Income Statement Data: Gross premiums written $538,036 $451,513 $364,991 $322,613 $300,293 Premiums ceded 46,804 53,614 42,066 38,573 60,506 -------- -------- -------- -------- -------- Net premiums written $491,232 $397,899 $322,925 $284,040 $239,787
Losses and loss adjustment expenses 337,784 293,513 213,505 173,500 144,586 Policy acquisition costs 133,931 110,341 93,103 76,725 64,946 General and administrative 10,422 6,458 7,206 6,280 5,395 Interest 6,851 5,708 3,218 2,592 2,565 Other expenses (a) 3,673 932 1,604 2,433 676 -------- -------- ------- -------- ------ Total expenses 492,661 416,952 318,636 261,530 218,168 -------- -------- ------- -------- -------
Statutory Operating Ratios: Loss 70.1% 75.3% 66.3% 67.3% 65.7% Expense 31.2 30.3 30.5 31.3 32.4 ---- ---- ---- ---- ---- Combined 101.3% 105.6% 96.8% 98.6% 98.1% ===== ===== ==== ==== ====
GAAP Operating Ratios: Loss 70.1% 75.3% 66.3% 67.4% 65.7% Expense 30.0 30.0 31.2 32.2 32.0 ---- ---- ---- ---- ---- Combined 100.1% 105.3% 97.5% 99.6% 97.7% ===== ===== ==== ==== ====
Year Ended December 31, ----------------------------------------------------- 1996 1995 1994 1993 1992 ---- ---- ---- ---- ---- (In thousands, except per share amounts and ratios)
Ratio of Net Premiums Written to Policyholders' Surplus (b) 1.94 2.19 2.42 2.32 2.26
On July 18, 1995, the Company completed its acquisition of Viking. The Viking acquisition has enabled the Company to increase its nonstandard private passenger automobile premiums, as well to expand its personal lines business into new territories, strengthen its personal lines market share position in existing states, and provide further flexibility in marketing its personal lines products. Calendar year 1996 is the first full year in which Viking's operating results are included in the consolidated financial statements. During 1995, Viking's operating results were included in the consolidated financial statements from the acquisition closing date forward. See Note 3 to the Consolidated Financial Statements for further discussion related to the Viking acquisition.
In July 1996, Company management announced a decision to integrate the Viking and Guaranty National personal lines divisions into one personal lines business unit. This decision was reached, in part, by the recognition of a trend in the nonstandard personal lines insurance industry which emphasizes the importance of a lower expense ratio. During the fourth quarter of 1996, a personal lines business unit President was named. The new President and the personal lines leadership group have begun to make management and staffing assignments for the personal lines business unit, and to focus on agency, geographic and product integration. The personal lines integration effort will continue throughout 1997. In addition to the decision to integrate the personal lines business unit, Company management evaluated the commercial specialty and general divisions during the third quarter of 1996. This evaluation led to a decision to reorganize into a contracts and brokerage division and a programs department. Company management expects this reorganization will enable the Company to operate more efficiently and to better serve its respective markets. The commercial standard division will, however, remain separate. Reorganization activities within these two commercial divisions will continue into 1997. As a result of these recent management decisions, the financial results of the personal lines business unit will no longer be delineated by division and the financial results of the commercial lines unit will be discussed in total.
controlled by Viking, issued a $1,300,000 surplus debenture to Viking. See Note 14 to the Consolidated Financial Statements for further discussion of this surplus debenture. As of December 31, 1996, the Company had no direct real estate or mortgages in its investment portfolio, other than investments in federal agency mortgage pools.
The Company maintains 62% of its investment portfolio in investment grade (rated "BBB" or above) fixed maturities. It invests a portion of its assets in noninvestment grade (rated "BB" or below) bonds and preferred stocks in order to increase its overall yield on its investment portfolio. At December 31, 1996, the Company had noninvestment grade fixed maturity securities of $55,205,000 with an estimated fair value of $56,477,000. Such securities were approximately eight percent of total invested assets at December 31, 1996, compared to approximately six percent at December 31, 1995. Securities which are not rated by independent rating services are assigned the comparable rating of the National Association of Insurance Commissioners. At December 31, 1996, less than one percent of total fixed maturity investments were not current on interest payments.
The personal lines business unit experienced a $60,263,000, or 31%, increase in gross premiums written in 1996 compared to 1995. The premium volume growth was the result of the Viking acquisition. Prior to the acquisition of Viking in 1995, the Company did not write personal lines business in the state of California. During 1996, this state accounted for 34% of the unit's total gross premiums written. The remaining net increase in this unit's gross premiums written represented the net effect of both increases in other states in which Viking writes business, and decreases in gross premiums written in several states where actions have been focused on improving the unit's profitability.
The personal lines business unit GAAP combined ratio decreased to 97.6% for the year ended December 31, 1996. The 7.3 point improvement was the result of a lower loss ratio (incurred losses and loss adjustment expense). The lower loss ratio resulted from a 9.3 point decrease in the incurred losses component, which was offset by a 2.0 point increase in the loss adjustment expense component. The decreased incurred losses component was primarily due to lower claim severity, as well as estimated incurred but not reported losses at the beginning of the year developing lower than expected. The increased loss adjustment expense component was due to this unit's emphasis on improved claim handling and on fighting insurance fraud, which resulted in increased legal expenses and increased staffing in the unit's Special Investigative Unit. Additionally, in the prior year the Company strengthened its personal lines loss and loss adjustment expense reserves by $5,010,000. Conversely, during 1996, prior year reserves were decreased as the result of lower than expected claim costs on settlement.
Collateral protection insurance, the Company's third operating unit, increased 1996 gross premiums written 46% to $79,089,000, compared to 1995. This significant increase was primarily due to this unit's two newest products, GAP and mortgage fire insurance. The gross premiums written from GAP and mortgage fire insurance increased approximately $16,534,000 over the prior year. Additionally, premiums from this unit's automobile business increased approximately $10,266,000 in 1996, compared to 1995. These increases were partly offset by a $3,282,000 decrease in gross premium written in Puerto Rico.
The Company operates under a primary reinsurance contract that provides both excess of loss and property catastrophe coverage up to $6,000,000 per occurrence for all major lines of business. The primary reinsurance contract for 1996 was with National Reinsurance Corporation ("NRC"), which is now owned by General Reinsurance Corporation ("General Re"), and served to limit the Company's maximum loss per occurrence on individual risks to $400,000 and for catastrophes to $500,000, through June 30, 1996. Effective July 1, 1996, as a result of the acquisition of NRC by General Re, the Company's contract was renegotiated under the terms of the treaty at a more favorable rate and the retentions were modified. The Company's maximum loss per occurrence on casualty losses remained at $400,000. However, on property losses it was reduced to $300,000, and on catastrophe losses it was increased to $600,000. Also, the contract will terminate December 31, 1997 rather than December 31, 1998.
The Company has purchased an additional layer of catastrophe coverage up to 95% of $14,000,000 per loss occurrence, for total catastrophe protection of $20,000,000. The Company continues to utilize facultative reinsurance for certain risks, primarily umbrella and property coverages, and quota-share reinsurance.
The Company's insurance operating units, in total, experienced $995,000 of favorable development in 1996 on 1995 and prior loss reserves, net of reinsurance. This compares to $12,787,000 of adverse development in 1995 on 1994 and prior loss reserves, net of reinsurance. The development equates to (0.3%) and 7.1% of loss reserves carried at December 31, 1995 and 1994, respectively. The small amount of redundant development in 1996 was primarily due to estimated incurred but not reported (IBNR) losses at the beginning of the year developing lower than expected, as well as better than expected settlement on 1995 personal lines acquired reserves. The favorable development within the personal lines business unit was partially offset by general liability losses and loss adjustment expenses on reported claims developing higher than expected, and collateral protection incurred but not reported losses developing higher than expected. The high adverse development in 1995 on prior accident years was primarily due to personal and commercial automobile liability losses on both reported and unreported claims developing higher than expected.
During 1996, the Company's catastrophic losses amounted to $1,689,000, or $0.11 per share, net of tax and reinsurance recoveries. This compares to $1,615,000 in catastrophic losses, or $0.12 per share, net of tax and reinsurance recoveries, during 1995. The catastrophic losses mainly affected the commercial and personal lines operating units, and primarily related to storms in the Central United States, Hurricane Fran and Hurricane Bertha.
Company management believes that its prudent level of reinsurance, as discussed above, and spread of coverage over a variety of geographic areas limits the Company's exposure to catastrophic events.
The Company's 1996 interest expense increased $1,143,000, or 20%, compared to 1995. This increase was due to an overall increase in bank borrowings during mid-1995. The 1995 borrowings were used to fund the Viking acquisition, and are pursuant to a reducing, revolving credit facility, which provides for a floating interest rate. In order to reduce the risk of changing interest rates, in 1995 the Company entered into two interest rate swap agreements to hedge $80,000,000 of the total borrowings until 1998. These agreements have given the Company a fixed interest rate, including the applicable London Interbank Offered Rate (LIBOR) margin outlined in the Company's reducing, revolving credit facility, of approximately 6.3% on the $80,000,000. See Note 11 to the Consolidated Financial Statements for further discussion of the interest rate swap transactions.
Overall, the Company's net earnings increased $18,577,000, to $27,506,000, for the year ended December 31, 1996, compared to the year ended December 31, 1995. Net earnings per common share were $1.84 at year end 1996, versus $0.67 at year end 1995. The majority of the improvement in the Company's net earnings and net earnings per common share was attributable to increased profitability in the Company's personal lines business unit. In the prior year, net earnings and net earnings per common share were substantially reduced by a $9,081,000, or $0.68 per share, net of tax, reserve strengthening charge within the personal and commercial units.
Gross premiums written increased 24% to $451,513,000 in 1995, from $364,991,000 in 1994. The personal lines business unit, experienced a $66,024,000, or 50%, increase in gross premiums written in 1995 compared to 1994. The majority of the premium volume growth was a result of the acquisition of Viking, which accounted for $61,766,000 of the overall increase in the personal lines business unit gross premiums written during 1995. The remaining increase in gross premiums written was primarily due to expansion into Indiana, Louisiana, and Ohio.
The collateral protection business is characterized by a loss ratio that is significantly lower, and an expense ratio that is significantly higher, than most other lines of business. However, during 1995 this unit improved its expense ratio by 5.0 points due to lower overall agency commissions. Additionally, during 1995 more blanket single interest policies were sold, which normally have a lower acquisition cost.
The consolidated net premiums written increased $74,974,000, or 23%, in 1995, compared to the previous year, primarily due to a higher volume of business as explained above. Premiums ceded to reinsurers, as a percentage of gross premiums written, remained constant during 1995. Increased commercial lines reinsurance costs were offset by increased personal lines business, which has a lower reinsurance charge than commercial lines due to the lower liability limits on personal lines policies. The Company maintains reinsurance treaties which cover almost all lines of business on an excess of loss basis, and which limit the Company's liability on catastrophe losses.
During 1995, the Company's known exposure to environmental losses, such as asbestos and pollution contamination, did not materially change. Based on the minimal claim activity to date and the nature of the business
written, primarily automobile coverage, the Company does not believe that it has a material exposure to environmental losses.
As a result of an overall increase in borrowings during 1995, the Company's interest expense increased $2,490,000, or 77%, compared to 1994. The borrowings were used to finance the Viking acquisition, discussed above and in more detail in Note 6 to the Consolidated Financial Statements. The borrowings are pursuant to a reducing, revolving credit facility entered into in June 1995, which provides for a floating interest rate. In order to reduce the risk of changing interest rates, during the third quarter of 1995 the Company hedged $80,000,000 of the total borrowings until 1998, by entering into two interest rate swap agreements, giving the Company a fixed interest rate. See Note 11 to the Consolidated Financial Statements for further discussion of the interest rate swap transactions.
Pretax net investment income increased $7,400,000 in 1995, compared to 1994, and after-tax net investment income increased $5,698,000 for the same period. These increases are primarily due to a 30% increase in average invested assets, which resulted primarily from the addition, effective July 18, 1995, of the Viking investment portfolio and positive operating cash flow. Viking's investment portfolio amounted to approximately $177,400,000 at the date of acquisition. Excluding Viking, the Company's after-tax net investment income increased 14%, to approximately $21,601,000, in 1995. The investment yield, on an after-tax basis, remained constant at approximately five percent. After-tax realized investment gains in 1995, and 1994, were $2,139,000 and $1,955,000, respectively. Other-than-temporary investment impairments of $1,388,000, after-tax, were recorded during 1995, while no impairments were deemed necessary during 1994.
The unrealized investment gains on fixed maturities available for sale and on equity securities as of December 31, 1995, were $12,063,000 and $11,814,000, respectively. The unrealized gain on the fixed maturities held to maturity portfolio was $2,126,000 as of December 31, 1995. The market value of the Company's fixed maturity investments generally varies inversely with changes in the general level of interest rates. The market value of Federal agency and other mortgage pool securities is subject to additional market value volatility due to the impact of changes in prepayment rates on the mortgages which underlie such securities.
The income tax benefit was 21.8% of pre-tax income in 1995 versus income tax expense of 23.8% in 1994. The 1995 income tax benefit was a combination of underwriting losses and nontaxable interest income and dividends received deduction.
Overall, the Company's net earnings decreased $13,622,000, for the year ended December 31, 1995, compared to the year ended December 31, 1994. Net earnings per common share were $0.67 for 1995, versus $1.86 for 1994. For the year ended December 31, 1995, the strengthening of the Company's loss reserves accounted for $9,081,000, or $0.68 per share, net of tax, of the decrease. The remaining decrease in earnings per share for the year is attributable to the increased loss ratios within the commercial and personal operating units.
The Company's operations have produced positive operating cash flow during the past nine years. Net cash provided by operating activities was $44,436,000, $29,101,000, and $39,478,000 for 1996, 1995 and 1994, respectively. The increase in operating cash flow in 1996, compared to 1995, was mainly the result of higher premiums and net investment income collected, as well as lower income tax payments. Additionally, the Company paid less agency contingent commissions during the current year, compared to the prior year. These fluctuations were partially offset by higher levels of loss and loss adjustment expense payments, policy acquisition costs and interest paid during 1996, compared to 1995. Overall, during 1996 the ratio of losses and loss adjustment expenses paid to losses and loss adjustment expenses incurred increased approximately 9%, when compared to this same ratio for 1995.
Net cash used in investing activities amounted to $38,506,000, $120,685,000, and $35,171,000 for 1996, 1995 and 1994, respectively. The $82,179,000 decrease in cash used in investing activities during 1996, compared to 1995, mainly related to a decline in cash used to acquire subsidiaries. As discussed above, in the prior year the Company acquired Viking. However, in the current year there were no acquisitions of subsidiaries. The decrease in funds used to acquire subsidiaries was offset, in part, by a net increase in purchases of all types of investments. The increased investment purchases were partially offset by increased sales and maturities of equity and fixed maturity securities.
Net cash used in financing activities was $8,736,000 in 1996, versus net cash provided by financing activities of $88,769,000 and $1,315,000 in 1995 and 1994, respectively. The net cash provided by financing activities during 1995 was used to finance the Viking acquisition. During 1996, the Company paid approximately $1,313,000 in principal payments on its 6.5% term loan, which is discussed in Note 6 to the Consolidated Financial Statements. As of December 31, 1996, the Company had $10,000,000 available under its reducing, revolving credit facility. The Company declared and paid a regular quarterly dividend of $0.125 in each of the four quarters during 1996.
Securities are classified as available for sale and carried at estimated fair value, unless they meet the Company's criteria to be classified as held to maturity. Such criteria include investment grade bonds with stated maturities less than 10 years. The unrealized investment gains on fixed maturities available for sale and on equity securities as of December 31, 1996, were $7,875,000 and $18,444,000, respectively. Overall, the unrealized gains on equity securities increased $6,630,000 during 1996, compared to 1995, due to the strong stock market. The December 31, 1996 unrealized gain on the fixed maturities held to maturity portfolio was $1,160,000. The estimated fair value of the Company's fixed maturity investments generally varies inversely with changes in the general level of interest rates. The estimated fair value of federal agency and other mortgage pool securities is subject to additional fair value volatility due to the impact of changes in prepayment rates on the mortgages which underlie such securities.
On July 2, 1996, Orion consummated its cash tender offer, which is discussed above, and purchased 4,600,000 shares of the Company's common stock at a price of $18.50 per share. In addition, on July 17, 1996 Orion purchased an additional 120,000 shares of the Company's common stock in the open market, increasing their ownership percentage of
On July 18, 1995, the Company acquired Viking for approximately $94,681,000 in cash, including acquisition expenses and net of cash acquired. In return, the Company received the common stock of Viking, with net assets valued at $86,613,000. Additionally, because Viking controls VCM, the Company and its affiliates receive 100% reinsurance services in the state of Texas from VCM. See Note 9 to the Consolidated Financial Statements for further discussion of the 100% reinsurance arrangement.
In conjunction with the Viking acquisition, there is an additional purchase price amount which may ultimately be paid to the seller depending on Viking's future loss development. This additional purchase price amount is estimated to be $4,333,000. See Note 3 to the Consolidated Financial Statements for further discussion of this obligation. There are no other significant contingencies or commitments known to management that would have a material impact on the Company's liquidity or financial condition.
In May 1996, Viking moved its Freeport, Illinois operations from a leased facility into an office building which was acquired by Viking in February 1996, for approximately $1,300,000. In May 1994, the Company consolidated its Colorado operations to a new facility, which provides facilities to support future growth. Expenditures for the new facility totaled $16,208,000, primarily funded from operating cash flow. Total nonrecurring relocation charges were $838,000 in 1994.
Some of the statements made in this Form 10-K Report, as well as statements made by the Company in periodic press releases, oral statements made by the Company's officials to analysts and shareholders in the course of presentations about the Company and conference calls following earnings releases, constitute "forward- looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 (the "Reform Act"). Such forward- looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Such factors include, among other things, (i) general economic and business conditions; (ii) interest rate changes; (iii) competition and regulatory environment in which the Company operates; (iv) claims frequency; (v) claims severity; (vi) severe adverse weather conditions; (vii) the cost of automobile repair; (viii) the number of new and renewal policy applications submitted by the Company's agents; and (ix) other factors over which the Company has little or no control.
The management of Guaranty National Corporation is responsible for the consolidated financial statements and the information included therein. The consolidated financial statements are fairly presented and have been prepared in accordance with generally accepted accounting principles and are appropriate in the circumstances, and, where necessary, include amounts based on management's informed estimates and judgments.
The Company has an internal control structure which it believes provides reasonable assurance that assets are safeguarded from loss or unauthorized use, transactions are recorded in accordance with management's policies and that the financial records are reliable for preparing consolidated financial statements. The internal control structure includes written policies and procedures which are communicated to all appropriate personnel and updated as necessary.
Compliance with the internal control structure is continuously maintained and monitored by management. The internal audit staff of the Company evaluates and reports on the adequacy of and adherence to these controls, policies and procedures. In addition, as part of its audit of the consolidated financial statements, Deloitte & Touche LLP, the independent auditors for the Company, evaluate the Company's internal control structure to the extent they consider necessary to express an opinion on the consolidated financial statements. Recommendations concerning the internal control structure are provided by both the internal auditors and Deloitte & Touche LLP, and management takes actions which are believed to be appropriate responses to these recommendations.
The Audit Committee of the Board of Directors is comprised of independent directors, and has general responsibility for oversight of financial controls and audit activities of the Company and its subsidiaries. The Audit Committee, which reports to the Board, annually reviews the qualifications of the independent auditors and meets periodically with them, the internal auditors and management to review the plans for and results of the audits. Both internal and independent auditors have free access to the Audit Committee, without members of management present, to discuss the adequacy of the internal control structure and any other matters which they believe should be brought to the attention of the Audit Committee.
We have audited the accompanying consolidated balance sheets of Guaranty National Corporation and subsidiaries ("the Company") as of December 31, 1996 and 1995, and the related consolidated statements of earnings, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
December 31, ----------------------- 1996 1995 ---- ---- Investments: Fixed maturities held to maturity, at cost $ 80,271 $ 75,017 Fixed maturities available for sale, at market 390,290 395,198 ------- ------- 470,561 470,215 Equity securities, at market 88,102 85,085 Other long-term investments 13,585 11,521 Short-term investments available for sale, at market 94,993 52,257 ------- ------- Total investments 667,241 619,078 Cash 3,988 6,794 Accrued investment income 7,971 7,603 Accounts receivable, (less allowance of $171 - 1996; $374 - 1995) 45,557 51,638 Reinsurance recoverables and prepaids, (less allowance of $200 - 1996; $200 - 1995 ) 90,781 81,825 Property and equipment, (less accumulated depreciation of $13,508 - 1996; $9,326 - 1995) 29,833 31,573 Deferred policy acquisition costs 44,456 37,637 Goodwill, (less accumulated amortization of $6,423 -1996; $5,263 - 1995) 34,639 33,133 Other assets 4,626 5,892 -------- -------- Total assets $929,092 $875,173 ======== ========
GUARANTY NATIONAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF EARNINGS (In thousands, except per share amounts)
Year Ended December 31, ----------------------------------- 1996 1995 1994 ---- ---- ----
Earnings per common share $ 1.84 $ 0.67 $ 1.86 ======== ========= ========
Deferred Unrealized Capital Compensation Investment Common in Excess Retained on Restricted Gains Treasury Stock of Par Earnings Stock (Losses) Stock ------ --------- -------- ------------- ---------- ------- Balance, January 1, 1994 $12,480 $83,991 $45,888 $ (663) $10,793 $ Net earnings 22,551 Change in unrealized investment (losses), less applicable deferred taxes (17,854) Purchase of treasury stock (6,636) Exercise of stock options and issuance of restricted stock, net of cancellation 74 (368) 294 Amortization of deferred compensation on restricted stock 8 250 Cash dividends declared and paid (6,049) ------ --------- -------- ------------- ---------- ------- Balance Decenber 31, 1994 12,480 84,073 62,390 (781) (7,061) (6,342) Net earnings 8,929 Change in unrealized investment gains, less applicable deferred taxes 22,581 deferred taxes Exercise of stock options and issuance of restricted stock, net of cancellations 20 329 (126) 327 Amortization of deferred compensation on restricted stock 8 263 Sale of common stock 1,550 22,670 Conversion of affiliate debt 911 13,970 6,015 Cash dividends declared and paid (6,655) ------- --------- -------- ------------- ---------- ------- Balance, December 31, 1995 14,961 121,050 64,664 (644) 15,520 Net earnings 27,506 Change in unrealized investment gains, less applicable deferred taxes 1,587 Exercise of stock options, net of cancellation 14 222 Amortization of deferred compensation on restricted stock 644 Cash dividends declared and paid (7,485) ------- --------- -------- ------------- ---------- ------- Balance, December 31, 1996 $14,975 $121,272 $84,685 $ $17,107 $ ======= ======== ======= ============ ========= ========
GUARANTY NATIONAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands)
Reconciliation of Net Earnings to Net Cash Provided By Operating Activities: Net earnings $27,506 $ 8,929 $22,551 Adjustments: Depreciation 4,392 3,490 2,692 Non-cash investment income (3,969) (275) (401) Realized investment gains (8,455) (3,291) (3,007) Amortization of goodwill 1,160 883 766 Deferred tax provision (benefit) 4,164 (3,543) 24 Other 1,061 979 774 Changes in assets and liabilities: Accrued investment income (368) (763) (206) Accounts receivable 6,081 (2,782) (2,248) Reinsurance recoverables and prepaids (8,956) (6,679) (8,070) Deferred policy acquisition costs (6,819) (3,775) 187 Other assets (44) 250 (25) Unpaid losses 13,110 26,620 15,778 Unpaid loss adjustment expenses 664 5,829 4,478 Unearned premiums 8,037 12,375 3,506 Reinsurance payables and deposits (1,022) (821) (4,261) Other liabilities 7,894 (8,325) 6,940 --------- ---------- --------- Total adjustments and changes 16,930 20,172 16,927 --------- ---------- --------- Net Cash Provided by Operating Activities $44,436 $29,101 $39,478 ========= ========== =========
a. Investments - Investments in bonds and redeemable preferred stocks are carried in the accompanying consolidated balance sheets as fixed maturities. Fixed maturities for which the Company has the positive intent and ability to hold until maturity are carried at amortized cost. Fixed maturities classified as available for sale are carried at estimated fair value with any unrealized gains or losses reflected in shareholders' equity, net of applicable deferred taxes. Losses considered other than temporary are recorded in earnings as a realized loss. The Company's criteria used to identify fixed maturities held to maturity as of December 31, 1996 and 1995, generally includes investment grade bonds
Investments in common stocks and nonredeemable preferred stocks are classified as available for sale and are carried at estimated fair value, with any unrealized gains or losses of securities reflected in shareholders' equity, net of applicable deferred taxes. Losses considered other than temporary are recorded in earnings as a realized loss.
b. Losses and loss adjustment expenses - Losses and loss adjustment expenses ("LAE") are charged to operations as incurred. Losses and LAE liabilities are determined on the basis of claims adjusters' evaluations and estimates based on historical experience including estimates of incurred but not reported losses and salvage and subrogation recoveries. Such liabilities are recorded gross of applicable reinsurance. The Company does not discount the liability for unpaid losses and LAE. Management believes that the recorded liabilities are a reasonable provision for all losses and loss adjustment expenses incurred. Notwithstanding the foregoing, no assurances can be given that further reserve development may not occur in the future as the process of establishing loss and LAE reserves is, by nature, imprecise. The estimates are continually reviewed and as adjustments to these estimates become necessary, such adjustments are reflected in current operations.
c. Revenue recognition - Unearned premiums are generally computed on a daily pro-rata method over the term of the policies in-force and are carried gross of related reinsurance. Historically, the Company has not experienced significant losses related to receivables because of short payment terms and the lack of concentrations of credit risk. Thus, the carrying amount approximates estimated fair value.
d. Deferred policy acquisition costs - Policy acquisition costs are deferred and charged to operations over the periods in which the related premiums are earned. The determination of recoverability of such deferred costs includes anticipated investment income.
e. Property, equipment and depreciation - Property and equipment are recorded at cost. Depreciation is computed using the straight-line method over the estimated useful lives.
g. Goodwill - The excess of Viking's cost over fair value of net assets acquired is being amortized by the straight-line method over 40 years. The excess of Orion's cost over fair value of net assets acquired and other goodwill recorded in the consolidated balance sheet is being amortized by the straight-line method over 31 to 36 years. Reflected in other expenses is amortization of goodwill of $1,160,000, $883,000, and $766,000 for the years ended December 31, 1996, 1995 and 1994, respectively.
GNIC VICW Year ended December 31, 1996 $20,450 $ 9,366 Year ended December 31, 1995 7,875 15,866 Year ended December 31, 1994 26,324
The total cost of the acquisition was $97,225,000, with total cash paid of approximately $94,681,000, including acquisition expenses and net of $878,000 cash acquired. The total consideration exceeded the fair value of the net assets of Viking by approximately $10,612,000. The total acquisition cost differs from the announced total consideration paid of $103,000,000 due to transaction expenses, the contingent purchase price adjustments, discussed below, and a $12,000,000 extraordinary dividend taken by Talegen Holdings, Inc. ("Seller") from Viking just prior to the sale.
Any payments to or receivables from the Seller, as a result of the positive or negative loss development, will include accrued interest from the acquisition closing date at an annual rate equal to 6.28%, for the initial loss development settlement payment as of December 31, 1998. For the final loss development settlement payment, as of December 31, 2001, the interest rate will equal the mid-term Applicable Federal Rate (as defined in the Internal Revenue Service Code) in effect as of January 1, 1999.
interest payable, in the accompanying consolidated financial statements. Loss and LAE reserves of Viking were recorded at the date of acquisition at amounts consistent with the Company's estimates of additional purchase price that will be paid.
The following summarized pro forma information (unaudited) assumes the Viking acquisition had occurred on January 1, 1995 and 1994 (in thousands, except per share amounts):
The amortized cost and estimated fair values of investments in fixed maturity and equity securities are as follows (in thousands):
Fixed maturity securities available for sale: U.S. Treasury and U.S. Government agencies 112,115 1,222 548 112,789 State and municipal 156,439 6,150 165 162,424 Corporate 113,861 3,290 2,074 115,077 ------- ------ ------ ------- 382,415 10,662 2,787 390,290 ------- ------ ------ ------- Total fixed maturity securities $462,686 $ 12,073 $ 3,039 $471,720 ======= ======= ====== ======= Equity securities: Common stocks $ 42,689 $ 17,966 $ 1,240 $ 59,415 Nonredeemable preferred stocks 26,969 3,096 1,378 28,687 ------- ------- ------ ------- Total equity securities $ 69,658 $ 21,062 $ 2,618 $ 88,102 ======= ======= ====== =======
Realized investment gains and losses, which include a write- downs for other-than-temporary investment impairments of $2,135,000 as of December 31, 1995, are as follows (in thousands):
Year Ended December 31, ----------------------------------- 1996 1995 1994 ---- ---- ---- Fixed maturities held to maturity: Gains $ $ 360 $ 174 Losses (269) (21) ------ ------ ------ 91 153 Fixed maturities available for sale: Gains 1,815 1,566 2,374 Losses (1,322) (2,869) (2,657) ----- ----- ----- 493 (1,303) (283) Equity securities: Gains 9,950 6,227 3,192 Losses (1,988) (1,724) (55) ----- ----- ----- 7,962 4,503 3,137 ----- ----- ----- Total $ 8,455 $ 3,291 $ 3,007 ===== ===== =====
The Company closely monitors the financial condition of issuers of securities that it owns, and if conditions are deemed appropriate, the Company ceases to accrete, discount, accrue interest or record "pay in-kind" interest or dividends. The Company had $315,000 and $230,000 of fixed maturities at estimated fair value at December 31, 1996 and 1995, respectively, which had been non-income producing for a portion of the previous twelve months. All fixed maturities at December 31, 1994 had been income producing during the year. At December 31, 1996 and 1995, total other-than-temporary investment impairments amounted to $1,700,000 and $2,135,000, respectively. There were no other-than-temporary investment impairments at December 31, 1994. In 1995, and as a result of the Statement of Financial Accounting Standards (SFAS) No. 115 "Implementation Guide" the Company transferred certain fixed maturities from the held to maturity portfolio to the available for sale portfolio. The amortized cost of this transfer was $41,643,000 and the unrealized gain was $916,000. During 1994, the Company transferred fixed maturity securities from the held to maturity portfolio to the available for sale portfolio due to the decrease in credit ratings of three issuers. The amortized cost of this transfer was $4,219,000 and the unrealized loss was $450,000.
Concentrations of credit risk exist for groups of issuers when they have similar economic characteristics that would cause their ability to meet their obligations to be similarly affected by changes in economic or other conditions. At December 31, 1996, the Company holds $35,543,000 of fixed maturity and equity securities of public utilities and $210,029,000 of fixed maturities of state and local governments; these holdings are not collateralized. The Company does not have a concentration of credit risk with any one issuer of fixed income or equity securities.
In conjunction with the Viking acquisition, in July 1995, the Company acquired two Viking owned properties, as well as various Viking owned equipment. The Viking owned properties consist of Viking's corporate office building located in Madison, Wisconsin, and a regional claims office located in Salem, Oregon. The estimated fair value of these two facilities, as well as the equipment, totaled approximately $7,028,000 at July 18, 1995, the acquisition closing date.
During 1994, the Company relocated its Colorado operations to a new home office facility. See Note 17 for further discussion of this relocation.
On June 2, 1995, the Company entered into a $110,000,000 credit agreement ("Credit Agreement") with several participating banks. The Agreement provides for an unsecured reducing revolving credit facility, used in part to fund the Viking acquisition (See Note 3), to retire the outstanding balance of $29,000,000 under the Company's previous revolving line of credit, and for working capital and general corporate purposes.
December 31, -------------------------------------------------- Available for Sale Held to Maturity ------------------ ---------------- Estimated Estimated Amortized Fair Amortized Fair Cost Value Cost Value --------- --------- --------- --------- - ---- Due in one year or less $ 46,601 $ 46,700 $ 2,000 $ 2,000 Due after one year through five years 95,761 96,236 39,321 40,333 Due after five years through ten years 63,395 66,057 33,330 33,615 After ten years 128,284 132,981 5,620 5,482 Federal agency and other mortgage pools 48,374 48,316 ------- ------- ------- ------ $382,415 $390,290 $ 80,271 $81,430 ======= ======= ======== ======
Due in one year or less $ 33,100 $ 33,342 $ 9,816 $ 9,861 Due after one year through five years 98,425 99,124 26,346 27,411 Due after five years through ten years 66,832 68,829 28,489 29,905 After ten years 132,220 139,818 10,366 9,966 Federal agency and other mortgage pools 52,558 54,085 ------- ------- ------ ------ $383,135 $395,198 $ 75,017 $ 77,143 ======= ======= ======= =======
The estimated fair value of financial hedge instruments, both of which are held for other than trading purposes, is the estimated amount the Company would pay to terminate the interest rate swap agreements, taking into consideration current interest rates and other relevant factors. The estimated amount at December 31, 1996 and 1995 was $214,000 and $678,000, respectively.
Effective July 2, 1996, the Company will be included in Orion's consolidated federal income tax return and is covered by income tax sharing agreements under which the Company computes its current federal income tax liability on a separate return basis and pays Orion any taxes due on this basis.
Year Ended December 31, ----------------------- 1996 1995 1994 ---- ---- ---- Income from continuing operations $ 9,375 $ (1,597) $ 7,036 Shareholders' equity, for unrealized investment gains (losses) 855 12,160 (9,493) Shareholders' equity, other 8 8 ------ ------- ------ $10,230 $10,571 $(2,449) ====== ====== ======
The following table reconciles the effective tax rate to the federal statutory rate of 35 percent for pretax earnings from continuing operations (in thousands): Year Ended December 31, ------------------------------------ 1996 1995 1994 ---- ---- ---- Earnings before taxes $36,881 $ 7,332 $29,587 ====== ====== ======
Expected income tax expense $12,908 $ 2,566 $10,355 Adjustments resulting from: Dividends received deduction (1,234) (1,875) (1,528) Nontaxable interest income (3,848) (3,451) (2,754) Proration 762 799 642 Nonrecurring tender offer charge (Note 17) 409 Other, net 378 364 321 ------ ------- ------- $ 9,375 $ (1,597) $ 7,036 ====== ======= =======
The approximate prepaid and recoverable amounts of reinsurance ceded to other companies, including subsidiaries of Orion under 100% reinsurance arrangements, are as follows (in thousands):
December 31, 1996 December 31, 1995 -------------------------- -------------------------- Non-Affiliates Affiliates Non-Affiliates Affiliates -------------- ---------- -------------- ---------- Premiums prepaid $ 2,244 $ 30 $ 4,435 $ 79 Paid losses recoverable 4,780 9,016 Unpaid losses recoverable 66,633 2,197 51,491 3,438 Unpaid LAE recoverable 12,238 2,659 10,048 3,318 ------ ------ ------ ------ $85,895 $ 4,886 $74,990 $ 6,835 ====== ====== ====== ======
Incurred Incurred Incurred -------- -------- -------- Losses and LAE: Direct $361,837 $309,298 $192,183 Assumed 20,268 32,281 54,892 Ceded (44,321) (48,066) (33,570) ------- ------- ------- Net $337,784 $293,513 $213,505 ======= ======= =======
Included in direct premiums earned above, for the years ended December 31, 1996, 1995 and 1994, were $97,000, $309,000 and $1,152,000, respectively, of premiums earned under 100% reinsurance agreements with subsidiaries of Orion. Also, included in direct losses incurred above, for the years ended December 31, 1996, 1995 and 1994, were $67,000, $218,000 and $854,000, respectively, of losses incurred under these same 100% reinsurance agreements with subsidiaries of Orion.
The Company's loss and LAE reserves are summarized below (in thousands):
Provision for incurred losses and LAE: Current year 338,779 280,726 212,458 Prior years (995) 12,787 1,047 ------- ------- ------- 337,784 293,513 213,505 ------- ------- -------
Payments for incurred losses and LAE: Current year 194,667 159,208 111,418 Prior years 144,775 108,433 88,112 ------- ------- ------- 339,442 267,641 199,530 ------- ------- ------- Net balance at end of year 284,681 286,339 179,775 Plus reinsurance recoverables 83,727 68,295 61,446 ------- ------- ------- Balance at end of year $368,408 $354,634 $241,221 ======= ======= =======
The 1995 adverse development in personal lines of $2,504,000 was a result of adverse trends in claim frequency which caused higher than expected development of outstanding claims and incurred but not reported losses. Development on personal lines during 1994 was favorable. Total adverse development in commercial lines during 1995 was $10,056,000, of which $7,266,000 was caused by commercial automobile liability higher claim severity primarily in 1994 through 1992. The remaining commercial lines 1995 adverse development was from general liability and other lines. The adverse development in commercial lines in 1994 was primarily due to loss development on professional, general and commercial automobile liability claims occurring prior to 1985. These accident years accounted for $920,000 of commercial lines' adverse development in 1995 and $1,300,000 in 1994. The remaining adverse development in 1995 of $227,000 was attributable to the collateral protection business unit.
The Company primarily writes automobile coverage, and therefore has limited exposure for environmental claims. In establishing the liability for unpaid losses and LAE related to environmental claims, the Company considers facts currently known, current state of the law, and coverage litigation. Liabilities are recognized for known claims when sufficient information has been developed to indicate the involvement of a specific insurance policy, and its liability can be reasonably estimated. In addition, liabilities have been established to cover additional exposures on both known and unasserted claims. Estimates of the liabilities are reviewed and updated continually. Developed case law and adequate claim history do not exist for such claims,
especially because significant uncertainty exists about the outcome of coverage litigation and whether past claim experience will be representative of future claim experience.
At December 31, 1996, the Company had two interest rate swap agreements outstanding, with participating commercial banks, having a total notional principal amount of $80,000,000, or $40,000,000 for each bank. These agreements effectively change the Company's interest rate exposure on $80,000,000 of the $100,000,000 million principal balance outstanding under the Credit Agreement, which is discussed in Note 6, to a fixed rate. The fixed rate interest percentage paid by the Company on the total notional amounts is approximately 6.3%. Net cash payments made or received under the swap agreements have been included within interest expense.
The interest rate swap agreements terminate on March 16, 1998. The interest rate swap floating rate, which is paid by the banks to the Company, resets every three months, beginning December 20, 1995, which coincides with the LIBOR determination dates available on the outstanding principal balance under the Company's Credit Agreement. The floating interest rate under the swap agreements is based upon the LIBOR rate at each determination date.
The Company rents various buildings for its branch office locations. Rent expense for operating leases was as follows: 1996- $1,697,000; 1995-$1,262,000; 1994-$1,450,000. Future minimum lease payments on building and equipment operating lease commitments are as follows: 1997-$1,520,000; 1998-$1,221,000; 1999-$451,000; 2000- $102,000; 2001-$16,000; 2002 and thereafter-$0.
In conjunction with the Viking acquisition there is additional purchase price which may ultimately be paid to the seller depending on Viking's future loss development. See Note 3 for further discussion of this contingency payment.
As discussed in the Company's report on Schedule 14D-9, filed with the Securities and Exchange Commission on May 22, 1996, as amended on June 1, 1996, June 7, 1996 and June 19, 1996, three separate complaints naming the Company and one or more of its directors, and Orion, as defendants were filed on behalf of the Company's shareholders, alleging that the Orion tender offer was unfair and inadequate. On July 2, 1996, counsel for Orion and the Company signed a Memorandum of Understanding providing for the settlement and dismissal of the three cases, based on the revisions which the Purchasers had made in the terms of the Offer to Purchase. In the judgment of the Company's management, the costs incurred to defend and settle these complaints will not have a materially adverse effect on the results of the Company's operations. The estimated settlement costs have been accrued in the Company's consolidated financial statements as of December 31, 1996, as part of the nonrecurring charge discussed in Note 17.
In addition to the three complaints described above, the Company is subject to litigation in the normal course of operating its insurance business. The Company is not engaged in any such litigation which it believes would have a material adverse impact on its financial condition or results of operations, taking into account the reserves established therefore and giving effect to insurance.
The amended and restated Credit Agreement, which is discussed in Note 6, imposes no dividend restrictions on the Company, but requires the Company to maintain consolidated net worth of $190,000,000, plus 30% of the aggregate positive consolidated net income for each fiscal quarter ending after December 31, 1996, plus 100% of the aggregate amount of increases in the stated capital and additional paid-in capital accounts resulting from the issuance of equity securities or other capital investments after December 31, 1996. According to the definition outlined in the Credit Agreement, consolidated net worth means the net worth of Guaranty and its subsidiaries determined in accordance with GAAP, and without regard to the requirements of Statement of Financial Accounting Standards No. 115. As of December 31, 1996, the required net worth under the bank loan agreement was $190,000,000 while the Company's actual net worth, as defined in the Credit Agreement, was $232,920,000.
Shareholders' equity of the Company is primarily represented by the surplus, including undistributed earnings, of GNIC and VICW. The Colorado dividend restriction law limits the annual dividend a Colorado domiciled insurance company may pay to its parent holding company during a twelve-month period to the greater of 10% of GNIC's statutory surplus as reported at the end of the preceding calendar year ($164,474,000 and $133,749,000 at December 31, 1996 and 1995, respectively), or GNIC's statutory net income, excluding realized capital gains ($9,332,000 and ($442,490) for 1996 and 1995, respectively) as reported at the end of the preceding calendar year. When a dividend is declared by GNIC to Guaranty, the Colorado Insurance Department must be notified of such declaration within five days thereafter, and at least ten business days before the payment of the dividend. The Wisconsin dividend restriction law limits the annual dividend that VICW may pay to Guaranty to the lesser of 10% of VICW's statutory surplus as of the end of the preceding calendar year ($88,597,000 and $86,872,000 at December 31, 1996 and 1995, respectively) or the greater of either the statutory net income of VICW for the preceding calendar year, less realized capital gains, ($7,524,000 and $14,591,000 at December 31, 1996 and 1995, respectively) or the aggregate of the net income of VICW for the three calendar years preceding the date of the dividend, less realized capital gains for those calendar years minus dividends paid or credited and distributions made within the first two of the preceding three calendar years ($10,642,000 and $17,521,000 at December 31, 1996 and 1995, respectively). When a dividend is paid by VICW to Guaranty, the Wisconsin Insurance Department must have been notified in writing at least 30 days prior to the payment of the dividend. During 1996, GNIC paid no dividends to Guaranty, while VICW paid dividends in the amount of $8,687,000 to Guaranty. In 1995, GNIC paid dividends of $16,500,000 to Guaranty, while VICW paid no dividends to Guaranty. The Company believes that GNIC and VICW will be in a position to pay dividends to Guaranty in the future.
During 1996, Orion increased its ownership in the Company by approximately 31.5%, to 81%. See Notes 12 and 17 for further discussion of this transaction
Orion manages a majority of the Company's investment portfolio. The Company paid investment management fees to Orion as follows: 1996-$650,000; 1995-$595,000; 1994-$550,000.
The son of the Company's Chairman of the Board is a managing director of Insurance Partners Advisors L.P., which manages Insurance Partners L.P., a partnership formed to make equity investments in the insurance industry. The Company has committed initial capital in an aggregate amount not to exceed $1,500,000 of the total $550,000,000 committed by all partners.
The Company provides incentive plans for key employees. These plans include the Company's 1987 Performance Unit Plan (the "Unit Plan") and the Equity Incentive Plan, which replaced the 1991 Long- Term Performance Incentive Plan (the "Incentive Plan").
Under the Unit Plan, units granted increase in value in relationship to the book value per share of the Company's common stock with certain adjustments. As of December 31, 1996, 225,707 units are outstanding. No units were issued during 1996.
Under the Incentive Plan, shares of restricted stock as well as stock options may be granted by the Company. The Incentive Plan, as adopted September 12, 1991, reserved 800,000 common shares for grant to key employees. During 1996, no restricted stock was issued. In 1995, 12,000 shares of restricted stock was issued, a portion of which was from treasury stock. Restricted stock is considered issued and outstanding when awarded, and is recorded as deferred compensation. As a result of the Orion tender offer, which was completed in July 1996 and is discussed in Note 17, all restrictions on the restricted stock lapsed in 1996. Therefore, the Company included $587,000 of compensation expense, which related to the restricted stock that became fully vested as a result of the Orion tender offer, in the nonrecurring tender offer charge, which is also discussed in Note 17. Prior to the Orion tender offer, the Company had recorded $57,000 as compensation expense on restricted stock during 1996. The compensation expense recognized on restricted stock during 1995 and 1994 was $263,000 and $250,000, respectively.
As a result of the Orion tender offer, all stock options granted prior to the completion of the tender offer became fully vested and became exercisable. At December 31, 1996, there were 400,500 options exercisable under the Incentive Plan and 39,986 common shares available for grant under the Incentive Plan.
The Equity Incentive Plan was approved by the Board of Directors on October 29, 1996, and reserved 700,000 shares to grant to key employees. All stock options under this plan must be granted at no less than fair market value at the date of grant. The options granted under the Equity Incentive Plan are exercisable proportionately from the first through fourth anniversaries of the grant dates and expire ten years after the date of the grant. At December 31, 1996, there were no options exercisable under the Equity Incentive Plan. The 162,747 stock options granted under this plan in 1996 are pending shareholder approval at the May 13, 1997 Annual Meeting of Shareholders. If approved, there would be 537,253 common shares available for grant under the Equity Incentive Plan at December 31, 1996. Additionally, the Equity Incentive Plan provides for performance unit awards, which allow for cash and common stock payments to be made, contingent on the future cumulative increases in book value of the Company's common stock. The awards allow for annual payments to be earned up to four years from the date of grant.
1996 1995 ---- ---- Net Income (In thousands) As Reported $27,506 $8,929 Pro Forma 27,093 (a) 8,727
(a) As a result of the Orion tender offer, approximately $361,000 of the compensation cost estimated under SFAS No. 123 would have been included in the 1996 nonrecurring charge.
1996 1995 ------------------------- -------------------------- Weighted Weighted Average Exercise Average Exercise Shares Price Shares Price ------ ---------------- ------ ---------------- Balance-January 1 471,500 $16.70 458,000 $16.44 Granted 302,749 16.50 90,000 17.25 Exercised (98,500) 14.28 (36,750) 14.98 Terminated (2,500) 17.50 (39,750) 16.64 ------- ----- ------- ----- Balance - December 31 673,249 $16.96 471,500 $16.70 ======= ===== ======= ===== Options exercisable at year end with the corresponding weighted-average exercise price 400,500 $17.05 237,625 $15.97 ======= ===== ======= =====
Weighted-average fair value of options granted during the year $ 4.16 $ 5.18 ======= =======
As of December 31, 1995, Viking terminated its defined benefit health care plan that provided for post-retirement medical benefits to individuals who retired or became permanently disabled while in service with Viking. Employees who were retired or disabled as of December 31, 1995 continue to be eligible for post-retirement medical benefits. Benefits generally are provided under this plan for retirees and their dependents until the death of the retiree. This plan is contributory and contains other cost sharing features which may be adjusted annually. Viking's policy is to fund the cost of plan benefits in amounts determined at the discretion of management.
The Rights become exercisable ten days following a public announcement that a person or group of acquires has acquired or obtained the rights to acquire beneficial ownership of 20% or more of the Company's Common Stock or ten business days following announcement of a tender offer or exchange offer that could result in beneficial ownership of 20% or more of the Company's Common Stock. Prior to consummation of such a transaction, each holder of a Right is entitled to purchase shares of the Company's Common Stock having a value equal to two times the exercise price of the Right. The Company has the right to redeem the Rights at $.01 per Right prior to the time they become exercisable. The Rights will expire on December 30, 2001.
On May 8, 1996, Orion commenced a cash tender offer (the "Offer") to purchase up to 4,600,000 shares of common stock of the Company at price of $17.50 per share. At the time the tender offer was made, Orion owned approximately 49.5 percent of the Company's outstanding common stock.
The Company relocated its Colorado operations to a new home office facility during the second quarter of 1994. New facility expenditures totaled $16,208,000, which were primarily funded from operating cash flow. Total nonrecurring relocation charges of $838,000 were incurred in 1994.