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Previous: MEADOWBROOK INSURANCE GROUP INC, 10-K405, 2000-03-30 |
Next: CENTURY ALUMINUM CO, 10-K, 2000-03-30 |
Exhibit 13
Description of Business
Meadowbrook Insurance Group, Inc. (the “Company”) is a program-oriented risk management company specializing in alternative risk management solutions for agents, brokers, professional / trade associations, and insureds of all sizes. The Company provides a broad array of insurance products and services through its subsidiaries. The Company owns insurance carriers, which are essential elements of the risk management process. Management defines its business segments as agency operations and program business operations based upon differences in products and services.
The agency segment was formed in 1955 as the Company’s original business. The insurance agency places principally commercial insurance, as well as personal property, casualty, life and accident and health insurance, with more than 50 insurance carriers from which it earns commission income. The agency has grown to be one of the largest agencies in Michigan and, with acquisitions, has expanded into Florida and California.
The program business segment is engaged primarily in developing and managing alternative risk management programs for defined client groups and their members. This includes providing services, such as reinsurance brokering, risk management consulting, claims handling, and administrative services, along with various types of property and casualty insurance coverage, including workers’ compensation, general liability and commercial multi-peril. Insurance coverage is primarily provided to associations or similar groups of members. A program is a set of coverages and services tailored to meet the specific requirements of a group of clients.
The Company categorizes its programs into four categories. In managed programs, the Company usually assumes no insurance risk and generates fee revenue through program management services. In fronted programs, the Company usually assumes 10% or less of the underwriting risk and generates fees which are accounted for as a reduction of underwriting expenses. In risk-sharing programs, the Company participates with the client or producing agent in the operating results of the programs through a captive, rent-a-captive or other such vehicles. In fully-insured programs, the Company provides traditional insurance without a risk-sharing mechanism and derives revenue exclusively from earned premiums and investment income. Fully-insured programs are developed only in response to a specific market opportunity and generally when the Company believes there is potential to transform into a risk-sharing program.
In recent years, the Company derived its revenue from the following sources (in thousands):
| For the Years Ended | |||||||||||||
| December 31, | |||||||||||||
| 1999 | 1998 | 1997 | |||||||||||
| Revenues | |||||||||||||
| Net earned premiums | $ | 124,906 | $ | 92,085 | $ | 68,493 | |||||||
| Management fees | 22,878 | 18,121 | 15,786 | ||||||||||
| Investment income | 11,319 | 9,620 | 8,248 | ||||||||||
| Program business | 159,103 | 119,826 | 92,527 | ||||||||||
| Agency operations | 16,391 | 14,713 | 10,666 | ||||||||||
| Reconciling items | 72 | 11 | 24 | ||||||||||
| Intersegment revenue | (572 | ) | (436 | ) | (2,092 | ) | |||||||
| Consolidated revenue | $ | 174,994 | $ | 134,114 | $ | 101,125 | |||||||
Acquisitions and other business changes items
On August 6, 1999, the Company acquired the assets of TPA Associates, Inc., all the outstanding stock of TPA Insurance Agency, Inc. and Preferred Insurance Agency, Inc. and approximately 94% of the outstanding stock of Preferred Insurance Company, Ltd., (collectively, “TPA”) at a purchase price of $16.2 million. This acquisition is not expected to have a material impact on the Company’s financial position or results of operations. This transaction resulted in goodwill of $12.9 million.
On April 30, 1998, the Company acquired the business of Villari & Associates, Inc. (“Villari”), at a purchase price of $5.6 million comprised of $4.5 million in cash and 33,433 shares of common stock, resulting in goodwill of $5.6 million. Villari is a Florida-based insurance agency which offers professional liability products and programs, group health and disability, and property and casualty products.
On July 31, 1998, the Company acquired Florida Preferred Administrators, Inc. (“Florida Preferred”) and Ameritrust Insurance Corporation (“Ameritrust”), at a purchase price of $12.3 million, resulting in goodwill of $7.0 million. Florida Preferred, a Florida based third party administrator, provides a broad range of risk management services to purchasers of workers’ compensation insurance from Ameritrust as well as other insurance carriers.
On July 1, 1997, the Company acquired Crest Financial Corporation, (“Crest”), at a purchase price of $9.4 million, resulting in goodwill of $3.2 million. Crest is a California based holding company which formerly owned Williamsburg National Insurance Company (“Williamsburg”), an insurance carrier, and Crest Financial Services, a risk management service company. Crest provides these services primarily to the trucking industry within California. Effective December 31, 1999, the Company reorganized its holding structure, which resulted in Crest assigning Williamsburg to Star Insurance Company (“Star”).
In December of 1996, the Company entered into a five-year joint underwriting agreement with Connecticut Surety Corporation. The agreement provided for the transfer of the underwriting risk on the majority of the Company’s existing surety bond business. In addition, Star continues to write, on a progressively diminishing basis, new surety business, utilizing its capital and licenses, and Connecticut Surety manages the operations and assumes the risk.
Overview
1999 compared to 1998:
Results from operations, excluding the cumulative effect of accounting change, decreased $13.7 million, or 233.7%, from net income of $5.9 million in 1998 to a loss of $7.8 million in 1999. The 1999 results reflect a $6.8 million increase in adverse development on prior accident years, a decrease in underwriting results of $9.9 million relating to pricing pressure on the 1999 accident year, a $1.8 million increase in the provision for uncollectible receivables, and establishment of a $300,000 liability for expense reduction actions taken in the fourth quarter of 1999.
Revenues increased 30.5% to $175.0 million in 1999 from $134.1 million in 1998. Excluding the impact of acquisitions, revenues grew 10.6%. The remaining increase reflects new and existing business growth.
The Company’s number one priority for the Year 2000 is to return to profitability. The Company’s plans focus on improving processing capabilities, integrating acquisitions, increasing pricing and fees where appropriate, leveraging e-commerce initiatives, and bringing operating costs into alignment with revenues.
1998 compared to 1997:
Net income in 1998 decreased $7.1 million, or 55.0%, from $13.0 million in 1997 to $5.9 million in 1998. The 1998 results reflect a $7.0 million increase in adverse development on prior accident years, a decrease in underwriting results of $1.4 million relating to pricing pressure on the 1998 accident year, a
Revenues increased 32.7% to $134.1 million in 1998 from $101.1 million in 1997. This growth primarily reflected recent acquisitions as well as growth from new and existing business.
Results of Operations
Program Business
The following table sets forth the revenues and results from operations for program business (in thousands):
| For the Years Ended | |||||||||||||
| December 31, | |||||||||||||
| 1999 | 1998 | 1997 | |||||||||||
| Revenue: | |||||||||||||
| Net earned premiums | $ | 124,906 | $ | 92,085 | $ | 68,493 | |||||||
| Management fees | 22,878 | 18,121 | 15,786 | ||||||||||
| Investment income | 11,319 | 9,620 | 8,248 | ||||||||||
| Total Revenue | $ | 159,103 | $ | 119,826 | $ | 92,527 | |||||||
| Pre-tax (loss) income: | |||||||||||||
| Program business | $ | (11,891 | ) | $ | 7,520 | $ | 16,778 | ||||||
1999 compared to 1998:
Revenues from program business increased $39.3 million, or 32.8% to $159.1 million in 1999 from $119.8 million in 1998. The increase reflects 35.6% growth in net earned premiums to $124.9 million in 1999 from $92.1 million in 1998. This increase reflects the acquisitions of Ameritrust and TPA, which contributed $18.8 million. Excluding the impact of these acquisitions, net earned premium increased 15.2% reflecting growth in existing business primarily from programs initiated in 1998. Management fees grew $4.8 million, or 26.3% to $22.9 million from $18.1 million. This increase reflects the acquisitions of Florida Preferred and TPA. Excluding these acquisitions, management fees would be slightly down reflecting a decrease in fees for claim services. The remaining increase reflects a $1.7 million, or 17.7% increase in investment income to $11.3 million in 1999 from $9.6 million in 1998. This increase reflects a 15.7% increase in average invested assets, primarily from the acquisition of TPA.
Program business in 1999 generated a pre-tax loss of $11.9 million, which compares to pre-tax income of $7.5 million in 1998. The 1999 results reflect a $6.8 million increase in adverse development on prior accident years, a decrease in underwriting results of $9.9 million relating to pricing pressure on the 1999 accident year, a $1.8 million increase in the provision for uncollectible receivables, and establishment of a $300,000 liability for expense reduction actions taken in the fourth quarter of 1999. The adverse development reflects the impact of adopting a more conservative reserving philosophy that relies on a line-of-business analysis to supplement the program specific analysis. The majority of the development was in programs in which the company has discontinued.
The Company initiated specific actions that focus on profitability in 2000. These actions include reductions in personnel and administrative costs in areas where full value was not being realized, pricing and fee adjustments, and a realignment of management which more closely aligns responsibility and authority with operating results.
1998 compared to 1997:
Revenues from program business increased $27.3 million, or 29.5% to $119.8 million in 1998 from $92.5 million in 1997. The increase reflects 34.4% growth in net earned premiums to $92.1 million in 1998 from $68.5 million in 1998. This increase reflects the acquisitions of Ameritrust and Crest, which contributed $11.9 million. Excluding the impact of these acquisitions, net earned premium increased 17.0% reflecting growth in existing business primarily from programs initiated in 1998. Management fees grew $2.3 million, or 14.8% to $18.1 million from $15.8 million. This increase reflects the acquisitions of Florida Preferred and Crest. Excluding these acquisitions, management fees increased slightly. The remaining increase reflects a $1.4 million, or 16.6% increase in investment income to $9.6 million in 1998 from $8.2 million in 1997. This increase reflects a 20.1% increase in average invested assets, primarily from the acquisition of Ameritrust.
Program business in 1998 generated a pre-tax income of $7.5 million, which compares to pre-tax income of $16.8 million in 1997. The 1998 results reflect a $7.0 million increase in adverse development on prior accident years, a decrease in underwriting results of $1.4 million relating to pricing pressure on the 1998 accident year, a $0.6 million increase in the provision for uncollectible receivables, and an increase in technology and administrative costs. While actions were taken in 1998 to address profitability shortfalls, the 1998 / 1999 actions anticipated growth from new business to absorb a portion of this shortfall. With the increased competitive environment in 1999 and the Company’s increased selectivity, the actual growth fell short of expectations and the expense controls were not sufficient to cover this shortfall.
Agency operations
The following table sets forth the revenues and results from operations for agency operations (in thousands):
| For the Years Ended December 31, | ||||||||||||
| 1999 | 1998 | 1997 | ||||||||||
| Net commission | $ | 16,391 | $ | 14,713 | $ | 10,666 | ||||||
| Pre-tax income | $ | 3,639 | $ | 2,757 | $ | 2,166 | ||||||
1999 compared to 1998:
Agency commissions increased $1.7 million, or 11.4%, to $16.4 million in 1999 from $14.7 million in 1998. Agency operations generated pre-tax income of $3.6 million in 1999 compared to $2.8 million in 1998. This increase primarily reflects the full year impact of the acquisition of Villari in 1998.
1998 compared to 1997:
Agency commissions increased $4.0 million, or 37.9%, to $14.7 million in 1998 from $10.7 million in 1997. Agency operations generated pre-tax income of $2.8 million in 1998 compared to $2.2 million in 1997. This increase primarily reflects the full year impact of the acquisition of Crest and the 1998 acquisition of Villari.
Other items
Interest Expense
Interest expense for 1999, 1998 and 1997 was $3.6 million, $2.0 million and $0.6 million, respectively. This interest expense relates to the use of the Company’s line of credit. The proceeds from the line of credit were used to fund acquisitions, as well as the stock repurchases. This increasing trend relates to an increase in average outstanding debt. The average outstanding debt increased approximately 300% and 75% from 1997 to 1998 and from 1998 to 1999, respectively.
Amortization Expense
Amortization expense for 1999, 1998 and 1997 was $1.6 million, $1.0 million and $0.4 million, respectively. This increase reflects the acquisitions in 1997, 1998, and 1999.
Taxes
The provision for income taxes was a benefit of $6.2 million in 1999 with an effective tax rate of 44.2%. The provision for income taxes was $0.8 million in 1998 and $4.3 million in 1997, representing effective tax rates of 11.7% and 25.0% in 1998 and 1997, respectively. The tax rates were significantly lower than the 34% corporate rate due to the Company’s heavily tax-exempt investment portfolio.
The decrease in the effective tax rate in 1998 reflects an unusually low proportion of underwriting and fee-based income in relation to net investment income. The fluctuations in the effective tax rate reflect the change in proportion of underwriting and risk management service income in relation to net investment income, as well as any changes in the level of tax exempt interest. During 1999, to maximize after-tax cash flow, the Company reduced its tax-exempt securities from 77.9% at December 31, 1998 to 53.7% of total debt securities at December 31, 1999.
At December 31, 1999, the Company had a deferred tax asset of $2.3 million related to a net operating loss carryforward (“NOL”). The company believes this asset will be recovered prior to the expiration of the NOL on December 31, 2019.
Liquidity and Capital Resources
The principal sources of funds for the Company are insurance premiums, investment income, proceeds from the maturity and sale of invested assets, risk management fees and agency commissions. Funds are primarily used for the payment of claims, commissions, salaries and employee benefits, and other operating expenses. In addition, the Company has a high volume of intercompany transactions due to the payment of management fees by the insurance subsidiaries to the risk management subsidiaries. Such fees are subject to regulatory approval by state insurance departments.
Cash flow provided by operations for 1999 and 1998 was $23.6 million and $10.3 million, respectively. This compares to cash used by operations of $1.7 million in 1997. The increase in cash provided by operations in 1999 compared to 1998, reflects high cash outflow in the first half of 1998 relating to the payment of 1997 contingent commissions paid in 1998. The positive cash flow in relation to the 1999 net loss reflects the strengthening of reserves that did not require cash payments in 1999. The cash used in operations during 1997 reflects significant written, but uncollected, premiums in the fourth quarter of 1997, the transfer of the surety bond program to Connecticut Surety and the payment of claims associated with the run-off of the surety bond program. The Company held $23.7 million in cash and cash equivalents at December 31, 1999.
The Company has one unsecured line of credit totaling $60.0 million, of which $55.6 million was outstanding at December 31, 1999. The line expires on August 1, 2002. The Company drew on this line of credit primarily to consummate the acquisitions made during 1997, 1998 and 1999.
At December 31, 1999, the Company fell below the minimum level of required net worth and the fixed charge coverage. The Company has reached an agreement with the bank group to waive these covenants. The Company has also reached agreement to amend the line of credit to reflect the current operating environment.
In addition, a standby letter of credit of $10,015,000 had been issued to an insurance subsidiary of the Company, under an agreement expiring with extensions granted on a yearly basis. This letter of credit is being used as security for the insurance subsidiary’s obligations under a reinsurance agreement.
In addition, a non-insurance subsidiary had a line of credit with a bank which permits borrowings up to 80% of the accounts receivable which collateralize the line. The line will expire March 31, 2000 and is automatically renewable each year. This line bears interest at 1% under the prime rate (prime was 8.5% at December 31, 1999). At December 31, 1999, $2,818,579 was outstanding under this line.
As of December 31, 1999 and 1998, the recorded values of the Company’s investment portfolio, including cash and cash equivalents, were $225.5 million and $201.0 million, respectively. The investment portfolio, at December 31, 1999, was 98.1% invested in investment grade A or above bonds (as defined by S&P). During 1999, in line with expectations, the Company increased its position in equity securities by $8.7 million. During 1999, to maximize after-tax cash flow, the Company reduced its tax-exempt securities from 77.9% at December 31, 1998 to 53.7% of total debt securities at December 31, 1999.
Shareholders’ equity was $100.4 million, or $11.80 per common share, at December 31, 1999, compared to $119.6 million at December 31, 1998, or $13.80 per common share. The decrease in shareholders’ equity during 1999 reflects the net loss, dividends, stock repurchases and unrealized depreciation on available-for-sale securities of $6.5 million. Changes in shareholders’ equity related to the unrealized values of underlying portfolio investments will continue to be volatile as market prices of debt securities fluctuate with changes in the interest rate environment.
A significant portion of the Company’s consolidated assets represents assets of the Company’s insurance subsidiaries that may not be transferable to the holding company in the form of dividends, loans or advances. The restriction on the transferability to the holding company from its insurance subsidiaries is limited by Michigan regulatory guidelines which are as follows: The maximum discretionary dividend that may be declared, based on data from the preceding calendar year, is the greater of the insurance company’s net income (excluding realized capital gains) OR 10% of the insurance company’s policyholders’ surplus (excluding unrealized gains). These dividends are further limited by a clause in the Michigan law which prohibits an insurer from declaring dividends except out of earned surplus earnings of the company. Earned surplus balances are calculated on a quarterly basis. Since Star is the parent insurance company, its maximum dividend calculation represents the combined insurance companies. Based upon the 1999 statutory financial statements of Star, as of January 1, 2000 Star may not pay any dividend to the Company, during the first quarter of 2000, without prior approval of the Michigan Commissioner of Insurance. The Company expects operating cash flow from non-regulated subsidiaries to meet cash needs in the event that dividends from the regulated subsidiaries are not available. On December 23, 1998, the Commissioner approved payment of a $5,000,000 dividend to the Company, which was used to increase the paid in capital and surplus of Williamsburg. No dividends were paid or returned in 1997.
The insurance subsidiaries are required to maintain certain deposits with regulatory authorities which totaled $45.4 million at December 31, 1999, and $35.9 million at December 31, 1998.
Regulatory Issues
Insurance operations are subject to various leverage tests (e.g. premium to statutory surplus ratios) which are evaluated by regulators and rating agencies. The Company’s target for gross written premium to statutory surplus remains at or below 4 to 1. This target reflects the impact of both the fronting and risk sharing program business in comparison to the composition of a traditional insurer which does not have significant fronting nor risk sharing business. While traditional insurers tend to drive industry standards, this target is consistent with the Company’s primary competitors in fronting and risk-sharing segments. The Company’s target for net written premium to statutory surplus remains at or below 2 to 1. For 1999, premium leverage ratios were 3.1 to 1 and 1.7 to 1 on a gross and net premium written basis, respectively.
The National Association of Insurance Commissioners (“NAIC”) has adopted a risk-based capital (“RBC”) formula to be applied to all property and casualty insurance companies. The formula measures required capital and surplus based on an insurance company’s products and investment portfolio and is to be used as a tool to identify weakly capitalized companies. At December 31, 1999 and 1998, Star, the parent
Reinsurance Considerations
The Company seeks to manage the risk exposure of its insurance subsidiaries and its clients through the purchase of excess-of-loss and quota share reinsurance. The Company’s reinsurance requirements are analyzed on a specific program basis to determine the appropriate retention levels and reinsurance coverage limits. The Company secures this reinsurance based on the availability, cost, and benefits of various reinsurance alternatives.
Reinsurance does not legally discharge an insurer from its primary liability for the full amount of risks assumed under insurance policies it issues, but it does make the assuming reinsurer liable to the insurer to the extent of the reinsurance ceded. Therefore, the Company is subject to credit risk with respect to the obligations of its reinsurers. In its selection of reinsurers, the Company evaluates the financial stability of its prospective reinsurers. To date, the Company has not experienced any material difficulties in collecting reinsurance recoverables. No assurance can be given, however, regarding the future ability of any of the Company’s reinsurers to meet their obligations. The following table sets forth information relating to the Company’s five largest reinsurers (other than client captive quota-share reinsurers) as of December 31, 1999:
| Reinsurance Premium Ceded | A.M. Best | |||||||
| Reinsurer | December 31, 1999 | Rating | ||||||
| (In thousands) | ||||||||
| Employers Reinsurance Corporation | $ | 14,290 | A++ | |||||
| Connecticut Surety Group | 6,222 | Not Rated | ||||||
| Terra Nova Insurance Company Ltd. | 4,165 | Not Rated | ||||||
| Hannover Ruck | 3,517 | Not Rated | ||||||
| Nac Reinsurance Corporation | 2,710 | A+ | ||||||
In its risk-sharing programs, the Company is also subject to credit risk with respect to the payment of claims by its clients’ captive insurers on the portion of risk exposure ceded to such captives. The capitalization and credit worthiness of prospective captive insurers is one of the factors considered by the Company in entering into and renewing risk-sharing programs. The Company secures reinsurance balances due from its non-admitted and not rated reinsurers through funds withheld trusts or letters of credit.
Dependence on Key Programs
The Company provides alternative risk management programs and services to certain large client groups and associations and then markets them to their individual members. In 1999 and 1998, the Company’s top four programs accounted for 26% and 38%, respectively, of the Company’s total revenue on an actual basis. The loss or cancellation of any of the Company’s significant programs by the relevant client groups, or the general availability of commercial market coverage to members of such groups on more favorable terms than provided under the Company’s programs, could have a material adverse effect on the Company’s results of operations. The Company has multiple year contracts with many of its clients.
Impact of Year 2000
The total cost of the required actions necessary to become Year 2000 compliant was $6.0 million.
Amounts spent in 1999 total about $2.2 million, including about $1.1 million in outside vendor costs and another $1.1 million in internal reprogramming and assessment costs.
The Company did not experience any material disruption of its business operations as a result of the Year 2000 issue and does not anticipate any future material disruption of its business operations as a result of the Year 2000 issue.
Qualitative and Quantitative Disclosures about Market Risk
Market risk is the risk of loss arising from adverse changes in market rates and prices, such as interest rates as well as other relevant market rate or price changes. The volatility and liquidity in the markets in which the underlying assets are traded directly influence market risk. The following is a discussion of the Company’s primary risk exposures and how those exposures are currently managed as of December 31, 1999. The Company’s market risk sensitive instruments are limited to debt securities and equity securities which are available for sale and not held for trading purposes.
Interest rate risk is managed within the context of asset and liability management where the target duration of investment portfolio is managed to approximate that of the liabilities as determined by actuarial analysis.
The fair value of Company’s investment portfolio was $201.8 million, 91.6% of which is invested in debt securities. The Company’s market risk to the investment portfolio is interest rate risk associated with debt securities. The Company’s exposure to equity price risk is not significant. The Company’s investment philosophy is one of maximizing after-tax earnings and has historically included significant investments in tax-exempt bonds. For the Company’s investment portfolio, there were no significant changes in the Company’s primary market risk exposures or in how those exposures are managed compared to the year ended December 31, 1998. The Company does not anticipate significant changes in the Company’s primary market risk exposures or in how those exposures are managed in future reporting periods based upon what is known or expected to be in effect in future reporting periods.
