Earnings per common share and cash dividends declared per common share have been retroactively restated for additional shares issued as a result of a three for two stock split to stockholders of record as of December 18, 1995.
All references to the Company include all of its subsidiaries; United Life Insurance Company, Addison Insurance Company and Lafayette Insurance Company. The Company operates in two segments; property and casualty insurance and life insurance. The following discussion is presented by segment, and should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements.
RESULTS OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 1998, COMPARED TO THE YEAR ENDED DECEMBER 31, 1997 PROPERTY AND CASUALTY INSURANCE SEGMENT
The largest storms affecting the Company occurred between May 30 and June 1, in Iowa, Minnesota, South Dakota and Wisconsin. These storms, although individually not large enough to penetrate our catastrophe reinsurance cover of $5,000,000, generated net incurred losses of $4,711,000. Other storms in Iowa and Minnesota, on May 15 and 16, resulted in net incurred losses in excess of $3,647,000. Severe storms occurring in several midwestern states between June 24 and 30, resulted in additional catastrophe net incurred losses of $3,620,000. Hurricane Georges hit Louisiana and Mississippi September 21 through September 28, causing over $4,000,000 in net incurred losses for the Company. Finally, storms occurring November 9 through November 11 in several midwestern states resulted in over $1,200,000 in net incurred losses.
As a profitability measure, the property and casualty industry uses the statutory combined ratio, which is calculated by dividing net losses and net loss adjustment expenses incurred by net premiums earned, plus expenses incurred divided by net premiums written. Generally, if the combined ratio is below 100 percent, the Company experiences an underwriting profit; if it is above 100 percent an underwriting loss exists. In 1998, the segment's combined ratio was 115 percent, compared to 98 percent in 1997 and 104 percent in 1996. The catastrophes discussed above added 11 percent to the 1998 combined ratio.
The Company's life insurance segment had record earnings in 1998. The segment reported net income after consolidating eliminations of $10,614,000, compared to $6,060,000 in 1997. Growth in net premiums earned of $6,064,000, or 32 percent, was a major factor in the favorable results. Much of the premium growth came from the segment's single premium credit life and accident and health products. Management anticipates smaller growth in the life insurance segment's premium income in 1999.
RESULTS OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 1997, COMPARED TO THE YEAR ENDED DECEMBER 31, 1996
The loss ratio (net losses incurred divided by net premiums earned) for the Company's automobile lines improved to 66.7 percent in 1997, compared to 83.7 percent in 1996. The other liability line had a loss ratio of 29.1 percent in 1997, compared to 33.4 percent in 1996. The reinsurance line also showed substantial improvement, decreasing to 59.9 percent in 1997 from 73.2 percent in 1996.
Growth in the Company's portfolio of fixed-income securities contributed to the 8 percent increase in investment income in 1997. The 1996 realized gains and other income results included $2,074,000 of interest received in connection with the settlement of a Federal Income Tax Revenue Agent Review for previous tax years.
Realized gains reported by the life segment decreased by $1,141,000 in 1997 compared to 1996. The larger gains recorded in 1996 were a result of the Company taking advantage of market conditions and selling some of its available-for-sale fixed-income securities.
Accounts receivable, all of which pertain to the property and casualty segment, are amounts due from insurance agents and brokers for premiums written, less commissions paid. The balance at December 31, 1998, of $44,868,000 has increased slightly from December 31, 1997. This change in receivables is due to the segment's flat premium growth. The Company has not experienced difficulties in collecting balances from its agents. An allowance for doubtful accounts of $731,000 has been established at December 31, 1998, compared to $1,030,000 at December 31, 1997. The Company's other assets are composed primarily of accrued investment income, property and equipment (primarily land and buildings), and reinsurance receivables (amounts due from the Company's reinsurers for losses and expenses).
The Company's largest liability is that of future policy benefits, which relates exclusively to the life segment. The liability increased by $92,752,000, or 19 percent, between December 31, 1997 and December 31, 1998. Future policy benefits are increased immediately by the full premiums paid by policyholders for annuity products and most universal life products. As these product lines have grown, the future policy benefits have grown proportionately. Claims and settlement expenses which relate to the property and casualty segment also increased in 1998. Direct and assumed reserves established for losses and expenses have increased $19,349,000 to $251,117,000, when compared to December 31, 1997. Of this increase, $4,603,000 relates to the 1998 catastrophe activity. Ceded recoverables on these losses are reflected in assets as reinsurance receivables of $12,910,000.
The Company's stockholders' equity decreased by $20,926,000 to $256,282,000 at December 31, 1998 compared to $277,208,000 at December 31, 1997. Decreases to stockholders' equity include $25,200,000 due to the retirement of 600,000 shares of treasury stock, $6,964,000 of declared dividends and net unrealized depreciation of $10,918,000. Net income increased the Company's stockholders' equity by $23,677,000.
have a financial effect upon application. The Company has not yet determined this impact. The changes would not affect the accompanying financial statements, which are based on GAAP. Prior to implementation of the codified rules, permitted statutory accounting practices are used when prescribed statutory practices do not address the accounting for transactions. The Company does not use permitted practices that individually or in the aggregate materially affect statutory surplus or risk- based capital.
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.
In addition to systems that the Company uses to conduct its business, the potential problems with the Year 2000 could also affect other aspects of the Company's operations. Such non-information systems include, but are not limited to, purchased worksheet programs, heating and air conditioning units, and building elevators. The Company has addressed all of the secondary systems in its Year 2000 project. Failure of these secondary systems would not have a material impact on the Company's operations.
Expenses incurred in connection with programming and testing have been expensed as incurred and absorbed into normal operating expenses. The Company estimates that the costs incurred during 1998 in connection with the Year 2000 project have totaled approximately $175,000. The Company believes the remaining costs for Year 2000 compliance will include salaries and overhead for existing company personnel of approximately $175,000 and replacement of hardware of approximately $150,000. Costs incurred prior to 1998 for the Year 2000 effort were salaries of approximately $900,000. No computer hardware or software was purchased specifically to replace non-compliant systems. Since the mid 1990s, any purchases of new hardware or software replacing obsolete systems were required to be Year 2000 compliant.
The failure of the Company's systems or the systems of its vendors to be compliant with the Year 2000 could result in the incorrect processing of critical financial and operational information. The Company is analyzing its processing in an effort to identify the nature and magnitude of problems that could result from such programming errors. The Company is preparing a contingency plan that will detail alternative processing methods in the event that systems, including secondary systems, fail. The Year 2000 contingency plan is expected to be completed by July 1, 1999.
The acquisition is conditioned upon approval by American Indemnity's common shareholders, approvals from insurance regulators in Texas, Colorado and Iowa, where the insurance companies are domiciled, compliance with all applicable provisions of the Hart-Scott-Rodino Antitrust
Last year, your Company's earnings were down 18 percent to $23,677,000 or $2.28 per share, compared to $28,732,000 or $2.68 per share for 1997. Poor underwriting results in your Company's property and casualty business were partially offset by an outstanding year for United Life Insurance Company and gains realized on the sale of securities. Neither Mother Nature nor the god who controls casualty claims was very kind to us.
Direct catastrophe losses in 1998 amounted to $21,000,000 compared with less than $7,000,000 in 1997. In four of those storms, your Company's losses exceeded $3,000,000. The two most noteworthy were the tornado that destroyed the small town of Spencer, South Dakota, on May 30 and September's Hurricane Georges. In Spencer, we estimate we had insured at least one of every four buildings destroyed. It's too bad we don't have that kind of market penetration in Cedar Rapids, Kansas City or Lincoln. That storm cost your Company more than $4,500,000. Hurricane Georges made landfall near Pascagoula, Mississippi, on September 27, and cost your Company over $4,000,000 in both direct and reinsurance losses.
Just as in 1992 when Mother Nature decided to teach the insurance business a lesson with Hurricane Andrew, our casualty experience was not very good, particularly workers' compensation, which had a 78.3 percent loss ratio. Apparently, the God of Casualty Claims decided we needed a dose of humility. The deterioration in our workers' compensation experience was the result of a combination of reckless competition, renewed inflation in health care costs and management shortcomings. The management problems have been addressed, the other problems may take a little longer. Workers' Compensation is too important a line to walk away from.
As stockholders, your natural question should be, "Is 1999 going to be any better?" I certainly hope so, but maybe I should answer that question by quoting those immortal words mumbled by our illustrious President: "That depends on what your definition of "is" is."
Of the $155,000,000 in statutory premiums, $120,000,000 were annuities. Among the Iowa-based companies including companies like Aegon, the Principal and the Equitable - your Company was the second largest annuity writer in Iowa in 1997, the latest year for which figures are available. We are confident we maintained that position in 1998. We now have over $400,000,000 in annuity reserves on which we have been able to maintain our spreads, even in an environment of declining interest rates. Last year, we earned a 7.7-percent return on the average invested assets in United Life, only ten basis points less than the year before.
Bottom line, in 1998, your Company earned $23,677,000 or $2.28 per share, compared to $28,732,000 or $2.68 per share the year before (approximately 636,000 or 6 percent of the shares outstanding were retired during 1998). Last year's earnings included $22,796,000 in realized investment gains, which amounted to 96 percent of our total earnings, compared to only $2,676,000, or less than 10 percent of earnings the year before. We recall hearing something about "irrational exuberance" and thought it might be prudent to take some of the profits we had in our stock portfolio. Unfortunately, that means our operations contributed very little to our bottom line as the good earnings of our life insurance business were offset by the losses in our property and casualty business.
Thanks to the hard work of Spike Hulit and his team at the Addison Insurance Company, we completed, in August, a month ahead of schedule, the transfer of our Lombard, Illinois operation to Cedar Rapids and the reorganization of our Midwest operations, with Lincoln assuming responsibility for North and South Dakota. As a result, we were able to reduce our payroll by approximately 20 employees. Not only is it gratifying to be able to report we were
able to realize substantial savings by this move, we were pleased with the number of our Lombard staff who decided to stay with us and move to Cedar Rapids. Spike did an outstanding job of selling Cedar Rapids. Maybe that is one of the advantages of not being from here. Of course, a good salesman can sell anything and Spike is a very good salesman.
The property and casualty business is notoriously cyclical. Many investment gurus counsel their clients to play that cycle and buy insurance stocks when the underwriting cycle reaches its nadir or, better yet, before it turns. One problem I have with that approach is that after more than 50 years in the business, I know less about that cycle now than I did when I started. However, it might be interesting to look at what some savvy insurance investors are doing.
Last June, Warren Buffett announced he would increase his interest in the insurance business by buying General Reinsurance. He was so interested in doing the deal, he broke one of his own rules and used something, if you believe everything he says, that he thinks is better than cash - Berkshire-Hathaway stock - to pay for it.
Another transaction that caught our attention was CIGNA's decision to exit the property and casualty business and sell it to ACE Ltd., a smart, aggressive insurance company with global ambitions. While we are not personally familiar with ACE, based in Bermuda, we understand it's run by some very capable refugees from the AIG. It's been our observation that anytime you can bet against CIGNA, it's usually a good way to make some money.
Also, W.R. Berkley, an insurance holding company, put its 10 regional property and casualty companies up for sale. This bothered us; we know Bill Berkley, we compete against a number of his companies and he's a good operator. We thought, for a while, that maybe he knew something we didn't. We were relieved when a couple months ago he announced he was taking them off the market and reorganizing them, something we could never understand why he hadn't done years ago.
No commentary on the year before the year that ends the millennium (although we all know the millennium won't really end until December 31, 2000) would be complete without a few words about those three little symbols "Y2K." Because of the long-term nature of some of the surety bonds we write and our life products, our programmers started working on upgrading our systems in the early 1990s and have tested our systems again and again. The latest test of critical systems was completed in December 1998 and all systems tested passed with flying colors.
At its August 21, 1998, meeting, your Board of Directors adopted a non-qualified stock option plan. Normally, this would not be good news to stockholders, as such plans are often used by management to enrich itself at the expense of stockholders. This is not why we adopted our plan. It is my hope that this plan will be primarily used as a reward and incentive for our good insurance technicians and middle management - underwriters, claims people, programmers, etc. - who may not be adequately compensated under conventional salary administration plans, the people upon whom the Company depends for its future success.
For the sixth consecutive year, Ward Financial Group, a highly recognized firm of insurance consultants, named your Company one of the 50 outstanding property and casualty companies in the United States, based on performance and security.
On May 19, your Board of Directors increased the dividend on your stock 6 percent to $.68 per share.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1998 AND 1997
CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
Premiums are reflected in income on a daily pro rata basis over the terms of the respective policies. Unearned premium reserves are established for the portion of premiums written applicable to the unexpired term of policies in force.
were issued. Health reserves are stated at amounts determined by estimates on individual cases and estimates of unreported claims based on past experience. Liabilities for universal-life-type and investment contracts are stated at policyholder account values before surrender charges. Liabilities for traditional immediate annuities are based primarily upon statutory reserves.
Policy claim liabilities are determined using actuarial estimates. These estimates are based on historical information along with certain assumptions about future events. Changes in assumptions for such things as medical costs, environmental hazards, and legal actions, as well as changes in actual experience could cause these estimates to change in the near term.
The Company expects to realize a spread of approximately 1.6 percent to 2.0 percent 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.
Investments in held-to-maturity fixed-income securities are recorded at amortized cost. The Company has the ability and intent to hold these investments until maturity. If, however, a permanent impairment occurs in a security, the Company writes the security down to the new value. Available-for-sale fixed-income securities, equity securities and other long-term investments are recorded at fair value. Mortgage loans are recorded at the unpaid balance amount. Policy loans and short-term investments are recorded at cost. Included in investments at December 31, 1998 and 1997, are securities on deposit with various regulatory authorities as required by law with carrying values of $651,173,000 and $543,801,000, respectively.
Realized gains or losses on disposition of investments are included in the computation of net income. Cost of investments sold is determined by the specific identification method. Changes in unrealized appreciation and depreciation, resulting from available-for-sale fixed-income securities, equity securities, other long-term investments and certain life deferred policy acquisition costs are reported as direct increases or decreases in stockholders' equity, less applicable income taxes.
For purposes of reporting cash flows, cash and cash equivalents include cash and non-negotiable certificates of deposit with original maturities of three months or less. Negative cash balances are included in accrued expenses and other liabilities. Income taxes paid during 1998, 1997 and 1996 were $11,201,000, $5,789,000 and $8,201,000, respectively. The Company received $2,074,000 in interest on Federal Income Taxes in 1996. There were no other significant payments of interest other than interest credited on policyholders' accounts in 1998, 1997 or 1996.
The Company files a consolidated Federal Income Tax return. Deferred tax assets and liabilities are determined at the end of each period, based on differences between the financial statement bases of assets and liabilities and the tax bases of those same assets and liabilities, using the currently enacted statutory tax rates. Deferred income tax expense is measured by the change in the net deferred income tax asset or liability during the year.
The Company adopted Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share" effective December 1997. This standard supersedes APB Opinion No. 15 "Earnings Per Share" and simplifies the standards for computing and presenting earnings per share ("EPS"). Under the new standard, the presentation of primary EPS has been replaced with a presentation of basic EPS. Basic EPS is computed excluding dilution caused by common stock equivalents such as stock options. The presentation of fully diluted EPS has been replaced with a presentation of diluted EPS, which is calculated in a similar fashion to how fully diluted EPS had been computed. This standard did not have a material effect on the Company's Consolidated Financial Statements or Notes to Consolidated Financial Statements.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," effective for all fiscal quarters for fiscal years beginning after June 15, 1999. A company may also implement SFAS No. 133 as of the beginning of any fiscal quarter after issuance. SFAS No. 133 cannot be applied retroactively. The new statement requires all derivatives (including certain derivative instruments imbedded in other contracts) to be recorded on the balance sheet as either an asset or a liability at fair value and establishes special accounting for certain types of hedges. The Company has had limited involvement with derivative financial instruments, and does not engage in the derivative market for hedging or speculative purposes. However, as part of the implementation of SFAS No. 133, the Company was allowed to reassess its held-to-maturity portfolio without "tainting" the remaining securities classified as held-to-maturity. The impact on the Company's Consolidated Financial Statements due to the reclassification from held-to-maturity to available-for-sale, effective January 1, 1999, increased the carrying value of available-for-sale fixed-income securities by approximately $9,250,000 and other comprehensive income by approximately $6,013,000, net of deferred income taxes.
SOP 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use," was issued in March 1998 and is effective for fiscal years beginning after December 15, 1998. This SOP requires that certain costs related to the development or purchase of internal-use software be capitalized and amortized over the estimated useful life of the software. The SOP also requires that costs related to the preliminary project stage and the post-implementation and operations stage of an internal-use computer software development project be expensed as incurred. The SOP will change the timing of the Company's software development expenses and the impact is not expected to have a material effect on the Company's Consolidated Financial Statements or Notes to Consolidated Financial Statements.
A reconciliation of the amortized cost (cost for equity securities) 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, 1998 and 1997 is as follows.
Proceeds from sales of available-for-sale investments during 1998, 1997 and 1996 were $78,471,000, $27,390,000, and $35,251,000, respectively. Gross gains of $23,208,000, $3,242,000, and $3,499,000, respectively, were realized on those sales. Gross losses of $385,000, $15,000 and $342,000, respectively, were realized on those sales in 1998, 1997 and 1996.
The net investment income for the years ended December 31, 1998, 1997 and 1996 is composed of the following.
The Company estimated the fair value of its financial instruments based on relevant market information or by discounting estimated future cash flows at estimated current market discount rates appropriate to the particular asset or liability shown.
In most cases, quoted market prices were used in determining the fair value of fixed maturities, equity securities and short-term investments. Where quoted market prices were unavailable, the estimate was based on recent trading. Market values for collateralized mortgage obligations were provided by various data vendors. Other long-term investments, consisting primarily of holdings in limited partnership funds, are valued by the various fund managers. In management's opinion, these values reflect fair value at December 31, 1998 and 1997.
A summary of the carrying value and estimated fair value of assets and liabilities meeting the definition of financial instruments at December 31, 1998 and 1997 is as follows.
The Company maintains a $15 million line of credit with a local bank. During 1998, the Company borrowed funds against the line of credit, with a maximum outstanding balance of $3,450,000. Under the terms of the agreement, interest on outstanding notes is payable at the lender's prevailing prime rate. There is no loan balance outstanding as of December 31, 1998. Interest expense in connection with the line of credit borrowing was $11,000 in 1998. During 1997, the Company borrowed $1,000,000 against the line of credit for four days.
The table below provides an analysis of changes in losses and LAE reserves for 1998, 1997 and 1996 (net of reinsurance amounts). Changes in the reserves are reflected in the income statement for the year when the changes are made. Loss and LAE development on claims occurring in prior years benefited underwriting profit (before tax) by $26,615,000 in 1998 and $33,544,000 in 1997. These gains are due in part to the effects of settling reported (case) and unreported (IBNR) reserves from claims established in prior years for less than expected.
Statutory stockholders' surplus and net income at December 31, 1998, 1997 and 1996 and for the years then ended are as follows.
The Company and its insurance subsidiaries prepare their statutory financial statements in conformity with practices prescribed or permitted by their state of domicile. Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners ("NAIC"), as well as state laws, regulations and general administrative rules. The NAIC is currently working on a project to codify insurance statutory accounting practices. The Company expects the State of Iowa to adopt codification by January 1, 2001, and the Company expects the new rules to have a financial effect upon application. The Company has not yet determined this impact. The changes would not affect the accompanying financial statements, which are based on GAAP. Prior to implementation of the codified rules, permitted statutory accounting practices are used when prescribed statutory practices do not address the accounting for transactions. The Company does not use permitted practices that individually or in the aggregate materially affect statutory surplus or risk-based capital.
The following table provides a reconciliation of the changes in the plans' benefit obligations and fair value of plan assets and a statement of the funded status for 1998 and 1997.
The following table provides the components of net periodic benefit cost for the plans for 1998, 1997 and 1996.
For measurement purposes, a 9.0% annual rate of increase in the per capita cost of covered health care benefits was assumed for 1998. The rate was assumed to decrease gradually each year to a rate of 5.5% for 2005 and remain at that level thereafter. For dental claims, a 6.5% annual rate of increase was assumed for 1998, decreasing gradually to 5.0% for 2004 and thereafter.
The Company has a profit sharing plan in which employees who meet service requirements are eligible to participate. The amount of the Company's contribution is discretionary and is determined annually but cannot exceed the amount deductible for Federal Income Tax purposes. The Company's contribution to the plan for the years ended December 31, 1998, 1997 and 1996, was $883,000, $936,000 and $717,000, respectively.
The property and casualty segment markets most forms of commercial and personal property and casualty insurance products, including fidelity and surety bonds and reinsurance. The business is generated through approximately 1,660 independent agencies and brokers in 36 states, with 65 percent of the Company's direct premiums originating in nine Midwestern states in 1998.
Depreciation expense and property and equipment acquisitions for the years ended December 31, 1998, 1997 and 1996, are reflected in the property and casualty insurance segment.
We have audited the accompanying consolidated balance sheets of United Fire & Casualty Company (an Iowa corporation) and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1998. These consolidated financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audits.
Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplementary data (Schedule III-Supplementary insurance information, Schedule IV-Reinsurance, and VI-Supplemental information concerning property and casualty insurance operations) are presented for purposes of additional analysis and are not a required part of the basic financial statements. This information has been subjected to the auditing procedures applied in our audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.