ORION CAPITAL CORPORATION AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Orion Capital Corporation ("Orion") and its wholly-owned subsidiaries (collectively the "Company") operate principally in the property and casualty insurance business. The Company reports its insurance operations in three segments as of December 31, 1998 as follows:
The Company increased its ownership of Guaranty National Corporation ("Guaranty National") to 100% in December 1997. Beginning in 1998, the commercial insurance operations of Guaranty National were consolidated with Connecticut Specialty to form a new company named Orion Specialty. Since the formation of Orion Specialty, OrionAuto's only business is nonstandard personal automobile insurance.
On April 30, 1998 the Company acquired the nonstandard personal automobile insurance business of North Carolina-based Strickland Insurance Group, Inc. ("Strickland"). The acquisition included two insurance companies, a premium finance company, a claim adjusting company and a general agency in Florida. In 1997, Strickland reported approximately $99 million of personal automobile gross premiums written and $46 million of net premiums written. The purchase price was $44.1 million including acquisition expenses. The acquisition was accounted for as a purchase and accordingly, the acquired business has been included in the Company's consolidated financial statements from the date of acquisition. The total consideration exceeded the fair value of the acquired net assets by approximately $28.7 million and is being amortized over 25 years.
In the third quarter of 1998, the Company announced an accelerated realignment of its Orion Specialty unit to address lines that had not met the Company's growth and profitability expectations. The realignment continued Orion Specialty's shift away from commodity business, primarily commercial auto and transportation, to a smaller number of more client-focused programs and specialty niches. The realignment involved exiting approximately $100 million in annualized net written premiums of unprofitable commodity and marginal lines of business, the reduction of approximately 90 employees related to the exited business, and the sale of its Colorado Casualty unit. Colorado Casualty produced approximately $55 million in annual net premiums, which consisted largely of business that did not fit the Company's specialization strategy.
On September 29, 1998, the Company sold Colorado Casualty resulting in a pre-tax gain of approximately $24.2 million. The Company recorded severance and program termination expenses of $7.0 million and asset write downs of $1.9 million related to the exited business in the third quarter of 1998. Subsequently, the Company recorded $1.9 million of charges against the severance and program termination liability for incurred costs during 1998.
Also a part of the Company's reshaping to focus resources on high potential lines of business, on March 11, 1999 the Company announced the signing of a definitive agreement to sell McGee. The transaction is expected to be complete by April 1999, subject to regulatory approvals and other closing conditions.
Earnings by segment before federal income taxes and minority interest expense are summarized as follows:
During the fourth quarter of 1998, the Company adopted FAS No.131, "Disclosure about Segments of an Enterprise and Related Information." FAS 131 establishes new standards for reporting information about operating segments and requires that the segments be based on the internal structure and reporting of the Company's operations. See footnote 17 to the consolidated financial statements for the Company's segment disclosure.
Operating earnings represents earnings after taxes, excluding net realized investment gains. For 1998, operating earnings of $68.6 million reflects a realignment of Orion Specialty and third-quarter losses from the Company's limited partnership investments. In the third quarter of 1998, the Company recorded $12.5 million of net pre-tax charges, or $0.35 per diluted share on an after-tax basis, in connection with a realignment of Orion Specialty and related reserve strengthening for exited business. In the third quarter of 1998, the Company reported pre-tax investment losses of $14.1 million, or $0.33 per diluted share on an after-tax basis, related to declines in the value of the Company's limited partnership investments which are accounted for on an equity basis. These charges and losses have obscured continued strong operating performance from the Company's insurance operations, in particular EBI, DPIC and OrionAuto. That performance is combined with an increase in after-tax investment gains to arrive at net earnings. For the five year period ended December 31, 1998, the Company's return on equity from net earnings and operating earnings has averaged 15.7% and 12.9% per year, respectively.
Weighted average common shares and diluted equivalents outstanding were 27,842,000, 27,900,000 and 27,788,000 for 1998, 1997 and 1996, respectively. The 1996 common stock and per common share data presented in this document has been restated to give effect to the 2-for-1 split of the Company's common stock issued on July 7, 1997.
Net premiums written for Workers Compensation increased by 20.4% in 1998 and 3.4% in 1997 compared to prior year periods largely due to new business written through EBI's multi-state accounts program established in 1997 and continued geographic expansion and penetration. The increases in net premiums written are mitigated, in part, by the effects of legislative reforms in certain states that have led to an increasingly competitive workers compensation marketplace with lower premium rates as well as a reduction in losses. Additionally, 1998 reflects lower premium retention from a change in EBI's reinsurance programs effective October 1998.
Net premiums written from Specialty Commercial for the years ended December 31 are as follows:
The assumed reinsurance business was sold in late 1996 resulting in the continued decline in net premiums written.
The Company's premiums earned increased 10.7%, or $145.3 million, to $1,503.0 million in 1998 and increased 4.4%, or $56.9 million, to $1,357.7 million in 1997 from $1,300.8 million in 1996. Premiums earned reflect the recognition of income from the changing levels of net premium writings.
Pre-tax net investment income decreased by $21.7 million in 1998 compared to 1997 primarily due to lower earnings on limited partnership investments accounted for on an equity basis, the continued shift in the fixed income portfolio from taxable to tax-advantaged securities, which generally provide lower income yields than taxable fixed income securities, and lower investment yields. Additionally, investment yields declined from the reinvestment of the proceeds of matured and called securities at declining rates during the year. Net investment income was favorably affected by positive operating cash flow.
Fixed maturity investments, which the Company has both the positive intent and the ability to hold-to-maturity, are recorded at amortized cost. Fixed maturity investments, which may be sold in response to, among other things, changes in interest rates, prepayment risk, income tax strategies or liquidity needs are classified as available-for-sale and are carried at market value. At December 31, 1998 and 1997 fixed maturities and short-term investments comprised 74.2% and 78.8%, respectively, of the Company's cash and investments. The effective duration of the Company's fixed income investment portfolio was 5.0 years at December 31, 1998.
The Company invests primarily in investment grade securities and strives to enhance the average return of its portfolio through limited investment in a diversified group of non-investment grade fixed maturity securities or securities that are not rated. The risk of loss due to default is generally considered greater for non-investment grade securities than for investment grade securities because the former, among other things, are often subordinated to other indebtedness of the issuer and are often issued by highly leveraged companies. At December 31, 1998 and 1997, the Company's investment in non-investment grade and non-rated fixed maturity securities were carried at $208.7 million and $256.7 million, respectively. These investments represented a total of 8.3% and 10.1% of cash and investments and 5.0% and 6.6% of total assets at December 31, 1998 and 1997, respectively.
The following table sets forth certain ratios of insurance operating expenses to premiums earned for the years ended December 31:
1998 1997 1996 ----- ----- ----- Loss and loss adjustment expenses 67.9% 66.7% 67.9% Policy acquisition costs and other insurance expenses 31.0% 31.2% 30.1% ----- ---- ---- Total before policyholders' dividends 98.9% 97.9% 98.0% Policyholders' dividends 1.6% 1.8% 1.8% ----- ---- ---- Combined ratio 100.5% 99.7% 99.8% ===== ==== ====
The loss ratio for Specialty Commercial increased in 1997 compared to 1996 primarily due to losses from certain programs cancelled by Orion Specialty, reserve strengthening for the Company's pools and associations and reinsurance business, and higher estimates for losses and loss adjustment expenses for the commercial automobile line of business written by Guaranty National. The 1997 loss ratio increase has been partly offset by the favorable effect of a change in this segment's mix of business, particularly the lower premiums and losses from the assumed reinsurance business that the Company exited in November 1996.
The loss ratio for Nonstandard Automobile improved in 1998 compared to 1997 primarily due to a decline in claims frequency and claims severity partly offset by higher loss expenses. The improvement in the Nonstandard Automobile loss ratio for 1997 compared to 1996 is primarily due to lower claims frequency. This improvement has been partly offset by costs incurred to improve claim handling and reduce insurance fraud.
Provisions for losses and loss adjustment expenses include development of loss and loss adjustment expense reserves relating to prior accident years, which increased the calendar year combined ratio by 2.3 percentage points in 1998 and 0.7 percentage points in both 1997 and 1996. During 1998, the Company's loss ratio was unfavorably affected by loss development in exited programs at Orion Specialty, the assumed reinsurance business discontinued in 1996, pools and associations (other than from McGee), and workers compensation line of business. In the third quarter of 1998, the Company recorded $17.0 million of loss reserves pertaining to prior accident years for business being exited in connection with the Orion Specialty realignment. Excluding this charge, adverse development of prior accident years increased the calendar year combined ratio by 1.1 percentage points in 1998. During 1997, the Company's loss ratio was unfavorably affected by loss development in the pools and associations, assumed reinsurance business discontinued in 1996 and cancelled program business, partly reduced by favorable development in the workers compensation insurance line of business.
The Company's environmental claims principally relate to asbestos and hazardous waste, arising from certain liability business written prior to the mid 1980's, which business was never a major element of the Company's operations. Environmental claims are also received from certain pools and associations where reserves are established based on information reported to the Company by the managers of those pools and associations. The Company discontinued its participation in these reinsurance pools and associations in the mid 1980's.
Equity in earnings (losses) of affiliate represents earnings (losses) from the Company's 26% investment in Intercargo and was $(0.7) million in 1998, $8.6 million in 1997 and $(0.4) million in 1996. The Company has agreed to sell its investment in Intercargo, which is expected to close late in the first quarter or early in the second quarter of 1999 pursuant to Intercargo's merger with X. L. America, Inc., a subsidiary of EXEL Limited. The Company recorded its share of Intercargo's results in the subsequent quarter as Intercargo reports its quarterly earnings after the Company reports its earnings. In 1997, equity in earnings of affiliates reflected a pre-tax gain of $7.0 million from Intercargo's sale of Kingsway Financial Services.
The Company's cash flows for the years ended December 31 was as follows:
(In millions) 1998 1997 1996 - ----------------------------------------------------------------- Cash flows: Operating activities ....... $ 29.9 $ 100.0 $ 167.7 Investing activities ....... 11.3 (207.4) (132.4) Financing activities ....... (32.5) 105.1 (27.3) -------- -------- -------- $ 8.7 $ (2.3) $ 8.0 ======== ======== ========
The decrease in operating cash flow for 1998 and 1997 is primarily the result of higher payments for losses, policy acquisition costs, federal income taxes (in 1998) and minority interest from trust preferred securities. The higher loss payments reflect both an acceleration of claims settlement in two of our operations during 1998 and loss payments related to the assumed reinsurance business exited by the Company. Higher payments for policy acquisition costs, are related to the Company's current rate of growth. Federal income tax payments for 1998 include $8.5 million of federal tax payments related to 1997 and a $20.0 million federal tax refund that was received by the Company in the first quarter of 1999. Partially offsetting these increased cash outflows are higher premiums collected, reflective of the Company's current rate of growth, as well as higher investment income collected.
Cash is used in or provided by investment activities primarily for purchases or from sales and maturities of investments, for acquisition activities, and for purchases of property and equipment. Investment purchases are funded by maturities and sales of investments, as well as by the net cash from operating cash flows after cash provided by or used in financing activities. Cash used for acquisitions totaled $80.1 million in 1998 and $132.6 million in 1997 (excluding acquired cash of $17.5 million in 1998 and $1.7 million in 1997). Cash used in acquisition activities (excluding cash acquired) in 1998 included $39.7 million for purchase of Strickland's nonstandard personal automobile insurance business, $32.4 million for purchase of Grocers, $5.1 million related to settlement of purchase price contingency for Guaranty National's acquisition of Viking Insurance Company of Wisconsin in 1995, and $2.9 million to tender the remaining shares of Guaranty National related to the December 1997 purchase. In September 1998, the Company sold Colorado Casualty providing cash proceeds of $13.1 million (net of cash sold with Colorado Casualty and before taxes). Cash used in acquisition activities (excluding cash acquired) in 1997 included $104.4 million for the purchase of Guaranty National common stock, $26.2 million for the purchase of Unisun, and a $2.0 million purchase price deposit for the acquisition of Strickland.
Orion's uses of cash consist of debt service, dividends to stockholders and overhead expenses. These cash uses are funded from existing available cash, financing transactions and receipt of dividends, reimbursement of overhead expenses, debt service costs from loans due from subsidiaries, and amounts in lieu of federal income taxes from Orion's insurance subsidiaries. Orion has received $55.2 million, $42.8 million and $35.3 million in dividends, $8.3 million, $8.1 million and $7.4 million for overhead expenses and federal tax payments of $20.8 million, $9.5 million and $7.5 million from its insurance subsidiaries in 1998, 1997 and 1996, respectively. Payments of dividends by Orion's insurance subsidiaries must comply with insurance regulatory limitations concerning stockholders' dividends and capital adequacy. State insurance regulators have broad discretionary authority with respect to limitations on the payment of dividends by insurance companies. Limitations under current regulations are well in excess of Orion's cash requirements.
The 8.73% and 7.701% Trust Preferred Securities are subordinated to all liabilities of the Company. The Company may defer interest distributions on these capital securities; however, during any period when such cumulative distributions have been deferred, Orion may not declare or pay any dividends or distributions on its common stock.
The Company issued a 2-for-1 split of its common stock on July 7, 1997 to shareholders of record on June 23, 1997. The Company has repurchased 836,100 shares, 42,916 shares and 482,228 shares of its common stock at an aggregate cost of $35.6 million, $1.5 million and $11.2 million under the Company's stock repurchase program in 1998, 1997 and 1996, respectively. The Company's Board of Directors increased authorization for purchases of its common stock by an additional $75 million in 1998. The remaining stock purchase authorization was $42.5 million at March 1, 1999.
With a timely start on correcting the Year 2000 problem, the Company has been able to address this potential exposure. This has allowed the Company to continue replacement of outdated systems with newer versions offering greater functionality and cost efficiencies. The Company completed replacing its financial, personnel, and payroll systems in 1998 and began phasing in new integrated processing systems for certain of its operations in 1999. The total cost for these major technology improvement projects are estimated at approximately $13.1 million of which $11.7 million had been capitalized through December 31, 1998. Additional technology projects are planned for 1999 as Year 2000 projects wind down. All costs are being funded through operating cash flows.
Evaluations of the most critical third parties have been initiated. These evaluations will be followed by the development of contingency plans, which have been prepared for third parties having near term Year 2000 impact or are being developed for other third parties, with completion during the first quarter of 1999. The Company believes that this aspect of its Year 2000 effort was on schedule at December 31, 1998.
The Company is unable to determine at this time whether the consequences of counter-parties Year 2000 failures will have a material impact on the Company's results of operations, liquidity or financial condition. The possibility exists that a portion of its third-party distribution channels may not be ready, that communications with its agents could be disrupted, that underwriting data, such as motor vehicle reports, could be unobtainable, that the claim settling process could be delayed or that the frequency and severity of losses may increase due to external factors. Where concern appears justified about an aspect of readiness, contingency plans have been prepared or are being developed. However, there can be no assurance that unanticipated Year 2000 issues of other entities will not have a material adverse impact on the Company's systems or results of operations.
This is a Year 2000 Readiness Disclosure statement. Readers are cautioned that forward-looking statements contained in "Year 2000 Compliance" should be read in conjunction with the Company's disclosures under the heading: "Forward-Looking Statements."
The Company is subject to market risk arising from the potential change in the value of its various financial instruments. These changes may be due to fluctuations in interest rates, and changes in credit spreads and in equity prices. The level of market risk is influenced by many factors, such as volatility, correlation and liquidity. Potential gains or losses from changes in market conditions can be estimated through statistical models that attempt to predict within a specified confidence level the " value at risk" based on historical price and volatility movements. For example, if historical probabilities indicate that the change in the value of a fixed income security would not be expected to exceed $1 million with a 95 percent probability within a given time period, then the security's value at risk at a 95 percent confidence level for that period is $1 million.
The Company's portfolio includes investments in limited partnerships ($111.1 million at December 31, 1998) that generally provide higher investment returns, but also carries higher volatility and market risk compared to the Company's other investments. Changes in the market value of limited partnership investments can vary considerably from year-to-year. However, the long-term performance of the Company's limited partnership investments has been favorable. The effect of limited partnership investments is not included in the value at risk disclosure shown below.
The overall after-tax value at risk for the Company at December 31, 1998 was as follows:
(In millions) - --------------------------------------------- Interest rate risk $ 19.5 Equity risk 6.0 Diversification benefit (9.8) --------- Total $ 15.7 =========
In June 1998, the Financial Accounting Standards Board issued FAS No. 133, Accounting for Derivative Instruments and Hedging Activities. This standard requires companies to record all derivatives on the balance sheet as either assets or liabilities and measure those instruments at fair value. The manner in which companies are to record gains or losses resulting from changes in the values of those derivatives depends on the use of the derivative and whether it qualifies for hedge accounting. This standard is effective for the Company's financial statements beginning January 1, 2000, with early adoption permitted. The Company is currently evaluating the impact of the adoption of this statement and the potential effect on its financial position or results of operations.
The Audit and Information Services Committee of the Board of Directors is comprised of independent directors, and has general responsibility for oversight of financial controls and audit activities of the Company and its subsidiaries. The Audit and Information Services Committee, which reports to the Board, annually reviews the qualifications of the independent auditors and meets periodically with them, the internal auditors and management to review the plans and results of the audits. Both internal and independent auditors have free access to the Audit and Information Services Committee, without members of management present, to discuss the adequacy of the system of internal control and any other matters which they believe should be brought to the attention of the Committee.
We have audited the accompanying consolidated balance sheets of Orion Capital Corporation and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of earnings, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1998. Our audits also included the financial statement schedules listed in the Index at Item 14(a)2. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
Hartford, Connecticut February 22, 1999 (except for Note 20, as to which the date is March 11, 1999)
December 31, ---------------------- (In millions) 1998 1997 - ------------------------------------------------------------------------------- Assets: Investments: - Fixed maturities, at amortized cost (market $272.7 - 1998 and $322.4 - 1997) .......... $ 260.6 $ 312.8 Fixed maturities, at market (amortized cost $1,305.5 - 1998 and $1,395.4 - 1997) .............. 1,349.9 1,469.8 Common stocks, at market (cost $200.3 - 1998 and $163.0 - 1997) ........................... 242.4 245.4 Non-redeemable preferred stocks, at market (cost $269.1 - 1998 and $183.6 - 1997) ............ 268.5 193.1 Other long-term investments .......................... 116.2 94.3 Short-term investments ............................... 248.7 228.3 ---------- ---------- Total investments .............................. 2,486.3 2,543.7
Cash ................................................. 18.0 9.3 Accrued investment income ............................ 27.0 29.6 Investment in affiliate .............................. 22.8 31.3 Accounts and notes receivable ( less allowance for doubtful accounts $3.4 - 1998 and $4.1 - 1997) .... 217.2 189.3 Reinsurance recoverables and prepaid reinsurance ..... 801.5 622.2 Deferred policy acquisition costs .................... 155.6 147.1 Property and equipment ( less accumulated depreciation $49.0 - 1998 and $35.9 - 1997) .................... 95.4 70.8 Excess of cost over fair value of net assets acquired ( less accumulated amortization $33.6 - 1998 $27.4 - 1997) ..................................... 167.7 140.0 Deferred federal income taxes ........................ 26.7 1.0 Other assets ......................................... 146.2 99.8 ---------- ---------- Total assets ................................... $ 4,164.4 $ 3,884.1 ========== ========== [FN]
Company-obligated mandatorily redeemable preferred capital securities of subsidiary trusts holding solely the junior subordinated debentures of the Company .... 250.0 125.0
Regulation - The Company's insurance subsidiaries are subject to comprehensive regulation by various state insurance departments including regulations limiting dividend payments to Orion and intercompany transactions. Under these regulations, the maximum dividends permitted at December 31, 1998 for the ensuing twelve months, without prior approval, aggregated $135.5 million. However, state insurance regulators have broad discretionary authority with respect to approving the payment of dividends by insurance companies. Policyholders' surplus of Orion's insurance subsidiaries determined in accordance with prescribed statutory accounting practices amounted to $732.1 million and $789.0 million at December 31, 1998 and 1997, respectively. Statutory net income amounted to $151.5 million, $146.1 million and $107.9 million for 1998, 1997 and 1996, respectively.
Deferred Policy Acquisition Costs - Costs that vary with, and are directly related to, the production of new and renewal business are deferred and amortized as the related premiums are earned. These costs primarily comprise commissions, premium taxes and salaries. The test for recoverability of such deferred
Federal Income Taxes - The Company recognizes taxes payable or refundable for the current year, and deferred taxes for the future tax consequences of differences between the financial reporting and tax basis of assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years the temporary differences are expected to reverse.
Segment disclosures - During the fourth quarter of 1998, the Company adopted FAS No. 131, "Disclosure about Segments of an Enterprise and Related Information." FAS 131 establishes new standards for reporting information about operating segments and related disclosures about products and services, geographic areas and major customers. It requires that the segments be based on the
internal structure and reporting of the Company's operations. The adoption of FAS 131 did not materially effect the Company's primary financial statements, but did affect the disclosure of segment information contained in Note 17 to the consolidated financial statement. The segment disclosures for prior years have been restated to conform to the current year presentation.
Strickland - On April 30, 1998 the Company completed the acquisition of the nonstandard personal automobile insurance business of North Carolina - based Strickland Insurance Group, Inc. ("Strickland"). The acquisition included two insurance companies, a premium finance company, a claims adjusting company and a general agency in Florida. In 1997, Strickland reported approximately $99 million of personal automobile gross premiums written and $46 million of net premiums written. The purchase price was $44.1 million in cash including acquisition expenses of $0.2 million. The Company made cash payments of $39.7 million in 1998 and $2.0 million in 1997 related to the Strickland acquisition with $2.4 million of the purchase price including interest retained by the Company in part to secure obligations of Strickland. Simultaneous with the acquisition, the Company repaid $9.4 million of Strickland bank debt. The acquisition includes a purchase price contingency for loss development incurred by the acquired business during the period from the acquisition date to December 31, 2000 relating to accident years prior to the acquisition date. The Company used cash and short-term investments to fund the acquisition. The acquisition was accounted for as a purchase and accordingly, the acquired business has been included in the Company's consolidated financial statements from the date of acquisition. The total consideration exceeded the fair value of the net assets acquired by approximately $28.7 million and is being amortized over 25 years. The pro forma consolidated results of the Company's operations, as if the Strickland purchase had been made as of the beginning of the year, would not be materially different than reported herein.
Guaranty National Corporation 1997 purchase - The Company completed a tender offer that increased its ownership of Guaranty National Corporation ("Guaranty National") from approximately 81% to 100% on December 10, 1997. The Company purchased the remaining or 2,970,000 shares of Guaranty National common stock in 1997 that were held by minority interest shareholders for $36 per share in cash ("1997 GNC Purchase"). Immediately following the 1997 GNC Purchase, Guaranty National was merged into a wholly owned subsidiary of the Company and delisted as a publicly traded company on the New York Stock Exchange. As part of the merger, 450,238 outstanding stock options granted by Guaranty National were converted into 358,090 stock options of the Company, with equivalent terms as the Guaranty National options except for the exercise price, which was adjusted to reflect the difference between the then current stock prices.
The 1997 GNC Purchase was recorded as a step acquisition using the purchase method of accounting. The aggregate purchase price was $116.1 million, including stock options converted of $8.4 million and acquisition expenses of $0.8 million. The Company recorded the excess of the cost over the estimated fair value of the 19.7% interest in Guaranty National's net assets acquired during 1997 of $59.5 million and eliminated the related minority interest. The excess of the cost over fair value will be amortized over 27 years, which is the remaining amortization period for goodwill recorded upon the Company's initial investment in Guaranty National.
Guaranty National Corporation 1996 purchase - On July 2, 1996, the Company completed a tender offer for 4,600,000 shares of Guaranty National common stock ("1996 GNC Purchase"). Together with the open-market purchase of 120,000 additional shares on July 17, 1996, the Company increased its ownership of Guaranty National from 49.5% to approximately 81%. The aggregate purchase price of approximately $88.2 million, including expenses, was paid in cash.
The 1996 GNC Purchase was recorded as a step acquisition using the purchase method of accounting as of June 30, 1996. The assets and liabilities of Guaranty National were consolidated in the Company's financial statements and minority interest for approximately 19% of Guaranty National's shareholders equity was recorded. Beginning in 1996, all revenues and expenses of Guaranty National have been consolidated with those of the Company, and minority interest expense has been recorded for the portion of Guaranty National's earnings that was attributable to the shares not owned by the Company until it became a wholly-owned subsidiary.
The increase in the Company's ownership in 1996 to over 80% of Guaranty National allowed the inclusion of Guaranty National in Orion's consolidated federal income tax return, as well as the reversal of a deferred tax liability previously established by the Company for its share of the undistributed earnings
ORION CAPITAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In millions, except for per share amounts) 1997 1996 - --------------------------------------------------------------------------
Total revenues $ 1,590.5 $ 1,491.2 =========== =========== Net earnings $ 116.9 $ 93.8 =========== =========== Net earnings per diluted share $ 4.16 $ 3.35 =========== ===========
In the third quarter of 1998, the Company announced an accelerated realignment of its Orion Specialty unit to address lines that had not met the Company's growth and profitability expectations. The realignment continued Orion Specialty's shift away from commodity business, primarily commercial auto and transportation, to a smaller number of more client-focused programs and specialty niches. The 1998 realignment has included the discontinuation of approximately $100 million in annualized net written premiums of unprofitable commodity and marginal lines of business, the reduction of approximately 90 employees related to the exited business, and the sale of Colorado Casualty. Colorado Casualty produced approximately $55 million in annual net premiums, which consisted largely of business that did not fit the Company's specialization strategy.
The Company recorded severance and program termination expenses of $7.0 million and asset write downs of $1.9 million related to the exited business in the third quarter of 1998. On September 29, 1998, the Company sold Colorado Casualty resulting in a pre-tax gain of approximately $24.2 million. Charges for severance and program termination expenses and asset write-offs, and the gain from the sale of Colorado Casualty, representing a net pre-tax gain of $15.3 million, are reflected as "Restructuring expenses and other" in the Company's Consolidated Statement of Earnings.
In connection with the third quarter realignment, the Company completed an actuarial analysis for the business to be exited resulting in a provision for losses and loss adjustment expenses of $27.8 million in the third quarter of 1998. The Company will continue in 1999 to assess Orion Specialty's remaining programs.
(In millions) 1998 1997 - ---------------------------------------------------------------------- At December 31: Cash and investments $ 109.6 $ 131.8 Other assets 55.6 54.0 ------- ------- 165.2 185.8 Policy liabilities (70.3) (72.7) Other liabilities (13.8) (29.2) ------- -------
Net investment income: Fixed maturities ............ $ 109.2 $ 115.8 $ 98.2 Equity securities ........... 19.4 18.4 19.9 Other long-term investments . 2.6 17.4 16.1 Short-term investments ...... 10.8 16.3 13.2 Accounts and notes receivable 0.7 0.5 0.3 Other ....................... 3.2 0.1 0.3 -------- -------- -------- Total investment income ..... 145.9 168.5 148.0 Less investment expenses .... 2.7 3.6 2.6 -------- -------- -------- Net investment income $ 143.2 $ 164.9 $ 145.4 ======== ======== ========
Certain information concerning realized and unrealized gains (losses) for fixed maturities and equity securities during the years ended December 31 is set forth below:
Fixed maturities available-for-sale: Gross realized gains ....................$ 31.1 $ 12.0 $ 10.3 Gross realized losses ................... (15.4) (7.4) (7.1) Provision for other than temporary Impairment ........................... (3.2) (2.0) (1.1) -------- -------- -------- $ 12.5 $ 2.6 $ 2.1 ======== ======== ========
Change in unrealized gains (losses) Recorded in stockholders' equity .....$ (30.0) $ 38.9 $ (11.1) ======== ======== ======== Equity securities: Gross realized gains ....................$ 80.9 $ 51.5 $ 29.0 Gross realized losses (a) ............... (39.8) (7.3) (6.6) Provision for other than temporary Impairment ........................... (1.1) (0.4) (0.3) -------- -------- -------- $ 40.0 $ 43.8 $ 22.1 ======== ======== ======== Change in unrealized gains (losses) Recorded in stockholders' equity .....$ (50.4) $ 18.4 $ 18.4 ======== ======== ========
Other long-term investments had aggregate carrying values of $116.2 million at December 31, 1998 and $94.3 million at December 31, 1997 including mortgage loans on real estate of $2.2 million and $2.3 million, respectively. Estimated market values of mortgage loans and other long-term investments approximate their carrying values. The carrying value of the Company's investments in principal-only securities and interest-only securities totaled approximately $1.5 million at December 31, 1998.
An analysis of the Company's calendar year net loss and loss adjustment expense reserves for the three years ended December 31, 1998 is summarized in the following table. The 1996 current year provision and payments include favorable loss development for Guaranty National of $1.0 million and payments of $144.8 million attributable to periods prior to the consolidation of Guaranty National's results in the Company's financial statements.
Loss reserve estimates are based on forecasts of the ultimate settlement of claims and are subject to uncertainty with respect to future events. Loss reserve amounts are based on management's informed estimates and judgments, using data currently available. Reserve amounts and the underlying actuarial factors and assumptions are regularly analyzed and adjusted to reflect new information. Such re-evaluation is a normal, recurring activity that is inherent in the process of loss reserve estimation and therefore, no assurances can be given that reserve development will not occur in the future. During the three years ended December 31, 1998 a substantial portion of the loss development experienced by the Company resulted from pools and associations, assumed reinsurance, and certain discontinued lines and program business (including $17.0 million in 1998 related to Orion Specialty realignment), partly reduced by favorable development in workers compensation.
An analysis of the Company's loss and loss adjustment expense environmental reserves and claim counts for the three years ended December 31, 1998 is presented below. Claim counts (excluding pools and associations) have been aggregated by year of coverage for each occurrence for which policyholders are being defended, and often include numerous claimants.
The Company's environmental claims principally relate to asbestos and hazardous waste, arising from certain liability business written prior to the mid 1980's, which business was never a major element of the Company's operations. Environmental claims are also received from certain pools and associations where reserves are established based on information reported to the Company by the managers of those pools and associations. In view of the lines of insurance that the Company has traditionally written, environmental claims have not represented, and are not expected to represent in the future, a material portion of the Company's total claims.
Establishing reserve liabilities for environmental claims is subject to significant uncertainties that make reserve estimation difficult. Legal decisions have tended to expand insurance coverage beyond the intent of the policies. The Company does not use discounting in determining its reserves for environmental claims. IBNR of $45.6 million and $51.0 million is included in net reserves for environmental claims at December 31, 1998 and 1997, respectively. The net reserve for environmental claims and IBNR increased in 1997 primarily due to higher claims reported to the Company by certain pools and associations, which is the basis of establishing such reserve, and higher loss reserve estimates.
Estimated Carrying Value Market Value ------------------ ------------------- (In millions) 1998 1997 1998 1997 - ----------------------------------------------------------- -------------------
The indentures for the 7.25% Senior Notes and the 9.125% Senior Notes limit the amount of liens and guarantees by the Company, and the Company's ability to incur secured indebtedness without equally and ratably securing the senior notes.
Company-Obligated Mandatorily Redeemable Preferred Capital Securities of Subsidiary Trusts Holding Solely the Junior Subordinated Debentures of the Company ("Trust Preferred Securities") at December 31 comprise the following:
Estimated Carrying Value Market Value ----------------- ---------------- (In millions) 1998 1997 1998 1997 - --------------------------------------------------------------------------- 8.73% Trust Preferred Securities due January 1, 2037 $ 125.0 $ 125.0 $ 119.0 $ 137.5 7.701% Trust Preferred Securities due April 15, 2028 125.0 - 112.0 - ------- ------- ------- ------- $ 250.0 $ 125.0 $ 231.0 $ 137.5 ======= ======= ======= =======
On January 13, 1997 Orion issued $125 million of 8.73% Junior Subordinated Deferrable Interest Debentures due January 1, 2037 (the "8.73% Debentures") to Orion Capital Trust I ("Trust I"), a Delaware statutory business trust sponsored by Orion. Trust I simultaneously sold $125 million of 8.73% capital securities (the "8.73% Trust Preferred Securities") which have substantially the same terms as the 8.73% Debentures. The net proceeds from the sale of the 8.73% Trust Preferred Securities were used in part for the acquisition of Guaranty National common stock in December 1997. The 8.73% Trust Preferred Securities may be redeemed without premium on or after January 1, 2007.
On February 2, 1998 Orion issued $125 million of 7.701% Junior Subordinated Deferrable Interest Debentures due April 15, 2028 (the "7.701% Debentures") to Orion Capital Trust II ("Trust II"), a Delaware statutory business trust sponsored by Orion. Trust II then sold $125 million of 7.701% capital securities (the "7.701% Trust Preferred Securities"), which have substantially the same terms as the 7.701% Debentures. Approximately $100 million of net proceeds from the sale of the 7.701% Trust Preferred Securities were used to repay bank indebtedness of Guaranty National in February 1998.
Orion and its wholly-owned subsidiaries file a consolidated federal income tax return, including Guaranty National from July 2, 1996. Substantially all federal income taxes incurred by Orion and its subsidiaries relate to domestic operations.
The components of the provision (benefit) for federal income taxes on income from operations and allocations of taxes (benefits) to other items for the years ended December 31 are as follows:
The tax effects of the temporary differences comprising the Company's net deferred tax asset at December 31 are as follows:
A reconciliation of expected federal income tax expense on pre-tax earnings at regular corporate rates to actual tax expense for the years ended December 31 is as follows:
During 1998, the Company's shareholders approved the Employees' Stock Purchase Plan to allow eligible employees of the Company and its subsidiaries to purchase, through payroll deductions, shares of the Company's common stock at 90 percent of the fair market value at specified dates. In May 1998, the Company reserved 300,000 shares of its common stock for issuance under the Employees' Stock Purchase Plan. The initial purchase period began on July 1, 1998 and ended December 31, 1998, resulting in 29,851 shares issued at an aggregate purchase price of $1.1 million. At December 31, 1998 approximately 24% of eligible employees participated in the plan and 270,149 shares are reserved for future issuance under the plan.
The Company maintains incentive plans for key employees, including the 1982 Long-Term Performance Incentive Plan and the Equity Incentive Plan (together the "Incentive Plans"). Orion has awarded both stock options and restricted stock to members of the Company's management under the Incentive Plans. All stock options are granted by Orion with exercise prices at fair market value at date of grant, and are intended to qualify to the maximum extent possible as incentive stock options. Stock options become exercisable from the first through fourth anniversaries of the date of grant, and expire ten years after the date of grant. Restricted stock is considered issued and outstanding when awarded. There are restrictions as to its transferability, which restrictions generally lapse in 25% increments over four or five year periods from the date of grant. For certain employees, the restrictions fully lapse after three years from the date of grant if the participant remains employed with the Company. As of December 31, 1998, the number of shares of stock reserved under the Incentive Plans is 1,693,152, of which 1,611,442 are for outstanding stock options and 81,710 are available for future awards under the Incentive Plans. Included in 1997 granted options of 696,600 were 358,090 of stock options relating to the 1997 acquisition of Guaranty National.
(Shares in thousands) December 31, 1998 - ------------------------------------------------------------------------------- Weighted Weighted Weighted Range of Average Average Average Exercise Options Exercise Remaining Options Exercise Prices Outstanding Price Years Exercisable Price
The Company applies Accounting Principles Board Opinion No. 25 and related interpretations in accounting for stock options granted under the Incentive Plans and the Employees' Stock Purchase Plan. Accordingly, no compensation cost has been recognized for activities related to these plans. Had compensation cost for these plans been recognized pursuant to FAS 123 "Accounting for Stock-Based Compensation," the Company's net earnings and earnings per diluted share on a proforma basis for the years ended December 31, 1998, 1997 and 1996 would have been approximately $100.8 million or $3.62 per diluted share, $114.9 million or $4.12 per diluted share, and $86.5 million or $3.11 per diluted share, respectively.
During 1998 and 1997 Orion granted 26,000 and 69,000 stock options, respectively, to directors at fair market value, which become exercisable one year from the date of grant and expire in ten years.
The total expense for 1998, 1997 and 1996 for the above savings, retirement and employee benefit plans, excluding amortization of deferred compensation on restricted stock, was $10.1 million, $10.9 million and $9.5 million, respectively.
During the fourth quarter of 1998, the Company adopted FAS 132 "Employers' Disclosures about Pensions and Other Postretirement Benefits," which modifies the Company's disclosure of such benefits.
McGee has a noncontributory defined benefit retirement plan covering all eligible employees. Unisun, which was acquired in December 1997, froze its defined benefit pension plan for all of its eligible employees.
The Company's benefit obligation, plan assets and recorded balances for the years ended December 31 are as follows:
(In millions) 1-Percentage Point Change - --------------------------------------------------------------------- 1998 1997 -------- -------- Effect on total of service and interest cost components $ 0.1 $ 0.3 Effect on postretirement benefit obligation $ 0.8 $ 0.6
(In millions) - ------------------------------------------ 1999 $ 22.6 2000 20.2 2001 15.7 2002 12.5 2003 10.0 2004 and thereafter 37.8 ----------- Minimum lease commitments $ 118.8 ===========
1997: Balance, beginning of year $ 72.3 $ (2.2) $ 70.1 Current year change 41.3 (2.2) 39.1 -------- -------- -------- Balance, end of year $ 113.6 $ (4.4) $ 109.2 ======== ======== ======== 1996: Balance, beginning of year $ 63.3 $ (4.0) $ 59.3 Current year change 9.0 1.8 10.8 -------- -------- -------- Balance, end of year $ 72.3 $ (2.2) $ 70.1 ======== ======== ========
Pre-tax unrealized investment holding gains (losses) arising during 1998 was $4.4 million. Pre-tax reclassification adjustment for gains included in net earnings was $84.7 million.
The Company reports its insurance operations in three segments at December 31, 1998. These reportable segments comprise operating units of the Company that have different insurance products and services, market focus and operational structure. The Company reportable segments comprise:
Workers Compensation - this segment provides workers compensation insurance products and services sold by the EBI Companies.
Nonstandard Automobile - specializes in nonstandard personal automobile insurance sold by OrionAuto.
(In millions) 1998 1997 1996 - ------------------------------------------------------------------------------- Net Premiums Written: Workers Compensation .................. $ 439.5 $ 365.1 $ 353.0 Specialty Commercial .................. 665.1 669.2 725.8 Nonstandard Automobile ................ 429.0 332.8 255.3 ---------- ---------- ---------- Consolidated ....................... $ 1,533.6 $ 1,367.1 $ 1,334.1 ========== ========== ==========
Quarterly results of operations and earnings per common share for 1998 and 1997 are summarized as follows:
Earnings per share are computed independently for the quarters presented. Therefore, the sum of the quarterly earnings per share may not equal the total computed for the year.
In June 1998, the Financial Accounting Standards Board issued FAS No. 133, Accounting for Derivative Instruments and Hedging Activities. This Standard requires companies to record all derivatives on the balance sheet as either assets or liabilities and measure those instruments at fair value. The manner in which companies are to record gains or losses resulting from changes in the values of those derivatives depends on the use of the derivative and whether it qualifies for hedge accounting. This Standard is effective for the Company's financial statements beginning January 1, 2000, with early adoption permitted. The Company is currently evaluating the impact of the adoption of this statement and the potential effect on its financial position or results of operations.