The Company's and Insurance Companies' main offices are located at 2929 Lititz Pike, Lancaster, Pennsylvania in a 33,000 square foot facility owned by Old Guard Mutual. Old Guard Fire owns a 25,000 square foot office facility near the main office at 147 West Airport Road in Lancaster. Goschenhoppen leases 7,500 square feet of office space in Quakertown, Pennsylvania.
On February 21, 1997 Old Guard Investment purchased a 21,507 square foot facility situated on 8.07 acres of land adjacent to the Company's headquarters. The purchase price was $1.1 million. The parcel of land will allow expansion to include an additional 50,000 square foot facility. The Company borrowed $880,000 from an unaffiliated lender for the purchase of such property. The mortgage loan is for a term of 15 years, carries a 20-year amortization schedule and bears interest at an annual rate equal to the federal funds rate, plus 1.90% per annum. The mortgage loan will be repaid in 180 consecutive monthly payments of principal and interest and will be secured by the purchased property. Old Guard Fire has listed the Airport Road facility for sale.
Premiums ceded to reinsurers increased $22.6 million to $34.4 million for the year ended December 31, 1996 compared to the year ended December 31, 1995. The increase in premiums ceded was directly attributable to the effects of instituting a quota share reinsurance treaty effective January 1, 1996 between the Insurance Companies and American Re. Under the treaty, the Insurance Companies cede 20% of all premiums, losses, and loss adjustment expenses and receive a 35% ceding commission on the ceded premium. Ceded premiums written and ceded premiums earned under the treaty amounted to $20.1 million and $13.6 million, respectively, for the year ending December 31, 1996. This reinsurance treaty is designed to lessen the financial impact of adverse loss experience and has had, and will continue to have, 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 treaty. This resulted in an increase in surplus reinsurance cessions of approximately $1.1 million. For 1997, the Insurance Companies anticipate reducing the quota share reinsurance treaty from 20% to 15% and may replace the surplus treaty with various excess of loss type reinsurance. In addition, the Insurance Companies may seek to increase its per risk retention on both property and casualty coverages.
Net Investment Income. Cash and invested assets decreased $10.7 million, or 10.6%, to $89.8 million on December 31, 1996 from $100.5 million on December 31, 1995. For the year ended December 31, 1996, the yield on average cash and invested assets was 4.5% compared to 4.7% for the year ended December 31, 1995. The result of these changes was that net investment income decreased $138,000, or 3.1%, to $4.3 million for the year ended December 31, 1996 from $4.5 million in 1995. Although the December 31, 1996 cash and invested asset balance declined substantially in comparison to December 31, 1995, the average annual cash and invested balance for each of the years decreased only slightly thus moderating the effect on net investment income.
Losses and Loss Adjustment Expense. Net losses and loss adjustment expenses incurred decreased by $6.2 million, or 12.2%, to $44.4 million for the year ended December 31, 1996 from $50.5 million in 1995. Losses and loss adjustment expenses before reinsurance on the quota share and aggregate excess of loss treaties 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 $3.5 million In addition, non- storm related losses and loss adjustment expenses increased $2.8 million for the 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 treaty effective January 1, 1996 pursuant to which the Insurance Companies ceded $10.7 million of losses and loss adjustment expenses during 1996. Also, the Insurance Companies recovered reinsurance of $1.8 million from their aggregate excess of loss reinsurer.
Premiums ceded to reinsurers decreased $1.4 million for the year ended December 31, 1995 compared to the year ended December 31, 1994. The decrease in premiums ceded in 1995 arose from: (i) a $1.5 million reduction in catastrophe reinsurance premiums due primarily to charges in 1994 for reinstatements of coverage as well as a mid-term placement of an additional cover in 1994, both of which arose directly as a result of 1994 winter storm events, and (ii) a redetermination of the expected ultimate premium rate for retrospectively rated casualty excess of loss reinsurance coverage. This result was offset slightly by an increase in certain pro rata cessions on farmowners business due to revisions in the manner in which such business is classified for reinsurance coverage purposes.
Net premiums written increased $1.5 million, or 2.2%, for the year ended December 31, 1995 to $67.1 million from $65.6 million in 1995. For the same comparative periods, net premiums earned increased by $3.2 million, or 5.2%, to $66.7 million from $63.5 million. The increase in net premiums earned was the result of the previously discussed increase in direct premiums written, the decrease in premiums ceded to reinsurers and an increase in the change in unearned premiums of $1.7 million.
The increase in income from fixed income securities was attributable to a shift in the portfolio from collateralized mortgage obligations ("CMOs") to corporate obligations. The corporate obligations provided slightly higher yields on a level investment base. The CMOs experienced an increase in the rate of principal repayment as interest rates fell during 1995 and therefore became a less attractive utilization of investment capital.
The common stock portfolio, comprised primarily of growth stocks, experienced an increase in dividend income due to the favorable results of the equities comprising the portfolio. The composition of the portfolio and general increases in dividend rates provided the Insurance Companies with the aforementioned increase in investment income from this segment of the portfolio.
Adjustments to loss reserves are made when analysis shows that reserve levels were estimated higher or lower than is necessary. Any adjustment to reserves is reflected as a charge or addition to income in the period in which it is made. The increase in net losses and loss adjustment expenses incurred in 1995 was attributable to the adverse development of prior year losses and loss adjustment expense reserves of $2.4 million; favorable loss reserve development occurred in 1994 and reduced losses and loss adjustment expenses by $5.5 million. The effect of the adverse development in 1995 increased the loss and loss adjustment expense ratio by 3.7 percentage points while the favorable development in 1994 decreased the ratio by 8.7 percentage points. On an accident year basis the loss and loss adjustment expense ratio was 72.1% in 1995 and 81.9% in 1994.
Underwriting Expenses. Underwriting expenses increased by $1.2 million, or 5.3%, for the year ended December 31, 1995 to $23.3 million from $22.1 million for 1994. This 5.3% increase in underwriting expenses is attributable to increased policy acquisition costs and closely parallels the associated 5.2% increase in net premiums earned for the year ended December 31, 1995 compared to the year ended December 31, 1994. For the year ended December 31, 1995 the Insurance Companies had an underwriting expense ratio of 34.9% compared to 34.8% for the year ended December 31, 1994.
Federal Income Tax Expense. Federal income tax expense decreased $152,000, resulting in a tax benefit of $684,000 in 1995 compared to a $532,000 tax benefit in 1994. The decrease in federal income tax expense is attributable to the decrease in taxable income in 1995 compared to 1994 offset by a decrease in tax exempt income of $644,000 for 1995 compared to 1994.
The Insurance Companies and their subsidiaries have in place unsecured lines of credit with local financial institutions under which they may borrow up to an aggregate of $9.2 million. At December 31, 1996, $1.55 million was outstanding on one of these lines of credit, which has an annual interest rate equal to the lending institutions' prime rate minus one-half percentage point. Old Guard Investment borrowed this $1.55 million to finance its initial investment in New Castle and First Delaware and subsequently repaid the loan in 1997 after the completion of the Conversion. In addition, at December 31, 1996, Old Guard Mutual had a $1.5 million surplus note outstanding. The holder elected to exchange the $1.5 million balance of the surplus note for 150,000 shares of Common Stock of the Company upon completion of the Conversion.
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 Insurance Companies 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.
The ESOP borrowed $4.0 million from an unaffiliated lender and $100,000 from the Company to purchase 10% of the Common Stock issued in the Conversion. The loans bear an 8.45% interest rate, and will require the ESOP to make monthly payments of approximately $49,000 for a term of 10 years. The loan will be secured by the shares of Common Stock purchased, the earnings thereon, and certain short-term securities. Shares purchased with such loan proceeds will be held in a suspense account for allocation among participants as the loan is repaid. The Company expects to contribute sufficient funds to the ESOP to repay such loan, plus such other amounts as the Company's Board of Directors may determine in its discretion.
The effects of inflation on the Insurance Companies are implicitly considered in estimating reserves for unpaid losses and loss adjustment expenses, and in the premium rate-making process. The actual effects of inflation on the Insurance Companies' results of operations cannot be accurately known until the ultimate settlement of claims. However, based upon the actual results reported to date, it is management's opinion that the Insurance Companies' loss reserves, including reserves for losses that have been incurred but not yet reported, make adequate provision for the effects of inflation.
To the Boards of Directors and Policyholders Old Guard Mutual Insurance Company, Old Guard Mutual Fire Insurance Company, and Goschenhoppen-Home Mutual Insurance Company and Subsidiary:
We have audited the accompanying combined balance sheets of Old Guard Mutual Insurance Company, Old Guard Mutual Fire Insurance Company, and Goschenhoppen-Home Mutual Insurance Company and subsidiary (the Group) as of December 31, 1996 and 1995, and the related combined statements of income, changes in surplus and cash flows for the years ended December 31, 1996, 1995 and 1994. These combined financial statements are the responsibility of the Group's management. Our responsibility is to express an opinion on these combined financial statements based on our audits.
As discussed in Note 15 to the combined financial statements, the Group has completed a demutualization plan which has been challenged by certain policyholders.
The accompanying notes are an integral part of the combined financial statements.
The Group sells personal, farmowners and commercial property and casualty insurance in Pennsylvania, Delaware and Maryland, with Pennsylvania comprising in excess of 95% of the direct premiums written. The principal lines of business are homeowners, farmowners, personal automobile and commercial multi-peril which represent approximately 27%, 18%, 26% and 13%, respectively, of the net premiums written.
Equity securities for all periods are stated at fair value with changes in fair value, net of deferred income tax, reflected in surplus. Realized gains and losses are calculated on the specific identification basis.
Acquisition costs such as commissions, premium taxes and certain other expenses which vary with and are directly related to the production of business, are deferred and amortized over the effective period of the related insurance policies. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to premiums to be earned, related investment income, loss and loss adjustment expenses and certain other maintenance costs expected to be incurred as the premiums are earned. To the extent that deferred policy acquisition costs are not realizable, the deficiency is charged to income currently.
Property and equipment are carried at cost less accumulated depreciation. Property is depreciated on a straight-line basis over the useful lives ranging from fifteen to fifty years. Equipment is depreciated on a straight-line basis with useful lives of five to ten years. Computer software is amortized on a straight-line basis over a useful life of five years.
Reserves for losses and loss adjustment expenses include amounts determined on the basis of claims adjusters' evaluations, other estimates and estimates of losses incurred but not reported, calculated using historical experience. 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 reserves for losses and loss adjustment expenses.
In accordance with Financial Accounting Standards Board Statement No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," reinsurance receivables and unearned premiums are reported as assets, and reserve liabilities are reported gross of reinsurance credits.
The Group's insurance members 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.
Financial instruments which potentially expose the Group to concentrations of credit risk consist primarily of cash and short-term investments, premiums in course of collection, investments and balances recoverable from reinsurers. Insureds primarily consist of individuals and commercial and agricultural businesses.
Risk based capital is designed to measure the acceptable amount of capital an insurer should have based on the inherent risks of the insurer's business. Insurers failing to meet adequate capital levels may be subject to insurance department scrutiny and ultimately rehabilitation or liquidation. Based on established standards, OGM, OGF and GHM maintain surplus in excess of prescribed risk based capital requirements.
Other includes adjustments as to the period of recognition of income or expense items between statutory and GAAP accounting.
Net investment income, net realized investment gains and change in unrealized capital gains (losses) on investment securities are as follows for each of the three years ended December 31:
The cost and estimated fair value of available-for-sale investment securities at December 31, 1996 and 1995 were as follows:
The gross realized gains and losses on investment securities for each of the years ended December 31, 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 $616,067 and $501,095 at December 31, 1996 and 1995, respectively.
The changes in the reserve estimates for prior years are primarily attributable to the paid and incurred loss development experience across all lines of business.
The Group has 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 generally seeks to reduce its exposure to catastrophe through individual risk selection and the purchase of catastrophe reinsurance.
Land $ 287,407 $ 287,407 Buildings and improvements 4,237,217 4,089,767 Furniture, fixtures and equipment 4,143,142 4,684,460
Assumed: Premiums earned $ 142,423 $ 114,395 $ (11,610) Unearned premiums $ 27,545 $ 22,431 $ 22,870 Losses and loss adjustment expenses incurred $ 180,604 $ 384,762 $ 83,347
Effective January 1, 1996 the Company executed a 20% quota share reinsurance treaty with its primary reinsurer. The treaty provides for a 35% flat ceding commission and is on the net business written by the Company. This treaty is intended to protect the Company from high frequency and low severity type losses. Ceded premiums earned were $13,647,111 and commissions on written premiums under this treaty were $7,048,013 during 1996. Reinsurance recoverable on paid and unpaid losses were $7,276,546 and $3,413,685, respectively, at December 31, 1996.
The Group performs credit reviews of its reinsurers, focusing on financial stability and commitment to the reinsurance business. At December 31, 1996, the Group had a reinsurance recoverable of approximately $20,896,000, net of applicable ceded reinsurance payable, due from its principal reinsurer, American Re-Insurance Company with an A.M. Best rating of A+.
The ceded premiums subject to retrospective rate adjustments were approximately $2,000,000, $1,600,000 and $1,100,000 for 1996, 1995 and 1994, respectively. No material adjustments from amounts originally estimated have been recorded.
The net deferred tax asset has not been reduced by a valuation allowance because management believes that, while it is not assured, it is more likely than not that it will generate sufficient future taxable income to utilize these net excess tax deductions. The amount of the deferred tax asset considered realizable, however, could be materially reduced in the near term if estimates of future taxable income in the years in which the differences are expected to reverse are not realized.
Actual income tax expense (benefit) differed from expected tax expense (benefit), computed by applying the United States federal corporate tax rate of 34% to income before income taxes, for each of the three years ended December 31 as follows:
The Group also maintains a voluntary defined contribution savings plan covering substantially all full-time employees. The Group matches employee contributions up to 3% of compensation. The Group's contribution to this plan amounted to $158,784, $144,367 and $136,121 for the years ended December 31, 1996, 1995, and 1994, respectively.
In the event a property and casualty insurer, operating in a jurisdiction where the Group also operated becomes or is declared insolvent, state insurance regulations provide for the assessment of other insurers to fund any capital deficiency of the insolvent insurer. Generally, this assessment is based upon the ratio of an insurer's voluntary written premiums to total written premiums for all insurers in that particular state. The Group charges these assessments to income in the period in which it is notified. The Group is not aware of any material assessments which have not been recorded at December 31, 1996.
The carrying amounts of cash and cash equivalents, short- term investments and subordinated debt approximate their fair value.
NMF is provided senior management services by CIMI for a fee as determined under the management agreement. Management fees recognized by CIMI during 1996 and 1995 were approximately $55,600 and $45,000, respectively.
NMF maintains a quota share reinsurance agreement with OGF whereby 90% of NMF's business was assumed by OGF during 1996 and 1995. The following summarizes the business ceded under the intercompany reinsurance agreement as of and for each of the years ended December 31:
Reserve for losses and loss adjustment expenses $ 305,440 $ 328,590 Receivable from NMF $ 258,430 $ 214,582
The following table presents, on a pro forma basis, an unaudited condensed combined balance sheet of OGGI at December 31, 1996, giving effect to the conversion as if it had occurred on that date.
The subordinated debt of $1,500,000 as of December 31, 1996 of OGM (see Note 8) was transferred to OGGI and the debt was converted to common stock by the third party as part of the demutualization plan.
In addition, a class and derivative action was filed by two policyholders, plaintiffs on February 7, 1997 in U.S. District Court for the Eastern District of Pennsylvania challenging the demutualization plan and the Act that permitted the conversion of the Insurance Companies. The suit was filed against the Boards of Directors of the Insurance Companies, the Insurance Companies and OGGI.
After-tax operating income (loss), net of realized investment gains and losses $ 591 $ 160 $ (200) $(3,385)
To the Board of Directors and Policyholders Old Guard Mutual Insurance Company, Old Guard Mutual Fire Insurance Company, and Goschenhoppen-Home Mutual Insurance Company and Subsidiary:
In our opinion, the financial statement schedules referred to above, when considered in relation to the basic combined financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein.
SCHEDULE I - SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES AS OF DECEMBER 31, 1996 (000'S OMITTED)