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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended Commission file number
December 31, 1998 1-12338
VESTA INSURANCE GROUP, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
Delaware 63-1097283
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
3760 River Run Drive, 35243
Birmingham, AL
(ADDRESS OF PRINCIPAL (ZIP CODE)
EXECUTIVE OFFICES)
Registrant's telephone number, including area code:
(205) 970-7000
Securities registered pursuant to Section 12(b) of the Act:
NAME OF EACH EXCHANGE
TITLE OF EACH CLASS CUSIP NUMBER: ON WHICH REGISTERED:
Common Stock, $.01 Par 925391104 New York Stock Exchange
Value
Securities registered pursuant to Section 12(g) of the Act:
None
INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS
REQUIRED TO BE FILED BY SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934 DURING THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE
REGISTRANT WAS REQUIRED TO FILE SUCH) AND (2) HAS BEEN SUBJECT TO SUCH FILING
REQUIREMENTS FOR THE PAST 90 DAYS.
YES [X] NO [_]
INDICATE BY CHECK MARK IF DISCLOSURE OF DELINQUENT FILERS PURSUANT TO ITEM 405
OF REGULATION S-K ((S)229.405 OF THIS CHAPTER) IS NOT CONTAINED HEREIN, AND
WILL NOT BE CONTAINED, TO THE BEST OF REGISTRANT'S KNOWLEDGE, IN DEFINITIVE
PROXY OR INFORMATION STATEMENTS INCORPORATED BY REFERENCE IN PART III OF THIS
FORM 10-K OR ANY AMENDMENT TO THIS FORM 10-K. [_]
THE AGGREGATE MARKET VALUE OF THE VOTING STOCK HELD BY NON-AFFILIATES OF THE
REGISTRANT AS OF MARCH 23, 1999 $63,027,605
THE NUMBER OF SHARES OUTSTANDING OF THE REGISTRANT'S COMMON STOCK, AS OF MARCH
23, 1999 is 18,653,404
DOCUMENTS INCORPORATED BY REFERENCE
PORTIONS OF THE VESTA INSURANCE GROUP, INC. PROXY STATEMENT FOR ITS 1999
ANNUAL MEETING OF STOCKHOLDERS ARE INCORPORATED BY REFERENCE INTO PART III
HEREOF.
Table of Contents
Part I Page
------ ----
Item 1 Business
Overview..................................................... 1
Business Strategy............................................ 3
Lines of Business............................................ 4
Reinsurance.................................................. 4
Primary Insurance Business................................... 6
Reinsurance Ceded............................................ 11
Claims....................................................... 11
Reserves..................................................... 12
Investments.................................................. 15
Regulation................................................... 16
A.M. Best.................................................... 20
Competition.................................................. 20
Relationship with Torchmark.................................. 21
Employees.................................................... 21
Item 2 Properties................................................... 21
Item 3 Legal Proceedings............................................ 21
Item 4 Submission of Matters to a Vote of Security Holders.......... 23
Part II
-------
Item 5 Market for Registrants' Common Equity and Related Stockholder 23
Matters.....................................................
Item 6 Selected Financial Data...................................... 24
Item 7 Management's Discussion and Analysis of Results of Operations
and Financial Condition..................................... 26
Item 8 Financial Statements and Supplementary Data.................. 38
Part III
--------
Item 10 Directors and Executive Officers of the Registrants.......... 67
Item 11 Executive Compensation....................................... 67
Item 12 Security Ownership of Certain Beneficial Owners and 67
Management..................................................
Item 13 Certain Relationships and Related Transactions............... 67
Part IV
-------
Item 14 Exhibits, Financial Statement Schedules, and Reports on Form 68
8-K.........................................................
i
Special Note Regarding Forward-Looking Statements
Any statement contained in this report which is not a historical fact, or
which might otherwise be considered an opinion or projection concerning the
Company or its business, whether express or implied, is meant as and should be
considered a forward-looking statement as that term is defined in the Private
Securities LItigation Reform Act of 1996. Forward-looking statements are based
on assumptions and opinions concerning a variety of known and unknown risks,
including but not necessarily limited to changes in market conditions, natural
disasters and other catastrophic events, increased competition, changes in
availability and cost of reinsurance, changes in governmental regulations, and
general economic conditions, as well as other risks more completely described
in the Company's filings with the Securities and Exchange Commission including
this Report of Form 10-K. If any of these assumptions or opinions prove
incorrect, any forward-looking statements made on the basis of such
assumptions or opinions may also prove materially incorrect in one or more
respects.
ii
PART I
BUSINESS
Overview
Vesta Insurance Group, Inc. (the "Company" or "Vesta") is a holding company
for a group of property/casualty insurance companies ("Vesta Group"),
including Vesta Fire Insurance Corporation ("Vesta Fire"), which offers treaty
reinsurance and primary insurance on personal and commercial risks. The
Company was incorporated in Delaware on July 9, 1993 to be the holding company
for the property and casualty insurance subsidiaries of Torchmark Corporation
("Torchmark"). Prior to its initial public offering of common stock in
November 1993, the Company was a wholly owned subsidiary of Torchmark. As of
December 31, 1998, Torchmark held approximately 23.9% of the outstanding
common stock of the Company. The Company's principal property and casualty
subsidiary is Vesta Fire. The Company's principal executive offices are at
3760 River Run Drive, Birmingham, Alabama 35243, and its telephone number is
(205) 970-7000.
In its reinsurance and personal insurance operations, the Company focuses
primarily on private passenger automobile and property coverages. Gross
premiums written by the Company in 1998 totalled $759 million. At December 31,
1998, the Company's stockholders' equity was $158.0 million.
The Company has historically provided treaty reinsurance, principally
through reinsurance intermediaries, for small and medium-sized companies and
regional specific reinsurance for larger insurance companies located
throughout the United States. The principal lines of business reinsured by the
Company include homeowner and commercial property coverages, non-standard
automobile insurance and collateral protection insurance. In 1996, prior to
the acquisition of Shelby and Vesta County Mutual, as discussed below, assumed
reinsurance represented 76 percent of gross premiums. As a result of these
acquisitions, assumed reinsurance represented 62 percent of 1997 gross
premiums. Primarily as a result of these acquisitions and pricing pressures in
the reinsurance market place, assumed reinsurance represented 38 percent of
1998 gross premiums. This shift to increased personal and commercial writings
is consistent with the Company's strategy to focus on personal auto and
property coverages in all of its lines of business while adjusting the mix and
volume of its writings and retentions to respond to change in market
conditions. In light of the recent downgrade in the A.M. Best rating to B++,
and given the increasingly competitive market conditions in the reinsurance
marketplace, the Company determined to focus on primary insurance and to exit
the reinsurance marketplace. Accordingly, in March of 1999, the Company
transferred a significant portion of its reinsurance operations to another
reinsurer exclusive of certain treaties for which the underlying policies are
being converted to direct business and certain other contracts. See, Business
Strategy section and Reinsurance Strategy section.
In its personal and commercial insurance operations, the Company has
developed insurance products and programs to meet particular market needs.
Personal and commercial insurance products offered by the Company have
included from time to time a variety of homeowner and dwelling insurance
products, private passenger automobile, specialty commercial transportation
products, commercial business coverages and certain financial services
products designed to protect the interests of financial institutions in real
and personal property collateral. Personal and commercial insurance products
are distributed through independent agents brokers and managing general
agents.
Recently, however, the Company determined the competitiveness of the
commercial marketplaces and the recent A.M. Best downgrade (See A.M. Best
section) will cause the corrective actions necessary to return the commercial
segment to profitability not to be justifiable. Therefore, the Company decided
to withdraw from a major part of its commercial segment effective June 1999
for new business and renewal policies. The Company will continue to write the
Partners, BOP and Transportation lines of business in States that have been
historically profitable. The Company has also
1
determined that the A.M. Best downgrade and the increased competition in the
reinsurance marketplace will cause a significant loss of reinsurance premiums
in 1999. The Company has decided to sell a significant portion of its
reinsurance book of business. See the Business-Strategy section and Note T of
the Notes to the Consolidated Financial Statements for further discussion.
Effective December 31, 1997, Vesta Fire entered into a business transfer and
management agreement with CIGNA Property and Casualty Insurance Company
("CIGNA"). The agreement calls for Vesta Fire to reinsure selected personal
lines (covered business) written by CIGNA through a 100% Quota Share
Reinsurance Treaty. The agreement also calls for CIGNA and Vesta Fire to
cooperate to effect the transfer of the covered business from CIGNA to Vesta
Fire as the issuing carrier. While CIGNA does not own "renewal rights" under
agreements with agents and brokers, CIGNA will use good faith efforts, working
with Vesta Fire, to encourage agents and brokers to enter into similar
agreements with Vesta Fire.
After the close of business on June 30, 1997, the Company completed its
acquisition of all the issued and outstanding stock of the operating
subsidiaries of Anthem Casualty Insurance Group, Inc., each of which are
property and casualty insurance companies, for an aggregate purchase price,
including expenses of $260.9 million. Anthem Casualty Insurance Company has
been renamed Shelby Casualty Insurance Company and all the subsidiaries
acquired are collectively referred to as "Shelby."
Shelby is a regional property and casualty insurer with approximately
$260 million in annual premiums. Shelby markets its insurance product through
approximately 2,200 independent agencies, located in the midwest and mid-
atlantic states. The majority of the business acquired consists of auto
insurance and homeowners insurance in small towns and suburbs. The remainder
of the acquired business consists primarily of small and medium sized
commercial insurance much of which the Company has recently determined not to
renew.
Effective December 31, 1996, the Company acquired control of Ranger County
Mutual Insurance Company through its acquisition of all of the issued and
outstanding capital stock of Ranger General Agency, Inc. from Ranger Insurance
Company ("Ranger"), located in Houston, Texas, for $7.5 million in cash.
Ranger County Mutual Insurance Company has moved its operations to Dallas, and
changed its name to Vesta County Mutual Insurance Company ("Vesta County
Mutual"). All of Vesta County Mutual's business at December 31, 1996, as well
as certain additional business which the Company permitted Ranger to write
through Vesta County Mutual for a period of two years thereafter, is reinsured
100% by Ranger, and the Company does not assume any risk associated with this
business.
Vesta County Mutual is a county mutual insurance company organized under
Chapter 17 of the Texas Insurance Code, and, as such, enjoys certain
regulatory advantages, including the ability to establish rates without the
approval of the Texas Insurance Commission. Prior to the acquisition, Vesta
Fire had historically reinsured certain automobile and associated lines of
business in Texas written by a similar mutual company for which it paid
commissions. Vesta Fire now writes the majority of these lines of business
through Vesta County Mutual and, by doing so, recognizes significant savings.
