The following selected financial data should be read in conjunction with the consolidated financial statements of First Central and related footnotes appearing elsewhere herein and Management's Discussion and Analysis of Financial Condition and Results of Operations. The selected financial data, with the exception of the ratio of earnings to fixed charges for each of the five years in the period ended December 31, 1996, are derived from First Central's audited consolidated financial statements for such years.
During 1996, First Central Insurance encountered intense competition and experienced a reduction in premiums written while at the same time, loss and loss adjustment expenses increased significantly. For the quarter ended December 31, 1996, First Central Insurance incurred a charge to earnings of $11.5 million for the purpose of increasing loss reserves, the primary reason First Central reported a loss of $13.1 million or $2.19 per share (after tax benefits) for the year ended December 31, 1996.
First Central Insurance is precluded from paying dividends to First Central while it has a deficiency in earned surplus. Since the only material source of income to First Central is dividends from First Central Insurance, First Central will not declare any further dividends on its common stock for the foreseeable future. In addition, unless First Central obtains another source of funds, First Central will be unable to pay its $1.8 million sinking fund obligation under the Debentures on August 1, 1997. Failure to pay the August 1, 1997 sinking fund obligation will constitute a default under the Debentures entitling the holders to accelerate the entire $4.9 million outstanding principal balance.
The events and uncertainties discussed above raise substantial doubt about First Central's ability to continue as a going concern. There can be no assurance that First Central will be successful in its attempt to revise operations to attain future profitability, raise additional capital and resume normal operations.
The following table illustrates First Central Insurance's direct premiums written and net premiums earned on a category-by-category basis for 1996, 1995, and 1994.
Net premiums written decreased 7.4% in 1996 when compared to 1995, the decrease was attributed to the aforementioned factors affecting direct premiums written, offset by the decrease in ceded premiums written in 1996 of 54.4% when compared to 1995.
Although direct premiums written increased, net premiums written decreased approximately $4,900,000 in 1995 when compared to 1994 because ceded premiums increased by approximately $11,600,000 during the same period. The increase in ceded premiums was the result of a change in First Central Insurance's reinsurance treaty as of April 1, 1995. The treaty with Nat Re was changed so that premiums ceded would be based on direct written premiums rather than earned premiums and the premium rate was increased prospectively with First Central Insurance being entitled to a commission on the ceded premiums. The treaty change caused First Central Insurance to record a liability, "Funds held for reinsurance treaty," for amounts due the reinsurer of $2,610,641 and $3,704,947 at December 31, 1996 and 1995, respectively. This liability is paid as the ceded premiums are earned.
During 1996, First Central reduced its holdings of equity securities by approximately $10,000,000 to 17.4% of investments from 28.5% of investments in 1995. During 1996, First Central also increased its holdings in fixed maturities by approximately $10,000,000 to 73.3% of investments from 68.6% in 1995. The increase was principally in U.S. Government securities while holdings in municipal bonds and mortgage backed securities were decreased in 1996. Holdings of municipal bonds were decreased in part because of a change in tax planning strategy and in part to increase portfolio yields. As of December 31, 1996, short-term investments, principally money market accounts, was 9.4% of total investments, an increase from 2.9% of total investments in 1995. In 1996, net investment income increased 2.0% when compared to 1995 primarily due to a decline in investment expenses of approximately $89,000. First Central recognized a net realized gain of $1,909,211 in 1996 as compared to the net realized gain of $1,100,200 in 1995. The increase in net realized gain in 1996 was primarily a result of favorable market conditions experienced during 1996.
During 1995 First Central Insurance sold approximately $16,400,000 of preferred stock and corporate debt securities and purchased government securities, therefore showing an increase in interest received on government securities while a decrease in corporate bond interest and dividends on preferred stock. In 1995, net investment income increased 2.5% when compared to 1994. This increase was due to the 22.7% (approximately $18,600,000) increase in invested assets during 1995. First Central Insurance recognized a net realized gain of $1,100,200 in 1995 as compared to the net realized gain of $950,898 in 1994. The increase in realized gains in 1995 was principally due to an increase in the market value of First Central Insurance's investment portfolio resulting from favorable stock and bond market conditions evident in 1995.
As of December 31, 1996, First Central had three available-for-sale securities that experienced a decline in market value considered other than temporary. As discussed below, in 1995 the carrying amount of Discovery Zone Inc. Subordinated Notes due 2000 was reduced to the December 31, 1995 market value of $772,500. During 1996, First Central Insurance sold $1,058,000 par value of such notes for $166,708, realizing a loss on disposal of $256,492, and reduced the carrying amount of the notes to the December 31, 1996 market value of $97,100. Additionally, First Central's holdings in Masco Technology Inc. Convertible Subordinated Debentures and its interest in Boston Financial Qualified Housing L.P. were written down to their December 31, 1996 market value of $415,000 and $172,000, respectively. The aggregate loss attributed to the write down of the Discovery Zone, Masco and Boston Financial investments was $472,136 in 1996.
The primary cause of the reserve increase in each of 1995 and 1996 was significant adverse development stemming from poor loss experience on policies written from 1992 through 1995, a period during which First Central Insurance substantially increased premium writings. In particular, beginning in 1993, First Central Insurance wrote policies for two large customers which resulted in extremely poor loss experience. Such business accounted for approximately $355,000, $3.3 million and $3.3 million of First Central Insurance's total written premiums in 1993, 1994 and 1995, respectively.
Total net reserves were increased by approximately $2.2 million, $2.5 million and $3.8 million in the first, second and third quarters of 1996, respectively, including increases in IBNR reserves of $250,000, $2 million and $1.35 million during such periods, respectively. However, 1996 witnessed continuing adverse loss development and, accordingly, during the fourth quarter of 1996, First Central Insurance performed an intensive evaluation of its case files, particularly those claims with low initial case reserves. The claims file evaluation consisted of a review of approximately 750 sample files identified by the independent actuary. In the fourth quarter of 1996, First Central Insurance transferred approximately $14 million in IBNR reserves to case reserves as a result of the case reserve file review and to compensate for further adverse loss development. It had been believed that the level of IBNR reserves would be sufficient to absorb such a transfer, but the continuing 1996 adverse loss development, which became apparent during the actuarial review, necessitated a further strengthening of IBNR reserves. The actuarial estimate of the required increase was $7.6 million. By this time, new management was in office and increased IBNR reserves by a further $3.8 million over that recommended by First Central Insurance's independent actuary based upon new management's evaluation of recent loss experience. Total net reserves at December 31, 1996 are above but near the middle point of the actuarial reasonableness range.
In 1996, incurred losses increased approximately $4,058,000, 11.7%, when compared to 1995 despite the decrease in net premiums written of approximately $3.8 million. Components of the increase included an increase of approximately $1,835,000 in the amount of additional unpaid loss reserves established, an increase in paid losses net of subrogation recoverables of approximately $1,184,000 and a decrease in paid losses ceded of approximately $1,040,000.
In 1996, incurred loss adjustment expenses increased 35.4% when compared to 1995. The increase was due to the rising legal fees associated with settling cases during 1996. To reduce legal fees, during the second quarter of 1996 First Central Insurance implemented pretrial fixed fees for certain categories of cases and negotiated lower hourly rates for legal services. In 1995 incurred loss adjustment expenses increased 20.1% over the corresponding period in 1994. This increase was due primarily to the increase in expenses relating to increased losses resulting from higher premium volume.
First Central Insurance's loss ratios (losses incurred to earned premium) on its commercial multiple peril line of insurance were 61.0% in 1996, 70.2% in 1995 and 43.1% in 1994. The decrease in loss ratio experienced in 1996 was primarily due to greater underwriting selectivity. The increased loss ratio in the 1995 year was due primarily to an approximately $6,800,000 increase in IBNR reserves when compared to 1994.
Underwriting Expenses are a combination of policy acquisition costs and other operating expenses as shown on the statement of operations.
First Central's interest expense in 1996, 1995 and 1994 was approximately $513,000, $607,000, and $642,000, respectively. Interest expense was attributable primarily to interest paid on the Debentures. The interest expense decrease is due to First Central's retiring $1,430,000, $425,000 and $1,060,000 principal amount of debentures in 1996, 1995 and 1994, respectively.
1996 operating expenses increased by 33.2% when compared to 1995, primarily due to statutory assessments on workers' compensation lines and an increase in amortization expense resulting from the write-off of goodwill. Operating expenses remained consistent for 1995 when compared to 1994.
During 1996, First Central incurred a net loss of approximately $13,100,000 compared to net income of approximately $361,000 in 1995. During 1996, First Central Insurance experienced a reduction in premiums written. At the same time, loss and loss adjustment expenses increased primarily as a result of an increase in loss reserves of approximately $18,798,000 over 1995. See "-- Losses and Loss Adjustment Expense Reserves." Net investment income, realized gain on investments, claims adjusting revenues increased and earned premiums, interest expense and policy acquisition costs decreased; doubtful accounts and other operating expenses increased.
First Central Insurance reinsures a portion of substantially all of the risks which it underwrites. First Central Insurance has entered into reinsurance treaties with Nat Re covering all risks underwritten by First Central Insurance. First Central Insurance also maintains an automatic facultative property loss reinsurance facility with Munich American, Gen Re, and Swiss Re. See "Business - -- Reinsurance Ceded" and Note 4 of the Notes to First Central's Consolidated Financial Statements for a discussion of those treaties.
In 1996, First Central Insurance ceded premiums of $9,908,347 on $56,712,187 of direct written premium whereas, in 1995, premiums of $21,725,782 were ceded on $72,293,513 of direct written premium. The decrease in ceded premiums for 1996 resulted from a change in First Central Insurance's reinsurance treaty as of April 1, 1995 which changed the method in which ceded premiums are calculated from earned to written premiums. Paid losses recovered by First Central Insurance in 1996 and 1995 amounted to approximately $5,553,000 and $6,592,000, respectively. Incurred losses on a ceded basis amounted to approximately $4,754,000 and $1,479,000 for 1996 and 1995, respectively.
As of January 1, 1996, First Central Insurance's retention per loss under its reinsurance treaty with Nat Re was increased from $200,000 to $250,000. This change had the effect of reducing First Central's ceded written premium percentage from 16.92% to 12.31% from January 1, 1996 through June 30, 1996. Beginning July 1, 1996, the ceded written premium percentage increased to 13.85%. In addition, First Central received a contingency commission payment from Nat Re in the amount of $242,798.
In 1996, First Central's liquidity and capital resources relative to its assets decreased significantly primarily as a result of First Central Insurance's losses from operations during 1996. First Central's Shareholder's Equity at December 31, 1996 declined to approximately $19.5 million.
First Central Insurance's losses from operations resulted in its earned surplus declining to a deficit of $4,276,000 (excluding unrealized gains). First Central Insurance will be precluded from paying dividends to First Central by reason of its earned surplus deficiency. Since the only material source of income to First Central are dividends from First Central Insurance, First Central will not declare any further dividends on its common stock for the foreseeable future. Management anticipates that Mercury will be able to pay a dividend to First Central sufficient for it to pay the August 1, 1997 interest of $220,500 due on the Debentures. However, unless First Central obtains another source of funds, First Central will be unable to pay the August 1, 1997 sinking fund obligation of $1.8 million on the Debentures. First Central is not currently in default under such Debentures but failure to pay either the aforementioned interest or sinking fund obligation will constitute a default under the Debentures entitling the holders to accelerate the outstanding amount, currently $4.9 million.
The computation of risk-based capital is a method of evaluating the minimum amount of capital which is appropriate for an insurance company to maintain in order to support its overall business operations considering its size and risk profile. First Central Insurance's risk-based capital at December 31, 1996 is at the "regulatory action level" requiring First Central Insurance to submit a comprehensive capital plan to the Insurance Department. See "Business -- Risk-Based Capital."
In addition to the foregoing provisions of the 1986 Tax Act and the 1990 Tax Act, which specifically affects the tax treatment of property and casualty insurance companies, both Acts also contain provisions which are applicable to corporations generally, including First Central. Among such provisions are (1) a decrease of the maximum federal income tax rate on corporations to 34%; (2) a decline of the dividends received deduction for corporations to 70%; (3) a repeal of the investment tax credit; (4) a change in the depreciation rules; and (5) replacement of the 15% corporate add-on minimum tax with an expanded alternative minimum tax (imposed at a 20% rate) under which, among other items, (a) tax-exempt interest earned on certain newly issued bonds and (b) for years after 1989, 75% of the amount by which a corporation's pre-tax financial statement income exceeds the alternative minimum taxable income are treated as tax preference items.
Information required by this item is submitted on pages 51 to 76.