The Group's main offices are located at 2929 Lititz Pike, Lancaster, Pennsylvania in a 33,000 square foot facility owned by Old Guard. Old Guard Fire owns a 25,000 square foot office facility near the main office at 147 West Airport Road in Lancaster. First Patriot leases 7,500 square feet of office space in Quakertown, Pennsylvania and First Delaware leases 6,750 square feet of office space in Smyrna, Delaware.
Premiums. Direct premiums written increased $5.3 million, or 6.7%, in 1997 compared to 1996. This increase in direct premiums written can be attributed, in part, to the acquisition of First Delaware which contributed $3.6 million to the increase. The remaining increase can be attributed to increases in personal and commercial automobile and farmowners business offset by a decrease in homeowners business. The increases in automobile writings reflects the Group's 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 as competition eased somewhat in the Group's primary market, Pennsylvania. Homeowners premiums decreased $435,000, or 2.0%, in 1997 as a result of a reunderwriting initiative which commenced in 1997 and is designed to improve the portfolio mix to include higher value dwellings and to ensure that the appropriate premium is received for the risk underwritten. To date, this initiative has been successful as the number of homeowners policies in force has declined at a faster rate than written premiums indicating that we are receiving more premium dollars for less risk. Workers' compensation premium rates decreased in 1997 because of a 25% rate reduction mandated by the Pennsylvania Workers' Compensation Rating Bureau. The decrease was driven by lower claim costs arising out of reforms adopted in 1994-1995. This rate reduction was offset by increases in policy count as the Group implemented several safety group programs to attract new and maintain existing business. The safety group programs offer dividends based upon the group's loss experience and to policyholders who are otherwise unable to obtain a dividend participating policy. By creating safety groups, the Group is able to offer this benefit and attract new business. Farmowners, homeowners, and personal automobile direct writings as a percentage of the total book of business were 21.0%, 25.0%, and 23.6%, respectively, in 1997 as compared to 20.6%, 27.2%, and 23.5%, respectively, for 1996.
Net Investment Income. Net investment income increased $1.4 million, or 30.7%, to $5.9 million in 1997 from $4.5 million in 1996. Cash and invested assets increased $38.5 million, or 42.9%, to $128.3 million on December 31, 1997 from $89.8 million on December 31, 1996. For 1997 the yield on average cash and invested assets was 5.3% compared to 5.1% for 1996. The increase in cash and invested assets can be attributed primarily to the $33.7 million in net proceeds from the Group's subscription offering in February 1997 and the increase in gross unrealized gains on investments of $2.8 million.
Underwriting Expenses. Underwriting expenses, which include amortization of deferred policy acquisition costs and operating expenses, increased $6.0 million, or 32.8%, in 1997 to $24.4 million from $18.4 million in 1996. The increase is primarily due to a $4.5 million reduction in ceded commissions arising out of the decrease in the quota share reinsurance agreement and a $1.4 million increase in other underwriting expenses. The other underwriting expense increase can be attributed to the acquisition of First Delaware that contributed $650,000 to the increase and initiatives undertaken by the Group's subsidiaries to upgrade their computer systems and to reunderwrite the homeowners book of business.
Premiums. Direct premiums written increased $2.6 million or 3.4% in 1996 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 increases in automobile and workers compensation reflect the 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.
Net Investment Income. Cash and invested assets decreased $10.7 million, or 10.6%, to $89.8 million on December 31, 1996 from $100.5 million on December 31, 1995. In 1996 and 1995, the yield on average cash and invested assets was 5.1%. The result of these changes was that net investment income decreased $191,000, or 4.1%, to $4.5 million in 1996 from $4.7 million in 1995. Although the December 31, 1996 cash and invested asset balance declined substantially in comparison to December 31, 1995, the average annual cash and invested balance for each of the years decreased only slightly thus moderating the effect on net investment income.
The Group restructured its portfolio from preferred stock and toward common stock in 1996. At December 31, 1996, the Group's preferred stock holdings as a percentage of invested asset balances was 6.3% compared to 10% at December 31, 1995, while common stock holdings as a percentage of invested asset balances increased to 8.4% at December 31, 1996 compared to 4.7% at December 31, 1995. This restructuring resulted in a 29.8% decrease in dividend income from preferred stock and a 38.3% increase in dividend income from common stock in 1996 compared to 1995.
Net Realized Investment Gains. Net realized investment gains were $1.4 million in 1996 compared to $1.0 million in 1995. The adverse claims experience of the first half of 1996 placed a severe burden on the Group's 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.
Underwriting Expenses. Underwriting expenses decreased by $4.5 million, or 19.8%, in 1996 to $18.6 million from $23.9 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 agreement offset by a $700,000 increase in operating expenses. In 1996 the Group had an underwriting expense ratio of 34.3% compared to 34.4% in 1995.
Net cash provided (used) by operating activities was $4.1 million, ($10.7) million and $4.9 million during 1997, 1996, and 1995, respectively. The negative cash flow from operating activities during 1996 was primarily attributable to the net loss for the period and an increase in reinsurance receivables and prepaid reinsurance premiums as a result of implementing the quota share agreement with American Re. Net cash provided by operating activities in 1995 was primarily attributable to the decrease in receivables.
The ESOP borrowed $4.1 million from an unaffiliated lender and $100,000 from OGGI to purchase 10% of the common stock issued in the Conversion. The loans bear an 8.45% interest rate, and will require the ESOP to make monthly payments of approximately $49,000 for a term of 10 years. The loan is secured by the shares of common stock purchased and the earnings thereon. Shares purchased with such loan proceeds will be held in a suspense account for allocation among participants as the loan is repaid. OGGI expects to contribute sufficient funds to the ESOP to repay such loan, plus such other amounts as the OGGI's Board of Directors may determine at its discretion.
The effects of inflation on the Group are implicitly considered in estimating reserves for unpaid losses and loss adjustment expenses, and in the premium rate-making process. The actual effects of inflation on the Group's results of operations cannot be accurately known until the ultimate settlement of claims. However, based upon the actual results reported to date, it is management's opinion that the liability for losses and LAE, including losses that have been incurred but not yet reported, make adequate provision for the effects of inflation.
In February 1997, the Financial Accounting Standards Board issued SFAS No. 128, "Earnings per Share." SFAS No. 128 is effective for all financial statements ending after December 15, 1997. SFAS No. 128 replaces the presentation of primary earnings per share (EPS) with basic EPS and required the presentation of both basic and diluted EPS on the face of the statement of income. In addition, SFAS No. 128 requires the restatement of all prior EPS data to conform to the provisions of the statement.
The unprecedented advances in computer technology over the past several decades have resulted in dramatic changes in the way companies do business. Most of these developments have been beneficial, but some have proven costly, as businesses have struggled to adapt to various features of the new technological landscape. One such well-publicized problem has arisen out of the worldwide use of the so called "Year 2000" programming convention, in which two digit numbers were generally used instead of four digit numbers to identify the years used in dates. As a consequence, most computers require relatively costly reprogramming to enable them to correctly perform data operations involving years 2000 or later, a problem anticipated to have substantial repercussions on the business world because computer operations involving date calculations are pervasive.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Old Guard Group, Inc. and subsidiaries as of December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for the years ended December 31, 1997, 1996 and 1995 in conformity with generally accepted accounting principles.
As discussed in Note 15 to the consolidated financial statements, Old Guard Group, Inc. has completed a plan of conversion which has been challenged by certain policyholders.
The consolidated financial statements include the accounts of Old Guard Group, Inc. and its wholly-owned subsidiaries (the Group), Old Guard Insurance Company (Old Guard), Old Guard Fire Insurance Company (Old Guard Fire), First Patriot Insurance Company (First Patriot) and Old Guard Investment Holding Company, Inc. (OGIHC) and its wholly-owned subsidiaries, Old Guard Insurance Management Company (OGIM) and 2929 Service Corporation and OGIHC's 80% owned subsidiary, First Delaware Insurance Company (First Delaware). During 1997, First Patriot changed its name from Goschenhoppen-Home Insurance Company and OGIM changed its name from Commonwealth Insurance Managers, Inc.
Total revenue $61,476,000 Loss before provision for income tax (3,200,000) Net loss (1,814,000) Loss per share (.46)
The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles. All significant intercompany transactions have been eliminated in consolidation. Certain amounts in the 1996 and 1995 financial statements have been reclassified to conform to the current year presentation.
The Group classifies fixed income and marketable equity securities as trading or available for sale. In addition, fixed income securities may be classified as held to maturity. Each security is evaluated at the time of purchase and periodically reevaluated. Held to maturity securities are carried at amortized cost. 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 shareholders' equity. Currently, no securities are classified as trading.
During the third quarter of 1997, the Group transferred $38.1 million of fixed income securities from available for sale to held to maturity reflecting management's intention and ability to hold these securities until maturity. The change in classification from available to sale to held to maturity did not have a material effect on the Group's financial position or results of operations.
Property and equipment are carried at cost less accumulated depreciation. Property is depreciated on a straight-line basis over the useful lives ranging from five to fifty years. Equipment is depreciated on a straight-line basis with useful lives of five to ten years. Computer software is amortized on a straight-line basis over a useful life of five years.
Stock-based compensation plans are accounted for under the provisions of Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. As such, compensation expense would be recorded on the date of a stock option grant only if the current market price of the underlying stock exceeded the exercise price. Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation," permits entities to recognize as expense, over the vesting period, the fair value of all stock-based awards on the date of grant. Alternately, SFAS No. 123 allows entities to apply the provision of APB Opinion No. 25 and provide pro forma net income and earnings per share disclosures for employee stock option grants as if the fair value method defined in SFAS No. 123 had been applied. The Group has elected to apply the provisions of APB Opinion No. 25 and provide pro forma disclosures under SFAS No. 123.
Effective for the 1997 tax year, the Group will file a consolidated federal income tax return.
In the normal course of business, the Group's insurance subsidiaries reinsure a portion of their exposure and pay to reinsurers a portion of premiums received on all policies reinsured. Insurance is ceded primarily to reduce net liability on individual risks, to mitigate the effect of individual loss occurrences (including catastrophe losses), to stabilize underwriting results and to increase underwriting capacity.
In February 1997, the Financial Accounting Standards Board issued SFAS No. 128 "Earnings Per Share". SFAS No. 128 is effective for all financial statements ending after December 15, 1997. SFAS No. 128 replaces the presentation of primary earnings per share (EPS) with basic EPS and requires the presentation of both basic and diluted EPS on the face of the statement of income. In addition, SFAS No. 128 requires the restatement of all prior EPS data to conform to the provisions of the statement.
The Group's insurance subsidiaries prepare their statutory financial statements in accordance with accounting principles and practices prescribed or permitted by the Insurance Department of the respective company's state of domicile. 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.
Risk based capital is designed to measure the acceptable amount of capital an insurer should have based on the inherent risks of the insurer's business. Insurers failing to meet adequate capital levels may be subject to insurance department scrutiny and ultimately rehabilitation or liquidation. Based on established standards, the Group's insurance subsidiaries maintain surplus in excess of prescribed risk based capital requirements.
Policyholders' surplus and net income (loss), determined in accordance with accounting practices prescribed or permitted by insurance regulatory authorities are as follows:
Collateralized mortgage obligations 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 2.0 years.
Land $ 767,407 $ 287,407 Buildings and improvements 4,992,202 4,237,217 Furniture, fixtures and equipment 7,599,114 4,143,142
The following amounts represent the Group's reinsurance activity with unrelated insurers in 1997, 1996 and 1995:
The Insurance Companies maintain a 15% (20% in 1996) quota share reinsurance agreement with their primary reinsurer, American Re-Insurance Company (American Re). The agreement provides for a 30% (35% in 1996) ceding commission on net business written. This agreement is intended to provide protection from high frequency and low severity type losses. The following summarizes activity under this treaty in 1997 and 1996:
Reinsurance recoverable under this agreement on paid and unpaid losses were $5,565,726 and $10,690,231 at December 31, 1997 and 1996, respectively.
During 1989, Old Guard received $6,000,000 in subordinated debt from a third party, the remaining balance of which was repaid as part of the Group's subscription offering in 1997. Repayment was in the form of 150,000 shares of the Group's stock. Old Guard paid interest of $19,603, $174,021 and $224,877 under the obligation in 1997, 1996 and 1995, respectively.
The components of income tax expense (benefit) for each of the three years ended December 31 are as follows:
First Patriot has a net operating loss carryforward at December 31, 1997 of approximately $1,476,000. First Patriot's net operating loss carryforward expires $58,000 in 2007, $261,000 in 2009, $780,000 in 2010 and $377,000 in 2011.
As of December 31, 1997, Old Guard and Old Guard Fire had alternative minimum tax credit carryforwards of approximately $88,000 and $152,000, respectively, available to offset future regular income tax.
The Group and it subsidiaries maintain certain stock compensation and retirement plans. The stock compensation plans were adopted by the Board of the Directors of the Group in connection with the initial public offering. The retirement plans are essentially the same as maintained by Old Guard prior to the Conversion.
The Stock Compensation Plan was adopted by the Board of Directors of the Group on December 20, 1996 and approved by shareholders at the first Annual Meeting on August 19, 1997. The purpose of the plan is to provide additional incentive to directors and employees by facilitating their purchase of stock of the Group. Awards under the plan may be made in the form of options, stock appreciation rights or grants of restricted stock. Awards up to 420,491 shares may be made under the Stock Compensation Plan. The Compensation Committee of the Board of Directors of the Group may, at their discretion, select employees to whom awards will be granted, the number of shares to be subject to such awards, the terms and conditions of such awards and other restrictions they deem appropriate. No awards of stock appreciation rights or restricted stock have been made as of December 31, 1997.
Basic earnings per share: As reported $ .92 Pro forma $ .79 The per share weighted-average fair value of options granted during 1997 was $10.75. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option- pricing model with the following weighted-average assumption used for grants in 1997: dividend yield of .50%, expected volatility of 20.00%; risk-free interest rate of 6.33% and an expected life of 5.40 years.
Information regarding activity in the Group's stock options plan is presented below:
The following table summarizes information about the Group's stock option plan at December 31, 1997:
On December 20, 1996, the Board of Directors of the Group also adopted a Management Recognition Plan (MRP) which is designed to reward and retain key employees of the Group at the time of the conversion. A total of 168,196 shares were authorized for possible award. On August 19, 1997, shareholders approved the granting of 142,371 shares under the MRP. Further grants are not expected to take place. Awards under the MRP vest over a period of five years following the award date. The Group is recognizing compensation cost over the vesting period equal to the value of the shares granted at the award date. In 1997, $196,877 of compensation cost was recognized under the MRP.
The Board of Directors has also adopted an Employee Stock Ownership Plan (ESOP) for the exclusive benefit of participating and eligible employees. Employees are eligible after having attained the age of 21 and completing one year of service with the Group or its subsidiaries. In connection with the subscription offering, the ESOP borrowed $4,054,910 in order to purchase 10% of the total shares issued by the Group. The loan bears interest at 8.45% and requires monthly payments of principal and interest of $49,178 for a term of 10 years. Because the Group has guaranteed repayment of the ESOP debt, the debt and related unearned compensation are recorded in the accompanying consolidated balance sheet as of December 31, 1997.
The Group also maintains a voluntary defined contribution savings plan covering substantially all full-time employees. The Group matches employee contributions up to 3% of compensation. The Group's contribution to this plan amounted to $168,064, $158,784 and $144,367 in 1997, 1996, and 1995, respectively.
The following table reconciles the numerator and denominator used in basic earnings per share to diluted earnings per share.
Options to purchase 10,000 shares of common stock at $19 to $22 per share were granted during the second half of 1997 but were not included in the computation of diluted earnings per share because the options' exercise price was greater than the average market price of the common shares. Earnings per share for 1996 and 1995 are computed on a pro forma basis assuming the initial public offering took place on January 1, 1995.
1997 1996 1995 Neffsville $110,200 $55,600 $45,000 New Castle $ 86,900 -- --
During 1997, Old Guard began to participate in New Castle's reinsurance program. The following summarizes the business assumed from New Castle as of and for the year ended December 31:
On February 10, 1997, the Group, 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 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 challenge the constitutionality of the Act. The plaintiffs are contending that the conversion plan violated the rights of the plaintiffs and members of the class under the United States and Pennsylvania, and that the Act is unconstitutional as applied by the conversion plan. 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 (Department) 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 were contemplated by the Plan. The stock-based compensation plans are expressly permitted by the Act, were approved by the Department and have subsequently been approved by shareholders. 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.
The Group, the Insurance Companies and the individual defendants filed a motion to dismiss the complaint in May 1997. In December 1997, the Court granted the motion with respect to two of the constitutional counts and denied the motion with respect to the remaining nine counts, including five of the constitutional claims. Discovery has begun and is scheduled to be completed by September 30, 1998.
Earnings per share Basic .16 .10 .05 -.80 Diluted .16 .10 .05 -.80