ITEM 1. Business
The Company
General. The Company's principal activities are the provision of management services to the P&C Group and the ownership and operation of the Insurance Subsidiaries. On April 15, 1997, OSL and IGL were sold to Great Southern Life Insurance Company, a subsidiary of Americo Life, Inc.. As of December 31, 1997, the Company had total assets of $12.1 billion, stockholder's equity of $6.8 billion and consolidated operating revenues for 1997 of $2.0 billion. As of December 31, 1997, the Company's remaining life insurance subsidiary, FNWL, had total assets of $5.4 billion, combined SAP capital and surplus (including asset valuation reserve) of $0.8 billion, combined SAP premium and deposits received for 1997 of $0.5 billion and policies-in-force of 1.1 million. The financial results and assets and liabilities of the P&C Group are not reflected in the consolidated financial statements of the Company.
In December 1988, BATUS Inc. ("BATUS"), a subsidiary of B.A.T Industries p.l.c. ("B.A.T"), acquired 100% ownership of the Company through its wholly owned subsidiary BATUS Financial Services. Immediately thereafter, BATUS Financial Services was merged into Farmers Group, Inc.. The acquisition was accounted for as a purchase and, accordingly, the acquired assets and liabilities were recorded in the Company's consolidated balance sheets based on their estimated fair values at December 31, 1988. In January 1990, ownership of the Company was transferred to South Western Nominees Limited, a subsidiary of B.A.T.
B.A.T is one of the United Kingdom's leading business enterprises with interests principally in tobacco and financial services. B.A.T operates in more than 180 countries, employing more than 141,000 people. As of December 31, 1997, B.A.T reported total assets of $84.9 billion (based on an exchange rate of $1.657 per British pound sterling as of December 31, 1997) and, for the year then ended, reported total revenues and income before taxes of $41.1 billion and $2.9 billion, respectively (based on an average exchange rate of $1.639 per British pound sterling for the year ended December 31, 1997).
On December 22, 1997, a definitive agreement was reached to merge B.A.T Industries' Financial Services Businesses ("BAFS") with Zurich Insurance Company ("Zurich"). Completion of the merger is subject to regulatory consents, tax clearance and the approval of the shareholders of B.A.T and Zurich, and is expected to be finalized in late 1998. Under the
agreement, the businesses of Zurich and BAFS, which include Farmers Group, Inc., will be transferred to Zurich Financial Services, a new Swiss company with headquarters in Zurich.
Financial Information About Industry Segments
Financial information about industry segments can be found in Note Z contained in the Notes to Consolidated Financial Statements. Following are descriptions of the Company's industry segments.
Provision of Management Services to the P&C Group. The insurers constituting the P&C Group are owned by their policyholders. Accordingly, the Company has no ownership interest in the P&C Group. The policyholders each appoint the Company as the exclusive attorney-in-fact ("AIF") to provide management services to the P&C Group. For such services, the Company earns management fees based primarily on the gross premiums earned by the P&C Group. Consequently, the Company is not directly affected by the underwriting results of the P&C Group. This is in contrast to a typical property and casualty insurance holding company which depends on dividends from owned and operated subsidiaries which are subject to fluctuations in underwriting results. The management fees comprise a major part of the Company's revenue and, as a result, the Company's ongoing financial performance depends on the volume of business written by, and the business efficiency and financial strength of, the P&C Group.
As manager and AIF of the P&C Group, the Company selects risks, prepares and mails policy forms and invoices, collects premiums, manages the investment portfolios and performs certain other administrative functions. The insurers of the P&C Group are responsible for the claims functions, including the settlement and payment of claims and claims adjustment expenses. They are also responsible for the payment of commissions, benefits for agents and district managers, and their respective premium and income taxes.
The Company is entitled to receive a management fee of up to 20% (25% in the case of Fire Insurance Exchange) of the gross premiums earned by the P&C Group. In order to enable the P&C Group to maintain appropriate capital and surplus while offering competitive insurance rates, the Company has historically charged a lower management fee than permitted. The Company has been able to do this while maintaining appropriate profit margins through enhanced operating efficiencies that encompass the use of economies of scale, the use of technology and the standardization of procedures. The range of fees has varied by line of business over time and from year to year. During the past five years, aggregate management fees averaged between 12% and 13% of gross premiums earned by the P&C Group. The P&C Group has reported a growing volume of premiums which has generated a corresponding rise in management fee income to the Company. Gross premiums earned by the P&C Group were $10.1 billion, $9.5 billion, and $9.0 billion for 1997, 1996 and 1995, respectively, giving rise to management fee revenues to the Company of $1.24 billion, $1.17 billion, and $1.11 billion, respectively, for the same years.
The P&C Group markets personal auto, homeowners and selected commercial insurance products in 31 states. For the year ended December 31, 1997, approximately 68.3% of net premiums earned was from auto insurance policies, 21.5% was from homeowner policies, and the remainder was from commercial policies. As of December 31, 1997, the P&C Group had total assets of $12.6 billion, surplus as regards policyholders of $3.6 billion, gross premiums earned of $10.1 billion and policies-in-force of 15.6 million.
Life Insurance Subsidiaries. On April 15, 1997, upon receipt of regulatory approval, the Company sold OSL and IGL to Great Southern Life Insurance Company, a subsidiary of Americo Life, Inc.. As a result, FNWL, a Washington insurance company, remains as the only life insurance subsidiary of FGI. FNWL markets a broad line of individual life insurance products, including universal life, term life and whole life insurance, and annuity products, predominately flexible premium deferred annuities. As of December 31, 1997, FNWL provided insurance to more than one million people and managed more than $1.5 billion of annuity funds. FNWL's investment philosophy emphasizes long-term fundamental value in the selection of the investment mix for its portfolio. As of December 31, 1997, approximately 91.3% of FNWL's portfolio was invested in fixed income securities and cash, 6.8% in other fixed income instruments, and 1.9% in equity securities and owned real estate. As of December 31, 1997, approximately 92.9% of FNWL's fixed income securities were rated investment grade. FNWL's ratio of SAP capital and surplus (including asset valuation reserve) to total assets as of December 31, 1997 was 20.6%, well over the industry average of approximately 11.9% as of September 30, 1997, as published in the Statistical Bulletin issued by the American Council of Life Insurance.
In 1997, OSL and IGL contributed $5,502,000 to net income. The combined net assets of these subsidiaries as of April 15, 1997 were $316,448,000. The sale of these subsidiaries resulted in an estimated $19,019,000 gain and was recorded on the "Gain on sale of subsidiaries" line of the income statement. In addition, taxes associated with the sale increased current year tax expense by an estimated $26,826,000 and were reflected on the "Provision for income taxes" line. Both of these amounts were reflected in the "Management services to property and casualty insurance companies; and other" section of the Company's consolidated income statement for the year ended December 31, 1997.
Other Businesses. The Prematic Service Corporation ("Prematic"), a subsidiary of the Company, was established in 1961 to enable individuals and businesses purchasing insurance from one or more members of the P&C Group and FNWL to combine all premiums due into a single monthly payment. In practice, Prematic combines amounts due from a single insured associated with auto, fire, commercial and life policies into a single amount, and Prematic then bills the insured on a monthly basis for all policies-in-force. For its services, Prematic collects a service fee, but since Prematic does not finance the premium, there is no interest charged. Approximately 21.6% of the P&C Group's policies-in-force and 6.1% of FNWL's policies-in-force are currently billed by Prematic, and in 1997, Prematic generated approximately $76 million in service charge income. Net income earned by this subsidiary was approximately $24 million in 1997. The Company has certain other nonmaterial subsidiaries, the results of which are included in the Company's consolidated results.
Employees	
As of December 31, 1997, the Company had 7,559 employees.
Business Environment
Strategic Objectives. The Company's strategic objectives are to assist the P&C Group in growing the volume of profitably underwritten insurance and to increase life insurance and annuity sales to the P&C Group's existing policyholder base. The Company intends to achieve these objectives by (i) cross-selling insurance products and services to the P&C Group's nearly 8.5 million existing households while focusing its efforts on the growth of FNWL, (ii) investing in technology to improve the efficiency and quality of service, (iii) maintaining its long-standing tradition of providing
high-quality customer service, (iv) capitalizing on the strong brand name recognition of Farmers Insurance Group of Companies in its 31 state operating territory, (v) selectively expanding into new geographic markets, and (vi) expanding the products and services offered to its policyholders by taking advantage of horizontal marketing opportunities.
Technology. The Company makes substantial use of information technology in its business. Information technology is utilized for accounting and billing, to provide management information services, to process policies, to analyze and select risks, and to automate premium remittance processing. An integrated network of computer workstations connects the Company's offices and the P&C Group's offices, district managers and agents with the Company's two data centers.
The Company is committed to an ongoing program of proprietary software development which enhances the operating efficiency of FNWL and the management services it provides to the members of the P&C Group. Examples of the Company's commitment to using technology to improve operating efficiencies are the Auto Policy Processing System ("APPS") and the Fire Policy Processing System ("FPPS"), which were developed to allow agents on-line access to auto and fire policy data. Additional projects under development are the Farmers EasyPay (SM) billing system, which is being developed in order to update the Prematic policy processing software system to allow for faster and more flexible policyholder billing, and the Auto Mainfile Replacement ("AMR") system, which is being developed to replace the existing automobile policy mainfile and will allow for easier and faster information retrieval and analysis.
These software systems are designed to significantly reduce the time and expense associated with processing and servicing a Personal Lines policy. In addition, by allowing network access to more comprehensive policy and policyholder information, these systems increase cross-selling opportunities for the agent and provide better data to monitor and manage the quality of the book of business. The above mentioned projects are expected to cost approximately $299 million, of which an aggregate of $286 million has already been capitalized as of December 31, 1997.
In 1995, the Company initiated the Year 2000 Project in order to prepare for the information processing problems presented by the approach of the new millennium. The project encompasses all major areas of the Company's operations, including internal and vendor mainframe applications, mainframe systems software, third party interfaces, non-mainframe system software, forms, facilities, and equipment. As the Company and the P&C Group rely on computer software logic to maintain accurate records, and as the business of the P&C Group involves providing accurate and timely information and service to its policyholders, the impact of the issues relating to the approach of the new millennium are significant to the Company's ongoing performance. As such, a phased plan has been developed for completing this project. As of December 31, 1997, the first two phases of the project (that is, the assessment and strategic planning phases) have been completed. The project is currently in its final phase (the conversion and implementation phase) which is expected to be completed in mid-year 1999.
The Company has communicated with all external entities with which it interfaces and is testing all third party applications, interfaces and system software for compliancy. Although the Company believes that all third party interfaces will be compliant by the year 2000, there can be no guarantee that the systems of other companies on which the Company's systems rely will be timely converted or that a failure to convert by another company would not have a material adverse effect on the Company.
The costs associated with the Year 2000 Project are being expensed as incurred. For the year ended December 31, 1997, such costs totaled $6.8 million, of which $1.5 million was allocated to the Exchanges. For the year ended December 31, 1996, such costs totaled $0.8 million, of which $0.2 million was allocated to the Exchanges. Total costs for this project are expected to be approximately $20.5 million, of which approximately $5.1 million is expected to be allocated to the Exchanges. The expenditures associated with the Year 2000 Project are not expected to have a material impact on the Company's results of operations, liquidity, or capital resources.
Marketing and Distribution. The P&C Group and FNWL operate under a common trade name and logo - Farmers Insurance Group of Companies - and distribute their respective insurance products in 29 states (primarily in western and midwestern states) through a common network of 14,447 direct writing agents and 497 district managers, each of whom is an independent contractor. The size, efficiency and scope of this agency force have made it a major factor in the Company's growth. Each agent is required to first submit business to the insurers in Farmers Insurance Group of Companies within the classes and lines of business written by such insurers. To the extent that such insurers decline such business or do not underwrite it, the agents may offer the business to other insurers.
The Farmers Insurance Group of Companies' agents direct their marketing efforts toward family accounts and small businesses. They leverage these relationships using an extensive portfolio of products to increase the number of policies per household or account. The P&C Group's existing relationships with nearly 8.5 million households provide a potential resource for future growth in policies-in-force and life insurance sales. Management believes that higher retention rates and profitability are achieved on business written with households having multiple policies.
Farmers Insurance Group of Companies maintains its brand name recognition throughout its operating territory through television, radio and print advertising on both a national and local basis. The Farmers Agency Information Management System provides the agency force with a marketing advantage by delivering high-quality consumer focused service at the point of sale. Furthermore, Farmers Insurance Group of Companies' formalized policyholder recontact program, the "Farmers Friendly Review", builds customer loyalty and provides a vehicle for enhanced policy retention and future internal growth through the cross-selling of property and casualty and life products.
In 1997, the P&C Group began offering preferred auto policies via direct telemarketing operations in the Commonwealth of Pennsylvania and the State of Maryland through Farmers Direct Insurance Company. The preferred auto policies are offered through direct solicitation via direct mail, television and other media.
Competition. Property and casualty insurance is a very competitive industry with over 3,000 insurers. Many property and casualty insurers with a small all-lines national market share have a significant market share within a single state or a specialty market. The P&C Group competes through brand name recognition of the Farmers Insurance Group of Companies, customer service, product features, financial strength, price and the direct writing agency force.
There is substantial competition among insurance companies seeking customers for the types of products sold by FNWL. Most of the 1,700 life insurance companies in the United
States offer products similar to those offered by FNWL, and many use similar marketing techniques. Competitiveness in the insurance business is affected by various factors including, but not limited to, price, financial and claims-paying ratings, size and strength of agency force, range of product lines, product quality, servicing ability and general reputation. FNWL competes on the basis of customer service, product features, financial strength and price. Many of FNWL's products contain significant cash accumulation features; therefore, these products compete with product offerings of banks, mutual funds and other financial institutions as well.
