The following analysis of the consolidated results of operations and financial condition of the Company should be read in conjunction with the Selected Financial Data, Consolidated Financial Statements, and Notes to Consolidated Financial Statements included elsewhere herein.
The Company, a regional insurance holding company, and its subsidiaries operate exclusively in the United States and primarily in the central and western states. The Company's largest segment includes three property-casualty insurance companies that write personal lines (primarily automobile and homeowners) and small commercial lines of insurance. The other reportable segment is excess & surplus lines insurance. The property-casualty insurance segment accounted for 85.7% of consolidated revenues in 1997 and 86.5% in 1996.
At December 31, 1997, The ALLIED Group Employee Stock Ownership Trust (ESOP Trust) owned 24.9% and ALLIED Mutual Insurance Company (ALLIED Mutual), an affiliated property-casualty insurance company, controlled 18.2% of the outstanding voting stock of the Company.
The Board of Directors authorized a 3-for-2 stock split issuable November 28, 1997 to common stockholders of record on November 14, 1997. All fractional shares were paid in cash. All share and per share amounts included throughout this report have been restated to reflect the stock split.
On December 31, 1997, the Company adopted Statement of Financial Accounting Standard 128, "Earnings per Share." The adoption of SFAS 128 changed the way earnings per share are calculated and required restatement of amounts in prior periods. All per share amounts included throughout this report have been restated to reflect the adoption of SFAS 128. See notes 1 and 17 of Notes to Consolidated Financial Statements for a further discussion of earnings per share.
Consolidated revenues for 1997 were $664.7 million, up 11.5% over the $596.4 million reported for 1996. The increase was primarily due to the 11% growth in earned premiums and in other income, which rose 22.4%. Other income includes service charges and other miscellaneous income in the property-casualty segment and total revenues generated by noninsurance operations.
Pooled net written premiums (including ALLIED Mutual's) totaled $835.4 million, an 8.9% increase over 1996 production. Growth in personal lines net written premiums was 11.2% for 1997. The average premium per policy for personal lines was up 3.5% to $618 while the policy count grew 6%. Commercial lines premiums grew by 4.1%. The average premium per policy for commercial lines increased 3.7% to $1,152, and policy count was up 3%. Earned premiums for the property-casualty segment were 68.1% personal lines and 31.9% commercial lines in 1997. The business mix for 1996 was 66.8% personal and 33.2% commercial lines.
Revenues for the property-casualty segment increased 10.4% to $569.4 million from $515.7 million for 1996. Direct earned premiums for the segment were $568.2 million for 1997 compared with $497.1 million one year earlier. Earned premiums increased 10.3% to $514.3 million from $466.2 million. The increase resulted primarily from growth in insurance exposure as well as from a larger average premium per policy.
The statutory combined ratio (after policyholder dividends) improved to 94.4 from the 97.7 reported in 1996, primarily due to a 2.5-point decrease in the loss and loss adjusting expense ratio. The Company's underwriting expense ratio also improved 0.8 points. Wind and hail losses decreased to $27.9 million from
$39.1 million in 1996, which accounted for a 3-point improvement in the loss and loss adjusting ratio. The impact of wind and hail losses on the statutory combined ratio was 5.4 points for 1997 and 8.4 points for 1996. The 1997 underwriting gain, on a generally accepted accounting principles basis (GAAP), rose to $26.8 million from the previous year's $9.9 million.
The personal auto statutory combined ratio decreased to 94.5 from 98.9 for 1996, reflecting a 3.4-point improvement in the loss and loss adjusting expense ratio. The statutory combined ratio for the homeowners line was 96.7 compared with 102.4 for 1996. The impact of wind and hail losses on the homeowners combined ratio was 15.4 points in 1997 and 23.6 points in 1996. Overall, the personal lines statutory combined ratio improved to 95.1 from 99.8 in 1996. The statutory combined ratio for commercial lines decreased slightly to 93.1 from 93.5 for the previous year.
The statutory combined ratio (after policyholder dividends) was 90.2, which produced a GAAP underwriting gain of $3.2 million. The statutory combined ratio of 92.5 for 1996 resulted in a GAAP underwriting gain of $1.8 million. The 1997 growth in earned premiums outpaced the increase in losses and loss adjusting expenses, resulting in a 2.8-point improvement in the loss and loss adjusting expense ratio.
The Company's effective income tax rate was down slightly to 28.3% from 28.4% for 1996. The decrease was the result of the decline in operating results of subsidiaries that have higher statutory tax rates. Higher 1997 consolidated operating income increased the income tax expense 28.4% to $26 million.
Book value per share at December 31, 1996 increased to $11.59 from $10.77. The increase in book value was constrained by higher dividend payments, increased wind and hail losses, and the stock repurchase program. The fair value of investments in fixed maturities was $17.1 million above amortized cost compared with $27.8 million above amortized cost at December 31, 1995. If the investments in fixed maturities were reported at amortized cost, book value per share at December 31, 1996 would have been $11.23 compared with $10.20 at December 31, 1995.
Investment income for 1996 was $42.3 million compared with $39.1 million in 1995. The pretax yield on invested assets was 6.3%, down from 6.4%. Investment income increased due to a larger average balance of invested assets, which more than offset the decrease experienced in the pretax yield. Realized investment gains were $180,000 compared with $236,000 for 1995. Other income increased slightly to $7 million from $6.9 million.
The personal auto statutory combined ratio increased to 98.9 from 96.5 for 1995, reflecting a 2.8-point increase in the loss and loss adjusting expense ratio. The statutory combined ratio for the homeowners line was 102.4 compared with 99.2 for 1995. Wind and hail losses increased the homeowners combined ratio 23.6 points in 1996 and 21.7 points in 1995. Overall, the personal lines statutory combined ratio deteriorated to 99.8 from 97.2. The statutory combined ratio for commercial lines increased to 93.5 from 92.7 for the prior year.
Earned premiums for 1996 decreased to $27.3 million from $29.7 million for 1995, primarily because of higher reinsurance costs. Direct earned premiums were nearly flat at $37.6 million compared with $37.2 million. Net written premiums were down 7.2% to $28.4 million from $30.6 million, reflecting a continuing soft market and management's decision not to sacrifice underwriting results for premium growth. For the year ended December 31, 1996, the segment's book of business was comprised of 2.8% personal and 97.2% commercial lines. For 1995, the business mix was 2.4% personal and 97.6% commercial lines.
The statutory combined ratio (after policyholder dividends) was 92.5, which produced an underwriting gain (on a generally accepted accounting principles basis) of $1.8 million. The statutory combined ratio of 102.2 for 1995 resulted in an underwriting loss of $855,000. The 1996 combined ratio improved primarily because of a 21.8% decrease in losses and loss adjusting expenses (11.4 points on the combined ratio). The decrease in the loss and loss adjusting expense ratio was primarily due to favorable loss development in 1996.
Income before income taxes for 1996 increased 66.4% to $8.1 million from $4.8 million for the previous year. The increase was primarily due to favorable loss development.
At December 31, 1996 the Company's investment portfolios consisted almost exclusively of fixed income securities; 99.7% were rated investment grade or higher. The portfolios contained no real estate or mortgage loans at December 31, 1996.
The Company's effective income tax rate for 1996 was 28.4% compared with 29.1% for 1995. The decrease in the effective rate was due primarily to a higher percentage of income from tax-exempt securities. The income tax expense decreased 5.8% to $20.2 million.
Substantial cash inflows for the Company are generated from premiums, pool administration fees, investment income, and proceeds from sales and maturities of investments. The principal outflows of cash are payments of claims, commissions, premium taxes, operating expenses, and income taxes and the purchase of fixed income and equity securities. In developing its strategy, the Company establishes a level of cash and highly liquid short- and intermediate-term securities that, combined with expected cash flow, is believed adequate to meet anticipated short-term and long-term payment obligations.
The Company relies primarily on dividends from its insurance subsidiaries to pay preferred and common stock dividends to shareholders. During 1997, the Company received dividend payments of $16.2 million from the property-casualty subsidiaries and $836,000 from noninsurance subsidiaries. During 1996 and 1995, the property-casualty subsidiaries paid the Company dividends of $23.7 million and $12 million, respectively; noninsurance subsidiaries paid dividends of $916,000 and $974,000, respectively.
In 1997 and 1996, the Company repurchased $10.2 million and $16.5 million of its common stock, respectively. No shares were repurchased in 1995. During 1997, the Company repurchased 412,850 shares of its common stock on the open market at an average price per share of $24.77. The first 85,500 shares were repurchased under a program approved by the Board of Directors (Board) on July 16, 1996 and completed March 13, 1997. An additional 327,350 shares were repurchased under a program approved by the Board March 4, 1997 and completed December 4, 1997. During 1996, the Company canceled 664,500 shares of its common stock purchased on the open market at an average price per share of $24.87.
The Company guaranteed the ESOP Trust's obligations under the terms of a Term Credit Agreement and Guaranty. See note 9 of Notes to Consolidated Financial Statements for a discussion of ESOP obligations. At December 31, 1997, the balance of the obligations was $22.4 million. Contributions plus dividends on leveraged shares held by the ESOP are used by the ESOP Trust to service the ESOP obligations. Dividends and payments for the employee lease fees from its subsidiaries are used by the Company to fund the amounts paid to the ESOP Trust. The Company made contributions to the ESOP Trust of $312,000 in 1997, $529,000 in 1996, and $733,000 in 1995. The Company paid dividends of $3.6 million in 1997, $3.5 million in 1996, and $2.8 million in 1995, which were used for such debt service. In connection with its guarantee of ESOP obligations, the Company is required to maintain minimum stockholders' equity and to comply with certain other financial covenants.
Historically, the insurance subsidiaries have generated sufficient funds from operations to pay their claims. While the property-casualty and excess & surplus lines insurance companies have maintained adequate investment liquidity, they have in the past required additional capital contributions to support premium growth. Industry guidelines suggest that a property-casualty insurer's annual net written premiums should not exceed approximately 300% of statutory surplus. At December 31, 1997, the property-casualty and excess & surplus lines segments' net written premiums were 160% and 84% of their statutory surplus, respectively.
The Company began converting its computer systems to be year 2000 compliant in 1996 and anticipates completion by the end of 1998. The Company actively monitors its progress and plans to start retesting applications in the spring of 1998. The costs associated with year 2000 are expensed as incurred; the Company does not expect such costs to have a material effect on its future financial position or results of operations.
On December 31, 1997, a complaint was filed by Mary M. Rieff, a policyholder of ALLIED Mutual, in the Iowa District Court in and for Polk County Iowa, against the Company and certain other individuals who are or were officers and/or directors of ALLIED Mutual and the Company. The complaint, an alleged policyholder derivative action brought on behalf of ALLIED Mutual, asserts, among other things, (a) that the defendants were responsible for the inappropriate transfer of ALLIED Mutual's corporate assets, the seizure of certain corporate opportunities, and the implementation of an improper de facto demutualization without informing or compensating policyholders or receiving the appropriate approval from regulatory authorities; (b) that this allegedly wrongful demutualization began on or about January 1, 1985 and was accomplished through transfers of ALLIED Mutual's assets to the Company and to the individual defendants for inadequate consideration; (c) that the individual defendants breached fiduciary duties owed to ALLIED Mutual, wasted its corporate assets, and intentionally interfered with its contracts, prospective business advantage, and business relationships; and (d) that the defendants improperly transferred substantial ownership of and control over the Company and ALLIED Mutual's insurance business. The complaint further asserts that as a result of the foregoing, ALLIED Mutual and its policyholders have suffered damages in excess of $500 million. The complaint requests an accounting of the assets allegedly wrongfully transferred to the Company and compensation to ALLIED Mutual for the value of such assets, for the seizure of corporate opportunities, and for the de facto demutualization of ALLIED Mutual. The complaint also asks for certain other relief, including attorneys' fees and costs, equitable relief and interest, and restitution for any assets wrongfully transferred or conveyed. The Company believes the suit is without merit and intends to defend this action vigorously. As is the case in all pending actions, the ultimate outcome is uncertain.
Management maintains a system of internal control designed to provide reasonable assurance as to the integrity and reliability of the financial statements, the protection of assets from unauthorized use or disposition, the prevention and detection of fraudulent financial reporting, and the appropriate division of responsibility. In addition, the Company's internal audit department systematically reviews these controls, evaluates their adequacy and effectiveness, and reports thereon. Management has considered internal audit recommendations and those of KPMG Peat Marwick LLP and has in its opinion responded appropriately to those recommendations. Management believes that as of December 31, 1997 the Company's system of internal control is adequate to accomplish the objectives discussed herein.
The Company's financial statements have been audited by KPMG Peat Marwick LLP, independent certified public accountants. The audit was conducted in accordance with generally accepted auditing standards, which included consideration of the Company's system of internal control to the extent necessary to form an independent opinion on the financial statements prepared by management.
/s/ Jamie H. Shaffer - ------------------------------------- Jamie H. Shaffer Chief Financial Officer
We have audited the accompanying consolidated balance sheets of ALLIED Group, Inc. and subsidiaries as of December 31, 1997 and 1996 and the related consolidated statements of income and comprehensive income, stockholders' equity, and cash flows for each of the years in the three-year 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 financial statements based upon our audits.
ALLIED Group, Inc. and Subsidiaries Consolidated Statements of Cash Flows (in thousands)
The accompanying consolidated financial statements include the accounts of ALLIED Group, Inc. (the Company) and its subsidiaries. The consolidated financial statements have been prepared in conformity with generally accepted accounting principles (GAAP). The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities for the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. All significant intercompany balances and transactions have been eliminated. Certain amounts in the financial statements for prior years have been reclassified to conform to the current year's presentation.
The noninsurance subsidiaries are ALLIED Group Mortgage Company (ALLIED Mortgage), The Freedom Group, Inc., ALLIED Group Information Systems, Inc., Midwest Printing Services, Ltd., ALLIED General Agency Company, and Premier Agency, Inc.
Liabilities for losses are based upon case-basis estimates of reported losses, estimates of unreported losses based upon prior experience adjusted for current trends, and estimates of losses expected to be paid under assumed reinsurance contracts. Liabilities for loss adjusting expenses are provided by estimating expenses expected to be incurred in settling the claims provided for in the loss reserve. Changes in estimates are reflected in current operating results (note 5).
believes approximates the realization of the related net servicing income. Amortization of servicing rights for the years ended December 31, 1997, 1996, and 1995 was $4.7 million, $5.4 million, and $4.7 million, respectively.
On January 1, 1996, the Company adopted Statement of Financial Accounting Standards (SFAS) 123, "Accounting for Stock-Based Compensation." SFAS 123 permits entities to recognize the fair value of stock options on the date of grant as compensation expense over the vesting period of such options. Alternatively, the standard allows entities to continue to apply the accounting provisions of Accounting Principles Board (APB) Opinion 25, "Accounting for Stock Issued to Employees," and related interpretations. Compensation expense then would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. The Company has elected to apply the accounting provisions of APB 25 and, as required by SFAS 123, provide pro forma net income and earnings per share disclosures for stock option grants made in 1995 and future years as if the fair-value-based method defined in SFAS 123 had been applied. The adoption of this statement had no effect on the Company's financial position, results of operations, or liquidity.
