Management's Discussion and Analysis of Financial Condition ------ ----------------------------------------------------------- and Results of Operations. -------------------------
The Parent maintains the principal borrowings for the Company and its non-banking subsidiaries and has provided working capital to certain of its subsidiaries. These borrowings have primarily been made on an unsecured basis from banks through various credit agreement facilities and term loans, and through public financings. During the year ended December 31, 1996, the Company did not use its $150,000,000 bank credit agreement facilities, except for minor amounts borrowed to meet daily cash requirements. At December 31, 1996, there were no amounts outstanding under such bank credit agreement facilities. The Company's bank borrowings bear interest based on the prime rate or LIBOR.
In February 1997, the Company replaced these credit facilities and its $50,000,000 of outstanding bank term loans with a new contractual bank credit facility of $200,000,000. The new facility bears interest based on the prime rate or LIBOR and matures in February 2002.
In October 1996, the Company sold $135,000,000 principal amount of its newly authorized 7-7/8% Senior Subordinated Notes due 2006 in an underwritten public offering at 99.487% of the principal amount. As of December 31, 1996, $114,000,000 of the net proceeds were used to purchase $102,656,000 aggregate principal amount of the Company's 10-3/8% Senior Subordinated Notes due 2002 (the "10-3/8% Notes"), plus accrued interest, through a tender offer and in open market purchases. In the fourth quarter of 1996, the Company reported an extraordinary loss on early extinguishment of these 10-3/8% Notes of $6,838,000, net of income tax benefit of $3,682,000. The Company intends to retire the 10-3/8% Notes that remain outstanding either through open market purchases or through early redemption of the 10-3/8% Notes in June 1997. The refinancing of the 10-3/8% Notes will result in annual expense savings of approximately $2,600,000.
in the form of loans or cash advances from regulated subsidiaries, although no amounts were outstanding at December 31, 1996 or borrowed to date in 1997. There are no restrictions on distributions from the non-regulated subsidiaries; the Parent and its non-regulated subsidiaries had aggregate cash and temporary investments of approximately $194,500,000 at December 31, 1996. The Parent also receives tax sharing payments from subsidiaries included in its consolidated income tax return, including certain regulated subsidiaries. Because of the tax loss carryforwards available to the Parent and certain subsidiaries, together with current interest deductions and corporate expenses, the amount paid by the Parent for income taxes is substantially less than tax sharing payments received from its subsidiaries. In addition, the Parent receives payments from the regulated and non-regulated entities for services provided by the Parent. Payments from regulated subsidiaries for dividends, tax sharing payments and other services totaled approximately $104,400,000 for the year ended December 31, 1996.
During each of the three years in the period ended December 31, 1996, the Company operated profitably and net cash was provided from operations.
The Company has entered into interest rate agreements to manage the impact of changes in interest rates on its variable rate debt and customer banking deposits. Counterparties to these agreements are major financial institutions, which the Company believes are able to fulfill their obligations; however, if they are not, the Company believes that any losses are unlikely to be material.
In April 1996, the Company formed PIB with PepsiCo, Inc to be the exclusive bottler and distributor of PepsiCo beverages in a large portion of central and eastern Russia, Kyrgyzstan and Kazakstan. The Company and PepsiCo have committed to make capital contributions to PIB of $79,500,000 and $26,500,000, respectively. As of December 31, 1996, the Company contributed $51,000,000; the balance was funded in January 1997. In February 1997, the Company, PepsiCo and PIB signed a term sheet with third party lenders to provide $90,000,000 of additional financing to PIB. Actual funding will require satisfactory negotiation and execution of definitive loan agreements, as well as, among other things, a license from the Russian Central Bank. Pending satisfaction of such requirements, bridge financing to PIB to cover operating costs and capital expenditures will be necessary. The Company estimates that its share of the bridge financing should not exceed $30,000,000.
significant start-up costs of this operation. The Company anticipates that PIB will continue to experience operating losses during the period that PIB is building production and distribution capacity and market share.
In July 1996, the Company committed to invest up to $25,000,000 for a 57.5% equity interest in an 809,000 square foot office building and garage and a minority interest in a Marriott hotel. This real estate project in Brooklyn, New York is currently under construction. The Company's equity investment is expected to be contributed toward the end of the anticipated two year construction period. The Empire Group will be a major tenant in the project, and as such will receive certain benefits, primarily from the City of New York, with a present value of approximately $36,000,000.
The Company's investments in Russia and Argentina are subject to foreign exchange and other risks. Investing in the emerging markets of Russia is subject to political risk and uncertainty concerning the government's ability to succeed in its program to convert to a market economy, both of which are beyond the Company's control. The Company's investments in Argentina and Russia are subject to foreign currency exchange risks, the volatility of the banking systems and securities markets in these countries, the overall health of their respective economies and the usual competitive factors experienced by companies.
The funds for the investments described above were or are expected to be provided from general corporate funds available to the Parent company.
The Company provides collateralized automobile loans to individuals with poor credit histories. In 1996, the Company continued to experience increased competition resulting in reduced volume and increased loan losses. During 1996, the Company tightened its underwriting standards in an effort to improve its loan loss experience and increased the reserve maintained on this portfolio. The Company's investment in these loans was $96,338,000, $134,668,000 and $129,512,000 at December 31, 1996, 1995 and 1994, respectively.
The Company and certain of its subsidiaries have substantial loss carryforwards and other tax attributes. The amount and availability of tax loss carryforwards are subject to certain qualifications, limitations and uncertainties. In order to reduce the possibility that certain changes in ownership could impose limitations on the use of these carryforwards, the Company's certificate of incorporation contains provisions which generally restrict the ability of a person or entity from accumulating at least five percent of the Common Shares and the ability of persons or entities now owning at least five percent of the Common Shares from acquiring additional Common Shares. The Company has recognized as an asset (net of reserves) certain of the benefits of such loss
The Company's most significant operations are its insurance businesses, where it is a specialty markets provider of property and casualty and life and health insurance to its niche markets. For the year ended December 31, 1996, the Company's insurance segments contributed 83% of total revenues and, at December 31, 1996, constituted 77% of total assets.
Earned premium revenues and commissions of the property and casualty insurance operations of the Empire Group were $326,400,000, $326,100,000 and $299,200,000 for the years ended December 31, 1996, 1995 and 1994, respectively. Beginning in the fourth quarter of 1995, higher premium rates were charged on certain lines of business, including in 1996 amounts related to increased minimum automobile liability coverage required by New York State. Such rate increases were largely offset by a decrease in the number of policies in force. This decrease primarily resulted from the depopulation of the assigned risk pools and reduced volume in other lines of business that have not been profitable, primarily certain specialty programs within voluntary commercial automobile lines. In addition, the Empire Group has experienced increased competition, primarily in workers' compensation and commercial package policies, which has reduced volume. The increase in 1995 as compared to 1994 principally was attributable to growth in policies in force and increased premium rates. The majority of the growth in 1995 resulted from service business.
The Company's property and casualty insurance operations combined ratios as determined under GAAP and SAP were as follows:
1996 1995 1994 ---- ---- ---- Colonial Penn P&C Group: GAAP 98.6% 97.0% 96.1% SAP 97.4% 97.3% 97.1%
The provision for insurance losses and policy benefits includes catastrophe losses, net of reinsurance recoveries, estimated at approximately $5,000,000, $4,600,000 and $18,300,000, for the years ended December 31, 1996, 1995 and 1994, respectively. The 1994 losses include approximately $11,700,000 related to the Northridge, California earthquake.
In 1996, the combined ratios of the Colonial Penn P&C Group increased due to increased levels of new voluntary automobile business for which higher loss reserves are provided than on renewal business and a retroactive adjustment to its New Jersey automobile pool involuntary assignment, offset in part by a favorable settlement of a special risk claim. The costs incurred to acquire new business combined with the related loss reserving policies depress operating results while the business grows. The Colonial Penn P&C Group believes that its strong underwriting procedures, emphasis on mature adult insureds and claims handling and settlement practices have enabled it to record combined ratios that compare favorably with the industry. The combined ratios for the Colonial Penn P&C Group increased slightly in 1995 as compared to 1994. The 1995 combined ratios reflected higher losses related to service business that were partially offset by increased service fee income. In addition, the combined ratios in 1995 were favorably affected by reduced catastrophe losses as compared to 1994.
The combined ratios of the Empire Group increased in 1996 due to unusually high assessments from the New York State workers' compensation fund, severance benefits for certain employees, a reduction in the estimate of fees earned as a servicing carrier for the New York Public Automobile Pool and reduced assigned risk business, offset in part by an improved 1996 accident year loss ratio. The Empire Group believes that the improvement in the 1996 accident year loss ratio results from its efforts to increase the profitability of its product lines, primarily through rate increases and improved underwriting procedures. Included in the Empire Group's results for 1996 and 1995 were approximately $28,000,000 and $34,500,000, respectively, for reserve strengthening related to losses from prior accident years. In 1996, the reserve strengthening primarily related to voluntary commercial automobile and commercial package lines of business, while in 1995 the reserve strengthening primarily related to automobile and workers' compensation lines of business. In 1995, the Empire Group's combined ratios increased as compared to 1994 primarily due to the reserve strengthening. The Empire Group will continue to analyze the adequacy of its loss reserves on a quarterly basis.
Premium revenue receipts on IOP products of the life insurance subsidiaries (which are not reflected as revenues) were $52,272,000 in 1996, $50,202,000 in 1995 and $108,080,000 in 1994. The principal IOP product sold during the three years ended December 31, 1996 was a VA product marketed directly to consumers. The Company believes the decline in premium revenue receipts of the VA product in 1995 was due to a combination of factors, including the public's perception of potential tax law changes, increased competition and the performance of the fund manager.
Earned premium revenues of the life and health insurance operations were $178,900,000 for 1996, $165,800,000 for 1995 and $172,400,000 for 1994. Included in these amounts were earned premium revenues for the Company's Graded Benefit Life product of $121,000,000, $117,700,000 and $113,700,000 for the years ended December 31, 1996, 1995 and 1994, respectively. The growth related to the Graded Benefit Life product reflects the Company's increased marketing efforts with respect to this product, which have been conducted at acquisition cost levels that result in adequate profitability.
Manufacturing revenues declined during each of the last two years due to the sale of certain divisions and the discontinuance of certain non-performing product lines. The Company recorded charges of $3,700,000 in 1996 and $7,300,000 in 1995 for losses on sales and shutdown expenses, which are primarily reflected in the caption "Selling, general and other expenses." The pre-tax results for this segment improved in 1996, primarily due to manufacturing and operating efficiencies at the bathroom vanities and plastics divisions and the disposal of non-performing businesses.
Equity in losses of associated companies increased in 1996 primarily due to start-up losses from the Company's equity investment in PIB of $17,104,000, losses from its interest in MK Gold of $6,478,000 and a $7,041,000 write-off of the Company's investment in an unsuccessful well drilled by its Siberian oil exploration joint venture.
Higher interest expense in each of 1996 and 1995 compared to the prior year principally reflected the increased level of outstanding debt. Interest expense also reflected the increased level of deposits at AIB and AIF and an increase in rates related to those deposits. Generally, interest rates on deposits are lower than on other available funds. Interest expense on deposits was $12,575,000 in 1996, $12,034,000 in 1995 and $8,304,000 in 1994.
The 1996 provision for income taxes was below the expected normal corporate tax rate primarily due to the favorable resolution of certain contingencies. The provision for income taxes for 1995 was below the expected normal corporate income tax rate principally due to the gain related to the return of the WMAC Companies, which was not taxable, and the favorable resolution of certain contingencies. The provision for income taxes for 1994 was below the expected normal corporate income tax rate principally because of a reduction in the valuation allowance applicable to the deferred tax asset due to the resolution of certain contingencies.