Item 1. BUSINESS.
Company Strategy
Acceptance underwrites and sells specialty property and casualty insurance coverages that serve niche markets or programs. The Company selects niche markets or programs for which the Company believes that its expertise affords it a competitive advantage and which integrate into a diversified-risk portfolio of coverages. The Company, through diversifying the risks insured, seeks to avoid concentration in particular risks so that, during years when particular lines of business are experiencing adverse operating results, overall operating results will remain within targeted returns to shareholders. The Company's goal is to achieve underwriting results better than the industry average, while managing its investment portfolio to maximize after-tax yield and at the same time emphasize stability and capital preservation and maintaining adequate liquidity to meet all cash needs.
The Company believes that its success in niche markets and programs requires that it be opportunistic. The Company believes its position as both an admitted (licensed) and non- admitted (excess and surplus lines) carrier provides the versatility to respond when different market conditions and opportunities are presented. At the same time, the Company manages loss exposure by diversifying its portfolio of coverages and maintaining reinsurance programs with the goal of reducing volatility as well as mitigating catastrophic or large loss exposure.
The Company has experienced significant revenue growth over the last five years through growth in existing programs and through acquisition of insurance operations or books of business. The Company regularly explores new opportunities where it has or can acquire experienced underwriters and other managers with a long and successful operating history in a particular line of business.
Organization
The Company underwrites its insurance products through six wholly-owned insurance company subsidiaries; Acceptance Insurance Company ("Acceptance Insurance"), Acceptance Indemnity Insurance Company ("Acceptance Indemnity"), Acceptance Casualty Insurance Company ("Acceptance Casualty"), American Growers Insurance Company ("American Growers"), Redland Insurance Company ("Redland"), and Phoenix Indemnity Insurance Company ("Phoenix Indemnity") (collectively referred to herein as the "Insurance Companies").
Collectively, the Insurance Companies are admitted in 46 states and the District of Columbia, and operate on a non- admitted basis in 46 states, the District of Columbia, Puerto Rico and the Virgin Islands. Two of the Insurance Companies have received their Certificate of Authority ("T" listing) from the U.S. Department of Treasury. Each of the Insurance Companies is rated A- (Excellent) by A.M. Best, with the exception of American Growers to which the A.M. Best rating system does not apply. A.M. Best bases its ratings upon factors that concern policyholders and agents, and not upon factors concerning investor protection.
The Company's insurance agency and insurance service subsidiaries principally write and service insurance coverages placed with one of the Insurance Companies.
Business Divisions
The Company has organized its insurance underwriting and marketing business by product line into four divisions, General Agency, Crop Insurance, Program Insurance and Non- Standard Automobile.
General Agency
Specialty insurance coverages written by the General Agency Division include the following principal lines:
Specialty Automobile, including liability and physical damage coverages for local haulers of specialized freight, and other classes of motor vehicles not normally underwritten by standard carriers.
Excess and Surplus Lines Liability and Substandard Property Coverages, including general liability, garage excess liability, liquor liability, property and commercial multi-peril coverages for small businesses which normally do not satisfy the underwriting criteria of standard carriers.
Complex General Liability Risks, including products and professional liability.
Crop Insurance
The principal lines of the Company's Crop insurance division are MPCI and crop hail insurance. MPCI is a federally- subsidized farm price support program designed to encourage farmers to share, through premium payments, in the federal government's price support programs. MPCI provides farmers with yield coverage for crop damage from substantially all natural perils. CRC is an extension of the MPCI program which provides farmers with protection from revenue loss caused by changes in crop prices, low yields, or a combination of the two. As used herein, the term MPCI includes CRC, unless the context indicates otherwise. For the year ended December 31, 1997, the Company was the third largest writer of MPCI business in the United States with a market share of approximately 15%.
The Company offers stand alone crop hail insurance, which insures growing crops against damage resulting from hail storms and which involves no federal participation. The Company also sells a small volume of insurance against damage to specific crops from other named perils.
Program Insurance
This division writes a number of diversified coverages, including coverages for transportation risks, focused workers' compensation, standard property and casualty coverages for the rural market, temporary help agencies, greyhound race tracks, condominiums, daily auto rental, auto dealers, family restaurants and fine arts.
Transportation coverages insure long haul truckers and upper Midwest regional and national trucking companies hauling rural products. The rural market consists of standard property and casualty coverages offered through Redland's agents, which includes farm owners, automobile, livestock mortality and limited commercial coverages.
Non-Standard Automobile
The Company writes non-standard private passenger automobile coverages principally in the southwestern United States. The Company has designed this product for drivers who are unable to obtain coverage from standard carriers due to prior driving records, other underwriting criteria or market conditions. Such drivers normally are charged higher premium rates than the rates charged for preferred or standard risk drivers and usually purchase only basic limits of liability in order to meet state financial responsibility laws.
The following table reflects the amount of net written premium for these four insurance divisions for the periods set forth below.
Marketing
The Company markets its property and casualty insurance products through a network of independent general agents who process and accept applications for insurance coverages from retail agents who sell insurance to insurance buyers. The Company also markets a portion of its property and casualty insurance products and its crop insurance products through a network of retail agents which specialize in the lines of insurance marketed by them. The Company compensates its agents through commissions based on a percentage of premiums produced. The Company also offers most of its agents a contingent commission based on volume and profitability and other programs designed to encourage agents to enhance the placement of profitable business with the Company.
Combined Ratios
The statutory combined ratio, which reflects underwriting results before taking into account investment income, is a traditional measure of the underwriting performance of a property and casualty insurer. A combined ratio of less than 100% indicates underwriting profitability whereas a combined ratio in excess of 100% indicates unprofitable underwriting. The following table reflects the loss ratios, expense ratios and combined ratios of the Company and the property and casualty insurance industry, computed in accordance with SAP, for the periods shown.
Underwriting
The Company organizes its underwriting staff by product line, enabling underwriters to focus on the unique risks associated with the specialty coverages written by the Company. The Company seeks to ensure that each specialty product or program fits into the Company's goals through a strategic planning process whereby divisional managers evaluate the historical and expected levels of underwriting profitability of the coverages written by such division. The Company then allocates its capital among product lines where it believes the best underwriting opportunities exist.
Within each division, each underwriter is required to comply with risk parameters, retention limits and rates and forms prescribed by the Company. All underwriting operations of the Company are subject to special periodic audit by the Company's home office personnel and the reinsurers which accept a portion of these risks.
Generally, the Company grants general agents the authority to sell and bind insurance coverages in accordance with detailed procedures and limitations established by the Company. The Company promptly reviews coverages bound by agents, decides whether the insurance is written in accordance with such procedures and limitations, and, subject to state law limits and policy terms, may cancel coverages that are not in compliance.
Within the General Agency operations, Acceptance Risk Managers and Professional Liability Insurance Managers, insurance agency operations that are not owned by the Company but currently write exclusively for Acceptance, underwrite more difficult casualty and professional lines business and grant no underwriting authority to general agents. Instead, each risk must be submitted to the underwriter for individual consideration.
The Company grants limited binding authority to certain independent agents in certain lines of business, and provides that all other agents submit all quotes to the Company's underwriting staff in order for such coverages to be bound.
Claims
The Company's claims department administers all claims and directs all legal and adjustment aspects of the claims handling process. To assist in settling claims the Company regularly uses independent adjusters, attorneys and investigators. The Company's claims department is organized into two parts, each supervised by a senior claims vice president. The Litigation Department, which is broken down by geographic area, handles larger litigation claims files and other complex and serious claims. The Claims Department, which also is broken down by geographic area, handles the other claims files and supervises the claims handlers. The Company emphasizes the use of internal staff rather than independent adjusters, improving claims processing systems and rapid response mechanisms. These systems have significantly reduced the number of claims handled by each claims examiner. The Company believes this structure will continue to reduce loss adjustment expense, shorten the life of open claim files and permit the Company to estimate more rapidly and consistently future claim liabilities.
Loss and Loss Adjustment Expense Reserves
In the property and casualty insurance industry, it is not unusual for significant periods of time, ranging up to several years, to elapse between the occurrence of an insured loss, the report of the loss to the insurer and the insurer's payment of that loss. The liability for losses and loss adjustment expenses is determined by management based on historical patterns and expectations of claims reported and paid, losses which have occurred but which are not yet reported, trends in claim experience, information available on an industry-wide basis, changes in the Company's claim handling procedures and premium rates. The Company's lines of specialty insurance business are considered less predictable than standard insurance coverages. The effects of inflation are implicitly reflected in these loss reserves through the industry data utilized in establishing such reserves. The Company does not discount its reserves to estimated present value for financial reporting purposes.
In examining reserve adequacy, historical data is reviewed, and, as additional experience and other data become available and are reviewed, estimates of reserves are revised, resulting in increases or decreases to reserves for insured events of prior years. In 1997, 1996 and 1995 the Company made additional provisions through a charge to earnings of $6.9 million, $9.5 million and $22.3 million, respectively, for its reestimated liability for losses and loss adjustment expenses for prior accident years.
The liability established represents management's best estimate and is based on sources of currently available evidence including an analysis prepared by an independent actuary engaged by the Company. Even with such extensive analyses, the Company believes that its ultimate liability may from time to time vary from such estimates.
The Company annually obtains an independent review of its loss reserving process and reserve estimates by a independent professional actuary as part of the annual audit of its financial statements.
The following table presents an analysis of the Company's reserves, reconciling beginning and ending reserve balances for the periods indicated:
The following table presents the development of balance sheet net loss reserves from calendar years 1987 through 1997. The top line of the table shows the loss reserves at the balance sheet date for each of the indicated years. These amounts are the estimates of losses and loss adjustment expenses for claims arising in all prior years that are unpaid at the balance sheet date, including losses that had been incurred but not yet reported to the Company. The middle section of the table shows the cumulative amount paid, expressed as a percentage of the initial reserve amount, with respect to previously recorded reserves as of the end of each succeeding year. The lower section of the table shows the reestimated amount, expressed as a percentage of the initial reserve amount, of the previously recorded reserves based on experience as of the end of each succeeding year. The estimate changes as more information becomes known about the frequency and severity of claims for individual years. The "Net cumulative redundancy (deficiency)" caption represents the aggregate percentage increase (decrease) in the initial reserves estimated. It should be noted that the table presents the "run off" of balance sheet reserves, rather than accident or policy year loss development. The Company computes the cumulative redundancy (deficiency) annually on a calendar year basis.
The establishment of reserves is an inherently uncertain process. The Company underwrites both property and casualty coverages in a number of specialty areas of business which may involve greater risks than standard property and casualty lines. These risk components may make more difficult the task of estimating reserves for losses, and cause the Company's underwriting results to fluctuate. Further, conditions and trends that have effected the development of loss reserves in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this information.
The Company adopted Statement of Financial Accounting Standards No. 113 ("SFAS #113"), "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," effective January 1, 1993. The application of SFAS #113 resulted in the reclassification of amounts ceded to reinsurers, which amounts were previously reported as a reduction in unearned premium and unpaid losses and loss adjustment expenses, to assets on the consolidated balance sheet. The table below includes a reconciliation of net loss and loss adjustment expense reserves to amounts presented on the consolidated balance sheet after reclassifications related to the adoption of SFAS #113. The gross cumulative deficiency is presented for 1992 through 1996, the only years on the table for which the Company has restated amounts in accordance with SFAS #113.
A significant component of the Company's business strategy involves the structuring of reinsurance to reduce volatility in its business segments as well as to avoid large or catastrophic loss exposure. Reinsurance involves an insurance company transferring, or ceding, all or a portion of its exposure on insurance to a reinsurer. The reinsurer assumes the ceded exposure in return for a portion of the premium received by the insurance company. Reinsurance does not discharge the insurer from its obligations to its insured. If the reinsurer fails to meet its obligations, the ceding insurer remains liable to pay the insured loss, but the reinsurer is liable to the ceding insurer to the extent of the reinsured portion of any loss.
The Company limits its exposure under individual policies by purchasing excess of loss and quota share reinsurance, as well as maintaining catastrophe reinsurance to protect against catastrophic occurrences where claims can arise under several policies from a single event, such as a hurricane, earthquake, wind storm, riot, tornado or other extraordinary event.
The Company generally retains the first $500,000 of risk under its property and casualty lines, ceding the next $1,500,000 (on a per risk basis) and $2,500,000 (on an occurrence basis), respectively, to reinsurers. On its complex liability and property exposure, the Company cedes losses in excess of $1,000,000 to its excess reinsurers and maintains a separate 80% quota share treaty on the first $1,000,000 of risk. To the extent that individual policies exceed reinsurance treaty limits, the Company purchases reinsurance on a facultative (specific policy) basis.
The Company maintains catastrophe reinsurance for its casualty lines which provides coverages of $17 million in excess of $3 million of aggregate risk per occurrence, and for its property lines, which provides catastrophe coverage (with close to complete reinsurer participation) of 95% of $77.5 million in excess of a retention of $2.5 million per occurrence. The Company reviews the concentrations of property values in its property lines of business continually, and models possible losses for catastrophic events through computer simulations of different levels of storm activity, adjusting the required limit of the liability or the concentrations of property coverages as appropriate.
In its workers' compensation line, the Company buys excess of loss protection on a statutory basis in excess of a $500,000 per occurrence retention.
The Company reinsures its MPCI business with various federal reinsurance pools administered by the RMA. In 1997, the Company ceded to the RMA an aggregate of 38% of its gross MPCI premium. The Company's net exposure on MPCI business is further reduced by excess of loss reinsurance purchased from private carriers. This excess of loss reinsurance generally provides coverage for 95% of losses in excess of a $3,000,000 deductible after the Company's loss ratio reaches specified limits for each line of business, specifically 77% on crop hail and named peril business and 100% on MPCI business. Additionally 70% of the Company's crop hail business is reinsured through quota share agreements.
At December 31, 1997, 90% of the Company's outstanding reinsurance recoverables were from domestic reinsurance companies or the federal government, 96% of which was from reinsurance companies rated A- (excellent) or better by A.M. Best or from the federal government. The balance was primarily placed with major international reinsurers.
Investments
The Company's investment policy is to maximize the after-tax yield of the portfolio while emphasizing the stability and preservation of the Company's capital base. Further, the portfolio is invested in types of securities and in an aggregate duration which reflect the nature of the Company's liabilities and expected liquidity needs. The Company manages its portfolio internally. The Company's fixed maturity securities are classified as available-for-sale and carried at estimated fair value. The investment portfolio at December 31, 1997 and December 31, 1996, consisted of the following:
The following table sets forth, as of December 31, 1997, the composition of the Company's fixed maturity securities portfolio by time to maturity:
The Company's investment results for the periods indicated are set forth below:
Regulation
As a general rule, an insurance company must be licensed to transact insurance business in each jurisdiction in which it operates, and almost all significant operations of a licensed insurer are subject to regulatory scrutiny. Licensed insurance companies are generally known as "admitted" insurers. Most states provide a limited exemption from licensing for insurers issuing insurance coverages that generally are not available from admitted insurers. Their coverages are referred to as "surplus lines" insurance and these insurers as "surplus lines" or "non-admitted" companies.
The Company's admitted insurance business is subject to comprehensive, detailed regulation throughout the United States, under statutes which delegate regulatory, supervisory and administrative powers to state insurance commissioners. The primary purpose of such regulations and supervision is the protection of policyholders and claimants rather than stockholders or other investors. Depending on whether the insurance company is domiciled in the state and whether it is an admitted or non-admitted insurer, such authority may extend to such things as (i) periodic reporting of the insurer's financial condition; (ii) periodic financial examination; (iii) approval of rates and policy forms; (iv) loss reserve adequacy; (v) insurer solvency; (vi) the licensing of insurers and their agents; (vii) restrictions on the payment of dividends and other distributions; (viii) approval of changes in control; and (ix) the type and amount of permitted investments.
The Company also is subject to laws governing insurance holding companies in Nebraska, Iowa, Arizona and Texas, where the Insurance Companies are domiciled. These laws, among other things, require the Company to file periodic information with state regulatory authorities including information concerning its capital structure, ownership, financial condition and general business operations; regulate certain transactions between the Company, its affiliates and the Insurance Companies, including the amount of dividends and other distributions and the terms of surplus notes; and restrict the ability of any one person to acquire certain levels of the Company's voting securities (generally 10%) without prior regulatory approval.
Except for interest on surplus notes issued by the Insurance Companies and payments on the American Agrisurance ("Am Ag") profit sharing, the Company is dependent for funds to pay its operating and other expenses upon dividends and other distributions from the Insurance Companies, the payment of which are subject to review and authorization by state insurance regulatory authorities. Under Nebraska law, no domestic insurer may make a dividend or distribution which, together with dividends or distributions paid during the preceding twelve months, exceeds the greater of (i) 10% of such insurer's policyholders' surplus as of the preceding December 31 or (ii) such insurer's statutory net income (excluding realized capital gains) for the preceding calendar year, until either it has been approved, or a thirty-day waiting period shall have passed during which it has not been disapproved by the Nebraska Insurance Director. Iowa and Texas have similar laws governing the payment of dividends or distributions of insurance companies domiciled in their state. In any case, the maximum amount of dividends the Insurance Companies may pay to Acceptance is limited to its earned surplus, also known as unassigned funds. Under Arizona law, payment of dividends or distributions by a domestic insurer is limited to the lesser of (i) 10% of such insurer's policyholders' surplus as of the preceding December 31 or (ii) such insurer's net investment income for the preceding calendar year. The tiered structure of the Company's insurance subsidiaries effectively imposes two levels of dividend restriction on the payment to the ultimate parent of dividends from Acceptance Indemnity, Phoenix Indemnity, American Growers and Acceptance Casualty. During 1998, the statutory limitation on dividends from the Insurance Companies to Acceptance without further insurance department approval is approximately $21.7 million.
Other regulatory and business considerations may further limit the ability of the Insurance Companies to pay dividends. For example, the impact of dividends on surplus could effect an insurers' competitive position, the amount of premiums that it can write and its ability to pay future dividends. Further, the insurance laws and regulations of Nebraska, Iowa, Arizona and Texas require that the statutory surplus of an insurance company domiciled therein, following any dividend or distribution by such company, be reasonable in relation to its outstanding liabilities and adequate for its financial needs.
While the non-insurance company subsidiaries are not subject directly to the dividend and other distribution limitations, insurance holding company regulations govern the amount which a subsidiary within the holding company system may charge any of the Insurance Companies for services (e.g., agents' commissions).
The Company's MPCI program is federally-regulated and supported by the federal government by means of premium subsidies to farmers and expense reimbursement and federal reinsurance pools for private insurers. Consequently, the MPCI program is subject to oversight by the legislative and executive branches of the federal government, including the RMA. The MPCI program regulations prescribe premiums which may be charged and generally require compliance with federal guidelines with respect to underwriting, rating and claims administration. The Company is required to perform continuous internal audit procedures and is subject to audit by several federal government agencies.
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 "market 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.
The NAIC has approved and recommended that states adopt and implement several regulatory initiatives designed to be used by regulators as an early warning tool to identify deteriorating or weakly capitalized insurance companies and to decrease the risk of insolvency of insurance companies. These initiatives include the implementation of the Risk Based Capital ("RBC") standards for determining adequate levels of capital and surplus to support four areas of risk facing property and casualty insurers: (a) asset risk (default on fixed income assets and market decline), (b) credit risk (losses from unrecoverable reinsurance and inability to collect agents' balances and other receivables), (c) underwriting risk (premium pricing and reserve estimates), and (d) off-balance sheet/growth risk (excessive premium growth and unreported liabilities). At December 31, 1997 the Insurance Companies meet the RBC requirements as promulgated by the domiciliary states of the Insurance Companies and the NAIC.
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 may 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. At December 31, 1997, of the six Insurance Companies only Acceptance Casualty had more than three ratios falling outside "normal ranges," specifically four out of the twelve IRIS ratios. This was primarily the result of two factors, an increase in Acceptance Casualty's intercompany pooling participation percentage and a $20 million capital contribution received from the Company in the form of a surplus note. The Company does not believe that these ratios will result in regulatory action having a material effect on the Company.
The eligibility of the Insurance Companies to write insurance on a surplus lines basis is dependent on their compliance with certain financial standards, including the maintenance of a requisite level of capital and surplus and the establishment of certain statutory deposits. State surplus lines laws typically: (i) require the insurance producer placing the business to show that he or she was unable to place the coverage with admitted insurers; (ii) establish minimum financial requirements for surplus lines insurers operating in the state; and (iii) require the insurance producer to obtain a special surplus lines license. In recent years, many jurisdictions have increased the minimum financial standards applicable to surplus lines eligibility.
The Insurance Companies also may be required under the solvency or guaranty laws of most states in which they are licensed to pay assessments (up to certain prescribed limits) to fund policyholder losses or liabilities of insolvent or rehabilitated insurance companies. These assessments may be deferred or forgiven under most guaranty laws if they would threaten an insurer's financial strength and, in certain instances, may be offset against future premium taxes. Some state laws and regulations further require participation by the Insurance Companies in pools or funds to provide types of insurance coverages which they would not ordinarily accept.
Uncertainties Affecting the Insurance Business
The property and casualty insurance business is highly competitive, with over 3,000 insurance companies in the United States, many of which have substantially greater financial and other resources, and may offer a broader variety of coverages than those offered by the Company. Beginning in the latter half of the 1980s, there has been severe price competition in the insurance industry which has resulted in a reduction in the volume of premiums written by the Company in some of its lines of businesses, because of its unwillingness to reduce prices to meet competition. In the crop insurance business, the Company competes with other crop insurance companies primarily on the basis of service and commissions to agents.
The specialty property and casualty coverages underwritten by the Company may involve greater risks than more standard property and casualty lines. These risks may include a lack of predictability, and in some instances, the absence of a long-term, reliable historical data base upon which to estimate future losses.
Pricing in the property and casualty insurance industry is cyclical in nature, fluctuating from periods of intense price competition, which led to record underwriting losses during the early 1980's, to periods of increased market opportunity as some carriers withdrew from certain market segments. Despite increased price competition in recent years, the Company has maintained consistent earned premium income during such periods, principally through geographic expansion, acquisitions and implementation of new insurance programs.
The Company's results also may be influenced by factors influencing the insurance industry generally and which are largely beyond the Company's control. Such factors include (a) weather-related catastrophes; (b) taxation and regulatory reform at both the federal and state level; (c) changes in industry standards regarding rating and policy forms; (d) significant changes in judicial attitudes towards liability claims; (e) the cyclical nature of pricing in the industry; and (f) changes in the rate of inflation, interest rates and general economic conditions. The Company's crop insurance results are particularly subject to wide fluctuations because of weather factors influencing crop harvests. Crop insurance results are not generally known until the last half of the year. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- General."
The insurance business is highly regulated and supervised in the states in which the Insurance Companies conduct business. The crop insurance lines are subject to significant additional federal regulation. The regulations relating to the property and casualty and crop insurance business at both the state and federal level are frequently modified and such modifications may impact future insurance operations. See "Regulation."
Adverse loss experience for 1994 and prior years resulted in a strengthening of loss reserves for the year ended December 31, 1995, in the amount of $22.3 million. The establishment of appropriate loss reserves is an inherently uncertain process, and, it has been necessary, and over time may continue to be necessary, to revise estimated loss reserve liabilities. See "Loss and Loss Adjustment Reserves," for a further discussion of the impact of the loss reserve strengthening in 1995 and other factors which may, in the future, influence loss reserve estimates.
Property and casualty insurance is a capital intensive business and the Company is obliged to maintain minimum levels of surplus in the Insurance Companies in order to continue writing insurance at current levels or to increase its writings, and also to meet various operating ratio standards established by state insurance regulatory authorities and by insurance rating bureaus. Without additional capital, the Company could be required to curtail growth or even to reduce its volume of premium writings in order to satisfy state regulations or to maintain its current A- (excellent) rating from A.M. Best. The Company's history is one of continuing premium growth, and it may be expected to require additional capital from time to time, through additional offerings of its securities, increase in its debt or otherwise. The Company continually reviews the surplus needs of the Insurance Companies, and may, from time-to-time, need to seek additional funding.
Employees
At March 23, 1998 the Company and its subsidiaries employed 18 salaried executives and 1,043 other personnel. Acceptance believes that relations with its employees are good.
Item 2.
Item 2. Properties.
The following table sets forth certain information regarding the principal properties of the Company.
Item 3.
Item 3. Legal Proceedings.
There are no material legal proceedings pending involving the Company or any of its subsidiaries which require reporting pursuant to this Item.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 1997.
PART II.
Item 5.
Item 5. Market for Registrant's Equity and Related Stockholder Matters.
The Common Stock is listed and traded on the New York Stock Exchange ("NYSE"). The following table sets forth the high and low sales prices per share of Common Stock as reported on the NYSE Composite Tape for the fiscal quarters indicated.
The closing sales price of the Common Stock on March 23, 1998, as reported on the NYSE Composite Tape, was $23 15/16 per share. As of March 23, 1998, there were approximately 1,800 holders of record of the Common Stock.
The Company has not paid cash dividends to its shareholders during the periods indicated above and does not anticipate that it will pay cash dividends in the foreseeable future. The Company's credit agreement with its lenders ("Credit Agreement") prohibits the payment of cash dividends to shareholders. See "Regulation" for a description of restrictions on payment of dividends to the Company from the Insurance Companies; and see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" for a description of the Company's Credit Agreement.
Item 6.
Item 6. Selected Consolidated Financial Data.
The following table sets forth certain selected consolidated financial data and should be read in conjunction with, and is qualified in its entirety by, the Consolidated Financial Statements and the notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing elsewhere herein. This selected consolidated financial data has been derived from the audited Consolidated Financial Statements of the Company and its subsidiaries.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of financial condition and results of operations of the Company and its consolidated subsidiaries should be read in conjunction with the Company's Consolidated Financial Statements and the notes thereto included elsewhere herein.
General
After five years of consistent growth in premiums written, both from internal growth and acquisitions, the Company experienced little growth in direct premiums written and a decrease in net premiums written during 1997. During 1997, the Company focused on improving operating margins by emphasizing profitable lines, restructuring and reunderwriting marginal lines and discontinuing clearly unprofitable lines. The Company's efforts were rewarded with record operating earnings of $57.9 million in 1997 as well as the continuation of a pattern of profitable quarters begun in the third quarter of 1992 when the phasing out of its prior non-insurance operations was substantially completed. The only exception to this pattern was a net loss of $6.0 million in the third quarter of 1995 when the Company strengthened loss reserves.
The Company has pursued a strategy of focusing on selected niche businesses through acquisitions, new agency relationships and additions of key professional staff. The Company's most significant acquisition was its purchase in July of 1993 of The Redland Group, Inc., a major writer of MPCI and other crop insurance coverages. In 1997, the Company was the third largest writer of MPCI business in the United States.
MPCI is a government-sponsored program with accounting treatment which differs from more traditional property and casualty insurance lines. For income statement purposes, gross premiums written consist of the aggregate amount of MPCI premiums paid by farmers, and does not include any related federal premium subsidies or expense reimbursement. The Company's profit or loss from its MPCI business is determined after the crop season ends on the basis of a profit sharing formula established by law and the RMA. For income statement purposes, any such profit share earned by the Company, net of the cost of third party reinsurance, is shown as net premiums written, which equals net premiums earned for MPCI business; whereas, any share of losses payable by the Company is charged to losses and loss adjustment expenses. Due to various factors, including timing and severity of losses from storms and other natural perils and crop production cycles, the profit or loss on MPCI premiums is primarily recognized in the second half of the calendar year. The Company relies on loss information from the field to determine (utilizing a formula established by the RMA) the level of losses that should be considered in estimating the profit or loss during this period. Based upon available loss information, the Company records an estimate of the profit or loss during the third quarter and then re-evaluates the estimate using additional loss information available at year-end to determine any remaining portion to be recorded in the fourth quarter. All expense reimbursements received are credited to underwriting expenses.
Certain characteristics of the Company's crop business may affect comparisons, including: (i) the seasonal nature of the business whereby profits or losses are generally recognized predominately in the second half of the year; (ii) the nature of crop business whereby losses are known within a short time period; and (iii) the limited amount of investment income associated with crop business. In addition, cash flows from such business differ from cash flows from certain more traditional lines. See "Liquidity and Capital Resources" below. The seasonal and short term nature of the Company's crop business, as well as the impact on such business of weather and other natural perils, may produce more volatility in the Company's operating results on a quarter to quarter or year to year basis than has historically been the case.
Forward-Looking Information
Except for the historical information contained in this Annual Report on Form 10-K, matters discussed herein may constitute forward-looking information. Such forward-looking information reflects the Company's current best estimates regarding future operations, but, since these are only estimates, actual results may differ materially from such estimates.
A variety of events, most of which are outside the Company's control, cannot be accurately predicted and may materially impact estimates of future operations. Important among such factors are weather conditions, natural disasters, changes in state and federal regulations, price competition impacting premium levels, changes in tax laws, financial market performance, changes in court decisions effecting coverages and general economic conditions.
The Company's results are significantly impacted by its crop business, particularly its MPCI line. Results from the crop lines are not generally known until the third and fourth quarters of the year, after crops are harvested. Crop results are particularly dependent on events beyond the Company's control, notably weather conditions during the crop growing seasons in the states where the Company writes a substantial amount of its crop insurance, and, with the introduction of the Company's new Crop Revenue Coverage, the market price of grains on various commodity exchanges. Additionally, federal regulations governing aspects of crop insurance are frequently modified, and any such changes may impact crop insurance results.
Forward-looking information set forth herein does not take into account any impact from any adverse weather conditions during the 1998 crop season, or the various other factors noted above which may affect crop and non-crop operation results.
RESULTS OF OPERATIONS Year Ended December 31, 1997 Compared to Year Ended December 31, 1996
The Company's net income increased 16.6% from $30.3 million in the year ended December 31, 1996 to $35.3 million in the year ended December 31, 1997. The Company's operating income increased 47.4% from $39.3 million in the year ended December 31, 1996 to $57.9 million in the year ended December 31, 1997. These improved results occurred despite a decrease in the Company's insurance premiums earned and the differential between the growth in net income and operating income occurred as the Company's tax rate returned to normal levels in 1997 after the Company's 1996 taxes were positively affected by the decrease in the valuation allowance relating to the unrealized loss from the Company's investment in Major Realty. The improved results were attributed primarily to improved loss and expense ratios in all of the Company's Property and Casualty divisions, excellent crop results resulting from an above average profit sharing earned in the Company's MPCI program, and increased investment income and realized gains from the Company's investment portfolio. These positive factors were partially offset by an increase in the expense ratio of the Crop division, increased interest expense, and an increase in the Company's effective tax rate.
After several years of growth in net insurance premiums earned, the Company experienced a decline in net insurance premiums earned from $348.7 million in 1996 to $335.2 million in 1997, a decline of approximately 3.9%. During 1997, the Company's goal in its Property and Casualty divisions was to improve underwriting results through an emphasis on profitable lines, a restructuring of marginal lines, and a discontinuation of unprofitable lines. During this process, growth in profitable lines of business was offset by declining volumes in the discontinued lines resulting in only a .8% increase in direct premiums written and a 2.3% increase in gross premiums written. In lines of business in which the Company was seeking to improve marginal results, the Company ceded additional amounts to reinsurers in order to reduce the impact of these lines as well as to help improve the net results of the Company. Due to the competitive environment in the Property and Casualty business, new programs which the Company initiated in 1997 were also heavily reinsured in order to diminish the impact on the Company's results until such time as these new programs confirmed their expected level of profitability. Accordingly, the Company increased its cessions to reinsurers by approximately $46.6 million from $284.1 million in 1996 to $330.7 million during 1997, resulting in a 8.7% decline in net premiums written during 1997 as compared to 1996.
In the Company's Crop division, the Company's premium levels were also relatively flat as direct written premiums decreased from $198.6 million in 1996 to $196.5 million in 1997 and gross premiums increased slightly from $242.9 million in 1996 to $248.0 million in 1997. These relatively level written premiums resulted as increases in the Company's policy count under the Company's largest program, the MPCI crop insurance program, were offset by reductions in commodity prices upon which the Company's premiums are based.
Underwriting results in all three of the Company's Property and Casualty divisions improved during 1997 as compared to 1996. The Company's General Agency division experienced a $4.0 million underwriting loss and a combined ratio of 102.7% in the twelve months ended December 31, 1997 as compared to a $10.8 million underwriting loss and a combined ratio of 106.9% for the twelve months ended December 31, 1996. The General Agency division's improved underwriting results were a result of a decrease in both the division's accident year and calendar year loss and loss adjustment expense ratios from 1996 to 1997. The division's loss and loss adjustment expense ratios fell from 69.9% and 75.0% on an accident and calendar year basis respectively during 1996 to 66.5% and 69.6% on an accident and calendar year basis respectively during 1997. These improved loss ratios were offset partially by an increase in the expense ratio of the division from 31.9% during 1996 to 33.0% during 1997. This increase in the expense ratio resulted from a decrease in net earned premiums from $155.3 million during 1996 to $148.5 million during 1997 with expenses remaining level at approximately $49 million in both years.
The Company's Non-Standard Auto division experienced its first unprofitable year in six years in 1996 as the division recorded a $5.5 million underwriting loss and a 114.9% combined ratio. The division's performance improved to an underwriting loss of $2.4 million and a 105.6% combined ratio in 1997. During 1997, the Company continued a pattern of regular rate increases combined with the cancellation of unprofitable programs and agents and was able to improve its loss and loss adjustment expense ratio from 82.5% in 1996 to 75.2% in 1997. In addition, the division was able to increase its insurance premiums earned by 14.1% while increasing expenses by only 7.1%, helping to lower its expense ratio from 32.3% in 1996 to 30.4% in 1997. The Company expects that profit improvement directives initiated in 1997 will continue to improve results within this division during 1998. The Company also expects continued growth within this division during the 1998 year resulting in continued improvement in the division's expense ratio.
The Program division improved from an underwriting loss of $15.6 million and a combined ratio of 117.5% during 1996 to an underwriting loss of $5.9 million and a combined ratio of 107.0% during 1997. These improved underwriting results were achieved by improvements of just over 5% in both the expense and loss ratios of the division. During 1996, many of the new programs within the division were in a start-up phase in which fixed expenses were not offset by adequate earned premiums. During 1997, growth in earned premium allowed fixed costs to move into a more normal relationship as a percentage of earned premiums, thus allowing the division to record a noticeable drop in its expense ratios from 36.3% during 1996 to 31.0% during 1997. The improvement in the loss ratio resulted from a change in the mix of business, emphasizing more profitable lines, restructuring of reinsurance to improve the Company's net results and the discontinuation of programs and agents with unprofitable loss ratios. The Company expects continued improvement in the results of the Program division as the benefit of the initiatives started in 1997 are realized in 1998.
During 1997, non-automobile lines of business continued to outperform the automobile lines of business within the Company's Property and Casualty divisions. For the year 1997, automobile lines recorded a 112.9% combined ratio while non-automobile lines recorded 99.9% combined ratio. The Company continues to effect significant underwriting changes within its automobile lines in order to bring them closer to the Company's desired goal of a combined ratio of 100.0% or less.
The Company's Crop division was a significant contributor to the underwriting earnings of the Company in both 1996 and 1997. During 1996, the division contributed $41.5 million to the Company's underwriting earnings as compared to $36.9 million during 1997. During 1997, the Company earned a profit share of 31.5% on its MPCI retained premium pool of approximately $155.5 million or $49.0 million. This compares with an earned profit share of 23.5% on a $161.4 million retained premium pool generating $37.9 million in 1996.
During the first quarter of 1996, the Company's operating income benefited from a $2.8 million profit in the Company's Crop Division. The principal component of this $2.8 million was the recording of an additional $3.8 million in profit sharing under the Company's MPCI program. The Company's estimate of its profit sharing under the MPCI program at December 31, 1995 was affected by a volatile crop growing season during which many of the rules pertaining to preventive planting payments were changed and a combination of unusual weather conditions manifested themselves in an unusually late harvest. As claims were closed during the first quarter of 1996 and the final preventive planting rules applied to these losses, the Company was able to earn additional profit sharing. The 1996 growing year did not experience this same degree of volatility, and the harvest was not delayed by unusual weather conditions. Consequently, the MPCI profit sharing income recorded at December 31, 1996 more accurately estimated actual results than had the profit sharing recorded at December 31, 1995. During the first quarter of 1997, the Company experienced operating income of approximately $900,000 from the operations of its Crop Division. The Company believes that the crop results for the first quarter of 1997 were more typical of a normal year than those experienced in the first quarter of 1996.
The improved profit sharing income in 1997 was offset by an increase in the Company's net operating expenses under the MPCI program. This increase in net expenses was due to a decrease in expense reimbursement from the federal government under the MPCI program from 31.0% for both MPCI and Crop Revenue Coverage (CRC) policies in 1996 to 29.0% and 25.0% respectively for MPCI and CRC policies in 1997. This resulted in an approximate $7.2 million decrease in expense reimbursement from 1996 to 1997. The Company was unable to pass along any of this expense reduction to its producing agents due to the competitive environment for MPCI business during 1997. The Company has initiated several automation and cost cutting programs in order to reduce its overall operating expense under the MPCI program. During 1998, the expense reimbursement from the federal government under the MPCI program declined again to 27.0% for MPCI policies and 23.25% for CRC policies. Further, the Company expects an additional reduction for the 1999 crop year. While the Company continues to emphasize cost reduction and automation initiatives, the Company will be unable to fully compensate for these reductions in expense reimbursements unless it is able to reduce agents commissions. Given the competitive environment for the MPCI policies, it is unknown at this time whether the Company will be able to effect such commission reductions without a loss of business in its MPCI line.
The Company's net income for 1997 also benefited from an increase in net investment income and net realized capital gains. The Company's net investment income increased 5.8% during the twelve months ended December 31, 1997 as compared to the twelve month period ended December 31, 1996 while the Company's net realized capital gains increased 40.4% in 1997 as compared to 1996. The increase in the Company's net investment income resulted from an increase in the average size of the Company's portfolio from $402.4 million during the year ended December 31, 1996 to $453.9 million during the year ended December 31, 1997, an increase of 12.8%. This increase in the size of the portfolio was offset by a decrease in the annualized investment yield of the portfolio from 6.6% during 1996 to 6.2% during 1997. This decrease in annual investment yield was due to an increase in the average amount of tax advantaged securities within the Company's portfolio and a lower interest rate environment during 1997.
The Company's interest expense increased 34.2% from $4.9 million during 1996 to $6.6 million during 1997. This increase in interest expense resulted from both an increase in the Company's average borrowings and the average interest rate paid by the Company. During 1997, the Company's average borrowings were $81.6 million and the average interest rate was 8.1% as compared to average borrowings in 1996 of $69 million and an average interest rate of 7.1%. The increased borrowings during 1997 were used to add statutory surplus to the Company's insurance company subsidiaries. The increase in the Company's average interest rate paid resulted from the issuance of $94.875 million in Trust Preferred Securities and the retirement of the Company's outstanding bank debt during the third quarter of 1997 (see discussion under Liquidity and Capital Resources).
The Company's 1996 taxes were positively effected by the decrease in the evaluation allowance related to the unrealized loss from the Company's investment in Major Realty. In October 1995, Major Realty announced that its Board of Directors had determined that it was in the best interest of the stockholders to seek a merger partner, otherwise seek a transaction for the sale of the company. At December 31, 1996, the Company believed that the realization of the capital loss associated with such a transaction was more likely than not due to sufficient carryforwards of capital gains as well as the likelihood of future capital gains. No such benefit was realized in 1997, and therefore, the Company's effective tax rate increased to a more normal level of 31.2% as compared to an effective tax rate of 9.6% in 1996.
Year Ended December 31, 1996 Compared to Year Ended December 31, 1995
The Company's net income increased approximately 629% from $4.2 million in the year ended December 31, 1995 to $30.3 million in the year ended December 31, 1996. This increase in net income resulted from improved underwriting results in the Company's Crop and General Agency divisions, growth in premium revenues, increased investment income and realized gains, and a decrease in the effective tax rate of the Company. These positive factors were offset by deteriorating results in the Company's Program division, increased interest expense, and a somewhat higher expense ratio for the Company.
The combined underwriting loss and expense ratio improved from 104.9% for the year ended December 31, 1995 to 97.3% for the 1996 year. This improvement in the Company's combined ratio was enhanced by growth in net premiums earned of 28.4%. The greatest contribution to these improved underwriting results was made by the Company's Crop division. The Company's Crop division increased its MPCI writings from $183.3 million for the year ended December 31, 1995 to $248.3 million for the 1996 year. In addition to this growth in MPCI premium, the Company increased its retained pool from $104.3 million in 1995 to $161.4 million in 1996. This growth in premium was aided by an increase in commodity prices for the major crops insured by the Company and the introduction of an enhancement to the MPCI policy. Improved weather conditions also contributed significantly to the improved results in the Crop division as the Company's MPCI profit sharing percentage realized during 1996 increased to 23.5% from 13.4% realized during 1995. In addition, the 1996 year benefited from $4.3 million of additional profit sharing realized in the first quarter of 1996 as final results of the late 1995 harvest were available.
Underwriting results in the Company's General Agency division also improved in 1996 as compared to 1995, as the Company's combined ratio in this division improved from 116.4% in 1995 to 106.9% in 1996. The Company's 1995 results were affected by a $22.3 million strengthening of reserves for prior year losses, and $16.5 million of the $22.3 million affected the General Agency division, contributing to the 116.4% combined ratio recorded during 1995. When comparing accident year loss ratios for 1995 and 1996 in the General Agency division, the results are similar. In the year ended December 31, 1995, the General Agency division 1995 accident year loss ratio was 69.8% as compared to a 1996 accident year loss ratio of 69.9%. The General Agency division was also able to improve its combined ratio through a reduction in expenses during 1996 as its expense ratio fell to 31.9% in 1996 as compared to 34.1% in 1995.
The Company also benefited from a 28.3% increase in investment income during 1996 as compared to that of 1995, and an increase in the realized investment gains of the Company of 92.7% when comparing the same periods. The increase in investment income was principally due to an increase in the average size of the investment portfolio. The average size of the Company's investment portfolio increased by 25.3% from $321.3 million for the twelve months ended December 31, 1995 to $402.4 million for the twelve months ended December 31, 1996, while the pre-tax yield on the portfolio increased from 6.4% in 1995 to 6.6% in 1996. The size of the Company's investment portfolio increased from retained earnings and positive cash flows from operations.
While the Company's income tax expense increased from $1.2 million for the twelve months ended December 31, 1995 to $3.2 million for the 1996 year, the Company's effective tax rate declined from 22.2% in 1995 to 9.6% in 1996. The Company's 1996 taxes were positively effected by the decrease in the valuation allowance relating to the unrealized loss from the Company's investment in Major Realty. In October 1995, Major Realty announced that its Board of Directors had determined that it was in the best interest of the stockholders to seek a merger partner or otherwise seek a transaction for the sale of the company. At December 31, 1996, the Company believed that the realization of the capital loss associated with such a transaction was more likely than not due to sufficient carryforwards of capital gains as well as the likelihood of further capital gains.
Positive factors effecting net income were partially offset by deteriorating underwriting results in the Company's Program division. The Program division's combined loss and expense ratio increased from 113.6% during 1995 to 117.5% during 1996. A variety of factors combined to cause this deterioration in underwriting results. In two of the division's departments, Rural America and Special Products, weather related incidents increased the frequency of losses. In the Rural America department, storms in areas where the Company had concentrations of farm business adversely effected the Company's loss ratio, while in the Company's Special Products department, prolonged sub-zero temperatures in the greater Chicago area increased the number and severity of freeze losses experienced in the Company's condominium program. The Company has taken steps to reduce its geographic concentrations in the Rural America department, and is making changes in the reinsurance structure of both of these departments in order to reduce volatility and improve net underwriting results.
Additionally in the Program division, the Company changed its strategies within its Workers' Compensation underwriting activities during 1996. In 1995 and previous years, the Company had followed a strategy of depopulating assigned risk pools through the application of intensive case management techniques with risks which had become unacceptable to the standard market due to frequency rather than severity. With the improvement of workers' compensation results for the industry as a whole, more companies were willing to write workers' compensation, and therefore, the number of risks fitting the Company's profile for removal from assigned risk pools was substantially depleted. During 1996, the Company moved to a strategy of partnership arrangements with select agencies in which the agent accepts part of the underwriting risk in return for an enhanced profit sharing from the Company. Due to the competitive market, this strategy is developing slowly, and, thus, the Company experienced a 65% decrease in its direct written premiums in this line of business. This transition phase caused the expense ratio in this line of business to increase more than 100%, and resulted in an underwriting loss for this line of business.
Offsetting these deteriorating results in the Program division were improved results in the Company's Transportation department. With the Transportation department, the Company's loss and expense ratio improved from 120.6% during the year ended December 31, 1995 to 103.6% during 1996.
The Company's Non-Standard underwriting activities experienced unprofitable results for the first time in six years as a result of an increase in both the severity and frequency of losses, particularly in the area of physical damage losses. The Company has increased rates beginning in 1996 and continuing into 1997, reduced commissions in certain areas with poor experience, and canceled agents with loss ratio problems.
The Company's interest expense also increased during 1996 as compared to 1995. This increase in interest expense was due to an increase in the Company's borrowings under its bank facility which increased from an average of $34.3 million during 1995 to $69.0 million during 1996. Offsetting this increase in the size of borrowings was a decline in the average interest rate under the bank facility from 7.6% during 1995 to 7.1% during 1996. The additional borrowings under the bank facility were contributed to the Company's subsidiaries in order to support underwriting activities and maintain capital adequacy ratios at a level commensurate with the Company's current A- rating by A.M. Best & Company.
The Company experienced a somewhat higher expense ratio during 1996 than during 1995. This ratio increased from 26.7% in 1995 to 27.5% in 1996 primarily due to higher net commission expense in the Program division of the Company. This higher net commission expense was a result of a changing mix of business with a lesser percentage of premiums produced in lower commission programs such as Workers' Compensation and Transportation and a higher percentage of premiums produced in higher commission lines of business. In addition, the Company decreased the use of quota share reinsurance within the Program division during 1996.
Liquidity and Capital Resources
The Company has included a discussion of the liquidity and capital resources requirement of the Company and the insurance subsidiaries.
The Company - Parent Only
As an insurance holding company, the Company's assets consist primarily of the capital stock of its subsidiaries, surplus notes issued by two of its insurance company subsidiaries and investments held at the holding company level. The Company's primary sources of liquidity are receipts from interest payments on the surplus notes, payments from the profit sharing agreement with American Agrisurance, the Company's wholly owned subsidiary which operates as the general agent for the Company's crop insurance programs, tax sharing payments from its subsidiaries, investment income from, and proceeds from the sale of, holding company investments, and dividends and other distributions from subsidiaries of the Company. The Company's liquidity needs are primarily to service debt, pay operating expenses and taxes, and make investments in subsidiaries.
The Company currently holds three surplus notes, each in the amount of $20 million, issued by two of its insurance company subsidiaries, bearing interest at the rate of 9% per annum payable semi-annually and quarterly. Although repayment of all or part of the principal of these surplus notes requires prior insurance department approval, no prior approval of interest payment is currently required.
Under the American Agrisurance profit sharing agreement, American Agrisurance receives up to 50% of the crop insurance profit after expenses and a margin retained by the Insurance Companies based upon a formula established by the Company and approved by the Nebraska Department of Insurance. If the calculated profit share is negative, such negative amounts are carried forward and offset future profit sharing payments. For the year ended December 31, 1997, American Agrisurance recorded $12.4 million, net of tax, related to the profit sharing agreement. This entire amount was distributed in the form of a dividend to the Company.
Dividends from the insurance subsidiaries of the Company are regulated by the regulatory authorities of the states in which each subsidiary is domiciled. The laws of such states generally restrict dividends from insurance companies to parent companies to certain statutorily approved limits. In 1998, the statutory limitation on dividends from insurance company subsidiaries to the parent without further insurance departmental approval is approximately $21.7 million.
The Company is currently a party to a tax sharing agreement with its subsidiaries, under which such subsidiaries pay the Company amounts in general equal to the federal income tax that would be payable by such subsidiaries on a stand-alone basis.
In August 1997, AICI Capital Trust, a Delaware business trust organized by the Company (the "Issuer Trust") issued 3.795 million shares or $94.875 million aggregate liquidation amount of its 9% Preferred Securities (liquidation amount $25 per Preferred Security). The Company owns all of the common securities (the "Common Securities") of the issue trust. The Preferred Securities represent preferred undivided beneficial interests in the Issuer Trust's assets. The assets of the Issuer Trust consist solely of the Company's 9% Junior Subordinated Debentures due 2027 which were issued in August of 1997 in an amount equal to the Preferred Securities and the Common Securities. The Company primarily used the net proceeds in the amount of $90.9 million from the sale of the Junior Subordinated Debentures to pay down the $90.0 million of borrowings under its Revolving Credit Facility. Distributions on the Preferred Securities and Junior Subordinated Debentures are cumulative, accrue from the date of issuance and are payable quarterly in arrears. The Junior Subordinated Debentures are subordinate and junior in right of payment to all senior indebtedness of the Company and are subject to certain events of default and redemptive provisions, all described in the Junior Debenture Indenture. At December 31, 1997, the Company had $94.875 million outstanding at a weighted annual interest cost of 9.2%.
On June 6, 1997, the Company amended its borrowing arrangements with its bank lenders providing a five-year revolving credit facility (the "Revolving Credit Facility"), with a final maturity of 2002, in amounts not to exceed $100 million. In August 1997, the Company used the net proceeds from the issuance of Junior Subordinated Debentures to repay the Company's outstanding indebtedness of $90 million under the Revolving Credit Facility. As a result of the Junior Subordinated Debentures, the Revolving Credit Facility was reduced from $100 million to $65 million. The Company selects its interest rate as either the prime rate or LIBOR plus a margin which varies depending on the Company's funded debt to equity ratio. Interest is payable quarterly. At December 31, 1997, the Company had no outstanding indebtedness under this arrangement. Borrowings and interest cost averaged $43.1 million and 7.0% during 1997. The Revolving Credit Facility contains covenants which do not permit the payment of dividends by the Company, requires the Company to maintain certain operating and debt service coverage ratios, required maintenance of specified levels of surplus and requires the Company to meet certain tests established by the regulatory authorities.
As of December 31, 1997, the Company held cash, invested assets excluding investments in subsidiaries, and dividends receivable of $13.3 million.
Insurance Companies
The principal liquidity needs of the Insurance Companies are to fund losses and loss adjustment expense payments and to pay underwriting expenses, including commissions and other expenses. The available sources to fund these requirements are net premiums received and, to a lesser extent, cash flows from the Company's investment activities, which together have been adequate to meet such requirements on a timely basis. The Company monitors the cash flows of the Insurance Companies and attempts to maintain sufficient cash to meet current operating expenses, and to structure its investment portfolio at a duration which approximates the estimated cash requirements for the payments of loss and loss adjustment expenses.
Cash flows from the Company's MPCI and crop hail businesses differ in certain respects from cash flows associated with more traditional property and casualty lines. MPCI premiums are not received from farmers until the covered crops are harvested, and when received are promptly remitted by the Company in full to the government. Covered losses are paid by the Company during the growing season as incurred, with such expenditures reimbursed by the government within three business days. Policy acquisition and administration expenses are paid by the Company as incurred during the year. The Company periodically throughout the year receives a payment in reimbursement of its policy acquisition and administration expenses.
The Company's profit or loss from its MPCI business is determined after the crop season ends on the basis of a profit sharing formula established by law and the RMA. Commencing with the 1997 year, the Company receives a profit share in cash, with 60% of the amount in excess of 17.5% of its MPCI Retention (as defined in the profit sharing agreement) in any year carried forward to future years, or it must pay its share of losses. Prior to the 1997 year, the amount carried forward to future years was any amount in excess of 15% of its MPCI retention. The Company recognized $49.0 million in profit sharing earned on the MPCI business during 1997, and in addition, recognized $1.0 million during 1997 in profit sharing earned on 1996 MPCI business. With the change in profit sharing payment rules including amounts payable for the 1997 crop year, the Company received $57.0 million in payments under the MPCI program in February of 1998.
In the crop hail insurance business, premiums are generally not received until after the harvest, while losses and other expenses are paid throughout the year.
Changes in Financial Condition
The NAIC has established a Risk Based Capital ("RBC") formula for property and casualty insurance companies. The RBC initiative is designed to enhance the current regulatory framework for the evaluation of the capital adequacy of a property and casualty insurer. The formula requires an insurer to compute the amount of capital necessary to support four areas of risk facing property and casualty insurers: (a) asset risk (default on fixed income assets and market decline), (b) credit risk (losses from unrecoverable reinsurance and inability to collect agents' balances and other receivables), (c) underwriting risk (premium pricing and reserve estimates), and (d) off balance sheet/growth risk (excessive premium growth and unreported liabilities). The Insurance Companies have reviewed and applied the RBC formula for the 1997 year and have exceeded these requirements.
The Company's stockholders' equity increased by approximately $45.9 million from December 31, 1996 to December 31, 1997. The principal components of this increase were net income of $35.3 million for the year ended 1997 and an increase in the value of the Company's investment portfolio causing the unrealized gain (loss) on available-for-sale securities net of tax to improve from a loss of $1.5 million to a gain of $6.9 million.
Consolidated Cash Flows
Cash flows from operations for the year ended December 31, 1997 were $10.1 million as compared to cash flows from operating activities of $42.9 million during 1996. The decrease in positive cash flows is a result of a decline in the growth of gross written premiums coupled with a higher percentage of gross written premiums ceded to reinsurers.
Cash flows from the Company's MPCI and crop hail business are different in certain respects from cash flows associated with more traditional property and casualty lines (see Liquidity and Capital Resources, Insurance Companies).
Inflation
The Company does not believe that inflation has had a material impact on its financial condition or results of operations.
Year 2000
The year 2000 issue is the result of computer programs which recognize only two digits rather than four to identify the year. Any of the Company's computer programs that have time sensitive software may recognize a date of "00" as the year 1900 rather than the year 2000. If not corrected, this could cause computer systems to fail or perform miscalculations.
The Company has identified the computer system applications that require modification to be Year 2000 compliant. The Company has developed a corrective plan whereby internal and external resources are being utilized to make the necessary modifications to and testing of the Company's computer systems. While some of the Company's computer systems are currently Year 2000 compliant, management expects the remaining systems to be Year 2000 compliant by December 31, 1998. The Company has expensed costs relating to the Year 2000 issue of approximately $1.4 million in 1997 and anticipates an additional $1.8 to $2.5 million of expenses to complete the project. The estimated costs and estimated date of completion of the Year 2000 project is based on management's best estimates. However, there can be no guarantee that these estimates will be achieved and actual results could differ from the Company's plan.
In addition, the Company is communicating with others with which it does business to determine if they are Year 2000 compliant. However, there can be no guarantee that the systems of these companies will achieve Year 2000 compliance in a timely manner.
Recent Statement of Financial Accounting Standards
In February 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 128 (SFAS No. 128), Earnings Per Share. This statement establishes accounting standards for the presentation of basic and diluted earnings per share. In addition, SFAS No. 128 requires a reconciliation of the numerator and denominator of the basic and diluted EPS computations. The Company adopted SFAS No. 128 in 1997 and accordingly, earnings per share has been restated for all periods presented.
In February 1997, the FASB issued SFAS No. 129, Disclosure of Information about Capital Structure. This statement establishes standards for disclosing information about an entity's capital structure. The Company adopted SFAS No. 129 in 1997. SFAS No. 129 contains no change in disclosure requirements for entities that were previously subject to the requirements of Accounting Principles Board Opinions Nos. 10 and 15 and SFAS No. 47 and as such the adoption of SFAS No. 129 did not have any effect on the Company's reporting.
In June 1997, FASB issued SFAS No. 130, Reporting Comprehensive Income. SFAS No. 130 establishes standards for the reporting and display of comprehensive income. The purpose of reporting comprehensive income is to present a measure of all changes in shareholders' equity that result from recognized transactions and other economic events of the period, other than transactions with owners in their capacity as owners. SFAS No. 130 is effective for financial statements issued for periods beginning after December 15, 1997. Adoption of SFAS NO. 130 will result in additional disclosures in the Company's financial statements but will not impact the Company's reported net income or net income per share.
In June 1997, FASB issued SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information. SFAS No. 131 specifies revised guidelines for determining an entity's operating segments and the type and level of financial information to be disclosed. SFAS No. 131 is effective for fiscal years beginning after December 15, 1997. Adoption of SFAS No. 131 may result in additional disclosures in the Company's financial statements.
Item 7A.
Item 7A. Not applicable.
Item 8.
Item 8. Financial Statements and Supplementary Data.
See Item 14 hereof and the Consolidated Financial Statements attached hereto.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
There have been no disagreements with the Registrant's independent accountants of the nature calling for disclosure under Item 9.
PART III.
Item 10.
Item 10. Directors and Executive Officers of the Registrant.
The information required by Item 10 with respect to the Registrant's executive officers and directors will be set forth in the Company's 1998 Proxy Statement included as Exhibit 99.6 hereto and incorporated herein by reference.
Item 11.
Item 11. Executive Compensation
The information required by Item 11 will be set forth in the Company's 1998 Proxy Statement included as Exhibit 99.6 hereto and incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
The information required by Item 12 will be set forth in the Company's 1998 Proxy Statement included as Exhibit 99.6 hereto and incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions.
The information required by Item B will be set forth in the Company's 1998 Proxy Statement included as Exhibit 99.6 hereto and incorporated herein by reference.
PART IV.
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
(a) The following documents are filed as a part of this Report:
1. Financial Statements. The Company's audited Consolidated Financial Statements for the years ended December 31, 1997 and 1996 consisting of the following:
Independent Auditors' Report Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Cash Flows Consolidated Statements of Stockholders' Equity Notes to Consolidated Financial Statements
2. Financial Statement Schedules
Schedule II. Condensed Financial Information of Registrant Schedule V. Valuation Accounts
3. The Exhibits filed herewith are set forth in the Exhibit Index attached hereto.
(b) No Current Reports on Form 8-K have been filed during the last fiscal quarter of the period covered by this Report.
Audited Consolidated Financial Statements for the Years Ended December 31, 1997 and December 31, 1996:
Independent Auditors' Report Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statement of Stockholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
ACCEPTANCE INSURANCE COMPANIES INC.
/s/ Kenneth C. Coon By _____________________________________ Dated: March 24, 1998 Kenneth C. Coon Chairman and Chief Executive Officer
/s/ Georgia M. Mace By _____________________________________ Dated: March 24, 1998 Georgia M. Mace Chief Financial Officer and Treasurer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
/s/ Jay A. Bielfield Dated: March 24, 1998 ______________________________ Jay A. Bielfield, Director
/s/ Kenneth C. Coon Dated: March 24, 1998 ______________________________ Kenneth C. Coon, Director
/s/ Edward W. Elliott, Jr. Dated: March 24, 1998 ______________________________ Edward W. Elliott, Jr., Director
/s/ Robert LeBuhn Dated: March 24, 1998 ________________________________ Robert LeBuhn, Director
/s/ Michael R. McCarthy Dated: March 24, 1998 ________________________________ Michael R. McCarthy, Director
/s/ John P. Nelson Dated: March 24, 1998 ________________________________ John P. Nelson, Director
/s/ R. L. Richards Dated: March 24, 1998 ________________________________ R. L. Richards, Director
/s/ David L. Treadwell Dated: March 24, 1998 ________________________________ David L. Treadwell, Director
/s/ Doug T. Valassis Dated: March 24, 1998 ________________________________ Doug T. Valassis, Director
ACCEPTANCE INSURANCE COMPANIES INC. ANNUAL REPORT ON FORM 10-K FISCAL YEAR ENDED DECEMBER 31, 1997
EXHIBIT INDEX
NUMBER EXHIBIT DESCRIPTION
3.1 Registrant's Restated Certificate of Incorporation, incorporated by reference to Registrant's Annual Report of Form 10-K for the period ending December 31, 1993, and Amendment thereto, incorporated by reference to Registrant's Quarterly Report on Form 10-Q for the period ended June 30, 1995.
3.2 Restated By-laws of Acceptance Insurance Companies Inc., incorporated by reference to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1993.
4.3 Form of Preferred Security (included in Exhibit 4.8). Incorporated by reference to Form S-3 Registration No.33-28749, filed July 29, 1997.
4.4 Form of Guarantee Agreement Between Acceptance Insurance Companies Inc. and Bankers Trust Company. Incorporated by reference to Form S-3 Registration No.33-28749, filed July 29, 1997.
4.5 Form of Junior Subordinated Indentures Between Acceptance Insurance Companies Inc. and Bankers Trust Company. Incorporated by reference to Form S-3 Registration No. 33-28749, filed July 29, 1997.
4.6 Certification of Trust of AICI Capital Trust. Incorporated by reference to Form S-3 Registration No. 33-28749, filed July 29, 1997.
4.7 Trust Agreement between Acceptance Insurance Companies Inc. and Bankers Trust (Delaware). Incorporated by reference to Form S-3 Registration No. 33-28749, filed July 29, 1997.
4.8 Form of Amended and Restated Trust Agreement among Acceptance Insurance Companies Inc., Bankers Trust Company and Bankers Trust (Delaware). Incorporated by reference to Form S-3 Registration No.33.28749, filed July 29, 1997.
4.9 Form of Stock Certificate representing shares of Acceptance Insurance Companies Inc., Common Stock, $.40 par value. Incorporated by reference to Exhibit 4.1 to Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992.
10.1 Intercompany Federal Income Tax Allocation Agreement between Acceptance Insurance Holdings Inc. and its subsidiaries and the Registrant dated April 12, 1990, and related agreements. Incorporated by reference to Exhibit 10i to the Registrant's Annual Report on Form 10-K for the fiscal year ended August 31, 1990.
10.2 Employment Agreement dated February 19, 1990 between Acceptance Insurance Holdings Inc., the Registrant and Kenneth C. Coon. Incorporated by reference to Exhibit 10.65 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991.
10.3 Employment Agreement dated July 2, 1993 between the Registrant and John P. Nelson. Incorporated by reference to Exhibit 10.6 to the Registrant's Quarterly Report on Form 10-Q for the period ended September 30, 1994.
10.4 Employment Agreement dated July 2, 1993 between the Registrant and Richard C. Gibson. Incorporated by reference to Exhibit 10.6 to the Registrant's Quarterly Report on Form 10-Q for the period ended September 30, 1994.
10.5 $100,000,000 Amended and Restated Credit Agreement by and Among the Registrant, The First National Bank of Chicago, Comerica Bank, First National Bank of Omaha, First Bank, N.A., Wells Fargo Bank, National Association and Mercantile Bank, N.A. and The First National Bank of Chicago, As Agent, and Comerica Bank, First National Bank of Omaha, and First Bank, N.A., As Co-Agents, dated as of June 6, 1997. Incorporated by reference to Exhibit 10.5 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997.
21 Subsidiaries of the Registrant.
23.1 Consent of Deloitte & Touche LLP.
23.2 Report on schedules of Deloitte & Touche LLP.
27 Financial Data Schedule.
99.1 The Registrant's 1997 Employee Stock Purchase Plan. Incorporated by reference to the Registrant's Proxy Statement filed on or about April 29, 1997.
99.2 The Registrant's Employee Stock Ownership and Tax Deferred Savings Plan as merged, amended and restated effective October 1, 1990. Incorporated by reference to Exhibit 10.4 to the Registrant's Quarterly Report on Form 10-Q for the quarter ended November 30, 1990.
99.3 First Amendment to the Registrant's Employee Stock Ownership and Tax Deferred Savings Plan. Incorporated by reference to Exhibit 99.4 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1993.
99.4 Second Amendment to the Registrant's Employee Stock Ownership and Tax Deferred Savings Plan. Incorporated by reference to Exhibit 99.5 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1993.
99.5 The Registrant's 1996 Incentive Stock Option Plan. Incorporated by reference to the Registrant's Proxy Statement filed on or about May 3, 1996.
99.6 Proxy Statement for 1998 Annual Meeting of Shareholders filed on or prior to April 30, 1998.