First Central Insurance owns its home office building, located at 266 Merrick Road, Lynbrook, New York, (the "Building"). The Building consists of approximately 30,000 square feet of office space and 2,000 square feet of retail space. Management believes that the Building is suitable for First Central's purposes for the foreseeable future. Approximately 8,900 square feet of office and retail space is leased to seven unaffiliated tenants who paid approximately, $203,000 and $205,000 in rent during 1996 and 1995, respectively. Effective December 1, 1995 through November 30, 1996 Simon New York had a lease for 3,900 square feet of office space in the Building. Since December 1, 1996, Simon New York has occupied such space on a month-to-month basis. Rent received from Simon New York in 1996 was approximately $76,800.
* Restated to reflect adoption of Statement of Financial Accounting Standards No. 113, effective January 1, 1993.
First Central Insurance's losses from operations resulted in its statutory surplus declining from $25.7 million at December 31, 1995 to $12.3 million at December 31, 1996 with earned surplus declining from $8.9 million to a deficit of $4.3 million during the same period. Primarily as a result of First Central Insurance's current financial condition, in February 1997, A.M. Best & Co., Inc. ("Best") reduced the B++ (Very Good) rating it assigned to First Central Insurance in June 1996 to D (Very Vulnerable). See "Business -- Best Rating."
In informal discussions with the Insurance Department, the Insurance Department requested that First Central Insurance submit and implement a plan designed to improve operations and raise additional capital. Such a plan will involve, among other things, the revision of operations to attain future profitability by raising underwriting standards, curtailing operating expenses, revising agreements to achieve a reduction in loss adjustment expenses, restructuring the claims department to achieve more favorable settlements of claims and restructuring management positions. First Central Insurance has engaged outside consultants to review the activities of the various operating departments and make recommendations, where necessary, for changes within those departments. The plan also requires First Central Insurance to raise additional capital and First Central has engaged an investment banker to assist in this effort. Without the additional capital, First Central Insurance's surplus may be insufficient to enable it to remain in operation. Pending implementation of the plan and the raising of additional capital, First Central Insurance has ceased the writing of new insurance business.
In October 1996, Andrew W. Attivissimo was engaged as President and Chief Operating Officer of each of First Central and First Central Insurance. In February 1997, Mr. Attivissimo was also appointed as Chairman and Chief Executive Officer of First Central and First Central Insurance, succeeding Martin J. Simon, the founder of First Central. See "Executive Officers of the Registrant."
During 1995, one security experienced a decline in market value considered other than temporary. As of December 31, 1995, First Central Insurance held $3,000,000 par value of the Discovery Zone Inc. Subordinated Notes due 2000 and realized a loss of $555,281 on this security, lowering the carrying amount to the December 31, 1995 market value of $772,500.
At December 31, 1996, fixed maturity securities with an amortized cost of $45,284,608 and an estimated market value of $45,019,345 were reclassified from the "held-to-maturity" classification to the "available-for-sale" classification because of uncertainties about First Central Insurance's ability to hold these securities until their maturity. The change in classification did not materially affect total shareholders' equity as of December 31, 1996, but it resulted in 100% of First Central's Insurance's fixed maturities portfolio being classified as available-for-sale. In the opinion of management, available-for-sale classifications of the fixed maturities portfolio is appropriate in the present circumstances. At December 31, 1996, the net unrealized appreciation applicable to First Central Insurance's available-for-sale securities amounted to $768,517, net of deferred taxes of $532,000. Unrealized holding gains amounted to $3,079,854 and unrealized holding losses totaled $1,779,337 before deferred taxes. At December 31, 1995, the net unrealized appreciation applicable to First Central Insurance's available-for sale securities amounted to $759,808, net of deferred taxes of $392,000. Unrealized holding gains amounted to $3,005,195 and unrealized holding losses totaled $1,853,387 before deferred taxes.
During 1995 and 1996, First Central Insurance increased total net reserves by $18.1 million and $20.9 million, respectively, to maintain its total loss reserves at or near the middle point of the actuarial reasonableness range.
Based on First Central Insurance's past loss experience, prior management responsible for claims policy increased total net reserves by approximately $2.0 million, $2.5 million and $3.3 million in the first, second and third quarters of 1995, respectively, including increases in IBNR reserves of $1 million, $960,000 and $370,000 during such periods, respectively. However, after a review of case files during the fourth quarter of 1995, First Central Insurance's independent actuary recommended a substantial IBNR reserve increase for the fourth quarter of 1995 because of the adverse development mentioned above. The $8.95 million increase in IBNR reserves in the fourth quarter of 1995 brought First Central Insurance's total reserves at December 31, 1995 in line with the estimate of First Central Insurance's independent actuary. Accordingly, First Central Insurance believed that total reserves had been adequately strengthened during 1995 for 1995 and years prior thereto.
The reserve strengthening in the fourth quarters of 1995 and 1996 resulted from significant adverse development stemming from extremely poor loss experience on policies written from 1992 through 1995, and prior management that was responsible for claims policy basing quarterly reserve estimate adjustments on historical loss experience.
In connection with the Insurance Department's triennial audit, First Central Insurance is in discussions with the Insurance Department concerning a number of issues including the adequacy of First Central Insurance's reserves at December 31, 1996. It is new management's and First Central Insurance's independent actuary's estimate that total net reserves at December 31, 1996 are adequate.
In 1995, incurred losses increased approximately $11,210,000, 47.7% when compared to 1994. This increase was due primarily to an approximate $7,400,000 increase in IBNR reserves and approximately $3,800,000 increase in paid losses during the 1995 year when compared to 1994. During 1995, IBNR reserves were increased $8,400,000 in the fourth quarter for a total annual increase of approximately $11,300,000.
In 1996, First Central Insurance's loss ratio on its workers' compensation line decreased to 7.2%. This decrease is the result of a reduction in previously established workers' compensation reserves for the 1993 policy year. Were it not for the reduction in previously established reserves, the 1996 loss ratio would have been 46.9%. In 1995 First Central Insurance's loss ratio on its workers' compensation line of business increased to 50.9% primarily due to approximately $1,600,000 increase in IBNR reserves when compared to 1994.
First Central Insurance's loss ratios on its general liability line of insurance were 155.5% in 1996, 62.0% in 1995, and 47.6% in 1994. The 155.5% loss ratio in 1996 was due principally to an increase in unpaid loss reserves and paid losses and the decrease in paid losses ceded and subrogation receivables discussed under 1996 incurred losses above. The loss ratio in 1995 increased primarily due to an increase in IBNR reserves of approximately $2,400,000 when compared to 1994.
First Central Insurance's loss ratio on automobile physical damage line of business did not vary significantly as it was: 49.2% in 1996, 47.7% in 1995, and 50.4% in 1994.
In 1996 First Central's underwriting expenses increased 6.4% when compared to 1995. This increase was a result of other operating expenses increasing 33.3% offset by policy acquisition costs decreasing 3.0% during 1996 when compared to 1995. The decrease in policy acquisition costs were primarily due to the decrease in commission and premium tax expenses associated with the reduced premium volume. On a ceded basis, commissions were reduced as a result of the January 1996 and April 1995 reinsurance treaty endorsements described in "Reinsurance Ceded" above. The increase in other operating expenses was primarily due to statutory assessments on workers' compensation lines and an increase in amortization expense resulting from the write-off of goodwill.
The provision for doubtful accounts during 1996, 1995 and 1994 was $3,592,223, $695,865 and $1,056,557, respectively. The 1996 increase in doubtful accounts resulted from a comprehensive review of outstanding balances and First Central Insurance's determination that the collectability of certain auditable workers' compensation and commercial packaged policy receivables is questionable. The 1995 decrease in the provision was due to a smaller percentage of auditable policies issued effecting the 1995 year.
Net income decreased 93.7% in 1995 when compared to 1994. This was a result of an increase in IBNR reserves and paid losses (see "-- Losses and Loss Adjustment Expense Reserves") as offset by increases in earned premiums, net investment income, realized gains, and claims adjusting revenue and a decrease in interest expense, underwriting expenses and doubtful accounts and income taxes.
The reinsurance treaty between Swiss Re and First Central Insurance provides for a contingent commission based on favorable loss ratios. The 1996 and 1995 loss ratios produced contingent commissions of $50,777 and $62,110, respectively.
The business capacity of an insurance company is based on its liquidity and capital resources. Insurance statutes and regulations which apply to insurers require maintenance of prescribed amounts in capital and surplus as well as statutory deposits with insurance authorities. The assets of insurers are maintained in statutorily prescribed investments. Insurers are also required to set up and have reserves for losses and loss adjustment expenses. Furthermore, substantial statutory and regulatory restrictions are imposed upon an insurer's ability to declare and pay cash dividends. See "-- Investments and Investment Portfolio", "Business -- Regulation," "Market for Registrant's Common Equity and Related Stockholder Matters -- Dividends" and "Business -- Losses and Loss Adjustment Expense Reserves" for a discussion of the foregoing factors as they relate to First Central Insurance. See also "-- Reinsurance."
The Insurance Department has requested that First Central Insurance submit and implement a plan designed to improve operations and raise additional capital. See "-- Recent Developments." Pending implementation of the operational and financial plan and the raising of additional capital, on March 10, 1997, First Central Insurance ceased to write new business. First Central Insurance continues to process renewals and service its existing business and expects to cease renewals on private passenger automobile policies. First Central has engaged an investment banker to assist in its effort to raise additional capital.
First Central Insurance's Statutory Surplus declined from $25.7 million at December 31, 1995 to $12.3 million at December 31, 1996. Based upon the required relationships between Net Premiums Written and Statutory Surplus, First Central Insurance expects that the reduction in Statutory Surplus will result in a significantly reduced premium volume for the foreseeable future. Primarily as a result of First Central Insurance's current financial condition, in February 1997, Best reduced First Central Insurance's rating to D (Very Vulnerable). See "Business -- Best Rating." The change in rating has adversely impacted policy renewals. The continuation of a D rating will severely affect First Central Insurance's future ability to compete with other insurers. It is anticipated that a reduced premium volume would have a further negative impact on First Central Insurance's liquidity and capital resources. Without additional capital, First Central Insurance's surplus may be insufficient to enable it to remain in operation.
The 1986 Tax Act contained provisions which significantly increased the federal income tax liabilities of property and casualty insurance companies, including First Central Insurance. Under the 1986 Tax Act, the reserve deduction for unpaid losses previously allowed to property and casualty insurance companies was modified in a manner which has resulted in increases in First Central Insurance's taxable income. Although First Central Insurance still is able to establish reserves for the estimated amount of losses incurred, the amount of such reserves must be discounted to reflect the present value of its liability to pay anticipated claims (using a discount rate of 100% of the average of the applicable federal mid-term rates). Furthermore, with respect to investments acquired after August 7, 1986, the 1986 Tax Act reduced the loss reserve deduction of property and casualty companies by 15% of any tax exempt interest income and the deductible portion of dividends received. The 1986 Tax Act also requires property and casualty companies to reduce their annual deduction for unearned premiums by 20%.
Management does not believe that the provisions of either of such Acts have materially affected First Central's future liquidity. Management further believes that increases in First Central's federal income tax liability occasioned by reason of the Acts' provisions have not materially impacted upon First Central's future results of operations or its sources or uses of capital resources.
On January 17, 1995 First Central Insurance purchased the premises in which it's corporate offices are located for a purchase price of $4,000,000 in cash. Prior to purchasing the Building, management analyzed the relative benefits and costs of the purchase verses, among other things, the renewal of (i) First Central Insurance's lease which was to expire on November 30, 1995 and (ii) Mercury's lease in the same building which was to expire on March 31, 1995.
Neither First Central, First Central Insurance, nor Mercury made any material commitment for capital for 1996 and, does not anticipate any for 1997.