During the past five years, the Company's other major segment, crop insurance, has met or exceeded the Company's operating margin expectations, and this trend continued during 1998. The Company is currently the third largest writer of MPCI business in the United States.
Certain characteristics of the Company's crop business may affect comparisons, including: (i) the seasonal nature of the business whereby profits or losses are generally recognized predominately in the second half of the year; (ii) the nature of crop business whereby losses are known within a short time period; and (iii) the limited amount of investment income associated with crop business. In addition, cash flows from such business differ from cash flows from certain more traditional lines. See "Liquidity and Capital Resources" below. The seasonal and short term nature of the Company's crop business, as well as the impact on such business of weather and other natural perils, may produce more volatility in the Company's operating results on a quarter to quarter or year to year basis than has historically been the case.
Forward-looking information set forth herein does not take into account any impact from any adverse weather conditions during the 1999 crop season, or the various other factors noted above which may affect crop and non-crop operation results.
Results of Operations Year Ended December 31, 1998 Compared to Year Ended December 31, 1997
The Companys net income decreased 84.3% from $35.3 million in the year ended December 31, 1997 to $5.5 million in the year ended December 31, 1998. The Companys operating income decreased 69.1% from $57.9 million in the year ended December 31, 1997 to $17.9 million in the year ended December 31, 1998. These deteriorating results occurred due to a decline in the Company's net premiums earned, an increase in the Company's incurred losses and loss adjustment expenses, an increase in the Company's underwriting and general and administrative expenses, an increase in the Company's interest expenses, and a decrease in the Company's net realized capital gains. These negative results were primarily a result of the failure of the Company's property and casualty operations to achieve underwriting profitability, whereas the Company's crop insurance operations were able to meet or exceed profitability expectations for the fifth consecutive year.
Underwriting expenses increased from $97.1 million during 1997 to $104.7 million during 1998, thus increasing the ratio of underwriting expenses to net premiums earned from 29.0% in 1997 to 31.9% in 1998. Underwriting expense in the Company's crop insurance operations increased from 1997 expenses of $9.0 million to underwriting expenses in 1998 of $14.8 million. This increase of $5.7 million resulted from a decrease in the expense reimbursement from the federal government in the Company's MPCI crop insurance program of $5.2 million, an increase in commissions paid to agents on MPCI policies purchased at the catastrophic level of $3.3 million as the market changed its commission practices on this type of policy from a flat fee to a percentage of imputed premiums, and, offsetting these increase in expenses, a decrease in the crop insurance segment's operating expenses of $2.8 million resulting from improvements in operating efficiencies. The Company's underwriting expenses in its property and casualty segment increased more modestly from $88.1 million or 32.0% of net premiums earned in 1997 to $90.0 million or 33.7% of net premiums earned in 1998. This increase in underwriting expenses in the property and casualty segment occurred principally from a shifting emphasis on casualty lines of business under which the Company pays a lower rate of commission to property lines of business in which the Company's acquisition expenses are greater, but where its historical loss ratios are lower. In the Company's property and casualty segment, the Company has sought to reduce overall operating expenses as part of its restructuring process, and therefore, believes that the ratio of underwriting expenses to net premiums earned will return to the level experienced in 1997 during 1999. In the Company's crop insurance operations, the federal government has again in 1999 reduced the expense reimbursement under the Company's MPCI crop insurance programs. The Company does not believe that the competitive marketplace for crop insurance will allow it to reduce commissions or other operating expenses commensurate with the reduction in federal reimbursement, and therefore, the Company expects underwriting expenses in its crop segment to again increase during 1999.
The Company's charges for general and administrative expenses increased from $2.1 million in 1997 to $3.5 million during 1998. The principal component of this increase was a $1.1 million charge recorded in 1998 related to the valuation of its non-standard automobile subsidiary that is being held for sale.
The Company's net investment income remained approximately the same during 1997 as its was in 1998, increasing from $28.0 million during 1997 to $28.3 million during 1998. This slight increase in net investment income was positively impacted by an increase in the average outstanding size of the Company's investment portfolio from $453.9 million during the twelve months ended December 31, 1997 to $497.7 million during the twelve months ended December 31, 1998. However, the before tax investment yield of the Company's investments declined from 6.2% during 1997 to 5.7% during 1998. This decrease in investment yield was a result of an overall lower interest rate environment during 1998 as compared to 1997 as well as an increase in the amount of municipal tax advantaged securities and common stock in the Company's investment portfolio during 1998 as compared to 1997. In addition, the Company's net realized capital gains decreased from $7.3 million during the twelve months ended December 31, 1997 to $6.8 million during the twelve months ended December 31, 1998.
After several years of growth in net insurance premiums earned, the Company experienced a decline in net insurance premiums earned from $348.7 million in 1996 to $335.2 million in 1997, a decline of approximately 3.9%. During 1997, the Company's goal in its Property and Casualty segment was to improve underwriting results through an emphasis on profitable lines, a restructuring of marginal lines, and a discontinuation of unprofitable lines. During this process, growth in profitable lines of business was offset by declining volumes in the discontinued lines resulting in only a .8% increase in direct premiums written and a 2.3% increase in gross premiums written. In lines of business in which the Company was seeking to improve marginal results, the Company ceded additional amounts to reinsurers in order to reduce the impact of these lines as well as to help improve the net results of the Company. Due to the competitive environment in the Property and Casualty business, new programs which the Company initiated in 1997 were also heavily reinsured in order to diminish the impact on the Company's results until such time as these new programs confirmed their expected level of profitability. Accordingly, the Company increased its cessions to reinsurers by approximately $46.6 million from $284.1 million in 1996 to $330.7 million during 1997, resulting in a 8.7% decline in net premiums written during 1997 as compared to 1996.
The Property and Casualty segment's improved underwriting results were due to a decrease in both the segment's accident year and calendar year loss and loss adjustment expense ratios from 1996 to 1997. The segment's loss and loss adjustment expense ratios fell from 74.6% and 78.0% on an accident and calendar year basis respectively during 1996 to 69.9% and 72.5% on an accident year calendar year basis respectively during 1997. The improvement in the loss and loss adjustment expense ratio resulted from a change in mix of business, emphasizing more profitable lines, restructuring reinsurance to improve the Company's net results and the cancellation of programs and agents with unprofitable loss and loss adjustment expense ratios.
Additionally, the Property and Casualty segment's expense ratio decrease from 33.4% during 1996 to 32.0% during 1997. During 1996, many of the new programs within the segment were in a start-up phase in which fixed expenses were not offset by adequate earned premiums. During 1997, growth in earned premiums in these programs allowed fixed costs to move into a more normal relationship as a percentage of earned premiums.
During 1997, non-automobile lines of business continued to outperform the automobile lines of business within the Company's Property and Casualty segment. For the year 1997, automobile lines recorded a 112.9% combined ratio while non-automobile lines recorded 99.9% combined ratio. The Company continues to effect significant underwriting changes within its automobile lines in order to bring them closer to the Company's desired goal of a combined ratio of 100.0% or less.
The Company's Crop segment was a significant contributor to the underwriting earnings of the Company in both 1996 and 1997. During 1996, the segment contributed $41.5 million to the Company's underwriting earnings as compared to $36.9 million during 1997. During 1997, the Company earned a profit share of 31.5% on its MPCI retained premium pool of approximately $155.5 million or $49.0 million. This compares with an earned profit share of 23.5% on a $161.4 million retained premium pool generating $37.9 million in 1996.
During the first quarter of 1996, the Company's operating income benefited from a $2.8 million profit in the Company's Crop segment. The principal component of this $2.8 million was the recording of an additional $3.8 million in profit sharing under the Company's MPCI program. The Company's estimate of its profit sharing under the MPCI program at December 31, 1995 was affected by a volatile crop growing season during which many of the rules pertaining to preventive planting payments were changed and a combination of unusual weather conditions manifested themselves in an unusually late harvest. As claims were closed during the first quarter of 1996 and the final preventive planting rules applied to these losses, the Company was able to earn additional profit sharing. The 1996 growing year did not experience this same degree of volatility, and the harvest was not delayed by unusual weather conditions. Consequently, the MPCI profit sharing income recorded at December 31, 1996 more accurately estimated actual results than had the profit sharing recorded at December 31, 1995. During the first quarter of 1997, the Company experienced operating income of approximately $900,000 from the operations of its Crop segment. The Company believes that the crop results for the first quarter of 1997 were more typical of a normal year than those experienced in the first quarter of 1996.
The Company's interest expense increased 34.2% from $4.9 million during 1996 to $6.6 million during 1997. This increase in interest expense resulted from both an increase in the Company's average borrowings and the average interest rate paid by the Company. During 1997, the Company's average borrowings were $81.6 million and the average interest rate was 8.1% as compared to average borrowings in 1996 of $69 million and an average interest rate of 7.1%. The increased borrowings during 1997 were used to add statutory surplus to the Company's insurance company subsidiaries. The increase in the Company's average interest rate paid resulted from the issuance of $94.875 million in Trust Preferred Securities and the retirement of the Company's outstanding bank debt during the third quarter of 1997 (see discussion under Liquidity and Capital Resources).
The Company's 1996 taxes were positively effected by the decrease in the valuation allowance related to the unrealized loss from the Company's investment in Major Realty. In October 1995, Major Realty announced that its Board of Directors had determined that it was in the best interest of the stockholders to seek a merger partner, otherwise seek a transaction for the sale of the company. At December 31, 1996, the Company believed that the realization of the capital loss associated with such a transaction was more likely than not due to sufficient carryforwards of capital gains as well as the likelihood of future capital gains. No such benefit was realized in 1997, and therefore, the Company's effective tax rate increased to a more normal level of 31.2% as compared to an effective tax rate of 9.6% in 1996.
The Company has included a discussion of the liquidity and capital resources requirement of the Company and the insurance subsidiaries.
The NAIC has established a Risk Based Capital ("RBC") formula for property and casualty insurance companies. The RBC initiative is designed to enhance the current regulatory framework for the evaluation of the capital adequacy of a property and casualty insurer. The formula requires an insurer to compute the amount of capital necessary to support four areas of risk facing property and casualty insurers: (a) asset risk (default on fixed income assets and market decline), (b) credit risk (losses from unrecoverable reinsurance and inability to collect agents' balances and other receivables), (c) underwriting risk (premium pricing and reserve estimates), and (d) off balance sheet/growth risk (excessive premium growth and unreported liabilities). The Insurance Companies have reviewed and applied the RBC formula for the 1998 year and have exceeded these requirements.
Cash flows from operations for the year ended December 31, 1998 were $34.0 million as compared to cash flows from operating activities of $10.1 million during 1997. The increase in positive cash flows is primarily the result of the profit sharing payments received from the federal government under the Company's MPCI crop insurance program. During 1997, this component of operating cash flows was $25.5 million while in 1998, it was $57.0 million.
Cash flows from the Company's MPCI and crop hail business are different in certain respects from cash flows associated with more traditional property and casualty lines (see Liquidity and Capital Resources, Insurance Companies).
The Company does not believe that inflation has had a material impact on its financial condition or results of operations.
At December 31, 1998, the Company had $346.6 million of fixed maturity securities and mortgage loans and $71.7 million of marketable equity securities that were subject to market risk. The Company's investment strategy is to manage the duration of the portfolio relative to the duration of the liabilities while managing interest rate risk. In addition, the Company has the ability to hold its maturity investments until maturity and therefore would not expect to recognize a material adverse impact on income or cash flows.
The Company uses two models to analyze the sensitivity of its market risk assets and liabilities. For its fixed maturity securities, mortgage loans and mandatorily redeemable Preferred Securities, the Company uses duration modeling to calculate changes in fair value. For its marketable equity securities, the Company uses a hypothetical 20% decrease in the fair value of these securities. Actual results may differ from the hypothetical results assumed in this disclosure due to possible actions taken by management to mitigate adverse changes in fair value and because fair values of securities may be affected by credit concerns of the issuer, prepayment speeds, liquidity of the security and other general market conditions. The sensitivity analysis duration model used by the Company produces a loss in fair value of $19.0 million on its fixed maturity securities and mortgage loans and a gain in fair value of $8.7 million on its mandatorily redeemable Preferred Securities, based on a 100 basis point increase in interest rates. The hypothetical 20% decrease in fair value of the Company's marketable equity securities produces a loss in fair value of $14.3 million.
The Company previously identified its information technology ("IT") systems requiring modification to be Year 2000 compliant. The Company developed and continues to implement a corrective plan utilizing both internal and external resources to make necessary modifications to, and to test, the Company's IT systems for Year 2000 compliance. The Company has addressed the Year 2000 issue with respect to the majority of the Company's IT systems and believes that they are Year 2000 compliant and management expects the remaining Company IT systems to be Year 2000 compliant by September 1, 1999.
One of the more significant third parties is the Risk Management Agency ("RMA") which, along with the Federal Crop Insurance Corporation ("FCIC"), administers the federal crop insurance program. The RMA calculates and settles the Company's MPCI profit share and expense reimbursement. The RMA has publicly stated that all RMA and FCIC systems will be Year 2000 compliant as of the filing date of this 10-K.
In June 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 133 (SFAS No. 133), Accounting for Derivative Instruments and Hedging Activities, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. Management does not expect the adoption of SFAS No. 133 to have a material impact to the Company's consolidated financial statements.