On February 21, 1997 OGGI purchased a 21,500 square foot facility situated on 8 acres of land adjacent to OGGI's headquarters. The purchase price was $1.1 million. The parcel of land allowed for the expansion of an additional 59,000 square foot facility. This expansion was begun in late 1997 and was completed in the fall of 1998. As of December 31, 1999, OGGI has approximately 27,800 square feet available for rent to tenants of which approximately 14,500 square feet is leased or under commitment to be leased.
Southern owns 5,716 square feet of land and a two-story office building containing 3,842 square feet occupied by the Charlottesville, Virginia branch office. Southern leases additional space in six other locations for its branch and home office operations. All of these leases are classified as operating leases and have terms that expire in the next seven years.
Ceded premiums written decreased $9.8 million, or 72.0%, to $3.7 million in 1999 compared to $13.5 million in 1998. The decrease in ceded written premiums was attributable to changes in the reinsurance program as of January 1, 1999 including reductions in rates. Changes in the reinsurance program included elimination of the first layers of the property and casualty excess of loss reinsurance agreements which covered losses in excess of $150,000 up to $500,000. This layer of reinsurance required premium payments equal to losses incurred plus a load subject to a maximum and minimum premium. OGGI's experience had generally been such that the actual premium paid was within the minimum and maximum. As a result, OGGI's effective retention was already at $500,000. OGGI also eliminated its 95% quota share reinsurance agreement on the first $1 million of umbrella liability coverage and included this risk in its casualty excess of loss reinsurance agreement. In addition, during the third quarter of 1999, OGGI commuted its aggregate excess of loss reinsurance agreement. This commutation resulted in the return of $579,000 of premium previously ceded under this agreement during 1999.
Net premiums written increased $34.3 million, or 40.8%, in 1999 to $118.2 million from $83.9 million in 1998. For the same comparative periods, net premiums earned increased $35.7 million, or 47.4%, to $111.0 million from $75.3 million. The increase in net premiums written and earned were directly attributable to the effects of the changes instituted in OGGI's reinsurance program and increases in gross premiums written as previously discussed.
NET INVESTMENT INCOME. Net investment income remained relatively constant in 1999 from 1998 while average cash and invested assets increased $8.9 million, or 7.4%. The increase in average invested assets is primarily attributable to investments acquired in the acquisition of Southern effective January 1, 1999. For 1999, the yield on average cash and invested assets was 4.8% compared to 5.2% for 1998.
NET REALIZED INVESTMENT GAINS. Net realized investment gains were $1,350,000 for 1999 compared to $1,290,000 in 1998, an increase of $60,000 or 4.7%.
OTHER REVENUE. Other revenue increased $2.2 million, or 100%, in 1999 to $4.4 million from $2.2 million in 1998. Other revenue from Southern, primarily search, title exam, copy charges and escrow fees, accounted for an increase of $3.6 million. Offsetting the other revenue from Southern was a decrease in OGIM's management fee income from New Castle of $1.3 million. In 1998, management fee income from New Castle was included in consolidation until its conversion on October 1, 1998.
OGGI's reinsurance program enumerated previously, growth, and increases in the loss and loss adjustment expense ratio for property and casualty operations. The loss and loss adjustment expense ratio for P&C operations was 70.8% versus 64.2% for the comparable periods in 1998. This increase is attributable to several large fire losses on commercial properties, a deterioration in results for personal automobile, and the aforementioned changes in reinsurance. The loss and loss adjustment expense ratio for title operations was 4.7%.
FEDERAL INCOME TAX BENEFIT. Federal income tax benefit as a percentage of pretax income or loss was 44.4% in 1999 compared to (37.3%) in 1998. The higher than expected effective tax rate in 1999 is attributable to income from minority interest earned by Southern which is not taxed. The unusual relationship of income tax benefit versus pretax income in 1998 is attributable to the low level of pretax income versus the magnitude of tax preference items (primarily tax exempt income and dividends received deduction) which do not vary with pretax income. In 1998, tax preference items were large enough to offset pretax income.
PREMIUMS. Gross premiums written increased $9.5 million, or 10.8%, in 1998 compared to 1997. The increase in gross premiums written can be attributed primarily to the affiliation with New Castle which contributed $8.0 million of homeowners and personal auto premiums. Specifically, $1.4 million of the increase from New Castle is attributable to direct premiums written in the fourth quarter (subsequent to OGGI's acquisition of New Castle) with the remaining increase of $6.6 million attributable to the assumption, through reinsurance, of 100% of New Castle's business during the first nine months of 1998. The remaining increase can be attributed to increases in direct premiums written for personal and commercial automobile, farmowners business and workers' compensation offset by a decrease in fire, allied line, and inland marine business.
NET REALIZED INVESTMENT GAINS. Net realized investment gains were $1.3 million for 1998 compared to $2.3 million in 1997, a decrease of $1.0 million or 44.6%. The decrease in realized gains were a result of the market volatility in the fourth quarter of 1998 which increased the spread between bid and ask prices making the sale of bonds and convertible securities unattractive and a loss of $817,000 related to the acquisition of New Castle. The loss resulted from writing down the carrying value of OGGI's surplus note investment in New Castle, forgiveness of interest on the note and costs related to the transaction.
OTHER REVENUE. Other revenue increased $1.7 million, or 419.8%, in 1998 to $2.1 million from $414,000 in 1997. This increase is attributable to increased management fees from Neffsville and New Castle.
LOSSES AND LOSS ADJUSTMENT EXPENSES. Net losses and loss adjustment expenses incurred increased by $9.9 million, or 25.7%, to $48.4 million in 1998 from $38.5 million in 1997. Losses and loss adjustment expenses increased in 1998 as compared to 1997 because of the $3.4 million of claims from tornadoes and severe thunderstorms during the first week of June 1998 compared to the absence of severe storms in 1997, more losses being retained by OGGI as a result of the termination of the quota share reinsurance agreement, and the $2.3 million favorable loss development in 1998 compared to 1997's favorable development of $4.3 million.
FEDERAL INCOME TAX EXPENSE (BENEFIT). Federal income tax expense (benefit) as a percentage of pre-tax income or loss was (37.3%) in 1998 compared to 36.6% in 1997. The unusual relationship of income tax benefit versus pretax income in 1998 is attributable to the low level of pretax income versus the magnitude of tax preference items (primarily tax exempt income and dividends received deduction) which do not vary with pretax income. In 1998, tax preference items were large enough to offset pretax income.
Net cash provided by operating activities was $11.9 million, $5.1 million and $4.1 million during 1999, 1998, and 1997, respectively. The increase in cash flow from operating activities in 1999 can be attributed to the increase in net premiums written.
In 1999, cash provided by financing activities was $3.3 million primarily as a result of OGGI obtaining a $6.0 million loan to help it finance its acquisition of Southern. The $6.0 million loan has a term of five years and an interest rate of LIBOR plus 1.5%. OGGI has entered into an interest rate swap agreement to fix the interest rate on the loan at 7.05%. During 1999, OGGI also borrowed $3.7 million, at LIBOR plus 1.5%, to fund the purchase of treasury stock. In 1998, cash used by financing activities was $2.4 million resulting from OGGI's purchase of treasury stock offset by mortgage financing obtained on OGGI's newly constructed office building. The $3.5 million mortgage requires principal payments over fifteen years and interest floating monthly at LIBOR plus 1.5%. OGGI converted $2.0 million of the mortgage to a fixed rate of 7.7% through the use of an interest rate swap. The $34.0 million provided by financing activities in 1997 was a direct result of OGGI's conversion.
OGGI's Employee Stock Ownership Plan (ESOP) borrowed $4.1 million from an unaffiliated lender and $100,000 from OGGI to purchase 10% of the common stock issued in OGGI's subscription offering. The loans bear an 8.45% interest rate, and will require the ESOP to make monthly payments of $50,417 for a term of 10 years. The loan is secured by the shares of common stock purchased and the earnings thereon. Shares purchased with such loan proceeds will be held in a suspense account for allocation among participants as the loan is repaid. OGGI expects to contribute sufficient funds to the ESOP to repay such loan, plus such other amounts as OGGI's Board of Directors may determine at its discretion.
In June 1998, SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," was issued. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as "derivatives") and for hedging activities. SFAS No. 133 requires that an entity recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (i) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (ii) a hedge of the exposure of variable cash flows of a forecasted transaction, or (iii) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction. The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation. In June 1999, SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB Statement No. 133," was issued which defers the effective date of SFAS No. 133 to fiscal years beginning after June 15, 2000. While OGGI is presently evaluating the impact of SFAS No. 133, the adoption of SFAS No. 133 is not expected to have a material impact on OGGI's financial condition, results of operations or liquidity.
Although there have been no apparent Year 2000 problems related to internal systems and third parties, OGGI may have underwriting exposure related to the Year 2000 Issue. Businesses materially damaged as a result of the Year 2000 Issue may attempt to recoup their losses by claiming coverage under various types of insurance policies underwritten by OGGI and by ceding companies to whom OGGI provides reinsurance. OGGI has attempted, whenever possible, to avoid or otherwise limit its potential Year 2000 exposure through it underwriting process. In the event that claims for Year 2000 Issues are asserted against OGGI, it is not possible to predict whether or not coverage could ultimately be found to exist by courts in various jurisdictions, or, if found, the effect thereof on OGGI. In addition, even if such coverage were found not to exist, which cannot be predicted, the costs of litigation could be material. In the absence of any claims experience at this time, such losses and costs are not currently reasonably estimable. As of March 22, 2000, OGGI has not received notice of any material claims from insureds based on the Year 2000 Issue.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income and comprehensive income, shareholders' equity and of cash flows present fairly, in all material respects, the financial position of Old Guard Group, Inc. and Subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
OLD GUARD GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 1999 AND 1998
OLD GUARD GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
Effective January 1, 1999, OGGI acquired Southern and its principal operating subsidiary, Southern Title Insurance Corporation. Pursuant to the stock purchase agreement, OGGI paid $6,750,000 in cash for 100% of Southern's capital stock. In addition, OGGI will make additional payments equal to 25% of Southern's pretax profits in 1999, 2000, and 2001. Such additional contingent payments will increase the carrying value of the title plant which had previously been written down in connection with the purchase. The additional payment due under this agreement for 1999 is $167,683. Effective October 1, 1998, New Castle Mutual Insurance Company converted from mutual to stock form and changed its name to New Castle Insurance Company of Delaware (New Castle). New Castle's conversion was pursuant to a plan of conversion approved by the Delaware Insurance Department and New Castle's policyholders. Along with the conversion, OGGI's $2.5 million surplus note investment in New Castle was converted to 1,500 shares of common stock and OGGI became the sole shareholder of New Castle. Accordingly, New Castle's results of operations, beginning October 1, 1998, are consolidated with those of OGGI in the financial statements presented herein. Pro forma results for 1998, including Southern and New Castle as if both companies had been fully owned for the entire year are as follows:
This pro forma financial information is not necessarily indicative of the actual results that would have occurred had the purchases been made on January 1, 1998 or of the results which may occur in the future.
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (CONTINUED) LOSSES AND LOSS ADJUSTMENT EXPENSES
Stock-based compensation plans are accounted for under the provisions of Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. As such, compensation expense is normally recorded on the date of a stock option grant only if the current market price of the underlying stock exceeded the exercise price. Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation," permits entities to recognize as expense, over the vesting period, the fair value of all stock-based awards on the date of grant. Alternately, SFAS No. 123 allows entities to apply the provision of APB Opinion No. 25 and provide pro forma net income and earnings per share disclosures for employee stock option grants as if the fair value method defined in SFAS No. 123 had been applied. OGGI has elected to apply the provisions of APB Opinion No. 25 and provide pro forma disclosures under SFAS No. 123.
Deferred income taxes are accounted for using the liability method wherein deferred tax assets or liabilities are calculated on the differences between the bases of assets and liabilities for financial statement purposes versus tax purposes (temporary differences) using enacted tax rates in effect for the year in which the differences are expected to reverse. Tax expense in the consolidated statements of income is equal to the sum of taxes currently payable, including the effect of the alternative minimum tax, if any, plus an amount necessary to adjust deferred tax assets and liabilities to an amount equal to period-end temporary differences at prevailing tax rates. OGGI and its subsidiaries file a consolidated federal income tax return.
In the normal course of business, OGGI's insurance subsidiaries reinsure a portion of their exposure and pay to reinsurers a portion of premiums received on all policies reinsured. Insurance is ceded primarily to reduce net liability on individual risks, to mitigate the effect of individual loss occurrences (including catastrophe losses), to stabilize underwriting results and to increase underwriting capacity.
OGGI's insurance subsidiaries are subject to assessments in the states in which each company is licensed. Assessments consist primarily of charges from the residual markets and guaranty fund associations. Expense for guaranty fund assessments is recognized when an insolvency has taken place, the amount of the related assessment is reasonably estimable and the event obligating OGGI to pay (the writing of premiums) has taken place.
Financial instruments which potentially expose OGGI to concentrations of credit risk consist primarily of cash and short-term investments, premiums in course of collection, investments and balances recoverable from reinsurers. Insureds primarily consist of individuals and commercial and agricultural businesses. No one insured accounted for a significant amount of premiums earned or premiums receivable in 1999, 1998 or 1997.
OGGI performs credit reviews of its reinsurers, focusing on financial stability and commitment to the reinsurance business. At December 31, 1999, OGGI's insurance subsidiaries had reinsurance balances of approximately $7,118,000, net of applicable ceded reinsurance payable, due from American Re. American Re's A.M. Best rating is A++.
In 1998, the NAIC adopted the Codification of Statutory Accounting Principles guidance, which will replace the current Accounting Practices and Procedures manual as the NAIC's primary guidance on statutory accounting. The NAIC is now considering amendments to the Codification guidance that would also be effective upon implementation. The Codification provides guidance for areas where statutory accounting has been silent and changes current statutory accounting in some areas, e.g. deferred income taxes are recorded. The Pennsylvania Insurance Department has adopted the Codification guidance to be effective January 1, 2001.
2. STATUTORY INFORMATION: (CONTINUED) Risk based capital is designed to measure the acceptable amount of capital an insurer should have based on the inherent risks of the insurer's business. Insurers failing to meet adequate capital levels may be subject to insurance department scrutiny and ultimately rehabilitation or liquidation. Based on established standards, OGGI's insurance subsidiaries maintain surplus in excess of prescribed risk based capital requirements.
Net investment income, net realized investment gains and change in unrealized investment gains on investment securities are as follows for each of the three years ended December 31:
The gross realized investment gains and losses on investment securities in 1999, 1998 and 1997, are as follows:
Insurance laws require that certain amounts be deposited with various state insurance departments for the benefit and protection of policyholders. The amortized cost of fixed income securities on deposit with governmental authorities was $1,428,658 and $924,399 at December 31, 1999 and 1998, respectively.
4. LOSSES AND LOSS ADJUSTMENT EXPENSES: (CONTINUED) informed estimates and judgments using data currently available. As additional experience and data become available regarding claim payments and reporting patterns, legislative developments, and economic conditions, the estimates are revised accordingly and the impact is reflected currently in the consolidated financial statements.
OGGI's insurance subsidiaries maintain reinsurance agreements which provide coverage for individual property and liability claims, as well as, catastrophic events. These reinsurance programs mitigate loss exposure from individually large losses and an aggregation of losses arising from a single loss event. OGGI is contingently liable for reinsured claims if the assuming reinsurers cannot meet their obligations under the reinsurance agreements.
The following amounts represent OGGI's reinsurance activity with unrelated insurers in 1999, 1998 and 1997:
During 1997 Old Guard, Old Guard Fire and First Patriot maintained a 15% quota share reinsurance agreement with their primary reinsurer, American Re-Insurance Company. The agreement provided for a 30% ceding commission on net business written. Effective January 1, 1998, the agreement was cancelled on a run-off basis. This agreement was intended to provide protection from high frequency and low severity type losses. The following summarizes activity under this treaty in 1999, 1998 and 1997:
Reinsurance recoverable on paid and unpaid losses under this agreement was $1,190,780 and $3,055,973 at December 31, 1999 and 1998, respectively.
The net deferred tax asset has not been reduced by a valuation allowance because management believes that, while it is not assured, it is more likely than not that it will generate sufficient future taxable income to utilize these net excess tax deductions. The amount of the deferred tax asset considered realizable, however, could be materially reduced in the near term if estimates of future taxable income in the years in which the differences are expected to reverse are decreased.
8. INCOME TAXES: (CONTINUED) Actual income tax expense (benefit) differed from expected income tax expense (benefit), computed by applying the federal corporate tax rate of 34% to income (loss) before income tax and minority interest, for each of the three years ended December 31 as follows:
OGGI has a net operating loss carryforward at December 31, 1999 of approximately $3,318,000. These net operating loss carryforwards expire $50,000 in 2006, $266,000 in 2008, $780,000 in 2009, $377,000 in 2010, $479,000 in 2013 and $1,366,000 in 2014.
As of December 31, 1999, OGGI had alternative minimum tax credit carryforwards of approximately $569,000 available to offset future regular income tax.
The Stock Compensation Plan was adopted by the Board of Directors of OGGI on December 20, 1996 and approved by shareholders at the first Annual Meeting on August 19, 1997. The purpose of the plan is to provide additional incentive to directors and employees by facilitating their purchase of stock of OGGI. Awards under the plan may be made in the form of options, stock appreciation rights or grants of restricted stock. Awards totaling up to 420,491 shares may be made under the Stock Compensation Plan. The Compensation Committee of the Board of Directors of OGGI may, at their discretion, select employees to whom awards will be granted, the number of shares to be subject to such awards, the terms and conditions of such awards and other restrictions they deem appropriate. No awards of stock appreciation rights or restricted stock have been made as of December 31, 1999.
9. EMPLOYEE BENEFIT PLANS (CONTINUED) OGGI applies the APB Opinion No. 25 expense recognition criteria of SFAS No. 123 and related interpretations in accounting for its stock compensation plan. Accordingly, no compensation cost has been recognized, except for the one-time charge of $2,016,931 described latter herein, in the accompanying financial statements for the difference between the fair value of stock-based compensation plans and the intrinsic value. Had compensation cost for stock-based compensation plans been determined using fair value, OGGI's net income and earnings per share would have been as follows:
Dividends on shares held by the ESOP are paid to the ESOP trust. Dividends on the unallocated ESOP shares together with OGGI's contributions, are used by the ESOP to repay principal and interest on the outstanding debt. Shares are released for allocation to participants as the debt is retired. Interest incurred on the ESOP debt amounted to $284,753, $309,671 and $282,079 in 1999, 1998 and 1997, respectively. OGGI paid dividends on the stock held by the ESOP of $40,317, $40,518 and $20,275 in 1999, 1998 and 1997, respectively.
OGGI also maintains a voluntary defined contribution savings plan covering substantially all full-time employees of its property and casualty subsidiaries. OGGI matches these employees' contributions 100% up to 3% of compensation. Contributions to this plan amounted to $218,676, $216,237 and $168,064 in 1999, 1998 and 1997, respectively.
In the event a property and casualty insurer becomes or is declared insolvent, state insurance regulations provide for the assessment of other insurers operating in that jurisdiction to fund any capital deficiency of the insolvent insurer. Generally, this assessment is based upon the ratio of an insurer's voluntary written premiums to total written premiums for all insurers in that particular state. OGGI charges these assessments to expense when the following criteria have been met:
c) the event obligating OGGI to pay has taken place (usually the writing of premiums).
Neffsville Mutual Fire Insurance Company (Neffsville) is affiliated with OGGI through common management and reinsurance programs.
The following table indicates OGGI's total revenues and pre-tax income by principle business segment:
On February 10, 1997, OGGI, Old Guard, Old Guard Fire, First Patriot (the Insurance Companies) and each of their respective directors were served with an eleven count combination class action and derivative lawsuit, filed in the United States District Court for the Eastern District of Pennsylvania by four policyholders. The lawsuit arises from the conversion of the Insurance Companies from mutual to stock companies pursuant to the Pennsylvania Mutual to Stock Conversion Act (the "Act"). By filing the class action portion of the lawsuit, these four policyholders purport to represent all policyholders of the Insurance Companies at the time of conversion.
OGGI, the Insurance Companies, and the individual defendants filed a motion to dismiss the complaint in May 1997. In December 1997, the Court granted the motion with respect to two of the constitutional counts and denied the motion with respect to the remaining nine counts, including five of the constitutional claims.
OGGI, the Insurance Companies, and the individual defendants filed a motion for summary judgment with respect to the remaining federal constitutional claims on July 13, 1998. On March 5, 1999, the Court granted the motion with respect to the two remaining counts under the U.S. Constitution and retained supplemental jurisdiction over the remaining state law claims. Those claims essentially allege that the proxy statement sent to policyholders omitted material facts and was inadequate and misleading. It is also asserted that the director-defendants violated their fiduciary obligations by wasting corporate assets and through self-dealing. OGGI and the directors have denied these claims.
- OGGI could be required to pay or distribute to all or some policyholders of the Insurance Companies, either on a mandatory basis or at the election of the policyholders, an amount equal to the statutory surplus of the Insurance Companies as of the date of the subscription offering as damages or otherwise. Such distribution could be required to be made in cash, common stock or other debt or equity securities. No assurance can be given that OGGI would have sufficient funds, or the capacity to borrow sufficient funds, at that time to honor any such obligation. Any required
In the event that obligations under any remedy imposed by the court could not be honored, Old Guard Group, Inc. could be forced to seek the protection of the bankruptcy laws and the Insurance Companies could be deemed insolvent and seized by the Department.
OGGI and its subsidiaries are also parties to other litigation in the normal course of business. Based upon information presently available to them, OGGI does not consider any threatened or pending litigation to be material, except as described above. However, given the uncertainties attendant to litigation, there can be no assurance that OGGI's results of operations and financial condition will not be materially adversely affected by any threatened or pending litigation.
To The Board of Directors and Shareholders Of Old Guard Group, Inc.
SCHEDULE IIB. CONDENSED FINANCIAL INFORMATION OF REGISTRANT--STATEMENTS OF INCOME (PARENT COMPANY)
SCHEDULE IIC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT--STATEMENTS OF CASH FLOW (PARENT COMPANY)