic initiatives: Products and Services Management believes that the Company is recognized by customers as a provider of "intelligent reinsurance" through innovative insurance products and services. ESG Re intends to maintain its competitive advantage by developing reinsurance products and services that are tailored to the needs of particular markets and by working closely with primary insurers and insureds to implement loss control techniques. The Company intends to (i) introduce and implement managed care techniques in selected European markets where these techniques have been underutilized; (ii) create private medical care and insurance products for emerging markets within Eastern Europe, Latin America and Asia; (iii) expand occupational injury and health reinsurance programs in Scandinavia; and (iv) continue to structure innovative special risk reinsurance programs for major sporting events and performances such as Soccer World Cup, and European Soccer Championships. Consistent with its practice and experience, ESG Re offers reinsurance of health risks in conjunction with loss-reducing products and services. The Company expects that its ceding clients will assist with the use and implementation of such products and services because of their favorable impact on claims expenses. In support of its loss prevention programs, the Company also provides claims assistance services that were previously provided by third parties. Assistance services include such functions as 24-hour emergency evacuation and repatriation, medical treatment referrals and supporting clinical services. In addition, the Company uses the European Specialty Insurance Management Services ("ESIMS") software system developed by the Company to assist ceding companies with portfolio and claims handling. New Businesses and Markets The Company entered the North American market in September 1997. Ms. Renate M. Nellich, Chief Executive Officer of European Specialty (North America) Limited ("ES North America"), has considerable experience in the North American health business and is pursuing opportunities in this market. In addition, access to specialized U.S. claims service providers and the consummation of strategic alliances will enable the Company to import managed care techniques that have proven successful in the United States, to Europe and other areas where they are currently underutilized by health care providers. Focus on High Growth Markets ESG Re focuses its health insurance underwriting activities on markets with high growth potential in developing areas such as Latin America, the Commonwealth of Independent States ("CIS"), Eastern Europe and Asia. The Company also targets selected developed markets for the introduction of innovative products. In Germany, for example, the Company is introducing progressive technologies that will establish new and more streamlined distribution channels. 3 4 Lines of Business The Company's major lines of business include medical expense, personal accident and disability, credit, life and special risk reinsurance. ESG Re's gross premiums written in 1998 totaled $199.9 million. The breakdown of gross premiums written for the year ended December 31, 1998 by major lines of business was as follows:
1998 Gross Premiums Written Medical Expense...................................................... 59.6% Personal Accident and Disability..................................... 26.1 Credit............................................................... 6.2 Life................................................................. 5.5 Special Risk......................................................... 2.6 ----- 100.0%
FURTHER SEGMENT INFORMATION IS DISCLOSED IN NOTE 16 OF THE CONSOLIDATED FINANCIAL STATEMENTS INCORPORATED BY REFERENCE FROM THE 1998 ANNUAL REPORT TO SHAREHOLDERS. Medical Expense Medical expense reinsurance consists primarily of medical expense reimbursement plans, short-term travel, defined illnesses and dread diseases, as well as medical expense add-on coverages, top-up benefits and carve-out programs. To properly evaluate these reinsurance risks, ESG Re relies on its detailed knowledge of the underlying insurance product and active risk management, instead of relying solely on past performance or general market pricing. ESG Re frequently underwrites risk only concurrently with the implementation of the Company's loss control measures and underwriting support systems. The Company generally does not underwrite business where the insured has no deductible or co-payment without being able to influence its loss ratios (by applying cost containment measures whenever prudent). To this end, the Company generally seeks to have insurers include deductibles and coinsurance requirements in the primary insurance contracts. In developing countries, ESG Re encourages ceding clients to develop adequate retention levels. ESG Re encourages its ceding clients to employ stringent cost control and loss prevention measures, such as managing a patient's choice of doctors and hospital networks, reducing benefit utilization and minimizing claims patterns. The Company introduces selected managed care concepts in Europe and emerging insurance markets through "intelligent reinsurance" (i.e., the combination of capacity, system and data management support and the application of preventative loss control). The Company believes insurance companies in these markets are receptive to managed care since they often have less experience with contemporary cost-containment measures. ESG Re believes that medical expense reinsurance is one of the strongest growing classes in the insurance industry. The restructuring of social security systems throughout numerous countries generates the need for private insurance and, consequently, generates reinsurance demand. New markets have emerged particularly in Eastern Europe, due to changes in laws that have transferred insurance responsibility from government funds to private institutions, such as trade unions. In the area of health reinsurance, ESG Re has focused its underwriting activities on both highly developed markets, like Germany, and less developed markets with high growth potential, like Latin America, the CIS, Eastern Europe and Asia. 4 5 Personal Accident Personal accident reinsurance covers death and dismemberment, disability, loss of license and special coverages for credit card issuing corporations relating to injuries to card holders. The reinsurance of nontraditional risks, such as tailor-made coverage for occupational injuries, also comprises an important part of ESG Re's personal accident reinsurance business. The Company favors the "local approach" to personal accident reinsurance (i.e., it acquires direct knowledge of the underlying business by establishing personal relationships and transacting business directly with the ceding clients or local brokers in the country of origin). ESG Re focuses its business in areas in which it has detailed knowledge of local culture, insureds' behavior, market conditions and other risk elements, since such knowledge allows the Company to assess and price risk appropriately. Credit/Life ESG Re provides reinsurance for credit/life, accident, disability and unemployment insurance. ES Management has considerable experience underwriting credit/life reinsurance in the American, French and Scandinavian markets. In 1998, the Company has entered the German and selected other European markets for credit/life reinsurance, applying the same underwriting practice it has employed in its existing markets (with the necessary adaptations for local markets). The Company has recently begun underwriting activities in the area of traditional life reinsurance, initially limited to developing markets. Because the Company does not intend to compete with established insurers and reinsurers in long-term life insurance or investment-related life products, it seeks to offer these products in less established markets. Special Risk Special risk reinsurance includes insurance with unique risk characteristics, such as sports disabilities, sports and entertainment contingency, non-appearance, cancellation and abandonment. For example, for the 1998 World Cup Soccer Tournament, ES Management controlled the placement of largest contingency insurance risk ever arranged in the global market. The Company has also been selected to structure and arrange the 2002 Soccer World Cup, with a record amount insured of over 2 billion Swiss francs. ES Management has also covered the 1994 World Soccer Tournament, the European Soccer Championships, the World Athletic Championship, the ATP finals, the European Athletic Association Cups and numerous performances by internationally renowned artists. Underwriting The Company employs a disciplined, analytical and forward-looking approach to underwriting in order to maximize underwriting profitability. The Company intends to construct a portfolio of reinsurance contracts in the personal and special risk markets that maximizes shareholders' return on equity, subject to prudent risk constraints. ESG Re's continued success rests squarely on its ability to generate consistent underwriting profits. Underwriting profits, not cash flow underwriting or investment speculation, are the cornerstone of the Company's profit strategy. Management believes that its strategy of "intelligent reinsurance" provides the appropriate tools for achieving the Company's mission. This is evidenced by the Company's underwriting performance, with combined loss and acquisition expense ratios of 89.1% and 90.5% for the years ended December 31, 1998 and 1997, respectively. ESG Re's products and services also serve to enhance the persistency of the portfolio, which in turn supports long-term profitability. With an emphasis on underwriting profitability, the Company has canceled contracts with ceding companies when underwriting profits were not in line with expectations. Underwriting new and renewal business is conducted on a risk-by-risk basis, with consideration given to the general direction of rates, policy terms, loss histories and future exposures, ESG Re's acceptance limits and general book of business. As part of its underwriting process, the Company focuses on the reputation of the proposed cedent, the likelihood of establishing a long-term relationship with the cedent, the geographic area in which the cedent conducts business and the cedent's market share. The Company reviews historical loss data in order to compare the cedent's 5 6 historical loss experience to industry averages, as well as the perceived financial strength of the cedent. Over time, the Company has developed its own manuals that serve as a detailed underwriting guideline. The Company protects its portfolio by effecting non-proportional reinsurance coverage in various layers to protect against large individual losses, serial losses and risk of known and unknown concentration. In addition, the Company will continue to effect proportional coverage on underwritten risks that might have fluctuating results. The Company, together with co-reinsurers, provides initially the following gross capacities: Medical Expense $5 million lifetime benefit per person Personal Accident and Disability $5 million any one person and $30 million in accumulated losses from any one known event Credit/Life $5 million any one person Special Risk $10 million any one event or series of events
Initially, the Company does not intend to expose itself to risk for any individual in excess of $500,000 for personal accident, special risk, medical, life and credit/life reinsurance, $1 million for any one known accumulation and $2,500,000 for contingency for major events, prior to additional reinsurance. Claims Normally, a reinsurer is not actively involved in claims handling. It is the task of the ceding client to adjust the original losses and settle claims made by its direct insureds. To the extent possible, the Company's approach differs from other reinsurers in that it actively seeks to reduce risks in most of its medical expense reinsurance lines while its reinsurance policies are in effect. The Company's claims handling activities, particularly for complicated cases, have proven to be successful in significantly reducing loss ratios of ceding clients' portfolios in comparison to their loss ratios before ESG Re's involvement. Involvement in claims handling also will allow the Company to be constantly aware of claims development in the health care field and to establish reserves more accurately at an early point in time. These claims support techniques have also proven to be an important tool in the acquisition of new business. Depending on the experience and the retention of the ceding client and the extent of non-proportional reinsurance made available to the Company, it will require either claims control or claims cooperation clauses in the reinsurance treaties it negotiates. Claims control clauses allow the reinsurer to determine the extent to which a claim will be paid, whereas claims cooperation clauses require the agreement of the insurer and reinsurer to jointly determine the extent to which a claim will be paid. These clauses may improve the claims performance of a ceding client which might not always be sufficiently experienced in dealing with complex issues. The Company performs audits at its ceding clients where deemed necessary. Such audits may include underwriting, claims, financial, and systems audits. Qualitatively, such audits do not serve solely to test compliance, but to discover weaknesses in the reporting and reserving system of a ceding client and thereby help the ceding client to arrive at a realistic and timely methodology to evaluate risk exposure. Operations The Company has structured its underwriting operations according to business lines. Underwriters are responsible for underwriting the business according to internal guidelines and procedural and underwriting manuals, as well as for supervising claims and handling claims subsequent to entering into the contracts. All business is continuously monitored. 6 7 The Company's management and underwriting information system provides a current database for individual and general risk assessment. In November 1998, the Company announced the opening of a new Shared Services Support Center in Dublin, Ireland, providing centralized global operational support for insurance administration, finance, systems and human resources. The consolidation of these services established the operating platform necessary to support and enhance the Company's accelerated growth and development to supply value-added leading edge services and to enable the Company to contain future costs in an increasingly competitive marketplace. The Company has entered into agreements with various companies for the provision of office space, certain administrative services, and accounting and regulatory reporting support in Ireland and Bermuda. Reserves The Company expects that, due to the short-tail nature of personal and special risk reinsurance claims, most claims under its treaties will generally become known and ascertainable within approximately 12 to 24 months from the date the insurance policy is written. However, a portion of the Company's business, written and classified as typical "London market business," is generally longer-tail in nature. The majority of the Company's reinsurance contracts permit annual adjustment of terms. The reserve for unpaid losses and loss adjustment expenses includes an estimate of reported case reserves and an estimate for losses incurred but not reported. Case reserves are estimated based on ceding company reports and other data considered relevant to the estimation process. The liability for losses incurred but not reported is based to a large extent on the expectations of ceding companies about ultimate loss ratios at the inception of the contracts, supplemented by industry experience and the Company's specific historical experience where available. As the Company has limited specific historical experience on a significant number of its programs on which to base its estimate of losses incurred but not reported, its reliance on ceding company expectations and industry experience is necessarily increased, which increases the uncertainty involved in the loss estimation process. The reserves as established by management are reviewed periodically, and adjustments are made in the periods in which they become known. Although management believes that an adequate provision has been made for the liability for losses and loss expenses, based on all available information, there can be no assurance that the ultimate losses will not differ significantly from the amounts provided. Investments As of December 31, 1998, the Company's cash and invested assets totaled $235.2 million. The Company has developed specific investment guidelines for the management of its investment portfolio. Although these guidelines stress diversification of risk, preservation of capital and market liquidity, investments are subject to market risks and fluctuations, as well as to risks inherent in particular securities. The Company's primary investment objective for the portfolio is to preserve the capital assets of the Company while achieving a total return commensurate with market conditions. The Company has allocated up to $25 million to fund "strategic investments." Strategic investments represent equity investments in, and loans to, reinsurance related enterprises, ceding companies or distribution channels that are expected to generate or secure additional profitable business for the Company. At year end, 1998, ESG Re had invested $5.9 million into four such enterprises with a further $2 million invested in its majority owned Georgian subsidiary, IMEDI L. Insurance Company Limited ("IMEDI"). The Company has entered into an Investment Advisory Agreement with Head Asset Management L.L.C. to supervise and direct the investment of the Company's asset portfolio in accordance with, and subject to, the investment objectives and guidelines established by the Company. Pursuant to the terms of the Investment Advisory Agreement, the Company will pay a fee, payable quarterly in arrears, equal to 0.25% per annum of the first $200 million of assets under 7 8 its management declining to 0.15% per annum of the assets under its management, in excess of $200 million. The Investment Advisory Agreement may be terminated upon 90 days written notice by the Investment Advisor or by the Company on five days notice or upon shorter notice upon mutual written agreement by the parties. See "Certain Relationships and Related Transactions." The performance of, and the fees paid to, the Investment Advisor will be reviewed periodically by the Board of Directors. Maturity and Duration of Portfolio The maximum effective maturity for any single security in the Company's investment portfolio is set at 30 years for U.S. government and U.S. government agency securities with full faith and credit guarantees and at 10 years for all other issues, measured from the date of settlement. The duration of the portfolio varies according to decisions taken by the Investment Advisor on the outlook for interest rate movements. The benchmark for such duration is approximately 3 years. Quality of Debt Securities in Portfolio The minimum average credit quality of the Company's investment portfolio is AA. Equity Securities and Real Estate The Company does not currently intend to invest any of its portfolio in publicly traded equity securities, although it may consider doing so in the future. Private equity investments ("strategic investments") have been placed with strategic partners in order to support ESG Re's core business or to secure distribution. The Company does not intend to invest in real estate other than for its own use. Diversification and Liquidity No more than 3% of the Company's investment portfolio may be invested in the securities of any single issuer, with the exception of sovereign governments or agencies, including supranational agencies, with an AA rating or better. Foreign Currency Exposures The Company's investment portfolio is invested predominantly in fixed income securities denominated in U.S. dollars, Euros and German Marks. The Company's primary risk exposures and premiums receivable are denominated predominantly in U.S. and Canadian dollars and European currencies. The Company intends to hold investments in the currencies in which it will collect premiums, pay claims and hold reserves thus creating a partial natural foreign exchange hedge against exchange rate fluctuations. Competition The reinsurance industry is highly competitive. The Company competes with other reinsurers, some of which have substantially greater financial, marketing, and management resources than the Company. It may also compete with new market entrants in the future. Management believes that virtually all major reinsurers write personal accident business, mainly through their property and casualty departments. A smaller number engage also in the fields of health, credit/life and special risks. On an international basis, excluding carriers which are predominantly focused on the United States, few reinsurers are considered lead reinsurers in the segments in which ESG Re is active. In other markets, however, certain traditional or domestic reinsurers hold a dominant position, creating highly competitive market conditions. Most reinsurers provide capacities for the various classes of personal reinsurance through discrete units or profit centers. ESG Re believes that it will benefit from being a flexible, innovative specialty reinsurer with its focus on 8 9 personal and special risk reinsurance (allowing specialized risk solutions from one source). Employees As of December 31, 1998, the Company had 76 employees. None of these employees is represented by a labor union. The Company expects to add additional underwriting, marketing and administrative staff consistent with the implementation of the Company's business plan. The Company believes that its employee relations are generally good. Regulation Bermuda The Companies Act 1981 (as amended) and Related Regulations. The Companies Act regulates the business of both the Company and ES Bermuda. The Insurance Act 1978 (as amended) and Related Regulations. The Insurance Act 1978 of Bermuda (as amended) and related regulations from time to time in force (the "Act"), which regulates the business of ES Bermuda, provides that no person shall carry on an insurance business in or from within Bermuda unless registered as an insurer under the Act by the Minister of Finance. The Minister of Finance, in deciding whether to grant registration, has broad discretion to act as he thinks fit in the public interest. The Minister of Finance is required by the Act to determine whether the applicant is a fit and proper body to be engaged in insurance business and, in particular, whether it has, or has available to it, adequate knowledge and expertise. In connection with registration, the Minister of Finance may impose conditions relating to the writing of certain types of insurance. An Insurance Advisory Committee and sub-committees thereof appointed by the Minister of Finance advises him on matters connected with the discharge of his functions and supervise and review the law and practice of insurance in Bermuda, including reviews of accounting and administrative procedures. The Act imposes on Bermuda insurance companies solvency and liquidity standards and auditing and reporting requirements and grants to the Minister of Finance powers to supervise, investigate and intervene in the affairs of insurance companies. Significant aspects of the Bermuda insurance regulatory framework are set out below. Cancellation of Insurer's Registration. An insurer's registration may be canceled by the Minister of Finance on certain grounds specified in the Act, including failure of the insurer to comply with its obligations under the Act or if, in the opinion of the Minister of Finance, after consultation with the Insurance Advisory Committee, the insurer has not been carrying on business in accordance with sound insurance principles. Independent Approved Auditor. Every registered insurer must appoint an independent auditor who will annually audit and report on the statutory financial statements and the statutory financial return of the insurer, which are required to be filed annually with the Registrar of Companies (the "Registrar"), who is the chief administrative officer under the Act. The auditor must be approved by the Minister of Finance as the independent auditor of the insurer. The approved auditor may be the same person or firm which audits the insurer's financial statements and reports for presentation to its shareholders. Statutory Financial Statements. An insurer must prepare annual statutory financial statements. The Act prescribes rules for the preparation and substance of such statutory financial statements (which include, in statutory form, a balance sheet, income statement, statement of capital and surplus, and detailed notes). The insurer is required to give detailed information and analyses regarding premiums, claims, reinsurance and investments. The statutory financial statements are not prepared in accordance with U.S. GAAP and are distinct from the financial statements prepared for presentation to the insurer's shareholders under The Companies Act 1981 of Bermuda, which financial statements may be prepared in accordance with U.S. GAAP. Copies of the Company's and ES Bermuda's statutory financial statements must be filed annually together with its statutory financial return. The statutory financial statements must be maintained 9 10 at the principal office of the insurer for a period of five years. Minimum Capital and Surplus. Under the Act, ES Bermuda has been designated as a Class 3 composite insurer. The Act requires $1.25 million minimum capital and surplus for Class 3 composite insurers (i.e. insurers which write both general business and long-term business) with a minimum paid up share capital of $370,000. Minimum Solvency Margin. The Act provides that the statutory assets of a Class 3 insurer writing general business must exceed its statutory liabilities by an amount equal to or greater than the applicable minimum solvency margin for that class. The applicable minimum solvency margin for a Class 3 insurer is 20% of net premiums written for the first $6 million of net premiums written plus 15% of net premiums written in excess of $6 million or 15% of loss and loss expense reserves, whichever is greater. The minimum solvency margin for writers of long-term business is $250,000. Minimum Liquidity Ratio. The Act provides a minimum liquidity ratio for insurers which write general business. An insurer engaged in general businesses is required to maintain the value of its relevant assets at not less than 75% of the amount of its relevant liabilities. Relevant assets include cash and time deposits, quoted investments, unquoted bonds and debentures, first liens on real estate, investment income due and accrued, accounts and premiums receivable, reinsurance balances receivable and funds held by ceding reinsurers. There are certain categories of assets which, unless specifically permitted by the Minister of Finance, do not automatically qualify as relevant assets, such as unquoted equity securities, investments in and advances to affiliates, real estate and collateral loans. The relevant liabilities are total general business insurance reserves and total other liabilities less deferred income tax and sundry liabilities (by interpretation, those not specifically defined) and certain letters of credit and guarantees. Statutory Financial Return. A Class 3 insurer is required to file with the Registrar an Annual Statutory Financial Return at the same time as it files its Statutory financial statements but, in any event, no later than four months from the insurer's financial year end (unless specifically extended). The Statutory Financial Return includes, among other matters, a report of the approved independent auditor on the Statutory financial statements of the insurer, a schedule of ceded reinsurers, an annual actuarial opinion on loss reserves prepared by the approved loss reserve specialist and a declaration of the statutory ratios and a solvency certificate. Supervision, Investigation and Intervention. The Minister of Finance may appoint an inspector with extensive powers to investigate the affairs of an insurer if the Minister of Finance believes that an investigation is required in the interest of the insurer's policyholders or persons who may become policyholders. In order to verify or supplement information otherwise provided to him, the Minister of Finance may direct an insurer to produce documents or information relating to matters connected with the insurer's business. If it appears to the Minister of Finance that there is a risk of the insurer becoming insolvent, the Minister of Finance may direct the insurer not to take on any new insurance business; not to vary any insurance contract if the effect would be to increase the insurer's liabilities; not to make certain investments; to realize certain investments; to maintain in Bermuda, or transfer to the custody of a Bermuda bank, certain assets; and to limit its premium income. An insurer is required to maintain a principal office in Bermuda and to appoint and maintain a principal representative in Bermuda to oversee the business of the Company and to report to the Minister of Finance and the Registrar of Companies in respect of certain events. Unless the approval of the Minister of Finance has been obtained, an insurer may not terminate the appointment of its principal representative, and the principal representative may not cease to act as such, unless 30 days notice in writing to the Minister of Finance is given of the intention to do so. It is the duty of the principal representative, within 30 days of his reaching the view that there is a likelihood of the insurer, for which he acts, becoming insolvent or its coming to his knowledge, or his having reason to believe, that an "event" has occurred, to make a written report to the Minister of Finance setting out all the particulars of the case that are available to him. Examples of such an "event" include failure by the reinsurer to comply substantially with a condition imposed upon the reinsurer by the Minister of Finance relating to a solvency margin or a liquidity or other ratio. Dividends. The Bermuda Companies Act 1981 would allow dividend payments when there are reasonable 10 11 grounds for believing that (i) ESG Re will be able to pay its debts as they fall due after payment of a dividend, and (ii) ESG Re's assets will exceed the aggregate value of its liabilities and its issued share capital and premium accounts. The Bermuda Insurance Act 1978 requires ES Bermuda to maintain a minimum solvency margin and a minimum liquidity ratio. Reduction of Statutory Capital. Approval is needed from the Minister of Finance for any reduction in total statutory capital of an insurance company of 15% or more. Applicants are required to show that the proposed reduction of capital will not cause ES Bermuda to fail to meet applicable statutory margin requirements in Bermuda. Germany The German regulatory framework for the insurance industry is provided by the Insurance Supervisory Law (Versicherungsaufsichtsgesetz, or "VAG"). The supervision of all insurance companies domiciled in Germany is the responsibility of the BAV, which is an agency of the Ministry of Finance. Other than the area of primary insurance, reinsurance has been largely liberalized. Consequently, except as set forth under "European Union" below, there are no detailed regulations for reinsurers under the law of the European Union or Germany. A professional reinsurance company requires no license from the BAV. Only a summary filing is required, setting forth the domicile and corporate form of the reinsurance company and the members of the executive and supervisory boards. The BAV encourages reinsurers to submit the names of the company's shareholders with such filings, and also to include the qualifications of the members of the executive and supervisory boards. The submission of a business plan is not necessary. Insurance and reinsurance companies are under the direct supervision of the BAV. For reinsurers, however, the level of supervision is substantially relaxed, and pertains primarily to the financial supervision of reinsurers, requiring only submission of financial statements. Except as set forth above, the provisions of the VAG and the Capitalization Law (Kapitalausstattungs VO) do not apply to reinsurers. Reinsurance mutuals (Ruckversicherungsverein VVaG) are subject to solvency controls. Reinsurance companies, such as ES Germany, are not subject to capitalization requirements, but the BAV prefers that reinsurance companies have the same level of capitalization as primary insurers (approximately 16- 18% of net premiums). Sections 55-59 VAG, pertaining to accounting and auditing of insurance companies, are also applicable to reinsurance companies. Ireland Irish law directly regulates only two of the Company's subsidiaries, ES Ireland and Accent. Regulation. Direct insurance business in Ireland is regulated by an extensive list of acts and regulations from the Assurance Companies Act 1909 to the Insurance Act 1989 and the European Communities (Non Life Insurance) Regulations 1976 to the European Communities (Non Life Insurance) Framework Regulations 1994. Direct insurance companies must be authorized by the Minister for Enterprise, Trade and Employment (the "Minister") before commencing business. Specialist reinsurers incorporated in Ireland, such as ES Ireland, are not subject to authorization by the Irish Government and are only required to notify the Minister that they carry on the business of Reinsurance pursuant to Section 22 of the Insurance Act 1989. Auditor's Report and Duties. The Companies Act 1963 requires all companies incorporated in Ireland to prepare and have audited annual accounts for their shareholders. Section 22(1) Insurance Act 1989 requires reinsurance 11 12 companies to prepare their accounts in such form as the Minister may specify and such audited accounts are required to be filed in the Companies Registration Office and are available for public inspection. Georgia Georgia law directly regulates only one of the Company's subsidiaries, IMEDI. Regulation. The Georgian Parliament adopted Insurance Regulation in 1996 regarding foreign ownership and capitalization requirements. There are no current requirements to cede any part of the reinsurance to a local Reinsurance Company. United States and Other The Company is not admitted to do business in any jurisdiction except Bermuda, Ireland, Germany and Georgia. The insurance laws of each state of the United States and of many foreign countries regulate the sale of insurance within their jurisdictions by alien insurers, such as the Company, which are not admitted to do business within such jurisdictions. With some exceptions, such sale of insurance within a jurisdiction where the insurer is not admitted to do business is prohibited. The Company does not intend to maintain an office or to solicit, advertise, settle claims or conduct other insurance activities in any jurisdiction where the conduct of such activities would require that the Company be so admitted and the Company is not so admitted. ITEM 2. PROPERTIES ESG Re leases office space in Bermuda, Dublin, Hamburg, Toronto, Miami, Hong Kong and London and owns an office located in the Soviet State of Georgia. The owned property is currently valued at $252,000. The Company believes its space is adequate to meet its current and expected needs. ITEM 3. LEGAL PROCEEDINGS There are no lawsuits pending, or to the knowledge of the Company threatened, to which the Company or any of its subsidiaries is a party or of which any of their properties is subject other than routine litigation incidental to the business. PART II. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of fiscal 1998. ITEM 5. MARKET FOR COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Market Information Since December 12, 1997, the common stock of the Company has been traded on NASDAQ under the symbol ESREF. The high and low market prices of the Company's common stock for each fiscal quarter since December 12, 1997 were as follows: 12 13
High Low ------------ ------------ From December 12 to December 31, 1997: $23.88 $21.50 From January 1 to March 31, 1998: $28.88 $21.00 From April 1 to June 30, 1998: $27.50 $19.88 From July 1 to September 30, 1998: $23.88 $13.50 From October 1 to December 31, 1998: $21.25 $12.75
Number of Record Holders of Common Stock The number of record holders of the common stock of the Company as of March 22, 1999 was 30. Dividend History and Restrictions On March 9, 1998, the Board of Directors declared a cash dividend of $0.075 per share payable April 3, 1998 to shareholders of record on March 28, 1998. On May 4, 1998, the Board of Directors declared cash dividend of $0.075 per share payable May 27, 1998 to shareholders of record on May 18, 1998. On August 6, 1998, the Board of Directors declared a cash dividend of $0.075 per share payable September 1, 1998 to shareholders of record on August 20, 1998. On November 10, 1998, the Board of Directors declared a cash dividend of $0.075 per share payable December 1, 1998 to shareholders of record on November 23, 1998. On February 25, 1999, the Board of Directors declared a cash dividend of $0.08 per share payable March 22, 1999 to shareholders of record on March 15, 1999. Restrictions on the payment of dividends is described in Item 1, "Regulation." ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA Selected Consolidated Financial Data of the Company is contained in the Annual Report and is incorporated herein by reference in response to this item. Reference is made to Item 14(a) of this Form 10-K. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS "Management's Discussion and Analysis of Financial Condition and Results of Operations" is contained in the Annual Report and is incorporated herein by reference in response to this item. Reference is made to Item 14(a) of this Form 10-K. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK "Management's Discussion and Analysis of Financial Condition and Results of Operations" is contained in the Annual Report and is incorporated herein by reference in response to this item. Reference is made to Item 14(a) of this Form 10-K. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Company's consolidated financial statements are contained in the Annual Report and are incorporated herein by reference in response to this item. Reference is made to Item 14(a) of this Form 10-K for the Financial Statement Schedules. 13 14 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY Executive Officers The table below sets forth the names, ages and titles of the persons who are executive officers of the Company and/or its principal operating subsidiaries as of March 22, 1999.
Name Age Position Wolfgang M. Wand.......................... 46 Managing Director and Chief Executive Officer Steven H. Debrovner....................... 61 Chief Underwriting and Marketing Officer Renate M. Nellich......................... 60 Chief Executive Officer of ES North America Joan H. Dillard........................... 47 Chief Financial Officer Gerhard Jurk.............................. 50 Audit and Compliance Officer
Wolfgang M. Wand has been active in the insurance business for over 20 years, 17 of which were in the international insurance market. In 1983, Mr. Wand founded a specialized health care insurance group in which Winterthur Insurance Group acquired a majority interest in 1989 and a 100% interest in 1993. Later in 1993, Mr. Wand co-founded ESG Germany, through which the Company operated its insurance businesses prior to the Offerings. Mr. Wand serves as a member of the German delegation of the International Chamber of Commerce and is a representative on the Chamber's Committee for insurance affairs in Eastern Europe. Following the reunification of Germany, Mr. Wand served on behalf of the German government's privatization agency, the Treuhandanstalt, in connection with the privatization and restructuring of the East German economy, as Chairman of the Board of Directors for certain segments of the German shoe manufacturing industry from 1991 to 1992. Mr. Wand also acts as designated legal representative of Les Mutuelles du Mans in Germany. Mr. Wand completed a degree in economics in 1974 and studied at Cologne and Wuppertal Universities. Steven H. Debrovner co-founded ESG Germany with Mr. Wand in 1993. From 1987 to 1992, Mr. Debrovner served as the head of marketing for all non-life business at CIGNA Worldwide headquarters in Philadelphia. In 1974, he created the European accident and health activities for AFIA and, subsequently, CIGNA. Mr. Debrovner received a bachelor's degree in history from Duke University in 1959. Mr. Debrovner has more than 30 years of insurance underwriting experience, having started with American International Group, Inc. in 1967. He has also been both a student and lecturer in Harvard's Graduate International Marketing Program. Renate M. Nellich has been Chief Executive Officer of ES North America since September 1997. Prior to that, Ms. Nellich was Chief Operating Officer of Swiss Re Life and Health/Mercantile and General Life Reinsurance Company Limited responsible for the Group Reinsurance Operation of the Americas from 1985 to 1997. Between 1975 and 1985, Ms. Nellich served in various capacities in the Mercantile and General's North American Group Division. Ms. Nellich has more than 25 years of experience in the North American life and health insurance industry. 14 15 Joan H. Dillard has been Chief Financial Officer of ESG Re since March, 1998. From 1993 to 1998, Ms. Dillard was Senior Vice President of TIG Insurance Company in Dallas, Texas. During this time, she served in various positions such as Chief Financial Officer of Personal Lines, Treasurer, and the Director of the Alternative Distribution Business Unit. Between 1990 and 1993, Ms. Dillard acted as Senior Vice President and Treasurer of USF&G Corporation in Baltimore, Maryland. Prior to that, Ms. Dillard served as Treasurer of American General Finance Company, Assistant Treasurer of American General Corporation and as Financial Manager of The Johns Hopkins Hospital. She holds the CMA and ARM professional designations. Ms. Dillard received a bachelor of art's degree from the University of Maryland in 1977 and a master's of business administration degree from the University of Baltimore in 1984. Gerhard Jurk has been Audit and Compliance Officer of ESG Re since December 1998 and served as Chief Financial Officer from 1996 to April 1998. From 1992 to 1996, Mr. Jurk was Chief Internal Auditor of the Transatlantic Insurance Group. In this function, he was a member of the audit team of Winterthur Insurance Group. Between 1993 and 1996, Mr. Jurk acted as Chief Executive Officer for a Winterthur Group underwriting subsidiary. Prior to that, from 1984 to 1992, Mr. Jurk was the Chief Officer of the Financial and Investment Department of the Transatlantic Insurance Group, then a subsidiary of ITT Corporation and subsequently a subsidiary of Winterthur Insurance Group. Mr. Jurk has worked in the insurance industry for more than 25 years and is an accountant certified by the German government. The information with respect to directors of the Company is contained under the captions "Election of Directors" in the Proxy Statement and is incorporated herein by reference in response to this item. ITEM 11. EXECUTIVE COMPENSATION The Information with respect to executive compensation is contained under the caption "Executive Compensation" in the Proxy Statement and is incorporated herein by reference in response to this item. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information with respect to security ownership of certain beneficial owners and management is contained under the caption "Information Regarding the Security Ownership of Certain Beneficial Owners, Management and Directors" in the Proxy Statement and is incorporated herein by reference in response to this item. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information with respect to certain relationships and related transactions is contained under the caption "Certain Relationships and Related Transactions" in the Proxy Statement and is incorporated herein by reference in response to this item. PART IV. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES AND REPORTS ON FORM 8-K (a) 1. FINANCIAL STATEMENTS: The Company has incorporated by reference from the 1998 Annual Report to Shareholders the following consolidated financial statements of the Company: 15 16
1998 Annual Report to Shareholders (Page) ------------------ Independent Auditors' Report 53 Consolidated Balance Sheets as of December 31, 34 1998 and 1997 Consolidated Statements of Operations for the years 35 ended December 31, 1998, 1997 and 1996 Consolidated Statements of Changes in 36 Shareholders' Equity for the years ended December 31, 1998, 1997 and 1996 Consolidated Statements of Cash Flows for the years 37 ended December 31, 1998, 1997 and 1996 Consolidated Statements of Comprehensive Income 38 for the years ended December 31, 1998, 1997 and 1996 Notes to the Consolidated Financial Statements for the years ended December 31, 1998, 1997 and 1996 39
In addition, "Management's Discussion and Analysis of Financial Condition and Results of Operations begins on page 25 of the 1998 Annual Report to Shareholders. 2. FINANCIAL STATEMENT SCHEDULES: The following Financial Statement Schedules are filed as part of this Report. Schedule I - Summary Of Investments Other Than Investments In Related Parties (Dollars in thousands)
Amount Amortized Shown in Type of investment Cost Fair Value Balance Sheet - ------------------------------------------------------- --------- ---------- ------------- Fixed maturities - available for sale Corporate securities $138,447 $138,727 $138,727 U.S. Treasury securities 31,887 31,698 31,698 Mortgage-backed securities/Asset-backed securities 9,230 9,232 9,232 Obligations of states and political subdivisions 24,231 24,647 24,647 Foreign currency debt securities 7,794 8,083 8,083 -------- -------- -------- Total fixed maturities - available for sale 211,589 212,387 212,387 Strategic investments 5,917 5,917 5,917 Cash and cash equivalents 16,942 16,942 16,492 -------- -------- -------- Total investments and cash $234,448 $235,246 $235,246 ======== ======== ========
16 17 Schedule III - Supplementary Insurance Information (Dollars in thousands)
Unpaid Deferred Losses and Net Net Acquisition Loss Unearned Premiums Investment Segment Costs Expenses Premiums Earned Income - -------------------- ------------ ------------ ------------ ------------ ------------- December 31, 1998 Total $37,625 $44,379 $111,884 $98,841 $12,930 ============ ============ ============ ============ ============= Paid Amortization Losses of Deferred Other Net and Loss Acquisition Operating Premiums Segment Expenses Costs Expenses Written - -------------------- ----------- -------------- ----------- ----------- December 31, 1998 Total $27,592 $26,714 $11,965 $25,392 =========== ============== =========== ===========
Schedule IV - Reinsurance (Dollars in thousands)
Percentage of Direct Ceded to Assumed Amount Gross Other from Other Net Assumed to Net Amount Companies Companies Amount Amount ----------------- --------------- ----------------- --------------- ------------------- December 31, 1998 Total premiums earned $-- $2,144 $100,985 $98,841 102% ================= =============== ================= =============== ===================
The report of the Company's independent auditors with respect to the above-listed Financial Statement Schedules is set forth in Exhibit 24.1(a) of this report. All other schedules are omitted because they are either inapplicable for the required information or are presented in the Consolidated Financial Statements of the Company or the Notes thereto, which are incorporated by reference in this Annual Report on Form 10-K. 3. EXHIBITS: 2.1* Share Exchange Agreement between ESG Re Limited and European Specialty Group (United Kingdom) Limited, dated as of November 13, 1997 2.2* Share Exchange Agreement between the shareholders of European Specialty Group Holding AG and European Specialty Group (United Kingdom) Limited, dated as of November 13, 1997 3.1* Memorandum of Association 3.2* Bye-Laws 4.1* Specimen Common Share certificate 4.2* Form of Class A Warrant 4.3* Form of Class B Warrant 10.1* Form of Subscription Agreement, between ESG Re Limited and certain Direct Purchasers, dated as of September 30, 1997 10.2* Employment Agreement between European Specialty Group (United Kingdom) Limited, ESG Re Limited and Wolfgang M. Wand, dated as of December 1, 1997 10.3* Employment Agreement between ESG Re Limited and Steven H. Debrovner, dated as of December 1, 1997 10.4* Employment Agreement between European Specialty Group Holding AG and Gerhard Jurk, dated as of December 1, 1997 10.5* Employment Agreement between European Specialty (North America) Limited and Renate M. Nellich, dated as of December 1, 1997 10.6* Investment Advisory Agreement between ESG Re Limited and Head Asset Management L.L.C., 17 18 dated as of December 1, 1997 10.7* Investment Advisory Agreement between European Specialty Ruckversicherung AG and Head Asset Management L.L.C., dated as of December 1, 1997 10.8* Form of Registration Rights Agreement between ESG Re Limited and the Direct Purchasers named therein 10.9** Form of Non-Management Directors' Compensation and Option Plan, approved on December 3, 1997 between ESG Re Limited and non-employee director optionees 10.10** Form of 1997 Stock Option Plan, approved on December 3, 1997 between ESG Re Limited and certain optionees 13.1 1998 Annual Report to Shareholders 22.1* Subsidiaries of the Registrant 24.1(b) Consent of Deloitte & Touche 27.1 Financial Data Schedule - ---------- * Incorporated by reference to Amendment No. 1 to the Registration Statement on Form F-1 of the Company, as filed with the Securities and Exchange Commission on December 9, 1997 (registration No. 333-40341). The Consent by the Company's independent auditors to incorporate by reference is set forth in Exhibit 24.1(b) of this report. ** Incorporated by reference to Exhibit 10.9 of the Company's Form 10-K for the year ended December 31, 1997, filed with the Securities and Exchange Commission on March 31, 1998. (b) Reports on Form 8-K. On March 10, 1998, the Company filed a report on Form 8-K. There were no other reports on Form 8-K filed during the period from January 1, 1998, to December 31, 1998. 18 19 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, thereunto authorized, on March 30, 1999. This report dealt with changes to the size and membership of the Board of Directors and the resulting cessation of qualification as a foreign private issuer pursuant to Rule 3b-4 under the Securities Act of 1934 and subsequent assumption of status of domestic private issuer. ESG RE LIMITED By: /s/ JOAN H. DILLARD ------------------------------ Name: Joan H. Dillard Title: Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Signature Title Date --------- ----- ---- /s/ WOLFGANG M. WAND - ------------------------------ Wolfgang M. Wand Managing Director and March 30, 1999 Chief Executive Officer and Director /s/ STEVEN H. DEBROVNER - ------------------------------ Steven H. Debrovner Chief Underwriting and March 30, 1999 Marketing Officer and Director /s/JOAN H. DILLARD - ------------------------------ Joan H. Dillard Chief Financial Officer March 30, 1999 /s/ JOHN C HEAD III - ------------------------------ John C Head III Chairman of the Board March 30, 1999 /s/ KENNETH P. MORSE - ------------------------------ Kenneth P. Morse Director March 30, 1999 /s/ DAVID L. NEWKIRK - ------------------------------ David L. Newkirk Director March 30, 1999 /s/ WILLIAM J. POUTSIAKA - ------------------------------ William J. Poutsiaka Director March 30, 1999 /s/ EDWARD A. TILLY - ------------------------------ Edward A. Tilly Director March 30, 1999
19 EX-13.1 2 1998 ANNUAL REPORT TO SHAREHOLDERS 1 INTELLIGENT REINSURANCE ESG RE LIMITED ANNUAL REPORT 1998 Intelligent Reinsurance ESGCM-AR-99 LIVING LONGER, LIVING BETTER. With an aging and increasingly affluent population, the demand for retirement planning has never been greater. Social systems may become less able to provide for their older citizens, creating a growing demand for products that allow individuals to protect themselves and their standard of living. ESG Re is committed to the delivery of innovative products and services in our field of expertise-the reinsurance of people, their health and well-being-thus enhancing the lifestyle of this important customer group. 3 Financial Highlights 4 Letters to Shareholders 8 Results for 1998 10 Operating Review 24 Selected Consolidated Financial Data 25 Management's Discussion and Analysis of Financial Condition and Results of Operations 34 Consolidated Financial Statements 53 Independent Auditors' Report 54 Corporate Directory 56 Shareholder Information 2 COMPANY PROFILE ESG Re Limited is a specialty reinsurance company providing accident, health, life, disability and related special risk reinsurance to the insurance industry on a worldwide basis. With four operating risk carriers located in Bermuda, Ireland and Germany, and offices in 10 countries, ESG Re underwrites risks in more than 50 nations. Focusing on the growing markets of health, accident, and disability, we specialize in applying "Intelligent Reinsurance," an analytical and innovative approach to product development and risk management. Our mission is to be the leading international underwriter in these markets, dedicated to providing risk solutions to the reinsurance challenges of the world's growing and emerging markets. We commit ourselves to provide tailor-made solutions for our clients, to honor our obligations to our ceding companies, and to consistently generate underwriting profit for our shareholders. We are aware of the role we assume as professional reinsurers when leading and supporting the trends that create more efficient welfare systems for the public. 3 FINANCIAL HIGHLIGHTS ESG Re began writing reinsurance for its own account in December 1997. Results for 1997, when the Company functioned both as a reinsurer and reinsurance management company, are not comparable.
