Relatively high short-term maturity investment positions are generally maintained to provide necessary liquidity for specific operating needs and to enhance flexibility in investment strategy. Changes in short-term investments reflect a large variety of seasonal and intermediate-term factors including seasonal operating cash needs, investment strategy, and expectations as to trends in interest yields. Accordingly, the future level of short-term investments will vary and respond to the dynamics of these factors and may, as a result, increase or decrease from current levels. During 1998 and 1997, the Corporation committed substantially all investable funds in short to intermediate-term fixed maturity securities with an emphasis on tax-exempt bonds. Old Republic continues to adhere to its long-term policy of investing primarily in investment grade, marketable securities; investable funds have not been directed to so-called "junk bonds" or types of securities categorized as derivatives. Old Republic's commitment to equity securities during 1998 increased by 40.7% vis-a-vis the related invested balance at year-end 1997. At December 31, 1998, the Company had no investments in default as to principal and/or interest.
Old Republic's capitalization of $2,450.6 at December 31, 1998 consisted of debt and debt equivalents of $145.1, convertible preferred stock of $1.2, and common shareholders' equity of $2,304.2. The increase in the common shareholders' equity account during the past three years reflects primarily the retention of earnings in excess of dividends declared on outstanding preferred and common shares, the conversion of redeemable convertible preferred stock in 1997, the issuance of additional shares to effect a debt conversion in 1996, and an increase during 1998 and 1997 compared to a decrease during 1996 in the value of bonds and stocks carried at market value. Common shareholders' equity increases in 1998 and 1997 were partially offset by the acquisition of $151.1 and $62.1, respectively, of common stock in open market transactions. At its March 12, 1998 meeting, the Company's Board of Directors authorized the reacquisition of up to $150.0 of common shares as market conditions would warrant during the twenty-four month period from that date; as of December 31, 1998, a total of $31.9 of this authorization remained unutilized.
In February 1996, the Company called for the redemption of its 10% debentures maturing in 2018 ($75.0 principal amount) and its 5.75% convertible subordinated debentures maturing in 2002 ($110.0 principal amount). In April 1996, the Company called for the redemption of its 11.5% debentures maturing in 2015 ($30.0 principal amount); redemption of these debentures was financed with internally available funds, while the subordinated debentures were converted by their terms into approximately 9.6 million Old Republic common shares. As a result of these redemptions and conversions, the Company's debt declined by $215.0 while its common shareholders' equity account rose by $108.6 during 1996. The early retirement of the debentures produced a net of tax charge of $4.4 ($0.03 per diluted common share) that has been reflected as an extraordinary item in 1996. In December 1996, the Company redeemed all ($54.8) of its Series "H" cumulative preferred stock with available funds. During the second quarter of 1997, the Company issued $115.0 of 7% debentures maturing June 15, 2007; proceeds from this offering were used principally to redeem commercial paper debt.
maturity of Old Republic's fixed maturity securities portfolio, a generally declining interest rate climate during the past three years, and the commitment of a larger percentage of investable funds to tax-exempt fixed maturity securities that typically bear lower pre-tax yields.
While the Company's investment policies have not been designed to maximize realized investment gains, such gains were higher in 1998 than those registered in 1997 and 1996. Dispositions of securities have been caused principally by calls prior to maturity by issuers of bonds and notes, and by sales of equity securities. In 1998, 58.3% of total fixed maturity securities dispositions represented contractual maturities and early calls of existing holdings; for the year 1997 and 1996 these amounted to 76.9% and 72.5%, respectively.
Consolidated benefit, claim, and related settlement costs, as a percentage of net premiums and fees earned, were approximately 43.2% in 1998, 48.4% in 1997 and 49.9% in 1996. Variations in these ratios, particularly in 1998, are partially due to the growth in revenue of the mortgage guaranty and title segments which have lower loss ratios than the general insurance segment. The general insurance portion of the claim ratio was affected positively by improving claims experience for liability insurance coverages and reduced costs associated with involuntary workers compensation pools; this was in part offset by higher loss ratios for physical damage coverages and a moderate amount of catastrophe claims in 1996 and 1998. The loss ratio for mortgage guaranty insurance decreased in 1998 compared to 1997 which itself had decreased slightly compared to that of 1996; the improvement was mostly attributable to the stable economic conditions of the past several years which have led to reduced mortgage defaults particularly in the California market. The title insurance loss ratio has been relatively flat in low single digits in each of the past three years due in part to favorable trends in claims frequency and severity for business underwritten since 1992.
The ratio of consolidated underwriting, acquisition, and insurance expenses to net premiums and fees earned was approximately 50.2% in 1998, 45.2% in 1997 and 46.0% in 1996. Variations in these ratios reflect a continually changing mix of coverages sold and attendant costs of producing business. The property and liability segment's expense ratios increased in 1998 compared to 1997 and 1996 due in part to the previously mentioned premium production trends. During the past three years, the mortgage guaranty segment, particularly in 1998, experienced higher operating expenses due to greater costs associated with contract underwriting operations. The title insurance expense ratio has trended lower, especially in 1998, due in part to an increase in premium and fees volume without a proportional increase in expenses, though higher litigation and related costs in the second half of 1998 increased this segment's expense ratio by approximately 3.5% for the year as a whole. Consolidated interest and other charges, were approximately the same in 1998 and 1997 compared to 1996, due principally to the aforementioned reduction in outstanding debt.
Consolidated income before taxes increased by 9.4%, 24.6% and 8.3% in 1998, 1997 and 1996, respectively. General insurance results declined in 1998 compared to 1997, due to poorer underwriting experience and a slight decrease in investment income; 1997 results increased compared to 1996 due to improved underwriting results in Old Republic's three largest segments and a slight increase in investment income. The general insurance segment continued as the largest contributor to consolidated earnings for each of the periods reported upon. The mortgage guaranty segment reflected rising earnings in each of the last three years due to increased revenues generating higher income from underwriting operations and a greater invested assets base. Increases in title insurance earnings during the past three years resulted from growth in premiums and fees, a stable loss ratio and a reduction in expense ratios. Life and disability operations, excluding the aforementioned non-recurring tax recovery item in 1997, have posted relatively flat earnings in the past three years.
Year 2000 issues could adversely affect the Old Republic subsidiaries' computer systems, and such other systems as communications, facilities management, service-related equipment and systems of customers, vendors and other important third party service providers. Possible adverse consequences include, but are not limited to, the inability to transact business, inability to execute transactions through financial institutions and the occurrence of Year 2000-related losses under certain insurance contracts. Accordingly, the Company could suffer material adverse financial effects if failure by major subsidiaries, significant vendors, important third parties or various governmental bodies to properly correct Year 2000 issues were to occur. The possible financial impact of all such effects cannot currently be estimated since the Company and its subsidiaries do not operate in a vacuum and cannot control the situations or actions of the various outside entities with which they deal.
Consolidated Balance Sheets........................................ 25-26 Consolidated Statements of Income................................... 27 Consolidated Statements of Comprehensive Income..................... 28 Consolidated Statements of Preferred Stock and Common Shareholders' Equity..................................... 29-30 Consolidated Statements of Cash Flows............................... 31 Notes to Consolidated Financial Statements......................... 32-52 Report of Independent Accountants................................... 53
(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 (generally carried at amortized costs for fixed maturity securities), (2) has available for sale (carried at fair value with adjustments to equity, net of deferred income taxes) or (3) has the intention of trading (carried at fair value with adjustments to income); as of December 31, 1998, the Company's invested assets were classified solely as "held to maturity" or "available for sale."
The amortized cost and estimated fair value at December 31, 1998, 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.
At December 31, 1998, 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 $1.5, $1.7 and $1.7 for the years ended December 31, 1998, 1997 and 1996, respectively. (2) Deferred income taxes do not apply since these securities are carried at amortized cost.
General insurance (property and liability) and level-term credit life insurance premiums are reflected in income on a pro-rata basis. Earned but unbilled premiums are generally taken into income on the billing date, and adjustments for retrospective premiums, commissions and similar charges are accrued on the basis of periodic evaluations of current underwriting experience and contractual obligations. First year and renewal mortgage guaranty premiums are recognized as income on a straight-line basis except that a portion of first year premiums received for certain high risk policies is deferred and reported as earned over the estimated policy life, including renewal periods. Single premiums for mortgage guaranty policies covering more than one year are earned on an accelerated basis over the policy term. Title insurance premiums are recognized as income
At December 31, 1998 and 1997, the Life Insurance Group had $6,740.5 and $4,912.9, respectively, of net life insurance in force. Future policy benefits and unearned premiums, consisted of the following:
The establishment of claim reserves by the Company's insurance subsidiaries is a reasonably complex and dynamic process influenced by a large variety of factors. These include past experience applicable to the anticipated costs of various types of claims, continually evolving and changing legal theories emanating from the judicial system, recurring accounting and actuarial studies, the professional experience and expertise of the Company's claim departments' personnel or attorneys and independent adjusters retained to handle individual claims, the effect of inflationary trends on future claim settlement costs, and periodic changes in claim frequency patterns such as those caused by natural disasters, illnesses, accidents, or work-related injuries. Consequently, the reserve-setting process relies on the judgments and opinions of a large number of persons, on historical precedent and trends, and on expectations as to future developments. At any point in time, the Company and the industry are exposed to possibly higher than anticipated claim costs due to the aforementioned factors, and to the evolution, interpretation, and expansion of tort law, as well as to the effects of unexpected jury verdicts.
Individual insurance companies and others who have evaluated the potential costs of litigating and settling A&E claims have noted with increasing concern the possibility that resolution of such claims, by applying liability retroactively in the context of the existing insurance system, could likely bankrupt or undermine seriously the financial condition of the property and liability insurance industry. In the light of this substantial public policy issue, the Corporation is of the view that the courts will not resolve in the near future the litigation gridlock stemming from the non-resolution to date of many environmental claims in particular. In recent times, the Executive Branch and/or the United States Congress have proposed changes in the legislation and rules affecting the determination of liability for environmental claims. As of December 31, 1998, however, there is no solid evidence to suggest that forthcoming changes might mitigate or reduce some or all of these claim exposures.
(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 $3.6 in 1998, $3.2 in 1997 and $4.6 in 1996.
A reconciliation of the funded status of the plans is as follows:
Note 2-Debt and Debt Equivalents-Consolidated debt of Old Republic and its subsidiaries is summarized below:
Scheduled maturities of the above debt (including common stock classified as a debt equivalent see (a)below) at December 31, 1998 are as follows: 1999: $14.6; 2000: $4.2; 2001: $1.0; 2002: $.4; 2003: $.6; 2004 and after: $123.9. During 1998, 1997 and 1996, $10.0, $9.6, and $10.8, respectively, of interest expense on debt was charged to consolidated operations.
Note 3-Shareholders' Equity - All common and preferred share data herein has been retroactively adjusted as applicable for stock dividends or splits declared through December 31, 1998.
(b) Cash Dividend Restrictions-The payment of cash dividends by the Corporation is principally dependent upon the amount of its insurance subsidiaries' statutory policyholders' surplus available for dividend distribution. The insurance subsidiaries' ability to pay cash dividends to the Corporation is in turn generally restricted by law or subject to approval of the insurance regulatory authorities of the states in which they are domiciled. These authorities recognize only statutory accounting practices for determining financial position, results of operations, and the ability of an insurer to pay dividends to its shareholders. Based on 1998 data, the maximum amount of dividends payable to the Corporation by its insurance and a small number of non-insurance company subsidiaries during 1999 without the prior approval of appropriate regulatory authorities is approximately $207.2. However, management does not expect to distribute all such dividends since reinvested earnings are the Corporation's major source of capital to promote its growth, and support its obligations to policyholders.
(d) Stock Option Plan-The Corporation has a stock option plan for certain eligible key employees. Outstanding options at any one time may not exceed 5% 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 anniversaries of the date of the grant. 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 Corporation may extend 15 year loans at a prevailing market rate of interest for a portion of the exercise price. The option plan also 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.
A summary of stock options outstanding and exercisable at December 31, 1998 follows:
The Corporation issued a total of 514,626 common shares valued at $4.6 and 1,112,400 common shares valued at $8.9 in 1998 and 1996, respectively to effect acquisitions which were not material to Old Republic's financial position or operating results.
(f) Undistributed Earnings-The equity of the Corporation in the undistributed earnings, determined in accordance with generally accepted accounting principles, and in the net unrealized investment gains (losses) of its respective subsidiaries at December 31, 1998 amounted to $1,481.3 and $81.0, respectively. Dividends declared during 1998, 1997 and 1996, to the Corporation by its subsidiaries amounted to $158.2, $226.6 and $152.8, respectively.
Reinsurance protection for General Insurance operations generally limits the net loss on any one risk to the following maximums (in thousands): workers' compensation-$1,000; auto liability-$600; general liability-$600; and property coverages-$300. A substantial portion of the mortgage guaranty insurance business is retained, with the exposure on any one risk currently averaging approximately $26. Title insurance risk assumptions, based on the title insurance subsidiary's financial resources, are currently limited to $25,000 as to any one policy. The maximum amount of ordinary life insurance retained on any one life by the Life Insurance Group is $300.
Note 5-Consolidated Quarterly Results-Unaudited - Old Republic's consolidated quarterly operating data for the two years ended December 31, 1998 is presented below. In the second quarter 1997, several life insurance subsidiaries recovered income taxes and related accumulated interest due to favorable resolutions with the Internal Revenue Service of various outstanding issues pertaining to income tax returns for the years 1979 through 1982. These cash recoveries, net of miscellaneous charges, increased other income by $12.6, reduced income tax expense by $5.9 and increased net income by $14.2 (10 cents per share).
- --------- In the above tables, net premiums earned on a GAAP basis differ slightly from statutory amounts due to certain differences in calculations of unearned premium reserves under each accounting method. (a) Including unallocated investment income derived from invested capital and surplus funds./(b) Represents results of holding company parent, consolidation eliminating adjustments, and general corporate expenses, as applicable./(c) 1997 includes $12.6 of interest income from settlement of prior years' tax issues./(d) The Company has entered into an agreement to sell its small annuity book of business; this will have no material effect on Old Republic's consolidated results or financial position. (see Note 1(f))
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, comprehensive income, preferred stock and common shareholders' equity and cash flows present fairly, in all material respects, the financial position of Old Republic International Corporation and its subsidiaries at December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.