-----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, T/kczXTpIvBOANHWzMt6TwRUrdpczUCkeeg0tqVVvwXb4FQjaPKRQY3DLyA3jwrA Z5zbwiX/A8+c+yLLKIlwiw== 0000950123-01-502419.txt : 20010515 0000950123-01-502419.hdr.sgml : 20010515 ACCESSION NUMBER: 0000950123-01-502419 CONFORMED SUBMISSION TYPE: 8-K/A PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 20010228 ITEM INFORMATION: ITEM INFORMATION: FILED AS OF DATE: 20010514 FILER: COMPANY DATA: COMPANY CONFORMED NAME: RADIAN GROUP INC CENTRAL INDEX KEY: 0000890926 STANDARD INDUSTRIAL CLASSIFICATION: SURETY INSURANCE [6351] IRS NUMBER: 232691170 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 8-K/A SEC ACT: SEC FILE NUMBER: 001-11356 FILM NUMBER: 1634025 BUSINESS ADDRESS: STREET 1: 1601 MARKET STREET STREET 2: 12TH FLOOR CITY: PHILADELPHIA STATE: PA ZIP: 19103 BUSINESS PHONE: 2155646600 MAIL ADDRESS: STREET 1: 1601 MARKET ST STREET 2: 12TH FLOOR CITY: PHILADELPHIA STATE: PA ZIP: 19103 FORMER COMPANY: FORMER CONFORMED NAME: CMAC INVESTMENT CORP DATE OF NAME CHANGE: 19960126 8-K/A 1 y48885e8-ka.txt RADIAN GROUP INC 1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 ------------------ FORM 8-K/A CURRENT REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Date of report (Date of earliest event reported): February 28, 2001 RADIAN GROUP INC. (Exact Name of Registrant as Specified in Charter) Delaware 1-11356 23-2691170 (State or Other (Commission File No.) (IRS Employer Jurisdiction of Identification No.) Incorporation) 1601 Market Street, Philadelphia, Pennsylvania 19103 (Address of Principal Executive Offices) (Zip Code) Registrant's telephone number, including area code: (215) 564-6600 ------------------ 2 Radian Group Inc., a Delaware corporation (the "Company"), hereby files Amendment No. 1 to its Current Report on Form 8-K filed on March 14, 2001, to include financial statements and pro forma financial information with respect to the Company's acquisition of Enhance Financial Services Group Inc., a New York corporation ("Enhance"), in accordance with Items 7(a) and 7(b) of Form 8-K within 60 days after the date of the initial filing. ITEM 2. ACQUISITION OR DISPOSITION OF ASSETS. On February 28, 2001, the Company, consummated its acquisition of Enhance, pursuant to that certain Agreement and Plan of Merger, dated November 13, 2000, among the Company, GOLD Acquisition Corporation, a New York corporation and wholly owned subsidiary of the Company ("Merger Sub"), and Enhance (the "Merger Agreement"). The Company's acquisition of Enhance was effected by merging Merger Sub with and into Enhance (the "Merger"), with Enhance surviving as a wholly owned subsidiary of the Company. Pursuant to the Merger Agreement, each outstanding share of common stock, par value $0.10 per share, of Enhance ("Enhance Common Stock"), other than Enhance Common Stock held directly or indirectly by Enhance, which was cancelled and retired, was converted into 0.22 shares (the "Exchange Ratio") of common stock, par value $0.001 per share, of the Company ("Company Common Stock"). Enhance stockholders who would otherwise receive fractional shares of Company Common Stock instead were entitled to receive a cash payment for their fractional share interest. In addition, each outstanding option to receive Enhance Common Stock became an option to receive Company Common Stock as adjusted by the Exchange Ratio. The terms of the Merger are described more fully in the Merger Agreement and the registration statement on Form S-4, as amended, filed by the Company (the "Registration Statement"), attached hereto as Exhibits 2.1 and 99.1, respectively, and incorporated herein by reference. 3 ITEM 7. FINANCIAL STATEMENTS, PRO FORMA FINANCIAL INFORMATION AND EXHIBITS. (a) Financial Statements of Business Acquired The Audited Financial Statements of Enhance for the fiscal years ended December 31, 1999, 1998 and 1997, the accompanying notes, and the accountant's report related thereto, are filed as Exhibit 99.2 to this Current Report on Form 8-K/A and are incorporated by reference. The Unaudited Consolidated Balance Sheet of Enhance as of September 30, 2000, Unaudited Consolidated Statements of Income of Enhance for the three and nine months ended September 30, 2000 and 1999, Unaudited Consolidated Statement of Shareholders' Equity of Enhance for the nine months ended September 30, 2000 and 1999, and Unaudited Consolidated Statements of Cash Flows of Enhance for the nine months ended September 30, 2000 and 1999, and the accompanying notes, are filed as Exhibit 99.3 to this Current Report on Form 8-K/A and are incorporated by reference. (b) Pro Forma Financial Information The (A) introduction to the Unaudited Pro Forma Condensed Combined Financial Statements of the Company and Enhance, (B) Unaudited Pro Forma Condensed Combined Balance Sheet of the Company and Enhance for the quarter ended September 30, 2000, (C) Unaudited Pro Forma Condensed Combined Statement of Income of the Company and Enhance for the nine months ended September 30, 2000, (D) Unaudited Pro Forma Condensed Combined Statement of Income of the Company and Enhance for the year ended December 31, 1999, and (E) Notes to Unaudited Pro Forma Condensed Combined Financial Statements of the Company and Enhance are filed as Exhibit 99.4 to this Current Report on Form 8-K/A and are incorporated by reference. (c) Exhibits
EXHIBIT NUMBER DESCRIPTION -------------- ----------- 2.1 Agreement and Plan of Merger, dated November 13, 2000, among Radian Group Inc., GOLD Acquisition Corporation and Enhance Financial Services Group Inc. (incorporated by reference to Exhibit 99.1 of the Form 8-K filed by Radian Group Inc. on November 15, 2000) 15.1 Letter from Deloitte & Touche LLP regarding unaudited interim financial information (filed herewith) 23.1 Consent of Deloitte & Touche LLP (filed herewith) 99.1 Form S-4 filed by Radian Group Inc. on December 27, 2000, as amended (incorporated by reference to the Form S-4/A filed by Radian Group Inc. on January 25, 2001) 99.2 Audited Financial Statements of Enhance Financial Services Group Inc. for the fiscal years ended December 31, 1999, 1998 and 1997, and accompanying notes, and the accountants report related thereto (filed herewith) 99.3 Unaudited (A) Consolidated Balance Sheet of Enhance Financial Services Group Inc. as of September 30, 2000, (B) Consolidated Statements of Income of Enhance Financial Services Group Inc. for the three and nine months ended September 30, 2000 and 1999, (C) Consolidated Statement of Shareholders' Equity of Enhance Financial Services Group Inc. for the nine months ended September 30, 2000 and 1999, and (D) Consolidated Statements of Cash Flows of Enhance Financial Services Group Inc. for the nine months ended September 30, 2000 and 1999, and the accompanying notes (filed herewith) 99.4 Unaudited (A) introduction to the Unaudited Pro Forma Condensed Combined Financial Statements of Radian Group Inc. and Enhance Financial Services Group Inc., (B) Unaudited Pro Forma Condensed Combined Balance Sheet of Radian Group Inc. and Enhance Financial Services Group Inc. for the quarter ended September 30, 2000, (C) Unaudited Pro Forma Condensed Combined Statement of Income of Radian Group Inc. and Enhance Financial Services Group Inc. for the nine months ended September 30, 2000, (D) Unaudited Pro Forma Condensed Combined Statement of Income of Radian Group Inc. and Enhance Financial Services Group Inc. for the year ended December 31, 1999, and (E) Notes to Unaudited Pro Forma Condensed Combined Financial Statements of Radian Group Inc. and Enhance Financial Services Group Inc. (filed herewith)
4 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized. Dated: May 11, 2001 RADIAN GROUP INC. By: /s/ Howard S. Yaruss ------------------------------------ Name: Howard S. Yaruss Title: Senior Vice President, Secretary and General Counsel 5 EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION -------------- ----------- 2.1 Agreement and Plan of Merger, dated November 13, 2000, among Radian Group Inc., GOLD Acquisition Corporation and Enhance Financial Services Group Inc. (incorporated by reference to Exhibit 99.1 of the Form 8-K filed by Radian Group Inc. on November 15, 2000) 15.1 Letter from Deloitte & Touche LLP regarding unaudited interim financial information (filed herewith) 23.1 Consent of Deloitte & Touche LLP (filed herewith) 99.1 Form S-4 filed by Radian Group Inc. on December 27, 2000, as amended (incorporated by reference to the Form S-4/A filed by Radian Group Inc. on January 25, 2001) 99.2 Audited Financial Statements of Enhance Financial Services Group Inc. for the fiscal years ended December 31, 1999, 1998 and 1997, and accompanying notes, and the accountant's report related thereto (filed herewith) 99.3 Unaudited (A) Consolidated Balance Sheet of Enhance Financial Services Group Inc. as of September 30, 2000, (B) Consolidated Statements of Income of Enhance Financial Services Group Inc. for the three and nine months ended September 30, 2000 and 1999, (C) Consolidated Statement of Shareholders' Equity of Enhance Financial Services Group Inc. for the nine months ended September 30, 2000 and 1999, and (D) Consolidated Statements of Cash Flows of Enhance Financial Services Group Inc. for the nine months ended September 30, 2000 and 1999, and accompanying notes (filed herewith) 99.4 Unaudited (A) introduction to the Unaudited Pro Forma Condensed Combined Financial Statements of Radian Group Inc. and Enhance Financial Services Group Inc., (B) Unaudited Pro Forma Condensed Combined Balance Sheet of Radian Group Inc. and Enhance Financial Services Group Inc. for the quarter ended September 30, 2000, (C) Unaudited Pro Forma Condensed Combined Statement of Income of Radian Group Inc. and Enhance Financial Services Group Inc. for the nine months ended September 30, 2000, (D) Unaudited Pro Forma Condensed Combined Statement of Income of Radian Group Inc. and Enhance Financial Services Group Inc. for the year ended December 31, 1999, and (E) Notes to Unaudited Pro Forma Condensed Combined Financial Statements of Radian Group Inc. and Enhance Financial Services Group Inc. (filed herewith)
EX-15.1 2 y48885ex15-1.txt EX-15.1 LETTER FROM DELOITTE & TOUCHE LLP 1 Exhibit 15.1 May 14, 2001 Enhance Financial Services Group Inc. 335 Madison Avenue New York, New York We have made a review, in accordance with standards established by the American Institute of Certified Public Accountants, of the unaudited interim financial information of Enhance Financial Services Group Inc. and subsidiaries for the periods ended September 30, 2000 and 1999 as indicated in our report dated November 17, 2000; because we did not perform an audit, we expressed no opinion on that information. We are aware that our report referred to above, which is included in your Quarterly Report on Form 10-Q/A for the quarter ended September 30, 2000 is being used in this Amendment No. 1 to the Current Report of Radian Group Inc. on Form 8-K/A and is incorporated by reference in Registration Statement No. 333-52762 on Form S-8, Registration Statement No. 333-54964 on Form S-3, Registration Statement No. 333-81549 on Form S-8, Registration Statement No. 333-40623 on Form S-8, Registration Statement No. 33-98106 on Form S-8, Registration Statement No. 33-67366 on Form S-8 and Registration Statement No. 33-57872 on Form S-8, each a Registration Statement of Radian Group Inc. We also are aware that the aforementioned report, pursuant to Rule 436(c) under the Securities Act of 1933, is not considered a part of any such Registration Statement prepared or certified by an accountant or a report prepared or certified by an accountant within the meaning of Sections 7 and 11 of that Act. /s/ Deloitte & Touche LLP New York, New York EX-23.1 3 y48885ex23-1.txt EX-23.1 CONSENT OF DELOITTE & TOUCHE LLP 1 Exhibit 23.1 INDEPENDENT AUDITORS' CONSENT We consent to the use in this Amendment No. 1 to the Current Report of Radian Group Inc. on Form 8-K/A and to the incorporation by reference in Registration Statement No. 333-52762 on Form S-8, Registration Statement No. 333-54964 on Form S-3, Registration Statement No. 333-81549 on Form S-8, Registration Statement No. 333-40623 on Form S-8, Registration Statement No. 33-98106 on Form S-8, Registration Statement No. 33-67366 on Form S-8 and Registration Statement No. 33-57872 on Form S-8, each a Registration Statement of Radian Group Inc., of our report related to the consolidated financial statements of Enhance Financial Services Group Inc. dated March 27, 2000 and our report related to Credit-Based Asset Servicing and Securitization LLC dated January 6, 2000, each appearing in the Annual Report on Form 10-K/A of Enhance Financial Services Group Inc. for the year ended December 31, 1999 and appearing in this Current Report of Radian Group Inc. on Form 8-K/A. /s/ Deloitte & Touche LLP New York, New York May 14, 2001 EX-99.2 4 y48885ex99-2.txt EX-99.2 AUDITED FINANCIAL STATEMENT 1 Exhibit 99.2 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES
Page ENHANCE FINANCIAL SERVICES GROUP INC Independent Auditors' Report 2 Consolidated Balance Sheets as of December 31, 1999 and 1998 3 Consolidated Statements of Income for the Years Ended December 31, 1999, 1998 and 1997 4 Consolidated Statements of Shareholders' Equity for the Years Ended December 31, 1999, 1998 and 1997 5 Consolidated Statements of Cash Flows for the Years Ended December 31, 1999, 1998 and 1997 6 Notes to Consolidated Financial Statements 7 CREDIT-BASED ASSET SERVICING AND SECURITIZATION LLC AND AFFILIATES, Combined Financial Statements for the Years Ended December 31, 1999, 1998 and 1997 Schedule I
All schedules not included are omitted because they are either not applicable or because the information required therein is included in Notes to Consolidated Financial Statements. 2 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 as of December 31, 1999 and 1998 and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1999. 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 Enhance Financial Services Group Inc. and Subsidiaries as of December 31, 1999 and 1998 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with generally accepted accounting principles. Deloitte & Touche LLP March 27, 2000 New York, New York 3 ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands except share amounts)
December 31, December 31, 1999 1998 -------- -------- ASSETS Investments: Fixed maturities, held to maturity, at amortized cost $ 177,607 $ 196,768 (market value $181,474 and $205,792) Fixed maturities available for sale, at market 745,963 694,374 (amortized cost $778,751 and $657,644) Other invested assets 10,935 -- Common stock - at market (cost $498) 839 839 Short-term investments 34,657 50,794 -------- -------- Total Investments 970,001 942,775 Investment in affiliates 108,001 96,867 Cash and cash equivalents 2,558 5,542 Federal income taxes recoverable 7,859 9,717 Premiums and other receivables 22,959 35,950 Accrued interest and dividends receivable 18,977 15,241 Deferred policy acquisition costs 119,213 103,794 Furniture, fixtures and equipment 10,206 4,506 Prepaid reinsurance premiums 8,772 7,000 Reinsurance recoverable on unpaid losses 2,286 2,500 Receivable from affiliates 1,170 16,710 Receivable for securities -- 9,590 Prepaid federal income tax 24,797 29,267 Deferred income taxes-net 68,587 -- Goodwill 24,196 23,200 Other assets 64,350 38,025 -------- -------- Total Assets $1,453,932 $1,340,684 ========== ========== LIABILITIES, DEFERRED CREDIT AND SHAREHOLDERS' EQUITY Liabilities Losses and loss adjustment expenses $ 51,970 $ 36,239 Reinsurance payable on paid losses and loss adjustment expenses 8,997 5,994 Deferred premium revenue 346,088 315,215 Accrued profit commissions 2,554 2,511 Deferred income taxes -- 108,836 Long-term debt 75,000 75,000 Short-term debt 113,941 54,290 Payable for securities -- 11,557 Accrued expenses and other liabilities 41,078 24,843 Payable to affiliates -- 43,553 -------- -------- Total Liabilities $639,628 $678,038 -------- -------- Deferred Credit 138,000 -- -------- Shareholders' Equity Common stock - $.10 par value Authorized - 100,000,000 shares Issued - 40,007,404 and 39,812,937 shares $ 4,001 $ 3,981 Additional paid-in capital 253,109 249,851 Retained earnings 477,715 418,214 Accumulated other comprehensive income (25,935) 23,186 Treasury stock (32,586) (32,586) -------- -------- Total Shareholders' Equity 676,304 662,646 -------- -------- Total Liabilities, Deferred Credit and Shareholders' Equity $1,453,932 $1,340,684 ========== ==========
See notes to consolidated financial statements 4 ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In thousands except per share amounts)
Years ended December 31, ------------------------------------------------- 1999 1998 1997 --------------- --------------- --------------- REVENUES Net premiums written $132,953 $129,299 $100,506 Increase in deferred premium revenue (29,102) (26,962) (15,051) --------------- --------------- ----------------- Premiums earned 103,851 102,337 85,455 Net investment income 58,053 53,423 50,618 Net realized (losses)gains on sale of investments (3,039) 2,434 657 Assignment sales 30,723 45,376 29,200 Other income 7,996 3,914 4,463 --------------- --------------- --------------- Total revenues 197,584 207,484 170,393 --------------- --------------- --------------- EXPENSES Losses and loss adjustment expenses 26,156 10,324 9,755 Policy acquisition costs 39,959 35,007 30,020 Profit commissions 1,019 1,073 719 Other operating expenses - insurance 17,802 13,683 12,225 - non-insurance 52,320 39,873 25,141 --------------- --------------- --------------- Total expenses 137,256 99,960 77,860 --------------- --------------- --------------- Income from operations 60,328 107,524 92,533 Equity in income of affiliates 19,708 14,066 8,778 Minority interest 429 -- - Foreign currency loss (32) (283) (38) Interest expense (10,989) (8,500) (7,317) --------------- --------------- --------------- Income before income taxes 69,444 112,807 93,956 Income taxes 820 30,350 25,150 --------------- --------------- --------------- NET INCOME $68,624 $82,457 $68,806 =============== =============== =============== Earnings per share - Basic $1.81 $2.20 $1.86 ----- ------ ----- - Diluted $1.76 $2.10 $1.78 ----- ------ ----- Weighted average shares outstanding - Basic 38,000 37,520 37,069 ------- ------- ------ - Diluted 39,024 39,275 38,627 ------- ------- ------
See notes to consolidated financial statements 5 ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1997, 1998 AND 1999 (In thousands except share amounts)
Common Stock Treasury Stock ------------------------- ------------------------ Additional Shares Amount Shares Amount Paid-in Capital ----------- ----------- ----------- ----------- --------------- Balance, December 31, 1996 37,066,650 $ 3,706 928,550 $ (7,758) $ 199,994 Comprehensive income: Net income for the period -- -- -- -- -- Unearned compensation adjustment (net of tax of $7) -- -- -- -- -- Unrealized gains during the period (net of tax of $7,106) -- -- -- -- -- Reclassification adjustment for gains included in net income (net of tax of $87) -- -- -- -- -- Total comprehensive income: -- -- -- -- -- Dividends paid ($0.22 per share) -- -- -- -- -- Exercise of stock options 598,992 60 -- -- 7,281 Issuance of common stock 1,006,228 101 -- -- 21,232 Purchase of treasury stock -- -- 355,850 (7,021) -- ----------- ----------- ----------- ----------- ----------- Balance, December 31, 1997 38,671,870 3,867 1,284,400 (14,779) 228,507 ----------- ----------- ----------- ----------- ----------- Comprehensive income: Net income for the period -- -- -- -- -- Unearned compensation adjustment (net of tax of $202) -- -- -- -- -- Unrealized foreign currency translation adjustment (net of tax of $159) -- -- -- -- -- Unrealized gains during the period (net of tax of $2,183) -- -- -- -- -- Reclassification adjustment for gains included in net income (net of tax of $718) -- -- -- -- -- Total comprehensive income: -- -- -- -- -- Dividends paid ($0.23 per share) -- -- -- -- -- Exercise of stock options 665,674 66 -- -- 9,854 Issuance of common stock 475,393 48 -- -- 11,490 Purchase of treasury stock -- -- 666,394 (17,807) -- ----------- ----------- ----------- ----------- ----------- Balance, December 31, 1998 39,812,937 3,981 1,950,794 (32,586) 249,851 ----------- ----------- ----------- ----------- ----------- Comprehensive income: Net income for the period -- -- -- -- -- Unrealized foreign currency translation adjustment (net of tax of $1,573) -- -- -- -- -- Unrealized losses during the period (net of tax of $25,582) -- -- -- -- -- Reclassification adjustment for losses included in net income (net of tax of $1,075) -- -- Total comprehensive income: -- -- -- -- -- Dividends paid ($0.24 per share) -- -- -- -- -- Exercise of stock options 192,349 19 -- -- 3,233 Issuance of common stock 2,118 1 -- -- 25 ----------- ----------- ----------- ----------- ----------- Balance, December 31, 1999 40,007,404 $ 4,001 1,950,794 $ (32,586) $ 253,109 ----------- ----------- ----------- ----------- -----------
Accumulated Other Comprehensive Income ----------------------------------------- Foreign Currency Unrealized Unearned Translation Holding Grant Retained Compensation Adjustment (Losses) Earnings Total ------------ ----------- ------------ ---------- --------- Balance, December 31, 1996 $ (20) $ -- $ 8,636 $ 283,791 $ 488,349 Comprehensive income: Net income for the period -- -- -- 68,806 -- Unearned compensation adjustment (net of tax of $7) 20 -- -- -- -- Unrealized gains during the period (net of tax of $7,106) -- -- 10,894 -- -- Reclassification adjustment for gains included in net income (net of tax of $87) -- -- (134) -- -- Total comprehensive income: -- -- -- -- 79,586 Dividends paid ($0.22 per share) -- -- -- (8,195) (8,195) Exercise of stock options -- -- -- -- 7,341 Issuance of common stock -- -- -- -- 21,333 Purchase of treasury stock -- -- -- -- (7,021) ----------- ----------- ----------- ----------- ----------- Balance, December 31, 1997 -- -- 19,396 344,402 581,393 ----------- ----------- ----------- ----------- ----------- Comprehensive income: Net income for the period -- -- -- 82,457 -- Unearned compensation adjustment (net of tax of $202) (493) -- -- -- Unrealized foreign currency translation adjustment (net of tax of $159) -- 714 -- -- -- Unrealized gains during the period (net of tax of $2,183) -- -- 5,318 -- -- Reclassification adjustment for gains included in net income (net of tax of $718) -- -- (1,749) -- -- Total comprehensive income: -- -- -- -- 86,247 Dividends paid ($0.23 per share) -- -- -- (8,645) (8,645) Exercise of stock options -- -- -- -- 9,920 Issuance of common stock -- -- -- -- 11,538 Purchase of treasury stock -- -- -- -- (17,807) ----------- ----------- ----------- ----------- ----------- Balance, December 31, 1998 (493) 714 22,965 418,214 662,646 ----------- ----------- ----------- ----------- ----------- Comprehensive income: Net income for the period -- -- -- 68,624 -- Unrealized foreign currency translation adjustment (net of tax of $1,573) -- (2,942) -- -- -- Unrealized losses during the period (net of tax of $25,582) -- -- (48,175) -- -- Reclassification adjustment for losses included in net income (net of tax of $1,075) -- 21 1,975 -- -- Total comprehensive income: -- -- -- -- 19,503 Dividends paid ($0.24 per share) -- -- -- (9,123) (9,123) Exercise of stock options -- -- -- -- 3,252 Issuance of common stock -- -- -- -- 26 ----------- ----------- ----------- ----------- ----------- Balance, December 31, 1999 $ (493) $ (2,207) $ (23,235) $ 477,715 $ 676,304 ----------- ----------- ----------- ----------- -----------
See notes to consolidated financial statements 6 ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)
Years ended December 31, ----------------------------------------------------------- 1999 1998 1997 ----------------- ------------------ ------------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $68,624 $82,457 $68,806 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization, net (6,272) (7,696) (8,869) Gain (loss) on sale of investments, net 3,039 (2,434) (657) Equity in income of affiliates (19,708) (14,066) (8,778) Compensation, restricted stock award program -- -- 20 Change in assets and liabilities, net of effects of purchase of Singer: Premiums receivable 12,991 (5,992) (4,775) Accrued interest and dividends receivable (3,736) (2,282) (1,525) Accrued expenses and other liabilities 16,235 8,699 12,072 Deferred policy acquisition costs (15,419) (8,149) (8,320) Deferred premium revenue, net 29,101 26,961 15,050 Accrued profit commissions 43 (1,257) 718 Losses and loss adjustment expenses, net 18,948 5,267 5,745 Payable to (receivable from) affiliates (28,013) 29,466 (5,671) Payable (receivable) for securities (1,967) (2,649) 4,903 Other (28,814) (18,932) (15,700) Income taxes, net (10,440) 6,281 14,789 ------- -------- -------- Net cash provided by operating activities 34,612 95,674 67,808 ------- -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment (7,287) (2,616) (2,027) Proceeds from sales and maturities of investments 362,863 309,582 412,892 Purchase of investments (459,900) (364,674) (444,793) Purchase of other invested assets (9,531) -- -- Sales(purchases) of short-term investments, net 16,137 33 (16,211) Investment in affiliates -- (32,401) (10,640) Return of capital from affiliates 6,317 -- -- Cash of previously unconsolidated subsidiary -- -- 147 ------- -------- -------- Net cash used in investing activities (91,401) (90,076) (60,632) ------- -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Capital stock 3,277 9,920 7,341 Short-term debt 59,651 10,790 1,000 Dividends paid (9,123) (8,645) (8,195) Purchase of treasury stock -- (17,807) (7,021) ------- -------- -------- Net cash provided by (used in) financing activities 53,805 (5,742) (6,875) ------- -------- -------- Net change in cash and cash equivalents (2,984) (144) 301 Cash and cash equivalents, beginning of year 5,542 5,686 5,385 ------- -------- -------- Cash and cash equivalents, end of year $2,558 $5,542 $5,686 ======= ======== ======== SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the year for income taxes $14,114 $3,000 $10,678 ======= ======== ======== Cash paid during the year for interest $8,817 $8,591 $8,136 ======= ======== ========
See notes to consolidated financial statements 7 ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 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 indirect wholly-owned, New York-domiciled insurance subsidiaries Enhance Reinsurance Company ("Enhance Re") and Asset Guaranty Insurance Company ("Asset Guaranty") (together, the "Insurance Subsidiaries"), which are owned by a wholly-owned subsidiary of Enhance Financial, Enhance Investment Corporation ("EIC"), in the reinsurance of financial guaranties of municipal and asset backed debt obligations issued by monoline financial guaranty insurers. EIC was dissolved in March 2000 and its assets, which primarily consist of the capital stock of the Insurance Subsidiaries, were transferred to Enhance Financial. 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 its consolidated subsidiaries, Singer Asset Finance Company, L.L.C. ("Singer", See Note 5), Enhance Life Benefits LLC ("ELB") and AGS Financial L.L.C. ("AGS Financial"), and partially-owned subsidiaries, Credit-Based Asset Servicing and Securitization LLC ("C-BASS", See Note 5) and Sherman Financial Group LLC ("Sherman" see Note 5), is also engaged in the origination, purchase, servicing and/or securitization of special assets, including lottery awards, structured settlement payments, viatical settlements, sub-performing/non-performing residential mortgages and unsecured delinquent consumer assets including credit cards receivables. 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 and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. The significant accounting policies of Enhance Financial and its subsidiaries are as follows: CONSOLIDATION The accompanying financial statements include the accounts of Enhance Financial, Enhance Investment Corporation, the Insurance Subsidiaries, AGS Financial, Singer, ELB, Van-Am and EnRe Bermuda (collectively the "Company"). Investments in which the Company owns from 20% to 50% of those companies and where the Company has a majority voting interest, but where the 8 minority shareholders have substantive participating rights, are accounted for in accordance with the equity method of accounting (See Note 5). All significant intercompany accounts and transactions, and intercompany profits and losses, including these transactions with equity method investee companies, have been eliminated. 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 for which the Company has the intent and has the ability to hold until maturity and are carried at amortized cost. There were no sales of or transfers of securities classified as held-to-maturity for the years ended December 31, 1999, 1998 and 1997. 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 accumulated other comprehensive income. 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 accumulated other comprehensive income. Realized gains or losses on sales of investments are determined on the basis of specific identification. Other invested assets consist of residential mortgage-backed securities (See Note 6), which are classified as trading securities and are carried at fair value, with changes in fair value recognized in income currently. At December 31, 1999, the carrying value approximates cost. DERIVATIVES The Company uses interest rate swaps and forward treasury lock agreements to hedge interest rate risk associated with unsecuritized assets held and anticipated acquisitions of assets by Singer. Gains and losses on such 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. The Company uses forward currency contracts to hedge foreign currency exchange risk associated with fixed maturity investments denominated in foreign currencies. Gains and losses on open forward currency exchange contracts, which qualify as accounting hedges are deferred and recognized as an adjustment of the carrying amount of the hedged assets. Gains and losses on expired contracts are recognized currently. The counterparties to the Company's derivative agreements are substantial and creditworthy multinational commercial banks or other financial institutions which are recognized market makers. 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, based upon information reported by primary insurers and management's estimate of the amortization of insured principal in those instances where information has not been reported to the Company. 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. 9 REINSURANCE 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 000s):
Years Ended December 31, 1999 1998 1997 ---- ---- ---- Written Earned Written Earned Written Earned ------- ------ ------- ------ ------- ------ Direct $ 53,999 $ 23,710 $ 30,484 $19,704 $25,477 $13,950 Assumed 85,001 83,228 99,922 84,248 82,675 75,665 Ceded (6,047) (3,087) (1,107) (1,615) (7,646) (4,160) ------- ------- ---------- ------- ------- ------- Net premiums $132,953 $103,851 $129,299 $102,337 $100,506 $85,455 ======== ======== ======== ======== ======== =======
The effect of reinsurance on losses and loss adjustments expenses for the years ended December 31, 1999, 1998 and 1997 was a decrease of $1,369,000, $1,230,000 and $335,000, respectively. 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. The percentage of assumed premiums written as a part of net premiums written for the years ended December 31, 1999, 1998 and 1997 was 63.9%, 77.3% and 82.3% respectively. ASSIGNMENT SALES The Company acquires financial assets from individuals, including the rights to receive lottery awards and structured settlement payments, and securitizes these payment streams. The Company recognizes revenue from assignment sales in accordance with the requirements of SFAS 125. Through the securitization process, the Company transfers control over such financial assets and recognizes income to the extent that net sale proceeds upon such transfer of control exceeds amounts paid to individuals, after deducting commissions and other fees paid to third parties. 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, after considering investment income. LOSSES AND LOSS ADJUSTMENT EXPENSES ("LAE") Reserves for losses and LAE in the financial guaranty business 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's estimation of total reserves considers known defaults, reports and individual loss estimates reported by primary 10 insurers and annual increases in the total net par amount outstanding of the Company's insured obligations ($85.6 billion as of December 31, 1999). The Company records a specific 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 non-specific reserves represent the Company's best estimate of total reserves, less provisions for specific reserves. Generally, when a case basis reserve is established or adjusted, a corresponding adjustment is made to the non-specific reserve. The Company discounts certain financial guaranty liabilities at annual rates which correspond to the Insurance Subsidiaries investment yields ranging from 5.95% to 6.35%. These discounted liabilities at December 31, 1999 and 1998 were $14.9 million and $17.5 million respectively, net of discounts of $12.0 million and $11.0 million, respectively. Reserves for losses and LAE for the Company's other lines of business, primarily trade credit reinsurance, are based on reports and individual loss estimates received from ceding companies, net of anticipated estimated recoveries under salvage and subrogation rights. In addition, a liability is included for losses and LAE incurred but not reported. The Company periodically evaluates its estimates for losses and LAE and may adjust such reserves based on the Company's actual loss experience, mix of business and economic conditions. Changes in total estimates for losses and LAE are reflected in current earnings. The Company believes that its total reserves for losses and LAE are adequate to cover the ultimate cost of all claims net of reinsurance recoveries. However, the reserves are based on estimates of losses and LAE, and there can be no assurance that the ultimate liability of the Company 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. See Note 6 for discussion relating to acquired deferred tax assets. 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 prepayments 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 11 accounting. Amounts related to anticipated obligations under the defined benefit pension plan and post-retirement benefits are recorded based on actuarial determinations. STOCK COMPENSATION PLANS The Company has in effect a stock option program for key employees and a directors' stock option program for the benefit of directors who are not employees of the Company. In March 1998, the board of directors adopted the Director Stock Ownership Plan pursuant to which directors are entitled to elect to receive all or a portion of their directors fees in the form of Enhance Financial common stock. 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 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. 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 comprise outstanding options pursuant to the Company's stock option programs. Following is a reconciliation of weighted average common shares outstanding to weighted average common and common equivalent shares outstanding for the years ended December 31, 1999, 1998 and 1997 (in 000s).
1999 1998 1997 ---- ---- ---- Weighted average common shares outstanding 38,000 37,520 37,069 Dilutive effect of common stock options 1,024 1,755 1,558 ------ ------ ------ Weighted average common and common equivalent shares outstanding 39,024 39,275 38,627 ====== ====== ======
NEW ACCOUNTING PRONOUNCEMENTS During 1998, the Company adopted SFAS No. 131, "Disclosures about Segments of Enterprise and Related Information." This pronouncement requires a company to present disaggregated information based on the internal segments used in managing its business. The adoption of this statement did not impact the Company's financial position or results of operations, but it did affect the presentation of the Company's segment disclosures (See Note 17). Effective in 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income." This pronouncement established new rules for the reporting and display of comprehensive income and its components in a full set of general purpose financial statements. The adoption of this statement had no impact on the Company's financial position or results of operations. SFAS No. 130 requires the Company's unrealized gains and losses and changes in foreign currency translation adjustment to be included in other comprehensive income. 12 In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No. 133, "Accounting for Derivatives Instruments and Hedging Activities," which becomes effective for the Company January 1, 2001. This pronouncement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. The Company will be required to recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The accounting for a change in fair value of a derivative in earnings or other comprehensive income will depend on the intended use of the derivative and the resulting designation. Derivatives can be designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or a firm commitment, (b) a hedge of the exposure to variable cash flows of a forecast transaction. or (c) a hedge of foreign currency exposure of a net investment in foreign operations, an unrecognized firm commitment, an available-for-sale security, or a foreign currency denominated forecasted transaction. The Company is currently reviewing the impact of the implementation of SFAS No. 133 on its financial statements. In March 1998, the National Association of Insurance Commissioners adopted the Codification of Statutory Accounting Principles (the "Codification"). The Codification is intended to standardize regulatory accounting and reporting for the insurance industry and is proposed to be effective January 1, 2001. However, statutory accounting principles will continue to be established by individual state laws and permitted practices, and it is uncertain when or if, the State of New York will require adoption of the Codification for the preparation of statutory financial statements. The Company has not finalized the quantification of the effects of Codification on its statutory financial statements. GOODWILL Goodwill represents the excess of cost of acquisitions over the tangible net assets acquired. Goodwill, which is substantially attributable to the acquisition of Singer, is amortized by the straight-line method over 20 years. FURNITURE AND FIXTURES AND EQUIPMENT Furniture, fixtures and equipment are carried at depreciated cost. Depreciation is provided using the straight-line method over the estimated economic lives of the assets, which range from 3 to 7 years. Leasehold improvements are amortized over the lesser of 5 years or the lease term. 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. STOCK SPLIT All references to number of common shares and per-share information reflect the two-for-one stock split which was effective on June 26, 1998. 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 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. The statutory basis policyholders' surplus of Enhance Re and Asset Guaranty, as reported to insurance regulatory authorities, was $214.8 million and $90.6 million, respectively at December 31, 1999 and $225.7 million and $98.5 million, respectively, at December 31, 1998. Statutory net income of Enhance Re and Asset Guaranty was $38.7 million and $8.4 million, respectively, for the year ended December 31, 1999. Statutory net income of Enhance Re and 13 Asset Guaranty was $51.7 million and $11.0 million, respectively, for the year ended December 31, 1998 and $40.7 million and $11.7 million, respectively, for the year ended December 31, 1997. 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 declared and paid a dividend of $22 million and Asset Guaranty declared and paid a dividend of $4 million for the year ended December 31, 1999. At December 31, 1999, the Insurance Subsidiaries had an additional $11.0 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, 1999 and 1998 (in 000s):
Gross Gross Amortized Unrealized Unrealized 1999 Cost Gains Losses Fair Value - ---- ---- ----- ------ ---------- HELD TO MATURITY Private placements $ 90,711 $ -- $ -- $ 90,711 Municipal obligations 77,231 3,767 -- 80,998 Corporate securities 3,593 102 -- 3,695 U.S. Government obligations 6,072 81 83 6,070 -------- -------- -------- -------- Total held to maturity $177,607 $ 3,950 $ 83 $181,474 ======== ======== ======== ======== AVAILABLE FOR SALE Municipal obligations $564,899 $ 3,259 $ 28,381 $539,777 Mortgage-backed securities 121,327 65 3,878 117,514 Corporate securities 56,213 82 1,490 54,805 Asset-backed securities 21,689 216 2,377 19,528 U.S. Government obligations 14,623 -- 284 14,339 -------- -------- -------- -------- Total available for sale $778,751 $ 3,622 $ 36,410 $745,963 ======== ======== ======== ========
14
Gross Gross Amortized Unrealized Unrealized 1998 Cost Gains Losses Fair Value - ---- ---- ----- ------ ---------- HELD TO MATURITY Private placements $ 96,289 $ -- $ -- $ 96,289 Municipal obligations 93,290 8,401 -- 101,691 Corporate securities 4,695 394 -- 5,089 U.S. Government obligations 2,494 229 2,723 -------- -------- -------- -------- Total held to maturity $196,768 $ 9,024 $ -- $205,792 -------- -------- -------- -------- AVAILABLE FOR SALE Municipal obligations $489,477 $ 31,233 $ 35 $520,675 Mortgage-backed securities 95,956 2,644 3,640 94,960 Corporate securities 46,732 2,349 605 48,476 Foreign securities 22,203 4,497 3 26,697 U.S. Government obligations 3,276 290 -- 3,566 -------- -------- -------- -------- Total available for sale $657,644 $ 41,013 $ 4,283 $694,374 ======== ======== ======== ========
The amortized cost and estimated fair value of fixed maturities at December 31, 1999 by contractual maturity are shown below (in 000s). 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.
Amortized Cost Fair Value -------------- ---------- Fixed maturities, held to maturity Due in one year or less $ 10,414 $ 10,500 Due after one year through five years 64,273 65,890 Due after five years through ten years 53,293 54,745 Due after ten years 49,627 50,339 --------- --------- $ 177,607 $ 181,474 ========= ========= Fixed maturities, available for sale Due in one year or less $ -- $ -- Due after one year through five years 47,102 47,520 Due after five years through ten years 128,283 129,450 Due after ten years 603,366 568,993 ------- ------- $ 788,751 $ 745,963 ========= =========
Proceeds from sales of available for sale investments in fixed maturities during 1999, 1998 and 1997 were approximately $348 million, $301 million and $407 million, respectively. Gross gains of $5.5 million and gross losses of $3.3 million were realized in 1999. A write-down of book values for fixed income securities, in the amount of $5.3 million, resulted in a net realized loss on the sale of investments of $3.0 million in 1999. Gross gains of $5.0 million and gross losses of $2.6 million were realized on those sales in 1998. Gross gains of $4.8 million and gross losses of $4.2 million were realized on those sales in 1997. Sources of the Company's consolidated net investment income are as follows (in 000s): 15
Years Ended December 31, ------------------------ 1999 1998 1997 ---- ---- ---- Fixed maturities $56,909 $53,312 $50,258 Short-term investments and cash equivalents 1,658 2,148 1,872 Other invested assets 1,405 - - Other 436 416 572 ------ ------ ------ Total investment income 60,408 55,876 52,702 Less investment expenses 2,355 2,453 2,084 ------ ------ ------ Net investment income $58,053 $53,423 $50,618 ======= ======= =======
The net unrealized appreciation (depreciation) of investments included as a component of other accumulated comprehensive income at December 31, 1999 and 1998 is as follows (in 000s):
1999 1998 ---- ---- Difference between market value and amortized cost of available for sale portfolio Fixed maturities $(32,788) $ 36,730 Equity securities 341 341 -------- -------- (32,447) 37,071 Deferred tax asset (liability) 9,212 (14,106) -------- -------- Net unrealized appreciation of investments $ (23,235) $ 22,965 ========= =======
Unrealized appreciation of investments in equity securities at December 31, 1999 and 1998 includes gross unrealized gains of $341,000. 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 $437 million and $312 million at December 31, 1999 and December 31, 1998, respectively. See Note 6 for information relating to Other Invested Assets. NOTE 5 - INVESTMENT IN AFFILIATES The Company owns 360,000 shares of EIC Corporation Ltd. ("Exporters"), 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% (which represents 54% voting interest) at December 31, 1999. The Company accounts for its investment in Exporters in accordance with the equity method of accounting as the control of Exporters does not rest with the Company and since the minority shareholders have substantial participating rights. The Company owns a controlling equity interest in the outstanding stock of Van-Am and accounts for its investment on a consolidated basis. Due to intense pricing competition in Van-Am's core business and a poor strategic fit with the Company's other operations, the Company 16 decided in 1998 to exit the financial responsibility bond line of business. The Company sold a portion of Van Am business in 1999 and will either sell its remaining interest in Van Am or wind-down Van Am's operations, thereby exiting this line of business. A wind-down of Van Am's operation may take ten or more years. An estimated $4.5 and $2.3 million of expenses associated with this action have been recognized in 1999 and 1998, respectively. 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. In 1996, the Company and MGIC Investment Corporation formed C-BASS, with members of management thereof. C-BASS evaluates, purchases, services and securitizes sub-performing, non-performing, and seller financed residential mortgages and real estate and subordinated residential mortgage-backed securities. At December 31,1999 the Company owned approximately a 48% interest in C-BASS, which is being accounted for on the equity basis of accounting. Effective January 1, 2000, the Company owns approximately a 46% interest in C-BASS. In 1998, the Company contributed substantially all of the assets of in LLSI to C-BASS as part of its initial capital commitment. At December 31, 1999, the Company had contributed $55.5 million of capital to C-BASS. The following table sets forth combined C-BASS financial data as of the date indicated and for the periods then ended (in millions):
December 31, ------------ 1999 1998 1997 ---- ---- ---- Mortgage-related assets $773.0 $550.1 $189.6 Other assets 161.5 73.4 40.0 ------ ------ ------ Total assets $934.5 $623.5 $229.6 ====== ====== ====== Funding arrangements $617.2 $360.8 $121.9 Other liabilities 127.6 107.6 45.0 ----- ----- ------ Total liabilities $744.8 $468.4 $166.9 ====== ====== ======
For the year ended December 31, ------------------------------- 1999 1998 1997 ---- ---- ---- Total revenues $114.1 $69.7 $36.2 Total expenses 73.7 43.7 21.0 ------ ----- ----- Net income $ 40.4 $26.0 $15.2 ====== ===== =====
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. Enhance Financial and Swiss Re, respectively, owns 45% equity interest in SBF Participacoes Ltda ("SBF"), a Brazilian insurance holding company, which is the parent holding company of UBF Garantias & Seguros SA, one of Brazil's largest credit insurance and surety insurance companies ("UBF"). The remainder of SBF is owned by UBF's management and private Brazilian investors. The Company anticipates that the business of UBF will expand in the Latin American insurance and other credit-related markets and opportunities. The Company's 17 investment in SBF as of December 31, 1999 and December 31, 1998 was approximately $3.4 and $4.5 million, respectively, and is being accounted for on the equity methods of accounting. In November 1998, the Company acquired through merger all of the outstanding shares of Alegis Group, Inc. ("Alegis"), the parent holding company of a Houston-based servicer and collector of delinquent consumer assets, the purchase price was approximately $11.7 million which approximated the fair market value of Alegis (see Note 8). In December 1998, the Company and MGIC formed a joint venture, Sherman, with members of management thereof, to provide analytic and due diligence services to purchasers of unsecured delinquent consumer assets; purchases, services and securitizes unsecured delinquent consumer assets. The Company owns a 45.5% interest in Sherman, which is being accounted for on the equity basis of accounting. In December 1999 as part of its initial capital commitment, the Company contributed substantially all the assets of one subsidiary of Alegis and the capital stock of other subsidiaries to Sherman. At December 31, 1999, the Company had committed to contribute an aggregate $20.0 million to the capital of Sherman, approximately $9.1 million of which had been contributed as of December 31, 1999. At December 31, 1999 the Company has guaranteed $10.9 million of Sherman's credit facility, which has an outstanding balance of $21.8 million. Total assets of the Company's unconsolidated subsidiaries and affiliates accounted for by the equity method of accounting at December 31, 1999 and 1998 were $1,275.5 and $707.2 million, respectively. Total liabilities at December 31, 1999 and 1998 were $868.4 and $507.3 million, respectively. Total net income for the years' ended December 31, 1999 and 1998 was $40.3 and $30.5 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. On April 8, 1999, the Company completed a $13.7 million purchase of a portfolio of approximately 500 residential mortgage-backed securities consisting of residual interests in real estate mortgage investment conduits ("REMICs") (classified as Investments - Other Invested Assets). Post-closing adjustments subsequently reduced the net purchase price to $9.4 million. The transaction was structured by C-BASS, which will also manage and service the portfolio for the Company. The purchase price was financed by a short-term credit facility with an initial principal balance of $10.3 million. As of December 31, 1999, the outstanding balance of that credit facility was $3.9 million. The transaction is expected to produce pre-tax economic profits over the life of the acquired portfolio, which is anticipated to be eight to ten years and to provide tax benefits that are expected to lower the Company's effective tax rate in 1999 and beyond. The Company currently expects that it will continue to receive tax benefits from the portfolio at a level comparable to the current year at least through 2001 and will receive some additional tax benefits over a period of six to eight years thereafter. However, the amount of pre-tax economic profits and tax benefits recognized from year to year may vary significantly depending on a variety of factors relating to the portfolio, some of which are outside the control of the Company. 18 One of the prior owners of the portfolio has been audited by the Internal Revenue Service ("IRS"). Upon completion of that audit, the IRS determined that certain tax strategies adopted by the prior owner with respect to the portfolio were improper and should be disallowed. The prior owner disputes the IRS's determination and has filed suit in the United States Tax Court to overturn the IRS's audit adjustments relating to the portfolio. The IRS has asserted a number of theories in support of its audit position, one of which conceivably could result in the loss of a material portion of the tax benefits that the Company expects to receive from the portfolio. After reviewing the pleadings filed in the pending litigation, Company counsel has reaffirmed its advice that the Company should be able to realize the expected tax benefits associated with the portfolio. Nonetheless, given the uncertainties involved in litigation, there can be no complete assurance that the pending Tax Court litigation will not have a material adverse effect on the tax benefits that the Company expects to realize from the portfolio. With respect to the acquired tax benefits, at December 31, 1999, the Company has recorded a $138.0 million deferred tax assets and a related deferred credit. The deferred tax asset is reduced and the deferred credit is amortized to income (as a reduction of current tax expense) as the tax benefits are realized (approximately $14.4 million for the year ended December 31, 1999). In addition, for the period from the acquisition of the portfolio in April 1999 through December 31, 1999, the Company has realized $1.4 million of investment income from the portfolio. The tax benefits result from the fact that, under the Internal Revenue Code (the "IRC"), the uniform yield to maturity method of recognizing interest income and expense on debt instruments generally causes a REMIC to recognize interest income with respect to its assets more rapidly than it recognizes interest expense with respect to its regular interests. This mismatching of interest income and expense generally results in the REMIC producing significant taxable income for the holder of the residual interest in its early years, followed by a corresponding amount of tax losses (which are deductible by the holder of the residual interest) in later years. The Company's tax benefits from the portfolio consists of the tax losses generated by the REMICs, which offset taxable income of the REMICs which was previously allocated to a prior owner of the portfolio. At December 31, 1999, the Company did not record a deferred federal income tax liability of $14.4 million for tax losses of $41.4 million associated with the portfolio because the tax law provides a means, through the use of a particular tax strategy which the Company intends to use, by which income tax benefits associated with this portfolio will not result in future tax obligations. The tax strategy involves numerous assumptions and requires that certain steps occur in a specific order. Although the Company believes that the assumptions are reasonable and that the Company can cause the required steps to occur in the proper order, certain of the assumptions and steps are outside the control of the Company and therefore there is no assurance that all the assumptions will be satisfied or all of the steps will occur in the proper order. In addition, this tax strategy is based on current law and there is no assurance that new laws, regulations or court decisions will not be enacted or occur that render the tax strategy ineffective. If (i) the Company were to dispose of the portfolio other than in accordance with its currently anticipated tax strategy, (ii) the Company were to determine that the Company would be unable or it would be unadvisable to utilize the tax strategy, (iii) current tax law were to change, or (iv) there were an unfavorable determination by the IRS regarding the Company's tax strategy, the Company may be required to record a deferred federal income tax liability for and/or recapture all or a significant portion of the tax losses associated with the portfolio that the Company previously recognized ($14.4 million as of December 31, 1999). The investment in the portfolio ($10.9 million at December 31, 1999) is carried at estimated market value (which approximates cost) and is classified on the consolidated balance sheet as Investment - Other Investment Assets. The components of the Company's consolidated provision for income taxes are as follows (in 000s):
Year Ended December 31, ------------------------------------------------- 1999 1998 1997 ---- ---- ---- Current income taxes $ 14,569 $10,815 $10,311 Deferred income taxes (13,749) 19,535 14,839 -------- ------- ------- Tax provision $ 820 $30,350 $25,150 ======== ======= =======
A reconciliation from the tax provision calculated at the federal statutory rate of 35% to the actual tax is as follows (in 000s):
Year Ended December 31, ------------------------------------------------- 1999 1998 1997 ---- ---- ---- Tax provision at statutory rate $ 24,305 $ 39,482 $ 32,884 Tax exempt interest and dividends (10,283) (9,796) (7,878) Residential mortgage backed securities (14,406) - - Other, net 1,204 664 144 --------- -------- -------- Actual tax provision $ 820 $ 30,350 $ 25,150 ========= ======== ========
The components of the net deferred income tax asset and liability as of December 31, 1999 and 1998 are as follows (in 000s): 19
December 31, 1999 December 31, 1998 ----------------- ----------------- Assets Liabilities Assets Liabilities ------ ----------- ------ ----------- Contingency reserves $ - $ 34,242 $ - $ 49,129 Deferred policy acquisition costs - 41,816 - 36,327 Deferred premium revenue - 13,693 - 10,060 Unrealized capital gains - - - 14,106 Unrealized capital losses 9,212 - - - Assignment sales income - 26,536 - 16,689 Alternative minimum tax credit carry forward - - 8,545 - Losses and LAE reserves 7,306 - 4,241 - Deferred income 652 - 1,455 - Impairment of investment asset 1,855 - - - Accrued expenses 4,686 - 2,903 - Net operating loss 22,689 - 1,781 - Other - net 2,031 1,557 2,559 4,009 Residential mortgage-backed securities acquired tax benefits 138,000 - - - ------- -------- ------- -------- $186,431 $117,844 $21,484 $130,320 ======= ======== ======= ========
Prepaid federal income taxes includes Tax and Loss Bonds of $24.8 million and $29.3 million as of December 31, 1999 and 1998, respectively. At December 31, 1999, the Company has net operating loss carryforwards of $12 million which expire in 2019. NOTE 7 - LONG-TERM DEBT AND CREDIT FACILITY The carrying value of the Company's indebtedness is as follows (in 000s):
December 31, ----------------------------------- 1999 1998 ---- ---- Debentures, due 2003 $ 75,000 $ 75,000 Short term debt 113,941 54,290 --------- --------- Total $ 188,941 $ 129,290 ========= =========
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. Enhance Financial maintains an unsecured credit facility through a credit agreement (the "Credit Agreement") with major commercial banks providing for borrowing by Enhance Financial of up to $100 million due June 27, 2000, (which was temporarily increased by $25 million from September 29, 1999 through March 31, 2000) 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 1999 was 6.02%. 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 or 50% of sum of the Insurance Subsidiaries combined statutory surplus and contingency reserves, and includes certain covenants, none of which significantly restricts the Company's operating activities or dividend-paying ability. The total outstanding under the Credit Agreement at December 31, 1999 was $110 million. 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 20 termination in the amount of $4.6 million. The gain ($1.8 million at December 31, 1999) has been deferred and is being amortized over the original term of the swap. See Note 6 for credit facility relating to Other Invested Assets. 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 1,500,000 shares of its common stock from that date. Enhance Financial purchased 666,394 and 355,850 shares of its common stock at an average price of $26.72 and $19.73 per share in 1998 and 1997 respectively. No shares were repurchased in 1999. In connection with the repurchase program, Enhance Financial entered into a forward purchase agreement during 1997 regarding 256,394 shares of its common stock at a forward purchase price of $21.25 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 was higher (lower) than the forward purchase price, the net differential was received (paid) by Enhance Financial. During 1998, settlements resulted in Enhance Financial receiving 106,394 shares, which were recorded as treasury shares. The agreement terminated in June 1998 after Enhance Financial repurchased the full amount under the program. During 1998, Enhance Financial issued 454,473 shares of common stock in connection with its acquisition of Alegis Group Inc. (See Note 5). During 1997, Enhance Financial issued 1,006,228 shares of common stock in connection 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 1,200,000 and 800,000 shares of Enhance Financial common stock at a purchase price of $12.24 per share. In 1997, Swiss Re acquired an additional 1,400,000 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, 1999 was $9.6 million. In connection with the Company's two-for-one stock split in June 1998, an additional 40,000,000 shares of common stock were authorized. 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 value of the residential mortgage-backed securities is based on the present value of the estimated net future cash flows, including annual distributions of net cash proceeds from the exercise of call rights using relevant market information. 21 DEFERRED PREMIUM REVENUE - The fair value of the Company's deferred premium revenue, net of prepaid reinsurance premium, 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, net of reinsurance recoverable on unpaid losses, 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. DERIVATIVE INSTRUMENTS - The fair values of foreign currency contracts are based on the estimated termination values as of the balance sheet date. The fair values of interest rate swaps and forward treasury lock agreements (notional amounts of $65 million and $15 million, respectively, at December 31,1999) are determined by the Company using relevant market information and appropriate valuation methodologies. The carrying amounts and estimated fair values of these financial instruments are as follows (in 000s):
DECEMBER 31, 1999 DECEMBER 31, 1998 ----------------- ----------------- Carrying Estimated Fair Carrying Estimated Fair Amount Value Amount Value ------ ----- ------ ----- ASSETS: Fixed maturity securities $923,570 $927,437 $891,142 $900,166 Common stock 839 839 839 839 Short-term investments 34,657 34,657 50,794 50,794 Other invested assets 10,935 10,935 - - LIABILITIES: Deferred premium revenue (net) 337,316 294,667 308,215 267,574 Loss and loss adjustment expense reserve (net) 49,684 49,684 33,739 33,739 Long-term debt 75,000 74,010 75,000 78,083 Short-term debt 113,941 113,941 54,290 54,290 DERIVATIVE INSTRUMENTS: Foreign currency contracts - - 256 256 Forward treasury lock agreements 77 77 (664) (664) Interest rate swap agreements 536 536 - -
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 22 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, 1999, the Company's aggregate insurance in force was $85.6 billion. The Company's insured portfolio as of December 31, 1999 was broadly diversified by geographic and bond market sector with no single credit representing more than 1.3% of the Company's net insurance in force. The composition of the Company's insurance in force by type of issue and by state of issue was as follows (in billions):
TYPE OF ISSUE December 31, ------------ 1999 1998 ---- ---- General obligation and other tax backed $22.9 $21.0 Non-municipal 12.2 15.3 Utilities 16.8 11.2 Health care 8.0 7.1 Airport/Transportation 9.2 7.7 Housing 1.5 1.5 Other municipal 5.3 5.1 Other insurance businesses 9.7 6.8 --- --- Total $85.6 $75.7 ===== =====
STATE OF ISSUE December 31, ------------ 1999 1998 ---- ---- California $ 9.4 $ 8.9 New York 9.7 8.1 Florida 5.4 4.7 Texas 5.0 4.3 Pennsylvania 4.2 3.7 Illinois 3.5 3.3 Other (each less than 3.5% for 1999 and 3.3% for 1998) 48.4 42.7 ---- ---- Total $85.6 $75.7 ===== =====
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. NOTE 11 - EMPLOYEE BENEFITS The Company maintains non-contributory defined benefit pension plans, including a non-qualified restoration pension plan effective July 1, 1999, 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 1999, 1998 and 1997, using the projected unit credit actuarial method of attribution includes the following components (in 000s): 23
Year Ended December 31, ----------------------- 1999 1998 1997 ---- ---- ---- Service cost $1,707 $1,022 $900 Interest cost 726 485 494 Expected return on plan assets (394) (415) (377) Amortization of transition obligation 1 2 2 Amortization of prior service cost 246 53 53 Recognized net actuarial gain (139) (129) (101) ----- ----- ----- Net periodic benefits cost $2,147 $1,018 $971 ====== ====== ====
The following table sets forth the funding status of the plans and the accrued pension cost recognized in the Company's consolidated balance sheets at December 31, 1999 and 1998 (in 000s):
December 31, ------------ 1999 1998 ---- ---- CHANGE IN BENEFIT OBLIGATION Benefit obligation at beginning of year $13,241 $8,131 Service cost 1,707 1,022 Interest cost 726 485 Actuarial gains (2,018) (1,092) Benefits paid (2,294) (1,463) ------- ------- Benefit obligation at year end 11,362 7,083 ------- ------- CHANGE IN PLAN ASSETS Fair value of plan assets at beginning of year 4,637 4,726 Actual return on plan assets 628 810 Employer contribution - 565 Benefits paid (2,294) (1,463) ------- ------- Fair value of plan assets at end of year 2,971 4,638 ----- ------- Funded Status (8,391) (2,445) Unrecognized transition obligation 11 13 Unrecognized prior service cost 6,820 907 Unrecognized net actuarial gain (4,057) (3,624) ------- ------- Accrued benefit cost $(5,617) $(5,149) ======== ========
Actuarial assumptions utilized to determine the projected benefit obligation and estimated unrecognized net actuarial gain were as follows:
Year ended December 31, ----------------------- 1999 1998 1997 ---- ---- ---- Discount rate 8.0% 7.0% 7.0% Expected return on plan assets 8.5% 8.5% 8.5% Rate of compensation increase 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. 24 The net post-retirement benefit cost for 1999, 1998, and 1997 was $180,000, $140,000, and $127,000, respectively, and includes service cost, interest cost and amortization of the transition obligation and prior service cost. At December 31, 1999 and 1998 the accumulated post-retirement benefit obligation was $896,000 and $715,000, respectively, and was not funded. At December 31, 1999, the discount rate used in determining the accumulated post-retirement benefit obligation was 8% and the health care trend was 10.5%, graded down to 5.5% after 12 years; at December 31, 1998, the discount rate used in determining the accumulated post-retirement benefit obligation was 7% and the health care trend was 12%, graded to 6% over 7 years. A one-percentage point change in assumed healthcare cost trend rates would have the following effects (In thousands):
1-Percentage Point 1-Percentage Point Increase Decrease -------- -------- Effect on total of service and interest cost components $ 35 ($ 27) Effect on post-retirement benefit obligation 140 (113)
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 50% on contributions up to 6% of base salary made to the plan by eligible employees. The Company's matching contributions were $275,000, $120,000, and $106,000 in 1999, 1998 and 1997, respectively. NOTE 12 - STOCK OPTION PROGRAMS The Company maintains a stock option program for its key employees. Substantially all 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. In March 1998, the board of directors adopted the Director Stock Ownership Plan, which as amended, allows each outside director to elect to receive up to 100% of his or her director fees in the form of shares of common stock valued at 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 coming year's fee. All options are exercisable at the option price, being the fair value of the stock at the date of grant. The board of directors has authorized a maximum of 11,631,050 shares of common stock to be awarded as options, of which 9,172,435 options for shares (net of expirations and cancellations) had been awarded as of December 31, 1999. Information regarding activity in the option programs follows: 25
Number of Weighted Average 1999 Options Shares Option Price Per Share Exercise Price ------------ ------ ---------------------- -------------- Outstanding at beginning of year 6,055,604 $7.25 - $34.281 $17.38 Granted - Employees 1,404,768 $16.438 - $29.375 17.82 - Directors 70,000 $16.25 16.25 Exercised (192,349) $7.25 - $28.21 11.10 Expired or canceled (141,526) $11.938 - $32.25 25.79 --------- Outstanding at year-end 7,196,497 $7.25 - $34.281 17.50 --------- Exercisable at year-end - Employees 3,969,601 $7.25 - $34.281 14.56 --------- - Directors 381,166 $8.563 - $29.75 18.35
Number of Weighted Average 1998 Options Shares Option Price Per Share Exercise Price ------------ ------ ---------------------- -------------- Outstanding at beginning of year 5,635,108 $7.25 - $29.75 $ 14.81 Granted - Employees 1,168,980 $24.937 - $34.281 25.49 - Directors 91,000 $30.00 30.00 Exercised (666,374) $7.25 - $20.75 9.89 Expired or canceled (173,110) $8.00 - $28.813 24.07 --------- Outstanding at year-end 6,055,604 $7.25 - $34.281 17.38 --------- Exercisable at year-end - Employees 3,234,202 $7.25 - $28.844 12.21 - Directors 306,166 $8.563 - $29.75 14.46
Number of Weighted Average 1997 Options Shares Option Price Per Share Exercise Price ------------ ------ ---------------------- -------------- Outstanding at beginning of year 5,106,220 $7.25 - $18.25 $ 10.91 Granted - Employees 1,220,374 $19.44 - $28.844 27.21 - Directors 91,000 $29.75 29.75 Exercised (598,792) $7.25 - $17.00 9.47 Expired or canceled (183,694) $8.00 - $19.44 13.36 --------- Outstanding at year-end 5,635,108 $7.25 - $29.75 14.81 --------- Exercisable at year-end - Employees 3,117,688 $7.25 - $19.44 10.27 - Directors 256,666 $8.563 - $18.25 11.07
Options Outstanding Options Exercisable ------------------- ------------------- Number Weighted Number Outstanding Average Weighted Exercisable Weighted Range of at December Remaining Average at December Average Exercise Prices 31, 1999 Contract Life Exercise Price 31, 1999 Exercise Price $ 7.25 - $10.99 2,026,390 3.1 $ 9.07 2,026,390 $ 9.07 $11.00 - $19.99 2,677,568 8.1 15.52 1,291,495 14.22 $20.00 - $34.281 2,492,539 8.5 26.47 1,032,882 27.17 --------- --------- 7,196,497 4,350,767 ========= =========
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 current and past stock option programs 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 26 income and earnings per share would have been reduced to the pro forma amounts indicated below:
1999 1998 1997 ---- ---- ---- Net income - as reported $68,624 $82,457 $68,806 - pro forma 66,168 $80,906 $67,475 Basic earnings per share - as reported $ 1.81 $ 2.20 $ 1.86 - pro forma 1.74 $ 2.16 $ 1.82 Diluted earnings per share - as reported $ 1.76 $ 2.10 $ 1.78 - pro forma 1.70 $ 2.06 $ 1.75
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 $6.78, $16.62, and $12.01 in 1999, 1998 and 1997, respectively. The following assumptions were used for option grants awarded in 1999, 1998 and 1997:
Options Granted --------------- 1999 1998 1997 ---- ---- ---- Dividend yield 0.8% to 1.5% 0.6% to 1.0% 0.8% to 1.1% Volatility 43.7% to 54.3% 24.1% to 75.1% 18.7% to 30.3% Risk-free interest rate 4.7% to 6.3% 4.3% to 5.8% 5.8% to 6.7% Assumed annual forfeiture rate 3.0% 3.0% 3.0% Expected life 10 years 10 years 10 years
NOTE 13 - COMMITMENTS, CONTINGENCIES AND OTHER MATTERS LEASE COMMITMENTS The Company has committed to lease office space under non-cancelable leases which expire at various dates through August 2015. 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 000s):
YEAR ENDED DECEMBER 31, OPERATING LEASES - ----------------------- ---------------- 2000 $ 2,300 2001 5,400 2002 6,100 2003 6,300 2004 6,300 Thereafter 67,800 -------- $ 94,200 ========
Rent expense, net of sublease income, was $3,228,000, $1,528,000, and $1,699,000, for the years ended December 31, 1999, 1998 and 1997, respectively. COMMITMENTS - OFFICE CAPITAL IMPROVEMENTS The Company has committed to make capital improvements to its offices in New York, New York and to purchase fixtures and furniture for such offices, in the aggregate amount of $11.0 million, net of building owner's reimbursement. 27 REINSURANCE AGREEMENTS The Company is a party to facultative agreements with all, and a party to treaty agreements with all except one of, the four largest primary financial guaranty insurance companies. The Company's facultative and treaty agreements are generally subject to termination (i) upon written notice (ranging from 90 to 120 days) prior to the specified deadline for renewal, (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 and to maintain a specified claims-paying ability or financial strength rating for the particular Insurance Subsidiary or (iii) upon certain changes of control of the Company. Upon termination under the conditions set forth in (ii) and (iii) above, the Company may be required (under some of its reinsurance agreements) 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. OTHER In August 1999, the senior long-term debt rating of Enhance Financial and the insurance financial strength rating of Enhance Reinsurance were downgraded from Aa3 to A2 and from Aaa to Aa2, respectively. The Company does not believe that the downgrade of the senior long-term debt rating of Enhance Financial from Aa3 to A2 has had or should have a material adverse effect on Enhance Financial, except to the extent that it could have a material adverse effect on Enhance Re. However, such downgrade could result in an increase, which could be significant, in the costs to Enhance Financial of borrowing funds or raising capital. Similarly, any additional downgrade of the senior long-term debt rating of Enhance Financial could increase costs of borrowing funds or raising capital, or could make certain types of borrowings or capital unavailable to the Company, which could have a material adverse effect on the Company. On February 29, 2000, Moody's advised the Company that it had placed on review for possible further downgrade both the above ratings. Moody's explained that this review will focus on the uncertainty surrounding management's strategy with respect to the Company's higher risk specialty finance businesses, the reliance on these business lines to achieve publicly stated earnings targets, the Company's future capital plans and the Company's financial flexibility. Moody's indicated that the outcome of the review will depend on the Company's future plans for achieving a balance between the financial guaranty insurance operations and the Company's other lines of business. The Company does not believe that a downgrade of Enhance Re's financial strength rating from Aa2 to Aa3, should it occur, should have a material adverse effect on Enhance Re's competitive position or Enhance Re's costs associated with cessions from primary insurers under their treaties with Enhance Re. This is because many of Enhance Re's reinsurance competitors do not have materially higher financial strength ratings from Moody's than would Enhance Re and because of the terms of the amendments of certain of its existing treaties and its new treaties with the Company's primary insurers. In cases where a prior treaty with a primary insurer remains in effect or a primary insurer had waived its rights with respect to the 1999 downgrade, any additional downgrade could result in those primary insurers recapturing business previously ceded to Enhance Re. However, a downgrade in Enhance Re's financial strength rating to (or below) A could have a material adverse effect on Enhance Re's competitive position. Such a downgrade may so diminish the value of Enhance Re's reinsurance to the 28 primary insurers that they could either materially increase the costs to Enhance Re associated with cessions under their treaties with Enhance Re or recapture business previously ceded to Enhance. In either case, the effect of such changes could materially adversely affect the Company's ability to continue to engage in the reinsurance of monoline financial guaranty insurers business. While the Company believes that the recapture of business by the primaries would otherwise be inconsistent with their long-standing risk-management practices, such action, if it occurs and depending on its magnitude, could have a material adverse effect on the Company. NOTE 14 - PARENT COMPANY FINANCIAL INFORMATION The following are the condensed balance sheets of Enhance Financial as of December 31, 1999 and 1998 and its condensed statements of income and cash flows for the years ended December 31, 1999, 1998 and 1997 (in 000s). CONDENSED BALANCE SHEETS
December 31, ------------ 1999 1998 ---- ---- ASSETS Cash $ 56 $ 2,715 Investments 19,497 7,095 Investment in affiliated companies 807,848 784,235 Other assets 59,025 4,865 -------- -------- $886,426 $798,910 -------- -------- LIABILITIES AND SHAREHOLDERS' EQUITY: Long-term debt $ 75,000 $ 75,000 Other liabilities 135,122 61,264 Shareholders' equity 676,304 662,646 ------- ------- $886,426 $798,910 ======== ========
CONDENSED STATEMENTS OF INCOME
Year Ended December 31, ----------------------- 1999 1998 1997 ---- ---- ---- Total revenues $ 690 $ 812 $ 510 Total expenses 21,545 17,514 14,652 ------ ------ ------ (20,855) (16,702) (14,142) Equity in income of affiliates 79,571 102,459 77,500 Minority interest 306 - - -------- --------- -------- Income before income taxes 59,022 85,757 63,358 Income tax (expense) benefit 9,602 (3,300) 5,448 -------- --------- -------- Net income $ 68,624 $ 82,457 $68,806 ======== ======== =======
29 CONDENSED STATEMENTS OF CASH FLOWS
Year Ended December 31, ----------------------- 1999 1998 1997 ---- ---- ---- Cash flows from operating activities: Net income $ 68,624 $ 82,457 $ 68,806 Adjustments to reconcile net income to net cash from operating activities Equity in income of affiliates (79,571) (102,459) (77,500) Other (40,273) 55,239 29,799 --------- --------- --------- Net cash provided by (used in) operating activities (51,220) 35,237 21,105 --------- --------- --------- Cash flows from investing activities: Investment in affiliates net of dividends received 6,317 (32,401) (7,186) Investments activities (14,852) 741 (2,396) Short-term investments, net 2,460 4,880 (4,648) --------- --------- --------- Net cash used in investing activities (6,075) (26,780) (14,230) --------- --------- --------- Cash flows from financing activities: Capital stock 3,277 9,920 7,341 Short-term debt 60,482 10,790 1,000 Dividends paid (9,123) (8,645) (8,195) Principal payment - senior notes -- -- Reissuance of treasury stock -- -- Purchase of treasury stock -- (17,807) (7,021) --------- --------- --------- Net cash provided by (used in) financing activities 54,636 (5,742) (6,875) --------- --------- --------- Net increase (decrease) in cash (2,659) 2,715 -- Cash, beginning of year 2,715 -- -- --------- --------- --------- Cash, end of year $ 56 $ 2,715 $ -- ========= ========== =========
NOTE 15 - MAJOR CUSTOMERS The Company derives a substantial portion of its premium writings from a small number of primary insurers. The following table states the percentage of gross premiums written for the years ended December 31, 1999, 1998 and 1997 for the Company's four most significant primary insurers:
For year ended December 31, Insurer #1 Insurer #2 Insurer #3 Insurer #4 ------------ ---------- ---------- ---------- ---------- 1999 20% 14% 9% 2% 1998 19% 19% 19% 5% 1997 25% 16% 9% 4%
This customer concentration results from the small number of primary insurance companies which are licensed to write financial guaranty insurance. Prior years' data has been restated to give retroactive effect to mergers between our primary insurers. 30 NOTE 16- LOSSES AND LOSS ADJUSTMENT EXPENSES Activity in the liability for losses and loss adjustment expenses ("LAE") is summarized as follows (in 000s):
In thousands Year Ended December 31, - ------------ ----------------------- 1999 1998 1997 ---- ---- ---- Balance at January 1, $36,239 $33,675 $28,081 Less reinsurance recoverables 2,500 2,688 1,823 ----- ----- ----- Net balance at January 1, 33,739 30,987 26,258 ------ ------ ------ Net incurred related to: Current year 16,645 6,000 6,002 Prior years 9,511 4,324 3,753 ----- ----- ----- Net incurred 26,156 10,324 9,755 ------ ------ ----- Net paid related to: Current year 1,512 352 720 Prior years 8,699 7,220 4,306 ----- ----- ----- Net paid 10,211 7,572 5,026 ------ ----- ----- Net balance at December 31, 49,684 33,739 30,987 Plus reinsurance recoverables 2,286 2,500 2,688 ----- ----- ----- Balance at December 31, $51,970 $36,239 $33,675 ======= ======= =======
The incurred loss and paid loss information presented above is classified as "current year" and "prior year" based upon the year in which the related reinsurance contract or insurance policy was underwritten. Therefore, amounts presented as "net incurred related to prior years" are not indicative of redundancies or deficiencies in total reserves held as of prior year ends. During the years ended December 31, 1999, 1998 and 1997, the actual adverse (redundant) development of reserves held as of prior year ends was $2.3 million, $(0.2) million, and $1.5 million, respectively. NOTE 17 - SEGMENT REPORTING The Company has two reportable segments: insurance and asset-based 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 asset-based businesses segment deals primarily with credit-based servicing and securitization of assets in underserved markets, in particular, the origination, purchase, servicing and securitization of special assets, including lottery awards, viatical settlements, structured settlement payments, sub-performing/non-performing and seller financed residential mortgages and delinquent consumer assets. The Company's reportable segments are strategic business units which are managed separately as each business requires different marketing and sales expertise. 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 the impact of capital and foreign 31 exchange gains and losses, and certain non-recurring items, net of taxes. Summarized financial information concerning the Company's operating segments is presented in the following tables (in 000s):
1999 ---- Insurance Asset-based Totals --------- ----------- ------ Revenues from external customers $ 103,557 $39,013 $142,570 Interest revenue 56,648 1,405 58,053 Interest expense 9,229 1,760 10,989 Equity in income of affiliates 2,103 17,605 19,708 Income tax expense (benefit) 10,417 (9,597) 820 Operating earnings 54,524 19,473 73,997 Investments in affiliates 8,029 99,972 108,001 Deferred policy acquisition cost 119,213 - 119,213 Identifiable assets 1,091,154 362,778 1,453,932
1998 ---- Insurance Asset-based Totals --------- ----------- ------ Revenues from external customers $ 104,820 $46,807 $ 151,627 Interest revenue 53,423 - 53,423 Interest expense 7,223 1,277 8,500 Equity in income of affiliates 2,054 12,012 14,066 Income tax expense 23,558 6,792 30,350 Operating earnings 66,500 16,021 82,521 Investments in affiliates 8,201 88,666 96,867 Deferred policy acquisition cost 103,794 - 103,794 Identifiable assets 1,143,293 197,391 1,340,684
1997 ---- Insurance Asset-based Totals --------- ----------- ------ Revenues from external customers $ 88,966 $30,152 $ 119,118 Interest revenue 50,618 0 50,618 Interest expense 5,881 1,436 7,317 Equity in income of affiliates 1,076 7,702 8,778 Income tax expense 19,486 5,664 25,150 Operating earnings 60,029 8,374 68,403 Investments in affiliates 6,086 32,776 38,862 Deferred policy acquisition cost 95,645 0 95,645 Identifiable assets 1,074,393 97,913 1,172,306
The following are reconciliations of reportable segment revenues and profit to Enhance Financial's consolidated totals (in 000s): 32
1999 1998 1997 --------- --------- --------- REVENUES Total revenues from external customers for reportable segments $ 142,570 $ 151,627 $ 119,118 Total interest revenue for reportable segments 58,053 53,423 50,618 Realized (losses)/gains (3,039) 2,434 657 --------- --------- --------- Total consolidated revenues $ 197,584 $ 207,484 $ 170,393 ========= ========= ========= NET INCOME Operating earnings for reportable segments $ 73,997 $ 82,521 $ 68,403 Capital and foreign exchange (losses)/gains net of tax (2,463) 1,398 403 Non-recurring Van-Am and other non-recurring expenses, net of tax (2,910) (1,462) -- --------- --------- --------- Net income $ 68,624 $ 82,457 $ 68,806 ========= ========= =========
The Company's revenues from external customers, by product line, are as follows (in 000s):
1999 1998 1997 -------- -------- -------- INSURANCE: Financial guaranty reinsurance $ 60,250 $ 66,264 $ 49,913 Financial guaranty direct 11,629 10,246 6,319 Trade credit reinsurance 20,234 15,973 19,165 Other 11,444 12,337 13,569 ASSET-BASED 39,013 46,807 30,152 -------- -------- -------- TOTAL REVENUES FROM EXTERNAL CUSTOMERS $142,570 $151,627 $119,118 ======== ======== ========
NOTE 18- QUARTERLY FINANCIAL INFORMATION (UNAUDITED) In millions except per share amounts
1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr. Year -------- -------- -------- -------- ------- 1999 Net premiums written $ 29.5 $ 34.9 $ 28.9 $ 39.7 $ 133.0 Premiums earned 24.3 26.1 24.9 28.6 103.9 Investment and other income 11.9 17.5 13.9 19.7 63.0 Assignment sales 8.3 8.0 12.2 2.2 30.7 Losses and loss adjustment expenses 2.8 2.6 3.8 17.0 26.2 Equity in income of affiliates 4.7 7.9 4.5 2.6 19.7 Income before income taxes 19.6 25.4 20.6 3.8 69.4 Net income 18.2 23.5 22.4 4.5 68.6 Earnings per share - Basic $ 0.48 $ 0.62 $ 0.59 $ 0.12 $ 1.81 -------- -------- -------- -------- -------- - Diluted $ 0.46 $ 0.61 $ 0.57 $ 0.12 $ 1.76 -------- -------- -------- -------- --------
33
1998 Net premiums written $ 33.7 $ 27.3 $ 27.6 $ 40.7 $ 129.3 Premiums earned 23.7 24.4 29.0 25.2 102.3 Investment and other income 14.2 15.0 17.4 13.2 59.8 Assignment sales 10.4 12.1 12.7 10.2 45.4 Losses and loss adjustment expenses 2.3 1.6 4.6 1.8 10.3 Equity in income of affiliates 2.6 3.8 3.2 4.5 14.1 Income before income taxes 27.1 28.2 30.8 26.7 112.8 Net income 19.2 20.5 22.7 20.1 82.5 Earnings per share - Basic $ 0.51 $ 0.55 $ 0.61 $ 0.53 $ 2.20 ------- ------- ------- ------- ------- - Diluted $ 0.49 $ 0.52 $ 0.58 $ 0.51 $ 2.10 ------- ------- ------- ------- -------
NOTE 19- POST BALANCE SHEETS EVENTS In February 2000, the Company announced that it had implemented cost control initiatives and a reduction in staff. The Company estimates a first quarter charge of approximately $1.9 million related to staff reductions. The Company has begun a review of its strategic alternatives in order to maximize shareholder value. In February 2000 Enhance Financial engaged Morgan Stanley Dean Witter & Co. to advise the Company in connection with such review. The Company's business strategy, including without limitation, its expectations regarding sources of future growth may be changed materially following such review of strategic alternatives. 34 SCHEDULE I CREDIT-BASED ASSET SERVICING AND SECURITIZATION LLC AND AFFILIATES, COMBINED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 AND INDEPENDENT AUDITORS' REPORT 35 CREDIT-BASED ASSET SERVICING AND SECURITIZATION LLC AND AFFILIATES
TABLE OF CONTENTS - -------------------------------------------------------------------------------- Page INDEPENDENT AUDITORS' REPORT 36 FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997: Combined Balance Sheets 37 Combined Statements of Operations 38 Combined Statements of Owners' Equity 39 Combined Statements of Cash Flows 40 Notes to Combined Financial Statements 41-53 COMBINED SCHEDULE OF MORTGAGE-RELATED ASSETS 54
36 INDEPENDENT AUDITORS' REPORT To the Owners of Credit-Based Asset Servicing and Securitization LLC and Affiliates We have audited the accompanying combined balance sheets as of December 31, 1999 and 1998, including the combined schedule of mortgage-related assets as of December 31, 1999, of Credit-Based Asset Servicing and Securitization LLC and Affiliates (the "Company") and the related combined statements of operations, owners' equity and cash flows for each of the three years in the period ended December 31, 1999. 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 combined financial statements present fairly, in all material respects, the combined financial position of Credit-Based Asset Servicing and Securitization LLC and Affiliates as of December 31, 1999 and 1998, and the combined results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with generally accepted accounting principles. As explained in Note 1, at December 31, 1999 and 1998, the combined financial statements include investments in mortgage-related assets valued at approximately $773 million and $550 million, respectively (83% and 88% of assets, respectively), whose values have been estimated by the Company's management in the absence of readily ascertainable market values. We have reviewed the procedures used by the Company's management in arriving at its estimate of value of such investments and have inspected the underlying documentation, and, in the circumstances, we believe the procedures are reasonable and the documentation appropriate. However, those estimated values may differ significantly from the values that would have been used had a ready market for the mortgage-related assets existed, and the difference could be material. Deloitte & Touche LLP January 6, 2000 New York, New York 37 CREDIT-BASED ASSET SERVICING AND SECURITIZATION LLC AND AFFILIATES
COMBINED BALANCE SHEETS DECEMBER 31, 1999 AND 1998 - --------------------------------------------------------------------------------------------- ASSETS 1999 1998 CASH AND CASH EQUIVALENTS $6,392,918 $4,115,708 MORTGAGE-RELATED ASSETS 772,979,564 550,125,141 RECEIVABLE FROM BROKERS 59,635,548 -- LEASEHOLD IMPROVEMENTS, FURNITURE AND EQUIPMENT - Net 9,718,224 5,857,488 SERVICING RIGHTS, GOODWILL AND OTHER INTANGIBLES - Net 38,356,757 32,078,103 SERVICING ADVANCES RECEIVABLE 20,920,484 12,531,238 ACCOUNTS RECEIVABLE AND OTHER ASSETS 26,548,507 18,822,227 ------------ ------------ TOTAL ASSETS $934,552,002 $623,529,905 ============ ============ LIABILITIES AND OWNERS' EQUITY LIABILITIES: Funding arrangements, including accrued interest $340,563,022 $159,552,484 Reverse repurchase agreements, including accrued interest 276,636,521 201,244,830 Subordinated debt, including accrued interest 52,850,625 Guaranteed term agreement, including accrued interest -- 50,300,000 Payable for open trades 62,239,826 50,275,185 Due to affiliates 2,029,024 334,675 Accrued expenses and other liabilities 10,433,819 6,656,016 ------------ ------------ Total liabilities 744,752,837 468,363,190 COMMITMENTS AND CONTINGENCIES OWNERS' EQUITY 189,799,165 155,166,715 ------------ ------------ TOTAL LIABILITIES AND OWNERS' EQUITY $934,552,002 $623,529,905 ============ ============
See notes to combined financial statements. -2- 38 CREDIT-BASED ASSET SERVICING AND SECURITIZATION LLC AND AFFILIATES
COMBINED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 - ----------------------------------------------------------------------------------------------------------------------------------- 1999 1998 1997 REVENUES: Gain on liquidation or securitization of mortgage-related assets $ 56,382,412 $ 30,047,452 $ 22,780,440 Unrealized (loss) gain on mortgage- related assets (2,217,513) 5,000,000 -- Servicing and subservicing fees 28,770,067 18,856,183 4,723,886 Interest income $ 67,280,609 $ 33,713,981 $ 10,288,524 Interest expense (41,231,054) 26,049,555 (19,201,007) 14,512,974 (6,985,627) 3,302,897 ------------ ------------ ------------ Other income, net 5,080,029 1,264,247 5,373,345 ------------- ------------- ------------- Total revenues 114,064,550 69,680,856 36,180,568 ------------- ------------- ------------- EXPENSES: Compensation and benefits 38,385,922 21,982,160 13,053,808 Servicing costs 3,746,535 2,752,443 1,137,944 Transaction costs 6,170,696 3,358,550 1,646,143 Amortization of servicing rights, goodwill and other intangibles 6,527,316 3,952,975 1,367,400 Other expenses 18,915,336 12,129,569 3,770,881 ------------- ------------- ------------- Total expenses 73,745,805 44,175,697 20,976,176 ------------- ------------- ------------- INCOME BEFORE TAXES 40,318,745 25,505,159 15,204,392 INCOME TAX BENEFIT 104,465 478,571 -- ------------- ------------- ------------- NET INCOME $ 40,423,210 $ 25,983,730 $ 15,204,392 ============= ============= =============
See notes to combined financial statements. -3- 39 CREDIT-BASED ASSET SERVICING AND SECURITIZATION LLC AND AFFILIATES
COMBINED STATEMENTS OF OWNERS' EQUITY YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 - --------------------------------------------------------------------------------------------------------- C-BASS ENHANCE MGIC HOLDING TOTAL ------------- ------------- ------------- ------------- BALANCE, JANUARY 1, 1997 $ 18,797,361 $ 15,823,337 $ 497,820 $ 35,118,518 Contributions 7,349,982 7,349,982 10,036 14,710,000 Distribution -- -- (535,825) (535,825) Net income 7,352,844 7,352,844 498,704 15,204,392 ------------- ------------- ------------- ------------- BALANCE, DECEMBER 31, 1997 33,500,187 30,526,163 470,735 64,497,085 Contributions 32,500,000 33,425,628 812,768 66,738,396 Distribution (2,048,396) -- (4,100) (2,052,496) Net income 12,455,734 12,455,734 1,072,262 25,983,730 ------------- ------------- ------------- ------------- BALANCE, DECEMBER 31, 1998 76,407,525 76,407,525 2,351,665 155,166,715 Distribution (2,500,000) (2,500,000) (790,760) (5,790,760) Net income 19,377,128 19,377,128 1,668,954 40,423,210 ------------- ------------- ------------- ------------- BALANCE, DECEMBER 31, 1999 $ 93,284,653 $ 93,284,653 $ 3,229,859 $ 189,799,165 ============= ============= ============= =============
See notes to combined financial statements. -4- 40 CREDIT-BASED ASSET SERVICING AND SECURITIZATION LLC AND AFFILIATES
COMBINED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 - ---------------------------------------------------------------------------------------------------------------- 1999 1998 1997 CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 40,423,210 $ 25,983,730 $ 15,204,392 Adjustments to reconcile net income to net cash used in operating activities: Unrealized loss (gain) on mortgage-related assets 2,217,513 (5,000,000) -- REMIC tax residual fee income -- -- (5,103,225) Depreciation and amortization 9,333,189 5,543,864 2,041,901 Deferred income taxes (2,130) (461,314) -- Equity in earnings of unconsolidated subsidiaries (159,322) (353,953) -- Changes in operating assets and liabilities: Increase in mortgage-related assets (225,071,936) (348,000,842) (106,374,849) (Increase) decrease in receivable from brokers (59,635,548) 15,589,073 (13,514,815) Increase in servicing rights (11,911,900) (9,333,988) (295,550) Increase in accounts receivable and other assets (16,203,350) (17,294,505) (8,620,733) Increase in payable for open trades 11,964,641 27,440,335 8,660,581 Increase (decrease) in due to affiliates 1,694,349 (136,615) (59,794) Increase (decrease) in accrued expenses and other liabilities 7,651,154 (2,179,771) 6,184,354 ------------- ------------- ------------- Net cash used in operating activities (239,700,130) (308,203,986) (101,877,738) ------------- ------------- ------------- CASH FLOWS FROM INVESTING ACTIVITIES: Investment in WSAT -- (17,317,638) -- Purchases of leasehold improvements, furniture and equipment (6,666,609) (4,664,828) (1,536,562) Purchase of intangible assets (894,070) (1,173,450) -- Distributions from unconsolidated subsidiaries 247,146 684,803 -- ------------- ------------- ------------- Net cash used in investing activities (7,313,533) (22,471,113) (1,536,562) ------------- ------------- ------------- CASH FLOWS FROM FINANCING ACTIVITIES: Net borrowings under reverse repurchase agreements and other funding facilities 255,081,633 233,791,374 68,303,232 (Repayments) borrowings under guaranteed term agreement (50,000,000) 30,000,000 20,000,000 Issuance of subordinated debt 50,000,000 -- -- Capital contributions from members -- 66,738,396 14,710,000 Distributions to members (5,790,760) (2,052,496) (535,825) ------------- ------------- ------------- Net cash provided by financing activities 249,290,873 328,477,274 102,477,407 ------------- ------------- ------------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 2,277,210 (2,197,825) (936,893) CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 4,115,708 6,313,533 7,250,426 ------------- ------------- ------------- CASH AND CASH EQUIVALENTS, END OF YEAR $ 6,392,918 $ 4,115,708 $ 6,313,533 ============= ============= ============= SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Interest and other financing costs $ 37,359,833 $ 18,231,531 $ 6,190,477 ============= ============= ============= Cash paid during the year for income taxes $ 37,292 $ 57,217 $ 39,998 ============= ============= =============
See notes to combined financial statements. -5- 41 CREDIT-BASED ASSET SERVICING AND SECURITIZATION LLC AND AFFILIATES NOTES TO COMBINED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997 - -------------------------------------------------------------------------------- 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND BASIS OF PRESENTATION - The accompanying financial statements present the financial position, results of operations and cash flows of Credit-Based Asset Servicing and Securitization LLC and its subsidiaries ("C-BASS") and of Litton Loan Servicing LP and its subsidiaries ("Litton") on a combined basis. All significant intercompany balances and transactions have been eliminated. C-BASS and Litton combined are hereinafter referred to as the "Company." Prior to January 2000, both C-BASS and Litton were owned by Enhance Financial Services Group, Inc. ("EFS") and a subsidiary of MGIC Investment Corporation ("MGIC"), each owning approximately 48%, with the remainder owned by C-BASS Holding LLC ("Holding") (collectively, the "Owners"). Holding is owned by certain members of C-BASS and Litton management. Effective January 1, 2000, the Owners contributed their interests in Litton and its general partner, Litton GP LLC, to C-BASS and Litton became an indirect, wholly-owned subsidiary of C-BASS. Also, effective January 1, 2000, each of MGIC and EFS sold 2% of its interest in the Company to certain members of senior management of C-BASS, which interests were contributed to Holding in exchange for additional interests in Holding. As a result, Holding's interest in C-BASS increased from approximately 4% to approximately 8%. Profits and losses are allocated to the Owners in accordance with their ownership percentages. C-BASS is a Delaware limited liability company that commenced operations on July 9, 1996. In connection with the formation of C-BASS, the Owners entered into a Transaction Agreement whereby Litton Loan Servicing, Inc. ("LLSI") (a wholly-owned subsidiary of EFS) would be transferred into a separate entity owned by the Owners in the same proportion as they owned C-BASS. To effect this transfer of ownership, a new entity, Litton, a Delaware limited partnership, was funded and capitalized by the Owners at approximately $1.0 million. Pursuant to the Transaction Agreement, during 1998, EFS contributed the assets and liabilities of LLSI to Litton for approximately $2.9 million. At the time of this transaction, MGIC and Holding contributed capital to Litton of approximately $925,000 and $112,000, respectively, and EFS was distributed approximately $2.0 million in cash. Because of common ownership and a continuity of operations and management, the accompanying financial statements include the operations of LLSI prior to its transfer to Litton as described above. The Company engages in the acquisition and resolution of delinquent single-family residential mortgage loans ("Mortgage Loans"). The Company also purchases and sells seller-financed notes ("Notes") and real estate owned ("REO"), invests in mortgage-backed securities ("Mortgage Securities") and interests in real estate mortgage investment conduit ("REMIC") residuals, and performs mortgage loan servicing and mortgage and contract collections. In addition, the Company issues mortgage-backed securities collateralized by Mortgage Loans, Mortgage Securities and/or Notes. The Company maintains several subsidiaries to perform certain activities and to hold specific assets. -6- 42 USE OF ESTIMATES - The preparation of financial statements in conformity with generally accepted accounting principles ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the combined financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates in the combined financial statements include the valuation of mortgage-related assets, goodwill, servicing rights and solicitation rights and the amortization thereof. MORTGAGE-RELATED ASSETS - C-BASS considers itself a nonregistered investment company for financial reporting purposes. GAAP for investment companies requires that the Mortgage Loans, Mortgage Securities, Notes and REO (collectively, "Mortgage-Related Assets") owned by C-BASS be carried at their estimated fair values, with the resulting net unrealized gains and losses reflected in earnings. Litton does not own significant Mortgage-Related Assets. Mortgage-Related Assets are generally recorded as of the date of purchase or sale (trade date), unless the Company anticipates an extended period between the trade date and the settlement date, in which case the settlement date is used. In January 2000, Litton became an indirect subsidiary of C-BASS, and C-BASS therefore no longer met the requirement to be considered a nonregistered investment company for financial reporting purposes. Beginning in 2000, Mortgage Securities will be classified as trading securities, with unrealized gains and losses reflected in earnings. Mortgage Loans and Notes will be carried at the lower of cost or fair value, and REO will be carried at cost, subject to an impairment test. Implementation of this change in accounting will not have a significant impact on the Company's financial position or results of operations. a. Mortgage Securities - Securities listed or traded on any United States national exchange are valued at the last sales price of the close of the principal securities exchange on which such securities are traded or, if there are no sales, at the mean of the last bid and asked prices. Many of the Mortgage Securities purchased by the Company or retained in the Company's securitizations consist of below-investment grade and nonrated subordinated interests ("B-Pieces"). The timing and amount of cash flows on these securities are significantly influenced by prepayments on the underlying loans and foreclosure losses. There is generally not an active public market for such securities, and market quotations are not readily available. The fair value of these securities is estimated by management by discounting future cash flows using discount rates and credit loss and prepayment estimates that approximate current market rates, and by comparison to values used by institutions providing financing to the Company on such securities. Given the complex nature of these securities and the market for them, the values estimated by management do not necessarily represent the amounts that would be received by the Company if it sold all or a portion of its portfolio. -7- 43 The following table sets forth the geographic distribution of the mortgage loans underlying the Company's Mortgage Securities as of December 31, 1999:
PERCENTAGE OF STATE PRINCIPAL BALANCE California 42% New York 4 Texas 4 Florida 4 All Other(1) 46 ---- 100% ====
(1) No other state contains more than 5% of the properties securing loans in the Company's Mortgage Securities portfolio. As of December 31, 1999, the Company used discount rates for below-investment grade and nonrated B-Pieces of 11.5% to 20% and 20% to 30%, respectively; annual prepayment estimates of 10% to 35% CPR for prime loans, 10% to 18% for FHA/VA loans, and 7.5% to 80% for sub-prime loans, and lifetime credit loss estimates of 0.15% to 15% of the original principal balances for prime loans, 0.1% to 1.5% for FHA/VA loans, and 2.5% to 6.0% for sub-prime loans. b. MORTGAGE LOANS AND NOTES - Mortgage Loans and Notes purchased by C-BASS are carried at estimated fair value. Fair value is generally determined based upon price quotations, broker price opinions regarding the value of the underlying collateral, and the Company's valuation model that considers the yields, maturities and characteristics of such assets and third-party indications of value under borrowing arrangements. The acquisition cost for a pool of loans is allocated to each loan in the pool based upon the Company's valuation model. Interest is accrued on mortgage loans that are less than 90 days in arrears or are reperforming. The Company also accrues interest on loans guaranteed by the Federal government, up to the amount that the Company estimates is guaranteed by the Federal government. In situations where the collateral is foreclosed on, the loans are transferred to REO upon receipt of title to the property. c. REAL ESTATE OWNED - Properties acquired directly are initially recorded at cost. Properties acquired through foreclosure are recorded at estimated fair value, less projected costs of disposal. Management periodically reviews each REO property's carrying value and adjusts it to fair value if changes in local real estate markets or the property's condition or situation warrant. Fair value is determined primarily on the basis of collateral value estimates obtained from real estate specialists. Sales proceeds and related costs are recognized when title has passed to the buyer. Interest income is recorded as earned, with purchase discounts or premiums amortized into income using the effective yield method. The gain on sale of mortgage-backed securities issued by the Company through securitization transactions is computed based on the price of the securities sold and the estimated fair value of any securities retained in accordance with Statement of Financial Accounting Standards ("SFAS") No. 125, ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENT OF LIABILITIES. -8- 44 Mortgage Loans, Notes, and Mortgage Securities are primarily collateralized by residential single-family properties. These assets expose the Company to the risk that the borrowers may be unable to repay principal of and interest on the amount borrowed. At the time of purchase of Mortgage Loans and Mortgage Securities, the Company evaluates the performance of the underlying collateral and, where appropriate, the ability and willingness of the borrower to repay principal of and interest on the amount of the loan outstanding. CASH AND CASH EQUIVALENTS - Cash and cash equivalents include cash held by depository institutions and short-term investments with remaining maturities at acquisition of less than three months. INTEREST RATE SWAPS - During 1999, the Company utilized interest rate swaps in a strategy intended to reduce the impact of changes in interest rates on the value of a portion of its Mortgage-Related Assets. At December 31, 1999, the Company had outstanding an aggregate notional amount of $510.0 million. During 1999, the Company had outstanding an average of $265.4 million. With respect to all such transactions, the notional amount represents the stated principal balance used as a basis for calculating payments. On the swaps outstanding at December 31, 1999, the Company receives a floating rate ranging from 5.404% to 5.608% based on various floating rate indices and pays fixed rates ranging from 4.755% to 6.140%. The swaps expire at various periods during 2000 and 2001. The Company incurred a net expense during the year ended December 31, 1999 of approximately $804,000 which is included in interest expense. The interest rate swaps are carried at their estimated fair values, determined using quotes obtained from dealers who make a market in such securities. The unrealized gain or loss on the swaps is included in earnings with the unrealized gain or loss on Mortgage-Related Assets. The fair value of the swaps was approximately $5.0 million at December 31, 1999, and is included in Mortgage-Related Assets at December 31, 1999. The Company had no interest rate swap contracts open at December 31, 1998. The interest rate swaps expose the Company to interest rate risk, as well as to credit loss in the event of non-performance by the counterparty to the swap. The Company does not anticipate non-performance by any counterparties. SHORT SALES - From time to time, the Company enters into contracts to sell securities it does not own ("short sales"), in a strategy intended to reduce the impact of changes in interest rates on the value of a portion of its Mortgage-Related Assets. Under these contracts, the Company sells securities, generally mortgage-backed securities or U.S. Treasury securities, borrowed from a broker. The proceeds from the sale are retained by the broker as collateral for the Company's obligation to deliver the borrowed securities at a specified date. The Company's obligation to deliver the borrowed securities is carried at fair value in the combined balance sheet as part of "payable for open trades," with changes in such fair value included in earnings with the unrealized gain or loss on Mortgage-Related Assets. The sales proceeds retained by the broker of $54.7 million, are included in "receivable from brokers" in the combined balance sheet. At December 31, 1999, the Company had an open obligation to deliver a FNMA TBA security on January 19, 2000 with a face amount of $55.0 million and a fair value of $54.4 million. The Company is exposed to credit risk in the event of nonperformance by a broker holding the sales proceeds as collateral for the securities borrowed. The Company does not anticipate nonperformance by any broker. LEASEHOLD IMPROVEMENTS, FURNITURE AND EQUIPMENT - Computer hardware and software, furniture and fixtures, and leasehold improvements are stated at cost. Depreciation and amortization is provided using the straight-line method over the estimated useful lives of the assets, which range from three to seven years. Leasehold improvements are amortized over the shorter of their useful lives or the lease term. -9- 45 CAPITALIZATION OF SOFTWARE COSTS - Costs related to the implementation of new software for internal use and costs related to development of software for external and internal use have been capitalized in accordance with Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, and Statement of Financial Accounting Standards No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed, respectively. Amortization is provided using the straight-line method over three years. ACCOUNTS RECEIVABLE - Accounts receivable consists of investor receivables, servicing receivables, advances and other receivables. Investor receivables consist primarily of amounts due from various companies which own the servicing rights on loans that the Company services under subservicing agreements. The balances in these accounts consist of subservicing fees, foreclosure advances and other miscellaneous charges incurred by the Company on behalf of the investors. Servicing receivables consist primarily of escrow advances and principal and interest advances. Escrow advances are Company payments made to escrow custodial accounts to avoid overdrafts in these accounts when tax or insurance payments are made for loans. The advances are recovered from future mortgage payments or from sale of the property or from investors if the mortgagee defaults. Principal and interest ("P&I") advances are Company payments to the P&I custodial accounts so that sufficient funds are available for the monthly remittance to security holders. These advances are recovered from future mortgage payments as they are received, or from sale of the property or from investors if the mortgagee defaults. Foreclosure advances represent foreclosure costs which are advanced by the Company as part of the mortgage loan foreclosure process and are recovered primarily from sale of the property, from investors or by filing claims with the various agencies or companies that insure the loans. SERVICING RIGHTS - Servicing rights ("SRs") are reported at the lower of amortized cost or fair value and are periodically evaluated for impairment based on the fair values of those rights determined by discounting estimated future net cash flows using a discount rate commensurate with the risks involved. This method of valuation incorporates assumptions that market participants would use in their estimates of future servicing income and expense, including assumptions about prepayment, default and interest rates. The fair value of SRs at December 31, 1999 was determined using discount rates ranging from approximately 10% to 15% and prepayment rates ranging from approximately 11% to 40%. For purposes of measuring impairment, the loans underlying the SRs are stratified on the basis of type (agency or nonagency). The amount of impairment, if any, is the amount by which the amortized cost of SRs by strata exceeds the fair value of that strata. SRs are amortized in proportion to, and over the period of, estimated net servicing revenues. -10- 46 REMIC RESIDUALS - The Company has acquired residual interests in REMICs which, at acquisition, are anticipated to generate substantial amounts of taxable income, with little, if any, cash flow, in the first several years after acquisition, and approximately equal amounts of taxable losses thereafter (REMIC residuals). Generally, issuers of REMICs do not retain such residuals, instead paying investors an inducement fee to take ownership of the residual and assume the tax liability. During 1999, 1998 and 1997, the Company sold REMIC residual interests, which resulted in a gain, after payment of inducement fees to the buyers, of $2.0 million, $0.2 million and $5.1 million, respectively. C-BASS no longer acquires REMIC residual securities for its own account. GOODWILL AND OTHER INTANGIBLES - Goodwill and other intangibles consist of goodwill and solicitation rights. Goodwill is stated at amortized cost and is being amortized over 12 years. The Company owns, through acquisitions, databases of names of seller-financed noteholders. These databases ("solicitation rights") are used to solicit, via direct mail, the purchase of the note from the noteholder. Solicitation rights are being amortized over the estimated life of the databases, which range from five to nine years. These assets are evaluated periodically to determine whether events and circumstances have developed that warrant revision of the estimated lives of the related assets or their write-off. LOAN SERVICING - The fees received for loan servicing or subservicing are generally based on either a monthly fee, payable on all loans serviced, or on a percentage of the outstanding principal balance of such loans, payable from interest collected from mortgagors. Such loan servicing fees are generally credited to income monthly or when the related mortgagor payments are collected. Late charges and other fees collected from mortgagors are credited to income when collected. Loan servicing costs are charged to expense as incurred. INCOME TAXES - Litton is a partnership. C-BASS is a limited liability company, and as such is generally treated as a partnership for Federal income tax purposes. Thus, the taxable income or loss of C-BASS and Litton is included in the tax returns of the Owners, and no provision or liability for income taxes has been recorded related to such companies' operations in the accompanying financial statements. Litton and C-BASS may be subject to state taxes in certain jurisdictions in which they operate. Income taxes applicable to the Company's C-corporation subsidiaries are accounted for under the liability method. Deferred income tax assets and liabilities are computed for differences between the financial statement and income tax basis of assets and liabilities that will result in taxable or deductible amounts in the future. The primary differences between taxable income and income under GAAP include those arising from REMIC residuals and the amortization of SRs, solicitation rights and goodwill. In 1997, LLSI was included in the consolidated Federal income tax return of its parent, EFS. Income taxes for 1997 were computed on a separate company basis, with any current tax liability or refund settled through intercompany accounts. -11- 47 REVERSE REPURCHASE AGREEMENTS - Transactions involving sales of securities under agreements to repurchase ("reverse repurchase agreements") are treated as collateralized financing transactions and are recorded at their contracted repurchase amounts plus accrued interest. The Company is generally required to deliver the securities that collateralize the reverse repurchase agreements to the counterparties. The Company is required to maintain agreed-upon amounts of collateral with these counterparties during the term of the reverse repurchase agreements. RECENT ACCOUNTING PRONOUNCEMENTS - The Company adopted SFAS No. 130, Reporting Comprehensive Income, in 1998. This statement established standards for reporting and display of comprehensive income and its components (revenue, expenses, gains and losses). SFAS No. 130 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. The Company had no items of comprehensive income during 1999, 1998 and 1997. SFAS No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. SFAS No. 133 requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. This statement is effective for the Company beginning January 1, 2001. The Company is currently reviewing the impact of the implementation of SFAS No. 133 on its financial statements. INVESTMENTS IN UNCONSOLIDATED SUBSIDIARIES - Investments in unconsolidated subsidiaries are accounted for under the equity method. RECLASSIFICATIONS - Certain prior year amounts have been reclassified to conform with the current year presentation. 2. ACQUISITIONS In February 1998, the Company established Wynwood Servicing and Technology LLC ("WSAT") with an initial capitalization of $18 million. In separate transactions, WSAT then acquired all of the shares of Wynwood, Inc. ("Wynwood") for approximately $15.0 million and all of the operations of South Plains Mortgage Company ("South Plains") for approximately $3 million. Wynwood and its subsidiaries are engaged primarily in the business of mortgage and contract collections. South Plains is engaged in the business of acquiring Notes for resale to investors. WYNWOOD ACQUISITION - The Wynwood purchase agreement provides for additional earn-out payments of a maximum of approximately $7.8 million to the sellers and certain members of management, if contract servicing, solicitation rights, and note or mortgage purchase thresholds specified in the agreement are met during the four-year period following the acquisition date. C-BASS has provided the sellers a guarantee of the earn-out payments required to be made. No payment has been made under such earn-out agreements. At December 31, 1999, no liability has been recorded under the earn-out provisions. SOUTH PLAINS ACQUISITION - The South Plains purchase agreement provides for additional earn-out payments of a maximum of approximately $1.0 million to the sellers if certain note purchase thresholds are met during the two-year period following the acquisition date. Through December 31, 1999, the Company has paid $750,000 in earn-out payments. -12- 48 3. FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS, requires the Company to report the estimated fair value of its financial instruments, as defined. At December 31, 1999 and 1998, substantially all of the Company's assets and liabilities are carried at estimated fair value or contracted amounts which approximate fair value. Mortgage Loans, Notes, Mortgage Securities and REO are carried at estimated fair value. Assets that are recorded at contracted amounts approximating fair value consist of receivables from affiliates and certain other receivables. Similarly, the Company's short-term liabilities consist primarily of reverse repurchase agreements, amounts payable to affiliates and certain other payables. Such amounts are recorded at contracted amounts approximating fair value. These instruments generally have variable interest rates and short-term maturities, or are payable upon demand, and accordingly are not materially affected by changes in interest rates. The carrying value of the Company's Senior Subordinated Notes approximates its fair value. 4. INCENTIVE COMPENSATION The Company paid "sign-on" bonuses totaling approximately $1.4 million to its officers at the inception of their employment. The amounts paid were capitalized and were amortized to compensation expense over the vesting periods, which ranged from 12 to 18 months. Amortization was approximately $891,000 in 1997. The capitalized amounts were fully amortized at December 31, 1997. The Company has established incentive bonus programs, which set forth the guidelines for computation of incentive bonus pools based on the Company's pretax, preincentive bonus return on equity for the twelve-month periods ending June 30, net of certain unrealized gains and losses, if any, and on the performance of certain managed portfolios (see Note 9). The allocation of the bonus pool is subject to review by the Company's Board of Managers. For each of the twelve-month periods ended June 30, 1999, 1998 and 1997, the Company paid incentive compensation of approximately $9.8 million, $8.0 million and $3.4 million as payable under the incentive bonus pool in July of 1999, 1998 and 1997, respectively. The Company has accrued approximately $5.3 million at December 31, 1999 based on results of operations and estimated portfolio performance for the six months ended December 31, 1999. 5. SERVICING RIGHTS The activity in the Company's SRs during 1999 and 1998 was as follows:
CONTRACT MORTGAGE SERVICING SERVICING RIGHTS RIGHTS TOTAL Balance, January 1, 1998 $ -- $ 4,768,472 $ 4,768,472 Acquisition of Wynwood 4,323,789 -- 4,323,789 Additions 326,446 9,007,542 9,333,988 Amortization (686,314) (1,785,200) (2,471,514) ------------ ------------ ------------ Balance, December 31, 1998 3,963,921 11,990,814 15,954,735 Additions 688,323 11,223,577 11,911,900 Amortization (784,347) (3,875,713) (4,660,060) ------------ ------------ ------------ Balance, December 31, 1999 $ 3,867,897 $ 19,338,678 $ 23,206,575 ============ ============ ============
-13- 49 In addition, the Company also accrued approximately $2.1 million at December 31, 1999 as incentive to manage an asset portfolio for EFS and MGIC, for which C-BASS receive an incentive fee (see Note 9). Cost approximates fair value at December 31, 1999 and 1998. During 1997, additions to mortgage servicing rights totaled approximately $295,000 and accumulated amortization was approximately $1.6 million at December 31, 1997. The unpaid principal balance of mortgage loans serviced for others is not included in the accompanying combined financial statements. These balances were approximately $3.4 billion at December 31, 1999 and $3.0 billion at December 31, 1998. The following table sets forth the geographic distribution of the mortgage loans underlying the mortgage servicing rights portfolio as of December 31, 1999:
PERCENTAGE OF PRINCIPAL BALANCE STATE SERVICED California 22% Texas 10% New York 10% Florida 5% All other(1) 53% ---- 100% ====
(1) No other state contains more than 5% of the properties securing loans in the Company's mortgage servicing rights portfolio. At December 31, 1999, the Company had errors and omissions insurance coverage of $5.0 million and fidelity insurance coverage of $5.0 million. Custodial escrow balances maintained in connection with the foregoing loan servicing were a net deficit of approximately $8.3 million and $3.1 million at December 31, 1999 and 1998, respectively. The Company has made advances to cover the deficit escrow balances. Included in accounts receivable at December 31, 1999 are $10.1 million of escrow advances due from borrowers and from investors. Escrow funds are held in trust for mortgagors at various financial institutions and are not included in the accompanying combined balance sheets. 6. GOODWILL AND OTHER INTANGIBLES As of December 31, 1999, goodwill and other intangible assets were comprised of the following:
1999 1998 Goodwill and other intangibles $ 14,867,355 $ 14,765,408 Accumulated amortization - goodwill and other intangibles (2,418,143) (1,101,252) Solicitation rights 3,631,544 2,839,421 Accumulated amortization - solicitation rights (930,574) (380,209) ------------ ------------ Total $ 15,150,182 $ 16,123,368 ============ ============
-14- 50 7. DEBT OBLIGATIONS Debt obligations are summarized as follows:
DECEMBER 31, 1999 1998 Warehouse Line of Credit with variable rates of interest. At December 31, 1999 and 1998, such rates were 5.44% and 5.50%, respectively. The weighted average interest rate during 1999 and 1998 was 6.38% and 7.21%, respectively. Borrowings are secured by Mortgage Loans, Notes, Mortgage Securities, mortgage servicing advances and SRs. $303,376,222 $146,051,893 Guaranteed Term Agreement with interest at the weekly Federal Funds rate plus 0.1%, payable monthly. At December 31, 1998, such rates was 5.67%. The weighted average interest rate during 1998 was 5.86%. -- 50,000,000 Senior Subordinated Notes due September 1, 2004, with interest at 15.91% payable semi-annually. 50,000,000 -- Reverse repurchase agreements with various counterparties. Such agreements accrue interest at variable rates based on one-month LIBOR plus a range of 0.5% to 2.25%. At December 31, 1999 and 1998, such rates ranged from 6.45% to 8.48% and 5.80% to 9.25%, respectively. The weighted average interest rate during 1999 and 1998 was 6.15% and 6.82%, respectively. Borrowings under such agreements are secured by Mortgage Securities and Mortgage Loans. 275,341,535 200,939,930 Revolving Credit Agreement with variable rate of interest based on LIBOR plus 2.50%. At December 31, 1999, such rate was 8.98%, and at December 31, 1998, such rate was 7.50%. During the years ended December 31, 1999 and 1998, the weighted average interest rate was 8.59% and 9.12%, respectively. The borrowings are secured by Mortgage Loans, Notes and REO. 34,301,788 10,511,152 Other notes and contracts payable with interest at rates ranging from 0% to 1,699,523 2,134,460 18% per annum.
The Company has a $400 million Warehouse Line of Credit Agreement (the "Warehouse Agreement") with a group of financial institutions, with a maturity date of June 19, 2000. The Warehouse Agreement provides for interest rates based on various indices, mainly Federal Funds and LIBOR, as selected by the Company. The Warehouse Agreement contains restrictive financial covenants that require the Company to meet, among other things, certain capital requirements and debt to adjusted equity ratios (as defined). The Warehouse Agreement also restricts the Company's ability to pay distributions. -15- 51 In 1997, the Company entered into a Guaranteed Term Agreement (the "Term Agreement") for a fixed amount of $20 million, later increased to $50 million. The Term Agreement was guaranteed by EFS and MG1C. The Term Agreement was repaid on July 30, 1999. On August 23, 1999, the Company issued $50 million of 15.91% Senior Subordinated Notes due September 1, 2004. Net proceeds, after purchasers' discount and offering expenses, was $47.4 million, resulting in a yield of approximately 17%. The Senior Subordinated Notes indenture contains restrictive financial covenants, including minimum net worth, maximum total debt to net worth, and maximum subordinated debt to net worth (as defined). The indenture also restricts the Company's ability to pay distributions. The notes may be redeemed at par plus a "make-whole" amount determined with respect to the discounted value of remaining scheduled payments. Included in reverse repurchase agreements are $85.6 million with Bank of America, $81.9 million with Merrill Lynch, $39.2 million with Greenwich Capital and $27.0 million with Bear Stearns. Most repurchase agreements have stated maturities of less than one year. In October 1998, the Company entered into a Revolving Credit Agreement with a bank (the "Credit Agreement") with a one-year term and borrowing limit of $40 million; the Credit Agreement has been extended to December, 2000. Substantially all of the Company's Mortgage-Related Assets, servicing rights and servicing advances are pledged as collateral under its debt obligations. The aggregate amount of minimum payments required on debt obligations for periods after December 31, 1999 are as follows: 2000 $ 607,020,704 2001 6,449,972 2002 184,860 2003 253,459 2004 50,258,924 Thereafter 551,149 ------------- $ 664,719,068 =============
8. INCOME TAXES The Company has several C-Corporation subsidiaries, subject to income tax. The components of the benefit for income taxes are as follows:
1999 1998 1997 ---------- ---------- --------- Current expense (benefit) $ (102,335) $ (17,257) $ 228,083 Deferred benefit (2,130) (461,314) (228,083) ---------- ---------- --------- Total benefit $ (104,465) $ (478,571) $ -- ========== ========== =========
-16- 52 At December 31, 1999 and 1998, the net deferred tax liability was comprised of the following temporary differences:
1999 1998 Deferred tax assets: Net operating losses $ 173,950 $ 447,425 ----------- ----------- Total 173,950 447,425 ----------- ----------- Deferred tax liabilities: Servicing rights and other intangibles (772,729) (1,012,010) Other (154,419) (190,743) ----------- ----------- Total (927,148) (1,202,753) ----------- ----------- Net deferred tax liability $ (753,198) $ (755,328) =========== ===========
The differences between the income tax benefit and the amount determined by applying the statutory Federal income tax rate of 34% to the pretax loss of taxable C-corporation subsidiaries at December 31, 1999 and 1998 are as follows:
1999 1998 Income tax benefit calculated at the statutory rate $ (448,062) $ (780,095) Goodwill amortization (GAAP-nondeductible) 327,540 298,485 Other 16,057 3,039 ----------- ----------- Income tax benefit $ (104,465) $ (478,571) =========== ===========
There was no significant difference between the 1997 tax provision and the provision determined by applying the statutory Federal income tax rate to pretax loss of taxable subsidiaries. 9. RELATED PARTY TRANSACTIONS EFS - The Company occupies certain office facilities leased by EFS and reimburses EFS for its occupancy costs. The Company incurred costs totaling approximately $435,000, $288,000 and $180,000 in 1999, 1998 and 1997, respectively. The Company had an outstanding borrowing from EFS at December 31, 1999 of approximately $786,000. These borrowings do not bear interest and are repayable upon demand. EFS acquired partnerships (the "EFS partnerships") holding interests in Mortgage Securities in the second quarter of 1999, and engaged C-BASS to manage the portfolio. C-BASS receives an annual base management fee and an incentive fee based on portfolio performance. The annual incentive fee is paid out over 4 years. The total management fee is estimated to be approximately $1.5 million for 1999. C-BASS, as manager for the EFS Partnerships, acquired and disposed of certain mortgage securities during 1999, resulting in net proceeds payable to the EFS Partnerships of approximately $1.1 million at December 31, 1999. MGIC - Affiliates of MGIC provide the Company with various services, including referral of investment opportunities. During 1999, 1998 and 1997, the Company paid MGIC approximately $7,000, $16,000 and $257,000 for such services, respectively. -17- 53 MGIC acquired partnerships (the "MGIC Partnerships") holding interests in Mortgage Securities in the second quarter of 1999, and engaged C-BASS to manage the portfolio. C-BASS receives an annual base management fee and an incentive fee based on portfolio performance. The annual incentive fee is paid out over 4 years. The total management fee is estimated to be approximately $0.9 million for 1999. C-BASS, as manager for the MGIC Partnerships, acquired and disposed of certain mortgage securities during 1999, resulting in net proceeds payable to the MGIC Partnerships of approximately $2.0 million. 10. COMMITMENTS AND CONTINGENCIES The Company and its subsidiaries are obligated under leases for office space through 2005. Minimum future lease commitments at December 31, 1999 are: 2000 $ 2,700,490 2001 2,645,536 2002 2,350,106 2003 2,262,461 2004 1,908,471 Thereafter 10,165,782 ------------ $ 22,032,846 ============
WSAT leases its office space in Tacoma, Washington from WTE, L.L.C., which is 17% owned by officers and the former owners of Wynwood. The Company is involved in various legal proceedings and pending claims arising in the ordinary course of business. The final outcome is uncertain. However, management does not expect the resolution of these matters to have a significant effect on the financial statements as of December 31, 1999. 11. DEFINED CONTRIBUTION PLANS The Company maintains 401(k) plans, which were established in 1997, that cover substantially all of its eligible employees. The permitted employee contributions vary among the entities comprising the Company, as do the employer matching contribution percentages. The employer matching percentages are at the Company's discretion and are subject to change. The Company's matching contributions totaled approximately $408,000 in 1999, $255,000 in 1998 and $155,000 in 1997. ****** -18- 54 CREDIT-BASED ASSET SERVICING AND SECURITIZATION LLC AND AFFILIATES COMBINED SCHEDULE OF MORTGAGE-RELATED ASSETS DECEMBER 31, 1999 - --------------------------------------------------------------------------------
NOTIONAL AMOUNT ISSUER VALUE MORTGAGE SECURITIES $ 157,907,451 C-BASS $ 109,412,894 114,961,248 PNC 52,155,866 48,222,491 Merrill Lynch 44,727,925 323,213,936 Other 158,946,641 510,000,000 Interest rate swaps 4,980,614 ------------- Total Mortgage Securities 370,223,940 MORTGAGE LOANS $448,380,000 unpaid principal balance 388,575,903 REAL ESTATE OWNED 195 Properties 14,179,721 ------------- TOTAL MORTGAGE-RELATED ASSETS $ 772,979,564 =============
See notes to combined financial statements. -19- EX-99.3 5 y48885ex99-3.txt EX-99.3 UNAUDITED INTERIM FINANCIAL INFORMATION 1 EXHIBIT 99.3 ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands except share amounts)
September 30, 2000 December 31, 1999 ------------------ ----------------- (unaudited) ASSETS Investments: Fixed maturities, held to maturity, at amortized cost (market value $160,904 and $181,474) $ 157,202 $ 177,607 Fixed maturities, available for sale, at market (amortized cost $819,406 and $778,751) 813,934 745,963 Other invested assets 11,055 10,935 Common stock, at market (cost $498) 839 839 Short-term investments 87,449 34,657 ----------- ----------- Total Investments 1,070,479 970,001 Cash and cash equivalents 1,562 2,558 Accrued interest receivable 13,694 18,977 Investment in affiliates 139,938 108,001 Premiums receivable 15,248 22,959 Furniture, fixtures and equipment 8,342 10,206 Deferred policy acquisition costs 126,270 119,213 Federal income taxes recoverable 6,073 6,713 Prepaid federal income tax 24,709 24,797 Deferred income taxes - net 67,634 68,587 Prepaid reinsurance premiums 6,663 8,772 Reinsurance recoverable on unpaid losses 264 2,286 Receivable from affiliates 1,316 1,170 Goodwill -- 24,196 ----------- ----------- Other assets 71,440 65,496 ----------- ----------- TOTAL ASSETS $ 1,553,632 $ 1,453,932 =========== =========== LIABILITIES, DEFERRED CREDIT AND SHAREHOLDERS' EQUITY LIABILITIES Losses and loss adjustment expenses $ 66,087 $ 51,970 Reinsurance payable on paid losses and loss adjustment expenses 6,797 8,997 Deferred premium revenue 355,342 346,088 Accrued profit commissions 2,814 2,554 Long-term debt 75,000 75,000 Short-term debt 174,382 113,941 Payable to affiliates 5,230 -- Accrued expenses and other liabilities 44,915 41,078 ----------- ----------- TOTAL LIABILITIES 730,567 639,628 ----------- ----------- DEFERRED CREDIT 122,250 138,000 ----------- ----------- SHAREHOLDERS' EQUITY Common stock-$.10 par value, Authorized-100,000,000 shares, issued-40,158,025 and 40,007,404 shares 4,016 4,001 Additional paid-in capital 254,763 253,109 Retained earnings 480,688 477,715 Accumulated other comprehensive loss (6,066) (25,935) Treasury stock (32,586) (32,586) ----------- ----------- TOTAL SHAREHOLDERS' EQUITY 700,815 676,304 ----------- ----------- TOTAL LIABILITIES, DEFERRED CREDIT AND SHAREHOLDERS' EQUITY $ 1,553,632 $ 1,453,932 =========== ===========
See notes to unaudited consolidated financial statements. 2 ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In thousands except per share amounts) (unaudited)
Three Months Ended Nine Months Ended September 30, September 30, ------------- ------------- 2000 1999 2000 1999 ---- ---- ---- ---- REVENUES Net premiums written $ 22,551 $ 28,928 $ 92,712 $ 93,358 Decrease (increase) in deferred premium revenue 3,450 (4,031) (11,363) (18,064) --------- --------- --------- --------- Premiums earned 26,001 24,897 81,349 75,294 Net investment income 16,344 15,274 47,277 42,762 Net realized gains (losses) on sale of investments 101 (140) (1,357) (4,480) Assignment revenue (751) 12,215 9,125 28,521 Other income (597) (1,271) 2,588 4,940 --------- --------- --------- --------- Total revenues 41,098 50,975 138,982 147,037 --------- --------- --------- --------- EXPENSES Losses and loss adjustment expenses 2,071 3,837 22,699 9,223 Policy acquisition costs 10,617 8,915 31,127 27,022 Profit commissions 230 155 1,237 711 Other operating expenses - insurance 5,233 3,912 14,061 12,114 - non-insurance 15,772 14,914 79,875 41,332 --------- --------- --------- --------- Total expenses 33,923 31,733 148,999 90,402 --------- --------- --------- --------- Income (loss) from operations 7,175 19,242 (10,017) 56,635 Equity in net income of affiliates 1,691 4,460 21,128 17,026 Minority interest -- -- 253 -- Foreign currency losses (50) (27) (98) (33) Interest expense (4,168) (3,070) (12,302) (7,998) --------- --------- --------- --------- Income (loss) before income taxes 4,648 20,605 (1,036) 65,630 Income tax (benefit) expense (10,924) (1,790) (10,880) 1,587 --------- --------- --------- --------- Net income $ 15,572 $ 22,395 $ 9,844 $ 64,043 ========= ========= ========= ========= Basic earnings per share $ 0.41 $ 0.59 $ 0.26 $ 1.69 ========= ========= ========= ========= Diluted earnings per share $ 0.40 $ 0.57 $ 0.25 $ 1.64 ========= ========= ========= ========= Basic weighted average shares outstanding 38,182 38,031 38,163 37,981 ========= ========= ========= ========= Diluted weighted average shares outstanding 38,782 39,027 38,659 39,074 ========= ========= ========= =========
See notes to unaudited consolidated financial statements. 3 ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1999 (In thousands except share and per share amounts) (unaudited)
Outstanding Common Stock Treasury Stock ----------------------- ---------------------- Additional Paid-in Shares Amount Shares Amount Capital ------ ------ ------ ------ ------- Balance, December 31, 1998 39,812,937 $ 3,981 1,950,794 $ (32,586) $ 249,851 Comprehensive income: Net income for the period -- -- -- -- -- Unrealized foreign currency translation adjustment (net of tax of $625) -- -- -- -- -- Unrealized losses during the period (net of tax of $19,324) -- -- -- -- -- Reclassification adjustment for realized losses included in net income (net of tax of $1,580) -- -- -- -- -- Total comprehensive income -- -- -- -- -- Dividends paid ($0.18 per share) -- -- -- -- -- Exercise of stock options 183,600 18 -- -- 2,083 ========== ========== ========== ========== ========== Balance, September 30, 1999 39,996,537 $ 3,999 1,950,794 $ (32,586) $ 251,934 ========== ========== ========== ========== ==========
Accumulated Other Comprehensive Income --------------------------------------- Foreign Currency Unrealized Unearned Translation Gains Retained Compensation Adjustment (Losses) Earnings Total ------------ ---------- -------- -------- ----- Balance, December 31, 1998 $ (493) $ 714 $ 22,965 $ 418,214 $ 662,646 Comprehensive income: Net income for the period -- -- -- 64,043 -- Unrealized foreign currency translation adjustment (net of tax of $625) -- (1,161) -- -- -- Unrealized losses during the period (net of tax of $19,324) -- -- (32,654) -- -- Reclassification adjustment for realized losses included in net income (net of tax of $1,580) -- 21 2,912 -- -- Total comprehensive income -- -- -- -- 33,161 Dividends paid ($0.18 per share) -- -- -- (6,840) (6,840) Exercise of stock options -- -- -- -- 2,101 ========== ========== ========== ========== ========== Balance, September 30, 1999 $ (493) $ (426) $ (6,777) $ 475,417 $ 691,068 ========== ========== ========== ========== ==========
See notes to unaudited consolidated financial statements. 4 ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2000 (In thousands except share and per share amounts) (unaudited)
Outstanding Common Stock Treasury Stock ---------------------- ---------------------- Additional Paid-in Shares Amount Shares Amount Capital ------ ------ ------ ------ ------- Balance, December 31, 1999 40,007,404 $ 4,001 1,950,794 $ (32,586) $ 253,109 Comprehensive income: Net income for the period -- -- -- -- -- Unrealized gains during the period (net of tax of $8,329) -- -- -- -- -- Reclassification adjustment for realized losses included in net income (net of tax $475) -- -- -- -- -- Total comprehensive income -- -- -- -- -- Dividends declared ($0.18 per share) -- -- -- -- -- Exercise of stock options 148,700 15 -- -- 1,625 Issuance of common shares 1,921 -- -- -- 29 ========== ========== ========== ========== ========== Balance, September 30, 2000 40,158,025 $ 4,016 1,950,794 $ (32,586) $ 254,763 ========== ========== ========== ========== ==========
Accumulated Other Comprehensive Income --------------------------------------- Foreign Currency Unrealized Unearned Translation Gains Retained Compensation Adjustment (Losses) Earnings Total ------------ ---------- -------- -------- ----- Balance, December 31, 1999 $ (493) $ (2,207) $ (23,235) $ 477,715 $ 676,304 Comprehensive income: Net income for the period -- -- -- 9,844 -- Unrealized gains during the period (net of tax of $8,329) -- -- 18,987 -- -- Reclassification adjustment for realized losses included in net income (net of tax $475) -- -- 882 -- -- Total comprehensive income -- -- -- -- 29,713 Dividends declared ($0.18 per share) -- -- -- (6,871) (6,871) Exercise of stock options -- -- -- -- 1,640 Issuance of common shares -- -- -- -- 29 ========== ========== ========== ========== ========== Balance, September 30, 2000 $ (493) $ (2,207) $ (3,366) $ 480,688 $ 700,815 ========== ========== ========== ========== ==========
See notes to unaudited consolidated financial statements. 5 ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (unaudited)
Nine Months Ended September 30, ------------------------------- 2000 1999 ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 9,844 $ 64,043 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization, net (3,924) (7,286) Write-off of goodwill 22,051 -- Net realized losses 1,357 4,480 Equity in net income of affiliates (21,128) (17,026) Loss on sale of assets 1,390 -- Change in assets and liabilities: Premiums and other receivables 7,711 11,541 Accrued interest receivable 5,283 (1,648) Accrued expenses and other liabilities 1,544 23,019 Deferred policy acquisition costs (7,057) (14,994) Deferred premium revenue, net 11,363 18,063 Accrued profit commissions 260 (128) Losses and loss adjustment expenses, net 13,940 4,334 Payable to (receivable from) affiliates 5,084 (25,632) Payable for securities -- 17,870 Other assets (1,221) (34,027) Income taxes, net (21,960) (1,625) --------- --------- Net cash provided by operating activities 24,537 40,984 --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment (687) (4,368) Proceeds from sales and maturities of investments 251,585 273,968 Purchase of investments (266,352) (350,927) Purchase of partnership interests -- (13,720) (Purchases) sales of short-term investments, net (52,793) 4,570 Other, net (119) -- Investment in affiliates (14,700) (2,497) --------- --------- Net cash used in investing activities (83,066) (92,974) --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Capital stock 1,670 2,101 Short-term debt 60,441 51,660 Dividends paid (4,578) (4,557) --------- --------- Net cash provided by financing activities 57,533 49,204 --------- --------- Net change in cash and cash equivalents (996) (2,786) Cash and cash equivalents, beginning of period 2,558 5,542 --------- --------- Cash and cash equivalents, end of period $ 1,562 $ 2,756 =========
SUPPLEMENTAL DISCLOSURE OF CERTAIN NON-CASH TRANSACTIONS: September 30, 2000 ------------------ Sale of interest in investment in affiliate including accrued interest $ 3,954 ======== Consideration received - note receivable $ 3,954 ========
See notes to unaudited consolidated financial statements. 6 ENHANCE FINANCIAL SERVICES GROUP INC. AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS PERIODS ENDED SEPTEMBER 30, 2000 AND 1999 (UNAUDITED) 1. BASIS OF PRESENTATION - MERGER AGREEMENT BASIS OF PRESENTATION: The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q under Rules and Regulations of the Securities and Exchange Commission and do not include all of the information and disclosures required by generally accepted accounting principles. These statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Annual Report on Form 10-K/A for the year ended December 31, 1999 (the "1999 Form 10-K/A") of Enhance Financial Services Group Inc. ("Enhance Financial"). The accompanying unaudited consolidated financial statements have not been audited by independent auditors in accordance with generally accepted auditing standards. However, in the opinion of management, such financial statements include all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position and results of operations of Enhance Financial and its subsidiaries (collectively the "Company"). The results of operations for the nine months ended September 30, 2000 may not be indicative of the results that may be expected for the year ending December 31, 2000. Certain of the 1999 amounts have been reclassified to conform to the current period(s) presentation. MERGER AGREEMENT: On November 13, 2000, Enhance Financial and Radian Group Inc. ("Radian") entered into an agreement (the "Merger Agreement') providing for the merger (the "Merger") of Enhance Financial with a wholly owned subsidiary of Radian. The Merger Agreement provides for Enhance Financial shareholders at the effective time of the Merger to receive .22 share of Radian common stock for each share of Enhance Financial common stock owned by them. Consummation of the Merger is subject to the satisfaction by each party of several conditions, including the approval of Enhance Financial and Radian shareholders, for which special meetings of shareholders are to be called as soon as practicable. The board of directors voted unanimously at a meeting held November 12, 2000 to approve the Merger and to recommend its approval to shareholders. At that meeting, the board received the opinion of Morgan Stanley Dean Witter & Company ("Morgan Stanley") that the Merger price was fair to the Enhance Financial shareholders from an economic point of view. Enhance Financial's entry into the Merger Agreement was the culmination of its efforts, for which it had retained Morgan Stanley in February 2000 to assist it, to identify and review strategic options to increase shareholder value. Radian provides private mortgage insurance coverage in the United States on residential mortgage loans. The closing prices of Enhance Financial common stock and Radian common stock on November 13, 2000, the last trading day prior to the announcement of the execution of the Merger Agreement, were$13-13/16 and $64-3/16, respectively. 7 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS PERIODS ENDED SEPTEMBER 30, 2000 AND 1999 (UNAUDITED) The Merger Agreement requires that Enhance Financial pay Radian a "break-up fee" of $20.0 million if the Enhance Financial board of directors withdraws its recommendation to shareholders that they approve the transaction, the shareholders fail to approve the transaction and the Company is sold to another party within twelve months thereafter (which fee increases to $25.0 million if the Company is sold to any of certain specified competitors of Radian). In addition, if Radian terminates the Merger Agreement for any of certain other specified reasons as permitted by the Merger Agreement, Radian will be entitled to reimbursement of its expenses in the transaction up to $5.0 million. On September 28, 2000, Enhance Financial and Residential Funding Corporation ("GMAC-RFC") had entered into an agreement providing for the sale to GMAC-RFC of Enhance Financial's wholly owned partnership (the "Partnership") which, in turn, holds a 46% interest in Credit-Based Asset Servicing and Securitization LLC ("C-BASS") and REMIC interests in securitizations. Enhance Financial and GMAC-RFC are each permitted to terminate the agreement if Enhance Financial enters into another agreement providing for the sale by Enhance Financial of the Partnership (including through the sale of the Company as an entirety) to another party. Enhance Financial is required to pay GMAC-RFC a "break-up fee" of $4 million if either party tenders a notice of termination prior to consummation of the sale. Pursuant to the terms of the Merger Agreement, Enhance Financial is required to provide such notice prior to the consummation of the Merger. Under the Merger Agreement, if the merger does not take place because necessary conditions (including shareholder approvals) are not fulfilled by June 30, 2001, because of a breach by Radian or under similar circumstances, the Company can require Radian to purchase the Company's 46% interest in C-BASS for a purchase price equal to 90% of the consideration GMAC-RFC would have been required to pay for the Partnership (approximately $90 million). The Company has realized approximately $24.8 million of tax benefits relating to REMIC residuals owned by the Partnership. If the Company sells those REMIC residuals or the Partnership, the Company will be subject to taxes which could be as much as $24.8 million, essentially as a recapture of that amount of the tax benefits it has received. If the merger does not take place, the Company would likely sell C-BASS, directly or by selling the Partnership. Because the sale contemplated by the Merger Agreement would be of C-BASS, not of the Partnership, it should not result in a tax related to the REMIC residuals. However, a sale of the Company's interest in C-BASS may require consents from other owners of interests in C-BASS, which would not be required if the Company sold the Partnership. Therefore, it is possible the only way the Company would be able to sell its interest in C-BASS would be by selling the Partnership. A sale of the Partnership would result in the taxes of as much as $24.8 million related to the REMIC residuals. The Merger Agreement was the result of the Company's efforts, commenced in February 2000, to identify and review strategic options to increase shareholder value. These efforts were, in turn, partly an outgrowth of a decision by Moody's Investor Service, Inc. ("Moody's) in August 1999 to downgrade the senior long term debt rating of Enhance Financial from Aa3 to A2 and the insurance financial strength rating of Enhance Financial's largest insurance subsidiary, Enhance Reinsurance Company ("Enhance Re"), from Aaa to Aa2. In February 2000, Moody's placed such debt and insurance financial strength ratings under review for possible further downgrade. It is possible that Moody's or the Company's other rating agencies may further downgrade Enhance Financial's long term debt rating and the financial strength rating of Enhance Re. See Note 13 of Notes to Consolidated Financial Statements in the 1999 Form 10-K/A for related issues and potential consequences as the foregoing may relate to the Company's reinsurance contracts. The Company is continuing to address its liquidity shortage, and its ability to meet its debt obligations and commitments pending consummation of the Merger. See Notes 7 and 8 regarding issues related to two non-insurance subsidiaries of Enhance Financial. Pending consummation of the Merger, the financial flexibility of the Company is limited. 2. DIVIDENDS DECLARED In the first nine months of 2000, Enhance Financial declared cash dividends of $.18 per share totaling $6,870,693. As a result of the net loss incurred in the second quarter 2000, the Company was prohibited by the terms of its bank credit agreement from declaring and paying a dividend to its shareholders for the third quarter 2000 and is similarly constrained with respect to a fourth quarter 2000 dividend. The dividend in the third quarter of $2,292,523 was accrued during the third quarter and subsequently paid in October 2000 after the Company obtained a waiver from its bank lenders therefor. However, the Company does not anticipate requesting a waiver from the bank lenders to pay a dividend to its shareholders for the fourth quarter 2000. 3. COMMON STOCK During the first nine months of 2000, Enhance Financial made no common stock purchases. 8 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS PERIODS ENDED SEPTEMBER 30, 2000 AND 1999 (UNAUDITED) 4. COMPREHENSIVE INCOME Comprehensive income for the three months and nine months ended September 30, 2000 and 1999 is shown in the table below (in millions). Other comprehensive income consists of unrealized gains and losses on available for sale securities, foreign currency translation adjustments and unearned compensation.
Three-months ended Nine-months ended September 30, September 30, - -------------------------------------------------------------------------------- 2000 1999 2000 1999 - -------------------------------------------------------------------------------- Net income $ 15.5 $ 22.4 $ 9.8 $ 64.0 Other comprehensive income: Increase (decrease) in unrealized appreciation of investments 9.7 (18.0) 27.3 (51.9) Applicable income taxes (3.3) 7.4 (8.3) 19.3 Reclassification adjustments for realized (gains) losses in net income (0.1) 0.2 1.4 4.5 Applicable income taxes 0.1 (0.1) (0.5) (1.6) Foreign currency translation losses: -- -- -- (1.7) Applicable income taxes -- -- -- 0.6 ------------------------------------ Comprehensive income $ 21.9 $ 11.9 $ 29.7 $ 33.2 ====================================
5. 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 Company has not recorded a deferred federal tax liability for the nine-month periods ended September 30, 2000 and September 30, 1999 of $10.5 million (aggregate $24.9 million for the nine months ended September 30, 2000 and $14.4 million for the nine months ended September 30, 1999), respectively, for the tax benefits associated with the Company's investment in a portfolio of residual mortgage-backed securities that consist of residual interests in real estate mortgage investment conduits ("REMICs") acquired in April 1999 because the Company believes that the tax law provides a means, through the use of a tax strategy, by which income tax benefits associated with this portfolio will not result in future tax obligations, and the Company intends to use such means. For the nine-month period ended September 30, 2000, the Company realized $10.5 million of tax benefits and $0.3 million of investment income from the portfolio of REMICs. For the nine-month period ended September 30, 2000, the Company realized tax benefits of $10.9 million on a loss of $1.0 million. The tax benefit includes $10.5 million realized from the REMICs. The effective tax rate would have been 36.7% excluding the REMIC benefit. For the comparable period of 1999, the Company had an effective tax rate of 2.4%, which included $14.4 million of tax benefits realized from REMICs. The effective rate would have been 24.4% excluding the REMIC benefit. 9 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS PERIODS ENDED SEPTEMBER 30, 2000 AND 1999 (UNAUDITED) As discussed in Note 6 of Notes to Consolidated Financial Statements in the 1999 Form 10-K/A, one of the prior owners of the REMICs was audited by the Internal Revenue Service ("IRS") for taxable years during which such owner owned the REMICs. Upon completion of that audit, the IRS determined that certain tax strategies adopted by the prior owner with respect to the REMICs were improper and should be disallowed. The prior owner disputed the IRS's determination and filed suit in the United State Tax Court to overturn the IRS's audit adjustments relating to the REMICs. In August 2000, the prior owner and the IRS reached a settlement in their Tax Court litigation and the Tax Court entered a series of stipulated decisions regarding the settlement. The stipulated decisions appear to be a concession by the IRS of the incorrectness of its audit determination that certain tax strategies adopted by the prior owner with respect to the REMICs were improper and should be disallowed. After reviewing the stipulated decisions, the Company's counsel has advised the Company that, at the present time, it is not appropriate to conclude that the settlement or any potential future IRS action will affect the Company's ability to realize the expected tax benefits associated with the REMICs. Nonetheless, given the private nature of the settlement, the lack of clarity regarding the basis for the settlement, and the uncertainties regarding the IRS's potential future action, there can be no complete assurance that the settlement or any potential future IRS action will not have a material adverse effect on the tax benefits that the Company expects to realize from the REMICs. 6. NEW ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No. 133, "Accounting for Derivatives Instruments and Hedging Activities," which becomes effective for the Company January 1, 2001. This pronouncement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. The Company will be required to recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The accounting for a change in fair value of a derivative in earnings or other comprehensive income will depend on the intended use of the derivative and the resulting designation. The Company is currently reviewing the impact of the implementation of SFAS No. 133 on its financial statements. In September 2000, the FASB issued SFAS No. 140 "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" which superceded SFAS No. 125. With respect to certain disclosure requirements, SFAS No. 140 is effective subsequent to December 15, 2000, with full compliance for its requirements by April 2001. SFAS No. 140 provides among other disclosure requirements, rules relating to Special Purpose Entities. The Company is currently reviewing the impact of the implementation of SFAS No. 140 on its financial statements. 10 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS PERIODS ENDED SEPTEMBER 30, 2000 AND 1999 (UNAUDITED) 7. SINGER ASSET FINANCE COMPANY, L.L.C. ("SINGER")/ENHANCE LIFE BENEFITS LLC ("ELB") As part of its review of strategic alternatives, the Company assessed the continuing value or impairment of goodwill recorded at approximately $22.1 million as of June 30, 2000, attributable to its wholly owned subsidiaries, Singer and ELB. The strategic analysis, which was performed by an investment banking firm, established that there is negligible investor interest in purchasing these companies and that it is unlikely that the Company would recover at minimum its recorded goodwill. In conjunction with this assessment, the Company also completed a long-term cash flow analysis. Additionally, Singer and ELB have continued to incur losses and generate negative cash flows throughout the first nine months of 2000. Accordingly, the Company determined as of June 30, 2000 that the entire recorded value of goodwill has been impaired and should be charged off, which charges has been included in non-insurance operating expenses. The Company is finalizing a plan to wind down, sell or otherwise dispose of the Singer and ELB business activities, operations and assets while meeting Singer's and ELB's servicing and financial obligations. A provision of $7.5 million has been recorded at September 30, 2000 to reflect severance and termination costs and other related wind-down costs, which charge has been included in non-insurance operating expenses. Additionally in October 2000, the Company sold certain assets and intangibles of ELB and has recorded an estimated loss of $1.4 million, which charge has been included in non-insurance operating expenses). As the Company continues to finalize this plan, it may incur further restructuring charges. The Company is also analyzing and evaluating those of its obligations that may remain in the event of run-off. This process includes the analysis and evaluation of the fixed and contingent exposures of Enhance Financial, Singer, ELB and the Company's non-consolidated entities (i.e. trusts and other special purpose entities) under servicing agreements, debt obligations and credit agreements. Enhance Financial has provided performance guarantees (in some cases with a direct performance obligation) to the respective lenders on behalf of Singer, ELB and related trusts, special purpose companies, etc. which were formed in conjunction with a number of securitizations. The guarantees relate to Singer and ELB's roles as originators and/or servicers of the securitized assets. Additionally, Enhance Financial has provided other forms of programmatic support, including the down-stream funding of tax credits related to the securitization of assignable state lottery awards and the guarantee of certain interest rate swap transactions entered into in connection with a number of the securitizations and to hedge interest rate risk to assets in the pipeline. In addition, Enhance Financial has indemnified many of Singer's and ELB's lenders against non-credit-related losses resulting from any breach of Singer's or ELB's representations, warranties or covenants. Enhance Financial will be responsible for servicing, in some cases for 15 years or longer, permanently financed securitized assets originated by Singer and ELB having an aggregate value of approximately $590.0 million and an additional $158.0 million currently placed in warehouse lines maturing before the end of 2000. In connection with Singer's lottery servicing obligations, related cash liquidity reserves of the Company totaling $7.5 million at September 30, 2000, which, while not pledged as credit support with respect to the assets, are at risk in the event of an uncured default by Singer or Enhance Financial. 11 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS PERIODS ENDED SEPTEMBER 30, 2000 AND 1999 (UNAUDITED) Enhance Financial is obligated to fund federal and state tax credits related to lottery payments, either which Enhance Financial utilizes in connection with its tax obligations or for which Enhance Financial applies for refunds, through 2016 as follows (in millions):
Year Tax Credits ---- ----------- 2000 $25.2 ($17.9 funded through September 30) 2001 25.2 2002 24.5 2003 23.0 2004 21.7 Thereafter 138.8
At September 30, 2000, Enhance Financial has guaranteed Singer's performance under interest rate swap agreements with a notional amount of $40.0 million. The fair market value of these swaps was approximately $(261,000). Deferred hedge losses as of September 30, 2000 totaled approximately $655,000. Offsetting this liability was approximately $43.0 million of lottery receivables residing in the pipeline or in an off-balance sheet warehouse. At September 30, 2000, Singer has arranged for approximately $158.0 million of over-collateralized debt, financed through two off-balance sheet warehouse lines, secured by assets held by non-consolidated entities. The financings mature on December 29 and 30, 2000. Should the respective lenders elect not to renew the facilities, it will be necessary for the Company to refinance or sell the assets. In the event of default, the Company is exposed to the potential loss of its equity of approximately $21.9 million and the reversal of gains previously recognized of approximately $13.0 million. Additionally, if the Company reacquires these assets, they would be subject to current mark-to-market adjustments. Also, Singer has arranged for approximately $590.0 million of off-balance sheet collateralized permanent financing, secured by assets held by the non-consolidated entities. At September 30, 2000, Singer is obligated to purchase approximately $21.0 million of lottery assets and $4.2 of structured settlements, at prices that approximate their market value and are substantially protected by hedge agreements. On August 10, 2000, the Company entered into a letter of intent with certain members of Singer's management for the sale of certain of Singer's off-balance sheet assets, including its pipeline of lottery and structured settlement transactions and certain intangibles. Although the letter has expired, the Company continues to negotiate the terms of such sale. 8. INVESTMENT IN NEW SUBSIDIARY In April 2000 Enhance Financial acquired a convertible preferred stock representing a majority equity interest in Credit2B.com Inc. ("Credit2B"), a newly formed corporation, in return for cash and future capital commitments aggregating $14.0 million. Through September 30, 2000, Enhance Financial has funded $3.4 million of the $14.0 million commitment. Additionally, in October 2000 Enhance Financial funded an additional $2.7 million. The goal of Credit2B is to facilitate business trade credit on the Internet. It seeks to integrate data, analytics, scoring, and financial alternatives for business-to-business exchanges and web sellers to approve transactions and to offload risk in real time. Credit2B and Enhance Financial have entered into employment agreements with several of Credit2B's officers (including its President and Chief Executive Officer and its Chief Operating Officer), which provide base and incentive compensation of approximately $3.3 million per annum ($1.7 million of which is attributable to the aforementioned two officers). Each such agreement is cancelable upon 30 days notice by either party. 12 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS PERIODS ENDED SEPTEMBER 30, 2000 AND 1999 (UNAUDITED) Enhance Financial currently intends to divest itself of its ownership of its stock in Credit2B prior to the end of 2000 and obtain value for Enhance Financial's shareholders. Accordingly, the Company at September 30, 2000 has accounted for its investment in Credit2B on the equity method of accounting notwithstanding that Enhance Financial's designees compose a majority of the Credit2B board of directors resulting in Enhance Financial having effective voting control of Credit2B. Enhance Financial's ability to complete its divestiture of Credit2B is subject to the current market-related uncertainties affecting the Internet businesses in general. Credit2B incurred a net loss for the period April 17, 2000 (date of inception) to September 30, 2000 of $2.9 million, of which Enhance Financial's share is $2.5 million ($2.1 million for the three-month period ended September 30, 2000). 9. RESTRUCTURING AND SHUTDOWN EXPENSES In September 2000, the Company determined to place Singer into wind-down and incurred $7.5 million for severance and related shutdown costs. See Note 7 for additional information regarding the October 2000 sale of certain assets of ELB. In May 2000, the Company ceased operations of its New Products and Ventures Group and incurred $2.9 million for severance and related shutdown costs. In May 2000, the Company transferred its entire equity interests in AGS Financial Group LLC , the entity that conducted a significant portion of the Company's South American operations, to the Company's partners (who constituted senior management of the enterprise) for nominal consideration. In connection with such transaction, the Company recognized a loss of $1.3 million. 10. LOSS RESERVE - CREDITRUST EXPOSURE The Company insured three securitization transactions in 1998 for special purpose subsidiaries of Creditrust Corporation ("Creditrust"), which has since filed for protection under the bankruptcy laws. In each case the Company insured notes issued by the special purpose vehicle and secured by pledges of receivables from pools of charged-off credit card obligations. The Company has concluded that the proceeds of the pledged receivables will likely be insufficient to satisfy the timely payment of the insured notes in two of those transactions and has, accordingly, established the indicated case-basis reserves aggregating $4.0 million of which $1.0 million has been charged to current earnings. In addition, the Company has received information alleging that certain of the data that Creditrust conveyed to the Company upon which the Company relied to gauge collection performance in the insured transactions for which reserves have been established had been altered and was therefore unreliable. Primarily as a result of these allegations, the Company filed a motion in Creditrust's bankruptcy proceeding seeking the appointment of a trustee to manage Creditrust's affairs. The Company believes the reserve amounts to be reasonable based on the information it currently has concerning the performance of the respective pools. The Company will continue to monitor these transactions closely for fluctuations in pool performance. See Note 13 for additional information regarding the litigation with Creditrust. 13 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS PERIODS ENDED SEPTEMBER 30, 2000 AND 1999 (UNAUDITED) 11. SEGMENT REPORTING The Company has two reportable segments: insurance and asset-based 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 asset-based businesses segment deals primarily with credit-based servicing and securitization of assets in underserved markets, in particular, the origination, purchase, servicing and securitization of special assets, including lottery awards, structured settlement payments, sub-performing/non-performing and seller financed residential mortgages and delinquent consumer assets. The Company's reportable segments are strategic business units, which are managed separately as each business requires different marketing and sales expertise. The Company evaluates performance based on net income. Summarized financial information concerning the Company's operating segments is presented in the following tables:
In thousands September 30, 2000 ------------------ Insurance Asset-based Total --------- ----------- ----- Revenues from external customers $82,607 $ 10,455 $93,062 Net investment income 46,995 282 47,277 Net income (loss) 37,235 (27,391) 9,844 Segment assets 1,098,470 455,162 1,553,632
September 30, 1999 ------------------ In thousands Insurance Asset-based Total --------- ----------- ----- Revenues from external customers $75,601 $ 33,154 $ 108,755 Net investment income 42,762 -- 42,762 Net income 51,020 13,023 64,043 Segment assets 1,213,998 220,865 1,434,863
The following are reconciliations of reportable segment revenues and profit to Enhance Financial's consolidated totals:
In Thousands September 30, ------------- 2000 1999 ---- ---- REVENUES Total revenues from external customers for reportable segments $ 93,062 $ 108,755 Net investment income for reportable segments 47,277 42,762 Realized losses (1,357) (4,480) --------- --------- Total consolidated revenues $ 138,982 $ 147,037 ========= =========
14 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS PERIODS ENDED SEPTEMBER 30, 2000 AND 1999 (UNAUDITED) 12. LITIGATION Creditrust and its president filed a complaint against Enhance Financial and its wholly owned subsidiary, Asset Guaranty Insurance Company ("Asset Guaranty") on April 4, 2000 in the United States District Court for the District of Maryland alleging that a senior employee of Enhance Financial had posted messages on an internet message board containing derogatory, false, misleading, and/or confidential information regarding Creditrust, in violation of various state and federal common law and statutory duties. This alleged misconduct would have been unauthorized and contrary to Company policy. The employee identified in the lawsuit is no longer employed by the Company. Nonetheless, the complaint alleges that the message board activity was undertaken on behalf of the Company to further its competitive interests. On May 9, 2000, Enhance Financial and Asset Guaranty filed a motion to dismiss the complaint, which has not yet been argued or decided. On October 19, 2000, Enhance Financial and Asset Guaranty entered into a settlement agreement with Creditrust and its president, which provides for dismissal with prejudice of the complaint against Enhance Financial and Asset Guaranty with no payment of money by Enhance Financial or Asset Guaranty (the "Settlement Agreement"). The Settlement Agreement was reached as part of a global resolution of claims between and among parties including Enhance Financial and Asset Guaranty and Creditrust and its president, which included the claims brought by Asset Guaranty against Creditrust in Creditrust's bankruptcy proceeding. The Settlement Agreement is subject to approval by the Bankruptcy Court, and it will not become effective, and the complaint against Enhance Financial and Asset Guaranty will not be dismissed (although it is currently stayed) unless and until the Bankruptcy Court approves a plan of reorganization filed by Creditrust, which incorporates the terms of the Settlement Agreement. The settlement is also subject to certain other contingencies, which may or may not be satisfied. In November 2000, the Official Committee of Unsecured Creditors of Creditrust filed objections to the Settlement Agreement and a plan of organization in connection with the Creditrust bankruptcy that does not contemplate implementation of the Settlement Agreement, and Wells Fargo Bank Minnesota, N.A., as trustee, filed certain objections to the plan of reorganization filed by Creditrust. Even if the Settlement Agreement does not become effective and the motion to dismiss is not granted, in whole or in part, the Company believes that Creditrust's claims against the Enhance Financial and Asset Guaranty are not well founded and that the outcome of this litigation will not be material to the Company's business. 15 INDEPENDENT ACCOUNTANTS' REVIEW REPORT To the Board of Directors and Shareholders of Enhance Financial Services Group Inc. New York, NY 10017 We have reviewed the accompanying consolidated balance sheet of Enhance Financial Services Group Inc. and subsidiaries (the "Company") as of September 30, 2000, and the related consolidated statements of income for the three-month and nine-month periods ended September 30, 2000 and 1999 and the consolidated statements of shareholders' equity and cash flows for the nine-month periods ended September 30, 2000 and 1999. These financial statements are the responsibility of the Company's management. We conducted our reviews in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and of making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to such consolidated financial statements for them to be in conformity with accounting principles generally accepted in the United States of America. We have previously audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet of the Company as of December 31, 1999, and the related consolidated statements of income, shareholders' equity and cash flows for the year then ended (not presented herein); and in our report dated March 27, 2000, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 1999 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. /s/ DELOITTE & TOUCHE LLP New York, New York November 17, 2000 EX-99.4 6 y48885ex99-4.txt EX-99.4 UNAUDITED PRO FORMA 1 Exhibit 99.4 UNAUDITED PRO FORMA CONDENSED FINANCIAL INFORMATION The following unaudited pro forma condensed financial information should be read in conjunction with the historical consolidated financial statements, including the notes thereto, of Radian and Enhance Financial Services. The unaudited pro forma information is presented for illustration purposes only, in accordance with the assumptions set forth below, and is not necessarily indicative of the operating results or financial position that would have occurred if the merger had been completed. Nor is it necessarily indicative of future operating results or the financial position of the combined enterprise. 2 NEW RADIAN GROUP INC. UNAUDITED PRO FORMA CONDENSED COMBINED BALANCE SHEET QUARTER ENDED SEPTEMBER 30, 2000
HISTORICAL ENHANCE HISTORICAL FINANCIAL PRO FORMA PRO FORMA RADIAN SERVICES ADJUSTMENTS COMBINED ---------- ---------- ----------- ---------- (DOLLARS IN THOUSANDS) ASSETS Investments......................... $1,665,145 $1,070,479 $2,735,624 Cash................................ 3,983 1,562 5,545 Investment in affiliates............ 0 139,938 139,938 Deferred policy acquisition costs... 67,103 126,270 (69,721)(1) 123,652 Prepaid and deferred federal income taxes............................ 265,250 92,343 3,884(1) 361,477 Other assets........................ 115,293 123,040 238,333 ---------- ---------- --------- ---------- TOTAL ASSETS................ $2,116,774 $1,553,632 $ (65,837) $3,604,569 ========== ========== ========= ========== LIABILITIES, DEFERRED CREDIT AND STOCKHOLDERS' EQUITY Liabilities Unearned premiums................... $ 67,169 $ 355,342 $ 422,511 Reserve for losses.................. 374,474 66,087 440,561 Short-term debt..................... 0 174,382 174,382 Long-term debt...................... 0 75,000 75,000 Deferred federal income taxes....... 277,578 0 24,906(1) 302,484 Other liabilities................... 88,290 59,756 31,550(1)(2) 179,596 ---------- ---------- --------- ---------- TOTAL LIABILITIES........... 807,511 730,567 56,456 1,594,534 ---------- ---------- --------- ---------- Deferred Credit Deferred credit..................... 0 122,250 0 122,250 ---------- ---------- --------- ---------- Preferred Stockholder's Equity Redeemable preferred stock.......... 40,000 0 40,000 ---------- ---------- --------- ---------- Common Stockholder's Equity Common stock........................ 38 4,016 (4,008)(1) 46 Additional paid-in capital.......... 541,600 254,763 323,751(1)(2) 1,120,114 Retained earnings................... 727,379 480,688 (480,688)(1) 727,379 Net unrealized gains (losses) on investments, net of tax.......... 2,405 (6,066) 6,066(1) 2,405 Treasury stock...................... (2,159) (32,586) 32,586(1) (2,159) ---------- ---------- --------- ---------- TOTAL COMMON STOCKHOLDERS' EQUITY.................... 1,269,263 700,815 (122,293) 1,847,785 ---------- ---------- --------- ---------- TOTAL LIABILITIES, DEFERRED CREDIT AND STOCKHOLDERS' EQUITY.................... $2,116,774 $1,553,632 $ (65,837) $3,604,569 ========== ========== ========= ==========
3 NEW RADIAN GROUP INC. UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF INCOME NINE MONTHS ENDED SEPTEMBER 30, 2000
HISTORICAL ENHANCE HISTORICAL FINANCIAL PRO FORMA PRO FORMA RADIAN SERVICES ADJUSTMENTS COMBINED ---------- ---------- ----------- --------- (IN THOUSANDS, EXCEPT PER-SHARE AMOUNTS) REVENUES Premiums earned........................ $387,072 $81,349 $468,421 Net investment income.................. 60,310 47,277 107,587 Equity in net income of affiliates..... 0 21,128 21,128 Other net income....................... 8,052 10,511 18,563 -------- ------- ------- -------- Total revenues................. 455,434 160,265 0 615,699 -------- ------- ------- -------- EXPENSES Provision for losses................... 115,038 22,699 137,737 Policy acquisition costs............... 38,822 31,127 (9,396)(3) 60,553 Other operating expenses............... 40,314 95,173 (24,196)(5) 111,291 Interest expense....................... 0 12,302 12,302 Merger expenses........................ 0 0 0 -------- ------- ------- -------- Total expenses................. 194,174 161,301 (33,592) 321,883 -------- ------- ------- -------- Pretax income (loss)................... 261,260 (1,036) 33,592 293,816 Provision for income taxes (benefit)... 76,733 (10,880) 22,257(3)(4)(5) 88,110 -------- ------- ------- -------- Net income..................... 184,527 9,844 11,335 205,706 ======== ======= ======= ======== Net income per common share -- basic... 4.84 0.26 4.42 ======== ======= ======== Net income per common share -- diluted.................... 4.78 0.25 4.36 ======== ======= ======== Average number of common shares outstanding -- basic................ 37,586 38,163 (29,767)(1) 45,982 ======== ======= ======= ======== Average number of common and common equivalent shares outstanding -- diluted.............. 38,065 38,659 (30,154)(1) 46,570 ======== ======= ======= ========
4 NEW RADIAN GROUP INC. UNAUDITED PRO FORMA COMBINED CONDENSED STATEMENT OF INCOME YEAR ENDED DECEMBER 31, 1999
HISTORICAL ENHANCE HISTORICAL FINANCIAL PRO FORMA PRO FORMA RADIAN SERVICES ADJUSTMENTS COMBINED ---------- ---------- ----------- --------- (IN THOUSANDS, EXCEPT PER-SHARE AMOUNTS) REVENUES Premiums earned.......................... $472,635 $103,851 $576,486 Net investment income.................... 67,259 58,053 125,312 Equity in net income of affiliates....... 0 19,708 19,708 Other net income......................... 12,917 36,077 48,994 -------- -------- ------- -------- Total revenues................... 552,811 217,689 0 770,500 -------- -------- ------- -------- EXPENSES Provision for losses..................... 174,143 26,156 200,299 Policy acquisition costs................. 58,777 39,959 (18,493)(3) 80,243 Other operating expenses................. 62,659 71,141 (946)(5) 132,854 Interest expense......................... 0 10,989 10,989 Merger expenses.......................... 37,766 0 37,766 -------- -------- ------- -------- Total expenses................... 333,345 148,245 (19,439) 462,151 -------- -------- ------- -------- Pretax income............................ 219,466 69,444 19,439 308,349 Provision for income taxes............... 71,328 820 21,210(3)(4)(5) 93,358 -------- -------- ------- -------- Net income....................... 148,138 68,624 (1,771) 214,991 ======== ======== ======= ======== Net income per common share -- basic....... 3.92 1.81 4.67 ======== ======== ======== Net income per common share -- diluted..... 3.83 1.76 4.56 ======== ======== ======== Average number of common shares outstanding -- basic..................... 36,975 38,000 (29,640)(1) 45,335 ======== ======== ======= ======== Average number of common and common equivalent shares outstanding -- diluted................... 37,856 39,024 (30,439)(1) 46,441 ======== ======== ======= ========
5 NEW RADIAN GROUP INC. NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL STATEMENTS The unaudited pro forma condensed combined balance sheet has been prepared assuming the acquisition took place as of September 30, 2000 and allocates the total estimated purchase price to the fair value of assets and liabilities of the acquired company based on preliminary valuations. The unaudited pro forma condensed combined statements of income combine Radian's and Enhance Financial Services' historical statements of income and give effect to the acquisition as if it occurred on January 1, 1999, the beginning of the earliest period presented. The total estimated purchase price of Enhance Financial Services has been allocated on a preliminary basis to assets and liabilities based on management's estimates of their fair values with the excess of net assets acquired over costs allocated to the present value of future insurance profits. These allocations are subject to change pending a final determination and analysis of the total purchase price and the fair values of the assets acquired and liabilities assumed. The impact of these changes could be material. (1) Adjustment to reflect the issuance of Radian common stock and related direct acquisition expenses as the total purchase price for the net assets of Enhance Financial Services, based on the assumed conversion of each of the Enhance Financial Services common shares into 0.22 of a Radian common share, the elimination of Enhance Financial Services stockholders' equity and the write-down of Enhance Financial Services' deferred policy acquisition asset, offset by the recognition of the present value of future insurance profits. The present value of future insurance profits of Enhance Financial Services is a preliminary estimate based on current facts and circumstances.
IN THOUSANDS ------------ Current income tax benefit............................. $ 3,884 Enhance Financial Services common stock................ 4,016 Enhance Financial Services additional paid in capital.............................................. 254,763 Enhance Financial Services retained earnings........... 480,688 Enhance Financial Services deferred policy acquisition asset................................. $ 69,721 Deferred income tax liability........................ 24,906 Enhance Financial Services net unrealized loss on investments, net of tax benefit................... 6,066 Enhance Financial Services treasury stock............ 32,586 Radian common stock.................................. 8 Radian additional paid in capital.................... 578,668 Accrued acquisition costs............................ 31,396 -------- -------- Totals................................................. $743,351 $743,351 ======== ========
The following chart indicates the components of the estimated purchase price of the acquisition inherent in the adjusting entry:
IN THOUSANDS ------------ Radian common stock......................................... $553,197 Issuance of Radian options.................................. 25,479 Estimated direct acquisition costs, net of tax.............. 27,512 -------- Total estimated purchase price.................... $606,188 ========
The estimated purchase price will be issued in exchange for the net assets of Enhance Financial Services on the closing date of the merger. The purchase price of Enhance Financial Services reflects the issuance of 8,405,591 shares of Radian common stock at $65.813 per share which is the average closing price of Radian common stock for the 6 three trading days preceding and the three days following the announcement of the acquisition. Under the terms of the merger agreement, Radian has also issued 1,332,120 Radian options to replace Enhance Financial Services options, 938,126 of which are already vested. The value of the assumed Radian option grant is based on a Black-Scholes valuation model assuming an average life of 2.3 years, a risk-free interest rate of 6.75%, volatility of 39.3% and a dividend yield of 0.18%. The following table provides the preliminary allocation of the purchase price inherent in the adjusting entry:
IN THOUSANDS ------------ Net assets of Enhance Financial Services: Cash and investments...................................... $1,072,041 Investment in affiliates.................................. 139,938 Deferred policy acquisition asset......................... 56,549 Other assets, net......................................... 130,721 Unearned premiums......................................... (355,342) Reserve for losses........................................ (66,087) External debt financing................................... (249,382) Deferred credit........................................... (122,250) ---------- Total purchase price........................................ $ 606,188 ==========
(2) Adjustment to accrue the cost of registering Radian shares to be issued for Enhance Financial Services of $154,000.
IN THOUSANDS ------------ Additional paid in capital.................................. $154 Accrued liabilities....................................... $154
(3) Adjustment to reflect the change in amortization expense and the related income tax expense associated with the write-down of Enhance Financial Services' deferred policy acquisition asset, offset by an increase in amortization expense and the related income tax benefit associated with the estimated present value of future insurance profits recognized at January 1, 1999. For the year ended December 31, 1999: Decrease in deferred policy acquisition amortization...... $(18,493) Increase in federal income tax expense.................... 6,473 For the nine months ended September 30, 2000: Decrease in deferred policy acquisition amortization...... $ (9,396) Increase in federal income tax expense.................... 3,288
7 (4) Adjustment to reflect the reversal of an income tax benefit relating to income tax reductions produced by an investment in a portfolio of approximately 500 residential mortgage backed securities consisting of residual interests in real estate mortgage investment conduits ("REMIC") owned by Enhance Financial Services. These deductions were treated by Enhance Financial Services as permanent tax differences due to a partnership exit strategy that will not be executed by Radian. Therefore, the tax deductions from the REMIC residuals will be treated as a timing difference which eliminates the income tax benefit for GAAP purposes. For or at the year ended December 31, 1999: Increase in deferred federal income taxes payable......... $14,406 Increase in federal income tax expense.................... 14,406 For or at the nine months ended September 30, 2000: Increase in deferred federal income taxes payable......... $10,500 Increase in federal income tax expense.................... 10,500
(5) Reflects the adjustments and related income tax expense required to eliminate the amortization of goodwill that was created as a result of prior acquisitions of Enhance Financial Services. For the year ended December 31, 1999: Decrease in goodwill amortization......................... $ (946) Increase in federal income tax expense.................... 331 For the nine months ended September 30, 2000: Decrease in goodwill amortization......................... $(24,196) Increase in federal income tax expense.................... 8,469
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