The Company leases approximately 62,563 square feet for its home office at 3760 River Run Drive, Birmingham, Alabama under a long-term operating lease from Torchmark Development Corporation, a wholly owned subsidiary of Torchmark Corporation. The Company considers the office facilities to be suitable and adequate for its current level of operations. However, the Company anticipates leasing additional space within the next year to accomodate the further consolidation of the Shelby companies operations.
- -------- (1) During the first quarter of 1993, Vesta adopted FASB Statement Number 109, which resulted in a one-time addition to after-tax earnings of $2,321,000. Vesta also adopted FASB Statement No. 106 which resulted in a one-time after tax charge to earnings of $382,000. The implementation of these standards is not expected to have a material impact on future earnings. (2) Effective as of January 1, 1993, the Company adopted FASB Statement Number 113. The prior periods have not been restated. See Note J of Notes to Consolidated Financial Statements. (3) Statutory data have been derived from the financial statements of the Company prepared in accordance with SAP and filed with insurance regulatory authorities. (4) The statutory industry data are taken from the A. M. Best Company, Aggregates and Averages, 1997 Edition. (5) 1997 estimate by A. M. Best, Best Week, March 16, 1998 Edition. (6) Restated for 3-for-2 stock split paid on January 22, 1996. (7) Effective as of December 31, 1997, the Company adopted FASB 128. The prior periods have been restated. See Note R of Notes to Consolidated Financial Statements. (8) The statutory combined ratio was negatively impacted by the one-time statutory accounting charge following discussions with the Alabama Department of Insurance during its routine examination. See "Business-- Regulation."
Significant factors influencing results of operations include the supply and demand for property and casualty insurance and reinsurance, as well as the number and magnitude of catastrophic losses such as hurricanes, windstorms, fires and severely cold weather. Premium rate levels are affected by the availability of insurance coverage which is influenced by levels of surplus in the industry and other factors. Increases in surplus have generally been accompanied by increased price competition among property and casualty insurers. Pricing in this business has weakened due to increased availability of reinsurance market capacity.
Prior to the Shelby and Vesta County Mutual acquisitions, assumed reinsurance was the dominant line of business, representing 80 percent of 1996 net premiums. As a result of these acquisitions, assumed reinsurance represented 61 percent of 1997 gross premiums. This shift to increase primary writing is consistent with the Company's strategy to focus on property coverages in all of its lines of business while adjusting the mix and volume of its writings and retentions to respond to change in market conditions.
Loss and loss adjustment expenses ("LAE") for reinsurance decreased by $76.3 million, or 30.8% to $171.8 million for the year ended December 31, 1997, from $248.1 for the year ended December 31, 1996. The dollar amount of loss and loss adjustment expenses incurred decreased during 1997 due to the decline in net premiums earned. The loss and LAE ratio for reinsurance for the year ended December 31, 1997 was 51.7% as compared to 59.8% for the year ended December 31, 1996.
Net premiums written for primary insurance increased by $87.8 million, or 92.8%, to $182.4 million for the year ended December 31, 1997, from $94.6 million for the year ended December 31, 1996. The increase in net premiums written was largely attributable to the writings from Shelby and the transfer of business from assumed reinsurance to personal lines following the acquisition of Vesta County Mutual. Net premiums earned for primary insurance increased $93.1 million, or 96.1% to $190.0 million for the year ended December 31, 1997, from $96.9 million for the year ended December 31, 1996.
Loss and loss adjustment expenses ("LAE") for primary insurance increased by $58.4 million, or 124.8% to $105.2 million for the year ended December 31, 1997, from $46.8 million for the year ended December 31, 1996. Included in the $58.4 increase in loss and loss adjustment expenses was $56.8 million in losses incurred by Shelby. The loss and LAE ratio for primary insurance for the year ended December 31, 1997 was 55.4% as compared to 48.3% at December 31, 1996.
Policy Acquisition Expenses and Other Operating Expenses. Policy acquisition expenses decreased by $4.8 million, or 3.5% to $122.7 million for the year ended December 31, 1997, from $127.5 million for the year ended December 31, 1996. The decrease in policy acquisition expenses is primarily attributable to the decrease in net written premiums. Other operating expenses include administrative costs not directly related to the generation of premium revenue, premium taxes and fees, interest on debt and goodwill amortization. Administrative costs (designated as operating expenses on the statement of operations) increased $17.7 million. The increase in administration costs is primarily attributable to the assimilation and administration of the Shelby operations. The increase in premium taxes and fees is directly related to the increase in direct premiums written. The increase in goodwill amortization is attributable to the $83 million of goodwill acquired on June 30, 1997 in connection with the Shelby acquisition.
Net Investment Income. Net investment income increased by $12.8 million, or 55.5%, to $35.9 million for the year ended December 31, 1997, from $23.1 million for the year ended December 31, 1996. The weighted average yield on invested assets (excluding realized and unrealized gains) was 5.8% for the year ended December 31, 1997, compared with 5.6% for the year ended December 31, 1996. The increase in net investment income is primarily attributable to an increase in average invested assets relating to the Shelby acquisition.
Federal Income Taxes. Federal income taxes increased by $10.5 million, or 42%, to $35.5 million for the year ended December 31, 1997. The effective rate on pre-tax income increased from 33.2% to 35.1% for the year ended December 31, 1997.
COMPARISON OF THE FISCAL YEAR 1996 TO THE FISCAL YEAR 1995
Gross premiums written for primary insurance decreased by $9.9 million, or 6.0%, to $154.2 million for the year ended December 31, 1996, from $164.1 million for the year ended December 31, 1995, due to a $13.9 million decrease in commercial lines premiums and a $4.0 million increase in personal lines premiums. Gross premiums written for commercial products decreased 23.6%, to $44.6 million for the year ended December 31, 1996, compared to $58.4 million for the year ended December 31, 1995, due primarily to the Company's re- underwriting of its book of business in an effort to increase profitability in commercial lines.
Net premiums written for primary insurance decreased by $6.3 million, or 6.2%, to $94.6 million for the year ended December 31, 1996, from $100.9 million for the year ended December 31, 1995. The decrease in net premiums written was largely attributable to a pro-rata reinsurance facility entered into by Vesta Fire Insurance Corporation ("Vesta Fire") to provide capital flexibility to take advantage of growth opportunities. Net premiums earned for primary insurance increased $5.7 million, or 6.3% to $96.9 million for the year ended December 31, 1996, from $91.2 million for the year ended December 31, 1995.
Net Investment Income. Net investment income increased by $5.1 million, or 28.3%, to $23.1 million for the year ended December 31, 1996, from $18.0 million for the year ended December 31, 1995. The weighted average yield on invested assets (excluding realized and unrealized gains) was 5.6 % for the year ended December 31, 1996, compared with 5.8% for the year ended December 31, 1995. The increase in net investment income is primarily attributable to an increase in average invested assets relating to the receipt of proceeds from the sale by the Company of $100 million of its 8.75% Senior Debentures due 2025 and operating cash flow.
The principal sources of funds for the Company's insurance subsidiaries are premiums, investment income and proceeds from the sale or maturity of invested assets. Such funds are used principally for the payment of claims, operating expenses, commissions and the purchase of investments. On a consolidated basis, net cash provided from (used in) operations for the year ended December 31, 1997 and 1996, was $(59.2) million and $13.8 million, respectively. The negative cash flow from operations in 1997 related primarily to the return of a loss reserve portfolio relating to a pro rata reinsurance contract commuted at the end of 1996 and the Shelby unearned premium portfolio transfer to the reinsurance facility. These transactions had the combined effect of reducing cash flow from operations by $73.2 million in 1997. Cash flow during 1996 was adversely affected by the settlement of the unearned premium portfolio transfer on the Company's pro rata reinsurance facility. This transaction had the effect of reducing cash flow from operations by $17.6 million in 1996.
Company expects current cash flow to be sufficient to meet operating needs, although invested assets have been categorized as available for sale in the event short-term cash needs exceed available resources. The Company adjusts its holdings of cash, short-term investments and invested assets available for sale according to its seasonal cash flow needs. Beginning in June of each year, the Company begins to increase its holdings of cash and short-term investments. This practice facilitates the Company's ability to meet its higher short-term cash needs during the hurricane season. See "Business-- Investments."
VESTA INSURANCE GROUP, INC. CONSOLIDATED BALANCE SHEETS (AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) NOTE A--SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Reinsurance: Reinsurance enables an insurance company, by assuming or ceding reinsurance, to diversify its risk and limit its financial exposure to risk and catastrophic events. However, reinsurance does not ordinarily relieve the primary insurer from its obligations to the insured. In the ordinary course of business, Vesta assumes business from other insurance organizations and also reinsures certain risks with other insurance organizations.
Reclassification: Certain amounts in the financial statements presented have been reclassified from amounts previously reported in order to be comparable between years. These reclassifications have no effect on previously reported stockholders' equity or net income during the period involved.
Income Per Share: The Company adopted SFAS 128, "Earnings per share," effective year end 1997. This standard requires the dual presentation of basic and diluted earnings per share ("EPS") on the face of the income statement and a reconciliation of basic EPS to diluted EPS. As required by SFAS 128, all prior-period EPS data has been restated for comparability. Basic EPS is computed by dividing income available to common stockholders by the weighted average common shares outstanding for the period. Weighted average common shares outstanding for each period are as follows: 1997 18,600,000, 1996 18,860,000, 1995 18,842,000. Diluted EPS is calculated by adding to shares outstanding the additional net effect of potentially dilutive securities or contracts which could be exercised or converted into common shares. Weighted average diluted shares outstanding for each period are as follows: 1997 19,053,000, 1996 19,157,000, 1995 18,970,000.
Recently Issued Accounting Standards: In June 1997, the FASB issued Financial Accounting Statement No. 130, Reporting Comprehensive Income, ("FAS130") and Financial Accounting Statement No. 131, Disclosures about Segments of an Enterprise and Related Information, ("FAS131"). FAS130 establishes reporting and presentation standards for comprehensive income and its components in a full set of general-purpose financial statements. Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances arising from nonowner sources. FAS130 is effective for both interim and annual financial statements issued for periods beginning after December 15, 1997, and also applies to financial statements presented for prior periods. FAS131 requires that financial and descriptive information be disclosed for each reportable operating segment based on the management approach. The management approach focuses on financial information that an enterprise's decision makers use to assess performance and make decisions about resource allocation. The statement also prescribes the enterprise-wide disclosures to be made about products, services, geographic areas and major customers. FAS131 is effective for annual financial statements issued for periods beginning after December 15, 1997, and for interim financial statements in the second year of application. The Company adopted FAS130 and FAS131 on January 1, 1998.
Insurance subsidiaries of Vesta are required to file statutory financial statements with state insurance regulatory authorities. Accounting principles used to prepare these statutory financial statements differ from GAAP. The tables set forth below reflect the effect of a one-time charge in certain statutory accounts in 1997 following discussion with the Alabama Department of Insurance during its current routine examination. Consolidated net income and stockholders' equity on a statutory basis for the insurance subsidiaries were as follows:
- -------- (1) Effective with its year end 1997 statutory filings, Vesta Fire has revised its statutory accounting for its assumed reinsurance business to reflect only accident/calendar year information. The adjustments essentially reversed, in the form of a one-time charge, the cumulative effect of the Company's prior practice of making estimates for reinsurance assumed on a combined underwriting and accident year basis, the accounting practice consistently applied over prior years.
Proceeds from sales of fixed maturities were $8 million in 1995, $40 million in 1996 and $284 million in 1997. Gross gains realized on those sales were $273 thousand in 1995, $23 thousand in 1996 and $3,386 thousand in 1997. Gross losses on those sales were $351 thousand in 1995, $161 thousand in 1996 and $329 thousand in 1997.
Depreciation expense on property and equipment used in the business was $1,037 thousand, $1,415 thousand, and $2,940 thousand in each of the years 1995, 1996, 1997.
Deferred policy acquisition costs for the years ended December 31, 1995 1996 and 1997 are summarized as follows:
Commissions comprise the majority of the additions to deferred policy acquisition costs in each year.
Vesta leases office space from Torchmark Development Corporation, a wholly owned subsidiary of Torchmark. Rent expense of $494 thousand, $566 thousand and $718 thousand was charged to operations for the years ended December 31, 1995, 1996 and 1997, respectively, related to this lease agreement.
Waddell & Reed Asset Management Company, a subsidiary of Torchmark ("WRAMCO"), provides investment advice and services to the Company and its subsidiaries in connection with the management of their respective portfolios pursuant to an Investment Services Agreement. The Company paid $222 thousand, $409 thousand and $394 thousand in fees to WRAMCO pursuant to the Investment Services Agreement in 1995, 1996 and 1997, respectively.
On September 13, 1993, Vesta Fire Insurance Corporation, a wholly owned subsidiary of the Company ("Vesta Fire"), and Liberty National Life Insurance Company ("Liberty National"), a wholly owned subsidiary of Torchmark, entered into a Marketing and Administrative Services Agreement, pursuant to which Vesta Fire marketed certain of its industrial fire insurance products through agents of Liberty National. Under this agreement, Liberty National pays to Vesta Fire an amount equal to all premiums collected by Liberty National after deducting all expenses incurred by Liberty National which are directly attributable to the industrial fire insurance products and after deducting a fee for administrative services. Such fee for 1995, 1996 and 1997 was $2,305 thousand, $1,702 thousand and $1,353 thousand, respectively. This agreement was terminated effective April 30, 1995, and these products are no longer marketed through Liberty National agents. However, Liberty National continues to service the existing business.
Litigation: The Company, through its subsidiaries, is routinely a party to pending or threatened legal proceedings and arbitrations. These proceedings involve alleged breaches of contract, torts, including bad faith and fraud claims and miscellaneous other causes of action. These lawsuits may include claims for punitive damages in addition to other specified relief. Based upon information presently available, and in light of legal and other defenses available to the Company and its subsidiaries, management does not consider liability from any threatened or pending litigation to be material.
Restrictions on Dividends: Vesta relies on dividends from its subsidiaries to meet its cash requirements and to pay dividends to its stockholders. The payment of dividends by Vesta's insurance subsidiaries are subject to certain limitations imposed by the insurance laws of the States of Alabama, Indiana, Ohio, Hawaii and Texas. The restrictions are generally based on certain levels of surplus, investment income and operating income, as determined under statutory accounting practices. Alabama, Indiana, Ohio, Texas and most other states that regulate Vesta's operations permit dividends in any year which together with other dividends or distributions made within the preceding 12 months, do not exceed the greater of (i) 10% of statutory surplus as of the end of the preceding year or (ii) the net income for the preceding year, with larger dividends payable only upon prior regulatory approval. Hawaii law limits dividends to the lesser of (i) and (ii) without prior approval. Certain other extraordinary transactions between an insurance company and its affiliates, including sales, loans or investments which in any twelve-month period aggregate at least 3% of its admitted assets or 25% of its statutory capital and surplus, also are subject to prior approval by the Department of Insurance. Based upon restrictions presently in effect, the maximum amount available for payment of dividends to the Company by its insurance subsidiaries in 1998 without prior approval of regulatory authorities is approximately $35.5 million.
Concentrations of Credit Risk: Vesta maintains a highly-diversified investment portfolio with limited concentrations in any given region, industry, or economic characteristic. At December 31, 1997, the investment portfolio consisted of securities of the U.S. government or U.S. government backed securities (13.1%); mortgage backed securities, GNMA collateral (9.3%); investment grade corporate bonds (29.9%); cash and short-term investments (21.4%); securities of state and municipal governments (22.6%); securities of foreign governments (.6%); and corporate common stocks (3.1%). Corporate equity and debt investments are made in a wide range of industries. All of Vesta's investments at year-end 1997 were rated investment-grade.
At December 31, 1997, the Company has unsecured reinsurance recoverables from six reinsurers that are in excess of 2% of statutory surplus, the largest of which is $34 million.
Vesta's effective income tax rate differed from the statutory income tax rate as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) NOTE K--INCOME TAXES (CONTINUED)
On July 19, 1995, the Company issued $100 million of its 8.75% Senior Debentures due July 15, 2025. The Debentures are not subject to redemption or any sinking fund prior to maturity. The Debentures are unsecured and rank on parity with all of its other unsecured and unsurbordinated indebtedness. The Debentures contain covenants that limit the ability of the Company or its subsidiaries to issue, sell or otherwise dispose of shares of voting common stock of any Restricted Subsidiary and limit the ability of the Company or its subsidiaries to pledge the shares of capital stock of any subsidiary. The Debentures also place certain limitations on the Company's ability to consolidate or merge with or sell its assets substantially as an entirety. The Company used the
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLAR AMOUNTS IN THOUSANDS) NOTE N--DEBT (CONTINUED)
proceeds from the sale to repay a $28,000,000 loan from a Torchmark affiliate, and to increase the capital and surplus of its principal insurance subsidiary, Vesta Fire Insurance Corporation.
On January 31, 1997, Vesta Capital Trust I, a Delaware business trust controlled by the Company, sold $100 million of its 8.525% Deferrable Capital Securities. These securities have a 30 year maturity and are not redeemable except in certain limited circumstances. These securities were sold in a private placement transaction to qualified institutional buyers and were not registered under Securities Act of 1933 pursuant to an exemption from registration provided by Rule 144A promulgated thereunder. A portion of the proceeds from the sale of these securities were used to repay indebtedness under the Company's existing lines of credit and for general corporate purposes.
Prior to completion of the Company's initial public offering, the Company's stockholders approved the Vesta Insurance Group, Inc. Long Term Incentive Plan ("Plan"), which provided for grants to the Company's executive officers of restricted stock, stock options, stock appreciation rights, and deferred stock awards, and in certain instances grants of options to directors. The Company's stockholders approved certain amendments to the Plan effective May 16, 1995, including an amendment to increase the shares of the Company's common stock available for awards under the Plan from 1,091,400 shares to 2,221,998 shares and an amendment to delete the provision for the grant of options to non- employee directors. The Company's stockholders also approved the Vesta Insurance Group, Inc.
Non-Employee Director Stock Plan ("Director Plan") effective May 16, 1995, which provides for grants to the Company's non-employee directors of stock options and restricted stock.
Of the 937,451 outstanding options at December 31, 1997, 549,087 were exercisable with the remaining having varying vesting periods. Exercise prices for options outstanding as of December 31, 1997 ranged from $14.88 to $55.44. Unexercised options with exercise prices of less than $25.00 for 589,852 shares had a weighted average contractual life of 6.9 years and a weighted average exercise price of $18.13 while unexercised options with exercise prices greater than $25.00 for 347,599 shares had a weighted average contractual life of 9.2 years and a weighted average exercise price of $38.42.
After the close of business on June 30, 1997, the Company completed its acquisition of all the issued and outstanding stock of the operating subsidiaries of Anthem Casualty Insurance Group, Inc., each of which are property and casualty insurance companies headquartered in Ohio, for $260.9 million. The acquired subsidiaries had $648 million of assets and approximately $217 million of stockholders' equity at June 30, 1997. The acquisition was accounted for as a purchase and the results of operations since the acquisition date were consolidated. Goodwill from the transaction is being amortized straight line over 15 years.
The above table represents the purchase price plus acquisition costs through December 31, 1997.