This analysis pertains to the consolidated accounts of Old Republic International Corporation. The Company conducts its business through four separate segments, namely its General (property and liability coverages), Mortgage Guaranty, Title, and Life insurance groups.
Old Republic's financial position at December 31, 1999 reflected decreases in assets and common shareholders' equity of 1.2% and 4.6%, respectively, while liabilities increased .5% when compared to the immediately preceding year-end. Cash and invested assets represented 69.6% and 70.5% of consolidated assets as of December 31, 1999 and 1998, respectively. Consolidated operations produced positive cash flows for the latest three years. 1999 cash flow, while positive, trended down due mainly to lower contributions from Old Republic's general insurance segment. In 1999, the invested asset base declined principally as a result of the Company's stock buy- back program, the sale of an inactive life insurance subsidiary in early 1999, a decrease in the value of bonds and stocks carried at market value, and the aforementioned reduced contributions from operating cash flow.
The Company does not own or utilize derivative financial instruments for the purpose of hedging, enhancing the overall return of its investment portfolio, or reducing the cost of its debt obligations. Old Republic 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 asset diversification and the purchase of investment grade securities. Reinvestment rate risk is controlled by concentrating on non-callable issues, and by taking asset-liability matching practices into account; purchases of mortgage and asset backed securities, which have variable principal prepayment options, are generally avoided. Market value risk is limited through the purchase of bonds of intermediate maturity. The combination of these investment management tenets generally provides a more stable long term fixed maturity investment portfolio that is not subject to extreme interest rate sensitivity and principal deterioration. The market value of the Company's long term fixed maturity investment portfolio is sensitive, however, to fluctuations in the level of interest rates, but not materially affected by changes in anticipated cash flows caused by any prepayments. 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. With a market value of approximately $4,242.0, the long term fixed maturity investment portfolio has an average maturity of 4.5 years and an indicated duration of 3.8. This implies that a 100 basis point parallel increase in interest rates from current levels would result in a possible decline in the market value of the long term fixed maturity investment portfolio of approximately 3.8%, or $162. With regard to its $157.5 common stock 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 $15.8 in
the market value of the Company's common stock portfolio. These possible declines in values for Old Republic's bond and stock portfolios would affect negatively 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.
Old Republic's capitalization of $2,407.5 at December 31, 1999 consisted of debt of $208.3, convertible preferred stock of $.7 and common shareholders' equity of $2,198.4. The changes in the common shareholders' equity account for the most recent three calendar years reflect primarily the retention of earnings in excess of dividends declared on outstanding preferred and common shares, the conversion of redeemable convertible preferred stock in 1997, an increase during 1998 and 1997 compared to a decrease during 1999 in the value of bonds and stocks carried at market value, and the acquisition of $188.1, $151.1 and $62.1, respectively, of common stock in open market transactions. At its March 11, 1999 meeting, the Company's Board of Directors authorized the reacquisition of up to $200.0 of common shares as market conditions would warrant during the eighteen month period from that date; as of December 31, 1999, a total of $43.8 of this authorization remained unutilized.
The effective consolidated income tax rates were 29.3% in 1999, 31.2% in 1998 and 30.3% in 1997. The rates for each year reflect primarily the varying proportions of pre-tax operating income derived from tax-sheltered investment income (principally tax-exempt interest) on the one hand, and the combination of fully taxable investment income, realized investment gains, and underwriting and service income, on the other hand. The lower rate in 1999 resulted from reduced income from underwriting and related services; the rate in 1997 was also affected positively by the above noted income tax recoveries for prior years.
Year 2000 issues relate primarily to computer programs which were written with only a two-digit designation for many years. Such programs are often unable to interpret dates beyond 1999 and as a result may fail or lead to computer errors which could create a disruption in operations.
Prior to December 31, 1999, the Company and its subsidiaries completed an implementation of changes and tests of those computer systems and programs that had been identified as being affected by Year 2000 issues. They also received confirmations of Year 2000 compliance from certain principal customers, vendors and other third parties with whom they have significant business relationships. The Company and its subsidiaries had also developed contingency plans for operations in the event Year 2000 issues were to arise in spite of the changes and tests effected.
Early in the current year, no issues are known to have developed nor affect adversely the Company or any of its subsidiaries. Although the Company considers it increasingly unlikely, it is possible that Year 2000 issues may have arisen but are not yet known. The aforementioned contingency plans are deemed appropriate to address such subsequent events; no significant additional costs are being anticipated with respect to Year 2000 issues.
Consolidated Balance Sheets........................................... 24-25 Consolidated Statements of Income..................................... 26 Consolidated Statements of Comprehensive Income....................... 27 Consolidated Statements of Preferred Stock and Common Shareholders' Equity........................................ 28 Consolidated Statements of Cash Flows................................. 29 Notes to Consolidated Financial Statements............................ 30-50 Report of Independent Accountants..................................... 51
Old Republic International Corporation and Subsidiaries Consolidated Balance Sheets ($ in Millions)
Old Republic International Corporation and Subsidiaries Consolidated Statements of Income ($ in Millions, Except Share Data)
(a) Consolidation Practices-The consolidated financial statements include the accounts of the Corporation and those of its major insurance underwriting and service subsidiaries. Non-consolidated insurance marketing and service sub- sidiaries are insignificant and are reflected on the equity basis of accounting. All significant intercompany accounts and transactions have been eliminated in consolidation.
(c) Investments-The Company may classify its invested assets in terms of those assets relative to which it either (1) has the positive intent and ability to hold until maturity (generally carried at amortized costs for fixed maturity securities), (2) has available for sale (carried at fair value with adjustments to equity, net of deferred income taxes) or (3) has the intention of trading (carried at fair value with adjustments to income); as of December 31, 1999, the Company's invested assets were classified solely as "held to maturity" or "available for sale."
Fixed maturity securities and redeemable preferred stocks classified as "held to maturity" are generally carried at amortized costs while fixed maturity securities classified as "available for sale" in addition to other preferred and common stocks (equity securities) are included at fair value. Fair values for fixed maturity securities and equity securities are based on quoted market prices or estimates using values obtained from independent pricing services as applicable. Mortgage and policy loans (other long-term investments) are carried on the basis of the lower of unpaid principal balances or estimated realizable value.
The amortized cost and estimated fair value at December 31, 1999, 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.
Bonds and other investments carried at $161.1 as of December 31, 1999 were on deposit with governmental authorities by the Corporation's insurance subsidiaries to comply with insurance laws.
At December 31, 1999, the Corporation and its subsidiaries had no non-income producing fixed maturity securities.
The following table reflects the composition of net investment income, net realized gains or losses, and the net change in unrealized investment gains or losses for each of the years shown:
- ------------ (1) Investment expenses consist of personnel costs and investment management and custody service fees, and includes interest incurred on funds held of $1.5, $1.5 and, $1.7 for the years ended December 31, 1999, 1998 and 1997, respectively. (2) Deferred income taxes do not apply since these securities are carried at amortized cost.
at the time of closing of the related escrow. Ordinary life and annuity premiums are recognized as revenue when due. Decreasing term credit life and credit disability/accident & health insurance premiums are generally earned on a sum-of-the-years-digits or similar method.
With respect to mortgage guaranty insurance (net insurance in force of $76,953.8 and $57,401.1, at December 31, 1999 and 1998, respectively) the Company's reserving policies are set forth below in Note 1(g).
The Company believes that its overall reserving practices have been consistently applied over many years, and that its aggregate net reserves have resulted in reasonable approximations of the ultimate net costs of claims incurred. However, no representation is made that ultimate net claim and related costs will not be greater or lower than previously established reserves.
Old Republic disagrees with the allegations of liability on virtually all A&E related claims of which it has knowledge on the grounds that exclusions in the policies preclude coverage for nearly all such claims, and that the Corporation never intended to assume such risks. Old Republic's exposure on such claims cannot therefore be calculated by conventional insurance reserving methods for this and a variety of reasons, including: a) the absence of statistically valid data inasmuch as such claims typically involve long reporting delays and very often uncertainty as to the number and identity of insureds against whom such claims have arisen or will arise; and b) the litigation history of such or similar claims for other insurance industry members that has produced court decisions that have been inconsistent with regard to such questions as when the alleged loss occurred, which policies provide coverage, how a loss is to be allocated among potentially responsible insureds and/or their insurance carriers, how policy coverage exclusions are to be interpreted, what types of environmental impairment or toxic tort claims are covered, when the insurer's duty to defend is triggered, how policy limits are to be calculated, and whether cleanup costs constitute property damage.
The provision for combined current and deferred income taxes reflected in the consolidated statements of income does not bear the usual relationship to operating income before taxes as the result of permanent and other differences between pre-tax income and taxable income determined under existing tax regulations. The more significant differences, their effect on the statutory income tax rate, and the resulting effective income tax rates are summarized below:
Life insurance companies domiciled in the United States and qualifying as life insurers for tax purposes are taxed under special provisions of the Internal Revenue Code. As a result of legislation, 1983 and prior years' tax deferred earnings (cumulatively $13.3 at December 31, 1999) credited to the former memorandum "policyholders' surplus account" will generally not be taxed unless they are subsequently distributed to shareholders. The Company does not presently anticipate any distribution or payment of taxes on such earnings in the future.
As a result of regular examinations of the tax returns for the Corporation and its subsidiaries, the Internal Revenue Service ("IRS") has proposed certain adjustments for additional taxes applicable to the years 1983 to 1995. The proposed adjustments pertain to the timing of certain deductions, the IRS's contention that contractually obligated premium refunds should be treated as dividends, deductions for certain loss and related reserves, a reinsurance transaction, and several other issues not involving material amounts. The Company and its tax counsel believe that substantially all of the proposed adjustments are without merit, that the Company will be successful in vigorously defending its positions, and that the ultimate adjustments, if any, will not significantly affect its financial condition or results of operations.
In 1997, several life insurance subsidiaries recovered income taxes and related accumulated interest due to favorable resolution with the Internal Revenue Service of various outstanding issues pertaining to income tax returns for the years 1979 through 1982. These cash recoveries, net of miscellaneous charges, increased other income by $12.6, reduced income tax expense by $5.9 and increased net income by $14.2.
(j) Title Plants and Records-Title plants and records are carried at original cost or appraised value at date of purchase. Such values represent the cost of producing or acquiring interests in title records and indexes and the appraised value of purchased subsidiaries' title records and indexes at dates of acquisition. The cost of maintaining, updating, and operating title records is charged to income as incurred. Title records and indexes are ordinarily not amortized unless events or circumstances indicate that the carrying amount of the capitalized costs may not be recoverable.
(m) Escrow Funds-Segregated cash deposit accounts and the offsetting liabilities for escrow deposits in connection with Title Insurance Group real estate transactions in the same amounts ($487.3 and $681.7 at December 31, 1999 and 1998, respectively) are not included as assets or liabilities in the accompanying consolidated balance sheets as the escrow funds are not available for regular operations.
Scheduled maturities of the above debt (including common stock classified as debt see (a)below) at December 31, 1999 are as follows: 2000: $82.2 ; 2001: $1.0; 2002: $.4; 2003: $.6; 2004: $.4; 2005 and after: $123.4. During 1999, 1998 and 1997, $10.3, $10.0 and $9.6, respectively, of interest expense on debt was charged to consolidated operations.
Convertible ----------- Preferred Stock Series: G(1) ----------- Annual cumulative dividend rate per share...................... $ (1) Conversion ratio of preferred into common shares .............. 1 for .95 Conversion right begins........................................ Anytime Redemption and liquidation value per share..................... (1) Redemption beginning in year................................... (1) Total redemption value (millions).............................. (1) Vote per share................................................. one Shares outstanding: December 31, 1998.............................................. 270,858 December 31, 1999.............................................. 153,183 ===========
(b) Cash Dividend Restrictions-The payment of cash dividends by the Corporation is principally dependent upon the amount of its insurance subsidiaries' statutory policyholders' surplus available for dividend distribution. The insurance subsidiaries' ability to pay cash dividends to the Corporation is in turn generally restricted by law or subject to approval of the insurance regulatory authorities of the states in which they are domiciled. These authorities recognize only statutory accounting practices for determining financial position, results of operations, and the ability of an insurer to pay dividends to its shareholders. Based on 1999 data, the maximum amount of dividends payable to the Corporation by its insurance and a small number of non-insurance company subsidiaries during 2000 without the prior approval of appropriate regulatory authorities is approximately $184.2.
(c) Debt Restrictions-Under the most restrictive covenants, the terms of Old Republic's guaranties relative to loan agreements described in Note 2(a) provide that while loans under such agreements are outstanding, Old Republic is restricted from, among other things, permitting "Debt" to exceed 25% of its consolidated tangible net worth (as adjusted for goodwill and net unrealized investment gains or losses, but including title plants and records) without approval of the lenders.
A summary of stock options outstanding and exercisable at December 31, 1999 follows:
(g) Statutory Data-The policyholders' surplus and net income (loss), determined in accordance with statutory accounting practices, of the Corporation's insurance subsidiaries was as follows at the dates and for the periods shown:
(b) Leases-Some of the Corporation's subsidiaries maintain their offices in leased premises. Certain of these leases provide for the payment of real estate taxes, insurance, and other operating expenses. At December 31, 1999, aggregate minimum rental commitments (net of expected sub-lease receipts) under noncancellable operating leases of $125.4 are summarized as follows: 2000: $30.2; 2001: $24.8; 2002: $19.3; 2003: $14.8; 2004: $10.9; 2005 and after: $25.2.
(d) Legal Proceedings-Legal proceedings against the Company arise in the normal course of business and generally pertain to claim matters related to insurance policies and contracts issued by the Corporation's insurance subsidiaries.
Various governmental entities have filed suit against or performed examinations of the records of an underwritten title agency subsidiary headquartered in the State of California. As a result, certain regulatory and class action litigation has commenced alleging that the subsidiary: 1) failed to escheat unclaimed escrow funds; 2) charged for services not necessarily provided; and 3) collected illegal interest payments or fees from banks on the basis of funds held for escrow customers. The subsidiary has in turn conducted an internal review of its records and concluded that it had certain liabilities for part of the issues denoted at (1) and (2). Management believes that the alleged practices denoted in (3) are common within the industry, are not in conflict with various laws and regulations, and that it has meritorious defenses, which will ultimately lead to a successful resolution of these practices. The subsidiary had paid or otherwise provided reserves of $16.2 and $19.5 in 1999 and 1998, respectively to cover its best estimate of litigation and related costs associated with all these issues.
Note 5-Consolidated Quarterly Results-Unaudited - Old Republic's consolidated quarterly operating data for the two years ended December 31, 1999 is presented below.
Real estate mortgage loan insurance produced by the Mortgage Guaranty Group protects lending institutions against certain losses, generally to the extent of 10% to 35% of the sum of the outstanding amount of each insured mortgage loan, and allowable costs incurred in the event of default by the borrower. The Corporation insures only first mortgage loans, primarily on residential properties having one-to-four family dwelling units. Mortgage guaranty insurance premiums originate from savings and loan associations, mortgage bankers and other lending institutions. The Corporation's residential real estate loan insurance business is originated, approximately 17% by savings and loan associations, 63% by mortgage bankers and 20% by other lenders.