The Company owns a three-story office building at 195 Lake Louise Marie Road, Rock Hill, New York, in which its executive offices and insurance operations for Frontier Insurance are located. A 50,000 square foot addition is under construction and is anticipated to be completed in September 1997. The Company also owns a one-story building in Rock Hill, New York, which it uses for storage and a portion of which is rented, and an airplane for which it leases facilities at a local airport.
The Company believes that upon completion of the addition at Rock Hill, New York, it will have adequate space for expansion of its existing operations.
A variety of factors accounted for the 35.6% growth in net premiums earned, the principal factor being increases in the majority of the Company's core and new program business, partially offset by a decrease in workers' compensation, particularly the cotton gin program, and by the increased ceding of net premiums earned under the Company's aggregate excess of loss reinsurance contract effective January 1, 1996, pursuant to which 13.5% and 14% of net premiums earned in 1996 and 1995, respectively, was ceded for all lines of business, except certain classes of surety bonds, realtors' errors and omissions and all of the net premiums earned by United Capitol and Regency.
Growth in the surety net premiums earned continued in 1996, primarily attributable to expanded writings of license and permit bonds, small contractors bonds, miscellaneous bonds, custom bonds and bail bonds.
Net premiums earned for the workers' compensation line decreased primarily as a result of decreases in the specialty niche program for cotton gins and feed lots, decreases in the social services programs due to price competition, and a lesser required participation in the National Workers' Compensation Reinsurance Pools. These decreases were partially offset by increases in workers' compensation from the alternative risk program which the Company initiated in 1996.
Net investment income before realized capital gains and losses increased 23.9% due principally to increases in invested assets resulting from the proceeds of the issuance of Convertible Trust Originated Preferred Securities ("Convertible TOPrS") in October 1996, cash inflow from regular operations, and the contribution to net investment income by United Capitol and Regency, partially offset by the interest charge on funds held by the Company for the benefit of the reinsurer of the Company's aggregate excess of loss reinsurance contract. Total net investment income increased 29.5% due to the aforementioned increase in net investment income and an increase in realized capital gains. The average annual pre-tax yield on investments, excluding the charge for funds held under the aggregate excess of loss reinsurance contract and realized capital gains and losses, was 6.4%, unchanged from the previous year. The average annual after-tax yield on investments, excluding the charge for funds held under the aggregate excess of loss reinsurance contract and realized capital gains and losses, was 4.8%, as compared to the previous year.
Total expenses increased by 35.6%, similar to the 35.6% increase in net premiums earned. Losses and loss adjustment expenses ("LAE") increased by 30.8% which included a 8.5% increase in losses and a 97.5% increase in LAE. The increase in losses was substantially lower than for net premiums earned as a result of a one-time reallocation of loss reserves to LAE reserves, favorable reserve development in accident years prior to 1996 for general liability and workers' compensation and recoveries under the aggregate excess of loss reinsurance contract which provides coverage for certain losses and LAE in excess of 65% of the net premiums earned for the 1996 accident year, partially offset by higher loss and LAE ratios for business written in 1996. The Company also increased prior years' reserves by approximately $13 million, which was entirely offset by an increase in the same amount of the subrogation recoverable recognized in conjunction with the favorable December 1995 ruling in the New York Court of Appeals, described in Note C of the Notes to Consolidated Financial Statements. Such increase in the subrogation recoverable resulted from further documentation and verification in the second quarter of 1996 of claims already paid by the Company and reserves held by the Company that the Company believes are reimbursable by the State of New York. The 97.5% increase in LAE resulted from the increase in loss and LAE ratios, a one-time reallocation of loss reserves to LAE reserves, partially offset by a change in the line of business mix to those having a lower percentage relationship
of LAE to losses and the allocation of recoveries under the aggregate excess of loss contract. Due to the disproportionate relationship of losses and LAE to net premiums earned, the loss and LAE component of the GAAP Combined Ratio was 2.1 percentage points lower than in the comparable 1995 period. The 40% increase in the amortization of policy acquisition costs, underwriting and other expenses was attributable primarily to an increase in direct commission expense resulting from growth in programs with higher commission rates, a decrease in reinsurance contingent commissions, increased staffing and marketing expenses related to expansion, a reduction in assessment recoveries from the Texas Workers' Compensation Insurance Facility, and salary increases. The 120% increase in interest expense was primarily the result of increased interest expense associated with the borrowing under the line of credit. The Company also incurred approximately $2,277,000 of expenses in 1996 associated with the Convertible TOPrS. See NOTE M of the NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS. As the non-claim related component of the GAAP Combined Ratio increased at a greater rate than premiums earned, the non-claim component was 1.2 percentage points higher than in the comparable 1995 period. The total GAAP Combined Ratio decreased by .9 percentage points to 91.8% as a result of the above.
The foregoing changes resulted in income before income taxes of $56.7 million for the year ended 1996, a 30.9% increase from the comparable 1995 period. Net income for the year increased by $8.9 million, or 28.4%.
Growth in the surety net premiums earned continued in 1995, primarily attributable to expanded writings of license and permit bonds, with bonds for small contractors, miscellaneous bonds, and bail bonds also showing substantial percentage increases. The increase in license and permit bonds was primarily attributable to the Company's acquisition in April 1994 of the license and permit bond business of a California insurance agency.
Net investment income before realized capital gains and losses increased 22.8% due principally to increases in invested assets resulting from the proceeds of the $25 million borrowing under a line of credit facility, the January 1995 commutation of certain medical malpractice reinsurance treaties, and cash inflow from regular operations, partially offset by the interest charge on funds held by the Company for the benefit of the reinsurer of the Company's aggregate excess of loss reinsurance contract. Total net investment income increased 30.8% due to the aforementioned increase in net investment income and a decrease in realized capital losses. The average annual pre-tax yield on investments, excluding the charge for funds held under the aggregate excess of loss reinsurance contract and realized capital gains and losses, decreased to 6.4% from 6.6%. This decrease is primarily the result of generally lower interest rates available for funds invested in 1994 and 1995, and a decrease in the Company's holdings of higher yielding investments, as a result of maturities and calls for redemption. The average annual after-tax yield on investments, excluding the charge for funds held under the aggregate excess of loss reinsurance contract and realized capital gains and losses, decreased to 4.9% from 5.4%, primarily for the reasons described above.
Gross claims adjusting income decreased 49.0% primarily as a result of a decrease in claim services provided to outside companies, principally Markel Corporation.
At December 31, 1996, the Company's total assets of $1.25 billion was comprised of the following: cash and investments, 67.9%; reinsurance recoverables, 15.5%; premiums receivable and agents balances, 6.2%; deferred expenses (policy acquisition costs and deferred federal income taxes), 4.9%; home office building, property and equipment, 3.0%; and other assets, 2.5%.
At December 31, 1996 and 1995, the Company's fixed maturity securities included mortgage-backed bonds of $297.8 million and $192.1 million, respectively, which are subject to risks associated with variable prepayments of the underlying mortgage loans. Prepayments cause those securities to have different actual maturities than that expected at the time of purchase. Securities that have an amortized cost greater than par that are backed by mortgages that prepay faster than expected will incur a reduction in yield or loss, while securities that have an amortized cost less than par that are backed by mortgages that prepay faster than expected will generate an increase in yield or gain. The degree to which a security is susceptible to either gains or losses is influenced by the difference between its amortized cost and par, the relative sensitivity of the underlying mortgages backing the assets to prepayments in a changing interest rate environment and the repayment priority of the securities in the overall securitization structure.
At December 31, 1996, the following table provides a profile of the Company's fixed maturity investment portfolio by rating:
Cash flow generated from operations for 1996, 1995, and 1994 was $116.5 million, $105.0 million, and $81.9 million, respectively, amounts adequate to meet all of the Company's obligations.
In January 1994 and 1995, investment funds were increased by $9.0 million and $3.9 million, respectively, from the commutation of the 1990, and 1991 treaty years under the medical malpractice reinsurance treaties, resulting in the receipt of $6.1 million and $3.9 million, respectively, in cash and a concomitant increase in reserves for unpaid losses and LAE, with the balance received from the collection of contingent commissions earned by the Company for the 1994 treaty year.
In April 1994, the Company completed the acquisition of Spencer Douglass Insurance Associates, Inc., a California license and permit bond insurance agency, for $3.2 million and entered into a five-year consulting agreement with the owner/principal of the agency. Personnel of the agency involved in placing and servicing the acquired business have become employees of the Company, operating from their respective locations in Phoenix, Arizona; Reno and Las Vegas, Nevada; and San Jose, Orange County and La Jolla, California. All new and renewal policies with respect to the approximately $5 million to $6 million of license and permit bond business acquired are issued by the Company.
As a result of a review by AM Best of Frontier Insurance Company's A- (Excellent) rating, the Company agreed with AM Best to make a $45 million capital infusion to Frontier Insurance Company by June 30, 1995 in order to fund its projected growth and retain its A- rating. At June 30, 1995, the Company had completed the $45 million capital infusion, utilizing a combination of funds previously held by the Company and loan proceeds from The Bank of New York loan.
In November 1995, the Company acquired the realtors' errors and omissions book of business from Bankers Multiple Line Insurance Company ("BMLIC") for $400,000. The personnel of BMLIC involved in placing and servicing the acquired business have become employees of the Company and will continue to operate from their location in Louisville, Kentucky.
In May 1996, the Company completed the acquisition of United Capitol Holding Company ("United Capitol Holding"), the direct or indirect parent of United Capitol Insurance Company, United Capitol Managers, Inc. (renamed Olympic Underwriting Mangers, Inc.) and Fischer Underwriting Group, Inc., for $31.0 million. United Capitol Holding, through its subsidiaries, underwrites specialty risks such as asbestos abatement, environmental liability and directors' and officers' liability.
In March 1992, the Company commenced quarterly cash dividend payments. Cash dividends declared in 1996, 1995 and 1994 were $7,300,000, $6,200,000, and $6,000,000, respectively.
On November 10, 1994, the Company authorized a stock repurchase program to purchase up to 1,000,000 shares of its Common Stock at such times and prices as the Company deems advantageous, in compliance with SEC Rule 10b-18 at the discretion of the Chairman of the Board. There is no commitment or obligation on the part of the Company to purchase any particular number of shares, and
The Company, through its subsidiary, United Capitol, in the ordinary course of business, writes insurance on accounts which have hazardous, unique or unusual risk characteristics. Since United Capitol's organization in 1986, its liability policies have included an absolute pollution coverage exclusions, except for policies providing pollution liability coverage to contractors involved in the remediation of pre-existing pollution. In addition, United Capitol's product liability and other primary general liability policies contain exclusions for coverage of claims for bodily injury or property damage caused by exposure to asbestos, other than for the policies providing coverage to asbestos abatement contractors for third party claims alleging bodily injury or property damage as a result of exposure to asbestos. Employees of the insured contractor and others required to be in the abatement area are excluded from coverage.
The Company has been served with several purported class actions alleging violations of federal securities laws by the Company and, in some cases, by certain of its officers and directors; certain other actions also allege violations of the common law. The complaints relate to the Company's November 5, 1994 announcement of its third-quarter financial results and allege that the Company previously had omitted and/or misrepresented material facts with respect to its earnings and profits. The Company believes the suits are without merit and has retained special legal counsel to contest them vigorously and believes that the Company's exposure to liability under such lawsuits, if any, would not have a material adverse effect on the Company's financial condition.