Physicians own a facility with approximately 56,000 square feet in Pickerington, Ohio. APL leases office space in Indianapolis, Indiana for its sales office located there. APL's Cleveland Regional Sales Director leases office space in Cleveland; APL is a party to the lease and reimburses the Regional Sales Director for all of the lease costs. APL also leases office space in Louisville, Kentucky for its Regional Sales Office located there. Sequoia leases office space for its headquarters in Pleasanton, California and for its regional claims and underwriting offices in Modesto, Monterey, Rancho Cordova, Ventura, Visalia, and Fairfield, California. CLM's only office space consists of a leased facility in Monterey, California.
These changes are a result of the November 20, 1996 merger of Physicians Insurance Company of Ohio and a subsidiary of Citation Insurance Group, in which Physicians Insurance Company of Ohio was the surviving corporation. Upon consummation of the Merger, Citation Insurance Group changed its name to PICO Holdings, Inc. For accounting purposes the transaction has been treated as a reverse acquisition with Physicians Insurance Company of Ohio being the acquiror. As a result, these financial statements reflect prior years data of Physicians Insurance Company of Ohio and its subsidiaries and affiliates only. Neither Citation Insurance Group's prior years' results or account balances, nor 1996 operating results prior to the Merger have been included in these financial statements. See Note 3 to the Consolidated Financial Statements entitled "Acquisitions" for further information on the accounting treatment of the reverse acquisition.
On November 20, 1996, Physicians and its subsidiaries merged with a subsidiary of CIG and CIG then changed its name to PICO Holdings, Inc. This reverse acquisition brought two more California property and casualty insurance companies, CIC and CNIC, into the affiliated group and provided a non-insurance holding company able to engage in portfolio investing and other activities with fewer restrictions than those imposed upon insurance companies.
The Company's operations are organized into five segments: portfolio investing, life and health insurance, MPL insurance, property and casualty insurance, and other operations.
PICO reported net income of $24.3 million, or $0.90 per share for 1996, compared with net income of $15.7 million, or $0.60 per share during 1995, and $14.7 million, or $0.61 per share in 1994. Prior years' per share calculations have been adjusted for comparison purposes to reflect the November 20, 1996 merger between Physicians and Citation. Year-to-year comparisons are somewhat distorted as a result of the inclusion of Sequoia beginning August 1, 1995 and the addition of the Citation group effective November 20, 1996. Excluding Sequoia's 1995 post-acquisition net loss of $2.5 million and 1996 net income of $1.5 million, in addition to Citation's 1996 post-merger income of $675,000, net income would have been $22.1 million for 1996 and $18.2 million for 1995 compared to $14.7 million in 1994.
Shareholders' equity per share increased $0.57 during 1996, principally as a result of the November 1996 merger with Citation and the Company's $24.3 million net income. Shareholders' equity per share at December 31, 1996 was $3.61, compared to $3.04 and $1.40 at December 31, 1995 and 1994, respectively. Prior years per share amounts have been adjusted to reflect the November 1996 merger.
Unrealized appreciation of investment holdings decreased $ 12.0 million during 1996, net of taxes. Of this $12.0 million decrease, $3 million was due to the sale of Fairfield Communities, Inc. ("Fairfield"), which produced a pre-tax realized gain of more than $29.5 million. One of Physicians' common stock holdings, PC Quote, declined more than $16 million in market value during 1996, after taxes. However, at December 31, 1996, the market value of this security was still above Physicians' cost. Excluding Fairfield and the decline in the value of PC Quote, Physicians' unrealized investment gains actually increased more than $7 million, after tax during 1996.
Shareholders' equity increased $30.9 million, or 39% compared to year-end 1995. In addition to $24.3 million in net income and the $12.0 million decrease in net unrealized appreciation, this increase included $24.3 million in equity from the Citation reverse acquisition, and a $5.8 million reduction in equity during the second quarter of 1996 due to recording 38.2 percent of the 850,000 pre-merger shares of Physicians stock purchased by GEC as treasury shares. GEC is recorded on the equity basis in the Company's financial statements, rather than at market value, due to the Company's level of control and operational involvement. However, this increase in shareholders' equity did not include negative goodwill of $6.3 million recorded on the Company's books as a result of the Merger. This $6.3 million negative goodwill will increase the Company's income by $629,000 each year over the next ten years, or until otherwise removed from PICO's books.
Realized investment gains accounted for $30.9 million of pre-tax operating income, principally as a result of the sale of Physicians' and APL's holdings in Fairfield common stock during the 1996 fourth quarter.
Revenues increased $37.8 million over 1995 and $43.4 million over 1994. Increases were realized in all segments except MPL insurance, which is no longer being written. Pre-tax operating income also showed significant increases over 1995 and 1994 in all segments except "other," which was heavily influenced by operating losses of Physicians' 76 percent-owned subsidiary, Stonebrige Partners AG ("Stonebridge"), a European broker of annuities and other insurance products.
Revenues and pre-tax operating income by segment are shown in the following schedules:
Portfolio investing operations are principally conducted by Physicians within certain regulatory guidelines established by the Ohio Department. It is expected that PICO, the holding company, will also engage in portfolio investing in the future as assets become available at the holding company level. Investment income revenues and realized investment gains or losses generated by Physicians and PRO are first allocated to MPL equal to the amount of loss reserve discount accretion recorded during the period. The remainder is shown as portfolio investing revenue.
Fairfield common stock was one of the first strategic investments made by Physicians during its transition from strictly an MPL insurance operation to an insurance and investment company. Numerous strategic investments have since been made. Nearly all have appreciated.
Net of expenses, but before taxes, portfolio investing contributed $23.3 million to pre-tax operating income for 1996 compared to $5.3 million during 1995 and $0.1 million in 1994. Realized investment gains accounted for nearly all the fluctuation between years, accompanied by the changes in investment income discussed above. Equity securities excluding GEC, which is valued on an equity basis, totaled $79.5 million and $99.9 million at December 31, 1996 and 1995, respectively. Equity securities are subject to changes in the stock market which may at times be volatile and cause PICO's shareholders' equity to fluctuate from period to period. These equity securities, excluding GEC, made up 24% and 37% of the Company's investments, cash and cash equivalents at year-ends 1996 and 1995, respectively. The breakdown of pre-tax operating income from portfolio investing operations follows:
Equity in unconsolidated subsidiaries represents the Company's share of GEC's net income.
The following exhibit shows the impact of the decline in health insurance premiums upon net earned premiums over the past three years:
Because the Merger occurred in November 1996, only two months (approximately) worth of CIC's and CNIC's revenues, expenses, and operating income are included in these financial statements and in this discussion for 1996. No prior years' data is shown for CIC and CNIC. Because Sequoia was acquired on August 1, 1995, only five months of Sequoia's financial information is included for 1995, and none for 1994.
Total P & C revenues for 1996 of $35.3 million far-exceeded 1995 partial year revenues of $2.5 million.
Sequoia's direct premium writings for 1996 were $38.0 million, down $4 million, or 9.6% from the $42.0 million reported by Sequoia on a statutory basis for the full year of 1995. The $42.0 million 1995 direct written premium total includes seven months of activity prior to Physicians' purchase of Sequoia on August 1, 1995. This reduction in premium writings reflects the increased underwriting selectivity of Sequoia's new management team. As policies came up for renewal in 1995 and through much of 1996, they were reviewed carefully by underwriting management for excessive loss experience and unwanted risks. While new business writings have not offset renewal policies cancelled or non-renewed, new policy writings have been better than expected. The loss of renewal policies with higher loss ratios and greater exposures to risk should improve Sequoia's loss ratios in the future.
Sequoia produced a net loss of $983,000 for 1996 based upon statutory accounting practices ("SAP") as filed with the California Department. On the basis of generally accepted accounting principles ("GAAP"), Sequoia reported 1996 net income of $1.5 million compared to a $2.5 million net loss for the five month 1995 period. The primary difference between the 1996 SAP net loss and GAAP net income was attributable to the deferral of a portion of policy acquisition expenses, which will be amortized into expense pro-rata as related premiums are earned.
Also contributing to the 1995 pre-tax operating loss were acquisition costs (such as commissions) based upon written premiums, which were much higher than net earned premiums. Since the previous owner of Sequoia took full responsibility for the unearned premium reserve at July 31, 1995, a considerable lag developed between Sequoia's written premiums and earned premiums. As a result, operating expenses were high compared to earned premiums. Normally, a portion of these acquisition expenses could have been deferred and expensed over the underlying policy periods.
The improvement in Sequoia's 1996 performance is attributable to improved loss experience and reduced expenses. As a result of improved loss and expense ratios, 1996 acquisition expenses have been capitalized and will be amortized over the premium recognition period, since a premium deficiency did not exist.
Physicians' and PRO's MPL insurance business was sold to Mutual on August 28, 1995. Between July 16, 1995 and December 31, 1995, all MPL business written by Physicians and PRO was 100% reinsured by Mutual. Except for a few minor policy coverage extensions and adjustments which are 100% reinsured by Mutual, for all intents and purposes, the Company ceased writing MPL policies effective January 1, 1996, the date Mutual began writing the business directly. The Company continues to administer and adjust the remaining claims and LAE reserves. Based upon careful analysis of various alternative scenarios for handling the runoff of the remaining claims reserves, the Company determined that the best option was to process the existing claims internally with existing staff, rather than through a third party administrator or through an outright sale of the claims and LAE reserves. In addition, it is expected that shareholders' equity will be better served by retaining the investments necessary to fund the payment of these claims and LAE reserves, managing them along with the rest of the Company's investment holdings, as opposed to selling of fully reinsuring these reserves and giving up the corresponding funds. Accordingly, although the Company ceased writing MPL insurance, MPL is treated as a separate business segment of continuing operations due to the continued management of claims and associated investments. Revenues from MPL operations included the following:
Since the withdrawal of Physicians and PRO from their personal automobile and homeowners lines of business in the late 1980's, MPL has, for all intents and purposes, been these two companies' only sources of insurance premiums. The decline in earned premium from $20.0 million in 1994 to $17.1 million in 1995 and $7.4 million in 1996 resulted from the withdrawal from the MPL line of business beginning with the 100 percent quota share treaty with Mutual effective with July 16, 1995 and subsequent new and renewal business.
MPL premiums continued to be earned during 1996 based upon premiums written prior to July 16, 1995, the effective date of the 100 percent quota share treaty with Mutual. Very few, if any, MPL premiums will be earned beyond 1996. Investment income revenues will continue to accrue to the MPL runoff.
MPL operations produced pre-tax operating income of $8.5 million for 1996 compared to $6.0 million and $16.3 million in income during 1995 and 1994, respectively. Pre-tax operating results for 1996 were bolstered by a $1.4 million take down of death, disability and retirement unearned premium reserves related to the Mutual transaction, and loss and LAE reserve reductions of approximately $6.0 million as MPL reserves continued to develop favorably. This favorable reserve development has been verified by two independent actuaries, as required by the Ohio Department regulations for MPL companies. The $6.0 million operating income recorded for 1995 was entirely attributable to the $6.0 million realized on the sale of Physicians' and PRO's MPL businesses. The $16.3 million recorded in 1994 benefited from more than $12.0 million in reserve reductions, net of additional reserve discount accretion associated with reducing the reserve discount rate to 4% from close to 5%. Investment income was also higher in 1995 and 1994 due to greater reserve levels and higher loss reserve discount accretion in 1994. The greater amounts of discount resulted in corresponding allocations of investment income to these years for the MPL segment.
Physicians' claims department staff continues to process the runoff of the remaining MPL loss and loss adjustment expense claims which is progressing routinely. At December 31, 1996, MPL reserves totaled $112.9 million, net of reinsurance and discount. This compares to $136.2 million and $154.4 million at December 31, 1995 and 1994, respectively. MPL loss and LAE reserves continue to decline as a result the disposition of claims, accompanied by the continued favorable reserve development discussed above.
Investment management revenues and operating income from Summit increased over 1995. Summit now has more than $400 million in assets under management. Summit's revenues increased over 1995 as a result of additional funds under management, including competitive portfolio management fees to the insurance companies. However, intercompany fees have been eliminated in this presentation. Summit's pre-tax operating income was $121,000 for 1996. This compares to a loss of $105,000 for 1995, for a $226,000 improvement.
Sales of real estate remained at about the same level in 1996 as in the previous two years. During the first quarter of 1996, consistent with Raven's plan of orderly withdrawal from the real estate development business, management was successful in selling a large tract of undeveloped land, which represented most of Raven's existing inventory. Raven now holds less than $200,000 in inventory of land for sale.
Under the category of "Other," Stonebridge Partners AG ("Stonebridge"), a Swiss corporation 76 percent owned by Physicians which brokers annuities and other insurance products within Europe, produced a pre-tax operating loss of $1 million for 1996. The pre-tax loss for 1995 was $234,000. Stonebridge began operations in late 1995, resulting in significant start-up costs in 1995, which continued into 1996. Management believes that the Stonebridge concept is a good one which fits well with the Company's other businesses; however, for various reasons, Stonebridge has been unsuccessful in marketing their brokerage business, as well as in collecting accounts which they believe are due them from clients.
Management has recently taken steps to limit additional downside exposure. Additional operating losses will most likely be incurred in 1997 as a result of Stonebridge.
LIQUIDITY AND CAPITAL RESOURCES -- YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
Although Sequoia's positive operating cash flows exceeded more than $10 million in 1996, and CIC's cash flows should become significant in 1997 and later years, Physicians' cash flows have had the greatest impact on the consolidated group during the past three years and should continue to do so for a number of years into the future.
As of December 31, 1995, Physicians reported discounted unpaid loss and loss adjustment expense reserves of approximately $140 million, net of reinsurance. Based upon projections from past actuarial information, more than 75%, or $105 million, of these reserves are expected to be settled by the end of the year 2000. Past experience indicates that funding requirements should be greatest in the first through third years, accounting for more than 60% of the total eventual reserve and loss adjustment expense payments. As expected, loss and LAE reserves at December 31, 1996 declined more than 22% to $109 million after payment of more than $30 million in claims and LAE. Operating expenses associated with the discontinued MPL line of business have been significantly reduced in 1995 and in 1996 and are expected to continue to decline. As evidence of PICO's cutbacks, employee counts have been reduced by nearly two-thirds compared to the year-end 1994 level.
approximately $177.3 million, plus cash and cash equivalents of $12.5 million. These invested assets are in excess of the present value of expected future payouts of losses and loss adjustment expenses (discounted at 4%) of $109 million, even if $77 million in investments in affiliates (GEC, Sequoia, Summit, PRO, APL and other affiliates) were excluded.
As an additional source of funding, PICO's subsidiaries as they grow and accumulate increasing amounts of retained earnings may be able to return some of PICO's investment in the form of dividend distributions; however, this cannot be assured. On December 30, 1996, Physicians paid a dividend of $13.2 million to PICO for further investment by PICO. This dividend was the maximum dividend that could be paid under Ohio insurance regulations without specific approval by the Ohio department. State insurance departments do not regulate funds invested at the holding company level.
In the past three years, Physicians has completed significant transactions impacting shareholders' equity and its ownership. In 1994, GPG infused capital into Physicians by exercising $3.0 million of its option to purchase $5 million of Physicians stock. GPG had previously invested $5 million in Physicians. In August 1995, Physicians purchased Sequoia for $1,350,000. In September 1995, Physicians acquired an approximate 38.2 percent interest in the common stock of GEC for approximately $34 million. In 1996, GPG sold approximately 16% of its interest in Physicians (850,000 pre-merger shares) to GEC. As a result of this ownership of each other's stock, treasury stock increased by $5.8 million--a reduction of shareholders' equity. Also, in November 1996, Physicians and Citation combined in a reverse acquisition, increasing shareholders' equity, assets and liabilities of the Company. This reverse acquisition resulted in the creation of $6.3 million of "negative goodwill" on the balance sheet of the Company, which will be amortized into income equally over 10 years.
During 1994, Physicians adopted the provisions of SFAS No. 115, which resulted in an increase in shareholders' equity upon adoption of $7.4 million.
the adequacy of an insurer's RBC. The State of Ohio enacted the NAIC's RBC rules effective March 3, 1996. However, disclosure of each company's RBC adequacy was required to be reported in their statutory annual statements filed with the various departments of insurance for 1994 and 1995. At December 31, 1996, the Physicians, PRO, APL, Sequoia, CIC, and CNIC annual statements reported more than adequate RBC levels. The actual percentages of Total Adjusted Surplus to Policyholders to Authorized Control Level Risk-Based Capital as shown on page 22 of the 1996 statutory Annual Statements for Physicians, PRO, APL, Sequoia, CIC and CNIC were 218%, 1,980%, 872%, 278%, 349%, and 4,545%, respectively.
Anything above 200% (i.e. two times Authorized Control Level RBC) required no further action on the part of the insurance company. Any company having results between 150% and 199% is classified as being at the Company Action Level. Lower levels of RBC such as the Regulatory Action Level (100% to 149%), the Authorized Control Level (70% to 99%) and the Mandatory Control Level (below 70%) require some form of insurance department action. Under the Regulatory Action Level, the insurer must submit a plan as in the Company Action Level. The Insurance Commissioner will perform an examination or other analysis and, based upon such exam or analysis, issue a corrective order. Under the Authorized Control Level, the same actions taken under the Regulatory Action Level will occur. In addition, the Commissioner may take action to rehabilitate or liquidate the insurer. Under the Mandatory Control Level, the Commissioner must rehabilitate or liquidate the insurer.
In addition to the risks and uncertainties discussed in the preceding sections entitled "Business" and "Managements' Discussion and Analysis of Financial Condition and Results of Operations," the following risk factors are also inherent in the Company's business operations:
DEPENDENCE ON KEY PERSONNEL. The Company has several key executive officers, the loss of whom could have a significant adverse effect on the Company. In particular, Ronald Langley, PICO's Chairman, and John R. Hart, PICO's President and Chief Executive Officer, play key roles in the Company's and GEC's investment decisions. Although neither officer is party to an employment agreement, they have entered into consulting agreements with PICO and various of its subsidiaries. Messrs. Langley and Hart are key to the implementation of the Company's new strategic focus, and the ability of the Company to implement its current strategy is dependent on its ability to retain the services of Messrs. Langley and Hart.
Cash flow needed to fund the day-to-day operations and the payment of claims and claims expenses will be provided by investment income, lease income, and proceeds from the sale or maturity of securities. Physicians and PRO have established reserves to cover losses and loss adjustment expense ("LAE") on claims incurred under the MPL policies issued or renewed to date. The amounts established and to be established by Physicians and PRO for loss and LAE reserves are estimates of future costs based on various assumptions and, in accordance with Ohio law, have been discounted (adjusted to reflect the time value of money). These estimates are based on actual and industry experience and assumptions and projections as to claims frequency, severity and inflationary trends and settlement payments. In accordance with Ohio law, Physicians and PRO annually obtain a certification that their respective reserves for losses and LAE are adequate from an independent actuary. Physicians and PRO also obtain a concurring actuarial opinion. Physicians' and PRO's reserves for losses and LAE for prior years developed favorably in 1994, and these reserves were decreased by $12.7 million in 1994. Reserves also developed favorably in 1995; however, accretion of reserve discount exceeded the amount of favorable development and retroactive reinsurance, resulting in a $3.2 million increase in liabilities for prior years' claims. As a result of continued favorable claims experience, reserves for prior years' claims were further reduced in the first and fourth quarters of 1996. Management believes that the reserving methods and assumptions are reasonable and prudent and that Physicians' and PRO's reserves for losses and LAE are adequate. Due to the inherent uncertainties in the reserving process there is a risk, however, that Physicians' and PRO's reserves for losses and LAE could prove to be inadequate which could result in a decrease in earnings and shareholders' equity. Adverse reserve development can reduce statutory surplus or otherwise limit the growth of such surplus.
RISKS REGARDING SUMMIT GLOBAL MANAGEMENT. Summit is registered as an investment adviser in California, Florida, Kansas, Louisiana, Oregon, Virginia and Wisconsin, as well as with the Securities and Exchange Commission (the "SEC"). Summit must file periodic reports with the SEC and must be available for periodic examination by the SEC. Summit is subject to Section 206 of the Investment Advisers Act of 1940, which prohibits material misrepresentations and fraudulent practices in connection with the rendering of investment advice, and to the general prohibitions of Section 208 of such Act. If Summit were to violate the Investment Advisers Act prohibitions, it would risk criminal prosecution, SEC injunctive actions and the imposition of sanctions ranging from censure to revocation of registration in an administrative hearing.
The investment adviser business is highly competitive. There are several thousand investment advisers registered in the states in which Summit does business, many of which are larger and have greater financial resources than Summit. There can be no assurance that Summit will be able to compete effectively in the markets that it serves.
GLOBAL DIVERSIFICATION OF INVESTMENTS. As a result of global diversification investment decisions already made and which may be made in the future, particularly with regard to GEC, the Company's revenues may be adversely affected by economic, political and governmental conditions in countries where it maintains investments or operations, such as volatile interest rates or inflation, the imposition of exchange controls which could restrict the Company's ability to withdraw funds, political instability and fluctuations in currency exchange rates.
The Company's financial statements as of December 31, 1996 and 1995 and for each of the three years in the period ended December 31, 1996 and the report of independent accountants are included in this report as listed in the index on page 45 of this report.
Summarized unaudited quarterly financial data (in thousands, except share and per share amounts) for 1995 and 1996 are shown below. In management's opinion, the interim financial data contains all adjustments, consisting of only normal recurring accruals, necessary for a fair presentation of results for such interim periods.
AUDITS OF CONSOLIDATED FINANCIAL STATEMENTS AS OF DECEMBER 31, 1996 AND 1995 AND FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1996
Consolidated Statement of Changes in Shareholders' Equity for the Years Ended December 31, 1996, 1995, and 1994 ......................... 50-51
We have audited the accompanying consolidated balance sheets of PICO Holdings, Inc. and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of operations, changes in 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.
As discussed in Note 12, the Company changed the discount rate used to record loss and loss adjustment expense reserves and related reinsurance balances in 1994.
PICO HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY for the years ended December 31, 1996, 1995 and 1994
Stonebridge Partners AG ("Stonebridge") is 76% owned by the Company. In October 1995, the Company formed Stonebridge, a corporation in Zurich, Switzerland. Stonebridge is a distributor of investment products and fund management services to institutions and insurance companies in Europe. Operating results for the year ended December 31, 1996 and for the period October 1995 through December 1995 were comprised of certain operating and startup expenses.
Investments in entities in which the Company owns between 20 to 50% of the voting interest and has the ability to exercise significant influence and which are made for long term operating purposes, are accounted for on the equity method of accounting. The Company acquired an approximate 38% interest in Global Equity Corporation ("GEC") during 1995 and accounts for this investment under the equity method of accounting. The Company's share of net income or loss from GEC is translated from its foreign currency at average rates of exchange in effect during the year.
The estimated fair value of fixed maturity and equity securities other than those carried at equity is based upon quoted market prices or dealer quotes for comparable securities. In addition, the Company owns certain warrants to purchase the common stock of a publicly traded company. The estimated fair value of such warrants is their intrinsic value based on the quoted market price of the underlying common stock of the investee company.
Short-term investments, which consist of certificates of deposit with an original maturity of greater than three months, are stated at cost, which approximates fair value.
Real estate represents costs incurred in connection with certain land development projects and commercial real estate held for resale. Indirect costs associated with the land development projects, including interest, are capitalized as part of real estate costs. Selling, general and administrative expenses related to development projects are expensed as incurred.
Property and equipment are carried at cost, net of accumulated depreciation. Depreciation is computed on the straight-line method over the estimated lives of the assets ranging from 5 to 45 years.
Certain costs of acquiring new insurance business, net of reinsurance ceding commissions, are deferred and amortized over the terms of the policy for property and liability insurance and over the average lives of investment and universal life-type contracts, based on the present value of the estimated gross profit amounts expected to be realized over the lives of the contracts, and over the premium paying periods of ordinary and group life insurance contracts. Future investment income has been taken into considered in determining the recoverability of such costs.
Goodwill represents the difference between the purchase price and the fair value of the net assets (including tax attributes) of companies acquired in purchase transactions. Both positive and negative goodwill are amortized on a straight-line basis over a period of 10 years. There was negative goodwill (i.e., excess of fair value of assets acquired over purchase price) as of December 31, 1996 resulting from the acquisition of Citation Insurance Group in November 1996 (Note 3).
The Company periodically evaluates whether events or circumstances have occurred that may affect the estimated useful life or the recoverability of the remaining balance of positive goodwill. Positive goodwill is included in "Other Assets" in the accompanying consolidated balance sheets. Impairment of positive goodwill is triggered when the estimated future undiscounted cash flows (excluding interest charges) do not exceed the carrying amount of the positive goodwill. If the events or circumstances indicate that the remaining balance of the positive goodwill may be permanently impaired, such potential impairment will be measured based upon the difference between the carrying amount of the positive goodwill and the fair value of such assets determined using the estimated future discounted cash flows (excluding interest charges) generated from the use and ultimate disposition of the respective acquired entity.
Liabilities for future policy benefits have been calculated using the net level premium method based on actuarial assumptions as to anticipated mortality, withdrawals and interest rates ranging from 3.5% to 8%. Annuity and other policyholders' funds have been calculated based on contract-holders' contributions plus interest credited, less applicable contract charges.
MPL and other property and casualty insurance premiums written are earned principally on a monthly pro rata basis over the life of the policy. The premiums applicable to the unexpired terms of the policies are included in unearned premiums.
Premiums on ordinary and group life contracts, including critical illness, are recognized when due, and premiums on accident and health contracts are recognized over the contract period. Unearned premiums have been principally calculated using the monthly pro rata method, resulting in the earning of premiums evenly over the terms of the policies
Primary net income per share is computed by dividing net income by the weighted average number of common stock and common stock equivalents outstanding for the period with the average number of common stock equivalents outstanding calculated using the treasury stock method based on the average market price of the shares during the period. Fully diluted net income per share is computed on the same basis, except that, if it results in a more dilutive impact, the number of common stock equivalents related to stock options is based on the period-end market value of the shares instead of the average market value during the period. The weighted average number of shares outstanding for the years ended December 31, 1995 and 1994 used in the calculation of earnings per share have been recomputed to give effect to the stock exchange ratio utilized in connection with the reverse acquisition of Citation Insurance Group consummated on November 20, 1996 (Note 3).
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses for each reporting period. The significant estimates made in the preparation of the Company's consolidated financial statements relate to the assessment of the carrying value of unpaid losses and loss adjustment expenses, future policy benefits, deferred policy acquisition costs, deferred income taxes and contingent liabilities. While management believes that the carrying value of such assets and liabilities are appropriate as of December 31, 1996 and 1995, it is reasonably possible that actual results could differ from the estimates upon which the carrying values were based.
In February 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 128 Earnings per Share ("SFAS No. 128"). SFAS No. 128 requires dual presentation of newly defined basic and diluted earnings per share on the face of the income statement for all entities with complex capital structures. The accounting standard is effective for fiscal years ending after December 15, 1997, including interim periods. The Company does not believe that the adoption of SFAS No. 128 will have a material impact on the computation of its earnings per share in future periods.
The Merger was accounted for under the purchase method of accounting. Financial results for the year ended December 31, 1996 include the operations of CIG as if the Merger had occurred on November 1, 1996. Financial activity for the period November 1, 1996 through November 20, 1996 was not significant.
The excess of the fair value of the net assets acquired over the purchase price of such net assets (negative goodwill) is being amortized over a 10 year period using the straight-line method. As discussed in Note 20, the Company entered into a Letter of Intent in January 1997 to sell the net assets related to CIC's workers' compensation operations. The sale of the net assets related to CIC's workers' compensation operations is expected to be completed in the second quarter of 1997.
- expected cash flows from the operations of the net assets of acquired entities that are expected to be sold within one year of the date of acquisition should be considered in the purchase price allocation, and
The Company has accounted for the allocation of the purchase price and the net assets of CIC's workers' compensation line of business in accordance with the EITF 87-11 guidance stated above. Accordingly, the net assets related to CIC's workers' compensation line of business as of December 31, 1996 have been reflected on a single line item in the accompanying balance sheet as Net Assets of Acquired Business Held for Sale. The fair value assigned to such net assets was based upon management's estimate of the proceeds from the sale of CIC's workers' compensation line of business of approximately $7.7 million less the estimated loss from operations for such line of business during the expected holding period of November 1996 through April 1997 of approximately $0.5 million.
The pre-tax loss from operations related to CIC's workers' compensation line of business excluded from the Company's statement of operations from November 21, 1996 to December 31, 1996 was approximately $101,000.
The difference between the carrying amount of the net assets of CIC's workers compensation line of business at the date of sale and the actual proceeds from such sale will result in a reallocation of the purchase price of CIG.
On August 1, 1995, the Company acquired from Sydney Reinsurance Corporation ("SRC") all the outstanding stock of SRC's wholly owned subsidiary, Sequoia, a property and casualty insurance company. The acquisition price of $1,350,000 was paid in cash August 1, 1995. Approximately $350,000 was paid to acquire Sequoia's fixed assets, while the remaining $1,000,000 was used in the purchase of intangible assets and goodwill. These intangible assets are being amortized over a 10-year period using the straight-line method. The Company used available working capital to make the purchase. All policy and claims liabilities of Sequoia prior to closing are the responsibility of SRC and have been unconditionally and irrevocably guaranteed by QBE Insurance Group Limited ("QBE"), a publicly-held corporation based in Sydney, Australia, of which SRC indirectly is a wholly-owned subsidiary. Sequoia's operating results are included in the consolidated statements of operations for the year ended December 31, 1996 and for the period August 1, 1995 to December 31, 1995.
On September 5, 1995, Physicians purchased 38.2% of the outstanding common shares of GEC for $34.4 million. Approximately $33.5 million was paid to acquire the net assets, while the remaining $887,000 was allocated to goodwill. The goodwill is being amortized over a 10-year period using the straight-line method. Physicians used available working capital to make the purchase. GEC is a publicly-held corporation and is listed on the Toronto Stock Exchange and The Montreal Exchange under the symbol "GEQ". The Chairman of the Board of Directors ("Chairman") and the Chief Executive Officer ("CEO") of the Company are the Chairman and CEO of GEC, respectively.
The Company carries its investment in GEC using the equity method of accounting. The consolidated statements of operations of the Company for the years ended December 31, 1996 and December 31, 1995 include the Company's 38.2% share of GEC's net income (loss) for the year ended December 31, 1996, and from October 1, 1995 to December 31, 1995, respectively.
Fixed maturity investments with an estimated fair value of $52,467,790 have been classified as net assets of acquired business held for sale.
Investment income is summarized as follows for the years ended December 31, 1996, 1995, and 1994:
All available-for-sale investments were income-producing in the last 12 months except for nine equity securities with a carrying amount totaling approximately $6,138,568.
Approximately $29.5 million of the total gross realized gains for the year ended December 31, 1996 were generated from the sale of the Company's investment in Fairfield Communities, Inc. in November 1996.
At December 31, 1996, the following available-for-sale securities exceeded 10% of shareholders' equity of the Company:
In addition, Resource America, Inc., has guaranteed certain mortgage notes held by APL with a carrying amount of $8,000,000 as of December 31, 1996.
The Company's ownership interest in PC Quote and Nooney Realty equity securities exceeded 20% of the total equity ownership interest of those companies as of December 31, 1996. However, these investments are carried at estimated fair value as opposed to on the equity basis as the investment was not made for long-term operating purposes.
Significant components of the Company's deferred tax assets and liabilities at December 31, 1996 and 1995 are as follows:
10. SHAREHOLDERS' EQUITY (ALL SHARE AMOUNTS HAVE BEEN RESTATED TO GIVE EFFECT TO THE STOCK EXCHANGE RATIO UTILIZED IN CONNECTION WITH THE REVERSE ACQUISITION OF CIG (NOTE 3)):
In December 1993, the Company issued 7,156,997 common shares (adjusted for the merger exchange rate) to Guinness Peat Group plc for $5,000,000. In accordance with their original stock purchase agreement, Guinness Peat Group plc was entitled to purchase additional common shares at a price based upon the average closing bid price of the stock for a period prior to the date of notice of intent to buy up to an aggregate purchase price of $5,000,000. In June 1994, the Company issued 3,164,147 common shares (adjusted for the merger exchange rate) to Guinness Peat Group plc for $3,000,000, increasing their ownership to approximately 40%. At December 31, 1996 and 1995, Guinness Peat Group plc was entitled to purchase additional common shares up to an aggregate purchase price of $2,000,000.
In connection with the merger, CIG's existing Employee Stock Ownership Plan was adopted. Such plan covers substantially all of the employees of the Company and its subsidiaries. Contributions are made to the plan at the discretion of the Board of Directors. No contributions were made to the plan in 1996.
The Company sponsors various stock-based incentive compensation plans (the "Plans"). The Company applies APB Opinion 25 and related interpretations in accounting for the Plans and, therefore, does not recognize any compensation cost related to such plans. In 1995, the FASB issued SFAS Statement No. 123 "Accounting for Stock-Based Compensation" ("SFAS 123"). Adoption of the cost recognition provisions of SFAS 123 is optional and the Company has decided not to elect these provisions of SFAS 123. However, pro forma disclosures of the impact on the Company's net income and earnings per share for the years ended December 31, 1996 and 1995 as if the Company adopted the cost recognition provisions of SFAS 123 are presented below.
The Company granted stock options in 1996 and 1995 to employees and directors. The stock options granted in 1996 and 1995 have terms of 10 years. The options granted to directors were vested immediately on the grant date. The options granted to employees vest either (I) at the rate of 25%, 33% or 50% per year on each of the first four, three or two year anniversaries of the date of grant, as applicable, or (ii) at a rate of 33% upon grant and 33% per year on each of the first two anniversaries of the date of grant. All options granted under the CIG plan became fully vested upon consummation of the merger.
A summary of the status of the Company's stock options as of December 31, 1996 and 1995 and the changes during the years then ended is presented below:
As more fully described in Note 3, immediately prior to the sale of Sequoia to Physicians by SRC, Sequoia and SRC entered into a reinsurance treaty whereby all policy and claims liabilities of Sequoia prior to the date of purchase by the Company are the responsibility of SRC. Payment of these reinsurance liabilities has been unconditionally and irrevocably guaranteed by QBE.
In 1994, the Company entered into a retrospective reinsurance arrangement with respect to its MPL business. As a result, Physicians initially recorded a deferred gain on retroactive reinsurance of $3,445,123 in 1994. Deferred gains are being amortized into income over the expected payout of the underlying claims using the interest method. The unamortized gain as of December 31, 1996 and 1995 was $2,874,128 and $3,188,811, respectively.
The following is a summary of the net effect of reinsurance activity on the consolidated financial statements for 1996, 1995, and 1994:
Physicians prepares its statutory financial statements in accordance with accounting practices prescribed or permitted by the Ohio Department of Insurance ("ODI"). CIC, CNIC and Sequoia prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by the California Department of Insurance. Prescribed statutory accounting practices include guidelines contained in various publications of the National Association of Insurance Commissioners, as well as state laws, regulations, and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. The ODI's prescribed accounting practices do not allow for discounting of claim liabilities. However, for the years ended December 31, 1996, 1995, and 1994, the ODI permitted Physicians to discount its losses and loss adjustment expenses related to its MPL claims to reflect investment income. Such permission was granted due primarily to the longer claims settlement period related to MPL business as compared to most other types of property and casualty insurance lines of business. Property and casualty insurance companies are permitted to discount claims liabilities under generally accepted accounting principles to the extent that the discounting of claims liabilities by such entities is prescribed or permitted by statutory accounting principles.
