- Management Analysis of Financial Position and Results of Operations ($ in Millions, Except Share Data) - -------------------------------------------------------------------------------
The Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 128 (FAS-128) Earnings Per Share, in February 1997. This statement has been adopted by Old Republic, and prior period data has been restated for comparative purposes.
Old Republic's financial position at December 31, 1997 reflected increases in assets, liabilities and common shareholders' equity of 4.0%, 0.7% and 13.3%, respectively, when compared to the immediately preceding year-end. Cash and invested assets represented 69.6% and 67.9% of consolidated assets as of December 31, 1997 and December 31, 1996, respectively.
Relatively high short-term maturity investment positions continued to be maintained as of most recent year ends to provide necessary liquidity for specific operating needs and to enhance flexibility in investment strategy. Changes in short-term investments reflect a large variety of seasonal and intermediate-term factors including seasonal operating cash needs, investment strategy, and expectations as to trends in interest yields. Accordingly, the future level of short-term investments will vary and respond to the dynamics of these factors and may, as a result, increase or decrease from current levels. During 1997 and 1996, the Corporation committed substantially all investable funds in short to intermediate-term fixed maturity securities with an emphasis on tax-exempt bonds. Old Republic continues to adhere to its long-term policy of investing primarily in investment grade, marketable securities; the Corporation has not directed its investable funds to so-called "junk bonds" or derivative types of securities. Old Republic's commitment to equity securities during 1997 was approximately equal to the related invested balance at year-end 1996. At December 31, 1997, the Company had no investments in default as to principal and/or interest.
The Company does not own or utilize derivative financial instruments for the purpose of hedging, enhancing the overall return of its investment portfolio, or reducing the cost of its debt obligations. Old Republic employs traditional investment management tools and techniques to address the yield and valuation exposures of its invested assets. The long term fixed maturity investment portfolio is managed so as to limit various risks inherent in the bond market. Credit risk is addressed through adequate diversification and the purchase of investment grade securities. Reinvestment rate risk is controlled by concentrating on non-callable issues, and through asset-liability matching practices. Purchases of mortgage and asset backed securities, which have variable principal prepayment options, are generally avoided. Market value risk is limited through the purchase of bonds of intermediate maturity. The combination of these investment management tenets generally provides
Old Republic's capitalization of $2,296.1 at December 31, 1997 consisted of debt and debt equivalents of $142.9, convertible preferred stock of $1.0, and common shareholders' equity of $2,152.1. The increase in the common shareholders' equity account during the past three years reflects primarily the retention of earnings in excess of dividends declared on outstanding preferred and common shares, the conversion of redeemable convertible preferred stock in 1997, the issuance of additional shares to effect a debt conversion in 1996, and an increase during 1997 and 1995 compared to a decrease during 1996 in the value of bonds and stocks carried at market value. Common shareholders equity increases in 1997 were partially offset by the acquisition of $62.1 of common stock in open market transactions. At its May 16, 1996 meeting, the Company's Board of Directors had authorized the reacquisition of up to $150.0 of common and preferred shares as market conditions would warrant during the twenty-four month period from that date; as of December 31, 1997, a total of $33.1 remained unutilized.
Common share data has been retroactively adjusted to reflect a 50% stock dividend of the Company's common shares approved by the Board of Directors on March 12, 1998. FAS-128 requires this stock dividend be reflected in the 1997 year-end financial statements.
Consolidated net premiums and fees earned increased by 8.0% in 1997 and 9.7% in 1996, while they declined by 3.5% in 1995. Property and liability earned premiums increased 4.5% in 1997 and 1.9% in 1996 and decreased by 1.5% in 1995; premium production trends in the past three years were affected by a soft pricing environment for most insurance coverages, and by lower participation in involuntary market (assigned risk) pools. Growth in mortgage guaranty premiums for the past three years was enhanced principally by a rise in the amount of renewal business, by territorial expansion, and by relatively strong mortgage lending activity. Title Group premiums and fee revenues increased 9.4% in 1997 and 20.3% in 1996, but decreased by 20.6% in 1995. Greater housing and mortgage finance activity were the main reasons for this rise in revenues in the most recent two years. Depressed conditions in the large California housing market and much lower refinancing activity nationwide resulted in reduced title insurance revenues in 1995. Life and disability premium volume increased moderately during the last three years as a result of greater term life and accident insurance production.
Consolidated benefit, claim, and related settlement costs, as a percentage of net premiums and fees earned, were approximately 48.4% in 1997, 49.9% in 1996 and 54.4% in 1995. This consolidated ratio was affected principally by an improving claim ratio for liability insurance coverages due mostly to reduced losses from involuntary workers compensation pool assessments, as well as reduced claim frequencies and severity generally. The loss ratio for mortgage guaranty insurance decreased slightly in 1997 compared to 1996 which increased compared to 1995; the 1996 increase was mostly due to a rise in frequency of claim occurrences, principally in the California market which has been affected by an economic slowdown for several years. The title insurance loss ratio in each of the past three years was affected by favorable trends in claims frequency and severity for business underwritten since 1992.
The ratio of consolidated underwriting, acquisition, and insurance expenses to net premiums and fees earned was approximately 45.2% in 1997, 46.0% in 1996 and 44.0% in 1995. Variations in these ratios reflect a continually changing mix of coverages sold and attendant costs of producing business. During the past three years, the property and liability and mortgage guaranty segments' expense ratios have remained relatively flat. The title insurance expense ratio has trended lower, particularly in 1997, due in part to an increase in premium and fees volume without a proportional increase in expenses. The decline in interest and other charges, particularly in 1997, is principally a result of the above noted reduction in outstanding debt.
The Company and its subsidiaries have been aware for several years of issues associated with programming codes in existing computer systems as the year 2000 approaches. The Company's subsidiaries are scheduled to complete by December 31, 1998, the identification and implementation of changes, and the testing of systems affected by this year 2000 issue. The costs of identifying, implementing, and testing the required changes has not been material to historical operating results. A significant portion of these costs was not incremental as the Company and its subsidiaries have mostly utilized existing resources.
Page No. -------- Consolidated Balance Sheets......................................... 24-25 Consolidated Statements of Income................................... 26 Consolidated Statements of Preferred Stock and Common Shareholders' Equity...................................... 27-28 Consolidated Statements of Cash Flows............................... 29 Notes to Consolidated Financial Statements.......................... 30-52 Report of Independent Accountants................................... 53
(c) Investments-The Company may classify its invested assets in terms of those assets relative to which it either (1) has the positive intent and ability to hold until maturity (generally carried at amortized costs for fixed maturity securities), (2) has available for sale (carried at fair value with adjustments to equity, net of deferred income taxes) or (3) has the intention of trading (carried at fair value with adjustments to income); as of December 31, 1997, the Company's invested assets were classified solely as "held to maturity" or "available for sale."
At December 31, 1997, the Corporation and its subsidiaries had no non-income producing investments.
All reserves are necessarily based on estimates which are periodically reviewed and evaluated in the light of emerging claim experience and changing circumstances. The resulting changes in estimates are recorded in operations of the periods during which they are made. Return and additional premiums and policyholders dividends, all of which tend to be affected by development of claims in future years, may offset in whole or in part developed claim redundancies or deficiencies for certain coverages such as workers compensation.
The Corporation's reserving methods, particularly as they apply to formula-based reserves, have been established to provide for normal claim occurrences as well as unusual exposures such as those pertaining to A&E claims and related costs. At times, however, the Corporation's insurance subsidiaries also establish specific formula and other reserves as part of their overall claim and claim expense reserves to cover claims such as those emanating from A&E exposures. These are intended to cover additional litigation and other costs that are likely to be incurred to protect the Company's interests in litigated cases in particular. At December 31, 1997, the Corporation's aggregate indemnity and loss adjustment expense reserves specifically identified with A&E exposures amounted to approximately $71.8 gross, and $36.3 net of reinsurance. Based on average annual claims payments during the five most recent calendar years, such reserves represented 9.4 years (gross) and 11.0 years (net) of average annual claims payments.
Old Republic disagrees with the allegations of liability on virtually all A&E related claims of which it has knowledge on the grounds that exclusions in the policies preclude coverage for nearly all such claims, and that the Corporation never intended to assume such risks. Old Republic's exposure on such claims cannot therefore be calculated by conventional insurance reserving methods for this and a variety of reasons, including: a) the absence of statistically valid data inasmuch as such claims typically involve long reporting delays and very often uncertainty as to the number and identity of insureds against whom such claims have arisen or will arise; and b) the litigation history of such or similar claims for other insurance industry members that has produced court decisions that have been inconsistent with regard to such questions as when the alleged loss occurred, which policies provide coverage, how a loss is to be allocated among potentially responsible insureds and/or their insurance carriers, how policy coverage exclusions are to be interpreted, what types of environmental impairment or toxic tort claims are covered, when the insurer's duty to defend is triggered, how policy limits are to be calculated, and whether clean-up costs constitute property damage.
(k) Goodwill-The costs of certain purchased subsidiaries in excess of related book values (goodwill) at date of acquisition are being amortized against operations principally over 40 years using the straight-line method. Amortization of goodwill amounted to $3.2 in 1997, $4.6 in 1996 and $3.2 in 1995.
The Company sponsors a leveraged Employee Savings and Stock Ownership Plan (ESSOP) in which a majority of its employees participate. The ESSOP acquired all of its stock of the Company in 1987 and prior years. Accordingly, it is not required to adopt the American Institute of Certified Public Accountants' SOP No. 93-6, "Employers' Accounting for Employee Stock Ownership Plans." Shares of Company stock owned by the ESSOP are released to participants based on a formula prescribed by the Employee Retirement Income Security Act of 1974, and dividends on released shares are allocated to participants as earnings. The Company's contributions are based on a formula considering growth in net income per share over consecutive five year periods. As of December 31, 1997, there were 9,345,677 Common Shares owned by the ESSOP of which 1,279,988 were unreleased and unallocated. There are no repurchase obligations in existence. (See Note 3).
(r) Comprehensive Income-The Financial Accounting Standards Board (FASB) issued, in June, 1997, Statement of Financial Accounting Standards No. 130 (FAS-130) "Reporting Comprehensive Income." FAS-130 establishes standards for the reporting of other comprehensive income in a financial statement and displaying the accumulated balance of other comprehensive income separately from retained earnings. This statement is effective for accounting periods beginning after December 15, 1997. Adoption of this accounting policy will require a new financial statement and not have a material impact on the Company's financial position or results of its operations.
Note 2-Investments - Bonds and other investments carried at $167.3 as of December 31, 1997 were on deposit with governmental authorities by the Corporation's insurance subsidiaries to comply with insurance laws.
- ------------ (a) The Company has guaranteed bank loans (balance at December 31, 1997 was $6.1) to a Trust established by the Old Republic Employees Savings and Stock Ownership Plan ("ESSOP"). The loans have been used to fund the purchase of Series D Redeemable Convertible Preferred Stock from the Company by the Trust for the original amount of the loans. All remaining Series D Preferred Stock shares were fully converted into common shares as of August 22, 1997. The Trust's loan principal repayments (currently scheduled at $1.0 in 1998, $2.6 in 1999 and $2.5 in 2000) are expected to be met by annual profit sharing contributions by the Corporation and its participating subsidiaries, while interest payments are to be covered by Trust income, including dividends on the Corporation's stock held by the ESSOP. The interest on the Trust's loans is payable quarterly and at rates ranging from 75% to 80% of the prime rate. See Notes 4a and 4c.
(b) In February 1996, the Company called for the redemption of its 10% debentures maturing in 2018 ($75.0 principal amount), and its 5.75% convertible subordinated debentures maturing in 2002 ($110.0 principal amount). In April 1996, the Company called for redemption its 11.5% debentures maturing in 2015 ($30.0 principal amount). Redemption of the debentures was effected with internally available funds, while the subordinated debentures were converted by their terms into approximately 9.6 million Old Republic common shares. The early retirement of the Company's debentures produced a net of tax charge of $4.4 (3 cents per share) that has been reflected as an extraordinary item in 1996.
Note 4-Shareholders' Equity - Common share data has been retroactively adjusted to reflect a 50% stock dividend of the Company's common shares approved by the Board of Directors on March 12, 1998. FAS-128 requires this stock dividend be reflected in the 1997 year-end financial statements. All common and preferred share data herein has been retroactively adjusted as applicable for stock dividends or splits declared through March 31, 1998.
(b) Cash Dividend Restrictions-The payment of cash dividends by the Corporation is principally dependent upon the amount of its insurance subsidiaries' statutory policyholders' surplus available for dividend distribution. The insurance subsidiaries' ability to pay cash dividends to the Corporation is in turn generally restricted by law or subject to approval of the insurance regulatory authorities of the states in which they are domiciled. These authorities recognize only statutory accounting practices for determining financial position, results of operations, and the ability of an insurer to pay dividends to its shareholders. Based on 1997 data, the maximum amount of dividends payable to the Corporation by its insurance and a small number of non-insurance company subsidiaries during 1998 without the prior approval of appropriate regulatory authorities is approximately $229.1. However, management does not expect to distribute all such dividends since reinvested earnings are the Corporation's major source of capital to promote its growth, and support its obligations to policyholders.
A summary of the status of the Corporation's stock options as of December 31, 1997, 1996 and 1995, and changes in outstanding options during the years then ended follows:
The Corporation issued a total of 1,112,400 common shares valued at $8.9 and 1,487,360 common shares valued at $13.7 in 1996 and 1995, respectively to effect acquisitions which were not material to Old Republic's financial position or operating results.
Reinsurance protection for General Insurance operations generally limits the net loss on any one risk to the following maximums (in thousands): workers' compensation-$1,000; auto liability-$500; general liability-$500; and property coverages-$250. A substantial portion of the mortgage guaranty insurance business is retained, with the exposure on any one risk currently averaging approximately $25. Title insurance risk assumptions, based on the title insurance subsidiary's financial resources, are currently limited to $25,000 as to any one policy. The maximum amount of ordinary life insurance retained on any one life by the Life Insurance Group is $250.
The following information relates to reinsurance and related data for the General Insurance, Mortgage Guaranty and Life Insurance Groups for the three years ended December 31, 1997. For the years 1995 to 1997, reinsurance transactions of the Title Insurance Group have not been material.
(b) Leases-Some of the Corporation's subsidiaries maintain their offices in leased premises. Certain of these leases provide for the payment of real estate taxes, insurance, and other operating expenses. At December 31, 1997, aggregate minimum rental commitments (net of expected sub-lease receipts) under noncancellable operating leases of $107.2 are summarized as follows: 1998: $28.2; 1999: $20.6; 2000: $14.3; 2001: $10.4 2002: $8.1; 2003 and after: $25.4.
Note 7-Information About Segments of Business - The contributions of Old Republic's insurance industry segments to consolidated revenues and operating results, and certain balance sheet data pertaining thereto are shown in the following tables on the basis of generally accepted accounting principles ("GAAP"). Each of the Corporation's segments underwrites and services only those insurance coverages which may be written by it pursuant to state insurance regulations and corporate charter provisions.
At December 31, 1997 and 1996, the Group held approximately 6.8% and 7.2%, respectively, of Old Republic's issued and outstanding common shares. For financial accounting purposes only, 10,110,690 and 9,988,352 of such shares have been treated as treasury shares at each respective date in consolidating the Group's accounts with those of the Corporation.
Pursuant to a branch management agreement, EGI supervises the solicitation and underwriting of all lines of insurance that two insurance subsidiaries of Old Republic are authorized to write. EGI's Texas domiciled insurance subsidiary has entered into a quota share reinsurance treaty with an insurance subsidiary of Old Republic. Under the reinsurance treaty, EGI's insurance subsidiary reinsures the net retained amount of business produced by EGI and its subsidiaries.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Old Republic International Corporation and subsidiaries as of December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles.