At December 31, 1995, the Company owned 16 of the buildings in which the Company's principal field offices were located. As part of a planned realignment of its field structure designed to reduce expenses, contribute to improvement of the combined ratio, and enhance growth (the "Realignment"), the Company announced it would dispose of 14 of the principal field offices and consolidate the functions of those offices into four regional offices. A $28.4 million pre-tax charge for loss on operating properties was charged to income in the fourth quarter of 1995. As of December 31, 1996, four of the offices had been sold. The location and approximate size of each of those offices are as follows:
(2) Interest expense incurred in 1996 is a direct result of, in May 1996, the Company assuming $100 million of LNC debt and issuing a $200 million note to LNC. See Note 5 to the Consolidated Financial Statements on page 48.
(3) Pro forma net income for the years ended December 31, 1996 and 1995 are presented to reflect the impact of the May 1996 initial public offering of the Company's Common Stock and related transactions as if they had occurred January 1, 1995. Pro forma net income for the years ended December 31, 1996 and 1995 includes the impact of (i) net investment income decreasing by $6.0 million and $14.4 million, respectively, representing the interest yield on $300 million of tax-exempt municipal securities, (ii) net investment income increasing by $6.0 million and $14.4 million, respectively, representing the interest yield on $215.2 million net proceeds from the initial public offering invested in risk free investments, (iii) interest expense increasing by $8.5 million and $20.4 million, respectively, representing the interest on the debt assumed and issued and (iv) the tax effect on the foregoing of $1.2 million and $2.9 million, respectively.
(8) Represents net income before (i) realized gain on investments (net of federal income taxes) of $23.3, $21.5, $13.0, $96.4, and $43.2 million in 1996, 1995, 1994, 1993 and 1992 respectively, (ii) the $28.4 million loss on operating properties in 1995, net of federal income taxes of $9.9 million, (iii) the estimated Realignment implementation costs accrued in 1995 of $21.0 million, net of federal income taxes of $7.3 million, and (iv) the cumulative effect of a change in accounting in 1993. The net effect of these amounts are included to assist the reader in analyzing the Company's results of operations by
(9) Amounts shown in 1992 through 1995 represent dividends declared on ASI stock, which were paid to LNC. ASI also declared $.1 million in dividends on publicly held preferred stock in 1992. This stock was called and retired in 1992. In 1996, ASI declared and distributed a $300 million dividend consisting primarily of tax-exempt securities ("Dividended Assets") to LNC. ASFC declared a $.21 per share dividend on its outstanding Common Stock in the third and fourth quarter of 1996.
The Company's revenues from operations are derived primarily from net premiums earned on policies written by the Company, investment income and realized gain on investments. Expenses consist primarily of payments for claims incurred, claims adjustment expenses and underwriting expenses, including agents' commissions and other operating expenses.
Significant factors influencing results of operations include the supply and demand for property and casualty insurance and life insurance, as well as the number and magnitude of catastrophe or natural peril losses, such as losses caused by wind, hail, water (including freezing water) and earthquakes. Although the property and casualty insurance industry has historically been highly cyclical, management of the Company believes that variability within each product line has become more pronounced than industry-wide cyclicality. Premium rate levels are related to the availability of insurance coverage, which varies according to, among other things, the level of surplus in the industry. The level of surplus in the industry varies with returns on invested capital and regulatory barriers to withdrawal of surplus. Surplus levels have been relatively high in recent years due in part to the gains in the investment portfolios of many insurers. Increases in surplus have generally been accompanied by increased price competition among property and casualty insurers. The industry's profitability can also be affected significantly by fluctuations in interest rates and other changes in the investment environment which affect market prices of insurance companies' investments and the income from those investments, inflationary pressures that affect the size of losses and judicial decisions affecting insurers' liabilities. The demand for property and casualty insurance can also vary, generally rising as the overall level of economic activity increases and falling as such activity decreases.
The Company seeks to manage its risk exposure by adjusting the mix and volume of business written in response to changes in price and by balancing the geographic distribution of its risks. Management believes that this strategy accounts, in part, for loss ratios that are lower than the property and casualty industry average.
COMPARISON OF THE YEAR ENDED DECEMBER 31, 1996 TO THE YEAR ENDED DECEMBER 31,
CONSOLIDATED The Company's revenues decreased 2.1% or $41.6 million to $1,984.0 in 1996 from $2,025.6 million in 1995. Net premiums earned and other revenue decreased 4.1% or $72.3 million to $1,674.1 million in 1996 from $1,746.4 million in 1995. Net investment income increased by $7.7 million, or 2.9%, while realized gain on investments decreased by $5.5 million.
____________________ (1) Most expenses specifically relate to, and are identified to, lines of business. Fixed expenses, including salaries and other operating expenses, are allocated to lines of business based on cost and time studies.
Net Premiums Written Total reported net premiums written decreased by $70.7 million, or 4.2%, to $1,600.9 million for 1996, from $1,671.6 million for 1995. This premium decline was attributable to (i) lower volume from involuntary workers' compensation (ii) the Company's planned reduction of exposure in California and Florida and (iii) a decrease in premium related to a retrospectively rated errors and omissions ("E&O") policy written on LNC.
Involuntary workers' compensation net premiums written, primarily from state mandated pools and associations, decreased $40.1 million, to $3.5 million, in 1996. This decrease was due in large part to the continuing impact of aggressive pricing and de-population programs implemented by most large state workers' compensation pools over the last few years. Another contributing factor was the decrease in the Company's share of the voluntary workers' compensation market in several states in 1995. Voluntary market share is a major component in the calculation of the volume of involuntary business assumed in each state. A decrease in voluntary market share tends to decrease the volume of involuntary business assumed. 1995 voluntary market share was used in determination of 1996 involuntary assumed percentages. Finally, reported premiums were negatively impacted by the re-estimation of premiums receivable. Reporting from the National Council of Compensation Insurers ("NCCI"), which constitutes nearly 90% of total assumed involuntary workers' compensation business, is two quarters in arrears, requiring the Company to estimate premium for the most recent two quarters. Reported premiums from NCCI declined dramatically in 1996, requiring a decrease in premiums receivable of approximately $12.9 million.
The Company's continued planned reduction of exposure in California and Florida, excluding all involuntary markets premium , decreased premiums $25.9 million, to $150.3 million, in 1996. While the Company plans continued risk exposure reduction in these two states in 1997, the rate of premium reduction should moderate from 1996 levels. This forward looking statement is based on (i) the gradual and continuous net decrease of agencies under contract in these markets in 1996 (ii) management's intention of achieving a continuing, yet much smaller net reduction of agency appointments in these markets in 1997 (iii) a continued de-emphasis of the sale of certain classes and lines of business in these markets, and (iv) no current plans by management to introduce new products or growth initiatives in these markets in 1997.
Finally, premiums on the retrospectively rated LNC E&O policy decreased $15.1 million in 1996. Prior year premiums were unusually high due to the settlement of a large casualty claim in 1995. The Company expects to record approximately $1.5 to $2.0 million in net written premium on this policy in 1997. This forward looking statement assumes that the frequency and severity of claim activity presented against this policy in 1997 will be consistent with historic levels, adjusted for unusual and isolated claims.
Net premiums written for commercial lines products decreased by $76.1 million, or 7.7%, to $915.5 million for 1996, compared to $991.6 million for 1995. Net premiums written for personal lines products increased by $3.4 million, or .5%, to $684.5 million for 1996, compared to $681.1 million for 1995.
Excluding the impacts of premium decreases caused by involuntary workers' compensation, the Company's planned reduction of exposure in California and Florida and the impacts of the E&O policy, net premiums written increased .3% in 1996 to $1,440.2 million, from $1,435.3 million in 1995. Net premiums written for commercial lines products decreased by $3.4 million, or .4%, to $831.1 million for 1996, compared to $834.5 million for 1995. Net premiums written for personal lines products increased by $8.4 million, or 1.4%, to $609.1 million for 1996, compared to $600.7 million for 1995.
Finally, as a result of continued price competition in the industry, the SAP loss ratio for 1996 was adversely impacted by a slight deterioration in the 1996 accident year underlying loss ratio on most commercial and personal lines of business. The underlying loss ratio is the total loss ratio less the impact of (i) natural peril losses and (ii) development on prior accident year loss reserves. The Company expects a continued slight deterioration in the 1997 accident year underlying loss ratio. This forward looking statement assumes (i) a continuation of significant price competition in most lines of business and (ii) no significant deviation from current underlying claim frequency or severity trends in the 1997 accident year.
Personal Lines In 1996 the personal lines SAP combined ratio also increased to 109.3%, from 104.8% in 1995, with all of the increase being attributable to the loss ratio component. Natural peril losses accounted for approximately half of this deterioration, with the most significant impact in the homeowners line of business. Private passenger results also deteriorated due to price competition and increased loss costs, primarily physical damage coverages.
Realized Gain On Investments Realized gain on investments was $34.2 million for 1996, compared to $38.8 million in 1995. This decrease was due primarily to the reduction in the Company's investment in unaffiliated common stocks during 1995, many of which were sold at a gain.
LIFE. The following table sets forth certain summarized financial and key operating data for the Company's life insurance operations for 1996 and 1995.
PROPERTY AND CASUALTY. The following table sets forth certain summarized financial data and key operating ratios for the Company's property and casualty operations for 1995 and 1994. All ratios are computed using data reported in accordance with SAP.
Net Premiums Written Net premiums written increased by $16.1 million, or 1.0%, to $1,671.6 million for 1995, from $1,655.5 million for 1994. This growth was largely attributable to an increase in premiums written on private passenger automobile and businessowners policies designed specifically for owners of small business. Net premiums written for commercial lines products increased by $6.5 million, or .7%, to $991.6 million for 1995, compared to $985.1 million for 1994. Net premiums written for personal lines products increased by $12.8 million, or 1.9%, to $681.1 for 1995, compared to $668.3 million for 1994. For the states of Illinois, Indiana, Kansas, Michigan, Missouri, Ohio, Oregon and Washington, which comprise the most significant part of the Company's target market, direct premiums written increased by 3.6% in 1995, while for the states of California and Florida, where the Company has been reducing its exposure due to unfavorable results, direct premiums written decreased by 6.5%. For all other states, 1995 direct premiums written were virtually unchanged from 1994.
Net Premiums Earned and Other Revenue Net premiums earned and other revenue (primarily finance and service fees) decreased by $3.9 million to $1,689.6 million for 1995, from $1,693.5 million for 1994.
Losses and Loss Adjustment Expense Losses and LAE decreased by $32.5 million to $1,193.7 million for 1995, from $1,226.2 million for 1994. The SAP loss ratio for 1995 was 59.3% as compared to 61.1% for 1994. The 1.8 percentage point decline in the loss ratio in 1995 was due primarily to the continuing benefit from the New Directions strategy implemented in late 1991. The Company's results of operations benefited materially in 1995 and 1994, as a result of reductions in the estimated amounts needed to settle prior years' claims, with such benefit being most significant in 1994. The overall favorable reserve development in both 1995 and 1994 was the result of improving trends, both industry-wide and related to the Company's New Directions initiatives, as well as enhancements made in the claim evaluation process.
The SAP LAE ratio was 11.8% for 1995, the same as in 1994. While the Company's SAP loss ratio decreased due to New Directions and other initiatives, the impact on the Company's LAE ratio has been less evident, due partially to increases in legal expense reserves relating to environmental claims. In 1995, the LAE ratio was favorably impacted by approximately $10.7 million of LAE reserve release due to positive development of prior accident years. Offsetting this, some unusual items increased expense in 1995. In the first quarter of 1995, the Company announced an early retirement plan for certain levels of management and the closing of two division offices and a service office; the second quarter of 1995 included the costs of settling a lawsuit and the fourth quarter included the costs of Realignment. These unusual items added $9.5 million of LAE-related expense during 1995.
Realized Gain On Investments Realized gain on investments was $38.8 million for 1995, compared to $19.2 million in 1994. This increase was due to the reduction in the Company's investment in unaffiliated common stocks, many of which were sold at a gain.
Loss On Operating Properties In 1995, a $28.4 million provision was made to recognize the expected loss on operating properties which the Company now occupies and plans to dispose of in connection with the Realignment.
Income Tax Expense Federal income taxes increased by $14.1 million to $23.5 million for 1995 from $9.4 million for 1994. The increase was due primarily to improved underwriting results and net investment income which reflected an investment portfolio containing a higher proportion of taxable securities.
Life insurance reflects steady growth in policy income, which increased by 8.2% for 1995, compared to 1994. Sales of life insurance, primarily universal life products, were strong. Account values at December 31, 1995, increased by 10.4% from December 31, 1994 levels. Net investment income increased by 10.8% during 1995, reflecting the growth in account values as well as the general growth of invested assets. Realized gain on investments increased $1.6 million to $2.3 million primarily as a result of sales of securities to take advantage of market opportunities. Net income increased by 12.4 % to $14.5 million in 1995, compared to 1994.
The primary sources of funds available to the Company are premiums, investment income and proceeds from the sale or maturity of invested assets. Such funds are used principally for the payment of claims, operating expenses, commissions, dividends, debt service and the purchase of investments. Cash outflows can be variable because of uncertainties regarding settlement dates for liabilities for unpaid losses and because of the potential for large losses either individually or in the aggregate. Accordingly, the Company maintains investment programs generally intended to provide adequate funds to pay claims without the forced sale of investments. Finally, as noted below, the Company has a $200 million revolving credit agreement, and intends to establish a medium-term note program, to augment its available liquidity. Based upon a quarterly dividend of $.21 per share and the terms of the Assumed Debt, Term Note and Line of Credit, Company management believes the Company has adequate liquidity and resources to meet its obligations.
premiums collected for the period. Operating cash flows in each of the last three years have been more than adequate to meet the liquidity requirements of the Company.
Since a substantial portion of the Company's revenues are generated from its invested assets, the performance, quality and liquidity of its investment portfolio materially effects the Company's financial condition and results of operations. The Company pursues a total return investment strategy which seeks an attractive level of current income combined with long-term capital appreciation. The following table details, at carrying value, the distribution of the Company's investment portfolio at December 31, 1996 (dollars in millions):
The Company attempts to minimize the risk of loss due to default by the borrower by maintaining a quality investment portfolio. As of December 31, 1996, approximately 89% of the Company's bond portfolio was rated "A" or higher, or was a U.S. government obligation, and only $24.4 million, or .7% of the carrying value of the bond portfolio, was rated below investment grade (Ba and below). Ratings are based on the ratings, if any, assigned by Moody's and/or Standard & Poors. If ratings were split, the rating used is generally the higher of the two. Approximately $241.5 million of securities are private placements for which ratings have been assigned by the Company based generally on equivalent ratings supplied by the National Association of Insurance Commissioners.
As of December 31, 1996, 48.3% of the Company's investment portfolio consisted of tax-exempt municipal securities as compared to 53.6% as of December 31, 1995. The Company has reduced its position in tax-exempt municipal securities in order to provide for greater diversification of the portfolio and to give the Company greater margin relative to the possibility of being in a federal alternative minimum tax position.
On February 5, 1996, the Company was incorporated in the State of Indiana to serve as the holding company for ASI. The formation of the Company was done in contemplation of an initial public offering. On April 22, 1996, ASI declared, and on May 15, 1996, it distributed to its parent, LNC, the $300 million Dividended Assets. On May 16, 1996, LNC transferred all of the outstanding shares of ASI to the Company in exchange for 50,000,000 shares of the Company's Common Stock. Concurrently with the transfer of the ASI stock, the Company assumed $100 million of LNC debt ("Assumed Debt") and issued a $200 million note to LNC (the "Term Note"). On May 29, 1996, the Company issued 10,000,000 shares of Common Stock at $23 per share to the public (the "Offering").
The Assumed Debt is governed by an agreement between the Company and LNC (the "Assumption Agreement") which provides for the payment by the Company of the currently outstanding 7 1/8% notes due July 15, 1999, originally issued to the public by LNC on July 15, 1992. The Assumption Agreement also provides that interest at 7 1/8% is payable semi-annually by the Company.
For additional liquidity, the Company intends to establish a medium-term note program (the "MTN Program") within the next year. The MTN Program, if established, would enable the Company to issue debt from time to time for general corporate purposes.
(2) In the fourth quarter of 1995, the Company announced a realignment plan which included the consolidation of 20 divisional offices into four regional offices. As part of the this plan, the Company recorded a $28.4 million valuation allowance on the sale of operating properties.
The consolidated financial statements of the Company follow on pages 34 through 57.
AMERICAN STATES FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
As noted above, the financial statements have been presented as if the Company had been organized at the earliest date presented herein. The formation of the Company was done in contemplation of an initial public offering. On April 22, 1996, ASI declared, and on May 15, 1996, it paid to LNC, a dividend of $300,000 consisting primarily of tax-exempt municipal securities ("Dividended Assets"). On May 16, 1996, LNC transferred all of the outstanding shares of ASI to the Company in exchange for 50,000,000 shares of Common Stock and $300,000 debt of the Company. The transfer of ASI stock to the Company by LNC in exchange for Company Common Stock and debt have been accounted for similar to a pooling of interests, thus the assets, liabilities, shareholders' equity and the results of operation of the Company and its subsidiaries have been combined at historical carrying values.
On May 29, 1996, the closing date of the initial public offering, the Company issued 10,000,000 shares of Common Stock at $23 per share to the public. The net proceeds, after deduction of underwriting discounts and offering expenses were $215,182. The Company contributed $140,500 of such net proceeds to ASI to enable it to invest in taxable securities for its investment portfolio and the remainder was retained by the Company for general corporate purposes.
The Company's Common Stock is publicly traded on the New York Stock Exchange under the symbol "ASX".
Mortgage loans on real estate are carried at the outstanding principal balances less unaccrued discounts and allowances for losses. Short-term investments which are carried at cost, include all highly liquid debt instruments purchased with a maturity of one year or less, and the carrying value approximates fair value.
Property and equipment are stated at cost, less allowances for depreciation. Depreciation is computed generally by the straight-line method at rates calculated to amortize costs over the estimated useful lives of the assets. Properties to be sold are carried at the lower of amortized cost or estimated fair value, less selling costs. The difference between book value and fair value is recognized by maintaining a valuation allowance.
Cost in excess of net assets from the purchase of subsidiaries is being amortized using the straight-line method up to 40 years. The carrying value of these assets will be reviewed if the facts and circumstances suggest that it may be impaired. If the undiscounted cash flows estimated to be generated by these assets are less than the carrying amounts, an impairment loss would be recognized.
The nature of the insurance business requires management to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results reported in future financial statements could differ from these estimates. The effects of changes in estimates are included in the operating results for the period in which such changes occur.
Premiums include property and casualty insurance premiums and life insurance premiums and contract charges earned. Direct property and casualty insurance premiums are earned ratably over the terms of the policies. Assumed reinsurance premiums are earned ratably over the terms of the original policies issued and terms of the reinsurance contracts. The reserve for unearned premiums is computed by the semi-monthly pro rata method. Life insurance premiums on traditional life business are generally earned when due. Revenues for universal life and investment products consist of policy charges for the cost of insurance, policy administration charges, amortization of policy initiation fees, and surrender charges assessed against policyholder account balances during the period. Expenses related to these products include interest credited to policyholder account balances and death benefits incurred in excess of policyholder account balances. Commissions, premium taxes, and certain other expenses incurred in the acquisition of business are deferred and amortized as the related premiums are earned. Acquisition costs that are not recoverable from future premiums and related investment income are expensed. The amounts of acquisition costs amortized were $338,012, $359,840 and $359,747 in 1996, 1995 and 1994, respectively.
A qualified non-contributory defined benefit retirement plan covers substantially all employees. Benefits are based on total years of service and the highest 60 months of compensation during the last 10 years of employment. The plan is funded by contributions to tax-exempt trusts consistent with requirements of federal law and regulations. Contributions are intended to provide not only the benefits attributed to service to date, but also those expected to be earned in the future. Plan assets consist principally of listed equity securities, corporate obligations, and United States government bonds.
Eligible employees also participate in a defined contribution plan. The Company's contribution to the plan is equal to a participant's pre-tax contribution, not to exceed 6% of base pay, multiplied by a percentage, ranging from 25% to 150%, which varies according to certain incentive criteria as determined by the Board of Directors. Expense for this plan amounted to $5,297, $6,644 and $11,419 in 1996, 1995 and 1994, respectively.
The Company utilizes the intrinsic value method of accounting to determine whether compensation expense should be recognized in conjunction with its stock option incentive plan. Using the intrinsic value method, compensation cost is the excess, if any, of the quoted market price of the stock at the grant date, or other measurement date, over the amount an employee must pay to acquire the stock. Since all options are granted at market price, the Company has not recognized compensation expense relating to the stock option incentive plan.
Amounts from prior periods have been reclassified to conform to the 1996 presentation. Net income and shareholders' equity have not been affected by these reclassifications.
The cost, unrealized gains and losses and fair value of securities available-for-sale are as follows:
The amortized cost and estimated fair value of fixed maturity securities at December 31, 1996, by contractual maturity, is shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations without call or prepayment penalties.
The Company had no impaired loans at the end of December 31, 1996 or 1995. A reconciliation of the mortgage loan allowance for losses is as follows:
In conjunction with the formation of the Company, $100,000 of debt was assumed from LNC ("Assumed Debt"). The Assumed Debt is governed by an agreement between the Company and LNC (the "Assumption Agreement") which provides for the payment by the Company of the currently outstanding 7 1/8% notes due July 15, 1999, originally issued to the public by LNC on July 15, 1992. LNC continues to be the primary obligor of this public debt; however, pursuant to the Assumption Agreement, the Company will make a $100 million principal payment on July 15, 1999 to repay the holders of the public debt. The Assumption Agreement also provides that interest at 7 1/8% is payable semi-annually by the Company.
Also in conjunction with the formation of the Company, a $200,000 term note was issued to LNC ("Term Note"). The Term Note will pay interest quarterly at a rate of 50 basis points over the rate on three year Treasury Notes through November 14, 1997, 50 basis points over the rate on two year Treasury Notes from November 15, 1997 through November 14, 1998 and 50 basis points over the rate on one-year Treasury Bills from November 15, 1998 through the maturity date. The current rate of interest on the Term Note is 6.7%. The Term Note will be payable in three equal principal payments due on August 15, 1997, 1998 and 1999. Pursuant to the provisions on the Term Note, the Company will have the right to prepay the Term Note at any time. The Term Note also contains covenants that will, among other things, (i) require the Company to maintain certain levels of adjusted consolidated net worth (as defined in the Term Note), and (ii) restrict the ability of the Company to incur indebtedness in excess of 50% of its adjusted consolidated net worth and to enter into a major corporate transaction unless the Company is the survivor and would not be in default.
In 1996, the Company incurred and paid interest cost of $12,372 and $7,218, respectively.
Net pension cost for the defined benefit pension plans includes the following components:
POSTRETIREMENT BENEFIT PLAN. The postretirement defined benefit plan is unfunded; however, the details of the amount included in other liabilities are as follows:
The calculation of the accumulated postretirement benefit obligation assumes a weighted-average annual assumed rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) of 8.5% for 1997 gradually decreasing to 5.0% by 2005. 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 at December 31, 1996 by $3,952, and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1996 by $431.
In addition, 50,515 restricted shares of the Company's Common Stock were issued to key personnel. The shares are restricted from sale or trade for three years after grant except in a situation relating to death or disability. In addition, at the time restrictions lapse, compensation equal to the amount of dividends that would have been paid during the period the shares were restricted is paid to the personnel.
The Company utilizes the intrinsic value method of accounting to determine whether compensation expense should be recognized in conjunction with its stock option incentive plan. As the amount the employee must pay to acquire the stock is equal to the quoted market price of the stock at the grant date, no compensation expense has been recognized for stock option incentive plans. Had compensation expense for the Company's stock option incentive plans for options been determined based on the estimated fair value at the grant date for awards under those plans, the Company's pro forma net income and earnings per share for 1996 would have been $168,266 or $3.01 per share, a decrease of $1,440 or $.02 per share. The effects on 1996 pro forma net income and earnings per share of expensing the estimated fair value of stock options are not necessarily representative of the effects on reported net income for future years due to factors such as the vesting period of the stock options and the potential for issuance of additional stock options in future years.
The fair value of options granted during 1996 were estimated as of the date of grant using a Black-Scholes option pricing model. The option pricing assumptions include a dividend yield of 3.7%; an expected volatility of 30%; a risk-free interest rate of 6.8%; and an expected life of 9 years. The average fair value per option granted during 1996 was $11.12 based on these assumptions.
The principal sources of reinsurance assumed are national and state associations. Reinsurance is ceded to other companies for risks which exceed retention limits and to provide for catastrophic claims.
At December 31, 1995, the Company had $37,910 invested in LNC's short-term investment pool. During 1996, the Company established its own short-term investment pool. In addition, the Company had $31,037 and $40,072, at cost, invested in mutual funds administered by a subsidiary of LNC with a fair value of $40,088 and $41,198 at December 31, 1996 and 1995, respectively.
LNC paid the Company $7,425, $6,277 and $5,298 during 1996, 1995 and 1994 for administrative services and insurance coverages provided by the Company to LNC. The Company paid LNC $2,757, $6,935 and $2,601 during 1996, 1995 and 1994 for services rendered by LNC to purchase corporate insurance coverages. The Company's life insurance subsidiary paid LNC $4,267, $3,042 and $3,528 during 1996, 1995 and 1994 for reinsurance coverages.
The operating expenses of the Company have all been considered to be allocable to the segments since the Company's activities were all directly related to those segments through December 31, 1996. Capital expenditures and depreciation expense are not material.
In November 1995, the Company approved a realignment plan which included the consolidation of the field operations from 20 divisional offices into four regional offices. Certain of the locations will be converted to service offices. Those operating properties owned by the Company that will not be used as a regional office will be sold. For each location to be downsized, job classifications, positions to be eliminated and individuals impacted were identified and severance benefits were communicated. This process was started in 1995 with the majority of the Realignment occurring in 1996 and the balance to be completed in 1997. Management estimated that the costs of realignment and valuation allowance for the sale of the operating properties based on independent appraisals with net carrying value representing the lower of cost or market, net of taxes, approximated $13,700 and $18,500, respectively, and was charged to income in 1995; accordingly, net income decreased $32,200.
During 1996, the Company sold 4 of the divisional offices. At December 31, 1995, the Company had estimated that it would incur approximately $21,000 related to the various costs associated with the realignment plan and had accrued such costs. Through December 31, 1996, approximately $14,000 of the accrued costs have been paid. Management believes the balance of $7,000 is adequate to cover future expected payments.
On February 14, 1996, three of the Company's property and casualty insurance subsidiaries were among 23 underwriters of real property insurance named defendants in a case brought in the United States District Court for the Western District of Missouri alleging that their underwriting, sales and marketing practices violated a number of civil rights laws (including, without limitation, the Fair Housing Act). The plaintiffs seek to represent themselves and a putative class of similarly situated persons in the State of Missouri. This action seeks injunction relief, unspecified compensatory damages, punitive damages and attorneys' fees. In response to motions filed by the defendants, the court dismissed the conspiracy court by Order dated October 2, 1996 but has required that the defendants answer the remaining counts and discovery has now begun. Management believes, based upon current information, that the Company's underwriting, sales and marketing practices have complied in all material respects with the applicable requirements of both state and federal law. The Company intends to vigorously defend this action.
On August 29, 1996, the first of two actions were brought in Missouri state courts alleging that underinsured motorist insurance coverage sold in that state by three of the Company's property and casualty insurance subsidiaries constitutes "phantom coverage" when sold at limits equal to the State's financial responsibility requirements. In both actions, the plaintiffs seek to represent themselves and a putative class of similarly situated persons in the State of Missouri. The actions seek both compensatory and punitive damages based upon a number of legal theories, including, without limitation, breach of fiduciary duty, negligence, breach of contract, unjust enrichment and misrepresentation. While it is too early to fully evaluate the plaintiffs' allegations, the potential defenses available or the size of the putative class of plaintiffs, management does not believe, based upon current information, that the allegations have merit and it therefore intends to defend these actions vigorously.