<PAGE>   1

                        Consolidated Financial Highlights

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------------
                                                            For the Years Ended December 31,
                                                       1997             1996              1995
--------------------------------------------------------------------------------------------------
<S>                                               <C>              <C>               <C>
Income Statement Data:
   Net premiums earned                            $  64,052,155    $  66,961,281    $  67,136,782
   Net investment income                              4,367,807        4,591,651        4,009,564
   Realized investment gains (losses)                 1,481,695          657,875         (276,311)
   Net income (loss)                                 (5,881,173        1,947,953       (5,093,755)
     Per share                                            (3.00)            1.00            (2.62)
   Dividends declared per share                             .30              .30             .285
Balance Sheet Data:
   Total assets                                   $ 161,648,714    $ 144,899,748    $ 138,113,936
   Stockholders' equity                              39,664,901       41,618,973       40,529,114
     Per share                                            20.21            21.32            20.82
   Average investment yield                                5.00%            5.32%            4.82%
Statutory Ratios:
   Statutory combined ratio                               120.3%           108.1%           113.4%
   Net premiums written/statutory surplus ratio        2.0 to 1         2.1 to 1         2.3 to 1
</TABLE>





                    Per Share Market and Dividend Information

<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------
                                                        Price of Common Stock              Dividends
                                                        High               Low               Paid
----------------------------------------------------------------------------------------------------
<S>                                                    <C>                <C>                <C>
1997 QUARTER ENDED:
MARCH 31                                               14                10 1/8              .075
JUNE 30                                                13 1/2            12                  .075
SEPTEMBER 30                                           15 1/2            12  1/8             .075
DECEMBER 31                                            15                11  1/4             .075

1996 Quarter Ended:
March 31                                               11 1/4             9  3/8             .075
June 30                                                13 3/8             9  5/8             .075
September 30                                           13                 9  3/4             .075
December 31                                            11 2/8             9  1/2             .075
</TABLE>

As of February 9, 1998 there were approximately 431 stockholders, not including
shares held beneficially in nominee accounts.




                 Net Premiums Written (In thousands of dollars)

<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------
                                                 For the Years Ended December 31,
                                  1997                      1996                      1995
-------------------------------------------------------------------------------------------------------
<S>                             <C>          <C>          <C>           <C>         <C>           <C>
Personal automobile             $15,598      25.3%        $17,844       25.9%       $19,764       29.4%
Commercial automobile            14,974      24.4          16,272       23.6         14,543       21.6
Commercial multiple peril        13,911      22.6          15,973       23.2         16,097       23.9
Homeowners multiple peril         6,133      10.0           5,506        8.0          4,154        6.2
Other liability                   5,786       9.4           7,646       11.1          6,626        9.8
Fire and allied lines             3,667       6.0           3,506        5.1          3,285        4.9
Inland marine                     1,361       2.2           1,366        2.0          1,439        2.1
All other                            58       0.1             750        1.1          1,407        2.1
-------------------------------------------------------------------------------------------------------
Net premiums written            $61,488     100.0%        $68,863      100.0%       $67,315      100.0%
-------------------------------------------------------------------------------------------------------
</TABLE>


                                       2
<PAGE>   2
            FIVE YEAR COMPARATIVE SUMMARY OF SELECTED FINANCIAL DATA


<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------------------------
                                                                For the Years Ended December 31,
                                            1997             1996            1995             1994             1993
-----------------------------------------------------------------------------------------------------------------------
<S>                                     <C>              <C>             <C>              <C>              <C>
Income Statement Data:
   Premiums earned                      $ 64,052,155     $ 66,961,281    $ 67,136,782     $ 65,346,464     $ 64,081,902
   Net investment income                   4,367,807        4,591,651       4,009,564        4,703,398        5,252,684
   Realized investment gains (losses)      1,481,695          657,875        (276,311)         (31,355)       1,274,693
   Net income (loss)                      (5,881,173)       1,947,953      (5,093,755)       8,249,105        5,722,617
   Net Income (loss) per share                 (3.00)            1.00           (2.62)            4.24             2.95
   Dividends declared per share                  .30              .30            .285              .21              .10
Balance Sheet Data:
   Total assets                         $161,648,714     $144,899,748    $138,113,936     $131,201,491     $135,803,519
   Stockholders' equity                   39,664,901       41,618,973      40,529,114       33,438,366       37,842,559
   Equity per share                            20.21            21.32           20.82            17.18            19.44
   Average investment yield                     5.00%            5.32%           4.82%            5.58%            6.16%
Statutory Ratios:
   Loss and loss adjustment expenses
      to premiums earned                        84.8%            70.9%           73.0%            66.8%            66.9%
   Underwriting expenses to
      premiums written                          36.4             36.4            37.4             36.1             33.0
   Retrospective premium adjustments
      to premiums written                        (.9)              .8             3.0               .4              2.2
-----------------------------------------------------------------------------------------------------------------------
      Statutory combined ratio                 120.3%           108.1%          113.4%           103.3%           102.1%
-----------------------------------------------------------------------------------------------------------------------
   Net premiums written/statutory
      surplus ratio                         2.0 TO 1         2.1 to 1        2.3 to 1         2.1 to 1         2.2 to 1
</TABLE>



                        SELECTED QUARTERLY FINANCIAL DATA


<TABLE>
<CAPTION>
---------------------------------------------------------------------------------
                            Net Premiums    Premiums        Net        Earnings
                               Written       Earned       Income       Per Share
---------------------------------------------------------------------------------
<S>                         <C>           <C>           <C>            <C>
1997
FIRST QUARTER               $16,408,628   $15,944,356   $  (258,833)   $   (.13)
SECOND QUARTER               15,872,624    15,736,393       387,907         .20
THIRD QUARTER                16,959,852    16,904,968       337,056         .17
FOURTH QUARTER               12,246,999    15,466,438    (6,347,303)      (3.23)

1996
First Quarter               $18,119,163   $16,875,476   $ 1,065,799    $    .55
Second Quarter               18,389,001    16,765,029    (1,166,984)       (.60)
Third Quarter                16,064,232    16,527,013       696,931         .36
Fourth Quarter               16,290,161    16,793,763     1,352,207         .69
</TABLE>



                                       13

<PAGE>   3

                MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL
                      CONDITION AND RESULTS OF OPERATIONS


     The following discussion and analysis should be read in conjunction with
the consolidated financial statements and related notes found on pages 20 to 34,
since they contain important information which is helpful in evaluating the
Company's financial position and results of operations.


LIQUIDITY

The Company has consistently been able to generate adequate amounts of cash to
meet its needs and management is unaware of any trends, demands or commitments
which will or are reasonably likely to have a significant effect on the
Company's liquidity.

OPERATING ACTIVITIES. Operating activities during 1997 produced positive net
cash flow despite a decrease in net premiums written and unfavorable
underwriting results during 1997 compared with 1996. The positive cash flow was
primarily the result of a decrease in the amount of funds required for claim
payments during 1997 compared with 1996.

     Net premiums written decreased approximately $7,375,000, or 10.7%, during
1997 compared with 1996 primarily as a result of a decrease in direct premiums
written and an increase in ceded premiums written. Direct premiums written
decreased $2,983,000, or 3.6%, during 1997 compared with 1996. This decrease
resulted primarily from soft market conditions during 1997, as the Company has
tried to remain competitive without engaging in severe price competition or
compromising its underwriting guidelines. The Company continually monitors its
rates on all lines of business and takes corrective actions when underwriting
results indicate it is justified. Although the number of policies in force have
decreased 2.3% in 1997 compared with 1996, the average premium per policy
remained essentially the same, which indicates that the Company maintained
consistent, conservative pricing for policies in all lines of business. The
increase in ceded premiums written was due to unanticipated unfavorable loss
experience under the first layer of the Company's multiple year retrospectively
rated casualty reinsurance contract. Retrospective premium adjustments due the
reinsurer under this contract, increased to $7,714,000 during 1997 compared with
$1,333,000 during 1996. The 1997 accruals reflect loss experience during the
year as well as an estimate of the future losses anticipated in the layer. The
Company has negotiated a fixed price contract for its casualty excess of loss
program for 1998. As a result of these accruals in 1997 and the use of a fixed
price contract for 1998, and while no assurances can be given, the Company
anticipates that the overall cost for this segment of our reinsurance program
will decline during 1998.

     Despite unfavorable underwriting results, which are discussed below, the
amount of funds required for claim payments, net of reinsurance, decreased
approximately $2,856,000, or 7.0%, during 1997 compared with 1996, primarily
attributable to the Company's personal and commercial automobile liability lines
of business. Underwriting results during 1997 were adversely impacted by an
increase of approximately $7,700,000 in the Company's loss and loss adjustment
expense reserves during 1997 as more fully discussed in the "Results of
Operations" section of this discussion.

     As a result of this increase in reserves, the Company announced in February
1998 the suspension of regular quarterly cash dividends to stockholders. It is
not anticipated that dividends to stockholders will resume within the
foreseeable future. Future dividends, if any, will be dependent upon future
favorable operating results of the Company.

     The underwriting results improved significantly during 1996 compared with
1995. Nevertheless, these underwriting results produced negative net cash flow
during 1996. The negative effect on cash flow from the underwriting results was
partially offset by a decrease in policy acquisition costs and an increase in
net investment income during 1996 compared with 1995. The Company's total net
loss resulting from weather-related catastrophes during 1996 decreased
significantly compared with 1995. Nevertheless, the negative cash flow from
underwriting results during 1996 was caused primarily by several weather-related
natural catastrophes. During 1996, the Company's total net loss resulting from
weather-related catastrophes was approximately $3,525,000 compared with
$6,281,000 during 1995. Policy acquisition costs decreased 2.6% during 1996
compared with 1995. This decrease resulted primarily from decreased overhead
expenses during 1996 compared with 1995. Overhead expenses decreased primarily
as a result of a decrease in legal expense. Net investment income increased
14.5% during 1996 compared with 1995, primarily as a result of increased yields
on the Company's derivative investments.



                                       14

<PAGE>   4



     Operating activities provided negative cash flow during 1995 primarily as a
result of an increase in the severity of weather-related natural catastrophes,
the settlement of several large liability claims in the Company's commercial
automobile and other liability lines of business, an increase in policy
acquisition costs and a decrease in net investment income.

     INVESTING ACTIVITIES. During 1997, the Company invested a portion of
available cash balances and the proceeds received from disposition of
investments into investment grade bonds and common stocks. The net cash flow
from investing activities was positive for 1997 because total investment sales
and maturities purchases exceeded total investment purchases.

     As shown in the Company's consolidated balance sheets, the unrealized
appreciation in market value of investments was approximately $6,525,000 at
December 31, 1997, compared to an unrealized appreciation of approximately
$2,080,000 at December 31, 1996, resulting in unrealized gains for 1997 of
approximately $4,445,000. Of that amount, unrealized gains in the Company's bond
portfolio were approximately $1,366,000 with unrealized gains on equity
securities constituting the balance of $3,079,000. These unrealized investment
gains were primarily the result of favorable bond and stock markets which
resulted in significant price appreciation in the Company's debt and equity
portfolios during 1997.

     Approximately $788,000 of the total $1,366,000 in unrealized investment
gains on bonds in 1997 were related to five issues of derivative securities
purchased by the Company in 1993. The Company's debt and equity securities are
reported on the Company's balance sheet at their respective market values which
fluctuate based upon a variety of market factors. Such fluctuations will result
in changes to the Company's unrealized investment gains or losses and will have
a corresponding impact on the Company's stockholders' equity. Substantially all
of the derivative securities mentioned above are known as inverse floaters as
their yields, which are adjusted periodically, vary inversely to certain LIBOR
rates. These derivative securities will probably exacerbate swings in unrealized
investment gains and losses and stockholders' equity in the event of significant
movement in interest rates, particularly LIBOR rates. Additionally, the yield
formulas for these securities will result in commensurate swings in investment
income. On various dates during 1998, $13,350,000 par value of the total
$19,850,000 of these derivative issues will mature, including the Guaranteed
Yield Security discussed below. As a result, net investment income in 1998 for
these derivative securities should decrease by approximately $487,000 compared
with 1997. However, management believes that the reinvestment of the proceeds
from these maturities should yield comparable investment returns, depending on
the portion of such proceeds available for reinvestment and future investment
market conditions. Any unrealized investment gains or losses and changes in
investment income will be reflected in the Company's financial reports. For the
year ended December 31, 1997, the average yield of these derivative investments,
including the guaranteed yield on one such issue discussed below, was
approximately 4.3%, their average term to maturity was one year, and the market
value carried on the Company's balance sheet was approximately $19,172,000. At
the date of the maturity of the Guaranteed Yield Security in March 1998, the
average yield of the remaining derivative investments will be approximately 2.6%
subject to future resets and their average term to maturity will be less that
two years. The market value of the remaining derivative securities as of
December 31, 1997 was approximately $8,184,000.

     Because the derivative securities were issued by government agencies, the
Company believes that their principal is assured at maturity. Barring unforeseen
circumstances, the Company has the ability to hold these debt securities until
their stated maturity. However, if conditions are favorable for their
disposition, the Company may dispose of all or a portion of these securities
prior to maturity. As a matter of investment policy, the Company no longer
invests in inverse floating rate securities.

     In connection with the settlement of an arbitration proceeding in 1995, the
Company received an agreement, effective December 8, 1995, guaranteeing the
yield rate on the largest derivative issue held by it ("Guaranteed Yield
Security"). The Guaranteed Yield Security has a par value of $11,000,000 and
matures in March 1998. The yield rate that is guaranteed equals the weekly
average yield rate for three month treasury bills during each interest period of
the security. The maximum amount guaranteed was $1,500,000 and the guarantee
will terminate no later than the security's maturity date at which time the
final guaranteed payment under the settlement agreement will be due to the
Company. At December 31, 1997, the stated interest rate for the Guaranteed Yield
Security was .063% and the guaranteed yield rate was 5.11%. Based on such
guaranteed yield rate, and assuming no change in the yield rate that determines
the guaranteed yield rate, net investment income earned by this security during
1998 should be approximately $128,000. This guarantee was originally secured by
two letters of credit which both expired prior to December 31, 1997.



                                       15

<PAGE>   5



     As a result of this guarantee, the yield of the Guaranteed Yield Security
is similar to that of a floating rate instrument whose coupon yield resets
weekly to the average three month treasury bill yield rate during each interest
period. The market value of this security at December 31, 1997 was determined
based upon the market values of other securities with similar yield resets and
similar maturities. As a result, the market value for this security as carried
on the Company's balance sheet at December 31, 1997 was approximately
$10,987,000.

     The net cash flow from investing activities was positive for 1996 because
total investment sales and maturities exceeded total investment purchases.
During 1996, the Company's cash flow from operating activities was negative. As
a result, additional funds were raised through the sale of investments. However,
whenever possible during 1996, management invested a portion of available cash
balances and the proceeds received from disposition of investments into
investment grade bonds and common stocks.

     The unrealized appreciation in market value of investments was
approximately $2,080,000 at December 31, 1996, compared to an unrealized
appreciation of approximately $2,384,000 at December 31, 1995, resulting in
unrealized losses for 1996 of approximately $304,000. Of these amounts,
unrealized losses in the Company's bond portfolio were approximately $1,067,000,
offset by unrealized gains on equity securities constituting the balance of
$763,000. The unrealized investment losses were primarily the result of the
negative effects of increased interest rates on the market value of the
Company's debt securities during 1996. Approximately $297,000 of the total
$1,067,000 in unrealized investment losses on bonds in 1996 were related to the
derivative securities purchased by the Company in 1993.

     The net cash flow from investing activities was positive for 1995. Due to
unfavorable underwriting results during 1995, the Company's cash flow from
operating activities was insufficient to cover the payment of claims and
underwriting expenses. As a result, additional funds were raised through the
sale of investments. However, whenever possible during 1995, management invested
a portion of available cash balances and the proceeds received from disposition
of investments into investment grade bonds and common stocks.

     During 1995, the overall returns in bond and stock markets were quite
favorable. As a result, there was significant price appreciation in the
Company's portfolio of equity securities and this, combined with the positive
effects of decreased interest rates on the market value of the Company's fixed
maturity bond portfolio and yield increases in certain derivative investments
held by the Company, resulted in significant unrealized investment gains during
1995. The unrealized appreciation in market value of investments was
approximately $2,384,000 at December 31, 1995, compared to an unrealized decline
of approximately $10,352,000 at December 31, 1994, resulting in unrealized gains
for 1995 of approximately $12,736,000. The unrealized gains in the Company's
bond portfolio constituted approximately $9,275,000 of this total with
unrealized gains on equity securities constituting the balance of $3,461,000.
Approximately $5,176,000 of the total $9,275,000 in unrealized investment gains
on bonds in 1995 were related to the derivative securities purchased by the
Company in 1993.

FINANCING ACTIVITIES. During 1997, the Company and United States National Bank,
Galveston, Texas, renewed and amended an existing line of credit in the
principal amount of $5,000,000, which was entered into on January 1, 1995.
Pursuant to the line of credit agreement, the Company can draw on this line of
credit at any time. The Company entered into this agreement in order to reduce
the need to dispose of investments during unfavorable market conditions in order
to meet potentially significant cash demands that could result, for example,
from a major catastrophic event such as a hurricane. The Company did not borrow
against this line of credit during 1997, 1996 or 1995. According to the terms of
the amended agreement, the collateral securing the line of credit was released
and collateral is only required when the Company has amounts outstanding under
the line of credit.

     In January 1996, the Company received $580,500 proceeds from a loan from
United States National Bank. The Company is required to make monthly payments at
an interest rate of 8.75% until the maturity date of February 1, 2002. The
Company may pre-pay without penalty all or a portion of the principal. These
funds were obtained to finance the purchase of computer software designed to
provide policy processing, claims administration, billing and collection,
reinsurance and management reporting needed as part of the Company's ongoing
effort to enhance its technology and re-engineer its business processes.



                                       16

<PAGE>   6



YEAR 2000 COMPLIANCE. During 1997, the Company upgraded its policy processing
and claims system to the PMSC Point system as a part of its technology
enhancement and Year 2000 compliance initiatives. A migration plan has been
developed and is being implemented to move by October 1, 1998 from the current
release of the PMSC Point system to a subsequent release which, the Company has
been advised by PMSC, is fully Year 2000 compliant. Other Company systems have
been addressed as to Year 2000 compliance and are, or are expected to be, Year
2000 compliant by the second or third quarter of 1998. The Company has received
information from and has been in contact with certain of its vendors to assure
their systems compliance as well, or alternatively, to determine to the extent
possible the extent the Company is vulnerable to those third parties' failure to
achieve Year 2000 compliance and if necessary to develop alternatives. As a
result of the Company's ongoing efforts to reengineer its business processes and
assuming compliance by third parties with whom the Company conducts business,
management believes that the impact on future earnings from efforts to achieve
Year 2000 compliance will not be significant. However, there can be no assurance
that the systems of other companies on which the Company's systems and
operations rely will be timely converted, or that a failure to convert by
another company would not have a material adverse effect on the Company's future
operations.


CAPITAL RESOURCES

The activities of insurance companies are regulated by state authorities and
adequate levels of reserves and equity capital are required to be maintained to
ensure that enough capital is retained in the business to provide sufficient
funds to meet its obligations. Management believes that the Company is in
compliance with all statutory and regulatory requirements and that sufficient
funds have been retained to meet its obligations. The Company has no current
commitments or plans for any new debt or equity financing.


RESULTS OF OPERATIONS

Premiums earned decreased during 1997 compared to 1996 primarily as a result of
soft market conditions experienced during the year. Despite such conditions, the
Company endeavored to remain competitive without engaging in severe price
competition or compromising its underwriting guidelines. Reinsurance costs,
which reduce premiums earned, increased as a result of unfavorable loss
experience under the first layer of the Company's casualty excess of loss
reinsurance contract. When unfavorable loss experience occurs, it creates a
retrospective premium adjustment due the reinsurer, and the total of such
adjustments increased during 1997 compared with 1996. Management believes that
the use of a fixed price excess loss reinsurance contract in 1998 should reduce
the overall cost of the Company's reinsurance program during the coming year.
Management intends to continue conservative expansion of all lines of business
at prices that reflect its experience.

     Net investment income decreased during 1997 compared with 1996 due to a
reduction in invested assets as well as lower portfolio yields. During 1997,
proceeds from the sale of certain investments were used to fund operating
activities of the Company, which resulted in net dispositions of invested
assets, as reflected in the Consolidated Statements of Cash Flows contained in
this report. The portfolio's average investment yield also declined to 5.00% in
1997 from 5.32% in 1996 as a result of increased allocations to lower yielding
common stocks and a decline in the yields offered on new purchases of fixed
maturity investments.

     In an effort to maximize the overall return on the Company's investment
portfolio, the Company elected to take advantage of favorable market conditions
and sold several issues of common and preferred stocks and fixed maturity bonds
which were held in the investment portfolio. As a result, realized investment
gains were approximately $1,482,000 during 1997 compared with $658,000 during
1996.

     Underwriting results were adversely impacted as a result of increases made
during 1997 in the Company's loss and loss adjustment expense reserves
("reserves"). As a result, the loss and loss adjustment expense ratio was 80.9%
for 1997 compared with 69.0% for 1996.

     The Company's independent actuary performed its analysis using 1997
calendar year data. The results of this analysis indicated unexpected
development in loss and loss adjustment expenses for the commercial multiple
peril and other liability lines of business and that the Company's reserves were
below the reserve range called for by such development. After extensive review
of the data and



                                       17

<PAGE>   7



subsequent discussions with the actuary, management believed it to be prudent to
further increase reserves. Loss and loss adjustment expenses were impacted by a
total of approximately $7,700,000 during 1997 as a result of these reserve
increases and other changes in reserves during the year. Management believes
that the Company's loss and loss adjustment expense reserves are reasonable and
adequate to cover the cost of all losses and loss adjustment expenses.

     Management has taken steps which it believes will help to improve loss and
loss adjustment expense development in the future. During 1995 and 1996, the
Company reduced the cost of its claims operations by severing relationships with
the more expensive alternative of independent claims adjusters and replacing
them with in-house staff claims adjusters. One of the largest components of
claims expense is litigation costs. During 1996, the Company instituted a
litigation management plan, which is essentially intended to set Company
standards for legal counsel to use in handling claim litigation for the Company
and acceptable cost standards for all aspects of claims investigation and
litigation performed by attorneys. The Company ceased doing business with those
firms that could not comply with the new standards and have since monitored
litigation activities and billing to assure compliance with the program. As with
any such changes, it will take time to reflect the benefits of these in the
Company's loss and loss adjustment expense payment patterns and the resulting
reserve range.

     Also, as a matter of normal business practice, the Company's reinsurers
conduct both operational and reserve audits of the Company's claims operations.
During the second half of 1997, the Company's reinsurers conducted an
operational review of the Company's claims function with an emphasis on the
casualty lines of business. There were two such audits, which reached
essentially the same conclusions and provided similar improvement suggestions.
The Company's claims function was rated as average and the Company undertook a
number of actions to implement the suggestions made in the audits, as well as
other actions, in order to improve this portion of its operation.

     During 1997, the Company upgraded it's policy processing and claims system
to the PMSC Point system as a part of its technology enhancement and Year 2000
compliance initiatives. During 1998, management intends to take full advantage
of the Company's improved database to get more timely and pertinent information
regarding loss and loss adjustment expenses.

     The policy acquisition cost ratio was 38.1% for 1997 compared with 36.6%
for 1996. This increase was primarily the result of the Company's costs
remaining essentially flat while, as discussed above, its premiums earned
decreased due primarily to the impact on premiums of soft market conditions
during 1997 and increased reinsurance premiums. Certain costs associated with
acquiring new business vary directly with premium volume while others remain
essentially fixed. While advances have been made in 1997 and 1996 in reducing
fixed costs of operating the Company, the costs associated with the Company's
strategic technology initiatives have resulted in fixed costs remaining flat
during 1997 when compared with 1996. When such fixed costs do not decline at the
same time as premiums earned decline, the policy acquisition cost ratio is
increased.

     The Company discontinued writing workers' compensation business in 1997,
however this business was written in previous years on a participation and
assessment basis, whereby the policyholder participated directly in the loss
experience of the policy through retrospective premium adjustments. If loss and
loss adjustment expenses incurred plus the Company's charge against premiums
earned was less than premiums earned under the policy, the difference was
refunded to the insured. Conversely, if the same total exceeded premiums earned
under the policy, the insured was assessed for the excess. As there were no
premiums earned for workers' compensation during 1997 and will not be in future
years, this expense will vary with loss experience under the expired workers'
compensation policies. Such loss experience during 1997 created an assessment
due from insureds compared with 1996 in which loss experience created a refund.

      The Company's deferred tax asset is projected based on the existence of
net operating loss carryforwards available to the Company and its projection of
future taxable income. As a result of the additions made to the Company's
reserves during 1997, the loss and loss adjustment expense ratios used in the
projection of future taxable income increased. As such, this reduced projected
future taxable income and also the total deferred tax asset, which resulted in a
deferred tax provision for 1997 compared with a deferred tax credit



                                       18

<PAGE>   8



during 1996.

     The net loss of the Company was approximately $5,881,000 for 1997 compared
with net income of approximately $1,948,000 during 1996. This resulted primarily
from the increase in the Company's reserves during 1997 as discussed above.

     Primarily as a result of strong competition in a soft market and the
Company's conservative pricing and strict underwriting standards, net premiums
earned decreased slightly during 1996 compared with 1995. Management intends to
continue conservative expansion of the Company's commercial lines of business
and to maintain current levels of premium writings in the personal lines of
business.

     As discussed above, net investment income increased 14.5% during 1996
compared with 1995, resulting in an increase in the Company's average investment
yield to 5.32% for 1996 compared with 4.82% for 1995.

     In an effort to maximize the overall return on the Company's investment
portfolio, management elected to take advantage of favorable market conditions
and in 1996 sold several issues of common and preferred stocks and fixed
maturity bonds which were held in the investment portfolio. As a result,
realized investment gains were approximately $658,000 during 1996 compared with
realized investment losses of approximately $276,000 during 1995.

     The underwriting results improved significantly during 1996 compared with
1995, as reflected in the decrease in loss and loss adjustment expenses
incurred. The loss and loss adjustment expense ratio was 68.3% for 1996 compared
with 73.8% for 1995. This decrease was primarily the result of a smaller number
and decreased severity of weather-related natural catastrophes during 1996
compared with 1995. Claims from weather-related natural catastrophes resulted in
approximately $3,525,000 in net losses during 1996 compared with approximately
$6,281,000 during 1995.

     The policy acquisition cost ratio was 36.6% for 1996 compared with 37.5%
for 1995. The decrease in this ratio resulted primarily from decreased overhead
expenses during 1996 compared with 1995. Overhead expenses decreased primarily
as a result of a decrease in legal expenses. Legal expenses incurred during 1995
included non-recurring expenses in connection with legal assistance used in
obtaining the guarantee of the yield on the Guaranteed Yield Security.
Management has established strategic initiatives to significantly reduce
overhead expense and policy acquisition costs in the long term.

     As a result of favorable loss experience during 1996 on workers'
compensation policies, retrospective premium adjustments on workers'
compensation policies were 0.7% of premiums earned for 1996 compared with 3.0%
for 1995.

     The net income of the Company was approximately $1,948,000 during 1996
compared with net loss of $5,094,000 during 1995. This improvement resulted
primarily from the decrease in claims from weather-related natural catastrophes,
the increase in net investment income, and the realized investment gains during
1996 compared with 1995.

RECENT ACCOUNTING PRONOUNCEMENTS. In June 1997, the Financial Accounting
Standards Board ("FASB") issued SFAS No. 130, "Reporting Comprehensive Income"
which establishes standards for reporting and displaying comprehensive income
and its components. Comprehensive income includes all changes in equity during a
period except those resulting from investments by owners and distributions to
owners. SFAS No. 130 is effective for the Company beginning in 1998. In February
1998, the FASB issued SFAS No. 132, "Employers' Disclosures about Pensions and
Other Postretirement Benefits" which revises required disclosures relating to
pensions and postretirement benefit plans. SFAS No. 132 is also effective for
the Company beginning in 1998. The Company will analyze these pronouncements
during 1998 to determine what, if any, additional disclosures will be required
thereunder.

FORWARD-LOOKING STATEMENTS. Certain statements made herein and in other public
filings and releases by the Company contain "forward-looking" information (as
defined in the Private Securities Litigation Reform Act of 1995) that involve
risk and uncertainty including, but not limited to changes in interest rates;
changes in premium volumes; the frequency and severity of catastrophic events;
increased competition; regulatory and legislative changes; changes in loss
payment patterns; changes in estimated overall adequacy of loss and loss
adjustment expense reserves; changes in key management personnel; changes in
general market or economic conditions; and other risk factors. Although the
Company believes that the expectations reflected in such forward-looking
statements are based upon reasonable assumptions, the Company can give no
assurance that these expectations will be achieved. Actual results and trends in
the future may differ materially depending on a variety of factors including,
but not limited to, the factors that are disclosed in conjunction with the
forward-looking statements included herein and in other public filings and
releases by the Company.



                                       19

<PAGE>   9
                           CONSOLIDATED BALANCE SHEETS


<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------------
                                                                                        December 31,
                                                                                      1997           1996
-------------------------------------------------------------------------------------------------------------
<S>                                                                               <C>            <C>
ASSETS
Investments:
   Fixed maturities - bonds:
      Available for sale - at market value (amortized cost $71,335,875
         in 1997 and $73,598,053 in 1996)                                         $ 71,213,819   $ 72,110,261
   Equity securities:
      Preferred stocks - at market value (cost $949,905 in 1997
         and $1,390,189 in 1996)                                                       972,407      1,377,438
      Common stocks - at market value (cost $11,065,265 in 1997
         and $8,839,325 in 1996)                                                    17,690,075     12,420,256
   Mortgage loans on real estate                                                                       19,710
-------------------------------------------------------------------------------------------------------------
         Total investments                                                          89,876,301     85,927,665
Cash and Cash Equivalents                                                            8,174,074      4,349,953
Accrued Investment Income                                                              761,421        826,791
Premiums in Course of Collection                                                     4,615,040      4,093,476
Direct Premium Bills Receivable, Net                                                11,855,079      9,659,722
Reinsurance Balances Receivable                                                     26,280,329     18,689,412
Prepaid Reinsurance Premiums                                                         1,803,202        651,050
Property and Equipment, Net                                                          3,888,399      4,072,394
Deferred Policy Acquisition Costs                                                    8,562,238      9,375,133
Deferred Income Taxes                                                                3,889,000      4,743,000
Other Assets                                                                         1,943,631      2,511,152
-------------------------------------------------------------------------------------------------------------
Total                                                                             $161,648,714   $144,899,748
-------------------------------------------------------------------------------------------------------------


LIABILITIES AND STOCKHOLDERS' EQUITY
Losses and Loss Adjustment Expenses:
   Unpaid losses                                                                  $ 54,291,620   $ 47,476,034
   Unpaid loss adjustment expenses                                                  16,763,162      8,125,895
Unearned Premiums                                                                   34,913,172     36,325,073
Reinsurance Balances Held or Payable                                                 6,703,466      1,657,874
Notes Payable to Bank                                                                  432,473        515,981
Accounts Payable and Other Accrued Liabilities                                       8,879,920      9,179,918
-------------------------------------------------------------------------------------------------------------
         Total Liabilities                                                         121,983,813    103,280,775
-------------------------------------------------------------------------------------------------------------


Contingencies
Stockholders' Equity:
   Preferred stock, authorized 2,000,000 shares; none outstanding
   Common stock, $3.33 1/3 par value; authorized, 2,500,000 shares;
      outstanding shares 1,962,410 in 1997 and 1,951,910 in 1996                     6,541,351      6,506,351
   Paid-in surplus                                                                  13,097,668     13,061,709
   Unrealized appreciation in market value of investments                            6,525,256      2,080,388
   Retained earnings                                                                13,500,626     19,970,525
-------------------------------------------------------------------------------------------------------------
         Total Stockholders' Equity                                                 39,664,901     41,618,973
-------------------------------------------------------------------------------------------------------------
Total                                                                             $161,648,714   $144,899,748
-------------------------------------------------------------------------------------------------------------
</TABLE>



          The accompanying notes to consolidated financial statements
               are an integral part of these financial statements.


                                       20

<PAGE>   10

                        CONSOLIDATED STATEMENTS OF INCOME


<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------
                                                                  For the Years Ended December 31,
                                                               1997            1996            1995
-------------------------------------------------------------------------------------------------------
<S>                                                        <C>             <C>             <C>
Premiums and Other Income
   Premiums earned                                         $ 64,052,155    $ 66,961,281    $ 67,136,782
   Net investment income                                      4,367,807       4,591,651       4,009,564
   Realized investment gains (losses)                         1,481,695         657,875        (276,311)
   Interest on premium bills receivable and other income        723,319         743,892         730,211
-------------------------------------------------------------------------------------------------------
         Total                                               70,624,976      72,954,699      71,600,246
-------------------------------------------------------------------------------------------------------
Expenses
   Losses and loss adjustment expenses:
      Losses incurred                                        38,532,416      38,916,069      40,862,977
      Loss adjustment expenses                               13,303,194       7,292,287       8,703,295
   Policy acquisition costs                                  24,400,724      24,531,623      25,188,691
   Retrospective premium adjustments on workers'
      compensation policies                                    (580,984)        511,767       2,020,126
-------------------------------------------------------------------------------------------------------
         Total                                               75,655,350      71,251,746      76,775,089
-------------------------------------------------------------------------------------------------------
Income (Loss) Before Federal Income Tax                      (5,030,374)      1,702,953      (5,174,843)
Provision (Credit) for Federal Income Tax
   Current                                                       (3,201)        (13,088)
   Deferred                                                     854,000        (245,000)        (68,000)
-------------------------------------------------------------------------------------------------------
      Total                                                     850,799        (245,000)        (81,088)
-------------------------------------------------------------------------------------------------------
Net Income (Loss)                                          $ (5,881,173)   $  1,947,953    $ (5,093,755)
-------------------------------------------------------------------------------------------------------
Net Income (Loss) Per Share                                $      (3.00)   $       1.00    $      (2.62)
-------------------------------------------------------------------------------------------------------
Dividends Declared Per Share                               $        .30    $        .30    $       .285
-------------------------------------------------------------------------------------------------------
</TABLE>

          The accompanying notes to consolidated financial statements
               are an integral part of these financial statements.



                                       21
<PAGE>   11

                      CONSOLIDATED STATEMENTS OF CASH FLOWS


<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------------------
                                                                   For the Years Ended December 31,
                                                                1997            1996            1995
--------------------------------------------------------------------------------------------------------
<S>                                                         <C>             <C>             <C>
Operating Activities
   Net income (loss)                                        $ (5,881,173)   $  1,947,953    $ (5,093,755)
   Adjustments to reconcile net income (loss) to net cash
      flow from operating activities:
   Decrease (Increase) in:
      Premiums in course of collection                          (521,564)        200,093       1,669,215
      Direct premium bills receivable                         (2,195,357)     (1,391,982)       (358,847)
      Reinsurance balances receivable                         (7,590,917)     (6,521,653)     (1,379,088)
      Prepaid reinsurance premiums                            (1,152,152)         65,582         610,852
      Deferred policy acquisition costs                          812,895        (533,428)        255,759
      Deferred income taxes                                      854,000        (245,000)        (68,000)
      Other assets                                               567,521         274,116          34,031
   Increase (Decrease) in:
      Unpaid losses and loss adjustment expenses              15,452,853       4,436,505         248,648
      Unearned premiums                                       (1,411,901)      1,835,695        (432,877)
      Reinsurance balances held or payable                     5,045,592      (1,186,824)       (932,849)
      Accounts payable and other accrued liabilities            (299,998)         94,596         938,775
   Realized investment (gains) or losses                      (1,481,695)       (657,875)        276,311
   Depreciation                                                  412,396         455,274         419,714
   Other                                                         160,478          73,634         109,127
--------------------------------------------------------------------------------------------------------
         Net cash flow from operating activities               2,770,978      (1,153,314)     (3,702,984)
--------------------------------------------------------------------------------------------------------
Investing Activities
   Sale of bonds                                               5,215,019       9,848,321       9,252,615
   Maturity of bonds                                           5,567,344       9,304,151       5,761,836
   Sale of preferred stocks                                                      184,396          49,338
   Redemption of preferred stocks                                455,302         705,368         170,018
   Sale of common stocks                                       3,230,021       2,936,366       6,234,399
   Maturity of long-term certificates of deposit                       0          60,000
   Purchase of bonds                                          (8,307,715)    (19,746,127)    (16,018,351)
   Purchase of common stocks                                  (3,973,749)     (2,090,731)       (496,370)
   Purchase of property and equipment                           (250,632)       (446,893)       (858,616)
   Other                                                        (281,172)          4,895           4,430
--------------------------------------------------------------------------------------------------------
         Net cash flow from investing activities               1,654,418         759,746       4,099,299
--------------------------------------------------------------------------------------------------------
Financing Activities
   Proceeds received from bank loan                                              580,500
   Payments on bank loan                                         (83,508)        (64,519)
   Cash dividends paid to stockholders                          (588,726)       (584,650)       (554,845)
   Proceeds received from exercise of stock options               70,959          30,624           2,552
--------------------------------------------------------------------------------------------------------
         Net cash flow from financing activities                (601,275)        (38,045)       (552,293)
--------------------------------------------------------------------------------------------------------
Net Increase (Decrease) in Cash and Cash Equivalents           3,824,121        (431,613)       (155,978)
--------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents, January 1                           4,349,953       4,781,566       4,937,544
--------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents, December 31                      $  8,174,074    $  4,349,953    $  4,781,566
--------------------------------------------------------------------------------------------------------
</TABLE>

          The accompanying notes to consolidated financial statements
               are an integral part of these financial statements.



                                       22
<PAGE>   12


               CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY


<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------------------------------
                                                             For the Three Years Ended December 31, 1997
-------------------------------------------------------------------------------------------------------------------------------
                                                                                                Unrealized
                                                                                               Appreciation
                                                  Common Stock                                 (Decline) in
                                                     Issued                     Paid-in        Market Value        Retained
                                            Shares           Par Value          Surplus       of Investments       Earnings
-------------------------------------------------------------------------------------------------------------------------------
<S>                                         <C>           <C>              <C>               <C>                <C>
Balance, January 1, 1995                    1,946,710     $   6,489,018    $   13,045,866    $   (10,352,340)   $  24,255,822
   Net loss                                                                                                        (5,093,755)
   Cash dividends ($.285 per share)                                                                                  (554,845)
   Change in market value of investments                                                          12,736,796
   Common Stock issued in connection
      with stock option plans                     400             1,333             1,219
-------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1995                  1,947,110         6,490,351        13,047,085          2,384,456       18,607,222
   Net income                                                                                                       1,947,953
   Cash dividends ($.30 per share)                                                                                   (584,650)
   Change in market value of investments                                                            (304,068)
   Common stock issued in connection
      with stock option plans                   4,800            16,000            14,624
-------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1996                  1,951,910         6,506,351        13,061,709          2,080,388       19,970,525
   Net loss                                                                                                        (5,881,173)
   Cash dividends ($ .30 per share)                                                                                  (588,726)
   Change in market value of investments                                                           4,444,868
   Common stock issued in connection
      with stock option plans                  10,500            35,000            35,959
-------------------------------------------------------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 1997                  1,962,410     $   6,541,351    $   13,097,668    $     6,525,256    $  13,500,626
-------------------------------------------------------------------------------------------------------------------------------
</TABLE>

          The accompanying notes to consolidated financial statements
               are an integral part of these financial statements.



                                       23

<PAGE>   13

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

--------------------------------------------------------------------------------
For the Three Years Ended December 31, 1997


1.  SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES

CONSOLIDATION. The consolidated financial statements include the accounts of
American Indemnity Financial Corporation (the "Company"), American Indemnity
Company ("American Indemnity") and American Indemnity's wholly-owned
subsidiaries, American Fire and Indemnity Company, Texas General Indemnity
Company and American Computing Company and American Indemnity's affiliate,
American Indemnity Lloyds. All material intercompany balances and transactions
have been eliminated in consolidation.

BASIS OF PRESENTATION. The consolidated financial statements have been prepared
in conformity with generally accepted accounting principles ("GAAP"). These
principles differ from practices prescribed or permitted by regulatory
authorities (the "statutory method") in the following material respects:

(a)  Under GAAP, commissions, salaries, premium taxes and other costs associated
     with writing new business are deferred and amortized against the related
     earned premiums, whereas under the statutory method those costs are
     expensed as incurred.

(b)  Under GAAP, the cost of furniture, fixtures and automobiles is capitalized
     and depreciation is recorded thereon; while under the statutory method
     certain assets are depreciated over different lives and certain costs are
     expensed as incurred.

(c)  Under GAAP, a deferred federal income tax asset is recorded which is
     attributable to the estimated recognition of the tax benefit of a portion
     of the Company's net operating loss carryforward. No deferred federal
     income tax is recorded under the statutory method.

(d)  Under GAAP, certain reserves required for statutory purposes are recorded
     as restrictions of retained earnings; such reserves, under the statutory
     method, are classified as liabilities on the balance sheet.

USE OF ESTIMATES. The preparation of financial statements in conformity with
generally accepted accounting principles 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 revenue and expenses during the reported
periods. Actual results could differ from those estimates.

PERMITTED STATUTORY ACCOUNTING PRACTICES. American Indemnity, domiciled in
Texas, prepares its statutory financial statements in accordance with accounting
practices prescribed or permitted by the Texas Department of Insurance.
Prescribed statutory accounting practices include a variety of publications of
the National Association of Insurance Commissioners ("NAIC"), as well as state
laws, regulations, and general administrative rules. Permitted statutory
accounting practices encompass all accounting practices not so prescribed.

     In all material respects, the Company does not use any permitted statutory
accounting practices in preparing its statutory financial statements which
differ from prescribed statutory accounting practices. Also, no material
transactions have arisen which prescribed statutory accounting practices do not
address.

INVESTMENTS. Fixed maturities are purchased to support the investment strategies
of the Company, which are based on many factors including rate of return,
maturity, credit risk, tax considerations and regulatory requirements. The
Company's investments in fixed maturities are recorded entirely as available for
sale and are stated at market value, accordingly.

     Investments in equity securities are stated at market value.

     Unrealized gains or losses on investments which are reported at market
value are credited or charged to stockholders' equity, net of a provision for
federal income tax, if any. Gains or losses on disposition are computed by the
identified certificate method and are recorded in the income statement at the
date of disposition.


                                       24
<PAGE>   14



DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS. In preparing disclosures
about the fair value of financial instruments, the Company has assumed that the
carrying amount approximates fair value for cash and cash equivalents,
receivables and payables because of the short maturities of those instruments.
The fair value of investments is estimated based on quoted market values when
available, independent pricing services, or on the current interest rates
available to the Company for investments with similar terms and remaining
maturities. At December 31, 1997 and 1996, the fair market value of all of the
Company's financial instruments approximated their reported values.

CASH AND CASH EQUIVALENTS. For purposes of reporting cash flows, the Company
considers all highly liquid debt instruments, purchased with a maturity of three
months or less, and all money market investments to be cash equivalents.

PROPERTY AND DEPRECIATION. Property and equipment is stated at cost.
Depreciation is computed principally using the straight-line method over the
estimated useful lives of the related assets ranging from three to forty years.

UNEARNED PREMIUMS. Insurance premiums are included in income as earned on the
semi-monthly pro-rata basis over the term of the related policies. The Company
considers anticipated investment income in determining whether a premium
deficiency exists.

UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES. The liability for unpaid losses is
based upon the aggregate of estimates for losses reported prior to the end of
the accounting period and estimates for unreported losses based on experience.
Unpaid loss adjustment expenses are based on historical ratios of adjustment
expenses to losses paid.

RETROSPECTIVE PREMIUMS. Retrospective premium adjustments on workers'
compensation policies represent refunds to (assessments due from) insureds which
reflect the difference between the premiums earned, net of American Indemnity's
charge against premiums earned, and losses and loss adjustment expenses
incurred.

INCOME TAXES. The provision or credit for federal income tax is based on
reported income, adjusted for differences arising in revenue or expense items,
per applicable tax laws and regulations, between reported income and taxable
income. The deferred portion relates to the change in the deferred tax asset or
liability, which arises from the current year's change in temporary differences
between the tax and book basis of assets or liabilities and the valuation
allowance related to the deferred tax asset.

     The deferred tax asset recorded in the Company's balance sheets is
attributable to the estimated recognition of the tax benefit of a portion of its
net operating loss carryforward.

PER SHARE DATA. In 1997, the Company adopted Statement of Financial Accounting
Standards ("SFAS") No. 128, "Earnings per Share." This statement requires that
basic and diluted earnings per share be presented. All prior period per share
amounts have been restated in accordance with the new requirements. The weighted
average number of shares outstanding was 1,961,602 for 1997, 1,948,710 for 1996,
and 1,946,843 for 1995. The weighted average number of shares outstanding on the
diluted basis was 1,963,407 for 1997, 1,954,067 for 1996 and 1,954,421 for 1995.
As the effect of the diluted shares was immaterial, all per share amounts
presented represent both basic and diluted earnings per share.

RECENT ACCOUNTING PRONOUNCEMENTS. In June 1997, the Financial Accounting
Standards Board ("FASB") issued SFAS No. 130, "Reporting Comprehensive Income"
which establishes standards for reporting and displaying comprehensive income
and its components. Comprehensive income includes all changes in equity during a
period except those resulting from investments by owners and distributions to
owners. SFAS No. 130 is effective for the Company beginning in 1998. In February
1998, the FASB issued SFAS No. 132, "Employers' Disclosures about Pensions and
Other Postretirement Benefits" which revises required disclosures relating to
pensions and postretirement benefit plans. SFAS No. 132 is also effective for
the Company beginning in 1998. The Company will analyze these pronouncements
during 1998 to determine what, if any, additional disclosures will be required
thereunder.


                                       25

<PAGE>   15



2.  INVESTMENTS AND INVESTMENT INCOME

FIXED MATURITIES - BONDS. The amortized cost and estimated market values of
investments in fixed maturities - bonds are as follows:

<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------------------------------------------------
                                                                                          December 31, 1997
                                                                                       Gross             Gross         Estimated
                                                                      Amortized     Unrealized        Unrealized        Market
                                                                        Cost           Gains            Losses           Value
---------------------------------------------------------------------------------------------------------------------------------
<S>                                                                <C>             <C>               <C>            <C>
United States Government and Government Agencies and Authorities   $  18,688,192   $    208,941      $     39,266   $ 18,857,867
Mortgage-backed Securities issued by U. S.
  Government Agencies and Authorities                                 29,274,280         74,247           723,989     28,624,538
Collateralized Mortgage Obligations                                   13,963,442         80,478            26,838     14,017,082
States, Municipalities and Political Subdivisions                      1,326,375         80,272               909      1,405,738
All Other                                                              8,083,586        225,008                        8,308,594
---------------------------------------------------------------------------------------------------------------------------------
  Totals                                                           $  71,335,875   $    668,946      $    791,002   $ 71,213,819
---------------------------------------------------------------------------------------------------------------------------------
</TABLE>


<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------------------------------------------------
                                                                                          December 31, 1996
                                                                                       Gross             Gross         Estimated
                                                                      Amortized     Unrealized        Unrealized        Market
                                                                        Cost           Gains            Losses           Value
---------------------------------------------------------------------------------------------------------------------------------
<S>                                                                <C>             <C>               <C>            <C>
United States Government and Government Agencies and Authorities   $  21,954,272   $    151,756      $    145,278   $ 21,960,750
Mortgage-backed Securities issued by U. S.
  Government Agencies and Authorities                                 27,627,789         13,084         1,599,173     26,041,700
Collateralized Mortgage Obligations                                   15,975,313         62,260            99,233     15,938,340
States, Municipalities and Political Subdivisions                      2,529,867         67,026             5,234      2,591,659
All Other                                                              5,510,812         67,000                        5,577,812
---------------------------------------------------------------------------------------------------------------------------------
  Totals                                                           $  73,598,053   $    361,126      $  1,848,918   $ 72,110,261
---------------------------------------------------------------------------------------------------------------------------------
</TABLE>

     The market value on one inverse floating rate derivative issue, which
matures in March 1998, with a par value of $11,000,000 is determined based on an
agreement the Company received in connection with an arbitration proceeding in
1995. The agreement provided a minimum guaranteed yield and effectively
converted the security into a floating rate instrument whose coupon yield resets
weekly to the average three month treasury bill rate during each interest
period. The market value of this security at December 31, 1997 was determined
based upon the market values of other securities with similar yield resets and
similar maturities. As a result, the market value carried on the Company's
balance sheet at December 31, 1997 for this security was approximately
$10,987,000. The market value of this security, exclusive of the guaranteed
yield agreement was approximately $10,890,000 at December 31, 1997.

     At December 31, 1997, bonds with an amortized cost of approximately
$8,663,000 were on deposit with regulatory authorities.

     The amortized cost and estimated market value of fixed maturities at
December 31, 1997, by estimated maturity are shown below. Actual maturities will
differ from estimated maturities because borrowers may have the right to call or
prepay obligations with or without call or prepayment penalties.


<TABLE>
<CAPTION>
-----------------------------------------------------------------------------
                                                    December 31, 1997
                                                                  Estimated
                                               Amortized           Market
Maturity Distribution                            Cost               Value
-----------------------------------------------------------------------------
<S>                                         <C>                <C>
Due in one year or less                     $  21,993,148      $  21,959,061
Due after one year through five years          38,812,399         38,350,346
Due after five years through ten years          7,900,750          8,211,144
Due after ten years                             2,629,578          2,693,268
-----------------------------------------------------------------------------
  Totals                                    $  71,335,875      $  71,213,819
-----------------------------------------------------------------------------
</TABLE>



                                       26
<PAGE>   16



INVESTMENT GAINS AND LOSSES. Realized investment gains and losses and unrealized
appreciation or decline in market value of investments are as follows:

<TABLE>
<CAPTION>
----------------------------------------------------------------------------------
                                                 Years Ended December 31,
                                           1997            1996            1995
----------------------------------------------------------------------------------
<S>                                   <C>             <C>             <C>
Realized Investment Gains (Losses):
   Fixed maturities-Bonds             $    (15,535)   $     72,391    $   (213,516)
   Equity securities                     1,497,230         585,484         (62,795)
----------------------------------------------------------------------------------
  Total                                  1,481,695         657,875        (276,311)
Unrealized Appreciation (Decline)
  in Market Value of Investments:
   Fixed maturities-Bonds                1,365,736      (1,068,353)      9,288,407
   Equity Securities                     3,079,132         772,620       3,461,895
----------------------------------------------------------------------------------
  Total                                  4,444,868        (295,733)     12,750,302
Total                                 $  5,926,563    $    362,142    $ 12,473,991
----------------------------------------------------------------------------------
</TABLE>


     Proceeds from sales of investments during 1997, 1996 and 1995 were
$7,721,611, $13,012,386, and $15,706,370, respectively. The gross realized
investment gains and losses for such sales were as follows: Realized investment
gains: 1997 - $1,487,300; 1996 - $803,138; and 1995 - $1,061,546. Realized
investment losses: 1997 - $20,773; 1996 - $160,025; and 1995 - $1,415,132. The
gross unrealized gains and losses on equity securities at December 31, 1997 were
approximately $6,942,000 and $295,000, respectively.

NET INVESTMENT INCOME.  Investment income and expenses are as follows:

<TABLE>
<CAPTION>
----------------------------------------------------------------------------
                                           Years Ended December 31,
                                     1997            1996            1995
----------------------------------------------------------------------------
<S>                             <C>             <C>             <C>
Fixed Maturities - Bonds        $  3,909,666    $  4,150,909    $  3,376,965
Equity Securities:
  Common stocks                      537,601         464,839         639,790
  Preferred stocks                    90,547         146,513         188,101
Mortgage Loans on Real Estate          1,313           2,199           2,634
Other Short-Term Investments         214,857         227,643         191,259
----------------------------------------------------------------------------
Total Investment Income            4,753,984       4,992,103       4,398,749
Less Investment Expenses            (386,177)       (400,452)       (389,185)
----------------------------------------------------------------------------
Net Investment Income           $  4,367,807    $  4,591,651    $  4,009,564
----------------------------------------------------------------------------
</TABLE>


3.  PROPERTY AND EQUIPMENT

Property and equipment and accumulated depreciation are as follows:

---------------------------------------------------------------------------
                                                    December 31,
                                               1997               1996
---------------------------------------------------------------------------
Land                                      $     263,503      $     263,503
Building and Improvements                     5,862,085          5,835,467
Furniture, Fixtures and Equipment             2,838,240          2,588,784
Automobiles                                     261,575            398,884
---------------------------------------------------------------------------
  Total                                       9,225,403          9,086,638
Less Accumulated Depreciation                 5,337,004          5,014,244
---------------------------------------------------------------------------
Property and Equipment, Net               $   3,888,399      $   4,072,394
---------------------------------------------------------------------------




                                       27
<PAGE>   17


4.  LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES

Reserving for all property and casualty claims continues to be a complex and
uncertain process, requiring the use of informed estimates and judgments. As
additional experience and other data become available and are reviewed or as new
or improved methodologies are developed or as current law changes, estimates and
judgments may be revised. Any such revisions could result in future changes in
estimates of losses or reinsurance recoverables, and would be reflected in
results of operations for the period in which the estimates are changed. While
the effect of any such changes in estimates of losses or reinsurance
recoverables could be material to future results of operations, management does
not expect such changes to have a material effect on the Company's liquidity or
financial condition. In management's judgment, information currently available
has been appropriately considered in estimating loss reserves and reinsurance
recoverables.

     The table below is a reconciliation of beginning and ending reserve
balances for loss and loss adjustment expenses for the years ended December 31:


<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------
                                                                    1997          1996          1995
----------------------------------------------------------------------------------------------------
<S>                                                          <C>           <C>           <C>
Gross reserves, beginning of year                            $55,602,000   $51,165,000   $50,917,000
Reinsurance recoverable, beginning of year                    18,769,000    11,974,000    10,624,000
----------------------------------------------------------------------------------------------------
Net reserves, beginning of year                               36,833,000    39,191,000    40,293,000
Net incurred loss and loss adjustment expenses related to:
  Current year                                                44,016,000    44,431,000    47,159,000
  Prior years                                                  7,820,000     1,777,000     2,407,000
----------------------------------------------------------------------------------------------------
Total net incurred                                            51,836,000    46,208,000    49,566,000
Net paid loss and loss adjustment expenses related to:
  Current year                                                21,708,000    24,941,000    27,910,000
  Prior years                                                 21,521,000    23,625,000    22,758,000
----------------------------------------------------------------------------------------------------
Total net paid                                                43,229,000    48,566,000    50,668,000
Net reserves, end of year                                     45,440,000    36,833,000    39,191,000
Reinsurance recoverable, end of year                          25,615,000    18,769,000    11,974,000
----------------------------------------------------------------------------------------------------
Gross reserves at December 31                                $71,055,000   $55,602,000   $51,165,000
----------------------------------------------------------------------------------------------------
</TABLE>

     As a result of changes in estimates of insured events in prior years, the
provision of loss and loss adjustment expenses increased by $7,820,000 in 1997
and $1,777,000 in 1996. The Company's loss and loss adjustment expense reserves
were reviewed by the Company's independent actuary. Based on this analysis the
Company strengthened its reserves to a level deemed appropriate (approximately
$7,700,000) in view of unexpected development in losses and loss adjustment
expenses in several major lines.

     The Company's exposure to environmental type claims has been insignificant.
However, liabilities have been recognized for known claims when sufficient
information has been developed to indicate the involvement of a specific
insurance policy and management can reasonably estimate its liability.


5.  FEDERAL INCOME TAX

Deferred income taxes reflect the net tax effects of (a) temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes and (b) operating loss
carryforwards. The tax effects of significant items comprising the Company's net
deferred income taxes as of December 31, 1997 and December 31, 1996 are as
follows:


<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------
                                                                 December 31,
                                                            1997            1996
-----------------------------------------------------------------------------------
<S>                                                    <C>             <C>
Deferred tax liabilities:
  Deferred policy acquisition costs                    $ (2,911,161)   $ (3,187,545)
  Differences between book and tax basis of property       (301,974)       (320,161)
  Unrealized investments gains                           (2,218,587)       (707,332)
  Other                                                    (303,863)       (341,959)
-----------------------------------------------------------------------------------
                                                         (5,735,585)     (4,556,997)
-----------------------------------------------------------------------------------
Deferred tax assets:
  Reserves not currently deductible                       5,355,530       5,167,237
  Operating loss carryforwards                           14,230,288      12,189,198
-----------------------------------------------------------------------------------
                                                         19,585,818      17,356,435
Net asset                                                13,850,233      12,799,438
Valuation allowance                                      (9,961,233)     (8,056,438)
-----------------------------------------------------------------------------------
Net deferred tax assets                                $  3,889,000    $  4,743,000
-----------------------------------------------------------------------------------
</TABLE>


                                       28

<PAGE>   18



     The Company is required to establish a valuation allowance for any portion
of the deferred tax asset that management believes will not be realized. The net
change in the total valuation allowance for the year ended December 31, 1997,
was an increase of $1,904,795. Based on a review of anticipated future earnings
and all other available evidence, both positive and negative, management has
concluded that it is "more likely than not" that the Company's deferred tax
asset recognized of $3,889,000 will be realized.

     The variance from federal statutory tax rates for each of the years
indicated below consisted of the following elements:

<TABLE>
<CAPTION>
------------------------------------------------------------------------------------------------------------------
                                                                                  Years Ended December 31,
                                                                             1997           1996           1995
------------------------------------------------------------------------------------------------------------------
<S>                                                                      <C>            <C>            <C>
Federal income tax provision (credit) computed at statutory rate (34%)   $(1,710,327)   $   579,004    $(1,759,445)
Increase in tax credit, or decrease in tax
   provision, resulting from:
  Tax exempt bond interest                                                   (37,303)       (75,135)       (99,375)
  Tax exempt dividends (70% of amount
   received from domestic corporations)                                     (149,499)      (145,502)      (178,595)
Reduction (recognition) of deferred tax asset                                854,000       (245,000)       (68,000)
Other                                                                         37,285         33,102         44,320
Reduction in tax provision (credit) for
  current year net operating loss limitation                               1,856,643       (391,469)     1,980,007
------------------------------------------------------------------------------------------------------------------
Provision (credit) for federal income tax                                $   850,799    $  (245,000)   $   (81,088)
------------------------------------------------------------------------------------------------------------------
</TABLE>

     The Company has a net operating loss carryforward for tax purposes of
$41,853,788, which expires if not previously utilized, in 1998 - $3,163,998;
1999 - $7,384,546; 2000 - $5,712,421; 2001 - $4,927,522; 2002 - $2,271,256; 2003
- $621,205; 2004 - $4,596,950; 2005 - $1,246,728; 2006 - $118,137; 2007 -
$43,352; 2008 - $13,450; 2009 - $13,410; 2010 - $4,604,277; 2011 - $989,347; and
2012 - $6,147,189.

     The Company received a federal income tax refund of $3,201 in 1997, paid
federal income tax of $15,000 in 1996 and received a federal income tax refund
of $36,779 in 1995.


6.  REINSURANCE AND CONTINGENCIES

Property insurance risks are reinsured under treaty arrangements whereby
$900,000 of losses in excess of $100,000 are automatically reinsured. American
Indemnity has additional automatic property facultative reinsurance agreements
for losses in excess of $1,000,000 up to a maximum of $2,300,000. Therefore, the
liability of American Indemnity on property risks is effectively limited to a
maximum of $100,000.

     American Indemnity carries excess catastrophe reinsurance which covers 95%
of all losses up to $36,000,000 in excess of $4,000,000. Additionally, American
Indemnity carries aggregate excess property and automobile catastrophe
reinsurance which covers 95% of all losses up to $4,000,000 in excess of
$2,000,000, subject to a $200,000 per occurrence retention.

     All claims on automobile liability and casualty insurance over $150,000 up
to $2,000,000 are automatically reinsured under a treaty.



                                       29
<PAGE>   19



Effective January 1, 1998, American Indemnity's retention for these claims will
increase to $175,000 from $150,000.

     American Indemnity, however, is contingently liable if the reinsurance
companies are unable to meet their obligations since such obligations would
become a direct liability of American Indemnity.

     Premiums earned, losses and loss adjustment expenses incurred, and unpaid
losses and loss adjustment expenses have been reduced by transactions with
reinsurance companies as follows:


<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------
                                                        Years Ended December 31,
                                                    1997          1996          1995
---------------------------------------------------------------------------------------
<S>                                             <C>           <C>           <C>
Premiums Earned:
  Catastrophe reinsurance                       $ 3,862,049   $ 4,216,768   $ 3,996,420
  Other reinsurance                              14,017,891    10,488,973    10,846,861
---------------------------------------------------------------------------------------
Total                                            17,879,940    14,705,741    14,843,281
---------------------------------------------------------------------------------------
Losses and Loss Adjustment Expenses Incurred:
  Catastrophe reinsurance                                                     2,700,000
  Other reinsurance                              15,779,541    13,025,638     8,167,619
---------------------------------------------------------------------------------------
Total                                            15,779,541    13,025,638    10,867,619
---------------------------------------------------------------------------------------
Unpaid Losses and Loss Adjustment
   Expenses at December 31                      $25,614,536   $18,768,740   $11,974,375
---------------------------------------------------------------------------------------
</TABLE>

     American Indemnity maintains loss reserves to cover the ultimate net cost
of losses on reported and unreported claims and loss adjustment expenses. In
view of the variability inherent in the estimation of such loss reserves, should
the ultimate net cost of such items prove to be substantially greater than the
loss reserves, the Company's operations, earnings and surplus could be adversely
affected. Management believes, however, that the Company's aggregate loss
reserves are reasonable and adequate to cover such ultimate net costs.


7.  STOCKHOLDERS' EQUITY

American Indemnity may pay cash dividends only from statutory basis retained
earnings, exclusive of special surplus funds and restricted reserves.
Furthermore, under Texas law, American Indemnity may not pay a dividend without
the consent of the Texas Insurance Commissioner if such dividend and all other
dividends paid during the preceding twelve months would exceed the greater of
(i) 10% of its statutory surplus as regards to policyholders as of the end of
the preceding calendar year or (ii) its statutory net investment income for such
year.

     The NAIC has established various model laws, regulations and guidelines as
part of its regulatory oversight of insurance companies. A state must adopt
these laws in order to maintain its accreditation from the NAIC. The NAIC Model
Insurance Company System Regulatory Act ("NAIC Model Act") contains restrictions
regarding payment of dividends which differ from restrictions under Texas law.
Although the state of Texas has not yet adopted these restrictions, the Texas
Department of Insurance has given notice it will vigorously scrutinize any
dividends deemed extraordinary under this act and may take a variety of actions.
The NAIC Model Act requires that American Indemnity may not pay any
extraordinary dividend or make any other extraordinary distribution to its
shareholders until thirty days after the Commissioner has received notice of the
declaration thereof and has not within that period disapproved the payment, or
until the Commissioner has approved the payment within the thirty-day period. An
extraordinary dividend or distribution includes any dividend or distribution of
cash or other property, whose fair market value together with that of other
dividends or distributions made within the


                                       30

<PAGE>   20



preceding twelve months exceeds the lesser of (i) ten percent of its statutory
surplus as regards to policyholders as of the end of the preceding calendar year
or (ii) the net income, not including realized capital gains or losses, for such
year. American Indemnity may carry forward net income from the previous two
calendar years that has not already been paid out as dividends. This
carryforward shall be computed by taking the net income from the second and
third preceding calendar years, not including realized capital gains or losses,
less dividends paid in the second and immediate preceding calendar years.

     The Company announced in February 1998 the suspension of regular quarterly
cash dividends to stockholders. It is not anticipated that dividends to
stockholders will resume within the foreseeable future. Future dividends, if
any, will be dependent upon future favorable operating results of the Company.

     At December 31, 1997, American Indemnity had no statutory retained earnings
available for payment of cash dividends. At December 31, 1997, American
Indemnity's reported statutory surplus as regards to policyholders was
$28,148,654. For the year ended December 31, 1997, American Indemnity's
unconsolidated statutory net investment income (including realized capital
gains) was $5,282,537 and its unconsolidated net income (loss) (excluding
realized capital gains) was $(7,054,493). The Company's stockholders' equity at
December 31, 1997, 1996 and 1995 and net income for the years then ended, as
reported under the statutory method, are as follows:


<TABLE>
<CAPTION>
------------------------------------------------------------------------------
                                         Statutory           Statutory
Years Ended December 31,               Stockholders'  Equity Net Income (Loss)
------------------------------------------------------------------------------
<S>                                    <C>                  <C>
1997                                   $ 30,407,297         $(3,755,332)
1996                                   $ 32,556,876         $ 2,159,102
1995                                   $ 30,682,608         $   310,914
</TABLE>

8.  EMPLOYEE AND NON-EMPLOYEE DIRECTOR STOCK OPTION PLANS

In 1982, the Company adopted an incentive stock option plan providing for the
grant of options to purchase its common stock by certain employees. The exercise
price of the options granted may not be less than the fair market value of
shares of its common stock on the date the option is granted. All options
granted may be exercised six months from the date of the grant and expire five
years from the date of the grant. Proceeds from options exercised are credited
to capital accounts. No amounts have been charged to income or expense in
connection with the issuance or exercise of options. No options may be granted
under this plan subsequent to March 1992. In 1992, the Company adopted the 1992
Employee Stock Option Plan, which includes similar provisions. No options may be
granted under the 1992 plan subsequent to January 2002.

     Activity of shares under the plans was as follows:

<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------
                                                           Number of      Exercise           Average
                                                            Shares          Price             Price
-----------------------------------------------------------------------------------------------------
<S>                                                          <C>        <C>                  <C>
Options outstanding, January 1, 1995                         21,200     $ 6.38 - 8.50        $ 7.93
Options exercised in 1995                                      (400)            (6.38)        (6.38)
-----------------------------------------------------------------------------------------------------
Options outstanding, December 31, 1995                       20,800      6.38 - 13.50          7.99
Options exercised in 1996                                    (4,800)            (6.38)        (6.38)
-----------------------------------------------------------------------------------------------------
Options outstanding, December 31, 1996                       16,000      6.38 - 13.50          8.47
Options exercised in 1997                                   (10,500)     (6.38 - 7.01)        (6.76)
Options forfeited in 1997                                    (1,500)            (7.01)        (7.01)
-----------------------------------------------------------------------------------------------------
Options outstanding and exercisable, December 31, 1997        4,000     $       13.50        $13.50
-----------------------------------------------------------------------------------------------------
</TABLE>


     At December 31, 1997, 108,500 shares of common stock were reserved for
issuance pursuant to the terms of the Company's employee stock option plans. At
December 31, 1997, the weighted average remaining contractual life for
outstanding options was 1.4 years.

     Also in 1992, the Company adopted a Non-Employee Director Stock Option Plan
providing for the grant of options to purchase its common stock by Directors who
are not employees of the Company or its subsidiaries. The exercise price of the
options granted shall be equal to the fair market value of shares of its common
stock on the date the option is granted and all options expire ten years from
the date of grant. In 1997, the Company adopted the 1997 Non-Employee Director
Stock Option Plan, which includes similar provisions. Proceeds from options
exercised are credited to capital accounts. No amounts have been charged to
income or expense in connection with



                                       31
<PAGE>   21

the issuance or exercise of options.

     Activity of shares under the Non-Employee Director Stock Option Plan was as
follows:

<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------
                                                            Number of         Exercise         Average
                                                             Shares             Price           Price
-------------------------------------------------------------------------------------------------------
<S>                                                           <C>         <C>                  <C>
Options outstanding, January 1, 1995                          11,000      $ 7.75 - 14.00       $11.59
-------------------------------------------------------------------------------------------------------
Options outstanding, December 31, 1995                        11,000        7.75 - 14.00        11.59
Options granted, April 1996                                    8,000       11.50 - 12.75        12.59
-------------------------------------------------------------------------------------------------------
Options outstanding, December 31, 1996                        19,000        7.75 - 14.00        12.01
Options granted, February 1997                                 1,000               12.50        12.25
-------------------------------------------------------------------------------------------------------
Options outstanding and exercisable, December 31, 1997        20,000      $ 7.75 - 14.00       $12.03
-------------------------------------------------------------------------------------------------------
</TABLE>

     At December 31, 1997, 25,000 shares of common stock were reserved for
issuance pursuant to the terms of the Company's 1997 Non-Employee Director Stock
Option Plan. At December 31, 1997, the weighted average remaining contractual
life for outstanding options was 6.9 years.

     The Company accounts for stock-based compensation in accordance with SFAS
No. 123, "Stock Based Compensation." Under this statement, a company may elect
to continue its previous method of accounting for stock-based compensation and
include additional disclosure in its financial statements or record expenses for
such compensation based on the fair value of the instruments on the date of
grant. The Company has elected to continue accounting for stock-based
compensation in accordance with Accounting Principles Board Opinion No. 25,
under which no compensation costs have been recognized for stock awards.
Accordingly, the consolidated financial statements do not include any charge for
the fair value of grants for stock-based compensation instruments. Had
compensation expense been determined under SFAS No. 123, the Company's pro forma
net income (loss) would have been ($5,884,173), $1,923,953 and ($5,093,755) for
1997, 1996 and 1995, respectively.


9.  RETIREMENT PLANS

American Indemnity sponsors a defined contribution plan (the "Plan"), whereby
eligible employees may elect to contribute a portion of their annual salary,
subject to limitation, to the plan. American Indemnity contributes an additional
amount, subject to limitation, based on the voluntary contribution of the
employee. American Indemnity's contributions charged to expense with respect to
the plan during the years ended December 31, 1997 and 1996 were approximately
$142,000 and $153,000, respectively.

     On January 1, 1996, American Indemnity converted its defined benefit plan
to a Cash Balance Pension Plan. Employees who were participants of the plan on
December 31, 1995 received credits for benefits earned under the defined
benefits plan as an opening balance in the Cash Balance Pension Plan. At the end
of each plan year, American Indemnity credits each eligible participant's
account with five percent of each participant's compensation earned that year
plus interest at a rate of six percent. Pension benefits are fully vested after
five years of service.

     The following table sets forth the defined benefit plan's funded status:

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------------------------
                                                                                           December 31,
                                                                                        1997           1996
--------------------------------------------------------------------------------------------------------------
<S>                                                                                 <C>            <C>
Actuarial Present Value of Benefit Obligations:
  Accumulated plan benefits, including vested benefits
   of $2,325,361 in 1997 and $2,156,658 in 1996                                     $ 2,399,191    $ 2,220,951
--------------------------------------------------------------------------------------------------------------
Projected benefit obligations for services rendered to date                         $(2,956,617)   $(2,785,203)
Plan assets at fair value, consisting primarily of equity securities                  3,238,901      2,941,658
--------------------------------------------------------------------------------------------------------------
Plan assets in excess of projected benefit obligations                                  282,284        156,455
Unrecognized net gain                                                                  (364,711)      (394,525)
Unrecognized net obligations, at adoption of plan, being recognized over 15 years       704,269        847,573
Unrecognized Prior Service Cost                                                      (1,014,033)    (1,084,828)
--------------------------------------------------------------------------------------------------------------
Accrued pension cost                                                                $  (392,191)   $  (475,325)
--------------------------------------------------------------------------------------------------------------
</TABLE>

     The weighted-average discount rate and rate of the increase in future
compensation levels used in determining the actuarial present


                                       32

<PAGE>   22



value of the projected benefit obligation were seven and one-half percent and
four percent, respectively, for 1997 and eight percent and four percent,
respectively, for 1996. The expected long-term rate of return on assets was nine
percent for 1997 and eight percent for 1996.

     Net pension cost included the following components:

<TABLE>
<CAPTION>
------------------------------------------------------------------------------------
                                                        Years Ended December 31,
                                                    1997         1996         1995
------------------------------------------------------------------------------------
<S>                                              <C>          <C>          <C>
Service cost-benefits earned during the period   $ 141,269    $ 152,401    $ 131,609
Interest cost on projected benefit obligations     206,248      199,882      215,042
Return on plan assets                             (474,800)    (462,436)    (388,691)
Net amortization and deferral                      274,046      343,021      339,845
------------------------------------------------------------------------------------
Net periodic pension cost                        $ 146,763    $ 232,868    $ 297,805
------------------------------------------------------------------------------------
</TABLE>

     American Indemnity's funding policy is to contribute annually an amount at
least sufficient to fund pension cost accrued. Contributions have been intended
to provide not only for benefits attributed to services to date but also those
expected to be earned in the future.


10.  POSTRETIREMENT HEALTH CARE AND LIFE INSURANCE BENEFITS

The Company accrues the cost of providing postretirement benefits to employees
during the employees' service period. The benefits provided to retired employees
are principally health care and life insurance. All of these benefits are funded
by the Company on a cash basis.

     The following table sets forth the unfunded status and amounts recognized
in the Company's consolidated financial statements:


<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------
                                                      For the years ended December 31,
                                                             1997           1996
--------------------------------------------------------------------------------------
<S>                                                      <C>            <C>
Accumulated postretirement benefit obligation:
  Retirees                                               $ 1,190,000    $ 1,082,000
  Fully eligible active participants                         204,000        274,000
  Other active participants                                  490,000        716,000
--------------------------------------------------------------------------------------
   Total accumulated postretirement benefit obligation     1,884,000      2,072,000
  Unrecognized net obligation, at adoption of plan,
       being recognized over 20 years                       (373,000)    (1,215,000)
  Prior service cost                                          55,000
  Unrecognized net gain (loss)                              (430,000)        79,000
--------------------------------------------------------------------------------------
Accrued postretirement benefit liability                 $ 1,136,000    $   936,000
--------------------------------------------------------------------------------------
</TABLE>

     Net postretirement benefit costs include the following components:

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------
                                               For the years ended December 31,
                                              1997          1996          1995
--------------------------------------------------------------------------------
<S>                                         <C>           <C>           <C>
Service cost                                $ 49,000      $ 57,000      $ 59,000
Interest cost                                170,000       155,000       187,000
Net amortization and deferral                 75,000        75,000       107,000
--------------------------------------------------------------------------------
  Net postretirement costs                  $294,000      $287,000      $353,000
--------------------------------------------------------------------------------
</TABLE>

     For measurement purposes, the assumed health care cost trend rate is 8
percent in 1998 and gradually declines to 4.5 percent in 2002 and thereafter.
Increasing the health care cost trend rate by one percentage point in each year
would have no significant effect on the accumulated postretirement benefit
obligation as of December 31, 1997 or on the net periodic postretirement benefit
cost. The calculation assumes a long-term rate of increase in compensation of
four percent for December 31, 1997 and 1996. The weighted-average discount rate
used in determining the accumulated postretirement benefit obligation was seven
and one-half percent and eight percent for 1997 and 1996, respectively.


11.  POLICY ACQUISITION COSTS

Policy acquisition costs incurred and expensed and policy acquisition costs
amortized to expense were as follows:


<TABLE>
<CAPTION>
--------------------------------------------------------------------------------
                                              Years Ended December 31,
                                           1997           1996           1995
--------------------------------------------------------------------------------
<S>                                    <C>            <C>            <C>
Costs Incurred and Expensed            $ 5,694,425    $ 6,538,408    $ 7,545,615
Costs Amortized to Expense              18,706,299     17,993,215     17,643,076
--------------------------------------------------------------------------------
Total                                  $24,400,724    $24,531,623    $25,188,691
--------------------------------------------------------------------------------
</TABLE>


12.  LEASE COMMITMENTS

The Company has several operating leases for office space and equipment. Total
lease expense was approximately $577,000 for 1997, $682,000 for 1996, and
$688,000 for 1995. Future minimum lease commitments for the Company are
approximately $478,000 for 1998, $415,000 for 1999, $322,000 for 2000, $31,000
for 2001 and $20,000 for 2002.


13.  NOTE PAYABLE TO BANK AND LINE OF CREDIT

In January 1997, the Company received $580,500 proceeds from a loan used to
purchase computer software. The Company is required to make monthly installments
of $10,447 including interest. The interest rate is fixed at 8.75% and the loan
maturity date is February 1, 2002. At December 31, 1997 the principal balance of
the loan was $432,473. The future principal payments of the note payable to bank
are as follows: 1998 - $91,116; 1999 - $99,416; 2000 - $108,472; 2001 -
$118,353; and 2002 - $15,116.

     The Company and United States National Bank, Galveston, Texas, renewed and
amended an existing line of credit in the principal amount of $5,000,000 which
was entered into on January 1, 1995. Pursuant to the line of credit agreement,
the Company can draw on this line of credit at any time. The Company did not
borrow against this line of credit during 1997, 1996 or 1995. According to the
terms of the amended agreement, the collateral securing the line of credit was
released and collateral is only required when the Company has amounts
outstanding under the line of credit.



                                       33
<PAGE>   23

                          INDEPENDENT AUDITORS' REPORT




                       [DELOITTE & TOUCHE LLP LETTERHEAD]



To The Stockholders of American Indemnity Financial Corporation:

     We have audited the accompanying consolidated balance sheets of American
Indemnity Financial Corporation and subsidiaries as of December 31, 1997 and
1996 and the related consolidated statements of income, cash flows and
stockholders' equity for each of the three years in the period ended December
31, 1997. These consolidated financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated 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
misstatements. 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 American Indemnity Financial
Corporation and subsidiaries at December 31, 1997 and 1996 and the results of
their operations and their cash flows for each of the three years in the period
ended December 31, 1997 in conformity with generally accepted accounting
principles.





/s/ DELOITTE & TOUCHE LLP
March 13, 1998



                                       34
<PAGE>   24



                    AMERICAN INDEMNITY FINANCIAL CORPORATION

COMMON STOCK
American Indemnity Financial Corporation
common stock is traded over the counter
through the National Market System with
the NASDAQ symbol AIFC.
     Should stockholders holding common
stock beneficially in "street name" wish to
receive corporate reports directly from the
Company, please write:
Mr. William H. Felts, Jr.
Stockholders' Relations Department
American Indemnity Financial
Corporation
P. O. Box 8985
Wilmington, Delaware 19899-8985




                                       36