The Company owns two buildings in Cedar Rapids, Iowa, which it occupies as its Home Office. One building is a five-story building which is occupied entirely by the Company. The other is an eight-story office building in which the first floor is leased to tenants. The Company occupies the fourth through eighth floors of this building and rents the third floor and an office on the second floor to its subsidiary, United Life Insurance Company. The two buildings are connected with a skywalk.
[A bar graph displaying earnings per common share and dividends declared for the five years ended December 31, 1997 appears here.]
Using a conservative investment practice the Company last utilized in 1987, the Company started writing covered call options on approximately 1% of its equity portfolio to generate additional portfolio income. This program will continue to be utilized and expanded as situations and market conditions merit such use.
Flat growth in premiums resulted in a 1% increase in accounts receivable from property and casualty insurance agents and brokers. The balance of this asset at December 31, 1997 was $44,060,000, compared to $43,433,000 at December 31, 1996.
Deferred policy acquisition costs ("DAC") are expenses such as commissions, premium taxes and other costs associated with underwriting insurance policies. At the beginning of a policy period, an asset is established for the associated costs, and is then amortized over the lives of the respective policy terms to achieve a matching of expenses to revenue. In 1997, the Company's DAC increased 7%.
Losses, expenses and reserves that are due to the Company from reinsurance brokers are classified as reinsurance receivables. This balance increased by $1,940,000 or 16% in 1997. The Company has not experienced significant collection problems with regard to these receivables and has no information indicating that any of its current reinsurance balances are uncollectible.
The property and casualty segment's gross liability before reinsurance for losses and settlement expenses increased 5% to $231,768,000 between 1997 and 1996. Gross reserves remaining on the 1994 Northridge earthquake were $4,058,000 as of December 31, 1997, compared to $4,599,000 at December 31, 1996. This is the only significant catastrophe related reserve that the Company has for both years.
The liability for future policy benefits and interest on policyholders' accounts increased 12%, due primarily to two factors. First, this liability is increased immediately by the full premiums paid by policyholders for annuity products and most universal life products. In 1997, the Company received premiums of $57,734,000 in non-internal rollovers on annuity products and $13,550,000 on universal life products. These same two product lines had $22,510,000 of interest credited during 1997 which also causes a direct increase to future policy benefits. In addition, fluctuations in surrender benefits paid as well as the future policy benefits for other product lines account for the remainder of the change.
The Company's employee benefit obligations increased $1,901,000 or 28% in 1997, compared to 1996. Changes to the pension plan benefits formula and new early retirement provisions contributed to this increase.
RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1997, COMPARED TO YEAR ENDED DECEMBER 31, 1996 PROPERTY AND CASUALTY OPERATIONS
A lack of significant catastrophe exposure has contributed to the Company's favorable underwriting results. The property and casualty segment sustained approximately $6,780,000 in gross direct catastrophe losses in 1997. The heaviest storm activity occurred in the states of Iowa, Illinois, Kansas, Wisconsin, and Nebraska during the spring, where hail and wind caused approximately $4,106,000 in incurred property damage. The remaining catastrophe activity occurred throughout the year in Louisiana, Arkansas, North Dakota, Colorado, and Mississippi.
The life segment's realized gains decreased $1,141,000 in 1997 compared to 1996. The gains in 1996 were a result of the Company taking advantage of market conditions and selling a few of its available-for-sale fixed income securities.
Growth in the Company's portfolio of fixed income securities contributed to the 8% increase in investment income. For 1996, realized gains and other income included $2,074,000 of interest received in connection with the settlement of a Federal income tax Revenue Agent Review for previous tax years.
Property and casualty premiums earned increased 16%, or $29,476,000 in 1996, when compared to 1995. Our direct business provided a majority of the growth, with much of the increase concentrated in the midwestern states and Louisiana.
The $12,280,000 increase in property and casualty underwriting and acquisition expenses was primarily due to an increase in commissions, premium taxes and other policy issue expenses, associated with growth in premiums.
Interest credited was flat in 1996 for two reasons. First, one block of universal life had withdrawals of $15,125,000 in December, 1995 and $15,561,000 in the first two months of 1996, which caused a reduction of approximately $2,025,000 in interest credited in 1996 compared to 1995. Second, deferred annuity policies with a five-year interest rate guaranteed between 7.1% and 8.0% renewed in 1996 at a rate between 5.0% and 5.5% representing approximately a $500,000 decrease in interest credited. Also, all deferred annuity policies with guarantees of less than 6.5% earned up to 1.0% less in 1996.
Growth in the Company's fixed maturity portfolio contributed to the 6% increase in investment income. The unusual increase in realized gains and other income resulted from primarily two sources. The Company took advantage of market conditions and sold a small number of its available-for-sale fixed income securities. In addition, the settlement of a Federal income tax Revenue Agent Review for previous tax years resulted in the receipt of $2,074,000 in interest, which is included in realized investment gains and other income.
As part of the NAIC and state insurance department's solvency regulations, the Company is required to calculate a minimum capital requirement based on insurance risk factors. The risk based capital results are used to identify companies that merit regulatory attention or the initiation of regulatory action. At December 31, 1997 and 1996, both the property and casualty and the life segment had capital well in excess of their required levels.
The Company is not aware of any other current recommendations by the NAIC or other regulatory authorities in the states in which the Company conducts business which, if or when implemented, would have a material effect on the Company's liquidity, capital resources or operations.
The Company is also reviewing its third-party vendors for compliance with Year 2000 and has received many affirmative responses. While the Company is reviewing its third part vendors' Year 2000 compliance, it cannot assure that the systems of these vendors that the Company relies on will be converted in a timely manner, or that their failure to convert would not have an adverse affect on the Company's systems.
The Company sold a small subsidiary, Crabtree Premium Finance Company, a premium finance company which was not contributing to Company growth or service strategy. On February 27, 1998, most of the assets of this subsidiary were sold to Mepco Insurance Premium Financing, Inc. of Chicago, Illinois.
The bad news is that last year underwriting experience for all property/casualty companies improved and the industry posted record earnings. Four years of a soft market with no relief in sight and the industry's combined ratio decreased by four points to 102%, its lowest in 18 years. According to the Property Claim Service, the 25 catastrophes reported during 1997 was the lowest number since 1987. It was a difficult year not to make money in the insurance business unless one were in the managed care business. A booming stock market made even the most inept insurance company managements look good.
Indicative of the soft environment in which we operate, total property and casualty premiums written increased by only 2% to $226,915,000 while direct workers' compensation premiums actually declined by 3%. Most of our growth came from our Denver and New Orleans regional offices which both had a very good year from a loss ratio and a production standpoint. Denver expanded into New Mexico and New Orleans continued to develop Mississippi and Arkansas to balance its exposures in Louisiana. The outlook for growth this year is not encouraging and we are not going to pursue business we believe to be inadequately priced. With medical costs once again on the rise and worker's compensation rates continuing to be under pressure the prospects for that line are not good.
Life insurance premiums increased 8% to $21,955,000 and annuity premiums, which are not included as insurance premiums under GAAP accounting, amounted to $92,095,000. Banks, especially small-town banks, continue to be an increasingly important source of this business and we were generally able to maintain our spread on this business despite a decline in interest rates. Life insurance earnings decreased $2,071,000 to $6,061,000 resulting in a return on equity for the life insurance segment of our business of 8%. In 1996 our life insurance earnings were favorably impacted by realized gains of $1,361,000 compared to $220,000 this year.
Rather than storms, pestilence or plagues, your Company's story this year is the story of its most important asset, its people. While I was indisposed most of the year, they performed admirably and demonstrated that if CEOs aren't completely unnecessary, they are a very expensive luxury that certainly aren't worth nearly what they are paid.
On July 1, Mike Hansen, Vice President in charge of our Fidelity and Surety Department, retired. Mike, who was our surety claims person (note: I can be politically correct, too) assumed responsibility for the department in 1989 when Dick Ehlinger passed away. At the time, many so-called experts questioned our judgment in putting a claims person in charge of the department, but Mike proved them wrong. Under Mike's leadership the department's premiums grew from $6,278,000 to $17,542,000 and its loss ratio averaged 10.4%. Now it's Jeff Chapin's and Dave Lange's turn. With a staff of 23 professionals we have no doubt they will succeed.
If the pundits are to be believed, sometime within the next two years the economy is going to grind to a halt, the sky will fall and chaos will reign as federal, state and local governments, credit cards and nearly every other aspect of modern life become infected with the Year 2000 virus. However, we are not panicking. Maybe we just don't know any better, but perhaps our policy of developing most of our major software systems in-house rather than relying on outside vendors permitted our Information Services Department to foresee and address this problem sooner than many. We think so and just to make sure will be running another test of all our systems this summer.
