A variety of events, most of which are outside the Company's control, cannot be accurately predicted and may materially impact estimates of future operations. Important among such factors are weather conditions, natural disasters, changes in state and federal regulations, price competition impacting premium levels, changes in tax laws, financial market performance, changes in court decisions effecting coverages and general economic conditions.
The Company's results are significantly impacted by its crop business, particularly its MPCI line. Results from the crop lines are not generally known until the third and fourth quarters of the year, after crops are harvested. Crop results are particularly dependent on events beyond the Company's control, notably weather conditions during the crop growing seasons in the states where the Company writes a substantial amount of its crop insurance, and, with the introduction of the Company's new Crop Revenue Coverage, the market price of grains on various commodity exchanges. Additionally, federal regulations governing aspects of crop insurance are frequently modified, and any such changes may impact crop insurance results.
Forward-looking information set forth herein does not take into account any impact from any adverse weather conditions during the 1998 crop season, or the various other factors noted above which may affect crop and non-crop operation results.
After several years of growth in net insurance premiums earned, the Company experienced a decline in net insurance premiums earned from $348.7 million in 1996 to $335.2 million in 1997, a decline of approximately 3.9%. During 1997, the Company's goal in its Property and Casualty divisions was to improve underwriting results through an emphasis on profitable lines, a restructuring of marginal lines, and a discontinuation of unprofitable lines. During this process, growth in profitable lines of business was offset by declining volumes in the discontinued lines resulting in only a .8% increase in direct premiums written and a 2.3% increase in gross premiums written. In lines of business in which the Company was seeking to improve marginal results, the Company ceded additional amounts to reinsurers in order to reduce the impact of these lines as well as to help improve the net results of the Company. Due to the competitive environment in the Property and Casualty business, new programs which the Company initiated in 1997 were also heavily reinsured in order to diminish the impact on the Company's results until such time as these new programs confirmed their expected level of profitability. Accordingly, the Company increased its cessions to reinsurers by approximately $46.6 million from $284.1 million in 1996 to $330.7 million during 1997, resulting in a 8.7% decline in net premiums written during 1997 as compared to 1996.
In the Company's Crop division, the Company's premium levels were also relatively flat as direct written premiums decreased from $198.6 million in 1996 to $196.5 million in 1997 and gross premiums increased slightly from $242.9 million in 1996 to $248.0 million in 1997. These relatively level written premiums resulted as increases in the Company's policy count under the Company's largest program, the MPCI crop insurance program, were offset by reductions in commodity prices upon which the Company's premiums are based.
The improved profit sharing income in 1997 was offset by an increase in the Company's net operating expenses under the MPCI program. This increase in net expenses was due to a decrease in expense reimbursement from the federal government under the MPCI program from 31.0% for both MPCI and Crop Revenue Coverage (CRC) policies in 1996 to 29.0% and 25.0% respectively for MPCI and CRC policies in 1997. This resulted in an approximate $7.2 million decrease in expense reimbursement from 1996 to 1997. The Company was unable to pass along any of this expense reduction to its producing agents due to the competitive environment for MPCI business during 1997. The Company has initiated several automation and cost cutting programs in order to reduce its overall operating expense under the MPCI program. During 1998, the expense reimbursement from the federal government under the MPCI program declined again to 27.0% for MPCI policies and 23.25% for CRC policies. Further, the Company expects an additional reduction for the 1999 crop year. While the Company continues to emphasize cost reduction and automation initiatives, the Company will be unable to fully compensate for these reductions in expense reimbursements unless it is able to reduce agents commissions. Given the competitive environment for the MPCI policies, it is unknown at this time whether the Company will be able to effect such commission reductions without a loss of business in its MPCI line.
The Company's net income for 1997 also benefited from an increase in net investment income and net realized capital gains. The Company's net investment income increased 5.8% during the twelve months ended December 31, 1997 as compared to the twelve month period ended December 31, 1996 while the Company's net realized capital gains increased 40.4% in 1997 as compared to 1996. The increase in the Company's net investment income resulted from an increase in the average size of the Company's portfolio from $402.4 million during the year ended December 31, 1996 to $453.9 million during the year ended December 31, 1997, an increase of 12.8%. This increase in the size of the portfolio was offset by a decrease in the annualized investment yield of the portfolio from 6.6% during 1996 to 6.2% during 1997. This decrease in annual investment yield was due to an increase in the average amount of tax advantaged securities within the Company's portfolio and a lower interest rate environment during 1997.
The combined underwriting loss and expense ratio improved from 104.9% for the year ended December 31, 1995 to 97.3% for the 1996 year. This improvement in the Company's combined ratio was enhanced by growth in net premiums earned of 28.4%. The greatest contribution to these improved underwriting results was made by the Company's Crop division. The Company's Crop division increased its MPCI writings from $183.3 million for the year ended December 31, 1995 to $248.3 million for the 1996 year. In addition to this growth in MPCI premium, the Company increased its retained pool from $104.3 million in 1995 to $161.4 million in 1996. This growth in premium was aided by an increase in commodity prices for the major crops insured by the Company and the introduction of an enhancement to the MPCI policy. Improved weather conditions also contributed significantly to the improved results in the Crop division as the Company's MPCI profit sharing percentage realized during 1996 increased to 23.5% from 13.4% realized during 1995. In addition, the 1996 year benefited from $4.3 million of additional profit sharing realized in the first quarter of 1996 as final results of the late 1995 harvest were available.
While the Company's income tax expense increased from $1.2 million for the twelve months ended December 31, 1995 to $3.2 million for the 1996 year, the Company's effective tax rate declined from 22.2% in 1995 to 9.6% in 1996. The Company's 1996 taxes were positively effected by the decrease in the valuation allowance relating to the unrealized loss from the Company's investment in Major Realty. In October 1995, Major Realty announced that its Board of Directors had determined that it was in the best interest of the stockholders to seek a merger partner or otherwise seek a transaction for the sale of the company. At December 31, 1996, the Company believed that the realization of the capital loss associated with such a transaction was more likely than not due to sufficient carryforwards of capital gains as well as the likelihood of further capital gains.
Additionally in the Program division, the Company changed its strategies within its Workers' Compensation underwriting activities during 1996. In 1995 and previous years, the Company had followed a strategy of depopulating assigned risk pools through the application of intensive case management techniques with risks which had become unacceptable to the standard market due to frequency rather than severity. With the improvement of workers' compensation results for the industry as a whole, more companies were willing to write workers' compensation, and therefore, the number of risks fitting the Company's profile for removal from assigned risk pools was substantially depleted. During 1996, the Company moved to a strategy of partnership arrangements with select agencies in which the agent accepts part of the underwriting risk in return for an enhanced profit sharing from the Company. Due to the competitive market, this strategy is developing slowly, and, thus, the Company experienced a 65% decrease in its direct written premiums in this line of business. This transition phase caused the expense ratio in this line of business to increase more than 100%, and resulted in an underwriting loss for this line of business.
The Company experienced a somewhat higher expense ratio during 1996 than during 1995. This ratio increased from 26.7% in 1995 to 27.5% in 1996 primarily due to higher net commission expense in the Program division of the Company. This higher net commission expense was a result of a changing mix of business with a lesser percentage of premiums produced in lower commission programs such as Workers' Compensation and Transportation and a higher percentage of premiums produced in higher commission lines of business. In addition, the Company decreased the use of quota share reinsurance within the Program division during 1996.
As an insurance holding company, the Company's assets consist primarily of the capital stock of its subsidiaries, surplus notes issued by two of its insurance company subsidiaries and investments held at the holding company level. The Company's primary sources of liquidity are receipts from interest payments on the surplus notes, payments from the profit sharing agreement with American Agrisurance, the Company's wholly owned subsidiary which operates as the general agent for the Company's crop insurance programs, tax sharing payments from its subsidiaries, investment income from, and proceeds from the sale of, holding company investments, and dividends and other distributions from subsidiaries of the Company. The Company's liquidity needs are primarily to service debt, pay operating expenses and taxes, and make investments in subsidiaries.
As of December 31, 1997, the Company held cash, invested assets excluding investments in subsidiaries, and dividends receivable of $13.3 million.
The NAIC has established a Risk Based Capital ("RBC") formula for property and casualty insurance companies. The RBC initiative is designed to enhance the current regulatory framework for the evaluation of the capital adequacy of a property and casualty insurer. The formula requires an insurer to compute the amount of capital necessary to support four areas of risk facing property and casualty insurers: (a) asset risk (default on fixed income assets and market decline), (b) credit risk (losses from unrecoverable reinsurance and inability to collect agents' balances and other receivables), (c) underwriting risk (premium pricing and reserve estimates), and (d) off balance sheet/growth risk (excessive premium growth and unreported liabilities). The Insurance Companies have reviewed and applied the RBC formula for the 1997 year and have exceeded these requirements.
The Company's stockholders' equity increased by approximately $45.9 million from December 31, 1996 to December 31, 1997. The principal components of this increase were net income of $35.3 million for the year ended 1997 and an increase in the value of the Company's investment portfolio causing the unrealized gain (loss) on available-for-sale securities net of tax to improve from a loss of $1.5 million to a gain of $6.9 million.
The year 2000 issue is the result of computer programs which recognize only two digits rather than four to identify the year. Any of the Company's computer programs that have time sensitive software may recognize a date of "00" as the year 1900 rather than the year 2000. If not corrected, this could cause computer systems to fail or perform miscalculations.
In February 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 128 (SFAS No. 128), Earnings Per Share. This statement establishes accounting standards for the presentation of basic and diluted earnings per share. In addition, SFAS No. 128 requires a reconciliation of the numerator and denominator of the basic and diluted EPS computations. The Company adopted SFAS No. 128 in 1997 and accordingly, earnings per share has been restated for all periods presented.
In June 1997, FASB issued SFAS No. 130, Reporting Comprehensive Income. SFAS No. 130 establishes standards for the reporting and display of comprehensive income. The purpose of reporting comprehensive income is to present a measure of all changes in shareholders' equity that result from recognized transactions and other economic events of the period, other than transactions with owners in their capacity as owners. SFAS No. 130 is effective for financial statements issued for periods beginning after December 15, 1997. Adoption of SFAS NO. 130 will result in additional disclosures in the Company's financial statements but will not impact the Company's reported net income or net income per share.
In June 1997, FASB issued SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information. SFAS No. 131 specifies revised guidelines for determining an entity's operating segments and the type and level of financial information to be disclosed. SFAS No. 131 is effective for fiscal years beginning after December 15, 1997. Adoption of SFAS No. 131 may result in additional disclosures in the Company's financial statements.