The majority of the real property occupied by the Company and its subsidiaries are owned or leased by ALLIED Mutual. A portion of the costs of the properties is paid by the Company. See "Relationship with ALLIED Mutual--Intercompany Operating Agreement." Management considers the properties to be adequate for its needs. The primary properties owned by ALLIED Mutual are the home office in Des Moines, Iowa, a data processing facility and claims center in Urbandale, Iowa, and regional offices in Denver, Colorado and Lincoln, Nebraska. The Company and its subsidiaries lease office space in Des Moines and Cedar Rapids, Iowa, Minneapolis, Minnesota, Lincoln, Nebraska, and Scottsdale, Arizona.
The Private Securities Litigation Reform Act of 1995 provides a safe harbor to encourage companies to provide prospective information so long as it is identified as forward-looking and accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those discussed. Forward-looking statements are related to the plans and objectives of management for the future operations, economic performance, or projections of revenues, income, earnings per share, capital expenditures, dividends, capital structure, or other financial items. In the following discussion and elsewhere in this report, statements containing words such as expect, anticipate, believe, goal, objective, or similar words are intended to identify forward-looking statements. ALLIED Group, Inc. (the Company) undertakes no obligation to update such forward-looking statements, and it wishes to identify important factors that could cause actual results to differ materially from those projected in the forward-looking statements contained in the following discussion and elsewhere in this report. The risks and uncertainties that may affect the operations, performance, development, and results of the Company's business include but are not limited to the following: (1) heightened competition, particularly intensified price competition; (2) adverse state and federal legislation and regulations; (3) changes in interest rates causing a reduction of investment income; (4) general economic and business conditions which are less favorable than expected; (5) unanticipated changes in industry trends; (6) adequacy of loss reserves; (7) catastrophic events or the occurrence of a significant number of storms and wind and hail losses; and (8) other risks detailed herein and from time to time in the Company's other reports.
Income before income taxes increased 28.9% to $91.9 million from $71.3 million for 1996. The improvement was due primarily to revenue growth and only a slight increase in losses for the year ended December 31, 1997. Wind and hail losses decreased 28.7% to $27.9 million from $39.1 million in 1996.
Net income for the year ended December 31, 1997 was up 28.1% to $65.4 million, raising diluted earnings per share to $2.01 from $1.51 in 1996. Diluted earnings per share excluding net realized investment gains were $2.00 for 1997 compared with $1.51. On a diluted basis, the impact of wind and hail losses was $0.59 per share versus $0.82 in 1996.
Book value per share at December 31, 1997 increased to $13.44 from $11.59 at year-end 1996. Higher dividend payments and the stock repurchase program had a dilutive effect on book value during 1997 that was ameliorated by larger unrealized gains in the investment portfolio. The fair value of investments in fixed maturities was $26.3 million above amortized cost compared with $17.1 million above amortized cost at December 31, 1996. If investments in fixed maturities were reported at amortized cost, book value per share at December 31, 1997 would have been $12.88 compared with $11.23 at December 31, 1996.
Investment income for 1997 was $44.3 million compared with $42.3 million for 1996. The pretax yield on invested assets was 6%, down from 6.3% one year earlier. Investment income increased due to a larger average balance of invested assets in 1997, which more than offset the decrease experienced in the pretax yield. Realized investment gains for 1997 were $96,000 compared with $180,000.
Other income increased to $10.7 million from $7 million in 1996. The 1997 amount included a $4.2 million performance fee paid by ALLIED Mutual to AMCO as pool administrator. See note 4 of the Notes to Consolidated Financial Statements for a discussion of the reinsurance pooling agreement.
Income before income taxes increased 37.8% to $81.9 million from $59.4 million in 1996. The improvement was due to revenues that increased faster than losses, which increased only slightly because of lower wind and hail loss experience in 1997. Since 1996 wind and hail experience was the worst on record, the 1997 improvement was anticipated.
Earned premiums for 1997 increased to $33.3 million from $27.3 million for 1996. Net written premiums were up 19.8% to $34.1 million from $28.4 million. The segment's major product lines all experienced increases in net written premiums due to intensified marketing efforts and the addition of 19 new agencies (a 27.1% increase) over the last 24 months. The segment's 1997 book of business was comprised of 3.1% personal and 96.9% commercial lines; the 1996 business mix was 2.8% personal and 97.2% commercial lines.
The segment's invested assets rose 8.7% from the previous year-end to $113.5 million at December 31, 1997. Investment income increased 9% to $6.8 million from $6.2 million because a larger average balance of invested assets more than offset a 20 basis-point decline in the pretax yield to 6.2% from the previous year's 6.4%. Realized investment losses were $4,000 compared with gains of $2,000 for the year ended December 31, 1996.
Revenues for the noninsurance operations (including mortgage banking, data processing, and employee leasing to affiliates) after eliminations increased 17.2% to $55.2 million from $47.1 million in 1996. The increase was primarily due to a 35.4% increased in data processing revenues to $23 million from $17 million. In 1997, outside sales increased $1.8 million and license fees to nonaffiliates were up $ 4.3 million . On a consolidated basis, revenues from nonaffiliates for the noninsurance operations are reported as other income. Income before income taxes was $29,000 for the year ended December 31, 1997 compared with $3.8 million in 1996. The increase in operating costs, primarily in the data processing operations and the holding company, more than offset the increase in revenues for the noninsurance operations.
The investment policy for the Company's insurance segments requires that the fixed maturity portfolio be invested primarily in debt obligations rated investment grade (BBB) or higher by Standard & Poor's Corporation or a recognized equivalent at the time of acquisition. The policy also states that equity securities are to be of United States and Canadian corporations listed on established exchanges or publicly traded in the over-the-counter market. Preferred stocks are to be comprised primarily of issues rated at least A3/A- by Standard & Poor's Corporation or Moody's. At December 31, 1997, the Company's investment portfolios consisted almost exclusively of fixed income securities and equity securities 90.1% and 8.7%, respectively. The ratings on 99.7% of the fixed income securities were investment grade or higher at December 31, 1997. The portfolios contained no real estate or mortgage loans at December 31, 1997.
Consolidated invested assets were up 10.8% to $908.2 million from $819.6 million at year-end 1996. Fixed maturities at amortized cost increased 2.2%. Consolidated investment income increased 3.9% to $51.1 million from $49.2 million in 1996. The increase was due primarily to a larger average balance of invested assets. The tax-equivalent yield was down in 1997 to 7.0% compared with 7.2% one year earlier due to lower short- and intermediate-term interest rates on investments. The aftertax yield for 1997 and 1996 was 4.6% and 4.7%, respectively.
Net income for the year ended December 31, 1996 was down 2.5% to $51.1 million, lowering diluted earnings per share to $1.51 from $1.54 in 1995. Diluted earnings per share excluding net realized investment gains were $1.51 for 1996 compared with $1.53. On a diluted basis, the impact of wind and hail losses was $0.82 per share versus $0.60 in 1995.
Revenues for the property-casualty segment increased to $515.7 million from $472 million for 1995. Direct earned premiums for the segment were $497.1 million for 1996 compared with $435.2 million for 1995. Earned premiums in 1996 increased 9.5% to $466.2 million from $425.8 million. The increase resulted primarily from growth in insurance exposure as well as a larger average premium per policy.
Pooled net written premiums (including ALLIED Mutual's) totaled $767.2 million, a 10.8% increase over 1995 production. The average premium per policy for personal lines was up 4.6% to $613 while the policy count grew 8.7%. The average premium per policy for commercial lines increased 2.2% to $1,110, and policy count was up 4.3%. Earned premiums for the property-casualty segment were 66.8% personal lines and 33.2% commercial lines in 1996. The business mix for 1995 was 65.7% personal and 34.3% commercial lines.
Income before income taxes decreased 7% to $59.4 million for 1996 from $63.9 million for 1995. The decrease was due primarily to higher losses and loss adjusting expenses brought on by higher wind and hail losses in the second and third quarters.
The statutory combined ratio (after policyholder dividends) deteriorated to 97.7 from the 95.7 reported in 1995, primarily due to a 2.6-point increase in the loss and loss adjusting expense ratio. Higher wind and hail losses accounted for 2.2 points of the deterioration. The deterioration was partially offset by a 0.5-point reduction in the Company's underwriting expense ratio achieved through improved efficiency and productivity. Wind and hail losses increased to $39.1 million from $28.7 million in 1995. The impact of wind and hail losses on the statutory combined ratio was 8.4 points for 1996 and 6.7 points for 1995. The 1996 GAAP underwriting gain was $9.9 million compared with $17.7 million for 1995.
The segment's invested assets rose 8.3% from the previous year-end to $104.4 million at December 31, 1996. Investment income increased 7% to $6.2 million from $5.8 million because a larger average balance of invested assets more than offset a decline in the pretax yield of 30 basis points to 6.4% from the prior year's 6.7%. Realized investment gains were $2,000 compared with losses of $136,000 for 1995.
Revenues for the noninsurance operations increased 3.8% to $47.1 million from $45.4 million in 1995. The increase was primarily due to higher data processing revenues. Income before income taxes was $3.8 million for 1996 compared with $5.1 million for 1995. Effective March 1, 1996, personnel of the Company previously providing computer-related services to a certain affiliate were employed by the affiliate. Since the effective date, those employees have been paid directly by the affiliate.
Consolidated invested assets were up 6.1% to $819.6 million from $772.3 million at year-end 1995. Fixed maturities at amortized cost increased 6.7%. Consolidated investment income increased 4.2% to $49.2 million from $47.2 million in 1995. The increase was due primarily to a larger average balance of invested assets. The tax-equivalent yield was down in 1996 to 7.2% from 7.6% in 1995. The aftertax yield for 1996 and 1995 was 4.7% and 4.9%, respectively.
In 1997, 1996, and 1995, the Company paid dividends of $17.5 million, $16.3 million, and $13.5 million, respectively. Dividend payments to common stockholders totaled $14 million for the year ended December 31, 1997, up from $12.2 million and $6.3 million in 1996 and 1995, respectively. In each year, dividends of $3.5 million on the 6-3/4% Series Preferred Stock was paid. In 1996 and 1995, dividends paid on the ESOP Series Preferred Stock (ESOP Series) were $595,000 and $3.7 million, respectively. The increase in dividends to common shareholders and the decrease in dividends on the ESOP Series were due to the conversion of the ESOP Series completed on March 7, 1996. See note 10 of the Notes to Consolidated Financial Statements for a further discussion of the conversion. Prior to the conversion, the Company and the ESOP Trustee entered into an agreement whereby the Company agreed to release additional shares held by the ESOP Trustee if the dividend paid on common stock is less than $0.09 per share per quarter on a post-split basis. The agreement is in effect from March 7, 1996 through March 7, 2000. The agreement ensures that the allocated shares in the ESOP Trust receive at least the same amount of dividends that would have been paid on the ESOP Series shares had they not been converted to common stock.
The Iowa state insurance regulations restrict the maximum amount of dividends the property-casualty subsidiaries can pay without prior regulatory approval. The maximum dividend allowed is the greater of either 10% of the subsidiary's statutory capital stock and surplus as of the preceding December 31 or net income of the preceding calendar year. In 1998 the maximum amount legally available for distribution to the Company without prior approval is $54.5 million. The excess & surplus lines subsidiary is domiciled in Arizona and operates under Arizona state laws. The maximum amount available for distribution as dividends from the excess & surplus lines subsidiary is limited to the lesser of 10% of stockholders' surplus as of the preceding December 31 or net investment income of the preceding year. The excess & surplus lines segment could pay $4 million in 1998 without prior notice to the insurance commissioner. The Company anticipates the excess & surplus lines segment will not pay dividends in 1998.
