The following table sets forth certain information regarding the principal properties of the Company.
After five years of consistent growth in premiums written, both from internal growth and acquisitions, the Company experienced little growth in direct premiums written and a decrease in net premiums written during 1997. During 1997, the Company focused on improving operating margins by emphasizing profitable lines, restructuring and reunderwriting marginal lines and discontinuing clearly unprofitable lines. The Company's efforts were rewarded with record operating earnings of $57.9 million in 1997 as well as the continuation of a pattern of profitable quarters begun in the third quarter of 1992 when the phasing out of its prior non-insurance operations was substantially completed. The only exception to this pattern was a net loss of $6.0 million in the third quarter of 1995 when the Company strengthened loss reserves.
The Company has pursued a strategy of focusing on selected niche businesses through acquisitions, new agency relationships and additions of key professional staff. The Company's most significant acquisition was its purchase in July of 1993 of The Redland Group, Inc., a major writer of MPCI and other crop insurance coverages. In 1997, the Company was the third largest writer of MPCI business in the United States.
RESULTS OF OPERATIONS Year Ended December 31, 1997 Compared to Year Ended December 31, 1996
Underwriting results in all three of the Company's Property and Casualty divisions improved during 1997 as compared to 1996. The Company's General Agency division experienced a $4.0 million underwriting loss and a combined ratio of 102.7% in the twelve months ended December 31, 1997 as compared to a $10.8 million underwriting loss and a combined ratio of 106.9% for the twelve months ended December 31, 1996. The General Agency division's improved underwriting results were a result of a decrease in both the division's accident year and calendar year loss and loss adjustment expense ratios from 1996 to 1997. The division's loss and loss adjustment expense ratios fell from 69.9% and 75.0% on an accident and calendar year basis respectively during 1996 to 66.5% and 69.6% on an accident and calendar year basis respectively during 1997. These improved loss ratios were offset partially by an increase in the expense ratio of the division from 31.9% during 1996 to 33.0% during 1997. This increase in the expense ratio resulted from a decrease in net earned premiums from $155.3 million during 1996 to $148.5 million during 1997 with expenses remaining level at approximately $49 million in both years.
The Company's Non-Standard Auto division experienced its first unprofitable year in six years in 1996 as the division recorded a $5.5 million underwriting loss and a 114.9% combined ratio. The division's performance improved to an underwriting loss of $2.4 million and a 105.6% combined ratio in 1997. During 1997, the Company continued a pattern of regular rate increases combined with the cancellation of unprofitable programs and agents and was able to improve its loss and loss adjustment expense ratio from 82.5% in 1996 to 75.2% in 1997. In addition, the division was able to increase its insurance premiums earned by 14.1% while increasing expenses by only 7.1%, helping to lower its expense ratio from 32.3% in 1996 to 30.4% in 1997. The Company expects that profit improvement directives initiated in 1997 will continue to improve results within this division during 1998. The Company also expects continued growth within this division during the 1998 year resulting in continued improvement in the division's expense ratio.
The Program division improved from an underwriting loss of $15.6 million and a combined ratio of 117.5% during 1996 to an underwriting loss of $5.9 million and a combined ratio of 107.0% during 1997. These improved underwriting results were achieved by improvements of just over 5% in both the expense and loss ratios of the division. During 1996, many of the new programs within the division were in a start-up phase in which fixed expenses were not offset by adequate earned premiums. During 1997, growth in earned premium allowed fixed costs to move into a more normal relationship as a percentage of earned premiums, thus allowing the division to record a noticeable drop in its expense ratios from 36.3% during 1996 to 31.0% during 1997. The improvement in the loss ratio resulted from a change in the mix of business, emphasizing more profitable lines, restructuring of reinsurance to improve the Company's net results and the discontinuation of programs and agents with unprofitable loss ratios. The Company expects continued improvement in the results of the Program division as the benefit of the initiatives started in 1997 are realized in 1998.
During 1997, non-automobile lines of business continued to outperform the automobile lines of business within the Company's Property and Casualty divisions. For the year 1997, automobile lines recorded a 112.9% combined ratio while non-automobile lines recorded 99.9% combined ratio. The Company continues to effect significant underwriting changes within its automobile lines in order to bring them closer to the Company's desired goal of a combined ratio of 100.0% or less.
The Company's Crop division was a significant contributor to the underwriting earnings of the Company in both 1996 and 1997. During 1996, the division contributed $41.5 million to the Company's underwriting earnings as compared to $36.9 million during 1997. During 1997, the Company earned a profit share of 31.5% on its MPCI retained premium pool of approximately $155.5 million or $49.0 million. This compares with an earned profit share of 23.5% on a $161.4 million retained premium pool generating $37.9 million in 1996.
During the first quarter of 1996, the Company's operating income benefited from a $2.8 million profit in the Company's Crop Division. The principal component of this $2.8 million was the recording of an additional $3.8 million in profit sharing under the Company's MPCI program. The Company's estimate of its profit sharing under the MPCI program at December 31, 1995 was affected by a volatile crop growing season during which many of the rules pertaining to preventive planting payments were changed and a combination of unusual weather conditions manifested themselves in an unusually late harvest. As claims were closed during the first quarter of 1996 and the final preventive planting rules applied to these losses, the Company was able to earn additional profit sharing. The 1996 growing year did not experience this same degree of volatility, and the harvest was not delayed by unusual weather conditions. Consequently, the MPCI profit sharing income recorded at December 31, 1996 more accurately estimated actual results than had the profit sharing recorded at December 31, 1995. During the first quarter of 1997, the Company experienced operating income of approximately $900,000 from the operations of its Crop Division. The Company believes that the crop results for the first quarter of 1997 were more typical of a normal year than those experienced in the first quarter of 1996.
The Company's 1996 taxes were positively effected by the decrease in the evaluation allowance related to the unrealized loss from the Company's investment in Major Realty. In October 1995, Major Realty announced that its Board of Directors had determined that it was in the best interest of the stockholders to seek a merger partner, otherwise seek a transaction for the sale of the company. At December 31, 1996, the Company believed that the realization of the capital loss associated with such a transaction was more likely than not due to sufficient carryforwards of capital gains as well as the likelihood of future capital gains. No such benefit was realized in 1997, and therefore, the Company's effective tax rate increased to a more normal level of 31.2% as compared to an effective tax rate of 9.6% in 1996.
Year Ended December 31, 1996 Compared to Year Ended December 31, 1995
The Company's net income increased approximately 629% from $4.2 million in the year ended December 31, 1995 to $30.3 million in the year ended December 31, 1996. This increase in net income resulted from improved underwriting results in the Company's Crop and General Agency divisions, growth in premium revenues, increased investment income and realized gains, and a decrease in the effective tax rate of the Company. These positive factors were offset by deteriorating results in the Company's Program division, increased interest expense, and a somewhat higher expense ratio for the Company.
Underwriting results in the Company's General Agency division also improved in 1996 as compared to 1995, as the Company's combined ratio in this division improved from 116.4% in 1995 to 106.9% in 1996. The Company's 1995 results were affected by a $22.3 million strengthening of reserves for prior year losses, and $16.5 million of the $22.3 million affected the General Agency division, contributing to the 116.4% combined ratio recorded during 1995. When comparing accident year loss ratios for 1995 and 1996 in the General Agency division, the results are similar. In the year ended December 31, 1995, the General Agency division 1995 accident year loss ratio was 69.8% as compared to a 1996 accident year loss ratio of 69.9%. The General Agency division was also able to improve its combined ratio through a reduction in expenses during 1996 as its expense ratio fell to 31.9% in 1996 as compared to 34.1% in 1995.
The Company's Non-Standard underwriting activities experienced unprofitable results for the first time in six years as a result of an increase in both the severity and frequency of losses, particularly in the area of physical damage losses. The Company has increased rates beginning in 1996 and continuing into 1997, reduced commissions in certain areas with poor experience, and canceled agents with loss ratio problems.
The Company's interest expense also increased during 1996 as compared to 1995. This increase in interest expense was due to an increase in the Company's borrowings under its bank facility which increased from an average of $34.3 million during 1995 to $69.0 million during 1996. Offsetting this increase in the size of borrowings was a decline in the average interest rate under the bank facility from 7.6% during 1995 to 7.1% during 1996. The additional borrowings under the bank facility were contributed to the Company's subsidiaries in order to support underwriting activities and maintain capital adequacy ratios at a level commensurate with the Company's current A- rating by A.M. Best & Company.
The Company currently holds three surplus notes, each in the amount of $20 million, issued by two of its insurance company subsidiaries, bearing interest at the rate of 9% per annum payable semi-annually and quarterly. Although repayment of all or part of the principal of these surplus notes requires prior insurance department approval, no prior approval of interest payment is currently required.
Dividends from the insurance subsidiaries of the Company are regulated by the regulatory authorities of the states in which each subsidiary is domiciled. The laws of such states generally restrict dividends from insurance companies to parent companies to certain statutorily approved limits. In 1998, the statutory limitation on dividends from insurance company subsidiaries to the parent without further insurance departmental approval is approximately $21.7 million.
