The principal executive offices of the Company are located in the Old Republic Building in Chicago, Illinois. This Company owned building contains 151,000 square feet of floor space of which approximately 50% is occupied by Old Republic, and the remainder is leased to others. In addition to the Company-owned principal executive offices, a subsidiary of the Title Insurance Group partially occupies its headquarters building. This building contains 110,000 square feet of floor space of which approximately 65% is occupied by the Old Republic National Title Insurance Company. The remainder of the building is leased to others. Eleven smaller buildings are owned by Old Republic and its subsidiaries in various parts of the country and are primarily used for its business. The carrying value of all buildings and related land at December 31, 1996 was approximately $13.1 million.
In November 1995, the Company reevaluated the classification of invested assets, as permitted by a Special Report issued by the Financial Accounting Standards Board (FASB) during that month. As a result, the Company reclassified from the "held to maturity" to the "available for sale" categories certain fixed maturity securities with an amortized cost of $1,365.7, fair value of $1,394.2 and an unrealized gain of $28.4. The unrealized gain, net of deferred income taxes of $9.9, was credited directly to a separate account in the common shareholders' equity section of the balance sheet in the final quarter of 1995.
Old Republic's financial position at December 31, 1996 reflected an increase in assets of 1.0%, a decrease in liabilities of 3.5%, and an increase in common shareholders' equity of 17.8%, when compared to the immediately preceding year-end. As indicated below, the largest changes in the liabilities and equity accounts were due to debt redemptions and conversions, respectively. Cash and invested assets represented 67.9% and 67.0% of consolidated assets as of December 31, 1996 and 1995, respectively. Relatively high short-term maturity investment positions continued to be maintained as of most recent year-ends to provide necessary liquidity for specific operating needs and to enhance flexibility in investment strategy. Changes in short-term investments reflect a large variety of seasonal and intermediate-term factors including seasonal operating cash needs, investment strategy, and expectations as to trends in interest yields. Accordingly, the future level of short-term investments will vary and respond to the dynamics of these factors and may, as a result, increase or decrease from current levels. During 1996 and 1995, the Corporation committed substantially all investable funds in short to intermediate-term fixed maturity securities, with an emphasis on tax-exempt bonds. Old Republic continues to adhere to its long-term policy of investing primarily in investment grade, marketable securities; the Corporation has not directed its investable funds to so-called "junk bonds" or derivative types of securities. During 1996, Old Republic's commitment to equity securities decreased by 8.0% vis-a-vis the related invested balance at year-end 1995. As of December 31, 1996, the carrying value of fixed maturity securities in default as to principal or interest was immaterial in relation to consolidated assets or shareholders' equity.
Old Republic's capitalization of $2,074.6 at December 31, 1996 consisted of debt and debt equivalents of $154.0, redeemable convertible preferred stock of $19.3 (excluding $8.8 of such stock classified as a debt equivalent), convertible preferred stock of $1.2, and common shareholders' equity of $1,900.0. The increase in the common shareholders' equity account during the past three years reflects primarily the retention of earnings in excess of dividends declared on outstanding preferred and common shares, the issuance of additional shares to effect the debt conversions noted below, and the conversion of preferred stock to common stock; this was offset to some degree in 1996 by a decline, compared to an increase in 1995, in the value of fixed maturity securities carried at market value.
Net investment income grew by 3.4%, 10.7% and 3.1% in 1996, 1995 and 1994, respectively. For each of the past three years, this revenue source was affected by positive consolidated operating cash flows and by a concentration of investable assets in interest-bearing, fixed maturity securities. In 1996, the Company, as previously mentioned, used internal funds to refund most of the above noted $105.0 of debt and $54.8 of preferred stock, thus reducing its invested asset base. The average annual yield on investments was 6.0%, 6.2% and 6.1% for the years ended December 31, 1996, 1995 and 1994, respectively. This yield pattern reflects at once the relatively short maturity of Old Republic's fixed maturity securities portfolio, changes in interest rates at various times during the past three years, and, during 1995 and 1996, the commitment of a larger percentage of investable funds to tax-exempt fixed maturity securities that typically bear lower yields.
