All of the other insurance operations of the Company are conducted from leased premises in or adjacent to major urban centers throughout the United States, Puerto Rico, Canada and in Bermuda. These operations, in the aggregate, occupy approximately 623,000 square feet, at an annual rental of approximately $11,540,000.
The purchases of Guaranty National shares were recorded as of June 30, 1996. All revenues and expenses of Guaranty National for 1996 have been consolidated with those of the Company, and minority interest expense has been recorded for the portion of Guaranty National's 1996 earnings that was attributable to the shares not owned by the Company. For 1994 and 1995 the Company's investment in Guaranty National was accounted for using the equity method.
The Company's insurance operations have experienced favorable trends for the past several years, as indicated by its combined ratio which has improved from 105.4% in 1992 to 103.2% in 1993, 101.2% in 1994, 100.3% in 1995 and 99.8% in 1996. Operating earnings (earnings after taxes, excluding the effects of the adoption of new accounting principles, extraordinary items and after-tax realized investment gains) were $72,944,000, $59,914,000 and $52,818,000, or $5.25, $4.22 and $3.68 per share, in 1996, 1995 and 1994, respectively, based on weighted average shares outstanding of 13,894,000 in 1996, 14,187,000 in 1995 and 14,348,000 in 1994. For the five year period ended December 31, 1996, the Company's return on equity from operating earnings averaged 14.3% per year.
Earnings (loss) by segment before federal income taxes and minority interest expense are summarized as follows for the three years in the period ended December 31, 1996:
The Company's investment philosophy is to achieve a superior rate of return after taxes, while maintaining a proper balance of safety, liquidity, maturity and marketability. The Company invests primarily in investment grade securities and strives to enhance the average return of its portfolio through limited investment in a diversified group of non-investment grade fixed maturity securities or securities that are not rated. The risk of loss due to default is generally considered greater for non-investment grade securities than for investment grade securities because the former, among other things, are often subordinated to other indebtedness of the issuer and are often issued by highly leveraged companies. At December 31, 1996 and 1995, the Company's investment in non-investment grade and unrated fixed maturity securities were carried at $219,473,000 and $139,075,000, respectively. The 1996 increases reflect the inclusion of Guaranty National's portfolio. These investments represented a total of 9.5% and 8.7% of cash and investments and 6.3% and 5.6% of total assets at December 31, 1996 and 1995, respectively.
The Company monitors the financial condition of the issuers of securities that it owns. When conditions are deemed appropriate, the Company ceases to accrete discount, or accrue interest and dividends, and, in cases where the value of such investments is deemed to be other than temporarily impaired, recognizes losses. The Company's non-investment grade investments are highly diversified, with an average investment per issuer of approximately $1,535,000 at December 31, 1996. Only one non-investment grade investment of $12,415,000 was in excess of $10,000,000 at December 31, 1996.
Net realized investment gains amounted to $24,180,000 in 1996, $11,885,000 in 1995 and $3,437,000 in 1994. Sales of equity securities resulted in net gains of $22,428,000, $16,531,000 and $3,845,000 and sales of fixed maturities resulted in net gains (losses) of $2,067,000, $(311,000) and $723,000 in 1996, 1995 and 1994, respectively. Realized investment gains were reduced by provisions for losses on securities deemed to be other than temporarily impaired. These provisions amounted to $315,000 in 1996, $285,000 in 1995 and $381,000 in 1994 for equity securities and $1,119,000, $4,050,000 and $750,000 in 1996, 1995 and 1994, respectively, for fixed maturity investments. Such provisions, based on available information at the time, were made in consideration of the decline in the financial condition of the issuers of these securities.
Year Ended December 31, -------------------------------- 1996 1995 1994 ---- ---- ---- (000s omitted) Net investment income ..................... $145,391 $ 99,040 $ 84,915 -------- -------- -------- Net realized gains (losses): Fixed maturities ........................ 2,067 (4,361) (27) Equity securities ....................... 22,113 16,246 3,464 -------- -------- -------- 24,180 11,885 3,437 -------- -------- -------- Net unrealized appreciation (depreciation): Fixed maturities ........................ (16,414) 89,932 (92,325) Equity securities ....................... 18,461 34,002 (18,827) -------- -------- -------- 2,047 123,934 (111,152) -------- -------- -------- $171,618 $234,859 $(22,800) ======== ======== ========
Realized gains (losses) vary from period to period, depending on market conditions relative to the Company's investment holdings, the timing of investment sales generating gains and losses, the occurrence of events which give rise to other than temporary impairment of investments, and other factors. At December 31, 1996 the Company held equity securities with unrealized appreciation of $73,523,000, and the market value of the fixed maturities portfolio exceeded amortized cost by $43,410,000. Such amounts can vary significantly depending upon fluctuations in the financial markets. Equity securities had unrealized appreciation of $18,461,000 for 1996, even after taking $22,428,000 of realized gains, which was largely offset by the impact of a rise in the interest rates resulting in unrealized depreciation of $16,414,000 for fixed maturities. The rise in market values during 1995 is primarily attributable to the decline in interest rates during the year. The average maturity of the Company's fixed maturities has not varied significantly in recent years.
The ratio of loss and loss adjustment expenses to premiums earned (the "loss ratio") was 67.9%, 68.4% and 72.1% in 1996, 1995 and 1994, respectively. The decreases in the 1996 and 1995 loss ratios were attributable to improvements in both the Regional Operations and Special Programs segments, offset in part by the consolidation of Guaranty National in 1996. The Company's efforts to reduce its loss costs have had a very positive impact on the Company's profitability.
Guaranty National's loss ratio for its personal lines book of business improved to 71.3% for 1996 from 78.6% for 1995. The commercial lines loss ratio also improved to 72.1% in 1996 from 78.0% in 1995. The lower loss ratios for 1996 are primarily attributable to Guaranty National having significantly strengthened its loss reserves for both personal and commercial lines in 1995 in response to adverse claim trends during 1995. Also during 1996, personal lines experienced lower claims severity and commercial lines had lower overall claims severity and frequency.
The ratio of deferred acquisition costs and other insurance expenses to premiums earned (the "expense ratio") was 30.1%, 29.0% and 27.0% in 1996, 1995 and 1994, respectively. The increases in the expense ratio are attributable to the Company's continued investment in building its loss prevention and claims management competencies as well as the costs of opening EBI offices in new territories. The increase for 1996 was also the result of the change in Connecticut Specialty's reinsurance, providing for lower ceding commissions, and the consolidation of Guaranty National. The 1994 expense ratio reflects a low level of assessments from certain assigned risk pools. The ratio of policyholders' dividends to premiums earned (the "dividend ratio") was 1.8%, 2.9% and 2.1% in 1996, 1995 and 1994, respectively. The decrease in the dividend ratio for 1996 results from the consolidation of premiums from Guaranty National, which does not have participating policies. The increase in the dividend ratio for 1995 is reflective of the lower loss ratios on workers compensation insurance coverages. The Company's combined ratio was 99.8% in 1996, 100.3% in 1995 and 101.2% in 1994.
Establishing reserve liabilities for environmental claims is subject to significant uncertainties that make reserve estimation difficult. Legal decisions have tended to expand insurance coverage beyond the intent of the policies. The disposition of such claims often requires lengthy and costly litigation. Uncertainties as to required clean-up remedies and difficulties in identifying the responsible parties add further to the complexity of reserve estimation for these claims. In recent years, the Company has intensified its efforts to settle and close environmental claims. To help minimize the cost of losses and claims, the Company maintains a dedicated environmental claims staff which administers and continually evaluates each claim and its defense and settlement possibilities. In 1996 (including Guaranty National), 1995 and 1994, the Company paid $4,771,000, $5,675,000 and $7,233,000, respectively, for the costs of defending and settling such claims. Payments in 1996, 1995 and 1994 related to 160, 213 and 292 claims, respectively, for the Company's direct business. Claim counts have been aggregated by year of coverage for each occurrence for which policyholders are being defended, and often include numerous claimants.
As of December 31, 1996 and 1995, the Company has environmental claims- related loss and loss adjustment expense reserves, net of reinsurance recoverables, of $57,028,000 (including Guaranty National) and $34,559,000, respectively, which include 632 and 474 claims, respectively, for direct business written by the Company. In estimating liabilities for environmental- related claims, the Company considers all pertinent information as it becomes available.
Other expenses were $42,932,000, $24,740,000 and $7,862,000 in 1996, 1995 and 1994, respectively. The increases in both other income and other expenses for 1996 and 1995 are primarily attributable to the inclusion of McGee's pool management revenue and expenses after it was acquired by the Company on June 30, 1995.
Equity in earnings of affiliates for 1996 consists of a loss of $389,000 recorded from the Company's investment in Intercargo. The Company records its share of Intercargo's results in the subsequent quarter, and the loss for 1996 reflects a loss reported by Intercargo in the fourth quarter of 1995. Earnings of $1,038,000 and $342,000 were recorded from the Intercargo investment in 1995 and 1994, respectively. In 1995 and 1994 Guaranty National was a non-majority owned affiliate of the Company and was therefore accounted for using the equity method. Included in equity in net earnings of affiliates from Guaranty National were $4,466,000 in 1995 and $11,244,000 in 1994.
Guaranty National became a majority-owned subsidiary in July 1996, and its results have been consolidated in the Company's financial statements for all of 1996. Minority interest expense of $8,692,000 was recorded for the after- tax portion of Guaranty National's 1996 earnings attributable to stockholders of Guaranty National other than the Company.
In June 1995 Guaranty National sold 1,550,000 shares of its common stock in an offering under Regulation S of the Securities Act of 1933, as amended, at a net offering price of $15.76 per share. The Company converted $20,896,000 of Guaranty National subordinated notes it held into 1,326,128 shares of Guaranty National common stock at the net price received by Guaranty National from the offering. The sale of stock and conversion of the subordinated notes increased the stockholders' equity of Guaranty National and facilitated the procurement of bank financing for Guaranty National's acquisition of Viking in July 1995.
Earnings before federal income taxes and minority interest expense were $127,356,000, $88,035,000 and $71,546,000 for 1996, 1995 and 1994, respectively. The increases in pre-tax earnings of 44.7% and 23.0% for 1996 and 1995 reflect improvement in insurance operations profitability of $27,026,000 and $8,041,000 and increases in realized investment gains of $12,295,000 and $8,448,000, respectively.
In October 1996 the Internal Revenue Service ("IRS") completed an examination of the Company's federal income tax returns through 1992. As described in previously issued financial statements of the Company, certain tax benefits from tax attributes existing at the date of the Company's reorganization in 1976 were not recognized pending completion of the IRS examination. Accordingly, the Company recorded a credit to capital surplus in 1996 for tax benefits of $11,900,000 with respect to the 1976 reorganization. The recording of this credit had no impact on the Company's earnings.
Primary earnings per common share amounted to $6.24 in 1996, $4.77 in 1995 and $3.85 in 1994. Fully diluted earnings per share is not presented as dilution is less than three percent for all periods.
Cash used in investment activities decreased $56,079,000 to $132,369,000 in 1996 from $188,448,000 in 1995 and increased $102,263,000 in 1995 from $86,185,000 in 1994. Cash is used in investment activities primarily for purchases of investments. The purchases are funded by maturities and sales of investments, as well as by the net cash from positive operating cash flows after cash provided by or used in financing activities. In July 1996 the Company purchased Guaranty National common stock for cash of approximately $88,206,000, including expenses. In June 1995 Orion paid $22,000,000 in cash plus acquisition costs to acquire McGee.
Orion's uses of cash consist of debt service, dividends to stockholders and overhead expenses. These cash uses are funded from existing available cash, financing transactions and receipt of dividends, reimbursement of overhead expenses and amounts in lieu of federal income taxes from Orion's insurance subsidiaries. Orion received $35,286,000, $30,546,000 and $30,013,000 in dividends, $7,410,000, $6,232,000 and $5,735,000 for overhead expenses and federal tax payments of $7,455,000, $4,500,000 and $6,000,000 from its insurance subsidiaries in 1996, 1995 and 1994, respectively. Payments of dividends by Orion's insurance subsidiaries must comply with insurance regulatory limitations concerning stockholder dividends and capital adequacy. State insurance regulators have broad discretionary authority with respect to limitations on the payment of dividends by insurance companies. Limitations under current regulations are well in excess of Orion's cash requirements.
The terms of Orion's indentures for its $100,000,000 of 7 1/4% Senior Notes due 2005 and its $110,000,000 of 9 1/8% Senior Notes due 2002 limit the amount of liens and guarantees by the Company, and the Company's ability to incur secured indebtedness without equally and ratably securing the senior notes. Management does not believe that these limitations unduly restrict the Company's operations or limit Orion's ability to pay dividends on its stock. At December 31, 1996 the Company was in compliance with the terms of its senior note indentures. Management believes that the Company continues to have substantial sources of capital and liquidity from the capital markets and bank borrowings.
The Company repurchased 241,114 shares, 173,181 shares and 442,327 shares of its common stock at an aggregate cost of $11,148,000, $7,183,000 and $13,745,000 in 1996, 1995 and 1994, respectively. The Company's remaining stock purchase authorization from its Board of Directors amounted to $4,514,000 at December 31, 1996.
All statements made in this Annual Report that do not reflect historical information are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Such factors include, among other things, (i) general economic and business conditions; (ii) interest rate changes; (iii) competition and regulatory environment in which the Company operates; (iv) claims frequency; (v) claims severity; (vi) medical cost inflation; (vii) increases in the cost of property repair; (viii) the number of new and renewal policy applications submitted to the Company; and (ix) other factors over which the Company has little or no control. The Company disclaims any obligation to update or to publicly announce the impact of any such factors or any revisions to any forward looking statements to reflect future events or developments.
W. Marston Becker Daniel L. Barry Chairman & Chief Executive Officer Chief Financial Officer
The Board of Directors and Stockholders Orion Capital Corporation New York, New York
We have audited the accompanying consolidated balance sheets of Orion Capital Corporation and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of earnings, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. Our audits also included the financial statement schedules listed in the Index at Item 14(a)2. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Orion Capital Corporation and subsidiaries as of December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1996 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
In the normal course of business, the Company's insurance subsidiaries reinsure certain risks, generally on an excess-of-loss or pro rata basis, with other companies in order to limit losses. Reinsurance does not discharge the primary liability of the original insurer. As of December 31, 1996 and 1995, recoverables for reinsurance ceded to the Company's four largest reinsurers were an aggregate of $150,175,000 and $84,654,000, respectively, excluding recoverables for reinsurance ceded to Phoenix Assurance Company of New York ("Phoenix"), the largest McGee pool member other than the Company in 1996 and the clearing company for the McGee pool in 1995. As of December 31, 1996, recoverables for reinsurance ceded to Phoenix were $85,105,000, versus $60,745,000 for 1995, and the Company had ceded balances payable to Phoenix of $19,042,000 and $22,660,000, respectively. The table below illustrates the effect of reinsurance on premiums written and premiums earned:
An analysis of the Company's calendar year net loss and loss adjustment expense reserves is summarized in the following table. The current year provision and payments for 1996 include favorable loss development for Guaranty National of $995,000 and payments of $144,775,000 attributable to periods prior to the consolidation of Guaranty National's results in the Company's financial statements.
Loss reserve estimates are based on forecasts of the ultimate settlement of claims and are subject to uncertainty with respect to future events. Loss reserve amounts are based on management's informed estimates and judgments, using data currently available. Reserve amounts and the underlying actuarial factors and assumptions are regularly analyzed and adjusted to reflect new information. Such reevaluation is a normal, recurring activity that is inherent in the process of loss reserve estimation and therefore, no assurances can be given that reserve development will not occur in the future. A substantial portion of the loss development experienced by the Company during the three years ended December 31, 1996 resulted from pools and associations, reinsurance, certain discontinued lines and program business, reduced by favorable development in workers compensation and professional liability lines of insurance. Reserve strengthening, higher initial reserving and increased stabilization in the Company's business have resulted in a decreasing level of loss development.
An analysis of the Company's loss and loss adjustment expense environmental reserves and related claim counts for the three years ended December 31, 1996 is presented below. Claim counts have been aggregated by year of coverage for each occurrence for which policyholders are being defended, and often include numerous claimants.
On June 2, 1995 Guaranty National entered into a $110,000,000 credit agreement ("Credit Agreement") with several participating banks. The Credit Agreement provides for an unsecured reducing revolving credit facility, which was used to fund the Viking acquisition, to retire the outstanding balance of $29,000,000 under Guaranty National's previous revolving line of credit, and for working capital and general corporate purposes. As of December 31, 1996, the outstanding loan balance under the Credit Agreement was $100,000,000, with an interest rate of 6.24%. Principal payments are due beginning April 15, 1999, until the loan is retired in 2002. Guaranty National is in compliance with the covenants in the Credit Agreement, including various financial covenants and restrictions. Guaranty National has two interest rate swap agreements with banks which effectively change the interest rate exposure on $80,000,000 of the loan to a fixed rate of approximately 6.3% through March 16, 1998. The estimated fair value of these interest rate swap agreements is a liability of $214,000 at December 31, 1996.
Notes payable are recorded at face value less unamortized discount. The carrying value and estimated market value of notes payable consist of the following:
[CAPTION] ORION CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Minimum lease commitments at December 31, 1996, with the majority having initial lease periods from one to twenty-five years, are as follows:
During 1996, the Company repurchased 241,114 shares of its common stock at an aggregate cost of $11,148,000. The Company repurchased 173,181 shares for $7,183,000 in 1995 and 442,327 shares for $13,745,000 in 1994.
The weighted average common shares outstanding for purposes of computing earnings per share amounted to 13,894,000, 14,187,000 and 14,348,000 shares for 1996, 1995 and 1994, respectively.
Guaranty National has a defined contribution profit sharing plan (the "Guaranty Plan"), which also qualifies under Section 401(k), for which substantially all of its employees are eligible. Guaranty National makes matching contributions to the Guaranty Plan in accordance with the limits of the Guaranty Plan and federal income tax law. Guaranty National has a non- qualified Supplemental Executive Retirement Plan ("SERP") for employees whose compensation meets a minimum requirement. The SERP provides deferred benefits for those employees who received less than the full employer contribution of Guaranty National's defined contribution profit sharing plan as a result of federal tax limitations on participation in the plan.
Orion maintains a non-qualified defined benefit retirement plan for members of the Board of Directors who are not employees. Benefits are based on years of service and director fee levels at retirement. In 1995, Orion's stockholders authorized 100,000 shares for a stock option plan for non-employee directors. During 1996 and 1995 Orion granted 9,000 and 54,000 stock options, respectively, to directors at fair market value, which become exercisable one year from the date of grant and expire in ten years.
The Company provides postretirement medical benefits to full-time employees (except for employees of Guaranty National and McGee), who have attained age 55 and have 10 years of consecutive service immediately prior to retirement. McGee employees that attain age 55 while in service with McGee are eligible for postretirement medical benefits if they have 10 years of service, with an increasing level of benefits for additional years of service up to 35. The postretirement health care plans are not funded. The accumulated postretirement benefit obligation of these plans included in other liabilities in the consolidated balance sheet is as follows:
December 31, ---------------- 1996 1995 ---- ---- (000s omitted) Retirees ................................. $ 3,864 $ 3,353 Fully eligible active plan participants .. 1,352 1,713 Other active plan participants ........... 3,510 3,585 Unrecognized net gains ................... 4,275 3,528 ------- ------- $13,001 $12,179 ======= =======
On January 13, 1997 Orion issued $125,000,000 of 8.73% Junior Subordinated Debentures due January 1, 2037 to Orion Capital Trust I, a Delaware statutory business trust sponsored by Orion. Orion Capital Trust I then sold $125,000,000 of 8.73% Capital Securities which mature on January 1, 2037 (the "Capital Securities") in a private placement. The Capital Securities are subordinate to all liabilities of the Company, and may be redeemed without premium on or after January 1, 2007. Orion agreed to register the Capital Securities under the Securities Act of 1933, and has accordingly filed a registration statement with the Securities and Exchange Commission.