The Company currently leases its corporate offices in Southfield, Michigan from 26600 Development Associates Limited Partnership. In 1998, the Company paid rent in the amount of approximately $1,130,986. The term of the lease for the offices in Southfield expires on September 30, 2004. The Company, through its subsidiaries, is also a party to various leases for locations in which such subsidiaries have offices. The Company does not consider any of these leases to be material.
Through these subsidiaries the Company develops programs, which are customized packages of services or coverages marketed to the group's members. The programs are categorized by the level of risk assumed by the Company. In managed programs, the Company usually assumes no insurance risk and generates fee revenue through program management services. In fronted programs, the Company usually assumes less than 10% or less of the underwriting risk and generates fees which are accounted for as a reduction of underwriting expenses in accordance with GAAP and statutory accounting practices. In risk-sharing programs, the Company participates with the client or producing agent in the operating results of the programs through a captive, retrospectively-rated program, or a contingent commission. In fully-insured programs, the Company provides traditional insurance without a risk-sharing mechanism and derives revenue exclusively from earned premiums and investment income. Fully-insured programs are developed only in response to a specific market opportunity and generally when the Company believes there is potential to develop a long-term risk-sharing partnership in the future.
The Company's major insurance subsidiaries, Star, Savers, Williamsburg and Ameritrust, issue insurance policies for fronted, risk-sharing and fully-insured programs. These companies are complimented by American Indemnity, which offers clients a rent-a-captive vehicle for risk-sharing programs.
The Company acquired ASI of Montgomery, Alabama in November, 1996. The acquisition was not material to the Company's results of operations. ASI is a full service risk-management operation focused on insurance pools and trust funds whose services include claims, loss control, managed care, and policy issuance. ASI's operations were consolidated with the Company's existing operations in Montgomery, Alabama.
business, utilizing its capital and licenses, and Connecticut Surety will manage the operations and assume the risk. This arrangement substantially reduces the Company's underwriting risk exposure. This enables the Company to refocus its efforts on its core business, alternative risk management.
On July 1, 1997, the Company acquired Crest, a California based holding company which owns 100% of Williamsburg, an insurance carrier, and Crest Financial Services, a risk management service company. Crest provides risk management and insurance services primarily to the trucking industry within California.
Net income in 1998 decreased $7.1 million, or 55.0%, from $13.0 million in 1997 to $5.9 million in 1998. The decrease in net income reflects charges made during the third quarter of 1998 ($8.6 million), and increased expenses for investments made in personnel and technology for future growth. These items were somewhat offset by contributions made by our recent acquisitions and growth in new and existing business in our insurance operations.
Net income in 1997 increased $4.3 million, or 49.8%, from $8.7 million in 1996 to $13.0 million in 1997. The increase in net income primarily reflects overall growth from our fee-based risk management operations as well as profitable underwriting results from our core program business. Total revenues decreased $8.1 million, or 7.4%, while total expenses decreased $14.6 million, or 14.8%. The decrease in expenses primarily relates to an increase in ceding commissions of $7.3 million, or 49.3%, a decrease in overall policy acquisition costs of $5.8 million, or 49.0%, associated with the transfer of the surety bond program, as well as overall savings in administrative costs.
Gross written premium increased by $39.6 million, or 27.0%, to $186.3 million in 1998 from $146.7 million in 1997. The increase reflects growth in existing business of $23.3 million and new programs totaling $29.2 million. This growth was somewhat offset by a one-time unearned premium transfer in 1997 ($6.5 million) and a reduction in the discontinued surety bond business ($5.4 million). The growth in existing business reflects a full year of premium writings in programs initiated in 1997, assumed business, and expansion into additional states. The increase in new business reflects the addition of twenty-four new programs in 1997, and $6.6 million from premiums produced by Ameritrust.
Net written premium increased by $18.5 million, or 24.7%, to $93.5 million in 1998 from $75.0 million in 1997. The increase reflects the acquisition of Ameritrust which contributed $5.8 million to net premiums written in 1998. Excluding the impact of Ameritrust, the greater growth in gross compared to net written premium reflects the addition of three new programs in which the Company retained limited risk, but generated risk management fees.
Gross written premium increased by $31.2 million, or 27.0%, to $146.7 million in 1997 from $115.6 million in 1996. The increase reflects growth in existing business of $13.2 million and new programs totaling $31.1 million. This growth was somewhat offset by the reduction in surety bond business and other discontinued programs. The growth in existing business reflects a full year of premium writings in programs initiated in 1996, assumed business, and expansion into additional states. The increase in new business reflects the addition of twelve new programs in 1996, and $3.7 million from premiums produced by Williamsburg.
Net written premium increased by $2.2 million, or 3.0%, to $75.0 million in 1997 from $72.8 million in 1996. The disproportionate growth between gross written and net written resulted from higher participation by risk sharing clients, fronting services, and the transfer of the surety bond program in December 1996.
Net earned premiums decreased by $16.1 million, or 19.0%, to $68.5 million in 1997 from $84.5 million in 1996. This decrease reflects the impact of the discontinuation of the surety bond program in December 1996, offset by growth in our core program business.
1997 from $16.6 million in 1996. Commissions and fees are derived from managed programs and the retail insurance agency operations and consist of the following (in thousands):
Net commissions and fees increased $8.0 million, or 33.0%, during 1998. The increase in Risk Management fees of $1.4 million primarily reflects management and claims fees from recent acquisitions. The $6.6 million increase in Agency and Sales Commissions reflects $6.1 million additional commissions from acquisitions. The remaining $0.5 million increase resulted from growth in Meadowbrook's existing agency business.
Net investment income increased $1.3 million in 1998, or 16.4%, to $9.6 million from $8.3 million in 1997 and $0.2 million in 1997, or 2.4%, from $8.0 million in 1996. The increase in investment income in 1998 was primarily the result of $23.0 million increase in cash and invested assets related to the acquisition of Ameritrust in July of 1998. The pre-tax weighted average yield on invested assets was 5.2%, 5.4%, and 5.3% in 1998, 1997, and 1996, respectively. The Company's investment philosophy is one of maximizing after-tax earnings through significant investments in tax-exempt bonds. Accordingly, the weighted average yield on invested assets on an after-tax basis was 4.6% in 1998 and 4.7% in both 1997 and 1996. Subsequent to year end the Company began to increase its position in equity securities. The Company plans to invest up to $10.0 million in equity securities. These investment activities will be provided for by cash from operations and cash from proceeds for the maturity of debt securities.
Salaries and employee benefits increased by $2.4 million, or 9.8%, to $27.4 million in 1997 compared to $25.0 million in 1996. This increase reflects additional 1997 salary and employee expenses of $3.3 million from Crest and ASI, which was somewhat offset by a reduction in surety department salaries due to the Connecticut Surety agreement.
The provision for income taxes was $0.8 million in 1998, $4.3 million in 1997 and $2.2 million in 1996, representing effective tax rates of 11.7%, 25.0% and 19.9% in 1998, 1997, 1996, respectively. The tax rates were significantly lower than the 34% corporate rate due to the Company's heavily tax-exempt investment portfolio.
In addition, one subsidiary had a secured line of credit with a bank which permits borrowings up to 80% of the accounts receivable which secure the line. The line expired February 28, 1999 and is automatically renewable each year. This line bears interest at 1% under the prime rate (prime was 7.75% at December 31, 1998). At December 31, 1998, $2,869,969 was outstanding under this line.
As of December 31, 1998 and 1997, the recorded values of the Company's investment portfolio, including cash and cash equivalents, were $200.4 million and $167.3 million, respectively. The Company's investment portfolio consists primarily of tax-exempt fixed income securities of varying maturities. The investment portfolio, at December 31, 1998, was 98.1% invested in investment grade A or above bonds (as defined by S&P). During 1999, the Company expects to increase its position in equity securities by approximately $10.0 million.
A significant portion of the Company's consolidated assets represents assets of the Company's insurance subsidiaries that may not be transferable to the holding company in the form of dividends, loans or advances. The restriction on the transferability to the holding company from its insurance subsidiaries is limited by Michigan regulatory guidelines which are as follows: The maximum discretionary dividend that may be declared, based on data from the preceding calendar year, is the greater of the insurance company's net income (excluding realized capital gains) OR ten percent of the insurance company's policyholders' surplus (excluding unrealized gains). These dividends are further limited by a clause in the Michigan law which prohibits an insurer from declaring dividends except out of earned surplus earnings of the company. Since Star is the parent insurance company, its maximum dividend calculation represents the combined insurance companies. Based upon the 1998 statutory financial statements of Star Insurance Company, as of January 1, 1999 Star may not pay any dividend to the Company, without prior approval of the Michigan Commissioner of Insurance. On December 23, 1998, the Commissioner approved payment of a $5,000,000 dividend to the Company, which was used to increase the paid in capital and surplus of Williamsburg. No dividends were paid or returned in 1997 and 1996.
The National Association of Insurance Commissioners ("NAIC") has adopted a risk-based capital ("RBC") formula to be applied to all property and casualty insurance companies. The formula measures required capital and surplus based on an insurance company's products and investment portfolio and is to be used as a tool to identify weakly capitalized companies. At December 31, 1998 and 1997, Star Insurance Company, the parent insurance company had a RBC ratio that exceeded applicable risk-based capital requirements. At December 31, 1998 and 1997, Star's statutory surplus was $70.0 million and $68.7 million, respectively; the threshold requiring regulatory involvement was $12.6 million in 1998 and $9.2 million in 1997.
The Company seeks to manage the risk exposure of its insurance subsidiaries and its clients through the purchase of excess-of-loss and quota share reinsurance. The Company's reinsurance requirements are analyzed on a specific program basis to determine the appropriate retention levels and reinsurance coverage limits. The Company secures this reinsurance based on the availability, cost, and benefits of various reinsurance alternatives.
Reinsurance does not legally discharge an insurer from its primary liability for the full amount of risks assumed under insurance policies it issues, but it does make the assuming reinsurer liable to the insurer to the extent of the reinsurance ceded. Therefore, the Company is subject to credit risk with respect to the obligations of its reinsurers. In its selection of reinsurers, the Company evaluates the financial stability of its prospective reinsurers. To date, the Company has not experienced any material difficulties in collecting reinsurance recoverables. No assurance can be given, however, regarding the future ability of any of the Company's reinsurers to meet their obligations. The following table sets forth information relating to the Company's five largest reinsurers (other than client captive quota-share reinsurers) as of December 31, 1998:
The company recognized the issues associated with the Year 2000 problem in 1995, and began a series of system replacements and upgrades to address the problem. Subsequent to the initial assessment of systems, the Company purchased a number of new entities, many of which had non-compliant systems. These systems are included in the Company's Year 2000 efforts.
Many of the system replacements and upgrades, provided the Company with dual purpose benefits in the form of new business functionality and Year 2000 compliance. The Company and each of its operating subsidiaries are in the process of implementing a Year 2000 Compliance Plan. The Company also created a corporate level steering committee to guide and monitor Year 2000 readiness.
The Company follows a 5-Step Compliance Plan which consists of the following steps: i) Investigate and inventory the assets; ii) Analyze the problems and prioritize; iii) Repair, replace, or retire the asset; iv) Test the changes at a unit and system level; and, v) Implement into production. Following this process, the Company has completed major phases by replacing and upgrading many of its operational systems and processors.
The Company has identified its significant service providers, vendors, suppliers, customers and governmental entities, and has ascertained their Year 2000 readiness through questionnaires, interviews and visits. The project recognizes that date sensitive systems may fail at different points in time depending on their function. For example, forward looking policy systems may fail earlier and therefore received corrective action sooner. Substantial numbers of the Company's operational systems are provided by third parties in either executable form or modifiable form only, and the third parties have provided Year 2000 replacement code. The Company feels that 80% of its critical operational systems have been brought into compliance, with 100% compliance expected by the 3rd Quarter of 1999.
The total cost associated with required actions necessary to become Year 2000 compliant is not expected to be material to the Company's financial position. The total estimated cost, from inception, of the necessary activities is currently estimated at $5.8 million. MEADOWBROOK INSURANCE GROUP, INC.
Amounts expended in 1998 include about $1.7 million to outside vendors to repair, upgrade or replace software and hardware problems and about $2.1 million in internal costs for planning, assessment and reprogramming incurred in the Year 2000 effort.
Amounts expected to be spent in 1999 total about $2.0 million, including about $1.0 million in outside vendor costs and another $1.0 in internal reprogramming and assessment costs.
In December 1997, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments" (SOP 97-3). SOP 97-3 provides guidance for determining when an entity should recognize a liability for guaranty-fund and other insurance-related assessments, how to measure that liability, and when an asset may be recognized for the recovery of such assessments through premium tax offsets or policy surcharges. This SOP is effective for financial statements for fiscal years beginning after December 15, 1998, and the effect of initial adoption is to be reported as a cumulative catch-up adjustment. Restatement of previously issued financial statements is not allowed. The Company has not yet determined the impact that SOP 97-3 will have on its consolidated financial statements and expects to implement it in 1999.