Management anticipates that short-term and long-term capital expenditures, cash dividends, and operating cash needs will be met from existing capital and internally generated funds. As of December 31, 1997, the Company had no material commitments for capital expenditures. Future debt and stock issuance will be considered as additional capital needs arise. The method of funding will depend upon financial market conditions.
Insurance premiums are established before the amount of losses and loss adjusting expenses or the extent to which inflation may affect such expenses is known. Consequently, the Company attempts to anticipate the impact of inflation in establishing premiums. Inflation is implicitly considered in the determination of reserves for losses and loss adjusting expenses since portions of the reserves are expected to be paid over extended periods of time. The importance of continually reviewing reserves is even more pronounced in periods of extreme inflation.
At its March 3, 1998 meeting, the Board approved a first-quarter 1998 common stock dividend of $0.13 per share. The dividend is $0.01 per share (8.3%) higher than the amount paid in the fourth quarter of 1997.
The Company's data processing segment has a line of property-casualty and life insurance software products which it markets to affiliated and nonaffiliated insurance companies. Management believes the segment's products are year 2000 compliant while operating in the Company's environment and will continue to retest the products throughout 1998. The segment's customers have been advised to test the software products in their operating environment for year 2000 compliance. Management believes any exposure to material liability was remote as of December 31, 1997.
California has been the source of approximately 25% of the pool's direct written premiums for the past ten years. Proposition 103, approved by California voters in 1988, provides for a rollback of rates on premiums collected in calendar year 1989 to the extent that the insurer's return on equity for each Proposition 103 line of business exceeded 10%. The rollback liability, if any, has not been finalized. Management continues to believe the insurance subsidiaries will not be liable for any material rollback of premiums.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ALLIED Group, Inc. and subsidiaries as of December 31, 1997 and 1996 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1997 in conformity with generally accepted accounting principles.
/s/ KPMG Peat Marwick LLP - --------------------------------------- KPMG Peat Marwick LLP Des Moines, Iowa February 3, 1998
ALLIED Group, Inc. and Subsidiaries Consolidated Statements of Stockholders' Equity (in thousands)
The Company's property-casualty segment operates through three subsidiaries: AMCO Insurance Company (AMCO), ALLIED Property and Casualty Insurance Company, and Depositors Insurance Company, which underwrite personal lines (primarily automobile and homeowners) and small commercial lines.
Western Heritage Insurance Company is the excess & surplus lines subsidiary, which primarily underwrites commercial lines.
During 1997, the Board of Directors authorized a 3-for-2 stock split issuable November 28, 1997 to stockholders of record on November 14, 1997. All fractional shares were paid in cash. All weighted average shares outstanding, per share amounts, and references in the footnotes to share information have been restated retroactively to reflect the stock splits.
Investments in fixed maturities where there is the positive intent and ability to hold to maturity are classified as held to maturity and carried at cost adjusted for amortization of premium or discount. Amortization of premiums and discounts on mortgage-backed securities incorporates a prepayment assumption to estimate the securities' expected lives. Except for declines that are other than temporary, changes in fair value are not reflected in the financial statements.
Investments in fixed maturities that may be sold prior to maturity and are not bought and held principally for the purpose of selling in the near term are segregated into an available for sale portfolio and are carried at fair value. Unrealized appreciation and depreciation of securities classified as available for sale are reported as accumulated other comprehensive income in stockholders' equity net of deferred income taxes. All of the Company's investments in fixed maturity securities were designated as available for sale at December 31, 1997, although the Company is not precluded from designating the securities as held to maturity at some future date.
Equity securities are carried at fair value with any unrealized appreciation and depreciation reported net of deferred income taxes as accumulated other comprehensive income in stockholders' equity. All short-term investments are recorded at cost, which approximates fair value.
Ceded reinsurance amounts with nonaffiliated re-insurers relating to reinsurance receivables for paid and unpaid losses and loss adjusting expenses and prepaid reinsurance are reported on the balance sheets on a gross basis. Amounts ceded to ALLIED Mutual relating to the affiliated reinsurance pooling agreement and the property catastrophe reinsurance agreement have not been grossed up because the contracts provide that receivables and payables may be offset upon settlement.
ALLIED Mortgage recognizes as separate assets the rights to service mortgage loans for others, whether acquired through purchases or loan originations. Capitalized mortgage servicing rights are assessed periodically for impairment based on the fair value of those rights. ALLIED Mortgage stratifies its mortgage servicing portfolio on the basis of certain risk characteristics, including loan type and note rate, and determines fair value based upon the present value of estimated future cash flows. Impairment is recognized through a valuation allowance for each impaired stratum. The total valuation allowance for capitalized mortgage servicing rights was $3 million as of December 31, 1997 and $2.7 million at December 31, 1996. The fair value of capitalized mortgage servicing rights as of December 31, 1997 and 1996 was approximately $53.3 million and $44.8 million, respectively. Capitalized mortgage servicing rights are amortized over twelve years using the straight-line method, which management
Deferred income taxes reflect the impact of temporary differences between the tax basis of assets and liabilities and the reported amounts of those assets and liabilities for financial reporting purposes. Deferred tax assets and liabilities are measured using enacted tax rates expected to be applicable to taxable income in the years in which the temporary differences are expected to be recovered or settled. Income tax expense provisions increase or decrease in the same period in which a change in tax rates is enacted.
The minority interest in a subsidiary represents the minority common stockholders proportionate share of the net assets and the results of operations of the majority-owned mortgage banking subsidiary. Options exercised by key employees of the mortgage banking subsidiary resulted in a 20% ownership in the outstanding common stock of the subsidiary on January 2, 1997. No additional options are outstanding. The minority interest in the subsidiary was $2.1 million at December 31, 1997 and is included in other liabilities. This transaction did not have a material impact on the Company's financial position, results of operations, or liquidity.
The Company also adopted SFAS 131, "Disclosures about Segments of an Enterprise and Related Information," on December 31, 1997 (note 18). SFAS 131 specifies the presentation and disclosure of operating segment information reported in the annual and interim reports issued to stockholders. SFAS 131 supersedes SFAS 14, "Financial Reporting for Segments of a Business Enterprise," and requires that segment information of earlier years be restated to conform to the new standard. The adoption of SFAS 131 resulted in revised and additional disclosures but had no effect on the financial position, results of operations, or liquidity of the Company.
Fixed maturities -- The estimated fair value is based upon the quoted market prices for the same or similar issues or from independent pricing services (note 3).
Equity securities -- The estimated fair value is based upon the quoted market prices where available or from independent pricing services (note 3).
Mortgage loans held for sale -- The fair value is estimated using quoted market prices and includes commitments to extend credit and forward sales commitments (note 14).
Guarantee of ESOP obligations -- Due to its floating interest rate, the guarantee approximates its fair value (note 9).
Other financial instruments -- Due to their short-term nature, their carrying amount approximates fair value.
The following table presents the amortized cost and estimated fair value table of fixed maturities by contractual maturity at December 31, 1997. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations without call or prepayment penalties.
As required by law, fixed maturities and short-term investments amounting to $12.5 million at December 31, 1997 and $10.5 million at year-end 1996 were on deposit with various insurance regulatory authorities.
As of December 31, 1997 and 1996, there were no investments that were non-income producing for the previous twelve months.
A summary of net investment income for the years ended December 31, 1997, 1996, and 1995 follows:
A summary of net realized investment gains (losses) and net changes in unrealized appreciation (depreciation) of investments for the years ended December 31, 1997, 1996, and 1995 follows:
Included in income from affiliates are revenues of $2.5 million, $2.4 million, and $2.8 million for the years ended December 31, 1997, 1996, and 1995, respectively, relating to data processing services provided by subsidiaries of the Company to ALLIED Mutual and its subsidiaries under a Management Information Services Agreement. Effective March 1, 1996, the agreement was amended and personnel previously providing computer-related services to a certain affiliate were employed by the affiliate. Fees paid for services provided by such personnel are now paid directly by the affiliate.
ALLIED Mutual participated with a nonaffiliated reinsurance company in a property catastrophe reinsurance agreement to cover the property-casualty segment's share of the pooled losses. ALLIED Mutual's participation in the agreement was 90%. Premiums paid by the property-casualty segment to ALLIED Mutual were $2.9 million, $2.7 million, and $2.3 million in 1997, 1996, and 1995, respectively. There were recoveries from ALLIED Mutual of $2 million, $3.4 million, and $2.6 million in 1997, 1996, and 1995, respectively.
The reserving process relies on the basic assumption that past experience, adjusted for current developments and likely trends, is an appropriate basis for predicting future events. Reserve amounts are necessarily based on management's informed estimates; as other data become available and are reviewed, these estimates and judgments are revised, resulting in increases and decreases to existing reserves. As a result of changes in estimates of insured events in prior years, the provision for losses and loss adjusting expenses decreased $1.9 million in 1997, decreased $680,000 in 1996, and increased $2 million in 1995. Development for losses and loss adjusting expenses on prior years is immaterial to the financial statements taken as a whole.
In establishing reserves, management considers exposure the Company may have to environmental claims. Because reported claim activity levels are minimal and the emphasis of the property-casualty business is primarily on personal lines and small commercial business, management believes exposure to material liability on such claims to be remote as of December 31, 1997. The Company routinely reviews its overall reserve position and reserving techniques as they relate to its exposure to environmental claims.
In the ordinary course of business, the property-casualty and excess & surplus lines subsidiaries cede insurance to other insurers for the purpose of limiting their maximum loss exposure through diversification of their risks. See note 4 for discussion of reinsurance contracts with ALLIED Mutual. Reinsurance contracts do not relieve the Company's insurance subsidiaries from their obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company's insurance subsidiaries; consequently, allowances are established for amounts deemed uncollectible. Management evaluates the financial condition of the reinsurers and monitors concentrations of credit risk arising from similar geographic regions, activities, or economic characteristics of the reinsurers to minimize exposure to significant losses from reinsurer insolvencies. As of December 31, 1997, reinsurance receivables and prepaid reinsurance premiums associated with three nonaffiliated reinsurers aggregated approximately $16.4 million, which represented a significant portion of the total prepaid reinsurance premiums and reinsurance receivables for losses and loss adjusting expenses. The property-casualty subsidiaries also assume insurance as members of various pools and associations.
The effect of reinsurance on premiums written and earned and losses and loss adjusting expenses incurred for the years ended December 31, 1997, 1996, and 1995 was as follows:
ALLIED Mortgage entered into an agreement with a life insurance company for $15 million of 8.4% senior secured notes due September 1, 2004. The notes are secured by mortgage servicing rights and are payable in equal annual installments of $1.5 million every September 1; interest is payable semiannually. At December 31, 1997 and 1996, the outstanding balance was $10.5 million and $12 million, respectively.
The Federal Home Loan Bank of Des Moines provides a $3 million committed credit facility through a line of credit agreement with AMCO that expires February 27, 1998. Interest on any outstanding borrowings is payable at an annual rate equal to the federal funds unsecured rate for federal reserve member banks, which was 5.8% as of December 31, 1997. The Company had an outstanding balance of $1.5 million as of December 31, 1997 and no outstanding balance as of December 31, 1996.
The Company was party to an interest rate swap agreement with a broker-dealer to reduce the financial statement impact of fluctuations in the Credit Agreement interest rate. The interest rate swap agreement expired on December 12, 1997. The interest rate swap involved the exchange of fixed and floating rate interest payments without the exchange of the underlying principal amount. During 1997, the Credit Agreement interest rates ranged from 6% to 6.3%. During 1996 and 1995, they ranged from 6% to 6.6% and from 6% to 6.8%, respectively.
The 6-3/4% Series preferred stock (6-3/4% Series), issued to ALLIED Mutual at a value of $28.50 per share, is perpetual, nonconvertible, voting, and cumulative with respect to dividends. The 6-3/4% Series has no preemptive rights and is not registered or traded. Upon any transfer by ALLIED Mutual, the 6-3/4% Series is callable under certain conditions and becomes nonvoting. Each share of the 6-3/4% Series has 3-3/8 votes. The annual dividend rate is 6-3/4% of the liquidation preference of $28.50 ($1.92 per share) and is payable quarterly.
The Company has reserved 562,500 shares of common stock for issuance under the ALLIED Life Employee Stock Purchase Plan. The Company receives fair market value for the shares issued under the plan. During 1997, 1,242 shares were issued at a weighted average price per share of $25.81. During 1996 and 1995, 834 and 4,512 shares were issued at a weighted average price per share of $17.81 and $12.78, respectively. At December 31, 1997, 555,113 shares were available for issuance.
The Company has granted stock options to key employees under four nonqualified plans as defined by the Internal Revenue Service: the ALLIED Group, Inc. Restated and Amended Stock Option Plan (Option Plan), the ALLIED Group, Inc. Nonqualified Stock Option Plan (Nonqualified Plan), the ALLIED Group Executive Equity Incentive Plan (Equity Plan), and the Freedom Group Incentive Plan (Freedom Plan). No options remain to be granted under the plans. During 1997, all Freedom Plan options were exercised; during 1996, all Equity Plan options were exercised. Upon exercise of the stock options under each plan, the Company receives an amount equal to the common stock's fair market value at the grant date. The options vest at various times and must be exercised ten years after the date of grant.
A summary of stock option activity and prices for 1997, 1996, and 1995 is presented below:
The issuance of SARs and restricted stock under the Incentive Plan reduces the number of options available for future issuance. During 1997 SARs or restrictive stocks were issued. During 1996 and 1995, 9,581 and 29,951 shares of restricted stock were awarded at $19.17 per share and $12.17 per share, respectively. During 1997 and 1996, the restriction was lifted on 11,137 and 2,359 shares, respectively. During 1997, 1996, and 1995, the number of restricted shares forfeited was 3,819, 260, and 914, respectively. At December 31, 1997, 24,577 restricted shares were outstanding. The following table presents SAR activity and prices for the years ended December 31, 1997, 1996, and 1995:
The Company has reserved 1,687,500 and 843,750 shares of common stock for issuance under the ALLIED Group, Inc. Employee Stock Purchase Plan (ESPP) and the ALLIED Group, Inc. Outside Director Stock Purchase Plan (DSPP), respectively. Under the plans, participants pay 85% of the fair market value of the shares issued, which are fully vested on the dates purchased. During 1997, 56,564 shares were issued at a weighted average price per share of $22.83. During 1996 and 1995, 62,447 and 69,065 shares were issued at a weighted average price per share of $14.62 and $11.39, respectively. At December 31, 1997, 526,483 and 789,763 shares were available for issuance under the ESPP and DSPP, respectively.
The following table includes selected information for the insurance subsidiaries as determined in accordance with accounting practices prescribed or permitted by insurance regulatory authorities:
Although loans serviced for others are not on the accompanying balance sheets, ALLIED Mortgage has credit risk associated with the mortgage servicing portfolio. As the loan servicer, ALLIED Mortgage is required to process delinquent loans through the foreclosure process, thereby incurring certain direct expenses which generally are, but may not be, reimbursed. At December 31, 1997, ALLIED Mortgage had sold loans totaling approximately $12.9 million while retaining recourse risk. ALLIED Mortgage established allowances for losses in connection with these various risks. These allowances are included in other liabilities on the accompanying balance sheets.
