- -------- (1) Ratios for 1993 exclude the effect of non-recurring items relating to the settlement of a premium rate dispute. (2) Combined ratio for 1994 is computed including the results of Bankers and Shippers for the period after the acquisition date of October 18, 1994. (3) After giving effect to the application of the proceeds of the sale of the Junior Subordinated Debentures, the pro forma ratio would have been 2.7x. (4) Includes results of Bankers and Shippers and Integon Preferred Insurance Company for the full year 1994.
The following important factors, among others, could cause actual results to differ materially from those set forth in the forward looking statements: claims frequency, claims severity, severe adverse weather conditions, the cost of automobile repair, economic activity, competitive pricing and the regulatory environment in which the Company operates. See "Item 1. Business-- Certain Considerations."
Net premiums written increased 28.6% from $620.4 million in 1995 to $798.0 million in 1996. Of that amount, nonstandard automobile insurance net premiums written increased from $568.1 million in 1995 to $722.9 million in 1996, or 27.3%. The increase in nonstandard automobile insurance net premiums written is attributable, in part, to a shift in the Company's business towards states with higher premium rates. Certain states' premium rates are generally higher because of competitive conditions, higher expected losses and expenses or higher limits of liability required. The increase is also attributable to the Company insuring a greater percent of its customers with 12 month policies instead of six month policies. Unit growth and, to a lesser extent, rate increases also contributed to the increase in net premiums written. Specialty auto products net premiums written increased 88.9% from $26.3 million in 1995 to $49.8 million in 1996. Premiums earned on all lines of business increased 29.1% from $567.0 million in 1995 to $732.0 million in 1996 and reflects the increase in net premiums written.
Policy acquisition and other underwriting expenses increased 33.7% from $122.7 million in 1995 to $164.0 million in 1996. The expense ratio, defined as policy acquisition and other underwriting expenses as a percentage of premiums earned, increased from 21.6% in 1995 to 22.4% in 1996. The increase in policy acquisition and other underwriting expenses was due to an increase in personnel-related and other information systems costs. Such costs were incurred primarily to enhance the Company's operations, and also included expenditures for beginning the modifications necessary to accommodate the Year 2000. Bad debt expense during 1996 increased from $8.1 million in 1995 to $16.1 in 1996 due in part to increased net premiums written and the extension of
more favorable credit terms to its insureds. During the fourth quarter of 1996, the Company, in addition, wrote-off $3.5 million in deferred acquisition costs as a result of the increase in the loss ratio in the last several months of the year.
Other income less other expenses resulted in expenses of $.8 million in 1996 and income of $2.5 million in 1995. The decrease in income primarily reflects the fact that 1995 results included $.9 million of income from the sale of a joint venture.
Net investment income increased 6.8% from $29.9 million in 1995 to $32.0 million in 1996 as a result of the $68.8 million increase in average invested assets. This higher level of invested assets was partially offset by a decrease in comparable investment yields and a higher percentage of tax-exempt securities, which resulted in a pre-tax yield on the investment portfolio of 5.9% in 1996 compared to 6.3% in 1995. The percentage of cash and invested assets invested in tax-exempt securities was 25.5% and 24.3% in 1996 and 1995, respectively. In addition to the variances discussed above, the Company realized investment gains of $2.7 million in 1996 after a $2.0 million write- down of bonds in its investment portfolio, compared to $9.7 million of realized investment gains in 1995.
Federal income taxes decreased $18.4 million from $16.3 million incurred in 1995 to a $2.1 million tax benefit in 1996. The tax benefit is a result of the Company having a loss from operations before federal income tax.
Income before extraordinary items decreased $36.4 million from $36.6 million in 1995 to $.2 million in 1996.
YEAR ENDED DECEMBER 31, 1995 COMPARED WITH YEAR ENDED DECEMBER 31, 1994
Loss and LAE increased 76.7% from $235.4 million in 1994 to $416.0 million in 1995. The loss ratio increased from 70.4% in 1994 to 73.4% in 1995. The increase in the loss ratio was due primarily to increased severity of physical damage claims resulting from newer automobiles that are more complicated and expensive to repair.
$.7 million of income associated with a joint venture that was sold during the year. The decrease in corporate expenses was due to lower legal expenses and reduced costs associated with directors' compensation. A settlement was reached in litigation early in the year which reduced legal expenses and a reduction in Board members in 1995 resulted in lower compensation expense compared to 1994.
Federal income taxes increased $6.6 million from $9.7 million in 1994 to $16.3 million in 1995. The effective tax rate increased from 30.0% in 1994 to 30.8% in 1995 due primarily to higher underwriting income and decreased holdings of tax-exempt securities in 1995. Underwriting income is taxed at the statutory rate of 35.0% while net investment income is taxed at a lower effective rate due to the investment in tax-exempt securities.
Income before extraordinary items increased $14.1 million from $22.5 million in 1994 to $36.6 million in 1995. Additionally, there were net realized investment losses of $1.1 million in 1994 compared to net realized investment gains of $9.7 million in 1995. Adjusting for these factors, income before extraordinary gains increased $7.1 million from $23.2 million to $30.3 million. Additional factors affecting results have been discussed above.
SOURCES OF FUNDS: The major sources of operating funds for Integon Corporation, the parent company, have been (i) dividends from its subsidiaries, (ii) reimbursements of costs and expenses in connection with the management agreement among the Company and its subsidiaries pursuant to which the Company provides certain services to such subsidiaries, (iii) tax sharing payments from the operating subsidiaries to the Company and (iv) borrowings under credit facilities. The Company files a consolidated federal income tax return including its subsidiaries and receives payments pursuant to a tax sharing agreement among the Company and its subsidiaries. Taxes are computed for each subsidiary and paid to the Company as if such subsidiary were filing a tax return on a stand-alone basis, thereby providing additional funds to the Company because the aggregate of such payments generally exceeds taxes to be paid by the Company on a consolidated basis.
As of December 31, 1996, Integon Corporation had approximately $1.4 million of cash and cash equivalents that were available for general corporate purposes, including debt service, dividend payments and working capital.
The principal sources of funds for the Company's subsidiaries are net premiums collected, proceeds from investment income and from investments that have been sold, matured or repaid, and premium financing revenues.
FINANCING ACTIVITIES: In July 1996, the Company's Credit Facility was increased from $25.0 million to $75.0 million to reflect the increased size of the Company and to pay parent company expenses as the insurance subsidiaries retain earnings to fund future growth. The interest rate charged on the Credit Facility is based on the bids of the participating lenders and, in the case of Eurodollar loans, a margin percentage ranging from .55% to .675% is added. The facility fee ranges from .20% to .35% of the total amount of the facility.
The Credit Facility contains certain covenants, including a limitation on net premiums written to statutory surplus of 3.25x and a maximum ratio of debt to total capitalization of 55%. The amount of the Credit Facility available, subject to the borrowing conditions thereunder, for future borrowings at December 31, 1996 was $31 million. The Company expects to use a portion of the proceeds from the sale of the Junior Subordinated Debentures to reduce the amount outstanding under the Credit Facility. See "Item 1. Business--Recent History; Strategy."
The Company's interest expense also includes payments with respect to its 9 1/2% Senior Notes due October 15, 2001 (the "9 1/2% Senior Notes") and its 8% Senior Notes due August 15, 1999 (the "8% Senior Notes" and together with the 9 1/2% Senior Notes, the "Senior Notes"). The indentures governing the Senior Notes contain covenants that restrict the ability of the Company and its subsidiaries to dispose of the capital stock of any subsidiary and to incur indebtedness secured by the capital stock of any subsidiary. The Senior Notes are not redeemable by the Company prior to maturity.
INVESTMENTS: In accordance with the Company's investment policy, the Company's investments at December 31, 1996 consisted primarily of investment- grade securities (rated Baa or better by Moody's or the equivalent). Consolidated cash and cash equivalents at December 31, 1996 amounted to $43.8 million, or 7.7% of total cash and invested assets.
If the insurance subsidiaries are not able to pay ordinary dividends and their requests for the payment of extraordinary dividends are not granted, and if amounts needed are in excess of the available funds under the credit facility, additional borrowings, the issuance of additional securities or obtaining other funds could be necessary to pay debt service, preferred and common stock dividends and other expenses of the Company.
NOTES TO FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
CASH AND CASH EQUIVALENTS: Included in cash and cash equivalents are investments that, at purchase, have a maturity of three months or less.
PROPERTY AND EQUIPMENT: Property and equipment consist primarily of office buildings, furniture, and equipment and are stated at cost less accumulated depreciation. Property and equipment are depreciated over the useful life of the assets using the straight-line method. Property and related improvements are depreciated over periods ranging from 15 to 45 years. Equipment is depreciated over 3 to 7 years. Depreciation expense for the years ended December 31, 1996, 1995 and 1994 was $6.3 million, $3.8 million, and $1.9 million, respectively.
Although prohibited by statutory accounting practices prescribed by North Carolina, the Company, during 1995, received written approval from the North Carolina Insurance Department to recognize anticipated salvage and subrogation in the determination of statutory unpaid loss reserves. As of December 31, 1996, that permitted transaction increased statutory surplus by $12.5 million over what it would have been had the prescribed accounting practice been followed.
REINSURANCE: Premiums and loss and loss adjustment expenses ceded to other companies are reported as a reduction of premiums and loss and loss adjustment expenses, respectively. Amounts applicable to reinsurance ceded for unearned premium reserve and claim liabilities are reported as prepaid reinsurance premiums and reinsurance receivable, respectively. Expense allowances received in connection with reinsurance ceded are accounted for as reductions of the related policy acquisition costs and are deferred and amortized accordingly. Reinsurance premiums, commissions, and reserves related to assumed reinsurance are accounted for on bases
consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts.
EARNINGS PER COMMON SHARE: Primary earnings per common share are calculated by dividing net income (after deducting preferred stock dividend requirements) by the weighted average number of shares of common and common equivalent shares outstanding during the period. Common equivalent shares include the assumed exercise and conversion of stock options. Fully diluted earnings per share are computed by dividing net income by the weighted average number of shares of common and common equivalents and assumes conversion of the $3.875 Convertible Preferred Stock unless assumed conversion has the effect of increasing earning per share.
PURCHASE OF INTEGON PREFERRED INSURANCE COMPANY: In June 1994, the Company acquired AMSTATS Insurance Company for $8.2 million of cash and created goodwill of $1.2 million. The company's name has since been changed to Integon Preferred Insurance Company ("Integon Preferred"). The acquisition of Integon Preferred was accounted for by the purchase method of accounting.
PURCHASE OF BANKERS AND SHIPPERS: In October 1994, the Company acquired Bankers and Shippers, which changed its name to Integon National Insurance Company, for a purchase price of $153.2 million. The transaction was financed through public offerings of $75.0 million principal amount of 9.5% Senior Notes due 2001, at a price of 99.947 to yield 9.51% and 1,437,500 shares of $3.875 Convertible Preferred Stock with an issue price of $50.00 per share, convertible at $19.05 per common share (collectively, the "Offerings"). The transaction was accounted for by the purchase method of accounting.
PURCHASE OF INTEGON SERVICES COMPANY: In December 1994, the Company acquired Integon Services Company ("ISC") at a purchase price equal to the net book value of ISC of approximately $3.0 million. Prior to such acquisition, ISC provided administrative and financial services to the Company pursuant to an agreement. See Note I.
FIXED MATURITIES AVAILABLE FOR SALE: In determining fair value for fixed maturities, the Company obtains market value information through independent pricing services. Market values are also obtained, to a lesser extent, from the Company's investment advisors who utilize financial market data systems and broker quotes to provide prices.
OTHER LONG-TERM INVESTMENTS: The fair values of some investments are estimated based on quoted market prices for similar investments. For other investments, a reasonable estimate of fair value is determined and is carried at the lower of cost or estimated market value.
The amortized cost and estimated market values of investments in fixed maturities were as follows:
At December 31, 1996, fixed maturities with a carrying value of approximately $23.1 million were on deposit with state regulatory authorities, as required by law.
A reconciliation between the federal income tax rate and the effective tax rate is as follows:
The impact of reinsurance on the income statements is shown below:
Adjustment services are provided on claims ceded to the NCRF for a fee established by the NCRF. These fees are reflected, as earned, as a reduction of loss adjustment expenses in the financial statements. Fees earned were approximately $17,221, $18,075 and $18,279, for the periods ended December 31, 1996, 1995, and 1994, respectively.
Mr. Head and Edward W. Ross, former Vice Chairman of the Board of Directors, provided advisory services to the Company pursuant to consulting agreements entered into with the Company effective January 1, 1993 for which each received $300 per year plus reimbursement of out-of-pocket expenses. These agreements terminated on December 31, 1995. Pursuant to these agreements, the Company paid Messrs. Head and Ross, respectively, as follows: 1995--$317 and $300; and 1994--$314 and $309. In connection with the acquisition of Bankers and Shippers by the Company, the Company paid an advisory fee to Head Company in the amount of $620.
ISC was also a party to a services agreement with ILC pursuant to which ISC provided the same type of services provided to the Company. Effective February 1, 1995, ISC and ILC mutually agreed to terminate such services agreement, and the Company entered into a services agreement with ILC's subsidiary, Integon Life Insurance Corporation ("ILIC"), pursuant to which ILIC purchases certain administrative and financial services from the Company. Services provided under the services agreement were charged based upon direct costs incurred. ILIC paid approximately $2.6 million for such services in 1995. The services agreement has been terminated.
RESTRICTIONS: The net assets of the Company's property and casualty insurance subsidiaries available for distribution to the Company are limited to the amounts that such assets, as determined in accordance with statutory accounting practices, exceed minimum statutory capital requirements. Payment of dividends is restricted and may be subject to approval by insurance regulatory authorities. The maximum amount of dividends that may be paid by the Company's insurance subsidiaries within any calendar year without prior regulatory approval is the lesser of (a) 10% of the policyholders' statutory surplus as of the preceding December 31 or (b) its statutory net income for the preceding calendar year, less the amount of dividends paid during the preceding twelve months.
Statutory surplus (capital and surplus) and statutory net income (including Bankers and Shippers results for the full year 1994) as determined in accordance with statutory accounting practices for the Company's insurance subsidiaries are shown below:
In July 1995, ILC, a former affiliate, paid the Company a nominal amount for the Company to acquire the common stock of International. The Company is now liable for any claims that may arise out of the business reinsured by International. However, management believes that the transfer of International will not have any material effect on the financial condition or results of operations of the Company.
The Company executed an indemnity letter in favor of certain former subsidiaries that were sold in which the Company agreed to indemnify, reimburse and hold harmless the subsidiaries for, among other things, (i) certain employment related liabilities provided any such liability arises solely on account of such subsidiaries' affiliation with the Company and its subsidiaries prior to the Restructuring under the Internal Revenue Code of 1986, as amended, or the Employment Retirement Income Security Act of 1974, as amended, and (ii) taxes assessed against such subsidiaries by reason of their being a member of an affiliated group of which the Company was a member. As of December 31, 1996, no amounts have been paid or requested to be paid under the indemnity letter.
Retired home office employees under age 65 are covered by a health maintenance organization under which benefits are generally paid at 100% after various co-payments. Retirees under this plan contribute to their own benefits and their dependents' benefits.
Retired employees under age 65, outside the service area, are covered by a self-insured indemnity plan which has a deductible with 80%-20% coinsurance. Under this plan, retirees only contribute toward dependent coverage. Retired employees 65 and older are covered under a self-insured type plan which has a deductible with 80%-20% coinsurance that coordinates with Medicare. Under this plan retirees only contribute toward dependent coverage.
Effective January 1, 1995, the Company amended its retirement benefit plan. The Company will continue to provide medical and reduced life benefits to current retirees and active, full-time employees who had attained age 55 with 10 years or more of service on or before December 31, 1994. Medical benefits are provided until age 65 or covered by Medicare, whichever comes first, and reduced life retirement benefits will continue to be available to active, full-time employees who were at least age 45 on or before December 31, 1994. No retiree medical and life insurance benefits will be available to employees who did not attain age 45 on or before December 31, 1994 or who were hired after December 31, 1994.
The components of the expense for postretirement benefits were as follows:
If the medical care inflation assumption increased by 1.0%, the accumulated postretirement benefit obligation would increase $329 or 7.1% and the 1996 service and interest expense would increase $24 or 8.2%.
The Retirement Savings Plan also provided for a discretionary Company profit sharing contribution, which was determined annually by the Board of Directors for the succeeding plan year. Participants vested 20% for each completed year of service, or became 100% vested in the event of death, attainment of age 65, disability or plan termination. Profit sharing contributions for the years ended December 31, 1995 and 1994 were $1,012 and $488, respectively. Effective January 1, 1996, the Retirement Savings Plan was amended to discontinue the discretionary profit sharing contributions and it has been replaced by the Employee Stock Ownership Plan.
The Company will make monthly contributions to the trust fund. The trust will primarily buy shares of Integon Corporation Common Stock with the Company's contribution. Allocations will be made to participants on a quarterly basis. The discretionary contribution for 1996 has been set by the Board of Directors at 2.75% of employees' eligible compensation. Participants vest 20% for each completed year of service, or become 100% vested in the event of death, attainment of age 65, permanent disability or plan termination. The Company's contribution for the year ended December 31, 1996 was $1.2 million.
EMPLOYEE STOCK PURCHASE PLAN: In September 1995, the Company established the Integon Corporation Employee Investment Program. The Program is designed to provide employees with a convenient and
economical way to purchase shares of the Corporation's Common Stock, through payroll deduction, and to reinvest their cash dividends in additional shares of Common Stock.
At December 31, 1996, the Company had two stock-based compensation plans, which are described below. The Company applies APB Opinion No. 25 and related Interpretations in accounting for these plans. Accordingly, no compensation cost has been recognized for stock options issued under either the 1992 Stock Option Plan or the Omnibus Long-Term Performance Incentive Compensation Plan. Had compensation cost for stock based compensation under these two plans been determined consistent with SFAS No. 123, the Company's net income and earnings per share for the years ended December 31, 1996 and 1995 would have been reduced to the pro forma amounts indicated below:
1992 STOCK OPTION PLAN: The 1992 Stock Option Plan ("1992 Plan") is a fixed stock option plan which was adopted in February 1992. Under the 1992 Plan, the Company may grant options to its employees for up to 1,430,000 shares of common stock. The exercise price of each option equals the closing market price of the Company's common stock on the date of grant, and an option's maximum term is ten years. The options become exercisable in 20% increments on each anniversary date of the grant.
The fair value of each option under the 1992 Plan is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 1996 and 1995, respectively: dividend yield of 1.80% and 2.06%; expected volatility of 32.58% and 32.94%; risk-free interest rates of 5.95% and 5.93%; and expected lives of 5 years.
A summary of the status of the Company's fixed stock option plan as of December 31, 1996, 1995 and 1994 and changes during the years ended on those dates is presented below:
In February 1996, the Company adopted the Omnibus Long-Term Performance Incentive Compensation Plan ("Omnibus Plan"), an incentive compensation plan designed to attract and retain both key employees and non-employee directors. The Omnibus Plan allows for the grant of incentive compensation awards for up to 1,000,000 shares of common stock and is administered by the Compensation and Personnel Committee ("Compensation Committee") of the Board of Directors. The type of awards available under the Omnibus Plan in 1996 included: (i) non- qualified stock options to key employees and non-employee directors, (ii) performance awards to key employees payable in cash and/or performance restricted stock, (iii) unit awards to key employees payable in unit restricted stock or cash, (iv) common stock awards for non-employee directors, and (v) common stock, deferral restricted stock and deferral stock options in lieu of cash compensation for non-employee directors.
The fair value of each option under the Omnibus Plan was estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions: risk-free interest rate of 6.85%, dividend yield of 1.96%, volatility of 32.83% and expected lives of 8.5 years.
A summary of the status of the performance stock options issued under the Omnibus Plan as of December 31, 1996 and the changes during the year then ended is presented below:
As of December 31, 1996, the 93,475 performance options outstanding under the Omnibus Plan have an exercise price of $18.38 and a weighted average remaining contractual life of 9.4 years. None of the performance options are currently vested.
Prior to being replaced by the Omnibus Plan, the 1992 Non-Employee Directors Stock Plan provided for annual grants of shares of common stock equal to $10 in unrestricted shares and 1,650 restricted shares. During 1995 and 1994, grants of restricted shares totaled 6,600 and 13,200, respectively. Under the Omnibus Plan, each non-employee director is eligible to receive an annual award of up to 1,650 shares of common stock. During 1996, non-employee directors received 7,858 shares of common stock under this provision of the Omnibus Plan.
Extraordinary items net of federal income tax expense (benefit) is composed of the following:
Litigation Settlement--On April 27, 1995, Integon Corporation paid to Southmark Corporation $3.8 million ($3.2 million after tax benefit) pursuant to a settlement of all claims and counterclaims asserted in a legal action commenced by Southmark Corporation against Integon Corporation on December 3, 1993 in the United States District Court for the Southern District of New York. Pursuant to the terms of the settlement, the Southmark action has been dismissed with prejudice.
- -------- (1) The Company's Common Stock trades on the New York Stock Exchange. The number of Common Stock shareholders of record at January 24, 1997 was 264.
In the event any person or group commences a tender or exchange offer that if consummated would result in such person or group becoming the beneficial owner of 20 percent or more of Integon's common stock, then after a specified period separate rights certificates will be distributed and each right will entitle its holder to purchase one-thousandth of a share of such preferred stock at a purchase price of $70.
Dividends from subsidiaries and furniture and equipment purchased includes $244 in leasehold improvements for the year ended December 31, 1995.
Investment in subsidiaries is accounted for by using the equity method of accounting.