The amount of compensation cost related to The ALLIED Group Employee Stock Ownership Plan (ESOP) is based on the cost of the shares allocated to participants plus interest expense incurred related to the debt of the ESOP reduced by dividends paid used to service the ESOP's debt (the shares allocated method). The income tax benefit for the tax deductible dividends paid on unallocated shares of the ESOP available for debt service is included as a direct addition to retained earnings.
On December 31, 1997, the Company adopted the provisions of SFAS 128, "Earnings per Share." SFAS 128 specifies the computation, presentation, and disclosure requirements for earnings per share (note 17). SFAS 128 supersedes APB 15, "Earnings per Share," and required restatement of all prior period per share data. If APB 15 had prevailed, the Company would have reported fully diluted earnings per share of $2.03.
Basic earnings per share are computed by dividing income available to common stockholders by the weighted average number of common shares outstanding. Diluted earnings per share are computed by dividing income available to common stockholders by the weighted average number of common shares and dilutive potential common shares outstanding. Securities that entitle their holders to obtain common stock during or after the reporting period (primarily stock options) are referred to as dilutive potential common shares.
On December 31, 1997, the Company adopted SFAS 130, "Reporting Comprehensive Income," and restated prior years' financial statements to conform to the reporting standard. SFAS 130 establishes standards for reporting and displaying comprehensive income and its components in a full set of general-purpose financial statements. Comprehensive income includes all changes in stockholders' equity during a period except those resulting from investments by owners and distributions to owners. The adoption of SFAS 130 resulted in revised and additional disclosures but had no effect on the financial position, results of operations, or liquidity of the Company.
The following methods and assumptions were used in estimating the fair value disclosures for financial instruments:
Short-term investments -- Due to their short-term nature, their carrying amount approximates fair value.
Notes payable to affiliates and nonaffiliates -- Due to the short maturity of the short-term notes payable, carrying value approximates fair value. The fair value of the long-term notes payable is estimated using current rates available for similar issues (notes 4 and 8).
The following table presents the carrying value and estimated fair value of the financial instruments at December 31, 1997 and 1996.
The estimated fair values presented in the table are based on pertinent information available to management as of December 31, 1997 and 1996. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been revalued for purposes of these financial statements since those dates; current estimates of fair value may differ significantly from the amounts presented herein.
The following table presents the gross realized gains and losses by portfolio included in the proceeds from calls, principal reductions, and sales of fixed maturities for the years ended December 31, 1997, 1996, and 1995.
The property-casualty segment and ALLIED Mutual participate in a reinsurance pooling agreement. The pooling agreement provides that AMCO (pool administrator) assumes from the pool participants premiums, losses, allocated loss adjusting expenses, commissions, premium taxes, service charge income, and dividends to policyholders. The pool participants assume from AMCO an amount of this pooled property-casualty business equal to their participation in the pooling agreement. AMCO pays certain underwriting expenses, unallocated loss adjusting expenses, and premium collection expenses for all of the pool participants and receives a fee equal to a specified percentage of premiums as well as a performance fee based on the attainment of certain combined ratios from each of the pool participants. AMCO charges each of the participants 12.85% of written premiums for underwriting services, 7.25% of earned premiums for unallocated loss adjusting expenses, and 0.75% of earned premiums for premium collection services. The administrative fees are subject to renegotiation during the term of the agreement upon at least five years' notice. AMCO received pool administrative fees of $66.8 million, $61.3 million, and $55.7 million from ALLIED Mutual in 1997, 1996, and 1995, respectively. In 1997, the Company also received a performance fee of $4.2 million from ALLIED Mutual. The pooling agreement extends through December 31, 2004 and may be terminated after such date upon notice. Changes to the pooling agreement must be approved by the coordinating committee of the Board of Directors.