2
Business Strategy
The Company was confronted with three major challenges during 1998. In June
1998, the Company completed an internal investigation, which resulted in a
reduction of net income of approximately $13.6 million in the fourth quarter
of 1997 and first quarter of 1998. The internal investigation focused on
accounting irregularities in the fourth quarter of 1997 and the first quarter
of 1998. The Company also corrected the methodology by which it recognized
earned premiums in its reinsurance segment. This resulted in a restatement of
its historical financial statements and a decrease in reported net income of
approximately $49 million for the years 1993 through 1997. Finally, the
insurance industry experienced one of the worst years for catastrophe losses
and continued to endure pricing pressures in the reinsurance market.
During the last quarter of 1998 and the first two months of 1999, the
Company analyzed the profitability of the reinsurance, personal lines and
commercial lines segments. The goal of the analysis was to determine which
segments would fit into the Company's strategy for 1999 and beyond. As a
result of the analysis, the Company decided to withdraw from a major part of
its commercial and reinsurance segments. The Company determined the
competitiveness of the commercial and reinsurance marketplace and the recent
A.M. Best downgrade (See A.M. Best section) will cause the corrective actions
necessary to return the commercial segments to profitability not to be
justifiable and the potential for maintaining its reinsurance portfolio to be
significantly impaired.
As discussed elsewhere in this report, the Company's current strategy is to
focus principally on personal auto and property coverages in all of its lines
of business while adjusting the mix and volume of its writings and retentions
to respond to changes in market prices and to manage its risk exposures. The
Company will also continue to write certain commercial risks on a limited
basis. The commercial risks, including transportation and BOP, will only be
written in areas that have historically produced profitable business.
Historically, the Company has made substantial use of reinsurance to reduce
its exposure to risks and the variability of its earnings. The Company plans
to continue to cede a portion of its insurance risks while increasing its
retentions of certain lines of business based on market conditions.
3
Lines of Business
The following table provides selected historical information on a Generally
Accepted Accounting Principles (GAAP) basis concerning the business written by
the Company and the associated underwriting results. This data should be read
in conjunction with the Company's Consolidated Financial Statements and
related notes thereto. For additional information on the Company's business
segments, see "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and Notes O to the Consolidated Financial Statements.
Year Ended December 31,
------------------------------------------------
1994 1995 1996 1997 1998
-------- -------- -------- -------- --------
(In thousands, except ratio data)
Reinsurance
Gross Premiums Written....... $214,430 $353,988 $497,537 $535,427 $287,617
Net Premiums Written......... 165,536 289,565 373,486 351,811 157,729
Net Premiums Earned.......... 164,101 221,933 342,452 335,360 194,261
Loss Ratio................... 55.5% 68.1% 59.9% 53.5% 90.5%
Personal
Gross Premiums Written....... $ 63,658 $105,643 $109,661 $244,719 346,992
Net Premiums Written......... 28,626 52,157 69,769 141,165 264,839
Net Premiums Earned.......... 39,223 44,796 63,206 139,425 247,064
Loss Ratio................... 67.2% 43.6% 40.5% 68.3% 66.7%
Commercial
Gross Premiums Written....... 49,018 58,428 44,573 85,905 124,412
Net Premiums Written......... 37,948 48,782 24,801 33,499 69,022
Net Premiums Earned.......... 29,028 46,349 33,678 42,873 68,368
Loss Ratio................... 59.1% 61.3% 62.8% 55.9% 80.0%
Combined
Gross Premiums Written....... $327,106 $518,059 $651,771 $866,051 759,021
Net Premiums Written......... 232,110 390,504 468,056 526,475 491,590
Net Premiums Earned.......... 232,352 313,078 439,336 517,658 509,693
Loss Ratio................... 57.9% 63.6% 57.3% 57.7% 77.6%
Expense Ratio................ 35.4% 30.0% 33.2% 34.9% 50.2%
Combined Ratio............... 93.3% 93.6% 90.5% 92.6% 127.8%
Reinsurance
Reinsurance is a contractual arrangement under which one insurer (the ceding
company) transfers to another insurer (the reinsurer) all or a portion of a
risk or risks that the ceding company has assumed under the insurance policy
or policies it has issued. A ceding company may purchase reinsurance for any
number of reasons including, to obtain, through the reduction of its
liabilities, greater underwriting capacity than its own capital resources
would support, to stabilize its underwriting results, to protect against
catastrophic loss, to withdraw from a line of business, and to manage risk
when entering a new line of business.
Reinsurance can be written on either a pro rata or excess of loss basis.
Under pro rata reinsurance, the reinsurer, in return for a predetermined
portion or share of the insurance premium charged by the ceding company,
indemnifies the ceding company against a predetermined portion or share of the
losses and loss adjustment expenses ("LAE") of the ceding company under the
covered primary policy or policies. Under excess of loss reinsurance, the
reinsurer indemnifies the ceding company against all or a specified portion of
losses and LAE on underlying insurance policies in excess of a specified
dollar amount, known as the ceding company's retention, subject to a
negotiated policy limit. Catastrophe reinsurance is a form of excess of loss
reinsurance which indemnifies the ceding company for losses resulting from a
particular catastrophic event. Excess of loss reinsurance
4
is often written in layers, with one or a group of reinsurers taking the risk
from the ceding company's retention layer up to a specified amount, at which
point either another reinsurer or a group of reinsurers takes the excess
liability or it remains with the ceding company. The reinsurer acquiring the
risk immediately above the ceding company's retention layer is said to write
working or low layer reinsurance. A loss that reaches just beyond the primary
insurer's retention layer will create a loss for the working layer reinsurer,
but not necessarily for the reinsurers on the higher layers.
Premiums that the ceding company pays to the reinsurer for excess of loss
coverage are not directly proportional to the premiums that the ceding company
receives because the reinsurer does not assume a proportionate risk. Excess of
loss coverage is priced separately and distinctly from the pricing employed by
the ceding company in connection with its risk since the probability of loss
is different for the reinsurer than the ceding company. In contrast, in pro
rata reinsurance, premiums that the ceding company pays to the reinsurer are
proportional to the premiums that the ceding company receives, consistent with
the proportional sharing of risk, and the reinsurer generally pays the ceding
company a ceding commission. Generally, the ceding commission is based upon
the ceding company's cost of obtaining the business being reinsured (i.e.,
commissions, premium taxes, assessments and miscellaneous administrative
expenses).
Substantially all of the reinsurance that the Company currently has written
is on personal (including automobile) and commercial property risks.
Management believes there are certain advantages in emphasizing the writing of
property reinsurance over casualty reinsurance, the most significant of which
is that ultimate property claims losses generally can be determined more
quickly than ultimate casualty claims losses. Long-tail reinsurance, such as
certain casualty coverages, frequently are slower to be reported and finally
determined. However, the earnings of property insurers are affected by
unpredictable catastrophic events. In addition, a continuing increase in the
severity of catastrophic losses as well as various other market forces could
affect the availability of adequate retrocessional coverage.
The Company's mix of reinsurance business on a gross premiums written basis
is set forth in the following table for the periods indicated:
Year Ended December 31,
----------------------------------------------
Type of Reinsurance 1996 1997 1998
- ------------------- -------------- -------------- --------------
(in thousands, except ratio data)
Property Reinsurance
Pro Rata....................... $383,637 77.1% $443,164 82.8% $213,877 74.3%
Catastrophe.................... 46,485 9.4 51,287 9.6 37,042 12.9
Excess Risk.................... 3,135 0.6 3,289 0.6 5,393 1.9
-------- ----- -------- ----- -------- -----
Total Property.................. 433,257 87.1 497,740 93.0 256,312 89.1
Casualty Reinsurance
Auto Liability................. 60,912 12.2 32,696 6.1 29,534 10.3
Other Casualty(1).............. 3,368 0.7 4,991 0.9 1,771 0.6
-------- ----- -------- ----- -------- -----
Total Casualty.................. 64,280 12.9 37,687 7.0 31,305 10.9
-------- ----- -------- ----- -------- -----
Total Reinsurance.............. $497,537 100.0% $535,427 100.0% $287,617 100.0%
======== ===== ======== ===== ======== =====
- --------
(1) Estimated casualty portion of total reinsurance excluding Auto Liability.
In 1998, the Company's pro rata reinsurance writings of private passenger
automobile decreased significantly over 1997. The acquisition of Vesta County
Mutual resulted in a further shift of a large portion of private passenger
automobile writings which had been recorded on the reinsurance line to
personal line. Additionally, the reinsurance market experienced increased
market capacity accompanied by increased price competition in the private
passenger automobile line of business. The
5
Company continued to terminate certain accounts, which reduced its writings of
pro rata reinsurance of private passenger automobile.
The principal lines of business reinsured by the Company include homeowner
and commercial property coverages and non-standard automobile insurance. For
1998, homeowner and commercial business comprised approximately 68% of gross
reinsurance premiums written, non-standard automobile insurance comprised
approximately 26% of gross reinsurance premiums written, and other lines
comprised approximately 6% of gross reinsurance premiums written. The Company
writes a small amount of casualty reinsurance for a certain number of its
property reinsurance clients. Casualty reinsurance risks assumed by the
Company consist largely of non-standard automobile liability insurance as well
as liability coverages provided under homeowner and commercial multi-peril
policies.
Marketing. The Company has historically provided reinsurance to small and
medium-sized regional insurance companies and regional specific reinsurance
for larger insurance companies located throughout the United States. Most of
the Company's reinsurance business was produced through major reinsurance
intermediaries in the United States. In 1996 the Company began writing
international reinsurance business with an emphasis on catastrophe
reinsurance. This was enhanced in September 1996 with the establishment of a
branch office in Copenhagen, Denmark, which improved access to the European
reinsurance market. Until recently, the Company's reinsurance division did
business through approximately 40 intermediaries, five of which were
responsible for approximately 85% of the division's premium volume during
1998.
Underwriting. Management's underwriting strategy is to practice strict
discipline in carrying out its major operating functions, risk selection and
retention. For selecting and managing its portfolio of reinsurance contracts,
the authority to bind the Company is limited to five employees whose duties
are concentrated primarily on identifying and accessing desirable business.
The Company utilizes computers and analytical software to assist underwriters
in evaluating and selecting risks and determining appropriate retention
levels. It has been the Company's practice to have direct contact, either by
underwriting audits or periodic visits of a more general nature, with ceding
companies with whom the Company has working pro rata and layer relationships,
both to enhance the quality of its underwriting process and to develop and
retain its business relationships.
Strategy. Given current market conditions in the reinsurance arena, the
Company determined that the recent downgrade in the A.M. Best rating to B++
(see A.M. Best section) will have a negative impact on its reinsurance
operations. Although the company enjoys an excellent relationship with its
reinsurance customers the potential for maintaining its reinsurance portfolio
has been hampered by the recent change in rating. The Company determined that
the A.M. Best downgrade and the increased competition in the reinsurance
marketplace would cause a significant loss of reinsurance premiums in 1999.
Therefore, the Company sold a significant portion of its reinsurance renewal
rights to Hartford Fire Insurance Company ("Hartford Fire") for $15 million
effective March 24, 1999. See Business Strategy (above) and Note T of the
Notes to the Consolidated Financial Statements for further discussion.
Primary Insurance Business
In its primary insurance operations, the Company has sought to identify
market opportunities and develop insurance products to meet particular market
needs. Prior to 1997, the Company's primary insurance operations focused on
selected personal and commercial property insurance lines as well as on
financial services products consisting of certain collateral protection
insurance policies for financial institutions. In 1997, however, the
acquisitions of the Shelby Insurance Companies and Vesta County Mutual
increased the personal automobile premiums significantly, making it the
Company's largest primary lines of business. The 1997 acquisition of the CIGNA
personal property book of
6
business, representing over $80 million in annual written premium, essentially
balanced the Company's personal lines writings evenly between automobile and
property coverages.
In the past, the Company has emphasized writing property coverages more than
liability. With the addition of the liability portions of the Shelby
automobile line, the Company's writings are also now fairly evenly balanced
between property and liability exposures. This balancing between liability and
property exposures provides better protection against severe impacts of
natural catastrophes, and thus more consistency to the Company's results.
The Company's independent agents may bind insurance coverages only in
accordance with guidelines established by the Company. The Company promptly
reviews all coverages bound by its agents and a decision is made as to whether
to continue such coverages. Because of the broad base of the Company's
independent agency force, the contractual limitation on their authority to
bind coverage and the Company's review procedures, the Company does not
believe that the authority of its agents to bind the Company presents any
material risk to the Company and its operations.
Personal Lines
Prior to 1997, the Company's personal lines business related primarily to
the insurance of residential properties and their contents. The purchase of
Shelby and Vesta County Mutual significantly increased the Company's direct
writings of personal automobile lines. The following table sets forth the
principal line of business distribution of the Company's gross premiums
written in its personal lines business for the three years indicated.
Year Ended December 31,
----------------------------------------------
1996 1997 1998
-------------- -------------- --------------
(in thousands, except percentage)
Personal Auto................... $ 8,379 7.6% $112,394 45.9% $223,425 64.4%
Homeowners...................... 66,954 61.1 88,599 36.2 93,762 27.0%
Financial Services.............. 25,945 23.7 37,344 15.3 20,682 6.0%
Other........................... 8,383 7.6 6,382 2.6 9,123 2.6%
-------- ----- -------- ----- -------- -----
$109,661 100.0% $244,719 100.0% $346,992 100.0%
======== ===== ======== ===== ======== =====
The Company offers personal auto insurance for preferred, standard and non-
standard drivers. In its standard auto line, the Company targets drivers over
age 45 with above average driving records. The non-standard auto line covers
the full spectrum of non-standard drivers.
Liability limits up to $500,000 are written on standard auto policies, with
an additional $5 million personal umbrella limit also available. However, the
vast majority of the personal umbrellas are written at limits of $1 million or
$2 million. For non-standard auto, the Company typically writes minimum basic
limits that vary by state.
The Company's personal property insurance products cover the full range of
homes starting with lower-valued dwellings in the $10,000 to $50,000 range,
through the middle-valued homes from $50,000 to $150,000, as well as higher
valued homes up to $10,000,000. The majority of homes insured are valued
between $40,000 and $250,000.
The Company also provides specialty products protecting collateral and
repossessed property of financial institutions. Certain of these products are
designed to protect the interests of financial institutions against physical
damage to private passenger automobiles and other personal property in those
cases where the borrower fails to insure the collateral in accordance with a
loan agreement. The Company also has mortgage security products that are
designed to protect the interest of the mortgagee and the mortgagor (borrower)
caused by the mortgagor's failure to obtain property insurance on the
mortgaged property. Coverage is also provided for the properties that are in
the process of foreclosure.
7
Marketing. Prior to 1997, the Company marketed personal lines in 15 states
through approximately 870 agencies, with premium concentrated in the property
lines in the Southeast. With the Shelby and CIGNA acquisitions, the Company
increased its marketing force to approximately 3800 agencies in 42 states.
Within certain parameters, the agents of the Company are authorized to write
policies without prior approval from the Company. However, all policies are
reviewed by Company's underwriting staff upon receipt of the application by
the Company.
The following table sets forth the principal geographic distribution of the
Company's gross premiums written in its personal lines business for the three
years indicated. The states listed below comprise the ten states with the
largest gross premiums written for 1998.
Year Ended December 31,
----------------------------------------------
1996 1997 1998
-------------- -------------- --------------
(in thousands, except percentages)
Texas........................... $ 4,588 4.2% $ 50,660 20.7% $ 77,567 22.3%
Pennsylvania.................... 20 0.0 24,455 10.0 50,185 14.4
West Virginia................... 358 0.3 12,823 5.3 27,593 8.0
Hawaii.......................... 41,927 38.2 35,686 14.6 25,175 7.3
Tennessee....................... 4,367 4.0 15,890 6.5 24,924 7.2
Illinois........................ 1,482 1.4 12,118 4.6 20,029 5.8
Ohio............................ 541 0.5 10,865 4.5 17,942 5.2
Alabama......................... 15,348 14.1 18,032 7.4 14,641 4.2
North Carolina.................. 1,354 1.2 5,186 2.2 11,966 3.4
Mississippi..................... 3,950 3.6 7,773 3.2 11,398 3.3
All Other....................... 35,726 32.5 51,231 21.0 65,572 18.9
-------- ----- -------- ----- -------- -----
Total......................... $109,661 100.0% $244,719 100.0% $346,992 100.0%
===== ===== =====
The geographic balance reflected above allows for greater profit protection
and more cost effective management of the property catastrophe exposures. The
Company employs marketing representatives to maintain and expand its agency
relationships in its personal lines business. In addition, the Company pays
competitive commission rates to its agents and utilizes a profit sharing plan
for agencies which is based on volume of premiums and loss ratios for business
written.
Underwriting. Underwriting of personal lines business is conducted in four
locations and performed by the Company's underwriting staff in accordance with
specific underwriting authority related to the acceptability of each risk for
the appropriate program profile. Management information reports are utilized
to measure risk selection and pricing in order to control underwriting
performance. The principal underwriting criteria for personal property
coverages is a financially stable owner with a well-maintained property. Rates
for lower valued properties are surcharged to reflect risk characteristics.
Within certain parameters, the agents of the Company are authorized to write
policies without prior approval from the Company.
It has been the Company's policy generally not to underwrite personal
property business in the Southeast within one hundred miles of a coastline
(except for Florida which is 10 miles) in order to limit its exposure to
typical coastal occurrences such as hurricanes and other types of storms. In
the Northeast and West, the Company does not impose as restrictive a criteria
for property location, but does endeavor to utilize high wind deductibles
whenever possible in order to limit its catastrophe exposure. The Company
continually monitors and controls its production in order to prudently manage
its risk in areas with significant exposure to natural disasters.
Future Plans. A significant potential for internal, organic growth exists in
personal lines through expansion of the Company's existing products to its
existing agency force. The largest potential exists
8
with both standard and non-standard auto, which are currently marketed in only
13 and 8 of the Company's active states, respectively. There are many of the
Company's appointed agencies in additional states to whom it plans to market
these products in the next several years, thus enabling them to cross-sell the
Company's current personal property policyholders. This cross-selling activity
will not only increase premium production, but should also improve renewal
retention, and therefore the Company's loss ratio and expenses.
In addition to the expansion of the Company's auto products to other active
states, the Company also plans to expand its Low-Valued Dwelling and High-
Valued Homeowners products to other active states, as appropriate, based on
state demographics. The Company recognizes that to be a successful personal
lines carrier, it is essential that the Company makes it as easy as possible
for its agents to do business with the Company. Therefore, the Company is
currently pursuing three key technological developments in personal lines to
accomplish its goal.
First, the Company is well along in its efforts to make its underwriting and
processing systems paperless, through the implementation of an imaging system.
This system enables the Company to service its agents and policyholders more
quickly and effectively by having policy information readily available on its
computer. The Company anticipates this will improve its policy processing
time.
Second, the Company continues to expand the number of agencies utilizing its
SEMCI agency download system, updating the agencies' management systems with
current policy data. Currently over 600 agencies utilize this service, and the
number of agencies continues to grow.
Third, the Company is currently developing an Internet-based interactive
inquiry, application, and endorsement service for its agents. The Company
anticipates introducing this service in the second or third quarter of 1999.
This inquiry service will put policy, billing, and claims information at the
agents' fingertips, thus enabling them to better serve their customers. In
addition, the application and endorsement service will enable the agents to
have direct access to the Company's policy issuance system, thus further
improving turnaround time for policy and endorsement processing.
Commercial Lines
The Company provides insurance products covering a select group of target
classes for which it has developed specific commercial industry expertise. The
Company typically provides a full spectrum of property, liability, and auto
coverage for these target classes, with the focus on small accounts. These
target classes include typical small office, service, and retail
businessowners, mini-storage facilities, artisan contractors, and small
service garages.
Until recently, the Company pursued a broader range of target classes which
focused on other classes such as hotels, manufacturers, restaurants,
motorcycle dealers, broadcasters and publishers. The Company concluded,
however, that in the continuing competitive marketplace, the Company could not
achieve adequate pricing for these classes of business as required for
profitability. Therefore, these classes of business will be discontinued in
the second quarter of 1999 (see the Business Strategy section), as the Company
elected to focus on the expansion of its small commercial Partners Program,
offering its Businessowners, Artisan Contractors, and small Service Garage
programs.
These continuing programs offer the advantages to the Company of more
controlled pricing, better renewal retention, greater growth potential due to
changing demographics, better opportunities for developing internal processing
efficiencies, and a better match with the marketing needs of our personal
lines agents.
In recognition of the need to make it easy for agents to do commercial
business with the Company, agents have been provided with personal computer
rating disks that enable the agents to
9
quote eligible small accounts and conduct initial underwriting screening. In
the future, once the commercial policy issuance systems are further developed,
the Company will utilize the personal lines Internet-based inquiry,
application and endorsement system to also improve the service and
efficiencies of the Partners Program.
The Company has also designed a complementary group of insurance products
for the trucking industry. These products are offered to independent owner-
operators of trucks and small fleets to cover physical damage, non-trucking
liability (non-business use of the vehicle), and cargo risks. Physical damage
protection is the principal product written by the Company in this line of
business.
Marketing. The Company's standard commercial lines products had been offered
in 29 states, but has now been narrowed to 14 states to enable the Company to
focus on the aforementioned Partners Program. In the next few years, the
Company will expand its Partners Program into other personal lines states. The
Company uses marketing representatives to market it's commercial lines
products to independent agents. These marketing representatives are employees
of the Company and are located in areas which the Company operates and targets
business development. Commercial business products are now being marketed
directly through approximately 2,000 independent agencies. Transportation
products are marketed through approximately 60 agencies which specialize in
this line of business. The Company believes that the commissions and profit
sharing arrangements it provides to contracted agents have been important
factors in the Company's ability to access and maintain profitable commercial
property-casualty and transportation business.
The following table sets forth the principal geographic distribution of the
Company's direct premiums written in its commercial lines of business for the
years indicated. The states listed below comprise the ten states with the
largest gross premiums written for 1998. As noted above, the volume of
premiums written in the Company's commercial lines of business are expected to
decrease significantly in 1999 as a result of the Company's decision to
withdraw from a major part of its commercial segment.
Year Ended December 31,
---------------------------------------------
1996 1997 1998
-------------- -------------- ---------------
(in thousands, except percentages)
North Carolina.................... $1,337 3.0% $10,869 12.4% $19,226 15.5%
Ohio.............................. 846 1.9 4,673 5.3 12,325 9.9
Texas............................. 11,035 24.8 11,804 13.5 9,222 7.4
Missouri.......................... 6,554 14.7 5,429 6.2 8,748 7.0
Connecticut....................... -- 0.0 4,131 4.7 8,608 6.9
Tennessee......................... 1,447 3.2 5,336 6.2 8,255 6.6
Indiana........................... 81 0.2 4,415 5.1 7,675 6.2
Georgia........................... 1,410 3.2 4,933 5.6 6,471 5.2
Kentucky.......................... 1,787 4.0 3,828 4.4 5,767 4.7
Rhode Island...................... 0 0.0 3,490 4.0 5,650 4.5
All Other......................... 20,076 45.0 26,997 32.6 32,465 26.1
------- ------ ------- ------ -------- ------
Total........................... $44,573 100.0% $85,905 100.0% $124,412 100.0%
======= ====== ======= ====== ======== ======
Underwriting. Underwriting of the Company's commercial business and
transportation products had been centralized in two locations (the Company's
home office and the Shelby office). The Company plans to consolidate all
commercial lines underwriting in the home office by the end of 1999. All
underwriting is performed by the Company's underwriting staff in accordance
with specific underwriting authority based upon the experience and knowledge
level of each underwriter. Risks that are perceived to be more difficult and
complex risk exposures are underwritten by the more experienced staff and
reviewed by management. Many underwriting factors are examined for the
commercial business line, such as quality of construction, occupancy,
protection against fire and other hazards, and financial condition of the
owners.
10
Transportation underwriting is heavily concentrated on a review of the
driver, including the driver's record and experience. However, other factors
are also considered, such as, in the case of cargo insurance, damageability
and theft exposure.
Limited binding authority is provided to contracted agents, but only for
risks which have been underwritten, priced and accepted by an authorized
underwriter of the Company or risks which qualify under specific and pre-set
guidelines and rate parameters established for a specified class of products.
Reinsurance Ceded
The Company seeks to manage its risk exposure through the purchase of
reinsurance, including retrocessional placements for its reinsurance business.
The Company obtains reinsurance principally to reduce its net liability on
individual risks and to provide protection for individual loss occurrences,
including catastrophic losses, in order to stabilize its underwriting results.
In exchange for reinsurance, the Company pays to its reinsurers a portion of
the premiums received under the reinsured policies. While the assuming
reinsurer is liable for losses to the extent of the coverage ceded,
reinsurance does not legally discharge the Company from primary liability for
the full amount of the policies ceded.
The Company generally purchases reinsurance separately for its primary
insurance business lines and its reinsurance business. Gross written premiums
ceded for 1997 were $339.6 million, which constituted 39.2% of the gross
premiums written, in order for 1998, were $267.4 million, which constituted
35.1% of the gross premiums written. The decrease in 1998 was primarily due to
the decrease in gross written premiums in 1998 and the cancellation of a
certain reinsurance treaty effective July 1, 1998. While the Company seeks to
reinsure a significant portion of its property catastrophe risks, there can be
no assurance that losses experienced by the Company will be within the
coverage limits of the Company's reinsurance and retrocessional programs.
The availability and cost of reinsurance and retrocessional coverage may
vary significantly over time and are subject to prevailing market conditions.
The Company seeks to evaluate the credit quality of the reinsurers and
retrocessionaires to which it cedes business. No assurance can be given
regarding the future ability of any of the Company's reinsurers to meet their
obligations.
Claims
Claims arising under the policies issued by the Company are managed by the
Company's Claims Department. When the Company receives notice of a loss, its
claims personnel open a claim file and establish a reserve with respect to the
loss. All claims are reviewed and all payments are made by the Company's
employees, with the exception of claims on certain products, which are
adjusted by a managing general agency and periodically audited by the
Company's claims personnel.
Most personal lines claims are adjusted and paid by staff claims adjusters.
Management believes that utilizing the Company's trained employee adjusters
permits faster, more efficient service at a lower cost.
Claims settlement authority levels are established for each adjuster or
manager based upon each employee's ability and level of experience. Upon loss
notification, each claim is reviewed and assigned to an adjuster or manager
based upon the type of claim. Claims-related litigation is monitored by home
office litigation supervisors. The Company emphasizes prompt, fair and
equitable settlement of meritorious claims, adequate reserving for claims and
controlling of claims adjustment and legal expenses.
11
Reserves
The Company's insurance subsidiaries maintain reserves to cover their
estimated ultimate liability for losses and loss adjustment expenses ("LAE")
with respect to reported and unreported claims incurred. To the extent that
reserves prove to be inadequate in the future, the Company would have to
increase such reserves and incur a charge to earnings in the period such
reserves are increased, which could have a material adverse effect on the
Company's results of operations and financial condition. The establishment of
appropriate reserves is an inherently uncertain process, and there can be no
assurance that ultimate losses will not materially exceed the Company's loss
and LAE reserves. Reserves are estimates involving actuarial and statistical
projections at a given time of what the Company expects to be the cost of the
ultimate settlement and administration of claims based on facts and
circumstances then known, estimates of future trends in claims severity and
other variable factors such as inflation. The inherent uncertainties of
estimating reserves generally are greater with respect to reinsurance
liabilities due to the diversity of development patterns among different types
of reinsurance contracts, the necessary reliance on ceding companies for
information regarding reported claims and differing reserving practices among
ceding companies.
With respect to reported claims, reserves are established on a case-by-case
basis. The reserve amounts on each reported claim are determined by taking
into account the circumstances surrounding each claim and policy provision
relating to the type of loss. Loss reserves are reviewed on a regular basis,
and as new data becomes available, appropriate adjustments are made to
reserves.
For incurred but not reported ("IBNR") losses, a variety of methods have
been developed in the insurance industry for determining estimates of loss
reserves. One common method of actuarial evaluation, which is used by the
Company, is the loss development method. This method uses the pattern by which
losses have been reported over time and assumes that each accident year's
experience will develop in the same pattern as the historical loss
development. The Company also relies on industry data to provide the basis for
reserve analysis on newer lines of business (lines written less than 3 years).
Provisions for inflation are implicitly considered in the reserving process.
The Company's reserves are carried at the total estimate for ultimate expected
loss without any discount to reflect the time value of money.
Reserves are computed by the Company based upon actuarial principles and
procedures applicable to the lines of business written by the Company. These
reserve calculations are reviewed regularly by management, and, as required by
state law, the Company periodically engages an independent actuary to render
opinions as to the adequacy of statutory reserves established by management.
The actuarial opinions are filed with the various jurisdictions in which the
Company is licensed. Based on the practice and procedures employed by the
Company management believes that the Company's reserves are adequate as of the
valuation date.
12
The following table provides a reconciliation of beginning and ending
liability balances on a GAAP basis for the years indicated:
Year Ended December 31,
------------------------------
1996 1997 1998
-------- --------- ---------
(in thousands)
Gross Losses and LAE reserves at beginning of
year......................................... $168,502 $ 173,275 $ 596,797
Reinsurance Receivable........................ (24,384) (60,343) (204,336)
-------- --------- ---------
Net Losses and LAE reserves at beginning of
year......................................... 144,118 112,932 392,461
Increases (decreases) in provisions for losses
and LAE for claims incurred:
Current year................................. 242,454 311,089 396,091
Prior year................................... 9,329 (12,451) (769)
Acquisition of Shelby......................... -- 300,315 --
Losses and LAE payments for claims incurred:
Current year................................. (158,409) (166,447) (269,369)
Prior year................................... (124,560) (152,977) (219,642)
-------- --------- ---------
Net Losses and LAE reserves at end of year ... 112,932 392,461 298,772
Reinsurance Receivable........................ 60,343 204,336 206,139
-------- --------- ---------
Gross loss and LAE Reserves................... $173,275 $ 596,797 $ 504,911
======== ========= =========
The reconciliation between statutory basis and GAAP basis reserves for each
of the three years in the period ended December 31, 1998 is shown on the
following page:
Year Ended December 31,
----------------------------
1996 1997 1998
-------- -------- --------
(in thousands)
Statutory reserves............................... $115,360 $391,069 $363,139
Adjustments for salvage and subrogation.......... (2,376) (15,553) (11,250)
Retroactive reinsurance amounts.................. -- 16,945 (53,117)
Gross-up of amounts netted against reinsurance
recoverable..................................... 60,291 204,336 206,139
-------- -------- --------
Reserves on a GAAP basis......................... $173,275 $596,797 $504,911
======== ======== ========
13
The following table shows the development of the reserves for unpaid losses
and loss adjustment expenses from 1988 through 1998 for the Company's
insurance subsidiaries on a GAAP basis net of reinsurance recoveries. The top
line of the table shows the liabilities at the balance sheet date for each of
the indicated years. This reflects the estimated amounts of losses and loss
adjustment expenses for claims arising in that year and all prior years that
are unpaid at the balance sheet date, including losses incurred but not yet
reported to the Company. The upper portion of the table shows the cumulative
amounts subsequently paid as of successive years with respect to the
liability. The lower portion of the table shows the reestimated amount of the
previously recorded liability based on experience as of the end of each
succeeding year. The estimates change as more information becomes known about
the frequency and severity of claims for individual years. A redundancy
(deficiency) exists when the reestimated liability at each December 31 is less
(greater) than the prior liability estimate. The "cumulative redundancy
(deficiency)" depicted in the table, for any particular calendar year,
represents the aggregate change in the initial estimates over all subsequent
calendar years.
