In the fourth quarter of 1995, the Company's Mortgage Guaranty Group adopted the accrual method for recording past-due premium revenues and the related premium receivable arising from new monthly premium policies. This new payment mode emerged as a significant factor for the mortgage guaranty industry beginning in mid-1994. Before adoption of this accrual method, such past-due premiums were recognized on receipt of cash. With the adoption of this accrual method, a cumulative increase in net premiums written of $9.8, net premiums earned of $6.3, and post-tax income of $3.9 or 4 cents per fully diluted share was reflected in the Company's final quarter and the year of 1995.
Consolidated operations produced positive cash flows for the latest three years. The decline in cash flow from operations in 1996 was due mainly to lower operating cash flow in Old Republic's general and life insurance segments. The parent holding company has met its liquidity and capital needs for the past three years through dividends paid by its subsidiaries. The insurance subsidiaries' ability to pay cash dividends to the parent company is generally restricted by law or subject to approval of the insurance regulatory authorities of the states in which they are domiciled. Additionally, the terms of guarantees by the Company of bank loans to the trustee of the Company's Employees Savings and Stock Ownership Plan require the Company to maintain a minimum consolidated tangible net worth and restrict the amount of debt the Company may incur, both of which covenants are being met.
The Corporation acquired $.9 of common stock in 1995 in open market transactions. At its May 16, 1996 meeting, the Company's Board of Directors authorized the reacquisition of up to $150.0 of common and preferred shares as market conditions warrant during the twenty-four month period from that date.
Net premiums and fees earned increased by 9.7% in 1996 and decreased by 3.5% and 1.6% in 1995 and 1994, respectively. In 1996, the increase in property and liability earned premiums was 1.9% as premium growth continued at a slow pace due to a soft pricing environment. In 1995 and 1994, lower property and liability premium growth was also due to the soft premium rate environment for most insurance coverages, and lower participation in involuntary market (assigned risk) pools. For the past three years, mortgage guaranty premiums have increased due to a rise in the amount of renewal and new business, and market expansion. Title Group premiums and fee revenues increased 20.3% in 1996; greater housing and mortgage finance activity were the main reasons for this rise in revenues. Depressed conditions in the large California housing market and much lower refinancing activity nationwide resulted in reduced title insurance revenues in 1995 and 1994. Life and disability premium volume increased moderately during the last three years as a result of greater term life and accident insurance production.
Income before taxes increased by 8.3% and 39.9% in 1996 and 1995, respectively, and decreased by 7.2% in 1994. General insurance results have trended up during the past five years and have continued as the largest contributor to consolidated earnings, principally as a result of greater investment income and improved underwriting results. The mortgage guaranty segment reflected significantly improved earnings in each of the last three years due to increased revenues. Title insurance earnings were much reduced in 1995 and 1994 due to the previously noted decline in revenues, while the increase in 1996 resulted from growth in premiums and fees and a reduction in loss and expense ratios. Life and disability operations have posted relatively flat earnings in the past three years. Consolidated pre-tax income for 1995 was also affected positively by greater than normal realization of investment gains.
The effective consolidated income tax rates were 31.6% in 1996, 32.7% in 1995 and 32.5% in 1994. The rates for each year reflect primarily the varying proportions of pre-tax operating income derived from tax-exempt investment income, on the one hand, and the combination of fully taxable investment income, realized investment gains, and underwriting and service income, on the other hand.
Old Republic International Corporation and Subsidiaries Notes to Consolidated Financial Statements ($ in Millions, Except as Otherwise Indicated) - -------------------------------------------------------------------------------
Investment income is reported net of allocated expenses and includes appropriate adjustments for amortization of premium and accretion of discount on fixed maturity securities acquired at other than par value. Dividends on equity securities are credited to income on the ex-dividend date. Realized investment gains and losses are reflected as revenues in the income statement and are determined on the basis of amortized value at date of sale for fixed maturity securities, and cost in regard to equity securities; such bases apply to the specific securities sold. Unrealized investment gains and losses, net of any deferred income taxes, are recorded directly in a separate account of shareholders' equity.
The following table reflects the composition of net investment income and net realized and unrealized investment gains or losses for each of the years shown:
(e) Deferred Policy Acquisition Costs-The Corporation's insurance subsidiaries, other than title companies, defer certain costs which vary with and are primarily related to the production of business. Deferred costs consist principally of commissions, premium taxes, marketing, and policy issuance expenses. With respect to most coverages, deferred acquisition costs are amortized on the same basis as the related premiums are earned or, alternatively, over the periods during which premiums will be paid or underwriting and claim services performed. The following table summarizes deferred policy acquisition costs and related data for the years shown:
With respect to mortgage guaranty insurance (net insurance in force of $45,651.6 and $38,862.7, at December 31, 1996 and 1995, respectively) the Company's reserving policies are set forth below in Note 1(g).
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 1982 to 1993. 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 material 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. During 1995, certain of the proposed adjustments were finally settled for immaterial amounts.
(I) Property and Equipment-Property and equipment is generally depreciated or amortized over the estimated useful lives of the assets, (2 to 45 years), substantially by the straight-line method. Expenditures for maintenance and repairs are charged to income as incurred, and expenditures for major renewals and additions are capitalized.
(j) Title Plants and Records-Title plants and records are carried at original cost or appraised value at date of pur chase. 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.
(n) Earnings Per Share-Consolidated primary earnings per share are based upon the weighted average number of shares outstanding during each year, retroactively adjusted for all stock dividends and splits declared through December 31, 1996. Dividend requirements of $4.7 in 1996, $4.9 in 1995 and $5.1 in 1994 on preferred stock have been considered in per share calculations. The average number of common shares used in 1996, 1995 and 1994 earnings per share calculations reflect the pro forma inclusion of 7,605,047, 7,748,065 and 7,984,755 incremental common shares, respectively, which would be issued upon conversion and/or exercise of dilutive convertible preferred and stock option shares. Fully diluted earnings per share are similarly calculated with the inclusion of substantially all convertible securities and stock options includable for each year; no such data is shown when the calculations are anti-dilutive.
(c) Debt Restrictions-Under the most restrictive covenants, the terms of Old Republic's guaranties relative to loan agreements described in Note 3(a) provide that while loans under such agreements are outstanding, Old Republic will maintain a minimum consolidated tangible net worth (excluding goodwill and net unrealized investment gains or losses, but including title plants and records) of at least $400.0. Such agreements also,
among other things, restrict Old Republic from permitting "Debt" to exceed 25% of its consolidated tangible net worth (as adjusted for goodwill and net unrealized investment gains or losses on equity securities) without approval of the lenders.
(d) Stock Option Plans-At December 31, 1996, the Corporation had two stock-based compensation plans, which are described below. The Corporation continues to apply Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees" ("APBO 25") and related Interpretations in accounting for these plans; accordingly, no compensation cost is charged to operations for these plans. The Corporation has not elected to adopt the fair value method of accounting encouraged by Financial Accounting Standard No.123 "Accounting for Stock Based Compensation" ("FAS 123"), issued in October, 1995. FAS 123 is applicable to the 5,000 and 936,000 options granted in 1996 and 1995, respectively. If all of these options vest, the gross potential compensation cost to the Corporation would be insignificant for the 1996 award and $4.6, for the 1995 grant. Had compensation cost for the plans been determined pursuant to FAS 123 (i.e. compensation cost recognized for options as vested) for 1996 and 1995, the effect on net income and earnings per share would be immaterial and have no significant effect.
Under the 1985 and 1992 plans, in the event the market price of Old Republic common stock reaches a pre-established value ("the vesting acceleration price"), optionees may exercise their options to the extent of 10% of the number of shares covered by the option for each year that the optionee has been employed by the Corporation or its subsidiaries. During 1996, the vesting acceleration price was reached on the majority of options granted in 1993 and 1995. Approximately 488,000 and 589,000 options were accelerated for the 1993 and 1995 grants, respectively.
A summary of the status of the Corporation's two fixed stock option plans as of December 31, 1996, 1995 and 1994, and changes during the years ended on those dates is presented below:
(e) Common Stock-There were 250,000,000 shares of common stock authorized at December 31, 1996. At the same date, there were 50,000,000 shares of Class "B" common stock authorized but none were issued or outstanding. Class "B" common shares have the same rights as common shares except for being entitled to 1/10th of a vote per share.
The Corporation issued a total of 741,600 common shares valued at $8.9 and 991,563 common shares valued at $13.7 in 1996 and 1995, respectively to effect acquisitions which were not material to Old Republic's financial position or operating results.
In computing the profit or loss before taxes for each segment, the following items have not been added or deducted: general corporate revenues and expenses, parent company interest expense, income taxes, and equity in operating results of, or dividends from, unconsolidated subsidiaries and affiliates. To reconcile the total assets shown for the General, Mortgage Guaranty, Title and Life Groups with total consolidated assets at December 31, 1996 and 1995, adjustments must be made for the parent company assets of $2,079.6 and $2,056.3, and consolidating eliminations of $2,477.6 and $2,417.5, respectively.
Revenues and assets connected with foreign operations are not significant in relation to consolidated totals.
Pursuant to underwriting and investment management agreements, Old Republic receives management fees for administering the affairs of the Group's reinsurance subsidiary and those of the Mutual. Pursuant to reinsurance treaties, the Group and the Mutual are quota share participants in various types of primary or assumed reinsurance contracts produced through Old Republic underwriting facilities. Fees received in the past three years by Old Republic were immaterial. The following table shows reinsurance cessions, retrocessions, and assumptions to or from the Group's reinsurance subsidiary and the Mutual for the last three years.
Certain subsidiaries of the Company have sold various accounts receivable to a finance company subsidiary of the Mutual. Total receivables sold as of December 31, 1996 and 1995 amounted to approximately $6.1 and $6.0, respectively.
At December 31, 1996 and 1995, the Group held approximately 7.2% and 7.8%, respectively, of Old Republic's issued and outstanding common shares. For financial accounting purposes only, 6,658,901 of such shares have been treated as treasury shares at each respective date in consolidating the Group's accounts with those of the Corporation.
At December 31, 1996, the Corporation owned 93% of the voting common stock of Employers General Insurance Group, Inc. ("EGI") an affiliated insurance holding company engaged in the property and liability insurance and reinsurance business, primarily in Texas. At such date, 7% of EGI's voting common stock was held by public shareholders.
EGI has also entered into an investment counsel agreement pursuant to which an Old Republic subsidiary provides investment advice, accounting services and assistance to EGI in executing purchases and sales of investments. Fees received by Old Republic were immaterial.
We have audited the accompanying consolidated balance sheets of Old Republic International Corporation and subsidiaries (the "Company") as of December 31, 1996 and 1995, and the related consolidated statements of income, preferred stock and common shareholders' equity and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Old Republic International Corporation and subsidiaries as of December 31, 1996 and 1995, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1996 in conformity with generally accepted accounting principles.