Lafayette Insurance Company owns and occupies a two-story building in New Orleans, Louisiana, which serves as its home office.
The selected financial data herein has been derived from the financial statements of United Fire and its subsidiaries. The data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the “Consolidated Financial Statements and related Notes”.
This discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are not historical facts and which involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. Such forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry in which we operate, management's beliefs, and assumptions made by management. Words such as "expects," "anticipates," "intends," "plans," "believes," "continues," "seeks," "estimates," "predicts," "should," "could," "may," "will continue," "might" and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed in such forward-looking statements. Among the factors that could cause our actual outcomes and results to differ are the following: uncertainties with respect to loss reserving; the occurrence of catastrophic events or other insured or reinsured events with a frequency or severity exceeding our estimates; the actual amount of new and renewal business and demand for our products and services; the competitive environment in which we operate, including price, product and service competition; developments in domestic and global financial markets that could affect our investment portfolio and financing plans; estimates of the financial statement impact of regulatory actions; uncertainties relating to government and regulatory policies; legal developments; changing rates of inflation, interest rates and other economic conditions; the impact of mergers and acquisitions, including the ability to successfully integrate acquired businesses and achieve cost savings; a continuation of the global economic slowdown or a broad downturn in the economy in general; our relationship with our agencies; the valuation of invested assets; the recovery of deferred acquisition costs; or our relationship with our reinsurers. These are representative of the risks, uncertainties and assumptions that could cause actual outcomes and results to differ materially from what is expressed in forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission, we do not have any intention or obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.
During the third quarter of 2001, we began a review of our exposure to the events of September 11, 2001. Because we do not write direct premiums in the eastern United States, we knew that we did not have any material direct exposure as a result of these events. However, we did have assumed reinsurance claims related to the terrorist attacks, resulting in after-tax charges in 2001 of $4,479,000, or $0.45 per share.
We recorded reserves for the September 11 events based upon the “one event” theory. If the insurance industry or the judicial system determines that the events of September 11 were multiple events, our reserves for the September 11 catastrophe could be inadequate, requiring us to increase these reserves.
On a consolidated basis, net income, which is net operating income plus net realized gains and losses on securities, was $24,093,000, or $2.40 per share in 2001, compared to $15,527,000, or $1.55 per share, in 2000. We recorded net realized after-tax losses of $121,000 in 2001 and $1,186,000 in 2000. In both years, other-than-temporary impairments on a small number of fixed income securities contributed to realized losses.
Losses and loss adjustment expenses incurred represent actual payments made and changes in estimated future payments to be made, including expenses required to settle both reported and unreported losses. For reported losses, we establish reserves based upon policy provisions, accident facts, injury or damage exposure, trends in the legal system, historical results and other factors. For unreported losses, we establish reserves for each line of business based on the probable number and nature of losses, determined on the basis of historical and statistical information. Once we have established reserves, we closely monitor and adjust them as losses develop. We regularly review our reserve calculations and, as required by state law, we engage an independent actuary to render opinions as to the adequacy of the statutory reserves we establish. We file the actuarial opinions in those states where we are licensed. There are no material differences between our statutory reserves and those established under generally accepted accounting principles.
”Other liability” is business insurance covering bodily injury and property damage arising from general business operations, accidents on the insured’s premises and products manufactured or sold.
Improvement in our commercial automobile business more than offset deterioration in our personal automobile business. In our commercial automobile business, we have imposed stricter underwriting guidelines and aggressively pursued rate increases. We also continue to increase rates and tighten eligibilities for our personal automobile business.
The pure loss ratio deteriorated (increased) to 72.7 percent in 2001 compared to 62.0 percent in 2000 in the fire and allied lines business, which includes fire, allied lines, homeowners, commercial multiple peril and inland marine. In 2001, we experienced a greater number of fire losses than in 2000. In 2000, our homeowners’ business was negatively affected by a hailstorm that swept through the New Orleans area in January 2000.
In 2001, Texas homeowners’ claims related to mold increased. While mold is a potential problem in several states, Texas is at the forefront of mold insurance issues. Texas is unlike many states because it does not permit insurance companies to exclude mold coverage from homeowners policies. In response, some property and casualty insurers no longer write homeowners insurance in Texas. In 2001, we responded to the mold issue by implementing more stringent underwriting guidelines, new claims handling procedures and price increases. We also plan to implement any coverage reforms permitted by the Texas Department of Insurance that would enable us to reduce our exposure in Texas to claims related to mold. Due to the uncertainty of potential changes in Texas regulation, we cannot estimate our future probable liability for mold claims.
The second component of the statutory combined ratio is the expense ratio. In 2001, our expense ratio improved to 30.3 percent, compared to 31.9 percent in 2000. Through a consolidation of functions we have been able to reduce underwriting expenses incurred relative to premiums written.
Our life insurance segment’s earnings are derived primarily from premium revenues plus investment results, including net realized gains and losses, reduced by interest credited, benefits to policyholders and expenses. In 2001, our life insurance segment recorded net income of $8,534,000, compared to net income of $5,717,000 in 2000. The results were driven in both years primarily by investment results. Net investment income earned in 2001 was $70,682,000, compared to $61,468,000 in 2000. Annuity deposits increased our life segment’s investment portfolio, leading to higher investment earnings. In 2001 and 2000, a small number of fixed income securities held by the life segment were written down as a result of other-than-temporary declines in market value. These write-downs were the primary reason for net realized losses, after-tax, of $1,346,000 recorded in 2001 and $3,089,000 recorded in 2000.
After intercompany eliminations, net premiums earned by the life segment in 2001 totaled $25,437,000, compared to $26,094,000 in 2000. Annuity deposits collected are not reflected in net premiums earned. Rather, revenues for annuities consist of policy surrender charges and investment income earned. Annuity deposits are invested and recorded as liabilities for future policy benefits. In 2001, annuity deposits were $163,115,000, compared to $165,181,000 in 2000.
In 2001 and 2000, we wrote down a small amount of holdings in our fixed income portfolio as a result of other-than-temporary declines in market value and recognized a net realized loss, before tax, of $3,841,000 in 2001 and $2,932,000 in 2000. We continue to review the other-than-temporarily impaired securities for appropriate valuation on an ongoing basis. Based on the existing status and condition of these securities, we do not currently anticipate additional losses, but continued credit deterioration of some securities is possible, which may result in further write-downs.
Although we do have loss exposure to below investment grade fixed income securities, we are committed to minimizing credit risks and maintaining a high quality portfolio. As of December 31, 2001, 89 percent of our fixed income securities were investment grade, as defined by the National Association of Insurance Commissioners Securities Valuation Office, and had ratings of Class 1 or Class 2.
The composition of our investment portfolio at December 31, 2001 is presented in the following table:
Available-for-sale fixed income securities are carried at fair value, while held-to-maturity fixed income securities are carried at amortized cost.
RESULTS OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2000, COMPARED TO THE YEAR ENDED DECEMBER 31, 1999
For the year 2000, our property and casualty segment recorded net income of $9,810,000, compared to net income of $6,062,000 for 1999. Despite the New Orleans hailstorm catastrophe, our property and casualty results improved in 2000 in several lines of business. The pure loss ratio decreased (showed improvement) in our automobile, other liability and workers’ compensation lines of business. Improvements in our underwriting function and a decrease in the severity of claims led to enhanced profitability in these lines.
A) Fire and allied lines business, with a pure loss ratio of 62.0 percent in 2000, compared to 52.5 percent in 1999, was negatively affected by the New Orleans hailstorm.
C) Our reinsurance line of business also deteriorated, with a pure loss ratio of 162.2 percent in 2000, compared to 122.6 percent in 1999. The bulk of the business we assumed was property reinsurance, with an emphasis on catastrophe coverage. In response to the tighter margins in this particular line, we decided to significantly reduce our writings in assumed reinsurance business. A majority of the business expired in 2000; however, we renewed certain of these contracts to write assumed reinsurance business with
a very limited number of brokers. We will continue to have exposure, primarily with respect to catastrophe coverage, related to the assumed reinsurance contracts that we previously wrote. We believe that as of December 31, 2000, the loss reserves established for the assumed reinsurance business were appropriate. The assumed reinsurance reserves will be adjusted as additional facts become known.
Net premiums, which are direct premiums plus assumed reinsurance less ceded reinsurance, written by the property and casualty segment increased by $70,838,000 to $325,052,000 between 2000 and 1999, due to price increases, new and renewal business and twelve months of business from American Indemnity Company. Net premiums written increased in every line of business, with the exception of reinsurance. The largest dollar growth in net premiums written was reported in fire and allied lines, which increased from $77,270,000 in 1999 to $103,385,000 in 2000. The largest percentage growth was in other liability, with a 43 percent increase in net premiums written, due in part to the stabilization of prices in the commercial lines of business.
In 2000, direct premiums written by the property and casualty segment increased $77,405,000, or 32 percent, over 1999. Iowa was the segment’s largest volume state, with direct premiums of $44,533,000. In 2000, as a result of our acquisition of American Indemnity Financial Corporation, Texas became our third largest volume state, with direct premiums of $40,596,000, compared to $13,730,000 in 1999.
In 2000, the segment’s statutory combined ratio was 106.1 percent compared to 109.2 percent in 1999. The improvement resulted from the growth in premiums and a lower expense ratio, due in part to the consolidation of functions and the closing of the branch offices of the American Indemnity group of companies. Catastrophes, including the New Orleans hailstorm, negatively affected the statutory combined ratio, adding 7.9 percent to the ratio in 2000 and 6.0 percent in 1999, and resulted in after-tax net incurred losses and expenses of $15,778,000, or $1.57 per share, in 2000, compared to $9,561,000, or $0.95 per share, in 1999.
As of December 31, 2001, when compared to December 31, 2000, our assets increased 11 percent, our liabilities increased 11 percent and our stockholders’ equity increased 8 percent. Invested assets, primarily fixed income securities, increased $157,927,000, or 11 percent, from 2000. Of this growth, $18,314,000 was attributable to changes in the market prices of our securities classified as available-for-sale and other invested assets, both of which are reported at fair value. The unrealized appreciation from these investments is reported net of tax as a separate component of stockholders’ equity.
Deferral of underwriting expenses involves the use of estimates and assumptions that effect the assets and expenses reported in our financial statements. Actual results could differ materially from our estimates. Although some variability is inherent in these estimates, we believe the deferred acquisition costs asset provided is appropriate. Our property and casualty insurance segment’s deferred acquisition costs asset increased to $29,313,000 at December 31, 2001, an increase of $5,928,000, or 25 percent, from the deferred acquisition costs asset at December 31, 2000. The growth was attributable to the increase in premiums written and reduced premium deficiency in unprofitable lines of business.
Deferred policy acquisition costs related to investment contracts and universal life contracts sold by our life segment are deferred and amortized using the retrospective deposit method. Under the retrospective deposit method, acquisition costs are amortized in proportion to the present value of expected gross profits from investment, mortality and expense margins and surrender charges. Actual gross profits can vary from our estimates, resulting in increases or decreases in the rate of amortization. We periodically review these estimates and evaluate the recoverability of the deferred acquisition costs asset. When appropriate, we revise our assumptions on the estimated gross profits of these contracts and the cumulative amortization for the books of business are re-estimated and adjusted by a cumulative charge or credit to income.
One component of our life segment’s estimate of the deferred acquisition costs asset related to universal life and annuity business is the impact of unrealized gains and losses resulting from certain available-for-sale securities in our investment portfolio. In 2001, the unrealized loss component of our life segment’s deferred acquisition costs calculation contributed a decrease of $10,253,000 in the reported deferred acquisition costs asset. This unrealized loss component of deferred acquisition costs was partially offset by an increase in the life segment’s net deferred expenses of $8,629,000.
deferred acquisition costs amortization. However, if we were to experience a material adverse deviation in certain critical assumptions, including surrender rates, mortality experience, or investment performance, there could be a negative affect to our reported earnings and stockholders’ equity.
Cash flow and liquidity is primarily derived from operating cash flows. We invest premiums and annuity deposits in assets maturing at regular intervals in order to meet our obligations to pay policy benefits, claims and claim adjusting expenses. Net cash provided by our operating activities was $24,612,000 through December 31, 2001, compared to $42,543,000 through December 31, 2000. This variance is attributed to timing differences in the recognition of certain accrued expenses between years. We also have significant cash flows from sales and scheduled and unscheduled investment security maturities, redemptions and prepayments. These cash flows totaled $205,739,000 in 2001 and $168,615,000 in 2000. If our operating and investment cash flows are not sufficient to support our operations, we have short-term investments which we could utilize for that purpose. We may also borrow up to $20 million on a bank line of credit.
In order to support the continued growth of our operations, we are in the process of registering an offering of cumulative convertible, redeemable preferred stock. We expect to use a portion of the net proceeds to provide capital to our life subsidiary for general corporate purposes and to increase the amount of insurance business it can write. The exact amount of net proceeds we will provide to our life subsidiary may vary depending upon the life subsidiary's need for capital. We expect to use the balance of the net proceeds for general corporate purposes and to increase our ability to write property and casualty insurance.
Stockholders’ equity increased from $257,429,000 at December 31, 2000 to $278,988,000 at December 31, 2001, an increase of 8 percent. Increases to equity included net income of $24,093,000 and net unrealized appreciation of $5,048,000, after-tax. Stockholder dividends of $7,225,000 decreased stockholders’ equity, as did a minimum pension liability of $357,000. The minimum pension liability resulted from a decrease in the discount rate and a less than expected return on pension assets. Book value per share at December 31, 2001 was $27.80, reflecting an 8 percent increase for the year. As of December 31, 2001, we had authorization granted by the board of directors to repurchase 89,210 shares of our common stock. In 2001, we repurchased 580 shares of our common stock, all of which were distributed to employees as awards. We did not retire any shares of our common stock in 2001.
To comply with the National Association of Insurance Commissioners’ and state insurance departments’ solvency regulations, we are required to calculate a minimum capital requirement based on insurance risk factors. The risk-based capital results are used to identify companies that merit regulatory attention or the initiation of regulatory action. At December 31, 2001, both our life segment and our property and casualty segment had capital well in excess of the required levels. We are not aware of any other current recommendations by the National Association of Insurance Commissioners or other regulatory authorities in the states in which we conduct business that, if or when implemented, would have a material effect on our liquidity, capital resources or operations.
In February 2002, we notified our employees that we will be consolidating the operations of our branch office in Lincoln, Nebraska with our Cedar Rapids, Iowa home office. The consolidation will be completed by the end of the third quarter of 2002. We expect the consolidation will result in processing efficiencies and cost savings.
Notes to Consolidated Financial Statements are an integral part of these statements
The accompanying Consolidated Financial Statements include: United Fire & Casualty Company, its wholly owned subsidiaries; United Life Insurance Company (“United Life”), Lafayette Insurance Company, Insurance Brokers & Managers, Inc., Addison Insurance Company, Addison Insurance Agency, UFC Premium Finance Company, American Indemnity Financial Corporation, American Indemnity Company, United Fire & Indemnity Company, Texas General Indemnity Company, American Computing Company; and the affiliate United Fire Lloyds, which is financially and operationally controlled by American Indemnity Company. All material intercompany items have been eliminated in consolidation.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The financial statement captions that are most dependent on management estimates and assumptions include investments, deferred policy acquisition costs and future policy benefits and losses, claims and settlement expenses.
On whole life and term insurance (traditional business), premiums are reported as earned when due, and benefits and expenses are associated with premium income so as to result in the recognition of profits over the lives of the related contracts. On universal life and annuity (nontraditional) business, income and expenses are reported as charged and credited to policyholder account balances through the use of the retrospective deposit method. This method results in the recognition of profits over the lives of the related contracts, which is accomplished by means of a provision for future policy benefits and the deferral and subsequent amortization of life policy acquisition costs.
profits is reflected in earnings in the period such estimated gross profits are revised. The effect on the deferred policy acquisition costs that would result from realization of unrealized gains (losses) is recognized with an offset to accumulated other comprehensive income in the Consolidated Statements of Stockholders’ Equity as of the balance sheet date. As of December 31, 2001, an adjustment to decrease deferred policy acquisition costs by $10,253,000 was made with a corresponding decrease to accumulated other comprehensive income. In 2000, the adjustment was to increase deferred policy acquisition costs by $336,000.
Policy claim liabilities are determined using actuarial estimates. These estimates are based on historical information, along with certain assumptions about future events. Changes in assumptions for such things as medical costs, environmental hazards and legal actions, as well as changes in actual experience, could cause these estimates to change in the near term.
Realized gains or losses on disposition of investments are included in the computation of net income. Cost of investments sold is determined by the specific identification method. Changes in unrealized appreciation and depreciation, resulting from available-for-sale fixed income securities, equity securities, other long-term investments and certain life deferred policy acquisition costs, are reported as direct increases or decreases in stockholders' equity, less applicable income taxes.
Our accounting policy for impairment recognition requires other-than-temporary impairment charges to be recorded when we determine that we are unable to recover our cost basis in an investment. Impairment charges on investments are included in net realized gains and losses. Factors considered in evaluating whether a decline in value is other-than-temporary include: the length of time and the extent to which the fair value has been less than cost; the financial conditions and near-term prospects of the issuer; and our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery.
Property and equipment is carried at cost less accumulated depreciation. Depreciation is computed primarily by the straight-line method over the estimated useful lives of the underlying assets. Depreciation expense totaled $3,208,000, $3,512,000, and $2,458,000 for the years ended December 31, 2001, 2000 and 1999, respectively.
Amortization expense totaled $845,000, $940,000, and $620,000 for the years ended December 31, 2001, 2000 and 1999, respectively. We reduced goodwill by $2,437,000 and $645,000 in 2001 and 2000, respectively, as a result of an adjustment to the deferred tax asset valuation allowance related to the acquisition of American Indemnity Financial Corporation. Refer to Note 9 for further discussion.
In June 1998, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities.” In June 1999, SFAS No.133 was amended by SFAS No. 137, “Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB No. 133-an amendment of FASB Statement No. 133”. SFAS No. 133 is now effective for all fiscal quarters of fiscal years beginning after June 15, 2000. A company may also implement SFAS No. 133 as of the beginning of any fiscal quarter after issuance. SFAS No. 133 cannot be applied retroactively. The new statement requires all derivatives (including certain derivative instruments embedded in other contracts) to be recorded on the balance sheet as either an asset or a liability at fair value and establishes special accounting for certain types of hedges. We have had limited involvement with derivative financial instruments, and do not engage in the derivative market for hedging purposes. Effective January 1, 1999, we early adopted SFAS No. 133. As part of the implementation of SFAS No. 133, we were allowed to reassess our held-to-maturity portfolio without “tainting” the remaining securities classified as held-to-maturity. The impact on our Consolidated Financial Statements due to the reclassification from held-to-maturity to available-for-sale, effective January 1, 1999, increased the carrying value of available-for-sale fixed income securities by approximately $9,250,000 and other comprehensive income by approximately $6,013,000, net of deferred income taxes. This is shown as a change in accounting principle in the Consolidated Statements of Stockholders’ Equity. There was no other material effect on our Consolidated Financial Statements. Refer to Note 3 for further discussion.
In June 2000, the FASB issued SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities - an amendment of FASB Statement No. 133”, which was effective for all fiscal quarters beginning after June 15, 2000, due to our early adoption of SFAS No. 133. This statement amends the accounting and reporting standards of SFAS No. 133 for certain derivative instruments and certain hedging activities. Because we have limited involvement with derivative financial instruments, and do not engage in the derivative market for hedging purposes, the adoption of SFAS No. 138 did not have a material effect on our Consolidated Financial Statements.
Effective January 1, 2000, we adopted Statement of Position (“SOP”) 98-7, “Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk.” The SOP provides guidance on accounting for insurance and reinsurance contracts that do not transfer insurance risk. All of our reinsurance agreements are risk-transferring arrangements, accounted for according to SFAS No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts.” The adoption of SOP 98-7 had no effect on our Consolidated Financial Statements.
Effective July 1, 2000, we adopted FASB Interpretation (“FIN”) No. 44, “Accounting for Certain Transactions Including Stock Compensation (an Interpretation of Accounting Principles Board (“APB”) Opinion No. 25).” FIN No. 44 clarifies the application of APB Opinion No. 25 for only certain issues, such as: (a) the definition of employee for purposes of applying APB Opinion No. 25; (b) the criteria for determining whether a plan qualifies as a noncompensatory plan; (c) the accounting consequence of various modifications to the terms of a previously fixed stock option or award; and (d) the accounting for an exchange of stock compensation awards in a business combination. The adoption of FIN No. 44 had no impact on our Consolidated Financial Statements.
Effective December 31, 2000, we adopted Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements.” The SAB summarizes the SEC staff’s views on applying
generally accepted accounting principles to the recognition of revenue in financial statements. The adoption of SAB No. 101 had no effect on our Consolidated Financial Statements.
In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which becomes effective for fiscal years beginning after December 15, 2001, and interim periods within those fiscal years. SFAS No. 144 revises and clarifies the existing professional guidance addressing: (a) recognition and measurement of the impairment of long-lived assets to be held and used; (b) the measurement of long-lived assets to be disposed of by sale; and (c) the reporting of discontinued operations and components of an entity that either has been disposed of (by sale, by abandonment, or in a distribution to owners) or is classified as held for sale. We have not yet determined the impact that the adoption of this statement will have on our Consolidated Financial Statements.
The amortized cost and fair value of held-to-maturity and available-for-sale fixed income securities at December 31, 2001, by contractual maturity, are shown on the following page. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
There were no sales of held-to-maturity securities during 2001, 2000 or 1999.
We write covered call options on our equity portfolio to generate additional portfolio income and do not use these instruments for hedging purposes. Covered call options are recorded at fair value and are included in accrued expenses and other liabilities. Any income or gains or losses, including the change in the fair value of the covered call options, is recognized currently in earnings and included in realized investment gains and other income. At December 31, 2001 and 2000, there were no open covered call options. In assessing the impact of any embedded derivative instruments, we have elected to apply SFAS No. 133 only to those instruments or contracts with embedded derivative instruments issued, acquired, or substantively modified by us after December 31, 1997. We have analyzed our financial instruments and contracts in accordance with SFAS No. 133 and determined there is no material effect on our Consolidated Financial Statements. As part of the implementation of SFAS No. 133, we were allowed to reassess our held-to-maturity portfolio without “tainting” the remaining securities classified as held-to-maturity. The cumulative effect of the impact on our Consolidated Financial Statements, due to the reclassification of $246,623,000 of fixed income securities from held-to-maturity to available-for-sale, effective January 1, 1999, increased the carrying value of available-for-sale fixed income securities by approximately $9,250,000 and other comprehensive income by approximately $6,013,000, net of deferred income taxes.
In most cases, quoted market prices were used in determining the fair value of fixed income securities, equity securities and short-term investments. Where quoted market prices were unavailable, the estimate was based on recent trading. Other long-term investments, consisting primarily of holdings in limited partnership funds, are valued by the various fund managers. In management’s opinion, these values reflect fair value at December 31, 2001 and 2000.
The fair value of the liabilities for annuity products, which are in a benefit payment phase, guaranteed investment contracts and structured settlements, is based on a discount rate of 6.25 and 7.0 percent at December 31, 2001 and 2000, respectively. The fair value of annuities currently in an accumulation phase is based on the net cash surrender value.
We maintain a $20 million bank line of credit. Under the terms of the agreement, interest on outstanding notes is payable at the lender’s prevailing prime rate minus 1.0 percent. For the years ended December 31, 2001 and 2000, we did not borrow against this available line of credit. There were no loan balances outstanding as of December 31, 2001 and 2000.
The property and casualty insurance companies cede portions of their insurance business to other insurance companies on both a pro rata and excess of loss basis. Insurance ceded by the property and casualty insurance companies does not relieve their primary liability as the originating insurers. Written premiums ceded were $25,167,000, $22,748,000 and $24,031,000 for the years ended December 31, 2001, 2000 and 1999, respectively. Earned premiums ceded were $23,963,000, $27,765,000 and $27,206,000 for the years ended December 31, 2001, 2000 and 1999, respectively. We believe all amounts are collectable and realizable with regard to reinsurance receivables and prepaid reinsurance premiums, respectively. There are no concentrations of credit risk associated with reinsurance.
The property and casualty insurance companies also assume portions of their insurance business from other insurance companies. Written premiums assumed for the years ended December 31, 2001, 2000 and 1999 were $15,708,000, $25,522,000 and $33,372,000, respectively. Assumed premiums earned for the years ended December 31, 2001, 2000 and 1999 were $19,171,000, $31,658,000 and $34,289,000, respectively.
United Life follows the policy of reinsuring the portion of the risk in excess of $200,000 on the life of any individual. Claims are stated after deduction of reserves and claims applicable to reinsurance ceded to other companies; however, United Life is contingently liable for these amounts in the event such companies are unable to pay their portion of the claims and is contingently liable for ceded insurance in force of $414,496,000 and $422,577,000 at December 31, 2001 and 2000, respectively. Approximately 66 percent of ceded life insurance in force as of December 31, 2001, has been ceded to two reinsurers. We believe all amounts are collectable with regard to reinsurance receivables.
The table below provides an analysis of changes in our property and casualty loss and loss adjustment expense (“LAE”) reserves for 2001 and 2000 (net of reinsurance amounts). Changes in reserves are reflected in the income statement for the year when the changes are made. The favorable development in 2001 primarily related to lower than expected claim severity in the other liability and commercial auto liability lines of business.
Conditions and trends that have affected the reserve development reflected in the table may change, and care should be exercised in extrapolating future reserve redundancies or deficiencies from such development.
Statutory stockholders’ surplus and net income at December 31, 2001, 2000 and 1999 and for the years then ended are as follows.
The insurance industry is governed by the NAIC and individual state insurance departments. All of the insurance departments of the states in which we are domiciled have adopted codification of insurance statutory accounting practices effective January 1, 2001. Previously, these principles were prescribed in a variety of publications, as well as state laws, regulations and general administrative rules. Due to the adoption of codification, the effect on the statutory financial statements as of January 1, 2001, was an increase to statutory policyholders’ surplus of approximately $10,300,000. This change does not affect the accompanying financial statements, which are based on generally accepted accounting principles. Pursuant to codification rules, permitted statutory accounting practices may be utilized, with approval from an insurer’s state of domicile insurance department; however, we do not use any statutory permitted practices. As part of the NAIC and state insurance department’s solvency regulations, we are required to calculate a minimum capital requirement based on insurance risk factors. The risk-based capital results are used by the NAIC and state insurance departments to identify companies that merit regulatory attention or the initiation of regulatory action. At December 31, 2001, both the life segment and the property and casualty companies had capital well in excess of their required levels.
A reconciliation of income tax expense computed at the applicable Federal tax rate of 35 percent in 2001, 2000 and 1999, respectively, to the amount recorded in the Consolidated Financial Statements is as follows.
Our effective income tax rates were 16 percent, 11 percent and 11 percent in 2001, 2000 and 1999, respectively.
The significant components of the net deferred tax liability at December 31, 2001 and 2000 are as follows.
Under prior federal income tax law, one-half of the excess of a life insurance company’s income from operations over its taxable investment income was not taxed, but was set aside in a special tax account designated as “Policyholders’ Surplus.” At December 31, 2001, we had approximately $2,121,000 of untaxed “Policyholders’ Surplus” on which no payment of federal income taxes will be required unless it is distributed as a dividend, or under other specified conditions. Barring the enactment of new tax legislation, we do not believe that any significant portion of the account will be taxed in the near future; therefore, no deferred tax liability has been recognized relating to the Policyholders’ Surplus balance. If the entire Policyholders’ Surplus balance became taxable at the current federal rate, the tax would be approximately $742,000.
Under the merged plan, the employment date of the non-retired American Indemnity Financial Corporation employees is considered to be January 1, 2000 for purposes of determining eligibility for plan benefits. The effect of the merger was the termination of the future accrual of medical and dental benefits and the forfeiture of said benefits previously accrued for these employees under the American Indemnity Financial Corporation postretirement health care plan. The change and elimination of medical and dental benefits resulted in a negative plan amendment of $253,000, which is considered negative prior service cost that will be amortized over a period of 11 years as a reduction to the net periodic postretirement benefit cost recognized in earnings. In addition, these employees will not be eligible for postretirement life insurance as previously accrued for under the American Indemnity Financial Corporation postretirement health care plan. The elimination of the accrued life insurance benefit resulted in a curtailment gain of $103,000, which is reflected as a current gain in 2000 earnings, and a negative plan amendment of $391,000, which is considered negative prior service cost that will be amortized to earnings over a period of 12 years. The retirees of American Indemnity Financial Corporation retained their health care and life insurance benefits provided under the American Indemnity Financial Corporation postretirement health care plan, having reached age 55 with 25 years of service, or age 60 with 20 years of service, or age 65 with 15 years of service as of December 31, 1999.
The unrecognized prior service cost and the actuarial loss are being amortized on a straight-line basis over an average period of eight years. This period represents the average remaining employee service period until the date of full eligibility.
During 2001, we recorded a minimum pension liability of $549,000 (before tax), which represents the amount that we must recognize to cover a $1,291,000 deficit occurring as a result of our liability already recognized as unfunded accrued pension cost being less than our unfunded accumulated benefit obligation at December 31, 2001. The amount of this deficit is first offset by any prepaid pension cost ($742,000) to arrive at the additional minimum pension liability required to be recognized in our Consolidated Financial Statements.
For measurement purposes, an 8.0 percent annual rate of increase in the per capita cost of covered health care benefits is assumed for 2002. The rate is assumed to decrease gradually each year to a rate of 5.25 percent for 2008 and remain at that level thereafter. For dental claims, a 5.25 percent annual rate of increase was assumed for 2002, decreasing gradually to 4.75 percent for 2005 and thereafter.
The pension plan owned 101,029 shares of United Fire common stock as of December 31, 2001, and has made deposits with United Life Insurance Company to be used by the plan to purchase retirement annuities from that company. The annuity fund, maintained by United Life Insurance Company, is credited with compound interest on the average fund balance for the year. The interest rate will be equivalent to the ratio of net investment income to mean assets of United Life Insurance Company.
Stock options are generally granted free of charge to the eligible employees of United Fire as designated by the Board of Directors. However, during 1999, eligible employees had the opportunity to purchase the options at $10 per option in lieu of receiving a cash bonus for services rendered, up to the total amount of bonus awarded for the year.
The following table sets forth the activity of our stock option plan for the years ended December 31, 2001 and 2000.
The weighted-average grant date fair value of the options granted under the plan has been estimated using the Black-Scholes option pricing model. Under this model, the following significant assumptions are used to estimate the fair value of options as of the grant date: (1) the expected life of the options granted; (2) the current risk-free interest rate over the expected life of the options; (3) the expected volatility in the underlying stock price; and (4) the expected annual dividend rate. The weighted average assumptions used for 2001 and 2000 were: (1) 10 years; (2) 5.1 percent; (3) 41 percent; (4)$.72 and (1) 10 years;(2) 6.5 percent; (3) 49 percent; (4)$.68, respectively.
The property and casualty segment markets most forms of commercial and personal property and casualty insurance products, including fidelity and surety bonds and reinsurance. The business is generated through approximately 1,220 independent agencies and brokers in 40 states. Of these states, our strongest property and casualty markets are Texas, Iowa, Louisiana, Missouri and Illinois, which accounted for approximately 55 percent of our direct property and casualty premiums written in 2001.
United Life underwrites and markets ordinary life (primarily universal life), annuities (primarily single premium) and credit life products to individuals and groups through approximately 1,470 independent agencies in 25 states. Of these states, Iowa, Minnesota, Wisconsin, Illinois and Missouri accounted for approximately 69 percent of our direct life insurance premiums written in 2001.
Total revenue by segment includes sales to both outside customers and intersegment sales that are eliminated to arrive at the total revenues as reported in our Consolidated Statements of Income. Intersegment sales are accounted for on the same basis as sales to outside customers. The table on the following page sets forth certain data for each of our business segments.
The primary components of our comprehensive income are net income and net unrealized gains and losses on available-for-sale securities. The following table sets forth the components of other comprehensive income (loss), and the related tax effects, for the years ended December 31, 2001, 2000 and 1999.
American Indemnity Financial Corporation, based in Galveston, Texas, is a holding company that is made up of the following regional property and casualty insurance companies: American Indemnity Company; United Fire & Indemnity Company; Texas General Indemnity Company; and United Fire Lloyds. The American Indemnity insurers offer personal and commercial lines of insurance through independent agents.
The pro forma financial information is presented for informational purposes only and is not necessarily indicative of the operating results that would have occurred had the acquisitions been consummated as of the above date, nor are such operating results necessarily indicative of future operating results.
We did not have direct exposure related to the September 11 national events. However, the 2001 results include claims of $6,892,000 (before tax) related to the terrorist attacks from assumed property reinsurance.
We have audited the accompanying consolidated balance sheets of UNITED FIRE & CASUALTY COMPANY (an Iowa corporation) AND SUBSIDIARIES as of December 31, 2001 and 2000, and the related consolidated statements of income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2001. These consolidated financial statements and the supplementary schedules referred to below are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and supplementary schedules based on our audits.
As explained in Note 1 to the consolidated financial statements, effective January 1, 1999, the Company and its subsidiaries changed their method of accounting for derivative instruments and hedging activities.
Certain amounts included in this schedule for earlier years have been reclassified to conform with the 2001 financial statement presentation. Amounts included herein are net of inter-company eliminations.
A liability for employee termination benefits and future contractual lease payments related to abandoned facilities in connection with the purchase of American Indemnity Financial Corporation.