Regulatory and Related Matters. The Insurance Subsidiaries and the P&C Group are subject to extensive state regulatory oversight in the jurisdictions in which they do business. The Company and the P&C Group are an insurance holding company system as defined by the insurance laws and regulations of various jurisdictions. As such, certain transactions between an insurance company and any other member company of the system, including investments in subsidiaries and distributions by an insurance company to its shareholders, are subject to regulation and oversight by the state of domicile of the applicable insurance company. Insurers having insufficient statutory capital and surplus are subject to varying degrees of regulatory action depending on the level of capital inadequacy. As of December 31, 1997, neither the P&C Group nor the Insurance Subsidiaries were subject to such regulatory actions. Most of FNWL's and the P&C Group's business is subject to regulation with respect to policy rates and related matters. In addition, assessments are levied against FNWL and the P&C Group as a result of participation in various types of mandatory state guaranty associations. Existing federal laws and regulations affect the taxation of life insurance products and insurance companies.
Investments
During the years ended December 31, 1997, 1996, and 1995, the Life Insurance Subsidiaries had pretax net investment income and realized investment gains of $306.4 million, $355.6 million, and $329.9 million, respectively, and the Company other than the Life Insurance Subsidiaries (collectively, the "FGI/Nonlife Account") had pretax net investment income and realized investment gains of $217.6 million, $117.9 million, and $79.5 million, respectively. As of December 31, 1997, the book value of the FNWL investment portfolio was approximately $3.9 billion and the book value of the FGI/Nonlife Account investment portfolio was approximately $2.7 billion. Both of these portfolios are managed by the Company's Investment Department in accordance with investment policies approved by the Board of Directors of the Company as well as the Investment Committee, which is comprised of 10 officers of the Company appointed by the Board of Directors of the Company.
The Company's investment philosophy for both the FNWL portfolio and the FGI/Nonlife Account portfolio emphasizes long-term fundamental value in the selection of the investment mix. For FNWL, the assets backing the interest sensitive portfolio are internally segregated along product lines in order to closely match the funding assets with the underlying liabilities to policyholders. The asset/liability matching system is the basis by which credited interest rates are determined. Relatively short maturities are maintained for the fixed income securities held in the FGI/Nonlife Account in order to maintain capital preservation and to ensure liquidity.
The FNWL portfolio and the FGI/Nonlife Account portfolio are both comprised of a broad range of assets, including corporate fixed income securities, mortgage-backed securities, taxable and tax-exempt government securities, preferred stock, common stock, owned real estate, commercial mortgage loans and short-term instruments. The FNWL portfolio also includes policy loans. Approximately 40.8% of the FGI/Nonlife Account portfolio consists of notes issued by B.A.T
Capital Corporation, a subsidiary of B.A.T, and surplus certificates issued by the P&C Group. See "Certain Relationships and Related Transactions" and Notes D and S contained in the Notes to the Consolidated Financial Statements.
Approximately 92.9% of the fixed income securities in the FNWL portfolio are rated investment grade and approximately 98.4% of the fixed income securities in the FGI/Nonlife Account portfolio are rated investment grade. Approximately 68.0% of the mortgage-backed securities in the FNWL portfolio are guaranteed by the Government National Mortgage Association ("GNMA"), Federal Housing Authority ("FHA"), Federal National Mortgage Association ("FNMA"), or Federal Home Loan Mortgage Corporation ("FHLMC"), and approximately 32.0% are rated "AAA". Approximately 63.6% of the mortgage-backed securities in the FGI/Nonlife Account portfolio are guaranteed by GNMA, FHA, FNMA, or FHLMC, and approximately 36.4% are rated "AAA".
The following table sets forth the book value of each portfolio, by asset category, as of December 31, 1997 and 1996.
Book Value of Invested Assets ($ in millions)
Investment Accounting Policies. The Company follows the provisions of Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities". This Statement addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. As of December 31, 1997 and 1996, the Company classified all investments in equity and debt securities as available-for-sale under SFAS No. 115. Correspondingly, these investments are reported on the balance sheet at fair value, with unrealized gains and losses, net of tax, excluded from earnings and reported as a component of stockholder's equity.
In compliance with a Securities and Exchange Commission ("SEC") staff announcement, the Company has recorded certain entries to the Deferred Policy Acquisition Costs ("DAC") and Value of Life Business Acquired line of the consolidated balance sheet in connection with SFAS No. 115. The SEC requires that companies record entries to those assets and liabilities that would have been adjusted had the unrealized investment gains or losses from securities classified as available-for-sale actually been realized, with corresponding credits or charges reported directly to stockholder's equity. 	 Bonds acquired prior to the December 31, 1988 acquisition of the Company by B.A.T were marked-to-market at the time of the acquisition and the resulting net writedown is being amortized over a period approximately equal to the remaining time to maturity.
Real estate investments are accounted for on a depreciated cost basis. Real estate acquired in foreclosure and held for sale is carried at the lower of fair value or depreciated cost less a valuation allowance. Short-term instruments are carried at cost. Other investments, which consist primarily of certificates in surplus of the Exchanges, policy loans and the B.A.T Capital Corporation notes, are carried at the unpaid principal balances.
Fixed Income Securities. As of December 31, 1997, approximately 91.1% of the FNWL portfolio and 23.1% of the FGI/Nonlife Account portfolio were invested in fixed income securities. These investments include taxable and tax-exempt government securities, domestic and foreign corporate bonds, redeemable preferred stock and mortgage-backed securities. Approximately 92.9% and 98.4% of the fixed income securities in the FNWL portfolio and FGI/Nonlife Account portfolio, respectively, are rated investment grade. The following table sets forth the market values of the various categories of fixed income securities included within the portfolios as of December 31, 1997.
Value of Fixed Income Securities ($ in millions)
Credit Ratings. The National Association of Insurance Commissioners ("NAIC") maintains a valuation system that assigns quality ratings known as "NAIC Designations" to publicly traded and privately placed fixed income securities. The NAIC Designations range from 1 to 6, with categories 1 (highest) and 2 considered investment grade and categories 3 through 6 (lowest) considered non-investment grade. As of December 31, 1997, FNWL held $252.3 million in below investment grade bonds, representing 6.5% of total invested assets, and the FGI/Nonlife Account portfolio held $7.8 million in below investment grade bonds, representing 0.3% of total invested assets.
Mortgage-backed Securities. Mortgage-backed securities ("MBS") are the largest component of FNWL's fixed income portfolio and represented approximately 48.0% of its fixed income portfolio as of December 31, 1997. The FGI/Nonlife Account's MBS represented approximately 11.0% of its fixed income portfolio as of December 31, 1997. Approximately 68.0% of the MBS in the FNWL portfolio are guaranteed by various government agencies and government sponsored entities, including the GNMA, FHA, FNMA, or FHLMC, and approximately 32.0% are rated "AAA". Approximately 63.6% of the MBS in the FGI/Nonlife Account portfolio are guaranteed by GNMA, FHA, FNMA, or FHLMC, and approximately 36.4% are rated "AAA". The primary risk in holding MBS is the cash flow uncertainty that arises from changes to prepayment speeds as interest rates fluctuate. To reduce the uncertainties surrounding the cash flows of MBS, the FNWL portfolio held significant MBS investments in collateralized mortgage obligations ("CMOs") including $702.5 million of planned amortization classes ("PACs") and $52.2 million of targeted amortization classes ("TACs"), and the FGI/Nonlife Account portfolio held $30.8 million of PACs. These securities provide protection by passing a substantial portion of the risk of prepayment uncertainty to other tranches.
Equity Investments-Common Stock. In 1997, the Company restructured its common stock portfolio to diversify and to limit its exposure in any one market sector. As a result, the Company's common stock portfolio is invested in the equities of many of the 3,000 largest United States Companies, which represents approximately 98% of the investable United States equity market.
During 1997, FNWL participated in a class action lawsuit against Structural Dynamics Research Corporation ("SDRC"). In settlement of this lawsuit, the Company received both cash and common shares of SDRC. The cost basis assigned to these common shares is zero, as any applicable costs of purchasing the original shares was charged to previous years' earnings as a result of the disposal of the securities. As of December 31, 1997, the fair value of the SDRC common shares owned by FNWL was $120,000.
Commercial Mortgage Loans. As of December 31, 1997, the FNWL portfolio included commercial mortgage loans with an aggregate book value of approximately $89.9 million (net of loss provisions of $7.9 million), or 2.3% of total invested assets, and the FGI/Nonlife Account portfolio included commercial mortgage loans of $0.2 million.
All commercial mortgage loans included in the FNWL portfolio are secured by first mortgages. The majority of the commercial mortgage loan portfolio consists of loans secured by office buildings, light industrial properties and retail properties located primarily in unanchored shopping centers. Exposure to potential losses from future commercial mortgage loan foreclosures and the operation or sale of properties acquired through foreclosures is limited because FNWL has not issued any commercial mortgage loans since 1989, and the majority of the individual remaining commercial mortgage loan balances are less than $1.0 million.
Owned Real Estate Investments. As of December 31, 1997, the FNWL portfolio included owned real estate investments with a book value of $69.3 million (net of loss provisions of $4.3 million), or 1.8% of total invested assets, and the FGI/Nonlife Account portfolio included owned real estate investments with a book value of $63.5 million, or 2.4% of total invested assets. The FNWL real estate holdings fall into two categories: real property assets that were acquired directly as an equity investment and foreclosed equity real estate properties. The FGI/Nonlife Account owned real estate holdings were all acquired directly as equity investments.
Problem Investments-Fixed Income Securities. As of December 31, 1997, none of the fixed income securities held in the FNWL or the FGI/Nonlife Account portfolios were classified as "problem" or "potential problem" assets.
Problem Investments-Mortgage Loan Investments. As of December 31, 1997, none of the mortgage loans held by the FNWL or the FGI/Nonlife Account were classified as "troubled loans".
ITEM 2.
ITEM 2. Properties
The Company owns three buildings in Los Angeles, six regional offices, seven business support centers and 1 commercial claims center in which its administrative operations are conducted. In addition, the Company owns a building in Washington in which the operations of FNWL are conducted.
ITEM 3.
ITEM 3. Legal Proceedings
The Company is a party to numerous lawsuits arising from its normal business activities. These actions are in various stages of discovery and development, and some seek punitive as well as compensatory damages. In the opinion of management, the Company has not engaged in any conduct which should warrant the award of any material punitive or compensatory damages. The Company intends to vigorously defend its position in each case, and management believes that, while it is not possible to predict the outcome of such matters with absolute certainty, ultimate disposition of these proceedings should not have a material adverse effect on the Company's consolidated results of operations or financial position. In addition, the Company is, from time to time, involved as a party in various governmental and administrative proceedings.
ITEM 4.
ITEM 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of security holders during the year ended December 31, 1997.
PART II
ITEM 5.
ITEM 5. Market for Farmers Group, Inc.'s Common Equity and Related Stockholder Matters
N/A
ITEM 6.
ITEM 6. Selected Financial Data
The following table sets forth summary consolidated income statement data, consolidated balance sheet data and other operating data for the periods indicated. The following consolidated income statement data of the Company for each of the years in the five-year period ended December 31, 1997, and the consolidated balance sheet data of the Company as of December 31, 1997 and each of the preceding four years ended December 31, have been derived from the Company's audited consolidated financial statements. The following data should be read in conjunction with the Company's Consolidated Financial Statements and related notes, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other financial information appearing elsewhere herein.
Income statement data includes the effect of amortizing the purchase accounting entries related to the acquisition of the Company by B.A.T in December 1988. See Note A to the Company's Consolidated Financial Statements. Major items incorporated in the purchase price of the Company include goodwill and the value of the AIF contracts of the P&C Group. The amortization of these two items, which is being taken on a straight-line basis over forty years, reduced annual pretax income by approximately $102.8 million in each of the years 1993 through 1997.
- ---------------------------- (1) Net income reflects the charge resulting from expensing the transition obligation upon the implementation of SFAS No. 112, "Employers' Accounting for Postemployment Benefits". Such amounts were $4.5 million and $0.2 million, after tax, for Management services to property and casualty insurance companies; and other and the Life Insurance Subsidiaries, respectively, for the year ended December 31, 1994. (2) Includes cash, short-term investments and notes receivable-affiliate. (3) The ratio of earnings to fixed charges has been determined by dividing the sum of net income before income taxes plus fixed charges by fixed charges. Fixed charges consist of interest, capitalized interest, dividends paid to QUIPS holders, amortization of QUIPS offering expenses and that portion of rent expenses deemed to be interest.
ITEM 7.
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
General
The Company's principal activities are the management of property and casualty insurance companies and the underwriting of life insurance and annuity products. Revenues and expenses relating to both of these principal business activities are reflected in the Company's Consolidated Financial Statements prepared in accordance with GAAP, which differs from SAP, which FNWL is required to use for regulatory reporting purposes.
The Company underwrites life insurance and annuity products through FNWL. Revenues attributable to traditional life insurance products, such as whole life or term life contracts, are classified as premiums as they become due. Future benefits are associated with such premiums (through increases in liabilities for future policy benefits), and prior period capitalized costs are amortized (through amortization of DAC) so that profits are generally recognized over the same period as revenue income. Revenues attributable to universal life products consist of policy charges for the cost of insurance, policy administration charges, surrender charges, and investment income on assets allocated to support policyholder account balances on deposit. Revenues for deferred annuity products consist of surrender charges and investment income on assets allocated to support policyholder account balances. Expenses on universal life and annuity policies include interest credited to policyholders on policy balances as well as benefit claims incurred in excess of policy account balances.
