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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1996
Commission File Number 33-83382
FIRST MERCURY FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 38-3164336
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
29621 Northwestern Highway, P.O. Box 5096 Southfield, Michigan 48086
(Address of principal executive offices) (zip code)
Registrant's telephone number, including area code: (810) 358-4010
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. |X|
Aggregate market value of the registrant's voting stock held by
non-affiliates of the registrant. Not applicable.
The number of shares outstanding of the registrant's Common Stock, par
value $.01, as of March 28, 1997 was 6,164.07.
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<PAGE>
PART I
ITEM 1. BUSINESS
First Mercury Financial Corporation ("Mercury") is an insurance holding
company incorporated in Delaware in December 1993 and engaged, through its
subsidiaries, in the underwriting of specialty commercial lines and non-standard
automobile insurance for individuals. Mercury's subsidiaries are First Mercury
Insurance Company ("FMIC"), an Illinois property and casualty insurance company
and successor to First Mercury Syndicate, Inc. (the "Syndicate"), All Nation
Insurance Company ("All Nation") and its wholly owned subsidiary, National
Family Insurance Corporation ("National Family"), both Minnesota property and
casualty insurance companies.
Mercury and its subsidiaries (the "Company") utilize the services of
the following service company affiliates in their operations (i) CoverX
Corporation ("CoverX"), which acted as a wholesale producer and underwriter of
insurance business for the Syndicate, and provides claims handling services on
Syndicate business to FMIC and (ii) Mercury Management, Inc. ("MM"), which is
responsible for the administrative and underwriting functions of FMIC and
provides certain administrative services to All Nation. CoverX and MM (the
"Service Companies") are controlled by Jerome M. Shaw, an officer, director and
major stockholder of Mercury. All Nation's operations are performed by its own
employees, with the exception of certain administrative functions that are
provided by MM pursuant to contract.
The Company, its predecessors and its affiliates have been underwriters
of specialty commercial lines of insurance for over twenty years. CoverX was
established in 1973 to market and underwrite specialty commercial lines of
insurance nationwide on behalf of specialty insurance companies. In 1985, the
Company formed the Syndicate to take advantage of the then favorable
underwriting opportunities within specialty commercial lines of insurance, and
the Syndicate was admitted as a member syndicate on the IIE to pursue risk
bearing activities on a surplus lines basis. In January 1992, the Company
expanded its insurance business to include personal lines through the
acquisition of All Nation. All Nation was founded in 1961 to underwrite
non-standard automobile insurance in the state of Minnesota. During the 1970's
and 1980's, All Nation expanded into several other Midwestern and Western
states. The Company currently underwrites non-standard automobile insurance
coverage in 10 states and is licensed to write multiple lines in 15 states.
Prior to its withdrawal from the Illinois Insurance Exchange ("IIE") in
December 1996, the Syndicate operated as an underwriting member of the IIE.
Under the eligibility of the IIE, the Syndicate wrote general liability
insurance, allied property, and auto physical damage coverage in 44 states, the
District of Columbia, and the U.S. Virgin Islands. On June 28, 1996, the
Syndicate formed FMIC as an Illinois domiciled property and casualty insurance
subsidiary with an initial capitalization of $5 million and a subsequent $15
million contribution to surplus. The formation of FMIC, a licensed Illinois
insurer, provided the Company with an affiliated company in which to potentially
place coverages offered by the Syndicate and in which to reinsure certain of the
Syndicate's outstanding liabilities. Under a loss portfolio transfer, on June
28, 1996, the Syndicate transferred approximately $35 million in loss and loss
adjustment expense reserves and corresponding assets to FMIC. In conjunction
with the formation of FMIC and the loss portfolio transfer, on July 8, 1996, the
Syndicate notified the IIE of its intention to withdraw from the IIE. On
November 7, 1996, the Syndicate and the IIE executed a withdrawal agreement.
Subsequent to the Syndicate's withdrawal, the Syndicate was merged into FMIC. As
of December 31, 1996, FMIC was an admitted carrier only in the state of
Illinois. As a result, FMIC and Empire Fire and Marine Insurance Company
("Empire"), an unaffiliated insurance company, entered into a quota share
reinsurance arrangement effective July 18, 1996 whereby Empire writes on a
direct basis the coverages previously offered by the Syndicate and cedes 50
percent of such business to FMIC.
2
<PAGE>
On May 1, 1996, an agreement was entered into between Mercury, All
Nation, Allstate Insurance Company ("Allstate") and its wholly owned subsidiary,
Deerbrook Insurance Company ("Deerbrook"), for the assignment of All Nation's
independent agent contracts to Deerbrook and the ceding of associated
prospective premium to Allstate on the agency-produced non-standard automobile
business of All Nation. The agreement also included a three year non-compete
clause and various financial guarantees by Mercury. Under the agreement, All
Nation continues to write agency non-standard automobile coverages and cedes
100% of the written business to Allstate under a quota share reinsurance
agreement for a period of up to two years, as Deerbrook is taking over the
direct writing and servicing responsibility from All Nation on a state-by-state
basis over the two-year period. In addition, All Nation provides underwriting
and administrative services for the ceded business on a percentage of premiums
basis for an initial period of up to two years. The agreements do not include
All Nation's direct response non-standard automobile business or agency-produced
non-standard automobile business written prior to May 1, 1996.
SPECIALTY COMMERCIAL LINES
Through FMIC and FMIC's relationships with the Service Companies and
Empire, the Company provides liability coverages primarily for security guard
and alarm companies, fire suppression equipment installation companies and
police and public officials on both an occurrence and a claims made basis. FMIC
provides reinsurance of these coverages under its arrangement with Empire,
however, FMIC intends to begin writing these coverages on a direct basis as it
becomes authorized or eligible to write insurance business in states where the
Syndicate wrote premium directly.
NON-STANDARD AUTOMOBILE INSURANCE
Through All Nation, the Company markets and underwrites primarily
non-standard automobile insurance for individuals on an occurrence basis.
Non-standard automobile insurance is designed for drivers who are unable to
purchase insurance in the preferred or standard market due to the lapse of
previous automobile coverage, limited driving experience, unsatisfactory prior
driving records or other restrictive underwriting criteria.
All Nation's business strategy is to be a low-cost provider of
non-standard automobile insurance while providing superior service to insureds.
The Company intends to achieve additional growth and profitability in its
non-standard automobile insurance business by marketing its products directly to
insureds and expanding its commercial liability book started in 1995. All Nation
began direct marketing of its non-standard automobile insurance products in the
states of Iowa and Illinois during the fourth quarter of 1994. The Company has
made a significant investment in the direct marketing program in the form of
personnel, systems and advertising. All Nation also plans to build upon the
current commercial business in the states of Minnesota, Montana and Idaho during
1997.
3
<PAGE>
The following table sets forth the gross written premiums derived from
all of the Company's lines of business for the periods presented:
<TABLE>
<CAPTION>
FOR THE YEAR ENDED DECEMBER 31,
-------------------------------------------------------------------
1994 1995 1996
------------------ ------------------- ------------------
AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT
------ ------- ------ ------- ------ -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
GROSS WRITTEN PREMIUMS:
Specialty commercial lines:
Security, fire and alarm......... $ 9,521 28.58% $ 9,745 28.55% $ 7,541 27.70%
Police........................... 3,777 11.34 1,581 4.63 428 1.57
Public officials................. 1,405 4.22 904 2.65 535 1.97
Other............................ 1,667 5.00 1,773 5.22 1,675 6.15
Non-standard automobile lines:
Agency personal auto liability... 13,087 39.29 14,246 41.75 12,480 45.85
Agency personal auto physical
damage........................... 3,700 11.11 4,003 11.73 3,586 13.17
Direct personal auto liability... 102 0.30 1,202 3.52 618 2.27
Direct personal auto physical
damage........................... 54 0.16 668 1.95 358 1.32
------- ------- ------- ------- ------- -------
Total gross written premiums....... $33,313 100.00% $34,122 100.00% $27,221 100.00%
======= ======= ======= ======= ======= =======
</TABLE>
4
<PAGE>
GEOGRAPHIC DISTRIBUTION OF DIRECT PREMIUMS
The geographical distribution of the Company's business for 1996, all
of which is in the United States, is set forth in the following table:
NON-STANDARD
SPECIALTY LINES AUTOMOBILE AGGREGATE
----------------- ------------------ -----------------
DIRECT DIRECT DIRECT
PREMIUMS PREMIUMS PREMIUMS
STATE EARNED PERCENT EARNED PERCENT EARNED PERCENT
- ---------------- -------- ------- -------- ------- -------- -------
(DOLLARS IN THOUSANDS)
Montana $ 175 2% $ 2,913 16% $ 3,088 11%
Washington 104 1 2,548 14 2,652 9
Idaho 24 -- 2,557 14 2,581 9
California 2,510 23 -- -- 2,510 9
Oregon 57 1 1,977 11 2,034 7
Utah 13 -- 1,673 9 1,686 6
South Dakota 15 -- 1,452 8 1,467 5
Iowa 126 1 1,283 7 1,409 5
Texas 1,305 12 -- -- 1,305 5
North Dakota 13 -- 1,288 7 1,301 4
Illinois 861 8 387 2 1,248 4
Wisconsin 60 1 1,142 6 1,202 4
Minnesota 363 3 737 4 1,100 4
Pennsylvania 804 7 -- -- 804 3
Other States* 4,313 40 30 -- 4,343 15
------- --- ------- --- ------- ---
Totals $10,743 100%+ $17,987 100%+ $28,730 100%
======= === ======= === ======= ===
- ----------
* All states with direct earned premiums of less than 2% of total.
+ Does not total 100% due to rounding.
LOSSES AND LOSS ADJUSTMENT EXPENSES
The Company is directly liable for loss and loss adjustment expense
payments under the terms of the insurance policies that it writes. In many
cases, particularly in the specialty commercial lines, several years may elapse
between the occurrence of an insured loss, the reporting of the loss to the
Company and the Company's payment of that loss. The Company reflects its
liability for the ultimate payment of all incurred losses and loss adjustment
expenses by establishing loss and loss adjustment expense reserves on an
undiscounted basis (i.e., without taking into account the time value of money),
which are balance sheet liabilities representing estimates of future amounts
needed to pay claims and related expenses with respect to insured events that
have occurred.
When a claim involving a probable loss is reported, the Company
establishes a case reserve for the estimated amount of the Company's ultimate
loss and loss adjustment expense payments. The estimate reflects an informed
judgement based on established reserving practices and the experience and
knowledge of All Nation's and the Service Companies' claims management staffs
and FMIC's officers regarding the nature and value of the claim as well as the
estimated expense of settling the claim, including legal and other fees, and
general expenses of administering the claims adjustment process. The case
reserving for the specialty commercial lines is highly subjective due to the
volatile nature of the claims and the potential for litigation. The case
reserving process for automobile lines is generally more predictable due to
shorter reporting and payment patterns.
5
<PAGE>
Management also establishes reserves on an aggregate basis to provide
for losses incurred but not reported, as well as future developments on losses
reported to the Company ("IBNR" reserves). The amount of an insurer's incurred
losses in a given period is determined by adding losses and loss adjustment
expenses paid during the period to case loss and loss adjustment expense
reserves and IBNR reserves (collectively, "loss reserves") at the end of the
period, then subtracting loss reserves existing at the beginning of the period.
As part of the reserving process, historical data are reviewed and
consideration is given to the anticipated effect of various factors, including
known and anticipated legal developments, changes in social attitudes, inflation
and economic conditions. Reserve amounts are necessarily based on management's
estimates, and as other data become available and are reviewed, these estimates
and judgements are revised, resulting in increases or decreases to existing
reserves.
In order to comply with state insurance laws and regulations, the
Company engages independent actuarial consultants to perform periodic loss
reserve analyses and to provide annual statements of actuarial opinion.
The following table sets forth a reconciliation of beginning and ending
reserves as shown on the Company's financial statements (on a GAAP basis) for
unpaid losses and loss adjustment expenses for the years indicated:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------------
1994 1995 1996
-------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
Reserves for losses and loss adjustment expenses
at beginning of year:
Gross .................................................... $ 61,461 $ 60,458 $ 56,570
Ceded .................................................... (6,915) (7,742) (3,556)
-------- -------- --------
Net ...................................................... 54,546 52,716 53,014
Reserves reassumed under reinsurance commutations .......... -- 2,368 --
Incurred losses and loss adjustment expenses:
Provision for insured events of the current year ......... 24,319 24,937 19,810
Decrease in provision for insured events of prior years .. (5,128) (1,696) (3,172)
-------- -------- --------
Total incurred losses and loss adjustment expenses ... 19,191 23,241 16,638
-------- -------- --------
Payments:
Losses and loss adjustment expenses attributable to
insured events of the current year ..................... 6,387 10,295 7,492
Losses and loss adjustment expenses attributable to
insured events of prior years .......................... 14,634 15,016 15,125
-------- -------- --------
Total payments ....................................... 21,021 25,311 22,617
-------- -------- --------
Reserves, end of year:
Net ...................................................... 52,716 53,014 47,035
Ceded .................................................... 7,742 3,556 8,484
-------- -------- --------
Gross .................................................... $ 60,458 $ 56,570 $ 55,519
======== ======== ========
</TABLE>
6
<PAGE>
The preceding table indicates that during the calendar years 1994
through 1996, the Company's results were favorably impacted by the loss and loss
adjustment expense development related to prior accident years. The significant
components of reserve development by calendar year are explained below. In its
specialty commercial lines, the Company has seen evidence of case reserve
redundancies in total for the older accident years. The Company's approach to
setting case reserves has remained consistent since inception. Prior to 1992,
the Company projected IBNR reserves in its specialty commercial lines based on
an expected loss ratio. Revisions to the expected loss ratio were infrequent
after the accident years started to mature. During 1992, the Company reevaluated
the required reserves for each accident year. Development on the earlier
accident years (1985 through 1989) indicated significant redundancies and a
portion of the redundancies were released in 1994 and 1995 as the Company's
ultimate loss for these years became more evident. These changes were the result
of the Company's ongoing analysis of the adequacy of loss reserves as additional
loss history became available. The Company's policy with regard to IBNR
reserving has been consistent since 1992, and continued release of IBNR
redundancies to the extent seen in fiscal 1994 is not anticipated.
During 1996, the Company experienced favorable development of
approximately $2,173,000 in specialty commercial reserves for accident years
1988 through 1995. Due to increased frequency in 1995 and increased severity in
1996, the Company strengthened reserves in the 1995 and 1996 accident years
rather than release any redundancies related to the more mature accident years.
In the personal automobile lines, the Company has experienced favorable
development in 1996 of approximately $865,000 on accident year 1995. Due to
deteriorating 1996 loss experience on the Company's personal automobile business
written through agents, the Company strengthened reserves for the 1996 accident
year rather than release any redundancies.
The Company experienced favorable development of approximately $876,000
and $1.7 million in its specialty commercial lines for calendar years 1995 and
1994, respectively. Significant redundancies occurred in the oldest accident
years and were partially offset by increases in the most recent accident years
as discussed above.
The Company experienced favorable development in the personal
automobile lines of approximately $630,000 and $1.0 million during calendar
years 1995 and 1994, respectively. The favorable development occurred primarily
in accident years 1993 and 1994 and resulted from conservative estimates of IBNR
reserves.
The following table presents the development of net unpaid loss and
loss adjustment expense reserves from 1986 through 1996 for the Company. The top
line of the table shows the estimated net reserve for unpaid losses and loss
adjustment expenses at the balance sheet date for each of the indicated years.
These figures represent the estimated amount of net unpaid losses and loss
adjustment expenses for claims arising in all prior years that were unpaid at
the balance sheet date, including losses that had been incurred but not yet
reported. The table also shows the reestimated amount of the previously recorded
reserve based on experience as of the end of each succeeding year. The estimate
changes as more information becomes known about the frequency and severity of
claims for individual years. Conditions and trends that have affected the
development of the reserves in the past may not necessarily occur in the future.
Accordingly, the data in the table may not be indicative of future redundancies
or deficiencies.
7
<PAGE>
<TABLE>
<CAPTION>
Years ended December 31,
--------------------------------------------------------------------------------
1986 1987 1988 1989 1990 1991 1992(5) 1993(5) 1994(5)
------- ------- ------- ------- ------- ------- ------- ------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Net reserves for losses and loss adjustment
expenses, as stated(1) ............... $13,442 $25,913 $35,322 $41,847 $45,272 $46,930 $58,180 $56,469 $54,864
Cumulative net paid as of(2):
One year later ....................... $ 912 $ 3,132 $ 4,989 $ 5,776 $ 7,898 $ 9,179 $16,379 $14,201 $17,878
Two years later ...................... 3,211 7,229 9,986 12,611 15,850 18,161 25,990 26,206 26,569
Three years later .................... 5,056 10,386 14,809 18,083 22,911 24,243 34,398 31,855
Four years later ..................... 5,886 13,279 18,401 22,320 27,315 28,591 37,691
Five years later ..................... 6,851 14,903 20,993 25,177 30,241 30,364
Six years later ...................... 7,528 16,139 22,343 26,460 31,276
Seven years later .................... 8,337 17,037 22,823 26,956
Eight years later .................... 8,393 17,504 22,952
Nine years later ..................... 8,813 17,509
Ten years later ...................... 8,813
Reserves reestimated as of(3):
One year later ....................... 12,740 25,123 36,479 40,111 44,874 45,225 53,715 51,067 53,722
Two years later ...................... 12,389 26,124 34,847 39,733 41,788 40,838 48,509 50,188 50,322
Three years later .................... 13,378 24,100 34,410 35,550 37,859 36,432 48,264 48,381
Four years later ..................... 12,024 24,057 29,590 31,377 34,081 35,327 47,938
Five years later ..................... 11,970 21,001 26,266 28,534 33,826 34,691
Six years later ...................... 9,762 18,972 24,300 28,560 33,737
Seven years later .................... 9,121 17,697 24,241 28,640
Eight years later .................... 8,605 17,745 24,246
Nine years later ..................... 8,828 17,746
Ten years later ...................... 8,828
------- ------- ------- ------- ------- ------- ------- ------- -------
Net cumulative redundancy (deficiency)(4) . $ 4,614 $ 8,167 $11,076 $13,207 $11,535 $12,239 $10,242 $ 8,088 $ 4,542
------- ------- ------- ------- ------- ------- ------- ------- -------
------- ------- ------- ------- ------- ------- ------- ------- -------
Reserves, end of year:
Gross................................. $63,384 $62,606
Ceded ................................ (6,915) (7,742)
------- -------
Net................................... $56,469 $54,864
------- -------
------- -------
Reestimation, one year later:
Gross................................. $55,333 $58,804
Ceded ................................ (4,266) (5,082)
------- -------
Net................................... $51,067 $53,722
------- -------
------- -------
Reestimation, two years later:
Gross................................. $53,591 $55,118
Ceded ................................ (3,403) (4,796)
------- -------
Net................................... $50,188 $50,322
------- -------
------- -------
Reestimation, three years later:
Gross................................. $51,843
Ceded ................................ (3,462)
-------
Net................................... $48,381
-------
Gross cumulative redundancy (deficiency) $11,541 $ 7,488
------- -------
------- -------
</TABLE>
Years ended December 31,
-----------------------
1995 1996
------- -------
Net reserves for losses and loss adjustment
expenses, as stated(1) ............... $53,014 $47,035
Cumulative net paid as of(2):
One year later ....................... $14,499
Two years later ......................
Three years later ....................
Four years later .....................
Five years later .....................
Six years later ......................
Seven years later ....................
Eight years later ....................
Nine years later .....................
Ten years later ......................
Reserves reestimated as of(3):
One year later ....................... 50,462
Two years later ......................
Three years later ....................
Four years later .....................
Five years later .....................
Six years later ......................
Seven years later ....................
Eight years later ....................
Nine years later .....................
Ten years later ......................
-------
Net cumulative redundancy (deficiency)(4) . $ 2,552
-------
-------
Reserves, end of year:
Gross................................. $56,570 $55,519
Ceded ................................ (3,556) (8,484)
------- -------
Net................................... $53,014 $47,035
------- -------
------- -------
Reestimation, one year later:
Gross................................. $53,408
Ceded ................................ (2,946)
-------
Net................................... $50,462
-------
-------
Reestimation, two years later:
Gross.................................
Ceded ................................
Net...................................
Reestimation, three years later:
Gross.................................
Ceded ................................
Net...................................
Gross cumulative redundancy (deficiency) $ 3,162
-------
-------
- ---------
(1) Sets forth the estimated liability in thousands for unpaid losses and LAE
recorded at the balance sheet date for each of the indicated years;
represents the estimated amount of losses and LAE for claims arising in the
current and all prior years that are unpaid at the balance sheet date,
including IBNR.
(2) Cumulative loss and LAE payments made in succeeding years for losses
incurred prior to the balance sheet date.
(3) Reestimated amount of the previously recorded losses based on experience
during each succeeding year as more information becomes known about actual
payments and the severity of remaining unpaid claims.
(4) The "redundancy (deficiency)" shows the cumulative redundancy or deficiency
at December 31, 1996 of the reserve estimate shown on the top line of the
corresponding column. A redundancy in reserves means that reserves
established in prior years exceeded actual losses and loss expenses or were
reevaluated at less than the originally reserved amount. A deficiency in
reserves means that the reserves established in prior years were less than
actual losses and loss expenses or were reevaluated at more than the
originally reserved amount.
(5) The 1992 through 1994 years have been restated to remove effects of a
personal lines quota share reinsurance agreement commuted during 1995. See
REINSURANCE.
8
<PAGE>
The cumulative redundancy or deficiency represents the aggregate change
in the reserve estimates over all prior years. It should be emphasized that the
table presents a run-off of balance sheet reserves rather than accident or
policy year loss development. Therefore, each amount in the table includes the
effects of changes in reserves for all prior years.
OPERATING RATIOS
The following ratios are frequently used in evaluating performance in
the insurance industry.
COMBINED RATIOS. The statutory combined ratio, which reflects
underwriting results but no investment income, is a traditional measure of
underwriting performance of a property and casualty insurer. A combined ratio of
less than 100% indicates underwriting profitability, while a combined ratio in
excess of 100% indicates an underwriting loss. The following table reflects the
loss ratio, expense ratio and combined ratio of the Company, on a GAAP and SAP
basis, and the property and casualty insurance industry, on a SAP basis.
<TABLE>
<CAPTION>
Years ended December 31,
------------------------------------
1992 1993 1994 1995 1996
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
THE COMPANY:
SAP BASIS
Loss and loss adjustment expense ratio .... 71.1% 70.7% 66.5% 78.3% 83.0%
Expense ratio ............................. 34.3 34.8 37.4 35.2 34.6
Combined ratio ............................ 105.4 105.5 103.9 113.5 117.6
GAAP BASIS
Loss and loss adjustment expense ratio .... 71.1% 70.7% 66.5% 78.3% 79.9%
Expense ratio ............................. 33.3 34.4 35.9 35.5 43.0
Combined ratio ............................ 104.4 105.1 102.4 113.8 122.9
PROPERTY AND CASUALTY INSURANCE INDUSTRY (1):
SAP BASIS
Loss and loss adjustment expense ratio .... 88.1% 79.5% 81.1% 78.7% 81.0%
Expense ratio ............................. 26.4 26.2 26.0 25.9 26.0
Combined ratio (2) ........................ 114.5 105.7 107.1 104.6 107.0
</TABLE>
- ----------
(1) Sources: With respect to 1992-1995, A.M. BEST'S AGGREGATES & AVERAGES,
PROPERTY-CASUALTY (1996 edition); with respect to 1996, these are
preliminary figures (subject to change) provided by A.M. Best Company.
(2) Property and casualty insurance industry combined ratios are shown before
policyholder dividends. The Company does not pay policyholder dividends.
REINSURANCE
The Company follows the customary industry practice of reinsuring a
portion of its underwriting risks. The Company cedes to reinsurers a portion of
its risks and pays a fee based on premiums received on all policies subject to
such reinsurance. These reinsurance agreements limit the Company's maximum net
loss which can arise from large single risks or risks in concentrated areas. The
Company is a party to reinsurance contracts ("quota share reinsurance" or
"excess loss reinsurance") under which certain types of policies are
automatically reinsured in some predetermined amount and to other reinsurance
contracts ("facultative agreements") which provide reinsurance on an individual
risk basis and require specific agreement of the reinsurer as to limits of
coverage provided.
Due to FMIC's inability to write premium on a direct basis in states
other than Illinois, the Company did not renew FMIC's reinsurance coverage for
the specialty commercial lines during 1996.