The trend towards consolidation, which has been sweeping all financial services, continues to gain momentum in the property and casualty business. Two recent mergers that particularly interested us were Safeco's acquisition of American States and St. Pauls' pending acquisition of USF&G.
Going back to the days of John Phelan, the long-time president of American States and a very good insurance person who built it into a well-respected company and who, like my father, flew his own plane, no company has made more passes at us over the years than American States. The story was always the same, they were larger, they had Lincoln National behind them, they would survive and we would make a good fit. Funny thing, we're still here but they aren't around anymore.
Another trend is demutualization. Even "the rock" is now considering becoming a stock company. Over two hundred years ago, Adam Smith extolled the virtues of the profit motive in the "Wealth of Nations". Today, even in what was once the Communist empire, its value is acknowledged so it shouldn't be any surprise that the managements of mutual insurance companies are finally beginning to see the light, too. One of the insurance departments' challenges will be to restrain managements' greed and make sure the mutuals' policyholders are fairly compensated for the surplus their managements covet.
Consolidated Statements of Operations Years Ended December 31, 1997, 1996 and 1995
Consolidated Statements of Stockholders' Equity Years Ended December 31, 1997, 1996 and 1995
The Company and its property and casualty subsidiaries market most forms of commercial and personal property and casualty insurance products, including fidelity and surety bonds and reinsurance. The business is generated through approximately 1,700 independent agencies and brokers in 35 states, with 70% of the Company's direct premiums originating in six Midwestern states in 1997.
Certain amounts included in the Consolidated Financial Statements for prior years have been reclassified to conform with the 1997 financial statement presentation.
Unpaid losses and settlement expenses are based on estimates of reported and unreported claims and related settlement expenses. While management believes the reserve for claims and settlement expenses is adequate, the reserve is continually reviewed and as adjustments become necessary, they are reflected in current operations. Changes in assumptions used in estimating reserves could cause the reserves to change in the near term.
Liabilities for future policy benefits are computed by the net level premium method using interest assumptions ranging from 4.5% to 8.0% and withdrawal, mortality and morbidity assumptions appropriate at the time the policies were issued. Health reserves are stated at amounts determined by estimates on individual cases and estimates of unreported claims based on past experience. Liabilities for universal life type and investment contracts are stated at policyholder account values before surrender charges. Liabilities for traditional immediate annuities are based primarily upon statutory reserves.
Investments in held-to-maturity fixed income securities are recorded at amortized cost. The Company has the ability and intent to hold these investments until maturity. If, however, a permanent impairment occurs in a security, the Company writes the security down to the new value. Available-for-sale fixed income securities, equity securities and other long-term investments are recorded at fair value. Mortgage loans are recorded at the unpaid balance amount. Policy loans and short-term investments are recorded at cost. Included in investments at December 31, 1997 and 1996 are securities on deposit with various regulatory authorities as required by law with carrying values of $543,801,000 and $481,703,000, respectively.
Realized gains or losses on disposition of investments are included in the computation of net income. Cost of investments sold is determined by the specific identification method. Changes in unrealized appreciation and depreciation resulting from available-for-sale fixed income securities, equity securities and other long-term investments, are reported as direct increases or decreases in stockholders' equity, less applicable income taxes.
For purposes of reporting cash flows, cash and cash equivalents include cash and non-negotiable certificates of deposit with original maturities of three months or less. Income taxes paid during 1997, 1996 and 1995 were $5,789,000, $8,201,000, and $8,801,000, respectively. The Company received $2,074,000 in interest on Federal income taxes in 1996. There were no other significant payments of interest other than interest credited on policyholders' accounts in 1997, 1996 or 1995.
The Company has a defined benefit postretirement health care plan that covers substantially all full-time employees. The plan pays stated percentages of most necessary medical and dental expenses incurred by retirees, after subtracting payments by Medicare or other providers and after a stated deductible has been met. Participants become eligible for the benefits if they retire from the Company after reaching age 55 with ten or more years of service in the plan. The plan is contributory, with retiree contributions adjusted annually.
The Company adopted Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share" effective December, 1997. This standard supersedes APB Opinion No. 15 " Earnings Per Share" and simplifies the standards for computing and presenting earning per share ("EPS"). Under the new standard, the presentation of primary EPS has been replaced with a presentation of basic EPS. Basic EPS is computed excluding dilution caused by common stock equivalents such as stock options. The presentation of fully diluted EPS has been replaced with a presentation of diluted EPS, which is calculated in a similar fashion to how fully diluted EPS had been computed. This standard does not have a material effect on the Company's Consolidated Financial Statements.
The amortized cost and fair value of held-to-maturity and available-for-sale fixed maturities at December 31, 1997, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
In most cases, quoted market prices were used in determining the fair value of fixed maturities, equity securities and short-term investments. Where quoted market prices were unavailable, the estimate was based on recent trading. Market values for collateralized mortgage obligations were provided by various data vendors. Other long-term investments, consisting primarily of holdings in limited partnership funds, are valued by the various fund managers. In management's opinion, these values reflect fair value at December 31, 1997 and 1996.
The estimated fair value of mortgage loans was based on the estimated discounted future cash flows using 6.25% at December 31, 1997 and 6.5% at December 31, 1996.
The fair value of the liabilities for annuity products which are in a benefit payment phase, guaranteed investment contracts and structured settlements are based on a discount rate of 6.25% at December 31, 1997 and 6.5% at December 31, 1996. The fair value of annuities currently in an accumulation phase is based on the net cash surrender value.
The property and casualty insurance companies cede portions of their insurance business to other insurance companies on both a pro rata and excess of loss basis. Insurance ceded by the property and casualty insurance companies does not relieve their primary liability as the originating insurers. Earned premiums ceded were $25,716,000, $27,106,000 and $26,053,000 for the years ended December 31, 1997, 1996 and 1995, respectively. The Company believes all amounts are collectible with regard to reinsurance receivables. There are no concentrations of credit risk associated with reinsurance.
United Life Insurance Company follows the policy of reinsuring that portion of the risk in excess of $200,000 on the life of any individual. Policy benefit reserves and claims are stated after deduction of reserves and claims applicable to reinsurance ceded to other companies; however, United Life Insurance Company is contingently liable for these amounts in the event such companies are unable to pay their portion of the claims and is contingently liable for ceded insurance in force of $339,430,000, and $432,836,000 at December 31, 1997 and 1996, respectively. Approximately 61% of ceded life insurance in force has been ceded to two reinsurers. The Company believes all amounts are collectible with regard to reinsurance receivables.
The State of Iowa Insurance Department imposes certain capital requirements on insurance companies on a statutory basis. Under the applicable regulations, the Company is required to maintain minimum capital stock of $2,500,000 and minimum additional paid-in capital and retained earnings in the aggregate amount of $2,500,000. At December 31, 1997, the Company's capital stock was $35,758,000 and total statutory paid-in capital and retained earnings were $195,568,000.
The following table sets forth the funded status of the Company's qualified pension plan and amounts recognized in the Consolidated Financial Statements.
The weighted average discount rate used in determining the actuarial present value of projected benefit obligation was 7.0% at September 30, 1997, 7.5% at September 30, 1996, and 7.0% at September 30, 1995. The rate of increase in future compensation levels was 4.0% at September 30, 1997, 4.5% at September 30, 1996 and 4.0% at September 30, 1995. The expected long-term rate of return on plan assets was 8.0% at September 30, 1997, 1996 and 1995.
The Company has a profit sharing plan in which employees who meet service requirements are eligible to participate. The amount of the Company's contribution is discretionary and is determined annually but cannot exceed the amount deductible for Federal income tax purposes. The Company's contribution to the plan for the years ended December 31, 1997, 1996 and 1995 was $936,000, $717,000 and $1,561,000, respectively.
For medical claims, a health care cost trend rate of 9.0% was assumed for 1997, decreasing annually to 5.5% in 2003. For dental claims, a health care cost trend rate of 6.5% was assumed for 1997, decreasing annually to 5.0% in 2003. The health care cost trend rate assumption has a significant effect on the amounts reported. To illustrate, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1997 by $1,210,000 and the aggregate of the service and interest cost components of net postretirement benefit expense for the year then ended by $173,000. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.0% and 7.5% as of December 31, 1997 and 1996, respectively.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE STOCKHOLDERS AND BOARD OF DIRECTORS OF UNITED FIRE & CASUALTY COMPANY:
We have audited the accompanying consolidated balance sheets of United Fire & Casualty Company (an Iowa corporation) and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1997. These consolidated financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of United Fire & Casualty Company and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles.
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplementary data (Schedule III - --Supplementary insurance information, Schedule IV--Reinsurance, and Schedule VI--Supplemental information concerning property and casualty insurance operations) are presented for purposes of additional analysis and are not a required part of the basic financial statements. This information has been subjected to the auditing procedures applied in our audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.