Year Ended December 31, 1997 Compared to Year Ended December 31, 1996
Management Services to Property and Casualty Insurance Companies; and Other
Operating Revenues. Operating revenues increased from $1,245.4 million in 1996 to $1,324.9 million in 1997, an increase of $79.5 million, or 6.4%. Operating revenues primarily consist of management fees paid to the Company as a percentage of gross premiums earned by the P&C Group. Such premiums increased from $9,458.2 million in 1996 to $10,070.1 million in 1997 due primarily to higher average premium levels for the Auto and Fire lines of business and an increase in the number of policies-in-force between years reflecting stricter enforcement of the California mandatory auto insurance law following enactment of California Assembly Bill 650 and the P&C Group's re-entry into the California homeowners' market. Partially offsetting these increases is the fact that, in recognition of expense savings realized as a result of improved operating efficiencies, the Company waived an additional 0.43% from the Farmers Preferred Auto Management fee rate that was in effect prior to November 1, 1996. This rate waiver resulted in a $22.3 million reduction in management fees in 1997 from what such fees would have been using the rates in effect during 1996.
Total Operating Expenses. Total operating expenses as a percentage of operating revenues decreased from 56.0% in 1996 to 55.6% in 1997, a decrease of 0.4%. Although total operating expenses increased by 5.7%, this increase was less than the 6.4% increase in operating revenues. Specifically, the Company continued to benefit from staffing efficiencies and improved information technology systems and hence was able to control its labor costs, reducing salaries and employee benefits from 27.1% of operating revenues in 1996 to 25.3% of operating revenues in 1997.
Salaries and Employee Benefits. Salaries and employee benefits decreased from $337.2 million in 1996 to $335.8 million in 1997, a decrease of $1.4 million, or 0.4%, primarily due to a reduction in employee complement.
Buildings and Equipment Expenses. Buildings and equipment expenses increased from $87.3 million in 1996 to $95.8 million in 1997, an increase of $8.5 million, or 9.7%. This increase was primarily due to higher amortization expense associated with information technology systems software.
Amortization of AIF Contracts and Goodwill. The purchase accounting entries related to the acquisition of the Company by B.A.T in December 1988 include goodwill (capitalized at $2.4 billion) and the value of the AIF contracts of the P&C Group (capitalized at $1.7 billion). The amortization of these two items, which is being taken on a straight-line basis over forty years, reduced pretax income by approximately $102.8 million for both 1997 and 1996.
General and Administrative Expenses. General and administrative expenses increased from $170.3 million in 1996 to $202.6 million in 1997, an increase of $32.3 million, or 19.0%. This increase was primarily due to higher expenses attributable to increased business levels and the re-entry of the P&C Group into the California homeowners' market. Also contributing to the increase in expense was a $4.6 million increase in costs associated with the modification of existing computer program logic to accommodate years 2000 and beyond (Year 2000 Project).
Net Investment Income. Net investment income increased from $112.8 million in 1996 to $144.2 million in 1997, an increase of $31.4 million, or 27.8%. This increase was primarily due to a larger invested asset base as a result of the common stock received as part of a $374.9 million dividend from FNWL to Farmers Group, Inc. in December 1996 and the reinvestment of cash generated by the sale of OSL and IGL.
Net Realized Gains. Net realized gains increased from $5.1 million in 1996 to $73.4 million in 1997, an increase of $68.3 million, due primarily to gains realized on equities formerly held by FNWL that were sold while restructuring the portfolio.
Gain on Sale of Subsidiaries. The estimated gain on the April 15, 1997 sale of OSL and IGL amounted to $19.0 million in 1997.
Dividends on Preferred Securities of Subsidiary Trusts. Dividends expense related to the $500.0 million of Cumulative Quarterly Income Preferred Securities ("QUIPS") issued in 1995 was $42.1 million in both 1996 and 1997.
Provision for Income Taxes. Provision for income taxes increased from $275.1 million in 1996 to $332.2 million in 1997, an increase of $57.1 million, or 20.8%. This increase was due to the increase in pretax income between years and an estimated $26.8 million of taxes associated with the sale of OSL and IGL.
Management Services Income. As a result of the foregoing, management services income increased from $348.5 million for the year ended December 31, 1996 to $450.2 million for the year ended December 31, 1997, an increase of $101.7 million, or 29.2%.
Life Insurance Subsidiaries
On April 15, 1997, OSL and IGL were sold to Great Southern Life Insurance Company, a subsidiary of Americo Life, Inc.. OSL and IGL contributed $5.5 million to net income in 1997, compared to $17.2 million in 1996 and $11.6 million in 1995. The following commentary addresses the results of the Company's remaining life insurance subsidiary, FNWL.
Total Revenues. Total revenues increased from $613.3 million in 1996 to $638.6 million in 1997, an increase of $25.3 million, or 4.1%.
Premiums. Premiums increased $15.0 million, or 11.0%, between years. This increase was due to growth in renewal and first year business. The increase in renewal premiums was attributable to a 12.2% growth in traditional life insurance in-force due in part to an increase in average policy size resulting from sales of the Premier Whole Life ("PWL") product. The higher first year premiums were due primarily to growth in sales of the PWL product.
Policy Charges. Policy charges increased $12.5 million, or 6.6%, over 1996, reflecting a 4.2% growth in universal life-type insurance in- force.
Investment Income. Net investment income increased $17.9 million in 1997, or 6.9%, over 1996 due largely to higher bond interest income resulting primarily from an increase in bond investments.
Net Realized Gains. Net realized gains decreased by $20.1 million, from $30.2 million in 1996 to $10.1 million in 1997 due to the fact that FNWL's common stock portfolio was transferred to Farmers Group, Inc. as part of the 1996 dividend.
Total Operating Expenses. Total operating expenses increased from $399.9 million in 1996 to $427.0 million in 1997, an increase of $27.1 million, or 6.8%.
Policyholders' Benefits. Policyholders' benefits expense increased from $260.3 million in 1996 to $274.5 million in 1997, an increase of $14.2 million, or 5.5%. Policy benefits, which consist primarily of death and surrender benefits on life products, increased $1.5 million over 1996 due to an increase in death claims resulting from an increase in insurance-in-force. Increase in liability for future benefits expense increased from $11.4 million in 1996 to $15.7 million in 1997. This increase was primarily attributable to lower terminations on older whole life business carrying higher future benefit provisions and the effect of PWL sales in 1997 and 1996. Interest credited to policyholders, which represents the amount credited under universal life-type contracts and deferred annuities for policyholder funds on deposit, increased from $138.0 million in 1996 to $146.4 million in 1997, or 6.1%, reflecting a 4.2% growth in universal life-type insurance in-force and a 3.5% increase in annuity funds on deposit.
Amortization of DAC and Value of Life Business Acquired. Amortization expense increased from $60.4 million in 1996 to $73.7 million in 1997, or 22.0%. This increase reflects the continued growth in the volume of universal life-type and traditional business in-force.
Commissions. Commissions decreased from $18.3 million in 1996 to $17.3 million in 1997, or 5.5%. The decrease results from the commutation, by IGL in the third quarter of 1997, of the block of business ceded to FNWL under the Yearly Renewable Term reinsurance treaty.
General and Administrative Expenses. General and administrative expenses increased from $60.9 million in 1996 to $61.5 million in 1997, or 1.0%, due primarily to higher legal and
consulting fees. Also contributing to the increase in expense was a $0.1 million increase in costs associated with the Year 2000 Project.
Provision for Income Taxes. Provision for income taxes increased from $71.1 million in 1996 to $73.8 million in 1997, an increase of $2.7 million, due to a decrease in tax preference items, particularly tax exempt interest.
FNWL Income. As a result of the foregoing, FNWL income decreased from $142.3 million in 1996 to $137.8 million in 1997, a decrease of $4.5 million, or 3.2%.
Consolidated Net Income
Consolidated net income of the Company increased from $507.9 million in 1996 to $593.5 million in 1997, an increase of $85.6 million, or 16.9%.
Year Ended December 31, 1996 Compared to Year Ended December 31, 1995
Management Services to Property and Casualty Insurance Companies; and Other
Operating Revenues. Operating revenues increased from $1,183.1 million in 1995 to $1,245.4 million in 1996, an increase of $62.3 million, or 5.3%. This growth reflects higher gross premiums earned by the P&C Group, which increased from $9,003.8 million in 1995 to $9,458.2 million in 1996 due primarily to higher average premium levels across all major lines of business and an increase in the number of policies-in-force between years. Partially offsetting these increases is a 0.45% reduction in the Farmers Preferred Auto Management fee rate, effective November 1, 1996. This resulted in a $4.1 million reduction in management fees in 1996 from what such fees would have been using the 1995 rates.
Total Operating Expenses. Total operating expenses as a percentage of operating revenues decreased from 58.9% in 1995 to 56.0% in 1996, a decrease of 2.9%. Specifically, labor costs (salaries and employee benefits) decreased from 29.5% of operating revenues for the year ended December 31, 1995 to 27.1% of operating revenues for the year ended December 31, 1996.
Salaries and Employee Benefits. Salaries and employee benefits decreased from $348.8 million in 1995 to $337.2 million in 1996, a decrease of $11.6 million, or 3.3%, primarily due to a reduction in employee complement.
Buildings and Equipment Expenses. Buildings and equipment expenses increased from $75.1 million in 1995 to $87.3 million in 1996, an increase of $12.2 million, or 16.2%. This increase was primarily due to the amortization of new information technology systems software, offset in part by a decrease in computer mainframe related expenses.
Amortization of AIF Contracts and Goodwill. Amortization expense was $102.8 million in both 1996 and 1995. These assets are being amortized on a straight-line basis over forty years.
General and Administrative Expenses. General and administrative expenses decreased $0.2 million between years, from $170.5 million in 1995 to $170.3 million in 1996.
Net Investment Income. Net investment income increased from $78.0 million in 1995 to $112.8 million in 1996, an increase of $34.8 million, or 44.6%. This increase was primarily due to higher yield rates and a larger invested asset base in 1996.
Net Realized Gains. Net realized gains increased from $1.5 million in 1995 to $5.1 million in 1996, an increase of $3.6 million, due mainly to gains realized on sales of bonds and investment real estate. 	 Dividends on Preferred Securities of Subsidiary Trusts. As a result of the $500.0 million of QUIPS issued in September and October 1995, dividend expense increased from $10.4 million in 1995 to $42.1 million in 1996.
Provision for Income Taxes. Provision for income taxes increased from $224.3 million in 1995 to $275.2 million in 1996, an increase of $50.9 million, or 22.7%. This increase was due in part to $22.5 million of taxes that resulted from the $374.9 million dividend paid to FGI by FNWL in December 1996. The remaining increase was attributable to an increase in pretax income between years.
Management Services Income. As a result of the foregoing, management services income increased from $330.8 million for the year ended December 31, 1995 to $348.5 million for the year ended December 31, 1996, an increase of $17.7 million, or 5.4%.
Life Insurance Subsidiaries
On April 15, 1997, OSL and IGL were sold to Great Southern Life Insurance Company, a subsidiary of Americo Life, Inc.. OSL and IGL contributed $17.2 million to net income in 1996 and $11.6 million in 1995. The following commentary addresses the results of the Company's remaining life insurance subsidiary, FNWL.
Total Revenues. Total revenues increased from $558.4 million in 1995 to $613.3 million in 1996, an increase of $54.9 million, or 9.8%.
Premiums. Premiums increased $12.2 million, or 9.8%, over 1995. This increase was due to growth in renewal and first year business. The increase in renewal premiums was attributable to an 11.9% growth in traditional life insurance in-force resulting from improved persistency and an increase in average policy size. The higher first year premiums were due primarily to growth in PWL and Mortgage Protection Plan products.
Policy charges. Policy charges increased $18.5 million, or 10.9%, over 1995, reflecting an 8.5% growth in universal life-type insurance-in-force.
Investment income. Net investment income increased $17.3 million in 1996, or 7.2%, over 1995 due largely to higher bond interest income resulting from a higher invested asset base.
Net realized gains. Net realized gains increased by $6.9 million in 1996 due primarily to gains realized on common stock as a result of favorable market conditions.
Total Operating Expenses. Total operating expenses increased from $369.9 million in 1995 to $399.9 million in 1996, an increase of $30.0 million, or 8.1%.
Policyholders' Benefits. Policyholders' benefits expense increased from $241.4 million in 1995 to $260.3 million in 1996, an increase of $18.9 million, or 7.8%. Policy benefits increased $4.9 million over 1995 primarily due to an increase in death claims resulting from higher average
insurance-in-force. Increase in liability for future benefits expense increased from $10.5 million in 1995 to $11.4 million in 1996, or 8.6%. This increase was primarily due to increases in PWL and other traditional product premiums and to lower terminations in 1996. Interest credited to policyholders increased from $124.9 million in 1995 to $138.0 million in 1996, or 10.5%, reflecting an 8.5% growth in universal life-type insurance in-force and a 7.3% increase in annuity funds on deposit.
Amortization of DAC and Value of Life Business Acquired. Amortization expense increased from $50.5 million in 1995 to $60.4 million in 1996, or 19.6%, reflecting the continued growth in universal life-type business and lower traditional terminations in 1996.
Commissions. Commissions increased from $17.7 million in 1995 to $18.3 million in 1996, reflecting increased renewal premiums from traditional and universal life products.