9
<PAGE>
The Company is currently providing reinsurance for specialty commercial lines
policies with a maximum of $1 million limits under the 50 percent quota share
reinsurance arrangement with Empire. Prior to its expiration, the Syndicate was
party to a reinsurance agreement with Reliance Insurance Company which provided
coverage to the Syndicate for losses incurred in excess of $500,000 per insured
per loss, up to a maximum of $1 million. For commercial business written by All
Nation, the Company retains a maximum of $200,000 per occurrence. Losses in
excess of $200,000 are covered under All Nation's reinsurance agreement with
General Reinsurance Corporation.
Property reinsurance is currently provided under a retrocession with
Munich American Reinsurance Company which primarily provides reinsurance on
commercial property risks in excess of $25,000.
Reinsurance for the Company's personal lines has been provided under
three treaties. Prior to their expiration, for agency and direct response
non-standard automobile coverage, the Company had a multiple reinsurer excess of
loss agreement covering losses in excess of $200,000 to a maximum of $500,000
and a second multiple reinsurer excess of loss agreement covering losses in
excess of $500,000 to a maximum of $1.5 million. Prior to May 1, 1996, All
Nation retained a maximum of $200,000 per occurrence on its agency-produced
non-standard automobile coverage. In conjunction with the sale of its agency
appointments, All Nation has entered into a 100 percent quota share reinsurance
agreement for these coverages with Allstate effective May 1, 1996. Under this
reinsurance agreement, All Nation has exposure on Allstate's losses on policies
written under the reinsurance agreement through December 31, 1996.
The foregoing is a summary of the Company's current reinsurance
program, and is subject to the terms, conditions, limitations, exclusions and
interpretations of its various reinsurance arrangements in effect from year to
year. Therefore, there may be circumstances in which the Company's total
exposure will be in excess of its retention.
The following table details the Company's reinsurers and the related
amounts recoverable, if any, as of December 31, 1996.
REINSURANCE AS OF DECEMBER 31, 1996
1995
Amount Percent A.M. Best
Recoverable of Total Rating
----------- -------- ---------
(Dollars in thousands)
SPECIALTY COMMERCIAL LINES
Reliance Insurance Company .................... $ 1,141 10.6% A-
TIG Reinsurance Company (1) ................... 820 7.6 A
National Reinsurance Corporation .............. 1,243 11.5 A+
General Reinsurance Corporation ............... 544 5.1 A++
Munich American Reinsurance Company ........... 719 6.7 A+
PERSONAL LINES
Allstate Insurance Company .................... 6,196 57.6 A
General Reinsurance Corporation ............... 62 0.6 A++
Frankona American Reinsurance Company ........ 38 0.3 A
------- ----
Total Company ............................... $10,763(2) 100%
======= ====
- ----------
(1) The treaty with TIG expired in mid 1993. Accordingly, premiums are no longer
being ceded. Recoverables are outstanding for prior period losses.
(2) The total amount at December 31, 1996 represented $479,000 in paid losses
and loss adjustment expenses recoverable, $3,501,000 in unpaid losses and
loss expenses recoverable relating to case reserves, $4,983,000 in unpaid
losses relating to IBNR reserves, and $1,800,000 in prepaid reinsurance
premiums.
10
<PAGE>
The Company is not aware of any impairment of the creditworthiness of
any of its reinsurers.
The amounts of premiums ceded under reinsurance treaties for the years
ending December 31, 1994, 1995 and 1996 were $5,293,000, $4,699,000 and
$10,577,000, respectively. The ceding of liability to a reinsurer does not
legally discharge the ceding insurer from its primary liability for the full
amount of the policies on which it obtains reinsurance, and the ceding insurer
will be required to pay the entire loss if the assuming reinsurer fails to meet
its obligations under the reinsurance agreement. The Company currently expects
that it will be able to collect all reinsurance receivables due it from the
Company's reinsurers.
The Company regularly assesses its reinsurance needs and from time to
time seeks to improve the terms of its reinsurance arrangements as market
conditions permit. Such improvements may involve increases in retentions,
commutations, modifications in premium rates, changes in reinsurers and other
matters.
INVESTMENTS
The Company's subsidiaries' investments are professionally managed by
Asset Allocation & Management Company, an unaffiliated entity which specializes
in investment management services for insurance companies. The Company's
subsidiaries' objectives are to maximize their total rate of return after income
taxes, but, at the same time, to protect and enhance policyholders' surplus on a
long-term basis and to maintain adequate liquidity for insurance operations. The
Company's subsidiaries' current investment policy prohibits investment in real
estate and limits total investments in equity securities, other than those of
the Company's subsidiaries, to 10% of the Company's total "admitted assets"
under SAP. The Company's subsidiaries also comply with applicable laws and
regulations which further restrict the type, quality and concentration of
investments. In general, these laws and regulations permit investments within
specified limits and subject to certain qualifications, in federal, state and
municipal obligations, corporate bonds, preferred and common equity securities
and real estate mortgages.
Mercury's current investment policy is to maintain at least $1.0
million in high quality investments with maturities of one year or less.
The Company's subsidiaries' investment policy is determined by the
Company's Board of Directors and is reviewed on a regular basis. Pursuant to
this investment policy, the Company's subsidiaries' investments are currently
concentrated in fixed income securities which are considered to be available for
sale for GAAP reporting purposes. The Company's subsidiaries regularly
reevaluate their portfolios based upon market conditions, which could cause the
Company's subsidiaries to restructure their portfolio and record gains or losses
in order to maximize their total return on investments and/or enhance liquidity.
11
<PAGE>
The following table shows the composition of the Company's investment
portfolio by type of security as of December 31, 1996.
ANALYSIS OF INVESTMENTS
December 31, 1996
---------------------
Carrying Percent of
Amount Total
-------- ----------
(Dollars in thousands)
Debt securities:
United States government securities ................. $14,777 19.34%
Collateralized mortgage obligations and other
asset-backed securities ............................. 28,617 37.44
Government agency mortgage-backed securities ........ 12,963 16.96
States, municipalities and political subdivisions ... 9,648 12.62
All other corporate bonds ........................... 5,867 7.68
------- -----
Total debt securities ............................. 71,872 94.04
------- -----
Equity securities:
Preferred stock ..................................... 2,691 3.52
Common stock ........................................ 52 0.07
------- -----
Total equity securities ........................... 2,743 3.59
------- -----
Short term investments ................................ 1,811 2.37
------- -----
Total investments ................................. $76,426 100.0%
======= =====
All debt and equity securities are classified as available for sale as
defined by FASB Statement No. 115. Accordingly, all debt and equity securities
are carried at market value with unrealized gains and losses net of income tax
effect included as a separate component of stockholders' equity. Short-term
investments are valued at cost, which approximates market value.
Debt securities held by the Company's subsidiaries have a weighted
average quality rating of "AAA" by independent rating agencies. The following
table shows the composition of the Company's subsidiaries' debt and equity
securities (at carrying amount), by rating as of December 31, 1996.
COMPOSITION OF DEBT AND EQUITY SECURITIES BY RATING
December 31, 1996
-----------------
Rating (1) Amount Percent
- ---------------------------------------------------------- ------- --------
(Dollars in thousands)
United States government securities....................... $14,777 19.8%
Aaa and/or AAA............................................ 46,502 62.3
Aa and/or AA.............................................. 3,151 4.2
A and/or A................................................ 4,687 6.3
Baa and/or BBB............................................ 3,443 4.6
Not rated................................................. 2,055 2.8
------- -------
Total................................................... $74,615 100%
======= =======
- ----------
(1) Ratings as assigned by Moody's and S&P, respectively. Such ratings are
generally assigned upon the issuance of the securities, subject to revision
on the basis of ongoing evaluations.
12
<PAGE>
The following table indicates the composition of the Company's
subsidiaries' debt securities (at carrying amount) by time to maturity at
December 31, 1996.
COMPOSITION OF INVESTMENTS BY MATURITY
December 31, 1996
-----------------
Maturity(1) Amount Percent
- ------------------------------------------------------- ------ -------
(Dollars in thousands)
One year or less ...................................... $ 2,613 3.7%
Over 1 year through 5 years ........................... 16,177 22.5
Over 5 years through 10 years ......................... 8,825 12.3
Over 10 years ......................................... 2,677 3.7
------- -----
Subtotal ............................................ 30,292 42.2
Collateralized mortgage obligations and
other asset-backed securities ......................... 28,617 39.8
Government agency mortgage-backed securities .......... 12,963 18.0
------- -----
Total debt securities ............................... $71,872 100.0%
======= =====
The preceding table reflects maturities based on stated maturity dates
without assumptions regarding prepayment. Maturities have been adjusted when put
or call provisions significantly reduced duration from the stated maturities.
Mortgage-backed securities and collateralized mortgage obligations typically
have effective maturities shorter than their scheduled maturities due to
unscheduled prepayments on the underlying mortgages. Giving effect to these
considerations, the weighted average maturity of the Company's debt securities
portfolio as of December 31, 1996 was approximately 3 years. The Company's
subsidiaries attempt to achieve a balanced maturity schedule in order to protect
investment income in the event of a downturn in interest rates in a year in
which a large amount of securities would mature. Additionally, the Company's
subsidiaries attempt to schedule maturities consistent with expected loss
payouts.
Investment results of the Company's subsidiaries for the periods
indicated are shown in the following table:
Year ended December 31,
------------------------------
1994(3) 1995(4) 1996
------- ------- ------
(Dollars in thousands)
Average total investments (1) $74,371 $85,113 $84,521
Net investment income (2) 4,323 5,440 5,484
Average pretax yield 5.8% 6.4% 6.5%
- ----------
(1) Average of the aggregate invested amounts at market value at the beginning
and end of the period.
(2) Investment income is net of the investment expenses and does not include net
realized or unrealized gains (losses) on investments or provision for income
taxes.
(3) Excludes $9.6 million net proceeds from sale of senior subordinated notes on
December 22, 1994.
(4) Excludes $500,000 yield maintenance fee received on early repayment of
mortgage loan.
A.M. BEST RATING
With respect to the year ended December 31, 1995, the Syndicate and All
Nation received ratings of "B++ (Very Good)" in June 1996 by A.M. Best, an
independent nationally recognized insurance publishing and rating service, as
part of A.M. Best's annual review process. National Family has not applied to be
rated by A.M. Best, and the Company is not rated as a group by A.M. Best. A.M.
Best ratings are based on a comparative analysis of the financial condition and
operating performance of insurance companies as determined by their publicly
available reports. A.M. Best
13
<PAGE>
ratings are based upon factors of concern to insureds and are not directed
toward the protection of investors.
The Company is currently discussing its 1996 A.M. Best rating with Best
personnel and expects to have resolution in the first part of 1996. The outcome
of such discussions on FMIC's or All Nation's 1996 rating is uncertain.
COMPETITION
The commercial property and casualty insurance industry, generally, and
the surplus lines market, specifically, are highly competitive. Many of the
Company's existing or potential competitors are larger, have considerably
greater financial and other resources, have greater experience in the insurance
industry, and offer a broader line of insurance products than the Company. FMIC
competes with many other insurance entities, including other surplus line
insurers, insurance organizations such as risk retention groups and alternative
self-insurance mechanisms. FMIC also competes with admitted insurers, because,
as a general rule, a risk may not be offered to a surplus lines insurer if an
admitted insurer is willing to insure the risk. FMIC cannot identify any
competitor that it believes is dominant in its segment of the industry.
All Nation competes with both large national and smaller regional
insurers for agents and insureds in each state in which it operates. Many of
these competitors are larger, have greater financial and marketing resources,
and may offer lower rates and higher commissions than the Company. While the
Company does not believe any insurer is dominant in All Nation's industry
segment, All Nation does compete in many of its markets with major national and
regional companies such as Auto Owners, Tri State, USF&G, Allstate Indemnity
Company, GEICO and the companies in the Progressive Insurance Group.
The Company's principal methods of competing are to offer combinations
of what it believes are superior products and services at competitive rates, to
distribute its products efficiently and to market them effectively.
REGULATION
The Company's subsidiaries are subject to substantial regulation, which
is designed to protect the interests of insurance policyholders, as opposed to
the interests of stockholders or debtholders. As an Illinois property and
casualty insurer, FMIC is subject to the primary regulatory oversight of the
Illinois Department of Insurance. Similarly, as a Minnesota property and
casualty insurance company, All Nation is subject to the primary regulatory
oversight of the Minnesota Department of Commerce. Such regulation relates to
authorized lines of business, capital and surplus requirements, investment
parameters, underwriting limitations, transactions with affiliates, dividend
limitations, changes in control and a variety of other financial and
non-financial components of the Company's business. The failure of the Company's
subsidiaries to comply with certain provisions of Illinois, Minnesota and other
applicable insurance laws and regulations could adversely affect the Company,
including its ability to continue its operations in Illinois or Minnesota, and
also in other jurisdictions. The Company's subsidiaries also are subject to
regulation in states in which they do business, and failure of the Company's
subsidiaries to comply with certain provisions of states in which the Company
writes significant premiums could adversely affect the Company. Additionally,
under applicable regulatory provisions, the Company's subsidiaries may be
subject to assessments based on the insolvency of insurers within certain
jurisdictions.
DIVIDEND LIMITATIONS. The Company's subsidiaries are limited in their
ability to pay dividends to stockholders. FMIC may declare and pay dividends
according to the provisions of the Illinois Insurance Holding Company Systems
Act, which require regulatory approval for the payment of
14
<PAGE>
dividends exceeding the greater of 10 percent of FMIC's policyholders' surplus
on the most recent statutory financial statement filed with the State of
Illinois or net income after taxes for the prior year.
Similarly, All Nation is subject to the provisions of the Minnesota
Insurance Holding Company Systems Act, which requires regulatory approval for
the payment of any dividends or other distributions that, during any consecutive
12-month period, exceed the greater of (i) 10% of policyholders' surplus as of
the 31st day of December next preceding, or (ii) net income (not including
realized capital gains), for the 12-month period ending the 31st day of December
next preceding.
After giving effect to the foregoing dividend restrictions, during
1997, Mercury could receive up to $3.2 million in dividends from FMIC and All
Nation without prior regulatory approval. In 1996, Mercury received $1.9 million
in dividends from its subsidiaries.
HOLDING COMPANY SYSTEMS REGULATION. Because of its ownership of FMIC,
the Company is subject to certain provisions of the Illinois Insurance Holding
Company Systems Act, which governs any direct or indirect changes in control of
FMIC and certain affiliated-party transactions involving FMIC or its assets. No
person may acquire any voting security of FMIC or Mercury without receiving the
prior approval of the Illinois Department of Insurance if, after the
consummation thereof, such person would, directly or indirectly, be in control
of either company. Control is presumed to exist if any person, directly or
indirectly, owns or controls ten percent (10%) or more of the voting securities
of the entity at issue. The determination of whether to approve any such
acquisition is based on a variety of factors, including an evaluation of the
acquirer's financial condition, the competence of its management and whether the
acquisition is likely to harm the insurance buying public. In addition, certain
material transactions between FMIC and any affiliate must be disclosed to the
Illinois Department of Insurance at least 30 days prior to the effective date of
the transaction. A transaction can be disapproved by the Illinois Department of
Insurance within such period if it does not meet certain standards. Transactions
with affiliates that require such approval include, but are not limited to,
sales, purchases or exchanges of assets, loans and extensions of credit,
reinsurance agreements and management agreements. FMIC is also required to file
periodic and updated statements reflecting the current status of its holding
company system, the existence of any related-party transactions and certain
financial information relating to the party that ultimately controls FMIC.
Because of its ownership of All Nation, the Company is subject to
certain provisions of the Minnesota Insurance Holding Company Systems Act, which
governs any direct or indirect changes in control of All Nation and certain
affiliated-party transactions involving All Nation or its assets. No person may
acquire any voting security of All Nation or Mercury without receiving the prior
approval of the Minnesota Department of Commerce if, after the consummation
thereof, such person would, directly or indirectly, be in control of either
company. Control is presumed to exist if any person, directly or indirectly,
owns or controls ten percent (10%) or more of the voting securities of the
entity at issue. The determination of whether to approve any such acquisition is
based on a variety of factors, including an evaluation of the acquirer's
financial condition, the competence of its management and whether the
acquisition is likely to harm the insurance buying public. In addition, certain
material transactions involving All Nation and any affiliate must be disclosed
to the Minnesota Department of Commerce at least 30 days prior to the effective
date of the transaction. A transaction can be disapproved by the Minnesota
Department of Commerce within such period if it does not meet certain standards.
Transactions with affiliates that require such approval include, but are not
limited to, sales, purchases or exchanges of assets, loans and extensions of
credit, reinsurance agreements and management agreements. The Minnesota
Department of Commerce approved the sale of All Nation's agency appointments for
the non-standard automobile business to Deerbrook. All Nation also is required
to file periodic and updated statements reflecting the current status of its
holding company system, the existence of any related-party transactions and
certain financial information relating to the party that ultimately controls All
Nation.
15
<PAGE>
INSURANCE GUARANTY FUNDS/RESIDUAL MARKET MECHANISMS. The Company is
subject to guaranty fund laws which can result in assessments, up to prescribed
limits, for losses incurred by policyholders as a result of the insolvency of
unaffiliated insurance companies. Typically, an insurance company is subject to
the guaranty fund laws of the states in which it conducts an insurance business;
however, companies which conduct business on a surplus lines basis in a
particular jurisdiction are generally exempt from that jurisdiction's guaranty
fund laws. FMIC is currently writing reinsurance coverages, and therefore, is
not subject to the guaranty fund laws of the State of Illinois. As a Minnesota
property and casualty insurance company, All Nation is subject to the provisions
of the Minnesota Insurance Guaranty Association Act, which provides for the
assessment of member insurance companies based on the amount of net direct
written premium in relation to the net direct written premiums of all member
insurers. All Nation is also subject to guaranty fund assessment in each state
in which it is an admitted insurer.
In addition to the foregoing, All Nation may be required to participate
in certain residual market mechanisms operating in the states in which it is
admitted. These residual market mechanisms, which may include automobile,
workers' compensation and urban property risk plans and other state sponsored
pooling arrangements, are designed to provide state residents with a market for
types of insurance which might otherwise be unavailable. As a participant in
these residual market plans, All Nation is required to contribute funds to state
sponsored pools and to accept risks assigned to it by such residual market
plans.
NATIONAL FAMILY. National Family is a Minnesota property and casualty
insurance company which was in rehabilitation under the oversight of the Ramsey
County District Court ("Court") until December 1996, when National Family
received an order of liquidation with a finding of insolvency from the Court.
Under generally accepted accounting principles, because All Nation lacks voting
control over National Family, the financial statements of National Family are
not consolidated with the financial statements of the Company. National Family
became affiliated with All Nation on March 1, 1985, when All Nation entered into
an agreement with National Family and the Court whereby National Family assumed
all of the assets and certain of the liabilities of National Family's
predecessor company, and All Nation obtained ownership of all issued and
outstanding shares of voting stock of National Family (although all voting
control was retained by the Minnesota Commissioner of Commerce). Neither
management of the Company nor of All Nation was involved with National Family
prior to National Family's affiliation with All Nation in 1985. All Nation
established its relationship with National Family in 1985 at the request of the
Minnesota Department of Commerce, also agreeing to provide general management
service to National Family.
The Company became affiliated with National Family in 1992 solely as a
result of the Syndicate's acquisition of shares of All Nation. The Company
acquired All Nation for strategic business reasons, but the Company's
affiliation with National Family was merely a by-product of the acquisition of
All Nation.
In 1992, the Minnesota Commissioner of Commerce stated in a letter that
the Minnesota Department of Commerce is not aware of any provision of law that
gave an affirmative responsibility to either All Nation or the Company to bring
National Family out of rehabilitation. Further, the Minnesota Department of
Commerce recognized in that letter that neither the Company nor All Nation
promised to infuse any capital into National Family. Given these assurances, the
Company believes it has no obligation to cure any deficit resulting from the
liquidation, although it is possible that a third party could challenge this
position in the future.
EMPLOYEES
As of December 31, 1996, neither Mercury nor FMIC had any employees,
relying instead on
16
<PAGE>
the Service Companies for certain services typically provided by employees.
However, both Mercury and FMIC have officers, all of whom are employed by
affiliates of the Company, to whom the Company pays no additional compensation.
Certain functions, such as the negotiation of reinsurance contracts, are handled
for FMIC by its officers. As of December 31, 1996, All Nation had 33 employees.
ITEM 2. PROPERTIES
The corporate headquarters of the Company are located in office space
in Southfield, Michigan, that is provided to the Company by CoverX pursuant to
the General Agency Agreement between the Syndicate, CoverX and MM. All Nation
owns the 18,000 square foot office building in which it is based, located at 155
Aurora Avenue, St. Paul, Minnesota 55103, and also owns five acres of land
located in Inver Grove Heights, Minnesota. The Company believes that these
existing facilities are adequate for its needs.
ITEM 3. LEGAL PROCEEDINGS
The Company's insurance subsidiaries are subject to routine legal
proceedings in connection with their property and casualty insurance business.
Neither Mercury nor any of its subsidiaries is involved in any pending or
threatened legal proceedings which reasonably could be expected to have a
material adverse impact on the Company's financial condition or results of
operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the
fourth quarter of 1996.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Not applicable.
17
<PAGE>
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data presented below under the
captions "Operations Statement Data" and "Balance Sheet Data" for, and as of the
end of, each of the years in the five-year period ended December 31, 1996 have
been derived from the Company's consolidated financial statements which have
been audited by KPMG Peat Marwick LLP. The statutory data are based on statutory
accounting practices ("SAP"). These data should be read in conjunction with the
consolidated financial statements, related notes, and other financial
information included elsewhere herein.
<TABLE>
<CAPTION>
Years ended December 31,
-----------------------------------------------------------
1992 1993 1994 1995 1996
--------- --------- --------- --------- ---------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C>
OPERATIONS STATEMENT DATA:
Gross written premiums ............................. $ 33,817 $ 36,231 $ 33,313 $ 34,122 $ 27,221
Net written premiums ............................... 28,990 30,052 28,019 29,424 16,644
========= ========= ========= ========= =========
Net premiums earned ................................ $ 28,848 $ 30,214 $ 28,839 $ 29,674 $ 20,814
Net investment income .............................. 5,468 4,868 4,323 5,940 5,484
Net realized investment gains (loss) ............... 427 497 (67) (14) 487
Other income (expense) ............................. 149 200 (275) 73 1,352
--------- --------- --------- --------- ---------
Total revenues ................................... 34,892 35,779 32,820 35,673 28,138
--------- --------- --------- --------- ---------
Net loss and loss adjustment expenses .............. 20,520 21,361 19,191 23,241 16,638
Acquisition costs and other underwriting expenses .. 9,761 10,602 10,067 11,624 9,300
--------- --------- --------- --------- ---------
Total losses and expenses ........................ 30,281 31,963 29,258 34,865 25,938
--------- --------- --------- --------- ---------
Income before income taxes and cumulative effect of
change in accounting for income taxes ............ 4,611 3,816 3,562 808 2,200
Income tax expense ................................. 806 184 689 860 617
--------- --------- --------- --------- ---------
Income (loss) before cumulative effect of change in
accounting for income taxes ...................... 3,805 3,632 2,873 (52) 1,583
Cumulative effect of change in accounting for income
taxes (1)......................................... -- 1,140 -- -- --
--------- --------- --------- --------- ---------
Net income (loss) .................................. $ 3,805 $ 4,772 $ 2,873 $ (52) $ 1,583
========= ========= ========= ========= =========
December 31,
-----------------------------------------------------------
1992 1993 1994 1995 1996
--------- --------- --------- --------- ---------
BALANCE SHEET DATA:
Total investments and cash ......................... $ 68,903 $ 73,387 $ 78,805 $ 88,072 $ 80,371
Premiums and other receivables ..................... 19,371 13,968 14,412 7,859 12,447
Total assets ....................................... 97,687 97,303 105,088 104,045 102,111
Unpaid loss and loss adjustment expenses ........... 65,559 61,461 60,458 56,570 55,519
Unearned premiums .................................. 10,062 9,662 8,928 8,800 5,657
Senior subordinated notes payable .................. -- -- 10,000 10,000 9,225
Total liabilities (including minority interests) ... 79,042 73,375 81,351 77,644 75,596
Total shareholders' equity ......................... 18,645 23,928 23,737 26,401 26,515
Years ended December 31,
-----------------------------------------------------------
1992 1993 1994 1995 1996
--------- --------- --------- --------- ---------
SELECTED STATUTORY DATA:
Policyholders' surplus(2) .......................... $ 19,365 $ 22,133 $ 32,704 $ 32,363 $ 29,561
Net premiums written to surplus .................... 1.5x 1.4x 0.9x 0.9x 0.6x
Loss and LAE ratio ................................. 71.1% 70.7% 66.5% 78.3% 83.0%
Expense ratio ...................................... 34.3 34.8 37.4 35.2 34.6
Combined ratio ..................................... 105.4 105.5 103.9 113.5 117.6
SELECTED PROPERTY AND CASUALTY INSURANCE
INDUSTRY STATUTORY DATA: (3)
Combined ratio ..................................... 115.8 109.2 108.4 105.9 107.0
</TABLE>
- ----------
(1) Reflects effect of adoption of SFAS 109. See "Item 7 -- Management's
Discussion and Analysis of Financial Condition and Results of Operations"
and Notes 1 and 5 to the Notes to Consolidated Financial Statements.
(2) 1994 statutory surplus amounts reflect $8.1 million of proceeds from the
issuance of senior subordinated notes down streamed to the insurance
subsidiaries.
(3) Sources: With respect to 1992-1995, A.M. BEST'S AGGREGATES & AVERAGES,
PROPERTY-CASUALTY (1996 edition); with respect to 1996, this is a
preliminary figure (subject to change) provided by A.M. Best Company.
18
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following table reflects net premiums earned of the Company for the years
ended December 31, 1994, 1995 and 1996:
<TABLE>
<CAPTION>
For the year ended December 31,
-------------------------------------------------
1994 1995 1996
--------------- --------------- ---------------
Amount Percent Amount Percent Amount Percent
------ ------- ------ ------- ------ -------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
NET PREMIUMS EARNED:
Specialty commercial lines:
Security, fire and alarm ....... $ 8,729 30.3% $ 8,215 27.7% $ 8,236 39.6%
Police ......................... 3,717 12.9 2,307 7.8 747 3.6
Public officials ............... 1,335 4.6 974 3.3 623 3.0
Other .......................... 1,088 3.8 1,250 4.2 1,132 5.4
Non-standard automobile lines:
Agency personal auto liability . 10,780 37.4 12,069 40.7 6,753 32.4
Agency personal auto physical
damage ......................... 3,162 11.0 3,396 11.4 2,076 10.0
Direct personal auto liability . 18 0.0 978 3.3 755 3.6
Direct personal auto physical
damage ......................... 10 0.0 485 1.6 492 2.4
------- ----- ------- ----- ------- -----
Total net premiums earned ........ $28,839 100.0% $29,674 100.0% $20,814 100.0%
======= ===== ======= ===== ======= =====
</TABLE>
YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995
NET PREMIUMS EARNED
Net premiums earned decreased 29.9% in 1996 to $20.8 million from $29.7
million in 1995. Net premiums earned for private passenger non-standard
automobile coverages decreased 40.5% in 1996 to $10.1 million from $16.9 million
for the year ended December 31, 1995. The decrease in non-standard automobile
coverages resulted primarily from the 100% reinsurance of all of the Company's
agency-produced non-standard automobile premium with Allstate effective May 1,
1996. Net premiums earned for direct response non-standard automobile coverages
have decreased slightly for the twelve months ended December 31, 1996 versus the
year earlier period as the Company refocuses its marketing efforts for this
program.
Net premiums earned for specialty commercial lines, which are comprised
of security, fire and alarm, police, public officials and miscellaneous
commercial coverages, declined 15.8% to $10.7 million for the year ended
December 31, 1996 as compared to $12.7 million for the year earlier. Within the
specialty commercial lines, net premiums earned for security, fire and alarm
coverages remained flat at $8.2 million. The Company has experienced a 38.6%
increase in policy counts from December 31, 1995 to December 31, 1996. The
Company has been actively targeting smaller insureds for its specialty
commercial coverages during this period. The Company has experienced some
deterioration in premium rates during 1996. The Company began writing these
coverages under a quota share reinsurance arrangement with Empire effective July
18, 1996. The Company believes that Empire's A+ (Superior) A.M. Best rating will
allow it to write these coverages more profitably in the future. During the
first quarter of 1996, the Company decided to non-renew a substantial amount of
the police business. As a result, net premiums earned for police and public
official coverages (often provided in tandem) declined 58.2% during 1996.
19
<PAGE>
NET INVESTMENT INCOME AND REALIZED INVESTMENT GAINS (LOSSES)
Net investment income decreased approximately $455,000 to $5.5 million
for the year ended December 31, 1996 as compared to $5.9 million for the year
ended December 31, 1995. The primary reason for the decrease was the Company's
recognition of a $500,000 yield maintenance fee on the early repayment of a
mortgage loan in the third quarter of 1995.
For the year ended December 31, 1996, the Company realized a net gain
on the sale of investments of $487,000 versus a net loss on the sale of
investments of $14,000 for the same period in the prior year. The net loss on
the sale of investments during 1995 primarily resulted from the Company's
decision to reduce its investments in tax-exempt securities in the first quarter
of 1995.
At December 31, 1996, the unrealized gain on investments available for
sale, net of tax, was $184,000 in comparison to a $1.3 million unrealized gain
as of December 31, 1995. The market value of the Company's portfolio has been
adversely affected by the general rise in interest rates during 1996.
At December 31, 1996, approximately 24% of the Company's portfolio was
deployed in conservatively structured collateralized mortgage obligations as
compared with 34% at December 31, 1995. The securities represented by this
sector are primarily planned amortization class ("PAC") securities with a small
allocation to sequential pay securities. The Company does not own any Interest
Only ("I.O.s"), Principal Only ("P.O.s") or other volatile, high risk
structures. The Company has deployed funds, to varying degrees, in the
mortgage-backed securities sector since 1988. Each mortgage-backed security is
analyzed utilizing extremely conservative scenarios regarding prepayment
estimates to gauge any particular bond's sensitivity to varying prepayment
scenarios. The bonds that the Company owns within the mortgage-backed sector are
conservative with considerably less volatility than other bonds available in the
collateralized mortgage obligation market. The Company believes that cash flow
variability is very modest and is more than offset by the incremental return
offered by this sector.
GAIN ON SALE OF AGENCY CONTRACTS AND MISCELLANEOUS INCOME
The Company recognized a gain on the sale of the All Nation agency
contracts to Deerbrook of $408,000 for the year ended December 31, 1996 (see
note 9 of Notes to Consolidated Financial Statements). The gain recognized
represents the net present value of the related payments from Deerbrook reduced
by All Nation's estimated liability for losses under the quota share reinsurance
contract with Allstate and costs attendant with the sale. Revenue related to the
non-compete clause of $318,000 has been recognized through December 31, 1996
under a straight-line amortization over the 36 month term of the non-compete
agreement.
LOSS AND LOSS ADJUSTMENT EXPENSES
Loss and loss adjustment expenses incurred decreased 28.4% to $16.6
million for the year ended December 31, 1996 from $23.2 million for the year
ended December 31, 1995. The loss and loss adjustment expense ratio for private
passenger automobile coverages increased to 85.0% for the year ended December
31, 1996 as compared to 81.7% for the year ended December 31, 1995. The increase
resulted primarily from declining rates during 1995 due to competitive pressures
in the non-standard automobile business placed through independent agents. The
Company implemented rate increases in all states during 1996 in an effort to
recognize pricing inadequacies and results have improved from the 103% loss
ratio experienced in the first quarter of 1996. Within the specialty commercial
lines, the loss and loss adjustment expense ratio increased to 72.0% for the
year ended December 31, 1996 versus 71.2% for the comparable period in the
preceding year. The 1995 loss ratio reflects a release of reserve redundancies
approximating $200,000. There were no reserve redundancy releases in 1996.
20
<PAGE>
AMORTIZATION OF DEFERRED ACQUISITION COSTS AND OTHER UNDERWRITING EXPENSES AND
INTEREST EXPENSE
Amortization of deferred acquisition costs and other underwriting
expenses represent the Company's costs to generate premium volume. For 1996,
acquisition costs and other underwriting expenses have decreased approximately
$2.3 million to $8.1 million for the year ended December 31, 1996 as compared to
$10.4 million for the same period in the preceding year. The Company's
underwriting expense ratio increased to 43.0% for the year ended December 31,
1996 in comparison to 35.2% for the year ended December 31, 1995. The increase
in the expense ratio principally occurred due to the amortization of deferred
acquisition costs in a declining premium environment and the recognition of
approximately $492,000 in expenses related to the Syndicate's withdrawal from
the IIE.
The Company incurred $1.2 million of interest expense related to the
$10 million senior subordinated notes during 1995 and 1996, respectively.
FEDERAL INCOME TAXES
The 1996 effective tax rate of 28.1% differs from the federal tax rate
of 34% primarily due to deductions for tax-exempt interest and dividends
received. The 1995 effective tax rate of 106.4% reflects the recording of a
deferred tax liability for the post-acquisition tax benefits of National Family
utilized by the Company. National Family is currently in liquidation and has
ceased all operations. IRS regulations ultimately require repayment of tax
benefits generated by National Family and used by the Company, therefore, the
Company provided for this liability in 1995.
NET INCOME (LOSS)
The Company recognized net income of $1.6 million in 1996 as compared
to a net loss of $52,000 in 1995. Net income for 1996 includes various
components of income in connection with the sale of All Nation's agency
appointments of approximately $1.5 million. The 1995 loss includes tax expense
of $472,000 related to the liability for tax benefits generated by National
Family. Excluding these two items, net income for 1996 decreased to $78,000 from
$420,000 in 1995 due primarily to the amortization of deferred acquisition costs
on a declining book of business and costs related to the Syndicate's withdrawal
from the IIE.
YEAR ENDED DECEMBER 31, 1995 COMPARED TO YEAR ENDED DECEMBER 31, 1994
NET PREMIUMS EARNED
Net premiums earned increased 2.9% in 1995 to $29.7 million from $28.8
million in 1994. Net premiums earned for private passenger non-standard
automobile coverages increased 21.2% in 1995 to $16.9 million from $14.0 million
for the year ended December 31, 1994. The increase resulted from several
factors, including the introduction of a direct marketing non-standard
automobile program late in 1994 that generated approximately $1.5 million in net
premiums earned in 1995. In addition, the Company commuted a 17.5 percent quota
share reinsurance agreement covering the non-standard automobile lines on
September 30, 1995. The Company retained approximately $900,000 additional net
premiums earned during the fourth quarter of 1995 because of the commutation.
The quota share agreement was in force during all of 1994. The Company also
recognized a modest increase in net premiums earned on its agency non-standard
automobile programs. Net premiums earned for specialty commercial lines declined
14.3% to $12.7 million for the year ended December 31, 1995 as compared to $14.9
million for the year earlier. Within the specialty commercial lines, net
premiums earned for security, fire and alarm coverages decreased 5.9% to $8.2
million primarily due to competitive pressures on rates. The Company actively
targeted smaller insureds in 1995, and as a result, policy counts for security,
fire and alarm coverages
21
<PAGE>
increased to 1,751 as of December 31, 1995 versus 1,192 as of December 31,1994.
Due to continued adverse loss development in the police line, the Company
implemented stricter underwriting standards and substantial rate increases in
early 1995. As a result, net premiums earned for police and public official
coverages (often provided in tandem) declined 35.1% during 1995. Policy counts
for police and public official coverages decreased 42.4% to 319 at December 31,
1995, down from 555 policies a year earlier. The Company decided in 1996 to
non-renew a substantial amount of the police business and review elimination of
the program in early 1997.
NET INVESTMENT INCOME AND REALIZED INVESTMENT GAINS (LOSSES)
Net investment income increased approximately $1.6 million to $5.9
million for the year ended December 31, 1995 as compared to $4.3 million for the
year ended December 31, 1994. The increase resulted from three factors,
including a $500,000 yield maintenance fee assessed in the third quarter of 1995
in connection with the repayment of the mortgage loan held by the Company. The
increase in net investment income also reflected an increase in the Company's
invested assets from the proceeds of the sale of senior subordinated notes in
December 1994. In addition, a shift in the Company's portfolio from tax-exempt
securities to taxable securities led to an increase in the pre-tax yield on
average invested assets to 6.4% for the year ended December 31, 1995 as compared
to 5.8% for the year earlier period.
For the year ended December 31, 1995, the Company realized a net loss
on the sale of investments of $14,000 versus $67,000 for the same period in the
prior year. The net loss on the sale of investments during 1995 primarily
resulted from the Company's decision to reduce its investments in tax-exempt
securities in the first quarter of 1995.
At December 31, 1995, the unrealized gain on investments available for
sale, net of tax, was $1.3 million in comparison to a $1.8 million unrealized
loss as of December 31, 1994. The market value of the Company's portfolio was
favorably affected by the decline in interest rates during 1995.
LOSS AND LOSS ADJUSTMENT EXPENSES
Loss and loss adjustment expenses incurred increased 21.1% to $23.2
million for the year ended December 31, 1995 from $19.2 million for the year
ended December 31, 1994. The loss and loss adjustment expense ratio for private
passenger automobile coverages increased to 81.7% for the year ended December
31, 1995 as compared to 69.7% for the year ended December 31, 1994. This
increase resulted from several factors. During 1995, the Company experienced
declining rates due to competitive pressures in the non-standard automobile
business placed through independent agents. In addition, severe weather
conditions in the winter months of 1995 adversely impacted the non-standard
automobile loss ratio. The 1994 loss and loss adjustment expense ratio was
favorably affected by mild weather in the winter months and the low average
severity and frequency of claims. In addition, the Company experienced highly
unfavorable loss development in 1995 in the startup of its direct marketing
program for non-standard automobile coverages. Due to software development
problems, the Company was unable to utilize the computer system anticipated to
be used in the direct marketing program, which made monitoring of losses related
to this program difficult. The Company purchased a new software package to
process its direct marketing program and discontinued related advertising until
the system was functional. Within the specialty commercial lines, the loss and
loss adjustment expense ratio increased to 71.2% for the year ended December 31,
1995 versus 63.6% for the comparable period in the preceding year. The primary
factors causing the increase in loss ratio were the emergence of claim severity
in the 1992 accident year for security coverages and the 1994 and 1995 accident
years for police claims made coverages and an increase in claim frequency across
the security and police lines in the 1995 accident year. The 1994 specialty
commercial lines loss ratio also included a $1.7 million release of reserve
redundancies. Approximately $200,000 in reserve redundancies were released from
the specialty commercial lines during 1995.
22
<PAGE>
AMORTIZATION OF DEFERRED ACQUISITION COSTS AND OTHER UNDERWRITING EXPENSES,
INTEREST EXPENSE AND MISCELLANEOUS INCOME (EXPENSE)
Amortization of deferred acquisition costs and other underwriting
expenses represent the Company's costs to generate premium volume. For 1995,
acquisition costs and other underwriting expenses increased approximately
$466,000 to $10.4 million for the year ended December 31, 1995 as compared to
$10.1 million for the same period in the preceding year. The Company's
underwriting expense ratio decreased to 35.2% for the year ended December 31,
1995 in comparison to 35.9% for the year ended December 31, 1994. The decrease
in the expense ratio principally occurred due to the 1994 write-off of
approximately $570,000 in expenses in conjunction with preparation for a public
equity offering the Company chose not to consummate.
Additionally, the Company incurred $1.2 million of interest expense
during 1995 related to the $10 million senior subordinated notes. The debt
originated late in the fourth quarter of 1994, therefore, the Company had
minimal interest expense in 1994.
FEDERAL INCOME TAXES
The 1995 effective tax rate of 106.4% exceeded the 1994 effective tax
rate of 19.4% due to a shift in the Company's investment portfolio from
tax-exempt to taxable securities and the recording of a deferred tax liability
for the post-acquisition tax benefits of National Family utilized to date by the
Company. National Family was anticipating an order of liquidation with a finding
of insolvency by a court of competent jurisdiction, with a subsequent cessation
of operations. IRS regulations ultimately require repayment of tax benefits
generated by National Family and used by the Company, therefore, the Company
provided for this liability in 1995.
NET INCOME (LOSS)
The Company realized a net loss of $52,000 in 1995 as compared to net
income of $2.9 million in 1994. The 1995 loss included interest expense of $1.1
million. Excluding interest expense, net income for 1995 decreased to $1.0
million from $2.8 million in 1994 due primarily to deteriorating loss ratios.
RECENT ACCOUNTING PRONOUNCEMENTS
The Company adopted SFAS No. 107 "Disclosures About Fair Value of
Financial Instruments" ("SFAS 107") in 1995. SFAS 107 requires disclosures of
fair-value information about financial instruments for which it is practicable
to estimate the value. The Company's financial instruments include investments,
cash and cash equivalents, the note receivable and the senior subordinated notes
payable. The adoption of SFAS 107 had no effect on the Company's financial
position or results of operations.
During 1995, the Financial Accounting Standards Board issued SFAS 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed of" ("SFAS 121"). SFAS 121 requires that long-lived assets and
certain identifiable intangibles to be held and used by an entity be reviewed
for impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. SFAS 121 was implemented by
the Company in 1996. The adoption of SFAS 121 did not have a material effect on
the operating results or financial condition of the Company.
23
<PAGE>
LIQUIDITY AND CAPITAL RESOURCES
Mercury is a holding company whose principal assets are its investment
in the capital stock of FMIC and All Nation. Mercury is dependent upon the
receipt of dividends from FMIC and All Nation to fund any necessary cash
requirements. FMIC and All Nation are restricted by regulation as to the amount
of dividends they may pay without regulatory approval. After giving effect to
those restrictions, during 1997, Mercury could receive up to $3.2 million in
dividends from its subsidiaries without prior regulatory approval. Mercury
received $1.9 million in dividends from its subsidiaries in 1996 (including $1.4
million in debt securities transferred from subsidiaries) which Mercury used for
payment of interest expense and preferred stock dividends. Mercury also received
$1.2 million during 1996 under its non-compete agreement with Deerbrook, with an
additional $1.2 million to be paid during 1997. In addition, Mercury receives
annual payments from its subsidiaries when appropriate pursuant to a tax
allocation agreement between Mercury and its subsidiaries.
Pursuant to the terms of the Mercury preferred stock, holders of
Mercury preferred stock generally have no voting rights or preemptive rights.
Cumulative dividends are payable at the rate of 13.2% per annum on a periodic
basis, as and when declared by the Board of Directors, before any dividends are
declared or paid on the outstanding Mercury common stock. Mercury preferred
stock is redeemable, at the option of Mercury, by resolution of its Board of
Directors, at any time at a redemption price of $125 per share plus accrued and
unpaid dividends, upon the giving of notice thereof to the holders of Mercury
preferred stock.
The Company's subsidiaries' primary sources of cash are from premiums
collected and amounts earned from the investment of this cash flow. The
principal uses of funds are the payment of claims and related expenses, other
operating expenses and interest expense. The Company's insurance operations
generated positive cash flow from operations of $1.3 million and $2.0 million
for the years ended December 31, 1994 and 1995, respectively, and utilized cash
from operations of $5.2 million for the year ended December 31, 1996. The
decrease in cash flow resulted from the decline in premium revenues at All
Nation under the quota share reinsurance agreement with Allstate.
At December 31, 1996, the insurance subsidiaries maintained cash and
cash equivalents and short-term investments of $5.8 million to meet short-term
payment obligations. In addition, the Company's investment portfolio is heavily
weighted toward short-term fixed maturities and a portion of the portfolio could
be liquidated without material adverse financial impact should further liquidity
be necessary.
As part of its investment strategy, and as required by debt covenants,
the Company establishes a level of cash and highly liquid short- and
intermediate-term securities which, combined with expected cash flow, is
believed adequate to meet foreseeable payment obligations. As part of this
strategy, the Company attempts to maintain an appropriate relationship between
the average duration of the investment portfolio and the approximate duration of
its liabilities.
Under IIE regulations, the Syndicate maintained a $1,000,000 deposit in
a Guaranty Fund Trust Account prior to its withdrawal from the IIE which
required at least 50 percent of the deposit to be in cash and/or marketable
securities. Under the terms of the Syndicate's withdrawal agreement with the
IIE, a $1,000,000 deposit must be maintained in the Guaranty Fund Account of the
IIE for a period of three years from November 7, 1996.
The Syndicate's withdrawal agreement also required FMIC to establish a
trust fund for the payment of claims under insurance policies issued and
reinsurance agreements entered into by the Syndicate. Investments held in trust
for the payment of Syndicate claims approximated $42.3 million at December 31,
1996.
24
<PAGE>
As of March 28, 1997, the Company had no outstanding commitments for
significant capital expenditures.
RISK-BASED CAPITAL REQUIREMENTS
The National Association of Insurance Commissioners ("NAIC") has
adopted certain risk-based capital standards for property and casualty insurance
companies. Risk-based capital requirements attempt to measure minimum statutory
capital needs based upon the risks in a company's mix of products and investment
portfolio. Both FMIC's and All Nation's ratios of total adjusted capital to
risk-based capital at December 31, 1996, substantially exceed the level which
would prompt regulatory action.
IMPACT OF INFLATION
Property and casualty insurance premiums are established before the
amounts of losses and loss expenses, or the extent to which inflation may affect
such amounts, are known. The Company attempts to anticipate the potential impact
of inflation in establishing its premiums and reserves. The Company, for
competitive reasons, is limited in the extent to which it can increase premiums
to account for anticipated inflation, and actual inflation may be greater than
anticipated. In either event, the Company, rather than its insureds, may have to
absorb any additional inflation costs.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and financial statement schedules, with the
independent auditor's report, listed in Item 14 are included in this Annual
Report on Form 10-K.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
25
<PAGE>
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS AND
EXECUTIVE OFFICERS
Each of the directors and officers of Mercury will hold office until
his or her successor is elected and qualified or until his or her earlier death,
resignation or removal. The directors and executive officers of Mercury are as
follows:
Name Age Position
- ------------------------- --- -----------------------------------------------
Jerome M. Shaw........... 53 Chief Executive Officer, Chairman of the Board
and Director
Richard H. Smith**....... 46 President and Chief Operating Officer
J. Michael Feeney........ 61 Executive Vice President, Secretary, Vice
Chairman of the Board and Director
William S. Weaver........ 54 Chief Financial Officer, Treasurer and Director
Peter M. Feeney.......... 37 Vice President and Director
A. Robert Armstrong*..... 67 Director
A. Michael Levin*........ 49 Director
William C. Tyler*........ 54 Director
- ----------
* Member of Audit Committee.
** Mr. Smith was hired effective January 1, 1996.
Jerome M. Shaw has been the Chief Executive Officer and Chairman of the
Board of Mercury since January 1994 and has been the chief architect of the
Company's strategy since he founded CoverX in 1973. He served as President of
Mercury from its inception until August 1994. Mr. Shaw has been the President
and a Director of MM since July 1985, the President, Secretary and a Director of
CoverX since November 1973 and a Director of All Nation since January 1992. Mr.
Shaw was the President of the Syndicate from July 1985 until its merger into
FMIC in December 1996. He has been the Chairman of the Board of FMIC since its
formation in 1996. Mr. Shaw also is a partner in Pledger-Cordwell Holdings, an
investment partnership that owns the property that serves as the Company's
headquarters. He was a member of the Board of Trustees of the IIE from 1986
through 1996, as well as having served as its Vice Chairman, Secretary and
Treasurer. Mr. Shaw has estimated that he devotes between two-thirds and
three-quarters of his business time to the affairs of the Company and the
Service Companies. He holds B.A., Ph.B. and J.D. degrees from Montieth College,
Wayne State University and Wayne State University College of Law, respectively,
and is a member of the Michigan Bar Association.
Richard H. Smith has served as President and Chief Operating Officer of
Mercury since January 1996. Mr. Smith has been President of All Nation since
March 1996. He has been the President and a Director of FMIC since its formation
in 1996. Mr. Smith has twenty years of insurance industry experience, serving in
several different capacities with his previous employer, Providian Corporation.
He holds B.S. and M.B.A. degrees from the University of Arkansas and the
University of Louisville, respectively.
J. Michael Feeney has been the Executive Vice President, Secretary and
a Director of Mercury since January 1994 and Vice Chairman of the Board since
September 1995. He has been a Vice President and a Director of MM since July
1985, a Vice President and Director of CoverX since November 1975, a Director of
All Nation since January 1992 and the Vice President of All Nation since March
1996. Mr.
26
<PAGE>
Feeney was a Vice President and Director of the Syndicate from July 1985 until
its merger into FMIC in December 1996. He has been the Secretary, a Vice
President and Director of FMIC since its formation in 1996. Mr. Feeney also is a
partner of Pledger-Cordwell Holdings. Mr. Feeney has estimated that he devotes
between two-thirds and three-quarters of his business time to the affairs of the
Company and the Service Companies.
William S. Weaver has been the Treasurer, Chief Financial Officer and a
Director of Mercury since January 1994 and is generally responsible for the
Company's financial operations. He has been the Secretary, Treasurer and a
Director of MM since December 1992 and the Treasurer and a Director of CoverX
since December 1993. Mr. Weaver was the Treasurer of the Syndicate from October
1992 until its merger into FMIC in December 1996. He has been the Treasurer and
a Director of FMIC since its formation in 1996. Mr. Weaver has estimated that he
devotes between two thirds and three-quarters of his business time to the
affairs of the Company and the Service Companies. He is a Certified Public
Accountant and has been a member of the Michigan Association of Certified Public
Accountants since 1972.
Peter M. Feeney has been a Vice President and Director of Mercury since
April 1995. He has been President of American Risk Pooling Consultants, Inc.
since April 1995. Mr. Feeney has estimated that he devotes half of his business
time to the affairs of the Company and the Service Companies.
A. Robert Armstrong has been a Director of Mercury since January 1994.
He served as a Director of the Syndicate from August 1990 until its merger into
FMIC in December 1996. Since 1972 he has been the President of Armstrong Leasing
& Rental, Inc. and the Vice President of Armstrong Buick, Inc.
A. Michael Levin has been a Director of Mercury since January 1994. Mr.
Levin was a Director of the Syndicate from February 1986 until its merger into
FMIC in December 1996. He has been President of Management and Sales of A.M.
Levin Insurance Associates, Inc. since July 1980. He has been a branch manager
for Sun Life Assurance Company of Canada since May 1986. Since May 1991, he has
been Vice President of Apple Industries Limited, a supplier to the phone
industry for equipment purchasing.
William C. Tyler has been a Director of Mercury since January 1994. Mr.
Tyler served as a Director of the Syndicate from February 1986 until its merger
into FMIC in December 1996. Since 1971 he has been Senior Vice President of
McKinley Associates, Inc., which engages in real estate financing and business
acquisitions and dispositions.
LIMITATION OF LIABILITY AND INDEMNIFICATION
Pursuant to the provisions of the Delaware General Corporation Law,
Mercury has adopted provisions in the Certificate of Incorporation which
eliminate the personal liability of its directors to Mercury or its stockholders
for monetary damages for breach of their duty of due care, and which require
Mercury to indemnify its directors and permit Mercury to indemnify its officers
or employees to the fullest extent permitted by Delaware law, including those
circumstances in which indemnification would otherwise be discretionary, except
that Mercury shall not be obligated to indemnify any such person (i) with
respect to proceedings, claims or actions initiated or brought voluntarily by
any such person and not by way of defense, or (ii) for any amounts paid in
settlement of an action indemnified against by Mercury without the prior written
consent of Mercury. Mercury has entered into indemnity agreements with each of
its directors and certain of its officers providing for such indemnification.
27
<PAGE>
ITEM 11. EXECUTIVE COMPENSATION
In 1996, the Service Companies, pursuant to various agreements, provide
underwriting, claims, administration, finance and other management services to
the Company, including the services of the Company's executive officers. With
the exception of Mr. Smith, under the terms of the agreements, the Company pays
no salary or other cash remuneration directly to its executive officers. A
portion of Mr. Smith's compensation is paid directly by All Nation. The
compensation received by the Company's executive officers from the Service
Companies is not directly related to services provided by them to the Company or
to results of the Company. Under the terms of the agreements, the commissions
paid by the Company to the Service Companies are not based on the time devoted,
or services provided, to the Company by personnel employed by the Service
Companies; rather, the commissions are based upon percentages of gross premium
and profit. In addition to its relationship with the Company, MM also receives
compensation and incurs expenses in connection with activities unrelated to the
Company. MM does not allocate its expenses, including the compensation paid to
those persons who serve as the Company's executive officers, between the Company
and MM's other activities.
The following table sets forth information with respect to the
compensation paid to the Chief Executive Officer of the Company and to each of
the Company's other executive officers whose total salary and bonus paid by the
Service Companies exceeded $100,000 during 1996, 1995 and 1994 (the "Named
Executive Officers"). No other executive officer of the Company received in
excess of $100,000 in total salary and bonus during 1994, 1995 and 1996 from the
Company or the Service Companies:
SUMMARY COMPENSATION TABLE
Annual Compensation
---------------------------------
Other Annual
Name and Principal Position Year Salary(1) Bonus(1) Compensation
- ------------------------------ ---- --------- -------- ------------
Jerome M. Shaw 1996 $ 420,744 $ 0 (2)
Chief Executive Officer 1995 $ 419,891 $ 175,000 (2)
and Chairman of the Board 1994 $ 414,800 $ 599,140 (2)
J. Michael Feeney 1996 $ 140,100 $ 21,000 (2)
Executive Vice President and 1995 $ 140,682 $ 68,000 (2)
Vice Chairman of the Board
Richard H. Smith
President and Chief Operating
Officer 1996 $ 220,690 $ 14,322 (2)
William S. Weaver 1996 $ 137,936 $ 15,500 (2)
Chief Financial Officer 1995 $ 135,804 $ 24,000 (2)
- ----------
(1) These amounts include all salary and bonus, as appropriate, paid by the
Service Companies for services rendered by the Named Executive Officers with
respect to the Service Companies (paid by All Nation for Mr. Smith). As
indicated elsewhere in this Form 10-K, the Service Companies received
revenue for services performed for entities other than the Company during
1996,1995 and 1994. See "Item 13 -- Certain Relationships and Related
Transactions -- Prime."
(2) The aggregate amount of such compensation did not exceed 10% of the total of
annual salary and bonus reported for the Named Executive Officer.
28
<PAGE>
KEY PERSON LIFE INSURANCE
FMIC is the beneficiary of key person life insurance policies on the
lives of Messrs. Shaw and Feeney in the aggregate amounts of $4.0 million and
$2.0 million, respectively.
DIRECTOR COMPENSATION
Each Director who is not an officer of the Company is entitled to
receive $500 for attendance at each meeting of the full Board of Directors.
Directors are also entitled to reimbursement for their expenses incurred in
attending meetings.
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<PAGE>
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth, as of the date hereof, certain
information with respect to the beneficial ownership of the Company's common
stock and preferred stock by (i) each person known by the Company to own
beneficially more than 5% of the outstanding shares of common stock, (ii) each
person known by the Company to own beneficially more than 5% of the outstanding
shares of preferred stock, (iii) each director of the Company, (iv) each of the
Named Executive Officers, and (v) all executive officers and directors as a
group.
<TABLE>
<CAPTION>
Shares of Shares of
Common Stock Percent of Preferred Stock Percent of
Beneficially Ownership of Beneficially Ownership of
Owned(1) Common Stock Owned(1) Preferred Stock
------------ ------------ --------------- ---------------
<S> <C> <C> <C> <C>
Jerome M. Shaw(2)(3)(4)(10)(11)* ..... 1,535.5 24.9% 5,250 25.2%
J. Michael Feeney(3)(6)(10)* ......... 835 13.5 3,000 14.4
Ronald N. Weiser(5) .................. 523.4 8.5 1,575 7.6
William S. Weaver(9)(10)* ............ 465 7.5 1,625 7.8
Richard H. Smith(10)* ................ 448 7.3 1,575 7.6
Peter M. Feeney(10)* ................. 448 7.3 1,575 7.6
4SFW, LLC(2) ......................... 448 7.3 1,575 7.6
Shaw Fin Holdings, LLC(2) ............ 356 5.8 1,200 5.8
Pledger-Cordwell Holdings, LLC(2) .... 312 5.1 1,200 5.8
A. Robert Armstrong* ................. 50 0.8 150 0.7
A. Michael Levin(7)* ................. 50 0.8 150 0.7
William C. Tyler(8)* ................. 47.2 0.8 150 0.7
All executive officers and directors
as a group (8 persons) ............. 1,774.7 28.9% 5,975 28.7%
</TABLE>
- ----------
(1) Other than as may be provided in the Agreement Among Stockholders and as
otherwise disclosed herein, the persons in the above table have sole voting
and investment power with respect to all shares shown as beneficially owned
by them. Pursuant to the Agreement Among Stockholders, Mr. Shaw has the
power to nominate a majority of the directors of the Company and the
stockholders of the Company are obligated to elect those persons so
nominated. Additionally, the stockholders of the Company, pursuant to the
Agreement Among Stockholders, have appointed Mr. Shaw as their proxy to
vote in Mr. Shaw's discretion upon matters involving (i) an increase or
decrease in the number of authorized shares of any class of the Company's
stock and (ii) stock splits, combinations or any dividend paid in shares,
in connection with any class of the Company's stock.
(2) The address of this stockholder is c/o First Mercury Financial Corporation,
29621 Northwestern Highway, P.O. Box 5096, Southfield, Michigan 48086.
(3) Includes 312 common shares and 1,200 preferred shares held by
Pledger-Cordwell Holdings, LLC over which all members have shared
investment and voting power.
(4) Includes 356 common shares and 1,200 preferred shares held by Shaw Fin
Holdings, LLC over which Mr. Shaw has shared investment and voting power.
(5) The address of this stockholder is McKinley Associates, Inc., 320 N. Main
Street, #200, Ann Arbor, Michigan 48104. Includes 139 common shares and 450
preferred shares held by McKinley Associates, of which Mr. Weiser is the
85% owner, and 12.5 common shares and 37.5 preferred shares that are owned
by his wife, Eileen Weiser.
(6) Includes 75 common shares and 225 preferred shares owned by Mr. Feeney in a
joint tenancy with right of survivorship with his wife, Ann E. Feeney.
(7) All of the shares attributed to Mr. Levin are owned by the A. Michael Levin
Revocable Trust.
(8) All of the shares attributed to Mr. Tyler are owned by WCT Investment
Trust, of which Mr. Tyler is the trustee.
(9) Includes 17 common shares and 50 preferred shares attributed to Mr. Weaver
from the Isadore Silverman Revocable Trust, of which Mr. Weaver is the
beneficiary of one-third of these shares.
(10) Includes 448 common shares and 1,575 preferred shares held by 4SFW over
which all members have shared investment and voting power.
(11) Includes 19.5 common shares and 75 preferred shares of CoverX Corporation
of which Mr. Shaw is the controlling stockholder.
* Represents an executive officer or a director of the Company.
30
<PAGE>
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The following are transactions and relationships currently in force, or
which are currently proposed, to which the Company is or is anticipated to be a
party:
AGREEMENT AMONG STOCKHOLDERS
The Company and its stockholders are subject to an Agreement Among
Stockholders that allows Mr. Shaw to nominate a majority of the directors of the
Company, and obligates the stockholders of the Company to elect those persons so
nominated. Pursuant to the Agreement Among Stockholders, the stockholders of the
Company also have appointed Mr. Shaw as their proxy, until and including
December 31, 2000, to vote in Mr. Shaw's discretion upon matters involving (i)
an increase or decrease in the number of authorized shares of any class of the
Company's stock, and (ii) stock splits, combinations or any dividend paid in
shares, in connection with any class of the Company's stock. Furthermore, the
Agreement Among Stockholders provides for certain restrictions on the
transferability of the Company's stock, including a first right of refusal to
the benefit of the Company and a second right of refusal to the benefit of both
the Company and the Company's stockholders. In addition, in the event the
Management Agreement between FMIC and MM is terminated or not renewed by the
Company, the Agreement Among Stockholders grants to the Shaw-Feeney Group the
option to "put" to the Company all shares of the Company's stock that are owned
by the Shaw-Feeney Group for cash at full book value, although, pursuant to the
Indenture, no payments can be made pursuant to the exercise of such "put" option
until holders of the Notes have been given the opportunity to redeem their Notes
and such redemptions have occurred. As of December 31, 1996, the stock owned by
the Shaw-Feeney Group represented approximately 17.6% and 17.1% of the issued
and outstanding shares of the Company's common stock and preferred stock,
respectively, and as of December 31, 1996, such a "put" by the Shaw-Feeney Group
would have resulted in a payment by the Company of approximately $4.7 million.
Furthermore, should the Shaw-Feeney Group receive a bona fide offer to purchase
all or substantially all of the outstanding stock of the Company, the
Shaw-Feeney Group may require the remaining stockholders of the Company to sell
all of their stock to the same party on the same terms and conditions and at the
same price per share as the shares of stock owned by the Shaw-Feeney Group. The
Agreement Among Stockholders may be amended, modified or terminated, subject to
certain restrictions, only by agreement of the holders of more than 90% of the
Company's common stock. The Agreement Among Stockholders automatically will
terminate on the date a registered public offering of the Company's common stock
is declared effective with the Securities and Exchange Commission.
SERVICE COMPANIES
Prior to its merger into FMIC, the Syndicate was party to a General
Agency Agreement with CoverX and a Management Agreement with MM whereby CoverX
and MM provide underwriting, administrative, marketing and claims handling
services to the Syndicate in exchange for certain percentages of the Syndicate's
annual gross written premiums. CoverX and MM are controlled by Jerome M. Shaw.
Under the General Agency Agreement, the Syndicate paid to Cover X as
compensation for services rendered and expenses incurred an amount equal to 21.5
percent of the gross written premium on the business that is subject to the
General Agency Agreement between the Syndicate and Cover X. The aggregate
compensation paid by the Syndicate to Cover X approximated $1,565,000 for the
year ended December 31, 1996.
31
<PAGE>
Additionally, Cover X was reimbursed each year on a cost per file basis
for the claims handling services it provided on Syndicate files. The aggregate
reimbursement paid to Cover X approximated $540,000 for the year ended December
31, 1996.
Under the Management Agreement between the Syndicate and MM, the
Syndicate paid to MM annual compensation equal to 6.5 percent of the Syndicate's
gross written premiums, which approximated $370,000 for the year ended December
31, 1996. The Syndicate also reimbursed MM in the amount of 3 percent of gross
written premiums (excluding premiums assumed from All Nation) for unallocated
loss adjustment expenses, which approximated $346,000 for the year ended
December 31, 1996.
Effective June 28, 1996, FMIC and MM entered into a management
agreement whereby MM administers certain aspects of the business of FMIC,
including marketing and promotional activities, administration, investment and
financial oversight services for compensation equal to 15 percent of FMIC's
direct and assumed written premium. Compensation paid to MM approximated
$288,000 for the year ended December 31, 1996. FMIC has no General Agency
Agreement with CoverX at December 31, 1996.
All Nation pays to MM an annual administrative fee equal to the greater
of 2.5% of All Nation's annual gross written premium or $500,000. The aggregate
compensation paid by All Nation to MM in 1996 was $500,000.
The Company's Board has approved an arrangement with MM whereby MM
receives a management and consulting fee in the amount of 2.5% of the gross
written premium of any insurance company or other risk-bearing entity that is
acquired by the Company. No such fees were paid in 1996.
The contracts between the insurance subsidiaries and the Service
Companies, including the consideration set forth therein, were structured to
provide that the Company's expenses (other than expenses attributable to losses
on insurance policies) would remain stable and fixed as a percentage of premium.
The consideration was set at rates that would be reasonable from the perspective
of the companies, yet still permit appropriate profit to the Service Companies.
Each of the contracts between the companies and the Service Companies was
unanimously approved by the companies' respective boards, including all
independent board members.
The Company believes that all of its past, current and proposed
transactions with affiliates were, are or will be, as the case may be, made and
entered into on terms neither materially more nor materially less favorable to
the Company than those available from unaffiliated third parties. The Company
submits all affiliated-party transactions, including the specific contemplated
terms and consideration of such transactions, for the consideration and approval
of the Company's full Board, including the approval of a majority of
disinterested directors. Additionally, certain affiliated-party transactions are
subject to notification or approval requirements of applicable regulatory
authorities. See "Item 1 -- Business -- Regulation -- Holding Company Systems
Regulation."
LOAN TO OKC APARTMENTS LIMITED PARTNERSHIP
On October 1, 1991, the Company extended a secured loan of $2,750,000
to OKC Apartments Limited Partnership ("OKC"), of which Ronald N. Weiser and
McKinley Associates, Inc., a Michigan corporation ("McKinley"), stockholders of
the Company, are general partners. William C. Tyler, a director of Mercury, is
an officer and minority owner of McKinley. The loan was secured by a
32
<PAGE>
mortgage on commercial real property and the borrower's investment in common
stock of Mercury, as well as by guarantees of the general partners of OKC.
Interest on the loan was payable quarterly at an annual rate of 11%. During
1995, the loan was repaid in full. The Company received a $500,000 yield
maintenance fee in 1995 as a result of the early repayment.
PRIME
Prime Syndicate, Inc., an Illinois corporation and member of the IIE,
began writing business in 1992, and participated until September 30, 1995 in a
reinsurance agreement whereby the Syndicate ceded certain business to Prime. The
reinsurance premiums ceded to Prime by the Syndicate in 1995 were $2,807,000. On
December 22, 1995, the management agreement between MM and Prime was terminated.
Messrs. Shaw and Feeney sold the shares of Prime they owned indirectly through
Pledger-Cordwell Holdings, and Messrs. Shaw, Feeney and Weaver resigned from
their positions as officers and/or directors of Prime.
33
<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this Form 10-K:
1. The following financial statements of the Company, with the report of
independent auditors, are filed as part of this Form 10-K:
Independent Auditors' Report
Consolidated Balance Sheets as of December 31, 1995 and 1996
Consolidated Statements of Operations for the Years Ended
December 31, 1994, 1995 and 1996
Consolidated Statements of Stockholders' Equity for the Years Ended
December 31, 1994, 1995 and 1996
Consolidated Statements of Cash Flows for the Years Ended December 31,
1994, 1995 and 1996
Notes to Consolidated Financial Statements
2. The following financial statement schedules of the Company are filed
as part of this Form 10-K:
Schedule I -- Summary of Investments
Schedule II -- Condensed Financial Statements of First Mercury
Financial Corporation (Parent Company)
Schedule IV -- Reinsurance
Schedule VI -- Supplemental Information Concerning
Property/Casualty Insurance Companies
All other financial schedules are omitted because such
schedules are not required or the information required has
been presented in the aforementioned financial statements.
34
<PAGE>
3. The following exhibits are filed with this Report or incorporated by
reference as set forth below.
Exhibit Number
- --------------
3.1* Amended and Restated Certificate of Incorporation of the Company
3.2* Amended and Restated Bylaws of the Company
4.1* Form of Indenture relating to the Notes
4.2* Form of Note (included in Exhibit 4.1)
10.1* Agreement Among Stockholders effective as of January 1, 1994 among
the Company (formerly known as Mercury Insurance Group, Inc.) and
its stockholders
10.2* Management Agreement dated February 5, 1991 between First Mercury
Syndicate, Inc. (the "Syndicate") and Mercury Management, Inc.
("MM")
10.3* General Agency Agreement dated November 29, 1985 between the
Syndicate, MM, and CoverX, as amended
10.4* Administration Agreement dated August 23, 1994 between All Nation
Insurance Company ("All Nation") and MM
10.5* Form of Directors' Indemnification Agreement
10.6* Stock Option Agreement dated April 2, 1993 between All Nation and
Insurance Services of Minnesota, Inc.
10.7** Quota Share Reinsurance Agreement effective January 1, 1992
between All Nation and the Syndicate, as amended
10.8** Excess Casualty Reinsurance Agreement effective November 1, 1992
between the Syndicate and Reliance Insurance Company, as amended
10.9* Automatic Facility Excess of Loss Reinsurance Agreement effective
July 1, 1991 between the Syndicate and National Reinsurance
Corporation
10.10* Property Facultative Binding Agreement effective November 1, 1990
between the Syndicate and Munich American Reinsurance Company
10.11* Quota Share Reinsurance Agreement effective April 1, 1993 between
the Syndicate and Prime Syndicate, Inc.
10.12* Loan Agreement, Mortgage Note, Guaranty Agreement, and Pledge and
Security Agreement dated October 1, 1991
10.13* Form of Agreement for the Sale and Purchase of Shares of Common
Stock of All Nation between the Syndicate and the Company
10.14** Tax Allocation Agreement dated March 1, 1995 among First Mercury
Financial Corporation, the Syndicate, All Nation and National
Family Insurance Corporation
10.15*** Excess Casualty Reinsurance Agreement effective November 1, 1995
between the Syndicate and Reliance Insurance Company
10.16*** Reinsurance Commutation effective September 30, 1995 between the
Syndicate and Prime
10.17*** Reinsurance Commutation effective September 30, 1995 between the
Syndicate and Prime
10.18**** Quota Share Reinsurance Contract effective May 1, 1996 between
Allstate Insurance Company and All Nation
10.19**** Service Agreement effective May 1, 1996 between All Nation,
Mercury, Allstate and Deerbrook
10.20***** Reinsurance Agreement effective June 28, 1996 between the
Syndicate and FMIC
10.21****** Withdrawal Agreement effective November 7, 1996 between the
Syndicate and the IIE
10.22 Trust Agreement effective December 16, 1996 between the Syndicate
and LaSalle National Trust, N.A.
10.23 Management Agreement dated December 24, 1996 between FMIC and MM
21* Subsidiaries of the Company
- ----------
* Incorporated by Reference to the same Exhibit number in the Company's
Registration Statement on Form S-1 (File No. 33-83382).
** Incorporated by Reference to the same Exhibit number in the Company's
December 31, 1994 Form 10-K (File No. 33-83382).
*** Incorporated by Reference to the same Exhibit number in the Company's
December 31, 1995 Form 10-K (File No. 33-83382).
**** Incorporated by Reference to the same Exhibit number in the Company's
March 31, 1996 Form 10-Q (File No. 33-83382).
***** Incorporated by Reference to the same Exhibit number in the Company's
June 30, 1996 Form 10-Q (File No. 33-83382).
****** Incorporated by Reference to the same Exhibit number in the Company's
September 30, 1996 Form 10-Q (File No. 33-83382).
(b) Reports on Form 8-K:
The Company did not file any reports on Form 8-K during the fourth
quarter of 1996.
35
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, on the 28th day of
March, 1997.
FIRST MERCURY FINANCIAL CORPORATION
By: /s/ JEROME M. SHAW
--------------------------------
Jerome M. Shaw,
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities indicated on the 28th day of March, 1997.
Signature Title
---------- -----
/s/ JEROME M. SHAW Chief Executive Officer (Principal Executive Officer)
- ------------------------ and a Director
Jerome M. Shaw
/s/ RICHARD H. SMITH President and Chief Operating Officer
- ------------------------
Richard H. Smith
/s/ J. MICHAEL FEENEY Executive Vice President and a Director
- ------------------------
J. Michael Feeney
/s/ WILLIAM S. WEAVER Chief Financial Officer (Principal Financial and
- ------------------------ Accounting Officer) and a Director
William S. Weaver
/s/ PETER M. FEENEY Vice President and a Director
- ------------------------
Peter M. Feeney
/s/ A. ROBERT ARMSTRONG Director
- ------------------------
A. Robert Armstrong
/s/ A. MICHAEL LEVIN Director
- ------------------------
A. Michael Levin
/s/ WILLIAM C. TYLER Director
- ------------------------
William C. Tyler
36
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Consolidated Financial Statements
For the Years Ended December 31, 1994, 1995 and 1996
(With Independent Auditors' Report Thereon)
37
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Table of Contents
Page(s)
-------
Independent Auditors' Report 1
Consolidated Balance Sheets 2
Consolidated Statements of Operations 3
Consolidated Statements of Stockholders' Equity 4
Consolidated Statements of Cash Flows 5
Notes to Consolidated Financial Statements 6-26
38
<PAGE>
Independent Auditors' Report
The Board of Directors
First Mercury Financial Corporation and Subsidiaries:
We have audited the accompanying consolidated balance sheets of First Mercury
Financial Corporation and subsidiaries (the Company) as of December 31, 1996 and
1995, and the related consolidated statements of operations, stockholders'
equity, and cash flows for each of the years in the three-year period ended
December 31, 1996. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the consolidated financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the consolidated financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
consolidated financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of First Mercury
Financial Corporation and subsidiaries at December 31, 1996 and 1995, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 1996, in conformity with generally accepted
accounting principles.
/s/ KPMG Peat Marwick LLP
Detroit, Michigan
March 14, 1997
39
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, 1995 and 1996
<TABLE>
<CAPTION>
Assets 1995 1996
------ ---- ----
<S> <C> <C>
Investments:
Debt securities $ 77,626,804 $ 71,871,818
Preferred stocks 3,694,910 2,691,194
Common stocks -- 52,200
Short-term investments 4,413,700 1,810,340
------------ ------------
Total investments 85,735,414 76,425,552
Cash and cash equivalents 2,336,140 3,945,289
Premiums receivable 2,962,607 2,105,725
Note receivable 300,000 300,000
Accrued investment income receivable 905,699 1,078,346
Reinsurance recoverable on paid losses 133,341 478,919
Reinsurance recoverable on unpaid losses 3,556,940 8,484,364
Prepaid reinsurance premiums 705,870 1,799,876
Deferred acquisition costs 1,673,291 691,319
Deferred federal income taxes 1,813,631 2,288,715
Federal income taxes recoverable 1,199,775 571,541
Fixed assets, net of accumulated depreciation 1,654,401 1,667,317
Installment and service contract receivable -- 898,779
Other assets 1,068,272 1,375,631
------------ ------------
Total assets $104,045,381 $102,111,373
============ ============
Liabilities and Stockholders' Equity
------------------------------------
Loss and loss adjustment expense reserves (includes $1,635,743
and $1,656,889 of related party unallocated loss adjustment
expense reserves at December 31, 1995 and 1996, respectively) 56,570,332 $ 55,519,174
Unearned premium reserves 8,800,175 5,656,660
Senior subordinated notes payable, net of repurchases of
$775,000 in 1996 10,000,000 9,225,000
Ceded reinsurance payable 254,657 87,373
Funds held under reinsurance contracts -- 842,295
Deferred revenue -- 2,181,975
Accounts payable and accrued expenses 2,015,347 2,080,221
------------ ------------
Total liabilities 77,640,511 75,592,698
Minority interest 3,634 3,278
Stockholders' equity:
Cumulative preferred stock, $0.01 par value. Authorized
23,000 shares; issued and outstanding 20,850 shares 209 209
Common stock, $0.01 par value. Authorized 7,000 shares;
issued and outstanding 6,164.07 shares 62 62
Gross paid-in and contributed capital 3,474,872 3,437,372
Net unrealized gains, net of federal income taxes of
$654,558 and $94,674 in 1995 and 1996, respectively 1,270,614 183,780
Retained earnings 21,655,479 22,893,974
------------ ------------
Total stockholders' equity 26,401,236 26,515,397
------------ ------------
Commitments and contingencies
Total liabilities and stockholders' equity $104,045,381 $102,111,373
============ ============
</TABLE>
See accompanying notes to consolidated financial statements.
40
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Consolidated Statements of Operations
For the years ended December 31, 1994, 1995 and 1996
<TABLE>
<CAPTION>
1994 1995 1996
---- ---- ----
<S> <C> <C> <C>
Revenues and other income:
Gross written premiums $ 33,312,655 $ 34,122,402 $ 27,221,164
Less:
Ceded premiums written (2,177,079) (1,891,846) (10,577,268)
Ceded premiums written - Prime Syndicate, Inc. (3,116,206) (2,806,892) --
------------ ------------ ------------
Net premiums written 28,019,370 29,423,664 16,643,896
Decrease in unearned premiums 819,347 250,474 4,170,445
------------ ------------ ------------
Net earned premiums 28,838,717 29,674,138 20,814,341
Net investment income 4,323,458 5,939,793 5,484,295
Realized gains (losses) on sales of investments (67,434) (13,607) 487,146
Gain on sale of agency-produced non-standard automobile business -- -- 407,692
Miscellaneous income (expense) (274,960) 72,951 994,156
------------ ------------ ------------
Total revenues and other income 32,819,781 35,673,275 28,137,630
------------ ------------ ------------
Expenses:
Losses and loss adjustment expenses 22,925,634 23,465,177 25,243,565
Less:
Ceded losses and loss adjustment expenses (1,579,335) 1,869,779 (8,605,199)
Ceded losses and loss adjustment expenses - Prime
Syndicate, Inc. (2,155,727) (2,094,182) --
------------ ------------ ------------
Losses and loss adjustment expenses, net (includes
related party loss adjustment expenses of
$1,167,698, $879,004 and $864,954 for the years
ended December 31, 1994, 1995, and 1996,
respectively) 19,190,572 23,240,774 16,638,366
Amortization of deferred acquisition expenses 5,748,216 5,850,480 3,905,689
Other underwriting expenses 2,719,480 3,260,777 3,033,955
Other underwriting expenses - related parties 1,593,060 1,320,864 1,158,147
Interest expense 6,027 1,192,085 1,201,919
------------ ------------ ------------
Total expenses 29,257,355 34,864,980 25,938,076
------------ ------------ ------------
Income before federal income taxes 3,562,426 808,295 2,199,554
Federal income taxes 689,616 860,025 617,034
------------ ------------ ------------
Net income (loss) 2,872,810 (51,730) 1,582,520
Less dividends on cumulative preferred stock (344,025) (344,025) (344,025)
------------ ------------ ------------
Net income (loss) available to common stockholders
$ 2,528,785 $ (395,755) $ 1,238,495
============ ============ ============
Per-share earnings (loss) $410.25 $(64.20) $200.92
======= ======= =======
</TABLE>
See accompanying notes to consolidated financial statements.
41
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Consolidated Statements of Stockholders' Equity
Years ended December 31, 1994, 1995 and 1996
<TABLE>
<CAPTION>
Net
Unrealized
Gains
Gross (Losses), Net
Paid-in of Federal
Cumulative and Income
Preferred Common Contributed Taxes Retained
Stock Stock Capital (Benefit) Earnings Total
---------- ------ ----------- -------------- -------- -----
<S> <C> <C> <C> <C> <C> <C>
Balances at December 31, 1993 $209 $ 62 $ 3,437,372 $ 968,214 $ 19,522,449 $ 23,928,306
Net Income -- -- -- 2,872,810 2,872,810
Dividends paid to cumulative preferred
stockholders -- -- -- (344,025) (344,025)
Change in net unrealized gains (losses)
on marketable investment securities
-- (2,720,461) -- (2,720,461)
---- ---- ----------- ----------- ------------ ------------
Balances at December 31, 1994 209 62 3,437,372 (1,752,247) 22,051,234 23,736,630
Net loss -- -- -- (51,730) (51,730)
Dividends paid to cumulative preferred
stockholders -- -- -- (344,025) (344,025)
Change in net unrealized gains (losses)
on marketable investment securities
-- -- 3,022,861 -- 3,022,861
Capital drawn under letters of credit -- 37,500 -- -- 37,500
---- ---- ----------- ----------- ------------ ------------
Balances at December 31, 1995 209 62 3,474,872 1,270,614 21,655,479 26,401,236
Net income -- -- -- 1,582,520 1,582,520
Dividends paid to cumulative preferred
stockholders -- -- -- (344,025) (344,025)
Return of capital drawn under letters of
credit -- (37,500) -- -- (37,500)
Change in net unrealized gains (losses)
on marketable investment securities -- -- (1,086,834) -- (1,086,834)
---- ---- ----------- ----------- ------------ ------------
Balances at December 31, 1996 $209 $ 62 $ 3,437,372 $ 183,780 $ 22,893,974 $ 26,515,397
==== ==== =========== =========== ============ ============
</TABLE>
See accompanying notes to consolidated financial statements.
42
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Years ended December 31, 1994, 1995 and 1996
<TABLE>
<CAPTION>
1994 1995 1996
---- ---- ----
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss) $ 2,872,810 $ (51,730) $ 1,582,520
Adjustments to reconcile net income (loss) to net cash provided by
operating activities:
Depreciation and amortization 519,402 (179,720) 181,159
Net (gains) losses on sales of investments 67,434 13,607 (487,146)
Changes in assets and liabilities:
Decrease (increase) in premiums receivable 473,722 (660,411) 856,882
Decrease (increase) in prepaid reinsurance premiums (79,855) 19,992 (1,094,006)
Decrease (increase) in prepaid reinsurance premiums - related party (6,035) 484,444 --
Decrease (increase) in reinsurance recoverable on paid losses (524,496) 391,155 (345,578)
Decrease (increase) in reinsurance recoverable on unpaid losses (602,728) 2,037,916 (4,927,424)
Decrease (increase) in reinsurance recoverable on unpaid losses -
related party (224,636) 2,147,823 --
Decrease (increase) in deferred acquisition costs 8,494 (27,075) 981,972
Decrease in deferred federal income taxes, net of effects of change
in net unrealized gains on marketable securities 366,661 1,551,222 84,800
Decrease (increase) in accrued investment income 434,259 (112,736) (172,647)
Decrease (increase) in federal income taxes recoverable (79,394) (711,197) 628,234
Increase in installment and service contract receivable -- -- (898,779)
Decrease (increase) in other assets 59,720 786,397 (307,359)
Decrease in liability for loss and loss adjustment expense reserves (1,002,930) (3,887,867) (1,051,158)
Decrease in unearned premium reserves (733,458) (127,997) (3,143,515)
Increase (decrease) in ceded reinsurance payable (594,062) 2,552 (167,284)
Decrease in ceded reinsurance payable - related party (80,620) (29,428) --
Increase in funds held under reinsurance contracts -- -- 842,295
Increase in deferred revenue -- -- 2,181,975
Increase in other payables and accrued expenses 397,099 336,067 64,874
------------ ------------ ------------
Net cash provided by (used in) operating activities 1,271,387 1,983,014 (5,190,185)
------------ ------------ ------------
Cash flows from investing activities:
Cost of short-term investments acquired (61,698,866) (44,376,279) (28,107,501)
Proceeds from disposals of short-term investments 51,095,479 53,564,020 30,710,861
Cost of debt securities acquired (39,935,511) (55,967,688) (17,654,793)
Proceeds from maturities of debt securities 5,376,203 6,633,127 9,434,012
Proceeds from debt securities sold 35,349,292 36,257,595 12,209,136
Cost of equity securities acquired -- (420,226) (990,403)
Proceeds from equity securities sold 62,308 -- 2,061,094
Proceeds from repayment of mortgage loan -- 2,750,000 --
Cost of fixed assets purchased (481,816) (70,839) (481,191)
Decrease in minority interest (9,413) (435) (356)
------------ ------------ ------------
Net cash provided by (used in) investing activities (10,242,324) (1,630,725) 7,180,859
------------ ------------ ------------
Cash flows from financing activities:
Proceeds from sale of senior subordinated notes 9,550,000 -- --
Capital contribution from stockholder -- 37,500 (37,500)
Dividends paid to preferred stockholders (344,025) (344,025) (344,025)
------------ ------------ ------------
Net cash provided by (used in) financing activities 9,205,975 (306,525) (381,525)
------------ ------------ ------------
Net increase in cash and cash equivalents 235,038 45,764 1,609,149
Cash and cash equivalents at beginning of year 2,055,338 2,290,376 2,336,140
------------ ------------ ------------
Cash and cash equivalents at end of year $ 2,290,376 $ 2,336,140 $ 3,945,289
============ ============ ============
Supplemental cash flow information - cash paid during the year for:
Income taxes $ 403,700 $ 20,000 $ 175,000
============ ============ ============
Interest $ -- $ 1,011,389 $ 1,100,000
============ ============ ============
</TABLE>
See accompanying notes to consolidated financial statements.
43
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1995 and 1996
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION
The consolidated financial statements include the accounts of First
Mercury Financial Corporation (FMFC) and its wholly owned subsidiaries
- First Mercury Insurance Company (FMIC), successor to First Mercury
Syndicate, Inc. (the Syndicate), and All Nation Insurance Company (All
Nation) collectively referred to as "the Company."
The Syndicate operated as an underwriting member of the Illinois
Insurance Exchange (the Exchange). Under the licensing of the Exchange,
the Syndicate wrote general liability insurance, allied property, and
auto physical damage coverages in 44 states, the District of Columbia,
and the U.S. Virgin Islands. Approximately 24 percent of the
Syndicate's direct premiums written in 1996 were in the State of
California. On June 28, 1996, the Syndicate formed FMIC as an Illinois
domiciled property and casualty insurance subsidiary with an initial
capitalization of $20 million. The formation of FMIC, a licensed
Illinois insurer, provided the Syndicate with an affiliated company in
which to potentially place coverages offered by the Syndicate and in
which to reinsure certain of the Syndicate's outstanding liabilities.
Under a loss portfolio transfer, on June 28, 1996, the Syndicate
transferred approximately $35 million in loss and loss adjustment
expense reserves and corresponding assets to FMIC. In conjunction with
the formation of FMIC and the loss portfolio transfer, on July 8, 1996,
the Syndicate notified the Exchange of its intention to withdraw from
the Exchange. On November 7, 1996, the Syndicate and the Exchange
executed a withdrawal agreement (see note 11). Upon the Syndicate's
withdrawal, the Syndicate was merged into FMIC.
All Nation is domiciled in the State of Minnesota, is licensed in 15
states, and writes predominantly private passenger auto liability, auto
physical damage and commercial multi-peril coverage (see note 9). The
majority of All Nation's premium volume originates in the northwest
region of the United States. All Nation owns 100 percent of National
Family Insurance Company (National Family), a property and casualty
company currently in liquidation in the State of Minnesota. National
Family has been in receivership since before being acquired by All
Nation and is currently under the supervision of the Minnesota
Commissioner of Commerce (see note 5). The State of Minnesota has
represented that it is unaware of any provision of law that imposes
responsibility on either All Nation or First Mercury to cure any
deficit resulting from liquidation. The Company has no intention of
infusing capital into National Family. Because of these considerations
and because All Nation currently lacks voting control over National
Family, it is not consolidated for financial statement purposes.
44
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION, CONTINUED
The consolidated financial statements have been prepared in accordance
with generally accepted accounting principles (GAAP), which vary in
certain respects from statutory accounting followed in reporting to
insurance regulatory authorities (see note 12 for a description of such
differences). In preparing the financial statements, management is
required to make estimates and assumptions that affect the reported
amounts of assets and liabilities as of the dates of the balance
sheets, and revenues and expenses for the periods then ended. Actual
results may differ from those estimates. Material estimates that are
susceptible to significant change in the near term relate to the
determination of the reserves for losses and loss adjustment expenses
and the recoverability of deferred tax assets.
Following is a description of the more significant risks facing
property/casualty insurers and how the Company mitigates those risks:
LEGAL/REGULATORY RISK is the risk that changes in the legal or
regulatory environment in which an insurer operates will change and
create additional loss costs or expenses not anticipated by the insurer
in pricing its products. That is, regulatory initiatives designed to
reduce insurer profits or new legal theories may create costs for the
insurer beyond those recorded in the financial statements. The Company
mitigates this risk through underwriting and loss adjusting practices
which identify and minimize the adverse impact of this risk.
CREDIT RISK is the risk that issuers of securities owned by the Company
will default, or other parties, including reinsurers which owe the
Company money, will not pay. The Company minimizes this risk by
adhering to a conservative investment strategy, by maintaining sound
reinsurance and credit and collection policies, and by providing for
any amounts deemed uncollectible.
INTEREST RATE RISK is the risk that interest rates will change and
cause a decrease in the value of an insurer's investments. The Company
mitigates this risk by attempting to match the maturity schedule of its
assets with the expected payout of its liabilities. To the extent that
liabilities come due more quickly than assets mature, the Company would
have to sell assets prior to maturity and recognize a gain or loss. At
December 31, 1996, the estimated market value of the Company's bond
portfolio was greater than its costs.
(a) CASH EQUIVALENTS
The Company considers all short-term investments with a
maturity date of three months or less from the date of
purchase to be cash equivalents. The carrying amount
approximates market value because of the short maturity of
those instruments.
45
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
(b) INVESTMENTS
The Company classifies its marketable investment securities in
one of three categories: trading, available-for-sale, or
held-to-maturity. Trading securities are bought and held
principally for the purpose of selling them in the near term.
Held-to-maturity securities are those securities which the
Company has the ability and intent to hold until maturity. All
other securities are classified as available-for-sale.
Available-for-sale securities are reported at market value.
Unrealized holding gains and losses, net of the related taxes,
on available-for-sale securities are excluded from earnings
and reported as a separate component of stockholders' equity
until realized.
A decline in the market value of any available-for-sale
security below cost that is deemed other than temporary is
charged to earnings and results in the establishment of a new
cost basis for the security.
Premiums and discounts are amortized or accreted over the life
of the related debt security as an adjustment to yield using
the effective-interest method. Dividend and interest income is
recognized when earned. Realized gains and losses are included
in earnings and are derived using the specific-identification
method for determining the cost of securities sold.
(c) DEFERRED POLICY ACQUISITION EXPENSES
Policy acquisition expenses, consisting of commissions and
other costs that vary with and are primarily related to the
production of new and renewal business, are deferred, subject
to ultimate recoverability, and charged to expense over the
period in which the related premiums are earned.
(d) FIXED ASSETS
Fixed assets are recorded at cost. Depreciation is provided on
the straight-line basis over the estimated useful lives of the
assets, as follows:
Office building 30 years
Real estate improvements 7-30 years
Data processing equipment 3-8 years
46
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
(d) FIXED ASSETS, CONTINUED
During 1995, the Financial Accounting Standards Board issued
SFAS No. 121, ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED
ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF. SFAS No.
121 requires that long-lived assets and certain identifiable
intangibles to be held and used by an entity be reviewed for
impairment whenever events or changes in circumstances
indicate that the carrying amount of an asset may not be
recoverable. SFAS No. 121 was implemented by the Company in
1996, which adoption had no material effect on the Company's
operating results or financial condition.
(e) LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
The reserves for losses and loss adjustment expenses
represents the accumulation of individual case estimates for
reported losses and loss adjustment expenses, and actuarial
estimates for incurred but not reported losses and loss
adjustment expenses. Assumed reserves are recorded as reported
by the ceding organization. The reserves for loss and loss
adjustment expenses are intended to cover the ultimate net
cost of all losses and loss adjustment expenses incurred but
unsettled through the balance sheet date. The reserves are
stated net of anticipated deductibles, salvage and
subrogation, and gross of reinsurance ceded. Reinsurance
recoverable on paid and unpaid losses is reflected as assets
on separate lines of the balance sheet. The reserve estimates
are continually reviewed and updated, and the ultimate
liability may be more or less than the current estimate. The
effects of changes in the estimated reserves are included in
the results of operations in the period in which the estimate
is revised.
(f) PREMIUMS
Premiums are recognized as earned using the daily pro rata
method over the terms of the policies. Unearned premiums
represent the portion of premiums written that relate to the
unexpired terms of policies in force. Prepaid reinsurance
premiums represent the portion of ceded premiums that relate
to the unexpired terms of reinsurance policies in force.
47
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
(g) FEDERAL INCOME TAXES
Deferred taxes are recognized for the future tax consequences
attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their
respective tax bases and operating loss and tax credit
carryforwards. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable
income in the years in which temporary differences are
expected to be recovered or settled. The effect of a change in
tax rate on deferred tax assets and liabilities is recognized
in income in the period of enactment.
(h) DEFERRED DEBT ISSUANCE COSTS
Deferred debt issuance costs, included in other assets in the
accompanying consolidated balance sheets, are amortized on a
straight-line basis over ten years, the term of the related
debt.
(i) RECLASSIFICATIONS
Certain 1995 balances have been reclassified to conform with
1996 presentation.
48
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(2) INVESTMENTS
The amortized cost, gross unrealized gains and losses, and market value
of marketable investment securities classified as available-for-sale at
December 31, 1996, by major security type, were as follows:
<TABLE>
<CAPTION>
Gross Unrealized
Amortized -------------------- Market
Cost Gains Losses Value
---- ----- ------ -----
<S> <C> <C> <C> <C>
Debt securities:
U.S. government
securities $14,754,463 $ 169,665 $ (147,043) $14,777,085
Government agency
mortgage-backed securities 13,070,436 34,023 (141,459) 12,963,000
Collateralized mortgage
obligations and other
asset-backed securities 28,323,392 443,357 (149,725) 28,617,024
Obligations of states and
political subdivisions 9,723,435 81,099 (156,977) 9,647,557
Corporate bonds 5,812,911 134,001 (79,760) 5,867,152
----------- ----------- ----------- -----------
Total debt securities 71,684,637 862,145 (674,946) 71,871,818
Common stocks 52,325 -- (125) 52,200
Preferred stocks 2,599,796 115,610 (24,212) 2,691,194
Short-term investments 1,810,340 -- -- 1,810,340
----------- ----------- ----------- -----------
Total $76,147,098 $ 977,755 $ (699,301) $76,425,552
=========== =========== =========== ===========
</TABLE>
49
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(2) INVESTMENTS, CONTINUED
The amortized cost, gross unrealized gains and losses, and market value
of marketable investment securities classified as available-for-sale at
December 31, 1995, by major security type, were as follows:
<TABLE>
<CAPTION>
Gross Unrealized
Amortized -------------------- Market
Cost Gains Losses Value
---- ----- ------ -----
<S> <C> <C> <C> <C>
Debt securities:
U.S. government
securities $17,216,149 $ 451,899 $ (6,980) $17,661,068
Government agency
mortgage-backed
securities 9,807,060 130,591 (11,857) 9,925,794
Collateralized mortgage
obligations and other
asset-backed securities 39,413,422 1,167,215 (46,773) 40,533,864
Obligations of states and
political subdivisions 2,521,795 66,704 (2,680) 2,585,819
Municipal and utility
bonds 3,991,609 123,488 (6,408) 4,108,689
Corporate bonds 2,771,378 87,009 (46,817) 2,811,570
----------- ----------- ----------- -----------
Total debt
securities 75,721,413 2,026,906 (121,515) 77,626,804
Preferred stocks 3,675,129 19,781 -- 3,694,910
Short-term investments 4,413,700 -- -- 4,413,700
----------- ----------- ----------- -----------
Total $83,810,242 $ 2,046,687 $ (121,515) $85,735,414
=========== =========== =========== ===========
</TABLE>
50
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(2) INVESTMENTS, CONTINUED
The amortized cost and market value of debt securities, by contractual
maturity, as of December 31, 1996, are shown below. Actual maturities
may differ from contractual maturities because borrowers may have the
right to call or prepay obligations with or without call or prepayment
penalties.
Amortized Market
Cost Value
---- -----
Due in one year or less $ 2,597,190 $ 2,613,260
Due after one year through five years 16,072,449 16,177,274
Due after five years through ten years 8,827,205 8,824,292
Due after ten years 2,793,965 2,676,968
----------- -----------
30,290,809 30,291,794
Government agency mortgage-backed securities 13,070,436 12,963,000
Collateralized mortgage obligations and
other asset-backed securities
28,323,392 28,617,024
----------- -----------
$71,684,637 $71,871,818
=========== ===========
Net investment income for the years ended December 31, 1994, 1995 and
1996, was as follows:
1994 1995 1996
---- ---- ----
Debt securities $ 3,793,742 $ 4,955,166 $ 5,153,875
Preferred stocks 181,690 197,428 184,779
Short-term investments 213,005 242,563 192,232
Mortgage loan 302,500 697,535 --
Note receivable 28,563 34,125 33,782
Installment note receivable (note 9) -- -- 155,778
Rental income 81,870 80,000 80,000
Investment expenses (313,256) (331,011) (394,453)
Other 35,344 63,987 78,302
----------- ----------- -----------
4,323,458 5,939,793 5,484,295
Realized gains (losses), net (67,434) (13,607) 487,146
----------- ----------- -----------
Net investment income $ 4,256,024 $ 5,926,186 $ 5,971,441
=========== =========== ===========
51
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(2) INVESTMENTS, CONTINUED
Details of realized and unrealized gains (losses) on investments are as
follows:
1994 1995 1996
---- ---- ----
Realized gains $ 425,000 $ 528,000 $ 531,000
Realized losses (493,000) (542,000) (44,000)
----------- ----------- -----------
(68,000) (14,000) 487,000
Unrealized, net (4,122,000) 4,580,000 (1,647,000)
----------- ----------- -----------
Total $(4,190,000) $ 4,566,000 $(1,160,000)
=========== =========== ===========
On October 1, 1991, the Company extended a secured loan of $2,750,000
to a partnership whose two partners are stockholders of the Company.
The full principal amount of the loan was due September 30, 1998.
During 1995, the loan was repaid in full. The Company received a
$500,000 yield maintenance fee as a result of the early repayment.
FMIC and All Nation maintain both escrow and trust accounts for the
protection of reinsureds, pursuant to the respective assumed
reinsurance contracts. These funds are to be used to pay or reimburse
the reinsureds for FMIC's or All Nation's share of any losses and
allocated loss adjustment expenses paid by the reinsureds if not
otherwise paid by FMIC or All Nation. The balances in the accounts are
calculated periodically by the reinsureds. At December 31, 1995 and
1996, cash and short-term investments held in these accounts totaled
$189,090 and $26,201, respectively.
At December 31, 1996, All Nation had marketable securities
approximating $2.1 million on deposit with the State of Minnesota, as
required by law. At December 31, 1996, FMIC had marketable securities
approximating $1.5 million on deposit with the State of Illinois, as
required by law.
52
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(3) FIXED ASSETS
The following is a summary of fixed assets as of December 31, 1995 and
1996:
1995 1996
---- ----
Office building $ 1,066,204 $ 1,066,204
Real estate improvements 337,810 346,563
Data processing equipment 882,249 1,040,703
Land held for future home office of subsidiary 339,000 339,000
Furniture and fixtures 39,544 42,999
----------- -----------
2,664,807 2,835,469
Accumulated depreciation (1,010,406) (1,168,152)
----------- -----------
Fixed assets, net $ 1,654,401 $ 1,667,317
=========== ===========
(4) RELATED PARTY TRANSACTIONS
Prior to its merger into FMIC, the Syndicate was party to a General
Agency Agreement with Cover X Corporation (Cover X) and a Management
Agreement with Mercury Management (Management) whereby Cover X and
Management provided underwriting, administrative, marketing, and claims
handling services to the Syndicate in exchange for certain percentages
of the Syndicate's gross written premiums. Cover X and Management are
principally owned and managed by Jerome M. Shaw, president and a
stockholder of FMFC. Prior to December 22, 1995, Shaw was also a
director and stockholder of Prime Syndicate, Inc. (Prime).
Under the General Agency Agreement, the Syndicate paid to Cover X, as
compensation for services rendered and expenses incurred, an amount of
equal to 21.5 percent of the gross written premium on the business
subject to the General Agency Agreement between the Syndicate and Cover
X. The aggregate compensation paid by the Syndicate to Cover X
approximated $3,347,000, $2,801,000 and $1,565,000 for the years ended
December 31, 1994, 1995, and 1996, respectively. Additionally, the
Syndicate reimbursed Cover X each year on a cost per file basis for the
claims handling services it provided to the Syndicate. The aggregate
reimbursement paid to Cover X approximated $600,000, $638,000 and
$540,000 for the years ended December 31, 1994, 1995 and 1996,
respectively.
53
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(4) RELATED PARTY TRANSACTIONS, CONTINUED
Under the Management Agreement between the Syndicate and Management,
the Syndicate paid to Management annual compensation equal to 6.5
percent of the Syndicate's gross written premiums (excluding premiums
assumed from All Nation under a quota share reinsurance agreement),
which approximated $1,612,000, $907,000 and $370,000 for the years
ended December 31, 1994, 1995 and 1996, respectively. The Syndicate
also reimbursed Management in the amount of 3 percent of gross written
premiums (excluding premiums assumed from All National and National
Family) for unallocated loss adjustment expenses, which reimbursement
approximated $477,000, $400,000 and $346,000 for the years ended
December 31, 1994, 1995 and 1996, respectively.
Effective June 28, 1996, FMIC and Management entered into a management
agreement whereby management conducts the business of FMIC, including
marketing and promotional activities, administration, investment and
financial oversight services in exchange for 15 percent of FMIC's
direct and assumed written premium. Compensation paid to Management
approximated $288,000 for the period June 28 through December 31, 1996.
FMIC has no General Agency Agreement with Cover X at December 31, 1996.
Effective January 1, 1995, All Nation entered into an administrative
agreement with Management whereby All Nation pays Management
compensation equal to 2.5 percent of All Nation's gross written
premiums, excluding premiums assumed by First Mercury and retroceded to
Prime. Effective January 1, 1996, a $500,000 minimum was established.
Compensation paid to Management under this agreement approximated
$437,000 and $500,000 for the years ended December 31, 1995 and 1996,
respectively.
The Company has an arrangement with Management whereby Management
receives, beginning January 1, 1995, a management and consulting fee in
the amount of 2.5 percent of the gross written premiums of any
insurance company or other risk-bearing entity that is acquired by the
Company. No such fees were paid in 1995 or 1996.
Prime participated in a reinsurance agreement whereby All Nation ceded
certain business to the Syndicate, which then retroceded the business
to Prime (see note 8).
(5) FEDERAL INCOME TAXES
FMFC, FMIC, All Nation, and National Family file a consolidated federal
income tax return. Taxes are allocated among the companies based on the
tax-sharing agreement employed by these entities, which provides that
taxes of the entities are calculated on a separate-return basis at the
highest marginal tax rate. To the extent a member of the group has net
operating losses which it cannot utilize that other members of the
group can utilize, the resulting tax benefits are not provided to the
member originating the net operating loss until that member can utilize
the loss on a separate-return basis.
54
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(5) FEDERAL INCOME TAXES, CONTINUED
At December 31, 1996, All Nation's remaining preacquisition net
operating loss carryforward approximates $3,500,000, which becomes
available at approximately $310,000 per year through 2005. The Company
has established a valuation allowance for the tax benefits attributable
to this entire remaining net operating loss carryforward, as it is
unlikely that it will be fully utilized. Of the original $4,400,000
preacquisition net operating loss carryforward, approximately $900,000
was used in 1994.
For 1994, 1995 and 1996, total income taxes (benefits) were allocated
as follows:
1994 1995 1996
---- ---- ----
Income from operations $ 689,616 $ 860,025 $ 617,034
Net unrealized gains (losses)
on available-for-sale securities
in stockholders' equity (1,401,450) 1,557,231 (559,884)
----------- ----------- -----------
$ (711,834) $ 2,417,256 $ 57,150
=========== =========== ===========
Income tax expense consists of:
1994 1995 1996
---- ---- ----
Current $ 323,000 $ (691,197) $ 532,234
Deferred 366,616 1,551,222 84,800
----------- ----------- -----------
$ 689,616 $ 860,025 $ 617,034
=========== =========== ===========
55
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(5) FEDERAL INCOME TAXES, CONTINUED
Federal income taxes in the accompanying consolidated statements of
operations differ from the statutory tax rate of 34 percent as follows:
<TABLE>
<CAPTION>
1994 1995 1996
---- ---- ----
<S> <C> <C> <C>
Tax provision at statutory rate 1,211,225 $ 274,820 $ 747,848
Tax effect of:
Tax-exempt interest (545,973) (78,806) (16,183)
Tax expense of unconsolidated subsidiary
229,500 471,800 --
Utilization of net operating loss
carryforwards of All Nation
(294,053) -- --
Other, net 88,917 192,211 (114,631)
---------- ---------- ----------
Federal income tax expense 689,616 $ 860,025 $ 617,034
========== ========== ==========
Effective tax rate 19.4% 106.4% 28.1%
==== ===== ====
</TABLE>
56
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(5) FEDERAL INCOME TAXES, CONTINUED
The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets and deferred tax liabilities are
presented below:
December 31,
-------------------
1995 1996
---- ----
Deferred tax assets:
Loss and loss adjustment expense reserve discount $ 3,931,420 $ 3,362,094
Unearned premiums 550,413 262,261
Net operating loss carryforwards 1,190,000 1,261,151
Deferred revenue -- 181,330
Alternative minimum tax credits 429,470 429,470
Other -- 111,554
----------- -----------
Total gross deferred tax assets 6,101,303 5,607,860
Less valuation allowance (1,190,000) (1,190,000)
----------- -----------
Net deferred tax assets 4,911,303 4,417,860
Deferred tax liabilities:
Deferred policy acquisition expenses (568,919) (235,048)
Bond discount accretion (557,017) (194,975)
Tax benefits of unconsolidated subsidiary (1,016,728) (1,227,882)
Investments carried at market (654,558) (94,674)
Other (300,450) (376,566)
----------- -----------
Total deferred tax liabilities (3,097,672) (2,129,145)
----------- -----------
Net deferred tax asset $ 1,813,631 $ 2,288,715
=========== ===========
In assessing the realizability of deferred tax assets, management
considers whether it is more likely than not that some portion or all
of the deferred tax assets will not be realized. The ultimate
realization of deferred tax assets is dependent upon the generation of
future taxable income during the periods in which those temporary
differences become deductible.
The Company has utilized tax benefits of $1,104,300 attributable to the
1992, 1993, 1995 and 1996 net operating losses of National Family. As
of December 31, 1996, National Family has received an order of
liquidation with a finding of insolvency by the Ramsey County District
Court in Minnesota, and accordingly, has ceased all operations. IRS
regulations will require repayment of tax benefits generated by
National Family and utilized by the Company. Accordingly, the Company
has provided for this cumulative liability as of December 31, 1996.
57
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(6) SENIOR SUBORDINATED NOTES PAYABLE
As of December 31, 1996, senior subordinated notes aggregating
$9,225,000 were outstanding. The notes bear interest at 11 percent per
annum, are due December 1, 2004, and are subordinate to senior
indebtedness of the Company, of which none was outstanding at December
31, 1996. The Company originally issued an aggregate of $10,000,000 of
notes, and has repurchased $775,000 of these notes during 1996. At
December 31, 1996, the Company was in compliance with the debt
covenants, which include dividend restrictions and maintenance of
minimum net worth, as defined. At December 31, 1996, the fair value of
senior subordinated notes payable, based on the net present value of
cash flows at the Company's incremental borrowing rate, was
approximately $10,355,000.
(7) LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
As discussed in note 1, the Company establishes a reserve for both
reported and unreported covered losses, which includes estimates of
both future payments of losses and related loss adjustment expenses.
The following represents changes in those aggregate reserves for the
Company during the years ended December 31, 1994, 1995 and 1996:
1994 1995 1996
---- ---- ----
Balance at January 1 $ 61,461,000 $ 60,458,000 $ 56,570,000
Less reinsurance recoverables (6,915,000) (7,742,000) (3,556,000)
------------ ------------ ------------
Net balance at January 1 54,546,000 52,716,000 53,014,000
Reserves reassumed under
reinsurance commutation
-- 2,368,000 --
Incurred related to:
Current year 24,319,000 24,937,000 19,810,000
Prior years (5,128,000) (1,696,000) (3,172,000)
------------ ------------ ------------
Total incurred 19,191,000 23,241,000 16,638,000
------------ ------------ ------------
Paid related to:
Current year 6,387,000 10,295,000 7,492,000
Prior years 14,634,000 15,016,000 15,125,000
------------ ------------ ------------
Total paid 21,021,000 25,311,000 22,617,000
------------ ------------ ------------
Net balance at December 31 52,716,000 53,014,000 47,035,000
Plus reinsurance recoverables 7,742,000 3,556,000 8,484,000
------------ ------------ ------------
Balance at December 31 $ 60,458,000 $ 56,570,000 $ 55,519,000
============ ============ ============
58
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(7) LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES, CONTINUED
The decreases in incurred losses related to prior accident years, as
noted in the above table, primarily result from favorable loss
development.
(8) REINSURANCE
In the normal course of business, FMIC and All Nation seek to reduce
the loss that may arise from catastrophes or other events that cause
unfavorable underwriting results by reinsuring certain levels of risk
in various areas of exposure with other insurance enterprises or
reinsurers. Amounts recoverable from reinsurers are estimated in a
manner consistent with the claim liability associated with the
reinsured policy.
For policies issued by the Syndicate, maximum retention per occurrence
is $500,000 for general liability and $50,000 for allied property and
auto physical damage coverages, respectively. Excess losses are
reinsured under both treaty and facultative agreements.
Through its membership in the Exchange, the Syndicate was approved or
eligible to write direct premium on a surplus lines basis in 44 U.S.
states or territories. As of December 31, 1996, FMIC is independently
licensed to write direct premium only in the state of Illinois. As a
result, FMIC and Empire Fire and Marine Insurance Company ("Empire")
entered into a quota share reinsurance arrangement effective July 18,
1996, whereby Empire writes on a direct basis the coverages previously
offered by the Syndicate and cedes 50 percent of such business to FMIC.
FMIC's maximum retention per occurrence under this reinsurance
arrangement is 50 percent of $1,000,000 limits.
Due to its lack of approval to write insurance in states other than
Illinois, FMIC's premium volume is currently dependent upon the
reinsurance arrangement with Empire. FMIC is aggressively pursuing
licensure or authority to write insurance business on a surplus lines
basis in additional states.
For direct response non-standard automobile and commercial multi-peril
coverage, All Nation retains a maximum of $200,000 per occurrence. For
losses in excess of its retention, All Nation maintains treaty
reinsurance agreements.
Prior to May 1, 1996, All Nation retained a maximum of $200,000 per
occurrence on its agency-produced non-standard automobile coverages. In
conjunction with the sale of its agency appointments (see note 9), All
Nation has fully reinsured these coverages with Allstate Insurance
Company (Allstate) effective May 1, 1996. Under this reinsurance
agreement, All Nation has exposure on Allstate's losses on policies
written under the reinsurance agreement through December 31, 1996.
59
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(8) REINSURANCE, CONTINUED
Prior to January 1, 1995, under a quota share reinsurance agreement,
the Syndicate assumed 50 percent of certain lines or sources of
business written by All Nation, then retroceded 35 percent of the
business assumed to Prime.
Effective January 1, 1995, the 50 percent reinsurance assumption from
All Nation was reduced to a 17.5 percent quota share arrangement with a
100 percent retrocession to Prime. Effective September 30, 1995, the
retrocession agreement with Prime was commuted. Prime returned loss and
loss adjustment expense reserves of $2,257,991 and unearned premiums of
$519,582 (net of commissions of $127,298) to the Syndicate in exchange
for $2,550,275 in cash.
Also effective September 30, 1995, a 35 percent quota share reinsurance
agreement of certain lines or sources of business assumed from National
Family by the Syndicate and retroceded to Prime was commuted. In
exchange for cash of $190,755, the Syndicate reassumed $109,718 of loss
and loss adjustment expense reserves and $107,333 of unearned premiums
(net of $26,297 in commissions).
Reinsurance contracts do not relieve the Company from its primary
obligations to policyholders. Failure of reinsurers to honor their
obligations could result in losses to the Company; consequently,
allowances are established for amounts deemed uncollectible. The
Company evaluates the financial condition of its reinsurers and
monitors the concentrations of credit risk arising from similar
geographic regions, activities, or economic characteristics of the
reinsurers to minimize its exposure to significant losses from
reinsurer insolvencies.
At December 31, 1996, the Company has reinsurance recoverables and
prepaid reinsurance premiums with the following reinsurers:
Prepaid
Reinsurance Reinsurance
Recoverables Premiums
------------ -----------
Allstate Insurance Company $4,676,000 $1,520,000
Reliance Reinsurance Company of New York 1,041,000 97,000
TIG Reinsurance Company 820,000 --
National Reinsurance Company 1,153,000 91,000
General Reinsurance Corporation 539,000 67,000
Munich American Reinsurance Company 695,000 25,000
Other 38,000 --
---------- ----------
$8,962,000 $1,800,000
========== ==========
60
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(8) REINSURANCE, CONTINUED
Net written and earned premiums including reinsurance activity, as well
as reinsurance recoveries, were as follows:
1994 1995 1996
---- ---- ----
Written premiums:
Direct $ 31,944,100 $ 32,511,700 $ 24,360,000
Assumed 1,368,600 1,610,700 2,861,200
Ceded (5,293,300) (4,698,700) (10,577,300)
------------ ------------ ------------
Net written premiums $ 28,019,400 $ 29,423,700 $ 16,643,900
============ ============ ============
Earned premiums:
Direct $ 32,749,400 $ 32,700,300 $ 29,130,100
Assumed 1,256,700 1,551,700 1,167,500
Ceded (5,207,400) (4,577,900) (9,483,300)
------------ ------------ ------------
Net earned premiums $ 28,838,700 $ 29,674,100 $ 20,814,300
============ ============ ============
Reinsurance recoveries $ 1,947,000 $ 2,569,500 $ 3,198,900
============ ============ ============
(9) GAIN ON SALE OF AGENCY-PRODUCED NON-STANDARD AUTOMOBILE BUSINESS
Effective May 1, 1996, an agreement was entered into between FMFC, All
Nation, Allstate and its wholly owned subsidiary, Deerbrook Insurance
Company (Deerbrook), for the assignment of All Nation's independent
agent contracts to Deerbrook and the ceding of associated prospective
premium to Allstate on the agency-produced non-standard automobile
business of All Nation. The stated price for the independent agent
contracts and associated prospective premium was $2.4 million with
another $2.4 million paid by Allstate in exchange for a non-compete
clause and various financial guarantees. Under the agreement, All
Nation continues to write agency non-standard automobile coverages and
cedes 100% of the written business to Allstate under a quota share
reinsurance agreement for a period of up to two years, as Deerbrook is
taking over the direct writing and servicing responsibility from All
Nation on a state-by-state basis over the two year period. In addition,
All Nation provides underwriting, claims and administrative services
for the ceded business on a percentage of premiums basis for an initial
period of up to two years as Deerbrook is taking over the direct
writing and servicing responsibility from All Nation or a
state-by-state basis over the two year period. The agreements exclude
All Nation's direct response non-standard automobile business or
agency-produced non-standard automobile business written prior to May 1
1996.
61
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(9) GAIN ON SALE OF AGENCY-PRODUCED NON-STANDARD AUTOMOBILE BUSINESS,
CONTINUED
FMFC recognized a net gain on the assignment of the agency contracts of
$408,000. The gain recognized represents the net present value of the
related payments from Deerbrook reduced by All Nation's estimated
liability for losses under the quota share reinsurance contract and
costs attendant with the sale. Revenue related to the non-compete
clause of $318,000 has been recognized through December 31, 1996 using
straight-line amortization over the thirty-six month term of the
non-compete agreement.
(10) CAPITAL STOCK
(a) CUMULATIVE PREFERRED STOCK
Each share of $0.01 par value cumulative preferred stock calls
for a dividend of 13.2 percent per annum ($16.50 per share),
but only when and as declared by FMFC's board of directors.
Dividends shall be payable only from funds legally available
to pay dividends; shall be paid on a quarterly, semiannual, or
annual basis; and shall be cumulative from the date of
issuance if not paid. However, dividend accumulations do not
bear interest.
The cumulative preferred stock is nonvoting and has no
preemptive rights, thereby not giving the holders thereof the
right to purchase any other stock or security of FMFC as and
when issued. The cumulative preferred stock is also
redeemable, at the option of FMFC's board of directors, at any
time after issuance, at a redemption price of $125 per share
plus accrued and unpaid dividends, upon giving notice to the
cumulative preferred shareholders.
The Company and its stockholders are subject to an Agreement
Among Stockholders (Agreement) which allows, among other
provisions, that in the event the agreement with Management
(see note 4) is terminated or not renewed by the Company, the
Agreement grants to certain stockholders, including Jerome
Shaw, the option to "put" to the Company all shares of stock
(both preferred and common) owned by these certain
stockholders for cash at full book value. As of December 31,
1996, such a "put" would have resulted in a payment by the
Company for all shares of stock of approximately $4,700,000.
In the event of any voluntary or involuntary liquidation,
dissolution, insolvency, or sale or distribution of FMFC's
assets, the holders of the cumulative preferred stock shall be
entitled to receive $125 per share plus all unpaid accrued
dividends thereon, without interest, before any payment is
made with respect to FMFC's common shareholders.
62
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(10) CAPITAL STOCK, CONTINUED
(b) COMMON STOCK
FMFC's insurance subsidiaries, FMIC and All Nation, are
limited in their ability to pay dividends to the holding
company. FMIC may declare and pay dividends according to the
provisions of the Illinois Insurance Holding Company Systems
Act, which provides that without prior approval of the
Illinois Insurance Department dividends may not exceed the
greater of 10 percent of FMIC's policyholders' surplus on the
most recent statutory financial statement filed with the State
of Illinois or net income after taxes for the prior year. In
1997, FMIC's dividends may not exceed approximately
$3,200,000.
All Nation may declare and pay dividends according to the
provisions of the Minnesota Insurance Holding Company Systems
Act, which provides that dividends may not exceed 10 percent
of policyholders' surplus on the most recent statutory
financial statement filed with the State of Minnesota or net
income after taxes, excluding capital gains or losses, for the
prior year. Additionally, in accordance with the terms of the
agreement reached with the Minnesota Department of Commerce,
All Nation must obtain the permission of the State before any
dividends are paid. Assuming State approval was obtained, All
Nation could pay dividends of up to $700,000 in 1997.
(11) REGULATORY REQUIREMENTS
(a) CAPITALIZATION
To obtain licensing to write insurance in the State of
Illinois, Illinois Insurance Department regulations require an
initial capitalization of $2 million, with a minimum of $1.5
million in statutory capital thereafter. To meet Department
regulations as an authorized Illinois reinsurer, FMIC must
maintain a minimum of $20 million in statutory capital. FMIC
was in compliance with these requirements as of December 31,
1996. The Syndicate was in compliance with Exchange
capitalization requirements as of December 31, 1995.
The state of Minnesota requires All Nation to maintain a
minimum of $1,500,000 in capital stock and surplus. All Nation
was in compliance with this requirement as of December 31,
1995 and 1996, respectively.
(b) INVESTMENTS HELD IN TRUST
The Syndicate's withdrawal agreement with the Exchange
required the Company to establish a trust fund for the payment
of claims under insurance policies issued and reinsurance
agreements entered into by the Syndicate. Investments held in
trust for the payment of Syndicate claims at December 31,
1996, approximated $42.5 million.
63
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(c) GUARANTY FUND TRUST ACCOUNT
Under Exchange regulations, the Syndicate maintained a
$1,000,000 deposit in a Guaranty Fund Trust Account prior to
its withdrawal from the Exchange which required at least 50
percent of the deposit to be in cash and/or marketable
securities. Under the terms of the Syndicate's withdrawal
agreement with the Exchange, a $1,000,000 deposit must be
maintained in the Guaranty Fund Trust Account of the Exchange
for a period of three years from November 7, 1996.
At December 31, 1995 and 1996, respectively, marketable
securities of $670,251 and $1,042,736 were on deposit in the
Guaranty Fund Trust Account. The remainder of the $1,000,000
required deposit at December 31, 1995, was satisfied with
letters of credit totaling $5,175,000 on deposit with the
Exchange.
(12) RECONCILIATION TO STATUTORY FINANCIAL STATEMENTS
The Company's statutory net income (loss) and stockholders' equity were
as follows:
Net Income (Loss) 1994 1995 1996
- ----------------- ---- ---- ----
FMIC $ 4,277,295 $ 3,396,327 $ 3,188,729
============ ============ ============
All Nation $ 474,245 $ (2,122,103) $ (504,912)
============ ============ ============
Stockholders' Equity 1995 1996
- -------------------- ---- ----
FMIC $ 26,737,255 $ 22,557,444
============ ============
All Nation $ 7,630,536 $ 7,003,408
============ ============
Significant differences between the consolidated statutory net income
(loss) and stockholders' equity and those amounts as reported in the
accompanying consolidated financial statements in accordance with GAAP
include the addition of the parent company (FMFC), and elimination of
intercompany transactions in consolidation adjustments, adjustments to
establish deferred income taxes and deferred acquisition costs,
adjustments to account for the Allstate transaction on a GAAP basis,
and elimination of the Syndicate's secured balances subject to call as
of December 31, 1995, which are included in stockholders' equity for
statutory purposes.
64
<PAGE>
FIRST MERCURY FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(13) FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107, DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS,
requires disclosures of fair-value information about financial
instruments, whether or not recognized in the balance sheet, for which
it is practicable to estimate the value. In situations where quoted
market prices are not available, fair values are to be based on
estimates using present value or other valuation techniques. SFAS No.
107 excludes certain financial instruments and all nonfinancial
instruments from its disclosure requirements.
Under SFAS No. 107, the Company's financial instruments include
investments, cash and cash equivalents, note receivable, and senior
subordinated notes payable. At December 31, 1996, the carrying amounts
of the Company's cash and cash equivalents and note receivable
approximated the fair value of these financial instruments. The fair
value of the Company's investments and senior subordinated notes
payable are disclosed in notes 2 and 6, respectively.
65
<PAGE>
Independent Accountants' Report on Financial Statement Schedules
The Board of Directors
First Mercury Financial Corporation:
The audits referred to in our report dated March 14, 1997, included the related
financial statement schedules as of December 31, 1996, and for each of the years
in the three-year period ended December 31, 1996, which are included in the Form
10-K. These financial statement schedules are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statement schedules based on our audits. In our opinion, such
financial statement schedules, when considered in relation to the basic
consolidated financial statements taken as a whole, present fairly in all
material respects the information set forth therein.
/s/ KPMG Peat Marwick LLP
Detroit, Michigan
March 27, 1997
66
<PAGE>
Schedule I
FIRST MERCURY FINANCIAL CORPORATION
Summary of Investments
(other than investments in related parties)
December 31, 1996
<TABLE>
<CAPTION>
Amount at
which shown
in the
Market Consolidated
Type of investment Cost (1) Value Balance Sheet
- ---------------------------------------------------- -------- ------ -------------
<S> <C> <C> <C>
Debt securities:
Bonds:
United States government and government agencies
and authorities ................................ $14,755 $14,777 $14,777
States, municipalities and political subdivisions 9,723 9,648 9,648
All other corporate bonds ....................... 5,815 5,867 5,867
Government agency mortgage-backed securities ...... 13,071 12,963 12,963
Collateralized mortgage obligations and
other asset-backed securities .................... 28,323 28,617 28,617
------- ------- -------
Total debt securities ............................. 71,687 71,872 71,872
Redeemable preferred stock .......................... 2,599 2,691 2,691
Common stock ........................................ 52 52 52
Short-term investments .............................. 1,811 1,811 1,811
------- ------- -------
Total investments ............................... $76,149 $76,426 $76,426
======= ======= =======
</TABLE>
- ----------
(1) Original cost of equity securities and, as to fixed maturities, original
cost reduced by repayments and adjusted for amortization of premiums or
accrual of discounts.
(2) Short-term investments are valued at cost, which approximates market.
67
<PAGE>
Schedule II
FIRST MERCURY FINANCIAL CORPORATION
Condensed Financial Statements of
First Mercury Financial Corporation (Parent Company)
December 31,
-------------------------
1995 1996
----------- -----------
BALANCE SHEETS
Assets:
Cash ............................................. $ 1,497,542 $ 1,926,035
Debt securities .................................. -- 1,437,390
Common stock ..................................... -- 52,200
Investment in subsidiaries ....................... 33,147,122 32,147,947
Federal income tax recoverable ................... 772,470 144,236
Receivable from subsidiaries ..................... 240,772 65,910
Installment receivable ........................... -- 1,155,431
Data processing equipment ........................ -- 372,428
Acquisition costs ................................ -- 423,930
Accrued investment income ........................ -- 7,251
Deferred debt issuance cost ...................... 857,380 755,461
----------- -----------
Total assets ............................... $36,515,286 $38,488,219
=========== ===========
Liabilities and Stockholders' Equity:
Liabilities:
Accounts payable ............................... $ 18,749 $ 43,722
Accrued interest ............................... 91,667 91,667
Deferred revenue ............................... -- 1,968,751
Deferred tax liability ......................... -- 10,405
Long-term debt ................................. 10,000,000 9,855,000
----------- -----------
Total liabilities ............................ 10,110,418 11,969,545
Minority interest ................................ 3,634 3,278
Stockholders' equity:
Cumulative preferred stock, $.01 par value ..... 209 209
Common stock, $.01 par value ................... 62 62
Gross paid-in and contributed capital .......... 3,474,872 3,437,372
Net unrealized gains (losses) net of tax ....... 1,270,614 183,780
Retained Earnings .............................. 21,655,479 22,893,973
----------- -----------
Total stockholders' equity ................... 26,401,236 26,515,396
----------- -----------
Total liabilities and stockholders' equity . $36,515,286 $38,488,219
=========== ===========
68
<PAGE>
Schedule II (continued)
FIRST MERCURY FINANCIAL CORPORATION
Condensed Financial Statements of
First Mercury Financial Corporation (Parent Company)
<TABLE>
<CAPTION>
Years ended December 31,
-----------------------------------------
1994 1995 1996
----------- ----------- -----------
<S> <C> <C> <C>
STATEMENTS OF OPERATIONS
Revenue under non-compete agreement ........................ $ -- $ -- $ 317,541
Net interest income ........................................ 12 31,751 135,393
Other expenses ............................................. -- (25,122) (13,803)
Interest expense ........................................... (6,027) (1,192,085) (1,201,919)
----------- ----------- -----------
Loss before federal income tax and equity in
undistributed earnings of subsidiaries .................. (6,015) (1,185,456) (762,788)
Federal income tax benefit ................................. 2,045 1,391,197 379,423
----------- ----------- -----------
Net income (loss) before equity in undistributed
earnings of subsidiaries ................................ (3,970) 205,741 (383,365)
Equity in undistributed earnings of subsidiaries ........... 2,876,780 (257,471) 1,965,885
----------- ----------- -----------
Net earnings (loss) ........................................ $ 2,872,810 $ (51,730) $ 1,582,520
=========== =========== ===========
Years ended December 31,
-----------------------------------------
1994 1995 1996
----------- ----------- -----------
STATEMENTS OF CASH FLOWS
Net income (loss) .......................................... $ 2,872,810 $ (51,730) 1,582,520
Adjustments to reconcile net income to net cash used in
operating activities:
Equity in undistributed earnings of subsidiaries ......... (2,876,780) 257,471 (1,965,885)
(Increase) decrease in federal income tax recoverable .... (2,045) (770,423) 628,234
(Increase) decrease in receivable from subsidiary ........ -- (240,772) 174,862
Increase in installment receivable ....................... -- -- (1,155,431)
Increase in acquisition costs ............................ -- -- (423,930)
Increase in accrued investment income .................... -- -- (7,251)
(Increase) decrease in deferred debt issuance costs ...... (491,678) 84,298 101,919
Increase (decrease) in accounts payable .................. 319,717 (300,968) 24,973
Increase in accrued interest ............................. 6,027 85,640 --
Increase in deferred revenue ............................. -- -- 1,968,751
Other .................................................... -- -- (34,778)
----------- ----------- -----------
Net cash provided by (used in) operating activities .... (171,949) (936,484) 893,984
----------- ----------- -----------
Cash flows from investing activities:
Capital contributions to subsidiaries .................. (8,100,000) -- --
Cost of debt securities acquired ....................... -- -- (139,200)
Cost of equity securities acquired ..................... -- -- (52,325)
Cost of fixed assets purchased ......................... -- -- (438,979)
----------- ----------- -----------
Net cash used in investing activities ............. (8,100,000) -- (630,504)
Cash flows from financing activities:
Proceeds from issuance of senior
subordinated notes payable ........................... 9,550,000 -- --
Dividends paid to preferred stockholders ............... (344,025) (344,025) (344,025)
Dividends received from subsidiaries ................... 344,025 1,500,000 546,538
Capital contribution from shareholder .................. -- -- (37,500)
----------- ----------- -----------
Net cash provided by financing activities ......... 9,550,000 1,155,975 165,013
----------- ----------- -----------
Net increase in cash ..................................... 1,278,051 219,491 428,493
Cash at beginning of year ................................ -- 1,278,051 1,497,542
----------- ----------- -----------
Cash at end of year ...................................... $ 1,278,051 $ 1,497,542 $ 1,926,035
=========== =========== ===========
</TABLE>
69
<PAGE>
Schedule IV
FIRST MERCURY FINANCIAL CORPORATION
Reinsurance
(For the years ended December 31, 1994, 1995 and 1996)
<TABLE>
<CAPTION>
Ceded to Assumed Percentage
Direct Other from Other Net of Assumed
Amount Companies Companies Amount to Net
------ --------- ---------- ------ ----------
<S> <C> <C> <C> <C> <C>
1994:
Premiums earned:
Auto liability/Auto physical damage.... $17,332 $ 3,466 $ 326 $14,192 2.30%
Other liability........................ 15,366 1,586 5 13,785 .04
Other commercial....................... 52 155 965 862 111.90
------- ------- ------- -------
Total................................ $32,750 $ 5,207 $ 1,296 $28,839
======= ======= ======= =======
1995:
Premiums earned:
Auto liability/Auto physical damage.... $19,742 $ 3,006 $ 375 $17,111 2.19%
Other liability........................ 12,922 1,419 5 11,508 .04
Other commercial....................... 36 153 1,172 1,055 111.09
------- ------- ------- -------
Total................................ $32,700 $ 4,578 $ 1,552 $29,674
======= ======= ======= =======
1996:
Premiums earned:
Auto liability/Auto physical damage.... $17,972 $ 8,218 $ 395 $10,148 3.89%
Other liability........................ 10,372 1,216 454 9,610 4.72
Other commercial....................... 386 110 779 1,056 73.77
------- ------- ------- -------
Total................................ $28,730 $ 9,544 $ 1,628 $20,814
======= ======= ======= =======
</TABLE>
70
<PAGE>
Schedule VI
FIRST MERCURY FINANCIAL CORPORATION
Supplemental Information Concerning Property / Casualty Insurance Company
(For the years ended December 31, 1994, 1995 and 1996)
<TABLE>
<CAPTION>
Losses and Loss
Gross Discount, Adjustment Expenses
Reserves for if any, Incurred
Deferred Losses and deducted -------------------
Policy Loss from Net
Acquisition Adjustment previous Unearned Net Premiums Investment Current Prior
Affiliation with Registrant Costs Expenses column (1) Premiums Earned Income (2) Year Years
- --------------------------- ----------- ------------ ---------- -------- ------------ ---------- ------- -----
(in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
1994:
First Mercury Syndicate,
Inc. and All Nation
Insurance Company $ 1,646 $60,458 -- $ 8,928 $28,839 $ 4,323 $24,319 $(5,128)
======= ======= ======== ======= ======= ======= ======= =======
1995:
First Mercury Syndicate,
Inc. and All Nation
Insurance Company $ 1,673 $56,570 -- $ 8,800 $29,674 $ 5,940 $24,937 $(1,696)
======= ======= ======== ======= ======= ======= ======= =======
1996:
First Mercury Insurance
Company and All Nation
Insurance Company $ 691 $55,519 -- $ 5,657 $20,814 $ 5,484 $19,810 $(3,172)
======= ======= ======== ======= ======= ======= ======= =======
</TABLE>
Acquisition
Costs and Paid Loss
Other and Loss Net
Underwriting Adjustment Premiums
Affiliation with Registrant Expenses Expenses Written
- --------------------------- ------------ ---------- --------
(in thousands)
1994:
First Mercury Syndicate,
Inc. and All Nation
Insurance Company $10,060 $21,021 $28,019
======= ======= =======
1995:
First Mercury Syndicate,
Inc. and All Nation
Insurance Company $10,432 $25,311 $29,424
======= ======= =======
1996:
First Mercury Insurance
Company and All Nation
Insurance Company $ 8,098 $22,617 $16,644
======= ======= =======
- ----------
(1) The Company does not employ any discounting techniques.
(2) Net investment income does not include net realized gains and losses.
71
<PAGE>
INDEX TO EXHIBITS
Exhibit Sequential Page
Number Number
- ------- ---------------
3.1* Amended and Restated Certificate of Incorporation
of the Company
3.2* Amended and Restated Bylaws of the Company
4.1* Form of Indenture relating to the Notes
4.2* Form of Note (included in Exhibit 4.1)
10.1* Agreement Among Stockholders effective as of
January 1, 1994 among the Company (formerly known
as Mercury Insurance Group, Inc.) and its
stockholders
10.2* Management Agreement dated February 5, 1991 between
First Mercury Syndicate, Inc. (the "Syndicate") and
Mercury Management, Inc. ("MM")
10.3* General Agency Agreement dated November 29, 1985
between the Syndicate, MM, and CoverX, as amended
10.4* Administration Agreement dated August 23, 1994
between All Nation Insurance Company ("All Nation")
and MM
10.5* Form of Directors' Indemnification Agreement
10.6* Stock Option Agreement dated April 2, 1993 between
All Nation and Insurance Services of Minnesota,
Inc.
10.7** Quota Share Reinsurance Agreement effective January
1, 1992 between All Nation and the Syndicate, as
amended
10.8** Excess Casualty Reinsurance Agreement effective
November 1, 1992 between the Syndicate and Reliance
Insurance Company, as amended
10.9* Automatic Facility Excess of Loss Reinsurance
Agreement effective July 1, 1991 between the
Syndicate and National Reinsurance Corporation
10.10* Property Facultative Binding Agreement effective
November 1, 1990 between the Syndicate and Munich
American Reinsurance Company
10.11* Quota Share Reinsurance Agreement effective April
1, 1993 between the Syndicate and Prime Syndicate,
Inc.
10.12* Loan Agreement, Mortgage Note, Guaranty Agreement,
and Pledge and Security Agreement dated October 1,
1991
10.13* Form of Agreement for the Sale and Purchase of
Shares of Common Stock of All Nation between the
Syndicate and the Company
10.14** Tax Allocation Agreement dated March 1, 1995 among
First Mercury Financial Corporation, the Syndicate,
All Nation and National Family Insurance
Corporation
10.15*** Excess Casualty Reinsurance Agreement effective
November 1, 1995 between the Syndicate and Reliance
Insurance Company
10.16*** Reinsurance Commutation effective September 30,
1995 between the Syndicate and Prime
10.17*** Reinsurance Commutation effective September 30,
1995 between the Syndicate and Prime
10.18**** Quota Share Reinsurance Contract effective May 1,
1996 between Allstate Insurance Company and All
Nation
10.19**** Service Agreement effective May 1, 1996 between All
Nation, Mercury, Allstate and Deerbrook
10.20***** Reinsurance Agreement effective June 28, 1996
between the Syndicate and FMIC
10.21****** Withdrawal Agreement effective November 7, 1996
between the Syndicate and the IIE
10.22 Trust Agreement effective November 7, 1996 between
FMIC and LaSalle National Trust, N.A.
10.23 Management Agreement dated June 28, 1996 between
FMIC and MM
21* Subsidiaries of the Company
- ----------
* Incorporated by Reference to the same Exhibit number in the Company's
Registration Statement on Form S-1 (File No. 33-83382).
** Incorporated by Reference to the same Exhibit number in the Company's
December 31, 1994 Form 10-K (File No. 33-83382).
*** Incorporated by Reference to the same Exhibit number in the Company's
December 31, 1995 Form 10-K (File No. 33-83382).
**** Incorporated by Reference to the same Exhibit number in the Company's
March 31, 1996 Form 10-Q (File No. 33-83382).
***** Incorporated by Reference to the same Exhibit number in the Company's
June 30, 1996 Form 10-Q (File No. 33-83382).
****** Incorporated by Reference to the same Exhibit number in the Company's
September 30, 1996 Form 10-Q (File No. 33-83382).
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EXHIBIT 10.22
TRUST AGREEMENT
THIS TRUST AGREEMENT (this "Agreement") is made and entered into as of
December 16, 1996 by and between First Mercury Insurance Company, an Illinois
insurance corporation ("Grantor"), and LaSalle National Trust, N.A. ("Trustee").
Grantor and Trustee are hereinafter each sometimes referred to individually as a
"Party" and collectively as the "Parties."
WHEREAS, Grantor; Grantor's 100% parent corporation, First Mercury
Syndicate, Inc. (the "Syndicate"); the Illinois Insurance Exchange, an Illinois
not-for-profit corporation operating as an insurance exchange pursuant to
Article V 1/2 of the Illinois Insurance Code (the "IIE"); the Illinois Insurance
Exchange Immediate Access Security Association, an Illinois not-for-profit
corporation created pursuant to Section 107.26 of the Illinois Insurance Code
(the "IASA"); and the Illinois Insurance Exchange Guaranty Fund, Inc., an
Illinois not-for-profit corporation created pursuant to Section 15.A.1. of the
IIE Regulations (the "Guaranty Fund"); have entered into a Withdrawal Agreement
dated November 7, 1996 (the "Withdrawal Agreement"), pursuant to which the
Syndicate has agreed to withdraw as an active syndicate on the IIE;
WHEREAS, pursuant to the terms of the Withdrawal Agreement, the
Syndicate will merge with and into Grantor, with Grantor begin the surviving
entity (the "Merger"), thereby resulting in Grantor assuming all of the
liabilities and obligations of the Syndicate;
WHEREAS, pursuant to the terms of the Withdrawal Agreement, Grantor has
agreed to establish a trust fund (the "Trust Fund") for the payment of claims,
allocated loss adjustment expenses and return premiums with respect to policies
issued and reinsurance agreements entered into by the Syndicate;
WHEREAS, Trustee has agreed to act as Trustee hereunder, and to hold
certain assets in trust in the Trust Fund for the benefit of the Beneficiaries
(as defined in Section 1 below); and
WHEREAS, this Agreement is made for the purpose of setting forth the
duties and powers of Trustee with respect to the Trust Fund.
NOW, THEREFORE, in consideration of the mutual covenants and agreements
set forth herein, and other good and valuable consideration, the receipt and
sufficiency of which hereby are acknowledged, the Parties hereby agree as
follows:
Section 1. BENEFICIARIES.
(A) The Trust Fund shall be established in order to ensure the
satisfaction of the obligations (i) of the Syndicate to its policyholders and
reinsureds and of Grantor, as the surviving entity in the Merger, to the
Syndicate's policyholders and reinsureds, and (ii) to Claimants (as defined in
Section 12 below) under policies issued and reinsurance agreements entered into
by the Syndicate (the "Beneficiaries"). In the event that the Guaranty Fund or
the IASA is required, pursuant to a final non-appealable order of a court of
competent jurisdiction or a settlement agreement consented to by such a court,
to pay a claim under a policy issued or reinsurance agreement entered into by
the Syndicate, the Guaranty Fund and the IASA shall be Beneficiaries of the
Trust Fund solely to the extent of the losses, costs and expenses incurred by
either such entity in connection with such a claim.
(B) The Beneficiaries shall have no right to cause any Assets (as
defined in Section 2(B) below) or Investment Income (as defined in Section 4(B)
below) to be withdrawn or distributed from the Trust Fund, such right being
expressly reserved hereunder to Grantor or to any liquidator, conservator or
rehabilitator appointed to liquidate or manage the affairs of Grantor.
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(C) Grantor shall be deemed a Beneficiary of the Trust Fund to the
extent of the portion of Investment Income to which it is entitled under Section
4(B) hereof and to the extent of the Assets and Investment Income which the
Grantor is permitted to withdraw in accordance with the terms of Sections 3.2(D)
and (E) of the Withdrawal Agreement.
Section 2. DEPOSIT OF ASSETS TO THE TRUST FUND.
(A) Grantor shall establish the Trust Fund and Trustee shall administer
the Trust Fund in its name as Trustee for the Beneficiaries. The Trust Fund
shall be subject to withdrawal solely as provided herein.
(B) Grantor shall transfer to Trustee, for deposit to the Trust Fund,
the assets listed in Exhibit A hereto, and may transfer to Trustee, for deposit
to the Trust Fund, such other assets as it from time to time may desire (each
such asset actually received in the Trust Fund is herein referred to
individually as an "Asset" and collectively as the "Assets"). The Assets shall
consist only of cash (United States legal tender) and Eligible Securities (as
defined in Section 12 below).
(C) Grantor hereby represents and warrants that all Assets transferred
by Grantor to Trustee for deposit to the Trust Fund consist only of cash and
Eligible Securities.
Section 3. WITHDRAWAL OF ASSETS FROM THE TRUST FUND.
(A) Grantor shall have the right, at any time and from time to time, to
withdraw from the Trust Fund, upon one (1) Business Day's written notice to
Trustee in the form of Exhibit B (the "Withdrawal Notice"), such Assets as are
specified in such Withdrawal Notice. The Withdrawal Notice must be executed on
behalf of Grantor by Jerome M. Shaw, Richard H. Smith or William S. Weaver, and
may designate a third party (the "Designee") to whom Assets specified therein
shall be delivered. Grantor need present no statement or document in addition to
a Withdrawal Notice in order to withdraw any Assets, nor is such right of
withdrawal or any other provision of this Agreement subject to any conditions or
qualifications not contained in this Agreement.
(B) Upon receipt of a Withdrawal Notice, Trustee shall immediately take
any and all action necessary to transfer the Assets specified in such Withdrawal
Notice and shall deliver such Assets as soon as reasonably possible, but in no
event later than five (5) Business Days, to or for the account of Grantor or
such Designee as specified in such Withdrawal Notice.
(C) Subject to Sections 1, 3, 5 and 11 of this Agreement, in the
absence of a Withdrawal Notice, Trustee shall allow no substitution or
withdrawal of any Asset from the Trust Fund.
(D) Trustee shall have no responsibility whatsoever to determine that
any Assets withdrawn from the Trust Fund pursuant to this Section 3 will be used
and applied in the manner contemplated by Section 4 of this Agreement.
Section 4. APPLICATION OF ASSETS. Grantor hereby covenants to the IIE
that Grantor shall use and apply any withdrawn Assets, without diminution
because of the conservation, rehabilitation or insolvency of the Grantor, for
the following purposes only:
(A) to pay claims made by and owed to policyholders and reinsureds of
the Syndicate and Claimants under policies issued by the Syndicate, and the
allocated loss adjustment expenses, if any, associated with each such claim;
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(B) to release to the Grantor such Assets and such amounts equal to all
cumulative interest, dividends and other earnings (including net realized
capital gains) received by Trustee with respect to the Assets (the "Investment
Income"), subject to Section 9 herein and as are permitted to be withdrawn
pursuant to Sections 3.2(D) and (E) of the Withdrawal Agreement, either as a
result of an actuarial analysis or the termination of the Trust Fund as
described therein; and
(C) where Grantor has received a Termination Notice (as defined in
Section 11 below) pursuant to Section 11 of this Agreement, to withdraw all
remaining Assets.
Section 5. REDEMPTION, INVESTMENT AND SUBSTITUTION OF ASSETS.
(A) Trustee shall surrender for payment all maturing Assets and all
Assets called for redemption and shall deposit the principal amount of the
proceeds of any such payment to the Trust Fund. The principal amount of such
proceeds shall be invested in accordance with Section 5(B) of this Agreement.
(B) From time to time, at the written order and direction of Grantor,
Trustee shall invest Assets in the Trust Fund only in cash or Eligible
Securities. Absent such order and direction, Trustee shall invest Assets in U.S.
treasury bills with a maturity of no more than ninety (90) days.
(C) From time to time, Grantor may direct Trustee to substitute
Eligible Securities for other Eligible Securities held in the Trust Fund at such
time, provided such substitute securities are equal in market value to the
Eligible Securities substituted. One (1) Business Day's notice shall be given to
Trustee by Grantor prior to any substitution. Trustee shall have no
responsibility whatsoever to determine the value of such substituted securities
or that such substituted securities constitute Eligible Securities.
(D) All investments and substitutions of securities referred to in
Sections 5(B) and (C) shall be in compliance with the definition of "Eligible
Securities" in Section 12 of this Agreement and as set forth in Exhibit C
hereto. Trustee shall have no responsibility whatsoever to determine that any
Assets in the Trust Fund are or continue to be Eligible Securities. Any
instruction or order concerning such investments or substitutions of securities
shall be referred to herein as an "Investment Order." Trustee shall execute or
arrange for the execution of Investment Orders and shall settle or arrange for
the settlement of securities transactions, and Trustee shall promptly notify
Grantor if Trustee is unable to do so.
(E) Subject to the order and direction of Grantor, Trustee shall not be
prohibited from investing in any mutual fund or other obligation for which
Trustee or any of its Affiliates may receive compensation.
(F) Any loss incurred from any investment pursuant the terms of this
Section 5 shall be borne exclusively by the Trust Fund. Trustee shall not be
liable for any loss due to changes in market rates or penalties for early
redemption.
Section 6. INVESTMENT INCOME. All Investment Income received with
respect to Assets in the Trust Fund shall be deposited by Trustee, subject to
deduction of Trustee's compensation and expenses as provided in Section 9 of
this Agreement, in the Trust Fund. When deposited in the Trust Fund, such
Investment Income shall be considered Assets in the Trust Fund to be invested
according to the provisions of Section 5 above.
Section 7. RIGHT TO VOTE ASSETS. Trustee shall forward to Grantor (i)
all annual and interim stockholder or debtholder reports received with respect
to Assets in the Trust Fund, and (ii) all proxies and proxy materials relating
to the Assets in the Trust Fund pursuant to Trustee's regular policies. Grantor
shall have the full and unqualified right to vote any Assets in the Trust Fund.
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Section 8. ADDITIONAL RIGHTS AND DUTIES OF TRUSTEE.
(A) Trustee shall notify Grantor in writing within five (5) Business
Days following each deposit to, or withdrawal from, the Trust Fund.
(B) Trustee may deposit any Assets in the Trust Fund in a book-entry
account maintained at the Federal Reserve Bank of Chicago or in depositories
such as the Depository Trust Company. Assets may be held in the name of a
nominee maintained by Trustee or by any such depository.
(C) Trustee shall accept and open all mail directed to Grantor or the
Beneficiaries in care of Trustee.
(D) Trustee shall furnish to Grantor and to the IIE a statement of all
Assets in and transactions occurring with respect to the Trust Fund upon the
inception of the Trust Fund and at the end of each calendar month thereafter.
(E) Upon the request of Grantor or the IIE, Trustee shall promptly
permit Grantor, the IIE or their respective agents, employees or independent
auditors to examine, audit, excerpt, transcribe and copy, during Trustee's
normal business hours, any books, documents, papers and records relating to the
Trust Fund or the Assets.
(F) Trustee is authorized to follow and rely upon all instructions
given by officers named in incumbency certificates furnished to Trustee from
time to time by Grantor, and by attorneys-in-fact acting under written authority
furnished to Trustee by Grantor, including, without limitation, instructions
given by letter, facsimile transmission or electronic media, if Trustee believes
such instructions to be genuine and to have been signed, sent or presented by
the proper party or parties. Trustee shall not incur any liability to anyone
resulting from actions taken by Trustee in reliance in good faith on such
instructions. Trustee shall not incur any liability in executing instructions
(i) from any officer of Grantor named in an incumbency certificate delivered
hereunder prior to receipt by Trustee of a more current certificate, or (ii)
from an attorney-in-fact prior to receipt by Trustee of notice of the revocation
of the written authority of the attorney-in-fact.
(G) The duties and obligations of Trustee shall only be such as are
specifically set forth in this Agreement, as it may from time to time be
amended. Trustee shall only be liable for its own negligence, willful misconduct
or lack of good faith.
(H) No provision of this Agreement shall require Trustee to take any
action which, in Trustee's reasonable judgment or upon advice of counsel, would
result in any violation of this Agreement or any provision of law.
Section 9. TRUSTEE'S COMPENSATION, EXPENSES AND INDEMNIFICATION.
Grantor shall pay Trustee, as compensation for its services under this
Agreement, a fee computed at rates determined by Trustee from time to time and
agreed to in writing by Grantor. The current fee schedule is attached hereto as
EXHIBIT F. Grantor shall pay or reimburse Trustee for all of Trustee's expenses
and disbursements in connection with its duties under this Agreement (including
attorneys' fees and expenses), except any such expense or disbursement as may
arise from Trustee's negligence, willful misconduct or lack of good faith.
Trustee shall be entitled to deduct its compensation and expenses from payments
of Investment Income with respect to the Assets held in the Trust Fund as
provided in Section 6 of this Agreement. To the extent that Trustee's
compensation and expenses are not covered by such income, Grantor shall pay such
deficiency to Trustee from funds other than Assets in the Trust Fund. Grantor
also hereby indemnifies Trustee for,
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and holds it harmless against, any loss, liability, costs or expenses (including
attorneys' fees and expenses) incurred or made without negligence, willful
misconduct or lack of good faith on the part of Trustee, arising out of or in
connection with the performance of its obligations in accordance with the
provisions of this Agreement, including any loss, liability, costs or expenses
arising out of or in connection with the status of Trustee and its nominee as
the holder of record of the Assets. No such reimbursement or indemnification
payments shall be made from Assets in the Trust Fund. Grantor hereby
acknowledges that the foregoing indemnities shall survive the resignation of
Trustee or the termination of this Agreement.
Section 10. RESIGNATION OR TERMINATION OF TRUSTEE.
(A) Trustee may resign or be terminated at any time by giving not less
than thirty (30) days' written notice thereof to the other Party and to the IIE,
such resignation or termination to become effective on the acceptance of
appointment by a successor trustee and the transfer to such successor trustee of
all Assets and Investment Income in the Trust Fund in accordance with Section
10(B).
(B) Upon receipt of Trustee's notice of resignation or delivery of
Grantor's notice of termination, Grantor shall appoint a successor trustee and
shall so notify the IIE. Any successor trustee shall be qualified to administer
trusts under the Illinois Corporate Fiduciary Act (205 ILCS 620/1-1 et seq.) and
shall not be a Parent, Subsidiary or Affiliate of Grantor. Upon the acceptance
of the appointment as trustee hereunder by a successor trustee and the transfer
to such successor trustee of all Assets and Investment Income in the Trust Fund,
the resignation of Trustee shall become effective. Thereupon, such successor
trustee shall succeed to and become vested with all the rights, powers,
privileges and duties of Trustee, and Trustee shall be discharged from any
future duties and obligations under this Agreement, but Trustee shall continue
after its resignation to be entitled to the benefits of the indemnities provided
herein for Trustee.
Section 11. TERMINATION OF THE TRUST FUND.
(A) The Trust Fund and this Agreement, except for the indemnities
provided herein, may be terminated only after (i) Grantor has given Trustee
written notice of its intention to terminate the Trust Fund in the form of
EXHIBIT D (the "Notice of Intention"), and (ii) Trustee has given Grantor and
the IIE the written notice specified in Section 11(B). The Notice of Intention
shall specify the date on which Grantor intends the Trust Fund to terminate (the
"Proposed Date").
(B) Within ten (10) Business Days following receipt by Trustee of the
Notice of Intention, Trustee shall give written notification in the form of
EXHIBIT E (the "Termination Notice") to Grantor and the IIE of the date (the
"Termination Date") on which the Trust Fund shall terminate. The Termination
Date shall be (i) the Proposed Date (or if not a Business Day, the next Business
Day thereafter), if the Proposed Date is at least thirty (30) days but no more
than forty-five (45) days subsequent to the date the Termination Notice is
given; (ii) thirty (30) days subsequent to the date the Termination Notice is
given (or if not a Business Day, the next Business Day thereafter), if the
Proposed Date is fewer than 30 days subsequent to the date the Termination
Notice is given; or (iii) forty-five (45) days subsequent to the date the
Termination Notice is given (or if not a Business Day, the next Business Day
thereafter), if the Proposed Date is more than forty-five (45) days subsequent
to the date the Termination Notice is given.
(C) On the Termination Date, Trustee shall transfer to Grantor any
Assets and Investment Income remaining in the Trust Fund, at which time all
liability of Trustee with respect to such Assets and Investment Income shall
cease.
Section 12. DEFINITIONS. Except as the context shall otherwise require,
the following terms shall have the following meanings for all purposes of this
Agreement (the definitions to be applicable to both the
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singular and the plural forms of each term defined if both such forms of such
term are used in this Agreement):
The term "Affiliate" with respect to any corporation shall mean a
corporation which directly, or indirectly through one or more intermediaries,
controls or is controlled by, or is under common control with, such corporation.
The term "control" (including with related terms "controlled by" and "under
common control with") shall mean the ownership, directly or indirectly, of more
than fifty percent (50%) of the voting stock of a corporation.
The term "Business Day" shall mean any day on which the offices of
Trustee in Chicago, Illinois are open for business.
The term "Claimant" shall mean any Person suffering injury or damage
for which a Person insured under a policy issued or reinsurance agreement
entered into by the Syndicate is legally liable.
The term "Eligible Securities" shall mean and include only those
investments or categories of investments described in EXHIBIT C hereto;
provided, however, that no such securities shall have been issued by a Parent,
Subsidiary or Affiliate of Grantor.
The term "Person" shall mean and include any individual, corporation,
limited liability company, partnership, association, trust, unincorporated
organization or government or political subdivision thereof.
The term "Parent" shall mean a Person that, directly or indirectly,
controls another Person.
The term "Subsidiary" shall mean a Person controlled, directly or
indirectly, by another Person.
Section 13. COUNTERPARTS. This Agreement may be executed in any number
of counterparts, each of which when so executed and delivered shall be deemed an
original, and such counterparts together shall constitute one instrument.
Section 14. REMEDIES. Except as otherwise provided in this Agreement,
upon the occurrence of a breach by any Party, the affected Party shall be
entitled to any and all rights and remedies which it may have at law or in
equity, including, but not limited to, the equitable remedies of specific
performance and injunctive relief. If a Party is successful in litigation
brought to enforce any rights hereunder, it shall be entitled to recover
reasonable attorneys' fees and costs attributable thereto.
Section 15. EXHIBITS. Each of the exhibits referred to in or and
attached to this Agreement is incorporated herein and made a part hereof by
reference with the same effect as if set forth herein at length.
Section 16. SUCCESSORS. The rights, duties and obligations set forth
herein shall inure to the benefit of and be binding upon the Parties and their
past, present and future officers, directors, employees, agents,
representatives, attorneys, receivers, successors and assigns.
Section 17. SEVERABILITY. The invalidity or unenforceability of any
particular provision of this Agreement shall not affect the other provisions
hereof, and this Agreement shall be construed in all respects as if such invalid
or unenforceable provision were amended and reformed so as to make it valid and
enforceable to the maximum extent permitted under law and within the general
intent of the original provision.
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Section 18. HEADINGS. Section headings are included in this Agreement
for convenience only and shall not affect the meaning or interpretation of this
Agreement.
Section 19. ENTIRE AGREEMENT AND AMENDMENTS. This Agreement, and the
Withdrawal Agreement and exhibits referred to in or attached to this Agreement,
constitute the entire agreement of the Parties with respect to the subject
matter hereof, and unless otherwise stated herein, supersede any previous
agreements, whether oral or written, regarding the subject matter hereof. This
Agreement may be amended only by a written instrument signed by the Parties.
Section 20. ASSIGNMENT. This Agreement and the rights and obligations
of the Parties hereunder shall not be assignable without the prior written
consent of all of the Parties.
Section 21. GOVERNING LAW. This Agreement shall be governed by and
construed in accordance with the laws of the State of Illinois, without regard
to principles of conflicts of law.
Section 22. WAIVER. No restriction, condition, obligation or provision
contained in this Agreement shall be deemed to have been abrogated or waived by
reason of any failure to enforce the same, irrespective of the number of
violations or breaches thereof that may occur.
Section 23. NOTICES. Any notice which a Party may desire or be required
to give to another Party shall be in writing, addressed to the Party at its
address set forth below or at such other location as such Party may have
designated by notice in writing in accordance herewith, and shall be deemed
given on the earlier of: (a) actual receipt, if and when personally delivered or
received by facsimile; (b) the Business Day after being placed for delivery by a
nationally recognized overnight courier; or (c) on the third (3rd) Business Day
after being deposited in the United States registered or certified mail, postage
prepaid, return receipt requested:
(A) To Grantor: First Mercury Insurance Company
29621 Northwestern Highway
P.O. Box 5096
Southfield, Michigan 48086
Attn: Richard H. Smith
with a copy to: Katten Muchin & Zavis
525 West Monroe Street
Suite 1600
Chicago, Illinois 60661-3693
Attn: Richard M. Seligman, Esq.
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(B) To Trustee: LaSalle National Trust, N.A.
135 South LaSalle Street
Chicago, Illinois 60603
Attn: Corporate Trust Department
(C) To the IIE: Illinois Insurance Exchange
311 South Wacker Drive
Suite 400
Chicago, Illinois 60606
Attn: Gerald F. Murray, Esq.
with a copy to: First Mercury Insurance Company
29621 Northwestern Highway
P.O. Box 5096
Southfield, Michigan 48086
Attn: Richard H. Smith
Section 24. THIRD PARTY BENEFICIARIES. The IIE shall be a third party
beneficiary of this Agreement. Other than the IIE, no Person other than the
Parties and their successors shall have any right to enforce or seek enforcement
of this Agreement.
Section 25. RECITALS. The recitals and prefatory phrases and paragraphs
set forth above are incorporated in full in this Agreement.
IN WITNESS WHEREOF, the Parties have caused this Agreement to be
executed by their respective duly authorized officers as of the date first above
written.
FIRST MERCURY INSURANCE COMPANY
By: /s/ Richard H. Smith
---------------------------------------
Richard H. Smith, President
LASALLE NATIONAL TRUST, N.A.
By: /s/ Diane Swanson
---------------------------------------
Diane Swanson, Assistant Vice President
Acknowledged and Accepted:
ILLINOIS INSURANCE EXCHANGE
By: /s/ Gerald F. Murray
--------------------------
Name: Gerald F. Murray
--------------------------
Its: Esquire
--------------------------
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Exhibit A to Trust Agreement dated December 16, 1996 by and between
FIRST MERCURY INSURANCE COMPANY
and
LASALLE NATIONAL TRUST, N.A.
List of Assets Deposited to the Trust Fund
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<PAGE>
Exhibit B to Trust Agreement dated December 16, 1996 by and between
FIRST MERCURY INSURANCE COMPANY
and
LASALLE NATIONAL TRUST, N.A.
Withdrawal Notice
In accordance with Section 3 of the Trust Agreement dated December 16,
1996 by and between First Mercury Insurance Company and LaSalle National Trust,
N.A., and in compliance with the provisions of the Trust Agreement, please
transfer the following Assets to the following account or Designee:
Assets Grantor Account or Designee to Receive Assets
------ ---------------------------------------------
FIRST MERCURY INSURANCE COMPANY
By: ___________________________
Name: ___________________________
Its: ___________________________
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Exhibit C to Trust Agreement dated December 16, 1996 by and between
FIRST MERCURY INSURANCE COMPANY
and
LASALLE NATIONAL TRUST, N.A.
List of Eligible Investments
Investments described in Sections 125.1a through and including Section
125.14a, and publicly traded investments described in Section 125.15b,
of the Illinois Insurance Code. The above sections of the Illinois
Insurance Code are attached hereto.
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Exhibit D to Trust Agreement dated December 16, 1996 by and between
FIRST MERCURY INSURANCE COMPANY
and
LASALLE NATIONAL TRUST, N.A.
Notice of Intention
In accordance with Section 11(A) of the Trust Agreement dated December
16, 1996 by and between First Mercury Insurance Company and LaSalle National
Trust, N.A., this letter shall constitute written notice of Grantor's intention
to terminate the Trust Fund (the "Notice of Intention," as defined in such Trust
Agreement). Grantor intends the Trust Fund to terminate on [date].
FIRST MERCURY INSURANCE COMPANY
By: ___________________________
Name: ___________________________
Its: ___________________________
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Exhibit E to Trust Agreement dated December 16, 1996 by and between
FIRST MERCURY INSURANCE COMPANY
and
LASALLE NATIONAL TRUST, N.A.
Termination Notice
In accordance with Section 11(B) of the Trust Agreement dated December
16, 1996 by and between First Mercury Insurance Company and LaSalle National
Trust, N.A., this letter shall constitute the Termination Notice, as such term
is defined in such Trust Agreement. Please be advised that the date on which the
Trust Fund shall terminate (the "Termination Date," as defined in such Trust
Agreement) shall be [date].
LASALLE NATIONAL TRUST, N.A.
By: ___________________________
Name: ___________________________
Its: ___________________________
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Exhibit F to Trust Agreement dated December 16, 1996 by and between
FIRST MERCURY INSURANCE COMPANY
and
LASALLE NATIONAL TRUST, N.A.
Fee Schedule
The fee schedule is attached hereto.
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EXHIBIT 10.23
ADMINISTRATIVE AND FINANCIAL MANAGEMENT AGREEMENT
THIS AGREEMENT is entered into as of the 24th day of December, 1996, by
and between First Mercury Insurance Company ("First Mercury"), an Illinois
insurance corporation, and Mercury Management, Inc. ("MM"), a Michigan
corporation.
WHEREAS, First Mercury is an admitted insurance carrier in the State of
Illinois; and
WHEREAS, MM and its personnel have experience in providing various
management and administrative services to insurance companies and other
organizations; and
WHEREAS, First Mercury and MM desire to enter into an administrative
and financial management agreement, whereby MM shall act as "Administrative and
Financial Manager" of First Mercury, according to the terms and conditions
herein provided.
NOW, THEREFORE, in consideration of the foregoing premises and the
covenants and agreements herein contained, it is mutually agreed as follows:
I. SCOPE AND AUTHORITY. First Mercury hereby engages MM as its
Administrative and Financial Manager, for the term set forth in Section III
hereof, and MM hereby accepts such engagement. As Administrative and Financial
Manager, MM shall have full, general authority to perform the duties hereinafter
set forth, subject to (i) the terms and conditions of this Agreement, (ii) the
authority and direction of First Mercury's Board of Directors and officers,
(iii) First Mercury's Articles of Incorporation and By-Laws, and (iv) the
statutes, rules and regulations governing the business and affairs of First
Mercury in Illinois and other applicable jurisdictions.
II. DUTIES. Without limiting the generality of Section I hereof, and
subject to the general and specific limitations set forth throughout this
Agreement, MM shall perform the following specific duties on behalf of First
Mercury:
a. Provide strategic planning, executive guidance and
consultation with respect to the business activities of First
Mercury, including, without limitation:
(i) the development of First Mercury's insurance
production force;
(ii) the development and implementation of advertising and
promotional strategies and materials;
(iii) the development of First Mercury's marketing
approach, including, without limitation, the
development of overall marketing procedures, policies
and objectives;
(iv) the preparation of market surveys and analyses;
(v) the review and evaluation of performance objectives;
b. Provide executive consultation and administrative oversight
with respect to the activities of First Mercury;
c. Provide and implement an investment program in accordance with
Section VI hereof;
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d. Provide financial oversight and consulting services with
respect to the assets of First Mercury;
e. Provide day to day administrative, records and financial
accounting services; and
f. Provide such other services incident to its performance of the
foregoing activities as reasonably shall be required.
MM further agrees that it will exercise its best efforts to generally
promote and assist in the development of the business of First Mercury, in
accordance with the objectives of First Mercury and in compliance with the
statutes, rules and regulations of the State of Illinois and other regulatory
agencies having jurisdiction over First Mercury.
III. TERM. The term of this Agreement shall commence as of June 28, 1996 and
shall remain in full force and effect until December 31, 2001 or until
terminated as hereinafter provided.
IV. RELATIONSHIP OF THE PARTIES.
a. Nothing herein contained shall be construed to create the
relationship of employer/employee, partners, or joint venturers between First
Mercury and MM or to provide MM with the exclusive or dominant right to manage
or control First Mercury.
b. MM is acting herein as an Administrative and Financial Manager and
may exercise its own judgment, within the parameters set forth herein and in any
written rules, regulations and instructions issued by the Board of Directors or
officers of First Mercury, as to the time and manner in which MM performs the
services required to be performed by it hereunder.
c. First Mercury from time to time may issue rules, regulations and
instructions regarding its business which may affect MM's rights and interests
hereunder, provided that such rules shall not have as their exclusive purpose
the frustration or material adverse impact upon this Agreement.
d. MM shall not have the right to produce any insurance business nor
negotiate any ceded or assumed reinsurance on behalf of First Mercury.
V. INFORMATION SUPPLIED BY FIRST MERCURY. First Mercury agrees to keep MM fully
informed at all times with regard to the securities owned by it, the funds
available or to become available to it for investment, and generally as to the
condition of its affairs. First Mercury periodically shall furnish MM with a
copy of its financial statements, including a signed copy of each report
prepared by certified public accountants with respect to such financial
statements, and with such other information regarding its affairs as MM from
time to time reasonably may request.
VI. INVESTMENT PROGRAM OF FIRST MERCURY.
a. MM agrees to provide financial management services to and to act as
financial manager for First Mercury in accordance with the provisions of this
Agreement. MM continuously shall provide to the Board of Directors of First
Mercury an investment program for the assets of First Mercury, including,
without limitation, advice, statistical data and recommendations with respect to
the acquisition
2
<PAGE>
(through purchase, exchange or otherwise) of securities and other assets of
First Mercury. All such advice and recommendations shall be consistent with and
in furtherance of the investment objectives and policies of First Mercury, as
heretofore adopted by First Mercury and communicated in writing to MM and as
such investment objectives and policies from time to time may be amended and
communicated in writing to MM, and in full compliance with all applicable laws,
rules and regulations.
b. Subject to the supervision and direction of the Board of Directors
and officers of First Mercury, MM shall take all action necessary or appropriate
to implement and carry into effect First Mercury's investment program or any
part thereof. With respect to the portfolio securities of First Mercury, MM
shall purchase on behalf of First Mercury such securities from or through and
sell such securities to or through brokers, dealers or other persons, within the
investment guidelines given to MM by the Board of Directors of First Mercury. MM
shall provide to the Board of Directors of First Mercury periodic reports with
respect to the implementation of First Mercury's investment program, or part
thereof, and any other reports which First Mercury reasonably may request.
VII. EXPENSES. First Mercury shall be responsible for, pay and discharge all of
its own operating expenses associated with the administrative and financial
management services provided hereunder (including fees or compensation due or
paid to subcontractors). With respect to the performance of services hereunder,
MM shall not incur any expenses to be charged to First Mercury, other than the
following expenses which may be incurred by MM on behalf of First Mercury and
which shall be borne and paid by First Mercury when so incurred:
a. Pension, fringe benefits and related expenses of First
Mercury's employees, officers and directors;
b. Legal, actuarial and accounting fees and expenses relating to
the operations and business of First Mercury;
c. Investment management and brokerage fees;
d. Security account custodial fees;
e. Expenses associated with the transfer of securities, including
transfer and other taxes; and
f. Other expenses of a similar nature consistent with the
foregoing.
VIII. COMPENSATION. As full compensation for the administrative and financial
management services rendered by MM hereunder, First Mercury shall pay to MM
fifteen percent (15%) of direct and assumed premiums written. Payment hereunder
shall be made to MM not less often than quarterly.
IX. DIRECTORS, OFFICERS AND EMPLOYEES - OUTSIDE INTERESTS. Nothing in this
Agreement shall limit or restrict the right of any director, officer, employee
or agent of MM who also may be a director, officer, employee or agent of First
Mercury or any affiliate thereof to engage in any other business or to devote
his time and attention to the management or other aspects of any other business,
whether of a similar or dissimilar nature, or limit or restrict the right of MM
to engage in any other business or to render services of any kind to any other
corporation, firm, individual or association; provided, however, that MM shall
disclose to First Mercury any such interests or relationships to the extent they
may represent a conflict of interest with respect to MM's duties and
responsibilities hereunder.
3
<PAGE>
X. INSPECTION OF BOOKS AND RECORDS. MM shall maintain during the term of this
Agreement all books and records necessary with respect to its obligations under
this Agreement until written authorization to return or destroy said books and
records is received from First Mercury and any governmental authority required
to give such authorization. Said books and records which reflect the
transactions of First Mercury shall remain at all times the property of First
Mercury, and MM, at its own expense, may retain duplicate copies of said books
and records. All books and records maintained by MM which pertain in any way to
this Agreement and the investments and other transactions entered into by MM on
behalf of First Mercury shall be made available for inspection to any duly
authorized representative of any governmental authority having jurisdiction over
MM or First Mercury.
XI. INDEMNIFICATION OF FIRST MERCURY.
a. MM shall perform its duties hereunder in accordance with all
applicable laws and regulations and immediately shall notify First Mercury of
any notice received of any alleged violations thereof and promptly shall correct
any such violation regardless of the source of the notice.
b. MM shall hold First Mercury harmless and indemnify First Mercury
from and against any expenses, damages, liability, actions, costs or other
claims, including but not limited to reasonable attorneys' fees and associated
costs, incurred by First Mercury either (i) as a result of the failure of MM or
any subcontractor appointed by MM to comply with any law or administrative
regulation, regardless of whether such failure was intentional or unintentional
or resulted from mistake, negligence or lack of MM's knowledge, or (ii) as a
result of or in connection with MM's breach of any duty or obligation hereunder
or the breach of any duty or obligation of any subcontractor appointed by MM.
First Mercury may set off against any amount due MM any amount due to First
Mercury pursuant to this or any other agreement to which the parties hereto are
also parties.
XII. TERMINATION. This Agreement may be terminated as follows:
a. At any time, by mutual agreement of First Mercury and MM,
without notice;
b. By either First Mercury or MM upon 90 days prior written
notice; or
c. Forthwith, upon written notice after the happening of any of
the following:
(i) any act committed by MM or First Mercury which would
render such acting party unable to pay its
liabilities as they become due;
(ii) the commencement of any proceeding in bankruptcy,
receivership or dissolution by or against MM or First
Mercury, and, if such proceeding is involuntarily com
menced, such proceeding is not dismissed within 60
days;
(iii) any material change in the management or control of
MM or MM's assets without First Mercury's prior
written consent; or
(iv) the termination or restriction of MM's authority to
conduct its business, or any part thereof, by any
public authority, board, commission, bureau or
officer.
XIII. GENERAL CONDITIONS.
4
<PAGE>
a. MM shall not at any time disclose or communicate to any
other person any confidential information or trade secrets relating to the
business of First Mercury, including business methods and techniques,
research data, marketing and sales information, customer lists, know-how and
any other information concerning the business of First Mercury or any
affiliate or agent of First Mercury, their manner of operation, their plans
or other data not disclosed to the general public, unless prior written
consent is obtained from First Mercury.
b. MM and First Mercury agree that no indulgence or acceptance
of any delinquent or partial payment by either or ratification after the fact
of any violation or breach of any provision of this Agreement by either shall
be construed as a waiver of any of its rights hereunder.
c. The terms and provisions contained herein constitute the
entire agreement between the parties and supersede any previous
communications, representations or agreements, either oral or written, with
respect to the subject matter hereof.
d. Any notice provided to MM or First Mercury shall be in
writing and shall be deemed sufficiently given on the date of service, if
served personally, or on the third business day after mailing, if mailed by
certified or registered mail, postage prepaid, or if sent by some other means
at least as fast and reliable as by mail, addressed as follows (or to such
other address as any party may give the other in the manner herein provided
for the giving of notice):
If to First Mercury: First Mercury Insurance Company
29621 Northwestern Highway
Southfield, Michigan 48034
Attn: Richard H. Smith, President
If to MM: Mercury Management, Inc.
29621 Northwestern Highway
Southfield, Michigan 48034
Attn: Jerome M. Shaw, President
e. The invalidity or unenforceability of any particular
provision of this Agreement shall not affect the other provisions hereof, and
this Agreement shall be construed in all respects as if the invalid or
unenforceable provision had been omitted. To the extent this Agreement
requires the approval of any public official, agency, board, commission or
bureau prior to becoming effective, it shall not be effective until such
approval shall have been obtained or otherwise as required by applicable law.
f. This Agreement shall be binding upon and inure to the
benefit of First Mercury and MM and their respective successors and assigns.
g. This Agreement shall be interpreted in all respects in
accordance with the internal laws of the State of Illinois, without regard to
principles of conflicts of law.
h. This Agreement may be amended only by a written document
signed by First Mercury and MM.
i. This Agreement may be executed in multiple counterparts,
each of which shall be considered an original, but all of which, together,
shall be considered one and the same instrument.
5
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<PAGE>
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<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> DEC-31-1996
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<RESERVE-OPEN> 53,014
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<PROVISION-PRIOR> (3,172)
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