Pursuant to the terms of the Intercompany Operating Agreement, the Company leases employees to its subsidiaries and ALLIED Mutual and certain of its subsidiaries. Each company that leases employees is charged a fee based upon costs incurred for salaries, related benefits, taxes, and expenses associated with the employees it leases. For the years ended December 31, 1997, 1996, and 1995, the Company received revenues of $2.6 million, $2.5 million, and $2.5 million, respectively, for employees leased to affiliates.
The Intercompany Operating Agreement between the Company and ALLIED Mutual also provides for the continued availability of office space, marketing services, agency forces, and computer and other facilities. Expenses are charged to the Company based on specific identification, or, if undeterminable, the expenses are allocated on the basis of cost and time studies that are updated annually. The agreement extends through December 31, 2004 and may be terminated after such date by either ALLIED Mutual or the Company upon two years notice.
The Company and its affiliates deposit their excess cash into a short-term investment fund. The fund was established to concentrate short-term cash in a single account to maximize yield. AID Finance Services, Inc., a wholly owned subsidiary of ALLIED Mutual, is the administrator of the fund. At December 31, 1997 and 1996, the Company had $8.3 million and $3.4 million, respectively, invested in the fund. The Company also had several unsecured short-term notes payable to the fund at December 31, 1997 that totaled $5.9 million; the interest rate on each was 8.8%. At December 31, 1996, the Company had three unsecured notes totaling $2.4 million payable to the investment fund.
The Company paid interest to affiliates of $424,000, $270,000, and $127,000 in 1997, 1996, and 1995, respectively.
During 1996, the Company received $620,000 as the final settlement on the 1994 sale of its investment in a savings and loan holding company. The payment represents the Company's share of the contingent purchase price held by the buyer until all known claims were settled.
The short-term notes payable to nonaffiliated companies include line of credit agreements used by ALLIED Mortgage primarily to finance its mortgage loans held for sale. At December 31, 1997 and 1996, ALLIED Mortgage had borrowed $39 million and $19.7 million, respectively, under mortgage loan warehousing agreements with three different commercial banks. Two of the agreements expire in May and June of 1998 and the third in May of 1999. Under the terms of the agreements, ALLIED Mortgage can borrow up to the lesser of $67 million or 98% of the mortgage credit borrowing base, which includes related sublines. At December 31, 1997, the outstanding borrowings of ALLIED Mortgage under these line of credit agreements were secured by mortgage loans held for sale of $29.5 million, mortgage servicing rights on loans with a principal balance of $2.9 billion, and foreclosure loans of $5.2 million. Interest rates applicable to these borrowing arrangements vary with the level of investable deposits maintained at the respective commercial banks.
The Company paid interest to nonaffiliates of $1.2 million, $1.5 million, and $1.6 million in 1997, 1996, and 1995, respectively.
The Company has guaranteed on an unsecured basis the ESOP Trust's reimbursement obligations under the Credit Agreement. The guarantee has been recorded in the consolidated balance sheets as a liability under the caption, "Guarantee of ESOP obligations." At December 31, 1997 and 1996, the Company had an outstanding guarantee of principal of $22.4 million and $24.4 million, respectively. Contributions to the ESOP Trust plus dividends on leveraged shares held by the ESOP Trust are used to meet interest and principal payments on the notes. As principal payments are made, the recorded ESOP guarantee is reduced.
The Credit Agreement includes various financial and operating covenants with which the Company must comply. The covenants include the maintenance of certain contractual relationships with ALLIED Mutual, continued ownership of certain subsidiaries, limitations on the issuance of security interests in certain assets, maintenance of various financial ratios, and minimum net equity requirements.
The Company has reserved 3,037,500 shares of common stock to be issued through the ALLIED Group, Inc. Dividend Reinvestment and Stock Purchase Plan. Any stockholder of record may participate in the plan and have cash dividends reinvested in additional shares of common stock. The plan also provides for optional cash payments. During 1997, 62,174 shares, purchased on the open market, were issued at a weighted average price per share of $26.35. During 1996 and 1995, 92,171 and 96,087 shares, purchased on the open market, were issued at a weighted average price per share of $17.65 and $13.34, respectively. At December 31, 1997, 1,256,277 shares were available for issuance.