General and Administrative Expenses. General and administrative expenses increased from $60.3 million in 1995 to $60.9 million in 1996, or 1.0%, due to higher salaries and benefits expense.
Provision for Income Taxes. Provision for income taxes increased from $60.2 million in 1995 to $71.1 million in 1996, an increase of $10.9 million. This increase was attributable to the increase in pretax operating income.
FNWL Income. As a result of the foregoing, FNWL income increased from $128.3 million in 1995 to $142.3 million in 1996, an increase of $14.0 million, or 10.9%.
Consolidated Net Income
Consolidated net income of the Company increased from $470.7 million in 1995 to $507.9 million in 1996, an increase of $37.2 million, or 7.9%.
Liquidity and Capital Resources
General. The principal uses of funds by the Company are (i) operating expenses, (ii) dividends to the shareholders of the Company's QUIPS, (iii) capital expenditures and (iv) dividends to its stockholder. In 1997, dividends paid on the QUIPS totaled $42.1 million, capital expenditures totaled $66.2 million and cash dividends paid to the stockholder totaled $337.2 million.
The principal sources of funds available to the Company are (i) the management fees that it receives for managing the P&C Group, (ii) investment income and (iii) dividends from its subsidiaries. Historically, funds available from the first two of these sources have been sufficient to satisfy the liquidity needs of the Company, and the Company anticipates that such funds will continue to be adequate to satisfy such needs in the future. A portion of the net income of FNWL is available for payment as a dividend to the Company, subject to certain limitations imposed by the insurance laws of the State of Washington and additional state taxation. As of December 31, 1997, an aggregate of $122.7 million was available for distribution as a dividend without approval of the state insurance department (see Note G). Additionally, as of December 31, 1997, the Company had available revolving credit facilities enabling it to borrow up to $500.0 million in the event such a need should arise (see Note T).
In order to maintain the policyholders' surplus of the Exchanges, the Company has purchased approximately $850.0 million of surplus certificates of the Exchanges ($400.0 million of which were purchased in 1996, $250.0 million of which were purchased in 1995 and $200.0
million of which were purchased in 1986 and repaid in 1996, see Note D). In addition, in 1991, the Company arranged for two subsidiaries of B.A.T to purchase an aggregate of $400.0 million of surplus notes of two subsidiaries of the Exchanges. The Company has, from time to time, made other surplus contributions to the Exchanges totaling approximately $34.4 million, receiving certificates of contribution which bear interest at various rates. The Company believes that these purchases of surplus certificates and notes have helped to support the historical growth in premiums earned and the related growth in management fees paid to the Company.
Net cash provided by operating activities decreased from $688.7 million in 1996 to $655.4 million in 1997, a decrease in cash of $33.3 million, or 4.8%. This decrease in cash was principally due to a $34.9 million decrease in Universal life type contracts as a result of a reduction in new life business due to the sale of OSL and IGL. In addition, cash decreased $89.1 million due to an increase in non-current assets. The above decreases in cash were partially offset by a $85.6 million increase in consolidated net income.
Net cash used in investing activities decreased from $532.1 million in 1996 to $351.9 million in 1997, an increase in cash of $180.2 million, or 33.9%, between years. This increase in cash was principally due to $336.7 million of proceeds received from the sale of OSL and IGL and a $200.0 million net decrease in the purchase of surplus certificates of the Exchanges between years ($0 in 1997 versus a net $200.0 million purchase in 1996). Partially offsetting this increase in cash was an increase in net purchases of investments available-for-sale of $381.5 million.
Net cash used in financing activities decreased $570.3 million in 1996 to $286.5 million in 1997, an increase in cash of $283.8 million, or 49.8%. This increase in cash was primarily due to the repayment of $200.0 million of 8.25% Notes Payable in July 1996 and the fact that cash dividends paid to B.A.T decreased $127.7 million, from $464.9 million in 1996 to $337.2 million in 1997.
Life Insurance Subsidiary. The principal uses of funds by FNWL are (i) policy benefits and claims, (ii) loans to policyholders, (iii) capital expenditures, (iv) operating expenses, and (v) stockholder's dividends. The principal sources of funds available to FNWL are premiums and amounts earned from the investment of premiums and deposits. These sources of funds have historically satisfied the liquidity needs of FNWL.
ITEM 8.
ITEM 8. Financial Statements and Supplementary Data
Index for Financial Statements and Supplementary Data
Page ----
Independent Auditors' Report 24 Consolidated Financial Statements of Farmers Group, Inc. and Subsidiaries Consolidated Balance Sheets as of December 31, 1997 and 1996 25 Consolidated Statements of Income for the years ended December 31, 1997, 1996 and 1995 27 Consolidated Statements of Stockholder's Equity for the years ended December 31, 1997, 1996 and 1995 28 Consolidated Statements of Cash Flows for the years ended December 31, 1997, 1996 and 1995 29 Notes to Consolidated Financial Statements 30 Quarterly Financial Data (Unaudited) 58
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of Farmers Group, Inc.
We have audited the consolidated balance sheets of Farmers Group, Inc. and subsidiaries (the "Company") as of December 31, 1997 and 1996, and the related consolidated statements of income, stockholder's equity, and cash flows for each of the three years in the period ended December 31, 1997. Our audits also included the financial statement schedules listed in the Index at Item 14. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules 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, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 1997 and 1996, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
/s/ Deloitte & Touche LLP
DELOITTE & TOUCHE LLP Los Angeles, California February 16, 1998
FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Amounts in thousands) ASSETS
FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Amounts in thousands) LIABILITIES AND STOCKHOLDER'S EQUITY
FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Amounts in thousands)
FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY Years ended December 31, 1997, 1996 and 1995 (Amounts in thousands)
FARMERS GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Amounts in thousands)
FARMERS GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A. Basis of presentation and summary of significant accounting policies
The consolidated financial statements have been prepared in accordance with generally accepted accounting principles ("GAAP"). All material inter-company transactions have been eliminated. Certain amounts applicable to prior years have been reclassified to conform with the 1997 presentation. The consolidated financial statements include Farmers Group, Inc. ("FGI") and its subsidiaries (together, the "Company"). On April 15, 1997, FGI sold two of its life insurance subsidiaries, The Ohio State Life Insurance Company ("OSL") and Investors Guaranty Life Insurance Company ("IGL"), to Great Southern Life Insurance Company, a subsidiary of Americo Life, Inc.. As a result, the 1997 balance sheet information includes FGI and its remaining life insurance subsidiary, Farmers New World Life Insurance Company ("FNWL"), whereas the 1996 information includes FGI as well as FNWL, OSL, and IGL (the "Life Insurance Subsidiaries"). 	 In December 1988, BATUS Inc. ("BATUS"), a subsidiary of B.A.T Industries p.l.c. ("B.A.T"), acquired 100% ownership of the Company for $5,212,619,000 in cash, including related expenses, through its wholly owned subsidiary BATUS Financial Services. Immediately thereafter, BATUS Financial Services was merged into Farmers Group, Inc.. The acquisition was accounted for as a purchase and, accordingly, the acquired assets and liabilities were recorded in the Company's consolidated balance sheets based on their estimated fair values at December 31, 1988. In January 1990, ownership of the Company was transferred to South Western Nominees Limited, a subsidiary of B.A.T.
On December 22, 1997, a definitive agreement was reached to merge B.A.T Industries' Financial Services Businesses ("BAFS") with Zurich Insurance Company ("Zurich"). Completion of the merger is subject to regulatory consents, tax clearance and the approval of the shareholders of B.A.T and Zurich, and is expected to be finalized in late 1998. Under the agreement, the businesses of Zurich and BAFS, which include Farmers Group, Inc., will be transferred to Zurich Financial Services, a new Swiss company with headquarters in Zurich.
The Company is attorney-in-fact ("AIF") for three inter-insurance exchanges: Farmers Insurance Exchange, Fire Insurance Exchange and Truck Insurance Exchange (collectively the "Exchanges"), which operate in the property and casualty insurance industry. As attorney-in-fact, FGI, or its subsidiaries, as applicable, manages the affairs of the Exchanges, their respective subsidiaries and Farmers Texas County Mutual Insurance Company (collectively the "P&C Group") and receives compensation based on a percentage of earned premiums. The management services generate a substantial portion of the Company's revenue and profits, and as a result, the Company's ongoing financial performance depends on the volume of business written by, and the efficiency and financial strength of, the P&C Group. A portion of the purchase price ($1,709,043,000) associated with the acquisition was assigned to these AIF contract relationships. The value so assigned is being amortized on a straight-line basis over forty years.
The excess of the purchase price over the fair value of the net assets ("Goodwill") of the Company at the date of acquisition ($2,401,755,000) is being amortized on a straight-line basis over forty years. The carrying amount of the Goodwill is regularly reviewed for indications of impairment in value which in the view of management are other than temporary, including unexpected or adverse changes in the following: (1) the economic or competitive environments in which the Company operates, (2) profitability analyses and (3) cashflow analyses. As of December 31, 1997, the reported value and the remaining life of Goodwill are considered appropriate.
Prior to April 15, 1997 the Company's life insurance operations were conducted by its three wholly owned subsidiaries. A portion of the purchase price ($662,778,000) was assigned to the "Value of Life Business Acquired", which represented an actuarial determination of the expected profits from the business in force at the date of acquisition. The amount so assigned is being amortized over its actuarially determined useful life with the unamortized amount included in "Deferred Policy Acquisition Costs and Value of Life Business Acquired" in the accompanying consolidated balance sheets.
On April 15, 1997, upon receipt of regulatory approval, the Company sold OSL and IGL. The sale of these subsidiaries resulted in an estimated $19,019,000 gain and was reported on the "Gain on sale of subsidiaries" line of the income statement. In addition, taxes associated with the sale increased current year tax expense by an estimated $26,826,000 and were reflected on the "Provision for income taxes" line. Both of these amounts were reflected in the "Management services to property and casualty insurance companies; and other" section of the Company's consolidated income statement for the year ended December 31, 1997. The decision to sell these subsidiaries was part of the Company's strategic plan to focus its life insurance efforts on the growth of FNWL, by far its largest insurance company, through increased sales to the P&C Group's customer base. FNWL markets a broad line of individual life insurance products, including universal life, term life and whole life insurance, and annuity products, predominately flexible premium deferred annuities. These products and services are sold directly by the Exchanges' agents.
Properties are depreciated over the following estimated useful lives:
Buildings and improvements 10 to 35 years Furniture and equipment 5 to 10 years Data processing equipment and software 5 years
Depreciation is calculated for financial statement purposes by the straight-line method. Repairs and maintenance are charged to operations; significant renewals and betterments are capitalized.
In 1997, the Company adopted Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities". This Statement establishes accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities based on a consistent application of a financial-components approach that focuses on the issue of control. This Statement was amended by SFAS No. 127, "The Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125", which delays for one year the effective date of the provisions that apply to certain transactions. These transactions include repurchase agreements, dollar-rolls, securities lending, secured borrowings and collateral. The adoption of these Statements did not have a material impact on the Company's consolidated financial statements.
In February 1997, the FASB released SFAS No. 128, "Earnings per Share". This Statement, effective for financial statements issued for periods ending after December 15, 1997, establishes standards for computing and presenting earnings per share and applies to entities with publicly held common stock or potential common stock. The Company does not have any publicly held common stock and, therefore, is not subject to the requirements of this Statement.
In February 1997, the FASB released SFAS No. 129, "Disclosure of Information about Capital Structure". This Statement, effective for financial statements issued for periods ending after December 15, 1997, establishes standards for disclosing information about an entity's capital structure. This Statement eliminates the exemption of nonpublic entities from certain disclosure requirements of Accounting Principles Board Opinion No. 15, "Earnings Per Share", as provided by SFAS No. 21, "Suspension of the Reporting of Earnings per Share and Segment Information by Nonpublic Enterprises". The adoption of this Statement did not have a significant impact on the Company's consolidated financial statements.
In June 1997, the FASB released SFAS No. 130, "Reporting Comprehensive Income". This Statement, effective for fiscal periods beginning after December 15, 1997, establishes standards for reporting and displaying comprehensive income and its components. This Statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement with the same prominence as other financial statements. The Company does not expect the adoption of this Statement to have a material impact on its consolidated financial statements.
In June 1997, the FASB released SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information". This Statement, effective for financial statements of public enterprises issued for periods beginning after December 15, 1997, establishes standards for reporting information about operating segments in annual financial statements and requires the reporting of selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. This Statement supersedes SFAS No. 14, "Financial Reporting for Segments of a Business Enterprise" and amends SFAS No. 94, "Consolidation of All Majority-Owned Subsidiaries". The Company does not expect the adoption of this Statement to have a significant impact on its consolidated financial statements.
The preparation of the Company's financial statements in conformity with GAAP 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 as well as the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
B. Life insurance accounting
Traditional product premiums are recognized as revenues when they become due, and future benefits and expenses are matched with such premiums so that the majority of profits are recognized over the premium-paying period of the policy. This matching of revenues and expenses is accomplished through the provision for future policy benefits and the amortization of deferred policy acquisition costs ("DAC").
Certain policy acquisition costs, principally first-year commissions and other expenses for policy underwriting and issuance (which are primarily related to and vary with the production of new
business), are deferred and amortized proportionately over the estimated period during which the related premiums will be recognized as income, based on the same assumptions that are used for computing the liabilities for future policy benefits. Liabilities for future policy benefits are computed principally by means of a net level premium method reflecting estimated future investment yields, mortality, morbidity and withdrawals. Interest rate assumptions range from 2.25% to 9.25%, depending on the year of policy issue. Mortality is calculated principally on select and ultimate tables in common usage in the industry, modified for the Life Insurance Subsidiaries' experience, and withdrawals are estimated based primarily on the Life Insurance Subsidiaries' experience.
Revenues associated with universal life products consist of policy charges for the cost of insurance, policy administration fees, surrender charges and investment income on assets allocated to support policyholder account balances. Revenues for deferred annuity products consist of surrender charges and investment income on assets allocated to support policyholder account balances. Expenses include interest credited to policyholder account balances and benefit claims incurred in excess of policyholder account balances. Liabilities for future policy benefits on universal life and deferred annuity products are determined under the retrospective deposit method. DAC is amortized in relation to the present value of expected gross profit margins on the policies, after giving recognition to differences between actual and expected gross profit margins to date. DAC and Value of Life Business Acquired also includes amounts associated with the unrealized gains and losses recorded as a component of stockholder's equity in accordance with the application of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities". Accordingly, DAC and Value of Life Business Acquired is increased or decreased for the impact on estimated future gross profits as if net unrealized gains or losses on securities had been realized at the balance sheet date. Net unrealized gains or losses on securities within stockholder's equity also reflects this impact. These entries decreased the DAC and Value of Life Business Acquired asset by $43,447,000 and $27,927,000 as of December 31, 1997 and 1996, respectively.
C. Property, plant and equipment
A schedule of the Company's operating properties, plant and equipment at cost as of December 31 follows:
D. Certificates in surplus of Exchanges
The Company, as attorney-in-fact for the Exchanges, has made surplus contributions to the Exchanges from time to time. In return, the Company has received the following certificates of contribution totaling $684,380,000 as of December 31, 1997:
A $100,000,000 certificate of contribution, issued on December 20, 1996, bearing interest at 8.95% annually.
A $135,000,000 certificate of contribution, issued on September 30, 1996, bearing interest at 8.95% annually.
A $165,000,000 certificate of contribution, issued on June 27, 1996, bearing interest at 8.95% annually.
A $250,000,000 certificate of contribution, issued in 1995, bearing interest at 8.95% annually.
Miscellaneous other certificates of contribution totaling $34,380,000 which bear interest at various rates.
Conditions governing repayment of these amounts are outlined in the certificates. Generally, repayment may be made only when the surplus balance of the appropriate Exchange reaches a certain specified level, and then only after approval is granted by the Exchange Board of Governors and the California Insurance Commissioner.
On July 1, 1996, the Company received $200,000,000 from the Exchanges in repayment of a surplus contribution made by the Company in 1986.
E. Company Obligated Mandatorily Redeemable Preferred Securities of Subsidiary Trusts Holding Solely Junior Subordinate Debentures
In 1995, Farmers Group Capital and Farmers Group Capital II (the "Subsidiary Trusts"), consolidated wholly owned subsidiaries of Farmers Group, Inc., issued $410 million of 8.45% Cumulative Quarterly Income Preferred Securities ("QUIPS"), Series A and $90 million of 8.25% QUIPS, Series B, respectively. In connection with the Subsidiary Trusts' issuance of the QUIPS and the related purchase by Farmers Group, Inc. of all of the Subsidiary Trusts' Common Securities ("Common Securities"), Farmers Group, Inc. issued to Farmers Group Capital $422,680,399 principal amount of its 8.45% Junior Subordinated Debentures, Series A due on December 31, 2025, (the "Junior Subordinated Debentures, Series A") and issued to Farmers Group Capital II $92,783,505 principal amount of its 8.25% Junior Subordinated Debentures, Series B due on December 31, 2025 (the "Junior Subordinated Debentures, Series B" and, together with the Junior Subordinated Debentures, Series A, the "Junior Subordinated Debentures"). The sole assets of Farmers Group Capital are the Junior Subordinated Debentures, Series A. The sole assets of Farmers Group Capital II are the Junior Subordinated Debentures, Series B. In addition, these arrangements are governed by various agreements between Farmers Group, Inc. and the Subsidiary Trusts (the Guarantee Agreements, the Trust Agreements, the Expense Agreements, the Indentures and the Junior Subordinated Debentures) which considered together constitute a full and unconditional guarantee by Farmers Group, Inc. of the Subsidiary Trusts' obligations under the Preferred Securities.
Under certain circumstances, the Junior Subordinated Debentures may be distributed to holders of the QUIPS and holders of the Common Securities in liquidation of the Subsidiary Trusts. The QUIPS are subject to mandatory redemption upon repayment of the Junior Subordinated Debentures at maturity, or upon their earlier redemption, at a redemption price of $25 per Preferred Security, plus accrued and unpaid distributions thereon to the date fixed for redemption. Farmers Group, Inc. will have the option at any time on or after September 27, 2000 to redeem, in whole or part, the Junior Subordinated Debentures.
As of December 31, 1997 and 1996, a total of 20,000,000 shares of QUIPS were outstanding.
F. Employees' profit sharing plans
The Company has two profit sharing plans providing for cash payments to all eligible employees. The two plans, Cash Profit Sharing (consisting of Cash and Cash Plus) and Deferred Profit Sharing, provide for a maximum aggregate expense of 16.25% of the Company's consolidated annual pretax earnings, as adjusted. The Deferred Profit Sharing Plan, limited to 15% of the salary or wage paid or accrued to the eligible employee, provides for an annual payment by the Company to a trust for eventual payment to employees as provided in the Plan. The Cash Profit Sharing Plan provides for annual cash distributions limited to 5% (Cash) and 1.25% (Cash Plus) of the salary or wage paid or accrued to the eligible employee.
Expense under these plans was $52,235,000, $55,772,000, and $55,070,000 in 1997, 1996 and 1995, respectively.
G. Retained earnings
Combined statutory capital and surplus of the Life Insurance Subsidiaries was $894,738,000 as of December 31, 1996 and combined statutory net income was $167,517,000 and $116,998,000 for the years ended December 31, 1996, and 1995, respectively. Due to the sale of OSL and IGL on April 15, 1997, statutory capital and surplus as of December 31, 1997 reflects only the results of the Company's remaining life insurance subsidiary, FNWL. However, statutory net income for the year ended December 31, 1997, reflects the results of FNWL for the year and the results of OSL and IGL through the date of sale. As a result, statutory capital and surplus of FNWL was $817,588,000, and statutory net income of the Life Insurance Subsidiaries was $122,863,000 for the year.
In December 1996, upon approval of the Washington State Department of Insurance, FNWL paid a $374,916,000 dividend to its parent company, Farmers Group, Inc., which consisted primarily of common stock investments. As of December 31, 1997, an aggregate of $122,667,000 was still available for distribution without approval from the State Department of Insurance in Washington, the state in which FNWL is domiciled.
H. Investments
The Company follows the provisions of SFAS No. 115. This Statement addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. As of December 31, 1997 and 1996, the Company classified all investments in equity and debt securities as available-for-sale under SFAS No. 115. Correspondingly, these investments are reported on the balance sheet at fair value, with unrealized gains and losses, net of tax, excluded from earnings and reported as a component of stockholder's equity. Real estate investments are accounted for on a depreciated cost basis. Real estate acquired in foreclosure and held for sale is carried at the lower of fair value or depreciated cost less a valuation allowance. Short-term instruments are carried at cost. Other investments, which consist primarily of certificates in surplus of the Exchanges, policy loans and the B.A.T Capital Corporation notes, are carried at the unpaid principal balances.
In compliance with a Securities and Exchange Commission ("SEC") staff announcement, the Company has recorded certain entries to the DAC and Value of Life Business Acquired line of the consolidated balance sheet in connection with SFAS No. 115. The SEC requires that companies record entries to those assets and liabilities that would have been adjusted had the unrealized
investment gains or losses from securities classified as available-for-sale actually been realized, with corresponding credits or charges reported directly to stockholder's equity.
The sources of investment income on securities owned by the Company (excluding the Life Insurance Subsidiaries) for the years ended December 31 are:
The sources of investment income on securities owned by the Life Insurance Subsidiaries for the years ended December 31 are:
Realized gains and losses on sales, redemptions and writedowns of investments owned by the Company (excluding the Life Insurance Subsidiaries) are determined based on either the cost of the individual securities or the depreciated cost of real estate. Net realized investment gains or losses for the years ended December 31 are:
Realized gains and losses on sales, redemptions and writedowns of investments owned by the Life Insurance Subsidiaries are determined based on either the cost of the individual securities or the depreciated cost of real estate. Net realized investment gains or losses for the years ended December 31 are:
The amortized cost, gross unrealized gains and losses, and estimated market values of investments in equity securities pertaining to non-redeemable preferred stocks and common stocks owned by the Company (excluding life insurance amounts) are as follows:
The amortized cost, gross unrealized gains and losses, and estimated market values of investments in equity securities pertaining to non-redeemable preferred stocks and common stocks owned by FNWL in 1997 and the Life Insurance Subsidiaries in 1996 are as follows:
The amortized cost, gross unrealized gains and losses, and estimated market values of investments in debt securities, including bonds and redeemable preferred stocks, owned by the Company (excluding life insurance amounts) are as follows:
The amortized cost, gross unrealized gains and losses, and estimated market values of investments in debt securities, including bonds and redeemable preferred stocks, owned by FNWL in 1997 and the Life Insurance Subsidiaries in 1996 are as follows:
The amortized cost and estimated market value of debt securities, including marketable securities, owned by the Company (excluding FNWL) as of December 31, 1997, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The amortized cost and estimated market value of debt securities owned by FNWL as of December 31, 1997, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Proceeds from sales of available-for-sale securities received by the Company were $735,192,000 and $551,122,000 during 1997 and 1996, respectively. Gross gains of $100,269,000 and $76,431,000 and gross losses of $21,274,000 and $32,009,000 were realized on sales and writedowns during 1997 and 1996, respectively.
Proceeds from sales and maturities of available-for-sale securities received by the Company were $541,376,000 during 1995. Gross gains of $45,944,000 and gross losses of $13,371,000 were realized on sales and writedowns during 1995.
The change in the net unrealized gains or losses of the Company (excluding life insurance amounts) for the years ended December 31 is as follows:
The change in the net unrealized gains or losses of FNWL in 1997 and the Life Insurance Subsidiaries in 1996 are as follows:
I. Equity-indexed annuities
During 1997, FNWL began selling an equity-indexed annuity product. At the end of its seven year term, this product credits interest to the annuity participant at a rate based on a specified portion of the change in the value of the Standard & Poor's 500 Composite Stock Price Index ("S&P 500 Index"), subject to a guaranteed annual minimum return. In order to hedge the interest liability generated on the annuities as the index rises, FNWL purchases call options on the S&P 500 Index. FNWL considers such call options to be held as a hedge. As of December 31, 1997, FNWL had call options with contract values of $13,180,000 and carrying values of $3,299,000.
Hedge accounting is used to account for the call options as FNWL believes that the options reduce the risks associated with increases in the account value of the annuities that result from increases in the S&P 500 Index. The call options effectively hedge the annuity contracts since they are both purchased and sold with identical parameters. Periodically, the value of the assets (S&P 500 call options) are matched to the potential liability (annuity contracts) to ensure the hedge has remained effective. The annuities were written based on a seven year investment term, absent early termination by participants. Therefore, the anticipated hedged transaction (i.e., payment of interest to the policyholder at the end of the investment term and maturity of the call option) for each annuity is generally expected to occur in seven years or less. For the year ended December 31, 1997, the amount of unrealized hedging losses deferred was $151,000.
The call options are included in other invested assets and are carried at estimated fair value. Unrealized gains and losses resulting from changes in the estimated fair value of the call options are recorded as an adjustment to the interest liability credited to policyholders. In addition, realized gains and losses from maturity or termination of the call options are offset against the interest credited to policyholders during the period incurred. Premiums paid on indexed call options are amortized to net investment income over the term of the contracts. There were no early terminations by annuity participants, or maturities or sales of the S&P 500 call options during 1997.
The cash requirement of the call options consists of the initial premium paid to purchase the index options. Should a liability exist to the annuity participant at maturity of the annuity policy, the termination or maturity of the option contracts will generate positive cash flow to FNWL. The appropriate amount of cash will then be remitted to the annuity participant based on the respective
participation rate. The index options are generally expected to be held for a seven year term, but can be terminated at any time.
There are certain risks associated with the index call options, primarily with respect to significant movements in the United States stock market and counterparty nonperformance. The Company believes that the counterparties to its call option agreements are financially responsible and that the counterparty risk associated with these transactions is minimal.
J. Fair value of financial instruments
The estimated fair values of financial instruments disclosed have been determined using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented may not be indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies could have a significant effect on the estimated fair value amounts.
The following methods and assumptions were used to estimate the fair value of financial instruments as of December 31, 1997 and 1996:
Cash and cash equivalents and short-term marketable securities The carrying amounts of these items are a reasonable estimate of their fair values.
Fixed maturities, non-redeemable preferred stocks and common stocks The estimated fair values of bonds, redeemable and non-redeemable preferred stocks and common stocks are based upon quoted market prices, dealer quotes, and prices obtained from independent pricing services.
Mortgage loans The estimated fair value of the mortgage loans portfolio is determined by discounting the estimated future cash flows, using a year-end market rate which is applicable to the yield, credit quality and average maturity of the composite portfolio. 	 Certificates in surplus of Exchanges The carrying amounts of these certificates are a reasonable estimate of their fair values.
Notes receivable-affiliate The fair values are estimated by discounting the future cash flows using the current rates at which similar loans would be made by the Company to borrowers for the same remaining maturities.
Joint ventures, at equity The estimated fair values are based upon quoted market prices, current appraisals, and independent pricing services.
Other assets Other assets consist primarily of advances to agents, the fair value of which is determined by discounting the estimated future cash flows using credit quality, the average maturity of related advances, and the current rates at which similar loans would be made to borrowers by the Company.
Policy loans The estimated fair values of policy loans are determined by discounting the future cash flows using the current rates at which similar loans would be made.
Other Investments Other investments consist of S&P 500 index call options purchased as hedges against the interest liabilities generated on the equity-indexed annuity products. These call options are carried at an estimated fair value based on stock price, strike price, time to expiration, interest rates, dividends and volatility per the methodology of the Black-Scholes Option Pricing Formula.
Assets held in separate account and liabilities related to separate account The carrying values are a reasonable estimate of their fair values since assets and liabilities of separate accounts are carried at market value. 	 Real estate mortgages payable The estimated fair values are determined by discounting the estimated future cash flows at a rate which approximates the Company's incremental borrowing rate.
Company obligated mandatorily redeemable preferred securities of subsidiary trusts holding solely junior subordinated debentures The estimated fair values are based on quoted market prices.
Future policy benefits-deferred annuities The estimated fair values of flexible premium and single premium deferred annuities are based on their cash surrender values.
K. Value of Life Business Acquired
The changes in the Value of Life Business Acquired were as follows:
Based on current conditions and assumptions as to future events, FNWL expects to amortize the December 31, 1997 balance as follows: approximately 3.2% in 1998 and 1999, 3.4% in 2000, 3.6% in 2001, and 3.9% in 2002. The discount rate used to determine the amortization rate of the Value of Life Business Acquired ranged from 12.5% to 7.5%.
L. Mortgage loans
The Company follows the principles of SFAS No. 118 (amending SFAS No. 114), "Accounting by Creditors for Impairment of a Loan". This Statement requires that an impaired loan be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of the collateral, if the loan is collateral dependent.
The total recorded investment in impaired mortgage loans and the amount of recorded investment for which an allowance for credit losses exists as of December 31 follows:
The Company records interest income received on impaired mortgage loans on a cash basis. The average recorded investment and income recognized on impaired mortgage loans follows:
The activity in the total allowance for credit losses related to impaired mortgage loans follows:
M. Security lending arrangement
The Company has a security lending agreement with a financial institution. The agreement in effect as of December 31, 1997 authorizes the institution to lend securities held in the Company's portfolio to a list of authorized borrowers. Concurrent with delivery of the securities, the borrower provides the Company with cash collateral equal to at least 102% of the market value of domestic securities and 105% of the market value of other securities subject to the "loan."
The securities are marked-to-market on a daily basis and the collateral is adjusted on the next business day. The collateral is invested in highly liquid, fixed income assets with a duration of less than one year. Income earned from the security lending arrangement was allocated 60% to the Company and 40% to the lending agent. Income earned by the Company was approximately $856,000 in 1997. As of December 31, 1997, the collateral under the agreement was $594,488,000.
In 1996 and 1995, the Life Insurance Subsidiaries had a security lending agreement with a financial institution which had the same terms as the agreement in effect as of December 31, 1997. Income earned by the Life Insurance Subsidiaries was $422,000 and $233,000 in 1996 and 1995, respectively. The collateral under these agreements as of December 31, 1996 was $221,216,000.
N. Employees' retirement plans
The Company has two noncontributory defined benefit pension plans (the Regular Plan and the Restoration Plan). The Regular Plan covers substantially all employees of the Company and the Exchanges who have reached age 21 and have rendered one year of service. Benefits are based on years of service and the employee's compensation during the last five years of employment. The Restoration Plan provides supplemental retirement benefits for certain key employees of the Company.
The Company's policy is to fund the amount determined under the aggregate cost method, provided it does not exceed funding limitations. There has been no change in funding policy from prior years.
Assets of the Regular Plan are held by an independent trustee. Assets held are primarily in fixed maturity and equity investments. The principal liability is for annuity benefit payments of current and future retirees. Assets of the Restoration Plan are considered corporate assets and are held in a grantor trust. In 1996, assets and liabilities of the Regular Plan were recorded by FNWL in Separate Accounts and were not commingled with the general assets and liabilities of that company (see Note V).
Information regarding the Regular Plan's funded status is not developed separately for the Company and the Exchanges. Information regarding the Restoration Plan pertains only to the
Company. The funded status of the Plans for the Company and the Exchanges as of December 1, 1997 and 1996 (the latest date for which information is available) was as follows:
Upon purchase of the Company in 1988, the Company allocated part of the purchase price to its portion of the Regular Plan assets in excess of the projected benefit obligation at the date of acquisition. The asset is being amortized for the difference between the Company's net pension cost and amounts contributed to the Plan. The unamortized balance as of December 31, 1997 and 1996 was $24,304,000 and $29,252,000, respectively.
Components of net periodic pension expense for the Company follow:
The Company uses the projected unit credit cost actuarial method for attribution of expense for financial reporting purposes. The interest cost and the actuarial present value of benefit obligations were computed using an interest rate of 7.25% in 1997, 1996 and 1995, while the expected return on plan assets was computed using an interest rate of 9.00% in 1997 and 1996 and 9.25% in 1995. The rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation was 5.00% in 1997 and 1996 and 4.50% in 1995.
The Company's postretirement benefits plan is a contributory defined benefit plan for employees who were retired or who were eligible for early retirement as of January 1, 1995, and is a contributory defined dollar plan for all other employees retiring after January 1, 1995. Health benefits are provided for all employees who participated in the Company's and the Exchanges' group medical benefits plan for 15 years prior to retirement at age 55 or later. A life insurance benefit of $5,000 is provided at no cost to retirees who maintained group insurance coverage for 15 years prior to retirement at age 55 or later.
There are no assets separated and allocated to this plan.
The funded status of the entire plan, which includes the Company and the Exchanges, as of December 1, 1997 and 1996 (the latest date for which information is available) was as follows:
The Company's share of the accrued postretirement benefit cost was approximately $49,404,000 in 1997 and $47,948,000 in 1996. The unrecognized net transition obligation of $19,665,000 in 1997 and $20,976,000 in 1996 represents the remaining transition obligation of the Exchanges.
Components of postretirement benefits expense for the Company follow:
The interest rate used in the above benefit computations was 7.25% in 1997, 1996 and 1995. Beginning in 1995, the initial medical inflation rate was 8.00%, to be graded over a 4-year period to 6.00% and level thereafter, and contribution levels from retirees were the same as applicable medical cost increases where defined benefits exist. The rate of increase in future compensation levels used in determining the actuarial present value of the accumulated benefit obligation was 5.00% in 1997 and 1996 and 4.50% in 1995. A 1.00% increase in the medical inflation rate assumption would have resulted in an approximate increase of $1,179,000 in 1997 and $1,231,000 in 1996 in the accumulated benefit obligation for the Company.
O. Commitments and contingencies
Rental expense incurred by the Company was $20,322,000, $20,121,000, and $21,944,000 in 1997, 1996 and 1995, respectively.
The Company has long-term operating lease commitments on equipment and buildings, with options to renew at the end of the lease periods. As of December 31, 1997, the remaining commitments payable over the next five years under these leases are:
The Company is a party to numerous lawsuits arising from its normal business activities. These actions are in various stages of discovery and development, and some seek punitive as well as compensatory damages. In the opinion of management, the Company has not engaged in any conduct which should warrant the award of any material punitive or compensatory damages. The Company intends to vigorously defend its position in each case, and management believes that, while it is not possible to predict the outcome of such matters with absolute certainty, ultimate disposition of these proceedings should not have a material adverse effect on the Company's consolidated results of operations or financial position.
The Company has entered into employment agreements with certain executives of the Company. Each agreement obligates the Company to compensate the executive should the executive's employment be terminated due to a qualifying event, as defined within the agreement. In the opinion of management, any payments made as a result of these agreements would not have a material adverse effect on the Company's consolidated results of operations or financial position.
P. Income taxes
The Company follows the provisions of SFAS No. 109, "Accounting for Income Taxes". Deferred tax assets and deferred tax liabilities are recorded to reflect the tax consequences in future years of differences between the tax bases of assets and liabilities and the corresponding bases used for financial statements. On April 15, 1997, OSL and IGL were sold pursuant to Internal Revenue Code Section 338(h)(10). Federal and state taxes incurred as a result of this transaction amounted to an estimated $26,826,000.
The components of the provision for income taxes are:
The table below reconciles the provision for income taxes computed at the U.S. statutory income tax rate of 35% to the Company's provision for income taxes:
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities as of December 31, 1997 and 1996 are presented in the following tables:
Q. Supplemental cash flow information
For financial statement purposes, the Company considers all investments with original maturities of 90 days or less as cash equivalents. Following is a reconciliation of the individual balance sheet cash and cash equivalent totals to the consolidated cash flow total.
Cash payments for interest were $3,725,000, $18,674,000, and $18,995,000 in 1997, 1996, and 1995, respectively, while cash payments for dividends to the holders of the Company's QUIPS were $42,070,000 in 1997 and 1996 and $10,414,000 in 1995. Cash payments for income taxes were $430,588,000, $379,455,000, and $315,603,000 in 1997, 1996 and 1995, respectively.
In 1997, net cash proceeds from the sale of OSL and IGL amounted to an estimated $336,714,000 and were in consideration primarily for the following:
Investments 823,666,000 Deferred policy acquisition costs and Value of Life Business Acquired 181,196,000 Life insurance policy liabilities (690,426,000)
Also in 1997, the change in the Separate Accounts assets and liabilities netted to $0 and was reflected in the Statements of Cash Flows (see Note V).
In July 1996, the Company used $200,000,000 of proceeds it received from the Exchanges in connection with the repayment of the 1986 surplus contribution (see Note D) to extinguish the $200,000,000 of 8.25% Notes Payable the Company issued in July 1986.
As a result of the adoption of SFAS No. 115, the Life Insurance Subsidiaries have decreased the DAC asset and increased the Value of Life Business Acquired asset to account for the impact on estimated future gross profits of the net unrealized gains or losses on securities.
R. Management fees
As attorney-in-fact, the Company, or its subsidiaries, as applicable, manages the affairs of the P&C Group and receives management fees for the services rendered to the Exchanges. As a result, the Company received management fees from the Exchanges of $1,241,153,000, $1,167,704,000 and $1,109,425,000 in 1997, 1996, and 1995, respectively.
S. Related parties
Certain directors of the Company are partners in legal firms that received fees for legal services from the Company and the Exchanges. These fees totaled $5,208,000, $1,853,000 and $2,231,000 in 1997, 1996 and 1995, respectively.
As of December 31, 1997, the Company had $407,000,000 in notes receivable related to loans made to B.A.T Capital Corporation, a subsidiary of B.A.T. These notes are fixed rate medium term notes with maturity dates as follows: $137,000,000 in October 1998, $135,000,000 in October 1999 and $135,000,000 in October 2000. Interest on these notes is paid semi-annually at coupon rates of 5.35%, 6.68% and 6.33%, respectively. On October 7, 1997, a four year $135,000,000 note with an interest rate of 5.10% matured and the $135,000,000 note maturing in October 2000 was subsequently issued at an interest rate of 6.33%. Income earned on the notes outstanding during 1997, 1996 and 1995 was $23,620,000, $21,245,000, and $20,697,000, respectively.
On October 7, 1996, a three year $135,000,000 note with an interest rate of 4.76% matured and the $135,000,000 note, maturing in October 1999, was subsequently issued at an interest rate of 6.68%.
T. Revolving credit agreement
As of December 31, 1997 and 1996, the Company had a revolving credit agreement with certain financial institutions and had an aggregate borrowing facility of $500,000,000. The
proceeds of the facility were available to the Company for general corporate purposes, including loans to the Exchanges. As of December 31, 1997 and 1996, facility fees were payable on the aggregate borrowing facility in the amount of 7 and 9 basis points per annum, respectively, and were reimbursable to the Company by the Exchanges. In the case of a draw on the facility, the Company has the option to borrow at annual rates equal to the prime rate, the banks' certificate of deposit rate plus 1%, the federal funds effective rate plus 1/2 of 1% or the London Interbank Offered Rate ("LIBOR") plus certain percentages. As of December 31, 1997 and 1996, the Company did not have any outstanding borrowings under the revolving credit agreement. Facility fees were $399,000, $592,000 and $526,000 for the years ended December 31, 1997, 1996 and 1995, respectively, and were reimbursed by the Exchanges. The revolving credit agreement in effect as of December 31, 1997 expires on July 1, 2002.
U. Real estate mortgages payable
As of December 31, 1997, the Company, excluding FNWL, was liable for two mortgages, one with an interest rate of 6.98% maturing in June 1998 and one with an interest rate of 7.24% maturing in June 2004. The amount of principal due within one year is approximately $67,000. As of December 31, 1997, there were no real estate mortgage notes payable by FNWL.
V. Separate Accounts
The assets and liabilities held in Separate Accounts as of December 31, 1996 related to the pension plan for the employees of the Company and the Exchanges. The assets were held primarily in fixed maturity and equity investments, while the principal liability was for annuity benefit payments under the pension plan. A review of the trust agreement with Chase Manhattan Bank, the trustee for the pension plan, led to the conclusion that Separate Account treatment was no longer required. Therefore, FNWL excluded the pension plan assets and liabilities from Separate Accounts as of November 30, 1997.
W. Participating policies
Participating business, primarily group insurance, comprised approximately 8.8% of FNWL's total insurance-in-force as of December 31, 1997 and 7.5% of the Life Insurance Subsidiaries' total insurance-in-force as of December 31, 1996. In addition, participating business represented 2.2% of FNWL's premium income for the year ended December 31, 1997, and 2.2% of the Life Insurance Subsidiaries' premium income for the years ended December 31, 1996 and 1995. 	 X. Life reinsurance	
In 1996 and 1995, the Life Insurance Subsidiaries had reciprocal reinsurance treaties in place among themselves so that the maximum exposure to the Life Insurance Subsidiaries, in the aggregate, for any one life was the sum of their individual retention levels, or $1,400,000. Due to the sale of OSL and IGL on April 15, 1997, the reciprocal reinsurance treaties which existed with FNWL ceased.
Premiums ceded to non-affiliates totaled $3,868,000 and $3,577,000 for the years ended December 31, 1996 and 1995, respectively. Reinsurance receivables, which totaled $10,621,000 as of December 31, 1996, were included in Other Assets of Life Insurance Subsidiaries.
In the fourth quarter of 1997, FNWL revised the retention limit for automatic reinsurance ceded. The primary change was to set the maximum retention on new issues at $2,000,000 per life for the Farmers Flexible Universal Life policy, $1,500,000 per life for all Traditional policies except Farmers Yearly Renewable Term, and $800,000 per life for Farmers Yearly Renewable Term. The excess is reinsured with a third party reinsurer. Premiums ceded under these agreements totaled $4,236,000 in 1997. Reinsurance receivables, which totaled $8,627,000 as of December 31, 1997 were included in Other Assets of Life Insurance Subsidiaries.
Y. Current liabilities accrued, other
Current liabilities accrued, other consisted of the following:
Z. Operations in different industries
The Company operates primarily in two industries - management of property and casualty insurance companies (principally reciprocal insurance exchanges) and the life insurance industry. Total revenue by industry includes both revenues as reported in the Company's consolidated income statement, and intersegment revenues which are eliminated in consolidation.
Operating profit is comprised of total revenues less operating expenses. Accordingly, investment income and realized gains on securities and real estate investment income earned as a result of the management services to the P&C Group have not been added, and general corporate expenses and income taxes have not been deducted. The Management Services to the P&C Group segment incurred depreciation expense of $51,579,000, $40,096,000, and $28,023,000 in 1997, 1996 and 1995, respectively, while depreciation for the Life Insurance Subsidiaries was $2,838,000 in 1997, $3,108,000 in 1996 and $3,699,000 in 1995. Capital expenditures for the Management Services to the P&C Group totaled $41,732,000, $51,605,000 and $55,811,000 in 1997, 1996 and 1995, respectively, while capital expenditures for the Life Insurance Subsidiaries were $1,696,000 in 1997, $132,000 in 1996 and $301,000 in 1995. The Other industry category includes certain subsidiary companies engaged in real estate investment and leasing activities. These companies incurred depreciation expenses of $18,634,000, $20,202,000 and $17,270,000 in 1997, 1996 and 1995, respectively. Capital expenditures within the Other industry category were $22,802,000 in 1997, $24,074,000 in 1996 and $17,493,000 in 1995.
Identifiable assets by industry are those assets used in the Company's operations within each industry. Corporate assets are principally marketable securities owned by the Company and its non-life subsidiaries and amounts invested by the Company in joint ventures.
Information regarding the Company's operations in different industries follows:
FARMERS GROUP, INC. AND SUBSIDIARIES QUARTERLY FINANCIAL DATA (Unaudited)
ITEM 9.
ITEM 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosures
None.
PART III
ITEM 10.
ITEM 10. Directors and Executive Officers of Farmers Group, Inc.
MANAGEMENT
Executive Officers and Directors
The following table sets forth certain information concerning each person who is an executive officer or director of FGI as of the filing date:
The present position and principal occupation during each of the last five years of the executive officers and directors named above are set forth below.
Martin D. Feinstein has served as Chairman of the Board since November 1997, Chief Executive Officer of FGI since January 1997, President of FGI since January 1995 and as a director of FGI since February 1995. Mr. Feinstein has also served as a director of B.A.T since January 1997. Previously, Mr. Feinstein held various positions with FGI, including serving as Vice President-Sales and Marketing from November 1989 to January 1993, as Senior Vice President-Special Projects from January 1993 to October 1993, as Senior Vice President-Property and Casualty Staff from October 1993 to January 1995 and as Chief Operating Officer of FGI from January 1995 to January 1997.
James A. MacKinnon has served as Executive Vice President-Insurance Operations since January 1997 and as a director of FGI since May 1997. Mr. MacKinnon served as Senior Vice President-Field Operations-Mid-West Zone of FGI from 1989 to 1995 and Senior Vice President-Personal Lines Operations of FGI from August 1995 to January 1997.
Keitha T. Schofield has served as Executive Vice President-Support Services and Chief Information Officer since January 1997 and as a director of FGI since May 1997. Ms. Schofield served as Senior Vice President and Chief Information Officer of FGI from May 1995 to January 1997. Previously, Ms. Schofield served as Vice President-Technology Division of Continental Airlines, Inc. from 1988 to May 1995.
Anthony L.R. Clark has served as Vice President and Chief Financial Officer of FGI since March 1995 and effective January 1996 was appointed Senior Vice President. Previously, Mr. Clark served as Finance Director of Eagle Star Insurance Co. Ltd., a subsidiary of B.A.T, from January 1991 to March 1995. Prior to this he held a number of financial positions with B.A.T including Group Chief Accountant.
Gerald E. Faulwell has served as Vice President-Strategic Planning, Budgeting and Administration of FGI since January 1993 and effective January 1996 was appointed Senior Vice President. Previously, Mr. Faulwell served as Vice President-Corporate Investments and Treasurer of FGI from January 1988 to January 1993.
Leonard H. Gelfand has served as Vice President-Commercial of FGI and President-Truck Underwriters Association since April 1991 and effective January 1995, was appointed Senior Vice President. Previously, Mr. Gelfand served as Vice President, Regional Manager of the Santa Ana Region from 1984 to 1987 and Regional Manager of the Pleasanton Region from 1987 to 1991.
Paul N. Hopkins has served as Vice President-Agencies since December 1994 and effective October 1997, was appointed Senior Vice President. Previously, Mr. Hopkins served as Assistant Vice President-Regional Operations from 1992 to 1994.
Jason L. Katz has served as Senior Vice President and General Counsel of FGI since February 1992 and as a director of FGI since May 1986. Mr. Katz served as Vice President and General Counsel from August 1984 through February 1992.
John H. Lynch has served as Vice President-Personal Lines Operations since January 1997 and effective October 1997, was appointed Senior Vice President. Previously, Mr. Lynch served as Vice President, Regional Manager of the Pleasanton Region from 1993 to 1995 and Regional Manager of the Colorado Springs Region from 1995 to 1996.
Paul G. Secord has served as Senior Vice President-Asset Management of FGI since December 1995. Previously, Mr. Secord served as Vice President-Equity of John Hancock Advisors from 1990 to 1993 and Senior Vice President-Equity of Penn Mutual from 1993 to 1995.
David P. Allvey has served as a director of FGI since February 1995. Mr. Allvey joined B.A.T as Group Deputy Tax Manager in 1980. His positions have included Finance Adviser and Manager of Taxation at British-American Tobacco Co., Head of Finance of B.A.T and Finance Director. Mr. Allvey was appointed Finance Director at B.A.T in April 1989.
Edwin A. Heafey, Jr. has served as a director of FGI since 1978. Mr. Heafey is a practicing attorney and has been a partner of the law firm of Crosby, Heafey, Roach and May since 1962.
Benjamin C. Neff has served as a director of FGI since 1995. Mr. Neff has served as Chairman of NECO Financial Services, Inc. since May 1995. During the period from May 1992 through May 1995, Mr. Neff was the Managing Director of Seabury & Smith, Inc., a wholly owned subsidiary of Marsh & McClennan, Inc.. Prior to May 1992, Mr. Neff served as the President of Smith Sternau Insurance Services, Inc., a wholly owned subsidiary of Marsh & McClennan, Inc..
Jack C. Parnell has served as a director of FGI since 1995. Mr. Parnell has served as a Governmental Relations Advisor to the law firm of Kahn, Soares & Conway and the public relations firm of Fleishman, Hilliard since 1991. Previously, Mr. Parnell served as the Deputy Secretary-United States Department of Agriculture from 1989 to 1991. Mr. Parnell also serves on the Board of Directors of Neogen Corporation, a company engaged in the veterinary instruments and diagnostics business.
Cornelius J. Pings has served as a director of FGI since August 1991. Dr. Pings has served as the President of the Association of American Universities since February 1993 and served as the Provost (Senior Vice President for Academic Affairs) for the University of Southern California from 1981 to early 1993. Dr. Pings also serves on the Board of Directors of Pacific Horizon Funds, Inc. and until 1992 served on the board of Maxtor, Inc., a company engaged in the disk drive business.
Van Gordon Sauter has served as a director of FGI since May 1996. Mr. Sauter is the President and General Manager of PBS affiliate KVIE in Sacramento, California. Previously, he served as President of CBS News and Fox News.
M. Faye Wilson has served as a director of FGI since May 1996. Ms. Wilson has served as Executive Vice President of BankAmerica since 1977. Ms. Wilson also serves on the Board of Directors of Home Depot, a company engaged in the retail hardware and building supplies business.
Clayton Yeutter has served as a director of FGI since 1994. Mr. Yeutter was appointed a non-executive director of B.A.T in January 1993. Mr. Yeutter is Of Counsel to the law firm of Hogan and Hartson since February 1993. During the preceding four years, he served in a series of positions in the Bush Administration, first as Secretary of Agriculture, then as Chairman of the Republican National Committee and finally as Counselor to the President for Domestic Policy.
ITEM 11.
ITEM 11. Executive Compensation
The following table sets forth the annual compensation for services in all capacities to FGI for the fiscal years ended December 31, 1997, 1996 and 1995 of those persons who were, as of December 31, 1997, (i) FGI's Chief Executive Officer and (ii) the other four most highly compensated executive officers of FGI (the "Named Executive Officers").
SUMMARY COMPENSATION TABLE
- --------------------- (1) Bonus amounts reported in the year in which service related to such bonus is rendered. Payment does not occur until the year subsequent to the year of service.
(2) In 1997, Messrs. Feinstein, Katz, MacKinnon, Secord and Ms. Schofield received awards of 17,982, 8,200, 8,000, 6,000 and 8,200 Premier Award Units ("PAUs"), respectively, under FGI's Premier Award Units Plan. In 1995, Messrs. Feinstein, Katz, MacKinnon and Ms. Schofield received awards of 7,495, 7,710, 5,805 and 4,995 PAUs. Mr. Secord received an interim award of 5,620 PAUs in 1996. The value of the PAUs is linked to performance goals set by the Compensation Committee based on the financial and operating results of the Company and the P&C Group and the price of B.A.T ADRs over a four-year period. The value of the PAUs will be paid to eligible employees in cash or in B.A.T ADRs if such ADRs are eligible for unrestricted issue pursuant to applicable law. The receipt of such amounts may be deferred at the election of participants, subject to the approval of the Compensation Committee. In the event of certain changes in the capital structure of FGI or other events relating to control of FGI, the Compensation Committee has the discretion to pay out the value of outstanding PAUs immediately or make other appropriate adjustments to the PAUs.
(3) Represents estimated amounts to be contributed by FGI under the Employees' Profit Sharing Savings Plan Trust (the "Deferred Plan") and reported in the year of service as earned. To the extent that a participant's annual benefits under the Deferred Plan exceed certain limits imposed by law, such amounts will be paid under FGI's nonqualified Employee Benefits Restoration Plan (the "Benefits Restoration Plan"), which is funded through a grantor trust.
Employees' Pension Plan
In addition to the compensation set forth above, the Named Executive Officers participate with all eligible employees of the Company in the Company's tax-qualified Employees' Pension Plan (the "Pension Plan"). The Named Executive Officers also participate in the Benefits Restoration Plan, funded through a grantor trust, which provides supplemental benefits to the extent amounts otherwise payable under the Pension Plan and the Deferred Plan are limited under applicable laws. (Together, the Pension Plan and the Benefits Restoration Plan are referred to as the "Retirement Plans").
Effective May 7, 1997, the Employee Benefits Restoration Plan was amended to include awards made under the Executive Incentive Plan as compensation in calculating pension benefits, starting with the 1996 awards paid in 1997. The entire benefit derived from inclusion of the Executive Incentive Plan award(s) will be paid from the Employee Benefits Restoration Plan. This amendment impacts certain key officers and includes the Named Executive Officers.
The Pension Plan bases retirement benefits upon the employee's final five-year average annual base salary and the total years of credited service, subject to a maximum of 35 years of credited service. Employees who are at least 21 years of age and who have completed one year of service participate in the Pension Plan retroactive to the first day of the month following their hire date. Eligible participants become vested and earn a nonforfeitable right to Pension Plan benefits after completing five years of service or upon reaching the first day of the month in which they become age 65. In addition, the Pension Plan provides that if, following a Change in Control of the Company (as defined in the Pension Plan), the Pension Plan is terminated or the employment of a participant in the Pension Plan is terminated, and if at the time of such termination there are surplus assets in the Pension Plan, such surplus assets shall be used to increase the benefits payable to each affected plan participant. The Retirement Plans both provide for the full vesting of accrued benefits in the event of a Change in Control.
Normal retirement benefits begin at age 62 with 30 years of service and at age 65 with less than 30 years of service, but participants may retire as early as age 55 at actuarially reduced rates, provided that they have at least 15 years of service. Participants who become totally and permanently disabled may qualify for disability retirement benefits if they have 10 or more years of service and are between the ages of 35 and 65.
For purposes of illustration, the following table provides examples of the annual pension benefits payable at age 65 pursuant to the defined benefit portions of the Retirement Plans, assuming benefits are paid in the form of a straight life annuity. Such benefits are not reduced for Social Security payments or other offset amounts.
At the end of 1997, Messrs. Feinstein, Katz, MacKinnon, Secord and Ms. Schofield were credited under the Pension Plans with 24.0, 13.4, 35.0, 2.0 and 2.6 years of service, respectively. The average annual salary for the five-year period ended December 31, 1997 for Messrs. Feinstein, Katz, MacKinnon, Secord and Ms. Schofield was $402,260, $350,880, $284,210, $311,580 and $289,420, respectively. These figures include the 1996 Executive Incentive Plan Awards paid in 1997.
Employment Agreements and Change-in-Control Arrangements
The Company has entered into employment agreements with each of Messrs. Feinstein, Katz, MacKinnon, Secord and Ms. Schofield. Each of the agreements provide that if the executive's employment is terminated following a "Change-in-Control" (as defined in the agreement), the executive will receive a severance payment equal to two (2) times the executive's "Cash Compensation" (as defined in the agreement, but generally including certain base salary, bonus and profit sharing plan allocation amounts). In addition to the Cash Compensation amount payable, the executive is also entitled to (i) continued coverage under applicable group welfare benefit plans of the Company (for example, the Company's life, disability and health insurance plans); (ii) a benefit under the Company's long-term incentive plan (determined as if the executive terminated employment due to retirement, and as if any remaining performance criteria had been waived), and (iii) a lump sum payment of certain enhanced benefit amounts under the Company's pension plans (including the supplemental pension plan). In the cases of Messrs. Feinstein and Katz, the agreements provide for a tax gross-up payment equal to the amount of any excise tax payable under Section 4999 of the Internal Revenue Code of 1986, as amended. In the case of the other executives, amounts payable under the agreements will be reduced to the extent necessary to avoid the application of such excise tax.
The payments under the agreement will be made if the executive is employed at the time of the Change-in-Control and his or her termination is (i) by the Company other than for "Cause" (as defined in the agreement); (ii) by the executive for "Good Reason" (as defined in the agreement) or (iii) other than due to the executive's death, disability or retirement.
The agreements are effective until December 31, 1999. In the event of a "Potential Change-in-Control" (as defined in the agreement), however, the term of the agreements will be extended for a period of two (2) years following the Potential-Change-in-Control (unless the
Potential-Change-in-Control is abandoned prior to a Change-in-Control). In the event of a Change-in-Control, the agreements will be extended for a period of two (2) years following the date of the Change-in-Control. In all cases, however, the agreements will expire upon the death, retirement or disability termination of the executive.
Compensation of Directors
Directors who are not employees of FGI or B.A.T receive an annual retainer of $21,000, together with $1,000 plus expenses for each FGI Board of Directors (the "Board") meeting attended in 1997. Additionally, committee members of the Board receive $950 plus expenses for each committee meeting attended and Committee Chairs receive $1,100 plus expenses for each committee meeting attended. Directors who are employees of FGI or of B.A.T do not receive the retainer fees, Board meeting fees or committee fees referred to above. Total payments, excluding reimbursement of expenses, to Messrs. Heafey, Neff, Parnell, Pings, Sauter, Yeutter and Ms. Wilson amounted to $29,400, $28,800, $32,600, $33,200, $28,800, $26,800 and $27,850, respectively, in 1997 for services rendered in that year.
FGI has established an Outside Directors' Retirement Benefit Program. Any director who is not an employee of FGI or of B.A.T who has attained age 70 at the time such director retires from service as a member of the Board and has either accrued 10 or more calendar years of service as a Board member or who was a Board member as of August 7, 1987, the inception date of this Program, is entitled to an annual benefit commencing in May of the calendar year following the director's retirement from the Board. Such annual benefit is equal to 100% of the annual retainer fee in effect during the last year the director served on the Board. Benefit payments are made for five or more years, depending on the director's length of service on the Board. Based on their tenure as Board members, Mr. Heafey has accrued benefits of seven annual payments, and Messrs. Neff, Parnell, Pings, Sauter, Yeutter and Ms. Wilson have accrued no benefits under this Program. Benefits for this Program were funded through a grantor trust through 1995. Effective January 1, 1996, retirement payments to directors retiring after January 1, 1996 will be paid directly by FGI. Payments under this Program to former Board members amounted to $51,000 in 1997.
Compensation Committee Interlocks and Insider Participation
During 1997, FGI's Compensation Committee (the "Committee") consisted of Mr. Heafey, who is Chairman, and Messrs. Allvey, Parnell, Pings, Sauter and Yeutter. None of these individuals is now or has ever been an officer or employee of the Company.
The Committee receives compensation recommendations from the Chief Executive Officer and amends or revises them as appropriate. The Committee then submits a recommendation regarding executive compensation to the Board. Compensation levels for Mr. Feinstein are approved by the Board of B.A.T following recommendations of that Board's Compensation Committee, whose composition consists of no members who are employees or executive officers of FGI. The compensation levels of certain senior officers are also reviewed by the Chief Executive's Committee of B.A.T.
The law firm of Crosby, Heafey, Roach and May received fees of $5,177,000 for legal services rendered to the Company or the Exchanges in 1997. Mr. Heafey is a partner in such firm and has been a director of FGI since 1978. In addition, the law firm of Hogan and Hartson, LLP, received fees of $31,000 for legal services rendered to the Company or the Exchanges in 1997. Mr. Yeutter is a partner in such firm and has been a director of FGI since 1994.
ITEM 12.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management
All of the outstanding voting securities of FGI are owned beneficially and of record by South Western Nominees Limited, Windsor House, 50 Victoria Street, London, England SW1H ONL. South Western Nominees Limited is a wholly owned subsidiary of B.A.T.
The following table sets forth information regarding beneficial ownership of B.A.T ADRs and ordinary shares as of December 31, 1997 by (a) the Chief Executive Officer of FGI, (b) each of the four most highly compensated executive officers of FGI other than the Chief Executive Officer and (c) all directors and executive officers of FGI, as a group.
______________
(1) Includes 173,770 options under the B.A.T Stock Plan "E" that become vested and exercisable on June 11, 2000 that were granted to Mr. Feinstein as a director of B.A.T.
(2) Less than 1% of the outstanding B.A.T ordinary shares.
(3) Less than 1% of the outstanding B.A.T ADRs.
ITEM 13.
ITEM 13. Certain Relationships and Related Transactions
Certain directors of the Company were partners in legal firms which received fees for legal services from the Company and the Exchanges. These fees totaled $5,208,000, $1,853,000 and $2,231,000 in 1997, 1996 and 1995, respectively.
As of December 31, 1997, the Company had $407,000,000 in notes receivable related to loans made to B.A.T Capital Corporation, a subsidiary of B.A.T. These notes are fixed rate medium term notes with maturity dates as follows: $137,000,000 in October 1998, $135,000,000 in October 1999 and $135,000,000 in October 2000. Interest on these notes is paid semi-annually at coupon rates of 5.35%, 6.68% and 6.33%, respectively. On October 7, 1997, a four year $135,000,000 note with an interest rate of 5.10% matured and the $135,000,000 note maturing in October 2000 was subsequently issued at an interest rate of 6.33%. Income earned on the notes outstanding during 1997, 1996 and 1995 was $23,620,000, $21,245,000, and $20,697,000, respectively.
On October 7, 1996, a three year $135,000,000 note with an interest rate of 4.76% matured and the $135,000,000 note, maturing in October 1999, was subsequently issued at an interest rate of 6.68%.
PART IV
ITEM 14.
ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) Exhibits and Financial Statement Schedules
(1) Exhibits 	 3.1 Restated Articles of Incorporation of FGI, as amended May 23, 1977, as further amended September 24, 1984, as further amended May 19, 1986 (i), as further amended February 3, 1989 (ii) 3.2 Bylaws of FGI (i) 3.3 Form of Certificate of Trust of the Issuer (ii) 3.4 Trust Agreement (ii) 4.1 Form of Amended and Restated Trust Agreement (ii) 4.2 Form of Indenture among FGI and The Chase Manhattan Bank, N.A., as Debenture Trustee (ii) 4.3 Form of Preferred Security (included in Exhibit 4.1) (ii) 4.4 Form of Junior Subordinated Debentures (included in Exhibit 4.2) (ii) 4.5 Form of Guarantee by FGI and The Chase Manhattan Bank, N.A., as Guarantee Trustee (ii) 10.1 Form of Subscription Agreement (Farmers Underwriters Association) (ii) 10.2 Form of Subscription Agreement (Truck Underwriters Association) (ii) 10.3 Form of Subscription Agreement (Fire Underwriters Association) (ii) 10.4 The Farmers Group, Inc. 1993 Premier Award Unit Plan, as amended November 4, 1993 (ii), as amended February 14, 1996 (iii), as further amended November 10, 1997 10.5 Farmers Group, Inc. Executive Incentive Program (ii), as amended May 7, 1997 and August 13, 1997 10.6 Description of Farmers Group, Inc. Outside Directors' Retirement Program (ii) 10.7 The Farmers Group, Inc. Discretionary Management Incentive Program for Exceptional Performance (ii), as amended December 1996 (iv) 10.8 Farmers Group, Inc. Employee Benefits Restoration Plan (ii), as amended May 7, 1997 10.9 Description of Phantom B.A.T ADR Stock Option Plan (ii) 10.10 Form of Employment Agreement with certain officers 12 Statement of Computation of the Ratio of Earnings to Fixed Charges 21 Subsidiaries of FGI 24 Power of Attorney (ii)
- -------------------- (i) Incorporated by reference to the corresponding Exhibit to FGI's Annual Report on Form 10-K for the year ended December 31, 1987.
(ii) Incorporated by reference to the corresponding Exhibit to FGI's Registration Statement No. 33-94670 and No. 33-94670-01 on Form S-1.
(iii) Incorporated by reference to the corresponding Exhibit to FGI's Annual Report on Form 10-K for the year ended December 31, 1995.
(iv) Incorporated by reference to the corresponding Exhibit to FGI's Annual Report on Form 10-K for the year ended December 31, 1996.
(2) Financial Statement Schedules Page ------ a. Financial Statements. See Index to Financial Statements and Supplementary Data for a list of financial statements included in this Report. 23
b. Financial Statement Schedules Schedule I - Marketable Securities - Other Investments, as of December 31, 1997 S-1 Schedule III - Supplementary Insurance Information, for the years ended December 31, 1997, 1996 and 1995 S-2 Schedule IV - Reinsurance, for the years ended December 31, 1997, 1996 and 1995 S-3 Schedule V - Valuation and Qualifying Accounts for the years ended December 31, 1997, 1996, and 1995 S-4
(b) Reports on Form 8-K
The Company did not file any Reports on Form 8-K during the year ended December 31, 1997.
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, in the City of Los Angeles, State of California on March 26, 1998.
FARMERS GROUP, INC. --------------------------------------------- (Registrant)
Date: March 26, 1998 By: /s/ Martin D. Feinstein --------------------------------------------- Martin D. Feinstein, Chairman of the Board, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date --------- ----- ----
Principal Executive Officer /s/ Martin D. Feinstein Chairman of the Board, March 26, 1998 - --------------------------------President and Chief (Martin D. Feinstein) Executive Officer
Principal Financial and Accounting Officer /s/ Anthony L.R. Clark Senior Vice President and March 26, 1998 - --------------------------------Chief Financial Officer (Anthony L.R. Clark)
Directors /s/ James A. MacKinnon Executive Vice President March 26, 1998 - --------------------------------and Director (James A. MacKinnon)
/s/ Keitha T. Schofield Executive Vice President March 26, 1998 - --------------------------------and Director (Keitha T. Schofield)
/s/ Jason L. Katz Senior Vice President, March 26, 1998 - --------------------------------General Counsel and Director (Jason L. Katz)
/s/ David P. Allvey Director March 26, 1998 - -------------------------------- (David P. Allvey)
/s/ Edwin A. Heafey, Jr. Director March 26, 1998 - -------------------------------- (Edwin A. Heafey, Jr.)
/s/ Benjamin C. Neff Director March 26, 1998 - -------------------------------- (Benjamin C. Neff)
/s/ Jack C. Parnell Director March 26, 1998 - -------------------------------- (Jack C. Parnell)
/s/ Cornelius J. Pings Director March 26, 1998 - -------------------------------- (Cornelius J. Pings)
/s/ Van Gordon Sauter Director March 26, 1998 - -------------------------------- (Van Gordon Sauter)
/s/ M. Faye Wilson Director March 26, 1998 - -------------------------------- (M. Faye Wilson)
/s/ Clayton Yeutter Director March 26, 1998 - -------------------------------- (Clayton Yeutter)
S-1
FARMERS GROUP, INC. AND SUBSIDIARIES SCHEDULE I - MARKETABLE SECURITIES - OTHER INVESTMENTS December 31, 1997
S-2
FARMERS GROUP, INC. AND SUBSIDIARIES SCHEDULE III - SUPPLEMENTARY INSURANCE INFORMATION For the years ended December 31, 1997, 1996, and 1995
S-3
FARMERS GROUP, INC. AND SUBSIDIARIES SCHEDULE IV - REINSURANCE For the years ended December 31, 1997, 1996, and 1995
S-4
FARMERS GROUP, INC. AND SUBSIDIARIES SCHEDULE V - VALUATION AND QUALIFYING ACCOUNTS