In August 1997, AICI Capital Trust, a Delaware business trust organized by the Company (the "Issuer Trust") issued 3.795 million shares or $94.875 million aggregate liquidation amount of its 9% Preferred Securities (liquidation amount $25 per Preferred Security). The Company owns all of the common securities (the "Common Securities") of the issue trust. The Preferred Securities represent preferred undivided beneficial interests in the Issuer Trust's assets. The assets of the Issuer Trust consist solely of the Company's 9% Junior Subordinated Debentures due 2027 which were issued in August of 1997 in an amount equal to the Preferred Securities and the Common Securities. The Company primarily used the net proceeds in the amount of $90.9 million from the sale of the Junior Subordinated Debentures to pay down the $90.0 million of borrowings under its Revolving Credit Facility. Distributions on the Preferred Securities and Junior Subordinated Debentures are cumulative, accrue from the date of issuance and are payable quarterly in arrears. The Junior Subordinated Debentures are subordinate and junior in right of payment to all senior indebtedness of the Company and are subject to certain events of default and redemptive provisions, all described in the Junior Debenture Indenture. At December 31, 1997, the Company had $94.875 million outstanding at a weighted annual interest cost of 9.2%.
On June 6, 1997, the Company amended its borrowing arrangements with its bank lenders providing a five-year revolving credit facility (the "Revolving Credit Facility"), with a final maturity of 2002, in amounts not to exceed $100 million. In August 1997, the Company used the net proceeds from the issuance of Junior Subordinated Debentures to repay the Company's outstanding indebtedness of $90 million under the Revolving Credit Facility. As a result of the Junior Subordinated Debentures, the Revolving Credit Facility was reduced from $100 million to $65 million. The Company selects its interest rate as either the prime rate or LIBOR plus a margin which varies depending on the Company's funded debt to equity ratio. Interest is payable quarterly. At December 31, 1997, the Company had no outstanding indebtedness under this arrangement. Borrowings and interest cost averaged $43.1 million and 7.0% during 1997. The Revolving Credit Facility contains covenants which do not permit the payment of dividends by the Company, requires the Company to maintain certain operating and debt service coverage ratios, required maintenance of specified levels of surplus and requires the Company to meet certain tests established by the regulatory authorities.
Cash flows from the Company's MPCI and crop hail businesses differ in certain respects from cash flows associated with more traditional property and casualty lines. MPCI premiums are not received from farmers until the covered crops are harvested, and when received are promptly remitted by the Company in full to the government. Covered losses are paid by the Company during the growing season as incurred, with such expenditures reimbursed by the government within three business days. Policy acquisition and administration expenses are paid by the Company as incurred during the year. The Company periodically throughout the year receives a payment in reimbursement of its policy acquisition and administration expenses.
The Company's profit or loss from its MPCI business is determined after the crop season ends on the basis of a profit sharing formula established by law and the RMA. Commencing with the 1997 year, the Company receives a profit share in cash, with 60% of the amount in excess of 17.5% of its MPCI Retention (as defined in the profit sharing agreement) in any year carried forward to future years, or it must pay its share of losses. Prior to the 1997 year, the amount carried forward to future years was any amount in excess of 15% of its MPCI retention. The Company recognized $49.0 million in profit sharing earned on the MPCI business during 1997, and in addition, recognized $1.0 million during 1997 in profit sharing earned on 1996 MPCI business. With the change in profit sharing payment rules including amounts payable for the 1997 crop year, the Company received $57.0 million in payments under the MPCI program in February of 1998.
Cash flows from operations for the year ended December 31, 1997 were $10.1 million as compared to cash flows from operating activities of $42.9 million during 1996. The decrease in positive cash flows is a result of a decline in the growth of gross written premiums coupled with a higher percentage of gross written premiums ceded to reinsurers.
The Company has identified the computer system applications that require modification to be Year 2000 compliant. The Company has developed a corrective plan whereby internal and external resources are being utilized to make the necessary modifications to and testing of the Company's computer systems. While some of the Company's computer systems are currently Year 2000 compliant, management expects the remaining systems to be Year 2000 compliant by December 31, 1998. The Company has expensed costs relating to the Year 2000 issue of approximately $1.4 million in 1997 and anticipates an additional $1.8 to $2.5 million of expenses to complete the project. The estimated costs and estimated date of completion of the Year 2000 project is based on management's best estimates. However, there can be no guarantee that these estimates will be achieved and actual results could differ from the Company's plan.
In addition, the Company is communicating with others with which it does business to determine if they are Year 2000 compliant. However, there can be no guarantee that the systems of these companies will achieve Year 2000 compliance in a timely manner.
In February 1997, the FASB issued SFAS No. 129, Disclosure of Information about Capital Structure. This statement establishes standards for disclosing information about an entity's capital structure. The Company adopted SFAS No. 129 in 1997. SFAS No. 129 contains no change in disclosure requirements for entities that were previously subject to the requirements of Accounting Principles Board Opinions Nos. 10 and 15 and SFAS No. 47 and as such the adoption of SFAS No. 129 did not have any effect on the Company's reporting.