Year Ended December 31, 1996 Compared to Year Ended December 31,
Premiums. The Insurance Companies increased direct premium writings $2.6 million or 3.4% in 1996 as compared to 1995. This increase in direct premiums written was concentrated in personal automobile which grew 10.8%, workers compensation which grew 8.8%, and farmowners which grew 5.6%. The increase in automobile and workers compensation reflect the Insurance Companies continuing focus on increasing liability business in an effort to balance the overall book of business between property and liability exposures. The farmowners line increased due to premium rate increases and reacquiring business lost in 1995 and 1994 due to pricing competition. Commercial multiple peril direct premiums declined by 4.6% in 1996 as compared to 1995. Farmowners, homeowners, and personal automobile direct writings as a percentage of the total book of business were 20.0%, 26.3%, and 22.7%, respectively, in 1996 as compared to 19.7%, 26.8%, and 21.3%, respectively, for 1995. A significant rate decrease in workers compensation premium rates was implemented by the Pennsylvania Workers Compensation Insurance Fund in late 1996. This rate decrease will be adopted by all carriers in 1997 and will likely decrease workers compensation premiums written for the Insurance Companies. The decrease was driven by lower claim costs arising out of reforms adopted in 1994-1995. The Insurance Companies are attempting to offset this revenue loss by writing workers compensation coverage through formal programs initiated certain trade associations.
Net premiums written decreased $19.4 million, or 28.9%, for the year ended December 31, 1996 to $47.7 million from $67.1 million in 1995. For the same comparative periods, net premiums earned decreased by $13.1 million, or 19.6%, to $53.6 million from $66.7 million. The decreases in net premiums written and net premiums earned were directly attributable to the effects of instituting the quota share reinsurance treaty between the Insurance Companies and American Re as well as the other factors discussed above.
Net Realized Investment Gains. Net realized investment gains were $1.4 million for the year ended December 31, 1996 compared to $1.0 million in 1995. The adverse claims experience of the first half of 1996 placed a severe burden on the Insurance Companies' cash flow and, accordingly, certain investments in bonds and preferred stocks were liquidated to meet cash needs. In addition, the investment portfolio was restructured during 1996 as described above. Interest rate and general economic conditions in 1996 also created capital gains opportunities.
Loss and loss adjustment expenses were 82.8% of net premiums earned for the year ended December 31, 1996 compared to 75.8% in 1995. The impact of the catastrophic losses in 1996 on the loss ratio was 6.5 percentage points.
Underwriting Expenses. Underwriting expenses decreased by $4.6 million, or 20.0%, for the year ended December 31, 1996 to $18.6 million from $23.3 million for 1995. The reduction is primarily due to a $5.5 million reduction in amortization of policy acquisition costs arising out of the implementation of the quota share reinsurance treaty offset by a $900,000 increase in operating expenses. For the year ended December 31, 1996 the Insurance Companies had an underwriting expense ratio of 34.7% compared to 34.9% for the year ended December 31, 1995.
Net Income. Net income decreased $1.2 million to a $1.9 million loss in 1996 from a net loss of $684,000 in 1995 primarily as a result of the foregoing factors.
Premiums. The Insurance Companies experienced a slight increase in direct premiums written in 1995 of $102,000 that was concentrated in personal automobile, which grew 5.5%, and homeowners, which grew 3.2%. Farmowners and workers' compensation direct premiums declined by 3.6% and 2.4%, respectively. The increases in personal lines premiums were the result of new business as well as modest rate increases. Farmowners writings declined due to competitive rate pressures and workers' compensation writings declined due to rate decreases arising out of improvements in loss experience attributable to legislative initiatives in 1993.
Net Investment Income. Cash and invested assets increased $10.3 million, or 11.4%, to $100.5 million for the year ended December 31, 1995 from $90.2 million for the year ended December 31, 1994. For the year ended December 31, 1995, the yield on invested assets was 4.7% compared to 4.1% for the year ended December 31, 1994. The net result of these changes was that net investment income increased $526,000, or 15.4%, to $4.5 million for the year ended December 31, 1995 from $3.9 million in 1994. Components of the increase in net investment income arose from an increase in gross income from fixed income securities of $785,000, or 21.4%, a decrease in income from the preferred stock portfolio of $431,000 and a decrease in investment expenses of $101,000. Income from the common stock portfolio increased $134,000, and income from short- term and other investments decreased by $63,000 accounting for the balance of the increase in net investment income.
Limited cash flow in 1994 and early 1995, as well as declines in short-term interest rates, caused short-term investment income to decline by $74,000 in 1995 as compared to 1994.
Underwriting Results. For the year ended December 31, 1995 the Insurance Companies had an underwriting loss of $7.1 million and a combined ratio of 110.7% compared to an underwriting loss of $5.1 million and a combined ratio of 108.0% for the year ended December 31, 1994. In both years the underwriting loss was primarily attributable to severe weather in the Insurance Companies' territory.
Losses and Loss Adjustment Expenses. Net losses and loss adjustment expenses incurred increased by $4.1 million, or 8.8%, to $50.5 million for the year ended December 31, 1995 from $46.4 million in 1994. Loss and loss adjustment expenses were 75.8% of net premiums earned for the year ended December 31, 1995 compared to 73.2% in 1994.
Affecting losses and loss adjustment expenses in both 1995 and 1994 were several significant weather events that individually resulted in increased property loss claims. In 1995 a series of localized wind storms produced $3.2 million of net claims. Because none of these events met the definition of a catastrophe under the Insurance Companies' catastrophe reinsurance programs, no catastrophe reinsurance recovery was made in 1995. The year 1994 produced the single most significant claim event in the Insurance Companies' history. Winter snow and ice storms produced nearly $19.2 million in gross claims. After recoveries under catastrophe reinsurance programs, the Insurance Companies incurred $3.1 million of net losses and loss adjustment expenses from these winter storms. The respective impact of these storms on the loss ratio was 4.8 percentage points and 4.9 percentage points for 1995 and 1994, respectively. For the five year period preceding 1994 the Insurance Companies never had a single event resulting in claims in excess of $2.7 million. The 1996 catastrophe reinsurance retention limit is $3.5 million.
Net Income. Net income decreased $828,000 to a $684,000 loss in 1995 from net income of $144,000 in 1994 primarily as a result of the foregoing factors.
Historically, the principal sources of the Insurance Companies' cash flow have been premiums, investment income, maturing investments and proceeds from sales of invested assets. In addition to the need for cash flow to meet operating expenses, the liquidity requirements of the Insurance Companies relate primarily to the payment of losses and loss adjustment expenses. The short- and long-term liquidity requirements of the Insurance Companies vary because of the uncertainties regarding the settlement dates for liabilities for unpaid claims and because of the potential for large losses, either individually or in the aggregate.
Net cash provided by (used in) investing activities was $7.4 million, ($3.3) million and $2.2 million during the years ended December 31, 1996, 1995 and 1994, respectively. The increase in net cash provided by investing activities during the year ended December 31, 1996 primarily resulted from a decrease in the Insurance Companies' fixed-income securities. The increase in net cash used in investing activities in 1995 as compared to 1994 resulted primarily from the net increase in cash available from the Company's operations during 1995. The increase in net cash provided by investing activities in 1994 resulted primarily from the sale of fixed income and equity securities materially exceeding the purchase of such securities.
The principal source of liquidity for the Company will be dividend payments and other fees received from the Insurance Companies. The Company's insurance subsidiaries, including the Insurance Companies, will be restricted by the insurance laws of the state of domicile as to the amount of dividends or other distributions they may pay to the Company without the prior approval of the state regulatory authority. Under Pennsylvania law, the maximum amount that may be paid by each of the Insurance Companies during any twelve-month period after notice to, but without prior approval of, the Department cannot exceed the greater of 10% of the Insurance Company's statutory surplus as reported on the most recent annual statement filed with the Department, or the net income of the Insurance Company for the period covered by such annual statement.
In our opinion, the combined financial statements referred to above present fairly, in all material respects, the combined financial position of the Group as of December 31, 1996 and 1995, and the combined results of their operations and their cash flows for the years ended December 31, 1996, 1995 and 1994 in conformity with generally accepted accounting principles.
OLD GUARD MUTUAL INSURANCE COMPANY, OLD GUARD MUTUAL FIRE INSURANCE COMPANY, AND GOSCHENHOPPEN-HOME MUTUAL INSURANCE COMPANY AND SUBSIDIARY Combined Balance Sheets as of December 31, 1996 and 1995
Combined Statements of Income for the years ended December 31, 1996, 1995 and 1994
OLD GUARD MUTUAL INSURANCE COMPANY, OLD GUARD MUTUAL FIRE INSURANCE COMPANY, AND GOSCHENHOPPEN-HOME MUTUAL INSURANCE COMPANY AND SUBSIDIARY
Combined Statements of Changes in Surplus for the years ended December 31, 1996, 1995 and 1994
Old Guard Mutual Insurance Company, Old Guard Mutual Fire Insurance Company, and Goschenhoppen-Home Mutual Insurance Company and Subsidiary
The combined financial statements include the accounts of Old Guard Mutual Insurance Company (OGM), Old Guard Mutual Fire Insurance Company (OGF) and Goschenhoppen-Home Mutual Insurance Company (GHM) and their subsidiary Old Guard Investment Holding Company, Inc. (OGIHC). 2929 Service Corporation and Commonwealth Insurance Managers, Inc. (CIMI) are wholly owned subsidiaries of OGIHC. The companies operate collectively as the Old Guard Insurance Group (the Group). Management believes that presentation of combined financial statements is the most meaningful given the pending transaction described in footnote 15A "Demutualization" and since the companies operate under common management and, through a pooling agreement, share in the premiums written and loss experience of each insurance company.
Each of the insurance company members of the Group, as described above, was a party to a joint application for approval to convert from mutual to stock form of organization which was approved by the Insurance Department of the Commonwealth of Pennsylvania (Insurance Department) on December 26, 1996. The approval granted the formation of an insurance holding company, incorporated in Pennsylvania, to purchase all of the authorized stock of OGM, OGF and GHM, which converted from the mutual to the stock form of organization on February 11, 1997 (see Note 15A). Until completion of the conversion, the insurance holding company did not engage in any significant operations and had no assets or liabilities as of December 31, 1996, except as noted in Note 15A.
The accompanying combined financial statements have been prepared in conformity with generally accepted accounting principles. All significant intercompany transactions have been eliminated in combination.
Effective January 1, 1994, the Group adopted Financial Accounting Standards Board Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115). Under SFAS 115 debt and marketable equity securities must be classified as held-to-maturity, trading, or available-for-sale. Due to periodic shifts in the portfolio arising out of income tax and asset-liability matching, as well as securities markets and economic factors, management considers the entire portfolio of fixed income securities as available-for-sale. Each new security is evaluated at the time of purchase and reevaluated at each balance sheet date. Available-for-sale securities are carried at fair value, with the unrealized gains and losses, net of deferred income tax, reported as a separate component of surplus. The cumulative effect as of January 1, 1994 of adopting SFAS 115, representing the unrealized gains on fixed income securities classified as available-for-sale, net of deferred income tax, was to increase surplus by $629,225.
The fair value of all investments is subject to various market fluctuations which include changes in equity markets, interest rate environment and general economic conditions. Interest on fixed maturities and short-term investments is credited to income as it accrues on the principal amounts outstanding, adjusted for amortization of premiums and accretion of discounts computed utilizing the effective interest rate method.
The Group cedes insurance to, and assumes insurance from, unrelated insurers to limit its maximum loss exposure through risk diversification.
Certain reinsurance contracts provide for retrospective rate adjustments based on experience. Management estimates the ultimate ceded premium based upon historical experience. Any adjustments resulting from changes in estimates are reflected in current operating results.
No one insured accounted for a significant amount of premiums earned or premiums in course of collection in 1996 and 1995.
The Group's insurance companies which are domiciled in the Commonwealth of Pennsylvania, prepare their statutory financial statements in accordance with accounting principles and practices prescribed or permitted by the Insurance Department. Prescribed statutory accounting practices include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (NAIC). Permitted statutory accounting practices encompass all accounting practices that are not prescribed; such practices differ from state to state, may differ from company to company within a state, and may change in the future. Furthermore, the NAIC has a project to codify statutory accounting practices, the result of which is expected to constitute the only source of "prescribed" statutory accounting practices. Accordingly, that project will likely change the definitions of what comprise prescribed versus permitted statutory accounting practices, and may result in changes to the accounting policies that insurance enterprises use to prepare their statutory financial statements. The effects of any such changes are not presently determinable and will not likely affect financial statements prepared under generally accepted accounting principles.
Statutory surplus and net income (loss), determined in accordance with accounting practices prescribed or permitted by the Insurance Department for the Group, are as follows:
A reconciliation of the Group's statutory net income and surplus to the Group's net income and surplus, under generally accepted accounting principles (GAAP), is as follows:
The Group is required to maintain a minimum aggregate surplus balance of approximately $9,825,000 on a statutory basis of accounting to satisfy regulatory requirements.
The amortized cost and estimated fair value of fixed income securities at December 31, 1996 by contractual maturity are shown below:
Due in one year or less $ 6,280,481 $ 6,238,100 Due after one year through five years 16,020,766 16,013,529 Due after five years through ten years 4,424,818 4,623,841 Due after ten years 11,426,237 11,512,503 Collateralized and asset backed securities 31,564,112 31,517,103
Collateralized and asset-backed securities consist of mortgage pass-through holdings and securities backed by credit card receivables, auto loans and home equity loans. These securities follow a structured principal repayment schedule and are of high credit quality rated "AA" or better by Standard & Poor's. These securities are presented separately in the maturity schedule due to the inherent risk associated with prepayment on early authorization. The average duration of this portfolio is 2.8 years.
Activity in the reserve for losses and loss adjustment expenses is summarized as follows:
The reserve for losses and loss adjustment expenses reflect management's best estimate of future amounts needed to pay claims and related settlement costs with respect to insured events which have occurred, including events that have not been reported to the Group. In many cases, significant periods of time, ranging up to several years, may elapse between the occurrence of an insured loss, the reporting of the loss, and the payment of that loss. As part of the process in determining these amounts, historical data is reviewed and consideration is given to the impact of various factors, such as legal developments, changes in social attitudes, and economic conditions.
Management believes that its reserve for losses and loss adjustment expenses are fairly stated, in accordance with generally accepted actuarial principles and practices. However, estimating the ultimate claims liability is a complex and judgmental process inasmuch as the amounts are based on management's informed estimates and judgments using data currently available. As additional experience and data become available regarding claim payments and reporting patterns, legislative developments, and economic conditions, the estimates are revised accordingly and the impact is reflected currently in the Group's combined financial statements.
The following amounts represent the Group's reinsurance activity with unrelated insurers for each of the three years ended December 31:
Ceded: Premiums earned $27,468,375 $11,600,070 $13,062,659 Unearned premiums $ 8,417,500 $ 1,469,316 $ 1,238,558 Losses and loss adjustment expenses incurred $30,508,137 $ 6,897,673 $19,217,783
During 1989, OGM received an advance to surplus for statutory purposes from a third party. Repayment of principal began in April 1991 and continues annually through 1998 in the amount of $750,000 per year. Interest, at 9%, is to be paid each December. Such repayments of principal and payments of interest are subject to certain notification and approval requirements of the Insurance Department. Amounts not paid in accordance with the aforementioned schedule will accrue interest at 9%. Certain additional terms related to liquidation, merger or demutualization of the Company provide for the principal to become due and payable (see Note 15A). OGM paid interest of $174,021, $224,877 and $309,025 under the obligation in 1996, 1995 and 1994, respectively.
Unearned premium $1,765,297 $1,815,247 Reserve for losses and loss adjustment expenses 1,676,812 2,166,680 Alternative minimum tax credit carryforward 565,204 324,356 Net operating loss carryforward 1,106,780 536,254 Other 417,375 211,823
The components of the provision (benefit) for income taxes for each of the three years ended December 31 are as follows:
Current federal income tax expense (benefit) $ (516,465) $ (22,803) $ 61,997
GHM has a net operating loss carryforward at December 31, 1996, of approximately $2,054,000. GHM's net operating loss carryforwards expire $289,000 in 2007, $554,000 in 2008, $780,000 in 2009 and $431,000 in 2011.
As of December 31, 1996, OGM had alternative minimum tax credit carryforwards of approximately $303,000 available to offset future tax liability.
The Group has a discretionary noncontributory profit sharing plan covering eligible employees. The Group's contribution to the plan amounted to $268,043, $262,945 and $233,214 for the years ended December 31, 1996, 1995, and 1994, respectively.
In July 1996, OGIHC executed a letter of understanding with a Delaware domiciled property and casualty insurance company. The letter provides for the Delaware insurance company to secure insurance management services from CIMI and pursue mutual to stock conversion and for the Group to purchase a $1.0 million convertible surplus note and at its discretion to purchase up to an additional $3.0 million of convertible surplus notes. The agreement became effective December 27, 1996.
On May 31, 1996, the individual Boards of Directors of the OGM, OGF and GHM (collectively Insurance Companies) approved a plan of conversion for changing the corporate form of the individual Insurance Companies from the mutual form to the stock form (conversion) and the simultaneous acquisition of the capital stock of each of the individual Insurance Companies by Old Guard Group, Inc. (OGGI), a newly formed Pennsylvania corporation and the proposed holding company of the Insurance Companies (demutualization plan). The demutualization plan was approved by the Insurance Department of the Commonwealth of Pennsylvania on December 26, 1996.
In accordance with the demutualization plan, policyholders as of May 31, 1996 were offered in January 1997, through a subscription offering, the opportunity to purchase stock in OGGI, the newly formed holding company. Pursuant to the demutualization plan, a special meeting of the Insurance Companies' policyholders was held on February 11, 1997, at which time the Insurance Companies (i) converted from Pennsylvania-chartered mutual insurance companies to a Pennsylvania chartered stock insurance companies, and (ii) simultaneously issued shares of capital stock of the Insurance Companies to OGGI, in exchange for $16.0 million of the net proceeds from the sale of common stock in OGGI through the subscription offering as part of the demutualization plan. The demutualization will be accounted for as a simultaneous reorganization, recapitalization and share offering which will not change the historical accounting basis of the Insurance Companies' financial statements.
Issuance costs represent amounts due to OGM from OGGI for costs incurred related to the common stock offering of OGGI. The issuance costs were reimbursed by OGGI to OGM in February 1997 in conjunction with the closing of OGGI's common stock offering.
Upon completion of the conversion, OGGI approved an ESOP for the benefit of participating employees. The ESOP borrowed funds in an amount sufficient to purchase 10% of the common stock for $4,054,910.
The demutualization plan was completed as of February 11, 1997, however if the Act, or any portion of the Act, is declared unconstitutional, the remedy the Court would grant is uncertain.
If the plaintiffs prevail in the above litigation, the remedy a court would grant or the amount of damages it might award is uncertain. A court has broad discretion to fashion a fair and equitable remedy in light of the nature of the constitutional or other violation, the relative harm to the parties, and the public interest. In some cases, relief is applied on a prospective basis only; in other cases, relief is applied on a retroactive basis. No prediction can be made concerning the remedy a court would fashion or the amount of damages it might award.
The plaintiffs demand judgment for themselves and for the class and derivatively for the Insurance Companies and OGGI. The plaintiff is contending that the demutualization plan violates the rights of the plaintiffs and members of the class under the United States and Pennsylvania constitution and under the Act, and that the Act is unconstitutional as applied by the demutualization plan. Final adjudication of the case by the U.S. District court could take a year or more.
On February 10, 1997, OGGI, the Insurance Companies and each of their respective directors were served with an eleven count combination class action and derivative lawsuit, filed in the United States District Court for the Eastern District of Pennsylvania against the Company, the Insurance Companies and their directors (Class Action) by four policyholders. By filing the class action portion of the lawsuit, these four policyholders purport to represent all 141,000 policyholders of the Insurance Companies. Seven of the eleven counts are similar to the claims of the January 7, 1997 suit challenging the constitutionality of the Act, although certain counts advance a different theory alleging unconstitutional impairment of contract. The remainder of the class action claims assert theories regarding purported violations of the Act, principally relating to the description of the Plan in the proxy statement approved by the Insurance Department of the Commonwealth of Pennsylvania and mailed to policyholders. The derivative claim was brought against the directors of Insurance Companies, purportedly on behalf of the Insurance Companies, alleging breach of the fiduciary duty of care in approving and implementing the Plan and the fiduciary duty of loyalty, presumably in approving the stock-based compensation plans which are contemplated by the Plan. The stock-based compensation plans are expressly permitted by the Act and were approved by the Insurance Department of the Commonwealth of Pennsylvania. The suit seeks such compensatory damages as may be allowed by law, a declaration that the Plan violates the Act and the United States and Pennsylvania Constitutions and the rights of the plaintiffs thereunder, and such other relief as the court deems appropriate.
Our report on the combined financial statements of Old Guard Mutual Insurance Company, Old Guard Mutual Fire Insurance Company, and Goschenhoppen-Home Mutual Insurance Company and subsidiary (the Group) is included in Item 8 of this Form 10-K. In connection with such audits of our financial statements, we have also audited the related financial statement schedules included in Item 8 of this Form 10-K. These financial statements schedules are the responsibility of the Group's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits.
OLD GUARD INSURANCE GROUP SCHEDULE IV - REINSURANCE FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994