[A bar graph displaying earnings per common share and dividends declared for the five years ended December 31, 1998 appears here.]
The property and casualty segment's largest expenditures are for losses and loss adjustment expenses. According to the Insurance Services Office, a supplier of property and casualty statistical information, U.S. property and casualty insurers will report catastrophe losses (excluding expenses) of approximately $10 billion for events occurring in 1998, making 1998 the third-worst year for catastrophe losses in the last 10 years. The Company's exposure to 23 of these catastrophes negatively impacted net income by $19,188,000 or $1.85 per share, net of tax. This amount includes losses and expenses, net of ceded reinsurance.
Experience in the Company's property lines of business deteriorated in 1998, as measured by the loss ratio (net losses incurred divided by net premiums earned). The fire and allied lines loss ratio increased to 73.5 percent, compared to 59.5 percent in 1997 and 66.1 percent in 1996. These are the lines of business most affected by catastrophe losses and include personal and commercial property coverage for homeowners and commercial businesses. Catastrophe activity negatively impacted the Company's reinsurance business as well. The loss ratio for net assumed reinsurance, which constitutes business assumed from other insurance companies, deteriorated to 95.9 percent in 1998, from 59.9 percent in 1997 and 73.2 percent in 1996. The Company's workers' compensation business is also experiencing decreasing underwriting profit. Reserve strengthening in the fourth quarter due to adverse legal decisions contributed to deteriorating workers' compensation experience. In addition, tough competition to retain market share also contributed to the unfavorable results. The Company's corporate workers' compensation claims manager resigned in January 1999, and a search for his replacement is underway. The Company's fidelity and surety business continues to be very profitable, with a loss ratio of 9.9 percent, down from 12.3 percent in 1997 and 12.7 percent in 1996.
Federal Reserve Chairman Dr. Alan Greenspan, described the United States economy as an "oasis of prosperity" in reference to other international economies that slumped in 1998 and experienced financial turmoil, defaults and currency devaluations. The United States experienced moderate economic growth of 3.9 percent, combined with low inflation of 1.6 percent, as declining commodity prices and increased labor productivity led the Dow Jones Industrial Average to a record high of 9374 and lower interest rates. During 1998, interest rates declined over 1 percent for various intermediate and longer-term bond maturities that the Company typically seeks to invest in. For perspective, the 30-year U.S. Treasury bond yield declined to its lowest level ever during the 21 years that it has been offered. This generally lower level of interest rates was partially offset by widening corporate bond spreads over U.S. treasury bonds. Fixed-income purchases in these corporate bonds, which included additional purchases of private placements and higher-yielding medium grade obligations (substantially all United States corporations), minimized the decline in yields added to the investment portfolio. For 1999, we are more conservative with our forecast on economic growth. Concerns of deflation, Year 2000 problems, competitiveness of the new Euro currency/members, and international financial instability are expected to slow United States earnings and economic growth (mostly in the second half) and pose further volatility to the financial markets.
The Company reported net investment income of $67,928,000, compared to $61,686,000 in 1997. More than 90 percent of the income originates from interest on fixed maturities. The remaining investment revenue is derived from dividends on equity securities, interest on other long-term investments, interest on mortgage loans, interest on policy loans and rent earned from tenants in the Company's home office. The Company's investment yield has remained fairly stable over the three-year period ending in 1998. The yield was 6.5 percent in 1998, 6.6 percent in 1997 and 6.9 percent in 1996.
The property and casualty segment had modest premium growth of 2 percent in 1997. Due to a lack of significant catastrophe exposure during 1997 and due to improvements in several lines of business, the segment reported favorable underwriting results. The statutory combined ratio (net losses and net loss adjustment expenses incurred to net premiums earned, plus expenses incurred to premiums written) was 98 percent for the year ended 1997, compared to 104 percent for 1996.
Workers' compensation results deteriorated in 1997, compared to 1996. Net premiums earned decreased $1,883,000, or 8 percent, and the loss ratio rose to 69.4 percent from 50.2 percent in 1996. An increase in claims severity in 1997, as well as continuing rate reductions due to competition contributed to those results.
Gross direct catastrophe losses were approximately $6,780,000 in 1997. The heaviest storm activity occurred in the states of Iowa, Illinois, Kansas, Wisconsin and Nebraska during the spring, where hail and wind caused approximately $4,106,000 in incurred property damage. The remaining catastrophe activity occurred throughout the year in Louisiana, Arkansas, North Dakota, Colorado and Mississippi. Gross losses incurred on all catastrophes for the years ending 1997, 1996 and 1995 were $8,926,000, $13,350,000 and $13,936,000, respectively. Losses and loss adjustment expenses recovered or recoverable from reinsurers on all catastrophes for the years ending 1997, 1996 and 1995 were $1,313,000, $2,839,000 and $3,119,000, respectively.
Underwriting and acquisition expenses incurred by the property and casualty segment increased 2 percent to $74,992,000 in 1997, compared to 1996. The 2 percent growth in premium writings produced corresponding moderate increases in expenses such as commissions and other policy-related expenses.
Life insurance losses incurred increased $4,190,000 over 1996, due primarily to an increase in claim activity during the fourth quarter. An increase in retention from $100,000 to $200,000 per insured, effective January 1, 1995, contributed to the increase in losses. In addition, claims activity had grown due to significant increases in the credit life and credit accident and health blocks of business. The amount of insurance in force in these lines increased by $37,201,000, or 25 percent, in 1997 compared to 1996.
Fixed maturities that the Company has the ability and intent to hold to maturity are classified as held-to-maturity. The remaining fixed maturities and all of the Company's equity securities are classified as available-for-sale. The Company does not currently have any securities classified as trading. At December 31, 1998, 65 percent of the fixed maturity portfolio was classified as held-to-maturity compared to 82 percent at December 31, 1997. The held-to- maturity securities are reported at amortized cost, while available-for-sale securities are reported at market value. Unrealized appreciation or depreciation of available-for-sale investments is reflected in a separate component of stockholders' equity.
The Company has had limited involvement with derivative financial instruments and does not engage in the derivative market for hedging or speculative purposes. During 1998, the Company wrote covered-call options to generate additional portfolio income. At December 31, 1998, options were written on approximately 4 percent of the equity portfolio, compared to nearly 1 percent at December 31, 1997. The Company also has investments in collateralized mortgage obligations (CMO). These securities account for 16 percent of the fixed-income portfolio at December 31, 1998, compared to 22 percent as of December 31, 1997. The decrease was the result of sales and prepayments of CMOs in 1998, which were subsequently replaced with corporate bonds.
Deferred acquisition costs constitute the Company's second largest asset, after investments. The total of $67,592,000 represents deferred underwriting and acquisition expenses associated with writing insurance policies. Deferred acquisition costs are amortized over the life of the policies written to attain a matching of revenue to expenses. The Company's life segment generated an increase in deferred acquisition costs of $9,272,000 due to its growth in premium volume. The property and casualty segment's deferred acquisition costs decreased in 1998 by $1,895,000, due to the decrease in premiums written.
Most of the cash the Company receives is generated from insurance premiums paid by policyholders and from investment income. Premiums are invested in assets maturing at regular intervals in order to meet the Company's obligations to pay policy benefits, claims and claim adjusting expenses. Net cash provided by the Company's operating activities was $18,061,000 in 1998, compared to $43,211,000 in 1997. Operating cash flows continue to be ample to meet obligations to policyholders.
Short-term investments, composed of money market accounts and fixed-income securities, are available for the Company's short-term cash needs. In addition, the Company maintains a $15 million line of credit with a local bank. During 1998, the Company borrowed funds against the line of credit, with a maximum outstanding balance of $3,450,000. Under the terms of the agreement, interest on outstanding notes is payable at the lender's prevailing prime rate. There is no loan balance outstanding as of December 31, 1998. Interest expense in connection with the line of credit borrowing was $11,000 in 1998. During 1997, the Company borrowed $1,000,000 against the line of credit for four days.
As part of the NAIC and state insurance department's solvency regulations, the Company is required to calculate a minimum capital requirement based on insurance risk factors. The risk-based capital results are used to identify companies that merit regulatory attention or the initiation of regulatory action. At December 31, 1998 and 1997, both the property and casualty and the life segments had capital well in excess of their required levels.
The Company has been aware for several years of the technological issues associated with the approaching Year 2000. Beginning in the early 1990s, the Company initiated an informal plan requiring the programming of four-digit date fields in anticipation of the new century. Both the testing phase and third-party vendor contact phase have been conducted through a formal project plan. Testing of the Company's "mission critical systems" was completed by December 31, 1998 and all systems tested were found to be compliant. All other systems will have been tested by the end of 1999. The Company is also reviewing its third-party vendors for Year 2000 compliance and is requiring written acknowledgment of testing and readiness. Third-party institutions providing banking services, including lockbox processing, checking and investment processing have all certified to the Company that their systems are or will be compliant by the end of 1999. The Company will continue to monitor this situation for compliance.
The Company and American Indemnity Financial Corporation ("American Indemnity") signed a definitive agreement on March 4, 1999, whereby the Company will purchase all outstanding stock of American Indemnity for approximately $30,600,000 in cash. Common stockholders of American Indemnity would receive approximately $14.60 per share at the closing of the transaction and deferred consideration of $1.00 per share in two years, subject to adjustments relating to indemnities.
Improvement Act of 1976 and the expiration of all applicable waiting periods thereunder and certain other customary conditions. It is anticipated that the acquisition will be complete by June 30, 1999.
The result was a statutory combined ratio on our property and casualty operations of 115 percent, 17 points worse than the preceding year and our worst underwriting results since 1992. For once, we did not do better than the industry whose combined ratio is estimated by A.M. Best at 105 percent, although it is our impression that most companies with a heavy Midwest exposure did not do nearly that well. Written premiums actually declined 3 percent to $221,000,000 and what is even more disturbing, written premiums were down 5 percent in Iowa to only $39,000,000.
Fortunately, a lousy year in property and casualty insurance was offset by an outstanding year for United Life Insurance Company, which had record earnings of $10,614,000. Statutory premiums increased 30 percent to $155,000,000 and United Life added over $100,000,000 in assets. It earned a 13-percent return on equity, which is just about in line with the big boys.
A couple years ago, an analyst for one of the omniscient rating agencies scolded us for becoming an "asset accumulator" We were dumbfounded. We never realized having an extra half-billion dollars lying around and the earnings off that money was such a bad thing!
To those who have visited our Web Site at "www.unitedfiregroup.com," the cover for this year's report should look familiar. We used the graphics from our Internet Home Page. Technologically, we believe our Internet project, which went live October 1, is one of the most innovative and exciting things we have ever done. It is an interactive site through which more than 400 agents can secure quotations for commercial insurance and current claim and account information. Colleen Sova and her team did an outstanding job.
In retrospect, maybe we should have changed the name of the Company to "unitedfiregroup.com." If we had, perhaps our price/earnings ratio would be 400 instead of 11 and no one would care whether we made any money or not.
During its development, I stayed as far away from the project and the people working on it for as long as I could. I didn't want to screw it up. But, as the project neared completion, my curiosity got the better of me. One day, I saw a sign directing the Beta Test Agents to our computer lab. I couldn't resist the temptation. Later, I went downstairs and quietly slipped into a chair in the back of the room. The minute I sat down, the whole system froze up and it took our people the rest of the day to get it operating again. It works much better now.
With property and casualty premiums increasing at only 1 to 2 percent and underwriting results continuing to deteriorate, consolidation in the property and casualty business continues to accelerate. Last year, we commented on some of the mergers which were of particular interest to us. This year, there have been so many that we've lost track. Unfortunately, many of the deals are being done for stock so the capacity in the industry is not being reduced.
Rather than our systems, my concern is about all those people who have made a career of sending out stupid questionnaires about "Y2K" and then harassing people when they don't answer their stupid questions. I must admit, I'm looking forward to January 1, 2000, when, hopefully, they will all be unemployed. Alas, I know I'll be disappointed. Given the bureaucratic nature of our society, I'm confident they will find something equally unproductive to do.
they rated all our insurance companies A+. This was particularly gratifying for we had always believed there was a size bias in S&P's approach to rating insurance companies.
(1) At December 31, 1998, 1997 and 1996, items in the accumulated other comprehensive income column include cumulative adjustments for unrealized appreciation (depreciation) net of tax on available-for-sale securities and other long-term investments of $19,008,000, $2,014,000 and $5,395,000, respectively. The gross change in net unrealized appreciation (depreciation) on available-for-sale securities and other long-term investments at December 31, 1998, 1997 and 1996 of $(16,217,000), $42,187,000 and $10,149,000, respectively, is recorded net of income taxes (benefit) of $(5,299,000), $14,799,000 and $3,518,000, respectively.
United Fire & Casualty Company and its insurance subsidiaries (the "Company") are engaged in the business of property and casualty insurance and life insurance.
The accompanying Consolidated Financial Statements include United Fire & Casualty Company and its wholly owned subsidiaries, United Life Insurance Company, Lafayette Insurance Company, Insurance Brokers & Managers, Inc., Addison Insurance Company, Addison Insurance Agency and UFC Premium Finance Company. All material intercompany items have been eliminated in consolidation.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
The costs of acquiring new life business, principally commissions and certain variable underwriting, agency and policy issue expenses, have been deferred and are being amortized to income over the premium paying period of the related traditional policies in proportion to the ratio of the expected annual premium revenue to the expected total premium revenue, and over the anticipated lives of nontraditional policies in proportion to the ratio of the expected annual gross margins to the expected total gross margins. The expected premium revenue and gross margins are based upon the same mortality and withdrawal assumptions used in determining future policy benefits. For nontraditional policies, changes in the amount or timing of expected gross margins will result in adjustment to the cumulative amortization of these costs. If the unrealized gains or losses on fixed-income securities carried at fair value would result in an adjustment to deferred policy acquisition costs had those gains or losses actually been realized, the related unamortized deferred policy acquisition costs are recorded as a reduction of the unrealized gains or losses included in stockholders' equity. As of December 31, 1998, an adjustment to reduce deferred policy acquisition costs of $726,000 was made with a corresponding decrease to accumulated other comprehensive income. There was no adjustment in 1997.
Liabilities for future policy benefits are computed by the net level premium method using interest assumptions ranging from 4.5 percent to 8.0 percent and withdrawal, mortality and morbidity assumptions appropriate at the time the policies
Effective January 1, 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income" governing the reporting and display of comprehensive income and its components, which includes items previously recorded directly in equity, such as unrealized gains or losses on available-for-sale securities. The impact of adopting SFAS No. 130 requires additional disclosure in the Consolidated Financial Statements and does not result in a material effect on the Company's Consolidated Financial Statements. See Consolidated Statement of Stockholders' Equity.
The Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" requiring that public businesses report financial and descriptive information about its reportable operating segments effective December 31, 1998. See Note 10 of the Notes to Consolidated Financial Statements.
Effective January 1, 1998, the Company adopted SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits." The new statement standardizes the disclosure requirements for these benefit plans. See Note 9 of the Notes to Consolidated Financial Statements.
In December 1997, the AICPA Accounting Standards Executive Committee issued Statement of Position ("SOP") 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments," effective for fiscal years beginning after December 15, 1998. The accounting guidance of this SOP focuses on the timing of recognition and measurement of liabilities for insurance-related assessments. Guidance is also provided on recording assets presenting future recoveries of assessments through premium tax offsets or policy surcharges. The SOP was issued to reduce diversity in practice and to improve comparability and disclosure. Under SOP 97-3, the Company will estimate its liabilities for insurance-related assessments, as opposed to recording the liability and expense when notified by insurance regulators. This change in timing is not expected to have a material effect on the Company's Consolidated Financial Statements or Notes to Consolidated Financial Statements.
SOP 98-7, "Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk," is effective for financial statements for fiscal years beginning after June 15, 1999. The SOP provides guidance on accounting for insurance and reinsurance contracts that do not transfer insurance risk. All of the Company's reinsurance agreements are risk-transferring arrangements, accounted for according to SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." The impact of adopting SOP 98-7 is not expected to have a material effect on the Company's Consolidated Financial Statements or Notes to Consolidated Financial Statements.
The amortized cost and fair value of held-to-maturity and available-for- sale fixed maturities at December 31, 1998, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The estimated fair value of mortgage loans was based on the estimated discounted future cash flows using 6.25 percent at December 31, 1998, and 1997.
The book value of policy loans is considered to be fair value as the interest rate is fixed and, in management's opinion, the interest rates in the existing portfolio are comparable to current policy loan interest rates.
The fair value of the liabilities for annuity products, which are in a benefit payment phase, guaranteed investment contracts and structured settlements are based on a discount rate of 6.25 percent at December 31, 1998 and 1997. The fair value of annuities currently in an accumulation phase is based on the net cash surrender value.
The property and casualty insurance companies cede portions of their insurance business to other insurance companies on both a pro rata and excess of loss basis. Insurance ceded by the property and casualty insurance companies does not relieve their primary liability as the originating insurers. Earned premiums ceded were $22,349,000, $25,716,000 and $27,106,000 for the years ended December 31, 1998, 1997 and 1996, respectively. The Company believes all amounts are collectible with regard to reinsurance receivables. There are no concentrations of credit risk associated with reinsurance.
The property and casualty insurance companies also assume portions of their insurance business from other insurance companies. Assumed premiums earned for the years ended December 31, 1998, 1997 and 1996 were $33,571,000, $40,198,000 and $38,545,000, respectively.
United Life Insurance Company follows the policy of reinsuring that portion of the risk in excess of $200,000 on the life of any individual. Policy benefit reserves and claims are stated after deduction of reserves and claims applicable to reinsurance ceded to other companies; however, United Life Insurance Company is contingently liable for these amounts in the event such companies are unable to pay their portion of the claims and is contingently liable for ceded insurance in force of $358,022,000 and $339,430,000 at December 31, 1998 and 1997, respectively. Approximately 54 percent of ceded life insurance in force has been ceded to two reinsurers. The Company believes all amounts are collectible with regard to reinsurance receivables.
NOTE 6. LIABILITY FOR PROPERTY AND CASUALTY LOSSES AND SETTLEMENT EXPENSES
NOTE 7. STATUTORY REPORTING, CAPITAL REQUIREMENTS AND DIVIDEND AND RETAINED EARNINGS RESTRICTIONS
As part of the NAIC and state insurance department's solvency regulations, the Company is required to calculate a minimum capital requirement based on insurance risk factors. The risk-based capital results are used by the NAIC and state insurance departments to identify companies that merit regulatory attention or the initiation of regulatory action. At December 31, 1998 and 1997, the life and property and casualty segments had adjusted capital well in excess of the required capital levels.
The State of Iowa Insurance Department governs the amount of dividends that may be paid to stockholders without prior approval by the Insurance Department. Based on these restrictions, the Company could make a maximum of $155,395,000 in dividend distributions to stockholders in 1999. Dividend payments by the insurance subsidiaries to the Company are subject to similar restrictions in the states in which they are domiciled. The Company received no dividends from its subsidiaries in 1998 or 1997.
The significant components of the net deferred tax liability at December 31, 1998 and 1997 are as follows.
The Company has a defined benefit pension plan covering substantially all employees. Under the plan, retirement benefits are primarily a function of the number of years of service and the level of compensation. It is the Company's policy to fund the plan on a current basis to the extent deductible under existing tax regulations. As permitted by SFAS No. 87, "Employers" Accounting for Pensions," the Company uses September 30 as the date for measuring plan assets and liabilities in order to obtain information necessary for the preparation of the financial statements on a timely basis.
Effective November 1, 1996, the pension plan was amended and the changes resulted in an increase to the Company's pension liability. The normal retirement benefit was changed from 1.25 percent of average monthly compensation times years of benefit service to 1.25 percent of average monthly compensation plus 0.5 percent of average monthly compensation in excess of the covered compensation limit all multiplied by years of benefit service. Years of benefit service was changed from a cap of 32 years to 35 years. Early retirement eligibility was changed from age 591/2 to age 55 with five years of service. Early retirement benefits were previously reduced actuarially for all retirees. Now, early retirement benefits have a subsidized reduction if the employee retires with 20 years of service.
The Company has a defined benefit postretirement health care plan that covers substantially all full-time employees. The plan pays stated percentages of most necessary medical and dental expenses incurred by retirees, after subtracting payments by Medicare or other providers and after the stated deductible has been met. Participants become eligible for the benefits if they retire from the Company after reaching age 55 with 10 or more years of service in the plan. The plan is contributory, with retiree contributions adjusted annually.
The unrecognized prior service cost and actuarial loss are being amortized on a straight-line basis over an average period of eight years. This period represents the average remaining employee service period until the date of full eligibility. The assumptions used in the measurement of the Company's benefit obligations are shown in the following table.
On August 21, 1998, the Company adopted a nonqualified employee stock option plan. The granting of the options will help to attract and retain the best available persons for positions of substantial responsibility and will provide certain employees with an additional incentive to contribute to the success of the Company and its subsidiaries. As of December 31, 1998, no options had been granted under the plan.
The Company has two reportable business segments in its operations; property and casualty insurance and life insurance. The property and casualty segment has four locations from which it conducts its business. All offices target a similar customer base and market the same products using the same marketing strategies and are therefore aggregated. The life insurance segment operates from the Company's home office. The accounting policies of the segments are the same as those described in Significant Accounting Policies in Note 1. The two segments are evaluated by management based on both a statutory and a GAAP basis. Results are analyzed based on profitability, expenses and return on equity. The Company's selling location is used in allocating revenues between foreign and
domestic, and as such, the Company has no revenues allocated to foreign countries. The analysis on the following page is reported on a GAAP basis and is reconciled to the Company's Consolidated Financial Statements.
The following table sets forth selected quarterly financial information of the Company.
The Company declared a three-for-two stock split in the form of a 50-percent stock dividend to stockholders of record as of December 18, 1995. Earnings per common share, weighted average common shares outstanding and cash dividends declared per common share have been retroactively restated for all periods presented. Cash dividends per common share of $.67 and $.63 were declared in 1998 and 1997, respectively.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of United Fire & Casualty Company 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.
/s/ Arthur Andersen LLP - ----------------------------- Arthur Andersen LLP Chicago, Illinois February 17, 1999
Certain amounts included in this schedule for earlier years have been reclassified to conform with the 1998 financial statement presentation.