HIG leases approximately 8,140 square feet for its operations at 1001 Bishop Street Pacific Tower, Honolulu, Hawaii under a long-term operating lease. The Company considers the office facilities to be suitable and adequate for HIG's current and anticipated level of operations.
The Company owns an office building with approximately 175,000 square feet located at 175 Mansfield Avenue, Shelby, Ohio for its Shelby operations.
- -------- * As a result of an internal investigation begun in the second quarter of 1998, the Company determined that certain inappropriate reductions of reserves and overstatements of premium income in the Company's reinsurance business had been recorded in the fourth quarter of 1997 and the first quarter of 1998. Based on the information discovered in that investigation, the Company has restated its previously issued financial statements in August 1998 to make the necessary
For its assumed reinsurance business, the Company had historically made estimates for its reinsurance reports received subsequent to a period end on a combined underwriting and accident year basis for both statutory and GAAP purposes. As a result of a routine examination by the Alabama Department of Insurance, the Company agreed to revise the accounting for its reinsurance business for statutory purposes. Effective with its year end 1997 statutory filings, Vesta Fire revised its statutory accounting for its assumed reinsurance business to reflect only accident/calendar year information. The adjustments essentially reversed, in the form of a one-time charge, the cumulative effect of the accounting practice consistently applied over prior years. On a GAAP basis, the correction was accounted for by restating prior financial statements.
The Company determined, subsequent to the issuance of the 1997 financial statements, that a specific reinsurance ceded contract entered into in 1997 contains retroactive elements as defined in Financial Accounting Standards Board ("FASB") Statement 113. The Company erroneously recorded a gain on this contract in the fourth quarter of 1997 and must adjust its previously issued financial statements to appropriately defer and recognize such gain in future periods. See Note B of the consolidated financial statements for further discussion.
The Company has historically followed a practice of maintaining low retentions in its primary and reinsurance business to reduce the variability of its earnings. The Company's loss reserve levels historically have remained relatively stable from year to year despite changes in premium volume. The Company is continuing to cede portions of insurance risks while using its capital base to gradually increase, on a selective basis, its retention of certain property risks.
Because catastrophe loss events are by their nature unpredictable, historical results of operations may not be indicative of expected results of future operations. The Company markets its primary personal insurance products throughout the United States. While the Company seeks to reduce its exposure to catastrophic events through the purchase of reinsurance, the occurrence of one or more major catastrophes in any given period could have a material adverse impact on the Company's results of operations and financial condition and could result in substantial outflows of cash as losses are paid. In addition, the increased underwritings of catastrophe
related reinsurance, and potential residual market assessments may also lead to increased variability in the Company's loss ratio.
Prior to the Shelby and Vesta County Mutual acquisitions, assumed reinsurance was the dominant line of business, representing 78 percent of 1996 net premiums. As a result of these acquisitions, assumed reinsurance represented 62 percent of 1997 gross premiums. In 1998, assumed reinsurance represented 38 percent of 1998 gross premiums. This shift to increase primary writing is consistent with the Company's strategy to focus on property coverages in all of its lines of business while adjusting the mix and volume of its writings and retentions to respond to change in market conditions.
In July of 1996, Vesta Fire entered into a pro rata reinsurance facility covering substantially all primary and assumed business in order to provide capital flexibility to take advantage of growth opportunities in the future. This reinsurance facility had the effect of reducing net premiums written in the second half of 1996 by $98.0 million. In 1997, the reinsurance facility had the effect of reducing net written premiums by $155.1 million, including reducing Shelby net written premiums by $37.5 million. In 1998, the reinsurance facility had the effect of reducing net premiums written by $70.2 million. Effective July 1, 1998, the reinsurance facility was cancelled on a run-off basis.
Gross premiums written for reinsurance decreased by $247.8 million, or 46.3%, to $287.6 million for the year ended December 31, 1998, from $535.4 million for the year ended December 31, 1997. The main contributors to the reduction of reinsurance gross premiums written were the continuation of increased competition in the market place coupled with the Company's unwillingness to follow the market price, the modification of one large treaty and the cancellation of another large treaty. The acquisition of Vesta County Mutual resulted in the further shift of $27 million of private passenger automobile writings which had been recorded on the reinsurance line in 1997 to personal lines in 1998. Net premiums written for reinsurance decreased $194.1 million, or 55.2%, to $157.7 million for the year ended December 31, 1998, from $351.8 million for the year ended December 31, 1997. Net premiums earned for reinsurance decreased $141.1 million, or 42.1% to $194.3 million for the year ended December 31, 1998, from $335.4 million for the year ended December 31, 1997.
Loss and LAE for reinsurance decreased by $3.8 million, or 2.1% to $175.7 million for the year ended December 31, 1998, from $179.5 for the year ended December 31, 1997. The dollar amount of loss and loss adjustment expenses incurred decreased during 1998 due to the decline in net premiums earned. The loss and LAE ratio for reinsurance for the year ended December 31, 1998 was 90.5% as compared to 53.5% for the year ended December 31, 1997. The increase in the loss ratio was primarily attributable to the decreases in earned premiums due to pricing pressures and market competition, higher ceded reinsurance costs in 1998 versus 1997 and an increase of $18.7 million in catastrophe losses.
Given current market conditions in the reinsurance arena the Company anticipates that the recent change in its A.M. Best rating to B++ will have a negative impact on its reinsurance operations. Although the company enjoys an excellent relationship with its reinsurance customers the potential for growth in its reinsurance portfolio has been hampered by the recent change in rating. The Company has determined that the A.M. Best downgrade and the increased competition in the reinsurance
marketplace will cause a significant loss of reinsurance premiums in 1999. Therefore, the Company has entered into an agreement to sell a significant portion of its reinsurance book of business. See the Business Strategy section and Note T of the Notes to the Consolidated Financial Statements for further discussion.
Included in the reinsurance results for 1998, were two large 100% Quota share reinsurance treaties for CIGNA and Homeplus which cover selected homeowners lines. As the covered business is renewed it will be transferred to Vesta Fire as the issuing carrier. These treaties were not included in the sale of the reinsurance book of business. In 1998, these treaties accounted for $107.4 million in gross written premiums.
Gross premiums written for personal lines increased by $102.3 million, or 41.8%, to $347.0 million for the year ended December 31, 1998, from $244.7 million for the year ended December 31, 1997. Included in the $102.3 increase in gross premiums written for personal lines was a $101.0 million increase in gross premiums written due to a full year of Shelby premiums in 1998 versus six months of Shelby premiums in 1997. The remaining increase of $1.3 million was primarily due to the transfer of business from assumed reinsurance to personal lines following the acquisition of Vesta County Mutual partially offset by premium reductions in the Financial Services lines and the Hawaiian Insurance and Guaranty Company Limited ("HIG").
Net premiums written for personal lines increased by $123.6 million, or 87.5%, to $264.8 million for the year ended December 31, 1998, from $141.2 million for the year ended December 31, 1997. The increase in net premiums written was largely attributable to the writings from Shelby and the transfer of business from assumed reinsurance to personal lines following the acquisition of Vesta County Mutual. Net premiums earned for personal lines increased $107.7 million, or 77.3% to $247.1 million for the year ended December 31, 1998, from $139.4 million for the year ended December 31, 1997.
Loss and LAE for personal lines increased by $69.7 million, or 73.2% to $164.9 million for the year ended December 31, 1998, from $95.2 million for the year ended December 31, 1997. The increase in loss and loss adjustment expenses was primarily attributable to a full year of losses for Shelby included in 1998 versus only six months of losses for Shelby in 1997. The loss and LAE ratio for personal lines for the year ended December 31, 1998 was 66.7% as compared to 68.3% at December 31, 1997.
Until recently, the Company pursued a broader range of target commercial classes which focused on hotels, manufacturers, restaurants, motorcycle dealers, broadcasters and publishers. The Company concluded, however, that in the continuing competitive marketplace, the Company could not achieve adequate pricing for these classes of business as required for profitability. Therefore, in the second June of 1999, the Company will withdraw from these classes of business, as the Company elected to focus on the expansion of its small commercial Partners program, offering its Businessowners, Artisan Contractors, and small Service Garage programs. See the Business Strategy section and Note T of the Notes to the Consolidated Financial Statements for further discussion.
Policy acquisition expenses increased by $23.0 million, or 17.2% to $156.0 million for the year ended December 31, 1998, from $133.0 million for the year ended December 31, 1997. The increase in policy acquisition costs is primarily attributable to additional marketing staff salaries and additional agents incentives. Other operating expenses include administrative costs not directly related to the generation of premium revenue, premium taxes and fees, interest on debt and goodwill amortization. Administrative costs (designated as operating expenses on the statement of operations) increased $52.5 million. The increase in administration costs is primarily attributable to $42.0 million in increased costs related to the Shelby operations. The remaining $10.5 million in increased costs is related primarily to increases in information systems costs and professional fees. The increase in premium taxes and fees is directly related to the increase in direct premiums written. The increase in goodwill amortization is attributable to a full year of amortization of the goodwill related to the Shelby acquisition versus six months of amortization in 1997.
Federal Income Taxes. Federal income taxes decreased by $80.4 million to a benefit of $57.3 million for the year ended December 31, 1998 from $23.1 million for the year ended December 31, 1997. This decrease was primarily due to the decrease in operating income.
Net Income (loss). For the reasons discussed above, net income decreased by $178.1 million, to a loss of $141.2 million for the year ended December 31, 1998, from $36.9 million for the year ended December 31, 1997.
In July of 1996, Vesta Fire entered into a pro rata reinsurance facility covering substantially all primary and assumed business in order to provide capital flexibility to take advantage of growth opportunities in the future. This reinsurance facility had the effect of reducing net premiums written in
Loss and LAE for reinsurance decreased by $25.5 million, or 12.4% to $179.5 million for the year ended December 31, 1997, from $205.0 for the year ended December 31, 1996. The dollar amount of loss and loss adjustment expenses incurred decreased during 1997 due to the decline in net premiums earned. The loss and LAE ratio for reinsurance for the year ended December 31, 1997 was 53.5% as compared to 59.9% for the year ended December 31, 1996. The decrease in the loss ratio was primarily attributable to the increased reinsurance writings of homeowners' lines of business which generally incurs a lower loss ratio than automobile lines.
Gross premiums written for personal lines increased by $135.0 million, or 123.1%, to $244.7 million for the year ended December 31, 1997, from $109.7 million for the year ended December 31, 1996. The increase in personal lines gross premiums is primarily due to the acquisition of Shelby and the transfer of business from assumed reinsurance to personal lines following the acquisition of Vesta County Mutual.
Net premiums written for commercial lines increased by $8.7 million, or 35.1%, to $33.5 million for the year ended December 31, 1997, from $24.8 million for the year ended December 31, 1996. Net premiums earned for commercial lines increased 9.2 million, or 27.3% to $42.9 million for the year ended December 31, 1997, from $33.7 million for the year ended December 31, 1996.
Policy acquisition expenses increased by $14.4 million, or 12.1% to $133.0 million for the year ended December 31, 1997, from $118.6 million for the year ended December 31, 1996. The increase in policy acquisition expenses is primarily attributable to the increase in net written premiums. Other operating expenses include administrative costs not directly related to the generation of premium revenue, premium taxes and fees, interest on debt and goodwill amortization. Administrative costs (designated as operating expenses on the statement of operations) increased $17.7 million. The increase in administration costs is primarily attributable to the assimilation and administration of the Shelby operations. The increase in premium taxes and fees is directly related to the increase in direct premiums written. The increase in goodwill amortization is attributable to the $83 million of goodwill acquired on June 30, 1997 in connection with the Shelby acquisition.
Net Investment Income. Net investment income increased by $12.9 million, or 55.4%, to $36.0 million for the year ended December 31, 1997, from $23.1 million for the year ended December 31, 1996. The weighted average yield on invested assets (excluding realized and unrealized gains) was 5.8% for the year ended December 31, 1997, compared with 5.6% for the year ended December 31, 1996. The increase in net investment income is primarily attributable to an increase in average invested assets relating to the Shelby acquisition.
Federal Income Taxes. Federal income taxes increased by $5.2 million, or 29.1%, to $23.1 million for the year ended December 31, 1997 from $17.9 million for the year ended December 31, 1996. The effective rate on pre-tax income increased from 32.7% to 35.4% for the year ended December 31, 1997.
Net Income. For the reasons discussed above, net income increased by $.1 million, or .3%, to $36.9 million for the year ended December 31, 1997, from $36.8 million for the year ended December 31, 1996.
The Company is a holding company whose principal asset is its investment in the capital stock of the companies constituting the Vesta Group, a group of wholly owned property and casualty insurance companies including Vesta Fire. The insurance company subsidiaries comprising Vesta Group are individually supervised by various state insurance regulators. Vesta Fire is the principal operating subsidiary of the Company.
As a holding company with no other business operations, the Company relies primarily upon dividend payments from Vesta Fire to meet its cash requirements (including its debt service) and to pay dividends to its stockholders. Transactions between Vesta Fire, and the Company, including the payment of dividends by Vesta Fire, are subject to certain limitations under the insurance laws of Alabama. Specifically, Alabama law permits the payment of dividends in any year which, together with other dividends or distributions made within the preceding 12 months, do not exceed the greater of 10% of statutory surplus as of the end of the preceding year or the net income for the preceding year, with larger dividends payable only after receipt of prior regulatory approval. In 1998, Vesta Fire voluntarily agreed that it will not declare any dividends, except for those required to service the Company's debt, until December 31, 1999, without the prior written approval of the Alabama Department of Insurance.
As of December 31, 1998, the Company had borrowed $70 million under its $200 million line of credit for general corporate purposes and for a capital contribution of $25 million to the Company's principal insurance subsidiary, Vesta Fire. The credit agreement related to this line of credit contains certain covenants that require, among other things, the Company to maintain a certain consolidated net worth ("Consolidated Net Worth Covenant"), maintain a certain amount of earnings before interest and taxes available for the payment of interest and dividend expense, ("Fixed Charge Coverage Ratio"), cause each insurance subsidiary to maintain a certain total adjusted statutory capital, ("Adjusted Statutory Capital Covenant"), and that limits the amount of indebtedness of the companies. As of December 31, 1998, the Company was not in compliance with all of its financial covenants.
Subsequent to December 31, 1998, the Company's banks agreed to amend the covenants and waive any event of default arising from non-compliance with the covenants as of December 31, 1998. The amended credit facility was restructured into a $70 million senior revolving credit facility, maturing July 31, 2000 ("the "Amended Facility"). The interest rate on the Amended Facility will be the prime rate plus 1%, provided that from and after September 30, 1999 the rate shall be increased to the prime rate plus 3% if the Company has not made permanent principal prepayments on the Amended Facility aggregating at least $25 million. The Company will also pay the banks a 1% Commitment Fee on all of the used and unused commitments under the Amended Facility.
The Amended Facility requires the Company to make a closing principal prepayment of $15 million less transaction expenses the net amount of which reduces the obligation to make permanent principal payment aggregating $25 million. The amended Facility also provides for warrants equal to approximately 6.6% of the Company's outstanding shares being issued to the banks participating on
the Amended Facility, which become exercisable in the event the Company does not make $25 million of permanent principal prepayments on the facility by March 15, 2000.
After the close of business on June 30, 1997, the Company completed its acquisition of Shelby, which are property and casualty insurance companies headquartered in Ohio for $260.9 million. The acquired subsidiaries had $648 million of assets and approximately $217 million of stockholders' equity at June 30, 1997. The Company funded the payment of the purchase price for this acquisition with available cash on hand, short term investments, cash available from its insurance subsidiaries and with funds available under its line of credit.
Year 2000: The failure to correct a material Year 2000 ("Y2K") problem could result in an interruption in, or failure of, the normal business operations of the Company including the delay in premium or claim processing and the disruption of service to its customers.
The Company and it subsidiaries are proceeding on schedule with efforts to convert its computer systems to be Y2K compliant. The Company has implemented a phased approach to transition computer systems to be Y2K compliant.
The Company has completed the first six of seven phases of the transition for its defined mission critical systems. Extraneous systems are either being discontinued or are in the remediation phase at this time. Implementation of Y2K compliance for these remaining systems is scheduled for completion by third quarter of 1999.
The third phase of the Y2K effort was the Pilot Project Phase the purpose of which was to test/prove the Y2K methodology developed in the prior phase. The Company selected the reinsurance system as the application to be made Y2K compliant as the Pilot System. This effort began in March, 1997 and was completed in June, 1997.
In January, 1999, the Company began its Non-Application Y2K Compliance Phase. This phase consists of the activities for identifying, evaluating, and remediating/replacing non mission critical hardware and software.
The Y2K issue is also a concern from an underwriting standpoint regarding the extent of liability for coverage under various general liability, property and directors and officers liability and product policies. The Company believes that minimal coverage could exist under some current liability and product policies. This exposure should be minimal as commercial lines business has historically excluded any manufacturing risks which produce computer and computer dependent products.
The Insurance Services Office (ISO) recently developed policy language that clarifies that there is no coverage for certain Y2K occurrences. The liability exclusion has been accepted in over 40 states and a companion filing for property has been accepted in at least 20 states at this time. Several states
have not adopted or approved the property exclusion form citing specifically that there is no coverage under the current property contracts and therefore, there is no reason to accept a clarifying endorsement. The Company is currently addressing the Y2K issue by attaching the ISO exclusionary language to all general liability policies with a rating classification the Company believes could potentially have Y2K losses. The ISO exclusionary language endorsement is included on all property policies. These actions should minimize the Company's exposure to Y2K losses.
Financial Statement Presentation: Vesta Insurance Group, Inc. (Vesta) and subsidiaries (the Company) was incorporated by Torchmark Corporation ("Torchmark") on July 9, 1993 and capitalized on July 16, 1993 with a $50 million contribution from Torchmark and the contribution from Torchmark of all of the outstanding common stock of J. Gordon Gaines, Inc., Liberty National Reinsurance Company, Ltd, and Vesta Fire Insurance Corporation (Vesta Fire) and its wholly-owned subsidiaries. On November 18, 1993, the Company completed an initial public offering of common stock which resulted in proceeds to the Company of approximately $51 million. At year-end 1998, Torchmark held approximately 23.9% of the outstanding common stock of the Company with the balance publicly traded.
Nature of Operations: The Company is a holding company for a group of property and casualty insurance companies (the "Vesta Group") that offer treaty reinsurance and primary insurance on personal and commercial risks. The lead insurer in the Vesta Group is Vesta Fire. In both its reinsurance and primary insurance operations, the Company focuses primarily on private passenger auto and property coverages. Gross premiums written by the Company in 1998 totaled $759.0 million. Gross premiums written in the reinsurance line were $287.6 million in 1998, substantially all of which were on personal (including automobile) risks and commercial property risks. Also, property (including auto physical damage) risks accounted for approximately 62% of the Company's gross premiums written in all lines in 1998.
Gains and losses realized on the disposition of investments are recognized as revenues and are determined on a specific identification basis. Unrealized gains and losses on equity securities and fixed maturities available for sale, net of deferred income taxes, are reflected directly in stockholders' equity.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar amounts in thousands) Note A--Significant Accounting Policies (continued)
Recognition of Premium Revenue: Earned premiums on primary business are generally recognized as revenue on a pro rata basis over the policy term. Earned premiums on assumed reinsurance are recognized as revenue when reported by the cedant. Also, due to the delay in reporting from its reinsurance cedants, the Company accrues unreported premium revenue on its assumed reinsurance business based on historical experience. The company estimates for its reinsurance reports received subsequent to a period end on a combined calendar/accident year basis. These accrued premiums are necessarily based on estimates and, while management believes that the accruals are reasonable, the ultimate reported premium may be less than or in excess of the amounts accrued.
Losses and Loss Adjustment Expenses: The liability for losses and loss adjustment expenses ("LAE") includes an amount determined from loss reports and individual cases. It also includes an amount for losses incurred but not reported which is based on past experience. Such liabilities are necessarily based on estimates and, while management believes that the amount is adequate, the ultimate liability may be in excess of or less than the amounts provided. The methods for making such estimates and for establishing the resulting liabilities are continually reviewed, and any adjustments are reflected in earnings currently. These reserves are established on an undiscounted basis and are reduced for estimates of salvage and subrogation.
Deferred Acquisition Costs: Commissions and other costs of acquiring insurance that vary with and are primarily related to the production of new and renewal business are deferred and amortized over the terms of the policies or reinsurance treaties to which they relate. Anticipated investment income is considered in determining recoverability of deferred acquisition costs on certain lines.
Property and Equipment: Property and equipment is reported at cost less allowances for depreciation. Depreciation is recorded primarily on the straight line method over the estimated useful lives of these assets which range from 2 to 5 years for equipment. Ordinary maintenance and repairs are charged to income as incurred.
The Company determined, subsequent to the issuance of the 1997 financial statements, that a specific reinsurance ceded contract entered into in 1997 contains retroactive elements as defined in SFAS 113. A contract is deemed retroactive when an assuming enterprise agrees to reimburse a ceding enterprise for liabilities incurred as a result of past insurable events. For such contracts, SFAS 113 requires that any initial gain and any benefit due from a reinsurer as a result of subsequent covered losses be deferred in the financial statements of the ceding enterprise and recognized into income over the settlement period of the underlying claims. The Company erroneously recorded a gain on this contract in the fourth quarter of 1997 and has adjusted its previously issued financial statements to appropriately defer and recognize such gain. Analysis of this contract under the recovery method resulted in the following adjustments to the 1997 financial statements included herein:
During the fourth quarter of 1998, management evaluated goodwill recoverability pursuant to the Company's existing policies. The evaluation indicated an impairment of goodwill acquired as part of the Shelby Acquisition (See Note Q). The events that led to this conclusion include the Company's inability to integrate the Shelby acquisition as planned and the resulting high level of expenses, and the recording of significant operating losses in 1998.
The Company's measurement of this impairment was based on cash flow analysis using projections for the remaining term of the goodwill and a weighted average cost of capital and terminal value deemed appropriate for evaluating companies similar to Vesta. The weighted average cost of capital and future premium growth rates used were 12% and 5% respectively. The assumptions used in this analysis represent management's best estimate of future results. However, actual results could differ from these estimates.
The Company's insurance subsidiaries are subject to regulation by the insurance departments of states in which they are licensed and undergo examinations by those departments. The Alabama Department of Insurance ("ADOI") completed its examination of Vesta Fire's 1997 statutory report and issued its report on December 18, 1998. The examination resulted in adjustments to decrease reported statutory surplus by $255 million. Management believes that it has appropriately recorded such adjustments in Vesta Fire's 1998 statutory report or that other remedies have been executed to render certain adjustments inappropriate for 1998 (for example, corrections of technical violations of reinsurance security letters of credit). The ADOI is currently conducting a target examination on Vesta Fire's 1998 filing. This examination could result in adjustments to Vesta Fire's statutory statements, including policyholder surplus. Management does not believe that such adjustments, if any, would have a material impact on the Company's financial position or results of operations or cash flows.
Restrictions on Dividends to Stockholders. The Company's insurance subsidiaries are subject to various state statutory and regulatory restrictions, generally applicable to each insurance company in its state of incorporation, which limit the amount of dividends or distributions by an insurance company to its stockholders. The payment of dividends by Vesta Fire is subject to certain limitations imposed by the insurance laws of the State of Alabama. The restrictions are generally based on certain levels of surplus, investment income and operating income, as determined under statutory accounting practices. Alabama and most other states that regulate Vesta Fire's operations permit dividends in any year which together with other dividends or distributions made within the preceding 12 months, do not exceed the greater of (i) 10% of statutory surplus as of the end of the preceding year or (ii) the statutory net income for the preceding year, with larger dividends payable only upon prior regulatory approval. Certain other extraordinary transactions between an insurance company and its affiliates, including sales, loans or investments which in any twelve-month period aggregate at least 3% of its admitted assets or 25% of its statutory capital and surplus, also are subject to prior approval by the Department of Insurance. In 1998, the Company voluntarily agreed that it will not pay any dividends, except those required to service "indebtedness" as defined under the $200 million Revolving Credit Facility Agreement (Note P), until December 31, 1999, without the prior written approval of the ADOI.
Risk-Based Capital Requirements. The NAIC adopted risk-based capital requirements that require insurance companies to calculate and report information under a risk-based formula which attempts to measure statutory capital and surplus needs based on the risks in a company's mix of products and investment portfolio. The formula is designed to allow state insurance regulators to identify potential weakly capitalized companies. Under the formula, a company determines its "risk-based capital" ("RBC") by taking into account certain risks related to the insurer's assets (including risks related to its investment portfolio and ceded reinsurance) and the insurer's liabilities (including underwriting risks related to the nature and experience of its insurance business). Risk-based capital rules provide for different levels of regulatory attention depending on the ratio of a company's total adjusted capital to its "authorized control level" ("ACL") of RBC. Based on calculations made by the Company, the RBC levels for each of the Company's insurance subsidiaries did not trigger regulatory attention.
Deferred policy acquisition costs for the years ended December 31, 1996, 1997 and 1998 are summarized as follows:
Vesta leases office space from Torchmark Development Corporation, a wholly owned subsidiary of Torchmark. Rent expense of $.6 million, $.7 million and $1.2 million was charged to operations for the years ended December 31, 1996, 1997 and 1998, respectively, related to this lease agreement.
On September 13, 1993, Vesta Fire Insurance Corporation, a wholly owned subsidiary of the Company ("Vesta Fire"), and Liberty National Life Insurance Company ("Liberty National"), a wholly owned subsidiary of Torchmark, entered into a Marketing and Administrative Services Agreement, pursuant to which Vesta Fire marketed certain of its industrial fire insurance products through agents of Liberty National. Under this agreement, Liberty National pays to Vesta Fire an amount equal to all premiums collected by Liberty National after deducting all expenses incurred by Liberty National which are directly attributable to the industrial fire insurance products and after deducting a fee for administrative services. Such fee for 1996, 1997 and 1998 was $1.7 million, $1.4 million and $.9 million, respectively. This agreement was terminated effective April 30, 1995, and these products are no longer marketed through Liberty National agents. However, Liberty National continues to service the existing business.
Litigation: Subsequent to the filing of its quarterly report on Form 10-Q for the period ended March 31, 1998 with the Securities and Exchange Commission, the Company became aware of certain accounting irregularities consisting of inappropriate reductions of reserves and overstatements of premium income in the Company's reinsurance business that had been recorded in the fourth quarter of 1997 and the first quarter of 1998. The Company promptly commenced an internal investigation to determine the exact scope and amount of such reductions and overstatements. This investigation concluded that inappropriate amounts had, in fact, been recorded and the Company determined it should restate its previously issued 1997 financial statements and first quarter 1998 Form 10-Q. Additionally, during its internal investigation the Company re-evaluated the accounting methodology being utilized to recognize earned premium income in its reinsurance business. The Company had historically reported certain assumed reinsurance premiums as earned in the year in which the related reinsurance contracts were entered even though the terms of those contracts frequently bridged two years. The Company determined that reinsurance premiums should be recognized as earned over the contract period and corrected the error in its accounting methodology by restating previously issued financial statements. The Company issued press releases, which were filed with the Securities and Exchange Commission, on June 1, 1998 and June 29, 1998 announcing its intention to restate its historical financial statements.
The class action lawsuit filed in the Circuit Court of Jefferson County, Alabama has been dismissed and the derivative case has been placed on the administrative docket. The class actions filed in the United States District Court for the Northern District of Alabama have been consolidated into a single action in that district. The purported class representatives in that action have filed (a) a consolidated amended complaint alleging that the defendants violated the federal securities laws and (b) a motion for class certification. The consolidated amended complaint also added as defendants Torchmark Corporation and the Company's predecessor auditors, KPMG Peat Marwick, LLP. The time for the defendants to respond to the complaint and the motion for class certification has not yet run. The consolidated amended complaint alleges various violations of the federal securities law and seeks unspecified but potentially significant damages.
The Company has notified its directors and officers liability insurance companies of these lawsuits and the consolidated amended complaint. The litigation is still in the preliminary stages and there has been no discovery or class certification. The Company intends to vigorously defend this litigation and intends to explore all available rights and remedies it may have under the circumstances. In related litigation, in September, 1998, Cincinnati Insurance Company ("Cincinnati"), one of the Company's directors and officers liability insurance carriers, filed a lawsuit in the United States District Court for the Northern District of Alabama seeking to avoid coverage under its directors and officers liability and other policies. The Company filed a motion to dismiss Cincinnati's complaint on jurisdictional grounds in federal court (which was granted), and filed a lawsuit against Cincinnati in the Circuit Court of Jefferson County, Alabama seeking damages arising out of Cincinnati's actions. Cincinnati has filed an answer
As discussed above, the Company corrected its accounting for assumed reinsurance business through restatement of its previously issued financial statements. Similar corrections were made on a statutory accounting basis through recording cumulative adjustments in Vesta Fire's 1997 statutory financial statements. The impact of this correction has been reflected in amounts ceded under the Company's 20 percent whole account quota share treaty which was terminated on June 30, 1998 on a run-off basis. The Company believes such treatment is appropriate under the terms of this treaty and has calculated the quarterly reinsurance billings presented to the treaty participants accordingly. The aggregate amount included herein as recoverable from such reinsurers totalled $60.4 million at December 31, 1998. Two of the three participants have notified the Company that they wish to audit the treaty computations as allowed by the terms of the treaty. The other participant, through various correspondence, has also expressed an interest in obtaining additional data. While management believes its interpretation of the treaty's terms and computations based thereon, are correct, the effects, if any, of participant audits or other actions cannot be determined at this time.
Concentrations of Credit Risk: Vesta maintains a highly-diversified investment portfolio with limited concentrations in any given region, industry, or economic characteristic. At December 31, 1998, the investment portfolio consisted of securities of the U.S. government or U.S. government backed securities (11.9%); mortgage backed securities, GNMA collateral (14.0%); investment grade corporate bonds (25.5%); cash and short-term investments (24.6%); securities of state and municipal governments (20.1%); securities of foreign governments (.6%); and corporate common stocks (3.3%). Corporate equity and debt investments are made in a wide range of industries. All of Vesta's investments at year-end 1998 were rated investment-grade.
Income tax expense (benefit) for the years ended December 31, 1996, 1997 and 1998 was allocated as follows:
Income tax expense benefit attributable to income from operations consists of:
The Company evaluates segment profitability based on pre-tax operating profit. Net investment income, interest expense and operating expenses are allocated based on certain assumptions and estimates; stated segment operating results would change if different methods were applied. The accounting policies of the operating segments are the same as those described in Note A.
On July 19, 1995, the Company issued $100 million of its 8.75% Senior Debentures due July 15, 2025. The Debentures are not subject to redemption or any sinking fund prior to maturity. The Debentures are unsecured and rank on parity with all of its other unsecured and unsubordinated indebtedness. The Debentures contain covenants that limit the ability of the Company or its subsidiaries to issue, sell or otherwise dispose of shares of voting common stock of any Restricted Subsidiary and limit the ability of the Company or its subsidiaries to pledge the shares of capital stock of any subsidiary. The Debentures also place certain limitations on the Company's ability to consolidate or merge with or sell its assets substantially as an entirety. The Company used the proceeds from the sale to repay a $28 million loan from a Torchmark affiliate, and to increase the capital and surplus of Vesta Fire.
The Amended Facility requires the Company to make a closing principal prepayment of $15 million less transaction expenses the net amount of which reduces the obligation to make permanent principal payments aggregating $25 million. The amended Facility also provides for warrants equal to approximately 6.6% of the Company's outstanding shares being issued to the banks participating on the Amended Facility, which become exerciseable in the event the Company does not make $25 million of permanent principal prepayments on the facility by March 15, 2000.
The Amended Facility requires the Company to suspend dividends on its common stock and defer payments of interest on its junior subordinated debentures due January 31, 2027 unless the Company has made $25 million of permanent principal prepayments on the Amended Facility by March 15, 2000. The Amended Facility contains certain covenants that require the Company to maintain minimum statutory surplus levels, minimum cumulative statutory net income levels and minimum cumulative GAAP net income levels.
Prior to completion of the Company's initial public offering, the Company's stockholders approved the Vesta Insurance Group, Inc. Long Term Incentive Plan ("Plan"), which provided for grants to the Company's executive officers of restricted stock, stock options, stock appreciation rights, and deferred stock awards, and in certain instances grants of options to directors. The Company's stockholders approved certain amendments to the Plan effective May 16, 1995, including an amendment to increase the shares of the Company's common stock available for awards under the Plan from 1,091,400 shares to 2,221,998 shares and an amendment to delete the provision for the grant of options to non-employee directors. The Company's stockholders also approved the Vesta Insurance Group, Inc. Non-Employee Director Stock Plan ("Director Plan") effective May 16, 1995, which provides for grants to the Company's non-employee directors of stock options and restricted stock.
After the close of business on June 30, 1997, the Company completed its acquisition of all the issued and outstanding stock of the operating subsidiaries of Anthem Casualty Insurance Group, Inc., each of which are property and casualty insurance companies headquartered in Ohio, for $260.9 million. The acquired subsidiaries had $648 million of assets and approximately $217 million of stockholders' equity at June 30, 1997. The acquisition was accounted for as a purchase and the results of operations since the acquisition date were consolidated. Goodwill from the transaction was being amortized straight line over 15 years. This goodwill was deemed impaired in 1998.
The table below presents supplemental pro forma information for 1996 and 1997 as if the Anthem acquisition were made at January 1, 1996, based on estimates and assumptions considered appropriate:
On March 15, 1999 the Company adopted a plan to discontinue its Commercial Lines business with the exception of its' Partners program, Transportation program and BOP programs in the States of Alabama, Alaska, Arizona, and Texas. Implementation of the plan will begin in June of 1999