A sensitivity analysis is defined as the measurement of potential loss in future earnings, fair values or cash flows of market sensitive instruments resulting from one or more selected hypothetical changes in interest rates and other market rates or prices over a selected period. In the Company’s sensitivity analysis model, a hypothetical change in market rates is selected that is expected to reflect reasonable possible near-term changes in those rates. The term near term means a period of time going forward up to one year from the date of the consolidated financial statements. In its sensitivity model, the Company uses fair values to measure its potential loss of debt securities assuming an upward parallel shift 100 basis point change in interest rates to measure the hypothetical change in fair values. Based upon this sensitivity model, a 100 basis point change in interest rates produces a loss in fair value of market sensitive instruments of approximately $8.1 million. This loss in fair value only reflects the impact of interest rate increases on the fair value of the Company’s debt securities, which constitute 1.5% of total assets. The other financial instruments, which include cash and cash equivalents, equity securities, premium receivables, reinsurance recoverables, line of credit and other assets and liabilities, when included in the sensitivity model do not produce a material loss in fair values.
New Accounting Pronouncements
The Financial Accounting Standards Board (“FASB”) has issued Statement of Financial Accounting Standards (“SFAS”) No. 133 “Accounting for Derivative Instruments and Hedging Activities”, which is effective for fiscal quarters of all fiscal years beginning after June 15, 2000 (as amended by SFAS No. 137). SFAS 133 requires that all derivative instruments be recorded on the balance sheet at fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. As the Company does not use derivative instruments, the management of the Company does not anticipate that the adoption of SFAS 133 will have an effect on the results of operations or financial position of the Company.
In March 1998, NAIC voted to adopt its Codification of Statutory Accounting Principles project (referred to hereafter as “codification”). Codification is a modified form of statutory accounting principles that will result in change to the current NAIC Accounting Practices and Procedures Manual applicable to insurance enterprises. Although adoption of codification by all states is not a certainty, the NAIC has recommended that all states enact codification as soon as practicable with an effective date of January 1, 2001. It is currently anticipated that codification will become an NAIC state accreditation requirement starting in 2002. In addition, the American Institute of Certified Public Accountants and the NAIC has agreed to continue to allow the use of certain permitted accounting practices when codification becomes effective in 2001. Any accounting differences from codification principles, however, must be disclosed and quantified in the footnotes to the audited financial statements. Therefore, codification will likely result in changes to what are currently considered prescribed statutory insurance accounting practices.
Certain information included in the Management’s Discussion and Analysis of Financial Condition and Results of Operations includes forward-looking statements. Actual results may differ from those in the forward looking statements as a result of the variability of market conditions. Statements relating to the Company’s future performance are based upon management’s interpretation of current market conditions. Some of the factors that management includes in its interpretation of market conditions are as follows: insurance market conditions which historically have been subject to significant variability due to premium rate competition, natural disasters and other catastrophic events, judicial trends, changes in the investment and interest rate environment, regulation and general economic conditions. Further information concerning factors that could significantly impact expected results is included in the business section of the Company’s Form 10-K that is filed with the SEC.
| For the Years Ended December 31, | ||||||||||||||||||||
| 1999 | 1998 | 1997 | 1996 | 1995 | ||||||||||||||||
| (In thousands, except per share and ratio data) | ||||||||||||||||||||
| Income Statement Data: | ||||||||||||||||||||
| Gross written premium | $ | 230,474 | $ | 186,332 | $ | 146,739 | $ | 115,580 | $ | 123,119 | ||||||||||
| Net written premium | 122,819 | 93,481 | 74,965 | 72,758 | 93,638 | |||||||||||||||
| Net earned premium | 124,906 | 92,085 | 68,493 | 84,547 | 82,698 | |||||||||||||||
| Net investment income | 11,608 | 9,579 | 8,128 | 8,002 | 5,325 | |||||||||||||||
| Net realized gain (loss) on investments | (227 | ) | 52 | 134 | 26 | 45 | ||||||||||||||
| Total revenue | 174,994 | 134,114 | 101,125 | 109,189 | 89,974 | |||||||||||||||
| Net losses and LAE | 95,358 | 56,703 | 36,143 | 41,265 | 43,795 | |||||||||||||||
| Policy acquisition and other expenses | 47,583 | 31,931 | 19,531 | 32,079 | 33,721 | |||||||||||||||
| Interest on notes payable | 3,636 | 1,979 | 649 | – | 341 | |||||||||||||||
| (Loss) income before income taxes | (14,056 | ) | 6,645 | 17,386 | 10,868 | 9,488 | ||||||||||||||
| Net (loss) income before cumulative effect | (7,847 | ) | 5,870 | 13,043 | 8,706 | 7,220 | ||||||||||||||
| Net (loss) income | (9,553 | ) | 5,870 | 13,043 | 8,706 | 7,220 | ||||||||||||||
| Earnings per share before cumulative effect — Diluted | $ | (0.91 | ) | $ | 0.65 | $ | 1.42 | $ | 0.95 | $ | 1.32 | |||||||||
| Earning per share — Diluted | $ | (1.11 | ) | $ | 0.65 | $ | 1.42 | $ | 0.95 | $ | 1.32 | |||||||||
| Dividends declared per share | $ | 0.12 | $ | 0.10 | $ | 0.08 | $ | 0.08 | $ | – | ||||||||||
| Balance Sheet Data: | ||||||||||||||||||||
| Total investments and cash and cash equivalents | $ | 225,523 | $ | 201,025 | $ | 167,292 | $ | 156,495 | $ | 148,977 | ||||||||||
| Total assets | 551,977 | 440,075 | 328,642 | 265,035 | 241,764 | |||||||||||||||
| Loss and LAE reserves | 229,244 | 148,844 | 98,979 | 92,390 | 86,986 | |||||||||||||||
| Shareholders’ equity | 100,408 | 119,567 | 115,446 | 100,201 | 92,216 | |||||||||||||||
| Other Data: | ||||||||||||||||||||
| GAAP ratios (insurance companies only) | ||||||||||||||||||||
| Net loss and LAE ratio | 79.0% | 65.0% | 55.7% | 52.1% | 53.2% | |||||||||||||||
| Expense ratio | 34.5% | 30.6% | 34.0% | 45.0% | 41.7% | |||||||||||||||
| Combined ratio | 113.5% | 95.6% | 89.7% | 97.1% | 94.9% | |||||||||||||||
| Statutory combined ratio | 114.2% | 98.7% | 90.2% | 98.1% | 94.2% | |||||||||||||||
| Industry statutory combined ratio | *107.5% | 105.0% | 101.6% | 105.8% | 106.4% | |||||||||||||||
| * | Estimated |
Management is responsible for the accompanying consolidated financial statements and all other financial information contained in the Annual Report. The financial statements have been prepared in conformity with generally accepted accounting principles and include amounts which of necessity are based on management’s best estimates and informed judgments under existing circumstances.
The Company maintains a system of internal controls designed to provide reasonable assurance, at appropriate costs, that assets are safeguarded, transactions are properly authorized and recorded, and that the financial records provide a reliable basis for the preparation of financial statements that are free of material misstatement.
The financial statements have been audited by the independent auditors PricewaterhouseCoopers LLP. Their role is to render an independent professional opinion on management’s financial statements based upon performance of procedures they deem appropriate under generally accepted auditing standards. As part of their audit, they evaluate the Company’s internal control structure to the extent they consider necessary to express their opinion on the consolidated financial statements.
The Audit Committee of the Board of Directors, composed of directors who are not officers or employees of the Company, meets periodically with management, the Company’s chief internal auditor, and with its independent auditors to discuss their evaluation of internal accounting controls and the quality of financial reporting. Both the independent auditors and the internal auditors have free access to the Audit Committee to discuss the results of audits.
/s/ Merton J. Segal
To the Board of Directors and Shareholders
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows present fairly, in all material respects, the financial position of Meadowbrook Insurance Group, Inc. and Subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
| /s/ PricewaterhouseCoopers LLP | |
| PricewaterhouseCoopers LLP |
Detroit, Michigan
| December 31, | ||||||||||||
| 1999 | 1998 | |||||||||||
| (In thousands, except per | ||||||||||||
| share and ratio data) | ||||||||||||
| ASSETS | ||||||||||||
| Investments | ||||||||||||
| Debt securities available for sale, at fair value (cost of $188,755 and $167,163 in 1999 and 1998, respectively) | $ | 185,241 | $ | 172,617 | ||||||||
| Equity securities available for sale, at fair value (cost of $17,087 and $7,585 in 1999 and 1998, respectively) | 16,569 | 7,898 | ||||||||||
| Cash and cash equivalents | 23,713 | 20,510 | ||||||||||
| Total investments and cash and cash equivalents | 225,523 | 201,025 | ||||||||||
| Accrued investment income | 2,759 | 2,359 | ||||||||||
| Premiums and agent balances receivable (net of allowance of $2,225 and $579 in 1999 and 1998, respectively) | 85,707 | 63,487 | ||||||||||
| Reinsurance recoverable on: | ||||||||||||
| Paid losses | 14,051 | 10,912 | ||||||||||
| Unpaid losses | 101,744 | 64,590 | ||||||||||
| Prepaid reinsurance premiums | 42,073 | 36,336 | ||||||||||
| Deferred policy acquisition costs | 10,030 | 8,900 | ||||||||||
| Deferred federal income taxes | 14,729 | 4,144 | ||||||||||
| Federal income taxes recoverable | 1,180 | 2,095 | ||||||||||
| Intangible assets (less accumulated amortization of $3,396 and $1,775 in 1999 and 1998, respectively) | 33,859 | 22,055 | ||||||||||
| Other assets | 20,322 | 24,172 | ||||||||||
| Total assets | $ | 551,977 | $ | 440,075 | ||||||||
| LIABILITIES AND SHAREHOLDERS’ EQUITY | ||||||||||||
| Liabilities | ||||||||||||
| Reserve for losses and loss adjustment expenses | $ | 229,244 | $ | 148,844 | ||||||||
| Unearned premiums | 90,095 | 77,948 | ||||||||||
| Payable to insurance companies | 23,732 | 13,747 | ||||||||||
| Accounts payable and accrued expenses | 15,814 | 12,076 | ||||||||||
| Reinsurance funds held and balances payable | 29,571 | 20,352 | ||||||||||
| Other liabilities | 4,650 | 6,588 | ||||||||||
| Line of credit | 58,463 | 40,953 | ||||||||||
| Total liabilities | 451,569 | 320,508 | ||||||||||
| Commitments and contingencies (note 12) | ||||||||||||
| Shareholders’ Equity | ||||||||||||
| Common stock, $0.01 stated value; authorized 20,000,000 shares; 8,511,655 and 8,663,434 shares issued and outstanding | 85 | 87 | ||||||||||
| Additional paid-in capital | 67,907 | 71,190 | ||||||||||
| Retained earnings | 35,809 | 45,105 | ||||||||||
| Note receivable from officer | (720 | ) | (661 | ) | ||||||||
| Accumulated other comprehensive income: | ||||||||||||
| Unrealized (depreciation) appreciation on available for sale securities, net of deferred tax (benefit) expense of ($1,359) and $1,921 in 1999 and 1998, respectively | (2,673 | ) | 3,846 | |||||||||
| Total shareholders’ equity | 100,408 | 119,567 | ||||||||||
| Total liabilities and shareholders’ equity | $ | 551,977 | $ | 440,075 | ||||||||
The accompanying notes are an integral part of the Consolidated Financial Statements.
| For the Years Ended | ||||||||||||||
| December 31, | ||||||||||||||
| 1999 | 1998 | 1997 | ||||||||||||
| (In thousands, except per | ||||||||||||||
| share and ratio data) | ||||||||||||||
| Revenues | ||||||||||||||
| Premiums earned | ||||||||||||||
| Gross | $ | 236,620 | $ | 176,242 | $ | 133,314 | ||||||||
| Ceded | (111,714 | ) | (84,157 | ) | (64,821 | ) | ||||||||
| Net earned | 124,906 | 92,085 | 68,493 | |||||||||||
| Net commissions and fees | 38,697 | 32,398 | 24,360 | |||||||||||
| Net investment income | 11,608 | 9,579 | 8,128 | |||||||||||
| Net realized (losses) gains on disposition of investments | (227 | ) | 52 | 134 | ||||||||||
| Miscellaneous income | 10 | – | 10 | |||||||||||
| Total Revenues | 174,994 | 134,114 | 101,125 | |||||||||||
| Expenses | ||||||||||||||
| Losses and loss adjustment expenses | 189,084 | 118,676 | 69,289 | |||||||||||
| Reinsurance recoveries | (93,726 | ) | (61,973 | ) | (33,146 | ) | ||||||||
| Net losses and loss adjustment expenses | 95,358 | 56,703 | 36,143 | |||||||||||
| Salaries and employee benefits | 42,473 | 36,856 | 27,416 | |||||||||||
| Other operating expenses | 47,583 | 31,931 | 19,531 | |||||||||||
| Interest on notes payable | 3,636 | 1,979 | 649 | |||||||||||
| Total Expenses | 189,050 | 127,469 | 83,739 | |||||||||||
| (Loss) income before taxes | (14,056 | ) | 6,645 | 17,386 | ||||||||||
| Federal income tax (benefit) expense | (6,209 | ) | 775 | 4,343 | ||||||||||
| Net (loss) income before cumulative effect of accounting change | (7,847 | ) | 5,870 | 13,043 | ||||||||||
| Cumulative effect of accounting for insurance related assessments, net of deferred taxes | (1,706 | ) | – | – | ||||||||||
| Net (loss) income | $ | (9,553 | ) | $ | 5,870 | $ | 13,043 | |||||||
| Earnings Per Share | ||||||||||||||
| Basic | ||||||||||||||
| Before cumulative effect of accounting change | $ | (0.91 | ) | $ | 0.67 | $ | 1.51 | |||||||
| Cumulative effect of accounting change | $ | (0.20 | ) | $ | – | $ | – | |||||||
| Net (loss) income | $ | (1.11 | ) | $ | 0.67 | $ | 1.51 | |||||||
| Diluted | ||||||||||||||
| Before cumulative effect of accounting change | $ | (0.91 | ) | $ | 0.65 | $ | 1.42 | |||||||
| Cumulative effect of accounting change | $ | (0.20 | ) | $ | – | $ | – | |||||||
| Net (loss) income | $ | (1.11 | ) | $ | 0.65 | $ | 1.42 | |||||||
| Weighted average number of common shares | ||||||||||||||
| Basic | 8,588,216 | 8,702,768 | 8,657,677 | |||||||||||
| Diluted | 8,588,216 | 9,026,180 | 9,176,754 | |||||||||||
The accompanying notes are an integral part of the Consolidated Financial Statements.
| For the Years Ended | ||||||||||||||
| December 31, | ||||||||||||||
| 1999 | 1998 | 1997 | ||||||||||||
| (in thousands) | ||||||||||||||
| Net (loss) income | $ | (9,553 | ) | $ | 5,870 | $ | 13,043 | |||||||
| Other comprehensive (loss) income, net of tax: | ||||||||||||||
| Unrealized (losses) gains on securities | (6,746 | ) | 920 | 3,252 | ||||||||||
| Less: reclassification adjustment for gains (losses) included in net income | 227 | (52 | ) | (134 | ) | |||||||||
| Other comprehensive (loss) income | (6,519 | ) | 868 | 3,118 | ||||||||||
| Comprehensive (loss) income | $ | (16,072 | ) | $ | 6,738 | $ | 16,161 | |||||||
The accompanying notes are an integral part of the Consolidated Financial Statements.
| For the Years ended December 31, 1999, 1998 and 1997 | ||||||||||||||||||||||||
| Accumulated | ||||||||||||||||||||||||
| Additional | Note | Other | Total | |||||||||||||||||||||
| Common | Paid-in | Retained | Receivable | Comprehensive | Shareholders’ | |||||||||||||||||||
| Stock | Capital | Earnings | from Officer | Income | Equity | |||||||||||||||||||
| (In thousands, except per share data) | ||||||||||||||||||||||||
| Balances January 1, 1997 | $ | 87 | $ | 72,873 | $ | 27,381 | $ | – | $ | (140 | ) | $ | 100,201 | |||||||||||
| Unrealized appreciation on available for sale securities | – | – | – | – | 3,118 | 3,118 | ||||||||||||||||||
| Dividends declared at $0.08 per share | – | – | (693 | ) | – | – | (693 | ) | ||||||||||||||||
| Issuance of 35,409 shares of common stock | – | 241 | – | – | – | 241 | ||||||||||||||||||
| Retirement of 24,591 shares of common stock | – | (575 | ) | – | – | – | (575 | ) | ||||||||||||||||
| Tax benefit of stock option exercises | – | 111 | – | – | – | 111 | ||||||||||||||||||
| Net income | – | – | 13,043 | – | – | 13,043 | ||||||||||||||||||
| Balances December 31, 1997 | 87 | 72,650 | 39,731 | – | 2,978 | 115,446 | ||||||||||||||||||
| Unrealized appreciation on available for sale securities | – | – | – | – | 868 | 868 | ||||||||||||||||||
| Dividends declared at $0.10 per share | – | – | (871 | ) | – | – | (871 | ) | ||||||||||||||||
| Issuance of 202,266 shares of common stock | 2 | 2,077 | – | – | – | 2,079 | ||||||||||||||||||
| Retirement of 198,996 shares of common stock | (2 | ) | (4,546 | ) | 375 | – | – | (4,173 | ) | |||||||||||||||
| Tax benefit of stock option exercises | – | 1,009 | – | – | – | 1,009 | ||||||||||||||||||
| Note receivable from officer | – | – | – | (661 | ) | – | (661 | ) | ||||||||||||||||
| Net income | – | – | 5,870 | – | – | 5,870 | ||||||||||||||||||
| Balances December 31, 1998 | 87 | 71,190 | 45,105 | (661 | ) | 3,846 | 119,567 | |||||||||||||||||
| Unrealized depreciation on available for sale securities | – | – | – | – | (6,519 | ) | (6,519 | ) | ||||||||||||||||
| Dividends declared at $0.12 per share | – | – | (1,031 | ) | – | – | (1,031 | ) | ||||||||||||||||
| Issuance of 13,945 shares of common stock | – | 93 | – | – | – | 93 | ||||||||||||||||||
| Retirement of 165,724 shares of common stock | (2 | ) | (3,414 | ) | 1,288 | – | – | (2,128 | ) | |||||||||||||||
| Tax benefit of stock option exercises | – | 38 | – | – | – | 38 | ||||||||||||||||||
| Note receivable from an officer | – | – | – | (59 | ) | – | (59 | ) | ||||||||||||||||
| Net loss | – | – | (9,553 | ) | – | – | (9,553 | ) | ||||||||||||||||
| Balances December 31, 1999 | $ | 85 | $ | 67,907 | $ | 35,809 | $ | (720 | ) | $ | (2,673 | ) | $ | 100,408 | ||||||||||
The accompanying notes are an integral part of the Consolidated Financial Statements.
| For the Years Ended | |||||||||||||||
| December 31, | |||||||||||||||
| 1999 | 1998 | 1997 | |||||||||||||
| (In thousands) | |||||||||||||||
| Net (Loss) Income | $ | (9,553 | ) | $ | 5,870 | $ | 13,043 | ||||||||
| Adjustments to reconcile net income to net cash provided by operating activities: | |||||||||||||||
| Amortization of intangible assets | 1,621 | 1,039 | 423 | ||||||||||||
| Depreciation of furniture and equipment | 3,172 | 2,332 | 2,391 | ||||||||||||
| Net accretion of discount on bonds | 31 | (85 | ) | (192 | ) | ||||||||||
| Loss (gain) on sale of investments | 227 | (52 | ) | (493 | ) | ||||||||||
| Deferred income tax (benefit) expense | (6,724 | ) | (897 | ) | 2,229 | ||||||||||
| Changes in operating assets and liabilities: | |||||||||||||||
| Decrease (increase) in: | |||||||||||||||
| Accrued investment income | (248 | ) | (593 | ) | 44 | ||||||||||
| Premiums and agent balances receivable | (16,509 | ) | (5,204 | ) | (22,723 | ) | |||||||||
| Reinsurance recoverable on paid and unpaid losses | (40,293 | ) | (26,644 | ) | (14,793 | ) | |||||||||
| Prepaid reinsurance premiums | (5,737 | ) | (9,105 | ) | (6,960 | ) | |||||||||
| Deferred policy acquisition costs | (1,130 | ) | (1,191 | ) | (1,866 | ) | |||||||||
| Federal income taxes recoverable | 1,229 | (1,029 | ) | (1,591 | ) | ||||||||||
| Other assets | 2,778 | (2,265 | ) | 1,000 | |||||||||||
| Increase (decrease) in: | |||||||||||||||
| Losses and loss adjustment expenses | 71,448 | 36,587 | 5,036 | ||||||||||||
| Unearned premiums | 8,225 | 10,770 | 12,956 | ||||||||||||
| Accounts payable and accrued expenses | 2,469 | 2,980 | 24 | ||||||||||||
| Insurance company payable | 7,086 | 2,809 | 2,382 | ||||||||||||
| Reinsurance funds held and balances payable | 9,219 | 189 | 17,091 | ||||||||||||
| Other liabilities | (3,678 | ) | (5,195 | ) | (9,734 | ) | |||||||||
| Total Adjustments | 33,186 | 4,446 | (14,776 | ) | |||||||||||
| Net cash provided by (used in) operating activities | 23,633 | 10,316 | (1,733 | ) | |||||||||||
| Cash Flows From Investing Activities | |||||||||||||||
| Purchase of equity securities available for sale | (10,858 | ) | (3,139 | ) | (3,866 | ) | |||||||||
| Purchase of debt securities available for sale | (74,297 | ) | (61,763 | ) | (25,927 | ) | |||||||||
| Proceeds from sale of equity securities available for sale | 1,362 | 473 | 461 | ||||||||||||
| Proceeds from sales and maturities of debt securities available for sale | 63,589 | 32,382 | 28,367 | ||||||||||||
| Proceeds from maturity of securities held to maturity | – | – | 4,611 | ||||||||||||
| Capital expenditures | (3,656 | ) | (8,058 | ) | (3,428 | ) | |||||||||
| Purchase of subsidiaries | (16,776 | ) | (18,921 | ) | (7,821 | ) | |||||||||
| Net cash of acquired subsidiaries | 3,795 | 23,019 | – | ||||||||||||
| Net cash used in investing activities | (36,841 | ) | (36,007 | ) | (7,603 | ) | |||||||||
| Cash Flows From Financing Activities | |||||||||||||||
| Proceeds from lines of credit | 107,703 | 51,947 | 30,410 | ||||||||||||
| Payment of lines of credit | (90,193 | ) | (22,459 | ) | (18,946 | ) | |||||||||
| Book overdraft | 2,031 | – | – | ||||||||||||
| Dividend paid on common stock | (1,037 | ) | (782 | ) | (692 | ) | |||||||||
| Retirement of common stock | (2,093 | ) | (2,720 | ) | (223 | ) | |||||||||
| Net cash provided by financing activities | 16,411 | 25,986 | 10,549 | ||||||||||||
| Increase in cash and cash equivalents | 3,203 | 295 | 1,213 | ||||||||||||
| Cash and cash equivalents, beginning of year | 20,510 | 20,215 | 19,002 | ||||||||||||
| Cash and cash equivalents, end of year | $ | 23,713 | $ | 20,510 | $ | 20,215 | |||||||||
| Supplemental Disclosure of Cash Flow Information: | |||||||||||||||
| Interest paid | $ | 3,636 | $ | 1,979 | $ | 644 | |||||||||
| Income taxes (received) paid, net of refund | $ | (1,639 | ) | $ | 2,430 | $ | 3,705 | ||||||||
| Supplemental Disclosure of Non Cash Investing and Financing Activities: | |||||||||||||||
| Common stock issued for net non cash assets of acquired subsidiaries | – | $ | 1,120 | – | |||||||||||
| Tax benefit from stock options | $ | 38 | $ | 1,009 | $ | 111 | |||||||||
| Note receivable from offer for issuance of stock | – | $ | 330 | – | |||||||||||
The accompanying notes are an integral part of the Consolidated Financial Statements.
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Financial Presentation
The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles (“GAAP”), which differ from statutory accounting practices prescribed or permitted for insurance companies by regulatory authorities. Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners (“NAIC”), as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed.
Principles of Consolidation
The financial statements consolidate the accounts and operations of Meadowbrook Insurance Group, Inc. (the “Company”) and its subsidiaries, all of which are wholly owned, after elimination of all intercompany accounts and transactions.
Business
The Company, through its subsidiaries, is engaged primarily in developing and managing alternative risk management programs for defined client groups and their members. This includes providing services, such as reinsurance brokering, risk management consulting, claims handling, administrative services, along with various types of property and casualty insurance coverage, including workers’ compensation, general liability and commercial multiple peril. The Company also operates insurance agencies, which primarily places principally commercial insurance as well as personal property, casualty, life and accident and health insurance with multiple insurance carriers. The Company does not have significant exposures to environmental/asbestos and catastrophic coverages. Insurance coverage is primarily provided to associations or similar groups of members, commonly referred to as programs. Four programs accounted for 25.9%, 37.7%, and 46.0% of the Company’s premium revenue in 1999, 1998 and 1997, respectively. The net earned premium of the largest program in each respective year represented 7.6%, 12.3% and 14.7% of the Company’s premium revenues in 1999, 1998 and 1997, respectively.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Investments
The Company’s investment securities at December 31, 1999 and 1998 are classified as available for sale. Investments classified as available for sale securities are available to be sold in the future in response to the Company’s liquidity needs, changes in market interest rates, and asset-liability management strategies, among other reasons. Available for sale securities are reported at fair value, with unrealized gains and losses reported in accumulated other comprehensive income component of shareholders’ equity, net of deferred taxes.
Realized gains or losses on sale or maturity of investments are determined on the basis of specific costs of the investments. Discount or premium on debt securities purchased at other than par value is amortized using the constant yield method. Investments with other than temporary declines in fair value are written down to estimated fair value and the related realized losses recognized in income. There were no investments written down in 1999, 1998 and 1997.
Cash and Cash Equivalents
Cash and cash equivalents includes cash on hand and highly liquid short-term investments. The Company considers all short-term investments purchased with a maturity of three months or less at the time of acquisition to be cash equivalents.
Deferred Policy Acquisition Costs
Commissions and other costs of acquiring insurance business that vary with and are primarily related to the production of new and renewal business are deferred and amortized over the terms of the policies or reinsurance treaties to which they relate. Investment earnings are anticipated in determining the recoverability of such deferred amounts.
Furniture and Equipment
Furniture and equipment are stated at cost and are depreciated using both accelerated and straight-line methods over the estimated useful lives of the assets, generally five to ten years. Upon sale or retirement, the cost of the asset and related accumulated depreciation are eliminated from their respective accounts, and the resulting gain or loss is included in income. Repairs and maintenance are charged to operations when incurred.
Intangible Assets
Goodwill resulting from acquisitions is amortized on a straight-line basis over 20 years. Other intangibles are amortized on a straight-line basis over 3 to 7 years.
Annually, the Company evaluates the net carrying value of goodwill to determine if there has been any impairment in value. The methodology used for this evaluation entails review of annual operating performance along with anticipated results for the ensuing year based on operating budgets. At December 31, 1999 the Company concluded that there had been no impairment in the net carrying value of goodwill.
Losses and Loss Adjustment Expenses
The liability for losses and loss adjustment expenses (“LAE”) represents (1) case basis estimates of reported losses and LAE on direct business, (2) estimates received from ceding reinsurers on assumed business and (3) actuarial estimates of incurred but not reported losses and LAE. Such liabilities, by necessity, are based upon estimates and, while management believes that the amount accrued is adequate, the ultimate liability may be greater or less than the amount provided. The methods for making such estimates and for establishing the resulting reserves are continually reviewed and updated.
Revenue Recognition
Premiums written are recognized as earned on a pro rata basis over the life of the policy term. Unearned premiums represent the portion of premiums written which are applicable to the unexpired terms of policies in force. Provisions for unearned premiums on reinsurance assumed from others are made on the basis of ceding reports when received. Certain premiums are subject to retrospective premium adjustments. The estimated ultimate premium is recognized over the term of the insurance contract.
Commission and fee income is recorded on the later of the effective date or the billing date of the policies on which it was earned.
The Company occasionally guarantees the financing of policies it writes. No material premium financing guarantees were in effect at December 31, 1999.
The majority of claims processing fees are recognized as revenue over the estimated life of the claims. For those contracts that provide services beyond the contractually defined termination date of the related contracts, fees are deferred in an amount equal to management’s estimate of the Company’s obligation to continue to provide services.
The Company reviews, on an ongoing basis, the collectibility of its receivables and establishes an allowance for estimated uncollectible accounts.
Income Taxes
The Company accounts for its income taxes under Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes,” which requires the asset and liability method of recording income taxes. Under the asset and liability method, deferred federal income taxes are recognized for the tax consequences of “temporary differences” by applying enacted statutory tax rates to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities.
Stock Options
Compensation expense, if any, resulting from stock options granted by the Company is determined based on the difference between the exercise price and the fair market value of the underlying common stock at the date of grant.
Earnings Per Share
Basic earnings per share are based on the weighted average number of common shares outstanding during the year while diluted earnings per share included the weighted average number of common shares and potential dilution from shares issuable pursuant to stock options using the treasury stock method. Shares issuable pursuant to stock options included in diluted earnings per share are 323,412 and 519,077 for the years ended December 31, 1998, and 1997, respectively. There are no shares issuable pursuant to stock options included in diluted earnings per share for 1999 as they were anti-dilutive. In addition, stock options were outstanding to purchase 60,770 shares in 1998 and 63,280 shares in 1997 at a weighted average price per share of $30.45. These shares were not included in the computation of diluted earnings per share as they were anti-dilutive.
Cumulative Effect of Accounting Change
As described in our 1998 Annual Report, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 97-3, “Accounting by Insurance and Other Enterprises for Insurance-Related Assessments” (SOP 97-3). SOP 97-3 provides guidance for determining when an entity should recognize a liability for guaranty-fund and other insurance-related assessments, how to measure that liability, and when an asset may be recognized for the recovery of such assessments through premium tax offsets or policy surcharges. As required, the Company adopted SOP 97-3 in the quarter ended March 31, 1999. The adoption of SOP 97-3 resulted in a non-cash after-tax $1.7 million (net of tax of $879,064), or $0.20 per share, cumulative effect accounting charge.
The current year impact of adopting SOP 97-3 was a pre-tax benefit of $144,112, which had no impact on earnings per share.
Reclassifications
Certain amounts in the 1998 and 1997 financial statements and notes to consolidated financial statements have been reclassified to conform with the 1999 presentation.
2. INVESTMENTS AND OTHER FINANCIAL INSTRUMENTS
The estimated fair value of investments in securities is determined based on published market quotations. Due to the short-term nature of other financial instruments such as cash equivalents, accrued investment income, premiums and agent balances receivable, reinsurance receivables and payables and other accounts payable, carrying value approximates fair value. Based on the borrowing rates available to the Company, the carrying value of the line of credit approximated fair value as of December 31, 1999 and 1998. The cost or amortized cost and estimated fair values of investments in securities at December 31, 1999 and 1998 are as follows (in thousands):
| December 31, 1999 | ||||||||||||||||||
| Cost or | Gross | Gross | Estimated | |||||||||||||||
| Amortized | Unrealized | Unrealized | Fair | |||||||||||||||
| Securities Available For Sale | Cost | Gains | Losses | Value | ||||||||||||||
| Debt Securities: | ||||||||||||||||||
| Debt securities issued by the U.S government and agencies | $ | 34,669 | $ | 62 | $ | (255 | ) | $ | 34,476 | |||||||||
| Obligations of states and political subdivisions | 122,248 | 753 | (3,279 | ) | 119,722 | |||||||||||||
| Corporate securities | 11,668 | 3 | (416 | ) | 11,255 | |||||||||||||
| Mortgage-backed securities | 20,170 | – | (382 | ) | 19,788 | |||||||||||||
| Total Debt Securities available for sale | 188,755 | 818 | (4,332 | ) | 185,241 | |||||||||||||
| Equity Securities: | ||||||||||||||||||
| Preferred Stocks | 5,128 | 114 | (29 | ) | 5,213 | |||||||||||||
| Common Stocks | 11,959 | 852 | (1,455 | ) | 11,356 | |||||||||||||
| Total Equity securities available for sale | 17,087 | 966 | (1,484 | ) | 16,569 | |||||||||||||
| Total Securities available for sale | $ | 205,842 | $ | 1,784 | $ | (5,816 | ) | $ | 201,810 | |||||||||
| December 31, 1998 | ||||||||||||||||||
| Cost or | Gross | Gross | Estimated | |||||||||||||||
| Amortized | Unrealized | Unrealized | Fair | |||||||||||||||
| Securities Available For Sale | Cost | Gains | Losses | Value | ||||||||||||||
| Debt Securities: | ||||||||||||||||||
| Debt securities issued by the U.S government and agencies | $ | 5,572 | $ | 388 | $ | (6 | ) | $ | 5,954 | |||||||||
| Obligations of states and political subdivisions | 150,989 | 5,245 | (251 | ) | 155,983 | |||||||||||||
| Corporate securities | 5,438 | 53 | (56 | ) | 5,435 | |||||||||||||
| Mortgage-backed securities | 5,164 | 86 | (5 | ) | 5,245 | |||||||||||||
| Total Debt Securities available for sale | 167,163 | 5,772 | (318 | ) | 172,617 | |||||||||||||
| Equity Securities: | ||||||||||||||||||
| Preferred Stocks | 6,222 | 269 | (1 | ) | 6,490 | |||||||||||||
| Common Stocks | 1,363 | 89 | (44 | ) | 1,408 | |||||||||||||
| Total Equity securities available for sale | 7,585 | 358 | (45 | ) | 7,898 | |||||||||||||
| Total Securities available for sale | $ | 174,748 | $ | 6,130 | $ | (363 | ) | $ | 180,515 | |||||||||
Gross unrealized appreciation and depreciation on available for sale securities were as follows (in thousands):
| December 31, | |||||||||
| 1999 | 1998 | ||||||||
| Unrealized appreciation | $ | 1,784 | $ | 6,130 | |||||
| Unrealized depreciation | (5,816 | ) | (363 | ) | |||||
| Net unrealized (depreciation) appreciation | (4,032 | ) | 5,767 | ||||||
| Deferred federal income taxes | 1,359 | (1,921 | ) | ||||||
| Net unrealized (depreciation) appreciation on investments, net of deferred federal income taxes | $ | (2,673 | ) | $ | 3,846 | ||||
The gross change, before tax (expense)/benefit, in unrealized appreciation/(depreciation) on available for sale debt securities was ($8,967,833) for 1999, $1,726,947 for 1998, and $3,922,161 for 1997. The gross change in unrealized appreciation/(depreciation) on available for sale equity securities was ($830,915), ($472,877), and $802,712 in 1999, 1998 and 1997, respectively.
The realized gains (losses) on the sale of available for sale debt securities and equity securities for the year ended December 31, 1999 were ($232,860) and $5,659, respectively. The proceeds from these sales were $53.7 million and $1.4 million, respectively.
The realized gains (losses) on the sale of available for sale debt securities and equity securities for the year ended December 31, 1998 were $103,964 and ($52,356), respectively. The proceeds from these sales were $17.6 million and $0.5 million, respectively.
The realized gains (losses) on the sale of available for sale debt securities and equity securities for the year ended December 31, 1997 were $510,659 and ($377,110), respectively. The proceeds from these sales were $19.4 million and $0.5 million, respectively.
The amortized cost and estimated fair value of available for sale debt securities at December 31, 1999, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without call or prepayment penalties (in thousands):
| Available for Sale | ||||||||
| Amortized | Estimated | |||||||
| Cost | Fair Value | |||||||
| Due in one year or less | $ | 10,840 | $ | 10,848 | ||||
| Due after one year through five years | 65,741 | 65,864 | ||||||
| Due after five years through ten years | 57,916 | 56,671 | ||||||
| Due after ten years | 34,088 | 32,070 | ||||||
| Mortgage-backed securities | 20,170 | 19,788 | ||||||
| $ | 188,755 | $ | 185,241 | |||||
Net investment income for the last three years ended December 31 was as follows (in thousands):
| 1999 | 1998 | 1997 | ||||||||||
| Investment Income On: | ||||||||||||
| Debt securities | $ | 9,190 | $ | 7,658 | $ | 7,154 | ||||||
| Equity securities | 734 | 295 | 246 | |||||||||
| Cash and cash equivalents | 1,932 | 1,998 | 1,070 | |||||||||
| Total gross investment income | 11,856 | 9,951 | 8,470 | |||||||||
| Less investment expenses | 248 | 372 | 342 | |||||||||
| Net investment income | $ | 11,608 | $ | 9,579 | $ | 8,128 | ||||||
United States government obligations, municipal bonds, and bank certificates of deposit aggregating $45,414,505 and $35,912,497 were on deposit with state regulatory authorities as required by law at December 31, 1999 and 1998, respectively.
3. LIABILITY FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
The Company regularly updates its reserve estimates as new information becomes available and further events occur which may impact the resolution of unsettled claims. Changes in prior reserve estimates are reflected in results of operations in the year such changes are determined to be needed and recorded. Activity in the reserves for losses and loss adjustment expenses is summarized as follows (in thousands):
| For the Years Ended | |||||||||||||
| December 31, | |||||||||||||
| 1999 | 1998 | 1997 | |||||||||||
| Balance, beginning of year | $ | 148,844 | $ | 98,979 | $ | 92,390 | |||||||
| Less reinsurance recoverables | 64,590 | 38,193 | 26,615 | ||||||||||
| Net balance, beginning of year | 84,254 | 60,786 | 65,775 | ||||||||||
| Total acquired reserves | 7,784 | 13,277 | 1,552 | ||||||||||
| Incurred related to: | |||||||||||||
| Current year | 80,296 | 48,477 | 34,908 | ||||||||||
| Prior years | 15,062 | 8,226 | 1,235 | ||||||||||
| Total incurred | 95,358 | 56,703 | 36,143 | ||||||||||
| Paid related to: | |||||||||||||
| Current year | 20,362 | 15,144 | 11,058 | ||||||||||
| Prior years | 39,534 | 31,368 | 31,626 | ||||||||||
| Total paid | 59,896 | 46,512 | 42,684 | ||||||||||
| Net balance, end of year | 127,500 | 84,254 | 60,786 | ||||||||||
| Plus reinsurance recoverables | 101,744 | 64,590 | 38,193 | ||||||||||
| Balance, end of year | $ | 229,244 | $ | 148,844 | $ | 98,979 | |||||||
As a result of unfavorable development in estimates of prior accident years’ reserves, the provision for losses and loss adjustment expenses increased by $15,062,000, $8,226,000, and $1,235,000 in 1999, 1998, and 1997, respectively.
Significant periods of time often elapse between the occurrence of an insured loss, the reporting of the loss to the Company, and the Company’s payment of that loss. To recognize liabilities for unpaid losses, the
The $15.0 million of adverse development in 1999 reflects the impact of adopting a more conservative reserving philosophy that relies on a line-of-business analysis to supplement the program specific analysis. The majority of this development related to programs the Company has discontinued.
The $8.2 million of adverse development in 1998 reflects the impact of isolated programs including professional liability for two distinct professions and two workers’ compensation programs.
4. REINSURANCE
The insurance company subsidiaries cede insurance to other insurers under pro rata and excess-of-loss contracts. These reinsurance arrangements diversify the Company’s business and minimize its losses arising from large risks or from hazards of an unusual nature. The ceding of insurance does not discharge the original insurer from its primary liability to its policyholder, and in the event that all or any of the reinsuring companies are unable to meet their obligations, the insurance company subsidiaries would be liable for such defaulted amounts. Therefore the Company is subject to a credit risk with respect to the obligations of its reinsurers. In order to minimize its exposure to significant losses from reinsurer insolvencies, the Company evaluates the financial condition of its reinsurers and monitors the economic characteristics of the reinsurers on an ongoing basis. The Company also assumes insurance from other insurers and reinsurers, both domestic and foreign, under pro rata and excess-of-loss contracts.
The Company receives ceding commissions in conjunction with reinsurance activities. These ceding commissions are offset against the related underwriting expenses and were $33,235,206, $33,288,731 and $22,168,969 in 1999, 1998, and 1997, respectively.
The Company has a recoverable for paid and unpaid losses of $115,795,000. The Company secures reinsurance balances due from non-admitted reinsurers through Funds Withheld Trust or Letters of Credit. The largest unsecured reinsurance recoverable is due from a reinsurer with an “A++” A.M. Best rating and accounts for 17.5% of the total recoverable for paid and unpaid losses.
Reconciliations of direct to net premiums, on both written and earned bases, for 1999, 1998, and 1997 are as follows (in thousands):
| 1999 | 1998 | 1997 | ||||||||||||||||||||||
| Written | Earned | Written | Earned | Written | Earned | |||||||||||||||||||
| Direct | $ | 215,333 | $ | 207,552 | $ | 168,729 | $ | 160,155 | $ | 133,477 | $ | 118,980 | ||||||||||||
| Assumed | 15,141 | 29,068 | 17,603 | 16,087 | 13,262 | 14,334 | ||||||||||||||||||
| Ceded | (107,655 | ) | (111,714 | ) | (92,851 | ) | (84,157 | ) | (71,774 | ) | (64,821 | ) | ||||||||||||
| Net | $ | 122,819 | $ | 124,906 | $ | 93,481 | $ | 92,085 | $ | 74,965 | $ | 68,493 | ||||||||||||
One reinsurer accounts for 13.3% of ceded premiums in 1999.
5. DEFERRED POLICY ACQUISITION COSTS
The following reflects the amounts of policy acquisition costs deferred and amortized (in thousands):
| For the Years Ended December 31: | ||||||||||||
| 1999 | 1998 | 1997 | ||||||||||
| Balance, beginning of period | $ | 8,900 | $ | 6,609 | $ | 4,265 | ||||||
| Acquisition costs deferred | 13,670 | 10,673 | 8,374 | |||||||||
| Amortized to expense during the period | (12,540 | ) | (8,382 | ) | (6,030 | ) | ||||||
| Balance, end of period | $ | 10,030 | $ | 8,900 | $ | 6,609 | ||||||
6. INCOME TAXES
The provision for income taxes consists of the following (in thousands):
| For the Years Ended December 31: | ||||||||||||
| 1999 | 1998 | 1997 | ||||||||||
| Current tax (benefit) expense | $ | (364 | ) | $ | 1,227 | $ | 2,114 | |||||
| Deferred tax (benefit) expense | (5,845 | ) | (452 | ) | 2,229 | |||||||
| Total provision for income taxes | $ | (6,209 | ) | $ | 775 | $ | 4,343 | |||||
A reconciliation of the Company’s tax provision on income from operations to the U.S. federal income tax rate of 34% in 1999, 1998, and 1997 is as follows (in thousands):
| For the Years Ended December 31 | |||||||||||||
| 1999 | 1998 | 1997 | |||||||||||
| Tax provision at statutory rate | $ | (4,779 | ) | $ | 2,259 | $ | 5,911 | ||||||
| Tax effect of: | |||||||||||||
| Tax exempt interest | (2,104 | ) | (1,814 | ) | (1,658 | ) | |||||||
| Other, net | 674 | 330 | 90 | ||||||||||
| Federal income tax (benefit) expense | $ | (6,209 | ) | $ | 775 | $ | 4,343 | ||||||
| Effective tax rate | 44.2% | 11.7% | 25.0% | ||||||||||
Deferred federal income taxes, under SFAS No. 109, reflect the estimated future tax effect of temporary differences between the bases of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws and regulations.
The components of deferred tax assets and liabilities as of December 31, 1999 and 1998 are as follows (in thousands):
| 1999 | 1998 | ||||||||||||||||
| Deferred | Deferred | Deferred | Deferred | ||||||||||||||
| Tax | Tax | Tax | Tax | ||||||||||||||
| Assets | Liabilities | Assets | Liabilities | ||||||||||||||
| Unpaid losses and loss adjustment expenses | $ | 7,349 | $ | – | $ | 5,532 | $ | – | |||||||||
| Unearned premium reserves | 3,001 | – | 2,628 | – | |||||||||||||
| Unrealized gains on investments | 1,359 | – | – | 1,921 | |||||||||||||
| Deferred policy acquisition expense | – | 3,369 | – | 3,001 | |||||||||||||
| Deferred compensation | 377 | – | 422 | – | |||||||||||||
| Deferred fee recognition | 204 | – | 406 | – | |||||||||||||
| Alternate minimum tax credit | 2,149 | – | 578 | – | |||||||||||||
| Net operating loss carryforward | 2,344 | – | – | – | |||||||||||||
| Other | 2,059 | 744 | 303 | 803 | |||||||||||||
| Total deferred taxes | 18,842 | 4,113 | 9,869 | 5,725 | |||||||||||||
| Net deferred tax assets | $ | 14,729 | $ | 4,144 | |||||||||||||
Realization of the deferred tax asset is dependent on generating sufficient taxable income prior to expiration of any net operating loss carryforwards (NOLs). Although realization is not assured, management believes it is more likely than not that the recorded deferred tax asset will be realized. The NOLs expire in 2019.
7. LINES OF CREDIT
At December 31, 1999 and 1998, the Company had one unsecured bank line of credit which permits borrowings up to $60,000,000 and $50,000,000, respectively, and expires on and is payable by August 1, 2002. This line bears interest at the prime rate (prime was 8.5% at December 31, 1999 and 7.75% at December 31, 1998). The Company also has the option to elect a eurodollar based rate in place of prime. At December 31, 1999 and 1998, $55,644,456 and $38,082,357, respectively, was outstanding under this line.
The Company’s unsecured bank line of credit contains various covenants, which, among other things, require the maintenance of certain financial ratios related to fixed charge coverage, minimum levels of net worth and debt to capital. At December 31, 1999, the Company fell below the minimum level of required net worth and the fixed charge coverage. The Company has reached an agreement with the bank group to waive these covenants. The Company has also reached agreement to amend the line of credit to reflect the current operating environment.
In addition, a non-insurance subsidiary had a line of credit with a bank, which permits borrowings up to 80% of the accounts receivable which collateralize the line. The line will expire March 31, 2000 and is automatically renewable each year. This line bears interest at 1% under the prime rate (prime was 8.5% at December 31, 1999 and 7.75% at December 31, 1998). At December 31, 1999 and 1998, $2,818,579 and $2,869,969, respectively, was outstanding under this line.
8. SHAREHOLDERS’ EQUITY
A significant portion of the Company’s consolidated assets represents assets of the Company’s insurance subsidiaries that may not be transferable to the holding company in the form of dividends, loans or advances. The restriction on the transferability to the holding company from its insurance subsidiaries is
Summarized 1999 and 1998 statutory basis information for the primary insurance subsidiaries, which differs from generally accepted accounting principles, follows (in thousands):
| 1999 | 1998 | |||||||||||||||||||||||||||||||
| Star | Savers | Williamsburg | Ameritrust | Star | Savers | Williamsburg | Ameritrust | |||||||||||||||||||||||||
| Statutory capital and surplus | $ | 70,158 | $ | 28,503 | $ | 11,532 | $ | 8,494 | $ | 68,691 | $ | 26,175 | $ | 10,880 | $ | 9,984 | ||||||||||||||||
| Minimum statutory capital and surplus | 5,000 | 20,000 | 2,600 | 5,000 | 5,000 | 20,000 | 2,600 | 5,000 | ||||||||||||||||||||||||
| Statutory net (loss) income | (11,017 | ) | 2,499 | 682 | 2,958 | (2,492 | ) | 3,173 | 2,008 | 4,148 | ||||||||||||||||||||||
| Net investment income | 8,039 | 3,027 | 499 | 1,416 | 4,366 | 2,986 | 514 | 533 | ||||||||||||||||||||||||
The net investment income and statutory net income in 1997 for Star were $6,760,010 and $8,274,148, respectively, and for Savers were $2,978,421 and $4,175,272 respectively.
The net investment income and statutory net income in 1997 since the date of acquisition July 1, 1997 for Williamsburg were $257,914 and $400,884, respectively.
The statutory capital and surplus, at December 31, 1998 and net investment income and statutory net income since the date of acquisition July 31, 1998 for Ameritrust were $9,984,045, $533,276 and $4,148,418, respectively.
In March 1998, NAIC voted to adopt its Codification of Statutory Accounting Principles project (referred to hereafter as “codification”). Codification is a modified form of statutory accounting principles that will result in change to the current NAIC Accounting Practices and Procedures Manual applicable to insurance enterprises. Although adoption of codification by all states is not a certainty, the NAIC has recommended that all states enact codification as soon as practicable with an effective date of January 1, 2001. It is currently anticipated that codification will become a NAIC State accreditation requirement starting in 2002. In addition, the American Institute of Certified Public Accountants and the NAIC has agreed to continue to allow the use of certain permitted accounting practices when codification becomes effective in 2001. Any accounting differences from codification principles, however, must be disclosed and quantified in the footnotes to the audited financial statements. Therefore, codification will likely result in changes to what are currently considered prescribed statutory insurance accounting practices.
The Company has a subsidiary that issues redeemable non-voting preferred shares to third parties. Redemption of the preferred share may occur on January 1 of each year upon the request by the shareholder. The redemption amount varies based upon the subsidiary’s performance. At December 31, 1999 and 1998, $1,136,000 and $741,000, respectively, of preferred shares were included in other
9. STOCK OPTIONS
The Company, through its 1995 Stock Option Plan (“the Plan”), may grant options to key executives and other management of the Company and its subsidiaries of up to 2,000,000 shares of the Company’s common stock. The Plan is administered by the Compensation Committee (the “Committee”) appointed by the Board of Directors. Option shares may be exercised subject to the terms of the Plan and the terms prescribed by the Committee at the time of grant. Currently, the Plan’s options have either five or ten year terms and are exercisable/vest in equal increments over the option term.
The Company measures compensation expense under APB No. 25 and has adopted the disclosure requirements of SFAS No. 123. If compensation cost for stock option grants had been determined based on a fair value method, net income (loss) and earnings per share on a pro forma basis for 1999, 1998 and 1997 would be as follows (in thousands):
| 1999 | 1998 | 1997 | |||||||||||
| Reported net (loss)income | $ | (9,553 | ) | $ | 5,870 | $ | 13,043 | ||||||
| Pro forma net (loss)income, using SFAS No. 123 | $ | (10,041 | ) | $ | 5,529 | $ | 12,785 | ||||||
| Earnings per share, diluted: | |||||||||||||
| Reported | $ | (1.11 | ) | $ | 0.65 | $ | 1.42 | ||||||
| Pro forma, using SFAS No. 123 | $ | (1.17 | ) | $ | 0.61 | $ | 1.39 | ||||||
The Black-Scholes valuation model utilized the following annualized assumptions for all applicable years: Risk-free interest rate of 4.75%, 5.25% and 6.25% for 1999, 1998 and 1997, respectively. The dividend yield was $0.12 per share in 1999 and 1998. The dividend yield was $0.08 per share in 1997. The volatility factor for the expected market price of the Company’s common stock of 0.337, 0.323 and 0.243 in 1999, 1998 and 1997, respectively. The weighted-average expected life of options for the 1999, 1998 and 1997 grants is 7.5.
The following is a summary of the Company’s stock option activity and related information for the years ended December 31:
| 1999 | 1998 | 1997 | ||||||||||||||||||||||
| Weighted- | Weighted- | Weighted- | ||||||||||||||||||||||
| Average | Average | Average | ||||||||||||||||||||||
| Exercise | Exercise | Exercise | ||||||||||||||||||||||
| Options | Price | Options | Price | Options | Price | |||||||||||||||||||
| Outstanding — beginning of year | 1,036,280 | $ | 16.38 | 1,020,144 | $ | 13.04 | 953,799 | $ | 11.78 | |||||||||||||||
| Exchange of existing options | – | – | – | – | – | – | ||||||||||||||||||
| Granted | 297,700 | 15.74 | 203,800 | 24.69 | 101,754 | 22.71 | ||||||||||||||||||
| Exercised | (13,945 | ) | 5.15 | (168,833 | ) | 5.68 | (35,409 | ) | 6.82 | |||||||||||||||
| Forfeited | (32,621 | ) | 21.74 | (18,831 | ) | 24.70 | – | |||||||||||||||||
| Outstanding — end of year | 1,287,414 | $ | 16.22 | 1,036,280 | $ | 16.38 | 1,020,144 | $ | 13.04 | |||||||||||||||
| Exercisable at end of year | 550,705 | $ | 15.62 | 396,956 | $ | 14.68 | 442,829 | $ | 10.65 | |||||||||||||||
| Weighted-average fair value of options granted during the year | $ | 6.06 | – | $ | 9.77 | – | $ | 7.30 | – | |||||||||||||||
The following table summarizes information about stock options outstanding at December 31, 1999:
| Options Outstanding | Options Exercisable | |||||||||||||||||||
| Weighted- | Weighted- | Weighted- | ||||||||||||||||||
| Average | Average | Average | ||||||||||||||||||
| Range of | Remaining | Exercise | Exercise | |||||||||||||||||
| Exercise Prices | Options | Life (Years) | Price | Options | Price | |||||||||||||||
| $5.10 to $8.11 | 339,854 | 3.9 | $ | 6.79 | 179,427 | $ | 6.56 | |||||||||||||
| $10.25 to $16.26 | 416,601 | 8.7 | 14.34 | 109,603 | 12.76 | |||||||||||||||
| $21.00 to $30.45 | 530,959 | 7.4 | 23.72 | 261,648 | 23.04 | |||||||||||||||
| 1,287,414 | 7.6 | $ | 16.22 | 550,705 | $ | 15.62 | ||||||||||||||
No compensation cost has been recorded for stock option grants issued during 1999, 1998 and 1997, as the market value equaled the exercise price at the date of grant.
10. ACQUISITIONS
The Company has completed several acquisitions, all of which have been accounted for as a purchase.
On August 6, 1999, the Company acquired the assets of TPA Associates, Inc., all the outstanding stock of TPA Insurance Agency, Inc. and Preferred Insurance Agency, Inc. and approximately 94% of the outstanding stock of Preferred Insurance Company, Ltd., (collectively, “TPA”) at a purchase price of $16.2 million. This acquisition is not expected to have a material impact on the Company’s financial position or results of operations. This transaction resulted in goodwill of $12.9 million.
On April 30, 1998, the Company acquired the business of Villari & Associates, Inc. (“Villari”), at a purchase price of $5.6 million comprised of $4.5 million in cash and 33,433 shares of common stock, resulting in goodwill of $5.6 million. Villari is a Florida-based insurance agency which offers professional liability products and programs, group health and disability, and property and casualty products.
On July 31, 1998, the Company acquired Florida Preferred Administrators, Inc. (“Florida Preferred”) and Ameritrust Insurance Corporation (“Ameritrust”), at a purchase price of $12.3 million, resulting in goodwill of $7.0 million. Florida Preferred, a Florida based third party administrator, provides a broad range of risk management services to purchasers of workers’ compensation insurance from Ameritrust as well as other insurance carriers.
On July 1, 1997, the Company acquired Crest Financial Corporation (“Crest”), at a purchase price of $9.4 million, resulting in $3.2 million of goodwill. Crest is a California based holding company, which formerly owned Williamsburg National Insurance Company (“Williamsburg”), an insurance carrier, and Crest Financial Services, a risk management service company. Crest provides these services primarily to the trucking industry within California. Effective December 31, 1999, the Company reorganized its holding structure which resulted in Crest assigning Williamsburg to Star.
The following pro forma financial information reflects the 1999, 1998 and 1997 acquisitions as if they had been completed as of the beginning of the previous year (unaudited).
| For Years Ended December 31, | ||||||||||||
| 1999 | 1998 | 1997 | ||||||||||
| (in thousands except per share data) | ||||||||||||
| Revenues | $ | 183,099 | $ | 163,543 | $ | 125,700 | ||||||
| Net (loss) income before cumulative effect of accounting change | (7,836 | ) | 6,824 | 13,492 | ||||||||
| Earnings per share before cumulative effect of accounting change, diluted | $ | (0.91 | ) | $ | 0.76 | $ | 1.47 | |||||
Certain of these acquisitions is subject to contingent earn-out provisions based upon achieving certain performance measures. To date, the Company has not been required to make any significant payments under these agreements. At December 31, 1999, the Company anticipates that approximately $4.0 million may be required to be paid under these agreements in 2000.
11. EMPLOYEE BENEFIT PLANS
Company employees over the age of 21 who have completed 12 months of service and worked at least 1,000 hours during those 12 months are eligible for participation in Meadowbrook’s 401(k) Profit Sharing Plan (the “Plan”). The Plan provides for discretionary matching contributions and/or profit sharing contributions at the discretion of the Board of Directors. In 1999, 1998 and 1997, the matching contributions were $421,278, $381,532 and $357,542, respectively. There were no profit sharing contributions in 1999, 1998 and 1997.
12. COMMITMENTS AND CONTINGENCIES
The Company has certain operating lease agreements for its offices and equipment. At December 31, 1999, future minimum rental payments required under non-cancelable long-term operating leases are as follows (in thousands):
| 2000 | $ | 3,399 | |||
| 2001 | 2,620 | ||||
| 2002 | 2,003 | ||||
| 2003 | 1,701 | ||||
| 2004 | 1,145 | ||||
| Thereafter | – | ||||
| Total minimum lease commitments | $ | 10,868 | |||
Rent expense for the year ended December 31, 1999, 1998, and 1997 amounted to $2,851,954, $2,536,713, and $1,972,044, respectively.
On June 26, 1995, two shareholders and an officer of a former agent (the “Primary Plaintiffs”) of Star, and a former spouse of one shareholder and an employee of the former agent (the “Individual Plaintiffs”) initiated legal proceedings against, among others, Star and Meadowbrook in the District Court for Washoe County, Reno, Nevada. All of the plaintiffs requested injunctive relief, compensatory damages, punitive and exemplary damages, and attorney’s fees in an unspecified amount. The Nevada Insurance Department revoked the license of one of the Primary Plaintiffs and one of the Individual Plaintiffs and denied further licensing of the other Primary Plaintiffs.
Meadowbrook and Star vigorously defended themselves and filed counterclaims against the Primary and Individual Plaintiffs. On April 1, 1998, the Court issued an Order dismissing all claims of the Primary Plaintiffs with prejudice.
On January 12, 1999, the remaining claims of the Individual Plaintiffs and the counterclaims of Meadowbrook and Star against the Primary and Individual Plaintiffs were tried. On February 2, 1999, the jury returned a verdict in favor of Meadowbrook and Star against the Primary and Individual Plaintiffs. In addition, the jury found against the Individual Plaintiffs and in favor of Meadowbrook and Star on their remaining claims. On April 21, 1999, the Court found in favor of Meadowbrook and Star and against the Primary and Individual Plaintiffs on all outstanding claims for equitable relief. It is not expected that the outcome of this litigation will have a material impact on the financial statements of the Company.
A Final Judgment has been entered with the Court. All plaintiffs have filed an appeal with the Nevada Supreme Court.
The Company is involved in other litigation arising in the ordinary course of operations. While the results of litigation cannot be predicted with certainty, management is of the opinion, after reviewing these matters with legal counsel, that the final outcome of such litigation will not have a material effect upon the Company’s financial statements.
13. LETTERS OF CREDIT
As of December 31, 1999, a standby letter of credit of $10,015,000 had been issued by a bank to an insurance subsidiary of the Company, under an agreement expiring June 30, 2000, with extensions granted on a yearly basis. This letter of credit is being utilized as security for a surety bond filed with one state. This bond was filed as a requirement for writing workers compensation business in that state. The letter of credit is collateralized by specifically identified marketable securities of the subsidiary, with a total fair market value of 110% of the $10,015,000 letter of credit.
As of December 31, 1999, a standby letter of credit of $6,385,000 had been issued by a bank to an insurance subsidiary of the Company, under an agreement expiring June 30, 2000, with extensions granted on a yearly basis. This letter of credit is being utilized as security for a surety bond filed with one state. This bond was filed as a requirement for writing workers compensation business in that state. The letter of credit is collateralized by specifically identified marketable securities of the subsidiary, with a total fair market value of 110% of the $6,385,000 letter of credit.
In addition, one subsidiary had a standby letter of credit of $10,700,000 issued by a bank, under an agreement expiring October 31, 2000, with extensions granted on a yearly basis. This letter of credit is being utilized as security for the insurance subsidiary’s obligations under a reinsurance agreement. This letter of credit is collateralized by specifically identified treasury bills of the subsidiary, with a total fair market value of 110% of the $10,700,000 letter of credit.
14. RELATED PARTY TRANSACTIONS:
At December 31, 1999 and 1998, respectively, the Company held a $720,462 and $661,000 note receivable, including $59,462 of accrued interest at December 31, 1999, from an officer/director. There was no accrued interest at December 31, 1998. This note arose from a transaction in late 1998 whereby the Company loaned the officer/director funds to exercise 64,718 common stock options to cover the exercise price and associated tax withholdings. The note provided for interest at the Company’s borrowing rate which was 8.5% and 7.75% at December 31, 1999 and 1998, respectively. The note is due on demand on or after January 1, 2002. The loan is collateralized by 64,718 shares of the Company’s common stock, pursuant to a stock pledge agreement.
15. SEGMENT INFORMATION:
The Company defines its operations as agency operations and program business operations based upon differences in products and services. The separate financial information of these segments is consistent with
Agency Operations
The agency segment was formed in 1955 as Meadowbrook’s original business. The insurance agency primarily places commercial insurance, as well as personal property, casualty, life and accident and health insurance, with more than 50 insurance carriers from which it earns commission income. The agency has grown to be one of the largest agencies in Michigan and, with recent acquisitions, expanded into Florida and California.
Program Business
The program business segment is engaged primarily in developing and managing alternative market risk management programs for defined client groups and their members. This includes providing services, such as reinsurance brokering, risk management consulting, claims handling, and administrative services, along with various types of property and casualty insurance coverage, including workers’ compensation, general liability and commercial multiple peril. Insurance coverage is primarily provided to associations or similar groups of members, commonly referred to as programs. A program is a set of coverages and services tailored to meet the specific requirements of a group of clients.
The following table sets forth the segment results (in thousands):
| For the Years Ended | |||||||||||||
| December 31, | |||||||||||||
| 1999 | 1998 | 1997 | |||||||||||
| Revenues | |||||||||||||
| Net earned premiums | $ | 124,906 | $ | 92,085 | $ | 68,493 | |||||||
| Management fees | 22,878 | 18,121 | 15,786 | ||||||||||
| Investment income | 11,319 | 9,620 | 8,248 | ||||||||||
| Program business | 159,103 | 119,826 | 92,527 | ||||||||||
| Agency operations | 16,391 | 14,713 | 10,666 | ||||||||||
| Reconciling items | 72 | 11 | 24 | ||||||||||
| Intersegment revenue | (572 | ) | (436 | ) | (2,092 | ) | |||||||
| Consolidated revenue | 174,994 | 134,114 | 101,125 | ||||||||||
| Pre-tax income | |||||||||||||
| Program business | (11,891 | ) | 7,520 | 16,778 | |||||||||
| Agency operations | 3,639 | 2,757 | 2,166 | ||||||||||
| Reconciling items | (5,804 | ) | (3,632 | ) | (1,558 | ) | |||||||
| Consolidated pre-tax (loss) income | (14,056 | ) | 6,645 | 17,386 | |||||||||
The pre-tax income reconciling items represent other expenses relating to the holding company, amortization and interest expense, which are not allocated among the segments.
16. QUARTERLY FINANCIAL DATA (Unaudited)
The following is a summary of unaudited quarterly results of operations for 1999 and 1998 (in thousands, except per share and ratio data):
| 1st | 2nd | 3rd | 4th | |||||||||||||
| Quarter | Quarter | Quarter | Quarter | |||||||||||||
| 1999: | ||||||||||||||||
| Gross written premium | $ | 58,761 | $ | 54,548 | $ | 55,197 | $ | 61,968 | ||||||||
| Net written premium | 31,324 | 28,818 | 30,699 | 31,978 | ||||||||||||
| Net earned premium | 26,159 | 29,782 | 32,541 | 36,424 | ||||||||||||
| Net commissions and fees | 9,048 | 9,148 | 9,307 | 11,194 | ||||||||||||
| Net investment income and realized gains/losses | 2,709 | 2,768 | 2,863 | 3,051 | ||||||||||||
| Net losses and LAE incurred | 20,791 | 20,912 | 23,984 | 29,671 | ||||||||||||
| Policy acquisition and other expenses | 9,167 | 8,402 | 13,797 | 16,217 | ||||||||||||
| Interest on notes payable | 840 | 621 | 1,037 | 1,138 | ||||||||||||
| Net (loss) income before cumulative effect | (1,438 | ) | 1,632 | (3,856 | ) | (4,185 | ) | |||||||||
| Net (loss) income | (3,144 | ) | 1,632 | (3,856 | ) | (4,185 | ) | |||||||||
| Earnings per share before cumulative effect | $ | (0.16 | ) | $ | 0.19 | $ | (0.45 | ) | $ | (0.49 | ) | |||||
| Earnings per share | $ | (0.35 | ) | $ | 0.19 | $ | (0.45 | ) | $ | (0.49 | ) | |||||
| Dividends declared per share | $ | 0.03 | $ | 0.03 | $ | 0.03 | $ | 0.03 | ||||||||
| GAAP combined ratio | 116.1% | 100.6% | 115.5% | 120.4% | ||||||||||||
| 1998: | ||||||||||||||||
| Gross written premium | $ | 41,883 | $ | 51,072 | $ | 42,528 | $ | 50,849 | ||||||||
| Net written premium | 21,144 | 20,790 | 22,690 | 28,857 | ||||||||||||
| Net earned premium | 19,063 | 20,950 | 23,785 | 28,287 | ||||||||||||
| Net commissions and fees | 7,758 | 8,521 | 7,460 | 8,659 | ||||||||||||
| Net investment income and realized gains/losses | 2,115 | 2,370 | 2,531 | 2,615 | ||||||||||||
| Net losses and LAE incurred | 10,367 | 11,133 | 19,574 | 15,629 | ||||||||||||
| Policy acquisition and other expenses | 6,258 | 6,723 | 10,306 | 10,623 | ||||||||||||
| Net income (loss) | 3,284 | 3,862 | (3,566 | ) | 2,290 | |||||||||||
| Earnings per share | $ | 0.36 | $ | 0.42 | $ | (0.39 | ) | $ | 0.26 | |||||||
| Dividends declared per share | $ | 0.02 | $ | 0.02 | $ | 0.03 | $ | 0.03 | ||||||||
| GAAP combined ratio | 91.7% | 90.0% | 120.4% | 90.0% | ||||||||||||
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