During 1988, the Company purchased a 587 acre parcel of land in Caledonia Township (southeast of Grand Rapids, Michigan) and constructed a 260,000 square foot corporate headquarters building on part of this property. Approximately 36 acres of this parcel currently is used for the corporate headquarters and the balance of the parcel is held as investment property. During 1997, the Company began construction of a 98,000 square foot office facility on part of its Caledonia Township property to house its growing workforce. The Company also sold approximately 26 acres of its property to the State of Michigan for a right of way for the M-6 Interstate Highway. The Company also leases several facilities in Cascade Township near Grand Rapids, Michigan for an additional 75,000 square feet of office, distribution, printing and warehouse space. The Company has other short-term leasehold interests in real property used for its claim service offices and captive agencies throughout the country.
The following section provides a narrative discussion about the Company's results of operation and financial condition. The following should be read in conjunction with the Company's Consolidated Financial Statements and related notes thereto.
The Company's standard lines of automobile and homeowners insurance combined for total written premium of $24.6 million in 1997, an increase of 37% over the $18 million written in 1996, which was 7% less than the $19.3 million written in 1995. The Company's direct marketing of auto and homeowners insurance through third-party endorsements expanded during 1997 as these programs are now available in 24 states. The Company also signed more third party endorsements during 1997. The Company believes that these endorsements provide favorable growth opportunities in the future.
Catastrophe losses' impact on property and casualty results declined in 1997 to, net of reinsurance, $36.9 million, compared to the record levels in 1996 of $69.7 million and $51.9 million in 1995. The only major storms of 1997 occurred in the Northwest during the first quarter of the year. The record catastrophe losses of 1996 resulted from significant storms in the Northwest and Northeast portions of the country during the first and fourth quarters. These storms created massive damage in Oregon, Washington, Pennsylvania and New York. Hurricane Fran also struck North Carolina in the third quarter of 1996. During 1995, hurricanes Opal and Erin along with spring and winter storms in California, Oregon and Washington, contributed to the third worst catastrophe year in the Company's history.
Management is committed to controlling expenses and has aggressively managed the Company's acquisition costs and general and administrative expenses. All expense categories are closely monitored and employees are constantly challenged to develop ideas and programs to continually improve results. These actions have helped reduce the Company's expense ratio from a high of 42.7 in 1988 to its current level of 34.0 in 1997.
The Company spent approximately $3.8 million to remediate Year 2000 issues in 1997 and expects that it will spend approximately $4 million and $1 million in 1998 and 1999, respectively. These costs primarily will consist of professional fees paid to third party providers of remedial services. It is the Company's policy to expense all costs associated with these systems changes. The Company also may invest in new or upgraded technology which has definable value lasting beyond 2000. In these instances, where Year 2000 compliance is merely ancillary, the Company may capitalize and depreciate such an asset over its estimated useful life.
The Company considers that the effects of inflation are unlikely to be a significant factor in the results of operations given the relatively short term nature of premiums receivable and expected loss payments from reserves for losses and loss expenses. The anticipated effect of inflation is implicitly considered when estimating reserves for losses and loss expenses, product pricing and investment decisions.
The Company engages an outside actuarial firm to attest to the adequacy of its carried property and casualty reserves. This firm has rendered their opinion for the year ended December 31, 1997, and they attest to the adequacy of the Company's held reserves. The Company is committed to maintaining adequate loss reserves and places a high priority on balance sheet integrity.
In the years 1995 through 1997, the Company and its subsidiaries generated positive cash flow of $130.6 million from operations, and paid back $13.2 million on long-term borrowings. The Company paid $31.8 million in dividends during the same period and repurchased $62.5 million of its common stock. For year to year comparisons of cash flow items, see the "Consolidated Statements of Cash Flows" on page 27.
The Company expects continuing positive cash flow from operations. Additionally, the investment portfolios of the Company's insurance operations have been structured to provide liquidity for operations. The portfolios are structured so that on average, approximately $27 million of investments mature every year over the next ten years, and are available for reinvestment or use in operations as required. The insurance products written by the Company's insurance subsidiaries are primarily property coverages which result in rapid claim payments. The average maturity of investments is between five and six years, which provides adequate asset/liability matching.
At December 31, 1997, the Company's capital structure consisted of 27,700,872 common shares outstanding, which reflects the Company's three-for-one stock split payable on January, 20 1998.
In 1995, the Company negotiated and entered into a credit agreement under which its lenders committed to provide a seven year non-amortizing $50 million term loan and a five year $40 million revolving credit facility. At year end 1997, $50 million remained outstanding on the term loan, and $8 million was outstanding on the revolving credit facility. In addition to the remaining $32 million available under the revolving credit facility, the Company has an uncommitted line of credit facility which may not exceed $20 million at any one time. This unsecured credit agreement expires on June 30, 1998.
During 1995, the Company entered into an interest rate swap agreement to effectively fix the interest rate at 7.15% on the $58 million outstanding under the new credit agreement. The swap will expire on August 31, 2000. In November 1997, the swap agreement was amended with the following changes: the interest rate was dropped to 7.095%; the maturity was extended to August 31, 2002 and the notional amount will be decreased from $58 million to $50 million on August 31, 2000. The interest rate swaps are non-amortizing. The Company's exposure to credit risk is limited to interest movements and is considered to be negligible. The Company does not hold or issue any other forms of derivative financial instruments.
After-tax investment income decreased by 3% in 1997, after increasing by 1% in 1996 and 7% in 1995. The decline in 1997 and the relatively flat results for 1996 were primarily due to the impact of catastrophe loss payments and common stock buy-backs on the Company's cash flow and investable asset base in the first quarter of 1997 and for the entire year of 1996. Declining interest rates also impacted the investment income results of 1997 and 1996. The increase in 1995 resulted from positive cash flow generated from the strong underwriting performance during that year.
The Company's financial results over the last several years allows management to take a longer term, total return view of investments. As opportunities become available, the Company has and expects to continue the strategy of increasing its asset allocation to total return investments. These investments consist of common and preferred stock as well as lower-rated bonds and other assets that achieve equity-like returns over a market cycle.
At December 31, 1997 the Company held securities in its investment portfolio which were either unrated or less than investment grade, high-yield corporate debt securities, including certain preferred stocks and limited partnerships. These securities had a cost basis of $31.5 million, with an aggregate market value of $33.9 million and none of them individually exceeded $5.8 million. These securities have different risks than other investment grade securities. Risk of loss upon default by the borrower is greater with these investments than with other corporate or governmental debt securities because these securities are generally unsecured and are often subordinated to other creditors of the issuer. These issuers usually have high levels of indebtedness
The remaining three real estate properties which were foreclosed upon in 1991 totaling $3.8 million were sold or disposed of during 1996 without any adjustments to their carrying values. No adjustments were made to the carrying values of these foreclosed assets during 1995. The Company has no further foreclosed real estate, nor are any of its real estate related securities in default at December 31, 1997.
In accordance with FASB Statement No. 109, "Accounting for Income Taxes," the Company has recognized certain tax assets whose realization depends upon generating future taxable income. The Company believes that it will realize these tax assets through the generation of future taxable income and other tax planning strategies. There are no tax credit or capital loss carryforwards as of December 31, 1997.
The Company and its subsidiaries routinely are engaged in litigation as plaintiff and defendant in the normal course of business. In the opinion of management, all litigation matters are not expected to have a material adverse effect on the Company's consolidated financial position, operating results, and cash flows. The aggregate ultimate liability, if any, of the Company and its subsidiaries for litigation is not determinable at December 31, 1997.
For further discussion of the Company's litigation matters, please refer to Part 1, Item 3.
The National Association of Insurance Commissioners requires property and casualty insurance companies to calculate and report information under a Risk Based Capital ("RBC") formula in their statutory annual statements. The RBC requirements are intended to assist regulators in identifying inadequately capitalized companies. The RBC calculation is based on the type and mix of risks inherent in the companies business and includes components for underwriting, asset, interest rate and other risks. The Company's insurance subsidiaries
substantially exceeded their RBC statutory surplus standards as of December 31, 1997.
Consolidated Statements of Income for the years ended December 31, 1997, 1996 and 1995 25
Property and Casualty Statements of Income for the years ended December 31, 1997, 1996 and 1995 28
The preparation of financial statements in accordance 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 most significant estimates in the Company's balance sheet are the determination of prepaid policy acquisition costs and the reserve for insurance losses and loss adjustment expenses. Management's best estimate of prepaid policy acquisition costs is based on historical studies and assumptions made regarding costs incurred. Management's best estimate of insurance losses and loss adjustment expenses is based on past loss experience and consideration of current claim trends as well as prevailing social, economic and legal conditions. Although management's estimates currently are not expected to change in the foreseeable future, the costs the Company will ultimately incur could differ from the amounts that are assumed to be incurred based on the assumptions made.
In accordance with SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," the Company's reinsurance receivables and prepaid reinsurance premiums are reported as assets and are not netted against unearned premiums and the liability for losses and loss adjustment expenses.
Assets- Investment Securities Quoted market prices for specific instruments owned, or for similar securities, are used to determine market value.
The Company capitalizes certain costs associated with software developed for its own use. Such costs are amortized over the expected useful lives of the software. These capitalized costs are included in equipment and other.
Interest paid was $8,278,000 in 1997, $8,177,000 in 1996 and $9,089,000 in 1995.
Certain reclassifications have been made in the 1996 and 1995 financial statements to conform to those classifications used in 1997.
The mortgage loans and land contracts are primarily the result of financing sales associated with the development of an office park, an industrial park and a condominium development by the Company. At December 31, 1997, 99.9% of the mortgage loans and land contracts were categorized as commercial, and .1% as residential. Investment real estate consists of vacant land for a future office park. The majority of mortgage loans, land contracts and investment real estate is concentrated in Michigan.
Acquisition costs are recognized on all premium written by the Company. Such costs are amortized over policy terms which are principally annual, but which range up to seven years. Policy acquisition costs deferred and amortized are as follows:
Real estate and equipment utilized by the Company is summarized as follows:
Borrowing rates on the term loan and revolving credit facility of the credit agreement are based on eurodollar and negotiated rates. During 1995, the Company entered into a interest rate swap agreement with a financial institution. The notional principle amount of the swap is $58 million and it matures on August 31, 2000. This agreement effectively fixed the interest rate on the entire $58 million outstanding under the credit agreement to 7.15%. In November 1997, the swap agreement was amended with the following changes: the interest rate was dropped to 7.095%; the maturity was extended to August 31, 2002 and the notional amount will be stepping down from $58 million to $50 million on August 31, 2000. The interest rate swap is non-amortizing. The Company's exposure to credit risk is limited to interest movements and is considered to be negligible.
The borrowing rate on the mortgage loan is fixed at 9.8%.
Maturities of long-term debt for each of the five years succeeding December 31, 1997 are as follows:
The provisions (credits) for income taxes in the Consolidated Statements of Income are made up of the following components:
In addition to the Company's net deferred tax liability, the liability for income taxes includes a current tax liability of $3,958,000 and $634,000 at December 31, 1997 and 1996, respectively.
Amounts due from reinsurance companies balances are primarily premium amounts due from unconsolidated insurance affiliates for business assumed, and loss recoverables from a major U.S. reinsurance company. Assumed reinsurance is predominantly from unconsolidated affiliates.
The Company also provides a Profit-Sharing Retirement and Savings Plan for all employees with one or more years of service. Under this plan the Company can make discretionary profit-sharing contributions as a percentage of eligible compensation. In 1997 and 1996, contributions equal to 5% of eligible compensation of all eligible employees were made by the Company. The savings feature of the plan is a 401(k) plan that allows for voluntary contributions by employees and provides a 50% Company-paid match of the employee's contribution, limited to 2% of the employee's eligible income.
The Company provides a Retirement Supplement Plan for certain key employees which provides monthly lifetime payments or lump sum payments upon retirement or disability, and lump sum payments to beneficiaries upon death. The retirement benefit is based on a percentage of the participant's final average earnings, less the participant's Money Purchase Pension Plan and Profit Sharing Plan benefits (excluding 401(k) plan benefits). The retirement benefits expected to be paid total $3,511,000. Life insurance contracts have been purchased to fund the retirement benefits. Key employees would receive their entire retirement benefit in the event of a change in control of the Company and their subsequent termination. The maximum contingent liability as of December 31, 1997 relating to the change in control provision is approximately $5,569,000.
The Company has a non-qualified stock option plan which authorizes the granting of options to purchase 650,000 shares of the Company's common stock to certain key employees. During 1995, the Company's Board of Directors authorized, and the stockholders' approved, an additional 400,000 shares of the Company's common stock for future grants under the plan, making a total of 1,050,000 shares authorized under the plan. Adjusting the authorized options for the three-for-one stock split issued on January 20, 1998, provides a total of 3,150,000 shares authorized under the plan. The options, granted at market value, vest at either a three or four year period, with a maximum term of 10 years.
The Company also has a restricted stock plan under which certain key employees were issued 194,442 shares of the Company's common stock in 1988, representing all of the shares available under the plan. The shares are registered in the name of the participant, who has all the rights of a stockholder, subject to restrictions as to transfer until the shares vest. Compensation expense is recorded over the periods in which the shares vest. The unamortized market value of the shares awarded is shown separately in stockholders' equity. As of December 31, 1997, 189,594 were vested, 204 shares were issued and non-vested and 4,644 shares remained unissued from forfeitures.
In 1995, the Company adopted and the stockholders' approved a restricted stock plan for the Company's Directors. Under the plan, the Company's Directors may elect to receive shares of the Company's common stock in lieu of their annual retainer fees. The shares are issued at market value and are registered in the name of the participant, who has all the rights of a stockholder, subject to restrictions as to transfer until they vest. Vesting occurs upon the completion of the Director's term. Up to 60,000 shares may be issued under the plan. In 1997 and 1996, 1,686 shares and 1,626 shares were issued, respectively.
The cost of the aforementioned benefit plans, excluding post-retirement benefits, for 1997, 1996 and 1995 was $4,378,000, $3,696,000 and $4,339,000, respectively.
The following is a schedule of future minimum lease payments under the Company's capitalized finance leases together with the present value of the net minimum lease payments as of December 31, 1997:
Rental expense charged to operations in 1997, 1996 and 1995 amounted to $5,354,000, $5,109,000 and $4,693,000, respectively, including amounts paid under short-term cancelable leases.
As a holding company, the principal source of the Company's cash available for debt service and payment of dividends (other than through the use of borrowed funds or the employment of other assets) is dividends received from its principal property and casualty insurance subsidiary, Foremost Insurance Company. State regulatory requirements limit the amount of annual dividends Foremost Insurance Company can pay to the Company without obtaining prior insurance department approval. These restrictions are not expected to significantly affect the Company's ability to meet its foreseeable cash requirements. The amount of dividends which Foremost Insurance Company can pay to the Company in 1998 without obtaining prior insurance department approval under the current statute is $39.8 million. In 1997 Foremost Insurance Company paid dividends in cash and other assets to the Company totaling $32.0 million. The insurance department allowed a $4.0 million extraordinary dividend in 1997.
Policyholders' surplus for the combined property and casualty insurance companies at December 31, 1997 and 1996 was $220.5 million and $201.3 million, respectively. Statutory net income for the combined property and casualty insurance companies for the years ended December 31, 1997, 1996 and 1995 was $49.8 million, $34.1 million and $49.3 million, respectively.
The Company has assigned its interest as tenant in a capital lease obligation. In the event of default by the assignee, a contingent liability exists of approximately $1.6 million at December 31, 1997.
In the event any person or group becomes the beneficial owner of 20% or more of the Company's common stock, or if a holder of 20% or more of the Company's common stock engages in self-dealing transactions, or if the Company becomes involved in a merger transaction, or sells 50% or more of its assets or earning power to another person, then each right not owned by the acquiring person or group will entitle its holder to purchase, at the right's then current exercise price, shares of the Company's common stock, or the common stock of the acquiring or surviving entity (or in certain circumstances, cash, property or securities of the Company) having a market value equal to twice the exercise price.
The rights expire on December 14, 1999 and may be redeemed by the Company for $.01 per right at any time until the 10th day following the public announcement that a person or group has acquired 20% or more of the Company's common stock. The Company has reserved 275,246 shares of its common stock for issuance upon exercise of the rights.
Detailed operating information for the property and casualty segment is presented herein. There are no significant intercompany transactions among the segments.
In 1990 and 1989, the Company assumed credit life premium under various reinsurance treaties. Under the terms of these treaties, the Company was obligated to reimburse the ceding companies only if the overall incurred loss ratio exceeded a certain percentage. In the fourth quarter of 1990, the ceding companies were declared insolvent and placed into liquidation. On June 11, 1996, with the sale of the Foremost Life Insurance Company, the amount reserved to cover these reinsurance treaties was transferred to an escrow account. On July 31, 1997, the Company and the liquidator settled all outstanding reinsurance and legal issues regarding these treaties. The escrow account was closed with the Company recording an after-tax gain of $110,000 for 1997. The financial results of the life insurance segment and the sale are reflected in the financial statements as discontinued operations for all years presented.
To the Stockholders and Board of Directors Foremost Corporation of America Grand Rapids, Michigan
We have audited the accompanying consolidated balance sheets of Foremost Corporation of America as of December 31, 1997 and 1996, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.