During 1997, the Company canceled 412,850 shares of its common stock repurchased on the open market at an average cost of $24.71 per share. During 1996, the Company canceled 996,750 shares of its common stock repurchased on the open market at an average cost of $16.58 per share. No shares were repurchased in 1995.
As of December 31, 1997, the ESOP Trust was the holder of 9,146,633 shares, or 30% of the Company's common stock. The Trustee is entitled to vote the shares held in the ESOP Trust on all matters submitted to a vote of the holders of the common stock of the Company. The ESOP Trust generally provides that each ESOP participant is entitled to direct the Trustee how to vote (or whether to tender or exchange) the shares allocated to the participant's account. During 1997, the ESOP Trust purchased 18,865 common shares at an average price per share of $28.62. During 1996, 2,992,710 ESOP Series shares were converted to 10,100,396 shares of common stock and the ESOP Trust purchased 36,572 shares at an average price per share of $21.93. During 1995, 174,960 ESOP Series shares were converted to 590,490 shares of common stock.
The dividend rate per common share was $0.46, $0.39, and $0.30 for 1997, 1996, and 1995, respectively.
In addition, the Company has reserved 1,350,000 shares of common stock for issuance to key employees under the ALLIED Group, Inc. Long-Term Management Incentive Plan (Incentive Plan). Under the Incentive Plan, shares of common stock are available for grant until December 31, 2003 as incentive and nonqualified stock options (collectively, Options), SARs, and restricted stock. Options, SARs, and restricted stock granted prior to November of 1996 begin to vest two years after the date of grant; those granted after November of 1996 begin to vest three years after the date of grant. Options, SARs, and restricted stock prices are based upon the fair market values as of the date of grant.
During 1997, the Company reserved 750,000 shares of common stock for issuance semiannually under the ALLIED Group, Inc. Agency Stock Purchase Plan (ASPP). Eligible agencies and agents pay 90% of the fair market value of the shares issued, which are fully vested on the dates purchased. During 1997, 128,703 shares were issued at an average price per share of $26.20. At December 31, 1997, 621,297 shares were available for issuance under the ASPP.
The Company applies APB 25 in accounting for its stock-based compensation plans, as permitted by SFAS 123. Accordingly, no compensation cost for the Company's stock option plans has been recognized in the accompanying financial statements. Compensation cost of $690,000, $386,000, and $167,000 was recognized in 1997, 1996, and 1995, respectively, under the Company's DSPP and ASPP and from the SARs. Had compensation cost been determined based on the fair value at the grant date of the stock option plans in accordance with SFAS 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts presented in the following table:
The pro forma amounts presented are not necessarily indicative of future amounts; SFAS 123 does not apply to awards granted prior to 1995. Therefore, the full impact of calculating comprehensive cost for stock options under SFAS 123 is not reflected in the pro forma amounts presented above because compensation cost is reflected over the options' vesting periods and grants awarded prior to 1995 are not considered.
The fair value of each option is estimated on the date of grant using the Black-Scholes option-pricing model. The following table shows weighted average assumptions for grants in 1997 and 1996:
In 1997, 1996, and 1995, the Company paid dividends of $17.5 million, $16.3 million, and $13.5 million, respectively.
Retained earnings of the property-casualty and excess & surplus lines subsidiaries available for distribution as dividends are limited by law to the amount of statutory unassigned surplus as of the date a dividend is authorized or paid. The maximum amount legally available for distribution in 1997 without regulatory approval is $58.5 million.
The Company and its subsidiaries lease data processing equipment and certain office facilities under operating leases expiring in various years through 2003. Rental expense amounted to $3.9 million, $3.2 million, and $2.6 million for the years ended December 31, 1997, 1996, and 1995, respectively. At December 31, 1997 future minimum lease payments under noncancelable operating leases amounted to $13.5 million; they will amount to $2.7 million in 1998, $2.8 million in 1999, $1.4 million in 2000, $768,000 in 2001, $782,000 in 2002, and $5 million in later years.
In the normal course of business, ALLIED Mortgage grants mortgage loan commitments to borrowers, subject to normal loan underwriting standards. As of December 31, 1997, ALLIED Mortgage had granted loan commitments of approximately $91.6 million, including floating rate commitments of $25.5 million. ALLIED Mortgage may enter into options, futures, or cash delivery contracts to reduce interest risk on certain mortgage loans held for sale and loan commitments. As of December 31, 1997, ALLIED Mortgage had cash delivery contracts to sell mortgage securities totaling approximately $69.8 million and had no outstanding options or future contracts. In connection with its commitments to buy and sell mortgages, ALLIED Mortgage is exposed to credit risk in the event the counterparty is unable to fulfill its contractual obligations.
California has been the source of approximately 25% of the pool's direct written premiums for the past ten years. Proposition 103, approved by California voters in 1988, provides for a rollback of rates on premiums collected in calendar year 1989 to the extent that the insurer's return on equity for each Proposition 103 line exceeded 10%. The rollback liability, if any, has not been finalized. Management of the Company continues to believe that the insurance subsidiaries will not be liable for any material rollback of premiums.
The Company is party to various lawsuits arising in the normal course of business. Management believes the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations.
In 1997, the Company and the ESOP Trustee entered into an agreement whereby the Company agreed to release additional shares held by the ESOP Trustee in the event the Company pays a dividend on the common stock of less than $0.09 per share per quarter on a post-split basis. The agreement is in effect from March 7, 1997 through March 7, 2000. The purpose of the agreement is to ensure that the allocated shares in the ESOP Trust receive at least the same amount of dividends that would have been paid on the ESOP Convertible Preferred Stock had it not been converted to common stock.
Net periodic postretirement benefit cost for the years ended December 31, 1997, 1996, and 1995 included the following:
Since the adoption of SFAS 109, there has not been a valuation allowance for deferred income tax assets. In assessing the realization of deferred tax assets, management considers whether it is more likely than not that the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the recognition of future taxable income during the periods in which those temporary differences become deductible. Management considers tax planning strategies and the scheduled reversal of deferred tax liabilities in making this assessment and believes it is more likely than not the Company ultimately will realize the benefits of the deductible differences recognized at December 31, 1997.
The actual income tax expense for the years ended December 31, 1997, 1996, and 1995 differed from the expected tax expense (computed by applying the federal corporate tax rate of 35% to income before income taxes). The difference was primarily a result of investment income exempt from federal income tax, which decreased tax expense by $5.5 million, $4.7 million, and $4.5 million in 1997, 1996, and 1995, respectively.
Included in income tax expense is a state income tax benefit of $84,000 for the year ended December 31, 1997 and state income tax expense of $55,000 and $402,000 for the years ended December 31, 1996, and 1995, respectively. The Company paid federal and state income taxes of $26.2 million, $18 million, and $19.1 million in 1997, 1996, and 1995, respectively.
The IRS is currently examining the 1995 and 1996 income tax returns. Any proposed adjustments are not expected to have a material impact on the Company's financial condition, results of operations, or liquidity.
Presented in the following table is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computation for the three years ended December 31, 1997, 1996, and 1995:
(1) The ESOP Series was converted on March 7, 1996 (note 10). (2) Options in subsidiary were exercised in 1997, producing minority interest reported on the Statements of Income and Comprehensive Income.
Options to purchase 75,000 shares of common stock at a weighted average price of $30.42 per share were outstanding at December 31, 1997 but not included in the computation of diluted earnings per share because the options' exercise price was greater than the average 1997 market price of common shares.
The following table presents a summary of the Company's operating segment for the three years ended December 31, 1997: