The Company also owns six other buildings in suburbs adjoining the corporate office complex, two buildings in Tampa, Florida, a building in Tempe, Arizona and a building in Tigard, Oregon. In total, these buildings contained approximately 782,900 square feet of office, warehouse and training facility space and are owned by subsidiaries of the Company. These locations are occupied by the Company's business units or other operations.
In December 1997, the Company purchased approximately 72 acres in Tampa, Florida to construct a three-building regional call center. It is estimated that, when completed, this facility will consist of approximately 307,000 square feet of space. The cost of the project is currently estimated at $42.0 million and $8.3 million has been paid as of December 31, 1997. The project is scheduled to be completed by the end of 1998. In addition, in November 1997, the Company purchased 91 acres in Mayfield Village, Ohio to construct an office complex, near the site of its current corporate headquarters. This office complex is part of a five-year cooperative effort with Mayfield Village to develop over 300 acres -- Progressive would serve as the anchor corporate user with additional business users and recreational facilities on the site. The Company plans to construct three buildings containing a total of approximately 485,000 square feet in 1998 and could build up to three additional buildings, containing about 500,000 additional square feet in total, in the future. The first phase of this project is estimated to cost $63.5 million. As of December 31, 1997, $5.3 million has been paid. The construction projects will be funded through operating cash flows or the issuance of new debt securities.
FINANCIAL CONDITION The Progressive Corporation is a holding company and does not have any revenue producing operations of its own. It receives cash through borrowings, equity sales, subsidiary dividends and other transactions, and may use the proceeds to contribute to the capital of its insurance subsidiaries in order to support premium growth, to repurchase its Common Shares and other outstanding securities, to retire its outstanding indebtedness, and for other business purposes. During 1997, the Company repurchased 30,193 of its Common Shares at a total cost of $2.9 million in connection with obligations under various employee benefit plans.
In March 1997, the Company acquired Midland Financial Group, Inc. by purchasing all of Midland's outstanding stock for about $50 million in cash. Midland underwrites and markets nonstandard private passenger automobile insurance through approximately 3,700 independent agents across 11 states, primarily in the southern and western United States. During 1997, Midland wrote $66.1 million of net premiums written.
In July 1995, the Company began converting its computer systems to be year 2000 compliant (e.g. to recognize the difference between '99 and '00 as one year instead of negative 99 years). The Company has evaluated internal production systems, hardware and software products, facilities implications, and interactions with business partners in relation to year 2000 issues. As of December 31, 1997, the Company has completed approximately 70% of its efforts to bring the production systems in compliance, with substantially all production systems expected to be compliant by the end of 1998. The total cost to modify these existing production systems, which include both internal and external costs of programming, coding and testing, is estimated to be $6.4 million, of which $3.1 million has been expensed as of December 31,
1997. The Company is also in the process of replacing some of its systems during 1998 with new systems which, in addition to being year 2000 compliant, will add increased functionality to the Company. The total cost of these systems, which include both internal and external costs, is estimated to be $4.8 million, and the projects are expected to be substantially complete by the end of 1998. As of December 31, 1997, $2.4 million has been expensed for these systems. All costs are being funded through operating cash flow. The Company continually evaluates computer hardware and software upgrades and, therefore, many of the costs to replace existing items with year 2000 compliant upgrades are not likely to be incremental costs to the Company. It is estimated that the majority of these upgrades will be completed in 1998. During 1998, the Company will continue to contact its business partners (e.g. agents, banks, credit bureaus, motor vehicle departments, rating agencies, etc.) to determine their status of compliance and to assess the impact of noncompliance to the Company. The Company believes that it is taking the necessary measures to mitigate issues that may arise relating to the year 2000. During 1998, the Company will develop contingency plans relating to year 2000 compliance issues, either internal or external, that cannot be guaranteed to be timely completed. To the extent any additional issues arise, the Company will evaluate the impact on its financial condition, cash flows and results of operations and, if material, make the necessary disclosures.
The majority of the portfolio is invested in high-grade, fixed-maturity securities, of which short- and intermediate-term securities represented $4,024.9 million, or 76.4%, at the end of 1997, compared to $3,275.6 million, or 73.6%, at the end of 1996. Long-term investment-grade securities, including greater than 10-year expected principal paydowns, were $143.4 million, or 2.7%, at the end of 1997, compared to $187.5 million, or 4.2%, at the end of 1996. Non-investment- grade fixed-maturity securities were $132.5 million, or 2.5%, at the end of 1997, compared $105.8 million, or 2.4%, at the end of 1996, and offer the Company higher returns and added diversification without a significant adverse effect on the stability and quality of the investment portfolio as a whole. Non-investment-grade securities may involve greater risks often related to creditworthiness, solvency and relative liquidity of the secondary trading market. The duration of the fixed-income portfolio was 3.3 years at December 31, 1997, compared to 3.2 years at December 31, 1996.
hedged securities. Derivative instruments may also be used for trading purposes. During 1997, net activity in the trading portfolio was not material to the Company's financial position, cash flows and results of operations. Net cash requirements of derivative instruments are limited to changes in market values which may vary based upon changes in interest rates and other factors. Exposure to credit risk is limited to the carrying value; collateral is not required to support the credit risk. The Company has stringent restrictions on the amount of open positions in the trading portfolios, limiting exposure to levels management deems acceptable. At December 31, 1997, trading positions had a net market value of $1.1 million; at December 31, 1996, there were no trading positions.
RESULTS OF OPERATIONS Operating income, which excludes net realized gains and losses from security sales and one-time items, was $336.0 million, or $4.46 per share, in 1997, $309.1 million, or $4.12 per share, in 1996 and $220.1 million, or $2.85 per share, in 1995. The GAAP combined ratio was 93.4 in 1997, 91.5 in 1996 and 94.3 in 1995.
Claim costs, the Company's most significant expense, represent actual payments made and changes in estimated future payments to be made to or on behalf of its policyholders, including expenses required to settle claims and losses. These costs include a loss estimate for future assignments and assessments, based on current business, under state-mandated involuntary automobile programs. Claims costs are influenced by inflation and loss severity and frequency, the impact of which is mitigated by adequate pricing. Increases in the rate of inflation increase loss payments, which are made after premiums are established. Accordingly, anticipated rates of inflation are taken into account when the Company establishes premium rates and loss reserves. Claim costs, expressed as a percentage of premiums earned, were 71% in 1997, compared to 70% in 1996 and 71% in 1995.
2000 exclusions in all new and renewal policies for commercial banks (representing approximately 70% of all policies written since that date) which have multi-year terms that extend beyond December 31, 1999. The Company is not currently aware of any other company in the industry that is including such exclusion provisions or increasing their premiums to cover potential exposure on year 2000 compliance issues. As a regulated industry, financial institutions are under pressure from government regulatory agencies and other interested parties to ensure they achieve readiness for the year 2000. The Company is monitoring its customers' compliance efforts and believes that substantially all such customers are pursuing plans to achieve year 2000 compliance. It is currently unknown whether the financial institutions will be able to completely avoid errors relating to year 2000 compliance and the Company is unable to predict to what extent such financial institutions will incur losses as a result of noncompliance and whether their directors and officers will be subject to individual liability for such noncompliance. At December 31, 1997, approximately 200 professional liability policies, or about 17% of all policies, do not contain year 2000 exclusion provisions and extend into the year 2000. In the event of a claim, applicable factual and coverage issues would have to be resolved. Based on information currently available and management's best estimate, the Company does not believe that it will incur any costs that will have a material impact on the Company's financial condition, cash flows or results of operations.
Recurring investment income (interest and dividends) increased 22% to $274.9 million in 1997, compared to $225.8 million in 1996 and $199.1 million in 1995, primarily due to an increase in the size of the investment portfolio. Net realized gains on security sales were $98.5 million in 1997, $7.1 million in 1996 and $46.7 million in 1995. Investment expenses were $9.9 million in 1997, compared to $6.1 million in 1996 and $8.1 million in 1995; in 1997, the Company purchased a new portfolio management system and incurred expenses related to the sale of the commercial mortgage-backed securities.
The following note is hereby added to Item 8 of the Company's 1997 Annual Report on Form 10-K, supplementing the Notes to the Consolidated Financial Statements which are incorporated by reference therein: