The headquarters building of the Company is owned by Meridian Mutual and is located near downtown Indianapolis, Indiana. The building is a multi-level structure containing approximately 205,000 square feet of office space. Expansion efforts completed in 1995, have allowed the Company and Meridian Mutual to consolidate the two Indianapolis satellite offices, two regional claim offices, and the Meridian Citizens Mutual operation previously in Red Wing, Minnesota into the home office facility.
Late in 1999, the Company entered into a marketing arrangement with InsWeb, a leading Internet insurance marketplace, to quote personal automobile products on the Internet. Meridian is initially quoting policies for consumers in Virginia, with Washington and Missouri expected soon. In addition, during 1999 Meridian added a direct website, www.meridiandirect.com, through which consumers are able to apply for Meridianr insurance products, receive quotations and purchase products in certain states in which the Company does not sell personal lines through independent agents.
The implementation of new distribution methods does not detract from the Company's strong support of the independent agency system. Marketing products through independent agents has been and continues to be the Company's primary source of distribution. The Company continues to build these relationships and has a growing group of nearly 1,400 independent agents.
The next stage of the process was to identify those systems and programs that contained date sensitive fields throughout the operating systems. The internal approach taken to address the issue was field expansion. This expansion allowed the date fields to be expanded and allowed programs to distinguish dates based upon an eight digit code as opposed to a six digit code. The Meridian Citizens approach implemented by the outside automation services provider, took into account the various operating platforms used to process data. A combination of field expansion and "windowing" was selected to address the Y2K issue. The "windowing" approach utilized a two digit year currently in the date fields and assumed the two digit century field fell within an established "window." For example, any result over 50 signified the 20th century and any under fifty, the 21st century.
During the fourth quarter of 1998, the Information Systems operations of the Meridian Citizens companies were moved to the Indianapolis home office location. This change allowed for certain cost savings and a more consistent application of programming discipline throughout the organization. Prior to the move, Y2K remediation efforts were completed by an outside vendor for the Meridian Citizens companies. While reviewing other processing issues, internal personnel discovered instances in which remediation efforts had not correctly been completed. These issues were resolved when discovered. The manner in which these systems were constructed or designed did not provide for a test environment. Therefore, a more detailed analysis was performed by a project team consisting of both internal and external resources. This extensive analysis encompassed applications which were previously understood to be compliant. These applications were reviewed for date sensitive related code to determine that the Y2K remediation was completed correctly. Re-programming efforts, as required, were performed to obtain Y2K compliance.
Costs for the Y2K remediation approximated $1.3 million upon completion. Such incremental costs have been estimated at approximately $200,000 in 1996, $400,000 in 1997 and 1998, with an additional $300,000 for 1999. The Company was able to manage the cost of its Y2K effort because of the early start of the project and the overall approach of hiring additional internal resources as opposed to extensively utilizing outside programmers. Approximately 50 percent of the total costs related to programming personnel. The remainder of these costs related to the replacement of software applications, hardware costs, and outside consulting fees. Due to the complexity and importance of the Y2K project, the Company engaged independent consultants to review the planning and methods utilized within the project for all subsidiaries. The written report received from the independent consultants contained comments and suggestions which were implemented and incorporated into the final Y2K action plans. Y2K costs were funded through operating revenues and represented less than 10 percent of the information systems annual budgets. Costs for the Meridian Citizens remediation were included under the automation programming charges incurred by the Company on a monthly basis and were therefore not distinguishable from normal programming fees.
No material effect on operations or financial results occurred because of the calendar year change. Any future problems are anticipated to be minimal and further reporting of Y2K issues will not be made, unless the occurrence is material to the Company.
Net income for 1999 declined to $7.3 million, or $0.90 diluted earnings per share, down from $12.2 million, or $1.50 per diluted share for 1998. Realized investment gains for 1999 decreased to $6.7 million, or $0.54 per share after tax, from $7.3 million, or $0.59 per share after tax, for 1998. Earnings per share included a $0.04 first quarter charge for the cumulative effect of an accounting change for certain insurance-related assessments. Also included was a fourth quarter non-recurring charge of approximately $625,000, or $0.05 per share after tax, for severance and other costs associated with closing the former Minnesota home office of the Meridian Citizens Insurance Companies.
General operating and amortization expenses of $62.2 million in 1999 increased from the $59.6 million recorded during 1998. Relative to the earned premium volume, the Company's 1999 expense ratio decreased slightly to 31.2 percent compared to 31.5 percent for 1998. The increase in premium volume over which to spread fixed costs was a factor behind this decrease, as was cost savings resulting from the prior year consolidation of the Meridian Citizens information systems into the Company's Indianapolis location.
The Company does not own or currently utilize derivative financial instruments for the purpose of hedging, enhancing the overall return of its investment portfolio, or reducing the cost of its bank debt. Meridian, through its outside professional portfolio managers, 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 through asset- liability matching practices and by addressing call characteristics in security selection. Market value risk is addressed through maturity selection. The market value of the Company's long term fixed maturity investment portfolio is sensitive to fluctuations in the level of interest rates. The impact of interest rate movements on the long term fixed maturity investment portfolio generally affects net realized gains or losses when securities are sold. The Company estimates that a 100 basis point increase in interest rates from current levels would result in a possible decline in the $226.4 million market value of the long term fixed maturity investment portfolio of approximately 4.1 percent, or $9.3 million. With regard to its $69.0 million equity security portfolio, the Company does not own nor engage in any type of option writing. A 10% decrease in the U.S. equity market prices could result in a decrease of $6.9 million in the market value of the Company's common equities. These possible declines in values for the bond and stock portfolios would, net of deferred income taxes, negatively affect the common shareholders' equity at any point in time, but would not necessarily result in the recognition of realized investment losses as long as operating cash flow and the ongoing emergence of bond maturities continued to provide sufficient funds to meet obligations to policyholders and claimants, as well as debt service and cash dividend requirements at the holding company level.
Beginning in 1994, state insurance regulators required companies to calculate Risk Based Capital ("RBC"). RBC is the capital required to cover the varying degrees of risk inherent in a company's assets, loss reserves, underwriting, and reinsurance. The "company action level" RBC is the minimum amount of capital required in order to avoid regulatory action. The adjusted capital of the Company's insurance subsidiaries is well above the required minimum.
In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) on page 50 present fairly, in all material respects, the financial position of Meridian Insurance Group, Inc. and its subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 in conformity with accounting principles generally accepted in the United States. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 14(a)(2) on page 50 present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated statements. These financial statements and financial statement schedules are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
LIABILITIES AND SHAREHOLDERS' EQUITY Losses and loss adjustment expenses $ 145,962,418 $ 154,252,671 Unearned premiums 88,698,507 81,223,095 Other post-employment benefits 2,204,739 1,935,616 Bank loan payable 8,500,000 10,125,000 Payable for securities --- 3,061,898 Reinsurance payables 9,142,015 9,811,976 Other liabilities 6,906,277 6,478,431 Total liabilities 261,413,956 266,888,687
Investments: Fixed maturity investments include bonds, notes, mortgage backed pass-through securities, collateralized mortgage obligations, other asset backed securities and sinking fund preferred stocks. The fixed maturity portfolio is invested entirely in securities classified as available for sale and is carried at quoted market values. Equity securities, consisting of unaffiliated common and perpetual preferred stocks, are reported at quoted market values. Short-term investments are recorded at cost, approximating market value. Other investments include limited partnerships recorded on the equity method.
Premium Revenue: Premiums are recognized as revenue on a monthly pro rata basis over the coverage terms of the respective policies. Any premiums applicable to the future terms of the policies are included in liabilities as unearned premiums.
Deferred Policy Acquisition Costs: Policy acquisition costs, principally commissions, premium taxes, and variable underwriting and policy issue expenses, have been deferred. Such costs are amortized as premium revenue is earned. The method used in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. It also considers the effects of anticipated investment income, losses and loss adjustment expenses, and certain other costs anticipated to be incurred as the premium is earned.
Losses and Loss Adjustment Expenses: Reserves for unpaid losses and loss adjustment expenses are based on both estimates of the ultimate costs of individual claims and on other non-discounted estimates, such as claims incurred but not reported and salvage and subrogation. The methods of making such estimates are continually reviewed and updated, and any reserve adjustments are reflected in current operating results.
Income Taxes: Deferred income taxes are provided to reflect the estimated future tax effects of temporary differences between the tax basis of an asset or liability and the basis recorded in financial statements. The deferred tax asset or liability is measured by using enacted tax rates expected to apply to future taxable income in the periods in which the temporary differences are expected to be recovered or settled. Accordingly, changes in future tax rates cause immediate adjustments to deferred taxes.
Earnings Per Share: The Company presents basic and diluted earnings per share in accordance with Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share". Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential that could occur if securities or other contracts to issued common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity.
Estimated Amortized Market Cost Value Available for sale: Due in one year or less $ 1,834,471 $ 1,840,032 Due after one year through five years 19,143,159 19,199,604 Due after five years through ten years 60,607,713 58,943,343 Due after ten years through fifteen years 53,241,844 51,038,374 Due after fifteen years through twenty years 27,381,699 27,586,263 Due after twenty years 29,039,843 28,072,720 Subtotal 191,248,729 186,680,336 Mortgage-backed securities 40,841,608 39,751,196 Total fixed maturity securities $ 232,090,337 $ 226,431,532
Proceeds from sales of investments in fixed maturity securities during 1999, 1998 and 1997, respectively, were $42,415,984, $78,138,240, and $26,135,592. During 1999, 1998 and 1997, respectively, gross gains of $110,779, $2,672,721, and $338,920 and gross losses of $404,864, $44,464, and $324,812 were realized on those sales.
3. Other Comprehensive Income The Company's other comprehensive income consists solely of net unrealized gains (losses) on securities. The total net unrealized gain (losses) on securities for the years ended December 31, 1999, 1998 and 1997 consist of the following:
As required by SFAS No. 131, the following table delineates the Company's products and revenues in a manner which is consistent with segment reporting: 1999 1998 1997 Personal lines: Automobile $ 91,123,405 $ 79,438,864 $ 78,609,066 Homeowners 24,271,745 25,649,226 26,262,790 Other 2,580,806 2,718,432 2,929,743 Total personal lines $ 117,975,956 $ 107,806,522 $ 107,801,599
5.Bank Loan Payable The 1996 acquisition of Citizens Security Group acquisition was funded in part through a $12,000,000 bank loan. The debt has a variable interest rate of LIBOR plus 50 basis points, which was 6.6613 percent and 5.7388 percent at December 31, 1999 and 1998, respectively. The bank loan will mature on August 1, 2003. The Company is required to make principal payments in accordance with the following schedule:
2000 $ 2,000,000 2001 2,125,000 2002 2,500,000 2003 1,875,000 Total payments outstanding $ 8,500,000
The principal balance of the bank loan as of December 31, 1999, approximates its market value. Interest paid on the loan during 1999 and 1998 amounted to $532,000 and $672,000, respectively. The bank debt includes certain financial covenants, the most significant of which concern the amounts of risk based capital, statutory policyholders' surplus, total debt, debt to capitalization and debt service coverage (the relationship of dividends available from the Company's insurance subsidiaries to required principal and interest payments).
For the year ended December 31, 1999, approximately 78 percent of the Company's total premium volume was derived from its participation in the pooling agreement. In 1998 and 1997, approximately 86 percent and 88 percent, respectively, were derived from the pooling arrangement.
Also as a result of the employee transfer, the Company assumed the operations of the previously established benefit plans of Meridian Mutual. Included in these benefit plans were a non-contributory pension plan that covers substantially all employees, a non-tax qualified supplemental retirement plan for certain key employees, and a multi-employer plan for other post-retirement benefits. See Note 10-Pension Plan and Other Post-Retirement Benefits. The Company also assumed a 401(k) plan whereby employees can contribute up to 16 percent of their compensation, with the Company contributing 50 percent of the employee contribution on the first 6 percent. Costs related to these benefit plans are allocated to each company in accordance with their percentage participation under the pooling agreement.
Catastrophe reinsurance provided coverage for multiple losses caused by a single catastrophic event such as a windstorm or earthquake. The combined retention under this contract was $6,000,000 plus five percent of losses up to contractual limits for windstorms of $65,000,000 and for earthquakes of $108,000,000. Another catastrophe reinsurance treaty provided coverage for 95% of losses sustained from multiple catastrophic events which aggregated beyond specified retentions and per event deductibles up to the contractual limits.
Approximately 97 percent of the Company's ceded reserves for losses and loss adjustment expenses were with Employers Reinsurance Corporation, Michigan Catastrophic Claims Association and Swiss Reinsurance America Corporation. The effect of reinsurance on premiums written, premiums earned and losses and loss adjustment expenses for the years ended December 31, 1999, 1998 and 1997 were as follows:
Premiums earned: Direct $ 216,078,155 $ 205,534,750 $ 211,105,812 Assumed 397,210 614,042 1,232,165 Ceded (17,055,306) (16,960,370) (17,751,345) Net $ 199,420,059 $ 189,188,422 $ 194,586,632
Deferred, beginning of period $ 17,671,856 $ 17,651,544 $ 16,690,275 Additions: Commissions 34,870,279 31,845,030 32,391,959 Premium taxes 3,074,928 2,416,582 2,375,996 Other 9,208,481 7,972,312 8,357,111 Total additions 47,153,688 42,233,924 43,125,066 Amortization expense 44,851,094 42,213,612 42,163,797 Deferred, end of period $ 19,974,450 $ 17,671,856 $ 17,651,544
10. Pension Plan and Other Post-Retirement Benefits The Company maintains a defined benefit pension plan for the benefit of eligible employees. Under the plan, all employees of the Company completing more than 1,000 hours of employment in a 12- month period become eligible to participate. The plan provides for a pension annuity beginning at age 65 based on the employee's average monthly base pay during the five highest consecutive salary years out of the last ten. Provisions for delayed retirement benefits, early retirements benefits after age 55, disability and death benefits, optional methods for benefit payment, payments to an employee who leaves after a certain number of years of service, and payments to an employee's surviving spouse are also covered under the plan.
Funded Status Funded status at December 31 $ (949,697) $ (1,050,623) Unrecognized prior service cost 193,522 216,599 Unrecognized loss 29,612 260,908 Accrued liability at December 31 $ (726,563) $ (573,116)
A 7.75 and 6.50 percent weighted average discount rate was assumed for 1999 and 1998, respectively, in determining the accumulated benefit obligation and a 5.0 percent average salary increase was used to project the additional pay increase on all plans. The expected return on assets for the defined pension plan was assumed to be 8.25 percent. Net periodic pension costs for the defined benefit pension plan for the years ended December 31, 1999, 1998, and 1997 included the following components:
Reconciliation of benefit obligation: Obligation at January 1 $ 1,909,278 $ 1,952,474 Service cost 210,680 211,586 Interest cost 121,129 133,691 Actuarial (gain) loss (223,453) (324,893) Benefit payments (78,476) (63,580) Obligation at December 31 $ 1,939,158 $ 1,909,278
Reconciliation of fair value of plan assets: Fair value of plan assets at January 1 $ --- $ --- Employer contributions 78,476 63,580 Benefit payments (78,476) (63,580) Fair value of plan assets at December 31 $ --- $ ---
1999 1998 1997 Service costs $ 155,903 $ 156,574 $ 107,313 Interest costs 89,636 98,931 75,838 Amortization of net loss (26,898) (11,864) (29,704) Net periodic benefit cost $ 218,641 $ 243,641 $ 153,447
The assumed rate of future increases in per capita cost of health care benefits was 9.0 percent for the first year and 5.0 percent for all years thereafter in 1999, and 7.0 percent for the first year and 4.0 percent for all years thereafter in 1998. The health care cost trend rate assumption affects the amounts reported. For example, increasing the assumed health care cost trend rate by one percentage point would increase the accumulated post-retirement benefit obligation by approximately $176,000 and the aggregate of the service and interest cost components of net periodic post- retirement benefit cost by approximately $41,000. A decrease in the assumed health care cost trend rate by one percentage point would decrease the accumulated post-retirement benefit obligation by approximately $154,000 and the aggregate of the service and interest cost components of net periodic post-retirement benefit cost by approximately $35,000.
11.Income Taxes Current tax expense for the following periods differed from the tax expected solely on pre-tax income by applying the applicable statutory corporate tax rate to the various differences identified as follows:
14. Shareholders' Equity In May 1997, the Shareholders of Meridian Insurance Group, Inc. approved an amendment to the Company's Articles of Incorporation to increase the number of authorized shares from 20,000,000 to 20,500,000, with the additional shares being preferred stock. The amendment provides that the preferred shares may be issued from time to time in one or more series. The Board of Directors, without further approval of the holders of common shares, would be authorized to fix the dividend rights and terms, liquidation preferences, sinking funds and any other rights, preferences, privileges, and restrictions applicable to each such series of preferred shares. On September 8, 1998, the Board of Directors of Meridian Insurance Group Inc., adopted a Shareholders Rights Plan. Under the Plan, a dividend of one preferred share purchase right was paid to shareholders of record on September 28, 1998 for each outstanding common share. Each Right entitles the holder to purchase one-thousandth of a share Series A Junior Participating Preferred Stock of the Company at a price of $75.00 per one- thousandth of a Preferred Share. If a person or group acquires 20% or more of the outstanding Common Shares (thereby becoming an Acquiring Person), each holder of a Right (except those held by the Acquiring Person and its affiliates and associates) will generally have the right to purchase Common Shares having equal to two times the purchase price of the Right. In other words, the Right's holders, other than the Acquiring Person, may purchase common shares or their equivalent at a 50 percent discount. The Rights will expire on September 18, 2008, unless the expiration date is extended by amendment or unless the Rights are earlier redeemed or exchanged by the Company.
In November 1995, the FASB issued SFAS No. 123, "Accounting for Stock-Based Compensation". This statement encourages, but does not require, companies to recognize compensation expense for grants of stock, stock options, and other equity instruments to employees based on the fair value method of accounting. The Company continues to account for stock options in accordance with Accounting Principles Board Opinion No. 25. Had compensation cost been determined using the fair value of the options at the grant dates in accordance with SFAS No. 123, the Company's net income and earnings per share for the periods ended December 31, 1999, 1998 and 1997 would have been reduced by the following pro-forma amounts: $49,000, $186,000, and $640,000 and $0.01, $0.02 and $0.08, respectively. The weighted average grant date fair value of options granted during the year was estimated to be $17.45, $17.07 and $17.26 using the Black-Scholes model with the following assumptions for 1999, 1998 and 1997, respectively: risk free interest rates of 5.94 percent, 5.31 percent and 6.29 percent; dividend yield of 2.04 percent, 1.80 percent and 2.29 percent; and volatility of 30.95 percent, 38.10 percent and 26.36 percent. As of December 31, 1999, options outstanding under these plans had an exercise price that ranged from $8.26 to $15.50 and a remaining weighted average contractual life of 8.89 years. Stock options granted by the Company for the periods ended December 31, 1999, 1998 and 1997, are summarized in the following table:
Revenues $ 52,841 $ 55,761 $ 56,716 $ 57,112 Net income $ 630 $ 2,280 $ 2,602 $ 1,738 Basic earnings per share $ 0.08 $ 0.28 $ 0.33 $ 0.22 Diluted earnings per share $ 0.08 $ 0.28 $ 0.32 $ 0.22