: Management's Discussion and Analysis of Financial Condition and Results of Operations.
As discussed in Note 2 to the Consolidated Financial Statements, on April 30, 1997, the Company completed the acquisition of Vik Brothers Insurance, Inc., renamed American Reliance, Inc. ("American Reliance"). The acquisition was accounted for under the purchase method of accounting and, accordingly, the consolidated financial statements include the results of American Reliance's operations only from date of acquisition. The results of the Company's consolidated operations for the periods indicated are set forth below:
as insurers compete to retain business. Second, service disruption in early 1998 associated with the implementation of a new policy issuance system at the end of 1997 negatively impacted new and renewal policy processing and agents' willingness to place business with the Company. Finally, the reduction in the A.M. Best rating of Highlands Insurance Company to B++ from A-, announced by A.M. Best in June 1998, caused a decline in premium production. The declines have been partially offset by approximately $15.3 million of increases in premiums under retrospectively rated policies.
Gross premiums written for retrospectively rated policies may be adjusted up or down, subject to certain limitations contained in the policy, based on the estimated loss experience of the insured during the policy period. The Company estimates ultimate losses for retrospectively rated policies and then adjusts gross premiums written and premiums due from policyholders for changes in estimated ultimate losses and loss adjustment expenses from the date of the prior valuation. These adjustments may cause gross premiums written and net premiums earned to fluctuate significantly from period to period. Experience rated contracts reduce but do not eliminate risk to the insurer.
Net Premiums Written. Net premiums written for 1998, 1997 and 1996 were $374.8 million, $277.7 million and $135.1 million, respectively. $62.5 million of the increase in 1998 is related to the same issues affecting gross premiums written. The remaining increase of $34.6 million resulted from the non- recurring return premium associated with the Company's termination of an Aggregate Excess of Loss Reinsurance Agreement ("Stop Loss Agreement") entered into in 1992.
Net premiums written for 1997 increased $142.6 million compared to 1996 primarily due to the inclusion of American Reliance for eight months in 1997 which amounted to $159.9 million. Excluding the American Reliance business, net premiums written for 1997 declined 12.8% compared to 1996 for the same reasons noted for gross premiums written.
Loss and Loss Adjustment Expenses Incurred. Loss and loss and adjustment expenses incurred for 1998, 1997 and 1996 were $328.4 million, $246.5 million and $156.6 million, respectively. The increase in 1998 of $81.9 million compared to 1997 was attributable to several factors. First, the termination of the Stop Loss Agreement noted above had the effect of increasing loss and loss adjustment expenses reported in 1998 by $50.0 million. Second, the Company experienced catastrophe losses primarily in the second quarter of $5.2 million in 1998 compared to $17.3 million in 1997. The catastrophe losses adversely impacted the entire industry in 1998 due to the high frequency of catastrophes. Third, during 1998, the Company experienced an increase in loss and loss adjustment expenses of $1.9 million ($8.0 million in 1998 compared to $6.1 million in 1997) related to California construction defect claims. Fourth, in 1998, there were higher incurred losses subject to retrospectively rated policies. Finally, the inclusion of American Reliance for the full year of 1998 compared to eight months in 1997 increased loss and loss adjustment expenses in 1998.
Investment Results. Net investment income for 1998, 1997 and 1996 was $78.0 million, $74.4 million and $51.0 million, respectively. Net investment income increased $3.6 million from 1997 due to the inclusion of American Reliance for the full year in 1998. The 1998 investment income increase was partially offset by lower interest rates in 1998 and a reduction in the size of the investment portfolio. Net investment income for 1997 increased from 1996 primarily due to the acquisition and inclusion of American Reliance. Net realized investment gains for the Company were $16.9 million, $5.6 million and $1.2 million for 1998, 1997 and 1996, respectively.
During the fourth quarter of 1998, the Board of Directors authorized a share repurchase of up to $20 million of the Company's Common Stock to be conducted by two of the Company's insurance subsidiaries, Highlands Insurance Company and Northwestern National Casualty Company, through March 31, 1999. As of December 31, 1998, those insurance subsidiaries purchased 430,900 shares of Common Stock at an aggregate cost of $5.3 million.
The Company began installing a new financial and management reporting IT system during 1998. Implementation is expected to be completed by July 1999.
Because American Reliance was acquired in April 1997, it has a discrete policy issuance and processing IT system from the rest of the Company, the status of which is set forth separately. In 1994, American Reliance, working with an outside vendor, began a project to create a single processing platform for all of its business that, among other things, would be able to process its Year 2000 business. In August 1997, Phase One of this project, covering new and renewal business for a portion of the commercial multiple peril line and the commercial automobile, general liability and personal lines, representing approximately 70% of its business, began to be implemented. A combination of internal and vendor related factors such as design errors, inadequate testing and poor implementation led to problems with this Phase and contributed to service problems. The Company has resolved a majority of the problems with Phase One. Phase Two of the project, covering the balance of the commercial multiple peril line and the workers' compensation and commercial umbrella lines, representing the remainder of its business, was implemented with few problems in November 1998. Although the claims processing system for policies issued under the new American Reliance system is Year 2000 compliant, the claims processing system for policies issued under the old system is not. The Company is developing primary and contingent plans to address claims in the old system. The plans are expected to be completed in April and implemented by the end of the year.
The Company has spent approximately $2.1 million through December 31, 1998 to make its IT systems and non-IT systems Year 2000 compliant (excluding $16 million of costs associated with the development of the two processing platforms). The Company expects to incur an additional $2 million in 1999 in this process. The Company's insurance subsidiaries are expected to fund these costs out of their operations. Although the Company's Year 2000 efforts have caused it to defer certain other IT system projects, the Company does not believe such deferral will have a material adverse effect on its financial position and results of operations.
The Company relies on third party vendors for many services such as communications, electricity and energy, banking and reinsurance. The Company has identified the entities which are material to its operations and is assessing whether they will be Year 2000 compliant through questionnaires and affirmation of Year 2000 compliance. The Company expects to complete this assessment in April 1999.
The Company's efforts have focused on renovating its IT systems, not on preparing contingency plans if it fails in such renovation efforts. The Company will develop contingency plans for those systems where renovation will not be completed when required. Contingency plans for other systems and material third party vendors which may not be Year 2000 compliant in time will be made on a case-by-case basis as part of the assessment process for each such system and vendor.
In addition to the Company's systems, the Year 2000 issues may affect its underlying business. The Company does not believe that Year 2000 occurrences are covered under property and casualty policies that it issues. The Company's insurance products are based on those developed by Insurance Services Office, Inc. ("ISO"), which recently developed policy language that clarifies that there is no coverage for Year 2000 occurrences. The Company has adopted the ISO exclusionary language in states where it has been approved. In states not accepting the ISO exclusionary language, the Company has filed its own exclusionary language. The Company is attaching either the ISO or its own exclusionary language to all policies with a rating classification the Company believes could potentially have Year 2000 losses. The Company's exposure for any such losses and expenses pursuant to policies it issues cannot be reasonably estimated at this time.
The estimated cost of the Company's Year 2000 efforts and the dates on which it believes it will complete such efforts are based on management's best estimates, which were derived using numerous assumptions regarding future events, including the continued availability of certain resources, third party remediation plans and other factors. There can be no assurance that these estimates will prove accurate. Actual results could differ materially from those currently anticipated. Specific factors that could cause such material differences include: the availability and costs of personnel trained in Year 2000 issues; the ability to identify, assess, renovate and test all relevant computer codes and embedded technology; the risk that reasonable testing will not uncover all Year 2000 problems; and similar uncertainties.
The statements included in this 1998 Annual Report regarding future financial performance and results and other statements that are not historical facts are forward-looking statements. The words "expect," "project," "estimate," "predict," "anticipate," "believes" and similar expressions are also intended to identify forward-looking statements. Such statements are subject to numerous risks, uncertainties and assumptions, including but not limited to, the uncertainties relating to industry and market conditions, natural disasters and other catastrophes, and other risks and uncertainties described in this 1998 Annual Report and in the Company's other filings with the Securities and Exchange Commission. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual outcomes may vary materially from those indicated.