YEARS ENDED DECEMBER 31, 1998 1997 - -------------------------------------------------------------------------------- U.S. dollars in thousands, except per share data CONSOLIDATED OPERATING DATA Gross managed premiums $224,204 $100,000 Net premiums written 195,578 25,392 Net premiums earned 98,841 13,411 Investment income 12,930 598 Total revenues 115,827 17,839 Losses and loss expenses 61,364 7,449 Acquisition costs 26,714 4,693 Class B Warrants expense -- 3,626 Administrative expenses 11,965 7,736 Total expenses 100,043 23,504 Net underwriting income 10,763 1,269 Loss ratio 62.1% 55.5% Acquisition cost ratio 27.0% 35.0% Loss and acquisition cost ratio 89.1% 90.5% CONSOLIDATED BALANCE SHEET DATA Investments and cash $235,246 $236,976 Total assets 466,373 283,553 Unpaid losses and loss expenses 44,379 7,846 Total shareholders' equity 244,841 234,375 Book value per share 17.58 16.83 Common stock Price range High $ 28.75 $ 23.88(1) Low $ 12.75 $ 21.50(1) - --------------------------------------------------------------------------------
(1) 1997 stock prices are for the period from December 12, 1997, the date of the initial public offering, to December 31, 1997. The initial public offering price was $20.00 per share. 3 4 CHAIRMAN'S LETTER At the end of 1997, we identified four specific objectives for ESG Re in 1998: o To expand its business by geographic region, by source and by producer; o To recruit, train and motivate the very best people; o To underwrite profitable business; and o To provide quality solutions to customer problems and to operate with the highest standards. In 1999, ESG Re will continue to pursue these principal objectives and to expand on what has already been accomplished. ESG Re now has reinsurance relationships with over 200 insurance companies in 57 countries. In 1998, ESG Re developed and strengthened its relationships with the world's major reinsurance intermediaries as well as with specialist brokers that are important in ESG Re's lines of business. Further expansion of our list of clients and brokers is envisaged in order to meet our goals for business development. One of ESG Re's most important competitive advantages is the quality and motivation of its people. In 1998, we substantially expanded the ESG Re team of professionals. They have made significant contributions to the growth of our business and to the quality of our administration and systems. As ESG Re builds for the future, we must continue to recruit, train and motivate the best people in the industry. This activity is not without its cost, as expenses will be incurred before new professionals can contribute to revenues and profits. However, investment in our people is critical if ESG Re is to meet the high expectations that we all share. In 1998, ESG Re underwrote approximately $200 million of gross written premiums. This business was profitable as written, with a combined ratio of 98.0%. According to generally accepted accounting principles, however, the majority of this business will be classified as earned premium in 1999. Consequently, most of the positive effect on earnings and profits will occur in 1999, rather than during the year in which the business was written. This will be a continuing pattern as ESG Re continues to grow rapidly its book of business. However, as long as the business is underwritten profitably, shareholder value will be created, regardless of the timing of the recognition of earned premiums. As we continue to expand our company, meeting the needs of our customers and operating with the highest professional and ethical standards will continue to be the cornerstones of our operating strategy. In 1999, we will continue to build on our accomplishments and to strive for industry leadership in our specialty field of reinsurance expertise. John C Head III, Chairman of the Board 5 CHIEF EXECUTIVE OFFICER'S LETTER Nineteen ninety-eight marks the first full year of operations for ESG Re Limited as a publicly traded company, following the successful transition from a leading reinsurance management company into a globally-trading professional reinsurance group specializing in the fields of health, accident, disability, life and related special risk insurance. Results achieved in 1998 evidence the success of ESG Re's strategic positioning. We increased our premium volume by over 100% in a general market environment where the industry grew at a rate of 3%. More importantly, our 1998 loss and acquisition ratio of 89.1% indicates that we achieved this growth and leadership position while maintaining our stringent underwriting standards and our focus on profitability. It is ESG Re's trademark, and our unique concept of "Intelligent Reinsurance," coupled with the wide-ranging relationship network of long-standing industry experts, the underwriting skills and the dedicated customer focus of our employees, which make ESG Re a desired partner of our customers, the ceding companies and the professional intermediaries. 6 "INTELLIGENT REINSURANCE" VERSUS CAPACITY The global reinsurance market has undergone rapid change in recent years. These changes have resulted in mergers among many well-known reinsurance providers, and the disappearance, or loss of independence, of significant capacities. Medium-sized reinsurers are finding it difficult to survive or to grow profitably due to the soft pricing environment; ceding companies have redefined their reinsurance purchasing strategy in favor of non-proportional coverage; and the flight to increased security continues. In addition, the current low interest rate environment cannot support unsatisfactory underwriting results. These paradigm shifts and rapid changes also represent opportunities. As the leading globally-trading expert in our lines of business - the reinsurance of people, their health, life and well-being - ESG Re helps the ceding customer to grow its portfolio with product design, coverage enhancements and marketing techniques, and to improve profitability by providing loss prevention and claims control measurements. ESG Re has provided a new definition of the often-neglected principle of insurer-reinsurer relationships: To Share the Fortune. The reinsurance cession becomes our share of the arrangement. By improving our customers' profits, we have been able to experience outstanding growth and very satisfactory technical underwriting results. GLOBAL DIVERSIFICATION Our portfolio is divided into three parts: approximately one-third of our premium comes from Europe, our traditional stronghold; one-third from North America; and one-third from the highly prospective growth markets of Latin America, the Far East and selected markets in Eastern Europe. ESG Re values and supports the local culture by combining global experience with the regional expertise of our offices located around the world. Investment in highly skilled professionals, and corresponding infrastructure, is a prerequisite for building long-term value as a leading specialist reinsurer. The major developments and investments of the last year have significantly contributed to ESG Re's current and future value: o The opening of European Specialty (North America) Limited, our Toronto-based operation, in the fall of 1997, represented a substantial investment for ESG Re. The Toronto office commenced underwriting in North America on January 1, 1998, and has produced solid results, both in quality and quantity of business. o We opened our Sydney operation and an additional branch in Hong Kong, to cover the Asia/ Pacific Rim. Again, early indications are very encouraging and we expect the results to come to full fruition in 1999. o Our U.K.-based underwriting team was strengthened to provide specialty underwriting services in the London market. o Accent Europe Insurance Company Limited, a direct writing company in Ireland, was formed to offer health and accident products and services on a pan-European basis. o We opened a subsidiary in Miami to serve the reinsurance needs of our growing Latin American customer base, an investment that has already contributed strongly to our results in the second half of 1998. o A Shared Services Center was opened in Dublin, Ireland, to concentrate our global accounting, administration and reinsurance processing. o ESG Re acquired a majority interest in our affiliate company, SportSecure, positioning this entity as the center for special risk underwriting in the rapidly growing field of sports and entertainment insurance. 7 OUTLOOK ESG Re is well positioned in the rapidly growing fields of health, accident, disability, life and related special risk reinsurance. Our market approach - "Intelligent Reinsurance" - gives us the ability to provide unique solutions to our partners and manifests our position as sole or lead reinsurer to ceding companies and professional intermediaries on a global basis. We base our growth outlook on two fundamental trends: o a continuing global shift from public welfare to the private sector; and o increasing insurance demands of a growing aging, affluent population. I am convinced that ESG Re is in a unique position to lead these trends of social welfare privatization. We will utilize our in-depth knowledge of local requirements, our understanding of underlying social security concerns and legislation, and our expertise in the active utilization of cost reduction and control techniques as practiced by our North American operations on these newly created and untapped reinsurance opportunities. Late in 1998 we undertook an initiative to introduce certain "managed care" concepts to Europe -- particularly Germany and Spain -- and Latin America. The results seen in certain Latin American markets are very encouraging and, although progress might be slower in Continental Europe than in less regulated markets, the opportunities are fascinating and ultimately will be of substantial benefit to ESG Re. We have selected portraits of elderly people for this annual report because the growing insurance demand of the aging represents widely untapped potential. One of the demanding projects ESG Re will be addressing in 1999 will be the exploration of opportunities presented by this affluent segment of the international population. We continue to pioneer the creation of sizable new markets that have not been adversely affected by excessive competition or soft pricing. Aside from these opportunities in the managed care and aging market spheres, I am very encouraged by the early indications of the 1999 renewal season, and ESG Re's enhanced recognition as a desired lead reinsurer. Many prospects for which we successfully laid the groundwork in 1998 are now coming to fruition. Therefore, I am convinced that we will experience another year of substantial growth, well above industry standards, which will further enhance profitability. We will continue to focus upon the traditional short-tail lines of business, thereby providing a transparency to our financial position that benefits both our shareholders and customers. SPECIAL THANKS The past year required strong dedication and extremely hard work from all of our employees around the globe. It also posed the challenge to integrate new teams of multicultural entrepreneurial leaders into the group. This challenge was met thanks to the commitment of our management and staff to demonstrate the flexibility and mobility required of a truly global company. We thank our shareholders, customers, ceding companies and the professional intermediaries for your vote of confidence in ESG Re. Wolfgang M. Wand, Managing Director and Chief Executive Officer 8 RESULTS FOR 1998 In December 1997 the Company raised over $250 million in capital through a private placement and an initial public offering, completing its transition from an underwriting manager to a specialty reinsurer. Therefore, the underwriting data for 1997 does not offer a meaningful comparison with 1998 results. For the year ending December 31, 1998 the Company reported net income of $14.5 million, or $1.04 net earnings per share. In 1998, the Company more than doubled its portfolio of managed premium to $224.2 million, of which $24.3 million was co-reinsured with strategically aligned reinsurance partners, resulting in $199.9 million of gross premiums written for the period. In its former function as a managing agent, the Company underwrote, on behalf of various reinsurers, approximately $100 million of gross premiums in 1997. Our exceptional growth was achieved within the parameters of our targeted product and geographic mix across Europe, North America and the emerging markets. The Company generated in excess of $186 million in new business in 1998. Total revenues for the year were $115.8 million, consisting of net premiums earned of $98.8 million, with net investment income of $12.9 million, realized investment gains of $2.2 million and management fee revenue of $1.9 million. ESG Re's loss and acquisition cost ratio was 89.1% in 1998, comparing favorably to 90.5% in the previous year. 9 OPERATING REVIEW INTELLIGENT REINSURANCE - MORE THAN CAPACITY ESG Re's business philosophy is centered on providing client-oriented solutions, not just reinsurance capacity. It is under the trademark of "Intelligent Reinsurance" that ESG Re conducts all of its underwriting activities, by offering a single source for a range of value-added services, including loss prevention, data management, product development and marketing support. LOSS PREVENTION Normally, a reinsurer is not actively involved in claims handling and it is the responsibility of the ceding client to adjust the original losses and settle claims made by its direct insureds. Although some of the business managed by ESG Re operates in this manner, our approach in healthcare differs from other reinsurers in that we actively seek to reduce claims exposure by utilizing proven "managed care" techniques while the reinsurance policies are in force. Working with ESG Re, one of the leading general insurers in the Middle East has been able to create a range of health products and services that offer the local market access to medical facilities both at home and abroad. ESG Re has provided its client with extensive loss prevention tools, including gatekeeping systems that afford direct control of treatment costs and help to prevent over-utilization. Also, by assisting in the recruitment and training of staff, ESG Re has helped the insurer to create the necessary competitive advantage to take a dominant position in its country's developing health insurance market. DATA MANAGEMENT Sharing information with our clients offers a highly analytical and proactive approach to risk management and offers more creative solutions to their underwriting needs. Centralized data capture and monitoring systems, combined with our technical underwriting expertise, ensure maximum control of all risks at all times. No matter where a policy may originate or whatever medical treatment is undertaken, our extensive knowledge of local facilities and services enables ceding companies to manage their business better. ESG Re's technology has assisted another client with a growing portfolio of multinational business to clearly identify the sources and composition of the insured population and to manage risk selection and overall exposure better. PRODUCT DEVELOPMENT Working in close relationship with our customers, we design and launch new products and services that enable ceding companies not only to remain competitive in their traditional markets, but also to enter new ones. From credit card enhancement programs to sophisticated multinational employee benefit plans, ESG Re's global experience and creative underwriting techniques provide ceding companies with an alternative approach to product development. In the former Soviet State of Georgia, ESG Re has helped to establish the first locally-managed insurance company to be run along Western business standards, supplying a range of innovative products and services, extensive management and training support, technical expertise and capital funding. MARKETING SUPPORT By applying a detailed knowledge and understanding of local markets and their cultural needs and demands, ESG Re is able to assist with corporate communications, sales techniques and product marketing. In the Far East, ESG Re's direct marketing expertise and management has enabled a major international financial institution to create and successfully tele-market a range of personal insurance products designed for their account holders. FINANCIAL STRENGTH The ESG Re group of companies offers high-quality financial security to our ceding clients and business partners. ESG Re has a Standard & Poor's rating of A- and total capitalization of over $240 million at December 31, 1998. "Intelligent Reinsurance" is more than capacity. ESG Re delivers the expertise, products, analysis and service that create a true and lasting partnership with our clients -- a partnership that delivers added value and enhances the success of their business. ESG RE'S GLOBAL DIVERSITY ESG Re provides "Intelligent Reinsurance" on a global basis. Our offices are strategically located in some of the world's most important business centers. An established global infrastructure with coordination among offices enables ESG Re to respond quickly and effectively with the appropriate products, programs and services necessary to capitalize on market opportunities. Last year ESG Re managed risks in more than 50 countries worldwide and, with the introduction of new products tailored to meet the needs of our clients, we continually enhance our global presence. MAJOR MARKETS ESG Re is a specialist provider of reinsurance solutions focused on those developed and emerging markets that allow for a satisfactory volume and growth potential while providing attractive underwriting margins. By taking advantage of the Company's global structure and its experienced management, we are able to "import" the best underwriting and management techniques from around the world to help tailor solutions for our customers' needs. EUROPE The deregulated European market is leading the trend toward globalization, and ESG Re has taken a leadership position in the creation of alternative concepts and distribution methods in these established and more saturated markets. The Company generated $62.0 million of managed premium in Europe in 1998, an increase of 18.5% over the prior year. We attribute our success in this market to the strength of our long-standing relationships and the pursuit of innovative product opportunities. In Germany, we are introducing progressive technologies that will open up new and more streamlined distribution channels. Coupled with the growing need for healthcare management techniques as the social welfare system adjusts, ESG Re has a distinct advantage as a specialized player. Able to respond quickly to market needs, we have already secured exclusivity in the German market for an EKG and Diabetic Telemedicine technology. ESG Re's "Intelligent Reinsurance" is the concept behind the recent formation of a healthcare association, COMED Interessengemeinschaft der Krankenversicherten e.V. ("COMED"), within the German market. COMED will provide sought-after services, such as physician referrals, a medical information hotline, second opinion services, and disease management advisors, with a target market of the estimated 70 million people within the German public healthcare system. 10 10 In Spain, ESG Re has created a unique medical program that provides a Second Opinion product to complement the services provided by the State healthcare system. EMERGING EUROPE For the past five years, ESG Re has assumed a pioneering role across the emerging markets of Eastern Europe and the former Soviet Union. The changing political, economic and demographic landscape of the region offers opportunities for the application of the "Intelligent Reinsurance" concept and our unique support services to ceding companies. In the wake of political and financial turmoil, governments are imposing more stringent capital requirements on local insurers, leading to the need for reinsurance to support current business volume as well as future growth and development. Our ongoing support is aimed at fostering the growth of a locally autonomous insurance industry. During 1998, ESG Re forged a partnership with IMEDI L International Insurance Company Limited, one of Georgia's leading insurance companies, to lend our experience in Western insurance practices and to introduce basic products to a growing customer base as their insurance needs emerge. In turn, this partnership enables ESG Re to test product offerings that may be exported into the surrounding countries of the Caucasus region. The provision of healthcare and pension coverages, following shortfalls in state funding, is becoming a risk line that local authorities are anxious to develop with reliable partners. LONDON INTERNATIONAL MARKET Despite continuing overcapacity and price competition in the London market, ESG Re distinguishes itself through its reputation for innovation. With a growing acceptance of the Company's financial strength and management expertise, and the creation of a specialist unit in London, we are well positioned in the international accident and health market. ESG Re offers facultative specialty lines mainly as a lead line underwriter of London market brokers' programs. Managed premium of $35.6 million was written in 1998. ESG Re's specialist knowledge and global approach have attracted a wide audience and increasing recognition in the London market. The strength of established relationships provides ESG Re the opportunity to access attractive pieces of business, to apply profit-oriented underwriting standards, and to build a long-term portfolio generating above-average returns. 11 NORTH AMERICA With annual premiums of more than $5 billion, North America is the world's largest health reinsurance marketplace. During the early 1990s, price competition was driven by new market entrants who put increasing pressure on terms and profitability. In the last 24 months, however, several companies have reduced their writings or exited the market entirely, resulting in shrinking capacity and hardening of market terms and conditions. ESG Re has been able to take advantage of these market changes by adopting a strategy emphasizing risk analysis, active control, and diligent management. The Company has capitalized on its existing business relationships and profited from key opportunities, while fostering a "partnership" philosophy where ESG Re and the client are able to work closely together to help minimize risk exposure. ESG Re's newly established operation in Toronto generated $89.2 million in managed premium in its first year, representing 39.8% of 1998 production. In North America, the majority of our business is sourced directly, although 47.0% is written through brokers and intermediaries. Medical expense programs are our primary product offering, with 39.3% written on a proportional basis and 60.7% on a nonproportional or stop loss basis. ESG Re is committed to assuming a leadership position in the North American market in the areas of both profitability and quality, and plans to export the concept of "managed care" to Europe and other markets. We are actively exploring and developing new health insurance techniques, products and services. We intend to pursue diversification of our product lines in North America, emphasizing personal accident and life business. In the past year, ESG Re has developed name recognition and has become a respected participant in the North American marketplace, where we are now well positioned for future growth. LATIN AMERICA ESG Re currently offers an extensive range of medical, personal accident, credit and life reinsurance programs to ceding companies throughout Latin America. A growing area of emphasis for ESG Re, Latin America generated $33.4 million of managed premium in 1998, growing from $19.2 million in 1997. ESG Re's strategy in the region is to combine capacity with controlled marketing and administration to secure profitability while pursuing a meaningful share of the market. In conjunction with a major financial services and insurance group, the Company has concentrated on developing a portfolio of individual and group medical plans that allows ESG Re to be directly involved in setting the pricing and underwriting parameters and in monitoring the claims handling practices. In various Latin American countries, ESG Re has established Third Party Administration faciliities ("TPA's") in conjunction with our strategic partners. Access to information through these TPA's enables us to calculate more accurate attachment points and to refine pricing. Regional claims management staff also interact directly with the local adjusters to coordinate managed care service. ESG Re is actively writing occupational injury accounts in Colombia and Peru, where the need for high limit accident benefits has been created by the privatization of the workers' compensation structures, previously handled by government controlled social security monopolies. In Latin America, ESG Re's long-standing relationships, dedication and partnership philosophy give us a clear competitive advantage. ASIA/PACIFIC The economic crisis in Asia has seriously affected the growth and profit projections of most insurance and reinsurance companies in the region. Consumer and business confidence is low due to the economic downturn, with pressure mounting on the individual social security programs. There will be significant opportunity for ESG Re in Asia as medical programs of various countries privatize over the next 5 to 10 years. The boom in the Asian economies over the past 10 to 20 years has seen insurance companies rapidly expand using traditional insurance agents as the principal means to distribute life and general products. The most successful companies have been those that were able to build larger agency distribution systems. Now, companies must streamline their distribution to protect profit margins. The successful companies will be those that target new means to distribute or develop new products made to suit the new, emerging economic environment. Currently, companies are racing to establish alternative distribution channels to replace or to compete with the expensive, career-agent structure prevalent in the region. These companies have witnessed the rapid growth of direct marketing programs in the United States and Europe and are attempting to build competitive strength in this channel. Many local insurance companies are captives of conglomerates that also own banks and credit card companies, giving them a base of potential insurance customers. 12 ESG Re's strategy and competitive strength in Asia centers on alternative distribution, direct marketing and telemarketing. During 1998, ESG Re built a platform to offer direct marketing and management services. Local insurance companies market under their own name, building brand recognition and their reputation. ESG Re is remunerated for its services by receiving a quota share cession of all business generated. The region might continue to see turbulent times in the next few years. ESG Re has invested in the infrastructure and talent necessary to capitalize on the huge market opportunities that will emerge as the cycle improves in Asia. ESG Re's "Intelligent Reinsurance" approach, adding value to ceding companies by providing expertise and service in return for reinsurance, will be well received and supported in Asia. MIDDLE EAST/AFRICA In the Middle East, where an increasing number of governments are now actively looking to transfer the responsibility of healthcare from the state to the private sector, ESG Re applies its specialist knowledge and "Intelligent Reinsurance" concepts. In what can be viewed as a difficult sector of the market, careful selection of "partners" from across the region has allowed the Company to control the types of risks being written and the claims settlement process. Services provided include the creation of preferred provider networks and the establishment of gatekeeping systems to control utilization and to avoid duplication of treatment. Health conditions of a serious nature are coordinated between the local ceding customers and ESG Re's London-based specialist healthcare division, European Specialty Insurance Management Services ("ESIMS"). MAJOR LINES OF BUSINESS MEDICAL EXPENSES As a specialist underwriter focusing on markets requiring dedicated know-how, ESG Re's extensive knowledge ensures that ongoing actuarial analysis, timely and efficient information systems, accurate risk evaluation and modern administrative methods act as a cornerstone to both initial and ongoing profitability. Medical expense coverage remains ESG Re's leading product line, with $132.1 in managed premium in 1998, representing 58.9% of the total portfolio. Proportional reinsurance programs represent 58.4% of our medical book, with 41.6% written on a non-proportional specific or stop loss basis. o Acceptance limit - $5 million lifetime limit per person o No accumulation limit PERSONAL ACCIDENT Our extensive experience has enabled ESG Re to underwrite both traditional and non-traditional risks through an innovative approach to risk acceptance and to create solutions to clients' personal accident and disability requirements. A dedicated know-how in the field of occupational injury has established ESG Re as a desired lead reinsurer in this demanding line within the personal accident arena. With 1998 managed premium of $59.4 million and very satisfactory underwriting results, personal accident lines have delivered consistent growth and profitability to the Company. o Acceptance limit - $5 million per person o $30 million known accumulation CREDIT/LIFE AND DISABILITY Providing group and substandard life capacity and pricing services, as well as credit/life, disability and unemployment insurance, ESG Re has built up considerable experience both in the North American and European markets. Managed premium from these product lines totaled $27.1 million in 1998. o Acceptance limit - $5 million any one person o No accumulation limit SPECIAL RISK Covering a wide range of insurance with unique risk characteristics such as professional sports, contingency, non-appearance, cancellation and abandonment, ESG Re's sports and entertainment business is managed by its affiliate company, SportSecure, one of the industry's leading underwriters in the specialist market. In 1998, Special Risk reinsurance totaled $5.6 million. As a recognized leader in this particular segment, we are capable of structuring and arranging even the largest event coverages, such as the 2002 Soccer World Cup, with a record sum insured exceeding 2 billion Swiss francs, o Acceptance limit - $5 million any one person o Up to $10 million any one event or series of events ESG Re Limited conducts its business through four operating companies that are risk carriers: European Specialty Reinsurance (Bermuda) Limited ("ES Bermuda"), a wholly owned subsidiary of ESG Re Limited; European Specialty Reinsurance (Ireland) Limited ("ES Ireland"), a wholly owned subsidiary of ES Bermuda; European Specialty Ruckversicherung AG ("ES Germany"), a wholly owned subsidiary of European Specialty Group Holding AG; and Accent Europe Insurance Company Limited ("Accent"), a wholly owned subsidiary of ES Ireland. Supporting underwriting services are provided by the group's subsidiaries in London, Toronto, Miami and Sydney, with further market support from branches and representative offices in Hong Kong and Moscow. With underwriting profits accruing primarily in Bermuda and Ireland, the Company benefits from the favorable tax environments in those jurisdictions.
CAPITALIZATION OF ESG'S RISK CARRIERS AT DECEMBER 31, 1998 ES Bermuda $140 million ES Ireland $101 million Accent $15 million ES Germany $12 million MOSCOW DUBLIN HAMBURG BERLIN LONDON TORONTO BERMUDA MIAMI HONG KONG SYDNEY
13 ESG RE IMPORTS THE BEST UNDERWRITING AND MANAGEMENT TECHNIQUES FROM AROUND THE WORLD TO HELP TAILOR SOLUTIONS FOR OUR CUSTOMERS' NEEDS. 1998 GROSS MANAGED PREMIUM BY OFFICE a. North America-39.8% b. Europe-27.7% c. London International-15.9% d. Latin America-14.8% e. Rest of World-1.8% 14 ESG RE'S BUSINESS PHILOSOPHY IS CENTERED ON PROVIDING CLIENT-ORIENTED SOLUTIONS, NOT JUST REINSURANCE CAPACITY. 1998 GROSS MANAGED PREMIUM DISTRIBUTION a. Medical Expense-58.9% b. Personal Accident-26.5% c. Credit/Life and Disability-12.1% d. Special Risk-2.5% 15 ORGANIZATION OF THE COMPANY ESG Re Limited ("ESG Re" or "the Company") European Specialty Reinsurance (Bermuda) Limited ("ES Bermuda") European Specialty Group (United Kingdom) Limited ("ESGUK") European Specialty Reinsurance (Ireland) Limited ("ES Ireland") European Specialty North America Limited ("ESNorth America") European Specialty Group Holding AG ("ESG Germany") Other Operating Subsidiaries Accent Europe Insurance Company Limited ("Accent") European Specialty Ruckversicherung AG ("ES Germany") Other Operating Subsidiaries 16 ESGRE LIMITED SELECTED CONSOLIDATED FINANCIAL DATA The following table sets forth the selected consolidated financial data for ESG Re Limited and subsidiaries. The financial statements included herein represent the financial performance and results of the Company as a reinsurer for the year ended December 31, 1998, as a reinsurer and reinsurance management company for the year ended December 31, 1997 and as a reinsurance management company only for the years prior to 1997. The consolidated statement of operations data for the years ended December 31, 1998, 1997, 1996 and 1995, and the consolidated balance sheet data as of December 31, 1998, 1997, 1996, 1995 and 1994, have been derived from the Company's audited Consolidated Financial Statements. The consolidated statement of operations data for the year ended December 31, 1994 has been derived from the Company's unaudited financial statements and, in the opinion of management, reflects all adjustments necessary for a fair presentation of the results of operations. The data should be read in conjunction with the Company's Consolidated Financial Statements, related notes, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other financial information appearing elsewhere herein.
Years Ended December 31, 1998 1997(1) 1996 1995 1994 ========================================================================================================== U.S. dollars in thousands except per share data STATEMENT OF OPERATIONS DATA: Net premiums earned(1) $ 98,841 $ 13,411 $ -- $ -- $ -- Management fee revenue 1,894 3,830 3,869 4,515 3,309 Net investment income 12,930 598 186 -- -- Total revenues 115,827 17,839 4,055 4,665 3,351 Total expenses (excludes tax benefits/expenses) 100,043 23,504 4,062 4,221 3,313 Net income (loss) 14,522 (5,096) (163) 146 (6) Basic net income (loss) per share(2) 1.04 (4.11) (1.38) -- -- Diluted net income (loss) per share(2) 1.03 (4.11) (1.38) -- -- =========== ========== =========== ======= ========
Years Ended December 31, 1998 1997(1) 1996 1995 1994 ========================================================================================================== U.S. dollars in thousands except per share data BALANCE SHEET DATA: Total investments and cash $235,246 $236,976 $ 15 $ 33 $ 21 Total assets 466,373 283,553 7,446 2,683 2,881 Unpaid loss and loss expenses 44,379 7,846 -- -- -- Total shareholders' equity (deficit) 244,841 234,375 (489) (152) (90) ======== ======== ======== ======== ========
The Company declared a dividend on February 25, 1999 of $0.08 per common share to be paid on March 22, 1999 to the shareholders of record on March 15, 1999. (1) In 1997, the Company began operations as a reinsurance company. (2) The 1996 per share data has been calculated on a recapitalized basis. Earnings per share data has not been calculated prior to 1996 as no shares were outstanding. ESGRE LIMITED 24 17 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is a discussion and analysis of the financial condition, results of operations, liquidity and capital resources of ESG Re Limited and its subsidiaries ("the Company" or "ESG"). This discussion and analysis should be read in conjunction with the "Selected Consolidated Financial Data" and the Company's Consolidated Financial Statements and related notes thereto included elsewhere in this annual report. This annual report contains forward-looking statements regarding future profit levels, premium growth, cash flows and other matters, which involve risks and uncertainties that may affect the actual results of operations of the Company. The following important factors, among others, could cause actual results to differ materially from those set forth in the forward-looking statements: claims frequency, claims severity, economic activity, competitive pricing, and the regulatory environment in which the Company operates. GENERAL The Company is a specialty reinsurance enterprise providing accident, health, life and related special risk reinsurance to insurers and selected reinsurers on a worldwide basis and, underwriting management services to co-reinsurers. In addition, the Company established a direct insurance company in the second quarter of 1998 to write pan-European products. In December 1997, the Company raised gross proceeds of $257 million in a private placement and an initial public offering (the "Offerings"). As a result of obtaining this capital, the Company is able to assume reinsurance risks for its own account. Prior to the Offerings, the Company operated solely as a reinsurance management services company. The December 31, 1998, financial statement results included herein reflect the Company's financial performance as a reinsurance company. The December 31, 1997 financial statement results reflect the Company's financial performance as a reinsurance company and as a reinsurance management services company. The 1996 financial statement results reflect the Company's operations as a reinsurance management services company only. RESULTS OF OPERATIONS The results of operations of the Company for the years ended December 31, 1998, 1997 and 1996 were as follows:
1998 1997 1996 ================================================================================= U.S. dollars in thousands except per share data Net underwriting income before allocated administrative costs $10,763 $ 1,269 $ -- Management fee revenue 1,894 3,830 3,869 Net investment income 12,930 598 186 Net realized investment gains 2,162 -- -- Administrative expenses and taxes 13,227 7,167 4,218 Class B Warrants expense -- 3,626 -- Net income (loss) 14,522 (5,096) (163) Net income (loss) per share 1.04 (4.11) (1.38) ========== ========== ==========
25 18 YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997 The Company reported net income of $14.5 million for 1998, compared to a net loss of $5.1 million for 1997. The year ended December 31, 1998 represents the first full year of the Company's operation as a reinsurance company. The net loss incurred in 1997 includes a one-time, non-cash charge for compensation expense of $3.6 million related to Class B Warrants issued in connection with the Offerings, and approximately $1.5 million of other Offerings related costs. NET UNDERWRITING INCOME For the year ended December 31, 1998, the Company managed, on behalf of itself and its co-reinsurers, total premiums of $224.2 million, of which it placed $24.3 million with co-reinsurers and retroceded $4.3 million, resulting in $195.6 million net premiums written for the period. In December 1997, the Company assumed a portion of the pool business it previously managed on behalf of reinsurance clients, retroactive to January 1, 1997. For the year ended December 31, 1997, the Company managed approximately $100 million of gross premiums written, of which it assumed approximately $26 million. Gross and net premiums written and net premiums earned for the 12 months ended December 31, 1998 and 1997 were as follows:
Years Ended December 31, 1998 1997 =============================================================================== U.S. dollars in millions Total premiums managed $224.2 $100.0 Amount placed with co-reinsurers or pool participants 24.3 73.9 Gross premiums written 199.9 26.1 Net premiums written 195.6 25.4 Net premiums earned 98.8 13.4 ====== ======
Total premiums managed for the 12 months ended December 31, 1998 consisted of the following: o New Business - approximately $186.2 million, or 83.0%, of total premiums managed was generated from new business. The Company's new representative office in Toronto underwrote $85.9 million of gross premiums. Two significant contracts for European medical, personal accident and life business were underwritten in the first quarter, including one for quota share treaty reinsurance incepting January 1, 1997. These contracts contributed $22.5 million to total premiums managed for the 12 months ended December 31, 1998. Additionally, one significant North American medical contract was underwritten in the third quarter, contributing $21.6 million to total premiums managed. o Renewal Business - approximately $38.0 million, or 17.0%, of total premiums managed was generated from renewal business. Underwriting results for the 12 months ended December 31, 1998 and 1997, by line of business and in total, were as follows:
Personal Year Ended December 31, 1998 Medical Accident Special Risk Credit Life Total ==================================================================================================================================== U.S. dollars in thousands Gross premiums written $ 119,157 $ 52,254 $ 5,120 $ 12,346 $ 10,995 $ 199,872 Net premiums written 117,353 50,814 4,943 11,910 10,558 195,578 Net premiums earned 40,875 46,038 2,571 4,856 4,501 98,841 Losses and loss expenses 24,646 29,003 859 3,448 3,408 61,364 Acquisition costs 14,241 10,207 906 837 523 26,714 Operating costs 3,584 4,036 228 420 534 8,802 --------- --------- --------- --------- --------- --------- Net underwriting income (loss) $ (1,596) $ 2,792 $ 578 $ 151 $ 36 $ 1,961 ========= ========= ========= ========= ========= =========
19
Personal Year Ended December 31, 1997 Medical Accident Special Risk Credit Life Total ==================================================================================================================================== U.S. dollars in thousands Gross premiums written $ 9,989 $ 9,357 $ 396 $ 6,401 $-- $ 26,143 Net premiums written 9,937 8,723 376 6,356 -- 25,392 Net premiums earned 5,964 3,778 243 3,426 -- 13,411 Losses and loss expenses 3,624 1,907 139 1,779 -- 7,449 Acquisition costs 2,099 1,303 85 1,206 -- 4,693 --------- --------- --------- --------- --------- --------- Net underwriting income $ 241 $ 568 $ 19 $ 441 $-- $ 1,269 ========= ========= ========= ========= ========= =========
The operating ratios for the 12 months ended December 31, 1998 and 1997, by line of business and in total, were as follows:
Personal Year Ended December 31, 1998 Medical Accident Special Risk Credit Life Total ==================================================================================================================================== Loss ratio 60.3% 63.0% 33.4% 71.0% 75.7% 62.1% Acquisition expense ratio 34.8% 22.2% 35.2% 17.2% 11.6% 27.0% --------- --------- --------- --------- --------- --------- Loss and acquisition expense ratio 95.1% 85.2% 68.6% 88.2% 87.3% 89.1% --------- --------- --------- --------- --------- --------- Administrative expense ratio 8.9% --------- Combined ratio 98.0% =========
Personal Year Ended December 31, 1997 Medical Accident Special Risk Credit Life Total ==================================================================================================================================== Loss ratio 60.8% 50.5% 57.2% 51.9% --% 55.5% Acquisition expense ratio 35.2% 34.5% 35.0% 35.2% --% 35.0% --------- --------- --------- --------- --------- --------- Loss and acquisition expense ratio 96.0% 85.0% 92.2% 87.1% --% 90.5% ========= ========= ========= ========= ========= =========
The 12 months ended December 31, 1998 constituted the first full 12-month period that the Company operated as a reinsurer writing for its own account. Accordingly, a combined ratio is presented inclusive of an administrative expense component to provide a meaningful indication of the underwriting results of the business. The administrative expense ratio of 8.9% for the 12 months ended December 31, 1998, was calculated by expressing total administrative expenses, net of management fee revenue and corporate office expenses, as a percentage of net premiums earned. In addition, during the year, the Company deferred $1.5 million of expenses which were identified by management as directly related to and, varying with, the volume of business generated. The deferral of such costs reflects a more appropriate matching of revenues with related expenses and improved the year-to-date combined ratio by 1.5%. Typically, the underwriting results of a reinsurance company are evaluated by its loss and loss expense ratio, acquisition cost ratio, administrative expense ratio and combined ratio. Management believes that it is not meaningful to evaluate the Company's 1997 performance with reference to the administrative expense ratio and combined ratio because of the Class B Warrant expense and other costs that were incurred by the Company as a result of the Offerings. GEOGRAPHIC SPREAD Geographic diversification of the Company's business continues to be demonstrated by the distribution of gross written premiums for the years ended December 31, 1998 and 1997, as follows:
Years Ended December 31, 1998 1997 =============================================================================== Western Europe 30.9% 62.7% North America 46.2% 1.5% Latin America 14.9% 19.2% Eastern Europe 0.1% 5.3% Other 7.9% 11.3% ----- ----- Total 100.0% 100.0% ===== =====
20 PRODUCT MIX The distribution of gross premiums written by line of business for the years ended December 31, 1998 and 1997 was as follows:
Years Ended December 31, 1998 1997 =============================================================================== Medical 59.6% 38.2% Personal Accident 26.1% 35.8% Special Risk 2.6% 1.5% Credit 6.2% 24.5% Life 5.5% --% ----- ----- Total 100.0% 100.0% ===== =====
MANAGEMENT FEE REVENUE The majority of management fee revenue in 1998 consists of fees earned on those premiums managed for the Company's co-reinsurers. Management fee revenue in 1998 includes an upward revision in management fees on pool underwriting years prior to 1998 in the amount of $144 thousand. NET INVESTMENT INCOME Net investment income increased by $12.3 million from $598 thousand in 1997 to $12.9 million in 1998. In December 1997, the Company raised net proceeds from the Offerings of $232 million. These proceeds were invested for the full year in 1998. The following table reflects the investment results for the 12 months ended December 31, 1998:
Net Annualized Net Realized Average Investment Effective Investment U.S. dollars in thousands Investments Income(1) Yield Gains ================================================================================================================= Fixed maturity investments $218,383 $12,160 5.57% $2,162 Short-term investments/strategic investments 7,721 440 5.70% -- Cash and cash equivalents 13,516 330 2.44% -- -------- ------- ---- ------ Total $239,620 $12,930 5.40% $2,162 ======== ======= ==== ======
(1) Net investment income is net of investment-related expenses. The Company's investment portfolio was positively affected by a general increase in prices in the U.S. bond markets, which allowed net investment gains to be realized on sales of fixed income securities during the year. ADMINISTRATIVE EXPENSES Total administrative expenses, which includes personnel costs, professional service fees, interest expense, other expenses and income taxes, increased by $6.0 million, or 85%, from $7.2 million in 1997 to $13.2 million in 1998. For the year ended December 31, 1998, the Company incurred significant expenses on professional services, on initiatives for improving accounting and control systems, hiring key executives, and identifying strategic investments, and on travel expenses related to all of the above activities. Total administrative expenses, less tax, for the 12 months ended December 31, 1998, were $12.0 million, or 6.1% and 12.1%, respectively, of net premiums written and net premiums earned, compared to $7.7 million in 1997. The prior year expenses include $1.5 million of travel expense and professional service fees associated with the Company's capital raising activity. Tax expense increased by $1.8 million to $1.3 million in 1998. In 1997, the Company had a tax benefit of $569 thousand. Personnel costs increased by $2.1 million from $2.3 million in 1997 to $4.4 million in 1998. This increase was a result of the significant investment in personnel made both prior to and since the Offerings and includes additions of executives and staff at the holding company and various representative offices. Professional service fees increased by $2.0 million from $1.6 million in 1997 to $3.6 million in 1998. These professional service fees incurred in 1998 relate to the Company's new public reporting requirements, staff recruiting efforts and computer systems improvements. Professional costs in 1997 include $1.2 million associated with the Company's capital-raising activity. Travel expenses decreased by $0.3 million to $1.0 million, compared to the corresponding prior year period. These travel expenses relate primarily to the Company's continuing identification and investigation of new business and underwriting opportunities. Foreign exchange gains of $141 thousand were recognized for the 12 months ended December 31, 1998. These gains were primarily unrealized and were incurred on the revaluation of assets and liabilities denominated in foreign currencies for reporting purposes. As the Company maintains a partial natural hedge, whereby foreign currency assets are held in the same currencies in which it must pay liabilities, the impact on cash flows from foreign exchange movements is reduced. 21 YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996 The Company incurred a net loss of $5.1 million for 1997 as compared to a net loss of $163 thousand for 1996. The principal reason for this increase in the net loss is a one-time, non-cash charge for compensation expense of $3.6 million related to Class B Warrants issued in connection with the Offerings. Also included in the net loss for 1997 are costs associated with the Offerings of approximately $1.5 million. NET UNDERWRITING INCOME No comparison with prior year net underwriting income is possible as 1997 was the first period in which the Company underwrote risks on its own behalf. Typically the underwriting results of a reinsurance company are evaluated by its loss and loss expense ratio, acquisition cost ratio, administrative expense ratio and combined ratio. Management believes that it is not meaningful to evaluate the Company's 1997 performance with reference to the administrative expense ratio and combined ratio because of the Class B Warrant expense and other costs that were incurred by the Company as a result of the Offerings. MANAGEMENT FEE REVENUE Management fee revenue decreased by $39 thousand, or 1%, from $3.9 million in 1996 to $3.8 million in 1997. This net decrease resulted from an increase in management fee revenue of $666 thousand due to increased participation in the reinsurance pools managed by the Company, offset by a 15% decline in the value of the Deutsche mark against the U.S. dollar. Included in 1997 management fee revenue is profit commission of $381 thousand relating to the 1996 underwriting year. This compares with profit commission recognized during 1996 of $398 thousand. NET INVESTMENT INCOME Net investment income increased by $412 thousand, or 222%, from $186 thousand in 1996, due to the Company's significantly larger investment portfolio as a result of the proceeds raised from the Offerings. ADMINISTRATIVE EXPENSES Total administrative expenses, which includes personnel costs, professional service fees, interest expense, other expenses, and income taxes, increased by $3.0 million, or 70%, from $4.2 million in 1996 to $7.2 million in 1997. Personnel costs increased by $900 thousand, from $1.4 million in 1996 to $2.3 million in 1997, of which $690 thousand was principally due to the employment of two executives who were previously consultants to the Company. The remainder of the increase results from the staffing of the new representative office in Toronto. Professional service fees increased by $356 thousand from $1.2 million in 1996 to $1.6 million in 1997, primarily due to costs of $1.2 million associated with the Company's capital-raising activity. This increase was partially offset by a reduction in consulting expenses for the two consultants who became executives. Other expenses increased by $2.4 million, from $1.4 million in 1996 to $3.8 million in 1997. This increase includes travel expenses associated with the Company's capital-raising activities, an increase in unrealized foreign exchange losses as a result of the strengthening of the U.S. dollar, and other miscellaneous expenses, including insurance, recruitment fees, taxes and utilities. The increase in administrative expenses was partially offset by a decline of approximately 15% in the value of the Deutsche mark against the U.S. dollar. CLASS B WARRANTS EXPENSE In connection with the Offerings, the Company issued Class A Warrants to purchase up to 1,381,200 Common Shares, and Class B Warrants to purchase up to 1,381,200 Common Shares if certain performance criteria are satisfied. The Class A Warrants have been treated as an offering cost and as such have been incorporated within equity. The Class B Warrants have been determined to be in the form of compensation for services rendered to the Company. As such, SFAS 123 "Accounting for Stock-Based Compensation" and Emerging Issues Task Force Consensus 96-18 "Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring or in Conjunction with Selling Goods or Services" require that the cost of these services be reflected as an expense for the year. As a result, the Company recognized a one-time accounting charge of $3.6 million relating to the Class B Warrants. The expense was calculated based on the fair value of the warrants as of the date of completion of the Offerings. As the expense was reflected as a charge to the statement of operations and as an increase to additional paid-in capital, there was no impact on the Company's total shareholders' equity or cash position. LIQUIDITY AND CAPITAL RESOURCES As of December 31, 1998, total investments and cash were $235.2 million, compared to $237.0 million at December 31, 1997. All fixed maturity securities in the Company's investment portfolio are classified as available for sale and are carried at fair value. The following table summarizes the fixed maturity investment portfolio as of December 31, 1998:
Average Fair Duration Market Credit U.S. dollars in thousands Value (Years) Yield Rating ================================================================================================================== Corporate securities $138,727 3.1 5.7% AA U.S. treasury securities and obligations of U.S. government corporations and agencies 31,698 1.5 4.4% AAA Asset-backed securities/Mortgage-backed securities 9,232 0.8 5.8% AAA Obligations of states and political subdivisions 24,647 2.3 5.9% AA Foreign currency debt securities 8,083 3.4 3.5% AA -------- --- --- --- Total $212,387 2.6 5.2% AA ======== === === ===
By comparison, at December 31, 1997, the entire portfolio was invested in U.S. treasury securities and obligations of government corporations and agencies. 22 The Company's investment policy objective is to maximize long-term investment returns while maintaining a liquid, high-quality portfolio. To this end, the investment policy requires that the portfolio have an average credit quality rating of AA, with no more than 3% of the portfolio invested in the securities of a single issuer (other than issues of sovereign governments with a rating of AA or better), and a target duration of 2.75 years. The Company's investment portfolio as of December 31, 1998 and 1997 complies with the adopted investment policy and guidelines. In 1999, the Company will continue to follow its investment policy and guidelines while seeking to improve long-term value by investing in selected strategic investments. A strategic investment is defined as an investment in a reinsurance-related enterprise, ceding company or distribution channel that is expected to generate or secure additional profitable business for the Company. In the aggregate, the Company will allocate up to $25 million to strategic investments. To date, ESGhas invested $2.0 million and acquired an 83% ownership interest in IMEDI L International, a provider of personal insurance products, including medical, life and pension products, based in Tbilisi, Georgia. Additionally, equity investments and loans totaling $5.9 million were extended primarily to four other companies with whom ESG has operating relationships. In December 1997, the Company was capitalized with gross proceeds of $257 million from the Offerings. The Company also incurred expenses of $25 million related to the Offering and repaid its outstanding debt, principally loans from shareholders and bank demand borrowings, of $3.5 million. Total assets increased by $281.1 million from $2.5 million in 1996 to $283.6 million in 1997 and total shareholders' equity increased by $234.9 million to $234.4 million at December 31, 1997. The proceeds of the Offering were used to capitalize ES Bermuda, ES Ireland and ES Germany with $55 million, $50 million and $12 million, respectively. In 1998, the Company increased the capital of ES Bermuda by $35 million, and ES Ireland by $50 million. Accent Europe Insurance Company, the direct writer formed in 1998, is capitalized at $15 million. Shareholders' equity as of December 31, 1998 was $244.8 million, compared to $ 234.4 million at December 31, 1997. The major factors influencing the increased level of shareholders' equity in the 12-month period included $14.5 million of net income, inclusive of net unrealized investment gains of approximately $2.6 million, offset partially by the declaration of four dividends, each of $0.075 per common share, aggregating to $4.2 million. Book value per common share increased to $17.58 as of December 31, 1998 from $16.83 as of December 31, 1997. The Company expects that its financial and operational needs for the foreseeable future will be met by funds generated from operations, but may consider acquiring additional funding as attractive market opportunities emerge. As of December 31, 1998, the Company had the following material commitments for operating leases and employment contracts:
Total Commitments In U.S. Dollars (in thousands) Lease Employee Years Ending December 31, Commitments Commitments Total ================================================================================================================= 1999 $ 476 $2,514 $2,990 2000 487 2,316 2,803 2001 349 1,130 1,479 2002 72 763 835 2003 -- 253 253 ------ ------ ------ Total $1,384 $6,976 $8,360 ====== ====== ======
In addition to the above commitments, the Company will periodically, pursuant to reinsurance contract provisions, be required to provide letters of credit to secure reinsurance balances, and to place funds on deposit with ceding companies. EXPOSURE MANAGEMENT The Company manages its underwriting risk exposures through geographic distribution and an excess of loss reinsurance program. This program generally provides limits up to a maximum of $30 million per occurrence, with a minimum attachment point generally of $100 thousand. CURRENT DEVELOPMENTS On February 25, 1999, the Board of Directors approved a quarterly dividend increase of $0.005 per common share, increasing the quarterly dividend from $0.075 to $0.08 per share. A quarterly cash dividend of $0.08 per share was declared on February 25, 1999 by the Company's Board of Directors, payable on March 22, 1999 to common shareholders of record on March 15, 1999. In June 1998, the Company increased its investment in SportSecure GmbH ("SportSecure"), a reinsurance intermediary specializing in sports and entertainment risks. ESG holds a majority ownership interest in SportSecure. In June 1998, the Company incorporated Accent Europe Insurance Company Ltd., a direct insurance company, in Ireland. With current capitalization at $15 million, Accent offers health and accident products on a pan-European basis directly to its insured parties. 23 Early in the fourth quarter, the Company began the process of establishing a global support center (the "Shared Services Center") in Dublin, Ireland. Corporate functions expected to operate from the Shared Services Center include operating and administrative functions such as systems and technology, finance and accounting, human resources, insurance claims, and policy administration. The Company has initiated the creation of a healthcare service association, COMED, in the German market. COMED has a target market of an estimated 70 million members covered in the German public healthcare system. Member services include physician referrals, a medical information hotline, second opinion services and access to disease management advisors. ESG has supported the formation and development of COMEDby extending a short-term credit facility up to the amount of $12 million to fund start-up operations. As of December 31, 1998 no funds had been advanced to COMED under this facility. MARKET RISK The Company is subject to market risk arising from the potential change in value of its various financial instruments. These changes may be due to fluctuations in interest rates or foreign currency rates, or both in the case of foreign currency investments. The Company monitors its exposure to interest rate and currency rate risk on a continuous basis and currently does not believe that the use of derivatives to manage such risk is necessary. The Company intends to reevaluate the need for a formal hedging strategy on a periodic basis, and may determine that such a strategy, including the use of derivative instruments, is appropriate in the future. INTEREST RATE RISK The largest source of market risk for the Company is interest rate risk on its portfolio of fixed maturity investments, especially fixed rate instruments. In addition, the credit worthiness of the issuer, relative values of alternative investments, liquidity and general market conditions may affect fair values of interest rate sensitive instruments. The Company's general strategy with respect to fixed maturity securities is to invest in high quality securities while maintaining diversification to avoid significant concentrations in individual issuers' industry segments or countries. Generally, it is expected that an increase in market interest rates will cause a decline in the value of the Company's investment portfolio, whereas a decrease in rates may cause an increase in value. The following table shows the approximate effect on the value of the Company's investment portfolio, based on hypothetical changes in market interest rates:
-150 -100 -50 Market +50 +100 +150 December 31, 1998 Basis Basis Basis Value Basis Basis Basis U.S. dollars in thousands Points Points Points 12/31/98 Points Points Points ==================================================================================================================================== Fixed maturities including accrued interest $227,404 $223,457 $219,664 $216,016 $212,511 $209,130 $205,867 ======== ======== ======== ======== ======== ======== ========
The values indicated above are estimates and are necessarily based on various assumptions that are subjective in nature. Accordingly, the actual impact of changes in market rates on the Company's investment portfolio may be significantly greater or less than those indicated above. FOREIGN CURRENCY RISK The Company's functional currency is the U.S. dollar. However, the Company writes reinsurance business in numerous geographic regions and currencies, giving rise to the risk that the ultimate settlement of receivables and payables on reinsurance transactions will differ from the amounts currently recorded as assets and liabilities in the financial statements. The Company intends to hold investments in currencies in which it will collect premiums and pay claims, thus creating a partial natural hedge against exchange rate fluctuations. INFLATION Inflation has not had a material impact on the Company's operations for any of the three years presented. However, it is possible that future inflationary conditions may impact subsequent accounting periods. THE EURO On January 1, 1999, a single currency, the "Euro," was adopted as the national currency of the 11 participating countries in the European Monetary Union, including Germany and Ireland, two of the countries in which the Company operates and in which the Company maintains a significant presence. ESG's German and Irish subsidiaries will not be required to use the euro for accounting purposes prior to January 1, 2002. Due to uncertainties related to the euro conversion, the impact of the conversion is not known. To date, the impact of the conversion has had no material impact on the Company's operations, accounting systems or financial reporting. 24 YEAR 2000 ISSUE The Year 2000 Issue relates to the ability of computer systems to properly interpret date information for the year 2000 and beyond. In January 1998, the Company initiated an enterprise-wide project to address Year 2000 issues with respect to the Company's computer software and information technology systems. The initiative has as its focus two distinct areas that include Year 2000 compliance of the Company's software, systems and technology platforms and the evaluation of the Year 2000 preparedness of significant third parties with whom the Company conducts business, including vendors and customers. The Company has substantially completed its assessment of Company software and systems and has adopted a plan to implement compliant components and to develop a disaster recovery plan, targeted to be substantially complete by the end of the second quarter of 1999. The Company estimates that through December 1998, the remediation and validation efforts are approximately 60% complete, with immaterial incremental costs incurred thus far as a result of usage of internal staff. Remaining testing and conversion efforts also are expected to be conducted primarily by internal staff; however, limited third-party assistance during the first two quarters of 1999 may be utilized. No significant third-party costs are anticipated. Future costs of remediation are not expected to have a material impact on the Company's financial position, results of operations or cash flows, although no assurance can be given in this regard. The Company's systems do not interface electronically with those of its customers or clients. As such, the Company's exposure to the Year 2000 Issue with respect to customers and clients is limited to the possibility that information supplied by these companies could not be of sufficient quality or timeliness and therefore could indirectly affect the quality or timeliness of the Company's own data. The Company is currently communicating with its significant clients and service providers to assess their vulnerability and readiness to comply with Year 2000 issues and will address compliance risks with each new significant vendor. ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 133, which is effective in the first quarter of 2000, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other financial instruments and contracts, and for hedging activities. The Company has not completed its analysis of the expected future impact of SFAS 133. 25 ESGRE LIMITED CONSOLIDATED BALANCESHEETS
As of December 31, 1998 1997 ==================================================================================================================================== U.S. dollars in thousands except share and per share data ASSETS Fixed maturities - available for sale, at fair value (cost: $211,589 and $218,694) $ 212,387 $ 218,867 Cash and cash equivalents 16,942 6,196 Strategic investments 5,917 -- Short-term investments -- 11,913 --------- --------- Total investments and cash 235,246 236,976 Accrued investment income 3,629 437 Management fees receivable 3,164 3,259 Premiums receivable 162,015 25,785 Reinsurance balances receivable 6,259 -- Reinsurance recoverable on incurred losses 2,761 397 Funds held by ceding companies 3,592 -- Prepaid reinsurance premiums 2,276 300 Deferred acquisition costs 37,625 4,147 Deferred tax asset 843 788 Other assets 2,222 979 Cash and cash equivalents held in a fiduciary capacity 6,741 10,485 --------- --------- TOTAL ASSETS $ 466,373 $ 283,553 ========= ========= LIABILITIES Unpaid losses and loss expenses $ 44,379 $ 7,846 Unearned premiums 111,884 12,168 Acquisition costs payable 45,487 10,335 Reinsurance balances payable 7,114 -- Accrued expenses, accounts payable, and other liabilities ($204 and $2,520 due to related parties) 5,927 8,344 Fiduciary liabilities 6,741 10,485 --------- --------- Total liabilities 221,532 49,178 --------- --------- SHAREHOLDERS' EQUITY Preference shares, 50,000,000 shares authorized; no shares issued and outstanding for 1998 and 1997 -- -- Class B common shares, 100,000,000 shares authorized; no shares issued and outstanding for 1998 and 1997 -- -- Common shares, par value $1 per share; 100,000,000 shares authorized; 13,923,799 shares issued and outstanding for 1998 and 1997 13,924 13,924 Additional paid-in capital 226,216 225,954 Accumulated other comprehensive income: Foreign currency translation adjustments (574) 32 Unrealized gains on securities (net of tax of $164 and $3) 634 170 --------- --------- Accumulated other comprehensive income 60 202 --------- --------- Retained earnings (deficit) 4,641 (5,705) --------- --------- Total shareholders' equity 244,841 234,375 --------- --------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 466,373 $ 283,553 ========= =========
The accompanying notes are an integral part of the consolidated financial statements. 26 ESGRE LIMITED CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 1998 1997 1996 ==================================================================================================================================== U.S. dollars in thousands except share and per share data REVENUES Net premiums written $ 195,578 $ 25,392 $ -- Change in unearned premiums (96,737) (11,981) -- ------------ ------------ ------------ Net premiums earned 98,841 13,411 -- Management fee revenue 1,894 3,830 3,869 Net investment income 12,930 598 186 Net realized investment gains 2,162 -- -- ------------ ------------ ------------ 115,827 17,839 4,055 ------------ ------------ ------------ EXPENSES Losses and loss expenses 61,364 7,449 -- Acquisition costs 26,714 4,693 -- Class B Warrants expense (for related party) -- 3,626 -- Personnel costs 4,352 2,282 1,382 Professional service fees (includes $378, $-- and $861 for related parties) 3,599 1,594 1,238 Other expenses 4,014 3,860 1,442 ------------ ------------ ------------ 100,043 23,504 4,062 ============ ============ ============ NET INCOME (LOSS) BEFORE TAXES 15,784 (5,665) (7) Income tax expense (benefit) 1,262 (569) 156 ------------ ------------ ------------ NET INCOME (LOSS) $ 14,522 $ (5,096) $ (163) ============ ============ ============ PER SHARE DATA Basic net income (loss) per share $ 1.04 $ (4.11) $ (1.38) ------------ ------------ ------------ Diluted net income (loss) per share $ 1.03 $ (4.11) $ (1.38) ------------ ------------ ------------ Weighted average shares outstanding Basic 13,923,799 1,238,757 117,863 Diluted 14,076,443 1,238,757 117,863 ============ ============ ============ Dividends declared per share $ .30 $ -- $ -- ============ ============ ============
The accompanying notes are an integral part of the consolidated financial statements. 27 ESGRE LIMITED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
Years Ended December 31, 1998 1997 1996 ==================================================================================================================================== U.S. dollars in thousands COMMON SHARES (PAR VALUE) Balance at January 1 $ 13,924 $ 62 $ -- Reorganization of holding company -- -- 62 Issuance of shares in connection with public and private offerings -- 13,936 -- Shares retired during year -- (74) -- --------- --------- --------- Balance at December 31 13,924 13,924 62 ========= ========= ========= ADDITIONAL PAID-IN CAPITAL Balance at January 1 225,954 62 -- Reorganization of holding company -- -- 62 Issuance of shares in connection with public and private offerings -- 216,113 -- Issuance of Class A Warrants to purchase common shares -- 6,215 -- Issuance of Class B Warrants to purchase common shares -- 3,626 -- Directors' fees taken as stock options 347 -- -- Additional offering costs (85) -- -- Shares retired during year -- (62) -- --------- --------- --------- Balance at December 31 226,216 225,954 62 ========= ========= ========= REGISTERED CAPITAL AND TREASURY CAPITAL Balance at January 1 -- -- 297 Reorganization of holding company -- -- (297) --------- --------- --------- Balance at December 31 -- -- -- ========= ========= ========= ACCUMULATED OTHER COMPREHENSIVE INCOME Balance at January 1 202 (4) (3) Foreign currency translation adjustments, net of tax (606) 36 (1) Unrealized gains on securities, net of tax 464 170 -- --------- --------- --------- Balance at December 31 60 202 (4) ========= ========= ========= RETAINED EARNINGS (DEFICIT) Balance at January 1 (5,705) (609) (446) Net income (loss) 14,522 (5,096) (163) Dividends (4,176) -- -- --------- --------- --------- Balance at December 31 4,641 (5,705) (609) --------- --------- --------- TOTAL SHAREHOLDERS' EQUITY (DEFICIT) $ 244,841 $ 234,375 $ (489) ========= ========= =========
The accompanying notes are an integral part of the consolidated financial statements. 28 ESGRE LIMITED CONSOLIDATED STATEMENTS OF CASHFLOWS
Years Ended December 31, 1998 1997 1996 =================================================================================================================================== U.S. dollars in thousands CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss) $ 14,522 $ (5,096) $ (163) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization 252 117 132 Realized investment gains (2,162) -- -- Amortization of premiums and discounts 200 -- -- Non-cash compensation expenses 347 3,665 -- Changes in assets and liabilities: Accrued investment income (3,192) (437) -- Management fees receivable 95 (1,769) 139 Premiums receivable (136,230) (25,785) -- Reinsurance balances receivable (6,259) -- -- Reinsurance recoverable on incurred losses (2,364) (397) -- Funds held by ceding companies (3,592) -- -- Prepaid reinsurance premiums (1,976) (300) -- Deferred acquisition costs (33,478) (4,147) -- Deferred tax asset (55) (573) (1) Unpaid losses and loss expenses 36,533 7,846 -- Unearned premiums 99,716 12,168 -- Acquisition costs payable 35,152 10,335 -- Reinsurance balances payable 7,114 -- -- Accrued expenses and accounts payable (2,579) 1,075 -- Other assets and liabilities (1,065) 775 32 --------- --------- --------- NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES 979 (2,523) 139 ========= ========= ========= CASH FLOWS FROM INVESTING ACTIVITIES Cost of fixed maturities acquired - available for sale (436,239) (218,694) -- Proceeds from sale of fixed maturities - available for sale 445,305 -- -- Change in short-term investments 11,913 (11,913) -- Purchases of fixed assets (967) (203) (109) Purchases of intangible assets (57) (230) (43) Funding of strategic investments (5,917) (16) (4) --------- --------- --------- NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES 14,038 (231,056) (156) ========= ========= ========= CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from issuance of shares -- 241,296 -- Changes to capital prior to initial public offering -- -- (13) Net change in short-term debt -- (1,622) 296 Repayments of long-term borrowings -- -- (272) Additional offering costs (85) -- -- Dividends paid (4,177) -- -- --------- --------- --------- NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES (4,262) 239,674 11 --------- --------- --------- EFFECT OF EXCHANGE RATE CHANGES ON CASH (9) 86 (12) ========= ========= ========= Net increase (decrease) in cash 10,746 6,181 (18) Cash and cash equivalents at January 1 6,196 15 33 --------- --------- --------- Cash and cash equivalents at December 31 $ 16,942 $ 6,196 $ 15 ========= ========= ========= SUPPLEMENTAL CASH FLOW INFORMATION Cash transactions Interest paid $ 8 $ 108 $ 124 Income taxes paid 40 109 156 Non-cash financing transaction Issuance of common stock in connection with Formation (Note 1) -- -- -- ========= ========= =========
The accompanying notes are an integral part of the consolidated financial statements. 29 ESGRe Limited Notes to the Consolidated Financial Statements ESGRE LIMITED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years Ended December 31, 1998 1997 1996 ==================================================================================================================================== U.S. dollars in thousands Net income (loss) $ 14,522 $ (5,096) $ (163) -------- -------- -------- Other comprehensive income, net of tax: Foreign currency translation adjustments (606) 36 (1) Unrealized gains on securities: Unrealized holding gains arising during period, net of tax of $172 and $32,615 170 -- Less reclassification adjustment for gains included in net income, net of tax of $11 (2,151) -- -- -------- -------- -------- Other comprehensive income (142) 206 (1) -------- -------- -------- Comprehensive income $ 14,380 $ (4,890) $ (164) ======== ======== ========
The accompanying notes are an integral part of the consolidated financial statements. 30 ESGRE LIMITED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Years ended December 31, 1998, 1997, 1996 1. ORGANIZATION AND BUSINESS ESG Re Limited ("the Company") was incorporated under the laws of Bermuda on August 21, 1997. Its principal activities conducted through its subsidiaries, are to provide accident, health, credit, life and special risk reinsurance and to provide underwriting management services for these lines. Prior to the incorporation, the Company's operations were conducted through its subsidiary, European Specialty Group Holding AG ("ESG Germany"). On December 2, 1997, the shareholders of ESG Germany entered into agreements to receive 900,000 common shares, par value $1 per share, of the Company in exchange for all of their interests in ESG Germany (the "Formation"). ESG Germany thereby became a subsidiary of the Company. On December 3, 1997, 2,673,799 common shares, Class A Warrants to purchase up to 1,381,200 common shares and Class B Warrants to purchase up to 1,381,200 common shares, subject to certain performance criteria, were sold (the "Direct Sales") for proceeds of $50 million. In December 1997, in an Initial Public Offering (the "IPO"), the Company issued 10,350,000 common shares for proceeds of $207 million. Costs including discounts and commissions associated with the Formation, Direct Sales and IPO were approximately $25.8 million, of which $21.3 million were reflected as a reduction of additional paid-in capital. The Formation, Direct Sales and IPO were accounted for as a recapitalization. Since 1994, ESG Germany has provided underwriting management services by operating as a personal and special risk reinsurance underwriter on behalf of certain reinsurers. ESG Germany earned a management fee from reinsurance companies for administering various underwriting pools without directly participating in the underwriting results as well as providing underwriting services to reinsurance companies outside of the pool structure. Subsequent to the IPO, the Company assumed for its own account, through retrocession, risks that ESG Germany previously underwrote on behalf of its reinsurance clients. The Company exercised a contractual right provided in the pool agreements to retrocede from its reinsurance clients a 30% share of the existing pool business, retroactive to January 1, 1997, of the 1997 business it managed for its reinsurance clients. The Company also assumed additional quota share reinsurance from various pool clients. The Company continues to manage the runoff of the reinsurance pools. The consolidated financial statements include the accounts of the Company and its subsidiaries. All material intercompany balances and transactions have been eliminated in consolidation. The financial statements for the year ended December 31, 1997 represent the financial performance of the Company both as a reinsurer for its own account and as a reinsurance management company. The comparative information for the year ended December 31, 1996 represents the financial performance of the Company as an underwriting management company. Certain items in the prior years' financial statements have been reclassified to conform to the current years' presentation. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The Company's consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP"). The Company's significant accounting policies include the following: (A) PREMIUM REVENUES Premiums written are estimated and recognized at the inception of the reinsurance contract, based upon information received from intermediaries and ceding companies. The Company compares estimated written premiums to actual premiums as reported by ceding companies on a periodic basis. The timeliness and frequency of ceding company reports vary considerably by ceding company, line of business and geographic area, which means that the actual ultimate premium written may not be known with certainty for prolonged periods. Differences between such estimates and actual amounts as reported by ceding companies are recorded in the period in which the actual amounts are determined. The reinsurance contracts entered into by the Company are primarily of short duration. Premiums written are recognized as earned over the coverage period in proportion to the amount of protection provided. Unearned premium reserves are established to cover the unexpired contract period. 31 (B) RESERVE FOR LOSSES AND LOSS EXPENSES The reserve for unpaid losses and loss adjustment expenses includes an estimate of reported case reserves and an estimate for losses incurred but not reported. Case reserves are estimated based on ceding company reports and other data considered relevant to the estimation process. The liability for losses incurred but not reported is based to a large extent on the expectations of ceding companies about ultimate loss ratios at the inception of the contracts, supplemented by industry experience and the Company's specific historical experience where available. As the Company has limited specific historical experience on a significant number of its programs on which to base its estimate of losses incurred but not reported, its reliance on ceding company expectations and industry experience is necessarily increased, which increases the uncertainty involved in the loss estimation process. The reserves as established by management are reviewed periodically, and adjustments are made in the periods in which they become known. Although management believes that an adequate provision has been made for the liability for losses and loss expenses, based on all available information, there can be no assurance that the ultimate losses will not differ significantly from the amounts provided. (C) INVESTMENTS Fixed maturity securities are classified as available for sale and are reported at estimated fair value. Investments that are available for sale are expected to be held for an indefinite period but may be sold depending on interest rates and other considerations. Short-term investments comprise investments with a maturity greater than 90 days but less than one year and are stated at cost, which approximates fair value. Strategic investments over which the Company exercises significant influence are accounted for under the equity method. Other strategic investments are accounted for at cost. Unrealized investment gains and losses on fixed maturity securities available for sale, net of applicable deferred income tax, are reported as a separate component of "accumulated other comprehensive income". Realized gains or losses on sale of investments are determined on the basis of average cost. The carrying values of fixed maturities and strategic investments are adjusted for impairments in value that are considered to be other than temporary. (D) DEFERRED ACQUISITION COSTS Acquisition costs, consisting principally of commissions and brokerage expenses incurred at the time a contract or policy is issued, are deferred and amortized over the period in which the related premiums are earned. Deferred policy acquisition costs are limited to their estimated realizable value based on the related unearned premiums, anticipated claims and claim expenses and anticipated investment income. (E) REINSURANCE PREMIUMS CEDED Reinsurance premiums ceded are reported as prepaid reinsurance premiums and amortized over the respective contract or policy periods in proportion to the amount of insurance protection provided. Commissions on reinsurance ceded will be deferred over the terms of the contracts of reinsurance to which they relate and amortized in proportion to the amount of insurance protection provided. (F) MANAGEMENT FEE REVENUE Management fee revenue consists primarily of fees earned as compensation for underwriting and managing the reinsurance portfolio on behalf of the Company's co-reinsurers. These fees are estimated and recognized at the inception of the contracts with the co-reinsurers. In addition, adjustments to management fees and profit commission arising from underwriting results for 1997 and prior years, when the Company operated as a reinsurance management company, are estimated and accrued. (G) INCOME TAXES The Company and its subsidiaries file income tax returns as required by the laws of each country in which it has operations. The Company accounts for income tax expenses and liabilities under the asset and liability method in accordance with Statement of Financial Accounting Standards Board ("SFAS") No. 109, "Accounting for Income Taxes." Deferred income taxes arise from the recognition of temporary differences between income reported for financial statement purposes and income for income tax purposes. These deferred taxes are measured by applying currently enacted tax rates. In addition, SFAS No. 109 requires the recognition of future benefits, such as for net operating loss carryforwards, to the extent that realization of such benefits is more likely than not. 32 (H) FOREIGN CURRENCY TRANSLATION The functional and reporting currency of the Company is U.S. dollars. Foreign currency receivables or payables that are denominated in a currency other than U.S. dollars are translated into U.S. dollars at the rates of exchange in effect at the balance sheet date. Revenues and expenses are translated into U.S. dollars using weighted average exchange rates for the period. The resulting exchange gains or losses are included in the results of operations. Exchange gains and losses related to the translation of investments available for sale are included in the net unrealized appreciation (depreciation) of investments, net of deferred income taxes, as a separate component of "accumulated other comprehensive income." Assets and liabilities related to foreign operations are translated into U.S. dollars at the exchange rate in effect at the balance sheet date; revenues and expenses are translated into U.S. dollars using weighted average exchange rates for the period. Gains and losses resulting from translating foreign currency financial statements, net of deferred income taxes, are excluded from income and included as a separate component of "accumulated other comprehensive income." (I) EARNINGS PER SHARE Basic earnings per share are computed by dividing net income by the weighted average number of common shares. Diluted earnings per common share reflect the maximum dilution that would have resulted from the exercise of stock options and warrants to purchase common shares. Diluted earnings per common share are computed by dividing net income by the weighted average number of common shares and all dilutive securities. (J) STOCK-BASED COMPENSATION SFAS No. 123, "Accounting for Stock-Based Compensation" defines a fair value based method of accounting for stock-based employee compensation plans. Under SFAS No. 123, companies are encouraged, but are not required, to adopt the fair value method for all employee awards granted. Companies are permitted to account for such transactions under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," but must disclose in a note to the financial statements, pro forma net income and earnings per share as if SFAS No. 123 had been applied. The Company accounts for stock-based compensation under APB No. 25 and provides the fair value method disclosures required by SFAS No. 123. (K) CASH AND CASH EQUIVALENTS Cash and cash equivalents include cash and bank deposits with original maturities of 90 days or less. (L) ESTIMATES The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period as well as the disclosure of such amounts. Actual results could materially differ from those estimates and assumptions. (M) ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS 133). SFAS 133, which is effective in the first quarter of 2000, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other financial instruments and contracts, and for hedging activities. The Company has not completed its analysis of the expected future impact of SFAS 133. 33 3. INVESTMENTS (A) FIXED MATURITIES The amortized cost, fair value and gross unrealized gains and losses of fixed maturity investments as of December 31, 1998 and 1997 are presented in the tables below:
Gross Gross Amortized Unrealized Unrealized Fair As of December 31, 1998 Cost Gains Losses Value - ------------------------------------------------------------------------------------------------------------------------------------ U.S. dollars in thousands Corporate securities $138,447 $ 307 $ 27 $138,727 U.S. treasury securities 31,887 108 297 31,698 Mortgage-backed securities/Asset-backed securities 9,230 15 13 9,232 Obligations of states and political subdivisions 24,231 416 -- 24,647 Foreign currency debt securities 7,794 289 -- 8,083 -------- -------- -------- -------- Total $211,589 $ 1,135 $ 337 $212,387 ======== ======== ======== ======== Gross Gross Amortized Unrealized Unrealized Fair As of December 31, 1997 Cost Gains Losses Value - ------------------------------------------------------------------------------------------------------------------------------------ U.S. dollars in thousands Fixed maturities - available for sale U.S. treasury securities and obligations of U.S. government agencies and corporations $218,694 $ 173 $ -- $218,867 -------- -------- -------- -------- Total $218,694 $ 173 $ -- $218,867 ======== ======== ======== ========
(B) MATURITY DISTRIBUTION The amortized cost and fair value of fixed maturities by contractual maturity are shown in the following table:
Amortized Fair As of December 31, 1998 Cost Value - -------------------------------------------------------------------------------- U.S. dollars in thousands Fixed maturities - available for sale Due in one year or less $ 10,512 $ 10,525 Due after one year through five years 131,337 131,930 Due after five years through ten years 30,030 30,023 Due after ten years 30,480 30,677 Mortgage-backed securities/Asset-backed securities 9,230 9,232 -------- -------- Total $211,589 $212,387 ======== ========
(C) REALIZED GAINS AND LOSSES Proceeds from the sales of investments available for sale for the year ended December 31, 1998 were $445.3 million. Realized investment gains and losses for the year ended December 31, 1998 were as follows:
1998 - -------------------------------------------------------------------------------- U.S. dollars in thousands Gross realized gains $ 2,165 Gross realized losses (3) ------- Total net realized gains $ 2,162 =======
No gains or losses were realized during 1997 or 1996. 34 (D) CHANGE IN NET UNREALIZED GAINS ON INVESTMENTS
As of December 31, 1998 1997 1996 - -------------------------------------------------------------------------------- U.S. dollars in thousands Change in unrealized gains on investments, net of deferred taxes, included in other comprehensive income: Fixed Maturities $ 2,787 $ 173 $ -- Deferred taxes (172) (3) -- ------- ------- ------- Total $ 2,615 $ 170 $ -- ======= ======= =======
(E) NET INVESTMENT INCOME The components of net investment income are presented in the table below:
Years Ended December 31, 1998 1997 1996 - -------------------------------------------------------------------------------- U.S. dollars in thousands Interest on fixed maturities $ 12,813 $ 438 $ -- Interest on short-term investments 440 71 -- Interest on cash and cash equivalents 294 -- -- Other 36 141 186 -------- -------- -------- Total investment income 13,583 650 186 Investment expenses (653) (52) -- -------- -------- -------- Net investment income $ 12,930 $ 598 $ 186 ======== ======== ========
4. STRATEGIC INVESTMENTS Strategic investments represents equity investments in, and loans to, reinsurance-related enterprises, ceding companies or distribution channels that are expected to generate or secure additional profitable business for the Company. Equity investments are $2.0 million while loans totalling $3.9 million are extended to three companies. The loans bear interest at rates between 6% and 9% and are repayable between one and five years. The fair value of strategic investments approximates their carrying value. 5. MANAGEMENT FEES RECEIVABLE Management fees receivable represents management fee and related revenues that are primarily due from the reinsurers participating in the reinsurance pools and from co-reinsurers to whom a portion of the Company's gross managed premium is allocated. Management fees receivable at December 31, 1998 and 1997 consist of the following:
1998 1997 - -------------------------------------------------------------------------------- Management fees on 1997 and prior reinsurance pools $1,542 $3,259 Fees from co-reinsurers 1,062 -- Consultancy fees 560 -- ------ ------ $3,164 $3,259 ====== ======
6. DEFERRED ACQUISITION COSTS Activity in deferred acquisition costs for the years ended December 31, 1998 and 1997 is summarized as follows:
Years Ended December 31, 1998 1997 - -------------------------------------------------------------------------------- U.S. dollars in thousands Balance at January 1 $ 4,147 $ -- Acquisition costs incurred 60,192 8,840 Amortization of acquisition costs (26,714) (4,693) -------- -------- Net change in deferred acquisition costs asset 33,478 4,147 -------- -------- Balance at December 31 $ 37,625 $ 4,147 ======== ========
35 7. LOSSES AND LOSS EXPENSES Activity in the reserve for unpaid losses and loss expenses for the years ended December 31, 1998 and 1997 is summarized as follows:
Years Ended December 31, 1998 1997 - -------------------------------------------------------------------------------- U.S. dollars in thousands Balance at January 1 $ 7,846 $ -- Incurred related to: Current year 60,912 7,449 Prior year 452 -- ------- ------- Total incurred losses and loss expenses 61,364 7,449 ------- ------- Paid related to: Current year 22,568 -- Prior year 5,024 -- ------- ------- Total paid losses and loss expenses 27,592 -- ------- ------- Net balance at December 31 41,618 7,449 Plus reinsurance recoverable on incurred losses 2,761 397 ------- ------- Balance at December 31 $44,379 $ 7,846 ======= =======
8. INCOME TAXES Under current Bermuda law, the Company is not required to pay taxes in Bermuda on either income or capital gains. Provision for income taxes consists of corporate and other applicable income taxes payable in the various jurisdictions in which the Company conducts its business including Germany, Ireland, Canada and the United Kingdom. The components of income taxes for the years presented are as follows:
Years Ended December 31, 1998 1997 1996 - -------------------------------------------------------------------------------- U.S. dollars in thousands Current tax expense Bermuda $ -- $ -- $ -- Foreign 1,435 4 157 ------- ------- ------- Total current tax expense 1,435 4 157 Total deferred tax (benefit) (173) (573) (1) ------- ------- ------- Total income tax expense (benefit) $ 1,262 $ (569) $ 156 ======= ======= =======
The actual income tax expense attributable to income for the three years in the period ended December 31, 1998 is based on the statutory tax rates in the Company's taxable jurisdictions, which range from 0% to approximately 50%.
Years Ended December 31, 1998 1997 1996 - -------------------------------------------------------------------------------- U.S. dollars in thousands Computed "expected tax expense" $ -- $ -- $ (4) Tax effect of foreign taxes 1,262 (569) 160 ------ ------ ------ Total income tax expense (benefit) $1,262 $ (569) $ 156 ====== ====== ======
Deferred income taxes reflect the tax effect of the temporary differences between the value of assets and liabilities for financial statement purposes and such values as measured by the tax laws and regulations. The principal items in the net deferred income tax asset (liability) are as follows:
Years Ended December 31, 1998 1997 - -------------------------------------------------------------------------------- U.S. dollars in thousands Deferred tax assets Net operating loss carryforward $ 1,874 $ 683 Other assets 470 161 ------- ------- Gross deferred tax assets 2,344 844 Less: valuation allowance (976) -- ======= ======= Deferred tax assets after valuation allowance $ 1,368 $ 844 ------- ------- Deferred tax liabilities Unrealized investment gains (164) (46) Other liabilities (361) (10) ------- ------- Total deferred tax liabilities $ (525) $ (56) ------- ------- Net deferred tax asset $ 843 $ 788 ======= =======
Realization of the deferred tax asset is dependent on generating sufficient taxable income in the future. During 1998, the Company recorded a valuation allowance of $976 thousand to reduce its deferred tax asset to estimated realizable value. The Company has tax loss carryforwards included in the calculation of the deferred tax asset as of December 31, 1998, of $3.4 million available to offset future foreign taxable income. Such tax loss carryforwards currently do not have an expiration date. 9. RETROCESSIONS The Company utilizes retrocessional agreements to reduce its exposure to large claims and catastrophic loss occurrences. These agreements provide for recovery from retrocessionaires of a portion of the losses and loss expenses under certain circumstances. They do not discharge the primary liability of the Company. In the event retrocessionaires were unable to meet their obligations under the retrocession agreements, the Company would not be able to realize the full value of the reinsurance recoverable balances. The Company believes that it has minimized the credit risk with respect to its retrocessionaires by monitoring its retrocessionaires and diversifying its retrocessions. 36 Losses and loss expenses incurred and earned premiums as reported in the statement of operations are after deduction for retrocessions. Written and earned premiums and losses incurred for the years ended December 31, 1998 and 1997 are comprised of the following:
Years Ended December 31, 1998 1997 - -------------------------------------------------------------------------------- U.S. dollars in thousands Premiums written: Assumed $ 199,872 $ 26,143 Retroceded (4,294) (751) --------- --------- Net premiums written $ 195,578 $ 25,392 ========= ========= Premiums earned: Assumed $ 100,985 $ 13,862 Retroceded (2,144) (451) --------- --------- Net premiums earned $ 98,841 $ 13,411 ========= ========= Losses and loss expenses: Assumed $ 63,728 $ 7,846 Retroceded (2,364) (397) --------- --------- Net losses and loss expenses $ 61,364 $ 7,449 ========= =========
10. EARNINGS PER SHARE RECONCILIATION OF NUMERATORS AND DENOMINATORS The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations for income from continuing operations:
Gain Shares Per Share Year Ended December 31, 1998 (Numerator) (Denominator) Amount - ------------------------------------------------------------------------------- U.S. dollars in thousands except share and per share data BASIC EARNINGS PER SHARE Gain allocable to common shareholders $ 14,522 13,923,799 $ 1.04 Effect of dilutive securities: Class A Warrants -- 100,401 -- Class B Warrants -- 34,143 -- Director and Employee Options -- 18,100 -- DILUTED EARNINGS PER SHARE ---------- ---------- ---------- Gain allocable to common shareholders $ 14,522 14,076,443 $ 1.04 ========== ========== ==========
Gain Shares Per Share Year Ended December 31, 1997 (Numerator) (Denominator) Amount - -------------------------------------------------------------------------------- U.S. dollars in thousands except share and per share data BASIC EARNINGS PER SHARE Loss allocable to common shareholders $ (5,096) 1,238,757 $ (4.11) Effect of dilutive securities: Class A Warrants -- -- -- Class B Warrants -- -- -- Director and Employee Options -- -- -- DILUTED EARNINGS PER SHARE --------- --------- --------- Loss allocable to common shareholders $ (5,096) 1,238,757 $ (4.11) ========= ========= =========
Class A Warrants to purchase 1,381,200 common shares at $20 per share and options to purchase up to 815,428 common shares, issued at exercise prices between $14.76 and $26.50, were outstanding as of December 31, 1998. For the year ending December 31, 1997 the effect of dilutive securities was not included in the computation of diluted earnings per share as required by SFAS 128, "Earnings per Share" because, as the Company incurred a loss for the year, the effect of these securities was antidilutive. 37 11. COMMITMENTS AND CONTINGENCIES (A) EMPLOYMENT CONTRACTS The Company has entered into various employment contracts with terms of up to five years that have total minimum commitments of $7 million, excluding any performance bonuses that are determined by the Board of Directors of the Company. The contracts include various noncompete clauses following termination of employment. (B) LEASE COMMITMENTS The Company and its subsidiaries have various lease obligations. Rental expenses are amortized on the straight-line basis over the term of the lease. Total rental expense was approximately $398 thousand, $286 thousand and $295 thousand for the years ended December 31, 1998, 1997 and 1996, respectively. The future minimum commitments under operating leases and employment contracts are as follows:
Lease Employment Years Ending December 31, Commitments Commitments Total - -------------------------------------------------------------------------------- U.S. dollars in thousands 1999 $ 476 $2,514 $2,990 2000 487 2,316 2,803 2001 349 1,130 1,479 2002 72 763 835 2003 -- 253 253 ------ ------ ------ Total $1,384 $6,976 $8,360 ====== ====== ======
(C) LETTERS OF CREDIT Unsecured Letters of Credit in the amount of $23.6 million have been issued in favor of ceding companies. (D) PENSION OBLIGATIONS Certain subsidiaries are obligated to make defined contributions to pension plans for their employees. As of December 31, 1998, there was an outstanding liability for pension contributions of $207 thousand. There was no outstanding liability for pension contributions as of December 31, 1997 and 1996. Pension contribution expense was $143 thousand, $29 thousand, and $20 thousand for the years ended December 31, 1998, 1997 and 1996, respectively. 12. FIDUCIARY ASSETS AND LIABILITIES As part of its prior underwriting pool management services, the Company collects premiums and pays claims on behalf of the pool participants. In addition to fees received for the underwriting services, the Company also earns interest income on funds it is authorized to hold in accordance with the underwriting management agreements between the Company and the pool participants. The Company is authorized to retain 25% of gross premiums as a claims fund held in bank accounts having trustee status with any interest accruing to such balances being credited to the Company on a quarterly basis. 13. WARRANTS In connection with the Direct Sales, the Company issued Class A Warrants to purchase up to 1,381,200 common shares and Class B Warrants to purchase up to 1,381,200 common shares if certain performance criteria are satisfied. The Class A Warrants are vested and are exercisable at $20 per share at any time prior to December 2007. Twenty percent of the Class B Warrants are available for vesting during each of the first five years following the closing date of the IPO, and will vest only if, for any 20 consecutive trading days during the one-year vesting period, the percentage change in the market price of the common shares since the closing date of the IPO exceeds the percentage change in the Wilshire 5000 Stock Price Index by at least 500 basis points. The Class B Warrants are exercisable for a period of 10 years from the date of vesting. The exercise price per Common Share is $20 and will be reduced by $1.50 on September 1, 2001. As of December 31, 1998, 276,240 of the Class B Warrants are vested and are exercisable. For the year ended December 31, 1997, in accordance with the Emerging Issues Task Force Consensus 96-18, "Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods and Services," the Company recorded compensation expense of $3.6 million paid to a related party. This expense was reflected as a charge to the statement of operations, and as an increase to additional paid-in capital. 38 14. STOCK-BASED COMPENSATION (A) EMPLOYEE STOCK OPTION PLAN On December 12, 1997, the Company adopted the 1997 Employees Stock Option Plan (the "Stock Option Plan") under which employees of the Company and its subsidiaries are eligible to participate. The Stock Option Plan is administered by the Board of Directors. Subject to the provisions of the Stock Option Plan, the Board of Directors has sole discretionary authority to interpret the Stock Option Plan and to determine the terms and conditions of the award. The exercise price of the option will be determined by the Board of Directors when the options are granted. Options granted under the Stock Option Plan are freely assignable subject to certain limitations. The Company has reserved 2,000,000 common shares for issuance under the Stock Option Plan. As of December 31, 1998, options to purchase a total of 609,000 shares of common stock were granted to officers and employees of the Company. Options granted under the Employee Stock Option Plan vest at 25% at the date of grant and at 25% on each of the second, third and fourth anniversaries of the date of grant. All options are exercisable at fair market value of the stock at the date of the grant and expire 10 years after the date of the grant. (B) DIRECTORS' STOCK OPTION PLAN On December 12, 1997, the Company adopted the ESG Re Limited Non-management Directors' Compensation and Option Plan (the "Directors' Plan"), under which non-management directors joining the Board of Directors within one year of the closing of the Offering shall receive stock options to purchase up to 10,000 common shares. Options granted on December 12, 1997, the date of the IPO, were granted at the IPO price of $20 per share. In addition, the Directors' Plan provides for automatic annual awards of options to purchase up to 5,000 common shares (or, in each case, a lesser amount prorated to the extent the participating director did not serve on the Board of Directors for the entire year preceding the relevant annual shareholders' meeting), at an exercise price per share equal to the then market price per share to be made to non-management directors on the date of each successive annual shareholders' meeting. In addition, each non-management director will receive fees for services as a member of the Board of Directors and its committees, in amounts determined by the Board of Directors, to be paid in a combination of cash and common shares, as determined by the Board of Directors, unless otherwise elected pursuant to the terms of the Directors' Plan, as described below. In any year, in lieu of such stock and cash payment, a Director may elect to receive all or a portion of such fees in options or to defer all or a portion of such fees. If a director elects to receive options, the director will receive options for common shares equal to two times the fees that would otherwise be payable. If the director elects to defer the receipt of the fees, he will receive deferred compensation indexed to the greater of (i) the total return on the common shares; or (ii) the one-year U.S. Treasury bill rate. Deferred compensation will be paid in cash at the time elected by the directors in accordance with the terms of the Directors' Plan. Shares granted under the Directors' Plan will be nontransferable for six months after receipt. The Company has reserved 1,000,000 common shares for issuance under the Directors' Plan. All non-management directors have elected to receive their fees as options to purchase shares. As a result, a total of 206,428 shares of common stock have been granted as stock options as of December 31, 1998. Compensation expense of $347 thousand and $39 thousand was recorded for the years ending December 31, 1998 and 1997, respectively. Options granted under the Directors' Plan vest 100% at the date of grant. All options are exercisable at fair market value of the stock at the date of grant and expire 10 years after the date of grant. A summary of the status of the Company's outstanding stock options as of December 31, 1998 and 1997 is presented below:
1998 1997 -------------------------- ---------------------------- Weighted Average Weighted Average Shares Exercise Price Shares Exercise Price - ------------------------------------------------------------------------------------------------------------------------------------ Outstanding at January 1 469,714 $ 20.00 -- -- Granted 355,214 $ 24.50 469,714 $ 20.00 Exercised -- -- -- -- Forfeited (9,500) $ 25.13 -- -- ------- ------- -------- ------- Outstanding at December 31 815,428 $ 21.90 469,714 $ 20.00 ------- ------- -------- ------- Options exercisable at December 31 358,678 $ 22.37 189,214 $ 20.00 ------- ------- -------- ------- Average fair value of options granted during the year $ 6.73 $ 7.00 ======= =======
The fair value of each option grant was estimated using the Black/Scholes option pricing model with the following assumptions: (i) dividend yield of 1.74%; (ii) expected volatility of 35%; (iii) risk-free rate of 4.8%; and (iv) expected life of 8 years. Had the compensation expense for the Company's stock-based compensation plans been determined based on the fair value at the grant dates for awards under those plans consistent with the method described in SFAS No. 123, the Company's net income and earnings per share would have been adjusted to the pro forma amounts indicated below:
Years Ended December 31, 1998 1997 - -------------------------------------------------------------------------------- U.S. dollars in thousands except share and per share data Net gain (loss) As reported $ 14,522 $ (5,096) Pro forma 12,526 (5,409) ---------- --------- Earnings (loss) per share As reported $ 1.04 $ (4.11) Pro forma 0.90 (4.37) ========== =========
15. RELATED PARTIES In 1997, the Company entered into an agreement with Head Asset Management L.L.C. ("Head Asset Management"), an affiliate of Head & Company L.L.C. ("Head Company"), relating to the provision of investment management services. The Chairman of the Board of Directors is a Managing Member of Head Company. Pursuant to this agreement, which is subject to the Company's investment guidelines and other restrictions, the Company will pay Head Asset Management a fee equal to the sum of (i) 0.25% per annum of the first $200 million of assets under management; and (ii) 0.15% per annum of assets under management in excess of $200 million. The Company incurred expenses of $549 thousand and $45 thousand under this agreement for the years ended December 31, 1998 and 1997, respectively. In 1997, Head Company provided support and assistance in connection with the planning, structuring and formation of the Company, as well as capital raising in connection with the Direct Sales and IPO. For advisory services rendered by Head Company, the Company incurred fees and expenses of $2.7 million of which $2.5 million was paid in January 1998. These expenses are reflected as a reduction of additional paid-in capital. In January 1998, the Company entered into an agreement with Head Company to provide financial advisory services as required by the Company for a monthly fee of $50 thousand. Under this agreement, the Company incurred fees and direct expenses of $378 thousand. The agreement was terminated in the second quarter of 1998. Certain former shareholders of ESG Germany who participated in the Formation have agreed to indemnify ESG Germany for certain contingent liabilities applicable to activity prior to 1997. Management believes that the likelihood of incurring a loss related to any of those contingent liabilities is remote. 16. SEGMENT INFORMATION SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," requires that an enterprise disclose information about its operating segments. The Company considers its reinsurance activities to constitute a single operating segment on the basis that such activities are monitored and evaluated primarily on a companywide basis. Investments are held in support of reinsurance activities and are considered to be a part of this single segment. However, the following table provides summary financial information by the Company's lines of business and geographic regions. Revenues are allocated geographically on the basis of the location of the legal entity that retains the reinsurance risk.
Personal Special Year Ended December 31, 1998 Medical Accident Risk Credit Life Total - ------------------------------------------------------------------------------------------------------------------------------------ U.S. dollars in thousands Gross premiums written $ 119,157 $ 52,254 $ 5,120 $ 12,346 $ 10,995 $ 199,872 Net premiums written 117,353 50,814 4,943 11,910 10,558 195,578 Net premiums earned 40,875 46,038 2,571 4,856 4,501 98,841 Losses and loss expenses 24,646 29,003 859 3,448 3,408 61,364 Acquisition costs 14,241 10,207 906 837 523 26,714 Operating costs 3,584 4,036 228 420 534 8,802 --------- --------- --------- --------- --------- --------- Net underwriting income (loss) $ (1,596) $ 2,792 $ 578 $ 151 $ 36 $ 1,961 ========= ========= ========= ========= ========= ========= Personal Special Year Ended December 31, 1998 Medical Accident Risk Credit Life Total - ------------------------------------------------------------------------------------------------------------------------------------ U.S. dollars in thousands Gross premiums written $ 9,989 $ 9,357 $ 396 $ 6,401 $ -- $ 26,143 Net premiums written 9,937 8,723 376 6,356 -- 25,392 Net premiums earned 5,964 3,778 243 3,426 -- 13,411 Losses and loss expenses 3,624 1,907 139 1,779 -- 7,449 Acquisition costs 2,099 1,303 85 1,206 -- 4,693 --------- --------- --------- --------- --------- --------- Net underwriting income $ 241 $ 568 $ 19 $ 441 $ -- $ 1,269 ========= ========= ========= ========= ========= ========= Years Ended December 31, 1998 1997 - ------------------------------------------------------------------------------------------------------------------------------------ U.S. dollars in thousands Revenue earned: Bermuda $ 43,839 $ 13,763 Ireland 59,281 -- Germany 8,812 3,989 Other 3,895 87 --------- --------- Total revenue earned $ 115,827 $ 17,839 ========= =========
39 17. SIGNIFICANT CLIENTS For the year ended December 31, 1998, one significant client relationship contributed $25.1 million to total revenue. For the year ended December 31, 1997, three significant client relationships contributed $3.6 million, $2.6 million and $2.4 million to total revenue. For the year ended December 31, 1996, one client contributed $774 thousand. 18. STATUTORY REQUIREMENTS AND DIVIDEND RESTRICTIONS Under Bermuda law, the Company is prohibited from declaring or paying a dividend if such payment would reduce the realizable value of its assets to an amount less than the aggregate value of its liabilities, issued share capital (common share capital) and share premium (additional paid-in capital) accounts. Under the Bermuda Insurance Act, 1978, amendments thereto and Related Regulations, ES Bermuda is required to maintain certain measures of solvency and liquidity. For the years ended December 31, 1998 and 1997, these requirements have been met. The statutory capital and surplus of ES Bermuda was $137.1 million and $101.5 million and the minimum required statutory capital and surplus was $8.7 million and $4.1 million as of December 31, 1998 and 1997, respectively. The minimum required level of liquid assets was $55.2 million and $22.3 million with actual liquid assets of $210.7 million and $81.1 million as of December 31, 1998 and 1997, respectively. 19. YEAR 2000 ISSUE The Year 2000 Issue relates to the ability of computer systems to properly interpret date information for the year 2000 and beyond. In January 1998, the Company initiated an enterprise-wide project to address Year 2000 issues with respect to the Company's computer software and information technology systems. The initiative has as its focus two distinct areas that include Year 2000 compliance of the Company's software, systems and technology platforms and the evaluation of the Year 2000 preparedness of significant third parties with whom the Company conducts business, including vendors and customers. The Company has substantially completed its assessment of Company software and systems and has adopted a plan to implement compliant components and to develop a disaster recovery plan, targeted to be substantially complete by the end of the second quarter 1999. The Company estimates that through December 1998, the remediation and validation efforts are approximately 60% complete, with immaterial incremental costs incurred thus far as a result of usage of internal staff. Remaining testing and conversion efforts also are expected to be conducted primarily by internal staff; however, limited third-party assistance during the first two quarters of 1999 may be utilized. No significant third-party costs are anticipated. Future costs of remediation are not expected to have a material impact on the Company's financial position, results of operations or cash flows, although no assurance can be given in this regard. The Company's systems do not interface electronically with those of its customers or clients. As such, the Company's exposure to the Year 2000 Issue with respect to customers and clients is limited to the possibility that information supplied by these companies could not be of sufficient quality or timeliness and therefore could indirectly affect the quality or timeliness of the Company's own data. The Company is currently communicating with its significant clients and service providers to assess their vulnerability and readiness to comply with Year 2000 issues and will address compliance risks with each new significant vendor. 40 20. UNAUDITED QUARTERLY FINANCIAL DATA
1998 Operating Data: First Quarter Second Quarter Third Quarter Fourth Quarter - ------------------------------------------------------------------------------------------------------------------------------------ U.S. dollars in thousands except per share data Net premiums written $ 84,156 $ 19,526 $ 53,915 $ 37,981 Net premiums earned 23,219 18,090 26,134 31,398 Management fee revenue 970 229 181 514 Net investment income 3,020 3,211 3,359 3,340 Losses and loss expenses 15,642 11,340 15,940 18,442 Acquisition costs 5,270 4,434 7,324 9,686 Underwriting profit 2,307 2,316 2,870 3,270 Net income (loss) 3,251 3,247 3,994 4,030 ========== ========== ========== ========== Earnings per common share: Basic net income (loss) per share $ 0.23 $ 0.23 $ 0.29 $ 0.29 Diluted net income (loss) per share 0.23 0.23 0.29 0.29 Weighted average shares outstanding (000's): Basic 13,924 13,924 13,924 13,924 Diluted 14,374 14,231 13,925 13,926 1997 Operating Data: First Quarter Second Quarter Third Quarter Fourth Quarter - ------------------------------------------------------------------------------------------------------------------------------------ U.S. dollars in thousands except per share data Net premiums written $ -- $ -- $ -- $ 25,392 Net premiums earned -- -- -- 13,411 Management fee revenue 2,378 217 356 879 Net investment income -- 15 6 577 Losses and loss expenses -- -- -- 7,449 Acquisition costs -- -- -- 4,693 Underwriting profit -- -- -- 1,269 Net income (loss) $ 450 $ (252) $ (310) $ (4,984) ========== ========== ========== ========== Earnings per common share: Basic net income (loss) per share $ 2.50 $ (1.40) $ (0.40) $ (1.32) Diluted net income (loss) per share 2.50 (1.40) (0.40) (1.32) Weighted average shares outstanding (000's): 180 180 783 3,778 ---------- ---------- ---------- ---------- Total
41 ESGRe Limited INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders of ESG Re Limited We have audited the accompanying consolidated balance sheets of ESG Re Limited and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, comprehensive income, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company and its subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with accounting principles generally accepted in the United States of America. DELOITTE & TOUCHE Chartered Accountants Hamilton, Bermuda March 8, 1999 ESGRE LIMITED CORPORATE DIRECTORY 53 42 BOARD OF DIRECTORS EXECUTIVE AND SENIOR MANAGEMENT JOHN C HEAD III(a) Chairman of the Board Managing Member Head & Company L.L.C. New York, New York WOLFGANG M. WAND Managing Director and Chief Executive Officer ESG Re Limited Hamilton, Bermuda STEVEN H. DEBROVNER Chief Underwriting and Marketing Officer ESG Re Limited Hamilton, Bermuda KENNETH P. MORSE Managing Director MIT Entrepreneurship Center and Senior Lecturer MIT Sloan School of Management Cambridge, Massachusetts DAVID L. NEWKIRK(a),(b) Vice President Booz-Allen & Hamilton International (U.K.) Ltd. London, England WILLIAM J. POUTSIAKA(b) President and Chief Executive Officer Arkwright Mutual Insurance Company Waltham, Massachusetts EDWARD A. TILLY(a),(b) Former Chairman and Chief Executive Consolidated Financial Insurance Group, Ltd. London, England ESG RE LIMITED WOLFGANG M. WAND Managing Director and Chief Executive Officer STEVEN H. DEBROVNER Chief Underwriting and Marketing Officer JOAN H. DILLARD Chief Financial Officer MICHAEL S. NUENKE Treasurer CORMAC G. TREACY Controller MARGARET L. WEBSTER General Counsel and Secretary ACCENT EUROPE INSURANCE COMPANY EDEL M. BOLGER Managing Director ES ASIA PACIFIC DARRYL S. GUMM Vice President ES LATIN AMERICA RAFAEL LA-ROTTA President ES NORTH AMERICA RENATE M. NELLICH President and Chief Executive Officer ES RUCKVERSICHERUNG DR. JUR. FRANZ GORI Executive Director GERHARD JURK Executive Director ESG U.K. ANDREW W. APPS Managing Director SPORTSECURE PATRICK GORLING Managing Director (a) Member of the Compensation Committee (b) Member of the Audit Committee 43 ESGRE LIMITED BOARDS OF DIRECTORS, MAJOR SUBSIDIARY COMPANIES EUROPEAN SPECIALTY REINSURANCE (BERMUDA) LIMITED WOLFGANG M. WAND Member of the Board ADRIAN LEE-EMERY Member of the Board EUROPEAN SPECIALTY REINSURANCE (IRELAND) LIMITED WOLFGANG M. WAND Member of the Board WILLIAM A. QUIRKE Member of the Board MICHAEL J. WALSH Member of the Board ACCENT EUROPE INSURANCE COMPANY LIMITED EDEL M. BOLGER Member of the Board DR. JUR. FRANZ GORI Member of the Board PATRICK GORLING Member of the Board WILLIAM A. QUIRKE Member of the Board MICHAEL J. WALSH Member of the Board EUROPEAN SPECIALTY GROUP (UNITED KINGDOM) LIMITED ANDREW W. APPS Managing Director, U.K. EUROPEAN SPECIALTY Group Holding AG WOLFGANG M. WAND Chairman YVES FORESTIER Member of the Board HARALD HERMANN Member of the Board EUROPEAN SPECIALTY RUCKVERSICHERUNG AG DR. JEAN CLAUDE MAYOR Chairman DR. JUR. HANS MOSER Deputy Chairman JURGEN GORLING Member of the Board Design by Addison www.addison.com This annual report was printed on recycled paper. ESGRE LIMITED SHAREHOLDER INFORMATION SHAREHOLDERS MEETING The Annual General Meeting will be held on May 7, 1999 at 11:00 a.m. at the Waterloo House, 100 Pitts Bay Road, Pembroke, Bermuda. INDEPENDENT ACCOUNTANTS Deloitte & Touche Corner House Church & Parliament Streets Hamilton, Bermuda COUNSEL PAUL, WEISS, RIFKIND, WHARTON & GARRISON 1285 Avenue of the Americas New York, New York APPLEBY, SPURLING & KEMPE Cedar House 41 Cedar Avenue Hamilton, Bermuda MARKET INFORMATION ESG Re Limited common shares are traded over the counter on the Nasdaq National Market under the symbol ESREF. STOCK TRANSFER AND DIVIDEND AGENT State Street Bank & Trust Company c/o Equiserve P.O. Box 8200 Boston, Massachusetts 02266-8200 Shareholder inquiries (800) 426-5523 ADDITIONAL INFORMATION ESG Re's Annual Report on Form 10-K, as filed with the Securities and Exchange Commission, is available upon request by writing to the Chief Financial Officer at the Corporate Headquarters in Bermuda. 55 44 ESG RE LIMITED ESG RE LIMITED 16 Church Street Hamilton, HM 11, Bermuda Telephone (1 441) 295 2185 Telefax (1 441) 292 1143 EUROPEAN SPECIALTY REINSURANCE (BERMUDA) LIMITED 16 Church Street Hamilton, HM 11, Bermuda Telephone (1 441) 295 2185 Telefax (1 441) 292 1143 EUROPEAN SPECIALTY REINSURANCE (IRELAND) LIMITED 3rd Floor, 12/13 Exchange Place I.F.S.C., Dublin 1 Telephone (353 1) 612 6550 Telefax (353 1) 612 6560 ACCENT EUROPE INSURANCE COMPANY LIMITED 12/13 Exchange Place I.F.S.C., Dublin 1 Telephone (353 1) 612 6580 Telefax (353 1) 612 6560 EUROPEAN SPECIALTY RUCKVERSICHERUNG AG Stadthausbrucke 1-3 Hamburg, 20355 Germany Telephone (49 40) 36 98 860 Telefax (49 40) 36 98 86 69 EUROPEAN SPECIALTY (NORTH AMERICA) LIMITED 141 Adelaide Street West Toronto, M5H 3L2, Canada Telephone (1 416) 864 7443 Telefax (1 416) 864 9615 EUROPEAN SPECIALTY ASIA PACIFIC PTY LIMITED Suite 2001, 20th Floor Australia Square 264 George Street Sydney 2000, Australia Telephone (61 2) 92 51 5205 Telefax (61 2) 92 41 7000 EUROPEAN SPECIALTY GROUP (UNITED KINGDOM) LIMITED 25-26 Lime Street London, EC3M 7HR, England Telephone (44 171) 220 7422 Telefax (44 171) 220 7593 EUROPEAN SPECIALTY LATIN AMERICA, INC. 1320 S. Dixie Highway Suite 375 Coral Gables, Florida 33146 Telephone (305) 668 5102 Telefax (305) 668 5104 SPORTSECURE INSURANCE BROKERS GMBH Stadthausbrucke 1-3 Hamburg, 20355 Germany Telephone (49 40) 36 98 86 91 Telefax (49 40) 36 98 86 92 56 EX-24.1.B 3 INDEPENDENT AUDITORS' CONSENT 1 EXHIBIT 24.1(B) INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statements of ESG Re Limited on Form S-8 (File No. 333-40341) and Form S-3 (File No. 333-69519) of our report dated March 8, 1999, appearing in and incorporated by reference in this Annual Report on Form 10-K of ESG Re Limited for the year ended December 31, 1998. Deloitte & Touche Chartered Accountants Hamilton, Bermuda March 31, 1999 20 EX-27 4 FINANCIAL DATA SCHEDULE
7 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE CONSOLIDATED BALANCE SHEETS AND CONSOLIDATED FINANCIAL STATEMENTS OF OPERATIONS AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 12-MOS DEC-31-1998 JAN-01-1998 DEC-31-1998 212,387 0 0 0 0 0 218,304 16,942 2,761 37,625 466,373 44,379 111,884 0 0 0 0 0 13,924 230,917 466,373 98,841 12,930 2,162 1,894 61,364 26,714 0 15,784 1,262 14,522 0 0 0 14,522 1.04 1.03 7,846 63,673 452 22,568 5,024 44,379 0
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