(1) The earnings per share amounts prior to 1997 have been restated as required to comply with Statement of Financial Accounting Standards No. 128, Earnings Per Share. For further discussion of earnings per share and the impact of Statement 128, SEE NOTE B to the NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS.
A variety of factors accounted for the 37.9% growth in net premiums earned, the principal factors being increases in the Company's core and new program business and an inclusion of the results of United Capitol and Regency, which were acquired in 1996, and Lyndon and, to a lesser extent Western, which were acquired in 1997. This increase was partially offset by (i) a decrease in workers' compensation, particularly the cotton gin program that the Company discontinued during 1996, and (ii) a decrease in the workers' compensation component of the social services programs due to price competition.
Growth in surety net premiums earned was primarily attributable to expanded writings of license and permit bonds, small contractors' bonds and miscellaneous bonds.
Net premiums earned for the workers' compensation line decreased primarily as a result of decreases in the specialty niche programs for cotton gins and feed lots and in social services programs due to price competition, partially offset by increases in the alternative risk program which the Company initiated in 1996.
Net premiums earned for the other lines of business increased primarily due to increased volume of commercial package and ocean marine policies issued by the Company.
Net investment income before realized capital gains and losses increased 50.8% due principally to increases in invested assets resulting from the proceeds of the Common Stock offering in August 1997, the Convertible Trust Originated Preferred Securities ("Convertible TOPrS") offering in October 1996, cash inflow from regular operations, and the contribution to net investment income resulting from the acquisitions of Lyndon, United Capitol, Western and Regency, partially offset by the interest charge on funds held by the Company for the benefit of the reinsurer of the Company's aggregate excess of loss reinsurance contract. Total net investment income increased 55.0% due to the aforementioned and a 147.3% increase in realized capital gains. The average annual pre-tax yield on investments, excluding the charge for funds held under the aggregate excess loss of reinsurance contract and realized capital gains and losses, was 6.4%, unchanged from the previous year. The average annual after-tax yield on investments, excluding the charge for funds held under the aggregate excess of loss reinsurance contract and realized capital gains and losses, was 4.6% as compared to 4.8% in the previous year.
Net premiums earned for the workers' compensation line decreased primarily as a result of decreases in the specialty niche program for cotton gins and feed lots , decreases in the social services programs due to price competition, and a lesser required participation in the National Workers' Compensation Reinsurance Pools. These decreases were partially offset by increases in workers' compensation from the alternative risk program which the Company initiated in 1996.
Net premiums earned for the other lines of business increased primarily due to increased volume in commercial package policies in the social services program, and in the mobile homeowners program and auto physical damage business as a result of the acquisition of Regency effective in June 1996. These increases were partially offset by decreases in other miscellaneous small programs.
Total expenses increased by 35.6%, similar to the 35.6% increase in net premiums earned. Losses and loss adjustment expenses ("LAE") increased by 30.8% which included a 8.5% increase in losses and a 97.5% increase in LAE. The increase in losses was substantially lower than for net premiums earned as a result of a one-time reallocation of loss reserves to LAE reserves, favorable reserve development in accident years prior to 1996 for general liability and workers' compensation and recoveries under the aggregate excess of loss reinsurance contract which provides coverage for certain losses and LAE in excess of 65% of the net premiums earned for the 1996 accident year, partially offset by higher loss and LAE ratios for business written in 1996. The Company also increased prior years' reserves by approximately $13 million, which was entirely offset by an increase in the same amount of the subrogation recoverable recognized in conjunction with the favorable December 1995 ruling in the New York Court of Appeals, described in Note D of the Notes to Consolidated Financial Statements. Such increase in the subrogation recoverable resulted from further documentation and verification in the second quarter of 1996 of claims already paid by the Company and reserves held by the Company that the Company believes are reimbursable by the State of New York. The 97.5% increase in LAE resulted from the increase in loss and LAE ratios, a one-time reallocation of loss reserves to LAE reserves, partially offset by a change in the line of business mix to those having a lower percentage relationship of LAE to losses and the allocation of recoveries under the aggregate excess of loss contract. Due to the disproportionate relationship of losses and LAE to net premiums earned, the loss and LAE component of the GAAP Combined Ratio was 2.1 percentage points lower than in the comparable 1995 period. The 40% increase in the amortization of policy acquisition costs, underwriting and other expenses was attributable primarily to an increase in direct commission expense resulting from growth in programs with higher commission rates, a decrease in reinsurance contingent commissions, increased staffing and marketing expenses related to expansion, a reduction in assessment recoveries from the Texas Workers' Compensation Insurance Facility, and salary increases. The 120% increase in interest expense was primarily the result of increased interest expense associated with the borrowing under the line of credit. The Company also incurred approximately $2.3 million of expenses in 1996 associated with the Convertible TOPrS. See NOTE N of the NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS. As the non-claim related component of the GAAP Combined Ratio increased at a greater rate than premiums earned, the non-claim component was 1.2 percentage points higher than in the comparable 1995 period. The total GAAP Combined Ratio decreased by .9 percentage points to 91.8% as a result of the above.
At December 31, 1997, the Company's total assets of $ 1.98 billion were comprised of the following: cash and investments, 63.9%; reinsurance recoverables, 19.9%; premiums receivable and agents balances, 4.8%; deferred expenses (policy acquisition costs and deferred federal income taxes), 4.3%; home office building, property and equipment, 2.4%; and other assets, 4.7%.
At December 31, 1997 and 1996, the Company's fixed maturity securities included mortgage-backed bonds of $368.6 million and $297.8 million, respectively, which are subject to risks associated with variable prepayments of the underlying mortgage loans. Prepayments cause those securities to have different actual maturities than those expected at the time of purchase. Securities that have an amortized cost greater than par that are backed by mortgages that prepay faster than expected will incur a reduction in yield or loss, while securities that have an amortized cost less than par that are backed by mortgages that prepay faster than expected will generate an increase in yield or gain. The degree to which a security is susceptible to either gains or losses is influenced by the difference between its amortized cost and par, the relative sensitivity of the underlying mortgages backing the assets to prepayments in a changing interest rate environment and the repayment priority of the securities in the overall securitization structure.
In December 1995, the Company reclassified all of its previously held securities classified as held-to-maturity, to available-for-sale as permitted by the FASB's Special Report, A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equities Questions and Answers. The reclassification increased shareholders' equity by $2.75 million at December 31, 1995.
Cash flow generated from operations for 1997, 1996, and 1995 was $95.1 million, $116.5 million, and $105.0 million, respectively, amounts adequate to meet all of the Company's obligations.
Effective September 1996, the Company completed the acquisition of Regency Insurance Company and Emrol Premium Discount, Inc. in exchange for 476,174 shares of the Company's Common Stock. Regency underwrites non-standard automobile insurance principally in North Carolina and Emrol finances premiums primarily for policyholders of Regency.
During 1997 and 1996, the Company expended $9.5 million and $1.2 million, respectively, in connection with the construction of an addition to its home office building. The Company plans to occupy the addition in 1998 and will expend approximately $3.4 million in additional funds to complete the facility.
On June 3, 1997, the Company completed the acquisition of Lyndon Property and its six subsidiaries, Lyndon Life Insurance Company, Twin Mercury Life Insurance Company, Gulfco Life Insurance Company, Lyndon Southern Insurance Company, Lyndon-DFS Warranty Services, Inc. and Lyndon General Agency of Texas, Inc., for $92 million.
On June 3, 1997, the Company obtained a five-year $100 million revolving loan credit facility from Deutsche Bank AG, New York Branch and/or Cayman Islands Branch, from which it borrowed $62 million at an initial floating interest rate of 6.04%, based upon Eurodollar interest rates, payable quarterly, to fund a portion of the $92 million purchase price of Lyndon. On August 21, 1997, the Company repaid all borrowings under the credit facility. The credit facility remains available to the Company and at December 31, 1997, no amounts were borrowed under it by the Company.
In July 1997, the Company acquired a 25% interest in American Country Holdings ("ACH") for $8.9 million. ACH through its wholly-owned subsidiary, American Country Insurance Company writes specialty insurance for the transportation industry, predominantly taxi cabs.
In August 1997, the Company sold approximately 4.5 million shares of its Common Stock in a public offering realizing net proceeds of approximately $144.5 million, of which $62 million was used to repay bank indebtedness, $78 million was used for strategic acquisitions and $5 million was used for an additional capital contribution to Regency.
In March 1992, the Company commenced quarterly cash dividend payments. Cash dividends declared in 1997, 1996 and 1995 were $8,200,000, $6,900,000, and $6,200,000, respectively.
Effective January 1, 1995, the Company entered into a stop loss reinsurance contract with Zurich Reinsurance (North America), Inc. ("Zurich N.A."), formerly Centre Reinsurance Company of New York ("Centre Re") for accident years' commencing 1995. Under the agreement, Zurich N.A. provides reinsurance protection within certain accident year and contract aggregate dollar limits for losses and LAE in excess of a predetermined ratio of these expenses to net premiums earned for a given accident year for all subject business. The loss and LAE ratio above which the reinsurance provides coverage is 66%, 65%, and 64% for accident years 1995 through 1997, respectively. The maximum amount recoverable for an accident year is 175% of the reinsurance premium paid for the accident year, or $162,500,000 in the aggregate for the three years.
In its ongoing effort to improve solvency regulation, the National Association of Insurance Commissioners ("NAIC") and individual states have enacted certain laws and financial statement changes. The NAIC has adopted Risk-Based Capital ("RBC") requirements for property/casualty insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, mortality and morbidity, asset and liability matching, benefit and loss reserve adequacy, and other business factors. The RBC formula is used by state insurance regulators as an early warning tool to identify, for the purpose of initiating regulatory action, insurance companies that potentially are inadequately capitalized. In addition, the formula defines new minimum capital standards that supplement the current system of low fixed minimum capital and surplus requirements on a state-by-state basis. Regulatory compliance is determined by a ratio of the enterprise's regulatory total adjusted capital, as defined by the NAIC, to its authorized control level RBC, as defined by the NAIC. Companies below specific trigger points or ratios are classified within certain levels, each of which requires specific corrective action. The levels and ratios are as follows:
The ratios of total adjusted capital to authorized control level RBC for the Company's insurance subsidiaries were all in excess of 3:1 at both December 31, 1997 and 1996.
The NAIC currently is in the process of recodifying statutory accounting practices, the result of which is expected to constitute the only source of "prescribed" statutory accounting practices. Accordingly, that project, which is expected to be completed in 1998, will likely change, to some extent, prescribed statutory accounting practices, and may result in changes in the Company's insurance subsidiaries' statutory surplus.
The thrust of these regulatory efforts at all levels is to improve the solvency of insurers. These regulatory initiatives, and the overall focus on solvency, may intensify the restructuring and consolidation of the insurance industry. While the impact of these regulatory efforts on the Company's operations cannot be quantified until enacted, the Company believes it will be adequately positioned to compete in an environment of more stringent regulation.
The Year 2000 issue is the result of computer hardware or software using two digits rather than four to define the applicable year. Any of the Company's computer systems that are time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send invoices, or engage in similar normal business activities.
The Company's main application software system has been upgraded during 1998 and is Year 2000 compliant. The Company has initiated formal communications with all of its significant customers and vendors to determine the extent to which the Company's business interface systems or leased software are vulnerable to those third parties failure to remediate their own Year 2000 issues.
Although the Company believes that such policies, together with the Company's general, professional and other liability policies, do not subject it to material exposure for environmental pollution claims, there can be no assurance of the Company's continued protection in view of the expansion of liability for environmental claims in recent litigation in the insurance industry.