On February 21, 1997, Old Guard Investment purchased a 21,500 square foot facility situated on 8 acres of land adjacent to the Group's headquarters. The purchase price was $1.1 million. The parcel of land permits construction of an additional 50,000 square foot facility. This expansion was begun in late 1997 and is expected to be completed in 1998. In addition, Old Guard Fire has listed the Airport Road facility for sale.
Ceded premiums written decreased $12.5 million to $21.9 million in 1997 compared to 1996. The decrease in premiums ceded was directly attributable to the effects of reducing from 20% to 15% the quota share reinsurance agreement with our primary reinsurer, American Re-Insurance Company (American Re). Ceded premiums written under this agreement amounted to $9.4 million and $20.1 million for 1997 and 1996, respectively. The remaining decrease in ceded premiums written related to a restructuring of our property reinsurance program effective January 1, 1997, from a combination of pro-rata and excess of loss to 100% excess of loss. This change in the property reinsurance program resulted in a $2.9 million decrease in ceded premiums written. Decreases in ceded premiums as a result of the aforementioned changes in our property reinsurance were offset by a $1.6 million increase associated with the acquisition of First Delaware.
During the third quarter of 1997, the Group transferred $38.1 million of fixed income securities from available to sale to held to maturity reflecting management's intention and ability to hold these securities until maturity. This will enable the Group to extend the duration of this portion of the portfolio which will allow for the purchase of higher yielding securities. The change in classification from available to sale to held to maturity did not have a material effect on the Group's financial position or results of operations.
Net Realized Investment Gains. Net realized investment gains were $2.3 million for 1997 compared to $1.4 million in 1996 an increase of $900,000 or 68.0%. The additional gains were realized as interest rate and general economic conditions in 1997 created capital gains opportunities particularly in the equity portfolio.
Losses and Loss Adjustment Expenses. Net losses and loss adjustment expenses incurred decreased by $5.8 million, or 13.2%, to $38.5 million in 1997 from $44.4 million in 1996. Losses and loss adjustment expenses decreased in 1997 as compared to 1996 because of the absence of catastrophic claims in 1997 which amounted to $3.7 million in 1996 and favorable loss development in 1997 on prior losses of $4.3 million as compared to adverse development in 1996 of $557,000. These decreases were offset by losses incurred associated with First Delaware that amounted to $1.1 million and the decrease in the quota share reinsurance agreement which increased incurred losses and loss adjustment expenses by $836,000.
Stock Option Compensation. The $2.0 million charge for stock compensation expense is a non-recurring, non-cash expense resulting from the grant of 237,286 stock options on February 11, 1997, at an exercise price equal to the $10 per share offering price in the Group's subscription offering, and approved by shareholders at the Group's first Annual Meeting on August 19, 1997. At the time of shareholder approval the Group's stock price was $18.50 per share. In accordance with the Group's accounting policy for stock-based compensation (the optional accounting treatment afforded under Statement of Financial Accounting Standards (SFAS) No. 123 which allows companies to follow the expense recognition criteria of Accounting Principles Board Opinion No. 25), the difference between the stock price at the approval date and the exercise price is charged to earnings. Further changes in the Group's stock price or future grants of options, shareholder approval of which will not be required and which are expected to be made at the then current price of the Group's stock, will not result in additional charges to earnings.
Federal Income Tax Expense (Benefit). Federal income tax expense (benefit) as a percentage of pre-tax income or loss was 36.6% in 1997 compared to (42.6%) in 1996. The increase in the rate can be attributed to the return to profitable operations in 1997, which generated taxable income versus operating losses in 1996, and the realization of $128,000 in research and experimentation tax credits in 1996.
Ceded premiums written increased $22.6 million to $34.4 million in 1996 compared to 1995. The increase in premiums ceded was directly attributable to the effects of instituting a quota share reinsurance agreement effective January 1, 1996 between the Insurance Companies and American Re. Under the agreement, the Insurance Companies ceded 20% of all premiums, losses, and loss adjustment expenses and received a 35% ceding commission on the ceded premium. Ceded premiums written and ceded premiums earned under the agreement amounted to $20.1 million and $13.6 million, respectively, in 1996. This reinsurance agreement was designed to lessen the financial impact of adverse loss experience and had a material effect on the financial condition and results of operations of the Insurance Companies. The balance of the increase in ceded premiums written was related to catastrophe reinsurance (reinstatement premiums of $800,000) and a change in methodology in determining risk cessions under the surplus reinsurance agreement. This resulted in an increase in surplus reinsurance cessions of approximately $1.1 million.
Net premiums written decreased $19.4 million, or 28.9%, in 1996 to $47.7 million from $67.1 million in 1995. For the same comparative periods, net premiums earned decreased by $13.1 million, or 19.6%, to $53.6 million from $66.7 million. The decreases in net premiums written and net premiums earned were directly attributable to the effects of instituting the quota share reinsurance agreement between the Insurance Companies and American Re as well as the other factors discussed above.
Losses and Loss Adjustment Expense. Net losses and loss adjustment expenses incurred decreased by $6.2 million, or 12.2%, to $44.4 million in 1996 from $50.5 million in 1995. Losses and loss adjustment expenses before reinsurance on the quota share and aggregate excess of loss agreements increased during 1996 due to substantial numbers of insurance claims arising out of abnormally severe winter storms during January, 1996. Net catastrophic losses arising directly out of these storms amounted to $3.3 million In addition, non-storm related losses and loss adjustment expenses increased $2.8 million in 1996 compared to 1995 primarily because of increases in winter, fire, and wind related claims. The difference in non-storm related losses and loss adjustment expenses between 1996 and 1995 was accentuated by exceptionally favorable experience during the first nine months of 1995 as compared to 1996. This difference was moderated by favorable weather experienced in December, 1996 as compared to December, 1995. These net losses and loss adjustment expense increases for 1996 totaling $6.3 million, were reduced by implementation of the 20% quota share reinsurance agreement effective January 1, 1996 pursuant to which Group ceded $7.8 million of losses and loss adjustment expenses during 1996. Also, the Group recovered reinsurance of $1.8 million from their aggregate excess of loss reinsurer.
Loss and loss adjustment expenses were 82.8% of net premiums earned in 1996 compared to 75.8% in 1995. The impact of the catastrophic losses in 1996 on the loss ratio was 6.5 percentage points.
Federal Income Tax Expense. Federal income tax decreased $743,000, resulting in a tax benefit of $1.4 million in 1996 compared to a $684,000 tax benefit in 1995. The decrease in federal income tax expense is attributable to the decrease in taxable income in 1996 compared to 1995 in addition to the recognition of $128,000 in research and experimentation credit in 1996.
The principal sources of the Group's cash flow are premiums, investment income, maturing investments and proceeds from sales of invested assets. In addition to the need for cash flow to meet operating expenses, the liquidity requirements of the Group relate primarily to the payment of losses and loss adjustment expenses. The short and long-term liquidity requirements of the Group vary because of the uncertainties regarding the settlement dates for liabilities for unpaid claims and because of the potential for large losses, either individually or in the aggregate.
In February 1996, Old Guard Investment and American Technologies, Inc., a California based software lessor, entered into a lease financing agreement in connection with the acquisition by the Group of a new policy processing software system for approximately $2.5 million. See "Business -- Strategy." The terms of the lease financing agreement provide for an aggregate lease facility up to $1.5 million. The implied interest rate under the lease is 9.5%. As of December 31, 1996, the lease facility was fully utilized. Under the terms of the lease financing agreement, Old Guard Investment is required to make payments of approximately $57,000 per month for 24 months.
In June 1997, SFAS No. 130, "Comprehensive Income", was issued. SFAS No. 130 establishes standards for the reporting and disclosure of comprehensive income and its components (revenues, expenses, gains and losses). SFAS No. 130 requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. SFAS No. 130 requires that an enterprise (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. SFAS No. 130 is effective for fiscal years beginning after December 15, 1997. The adoption of SFAS No. 130 will not impact the Group's financial position and results of operations, but may change the presentation of certain of the Group's financial statements and related notes.
In June 1997, SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," was issued. SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. SFAS No. 131 also establishes standards for related disclosures about products and services, geographic areas and major customers. SFAS No. 131 is effective for fiscal years beginning after December 15, 1997. The Group will adopt SFAS No. 131 in 1998 and is currently in the process of determining the effect of SFAS No. 131 upon its financial reporting requirements.
Beginning in 1991, the Group began evaluating and reprogramming its own computer systems to address the Year 2000 problem. By the end of 1992, all necessary programming work was completed and implemented. With the completion of these changes, Year 2000 issues are not likely to result in any material adverse disruption in the Group's computer systems or its internal business operations. The cost of this work through 1992 was approximately $140,000.
To ensure that all software applications are Year 2000 compliant, the Group is currently testing all applications in a true Year 2000 environment. This testing is being conducted on hardware and system operating software that has the operating system date beyond 1999. This project is scheduled to be completed by June 30, 1998. It is estimated that the total remaining cost to complete this phase and become Year 2000 compliant will be approximately $10,000.
Many experts now believe that the Year 2000 problem may have a material adverse impact on the national and global economy generally, In addition, it seems likely that if businesses are materially damaged as a result of Year 2000 problems, at least some such businesses may attempt to recoup their losses by claiming coverage under various types of insurance policies. And, although management has concluded that under a fair reading of the various policies of insurance issued by it no coverage for Year 2000 problems should be considered to exist, it is not possible to predict whether or to what extent any such coverage could ultimately be found to exist by courts in the various jurisdictions. Accordingly, important factors which could cause actual results to differ materially from those expressed in the forward looking statements include, but are not limited to, the inability of the Group to accurately estimate the impact of the Year 2000 problem on the insurance issued by, or other business operations of the Group.
Certain statements contained in the Management's Discussion and Analysis and other statements made throughout this report constitute "forward-looking statements" (as such term is defined in the Private Securities Litigation Reform Act of 1995). Such forward-forwarding statements involve certain assumptions, risks and uncertainties that could cause actual results to differ materially from those included in or contemplated by the statements. These assumptions, risks and uncertainties include, but are not limited to those associated with factors affecting the property-casualty insurance industry generally, including price competition, size and frequency of claims, escalating damage awards, natural disasters, fluctuations in interest rates and general business conditions; the Group's dependence on investment income; the geographic concentration of the Group's business in the Northeast United States, the adequacy of the Group's liability for losses and loss adjustment expenses; government regulation of the insurance industry and the other risks and uncertainties discussed or indicated in all documents filed by the Group with the Securities and Exchange Commission. The Group expressly disclaims any obligation to update any forward-looking statements as a result of developments occurring after the release of this report.
The Group is a regional insurance holding company that, on February 11, 1997, completed a subscription offering in which it raised $38.3 million, net of issuance costs of $3.7 million, in exchange for 4.2 million shares of no par common stock. Concurrent with the offering and in accordance with a plan of conversion, Old Guard, Old Guard Fire and First Patriot (collectively, the Insurance Companies) were converted from mutual to stock insurance companies and issued shares of common stock to the Group in exchange for $16.0 million. As a result of the conversion, the Insurance Companies are wholly-owned subsidiaries of the Group. Effective January 1, 1997, OGIHC acquired 80% of the outstanding common stock of First Delaware for $3.3 million which included a capital infusion of $1.5 million. Pro forma results for 1996, including First Delaware as if it had been 80% owned during that period and as if the Group had converted to the stock form, are as follows:
The Group is a property and casualty insurer of farms , small and medium size businesses and residences in rural and suburban communities in Pennsylvania, Delaware and Maryland, with Pennsylvania comprising in excess of 85% of total direct premiums written. The principal lines of business are homeowners, farmowners, personal automobile and commercial multi- peril which represent approximately 25%, 21%, 24% and 14%, respectively, of direct premiums written.
Premiums written are earned on a pro rata basis over the terms of the respective policies. Unearned premiums represent the unexpired portion of the policies in-force.
The liability for losses and loss adjustment expenses includes amounts determined on the basis of claims adjusters' evaluations, estimates of losses incurred but not reported calculated using historical experience and other estimates. Any adjustments resulting from changes in estimates are reflected in current operating results. Estimated amounts of salvage and subrogation recoverable on paid and unpaid losses are reflected as a reduction of the liability for losses and loss adjustment expenses.
The Group's insurance subsidiaries are subject to assessments in the states in which each insurance company is licensed. Assessments consist primarily of charges from the residual markets and guaranty fund associations. The expense is recognized upon notification.
A reconciliation of the Group's statutory net income and policyholders' surplus to the Group's net income and shareholders' equity, under generally accepted accounting principles (GAAP), is as follows:
The cost and estimated fair value of investments at December 31, 1997 and 1996 were as follows:
The gross realized gains and losses on investment securities in 1997, 1996 and 1995, are as follows:
Insurance laws require that certain amounts be deposited with various state insurance departments for the benefit and protection of policyholders. The amortized cost of fixed income securities on deposit with governmental authorities was $820,402 and $616,067 at December 31, 1997 and 1996, respectively.
Changes in estimates for prior years in 1997 are attributable to favorable loss development primarily in workers' compensation reserves. The changes in estimates for prior years in 1996 and 1995 are primarily attributable to incurred loss development experience across all lines of business.
The Group's insurance subsidiaries have geographic exposure to catastrophic losses in certain Mid Atlantic states. Catastrophes can be caused by various events including hurricanes, windstorms, earthquakes, hail, explosions, severe weather and fires, and the incidence and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Most catastrophes are restricted to small geographic areas; however, hurricanes and earthquakes may produce significant damage in large, heavily populated areas. The Group's insurance subsidiaries generally seek to reduce their exposure to catastrophe through individual risk selection and the purchase of catastrophe reinsurance.
Management believes that its liability for losses and loss adjustment expenses is fairly stated, in accordance with generally accepted actuarial principles and practices. However, estimating the ultimate claims liability is a complex and judgmental process inasmuch as the amounts are based on management's informed estimates and judgments using data currently available. As additional experience and data become available regarding claim payments and reporting patterns, legislative developments, and economic conditions, the estimates are revised accordingly and the impact is reflected currently in the consolidated financial statements.
Property and equipment consisted of the following at December 31, 1997 and 1996:
The Group's insurance subsidiaries maintain reinsurance agreements which provide coverage for individual property and liability claims, as well as, catastrophic events. These reinsurance programs mitigate loss exposure from individually large losses and an aggregation of losses arising from a single loss event. The Group is contingently liable for reinsured claims if the assuming reinsurers cannot meet their obligations under the reinsurance agreements.
Earned premiums $10,732,903 $13,647,111 Unearned premiums $5,198,631 $4,867,616 Losses and loss adjustment expenses incurred $6,943,898 $7,779,576
The Group performs credit reviews of its reinsurers, focusing on financial stability and commitment to the reinsurance business. At December 31, 1997, the Group had a reinsurance recoverable of approximately $13,792,000, net of applicable ceded reinsurance payable, due from American Re. American Re's A.M. Best rating is A+.
Ceded premiums subject to retrospective rate adjustments were approximately $1,450,000, $2,000,000 and $1,600,000 for 1997, 1996 and 1995, respectively. No material adjustments from amounts originally estimated have been recorded.
Subsidiaries of the Group jointly maintain cash management programs with a local financial institution. The programs provide for draws by any member of the Group against a line of credit in the event of overdrafts. The line of credit is subject to a maximum of $1,500,000 and bears interest at prime. The Group must maintain zero balances on the lines for one thirty-day period each year and must meet certain demand deposit requirements. No borrowings were made under these arrangements during 1997 or 1996. The Group also maintains a $15,000,000 acquisition line of credit which is subject to certain approvals by the granting institution before funds can be drawn.
The tax effect of significant temporary differences that give rise to the Group's net deferred tax asset as of December 31, is as follows:
The Group applies the APB Opinion No. 25 expense recognition criteria of SFAS No. 123 and related interpretations in accounting for its stock compensation plan. Accordingly, no compensation cost has been recognized, except for the one-time charge of $2,016,931 described later herein, in the accompanying financial statements for the difference between the fair value of stock-based compensation plans and the intrinsic value. Had compensation cost for stock-based compensation plans been determined using fair value, the Group's net income and earnings per share for 1997 would have been as follows:
On February 11, 1997, in connection with the Group's subscription offering, 237,286 stock options were granted to directors and officers. These options have an exercise price of $10 per share and are exercisable by the grantee for a period of ten years. The granting of these options was approved by shareholders at the Group's first Annual Meeting on August 19, 1997. At that time the price of the Group's stock was $18.50 per share. The difference between the price of the stock at the measurement date and the exercise price of the options has been charged to earnings in 1997. Since these options were granted as non-qualified incentive stock options, the Group has recognized a deferred tax asset on the difference between the exercise price and the value of the options at the measurement date.
Outstanding at January 1, 1997 - N/A Granted in 1997 247,286 $10.42 Exercised in 1997 - N/A Forfeited in 1997 - N/A Outstanding at December 31, 1997 247,286 $10.42
Dividends on shares held by the ESOP are paid to the ESOP trust and together with Group contributions, are used by the ESOP to repay principal and interest on the outstanding debt. Shares are released for allocation to participants as the debt is retired. Interest incurred on the ESOP notes amounted to $ 282,079 in 1997. The Group paid dividends on the stock held by the ESOP of $20,275.
The Group has a discretionary noncontributory profit sharing plan covering eligible employees. The Group's contribution to the plan amounted to $58,224, $268,043 and $262,945 in 1997, 1996, and 1995, respectively.
Neffsville Mutual Fire Insurance Company (Neffsville) and New Castle Mutual Insurance Company (New Castle) are affiliated with the Group through common management and reinsurance programs.
Neffsville maintains a quota share reinsurance agreement with OGF whereby 90% of Neffsville's business was assumed by Old Guard Fire during 1997, 1996 and 1995. The following summarizes the business ceded under the reinsurance agreement as of and for each of the years ended December 31:
- A requirement that the Group pay all purchasers of common stock, either on a mandatory basis or at the election of the purchaser, as damages or otherwise, (I) the purchase price paid per share of common stock acquired in the Conversion, plus interest, (ii) the market value per share of common stock acquired, or (iii) the greater of (I) or (ii), less, in each case, any proceeds received by such purchaser from the sale of the common stock. No assurance can be given that the group would have sufficient funds at that time to honor any such obligation; or
- The Group could be required to pay or distribute to all or some policyholders of the Insurance Companies, either on a mandatory basis or at the election of the policyholders, an amount equal to the statutory surplus of the Insurance Companies as of the date of the Conversion as damages or otherwise. Such distribution could be required to be made in cash, common stock or other debt or equity securities. No assurance can be given that the Group would have sufficient funds, or the capacity to borrow sufficient funds, at that time to honor any such obligation. Any required distribution of common stock or other equity securities would materially dilute the interests of existing holder of the common stock.
In the event that the Group could not honor its obligations under any remedy imposed by the Court, the Group could be forced to seek the protection of the bankruptcy laws and the Insurance Companies could be deemed insolvent and seized by the Department.
Earnings per share Basic .31 .07 .24 .30 Diluted .30 .07 .24 .30
Our report on the consolidated financial statements of Old Guard Group, Inc. (the Group) is included in Item 8 of this Form 10-K. In connection with such audits of our financial statements, we have also audited the related financial statement schedules included in Item 8 of this Form 10-K. These financial statements schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits.