Increased premium volume in recent periods has been the result of the Company's strategy of acquiring niche businesses and increasing premiums written in selected lines. The Company's most significant recent acquisition was its purchase in July 1993 of The Redland Group, Inc., which provides MPCI, crop hail and other named peril crop insurance and certain standard property and casualty coverages to the rural market. Following its acquisition by the Company, Redland has increased the volume of its MPCI Premium, and was the fourth largest MPCI writer in the United States in 1996.
Forward-looking information set forth herein does not take into account any impact from any adverse weather conditions during the 1997 crop season, or the various other factors noted above which may affect crop and non-crop operation results.
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, CRC, which generated significantly higher premiums per policy than the traditional 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.
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 believes that this line of business can return to profitability as the new partnership arrangements grow.
Offsetting these deteriorating results in the Program division were improved results in the Company's Transportation department. Within the Transportation department, the Company's loss and expense ratio improved from 120.6% during the year ended December 31, 1995 to 103.6% during 1996. While the department did not produce an underwriting profit, the Company believes that the improvement in the Company's underwriting ratios indicates that the actions taken during 1995 and 1996 to reorganize this department are having a positive effect.
The Company's interest expense also increased during 1996 as compared to 1995. This increase in interest expense was due to an increase in the Company's borrowings under its bank facility which increased from an average of $34.3 million during the 1995 to $69.0 million during 1996. Offsetting this increase in the size of borrowings was a decline in the average interest rate under the bank facility from 7.6% during 1995 to 7.1% during 1996. The additional borrowings under the bank facility were contributed to the Company's subsidiaries in order to support underwriting activities and maintain capital adequacy ratios at a level commensurate with the Company's current A- rating by A.M. Best & Company.
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. During 1997, the Company expects to again increase the use of quota share reinsurance within the Program division, and with the continued growth in new programs offsetting high initial expenses, expects the expense ratio of this division to fall in 1997.
The Company's net income fell 80.3% from the year ended December 31, 1995 from $21.1 million in 1994 to $4.2 million in 1995. This reduction in net income resulted as premium growth in the Company's General Agency and Program divisions, an increase in investment income and an increase in underwriting profits from the Company's Crop division were offset by higher than expected losses in the General Agency and Program divisions, an increase in the Company's expense ratio and a change in the Company's tax status.
The Company's Non-Standard Auto division did not grow during 1995 as premiums remained relatively stable with $29.3 million in direct written premium during 1995 as compared to $29.4 million during 1994. This lack of growth during 1995 resulted primarily from the Company's desire to establish new computer software for its principal programs before seeking additional growth opportunities.
The Company's Crop division also experienced strong premium growth in 1995 as direct written premiums and net earned premiums increased 21.9% and 30.1% respectively from 1994 to 1995. This premium growth resulted from an increase in the Federal MPCI program, and increases in premium levels under the Company's crop hail insurance program resulting from an increase in rates and the writing of more exposure units in certain states. In late 1994, Congress expanded the MPCI program by enacting the Reform Act. The Act seeks to encourage farmers to participate in the MPCI program and thereby reduce dependencies on traditional disaster relief measures. As a result, the Company's MPCI premium increased 42.8% from $128.4 million in 1994 to $183.3 million in 1995. In addition, the Company's MPCI retention also increased from $77.4 million in 1994 to $104.3 million in 1995. The crop industry had experienced several years of adverse experience in the crop hail business prior to 1995, and as a result, crop hail rates have increased while capacity has decreased. Therefore, the Company was able to increase its crop hail writings from $46.5 million in direct written premiums in 1994 to $62.8 million in direct written premiums for 1995.
The Company's investment income increased 55.6% from $13.3 million in 1994 to $20.7 million in 1995 while the Company's net realized capital gains increased 388.6% from $0.6 million in 1994 to $2.7 million in 1995. Investment income increased from both an increase in the average size of the Company's investment portfolio as well as an increase in the average yield on the Company's fixed income investments. The average size of the investment portfolio increased from $220.1 million in 1994 to $321.3 million in 1995 while the Company's pre-tax yield on its portfolio increased from 6.0% in 1994 to 6.4% in 1995. The Company's investment portfolio increased from additional borrowings under the Company's credit facility, positive cash flows from operations, funds from the exercise of warrants in December of 1994 as well as retained earnings. Investment yields increased as the overall interest rate environment provided higher yields during 1995 as compared to 1994.
While 1995 was a difficult growing season, the Company's underwriting income within its Crop division increased from $12.3 million in 1994 to $14.9 million in 1995. This increase was a result of the growth in the MPCI premium and better results in the Company's hail division, offsetting negative results in the Company's named peril crop programs principally from an active storm season in California during 1995. The 1995 growing season in the upper midwest was afflicted with wet weather during the planting season resulting in delayed planting of crops, followed by periods of severe heat in July, stressing newly emerging crops, and an early frost in September of 1995. No such adverse activity occurred in 1994. In addition, the Reform Act changed the profit sharing matrix for participants in the MPCI program providing a higher degree of profit sharing, particularly for companies accepting risks in the commercial underwriting pool. These two factors combined to change the percentage of the Company's profit sharing under the MPCI program from 22.0% in 1994 to 13.4% in 1995. This decrease in the profit sharing percentage was more than offset by the described increase in MPCI premiums and improved crop hail results. The Reform Act was not passed until October of 1994, and therefore, the federal agencies charged with the oversight of the program had a limited time frame in which to enact guidelines and administrative rules and procedures for changes brought about by the Reform Act. In addition, the wet planting season created additional stress on the MPCI program which required further administrative changes by the federal government. As a result, exact results of the MPCI program were more difficult to estimate at December 31, 1995 than they had been in previous years.
The aforementioned positive factors were offset by higher than expected losses in the Company's General Agency and Program division, including losses resulting from the strengthening of reserves during 1995 for prior year losses. During the second quarter of 1995, the Company experienced a deterioration in the loss ratio of its commercial automobile liability business. At that time, this was principally attributable to a more rapid emergence of losses from the 1994 year than had been expected by the Company. This trend continued in the third quarter of 1995, and while the noted deterioration was principally in the automobile liability business, the Company believed that similar deviations were likely to appear in other lines of business which develop more slowly than automobile, and therefore, the Company chose in the third quarter to evaluate all major lines of business. After an extensive study by the Company in consultation with its independent actuaries, a pre-tax charge of $17.5 million was made in the third quarter for prior year losses. For the year, the Company increased its reserves for 1994 and prior year losses by $22.3 million pre-tax.
As an insurance holding company, the Company's assets consist primarily of the capital stock of its subsidiaries, two surplus notes issued by one of its insurance company subsidiaries and investments held at the holding company level. The Company's primary sources of liquidity are dividends and other distributions from subsidiaries, interest payments on the surplus notes, tax sharing payments from its subsidiaries and net investment income from, and proceeds from the sale of, holding company investments. The Company's liquidity needs are primarily to service debt, pay operating expenses and taxes, and make investments in subsidiaries.
The principal liquidity needs of the Insurance Companies are to fund losses and loss adjustment expense payments and to pay underwriting expenses, including commissions and other expenses. The available sources to fund these requirements are net premiums received and, to a lesser extent, cash flows from the Company's investment activities, which together have been adequate to meet such requirements on a timely basis. The Company monitors the cash flows of the Insurance Companies and attempts to maintain sufficient cash to meet current operating expenses, and to structure its investment portfolio at a duration which approximates the estimated cash requirements for the payment of loss and loss adjustment expenses.
The Company's profit or loss from its MPCI business is determined after the crop season ends on the basis of a profit sharing formula established by law and the RMA. At such time, the Company receives a profit share in cash, with any amount in excess of 15% of its MPCI Retention in any year carried forward to future years, or it must pay its share of losses. The Company recognized $37.9 million, before private reinsurance, in profit sharing earned on the MPCI business during 1996, and in addition, recognized $4.3 million during 1996 in profit sharing earned on 1995 MPCI business.
In the crop hail insurance business, premiums are generally not received until after the harvest, while losses and other expenses are paid throughout the year.
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 1996 year and have exceeded these requirements.
The Company's stockholder's equity increased by approximately 17% or $30 million from December 31, 1995 to December 31, 1996. The principal components of this change in stockholder's equity were an increase in the Company's retained earnings from an accumulated deficit at December 31, 1995 of $18.8 million to retained earnings of $11.4 million at December 31, 1996, an increase in capital in excess of par value of $1.3 million as a result of the exercise of certain outstanding warrants and stock options, and an increase in the Company's unrealized loss on available-for-sale securities, net of tax, of $1.5 million.
Cash flows from operations for the year ended December 31, 1996 were $42.9 million as compared to cash flows from operating activities of $46.5 million during 1995. The positive cash flows for both 1996 and 1995 have provided adequate capital to meet all of the Company's cash needs.