The Company also owns six other buildings in suburbs adjoining the corporate office complex and two buildings in Tampa, Florida. In total, these buildings contained approximately 629,100 square feet of office, warehouse and training facility space and are owned by subsidiaries of the Company. These locations are occupied by the Company's business units or other operations.
The Company leases approximately 320,000 square feet of modern office and warehouse space at various locations throughout the United States for its other business units and staff functions. In addition, the Company leases approximately 340 processing and claim offices, or 1,082,000 square feet, at various locations throughout the United States. Two offices are leased in Canada. These leases are generally short-term to medium-term leases of standard commercial office space.
As the Company continues to grow, it expects the need for additional space and is actively engaged in seeking out additional locations to meet its current and anticipated needs.
During the three-year period ended December 31, 1996, the Company repurchased 2.1 million Common Shares at a total cost of $75.9 million (average cost of $36.42 per share) and .4 million of its 9 3/8% Serial Preferred Shares, Series A, at a total cost of $10.6 million (average cost $25.69 per share). The Company also sold $300.0 million of Notes. During the same period, The Progressive Corporation received $178.2 million from its insurance subsidiaries, net of capital contributions made to these subsidiaries. The regulatory restrictions on subsidiary dividends are described in Item 5(c) on page 12 herein.
The Company has substantial capital resources and is unaware of any trends, events or circumstances that are reasonably likely to affect its capital resources in a material way. The Company also has available a $20.0 million revolving credit agreement. Given its 32% debt to equity ratio, the Company believes it has sufficient borrowing capacity and other capital resources to support current and anticipated growth.
The Company's insurance operations create liquidity by collecting and investing premiums from new and renewal business in advance of paying claims. For the three years ended December 31, 1996, operations generated a positive cash flow of $1,634.1 million, and cash flow is expected to be positive in both the short-term and reasonably foreseeable future. The Company's substantial investment portfolio is highly liquid, consisting almost entirely of readily marketable securities.
In November 1996, the Company signed a definitive agreement to acquire all of Midland Financial Group, Inc.'s outstanding stock (approximately 5.5 million shares) for a total cost of $49.5 million, or $9 per share, in cash. Midland underwrites and markets nonstandard private passenger automobile insurance through approximately 8,500 independent agents across 20 states, primarily in the southern and western United States. During 1996, Midland wrote $116.6 million of net premiums written. The transaction was approved by Midland's shareholders on March 7, 1997, and funded through current investments of the Company.
In January 1997, the Company signed a letter of intent under which it was contemplated that the Company would purchase approximately 11 million newly-issued shares (42% of the outstanding voting stock) of Danielson Holding Corporation for consideration having a total value of approximately $73 million, or $6.60 per share. Danielson is engaged, through its subsidiaries, in insurance services, primarily writing private and commercial nonstandard insurance in California and workers' compensation insurance in California and certain other western states. During 1996, Danielson's insurance subsidiaries wrote $36.1 million of net premiums written. In March 1997, negotiations between Danielson and the Company were terminated by the Company for internal corporate reasons.
The Company does not expect any material changes in its cash requirements and is not aware of any trends, events or uncertainties that are reasonably likely to have a material effect on its liquidity.
In January 1996, the Company began converting its computer systems to be year 2000 compliant (e.g. to recognize the difference between '99 and '00 as one year instead of negative 99 years). At December 31, 1996, approximately 40% of the Company's systems were compliant, with all systems expected to be compliant by the end of 1998. The total cost of the project is estimated to be $4.3 million and is being funded through operating cash flows. The Company is expensing all costs associated with these system changes. As of December 31, 1996, $1.6 million had been expensed.
A relatively small portion of the investment portfolio was invested in marketable equity securities providing risk/reward balance and diversification. Common stocks represented $540.1 million, or 12.1%, in 1996, and $310.0 million, or 8.2%, in 1995. The increase in common stocks reflects the Company's objective of increasing its position in common stock investments to approximately 15% of the entire portfolio and to optimize value and further diversify the portfolio through foreign equity investments. The foreign equity portfolio, which may utilize stock index futures and foreign currency forwards, comprised $149.5 million of the common stock portfolio at December 31, 1996, and $46.4 million at December 31, 1995. The remainder of the equity portfolio ($341.6 million, or 7.7%, in 1996, and $382.3 million, or 10.1%, in 1995) was comprised of over 94% of fixed-rate preferred stocks with mechanisms that may provide an opportunity to liquidate at par.
As of December 31, 1996, the Company's portfolio had $114.1 million in unrealized gains, compared to $78.7 million in 1995, resulting from increased stock prices as the S&P 500 index rose from 615.9 to 740.7 during the year. The weighted average fully taxable equivalent book yield of the portfolio was 6.7%, 6.9% and 6.7% for the years ended December 31, 1996, 1995 and 1994, respectively.
As of December 31, 1996, the Company held $1,088.3 million of asset-backed securities which represented 24.5% of the total investment portfolio. The portfolio included collateralized mortgage obligations (CMOs) and commercial mortgage-backed obligations (CMBs) totaling $303.0 million and $480.2 million, respectively. As of December 31, 1996, the CMO portfolio included sequential bonds representing 88.8% of the CMO portfolio ($269.0 million) with an average life of 2.9 years, and planned amortization class bonds representing 11.2% of the CMO portfolio ($34.0 million) with an average life of 1.4 years. The CMO portfolio had a weighted average Moody's or Standard & Poor's rating of AAA. At December 31, 1996, the CMB portfolio had an average life of 5.4 years and a weighted average Moody's or Standard & Poor's rating of AA-. The CMB portfolio included $122.7 million of CMB interest-only certificates, which had an average life of 5.1 years and a weighted average Moody's or S&P's rating of AAA at December 31, 1996. At December 31, 1996,
the CMO and CMB portfolios had unrealized gains of $1.7 million and $2.1 million, respectively. The single largest unrealized loss in any individual CMO and CMB security was $.3 million and $.8 million, respectively, at December 31, 1996. Both the CMO and CMB portfolios are highly liquid with readily available quotes and contain no residual interests. The remainder of the asset-backed portfolio is invested primarily in auto loan and other asset-backed securities.
Operating income, which excludes net realized gains and losses from security sales and one-time items, was $309.1 million, or $4.08 per share, in 1996, $220.1 million, or $2.84 per share, in 1995 and $212.7 million, or $2.76 per share, in 1994. The GAAP combined ratio was 91.5 in 1996, 94.3 in 1995 and 91.7 (88.5 including the elimination of the "supplemental reserve" discussed below) in 1994.
Direct premiums written increased 19% to $3,638.4 million in 1996, compared to $3,068.9 million in 1995 and $2,645.1 million in 1994. Net premiums written increased 18% to $3,441.7 million, compared to $2,912.8 million in 1995 and $2,457.2 million in 1994. The difference between direct and net premiums written is largely attributable to premiums written under state-mandated involuntary Commercial Auto Insurance Procedures (CAIP), for which the Company retains no indemnity risk, of $99.5 million in 1996, $105.4 million in 1995 and $115.4 million in 1994. The Company provided policy and claim processing services to 27 state CAIPs in 1996, compared to 28 in 1995 and 1994. Premiums earned, which are a function of the amount of premiums written in the current and prior periods, increased 17% in 1996, compared to 24% in 1995 and 31% in 1994.
The Company's Core business units' net premiums written grew 19%, 21% and 38% in 1996, 1995 and 1994, respectively, primarily driven by an increase in unit sales. In 1996, the Company raised rates an average of 2.5%, compared 6.5% in 1995 and no rate changes in 1994. The Company continues to write standard and preferred auto risks which represented between 10% and 15% of total Core business volume. To encourage writing more standard and preferred risks and to improve customer retention, the Company adjusted the contingent cash incentive compensation program for 1997 to credit its conservative estimates of the increase in value created by adding new customers. The Company believes that growing the numbers of policyholders, particularly standard and preferred risks with their higher retention rates, builds intrinsic
During 1994, based on a review of the adequacy of its total loss reserves, the Company eliminated its $71.0 million "supplemental reserve," resulting in a one-time increase in earnings of $.62 per share, a 3.2 point increase in the underwriting profit margin and a $46.2 million increase in capital. The Company historically established case and IBNR reserves by product with the objective of being accurate to within plus or minus 2%. Pricing has been based on these estimates of reserves by product. Because the Company desired a very high degree of comfort that aggregate reserves were adequate, aggregate reserves were established near the upper end of the reasonable range of reserves, and the difference between such aggregate reserves and the midpoint of the reasonable range of case and IBNR reserves was called the "supplemental reserve." The Company concluded, after examining its historical aggregate reserves, that the practice of setting aggregate reserves at the upper end of the range of reasonable reserves provided an unnecessarily high level of comfort. At December 31, 1994, even without the high level of comfort provided by the "supplemental reserve," the Company's reserves would have been redundant by approximately 2% to 4% over the previous 5 years. The Company believes that this change in the estimate of its reserves placed it more in line with the practices of other companies in the industry.
Recurring investment income (interest and dividends) increased 13% to $225.8 million in 1996, compared to $199.1 million in 1995 and $158.5 million in 1994, primarily due to an increase in the average investment portfolio. Net realized gains on security sales were $7.1 million in 1996, $46.7 million in 1995 and $23.8 million in 1994.
The Consolidated Financial Statements of the Company, along with the related notes, supplementary data and report of independent accountants, are incorporated by reference from the Company's 1996 Annual Report, pages 33 through 46 and pages 50 through 55.
New Accounting Standards - In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) 128, "Earnings Per Share." The statement simplifies the computation of earnings per share (EPS). Under the statement, primary EPS would be replaced by a simpler calculation called "basic" EPS. Basic EPS would be calculated by dividing income available to common shareholders by the weighted average number of shares outstanding. Stock options and other common stock equivalents (CSE) would be excluded from the basic EPS calculation. The current fully diluted EPS would be replaced with "diluted" EPS. The primary difference in the diluted EPS calculation would require the average common stock price be used in determing the number of CSE relating stock options, rather than the greater of the average price or closing price. SFAS 128 requires dual presentation of basic and diluted EPS on the face of the income statement, including a reconciliaiton of the numerator and denominator used in computing basic and diluted EPS. For 1996, the Company would have reported basic EPS of $4.29 and diluted EPS of $4.14. SFAS 128 is effective for periods beginning after December 15, 1997. Earlier application is not permitted.