- Management Analysis of Financial Position and Results of Operations ($ in Millions, Except Share Data) - -------------------------------------------------------------------------------- OVERVIEW
This analysis pertains to the consolidated accounts of Old Republic International Corporation which are presented on the basis of generally accepted accounting principles ("GAAP"). The Company conducts its business through four separate segments, namely its General (property and liability coverages), Mortgage Guaranty, Title, and Life insurance groups.
During 2001, the Financial Accounting Standards Board issued two pronouncements affecting accounting for business combinations occurring after June 30, 2001, and the related treatment of goodwill and intangible assets recorded pursuant to such or earlier combinations. In general terms, the first pronouncement requires that business combinations initiated after June 30, 2001 be treated as purchases for financial accounting purposes, that the alternative pooling of interests method of accounting be eliminated, and that identifiable assets meeting certain criteria for intangibles be set apart from any purchased goodwill. This pronouncement had no impact on the Company in 2001. Under the second pronouncement, which takes effect for fiscal years beginning after December 15, 2001, all goodwill resulting from business combinations will no longer be amortized against operations but must be tested periodically for possible impairment of its continued value. Within six months of application of this second pronouncement, a transitional goodwill impairment test needs to be performed and any resulting charge is to be reported as a change in accounting principle. Old Republic will adhere to these pronouncements in 2002 and will determine the impact, if any, of the transitional or subsequent annual impairment tests on its financial position and results of operations. As of December 31, 2001, the Company's consolidated unamortized goodwill asset balance was $84.8, and the average annual charge from goodwill amortization to operating results for the three most recent calendar years was approximately $4.0 (or 3 cents per average diluted share).
Old Republic's financial position at December 31, 2001 reflected increases in assets, liabilities and common shareholders' equity of 8.8%, 6.1% and 14.1%, respectively, when compared to the immediately preceding year-end. Cash and invested assets represented 70.5% and 70.6% of consolidated assets as of December 31, 2001 and 2000, respectively. Consolidated operations produced positive cash flows for the latest three years. The increases in operating cash flow for 2001 and 2000 were mostly due to greater contributions by the Company's three largest operating segments. In 2001, the invested asset base increased 8.6% to $5,586.7 principally as a result of greater operating cash flow in each of its business segments, and an increase in the value of fixed maturity and equity securities carried at market value.
the Company does not own nor engage in any type of option writing. A 10% decrease in the U.S. equity market prices could result in a decrease of $38.9 in the market value of the Company's common stock portfolio. These possible declines in values for Old Republic's bond and stock portfolios would affect negatively the level of the common shareholders' equity account at any point in time, but would not necessarily result in the recognition of realized investment losses as a likely combination of positive operating cash flow and the scheduled emergence of bond maturities should provide sufficient funds to meet obligations to policyholders and claimants, as well as debt service and cash dividend requirements at the holding company level.
Among other major assets, substantially all of the Company's accounts and notes receivable are not past due, and reinsurance receivable balances on paid or estimated unpaid losses are deemed to be fairly stated and recoverable from responsible reinsurers. Regulatory and related GAAP reclassifications that took effect at the beginning of 2001 pertained mostly to the recording of estimated premiums due subsequent to each balance sheet date and had the approximate effect of increasing accounts receivable by $110.9, deferred acquisition costs by $15.7, and unearned premiums by $110.9 as of December 31, 2001. These changes had no effect on the Company's net income for 2001.
Old Republic's capitalization of $2,943.1 at December 31, 2001 consisted of long and short-term debt of $159.0, a minor amount of convertible preferred stock, and common shareholders' equity of $2,783.7. Changes in the common shareholders' equity account for the three most recent years reflect primarily the retention of earnings in excess of dividends declared on outstanding preferred and common shares, an increase during 2001 and 2000 compared to a decrease during 1999 in the value of bonds and stocks carried at market value, and the acquisition of $66.4 and $188.1 in 2000 and 1999, respectively, of the Company's common shares in open market transactions. In March 2000, the Company canceled 36.4 million common shares previously reported as treasury stock, restoring them to unissued status; this had no effect on total shareholders' equity or the financial condition of the Company. At its March 23, 2000 meeting, the Company's Board of Directors authorized the reacquisition of up to $200.0 of common shares as market conditions would warrant during the two year period from that date. As of December 31, 2001 a total of $177.3 of this authorization remained unutilized and is expected to be extended for an additional period of time in 2002.
RESULTS OF OPERATIONS Revenues: Consolidated net premiums and fees earned increased by 16.9% in 2001, and decreased by 2.5% and 1.6% in 2000 and 1999, respectively. Property and liability earned premiums increased 16.6% and 0.5% in 2001 and 2000, respectively, and decreased 5.4% in 1999. Positive premium production trends in this segment reflect pricing and risk selection improvements implemented for the past two years or so; during 2001 in particular, Old Republic experienced greater success in retaining existing accounts and obtaining new accounts at generally rising prices. Growth in mortgage guaranty premiums for the past three years was enhanced principally by relatively strong mortgage lending activity nationwide, and in 2001 in particular, by much greater refinancing activity due to a downtrend in mortgage rates. Title Group premium and fee revenues increased by 26.6% and 2.8% in 2001 and 1999, respectively, but declined by 13.9% in 2000. These results largely reflect varying levels of housing and mortgage lending activity during these years, with 2001's much greater refinancing activity accounting for a major portion of the increase. The decline in 2000 title premiums and fees resulted mostly from a substantial drop in mortgage refinancing activity. Life and disability premiums decreased in 2001 and were approximately the same in 2000 and 1999.
The Company's mix of coverages, industries served, and long-standing objective of assuring wide dispersion of risks in selected geographical areas, have likely minimized claim exposures related to the September 11, 2001 terrorist attack on America. The income statement for the year ended December 31, 2001 nonetheless includes charges aggregating approximately $4.0 to cover the possibility of isolated property, workers' compensation, trip delay and life insurance claims. The resulting aggregate post tax charge of $2.6 reduced consolidated net income 2 cents per share.
The ratio of consolidated underwriting, acquisition, and insurance expenses to net premiums and fees earned was approximately 48.8% in 2001, 49.6% in 2000 and 52.6% in 1999. Variations in these ratios reflect a continually changing mix of coverages underwritten and attendant costs of producing business for each of the Company's segments. The property and liability segment's expense ratio remained approximately the same, averaging 27.9% during the latest three year period. The mortgage guaranty segment's expense ratio decreased to 27.5% in 2001 compared to 29.6% in 2000 and 33.5% in 1999 due to greater efficiencies gained in the distribution and servicing of its products. The title insurance expense ratio was higher in 2000 and 1999 due in part to the aforementioned decline or reduced growth in premium and fee volume relative to operating costs; a much increased title sales volume in 2001 led to a lower expense ratio. Consumer and regulatory litigation affecting Old Republic's California title insurance subsidiary was responsible for expenses of $6.8, $4.1 and $16.2 charged to 2001, 2000 and 1999 operations, respectively. Consolidated interest and other corporate charges decreased in 2001 due primarily to reduced interest costs on a gradually lower debt level.
- ---------- (*) At December 31, 2001 and 2000, there were 75,000,000 shares of $0.01 par value preferred stock authorized, of which 44,591 in 2001 and 138,878 in 2000 were convertible preferred shares issued and outstanding. As of the same dates, there were 500,000,000 shares of common stock, $1.00 par value, authorized, of which 122,168,699 in 2001 and 121,444,862 in 2000 were issued and outstanding. At December 31, 2001 and 2000 there were 100,000,000 shares of Class B Common Stock, $1.00 par value, authorized, of which no shares were issued. Common shares classified as treasury stock were 3,191,368 and 3,191,362 as of December 31, 2001 and 2000, respectively.
Old Republic International Corporation and Subsidiaries Notes to Consolidated Financial Statements ($ in Millions, Except as Otherwise Indicated) - --------------------------------------------------------------------------------
Old Republic International Corporation is a Chicago-based insurance holding company with subsidiaries engaged in the general (property & liability), mortgage guaranty, title, and life (life & disability) insurance businesses. In this report, "Old Republic", "the Corporation", or "the Company" refers to Old Republic International Corporation and its subsidiaries as the context requires. The aforementioned insurance segments are organized as the Old Republic General Insurance, Mortgage Guaranty, Title Insurance, and Life Insurance Groups, and references herein to such groups apply to the Company's subsidiaries engaged in the respective segments of business. See Note 6 for a discussion of the Company's business segments.
(c) Investments-The Company may classify its invested assets in terms of those assets relative to which it either (1) has the positive intent and ability to hold until maturity, (2) has available for sale or (3) has the intention of trading (carried at fair value with adjustments to income). As of December 31, 2001, the Company's invested assets were classified solely as "held to maturity" or "available for sale."
Fixed maturity securities and redeemable preferred stocks classified as "held to maturity" are generally carried at amortized costs while fixed maturity securities classified as "available for sale" in addition to other preferred and common stocks (equity securities) are included at fair value with changes in such values, net of deferred income taxes, reflected directly in shareholders' equity. Fair values for fixed maturity securities and equity securities are based on quoted market prices or estimates using values obtained from independent pricing services as applicable. The Company periodically reviews the securities in its investment portfolio, and the carrying values of investments which are deemed to be other than temporarily impaired are adjusted as appropriate.
The amortized cost and estimated fair value at December 31, 2001, by contractual maturity, are shown below. 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.
Investment income is reported net of allocated expenses and includes appropriate adjustments for amortization of premium and accretion of discount on fixed maturity securities acquired at other than par value. Dividends on equity securities are credited to income on the ex-dividend date. Realized investment gains and losses are reflected as revenues in the income statement and are determined on the basis of amortized value at date of sale for fixed maturity securities, and cost in regard to equity securities; such bases apply to the specific securities sold. Unrealized investment gains and losses, net of any deferred income taxes, are recorded directly as a component of accumulated other comprehensive income.
At December 31, 2001, the Corporation and its subsidiaries had no non-income producing fixed maturity securities.
- ---------- (1) Investment expenses consist of personnel costs and investment management and custody service fees, and includes interest incurred on funds held of $1.4, $1.5 and $1.5 for the years ended December 31, 2001, 2000 and 1999, respectively. (2) Deferred income taxes do not apply since these securities are carried at amortized cost.
At December 31, 2001 and 2000, the Life Insurance Group had $7,500.4 and $6,849.1, respectively, of net life insurance in force. Future policy benefits and unearned premiums, consisted of the following:
No assurance can be given that unearned premiums will be greater or less than ultimate incurred losses on these policies.
With respect to mortgage guaranty insurance (net insurance in force of $97,709.0 and $85,461.1, at December 31, 2001 and 2000, respectively) the Company's reserving policies are set forth below in Note 1(g).
(g) Losses, Claims and Settlement Expenses-Reserves are estimates that provide for the ultimate expected cost of settling unpaid losses and claims reported at each balance sheet date. Losses and claims incurred but not reported, as well as expenses required to settle losses and claims are established on the basis of various criteria, including historical cost experience and anticipated costs of servicing reinsured and other risks. Long-term disability-type workers' compensation reserves, however, are discounted to present value based on interest rates ranging from 3.5% to 4.0%.
The Corporation's reserving methods, particularly as they apply to formula-based reserves, have been established to provide for normal claim occurrences as well as unusual exposures such as those pertaining to A&E claims and related costs. At times, however, the Corporation's insurance subsidiaries also establish specific formula and other reserves as part of their overall claim and claim expense reserves to cover claims such as those emanating from A&E exposures. These are intended to cover additional litigation and other costs that are likely to be incurred to protect the Company's interests in litigated cases in particular. At December 31, 2001, the Corporation's aggregate indemnity and loss adjustment expense reserves specifically identified with A&E exposures amounted to approximately $80.6 gross, and $49.6 net of reinsurance. Based on average annual claims payments during the five most recent calendar years, such reserves represented 9.2 years (gross) and 18.5 years (net) of average annual claims payments.
Pursuant to special provisions of the Internal Revenue Code pertaining to mortgage guaranty insurers, a contingency reserve (established in accordance with insurance regulations designed to protect policyholders against extraordinary volumes of claims) is deductible from gross income. The tax benefits obtained from such deductions must, however, be invested in a special type of non-interest bearing U.S. Government Tax and Loss Bond. For Federal income tax purposes, the amounts deducted for the contingency reserve are taken into gross statutory taxable income (a) when the contingency reserve is permitted to be charged for losses under state law or regulation, (b) in the event operating losses are incurred, or (c) in any event upon the expiration of ten years.
As a result of regular examinations of the tax returns for the Corporation and its subsidiaries, the Internal Revenue Service ("IRS") has proposed certain adjustments for additional taxes applicable to the years 1991 through 1995. The proposed adjustments pertain to the timing of certain deductions, the IRS' contention that certain salvage does not qualify for transition rule benefits, deductions for certain loss and unearned premium reserves, and several other issues not involving material amounts. The Company believes that substantially all of the proposed adjustments are without merit, that the Company will be successful in vigorously defending its positions, and that the ultimate adjustments, if any, will not significantly affect its financial condition or results of operations.
(k) Goodwill-The costs of certain purchased subsidiaries in excess of related book values (goodwill) at date of acquisition are being amortized against operations principally over 40 years using the straight-line method. Amortization of goodwill amounted to $4.2 in 2001, $4.1 in 2000 and $3.5 in 1999.
Under Statement of Financial Accounting Standards No. 142 (FAS-142) "Goodwill and Other Intangible Assets", which takes effect for fiscal years beginning after December 15, 2001, all goodwill resulting from business combinations will no longer be amortized against operations but must be tested periodically for possible impairment of its continued value.
The projected benefit obligations for the plans were determined using the following weighted-average assumptions at the dates shown:
The Company sponsors an Employees Savings and Stock Ownership Plan (ESSOP) in which a majority of its employees participate. The ESSOP acquired all of its stock of the Company in 1987 and prior years. Accordingly, it is not required to adopt the American Institute of Certified Public Accountants' SOP No. 93-6, "Employers' Accounting for Employee Stock Ownership Plans." Shares of Company stock owned by the ESSOP are released to participants based on a formula prescribed by the Employee Retirement Income Security Act of 1974, and dividends on released shares are allocated to participants as earnings. The Company's contributions are based on a formula considering growth in net income per share over consecutive five year periods. As of December 31, 2001, there were 6,827,775 Common Shares owned by the ESSOP all of which were released and allocated. There are no repurchase obligations in existence.
Scheduled maturities of the above debt at December 31, 2001 are as follows: 2002: $35.3; 2003: $.6; 2004: $.4; 2005: $.6; 2006: $4.7; 2007 and after: $117.1. During 2001, 2000 and 1999, $13.1, $15.9 and $10.3, respectively, of interest expense on debt was charged to consolidated operations.
- --------- (1) The Corporation has authorized up to 1,000,000 shares of Series G Convertible Preferred Stock for issuance pursuant to the Corporation's Stock Option Plan. Series G had been issued under the designation "G-2". In 2001, the Corporation created a new designation, "G-3", from which no shares have been issued as of December 31, 2001. Management believes this designation will be the source of possible future issuances of Series G stock. Except as otherwise stated, Series "G-2" and Series "G-3" are collectively referred to as Series "G". Each share of Series G pays a floating rate dividend based on the prime rate of interest. At December 31, 2001, the annual dividend rate for Series G-2 was $.65 per share. Each share of Series G is convertible at any time, after being held six months, into 0.95 shares of Common Stock (See 3(c)). Unless previously converted, Series G shares may be redeemed at the Corporation's sole option five years after their issuance.
(c) Stock Option Plan- The Corporation has a stock option plan for certain eligible key employees. Outstanding options at any one time may not exceed 6% of the Old Republic common stock then issued and outstanding. The exercise price of options is equal to the market price of the Corporation's stock on the date of grant; the term of each option is generally ten years from such date. Options may be exercised to the extent of 10% of the number of shares covered thereby on and after the date of grant, and cumulatively to the extent of an additional 10% on and after each of the first through ninth subsequent calendar years. In the event the market closing price of the Old Republic common stock reaches a pre-established value ("the vesting acceleration price"), however, optionees may exercise their options to the extent of 10% of the number of shares covered by the option for each year of employment by the optionee. The option plan enables optionees to, alternatively, exercise their options into Series "G" Convertible Preferred Stock. The exercise of options into such Preferred Stock reduces by 5% the number of equivalent common shares which would otherwise be obtained from the exercise of options into common shares.
(d) Common Stock- There were 500,000,000 shares of common stock authorized at December 31, 2001. At the same date, there were 100,000,000 shares of Class "B" common stock authorized but none were issued or outstanding. Class "B" common shares have the same rights as common shares except for being entitled to 1/10th of a vote per share. In March 2000, the Company canceled 36,420,135 common shares previously reported as treasury stock, restoring them to unissued status; this had no effect on total shareholders' equity or the financial position of the Company.
(f) Statutory Data- The policyholders' surplus and net income (loss), determined in accordance with statutory accounting practices, of the Corporation's insurance subsidiaries was as follows at the dates and for the periods shown:
In December, 1998, the National Association of Insurance Commissioners adopted a revised Accounting Practices and Procedures Manual ("Codification"). This Codification is a comprehensive compilation of statutory accounting practices and principles and was effective for accounting periods beginning after January 1, 2001. The adoption of codification resulted in an increase of $23.2 in the Company's statutory policyholders' surplus principally due to the net effect of increases in premiums written, acquisition costs and deferred income taxes.
(a) Reinsurance- In order to maintain premium production within their capacity and to limit maximum losses for which they might become liable under policies underwritten, Old Republic's insurance subsidiaries, as is the common practice in the insurance industry, cede all or a portion of their premiums and liabilities on certain classes of business to other insurers and reinsurers. Although the ceding of insurance does not ordinarily discharge an insurer from liability to a policyholder, it is industry practice to establish the reinsured part of risks as the liability of the reinsurer. Old Republic also employs retrospective premium, contingent commission, and profit sharing arrangements for parts of its business in order to minimize losses for which it might become liable under insurance policies underwritten by it. To the extent that any reinsurance companies or retrospectively rated risks or producers might be unable to meet their obligations under existing reinsurance or retrospective insurance and agency agreements, Old Republic would be liable for the defaulted amounts. As deemed necessary, reinsurance ceded to other companies is secured by letters of credit, cash, and/or securities.
The following information relates to reinsurance and related data for the General Insurance, Mortgage Guaranty and Life Insurance Groups for the three years ended December 31, 2001. For the years 1999 to 2001, reinsurance transactions of the Title Insurance Group have not been material.
- ---------- (1) Various A&H coverages written in the Life Insurance Group are ceded to the General Insurance Group. Such amounts are recorded as premiums ceded and premiums assumed in the respective segments of this table.
(b) Leases- Some of the Corporation's subsidiaries maintain their offices in leased premises. Certain of these leases provide for the payment of real estate taxes, insurance, and other operating expenses. At December 31, 2001, aggregate minimum rental commitments (net of expected sub-lease receipts) under noncancellable operating leases of $128.4 are summarized as follows: 2002: $33.7; 2003: $27.8; 2004: $19.0; 2005: $11.4; 2006: $8.0; 2007 and after: $28.3.
The City and County of San Francisco and certain escrow customers of an underwritten title agency subsidiary headquartered in the State of California filed lawsuits alleging that the subsidiary: 1) failed to escheat unclaimed escrow funds; 2) charged for services not necessarily provided; and 3) collected illegal interest payments or fees from banks on the basis of funds held for escrow customers. The subsidiary in turn conducted an internal review of its records and concluded that it had certain liabilities for part of the issues denoted at (1) and (2). The subsidiary defended against the alleged practice denoted at (3) on the grounds that such practices are common within the industry, are not in conflict with any laws or regulations, and other meritorious defenses. The consolidated lawsuits have been tried and a judgement rendered, affirming in part and denying in part the subsidiary's defenses. In the aggregate, the judgement, excluding post-judgement interest, amounts to approximately $33.0. The subsidiary has made preparations to appeal the judgement, and management believes that the judgement will be substantially reduced on appeal. The subsidiary has continually evaluated its exposures and has paid or otherwise provided for its best estimate of litigation and related costs associated with all these issues in the amounts of $6.8, $4.1 and $16.2 in 2001, 2000 and 1999, respectively, and $46.6 for all years combined since 1998.
Note 5-Consolidated Quarterly Results-Unaudited - Old Republic's consolidated quarterly operating data for the two years ended December 31, 2001 is presented below.
In the opinion of management, all adjustments consisting of normal recurring adjustments necessary to a fair presentation of quarterly results have been reflected in the data which follows. It is also management's opinion, however, that quarterly operating data for insurance enterprises is not indicative of results to be achieved in succeeding quarters or years. The long-term nature of the insurance business, seasonal and cyclical factors affecting premium production, the fortuitous nature and at times delayed emergence of claims, and changes in yields on invested assets are some of the factors necessitating a review of operating results, changes in shareholders' equity, and cash flows for periods of several years to obtain a proper indicator of performance. The data below should be read in conjunction with the "Management Analysis of Financial Position and Results of Operations":
Private mortgage insurance produced by the Mortgage Guaranty Group protects mortgage lenders and investors from default related losses on residential mortgage loans made primarily to homebuyers who make down payments of less than 20% of the home's purchase price. The Corporation insures only first mortgage loans, primarily on residential properties having one-to-four family dwelling units. The Corporation's mortgage insurance business originates from mortgage bankers (63.7%), commercial banks (18.0%), savings institutions (13.2%) and other mortgage originators (5.1%). The Mortgage Guaranty segment's ten largest customers were responsible for approximately 65.6%, 60.3% and 48.9% of direct insurance in force as of December 31, 2001, 2000 and 1999, respectively. The largest single customer accounted for 11.5% of the direct insurance in force as of December 31, 2001 compared to 11.7% and 9.5% as of December 31, 2000 and 1999, respectively.