-----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, Bp6VIWcv+a+Xu8B7uu2PKCI0zj5Cc+xz2Bx5CuTpdYkAeP74AbBSOGHHxbuMTi1g O9e5NG90q/k7e/fK0EOu+w== 0001005477-98-001051.txt : 19980401 0001005477-98-001051.hdr.sgml : 19980401 ACCESSION NUMBER: 0001005477-98-001051 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980331 SROS: NASD 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: 98582962 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-K - -------------------------------------------------------------------------------- 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, 1997 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.) incorporation 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: None 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 20, 1998, was $316,396,896.70 based on the closing price of $26.125 on that date. The number of the Registrant's common shares (par value $1.00 per share) outstanding as of March 20, 1998, was 13,923,799. Documents Incorporated by Reference: Certain portions of the Annual Report to Shareholders for 1997 (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 1998 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, 1997, are incorporated by reference in Part III of this Form 10-K. 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 for its own account risks that its wholly owned reinsurance management subsidiary, ES Management, previously underwrote on behalf of unaffiliated reinsurance companies. Subsequent to the Offerings, ESG Re assumed a 30% share of the pool business which ES Management underwrote in 1997 on behalf of other reinsurance companies (the "Pool Participants"). In addition, the Company separately negotiated additional retrocessions with certain Pool Participants. The Company distinguishes itself by offering "intelligent reinsurance" products and services for particular underwriting problems (including software developed by reinsurance and healthcare professionals to predict the severity of medical conditions based on current diagnoses), 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, particularly in Western Europe; (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. 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: 2 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 working closely with primary insurers and insureds to implement loss control techniques. The Company intends to (i) introduce and implement managed care techniques in Germany, Spain, Italy and other 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 World Cup Soccer, 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 intends to assume responsibility for 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 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. Standing as a Specialist Lead Reinsurer The Company believes that its reputation as a specialist lead reinsurer and its substantial capitalization will qualify it to be included on the security lists of major reinsurance brokers and ceding clients and, as a result, will be presented with lead and participation risk opportunities not previously available to the Company in its previous function as a reinsurance management company. Management expects that ES Management's profitable underwriting history on behalf of unaffiliated reinsurance companies will give ESG Re opportunities to participate in additional reciprocal reinsurance programs with its current reinsurance partners as well as with new reinsurers in strategic alliances. The Company generally showed operating losses in its previous function as an underwriting management company as a result of the expense of initial system development and, in 1996 and 1997, due to charges relating to the Company's reorganization to become a reinsurer. The Company believes that its losses as a reinsurance management company are not indicative of its future performance as a reinsurer and will not adversely affect the Company's ability to attract ceding clients. 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, 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 public health sector is undergoing rapid changes, attributable in part to health reform legislation recently enacted by the German parliament. ESG Re believes these changes will lead to greater demand for health reinsurance. 3 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 for its own account in 1997 totaled $26.1 million. The breakdown of gross premiums written for the year ended December 31, 1997 by major lines of business was as follows: 1997 Gross Premiums Written Medical Expense ................................. 38% Personal Accident and Disability ................ 36 Credit/Life ..................................... 24 Special Risk .................................... 2 --- 100% === 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 usually underwrites risk only concurrently with the implementation of the Company's loss control measures and underwriting support systems. ESG Re focuses on underwriting high net worth individuals, frequent travelers and expatriates, with less emphasis on underwriting volume group business. 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 requires 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 implements 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. As part of the intelligent reinsurance concept, ESG Re has developed a complete software package, which includes medical tarification, policy issuance, portfolio management and claims handling. An advanced clinically driven loss prevention and early warning software program called EcuQuest is integrated into the Company's system. EcuQuest, for which ESG Re acquired the license rights outside North America, was developed by a subsidiary of Swiss Re Life & Health/The Mercantile & General Life Reinsurance Company Limited and enables the Company to equip ceding clients with clinically driven data management for the early identification of potential shock losses or disease developments. 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 4 markets, like Germany, and less developed markets with high growth potential, like Latin America, the CIS, Eastern Europe and Asia. In Bulgaria, ES Management and Bulstrad, the leading Bulgarian insurer, created the first national health care policy which is modeled on international private healthcare standards. Personal Accident and Disability 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 is reluctant to solicit business through nonlocal brokers or to conduct business in areas in which it does not have 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. In this market, the Company seeks to avoid single premium coverage where it cannot vary terms annually. ES Management has considerable experience underwriting credit/life reinsurance in the American, French and Scandinavian markets. The Company will seek to enter the German and selected 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 the Eastern European and CIS 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 character, such as sports disabilities, sports and entertainment contingency, non-appearance, cancellation and abandonment. For example, for the 1998 World Cup Soccer Tournament, ES Management through its affiliate SportSecure GmbH controlled the largest contingency insurance risk ever arranged in the global market. 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 such as Ziegfried & Roy and the Holiday on Ice events. Underwriting Consistent with ES Management's past practices, 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 has been demonstrated to date by the Company's underwriting performance, with an average pro forma combined loss and acquisition expense ratio of 91% over the last four years. ESG Re's products and services also serve to enhance the persistency of the portfolio, which in turn supports long-term profitability. Persistency, as measured by renewal premium compared to the prior twelve months, has been excellent, with an average of 86% for the last three renewal seasons. With an emphasis on underwriting profitability, the Company has canceled contracts with ceding companies when underwriting profits were not in line with expectations. 5 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 historical loss experience to industry averages, as well as the perceived financial strength of the cedent. Over time, the Company has developed its own underwriting manuals that serve as a detailed 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 life time 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 $1 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 co-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. The Company, therefore, believes that its exposure to incurred but not reported ("IBNR") losses after it begins reinsuring for its own account should be less than that of its competitors. 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 through 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 improve the claims performance of a ceding client which might not always be sufficiently experienced in dealing with complex issues. The Company performs regular 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 6 at a realistic and timely methodology to evaluate risk exposure. The Company has begun to conduct a portion of the audits electronically by directly linking EcuQuest technology into the Company's operations and expects to offer this service to a majority of its customers in 1998. Operations The Company has structured its 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. The Company's recently introduced management and underwriting information system, Open Co, provides a current database for individual and general risk assessment. 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. In its previous function as a reinsurance management company, the Company had not been required to establish reserves for losses and loss expenses to date, although it recommended appropriate levels for such reserves for its reinsurance customers. The reserve for losses and loss expenses established by the Company include reserves for unpaid reported losses and loss expenses and for IBNR losses. Such reserves are estimated by management based upon reports received from ceding clients, supplemented by the Company's estimates of reserves for which ceding client reports have not been received and its historical experience. To the extent that the Company's own historical experience is not sufficient for estimating reserves, such estimates may be actuarially determined based upon industry experience and management's judgment. The estimates will be continually reviewed and reflected in current operations as adjustments to reserves become necessary. Loss reserves represent estimates of what an insurer or reinsurer ultimately expects to pay on claims at a given time, based on facts and circumstances then known, and it is possible that the ultimate liability may exceed or be less than such estimates. The estimates are not precise in that, among other things, they are based on predictions of future developments and estimates of future trends in claim severity and other variable factors such as inflation. During the loss settlement period, it often becomes necessary to refine and adjust the estimates of liability on a claim either upward or downward. Even after such adjustments, ultimate liability may exceed or be less than the revised estimates. The estimation of reserves by new reinsurers, such as the Company, may be inherently less reliable than the reserve estimations of a reinsurer with a stable volume of business and an established loss history. Investments As of December 31, 1997, the Company's cash and invested assets totaled $237.0 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 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 7 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 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 Company invests only in securities rated A or better. 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 equity securities, although it may do so in the future in order to support its core business with strategic investments. 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 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 natural foreign exchange hedge so that resulting foreign exchange rate gains and losses can be reduced to the extent assets equal liabilities. 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 personal and special risk reinsurance (allowing specialized risk solutions from one source). Employees As of December 31, 1997, the Company had 39 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 at the principal office of the insurer for a period of five years. 9 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 or loss reserves prepared by the approved loss 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 grounds for believing that (i) ESG Re will be able to pay its debts as they fall due after payment of a 10 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 one of the Company's subsidiaries, ES Ireland. 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 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. 11 European Union The European Communities (Insurance Undertakings: Accounts) Regulations 1996 (the "1996 Regulations") apply both to direct insurance companies and reinsurance companies (but not reinsurance management companies, such as the Company in its previous function), and provide that reinsurers must calculate their reserves and value the assets representing them on the same basis as direct insurance underwriters. Technical reserves consist of the aggregate provisions for outstanding claims (including those incurred but not yet reported at the end of the Company's financial year). The 1996 Regulations set out the detailed requirements for the preparation of the accounts of insurance and reinsurance underwriters. The 1996 Regulations also require insurance and reinsurance underwriters to demonstrate that they possess sufficient free assets to cover a safety margin, that is financial resources exceeding those necessary to cover the technical reserves. United States and Other The Company is not admitted to do business in any jurisdiction except Bermuda, Ireland and Germany. 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 leases office space in Bermuda, Dublin, Hamburg, Toronto and London. The Company does not own any real property. 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 Prior to the initial public offering, the Company's shareholders took action at two General Meetings of Shareholders and twice by written resolution. The first Annual General Meeting of Shareholders of the Company was held on August 21, 1997. The shareholders approved the bye-laws of the Company, and John C Head III and Wolfgang M. Wand were elected to fill two directorships. The shareholders appointed Deloitte & Touche, Bermuda, to serve as the Company's auditors until the close of the next Annual General Meeting of Shareholders of the Company. A special meeting of the shareholders of the Company was held on September 20, 1997. The shareholders resolved that the Company's authorized share capital be increased to $250,000,000 consisting of: 100,000,000 Common Shares, par value $1.00 per share; 100,000,000 Class B Common Shares, par value $1.00 per share; and 50,000,000 Preference Shares, par value $1.00 per share. On December 2, 1997, the shareholders acted by unanimous written resolution to set the size of the Board of Directors between 5 and 15, as the Board of Directors may from time to time determine. The shareholders elected, in the classes set forth below, the following directors: 12 Class 1 John C Head III, Wolfgang M. Wand Class 2 Gerhard Jurk*, William J. Poutsiaka Class 3 Edward A. Tilly, David L. Newkirk * Mr. Jurk has since resigned his directorship. On December 3, 1997, the shareholders took action by unanimous written resolution. The shareholders resolved to purchase and cancel for nil consideration the 12,000 common shares of the Company that were outstanding on December 3, 1997. The shareholders adopted new bye-laws, providing for a staggered Board of Directors divided into three classes and authorizing the Board of Directors to fill any remaining vacancies on the Board. The shareholders approved the Company's 1997 Stock Option Plan and the Company's Non-Management Directors' Compensation and Option Plan. ITEM 5. MARKET FOR COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Sales of Unregistered Securities The Company was incorporated in August 1997 under the laws of Bermuda. On August 21, 1997, the Company issued 6,000 of its common shares to ESG Partners (Bermuda) L.P. (then known as Head Insurance Investors IX (Bermuda) L.P.), and 3,000 each to Gerhard Jurk and Wolfgang M. Wand. The General Partner of ESG Partners (Bermuda) L.P. is an affiliate of Head & Company L.L.C. ("Head Company"). Such securities were sold in a private placement outside the United States and therefore are exempt from registration under the Securities Act pursuant to Section 4(2) thereof. These securities were retired prior to Formation. On December 2, 1997, the Company issued 900,000 common shares in exchange for all of the outstanding capital stock of European Specialty Group (United Kingdom) Limited ("ESG UK"). Such securities were sold in a private placement outside the United States and therefore are exempt from registration under the Securities Act pursuant to Regulation S under the Securities Act. The Company issued 900,000 Common Shares in exchange for all of the outstanding capital stock of ESG UK. At the time of this exchange, European Specialty Group Holding AG was a wholly owned subsidiary of ESG UK. On December 3, 1997, certain affiliates of Head & Company L.L.C. (the "Head Group") and certain other investors severally purchased for investment directly from the Company (i) an aggregate of 2,673,799 Common Shares, (ii) Class A Warrants to purchase up to 1,247,284 Common Shares, and (iii) in the case of the Head Group, Class B Warrants to purchase up to 1,247,284 Common Shares (if certain performance criteria were satisfied), at an aggregate price equal to 2,673,799 multiplied by the initial public offering price per Common Share less the underwriting discounts and commissions. Use of Proceeds In December 1997 the Company was capitalized with gross proceeds of $257 million from the Offerings. The proceeds were used to capitalize ES Bermuda, ES Ireland and ES Germany with $55 million, $50 million, and $12 million, respectively. The Company also incurred expenses of the Offerings of approximately $25 million and repaid its outstanding debt, principally loans from shareholders and bank demand borrowings, of $3.5 million. The remainder of the proceeds not allocated to the operating reinsurance subsidiaries is being held until such time as the implementation of the Company's strategic plan requires those funds. 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 since December 12, 1997 were as follows: 13 High Low ------ ----- From December 12 to December 31, 1997: $23.88 $21.50 Number of Record Holders of Common Stock The number of record holders of the common stock of the Company as of March 20, 1998 was 32. 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 Common shareholders of record on March 28, 1998. 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 Not applicable. 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. 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. 14 Name Age Position Wolfgang M. Wand................... 45 Managing Director and Chief Executive Officer Steven H. Debrovner................ 60 Chief Operating Officer Gerhard Jurk....................... 49 Chief Financial Officer Renate M. Nellich.................. 59 Chief Executive Officer of ES North America Anthony Parfitt.................... 31 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. Gerhard Jurk has been Chief Financial Officer of ES Management since 1996. 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. 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 is a Director of Avandel Healthcare, Inc. Ms. Nellich has more than 25 years of experience in the North American life and health insurance industry. Anthony Parfitt has been Assistant Managing Director of ESG Germany since 1995 and was the 15 technical account manager in 1994. From 1991 to 1994 Mr. Parfitt was the head of the International Risk Placement Department of the predecessor of ESG Germany. 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 1997 Annual Report to Shareholders the following consolidated financial statements of the Company: 1997 Annual Report to Shareholders (Page) ------------------ Independent Auditors' Report 53 Consolidated Balance Sheets as of December 31, 28 1997 and 1996 Consolidated Statements of Operations for the years 29 ended December 31, 1997, 1996 and 1995 Consolidated Statements of Changes in 30 Shareholders' Equity for the years ended December 31, 1997, 1996 and 1995 Consolidated Statements of Cash Flows for the years 31 ended December 31, 1997, 1996 and 1995 16 Consolidated Statements of Comprehensive Income 32 for the years ended December 31, 1997, 1996 and 1995 Notes to the Consolidated Financial Statements for the years ended December 31, 1997, 1996 and 1995 33 In addition, "Management's Discussion and Analysis of Financial Condition and Results of Operations" begins on page 21 of the 1997 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 Bonds: U.S. Government and government agencies $218,694 $218,867 $218,867 ----------------------------------- Total fixed maturities - available for sale 218,694 218,867 218,867 Short-term investments 11,913 11,913 11,913 Cash and cash equivalents 6,196 6,196 6,196 ----------------------------------- Total investments and cash $236,803 $236,976 $236,976 ===================================
Schedule III - Supplementary Insurance Information (Dollars in thousands)
Unpaid Paid Amortization Deferred Losses and Net Net Losses of Deferred Other Net Acquisition Loss Unearned Premiums Investment and Loss Acquisition Operating Premiums Segment Costs Expenses Premiums Earned Income Expenses Costs Expenses Written - ----------------- ---------- ---------- ---------- ---------- ----------- --------- ------------ --------- --------- December 31, 1997 Bermuda $4,147 $7,846 $12,168 $13,411 $598 $ -- $4,693 $11,362 $25,392 ---------------------------------------------------------------------------------------------------------- $4,147 $7,846 $12,168 $13,411 $598 $ -- $4,693 $11,362 $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, 1997 Total premiums earned $ -- $451 $13,862 $13,411 103% ======================================================== 17 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., 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 1997 Annual Report to Shareholders 22.1* Subsidiaries of the Registrant 24.1(a) Independent Auditors' Report of Deloitte & Touche 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. (b) Reports on Form 8-K. The Company did not file any reports on Form 8-K during the period from August 21, 1997, to December 31, 1997. 18 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, 1998. ESG RE LIMITED By: /s/ GERHARD JURK --------------------- Name: Gerhard Jurk 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, 1998 Chief Executive Officer and Director /s/ STEVEN H. DEBROVNER - --------------------------- Steven H. Debrovner Chief Operating Officer March 30, 1998 and Director /s/ GERHARD JURK - --------------------------- Gerhard Jurk Chief Financial Officer March 30, 1998 /s/ JOHN C HEAD III - --------------------------- John C Head III Chairman of the Board March 30, 1998 /s/ KENNETH P. MORSE - --------------------------- Kenneth P. Morse Director March 30, 1998 /s/ DAVID L. NEWKIRK - --------------------------- David L. Newkirk Director March 30, 1998 /s/ WILLIAM J. POUTSIAKA - --------------------------- William J. Poutsiaka Director March 30, 1998 /s/ EDWARD A. TILLY - --------------------------- Edward A. Tilly Director March 30, 1998 19 EX-10.9 2 FORM OF NON-MANAGEMENT DIRECTORS' COMPENSATION Exhibit 10.9 Form of Non-Management Directors' Compensation and Option Plan ESG Re Limited Non-Management Directors' Compensation and Option Plan Stock Option Agreement STOCK OPTION AGREEMENT, dated as of December 12, 1997, between ESG Re Limited (the "Company"), and [Optionee] (the "Optionee"), a non-employee director of the Company. The ESG Re Limited Non-Management Directors' Compensation and Option Plan (the "Plan") provides for awards of options to directors of the Company who are not full time employees of the Company and for such awards to be evidenced by an individual agreement ("Agreement") with such terms and provisions not inconsistent with the Plan as the Board of Directors (the "Board") shall provide. Capitalized terms defined in the Plan and not otherwise defined herein shall have the meaning given such terms in the Plan. In consideration of the foregoing and of the mutual undertakings set forth in this Agreement, the Company and the Optionee agree as follows: SECTION 1. Grant of Option. In accordance with Section 6 of the Plan, the Company hereby grants to the Optionee an option (the "Option") to purchase a total of ___________ shares of Common Stock, at an exercise price equal to $20.00 per share, on the terms and conditions provided in the Plan and in this Agreement. The Company urges you to consult with your own advisor as to the tax and other consequences of the Option. SECTION 2. Vesting and Exercisability. 2.1 The Option shall be 100% vested and exercisable the date of grant. 2.2 The Option may at any time and from time to time be exercised in whole or in part for the shares of Common Stock subject thereto, within the limitations on exercisability set forth herein. 2.3 Unless terminated earlier, the unexercised portion of the Option shall automatically and without notice terminate and become null and void on the expiration of 10 years from the date on which such Option was granted. SECTION 3. Method of Exercise. 3.1 An Option granted under the Plan shall be deemed exercised when the person entitled to exercise the option: (i) delivers written notice to the Company, in the form attached as Exhibit A hereto, at its principal business office, directed to the attention of the Chairman of the Board, of the decision to exercise; and (ii) concurrently tenders to the Company full payment for the shares to be purchased pursuant to such exercise. 3.2 Payment for shares with respect to which an Option is exercised may be made in any combination of the following: (i) by certified or official bank check payable to the Company (or the equivalent thereof acceptable to the Board); (ii) with the consent of the Board in its sole discretion, by personal check (subject to collection) and which may in the Board's discretion be deemed conditional; and (iii) by delivery of previously-acquired shares of Common Stock owned by the grantee for at least six months (or such longer or shorter period as the Board of Directors may prescribe) having a fair market value (determined as of the option exercise date) equal to the portion of the option exercise price being paid thereby. In addition, subject to such rules as may be established by the Board, payment may be deemed to be satisfied by delivery to the Company of an assignment of a sufficient amount of the proceeds from the sale of Common Stock acquired upon exercise to pay for all of the Common Stock acquired upon exercise and an authorization to the broker or selling agent to pay that amount to the Company, which sale shall be made at the Optionee's direction at the time of exercise. 3.3 Options shall be granted to permit a Participant to reacquire any Shares such Participant delivered to the Company as payment of the exercise price in connection with the exercise of the Option hereunder or to reacquire any Shares retained by the Company to satisfy the Participant's withholding obligation in connection with the exercise of the Option hereunder (a "Reload Option"). The terms of such Option shall be identical in all material respects to the terms of this Option, provided, however, that the exercise price for each Share granted under the Reload Option shall be the Fair Market Value of a Share at the time such Reload Option is granted. SECTION 4. Transferability. (i) Subject to subsection (ii) below, each Option shall be exercisable only by the Optionee during the Optionee's lifetime, or, if permissible under applicable law, by the Optionee's legal guardian or representative. No Option may be assigned, alienated, pledged, attached, sold or otherwise transferred or encumbered by an Optionee otherwise than by will or by the laws of descent and distribution and any such purported assignment, alienation, pledge, attachment, sale, transfer or encumbrance shall be void and unenforceable against the Company; provided that the designation of a beneficiary shall not constitute an assignment, alienation, pledge, attachment, sale, transfer or encumbrance. (ii) Notwithstanding the foregoing, the Option may be transferred by the Optionee without consideration, subject to such rules as the Board may adopt to preserve the purposes of the Plan, to: (A) the Optionee's spouse, children or grandchildren (including adopted and stepchildren and grandchildren) (collectively, the "Immediate Family"); (B) a trust solely for the benefit of the Optionee and his or her Immediate Family; or (C) a partnership, corporation or limited liability company whose only partners, shareholders or members are the Optionee and his or her Immediate Family members; (each transferee described in clauses (A), (B) and (C) above is hereinafter referred to as a "Permitted 2 Transferee"); provided that the Optionee gives the Board advance written notice describing the terms and conditions of the proposed transfer and the Board notifies the grantee in writing that such a transfer would comply with the requirements of the Plan and this Agreement. The terms of the transferred option shall apply to the Permitted Transferee and any reference in the Plan or this Agreement shall be deemed to refer to the Permitted Transferee, except that (a) Permitted Transferees shall not be entitled to transfer the Option, other than by will or the laws of descent and distribution; (b) Permitted Transferees shall not be entitled to exercise the transferred Option unless there shall be in effect a registration statement on an appropriate form covering the shares to be acquired pursuant to the exercise of such Option if the Board determines that such a registration statement is necessary or appropriate, and (c) the Board or the Company shall not be required to provide any notice to a Permitted Transferee, whether or not such notice is or would otherwise have been required to be given to the Optionee under the Plan or this Agreement or otherwise. SECTION 5. Right of Discharge Reserved. Nothing in the Plan or this Agreement shall confer upon the Optionee the right to continue in the service of the Company or affect any right that the Company may have to terminate the service of the Optionee. SECTION 6. No Stockholder Rights. Neither the Optionee nor any person succeeding to the Optionee's rights hereunder shall have any rights as a stockholder with respect to any shares subject to the Option until the date of the issuance of a stock certificate or certificates to him or her for such shares. Except for adjustments made pursuant to section 7 of the Plan, no adjustment shall be made for dividends, distributions or other rights (whether ordinary or extraordinary, and whether in cash, securities or other property) for which the record date is prior to the date such stock certificate is issued. SECTION 7. Plan Provisions to Prevail. This Agreement shall be subject to all of the terms and provisions of the Plan, which are incorporated hereby and made a part hereof, including, without limitation, the provisions of section 8 of the Plan (generally relating to withholding tax obligations) and section 7 of the Plan (generally relating to adjustments to the number of shares of Common Stock subject to the Option and the Option price, upon certain changes in capitalization). If there is any inconsistency between any of the provisions of the Agreement and the Plan, the provisions of the Plan shall govern. SECTION 8. Optionee's Acknowledgments. By entering into this Agreement the Optionee agrees and acknowledges that (a) the Optionee has received and read a copy of the Plan, and (b) neither the Company nor the Board and its respective shareholders, officers, directors, employees, agents and counsel shall be liable for any action or determination with respect to the Plan or any award thereunder or this Agreement. 3 SECTION 9. Successors and Assigns. This Agreement shall be binding upon and inure to the benefit of the parties hereto and the successors and assigns of the Company and, to the extent set forth in Section 4, the heirs, personal representatives, conservator and committee of the Optionee. SECTION 10. Governing Law. THIS AGREEMENT IS SHALL BE GOVERNED BY THE LAWS OF BERMUDA APPLICABLE TO AGREEMENTS MADE AND TO BE PERFORMED ENTIRELY THEREIN. SECTION 11. Notices. All notices and other communications hereunder shall be given in writing, shall be personally delivered against receipt or sent by registered or certified mail, return receipt requested, shall be deemed given on the date of delivery or of mailing, and if mailed, shall be addressed (a) to the Company, at its principal business office, Attention: Chairman, and (b) to the Optionee, at the Optionee's principal residential address last furnished to the Company. Either party may, by notice, change the address to which notice to such party is to be given. SECTION 12. Section Headings. The Section headings contained herein are for the purposes of convenience only and are not intended to define or limit the contents of said Sections. IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date and year first above written. ESG Re Limited By ---------------------------- Name: Title: OPTIONEE: ---------------------------- Name: 4 EXHIBIT A EXERCISE NOTICE [To be executed upon exercise of Stock Option] ESG Re Limited: The undersigned hereby irrevocably elects to exercise the right of purchase represented by the attached Stock Option Agreement ("Agreement") dated ___________, 1997, for, and to purchase thereunder, ____________ shares of Common Stock, par value $1.00 per share, of ESG Re Limited ("Common Stock"), as provided for in such Agreement, and tenders herewith payment of the exercise price in full in a form permitted under Section 3.2 of the Agreement. Payment of the option exercise price is being made in full [Check Applicable Item]: ________ in the form of a certified or official bank check or the equivalent thereof acceptable to the Board; ________ by delivery to the Company of an assignment of the proceeds from the sale of Common Stock acquired upon exercise and an authorization to the broker or selling agent to pay that amount to the Company; ________ if so permitted by the Board, by personal check (subject to collection); or ________ by delivery of shares of Common Stock already owned by the undersigned for at least six months prior to such delivery. The undersigned agrees and acknowledges that he has received a copy of the current prospectus relating to the issuance of shares under the ESG Re Limited Non-Management Directors' Compensation and Option Plan (the "Plan"). The undersigned hereby further agrees to be bound by the provisions of the Plan and the Agreement. 5 Please issue a certificate or certificates for such shares of Common Stock, to me at the address set forth in the Agreement, or in the name of ____________________________ at the address listed below: (Please Print) Name of Optionee:____________________________________ Address:_____________________________________________ Signature:____________________________ Date:_____________ 6 EX-10.10 3 FORM OF STOCK OPTION AGREEMENT Exhibit 10.10 Form of Stock Option Agreement ESG Re Limited 1997 Stock Option Plan Stock Option Agreement THIS AGREEMENT (the "Agreement") is made effective as of the __ day of _____, 199_ (hereinafter called the "Date of Grant"), between ESG Re Limited (hereinafter called the "Company"), and [Optionee] (hereinafter called the "Participant" or the "Optionee"): R E C I T A L S: WHEREAS, the Company has adopted the ESG Re Limited 1997 Stock Option Plan (the "Plan"), which Plan is incorporated herein by reference and made a part of this Agreement. Capitalized terms not otherwise defined herein shall have the same meanings as in the Plan; and WHEREAS, the Committee has determined that it would be in the best interests of the Company and its stockholders to grant the option provided for herein (the "Option") to the Participant pursuant to the Plan and the terms set forth herein. NOW THEREFORE, in consideration of the mutual covenants hereinafter set forth, the parties hereto agree as follows: 1. Grant of the Option. The Company hereby grants to the Participant the right and option (the "Option") to purchase, on the terms and conditions hereinafter set forth, all or any part of an aggregate of ___________ Shares, subject to adjustment as set forth in the Plan. The purchase price of the Shares subject to the Option shall be $20.00 per Share (the "Exercise Price"). 2. Vesting. (a) The Option will be 1/4 vested on the Date of Grant and, subject to the Participant's continued employment with the Company, the remainder of the option shall vest in 1/3 increments on each of the second, third and fourth anniversaries of the Date of the Grant; provided, however, that the option shall become 100% vested upon the death of the Optionee or upon a Change of Control (as defined below). At any given time, the portion of the Option which has become vested and exercisable as described above is hereinafter referred to as the "Vested Portion". For purposes of this Agreement, "Change in Control" shall mean the occurrence of any of the following: (i) the sale, lease, transfer or other disposition, in one or a series of related transactions, of all or substantially all of the assets of the Company other than to the Company or any of the Affiliates, or (ii) a merger or sale of the Company pursuant to which the shareholders of the Company immediately prior to such merger or sale do not own a majority of the stock of the Company or the surviving corporation immediately after such merger or sale. (b) If the Participant's employment with the Company is terminated for any reason, the Option shall, to the extent not then vested, be canceled by the Company without consideration and the Vested Portion of the Option shall remain exercisable for the period set forth in Section 3(a). 3. Exercise of Option. (a) Period of Exercise. Subject to the provisions of the Plan and this Agreement, the Participant may exercise all or any part of the Vested Portion of the Option at any time prior to the earlier of (i) six months following the Participant's termination of employment other than by the Company for Cause (as defined below) or, if so provided in the Participant's employment agreement, by the Participant other than for Good Reason (as defined in the Participant's employment agreement); (ii) termination of the Participant's employment by the Company for Cause or, if so provided in a Participant's employment agreement, by the Executive other than for Good Reason; or (iii) the tenth anniversary of the Date of Grant; provided, however, that the Option shall automatically terminate and expire upon violation of any non-competition, non-solicitation or confidentiality provision in the Participant's employment agreement, if any. For purposes of this Agreement, "Cause" shall mean "Cause" as defined in the Participant's employment agreement, or if no employment is in effect "Cause" shall mean: (i) Participant's failure or refusal to perform his or her duties or to perform specific directives of the Board, provided that such directives do not violate any applicable law or industry standards; (ii) dishonesty of Participant affecting the Company, or any affiliates; (iii) alcoholism or use of drugs or any controlled substances which interferes with the performance of Participant's duties and responsibilities; (iv) any gross or willful conduct of Participant resulting in substantial loss to or theft from the Company or any of its affiliates; or substantial damage to the Company or any of its affiliates' reputation or theft from the Company or any of its affiliates; or (v) Participant is charged with a felony or other serious crime, whether or not related to the business of the Company or its affiliates, including but not limited to, any crime related to tax evasion, bribery, theft, political payoffs, etc. (b) Method of Exercise. (i) An option granted under the Plan shall be deemed exercised when the person entitled to exercise the Option delivers written notice to the Company, in the form attached as Exhibit A hereto, at its principal business office, directed to the attention of the Chairman of the Board, of the decision to exercise; and (ii) concurrently tenders to the Company full payment for the shares to be purchased pursuant to such exercise. (c) Payment for shares with respect to which an Option is exercised may be made in any combination of the following: (i) by certified or official bank check payable to the Company (or the equivalent thereof acceptable to the Board); (ii) with the consent of the Board in its sole discretion, by personal check (subject to collection) and which may in the Board's discretion be deemed conditional; and (iii) by delivery of previously-acquired shares of Common Stock owned by the grantee for at least six months (or such longer or shorter period as the Board of Directors may prescribe) having a fair market value (determined as of the option exercise date) equal to the portion of the option exercise price being paid thereby. In addition, subject to such rules as may be established by the Board, payment may be deemed to 2 be satisfied by delivery to the Company of an assignment of a sufficient amount of the proceeds from the sale of Common Stock acquired upon exercise to pay for all of the Common Stock acquired upon exercise and an authorization to the broker or selling agent to pay that amount to the Company, which sale shall be made at the Optionee's direction at the time of exercise. 4. Reload Options. Options shall be granted to permit a Participant to reacquire any Shares such Participant delivered to the Company as payment of the exercise price in connection with the exercise of the Option hereunder or to reacquire any Shares retained by the Company to satisfy the Participant's withholding obligation in connection with the exercise of the Option hereunder (a "Reload Option"). The terms of such Option shall be identical in all material respects to the terms of this Option, provided, however, that the exercise price for each Share granted under the Reload Option shall be the Fair Market Value of a Share at the time such Reload Option is granted. 5. No Right to Continued Employment. Neither the Plan nor this Agreement shall be construed as giving the Participant the right to be retained in the employ of, or in any consulting relationship to, the Company or any Affiliate. Further, the Company or an Affiliate may at any time dismiss the Participant or discontinue any consulting relationship, free from any liability or any claim under the Plan or this Agreement, except as otherwise expressly provided herein. 6. Legend on Certificates. The certificates representing the Shares purchased by exercise of the Option shall be subject to such stop transfer orders and other restrictions as the Board may deem advisable under the Plan or the rules, regulations, and other requirements of the United States Securities and Exchange Commission, any stock exchange upon which such Shares are listed, and any applicable Federal or state laws, and the Board may cause a legend or legends to be put on any such certificates to make appropriate reference to such restrictions. 7. Transferability. (a) Subject to subsection (b) below, each Option shall be exercisable only by the Optionee during the Optionee's lifetime, or, if permissible under applicable law, by the Optionee's legal guardian or representative. No Option may be assigned, alienated, pledged, attached, sold or otherwise transferred or encumbered by an Optionee otherwise than by will or by the laws of descent and distribution or, if inapplicable, transmission on death in accordance with the Bye-Laws of the Company and any such purported assignment, alienation, pledge, attachment, sale, transfer or encumbrance shall be void and unenforceable against the Company; provided that the designation of a beneficiary shall not constitute an assignment, alienation, pledge, attachment, sale, transfer or encumbrance. (b) Notwithstanding the foregoing, the Option may be transferred by the Optionee without consideration, subject to such rules as the Board may adopt to preserve the purposes of the Plan, to: (i) the Optionee's spouse, children or grandchildren (including adopted and stepchildren and grandchildren) (collectively, the "Immediate Family"); (ii) a trust solely for the benefit of the Optionee and his or her Immediate Family; or (iii) a partnership, corporation or limited liability company whose only partners, 3 shareholders or members are the Optionee and his or her Immediate Family members; (each transferee described in clauses (A), (B) and (C) above is hereinafter referred to as a "Permitted Transferee"); provided that the Optionee gives the Board advance written notice describing the terms and conditions of the proposed transfer and the Board notifies the grantee in writing that such a transfer would comply with the requirements of the Plan and this Agreement. The terms of the transferred option shall apply to the Permitted Transferee and any reference in the Plan or this Agreement shall be deemed to refer to the Permitted Transferee, except that (a) Permitted Transferees shall not be entitled to transfer the Option, other than by will or the laws of descent and distribution; (b) Permitted Transferees shall not be entitled to exercise the transferred Option unless there shall be in effect a registration statement on an appropriate form covering the shares to be acquired pursuant to the exercise of such Option if the Board determines that such a registration statement is necessary or appropriate, and (c) the Board or the Company shall not be required to provide any notice to a Permitted Transferee, whether or not such notice is or would otherwise have been required to be given to the Optionee under the Plan or this Agreement or otherwise. 8. Securities Laws. Upon the acquisition of any Shares pursuant to the exercise of the Option, the Participant will make or enter into such written representations, warranties and agreements as the Board may reasonably request in order to comply with applicable securities laws or with this Agreement. 9. Notices. Any notice necessary under this Agreement shall be addressed to the Company in care of its Secretary at the principal executive office of the Company and to the Participant at the address appearing in the personnel records of the Company for the Participant or to either party at such other address as either party hereto may hereafter designate in writing to the other. Any such notice shall be deemed effective upon receipt thereof by the addressee. 10. Choice of Law. THE INTERPRETATION, PERFORMANCE AND ENFORCEMENT OF THIS AGREEMENT SHALL BE GOVERNED BY THE LAWS OF BERMUDA WITHOUT REGARD TO PRINCIPLES OF CONFLICTS OF LAW. 11. Option Subject to Plan/Optionees Acknowledgments. By entering into this Agreement the Participant agrees and acknowledges that (a) the Participant has received and read a copy of the Plan and (b) neither the Company nor the Board and its respective shareholders, officers, directors, employees, agents and counsel shall be liable for any action or determination with respect to the Plan or any award thereunder or this Agreement. The agent shall be subject to all the terms and provisions of the Plan which are incorporated hereby and made a part hereof including the provisions of Section 8(d) of the Plan (generally relating to withholding) and Section 7 (relating to amendments and adjustments). In the event of a conflict between any term or provision contained herein and a term or provision of the Plan, the applicable terms and provisions of the Plan will govern and prevail. 12. Signature in Counterparts. This Agreement may be signed in counterparts, each of which shall be an original, with the same effect as if the signatures thereto and hereto were upon the same instrument. IN WITNESS WHEREOF, the parties hereto have executed this Agreement. 4 Accepted ___________, 1997 ESG Re Limited By:__________________________ Wolfgang M. Wand Chief Executive Officer Optionee By:__________________________ Name: 5 EXHIBIT A EXERCISE NOTICE [To be executed upon exercise of Stock Option] ESG Re Limited: The undersigned hereby irrevocably elects to exercise the right of purchase represented by the attached Stock Option Agreement ("Agreement") dated ___________, 1997, for, and to purchase thereunder, ____________ shares of Common Stock, par value $1.00 per share, of ESG Re Limited ("Common Stock"), as provided for in such Agreement, and tenders herewith payment of the exercise price in full in a form permitted under __________ of the Agreement. Payment of the option exercise price is being made in full [Check Applicable Item]: _______ in the form of a certified or official bank check or the equivalent thereof acceptable to the Board; _______ by delivery to the Company of an assignment of the proceeds from the sale of Common Stock acquired upon exercise and an authorization to the broker or selling agent to pay that amount to the Company; _______ if so permitted by the Board, by personal check (subject to collection); or _______ by delivery of shares of Common Stock already owned by the undersigned for at least six months prior to such delivery. The undersigned agrees and acknowledges that he has received a copy of the current prospectus relating to the issuance of shares under the ESG Re Limited 1997 Stock Option Plan (the "Plan"). The undersigned hereby further agrees to be bound by the provisions of the Plan and the Agreement. 6 Please issue a certificate or certificates for such shares of Common Stock, to me at the address set forth in the Agreement, or in the name of ________________________________ at the address listed below: (Please Print) Name of Optionee:___________________________________________________ Address:____________________________________________________________ Signature:_____________________________ Date:_________________ 7 EX-13.1 4 ANNUAL REPORT ESG [LOGO] INTELLIGENT REINSURANCE ESG Re Limited ANNUAL REPORT 1997 [PHOTO OMITTED] About the Children To illustrate ESG Re Limited's commitment to the well-being of children, we have selected Children as our theme for this report. The Company provides innovative solutions to insurance problems that directly impact the lives of children such as Children's Disability programs with Union Nationale des Mutuelles Mieux-Etre in France and Consolidated Financial Insurance in Denmark. ESG Re plans to expand this program globally. [PHOTO OMITTED] ESG [LOGO] TABLE OF CONTENTS Company Profile 2 Financial Highlights 3 Letters to Shareholders 4 Operating Review 10 Selected Consolidated Financial Data 20 Management's Discussion and Analysis of Financial Conditions and Results of Operations 21 Consolidated Financial Statements 28 Independent Auditors' Report 53 Corporate Directory 54 Shareholder Information 56 Company Profile ESG Re Limited is a specialty reinsurance company providing accident, health, life, and special risk reinsurance to insurers and selected reinsurers on a worldwide basis. With three operating subsidiaries located in Bermuda, Germany, and Ireland, and offices in ten cities, ESG Re writes reinsurance in more than 50 countries. ESG Refocuses on growing business lines in the personal and health fields and specializes in applying "Intelligent Reinsurance"--a profitable and analytical approach--to its ceding customers. ESG Re is dedicated to offering creative risk solutions to reinsurance challenges in growing and emerging markets. 2 FINANCIAL HIGHLIGHTS ESG Re began writing reinsurance for its own account in December 1997. Comparative results from prior years, when the Company functioned as a managing agent, are therefore not relevant. The following highlights reflect operating data for the reinsurance operations: (U.S. dollars in thousands, except per share data) 1997 ================================================================================ Operating Data Net premiums written $ 25,392 Net premiums earned 13,411 Total revenues 13,868 Losses and loss expenses 7,449 Acquisition expenses 4,693 - -------------------------------------------------------------------------------- Total expenses 12,142 - -------------------------------------------------------------------------------- Net underwriting income 1,269 ================================================================================ Loss ratio(2) 55.5% - -------------------------------------------------------------------------------- Acquisition expense ratio(2) 35.0% - -------------------------------------------------------------------------------- Loss and acquisition expense ratio(2) 90.5% ================================================================================ Consolidated Balance Sheet Data Investments and cash $236,976 Total assets 273,068 Total shareholders' equity 234,375 Book value per share 16.83 Diluted book value per share 16.61 Common Stock Price Range (1) High $ 23.88 Low $ 21.50 (1) 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. (2) Ratios are calculated on U.S. GAAP basis. 3 CHAIRMAN'S LETTER [PHOTO OMITTED] In December 1997, ESG Re Limited became an international reinsurer of health, accident, life and sports/entertainment risks. ESG is now well capitalized, highly regarded and moving forward to implement its business plan. The Board of Directors, working with senior management, will provide guidance and overall strategic input so that in 1998 ESG Re will: o Expand its existing lines of business into more countries and regions; o Recruit, train and motivate the very best people in North America, Europe and Asia; o Underwrite profitable business and produce investment income to provide shareholders with an acceptable return on equity; and o Develop its standing in the reinsurance market as a company operating to the highest standards and providing quality solutions to customer problems. To our fellow shareholders, your Board of Directors is committed to achieving these objectives. /s/ John C Head III John C Head III Chairman of the Board 4 CHIEF EXECUTIVE OFFICER'S LETTER [PHOTO OMITTED] ESG [LOGO] We are delighted to welcome you to ESG Re Limited and our first annual report. ESG Re's successful initial public offering in December 1997 raised over $250 million. With this capital, ESG completed its transformation from a reinsurance management company with a predominantly European focus, to a specialty reinsurer underwriting for its own account on a global basis. Our reinsurance focus is on people--their lives, health, and well-being. In its former reinsurance management role, ESG produced exceptional results. Premiums managed by us grew from $36 million in 1994 to $100 million in 1997, with combined loss and acquisition expense ratios averaging 91%. We developed a reputation as a recognized lead reinsurer, and our partner relationships include some of the world's strongest reinsurers. Ceding clients and professional brokers demand the highest quality financial security from their reinsurance partners. Standard and Poor's Corporation has affirmed the strong financial position of ESG Re by rating us A-. ESG Re's seasoned management, motivated underwriting teams, and strong capital base position the Company as a sophisticated specialty reinsurer in the fields of health, personal accident, life, credit/life and disability reinsurance, as well as the growing area of special risk in the sports and entertainment industry. ESG Re's unique concept of "Intelligent Reinsurance" provides value-added solutions, as well as capacity to ceding companies and professional brokers. We believe that "Intelligent Reinsurance" will become known as a standard of excellence in the reinsurance community. 5 GROWING MARKETS AND OPPORTUNITIES Global reinsurance markets have changed significantly during the last several years with the last two years being particularly difficult because of excess capacity and competition. We are encouraged, however, by signs of a cyclical upturn and some firming of prices in certain markets, particularly in North America. In addition, certain segments of the reinsurance market are experiencing substantial growth--particularly our areas of strategic focus. Contributing to this growth are the following factors: o A worldwide trend of transferring social security and national health responsibility to the private sector suggests that medical expense reinsurance will be one of the fastest growing areas in the insurance industry. o Demand for new insurance products, particularly in the health care area, is being generated as a result of economic growth in emerging markets such as Eastern Europe, Asia, and Latin America. o New trade directives from the European Union will cause certain European countries to deregulate insurance markets, providing opportunities for creative product solutions. o As the world's population continues to live longer and require more health care services, demand for health insurance will increase. o Capacity requirements for the insurance of major global sports and entertainment events continue to increase. STRATEGIC DIRECTIONS An improved industry environment combined with growing markets provides an excellent opportunity for ESG Re to enter the market as a reinsurer for its own account. 6 ESG [LOGO] During 1998, ESG Re intends to pursue the following strategic initiatives: o Import and implement managed health care techniques that have proven to be successful in the United States to Germany, Spain, Italy and other European markets where these concepts have been underutilized. o Create private medical care and insurance products for high growth emerging markets such as Eastern Europe, the Commonwealth of Independent States, Latin America and Asia. o Expand occupational injury and health reinsurance programs in Scandinavia. o Continue to structure innovative special risk reinsurance programs for major sporting events and performances such as World Cup Soccer and the European Soccer Championships. COMPETITIVE ADVANTAGES To implement these strategies successfully, and to produce profitable results, requires a strong capital base and balance sheet, specialized expertise, and prudent underwriting discipline. In addition to these strengths, ESG Re has the following competitive advantages: o Far-ranging and well-established relationships with many of the leading global insurance and reinsurance companies; o Seasoned senior management with an average of 25 years of experience in the insurance/reinsurance industry; o Highly motivated employees--all shareholders; o Flexible and efficient underwriting teams, strategically located in key markets; o A reputation for uncompromising service to ceding clients; and o An organizational structure that provides the advantages of favorable tax jurisdictions. 7 RESULTS FOR 1997 ESG Re operated primarily as a reinsurance management company for all but the final two weeks of the year. Therefore, underwriting premiums and earnings for 1997 are not indicative of future results. For the year ended December 31, 1997, the Company reported a net loss of $5.1 million, reflecting expenses incurred in its initial public offering and a one-time accounting charge of $3.6 million for compensation-related expenses. In its former function as a managing agent, the Company underwrote, on behalf of various reinsurers, approximately $100.0 million of gross premiums in 1997, of which $60.0 million was managed in reinsurance pools for the Company's reinsurance partners. In December 1997, the Company exercised its contractual right to assume, for its own account, a 30% share of this pool business, retroactive to January 1, 1997. In addition, the Company separately negotiated retrocessions with certain pool participants, resulting in net premiums written of $25.4 million and net underwriting income of $1.3 million for 1997. Total revenues for the year were $17.8 million, consisting of net premiums earned of $13.4 million, net investment income of $0.6 million and management fee revenue of $3.8 million. ESG Re's combined loss and acquisition expense ratio, a key measure for assessing the performance of the reinsurance business, was 90.5% in 1997. OUTLOOK 1998 will be our first full year operating as a reinsurance company and we have entered it with enthusiasm and confidence. ESG Re's high level of renewals, broad geographical spread of operations, and the 8 ESG [LOGO] opportunities which are expected to present themselves in the course of 1998 fill us with optimism and excitement. Reinsurance is a highly personal business which is largely relationship driven. We have worked diligently over the years to establish a reputation of not only excellence and expertise, but also of trust and confidence between ourselves and our ceding partners. These long-term relationships will continue to play a crucial role in our future success. Our involvement in health care and disability places us in a unique position of influence regarding the quality and cost of these essential services. We believe that by taking this social responsibility seriously, we are acting in the best interest of all stakeholders--our ceding customers, their original insureds, and our shareholders. Our strategies for growth, combined with our competitive strengths and an emphasis on underwriting profitability rather than market share, position us as an industry leader in the fastest growing segments of the insurance world. We wish to thank our shareholders for their support and interest in ESG Re Limited and our employees for their enthusiasm and dedication. As co-owners, we all look forward to building a strong and successful company. /s/ Wolfgang M. Wand Wolfgang M. Wand Managing Director and Chief Executive Officer 9 OPERATING REVIEW "Intelligent Reinsurance" as a Business Philosophy It is our ongoing objective to have "Intelligent Reinsurance" become ESG Re's recognized trademark. "Intelligent Reinsurance" is a business philosophy centered on providing client-oriented solutions--not just capital. ESG Re strives to provide one source for a full range of value-added reinsurance products and expertise combined with unsurpassed client service. [PHOTO OMITTED] ESG Re gains market advantage by sharing with clients expertise, market knowledge, specialized technologies and other services. We do not charge our clients for "Intelligent Reinsurance" products or services; our clients choose us as their reinsurance partner because we help them to manage their risks better through "Intelligent Reinsurance". Integral to the "Intelligent Reinsurance" concept of offering clients alternative and creative solutions to underwriting challenges is a highly analytical and proactive approach to risk management. Key elements include: o Applying detailed knowledge and analysis of underlying local markets to better understand the factors that affect losses and incorporating that knowledge into reinsurance solutions, including the establishment of rating tables and tariffs; o Collecting, assessing, and sharing new information about markets in which risks are based; o Utilizing extensive case management principles and managed care techniques to improve customer service and reduce costs; and o Ensuring early involvement in claims management to minimize claims expense without limiting benefits available to customers. 10 ESG [LOGO] Technology plays a critical role in supporting "Intelligent Reinsurance". Our computer-based underwriting and claims management system--European Specialty Insurance Management Services (ESIMS)--provides product support and design, as well as loss prevention and disease management functions, enabling the accurate prediction of potentially severe medical conditions. ESIMS streamlines the process of entering new markets, developing products, administering claims and managing risk, thereby enhancing profitability and service quality. We believe that "Intelligent Reinsurance" creates a true partnership between ceding customers and ESG Re--a partnership tied to the value we add and the success of our clients' products. Intelligent Reinsurance Solutions Our goal is to foster an environment in which creative and innovative reinsurance and insurance solutions are developed to meet the needs of clients and customers in markets worldwide. For example: o In Eastern Europe, we helped to create the first private health care program using Western benefit and insurance standards. o In Russia, we have been mandated by the Moscow City Health Fund to help restructure the delivery of health care services to more than 13 million Moscovites. o In Latin America, ESG Re has for many years played a major role in the development of innovative medical expense programs that allow policyholders to seek treatment in the United States, with direct access to one of the world's leading preferred provider hospital networks. 11 Major Lines of Business Medical Expense With the restructuring of national health care systems around the world generating new demand for private health insurance, reinsurance for medical expenses has become one of the fastest growing classes in the insurance industry. Our growth strategy centers on exporting products and services from centers of excellence to areas of growing demand and to adjust these products and services in a timely fashion if adverse developments occur. ESG Re's management helped pioneer professional health care reinsurance in the early 1970s. Leveraging this expertise, ESG Re now offers medical reinsurance--comprehensive medical expense insurance, and short-term travel, hospital daily income, defined illness and dread disease coverages. Through this range of product solutions ESG Re provides both the tools and the framework to underwrite more profitable business focused on high net worth individuals, frequent travelers, and expatriates. [The following table was depicted as a pie chart in the printed material.] 1997 GROSS PREMIUMS DISTRIBUTION Medical Expense 38.2% Personal Accident 35.8% Credit/life and Disability 24.5% Special Risk 1.5% With access to over 4,600 hospitals, 23,000 service providers and 250,000 physicians worldwide, we offer one of the largest networks of specialist service providers. Clinically trained staff provide immediate advice and support for a wide range of services--from information on obtaining local medical care, to arranging complete transportation from one country to another. This service benefits the insured and substantially reduces claims exposure as a result of discounts prearranged with hospitals and providers. 12 ESG [LOGO] With the capacity to provide up to $5 million in coverage per person, ESG Re is a desired lead capacity provider capable of providing up to 100% of required reinsurance capacity for most programs. Personal Accident ESG Re continues to expand its role as a personal accident and disability reinsurance provider throughout Europe, Latin America, the Far East, and the countries of the former Soviet Union. In North America, we continue to develop and redefine existing programs as opportunities arise. Our innovative programs include: o Coverage for credit card issuing corporations and banks to cover high concentration flight risk exposure; o Occupational injury and health reinsurance programs in Scandinavia; and o Children's Disability programs developed with European ceding clients and telemarketing programs to promote these products. We will continue to develop and package features that fit particular market needs and to strengthen relationships with our ceding clients by offering programs with an acceptance capacity limit of $5 million on any one person and an event capacity limit of $30 million. Credit/Life and Disability Demand for credit/life reinsurance products is increasing worldwide. ESG Re plans to expand this line globally by utilizing our experience in credit/life reinsurance in the North American, German, French, and Scandinavian markets. 13 ESG Re writes coverage for several types of exposures in this line, including group life, individual credit/life, credit disability and credit unemployment. However, the Company typically does not engage in long-term life or surplus relief reinsurance programs. [PHOTO OMITTED] Much of our group life business is provided in conjunction with underwriting services related to personal accident, health, and credit/life and disability reinsurance programs. Furthermore, most of our credit/life programs protect short-term consumer loans, providing coverage for ongoing interest payments and options for principal repayments. ESG Re generally offers unemployment benefits as part of credit/life and disability programs only in sophisticated markets where solid and reliable benefit control systems are available through government unemployment agencies. ESG Re maintains a capacity limit of $1 million for any one person. Special Risk In the current economic environment, many people are spending more of their income on sports and entertainment events. Meeting this demand are promoters who invest increasing sums on presenting events with highly paid stars, while corporations compete to provide increasingly larger sums through sponsorship. These activities generate enormous risks and create new demand for reinsurance capacity related to individual events and the appearances of star performers. SportSecure GmbH, our affiliated special risks company, has substantial experience in providing special risk reinsurance around the globe for sports disabilities, sports and entertainment contingency, nonappearance, cancellation and abandonment, accident and disability, 14 ESG [LOGO] and medical insurance and assistance. From tennis championships and the Soccer World Cup, the largest contingency coverage ever structured, to classical recitals and rock concerts, SportSecure has a strong reputation of insuring some of the world's leading events, athletes and artists. We also provide coverage in the event of television transmission breakdown, and auxiliary benefits connected with major events. SportSecure is an acknowledged market leader in sports and entertainment reinsurance. We maintain our own market intelligence database which allows us to evaluate coverage and policy features with the goal of reducing risk. Our capacity acceptance is $10 million for any one event or a related series of events. Developing Globally, Delivering Locally ESG Re provides "Intelligent Reinsurance" on a global basis. As shown on the map below, our offices are strategically located in the world's most important business centers to provide service and support to our clients. [GRAPHIC OMITTED] [Graphic in the form of a map depicts offices in Berlin, Bermuda, Dublin, Hamburg, Hong Kong, London, Miami, Moscow, Sydney and Toronto.] An established global infrastructure with seamless coordination among offices enables ESG Re to respond quickly and effectively 15 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 in the year ahead, we will enhance our global presence with the introduction of new products tailored to meet the needs of our clients. [PHOTO OMITTED] Major Markets Our objective is to have Europe, North America, and the emerging markets each contribute one-third of total gross premiums written. North America--North America is the world's largest reinsurance market. Annual premiums currently exceed $4 billion with significant growth anticipated over the next five years. ESG Re intends to pursue opportunities in this market and has opened an office in Toronto with a strong senior management team supported by seasoned underwriters. The group will build on its existing client relationships and focus primarily on health and accident reinsurance. The Company will also capitalize on extensive information exchange--importing ESG Re's global expertise into the North American market where it is advantageous to do so, and exporting managed care techniques developed in the North American market to areas where such products are in demand. Many countries in Europe and other parts of the world are looking to North America for solutions to their own health care crises. Certain techniques used in North America can be adapted and transferred to other parts of the world. We plan to participate from the onset in the creation of new health care models in various markets. 16 ESG [LOGO] Europe--ESG Re is active in most European markets and focuses on providing tailored product solutions which reflect our understanding of global trends as well as local nuances. The demand for innovative products resulting from continuing EU deregulation and progressive reform of health systems will provide new opportunities for ESG Re to apply its expertise in creating and supporting innovative risk solutions. Markets of particular importance to ESG Re include Germany, where changes in the public health sector will result in greater demand for health reinsurance products and services. We also offer credit/life insurance and reinsurance programs combined with unemployment coverage, product lines not previously available in Germany. [The following table was depicted as a pie chart in the printed material.] 1997 MARKET DISTRIBUTION Western Europe 52.3% Latin America 19.2% United Kingdom 10.4% Rest of World 9.8% Eastern Europe 5.3% Asia 1.5% North America 1.5% In Spain, ESG Re is currently creating a range of unique private medical insurance and reinsurance products, including the initiation of new managed health care products which are self-funded by employees. These product applications will use sophisticated claims management technology developed by the Company. Emerging Europe--Continuing economic growth, increasing per capita income and the erosion of traditional state health care systems are creating considerable opportunity for targeted risk solutions in this region. ESG Re provides both reinsurance solutions and supporting services to ceding companies throughout this newly emerging market. Our ability to support young and fast-growing local companies with complete and efficient software solutions provides another competitive advantage. ESG Re has been working closely with local ceding companies to create private insurance products modeled on Western standards. 17 Providing not only reinsurance capacity but also extensive product development and training support, we are now developing a range of supplementary programs including out-of-country medical, life, personal accident, and travel medical plans. Currently, ESG Re supports annual travel medical and trip programs throughout the Commonwealth of Independent States, including Russia, Lithuania, Latvia, Georgia, Uzbekistan, and Kazakhstan. Other Regions--ESG Re is well positioned in Latin America, the Pacific Rim and the Middle East. For example: [PHOTO OMITTED] o We offer health and occupational injury reinsurance in all Latin American countries where the progressive growth of the middle class, higher per capita income and the restructuring of health care systems are well underway. o In the Far East, ESG Re is active in the main Asian reinsurance market and is able to respond to increased demand for health insurance and reinsurance support across the region. Despite the current adverse economic conditions in this area, we continue to consider these markets to be important. Our opening of a new regional headquarters in Sydney, Australia, effective in the spring of 1998, is further evidence of our commitment to the region. o The Middle East also presents new opportunities. We have pioneered managed care programs in Saudi Arabia, the United Arab Emirates, Lebanon, and Egypt. With the anticipated restructuring of social health care systems throughout the Gulf Region, medical insurance and reinsurance programs have started to take on a greater importance. 18 ESG [LOGO] Organization of the Company ESG Re Limited conducts its business through three operating subsidiaries: European Specialty Reinsurance (Bermuda) Limited ("ES Bermuda"), European Specialty Reinsurance (Ireland) Limited ("ES Ireland") and European Specialty Ruckversicherung AG ("ES Germany"). European Specialty Group (United Kingdom) and European Specialty (North America) conduct business on behalf of ES Bermuda and ES Ireland. With underwriting profits accruing primarily in Bermuda and Ireland, the Company benefits from the favorable tax environments in those jurisdictions. --------------------------- ESG Re Limited ("ESG Re" or the "Company") --------------------------- ------------------------------------------------------- - ---------------------- ---------------------- European Specialty European Specialty Reinsurance (Bermuda) Group (United Kingdom) Limited ("ES Bermuda") Limited - ---------------------- ---------------------- --------------------------------------------- - ---------------------- ------------------------ ------------------ --------------- European Specialty European Specialty Reinsurance (Ireland) European Specialty Group Holding AG Other Operating Limited ("ES Ireland") (North American) Limited ("ESG Germany") Subsidiaries - ---------------------- ------------------------ ------------------ --------------- ----------------------- ------------------- --------------- European Specialty Ruckversicherung AG Other Operating ("ES Germany") Subsidiaries ------------------- ---------------
19 ESG Re 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 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, 1997, 1996, 1995, and 1994, and the consolidated balance sheet data as of December 31, 1997, 1996, and 1995, have been derived from the Company's audited Consolidated Financial Statements. The consolidated statement of operations data for the year ended December 31, 1993 and the consolidated balance sheet data as of December 31, 1994 and 1993, have been derived from the Company's unaudited consolidated financial statements and, in the opinion of management, reflect all adjustments necessary for a fair presentation of the results of operations and financial condition. The data should be read in conjunction with the Company's Consolidated Financial Statements, related notes, "Management's Discussion and Analysis of Financial Conditions and Results of Operations" and other financial information appearing elsewhere herein.
Years Ended December 31, 1997(1) 1996 1995 1994 1993(2) - ------------------------------------------------------------------------------------------------------ U.S. dollars in thousands except per share data Statement of Operations Data: Net premiums earned $ 13,411 $ -- $ -- $ -- $ -- Management fee revenue 3,830 3,869 4,515 3,309 1,779 Total revenues 17,839 4,055 4,665 3,351 1,821 Total expenses (excludes tax benefits/expenses) 23,504 4,062 4,221 3,313 2,329 Net income (loss) (5,096) (163) 146 (6) (165) Basic net loss per share(3) (4.11) (1.38) -- -- -- Diluted net loss per share(3) (4.11) (1.38) -- -- -- ====================================================================================================== As of December 31, 1997(1) 1996 1995 1994 1993(2) - ------------------------------------------------------------------------------------------------------ U.S. dollars in thousands Balance Sheet Data: Total investments and cash $ 236,976 $ 15 $ 33 $ 21 $ -- Total assets 273,068 2,518 2,683 2,881 1,505 Short-term and current portion of long-term debt -- 1,812 1,746 537 674 Long-term debt -- -- 195 1,737 724 Total shareholders' equity (deficit) 234,375 (489) (152) (90) (77) ======================================================================================================
The Company declared a dividend on March 9, 1998 of $0.075 per common share to be paid on April 13, 1998 for shareholders of record on March 26, 1998. (1) In 1997, the Company began operations as a reinsurance company. (2) In 1994, the Company began operations as an underwriting management company. Prior to 1994, the Company operated principally as a reinsurance intermediary. (3) The 1996 per share data have been calculated on a recapitalized basis. Earnings per share data have not been calculated prior to 1996 as no shares were outstanding. 20 ESG Re Limited Management's Discussion and Analysis of Financial Conditions 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 subsidiaries ("the Company"). This discussion 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 which provides accident, health, life, and special risk reinsurance to insurers and selected reinsurers on a worldwide basis. The Company also provides underwriting management services to selected reinsurers. The December 31, 1997, financial statement results included herein represent the Company's financial performance as a reinsurance entity and an underwriting management company. The 1996 and 1995 financial statement results reflect only the Company's operations as an underwriting management company. 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 was able to assume reinsurance risks for its own account which it had previously managed for others as an underwriting management company. Results of Operations The results of operations of the Company for the years ended December 31, 1997, 1996 and 1995 were as follows: 1997 1996 1995 - -------------------------------------------------------------------------------- U.S. dollars in thousands except per share data Net underwriting income $ 1,269 $ -- $ -- Management fee revenue 3,830 3,869 4,515 Net investment income 598 186 150 Administrative expenses and taxes 7,167 4,218 4,519 Class B Warrants expense 3,626 -- -- Net income (loss) (5,096) (163) 146 Net loss per share (4.11) (1.38) -- ================================================================================ 21 ESG Re Limited Management's Discussion and Analysis of Financial Conditions and Results of Operations 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 result of 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 Net underwriting income for the year ended December 31, 1997 is summarized as follows:
Medical Personal Accident Credit Special Risk Total --------------------------------------------------------------------------------------------------- Amount Ratio Amount Ratio Amount Ratio Amount Ratio Amount Ratio - ------------------------------------------------------------------------------------------------------------------------------ U.S. dollars in thousands Gross premiums written $ 9,989 $ 9,357 $ 6,401 $ 396 $26,143 Net premiums written 9,937 8,723 6,356 376 25,392 Net premiums earned 5,964 3,778 3,426 243 13,411 Losses and loss expenses 3,624 61% 1,907 51% 1,779 52% 139 57% 7,449 56% Acquisition costs 2,099 35% 1,303 34% 1,206 35% 85 35% 4,693 35% - ------------------------------------------------------------------------------------------------------------------------------ Net underwriting income $ 241 $ 568 $ 441 $ 19 $ 1,269 ==============================================================================================================================
Ratios are calculated on U.S. GAAP basis 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 reference to 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 the combined ratio because of the Class B warrant expense and other costs that were incurred by the Company as a result of the Offerings. The Company manages its underwriting risk exposure by operating two forms of retrocession: an excess of loss insurance policy and co-reinsurance. The Company's excess liability insurance policy generally provides limits up to a maximum of $10 million per occurrence, with a minimum attachment point generally of $100 thousand. Effective January 1, 1998, the Company increased the maximum limit to $30 million per occurrence for all new and renewal business. Effective January 1, 1998, all of the Company's non-North American business will be co-reinsured with two other reinsurance companies that will participate with underwriting lines of 7.5% and 5.0%. 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 or 17% which was due to an increased participation in the reinsurance pools managed by the Company. This increase was offset by a decline of approximately 15% in the value of the 22 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. As a result of the Company becoming a reinsurer for its own account in 1997, the Company will discontinue its operations as an underwriting management company in 1998 except to manage the run-off of the business written between 1994 and 1997. Consequently, management fee revenue will decrease significantly in 1998 and for the years thereafter. Net Investment Income Net investment income increased by $412 thousand or 222% from $186 thousand in 1996 to $598 thousand in 1997 due to the Company's significantly larger investment portfolio as a result of the proceeds raised from the Offerings. The Company anticipates that there will be a significant increase in investment income for the 1998 year as a result of the proceeds of the Offerings being available for the full year. Administrative Expenses and Taxes 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 is due to employees for the new representative office in Toronto. Professional services 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 $1.3 million in 1996 to $3.7 million in 1997. This increase includes travel expenses associated with the Company's capital raising activities of $314 thousand, an increase in unrealized foreign exchange losses of $436 thousand 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 offset primarily 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 23 ESG Re Limited Management's Discussion and Analysis of Financial Conditions and Results of Operations 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. Year Ended December 31, 1996 Compared to Year Ended December 31, 1995 Total revenues decreased by $610 thousand or 13% from $4.7 million in 1995 to $4.1 million in 1996. This decrease was caused by a management decision to reduce management fees and commissions by approximately 20% in order to enhance the Company's competitive position and the underwriting profitability of the business underwritten for the pools. This decision resulted in a decrease in fee revenue of approximately $882 thousand. There was a further decline in total revenue of $253 thousand due to a decline of approximately 6% in the value of the Deutsche Mark against the U.S. dollar. These decreases were offset in part by the recognition of approximately $398 thousand of profit commissions in 1996 of which no amounts were recognized in prior years. The Company earns a profit commission based on the underlying profitability of the pool business. The Company recorded its first profit commission revenue in 1996 based upon the clear emergence of profitability in the underlying pools whereas no profit commission was recorded in 1995 and 1994. Total expenses decreased by $159 thousand or 4% from $4.2 million in 1995 to $4.1 million in 1996 which was the result of increased expenses offset by the decline of approximately 6% in the value of the Deutsche Mark against the U.S. dollar. Personnel costs increased by $80 thousand which resulted from an increase in the numbers of staff of $165 thousand and a decrease caused by a decline of $85 thousand in the value of the Deutsche Mark against the U.S. dollar. In addition, professional service fees of $252 thousand were incurred for advice relating to the capitalization of the Company. These increases were offset by a decrease of $254 thousand in total operating expenses due to a decline of approximately 6% in the value of the Deutsche Mark against the U.S. dollar. In addition, in 1996, the Company incurred a one-time tax expense related to the reorganization of ESG Germany of $121 thousand. Year Ended December 31, 1995 Compared to Year Ended December 31, 1994 Total revenues increased in 1995 by $1.3 million or 39% from $3.4 million in 1994 to $4.7 million in 1995. This increase was primarily attributable to the increased underwriting activities of the Company on behalf of reinsurance partners in the 24 personal accident market. Management fee revenue from the personal accident market increased by $888 thousand from 1994 to 1995. In addition, revenues increased by $440 thousand reflecting the increase of approximately 11% in the value of the Deutsche Mark against the U.S. dollar. Total expenses increased by $908 thousand or 27% from $3.3 million in 1994 to $4.2 million in 1995. Personnel costs accounted for $276 thousand of this increase. This increase was due to an increase in the number of staff and employee compensation of $150 thousand, and an increase of $126 thousand due to the increase of approximately 11% in the value of the Deutsche Mark against the U.S. dollar. In addition, marketing and selling-related costs increased by $190 thousand principally for the opening of new representative offices to cover the Eastern European markets. In addition, expenses increased by $397 thousand reflecting the increase of approximately 11% in the value of the Deutsche Mark against the U.S. dollar. Liquidity and Capital Resources For the 1997 Year In December 1997, the Company was capitalized with gross proceeds of $257 million from the Offerings. The proceeds were used to capitalize ES Bermuda, ES Ireland and ES Germany with $55 million, $50 million and $12 million, respectively. The Company also incurred expenses of the Offerings of approximately $25 million and repaid its outstanding debt, principally loans from shareholders and bank demand borrowings, of $3.5 million. Total assets increased by $270.6 million from $2.5 million in 1996 to $273.1 million in 1997 and total shareholders' equity increased by $234.9 million to $234.4 million at December 31, 1997. The increase in total assets and shareholders' equity was due primarily to the proceeds received from the Offerings. At December 31, 1997, the Company had $237.0 million in total investments and cash. All fixed maturity securities in the Company's investment portfolio are classified as available for sale and are carried at fair value. At December 31, 1997, the fixed maturity investment portfolio had an average credit quality of AAA, an average duration of 2.3 years and an average yield of 5.7%. The Company's 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 has an average credit quality rating of AA and no more than 3% of the portfolio is invested in a single issuer (other than issues of sovereign governments with a rating of AA or better). The initial target duration is 2.75 years. In 1998, the Company will continue to pursue its investment objective. The cash flows from underwriting operations along with other factors, including interest rate trends, composition of reinsurance liabilities, liquidity needs, global currency developments and emerging investment opportunities, will be determining factors in the composition of the Company's investment portfolio. 25 ESG Re Limited Management's Discussion and Analysis of Financial Conditions and Results of Operations As of December 31, 1997, the Company had the following material commitments for operating leases and employment contracts: U.S. Dollars Years Ending December 31, (in thousands) - -------------------------------------------------------------------------------- 1998 $ 2,002 - -------------------------------------------------------------------------------- 1999 1,732 - -------------------------------------------------------------------------------- 2000 1,547 - -------------------------------------------------------------------------------- 2001 401 - -------------------------------------------------------------------------------- 2002 77 - -------------------------------------------------------------------------------- Thereafter -- - -------------------------------------------------------------------------------- Total $ 5,759 ================================================================================ 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. The Company expects that its financing and operational needs for the foreseeable future will be met by the proceeds of the Offerings, as well as by funds generated from ongoing operations. However, no assurance can be given that the Company will be successful in the implementation of its operating strategy as a reinsurance company. For the 1996 Year In 1996, the Company entered into a series of equity transactions to simplify its capital structure, resulting, upon the settlement of certain of these transactions, in a reduction of shareholders' equity at December 31, 1996 of $173 thousand. Subsequent to December 31, 1996, certain other of these transactions settled and resulted in an increase in capital of $516 thousand. The Company's total outstanding debt decreased by $129 thousand from $1.9 million in 1995 to $1.8 million in 1996. This decrease was the result of principal repayments of $133 thousand to a former shareholder and $139 thousand to banks for long-term debt. This decrease was offset by an increase in short-term debt of $296 thousand and the effect of translating the Deutsche Mark into the U.S. dollar. The Company also purchased $153 thousand of fixed assets and intangible assets. For the 1995 Year During 1995, the Company reduced its outstanding debt by repaying $771 thousand of long-term debt, including $633 thousand to a former shareholder, which was partially offset by an increase in short-term borrowings from banks of $251 thousand. The Company also made capital purchases for furniture and equipment of $46 thousand and the Company agreed to repurchase from a selling shareholder $203 thousand of registered equity capital. Current Developments The first quarterly cash dividend of $0.075 per share was declared on March 9, 1998 by the Company's Board of Directors payable on April 3, 1998, to common shareholders of record on March 26, 1998. 26 Currency The Company's functional currency is the U.S. dollar. However, because the Company underwrites reinsurance exposures and collects premiums in currencies other than the U.S. dollar, the Company experiences foreign exchange gains and losses, which, in turn affects the results of operations. The Company intends to hold investments in the currencies in which it will collect premiums, pay claims and hold reserves, thus creating a natural foreign exchange hedge so that resulting foreign exchange rate gains and losses can be reduced to the extent assets equal liabilities. If in the future this hedging strategy is not effective, the Company may consider other hedging activities to reduce its foreign currency exposures. Inflation The Company does not believe inflation has had a material impact on its operations for any of the three years presented. Year 2000 The inability of computers, software and other equipment utilizing microprocessors to recognize data fields containing a two-digit code for year 2000 and beyond is commonly referred to as the Year 2000 Compliance Issue. As the year 2000 approaches, some systems may be unable to process certain date-based information accurately. Based upon a review of the Company's computer systems, management believes that they are Year 2000 compliant. The Company's systems do not currently electronically interface with 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. During 1998, the Company will initiate discussions with significant customers and clients to determine the extent to which these companies are vulnerable to the year 2000 Compliance Issue. The Company anticipates that certain reinsurance management software systems will electronically interface with the customers' systems in the near future. The Company believes that those customers are currently in the process of evaluating their systems with regard to the Year 2000 Compliance Issues. There can be no guarantee that the systems of other companies on which the Company relies for information will be converted in a timely manner and would not have an adverse effect on the Company's financial position or results of operations. The total cost to the Company of these Year 2000 Compliance activities has not been and is not anticipated to be material to its financial position or results of operations in any given year. These costs are based on management's best estimates. However, there can be no guarantee that these estimates will be achieved and actual results could differ significantly from those estimates. Accounting Pronouncements In February 1997, the Financial Accounting Standard Board ("FASB") issued SFAS No. 128, "Earnings per Share" and SFAS No. 129, "Disclosure of Information about Capital Structure" and in June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income" and SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." The Company has adopted each of these pronouncments. 27 ESG Re Limited Consolidated Balance Sheets As of December 31, 1997 1996 - -------------------------------------------------------------------------------- U.S. dollars in thousands except share and per share data ASSETS Fixed maturities-available for sale, at fair value (cost: $218,694 and $-) $ 218,867 $ -- Short-term investments 11,913 -- Cash and cash equivalents 6,196 15 - -------------------------------------------------------------------------------- Total investments and cash 236,976 15 Accrued investment income 437 -- Management fees receivable 3,259 1,780 Premiums receivable 25,785 -- Reinsurance recoverable on incurred losses 397 -- Prepaid reinsurance premiums 300 -- Deferred acquisition costs 4,147 -- Deferred tax asset 788 272 Other assets 979 451 - -------------------------------------------------------------------------------- TOTAL ASSETS $ 273,068 $ 2,518 ================================================================================ LIABILITIES Unpaid losses and loss expenses $ 7,846 $ -- Unearned premiums 12,168 -- Acquisition costs payable 10,335 -- Costs of offering payable ($ 2,520 and $-due to related parties) 5,802 -- Accrued expenses and accounts payable 2,309 822 Debt ($-and $868 due to related parties) -- 1,812 Liability for share transactions -- 373 Other liabilities 233 -- - -------------------------------------------------------------------------------- Total liabilities 38,693 3,007 Fiduciary liabilities 10,485 4,928 Less: Cash and cash equivalents held in a fiduciary capacity (10,485) (4,928) Commitments and contingencies (Note 11) -- -- SHAREHOLDERS' EQUITY Preference shares, 50,000,000 and no shares authorized; no shares issued and outstanding for 1997 and 1996, respectively -- -- Class B common shares, 100,000,000 and no shares authorized; no shares issued and outstanding for 1997 and 1996, respectively -- -- Common shares, par value $1 and 5DM per share; 100,000,000 and 100,000 shares authorized; 13,923,799 and 20,000 shares issued and outstanding for 1997 and 1996, respectively 13,924 62 Additional paid-in capital 225,954 62 Accumulated other comprehensive income: Foreign currency translation adjustments, net of tax 32 (4) Unrealized gains on securities, net of reclassification adjustments and tax 170 -- - -------------------------------------------------------------------------------- Accumulated other comprehensive income 202 (4) - -------------------------------------------------------------------------------- Retained deficit (5,705) (609) - -------------------------------------------------------------------------------- Total shareholders' equity (deficit) 234,375 (489) - -------------------------------------------------------------------------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 273,068 $ 2,518 ================================================================================ The accompanying notes are an integral part of the Consolidated Financial Statements. 28 ESG Re Limited Consolidated Statements of Operations Years Ended December 31, 1997 1996 1995 - -------------------------------------------------------------------------------- U.S. dollars in thousands except share and per share data REVENUES Net premiums written $ 25,392 $ -- $ -- Change in unearned premiums (11,981) -- -- - -------------------------------------------------------------------------------- Net premiums earned 13,411 -- -- Management fee revenue 3,830 3,869 4,515 Net investment income 598 186 150 - -------------------------------------------------------------------------------- TOTAL REVENUES 17,839 4,055 4,665 ================================================================================ EXPENSES Losses and loss expenses 7,449 -- -- Acquisition costs 4,693 -- -- Class B Warrants expense (for related party) 3,626 -- -- Personnel costs 2,282 1,382 1,302 Professional services fees (includes $-, $861 and $793 for related parties) 1,594 1,238 1,005 Interest expense (includes $33, $68 and $129 for related parties) 119 141 185 Other expenses 3,741 1,301 1,729 - -------------------------------------------------------------------------------- TOTAL EXPENSES 23,504 4,062 4,221 ================================================================================ NET INCOME (LOSS) BEFORE TAXES (5,665) (7) 444 Income tax expense (benefit) (569) 156 298 - -------------------------------------------------------------------------------- NET INCOME (LOSS) $ (5,096) $ (163) $ 146 ================================================================================ PER SHARE DATA (Note 10) Basic net loss per share $ (4.11) $ (1.38) $ -- - -------------------------------------------------------------------------------- Diluted net loss per share $ (4.11) $ (1.38) $ -- - -------------------------------------------------------------------------------- Weighted average shares outstanding --basic and diluted 1,238,757 117,863 -- ================================================================================ The accompanying notes are an integral part of the Consolidated Financial Statements. 29 ESG Re Limited Consolidated Statements of Changes in Shareholders' Equity Years Ended December 31, 1997 1996 1995 - -------------------------------------------------------------------------------- U.S. dollars in thousands COMMON SHARES (PAR VALUE) Balance at January 1 $ 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 62 -- ================================================================================ ADDITIONAL PAID-IN CAPITAL Balance at January 1 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 -- -- Shares retired during year (62) -- -- - -------------------------------------------------------------------------------- Balance at December 31 225,954 62 -- ================================================================================ REGISTERED CAPITAL Balance at January 1 -- 316 316 Reorganization of holding company -- (316) -- - -------------------------------------------------------------------------------- Balance at December 31 -- -- 316 ================================================================================ TREASURY CAPITAL Balance at January 1 -- (19) (19) Reorganization of holding company -- 19 -- - -------------------------------------------------------------------------------- Balance at December 31 -- -- (19) ================================================================================ ACCUMULATED OTHER COMPREHENSIVE INCOME Balance at January 1 (4) (3) -- Foreign currency translation adjustments, net of tax 36 (1) (3) Unrealized gains on securities, net of reclassification adjustments and tax 170 -- -- - -------------------------------------------------------------------------------- Balance at December 31 202 (4) (3) ================================================================================ RETAINED DEFICIT Balance at January 1 (609) (446) (408) Net income (loss) (5,096) (163) 146 Capital repurchased -- -- (184) - -------------------------------------------------------------------------------- Balance at December 31 (5,705) (609) (446) - -------------------------------------------------------------------------------- TOTAL SHAREHOLDERS' EQUITY (DEFICIT) $ 234,375 $ (489) $ (152) ================================================================================ The accompanying notes are an integral part of the Consolidated Financial Statements. 30 ESG Re Limited Consolidated Statements of Cash Flows Years Ended December 31, 1997 1996 1995 - -------------------------------------------------------------------------------- U.S. dollars in thousands CASH FLOWS FROM OPERATING ACTIVITIES Net income (loss) $ (5,096) $(163) $ 146 Increase in equity investment (16) (4) (5) Depreciation and amortization 117 132 93 Non-cash compensation expenses 3,665 -- -- Adjustments to reconcile net income (loss) to net cash provided by operating activities: (Increase) in accrued investment income (437) -- -- (Increase) decrease in management fees receivable (1,769) 139 159 (Increase) in premiums receivable (25,785) -- -- (Increase) in reinsurance recoverable on incurred losses (397) -- -- (Increase) in prepaid reinsurance premiums (300) -- -- (Increase) in deferred acquisition costs (4,147) -- -- (Increase) decrease in deferred tax asset (573) (1) 223 Increase in unpaid losses and loss expenses 7,846 -- -- Increase in unearned premiums 12,168 -- -- Increase in acquisition costs payable 10,335 -- -- Increase in accrued expenses and accounts payable 1,075 -- -- (Increase) decrease in other assets and liabilities 775 32 (60) - -------------------------------------------------------------------------------- Net cash provided by (used in) operating activities (2,539) 135 556 ================================================================================ CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from sale of equity investment -- -- 21 Cost of fixed maturities acquired - available for sale (218,694) -- -- Cost of other investment assets acquired (11,913) -- -- Purchases of fixed assets (203) (109) (46) Purchases of intangible assets (230) (43) (3) - -------------------------------------------------------------------------------- Net cash used in investing activities (231,040) (152) (28) ================================================================================ CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from issuance of shares 241,296 -- -- Repurchase of capital -- (204) -- Reorganization of holding company -- 58 -- Sale of shares -- 66 -- Advance for issuance of shares -- 67 -- Net change in short-term debt (1,622) 296 251 Repayments of long-term borrowings -- (272) (771) - -------------------------------------------------------------------------------- Net cash provided by (used in) financing activities 239,674 11 (520) - -------------------------------------------------------------------------------- EFFECT OF EXCHANGE RATE CHANGES ON CASH 86 (12) 4 ================================================================================ Net increase (decrease) in cash 6,181 (18) 12 Cash and cash equivalents at January 1 15 33 21 - -------------------------------------------------------------------------------- Cash and cash equivalents at December 31 $ 6,196 $ 15 $ 33 ================================================================================ SUPPLEMENTAL CASH FLOW INFORMATION Cash transactions Interest paid $ 108 $ 124 $ 193 Income taxes paid 109 156 75 Noncash financing transaction Issuance of common stock in connection with Formation (Note 1) -- -- -- ================================================================================ The accompanying notes are an integral part of the Consolidated Financial Statements. 31 ESG Re Limited Consolidated Statements of Comprehensive Income Years Ended December 31, 1997 1996 1995 - -------------------------------------------------------------------------------- U.S. dollars in thousands Net income (loss) $(5,096) $ (163) $ 146 - -------------------------------------------------------------------------------- Other comprehensive income, net of tax: Foreign currency translation adjustments 36 (1) (3) Unrealized gains on securities: Unrealized holding gains arising during period 170 -- -- Less reclassification adjustment for gains (losses) Included in net income -- -- -- - -------------------------------------------------------------------------------- Other comprehensive income 206 (1) (3) - -------------------------------------------------------------------------------- Comprehensive income $(4,890) $ (164) $ 143 ================================================================================ The accompanying notes are an integral part of the Consolidated Financial Statements. 32 ESG Re Limited Notes to the Consolidated Financial Statements Years Ended December 31, 1997, 1996 and 1995 1. Organization and Business ESG Re Limited (the "Company") was incorporated under the laws of Bermuda on August 21, 1997. Its principal activities, through subsidiaries, are to provide accident, health, life and special risk reinsurance and to provide underwriting management services for accident, health, life and special risk reinsurance. 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 earns 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. In 1998, the Company intends to discontinue its management services business except to manage the runoff of the reinsurance pools. The consolidated financial statements include the accounts of its direct wholly-owned subsidiaries, European Specialty Reinsurance (Bermuda) Limited ("ES Bermuda"), European Specialty Group (United Kingdom) Limited, and their indirect, wholly-owned subsidiaries European Specialty Reinsurance (Ireland) Limited, ESG Germany and European Specialty (North America) Limited. All material intercompany balances and transactions have been eliminated in consolidation. 33 ESG Re Limited Notes to the Consolidated Financial Statements 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 an underwriting management company. The comparative information for years ended December 31, 1996 and 1995 represent the financial performance of the Company as an underwriting management company. Certain reclassifications have been made to the 1996 and 1995 financial statements to conform to the 1997 presentations. 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 based upon reports received from ceding companies, supplemented by the Company's estimate of premiums written for which ceding company reports have not been received. Differences between such estimates and actual amounts 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 period of the contracts or policy in proportion to the amount of insurance protection provided. Unearned premium reserves are established to cover the remainder of the unexpired contract period. Such reserves are established based upon reports received from ceding companies or computed using pro rata methods based on statistical data. Written and earned premiums, and the related costs, which have not yet been reported to the Company are estimated and accrued. (b) Reserve for Losses and Loss Expenses The reserve for unpaid losses and loss adjustment expenses is based on individual case estimates and reports received from ceding companies. A provision is included for losses and loss expenses incurred but not reported ("IBNR") based on past experience. To the extent that the Company's historical experience is inadequate for estimating reserves, such estimates may be actuarially determined based upon industry experience and management's judgment. The reserves are reviewed continually and any change in estimates is reflected in earnings in the period the adjustment is made. Management believes that adequate provision has been made for the Company's losses and loss expenses. However, there can be no assurance that losses will not exceed the Company's total reserves. (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 34 ESG Re Limited Notes to the Consolidated Financial Statements value. 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 value of fixed maturities 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 are recorded net of retrocessions (ceded reinsurance). 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. The Company provides reserves for uncollectible reinsurance balances based on management's assessment of the collectibility of the outstanding balances. (f) Management Fee Revenue Management fee revenue consists primarily of underwriting management and related fees and profit commissions based on the underwriting results of the reinsurance pools, as well as commissions for facultative business placed with reinsurers that do not participate in the pools. Management and related fees are recorded based on the estimated gross premiums written in each underwriting year net of estimated uncollectible amounts. These fees are recognized in revenue when the underwriting contract between the reinsurance pool and the ceding insurance company becomes effective since substantially all services have been provided by such date. The Company has had no provision for uncollectible fees for each of the three years in the period ended December 31, 1997. The recognition of fee revenue as of the effective date of the underwriting contract is based upon the fact that the Company has no future obligations regarding these contracts except to provide ancillary administrative services. Management and related fees, which generally are collected over a period up to 24 months, are discounted for any amounts expected to be collected after the first 12 months of the underwriting contract. Any adjustments to management and related fees are made in the period in which ceding companies report information requiring such changes. The Company is only entitled to receive its management fees to the extent that gross written premiums are collected. Profit commissions due from reinsurance pools are based upon the actual underwriting results of each 35 ESG Re Limited Notes to the Consolidated Financial Statements underwriting pool and are generally calculated and earned 12 to 24 months after the end of each underwriting year. The Company relies on data from ceding companies and the expertise of its actuarial staff to determine when profit commissions are earned. It is possible that profit commissions from various underwriting years may be earned and recognized in the same accounting year. For the year ended December 31, 1995, no profit commissions were recognized. For the year ended December 31, 1996, profit commissions of $398 thousand were recognized as earned from the 1994 and 1995 underwriting years. For the year ended December 31, 1997, profit commissions of $381 thousand were recognized as earned from the 1996 underwriting year. As of December 31, 1997, no profit commission has been recognized to date with respect to the 1997 underwriting year. Expenses for future administrative services that the Company is obligated to provide are accrued when the underwriting contract is established. Such accrued expenses were $66 thousand and $77 thousand as of December 31, 1997 and 1996, respectively, and are included in "Accrued expenses and accounts payable". (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 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 are more likely than not. (h) Other Assets (i) Equity Investment As of December 31, 1997, the Company had a 40% ownership interest in SportSecure GmbH, a reinsurance intermediary specializing in sports and entertainment risks, and a 30% ownership interest in European Specialty Berlin GmbH, a representative office. These investments are accounted for under the equity method. The Company's equity in earnings of such investments was $16 thousand, $4 thousand and $5 thousand for the years ended December 31, 1997, 1996 and 1995, respectively. (ii) Intangible Assets Intangible assets consist primarily of exclusive marketing rights, software licenses, trademark rights and certain organizational costs. These assets are recorded at cost and are amortized on a straight-line basis over useful lives of three to five years. Balances are periodically reviewed and evaluated for impairment. (iii) Fixed Assets Fixed assets primarily consist of computer equipment and office furniture and are depreciated over the estimated useful lives of the assets by the straight-line 36 ESG Re Limited Notes to the Consolidated Financial Statements method. The estimated useful lives of assets range between three and ten years depending on the type of the asset. Leasehold improvements are amortized over the shorter of the term of the lease or the estimated useful lives of the improvements. (i) 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". (j) 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. (k) 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. (l) Accounting Pronouncements In February 1997, the Financial Accounting Standard Board ("FASB") issued SFAS No. 128, "Earnings per Share" and SFAS No. 129, "Disclosure of Information about Capital Structure" and in June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income" and SFAS No. 131, "Disclosures about Segments of an 37 ESG Re Limited Notes to the Consolidated Financial Statements Enterprise and Related Information". The Company has adopted each of these pronouncements. (m) Cash and Cash Equivalents Cash and cash equivalents include cash and bank deposits with original maturities of 90 days or less. (n) Estimates The preparation of financial statements in accordance with U.S. GAAP 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. 3. Investments (a) Fixed Maturities The amortized cost, fair value and gross unrealized gains and losses of fixed maturity investments are presented in the table below:
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 ===================================================================================================
As the Company did not have any fixed maturity or short-term investments in 1996 or 1995, no comparative information has been shown. (b) Maturity Distribution The amortized cost and market value of fixed maturities are shown in the following table by contractual maturities: Amortized Fair As of December 31, 1997 Cost Value ================================================================================ U.S. dollars in thousands Fixed maturities -- available for sale Due in one year or less $ 22,247 $ 22,295 Due after one year through five years 196,447 196,572 - -------------------------------------------------------------------------------- Total $218,694 $218,867 ================================================================================ (c) Realized Gains and Losses No gains or losses were realized during 1997. 38 ESG Re Limited Notes to the Consolidated Financial Statements (d) Change in Net Unrealized Gains on Investments The change in net unrealized gains on investments is derived from the following sources: As of December 31, 1997 - -------------------------------------------------------------------------------- U.S. dollars in thousands Change in unrealized gains on investments, net of deferred taxes, included in other comprehensive income: Fixed maturities $ 173 Deferred taxes (3) - -------------------------------------------------------------------------------- Total $ 170 ================================================================================ (e) Net Investment Income The components of net investment income are presented in the table below: Years Ended December 31, 1997 1996 1995 - -------------------------------------------------------------------------------- U.S. dollars in thousands Interest on fixed maturities $ 438 $ -- $ -- Interest on short-term investments 71 -- -- Interest on funds held in a fiduciary capacity 35 73 45 Amortization of discount on long-term management fee receivables 106 113 105 - -------------------------------------------------------------------------------- Total investment income 650 186 150 Investment expenses (52) -- -- - -------------------------------------------------------------------------------- Net investment income $ 598 $ 186 $ 150 ================================================================================ 4. Management Fees Receivable Management fees receivable represents management fee and related revenue which are primarily due from the reinsurers participating in the reinsurance pools. The receivable is recorded net of $0 and $244 thousand of advances from the pool participants as of December 31, 1997 and 1996, respectively. As described in Note 2(f), the receivable is discounted for any amounts expected to be collected after the first 12 months of the underwriting contract. The discount rates used by the Company were 5.8% for 1997, and 6.1% for 1996 and 1995, which approximate U.S. Treasury rates. The discount on the receivable is amortized into "Net investment income" over a period of 24 months. The Company's fees are collectible in various currencies. In selective instances, the Company has entered into foreign currency contracts in order to hedge the risk of fluctuations in exchange rates. Net foreign currency realized gains and (losses), including results from foreign currency contracts, are reflected in "Other expenses" and amounted to $(228) thousand, $87 thousand and $(128) thousand for the years ended December 31, 1997, 1996 and 1995, respectively. 39 ESG Re Limited Notes to the Consolidated Financial Statements 5. Deferred Acquisition Costs Activity in deferred acquisition costs for the year ended December 31, 1997 is summarized as follows: Year Ended December 31, 1997 - -------------------------------------------------------------------------------- U.S. dollars in thousands Balance at January 1 $ -- Acquisition costs incurred 8,840 Amortization of acquisition costs (4,693) - -------------------------------------------------------------------------------- Net change in deferred acquisition costs asset 4,147 - -------------------------------------------------------------------------------- Balances at December 31 $ 4,147 ================================================================================ As the Company did not have any acquisition costs in 1996 or 1995, no comparative information has been shown. 6. Losses and Loss Expenses Activity in the reserve for unpaid losses and loss expenses for the year ended December 31, 1997 is summarized as follows: Year Ended December 31, 1997 - -------------------------------------------------------------------------------- U.S. dollars in thousands Balance at January 1 $ -- Incurred related to: Current year 7,449 - -------------------------------------------------------------------------------- Total incurred losses and loss expenses 7,449 - -------------------------------------------------------------------------------- Paid related to: Current year -- - -------------------------------------------------------------------------------- Total paid losses and loss expenses -- - -------------------------------------------------------------------------------- Net balance at December 31 7,449 Plus reinsurance recoverable on incurred losses 397 - -------------------------------------------------------------------------------- Balance at December 31 $7,846 ================================================================================ 40 ESG Re Limited Notes to the Consolidated Financial Statements 7. Debt The Company has outstanding debt as of December 31, 1997 and 1996 as follows: As of December 31, 1997 1996 - -------------------------------------------------------------------------------- U.S. dollars in thousands Shareholder loan, due December 1997, balloon payment, interest at 5.7% $ -- $ 707 Shareholder loan, due December 1997, balloon payment, interest at 5.7% -- 161 Bank borrowings, payable on demand, interest at 8.0%-8.5% -- 924 Bank loan, due January 1997, interest at 7.2% -- 9 Bank loan, due March 1997, interest at 7.7% -- 11 - -------------------------------------------------------------------------------- Total debt $ -- $1,812 - -------------------------------------------------------------------------------- Current portion of debt $ -- $1,812 - -------------------------------------------------------------------------------- Long-term portion of debt $ -- $ -- ================================================================================ 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 operates 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, 1997 1996 1995 - -------------------------------------------------------------------------------- U.S. dollars in thousands Current tax expense Bermuda $ -- $ -- $ -- Foreign 4 157 75 - -------------------------------------------------------------------------------- Total current tax expense 4 157 75 Total deferred tax expense (benefit) (573) (1) 223 - -------------------------------------------------------------------------------- Total income tax expense (benefit) $(569) $ 156 $ 298 ================================================================================ The actual income tax expense attributable to income for the three years in the period ended December 31, 1997 differed from the amount computed by applying the combined effective rate of 0% under Bermuda law for 1997 and 48.375% 41 ESG Re Limited Notes to the Consolidated Financial Statements to income before income taxes under German law for 1996 and 1995, as a result of the following: Years Ended December 31, 1997 1996 1995 - -------------------------------------------------------------------------------- U.S. dollars in thousands Computed "expected tax expense" $ -- $ (4) $ 215 Tax effect of: Foreign taxes (610) 19 50 Taxable gain on reorganization of Company -- 121 -- Nondeductible expenses 15 7 10 Other 26 13 23 - -------------------------------------------------------------------------------- Total income tax expense (benefit) $(569) $ 156 $ 298 ================================================================================ 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: As of December 31, 1997 1996 - -------------------------------------------------------------------------------- U.S. dollars in thousands Deferred tax assets Net operating loss carryforward $ 683 $ 178 Investments 18 54 Rent expense 83 32 Foreign currency translation 14 16 Other assets 46 14 - -------------------------------------------------------------------------------- Total deferred tax assets 844 294 - -------------------------------------------------------------------------------- Deferred tax liabilities Unrealized investment gains (46) -- Management fee income (10) (22) - -------------------------------------------------------------------------------- Total deferred tax liabilities (56) (22) - -------------------------------------------------------------------------------- Net deferred tax asset $ 788 $ 272 ================================================================================ Realization of the deferred tax asset is dependent on generating sufficient taxable income in the future. Although realization is not assured, management believes it is more likely than not that all of the deferred tax asset will be realized. The amount of the deferred tax asset considered realizable could be reduced in the near term if estimates of future taxable income are reduced. The Company has a tax loss carryforward included in the calculation of the deferred tax asset as of December 31, 1997 of $1.2 million available to offset future foreign taxable income. This tax loss carryforward currently does not have an expiration date. Management believes it is more likely than not that the realization of the net deferred tax asset will not be affected by the recapitalization. 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 42 ESG Re Limited Notes to the Consolidated Financial Statements 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 retrocessions by monitoring its retrocessionaires and diversifying its retrocessions. 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 year ended December 31,1997 are comprised of the following: Year Ended December 31, 1997 - -------------------------------------------------------------------------------- U.S. dollars in thousands Premiums written: Assumed $ 26,143 Retroceded (751) - -------------------------------------------------------------------------------- Net premiums written $ 25,392 ================================================================================ Premiums earned: Assumed $ 13,862 Retroceded (451) - -------------------------------------------------------------------------------- Net premiums earned $ 13,411 ================================================================================ Losses and loss expenses: Assumed $ 7,846 Retroceded (397) - -------------------------------------------------------------------------------- Net losses and loss expenses $ 7,449 ================================================================================ 10. Earnings Per Share (a) 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: Loss 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 stockholders $ (5,096) 1,238,757 $(4.11) Effect of Dilutive Securities: Class A Warrants -- -- -- Director and Employee Options -- -- -- Diluted earnings per share - -------------------------------------------------------------------------------- Loss allocable to common stockholders $ (5,096) 1,238,757 $(4.11) ================================================================================ Year Ended December 31, 1996 - -------------------------------------------------------------------------------- U.S. dollars in thousands except share and per share data Basic earnings per share Loss allocable to common stockholders $ (163) 117,863 $(1.38) Effect of Dilutive Securities -- -- -- Diluted earnings per share - -------------------------------------------------------------------------------- Loss allocable to common stockholders $ (163) 117,863 $(1.38) ================================================================================ 43 ESG Re Limited Notes to the Consolidated Financial Statements Class A Warrants to purchase 1,381,200 common shares at $20 per share and options to purchase up to 469,714 common shares at $20 per share were outstanding as of 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 ended December 31, 1997, the effect of these securities was antidilutive. As discussed in Note 1, the Company was recapitalized in December 1997. In order to provide a presentation comparable to 1997, all 1996 share amounts used in the earnings per share calculation have been presented on a recapitalized basis. No earnings per share information has been provided for the year ended December 31, 1995, as there were no common shares outstanding. (b) Pro Forma Calculation of Earnings per Share (Unaudited) As described in Note 1 to the financial statements, on December 29, 1997, 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. As a result of this contractual right, the Company recorded fourth quarter revenues and expenses commensurate with a 30% share of the reinsurance pool activity for all of 1997. The common shares of the Company however were outstanding only for the period beginning December 12, 1997. Since the Company's ability to exercise the option to assume 30% of the pool's 1997 business was contingent upon successful completion of the Direct Sales and IPO, management believes that it is appropriate to include a calculation of basic and diluted earnings per share as if the common shares were outstanding also as at the beginning of the year. Following are pro forma calculations of basic and diluted earnings per share for the year ended December 31, 1997: PRO FORMA PER SHARE DATA U.S. dollars in thousands except share and per share data - -------------------------------------------------------------------------------- Net loss after tax $ (5,096) - -------------------------------------------------------------------------------- Basic net loss per share $ (0.37) - -------------------------------------------------------------------------------- Diluted net loss per share $ (0.37) - -------------------------------------------------------------------------------- Weighted average shares outstanding --basic and diluted 13,923,799 ================================================================================ 44 ESG Re Limited Notes to the Consolidated Financial Statements The reconciliation of the numerators and denominators of the pro forma basic and diluted earnings per share computations for income from continuing operations is as follows: Loss 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 stockholders $ (5,096) 13,923,799 $(0.37) Effect of Dilutive Securities Warrants -- -- -- Director and Employee Options -- -- -- Diluted earnings per share Loss allocable to common stockholders $ (5,096) 13,923,799 $(0.37) ================================================================================ The effect of dilutive securities was not included in the computation of pro forma diluted earnings per share. 11. Commitments and Contingencies (a) Employment Contracts The Company has entered into employment contracts with five employees for terms of three years which have total minimum commitments of $4 million, excluding any performance bonuses which 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 $286 thousand, $295 thousand and $193 thousand for the years ended December 31, 1997, 1996 and 1995, respectively. The future minimum commitments under lease and employment agreements are as follows: Employment Lease Years Ending December 31, Commitments Commitments Total - -------------------------------------------------------------------------------- U.S. dollars in thousands 1998 $1,618 $ 384 $2,002 1999 1,276 456 1,732 2000 1,078 469 1,547 2001 62 339 401 2002 -- 77 77 - -------------------------------------------------------------------------------- Total $4,034 $1,725 $5,759 ================================================================================ 45 ESG Re Limited Notes to the Consolidated Financial Statements (c) Pension Obligations Certain subsidiaries are obligated to make defined contributions to pension plans for their employees. There was no outstanding liability for pension contributions as of December 31, 1997 and 1996. Pension contribution expense was $29 thousand, $20 thousand and $24 thousand for the years ended December 31, 1997, 1996 and 1995, respectively. 12. Underwriting Management Services As part of its 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 agreement 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. Interest income on these funds amounted to $35 thousand, $73 thousand and $45 thousand for the years ended December 31, 1997, 1996 and 1995, respectively. All of the underwriting pool funds are invested in short-term investments with original maturities of less than 90 days. The total amount of funds held on behalf of the pools was $10.5 million and $4.9 million at December 31, 1997 and 1996, respectively. 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. In accordance with the Emerging Issues Task Force Consensus 96-18, the Company has recorded compensation expense of $3.6 million. This expense was reflected as a charge to the statement of operations for the year ended December 31, 1997, and as an increase to additional paid-in capital. On February 5, 1998, 276,240 of the Class B Warrants vested and are immediately exercisable. 46 ESG Re Limited Notes to the Consolidated Financial Statements 14. Stock-Based Compensation Plans (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. Under the 1997 Employee Stock Option Plan, options to purchase a total of 374,000 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 grant and expire 10 years after the date of 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 nonmanagement 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 nonmanagement directors on the date of each successive annual shareholders' meeting. In addition, each nonmanagement 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 with a value, as determined by the Board, 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 47 ESG Re Limited Notes to the Consolidated Financial Statements 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. On December 12, 1997, all nonmanagement directors elected to receive their fees as options to purchase shares. As a result, 55,714 shares of Common Stock have been granted as stock options. Compensation expense equal to the Directors' fee payable of $195 thousand, will be recognized over the period in which the services are to be provided. For the year ended December 31, 1997, compensation expense of $39 thousand was recorded. In addition, under the 1997 Directors' Stock Option Plan, an additional 40,000 shares of Common Stock were granted as stock options to nonmanagement directors of the Company. Options granted under the Directors' Stock Option 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 stock option plans as of December 31, 1997 is presented below: Weighted Average Shares Exercise Price - -------------------------------------------------------------------------------- Outstanding at January 1 -- -- Granted 469,714 $20.00 - -------------------------------------------------------------------------------- Outstanding at December 31 469,714 $20.00 - -------------------------------------------------------------------------------- Options exercisable at December 31 189,214 $20.00 - -------------------------------------------------------------------------------- Weighted average fair value of options granted during the year $ 7.00 ================================================================================ The fair value of each option grant was estimated on the date of grant using the Black/Scholes option pricing model with the following assumptions: (i) dividend yield of 1.13%; (ii) expected volatility of 20.9%; (iii) risk-free interest rate of 5.841%; and (iv) expected life of 8 years. The following table summarizes information about stock options outstanding as of December 31, 1997:
Options Outstanding Options Exercisable - ---------- -------------------------------------------------------- ---------------------------------- Number Weighted Average Weighted Number Weighted Exercise Outstanding at Remaining Average Exercisable at Average Price December 31, 1997 Contractual Life Exercise Price December 31, 1997 Exercise Price - ---------------------------------------------------------------------------------------------------------- $20.00 469,714 10 years $20.00 189,214 $20.00 ==========================================================================================================
48 ESG Re Limited Notes to the Consolidated Financial Statements 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 loss and loss per share would have been adjusted to the pro forma amounts indicated below: Year Ended December 31, 1997 - -------------------------------------------------------------------------------- U.S. dollars in thousands except share and per share data Net Loss As reported $ (5,096) Pro forma (5,409) ================================================================================ Loss per share - basic and diluted As reported $ (4.11) Pro forma (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 expensed $45 thousand under this agreement for the year ended December 31, 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. Certain of the 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. 49 ESG Re Limited Notes to the Consolidated Financial Statements 16. Notes to the Statement of Comprehensive Income (a) Tax Effect of Components of Comprehensive Income As of December 31, 1997 Before Tax Tax Expense Net of Tax ================================================================================ U.S. dollars in thousands Foreign currency translation adjustments $ 36 $ -- $ 36 Unrealized gains on securities: Unrealized holding gains arising during the period 173 (3) 170 Less reclassification adjustment for gains included in net income -- -- -- - -------------------------------------------------------------------------------- Unrealized gains on securities net of reclassification adjustment 173 (3) 170 - -------------------------------------------------------------------------------- Other comprehensive income $ 209 $ (3) $ 206 ================================================================================ As of December 31, 1996 - -------------------------------------------------------------------------------- Foreign currency translation adjustments $ (1) $ -- $ (1) - -------------------------------------------------------------------------------- Other comprehensive income $ (1) $ -- $ (1) ================================================================================ As of December 31, 1995 - -------------------------------------------------------------------------------- Foreign currency translation adjustments $ (3) $ -- $ (3) - -------------------------------------------------------------------------------- Other comprehensive income $ (3) $ -- $ (3) ================================================================================ (b) Accumulated Other Comprehensive Income Foreign Accumulated Currency Unrealized Other Translation Gains on Comprehensive As of December 31, 1997 Adjustments Securities Income - -------------------------------------------------------------------------------- U.S. dollars in thousands Beginning balance $ (4) $ -- $ (4) Current period change 36 170 206 - -------------------------------------------------------------------------------- Ending balance $ 32 $ 170 $ 202 ================================================================================ As of December 31, 1996 - -------------------------------------------------------------------------------- Beginning balance $ (3) $ -- $ (3) Current period change (1) -- (1) - -------------------------------------------------------------------------------- Ending balance $ (4) $ -- $ (4) ================================================================================ As of December 31, 1995 - -------------------------------------------------------------------------------- Beginning balance $ -- $ -- $ -- Current period change (3) -- (3) - -------------------------------------------------------------------------------- Ending balance $ (3) $ -- $ (3) ================================================================================ 50 ESG Re Limited Notes to the Consolidated Financial Statements 17. Segment Information SFAS No. 131 requires that an enterprise disclose information about its operating segments. The following table provides summary financial information of the Company's reportable segment by its geographic region: Years Ended December 31, 1997 1996 1995 - -------------------------------------------------------------------------------- U.S. dollars in thousands Revenue earned: Bermuda $13,763 $ -- $ -- Germany 3,989 4,055 4,665 Other 87 -- -- - -------------------------------------------------------------------------------- Total revenue earned $17,839 $ 4,055 $ 4,665 ================================================================================ Deferred Policy Acquisition Deferred Tax As of December 31, 1997 Costs Assets ================================================================================ U.S. dollars in thousands Bermuda $4,147 $ -- Other foreign countries -- 788 - -------------------------------------------------------------------------------- $4,147 $ 788 ================================================================================ As of December 31, 1996 - -------------------------------------------------------------------------------- Bermuda $ -- $ -- Other foreign countries -- 272 - -------------------------------------------------------------------------------- $ -- $ 272 - -------------------------------------------------------------------------------- 18. Significant Clients 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. For the years ended December 31, 1995, two clients contributed $921 thousand and $469 thousand. 19. Fair Value Information The fair value of financial instruments as of December 31, 1997 and 1996 was as follows: 1997 1996 - -------------------------------------------------------------------------------- Carrying Fair Carrying Fair Value Value Value Value - -------------------------------------------------------------------------------- U.S. dollars in thousands Assets: Fixed maturities available for sale $218,867 $218,867 $ -- $ -- Short-term investments 11,913 11,913 -- -- Cash and cash equivalents 6,196 6,196 15 15 Foreign exchange contracts -- -- -- (12) Short-term debt -- -- 1,812 1,812 ================================================================================ 51 ESG Re Limited Notes to the Consolidated Financial Statements 20. 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 of Bermuda, ES Bermuda is required to maintain certain measures of solvency and liquidity. For the year ended December 31, 1997, these requirements have been met. The statutory capital and surplus of ES Bermuda was $101.5 million and the minimum required statutory capital and surplus was $4.1 million as of December 31, 1997. The minimum required level of liquid assets was $22.3 million with actual liquid assets of $81.1 million as of December 31, 1997. 21. Unaudited Quarterly Financial Data
1997 Operating data: 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter - ------------------------------------------------------------------------------------------ U.S. dollars in thousands except per share data Gross premiums written $ -- $ -- $ -- $ 26,143 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 1996 Operating data: - ------------------------------------------------------------------------------------------- U.S. dollars in thousands except per share data Management fee revenue $ 2,781 $ 357 $ 209 $ 522 Net income (loss) 669 (228) (573) (31) ========================================================================================== Earnings per common share: Basic net loss per share $ -- $ (2.09) $ (3.18) $ (0.17) Diluted net loss per share $ -- $ (2.09) $ (3.18) $ (0.17) Weighted average shares outstanding (000's) 0 109 180 180 ==========================================================================================
52 ESG Re 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, 1997 and 1996, 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, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with 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, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with accounting principles generally accepted in the United States of America. Deloitte & Touche Chartered Accountants Hamilton, Bermuda February 19, 1998 53 ESG Re Limited Corporate Directory Board of Directors 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 Operating 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) Chairman and Chief Executive Consolidated Financial Insurance Group, Ltd. London, England Executive Management Wolfgang M. Wand Managing Director and Chief Executive Officer Steven H. Debrovner Chief Operating Officer Gerhard Jurk Chief Financial Officer Renate M. Nellich Chief Executive Officer European Specialty (North America) Limited Corporate Secretary Anthony Parfitt Investor Relations Hugo Idler (a) Member of the Compensation Committee (b) Member of the Audit Committee 54 ESG Re Limited Subsidiary Companies-Supervisory Boards 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 Dr. Jur. Franz Gori Member of the Board Jurgen Gorling Member of the Board European Specialty Group (United Kingdom) Limited Andrew W. Apps Managing Director, U.K. Darryl Gumm Managing Director, Pacific Region 55 ESG Re Limited Shareholder Information Shareholders Meeting The Annual General Meeting will be held on May 4, 1998 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. As of March 20, 1998, the approximate number of common shareholders was 1550. Stock Transfer and Dividend Agent State Street Bank & Trust Company c/o Boston Equiserve, L.P. 150 Royall Street Canton, Massachusetts 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 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 11 Windsor Place Lower Pembroke Street Dublin, 2 Ireland Telephone (353-1) 676 8766 Telefax (353-1) 676 8792 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 (North America) Limited 141 Adelaide Street West Toronto, M5H 3L2, Canada Telephone (1 416) 864 7443 Telefax (1 416) 864 9615 European Specialty Ruckversicherung AG Fleethof Stadthausbrucke 1-3 Hamburg, 20355 Germany Telephone (49 40) 36 98 860 Telefax (49 40) 36 98 86 69 SportSecure GmbH Fleethof Stadthausbrucke 1-3 Hamburg, 20355 Germany Telephone (49 40) 36 98 86 91 Telefax (49 40) 36 98 86 92 Jeffrey Leder Inc. Marketing Design NYC 56 ESG [LOGO] INTELLIGENT REINSURANCE EX-24.1(A) 5 INDEPENDENT AUDITORS' REPORT Exhibit 24.1(a) Independent Auditors' Report To the Board of Directors and Shareholders of ESG Re Limited We have audited the consolidated financial statements of ESG Re Limited (the "Company") as of December 1997 and 1996, and for each of the three years in the period ended December 31, 1997, and have issued our report thereon dated February 19, 1998; such consolidated financial statements and report are included in your 1997 Annual Report to Shareholders and are incorporated herein by reference. Our audits also included the consolidated financial statement schedules of the Company, listed in Item 14. These consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. Deloitte & Touche Chartered Accountants Hamilton, Bermuda February 19, 1998 EX-24.1(B) 6 INDEPENDENT AUDITORS' CONSENT EXHIBIT 24.1(b) INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statement No. 333-40341 of ESG Re Limited on Form S-8 of our reports dated February 19, 1998, appearing in and incorporated by reference in this Annual Report on Form 10-K of ESG Re Limited for the year ended December 31, 1997. Deloitte & Touche Chartered Accountants Hamilton, Bermuda March 27, 1998 EX-27.1 7 FDS
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. YEAR DEC-31-1997 JAN-01-1997 DEC-31-1997 218,867 0 0 0 0 0 230,780 6,196 397 4,147 273,068 7,846 12,168 0 0 0 0 0 13,924 220,451 273,068 13,411 598 0 3,830 7,449 4,693 0 (5,665) (569) (5,096) 0 0 0 (5,096) (4.11) (4.11) 0 7,846 0 0 0 7,846 0
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