Management believes that the properties of the Company are adequate for conducting its business.
The Company's total assets grew by 13% to $1,157,922,000 in 1997. A majority of the increase was in the portfolio of fixed income securities. The Company's investment strategy has been to invest primarily in long-term, high-quality securities. Held-to-maturity investments comprise 82% of the total fixed income portfolio, as compared to 91% at December 31, 1996. During 1997, the Company purchased and classified more securities as available-for-sale in an effort to expand its portfolio management strategy and to increase total returns. The Company expects this trend to continue in 1998. The Company did not classify any securities as trading in 1997 or 1996. Net unrealized gains of $1,913,000 were recorded in 1997 on the available-for-sale fixed income securities, compared to net unrealized losses of $1,415,000 in 1996.
Property and equipment grew by 14% to $14,443,000 during 1997 due primarily to purchases, net of disposals, of $1,362,000 in new electronic data processing equipment.
Most of the cash that the Company receives is generated from insurance premiums paid by policyholders. The premiums are invested in assets maturing at regular intervals in order to meet the Company's obligations to pay policy benefits, claims and claim adjusting expenses. Net cash provided by the Company's operating activities was $43,211,000 in 1997, compared to $43,921,000 in 1996. Operating cash flows continue to be ample to meet policyholders obligations.
The Company is not aware of any significant contingent liabilities as far as environmental issues are concerned. Because of the type of property coverage the Company writes, there exists the potential for exposure to environmental pollution and asbestos claims. The Company's underwriters are aware of these exposures and use limited riders or endorsements to limit exposure.
Deferred income taxes grew 120% to $27,868,000. A deferred tax liability of $37,549,000 on unrealized appreciation was a major contributor to the growth in this liability.
The property and casualty segment had a statutory combined ratio (net losses incurred and net loss adjustment expenses incurred to net premiums earned, plus expenses incurred to premiums written) of 98% for the year ended 1997, compared to 104% for 1996.
The Company has experienced very moderate premium growth, as has most of the property and casualty industry. Premiums written increased 2% between 1997 and 1996. Overall industry growth is projected to be around 3%.
On the loss side, the Company's automobile lines of business improved considerably in 1997, with a loss ratio (net losses incurred to net premiums earned) of 66.7%, compared to 83.7% in 1996. Another significant line of business for the Company is other liability with a loss ratio of 29.1% in 1997, compared to 33.4% in 1996. The reinsurance line also showed substantial improvement decreasing to 59.9% in 1997 from 73.2% in 1996.
Results in the workers' compensation line deteriorated in 1997, when compared to 1996. Net premiums earned decreased $1,883,000 or 8% and the loss ratio rose to 69.4% from 50.2% in 1996. An increase in claims severity in 1997, as well as continuing rate reductions due to competition have contributed to these results.
The property and casualty segment's underwriting and acquisition expenses increased 2% to $74,992,000. The 2% growth in premium writings have produced corresponding moderate increases in expenses such as commissions and other policy related expenses.
Losses incurred showed an increase of $4,190,000 over 1996 primarily due to an increase in claim activity during the fourth quarter. An increase in retention from $100,000 to $200,000 per insured effective January 1, 1995, contributed to the increase in losses. In addition, claims activity has grown due to a significant increase in the credit life and credit accident and health blocks of business. The amount of insurance in force in these lines increased by $37,201,000 or 25% over 1996.
RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1996, COMPARED TO YEAR ENDED DECEMBER 31, 1995 PROPERTY AND CASUALTY OPERATIONS
Loss and settlement expenses incurred by the property and casualty segment for 1996 increased 32% or $37,589,000 over 1995. While 1996 and 1995 produced an unusually large number of hurricanes, the Company did not have much exposure related to these storms. Several other factors did contribute to underwriting results. The Company's consistent and long-term growth inevitably led to a higher number of claims. During the first quarter of 1996, frigid weather causing frozen water pipes resulted in substantial water damage. Several large fire losses also occurred during the first few months of the year. Wind and hail storms occurring during the summer months in the midwestern states led to an increase in loss activity. In addition, a small number of large commercial auto liability losses were incurred throughout the year.
The decrease of $2,204,000 in premiums earned was attributable to a decrease in collected traditional life premiums of $2,854,000. One product, single premium whole life, saw a decrease of $3,591,000.
Other underwriting and operating expenses decreased $1,979,000 due to a larger deferral of expenses associated with acquisition of new business. An increase in premiums collected of $10,305,000 in the single premium deferred annuity block along with additional acquisition expenses is responsible for 50% of this decrease. The balance of the decrease was due to a combination of slight increases in premiums collected and refinement in the way deferrable acquisition expenses are determined and allocated.
The insurance industry is governed by the National Association of Insurance Commissioners ("NAIC"), as well as individual state insurance departments. These governing agencies are working on a project to codify insurance statutory accounting practices. Currently, these practices are prescribed in a variety of publications, as well as state laws, regulations, and general administrative rules. The project, originally expected to be completed by January 1, 1998, has been extended to 1999. It is expected that the new rules would have financial effects on the insurance industry's statutory results, including those of the Company. Due to the incomplete and complex proposed changes, it is impossible to estimate the impact at this time. The changes would not affect the accompanying financial statements, which are based on generally accepted accounting principles.
The insurance industry is data intensive and utilizes computer technology extensively. An important issue facing all computer users is the approaching Year 2000. Many computer systems and applications have been designed with two-digit date fields. With the turn of the century, these programs may recognize the Year 2000 as 1900 or not at all. If left unresolved, this could cause systems to process critical financial and operational information incorrectly. The Company is aware of this issue and is finalizing its systems for compliance for the Year 2000. Beginning in 1984, programming to accommodate four-digit date fields was initiated. Testing is currently being conducted on all systems and will be completed in 1998. Expenses incurred in connection with the conversions and testing have been expensed as incurred and absorbed into normal operating expenses. The remaining costs for Year 2000 compliance are not expected to be material to operations.
Management expects premium growth to be modest to flat during 1998. The Company will continue to explore new geographic areas, in addition to our current development of Arkansas, Mississippi and New Mexico, for expansion.
A new management team was created with the appointment of John A. Rife, a 21-year veteran with the Company, as President. He maintains his position as President of United Life Insurance Company, a position he has held for 13 years. Kevin Kubik joined the Company, filling the newly created position of Vice President and Chief Investment Officer.
The good news is that last year your Company's net income increased 31% to $28,732,000 or $2.68 per share, just $71,000 shy of a record. In 1995, its best year ever, it earned $28,803,000 or $2.66 per share (that year there was an average of 102,000 more shares outstanding than in 1997). Stockholders' equity increased $49,349,000 or 22% to $277,208,000 or $ 25.84 per share. The return on equity was 11%.
Your Company's combined ratio, a measure of the underwriting profitability of its property and casualty business, improved by six points to 98%. Over the past five years it has averaged 100%. Fortunately during the year we experienced no major catastrophes.
Last May, John Rife, who has been the President of United Life Insurance Company for the past 13 years, was also named President of United Fire & Casualty Company. As I was sure it would be, his appointment has been well received by the staff. I am confident he will continue the people-oriented policies which I believe have been one of the foundations for your Company's success. Actually, John had been my point person since my hospitalization earlier in the year.
Under John's leadership, United Life has grown to a company with over $596,000,000 in assets and the book value of your Company's $24,473,000 investment has grown to over $97,000,000. In recent years it has consistently been one of the best performers among its peers, i.e., small to medium-sized life insurers affiliated with property and casualty companies. Not bad for a company that is in a category that A.M. Best and other pundits say is doomed to failure.
One of my favorite pastimes is looking at insurance companies that might be acquisition candidates. Several years ago we were interested in a small Iowa life insurance company that was for sale. Their products were compatible with ours, we used the same actuary and even the names were similar. We thought it would make a good fit with our United Life but could never make a deal. In the course of our discussions we discovered one of their hidden assets was the assistant in their accounting department. Later Sam Hague joined us to head up our Life Accounting Department. When John assumed responsibility for our entire operations, Sam was promoted to Executive Vice President of United Life responsible for all our life operations. In a position usually filled by "high-pressure sales types" he's doing an excellent job. One reason we never stop looking is you never know when you're going to find a gem.
Like USF&G, your Company is often referred to in the trade by its initials, UF&C and the similarity has sometimes caused confusion. When we were small and unknown we took it as a compliment, later as USF&G lost its way and got into trouble it became an embarrassment. Therefore, we were pleased when the St. Paul announced they would spend $2.8 billion to solve our problem of mistaken identity.
On May 20th, your Board of Directors voted to increase the dividend seven percent to $.64 per share. This too is becoming a boring story, but one of which, hopefully, you won't tire either.
The Consolidated Financial Statements have been prepared on the basis of generally accepted accounting principles ("GAAP") which differ in some respects from those followed in reports to insurance regulatory authorities.
The accompanying Consolidated Financial Statements include United Fire & Casualty Company and its wholly owned subsidiaries, United Life Insurance Company, Lafayette Insurance Company, Insurance Brokers & Managers, Inc., Addison Insurance Company, Addison Insurance Agency and Crabtree Premium Finance Company. All material intercompany items have been eliminated in consolidation.
The Company expects to realize a spread of approximately 1.5% to 2.0% between interest earned and interest credited on its Universal Life Plans and deferred annuities, for which the liability is equal to total policy account values plus deferred front-end loads.
The Company has a defined benefit pension plan covering substantially all employees. Under the plan, retirement benefits are primarily a function of the number of years of service and the level of compensation. It is the Company's policy to fund the plan on a current basis to the extent deductible under existing tax regulations.
In February, 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 129, "Disclosure of Information about Capital Structure." SFAS No. 129, adopted by the Company effective December 31, 1997, contains disclosure requirements including liquidation preferences of preferred stock, rights and privileges of the outstanding equity securities and the redemption amounts for all issues of capital stocks that are redeemable. SFAS No. 129 does not have a material effect on the Company's Consolidated Financial Statements.
The Company adopted SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of", effective January 1, 1996. SFAS No. 121 requires the separation of long-lived assets and certain identifiable intangibles into two categories for purposes of accounting for an impairment of assets: those to be held and used and those to be disposed of. The Company has intangibles to be held and used from the purchase of Addison Insurance Company and the assumption of a book of business in 1990. SFAS No. 121 requires that intangibles to be held and used should be reviewed whenever events or changes in circumstances indicate that the carrying value may not be recoverable. The Company has determined that its intangible assets are not impaired and has not written down their value.
In June, 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income" governing the reporting and display of comprehensive income and its components which includes items previously recorded directly in equity, such as unrealized gains or losses on securities available-for-sale and SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" requiring that public businesses report financial and descriptive information about its reportable operating segments. SFAS No. 130 is effective for interim periods beginning after December 15, 1997 and SFAS No. 131 is effective for annual periods beginning after December 15, 1997 for the initial year of adoption and interim periods thereafter. The impact of adopting SFAS No. 130 and SFAS No. 131 will require additional disclosure in the Consolidated Financial Statements and is not expected to have a material effect on the Company's Consolidated Financial Statements or Notes to Consolidated Financial Statements.
In February, 1998, the FASB issued SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits", effective for fiscal years beginning after December 15, 1997. The new statement standardizes the disclosure requirements for these benefit plans and the impact is not expected to have a material effect on the Company's Consolidated Financial Statements or Notes to Consolidated Financial Statements.
Approximately 22% of the fixed income portfolio is invested in collateralized mortgage obligations ("CMOs"), compared to 26% at December 31, 1996. The Company did not add to its mortgage-backed securities/CMO holdings during the last half of 1997. Returns were not as attractive as those found in other investment alternatives. The Company minimized its prepayment risk by buying most issues priced at a slight discount. While buying at a discount does not prevent prepayment, the yield is not penalized as is the case when a premium is paid. In addition, although the stated maturity is longer than the average life of the issues, the Company concentrated on buying issues with an expected maturity in the seven-to-twelve-year range.
A reconciliation of the amortized cost to fair values of investments in held-to-maturity and available-for-sale fixed maturities, equity securities and other long-term investments as of December 31, 1997 and 1996 is as follows.
Proceeds from sales of available-for-sale investments during 1997, 1996 and 1995 were $27,390,000, $35,251,000, and $1,344,000, respectively. Gross gains of $3,242,000, $3,499,000, and $790,000, respectively, were realized on those sales. Gross losses of $15,000, $342,000 and zero, respectively, were realized on those sales in 1997, 1996 and 1995.
The net investment income for the years ended December 31, 1997, 1996 and 1995 is composed of the following.
For accrued investment income, carrying value is a reasonable estimate of fair value, due to its short-term nature.
A summary of the carrying value and estimated fair value of assets and liabilities meeting the definition of financial instruments at December 31, 1997 and 1996 is as follows.
The Company maintains a six-million dollar line of credit with a local bank. Under the terms of the agreement, interest on outstanding notes would be payable at the lender's then prevailing prime rate. During 1997, the Company borrowed $1,000,000 at 8.5% against the line of credit for 4 days. No funds were borrowed during 1996.
The property and casualty insurance companies also assume portions of their insurance business from other insurance companies. Assumed premiums earned for the years ended December 31, 1997, 1996 and 1995 were $40,198,000, $38,545,000 and $33,014,000, respectively.
In 1997, all lines of business contributed to the $33,544,000 decrease in estimated losses and LAE for claims occurring in prior years. In 1996 as well, the Company experienced favorable loss development. The lines of business contributing to this $29,129,000 redundancy included commercial multiple peril, other liability, personal auto liability and workers' compensation lines.
Statutory stockholders' surplus and net income at December 31, 1997, 1996 and 1995 and for the years then ended are as follows.
In addition, the insurance departments governing the Company and its subsidiaries have imposed risk-based capital ("RBC") requirements. The regulation is based on a model adopted by the NAIC. An RBC formula establishes capital requirements for insurance companies based on an individual company's major areas of risk, including assets, credit, underwriting and off-balance sheet risk. The results are used by the NAIC and state insurance departments to identify companies that merit regulatory attention or the initiation of regulatory action. At December 31, 1997 and 1996, the life and property and casualty segments had adjusted capital well in excess of the required capital levels.
A reconciliation of income tax expense computed at the applicable Federal tax rate of 35% in 1997, 1996 and 1995 to the amount recorded in the Consolidated Financial Statements is as follows.
The significant components of the net deferred tax liability at December 31, 1997 and 1996 are as follows.
Effective November 1, 1996, the pension plan was amended and the changes resulted in an increase to the Company's pension liability. The normal retirement benefit was changed from 1.25% of average monthly compensation times years of benefit service to 1.25% of average monthly compensation plus .5% of average monthly compensation in excess of the covered compensation limit all multiplied by years of benefit service. Years of benefit service was changed from a cap of 32 years to 35 years. Early retirement eligibility was change from age 59 1/2 to age 55 with five years of service. Early retirement benefits were previously reduced actuarially for all retirees. Now, early retirement benefits have a subsidized reduction if the employee retires with 20 years of service.
The Company also has an Employee Stock Ownership Plan for the benefit of eligible employees and their beneficiaries. All employees are eligible to participate in the plan upon completion of one year of service and attaining age twenty-one. Contributions to this plan are made at the discretion of the Board of Directors. These contributions are based upon a percentage of total payroll and are allocated to participants on the basis of compensation. Contributions are made in cash which is used by the Trustee to acquire shares of the Company stock to allocate to participants' accounts. As of December 31, 1997, 1996 and 1995, the Trustee owned 93,127, 92,806 and 86,712 shares of Company stock, respectively. The Company did not make a contribution to the plan in 1997. In 1996 and 1995, the Company made a contribution to the plan of $142,000 and zero, respectively.
The following table reconciles the accrued postretirement benefit obligation and amounts recognized in the Consolidated Financial Statements.
The unrecognized prior service cost and actuarial loss are being amortized on a straight-line basis over an average period of eight years. This period represents the average remaining employee service period until the date of full eligibility.
Depreciation expense and property and equipment acquisitions for the years ended December 31, 1997, 1996 and 1995, are reflected in the property and casualty insurance segment.
The Company declared a three for two stock split in the form of a 50% stock dividend to stockholders of record as of December 18, 1995. Cash dividends per common share of $.63 and $.60 were declared in 1997 and 1996, respectively. Earnings per common share, weighted average common shares outstanding and cash dividends declared per common share have been retroactively restated for all periods presented.
Certain amounts included in this schedule for earlier years have been reclassified to conform with the 1997 financial statement presentation.