The principal office of the Company in Red Wing, Minnesota, consists of approximately 30,000 square feet and is leased by Citizens Mutual under a lease expiring on December 31, 2002. Citizens Mutual may terminate the lease upon prior written notice of one year. Citizens Mutual also has the option to extend the lease for two periods of five years. Under the terms of the Management Services Agreement, Citizens Mutual and the Company have the right to occupy the premises jointly. Citizens Mutual also leases an additional office in Red Wing, Minnesota, consisting of approximately 3,300 square feet under a lease expiring on June 30, 1998. The lease is automatically extended for an additional 60 months. Although, Citizens Mutual may terminate the lease upon written notice prior to April 1, 1998. ICO leases an office in Mansfield, Ohio, which consists of approximately 2,700 square feet under a lease which expires on January 3, 1997. ICO is subleasing the Mansfield, Ohio office space.
The annual rent on offices is currently $314,412 plus the amount of real estate taxes, utility, insurance and common area maintenance expenses. Citizens Fund and ICO pay 75% of the rent and all other expenses under the leases. If the Pooling Agreement is amended, the Management Services Agreement provides that this percentage will change to equal the new percentage of the pool allocated to Citizens Fund and ICO.
The consolidated financial statements and the related notes included in Part II, Item 8, "Financial Statements and Supplementary Data" should be read in conjunction with the following discussion as they contain important information for evaluation of the Company's financial condition and operating results.
The property and casualty insurance industry experienced record catastrophe losses in recent years as a result of hurricanes, floods, earthquakes and other natural disasters. While the Company was not adversely affected by these catastrophic losses, they will have a lasting effect on how the insurance industry evaluates exposures.
Direct premiums written increased 7.9 percent in 1995 over the comparable amount in 1994 primarily because of growth in commercial lines of business. The growth is also attributable to an increase in policies written with agents that the Company has designated as "Partner" agencies. As anticipated, this growth was somewhat offset by the effect of the Company's decision not to write new business with certain agencies that do not fit within the Company's long-term marketing strategies.
Net premiums earned increased 12.0 percent in 1995 over 1994. In the first quarter of 1995, net premiums earned were positively affected by a $592,398 refund of excess ceded premiums received from the Minnesota Workers' Compensation Reinsurance Association ("MWCRA").
The property and casualty insurance market continues to be competitive. Although revenues from the Company's association business grew approximately 32 percent in 1995 compared to association revenues during 1994, the workers' compensation market in Minnesota and Wisconsin is intensely competitive. The Company's current strategy is to maintain rate adequacy in order not to jeopardize underwriting results.
The Company continued to decrease loss adjustment expenses in 1995. The Company's loss adjustment expense ratio (loss adjustment expenses to premiums earned) was 7.7 percent in 1995 compared to 8.6 percent in 1994. The majority of this decrease occurred as a result of utilizing one outside vendor to handle certain adjusting functions previously handled by many outside vendors.
The Company's expense ratio (total operating expenses to premiums earned) in 1995 was approximately the same as the expense ratio reported in 1994.
Net income was $1,440,523, or $.64 per common share, in 1995 compared to net income of $1,381,538, or $.57 per common share, in 1994.
Direct premiums written increased 13.5 percent in 1994 over the comparable amount in 1993. The growth was primarily attributable to an increase in the number of policies written for personal automobile, commercial multi-peril, workers' compensation and related commercial lines in Iowa, Minnesota and Wisconsin.
The Company's loss ratio was 59.3 percent in 1994 compared to 54.5 percent in 1993. The Company experienced a 13.5 percent increase in the number of claims for the year ended December 31, 1994 compared to the same period in 1993. In addition, the Company experienced an increase in the severity of claims during 1994. The majority of the increase in claim frequency and severity occurred in the homeowners line of business as a result of a catastrophe hailstorm which occurred on August 18 and 19, 1994, in three separate locations in Iowa, Minnesota and North Dakota. The increase in claim frequency and severity was partially offset by favorable development primarily in commercial multi-peril, commercial automobile liability and homeowners lines of business related to claims incurred prior to 1994.
The Company aggressively decreased loss adjustment processing costs in 1994. The Company's loss adjustment expense ratio was 8.6 percent in 1994 compared to 12.5 percent in 1993. The majority of this decrease occurred as a result of adding in-house staff to handle certain adjusting functions previously handled by outside vendors. The Company also realized a decrease of approximately $169,000 in loss adjustment expenses during 1994 as a result of a reclassification of expenses into insurance operating expenses based on a recent study of the allocation of expenses between loss adjustment and underwriting.
In December 1993, the National Association of Insurance Commissioners approved a model risk-based capital formula for property and casualty insurers to be effective with the 1994 statutory annual statement. The Company's subsidiaries have adequate surplus to meet these requirements.
In addition to the cash provided from operations, the Company maintains liquidity in its subsidiaries' investment portfolios. At December 31, 1995, Citizens Fund and ICO had total investments, at market value, of $39,275,897 compared to $34,161,671 at December 31, 1994.
The Company's subsidiaries' investment portfolios are managed by an investment advisor under the direction of the Company's Board of Directors.
On November 3, 1989, the Company obtained a $6,000,000, seven-year bank loan to fund the purchase of ICO. On November 9, 1995, the bank loan was assigned by the lender to Goodhue County National Bank of Red Wing, Minnesota ("GCNB"). The principal balance of the bank loan remaining to be paid as of December 31, 1995 was $999,000. The current interest rate is 8.75 percent, but the rate is variable and is tied to the prime rate. Under the bank loan agreement, the Company agreed to certain restrictive covenants. See Note 9 of Notes to Consolidated Financial Statements included in Part II, Item 8, "Financial Statements and Supplementary Data."
The Subsidiaries and Citizens Mutual are parties to a reinsurance pooling agreement. Under the pooling agreement, all premiums, losses, loss adjustment expenses and underwriting expenses of the three companies are combined and prorated between the parties based on their participation in the pool. Since October 20, 1989, the Subsidiaries have been 75 percent participants in the pool and Citizens Mutual has been a 25 percent participant.
Citizens Fund and Citizens Mutual losses incurred prior to October 20, 1989 (but not prior to December 24, 1986) are pooled 70 percent to Citizens Fund and 30 percent to Citizens Mutual. Losses incurred prior to December 24, 1986 are incurred solely by Citizens Mutual.
Pursuant to a loss and loss adjustment expense agreement between Prudential-LMI Commercial Insurance Company ("Prudential-LMI") and ICO, ICO losses incurred prior to October 20, 1989 are incurred solely by Prudential-LMI regardless of when such losses are reported or paid.
The Company entered into a capital access fee agreement on March 31, 1994 under which the Subsidiaries and Citizens Mutual pay a fee to the Company in consideration of its ability to raise capital for the combined insurance operations of the Subsidiaries and Citizens Mutual. The fee is paid monthly in an amount equal to one percent of the aggregate direct written premiums of the Subsidiaries and Citizens Mutual. Of the total monthly fee, 75 percent of the fee is paid by the Subsidiaries and 25 percent by Citizens Mutual. Citizens Mutual's obligation to pay its portion of the fee will terminate on the earlier of (i) the date on which the Company's currently outstanding bank loan (or any indebtedness incurred to refinance such loan) is repaid in full or (ii) the closing date of the Company's next public offering of securities.
On February 8, 1996, Meridian Insurance Group, Inc., ("Meridian") and the Company announced that they entered into a letter of intent providing for Meridian's acquisition of the Company for approximately $29 million in cash. Common shareholders of the Company would receive approximately $12.50 per common share, and the preferred shareholder, Citizens Mutual, would receive approximately $4.4 million for the Company's preferred stock. In conjunction with the transaction, Meridian would also assume control of Citizens Mutual and the Subsidiaries and Citizens Mutual would enter into arrangements with the Meridian Insurance Group companies relating to the pooling of insurance.
Short-term investments include investments maturing within one year, money market instruments and mutual funds. Short-term investments with original maturities of three months or less are considered cash equivalents for purposes of the Consolidated Statements of Cash Flows. The carrying amount reported in the balance sheets for cash and short-term investments approximate their fair value.
Realized gains or losses on sales of investments, based on specific identification of the investments sold, are credited or charged to income. Changes in unrealized appreciation or depreciation resulting from changes in the market value of investments are credited or charged to shareholders' equity, net of deferred income taxes, if any.
DEFERRED POLICY ACQUISITION COSTS Policy acquisition costs such as commissions, premium taxes and certain other underwriting expenses, which vary with and are primarily related to the production of business, are deferred and amortized over the effective period of the related insurance policies. If deferred policy acquisition expenses were to exceed the sum of unearned premiums and related anticipated investment income less losses and loss adjustment expenses, the excess costs would be expensed immediately.
BANK LOAN PAYABLE The carrying amount reported in the Consolidated Balance Sheets for the bank loan payable approximates its fair value.
INCOME TAXES Deferred Federal income taxes are provided to recognize temporary differences between income determined for financial reporting purposes and income determined for Federal income tax purposes and changes during the year in cumulative temporary differences between the tax basis and book basis and liabilities.
USE OF ESTIMATES The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the
The following schedule summarizes information related to equity securities as of December 31:
Realized and unrealized gains (losses) from investments are summarized as follows:
At December 31, 1995 and 1994, there were no investments, other than investments in U.S. Government or U.S. Government Agency securities, which exceeded 10 percent of shareholders' equity.
The Company implemented SFAS No. 109, "Accounting for Income Taxes," in the first quarter of 1993. The cumulative effect of this change was a one-time increase to earnings of $38,000 or $.01 per share.
SFAS No. 109 changed the way the Company calculates tax expense shown in the financial statements. Under prior rules, the primary objective was to match the tax expense with pretax operating income on the Consolidated Statements of Income. Under SFAS No. 109, the primary objective is to ensure the deferred tax asset or liability on the balance sheet properly reflects the amount due to or from the government in the future. As a consequence, the portion of the tax expense resulting from the change in the deferred tax asset or liability may not always be consistent with the income reported in the Consolidated Statements of Income.
Some items of revenue and expense included in the Consolidated Statements of Income may not be currently taxable or deductible on income tax returns. Therefore, the income tax assets and liabilities are divided into a current portion, which is the amount attributable to the current year's tax return, and a deferred portion, which is the amount attributable to another year's tax return. The revenue and expense items not currently taxable or deductible are called temporary differences. Income tax expense or benefits are recorded in various places in the Company's financial statements. A summary of these amounts is as follows:
Federal income tax expense is less than the U.S. Federal income tax rate of 34 percent applied to income before income taxes. The reasons for this difference and the related tax effects are as follows:
The tax effects of temporary differences giving rise to significant portions of the deferred tax assets and deferred tax liabilities are presented as follows:
On April 18, 1995, the Company amended the 1986 Stock Option Plan (a) to extend the term of such plan from September 16, 1996 to September 16, 2006, (b) to increase the number of shares of the Company's Common Stock authorized for issuance from 225,000 to 375,000 and (c) to satisfy the requirements of Section 162(m) of the Internal Revenue Code of 1986. The Company has reserved a maximum of 375,000 and 225,000 shares of common stock for issuance under the 1986 Stock Option Plan as of December 31, 1995 and December 31, 1994, respectively. At December 31, 1995 and 1994, options to purchase 285,000 and 196,500 shares, respectively, had been granted at exercise prices ranging from $3.13 to $4.00. No options have been exercised under this plan.
Citizens Mutual had a defined benefit pension plan covering substantially all of its employees which was curtailed on June 20, 1992. The Company recognized a gain of $3,266 on the final settlement which occurred in early 1993.
Citizens Mutual leases the home office, a branch office, automobiles and equipment under various agreements. Under the terms of the management services agreement, Citizens Mutual and the Company have the right to occupy the offices jointly, and the Company pays 75 percent of the rent and all other expenses under the leases. The Company's portion of rental expense for these leases was $316,729, $275,894 and $295,232 in 1995, 1994 and 1993, respectively. The Company's portion of future rentals under these leases are $328,320, $106,685, $37,852, $22,679 and $2,870 in the years 1996, 1997, 1998, 1999 and 2000, respectively. Lease payments include amounts paid to an affiliated company for the rental of computer software and equipment. The Company's annual portion of this lease is $81,795 in 1996 and 1997, $26,625 in 1998, $21,610 in 1999 and $1,801 in 2000. The future rentals do not include insurance and real estate taxes which are also payable by the Company. The home and branch office rentals also do not include utilities and maintenance expenses.
The Company has not established a liability for environmental-related losses because it does not offer a pollution liability policy. The Company's commercial liability policies contain standard Insurance Services Office pollution exclusions and no claims have been reported to date.
On November 3, 1989, the Company obtained a $6,000,000, seven-year bank loan from First Bank National Association, which has subsequently been purchased on November 9, 1995 by Goodhue County National Bank, Red Wing, Minnesota. The principal balance of the bank loan remaining to be paid as of December 31, 1995, was $999,000. The current interest rate is 8.75 percent, but the rate is variable and is tied to the prime rate. On March 31, 1994, the Company and First Bank National Association amended the bank loan to change the debt repayment schedule and revise certain covenants. The Company is now required to make quarterly principal payments of $100,000 until October 1996 when the remaining principal amount of $699,000 is due. Principal may be prepaid. Principal payments of $519,920 were made in 1995. Interest payments in 1995, 1994 and 1993 totaled $121,669, $202,928 and $243,563, respectively.
These restrictive covenants further require that the Subsidiaries maintain specified levels of capital and policyholders' surplus and that net written premiums to policyholders' surplus and combined trade ratios not exceed specified levels. The Company is currently in compliance with all requirements of the loan agreement.
Ceded reinsurance involves having other insurance companies agree to share certain risks with the Company. The primary purpose of ceded reinsurance is to protect the Company from potential losses in excess of the amount it is prepared to accept. Reinsurance may be on an individual policy basis or to protect against catastrophic losses.
During 1993, the Company implemented SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." This statement requires the Company to report balances pertaining to reinsurance transactions "gross" on the balance sheet. The Company now records reinsurance recoverables on unpaid losses and ceded unearned premiums as assets, in contrast to the Company's prior practice of netting these amounts against the corresponding liabilities. Adoption of SFAS No. 113 had no impact on net income or shareholders' equity.
The Company expects the companies with whom reinsurance is placed to honor their obligations to the Company. In the event these companies are unable to honor their obligations, the Company will pay these amounts. As of December 31, 1995, approximately 74 percent of the prepaid reinsurance premiums was with Mutual Reinsurance Bureau. All business written with that company is automatically assumed on an equal and joint basis by its six owner/assuming companies and the six
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Citizens Security Group Inc. and Subsidiaries December 31, 1995, 1994 and 1993
companies are rated from "A" to "A++" by A.M. Best Company. As of December 31, 1995, approximately 54 percent of the total reinsurance recoverable was with Swiss Reinsurance America Corporation, formerly known as the North American Reinsurance Corporation. Swiss Reinsurance America Corporation is rated "A" by A.M. Best Company and "AAA" by Standard and Poor's for its property/liability claims-paying ability.
The effect of assumed and ceded reinsurance on premiums written, premiums earned and insurance losses and loss adjustment expenses is reflected in the following table.
The following table contains information concerning the reserves of Citizens Fund and ICO for losses and Loss Adjustment Expenses ("LAE").
In December 1993, the National Association of Insurance Commissioners approved a model risk-based capital formula for property and casualty insurers to be effective with the 1994 statutory annual statement. The Subsidiaries have adequate surplus to meet these requirements.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Citizens Security Group Inc. and subsidiaries as of December 31, 1995 and 1994, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1995 in conformity with generally accepted accounting principles.
As discussed in Notes 2 and 5 to the consolidated financial statements, the Company in 1993 adopted the provisions of the Financial Accounting Standards Board's Statements of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and No. 109, "Accounting for Income Taxes."
/s/ KPMG PEAT MARWICK LLP ------------------------- Minneapolis, Minnesota March 15, 1996