Consolidated benefit, claim, and related settlement costs, as a percentage of net premiums and fees earned, were approximately 49.9% in 1996, 54.4% in 1995 and 53.5% in 1994. This consolidated ratio was affected principally by an improving claim ratio for liability insurance coverages due mostly to reduced losses from involuntary workers compensation pool assessments, as well as reduced claim frequencies and severity generally. Policyholders' dividends incurred mainly for the Corporation's workers compensation insurance coverages for each year reflect changes in the loss ratio for individual experience-rated policies. The loss ratio rose in each of the past three years in the mortgage guaranty insurance line due to a rise in frequency of claim occurrences, mostly in the California market which has been affected by an economic slowdown for the past several years. The title insurance loss ratio in each of the past three years was affected by favorable trends in claims frequency and severity for business underwritten since 1992.
The ratio of consolidated underwriting, acquisition, and insurance expenses to net premiums and fees earned was approximately 46.0% in 1996, 44.0% in 1995 and 47.0% in 1994. Variations in these ratios reflect a continually changing mix of coverages sold and attendant costs of producing business. During the past three years the property and liability expense ratio has remained relatively flat and that of the mortgage guaranty segment has been trending down. The title insurance expense ratio was lower in 1996 due in part to an increase in premium and fees volume, while it was higher in 1994 and 1995 as premiums and fees volume in this segment declined at a faster rate than operating costs could be reduced.
In 1996, interest and other charges declined principally as a result of the above noted reduction in outstanding debt.
Historical data pertaining to the operating results, liquidity, and other financial matters applicable to an insurance enterprise such as the Company are not necessarily indicative of results to be achieved in succeeding years. The long-term nature of the insurance business, seasonal and annual patterns in premium production and incidence of claims, changes in yields obtained on invested assets, changes in government policies and free markets affecting inflation rates and general economic conditions, and changes in legal precedents or the application of law affecting the settlement of disputed claims are some of the factors which have a bearing on quarter-to-quarter and year-to-year comparisons and future operating results.
Note 1-Summary of Significant Accounting Policies- The significant accounting policies employed by Old Republic International Corporation and its subsidiaries are set forth in the following summary.
(c) Investments-The Company may classify its invested assets in terms of those assets relative to which it either (1) has the positive intent and ability to hold until maturity (generally carried at amortized costs for fixed maturity securities), (2) has available for sale (carried at fair value with adjustments to equity, net of deferred income taxes) or (3) has the intention of trading (carried at fair value with adjustments to income); as of December 31, 1996, the Company's invested assets were classified solely as "held to maturity" or "available for sale."
In November 1995, the Company reevaluated the classification of invested assets, as permitted by a Special Report issued by the Financial Accounting Standards Board (FASB) during that month. As a result, the Company reclassified from "held to maturity" to "available for sale", certain fixed maturity securities with an amortized cost of $1,365.7, fair value of $1,394.2 and an unrealized gain of $28.4. The unrealized gain, net of deferred income taxes of $9.9, was credited directly to a separate account in the common shareholders' equity section of the balance sheet in the final quarter of 1995.
Fixed maturity securities and redeemable preferred stocks classified as "held to maturity" are generally carried at amortized costs while fixed maturity securities classified as "available for sale" in addition to other preferred and common stocks (equity securities) are included at fair value. Fair values for fixed maturity securities are based on quoted market prices or estimated using values obtained from independent pricing services as applicable. Mortgage and policy loans (other long-term investments) are carried on the basis of the lower of unpaid principal balances or estimated realizable value. The aggregate fair value of fixed maturity securities - "held to maturity" at December 31, 1996 was above their carrying values.
The amortized cost and estimated fair value at December 31, 1996, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
At December 31, 1996, the Corporation and its subsidiaries had no non-income producing investments.
General insurance (property and liability) and level-term credit life insurance premiums are reflected in income on a pro-rata basis. Earned but unbilled premiums are generally taken into income on the billing date, and adjustments for retrospective premiums, commissions and similar charges are accrued on the basis of periodic evaluations of current underwriting experience and contractual obligations. Title insurance premiums are recognized as income upon the substantial completion of the policy issuance process. Title abstract, escrow, service, and other fees are taken into income at the time of closing of the related escrow. First year and renewal mortgage guaranty premiums are recognized as income on a straight-line basis except that a portion of first year premiums received for certain high risk policies is deferred and reported as earned over the estimated policy life, including renewal periods. Single premiums for mortgage guaranty policies covering more
than one year are earned on an accelerated basis over the policy term. Ordinary life and annuity premiums are recognized as revenue when due. Decreasing term credit life and credit disability/accident & health insurance premiums are generally earned on a sum-of-the-years-digits or similar method.
At December 31, 1996 and 1995, the Life Insurance Group had $3,969.6 and $4,237.0, respectively, of net life insurance in force. Future policy benefits and unearned premiums, consisted of the following:
(g) Losses, Claims and Settlement Expenses-Reserves are estimates that provide for the ultimate expected cost of settling unpaid losses and claims reported at each balance sheet date. Losses and claims incurred but not reported, as well as expenses required to settle losses and claims are established on the basis of various criteria, including historical cost experience and anticipated costs of servicing reinsured and other risks. Long-term disability-type workers' compensation reserves, however, are discounted to present value based on interest rates ranging from 3.5% to 4%.
The establishment of claim reserves is a reasonably complex and dynamic process influenced by a large variety of factors. These include past experience applicable to the anticipated costs of various types of claims, continually evolving and changing legal theories emanating from the judicial system, actuarial studies, the professional experience and expertise of the Company's claim departments' personnel or attorneys and independent adjusters retained to handle individual claims, the effect of inflationary trends on future claim settlement costs, and periodic changes in claim frequency patterns such as those caused by natural disasters, illnesses, accidents, or work-related injuries. Consequently, the reserve-setting process relies on the judgments and opinions of a large number of persons, on historical precedent and trends, and on expectations as to future developments. At any point in time, the Company and the industry are exposed to possibly higher than anticipated claim costs due to the aforementioned factors, and to the evolution, interpretation, and expansion of tort law, as well as to the effects of unexpected jury verdicts.
The following table shows an analysis of changes in aggregate reserves for the Company's losses, claims and settlement expenses for each of the years shown.
The Corporation's reserving methods, particularly as they apply to formula-based reserves, have been established to provide for normal claim occurrences as well as unusual exposures such as those pertaining to A&E claims and related costs. At times, however, the Corporation's insurance subsidiaries also establish specific formula and other reserves as part of their overall claim and claim expense reserves to cover claims such as those emanating from A&E exposures. These are intended to cover additional litigation and other costs that are likely to be incurred to protect the Company's interests in litigated cases in particular. At December 31, 1996, the Corporation's aggregate indemnity and loss adjustment expense reserves specifically identified with A&E exposures amounted to approximately $92.3 million gross, and $64.2 million net of reinsurance. Based on average annual claims payments during the five most recent calendar years, such reserves represented 9.7 years (gross) and 11.9 years (net) of average annual claims payments.
Individual insurance companies and others who have evaluated the potential costs of litigating and settling A&E claims have noted with increasing concern the possibility that resolution of such claims, by applying liability retroactively in the context of the existing insurance system, could likely bankrupt or undermine seriously the financial condition of the property and liability insurance industry. In the light of this substantial public policy issue, the Corporation is of the view that the courts will not resolve in the near future the litigation gridlock stemming from the non-resolution to date of many environmental claims in particular. In recent times, the Executive Branch and/or the United States Congress have proposed changes in the legislation and rules affecting environmental claims. As of December 31, 1996, however, there is no solid evidence to suggest that forthcoming changes might mitigate or reduce some or all of these claim exposures.
Because of the above issues and uncertainties, estimation of reserves for losses and allocated loss adjustment expenses for the above noted types of claims is extremely difficult or impossible. Accordingly, no representation can be made that the Corporation's reserves for such claims and related costs will not prove to be overstated or understated in the future.
Life Insurance companies domiciled in the United States and qualifying as life insurers for tax purposes are taxed under special provisions of the Internal Revenue Code. As a result of legislation, 1983 and prior years' tax deferred earnings (cumulatively $20.4 at December 31, 1996) credited to the former memorandum "policyholders' surplus account" will generally not be taxed unless they are subsequently distributed to shareholders. The Company does not presently anticipate any distribution or payment of taxes on such earnings in the future.
(l) Employee Benefit Plans- The Corporation has several pension plans covering a portion of its work force. The plans are defined benefit plans pursuant to which pension payments are based primarily on years of service and employee compensation near retirement. It is the Corporation's policy to fund the plans' costs as they accrue. Plan assets are comprised principally of bonds, common stocks and short-term investments.
The components of annual net periodic pension cost (credit) for the plans consisted of the following:
The Company sponsors a leveraged Employee Savings and Stock Ownership Plan (ESSOP) in which a majority of its employees participate. The ESSOP acquired all of its stock of the Company in 1987 and prior years. Accordingly, it is not required to adopt the American Institute of Certified Public Accountants' SOP No. 93-6, "Employers' Accounting for Employee Stock Ownership Plans." Shares of Company stock owned by the ESSOP are released to participants based on a formula prescribed by the Employee Retirement Income Security Act of 1974, and dividends on released shares are allocated to participants as earnings. The Company's contributions are based on a formula considering growth in net income per share over consecutive five year periods. As of December 31, 1996, there were 32,575,883 Series "D" Redeemable Convertible Preferred Shares and 34,575 Common Shares owned by the ESSOP of which 5,731,675 Series "D" Redeemable Convertible Preferred Shares and 26,801 Common Shares were unreleased and unallocated. There are no repurchase obligations in existence. (See Note 3).
(m) Escrow Funds-Segregated cash deposit accounts and the offsetting liabilities for escrow deposits in connection with Title Insurance Group real estate transactions in the same amounts ($390.2 and $299.5 at December 31, 1996 and 1995, respectively) are not included as assets or liabilities in the accompanying consolidated balance sheets as the escrow funds are not available for regular operations.
Note 2-Investments - Bonds and other investments carried at $167.9 as of December 31, 1996 were on deposit with governmental authorities by the Corporation's insurance subsidiaries to comply with insurance laws.
(b) Cash Dividend Restrictions-The payment of cash dividends by the Corporation is principally dependent upon the amount of its insurance subsidiaries' statutory policyholders' surplus available for dividend distribution. The insurance subsidiaries' ability to pay cash dividends to the Corporation is in turn generally restricted by law or subject to approval of the insurance regulatory authorities of the states in which they are domiciled. These authorities recognize only statutory accounting practices for determining financial position, results of operations, and the ability of an insurer to pay dividends to its shareholders. Based on 1996 data, the maximum amount of dividends payable to the Corporation by its insurance and a small number of non-insurance company subsidiaries during 1997 without the prior approval of appropriate regulatory authorities is approximately $233.2. However, management does not expect to distribute all such dividends since reinvested earnings are the Corporation's major source of capital to promote its growth, and support its obligations to policyholders.
The Corporation's two existing plans (the 1985 and 1992 plans) are fixed option plans for its key employees and those of its eligible subsidiaries. All options granted under its 1979 plan were exercised, cancelled or forfeited as of December 31, 1994. All plans provide for the issuance of options for up to 5% of the Old Republic common stock issued and outstanding at any one time. The exercise price of each option equals the market price of the Corporation's stock on the date of grant. The term of each option is generally ten years from the date of grant. Under ordinary circumstances, options may be exercised to the extent of 10% of the number of shares covered thereby on and after the date of grant and cumulatively to the extent of an additional 10% on and after each of the first through ninth anniversaries of the date of grant. The Corporation may extend 15 year loans at a prevailing market rate of interest for a portion of the exercise price. Amendments to the plans also enable optionees to, alternatively, exercise their options into Series "G" or Series "G-2" Convertible Preferred Stock. The exercise of options into such Series "G" or Series "G-2" Convertible Preferred Stock reduces by 5% the number of equivalent common shares which would otherwise be obtained from the exercise of options into common shares.
(f) Undistributed Earnings-The equity of the Corporation in the undistributed earnings, determined in accordance with generally accepted accounting principles, and in the net unrealized investment gains (losses) of its respective subsidiaries at December 31, 1996 amounted to $1,253.2 and $44.6, respectively. Cash dividends declared during 1996, 1995 and 1994, to the Corporation by its subsidiaries amounted to $152.8, $106.8 and $55.4, respectively.
(g) Treasury Stock-A total of 8,310,540 common shares issued and outstanding are held by consolidated affiliates. See "Related Party Transactions" herein.
Reinsurance protection for General Insurance operations generally limits the net loss on any one risk to the following maximums (in thousands): fire and other physical perils-$300; accident and health-$100; workers' compensation-$1,000; other liability-$500; and loan credit guaranty-$200. A substantial portion of the mortgage guaranty insurance business is retained, with the exposure on any one risk currently averaging less than $24. Title insurance risk assumptions, based on the title insurance subsidiary's financial resources, are currently limited to $25,000 as to any one policy. The maximum amount of ordinary life insurance retained on any one life by the Life Insurance Group is $250.
The following information relates to reinsurance and related data for the General Insurance, Mortgage Guaranty and Life Insurance Groups for the three years ended December 31, 1996. For the years 1994 to 1996, reinsurance transactions of the Title Insurance Group have not been material.
(b) Leases-Some of the Corporation's subsidiaries maintain their offices in leased premises. Certain of these leases provide for the payment of real estate taxes, insurance, and other operating expenses. At December 31, 1996, aggregate minimum rental commitments (net of expected sub-lease receipts) under noncancellable operating leases of $106.3 are summarized as follows: 1997: $27.6; 1998: $20.8; 1999: $14.1; 2000: $8.8; 2001: $6.6; 2002 and after: $28.2.
Note 6-Consolidated Quarterly Results-Unaudited - Old Republic's consolidated quarterly operating data for the two years ended December 31, 1996 is presented below. In February 1996, the Company called for the redemption of its 10% debentures maturing in 2018 ($75.0 principal amount); in April 1996, the Company called for redemption of its 11.5% debentures maturing in 2015 ($30.0 principal amount); redemption of these debentures was effected with internally available funds. The early retirement of the Company's 10% debentures of 2018 produced a net of tax charge of $3.3 (4 cents per share) that has been reflected as an extraordinary item in the first quarter of 1996, while the retirement of the Company's 11.5% debentures of 2015 produced an additional net of tax charge of $1.1 (1 cent per share) that was reflected as an extraordinary item in the second quarter of 1996. Accordingly, the total extraordinary item reflected in the results for 1996 was $4.4 (5 cents per share).
In the fourth quarter of 1995, the Company's Mortgage Guaranty Group adopted the accrual method for recording past-due premium revenues and the related premium receivable arising from new monthly premium policies. This new payment mode has emerged as a significant factor for the mortgage guaranty industry beginning in mid-1994. Before adoption of this accrual method, such past-due premiums were recognized on receipt of cash. With the adoption of this accrual method, a cumulative increase in net premiums written of $9.8, net premiums earned of $6.3, and post-tax income of $3.9 or 4 cents per fully diluted share was reflected in the Company's final quarter and the year of 1995.
Note 8-Related Party Transactions - At December 31, 1996 and 1995, the Corporation owned 98.85% of the non-voting common shares, and 40% of the voting common and preferred shares of the American Business & Mercantile Insurance Group, Inc., ("AB&M Group" or "Group"), an affiliated insurance holding company engaged in the property and liability reinsurance business. As of the same dates, the American Business & Personal Insurance Mutual, Inc. ("Mutual"), a property & liability mutual insurer owned by its policyholders, held directly or through a subsidiary .04% of the non-voting common shares and 60% of the Group's voting common and preferred shares. At both dates, 1.11% of the Group's non-voting common shares were held by public shareholders.
In the normal course of business, the Company cedes, on the same terms as apply to unrelated reinsurers, certain parts of its outgoing reinsurance to a foreign reinsurer in which it has an equity interest. Total premiums ceded to this reinsurer amounted to approximately $4.3 in 1996, $6.0 in 1995 and $6.1 in 1994. As of December 31, 1996 and 1995, total premium and loss reserve credits taken on account of cumulative cessions aggregated $64.1 and $65.6, respectively, all of which credits were collateralized by cash, investments and funds held amounting to $70.1 and $73.2, respectively.