ITEM 1. BUSINESS
GENERAL DESCRIPTION
GAINSCO, INC. is a holding company, the only operations of which are to provide administrative and financial services for its wholly-owned subsidiaries. The term "Company" as used in this document includes GAINSCO, INC. and its subsidiaries, unless the context otherwise requires. The Company was incorporated in Texas on October 11, 1978. It completed its initial public offering on November 14, 1986.
The Company is a property and casualty insurance company concentrating its efforts on certain specialty excess and surplus markets within the commercial auto, auto garage and general liability insurance lines. The Company's insurance operations are conducted through three insurance companies, General Agents Insurance Company of America, Inc., an Oklahoma corporation, MGA Insurance Company, Inc., a Texas corporation, and GAINSCO County Mutual Insurance Company, a Texas chartered company. The Company is approved to write insurance in 49 states and the District of Columbia on a non-admitted basis and in 45 states on an admitted basis. The Company markets its lines of insurance through 186 non-affiliated general agents' offices. Approximately 71% of the Company's gross premiums written during 1997 resulted from risks located in California, Florida, Kentucky, Louisiana, Pennsylvania, Tennessee and Texas.
Excess and surplus lines of insurance are generally written on classes of risks which admitted insurers will not write; many of which are too small in premium size for larger companies to handle efficiently. For a description of the product lines presently written by the Company, see "Business-Product Lines." Because of the lack of availability of coverage from admitted insurers, premium levels for excess and surplus policies are generally higher than for standard coverages provided by admitted insurers. State insurance authorities permit excess and surplus lines companies greater rate and policy form flexibility than admitted companies. The Company, therefore, sets its policy premiums by applying its own judgment after consideration of the risks involved. Part of its analysis includes the review of historical premium rate and loss cost information as compiled and reported by independent rating bureaus. The Company's current premiums typically range from 160% to 275% of the loss costs published by the rating organizations. These loss cost multipliers approximate a range of 100% to 170% of manual rates.
The strategy of the Company is to identify various types of risks where it can price its coverages favorably and maximize the potential for underwriting profit. This strategy has resulted in changes in product mix and product design from time to time.
The Company, through a wholly-owned subsidiary, has developed and is marketing a computer software package related to general agency operations. Through another wholly-owned subsidiary, the Company is engaged in the premium finance business. Through MGA Insurance Company, Inc., a wholly-owned subsidiary, the Company earns fee revenues by acting as a servicing carrier for the Commercial Automobile Insurance Procedures of Arkansas, California, Louisiana, and Mississippi and the Commercial Assignment Procedure of Pennsylvania. Through GAINSCO County Mutual Insurance Company, the Company has fronting agreements with two non-affiliated insurance companies. The business written under these agreements is ceded 100% to reinsurers rated "A- (Excellent)" or better by A. M. Best Company (Best's) and 100% of the liabilities are fully collateralized with pledged investment grade securities or letters of credit.
PRODUCT LINES
The Company's principal products serve certain specialty markets within the commercial auto, auto garage and general liability insurance lines. The following table sets forth, for each product line, gross premiums written (before ceding any amounts to reinsurers), percentage of gross premiums written for the periods indicated and the number of policies in force at the end of each period.
Commercial Auto The commercial auto coverage underwritten by the Company includes risks associated with local haulers of specialized freight (e.g. sand and gravel), tradespersons' vehicles and trucking companies (other than long haulers). Policies are written only for vehicles primarily operated within the state of garaging and one state beyond or 1,000 miles, whichever is the greater distance. Liability and physical damage coverages for these risks are currently limited to $1,000,000 per accident and $100,000 per unit, respectively.
Auto Garage The Company's auto garage program includes garage liability, garage keepers' legal liability and dealers' open lot coverages. The maximum limit on these coverages is $1,000,000. The Company targets its coverage to used car dealers, recreational vehicle dealers, automobile repair shops and wrecker/towing risks.
General Liability The Company underwrites general liability insurance with liability limits up to $1,000,000 for small businesses such as car washes, janitorial services, small contractors, apartment buildings, rental dwellings and retail stores. The Company does not underwrite professional liability, manufacturers' products liability, liquor liability, heavy contracting liability, oil well drilling liability, marine liability or municipality risks.
Other Lines The Company also issues a variety of other property and casualty insurance coverages including monoline property insurance. The Company's restricted commercial property policy covers fire, extended coverage, vandalism and malicious mischief for commercial establishments. This policy covers property damage up to $200,000.
REINSURANCE
The Company purchases reinsurance in order to reduce its liability on individual risks and to protect against catastrophe claims. A reinsurance transaction takes place when an insurance company transfers, or "cedes", to another insurer a portion or all of its exposure. The reinsurer assumes the exposure in return for a portion or all of the premium. The ceding of insurance does not legally discharge the insurer from its primary liability for the full amount of the policies, and the ceding company is required to pay the claim if the reinsurer fails to meet its obligations under the reinsurance agreement.
The Company writes casualty policy limits of $1,000,000. For policies with an effective date occurring from 1992 through 1994, the Company has excess reinsurance for 100% of casualty claims exceeding $300,000 up to the $1,000,000 policy limits. For policies with an effective date occurring in 1995 or after, the Company has excess reinsurance for 100% of casualty claims exceeding $500,000 up to the $1,000,000 policy limits which results in a maximum net claim retention per risk of $500,000. The Company's maximum net claim retention per risk is $300,000 for policies with an effective date occurring from 1992 through 1994.
Excess casualty reinsurance carried by the Company includes "extra-contractual obligations" coverage. This coverage protects the Company against claims arising out of certain legal liability theories not directly based on the terms and conditions of the Company's policies of insurance. Extra-contractual obligation claims are covered 90% under the excess casualty reinsurance treaty up to its respective limits.
The Company is operating under excess casualty reinsurance treaties with three reinsurance companies, each of which reinsures a given percentage of ceded risks. The Company's excess reinsurance is provided in varying amounts by these reinsurers which are rated "A- (Excellent)" or better by A. M. Best Company. See
"Business--Rating." The following table identifies each such reinsurer and sets forth the percentage of the coverage assumed by each of them:
The Company carries catastrophe property reinsurance to protect it against catastrophe occurrences for 95% of the property claims which exceed $500,000 but do not exceed $8,000,000. From time to time the Company makes use of facultative reinsurance to cede unusual risks on a negotiated basis.
Beginning in 1995, the Company has entered into reinsurance fronting arrangements with non-affiliated insurance companies. The Company retains no portion as the business written under these agreements is 100% ceded. Although these cessions are made to authorized reinsurers rated "A- (Excellent)" or better by Best's, the agreements require that collateral (in the form of trust agreements and/or letters of credit) be maintained to assure payment of the unearned premiums and unpaid claims and claim adjustment expenses relating to the risks insured under these fronting arrangements.
The Company has signed contracts in force for its reinsurance treaties for all years through 1997. The Company has written confirmations from reinsurers for 1998 regarding the basic terms and provisions under which they will assume the Company's risks, but, as of the date hereof, formal reinsurance treaty contracts with these reinsurers have not been executed. It is customary in the industry for insurance companies and reinsurers to operate under such commitments pending the execution of formal reinsurance treaties. No assurance can be given that such reinsurance treaties will be executed or, if executed, that the terms and provisions thereof will not be modified.
MARKETING AND DISTRIBUTION
The Company markets its insurance products through 186 non-affiliated general agents' offices, commonly referred to as wholesale agents. These general agents each represent several insurance companies, some of which may compete with the Company. The general agents solicit business from independent local agents or brokers, commonly referred to as retail agents, who are in direct contact with insurance buyers.
The Company has elected to utilize general agents to market its insurance products in order to avoid the fixed costs of a branch office system. These general agents have experience in the specialty lines of coverages in which the Company concentrates and, in many instances, a long business history with members of the Company's management. The Company requires that its general agents have a specified level of errors and omissions insurance coverage, which indirectly protects the Company against certain negligence on the part
of general agents. The Company performs annual financial reviews and does limited quarterly reviews on each of its agent entities. Strict financial solvency and liquidity levels must be maintained by each general agent. The Company has errors and omissions insurance coverage to protect against negligence on the part of its employees.
The Company has developed underwriting manuals to be used by its general agents. The general agents are authorized to bind the Company to provide insurance if the risks and terms involved in the particular coverage are within the underwriting guidelines set forth in the Company's underwriting manuals. The Company has devoted extensive resources to the development of detailed underwriting manuals so that its general agents can consistently price and select risks, and the Company believes its manuals have been a significant factor in consistently producing superior underwriting results. All manuals stipulate minimum rates to be charged for the various classes of coverage offered.
The general agents are compensated on a commission basis which varies by line of business. In addition, the general agency contracts between the Company and its general agents contain significant profit contingency inducements designed to reward those general agents with superior claim ratios who write certain minimum levels of premium with the Company. The general agents also retain a portion of the payment made by the insured as policy fee in connection with the issuance of most of the Company's non-admitted policies.
Certain coverages, such as auto liability, may only be written in some states by companies with the authority to write insurance on an admitted basis in such states. The Company currently is approved to write insurance on an admitted basis in 45 states and plans to seek authority to write insurance on an admitted basis in all of the remaining states, but no assurance can be given of when or if this goal will be reached.
UNPAID CLAIMS AND CLAIM ADJUSTMENT EXPENSES
The Company maintains reserves for the payment of claims and claim adjustment expenses for both reported and unreported claims. Claim reserves are estimates, at a given point in time, of amounts that the Company expects to pay on incurred claims based on facts and circumstances then known. The amount of claim reserves for reported claims is primarily based upon a case-by-case evaluation of the type of claim involved, the circumstances surrounding the claim, and the policy provisions relating to the type of claim. The amount of claim reserves for unreported claims and case reserve development is determined on the basis of historical information and anticipated future conditions by lines of insurance and actuarial review. Reserves for claim adjustment expenses are intended to cover the ultimate costs of settling claims, including investigation and defense of lawsuits resulting from such claims. Inflation is implicitly reflected in the reserving process through analysis of cost trends and review of historical reserve results.
Ultimate liability may be greater or lower than current reserves. Reserves are continually monitored by the Company using new information on reported claims and a variety of statistical techniques. The Company does not discount to present value that portion of its claim reserves expected to be paid in future periods.
The following table sets forth the changes in unpaid claims and claim adjustment expenses, net of reinsurance cessions, as shown in the Company's consolidated financial statements for the periods indicated:
(1) The Company commuted its 1993 and 1994 quota-share reinsurance treaties in 1995, and thereby reassumed all risks and the related unpaid claims and claim adjustment expenses of $2,223,000 (see note 4 to the consolidated financial statements). This was accounted for using the paid claim method, whereby unpaid claims and claim adjustment expenses were increased $2,223,000 and paid claims and claim adjustment expenses were decreased $2,223,000, thus preventing distortion of claims and claim adjustment expenses incurred.
The development in claims and claim adjustment expenses incurred from prior periods was largely a result of claim reserve increases recorded for commercial auto claims in Kentucky for the 1996 and 1995 accident years and adverse development in claim adjustment expense reserves for commercial auto in the 1996, 1995 and 1994 accident years.
The following table sets forth, as of December 31, 1997, 1996, and 1995, differences between the amount of net unpaid claims and claim adjustment expenses reported in the Company's statements, prepared in accordance with statutory accounting principles ("SAP"), and filed with the various state insurance departments, and those reported in the consolidated financial statements prepared in accordance with generally accepted accounting principles ("GAAP"):
The following table represents the development of GAAP balance sheet reserves for the period 1987 through 1997. The top line of the table shows the reserves for unpaid claims and claim adjustment expenses for the current and all prior years as recorded at the balance sheet date for each of the indicated years. The reserves represent the estimated amount of claims and claim adjustment expenses for claims arising in the current and all prior years that are unpaid at the balance sheet date, including claims that have been incurred but not yet reported to the Company.
The upper portion of the following table shows the net cumulative amount paid with respect to the previously recorded liability as of the end of each succeeding year. The lower portion of the table shows the reestimated amount of the previously recorded net reserves based on experience as of the end of each succeeding year, including net cumulative payments made since the end of the respective year. For example, the 1990 liability for net claims and claim adjustment expenses reestimated seven years later (as of December 31, 1997) was $28,908,000 of which $28,734,000 has been paid, leaving a net reserve of $174,000 for claims and claim adjustment expenses in 1990 and prior years remaining unpaid as of December 31, 1997.
"Net cumulative redundancy (deficiency)" represents the change in the estimate from the original balance sheet date to the date of the current estimate. For example, the 1990 net reserve for unpaid claims and claim adjustment expenses indicates a $2,000 net deficiency from December 31, 1990 to December 31, 1997 (seven years later). Conditions and trends that have affected development of liability 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 table.
The Company has an indicated deficiency of approximately 10% of unpaid claims and claim adjustment expenses (C & CAE) for the 1996 year for reasons mentioned previously. Net unpaid C & CAE at December 31, 1997 was approximately $83,703,000, which the Company believes is adequate.
OPERATING RATIOS
CLAIMS, EXPENSE AND COMBINED RATIOS: Claims and expense ratios are traditionally used to interpret the underwriting experience of property and casualty insurance companies.
Statutory Accounting Principles (SAP) Basis - Claims and claim adjustment expenses are stated as a percentage of premiums earned because claims may occur over the life of a particular insurance policy. Underwriting expenses on a SAP basis are stated as a percentage of net premiums written rather than premiums earned because most underwriting expenses are incurred when policies are written and are not spread over the policy period. Underwriting profit margin is achieved when the combined ratio is less than 100%. The
Company's claims, expense and combined ratios and the property and casualty industry's claims, expense and combined ratios, both on a SAP basis, are shown in the following table:
(1) The property and casualty industry as a whole, not companies with comparable lines of coverage, was used in the calculation of these ratios by Best's. Ratios for 1997 are estimated.
The Company has continued to produce favorable claims ratios when compared to the industry. This has resulted from the Company maintaining its high underwriting standards and closely monitoring its pricing structure and adjusting it when needed. The unfavorable variance to the industry with regard to the expense ratios is because of the specific lines that the Company writes and the profit contingency inducements. The Company's commission expense ratio is higher than the average of the overall industry on a net premiums written basis. Its higher expense ratios are more than offset by lower claims ratios (favorable by an estimated 13.7 percentage points in 1997 and 24.1 percentage points in 1996, when compared to the industry) which results in the favorable combined ratio variances of an estimated 6.0 and 15.9 percentage points in 1997 and 1996, respectively. It should be noted that the Company ratios relate only to insurance operations. The holding company provides administrative and financial services for its wholly-owned subsidiaries. The allocation of the holding company's expenses solely to its insurance companies would have an impact on their results of operations and would also affect the ratios presented.
Generally Accepted Accounting Principles (GAAP) Basis - Claims and claim adjustment expenses are stated as a percentage of premiums earned as they are on a SAP basis. However, earned premiums include net policy fees earned whereas on a SAP basis policy fees earned are recorded on a gross basis. The GAAP expense ratio is based on premiums earned and includes the change in policy acquisition costs and underwriting expenses. Other differences include the treatment of the allowance for doubtful accounts. The following table presents the Company's claims, expense and combined ratios on a GAAP basis:
PREMIUM TO SURPLUS RATIO: The following table shows, for the periods indicated, the Company's statutory ratios of statutory net premiums written to statutory policyholders' surplus. While there is no statutory requirement which establishes a permissible net premiums written to surplus ratio, guidelines established by the National Association of Insurance Commissioners (NAIC) provide that this ratio should be no greater than 3 to 1.
INVESTMENTS
The Company's investment portfolio is under the direction of the Board of Directors acting through the Investment Committee. The Investment Committee establishes the Company's investment policy, which is to maximize after-tax yield while maintaining safety of capital together with adequate liquidity for insurance operations. The investment portfolio consists primarily of fixed maturity tax-exempt municipal bonds and United States Government securities. The Company does not invest in high yield ("junk") securities. As of December 31, 1997 and 1996, the Company had no high-yield fixed maturity securities nor non-performing fixed maturity securities. Furthermore, the Company has never bought nor sold either high-yield fixed maturity securities or derivatives. The Company does not actively trade its bonds, however, it does classify certain bond securities as available for sale. The Company holds no equity securities in issuers of high-yield debt securities.
The following table sets forth, for the periods indicated, the Company's investment results, before income tax effects:
- ---------- (1) Average investments is the average of beginning and ending investments at amortized cost, computed on an annual basis.
(2) Includes taxable and tax-exempt securities.
The following table sets forth the composition of the investment portfolio of the Company.
The maturity distribution of the Company's investments in fixed maturities is as follows:
RATING
Best's insurance reports, property-casualty, has currently assigned an "A+ (Superior)" pooled rating to the Company. Best's ratings are based on an analysis of the financial condition and operation of an insurance company as they relate to the industry in general. Best's generally reviews its ratings on a quarterly basis.
GOVERNMENT REGULATION
The Company's insurance companies are subject to varied governmental regulation in the states in which they conduct business. Such regulation is vested in state agencies having broad administrative power dealing with all aspects of the Company's business and is concerned primarily with the protection of policyholders rather than shareholders.
The Company is also subject to statutes governing insurance holding company systems in the states of Oklahoma and Texas. These statutes require the Company to file periodic information with the state regulatory authorities, including information concerning its capital structure, ownership, financial condition and general business operation. These statutes also limit certain transactions between the Company and its insurance companies, including the amount of dividends which may be declared and paid by the insurance companies (see note 6 to the consolidated financial statements). Additionally, the Texas statutes restrict the ability of any one person to acquire 10% or more of the Company's voting securities without prior regulatory approval while the Oklahoma statute restricts the ability of any one person to acquire 15% or more of the Company's voting securities without prior regulatory approval.
COMPETITION
The property and casualty insurance industry is highly competitive, with over 2,500 insurance companies transacting business in the United States. The Company underwrites specialty lines of insurance on risks not generally insured by many of the large standard property and casualty insurers. However, few barriers exist to prevent property and casualty insurance companies from entering into the Company's segments of the industry. To the extent this occurs, the Company can be at a competitive disadvantage because many of these companies have substantially greater financial and other resources and can offer a broader variety of specialty risk coverages. The Company's competitive advantages are 1) specialized expertise in its product lines which enables it to price with a great deal of accuracy and 2) superior service in underwriting and claims handling which provides its agents with a competitive advantage and a stable market.
EMPLOYEES
As of December 31, 1997, the Company employed 168 persons, of which 12 were officers, 142 were staff and administrative personnel, and 14 were part-time employees.
EXECUTIVE OFFICERS OF THE REGISTRANT
Information concerning the executive officers of the Company as of February 28, 1998 is set forth below:
Mr. Joseph D. Macchia is the founder of the Company and has served as Chairman of the Board, President and Chief Executive Officer since its formation in 1978. Mr. Macchia has been engaged in the property and casualty insurance business since 1961.
Mr. Daniel J. Coots has served as Vice President, Treasurer and Chief Financial Officer of the Company since 1987. In 1991 Mr. Coots was promoted to Senior Vice President. Mr. Coots has been engaged in the property and casualty insurance business since 1983.
Mr. Norman Alberigo has served as Vice President of the Company since 1988. From 1986 to 1988, Mr. Alberigo served as Assistant Vice President of the Company. Mr. Alberigo has been engaged in the property and casualty insurance business since 1970.
Mr. Richard M. Buxton has served as Vice President of the Company since December of 1996. From 1986 to 1996 Mr. Buxton was with KN Energy, Inc. in the position of Vice President of Strategic Planning and Financial Services.
Ms. Brigitte G. Doyle has served as Vice President of the Company since June of 1997. From 1994 to May of 1997, Ms. Doyle served as Assistant Vice President of the Company. Ms. Doyle has served in various management capacities with the Company since 1984. Ms. Doyle has been engaged in the property and casualty business since 1984.
Mr. J. Landis Graham has served as Vice President of the Company since September of 1993. From 1988 to 1993, Mr. Graham was with Maryland Casualty Company in the position of Claim Manager. Mr. Graham has been engaged in the property and casualty insurance business since 1976.
Mr. Richard A. Laabs has served as Vice President of the Company since June of 1996. From August of 1995 to May of 1996, Mr. Laabs served as Assistant Vice President of the Company. From 1990 to 1995, Mr. Laabs was with Scottsdale Insurance Company in the position of Senior Information Systems Services Director. Mr. Laabs has been engaged in the property and casualty insurance business since 1978.
Mr. Joseph W. Pitts has served as Vice President of the Company since August of 1997. From 1992 to 1997, Mr. Pitts was with USAA in the position of Actuary and Manager. Mr. Pitts has been engaged in the property and casualty business since 1988.
Ms. Carolyn E. Ray has served as Vice President of the Company since 1986. From 1984 to 1985, Ms. Ray served as Assistant Vice President of the Company. Ms. Ray has been engaged in the property and casualty insurance business since 1976.
Ms. Sharon B. Sholden has served as Vice President of the Company since December of 1997. From August 1995 to 1997, Ms. Sholden served as Program Manager for TIG Insurance. From 1993 to 1995, Ms. Sholden was with Associates Insurance in the position of Vice President. Ms. Sholden has been engaged in the property and casualty business since 1982.
Mr. Sam Rosen has served as the Secretary and a Director of the Company since 1983. Mr. Rosen is a partner with the law firm of Shannon, Gracey, Ratliff & Miller, L.L.P. He has been a partner in that firm or its predecessors since 1966.
ITEM 2.
ITEM 2. PROPERTY
The Company owns its Corporate offices which provide approximately 35,000 square feet of office space, and additionally provides parking. Future expansion will be possible by converting the parking area into office space.
The Company owns a 3.28 acre tract of land in Fort Worth, Texas and all improvements located thereon, including a 10,000 square foot office building, which previously served as its corporate offices. The Company currently has this property under lease.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
In the normal course of its operations, the Company has been named as defendant in various legal actions seeking payments for claims denied by the Company and other monetary damages. In the opinion of the Company's management the ultimate liability, if any, resulting from the disposition of these claims will not have a material adverse effect on the Company's consolidated financial position or results of operations. The Company's management believes that unpaid claims and claim adjustment expenses are adequate to cover liabilities from claims which arise in the normal course of its insurance business.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS.
The Company's Common Stock is listed on the New York Stock Exchange (Symbol: GNA). The following table sets forth for the fiscal periods indicated the high and low closing sales prices per share of the Common Stock as reported by the American Stock Exchange, as adjusted for stock dividends through July 30, 1996 and by the New York Stock Exchange from July 31, 1996 through December 31, 1997. The prices reported reflect actual sales transactions on these exchanges.
Cash dividends of $.01 per share were paid to shareholders of record on March 31, June 30 and September 30, 1995. Cash dividends of $.0125 per share were paid to shareholders of record on December 31, 1995, March 29 and June 28, 1996. Cash dividends of $.015 per share were paid to shareholders of record on September 30 and December 31, 1996 and March 31, June 30 and September 30, 1997. Cash dividends of $.0175 per share were paid to shareholders of record on December 31, 1997. On February 18, 1998, the Company declared a $.0175 per share cash dividend payable to shareholders of record on March 31, 1998. The Company depends on cash flow from cash dividends paid by its subsidiaries.
Stock dividends of 5% were paid to shareholders of record on March 31 and September 30, 1995. In November, 1995, the Board of Directors discontinued the semi-annual stock dividends.
The Company purchased 243,932 shares of its Common Stock during 1997. Additionally, a total of 17,200 shares were purchased in January and February of 1998. The Company has not purchased shares of its stock since February of 1998 and has no plans to purchase additional shares.
As of February 28, 1998, there were 432 shareholders of record of the Company's Common Stock.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data presented below for, and as of the end of each of the years ended December 31, have been derived from the consolidated financial statements of the Company which have been audited by KPMG Peat Marwick LLP, independent certified public accountants. The consolidated balance sheets as of December 31, 1997 and 1996, and the consolidated statements of operations, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1997, and the report thereon are included elsewhere in this document. The information presented below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations," consolidated financial statements and the notes thereto, and the other financial information included herein.
- ---------- (1) Excludes premiums of $40,136,000 in 1997, $31,603,000 in 1996, $8,893,000 in 1995, $5,056,000 in 1994 and $5,418,000 in 1993 from the Company's fronting arrangements and the commercial automobile plans of Arkansas, California, Louisiana, Mississippi, and Pennsylvania under which the Company is a servicing carrier.
(2) Includes after tax net realized gains of $212,000, $307,000, $70,000, $87,000 and $3,000 for 1997, 1996, 1995, 1994, and 1993, respectively.
(3) All years retroactively adjusted for stock dividends and stock splits effected as stock dividends as follows: two 5% in 1995, two 5% in 1994 and two 5% in 1993. All prior years have been restated to comply with Statement of Financial Accounting Standards No. 128, "Earnings Per Share".
(4) Based on number of shares outstanding at the end of each year, retroactively adjusted for stock dividends and stock splits effected as stock dividends.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
BUSINESS OPERATIONS
Net income for 1997 decreased 26% to $11,923,526, or $.56 per share (diluted) compared to 1996 net income of $16,019,567, or $.74 per share (diluted) and 1995 net income of $17,627,855, or $.81 per share (diluted). The Company recorded an 11% return on beginning equity and a GAAP combined ratio of 94.4% in 1997.
The discussion below primarily relates to the Company's insurance operations, although the selected consolidated financial data appearing elsewhere is on a consolidated basis. The revenue item "Insurance services" includes revenues from the computer software, the plan servicing, the premium finance and the fronting reinsurance operations. The expense item "Underwriting and operating expenses" includes the operating expenses of these operations.
RESULTS OF OPERATIONS
Gross premiums written in 1997 of $99,775,854 were 9% below the $110,000,103 recorded in 1996. In 1996, gross premiums written increased 2% over the 1995 level. The cancellation of the Kentucky coal truck program and a taxi program in New Jersey contributed 3 percentage points (points) of decrease while increased competition in the Florida, Georgia, Pennsylvania and Virginia markets contributed another 4 points of decrease in 1997. In 1996, the small growth rate was the result of Texas contributing 4 points of decrease due to intensified competition. The following table compares the major product lines between the years for gross premiums written:
COMMERCIAL AUTO was down 9% in 1997 from 1996 and flat in 1996 from 1995. Kentucky contributed 4 points of decrease with Georgia, New Jersey, Pennsylvania and Virginia accounting for the remaining 5 points of decrease. A decision was made during the year to discontinue writing Kentucky coal truck risks and a New Jersey taxi cab program because of adverse claim results. In Pennsylvania several new carriers have entered the market and they are specifically targeting the Company's lines of business. In Georgia and Virginia competition has dramatically intensified with regard to pricing. In 1996, the flat premium growth was the result of decreases from Texas and Pennsylvania being offset with growth from Kentucky. The AUTO GARAGE product line resulted in a 13% decrease in 1997 after a 6% increase in 1996. The majority of the decrease came from Connecticut, Florida, Pennsylvania and Virginia. In Connecticut several new entrants to the market increased the competition by writing garage lines they had not previously written. Competition in Florida was in the form of price cutting from existing markets. In Pennsylvania the auto garage situation was similar to commercial auto, i.e., new carriers entered the market and targeted the Company's lines of
business. In 1996 the auto garage line recorded a 6% increase with Florida, Kentucky and Pennsylvania all producing significant increases. The GENERAL LIABILITY line decreased 10% in 1997 after an increase of 4% in 1996. California and Florida accounted for 6 points and 2 points of decrease, respectively. An underwriting decision was made in California to not renew large general contractors in light of the Montrose case. In Florida, increased competition from new and existing companies contributed to the decrease. In 1996, California and Florida were contributors to the increase while Texas was down. For 1997, gross premiums written percentages by significant state/product line are as follows: Texas commercial auto (22%), Kentucky commercial auto (6%), Pennsylvania commercial auto (6%), Texas general liability (6%), and Florida auto garage (5%) with no other individual state/product line comprising 5% or more. The persistency rate increased to 46% in 1997 from 45% in 1996. Premiums earned decreased 4% in 1997 to $102,255,979 and increased 10% in 1996 to $106,792,928 as a direct result of the level of premiums written.
Net investment income increased 6% in 1997 over 1996 and increased 12% in 1996 over 1995. These increases are the result of growth in the portfolio due to continued positive cash flows from operations. The return on average investments for 1997 is 4.7% versus 4.8% in 1996 and 1995. Inflation can cause interest rates to increase, which would cause the Company's interest income to increase. Because of the Company's profitability in the underwriting operations, the Company achieves the highest after tax net income by investing predominantly in tax-exempt securities as compared to taxable fixed income securities. At December 31, 1997, 83% of the Company's investments were in investment grade tax-exempt bonds with an average maturity of approximately 3.4 years. Since the majority of the Company's investments are tax-exempt, the yields appear lower than those of the industry; however, the industry as a whole has a significantly larger percentage of investments in taxable securities with substantially longer maturities. On a taxable equivalent basis the return on average investments was 6.5% in 1997 and 6.6% in 1996 and 1995. The Company has the ability to hold its fixed maturity securities until their maturity date. The Company does not actively trade its bonds, however, it does classify certain bond securities as available for sale. At December 31, 1997, approximately 16% of the Company's investments were in U.S. Treasury securities and 1% were in short-term money market funds. The Company has not and does not intend to invest in derivatives or high-yield ("junk") securities, nor equity securities in issuers of "junk" debt securities. The Company does not have any non-performing fixed maturity securities.
The Company recorded net realized capital gains of $326,905 in 1997 versus $471,956 in 1996 and $108,024 in 1995. All of these gains were generated from the bonds available for sale category of the fixed maturity portfolio.
Insurance services revenues increased $252,165 from 1996 to 1997 following an increase of $196,645 in 1996 from 1995. The table below presents the components.
Plan servicing revenues from commercial automobile plans decreased 12% in 1997 from 1996 following an 11% decrease in 1996. Written premiums in 1997 are 14% below 1996 as a result of decreases in the Louisiana and Pennsylvania plans. In 1996, the California, Louisiana and Pennsylvania plans all recorded decreases in written premiums from 1995. These plans are depopulating as risks are moving into the voluntary market due to lower pricing. The Company continues to pursue management contracts with other states to administer their commercial automobile plans and is seeking a larger participation in existing plans.
Fee income increased $265,021 in 1997 over 1996 and $280,838 in 1996 over 1995 as a result of continued significant growth in the fronting reinsurance operation.
Revenues in the computer software operation increased 39% in 1997 from 1996 after being flat from 1995 to 1996. A significant increase in system sales occurred in 1997 as a result of marketing initiatives implemented in late 1996. New management brought in during the third quarter of 1995 has improved this operation and revenues are expected to show increases in the future.
Revenues from the premium finance operation are down 17% in 1997 from the 1996 level which was 23% above the 1995 level. The decrease is a result of the taxi cab programs that were discontinued, increased competition and the decision to offer interest free payment plans from the Company's insurance companies in order to increase premium writings. Amounts financed in 1997 were 32% below 1996 which had increased 5% over 1995. Premium finance notes receivable were approximately $1,400,000 at December 31, 1997 versus $1,991,000 at December 31, 1996 and the average return was 17% for 1997 and 1996 versus 19% in 1995.
Claims and claim adjustment expenses (C & CAE) increased $3,706,923 in 1997 over 1996 and $9,913,707 in 1996 over 1995. The C & CAE ratio was 60.7% in 1997, 54.7% in 1996 and 49.8% in 1995. The increase in the C & CAE ratio of 6 percentage points in 1997 is the result of claim reserve increases recorded for commercial auto claims in Kentucky from the 1995 and 1996 accident years and adverse development in claim adjustment expense reserves for commercial auto in the 1994, 1995 and 1996 accident years. The increase in the C & CAE ratio of 4.9 percentage points in 1996 was also related to commercial auto claims in the 1995 and 1994 accident years. While the Company writes a material amount of business in areas where catastrophes have recently occurred, the gross and net claims incurred from these events were immaterial because the Company primarily writes liability coverages. With regard to environmental and product liability claims, the Company has an immaterial amount of exposure. The Company does not provide environmental impairment coverage and excludes pollution and asbestos related coverages in its policies. Approximately 2% of the Company's premium writings are for product liability coverages and this is limited to non-manufacturing risks only. Inflation impacts the Company by causing higher claim settlements than may have originally been estimated. Inflation is implicitly reflected in the reserving process through analysis of cost trends and review of historical reserve results.
The decrease in commissions from 1996 to 1997 is related to the decrease in gross premiums written. The increase in commissions from 1995 to 1996 is related to the increase in gross premiums written and to a decrease of approximately $1,669,000 in commission income from reinsurance treaties. The ratio of commissions to gross premiums written increased to 22% in 1997 and 1996 from the 20% level in 1995. The increase in 1996 is a result of a decrease in commission income. The ratio of commissions to premiums earned was 21% for 1997 as compared to 23% for 1996 and 1995. The decrease in 1997 was related to the decrease in the commission expense rate in 1997 attributable to lower contingent commissions resulting from higher C & CAE ratios.
The change in deferred policy acquisition costs and deferred ceding commission income (DAC) resulted in a net decrease to income of $1,015,802 for 1997 and a net increase to income of $519,257 and $2,284,138 for 1996 and 1995, respectively. The change in the amount of the increase or decrease in DAC between the comparable periods is directly related to the rate at which unearned premiums are growing or declining as a result of premium writings. Since DAC (asset) is a function of unearned premiums (liability), an increase in the growth rate of net unearned premiums would correspondingly result in an increase in the growth rate of DAC and vice versa. The ratio of DAC to net unearned premiums was 25.9%, 25.8% and 25.5% at December 31, 1997, 1996 and 1995, respectively.
Underwriting and operating expenses were up slightly in 1997 from 1996, and down slightly in 1996 from 1995. As a percent of operating revenues (premiums earned and insurance services revenues) the ratio remained relatively flat at 14.8% in 1997 while 1996 decreased to 14.2% from the 1995 level of 15.7%. The increase in the rate in 1997 is related to the 4% decrease in operating revenues for 1997. The decrease in 1996 was the result of savings from variable expenses in personnel costs and in the plan servicing operation. In March 1997, the Company began converting its computer systems to be year 2000 compliant. At December 31, 1997, approximately 70 percent of the Company's systems were compliant, with all systems expected to be compliant by the end of 1998. The total cost of the project is estimated to be $850,000 and is being funded through operating cash flows. The Company is expensing all costs associated with these system changes. As of December 31, 1997, the amount expensed was immaterial.
The effective tax rate of the Company was 19% in 1997, 24% in 1996, and 26% in 1995. The lower rates in 1997 and 1996 are largely the result of tax-exempt net investment income representing a larger portion of income than in 1995. For the Company, the fresh start adjustment (tax benefit) was immaterial for all years presented. A reconciliation between income taxes computed at the Federal statutory rates and the provision for income taxes is included in Note 5 of Notes to Consolidated Financial Statements.
For 1998 the Company is targeting premiums written to be within a $105-115 million range with a GAAP combined ratio of 87.5-92.5% and a return on beginning equity of better than 11.5%. While the Company is optimistic these forward-looking goals can be attained, no assurances can be given they will occur.
LIQUIDITY AND CAPITAL RESOURCES
The primary sources of the Company's liquidity are funds generated from insurance premiums, net investment income and maturing investments. The short-term investments and cash are intended to provide adequate funds to pay claims without selling fixed maturity investments. At December 31, 1997, the Company held short-term investments and cash of $3,519,906 which the Company believes is adequate liquidity for the payment of claims and other short-term commitments.
With regard to long term liquidity, the average duration of the investment portfolio is approximately 3 years. The fair value of the fixed maturity portfolio at December 31, 1997 was $2,422,271 above amortized cost. With regard to the availability of funds to the holding company, see Note 6 of Notes to Consolidated Financial Statements for restrictions on the payment of dividends by the insurance companies. Various insurance departments of states in which the Company operates require the deposit of funds to protect policyholders within those states. At December 31, 1997 and 1996, the balance on deposit for the benefit of such policyholders totaled approximately $12,965,000 and $12,615,000, respectively.
The increase in investments is primarily attributable to continued positive cash flows from operating activities which are the result of continued and substantial underwriting profits. Premiums receivable and Deferred policy acquisition costs decreased as a result of the decrease in premiums written. Ceded unpaid claims and claim adjustment expenses as well as ceded unearned premiums increased largely as a result of the increase in fronting reinsurance activity mentioned previously.
Unpaid claims and claim adjustment expenses increased largely as a result of increases to reserves on retained business as well as material increases from plan servicing and fronting reinsurance. Unearned premiums decreased because of the decrease in premiums written, offset to some extent by an increase in fronting reinsurance. Accounts payable decreased because of contingent payables based upon profitability levels that have decreased. Drafts payable increased because a large amount of drafts were issued in the fourth quarter of 1997 in an aggressive effort to bring specifically targeted claims to an early and fair conclusion. The Company's liquidity position remains strong as a result of cash flows from underwriting and investment activities.
The unrealized gains or losses on fixed maturities available for sale are presented, net of tax, as a separate component of shareholders' equity (see Note 2 of Notes to Consolidated Financial Statements). The net unrealized gain on the fixed maturities classified as held to maturity was $794,166 at December 31, 1997.
The Company purchased 243,932 shares of its common stock during 1997 at a cost of $2,113,560 or $8.66 per share which accounts for the increase in Treasury stock.
During 1997, the Financial Accounting Standards Board issued Statement 130, "Reporting Comprehensive Income". The Statement is effective for fiscal years beginning after December 15, 1997 and will be adopted by the Company in the first quarter of 1998.
The Company is not aware of any current recommendations by the regulatory authorities, which if implemented, would have a material effect on the Company's liquidity, capital resources or results of operations. The Company's statutory capital significantly exceeds the benchmark capital level under the Risk Based Capital formula for its major insurance companies.
FORWARD LOOKING STATEMENTS
This Form 10-K Report and the Company's shareholder reports contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Investors are cautioned that all forward-looking statements involve certain risks and uncertainties that could cause actual results to differ materially from those contained in the forward-looking statements. Important factors include, but are not limited to, (i) heightened competition, including price competition from existing competitors, from newly formed competitors and from the entry into the Company's markets of standard insurance companies which historically have not competed in the Company's specialty markets, (ii) contraction of the markets for the Company's various lines of business, (iii) development and performance of new specialty programs, (iv) the ongoing level of claims and claims-related expenses, (v) adequacy of claim reserves, and (vi) general economic conditions.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following consolidated Financial Statements are on pages 34 through 58:
The following Consolidated Financial Statements Schedules are on pages 59 through 70:
ITEM 9.
ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item with regard to Executive Officers is included in Part 1 of this report under the heading "Executive Officers of the Registrant".
The other information required by this item is hereby incorporated by reference from the Registrant's definitive 1998 Proxy Statement.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is hereby incorporated by reference from the Registrant's definitive 1998 Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is hereby incorporated by reference from the Registrant's definitive 1998 Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is hereby incorporated by reference from the Registrant's definitive 1998 Proxy Statement.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Documents filed as part of the report:
1. The following financial statements filed under Part II, Item 8:
Independent Auditors' Report
Consolidated Balance Sheets as of December 31, 1997 and 1996
Consolidated Statements of Operations for the Years Ended December 31, 1997, 1996 and 1995
Consolidated Statements of Shareholders' Equity for the Years Ended December 31, 1997, 1996 and 1995
Consolidated Statements of Cash Flows for the Years Ended December 31, 1997, 1996 and 1995
Notes to Consolidated Financial Statements, December 31, 1997, 1996 and 1995
2. The following Consolidated Financial Statement Schedules are filed Under Part II, Item 8:
3. The following Exhibits:
(b) Reports on Form 8-K
During the last quarter of the fiscal year ended December 31, 1997, no reports on Form 8-K have been filed by the Company.
(c) Exhibits required by Item 601 of Regulation SK
The exhibits listed in Item 14(a) 3 of this Report, and not incorporated by reference to a separate file are filed herewith.
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.
GAINSCO, INC. (Registrant)
/s/ Joseph D. Macchia - ----------------------------------- By: Joseph D. Macchia, President
Date: 03/30/98 ------------------------------
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.
*By: /s/ Joseph D. Macchia ----------------------------------- Joseph D. Macchia, Attorney in-fact Under Power of Attorney
Subsequent to the filing of the Annual Report on this Form, an Annual Report to Security Holders covering the Registrant's last fiscal year and a Proxy Statement and Form of Proxy will be sent to more than ten of the Registrant's security holders with respect to the Annual Meeting.
REPORT OF MANAGEMENT
The accompanying consolidated financial statements were prepared by the Company, which is responsible for their integrity and objectivity. The statements have been prepared in conformity with generally accepted accounting principles and include some amounts that are based upon the Company's best estimates and judgement. Financial information presented elsewhere in this report is consistent with the accompanying consolidated financial statements.
The accounting systems and controls of the Company are designed to provide reasonable assurance that transactions are executed in accordance with management's criteria, that the financial records are reliable for preparing financial statements and maintaining accountability for assets, and that assets are safeguarded against claims from unauthorized use or disposition.
The Company's consolidated financial statements have been audited by KPMG Peat Marwick LLP, independent auditors. The auditors have full access to each member of management in conducting their audits.
The Audit Committee of the Board of Directors, comprised solely of directors from outside of the Company, meets regularly with management and the independent auditors to review the work and procedures of each. The auditors have free access to the Audit Committee, without management being present, to discuss the results of their work as well as the adequacy of the Company's accounting controls and the quality of the Company's financial reporting. The Board of Directors, upon recommendation of the Audit Committee, appoints the independent auditors, subject to shareholder approval.
/s/ Joseph D. Macchia ------------------------------- Joseph D. Macchia Chairman of the Board, President and Chief Executive Officer
/s/ Daniel J. Coots ------------------------------ Daniel J. Coots Senior Vice President and Chief Financial Officer
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Shareholders GAINSCO, INC.:
We have audited the consolidated balance sheets of GAINSCO, INC. and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of GAINSCO, INC. and subsidiaries at December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1997, in conformity with generally accepted accounting principles.
We have also previously audited, in accordance with generally accepted auditing standards, the consolidated balance sheets of GAINSCO, INC. and subsidiaries as of December 31, 1995, 1994 and 1993, and the related consolidated statements of operations, shareholders' equity and cash flows for the years ended December 31, 1994 and 1993, and we expressed unqualified opinions on those consolidated financial statements.
In our opinion, the information set forth in the selected consolidated financial data for each of the years in the five- year period ended December 31, 1997, appearing on pages 19 and 20, is fairly presented, in all material respects, in relation to the consolidated financial statements from which it has been derived.
KPMG Peat Marwick LLP
Dallas, Texas February 16, 1998
GAINSCO, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, 1997 and 1996
See accompanying notes to consolidated financial statements.
GAINSCO, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, 1997 and 1996
See accompanying notes to consolidated financial statements.
GAINSCO, INC. AND SUBSIDIARIES
Consolidated Statements of Operations
Years ended December 31, 1997, 1996 and 1995
See accompanying notes to consolidated financial statements.
GAINSCO, INC. AND SUBSIDIARIES
Consolidated Statements of Shareholders' Equity
Years ended December 31, 1997, 1996, and 1995
(continued)
GAINSCO, INC. AND SUBSIDIARIES
Consolidated Statements of Shareholders' Equity
Years ended December 31, 1997, 1996, and 1995
See accompanying notes to consolidated financial statements.
GAINSCO, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Years ended December 31, 1997, 1996 and 1995
(continued) GAINSCO, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Years ended December 31, 1997, 1996 and 1995
See accompanying notes to consolidated financial statements.
GAINSCO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1997, 1996 and 1995
(1) SUMMARY OF ACCOUNTING POLICIES
(a) Basis of Consolidation
The accompanying consolidated financial statements include the accounts of GAINSCO, INC. (the Company) and its wholly-owned subsidiaries, General Agents Insurance Company of America, Inc. (General Agents), General Agents Premium Finance Company (GAPFCO), Agents Processing Systems, Inc., Risk Retention Administrators, Inc. and GAINSCO Service Corp. (GSC). General Agents has one wholly-owned subsidiary, MGA Insurance Company, Inc. (MGAI) which, in turn, owns 100% of MGA Agency, Inc. GSC has one wholly- owned subsidiary, MGA Premium Finance Company. GSC controls the management contract and charter of GAINSCO County Mutual Insurance Company (GCM) and its accounts have been included in the accompanying consolidated financial statements. All significant intercompany accounts have been eliminated in consolidation.
The accompanying consolidated financial statements are prepared in conformity with generally accepted accounting principles. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
(b) Nature of Operations
The Company is predominantly a property and casualty insurance company concentrating its efforts on certain specialty excess and surplus markets within the commercial auto, auto garage and general liability insurance lines. The Company is approved to write insurance in 49 states and the District of Columbia on a non-admitted basis and in 45 states on an admitted basis. The Company markets its lines of insurance through 186 non-affiliated general agents' offices. Approximately 71% of the Company's gross premiums written during 1997 resulted from risks located in California, Florida, Kentucky, Louisiana, Pennsylvania, Tennessee and Texas.
GAINSCO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1997, 1996 and 1995
(c) Investments
Bonds held to maturity are stated at amortized cost, bonds available for sale are stated at fair value. Short-term investments are stated at cost. The "specific identification" method is used to determine costs of investments sold. Since investments not available for sale are held until maturity, provisions for possible losses are recorded only when the values have experienced impairment considered "other than temporary". Proceeds from the sale of bond securities totalled $37,694,342, $38,403,636 and $10,741,080 in 1997, 1996 and 1995, respectively. The realized gains were $384,184, $516,997 and $108,024 in 1997, 1996 and 1995, respectively. The realized losses were $57,279, $45,041 and $0 in 1997, 1996 and 1995, respectively.
(d) Financial Instruments
For premiums receivable, which include premium finance notes receivable, and all other accounts (except investments) defined as financial instruments in Financial Accounting Standards Board (FASB) Statement 107, "Disclosures About Fair Values of Financial Instruments," the carrying amount approximates fair value due to the short-term nature of these instruments. These balances are disclosed on the face of the balance sheet.
Fair values for investments, disclosed in note 2, were obtained from independent brokers and published valuation guides.
(e) Deferred Policy Acquisition Costs and Deferred Ceding Commission Income
Policy acquisition costs, principally commissions, marketing and underwriting expenses, are deferred and charged to operations over periods in which the related premiums are earned. Ceding commission income, which is realized on a written basis, is deferred and recognized over periods in which the premiums are earned. Deferred ceding commission income is netted against deferred policy acquisition costs. The marketing expenses are predominately salaries, salary related expenses and travel expenses of the Company's marketing representatives who actively solicit business from the independent general agents.
GAINSCO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1997, 1996 and 1995
The change in the resulting deferred asset is charged (credited) to operations. Information relating to these net deferred amounts, as of and for the years ended December 31, 1997, 1996 and 1995 is summarized as follows:
(f) Property and Equipment
Property and equipment are stated at cost. Depreciation is calculated using the straight-line method over the estimated useful lives of the respective assets (30 years for buildings and primarily 5 years for furniture, equipment and software).
The following schedule summarizes the components of property and equipment:
There are no material capital leases.
GAINSCO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1997, 1996 and 1995
(g) Software Costs
The Company capitalizes certain costs of developing computer software intended for resale. Costs relating to programs for internal use are recorded in property and equipment and are amortized using the straight-line method over five years or the estimated useful life, whichever is shorter. The deferred cost is also reduced by incidental sales of programs developed for internal use.
(h) Treasury Stock
The Company records treasury stock in accordance with the "cost method" described in Accounting Principles Board Opinon (APB) 6. The Company held 826,894 shares and 582,962 shares as treasury stock at December 31, 1997 and 1996, respectively, with a cost basis of $9.13 and $9.33 per share, respectively.
(i) Premium Revenues
Premiums are recognized as earned on a pro rata basis over the period the Company is at risk under the related policy. Unearned premiums represent the portion of premiums written which are applicable to the unexpired terms of policies in force.
(j) Claims and Claim Adjustment Expenses
Claims and claim adjustment expenses, less related reinsurance, are provided for as claims are incurred. The provision for unpaid claims and claim adjustment expenses includes: (1) the accumulation of individual case estimates for claims and claim adjustment expenses reported prior to the close of the accounting period; (2) estimates for unreported claims based on past experience modified for current trends; and (3) estimates of expenses for investigating and adjusting claims based on past experience.
Liabilities for unpaid claims and claim adjustment expenses are based on estimates of ultimate cost of settlement. Changes in claim estimates resulting from the continuous review process and differences between estimates and ultimate payments are reflected in expense for the year in which the revision of these estimates first became known.
GAINSCO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1997, 1996 and 1995
The following table sets forth the changes in unpaid claims and claim adjustment expenses, net of reinsurance cessions, as shown in the Company's consolidated financial statements for the periods indicated:
(1) The Company commuted its 1993 and 1994 quota-share reinsurance treaties in 1995 and thereby reassumed all risks and the related unpaid claims and claim adjustment expenses of $2,223,000 (see note 4 to the consolidated financial statements). This was accounted for using the paid claim method, whereby unpaid claims and claim adjustment expenses were increased $2,223,000 and paid claims and claim adjustment expenses were decreased $2,223,000, thus preventing distortion of claims and claim adjustment expenses incurred.
GAINSCO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1997, 1996 and 1995
The development in net claims and claim adjustment expenses incurred from prior periods was largely a result of claim reserve increases recorded for commercial auto claims in Kentucky for the 1996 and 1995 accident years and adverse development in claim adjustment expense reserves for commercial auto in the 1996, 1995 and 1994 accident years.
(k) Income Taxes
The Company and its subsidiaries file a consolidated Federal income tax return. Deferred income tax items are accounted for under the deferred method which provides for timing differences between the reporting of earnings for financial statement purposes and for tax purposes, primarily deferred policy acquisition costs, the discount on unpaid claims and claim adjustment expenses and the nondeductible portion of the change in unearned premiums. The Company paid income taxes of $3,175,000, $6,617,909 and $5,413,486 during 1997, 1996 and 1995, respectively.
(l) Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per share:
GAINSCO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1997, 1996 and 1995
(m) Stock-Based Compensation
In October 1995, the FASB issued Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" (Statement 123). Statement 123 defines a fair value based method of accounting for an employee stock option or similar equity instrument. Under Statement 123, the Company elects to measure compensation costs using the intrinsic value based method of accounting prescribed by APB 25.
(n) Accounting Pronouncements
In February 1997, the FASB issued Statement 128, "Earnings Per Share". The Statement was effective for financial statements issued for periods ending after December 15, 1997. Earnings per share for prior years presented in these financial statements have been restated to comply with Statement 128.
(2) INVESTMENTS
The following schedule summarizes the components of net investment income:
GAINSCO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1997, 1996 and 1995
The following schedule summarizes the amortized cost and estimated fair values of investments in debt securities:
The amortized cost and estimated fair value of debt securities at December 31, 1997 and 1996, by maturity, are shown below.
GAINSCO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1997, 1996 and 1995
Investments of $1,100,000 were maintained in escrow at December 31, 1996 on behalf of certain insurance companies under the terms of their reinsurance agreements with General Agents. In addition, investments of $12,965,000 and $12,615,000, at December 31, 1997 and 1996, respectively, were on deposit with various regulatory bodies as required by law.
The FASB has issued Statement 115 "Accounting for Certain Investments in Debt and Equity Securities" (Statement 115). Under this statement, the Company carries certain debt securities classified as "available for sale" at fair value. The unrealized gain or loss, net of tax, is presented as a separate component of shareholders' equity.
(3) NOTE PAYABLE TO BANK
The Company made a principal payment of $1,750,000 in May, 1996. This payment represented the retirement of the note. Interest was paid monthly at a rate that approximated the prime lending rate. The Company recorded interest expense (which approximates interest paid) of $61,335 and $221,934 in 1996 and 1995, respectively.
(4) REINSURANCE
In 1997, 1996 and 1995, General Agents and MGAI (the Insurers) wrote casualty policy limits of $1,000,000. For policies with an effective date occurring in 1995 or after, the Insurers have excess reinsurance for 100% of casualty claims exceeding $500,000 up to the $1,000,000 policy limits. The Company's excess reinsurance is provided in varying amounts by three reinsurers rated "A- (Excellent)" or better by A. M. Best Company.
In 1995, the Insurers terminated the quota-share reinsurance treaties that were in effect for 1994 and 1993. Under the terms of the termination agreement, the reinsurer returned assets to the Insurers equal to the remaining unpaid claims and claim adjustment expenses of $2,223,000. The Insurers reassumed all risks and the reinsurer was relieved of any further liability with respect to risks previously covered by the contract.
During 1996 and 1995, GCM entered into fronting arrangements with non-affiliated insurance companies. GCM retains no portion as the business written under these agreements is 100% ceded. Although these cessions are made to authorized reinsurers rated "A- (Excellent)" or better by A. M. Best Company, the agreements require that collateral (in the form of trust agreements and/or letters of credit) be maintained to assure payment of the unearned premiums and unpaid claims and claim adjustment expenses relating to the risks insured under these fronting arrangements. The balances in such accounts as of December 31, 1997 and 1996 total $29,943,000 and $20,174,000, respectively.
The amounts deducted in the consolidated financial statements for reinsurance ceded as of and for the years ended December 31, 1997, 1996, and 1995 respectively, are set forth in the following table.
GAINSCO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1997, 1996 and 1995
Premiums and claims ceded to the commercial automobile plans of Arkansas, California, Louisiana, Mississippi and Pennsylvania are designated as "plan servicing".
The amounts included in the Consolidated Balance Sheets for reinsurance ceded under fronting arrangements and reinsurance ceded to the commercial automobile plans of Arkansas, California, Louisiana, Mississippi, and Pennsylvania were as follows:
GAINSCO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1997, 1996 and 1995
The Insurers remain directly liable to their policyholders for all policy obligations and the reinsuring companies are obligated to the Insurers to the extent of the reinsured portion of the risks.
The Insurers, for years prior to 1993, utilized reinsurance arrangements with various non-affiliated admitted insurance companies, whereby the Insurers underwrote the coverage and assumed the policies 100% from the companies. During 1995, 1994 and 1993, the business generated from these arrangements was in a run-off position. These arrangements require that the Insurers maintain escrow accounts to assure payment of the unearned premiums and unpaid claims and claim adjustment expenses relating to risks insured through such arrangements and assumed by the Insurers. For the years ended December 31, 1997, 1996, and 1995, the balance in such escrow accounts totalled $0, $1,100,000 and $1,100,000, respectively. For 1997, 1996 and 1995, the premiums earned by assumption were $0, $0 and $(2,496), respectively and the assumed unpaid claims and claim adjustment expenses were $810,000, $1,845,000 and $4,427,000, respectively.
The Company has not and does not intend to utilize retrospectively rated reinsurance contracts with indefinite renewal terms. This form of reinsurance is commonly known as a "funded cover". Under a funded cover reinsurance arrangement, an insurance company essentially deposits money with a reinsurer to help cover future losses and records the "deposit" as an expense instead of as an asset; or, the insurance company can borrow from a reinsurer recording the "loan" as income instead of as a liability with the future "loan" payments recorded as expense when the payments are made.
(5) FEDERAL INCOME TAXES
In the accompanying consolidated statements of operations, the provisions for Federal income tax as a percent of related pretax income differ from the Federal statutory income tax rate. A reconciliation of income tax expense using the Federal statutory rates to actual income tax expense follows:
The FASB issued Statement 109 "Accounting for Income Taxes" which changed the Company's method of accounting for income taxes. Under APB 11, the primary objective was to match the tax expense with pre-tax operating income on the statement of operations. Under Statement 109, the primary objective is to establish deferred tax assets and liabilities for the temporary differences
GAINSCO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1997, 1996 and 1995
between the financial reporting basis and the tax basis of the Company's assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. As a consequence, the portion of the tax expense which is a result of the change in the deferred tax asset or liability may not always be consistent with the income reported on the statement of operations. In the Company's opinion, there will be adequate earnings in future years to recover its deferred tax asset and as such, the Company has not established a valuation allowance.
The following table represents the tax effect of temporary differences giving rise to the net deferred tax asset established under Statement 109.
(6) SHAREHOLDERS' EQUITY
The Company has 250,000,000 shares of authorized $.10 par value common stock. Of the authorized shares, 21,701,118 and 21,670,369 were issued as of December 31, 1997 and 1996, respectively and 20,874,224 and 21,087,407 were outstanding as of December 31, 1997 and 1996, respectively. The Company also has 10,000,000 shares of preferred stock with $100 par value authorized of which no shares have been issued. The Board of Directors can designate the relative rights and preferences of the authorized preferred stock to be issued.
In 1991, the Company adopted a policy to pay a quarterly cash dividend of $.01 per share on its common stock every quarter until further action by the Board of Directors. The Board of Directors increased the cash dividend to: $.0125 per share in November of 1995, $.015 per share in August of 1996, and $.0175 per share in November of 1997. In November of 1995, the Board of Directors announced the discontinuance of the semi-annual stock dividends. The Board of Directors granted 5% stock dividends to shareholders of record on March 31, 1995 and September 30, 1995. The market value of the stock dividends was charged to retained earnings, common stock was credited for
GAINSCO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1997, 1996 and 1995
the par value, the excess of market value over par value was credited to additional paid-in capital and cash was paid in lieu of issuing fractional shares. The earnings per share computation and the number of stock options and their exercise price have been retroactively adjusted for the effect of the stock dividends.
The amount of consolidated statutory shareholder's equity or policyholders' surplus of General Agents and MGAI was $76,495,883, $57,011,890 and $47,880,301 at December 31, 1997, 1996 and 1995, respectively, and the amount of consolidated statutory net income was $14,155,450, $15,829,108 and $15,167,151 for the years ended 1997, 1996, and 1995, respectively. The amount of policyholders' surplus of GCM was $2,000,000, $2,000,001 and $2,260,001 at December 31, 1997, 1996 and 1995, respectively, and the amount of statutory net income was $44,569, $115,563 and $369,356 for the years ended December 31, 1997, 1996 and 1995, respectively. The Company's statutory capital significantly exceeds the benchmark capital level under the Risk Based Capital formula for its major insurance companies.
Statutes in Texas and Oklahoma restrict the payment of dividends by the insurance company subsidiaries to the available surplus funds derived from their realized net profits. The maximum amount of cash dividends that each subsidiary may declare without regulatory approval in any 12-month period is the greater of net income for the 12-month period ended the previous December 31 or ten percent (10%) of policyholders' surplus as of the previous December 31. At December 31, 1997, General Agents, the Oklahoma subsidiary, had net income of $15,449,442 and policyholders' surplus of $76,495,883 and MGAI, the Texas subsidiary, had net income of $3,456,008 and policyholders' surplus of $21,026,541.
In 1988, the Board of Directors declared, pursuant to a Rights Plan, a dividend distribution of one common share purchase right on each outstanding share of $.10 par value common stock. The dividend distribution was made on March 18, 1988, payable to shareholders of record on that date. In 1993, the Board of Directors amended the Rights Plan and extended the expiration date of these rights from March 18, 1998 to May 25, 2003. Each right, as amended during 1993, has an exercise price of $70. The rights are not exercisable until the Distribution Date (as defined in the Rights Plan). The Rights Plan provides, among other things, that if any person or group (other than the Company, one of its subsidiaries or an employee benefit plan of the Company or a subsidiary) acquires 20% or more of the Company's common stock (except pursuant to an offer for all outstanding common stock which the Continuing Directors (as defined in the Rights Plan) have determined to be in the best interests of the Company and its shareholders), if a 20% holder engages in certain self-dealing transactions or if a holder of 15% or more of the Company's common stock is declared an Adverse Person (as defined in the Rights Plan) by the Board of Directors, each holder of a right (other than the 20% holder or the Adverse Person, whose rights would become null and void) would have the right to receive, upon exercise of the right, common stock having a market value of two times the exercise price of the right. The Company is able to redeem rights under certain conditions set forth in the Rights Plan. If, following a public announcement that a person has acquired 20% or more of the common stock, the Company is acquired in a merger (other than a merger which follows an offer approved by the Continuing Directors as defined in the Rights Plan) or other business combination transaction or if 50% of the assets or earning power of the Company is sold, each right (except rights
GAINSCO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1997, 1996 and 1995
which have previously become null and void as described above), will entitle its holder to purchase, at the right's then-current exercise price, shares of the acquiring Company's common stock having a market value of two times the exercise price of the right.
(7) BENEFIT PLANS
At December 31, 1997, the Company had two stock option plans, the 1990 Stock Option Plan (90 Plan) and the 1995 Stock Option Plan (95 Plan). Under the 90 Plan, all options available have been granted and are fully vested. Any unexercised options will expire in the year 2000. The 95 Plan approved by the shareholders on May 10, 1996, reserved 1,071,000 shares for issuance under this plan. Options granted under the 95 Plan have a maximum ten year term and are exercisable at the rate of 20% immediately upon grant and 20% on each of the first four anniversaries of the grant date. The exercise price of each option equals the market price of the Company's stock on the date of grant.
A summary of the status of the Company's outstanding options as of December 31, 1997 and 1996, and changes during the years ended December 31, 1997 and 1996 is presented below:
GAINSCO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1997, 1996 and 1995
The following table summarizes information for the stock options outstanding at December 31, 1997:
The Company applies APB 25 and related Intepretations in accounting for its plans. Accordingly, no compensation cost has been recognized for its stock option plans. Had compensation cost been determined consistent with Statement 123 for the options granted, the Company's net income and earnings per share would have been the pro forma amounts indicated below:
The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions for 1997 and 1996, respectively: expected volatility of 33.6% and 34.0%, risk free interest rates of 5.88% and 6.05%, expected dividend yields of .74% and .57% and an expected life of 7.5 years for both periods presented.
The Company has a profit sharing and trust plan for the benefit of its eligible employees. Contributions are made in such amounts as the Company elects. The annual contributions amounted to $396,838, $578,107, and $605,935 for 1997, 1996 and 1995, respectively.
The Company has an incentive compensation plan in which certain key officers of the Company participate and earn bonuses. The fund from which bonuses are paid is comprised of net income for
GAINSCO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1997, 1996 and 1995
the current year that is in excess of ten percent (10%) of beginning shareholders' equity for the current year, with the fund not to exceed ten percent (10%) of net income for the current year.
(8) CONTINGENCIES
In the normal course of its operations, the Company has been named as defendant in various legal actions seeking payments for claims denied by the Company and other monetary damages. The Company's management believes that unpaid claims and claim adjustment expenses are adequate to cover possible liability from lawsuits which arise in the normal course of its insurance business. In the opinion of the Company's management the ultimate liability, if any, resulting from the disposition of all claims will not have a material adverse effect on the Company's consolidated financial position or results of operations. The Company does not have any financial instruments where there is off-balance-sheet-risk of accounting loss due to credit or market risk. There is credit risk in the premiums receivable and reinsurance balances receivable of the Company. At December 31, 1997 and 1996 the Company did not have a premiums receivable balance nor a reinsurance balance receivable from any one entity that was material with regard to shareholders' equity.
(9) QUARTERLY FINANCIAL DATA (UNAUDITED)
The following table contains selected unaudited consolidated financial data for each quarter (in thousands, except per share data):
(a) All periods have been restated to comply with FASB Statement 128, "Earnings Per Share". (b) As reported by the American Stock Exchange from January 1, 1996 to July 30, 1996. As reported by the New York Stock Exchange thereafter.
INDEPENDENT AUDITORS' REPORT ON SUPPLEMENTARY INFORMATION
The Board of Directors and Shareholders GAINSCO, INC:
Under date of February 16, 1998, we reported on the consolidated balance sheets of GAINSCO, INC. and subsidiaries as of December 31, 1997 and 1996 and the related consolidated statements of operations, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1997. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits.
In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
KPMG Peat Marwick LLP
Dallas, Texas February 16, 1998
Schedule I
GAINSCO, INC. AND SUBSIDIARIES
Summary of Investments - Other Than Investments in Related Parties
(Amounts in thousands)
See accompanying independent auditors' report on supplementary information.
Schedule II
CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT
GAINSCO, INC. (PARENT COMPANY)
Balance Sheets December 31, 1997 and 1996
See accompanying notes to condensed financial statements. See accompanying independent auditors' report on supplementary information.
Schedule II
CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT
GAINSCO, INC. (PARENT COMPANY)
Statements of Operations Years ended December 31, 1997, 1996 and 1995
See accompanying notes to condensed financial statements. See accompanying independent auditors' report on supplementary information.
Schedule II
CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT
GAINSCO, INC. (PARENT COMPANY)
Statements of Shareholders' Equity Years ended December 31, 1997, 1996 and 1995
(continued)
Schedule II
CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT
GAINSCO, INC. (PARENT COMPANY)
Statements of Shareholders' Equity Years ended December 31, 1997, 1996 and 1995
See accompanying notes to condensed financial statements. See accompanying independent auditors' report on supplementary information.
Schedule II
CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT
GAINSCO, INC. (PARENT COMPANY)
Statements of Cash Flows Years ended December 31, 1997, 1996 and 1995
(continued)
Schedule II
CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT
GAINSCO, INC. (PARENT COMPANY)
Statements of Cash Flows Years ended December 31, 1997, 1996 and 1995
See accompanying notes to condensed financial statements. See accompanying independent auditors' report on supplementary information.
Schedule II
CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT
GAINSCO, INC. (PARENT COMPANY)
Notes to Condensed Financial Statements December 31, 1997, 1996 and 1995
(1) GENERAL
The accompanying condensed financial statements should be read in conjunction with the notes to the consolidated financial statements for the years ended December 31, 1997, 1996 and 1995 included elsewhere in this Annual Report.
(2) RELATED PARTIES
During 1997, the Company made a capital contribution to GAINSCO Service Corp. by forgiving an intercompany debt in the amount of $5,390,712.
The following table presents the components of the Net receivables from subsidiaries at December 31, 1997 and 1996:
See accompanying independent auditors' report on supplementary information.
Schedule III
GAINSCO, INC. AND SUBSIDIARIES
Supplementary Insurance Information
Years ended December, 1997, 1996 and 1995 (Amounts in thousands)
(1) Net of the amortization of deferred ceding commission income.
See accompanying independent auditors' report on supplementary information.
Schedule IV
GAINSCO, INC. AND SUBSIDIARIES
Reinsurance
Years ended December 31, 1997, 1996 and 1995 (Amounts in thousands, except percentages)
See accompanying independent auditors' report on supplementary information.
Schedule VI
GAINSCO, INC. AND SUBSIDIARIES
Supplemental Information
Years ended December 31, 1997, 1996 and 1995 (Amounts in thousands)
(1) Net of the amortization of deferred ceding commission income.
See accompanying independent auditors' report on supplementary information.
EXHIBIT INDEX