On December 31, 1997, a complaint was filed by Mary M. Rieff, a policyholder of ALLIED Mutual in the Iowa District Court in and for Polk County, Iowa, against the Company and certain other individuals who are or were officers and/or directors of ALLIED Mutual and the Company. The complaint, an alleged policyholder derivative action brought on behalf of ALLIED Mutual, asserts, among other things, (a) that the defendants were responsible for the inappropriate transfer of ALLIED Mutual's corporate assets, the seizure of certain corporate opportunities, and the implementation of an improper de facto demutualization without informing or compensating policyholders or receiving the appropriate approval from regulatory authorities; (b) that this allegedly wrongful demutualization began on or about January 1, 1985 and was accomplished through transfers of ALLIED Mutual's assets to the Company and to the individual defendants for inadequate consideration; (c) that the individual defendants breached fiduciary duties owed to ALLIED Mutual, wasted its corporate assets and intentionally interfered with its contracts, prospective business advantage and business relationships; and (d) that defendants improperly transferred substantial ownership of and control over the Company and ALLIED Mutual's insurance business. The complaint further asserts that as a result of the foregoing, ALLIED Mutual and its policyholders have suffered damages in excess of $500 million. The complaint requests an accounting of the assets allegedly wrongfully transferred to the Company and compensation to ALLIED Mutual for the value of such assets, for the seizure of corporate opportunities, and for the de facto demutualization of ALLIED Mutual. The complaint also asks for certain other relief, including attorneys' fees and costs, equitable relief and interest, and restitution for any assets wrongfully transferred or conveyed. The Company believes that the suit is without merit and intends to defend this action vigorously. As is the case in all pending actions, the ultimate outcome is uncertain.
The ESOP established by the Company covers all of its employees who meet age and service requirements. Shares of common stock are allocated annually to each employee's account pursuant to a formula and held in trust until the employee's termination, retirement, or death. As shares of common stock are allocated to parti- cipants, the cost of such shares is expensed and deducted from unearned compensation related to ESOP included in stockholders' equity.
The Company's ESOP expense was $2.4 million in 1997, $1 million in 1996, and $2.7 million in 1995. Of those respective amounts, $44,000, $14,000, and $65,000 were included in the employee lease fee received from affiliates pursuant to the terms of the Intercompany Operating Agreement for the years ended December 31, 1997, 1996, and 1995, respectively.
During 1997, 1996, and 1995, the ESOP Trust received $3.6 million, $3.5 million, and $2.8 million, respectively, from dividends on the leveraged shares used to service debt on the ESOP obligations and to purchase stock for participants. The Company made ESOP contributions of $312,000 in 1997, $529,000 in 1996, and $733,000 in 1995. Interest incurred on the ESOP debt, which is included as a component of ESOP expense, was $1.5 million, $1.6 million, and $1.8 million in 1997, 1996, and 1995, respectively. The ESOP shares as of December 31, 1997 and 1996 were as follows:
A 7.5% weighted average discount rate was used to determine the accumulated postretirement benefit obligation at December 31, 1997 and 1996.
For measurement purposes, an 7% annual rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) was assumed for 1998; the rate was assumed to decrease in equal annual increments to 5% by the year 2000 and to remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation by approximately $540,000 and the aggregate of the service and interest cost components of net periodic postretirement benefit cost by approximately $40,000.
Total income taxes for the years ended December 31, 1997, 1996, and 1995 were allocated as follows:
The tax effects of temporary differences that gave rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1997 and 1996 relate to the following:
The Company has two reportable operating segments: property-casualty and excess & surplus lines. The segments are managed separately due to the differences in the insurance products sold, underwriting risk, and the environments in which they operate.
The property-casualty segment accounted for 85.7% of 1997 consolidated revenues. It underwrites personal lines (primarily automobile and homeowners) and small commercial lines through three subsidiaries and markets its products through three distribution systems: independent agencies, exclusive agencies, and direct response marketing. The segment operates primarily in central and western states. California and Iowa accounted for 23.7% and 21.4%, respectively, of 1997 direct written premiums. The Company evaluates the property-casualty segment's performance on the basis of growth in direct written premiums and profit.
The Company accounts for intercompany sales and transactions as if they were to third parties and attempts to set fees consistent with those that would apply in an arm's length transaction with a nonaffiliate. There can be no assurance the rates charged reflect those that would have been agreed upon following an arm's length negotiation.
The following table shows the detail of intersegment eliminations for segment assets shown in the previous table: