During 1998, the Company continued to focus on improving operating margins in its property and casualty business by emphasizing profitable lines, reunderwriting marginal lines and eliminating unprofitable lines. This process led to a restructuring of the Company's property and casualty business in the fourth quarter of 1998 including the elimination of $151.0 million in gross written premiums from unprofitable lines of business, reinsurance agreements transferring run-off of the eliminated lines of business, and the strengthening of the Company's loss and loss adjustment expense reserves, principally on the eliminated lines of business.
MPCI is a government-sponsored program with accounting treatment which differs from more traditional property and casualty insurance lines. For income statement purposes, gross premiums written consist of the aggregate amount of MPCI premiums paid by farmers, and does not include any related federal premium subsidies or expense reimbursement. The Company's profit or loss from its MPCI business is determined after the crop season ends on the basis of a profit sharing formula established by law and the RMA. For income statement purposes, any such profit share earned by the Company, net of the cost of third party reinsurance, is shown as net premiums written, which equals net premiums earned for MPCI business; whereas, any share of losses payable by the Company is charged to losses and loss adjustment expenses. Due to various factors, including timing and severity of losses from storms and other natural perils and crop production cycles, the profit or loss on MPCI premiums is primarily recognized in the second half of the calendar year. The Company relies on loss information from the field to determine (utilizing a formula established by the RMA) the level of losses that should be considered in estimating the profit or loss during this period. Based upon available loss information, the Company records an estimate of the profit or loss during the third quarter and then re-evaluates the estimate using additional loss information available at year-end to determine any remaining portion to be recorded in the fourth quarter. All expense reimbursements received are credited to underwriting expenses.
During 1998, as in 1997, the Company's goal in its property and casualty segment was to improve underwriting results through an emphasis on profitable lines, modification of marginal lines, and a discontinuation of unprofitable lines. By the fourth quarter of 1998, it became clear that this process was not meeting the Company's goals for underwriting profitability, and therefore, the Company undertook substantial restructuring of its property and casualty operations in order to focus on profitable lines of speciality business generated by its general agents and program managers. This restructuring eliminated approximately $151.0 million in annual gross written premiums from lines of business the Company believed had developed into commodity insurance products no longer meeting the criteria of its core specialty business. As part of the property and casualty operations restructuring, the Company entered into discussions for sale of some discontinued business, most notably the non-standard automobile business, and entered into reinsurance agreements transferring the runoff of the remaining discontinued lines to reinsurers. The Company also strengthened its loss and loss adjustment reserves primarily due to continued unexpected development, principally on the discontinued lines of business. As part of the restructuring plan, the Company recorded an after tax charge in the fourth quarter of 1998 of approximately $23.3 million, and the Company expects an after tax charge of approximately $.9 million to be recorded in the first quarter of 1999. Before the charges associated with the restructuring, the Company's net income for 1998 was $28.8 million. In addition to the non-standard automobile business, the Company discontinued several product lines including coverages for certain specialty automobile lines, aviation, and complex general liability risks. The remaining property and casualty lines of business have historically achieved underwriting loss and expense ratios below 100%, and with the reinsurance of discontinued lines and the strengthening of reserves for the discontinued business, the Company believes that it has enhanced the ability of its property and casualty operations to return to profitability in 1999.
The Company's crop segment was a significant contributor to the underwriting earnings of the Company in both 1997 and 1998. During 1997, this segment contributed $36.9 million to the Company's underwriting earnings as compared to $30.0 million during 1998. During 1997, the Company earned a profit share of 31.5% on its MPCI retained premium pool of approximately $155.5 million or $49.0 million. In addition, the Company recorded in the first quarter of 1998 additional profit share of 2.5% or $4.0 million for the 1997 year. This compares with an earned profit sharing of 25.0% on $196.5 million retained premium pool generating $49.1 million in 1998.
The Company's net income was also negatively impacted by an increase in the Company's interest expense of 36.9% from $6.6 million during the year ended December 31, 1997 to $9.0 million during the year ended December 31, 1998. The increase in interest expense was a result of both an increase in the Company's average outstanding borrowings from $81.6 million during the twelve months ended December 31, 1997 to $100.0 million for the twelve months ended December 31, 1998, and an increase in the average interest rate from 8.1% during 1997 to 9.0% during 1998. The increased borrowings were used to add statutory surplus to the insurance Company's subsidiaries as well as to repurchase shares of the Company's stock under the Company's Stock Repurchase Program approved by the Board of Directors in May, 1998. During the remainder of 1998, the Company repurchased one million shares of the Company's stock at a cost of approximately $22.1 million. The Company funded these repurchases using available cash and $15 million of borrowings under its Revolving Credit Facility. The Company expects to pay off its outstanding bank borrowings during the second quarter of 1999 from available cash, but may consider repurchasing additional shares of the Company's stock again in 1999 if excess cash flows are developed. The increase in the Company's average interest rate resulted from the issuance of $94.875 million in trust preferred securities and the retirement of the Company's outstanding bank debt during the third quarter of 1997 (See Liquidity and Capital Resources).
Results of Operations Year ended December 31, 1997 Compared to Year Ended December 31, 1996
The Company's net income increased 16.6% from $30.3 million in the year ended December 31, 1996 to $35.3 million in the year ended December 31, 1997. The Company's operating income increased 47.4% from $39.3 million in the year ended December 31, 1996 to $57.9 million in the year ended December 31, 1997. These improved results occurred despite a decrease in the Company's insurance premiums earned and the differential between the growth in net income and operating income occurred as the Company's tax rate returned to normal levels in 1997 after the Company's 1996 taxes were positively affected by the decrease in the valuation allowance relating to the unrealized loss from the Company's investment in Major Realty. The improved results were attributed primarily to improved loss and expense ratios in the Company's Property and Casualty segment, excellent crop results resulting from an above average profit sharing earned in the Company's MPCI program, and increased investment income and realized gains from the Company's investment portfolio. These positive factors were partially offset by an increase in the expense ratio of the Crop segment, increased interest expense, and an increase in the Company's effective tax rate.
In the Company's Crop segment, the Company's premium levels were also relatively flat as direct written premiums decreased from $198.6 million in 1996 to $196.5 million in 1997 and gross premiums increased slightly from $242.9 million in 1996 to $248.0 million in 1997. These relatively level written premiums resulted as increases in the Company's policy count under the Company's largest program, the MPCI crop insurance program, were offset by reductions in commodity prices upon which the Company's premiums are based.
Underwriting results in the Company's Property and Casualty segment improved during 1997 as compared to 1996. This segment experienced a $12.3 million underwriting loss and a combined ratio of 104.5% in the twelve months ended December 31, 1997 as compared to a $31.9 million underwriting loss and a combined ratio of 111.3% for the twelve months ended December 31, 1996.
The improved profit sharing income in 1997 was offset by an increase in the Company's net operating expenses under the MPCI program. This increase in net expenses was due to a decrease in expense reimbursement from the federal government under the MPCI program from 31.0% for both MPCI and Crop Revenue Coverage (CRC) policies in 1996 to 29.0% and 25.0% respectively for MPCI and CRC policies in 1997. This resulted in an approximate $7.2 million decrease in expense reimbursement from 1996 to 1997. The Company was unable to pass along any of this expense reduction to its producing agents due to the competitive environment for MPCI business during 1997.
Dividends from the insurance subsidiaries of the Company are regulated by the regulatory authorities of the states in which each subsidiary is domiciled. The laws of such states generally restrict dividends from insurance companies to parent companies to certain statutorily approved limits. In 1999, the statutory limitation on dividends from insurance company subsidiaries to the parent without further insurance departmental approval is approximately $15.9 million.
In August 1997, AICI Capital Trust, a Delaware business trust organized by the Company (the "Issuer Trust") issued 3.795 million shares or $94.875 million aggregate liquidation amount of its 9% Preferred Securities (liquidation amount $25 per Preferred Security). The Company owns all of the common securities (the "Common Securities") of the issue trust. The Preferred Securities represent preferred undivided beneficial interests in the Issuer Trust's assets. The assets of the Issuer Trust consist solely of the Company's 9% Junior Subordinated Debentures due 2027 which were issued in August of 1997 in an amount equal to the Preferred Securities and the Common Securities. The Company primarily used the net proceeds in the amount of $90.9 million from the sale of the Junior Subordinated Debentures to pay down the $90.0 million of borrowings under its Revolving Credit Facility. Distributions on the Preferred Securities and Junior Subordinated Debentures are cumulative, accrue from the date of issuance and are payable quarterly in arrears. The Junior Subordinated Debentures are subordinate and junior in right of payment to all senior indebtedness of the Company and are subject to certain events of default and redemptive provisions, all described in the Junior Debenture Indenture. At December 31, 1998, the Company had Preferred Securities of $94.875 million outstanding at a weighted annual interest cost of 9.1%.
In June 1997, the Company amended its borrowing arrangements with its bank lenders providing a five-year revolving credit facility (the "Revolving Credit Facility"), with a final maturity of 2002, in amounts not to exceed $100 million. In August 1997, the Company used the net proceeds from the issuance of Junior Subordinated Debentures to repay the Company's outstanding indebtedness of $90 million under the Revolving Credit Facility. As a result of the Junior Subordinated Debentures, the Revolving Credit Facility was reduced from $100 million to $65 million. The Company selects its interest rate as either the prime rate or LIBOR plus a margin which varies depending on the Company's funded debt to equity ratio. Interest is payable quarterly. At December 31, 1998, the Company had $15 million outstanding under this arrangement. Borrowings and interest cost averaged $5.2 million and 6.5% during 1998. The Revolving Credit Facility contains covenants which do not permit the payment of dividends by the Company, requires the Company to maintain certain operating and debt service coverage ratios, required maintenance of specified levels of surplus and requires the Company to meet certain tests established by the regulatory authorities.
At its May 29, 1998 meeting, the Company's Board of Directors approved a stock repurchase plan providing for the repurchase of up to one million shares of the Company's stock. As of December 31, 1998, the Company has repurchased one million shares at an average cost of $22.07 per share. The Company funded these repurchases using available cash and $15.0 million of borrowings under its Revolving Credit Facility.
As of December 31, 1998, the Company held cash, invested assets excluding investments in subsidiaries, and dividends receivable of $19.1 million.
The Company's profit or loss from its MPCI business is determined after the crop season ends on the basis of a profit sharing formula established by law and the RMA. Commencing with the 1997 year, the Company receives a profit share in cash, with 60% of the amount in excess of 17.5% of its MPCI Retention (as defined in the profit sharing agreement) in any year carried forward to future years, or it must pay its share of losses. Prior to the 1997 year, the amount carried forward to future years was any amount in excess of 15% of its MPCI retention. The Company recognized $49.1 million in profit sharing earned on the MPCI business during 1998, and in addition, recognized $4.5 million during 1998 in profit sharing earned on 1997 MPCI business. The Company received $51.5 million in payments under the MPCI program in March of 1999.
The Company's stockholders' equity decreased by approximately $17.5 million from December 31, 1997 to December 31, 1998. The principal components of this change were the repurchase of one million shares of the Company's stock at an aggregate cost of $22.1 million, net income of $5.5 million for the year ended 1998, and a decrease in the value of the Company's investment portfolio causing the unrealized gain (loss) on available-for-sale securities net of tax to decrease from a gain of $6.9 million to a gain of $5.3 million.
The Company's Preferred Securities of $94.875 million at December 31, 1998, mature in August 2027 and are redeemable at the Company's option in August 2002. The Company will continue to monitor the interest rate environment and evaluate refinancing opportunities as the redemption and maturity date approaches.
The Year 2000 issue is the result of computer programs and microcontrollers which recognize only two digits rather than four to identify the year. Any computer program or microcontroller that has a date sensitive function may recognize a date of '00" as the year 1900 rather than the year 2000. If not corrected, this could cause computers and other devices dependent upon microcontrollers to fail or perform miscalculations.
Additionally, the Company is reviewing its Non-IT systems which rely on microprocessors, such as copiers, fax machines, telephone equipment and mail room equipment, to determine whether they require modification to be Year 2000 compliant. The Company currently also is communicating with the lessors and other providers of its Non-IT systems in regards to their Year 2000 compliance status.
The Company relies on various third parties in the normal course of its operations and has identified certain third parties with which it has material relationships. These include insurance producers, reinsurers, government agencies, banks and providers of telecommunication and utility. The Company currently is communicating with these material third parties to determine if they are Year 2000 compliant.
The Company has expensed costs of approximately $2.9 million relating to the year 2000 issue since inception of the project, including $1.5 million during the twelve months ended December 31, 1998. The Company anticipates an additional $.3 to $.8 million of expenses to complete the project.
Although the Company plans to have addressed the Year 2000 issues prior to being affected by such issues, it currently is assessing the need to develop contingency plans, particularly with respect to certain third parties with whom it has material relationships. The Company anticipates this assessment will be complete, and contingency plans with respect to certain third parties will be in the development stage, by September 1999.
Particularly because of the potentially wide-scale disruption of general infrastructure and business systems, and despite the Company's activities in regards to the Year 2000 issue, there can be no assurance that computer and microcontroller failures related to the Year 2000 will not interfere with the Company's normal business operations, result in unintended and unexpected claims under policies of insurance written by the Company, or otherwise have a material adverse affect upon the Company's business, financial condition and results of operations.