-----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, ANrCBFlqLCSMPYfjw2ypgMwcZbiacpErN9tQy3XCAWOPIe4ROBNC9KixfXBGWxgM YTBkw1pENy3BhT6W3x4WrQ== 0001047469-98-012919.txt : 19980401 0001047469-98-012919.hdr.sgml : 19980401 ACCESSION NUMBER: 0001047469-98-012919 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 10 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980331 SROS: NYSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: ENHANCE FINANCIAL SERVICES GROUP INC CENTRAL INDEX KEY: 0000881889 STANDARD INDUSTRIAL CLASSIFICATION: INSURANCE CARRIERS, NEC [6399] IRS NUMBER: 133333448 STATE OF INCORPORATION: NY FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 001-10967 FILM NUMBER: 98582090 BUSINESS ADDRESS: STREET 1: 335 MADISON AVE CITY: NEW YORK STATE: NY ZIP: 10017 BUSINESS PHONE: 2129833100 MAIL ADDRESS: STREET 1: 335 MADISON AVENUE STREET 2: 25TH FLOOR CITY: NEW YORK STATE: NY ZIP: 10017 10-K405 1 10-K405 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 Commission file December 31, 1997 number 1-10967 ENHANCE FINANCIAL SERVICES GROUP INC. ------------------------------------------------------ (Exact name of registrant as specified in its charter) New York 13-3333448 ------------------------------- ------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 335 Madison Avenue, New York, NY 10017 ---------------------------------------- ---------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: 212-983-3100 Securities registered pursuant to Section 12(b) of the Act: Common Stock, $.10 par value New York Stock Exchange, Inc. - ---------------------------- ------------------------------------------- (Title of Class) (Name of each exchange on which registered) Securities registered pursuant to Section 12(g) of the Act: None ---------------- (Title of class) Indicate by check mark whether 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 approximate aggregate market value of voting stock held by non-affiliates of the registrant as of the close of trading on March 27, 1998 was $867,917,400. The number of shares of Common Stock outstanding as of that date was 18,794,519. For purposes of this calculation, shares of Common Stock held by directors, executive officers and shareholders whose ownership exceeds ten percent of the Common Stock outstanding on that date were excluded. Exclusion of shares held by any person should not be construed to indicate that such person possesses the power, direct or indirect, to direct or cause the direction of the management or policies of the registrant, or that such person is controlled by or under common control with the registrant. PART I Item 1. Business. GENERAL Enhance Financial Services Group Inc. ("Enhance Financial," and together with its consolidated subsidiaries, the "Company") is a holding company engaged, through its subsidiaries, principally in the reinsurance of financial guaranties of municipal and asset-backed debt obligations issued by monoline financial guaranty insurers. In addition, the Company is engaged in other insurance, reinsurance and non-insurance businesses that utilize the Company's expertise in performing sophisticated analysis of complex, credit-based risks. Enhance Financial has since its inception conducted the major portion of its business through its wholly-owned financial guaranty insurance subsidiaries, Enhance Reinsurance Company ("Enhance Re") and Asset Guaranty Insurance Company ("Asset Guaranty" and together with Enhance Re, the "Insurance Subsidiaries"). The Company conducts a smaller portion of its business through other insurance and non-insurance subsidiaries and companies (including a Brazilian surety company) in which it has equity investments. The Company expects that a significant portion of its growth will come from non-financial guaranty businesses. The Company's business strategy is to maintain its financial guaranty business, both primary and reinsurance and its commitment to intensive and prudent credit underwriting and conservative investment policies; to utilize its expertise in underwriting credit risks to expand and develop its other insurance businesses; and to continue to pursue its diversification efforts utilizing its credit analysis skills in areas that the Company believes have strong profit and growth potential relative to risk. As part of its diversification and global expansion efforts, the Company expects to further develop the strategic relationship with Swiss Reinsurance Company ("Swiss Re") which it initiated in 1996. Reinsurance of financial guaranties issued by monoline financial guaranty insurers represented 54.3% of the Company's gross premiums written for the year ended December 31, 1997. During the year ended December 31, 1997, the Company received 25.4% of the total reinsurance premiums ceded by all monoline financial guaranty insurers. The Company's other insurance businesses include the issuance of direct financial guaranties of smaller debt obligations, trade credit reinsurance, financial responsibility bonds and excess-SIPC/excess-ICS and related types of bonds. These other insurance businesses represent 45.7% of the Company's gross premiums written for the year ended December 31, 1997. The Company is also engaged in the origination, purchase, servicing and/or securitization of special assets, including winning lottery tickets, structured settlements and sub-performing/non-performing residential mortgages. The Company is continuing to expand these businesses and is diversifying its products and services into other areas that the Company believes have strong growth potential and in which the Company's strengths in credit analysis and securitization can provide a competitive advantage. Enhance Re has been rated by Standard & Poor's Corporation ("Standard & Poor's"), Moody's Investors Service, Inc. ("Moody's") and Duff & Phelps Credit Rating Company ("Duff & Phelps"), which have assigned it triple-A claims-paying ability ratings, their highest rating. Asset Guaranty has been rated by Duff & Phelps and Standard & Poor's, which have assigned it triple-A and double-A claims-paying ability ratings, respectively. FINANCIAL GUARANTY INSURANCE INDUSTRY OVERVIEW General Financial guaranty insurance provides an unconditional and irrevocable guaranty to the holder of a debt obligation of full and timely payment of principal and interest. In the event of a default under the obligation, the insurer has recourse against the issuer and/or any related collateral (which is a more common component in the case of insured asset-backed obligations or other non-municipal debt) for amounts paid under the terms of the policy. Payments under the insurance policy may not be accelerated by the holder of the debt obligation. Absent payment in full at the option of the insurer, in the event of a default under an insured obligation, the holder continues to receive payments of principal and interest on schedule, as if no default had occurred. Each subsequent purchaser of the obligation generally receives the benefit of such guaranty. The issuer of the obligation pays the premium for financial guaranty insurance either in full at the inception of the policy or, less commonly, in installments on an annual basis. Premium rates are typically calculated as a percentage of either the principal amount of the debt or total exposure (principal and interest). Rate setting reflects such factors as the credit strength of the issuer, type of issue, sources of income, collateral pledged, restrictive covenants, maturity and competition from other insurers. Premiums are generally non-refundable and are earned over the life of the insured obligation. This long and relatively predictable earnings pattern is characteristic of the financial guaranty insurance industry and provides a relatively stable source of future revenues and claims-paying ability to financial guaranty insurers and reinsurers. There are currently four major monoline primary U.S. financial insurers: Municipal Bond Investors Assurance Corporation ("MBIA"), AMBAC Indemnity Corporation ("AMBAC"), Financial Guaranty Insurance Company ("FGIC") and Financial Security Assurance Inc. ("FSA"). Two previous primary U.S. financial insurers, Capital Market Assurance Corporation ("CapMAC") and Construction Loan Insurance Corporation ("Connie Lee"), were acquired by MBIA in February 1998 and by AMBAC in December 1997, respectively. Financial Guaranty Market The primary financial guaranty insurance market consists of two main sectors: municipal bond insurance and insurance on asset-backed debt. Municipal Bond Market. Municipal bond insurance provides credit enhancement of bonds, notes and other evidences of indebtedness issued by states and their political subdivisions (for example, counties, cities, or towns), utility districts, public universities and hospitals, public housing and transportation authorities, and other public and quasi-public entities. Municipal bonds are supported by the issuer's taxing power in the case of general obligation or special tax-supported bonds, or by its ability to impose and collect fees and charges for public services or specific projects in the case of most revenue bonds. Insurance provided to the municipal bond market has been and continues to be the major source of revenue for the financial guaranty insurance industry. -2- The following table sets forth certain information regarding new-issue long term (over one year) municipal bonds and new-issue insured long term municipal bonds, in each case issued during the years indicated:
New Insured Volume New New as Percent of Year Total Volume (1) Insured Volume (1) New Total Volume - ---- ---------------- ------------------ ---------------- (Dollars in billions) 1993 $ 292.0 $ 107.9 37.0% 1994 164.5 61.3 37.3 1995 160.3 68.3 42.6 1996 184.4 85.2 46.2 1997 220.4 107.5 48.8
- ---------- (1) Based upon estimated data provided by The Bond Buyer, February 9, 1998. The overall increase in the volume of municipal bond issuance in 1997 resulted from an increase in refunding issues, which represented 26.8% of total issuance compared to 31.0% in 1996, as well as a higher amount of bonds issued for new money purposes, which increased to $140.9 billion in 1997 from $124.0 billion in 1996. Asset-Backed Debt Market. Asset-backed transactions or securitizations constitute a form of structured financing which are distinguished from unsecured debt issues by being secured by a specific pool of assets held by the issuing entity, rather than relying on the general unsecured creditworthiness of the issuer of the obligation. While most asset-backed debt obligations represent interests in pools of assets, such as residential and commercial mortgages and credit card and auto loan receivables, monoline financial guarantors have also insured asset-backed debt obligations secured by one or a few assets, such as utility mortgage bonds and multi-family housing bonds. While the asset-backed securities market has grown significantly in recent years, consensus estimates are lacking as to the insured volume. Reinsurance Reinsurance is the commitment by one insurance company, the "reinsurer," to reimburse another insurance company, the "ceding company," for a specified portion of the insurance risks underwritten by the ceding company. Because the insured party contracts for coverage solely with the ceding company, the failure of the reinsurer to perform does not relieve the ceding company of its obligation to the insured party under the terms of the insurance contract. While reinsurance provides various benefits to the ceding company, perhaps most importantly it enables a primary insurer to write greater single risks and greater aggregate risks without contravening the capital requirements of applicable state insurance laws and rating agency guidelines. State insurance regulators allow primary insurers to reduce the liabilities appearing on their balance sheets to the extent of reinsurance coverage obtained from licensed reinsurers or from unlicensed reinsurers meeting certain solvency and other financial criteria. Similarly, the rating agencies permit such a reduction for reinsurance in an amount that depends on the claims-paying ability rating of the reinsurer. See "Insurance Regulatory Matters" and "Description of Business -- Rating Agencies." The principal forms of reinsurance are treaty and facultative. Under a treaty arrangement the ceding company is obligated to cede, and the reinsurer is correspondingly obligated to -3- assume, a specified portion of a specified type of risk or risks insured by the ceding company during the term of the treaty (although the reinsurance risk thereafter extends for the life of the respective underlying obligations). Under a facultative agreement, the ceding company from time to time during the term of the agreement offers a portion of specific risks to the reinsurer, usually in connection with particular debt obligations. A facultative arrangement further differs from a treaty arrangement in that under a facultative arrangement the reinsurer oftentimes performs its own underwriting credit analysis to determine whether to accept a particular risk, while in a treaty arrangement the reinsurer generally relies on the ceding company's credit analysis. Both treaty and facultative agreements are typically entered into for an indefinite term, subject to a right of termination under certain circumstances. Treaty and facultative reinsurance are typically written on either a proportional or non-proportional basis. Proportional relationships are those in which the ceding company and the reinsurer share the premiums, as well as the losses and expenses, of a single risk or group of risks in an agreed percentage. In addition, the reinsurer generally pays the ceding company a ceding commission, which is typically related to the ceding company's cost of obtaining the business being reinsured. Non-proportional reinsurance relationships are typically on an excess-of-loss basis. An excess-of-loss relationship provides coverage to a ceding company to the extent that losses exceed a certain amount, in an amount up to a certain dollar limit. Reinsurers may also, in turn, purchase reinsurance under what are called "retrocessional agreements" to cover all or a portion of their own exposure for reasons similar to those that cause primary insurers to purchase reinsurance. See "Description of Business -- Reinsurance Ceded." DESCRIPTION OF BUSINESS Reinsurance of Monoline Financial Guaranty Insurers The Company's principal business is the reinsurance of financial guaranty insurance written by the U.S. monoline financial guaranty insurers. The Company provides reinsurance on a treaty and/or a facultative basis for such companies. See "Sources of Premiums" in this item. As of December 31, 1997, 47.3% of the Company's insurance in force attributable to the monoline financial guaranty insurers represented business underwritten on a treaty basis, with the balance being facultative. The reinsurance written by the Company is subject to a detailed underwriting review. Most of the Company's reinsurance activity is written on a proportional reinsurance basis. The Company believes that the reinsurance of municipal bond guaranties, which the Company expects will grow in response to the anticipated long-term growth in the municipal bond market, provides a relatively stable source of premium income for the Company. In addition, premiums received are credited as deferred premium revenue and are earned as the related risks amortize, thereby providing a relatively stable, predictable source of earned premiums. Premiums Ceded by Individual Primary Insurers. The following table sets forth certain information regarding premiums ceded by the monoline financial guaranty insurers to the Company in 1997, 1996 and 1995: -4-
Year Ended December 31, ------------------------------------------------------------------------------------------- 1997 1996 1995 ---- ---- ---- Gross Gross Gross Primary Premiums Percent of Premiums Percent of Premiums Percent of Insurer Ceded Total Ceded Total Ceded Total - ------- ----- ----- ----- ----- ----- ----- (Dollar amounts in millions) AMBAC $ 9.8 16.7% $ 9.4 16.5% $19.2 34.9% CapMAC 8.0 13.6 6.2 10.9 3.6 6.6 CGIC (1) -- -- -- -- 1.1 2.0 Connie Lee 0.3 0.5 2.3 4.0 0.9 1.6 FGIC 4.8 8.2 7.3 12.8 6.7 12.2 FSA 17.3 29.4 14.0 24.6 7.2 13.1 MBIA 18.6 31.6 17.7 31.2 16.3 29.6 ----- ----- ----- ----- ----- ----- Total $58.8 100.0% $56.9 100.0% $55.0 100.0% ===== ===== ===== ===== ===== =====
- ---------- (1) The corporate parent of FSA acquired CGIC in December 1995. Insurance Portfolio Data. The Company seeks to maintain a diversified insurance portfolio designed to spread its risk based on issuer, type of debt obligation insured and geographic concentration. The following table sets forth the distribution of the Company's reinsured monoline-guarantied obligations by bond type as of December 31, 1997. As of December 31, 1997 -------------------------------------- Type of Obligation Insurance in Force Percent of Total - ------------------ ------------------ ---------------- (In billions) Municipal: General obligation/tax supported... $ 18.8 31.3% Water/sewer/electric/gas .......... 10.3 17.1 Health care ....................... 6.8 11.3 Airports/transportation ........... 6.8 11.3 Housing revenue ................... 1.5 2.5 Other (2) ......................... 2.4 4.0 ----- ----- Total municipal ................ 46.6 77.5 ----- ----- Non-municipal Consumer obligations .............. 6.8 11.3 Investor-owned utilities .......... 3.4 5.7 Commercial mortgage ............... 0.2 0.3 Other (3) ......................... 3.1 5.2 ----- ----- Total non-municipal ............ 13.5 22.5 ----- ----- Total .......................... $60.1 100.0% ===== ===== - ---------- (1) Represents the Company's proportionate share of the aggregate outstanding principal and interest payable on such insured obligations. -5- (2) Represents other types of municipal obligations, none of which individually constitutes a material amount or percentage of the Company's insurance in force. (3) Includes $1.3 billion collateralized by corporate debt obligations. The balance represents other types of assets which collateralize obligations reinsured by the Company, none of which individually constitutes a material amount or percentage of the Company's insurance in force. The following table identifies by issuer the Company's ten largest single-risk insurance in force amounts outstanding as of December 31, 1997 and the credit rating assigned by Standard & Poor's as of that date (in the absence of financial guaranty insurance) to each such issuer:
Insurance in Force as Credit Credit Rating Obligation Type of December 31, 1997 - ------ ------------- --------------- -------------------- (In millions) New York City Municipal Water Finance Authority.............. A+ Water & Sewer $891.6 New York City, NY................. BBB+ General Obligation 670.9 State of California............... A+ General Obligation 621.6 Commonwealth of Puerto Rico.................... A General Obligation 611.7 Dade County, Florida Water & Sewer System................... A Water & Sewer 602.7 Houston, TX Combined Water & Sewer System................... A- Water & Sewer 598.1 Massachusetts Turnpike System......................... A+ Transportation 508.5 Commonwealth of Massachusetts.................. A+ General Obligation 468.4 Nassau County, NY................. A- General Obligation 465.6 Public Service Elec. & Gas of New Jersey..................... BBB+ Investor Owned Utility 446.7
The following table sets forth the distribution by state of the Company's insurance in force in connection with its reinsurance of monoline-guarantied obligations as of December 31, 1997: As of December 31, 1997 ---------------------------------------------- Jurisdiction Insurance in Force Percent of Portfolio - ------------ ------------------ -------------------- (In billions) California...................... $7.8 13.0% New York........................ 6.2 10.3 Florida......................... 4.1 6.8 Texas........................... 3.7 6.2 Pennsylvania.................... 2.9 4.8 New Jersey...................... 2.6 4.3 Illinois........................ 2.5 4.2 Massachusetts................... 2.3 3.8 Puerto Rico..................... 1.6 2.7 Ohio............................ 1.5 2.5 Other (1)....................... 24.9 41.4 ----- ----- Total.................. $60.1 100.0% ===== ===== -6- - ---------- (1) Includes $10.5 billion related to pooled or foreign credits for which specific allocation by state is not available. The balance represents all remaining states, the District of Columbia and several foreign countries, in which obligations insured and reinsured by the Company arise, none of which individually constitutes a material portion of the Company's insurance in force. Underwriting Staffing, Policies and Procedures. The Company believes that its underwriting discipline has been critical to its profitable growth. The Company has a structured underwriting process to determine the characteristics and creditworthiness of risks that it reinsures, which process supplements the underwriting procedures of the primary insurers. Rather than relying entirely upon the underwriting performed by the primary insurers, both the Company and the rating agencies conduct extensive reviews of the primary insurers. The Company conducts periodic detailed reviews of each monoline primary carrier with which it does treaty or facultative business. That review entails an examination of the primary insurer's operating, underwriting and surveillance procedures; personnel; organization and existing book of business, as well as the primary insurer's underwriting of a sample of business assumed under the treaty. Facultative transactions are reviewed individually under procedures adopted by the Company's credit committee. Any underwriting issues are discussed internally by the Company's credit committee and with the primary insurer's personnel. Moreover, the Company relies on ongoing oversight by its credit committee to avoid undue exposure concentration in any given type of obligation or geographic area. Moreover, the ceding insurer is typically required to retain at least 25% of the exposure on any single risk assumed. Limitations on the Company's single-risk exposure derive from state insurance regulation, rating agency guidelines and internally established criteria. The primary factor in determining single-risk capacity is the class or sector of business being underwritten. For municipal credits, the Company has self-imposed single-risk guidelines which range widely, depending upon the perceived risk of default of the municipal obligation reinsured. For asset-backed transactions, the Company's single-risk guidelines generally follow state insurance regulation limitations, as well as self-imposed single risk and cumulative servicer-related risk guidelines. On individual underwritings, the Company's credit committee may limit the allocation of capacity to an amount below that allowed by the single-risk guidelines noted above. The Company's surveillance procedures include reviews of those exposures assumed as a reinsurer as to which it may have concerns. The Company also maintains regular communication with the surveillance departments of the ceding primary insurers. Other Insurance Businesses The Company services certain insurance specialty markets not served by the monoline financial guaranty industry. In certain of these new business areas, the Company operates as a primary insurer in areas or for transactions where the monoline financial guaranty primaries may decline to provide coverage; others involve the Company serving as a reinsurer for certain specialty primary insurers, in some of which the Company has significant equity interests or is otherwise a participant. -7- In writing these other insurance lines of business, the Company utilizes its expertise in evaluating complex credit-based risks. These businesses represent 45.7% of the Company's gross premiums written for the year ended December 31, 1997, compared to 40.0% for the year ended December 31, 1996. The Company's business strategy is to expand and develop further these other insurance lines, which the Company believes have strong profit and growth potential and where the Company's expertise can be utilized. Premiums in respect of certain of the Company's other insurance businesses are earned over a significantly shorter period than those in respect of the Company's monoline reinsurance business. The Company's ability to realize consistent levels of earned premiums in these insurance businesses will therefore depend on its ability to write consistent levels of new insurance. The following tables set forth certain information concerning the Company's other insurance businesses as of December 31, 1997 and for the year then ended: Category of Other Insurance Business Insurance in Force* As of December 31, 1997 ----------------------- (In billions) Municipal bonds - direct......................... $3.5 Multi-family housing-backed financings........... 0.3 Financial responsibility bonds................... 0.3 Other financial guaranty......................... 0.2 ---- Total $4.3 ==== - ---------- * Does not include insurance in force pursuant to the excess-SIPC/excess-ICS program and credit reinsurance described below in this section. Year Ended December 31, 1997 ---------------------------------- Net Premiums Category of Other Insurance Business Written Premiums Earned - ------------------------------------ ------- --------------- (In millions) Credit reinsurance........................ $19.5 $19.2 Excess-SIPC/excess-ICS and other.......... 12.2 8.5 Municipal bonds - direct.................. 9.0 4.0 Financial responsibility bonds............ 3.3 3.8 ----- ----- Total $44.0 $35.5 ===== ===== Municipal bonds. The Company writes municipal bond insurance as a primary insurer in certain transactions where the financial guaranty monoline primary insurers generally elect not to participate. This writing is focused on various market sectors including tax-backed obligations, infrastructure revenue bonds, healthcare bonds, higher education bonds and municipal lease obligations. Each such issue, subsequent to its being insured, are reviewed by Standard & Poor's and Duff & Phelps, which determine the credit quality of the issue and, after their review, report their findings to the Company. Credit Reinsurance. Credit reinsurance protects sellers of goods under certain circumstances against non-payment of the receivables they hold from buyers of those goods. The Company covers receivables both where the buyer and seller are in the same country as -8- well as cross-border receivables. Sometimes in the latter instance, the coverage extends to certain political risks (foreign currency controls, expropriation, etc.) which interfere with the payment from the buyer. As of December 31, 1997, Enhance Financial owned an indirect 36.5% equity interest (representing 55% of the voting interest) in Exporters Insurance Company Ltd. ("Exporters"), an insurer of domestic and foreign trade receivables for multinational companies. The Company provides significant reinsurance capacity to this joint venture on a proportional quota-share basis. The Company is a member-reinsurer, together with Great American Insurance Company, of the Foreign Credit Insurance Association ("FCIA"), which guaranties export financing for transactions between exporters and foreign purchasers. In addition, the Company participates in proportional and non-proportional reinsurance treaties with approximately 20 credit insurers, frequently in Europe. The largest relationships in terms of premiums are with the FCIA (domiciled in the United States) and the Euler Group (major subsidiaries domiciled in France, Belgium, the Netherlands, the United Kingdom and the United States). Financial Responsibility Bonds. The Company owns a controlling equity interest in Van-American Insurance Company ("Van-Am"), which writes reclamation bonds for the coal mining industry, generally in strip mining ventures, and surety bonds covering the closure and post-closure obligations of landfill operators. Asset Guaranty reinsures the reclamation bonds for the coal mining industry issued by Van-Am on both a treaty and facultative basis and surety bonds for landfill operators issued by Van-Am on a facultative basis only. Excess-SIPC/Excess-ICS. The Company writes surety bonds for the protection of customers of large securities brokers against the loss of securities in their brokerage accounts in the event of the broker's insolvency and liquidation. Bonds issued under this program typically provide coverage for loss per account in excess of the $500,000 in the case of loss covered by the U.S.-government-established Securities Investor Protection Corporation ("SIPC"), or 48,000 pounds sterling (approximately $79,000) in the case of loss covered by the U.K.-government-established Investors Compensation Scheme ("ICS"). Bonds issued under this program generally provide coverage for customers of United States-domiciled and United Kingdom-domiciled securities brokers, including customers of their affiliated securities brokerage concerns domiciled in other countries which clear transactions through them. Customers in the latter category are entitled to payment for covered losses only upon the insolvency and liquidation of the U.S.- or U.K.-domiciled broker clearing their account. The coverage is offered only to members of the securities brokerage community that meet specific financial, legal and operating criteria established by the Company. Although the dollar value of customer account assets protected by the Company's excess-SIPC/excess-ICS policies totals in the billions, the Company's estimated exposure is considerably lower. Losses in a brokerage account occur only to the extent, if any, a covered broker-dealer becomes insolvent and securities are missing and the individual customer losses, which are prorated among all the customers of that broker-dealer, exceed the applicable deductible amount, which ranges from $500,000 for losses covered by SIPC, or 48,000 pounds sterling for losses covered by ICS. As part of its underwriting process, the Company reviews the operations and exposure amounts of each broker-dealer applying for coverage and calculates a maximum loss based on the normal day-to-day operational exposures of that broker-dealer. -9- Underwriting Process and Surveillance. The underwriting criteria applied in evaluating a given issue for primary insurance coverage and the internal procedures (for example, credit committee review) for approval of the issue are substantially the same as for the underwriting of reinsurance. See "Reinsurance of Monoline Financial Guaranty Insurers -- Underwriting Staffing, Policies and Procedures." The entire underwriting responsibility rests with the Company as the primary insurer. As a result, the Company participates more actively in the structuring of the transaction than it does as a reinsurer. The Company conducts, in most cases annually, in-depth surveillance of issues insured as a primary. Other Businesses and Investments The Company owns the entire interest in Singer Asset Finance Company, L.L.C. ("Singer"), having acquired its partner's 50% interest in 1997. Conducting business from New York City and Boca Raton, Florida offices, Singer purchases from individuals state lottery prizes, structured settlement payment rights and other long-term payment streams. Working with leading financial institutions, Singer securitizes lottery prizes and structured settlement payment streams, i.e., sells pools of such assets into the securities market. In 1996, in furtherance of its diversification effort, the Company formed Credit-Based Asset Servicing and Securitization LLC ("C-BASS"), a New York City-based joint venture in which the Company and Mortgage Guaranty Insurance Corporation ("MGIC"), a leading U.S. provider of private mortgage insurance coverage, each own approximately 48% interests. Integrating modeling, analytic and securitization skills and specialty servicing capabilities, C-BASS evaluates, purchases, services and securitizes assets in the large market of sub-performing and non-performing residential mortgages. Both Singer and C-BASS, which are larger scale opportunities than the Company's previous diversification activities, utilize the Company's strategic relationships and its core skills in complex credit analysis and securitization. In November 1997, the Company and Swiss Re, respectively, acquired 25% equity interests in Seguradores Brasilieras de Fiancas ("SBF"), one of Brazil's largest surety companies. The remaining interest in SBF is held by Banco Pactual, S.A., one of Brazil's largest investment banks. The terms of the joint venture call for the expansion of SBF in the Latin American insurance and other credit-related markets and opportunities. Sources of Premiums The following table sets forth certain information regarding insurance business assumed and written by the Company: -10-
Year Ended December 31, 1997 ------------------------------------------------------------------------------------------ Premiums Gross Premiums Earned as Written as Percent of Gross Net Percent of Total Premium Earned Premiums Premiums Premiums Total Gross Premiums as Percent of Sources of Premiums Written Written Earned Premiums Written Earned Total Revenues ------------------- ------- ------- ------ ---------------- ------ -------------- (Dollars in millions) Financial guaranty reinsurance AMBAC............ $ 9.8 $ 9.3 $ 5.9 9.1% 6.9% 3.5% CapMAC........... 8.0 8.0 4.1 7.4 4.7 2.4 Connie Lee....... 0.3 0.3 2.4 0.3 2.8 1.4 FGIC............. 4.8 4.7 8.9 4.4 10.4 5.2 FSA.............. 17.3 16.9 10.9 16.0 12.8 6.4 MBIA............. 18.6 17.5 17.0 17.2 19.9 10.0 Other insurance (1)... 49.4 44.0 36.5 45.6 42.7 21.4 XOL Retrocessions..... -- (0.2) (0.2) -- (0.2) (0.1) ------ ------ ----- ----- ----- ----- $108.2 $100.5 $85.5 100.0% 100.0% 50.2% ====== ====== ===== ===== ===== =====
- ---------- (1) Includes business written by the Company as a primary insurer. For the year ended December 31, 1997, no single primary insurer included in "Other insurance" provided greater than 4.2%, 4.5% and 5.3% of gross premiums written, net premiums written and premiums earned, respectively. The Company has maintained close and long-standing relationships with its monoline financial guaranty insurer clients, dating essentially from either the Company's or the given primary insurer's inception. In the Company's opinion, these relationships provide the Company with a comprehensive understanding of its clients' procedures and reinsurance requirements and allow the clients to utilize the Company's underwriting expertise effectively, thus improving the service they receive. The Company is a party to treaty agreements with all major monoline primary insurers except one, which terminated its treaty with the Company in 1997, and it has facultative agreements with active monoline primary insurers. The Company's treaty and facultative agreements usually are entered into for an indefinite term, subject to termination (i) upon written notice (ranging from 90 to 120 days) prior to the specified deadline for renewal or (ii) at the option of the primary insurer if the Company fails to maintain certain financial, regulatory and rating agency criteria which are equivalent to or more stringent than those the Company is otherwise required to maintain for its own compliance with the New York Insurance Law (the "Insurance Law") and, in the case of the agreements with the primary monoline insurers, to maintain a specified claims-paying ability rating for the particular Insurance Subsidiary. Upon termination under the conditions set forth in (ii) above, the Company may be required to return to the primary insurer all unearned premiums, less ceding commissions, attributable to reinsurance ceded pursuant to such agreements. Upon the occurrence of the conditions set forth in (ii) above, whether or not an agreement is terminated, the Company may be required to obtain a letter of credit or alternative form of security to collateralize its obligation to perform under such agreement. -11- Of the Company's aggregate monoline reinsurance exposure of $60.1 billion as of December 31, 1997, $31.7 billion, or 52.7%, was derived through its treaty relationships with the primary insurers. Loss Experience The Company establishes a provision for losses and related loss adjustment expenses ("LAE") when reported by primary insurers or when, in the Company's opinion, an insured risk is in default or a default is probable and the amount of the loss is reasonably estimable. Provisions for losses and LAE are established based on the estimated loss, including expenses associated with settlement of the loss, through the full term of the insured obligation. In the case of obligations with fixed periodic payments, the provision for losses and LAE represents the present value of the Company's ultimate expected losses, adjusted for estimated recoveries under salvage or subrogation rights. On any given municipal and asset-backed reinsurance transaction, the Company and its primary insurer clients underwrite with a zero-loss underwriting objective. For the credit reinsurance business, loss reserves are established based on historical loss development patterns experienced by the Company and by ceding companies in similar businesses. The estimate of reserves for losses and LAE, which includes a non-specific loss reserve, is periodically evaluated by the Company, and changes in estimate are reflected in income currently. As the Company anticipated when it commenced its other insurance businesses, it has experienced relatively higher loss levels in certain of these businesses than it experienced in connection with its financial guaranty reinsurance business. See "Other Insurance Businesses" in this section. The Company believes that the higher premiums it receives in these businesses adequately compensate it for the risks involved. At December 31, 1997, the Company had established $31.0 million in net reserves for losses and LAE (of which $18.5 million comprised incurred but not reported and non-specific reserves). The following table sets forth certain information regarding the Company's loss experience for the years indicated:
Year Ended December 31, ------------------------------------------------------------- 1997 1996 1995 ---- ---- ---- (In millions) Net reserve for losses and LAE beginning of year......................................... $26.2 $29.0 $26.7 Net provision for losses and LAE Occurring in current year ............... 6.0 6.1 3.5 Occurring in prior years ................ 3.8 3.1 6.0 ----- ----- --- Total .............................. 9.8 9.2 9.5 ----- ----- --- Net payments for losses and LAE Occurring in current year ................ 0.7 0.6 2.7 Occurring in prior years ................. 4.3 11.3 4.6 ----- ----- ----- Total .............................. 5.0 11.9 7.3 ----- ----- ----- Net reserve for losses and LAE at end of year......................................... $31.0 $26.3 $28,9 ===== ===== =====
-12- In 1997, 1996 and 1995 the Company recorded losses of $8.1 million, $7.3 million and $6.1 million, respectively, in connection with its credit and surety businesses, commensurate with the continued growth in premiums written from these businesses. The Company believes that the reserves for losses and LAE, including the case and non-specific reserves, are adequate to cover the ultimate net cost of claims. However, the reserves are necessarily based on estimates, and there can be no assurance that the ultimate liability will not exceed such estimates. Investments and Investment Policy The Company's investment portfolio is managed with a view to maximizing after-tax performance. While the Company allocates much of its portfolio to four external specialty managers, a portion of the portfolio consisting of privately placed securities and municipal bonds is managed internally. All investments are guided by the Company's general investment objectives and policies, including guidelines relating to average maturities and quality, which are periodically reviewed and revised as appropriate. The investment policies are designed to achieve diversification of the portfolio and generally to preclude investments in obligations insured by the Company. Investments are almost entirely fixed income securities, with a mix of taxable and tax-exempt investments looking to maximize the net income of the Company. In accordance with Statement of Financial Accounting Standards ("SFAS") No. 115, Accounting for Certain Investments in Debt and Equity Securities, the Company classifies all securities at the time of purchase as either "held to maturity" or "available for sale." Securities held to maturity are those securities which the Company intends and has the ability to hold until maturity and are carried at amortized cost. All other fixed maturity securities are classified as available for sale, are carried at fair value and may be sold in response to changes in interest rates, prepayment risk, payment of losses and other factors. Unrealized gains and losses, net of taxes, on the available-for-sale portfolio are charged or credited to shareholders' equity. The Company internally manages and controls invested assets representing approximately 61.8% of the book value of the investment portfolio at December 31, 1997. The Company intends to hold 24.9% (based on carrying value) of its invested assets to maturity, and, accordingly, in accordance with SFAS No. 115, they are accounted for on an amortized cost basis. The following tables set forth certain information concerning the types of investments and maturities composing the investment portfolio of the Company. As of December 31, 1997 ------------------------------------- Weighted Average Investment Category (1) Carrying Value (2) Yield (3) ----------------------- ------------------ --------- (in millions) Fixed Maturities, held to maturity Private placements................... $ 105.1 8.94% Municipal obligations - tax exempt .. 97.0 6.65 Corporate securities................. 5.8 8.17 U.S. Government obligations ......... 2.5 6.65 ----- Total.............................. 210.4 7.99 ----- -13- As of December 31, 1997 ------------------------------------- Weighted Average Investment Category (1) Carrying Value (2) Yield (3) ----------------------- ------------------ --------- (in millions) Fixed maturities, available for sale Municipal obligations - tax exempt... 439.1 5.57 Mortgage-backed securities........... 73.7 7.58 Corporate securities................. 46.9 7.18 Foreign securities................... 35.4 7.58 U.S. Government obligations ......... 13.0 6.20 ----- Total.............................. 608.1 6.07 ----- Short-term investments (4).............. 56.5 5.14 Common stocks........................... 0.8 8.57 ------ Total Investments.................. $875.8 6.49% ====== - ---------- (1) Excludes investment in affiliates and other invested assets. See Note 5 of Notes to Consolidated Financial Statements. (2) Investments in fixed maturities in the held-to-maturity portfolio are carried at amortized cost. Investments in fixed maturities in the available-for-sale portfolio are carried at market value. Short-term investments are carried at cost, which approximates their market values. Common stocks are carried at market value. Unrealized gains and losses on fixed maturities available for sale and common stocks are reflected in shareholders' equity net of tax. (3) Represents yield to maturity on fixed maturities and current yield on common stocks and certain short-term investments. All amounts are stated on a pre-tax basis. (4) Includes $5.7 million of cash and cash equivalents as of December 31, 1997.
Maturity of Fixed Maturities Carrying Value as of December 31, 1997 ---------------------------- -------------------------------------- (In thousands) Held to Maturity (1) Due in one year or less........................... $ 18.8 Due after one year through five years ............ 80.8 Due after five years through ten years............ 79.0 Due after ten years............................... 31.8 ------ Total(2)................................. $210.4 ====== Available for Sale (3) Due in one year or less........................... $ 7.9 Due after one year through five years ............ 26.7 Due after five years through ten years ........... 167.6 Due after ten years............................... 405.9 ------ Total(4)................................. $608.1 ======
-14- - ---------- (1) The weighted average maturity of the portfolio is estimated to be 4.9 years as of December 31, 1997. (2) Investments in fixed maturities in the held-to-maturity portfolio are carried at amortized cost. Total market value as of December 31, 1997 of fixed maturities, held to maturity, was $219.8 million. (3) The weighted average maturity of the portfolio as of December 31, 1997 is estimated to be 13.3 years. (4) Investments in fixed maturities in the available-for-sale portfolio are carried at market value. Total amortized cost of fixed maturities, available for sale, as of December 31, 1997 was $577.4 million. The Company has an investment policy of maintaining an investment portfolio having a weighted average credit rating of not lower than AA. The Company's adherence to these policies is reflected in the following table setting forth certain information concerning the rating of the Company's investments by Standard & Poor's. Percent of Investment Portfolio Rating As of December 31, 1997 - ------ ----------------------- AAA (1) ................................ 43.5% AA ..................................... 34.5% A ..................................... 17.8% Other (2) .............................. 4.2% - ---------- (1) Includes U.S. Treasury and agency obligations, which constituted 7.8% of the total portfolio as of December 31, 1997. (2) Consists of common stock, unrated securities and securities rated less than A. Reinsurance Ceded The Company is a party to certain facultative retrocession agreements, pursuant to which it cedes to certain retrocessionnaires a portion of its reinsurance exposure. Since it is required to pay its obligations in full to the primary insurer regardless of whether it is entitled to receive payments from its retrocessionnaire, the Company therefore believes that in most cases it is vital that retrocessions be made only to very creditworthy retrocessionnaires. The Company also cedes to reinsurers a portion of its direct insurance exposure, and the foregoing also describes in general the relationship between the Company and its reinsurers. The Company has historically retroceded relatively little of its financial guaranty reinsurance exposure mainly because the economic gain was not deemed sufficient to offset both the costs of developing a program and the additional risks the Company would assume. These risks include that of the solvency of the retrocessionnaire and possible additional risk if the retrocession is effected on a non-proportional basis. -15- Enhance Re is party to an excess-of-loss reinsurance agreement with Hannover Ruckversicherungs AG ("Hannover Re") under which it will be entitled, subject to certain conditions, to draw from Hannover Re up to $25 million under certain circumstances. The agreement has a term of one year and is cancelable annually at the option of either party, except that the Company has the option to force a seven-year run-off period. Hannover Re is a German reinsurance company which has a claims-paying ability rating from Standard & Poor's of AA+. Gross written premiums of $7.6 million were ceded or retroceded by the Insurance Subsidiaries to unaffiliated companies in 1997, of which amount 49.0% was paid to insurance companies having AAA claims-paying ability ratings from Standard & Poor's. Marketing Most of the Company's business derives from relationships it has established and maintains with primary insurance companies. These relationships provide business for the Company in the following major areas: (1) reinsurance for municipal bonds and asset-backed securities (in which area the Company currently has either treaty or facultative agreements with all the monoline primary companies); (2) credit reinsurance (in which the Company collected premiums from 20 credit insurers in 1997, primarily domiciled in Europe); and (3) affiliated-company reinsurance (including Exporters and FCIA). The Company markets directly to the monoline insurers writing credit enhancement business and has direct relationships with its affiliated primary insurers. Specialist reinsurance intermediaries, most of which are located in London, usually present to the Company reinsurance opportunities in the credit insurance sector. These brokers work with the Company's marketing personnel in introducing the Company to the primary credit insurance markets and in structuring reinsurance to meet the needs of the primary insurers. Intermediaries are typically compensated by the reinsurer based on a percentage of premium assumed, which varies from agreement to agreement. The Company markets its excess SIPC/excess ICS polices through specialist intermediaries. These brokers work with the Company's marketing personnel in introducing the Company to large securities brokers to meet the needs of such securities brokers. These brokers are typically compensated by the Company based on a percentage of premium collected, which varies from agreement to agreement. Competition Reinsurance of Monoline Financial Guaranties. The Company is subject to direct competition from one other U.S. company, Capital Reinsurance Company ("Capital Re"), and one foreign company, Axa Reassurance Finance S.A. ("Axa Re"), specializing in the reinsurance of financial guaranty insurance. These entities, together with the Company, provide most of the reinsurance capacity for the monoline financial guaranty primary insurers, particularly with respect to facultative insurance. In addition, a new Bermuda-based financial guaranty reinsurer, RAM Reinsurance Co. Ltd. ("RAM Re"), commenced business in February 1998. The Company believes that it and Capital Re have generally participated in roughly equal percentages in treaties with primary insurers, with AXA Re having participated to a significantly lesser extent. Almost all U.S. multiline insurers have declined to participate in this reinsurance market, a decision which the Company ascribes primarily to their lack of the special expertise and underwriting skills necessary for this line of reinsurance. However, several foreign insurers and -16- reinsurers in addition to Axa Re and RAM Re do compete with the Company on both treaty and facultative bases in the provision of reinsurance for municipal and asset-backed transactions. Certain of these are companies with which some of the U.S. primary financial guaranty insurers have formed strategic alliances. Competition in the financial guaranty reinsurance business is based upon many factors, including overall financial strength, pricing, service and evaluation by the rating agencies of claims-paying ability. The agencies allow credit to a ceding primary insurer's capital requirements and single-risk limits for reinsurance ceded in an amount which is a function of the claims-paying ability rating of the reinsurer. See "Rating Agencies". The Company believes that competition from multiline reinsurers and new monoline financial guaranty insurers will continue to be limited due to (a) the declining number of multiline insurers with the requisite financial strength and (b) the barriers to entry for new reinsurers posed by state insurance law and rating agency criteria governing minimum capitalization. Financial guaranty reinsurance also faces competition from other forms of credit enhancement including letters of credit, credit derivatives and other securitized structures, provided by foreign banks and other financial institutions, some of which are governmental entities or have been assigned the highest credit ratings awarded by one or more of the major rating agencies. However, these credit enhancements generally do not qualify as capital for state regulatory purposes, nor do they constitute credit against specific liabilities which would allow the primary insurer greater single-risk capacity. Other Insurance Businesses. The Company believes that there are a number of direct competitors of the Company in its other insurance businesses, some of which have greater financial and other resources than the Company. The Company has limited its activities in these market areas to those activities which are not served by the Company's financial guaranty monoline primary insurer clients. As a primary insurer, the Company writes insurance on those municipal bonds with respect to which such primary insurers have generally declined to participate because of the size or complexity of such bond issuances relative to the anticipated returns. The Company also serves as a reinsurer for certain specialty primary insurers which are not monoline financial guaranty insurers, in which the Company has significant equity interests or is otherwise a participant. Such reinsurance accounted for 6.2% of the Company's gross premiums written in 1997. These specialty primary insurers are themselves subject to competition from other primary insurers, many of which have greater financial and other resources. Rating Agencies The rating agencies allow credit to a ceding primary insurer's capital requirements and single-risk limits for reinsurance ceded in an amount depending on the claims-paying ability rating of the reinsurer. The rating criteria used by the rating agencies focus on the following factors: capital resources, financial strength and, primarily in the case of a reinsurer whose common equity is not publicly traded, commitment of the reinsurer's institutional stockholders; demonstrated management expertise in financial guaranty and traditional reinsurance, credit analysis, systems development, marketing, capital markets and investment operations; and a minimum policyholders' surplus comparable to primary company requirements, with initial capital sufficient to meet projected growth as well as access to such additional capital as may be necessary to continue to meet standards for capital adequacy. As part of their rating process, Standard & Poor's, Moody's and Duff & Phelps test the capital adequacy of the Insurance Subsidiaries by subjecting them to a "worst-case depression scenario." Expected losses over a -17- depression period are established by applying capital charges to the existing and projected insurance portfolio. The claims-paying ability ratings assigned by the rating agencies to a reinsurance or insurance company are based upon factors relevant to policyholders and are not directed toward the protection of the reinsurer's or insurer's securityholders. Such a rating is neither a rating of securities nor a recommendation to buy, hold or sell any security. Claims-paying ability ratings assigned to the Insurance Subsidiaries should not be viewed as indicative of or relevant to any ratings which may be assigned to the Company's outstanding debt securities by any rating agency and should not be considered an evaluation of the likelihood of the timely payment of principal or interest under such securities. The Company's ability to compete with other triple-A rated financial guaranty reinsurers, and consequently its results of operations, would be materially adversely affected by any downgrade in Enhance Re's or Asset Guaranty's ratings. Moreover, in addition to the loss of new business that would result from any such downgrade, several treaties to which either Insurance Subsidiary is a party grant the respective primary insurers the right to recapture business previously ceded to such Insurance Subsidiary should it suffer a downgrade of a specified magnitude in its claims-paying ability rating. This could result in a material adverse effect on the Company's deferred premium revenue and its recognition of future income therefrom. The Company's ability to continue engaging in certain specialty insurance businesses, principally insurance of municipal bonds, could be materially adversely affected by a downgrade in Asset Guaranty's rating by Standard & Poor's or Duff & Phelps. See "Specialty Insurance Businesses" in this section. Data Processing The Company believes that its data processing system is adequate to support its current needs and has the capacity to support a greater volume of reinsurance business. The Company completed a significant upgrade of its technology infrastructure in 1997, updating and modernizing its hardware, software and network. This modernization program provides a more reliable and resilient information technology environment. The Company has also improved the speed, security and accessible volume of information available to the Company. The Company also embarked in 1997 on application development programs that will provide operational support to many departments. One of the ultimate objectives of the major application development programs is to restructure, streamline and strengthen the Company's databases. Employees As of March 6, 1998, the Company had 232 employees. None of the employees are covered by collective bargaining agreements. The Company considers its employee relations to be good. -18- INSURANCE REGULATORY MATTERS Financial Guaranty Insurance Regulations The Insurance Subsidiaries are domiciled and licensed in the State of New York as financial guaranty insurers under that portion of the Insurance Law constituting the financial guaranty insurance statute. They are also subject to the provisions of the Insurance Law and related rules and regulations governing property-casualty insurers to the extent such provisions are not inconsistent with the financial guaranty insurance statute. Both Insurance Subsidiaries are also licensed under the Insurance Law to write surety insurance, credit insurance and residual value insurance, which are the only other types of insurance that a financial guaranty insurer licensed under the Insurance Law may be authorized to write. The Insurance Subsidiaries are required by New York and each other jurisdiction in which they are licensed to make various filings, including quarterly and annual financial statements prepared in accordance with statutory accounting practices, with those jurisdictions and with the National Association of Insurance Commissioners (the "NAIC"). The Insurance Law requires that each financial guaranty insurer and reinsurer maintain both a reserve for unearned premiums and for known incurred losses (similar to the reserve described in "Description of Business -- Loss Experience" in this section) and a special, formulaically derived "contingency reserve" to protect policyholders against the impact of excessive losses occurring during adverse economic cycles. As of December 31, 1997, the statutory contingency reserves of the Insurance Subsidiaries aggregated $171.7 million. Each calculated reserve may be drawn on with the approval of the New York Insurance Department (the "Department") under specified but limited circumstances. The Insurance Law establishes single-risk limits applicable to all obligations insured by a single entity and backed by a single revenue source and aggregate risk limits on the basis of aggregate net liability and policyholders' surplus requirements. The Insurance Law also regulates the types of securities in which the Insurance Subsidiaries may invest their minimum policyholders' surplus and imposes restrictions on the amount of dividends that the Insurance Subsidiaries may pay. See Item 5. "Market for Registrant's Common Equity and Related Stockholder Matters -- Dividend Policy." The Company believes that each of Enhance Financial and the Insurance Subsidiaries is in material compliance with all applicable laws and regulations of the State of New York pertaining to its business and operations. The Insurance Subsidiaries are also subject to the insurance laws in each jurisdiction in which they are licensed to transact insurance. Reinsurance activities are generally not directly regulated by state law, but are generally subject to limited indirect regulation in most states through the regulation of ceding primary insurers domiciled in those states. Insurance Holding Company Regulations Enhance Financial, as the parent, and the Insurance Subsidiaries, as controlled insurers, are subject to regulation under the insurance holding company laws of New York, which require the Insurance Subsidiaries to register with the Department and to file with it certain informational reports. -19- State holding company laws also require prior notice or regulatory approval of direct or indirect changes in control of an insurer or its holding company and of certain material intercorporate transfers within the holding company structure. Upon obtaining control, the acquiror would become subject to various ongoing regulatory requirements in New York and certain other states. Under the Insurance Law, any person holding or acquiring, directly or indirectly, 10% or more of the voting securities of an insurance company is presumed to be holding or acquiring "control" of such company and its subsidiaries, unless the Department determines upon application that such acquiror would not control such company. As a beneficial owner of more than 10% of the voting shares of Enhance Financial, U S WEST, Inc. ("U S WEST") is presumed under the Insurance Law indirectly to control the Insurance Subsidiaries. Pursuant to applications made under Section 1501(c) of the Insurance Law, the Department has determined, subject to certain conditions, that U S WEST is not considered the ultimate controlling person of either Insurance Subsidiary. See Item 12. "Security Ownership of Certain Beneficial Owners and Management." NAIC/IRIS Ratios The NAIC developed the Insurance Regulatory Information System primarily to assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. The system identifies eleven industry ratios and specifies "usual values" for each ratio. Departure from these "usual values" on four or more of the ratios can lead to inquires from individual state insurance commissioners as to certain aspects of an insurer's business. The values of such ratios of the Insurance Subsidiaries fell within these "usual values" except for the liabilities to liquid assets ratio for Enhance Re. This one ratio fell outside the "usual value" as a result of an increase in funds held by or deposited with reinsured companies. Accreditation The NAIC has instituted the Financial Regulatory Accreditation Standards Program ("FRASP") in response to federal initiatives to regulate the business of insurance. FRASP provides standards intended to establish effective state regulation of the financial condition of insurance companies. FRASP requires states to adopt certain laws and regulations, institute required regulatory practices and procedures, and have adequate personnel to enforce such items in order to become "accredited." In accordance with the NAIC's Model Law on Examinations, accredited states are not permitted to accept certain financial examination reports of insurers prepared solely by the insurance regulatory agency in states not accredited by January 1, 1994. Although the State of New York is not accredited, no states where the Insurance Subsidiaries are licensed have refused to accept the Department's Reports on Examination for the Insurance Subsidiaries. However, there can be no assurance that, should the Department remain unaccredited, other states that are accredited will continue to accept financial examination reports prepared solely by New York. The Company does not believe that the refusal by an accredited state to continue accepting financial examination reports prepared by New York, should that occur, will have a material adverse impact on the Company's insurance businesses. -20- Item 2. Properties. The Company, excluding Singer and Van-Am, occupies 40,550 square feet of office space comprising its executive offices at 335 Madison Avenue, New York, New York pursuant to a sublease expiring April 2000. Singer occupies 2,165 square feet of office space at the same address pursuant to a sublease expiring August 1999 and 25,000 square feet of office space at 700 Banyan Trail Road, Boca Raton, Florida pursuant to a lease expiring August 2005. Van-Am occupies 6,300 square feet of office space at 167 East Main Street, Lexington, Kentucky pursuant to a lease expiring December 1999. Item 3. Legal Proceedings. The Company is not a party, nor is any of its property subject, to any material legal proceedings. Item 4. Submission of Matters to a Vote of Securityholders. Not applicable. -21- PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. SHARE INFORMATION The following table sets forth the high and low sales prices for the Common Stock for the calendar quarters indicated as reported in the New York Stock Exchange consolidated transaction system: High Low ---- --- 1996 1st quarter...................... $27-7/8 $23-1/8 2nd quarter...................... 29-3/4 26 3rd quarter...................... 33-1/8 26-1/2 4th quarter...................... 36-1/2 32-3/8 1997 1st quarter...................... $39-1/2 $34-1/4 2nd quarter...................... 45-3/16 37-5/8 3rd quarter...................... 56 44 4th quarter...................... 62-1/8 49-1/8 1998 1st quarter (through March 27)... $70 $52 As of March 27, 1998, there were 95 holders of record of the Common Stock. DIVIDEND POLICY Enhance Financial paid an aggregate dividend of $0.44 per share in 1997, and the board of directors, having decided not to increase the dividend for 1998, declared a dividend in the first quarter of 1998 of $0.11 per share. The amount of dividends payable in the future will be reviewed periodically by the board of directors in light of the Company's earnings, financial condition and capital requirements. The declaration and payment of dividends are subject to the discretion of the board of directors of Enhance Financial, and there is no requirement or assurance that dividends will be paid. Enhance Financial's ability to pay dividends as well as its operating, debt service and other expenses depends upon the ability of the Insurance Subsidiaries to pay dividends to Enhance Financial and is subject to restrictions contained in an agreement relating to Enhance Financial's indebtedness. The Insurance Subsidiaries' ability to pay dividends to Enhance Financial is subject to restrictions contained in the Insurance Law. The Company expects that such restrictions will not affect the ability of such subsidiaries to declare and pay dividends sufficient to support the payment of dividends by Enhance Financial consistent with the practice adopted in recent years. Enhance Financial is limited by the agreements relating to indebtedness in its ability to pay dividends under certain circumstances. As of December 31, 1997, up to $14.4 million was available for the payment of dividends to Enhance Financial by the Insurance Subsidiaries without the prior approval of the insurance regulatory authorities. See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" and Note 8 of Notes to Consolidated Financial Statements. -22- Item 6. SELECTED HISTORICAL CONSOLIDATED FINANCIAL INFORMATION. The following table presents selected historical consolidated financial information derived from the historical consolidated financial statements of the Company as of and for each of the years in the five-year period ended December 31, 1997. This information should be read in conjunction with the historical consolidated financial statements of the Company and the related notes thereto and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations."
Year Ended December 31, ----------------------------------------------- 1997 1996 1995 1994 1993 ---- ---- ---- ---- ---- (Dollars in millions except per share and percentage amounts) Statement of Income Data: Gross premiums written..................... $108.2 $ 98.6 $ 87.2 $ 85.1 $ 89.8 Net premiums written ...................... 100.5 95.7 83.0 80.7 86.6 Premiums earned............................ 85.4 77.4 63.0 61.8 59.6 Assignment sales........................... 29.2 - - - - Net realized gains (losses) on sale of investments...................... .7 4.0 3.5 (5.8) 16.6 Net investment income (1).................. 50.6 47.5 44.2 38.2 32.2 Total revenues............................. 170.4 131.6 112.5 95.7 109.7 Income before income taxes................. 94.0 76.4 63.8 32.7 50.3 Net income................................. 68.8 55.7 47.3 26.6 38.0 Basic earnings per share................... 3.71 3.12 2.73 1.49 2.09 Diluted earnings per share................. 3.56 3.04 2.73 1.49 2.09 Diluted operating earnings per share (2)... 3.54 2.91 2.58 1.71 1.51 Selected Financial Ratios (3) Loss ratio................................. 11.4% 11.9% 15.1% 37.0% 37.0% Insurance expense ratio.................... 50.3% 49.2% 50.9% 55.5% 53.8% Combined ratio............................. 61.7% 61.1% 66.0% 92.5% 90.8% Year Ended December 31, ----------------------------------------------- 1997 1996 1995 1994 1993 ---- ---- ---- ---- ---- (Dollars in millions except per share amounts) Balance Sheet Data: Investment portfolio (4).................. $875.9 $797.1 $749.2 $639.9 $622.3 Total assets.............................. 1,147.5 983.4 886.0 749.4 725.0 Deferred premium revenue.................. 281.3 266.2 248.1 227.9 209.0 Total liabilities......................... 566.1 495.1 462.0 389.1 360.6 Total shareholders' equity................ 581.4 488.3 423.9 360.3 364.5 Book value per share...................... 31.10 27.03 24.59 20.45 20.14 Statutory Basis Reserves (5): Contingency reserves...................... $171.7 $149.8 $120.8 $98.6 $79.4 Policyholders' surplus.................... 324.2 312.0 294.5 287.6 300.0 ------- ------- ------- ------- ------- Qualified statutory capital............... 495.9 461.8 415.3 386.2 379.4 Unearned premiums......................... 345.7 323.2 298.2 269.8 243.0 Losses and LAE reserves................... 22.5 17.7 22.0 19.5 5.8 ------- ------- ------- ------- ------- Total policyholders' reserves............. $864.1 $802.7 $735.5 $675.5 $628.2 ======= ======= ======= ======= ====== Leverage ratio (6)........................ 130:1 122:1 128:1 124:1 108:1
(1) Excludes capital gains and losses. (2) Operating earnings is not a substitute for net income computed in accordance with GAAP, but is an important measure used by management, equity analysts and investors to measure the financial results of the Company. -23- (3) The loss ratio is the quotient derived by dividing losses and LAE incurred by premiums earned. The expense ratio is the quotient derived by dividing underwriting and insurance related operating expenses by premiums earned. The combined ratio is the sum of the loss and expense ratios. (4) Excludes investment in affiliates and other invested assets. See Note 5 of Notes to Consolidated Financial Statements for information concerning Enhance Financial's investment in affiliates. (5) Represents the combined financial position of the Insurance Subsidiaries presented on a statutory basis. (6) Represents the quotient derived by dividing net insurance in force by qualified statutory capital. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. GENERAL The Company principally engages, through the Insurance Subsidiaries, in the reinsurance of financial guaranties of municipal and asset backed debt obligations issued by monoline financial guaranty insurers. In addition, the Company is engaged in other insurance, reinsurance and non-insurance businesses that utilize the Company's expertise in performing sophisticated analyses of complex, credit-based risks. The Company's other insurance businesses involve the issuance of direct financial guaranties of smaller municipal debt obligations, trade credit reinsurance, financial resposibility bonds and excess-SIPC/excess-ICS and related type bonds. These other insurance businesses are conducted by Van-Am, a Kentucky domiciled insurer, and ERE-Bermuda, a Bermuda domiciled insurer. The Company, through its consolidated subsidiary, Singer and a partially owned affiliate, C-BASS, is also engaged in the origination, purchase, servicing and/or securitization of special assets, including lottery awards, structured settlement payments and sub-performing/non-performing residential mortgages. The Company's revenues consist primarily of (a) premiums earned on insurance and reinsurance contracts, (b) investment income and (c) the sale of securitized lottery awards and structured settlement payments. YEAR ENDED DECEMBER 31, 1997 VERSUS YEAR ENDED DECEMBER 31, 1996 Gross premiums written in 1997 increased 9.7% to $108.2 million from $98.6 million in 1996. Total premium writings in 1997 benefited from a 25.2% increase in gross premiums derived from the Company's other insurance lines. Net premiums written increased 5.1% to $100.5 million in 1997 from $95.7 million in 1996, as a result of the increase in gross premiums partially offset by an increase in ceded premiums written from $2.9 million in 1996 to $7.6 million in 1997. The following table shows net premiums written by line of business for the periods presented: Net Premiums Written (in millions) 1997 1996 - ---------------------------------- ---- ---- Municipal Reinsurance $ 34.3 $ 41.2 Non-Municipal Reinsurance 22.2 17.4 Other Insurance Lines 44.0 37.1 ------- ------- $ 100.5 $ 95.7 ======= ======= The Company's other insurance lines include direct bond insurance, credit reinsurance, financial responsibility, excess-SIPC/excess-ICS and other surety lines. Net premiums written from these businesses have grown from $8.6 million (15.6%) in 1991 to $44.0 million (43.8%) in 1997. The Company expects that these other insurance lines will continue to comprise a significant component of its written premiums. In connection with certain of its other insurance lines, the Company underwrites with the anticipation of higher loss levels than those associated with its core municipal and non-municipal reinsurance business. The Company takes these higher loss levels into account in determining appropriate premium rates. -24- Net premiums earned grew 10.4% to $85.5 million in 1997 from $77.4 million in 1996. This growth in premiums earned was in large part attributable to increased earnings from the Company's other insurance lines as discussed in the preceding paragraph. The following table shows net premiums earned by line of business for the periods presented: Net Premiums Earned (in millions) 1997 1996 - --------------------------------- ---- ---- Municipal Reinsurance ...................... $37.3 $34.4 Non-Municipal Reinsurance .................. 12.6 13.0 Other Insurance Lines ...................... 35.5 30.0 ----- ----- $85.4 $77.4 ===== ===== Monoline reinsurance earned premiums increased 5.3% as a result of a $3.9 million (10.4%) growth in earned premiums before the effect of refundings. This growth was partially offset by a decrease in refunded earned premiums from $9.9 million in 1996 to $8.6 million in 1997. A refunding eliminates the Company's reinsurance exposure to the refunded obligation and, as a result, the Company recognizes in current earnings the remaining related deferred premium revenue. The growth in premiums earned also reflects the amortization of the deferred premium revenue balance which has grown to $281.3 million at year-end 1997 from $266.2 million at year-end 1996. Net investment income increased 6.6% to $50.6 million in 1997 from $47.5 million for 1996 reflecting the growth in invested assets in the period offset, in part, by a shift in the portfolio towards tax-exempt securities. After-tax investment income increased 9.4% in 1997 over 1996. The average yields on the Company's investment portfolio, after deducting associated costs, were 6.2% and 6.4% for the years ended December 31, 1997 and 1996, respectively. The average yields on the Company's investment portfolio on an after-tax basis, net of associated costs were 5.1% and 5.0% for the years ended December 31, 1997 and 1996, respectively. In addition, the Company realized $0.7 million and $4.0 million of net capital gains in 1997 and 1996, respectively. Net investment income is presented after deduction of both external investment management fees and internal costs associated with managing the investment portfolio. Assignment sales for 1997 were $29.2 million. This revenue results from Singer's operations being consolidated with the Company's, commencing March 21, 1997. Incurred losses and loss adjustment expenses ("LAE") were $9.8 million in 1997 compared with $9.2 million in 1996. Of these amounts, $8.1 million and $7.3 million were incurred in connection with the Company's credit and surety businesses in 1997 and 1996, respectively. The Company believes that the reserves for losses and LAE, including case and non-specific reserves, are adequate to cover the ultimate net cost of claims. However, the reserves are necessarily based on estimates, and there can be no assurance that the ultimate liability will not exceed or be less than such estimates. The Company's insurance operating expense ratio for 1997 was 50.3% compared to 49.2% in 1996. Policy acquisition costs, which vary with and are directly related to the generation of new and renewal premiums, totaled $30.0 million and $26.7 million in 1997 and 1996, respectively, representing 35.1% and 34.5% of premiums earned in those respective periods. Other operating expenses increased to $12.2 million in 1997 from $10.5 million in 1996. Interest expense of $7.3 million was incurred in 1997 compared to $5.5 million in 1996 reflecting an increase in the average borrowings outstanding under the Company's line of credit under a bank credit agreement (as amended, the "Credit Agreement") in 1997 compared to 1996. The Company's effective tax rate was 26.8% for 1997 compared to 27.1% in 1996. The lower 1997 rate reflects the Company's strategy of migrating a greater proportion of its investment portfolio to tax-exempt securities in 1997 partially offset by an increase in income taxed at the statutory rate. Net income for 1997 increased 23.5% to $68.6 million from $55.7 million in 1996. On a per share basis, basic earnings per share increased 18.9% to $3.71 in 1997 from $3.12 in 1996, while diluted earnings per share increased 17.1% to $3.56 in 1997 from $3.04 in 1996. Basic operating earnings per share -25- increased 24.2% to $3.69 in 1997, while diluted operating earnings per share increased 22.1% to $3.54 in 1997. The Company defines operating earnings as net income, less the effect of net realized capital gains and losses and foreign exchange gains and losses. The per-share increases were offset, in part, by the higher weighted average outstanding shares in 1997 following the issuance of 503,114 shares by Enhance Financial to acquire its partner's 50% interest in Singer and 299,496 shares in connection with the exercise of employee stock options, partially offset by the repurchase of 177,925 shares. The weighted average shares outstanding for 1997 was 18.53 million compared to 17.88 million for 1996. YEAR ENDED DECEMBER 31, 1996 VERSUS YEAR ENDED DECEMBER 31, 1995 Gross premiums written in 1996 increased 13.1% to $98.6 million from $87.2 million in 1995. Total premium writings in 1996 benefited from a 19.2% increase in non-municipal reinsurance writings and a 22.8% increase in the Company's other insurance lines. Net premiums written increased 15.3% to $95.7 million in 1996 from $83.0 million in 1995, consistent with the increase in gross premiums discussed above. Of the Company's net premiums written in 1996, 43.0%, 18.2% and 38.8% were derived from the reinsurance of municipal bonds, the reinsurance of asset-backed debt obligations and the Company's specialty activities, respectively, compared to 47.9%, 16.3% and 35.8% in 1995. Net premiums earned grew 23.0% to $77.4 million in 1996 from $62.9 million in 1995. This growth in premiums earned was in large part attributable to increased earnings from the Company's other insurance lines as discussed in the preceding paragraph. Monoline reinsurance premiums earned increased 21.8% due, in part, to refundings which contributed $9.9 million (12.8%) of premiums earned in 1996 compared to $5.7 million (9.0%) in 1995. A refunding eliminates the Company's reinsurance exposure to the refunded obligation and as a result, the Company recognizes in current earnings the remaining related deferred premium revenue. Excluding the impact of refundings, monoline reinsurance premiums earned increased 18.0% over the prior year. The growth in premiums earned also reflects the amortization of the deferred premium revenue balance which grew to $266.2 million at year-end 1996 from $248.1 million at year-end 1995. Net investment income increased 7.5% to $47.5 million in 1996 from $44.2 million for 1995 consistent with the growth in invested assets in the period. The average yields on the Company's investment portfolio, after deducting associated costs, were 6.4% for 1996 and 1995. In addition, the Company realized $4.0 million and $3.5 million of net capital gains in 1996 and 1995, respectively. Net investment income is presented after deduction of both external investment management fees and internal costs associated with managing the investment portfolio. Incurred losses and LAE were $9.2 million in 1996 compared with $9.5 million in 1995. Of these amounts, $7.3 million and $6.1 million were incurred in connection with the Company's credit and surety businesses in 1996 and 1995, respectively. The Company believes that the reserves for losses and LAE, including case and non-specific reserves, are adequate to cover the ultimate net cost of claims. However, the reserves are necessarily based on estimates, and there can be no assurance that the ultimate liability will not exceed or be less than such estimates. The Company's insurance operating expense ratio for 1996 was 49.2% compared to 50.9% in 1995. Policy acquisition costs, which vary with and are directly related to the generation of new and renewal premiums, totaled $26.7 million and $21.1 million in 1996 and 1995, respectively, representing 34.5% and 33.4% of premiums earned in those respective periods. Other operating expenses decreased marginally to $10.5 million in 1996 from $10.6 million in 1995. -26- Interest expense of $5.5 million was incurred in 1996 compared to $5.6 million in 1995. The Company's effective tax rate was 27.1% for 1996 compared to 25.9% in 1995. The higher 1996 rate reflected the continuing reduction in the percentage of pre-tax income represented by income from tax-exempt assets. This impact has been reduced in part by the Company's strategy of directing a greater proportion of its new cash flow to the purchase of tax-exempt securities in 1996. Net income for 1996 increased 17.8% to $55.7 million from $47.3 million in 1995. Basic earnings per share increased 14.3% to $3.12 in 1996 from $2.73 in 1995. Basic operating earnings per share, which excludes the impact of capital gains and losses and foreign exchange gains and losses, increased 15.1% to $2.97 in 1996. Diluted operating earnings per share increased 12.8% to $2.91 from $2.58 in 1995. The per-share increases were offset, in part, by the higher weighted average shares in 1996 following the reissuance, in the first quarter of 1996, of 600,000 treasury shares to Swiss Reinsurance Company and the issuance at various times throughout 1996 of 231,275 new shares in connection with the exercise of stock options. The weighted average shares outstanding for 1996 was 17.88 million compared to 17.32 million for 1995. LIQUIDITY AND CAPITAL RESOURCES As a holding company, Enhance Financial finances the payment of its operating expenses, principal and interest on its debt obligations, dividends, if any, to its shareholders and the repurchase of its common stock primarily from dividends and other payments from the Insurance Subsidiaries, manages cash flows associated with the Company's diversification activities and draws on its line of credit provided under the Credit Agreement. Payment of dividends to Enhance Financial by the Insurance Subsidiaries are subject to restrictions relating to statutory capital and surplus and net investment income. Enhance Re and Asset Guaranty declared and paid a total of $22.0 and $2.0 million, respectively, in dividends in 1997. As of December 31, 1997, under the Insurance Law, the Insurance Subsidiaries had an additional $14.4 million available for dividends to Enhance Financial compared with $21.2 million available as of December 31, 1996. Payments of dividends by Enhance Financial to its shareholders are further restricted by the terms of the Credit Agreement. At December 31, 1997, the maximum amount of dividends which may be paid by Enhance Financial to its shareholders in compliance with the terms of such agreement was $35.1 million. Enhance Financial paid dividends of $8.2 million to shareholders in 1997. As of December 31, 1997, the statutory policyholders' surplus of Enhance Re and Asset Guaranty were $228.3 million and $94.9 million, respectively, compared to the minimum $68.4 million required by each under the Insurance Law and compared to $225.3 million and $86.7 million at December 31, 1996. Enhance Financial is party to the Credit Agreement with major commercial banks providing for borrowing by Enhance Financial of up to $75.0 million to be used for general corporate purposes. The Credit Agreement provides for a revolving credit facility under which individual advances may be converted, at Enhance Financial's discretion, into a four-year term loan. The total outstanding under the Credit Agreement at year-end 1997 was $43.5 million. The Company believes that the operating liquidity needs of the Insurance Subsidiaries can be funded exclusively from their respective operating cash flows. The Company's cash flow from operations consists principally of insurance and reinsurance premiums collected, income earned on invested assets and sales of assignments, which in turn is applied to the payment of claims, operating expenses and income taxes. The Company's cash flow from operations was $73.5 million, $59.8 million and $66.3 million for the years 1997, 1996 and 1995, respectively. The Company paid a total of $5.0 million, $11.9 million and $7.3 million in claims in 1997, 1996 and 1995, respectively. Of the claim payments made in 1997, $4.3 million related to reserves established in prior years. -27- Liquidity is also provided by the Company's sales of securities in its available-for-sale portfolio as well as payments of principal on investments upon maturity. In July 1996, the Company formed C-BASS, a joint venture in which the Company and MGIC each own 48% interests. The Company contributed $15.8 million in cash in 1996, $6.8 million in cash in 1997 and is expected to contribute an additional $2.4 million (including its 100% interest in LLSI) in 1998. In addition, in January 1998 the Company guarantied repayment of up to $25 million of the amount outstanding under a $50 million LIBOR-based unsecured revolving credit facility that C-BASS obtained from a major commercial bank. The outstanding principal under the facility currently is due not later than January 29, 1999. As of March 27, 1998, the Company had guaranteed $25 million under this facility. The Company believes there are now more attractive financing alternatives available to C-BASS, which are being pursued actively. In 1995, the Company acquired a 50% joint venture interest in Singer. In 1997, the Company acquired the remaining 50% of Singer in a series of all-stock transactions. The Company issued 503,114 shares of its common stock in connection with the 1997 transactions. Enhance Financial makes available to Singer a $17 million LIBOR-based secured revolving credit facility and a LIBOR-based working capital credit line for its use in originating assets for securitization. At December 31, 1997, $11.2 million and $5.8 million were outstanding under the secured credit facility and the working capital credit line, respectively. Since all intercompany amounts are eliminated in consolidation, these amounts are included in the borrowings outstanding under the Credit Agreement. In December 1996, the board of directors terminated the then existing stock repurchase program and authorized the repurchase of up to 750,000 shares of Enhance Financial's common stock from that date. In 1997, Enhance Financial purchased 177,925 shares of its common stock for an aggregate consideration of $7.0 million Based on the historical cash flow of the Company, the Company's current financial results and the Company's expectation as to the level of the Company's net premiums written during 1998, the Company believes that cash flow provided by operating activities of the Insurance Subsidiaries during 1998 will provide sufficient liquidity for the operations of the Company, as well as funds to Enhance Financial so that Enhance Financial will be able to meet its debt service and other obligations. The ability of Enhance Financial to meet its debt service and other obligations after 1998 will depend upon the cash flow generated by its operating activities and the availability to Enhance Financial of sufficient amounts of funds from those operating activities in the form of dividends or other payments. The Company's cash flow to Enhance Financial after 1998 may be influenced by a variety of factors, including market changes, insurance regulatory changes and changes in general economic conditions. Consequently, although the Company currently anticipates that it will be able to meet all debt service and other obligations over the long term, no assurance can be given that the available net cash provided by the Company's operating activities will provide sufficient liquidity for Enhance Financial to meet all its long-term liquidity needs. At December 31, 1997, 1996 and 1995, the carrying value of the Company's investment portfolio, total investments less investment in affiliates and other invested assets, was $876 million, $797 million and $749 million, respectively, on which was earned $50.6 million, $47.5 million and $44.2 million in those years, respectively, excluding $0.7 million, $4.0 million and $3.5 million of net realized capital gains in those years, respectively. The increase in investments resulted principally from cash flows from operations generated during the period. As of December 31, 1997, the Company held approximately $50.8 million and $5.7 million in short-term investments and cash and cash equivalents, respectively, to meet liquidity needs. In 1997, the Company incurred annual debt service on its long- and short-term borrowings of $7.3 million and is anticipated to incur similar debt service expense in 1998. The Company has no other material commitments for capital or other expenditures during 1998 or thereafter. -28- On March 13, 1998, Enhance Financial filed a shelf registration statement for up to $100 million of debt and/or equity securities. Enhance Financial may issue these securities from time to time depending on market conditions, providing capital flexibility for further growth. Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Not applicable. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES Page ---- Independent Auditors' Report 30 Consolidated Balance Sheets as of December 31, 1997 and 1996 31 Consolidated Statements of Income for the Years Ended December 31, 1997, 1996 and 1995 32 Consolidated Statements of Shareholders' Equity for the Years Ended December 31, 1997, 1996 and 1995 33 Consolidated Statements of Cash Flows for the Years Ended December 31, 1997, 1996 and 1995 34 Notes to Consolidated Financial Statements 35 -29- INDEPENDENT AUDITORS' REPORT To the Board of Directors Enhance Financial Services Group Inc. We have audited the accompanying consolidated balance sheets of Enhance Financial Services Group Inc. and Subsidiaries (the "Company") as of December 31, 1997 and 1996 and the related consolidated statements of income, 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 generally accepted auditing standards. 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 as of December 31, 1997 and 1996 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles. Deloitte & Touche LLP February 17, 1998 New York, New York -30-
ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands except share amounts) December 31, December 31, ------------ ------------ 1997 1996 ---- ---- Assets Investments: Fixed maturities, held to maturity, at amortized cost (market value $219,763 and $227,048)................... $ 210,436 $217,692 Fixed maturities, available for sale, at market (amortized cost $577,388 and $526,973)................. 608,077 539,884 Common stock, at market (cost $498)..................... 833 878 Investment in affiliates................................ 38,862 24,182 Other invested assets................................... 29,050 0 Short-term investments.................................. 50,827 33,247 Cash and cash equivalents............................... 5,686 5,385 ---------- -------- Total Investments...................................... 943,771 821,268 Premiums and other receivables............................ 29,958 22,472 Accrued interest and dividends receivable................. 12,959 11,434 Deferred policy acquisition costs......................... 95,645 87,325 Federal income taxes recoverable.......................... 3,366 1,428 Prepaid reinsurance premiums.............................. 6,281 2,793 Reinsurance recoverable on unpaid losses.................. 2,688 1,823 Receivable from affiliates................................ 10,640 22,205 Receivable for securities................................. 702 2,370 Other assets.............................................. 41,499 10,325 ---------- -------- TOTAL ASSETS........................................... $1,147,509 $983,443 ========== ======== Liabilities and Shareholders' Equity LIABILITIES Losses and loss adjustment expenses....................... $33,675 $28,081 Reinsurance payable on paid losses and loss adjustment.... 3,479 2,463 Deferred premium revenue.................................. 287,535 268,997 Accrued profit commissions................................ 3,768 3,050 Deferred income taxes..................................... 64,680 46,402 Long-term debt............................................ 75,000 75,000 Short-term debt........................................... 43,500 42,500 Payable for securities.................................... 5,318 2,083 Accrued expenses and other................................ 49,161 26,518 ---------- -------- TOTAL LIABILITIES...................................... 566,116 495,094 ---------- -------- SHAREHOLDERS' EQUITY Common stock-$.10 par value Authorized-30,000,000 shares Issued-19,335,935 and 18,533,325 shares................. 1,934 1,853 Additional paid-in capital................................ 230,440 201,847 Retained earnings......................................... 344,402 283,791 Unearned compensation..................................... 0 (20) Unrealized gains.......................................... 19,396 8,636 Treasury stock............................................ (14,779) (7,758) ---------- -------- TOTAL SHAREHOLDERS' EQUITY............................. 581,393 488,349 ---------- -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY............. $1,147,509 $983,443 ========== ========
See notes to consolidated financial statements -31-
ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In thousands except share and per share amounts) Years ended December 31, ---------------------------------------- 1997 1996 1995 ---------- ---------- ---------- Revenues Net premiums written............................. $100,506 $ 95,662 $ 82,988 Increase in deferred premium revenue............. (15,051) (18,229) (20,038) -------- -------- -------- Premiums earned............................... 85,455 77,433 62,950 Net investment income............................ 50,618 47,462 44,159 Net realized gains on sale of investments........ 657 4,008 3,478 Assignment sales................................. 29,200 - - Other income..................................... 4,463 2,738 1,869 -------- -------- -------- Total revenues................................ 170,393 131,641 112,456 -------- -------- -------- Expenses Losses and loss adjustment expenses.............. 9,755 9,184 9,513 Policy acquisition costs......................... 30,020 26,703 21,053 Profit commissions............................... 719 850 359 Other operating expenses - insurance............. 12,225 10,537 10,629 - non-insurance......... 25,141 2,660 2,086 -------- -------- -------- Total expenses................................ 77,860 49,934 43,640 -------- -------- -------- Income from operations........................... 92,533 81,707 68,816 Equity in income of affiliates................... 8,778 274 115 Foreign currency gain(loss)...................... (38) (69) 547 Interest expense................................. (7,317) (5,522) (5,638) -------- -------- -------- Income before income taxes.................... 93,956 76,390 63,840 Income taxes..................................... 25,150 20,686 16,543 -------- -------- -------- Net income.................................... $ 68,806 $ 55,704 $ 47,297 ======== ======== ======== Earnings per share - Basic........................ $ 3.71 $ 3.12 $ 2.73 -------- -------- -------- - Diluted...................... $ 3.56 $ 3.04 $ 2.73 -------- -------- -------- Weighted average shares outstanding - Basic....... 18,534 17,875 17,316 -------- -------- -------- - Diluted..... 19,314 18,353 17,316 -------- -------- --------
See notes to consolidated financial statements -32-
ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997 (In thousands except share amounts) Unearned Additional Compensation/ Common Stock Treasury Stock Paid-in Excess Pension Shares Amount Shares Amount Capital Liability ------------ ---------- -------------- ---------- ---------- -------------- Balance, December 31, 1994.............. 18,277,475 $1,828 657,875 $(11,311) $192,466 $(264) Amortization of unearned compensation (net of income tax benefit............. 229 160 Change in unrealized gains (losses)..... Dividends paid ($0.36 per share)........ Exercise of stock options............... 24,575 2 413 Registration costs of common stock...... (243) Purchase of treasury stock.............. 404,800 (6,732) Net income.............................. ---------- ------ --------- -------- -------- ----- Balance, December 31, 1995.............. 18,302,050 1,830 1,062,675 (18,043) 192,865 (104) Amortization of unearned compensation (net of income tax benefit............. 282 84 Change in unrealized gains (losses)..... Dividends paid ($0.40 per share)........ Exercise of stock options............... 231,275 23 4,722 Registration costs of common stock...... (184) Reissuance of treasury stock............ (600,000) 10,323 4,162 Purchase of treasury stock.............. 1,600 (38) Net income.............................. ---------- ------ --------- -------- -------- ----- Balance, December 31, 1996.............. 18,533,325 1,853 464,275 (7,758) 201,847 (20) ---------- ------ --------- -------- -------- ----- Amortization of unearned compensation (net of income tax benefit............. 20 Change in unrealized gains (losses)..... Dividends paid ($0.44 per share)........ Exercise of stock options............... 299,496 30 7,311 Issuance of common stock................ 503,114 51 21,282 Purchase of treasury stock.............. 177,925 (7,021) Net income.............................. ---------- ------ --------- -------- -------- ----- Balance, December 31, 1997.............. 19,335,935 $1,934 642,200 $(14,779) $230,440 $ 0 ========== ====== ========= ======== ======== ===== Unrealized Retained Gains (Losses) Earnings Total -------------- -------- --------- Balance, December 31, 1994.............. $(16,669) $194,211 $360,261 Amortization of unearned compensation (net of income tax benefit............. 389 Change in unrealized gains (losses)..... 28,773 28,773 Dividends paid ($0.36 per share)........ (6,223) (6,223) Exercise of stock options............... 415 Registration costs of common stock...... (243) Purchase of treasury stock.............. (6,732) Net income.............................. 47,297 47,297 -------- -------- -------- Balance, December 31, 1995.............. 12,104 235,285 423,937 -------- -------- -------- Amortization of unearned compensation (net of income tax benefit............. 366 Change in unrealized gains (losses)..... (3,468) (3,468) Dividends paid ($0.40 per share)........ (7,198) (7,198) Exercise of stock options............... 4,745 Registration costs of common stock...... (184) Reissuance of treasury stock............ 14,485 Purchase of treasury stock.............. (38) Net income.............................. 55,704 55,704 -------- -------- -------- Balance, December 31, 1996.............. 8,636 283,791 488,349 -------- -------- -------- Amortization of unearned compensation (net of income tax benefit............. 20 Change in unrealized gains (losses)..... 10,760 10,760 Dividends paid ($0.44 per share)........ (8,195) (8,195) Exercise of stock options............... 7,341 Issuance of common stock................ 21,333 Purchase of treasury stock.............. (7,021) Net income.............................. 68,806 68,806 -------- -------- -------- Balance, December 31, 1997.............. $ 19,396 $344,402 $581,393 ======== ======== ========
See notes to consolidated financial statements. -33-
ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Years ended December 31, ---------------------------------------- 1997 1996 1995 ---------- ---------- ---------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income........................................... $ 68,806 $ 55,704 $ 47,297 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization, net................. (8,869) (8,333) (6,054) Gain on sale of investments, net................... (657) (4,008) (3,478) Equity in income of affiliates..................... (8,778) (274) (115) Compensation, restricted stock award program 20 84 160 Change in assets and liabilities, net of effects of purchase of Singer: Other invested assets............................. (16,418) - - Premiums receivable............................... (4,775) (1,255) (11,376) Accrued interest and dividends receivable......... (1,525) (695) (147) Accrued expenses and other liabilities............ 16,975 2,812 17,386 Deferred policy acquisition costs................. (8,320) (6,128) (7,174) Deferred premium revenue, net..................... 15,050 18,153 20,168 Accrued profit commissions........................ 718 (669) (3,944) Losses and loss adjustment expenses,net........... 5,745 (2,870) 762 Other assets...................................... 718 (2,741) (432) Income taxes, net................................. 14,789 9,999 13,220 --------- --------- --------- Net cash provided by operating activities............ 73,479 59,779 66,273 --------- --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment................... (2,027) (599) (345) Proceeds from sales and maturities of investment..... 412,892 663,573 546,218 Purchase of investments.............................. (444,793) (735,346) (585,833) Sales(purchases) of short-term investments, net...... (16,211) 10,856 (15,633) Investment in affiliates............................. (10,640) (16,667) (5,709) Cash of previously unconsolidated subsidiary......... 147 - - --------- --------- --------- Net cash used in investing activities................ (60,632) (78,183) (61,302) --------- --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Receivable from affiliates........................... (5,671) (21,260) - Capital stock........................................ 7,341 4,843 401 Short-term debt...................................... 1,000 27,575 12,000 Dividends paid....................................... (8,195) (7,198) (6,223) Principal payment long-term debt..................... - (3,400) (1,400) Reissuance of treasury stock......................... - 14,485 - Purchase of treasury stock........................... (7,021) (38) (6,732) --------- --------- --------- Net cash provided by (used in) financing activities... (12,546) 15,007 (1,954) --------- --------- --------- Net change in cash and cash equivalents................ 301 (3,397) 3,017 Cash and cash equivalents, beginning of year........... 5,385 8,782 5,765 --------- --------- --------- Cash and cash equivalents, end of year................. $ 5,686 $ 5,385 $ 8,782 ========= ========= ========= SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the year for income taxes......... $ 10,678 $ 4,608 $ 3,772 ========= ========= ========= Cash paid during the year for interest............. $ 8,136 $ 6,326 $ 6,233 ========= ========= =========
See notes to consolidated financial statements -34- ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years Ended December 31, 1997, 1996 and 1995 Note 1 - ORGANIZATION Enhance Financial Services Group Inc. ("Enhance Financial", and together with its consolidated subsidiaries, the "Company") is a holding company which was incorporated in the State of New York in December 1985 and commenced operations in November 1986. The Company principally engages, through its wholly-owned, New York-domiciled insurance subsidiaries Enhance Reinsurance Company ("Enhance Re") and Asset Guaranty Insurance Company ("Asset Guaranty") (together, the "Insurance Subsidiaries") in the reinsurance of financial guaranties of municipal and asset backed debt obligations issued by monoline financial guaranty insurers. In addition, the Company is engaged in other insurance, reinsurance and non-insurance businesses that utilize the Company's expertise in performing sophisticated analyses of complex, credit-based risks. The Company's other insurance businesses involve the issuance of direct financial guaranties of smaller municipal debt obligations, trade credit reinsurance, financial responsibility bonds and excess-SIPC/excess-ICS and related type bonds. These other insurance businesses are conducted by the Company's Insurance Subsidiaries, Van-American Companies, Inc. and subsidiaries ("Van-Am", see Note 5), and Enhance Reinsurance (Bermuda) Limited ("EnRe Bermuda"), a Bermuda domiciled insurer. The Company, through a consolidated subsidiary, Singer Asset Finance Company, LLC ("Singer", see Note 5) and a partially owned affiliate, Credit-Based Asset Servicing and Securitization LLC ("C-BASS", see Note 5), is also engaged in the origination, purchase, servicing and/or securitization of special assets, including lottery awards, structured settlement payments and sub-performing/non-performing residential mortgages. Note 2 - SIGNIFICANT ACCOUNTING POLICIES The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles ("GAAP") which, for the Insurance Subsidiaries, differ in certain material respects from the accounting practices prescribed or permitted by regulatory authorities (see Note 3). The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. The significant accounting policies of Enhance Financial and its subsidiaries are as follows: -35- CONSOLIDATION The accompanying financial statements include the accounts of Enhance Financial, the Insurance Subsidiaries, Singer, Van-Am and EnRe Bermuda (collectively the "Company"). All significant intercompany accounts and transactions have been eliminated. Investments in immaterial wholly owned subsidiaries and in investments in which the Company owns from 20% to 50% of those companies are accounted for in accordance with the equity method of accounting (see Note 5). INVESTMENTS In accordance with Statement of Financial Accounting Standards ("SFAS") No. 115 "Accounting for Certain Investments in Debt and Equity Securities," management classifies all securities at the time of purchase as "held to maturity" or "available for sale." Fixed maturity securities held to maturity are those securities which the Company intends and has the ability to hold until maturity and are carried at amortized cost. All other fixed maturity securities are classified as available for sale and carried at fair value. Unrealized gains and losses, net of taxes, on the available for sale portfolio are charged or credited to shareholders' equity. Common stocks are carried at fair value. Short-term investments are carried at cost, which approximates market. Unrealized gains and losses, net of taxes, on common stocks are reflected in shareholders' equity. Realized gains or losses on sales of investments are determined on the basis of specific identification. Other invested assets are trading securities and are carried at fair value, which is determined as the net present value of the future cash flows purchased, discounted at market rates. Mark to market adjustments on these assets are included in other income. DERIVATIVES The Company uses derivative financial instruments for hedging purposes as part of its overall risk management strategy. Gains and losses on the derivative financial instruments that qualify as accounting hedges are deferred until the underlying hedged asset is sold, at which time the gain or loss on the related hedge is recognized in income. PREMIUM REVENUE RECOGNITION Premiums are earned in proportion to the level amortization of insured principal over the contract period. Deferred premium revenue represents that portion of premiums which will be earned over the remainder of the contract period. When insured issues are refunded or called, the remaining deferred premium revenue is generally earned at that time, since the risk to the Company is considered to have been eliminated. -36- REINSURANCE CEDED In the normal course of business, the Insurance Subsidiaries reinsure portions of their direct and assumed exposures with other insurance companies through contracts designed to limit losses from certain risks and to protect capital and surplus. The following summarizes the effect of reinsurance on premiums written and earned: In thousands Years Ended December 31, 1997 1996 1995 ---- ---- ---- Written Earned Written Earned Written Earned ------- ------ ------- ------ ------- ------ Direct $ 25,477 $13,950 $16,946 $ 9,676 $12,313 $ 6,605 Assumed 82,675 75,665 81,642 70,145 74,846 58,865 Ceded (7,646) (4,160) (2,926) (2,388) (4,171) (2,520) -------- ------- ------- ------- ------- ------- Net premiums $100,506 $85,455 $95,662 $77,433 $82,988 $62,950 ======== ======= ======= ======= ======= ======= In the event that any or all of the reinsurers were unable to meet their obligations, the Insurance Subsidiaries would be liable for such defaulted amounts. ASSIGNMENT SALES The Company, through its subsidiaries, acquires from individuals the right to receive lottery awards and structured settlement payments and securitizes these payment streams. Income is recognized at the time of sale through the securitization process for the difference between the net sales proceeds and the purchase price paid to individuals. DEFERRED POLICY ACQUISITION COSTS Deferred policy acquisition costs comprise those expenses that vary with and are primarily related to the production of insurance premiums, including: commissions paid on reinsurance assumed, salaries and related costs of underwriting and marketing personnel, rating agency fees, premium taxes and certain other underwriting expenses, offset by ceding commission income on premiums ceded to reinsurers. Acquisition costs are deferred and amortized over the period in which the related premiums are earned. Deferred policy acquisition costs are reviewed periodically to determine that they do not exceed or be less than recoverable amounts. -37- LOSSES AND LOSS ADJUSTMENT EXPENSES ("LAE") Reserves for losses and LAE are established based on the Company's best estimate of specific and non-specific losses, including expenses associated with settlement of such losses, on its insured and reinsured obligations. The Company records a provision for losses and related LAE when reported by primary insurers or when, in the Company's opinion, an insured risk is in default or a default is probable and the amount of the loss is reasonably estimable. In the case of obligations with fixed periodic payments, the provision for losses and LAE represents the present value of the Company's ultimate expected losses, adjusted for estimated recoveries under salvage or subrogation rights. The estimates for losses and LAE are periodically evaluated by the Company, and changes in estimates are reflected in income currently. The Company believes that the reserves are adequate to cover the ultimate cost of all claims net of reinsurance recoveries. However, the reserves are necessarily based on estimates, and there can be no assurance that the ultimate liability will not exceed such estimates. FEDERAL INCOME TAXES In accordance with SFAS No. 109, "Accounting for Income Taxes," deferred federal income taxes are provided for temporary differences between the tax and financial reporting basis of assets and liabilities that will result in deductible or taxable amounts in future years when the reported amount of the asset or liability is recovered or settled. In the case of the Company, such temporary differences relate principally to premium revenue recognition and deferred acquisition costs. The Internal Revenue Code permits municipal bond insurance companies to deduct from taxable income, subject to certain limitations, the amounts added to the statutory mandatory contingency reserve during the year. The deduction taken is allowed only to the extent that U.S. Treasury non-interest-bearing tax and loss bonds are purchased at their par value prior to the original due date of the Company's consolidated Federal tax return and held in an amount equal to the tax benefit attributable to such deductions. The amounts deducted must be included in taxable income when the contingency reserve is released, at which time the Company may redeem the tax and loss bonds to satisfy the additional tax liability. The purchases of tax and loss bonds are recorded as payments of federal income taxes and are not reflected in the Company's current tax provision. POST-RETIREMENT AND POST-EMPLOYMENT BENEFITS The Company provides various post-retirement and post-employment benefits, including pension, health and life insurance benefits covering substantially all employees who meet certain age and service criteria. The Company accounts for these benefits under the accrual method of accounting. Amounts related to anticipated obligations under the defined benefit pension plan and post-retirement benefits are recorded based on actuarial determinations. -38- STOCK COMPENSATION PLANS In 1991, the Company implemented a stock option program for key employees. In 1992, the Company implemented a directors' stock option program for the benefit of directors who are not employees of the Company. Under these programs, awards are granted to eligible employees and directors of the Company in the form of Incentive Stock Options, where they qualify under the Internal Revenue Code, or Non-Qualified Stock Options. The Company follows the intrinsic value based method of accounting for stock based compensation as prescribed by APB Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). In accordance with SFAS No. 123, "Accounting for Stock-Based Compensation", the Company has provided pro forma disclosures of net income and earnings per share as if the fair value based method of accounting had been applied (see Note 12). EARNINGS PER SHARE Beginning in the fourth quarter of 1997, in accordance with SFAS No. 128, "Earnings per Share," the Company reports "basic" and "diluted" earnings per share ("EPS"). Basic EPS is determined by dividing net income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that would occur if securities such as employee stock options were exercised. All prior period EPS data has been restated to conform to the new standard. Diluted EPS is computed using the treasury stock method to determine the weighted average number of common stock equivalents outstanding during each year. For all periods presented common stock equivalents are comprised of outstanding options pursuant to the Company's stock option programs. NEW ACCOUNTING PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information Footnotes", which became effective for the Company beginning January 1, 1998. SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. Management believes that the presentation of financial information under the new statement will not be materially different than the current presentation. -39- In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income", which became effective for the Company beginning January 1, 1998. SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains and losses) in a full set of general-purpose financial statements. This Statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. It does not require a specific format for that financial statement but requires that an enterprise display an amount representing total comprehensive income for the period in that financial statement. CASH AND CASH EQUIVALENTS For purposes of the statements of cash flows, the Company considers all highly liquid short-term investments with an original maturity of three months or less to be cash equivalents. RECLASSIFICATIONS Certain of the prior years' amounts have been reclassified to conform to the current year presentation. Note 3 -INSURANCE REGULATORY MATTERS The consolidated financial statements are prepared on the basis of generally accepted accounting principles ("GAAP") which, for the Insurance Subsidiaries, differ in certain material respects from accounting practices prescribed or permitted by insurance regulatory authorities. The significant differences result from statutory accounting practices which treat premiums earned, policy acquisition costs, deferred income taxes, investments in fixed maturities and loss reserves differently. At December 31, 1997, the statutory basis policyholders' surplus of Enhance Re and Asset Guaranty, as reported to insurance regulatory authorities, was $228.3 million and $94.9 million, respectively. Statutory net income of Enhance Re and Asset Guaranty was $40.7 million and $11.7 million, respectively, for the year ended December 31, 1997. At December 31, 1996, the statutory basis policyholders' surplus of Enhance Re and Asset Guaranty, as reported to insurance regulatory authorities, was $225.3 million and $86.7 million, respectively. Statutory net income of Enhance Re and Asset Guaranty was $46.5 million and $8.8 million, respectively, for the year ended December 31, 1996. Statutory net income of Enhance Re and Asset Guaranty was $39.0 million and $10.5 million, respectively, for the year ended December 31, 1995. -40- The New York Insurance Law requires financial guaranty insurers to maintain a minimum policyholders' surplus of $65 million. When added to the minimum policyholders' surplus of $3.4 million separately required for the other lines of insurance which it is licensed to write, each of the Insurance Subsidiaries is required to have an aggregate minimum policyholders' surplus of $68.4 million. Under the New York Insurance Law, the Insurance Subsidiaries may declare or distribute dividends only out of earned surplus. The maximum amount of dividends which may be paid by the Insurance Subsidiaries to Enhance Financial without prior approval of the Superintendent of Insurance is subject to restrictions relating to statutory surplus and net investment income as defined by statute. Enhance Re and Asset Guaranty declared and paid a total of $22.0 million and $2.0 million, respectively, in dividends to Enhance Financial for the year ended December 31, 1997. At December 31, 1997, the Insurance Subsidiaries had an additional $14.4 million available for dividend distribution. The New York Insurance Law establishes single risk limits applicable to all obligations issued by a single entity and backed by a single revenue source. Under the limit applicable to municipal bonds, the insured average annual debt service for a single risk, net of reinsurance and collateral, may not exceed 10% of the sum of the insurer's policyholders' surplus and contingency reserves. In addition, insured principal of municipal bonds attributable to any single risk, net of reinsurance and collateral, is limited to 75% of the insurer's policyholders' surplus and contingency reserves. Additional single risk limits, which generally are more restrictive than the municipal bond single risk limit, are also specified for several other categories of insured obligations. Note 4 - INVESTMENTS The following is a summary of the Company's investments in fixed maturities at December 31, 1997 and 1996: Gross Gross In thousands Amortized Unrealized Unrealized Fair 1977 Cost Gains Losses Value --------- --------- ---------- -------- HELD TO MATURITY Private placements $ 105,125 $ - $ - $105,125 Municipal obligations 96,959 8,877 105,836 Corporate securities 5,832 324 6,156 U.S. Government obligations 2,520 126 2,646 --------- -------- -------- -------- Total held to maturity $ 210,436 $ 9,327 $ $219,763 ========= ======== ======== ======== AVAILABLE FOR SALE Municipal obligations $ 415,131 $ 23,917 $ 6 $ 439,042 Mortgage-backed securities 71,361 2,375 - 73,736 Corporate securities 44,836 2,077 2 46,911 Foreign securities 33,282 2,663 516 35,429 U.S. Government obligations 12,778 183 2 12,959 --------- -------- -------- -------- Total available for sale $ 577,388 $ 31,215 $ 526 $608,077 ========= ======== ======== ======== -41- Gross Gross Gross In thousands Amortized Unrealized Unrealized Fair 1996 Cost Gains Losses Value --------- --------- --------- --------- HELD TO MATURITY Private placements $ 108,064 $ - $ - $ 108,064 Municipal obligations 98,513 8,930 - 107,443 Corporate securities 8,039 372 - 8,411 U.S.Government obligations 3,076 94 40 3,130 --------- --------- --------- --------- Total held to maturity $ 217,692 $ 9,396 $ 40 $ 227,048 ========= ========= ========= ========= AVAILABLE FOR SALE Municipal obligations $ 347,575 $ 10,038 $ 1,087 $ 356,526 Mortgage-backed securities 77,413 844 71 78,186 Corporate securities 46,197 1,100 146 47,151 Foreign securities 46,108 2,158 36 48,230 U.S. Government obligations 9,680 120 9 9,791 --------- --------- --------- --------- Total available for sale $ 526,973 $ 14,260 $ 1,349 $ 539,884 ========= ========= ========= ========= The amortized cost and estimated fair value of fixed maturities at December 31, 1997 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. In thousands Amortized Fair Cost Value ---------- ---------- Fixed maturities, held to maturity Due in one year or less $ 18,782 $ 18,808 Due after one year through five years 80,789 83,129 Due after five years through ten years 79,053 83,486 Due after ten years 31,812 34,340 ---------- ---------- $ 210,436 $ 219,763 ========== ========== Fixed maturities, available for sale Due in one year or less 7,914 7,895 Due after one year through five years 25,915 26,688 Due after five years through ten years 159,287 167,607 Due after ten years 384,272 405,887 ---------- ---------- $ 577,388 $ 608,077 ========== ========== Proceeds from sales of available for sale investments in fixed maturities during 1997, 1996 and 1995 were approximately $407 million, $640 million and $529 million, respectively. Gross gains of $4.8 million and gross losses of $4.2 million were realized on those sales in 1997. Gross gains of $7.7 million and gross losses of $3.7 million were realized on those sales in 1996. Gross gains of $10.1 million and gross losses of $6.6 million were realized on those sales in 1995. -42- Sources of the Company's consolidated net investment income are as follows: In thousands YEARS ENDED DECEMBER 31, 1997 1996 1995 ------- ------- ------- Fixed maturities $50,258 $46,102 $42,188 Short-term investments and cash equivalents 1,872 3,184 4,131 Other 572 188 261 ------- ------- ------- Total investment income 52,702 49,474 46,580 Less investment expenses 2,084 2,012 2,421 ------- ------- ------- Net investment income $50,618 $47,462 $44,159 ======= ======= ======= Under agreements with its primaries and in accordance with statutory requirements, the Insurance Subsidiaries maintain funds (fixed maturities and cash equivalents) in trust accounts principally for the benefit of reinsured companies and for the protection of policyholders in states in which the Insurance Subsidiaries are not licensed. The Company maintains full control over the management of assets held in trust accounts. The carrying amount of such restricted balances amounted to approximately $286 million and $212 million at December 31, 1997 and December 31, 1996, respectively. Note 5 - INVESTMENT IN AFFILIATES The Company owns 360,000 shares of EIC Corporation Ltd. ("EIC"), an insurance holding company which, through its wholly owned insurance subsidiary licensed in Bermuda, insures foreign trade receivables. The Company's investment represented an equity interest of approximately 41% at the date of acquisition and approximately 36.5% at December 31, 1997. The Company accounts for its investment in EIC in accordance with the equity method of accounting. In 1997, as part of the recapitalization of Van-Am, the Company contributed $2.0 million to Van-Am. The Company owns a controlling equity interest in the outstanding stock of Van Am and accounts for its investment on a consolidated basis. In 1995, the Company acquired all of the outstanding shares of Litton Loan Servicing, Inc. ("LLSI"), a Houston-based loss mitigation residential mortgage servicer. The purchase price approximated the fair market value of the acquired assets and liabilities at the date of acquisition. -43- In 1996, the Company and MGIC Investment Corporation formed a joint venture C-BASS, which evaluates, purchases, services and securitizes sub-performing and non-performing residential mortgages. At December 31, 1997, the Company had contributed $22.6 million of its required initial capital contribution of $24 million to the C-BASS joint venture. The Company owns a 48% interest in C-BASS, which is being accounted for on the equity basis of accounting. As part of its commitment to capitalize C-BASS, the Company will contribute the entire interest in LLSI to the joint venture. Since Enhance Financial's current 100% ownership interest in LLSI is temporary, the Company has also accounted for this investment on the equity basis of accounting. In January 1998, C-BASS entered into a revolving credit facility agreement with a major commercial bank. Pursuant to this agreement, Enhance Financial has guarantied repayment of up to $25 million of the amount outstanding. At February 17, 1998, Enhance Financial has guaranteed $25 million under this facility. In 1995, the Company acquired, for cash, a 50% joint venture interest in Singer, which originates, securitizes and sells various types of special assets such as lottery awards, structured settlement payments and similar obligations. In 1997, the Company acquired the remaining 50% of Singer in a series of all-stock transactions for an aggregate purchase price valued at $21.3 million. The excess (approximately $20.4 million) of the Company's aggregate cost over the fair value of the net assets of Singer represents goodwill and is being amortized on a straight line basis over 20 years. In November 1997, the Company purchased a 25% interest of Seguradores Brasilieras de Fiancas S.A. ("SBF") at book value. SBF is a Brazilian-based surety insurance company. SBF is a joint venture among the Company, Swiss Re and Banco Pactual S.A., through which the Company anticipates developing and marketing innovative credit-based insurance products throughout Latin America. Total assets and total liabilities at December 31, 1997 and total net income for the year then ended, of the Company's unconsolidated subsidiaries and affiliates accounted for by the equity method of accounting, were $293.4 million $194.7 million and $17.1 million, respectively. Note 6 - INCOME TAXES The Company files a consolidated federal income tax return with its includable subsidiaries. Subject to the provisions of a tax sharing agreement, income tax allocation is based upon separate return calculations. The components of the Company's consolidated provision for income taxes are as follows: In thousands YEARS ENDED DECEMBER 31, 1997 1996 1995 ------- ------- ------- Current income taxes $10,311 $ 9,992 $ 5,447 Deferred income taxes 14,839 10,694 11,096 ------- ------- ------- Tax provision $25,150 $20,686 $16,543 ======= ======= ======= -44- A reconciliation from the tax provision calculated at the federal statutory rate of 35% to the actual tax is as follows: In thousands Years Ended December 31, 1997 1996 1995 ------- ------- ------- Tax provision at statutory rate $ 32,884 $ 26,736 $ 22,344 Tax exempt interest and dividends (7,878) (6,492) (5,816) Other, net 144 442 15 ------- ------- ------- Actual tax $ 25,150 $ 20,686 $ 16,543 ======== ======== ======== The components of the net deferred income tax liability as of December 31, 1997 and 1996 are as follows: In thousands DECEMBER 31, 1997 DECEMBER 31, 1996 ------------------- --------------------- ASSETS LIABILITIES ASSETS LIABILITIES ------ ---------- ------ ----------- Contingency reserves $ 43,027 $ 36,920 Deferred policy acquisition costs 33,547 30,564 Deferred premium revenue 10,446 7,841 Unrealized capital gains 10,490 4,522 Capitalized expenditures $ 1,183 Assignment sales income 8,438 Tax and loss bonds 24,797 $ 19,565 Alternative minimum tax credit carryforward 6,334 4,900 Losses and LAE reserves 5,509 4,575 Deferred income 1,883 2,137 Other 5,816 4,254 5,472 3,204 --------- --------- --------- --------- $ 45,522 $ 110,202 $ 36,649 $ 83,051 ========= ========= ========= ========= Note 7 - LONG-TERM DEBT AND CREDIT FACILITY The carrying value of the Company's indebtedness is as follows: In thousands DECEMBER 31, 1997 1996 --------- --------- Debentures, due 2003 $ 75,000 $ 75,000 Short term credit facility 43,500 42,500 --------- --------- Total $ 118,500 $ 117,500 ========= ========= -45- The debentures were issued at par and bear interest at 6.75% payable in March and September each year. The debentures are non-callable obligations of Enhance Financial secured by shares of common stock of Enhance Re. Enhance Financial maintains a credit facility through a credit agreement (the "Credit Agreement") with major commercial banks providing for borrowing by Enhance Financial of up to $75 million to be used for general corporate purposes. Advances under the Credit Agreement bear interest at variable LIBOR-based rates. The average interest rate paid on such advances in 1997 was 6.15%. Enhance Financial has pledged shares of Enhance Re common stock representing 46.8% of such class outstanding to secure equally and ratably the indebtedness outstanding under the Credit Agreement and that outstanding under the indenture dated as of March 5, 1993 (the "Indenture") governing the debenture. The pledge of shares to secure the latter indebtedness was required under the terms of the Indenture as a result of the increase in outstanding borrowings under the Credit Agreement to a level exceeding $30 million. Additionally, the Credit Agreement prohibits the Company from incurring additional indebtedness to the extent the resulting total would exceed 25% of the Company's total capitalization as defined and includes certain convenants, none of which significantly restricts the Company's operating activities or dividend-paying ability. In 1995, the Company entered into a reverse interest-rate swap transaction based on a notional amount of $50 million over the term equal to the remaining term of Enhance Financial's 6.75% Debentures. On June 1, 1995, the Company terminated the swap and realized a gain on termination in the amount of $4.6 million. The gain has been deferred and is being amortized over the original term of the swap. Note 8 - SHAREHOLDERS' EQUITY AND DIVIDENDS In December 1996, the board of directors terminated the then existing repurchase program and authorized the repurchase of up to 750,000 shares of its common stock from that date. Enhance Financial purchased 177,925, 1,600 and 404,800 shares of its common stock at an average price of $39.46, $23.82 and $16.63 per share in 1997, 1996, and 1995, respectively. In 1997, Enhance Financial entered into a forward purchase agreement regarding 128,197 shares of its common stock at a forward purchase price of $42.50 per share. The agreement settles quarterly on a net basis in shares of Enhance Financial stock or in cash at Enhance Financial's election. To the extent that the market price of Enhance Financial common stock on a settlement date is higher (lower) than the forward purchase price, the net differential is received (paid) by Enhance Financial. During 1997, settlements resulted in Enhance Financial receiving 75,000 shares, which were recorded as treasury shares. -46- During 1997, Enhance Financial issued 503,114 shares of common stock in connections with its acquisition of the remaining 50% ownership interest in Singer (see Note 5). In 1996, Swiss Reinsurance Company ("Swiss Re") acquired from Enhance Financial and one of its shareholders, respectively, 600,000 and 400,000 shares of Enhance Financial common stock at a purchase price of $24.48 per share. In 1997, Swiss Re acquired an additional 700,000 shares of Enhance Financial common stock in the open market. Under the terms of the Credit Agreement, the maximum amount of dividends which may be paid by Enhance Financial as of December 31, 1997 was $35.1 million. Note 9 - FAIR VALUES OF FINANCIAL INSTRUMENTS The following estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amount the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. FIXED MATURITY SECURITIES - The fair values of fixed maturity securities are based on quoted market prices or dealer quotes. For private placements, fair value approximates amortized cost. SHORT-TERM INVESTMENTS - Fair values of short-term investments are assumed to equal cost. OTHER INVESTED ASSETS - The fair values of the Company's other invested assets are based on the net present value, discounted at market rates, of the future cash flows purchased. DEFERRED PREMIUM REVENUE - The fair value of the Company's deferred premium revenue is based on the estimated cost of entering into a cession of the entire portfolio with third-party reinsurers under market conditions. This figure was determined by using the statutory basis unearned premiums adjusted for ceding commission based on current market rates. LOSS AND LOSS ADJUSTMENT RESERVES - The carrying amount is composed of the present value of the expected cash flows for specifically identified claims combined with a general estimate for non-specific reserves. Therefore, the carrying amount is a reasonable estimate of the fair value of the reserve. LONG-TERM DEBT - The fair value is estimated based on the quoted market prices for the same or similar issue or on the current rates offered to the Company for debt of the same remaining maturities. SHORT-TERM DEBT -The fair value of short-term debt, which bears interest at variable rates, is assumed to equal the carrying value of the debt. -47- The carrying amounts and estimated fair values of these financial instruments are as follows: In thousands DECEMBER 31, 1997 DECEMBER 31, 1996 ----------------- ----------------- Estimated Estimated Carrying Fair Carrying Fair Amount Value Amount Value ------ ----- ------ ----- ASSETS: Fixed maturity securities $818,513 $827,840 $757,576 $766,932 Common stock 833 833 878 878 Short-term investments 50,827 50,827 33,247 33,247 Other invested assets 29,050 29,050 - - LIABILITIES: Deferred premium revenue 281,254 242,708 266,204 227,123 Loss and loss adjustment expense reserve 30,987 30,987 26,258 26,258 Long-term debt 75,000 75,458 75,000 74,933 Short-term debt 43,500 43,500 42,500 42,500 Note 10 - INSURANCE IN FORCE The Company principally insures and reinsures financial guaranties issued to support public and private borrowing arrangements, including commercial paper, bond financings, and similar transactions. Financial guaranties are conditional commitments which guaranty the performance of a customer to a third party. The Company's potential liability in the event of nonperformance by the issuer of the insured obligation is represented by its proportionate share of the aggregate outstanding principal and interest payable ("insurance in force") on such insured obligation. At December 31, 1997, the Company's aggregate insurance in force was $64.4 billion. The Company's insured portfolio as of December 31, 1997 was broadly diversified by geographic and bond market sector with no single credit representing more than 1.4% of the Company's net insurance in force. -48- The composition of the Company's insurance in force by type of issue and by state of issue was as follows: TYPE OF ISSUE In billions December 31, 1997 1996 ---- ---- General obligation and other tax backed $18.8 $15.8 Non-municipal 13.5 12.2 Utilities 10.3 9.2 Health care 6.8 6.2 Airport/Transportation 6.8 5.9 Housing 1.5 1.5 Other municipal 2.4 2.3 Other insurance businesses 4.3 3.5 ----- ----- Total $64.4 $56.6 ===== ===== STATE OF ISSUE In billions December 31, 1997 1996 ---- ---- California $7.7 $6.9 New York 6.2 6.2 Florida 4.1 4.2 Texas 3.7 3.1 Pennsylvania 2.9 3.1 New Jersey 2.6 2.1 Illinois 2.5 2.6 Other (each less than 2.5%) 34.7 28.4 ----- ----- Total $64.4 $56.6 ===== ===== The Company manages its exposure to credit risk through a structured underwriting process which includes detailed credit analysis, review of primaries' underwriting guidelines, surveillance policies and procedures, and the use of reinsurance. -49- Note 11 - EMPLOYEE BENEFITS The Company maintains a non-contributory defined benefit pension plan for the benefit of all eligible employees. Employer contributions are based upon a fixed percentage of employee salaries determined at the discretion of the Company. Plan assets consist of domestic equity and high quality fixed income securities. The actuarially computed net pension cost for 1997, 1996, and 1995 using the projected unit credit actuarial method of attribution includes the following components: In thousands YEARS ENDED DECEMBER 31, 1997 1996 1995 ---- ------ ------ Service cost-benefits earned during the period $900 $1,298 $1,225 Interest cost on projected benefit obligation 494 485 396 Actual return on plan assets (958) (579) (320) Net amortization and deferral 535 205 55 ---- ------ ------ Net periodic pension cost $971 $1,409 $1,356 ==== ====== ====== The following table sets forth the funding status of the plan and the accrued pension cost recognized in the Company's consolidated balance sheets: In thousands YEARS ENDED DECEMBER 31, 1997 1996 1995 ------- ------- ------- Accumulated benefits obligation, including vested benefits of $4,666, $4,457 and $4,879 $(5,025) $(4,635) $(5,809) ------- ------- ------- Projected benefit obligation $(8,131) $(6,475) $(8,824) Plan assets at fair value 4,726 4,437 5,053 ------- ------- ------- Projected benefit obligation in excess of plan assets (3,405) (2,038) (3,771) ------- ------- ------- Unrecognized prior service cost 961 1,014 1,067 Unrecognized transition net asset 14 16 17 Unrecognized net (gain)loss (2,266) (2,717) 189 ------- ------- ------- Accrued pension cost $(4,696) $(3,725) $(2,498) ======= ======= ======= Actuarial assumptions utilized to determine the projected benefit obligation and estimated unrecognized net loss were as follows: 1997 1996 1995 ---- ---- ---- Discount rate 7.0% 7.5% 5.5% Expected long-term rate of return on plan assets 8.5% 8.5% 8.5% Rate of increase in future compensation levels 6.0% 6.0% 6.0% In addition to pension benefits, the Company provides certain health care benefits for retired employees. Substantially all employees of Enhance Financial and the Insurance Subsidiaries may become eligible for these benefits if they reach retirement age while working for the Company. -50- The net post-retirement benefit cost for 1997, 1996, and 1995 was $127,000, $118,000, and $105,000, respectively, and includes service cost, interest cost and amortization of the transition obligation. At December 31, 1997, the accumulated post-retirement benefit obligation was $592,000 and was not funded. The discount rate used in determining the accumulated post-retirement benefit obligation was 7% and the health care cost trend rate was 13%, graded to 6% over 8 years. In January 1996, the Company implemented a 401(k) retirement savings plan covering substantially all employees of the Company. Under this plan, the Company provides a matching contribution of 25% on contributions up to 6% of base salary made to the plan by eligible employees. The Company's matching contribution was $106,000 and $98,000 in 1997 and 1996, respectively. Note 12 - STOCK OPTION PROGRAMS The Company maintains a stock option program for its key employees. Options issued under the program vest in four equal annual installments commencing one year after the date of grant. The Company also maintains a directors' option program pursuant to which directors of Enhance Financial and the Insurance Subsidiaries who are not employees of the Company are granted non-qualified stock options. Options under this program vest in two equal annual installments commencing on December 31 next following the date of grant. All options are exercisable at the option price, being the fair value of the stock at the date of grant. The board of directors of Enhance Financial has authorized a maximum of 4,850,000 shares of Enhance Financial common stock to be awarded as options of which 3,938,500 options for shares (net of expirations and cancellations) had been awarded as of December 31, 1997. Information regarding activity in the option programs follows: -51- 1997 NUMBER OPTION PRICE OPTIONS OF SHARES PER SHARE - ------- --------- --------- Outstanding at beginning of year 2,553,110$ $14.50 - $36.50 Granted - Employees 610,050 $38.875 - $57.6875 - Directors 45,500 $59.50 Exercised (299,496) $14.50 - $34.00 Expired or canceled (99,650) $16.00 - $38.875 ---------- Outstanding at year-end 2,809,514 $14.50 - $59.50 ---------- Exercisable at year-end - Employees 1,474,525 $14.50 - $38.875 - Directors 125,333 $17.125 - $36.50 1996 NUMBER OPTION PRICE OPTIONS OF SHARES PER SHARE - ------- --------- --------- Outstanding at beginning of year 2,415,721 $14.50 - $26.625 Granted - Employees 400,110 $26.875 - $34.00 - Directors 26,000 $36.50 Exercised (231,275) $14.50 - $20.25 Expired or canceled (57,446) $16.00 - $23.875 ---------- Outstanding at year-end 2,553,110 $14.50 - $36.50 ---------- Exercisable at year-end - Employees 1,321,457 $14.50 - $23.875 - Directors 143,333 $17.125 - $26.625 1995 NUMBER OPTION PRICE OPTIONS OF SHARES PER SHARE - ------- --------- --------- Outstanding at beginning of year 1,944,759 $14.50 - $20.25 Granted - Employees 490,350 $17.25 - $23.875 - Directors 30,000 $26.625 Exercised (24,575) $14.50 - $20.25 Expired or canceled (24,813) $16.00 - $20.25 ---------- Outstanding at year-end 2,415,721 $14.50 - $26.625 ---------- Exercisable at year-end - Employees 1,166,213 $14.50 - $20.25 - Directors 114,333 $17.125 - $19.875 -52- The Company applies the provisions of APB Opinion No.25 "Accounting for Stock Issued to Employees" in accounting for its stock option program. Accordingly, no compensation expense has been recognized for options granted under its stock option program and the Company has adopted the disclosure-only provisions of SFAS No.123, "Accounting for Stock-Based Compensation." Had compensation cost for the Company's stock option program been determined based upon the fair value at the grant date for awards under these plans consistent with the methodology prescribed under SFAS No. 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below: 1997 1996 ---- ---- Net income - as reported $68,806 $55,704 - pro forma $67,475 $55,046 Basic earnings per share - as reported $3.71 $3.12 - pro forma $3.64 $3.08 Diluted earnings per share - as reported $3.56 $3.04 - pro forma $3.49 $3.00 The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. The weighted average grant date fair value of option grants were $24.02, $10.88 and $7.27 in 1997, 1996 and 1995, respectively. The following assumptions were used for option grants awarded in 1997, 1996 and 1995: Options Granted 1997 1996 1995 ---- ---- ---- Dividend yield 0.8% to 1.1% 1.1% to 1.5% 1.4% to 2.0% Volatility 18.7% to 30.3% 20.5% to 30.3% 26.5% to 31.1% Risk-free interest rate 5.8% to 6.7% 6.2% to 6.8% 5.6% to 7.2 % Assumed annual forfeiture rate 3.0% 3.0% 3.0% Expected life 10 years 10 years 10 years -53- Note 13 - LEASE COMMITMENTS LEASES The Company has committed to lease office space under non-cancelable leases which expire in August 1999, December 1999, April 2000, August 2000 and August 2005. The leases provided for escalations resulting from increased assessments for taxes, utilities and maintenance. Future minimum rental payments on all leases, before any deductions for estimated sublease income, are as follows: In thousands Operating Years Ended December 31, Leases --------- 1998 $ 2,595 1999 2,572 2000 2,366 2001 877 2002 442 Thereafter 1,540 -------- $ 10,392 ======== Rent expense was $1,699,000, $1,139,000 and $1,236,000 for the years ended December 31, 1997, 1996 and 1995, respectively, net of sublease income. Note 14 - PARENT COMPANY FINANCIAL INFORMATION The following are the condensed balance sheets of Enhance Financial as of December 31, 1997 and 1996 and its condensed statements of income and cash flows for the years ended December 31, 1997, 1996 and 1995. -54- CONDENSED BALANCE SHEETS In thousands December 31, 1997 1996 --------- --------- ASSETS Investments $ 12,706 $ 10,213 Investment in affiliated companies 658,609 563,395 Other assets 46,161 38,386 --------- --------- $ 717,476 $ 611,994 ========= ========= LIABILITIES AND SHAREHOLDERS' EQUITY: Long-term debt $ 75,000 $ 75,000 Other liabilities 61,083 48,645 Shareholders' equity 581,393 488,349 --------- --------- $ 717,476 $ 611,994 ========= ========= CONDENSED STATEMENTS OF INCOME In thousands Years Ended December 31 1997 1996 1995 --------- --------- --------- Total revenues $ 510 $ 1,312 $ 272 Total expenses 14,652 12,343 11,321 --------- --------- --------- (14,142) (11,031) (11,049) Equity in income of affiliates 77,500 61,727 55,873 --------- --------- --------- Income before income taxes 63,358 50,696 44,824 Income tax benefit 5,448 5,008 2,473 --------- --------- --------- Net income $ 68,806 $ 55,704 $ 47,297 ========= ========= ========= CONDENSED STATEMENTS OF CASH FLOWS In thousands Years Ended December 31, 1997 1996 1995 -------- -------- -------- Cash Flows from Operating Activities: Net income $ 68,806 $ 55,704 $ 47,297 Adjustments to reconcile net income to net cash from operating activities Equity in income of affiliates (77,500) (61,727) (55,873) Other 29,799 (22,188) (3,577) -------- -------- -------- Net cash used in operating activities 21,105 (28,211) (12,153) -------- -------- -------- Cash Flows from Investing Activities: Investment in affiliates net of dividends received (7,186) (3,423) 14,328 Purchase of investments - - (2,456) Sale of investments (2,396) 750 1,498 Sales of short-term investments, net (4,648) (5,529) 837 -------- -------- -------- Net cash provided by (used in) investing activities (14,230) (8,202) 14,207 -------- -------- -------- Cash Flows from Financing Activities: Capital stock 7,341 4,843 401 Short-term debt 1,000 27,500 12,000 Dividends paid (8,195) (7,198) (6,223) Principal payment - senior notes - (3,400) (1,400) Reissuance of treasury stock - 14,485 Purchase of treasury stock (7,021) (38) (6,732) -------- -------- -------- Net cash provided by (used in) financing activities (6,875) 36,192 (1,954) -------- -------- -------- Net increase (decrease) in cash - (221) 100 Cash, beginning of year - 221 121 -------- -------- -------- Cash, end of year $ - $ - $ 221 ======== ======== ======== -55- Note 15 - MAJOR CUSTOMERS The Company derives a substantial portion of its premium writings from a small number of primary insurers. Specifically: - In 1997 four primary insurers accounted for 17%, 16%, 9% and 7% of gross premiums written. - In 1996 four primary insurers accounted for 19%, 13%, 10% and 7% of gross premiums written. - In 1995 four primary insurers accounted for 22%, 18%, 8% and 8% of gross premiums written. This customer concentration results from the small number of primary insurance companies which are licensed to write financial guaranty insurance. -56- Note 16- LOSSES AND LOSS ADJUSTMENT EXPENSES Activity in the liability for losses and loss adjustment expenses ("LAE") is summarized as follows: In thousands Years Ended December 31, 1997 1996 1995 ------- ------- ------- Balance at January 1, $28,081 $30,799 $29,337 Less reinsurance recoverables 1,823 1,853 2,620 ------- ------- ------- Net balance at January 1, 26,258 28,946 26,717 ------- ------- ------- Net incurred related to: Current year 6,002 6,087 3,491 Prior years 3,753 3,097 6,022 ------- ------- ------- Net incurred 9,755 9,184 9,513 ------- ------- ------- Net paid related to: Current year 720 587 2,705 Prior years 4,306 11,285 4,579 ------- ------- ------- Net paid 5,026 11,872 7,284 ------- ------- ------- Net balance at December 31, 30,987 26,258 28,946 Plus reinsurance recoverables 2,688 1,823 1,853 ------- ------- ------- Balance at December 31, $33,675 $28,081 $30,799 ======= ======= ======= The liability for losses and LAE increased by $6.0 million in 1995 principally as a result of changes in estimates of ultimate loss on certain real estate-backed transactions in the Company's discontinued commercial real estate portfolio. The terms "current year" and "prior years" in the foregoing table refer to the year in which case reserves were established. -57- Note 17 - SEGMENT REPORTING The Company has two reportable segments: insurance and non-insurance businesses. The insurance segment provides credit-related insurance coverage to meet the needs of customers in a wide variety of domestic and international markets. The Company's largest insurance business is the provision of reinsurance to the monoline primary financial guaranty insurers for both municipal bonds and non-municipal obligations. The Company also provides trade credit reinsurance, financial responsibility bonds, excess-SIPC insurance and direct financial guaranty insurance. The non-insurance businesses segment deals primarily with credit-based servicing and securitization of assets in underserved markets, in particular, the origination, purchase, servicing and/or securitization of special assets, including lottery awards, structured settlement payments and sub-performing/non-performing residential mortgages. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on profit or loss from operating earnings, which it defines as net income excluding capital and foreign exchange gains and losses, net of taxes. The company also evaluates performance based on operating earnings after allocation of corporate overhead expenses. 1997 ---- In thousands Insurance Non- Insurance Totals --------- -------------- ------ Revenues from external customers $ 88,966 $ 30,152 $ 119,118 Interest revenue 50,618 - 50,618 Interest expense 5,881 1,436 7,317 Equity in income of affiliates 1,075 7,703 8,778 Income tax expense 19,270 5,664 24,934 Operating income - pre-allocation 57,884 10,519 68,403 Operating income - post-allocation 60,029 8,374 68,403 Identifiable assets 1,049,596 97,913 1,147,509 The following are reconciliations of reportable segment revenues and profit to Enhance Financial's consolidated totals: -58- 1997 ---- REVENUES Total revenues for reportable segments $ 119,118 Total interest revenue for reportable segments 50,618 Realized gains 657 --------- Total consolidated revenue $ 170,393 ========= INCOME Total income for reportable segments $ 68,403 Capital and foreign exchange gains (losses), net of tax 403 --------- Net income $ 68,806 ========= The non-insurance reportable segment information in 1996 and 1995 consisted of equity in net income (loss) of affiliates of $(402,000) and $(393,000) and investment in affiliates of $19,205,000 and $3,857,000, respectively. All other revenues and assets for those years were attributable to the company's insurance segment. -59- Note 18- QUARTERLY FINANCIAL INFORMATION (Unaudited)
In millions except per share amounts 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr. Year 1997 Net premiums written $21.6 $25.7 $25.5 $27.7 $100.5 Premiums earned 19.5 21.3 21.3 23.4 85.5 Investment and other income 10.5 13.9 13.2 18.1 55.7 Assignment sales 2.5 9.9 7.6 9.2 29.2 Losses and loss adjustment expenses 2.0 2.2 2.7 2.9 9.8 Equity in income of affiliates 0.1 0.2 3.8 4.7 8.8 Income before income taxes 18.4 23.4 23.6 28.6 94.0 Net income 13.9 17.0 17.5 20.4 68.8 Earnings per share - Basic $0.76 $0.91 $0.94 $1.10 $ 3.71 ----- ----- ----- ----- ------ - Diluted $0.74 $0.88 $0.90 $1.05 $ 3.56 ----- ----- ----- ----- ------ Operating earnings per share - Diluted $0.82 $0.87 $0.91 $0.95 $ 3.54 ----- ----- ----- ----- ------ 1996 Net premiums written $20.4 $25.2 $20.8 $29.3 $95.7 Premiums earned 19.3 17.8 18.7 21.6 77.4 Investment and other income 13.3 11.0 13.1 16.8 54.2 Losses and loss adjustment expenses 2.4 1.9 2.1 2.8 9.2 Income before income taxes 18.1 15.8 18.7 23.8 76.4 Net income 13.2 11.9 13.9 16.7 55.7 Earnings per share - Basic $0.76 $0.66 $0.77 $0.93 $3.12 ----- ----- ----- ----- ------ - Diluted $0.74 $0.65 $0.75 $0.90 $3.04 ----- ----- ----- ----- ------ Operating earnings per share - diluted $0.69 $0.69 $0.73 $0.78 $2.90 ----- ----- ----- ----- ------ 1995 Net premiums written $11.6 $24.6 $18.4 $28.4 $83.0 Premiums earned 14.2 15.9 15.3 17.6 63.0 Investment and other income 11.0 10.4 12.3 15.8 49.5 Losses and loss adjustment expenses 2.4 2.3 2.0 2.8 9.5 Income before income taxes 13.7 14.6 15.8 19.7 63.8 Net income 10.5 11.1 11.7 14.0 47.3 Earnings per share - Basic $0.60 $0.64 $0.68 $0.81 $2.73 ----- ----- ----- ----- ------ - Diluted $0.60 $0.64 $0.68 $0.81 $2.73 ----- ----- ----- ----- ------ Operating earnings per share - diluted $0.60 $0.65 $0.67 $0.67 $2.58 ----- ----- ----- ----- ------
-60- Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III Item 10. Directors and Executive Officers of the Registrant. Set forth below is certain information concerning directors and executive officers of Enhance Financial. Each director holds office (subject to Enhance Financial's by-laws) until the next annual meeting of shareholders and until his or her successor has been elected and qualified. The information concerning the directors has been furnished by them to Enhance Financial. Position with Enhance Name Age(1) Financial - ------- -------- --------------------------- Allan R. Tessler 61 Chairman of the Board Wallace O. Sellers 68 Vice Chairman of the Board Daniel Gross 55 President, Chief Executive Officer and Director Samuel Bergman 50 Executive Vice President and Secretary Ronald M. Davidow 47 Executive Vice President Arthur Dubroff 47 Executive Vice President and Chief Financial Officer Elaine J. Eisenman(2) 49 Executive Vice President Tony M. Ettinger 41 Executive Vice President Paul C. Kwiatkoski 42 Executive Vice President Brenton W. Harries 70 Director David R. Markin 67 Director Robert P. Saltzman 55 Director Richard J. Shima 58 Director Spencer R. Stuart 75 Director Adrian U. Sulzer 51 Director Frieda K. Wallison 55 Director Jerry Wind 60 Director - ---------- (1) As of March 31, 1998. (2) Commenced employment with the Company in January 1998. Mr. Tessler has held the position with Enhance Financial set forth above since its inception. He has also since 1987 been Chairman of the Board and Chief Executive Officer of International Financial Group, Inc., a merchant banking concern, and since 1992 served as Co-Chairman of the Board and Co-Chief Executive Officer of Data Broadcasting Corporation ("DBC"), a provider of market data services to the investment community. Mr. Tessler is also Chairman of the Board of Checker Holdings Inc. and of Jackpot Enterprises Inc. ("Jackpot") and a director of The Limited, Inc. -61- Mr. Sellers has held the position with Enhance Financial set forth above since 1995, and he also serves as a consultant to the Company. Prior thereto, he served as President, Chief Executive Officer and a director of Enhance Financial and Chairman of the Board and Chief Executive Officer of the Insurance Subsidiaries from their inception. Mr. Sellers also serves as a director and a member of the compensation committee of Danielson Holding Corporation and as Chairman of the Board of Directors of United Oilfield Services Inc. Mr. Gross has held the position with Enhance Financial set forth above and has served as Chief Executive Officer of the Insurance Subsidiaries since 1995. Prior thereto he held senior executive positions with Enhance Financial and Enhance Re from their inception and was among the founders of the Company in 1986. Mr. Gross also serves as a director of MGIC. Mr. Bergman has been Executive Vice President of the Company since 1991. He has been Secretary of Enhance Financial since 1991 and Secretary of each of the Insurance Subsidiaries since their inception. He was a member of the law firm of Shea & Gould from 1980 to 1991. Messrs. Davidow and Kwiatkoski have each served as senior executive officers of the Insurance Subsidiaries since such companies' inception, and as officers of Enhance Financial since 1990. Mr. Dubroff has held the position with Enhance Financial set forth above since 1996. From 1993 to 1996, Mr. Dubroff served in various senior management capacities at First Data Corporation, a provider of high-volume information processing and related services. Mr. Dubroff served as a director of Enhance Financial from 1986 to 1991 and from 1992 to 1996 and of Enhance Re from 1986 to 1992. Ms. Eisenman has held the position with Enhance Financial set forth above since January 1998, having previously served as an independent consultant to the Company. She also previously served as Senior Vice President - Worldwide Staffing, Development and Succession of American Express Company from 1994 to 1997. She previously served from 1990 to 1994 as Vice President and General Manager of the Eastern Region of Personnel Decisions International, Inc. Ms. Eisenman also serves as a director of UST, Inc. Mr. Ettinger has held the position with Enhance Financial set forth above since 1995. From 1993 to 1995 he rendered consulting and strategic planning services to life insurance companies. Mr. Harries has served as a director of Enhance Financial since 1991, having previously served as a director of the Insurance Subsidiaries since 1986. He has been retired since 1986, having previously served from 1985 as President of Global Electronic Markets Company, a joint venture of McGraw-Hill and Citicorp dealing in electronic trading of commodities. Mr. Harries also serves as a trustee of the Alliance Funds, Inc. and the Hudson River Trust. Mr. Markin has served as a director of Enhance Financial since 1986. He has served as President of Checker Motors Corporation for more than five years. From 1989 to December 1996, he also served as President and Chief Executive Officer of International Controls Corp. and its successor corporation, Great Dane Holdings, Inc. Mr. Markin serves as a director of Jackpot and DBC. -62- Mr. Saltzman has served as a director of Enhance Financial since 1996. He has been President and Chief Executive Officer of Jackson Life Insurance Company since 1994. He previously served from 1983 as Executive Vice President of SunAmerica Inc. and as President of its subsidiary life insurance company. Mr. Shima has served as a director of Enhance Financial since 1993. He has been an independent consultant since 1993, having previously thereto from 1992 served as Managing Director of Russell Miller, Inc., an investment banking concern specializing in the insurance industry. Mr. Shima also serves as a director of CTG Resources, Inc. and a trustee of the Evergreen Mutual Funds. Mr. Stuart has served as a director of Enhance Financial since 1992, having also served as a director of Asset Guaranty from its inception until 1995. He has for the last ten years served as an independent consultant regarding organizational and personnel matters. He served from 1990 to 1992 as Chairman of the Council of Management Advisors of Dean Witter Reynolds Inc. He is the founder and honorary chairman of Spencer Stuart Executive Recruiting Consultants and also serves as a director of US Timberlands, L.P. Mr. Sulzer has served as a director of Enhance Financial since 1996. He has since 1991 served in various management capacities with Swiss Re, a shareholder of Enhance Financial, currently serving since July 1997 as Co-Head of Underwriting in its New Markets Division of Swiss Re. From January 1991 to that date he served as head of Swiss Re's Credit and Bonding Department. Mr. Sulzer also served as a director of Societa Italiana Cauzioni, Rome, Italy, and American Credit Indemnity. Ms. Wallison has served as a director of Enhance Financial since 1992, having also served as a director of each of the Insurance Subsidiaries since its inception until 1995. She has since 1983 been a member of the law firm of Jones, Day, Reavis & Pogue, resident in its Washington, D.C. office. Mr. Wind has served as a director of Enhance Financial since 1996. He has been on the faculty of the Wharton School of the University of Pennsylvania since 1967, currently serving as The Lauder Professor and Professor of Marketing. He also serves as a business consultant to several publicly and privately held, U.S. and non-U.S. corporations and has served on the editorial boards of and as a contributor to numerous journals on marketing. Item 11. Executive Compensation. Summary Compensation Table The following table sets forth certain information regarding compensation paid during each of the Company's last three fiscal years to the Company's Chief Executive Officer and each of the Company's four other most highly compensated executive officers, based on salary and bonus earned during 1997. Except as described below in this item under "Employment Agreement," the Company -63- has not entered with any executive officer into (i) an employment agreement or (ii) any compensatory plan or arrangement which is activated upon the resignation, termination or retirement of the executive officer or upon a change in control of the Company or change in the executive officer's responsibilities following a change in control.
Long-Term Annual Compensation Compensation ---------------------------------------------- ------------ Securities Name and Underlying Principal Position Year Salary Bonus Options/SARs - ------------------ ---- ------ ----- ------------ Daniel Gross 1997 $500,000 $1,150,000 175,000 President and Chief 1996 480,000 675,000 75,000 Executive Officer 1995 450,000 420,000 60,000 Tony M. Ettinger 1997 273,863 260,000 20,000 Executive Vice 1996 261,041 132,500 14,000 President 1995 211,718 100,000 15,000 Samuel Bergman 1997 313,281 200,000 14,000 Executive Vice 1996 301,042 145,000 14,000 President and 1995 293,125 100,000 20,000 Secretary Arthur Dubroff 1997 281,400 220,000 20,000 Executive Vice 1996 123,462 175,000(2) 75,000(2) President and Chief Financial Officer(1) Ronald M. Davidow 1997 268,838 180,000 13,500 Executive Vice 1996 260,625 127,500 13,500 President 1995 250,833 87,000 20,000
- ---------- (1) Became an officer of the Company in 1996. (2) Includes a bonus of $100,000 and a stock option for 55,000 shares of Common Stock granted to Mr. Dubroff upon commencement of his employment. See "Agreements with Executive Officers" in this section. -64- Option/SAR Grants During 1997 The following table provides information regarding stock options/SARs granted to the named executive officers during 1997:
Individual Grants --------------------------------------------------------------------------------------- Percent of Number of Total Options Securities Granted to Underlying Employees in Grant Date Name and Options Fiscal Exercise or Expiration Present Value Principal Position Granted(1) Year Base Price Date (2) ------------------ ---------- ---- ---------- ---- --- Daniel Gross 75,000 12.3 41.63 5/31/07 $1,352,070(3) President and Chief 100,000 16.4 57.44 12/31/07 2,495,350(4) Executive Officer Tony M. Ettinger 20,000 3.3 57.63 12/31/07 509,834(5) Executive Vice President Samuel Bergman 14,000 2.3 57.63 12/31/07 356,884(5) Executive Vice President and Secretary Arthur Dubroff 20,000 3.3 57.63 12/31/07 509,834(5) Executive Vice President and Chief Financial Officer Ronald M. Davidow 13,500 2.2 57.63 12/31/07 344,138(5) Executive Vice President
- ---------- (1) Options granted pursuant to the Incentive Plan. Such options vest, subject to continuation of employment, in 25% increments during the consecutive four-year period commencing on the last date of the month of grant. The options are not transferable except by the laws of descent and distribution and, accordingly, may be exercised during the life of the optionee only by the optionee or the optionee's legal representative and after the optionee's death only by the beneficiary previously designated by the optionee. (2) The present value is, in each case, based upon the Black-Scholes option valuation model. The valuation assumes no specific time of exercise since this is viewed by the Company as entirely indeterminate, but takes into account the term of the option, ten years in each case. -65- The actual value, if any, an executive may realize will depend on the excess of the stock price over the exercise price on the date the option is exercised, so that there is no assurance the value realized will be at or near the value estimated by the Black-Scholes model. (3) The Black-Scholes option valuation assumes a volatility of 19.3, a risk-free rate of return of 6.667%, a dividend yield of 1.1% and a discount due to the risk of forfeiture of 3%. (4) The Black-Scholes option valuation assumes a volatility of 28.2, a risk-free rate of return of 5.80%, a dividend yield of 0.76% and a discount due to the risk of forfeiture of 3%. (5) The Black-Scholes option valuation assumes a volitility of 29.1, a risk-free rate of return of 5.88%, a dividend yield of 0.76% and a discount due to the risk of forfeiture of 3%. Aggregated Option/SAR Exercises During 1997 and Fiscal Year-End Option Values - ------------------------------------------- The following table provides information as to the named executive officers regarding stock option exercises and the number and value of stock options/SARs held by them at December 31, 1997.
No. of Securities Underlying Value of Unexercised In-The- Unexercised Stock Options/ Money Options/SARs as Shares SARs at December 31, December 31, 1997(1) Acquired ------------------------------- ---------------------------- Name and on Value Principal Position Exercise Realized Exercisable Unexercisable Exercisable Unexercisable - ------------------ -------- -------- ----------- ------------- ----------- ------------- Daniel Gross President and Chief Executive Officer -0- -0- 271,250 276,250 $10,827,188 $4,702,500 Tony M. Ettinger Executive Vice President 13,125 $208,828 13,500 47,375 464,016 912,281 Samuel Bergman Executive Vice President and Secretary 12,400 282,600 71,000 39,500 2,796,188 867,750 Arthur Dubroff Executive Vice President and Chief Financial Officer -0- -0- 18,750 76,250 576,094 1,765,781 Ronald M. Davidow Executive Vice President -0- -0- 61,500 38,000 2,397,938 830,063
- --------------- -66- (1) Calculated on the basis of (a) the excess of the closing price of the Common Stock as reported by the New York Stock Exchange on December 31, 1997 over the option exercise price multiplied by (b) the number of shares of Common Stock underlying the option. Enhance Reinsurance Pension Plan The Company maintains a defined benefit pension plan named the "Enhance Reinsurance Pension Plan" (the "Pension Plan") which is intended to be a tax-qualified plan under Section 401(a) of the Code. All employees of the Company (other than Singer and Van-Am) who have attained age 21 and who have completed at least one year of service are eligible to participate in the Pension Plan. The Pension Plan provides a normal retirement benefit at normal retirement (the earlier of the date on which a participant (a) has attained age 65 and completed five years of participation or (b) has attained age 62 and completed ten years of participation) equal to 2.25% of the participant's compensation multiplied by his or her years of service up to his or her first 15 years, plus 1.75% of the participant's compensation multiplied by his or her years of service for his or her next ten years, plus 1% of the participant's compensation multiplied by his or her years of service for his or her next five years. Compensation is defined as the average of the participant's three highest consecutive years of earnings. (See Note 2 to the table below regarding the maximum compensation considered "earnings" for the foregoing purposes. No such maximum applies with respect to the determination of compensation for purposes of the Summary Compensation Table above in this item.) A participant whose service terminates prior to normal retirement is also eligible for percentage of his or her normal retirement benefit at normal retirement date multiplied by a retirement benefit, payable at normal retirement age, in an amount equal to the vested fraction, the numerator of which is the number of years of plan participation by him or her as of the date of his or her termination and the denominator of which is the number of years of participation he or she would have had under the Pension Plan had he or she remained a participant until normal retirement. The actuarial equivalent of such vested benefit may be distributed in a lump sum prior to normal retirement age. The vested percentage of a participant increases 20% per year beginning after two years of service, such that his or her vested percentage is 100% after six years. For purposes of determining a participant's retirement benefit and vested percentage, "years of service" and "years of participation," while not synonymous, include service with the Company and certain service with predecessor employers. The following table illustrates annual pension benefits payable under the Pension Plan assuming retirement at normal retirement age at various levels of compensation and years of service. Such benefits are based on a straight life annuity and are not subject to any deduction for Social Security or other offset amounts. -67- PENSION PLAN TABLE
Years of Service ---------------------------------------------------------------------------------- Highest Average 15 20 25 30 35* Earnings - -------- ---------------------------------------------------------------------------------- $100,000 $ 33,750 $ 42,500 $ 51,250 $ 56,250 $ 56,250 125,000 42,188 53,125 64,063 70,313 70,313 150,000 50,625 63,750 76,875 84,375 84,375 175,000(2) 59,063 74,375 89,688 98,438 98,438 200,000(2) 67,500 85,000 102,500(1) 112,500(1) 112,500(1) 225,000(2) 75,938 95,625 115,313(1) 126,563(1) 126,563(1) 250,000(2) 84,375 106,250(1) 128,125(1) 140,625(1) 140,625(1) 300,000(2) 101,250(1) 127,500(1) 153,750(1) 168,750(1) 168,750(1) 400,000(2) 135,000(1) 170,000(1) 205,000(1) 225,000(1) 225,000(1) 450,000(2) 151,875(1) 191,250(1) 230,625(1) 253,125(1) 253,125(1) 500,000(2) 168,750(1) 212,500(1) 256,250(1) 281,250(1) 281,250(1)
- ---------- * Plan limits service to 30 years for benefit purposes. (1) These are hypothetical benefits based upon the Pension Plan's normal retirement benefit formula. The maximum annual benefit permitted under Section 415 of the Code in 1997 is $100,000, which will increase in 1998 to $104,000. (2) The benefits shown corresponding to these compensation ranges are hypothetical benefits based upon the Pension Plan's normal retirement benefit formula. Under Section 401(a)(17) of the Code, a participant's compensation in excess of a specified maximum is disregarded for purposes of determining highest average earnings. (Such specified maximum amount (as adjusted to reflect cost of living increases) was $235,840 for the plan year beginning on or prior to November 1, 1994, decreasing to $150,000 for plan years beginning November 1, 1995 and November 1, 1996 and will increase to $160,000 for plan years beginning thereafter.) As of December 31, 1997, Messrs. Gross, Bergman, Dubroff, Davidow and Ettinger had ten, five, one, thirteen and two years of service, respectively, and ten, five, one, ten and two years of participation, respectively, under the Pension Plan. -68- Agreements with Executive Officers Enhance Financial and Arthur Dubroff, Executive Vice President and Chief Financial Officer, are parties to an employment agreement which provides for the payment of an annual base salary to Mr. Dubroff of not less than $275,000 plus an annual target bonus of 45% of such base salary. Under the employment agreement, Mr. Dubroff was granted in 1996 and 1997 options to purchase 75,000 and 20,000 shares of Common Stock, respectively, and is entitled to a grant of a stock option to purchase 20,000 shares of Common Stock in 1998 (or, at Enhance Financial's election, the cash value thereof). If Mr. Dubroff's employment is terminated by Enhance Financial within a 12-month period following a change of control (as defined), Enhance Financial is required to pay Mr. Dubroff a prorated portion of his annual bonus and, for the greater of the remainder of the term of his employment agreement and 12 months from the date of termination of his employment, his base salary. The employment agreement terminates on December 31, 1999 unless renewed by the parties. Enhance Financial and Elaine J. Eisenman are parties to an agreement which entitles Ms. Eisenman to the following in the event of her discharge by Enhance Financial or a material diminution in her title, authority, management responsibilities or compensation for any reason other than for "Cause," as therein defined leading to her resignation as an employee of the Company: o One year's severance payment equal to her then salary plus that year's target bonus (equal to 50% of her then salary); o Continued vesting during the one year's severance payment period of outstanding stock options previously granted to her under Enhance Financial's employee compensation plans; and o Continuation at Enhance Financial's expense during the one year's severance payment period of employee medical and other benefits. Directors' Compensation Fee Compensation. Directors who are employees of the Company receive no fees or other compensation for services rendered as members of the board of directors of Enhance Financial. Mr. Tessler received a basic fee of $105,000 in 1997, and each other director of Enhance Financial who is not employed by the Company received a basic fee of $16,000. In addition, each such outside director who also served as chair of any committee of the board received in 1997 an additional $5,000 for all committees chaired by such director. Each outside director also received an additional $2,000 for each regular meeting of the board of directors attended plus $1,250 for each committee meeting attended which was held on a day other than a day on which the board met. No directors' fees were payable to corporate shareholders in respect of directorships occupied by their designees. All directors are reimbursed for travel and related expenses incurred in attending meetings of the board or committees. In March 1998, the board of directors adopted the Director Stock Ownership Plan, which provides each director who is not an employee of the Company with the opportunity to receive, at such director's election, up to 100% of the aforesaid fees in the form of shares of Common Stock. The shares will be issued to electing directors on or as of the date of any payment by Enhance Financial of director fees. The "purchase price" at which the shares will be issued will be equal to the closing price of the Common Stock on the New York Stock Exchange on that date. Each eligible director is entitled to make a new election annually for that year's fees. The plan will take effect with -69- respect to fees payable from and after the regular meeting of directors scheduled for June 1998. Non-Employee-Director Stock Option Plan. Pursuant to the Directors' Option Plan, on each December 31 during the period in which the plan is in effect, each director of Enhance Financial or either Insurance Subsidiary who is not an employee of the Company was granted a non-qualified stock option to purchase 2,000 shares of Common Stock at an exercise price equal to the closing price of the Common Stock on the New York Stock Exchange on such date. Pursuant to an amendment to the plan adopted by the directors in December 1997, annual stock option grants for 1997 and thereafter were increased to 3,500 shares. The amendment and the additional 1,500 share grants in December 1997 are subject to the approval of Enhance Financial shareholders, to be sought at their 1998 annual meeting. There are reserved for issuance upon the exercise of options under the Directors' Option Plan an aggregate of 400,000 shares of Common Stock (subject to anti-dilutive adjustment), of which options for 183,833 shares were subject to outstanding options after the option grants made on December 31, 1997. Options granted under the Directors' Option Plan become exercisable as to one half the shares subject thereto on each of the first and second anniversaries of grant, subject to continuation of service on the board of directors and other terms of the option grants; expire on the tenth anniversary of the date of grant; are not transferrable except by the laws of descent and distribution; and, accordingly, may be exercised during the life of the optionee only by the optionee or the optionee's legal representative and after the optionee's death only by the beneficiary previously designated by the optionee. The unvested portion of an outstanding option lapses upon the resignation or removal of the optionee from the boards of directors of Enhance Financial and the Insurance Subsidiaries. Compensation Committee Interlocks and Insider Participation The persons who served as members of the Compensation Committee during 1997 are Spencer R. Stuart (Chairman), Brenton W. Harries, David R. Markin, Richard J. Shima and Allan R. Tessler. The only person of the foregoing who is currently or has at any time been an officer or employee of the Company is Mr. Tessler, who serves as Chairman of the Board of Enhance Financial. Non-Competition Agreements Messrs. Tessler, Sellers, and Gross are parties to non-competition agreements with Enhance Financial prohibiting them from, among other things, competing with the Company for a period of two years following their respective cessation of employment by or service to the Company. Item 12. Security Ownership of Certain Beneficial Owners and Management. The following table sets forth certain information with respect to the beneficial ownership of the Common Stock as of March 27, 1998 by (a) each shareholder known to Enhance Financial to be the beneficial owner, within the meaning of Section 13(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), of more than 5% of the outstanding shares of Common Stock; (b) each director of Enhance Financial; (c) each of the five most highly compensated executive officers of Enhance Financial; and (d) all executive officers and directors of Enhance Financial as a group. -70- Unless otherwise indicated, the address of each such person is c/o Enhance Financial Services Group Inc., 335 Madison Avenue, New York, New York 10017. Number of Percent Name and Address Shares(1) of Class - ---------------- --------- -------- US WEST, Inc...................... 5,430,800(2)(3) 28.9 7800 East Orchard Rd. Suite 200 Englewood, Colorado 80111 FMR Corp.......................... 1,327,200(4) 7.1 82 Devonshire St. Boston, MA 02109 Swiss Reinsurance Company ........ 1,700,000 9.1 Mythenquai 50/60 8022 Zurich Switzerland Allan R. Tessler.................. 243,500(5)(6) 1.3 Wallace O. Sellers................ 417,500(5)(6) 2.2 Daniel Gross...................... 481,250(5) 2.5 Samuel Bergman.................... 72,350(5) * Ronald M. Davidow................. 115,525(5) * Arthur Dubroff.................... 26,750(5)(7) * Tony M. Ettinger.................. 13,600(5) * Brenton W. Harries................ 12,000(6) * David R. Markin................... 111,000(6) * Robert P. Saltzman................ 61,000(6)(8) * Richard J. Shima.................. 9,000(6) * Spencer R. Stuart................. 12,000(6)(9) * Adrian U. Sulzer.................. 1,000(6) * Frieda K. Wallison................ 14,224(6) * Jerry Wind........................ 6,000(6) * All executive officers and directors as a group............. 1,664,069(10) 8.5 - ---------- * Less than 1%. (1) The table in this section is based upon information supplied by directors, officers, and -71- principal shareholders and Schedules 13D and 13G, if any, filed with the Securities and Exchange Commission. Unless otherwise indicated in the footnotes to the table and subject to the community property laws where applicable, each of the stockholders named in this table has sole voting and investment power with respect to the shares shown as beneficially owned by him or her. (2) In 1995, U S WEST sold its 7.625% Exchangeable Notes due December 15, 1998 ("Debt Exchangeable for Common Stock" or "DECS"). At maturity (including as a result of acceleration or otherwise), the principal amount of the DECS will be mandatorily exchanged by U S WEST for up to 5,430,800 shares of Common Stock (or, at US WEST's option under certain circumstances, the cash equivalent thereof). (3) See Item 13. "Certain Relationships and Related Transactions" for information regarding special powers of U S WEST under Enhance Financial's certificate of incorporation and the manner in which U S WEST has announced its intention to vote the shares owned by it. (4) On February 10, 1998, FMR Corp. filed a Schedule 13G stating its ownership of shares of Common Stock at December 31, 1997. According to such Schedule 13G, beneficial ownership of 1,107,900 of the shares is a result of Fidelity Management & Research Company, a wholly-owned subsidiary of FMR Corp., acting as investment advisor to various investment companies (the "Fidelity Funds"), including 1,019,700 shares resulting from the assumed conversion of DECS owned by such Fidelity Funds into shares of Common Stock. According to such Schedule 13G, beneficial ownership of the remaining 219,300 of the shares is a result of Fidelity Management Trust Company, a wholly-owned subsidiary of FMR Corp., serving as investment manager of certain institutional account(s) (the "Institutional Accounts"), including 90,800 shares resulting from the assumed conversion of DECS owned by such Institutional Accounts into shares of Common Stock. According to such Schedule 13G, FMR Corp., directly or through subsidiaries, has the sole power to vote only 187,600 of the shares of Common Stock beneficially owned by it. FMR Corp. does not have sole power to vote or direct the vote the shares owned directly by the Fidelity Funds and 31,700 shares of Common Stock owned by the Institutional Accounts, as such power resides with the Fidelity Funds' board of trustees or by the institutions owning such accounts, as the case may be. (5) Includes the shares set forth in: (a) Column A below issuable to the named officer upon the exercise of presently exercisable options granted under the Incentive Plan and (b) Column B below owned beneficially by the named officer's wife and children or in trusts of which such officer is a trustee (as to which shares such officer disclaims beneficial ownership). Name A B ---- --- --- Allan R. Tessler 18,500 2,000 Wallace O. Sellers 156,000 258,500 Daniel Gross 271,250 93,500 -72- Samuel Bergman 68,500 3,850 Ronald M. Davidow 61,500 -0- Arthur Dubroff 18,750 -0- Tony M. Ettinger 13,500 -0- (6) Includes shares issuable upon the exercise of the currently exercisable portion of options granted to such director under the Directors' Option Plan, as follows: Brenton W. Harries -- 11,000 shares; David E. Markin -- 11,000 shares; Robert P. Saltzman -- 1,000 shares; Wallace O. Sellers -- 1,000 shares; Richard J. Shima -- 7,000 shares; Spencer R. Stuart -- 11,000 shares; Adrian U. Sulzer -- 1,000 shares; Allan R. Tessler -- 3,000 shares; and Frieda K. Wallison -- 11,000 shares; and Jerry Wind -- 1,000 shares. (7) Includes 7,000 shares issuable upon the exercise of the currently exercisable portion of options granted to Mr. Dubroff under the Directors' Option Plan prior to the commencement of his employment with the Company. (8) Held in a living trust account of which Mr. Saltzman and his wife are co-trustees. (9) Mr. Stuart's wife holds a durable power of attorney granting her joint voting and dispositive power over all shares owned by Mr. Stuart. (10) Includes 65,000 shares issuable to the directors who are not employees of the Company (as of the date of grant) upon the exercise of the currently exercisable portion of options granted to them under the Directors' Option Plan; 656,250 shares issuable to the executive officers upon the exercise of currently exercisable options granted to them under the Incentive Plan; 358,050 shares owned beneficially by spouses of executive officers in trusts of which such officers are trustees or by executive officers or their spouses as custodians for their children. Such persons disclaim beneficial ownership of such shares owned by their spouses, individually or as custodians, or by such trusts. Item 13. Certain Relationships and Related Transactions. U S WEST The certificate of incorporation of Enhance Financial grants to U S WEST the right to preclude the Company from entering into certain activities or owning an equity interest in any entity that engages in any such activity unless they are determined by U S WEST's legal counsel not to be prohibited to U S WEST and its subsidiaries under the Modification of Final Judgment (the "Judgment") entered in 1984 in connection with the settlement of the legal action entitled United States v. Western Electric Company, Inc. These activities consist of providing information services or long distance telephone service or manufacturing telecommunications equipment. The Company has not entered, and does not intend to enter, into any of the specified activities, and, accordingly, the aforesaid provision has not had, and is not expected to have, any material effect on the business of the Company. Enhance Financial intends to propose at the meeting -73- of shareholders next following the time at which US WEST ceases to own shares of Common Stock the elimination of the aforesaid provision from the certificate of incorporation, which will require the vote of the holders of a majority of shares of Common Stock outstanding. U S WEST has advised Enhance Financial that it intends, but is not legally obligated, to vote its shares of Common Stock proportionately to the votes cast by non-U S WEST shareholders; provided, however, that if (i) a person or group of persons other than U S WEST is deemed to own more than 15% of the Common Stock within the meaning of Section 13(d) of the Exchange Act and (ii) there occurs a contested proxy solicitation within the meaning of Rule 14a-11(a) promulgated under the Exchange Act, U S WEST intends to vote its shares of Common Stock in a manner U S WEST deems appropriate. In addition, although U S WEST currently has no designees on the Enhance Financial board of directors, it has retained the right to nominate directors. Registration Rights Agreement The shares of Common Stock offered in connection with the sale of the DECS were registered pursuant to a registration rights agreement, dated October 31, 1986, as amended, among Enhance Financial, U S WEST and Swiss Re. Each of U S WEST and Swiss Re has one demand and unlimited piggyback registration rights, subject to certain limitations. Substantially all the expenses of any future demand or piggyback registration are to be borne by Enhance Financial. The registration rights agreement contains cross-indemnification covenants by Enhance Financial on the one hand and U S WEST and Swiss Re on the other for damages sustained and expenses incurred resulting from material misstatements or omissions in connection with any such offering. Seguradores Brasilieras de Fiancas In November 1997, Enhance Financial and Swiss Re each purchased 25% equity interests in SBF for a respective initial investments of $3.3 million. It is anticipated that Enhance Financial and Swiss Re will from time to time make additional investments in SBF as its capital needs may require. See Item 1. "Business - Description of Business - Other Businesses and Investments." Reinsurance of FSA Business U S WEST owns a substantial interest in FSA, a financial guaranty insurer which reinsures a portion of its business with the Company, all on terms and provisions equivalent to those in comparable transactions currently in effect with unaffiliated entities. FSA accounted for 16.0 % of the Company's total gross premiums written in 1997. The Company believes that it and FSA conduct their business with each other on an arms'-length basis and with terms no more favorable to the other than would be the case absent the aforesaid relationship. However, no assurance can be given that conflicts of interest may not develop in the future or that the business conducted with FSA may not diminish in future periods regardless of whether payment of the DECS is made in the form of shares of Common Stock. See Item 1. "Business -- Description of Business -- Reinsurance of Monoline Financial Guaranty Insurers" and Item 12. "Security Ownership of Certain Beneficial Owners and Management." Jones, Day, Reavis & Pogue Frieda K. Wallison, a director of Enhance Financial, is a member of Jones, Day, Reavis & Pogue, a law firm retained by the Company during 1997. -74- PART IV Item 14. - Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The following documents are filed as a part of this report: (1) Financial Statements - See Part II, Item 8. (2) Financial Statement Schedules: All schedules are omitted, as the required information is nonapplicable or the information is presented in the financial statements or related notes. (3) Exhibits: 3.1.1 Restated certificate of incorporation of the registrant filed with the State of New York on February 18, 1992. (Incorporated by reference to Exhibit 3.3.1 to the Annual Report on Form 10-K for the year ended December 31, 1991 of the registrant.) 3.1.2 Certificate of amendment to the restated certificate of incorporation of the registrant filed with the State of New York on June 6, 1996. (Incorporated by reference to Exhibit 3.1.2 to the Annual Report on Form 10-K for the year ended December 31, 1996 of the registrant (the "1996 Form 10-K").) 3.2 By-laws of the registrant, as amended through December 3, 1991. (Incorporated by reference to Exhibit 3.2 to Amendment No. 1 filed with the Securities and Exchange Commission (the "Commission") on January 21, 1992 ("Amendment No. 1") to the registrant's Registration Statement on Form S-1 (File No. 33-44322) filed with the Commission on December 11, 1991 (the "1991 Registration Statement").) 4.1 Specimen certificate evidencing shares of Common Stock. (Incorporated by reference to Exhibit 4.1 to Amendment No. 4 to the 1991 Registration Statement, filed with the Commission on February 12, 1992 ("Amendment No. 4").) 4.2.1 Amended and restated credit agreement dated as of November 24, 1992, as amended and restated October 1, 1996 (the "Credit Agreement"), among the registrant and The Chase Manhattan Bank ("Chase"), as lender and administrative agent, and Fleet National Bank and Bank of Tokyo-Mitsubishi Trust Company, as lenders. (Incorporated by reference to Exhibit 4.2.1 to the 1996 Form 10-K.) 4.2.2 Amended and restated pledge agreement dated as of November 24, 1992 amended and restated as of March 27, 1998 between the registrant and Chase, as agent. 4.2.3 Amendment No. 1, dated as of December 31, 1997 to the Credit Agreement. 4.2.4 Amendment No. 2, dated as of March 27, 1998, to the Credit Agreement. -75- 4.3.1 Form of Indenture dated as of February ____, 1993 (the "Indenture") between the registrant and Chase, as Trustee. (Incorporated by reference to Exhibit 4.1 to Amendment No. 2 filed with the Commission on February 10, 1993 ("Amendment No. 2") to the Registration Statement on Form S-1 (File No. 33-55958) filed with the Commission on December 18, 1992 (the "1992 Registration Statement"). 4.3.2 Form of Enhance Financial Services Group Inc. ____% Debentures due 2003. (Incorporated by reference to Exhibit 4.3.3 to Amendment No. 2 to the 1992 Registration Statement.) 4.4.1 Form of Indenture (Senior Debt Securities) dated as of March __, 1998 between the registrant and Chase, as Trustee. (Incorporated by reference to Exhibit 4.1 to the registrant's Registration Statement on Form S-3 (File No. 333-47895) filed with the Commission on March 13, 1998 (the "1998 Registration Statement").) 4.4.2 Form of Indenture (Subordinated Debt Securities) dated as of March __, 1998 between the registrant and Chase, as Trustee. (Incorporated by reference to Exhibit 4.2 to the 1998 Registration Statement.) 10.1.1 Non-competition agreement dated as of March 5, 1986 between the registrant and Allan R. Tessler. (Incorporated by reference to Exhibit 10.2.1 to the 1991 Registration Statement.) 10.1.2 Non-competition agreement dated as of March 5, 1986 between the registrant and Wallace O. Sellers. (Incorporated by reference to Exhibit 10.2.2 to the 1991 Registration Statement.) 10.1.3 Non-competition agreement dated as of March 5, 1986 between the registrant and Daniel J. Gross. (Incorporated by reference to Exhibit 10.2.3 to the 1991 Registration Statement.) 10.2.1 1987 Long Term Incentive Plan for Key Employees, as amended (the "1987 Incentive Plan"). (Incorporated by reference to Exhibit 10.2.2 to the 1996 Form 10-K.) 10.2.2 Form of option grant certificate under the 1987 Incentive Plan for options granted in December 1997. 10.2.3 1997 Long Term Incentive Plan for Key Employees (the "1997 Incentive Plan"). 10.2.4 Form of option grant certificate under the 1997 Incentive Plan for options granted in December 1997. 10.3.1 Non-Employee-Director Stock Option Plan (the "Directors' Option Plan"). (Incorporated by reference to Exhibit 10.6.4 to the 1992 Registration Statement.) 10.3.2 Form of option grant certificate under the Directors' Option Plan for options granted in 1992. (Incorporated by reference to Exhibit 10.6.5 to the 1992 Registration Statement.) 10.3.3 Director Stock Ownership Plan. -76- 10.4 Initial Purchasers' Registration Rights Agreement dated as of March 5, 1986 among the registrant and certain of its employees. (Incorporated by reference to Exhibit 10.7 to the 1991 Registration Statement.) 10.5.1 Subscribers' Registration Rights Agreement dated as of October 31, 1986 among the registrant and certain of its shareholders (the "Registration Rights Agreement"). (Incorporated by reference to Exhibit 10.8.1 to Amendment No. 1 to the 1991 Registration Statement.) 10.5.2 Amendment No. 1 dated as of April 1, 1987 to the Registration Rights Agreement. (Incorporated by reference to Exhibit 10.8.2 to the 1991 Registration Statement.) 10.5.3 Amendment No. 2 dated as of May 10, 1988 to the Registration Rights Agreement. (Incorporated by reference to Exhibit 10.8.3 to the 1991 Registration Statement.) 10.5.4 Combined Amendments to Registration Rights Agreements dated as of June 29, 1990 (including Amendment No. 3 to the Registration Rights Agreement). (Incorporated by reference to Exhibit 10.8.4 to the 1991 Registration Statement.) 10.5.5 Amendment No. 4 dated as of December 19, 1991 to the Registration Rights Agreement. (Incorporated by reference to Exhibit 10.8.5 to Amendment No. 1 to the 1991 Registration Statement.) 10.5.6 Letter agreement dated October 3, 1995 between the registrant and The Manufacturers Life Insurance Company constituting Amendment No. 5 to the Registration Rights Agreement. (Incorporated by reference to Exhibit 10.3 to the Registration Statement on Form S-3 (File No. 333-2064) filed with the Commission on March 8, 1996 (the "1996 Registration Statement")). 10.5.7 Amendment No. 6 dated February 23, 1996 to the Registration Rights Agreement. (Incorporated by reference to Exhibit 10.4 to the 1996 Registration Statement.) 10.6 Employment agreement dated July 16, 1996 between the registrant and Arthur Dubroff. (Incorporated by reference to Exhibit 10.6 of the 1996 Form 10-K.) 10.7 Agreement dated December 11, 1997 between the registrant and Elaine J. Eisenman. 10.8 Stock purchase agreement dated February 9, 1996 among the registrant, The Manufacturers Life Insurance Company, Manulife (International) Limited and Swiss Reinsurance Company. (Incorporated by reference to Exhibit 10.1 to the 1996 Registration Statement.) 21.1 Subsidiaries of the registrant. 23.1 Consent of Deloitte & Touche LLP 24.1 Power of Attorney. (Included on signature page of this report.) (b) Reports on Form 8-K. The Company did not file any reports on Form 8-K during the fourth quarter of 1997. -77- SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 30, 1998. ENHANCE FINANCIAL SERVICES GROUP INC. By: /s/ Daniel Gross ------------------------------------- Daniel Gross President and Chief Executive Officer POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Daniel Gross and Samuel Bergman, and each of them individually, as his or her true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him and his name, place and stead in any and all capacities, to sign any or all amendments to this report, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or their substitutes, may lawfully do or cause to be done by virtue hereof. Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below on March 30, 1998 by the following persons on behalf of the registrant and in the capacities and on the dates indicated. /s/ Daniel Gross ------------------------------------ Daniel Gross President and Chief Executive Officer and a director (principal executive officer) /s/ Arthur Dubroff ------------------------------------ Arthur Dubroff Executive Vice President (principal financial officer and principal accounting officer) -78- /s/ Brenton W. Harries ------------------------------------ Brenton W. Harries Director /s/ David R. Markin ------------------------------------ David R. Markin Director /s/ Wallace O. Sellers ------------------------------------ Wallace O. Sellers Director /s/ Richard J. Shima ------------------------------------ Richard J. Shima Director /s/ Robert P. Saltzman ------------------------------------ Robert P. Saltzman Director /s/ Spencer R. Stuart ------------------------------------ Spencer R. Stuart Director /s/ Adrian U. Sulzer ------------------------------------ Adrian U. Sulzer Director /s/ Allan R. Tessler ------------------------------------ Allan R. Tessler Director /s/ Frieda K. Wallison ------------------------------------ Frieda K. Wallison Director /s/ Jerry Wind ------------------------------------ Jerry Wind Director -79- EX-4.(2)(2) 2 AMENDED & RESTATED PLEDGE AGREEMENT EXHIBIT 4.2.2 [EXECUTION COPY] AMENDED AND RESTATED PLEDGE AGREEMENT AMENDED AND RESTATED PLEDGE AGREEMENT dated as of November 24, 1992, amended and restated as of March 27, 1998 (the "RESTATEMENT DATE"), between ENHANCE FINANCIAL SERVICES GROUP INC., a corporation duly organized and validly existing under the laws of the State of New York (the "COMPANY"); and THE CHASE MANHATTAN BANK, as agent for the Secured Creditors (as defined below) (in such capacity, together with its successors in such capacity, the "COLLATERAL AGENT"). The Company and the Administrative Agent (as defined in the Credit Agreement referred to below) are parties to a Pledge Agreement dated as of November 24, 1992, amended by Amendment No. 1 dated as of September 30, 1996 (as modified and supplemented and in effect immediately prior to the Restatement Date, the "EXISTING PLEDGE AGREEMENT"), pursuant to which the Company has pledged and granted a security interest in, INTER ALIA, certain shares of stock. The Company, certain Banks and the Administrative Agent are parties to an Amended and Restated Credit Agreement dated as of November 24, 1992, amended and restated as of October 1, 1996, amended by a letter agreement dated April 2, 1997, further amended by Amendment No. 1 dated as of December 31, 1997 and further amended by Amendment No. 2 dated as of the Restatement Date (the "CREDIT AGREEMENT"). The Company is also party to an Indenture with The Chase Manhattan Bank (the "INDENTURE TRUSTEE") dated as of March 5, 1993 (as modified and supplemented and in effect from time to time, the "INDENTURE"), providing, subject to the terms and conditions thereof, for the issuance from time to time of its debentures, notes or other evidences of indebtedness. For good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the Company has agreed to amend and restate the Existing Pledge Agreement. Accordingly, the parties hereto agree to amend and restate the Existing Pledge Agreement so that, as amended and restated, it reads in its entirety as herein provided. Section 1. DEFINITIONS. Terms defined in the Credit Agreement are used herein as defined therein. In addition, as used herein: "COLLATERAL" shall have the meaning ascribed thereto in Section 3 hereof. "COLLATERAL ACCOUNT" shall have the meaning ascribed thereto in Section 4.01 hereof. "CREDIT AGREEMENT OBLIGATIONS" shall mean, together, (a) the principal of and interest on the Loans made by the Banks and the Swingline Bank to, and the Note(s) held by each Bank and the Swingline Bank of, the Company, (b) all other amounts from time to time payable by the Company to the Banks, the Swingline Bank and the Administrative Agent under the Credit Agreement and (c) all obligations hereunder of the Company to the Banks, the Swingline Bank and the Administrative Agent. "DEBENTURES" shall mean the debentures issued by the Company under the Indenture before the Restatement Date in any aggregate principal amount not in excess of $75,000,000. "DEBENTURE ACCELERATION EVENT" shall mean the declaration of the principal of the Debentures to be due and payable in accordance with Section 502 of the Indenture, which declaration shall not have been rescinded or annulled. "DEBENTURE OBLIGATIONS" shall mean the obligations of the Company to pay the principal of, premium (if any) on and interest on the Debentures issued under, and all other amounts from time to time payable by the Company under, the Indenture. "ISSUER" shall mean the issuer of any Pledged Stock. "PERMITTED INVESTMENTS" shall mean: (a) direct obligations of the United States of America, or of any agency thereof, or obligations guaranteed as to principal and interest by the United States of America, or of any agency thereof, in either case maturing not more than 90 days from the date of acquisition thereof; (b) certificates of deposit issued by any bank or trust company organized under the laws of the United States of America or any state thereof and having capital, surplus and undivided profits of at least $500,000,000, maturing not more than 90 days from the date of acquisition thereof; and (c) commercial paper rated A-1 or better or P-1 or better by Standard & Poor's Corporation or Moody's Investors Services, Inc., respectively, maturing not more than 90 days from the date of acquisition thereof. "PLEDGED STOCK" shall have the meaning ascribed thereto in Section 3(a) hereof. "REQUIRED SECURED CREDITORS" shall mean (a) other than in the case of directing the Collateral Agent to enforce its rights under, or take actions pursuant to, Section 5.05(c) hereof, the Majority Banks and (b) in the case of directing the Collateral Agent to enforce its rights under, and to take action pursuant to, Section 5.05(c) hereof, the Majority Banks, provided that if (i) a Debenture Acceleration Event has occurred and is continuing and (ii) the Company shall remain in default in the payment of the principal of or interest on the Debentures for more than 180 days after the occurrence of such Debenture Acceleration Event and (iii) the Collateral Agent has not commenced enforcement action under Section 5.05(c) hereof, the Required Secured Creditors for the purpose of directing the Collateral Agent to enforce its rights under, and to take action pursuant to, Section 5.05(c) hereof, shall be Secured Creditors holding a majority of the outstanding amount of Secured Obligations (for which purpose calculation of the requisite amount of Secured Obligations shall exclude all Debentures owned by the Company or any other Subsidiary or Affiliate of the Company). "RESTATEMENT DATE" shall mean March 27, 1998. -2- "SECURED CREDITORS" shall mean the Administrative Agent and the Banks, together with the Indenture Trustee and the holders of the Debentures. "SECURED OBLIGATIONS" shall mean, collectively, (i) the Credit Agreement Obligations, (ii) the Debenture Obligations and (iii) all obligations of the Company to the Secured Creditors and the Collateral Agent hereunder. "UNIFORM COMMERCIAL CODE" shall mean the Uniform Commercial Code as in effect from time to time in the State of New York. Section 2. REPRESENTATIONS AND WARRANTIES. The Company represents and warrants to the Banks and the Administrative Agent that at the time of the delivery to the Collateral Agent of certificates representing any Pledged Stock: (a) the Company will be the sole beneficial owner of such Pledged Stock and no Lien will exist upon such Pledged Stock at any time (and no right or option to acquire the same exists in favor of any other Person), except for the pledge and security interest in favor of the Collateral Agent for the benefit of the Secured Creditors created or provided for herein, which pledge and security interest constitute a first priority perfected pledge and security interest in and to all of such Pledged Stock (b) such Pledged Stock will be duly authorized, validly existing, fully paid and non-assessable and none of such Pledged Stock will be subject to any contractual restriction, or any restriction under the charter or by-laws of the Issuer thereof (except for any such restriction contained herein or in the Credit Agreement). Section 3. THE PLEDGE. As collateral security for the prompt payment in full when due (whether at stated maturity, by acceleration or otherwise) of the Secured Obligations, the Company hereby pledges and grants to the Collateral Agent, for the benefit of the Secured Creditors as hereinafter provided, a security interest in all of the Company's right, title and interest in the following property, whether now owned by the Company or hereafter acquired and whether now existing or hereafter coming into existence (all being together referred to herein as "COLLATERAL"): (a) the shares of common stock of ERC represented by certificates delivered to the Collateral Agent by the Company at any time or from time to time (the "PLEDGED STOCK"); (b) all shares, securities, moneys or property representing a dividend on any of the Pledged Stock, or representing a distribution or return of capital upon or in respect of the Pledged Stock, or resulting from a split-up, revision, reclassification or other like -3- change of the Pledged Stock or otherwise received in exchange therefor, and any subscription warrants, rights or options issued to the holders of, or otherwise in respect of, the Pledged Stock; (c) without affecting the obligations of the Company under any provision prohibiting such action hereunder or under the Credit Agreement, in the event of any consolidation or merger in which an Issuer is not the surviving corporation, the shares of each class of the capital stock of the successor corporation formed by or resulting from such consolidation or merger corresponding to the shares of Pledged Stock redeemed or exchanged pursuant to such consolidation or merger; (d) the balance from time to time in the Collateral Account; and (e) all proceeds of and to any of the property of the Company described in the preceding clauses of this Section 3. Section 4. CASH PROCEEDS OF COLLATERAL. 4.01 COLLATERAL ACCOUNT. The Collateral Agent may at any time cause to be established at Chase a cash collateral account (the "COLLATERAL ACCOUNT") in the name and under the control of the Collateral Agent into which there shall be deposited from time to time the cash proceeds of any of the Collateral required to be delivered to the Collateral Agent pursuant to Section 5.04(c) hereof and into which the Company may from time to time deposit any additional amounts which it wishes to pledge to the Collateral Agent for the benefit of the Secured Creditors as additional collateral security hereunder. The balance from time to time in the Collateral Account shall constitute part of the Collateral hereunder and shall not constitute payment of the Secured Obligations until applied as hereinafter provided. Except as expressly provided in the next sentence, the Collateral Agent shall remit the collected balance standing to the credit of the Collateral Account to or upon the order of the Company as the Company shall from time to time instruct. However, at any time following the occurrence and during the continuance of an Event of Default or a Debenture Acceleration Event, the Collateral Agent may (and, if instructed by the Banks as specified in Section 10.03 of the Credit Agreement, shall) in its (or their) discretion apply or cause to be applied (subject to collection) the balance from time to time standing to the credit of the Collateral Account to the payment of the Secured Obligations in the manner specified in Section 5.08 hereof. The balance from time to time in the Collateral Account shall be subject to withdrawal only as provided herein. In addition to the foregoing, the Company agrees that if the proceeds of any Collateral hereunder shall be received by it, the Company shall as promptly as possible deposit such proceeds into the Collateral Account. Until so deposited, all such proceeds shall be held in trust by the Company for and as the property of the Collateral Agent and shall not be commingled with any other funds or property of the Company. 4.02 INVESTMENT OF BALANCE IN COLLATERAL ACCOUNT. Amounts on deposit in the Collateral Account shall be invested from time to time in such Permitted Investments as the Company (or, after the occurrence and during the continuance of a Default, the Collateral Agent) shall determine, which Permitted Investments shall be held in the name and be under the control -4- of the Collateral Agent, PROVIDED that at any time after the occurrence and during the continuance of an Event of Default or a Debenture Acceleration Event, the Collateral Agent may (and, if instructed by the Banks as specified in Section 10.03 of the Credit Agreement, shall) in its (or their) discretion at any time and from time to time elect to liquidate any such Permitted Investments and to apply or cause to be applied the proceeds thereof to the payment of the Secured Obligations in the manner specified in Section 5.08 hereof. Section 5. FURTHER ASSURANCES; REMEDIES. In furtherance of the grant of the pledge and security interest pursuant to Section 3 hereof, the Company hereby agrees with each Bank and the Collateral Agent as follows: 5.01 DELIVERY AND OTHER PERFECTION. The Company shall: (a) if any of the above-described shares, securities, moneys or property required to be pledged by the Company under clauses (b) or (c) of Section 3 hereof are received by the Company, forthwith either (x) transfer and deliver to the Collateral Agent such shares or securities so received by the Company (together with the certificates for any such shares and securities duly endorsed in blank or accompanied by undated stock powers duly executed in blank), all of which thereafter shall be held by the Collateral Agent, pursuant to the terms of this Agreement, as part of the Collateral or (y) take such other action as the Collateral Agent shall deem necessary or appropriate to duly record the Lien created hereunder in such shares, securities, moneys or property in said clauses (b) and (c); (b) give, execute, deliver, file and/or record any financing statement, notice, instrument, document, agreement or other papers that may be necessary or desirable (in the judgment of the Collateral Agent) to create, preserve, perfect or validate the security interest granted pursuant hereto or to enable the Collateral Agent to exercise and enforce its rights hereunder with respect to such pledge and security interest; (c) keep full and accurate books and records relating to the Collateral, and stamp or otherwise mark such books and records in such manner as the Collateral Agent may reasonably require in order to reflect the security interests granted by this Agreement; and (d) permit representatives of the Collateral Agent, upon reasonable notice, at any time during normal business hours to inspect and make abstracts from its books and records pertaining to the Collateral, and permit representatives of the Collateral Agent to be present at the Company's place of business to receive copies of all communications and remittances relating to the Collateral, and forward copies of any notices or communications received by the Company with respect to the Collateral, all in such manner as the Collateral Agent may require. 5.02 OTHER FINANCING STATEMENTS AND LIENS. Without the prior written consent of the Collateral Agent (granted with the authorization of the Banks as specified in Section 10.09 of the Credit Agreement), the Company shall not file or suffer to be on file, or authorize or permit to be filed or to be on file, in any jurisdiction, any financing statement or like instrument with -5- respect to the Collateral in which the Collateral Agent is not named as the sole secured party for the benefit of the Secured Creditors. 5.03 PRESERVATION OF RIGHTS. The Collateral Agent shall not be required to take steps necessary to preserve any rights against prior parties to any of the Collateral. 5.04 COLLATERAL. (a) So long as no Event of Default or Debenture Acceleration Event shall have occurred and be continuing, the Company shall have the right to exercise all voting, consensual and other powers of ownership pertaining to the Collateral for all purposes not inconsistent with the terms of this Agreement, the Credit Agreement, the Notes, the Indenture or any other instrument or agreement referred to herein or therein, PROVIDED that the Company agrees that it will not vote the Collateral in any manner that is inconsistent with the terms of this Agreement, the Credit Agreement, the Notes, the Indenture or any such other instrument or agreement; and the Collateral Agent shall execute and deliver to the Company or cause to be executed and delivered to the Company all such proxies, powers of attorney, dividend and other orders, and all such instruments, without recourse, as the Company may reasonably request for the purpose of enabling the Company to exercise the rights and powers which it is entitled to exercise pursuant to this Section 5.04(a). (b) Unless and until an Event of Default or a Debenture Acceleration Event has occurred and is continuing, the Company shall be entitled to receive and retain any dividends on the Collateral paid in cash out of earned surplus. Upon receipt of any such dividends that the Company is entitled to receive and retain as aforesaid, the security interest on such dividends provided for hereunder shall terminate. (c) If any Event of Default or Debenture Acceleration Event shall have occurred, then so long as such Event of Default or Debenture Acceleration Event shall continue, and whether or not the Collateral Agent or any Secured Creditor exercises any available right to declare any Secured Obligation due and payable or seeks or pursues any other relief or remedy available to it under applicable law or under this Agreement, the Credit Agreement, the Notes, the Indenture or any other agreement relating to such Secured Obligation, all dividends and other distributions on the Collateral shall be paid directly to the Collateral Agent and retained by it in the Collateral Account as part of the Collateral, subject to the terms of this Agreement, and, if the Collateral Agent shall so request in writing, the Company agrees to execute and deliver to the Collateral Agent appropriate additional dividend, distribution and other orders and documents to that end, PROVIDED that if such Event of Default is cured or Debenture Acceleration Event is rescinded or annulled, any such dividend or distribution theretofore paid to the Collateral Agent shall, upon request of the Company (except to the extent theretofore applied to the Secured Obligations), be returned by the Collateral Agent to the Company. (d) If at any time there are no Loans outstanding, at the request of the Company, the Collateral Agent shall forthwith cause to be delivered, against receipt but without any recourse, warranty or representation whatsoever, any remaining Collateral to the Company. -6- (e) At the time of the delivery to the Collateral Agent of the quarterly or annual Statutory Statement of ERC, together with the certificate of a senior financial officer of the Company, as required by paragraphs (c) and (d) of Section 8.01 of the Credit Agreement, if such certificate indicates that the Value of the Pledged Stock as at the date of such Statutory Statement exceeds 175% of the aggregate unpaid principal amount of all Loans and Debentures less any collected funds standing to the credit of the Collateral Account then outstanding, then at the request of the Company, so long as no Default has then occurred and is continuing, the Collateral Agent shall promptly release to the Company the maximum number of shares of Pledged Stock so that, after giving effect to such release, the Value of the Pledged Stock is not less than 166-2/3% of the aggregate unpaid principal amount of the Loans and Debentures then outstanding less any collected funds standing to the credit of the Collateral Account. 5.05 EVENTS OF DEFAULT, ETC. During the period during which an Event of Default or a Debenture Acceleration Event shall have occurred and be continuing: (a) the Collateral Agent shall have all of the rights and remedies with respect to the Collateral of a secured party under the Uniform Commercial Code (whether or not said Code is in effect in the jurisdiction where the rights and remedies are asserted) and such additional rights and remedies to which a secured party is entitled under the laws in effect in any jurisdiction where any rights and remedies hereunder may be asserted, including, without limitation, the right, to the maximum extent permitted by law, to exercise all voting, consensual and other powers of ownership pertaining to the Collateral as if the Collateral Agent were the sole and absolute owner thereof (and the Company agrees to take all such action as may be appropriate to give effect to such right, including, without limitation, causing certificates representing the Pledged Stock to be registered in the name of the Collateral Agent); (b) the Collateral Agent in its discretion may, in its name or in the name of the Company or otherwise, demand, sue for, collect or receive any money or property at any time payable or receivable on account of or in exchange for any of the Collateral, but shall be under no obligation to do so; and (c) the Collateral Agent may, and upon the direction of the Required Secured Creditors shall, upon ten business days' prior written notice to the Company of the time and place, with respect to the Collateral or any part thereof which shall then be or shall thereafter come into the possession, custody or control of the Collateral Agent, any of the Secured Creditors or any of their respective agents, sell, lease, assign or otherwise dispose of all or any part of such Collateral, at such place or places as the Collateral Agent deems best, and for cash or for credit or for future delivery (without thereby assuming any credit risk), at public or private sale, without demand of performance or notice of intention to effect any such disposition or of the time or place thereof (except such notice as is required above or by applicable statute and cannot be waived), and the Collateral Agent or any Secured Creditor or anyone else may be the purchaser, lessee, assignee or recipient of any or all of the Collateral so disposed of at any public sale (or, to the extent permitted by law, at any private sale) and thereafter hold the same absolutely, free from any claim or right of whatsoever kind, including any right or equity of -7- redemption (statutory or otherwise), of the Company, any such demand, notice and right or equity being hereby expressly waived and released. The Collateral Agent may, without notice or publication, adjourn any public or private sale or cause the same to be adjourned from time to time by announcement at the time and place fixed for the sale, and such sale may be made at any time or place to which the sale may be so adjourned. The proceeds of each collection, sale or other disposition under this Section 5.05 shall be applied in accordance with Section 5.08 hereof. The Company recognizes that, by reason of certain prohibitions contained in the Securities Act of 1933, as amended, and applicable state securities laws, the Collateral Agent may be compelled, with respect to any sale of all or any part of the Collateral, to limit purchasers to those who will agree, among other things, to acquire the Collateral for their own account, for investment and not with a view to the distribution or resale thereof. The Company acknowledges that any such private sales may be at prices and on terms less favorable to the Collateral Agent than those obtainable through a public sale without such restrictions, and, notwithstanding such circumstances, agrees that any such private sale shall be deemed to have been made in a commercially reasonable manner and that the Collateral Agent shall have no obligation to engage in public sales and no obligation to delay the sale of any Collateral for the period of time necessary to permit the issuer thereof to register it for public sale. 5.06 DEFICIENCY. If the proceeds of sale, collection or other realization of or upon the Collateral pursuant to Section 5.05 hereof are insufficient to cover the costs and expenses of such realization and the payment in full of the Secured Obligations, the Company shall remain liable for any deficiency. 5.07 PRIVATE SALE. The Collateral Agent and the Secured Creditors shall incur no liability as a result of the sale of the Collateral, or any part thereof, at any private sale pursuant to Section 5.05 hereof conducted in a commercially reasonable manner. The Company hereby waives any claims against the Collateral Agent or any Secured Creditor arising by reason of the fact that the price at which the Collateral may have been sold at such a private sale was less than the price which might have been obtained at a public sale or was less than the aggregate amount of the Secured Obligations, even if the Collateral Agent accepts the first offer received and does not offer the Collateral to more than one offeree. 5.08 APPLICATION OF PROCEEDS. Except as otherwise herein expressly provided in the third sentence of Section 4.01 hereof, the proceeds of any collection, sale or other realization of all or any part of the Collateral pursuant hereto, and any other cash at the time held by the Collateral Agent under Section 4 hereof or this Section 5, shall be applied by the Collateral Agent: FIRST, to the payment of the costs and expenses of such collection, sale or other realization, including reasonable out-of-pocket costs and expenses of the Collateral Agent and the reasonable fees and expenses of its agents and counsel, and all expenses incurred and advances made by the Collateral Agent in connection therewith; -8- NEXT, to the payment in full of the Secured Obligations (whether or not then due), in each case equally and ratably in accordance with the respective amounts thereof, or as the Secured Creditors holding the same may otherwise agree; and FINALLY, to the payment to the Company, or its successors or assigns, or as a court of competent jurisdiction may direct, of any surplus then remaining. Proceeds of Collateral to be applied by the Collateral Agent to the payment of any of (a) the Debenture Obligations shall be paid to the Indenture Trustee and (b) the Credit Agreement Obligations shall be paid to the Administrative Agent and, (i) to the extent that any such Debenture Obligations shall not then be due, such payment shall be applied by the Indenture Trustee as agreed between the Company and the Indenture Trustee and (ii) to the extent that any such Credit Agreement Obligations shall not then be due, such payment shall be applied by the Administrative Agent as agreed between the Company and the Administrative Agent or as otherwise required by the Indenture. As used in this Section 5, "PROCEEDS" of Collateral shall mean cash, securities and other property realized in respect of, and distributions in kind of, Collateral, including any thereof received under any reorganization, liquidation or adjustment of debt of the Company or any issuer of or obligor on any of the Collateral. 5.09 ATTORNEY-IN-FACT. Without limiting any rights or powers granted by this Agreement to the Collateral Agent while no Event of Default or Debenture Acceleration Event has occurred and is continuing, upon the occurrence and during the continuance of any Event of Default or Debenture Acceleration Event the Collateral Agent is hereby appointed the attorney-in-fact of the Company for the purpose of carrying out the provisions of this Section 5 and taking any action and executing any instruments which the Collateral Agent may deem necessary or advisable to accomplish the purposes hereof, which appointment as attorney-in-fact is irrevocable and coupled with an interest. Without limiting the generality of the foregoing, so long as the Collateral Agent shall be entitled under this Section 5 to make collections in respect of the Collateral, the Collateral Agent shall have the right and power to receive, endorse and collect all checks made payable to the order of the Company representing any dividend, payment or other distribution in respect of the Collateral or any part thereof and to give full discharge for the same. 5.10 TERMINATION. When all Credit Agreement Obligations shall have been paid in full and the Commitments of the Banks under the Credit Agreement shall have expired or been terminated, and so long as no Debenture Acceleration Event shall have occurred and be continuing, this Agreement shall terminate, and the Collateral Agent shall forthwith cause to be assigned, transferred and delivered, against receipt but without any recourse, warranty or representation whatsoever, any remaining Collateral and money received in respect thereof, to or on the order of the Company. 5.11 EXPENSES. The Company agrees to pay to the Collateral Agent all out-of-pocket expenses (including reasonable expenses for legal services) of, or incident to, the enforcement of any of the provisions of this Section 5, or performance by the Collateral Agent of any obligations of the Company in respect of the Collateral which the Company has failed or refused to perform, or any actual or attempted sale, or any exchange, enforcement, collection, -9- compromise or settlement in respect of any of the Collateral, and for defending or asserting rights and claims of the Collateral Agent in respect thereof, by litigation or otherwise, and all such expenses shall be Secured Obligations to the Collateral Agent secured under Section 3 hereof. 5.12 FURTHER ASSURANCES. The Company agrees that, from time to time upon the written request of the Collateral Agent, the Company will execute and deliver such further documents and do such other acts and things as the Collateral Agent may reasonably request in order fully to effect the purposes of this Agreement. Section 6. THE COLLATERAL AGENT. A. The Collateral Agent shall hold in accordance with this Agreement all items of the Collateral at any time received under this Agreement. It is expressly understood and agreed that the obligations of the Collateral Agent as holder of the Collateral and interests therein and with respect to the disposition thereof, and otherwise under this Agreement, are only those expressly set forth in this Agreement. The Collateral Agent shall act hereunder on the terms and conditions set forth herein and shall have no liability to any Secured Creditor in so acting. B. No single Secured Creditor shall have the right to cause the Collateral Agent to take any action with respect to the Collateral and the Collateral Agent shall take such action with respect to the Collateral as directed by the Required Secured Creditors consistent with the terms and conditions of this Agreement. If the Collateral Agent shall request instructions from the Required Secured Creditors with respect to any act or action (including failure to act) in connection with this Agreement, the Collateral Agent shall be entitled to refrain from such act or taking such action unless and until it shall have received instructions from the Required Secured Creditors, and to the extent requested, appropriate indemnification in respect of actions to be taken; and the Collateral Agent shall not incur liability to any Person by reason of so refraining. Without limiting the foregoing, no Secured Creditor shall have any right of action whatsoever against the Collateral Agent as a result of the Collateral Agent acting or refraining from action hereunder in accordance with the instructions of the Required Secured Creditors as aforesaid. C. The Collateral Agent has been appointed as agent for the Banks hereunder by the Banks and shall be entitled to the benefits of Section 10 of the Credit Agreement, MUTATIS MUTANDIS. By requesting, asserting, accepting or enforcing any benefits hereunder, the Indenture Trustee and the holders of the Debentures agree that the provisions of Section 10 of the Credit Agreement shall apply, MUTATIS MUTANDIS, to their relationship with the Collateral Agent. Section 7. MISCELLANEOUS. 7.01 NO WAIVER. No failure on the part of the Collateral Agent or any of its agents to exercise, and no course of dealing with respect to, and no delay in exercising, any right, power or remedy hereunder shall operate as a waiver thereof; nor shall any single or partial exercise by the Collateral Agent or any of its agents of any right, power or remedy hereunder preclude any other or further exercise thereof or the exercise of any other right, power or remedy. The remedies herein are cumulative and are not exclusive of any remedies provided by law. -10- 7.02 GOVERNING LAW. This Agreement shall be governed by, and construed in accordance with, the law of the State of New York. 7.03 NOTICES. All notices, requests, consents and demands hereunder shall be in writing and telexed, telecopied or delivered to the intended recipient (i) in the case of the Banks, at its "Address for Notices" specified pursuant to Section 11.02 of the Credit Agreement (which notice shall be deemed to have been given at the times specified in said Section 11.02) and (ii) in the case of the holders of the Debentures, at the Indenture Trustee's address as specified in the Indenture. 7.04 WAIVERS, ETC. The terms of this Agreement may be waived, altered or amended only by an instrument in writing duly executed by the Company and the Collateral Agent (with the consent of the Banks as specified in Section 10.09 of the Credit Agreement). Any such amendment or waiver shall be binding upon all Secured Creditors, each subsequent holder of any of the Secured Obligations, and each other party to this Agreement. 7.05 SUCCESSORS AND ASSIGNS. This Agreement shall be binding upon and inure to the benefit of the respective successors and assigns of the Company, the Collateral Agent, the Banks and each other holder of any of the Secured Obligations (PROVIDED, however, that the Company shall not assign or transfer its rights hereunder without the prior written consent of the Collateral Agent). 7.06 SEVERABILITY. If any provision hereof is invalid and unenforceable in any jurisdiction, then, to the fullest extent permitted by law, (i) the other provisions hereof shall remain in full force and effect in such jurisdiction and shall be liberally construed in favor of the Collateral Agent and the Secured Creditors in order to carry out the intentions of the parties hereto as nearly as may be possible and (ii) the invalidity or unenforceability of any provision hereof in any jurisdiction shall not affect the validity or enforceability of such provision in any other jurisdiction. -11- IN WITNESS WHEREOF, the parties hereto have caused this Amended and Restated Pledge Agreement to be duly executed and delivered as of the day and year first above written. ENHANCE FINANCIAL SERVICES GROUP INC. By /s/ Arthur Dubroff ------------------------- Title: Executive Vice President and Chief Financial Officer THE CHASE MANHATTAN BANK as Collateral Agent By /s/ Helen L. Newcomb ------------------------- Title: Vice President -12- EX-4.(2)(3) 3 AMENDMENT NO. 1 TO THE CREDIT AGREEMENT EXHIBIT 4.2.3 AMENDMENT NO. 1 AMENDMENT NO. 1 dated as of December 31, 1997 to the AMENDED AND RESTATED CREDIT AGREEMENT dated as of November 24, 1992, Amended and Restated as of October 1, 1996 among ENHANCE FINANCIAL SERVICES GROUP INC., the Banks signatory thereto and THE CHASE MANHATTAN BANK, as Administrative Agent. W I T N E S S E T H: WHEREAS, the Company, the Banks and the Agent are parties to the Amended and Restated Credit Agreement referred to above (the "CREDIT AGREEMENT") pursuant to which the Banks have agreed to extend credit to the Company as provided therein. WHEREAS, the Company has requested the Banks and the Administrative Agent to amend the Credit Agreement to increase the aggregate Commitments from $60,000,000 to $75,000,000. WHEREAS, the Bank and the Administrative Agent are agreeable to such amendment on the terms and conditions set forth below. NOW, THEREFORE, in consideration of the foregoing and the mutual agreements contained herein it is hereby agreed as follows: 1. DEFINITIONS. All terms defined in the Credit Agreement shall be used herein as defined in the Credit Agreement unless otherwise defined herein or the context otherwise requires. 2. AMENDMENTS AND AGREEMENT. (a)Section 1.01 of the Credit Agreement is hereby amended by restating it its entirety to read as follows: "COMMITMENT' shall mean, as to each Bank, the obligation of such Bank to make Loans in an aggregate amount not exceeding the amount set forth opposite such Bank's name on the signature pages of Amendment No. 1 under the caption "Commitment" (as the same may be reduced at any time or from time to time pursuant to Section 2.03 hereof)." (b)Section 1.00 of the Credit Agreement is hereby amended by adding the following new definition in alphabetical order therein: "AMENDMENT NO. 1' shall mean Amendment No. 1 to this Agreement dated as of December 31, 1997." 3. REPRESENTATION AND WARRANTIES In order to induce the Bank and the Administrative Agent o make this Amendment, the Company hereby represents that: (a)the execution and delivery of this Amendment and the Notes and the performance of the Company thereunder and under the Credit Agreement as amended hereby (i) have been duly authorized by all necessary corporate action, will not violate any provision of law, or the Company's charter or by-laws, or result in the breach of or constitute a default, or require a consent, under any indenture or other agreement or instrument to which the Company or any of its Subsidiaries is a party or by which the Company or any of its Subsidiaries or their respective property may be bound or affected, and (ii) each of this Amendment, the Notes and the Credit Agreement as amended hereby constitutes the legal, valid and biding obligation of the Company enforceable against the Company in accordance with its terms; (b)the representations and warranties in Section 7 of the Credit Agreement are true and correct as of the Closing Date (hereinafter defined) as if they were being made on such date; and (c)no Event of Default or event which with notice or lapse of time, or both, would constitute an Event of Default, has occurred and is continuing on the Closing Date. 4. CONDITIONS OF EFFECTIVENESS This Amendment shall be effective (as of the date hereof) on the date when all of the following conditions shall have been met, and such date shall be the "Closing Date". (a)Counterparts of this Amendment shall have been executed by the Company, the Banks and the Administrative Agent; (b)Each Bank shall have received a replacement Note in the form of Exhibit A attached hereto, duly completed and executed by the Company; (c)The Administrative Agent shall have received copies of all corporate resolutions of the Company authorizing the execution and delivery of this Amendment and the Notes and the performance of the Company thereunder and under the Credit Agreement as hereby amended, certified as of the Closing Date by the Secretary or Assistant Secretary of the Company; (d)The Administrative Agent shall have received a certificate dated the Closing Date specifiying the names and tittles and including specimen signatures of the officers authorized to sign this Amendment and the Notes; 5. MISCELLANEOUS (a)Except as specifically amended hereby, all the provisions of the Credit Agreement shall remain unamended and in full force and effect, and the term "Credit Agreement", and words of like import shall be deemed to refer to the Credit Agreement as amended by this Amendment unless otherwise provided herein or the context otherwise requires. Nothing herein shall affect the obligations of the Company under the Credit Agreement with respect to any period prior to the effective date hereof. (b)This Amendment shall be governed by and construed and interpreted in accordance with the laws of the State of New York. IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be executed by their duly authorized officers as of the day and year first above written. ENHANCE FINANCIAL SERVICES GROUP, INC. By: /s/ Jeffrey A. Figurelli ---------------------------- Name: Jeffrey A. Figurelli Title: Senior Vice President 2 COMMITMENT THE CHASE MANHATTAN BANK, as Administrative Agent and a Bank $30,000,000 By: /s/ Heather A. Lindstrom --------------------------- Name: Heather A. Lindstrom Title: Vice President 3 COMMITMENT FLEET NATIONAL BANK $20,000,000 By: /s/ Vijay Nazareth ---------------------------- Name: Vijay Nazareth Title: Vice President 4 COMMITMENT BANK OF TOKYO-MITSUBISHI TRUST COMPANY $25,000,000 By: /s/ J. Beckwith --------------------------- Name: J. Beckwith Title: Vice President 5 EXHIBIT A [Form of Revolving Credit Note] PROMISSORY NOTE December 31, 1997 $____________ New York, New York FOR VALUE RECEIVED, ENHANCE FINANCIAL SERVICES GROUP INC., a New York corporation (the "COMPANY"), hereby promises to pay to _______________ (the "PAYEE"), for account of its respective Applicable Lending Offices provided for by the Credit Agreement referred to below, at the principal office of The Chase Manhattan Bank at 270 Park Avenue, New York, NY 10017, the principal sum of _______________ Dollars (or such lesser amount as shall equal the aggregate unpaid principal amount of the Revolving Credit Loans made by the Payee to the Company under the Credit Agreement), in lawful money of the United States of America and in immediately available funds, on the dates and in the principal amounts provided in the Credit Agreement, and to pay interest on the unpaid principal amount of each such Revolving Credit Loan, at such office in like money and funds, for the period commencing on the date of such Revolving Credit Loan until such Revolving Credit Loan shall be paid in full, at the rates per annum and on the dates provided in the Credit Agreement. The date, amount, interest rate and duration of Interest Period of each Revolving Credit Loan made by the Payee to the Company, and each payment made on account of the principal thereof, shall be recorded by the Payee on its books and, prior to any transfer of this Note, endorsed by the Payee on the schedule attached hereto or any continuation thereof, PROVIDED that the failure of the Payee to make any such recordation or endorsement shall not affect the obligations of the Company to make a payment when due of any amount owing under the Credit Agreement or hereunder in respect of the Revolving Credit Loans made by the Payee. This Note is one of the Revolving Credit Notes referred to in the Amended and Restated Credit Agreement dated as of November 24, 1997 amended and restated as of October 1, 1996 (as modified and supplemented and in effect from time to time, the "CREDIT AGREEMENT") among the Company, the Banks and The Chase Manhattan Bank, as Administrative Agent, and evidences Revolving Credit Loans made by the Payee thereunder. Terms used but not defined in this Notes have the respective meanings assigned to them in the Credit Agreement. The Credit Agreement provides for the acceleration of the maturity of this Note upon the occurrence of certain events and for prepayments of Loans upon the terms and conditions specified therein. Except as permitted by Sections 11.06(b) and 11.06(d) of the Credit Agreement, this Noted may not be assigned by the Payee to nay other Person. This Note shall be governed by, and construed in accordance with, the law of the State of New York. ENHANCE FINANCIAL SERVICES GROUP INC. By: __________________________ Name: Title: SCHEDULES OF REVOLVING CREDIT LOANS This Note evidences Revolving Credit Loans made, Continued or Converted under the withindescribed Credit Agreement to the Company, on the dates, in the principal amounts, of the Types bearing interest at the rates and having Interest Periods (if applicable) of the durations set forth below, subject to the payments and prepayments, Continuations, Conversions of principal set forth below:
AMOUNT PAID, DATE MADE, PRINCIPAL DURATION OF PREPAID, UNPAID CONTINUED OR TYPES OF AMOUNT INTEREST INTEREST CONTINUED OR PRINCIPAL NOTATION CONVERTED LOAN OF LOAN RATE PERIOD CONVERTED AMOUNT MADE BY
2 EX-4.(2)(4) 4 AMENDMENT NO. 2 TO THE CREDIT AGREEMENT EXHIBIT 4.2.4 AMENDMENT NO. 2 AMENDMENT NO. 2 dated as of March 27, 1998, among ENHANCE FINANCIAL SERVICES GROUP INC., a corporation duly organized and validly existing under the laws of the State of New York (together with its successors and assigns, the "COMPANY"); each of the lenders that is a signatory hereto (together with its successors and assigns, individually, a "BANK" and, collectively, the "BANKS"); and THE CHASE MANHATTAN BANK, as Swingline Bank (in such capacity, together with its successors and permitted assigns in such capacity, the "SWINGLINE BANK") and as agent for the Banks (in such capacity, together with its successors in such capacity, the "ADMINISTRATIVE AGENT"). The Company, certain of the Banks, the Swingline Bank and the Administrative Agent are parties to an Amended and Restated Credit Agreement dated as of November 24, 1992, amended and restated as of October 1, 1996, as further amended by a letter dated April 2, 1997 and by Amendment No. 1 dated as of December 31, 1997 (as heretofore modified and supplemented and in effect on the date hereof, the "CREDIT AGREEMENT"), providing, subject to the terms and conditions thereof, INTER ALIA, for extensions of credit (by the making of loans) to be made by said Banks to the Company in an aggregate principal not exceeding $75,000,000. The Company, the Banks, the Swingline Banks and the Administrative Agent wish to amend the Credit Agreement in certain respects, and accordingly, the parties hereto hereby agree as follows: Section 1. DEFINITIONS. Except as otherwise defined in this Amendment No. 2, terms defined in the Credit Agreement are used herein as defined therein. Section 2. AMENDMENTS. Subject to the satisfaction of the conditions precedent specified in Section 4 below, but effective as of the date hereof, the Credit Agreement shall be amended as follows: 2.01. Section 1.01 of the Credit Agreement shall be amended by adding the following new definitions and inserting the same in the appropriate alphabetical locations to read in their entirety as follows: "'DEBENTURES' shall mean the debentures issued by the Company under the Indenture before the Restatement Date (as defined in the Pledge Agreement) in any aggregate principal amount not in excess of $75,000,000. 'INDENTURE' shall mean the Indenture dated as of March 5, 1993 between the Company and The Chase Manhattan Bank, as Trustee, as the same shall be modified and supplemented and in effect from time to time." 2.02. Section 2.08 of the Credit Agreement is hereby amended by inserting "and Debentures" immediately following "amount of the Loans" and immediately preceding ", less any collected". AMENDMENT NO. 2 -2- 2.03. Section 6.03(c) of the Credit Agreement is hereby amended by inserting "and Debentures" immediately following "Loans" therein. Section 3. REPRESENTATIONS AND WARRANTIES. The Company represents and warrants to the Banks that the representations and warranties set forth in Section 7 of the Credit Agreement are true and complete on the date hereof as if made on and as of the date hereof and as if each reference in said Section 7 to "this Agreement" included reference to this Amendment No. 2. Section 4. CONDITIONS PRECEDENT. As provided in Section 2 above, the amendments to the Credit Agreement set forth in said Section 2 shall become effective, as of the date hereof, upon the satisfaction of the following conditions precedent: 4.01. EXECUTION BY ALL PARTIES. This Amendment No. 2 shall have been executed and delivered by the Company, the Administrative Agent and each of the Banks. 4.02. DOCUMENTS. The Administrative Agent shall have received the following documents, each of which shall be satisfactory to the Administrative Agent in form and substance: (1) CORPORATE DOCUMENTS. Certified copies of board of director resolutions of the Company with respect to the execution, delivery and performance of this Amendment No. 2 and the Credit Agreement as amended hereby and the Pledge Agreement and the Pledge Agreement as amended by the Pledge Agreement Amendment. (2) OPINION OF COUNSEL TO THE COMPANY. An opinion of Rogers & Wells, New York counsel to the Company, satisfactory to the Administrative Agent in form and substance (and the Company hereby instructs such counsel to deliver such opinion to the Banks and the Administrative Agent). (3) OTHER DOCUMENTS. Such other documents as the Administrative Agent or any Bank or special New York counsel to the Administrative Agent may reasonably request. 4.03 AMENDMENT TO PLEDGE AGREEMENT. The amendments to the Pledge Agreement contemplated by Exhibit A hereto (the "PLEDGE AGREEMENT AMENDMENT") shall become effective. Section 5. MISCELLANEOUS. Except as herein provided, the Credit Agreement shall remain unchanged and in full force and effect. This Amendment No. 2 may be executed in any number of counterparts, all of which taken together shall constitute one and the same amendatory instrument and any of the parties hereto may execute this Amendment No. 2 by signing any such counterpart. This Amendment No. 2 shall be governed by, and construed in accordance with, the law of the State of New York. AMENDMENT NO. 2 -3- IN WITNESS WHEREOF, the parties hereto have caused this Amendment No. 2 to be duly executed and delivered as of the day and year first above written. ENHANCE FINANCIAL SERVICES GROUP INC. By /s/ Arthur Dubroff ------------------------------------ Title: Executive Vice President and Chief Financial Officer THE CHASE MANHATTAN BANK By /s/ Helen L. Newcomb ------------------------------------ Title: Vice President FLEET NATIONAL BANK By /s/ Vijay Nazareth ------------------------------------ Title: Vice President BANK OF TOKYO-MITSUBISHI TRUST COMPANY By /s/ J. Beckwith ------------------------------------ Title: Vice President THE CHASE MANHATTAN BANK, as Swingline Bank By /s/ Helen L. Newcomb ------------------------------------ Title: Vice President THE CHASE MANHATTAN BANK as Administrative Agent By /s/ Helen L. Newcomb ------------------------------------ Title: Vice President AMENDMENT NO. 2 EXHIBIT A See Exhibit 4.2.2. EX-10.(2)(2) 5 FORM OF OPTION GRANT CERTIFICATE DTD 12/97 EXHIBIT 10.2.2 OPTION GRANT CERTIFICATE ENHANCE FINANCIAL SERVICES GROUP INC., a New York corporation (the "Company"), hereby grants to _______________ (the "Executive") an Incentive Stock Option (the "Option") to purchase ______ shares (the "Option Shares") of common stock, par value $.10 per share ("Common Stock"), pursuant to the Company's 1987 Long-Term Incentive Plan for Key Employees (as such may be amended from time to time, the "Plan"). 1. Basic Terms of Option. (a) Term of Option. The option shall expire December 31, 2007. (b) Exercise Price. The exercise price shall be $57.63 per Option Share (the "Purchase Price"). (c) Vesting. The Option shall become exercisable in equal installments in accordance with Article 3. (d) Method of Exercise. The Option may be exercised by the Executive in accordance with the terms hereof and of the Plan for any and all Option Shares by written notice (the "Exercise Notice") from the Executive to the Company substantially in the form of Annex A hereto. Payment of the Purchase Price may be made in the form of cash or shares of Common Stock, as permitted by the Plan, and shall accompany the Exercise Notice to the Company; provided that, if such Exercise Notice indicates that the Executive is simultaneously using the stock option exercise program of Merrill Lynch Pierce Fenner & Smith Incorporated or other brokerage concern approved by the Company, the Purchase Price shall be payable on the fifth business day following the date of delivery of the Exercise Notice. 2. Option Shares. (a) Status of Option Shares. Effective upon the exercise of the Option in whole or in part and the receipt by the Company of the Purchase Price for the Option Shares being purchased, the Executive shall be the holder of record of such shares and shall have all of the rights of a shareholder with respect thereto (including the right to vote such shares at any meeting at which the holders of the Common Stock may vote, the right to receive all dividends declared and paid upon such shares and the right to exercise any rights or warrants issued in respect of any such shares). The Company shall, upon receipt of the Purchase Price, issue in the name of the Executive a certificate representing the Option Shares purchased from time to time. -1- (b) Option Shares Unregistered. As of the date of grant of the Option, the Option Shares have not been registered under the Securities Act of 1933, as amended (the "Act"), and the Company has no obligation to effect or maintain the effectiveness of the registration of the Option Shares under the Act. Unless the Option Shares issuable upon a given exercise are then subject to an effective registration statement under the Act, the certificate representing such shares shall bear the following legend or such other legend as the Company's counsel may deem appropriate: "The shares represented by this certificate have not been registered under the Securities Act of 1933, as amended, and may in no event be offered, sold, transferred or assigned unless and until the shares have been so registered or, in the opinion of counsel to Enhance Financial Services Group Inc., an exemption from such registration is available." (c) Investment Intent. If the certificate representing the Option Shares issuable upon a given exercise is required to bear the legend set forth above (or a legend to like effect), the Executive shall, by such exercise of the Option, be deemed conclusively to represent and to agree with the Company that he or she is acquiring the Option Shares then being purchased for his or her own account and not for the account of others, for investment only and not with a view to public sale or distribution. (d) Restriction Relating to Certain Mergers. In the event of a merger or consolidation of the Company with a third party which is proposed to be accounted for as a pooling of interests, the Executive shall, if so requested by the Company and notwithstanding any other provision of this Certificate, agree not to sell, assign, or gift or in any other way reduce his or her risk relative to the Option Shares and all other shares of Common Stock owned by the Executive for such period after the consummation of such merger or consolidation as the Company shall, upon the advice of its outside accountants, conclusively determine as necessary to ensure that such merger or consolidation may be validly accounted for as a pooling of interests. (e) Prior Conditions. The Company shall not be required to issue or deliver any certificate representing Option Shares prior to (i) the admission of such shares to listing on any stock exchange on which the Common Stock may then be listed, (ii) the completion of any registration or any other qualification of such shares under any federal or state law or any rulings or regulations of any governmental regulatory body, (iii) the obtaining of any consent or approval or other clearance from any governmental agency which the Company shall, in its sole discretion, determine to be necessary or advisable, and (iv) the payment to the Company, upon its request, of any amount requested by the Company for the purposes of satisfying its liability, if any, to withhold taxes of any kind or any other applicable assessment (plus interest or penalties thereon, if any, caused by a delay in making such payment) incurred by reason of the exercise of the Option. 3. Vesting of Option. (a) Vesting Conditions. If the Executive remains in the continuous employ of the Company or a Subsidiary through the close of business on each date indicated in Column I below, the Option shall thereupon vest (on a cumulative basis) as to the portion of the Option Shares indicated opposite such date in Column II below: -2- (I) (II) the % (or additional %) If employment of the Option continuous through then which vests is ------------------ ---------------- December 31, 1998 25% December 31, 1999 25% December 31, 2000 25% December 31, 2001 25% (b) Effect of Termination of Employment. If the Executive's employment with the Company and its Subsidiaries is terminated for any reason whatsoever before all installments of the Option shall have vested pursuant to Paragraph 3(a), then any portion of the Option which is not vested at the time of such termination shall automatically terminate on the date of the termination of employment, and all rights and interests of the Executive in and to such unvested portion of the Option shall thereupon terminate. Should the Executive's employment be terminated before any given date set forth in Paragraph 3(a) upon his or her death, Disability or Retirement, then the installments of the Option which are vested at the time of such termination shall remain exercisable in accordance with the terms hereof as if such termination of employment shall not have occurred. Should the Executive's employment be terminated by the Company or a Subisidiary before any given date set forth in Paragraph 3(a) other than for Cause, the vested portion of the Option not subsequently exercised on or before the 90th day after such termination shall thereupon automatically terminate. Should the Executive's employment be terminated before any given date set forth in Paragraph 3(a) under any other circumstances, the vested portion of the Option shall thereupon automatically terminate. (c) Effect of Leave of Absence. A leave of absence from the Company or any Subsidiary which is approved by the President shall not be considered a termination of the Executive's employment with the Company for purposes of this Article 3 or any other provision of this Certificate, provided that each date set forth in the table in Paragraph 3(a) which shall follow the commencement of the leave of absence shall be automatically deferred for a period equal to the period of the leave of absence. (d) Board's Right to Waiver or Acceleration. Any provision of this Article 3 to the contrary notwithstanding, the Board reserves the right, in its sole discretion, to waive any condition to the vesting of the Option and accelerate the date on which any installment of the Option shall vest in the event of a change in control of the Company or a public offering of shares of Common Stock or otherwise. 4. Definitions. Unless defined below or elsewhere in this Certificate, the capitalized terms used in this Certificate shall have the meanings ascribed thereto in the Plan. -3- (a) "Cause" shall consist of, the failure of the Executive to perform or observe the provisions of any employment agreement with the Company or a Subsidiary, dishonesty or insubordination in the performance of his or her duties, misappropriation of funds, material and willful misconduct, habitual insobriety or conviction of a crime involving moral turpitude. (b) "Disability" means a disability which entitles the Executive to benefits under the long-term disability insurance program of the Company or a Subsidiary applicable to the Executive, or which would entitle the Executive to such benefits after any applicable waiting period. (c) "Retirement" means termination of the Executive's employment with the Company and its Subsidiaries (other than for Cause or upon death or Disability) on or after the later to occur of (i) the conclusion of ten continuous years of employment by the Company or any Subsidiary or (ii) the date on which the Executive attains age 55. 5. General Provisions. (a) Administration and Construction. The provisions hereof shall be administered and construed by the Board (or any authorized committee thereof), whose decisions shall be conclusive and binding on the Company, the Executive and anyone claiming under or through either of them. Without limiting the generality of the foregoing, any determination as to whether or not an event has occurred or failed to occur which causes any unvested portion of the Option to be forfeited or become vested pursuant hereto, shall be made in the good faith but otherwise absolute discretion of the Board. By the Executive's acceptance of this Certificate, the Executive and each person claiming under or through the Executive irrevocably consents and agrees to all actions, decisions and determinations to be taken or made by the Board in good faith pursuant to this Certificate and the Plan. (b) Option Not Assignable or Transferable. The Option is not assignable or transferable other than by will or the laws of descent and distribution, either voluntarily, or, to the full extent permitted by law, involuntarily, by way of encumbrance, pledge, attachment, levy or charge of any nature. Any rights of the Executive hereunder shall be exercisable during the Executive's lifetime only by him or her or by his or her guardian or legal representative. (c) No Employment Rights. No provision of this Certificate or of the Plan shall confer upon the Executive any right to continue in the employ of the Company or a Subsidiary or shall in any way affect the right of the Company or a Subsidiary to dismiss, or otherwise terminate the employment of, the Executive at any time for any reason or no reason, or shall impose upon the Company or any Subsidiary any liability for any forfeiture of any unvested portion of the Option which may result under this Certificate if the Executive's employment is so terminated. (d) Recapitalization. If the Executive receives, with respect to the Option, any other option or warrant to purchase securities of the Company, of a Subsidiary or of any other entity as a result of any recapitalization, merger, consolidation, combination, or exchange of shares or a similar corporate change, any such other option or warrant received by the Executive shall likewise be subject to the terms and conditions of this Certificate and shall be included in the term "Option." Similarly, any securities or other property as to which such other option or warrant is exercisable shall be included in the term "Option Shares." In the event of any such corporate change, the Purchase Price set forth -4- in Paragraph 1(b) shall be appropriately adjusted by the Board such that the aggregate price for all such Option Shares is not changed. (e) Legal Representative. In the event of the Executive's death or a judicial determination of his or her incompetence, reference in this Certificate to the Executive shall be deemed to refer to his or her legal representative or, where appropriate, to the Beneficiary. (f) Holidays. If any event provided for in this Certificate is scheduled to take place on a legal holiday, such event shall take place on the next succeeding day that is not a legal holiday. (g) Notices to the Company. Any notice or other communication to the Company pursuant to any provision of this Certificate shall be deemed to have been delivered when delivered in person to the Corporate Secretary of the Company or when deposited in the United States mail, first class postage prepaid, addressed to the Corporate Secretary of the Company at 335 Madison Avenue, New York, New York 10017 or at such other address of which the Company may from time to time give the Executive written notice in accordance with Paragraph 5(h). (h) Notices to the Executive. Any notice or other communication to the Executive pursuant to any provision of this Certificate shall be deemed to have been delivered when delivered to the Executive in person or when deposited in the United States mail, first class postage prepaid, addressed to the Executive at his or her address on the security holder records of the Company or at such other address of which the Executive may from time to time give the Company written notice in accordance with Paragraph 5(g). (i) Agreement Subject to Plan. This Option Grant Certificate is being executed and delivered pursuant to and is subject in all events to the Plan, a copy of which, if not previously delivered to the Executive in connection with a prior grant thereunder, is being delivered to the Executive concurrently with this Certificate and which is incorporated in this Certificate by reference. Each provision of this Certificate shall be administered and construed in accordance with the Plan, and any provision that cannot be so administered or construed shall to that extent be disregarded. ENHANCE FINANCIAL SERVICES GROUP INC. Date: As of December 31, 1997 By:__________________________ Daniel Gross President -5- Annex A Enhance Financial Services Group Inc. 335 Madison Avenue New York, New York 10017 Ladies and Gentlemen: I am an optionee under the Enhance Financial Services Group Inc. Long-Term Incentive Plan for Key Employees (the "Plan"), having been granted on December 31, 1997 an option for ________ shares at an exercise price of $57.63 per share. Of such grant, options for _________ shares remain unexercised and unexpired. Of such number of unexercised and unexpired options, options for ________ shares are vested as of this date. SELECT, BY INDICATING WITH AN "X", ONE EXERCISE METHOD: ___ I hereby exercise the aforesaid option for _______ shares using the Merrill Lynch "Corporate Stock Option Exercise Program." Accordingly, payment will be remitted to the company on my behalf by Merrill Lynch. ___ I hereby exercise the aforesaid option for _______ shares not using the Merrill Lynch "Corporate Stock Option Exercise Program" and enclose my check, payable to the order of Enhance Financial Services Group Inc., for $________ in payment of the purchase price and applicable withholding taxes for such shares. I ask that the certificate for the option shares be delivered to me. Very truly yours, Date: _____________________ Name: EX-10.(2)(4) 6 FORM OF OPTION GRANT UNDER 1997 INCENT EXHIBIT 10.2.4 OPTION GRANT CERTIFICATE ENHANCE FINANCIAL SERVICES GROUP INC., a New York corporation (the "Company"), hereby grants to __________________(the "Executive") an Incentive Stock Option (the "Option") to purchase _______ shares (the "Option Shares") of common stock, par value $.10 per share ("Common Stock"), pursuant to the Company's 1997 Long-Term Incentive Plan for Key Employees (as such may be amended from time to time, the "Plan"). 1. BASIC TERMS OF OPTION. (a) Term of Option. The option shall expire December 31, 2007. (b) Exercise Price. The exercise price shall be $______ per Option Share (the "Purchase Price"). (c) Vesting. The Option shall become exercisable in equal installments in accordance with Article 3. (d) Method of Exercise. The Option may be exercised by the Executive in accordance with the terms hereof and of the Plan for any and all Option Shares by written notice (the "Exercise Notice") from the Executive to the Company substantially in the form of Annex A hereto. Payment of the Purchase Price may be made in the form of cash or shares of Common Stock, as permitted by the Plan, and shall accompany the Exercise Notice to the Company; provided that, if such Exercise Notice indicates that the Executive is simultaneously using the stock option exercise program of Merrill Lynch Pierce Fenner & Smith Incorporated or other brokerage concern approved by the Company, the Purchase Price shall be payable on the fifth business day following the date of delivery of the Exercise Notice. 2. OPTION SHARES. (a) Status of Option Shares. Effective upon the exercise of the Option in whole or in part and the receipt by the Company of the Purchase Price for the Option Shares being purchased, the Executive shall be the holder of record of such shares and shall have all of the rights of a shareholder with respect thereto (including the right to vote such shares at any meeting at which the holders of the Common Stock may vote, the right to receive all dividends declared and paid upon such shares and the right to exercise any rights or warrants issued in respect of any such shares). The Company shall, upon receipt of the Purchase Price, issue in the name of the Executive a certificate representing the Option Shares purchased from time to time. (b) Option Shares Unregistered. As of the date of grant of the Option, the Option Shares have been registered under the Securities Act of 1933, as amended (the "Act"). However, the Company has no obligation to maintain the effectiveness of the registration of the Option Shares under the Act. Unless the Option Shares issuable upon a given exercise are then subject to an effective registration statement under the Act, the certificate representing such shares shall bear the following legend or such other legend as the Company's counsel may deem appropriate: "The shares represented by this certificate have not been registered under the Securities Act of 1933, as amended, and may in no event be offered, sold, transferred or assigned unless and until the shares have been so registered or, in the opinion of counsel to Enhance Financial Services Group Inc., an exemption from such registration is available." (c) Investment Intent. If the certificate representing the Option Shares issuable upon a given exercise is required to bear the legend set forth above (or a legend to like effect), the Executive shall, by such exercise of the Option, be deemed conclusively to represent and to agree with the Company that he or she is acquiring the Option Shares then being purchased for his or her own account and not for the account of others, for investment only and not with a view to public sale or distribution. (d) Restriction Relating to Certain Mergers. In the event of a merger or consolidation of the Company with a third party which is proposed to be accounted for as a pooling of interests, the Executive shall, if so requested by the Company and notwithstanding any other provision of this Certificate, agree not to sell, assign, or gift or in any other way reduce his or her risk relative to the Option Shares and all other shares of Common Stock owned by the Executive for such period after the consummation of such merger or consolidation as the Company shall, upon the advice of its outside accountants, conclusively determine as necessary to ensure that such merger or consolidation may be validly accounted for as a pooling of interests. (e) Prior Conditions. The Company shall not be required to issue or deliver any certificate representing Option Shares prior to (i) the admission of such shares to listing on any stock exchange on which the Common Stock may then be listed, (ii) the completion of any registration or any other qualification of such shares under any federal or state law or any rulings or regulations of any governmental regulatory body, (iii) the obtaining of any consent or approval or other clearance from any governmental agency which the Company shall, in its sole discretion, determine to be necessary or advisable, and (iv) the payment to the Company, upon its request, of any amount requested by the Company for the purposes of satisfying its liability, if any, to withhold taxes of any kind or any other applicable assessment (plus interest or penalties thereon, if any, caused by a delay in making such payment) incurred by reason of the exercise of the Option. 2 3. VESTING OF OPTION. (a) Vesting Conditions. If the Executive remains in the continuous employ of the Company or a Subsidiary through the close of business on each date indicated in Column I below, the Option shall thereupon vest (on a cumulative basis) as to the portion of the Option Shares indicated opposite such date in Column II below: (I) (II) the % (or additional %) If employment of the Option continuous through then which vests is ------------------ --------------- December 31, 1998 25% December 31, 1999 25% December 31, 2000 25% December 31, 2001 25% (b) Effect of Termination of Employment. Should the Executive's employment with the Company and its Subsidiaries be terminated for any reason whatsoever before all installments of the Option shall have vested pursuant to Paragraph 3(a), then any portion of the Option which is not vested at the time of such termination shall automatically terminate on the date of the termination of employment, and all rights and interests of the Executive in and to such unvested portion of the Option shall thereupon terminate. Should the Executive's employment be terminated before any given date set forth in Paragraph 3(a) upon his or her death, Disability or Retirement, then the installments of the Option which are vested at the time of such termination shall remain exercisable in accordance with the terms hereof as if such termination of employment shall not have occurred. Should the Executive's employment be terminated by the Company or a Subisidiary other than for Cause, the vested portion of the Option not subsequently exercised on or before the 90th day after such termination shall thereupon automatically terminate. Should the Executive's employment be terminated under any other circumstances, the vested portion of the Option shall thereupon automatically terminate. (c) Effect of Leave of Absence. A leave of absence from the Company or any Subsidiary which is approved by the Board or the President of the Company with specific reference to the grant evidenced by this Certificate shall not be considered a termination of the Executive's employment with the Company for purposes of this Article 3 or any other provision of this Certificate, provided that each date set forth in the table in Paragraph 3(a) which shall follow the commencement of the leave of absence shall be automatically deferred for a period equal to the period of the leave of absence. 3 (d) Board's Right to Waiver or Acceleration. Any provision of this Article 3 to the contrary notwithstanding, the Board reserves the right, in its sole discretion, to waive any condition to the vesting of the Option and accelerate the date on which any installment of the Option shall vest in the event of a change in control of the Company or a public offering of shares of Common Stock or otherwise. 4. DEFINITIONS. Unless defined below or elsewhere in this Certificate, the capitalized terms used in this Certificate shall have the meanings ascribed thereto in the Plan. (a) "Cause" shall consist of the failure of the Executive to perform or observe the provisions of any employment agreement with the Company or a Subsidiary, dishonesty or insubordination in the performance of his or her duties, misappropriation of funds, material and willful misconduct, habitual insobriety or conviction of a crime involving moral turpitude. (b) "Disability" means a disability which entitles the Executive to benefits under the long-term disability insurance program of the Company or a Subsidiary applicable to the Executive, or which would entitle the Executive to such benefits after any applicable waiting period. (c) "Retirement" means termination of the Executive's employment with the Company and its Subsidiaries (other than for Cause or upon death or Disability) on or after the later to occur of (i) the conclusion of ten years of continuous employment by the Company or any Subsidiary or (ii) the date on which the Executive attains age 55. 5. GENERAL PROVISIONS. (a) Administration and Construction. The provisions hereof shall be administered and construed by the Board (or any authorized committee thereof), whose decisions shall be conclusive and binding on the Company, the Executive and anyone claiming under or through either of them. Without limiting the generality of the foregoing, any determination as to whether or not an event has occurred or failed to occur which causes any unvested portion of the Option to be forfeited or become vested pursuant hereto, shall be made in the good faith but otherwise absolute discretion of the Board. By the Executive's acceptance of this Certificate, the Executive and each person claiming under or through the Executive irrevocably consents and agrees to all actions, decisions and determinations to be taken or made by the Board in good faith pursuant to this Certificate and the Plan. 4 (b) Option Not Assignable or Transferable. The Option is not assignable or transferable other than by will or the laws of descent and distribution, either voluntarily, or, to the full extent permitted by law, involuntarily, by way of encumbrance, pledge, attachment, levy or charge of any nature. Any rights of the Executive hereunder shall be exercisable during the Executive's lifetime only by the Executive's or by his or her guardian or legal representative. (c) No Employment Rights. No provision of this Certificate or of the Plan shall confer upon the Executive any right to continue in the employ of the Company or a Subsidiary or shall in any way affect the right of the Company or a Subsidiary to dismiss, or otherwise terminate the employment of, the Executive at any time for any reason or no reason, or shall impose upon the Company or any Subsidiary any liability for any forfeiture of any unvested portion of the Option which may result under this Certificate if the Executive's employment is so terminated. (d) Recapitalization. If the Executive receives, with respect to the Option, any other option or warrant to purchase securities of the Company, of a Subsidiary or of any other entity as a result of any recapitalization, merger, consolidation, combination, or exchange of shares or a similar corporate change, any such other option or warrant received by the Executive shall likewise be subject to the terms and conditions of this Certificate and shall be included in the term "Option." Similarly, any securities or other property as to which such other option or warrant is exercisable shall be included in the term "Option Shares." In the event of any such corporate change, the Purchase Price set forth in Paragraph 1(b) shall be appropriately adjusted by the Board such that the aggregate price for all such Option Shares is not changed. (e) Legal Representative. In the event of the Executive's death or a judicial determination of the Executive's incompetence, reference in this Certificate to the Executive shall be deemed to refer to the Executive's legal representative or, where appropriate, to the Beneficiary. (f) Holidays. If any event provided for in this Certificate is scheduled to take place on a legal holiday, such event shall take place on the next succeeding day that is not a legal holiday. (g) Notices to the Company. Any notice or other communication to the Company pursuant to any provision of this Certificate shall be deemed to have been delivered when delivered in person to the Corporate Secretary of the Company or when deposited in the United States mail, first class postage prepaid, addressed to the Corporate Secretary of the Company at 335 Madison Avenue, New York, New York 10017 or at such other address of which the Company may from time to time give the Executive written notice in accordance with Paragraph 5(h). 5 (h) Notices to the Executive. Any notice or other communication to the Executive pursuant to any provision of this Certificate shall be deemed to have been delivered when delivered to the Executive in person or when deposited in the United States mail, first class postage prepaid, addressed to the Executive at his or her address on the security holder records of the Company or at such other address of which the Executive may from time to time give the Company written notice in accordance with Paragraph 5(g). (i) Agreement Subject to Plan. This Option Grant Certificate is being executed and delivered pursuant to and is subject in all events to the Plan, a copy of which has previously been delivered to the Executive or is being delivered to the Executive concurrently with this Certificate and which is incorporated in this Certificate by reference. Each provision of this Certificate shall be administered and construed in accordance with the Plan, and any provision that cannot be so administered or construed shall to that extent be disregarded. ENHANCE FINANCIAL SERVICES GROUP INC. Date: As of December 11, 1997 By: --------------------------- Executive Vice President 6 Annex A Enhance Financial Services Group Inc. 335 Madison Avenue New York, New York 10017 Ladies and Gentlemen: I am an optionee under the Enhance Financial Services Group Inc. 1997 Long-Term Incentive Plan for Key Employees, having been granted effective December 15, 1997 an option for 3,000 shares at an exercise price of $57.69 per share. Of such grant, options for _________ shares remain unexercised and unexpired. Of such number of unexercised and unexpired options, options for ________ shares are vested as of this date. Select, by indicating with an "X", one exercise method: ___ I hereby exercise the aforesaid option for _______ shares using the Merrill Lynch "Corporate Stock Option Exercise Program." Accordingly, payment will be remitted to the company on my behalf by Merrill Lynch. ___ I hereby exercise the aforesaid option for _______ shares not using the Merrill Lynch "Corporate Stock Option Exercise Program" and enclose my check, payable to the order of Enhance Financial Services Group Inc., for $________ in payment of the purchase price and applicable withholding taxes for such shares. I ask that the certificate for the option shares be delivered to me. Very truly yours, Date: _____________________ Name: Marilyn Bauer (b) Option Shares Unregistered. As of the date of grant of the Option, the Option Shares have not been registered under the Securities Act of 1933, as amended, or any state securities act (the "Act"). The Company has no obligation to register the Option Shares under any such Act in connection with any future public offering of the Company's securities or otherwise. Unless the Option Shares issuable upon a given exercise have been registered under the Securities Act of 1933, as amended, the certificate representing such shares shall bear the following legend or such other legend as the Company's counsel may deem appropriate: "The shares represented by this certificate have not been registered under the Securities Act of 1933, as amended, and may in no event be offered, sold, transferred or assigned unless and until the shares have been so registered or, in the opinion of counsel to Enhance Financial Services Group Inc., an exemption from such registration is available." (c) Investment Intent. If the certificate representing the Option Shares issuable upon a given exercise is required to bear the legend set forth above (or a legend to like effect), the Executive shall, by such exercise of the Option, be deemed conclusively to represent and to agree with the Company that he or she is acquiring the Option Shares then being purchased for his or her own account and not for the account of others, for investment only and not with a view to public sale or distribution. (d) Restriction Relating to Certain Mergers. In the event of a merger or consolidation of the Company with a third party which is proposed to be accounted for as a pooling of interests, the Executive shall, if so requested by the Company and notwithstanding any other provision of this Certificate, agree not to sell, assign, or gift or in any other way reduce his or her risk relative to the Option Shares and all other shares of Common Stock owned by the Executive for such period after the consummation of such merger or consolidation as the Company shall, upon the advice of its outside accountants, conclusively determine as necessary to ensure that such merger or consolidation may be validly accounted for as a pooling of interests. (e) Prior Conditions. The Company shall not be required to issue or deliver any certificate representing Option Shares prior to (i) the admission of such shares to listing on any stock exchange on which the Common Stock may then be listed, (ii) the completion of any registration or any other qualification of such shares under any federal or state law or any rulings or regulations of any governmental regulatory body, (iii) the obtaining of any consent or approval or other clearance from any governmental agency which the Company shall, in its sole discretion, determine to be necessary or advisable, and (iv) the payment to the Company, upon its request, of any amount requested by the Company for the purposes of satisfying its liability, if any, to withhold taxes of any kind or any other applicable assessment (plus interest or penalties thereon, if any, caused by a delay in making such payment) incurred by reason of the exercise of the Option. EX-10.(3)(3) 7 DIRECTOR STOCK OWNERSHIP PLAN EXHIBIT 10.3.3. _______________________________________________________________________________ ENHANCE FINANCIAL SERVICES GROUP INC. DIRECTOR STOCK OWNERSHIP PLAN Effective as of March 13, 1998 _______________________________________________________________________________ Table of Contents Page 1. PURPOSE OF PLAN . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2. DEFINITIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 3. EFFECTIVE DATE. . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 4. ADMINISTRATION. . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (a) DUTIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (b) ADVISORS . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 (c) INDEMNIFICATION. . . . . . . . . . . . . . . . . . . . . . . . . 3 (d) MEETINGS . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 (e) DETERMINATIONS . . . . . . . . . . . . . . . . . . . . . . . . . 3 5. COMMON STOCK; ADJUSTMENT UPON CERTAIN EVENTS. . . . . . . . . . . . . 3 (a) COMMON STOCK TO BE DELIVERED; FRACTIONAL SHARES. . . . . . . . . 3 (b) ADJUSTMENTS. . . . . . . . . . . . . . . . . . . . . . . . . . . 4 (c) CAPITAL STRUCTURE. . . . . . . . . . . . . . . . . . . . . . . . 4 6. AWARDS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 (a) COMMON STOCK ELECTION. . . . . . . . . . . . . . . . . . . . . . 4 (b) FORM OF ELECTION . . . . . . . . . . . . . . . . . . . . . . . . 4 (c) ISSUE DATE . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 (d) COMMON STOCK . . . . . . . . . . . . . . . . . . . . . . . . . . 5 7. NON-TRANSFERABILITY . . . . . . . . . . . . . . . . . . . . . . . . . 5 8. TERMINATION, AMENDMENT AND MODIFICATION . . . . . . . . . . . . . . . 5 9. GENERAL PROVISIONS. . . . . . . . . . . . . . . . . . . . . . . . . . 5 (a) REPRESENTATIONS AND ADDITIONAL LEGENDS . . . . . . . . . . . . . 5 (b) RIGHT TO TERMINATE DIRECTORSHIP. . . . . . . . . . . . . . . . . 6 (c) TRUSTS, ETC. . . . . . . . . . . . . . . . . . . . . . . . . . . 6 (d) SEVERABILITY OF PROVISIONS . . . . . . . . . . . . . . . . . . . 6 (e) HEADINGS AND CAPTIONS. . . . . . . . . . . . . . . . . . . . . . 6 (f) COSTS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 (g) CONTROLLING LAW. . . . . . . . . . . . . . . . . . . . . . . . . 6 10. LISTING OF COMMON STOCK AND RELATED MATTERS . . . . . . . . . . . . . 6 11. WITHHOLDING TAXES . . . . . . . . . . . . . . . . . . . . . . . . . . 6 ENHANCE FINANCIAL SERVICES GROUP INC. DIRECTOR STOCK OWNERSHIP PLAN Effective as of March 13, 1998 1. Purpose of Plan. The purpose of this Director Stock Ownership Plan, (this "Plan") is to enhance the profitability and value of Enhance Financial Services Group Inc. for the benefit of its shareholders by enabling the Company to offer shares of Common Stock to Non-Employee Directors, in lieu of cash payment of their Director Fees, thereby attracting, retaining and rewarding Non-Employee Directors, and strengthening the mutuality of interests between Non-Employee Directors and the Company's shareholders. Capitalized terms used herein shall have the meanings ascribed to them in Section 2 hereof. 2. Definitions. For purposes of this Plan, the following terms will have the following meanings when used herein with initial capital letters: "Board" means the Board of Directors of the Company. "Code" means the Internal Revenue Code of 1986, as amended (or any successor statute). "Committee" means a committee or subcommittee of the Board, appointed from time to time by the Board, which committee or subcommittee shall be intended to consist of two or more directors who are non-employee directors as defined in Rule 16b-3. "Common Stock" means the common stock of the Company, par value $.10 per share. "Company" means Enhance Financial Services Group Inc., a New York corporation, and any successor thereto. "Director Fees" means, for any calendar year, the sum of: (i) any retainer fees to which a Non-Employee Director is entitled for service on the Board as a director and (ii) any other fees to which a Non-Employee Director is entitled including, without limitation, fees for attending meetings of the Board or any committee of the Board of which the Non-Employee Director is a member or fees paid for services as chair of any committee of the Board. "Effective Date" has the meaning given to it in Section 3. "Exchange Act" means the Securities Exchange Act of 1934, as amended. "Fair Market Value" for purposes of this Plan, unless otherwise required by any applicable provision of the Code or any regulations issued thereunder, means the last sales price reported for the Common Stock on such date: (i) as reported on the principal national securities exchange on which it is then traded, (ii) if not traded on any such national securities exchange, as quoted on an automated quotation system sponsored by the National Association of Securities Dealers, Inc., or (iii) if the Common Stock is not readily tradable on a national securities exchange or any automated quotation system sponsored by the National Association of Securities Dealers, Inc., the value determined in good faith by the Board. "ISSUE DATE" has the meaning given to it in Section 6(c). "Non-Employee Director" means a member of the Board who is not an employee of the Company or of any Subsidiary. "PARTICIPANT" means a Non-Employee Director who has elected to receive Common Stock under this Plan. "PLAN" has the meaning given to it in Section 1. "RULE 16b-3" means Rule 16b-3 under Section 16(b) of the Exchange Act as then in effect or any successor provisions. "SECURITIES ACT" means the Securities Act of 1933, as amended. "SUBSIDIARY" means a corporation or other form of business association whose capital stock (or other ownership interests) having more than 50% of the voting power is owned or controlled, directly or indirectly, by the Company. 3. EFFECTIVE DATE. This Plan shall become effective as of March 13, 1998 (the "EFFECTIVE DATE"). 4 ADMINISTRATION. (a) Duties. This Plan shall be administered by the Board. If and to the extent the Board so directs, this Plan shall be administered by the Committee and all references to the Board in this Plan shall be deemed to refer to the Committee. The Board shall have full authority to interpret this Plan and to decide any questions and settle all controversies and disputes that may arise in connection with this Plan; to establish, amend and rescind rules for carrying out this Plan; to administer this Plan, subject to its provisions; and to make all other determinations and to take all such steps in connection with this Plan and the Common Stock issued under this Plan as the Board, in its sole discretion, deems necessary or desirable. To the extent applicable, this Plan is intended to comply with the applicable requirements of Rule 16b-3 and shall be limited, construed and interpreted in a manner so as to comply therewith. If for any reason the appointed Committee does not meet the requirements of Rule 16b-3, such noncompliance with the requirements of Rule 16b-3 shall not affect the validity of the interpretations or other actions of the Committee. If and to the extent that no Committee exists which has the authority to administer this Plan, the functions of the Committee shall be exercised by the Board. (b) Advisors. The Board and the Committee may employ such legal counsel, consultants and agents as it may deem desirable for the administration of this Plan, and may rely 2 upon any advice or opinion received from any such counsel or consultant and any computation received from any such consultant or agent. Expenses incurred by the Board and the Committee in the engagement of such counsel, consultant or agent shall be paid by the Company. (c) Indemnification. To the maximum extent permitted by applicable law, no officer or former officer of the Company or member or former member of the Board or the Committee shall be liable for any action or determination made in good faith with respect to this Plan or any Common Stock issued under this Plan. To the maximum extent permitted by applicable law and the Certificate of Incorporation and By-Laws of the Company and to the extent not covered by insurance, each officer or former officer and member or former member of the Board or the Committee shall be indemnified and held harmless by the Company against any cost or expense (including reasonable fees of counsel reasonably acceptable to the Company) or liability (including any sum paid in settlement of a claim with the approval of the Company), and advanced amounts necessary to pay the foregoing at the earliest time and to the fullest extent permitted, arising out of any act or omission to act in connection with this Plan or any Common Stock issued under this Plan, except to the extent arising out of such officer's or former officer's, member's or former member's own fraud or bad faith. Such indemnification shall be in addition to any rights of indemnification the officers, directors or members or former officers, directors or members may have under applicable law or under the Certificate of Incorporation or By-Laws of the Company. Notwithstanding anything else herein, this indemnification will not apply to the actions or determinations made by an individual with regard to Common Stock issued to him or her under this Plan. (d) Meetings. The Board or the Committee shall adopt such rules and regulations as it shall deem appropriate concerning the holding of its meetings and the transaction of its business. All determinations by the Board or the Committee shall be made by the affirmative vote of a majority of its members. Any such determination may be made at a meeting duly called and held at which a majority of the members of the Board or the Committee, as applicable, are in attendance in person or through telephonic communication. Any determination set forth in writing and signed by all the members of the Board or the Committee, as applicable, shall be as fully effective as if it had been made by a majority vote of the members at a meeting duly called and held. (e) Determinations. Each determination, interpretation or other action made or taken pursuant to the provisions of this Plan by the Board or the Committee shall be final, conclusive and binding for all purposes and upon all persons, including, without limitation, the Participants, the Company, directors, officers and other employees of the Company, and the respective heirs, executors, administrators, personal representatives and other successors in interest of each of the foregoing. 5 COMMON STOCK; ADJUSTMENT UPON CERTAIN EVENTS. (a) Common Stock to be Delivered; Fractional Shares. Shares of Common Stock to be issued under this Plan shall be made available from issued shares of Common Stock reacquired by the Company and held in treasury. No fractional shares of Common Stock will be issued. The Company shall pay a Participant cash in lieu of any fractional share of Common Stock to which such 3 Participant would otherwise be entitled, the amount of which shall be based on the Fair Market Value of a share of Common Stock and determined in accordance with SECTION 6(D). (b) Adjustments. The existence of this Plan and the Common Stock issued hereunder shall not affect in any way the right or power of the Board or the shareholders of the Company to make or authorize any adjustment, recapitalization, reorganization or other change in the Company's capital structure or its business, any merger or consolidation of the Company, any issue of bonds, debentures, preferred or prior preference stocks ahead of or affecting Common Stock, the dissolution or liquidation of the Company or any sale or transfer of all or part of its assets or business, or any other corporate act or proceeding. (c) Capital Structure. In the event of (i) any change in the capital structure or business of the Company by reason of any stock dividend or extraordinary dividend, stock split or reverse stock split, recapitalization, reorganization, merger, consolidation, or exchange of shares, reclassification of its capital stock, any sale or transfer of all or part of the Company's assets or business, or any similar change affecting the Company's capital structure or business and (ii) the determination by the Board that adjustment is appropriate under this Plan, then the aggregate number and kind of shares of Common Stock which thereafter may be issued under this Plan shall be appropriately adjusted consistent with such change in such manner as the Board may deem equitable to prevent substantial dilution or enlargement of the rights granted to, or available for, Participants under this Plan or as otherwise necessary to reflect the change, and any such adjustment determined by the Board in good faith shall be binding and conclusive on the Company and all Participants and directors and their respective heirs, executors, administrators, successors and assigns. 6 AWARDS. (a) Common Stock Election. Each Non-Employee Director may elect, as provided in SECTION 6(B), to receive any of the following as payment for Director Fees: (i) shares of Common Stock equal to 100% of the Director Fees as described in SECTION 6(D), (ii) a cash payment equal to 100% of the Director Fees, or (iii) a cash payment equal to 50% of the Director Fees and shares of Common Stock equal to 50% of the Director Fees as described in SECTION 6(D). (b) Form of Election. Any election under SECTION 6(A) shall be made in writing to the Board (on a form prescribed by the Board) on or prior to the date of the last regularly scheduled meeting of the Board immediately preceding the commencement of the calendar year during which the Director Fees will be earned; provided, however, that with respect to the 1998 calendar year, any election under SECTION 6(A) shall be made in writing to the Board on or prior to the first regularly scheduled meeting of the Board occurring in the second calendar quarter with respect to Director Fees earned in the 1998 calendar year subsequent to March 31, 1998. All Director Fees earned prior to March 31, 1998 will be payable in cash. An election under this SECTION 6(B) is irrevocable and, except with respect to the 1998 calendar year, is valid only for the calendar year commencing immediately following the date of the election. If no election is made or if a new election is not made with respect to any subsequent calendar year, all Director Fees earned during such subsequent calendar year will be paid in cash. An individual who becomes a Non-Employee Director after the date by which an election would otherwise be required to be made hereunder with respect to a calendar year may not elect to receive shares of Common Stock under this Plan for such 4 calendar year. Elections made by Non-Employee Directors are not intended to result in any tax-deferral of Director Fees. (c) Issue Date. Shares of Common Stock under this Plan will be issued in accordance with each Non-Employee Director's annual election on or as of the date (the "Issue Date") on which cash payment for the Director Fees attributable to such shares would have otherwise been made by the Company. (d) Common Stock. On or as of each Issue Date, each Non-Employee Director shall be issued the number of shares of Common Stock determined by dividing: (i) that portion of the Director Fees payable to him on such Issue Date that the Non-Employee Director elected to receive in Common Stock, by (ii) the Fair Market Value of the Common Stock on the Issue Date. 7 NON-TRANSFERABILITY. No rights or interests of a Participant under this Plan with respect to an election to receive Common Stock may be anticipated, alienated, hypothecated, attached, sold, assigned, pledged, encumbered, charged or otherwise transferred in any manner by a Participant otherwise than by will or by the laws of descent and distribution prior to the date on which the shares of Common Stock are issued, or, if later, the date on which any applicable restriction thereon lapses. Any attempt to anticipate, alienate, hypothecate, attach, sell, assign, pledge, encumber, charge or otherwise transfer any such rights or interests shall be void, and no such rights or interests shall in any manner be used for the payment of, subject to, or otherwise encumbered by or hypothecated for the debts, contracts, liabilities, engagements or torts of any person who shall be entitled to such rights or interests, nor shall it be subject to attachment or legal process for or against such person. 8 TERMINATION, AMENDMENT AND MODIFICATION. This Plan shall continue in effect without limit unless and until the Board otherwise determines. The termination of this Plan shall not terminate any outstanding election that by its terms continues beyond such termination date. The Board at any time or from time to time may amend this Plan in any manner it deems appropriate. Notwithstanding the foregoing, solely to the extent required by law, the Board may not effect any amendment that would require the approval of the shareholders of the Company under applicable law or under any regulation of a principal national securities exchange or automated quotation system sponsored by the National Association of Securities Dealers, Inc. on which the Common Stock is traded unless such approval is obtained. Except as otherwise required by law, no termination, amendment or modification of this Plan may, without the consent of the Participant, alter or impair the rights and obligations arising under any then outstanding election. 9 GENERAL PROVISIONS. (a) Representations and Additional Legends. The Board or the Committee may require each person receiving shares of Common Stock under this Plan to represent to and agree with the Company in writing that the Participant is acquiring the shares for investment and without a view to distribution thereof. In addition to any legend required by this Plan, the certificates for such shares may include any legend which the Committee deems appropriate to reflect any restrictions on transfer. All certificates for shares of Common Stock delivered under this Plan shall be subject to such stock transfer orders and other restrictions as the Board or Committee may deem advisable under the rules, regulations and other requirements of the Securities and Exchange Commission, any 5 stock exchange upon which the Common Stock is then listed or any national securities association system upon whose system the Common Stock is then quoted, any applicable Federal or state securities law, and any applicable corporate law, and the Board or Committee may cause a legend or legends to be put on any such certificates to make appropriate reference to such restrictions. (b) Right to Terminate Directorship. This Plan shall not impose any obligations on the Company to retain any Participant as a director, nor shall it impose any obligation on the part of any Participant to remain as a director of the Company. (c) Trusts, etc. Nothing contained in this Plan and no action taken pursuant to this Plan (including, without limitation, the issuance of any Common Stock hereunder) shall create or be construed to create a trust of any kind, or a fiduciary relationship, between the Company and any Participant or the executor, administrator or other personal representative or designated beneficiary of such Participant, or any other persons. If and to the extent that any Participant or such Participant's executor, administrator or other personal representative, as the case may be, acquires a right to receive any payment from the Company pursuant to this Plan, such right shall be no greater than the right of an unsecured general creditor of the Company. (d) Severability of Provisions. If any provision of this Plan shall be held invalid or unenforceable, such invalidity or unenforceability shall not affect any other provisions of this Plan, and this Plan shall be construed and enforced as if such provision had not been included. (e) Headings and Captions. The headings and captions herein are provided for reference and convenience only. They shall not be considered part of this Plan and shall not be employed in the construction of this Plan. (f) Costs. The Company shall bear all expenses of administering this Plan, including expenses of issuing Common Stock. (g) Controlling Law. This Plan shall be construed and enforced according to the laws of the State of New York, without giving effect to rules governing the conflict of laws. 10. LISTING OF COMMON STOCK AND RELATED MATTERS. If at any time the Board or the Committee shall determine in its sole discretion that the listing, registration or qualification of the Common Stock covered by this Plan upon any national securities exchange or under any state or federal law, or the consent or approval of any governmental regulatory body, is necessary or desirable as a condition of, or in connection with, the issuance of Common Stock under this Plan, no Common Stock will be delivered, as the case may be, unless and until such listing, registration, qualification, consent or approval shall have been effected or obtained, or otherwise provided for, free of any conditions not acceptable to the Board. 11. WITHHOLDING TAXES. The Company shall have the right to require, prior to the issuance or delivery of any shares of Common Stock, payment by the Participant of any federal, state or local taxes required by law to be withheld. 6 __________, 1998 Re: ELECTION TO RECEIVE PAYMENT OF DIRECTOR FEES IN COMMON STOCK As a Non-Employee Director of Enhance Financial Services Group Inc. (the "Company") eligible to participate in the Company's Director Stock Ownership Plan (the "Plan"), I hereby elect to have the following percentage of my Director Fees to be earned during 1998 after March 31, 1998 paid in Common Stock as specified below: / / 100% of Directors Fees; / / 50% of Director Fees (with remaining 50% paid in cash), or / / 0% of Director Fees (i.e., 100% paid in cash) I understand and agree that: the percentages in this election may NOT be modified; this election is irrevocable and is valid only for 1998; and if no election is made or if no new election is made with respect to any subsequent years, the Director Fees earned by me in each such calendar years shall be paid in cash. This election shall be subject to all the terms, conditions, limitations, and restrictions contained in the Plan. I acknowledge that I have received a copy of the Plan and understand that all words or phrases not defined herein shall have the meaning set forth in the Plan. I understand that I am responsible for the reporting and payment of any taxes resulting from my election hereunder. Very truly yours, _______________________ Name of Participant Date:__________, 1998 Re: ELECTION TO RECEIVE PAYMENT OF DIRECTOR FEES IN COMMON STOCK As a Non-Employee Director of Enhance Financial Services Group Inc. (the "Company") eligible to participate in the Company's Director Stock Ownership Plan (the "Plan"), I hereby elect to have the following percentage of my Director Fees to be earned during 199_ paid in Common Stock as specified below: / / 100% of Directors Fees; / / 50% of Director Fees (with remaining 50% paid in cash), or / / 0% of Director Fees (i.e., 100% paid in cash) I understand and agree that: the percentages in this election may NOT be modified; this election is irrevocable and is valid only for 1998; and if no election is made or if no new election is made with respect to any subsequent years, the Director Fees earned by me in each such calendar years shall be paid in cash. This election shall be subject to all the terms, conditions, limitations, and restrictions contained in the Plan. I acknowledge that I have received a copy of the Plan and understand that all words or phrases not defined herein shall have the meaning set forth in the Plan. I understand that I am responsible for the reporting and payment of any taxes resulting from my election hereunder. Very truly yours, ____________________________ Name of Participant [LETTERHEAD OF ENHANCE] MEMORANDUM To: Board of Directors From: Elaine Eisenman Samuel Bergman Re: Director Stock Ownership Plan Date: March 17, 1998 - ------------------------------------------------------------------------------ As requested by the board, management has prepared a draft plan, entitled the "Director Stock Ownership Plan," to allow directors to elect to receive all or a portion of their fees in the form of Enhance common stock. The draft plan is being submitted to the Compensation and Nominating Committee for consideration at its March meeting with the expectation that, if it is approved by the committee, it will thereafter be submitted to the full board for consideration at its March meeting. The following is a summary of the proposed plan, the text of which accompanies this memorandum. Commencing with the June 1998 regular board meeting, each director of Enhance Financial Services Group Inc. who is not an employee of Enhance or any of its subsidiaries will be entitled to receive at the director's election, either no portion, 50% or all of his or her combined retainer, meeting and committee chair fees for a given year in the form of shares of Enhance common stock. Eligible directors will have the opportunity to make a new election with respect to each year's fees. For this purpose (other than in 1998, for which a modified procedure will be prescribed), directors will receive at the penultimate (historically September) regular board meeting in each year a form on which to make an election for the following year. The form is to be completed and returned to Enhance not later than the last (historically December) regular meeting of the year. (Copies of the proposed forms for 1998 and for subsequent elections accompany this memo.) A director who fails to submit an election form by this deadline will receive all his or her fees for the subject year in cash. The same applies to person who become directors after the deadline for making an election. Elections will be irrevocable for the year to which they relate. The shares will be issued to electing directors o nor as of the date of any payment by Enhance of director fees. The "purchase price" at which the shares will be issued will be equal to the closing price of Enhance stock on the New York Stock Exchange on that date. The foregoing protocol will be modified slightly for 1998. Directors will have the opportunity to make their elections for the remainder of 1998 not later than June 3, the date of the second quarter board meeting. However, as will be the case with subsequent years, the purchase price of the shares issued as fees for the second quarter and subsequent quarters of 1998 will be equal to the NYSE closing price of Enhance stock on the dates of issue, as described in the preceding paragraph. Shares issuable under the plan will be registered under the Securities Act under a registration statement which we propose to prepare and file promptly after the March meeting. Accordingly, that shares will be immediately salable by a director after receipt provided the director has filed with the SEC a Form 144 covering the sale. The plan will be administered by the full board or a committee designated by the board consisting of non-employee directors of Enhance. In drafting the proposed board resolutions for the adoption of the plan, we have taken the liberty of providing for the appointment to that committee of the same person constituting the Stock Option Subcommittee of the Compensation and Nominating Committee. 2 EX-10.7 8 AGREEMENT DTD. 12/11/97 EXHIBIT 10.7 Elaine J. Eisenman, Ph.D. 80 Greenway Drive Irvington, NY 10533 December 10, 1997 Mr. Daniel Gross President and Chief Executive Officer Enhance Financial Services Group Inc. 335 Madison Avenue New York, New York 10017 Dear Dan: I am delighted to accept your offer of the position of Executive Vice President of Human Resources and Administration (an acceptable descriptor at this point) of Enhance Financial Services Group Inc. ("Enhance") as set forth in your letter to me dated December 5, 1997, subject to certain additional conditions of employment, that we have discussed, as set forth in this letter. Unfortunately, as you know, due to other outstanding professional and consulting commitments, I will not be able to begin my employment with Enhance until Monday, January 12, 1998. With regard to the option grant of 16,000 shares of Enhance's common stock, this is in lieu of a cash sign-on bonus and, as we discussed, I will be eligible for the standard EVP-level option award in December of 1998, determined without regard to the 16,000 options granted in January 1998 under your offer. Also, as I discussed with both you and Spencer Stuart, I will be terminating my consulting practice in order to assume this position with Enhance. Both of you further understood and agreed that I have foregone opportunities to build my consulting practice further by accepting this position with Enhance. Clearly, I must wind down my involvement with my current clients and not accept any new clients. The reason that I am closing my practice to join Enhance is due to the expansiveness of the role that you envision for me. In the event that there is any material diminution in my title, authority, management responsibilities or compensation (not directly related to Enhance's financial performance), for any reason, including, but not limited to, change in senior management, corporate reorganization, acquisition, divestiture, merger, or any other business transaction, but excluding the circumstances where such diminution (including termination of my employment) is due to an event constituting "Cause" (as defined below), then Enhance will provide at the time of such diminution: - - One year of severance, which is to be equal to my base compensation, as of the time such diminution occurs, plus an amount equal to my target bonus, which in no event shall be less than $142,000. This amount shall in no way replace the payment of any earned bonus. The severance amount shall be paid in the same manner as Enhance pays regular wages. - - Continued vesting during the one-year severance period of all outstanding options granted. - - Coverage under all of Enhance's employee benefit plans, including, but not limited to medical, dental, short and long term disability, life insurance, pension, 40l(k) plans, for the duration of the one-year severance period. Should the plan not allow for continuation of health benefits, Enhance will pay the full amount of COBRA for the severance period if and to the extent permitted under such plan. "Cause" shall mean the occurrence of any of the following: (a) gross negligence or willful misconduct on my part which is injurious to Enhance or its subsidiaries, (b) the commission by Mr. Daniel Gross December 10, 1997 Page 2 me of an act involving dishonesty or fraud with respect to Enhance or its subsidiaries, (c) my conviction for, or a plea by me of nolo contendere to, a felony or (d) the refusal or material failure by me to perform the duties required of me consistent with my position and this letter which failure or refusal is not cured within 20 days after Enhance shall have given me notice thereof. Finally, as we also discussed, my continued role as a member of various boards of directors and continued participation in professional associations, meetings and conferences adds value to my perspective as a senior executive at Enhance. Realizing that such activities involve a commitment of time, time spent on these activities will in no way diminish vacation time, sick days, compensation, or any other benefit or condition of employment to which I am entitled. The terms and conditions of employment as set forth in your letter of December 5, 1997, and this letter shall be binding on any successor(s) interest or assignee(s) of Enhance and any of Enhance's affiliates or subsidiaries. While this letter sounds awfully formal and legalistic, I also want to emphasize how excited I am about joining Enhance and how much I look forward to working with you and your team in making Enhance an even greater success. If the foregoing correctly sets forth the agreement between us, I ask that you so indicate by signing the accompanying copy and returning it to me. Sincerely, /s/ Elaine J. Eisenman ------------------------------ Elaine J. Eisenman Accepted: ENHANCE FINANCIAL SERVICES GROUP INC. By /s/ Daniel Gross ------------------------------ Daniel Gross President Date: December 10, 1997 EX-21.2 9 SUBSIDIARIES OF THE REGISTRANT Exhibit 21.2 The following is a list of all subsidiaries of the registrant. The names of particular subsidiaries have been omitted since such unnamed subsidiaries, considered in the aggregate as a single subsidiary, would not constitute a significant subsidiary as of the end of the year covered by this report as permitted by Item 601(b)(21) of Regulation S-K promulgated under the Securities Act of 1933, as amended and the Securities Exchange Act of 1934, as amended. Name Jurisdiction of Organization Enhance Reinsurance Company.................. New York Asset Guaranty Insurance Company............. New York Van-American Companies, Inc.................. Delaware Singer Asset Finance Company, L.L.C. ........ Delaware EX-23.1 10 INDEPENDENT AUDITORS' CONSENT Exhibit 23.1 INDEPENDENT AUDITORS' CONSENT - ----------------------------- We consent to the incorporation by reference in Registration Statement No. 333-47895 of Enhance Financial Services Group, Inc. on Form S-3 of our report dated February 17, 1998, appearing in this Annual Report on Form 10-K of Enhance Financial Services Group Inc. for the year ended December 31, 1997. /s/ Deloitte & Touche LLP New York, New York March 31, 1998 -----END PRIVACY-ENHANCED MESSAGE-----