Year Ended December 31,
---------------------------------------------------------------------------------------------------
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
------- ------- ------- ------- ------- ------- ------- -------- -------- -------- --------
(in thousands)
Liability for unpaid
losses and LAE..... $40,837 $32,861 $27,823 $21,919 $21,976 $29,688 $66,648 $118,733 $112,932 $392,461 $298,772
Paid (cumulative) as of
One year later..... 19,730 19,611 11,864 13,166 20,517 20,761 51,527 88,377 86,978 197,477
Two years later.... 28,475 24,063 14,949 17,054 20,272 28,766 65,360 116,388 114,704
Three years later.. 32,443 27,199 17,096 16,810 20,281 34,776 66,490 125,299
Four years later... 34,628 29,235 18,093 16,622 23,272 33,139 72,273
Five years later... 36,703 29,960 19,206 18,140 20,994 38,222
Six years later.... 37,535 30,976 20,683 16,218 22,964
Seven years later.. 38,602 32,303 20,391 17,922
Eight years later.. 40,150 31,856 22,284
Nine years later... 39,524 33,171
Ten years later.... 40,268
Liability
reestimated as of
End of year....... 40,837 32,861 27,823 21,919 21,976 29,688 66,648 118,733 112,932 392,461 298,772
One year later..... 42,097 34,078 28,779 21,853 28,530 28,930 61,033 127,790 99,708 391,692
Two years later.... 42,702 33,304 29,431 19,009 27,914 34,219 66,582 110,437 144,986
Three years later.. 42,665 33,851 29,130 19,817 26,120 38,940 66,713 118,657
Four years later... 42,493 32,097 29,578 16,470 30,435 41,517 76,863
Five years later... 40,132 34,549 26,291 19,862 33,845 50,993
Six years later.... 42,973 31,205 29,493 23,760 40,317
Seven years later.. 39,464 34,280 36,400 29,574
Eight years later.. 42,525 38,955 40,568
Nine years later... 46,648 44,587
Ten years later.... 52,146
Cumulative
redundancy/
(deficiency)....... (11,309) (11,726) (12,745) (7,655) (18,341) (21,305) (10,215) 76 (32,054) 769
The table above was significantly affected by the 1998 restatement of Vesta
Fire's statutory loss development (Schedule P) required by the Alabama
Department of Insurance, which corrected the assignment of certain losses to
accident years and is reflected above. The table differs significantly from
statutory loss development tables due to GAAP adjustments (see Note D of the
Notes to Consolidated Financial Statements) and the 1997 acquisitions of
Shelby and VCM.
The Company reinsured a number of casualty risks in the early 1980's which
could result in claims for coverage of asbestos related and other
environmental impairment liabilities to the extent that such liabilities were
not excluded from the underlying policies. The attachment points in
reinsurance treaties relating to these risks are relatively high, and the
Company's percentage participation in the layers of reinsurance in which it
participates is relatively low. In addition, the Company carries reinsurance
which would mitigate the effect of any losses under these treaties. While
there exists a possibility that the Company could suffer material loss in the
event of a high number of large losses under these treaties, this is unlikely
in management's judgment.
14
Investments
The Company's investment portfolio consists primarily of investment grade
fixed income securities. Waddell & Reed Asset Management Company ("WRAMCO")
provides investment advisory services to the Company subject to investment
policies and guidelines established by management and the Board of Directors.
The Company's investments at December 31, 1998 totaled approximately $634.7
million and were classified as follows:
Amount at which % of
Type of Investment Shown on Balance Sheet Portfolio
- ------------------ ---------------------- ---------
(in thousands)
Cash and short-term investments................ $156,350 24.6%
United States Government securities............ 75,416 11.9%
Asset-backed securities........................ 88,760 14.0%
Corporate bonds................................ 161,582 25.5%
Foreign government............................. 3,717 .6%
Municipal bonds................................ 127,744 20.1%
Equity securities.............................. 21,099 3.3%
-------- -----
Total........................................ $634,668 100.0%
======== =====
The value of the fixed maturities portfolio, classified by category, as of
December 31, 1998, was as follows:
Amortized Cost Fair Value
-------------- ----------
(in thousands)
United States Government.............................. $ 72,935 $ 75,416
Asset-backed securities............................... 87,773 88,760
Municipal............................................. 124,358 127,744
Foreign government.................................... 3,619 3,717
Corporate............................................. 157,831 161,582
-------- --------
Total............................................... $446,516 $457,219
======== ========
The composition of the fixed maturities portfolio, classified by Moody's
rating as of December 31, 1998 was as follows:
Amortized Cost % of Total
-------------- ----------
(in thousands)
Aaa................................................... $240,083 53.8%
Aa.................................................... 61,758 13.8%
A..................................................... 130,167 29.2%
Baa................................................... 14,508 3.2%
-------- -----
Total............................................... $446,516 100.0%
======== =====
The NAIC has a bond rating system that assigns securities to classes called
"NAIC designations" that are used by insurers when preparing their annual
statutory financial statements. The NAIC assigns designations to publicly-
traded as well as privately-placed securities. The designations assigned by the
NAIC range from class 1 to class 6, with a rating in class 1 being of the
highest quality. As of December 31, 1998, 100% of the Company's fixed
maturities portfolio, measured on a statutory carrying value basis, was
invested in securities rated in class 1 or 2 by the NAIC, which are considered
investment grade. The weighted average maturity of the Company's fixed income
portfolio at December 31, 1998 was 6.1 years. The weighted average duration of
the Company's fixed income portfolio was 3.1 years.
15
As of December 31, 1998, none of the Company's fixed maturities portfolio
was invested in securities that were rated below investment grade. Less than
5% of the Company's assets were invested in equity securities, and less than
20% of the Company's assets were invested in collateralized mortgage
obligations secured by residential mortgages.
Regulation
The Company's insurance companies are subject to regulation by governmental
agencies in the states in which they do business. The nature and extent of
such regulation varies by jurisdiction, but typically involves prior approval
of the acquisition of control of an insurance company or of any company
controlling an insurance company, regulation of certain transactions entered
into by an insurance company with any of its affiliates, approval of premium
rates for many lines of insurance, standards of solvency and minimum amounts
of capital and surplus which must be maintained, limitations on types and
amounts of investments, restrictions on the size of risks which may be insured
by a single company, licensing of insurers and agents, deposits of securities
for the benefit of policyholders, and reports with respect to financial
condition and other matters. In addition, state regulatory examiners perform
periodic examinations of insurance companies. Such regulation is generally
intended for the protection of policyholders rather than security holders.
For its assumed reinsurance business, the Company has historically made
estimates for its reinsurance reports received subsequent to a period end on a
combined underwriting and accident year basis for both statutory and GAAP
purposes. As a result of a routine examination by the Alabama Department of
Insurance, the Company agreed to revise the accounting for its reinsurance
business for statutory purposes. Effective with its year end 1997 statutory
filings, Vesta Fire revised its statutory accounting for its assumed
reinsurance business to reflect only accident/calendar year information. The
adjustments essentially reversed, in the form of a one-time charge, the
cumulative effect of the accounting practice consistently applied over prior
years. On a GAAP basis, the correction was accounted for by restating prior
financial statements.
In addition to the regulatory supervision of the Company's insurance
subsidiaries, the Company is also subject to regulation under the Alabama,
Ohio, Indiana, Hawaii and Texas Insurance Holding Company System Regulatory
Acts (the "Holding Company Acts"). The Holding Company Acts contain certain
reporting requirements including those requiring the Company, as the ultimate
parent company, to file information relating to its capital structure,
ownership, and financial condition and general business operations of its
insurance subsidiaries. The Holding Company Acts contain special reporting and
prior approval requirements with respect to transactions among affiliates. The
Alabama Holding Company Act is generally the most significant to the Company
since it governs the Company's relationship with Vesta Fire, the Company's
principal insurance subsidiary.
During 1998, the Alabama Department of Insurance completed its examination
of Vesta Fire's December 31, 1997 Annual Statement. The examination resulted
in certain adjustments to the as-filed Annual Statement. The adjustments
reduced the previously reported 1997 capital and surplus of $355.3 million to
$100.8 million. The Alabama Department did not require the Company to refile
Vesta Fire's 1997 Annual Statement. The examination changes have been taken
into account in preparation of Vesta Fire's 1998 Annual Statement. Using the
basis of accounting established in the examination, Vesta Fire's 1998
statutory capital and surplus was $217.3 million after giving effect in 1998
to $125.8 million of adjustments arising from the 1997 examination. The
Alabama Department of Insurance is currently performing a follow-up target
examination on selected financial information. Management does not expect that
any adjustment that may result from the target examination to have a material
impact on the Company's financial position, results of operations or cash
flows.
On February 11, 1999, the Connecticut Department of Insurance informed the
Company that it intended to restrict the Vesta Fire's Certificate of
Authority. Management of the Company is engaged in discussions with the
Connecticut Department of Insurance to reach a mutual agreement on the scope
and extent of the restriction, should it be formally imposed. If this
Certificate of Authority is fully
16
restricted, Vesta Fire will no longer be able to write new policies of
insurance in the State of Connecticut.
On March 3, 1999, the North Carolina Department of Insurance unilaterally
restricted the Vesta Fire's and its insurance subsidiaries (the Group)
Certificates of Authority, which restriction effectively prohibited the Group
from writing new policies of insurance in the State of North Carolina.
Following meetings with management of the Company and submission of additional
data the North Carolina Department of Insurance agreed to temporarily defer
the effectiveness of these restrictions pending their review of the additional
data submitted by the Company. The Group is engaged in ongoing discussions
with the North Carolina Department of Insurance to reach an agreement on the
scope and extent of any restrictions, if any, which will be finally imposed on
the Group's Certificates of Authority. If the restriction originally imposed
is reinstated, the Group will no longer be able to write new policies of
insurance in the State of North Carolina.
The federal government does not directly regulate the insurance business.
However, federal legislation and administrative policies in several areas,
including pension regulation, age and sex discrimination, financial services
regulation and federal taxation, do affect the insurance business. Recently, a
number of state legislatures have considered or have enacted legislative
proposals that alter, and in many cases increase, the authority of state
agencies to regulate insurance companies and holding company systems. In
addition, legislation has been introduced from time to time in recent years
which, if enacted, could result in the federal government assuming a more
direct role in the regulation of the insurance industry.
In 1998, the NAIC adopted the Codification of Statutory Accounting
Principles guidance which will replace the current NAIC Annual Statement
Instructions and Accounting Practices and Procedures manual as the NAIC's
primary guidance on statutory accounting. The Codification provides guidance
for areas where statutory accounting has been silent and changes current
statutory accounting in some areas. The implementation date established by the
NAIC is January 1, 2001; however, the effective date will be specified by each
insurance company's state of domicile. The Company is currently evaluating the
potential effect of the Codification guidance, but does not expect it to have
a material impact on the Company's statutory surplus.
State insurance regulators and the NAIC periodically re-examine existing
laws and regulations and their application to insurance companies. In recent
years, the NAIC has approved, the recommended to the states for adoption and
implementation, several regulatory initiatives designed to decrease the risk
of insolvency of insurance companies. These initiatives include risk based
capital ("RBC")
requirements for determining the levels of capital and surplus an insurer must
maintain in relation to its insurance and investment risks. Other NAIC
regulatory initiatives impose restrictions on an insurance company's ability
to pay dividends to its stockholders. These initiatives may be adopted by the
various states in which the Company's subsidiaries are licensed; the ultimate
content and timing of any statutes and regulations adopted by the states
cannot be determined at this time. It is not possible to predict the future
impact of changing state and federal regulation on the Company's operations,
and there can be no assurance that existing insurance related laws and
regulations will not become more restrictive in the future or that laws and
regulations enacted in the future will not be more restrictive.
The NAIC's RBC requirements are intended to be used as an early warning tool
to help insurance regulators identify deteriorating or weakly capitalized
companies in order to initiate regulatory action. Such requirements are not
intended as a mechanism for ranking adequately capitalized companies. The
formula defines a new minimum capital standard which supplements the low,
fixed minimum capital and surplus requirements previously implemented on a
state-by-state basis.
The NAIC adopted risk-based capital requirements that require insurance
companies to calculate and report information under a risk-based formula which
attempts to measure statutory capital and surplus needs based on the risks in
a company's mix of products and investment portfolio. The formula
17
is designed to allow state insurance regulators to identify potential weakly
capitalized companies. Under the formula, a company determines its "risk-based
capital" ("RBC") by taking into account certain risks related to the insurer's
assets (including risks related to its investment portfolio and ceded
reinsurance) and the insurer's liabilities (including underwriting risks
related to the nature and experience of its insurance business). Risk-based
capital rules provide for different levels of regulatory attention depending
on the ratio of a company's total adjusted capital to its "authorized control
level" ("ACL") of RBC.
At December 31, 1998 the total RBC as a percentage of authorized control
level were as follows for the Company's insurance subsidiaries:
Vesta Fire Insurance Corporation...................................... 275%
The Hawaiian Insurance & Guaranty Company, Limited.................... 9900%
Shelby Casualty Insurance Company..................................... 2663%
The Shelby Insurance Company.......................................... 6221%
Insura Property and Casualty Company.................................. 2591%
Affirmative Insurance Company......................................... 17029%
Sheffield Insurance Corporation....................................... 2225%
Vesta Insurance Corporation........................................... 4988%
Vesta County Mutual Insurance Company................................. 844%
Vesta Lloyds Insurance Company........................................ 9643%
Restrictions on Dividends to Stockholders. The Company's insurance
subsidiaries are subject to various state statutory and regulatory
restrictions, generally applicable to each insurance company in its state of
incorporation, which limit the amount of dividends or distributions by an
insurance company to its stockholders. The restrictions are generally based on
certain levels of surplus, investment income and operating income, as
determined under statutory accounting practices. Alabama, Ohio, Indiana and
Texas law permits dividends in any year which, together with other dividends
or distributions made within the preceding 12 months, do not exceed the
greater of (i) 10% of statutory surplus as of the end of the preceding year or
(ii) the net income for the preceding year, with larger dividends payable only
after receipt of prior regulatory approval. Hawaii law limits dividends to the
lesser of (i) and (ii) without prior approval. Certain other extraordinary
transactions between an insurance company and its affiliates, also are subject
to prior approval by the Department of Insurance. Future dividends from the
Company's subsidiaries may be limited by business and regulatory
considerations. In 1998 Vesta Fire voluntarily agreed that it will not pay any
dividends to the Company, except those required to service certain
indebtedness of the Company, until December 31, 1999, without the prior
written approval of the Alabama Department of Insurance. See Note D of the
Notes to the Consolidated Financial Statements.
Insurance Regulation Concerning Change or Acquisition of Control. Certain
subsidiaries of the Company are domestic property and casualty insurance
companies organized under the insurance codes of Alabama, Ohio, Indiana,
Hawaii and Texas (the "Insurance Codes"). The Insurance Codes contain a
provision to the effect that the acquisition or change of "control" of a
domestic insurer or of any person that controls a domestic insurer cannot be
consummated without the prior approval of the relevant insurance regulatory
authority. A person seeking to acquire control, directly or indirectly, of a
domestic insurance company or of any person controlling a domestic insurance
company must generally file with the relevant insurance regulatory authority
an application for change of control (commonly known as a "Form A") containing
certain information required by statute and published regulations and provide
a copy of such Form A to the domestic insurer. In Alabama, control is presumed
to exist if any person, directly or indirectly, owns, controls, holds with the
power to vote or holds proxies representing 5% or more of the voting
securities of any other person. In Texas and Hawaii, control is presumed to
exist if any person, directly or indirectly, or with members of the person's
immediate family, owns, controls, or holds with the power to vote, or if any
person other than
18
a corporate officer or director of a person holds proxies representing, 10% or
more of the voting securities of any other person.
In addition, many state insurance regulatory laws contain provisions that
require pre-notification to state agencies of a change in control of a non-
domestic admitted insurance company in that state. While such prenotification
statutes do not authorize the state agency to disapprove the change of
control, such statutes do authorize issuance of a cease and desist order with
respect to the non-domestic admitted insurer if certain conditions exist, such
as undue market concentration.
Any future transactions that would constitute a change in control of the
Company would also generally require prior approval by the Insurance
Departments of Alabama, Ohio, Indiana, Hawaii and Texas and would require
preacquisition notification in those states which have adopted preacquisition
notification provisions and wherein the insurers are admitted to transact
business. Such requirements may deter, delay or prevent certain transactions
affecting the control of the Company or the ownership of the Company's common
stock, including transactions that could be advantageous to the stockholders
of the Company.
Membership in Insolvency Funds and Associations; Mandatory Pools. Most
states require property and casualty insurers to become members of insolvency
funds or associations which generally protect policyholders against the
insolvency of an insurer writing insurance in the state. Members of the fund
or association must contribute to the payment of certain claims made against
insolvent insurers. Maximum contributions required by law in any one year vary
between 1% and 2% of annual premiums written by a member in that state.
The Company is also required to participate in various mandatory insurance
facilities or in funding mandatory pools, which are generally designed to
provide insurance coverage for consumers who are unable to obtain insurance in
the voluntary insurance market. Among the pools in which the Company
participates are those established in coastal states to provide windstorm and
other similar types of property coverage. These pools typically require all
companies writing property insurance in the state for which the pool has been
established to fund deficiencies experienced by the pool based upon each
company's relative premium writings in that state, with any excess funding
typically distributed to the participating companies on the same basis. To the
extent that these assessments are not covered by the Company's reinsurance
treaties, they may have an adverse effect on the Company.
Total assessments from insolvency funds, associations and mandatory pools
were $.5 million, $.3 million and $2.9 million for 1996, 1997 and 1998,
respectively. Some of these payments are recoverable through future policy
surcharges and premium tax reductions.
Various states in which the Company is doing business have established
certain shared market facilities with respect to the coverage of windstorm and
hurricane losses in the state. The Company is subject to assessments under
these facilities up to certain prescribed limits (which are generally based on
its share of the property insurance market in the state) if funds in the state
facility are inadequate to pay such losses on insured risks. The Company
believes that such assessments generally would be treated as a catastrophic
loss under the Company's catastrophe reinsurance programs.
During the past several years, various regulatory and legislative bodies
have adopted or proposed new laws or regulations to deal with the cyclical
nature of the insurance industry, catastrophic events and insurance capacity
and pricing. These regulations include (i) the creation of "markets assistance
plans" under which insurers are induced to provide certain coverages, (ii)
restrictions on the ability of insurers to cancel certain policies in mid-
term, (iii) advance notice requirements or limitations imposed for certain
policy non-renewals and (iv) limitations upon or decreases in rates permitted
to be charged.
Effect of Federal Legislation. Although the federal government does not
directly regulate the business of insurance, federal initiatives often affect
the insurance business in a variety of ways.
19
Current and proposed federal measures which may significantly affect the
insurance business include federal government participation in asbestos and
other product liability claims, pension regulation (ERISA), examination of the
taxation of insurers and reinsurers, minimum levels of liability insurance and
automobile safety regulations.
NAIC-IRIS Ratios. The NAIC has developed its Insurance Regulatory
Information System ("IRIS") to assist state insurance departments in
identifying significant changes in the operations of an insurance company,
such as changes in its product mix, large reinsurance transactions, increases
or decreases in premiums received and certain other changes in operations.
Such changes may not result from any problems with an insurance company but
merely indicate changes in certain ratios outside ranges defined as normal by
the NAIC. When an insurance company has four or more ratios falling outside
"normal ranges," state regulators may investigate to determine the reasons for
the variance and whether corrective action is warranted. In 1996, Vesta Fire
had no ratios which varied unfavorably from the "usual value" range. In 1997,
Vesta Fire's IRIS ratios may be negatively impacted by the one-time statutory
charge. In 1998, Vesta Fire had 6 ratios which varied unfavorably from the
"usual value" range. The unfavorable ratios were primarily due to 1998
operating results and the Company's overall reserve strengthening during the
year.
A.M. Best Rating
A.M. Best, which rates insurance companies based on factors of concern to
policyholders, recently lowered its rating on the Company's insurance
subsidiaries to "B++" (Very Good, its fifth highest rating category) from "A-"
(Excellent, its fourth highest rating category). Some of the factors noted by
A.M. Best as contributing to the downgrade include the Company's operating
performance, which was affected in part by heavy catastrophe losses, the
Company's debt level, and the uncertainty associated with the Company's then
ongoing negotiations with its lenders to amend its credit agreement in light
of then existing covenant defaults. See, Managements Discussion and Analysis--
Liquidity. The Company does not believe the downgrade will have a material
impact on its personal lines. The Company has determined that the impact of
the A.M. Best downgrade on the commercial line of business will necessitate
corrective actions in excess of what the marketplace will accept. Therefore,
the Company will withdraw from certain commercial lines of business in the
second quarter of 1999. The Company has also determined that the impact of the
downgrade on the reinsurance segment has significantly impaired the Company's
ability to compete effectively in the current reinsurance marketplace.
Therefore, effective March 24, 1999 the Company transferred a significant
portion of its reinsurance operations to another reinsurer in exchange for $15
million.
Competition
The property and casualty insurance industry is highly competitive on the
basis of both price and service. The Company competes for direct business with
other stock companies, specialty insurance organizations, mutual insurance
companies and other underwriting organizations, some of which are
substantially larger and have greater financial resources than the Company. In
recent years there has been a trend in the property and casualty industry
toward consolidation which could result in even more competitive pricing. The
Company also faces competition from foreign insurance companies and from
"captive" insurance companies and "risk retention" groups (i.e., those
established by insureds to provide insurance for themselves.) In the future,
the industry, including the Company, may face increasing insurance
underwriting competition from banks and other financial institutions.
The property and casualty reinsurance business is also highly competitive.
Competition in the types of reinsurance in which the Company is engaged is
based on many factors, including the perceived overall financial strength of
the reinsurer, premiums charged, contract terms and conditions, services
offered, speed of claims payment, reputation and experience. Competitors
include independent reinsurance companies, subsidiaries or affiliates of
established domestic or worldwide
20
insurance companies, reinsurance departments of certain primary insurance
companies and underwriting syndicates.
Relationship with Torchmark
Prior to the initial public offering of its common stock in November 1993,
the Company was a wholly owned subsidiary of Torchmark. As of December 31,
1998, Torchmark owned approximately 23.9% of the issued and outstanding common
stock of the Company. Prior to its initial public offering, the Company
entered into several agreements with Torchmark and certain of its subsidiaries
regarding the future relationship of the Company and Torchmark. Among these
are a lease agreement, pursuant to which the Company leases its headquarters
building, and an investment services agreement, pursuant to which the Company
receives investment advice and services in connection with the management of
the Company's investment portfolio. Prior to May of 1995, the Company marketed
lower value personal dwelling insurance in six states through agents of
Liberty National Life Insurance Company (LNF), pursuant to a written marketing
agreement between the Company and LNL. However, LNL terminated this agreement
in 1995 and will no longer market these products through its agents.
Employees
As of December 31, 1998, the Company employed 655 persons. The Company's
employees are neither represented by labor unions nor are they subject to any
collective bargaining agreements. Management knows of no current efforts to
establish labor unions or collective bargaining agreements.
Item 2. Properties
The Company leases approximately 111,099 square feet for its home office at
3760 River Run Drive, Birmingham, Alabama under a long-term operating lease
from Torchmark Development Corporation, a wholly owned subsidiary of Torchmark
Corporation. The Company considers the office facilities to be suitable and
adequate for its current level of operations.
HIG leases approximately 8,140 square feet for its operations at 1001 Bishop
Street Pacific Tower, Honolulu, Hawaii under a long-term operating lease. The
Company considers the office facilities to be suitable and adequate for HIG's
current and anticipated level of operations.
The Company owns an office building with approximately 175,000 square feet
located at 175 Mansfield Avenue, Shelby, Ohio for its Shelby operations.
Item 3. Legal Proceedings
Subsequent to the filing of its quarterly report on Form 10-Q for the period
ended March 31, 1998 with the Securities and Exchange Commission, the Company
became aware of certain accounting irregularities consisting of inappropriate
reductions of reserves and overstatements of premium income in the Company's
reinsurance business that had been recorded in the fourth quarter of 1997 and
the first quarter of 1998. The Company promptly commenced an internal
investigation to determine the exact scope and amount of such reductions and
overstatements. This investigation concluded that inappropriate amounts had,
in fact, been recorded and the Company determined it should restate its
previously issued 1997 financial statements and first quarter 1998 Form 10-Q.
Additionally, during its internal investigation the Company re-evaluated the
accounting methodology being utilized to recognize earned premium income in
its reinsurance business. The Company had historically reported certain
assumed reinsurance premiums as earned in the year in which the related
reinsurance contracts were entered even though the terms of those contracts
frequently bridged two years. The Company determined that reinsurance premiums
should be recognized as earned over the contract period and corrected the
error in its accounting methodology by restating previously issued financial
21
statements. The Company issued press releases, which were filed with the
Securities and Exchange Commission, on June 1, 1998 and June 29, 1998
announcing its intention to restate its historical financial statements.
The Company restated its previously issued financial statements for 1995,
1996 and 1997 and its first quarter 1998 Form 10-Q for the above item by
issuance of a current report on Form 8-K dated August 19, 1998. These
restatements resulted in a cumulative decrease to stockholder' equity of $75.2
million through March 31, 1998.
Commencing in June, 1998, the Company and several of its current and former
officers and directors were named in several purported class action lawsuits
in the United States District Court for the Northern District of Alabama and
in one purported class action lawsuit in the Circuit Court of Jefferson
County, Alabama. Several of Vesta's officers and directors also have been
named in a derivative action lawsuit in the Circuit Court of Jefferson County,
Alabama, in which Vesta is a nominal defendant.
The class action lawsuit filed in the Circuit Court of Jefferson County,
Alabama has been dismissed and the derivative case has been placed on the
administrative docket. The class actions filed in the United States District
Court for the Northern District of Alabama have been consolidated into a
single action in that district. The purported class representatives in that
action have filed (a) a consolidated amended complaint alleging that the
defendants violated the federal securities laws and (b) a motion for class
certification. The consolidated amended complaint also added as defendants
Torchmark Corporation and the Company's predecessor auditors, KPMG Peat
Marwick, LLP. The time for the defendants to respond to the complaint and the
motion for class certification has not yet run. The consolidated amended
complaint alleges various violations of the federal securities law and seeks
unspecified but potentially significant damages.
The Company has notified its directors and officers liability insurance
companies of these lawsuits and the consolidated amended compliant. The
litigation is still in the preliminary stages and there has been no discovery
or class certification. The Company intends to vigorously to defend this
litigation and intends to explore all available rights and remedies it may
have under the circumstances. In related litigation, in September, 1998,
Cincinnati Insurance Company ("Cincinnati"), one of the Company's directors
and officers liability insurance carriers, filed a lawsuit in the United
States District Court for the Northern District of Alabama seeking to avoid
coverage under its directors and officers liability and other policies. The
Company filed a motion to dismiss Cincinnati's complaint on jurisdictional
grounds in federal court (which was granted), and filed a lawsuit against
Cincinnati in the Circuit Court of Jefferson County, Alabama seeking damages
arising out of Cincinnati's actions. Cincinnati has filed an answer and
counterclaim in that case again seeking to avoid coverage. The Company intends
to vigorously resist Cincinnati's efforts to avoid coverage. Because these
matters are in their early stages, their ultimate outcome cannot be
determined. Accordingly, no provision for any liability that may result
therefrom has been made in the accompanying consolidated financial statements.
As discussed above, the Company corrected its accounting for assumed
reinsurance business through restatement of its previously issued financial
statements. Similar corrections were made on a statutory accounting basis
through recording cumulative adjustments in Vesta Fire's 1997 statutory
financial statements. The impact of this correction has been reflected in
amounts ceded under the Company's 20 percent whole account quota share treaty
which was terminated on June 30, 1998 on a run-off basis. The Company believes
such treatment is appropriate under the terms of this treaty and has
calculated the quarterly reinsurance billings presented to the treaty
participants accordingly. The aggregate amount included herein as recoverable
from such reinsurers totalled $60.4 million at December 31, 1998. Two of the
three participants have notified the Company that they wish to audit the
treaty computations as allowed by the terms of the treaty. The other
participant, through various correspondence, has also expressed an interest in
obtaining additional data. While management believes its interpretation of the
treaty's terms and computations based thereon, are correct, the effects, if
any, of participant audits or other actions cannot be determined at this time.
22
The Company, through its subsidiaries, is routinely a party to pending or
threatened legal proceedings and arbitrations. These proceedings involve
alleged breaches of contract, torts, including bad faith and fraud claims and
miscellaneous other causes of action. These lawsuits may include claims for
punitive damages in addition to other specified relief. Based upon information
presently available, and in light of legal and other defenses available to the
Company and its subsidiaries, management does not consider liability from any
threatened or pending litigation or arbitration to be material.
Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matter
(a) Market Information
Since November 11, 1993, the Common Stock has been traded on the New York
Stock Exchange under the symbol "VTA". Prior to November 11, 1993, there was
no established public trading market for the Common Stock. The stock began
trading on November 11, 1993, at $16.67 per share.
Quarterly high and low market prices of the Company's common stock in 1997
were as follows:
Quarter Ended High Low
------------- ------ ------
March 31.................................................... $41.50 $30.88
June 30..................................................... 49.00 32.75
September 30................................................ 59.00 43.63
December 31................................................. 64.50 54.88
Quarterly high and low market prices of the Company's common stock in 1998
were as follows:
Quarter Ended High Low
------------- ------ ------
March 31.................................................... $64.75 $52.13
June 30..................................................... 59.00 20.00
September 30................................................ 22.13 6.75
December 31................................................. 9.88 5.00
(b) Number of Holders of Common Stock
There were 178 shareholders of record on January 15, 1999 including
shareholder accounts held in nominee form.
(c) Dividend History and Restrictions
The declaration and payment of dividends will be at the discretion of the
Company's Board of Directors and will depend upon many factors, including the
Company's financial condition and earnings, the capital requirements of the
Company's operating subsidiaries, legal requirements and regulatory
constraints. The Company has agreed not to pay dividends to its common
stockholders until it satisfies certain financial commitment to its commercial
lenders. See Management Discussion and Analysis--Liquidity Section.
The dividends paid by the Company on its common stock for the past two years
were as follows (in thousands):
Quarter 1997 1998
------- ---- ----
First............................. $697 $691
Second............................ 697 687
Third............................. 701 695
Fourth............................ 702 697
Alabama imposes restrictions on the payment of dividends to the Company by
the Company's insurance subsidiary in excess of certain amounts without prior
regulatory approval (see the "Restrictions on Dividends to Stockholders"
section in Item 1).
23
Item 6. Selected Financial Data
The following information should be read in conjunction with the Company's
Consolidated Financial Statements and related notes reported elsewhere in this
Form 10-K.
(Amounts in Thousands Except Per Share and Percentage Data)
Year Ended December 31,
------------------------------------------------------
1994 1995 1996 1997 1998
-------- -------- -------- ------------- ----------
(restated)(4)
Statement of Operations
Data*
Gross Premiums Written. $327,106 $518,059 $651,771 $ 866,051 759,021
Net Premiums Written... 232,110 390,504 468,056 526,475 491,590
Net Premiums Earned.... 232,352 313,078 439,336 517,658 509,693
Net Investment Income.. 12,999 17,972 23,148 35,960 35,058
Investment Gains
(Losses).............. (695) 276 32 3,283 3,272
Other.................. 100 216 188 2,094 5,473
-------- -------- -------- ---------- ----------
Total Revenues......... 244,756 331,542 462,704 558,995 553,496
-------- -------- -------- ---------- ----------
Losses and LAE
Incurred.............. 134,557 198,962 251,783 298,638 395,322
Policy Acquisition and
Other Underwriting
Expenses.............. 82,264 93,983 145,703 180,464 255,994
Loss on Asset
Impairment............ -- -- -- -- 74,496
Amortization of
Goodwill.............. -- 264 484 4,007 6,609
Interest Expense....... 1,708 5,273 10,059 10,859 14,054
-------- -------- -------- ---------- ----------
Total Losses and
Expenses.............. 218,529 298,482 408,029 493,968 746,475
-------- -------- -------- ---------- ----------
Income (Loss) From
Operations Before
Income Tax............ 26,227 33,060 54,675 65,027 (192,979)
Income Taxes (benefit). 7,352 10,468 17,862 23,116 (57,244)
Deferrable capital
securities interest,
net of income tax..... -- -- -- 5,051 5,449
-------- -------- -------- ---------- ----------
Net income (loss)...... $ 18,875 $ 22,592 $ 36,813 $ 36,860 $ (141,184)
Basic Earnings Per
Share (2)(3).......... $ 1.00 $ 1.20 $ 1.95 $ 1.98 $ (7.61)
Shares used in per
share calculation
(2)(3)................ 18,812 18,842 18,860 18,600 18,548
Diluted Earnings Per
Share continuing
operations (2)(3)..... $ 1.00 $ 1.19 $ 1.92 $ 1.93 $ (7.61)
Shares used in per
share calculation
(2)(3)................ 18,834 18,970 19,157 19,053 18,548
Cash dividends per
share................. .15 .13 .20 .15 .15
Balance Sheet Data (at
end of period)
Total Investments and
Cash.................. $300,186 $422,516 $427,276 $ 656,816 $ 634,668
Total Assets........... 479,325 735,758 871,385 1,636,859 1,347,702
Reserves For Losses and
LAE................... 110,297 168,502 173,275 596,797 504,911
Long Term Debt......... 28,000 98,163 98,279 98,602 98,302
Total Liabilities...... 258,703 488,499 599,466 1,239,523 1,089,675
Deferrable Capital
Securities............ -- -- -- 100,000 100,000
Stockholders' Equity... 220,622 247,259 271,919 297,336 158,027
Certain Financial Ratios
and Other Data
GAAP
Loss and LAE Ratio..... 57.9% 63.6% 57.3% 57.7% 77.6%
Underwriting Expense
Ratio................. 35.4 30.0 33.2 34.9 50.2
-------- -------- -------- ---------- ----------
Combined Ratio......... 93.3% 93.6% 90.5% 92.6% 127.8%
======== ======== ======== ========== ==========
SAP (1)
Loss and LAE Ratio..... 54.0% 57.2% 57.9% 65.6% 90.4%
Underwriting Expense
Ratio................. 35.4 33.4 31.8 51.7 42.1
-------- -------- -------- ---------- ----------
Combined Ratio......... 89.4% 90.6% 89.7% 117.3% 132.5%
======== ======== ======== ========== ==========
Net Premiums Written to
Surplus Ratio......... 1.18x 1.44x 1.53x 1.49x 2.81x
Surplus................ $212,507 $318,997 $352,695 $317,875 $ 220,210
- --------
* As a result of an internal investigation begun in the second quarter of
1998, the Company determined that certain inappropriate reductions of
reserves and overstatements of premium income in the Company's reinsurance
business had been recorded in the fourth quarter of 1997 and the first
quarter of 1998. Based on the information discovered in that investigation,
the Company has restated its previously issued financial statements in
August 1998 to make the necessary
24
corrections. In addition, the Company has revised its statutory accounting
for its assumed reinsurance business to reflect only accident/calendar year
information. Effective with its year end 1997 statutory filings, the
adjustments reversed, in the form of a one-time charge, the cumulative
effect of the Company's prior practice of making estimates for reinsurance
assumed on a combined underwriting and accident year basis, the accounting
practice consistently applied over prior years. On a GAAP basis, the
correction was accounted for by restating prior financial statements.
(1) Statutory data have been derived from the financial statements of the
Company prepared in accordance with SAP and filed with insurance
regulatory authorities.
(2) Restated for 3-for-2 stock split paid on January 22, 1996.
(3) Effective as of December 31, 1997, the Company adopted FASB 128. The prior
periods have been restated. See Note R of Notes to Consolidated Financial
Statements.
(4) The Company determined, subsequent to the issuance of the 1997 financial
statements, that a specific reinsurance ceded contract entered into in
1997 contains retroactive elements as defined in FAS 113. The Company
erroneously recorded the initial gain on this contract in 1997 and must
adjust its previously issued financial statements to appropriately defer
and recognize such gain. See Note B for further discussion.
25
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Overview
The Company writes treaty reinsurance and primary insurance on selected
personal and commercial lines risks. In its reinsurance operations, the
Company focuses principally on property coverages, for which ultimate losses
generally can be more promptly determined than on casualty risks. In the past,
the Company's primary operations have emphasized writing property coverages
more than liability. With the addition of the liability portions of the Shelby
automobile lines, the Company's writings are also now more evenly balanced
between property and liability exposures. The Company's revenues from
operations are derived primarily from net premiums earned on risks written or
reinsured by the Company, investment income and investment gains or losses,
while expenses consist primarily of payments for claims losses and
underwriting expenses, including agents' commissions and operating expenses.
Significant factors influencing results of operations include the supply and
demand for property and casualty insurance and reinsurance, as well as the
number and magnitude of catastrophic losses such as hurricanes, windstorms,
fires and severely cold weather. Premium rate levels are affected by the
availability of insurance coverage which is influenced by levels of surplus in
the industry and other factors. Increases in surplus have generally been
accompanied by increased price competition among property and casualty
insurers. Pricing in this business has weakened due to increased reinsurance
market capacity.
For its assumed reinsurance business, the Company had historically made
estimates for its reinsurance reports received subsequent to a period end on a
combined underwriting and accident year basis for both statutory and GAAP
purposes. As a result of a routine examination by the Alabama Department of
Insurance, the Company agreed to revise the accounting for its reinsurance
business for statutory purposes. Effective with its year end 1997 statutory
filings, Vesta Fire revised its statutory accounting for its assumed
reinsurance business to reflect only accident/calendar year information. The
adjustments essentially reversed, in the form of a one-time charge, the
cumulative effect of the accounting practice consistently applied over prior
years. On a GAAP basis, the correction was accounted for by restating prior
financial statements.
The Company determined, subsequent to the issuance of the 1997 financial
statements, that a specific reinsurance ceded contract entered into in 1997
contains retroactive elements as defined in Financial Accounting Standards
Board ("FASB") Statement 113. The Company erroneously recorded a gain on this
contract in the fourth quarter of 1997 and must adjust its previously issued
financial statements to appropriately defer and recognize such gain in future
periods. See Note B of the consolidated financial statements for further
discussion.
The Company seeks to manage its risk exposure by adjusting the mix and
volume of business written in response to changes in price, maintaining
extensive reinsurance and retrocessional programs and applying the Company's
knowledge of primary insurance markets to its reinsurance business.
The Company has historically followed a practice of maintaining low
retentions in its primary and reinsurance business to reduce the variability
of its earnings. The Company's loss reserve levels historically have remained
relatively stable from year to year despite changes in premium volume. The
Company is continuing to cede portions of insurance risks while using its
capital base to gradually increase, on a selective basis, its retention of
certain property risks.
Because catastrophe loss events are by their nature unpredictable,
historical results of operations may not be indicative of expected results of
future operations. The Company markets its primary personal insurance products
throughout the United States. While the Company seeks to reduce its exposure
to catastrophic events through the purchase of reinsurance, the occurrence of
one or more major catastrophes in any given period could have a material
adverse impact on the Company's results of operations and financial condition
and could result in substantial outflows of cash as losses are paid. In
addition, the increased underwritings of catastrophe
26
related reinsurance, and potential residual market assessments may also lead
to increased variability in the Company's loss ratio.
Prior to the Shelby and Vesta County Mutual acquisitions, assumed
reinsurance was the dominant line of business, representing 78 percent of 1996
net premiums. As a result of these acquisitions, assumed reinsurance
represented 62 percent of 1997 gross premiums. In 1998, assumed reinsurance
represented 38 percent of 1998 gross premiums. This shift to increase primary
writing is consistent with the Company's strategy to focus on property
coverages in all of its lines of business while adjusting the mix and volume
of its writings and retentions to respond to change in market conditions.
On December 31, 1996 the Company terminated the 75% pro rata reinsurance
contract on its homeowners and dwelling lines of business (excluding HIG)
produced through independent agents and also on its homeowners and dwelling
lines of business in the financial services business. The cancellation enabled
the Company to increase its net writings in the personal lines of business.
In July of 1996, Vesta Fire entered into a pro rata reinsurance facility
covering substantially all primary and assumed business in order to provide
capital flexibility to take advantage of growth opportunities in the future.
This reinsurance facility had the effect of reducing net premiums written in
the second half of 1996 by $98.0 million. In 1997, the reinsurance facility
had the effect of reducing net written premiums by $155.1 million, including
reducing Shelby net written premiums by $37.5 million. In 1998, the
reinsurance facility had the effect of reducing net premiums written by $70.2
million. Effective July 1, 1998, the reinsurance facility was cancelled on a
run-off basis.
Comparison of Fiscal Year 1998 to Fiscal Year 1997
Premiums, Loss and LAE--Reinsurance
Gross premiums written for reinsurance decreased by $247.8 million, or
46.3%, to $287.6 million for the year ended December 31, 1998, from $535.4
million for the year ended December 31, 1997. The main contributors to the
reduction of reinsurance gross premiums written were the continuation of
increased competition in the market place coupled with the Company's
unwillingness to follow the market price, the modification of one large treaty
and the cancellation of another large treaty. The acquisition of Vesta County
Mutual resulted in the further shift of $27 million of private passenger
automobile writings which had been recorded on the reinsurance line in 1997 to
personal lines in 1998. Net premiums written for reinsurance decreased $194.1
million, or 55.2%, to $157.7 million for the year ended December 31, 1998,
from $351.8 million for the year ended December 31, 1997. Net premiums earned
for reinsurance decreased $141.1 million, or 42.1% to $194.3 million for the
year ended December 31, 1998, from $335.4 million for the year ended December
31, 1997.
Loss and LAE for reinsurance decreased by $3.8 million, or 2.1% to $175.7
million for the year ended December 31, 1998, from $179.5 for the year ended
December 31, 1997. The dollar amount of loss and loss adjustment expenses
incurred decreased during 1998 due to the decline in net premiums earned. The
loss and LAE ratio for reinsurance for the year ended December 31, 1998 was
90.5% as compared to 53.5% for the year ended December 31, 1997. The increase
in the loss ratio was primarily attributable to the decreases in earned
premiums due to pricing pressures and market competition, higher ceded
reinsurance costs in 1998 versus 1997 and an increase of $18.7 million in
catastrophe losses.
Given current market conditions in the reinsurance arena the Company
anticipates that the recent change in its A.M. Best rating to B++ will have a
negative impact on its reinsurance operations. Although the company enjoys an
excellent relationship with its reinsurance customers the potential for growth
in its reinsurance portfolio has been hampered by the recent change in rating.
The Company has determined that the A.M. Best downgrade and the increased
competition in the reinsurance
27
marketplace will cause a significant loss of reinsurance premiums in 1999.
Therefore, the Company has entered into an agreement to sell a significant
portion of its reinsurance book of business. See the Business Strategy section
and Note T of the Notes to the Consolidated Financial Statements for further
discussion.
Included in the reinsurance results for 1998, were two large 100% Quota
share reinsurance treaties for CIGNA and Homeplus which cover selected
homeowners lines. As the covered business is renewed it will be transferred to
Vesta Fire as the issuing carrier. These treaties were not included in the
sale of the reinsurance book of business. In 1998, these treaties accounted
for $107.4 million in gross written premiums.
Premiums, Loss and LAE--Personal lines
Gross premiums written for personal lines increased by $102.3 million, or
41.8%, to $347.0 million for the year ended December 31, 1998, from $244.7
million for the year ended December 31, 1997. Included in the $102.3 increase
in gross premiums written for person