The Company's executive office is located at 9 Farm Springs Road, Farmington, Connecticut, 06032. The Company's executive office facility consists of approximately 140,000 square feet and is leased at an annual rental of approximately $3.2 million. DPIC owns its office building, which consists of approximately 42,000 square feet, in Monterey, California. OrionAuto owns facilities in Englewood, Colorado; Salem, Oregon; Freeport, Illinois; and Goldsboro, North Carolina. Those facilities consist, in the aggregate, of approximately 254,000 square feet. Grocers owns its office building, which consists of 43,500 square feet, in Portland, Oregon.
All of the other insurance operations of the Company are conducted from leased premises in or adjacent to major urban centers throughout the United States, Puerto Rico, Canada and Bermuda. These operations, in the aggregate, occupy approximately 1,070,000 square feet, at an annual rental of approximately $12.0 million. The Company believes that its current facilities are suitable and adequate for their present use and anticipated requirements.
The following table summarizes information with respect to the operations and financial condition of Orion and its subsidiaries. Common stock and per common share data have been restated to give effect to the 2-for-1 stock split issued on July 7, 1997. The Company owned slightly less than 50% of Guaranty National Corporation until the Company increased its ownership to 81% in July 1996 and 100% in December 1997. Guaranty National Corporation is included in the financial statements of the Company on a consolidated basis beginning on January 1, 1996 with recognition of minority interest expense for the portion of Guaranty National Corporation's earnings attributable to shares not owned by the Company until it became a wholly-owned subsidiary. For 1994 and 1995, the Company's investment in Guaranty National Corporation was accounted for using the equity method. The Company's acquisitions have been included in its financial statements from date of purchase and up to the date of sale for divestitures.
Workers Compensation - this segment includes the workers compensation insurance products and services sold by the EBI Companies ("EBI").
On December 16, 1997 the Company purchased Unisun Insurance Company ("Unisun") from Michigan Mutual Insurance Company for $26.2 million in cash including acquisition expenses. Unisun is the largest automobile insurance facility carrier in South Carolina and also writes personal automobile insurance in the States of Alabama, Georgia and North Carolina. Unisun has been included in the Company's consolidated financial statements from the date of acquisition. Total net premiums written by Unisun for 1997 are approximately $20 million. The total consideration exceeded the fair value of the acquired net assets by approximately $5.3 million and is being amortized over 25 years.
On July 9, 1998 the Company completed the acquisition of Grocers Insurance Group ("Grocers") from United Grocers, Inc. for $36.7 million in cash including acquisition expenses. Grocers, an Oregon-based specialty insurance holding company, is a recognized leader in providing specialized insurance programs to the grocery and food service industry. In 1997, Grocers wrote approximately $23 million of net premiums, principally general liability, property and workers compensation with the majority of its volume concentrated in the Northwestern states. The acquisition was accounted for as a purchase and, accordingly, Grocers has been included in the Company's consolidated financial statements from the date of acquisition. The total consideration exceeded the fair value of the net assets acquired by approximately $8.1 million and is being amortized over 25 years.
In connection with the third quarter realignment, the Company performed an actuarial analysis for the business to be exited resulting in a provision for losses and loss adjustment expenses of $27.8 million in the third quarter of 1998, including reserve strengthening of $10.8 million related to the 1998 accident year. The Company will continue in 1999 to assess Orion Specialty's remaining programs.
In December 1998, the Company agreed to sell its investment in Intercargo for $22.8 million or $12 per share, in cash pursuant to the terms of Intercargo's merger with X. L. America, Inc, a subsidiary of EXEL Limited. The Company reduced the carrying value of its investment in Intercargo to $22.8 million resulting in $7.0 million pre-tax realized investment loss during December 1998. The sale of Intercargo is expected to be complete late in the first quarter or early in the second quarter of 1999, subject to regulatory approval.
% Change -------------- (In millions, except for %) 1998 1997 1996 98/97 97/96 - ---------------------------------------------------------------------
Operating earnings, after-tax realized investment gains, net earnings and per diluted common share amounts for the years ended December 31 are summarized as follows:
% Change ------------------ (In millions, except for %) 1998 1997 1996 98/97 97/96 - ------------------------------------------------------------------------------ Orion Specialty ... $ 376.2 $ 402.8 $ 409.6 -6.6% -1.7% DPIC .............. 185.0 198.7 195.6 -6.9% 1.7% McGee ............. 104.4 57.1 41.6 82.8% 37.4% -------- -------- -------- ---- ---- 665.6 658.6 646.8 1.1% 1.8% Assumed reinsurance (0.5) 10.6 79.0 (a) (a) -------- -------- -------- ---- ---- $ 665.1 $ 669.2 $ 725.8 -0.6% -7.8% ======== ======== ======== ==== ====
Net premiums written by DPIC for professional liability insurance decreased by 6.9% in 1998 compared to 1997 primarily due to rate reductions resulting from the competitive professional liability insurance market and growth in its more heavily reinsured products areas, partly offset by continual high levels of policy renewals and growth in project policies. The 1.7% increase in 1997 compared to 1996 is primarily attributable to the DPIC's continued high levels of policy renewals and new business offset in part by rate reductions in a competitive professional liability insurance market.
Orion Specialty's net premiums written decreased by 6.6% in 1998 compared to 1997 primarily due to its exit of unprofitable commodity program business and marginal lines of business related to a realignment of this unit. Exited programs during the past two years with the largest year-over-year impact on net premiums written were truck liability, marine, coal mine and nonstandard automobile personal injury protection. Net premiums written also reflect lower premiums from Orion Specialty's collateral protection business and from Colorado Casualty, which was sold on September 29, 1998 as part of realigning Orion Specialty. These decreases were partly offset by higher premiums from the acquisition of Grocers on July 9, 1998.
In 1997 compared to 1996, Orion Specialty's net premiums written decreased by 1.7% primarily due to the cancellation of marine programs and lower premiums of the commercial nonstandard business of Guaranty National resulting from agent and program cancellations, increased competition and lower production. These decreases were partly offset by higher premiums written by the former Connecticut Specialty unit from transportation programs and low exposure professional liability programs, higher retentions after a change in reinsurance effective May 1996, and premium volume growth for Orion Specialty's collateral protection business.
McGee's net premiums written increased by 82.8% in 1998 compared to 1997 due to the Company's greater participation in the underwriting pools managed by McGee and increased premium retention reflecting a change in McGee's reinsurance programs effective July 1998. The Company's participation in McGee's United States pool was 71.5% in 1998, 52% in 1997 and 37% in 1996. Participation in McGee's Canadian pool was 72% in 1998, 61% in 1997 and 49% in 1996.
The net premiums written growth of 30.3% for Nonstandard Automobile in 1997 compared to 1996 is due to newly-enacted legislation in the state of California which requires all drivers to maintain minimum liability insurance effective January 1997. This change in California law resulted in a 75% increase in the Nonstandard Automobile's one-month product business to approximately $155 million in 1997.
Net investment income increased by $19.5 million in 1997 compared to 1996 primarily due to a higher investment base and a slight increase in pre-tax investment yields. The higher investment base for 1997 reflects the proceeds from the issuance of $125 million of trust preferred securities in January 1997 and the effects of positive operating cash flow. These increases have been offset in part by the July 1996 cash outlay of approximately $88.2 million for the purchase of Guaranty National common shares.
Net investment income reflects limited partnership investment equity earnings of $2.6 million in 1998, $17.1 million in 1997 and $16.0 million in 1996. The decrease in limited partnership earnings in 1998 as compared to 1997 is due primarily to a $14.1 million pre-tax investment loss recorded in the third quarter of 1998. This loss was attributed to volatility and declines in the financial markets during the third quarter of 1998 resulting in significant declines in value of three of the Company's larger limited partnership investments. The increase in limited partnership earnings for 1997 as compared to 1996 is primarily attributable to favorable performance for a majority of the limited partnership investments. Earnings (losses) from limited partnership investments can vary considerably from year-to-year. The Company's long-term experience with limited partnership investments has been quite favorable; however, they represented only 4.5% and 3.6% of total investments at December 31, 1998 and 1997, respectively. The Company currently plans to modestly reduce its limited partnership investments in 1999.
The Company monitors the financial condition of the issuers of securities that it owns. When conditions are deemed appropriate, the Company ceases to accrete discounts, or accrue interest and dividends and, in cases where the value of such investments is deemed to be other than temporarily impaired, recognizes losses. The Company's non-investment grade securities are highly diversified, with an average investment per issuer of approximately $1.7 million at December 31, 1998. The largest non-investment grade security had a carrying value of $12.0 million at December 31, 1998.
Net realized investment gains are $52.5 million, $47.8 million and $24.2 million for 1998, 1997 and 1996, respectively. Realized investment gains (losses) vary from period to period, depending on market conditions relative to the Company's investment holdings, the timing of investment sales generating gains and losses, the occurrence of events which give rise to other-than-temporary impairment of investments, and other factors. Approximately 25% of the 1998 net realized investment gains resulted from the sale of two investments in entities which were acquired or taken public during the first quarter. In the fourth quarter of 1998, the Company recorded a $7.0 million realized loss in connection with the pending sale of its investment in Intercargo. Excluding provisions for other-than-temporary impairment, sales of equity securities have resulted in net gains of $41.1 million, $44.2 million and $22.4 million and sales of fixed maturity investments have resulted in net gains of $15.7 million, $6.0 million and $3.2 million in 1998, 1997 and 1996, respectively. Realized investment gains may be reduced by provisions for losses on securities deemed to be other-than-temporarily impaired. Impairment provisions of $1.1 million, $0.4 million and $0.3 million for equity securities and $3.2 million, $2.0 million and $1.1 million for fixed maturity investments were recognized in 1998, 1997 and 1996, respectively. Any such provision is based on available information at the time and is made in consideration of the decline in the financial condition of the issuers of such securities.
Net unrealized investment appreciation (depreciation) for equity securities and fixed maturities classified as available-for-sale are recorded in stockholders' equity, net of federal taxes. Unrealized investment appreciation (depreciation) can vary significantly depending upon fluctuations in interest rates, changes in credit spreads and in equity prices. For 1998, equity securities and fixed maturities recorded in stockholders' equity had unrealized depreciation of $50.4 million and $30.0 million, respectively, after taking $52.5 million of realized net gains. For 1997, equity securities and fixed maturities recorded in stockholders' equity had unrealized appreciation of $18.4 million and $38.9 million, respectively, after taking $47.8 million of realized net gains. See section titled "Market Risk of Financial Instruments" on pages 47-48.
Loss and loss adjustment expenses ratio by segment: Workers Compensation 57.5% 53.7% 58.8% Specialty Commercial 74.0% 72.1% 71.3% Nonstandard Automobile 69.1% 70.0% 71.3%
The loss ratio for Workers Compensation increased in 1998 compared to 1997 due to the effects of competitive pricing pressure and a change in loss development reflecting upward adjustments to initial reserve estimates for the 1997 and prior accidents years. The benefit of EBI's service-oriented approach, working with its customers to prevent losses and reduce claim costs, has partially offset this impact. The loss ratio for Workers Compensation decreased in 1997 compared to 1996 due to favorable loss development and loss experience achieved by EBI through its service-oriented approach.
Establishing reserve liabilities for environmental claims is subject to significant uncertainties that make reserve estimation difficult. Judicial decisions have tended to expand insurance coverage beyond the intent of the policies. The disposition of such claims often requires lengthy and costly litigation. Uncertainties as to required clean-up remedies and difficulties in identifying the responsible parties add further to the complexity of reserve estimation for these claims. In recent years, the Company has intensified its efforts to settle and close environmental claims. In recognition of these efforts, reserves have also been increased to provide for the costs related to settling claims. To help minimize the cost of losses and claims, the Company maintains a dedicated environmental claims staff, which administers and continually evaluates each claim and its defense and settlement possibilities. In 1998, 1997 and 1996, the Company paid $7.5 million, $6.8 million and $4.8 million, respectively, for the costs of defending and settling such claims. Claim counts have been aggregated by year of coverage for each occurrence for which policyholders are being defended, and often include numerous claimants.
Interest expense was $19.4 million in 1998 and $24.7 million for both 1997 and 1996, decreasing 21.6% in 1998 compared to 1997. Interest expense declined in 1998 as a result of the repayment of the $100 million bank indebtedness of Guaranty National in February 1998 with proceeds from the issuance of the Company's 7.701% Trust Preferred Securities.
Other expenses were $44.0 million, $45.0 million and $43.0 million in 1998, 1997 and 1996, respectively. During the fourth quarter of 1998, the Company closed its corporate office in New York City and integrated the investment function into the corporate office located in Farmington, Connecticut. These actions resulted in a $2.3 million pre-tax charge for severance and office closure expenses.
Federal income taxes, including tax benefits from trust preferred securities, and the related effective tax rates are $34.3 million (25.0%) for 1998, $42.8 million (25.8%) for 1997 and $32.0 million (25.2%) for 1996. The Company's effective tax rates are less than the statutory tax rate of 35% primarily because of income derived from tax-advantaged securities.
Minority interest expense in trust preferred securities was $12.8 million for 1998 and $6.9 million for 1997. Minority interest expense in trust preferred securities represents the financing cost, after the federal income tax benefit, on Orion's 8.73% and 7.701% Trust Preferred Securities. The increase in 1998 and 1997 reflects minority interest expense associated with the issuance of the 7.701% and 8.73% Trust Preferred Securities in February 1998 and January 1997, respectively.
Minority interest expense in subsidiary net earnings of $7.0 million in 1997 and $8.7 million in 1996 was recorded for the after-tax portion of Guaranty National's earnings attributable to stockholders of Guaranty National other than the Company. Guaranty National became a wholly-owned subsidiary of the Company in December 1997.
Orion's insurance subsidiaries maintain liquidity in their investment portfolios substantially in excess of that required to pay claims and expenses. The insurance subsidiaries held cash and short-term investments of $242.4 million and $160.4 million at December 31, 1998 and 1997, respectively. The consolidated policyholders' surplus of Orion's insurance subsidiaries was $732.1 million and $789.0 million at December 31, 1998 and 1997, respectively. The Company's statutory operating leverage ratios of trailing twelve months net premiums written to policyholders' surplus was 2.1:1 at December 31, 1998 and 1.8:1 at December 31, 1997.
On July 8, 1998 the Company entered into a five year credit agreement with a group of banks which provides for unsecured borrowings up to $150 million, of which $8.0 million was outstanding at December 31, 1998. The Company intends to use the credit facility for general corporate purposes, which may include acquisitions. Borrowings under the credit agreement bear interest at LIBOR (London Interbank Offered Rate) plus a margin based upon the Company's credit ratings. The credit agreement requires the Company to maintain certain defined financial covenants including a maximum debt to total capitalization ratio and a minimum combined statutory surplus. Also, the credit agreement limits the Company's ability to incur secured indebtedness or certain contingent obligations except for indebtedness secured by liens specifically permitted by the credit agreement and additional secured indebtedness with a principal amount not exceeding a defined percentage of the Company's consolidated net worth. The Company is in compliance with the terms of this credit agreement. Management does not believe that the credit agreement's covenants or limitations unduly restrict the Company's operations or limit Orion's ability to acquire additional indebtedness.
The terms of Orion's indentures for its $100 million of 7.25% Senior Notes due 2005 and its $110 million of 9.125% Senior Notes due 2002 limit the amount of liens and guarantees by the Company and its ability to incur secured indebtedness without equally and ratably securing the senior notes. The senior notes are non-callable to maturity. Management does not believe that these limitations unduly restrict the Company's operations or limit Orion's ability to pay dividends on its stock. At December 31, 1998 the Company is in compliance with the terms of its senior note indentures. Management believes that the Company continues to have substantial sources of capital and liquidity from the capital markets and bank borrowings.
On February 2, 1998 Orion issued $125 million of 7.701% Junior Subordinated Deferrable Interest Debentures due April 15, 2028 (the "7.701% Debentures") to Orion Capital Trust II ("Trust II"), a Delaware statutory business trust sponsored by Orion. Trust II then sold $125 million of 7.701% capital securities (the "7.701% Trust Preferred Securities"), which have substantially the same terms as the 7.701% Debentures. Approximately $100 million of net proceeds from the sale of the 7.701% Trust Preferred Securities were used to repay bank indebtedness of Guaranty National in February 1998. The 7.701% Trust Preferred Securities are non-callable to maturity.
The "Year 2000 problem" exists because many computer programs which companies use rely on only the last two digits to refer to a particular year. As a result, these computer programs may interpret the Year 2000 as 1900. If not corrected, computer software may fail or create erroneous results. The potential impact of the Year 2000 problem on business, financial and governmental entities throughout the world is not known and, if not timely corrected, may broadly affect the national economy in which we operate.
The Company concluded that as an extensive user of technology, it has a material exposure to the Year 2000 problem and has taken steps to assess and address that exposure. In response to this issue, the Company has inventoried and assessed, for all its operations and locations, its insurance policy issuance, billing and collection, claims paying, and other operational systems, along with the hardware and software used in its computing facilities, embedded chips used in its physical structures, third party data-exchanges, and reliance on external business relations. This work has been carried out by the Company through central coordination supported by dedicated teams working at each Company site. Progress has been reviewed regularly by senior management. The process by which the Company is managing its Year 2000 efforts has also been reviewed by independent consultants.
The Company began addressing its computer programs in 1996 at the locations where its most significant technology concentration exists. Similar work commenced shortly thereafter at other locations.
In addition to addressing its own hardware, software and processing exposure, the Company has been engaged since 1996 in a process of identifying and prioritizing critical suppliers and customers at the direct interface level, and communicating with them about their plans and progress in addressing the Year 2000 problem.
The Company has mailed letters to significant vendors and service providers and has verbally communicated with many strategic customers to determine the extent to which interfaces with such entities are vulnerable to Year 2000 problems and whether the products and services purchased from or by such entities are Year 2000 compliant. As of December 31, 1998, the Company had received responses from approximately 65% of the third parties of whom it has inquired and 90% of the companies that have responded have provided written assurances that they expect to address all their significant Year 2000 problems on a timely basis.
A follow-up mailing to significant vendors and service providers that did not initially respond, or whose responses were deemed unsatisfactory by the Company, is expected to be completed by March 31, 1999. The Company will also expand its survey to vendors and service providers who do not directly interface with the Company's systems.
The Company presently believes that the Year 2000 problems will not pose significant operational problems for the Company. However, if all Year 2000 problems are not properly identified, or assessment, remediation and testing are not effected timely with respect to Year 2000 problems that are identified, there can be no assurance that the Year 2000 issue will not materially adversely impact the Company's results of operations or adversely affect the Company's relationships with customers, vendors, or others.
In addition to interest rate risk, the Company's common equity portfolio of $242.4 million at December 31, 1998 is subject to changes in value based on changes in equity prices in United States markets. The Company's common equity portfolio is highly correlated with the S&P 500 and Russell 2000 indices in equal amounts.
The Company manages its total investments, so that at all times, there are fixed income securities that are adequate in amount and duration to meet the cash requirements of current operations and longer term liabilities, as well as to meet insurance regulatory requirements with respect to investments under specific state insurance laws. To the extent that there are funds available for investment beyond these requirements, the investment objective for such funds is to maximize total return within a prudent level of risk, taking into account the potential impact on the volatility of reported earnings and reserves. The Company shall adjust investment risk to offset or complement insurance risk based upon total corporate risk tolerance. The Company has investment guidelines for fixed income and equity portfolios covering portfolio characteristics, permitted investments, diversification and performance benchmarks.
Value at risk estimates are presented in the table below and represent the potential after-tax change in value of the Company's invested assets, which, to the extent unrealized, would generally be included directly in stockholders' equity. Caution should be used in evaluating the Company's overall market risk from the information below, since actual results could differ materially because the information was developed using estimates and assumptions as described in this section. These estimates exclude any potentially offsetting effect resulting from movements in the economic value of the Company's liabilities, most importantly, loss reserves and reinsurance recoverables on unpaid losses. The estimates shown in the table were calculated using Monte Carlo simulation involving 5,000 stochastic paths with a 95 percent confidence level based on weekly correlation's and volatilities based upon observed values for 1991 - 1998. Mean assumptions included no change in weekly interest rates and an 8.0% annual appreciation for the common equity portfolio. The Company's total value at risk includes a diversification benefit since interest rate and equity risks are only partially correlated.
In March 1998, the AICPA issued SOP 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. This statement provides guidance on accounting for costs of computer software developed or obtained for internal use including when incurred costs are and are not eligible for capitalization. This statement is effective for 1999 financial statements with early adoption permitted. The Company is currently evaluating the impact of the adoption of this statement and the potential effect on its financial position and result of operations.
All statements made in this annual report that do not reflect historical information are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Such factors include, among other things, (i) general economic and business conditions; (ii) interest rate changes; (iii) competition and regulatory environment in which the Company operates; (iv) claims frequency; (v) claims severity; (vi) medical cost inflation; (vii) increases in the cost of property repair; (viii) the number of new and renewal policy applications submitted to the Company; (ix) Year 2000 problems and (x) other factors over which the Company has little or no control. The Company's expectation that its plan for Year 2000 Compliance will be completed on schedule depends, in large part, on the Company's own efforts and expenditures on hardware, software and systems, which is on schedule as to those exposures which the Company has been able to identify. However, Year 2000 problems could also arise because of unanticipated non-compliance on the part of vendors, agents, customers and other third parties including governmental entities. Significant Year 2000 problems could materially and adversely affect future performance and results of operations. The Company disclaims any obligation to update or to publicly announce the impact of any such factors or any revisions to any forward-looking statements to reflect future events or developments.
The Company has a system of internal control which it believes provides reasonable assurance that assets are safeguarded from loss or unauthorized use, that transactions are recorded in accordance with management's policies and that the financial records are reliable for preparing financial statements. The system of internal control includes written policies and procedures that are communicated to all appropriate personnel and updated as necessary.
Compliance with the system of internal control is continuously maintained and monitored by management. The internal audit staff of the Company evaluates and reports on the adequacy of and adherence to these controls, policies and procedures. In addition, as part of its audit of the consolidated financial statements, Deloitte & Touche LLP, the independent auditors for the Company, perform an evaluation of the system of internal control to the extent they consider necessary to express an opinion on the consolidated financial statements. Both the internal auditors and Deloitte & Touche LLP provide recommendations concerning the system of internal control, and management takes actions, which are believed to be appropriate responses to these recommendations.
W. Marston Becker Michael L. Pautler Chairman & Chief Executive Officer Senior Vice President & Chief Financial Officer
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Orion Capital Corporation and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
ORION CAPITAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET LIABILITIES AND STOCKHOLDERS' EQUITY
Stockholders' equity: Preferred stock, authorized 5,000,000 shares; issued and outstanding - none Common stock, $1 par value; authorized 50,000,000 shares; issued 30,675,300 shares ..................... 30.7 30.7 Capital surplus ......................................... 149.6 152.1 Retained earnings ....................................... 553.2 469.5 Accumulated other comprehensive income .................. 58.5 109.2 Treasury stock, at cost (3,505,091 shares - 1998 and 3,069,756 shares - 1997)...................... (57.8) (34.3) Deferred compensation on restricted stock ............... (6.9) (4.1) --------- --------- Total stockholders' equity .......................... 727.3 723.1 --------- --------- Total liabilities and stockholders' equity ..........$ 4,164.4 $ 3,884.1 ========= ========= [FN]
Investments - Fixed maturity investments include bonds, preferred stocks with mandatory redemption features, and certificates of deposit that mature more than one year after the balance sheet date. Fixed maturity investments that the Company has both the positive intent and the ability to hold to maturity are recorded at amortized cost. Fixed maturity investments, which may be sold in response to, among other things, changes in interest rates, prepayment risk, income tax strategies or liquidity needs are classified as available-for-sale and are carried at market value. Common stocks and non-redeemable preferred stocks are also carried at market value. Fluctuations in the market value of these available-for-sale securities are recorded as unrealized investment gains or losses and credited or charged to stockholders' equity. Other long-term investments principally include equity ownership interests in limited partnerships, which are recorded using the equity method of accounting. Short-term investments include certificates of deposit and commercial paper that mature within one year of the balance sheet date, money market accounts and United States Treasury Bills. Short-term investments are recorded at market value, which approximates cost. Market values are generally based on quoted market prices or dealer quotes. Realized investment gains and losses, including provision for other than temporary impairment of investment securities, are recognized on the specific identification method.
Excess of Cost Over Fair Value of Net Assets Acquired - The excess of the cost of acquiring subsidiaries over the fair value of their net assets ("goodwill") is amortized on a straight-line basis over periods of 25 to 40 years. The Company evaluates the recoverability of goodwill from expected future cash flows, and impairments would be recognized in operating results if a permanent diminution in value were to occur.
Policy Liabilities and Reinsurance - Loss and loss adjustment expense liabilities are established in consideration of individual cases for reported losses and past experience for incurred but not yet reported losses ("IBNR"). Estimated reinsurance receivables are recognized in a manner consistent with the liabilities relating to the underlying reinsured contracts. At December 31, 1998 and 1997, long-term disability workers compensation loss reserves are carried at $46.0 million and $52.9 million, respectively, in the consolidated financial statements at net present value using a statutory interest rate of 3.5%. Policyholders' dividends on participating policies are accrued at estimated payment rates as the related premiums are earned. Participating business represented 19% and 18% of premiums in-force at December 31, 1998 and 1997, respectively. As a percent of premiums earned, participating business amounted to 19% in 1998, 18% in 1997 and 16% in 1996.
Earnings Per Common Share - In the fourth quarter of 1997, the Company adopted Statement of Financial Accounting Standards ("FAS") No. 128, "Earnings per Share," for all periods presented. Basic earnings per share computations are based on the average number of shares of common stock outstanding during the year. Diluted earnings per share reflect the assumed exercise and conversion of all securities, including stock options. All common stock and per share common stock data presented has been restated to give effect to the 2-for-1 stock split of the Company's common stock issued on July 7, 1997.
Comprehensive Income - As of January 1, 1998 the Company adopted FAS No. 130, "Reporting Comprehensive Income". This statement establishes standards for the reporting and presentation of comprehensive income and its components in financial statements. Comprehensive income encompasses all changes in shareholders' equity (except those arising from transactions with shareholders) and includes net income, net unrealized capital gains or losses on available-for-sale securities and foreign currency translation adjustments. This standard requires additional disclosures and does not affect the Company's financial position or results of operations.
Reclassifications - The 1997 and 1996 consolidated financial statements have been reclassified to conform to the 1998 presentation.
Grocers - On July 9, 1998 the Company completed the acquisition of Grocers Insurance Group ("Grocers") from United Grocers, Inc ("United"). Grocers is an Oregon-based specialty insurance holding company serving the grocery and food service industry. In 1997, Grocers reported approximately $23 million of net premiums written, principally general liability, property and workers compensation with the majority of its volume concentrated in the Northwestern states. The purchase price was $36.7 million in cash including acquisition expenses of $ 0.4 million. The Company made cash payments of $32.4 million in 1998 related to the purchase of Grocers. At December 31, 1998 the Company retained $4.0 million of the purchase price due to United to secure obligations of United and Grocers. The Company used cash and short-term investments to fund the purchase. The acquisition was accounted for as a purchase and accordingly, Grocers has been included in the Company's consolidated financial statements from the date of acquisition. The total consideration exceeded the fair value of the net assets acquired by approximately $8.1 million and is being amortized over 25 years. The pro forma consolidated results of the Company's operations, as if the Grocers purchase had been made as of the beginning of the year, would not be materially different than reported herein.
Unisun - On December 16, 1997, the Company purchased Unisun Insurance Company ("Unisun") from Michigan Mutual Insurance Company for $26.2 million in cash including acquisition expenses of $0.2 million. Unisun is the largest automobile insurance facility carrier in South
Carolina and also writes personal automobile insurance in the States of Alabama, Georgia and North Carolina. Total net premiums written by Unisun for 1997 were approximately $20.0 million. The acquisition includes a purchase price contingency for loss development incurred by Unisun during the period from the acquisition date to December 31, 2002 relating to accident years prior to the acquisition date. The acquisition of Unisun was accounted for as a purchase, and accordingly, Unisun has been included in the Company's financial statements from the date of acquisition. The total consideration exceeded the estimated fair value of net assets of Unisun by $5.3 million, which is being amortized over 25 years. The pro forma consolidated results of the Company's operations, as if the Unisun purchase had been made as of the beginning of the year, would not be materially different than reported herein.
of Guaranty National. The excess of cost over the estimated fair value of the 31.5% interest in Guaranty National's net assets acquired during 1996 was $9.1 million, after the reversal of $21.5 million of deferred taxes, and will be amortized over 28 years, which was the remaining amortization period for goodwill recorded upon Orion's initial investment in Guaranty National.
The restructuring liability activity for the year ended December 31, 1998 is as follows:
The carrying values of the Company's investment in affiliates were $22.8 million at December 31, 1998 and $31.3 million at December 31, 1997. The carrying value included $3.0 million and $10.5 million of goodwill at December 31, 1998 and 1997, respectively. In August 1997, Intercargo recognized a gain before taxes of $49.4 million from the sale of substantially all of its interest in Kingsway Financial Services. The Company reflected its portion of the Kingsway sale by recording a gain before taxes of $7.0 million in the fourth quarter of 1997.
Summarized financial information for the Company's affiliate is set forth below:
(a) 1998 includes $7.0 million realized loss related to the planned sale of Intercargo.
The amortized cost and estimated market values of fixed maturity and short-term investments at December 31, 1998, by contractual fiscal maturity, are shown below. Expected maturities will differ from contractual maturities because issuers of securities may have the right to call or prepay obligations with or without call or prepayment penalties.
The carrying value of securities on deposit with state regulatory authorities in accordance with statutory requirements totaled $242.4 million and $223.4 million at December 31, 1998 and 1997, respectively. Excluding investments in securities of the United States Government and its agencies, the Company had investments in only one issuer (AAA rated fixed income securities totaling $26.7 million) that exceeded $25.0 million. The Company had $0.2 million of fixed maturity investments for which it was not accruing income for both 1998 and 1997.
In the normal course of business, the Company's insurance subsidiaries reinsure certain risks, generally on an excess-of-loss or pro rata basis, with other companies to limit exposure to losses. Reinsurance does not discharge the primary liability of the original insurer. As of December 31, 1998 and 1997, recoverables for reinsurance ceded to the Company's two largest reinsurers were an aggregate of $71.7 million and $132.8 million, respectively. As of December 31, recoverables for reinsurance ceded to the two largest McGee pool members other than the Company aggregated $50.6 million for 1998, and $54.7 million for 1997, and the Company had ceded balances payable to these pool members of $6.3 million and $21.0 million, respectively.
The table below illustrates the effect of reinsurance on premiums written and premiums earned for the years ended December 31:
Reinsurance recoverables and prepaid reinsurance includes prepaid reinsurance of $129.8 million at December 31, 1998 and $125.5 million at December 31, 1997.
Net balance, beginning of year . $ 1,390.7 $ 1,368.4 $ 994.0 Effect of acquisitions and other 16.9 8.9 286.3 ---------- ---------- ---------- 1,407.6 1,377.3 1,280.3 ---------- ---------- ---------- Provision: Current year ................ 986.6 896.3 874.1 Prior years ................. 33.9 9.2 8.9 ---------- ---------- ---------- 1,020.5 905.5 883.0 ---------- ---------- ---------- Payments: Current year ................ 450.3 370.9 499.2 Prior years ................. 559.4 521.2 295.7 ---------- ---------- ---------- 1,009.7 892.1 794.9 ---------- ---------- ---------- Net balance, end of year ....... 1,418.4 1,390.7 1,368.4 Add reinsurance recoverables 599.3 481.0 417.3 ---------- ---------- ---------- Balance, end of year ........... $ 2,017.7 $ 1,871.7 $ 1,785.7 ========== ========== ==========
$110.0 face amount, 9.125% Senior Notes, due September 1, 2002 . $ 109.9 $ 109.9 $ 118.9 $ 121.2 $100.0 face amount, 7.25% Senior Notes, due July 15, 2005 ..... 99.5 99.4 102.9 103.2 Bank credit facility ............ 8.0 -- 8.0 -- Loan agreement with banks ....... -- 100.0 -- 100.0 Collateralized term loan ........ -- 0.9 -- 0.9 -------- -------- -------- -------- $ 217.4 $ 310.2 $ 229.8 $ 325.3 ======== ======== ======== ========
The $100 million borrowings under the loan agreement between Guaranty National and several banks outstanding at December 31, 1997 was fully repaid by the Company in February 1998 from proceeds of the sale of the 7.701% Trust Preferred Securities (See Note 9).
The 8.73% and 7.701% Trust Preferred Securities are subordinate to all liabilities of the Company. The Company may defer interest distributions on these Trust Preferred Securities; however, during any period when such cumulative distributions have been deferred, Orion may not declare or pay any dividends or distributions on its common stock. The Company registered the Trust Preferred Securities under the Securities Act of 1933. The Trusts are consolidated in the Company's financial statements because they are wholly-owned by the Company. The sole assets of the Trusts are the Debentures issued by Orion. Orion has given its partial guarantee, which when taken together with the Company's obligations under the declaration of the Trust, the Debentures, and the indenture pursuant to which the Trust Preferred Securities are issued including its obligations to pay costs, expenses, debts and liabilities of the Trusts (other than with respect to the Trust Preferred Securities), provides a full and unconditional guarantee of amounts due on the Trust Preferred Securities.
In October 1996 the Internal Revenue Service ("IRS") completed an examination of the Company's federal income tax returns through 1992. Certain tax benefits from tax attributes existing at the date of the Company's reorganization in 1976 were not recognized pending completion of the IRS examination. Accordingly, the Company recorded a credit to capital surplus in 1996 for tax benefits of $11.9 million with respect to the 1976 reorganization. The recording of this credit had no impact on the Company's earnings.
(In millions) 1998 1997 - ----------------------------------------------------------- Deferred tax assets: Loss reserve discounting ........ $ 71.8 $ 72.2 Unearned premium reserves ....... 32.6 30.1 Policyholders' dividends ........ 6.3 7.1 Retiree medical benefits ........ 5.4 4.6 Deferred compensation ........... 5.0 7.8 Other ........................... 20.9 19.8 ------- ------- 142.0 141.6 ------- ------- Deferred tax liabilities: Deferred policy acquisition costs 54.7 51.5 Unrealized investment gains ..... 30.2 58.4 Investment income ............... 18.3 16.5 Other ........................... 12.1 14.2 ------- ------- 115.3 140.6 ------- ------- Net deferred tax asset ....... $ 26.7 $ 1.0 ======= =======
The Company maintains 401(k) and Profit Sharing Plan(s) ("Plans"), qualified under the Internal Revenue Code Section 401(a) for eligible employees of the Company. (These Plans include the Orion Capital 401(k) and Profit Sharing Plan, Orion Capital Corporation Retirement Savings Plan for the Employees of Guaranty National Insurance Company and Wm. H. McGee & Co., Inc. Profit Sharing Plan.) Employee and employer matched contributions to the Plans are limited to the extent allowable under the Plans and in accordance with Internal Revenue Code limits. The Plans also provide a provision that allows the Company to make annual profit sharing contributions to the Plans based on percentage of employee's compensation. The profit sharing contribution is determined annually by the Company. Employees vest in the Company's contributions on a graduated scale over a six-year or seven-year period. In addition to the active plans, Strickland, acquired in April 1998, froze its 401(k) defined contribution plan for all its eligible employees. The Company has adopted supplemental benefit plans to provide
accrual of benefits for those eligible employees who receive less than the full employer contributions to the Company's qualified plans as a result of the Internal Revenue Code limitations.
$ 10.01 - $ 17.50 167.3 $ 15.12 5.1 167.3 $ 15.12 17.51 - 25.00 310.5 21.48 6.9 210.3 21.44 25.01 - 40.00 791.2 32.32 9.0 140.4 25.89 40.01 - 46.00 305.4 43.87 8.8 76.4 43.87 46.01 - 57.00 37.0 52.95 9.3 - - ------- --------- 10.01 - 57.00 1,611.4 31.10 8.1 594.4 23.59 ======= ======== === ========= =========
The weighted average fair value of options granted was $10.62 per share for 1998, $14.08 per share for 1997 and $14.58 per share for 1996. The fair value of options granted was estimated on the date of grant using the binomial option-pricing model with the following weighted-average assumptions: dividend yield of 1.9% - 1998 and 1996, and 1.5% - 1997; expected volatility of 22% - 1998, 23% - 1997 and 19% - 1996; risk free interest rate of 5.4% - 1998, 5.5% - 1997 and 6.0% - 1996; and expected life 7.0 years - both 1998 and 1997 and 7.1 years in 1996.
The Company and subsidiaries provide postretirement benefits to eligible employees, who have attained age 55 and have 10 years of consecutive service immediately prior to retirement. The Company premium subsidy provided to eligible participants electing continuation of medical Plan benefits coverage is a service formula based on years of service up to a maximum of 25 years.
Orion maintained a non-qualified defined benefit retirement plan for members of the Board of Directors who are not employees. On December 31, 1997, the Company terminated this plan resulting in $0.3 million of benefits payments in January 1998 with the remaining accrued benefits of $0.4 million to be paid with interest in future periods. Benefits were based on years of service and director fee levels at retirement or termination date of the plan.
Minimum lease commitments at December 31, 1998, with the majority having initial lease periods from one to twenty-five years, are as follows:
Rent expense amounted to $20.2 million, $23.1 million and $19.8 million for 1998, 1997 and 1996, respectively. Substantially all leases are for office space and equipment. A number of lease commitments contain renewal options ranging from one to thirty years.
During 1998, the Company repurchased 836,100 shares of its common stock at an aggregate cost of $35.6 million under the stock repurchase program authorized by the Board of Directors and repurchased 45,615 shares at an aggregate cost of $2.4 million related to its employee benefit plans. The Company repurchased 42,916 shares for $1.5 million in 1997 and 482,228 shares for $11.2 million in 1996 under the stock repurchase program.
Orion declared dividends on its common stock of $19.1 million, $17.1 million and $14.3 million, or $0.70, $0.62 and $0.51 per share in 1998, 1997 and 1996, respectively.
A reconciliation of basic and diluted earnings per share ("EPS") for the years ended December 31 is as follows:
Net Average Per Share (In millions, except for per share amounts) Earnings Shares Amount - ------------------------------------------------------------------------------- 1998 - Basic EPS: Net earnings available to common stockholders $ 102.8 27.2 $ 3.78 ========== Stock options and awards - 0.6 --------- --------- Diluted EPS: Net earnings available to common stockholders with assumed exercises $ 102.8 27.8 $ 3.69 ========= ========= ========== 1997 - Basic EPS: Net earnings available to common stockholders $ 115.8 27.3 $ 4.24 ========== Stock options and awards - 0.6 --------- --------- Diluted EPS: Net earnings available to common stockholders with assumed exercises $ 115.8 27.9 $ 4.15 ========= ========= ========== 1996 - Basic EPS: Net earnings available to common stockholders $ 86.6 27.4 $ 3.16 ========== Stock options and awards - 0.4 --------- --------- Diluted EPS: Net earnings available to common stockholders with assumed exercises $ 86.6 27.8 $ 3.12 ========= ========= =========
Effective as of September 11, 1996, Orion redeemed its old stockholder rights plan and adopted a new Stockholder Rights Plan ("Rights Plan"). Under the Rights Plan each outstanding share of common stock includes one preferred stock purchase right ("Right"). The Rights Plan is designed to assure
Accumulated other comprehensive income balances, net of taxes, for the years ended December 31 are as follows:
Unrealized Unrealized Foreign Accumulated Unrealized Exchange Accumulated Other Investment Gains Translation Comprehensive (In millions) (Losses) Gains (Losses) Income (Loss) - -------------------------------------------------------------------------------- 1998: Balance, beginning of year $ 113.6 $ (4.4) $ 109.2 Current year change (52.4) 1.7 (50.7) -------- -------- -------- Balance, end of year $ 61.2 $ (2.7) $ 58.5 ======== ======== ========
The pre-tax unrealized investment gains (losses) were $(80.4) million, $62.9 million and $14.0 million for the year ended December 31, 1998, 1997 and 1996, respectively. The pre-tax unrealized foreign exchange translation gains (losses) were $2.6 million, $(3.4) million and $2.8 million for the year ended December 31, 1998, 1997 and 1996, respectively.
The components of change in accumulated other comprehensive income related to changes in unrealized investment gains (losses) for 1998 are as follows:
Specialty Commercial - this segment markets various specialty commercial products and services and includes professional liability insurance through DPIC Companies; client-focused specialty insurance programs through Orion Specialty; underwriting management specializing in ocean marine, inland marine and commercial property insurance through Wm. H. McGee; insurance for international trade through the Company's 26% interest in Intercargo Corporation; and also includes the run-off operations of the Company' assumed reinsurance business, SecurityRe, which was sold in late 1996. McGee and Intercargo are expected to be sold in 1999 as discussed in Notes 20 and 4.
Financial information for the Company's segments for the years ended December 31 is shown below:
Revenues: Workers Compensation - Premiums earned ....................... $ 429.8 $ 362.1 $ 356.8 Net investment income ................. 35.2 41.8 38.2 Realized investment gains ............. 19.1 13.8 6.8 Other income .......................... 0.6 0.3 0.2 ---------- ---------- ---------- Total Workers Compensation ......... 484.7 418.0 402.0 ---------- ---------- ---------- Specialty Commercial - Premiums earned ....................... 656.0 673.2 686.5 Net investment income ................. 82.9 90.5 82.4 Realized investment gains ............. 30.0 28.7 13.2 Other income .......................... 14.0 19.7 22.7 ---------- ---------- ---------- Total Specialty Commercial ......... 782.9 812.1 804.8 ---------- ---------- ---------- Nonstandard Automobile - Premiums earned ....................... 417.2 322.4 257.5 Net investment income ................. 21.2 21.8 19.7 Realized investment gains ............. 3.1 5.5 6.3 ---------- ---------- ---------- Total Nonstandard Automobile ....... 441.5 349.7 283.5 ---------- ---------- ---------- Other .................................... 7.6 10.8 3.2 ---------- ---------- ---------- Consolidated ....................... $ 1,716.7 $ 1,590.6 $ 1,493.5 ========== ========== ========== Pre-tax Earnings before Minority Interest: Workers Compensation .................. $ 86.2 $ 86.8 $ 68.4 Specialty Commercial .................. 54.2 65.3 56.5 Nonstandard Automobile ................ 37.1 40.7 23.3 Other ................................. (20.8) (16.6) (20.9) ---------- ---------- ---------- Consolidated ....................... $ 156.7 $ 176.2 $ 127.3 ========== ========== ==========
Identifiable Assets at December 31: Workers Compensation .................. $ 989.7 $ 936.2 Specialty Commercial .................. 2,240.5 2,066.2 Nonstandard Automobile ................ 883.3 811.4 Other ................................. 50.9 70.3 ---------- ---------- Consolidated ....................... $ 4,164.4 $ 3,884.1 ========== ==========
The miscellaneous income and expenses (primarily interest, general and administrative expenses and other consolidating elimination entries) of the parent company are reported as "Other" in the above table.
The accounting policies of the segments are the same as those described in Note 1 to the consolidated financial statements included herein. Investments, net investment income and realized investment gains are allocated to each segment based on the cash flows of these segments. Earnings for the segments represents earnings (loss) before federal income taxes and minority interest expense, and includes an allocation of payroll, office and other expenses incurred by the parent company to support the operations of the Company's segments. Earnings for Specialty Commercial include equity earnings (loss) of affiliate of $(0.7) million in 1998, $8.6 million in 1997 and $(0.4) million in 1996. Additionally, identifiable assets for Specialty Commercial include investment in affiliate, Intercargo, of $22.8 million and $31.3 million at December 31, 1998 and 1997, respectively.
Less than 2% of the Company's premiums are derived from operating units located outside the United States. Substantially all of the Company's long-lived assets are located in the United States. No one single customer represents 10% or more of the Company's revenue for 1998, 1997 and 1996.
In March 1998, the AICPA issued SOP 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. This Statement provides guidance on accounting for costs of computer software developed or obtained for internal use including when incurred costs are and are not eligible for capitalization. This Statement is effective for 1999 financial statements with early adoption permitted. The Company is currently evaluating the impact of the adoption of this Statement and the potential effect on its financial position and results of operations.
As a part of the Company's reshaping to focus resources on high potential lines of business, on March 11, 1999, the Company announced the signing of a definitive agreement to sell McGee. The transaction is expected to be complete by April 1999, subject to regulatory approvals and other closing conditions.