Neither the Company nor any of its subsidiaries owns real property. Home State leases 29,615 square feet at 3 South Revmont Drive, Shrewsbury, New Jersey and 22,784 square feet at 1030 Broad Street, also in Shrewsbury, New Jersey. Both leases extend until March 31, 2005 and provide for annual lease payments of $554,106 escalating to a maximum of $874,039 by the end of the lease term.
Home State is currently obligated on an existing lease for 20,833 square feet at One Harding Road, Red Bank, New Jersey, which lease extends until April 1, 2000 and provides for annual lease payments of $291,592 in 1996, escalating to $312,420 by the end of the term. Home State has sub-leased approximately 17,660 square feet for varying rates and terms. In recognition of the liability of the Red Bank lease and the reduced market rates attainable in the immediate vicinity for such sub-leasing activities, the Company recognized a non-recurring charge of approximately $380,000 during 1994. No additional charge was required during 1995 or 1996.
Quaker City leases 3,128 square feet at Eight Neshaminy Interplex, Trevose, Pennsylvania. The lease extends until December 31, 1997 and provides for annual lease payments of $59,901.
The Company is primarily engaged in underwriting personal and commercial auto insurance. The Company reported a net loss of $20.5 million in 1996, compared to net income of $6.1 million for the year ended December 31, 1995.
The loss in 1996 is principally due to an increase in the Company's loss and LAE ratio, computed under Generally Accepted Accounting Principles ("GAAP"), from 76% in 1995 to 113% in 1996.
The process of estimating the ultimate liability for losses and LAE has been a particular challenge for the Company due to the significant growth in business, which has resulted in a substantial increase in claims reported, and the use of industry data while the Company's loss experience continues to develop.
During the second quarter of 1996, the Company noted a significant increase in the volume of reported claims falling below the reinsurance attachment points, over and above the frequency anticipated in its calculation of loss reserves. At the same time, the Company conducted a thorough overall re-evaluation of its business plan and the profitability of the underlying business. In response to this review, management increased reserves by $12 million in the second quarter, predominantly within IBNR.
The review of open case reserves was concurrent with the hiring of a Senior Vice President of Claims and the initiation of a new case reserving philosophy. The new case reserving philosophy is based on earlier recognition of the ultimate settlement value for a given claim. While information concerning the comparative negligence of the persons involved in the occurrence is still utilized in establishing reserves, it receives less emphasis as compared to prior years. The Company still evaluates all provisions of the policy, anticipated net effect of salvage and subrogation, the ultimate settlement value and, where appropriate, the opinion of outside counsel and claims consultants.
Management's emphasis in the fourth quarter of 1996 was to ensure that the new case reserving philosophy was fully implemented in all open claim files during the file review. During this process, the Company also implemented a formula reserve program for its new claims as well as more aggressive practices in managing pending claims file count per adjuster. These changes in case reserving were taken into account in setting the assumptions used in calculating the Company's total reserves requirement at December 31, 1996. These actions have also resulted in greater case reserves being established quicker than in the past.
The Company uses reinsurance in order to manage its risk and to maintain premium to surplus ratios recommended by regulatory authorities and rating agencies. The Company has historically maintained low retention to support its previous growth objectives through the use of excess of loss reinsurance.
Although a majority of the profits on the ceded premium is retained by reinsurers, the Company participates in the profitability of such reinsurance in varying percentages, depending on the line of business. As a result of the significant reserve adjustments discussed above, the associated reinsurance profit sharing income recognized in prior years has been reduced significantly. As this has reduced total income, this has also negatively impacted the 1996 loss ratio. The Company recorded a pre-tax charge to earnings of $11.4 million in relation to return profit share on 1995 and prior accident years, offset by profit share income accrued for the 1996 accident year of $9 million (thereby recording a net charge to income of $2.4 million).
As a result of the net loss incurred during 1996, and the resulting increase on leverage on the Company's surplus, management has slowed premium growth rates and reduced the size of its agency force.
As discussed above, in order to better control its loss experience, the Company has instituted a significant change in case reserving methodologies and taken actions to strengthen its balance sheet to compliment its revised growth targets. New claims management and loss reserving philosophies provide the Company with a more timely assessment of the loss characteristics of the Company's book of business. The change in claim reserving has assisted the Company in managing its policy renewal and growth efforts, particularly in the more competitive commercial lines business. Management is continuing to identify and non-renew commercial accounts which have exhibited poor loss characteristics, in addition to holding prices where possible in a highly competitive environment.
Other recent management initiatives include a comprehensive claims management program, designed with the assistance of the Company's reinsurers to assist in reducing the pending file counts, thereby providing company staff adjusters the ability to focus on more recent accident year claims. The Company's goal is to reduce the period of time between when a claim is reported and when it is settled. The focus of claims management in 1997 will continue to be enhancement of operating practices to improve efficiency.
For a discussion of certain factors which could affect the Company's results of operations and financial position, see "-Safe Harbor Disclosure" below.
Year Ended December 31, 1996 Compared To Year Ended December 31, 1995
Gross premiums written by the Company increased 66% from $124.8 million for the year ended December 31, 1995 to $207.4 million (including $25.4 million assumed from Home Mutual) for the year ended December 31, 1996. The Company's net earned premiums increased 72% from $58.9 million for the year ended December 31, 1995 to $101.7 million (including $9.9 million resulting from the pooling with Home Mutual) in the year ended December 31, 1996. The increase in net earned premiums resulted from increased premium volume, primarily in the Company's personal auto book of business, as well as the pooling of Home Mutual's underwriting results.
The Company had $5,000 of net realized gains in 1996 derived from the call of fixed maturity investments as compared to $269,000 of net realized gains from the sale of securities in 1995.
Insurance losses and LAE increased from $49.3 million in 1995 to $112.4 million in 1996 as a result of the increase in volume and risks assumed under premiums in force and the significant loss reserve development and establishment of new loss reserving philosophies during 1996 as discussed in the "Overview" section above.
The Company's GAAP expense ratio increased from 17% in 1995 to 25% in 1996. The increase in the GAAP expense ratio in 1996 is the result of a reduction in reinsurance profit sharing and the Company's ceding commission rates under its new reinsurance agreements which has the effect of increasing net commission expenses. Additionally, Home Mutual entered into a service agreement to sell its assigned risk business which has resulted in a shift of expenses from losses to underwriting expense. The associated expense for servicing this business is now being reflected in the statement of operations as a result of the pooling agreement entered into in 1996 between Home Mutual and Merchant Bakers. Additionally, the Company's loss reserve increase has impacted the amount of policy acquisition costs deferred due to higher loss ratios used in determining the amount of acquisition costs that can be deferred. The impact of this has been mitigated to some extent by a change in the Company's method of accounting for deferred policy acquisition costs in the fourth quarter of 1996 to consider anticipated investment income.
Home Mutual has incurred after pooling operating losses for the year ended 1996 of $1.9 million and as of December 31, 1996, its statutory based surplus is approximately $1.55 million. As a result, the Company recorded a charge to other expenses of $2.6 million during the last six months of 1996, representing a write down of its surplus notes in Home Mutual to their estimated net realizable value of $2.4 million. Also included in other expenses in 1996 is the benefit of $3.1 million from the acceleration of the amortization period of the excess of fair value over cost of the Merchant Bakers acquisition. The remaining other expenses for 1996 and all of 1995 are the operating expenses of the financial services group and parent company.
Interest expense on the Company's subordinated notes payable and notes payable to bank increased to $2.8 million in 1996 from $2.1 million in 1995 due to the interest expense related to the bank credit facilities which were not fully utilized during 1995.
Year Ended December 31, 1995 Compared To Year Ended December 31, 1994
Gross premiums written by the Company increased by 114% from $58.2 million in 1994 to $124.8 million in 1995 (of which $22.8 million represents Merchant Bakers) due to the continued expansion of Home State's personal auto line of business in addition to the growth of Westbrook and Pinnacle (late 1994 acquisitions). The Company's net earned premiums increased 97% from $29.9 million in 1994 to $58.9 million in 1995 (of which $14.9 million represents Merchant Bakers).
Recoveries on reinsurance premiums increased from $3.7 million in 1994 to $6.0 million in 1995 (of which $2.8 million represents Merchant Bakers). This increase is a direct result of an increase of $25.5 million in ceded earned premium volume (of which $15.9 million is attributable to Merchant Bakers), and an increase in physical damage quota share adjustments, which were partially offset by unfavorable development on the Company's ceded risks of prior years. The volume of reinsurance profit sharing income is impacted by the amount of premiums ceded to reinsurers as well as the reinsurers' historical cumulative (over a three year period) loss experience on such premiums. Although adverse loss development could retroactively reduce profit sharing income, such retroactive adjustments cannot exceed the amount of the profit sharing previously recognized by the Company on reinsurance premiums.
Net investment income increased from $1.9 million in 1994 to $3.5 million in 1995. The increase in net investment income was primarily a result of an increase in invested assets as well as the inclusion of Merchant Bakers. Cash and invested assets increased from $52.0 million in 1994 to $88.3 million in 1995 primarily as a result of the inclusion of Merchant Bakers and additional cash flows provided by operating activities.
Interest expense increased to $2.1 million in 1995 from $503,000 in 1994 due to the interest expense related to the private placement of subordinated debt completed in October 1994 and an unsecured line of credit.
Tax expense decreased from $2.5 million in 1994 to $2.0 million in 1995 due primarily to an increase in the ratio of tax free income to taxable income. The Company's effective tax rate decreased from 30% (before non-recurring adjustments) in 1994 to 26% in 1995.
Net income increased from $4.5 million in 1994 to $6.1 million in 1995 and the Company's GAAP combined ratio increased from 88% in 1994 to 93% in 1995 as a result of the factors noted above.
In October 1994, the Company completed a private placement of $17.0 million of subordinated notes and warrants (the "Private Placement"). During 1996, the Company secured an $18 million line of credit with its bank lenders to support the premium finance operations as well as provide a working capital facility for the holding company of which $5.6 million was outstanding at December 31, 1996. In March, 1997, such line of credit availability was eliminated for the premium finance operation and was reduced to $4.0 million for the holding company (none of which may be re-borrowed) in connection with a waiver of certain defaults resulting from the Company's failure to make a required pay down of the line of credit in the first quarter of 1997 and as a result of the Company's 1996 net loss. In connection with such waiver, the Company repaid all outstanding borrowings of Tower Hill. The amendment and waiver entered into with the banks provides, among other things, for an increase in interest rates, a February 28, 1998 maturity date and for the Company to make monthly principal repayments of $100,000 and prepayments of the net proceeds from any sale of a subsidiary or a subsidiary's assets or from the available portion of an anticipated tax refund. The March 31, 1997 amendment and waiver also provides for changes to certain of the debt covenants, including a requirement to maintain consolidated net worth, as defined of at least $28.5 million. See Note 6 to the Consolidated Financial Statements.
The absence of financing for Tower Hill's business would have an adverse effect on the Company's financial services income. Although management plans to seek an alternate source of financing, there can be no assurance that such facilities will be secured. Furthermore, the reduction of the holding company's line of credit and its inability to re-borrow amounts repaid will have an adverse effect on the Company's liquidity and capital resources.
On March 31, 1997, the holders of the Preferred Stock waived a default for the year ended December 31, 1996 in a covenant requiring the maintenance of a net written premiums to statutory surplus ratio. In connection with such waiver, the Company agreed to elect an additional Director acceptable to the parties and to form a Strategic Planning Committee of the Board (to be chaired by such additional Director), the functions of which would include pursuing strategic alternatives for the Company to improve its financial condition.
The Company's insurance subsidiaries are subject to certain restrictions on their ability to transfer funds to the parent company in the form of cash dividends, loans or advances without regulatory approval. These restrictions, described below, are not expected to impair the ability of the Company to meet its cash obligations. However, to the extent the Company seeks to increase the capital of its insurance subsidiaries or pursue additional business opportunities, additional financing will be required. Accordingly, the Company is currently exploring financing alternatives which could take the form of regular debt, convertible debt, equity securities or some combination thereof. There can, however, be no assurance that financing will be available or that the Company will obtain financing on terms it deems acceptable.
The reserve increases and reduction in reinsurance profit sharing experienced in 1996 have negatively impacted the statutory surplus levels of the insurance subsidiaries. These subsidiaries still maintain reported surplus at December 31, 1996 in excess of both minimum surplus and authorized control level risk based capital. Management does not anticipate this changing in 1997. To the extent that future premium writings exceed the statutory required leverage ratios (i.e., net premium writings to surplus), the Company believes it has the ability to either reduce those premium writings or effect reinsurance in order to bring the leverage ratios to interim statutory accepted guidelines.
In view of the Company' rapid growth in premiums written, heavy reliance on reinsurance and unfavorable results in 1996, in February 1997 the Company retained Donaldson, Lufkin and Jenrette to assist in the Company's review of strategic alternatives to maximize the perceived inherent value in the direct premiums produced by the Company. Strategic alternatives could include the raising of additional capital or a sale of the Company. There can be no assurance that any such strategic alternative will be successfully achieved.
As of December 31, 1996, the Company had approximately $91.4 million of investments and $11.8 million of cash and cash equivalents. The Company maintains a significant portion of its assets in high quality, fixed income investments with short maturities. An increase in interest rates will generally cause a decline in the market value of fixed income securities although presenting the opportunity to reinvest proceeds from maturing securities at higher yields. A decline in interest rates may result over time in lower yields as the proceeds from maturing securities are reinvested, although this may be offset by increases in the market value of fixed income investments with longer maturities. Because of the relatively short maturities of the Company's investments, the Company does not anticipate changes in interest rates to materially affect its liquidity and capital resources.
SFAS 128 is effective for financial statements issued for periods ending after December 15, 1997 and requires restatement of all prior period EPS data presented.
capital and surplus, reserves, losses, expenses, earnings (including earnings per share), cash flows, plans for future operations, common stockholders' equity, financing needs, capital plans, potential corporate transactions, plans relating to products or services of the Company and estimates concerning the effects of litigation or other disputes, as well as assumptions for any of the foregoing and are generally expressed with words such as "believes", "estimates", "expects", "anticipates", "could have", "may have" and similar expressions.
Forward-looking statements are inherently subject to risks and uncertainties. The Company cautions that factors which may cause its results to differ materially from such forward-looking statements include, but are not limited to, the following:
The consolidated financial statements required in response to Item 8 appear elsewhere in this Report as listed in Item 14(a) of this Report.