The Company owns a three-story office building at 195 Lake Louise Marie Road, Rock Hill, New York, in which its executive offices and insurance operations for Frontier Insurance are located. A 50,000 square foot addition is under construction and is anticipated to be completed in April 1998. The Company also owns a one-story building in Rock Hill, New York, which it uses for storage and a portion of which is rented, an airplane and a hanger at a local airport.
The following discussion and analysis should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this report.
Net premiums earned for the general liability line increased primarily because of increases in various programs, including continued growth in the social services, artisans contractor, demolition contractors, and excess employers' liability programs, and, the acquisition of United Capitol in May 1996. These increases were partially offset by a decrease in net premiums earned in the umbrella and crane operator liability programs.
Net premiums earned for the commercial earthquake program decreased marginally as planned.
Net premiums earned for the specialty personal lines increased primarily due to increased volume in the mobile homeowners' program and auto physical damage insurance as a result of the acquisition of Regency and Lyndon.
Net premiums earned for the credit-related products increased as a result of the acquisition of Lyndon.
Gross claims adjusting income has been eliminated as a separate item as claims adjusting services provided to outside companies have essentially terminated.
Total expenses increased by 53.6%, compared to the 37.9% increase in net premiums earned. Losses and loss adjustment expenses ("LAE") increased at a 50.4% rate as a result of a 70.0% increase in losses and a 18.1% increase in LAE. The increase in losses and LAE was disproportionate to that of net premiums earned due to the $35 million reserve strengthening, predominantly in the medical malpractice line of business for accident years prior to 1995, partially offset by the aggregate excess of loss reinsurance contract which provides coverage for losses and LAE in excess of 64% and 65% for the 1997 and 1996 accident years, respectively, which, together, resulted in a loss and LAE component of the GAAP Combined Ratio 6.9 percentage points higher than in the comparable 1996 period. The 18.1% increase in LAE resulted from a change in the line of business mix to those having a higher percentage relationship of LAE to losses and to the $35 million reserve strengthening of which $9.7 million was allocated to LAE. The 53.2% increase in the amortization of policy acquisition costs, underwriting and other expenses was attributable primarily to an increase in direct commission expense resulting from growth in programs with higher commission rates, increased staffing and marketing expenses related to expansion, salary increases and the total expenses attributable to Lyndon, United Capitol, Western and Regency, partially offset by the recognition of $5.8 million of the amortization of the excess of net assets over the purchase price associated with the Lyndon acquisition. The 46.4%
decrease in interest expense was primarily the result of the repayment and termination of the line of credit in the fourth quarter of 1996, partially offset by the interest expense associated with the draw-down of $62 million from a revolving credit facility that the Company obtained on June 3, 1997. The Company also incurred approximately $10.8 million of expenses in 1997 attributable to the Convertible TOPrS. As the non-claim related component of the GAAP Combined Ratio increased at a greater rate than premiums earned , the non-claim component was 2.3 percentage points higher than in the comparable 1996 period. The total GAAP Combined Ratio increased by 9.2 percentage points to 101% as a result of the above.
The foregoing changes resulted in income before taxes of $45.8 million for the year ended 1997, a 19.1% decrease from the comparable 1996 period. Net income for the year decreased by $7.8 million or 19.4%.
A variety of factors accounted for the 35.6% growth in net premiums earned, the principal factor being increases in the majority of the Company's core and new program business, partially offset by a decrease in workers' compensation, particularly the cotton gin program, and by the increased ceding of net premiums earned under the Company's aggregate excess of loss reinsurance contract effective January 1, 1996, pursuant to which 13.5% and 14% of net premiums earned in 1996 and 1996, respectively, was ceded for all lines of business, except certain classes of surety bonds, realtors' errors and omissions and all of the net premiums earned by United Capitol and Regency.
The increase in medical malpractice net premiums earned was primarily attributable to an increase in the number of physicians insured, principally those associated with mental health, home care and other social service organizations, growth in the programs for psychiatrists and alternative risks, geographical expansion in Ohio, Texas, Michigan and Illinois, growth in the dental program endorsed by the Academy of General Dentistry, and rate increases in Florida.
Gross claims adjusting income decreased 57.7% primarily as a result of a decrease in claim services provided to outside companies, principally Markel Corporation.
The Company generally invests in securities with fixed maturities with the objective of providing reasonable returns while limiting liquidity and credit risk. As a result, its investment portfolio consists primarily of government and governmental agency securities and high-quality marketable corporate securities which are rated at investment grade levels. At December 31, 1997, the Company held rated, or better-than-investment grade, fixed maturity debt securities with a carrying amount of $1.06 billion, constituting 98.5% of the Company's fixed maturity investments.
The following table provides a profile of the Company's fixed maturity investment portfolio by rating at December 31, 1997:
The Company is a holding company, receiving cash principally through sales of equities, borrowings, and dividends from its subsidiaries, certain of which are subject to dividend restrictions described in Note J of the Notes to the Consolidated Financial Statements. The ability of insurance and reinsurance companies to underwrite insurance and reinsurance is based on maintaining liquidity and capital resources sufficient to pay claims and expenses as they become due. The primary sources of liquidity for the Company's subsidiaries are funds generated from insurance and reinsurance premiums, investment income, commission and fee income, capital contributions from the Company and proceeds from sales and maturities of portfolio investments. The principal expenditures are for payment of losses and LAE, underwriting and other operating expenses, commissions, and dividends to shareholders and policyholders.
In May 1995, the Company and R. Spencer Douglas III ("Douglass") formed a California limited liability corporation, Douglass/Frontier, LLC ("Douglass/Frontier"), a bail bond insurance agency to which the Company contributed $2.4 million in cash and Douglass contributed the assets of his wholly-owned existing bail bond agency. The Company and Douglass share equally in the ownership of Douglass/Frontier.
On June 29, 1995, the Company obtained a 4 1/2 year, $35 million line of credit facility from The Bank of New York, under which it borrowed $25 million at an interest rate of 6.87% per annum, payable quarterly. In June and September 1996, the Company borrowed an additional $4.2 million and $2.9 million from The Bank of New York (outside of the line of credit) at annual interest rates of 6.125% and 6.3125%, respectively, payable quarterly, due October 1996. In the fourth quarter of 1996, the Company repaid all borrowings and terminated the facility.
As a result of a review by AM Best of Frontier Insurance Company's A-(Excellent) rating, the Company agreed with AM Best to make a $45 million capital infusion to Frontier Insurance Company by June 30, 1995 in order to fund its projected growth and retain its A- rating. At June 30, 1995, the Company had completed the $45 million capital infusion, utilizing a combination of funds previously held by the Company and loan proceeds from The Bank of New York loan.
In May 1996, the Company completed the acquisition of United Capitol Holding Company ("United Capitol Holding"), the direct or indirect parent of United Capitol Insurance Company, United Capitol Managers, Inc. (renamed Olympic Underwriting Mangers, Inc.) and Fischer Underwriting Group, Inc., for
$31.0 million. United Capitol Holding, through its subsidiaries, underwrites specialty risks such as asbestos abatement, environmental liability and directors' and officers' liability.
In October 1996, the Company completed a $172.5 million offering of Convertible TOPrS, issued through Frontier Financing Trust, a Delaware business trust formed by Frontier for the purpose of the transaction. The Convertible TOPrS have a dividend rate of 6 1/4% and are convertible into 2.1328 shares of the Company's Common Stock, equivalent to a conversion price of $23.44 per share. See NOTE N of the NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS. Net proceeds to the Company from this offering were $166.9 million of which $32.1 million was applied to repay bank debt, $60 million was contributed to the surplus of Frontier Insurance and the remaining balance was available for general corporate purposes.
In December 1997, the Company completed the acquisition of Western Indemnity Insurance Company ("Western") for $48 million. Western is a specialized health carrier, underwriting coverage for both physician and hospitals. Also, in December 1997, the Company acquired Environmental and Commercial Insurance Agency, Inc. ("ECI") for $4.5 million. ECI is an underwriting manager of environmental errors and omissions and construction specialties, placing the majority of its business written with United Capitol.
On November 10, 1994, the Company authorized a stock repurchase program to purchase up to 1 million shares of its Common Stock at such times and prices as the Company deems advantageous, in
In December 1990, the New York State Court of Claims rendered a decision in favor of the Company holding that a State University of New York ("SUNY") medical school faculty member engaged in the clinical practice of medicine at a SUNY medical facility, corollary to such physician's faculty activities, was within the scope of such physician's employment by SUNY and was protected against malpractice claims arising out of such activity by the State of New York and not under the Company's medical malpractice policy. The decision was affirmed on appeal by the New York State Appellate Division in November 1991 and not appealed by the State. In July 1992, the State of New York enacted legislation eliminating medical school faculty members of SUNY engaged in the clinical practice of medicine at a SUNY medical facility from indemnification by the State with respect to malpractice claims arising out of such activity, retroactive to July 1, 1991. In an opinion filed on September 3, 1993 the Court of Claims of the State of New York held, inter alia, that the July 1992 legislation by the State of New York eliminating SUNY medical school faculty members engaged in the clinical practice of medicine, as part of their employment by SUNY, from indemnification by the State with respect to malpractice claims arising out of such activity, was not to be applied retroactively. This decision was affirmed by the New York State Appellate Division in April 1994. Subsequently, in February 1995, the Appellate Division granted leave to Frontier and the State of New York to have the issues of Frontier's entitlement to recover its costs of defense and its costs of settlement ruled on by the State's highest Court, the New York Court of Appeals. In December 1995, the New York Court of Appeals ruled on this issue and concluded that Frontier was entitled to recoveries from the State for such medical malpractice claims. As a result of this decision, the Company believes that it will benefit economically by not being ultimately responsible for certain claims against SUNY physicians for whom it presently carries reserves is entitled to reimbursement of certain claims previously paid; accordingly, effective June 30, 1996 and December 31, 1995, Frontier recorded subrogation recoverables of approximately $13,000,000 and $19,000,000, respectively, representing the amount of claims already paid and the reserves currently held by Frontier on open cases that management believes are reimbursable by the State of New York. In January 1997, the New York Court of Claims rendered a decision granting summary judgement to the Company on three SUNY cases that were previously paid by the Company. This decision has been appealed by the State of New York. In January 1998, the New York Legislature approved a bill to eliminate the right of SUNY physicians to obtain indemnification from New York State for claims arising out of their clinical practice of medicine, retroactive to August 5, 1978, which bill was vetoed by the Governor in February 1998. Prior to the veto, the Company's management and members of the offices of the Governor and of the Attorney General held joint discussions for a comprehensive settlement of the amount of reimbursement to which the Company is entitled from the State. Discussions are continuing, but to date no resolution has been reached. To the extent that the amount of the actual recovery varies, such difference will be reported in the period recognized. The
The Company will complete a formal Year 2000 plan by July of 1998 which will detail all needed steps to achieve Year 2000 compliance and specify the time frames for these steps. It's anticipated that all major processing systems will be fully compliant by November 1998. The Company does not expect the costs of the Year 2000 project to have a material impact on its financial position or results of operations. The amount expensed in 1997 was immaterial.
See List of Financial Statements and Financial Statement Schedules on Page.