The method of discounting utilized by Physicians is based on historical payment patterns and assumes an interest rate at or below Physicians' investment yield, and is the same rate used for statutory reporting purposes. Prior to 1994, direct and assumed MPL loss reserves and reinsurance recoverables were discounted at a rate of 7.5% (an investment yield rate) for 1987 and prior accident years. Physicians used 5.5% for the 1988 accident year, 5% for the accident years 1989, 1990 and 1991, and 4% for the 1992 and 1993 accident years, which rates were agreed to between Physicians and the Ohio Department of Insurance. These rates represented a level somewhat below Physicians' investment yield rate as required by such agreement. During 1994, Physicians changed its accounting for the discount rate retroactively and lowered its discount rate to 4% for all accident years, including all prior accident years. Physicians considered this change in discount rate to be a change to a preferable rate, the maximum rate currently prescribed for discounting by the Ohio Department of Insurance. The cumulative effect of this change, as of January 1, 1994, was $4,109,941 and was charged to earnings in 1994. The carrying value of MPL reserves gross as to reinsurance was approximately $141.8 million, net of discounting of $15.5 million at December 31, 1996 and $167.3 million, net of discounting of $20.3 million at December 31, 1995.
Plan assets for the defined contribution plan are held by one of the Company's subsidiaries. Another subsidiary is responsible for management of the Plan's assets.
The Company is subject to various litigation which arises in the ordinary course of its business. Based upon information presently available, management is of the opinion that such litigation will not have a material adverse effect on the consolidated financial position or results of operations of the Company.
SGM is a Registered Investment Advisor providing investment advisory services to managed accounts including the Company's subsidiaries. Although dormant for several years, SGM commenced active operations on January 1, 1995. SGM's President and CEO has an option expiring December 31, 2004 to purchase 49% of SGM's common shares for a nominal amount. Two of the Company's directors were instrumental in establishing the operations of SGM and are entitled to receive 50% of the first $1,000,000 of profits attributed to Physicians' ownership of common stock. The compensation paid to each of those Directors under this arrangement was $0 and $0 in 1996 and 1995, respectively. Effective January 1, 1996, SGM entered into a contract to provide investment management services to Physicians, PRO, Sequoia, APL, and Separate Accounts A and B of APL.
On September 26, 1995, the same two directors of the Company, who are also officers and directors of GEC, were granted options by GEC to purchase up to 1,549,833 shares of common stock of GEC at an exercise price of $2.50 (Canadian) per share, which was the closing market price of GEC shares on the Toronto Stock Exchange on the date of grant. Such options are immediately exercisable. In addition, on October 24, 1995, each was granted options by GEC to purchase an additional 950,167 shares of common stock of GEC at an exercise price of $2.45 (Canadian) per share. Such options do not become exercisable until the earlier to occur of (a) approval by the shareholders of GEC or (b) shares becoming available as a result of the cancellation of options held by other option holders.
In January 1997, the consulting arrangements described above between two of the Company's directors and the Company, SGM, and GEC were terminated and were replaced with a single consulting arrangement between each of the directors, GEC and the Company. Under the new consulting arrangement, the Company's Board of Directors increased the annual base consulting fees for the two directors who perform consulting services related to investment activities, investment banking services and analysis of operations to $800,000 each beginning January 1, 1997. In addition, each is entitled to an incentive award based on the growth of the Company's book value during 1997, above a threshold rate of return. Physicians will be responsible for two-thirds of the consulting fee and GEC will be responsible for one-third.
Certain insurance subsidiaries are owned by other insurance subsidiaries. In the table above, investments in such subsidiary-owned insurance companies are reflected in statutory surplus of both the parent and subsidiary-owned insurance company. As a result, at December 31, 1996, 1995, and 1994, statutory surplus of approximately $38,423,146, $25,937,298 and $18,625,539, respectively, is reflected in both the parent and subsidiary-owned insurance companies.
(A) Portfolio investing identifiable assets include certain investments held by one of the Company's regulated insurance subsidiaries which is no longer writing new business. Management believes that this component of the insurance subsidiary's assets is in excess of the amount of the subsidiary's assets that will be required to settle its claims liabilities. The amount of the insurance subsidiary's assets included in the portfolio investing segment were approximately $56 million, $58 million and $26 million as of December 31, 1996, 1995, and 1994, respectively. Investment income revenue thereon was approximately $27 million, $8 million and $2 million, for the years ended December 31, 1996, 1995, and 1994, respectively.
- FIXED MATURITIES AND EQUITY INVESTMENT SECURITIES: Fair values are based upon quoted market prices, or dealer quotes for comparable securities. In addition, the Company owns certain warrants to purchase the common stock of a publicly traded company. The estimated fair value of such warrants is their intrinsic value based on the quoted market price of the underlying common stock of the investee company.
- INVESTMENT IN AFFILIATE: Estimated fair value of GEC is based upon its quoted market price on the Toronto Stock Exchange translated at the exchange rates in effect at the balance sheet date.