-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, I6OQkq2wKe7woGd9J2YLZyXVOuYE3nksMIRGV711rcUOcBsIdx9whU+3BsOqoiHx gXYSctMGG7xVRFWdGRlrwg== 0000774624-98-000031.txt : 19980317 0000774624-98-000031.hdr.sgml : 19980317 ACCESSION NUMBER: 0000774624-98-000031 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980316 SROS: NYSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: ALLIED GROUP INC CENTRAL INDEX KEY: 0000774624 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 420958655 STATE OF INCORPORATION: IA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 001-12663 FILM NUMBER: 98566206 BUSINESS ADDRESS: STREET 1: 701 FIFTH AVE CITY: DES MOINES STATE: IA ZIP: 50309 BUSINESS PHONE: 5152804211 MAIL ADDRESS: STREET 1: 701 5TH AVENUE CITY: DES MOINES STATE: IA ZIP: 50391-2000 FORMER COMPANY: FORMER CONFORMED NAME: AID CORP DATE OF NAME CHANGE: 19870519 10-K 1 1997 ANNUAL REPORT ON FORM 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 Form 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1997 Commission File Number 0-14243 ALLIED Group, Inc. (Exact name of registrant as specified in its charter) Iowa (State or other jurisdiction of incorporation or organization) 42-0958655 (I.R.S. Employer Identification No.) 701 Fifth Avenue, Des Moines, Iowa 50391-2000 Address of principal executive offices) (Zip Code) 515-280-4211 (Registrant's telephone number including area code) Securities registered pursuant to Section 12(b) of the Act: Common Stock, no par value (Title of Class) Securities registered pursuant to Section 12(g) of the Act: None (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days. Yes [ X ] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] As of February 27, 1998 the number of Registrant's Common Stock, no par value, outstanding was 30,549,214. The aggregate market value of the Common Stock of the Registrant held by nonaffiliates at February 27, 1998 was $944,868,332. Documents Incorporated By Reference The Registrant's definitive proxy statement (1998 Proxy Statement), which will be filed with the Securities and Exchange Commission within 120 days after December 31, 1997, is incorporated by reference under Part III. The index to the exhibits is located on page 76. This document contains 93 pages. 2 TABLE OF CONTENTS Part I Item 1. Business..........................................................3 Item 2. Properties.......................................................18 Item 3. Legal Proceedings................................................18 Item 4. Submission of Matters to a Vote of Security Holders..............18 Part II Item 5. Market for Registrant's Common Equity and Related Stockholders' Matters...........................................19 Item 6. Selected Financial Data...........................................20 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.......................................21 Item 8. Financial Statements and Supplementary Data.......................29 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure........................................58 Part III Item 10.Directors and Executive Officers of the Registrant...................59 Item 11.Executive Compensation...............................................59 Item 12.Security Ownership of Certain Beneficial Owners and Management.......59 Item 13.Certain Relationships and Related Transactions.......................59 Part IV Item 14.Exhibits, Financial Statement Schedules, and Reports on Form 8-K.....60 Index to Financial Statement Schedules........................................60 Signatures....................................................................75 Index to Exhibits.............................................................76 3 Part I Item 1. Business ALLIED Group, Inc. (the Company) was incorporated in 1971 as an Iowa corporation and operates as a regional insurance holding company headquartered in Des Moines, Iowa. The Company and its subsidiaries operate exclusively in the United States and primarily in the central and western states. At year-end 1997, The ALLIED Group Employee Stock Ownership Trust owned 24.9% and ALLIED Mutual Insurance Company (ALLIED Mutual), an affiliated property-casualty insurance company, controlled 18.2% of the outstanding voting stock of the Company. The Company has two reportable business segments: property-casualty insurance and excess & surplus lines insurance. Property-casualty insurance was the most significant segment in 1997, accounting for 85.7% of consolidated revenues. The Company's segment information is contained in note 18 of Notes to Consolidated Financial Statements. Property-casualty Insurance The property-casualty segment operates through three subsidiaries: AMCO Insurance Company (AMCO), ALLIED Property and Casualty Insurance Company (ALLIED Property and Casualty), and Depositors Insurance Company (Depositors), which write personal lines (primarily automobile and homeowners) and small commercial lines. The segment and ALLIED Mutual pool their property-casualty business. See notes 4 and 6 of Notes to Consolidated Financial Statements and "Business Relationship with ALLIED Mutual--Pooling Agreement." A.M. Best has assigned a rating of A+ (Superior) to each of the property-casualty subsidiaries and to ALLIED Mutual for 1997 with respect to their financial strength and their ability to meet policyholder and other contractual obligations based on the review of the pool's 1996 statutory results and operating performance. The profitability of the property-casualty segment is affected by many factors, including, but not limited to, industry price competition, the frequency and severity of losses incurred in connection with weather-related and other catastrophic events, the adequacy of prior-year estimates of loss and loss adjusting expense reserves, insurance laws and regulations, fluctuations in the financial markets, interest rates, reinsurance costs, and general business and economic conditions. The property-casualty segment pursues a strategy of growth in personal lines of insurance primarily through a system of more than 2,300 independent agencies, a growing number of which represent the property-casualty subsidiaries on an exclusive basis for their personal lines of insurance. For the year ended December 31, 1997, 68.1% of the property-casualty subsidiaries' net earned premiums were attributable to personal lines of insurance. While the majority of the revenues are attributable to personal lines, the segment also writes commercial lines of insurance for small businesses through such agents. Because the primary focus, and the primary market served by the segment's independent agency force, is personal lines of insurance and because management perceives the risks to be greater in commercial lines, the property-casualty segment has been conservative in the types of commercial risks it underwrites and in the pricing of the commercial risks. Historically, this has resulted in writing less commercial business than the segment might otherwise have if a more aggressive strategy in commercial lines was adopted. It has also resulted in a lower combined ratio for the commercial lines compared with its core personal lines business. The property-casualty segment markets its products through three distribution systems: independent agencies, exclusive agencies, and direct response marketing. Generally, AMCO writes, through independent agencies, personal and commercial property-casualty insurance lines, consisting primarily of private passenger automobile and homeowners, with lesser emphasis on special multiple peril, workers' compensation, inland marine, and other miscellaneous lines of business. ALLIED Property and Casualty generally writes personal lines insurance products through agents who sell ALLIED Property and Casualty personal lines exclusively, and Depositors generally writes personal lines through a direct mail and telemarketing agency, ALLIED Group Insurance Marketing Company, an affiliate of ALLIED Mutual. Neither the insurance subsidiaries in the property-casualty segment nor ALLIED Mutual appoint managing general agents, and each retains all underwriting, claims, and reinsurance authority. While the insurers provide contractual binding authority to most agents, such authority is subject to express limitations on the nature, type, and extent of each risk. With respect to the 4 ability of the agents to bind the insurers, the insurers have no right to reject any contracts entered into by the agents even if the agent exceeds the express limitations; however, such instances occur infrequently and constitute no material financial risk to the Company. The pooling agreement provides that ALLIED Mutual, ALLIED Property and Casualty, and Depositors cede to AMCO (pool administrator) premiums, losses, allocated loss adjusting expenses, commissions, premium taxes, service charge income, and dividends to policyholders and assume from AMCO an amount of this pooled property-casualty business equal to their participation in the pooling agreement. ALLIED Mutual's crop hail business is not pooled. AMCO pays certain underwriting expenses, unallocated loss adjusting expenses, and premium collection expenses for all of the pool participants and receives a fee equal to a specified percentage of premiums as well as a performance fee based on the attainment of certain combined ratios from each of the pool participants. The pooling arrangement provides ALLIED Mutual, ALLIED Property and Casualty, and Depositors more predictable expense levels by limiting such expenses to a specified percentage of their premiums. AMCO has opportunities to profit from the efficient administration of such underwriting, loss adjusting, and premium collection activities and to provide similar services to nonaffiliated insurance companies in the future. The property-casualty segment's participation in the pool was 64% for 1997, 1996, and 1995. As of December 31, 1997, the statutory capital and surplus of ALLIED Mutual and the Company's property-casualty segment were $259.6 million and $335.7 million, respectively. The following table sets forth statutory and generally accepted accounting principles (GAAP) basis information for the property-casualty subsidiaries for the years indicated.
At or for the year ended December 31, ------------------------------------------ 1997 1996 1995 ----------- ---------- ---------- (dollars in thousands) Reinsurance pool percentage 64% 64% 64% Net written premiums $ 531,679 $ 488,189 $ 440,838 =========== ========== ========== Earned premiums $ 514,303 $ 466,211 $ 425,838 Losses and loss adjusting expenses 357,841 335,615 295,583 Underwriting expenses 131,071 124,622 114,511 ----------- ---------- ---------- Statutory underwriting gain 25,391 5,974 15,744 GAAP adjustments 1,411 3,965 1,943 ----------- ---------- ---------- GAAP underwriting gain 26,802 9,939 17,687 Investment income excluding realized gains 44,258 42,296 39,110 Realized investment gains 97 180 236 Other income 10,718 7,020 6,850 ----------- ---------- ---------- Income before income taxes $ 81,875 $ 59,435 $ 63,883 =========== ========== ========== GAAP combined ratio 94.8 97.9 95.8 Wind and hail losses, net of reinsurance $ 27,886 $ 39,111 $ 28,664 Impact of wind and hail losses on combined ratio 5.4 8.4 6.7 Invested assets $ 845,751 $ 710,629 $ 658,044 Loss and loss adjusting expense reserves, net of reinsurance $ 309,008 $ 297,343 $ 277,819 Statutory capital and surplus $ 335,694 $ 285,854 $ 257,845
The underwriting experience of the pool is indicated by the statutory combined ratio, a measure of underwriting profitability which excludes investment income and income taxes. Generally, a ratio below 100 indicates underwriting 5 profitability and a ratio exceeding 100 indicates an underwriting loss. The following table sets forth the net earned premiums and the statutory combined ratios (after policyholder dividends) by line of insurance business for the property-casualty segment for the years indicated.
Year ended December 31, ------------------------------------------------------------------------------ 1997 1996 1995 ------------------------- ------------------------ ------------------------- Net Statutory Net Statutory Net Statutory earned combined earned combined earned combined premiums ratio premiums ratio premiums ratio ----------- --------- ----------- --------- ----------- --------- Line of business (dollars in thousands) ---------------- Personal automobile $ 256,398 94.5 $ 229,894 98.9 $ 208,873 96.5 Homeowners 93,833 96.7 81,617 102.4 71,035 99.2 ----------- ---------- ---------- Personal lines 350,231 95.1 311,511 99.8 279,908 97.2 ----------- ---------- ---------- Commercial automobile 25,991 90.3 25,272 98.8 23,873 95.2 Workers' compensation 23,838 93.6 25,499 76.5 29,443 70.2 Other property and liability 111,812 94.3 101,591 97.3 90,302 100.2 Other lines 2,431 59.7 2,338 45.7 2,312 50.2 ----------- ---------- ---------- Commercial lines 164,072 93.1 154,700 93.5 145,930 92.7 ----------- ---------- ---------- Total $ 514,303 94.4 $ 466,211 97.7 $ 425,838 95.7 =========== ========== ==========
The following table sets forth the components of the statutory combined ratio and wind and hail loss information for the property-casualty segment for the years indicated.
Year ended December 31, -------------------------------- 1997 1996 1995 ---- ----- ---- Statutory combined ratio Loss ratio 58.7 62.6 60.1 Loss adjusting expense ratio 10.8 9.4 9.3 Underwriting expense ratio 24.7 25.5 26.0 Dividend ratio 0.2 0.2 0.3 ---- ---- ---- Total 94.4 97.7 95.7 ==== ==== ==== Impact of wind and hail losses on the statutory combined ratio - --------------------------------- Personal automobile 1.9 3.9 1.8 Homeowners 15.4 23.6 21.7 Personal lines 5.5 9.1 6.8 Commercial lines 5.2 7.1 6.5 Total 5.4 8.4 6.7
Wind and hail losses are calculated by adding together all claims with a cause of loss from wind or hail and then deducting the related reinsurance recoveries. The information provides an indication of how weather-related losses impact the property-casualty segment's operating results for the years presented. Losses not resulting from either wind or hail are excluded from these calculations. 6 The following table sets forth premium information and agency counts for the property-casualty pool (including ALLIED Mutual) for the years indicated.
At or for the year ended December 31, ----------------------------------------- 1997 1996 1995 ---------- ---------- ---------- (dollars in thousands) Direct written premiums by distribution system Independent agency system $ 562,202 $ 549,598 $ 503,922 Exclusive agency system 263,046 210,648 180,799 Direct response marketing system 33,436 28,437 22,136 ---------- ---------- ---------- Total direct written premiums, excluding crop hail premiums 858,684 788,683 706,857 Crop hail premiums (non-pooled) 7,038 7,049 7,781 ---------- ---------- ---------- Total direct written premiums $ 865,722 $ 795,732 $ 714,638 ========== ========== ========== Agency counts Independent agencies 2,038 2,000 1,968 Exclusive agencies 293 257 192 Net written premiums $ 841,833 $ 773,593 $ 699,608 Net earned premiums $ 814,682 $ 739,251 $ 676,169
The following table sets forth the geographic percentage distribution of property-casualty pool (including ALLIED Mutual) direct written premiums for the years indicated.
1997 1996 1995 ----- ----- ----- California 23.7% 24.5% 24.0% Iowa 21.4 21.7 23.3 Kansas 8.0 8.1 8.4 Nebraska 7.4 7.4 7.9 Minnesota 7.1 7.3 7.6 Missouri 5.1 4.8 4.8 Illinois 3.7 3.5 3.1 Colorado 3.6 3.6 3.6 Utah 3.0 2.9 2.5 Tennessee 3.1 2.7 2.4 Washington 2.5 2.3 2.1 Other * 11.4 11.2 10.3 ----- ----- ----- 100.0% 100.0% 100.0% ===== ====== ====== *Includes all other states, none of which accounted for more than 2% in 1997.
Excess & Surplus Lines Western Heritage Insurance Company (Western Heritage) is an excess & surplus lines insurance subsidiary, which primarily underwrites commercial lines. A.M. Best has assigned a rating of A- (Excellent) to Western Heritage for 1997 based on the review of their 1996 statutory results and operating performance. For 1997, Western Heritage's net earned premiums were 58.1% specialty commercial casualty, 9.5% commercial property, 29.3% commercial transportation, and 3.1% personal lines coverages. Specialty commercial casualty lines include general liability, multiple peril, and product liability coverages for special events, such as concerts, fairs, exhibitions, and parades as well as coverages for merchants and artisan contractors. Specialty commercial property lines include coverages for buildings that are older, in higher risk locations, or vacant; 7 agricultural and contractor equipment; and protection against vandalism. Commercial transportation coverages include liability, physical damage, and garagekeepers insurance written for used car dealers and repair shops. The personal lines consist primarily of basic property coverages for dwellings. Western Heritage agents are accorded contractual binding authority for risks which meet the insurer's written underwriting guidelines and rules. Western Heritage appoints no managing general agents, however, and retains all underwriting, claims, and reinsurance authority. With respect to the ability of the agents to bind Western Heritage, Western Heritage has no right to reject any contracts entered into by the agents even if the agent exceeds the express limitations; however, such instances occur infrequently and constitute no material financial risk to the Company. The following table sets forth statutory and GAAP basis information for the excess & surplus lines segment for the years indicated.
At or for the year ended December 31, -------------------------------------------- 1997 1996 1995 ----------- ----------- ----------- (dollars in thousands) Net written premiums $ 34,056 $ 28,417 $ 30,606 =========== =========== =========== Earned premiums $ 33,294 $ 27,314 $ 29,661 Losses and loss adjusting expenses 20,369 17,484 22,357 Underwriting expenses 9,884 8,106 8,202 ----------- ----------- ----------- Statutory underwriting gain (loss) 3,041 1,724 (898) GAAP adjustments 169 86 43 ----------- ----------- ----------- GAAP underwriting gain (loss) 3,210 1,810 (855) Investment income excluding realized gains 6,803 6,241 5,830 Realized investment gains (losses) (4) 2 (135) ----------- ----------- ----------- Income before income taxes $ 10,009 $ 8,053 $ 4,840 =========== =========== =========== GAAP combined ratio 90.4 93.4 102.9 Invested assets $ 113,521 $ 104,403 $ 96,435 Loss and loss adjusting expense reserves, net of reinsurance $ 50,984 $ 49,319 $ 47,120 Statutory capital and surplus $ 40,501 $ 33,478 $ 27,770
The following table sets forth the net earned premiums and statutory combined ratios of the commercial casualty, commercial property, commercial transportation, and personal lines written by Western Heritage for the years indicated.
Year ended December 31, ---------------------------------------------------------------------------- 1997 1996 1995 ------------------------- ------------------------ ----------------------- Net Statutory Net Statutory Net Statutory earned combined earned combined earned combined premiums ratio premiums ratio premiums ratio ----------- --------- ----------- --------- ----------- --------- (dollars in thousands) Commercial casualty $ 19,329 88.6 $ 17,508 92.1 $ 22,031 103.9 Commercial property 3,158 95.6 2,513 70.2 2,676 91.2 Commercial transportation 9,768 91.9 6,538 103.7 4,254 98.6 Personal lines 1,039 86.0 755 86.9 700 115.1 ----------- ----------- ----------- Total $ 33,294 90.2 $ 27,314 92.5 $ 29,661 102.2 =========== =========== ===========
8 The following table sets forth the geographic percentage distribution of excess & surplus lines direct written premiums for the years indicated.
1997 1996 1995 ----- ----- ----- Texas 21.3% 25.0% 23.3% California 8.6 8.0 8.8 Illinois 7.8 8.6 9.9 Florida 6.0 5.5 7.2 Alabama 4.5 3.9 3.1 Connecticut 4.2 2.8 0.6 Louisiana 3.8 3.2 3.0 Missouri 3.7 3.9 3.0 Oklahoma 3.1 4.0 4.3 Colorado 2.7 2.9 2.8 Hawaii 2.5 3.0 3.7 Ohio 2.4 2.7 2.9 Washington 2.3 1.8 1.8 Indiana 2.1 2.0 1.9 Mississippi 2.1 2.9 2.6 Michigan 2.0 1.7 1.4 Other* 20.9 18.1 19.7 ----- ----- ----- 100.0% 100.0% 100.0% ===== ===== ===== *Includes all other states, none of which accounted for more than 2% in 1997.
Reinsurance The insurance subsidiaries follow the industry practice of reinsuring a portion of their insured risks, paying to the reinsurer a portion of the premiums received on all policies. Insurance is ceded principally to reduce the net liability on individual risks and to protect against catastrophic losses. The subsidiaries monitor the availability of replacement coverages in the reinsurance market, and believe that replacement coverages from financially responsible reinsurers is available and accordingly do not deem existing reinsurance arrangements to be material. The basic reinsurance treaties benefiting the parties to the pooling agreement insure risks in excess of specific amounts. Except for crop-hail reinsurance, all reinsurance is obtained by the pool participants directly and the pool administrator does not have any additional or special reinsurance arrangements other than as a pool participant. The financial stability of each participating reinsurer is independently monitored by the pool participants and by their reinsurance intermediaries. See "Business Relationship with ALLIED Mutual Other Relationships" for the pooled property catastrophe reinsurance agreement with ALLIED Mutual and a nonaffiliated reinsurance company. With the exception of Western Heritage, all retentions discussed in this section are for the entire pool. The property-casualty subsidiaries are allocated a portion of the stated pool retentions based upon their respective pool participation percentage. The parties to the pooling agreement are covered by a property treaty which provides per risk property reinsurance in excess of a retention of $500,000 to a maximum limit of $5,000,000 per risk. Such parties are also covered by a property treaty that provides coverage on a facultative basis in excess of a retention of $5,000,000 to a maximum limit of $15,000,000. The pool participants purchase property catastrophe reinsurance from a large number of reinsurers each of which provides a relatively small percentage of the total cover. For 1998, the pool liability limit of the cover is 90% of $120,000,000 with retention of $11,000,000. A reinstatement agreement exists allowing purchases of reinsurance for an additional catastrophe occurring in the same year. 9 The pool's retention for most casualty risks is $375,000, with a reinsurance limit of $1,000,000 per occurrence. Other treaties provide reinsurance for each workers' compensation loss over $375,000 and up to $5,000,000. Catastrophe workers' compensation treaties increase the reinsurance to $35,000,000. Western Heritage, which is not a participant in the property-casualty pool, purchased surplus reinsurance on property risks covering 75% of the risk with limits in excess of $50,000 to a maximum of $1,000,000, which is the largest property risk insured. Western Heritage also purchased casualty reinsurance covering 92.5% of the risk in excess of $200,000 to a maximum of $1,000,000, the largest casualty risk insured. Western Heritage also purchased two layers of reinsurance, each of which covers $1,000,000 in excess of the underlying layers for both property and casualty coverages. Each of the layers contain a reinstallment provision. Western Heritage does not write workers' compensation or primary auto coverage. For 1998, Western Heritage's reinsurance program provides for all property and casualty risks on a loss event basis. The first excess per event contract provides reinsurance for an event in excess of $300,000 in loss and loss adjusting expenses up to a maximum of $1 million. The second excess per event contract provides reinsurance for an event in excess of $1 million in loss and loss adjusting expenses up to a maximum of $5 million. The largest amount insured by Western Heritage is $2 million. If limits exceed $1 million, Western Heritage purchases facultative reinsurance for the limits in excess of $1 million. Also in place is an aggregate stop loss treaty, which provides reinsurance for 10 percentage points of loss and loss adjusting expenses in excess of 62.5% of net earned premiums. Although reinsurance does not legally discharge an insurer from its primary liability for the full amount of the policies, it does make the assuming reinsurer liable to the insurer to the extent of the reinsurance ceded. As of December 31, 1997, the property-casualty subsidiaries had no past due amounts from reinsurers and Western Heritage had $76,000 in dispute. Historically, the Company has had no adverse collection experience with its reinsurers. Losses and Loss Adjusting Expense Reserves In many cases, several years may elapse between the occurrence of an insured loss, the reporting of the loss to the insurer, and the insurer's payment of that loss. To recognize liabilities for unpaid losses, the insurance subsidiaries establish reserves, which are balance sheet liabilities representing estimates of future amounts needed to pay claims and related expenses with respect to insured events which have occurred. The insurance subsidiaries do not discount loss reserves for financial statement purposes. When a claim is reported, a case reserve for the estimated amount of the ultimate payment is established. The estimate reflects an informed judgment based on general corporate reserving practices and the Company's experience and knowledge regarding the nature and value of the specific type of claim. Reserves are also established on an aggregate basis to provide for losses incurred but not yet reported to the insurer and the overall adequacy of case reserves. The insurance subsidiaries also establish reserves representing the estimated expenses of settling claims, including legal and other fees and general expenses of administering the claims adjustment process. As part of the reserving process, historical data is reviewed and consideration is given to the anticipated impact of various factors such as known and anticipated legal developments, changes in social attitudes, inflation, and economic conditions. This process relies on the basic assumption that past experience, adjusted for the effect of current developments and likely trends, is an appropriate basis for predicting future events. Reserve amounts are necessarily based on management's informed estimates, and as other data becomes available and is reviewed, these estimates and judgments are revised, resulting in increases or decreases to existing reserves. While the methods for setting the reserve structure are well tested, some assumptions about loss patterns have changed. In particular, recent higher jury verdicts and judicial decisions which expand coverage to new theories of liability have increased the demands against the loss and loss adjusting expense reserves of the insurance subsidiaries. Not only have anticipated claims increased in severity, but unanticipated claims have risen. In establishing reserves, management considers exposure the Company may have to environmental claims. Because reported claim activity levels are minimal and the emphasis of the Company's property-casualty business is primarily on personal lines and small commercial business, management believes exposure to material liability on environmental claims to be remote as of December 31, 1997. Management continues to monitor legal developments as they relate to the Company's exposure to environmental claims. 10 The following table presents the development of losses and loss adjusting expense reserves for 1987 to 1996 for the pool (which includes ALLIED Mutual) and Western Heritage. The top line of the table shows the estimated reserve for losses and loss adjusting expenses at the balance sheet date for each of the indicated years. These figures represent the estimated amount of losses and loss adjusting expenses, net of reinsurance recoverables, for claims arising in the current and all prior years that were unpaid at the balance sheet date, including losses that had been incurred but not yet reported. The lower portion of the table shows the re-estimated amount of net reserves as a percentage of the previously recorded net reserves based on experience as of the end of each succeeding year. The re-estimated reserves change as more information becomes known about the frequency and severity of claims for individual years.
At or for the year ended December 31, ------------------------------------------------------------------------------------------------------------ 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- (dollars in thousands) Reserves for losses and loss adjusting expenses, net $160,152 $210,746 $248,870 $280,443 $312,089 $355,092 $386,936 $424,595 $471,247 $503,638 $522,317 Paid (cumulative) as of (1) 1 year later 47.5% 41.7% 43.6% 44.2% 43.6% 40.1% 40.8% 39.9% 43.1% 43.2% 2 years later 70.8 64.0 65.8 67.2 66.3 61.9 60.7 61.7 63.4 3 years later 85.8 77.2 79.3 80.4 79.8 72.6 73.2 73.9 4 years later 93.6 84.1 86.3 88.5 86.0 78.8 79.6 5 years later 97.9 87.7 91.5 92.5 89.6 82.8 6 years later 101.0 90.2 94.1 95.2 92.2 7 years later 102.8 92.1 96.0 96.9 8 years later 104.3 93.6 97.4 9 years later 106.0 94.4 10 years later 106.7 Net reserves re- estimated as of end of year (1) 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 1 year later 103.6 98.3 100.4 101.0 100.2 97.7 98.3 100.1 100.0 99.7 2 years later 106.3 97.6 99.6 101.1 101.1 96.8 98.9 98.9 99.1 3 years later 106.8 97.3 99.6 102.6 102.4 97.2 97.4 98.1 4 years later 107.1 97.5 101.5 104.6 103.1 96.3 97.4 5 years later 107.8 98.1 103.4 105.7 102.9 96.4 6 years later 108.9 99.3 104.5 105.7 102.8 7 years later 110.5 100.4 104.8 105.6 8 years later 111.8 100.7 104.6 9 years later 112.1 100.2 10 years later 111.9 Net cumulative redundancy (deficiency) Dollars $(19,031) $ (476) $(11,400) $(15,725) $ (8,637) $ 12,773 $ 10,247 $ 8,230 $ 4,039 $ 1,284 Percentage (11.9)% (0.2)% (4.6)% (5.6)% (2.8)% 3.6% 2.6% 1.9% 0.9% 0.3% Gross reserves- end of year $373,958 $400,912 $447,311 $492,304 $522,366 $544,696 Reinsurance recoverables 18,866 13,976 22,716 21,057 18,728 22,379 -------- -------- -------- -------- -------- -------- Net reserves- end of year $355,092 $386,936 $424,595 $471,247 $503,638 $522,317 ======== ======== ======== ======== ======== ======== Gross re-estimated reserves - latest (2) 99.0% 100.6% 100.0% 100.3% 100.9% Re-estimated recoverables - latest (2) 148.6% 191.1% 136.0% 126.1% 131.0% Net re-estimated reserves - latest (2) 96.4% 97.4% 98.1% 99.1% 99.7% Gross cumulative redundancy (deficiency) Dollars $ 3,612 $ (2,483) $ 43 $ (1,449) $ (4,518) Percentage 0.9% (0.6)% 0.0% (0.3)% (0.9)% (1) Shown as a percentage of reserves for losses and loss adjusting expenses. (2) Shown as a percentage of gross reserves, reinsurance recoverables and net reserves.
The cumulative redundancy or deficiency represents the aggregate change in the estimates over all prior years. It should be emphasized that the table presents a run-off of balance sheet reserves rather than accident or policy year loss development. Therefore, each amount in the table includes the effects of changes in reserves for all prior years. 11 The following table reconciles the reserves for losses and loss adjusting expenses from the previous table to the amount shown on the Company's consolidated balance sheets.
Year ended December 31, ---------------------------- 1997 1996 ---------- ---------- (in thousands) Loss and loss adjusting expense reserves for the property-casualty pool and Western Heritage $ 522,317 $ 503,638 Less: Loss and loss adjusting expense reserves of ALLIED Mutual 162,324 156,975 ---------- ---------- 359,993 346,663 Add: Reinsurance recoverables 18,033 15,528 ---------- ---------- Loss and loss adjusting expense reserves (GAAP) $ 378,026 $ 362,191 ========== ==========
The next table sets forth a reconciliation of beginning and ending GAAP reserves for losses and loss adjusting expenses for the years indicated, net of reinsurance recoverables. The table includes property-casualty and excess & surplus lines insurance loss and loss adjusting expense reserves. Developments for losses and loss adjusting expenses on prior years is immaterial to the Company's consolidated financial statements taken as a whole.
Year ended December 31, ----------------------------------------- 1997 1996 1995 ---------- ---------- ---------- (in thousands) Net reserves for losses and loss adjusting expenses at beginning of year $ 346,663 $ 324,939 $ 292,674 ---------- ---------- ---------- Incurred losses and loss adjusting expenses Provision for insured events of current year 379,952 353,675 315,956 (Decrease) increase in provision for insured events of prior years (1,853) (680) 1,984 ---------- ---------- ---------- Total incurred losses and loss adjusting expenses 378,099 352,995 317,940 ---------- ---------- ---------- Payments Losses and loss adjusting expenses attributable to insured events of current year 216,920 194,735 169,254 Losses and loss adjusting expenses attributable to insured events of prior years 147,849 136,536 116,421 ---------- ---------- ---------- Total payments 364,769 331,271 285,675 ---------- ---------- ---------- Net reserves for losses and loss adjusting expenses at end of year $ 359,993 $ 346,663 $ 324,939 ========== ========== ==========
Noninsurance Operations ALLIED Group Mortgage Company (ALLIED Mortgage), purchases, originates, and services single-family residential mortgages. It acquires mortgage servicing rights from savings and loan associations, banks, other mortgage companies, and other financial institutions. The market in which ALLIED Mortgage originates mortgages is primarily Polk County, Iowa, which includes the Des Moines area. ALLIED Mortgage purchases and services mortgages on a nationwide basis. See "Business Competition." ALLIED Mortgage began operations in 1987, and by year-end 1997, its servicing portfolio included 53,078 mortgages for a total value of $2.9 billion. ALLIED Mortgage is an approved seller-servicer of mortgages guaranteed by Government National Mortgage Association, Federal National Mortgage Association, and 12 Federal Home Loan Mortgage Corporation. See "Business--Regulation." Working capital requirements are managed through short-term financing with commercial banks. See note 8 of Notes to Consolidated Financial Statements. The Company's data processing segment consists of The Freedom Group, Inc. (Freedom) and its subsidiary ALLIED Group Information Systems, Inc. (AGIS), which have a line of property-casualty and life insurance software products and data processing services which are marketed under the name "Freedom Group" primarily to nonaffiliated insurance companies. Prior to March 1, 1996, AGIS provided management information services to ALLIED Mutual, ALLIED Life Insurance Company (ALLIED Life), the Company and other company subsidiaries. These services included the processing of policies and claims, billing, rating, statistical and regulatory reporting, and recordkeeping. AGIS also provided automated systems to the property-casualty segment's agency force. Prior to March 1, 1996, the majority of the AGIS's revenues and operating profits came from affiliated companies. See note 4 of Notes to Consolidated Financial Statements. Through its direct sales force, AGIS licenses property-casualty insurance software to property-casualty insurance companies generally on a national basis. AGIS also provides certain consulting services and software maintenance services. On a nationwide basis, Freedom licenses statutory accounting insurance software to property-casualty and life insurance companies on primarily a direct sales basis. Investments The Company uses its investments to generate the majority of its operating profit and provide liquidity. Investments in fixed maturities are classified as available for sale. See note 1-"Investments" of Notes to Consolidated Financial Statements. The Company's invested assets are managed by Conning & Company, subject to restrictions on permissible investments under applicable state insurance codes and the Company's investment policies. Those policies require that the fixed maturity portfolio be invested primarily in debt obligations rated "BBB" (investment grade) or higher by Standard & Poor's Corporation (Standard & Poor's) or a recognized equivalent at the time the security is acquired by the Company. The policy also states that equity securities are to be of United States and Canadian Corporations listed on established exchanges or publicly traded in the over-the-counter market. Preferred stocks are to be comprised primarily of issues rated at least A3/A- by Standard & Poor's Corporation or Moody's. The Company monitors the investment quality of the fixed maturity portfolio subsequent to acquisition by reviewing on a quarterly basis the current debt ratings assigned to each of the securities in the fixed maturity portfolio. Fixed income securities comprised 90.1% of the Company's invested assets, 99.7% of those had a "BBB" rating or higher from Standard & Poor's (or the equivalent from Moody's) at December 31, 1997. Equity Securities comprised 8.7% of the invested assets at December 31, 1997. The portfolio contained no real estate or mortgage loans. At year-end 1997, the Company held $2.7 million of nonrated securities. Evaluation of the issuers' rating and ratings for the issuers' other securities supports management's view that the nonrated securities are investment grade. At December 31, 1997, the fair value of the Company's fixed maturity portfolio was $26.3 million over amortized cost. The carrying values of all the Company's investments in fixed maturities are reviewed for impairment on an ongoing basis. If this review indicates a decline in fair value below cost is other than temporary, the Company's carrying value in the investment is reduced to its estimated realizable value and a specific write-down is taken. Such reductions in carrying value are recognized as realized losses and charged to income. 13 The table below shows the classifications of the Company's investments at December 31, 1997.
Carrying Percent value of total ---------- -------- (dollars in thousands) Fixed maturities U.S. Government obligations (1) $ 95,312 10.5% U.S. Government corporations and agencies 117,727 13.0 State municipalities and political subdivisions 400,490 44.1 Public utilities 9,747 1.1 All other corporate bonds 194,940 21.4 ---------- ----- Total fixed maturities 818,216 90.1 ---------- ----- Equity securities Common stock Public utilities 798 0.1 Banks, trusts, and insurance companies 7,534 0.8 Industrial, miscellaneous and all other 28,162 3.1 ---------- ----- 36,494 4.0 Preferred stock 42,688 4.7 ---------- ----- 79,182 8.7 Short-term investments at cost 10,846 1.2 ---------- ----- $ 908,244 100.0% ========== ===== (1) All such securities are backed by the full faith and credit of the United States Government.
The following table sets forth the composition of the Company's fixed maturity investment portfolio by rating at December 31, 1997.
Carrying Percent of value portfolio ---------- ---------- Rating (1) (dollars in thousands) --------- AAA $ 542,556 66.3% AA 144,456 17.7 A 116,584 14.2 BBB 11,945 1.5 Nonrated 2,675 0.3 ---------- ----- Total $ 818,216 100.0% ========== ===== (1) Ratings are assigned primarily by Standard & Poor's with remaining ratings assigned by Moody's and converted to the equivalent Standard & Poor's ratings.
The following table sets forth contractual maturities in the fixed maturity investment portfolio at December 31, 1997. 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.
Carrying Percent of value portfolio ---------- ---------- Maturity (dollars in thousands) One year or less $ 23,499 2.9% Over 1 year through 5 years 314,202 38.4 Over 5 years through 10 years 276,560 33.8 Over 10 years 42,979 5.2 ---------- ------ 657,240 80.3 Mortgaged-backed securities 160,976 19.7 ---------- ------ Total $ 818,216 100.0% ========== ======
14 Investment results of the Company for each year in the three years ended December 31, 1997 are shown in the following table.
1997 1996 1995 ----------- ---------- --------- (dollars in thousands) Average invested assets $ 856,008 $ 784,247 $ 714,720 Investment income (1) 51,124 49,222 47,242 Average annual yield on total investments 6.0% 6.3% 6.6% Tax equivalent yield on total investments (2) 7.2% 7.4% 7.8% Realized investment gains $ 391 $ 49 $ 505 (1) Investment income is net of investment expenses and does not include realized investment gains or losses or provision for income taxes. (2) Assuming an effective tax rate of 35%.
Competition The insurance subsidiaries compete in a highly competitive industry with numerous insurance companies, many of which are substantially larger and have considerably greater financial resources. Because the insurance subsidiaries operate through independent agents and such agents represent more than one company, they face competition within each agency. The insurance subsidiaries compete by underwriting criteria, pricing, automation, service, and product design. The Company believes that its management information systems and procedures for selecting and rating risks accord it a competitive advantage. Competition in the excess & surplus lines market stiffened in recent years as standard market capacity increased and prices decreased. Western Heritage competes in its chosen market (primarily in the Midwest, West, and South) with numerous insurers on the basis of service, price, and financial strength. ALLIED Mortgage, in originating residential mortgages in central Iowa and servicing residential mortgages nationally, competes through competitive pricing and service. Nationally, ALLIED Mortgage is a small-sized company servicing mortgages with remaining principal balances aggregating $2.9 billion at December 31, 1997. The largest competitors service in excess of $214 billion of mortgages. With greater capital and greater efficiencies, the larger companies have an advantage in originating and purchasing mortgages to obtain the servicing rights. ALLIED Mortgage has access to capital due to its association with the Company and competes in the purchase of servicing on the basis of price and in mortgage originations on the basis of price and quality of service. Regulation The insurance subsidiaries are subject to varying degrees of regulation and supervision in the jurisdictions in which they transact business under statutes which delegate regulatory, supervisory, and administrative powers to state insurance commissioners. Such regulation is designed generally to protect policyholders rather than investors and relates to such matters as the standards of solvency which must be met and maintained; the licensing of insurers and their agents; the nature of and examination of the affairs of insurance companies, which includes periodic market conduct and financial examinations by the regulatory authorities; annual and other reports, prepared on a statutory accounting basis, required to be filed on the financial condition of insurers for other purposes; establishment and maintenance of reserves for unearned premiums and losses and loss adjusting expenses; and requirements regarding numerous other matters. In general, the insurance subsidiaries must file all rates for insurance directly underwritten with the insurance department of each state in which they operate; reinsurance generally is not subject to rate regulation. Further, state insurance statutes typically place limitations on the amount of dividends or other distributions payable by insurance companies in order to protect their solvency. See "Management's Discussion and Analysis of Financial Condition and Results of Operations Regulations". 15 California has been the source of approximately 25% of the pool's direct written premiums for the past ten years. Proposition 103, approved by California voters in 1988, provides for a rollback of rates on premiums collected in calendar year 1989 to the extent that the insurer's return on equity for each Proposition 103 line of business exceeded 10%. The rollback liability, if any has not been finalized. Management of the Company continues to believe that the insurance subsidiaries will not be liable for any material rollback of premiums. The Company is also subject to statutes governing insurance holding company systems in various jurisdictions. Typically, such statutes require the Company periodically to file information with the state insurance regulatory authority, including information concerning its capital structure, ownership, financial condition and general business operations. Under the terms of applicable state statutes, any person or entity desiring to acquire more than a specified percentage (commonly 10%) of the Company's outstanding voting securities is required first to obtain approval from the applicable state insurance regulators. Chapter 521A of the Iowa Code relating to holding companies, to which the Company is subject, requires disclosure of transactions between the Company and its insurance subsidiaries or between an insurer and another subsidiary, that such transactions satisfy certain standards, including that they be fair, equitable, and reasonable and that certain material transactions be specifically non-disapproved by the Iowa Insurance Division. Further, prior approval by the Iowa Insurance Division is required of affiliated sales, purchases, exchanges, loans or extensions of credit, guarantees, or investments, any of which involve 5% or more of the insurer's admitted assets as of the preceding December 31st. Under insolvency or guaranty fund laws in most states in which the insurance subsidiaries and ALLIED Mutual operate, insurers doing business in those states can be assessed, up to prescribed limits, for losses incurred by policyholders as a result of the insolvency of other insurance companies. The amounts and timing of such assessments are beyond the control of the Company and generally have an adverse impact on the Company's earnings. Additionally, the insurance subsidiaries are required to participate in various mandatory pools or underwriting associations in amounts related to the amount of direct writings in the applicable state. Recently, the insurance regulatory framework has received increased scrutiny by various states, the federal government, and the National Association of Insurance Commissioners (NAIC). The NAIC has recommended to the states for adoption and implementation several regulatory initiatives designed to reduce the risk of insurance company insolvencies. None of these are expected to be significant to the Company. ALLIED Mortgage is subject to the rules and regulations of, and examination by, the United States Department of Housing and Urban Development, Federal National Mortgage Association (FNMA), and Government National Mortgage Association (GNMA) with respect to originating, processing, selling, and servicing mortgage loans. These rules and regulations, among other things, prohibit discrimination, provide for inspection and appraisals of properties, require credit reports on prospective borrowers, and sometimes fix maximum interest rates, fees, and loan amounts. GNMA requires the maintenance of specified amounts of net worth that vary with the amount of GNMA mortgage-backed securities issued by ALLIED Mortgage. There are also various state laws affecting mortgage banking operations. Relationship with ALLIED Mutual The Company is operated as a part of the ALLIED Group of insurance companies. ALLIED Mutual has operated as a mutual property-casualty insurance company since 1929. In 1971, it organized the Company as a wholly owned subsidiary and transferred to it certain assets, including the stock of AMCO, which had operated as a subsidiary of ALLIED Mutual since 1959. In 1985, the Company effected an initial public offering which then resulted in public ownership of approximately 22% of its common stock. As of December 31, 1997, ALLIED Mutual controlled 18.2% of the outstanding voting stock of ALLIED. The operations of the Company are interrelated with the operations of ALLIED Mutual. The Company and ALLIED Mutual share common executive officers, and three directors of the Company are also directors of ALLIED Mutual. For the year ended December 31, 1997, ALLIED Mutual reported, in accordance with Statutory Accounting Practices, net income of $13.7 million, a statutory combined ratio of 101.1, and admitted assets and surplus at December 31, 1997 of $576.2 million and $259.6 million, respectively. As of December 31, 1997, ALLIED Mutual's invested assets were $520.6 million. Invested assets included a fixed 16 maturity portfolio of $367.8 million (at amortized cost), of which over 98.5% was rated "BBB" or higher by Standard & Poor's or a recognized equivalent rating agency. Invested assets also included $83.7 million in equity investments in affiliates (which includes the Company, ALLIED Life Financial Corporation (ALFC), which is a 56.2% owned subsidiary of ALLIED Mutual, and AID Finance Services, Inc.). ALLIED Mutual files its statutory-basis financial reports with the state insurance departments in the territories in which it operates. The Company and ALLIED Mutual formalized their relationship by entering into an Intercompany Operating Agreement, a Pooling Agreement, and a Stock Rights Agreement. Intercompany Operating Agreement The Company, ALLIED Mutual, ALFC, and each of their respective subsidiaries are parties to an Intercompany Operating Agreement providing for the sharing of employees, office space, agency forces, data processing, and other services and facilities. The Company receives from and pays to ALLIED Mutual and its subsidiaries fees and cost reimbursements for the employees, services, and facilities provided. In determining the allocated costs to the companies, each provider of the various services (e.g., ALLIED Mutual leases office facilities, the Company leases employees etc.) attempts to set fees on a basis consistent with that which would apply in an arm's length transaction with nonaffiliates. However, there can be no assurance that the actual rates charged reflect those which would be obtained if the Company and ALLIED Mutual were not affiliated and had agreed upon rates following arm's length negotiation. See "Relationship with ALLIED Mutual Pooling Agreement" for a further discussion of expense sharing arrangements between ALLIED Mutual and the Company. The Company leases to ALLIED Mutual and certain of its subsidiaries all of the employees utilized in their operations for a fee and reimbursement of personnel costs based on certain allocation methods. The Company is obligated to provide the entire requirements for employees of ALLIED Mutual and certain of its subsidiaries, but ALLIED Mutual reserves the right to hire employees independently rather than leasing them from the Company. In 1997, 1996, and 1995, ALLIED Mutual and its subsidiaries paid the Company $2.6 million, $2.5 million, and $2.5 million, respectively, for leased employees, substantially all of which represented cost reimbursement. The Intercompany Operating Agreement (IOA) also provides for the leasing by ALLIED Mutual to the Company of substantially all of the office space utilized by the Company and its subsidiaries. ALLIED Mutual and property-casualty subsidiaries share agency forces as well as other services and facilities. The IOA contains a covenant not to compete that binds each of the Company, ALLIED Mutual, and ALFC not to engage in a business Intercompany Operating Agreement and five years thereafter. The IOA is in effect to December 31, 2004 and continues thereafter subject to any party providing two years notice that such party intends to cease participation. Termination prior to December 31, 2004 requires the Coordinating Committee's approval. Pooling Agreement The Pooling Agreement provides that ALLIED Mutual, ALLIED Property and Casualty, and Depositors cede to AMCO premiums, losses, allocated loss adjusting expenses, commissions, premium taxes, service charge income, and dividends to policyholders and assume from AMCO an amount of this pooled property-casualty business equal to their participation in the Pooling Agreement. ALLIED Mutual's crop hail business is not pooled. AMCO pays certain underwriting expenses, unallocated loss adjusting expenses, and premium collection expenses for all of the pool participants and receives a fee equal to a specified percentage of premiums as well as a performance fee based on the attainment of certain combined ratios from each of the pool participants. AMCO charges each of the other pool participants 12.85% of written premiums for underwriting services, 7.25% of earned premiums for unallocated loss adjusting expenses, and 0.75% of earned premiums for premium collection services. AMCO received pool administrative fees of $66.8 million, $61.3 million, and $55.7 million from ALLIED Mutual in 1997, 1996, and 1995, respectively. In 1997, AMCO also received a performance fee of $4.2 million from ALLIED Mutual. The administrative fees are subject to renegotiation during the term of the pooling agreement upon five years notice. The pooling agreement provides ALLIED Mutual, ALLIED Property and Casualty, and Depositors more predictable expense levels by limiting such expenses to a specified percentage of their premiums. These arrangements give AMCO opportunities to profit from the efficient administration of such underwriting, loss settlement, and premium collection activities and to provide similar services to nonaffiliated insurance companies in the future. 17 The Pooling Agreement may be terminated by a participant to the agreement on or after December 31, 2004 upon giving notice at least five years prior to the date of termination. Termination of the Pooling Agreement prior to December 31, 2004 must be approved by the Coordinating Committee. The Pooling Agreement may also be terminated or extended by ALLIED Mutual upon the occurrence of certain events. See "Relationship with ALLIED Mutual--Intercompany Operating Agreement." In addition, ALLIED Mutual, the Company, and ALFC have certain rights under the Pooling Agreement and the IOA in the event a nonaffiliated party acquires the ownership of 50% or more of the voting stock of the Company or ALFC. If such an event were to occur, ALLIED Mutual, the Company, or ALFC, as the case may be, have the right to (i) terminate such agreements upon six months notice (ii) extend the term such agreements for up to ten additional years beyond December 31, 2004, upon six months notice, or (iii) allow such agreements to continue in effect. Stock Rights Agreement The Company and ALLIED Mutual are parties to a Stock Rights Agreement, which grants certain rights to, and imposes certain restrictions on, ALLIED Mutual in respect of its holdings of the Company's common and preferred stock. This Agreement expires in 2005. Pursuant to the Stock Rights Agreement, ALLIED Mutual is entitled to nominate, and the Company is required to use its best efforts to cause the election or retention of, a number of members of the Company's Board of Directors in proportion to ALLIED Mutual's percentage ownership of the total number of shares of the Company's voting stock outstanding at the time of nomination. In addition, the Company is required to elect to its Executive Committee at least one director who has been nominated by ALLIED Mutual but who is not an officer or employee of ALLIED Mutual. The Stock Rights Agreement also restricts the ability of ALLIED Mutual to grant proxies and solicit other shareholders of the Company. Under the Stock Rights Agreement, ALLIED Mutual is prohibited from initiating or accepting a tender offer for shares of the Company's common stock except under certain conditions. The Company has a right of first refusal with respect to any sale by ALLIED Mutual of the Company's common stock, subject to certain exceptions, including a distribution of such stock to the public in a registered public offering or sale pursuant to Rule 144. ALLIED Mutual has incidental registration rights and three demand registration rights with respect to the Company's common and 6-3/4% Series preferred stock (6-3/4% Series) it owns. The limitations on ALLIED Mutual's ability to initiate, or tender shares, in a tender offer as well as the limitations on its ability to grant proxies and solicit other shareholders of the Company terminate upon a consolidation or merger of the Company with another corporation in which the Company is not the surviving corporation, a sale of substantially all of its assets, or the holding, by any person other than ALLIED Mutual, of 50% or more of the voting securities of the Company then outstanding. The Stock Rights Agreement will be suspended for as long as ALLIED Mutual holds less than 10% of the outstanding common stock and 6-3/4% Series stock of the Company. The Coordinating Committee Under the IOA, the Company, ALLIED Mutual, and ALFC have formed a Coordinating Committee comprised of two independent directors of the Company, two directors of ALLIED Mutual, and two independent directors of ALFC, none of whom serve on other ALLIED boards. All disputes arising under the IOA as well as other intercompany agreements are to be submitted to the Coordinating Committee for resolution. Decisions of this Coordinating Committee must be unanimous and are binding on the parties. Historically, all issues that have been submitted to the Coordinating Committee have been resolved by the Committee. The Company anticipates that any future issues would be similarly resolved. If an issue is not resolved by the Coordinating Committee, it will be submitted to arbitration. In such arbitration, each party to the dispute selects one arbitrator, and if such dispute involves only two parties, such arbitrators select a third arbitrator. Other Relationships Effective January 1, 1997, the Company's property-casualty subsidiaries entered into a property catastrophe reinsurance agreement with ALLIED Mutual and a nonaffiliated reinsurer. ALLIED Mutual's participation in the agreement was 90%. 18 The reinsurance agreement was an aggregate catastrophe program that covers the property-casualty segment's share of pooled losses up to $30 million in excess of $20 million in the aggregate for any one quarter or in excess of $50 million in the aggregate for any one year. See notes 4 and 6 of Notes to Consolidated Financial Statements for additional information concerning transactions between the Company and ALLIED Mutual. Prior to 1997, ALLIED Mutual's and American Re-Insurance Company's respective participation in the reinsurance agreement were 90% and 10% and covered the property-casualty segment's share of pooled losses up to $5,000,000 in excess of $5,000,000. This agreement was canceled effective December 31, 1996. Employees At December 31, 1997, the Company was the direct employer of personnel for all subsidiaries of the Company and of ALLIED Mutual and its subsidiaries other than ALFC, employing 2,646 persons. None of the Company's employees are members of a collective bargaining unit. Management believes that its employee relations are good. Item 2. Properties The majority of the real property occupied by the Company and its subsidiaries are owned or leased by ALLIED Mutual. A portion of the costs of the properties is paid by the Company. See "Relationship with ALLIED Mutual--Intercompany Operating Agreement." Management considers the properties to be adequate for its needs. The primary properties owned by ALLIED Mutual are the home office in Des Moines, Iowa, a data processing facility and claims center in Urbandale, Iowa, and regional offices in Denver, Colorado and Lincoln, Nebraska. The Company and its subsidiaries lease office space in Des Moines and Cedar Rapids, Iowa, Minneapolis, Minnesota, Lincoln, Nebraska, and Scottsdale, Arizona. Item 3. Legal Proceedings The Company is party to various lawsuits arising in the normal course of business. The Company believes the resolution of these lawsuits will not have a material adverse effect on its financial condition, results of operations, or liquidity. For a description of certain lawsuits pending against the Company, see item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," of this report which is incorporated herein by reference. Item 4. Submission of Matters to a Vote of Securities Holders During the fourth quarter of 1997 no matters were submitted to a vote of holders of ALLIED Group, Inc. stock. 19 PART II Item 5. Market for Registrant's Common Equity and Related Stockholders' Matters ALLIED Group, Inc.'s common stock traded on The New York Stock Exchange under the symbol GRP. As of December 31, 1997, there were 1,252 stockholders of record. The following table shows the high and low market prices and dividends paid per share for each calendar quarter for the two most recent years. The prices and dividends per share have been restated for the November 28, 1997 3-for-2 stock split and rounded to the nearest 1/64.
First Second Third Fourth 1997 Quarter Quarter Quarter Quarter --------- ------------ ------------ ------------ ------------ High $ 25- 3/4 $ 27- 1/2 $ 35-51/64 $ 33-53/64 Low 20- 2/3 22- 5/32 25- 5/32 26- 1/4 Dividends 0.11- 1/3 0.11- 1/3 0.11- 1/3 0.12 First Second Third Fourth 1996 Quarter Quarter Quarter Quarter --------- ------------ ------------ ------------ ------------ High $ 19- 2/3 $ 19- 1/3 $ 19- 7/32 $ 22- 5/32 Low 15- 9/16 15-49/64 14-57/64 16-57/64 Dividends 0.09- 3/4 0.09- 3/4 0.09- 3/4 0.10
There are certain regulatory restrictions relating to the payment of dividends (see Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources). It is the present intention of the Board of Directors to declare quarterly cash dividends. 20 Item 6. Selected Financial Data *
At or for the year ended December 31, ------------------------------------------------------------------------- 1997 1996 1995 1994 1993 ----------- ----------- ----------- ----------- ----------- (dollars in thousands, except per share data) Income Statement Data Premiums earned Personal $ 350,231 $ 311,511 $ 279,908 $ 252,916 $ 225,594 Commercial 164,072 154,700 145,930 133,816 118,728 ----------- ----------- ----------- ----------- ----------- Total property-casualty 514,303 466,211 425,838 386,732 344,322 Excess & Surplus Lines 33,294 27,314 29,661 25,786 24,014 ----------- ----------- ----------- ----------- ----------- Total 547,597 493,525 455,499 412,518 368,336 Investment income 51,124 49,222 47,242 41,070 39,030 Realized investment gains 391 49 505 2,888 1,396 Other income 65,570 53,558 49,519 50,888 73,680 ----------- ----------- ----------- ----------- ----------- Total revenues 664,682 596,354 552,765 507,364 482,442 Losses and expenses 572,770 525,043 478,917 440,665 425,685 ----------- ----------- ----------- ----------- ----------- Income from before income taxes and minority interest 91,912 71,311 73,848 66,699 56,757 Income taxes 25,973 20,227 21,471 19,074 16,835 ----------- ----------- ----------- ----------- ----------- 65,939 51,084 52,377 47,625 39,922 Minority interest in net income of consolidated subsidiary 503 --- --- --- --- ----------- ----------- ----------- ----------- ----------- Net income $ 65,436 $ 51,084 $ 52,377 $ 47,625 $ 39,922 =========== =========== =========== =========== =========== Diluted earnings per share Net income $ 2.01 $ 1.51 $ 1.54 $ 1.40 $ 1.17 =========== =========== =========== =========== =========== Realized investment gain $ .01 $ --- $ .01 $ .06 $ .02 =========== =========== =========== =========== =========== Balance Sheet Data Total investments $ 908,244 $ 819,645 $ 772,299 $ 655,906 $ 606,511 Total assets $ 1,201,233 $ 1,077,659 $ 1,010,598 $ 892,751 $ 855,525 Notes payable $ 56,938 $ 34,094 $ 39,465 $ 43,541 $ 82,459 Guarantee of ESOP obligations $ 22,380 $ 24,370 $ 26,270 $ 28,150 $ 29,500 Shares outstanding (in thousands) Preferred shares 1,827 1,827 4,820 4,981 5,070 Common shares 30,532 20,383 9,445 9,000 9,026 Other Data Book value per share $ 13.44 $ 11.59 $ 10.77 $ 8.75 $ 7.99 Closing stock price per share $ 28.63 $ 21.75 $ 16.00 $ 11.00 $ 11.67 Property-casualty wind and hail losses $ .59 $ .82 $ .60 $ .51 $ .40 Dividends paid $ .46 $ .39 $ .30 $ .27 $ .23 Return on average book value per share 16.3% 13.7% 15.9% 16.8% 16.1% Pretax investment yield 6.0% 6.3% 6.6% 6.5% 7.1% Effective tax rate 28.3% 28.4% 29.1% 28.6% 29.7% Cash dividends to closing stock price 1.6% 1.8% 1.9% 2.4% 1.9% Closing stock price to earnings ratio 14.2 14.4 10.4 7.9 10.0 Property-casualty statutory combined ratio 94.4 97.7 95.7 97.1 99.3 * Per share data have been restated to retroactively reflect the 3-for-2 stock split issued in 1997.
21 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Forward-looking Information The Private Securities Litigation Reform Act of 1995 provides a safe harbor to encourage companies to provide prospective information so long as it is identified as forward-looking and accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those discussed. Forward-looking statements are related to the plans and objectives of management for the future operations, economic performance, or projections of revenues, income, earnings per share, capital expenditures, dividends, capital structure, or other financial items. In the following discussion and elsewhere in this report, statements containing words such as expect, anticipate, believe, goal, objective, or similar words are intended to identify forward-looking statements. ALLIED Group, Inc. (the Company) undertakes no obligation to update such forward-looking statements, and it wishes to identify important factors that could cause actual results to differ materially from those projected in the forward-looking statements contained in the following discussion and elsewhere in this report. The risks and uncertainties that may affect the operations, performance, development, and results of the Company's business include but are not limited to the following: (1) heightened competition, particularly intensified price competition; (2) adverse state and federal legislation and regulations; (3) changes in interest rates causing a reduction of investment income; (4) general economic and business conditions which are less favorable than expected; (5) unanticipated changes in industry trends; (6) adequacy of loss reserves; (7) catastrophic events or the occurrence of a significant number of storms and wind and hail losses; and (8) other risks detailed herein and from time to time in the Company's other reports. Overview The following analysis of the consolidated results of operations and financial condition of the Company should be read in conjunction with the Selected Financial Data, Consolidated Financial Statements, and Notes to Consolidated Financial Statements included elsewhere herein. The Company, a regional insurance holding company, and its subsidiaries operate exclusively in the United States and primarily in the central and western states. The Company's largest segment includes three property-casualty insurance companies that write personal lines (primarily automobile and homeowners) and small commercial lines of insurance. The other reportable segment is excess & surplus lines insurance. The property-casualty insurance segment accounted for 85.7% of consolidated revenues in 1997 and 86.5% in 1996. At December 31, 1997, The ALLIED Group Employee Stock Ownership Trust (ESOP Trust) owned 24.9% and ALLIED Mutual Insurance Company (ALLIED Mutual), an affiliated property-casualty insurance company, controlled 18.2% of the outstanding voting stock of the Company. The Board of Directors authorized a 3-for-2 stock split issuable November 28, 1997 to common stockholders of record on November 14, 1997. All fractional shares were paid in cash. All share and per share amounts included throughout this report have been restated to reflect the stock split. On December 31, 1997, the Company adopted Statement of Financial Accounting Standard 128, "Earnings per Share." The adoption of SFAS 128 changed the way earnings per share are calculated and required restatement of amounts in prior periods. All per share amounts included throughout this report have been restated to reflect the adoption of SFAS 128. See notes 1 and 17 of Notes to Consolidated Financial Statements for a further discussion of earnings per share. The operating results of the property-casualty insurance industry are subject to significant fluctuations from quarter to quarter and from year to year due to the effects of the competition on pricing, the frequency and severity of losses incurred in connection with weather-related and other catastrophic events, the general economic conditions, and other factors such as changes in tax laws and the regulatory environment. 22 1997 Compared with 1996 Consolidated revenues for 1997 were $664.7 million, up 11.5% over the $596.4 million reported for 1996. The increase was primarily due to the 11% growth in earned premiums and in other income, which rose 22.4%. Other income includes service charges and other miscellaneous income in the property-casualty segment and total revenues generated by noninsurance operations. Income before income taxes increased 28.9% to $91.9 million from $71.3 million for 1996. The improvement was due primarily to revenue growth and only a slight increase in losses for the year ended December 31, 1997. Wind and hail losses decreased 28.7% to $27.9 million from $39.1 million in 1996. Net income for the year ended December 31, 1997 was up 28.1% to $65.4 million, raising diluted earnings per share to $2.01 from $1.51 in 1996. Diluted earnings per share excluding net realized investment gains were $2.00 for 1997 compared with $1.51. On a diluted basis, the impact of wind and hail losses was $0.59 per share versus $0.82 in 1996. Book value per share at December 31, 1997 increased to $13.44 from $11.59 at year-end 1996. Higher dividend payments and the stock repurchase program had a dilutive effect on book value during 1997 that was ameliorated by larger unrealized gains in the investment portfolio. The fair value of investments in fixed maturities was $26.3 million above amortized cost compared with $17.1 million above amortized cost at December 31, 1996. If investments in fixed maturities were reported at amortized cost, book value per share at December 31, 1997 would have been $12.88 compared with $11.23 at December 31, 1996. Property-casualty Pooled net written premiums (including ALLIED Mutual's) totaled $835.4 million, an 8.9% increase over 1996 production. Growth in personal lines net written premiums was 11.2% for 1997. The average premium per policy for personal lines was up 3.5% to $618 while the policy count grew 6%. Commercial lines premiums grew by 4.1%. The average premium per policy for commercial lines increased 3.7% to $1,152, and policy count was up 3%. Earned premiums for the property-casualty segment were 68.1% personal lines and 31.9% commercial lines in 1997. The business mix for 1996 was 66.8% personal and 33.2% commercial lines. Revenues for the property-casualty segment increased 10.4% to $569.4 million from $515.7 million for 1996. Direct earned premiums for the segment were $568.2 million for 1997 compared with $497.1 million one year earlier. Earned premiums increased 10.3% to $514.3 million from $466.2 million. The increase resulted primarily from growth in insurance exposure as well as from a larger average premium per policy. Investment income for 1997 was $44.3 million compared with $42.3 million for 1996. The pretax yield on invested assets was 6%, down from 6.3% one year earlier. Investment income increased due to a larger average balance of invested assets in 1997, which more than offset the decrease experienced in the pretax yield. Realized investment gains for 1997 were $96,000 compared with $180,000. Other income increased to $10.7 million from $7 million in 1996. The 1997 amount included a $4.2 million performance fee paid by ALLIED Mutual to AMCO as pool administrator. See note 4 of the Notes to Consolidated Financial Statements for a discussion of the reinsurance pooling agreement. Income before income taxes increased 37.8% to $81.9 million from $59.4 million in 1996. The improvement was due to revenues that increased faster than losses, which increased only slightly because of lower wind and hail loss experience in 1997. Since 1996 wind and hail experience was the worst on record, the 1997 improvement was anticipated. The statutory combined ratio (after policyholder dividends) improved to 94.4 from the 97.7 reported in 1996, primarily due to a 2.5-point decrease in the loss and loss adjusting expense ratio. The Company's underwriting expense ratio also improved 0.8 points. Wind and hail losses decreased to $27.9 million from 23 $39.1 million in 1996, which accounted for a 3-point improvement in the loss and loss adjusting ratio. The impact of wind and hail losses on the statutory combined ratio was 5.4 points for 1997 and 8.4 points for 1996. The 1997 underwriting gain, on a generally accepted accounting principles basis (GAAP), rose to $26.8 million from the previous year's $9.9 million. The personal auto statutory combined ratio decreased to 94.5 from 98.9 for 1996, reflecting a 3.4-point improvement in the loss and loss adjusting expense ratio. The statutory combined ratio for the homeowners line was 96.7 compared with 102.4 for 1996. The impact of wind and hail losses on the homeowners combined ratio was 15.4 points in 1997 and 23.6 points in 1996. Overall, the personal lines statutory combined ratio improved to 95.1 from 99.8 in 1996. The statutory combined ratio for commercial lines decreased slightly to 93.1 from 93.5 for the previous year. Excess & Surplus Lines Earned premiums for 1997 increased to $33.3 million from $27.3 million for 1996. Net written premiums were up 19.8% to $34.1 million from $28.4 million. The segment's major product lines all experienced increases in net written premiums due to intensified marketing efforts and the addition of 19 new agencies (a 27.1% increase) over the last 24 months. The segment's 1997 book of business was comprised of 3.1% personal and 96.9% commercial lines; the 1996 business mix was 2.8% personal and 97.2% commercial lines. The segment's invested assets rose 8.7% from the previous year-end to $113.5 million at December 31, 1997. Investment income increased 9% to $6.8 million from $6.2 million because a larger average balance of invested assets more than offset a 20 basis-point decline in the pretax yield to 6.2% from the previous year's 6.4%. Realized investment losses were $4,000 compared with gains of $2,000 for the year ended December 31, 1996. The statutory combined ratio (after policyholder dividends) was 90.2, which produced a GAAP underwriting gain of $3.2 million. The statutory combined ratio of 92.5 for 1996 resulted in a GAAP underwriting gain of $1.8 million. The 1997 growth in earned premiums outpaced the increase in losses and loss adjusting expenses, resulting in a 2.8-point improvement in the loss and loss adjusting expense ratio. Income before income taxes for 1997 increased 24.3% to $10 million from $8.1 million. The increase was primarily due to top line growth. Noninsurance Operations Revenues for the noninsurance operations (including mortgage banking, data processing, and employee leasing to affiliates) after eliminations increased 17.2% to $55.2 million from $47.1 million in 1996. The increase was primarily due to a 35.4% increased in data processing revenues to $23 million from $17 million. In 1997, outside sales increased $1.8 million and license fees to nonaffiliates were up $ 4.3 million . On a consolidated basis, revenues from nonaffiliates for the noninsurance operations are reported as other income. Income before income taxes was $29,000 for the year ended December 31, 1997 compared with $3.8 million in 1996. The increase in operating costs, primarily in the data processing operations and the holding company, more than offset the increase in revenues for the noninsurance operations. Investments and Investment Income The investment policy for the Company's insurance segments requires that the fixed maturity portfolio be invested primarily in debt obligations rated investment grade (BBB) or higher by Standard & Poor's Corporation or a recognized equivalent at the time of acquisition. The policy also states that equity securities are to be of United States and Canadian corporations listed on established exchanges or publicly traded in the over-the-counter market. Preferred stocks are to be comprised primarily of issues rated at least A3/A- by Standard & Poor's Corporation or Moody's. At December 31, 1997, the Company's investment portfolios consisted almost exclusively of fixed income securities and equity securities 90.1% and 8.7%, respectively. The ratings on 99.7% of the fixed income securities were investment grade or higher at December 31, 1997. The portfolios contained no real estate or mortgage loans at December 31, 1997. 24 Consolidated invested assets were up 10.8% to $908.2 million from $819.6 million at year-end 1996. Fixed maturities at amortized cost increased 2.2%. Consolidated investment income increased 3.9% to $51.1 million from $49.2 million in 1996. The increase was due primarily to a larger average balance of invested assets. The tax-equivalent yield was down in 1997 to 7.0% compared with 7.2% one year earlier due to lower short- and intermediate-term interest rates on investments. The aftertax yield for 1997 and 1996 was 4.6% and 4.7%, respectively. Income Taxes The Company's effective income tax rate was down slightly to 28.3% from 28.4% for 1996. The decrease was the result of the decline in operating results of subsidiaries that have higher statutory tax rates. Higher 1997 consolidated operating income increased the income tax expense 28.4% to $26 million. 1996 Compared with 1995 Consolidated revenues for 1996 were $596.4 million, up 7.9% over the $552.8 million reported for 1995. The increase occurred primarily because of the 8.3% growth in earned premiums. Income before income taxes decreased 3.4% to $71.3 million from $73.8 million for 1995. The decrease was due primarily to the highest ever wind and hail losses for the year ended December 31, 1996. Wind and hail losses increased 36.4% to $39.1 million from $28.7 million in 1995. Net income for the year ended December 31, 1996 was down 2.5% to $51.1 million, lowering diluted earnings per share to $1.51 from $1.54 in 1995. Diluted earnings per share excluding net realized investment gains were $1.51 for 1996 compared with $1.53. On a diluted basis, the impact of wind and hail losses was $0.82 per share versus $0.60 in 1995. Book value per share at December 31, 1996 increased to $11.59 from $10.77. The increase in book value was constrained by higher dividend payments, increased wind and hail losses, and the stock repurchase program. The fair value of investments in fixed maturities was $17.1 million above amortized cost compared with $27.8 million above amortized cost at December 31, 1995. If the investments in fixed maturities were reported at amortized cost, book value per share at December 31, 1996 would have been $11.23 compared with $10.20 at December 31, 1995. Property-casualty Revenues for the property-casualty segment increased to $515.7 million from $472 million for 1995. Direct earned premiums for the segment were $497.1 million for 1996 compared with $435.2 million for 1995. Earned premiums in 1996 increased 9.5% to $466.2 million from $425.8 million. The increase resulted primarily from growth in insurance exposure as well as a larger average premium per policy. Pooled net written premiums (including ALLIED Mutual's) totaled $767.2 million, a 10.8% increase over 1995 production. The average premium per policy for personal lines was up 4.6% to $613 while the policy count grew 8.7%. The average premium per policy for commercial lines increased 2.2% to $1,110, and policy count was up 4.3%. Earned premiums for the property-casualty segment were 66.8% personal lines and 33.2% commercial lines in 1996. The business mix for 1995 was 65.7% personal and 34.3% commercial lines. Investment income for 1996 was $42.3 million compared with $39.1 million in 1995. The pretax yield on invested assets was 6.3%, down from 6.4%. Investment income increased due to a larger average balance of invested assets, which more than offset the decrease experienced in the pretax yield. Realized investment gains were $180,000 compared with $236,000 for 1995. Other income increased slightly to $7 million from $6.9 million. Income before income taxes decreased 7% to $59.4 million for 1996 from $63.9 million for 1995. The decrease was due primarily to higher losses and loss adjusting expenses brought on by higher wind and hail losses in the second and third quarters. 25 The statutory combined ratio (after policyholder dividends) deteriorated to 97.7 from the 95.7 reported in 1995, primarily due to a 2.6-point increase in the loss and loss adjusting expense ratio. Higher wind and hail losses accounted for 2.2 points of the deterioration. The deterioration was partially offset by a 0.5-point reduction in the Company's underwriting expense ratio achieved through improved efficiency and productivity. Wind and hail losses increased to $39.1 million from $28.7 million in 1995. The impact of wind and hail losses on the statutory combined ratio was 8.4 points for 1996 and 6.7 points for 1995. The 1996 GAAP underwriting gain was $9.9 million compared with $17.7 million for 1995. The personal auto statutory combined ratio increased to 98.9 from 96.5 for 1995, reflecting a 2.8-point increase in the loss and loss adjusting expense ratio. The statutory combined ratio for the homeowners line was 102.4 compared with 99.2 for 1995. Wind and hail losses increased the homeowners combined ratio 23.6 points in 1996 and 21.7 points in 1995. Overall, the personal lines statutory combined ratio deteriorated to 99.8 from 97.2. The statutory combined ratio for commercial lines increased to 93.5 from 92.7 for the prior year. Excess & Surplus Lines Earned premiums for 1996 decreased to $27.3 million from $29.7 million for 1995, primarily because of higher reinsurance costs. Direct earned premiums were nearly flat at $37.6 million compared with $37.2 million. Net written premiums were down 7.2% to $28.4 million from $30.6 million, reflecting a continuing soft market and management's decision not to sacrifice underwriting results for premium growth. For the year ended December 31, 1996, the segment's book of business was comprised of 2.8% personal and 97.2% commercial lines. For 1995, the business mix was 2.4% personal and 97.6% commercial lines. The segment's invested assets rose 8.3% from the previous year-end to $104.4 million at December 31, 1996. Investment income increased 7% to $6.2 million from $5.8 million because a larger average balance of invested assets more than offset a decline in the pretax yield of 30 basis points to 6.4% from the prior year's 6.7%. Realized investment gains were $2,000 compared with losses of $136,000 for 1995. The statutory combined ratio (after policyholder dividends) was 92.5, which produced an underwriting gain (on a generally accepted accounting principles basis) of $1.8 million. The statutory combined ratio of 102.2 for 1995 resulted in an underwriting loss of $855,000. The 1996 combined ratio improved primarily because of a 21.8% decrease in losses and loss adjusting expenses (11.4 points on the combined ratio). The decrease in the loss and loss adjusting expense ratio was primarily due to favorable loss development in 1996. Income before income taxes for 1996 increased 66.4% to $8.1 million from $4.8 million for the previous year. The increase was primarily due to favorable loss development. Noninsurance Operations Revenues for the noninsurance operations increased 3.8% to $47.1 million from $45.4 million in 1995. The increase was primarily due to higher data processing revenues. Income before income taxes was $3.8 million for 1996 compared with $5.1 million for 1995. Effective March 1, 1996, personnel of the Company previously providing computer-related services to a certain affiliate were employed by the affiliate. Since the effective date, those employees have been paid directly by the affiliate. Investments and Investment Income At December 31, 1996 the Company's investment portfolios consisted almost exclusively of fixed income securities; 99.7% were rated investment grade or higher. The portfolios contained no real estate or mortgage loans at December 31, 1996. Consolidated invested assets were up 6.1% to $819.6 million from $772.3 million at year-end 1995. Fixed maturities at amortized cost increased 6.7%. Consolidated investment income increased 4.2% to $49.2 million from $47.2 million in 1995. The increase was due primarily to a larger average balance of invested assets. The tax-equivalent yield was down in 1996 to 7.2% from 7.6% in 1995. The aftertax yield for 1996 and 1995 was 4.7% and 4.9%, respectively. 26 Income Taxes The Company's effective income tax rate for 1996 was 28.4% compared with 29.1% for 1995. The decrease in the effective rate was due primarily to a higher percentage of income from tax-exempt securities. The income tax expense decreased 5.8% to $20.2 million. Liquidity and Capital Resources Substantial cash inflows for the Company are generated from premiums, pool administration fees, investment income, and proceeds from sales and maturities of investments. The principal outflows of cash are payments of claims, commissions, premium taxes, operating expenses, and income taxes and the purchase of fixed income and equity securities. In developing its strategy, the Company establishes a level of cash and highly liquid short- and intermediate-term securities that, combined with expected cash flow, is believed adequate to meet anticipated short-term and long-term payment obligations. In 1997, operating activities generated cash flows of $94.2 million; in 1996, the total was $95.1 million; in 1995, the total was $97.9 million. For each year, the primary source of funds was from premiums written in the property-casualty insurance operations. In 1997, the funds generated from operating activities were primarily used to purchase fixed maturities and equity securities, repurchase the Company's common stock, and pay cash dividends. In 1996 and 1995, the funds generated from operating activities in those years were primarily used to purchase investment-grade securities and to repurchase the Company's common stock. The net cash used in investing activities in 1997, 1996, and 1995 was $79.2 million, $65.7 million, and $88.8 million, respectively. In 1997, 1996, and 1995, the Company paid dividends of $17.5 million, $16.3 million, and $13.5 million, respectively. Dividend payments to common stockholders totaled $14 million for the year ended December 31, 1997, up from $12.2 million and $6.3 million in 1996 and 1995, respectively. In each year, dividends of $3.5 million on the 6-3/4% Series Preferred Stock was paid. In 1996 and 1995, dividends paid on the ESOP Series Preferred Stock (ESOP Series) were $595,000 and $3.7 million, respectively. The increase in dividends to common shareholders and the decrease in dividends on the ESOP Series were due to the conversion of the ESOP Series completed on March 7, 1996. See note 10 of the Notes to Consolidated Financial Statements for a further discussion of the conversion. Prior to the conversion, the Company and the ESOP Trustee entered into an agreement whereby the Company agreed to release additional shares held by the ESOP Trustee if the dividend paid on common stock is less than $0.09 per share per quarter on a post-split basis. The agreement is in effect from March 7, 1996 through March 7, 2000. The agreement ensures that the allocated shares in the ESOP Trust receive at least the same amount of dividends that would have been paid on the ESOP Series shares had they not been converted to common stock. The Company relies primarily on dividends from its insurance subsidiaries to pay preferred and common stock dividends to shareholders. During 1997, the Company received dividend payments of $16.2 million from the property-casualty subsidiaries and $836,000 from noninsurance subsidiaries. During 1996 and 1995, the property-casualty subsidiaries paid the Company dividends of $23.7 million and $12 million, respectively; noninsurance subsidiaries paid dividends of $916,000 and $974,000, respectively. The Iowa state insurance regulations restrict the maximum amount of dividends the property-casualty subsidiaries can pay without prior regulatory approval. The maximum dividend allowed is the greater of either 10% of the subsidiary's statutory capital stock and surplus as of the preceding December 31 or net income of the preceding calendar year. In 1998 the maximum amount legally available for distribution to the Company without prior approval is $54.5 million. The excess & surplus lines subsidiary is domiciled in Arizona and operates under Arizona state laws. The maximum amount available for distribution as dividends from the excess & surplus lines subsidiary is limited to the lesser of 10% of stockholders' surplus as of the preceding December 31 or net investment income of the preceding year. The excess & surplus lines segment could pay $4 million in 1998 without prior notice to the insurance commissioner. The Company anticipates the excess & surplus lines segment will not pay dividends in 1998. 27 In 1997 and 1996, the Company repurchased $10.2 million and $16.5 million of its common stock, respectively. No shares were repurchased in 1995. During 1997, the Company repurchased 412,850 shares of its common stock on the open market at an average price per share of $24.77. The first 85,500 shares were repurchased under a program approved by the Board of Directors (Board) on July 16, 1996 and completed March 13, 1997. An additional 327,350 shares were repurchased under a program approved by the Board March 4, 1997 and completed December 4, 1997. During 1996, the Company canceled 664,500 shares of its common stock purchased on the open market at an average price per share of $24.87. The Company guaranteed the ESOP Trust's obligations under the terms of a Term Credit Agreement and Guaranty. See note 9 of Notes to Consolidated Financial Statements for a discussion of ESOP obligations. At December 31, 1997, the balance of the obligations was $22.4 million. Contributions plus dividends on leveraged shares held by the ESOP are used by the ESOP Trust to service the ESOP obligations. Dividends and payments for the employee lease fees from its subsidiaries are used by the Company to fund the amounts paid to the ESOP Trust. The Company made contributions to the ESOP Trust of $312,000 in 1997, $529,000 in 1996, and $733,000 in 1995. The Company paid dividends of $3.6 million in 1997, $3.5 million in 1996, and $2.8 million in 1995, which were used for such debt service. In connection with its guarantee of ESOP obligations, the Company is required to maintain minimum stockholders' equity and to comply with certain other financial covenants. Historically, the insurance subsidiaries have generated sufficient funds from operations to pay their claims. While the property-casualty and excess & surplus lines insurance companies have maintained adequate investment liquidity, they have in the past required additional capital contributions to support premium growth. Industry guidelines suggest that a property-casualty insurer's annual net written premiums should not exceed approximately 300% of statutory surplus. At December 31, 1997, the property-casualty and excess & surplus lines segments' net written premiums were 160% and 84% of their statutory surplus, respectively. Management anticipates that short-term and long-term capital expenditures, cash dividends, and operating cash needs will be met from existing capital and internally generated funds. As of December 31, 1997, the Company had no material commitments for capital expenditures. Future debt and stock issuance will be considered as additional capital needs arise. The method of funding will depend upon financial market conditions. Insurance premiums are established before the amount of losses and loss adjusting expenses or the extent to which inflation may affect such expenses is known. Consequently, the Company attempts to anticipate the impact of inflation in establishing premiums. Inflation is implicitly considered in the determination of reserves for losses and loss adjusting expenses since portions of the reserves are expected to be paid over extended periods of time. The importance of continually reviewing reserves is even more pronounced in periods of extreme inflation. The Company's mortgage banking subsidiary, ALLIED Group Mortgage Company (ALLIED Mortgage), has separate credit agreements to support its operations. Short-term and long-term notes payable to nonaffiliated companies are used by ALLIED Mortgage to finance its mortgage loans held for sale, to purchase servicing rights, and to purchase short-term investments. These notes payable are not guaranteed by the Company. At December 31, 1997, ALLIED Mortgage had short-term borrowings of $39 million, which are to be repaid through the subsequent sale of its mortgage loan inventory. The amount of short-term borrowings fluctuates daily depending on the level of inventory being financed. Long-term borrowings amounted to $10.5 million to be repaid over the next seven years. See note 8 of Notes to Consolidated Financial Statements for a further discussion of ALLIED Mortgage's finance arrangements. In the normal course of its business, ALLIED Mortgage also makes commitments to buy and sell securities that may result in credit and market risk in the event the counterparty is unable to fulfill its obligation. See note 14 of Notes to Consolidated Financial Statements for a further discussion of such commitments. At its March 3, 1998 meeting, the Board approved a first-quarter 1998 common stock dividend of $0.13 per share. The dividend is $0.01 per share (8.3%) higher than the amount paid in the fourth quarter of 1997. 28 Year 2000 The Company began converting its computer systems to be year 2000 compliant in 1996 and anticipates completion by the end of 1998. The Company actively monitors its progress and plans to start retesting applications in the spring of 1998. The costs associated with year 2000 are expensed as incurred; the Company does not expect such costs to have a material effect on its future financial position or results of operations. The Company's data processing segment has a line of property-casualty and life insurance software products which it markets to affiliated and nonaffiliated insurance companies. Management believes the segment's products are year 2000 compliant while operating in the Company's environment and will continue to retest the products throughout 1998. The segment's customers have been advised to test the software products in their operating environment for year 2000 compliance. Management believes any exposure to material liability was remote as of December 31, 1997. Contingencies California has been the source of approximately 25% of the pool's direct written premiums for the past ten years. Proposition 103, approved by California voters in 1988, provides for a rollback of rates on premiums collected in calendar year 1989 to the extent that the insurer's return on equity for each Proposition 103 line of business exceeded 10%. The rollback liability, if any, has not been finalized. Management continues to believe the insurance subsidiaries will not be liable for any material rollback of premiums. On December 31, 1997, a complaint was filed by Mary M. Rieff, a policyholder of ALLIED Mutual, in the Iowa District Court in and for Polk County Iowa, against the Company and certain other individuals who are or were officers and/or directors of ALLIED Mutual and the Company. The complaint, an alleged policyholder derivative action brought on behalf of ALLIED Mutual, asserts, among other things, (a) that the defendants were responsible for the inappropriate transfer of ALLIED Mutual's corporate assets, the seizure of certain corporate opportunities, and the implementation of an improper de facto demutualization without informing or compensating policyholders or receiving the appropriate approval from regulatory authorities; (b) that this allegedly wrongful demutualization began on or about January 1, 1985 and was accomplished through transfers of ALLIED Mutual's assets to the Company and to the individual defendants for inadequate consideration; (c) that the individual defendants breached fiduciary duties owed to ALLIED Mutual, wasted its corporate assets, and intentionally interfered with its contracts, prospective business advantage, and business relationships; and (d) that the defendants improperly transferred substantial ownership of and control over the Company and ALLIED Mutual's insurance business. The complaint further asserts that as a result of the foregoing, ALLIED Mutual and its policyholders have suffered damages in excess of $500 million. The complaint requests an accounting of the assets allegedly wrongfully transferred to the Company and compensation to ALLIED Mutual for the value of such assets, for the seizure of corporate opportunities, and for the de facto demutualization of ALLIED Mutual. The complaint also asks for certain other relief, including attorneys' fees and costs, equitable relief and interest, and restitution for any assets wrongfully transferred or conveyed. The Company believes the suit is without merit and intends to defend this action vigorously. As is the case in all pending actions, the ultimate outcome is uncertain. 29 Item 8. Financial Statements and Supplementary Data Management Representation The management of ALLIED Group, Inc. is responsible for the integrity and fair presentation of the consolidated financial statements, related notes, and all other information presented herein. The statements were prepared in accordance with generally accepted accounting principles and include amounts that are based on management's best estimates and judgments. Management maintains a system of internal control designed to provide reasonable assurance as to the integrity and reliability of the financial statements, the protection of assets from unauthorized use or disposition, the prevention and detection of fraudulent financial reporting, and the appropriate division of responsibility. In addition, the Company's internal audit department systematically reviews these controls, evaluates their adequacy and effectiveness, and reports thereon. Management has considered internal audit recommendations and those of KPMG Peat Marwick LLP and has in its opinion responded appropriately to those recommendations. Management believes that as of December 31, 1997 the Company's system of internal control is adequate to accomplish the objectives discussed herein. The Company's financial statements have been audited by KPMG Peat Marwick LLP, independent certified public accountants. The audit was conducted in accordance with generally accepted auditing standards, which included consideration of the Company's system of internal control to the extent necessary to form an independent opinion on the financial statements prepared by management. The audit committee of the Board of Directors, composed solely of outside directors, oversees management's discharge of its financial reporting responsibilities. The committee meets periodically with management, internal auditors, and representatives of KPMG Peat Marwick LLP to discuss auditing, financial reporting, and internal control matters. Both internal and independent auditors have access to the audit committee without management's presence. /s/ Jamie H. Shaffer - ------------------------------------- Jamie H. Shaffer Chief Financial Officer 30 Report of Independent Auditors The Board of Directors and Stockholders ALLIED Group, Inc. We have audited the accompanying consolidated balance sheets of ALLIED Group, Inc. and subsidiaries as of December 31, 1997 and 1996 and the related consolidated statements of income and comprehensive income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based upon 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 consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ALLIED Group, Inc. and subsidiaries as of December 31, 1997 and 1996 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1997 in conformity with generally accepted accounting principles. /s/ KPMG Peat Marwick LLP - --------------------------------------- KPMG Peat Marwick LLP Des Moines, Iowa February 3, 1998 31
ALLIED Group, Inc. and Subsidiaries Consolidated Balance Sheets(in thousands) December 31, ----------------------------------- 1997 1996 ---------------- --------------- Assets Investments (notes 2 and 3) Fixed maturities at fair value $ 818,216 $ 792,268 Equity securities at fair value 79,182 20,384 Short-term investments at cost (note 4) 10,846 6,993 ---------------- --------------- Total investments 908,244 819,645 Cash 2,168 1,067 Accrued investment income 11,634 11,563 Indebtness from affiliates (note 4) 3,035 --- Accounts receivable 91,596 84,706 Current income taxes recoverable (note 16) 3,005 2,878 Reinsurance receivables for losses and loss adjusting expenses 23,906 18,183 Mortgage loans held for sale (notes 2 and 8) 29,521 12,054 Deferred policy acquisition costs 50,695 46,671 Prepaid reinsurance premiums 8,866 7,838 Mortgage servicing rights (note 8) 35,931 33,094 Other assets 32,632 39,960 ---------------- --------------- Total assets $ 1,201,233 $ 1,077,659 ================ ===============
See accompanying Notes to Consolidated Financial Statements. 32
December 31, ----------------------------------- 1997 1996 ---------------- --------------- Liabilities Losses and loss adjusting expenses (notes 5 and 6) $ 378,026 $ 362,191 Unearned premiums 239,763 220,596 Indebtedness to affiliates (note 4) --- 2,130 Notes payable to nonaffiliates (notes 2 and 8) 51,038 31,744 Notes payable to affiliates (notes 2 and 4) 5,900 2,350 Guarantee of ESOP obligations (notes 2 and 9) 22,380 24,370 Deferred income taxes (note 16) 5,515 2,244 Other liabilities (notes 14 and 15) 68,527 61,443 ---------------- --------------- Total liabilities 771,149 707,068 ---------------- --------------- Stockholders' equity Preferred stock, no par value, issuable in series, authorized 7,500 shares (note 10) 6-3/4% Series, 1,827 shares issued and outstanding 37,812 37,812 Common stock, no par value, $1 stated value, authorized 80,000 shares, issued and outstanding 30,532 shares in 1997 and 20,383 shares in 1996 (notes 11 and 12) 30,532 20,383 Additional paid-in capital 112,490 126,078 Retained earnings (note 13) 244,079 195,276 Accumulated other comprehensive income 23,314 12,699 Unearned compensation related to ESOP (note 9) (18,143) (21,657) ---------------- --------------- Total stockholders' equity 430,084 370,591 ---------------- --------------- Commitments and contingent liabilities (notes 6 and 14) Total liabilities and stockholders' equity $ 1,201,233 $ 1,077,659 ================ ===============
See accompanying Notes to Consolidated Financial Statements. 33
ALLIED Group, Inc. and Subsidiaries Consolidated Statements of Income and Comprehensive Income (in thousands, except per share data) Year ended December 31, ------------------------------------------------ 1997 1996 1995 ------------- ------------- ------------- Revenues Earned premiums (notes 4 and 6) $ 547,597 $ 493,525 $ 455,499 Investment income (note 3) 51,124 49,222 47,242 Realized investment gains (notes 3 and 7) 391 49 505 Income from affiliates (note 4) 5,125 4,880 5,285 Other income 60,445 48,678 44,234 ------------- ------------- ------------- 664,682 596,354 552,765 ------------- ------------- ------------- Losses and expenses (note 4) Losses and loss adjusting expenses (notes 5 and 6) 378,099 352,995 317,940 Amortization of deferred policy acquisition costs 120,256 108,315 100,120 Other underwriting expenses 19,177 20,438 20,583 Other expenses 53,652 41,650 38,713 Interest expense (note 8) 1,586 1,645 1,561 ------------- ------------- ------------- 572,770 525,043 478,917 ------------- ------------- ------------- Income before income taxes and minority interest 91,912 71,311 73,848 ------------- ------------- ------------- Income taxes (note 16) Current 28,482 17,890 22,293 Deferred (2,509) 2,337 (822) ------------- ------------- ------------- 25,973 20,227 21,471 ------------- ------------- ------------- Net income before minority interest 65,939 51,084 52,377 Minority interest in net income of consolidated subsidiary 503 --- --- ------------- ------------- ------------- Net income 65,436 51,084 52,377 ------------- ------------- ------------- Other comprehensive income, net of tax Unrealized holding gain arising during the period (net of deferred income tax of $(5,934), $3,207, and $(12,956)) 10,826 (6,000) 23,847 Reclassification adjustment for (gains) losses included in net income (net of income tax expense (benefit) of $139, ($207), and $182) (211) 364 (271) ------------- ------------- ------------- 10,615 (5,636) 23,576 ------------- ------------- ------------- Comprehensive Income $ 76,051 $ 45,448 $ 75,953 ============= ============= ============= Net income applicable to common stock $ 61,921 $ 46,973 $ 45,160 ============= ============= ============= Earnings per share Basic $ 2.03 $ 1.61 $ 2.18 ============= ============= ============= Diluted $ 2.01 $ 1.51 $ 1.54 ============= ============= =============
See accompanying Notes to Consolidated Financial Statements. 34 ALLIED Group, Inc. and Subsidiaries Consolidated Statements of Stockholders' Equity (in thousands)
Year ended December 31, ------------------------------------------------- 1997 1996 1995 ------------- ------------- -------------- Preferred stock Beginning of year $ 37,812 $ 83,648 $ 85,566 Issuance of shares of ESOP Series (note 10) --- --- 699 ESOP Series shares converted to common shares (note 11) --- (45,836) (2,617) ------------- ------------- -------------- End of year 37,812 37,812 83,648 ------------- ------------- -------------- Common stock Beginning of year 20,383 9,445 9,000 Issuance of shares of common stock (notes 11 and 12) 270 4,597 445 Repurchase of shares of common stock (note 11) (307) (443) --- Effect of 3-for-2 stock split 10,186 6,784 --- ------------- ------------- -------------- End of year 30,532 20,383 9,445 ------------- ------------- -------------- Additional paid-in capital Beginning of year 126,078 104,596 98,926 Issuance of shares of common stock (notes 11 and 12) 7,609 44,356 5,670 Repurchase of shares of common stock (note 11) (9,919) (16,082) --- Effect of 3-for-2 stock split (10,186) (6,792) --- Minority interest (1,092) --- --- ------------- ------------- -------------- End of year 112,490 126,078 104,596 ------------- ------------- -------------- Retained earnings Beginning of year 195,276 159,470 119,752 Net income 65,436 51,084 52,377 Dividends paid on preferred stock (note 10) (3,515) (4,111) (7,217) Dividends paid on common stock (note 11) (14,027) (12,156) (6,291) Tax benefits attributable to tax-deductible dividends on unallocated shares of the ESOP 909 989 849 ------------- ------------- -------------- End of year 244,079 195,276 159,470 ------------- ------------- -------------- Accumulated other comprehensive income Beginning of year 12,699 18,335 (5,241) Change in unrealized appreciation (depreciation), net 10,615 (5,636) 23,576 ------------- ------------- -------------- End of year 23,314 12,699 18,335 ------------- ------------- -------------- Unearned compensation related to ESOP Beginning of year (21,657) (23,908) (26,122) Cost of ESOP Series shares allocated 3,514 2,251 2,214 ------------- ------------- -------------- End of year (18,143) (21,657) (23,908) ------------- ------------- -------------- Total stockholders' equity $ 430,084 $ 370,591 $ 351,586 ============= ============= ==============
See accompanying Notes to Consolidated Financial Statements. 35 ALLIED Group, Inc. and Subsidiaries Consolidated Statements of Cash Flows (in thousands)
Year ended December 31, ------------------------------------------------ 1997 1996 1995 ------------- ------------- ------------- Cash flows from operating activities Net income $ 65,436 $ 51,084 $ 52,377 Adjustments to reconcile net income to net cash provided by operating activities Losses and loss adjusting expenses 15,835 20,327 30,868 Unearned premiums, net 18,139 23,081 15,945 Deferred policy acquisition costs (4,024) (4,983) (3,419) Accounts receivable, net (12,612) (7,478) (6,009) Depreciation and amortization 15,009 11,030 9,583 Realized investment gains (391) (49) (505) Mortgage loans held for sale, net 326 (2,602) (1,529) Indebtedness with affiliates (5,165) 1,111 1,591 Accrued investment income (71) (1,096) (118) Other assets (4,607) (8,376) (6,644) Cost of ESOP shares allocated 3,514 2,251 2,214 Current income taxes (127) (1,548) 1,264 Deferred income taxes (2,509) 2,337 (822) Other, net 5,482 10,053 3,109 ------------- ------------- ------------- Net cash provided by operating activities 94,235 95,142 97,905 ------------- ------------- ------------- Cash flows from investing activities Purchase of fixed maturities (149,420) (222,566) (184,600) Purchase of equity securities (53,101) (10,990) (4,819) Purchase of equipment (6,132) (8,313) (7,794) Sale of fixed maturities (note 3) 51,391 81,689 48,012 Maturities, calls, and principal reductions of fixed maturities 80,067 90,907 61,966 Sale of equity securities 1,624 682 2,072 Short-term investments, net (3,853) 2,809 (4,146) Sale of equipment 220 86 470 ------------- ------------- ------------- Net cash used in investing activities (79,204) (65,696) (88,839) ------------- ------------- ------------- Cash flows from financing activities Notes payable to nonaffiliates, net 1,500 --- (2,180) Notes payable to affiliates, net 3,550 (1,150) 1,500 Issuance of preferred stock --- --- 699 Issuance of common stock 7,879 3,109 3,498 Repurchase of common stock (10,226) (16,525) --- Dividends paid to stockholders, net of income tax benefit (16,633) (15,278) (12,659) ------------- -------------- ------------- Net cash used in financing activities (13,930) (29,844) (9,142) ------------- -------------- ------------- Net increase (decrease) in cash 1,101 (398) (76) Cash at beginning of year 1,067 1,465 1,541 ------------- -------------- ------------- Cash at end of year $ 2,168 $ 1,067 $ 1,465 ============= ============== =============
See accompanying Notes to Consolidated Financial Statements. 36 Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies Principles of Consolidation and Basis of Presentation The accompanying consolidated financial statements include the accounts of ALLIED Group, Inc. (the Company) and its subsidiaries. The consolidated financial statements have been prepared in conformity with generally accepted accounting principles (GAAP). The preparation of the 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 for the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. All significant intercompany balances and transactions have been eliminated. Certain amounts in the financial statements for prior years have been reclassified to conform to the current year's presentation. The Company's property-casualty segment operates through three subsidiaries: AMCO Insurance Company (AMCO), ALLIED Property and Casualty Insurance Company, and Depositors Insurance Company, which underwrite personal lines (primarily automobile and homeowners) and small commercial lines. Western Heritage Insurance Company is the excess & surplus lines subsidiary, which primarily underwrites commercial lines. The noninsurance subsidiaries are ALLIED Group Mortgage Company (ALLIED Mortgage), The Freedom Group, Inc., ALLIED Group Information Systems, Inc., Midwest Printing Services, Ltd., ALLIED General Agency Company, and Premier Agency, Inc. During 1997, the Board of Directors authorized a 3-for-2 stock split issuable November 28, 1997 to stockholders of record on November 14, 1997. All fractional shares were paid in cash. All weighted average shares outstanding, per share amounts, and references in the footnotes to share information have been restated retroactively to reflect the stock splits. At year-end 1997, the ALLIED Group Employee Stock Ownership Trust (ESOP Trust) owned 24.9% and ALLIED Mutual Insurance Company (ALLIED Mutual), an affiliated property-casualty insurance company, controlled 18.2% of the outstanding voting stock of the Company. Investments Investments in fixed maturities where there is the positive intent and ability to hold to maturity are classified as held to maturity and carried at cost adjusted for amortization of premium or discount. Amortization of premiums and discounts on mortgage-backed securities incorporates a prepayment assumption to estimate the securities' expected lives. Except for declines that are other than temporary, changes in fair value are not reflected in the financial statements. Investments in fixed maturities that may be sold prior to maturity and are not bought and held principally for the purpose of selling in the near term are segregated into an available for sale portfolio and are carried at fair value. Unrealized appreciation and depreciation of securities classified as available for sale are reported as accumulated other comprehensive income in stockholders' equity net of deferred income taxes. All of the Company's investments in fixed maturity securities were designated as available for sale at December 31, 1997, although the Company is not precluded from designating the securities as held to maturity at some future date. The carrying values of all investments in fixed maturities are reviewed for impairment on an ongoing basis. If this review indicates that a decline in fair value below cost is other than temporary, the Company's carrying value in the investment is reduced to its estimated realizable value and a specific write-down is taken. Such reductions in carrying value are recognized as realized losses and charged to income. Realized gains and losses on disposition of investments are based on specific identification of the investments sold. 37 Equity securities are carried at fair value with any unrealized appreciation and depreciation reported net of deferred income taxes as accumulated other comprehensive income in stockholders' equity. All short-term investments are recorded at cost, which approximates fair value. Property-casualty and Excess & Surplus Lines Premiums are recognized as revenue ratably over the terms of the respective policies. Unearned premiums are calculated on the monthly pro rata basis. Amounts paid for ceded reinsurance premiums are reported as prepaid reinsurance premiums and amortized over the remaining contract period in proportion to the amount of insurance protection provided. Premiums receivable from policyholders and agents are recorded at cost less an allowance for doubtful accounts. Policy acquisition costs such as commissions, premium taxes, and certain other underwriting and agency expenses that vary with and are directly related to the production of business have been deferred. Such deferred policy acquisition costs are being amortized as premium revenue is recognized. The method followed in computing deferred policy acquisitions costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, losses and loss adjusting expenses, and certain other costs expected to be incurred as the premium is earned. Liabilities for losses are based upon case-basis estimates of reported losses, estimates of unreported losses based upon prior experience adjusted for current trends, and estimates of losses expected to be paid under assumed reinsurance contracts. Liabilities for loss adjusting expenses are provided by estimating expenses expected to be incurred in settling the claims provided for in the loss reserve. Changes in estimates are reflected in current operating results (note 5). Ceded reinsurance amounts with nonaffiliated re-insurers relating to reinsurance receivables for paid and unpaid losses and loss adjusting expenses and prepaid reinsurance are reported on the balance sheets on a gross basis. Amounts ceded to ALLIED Mutual relating to the affiliated reinsurance pooling agreement and the property catastrophe reinsurance agreement have not been grossed up because the contracts provide that receivables and payables may be offset upon settlement. The liabilities for losses and loss adjusting expenses are considered adequate to cover the ultimate cost of losses and claims incurred to date net of estimated salvage and subrogation recoverable. Since the provisions are necessarily based on estimates, the ultimate liability may be more or less than such provisions. Noninsurance Operations Mortgage loans held for sale by ALLIED Mortgage are reported at the lower of cost or fair value on an aggregate basis. The fair value calculation includes consideration of all open positions, outstanding commitments from investors, related fees paid, and unrealized gains and losses from open options and financial futures contracts. Loan origination fees and certain direct costs related to loan origination are deferred and recognized at the time the related loans are sold. In the normal course of business, ALLIED Mortgage protects its position in mortgages by taking positions in options, futures, and cash markets. Market risk exists in the event of fluctuations in market prices on the unhedged portions of mortgage loans held for sale and outstanding commitments. ALLIED Mortgage recognizes as separate assets the rights to service mortgage loans for others, whether acquired through purchases or loan originations. Capitalized mortgage servicing rights are assessed periodically for impairment based on the fair value of those rights. ALLIED Mortgage stratifies its mortgage servicing portfolio on the basis of certain risk characteristics, including loan type and note rate, and determines fair value based upon the present value of estimated future cash flows. Impairment is recognized through a valuation allowance for each impaired stratum. The total valuation allowance for capitalized mortgage servicing rights was $3 million as of December 31, 1997 and $2.7 million at December 31, 1996. The fair value of capitalized mortgage servicing rights as of December 31, 1997 and 1996 was approximately $53.3 million and $44.8 million, respectively. Capitalized mortgage servicing rights are amortized over twelve years using the straight-line method, which management 38 believes approximates the realization of the related net servicing income. Amortization of servicing rights for the years ended December 31, 1997, 1996, and 1995 was $4.7 million, $5.4 million, and $4.7 million, respectively. Depreciation and Amortization Equipment and software are included in other assets at historic cost net of accumulated depreciation and amortization. For financial reporting purposes, depreciation and amortization are provided primarily on the straight-line basis over the estimated useful lives of the assets, ranging from two to seven years. Accelerated depreciation methods are utilized for income tax purposes. Stock Option Plans On January 1, 1996, the Company adopted Statement of Financial Accounting Standards (SFAS) 123, "Accounting for Stock-Based Compensation." SFAS 123 permits entities to recognize the fair value of stock options on the date of grant as compensation expense over the vesting period of such options. Alternatively, the standard allows entities to continue to apply the accounting provisions of Accounting Principles Board (APB) Opinion 25, "Accounting for Stock Issued to Employees," and related interpretations. Compensation expense then would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. The Company has elected to apply the accounting provisions of APB 25 and, as required by SFAS 123, provide pro forma net income and earnings per share disclosures for stock option grants made in 1995 and future years as if the fair-value-based method defined in SFAS 123 had been applied. The adoption of this statement had no effect on the Company's financial position, results of operations, or liquidity. Retirement Plan Costs The amount of compensation cost related to The ALLIED Group Employee Stock Ownership Plan (ESOP) is based on the cost of the shares allocated to participants plus interest expense incurred related to the debt of the ESOP reduced by dividends paid used to service the ESOP's debt (the shares allocated method). The income tax benefit for the tax deductible dividends paid on unallocated shares of the ESOP available for debt service is included as a direct addition to retained earnings. Income Taxes Deferred income taxes reflect the impact of temporary differences between the tax basis of assets and liabilities and the reported amounts of those assets and liabilities for financial reporting purposes. Deferred tax assets and liabilities are measured using enacted tax rates expected to be applicable to taxable income in the years in which the temporary differences are expected to be recovered or settled. Income tax expense provisions increase or decrease in the same period in which a change in tax rates is enacted. Minority Interest The minority interest in a subsidiary represents the minority common stockholders proportionate share of the net assets and the results of operations of the majority-owned mortgage banking subsidiary. Options exercised by key employees of the mortgage banking subsidiary resulted in a 20% ownership in the outstanding common stock of the subsidiary on January 2, 1997. No additional options are outstanding. The minority interest in the subsidiary was $2.1 million at December 31, 1997 and is included in other liabilities. This transaction did not have a material impact on the Company's financial position, results of operations, or liquidity. 39 Earnings per Share On December 31, 1997, the Company adopted the provisions of SFAS 128, "Earnings per Share." SFAS 128 specifies the computation, presentation, and disclosure requirements for earnings per share (note 17). SFAS 128 supersedes APB 15, "Earnings per Share," and required restatement of all prior period per share data. If APB 15 had prevailed, the Company would have reported fully diluted earnings per share of $2.03. Basic earnings per share are computed by dividing income available to common stockholders by the weighted average number of common shares outstanding. Diluted earnings per share are computed by dividing income available to common stockholders by the weighted average number of common shares and dilutive potential common shares outstanding. Securities that entitle their holders to obtain common stock during or after the reporting period (primarily stock options) are referred to as dilutive potential common shares. Cash Flows For purposes of reporting cash flows, changes in notes payable issued by ALLIED Mortgage to purchase mortgage loans held for sale are included in cash flows from operating activities. Other New Accounting Pronouncements On December 31, 1997, the Company adopted SFAS 130, "Reporting Comprehensive Income," and restated prior years' financial statements to conform to the reporting standard. SFAS 130 establishes standards for reporting and displaying comprehensive income and its components in a full set of general-purpose financial statements. Comprehensive income includes all changes in stockholders' equity during a period except those resulting from investments by owners and distributions to owners. The adoption of SFAS 130 resulted in revised and additional disclosures but had no effect on the financial position, results of operations, or liquidity of the Company. The Company also adopted SFAS 131, "Disclosures about Segments of an Enterprise and Related Information," on December 31, 1997 (note 18). SFAS 131 specifies the presentation and disclosure of operating segment information reported in the annual and interim reports issued to stockholders. SFAS 131 supersedes SFAS 14, "Financial Reporting for Segments of a Business Enterprise," and requires that segment information of earlier years be restated to conform to the new standard. The adoption of SFAS 131 resulted in revised and additional disclosures but had no effect on the financial position, results of operations, or liquidity of the Company. (2) Fair Value of Financial Instruments The estimated fair value amounts have been determined by using available market information and appropriate valuation methods. The estimates presented herein are not necessarily indicative of the amounts that would be realized in a current market exchange, and the use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The following methods and assumptions were used in estimating the fair value disclosures for financial instruments: Fixed maturities -- The estimated fair value is based upon the quoted market prices for the same or similar issues or from independent pricing services (note 3). Equity securities -- The estimated fair value is based upon the quoted market prices where available or from independent pricing services (note 3). Short-term investments -- Due to their short-term nature, their carrying amount approximates fair value. 40 Mortgage loans held for sale -- The fair value is estimated using quoted market prices and includes commitments to extend credit and forward sales commitments (note 14). Notes payable to affiliates and nonaffiliates -- Due to the short maturity of the short-term notes payable, carrying value approximates fair value. The fair value of the long-term notes payable is estimated using current rates available for similar issues (notes 4 and 8). Guarantee of ESOP obligations -- Due to its floating interest rate, the guarantee approximates its fair value (note 9). Interest rate swap agreement (derivative) -- The fair value reflects the estimated amount the Company would pay to terminate the contract at year-end, thereby taking into account the current unrealized gains or losses of the open contract. Dealer quotes are available for the Company's derivative (note 9). Other financial instruments -- Due to their short-term nature, their carrying amount approximates fair value. The following table presents the carrying value and estimated fair value of the financial instruments at December 31, 1997 and 1996.
Estimated Carrying fair value value ------------- ------------- (in thousands) 1997 Fixed maturities $ 818,216 $ 818,216 Equity securities 79,182 79,182 Short-term investments 10,846 10,846 Mortgage loans held for sale 29,521 29,621 Notes payable to nonaffiliates (51,038) (51,180) Notes payable to affiliates (5,900) (5,900) Guarantee of ESOP obligations (22,380) (22,380) 1996 Fixed maturities $ 792,268 $ 792,268 Equity securities 20,384 20,384 Short-term investments 6,993 6,993 Mortgage loans held for sale 12,054 12,115 Notes payable to nonaffiliates (31,744) (31,604) Notes payable to affiliates (2,350) (2,350) Guarantee of ESOP obligations (24,370) (24,370) Interest rate swap agreement --- (449)
The estimated fair values presented in the table are based on pertinent information available to management as of December 31, 1997 and 1996. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been revalued for purposes of these financial statements since those dates; current estimates of fair value may differ significantly from the amounts presented herein. 41 (3) Investments Following is a schedule of amortized costs and estimated fair values of investments in fixed maturities and equity securities as of December 31, 1997 and 1996. The estimated fair values for fixed maturities and equity securities are based on quoted market prices for the same or similar issues or from independent pricing services.
Gross Gross Estimated Amortized unrealized unrealized fair cost gains losses value ----------- ----------- ----------- ----------- (in thousands) 1997 Fixed maturities U.S. Treasury securities $ 55,578 $ 1,133 $ --- $ 56,711 U.S. government corporations and agencies 27,277 619 7 27,889 Obligations of states and political subdivisions 383,941 14,475 10 398,406 Foreign governments 2,036 48 --- 2,084 Corporate securities and public utilities 168,340 3,839 29 172,150 Mortgage-backed securities 154,773 6,255 52 160,976 ----------- ----------- ----------- ----------- $ 791,945 $ 26,369 $ 98 $ 818,216 =========== =========== =========== =========== Equity securities Common stock Public utilities $ 679 $ 122 $ 3 $ 798 Banks, trusts, and insurance companies 5,940 1,604 10 7,534 Industrial, misc., and all other 21,412 7,145 395 28,162 ----------- ----------- ----------- ----------- 28,031 8,871 408 36,494 Preferred stock 41,421 1,304 37 42,688 =========== ----------- ----------- ----------- Total $ 69,452 $ 10,175 $ 445 $ 79,182 =========== =========== =========== =========== 1996 Fixed maturities U.S. Treasury securities $ 61,557 $ 1,074 $ 9 $ 62,622 U.S. government corporations and agencies 27,453 480 13 27,920 Obligations of states and political subdivisions 327,487 9,613 379 336,721 Foreign governments 2,064 32 9 2,087 Corporate securities and public utilities 190,244 2,860 415 192,689 Mortgage-backed securities 166,361 4,049 181 170,229 ----------- ----------- ----------- ----------- $ 775,166 $ 18,108 $ 1,006 $ 792,268 =========== =========== =========== =========== Equity securities Common stock Public utilities $ 476 $ 11 $ 22 $ 465 Banks, trusts, and insurance companies 4,128 480 --- 4,608 Industrial, misc., and all other 10,679 2,240 202 12,717 ----------- ----------- ----------- ----------- 15,283 2,731 224 17,790 Preferred stock 2,597 9 12 2,594 ----------- ----------- ----------- ----------- Total $ 17,880 $ 2,740 $ 236 $ 20,384 =========== =========== =========== ===========
42 The following table presents the amortized cost and estimated fair value table of fixed maturities by contractual maturity at December 31, 1997. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations without call or prepayment penalties.
Estimated Amortized fair cost value ----------- ----------- (in thousands) Due in 1 year or less $ 23,268 $ 23,499 Due after 1 year through 5 years 305,807 314,202 Due after 5 years through 10 years 266,035 276,560 Due after 10 years 42,062 42,979 ----------- ----------- 637,172 657,240 Mortgage-backed securities 154,773 160,976 ----------- ----------- Totals $ 791,945 $ 818,216 =========== ===========
The following table presents the gross realized gains and losses by portfolio included in the proceeds from calls, principal reductions, and sales of fixed maturities for the years ended December 31, 1997, 1996, and 1995.
1997 1996 1995 ----------- ----------- ---------- (in thousands) Available for sale Gross realized gains $ 172 $ 406 $ 957 Gross realized losses (152) (1,022) (910) ----------- ----------- ---------- 20 (616) 47 ----------- ----------- ---------- Held to maturity Gross realized gains --- --- 54 Gross realized losses --- --- (1) ----------- ----------- ---------- --- --- 53 ----------- ----------- ---------- Net realized gains (losses) $ 20 $ (616) $ 100 =========== ============ ==========
As required by law, fixed maturities and short-term investments amounting to $12.5 million at December 31, 1997 and $10.5 million at year-end 1996 were on deposit with various insurance regulatory authorities. As of December 31, 1997 and 1996, there were no investments that were non-income producing for the previous twelve months. A summary of net investment income for the years ended December 31, 1997, 1996, and 1995 follows:
1997 1996 1995 ----------- ----------- ----------- (in thousands) Interest on fixed maturities $ 49,969 $ 48,770 $ 47,160 Dividends on equity securities 1,287 478 167 Interest on short-term investments 782 771 665 Equity earnings in unconsolidated subsidiaries 48 52 11 Other, net --- 703 20 ----------- ----------- ----------- Total investment income 52,086 50,774 48,023 Investment expense 812 705 584 Interest expense 150 847 197 ----------- ----------- ----------- Net investment income $ 51,124 $ 49,222 $ 47,242 =========== =========== ===========
43 A summary of net realized investment gains (losses) and net changes in unrealized appreciation (depreciation) of investments for the years ended December 31, 1997, 1996, and 1995 follows:
1997 1996 1995 ----------- ----------- ----------- (in thousands) Net realized investment gains (losses) Fixed maturities Available for sale $ 20 $ (616) $ 47 Held to maturity --- --- 53 Equity securities 371 45 405 Other investments (note 7) --- 620 --- ----------- ----------- ----------- 391 49 505 ----------- ----------- ----------- Net changes in unrealized appreciation (depreciation) of investments Fixed maturities Available for sale 9,169 (10,719) 36,063 Held to maturity --- --- 13,231 Equity securities 7,226 2,083 289 ----------- ----------- ----------- 16,395 (8,636) 49,583 ----------- ----------- ----------- Net realized investment gains (losses) and changes in unrealized appreciation (depreciation) of investments $ 16,786 $ (8,587) $ 50,088 =========== =========== ===========
(4) Transactions with Affiliates The property-casualty segment and ALLIED Mutual participate in a reinsurance pooling agreement. The pooling agreement provides that AMCO (pool administrator) assumes from the pool participants premiums, losses, allocated loss adjusting expenses, commissions, premium taxes, service charge income, and dividends to policyholders. The pool participants assume from AMCO an amount of this pooled property-casualty business equal to their participation in the pooling agreement. AMCO pays certain underwriting expenses, unallocated loss adjusting expenses, and premium collection expenses for all of the pool participants and receives a fee equal to a specified percentage of premiums as well as a performance fee based on the attainment of certain combined ratios from each of the pool participants. AMCO charges each of the participants 12.85% of written premiums for underwriting services, 7.25% of earned premiums for unallocated loss adjusting expenses, and 0.75% of earned premiums for premium collection services. The administrative fees are subject to renegotiation during the term of the agreement upon at least five years' notice. AMCO received pool administrative fees of $66.8 million, $61.3 million, and $55.7 million from ALLIED Mutual in 1997, 1996, and 1995, respectively. In 1997, the Company also received a performance fee of $4.2 million from ALLIED Mutual. The pooling agreement extends through December 31, 2004 and may be terminated after such date upon notice. Changes to the pooling agreement must be approved by the coordinating committee of the Board of Directors. Pursuant to the terms of the Intercompany Operating Agreement, the Company leases employees to its subsidiaries and ALLIED Mutual and certain of its subsidiaries. Each company that leases employees is charged a fee based upon costs incurred for salaries, related benefits, taxes, and expenses associated with the employees it leases. For the years ended December 31, 1997, 1996, and 1995, the Company received revenues of $2.6 million, $2.5 million, and $2.5 million, respectively, for employees leased to affiliates. The Intercompany Operating Agreement between the Company and ALLIED Mutual also provides for the continued availability of office space, marketing services, agency forces, and computer and other facilities. Expenses are charged to the Company based on specific identification, or, if undeterminable, the expenses are allocated on the basis of cost and time studies that are updated annually. The agreement extends through December 31, 2004 and may be terminated after such date by either ALLIED Mutual or the Company upon two years notice. Included in income from affiliates are revenues of $2.5 million, $2.4 million, and $2.8 million for the years ended December 31, 1997, 1996, and 1995, respectively, relating to data processing services provided by subsidiaries of the Company to ALLIED Mutual and its subsidiaries under a Management Information Services Agreement. Effective March 1, 1996, the agreement was amended and personnel previously providing computer-related services to a certain affiliate were employed by the affiliate. Fees paid for services provided by such personnel are now paid directly by the affiliate. 44 ALLIED Mutual participated with a nonaffiliated reinsurance company in a property catastrophe reinsurance agreement to cover the property-casualty segment's share of the pooled losses. ALLIED Mutual's participation in the agreement was 90%. Premiums paid by the property-casualty segment to ALLIED Mutual were $2.9 million, $2.7 million, and $2.3 million in 1997, 1996, and 1995, respectively. There were recoveries from ALLIED Mutual of $2 million, $3.4 million, and $2.6 million in 1997, 1996, and 1995, respectively. All expenses incurred on the Company's behalf by its affiliates have been reflected in the accompanying financial statements. Management believes the costs incurred by its affiliates and allocated to the Company are reasonable and would not be materially different than if they had been incurred from a third party nonaffiliate. During the normal course of business the aforementioned transactions result in intercompany balances that are created and are settled on a monthly basis. The Company and its affiliates deposit their excess cash into a short-term investment fund. The fund was established to concentrate short-term cash in a single account to maximize yield. AID Finance Services, Inc., a wholly owned subsidiary of ALLIED Mutual, is the administrator of the fund. At December 31, 1997 and 1996, the Company had $8.3 million and $3.4 million, respectively, invested in the fund. The Company also had several unsecured short-term notes payable to the fund at December 31, 1997 that totaled $5.9 million; the interest rate on each was 8.8%. At December 31, 1996, the Company had three unsecured notes totaling $2.4 million payable to the investment fund. The Company paid interest to affiliates of $424,000, $270,000, and $127,000 in 1997, 1996, and 1995, respectively. (5) Losses and Loss Adjusting Expenses The following table sets forth the reconciliation of beginning and ending reserves for losses and loss adjusting expenses for the years indicated. Reinsurance recoverables on unpaid losses and loss adjusting expenses are included on the consolidated balance sheets within reinsurance receivables for losses and loss adjusting expenses. The following table includes property-casualty and excess & surplus lines reserves for losses and loss adjusting expenses.
Year ended December 31, 1997 1996 1995 ----------- ----------- ----------- (in thousands) Reserves for losses and loss adjusting expenses at beginning of year $ 362,191 $ 341,864 $ 310,996 Less reinsurance recoverables 15,528 16,925 18,322 ----------- ----------- ----------- Net reserves for losses and loss adjusting expenses at beginning of year 346,663 324,939 292,674 ----------- ----------- ----------- Incurred losses and loss adjusting expenses Provision for insured events of current year 379,952 353,675 315,956 (Decrease) increase in provisions for insured events of prior years (1,853) (680) 1,984 ----------- ----------- ----------- Total incurred losses and loss adjusting expenses 378,099 352,995 317,940 ----------- ----------- ----------- Payments Losses and loss adjusting expenses attributable to insured events of current year 216,920 194,735 169,254 Losses and loss adjusting expenses attributable to insured events of prior years 147,849 136,536 116,421 ----------- ----------- ----------- Total payments 364,769 331,271 285,675 ----------- ----------- ----------- Net reserves for losses and loss adjusting expenses at end of year 359,993 346,663 324,939 Plus reinsurance recoverables 18,033 15,528 16,925 ----------- ----------- ----------- Reserves for losses and loss adjusting expenses at end of year $ 378,026 $ 362,191 $ 341,864 =========== =========== ===========
45 The reserving process relies on the basic assumption that past experience, adjusted for current developments and likely trends, is an appropriate basis for predicting future events. Reserve amounts are necessarily based on management's informed estimates; as other data become available and are reviewed, these estimates and judgments are revised, resulting in increases and decreases to existing reserves. As a result of changes in estimates of insured events in prior years, the provision for losses and loss adjusting expenses decreased $1.9 million in 1997, decreased $680,000 in 1996, and increased $2 million in 1995. Development for losses and loss adjusting expenses on prior years is immaterial to the financial statements taken as a whole. In establishing reserves, management considers exposure the Company may have to environmental claims. Because reported claim activity levels are minimal and the emphasis of the property-casualty business is primarily on personal lines and small commercial business, management believes exposure to material liability on such claims to be remote as of December 31, 1997. The Company routinely reviews its overall reserve position and reserving techniques as they relate to its exposure to environmental claims. (6) Reinsurance In the ordinary course of business, the property-casualty and excess & surplus lines subsidiaries cede insurance to other insurers for the purpose of limiting their maximum loss exposure through diversification of their risks. See note 4 for discussion of reinsurance contracts with ALLIED Mutual. Reinsurance contracts do not relieve the Company's insurance subsidiaries from their obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to the Company's insurance subsidiaries; consequently, allowances are established for amounts deemed uncollectible. Management evaluates the financial condition of the reinsurers and monitors concentrations of credit risk arising from similar geographic regions, activities, or economic characteristics of the reinsurers to minimize exposure to significant losses from reinsurer insolvencies. As of December 31, 1997, reinsurance receivables and prepaid reinsurance premiums associated with three nonaffiliated reinsurers aggregated approximately $16.4 million, which represented a significant portion of the total prepaid reinsurance premiums and reinsurance receivables for losses and loss adjusting expenses. The property-casualty subsidiaries also assume insurance as members of various pools and associations. The effect of reinsurance on premiums written and earned and losses and loss adjusting expenses incurred for the years ended December 31, 1997, 1996, and 1995 was as follows:
1997 1996 1995 ------------ ------------ ----------- (in thousands) Direct written premiums $ 638,997 $ 568,277 $ 494,462 Assumed from nonaffiliates 5,461 6,536 8,572 Net ceded to ALLIED Mutual (47,840) (26,639) (6,151) Ceded to nonaffiliates (30,883) (31,568) (25,439) ------------ ------------ ----------- Net written premiums $ 565,735 $ 516,606 $ 471,444 ============ ============ =========== Direct earned premiums $ 611,415 $ 534,738 $ 472,407 Assumed from nonaffiliates 5,630 7,231 8,831 Net ceded to ALLIED Mutual (39,591) (17,933) (703) Ceded to nonaffiliates (29,857) (30,511) (25,036) ------------ ------------ ----------- Net earned premiums $ 547,597 $ 493,525 $ 455,499 ============ ============ =========== Direct losses and loss adjusting expenses $ 427,909 $ 398,748 $ 335,779 Assumed from nonaffiliates 5,285 4,239 5,889 Net ceded to ALLIED Mutual (37,365) (37,957) (14,648) Ceded to nonaffiliates (17,730) (12,035) (9,080) ------------ ------------ ----------- Net losses and loss adjusting expenses incurred $ 378,099 $ 352,995 $ 317,940 ============ ============ ===========
46 (7) Dispositions During 1996, the Company received $620,000 as the final settlement on the 1994 sale of its investment in a savings and loan holding company. The payment represents the Company's share of the contingent purchase price held by the buyer until all known claims were settled. (8) Notes Payable to Nonaffiliates The short-term notes payable to nonaffiliated companies include line of credit agreements used by ALLIED Mortgage primarily to finance its mortgage loans held for sale. At December 31, 1997 and 1996, ALLIED Mortgage had borrowed $39 million and $19.7 million, respectively, under mortgage loan warehousing agreements with three different commercial banks. Two of the agreements expire in May and June of 1998 and the third in May of 1999. Under the terms of the agreements, ALLIED Mortgage can borrow up to the lesser of $67 million or 98% of the mortgage credit borrowing base, which includes related sublines. At December 31, 1997, the outstanding borrowings of ALLIED Mortgage under these line of credit agreements were secured by mortgage loans held for sale of $29.5 million, mortgage servicing rights on loans with a principal balance of $2.9 billion, and foreclosure loans of $5.2 million. Interest rates applicable to these borrowing arrangements vary with the level of investable deposits maintained at the respective commercial banks. ALLIED Mortgage entered into an agreement with a life insurance company for $15 million of 8.4% senior secured notes due September 1, 2004. The notes are secured by mortgage servicing rights and are payable in equal annual installments of $1.5 million every September 1; interest is payable semiannually. At December 31, 1997 and 1996, the outstanding balance was $10.5 million and $12 million, respectively. The Federal Home Loan Bank of Des Moines provides a $3 million committed credit facility through a line of credit agreement with AMCO that expires February 27, 1998. Interest on any outstanding borrowings is payable at an annual rate equal to the federal funds unsecured rate for federal reserve member banks, which was 5.8% as of December 31, 1997. The Company had an outstanding balance of $1.5 million as of December 31, 1997 and no outstanding balance as of December 31, 1996. The Company paid interest to nonaffiliates of $1.2 million, $1.5 million, and $1.6 million in 1997, 1996, and 1995, respectively. (9) Guarantee of ESOP Obligations On July 12, 1990, the ESOP Trust issued Remarketed Floating Rate Notes (FRN) totaling $35 million with a final maturity of July 12, 2005. The proceeds from the FRN were used to acquire Series A ESOP Convertible Preferred Stock. During 1995, the ESOP Trust refinanced its $28.2 million of FRN under the terms of a Term Credit Agreement and Guaranty (Credit Agreement) with two separate commercial banks. The loans mature July 12, 2005, and interest rates applicable to the borrowings are adjusted at the beginning of each interest period. The interest periods may be one, three, or six months at the discretion of the ESOP Trust. The Company has guaranteed on an unsecured basis the ESOP Trust's reimbursement obligations under the Credit Agreement. The guarantee has been recorded in the consolidated balance sheets as a liability under the caption, "Guarantee of ESOP obligations." At December 31, 1997 and 1996, the Company had an outstanding guarantee of principal of $22.4 million and $24.4 million, respectively. Contributions to the ESOP Trust plus dividends on leveraged shares held by the ESOP Trust are used to meet interest and principal payments on the notes. As principal payments are made, the recorded ESOP guarantee is reduced. The Company was party to an interest rate swap agreement with a broker-dealer to reduce the financial statement impact of fluctuations in the Credit Agreement interest rate. The interest rate swap agreement expired on December 12, 1997. The interest rate swap involved the exchange of fixed and floating rate interest payments without the exchange of the underlying principal amount. During 1997, the Credit Agreement interest rates ranged from 6% to 6.3%. During 1996 and 1995, they ranged from 6% to 6.6% and from 6% to 6.8%, respectively. The Credit Agreement includes various financial and operating covenants with which the Company must comply. The covenants include the maintenance of certain contractual relationships with ALLIED Mutual, continued ownership of certain subsidiaries, limitations on the issuance of security interests in certain assets, maintenance of various financial ratios, and minimum net equity requirements. 47 (10) Preferred Stock The Company is authorized to issue 7,500,000 shares of preferred stock without par value. The preferred stock may be issued from time to time by the Board of Directors in one or more series with such dividend rights, conversion rights, voting rights, redemption provisions, liquidation preferences, and other rights and restrictions as the Board of Directors may determine. 6-3/4% Series The 6-3/4% Series preferred stock (6-3/4% Series), issued to ALLIED Mutual at a value of $28.50 per share, is perpetual, nonconvertible, voting, and cumulative with respect to dividends. The 6-3/4% Series has no preemptive rights and is not registered or traded. Upon any transfer by ALLIED Mutual, the 6-3/4% Series is callable under certain conditions and becomes nonvoting. Each share of the 6-3/4% Series has 3-3/8 votes. The annual dividend rate is 6-3/4% of the liquidation preference of $28.50 ($1.92 per share) and is payable quarterly. The Company entered into a Stock Rights Agreement with ALLIED Mutual to grant both parties certain rights in terms of registration, transfer, voting, board nominations, and other matters. Pursuant to the Stock Rights Agreement executed July 5, 1990, ALLIED Mutual is entitled to nominate for election to the Company's Board of Directors a number of director nominees that most closely approximates the same percentage of the total number of members of the Company's Board of Directors as is equal to ALLIED Mutual's percentage ownership of the total number of shares of the Company voting stock. ESOP Series On March 7, 1996, the commercial bank acting on behalf of the ESOP participants as the trustee for the ESOP Trust (Trustee) converted all of its shares of ESOP Convertible Preferred Stock (ESOP Series) to shares of common stock. (11) Common Stock The Company has reserved 3,037,500 shares of common stock to be issued through the ALLIED Group, Inc. Dividend Reinvestment and Stock Purchase Plan. Any stockholder of record may participate in the plan and have cash dividends reinvested in additional shares of common stock. The plan also provides for optional cash payments. During 1997, 62,174 shares, purchased on the open market, were issued at a weighted average price per share of $26.35. During 1996 and 1995, 92,171 and 96,087 shares, purchased on the open market, were issued at a weighted average price per share of $17.65 and $13.34, respectively. At December 31, 1997, 1,256,277 shares were available for issuance. The Company has reserved 562,500 shares of common stock for issuance under the ALLIED Life Employee Stock Purchase Plan. The Company receives fair market value for the shares issued under the plan. During 1997, 1,242 shares were issued at a weighted average price per share of $25.81. During 1996 and 1995, 834 and 4,512 shares were issued at a weighted average price per share of $17.81 and $12.78, respectively. At December 31, 1997, 555,113 shares were available for issuance. During 1997, the Company canceled 412,850 shares of its common stock repurchased on the open market at an average cost of $24.71 per share. During 1996, the Company canceled 996,750 shares of its common stock repurchased on the open market at an average cost of $16.58 per share. No shares were repurchased in 1995. As of December 31, 1997, the ESOP Trust was the holder of 9,146,633 shares, or 30% of the Company's common stock. The Trustee is entitled to vote the shares held in the ESOP Trust on all matters submitted to a vote of the holders of the common stock of the Company. The ESOP Trust generally provides that each ESOP participant is entitled to direct the Trustee how to vote (or whether to tender or exchange) the shares allocated to the participant's account. During 1997, the ESOP Trust purchased 18,865 common shares at an average price per share of $28.62. During 1996, 2,992,710 ESOP Series shares were converted to 10,100,396 shares of common stock and the ESOP Trust purchased 36,572 shares at an average price per share of $21.93. During 1995, 174,960 ESOP Series shares were converted to 590,490 shares of common stock. The dividend rate per common share was $0.46, $0.39, and $0.30 for 1997, 1996, and 1995, respectively. 48 (12) Stock-based Compensation Plans The Company has granted stock options to key employees under four nonqualified plans as defined by the Internal Revenue Service: the ALLIED Group, Inc. Restated and Amended Stock Option Plan (Option Plan), the ALLIED Group, Inc. Nonqualified Stock Option Plan (Nonqualified Plan), the ALLIED Group Executive Equity Incentive Plan (Equity Plan), and the Freedom Group Incentive Plan (Freedom Plan). No options remain to be granted under the plans. During 1997, all Freedom Plan options were exercised; during 1996, all Equity Plan options were exercised. Upon exercise of the stock options under each plan, the Company receives an amount equal to the common stock's fair market value at the grant date. The options vest at various times and must be exercised ten years after the date of grant. In addition, the Company has reserved 1,350,000 shares of common stock for issuance to key employees under the ALLIED Group, Inc. Long-Term Management Incentive Plan (Incentive Plan). Under the Incentive Plan, shares of common stock are available for grant until December 31, 2003 as incentive and nonqualified stock options (collectively, Options), SARs, and restricted stock. Options, SARs, and restricted stock granted prior to November of 1996 begin to vest two years after the date of grant; those granted after November of 1996 begin to vest three years after the date of grant. Options, SARs, and restricted stock prices are based upon the fair market values as of the date of grant. The following table summarizes information about stock options outstanding at December 31, 1997:
Weighted average ---------------------- Weighted Exercise price Remaining average Compensation range per Options contractual Exercise Options exercise plan share outstanding life price exercisable price - ------------------ --------------- ----------- ----------- -------- ----------- -------- Option Plan $ 9.39 - 12.94 306,853 5.7 $11.41 145,126 $11.07 Nonqualified Plan 12.22 - 12.94 114,824 6.9 12.38 6,550 12.94 Incentive Plan 10.78 - 30.84 575,842 7.9 17.72 20,801 12.29 ----------- ----------- 997,519 172,477 =========== ===========
A summary of stock option activity and prices for 1997, 1996, and 1995 is presented below:
1997 1996 1995 --------------------- -------------------- --------------------- Weighted Weighted Weighted average average average exercise exercise exercise Stock options Shares price Shares price Shares price - --------------------------- --------- --------- --------- -------- --------- -------- Outstanding at beginning of year 931,056 $12.67 851,034 $10.71 904,869 $ 7.75 Granted 240,000 25.26 193,500 17.98 292,500 12.25 Exercised (173,537) 9.69 (113,478) 7.14 (308,259) 4.18 Canceled --- --- --- --- (38,076) 4.97 --------- --------- --------- -------- --------- ------- Outstanding at end of year 997,519 $16.09 931,056 $12.67 851,034 $10.71 ========= ========= ========= ======== ========= ======= Options exercisable at end of year 172,477 154,517 105,686 ========= ========= ========= Weighted average fair value of options granted during the year $ 7.79 $ 6.13 $ 4.61 ========= ========= =========
49 The issuance of SARs and restricted stock under the Incentive Plan reduces the number of options available for future issuance. During 1997 SARs or restrictive stocks were issued. During 1996 and 1995, 9,581 and 29,951 shares of restricted stock were awarded at $19.17 per share and $12.17 per share, respectively. During 1997 and 1996, the restriction was lifted on 11,137 and 2,359 shares, respectively. During 1997, 1996, and 1995, the number of restricted shares forfeited was 3,819, 260, and 914, respectively. At December 31, 1997, 24,577 restricted shares were outstanding. The following table presents SAR activity and prices for the years ended December 31, 1997, 1996, and 1995:
Weighted Number average SARs of shares price ------------------------------------------- --------------- ----------- Outstanding at January 1, 1995 18,000 $ 10.82 Granted 17,252 12.28 Exercised (2,250) 10.78 -------- Outstanding at December 31, 1995 33,002 11.59 Granted 19,125 17.89 Exercised (2,813) 10.87 -------- Outstanding at December 31, 1996 49,314 14.02 Exercised (10,202) 12.24 -------- Outstanding at December 31, 1997 39,112 $ 14.56 ========
The Company has reserved 1,687,500 and 843,750 shares of common stock for issuance under the ALLIED Group, Inc. Employee Stock Purchase Plan (ESPP) and the ALLIED Group, Inc. Outside Director Stock Purchase Plan (DSPP), respectively. Under the plans, participants pay 85% of the fair market value of the shares issued, which are fully vested on the dates purchased. During 1997, 56,564 shares were issued at a weighted average price per share of $22.83. During 1996 and 1995, 62,447 and 69,065 shares were issued at a weighted average price per share of $14.62 and $11.39, respectively. At December 31, 1997, 526,483 and 789,763 shares were available for issuance under the ESPP and DSPP, respectively. During 1997, the Company reserved 750,000 shares of common stock for issuance semiannually under the ALLIED Group, Inc. Agency Stock Purchase Plan (ASPP). Eligible agencies and agents pay 90% of the fair market value of the shares issued, which are fully vested on the dates purchased. During 1997, 128,703 shares were issued at an average price per share of $26.20. At December 31, 1997, 621,297 shares were available for issuance under the ASPP. The Company applies APB 25 in accounting for its stock-based compensation plans, as permitted by SFAS 123. Accordingly, no compensation cost for the Company's stock option plans has been recognized in the accompanying financial statements. Compensation cost of $690,000, $386,000, and $167,000 was recognized in 1997, 1996, and 1995, respectively, under the Company's DSPP and ASPP and from the SARs. Had compensation cost been determined based on the fair value at the grant date of the stock option plans in accordance with SFAS 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts presented in the following table:
Basic Diluted Net earnings earnings income per share per share --------- --------- --------- (in thousands, except per share data) 1997 As reported $ 65,436 $ 2.03 $ 2.01 Pro forma 64,443 2.01 1.99 1996 As reported $ 51,084 $ 1.61 $ 1.51 Pro forma 50,624 1.58 1.50 1995 As reported $ 52,377 $ 2.18 $ 1.54 Pro forma 52,140 2.15 1.54
50 The pro forma amounts presented are not necessarily indicative of future amounts; SFAS 123 does not apply to awards granted prior to 1995. Therefore, the full impact of calculating comprehensive cost for stock options under SFAS 123 is not reflected in the pro forma amounts presented above because compensation cost is reflected over the options' vesting periods and grants awarded prior to 1995 are not considered. The fair value of each option is estimated on the date of grant using the Black-Scholes option-pricing model. The following table shows weighted average assumptions for grants in 1997 and 1996:
Risk-free Dividend interest Expected Expected Plans yield rate volatility life (yrs) --------------------------------- -------- --------- ---------- --------- 1997 Incentive 2.0% 6.3% 22.4% 7.0 1996 Incentive 2.0% 6.2% 32.8% 5.5 1995 Option and Nonqualified 2.0% 7.2% 31.7% 7.0 Incentive 2.0 7.1 33.4 5.5
(13) Retained Earnings In 1997, 1996, and 1995, the Company paid dividends of $17.5 million, $16.3 million, and $13.5 million, respectively. Retained earnings of the property-casualty and excess & surplus lines subsidiaries available for distribution as dividends are limited by law to the amount of statutory unassigned surplus as of the date a dividend is authorized or paid. The maximum amount legally available for distribution in 1997 without regulatory approval is $58.5 million. The following table includes selected information for the insurance subsidiaries as determined in accordance with accounting practices prescribed or permitted by insurance regulatory authorities:
As of December 31, 1997 1996 - --------------------------------------- ------------- ------------- (in thousands) Statutory capital and surplus Property-casualty $ 335,694 $ 285,854 ============= ============= Excess & surplus lines $ 40,501 $ 33,478 ============= =============
Year ended December 31, 1997 1996 1995 - --------------------------------------- ------------- ------------- ------------- (in thousands) Statutory net income Property-casualty $ 53,436 $ 47,492 $ 41,995 ============= ============= ============= Excess & surplus lines $ 7,056 $ 5,669 $ 2,773 ============= ============= =============
51 (14) Commitments and Contingencies Commitments The Company and its subsidiaries lease data processing equipment and certain office facilities under operating leases expiring in various years through 2003. Rental expense amounted to $3.9 million, $3.2 million, and $2.6 million for the years ended December 31, 1997, 1996, and 1995, respectively. At December 31, 1997 future minimum lease payments under noncancelable operating leases amounted to $13.5 million; they will amount to $2.7 million in 1998, $2.8 million in 1999, $1.4 million in 2000, $768,000 in 2001, $782,000 in 2002, and $5 million in later years. In the normal course of business, ALLIED Mortgage grants mortgage loan commitments to borrowers, subject to normal loan underwriting standards. As of December 31, 1997, ALLIED Mortgage had granted loan commitments of approximately $91.6 million, including floating rate commitments of $25.5 million. ALLIED Mortgage may enter into options, futures, or cash delivery contracts to reduce interest risk on certain mortgage loans held for sale and loan commitments. As of December 31, 1997, ALLIED Mortgage had cash delivery contracts to sell mortgage securities totaling approximately $69.8 million and had no outstanding options or future contracts. In connection with its commitments to buy and sell mortgages, ALLIED Mortgage is exposed to credit risk in the event the counterparty is unable to fulfill its contractual obligations. Although loans serviced for others are not on the accompanying balance sheets, ALLIED Mortgage has credit risk associated with the mortgage servicing portfolio. As the loan servicer, ALLIED Mortgage is required to process delinquent loans through the foreclosure process, thereby incurring certain direct expenses which generally are, but may not be, reimbursed. At December 31, 1997, ALLIED Mortgage had sold loans totaling approximately $12.9 million while retaining recourse risk. ALLIED Mortgage established allowances for losses in connection with these various risks. These allowances are included in other liabilities on the accompanying balance sheets. Contingencies California has been the source of approximately 25% of the pool's direct written premiums for the past ten years. Proposition 103, approved by California voters in 1988, provides for a rollback of rates on premiums collected in calendar year 1989 to the extent that the insurer's return on equity for each Proposition 103 line exceeded 10%. The rollback liability, if any, has not been finalized. Management of the Company continues to believe that the insurance subsidiaries will not be liable for any material rollback of premiums. The Company is party to various lawsuits arising in the normal course of business. Management believes the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations. On December 31, 1997, a complaint was filed by Mary M. Rieff, a policyholder of ALLIED Mutual in the Iowa District Court in and for Polk County, Iowa, against the Company and certain other individuals who are or were officers and/or directors of ALLIED Mutual and the Company. The complaint, an alleged policyholder derivative action brought on behalf of ALLIED Mutual, asserts, among other things, (a) that the defendants were responsible for the inappropriate transfer of ALLIED Mutual's corporate assets, the seizure of certain corporate opportunities, and the implementation of an improper de facto demutualization without informing or compensating policyholders or receiving the appropriate approval from regulatory authorities; (b) that this allegedly wrongful demutualization began on or about January 1, 1985 and was accomplished through transfers of ALLIED Mutual's assets to the Company and to the individual defendants for inadequate consideration; (c) that the individual defendants breached fiduciary duties owed to ALLIED Mutual, wasted its corporate assets and intentionally interfered with its contracts, prospective business advantage and business relationships; and (d) that defendants improperly transferred substantial ownership of and control over the Company and ALLIED Mutual's insurance business. The complaint further asserts that as a result of the foregoing, ALLIED Mutual and its policyholders have suffered damages in excess of $500 million. The complaint requests an accounting of the assets allegedly wrongfully transferred to the Company and compensation to ALLIED Mutual for the value of such assets, for the seizure of corporate opportunities, and for the de facto demutualization of ALLIED Mutual. The complaint also asks for certain other relief, including attorneys' fees and costs, equitable relief and interest, and restitution for any assets wrongfully transferred or conveyed. The Company believes that the suit is without merit and intends to defend this action vigorously. As is the case in all pending actions, the ultimate outcome is uncertain. 52 (15) Employee Benefit Plans Retirement Plan The ESOP established by the Company covers all of its employees who meet age and service requirements. Shares of common stock are allocated annually to each employee's account pursuant to a formula and held in trust until the employee's termination, retirement, or death. As shares of common stock are allocated to parti- cipants, the cost of such shares is expensed and deducted from unearned compensation related to ESOP included in stockholders' equity. The Company's ESOP expense was $2.4 million in 1997, $1 million in 1996, and $2.7 million in 1995. Of those respective amounts, $44,000, $14,000, and $65,000 were included in the employee lease fee received from affiliates pursuant to the terms of the Intercompany Operating Agreement for the years ended December 31, 1997, 1996, and 1995, respectively. During 1997, 1996, and 1995, the ESOP Trust received $3.6 million, $3.5 million, and $2.8 million, respectively, from dividends on the leveraged shares used to service debt on the ESOP obligations and to purchase stock for participants. The Company made ESOP contributions of $312,000 in 1997, $529,000 in 1996, and $733,000 in 1995. Interest incurred on the ESOP debt, which is included as a component of ESOP expense, was $1.5 million, $1.6 million, and $1.8 million in 1997, 1996, and 1995, respectively. The ESOP shares as of December 31, 1997 and 1996 were as follows:
1997 1996 ------------- ------------ Allocated shares 4,783,464 4,318,791 Unallocated shares 4,363,167 5,404,544 ------------- ------------ Total ESOP shares 9,146,631 9,723,335 ============= ============
In 1997, the Company and the ESOP Trustee entered into an agreement whereby the Company agreed to release additional shares held by the ESOP Trustee in the event the Company pays a dividend on the common stock of less than $0.09 per share per quarter on a post-split basis. The agreement is in effect from March 7, 1997 through March 7, 2000. The purpose of the agreement is to ensure that the allocated shares in the ESOP Trust receive at least the same amount of dividends that would have been paid on the ESOP Convertible Preferred Stock had it not been converted to common stock. Other Postretirement Benefit Plan In addition to the ESOP, the Company sponsors a health care plan that provides postretirement medical benefits to full-time employees who meet age and service requirements. The plan is contributory with retiree contributions adjusted annually, and contains other cost-sharing features such as deductibles and coinsurance. The Company's policy is to fund the cost of medical benefits in amounts determined at the discretion of management. The following table presents the plan's postretirement benefit obligations as of December 31, 1997 and 1996 reconciled with the plan's funded status and the amount recognized in the Company's consolidated balance sheets:
1997 1996 ------------ ------------ (in thousands) Accumulated postretirement benefit obligation Retirees $ (4,130) $ (3,520) Other fully eligible plan participants (690) (680) Other active plan participants (2,780) (2,700) ------------ ------------ (7,600) (6,900) Plan assets --- --- ------------ ------------ Funded status (7,600) (6,900) Unrecognized transition obligation 3,620 3,860 Unrecognized net loss 440 230 Fourth-quarter payments 110 80 ------------ ------------ Accrued postretirement benefit liability $ (3,430) $ (2,730) ============ ============
53 A 7.5% weighted average discount rate was used to determine the accumulated postretirement benefit obligation at December 31, 1997 and 1996. Net periodic postretirement benefit cost for the years ended December 31, 1997, 1996, and 1995 included the following:
1997 1996 1995 ----------- ----------- ----------- (In thousands) Service cost $ 380 $ 340 $ 350 Interest cost 500 460 420 Return on assets --- --- --- Amortization of transition obligation 240 240 240 ----------- ----------- ----------- Net periodic postretirement benefit cost $ 1,120 $ 1,040 $ 1,010 =========== =========== ===========
For measurement purposes, an 7% annual rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) was assumed for 1998; the rate was assumed to decrease in equal annual increments to 5% by the year 2000 and to remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation by approximately $540,000 and the aggregate of the service and interest cost components of net periodic postretirement benefit cost by approximately $40,000. (16) Income Taxes Total income taxes for the years ended December 31, 1997, 1996, and 1995 were allocated as follows:
1997 1996 1995 ----------- ------------ ------------ (in thousands) Net income $ 25,973 $ 20,277 $ 21,471 ----------- ------------ ------------ Stockholders' equity Unrealized appreciation (depreciation) of investments 5,780 (3,000) 12,776 Tax-deductible dividends paid on unallocated ESOP Series shares (909) (989) (849) Tax-basis compensation expense in excess of amounts recognizedfor financial reporting purposes from the exercise of stock options (1,007) (371) (1,064) ----------- ----------- ------------ 3,864 (4,360) 10,863 ----------- ----------- ------------ Total $ 29,837 $ 15,867 $ 32,334 =========== =========== ============
54 The tax effects of temporary differences that gave rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1997 and 1996 relate to the following:
1997 1996 ------------ ----------- (in thousands) Deferred tax assets Loss and loss adjusting expense reserve discounting $ 13,808 $ 14,258 Unearned premium reserve 16,163 14,893 Accrued employee benefits 3,250 2,858 Other 2,561 1,314 ------------ ----------- Total gross deferred tax assets 35,782 33,323 Less valuation allowance --- --- ------------ ----------- Net deferred tax assets 35,782 33,323 ------------ ----------- Deferred tax liabilities Deferred policy acquisition costs (17,743) (16,335) Mortgage servicing rights (4,939) (4,533) Unrealized appreciation of investments (12,687) (6,907) Deferred software development costs and fees (2,761) (4,886) Other (3,167) (2,906) ------------ ----------- Total gross deferred tax liabilities (41,297) (35,567) ------------ ----------- Net deferred tax liabilities $ (5,515) $ (2,244) ============ ===========
Since the adoption of SFAS 109, there has not been a valuation allowance for deferred income tax assets. In assessing the realization of deferred tax assets, management considers whether it is more likely than not that the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the recognition of future taxable income during the periods in which those temporary differences become deductible. Management considers tax planning strategies and the scheduled reversal of deferred tax liabilities in making this assessment and believes it is more likely than not the Company ultimately will realize the benefits of the deductible differences recognized at December 31, 1997. The actual income tax expense for the years ended December 31, 1997, 1996, and 1995 differed from the expected tax expense (computed by applying the federal corporate tax rate of 35% to income before income taxes). The difference was primarily a result of investment income exempt from federal income tax, which decreased tax expense by $5.5 million, $4.7 million, and $4.5 million in 1997, 1996, and 1995, respectively. Included in income tax expense is a state income tax benefit of $84,000 for the year ended December 31, 1997 and state income tax expense of $55,000 and $402,000 for the years ended December 31, 1996, and 1995, respectively. The Company paid federal and state income taxes of $26.2 million, $18 million, and $19.1 million in 1997, 1996, and 1995, respectively. The IRS is currently examining the 1995 and 1996 income tax returns. Any proposed adjustments are not expected to have a material impact on the Company's financial condition, results of operations, or liquidity. 55 (17) Earnings per Share Presented in the following table is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computation for the three years ended December 31, 1997, 1996, and 1995:
Basic earnings per share Dilutive earnings per share ------------------------------------- --------------------------------------------------- Income Dilutive Income available to ESOP(1) Stock(2) potential available to Net Preferred common Series if options in common common income dividends stockholders converted subsidiaries shares stockholders --------- --------- ------------ --------- ------------ --------- ------------ 1997 Income $ 65,436 $ (3,515) $ 61,921 --- --- --- $ 61,921 Weighted average shares outstanding 30,487 --- 30,487 --- --- 325 30,812 ------------ ------------ Earnings per share $ 2.03 $ 2.01 ============ ============ 1996 Income $ 51,084 $ (4,111) $ 46,973 $ 595 $ (470) --- 47,098 Weighted average shares outstanding 29,112 --- 29,112 1,838 --- 193 31,143 ------------ ------------ Earnings per share $ 1.61 $ 1.51 ============= ============ 1995 Income $ 52,377 $ (7,217) $ 45,160 $ 3,534 $ (388) --- 48,306 Weighted average shares outstanding 20,710 --- 20,710 10,417 --- 179 31,306 ------------- ----------- Earnings per share $ 2.18 $ 1.54 ============= ===========
(1) The ESOP Series was converted on March 7, 1996 (note 10). (2) Options in subsidiary were exercised in 1997, producing minority interest reported on the Statements of Income and Comprehensive Income. Options to purchase 75,000 shares of common stock at a weighted average price of $30.42 per share were outstanding at December 31, 1997 but not included in the computation of diluted earnings per share because the options' exercise price was greater than the average 1997 market price of common shares. 56 (18) Segment Information The Company has two reportable operating segments: property-casualty and excess & surplus lines. The segments are managed separately due to the differences in the insurance products sold, underwriting risk, and the environments in which they operate. The property-casualty segment accounted for 85.7% of 1997 consolidated revenues. It underwrites personal lines (primarily automobile and homeowners) and small commercial lines through three subsidiaries and markets its products through three distribution systems: independent agencies, exclusive agencies, and direct response marketing. The segment operates primarily in central and western states. California and Iowa accounted for 23.7% and 21.4%, respectively, of 1997 direct written premiums. The Company evaluates the property-casualty segment's performance on the basis of growth in direct written premiums and profit. The excess & surplus lines segment accounted for 6% of 1997 consolidated revenues, and its performance is evaluated on profit. Included in all other are mortgage banking, data processing operations, and employee leasing services to affiliated companies. All segments of the Company operate exclusively in the United States. The Company accounts for intercompany sales and transactions as if they were to third parties and attempts to set fees consistent with those that would apply in an arm's length transaction with a nonaffiliate. There can be no assurance the rates charged reflect those that would have been agreed upon following an arm's length negotiation. 57 The following table presents a summary of the Company's operating segment for the three years ended December 31, 1997:
Property- Excess & All Intersegment Reported casualty surplus other eliminations balances ----------- ----------- ----------- ------------ ---------- (in thousands) 1997 Revenues from nonaffiliates $ 524,109 $ 33,291 $ 51,033 $ --- $ 608,433 Revenues from affiliates 1,008 --- 117,209 (113,092) 5,125 Net investment income 44,258 6,802 383 (319) 51,124 Income before income taxes and minority interest* 81,875 10,009 28 --- 91,912 Income taxes 18,247 1,323 1,901 --- 21,471 Depreciation & amortization 9,039 66 5,904 --- 15,009 Capital expenditures 5,148 65 919 --- 6,132 Segment assets 1,012,926 141,814 560,270 (513,777) 1,201,233 1996 Revenues from nonaffiliates $ 472,931 $ 27,316 $ 42,005 $ --- $ 542,252 Revenues from affiliates 479 --- 105,156 (100,755) 4,880 Net investment income 42,296 6,241 756 (71) 49,222 Income before income taxes* 59,435 8,053 3,823 --- 71,311 Income taxes 16,689 2,373 1,165 --- 20,227 Depreciation & amortization 3,812 65 7,153 --- 11,030 Capital expenditures 7,101 34 1,178 --- 8,313 Segment assets 917,537 131,405 477,760 (449,043) 1,077,659 1995 Revenues from nonaffiliates $ 432,924 $ 29,526 $ 37,788 $ --- $ 500,238 Revenues from affiliates --- --- 121,247 (115,962) 5,285 Net investment income 39,110 5,830 2,302 --- 47,242 Income before income taxes* 63,883 4,840 5,125 --- 73,848 Income taxes 23,503 2,953 (483) --- 25,973 Depreciation & amortization 851 58 8,674 --- 9,583 Capital expenditures 3,390 131 4,273 --- 7,794 Segment assets 847,401 122,200 466,459 (425,462) 1,010,598
*includes realized gains or losses The following table shows the detail of intersegment eliminations for segment assets shown in the previous table:
1997 1996 1995 ----------- ----------- ----------- (in thousands) Segment assets eliminations Investment in subsidiaries $ 503,785 $ 437,979 $ 416,951 Other consolidating adjustments 9,992 11,064 8,511 ----------- ----------- ----------- $ 513,777 $ 449,043 $ 425,462 =========== =========== ===========
58 (19) Unaudited Interim Financial Information
Quarter ended March 31 June 30 September 30 December 31 - -------------------------------- ------------- -------------- ------------- ------------- (in thousands, except per share data) 1997 Operating Summary Earned premiums $ 131,867 $ 135,876 $ 137,816 $ 142,038 ============= ============== ============= ============= Investment income $ 12,652 $ 12,874 $ 12,968 $ 12,630 ============= ============== ============= ============= Realized investment gains (losses) $ (7) $ 7 $ 17 $ 374 ============= ============== ============= ============= Total revenues $ 158,744 $ 163,707 $ 166,166 $ 176,065 ============= ============== ============= ============= Losses and expenses $ 136,168 $ 141,821 $ 143,429 $ 151,352 ============= ============== ============= ============= Net income $ 15,942 $ 15,655 $ 16,067 $ 17,772 ============= ============== ============= ============= Diluted earnings per share Net income $ .49 $ .48 $ .49 $ .55 ============= ============== ============= ============= 1996 Operating Summary Earned premiums $ 118,870 $ 121,114 $ 124,246 $ 129,295 ============ ============== ============= ============= Investment income $ 12,119 $ 12,044 $ 12,445 $ 12,614 ============= ============== ============= ============= Realized investment gains (losses) $ 8 $ 31 $ 26 $ (16) ============= ============== ============= ============= Total revenues $ 143,335 $ 146,585 $ 150,719 $ 155,715 ============= ============== ============= ============= Losses and expenses $ 123,551 $ 136,044 $ 130,438 $ 135,010 ============= ============== ============= ============= Net income $ 13,948 $ 7,548 $ 14,459 $ 15,129 ============= ============== ============= ============= Diluted earnings per share Net income $ .41 $ .21 $ .44 $ .46 ============= ============== ============= ============= Caution should be exercised in comparing the results of consecutive quarters.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures. None. 59 PART III Item 10. Directors and Executive Officers of the Registrant The information under the caption "Directors and Executive Officers" in the 1998 Proxy Statement is incorporated herein by reference. Item 11. Executive Compensation The information under the caption "Compensation of Executive Officers" in the 1998 Proxy Statement is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management The information under the caption "Security Ownership of Directors and Executive Officers" in the 1998 Proxy Statement is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions The information under the caption "Certain Transactions and Relationships" in the 1998 Proxy Statement is incorporated herein by reference. 60 PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) List of Financial Statements and Schedules. Form 10-K Page(s) --------- 1. Financial Statements. Independent Auditors' Report. 30 Consolidated Balance Sheets as of December 31, 1997 and 1996. 31 Consolidated Statements of Income and Comprehensive Income for the Years ended December 31, 1997, 1996 and 1995. 33 Statements of Stockholders' Equity for the Years ended December 31, 1997, 1996 and 1995. 34 Consolidated Statements of Cash Flows for the Years ended December 31, 1997, 1996 and 1995. 35 Notes to Consolidated Financial Statements. 36 2. Schedules. Report of Independent Auditors on Schedules. I - Summary of Investments Other Than Investments in Related Parties. 67 II - Condensed Financial Information of Registrant. 68 III - Supplementary Insurance Information. 72 IV - Reinsurance. 73 VI - Supplemental Information. 74 All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. 3. Executive Compensation Plans and Arrangements. ALLIED Group Restated and Amended Stock Option Plan (Incorporated by reference to Exhibit 10.19 to the Company's December 31, 1992 Form 10-K on file with the Commission), Exhibit 10.18. ALLIED Group, Inc. Nonqualified Stock Option Plan (Incorporated by reference to Exhibit 10.20 to the Company's December 31, 1992 Form 10-K on file with the Commission), Exhibit 10.19. 61 ALLIED Group, Inc. Outside Director Stock Purchase Plan (Incorporated by reference to Exhibit 10.21 to the Company's December 31, 1992 Form 10-K on file with the Commission), Exhibit 10.20. ALLIED Group, Inc. Long-Term Management Incentive Plan (Incorporated by reference to Exhibit 10.42 to the Company's March 31, 1994 Form 10-Q on file with the Commission), Exhibit 10.42. Consulting Agreement between John E. Evans and ALLIED Group, Inc., ALLIED Mutual Insurance Company, and ALLIED Life Financial Corporation (Incorporated by reference to Exhibit 10.48 to the Company's December 31, 1994 Form 10-K on file with the Commission), Exhibit 10.48. ALLIED Group Short Term Management Incentive Plan for 1995 (Incorporated by reference to Exhibit 10.49 to the Company's December 31, 1994 Form 10-K on file with the Commission), Exhibit 10.49. ALLIED Group Short Term Management Incentive Plan for 1996, (Incorporated by reference to Exhibit 10.49 to the Company's December 31, 1995 Form 10-K on file with the Commission), Exhibit 10.52. Amendment to Consulting Agreement between John E. Evans and ALLIED Group, Inc., ALLIED Mutual Insurance Company, and ALLIED Life Financial Corporation (Incorporated by reference to Exhibit 10.54 to the Company's December 31, 1996 Form 10-K on file with the Commission), Exhibit 10.54. ALLIED Group Short Term Management Incentive Plan for 1997 (Incorporated by reference to Exhibit 10.55 to the Company's December 31, 1996 Form 10-K on file with the Commission), Exhibit 10.55. Second Amendment to Consulting Agreement between John E. Evans and ALLIED Group, Inc., ALLIED Mutual Insurance Company, and ALLIED Life Financial Corporation (Incorporated by reference to Exhibit 10.62 to the Company's June 30, 1997 Form 10-Q on file with the Commission), Exhibit 10.61. ALLIED Group Short Term Management Incentive Plan for 1998, Exhibit 10.63. (b) Reports on Form 8-K. None. (c) Exhibits. NOTE: See "Index to Exhibits" on page number 76, which discloses the specific page numbers for the exhibits included in this Form 10-K. 2. Plan of acquisition, reorganization, arrangement, liquidation or succession. 2.2 Stock Rights Agreement between ALLIED Mutual Insurance Company and ALLIED Group, Inc. dated July 5, 1990 (Incorporated by reference to Exhibit 2.4 to the Company's July 1, 1990 Form 8-K on file with the Commission). 2.3 First Amendment to Stock Rights Agreement between ALLIED Mutual Insurance Company and ALLIED Group, Inc. (Incorporated by reference to Exhibit 2.5 to the Company's September 30, 1992 Form 10-Q on file with the Commission). 3. Articles of incorporation and bylaws. 3.1 Amended and Restated Articles of Incorporation of ALLIED Group, Inc. as of May 1, 1996 (Incorporated by reference to Exhibit 3.1 to the Company's March 31, 1996 Form 10-Q on file with the Commission). 62 3.2 Bylaws of the Company as of July 9, 1991, as amended March 3, 1992, December 2, 1992, October 14, 1993, December 14, 1994, and March 4, 1997 (Incorporated by reference to Exhibit 3.2 to the Company's December 31, 1996 Form 10-K on file with the Commission). 3.3 Articles of Amendment dated May 13, 1997 to the Amended and Restated Articles of Incorporation (Incorporated by reference to Exhibit 3.3 to the Company's June 30, 1997 Form 10-Q on file with the Commission) 4. Instruments defining the rights of security holders including indentures. 4.7 Agreement between ALLIED Group, Inc. and State Street Bank and Trust Company, dated March 7, 1996. (Incorporated by reference to Exhibit 4.7 to the Company's December 31, 1995 Form 10-K on file with the Commission). 4.8 Stock Purchase Agreement between ALLIED Group, Inc. and State Street Bank and Trust Company dated December 30, 1994. (Incorporated by reference to Exhibit 4.8 to the Company's December 31, 1995 Form10-K on file with the Commission). 4.9 Stock Purchase Agreement between ALLIED Group, Inc. and State Street Bank and Trust Company dated December 29, 1995. (Incorporated by reference to Exhibit 4.9 to the Company's December 31, 1995 Form 10-K on file with the Commission). 4.10 Stock Purchase Agreement between ALLIED Group, Inc. and State Street Bank and Trust Company dated December 31, 1996. (Incorporated by reference to Exhibit 4.10 to the Company's December 31, 1996 Form 10-K on file with the Commission). 10. Material contracts. 10.7 Amended and Restated Management Information Services Agreement between AMCO Insurance Company and certain of its affiliated companies (Incorporated by reference to Exhibit 10.7 to the Company's December 31, 1996 Form 10-K on file with the Commission). 10.8 First Amendment to Amended and Restated Management Information Services Agreement (Incorporated by reference to Exhibit 10.8 to the Company's December 31, 1996 Form 10-K on file with the Commission). 10.14 Second Amended and Restated Reinsurance Pooling Agreement between ALLIED Mutual Insurance Company and the Company's property-casualty insurance subsidiaries (Incorporated by reference to Exhibit 10.13 to the Company's Registration Statement on Form S-3 filed with the Commission on December 15, 1992, Registration No. 33-55714). 10.15 First Amendment to the Second Amended and Restated Reinsurance Pooling Agreement between ALLIED Mutual Insurance Company and the Company's property-casualty insurance subsidiaries (Incorporated by reference to Exhibit 10.43 to the Company's March 31, 1993 Form 10-Q on file with the Commission). 10.16 Amended and Restated ALLIED Group Intercompany Operating Agreement between the Company and its affiliated companies dated August 25, 1993 and amendment thereto dated November 1, 1993 (Incorporated by reference to Exhibit 10.14 to the Company's September 30, 1993 Form 10-Q on file with the Commission). 10.17 ALLIED Group, Inc. Federal Income Tax Sharing Agreement. 10.18 ALLIED Group Restated and Amended Stock Option Plan (Incorporated by reference to Exhibit 10.19 to the Company's December 31, 1992 Form 10-K on file with the Commission). 63 10.19 ALLIED Group, Inc. Nonqualified Stock Option Plan (Incorporated by reference to Exhibit 10.20 to the Company's December 31, 1992 Form 10-K on file with the Commission). 10.20 ALLIED Group, Inc. Outside Director Stock Purchase Plan (Incorporated by reference to Exhibit 10.21 to the Company's December 31, 1992 Form 10-K on file with the Commission). 10.21 ALLIED Group Executive Equity Incentive Plan (Incorporated by reference to Exhibit 10.22 to the Company's December 31, 1992 Form 10-K on file with the Commission). 10.22 Agency Agreement between ALLIED Group Insurance Marketing Company and Depositors Insurance Company, AMCO Insurance Company, and ALLIED Property and Casualty Insurance Company (Incorporated by reference to Exhibit 10.17 to the Company's December 31, 1991 Form 10-K on file with the Commission). 10.28 The ALLIED Group Employee Stock Ownership Trust (Incorporated by reference to Exhibit 10.27 to the Company's March 31, 1991 Form 10-Q on file with the Commission). 10.29 The ALLIED Group Employee Stock Ownership Plan, as amended and restated effective January 1, 1996 (Incorporated by reference to Exhibit 10.29 to the Company's September 30, 1997 Form 10-Q on file with the Commission). 10.32 Term Credit Agreement and Guaranty between ALLIED Group, Inc., ALLIED Group Employee Ownership Trust, Bank of Montreal, and Norwest Bank Iowa, N.A. (Incorporated by reference to Exhibit 10.29 to the Company's March 31, 1995 Form 10-Q on file with the Commission). 10.33 First Amendment to the Term Credit Agreement and Guaranty, dated October 12, 1995. (Incorporated by reference to Exhibit 10.30 to the Company's September 30, 1995 Form 10-Q on file with the Commission). 10.34 Second Amendment to the Term Credit Agreement and Guaranty, dated March 6, 1996 (Incorporated by reference to Exhibit 10.30 to the Company's March 31, 1996 Form 10-Q on file with the Commission). 10.35 Third Amendment to the Term Credit Agreement and Guaranty, dated September 26, 1997 (Incorporated by reference to Exhibit 10.35 to the Company's September 30, 1997 Form 10-Q on file with the Commission). 10.36 Fourth Amendment to the Term Credit Agreement and Guaranty, dated November 17, 1997. 10.38 The ALLIED Group Marketing Agreement between the Company's property-casualty subsidiaries and certain of its affiliated companies dated August 25, 1993 and amendment thereto dated November 1, 1993 (Incorporated by reference to Exhibit 10.39 to the Companies September 30, 1993 Form 10-Q on file with the Commission). 10.42 ALLIED Group, Inc. Long-Term Management Incentive Plan (Incorporated by reference to Exhibit 10.42 to the Company's March 31, 1994 Form 10-Q on file with the Commission). 10.44 Second Amendment to Amended and Restated ALLIED Group Intercompany Operating Agreement dated May 16, 1994 (Incorporated by reference to Exhibit 10.42 to the Company's June 30, 1994 Form 10-Q on file with the Commission). 10.45 Second Amendment to the ALLIED Group Marketing Agreement between the Company's property-casualty subsidiaries and certain of its affiliated companies, dated August 25, 1994 (Incorporated by reference to Exhibit 10.45 to the Company's September 30, 1994 Form 10-Q on file with the Commission). 64 10.46 Third Amendment to Amended and Restated ALLIED Group Intercompany Operating Agreement (Incorporated by reference to Exhibit 10.46 to the Company's December 31, 1994 Form 10-K on file with the Commission). 10.47 Second Amendment to Amended and Restated Reinsurance Pooling Agreement (Incorporated by reference to Exhibit 10.47 to the Company's December 31, 1994 Form 10-K on file with the Commission). 10.48 Consulting Agreement between John E. Evans and ALLIED Group, Inc., ALLIED Mutual Insurance Company, and ALLIED Life Financial Corporation (Incorporated by reference to Exhibit 10.48 to the Company's December 31, 1994 Form 10-K on file with the Commission). 10.49 ALLIED Group Short Term Management Incentive Plan for 1995 (Incorporated by reference to Exhibit 10.49 to the Company's December 31, 1994 Form 10-K on file with the Commission). 10.50 Intercompany Cash Concentration Fund Agreement, dated April 24, 1995 (Incorporated by reference to Exhibit 10.52 to the Company's June 30, 1995 Form 10-Q on file with the Commission). 10.51 Amendment to the Nonqualified Stock Option Plan, dated October 20, 1995 (Incorporated by reference to Exhibit 10.53 to the Company's September 30, 1995 Form 10-Q on file with the Commission). 10.52 ALLIED Group Short Term Management Incentive Plan for 1996 (Incorporated by reference to Exhibit 10.52 to the Company's December 31, 1995 Form 10-K on file with the Commission). 10.54 Amendment to Consulting Agreement between John E. Evans, and ALLIED Group, Inc., ALLIED Mutual Insurance Company, and ALLIED Life Financial Corporation (Incorporated by reference to Exhibit 10.54 to the Company's December 31, 1996 Form 10-K on file with the Commission). 10.55 ALLIED Group Short Term Management Incentive Plan for 1997 (Incorporated by reference to Exhibit 10.55 to the Company's December 31, 1996 Form 10-K on file with the Commission). 10.56 Amendment dated December 16, 1996, ALLIED Group, Inc. Long-Term Management Incentive Plan (Incorporated by reference to Exhibit 10.56 to the Company's December 31, 1996 Form 10-K on file with the Commission). 10.57 Amendment dated February 11, 1997, ALLIED Group, Inc. Outside Director Stock Purchase Plan (Incorporated by reference to Exhibit 10.57 to the Company's December 31, 1996 Form 10-K on file with the Commission). 10.58 Amendment dated February 11, 1997, ALLIED Group, Inc. Nonqualified Stock Option Plan (Incorporated by reference to Exhibit 10.58 to the Company's December 31, 1996 Form 10-K on file with the Commission). 10.59 Amendment dated February 11, 1997, ALLIED Group, Inc. Restated and Amended Stock Option Plan (Incorporated by reference to Exhibit 10.59 to the Company's December 31, 1996 Form 10-K on file with the Commission). 10.60 Amendment dated February 11, 1997, ALLIED Group, Inc. Long-Term Management Incentive Plan (Incorporated by reference to Exhibit 10.60 to the Company's December 31, 1996 Form 10-K on file with the Commission). 10.61 ALLIED Mutual and General Re-insurance Corporation Property Catastrophe Agreement (Incorporated by reference to Exhibit 10.61 to the Company's June 30, 1997 Form 10-Q on file with the Commission). 65 10.62 Second Amendment to Consulting Agreement between John E. Evans, ALLIED Group, Inc., ALLIED Mutual Insurance Company, and ALLIED Life Financial Corporation (Incorporated by reference to Exhibit 10.62 to the Company's June 30, 1997 Form 10-Q on file with the Commission). 10.63 ALLIED Group Short Term Management Incentive Plan for 1998. 21. Subsidiaries of the Registrant. 23. Consent of Independent Auditors. 27. Financial Data Schedule. (d) Financial Statements required by Regulation S-X which are excluded from the Annual Report to Stockholders by Rule 14a-3(b)(1). None. 66 REPORT OF INDEPENDENT AUDITORS ON SCHEDULES The Board of Directors and Stockholders ALLIED Group, Inc.: Under date of February 3, 1998 we reported on the consolidated balance sheets of ALLIED Group, Inc. and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income and comprehensive income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1997, as contained in the 1997 Annual Report. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related consolidated financial statement schedules listed in Part IV, Item 14(a)2. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG Peat Marwick LLP Des Moines, Iowa February 3, 1998 67 ALLIED Group, Inc. and Subsidiaries SCHEDULE I SUMMARY OF INVESTMENTS OTHER THAN INVESTMENTS IN RELATED PARTIES December 31, 1997
Amount at Market which shown in Type of investment Cost value the balance sheet ------------------ -------------- -------------- ----------------- Fixed maturities - bonds U.S. Government and government agencies and authorities $ 205,403,262 $ 213,038,931 $ 213,038,931 States, municipalities, and political subdivisions 385,977,158 400,490,494 400,490,494 All other corporate bonds 200,565,024 204,686,615 204,686,615 -------------- -------------- -------------- Total fixed maturities 791,945,444 $ 818,216,040 818,216,040 -------------- ============== -------------- Equity securities Common stock Public utilities 678,403 797,560 797,560 Banks, trust and insurance companies 5,939,548 7,533,558 7,533,558 Industrial, miscellaneous and all other 21,412,347 28,162,892 28,162,892 Nonredeemable preferred stocks 41,421,245 42,688,080 42,688,080 -------------- -------------- -------------- Total equity securities 69,451,543 $ 79,182,090 79,182,090 -------------- ============== -------------- Short-term investments 10,846,274 10,846,274 -------------- -------------- Total investments $ 872,243,261 $ 908,244,404 ============== ==============
68 ALLIED Group, Inc. and Subsidiaries SCHEDULE II CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS December 31, 1997 and 1996
Assets 1997 1996 -------------- -------------- Indebtedness from affiliates $ 4,081,481 $ 2,067,575 Accrued investment income 10,075 6,078 Short-term investments 3,856,954 2,040,475 Fixed maturities at fair value (amortized cost $74,788 in 1997 and $74,788 in 1996) 74,788 74,773 Equity securities at fair value (cost $2,920,040 in 1997 and $2,567,741 in 1996) 4,432,425 3,356,145 Investment in subsidiaries at equity (note 1) 448,440,840 390,149,644 Current income taxes recoverable 1,308,590 972,757 Deferred income taxes 431,080 246,677 Other assets 889,533 1,224,474 -------------- -------------- Total assets $ 463,525,766 $ 400,138,598 ============== ============== Liabilities Guarantee of ESOP obligations $ 22,380,000 $ 24,370,000 Other liabilities 11,061,367 5,177,116 -------------- -------------- Total liabilities 33,441,367 29,547,116 -------------- -------------- Stockholders' Equity Preferred stock, no par value, issuable in series, authorized 7,500,000 shares; issued and outstanding 1,827,222 shares in 1997 and 1,827,222 in 1996 37,812,387 37,812,387 Common stock, no par value, $1 stated value, authorized 80,000,000 shares; issued and outstanding 30,532,074 in 1997 and 20,382,954 in 1996 30,532,074 20,382,954 Additional paid-in capital 112,489,977 126,078,569 Retained earnings 244,078,690 195,276,063 Accumulated other comprehensive income 23,314,537 12,698,554 Unearned compensation related to ESOP (18,143,266) (21,657,045) -------------- -------------- Total stockholders' equity 430,084,399 370,591,482 -------------- -------------- Total liabilities and stockholders' equity $ 463,525,766 $ 400,138,598 ============== ==============
See accompanying Notes to Condensed Financial Statements 69 ALLIED Group, Inc. and Subsidiaries SCHEDULE II CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued) CONDENSED STATEMENTS OF INCOME Years ended December 31, 1997, 1996, and 1995
1997 1996 1995 ------------- ------------- ------------- Revenues Equity in undistributed earnings of subsidiaries (note 1) $ 49,097,371 $ 25,918,314 $ 38,478,651 Dividends received from subsidiaries (note 1) 17,059,064 24,631,481 12,985,307 Employee leasing income 116,671,728 99,771,562 93,265,042 Realized investment gains (losses) 298,039 (132,737) 405,654 Investment income 239,637 590,435 654,489 Other income 10,233 56,167 47,621 ------------- ------------- ------------- 183,376,072 150,835,222 145,836,764 ------------- ------------- ------------- Expenses Salaries, benefits, payroll taxes and other employee leasing costs 116,150,599 98,322,653 91,929,248 Operating expenses 2,906,781 1,725,301 1,375,281 Interest expense 382,886 183,182 4,014 ------------- ------------- ------------- 119,440,266 100,231,136 93,308,543 ------------- ------------- ------------- Income from operations before income taxes 63,935,806 50,604,086 52,528,221 Income tax (benefit) expense (1,499,791) (480,127) 151,392 ------------- ------------- ------------- Net income 65,435,597 51,084,213 52,376,829 Other comprehensive income, net of deferred taxes of $(5,779,787), $2,999,925, $(12,775,452) 10,615,983 (5,637,079) 23,576,516 ------------- ------------- ------------- Comprehensive income $ 76,051,580 $ 45,447,134 $ 75,953,345 ============= ============= =============
See accompanying Notes to Condensed Financial Statements. 70 ALLIED Group, Inc. and Subsidiaries SCHEDULE II CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued) CONDENSED STATEMENTS OF CASH FLOWS Years ended December 31, 1997, 1996, and 1995
1997 1996 1995 ------------- -------------- ------------- Cash flows from operating activities: Net income $ 65,435,597 $ 51,084,213 $ 52,376,829 Adjustments to reconcile net income to net cash provided by operating activities Equity in undistributed earnings (49,097,371) (25,918,314) (38,478,651) Realized investment (gains) losses (298,039) 132,737 (405,654) Indebtedness from affiliates (2,013,906) 2,701,195 (1,339,475) Accrued investment income (3,997) 66,440 (6,665) Cost of ESOP shares allocated 3,513,779 2,250,971 2,213,911 Current taxes (335,833) (893,628) 190,468 Deferred taxes (479,069) (292,999) (656,689) Other, net 3,137,121 (4,336,578) 529,635 ------------- -------------- ------------ Net cash provided by operating activities 19,858,282 24,794,037 14,423,709 ------------- -------------- ------------ Cash flows from investing activities: Investments in subsidiaries 992,828 (8,081,482) 539 Purchase of fixed maturities --- --- (3,276,014) Purchase of equity securities (782,190) (854,643) (1,630,622) Short-term investments, net (1,816,479) 3,980,545 (3,500,734) Sale of fixed maturities --- 8,602,567 --- Maturities, calls, and principal reductions of fixed maturities --- 167,853 235,608 Sale of equity securities 727,930 83,220 2,045,080 ------------- -------------- ------------ Net cash (used in) provided by investing activities (877,911) 3,898,060 (6,126,143) ------------- -------------- ------------ Cash flows from financing activities: Issuance of preferred stock --- --- 699,559 Issuance of common stock 7,878,567 3,110,431 3,497,199 Repurchase of common stock (10,225,968) (16,524,753) --- Dividends paid to stockholders, net of income tax benefit (16,632,970) (15,277,775) (12,659,236) ------------- -------------- ------------- Net cash used in financing activities (18,980,371) (28,692,097) (8,462,478) ------------- -------------- ------------- Net decrease in cash --- --- (164,912) Cash beginning of year --- --- 164,912 ------------- -------------- ------------- Cash end of year $ --- $ --- $ --- ============= ============== =============
See accompanying Notes to Condensed Financial Statements. 71 ALLIED Group, Inc. and Subsidiaries SCHEDULE II CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued) NOTES TO CONDENSED FINANCIAL STATEMENTS The accompanying condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto of ALLIED Group, Inc. and its subsidiaries. (1) The Company's investment in subsidiaries, undistributed earnings of subsidiaries, and dividends received from subsidiaries are shown by segment below:
Property- Excess & casualty Surplus Other Total --------------- -------------- ------------- -------------- Year ended December 31, 1997 Investment in subsidiaries $ 376,381,705 $ 49,852,582 $ 22,206,553 $ 448,440,840 Equity in undistributed earnings of subsidiaries $ 42,148,797 $ 7,055,787 $ (107,213) $ 49,097,371 Dividends received from subsidiaries $ 16,223,064 $ --- $ 836,000 $ 17,059,064 Year ended December 31, 1996 Investment in subsidiaries $ 324,239,950 $ 42,083,857 $ 23,825,837 $ 390,149,644 Equity in undistributed earnings of subsidiaries $ 19,074,658 $ 5,680,219 $ 1,163,437 $ 25,918,314 Dividends received from subsidiaries $ 23,672,759 $ --- $ 958,722 $ 24,631,481 Year ended December 31, 1995 Investment in subsidiaries $ 293,167,247 $ 37,291,129 $ 31,568,103 $ 362,026,479 Equity in undistributed earnings of subsidiaries $ 33,655,150 $ 3,516,974 $ 1,306,527 $ 38,478,651 Dividends received from subsidiaries $ 12,011,307 $ --- $ 974,000 $ 12,985,307
72
ALLIED Group, Inc. and Subsidiaries SCHEDULE III SUPPLEMENTARY INSURANCE INFORMATION Years ended December 31, 1997, 1996, and 1995 Reserves for Amortization Deferred losses and Losses of deferred Other policy loss Net and loss policy under- acquisition adjusting Unearned Earned investment adjusting acquisition writing Written Segments costs expenses premiums premiums income expenses costs expenses premiums -------- ----------- ------------ ---------- ---------- ---------- ---------- ------------ --------- ---------- (in thousands) 1997 Property-casualty $ 47,504 $ 316,689 $ 220,327 $ 514,303 $ 44,258 $ 357,730 $ 113,147 $ 16,624 $ 531,679 Excess & Surplus 3,191 61,337 19,436 33,294 6,802 20,369 7,109 2,606 34,056 Other operations --- --- --- --- 383 --- --- --- --- Eliminations --- --- --- --- (319) --- --- (53) --- ----------- ------------ ---------- ---------- ---------- ---------- ------------ --------- ---------- Consolidated $ 50,695 $ 378,026 $ 239,763 $ 547,597 $ 51,124 $ 378,099 $ 120,256 $ 19,177 $ 565,735 =========== ============ ========== ========== ========== ========== ============ ========= ========== 1996 Property-casualty $ 43,681 $ 303,014 $ 202,378 $ 466,211 $ 42,296 $ 335,511 $ 102,566 $ 18,193 $ 488,189 Excess & Surplus 2,990 59,177 18,218 27,314 6,241 17,484 5,749 2,272 28,417 Other operations --- --- --- --- 756 --- --- --- --- Eliminations --- --- --- --- (71) --- --- (27) --- ----------- ------------ ---------- ---------- ---------- ---------- ------------ --------- ---------- Consolidated $ 46,671 $ 362,191 $ 220,596 $ 493,525 $ 49,222 $ 352,995 $ 108,315 $ 20,438 $ 516,606 =========== ============ ========== ========== ========== ========== ============ ========= ========== 1995 Property-casualty $ 38,846 $ 285,385 $ 180,217 $ 425,838 $ 39,110 $ 295,583 $ 93,684 $ 18,859 $ 440,838 Excess & Surplus 2,842 56,479 16,244 29,661 5,830 22,357 6,436 1,724 30,606 Other operations --- --- --- --- 2,302 --- --- --- --- Eliminations --- --- --- --- --- --- --- --- --- ----------- ------------ ---------- ---------- ---------- ---------- ------------ --------- ---------- Consolidated $ 41,688 $ 341,864 $ 196,461 $ 455,499 $ 47,242 $ 317,940 $ 100,120 $ 20,583 $ 471,444 =========== ============ ========== ========== ========== ========== ============ ========= ==========
73 ALLIED Group, Inc. and Subsidiaries SCHEDULE IV REINSURANCE Years ended December 31, 1997, 1996, and 1995
Percentage Ceded Assumed of amount Gross to other from other Net assumed to amount companies(1) companies amount net ------------- -------------- ----------------- -------------- ---------- (in thousands) 1997 Premiums: Property-casualty $ 568,160 $ 321,706 $ 267,849 $ 514,303 52.1% Excess & surplus lines 43,254 9,960 --- 33,294 --- ------------- -------------- ----------------- -------------- Total premiums $ 611,414 $ 331,666 $ 267,849 $ 547,597 48.9% ============= ============== ================= ============== 1996 Premiums: Property-casualty $ 497,099 $ 293,986 $ 263,098 $ 466,211 56.4% Excess & surplus lines 37,639 10,325 --- 27,314 --- ------------- -------------- ----------------- -------------- Total premiums $ 534,738 $ 304,311 $ 263,098 $ 493,525 53.3% ============= ============== ================= ============== 1995 Premiums: Property-casualty $ 435,223 $ 265,571 $ 256,186 $ 425,838 60.2% Excess & surplus lines 37,184 7,523 --- 29,661 --- ------------- -------------- ----------------- -------------- Total premiums $ 472,407 $ 273,094 $ 256,186 $ 455,499 56.2% ============= ============== ================= ==============
(1) See note 6 of Notes to Consolidated Financial Statements for additional information on amounts ceded to ALLIED Mutual Insurance Company in accordance with the affiliated reinsurance pooling agreement. 74 ALLIED Group, Inc. and Subsidiaries SCHEDULE VI SUPPLEMENTAL INFORMATION Years ended December 31, 1997, 1996, and 1995
Losses and loss adjusting expenses incurred related to -------------------------------- Discount if any aid losses deducted and loss from Current Prior adjusting Segment reserves year years expenses ------- --------------- -------------- ------------- -------------- (in thousands) 1997 Property-casualty $ --- $ 356,864 $ 866 $ 346,065 Excess & surplus lines --- 23,088 (2,719) 18,704 --------------- -------------- ------------- -------------- Total $ --- $ 379,952 $ (1,853) $ 364,769 =============== ============== ============= ============== 1996 Property-casualty $ --- $ 334,245 $ 1,266 $ 315,987 Excess & surplus lines --- 19,430 (1,946) 15,284 --------------- -------------- ------------- -------------- Total $ --- $ 353,675 $ (680) $ 331,271 =============== ============== ============= ============== 1995 Property-casualty $ --- $ 294,176 $ 1,407 $ 270,373 Excess & surplus lines --- 21,780 577 15,302 --------------- -------------- ------------- -------------- Total $ --- $ 315,956 $ 1,984 $ 285,675 =============== ============== ============= ==============
75 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. ALLIED Group, Inc. (Registrant) Date: March 3, 1998 By /s/Jamie H. Shaffer ---------------------------------- Jamie H. Shaffer (Principal Financial Officer and Principal Accounting 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 on the dates indicated.
By: /s/ Douglas L. Andersen By: /s/ Jamie H. Shaffer By: /s/ John E. Evans - ------------------------------------ ------------------------------------ ------------------------------- Douglas L. Andersen Jamie H. Shaffer John E. Evans President, CEO, and Director Senior Vice President, CFO Chairman of the Board March 3, 1998 and Treasurer and Director March 3, 1998 March 3, 1998 By: /s/ James W. Callison By: /s/ Harold S. Carpenter By: /s/ Charles I. Colby - ------------------------------------ ------------------------------------ -------------------------------- James W. Callison Harold S. Carpenter Charles I. Colby Director Director Director March 3, 1998 March 3, 1998 March 3, 1998 By: /s/ Harold S. Evans By: /s/ Richard O. Jacobson By: /s/ John P. Taylor - ------------------------------------ ------------------------------------ -------------------------------- Harold S. Evans Richard O. Jacobson John P. Taylor Director Director Director March 3, 1998 March 3, 1998 March 3, 1998 By: /s/ William E. Timmons By: /s/ Donald S. Willis - ------------------------------------ ------------------------------------ William E. Timmons Donald S. Willis Director Director March 3, 1998 March 3, 1998
76 ALLIED Group, Inc. and Subsidiaries INDEX TO EXHIBITS Exhibit Number Item Page 10.17 ALLIED Group, Inc. Federal Income Tax Sharing Agreement. 77 10.36 Fourth Amendment to the Term Credit Agreement and Guaranty, 82 dated November 17, 1997. 10.63 ALLIED Group Short Term Management Incentive Plan for 1998. 83 21 Subsidiaries of the Registrant 91 23 Consent of Independent Auditors 92 27 Financial Data Schedule 93 EX-10 2 EXHIBIT 10.17 - TAX SHARING AGREEMENT 77 EXHIBIT 10.17 TAX SHARING AGREEMENT Agreement effective January 1, 1997 by and among ALLIED Group, Inc. ("Parent") and each of its undersigned subsidiaries. WHEREAS, the parties hereto are members of an affiliated group ("Affiliated Group") as defined in Section 1504(a) of the Internal Revenue Code of 1986 as amended; and WHEREAS, some of the parties hereto may be members of a unitary group ("Unitary Group") as defined by various state laws; and WHEREAS, the parties hereto may elect or be required to file their federal income tax returns on a consolidated basis and file their various state income tax returns on a consolidated, unitary or separate basis and desire to properly account for the economic consequences of this arrangement, WHEREAS, it is the intent and desire of the parties hereto that a method be established for reimbursing the Parent for payment of tax liability, for compensating any party for use of its losses or tax credits, and to provide for the allocation and payment of any refund arising from a carryback of losses or tax credits from subsequent taxable years, NOW THEREFORE, in consideration of the mutual covenants and promises contained herein, the parties hereto agree as follows: 1. Parent to Prepare and File Returns. A consolidated federal income tax return and consolidated, unitary, or separate state tax income tax returns shall be prepared and filed by the Parent for the taxable year ended December 31, 1997 and for each subsequent taxable period in respect of which this agreement is in effect. Each subsidiary shall execute and file such consent, elections, and other documents that may be required or appropriate for the proper filing of such returns. 2. Federal Tax Allocation. For each taxable period, each member of the Affiliated Group shall compute its separate tax liability as if it had filed a separate tax return and shall pay such amount to the Parent. The separate return tax liability of each member shall be computed pursuant to the provision of Regulations Section 1.1502-33(d)(3) in a manner provided by Regulations Section 1.1502-33(d)(2)(ii) in conjunction with the method described in Regulations Section 1.1552-1(a)(2). 3. State Tax Allocation. (a) Separate Returns. The Parent and each subsidiary shall be allocated its own separately computed state income tax liability from those states requiring tax to be computed on a separate return basis. 78 (b) Unitary Group and Affiliated Group Returns. The Unitary or Affiliated Group shall allocate to each member the total state income tax liability from those states requiring a consolidated or unitary return filing based on the following formula: [each members separate company state taxable income or loss before apportionment and net operating loss deduction] divided by [total sum of all members separate state taxable income or loss before apportionment and net operating loss deduction] multiplyed by [total affiliated or unitary state income tax on taxable income before net operating deduction and tax credits] All prior tax year carryover tax credits and tax benefits of net operating loss deductions shall be specifically allocated to those members based on the allocation used in the tax year in which the net operating loss or tax credit was originally created. All tax credits except prior tax year carryover credits shall be specifically allocated to the unitary members computed on a separate return basis. All tax credits and net operating losses carried forward from years prior to a member joining the Affiliated or Unitary Group shall be specially allocated to that member. 4. Payments. Each subsidiary shall pay to the Parent its allocation of quarterly estimated, final or amended return taxes payable to the Internal Revenue Service and any other state taxing authority within five days of receiving notice of such payment from the Parent. 5. Refund of Overpayment. If for any taxable period the separate return liability of each member of the Affiliated Group, including the Parent or Unitary Group, exceeds the consolidated or unitary tax liability for such period as a result of any excess losses or tax credits of one or more members, then the Parent shall pay to each such member its allocable portion of such excess amount within sixty days after the date of filing of the consolidated or unitary return for such period. The excess federal tax amount to be reimbursed to such member shall be computed in a manner consistent with the provisions of Regulation Section 1.1502-33(d)(2)(ii). In utilization of this Regulation Section, the percentage referred to in Regulation Section 1.1502-33(d)(2)(ii)(b) shall be 100 percent. 6. Carryback or Forward of Unused Federal Loss or Tax Credit. If part of all of an unused loss or tax credit is allocated to a member of the Affiliated Group pursuant to Regulation Section 1.1502-79, and it is carried back or forward to a year in which such member filed a separate return or a consolidated return with another affiliated group, any refund or reduction in tax liability arising from the carryback or carryover shall be retained by such member. Notwithstanding the above, the Parent shall determine whether an election shall be made not to carryback part or all of the consolidated net operating loss for any taxable year in accordance with Section 172(b)(3)(c) of the Internal Revenue Code of 1986 as amended. 79 7. Adjustment of Taxable Period. If the consolidated or unitary tax liability is adjusted for any taxable period, whether by means of an amended return, claim for refund or after a tax audit by the Internal Revenue Service or respective states, the liability of each member shall be recomputed to give effect to such adjustments, and in the case of a refund, the Parent shall make payment to each member for its share of the refund, determined in the same manner as in paragraph (5) above, within thirty days after the refund is received by the Parent, and in the case of an increase in tax liability, each member shall pay to the parent its allocable share of such increased tax liability within five days after receiving notice of such liability from the Parent. In the event that the taxing authority levies upon a member's assets in excess of its adjusted portion of the consolidated tax liability, the member will be adequately indemnified by the other members. 8. Acquisition through Organization or Additional Corporation. If during a consolidated return period the Parent or any subsidiary acquires or organizes another corporation that is required to be included in the consolidated return, then such corporation shall join in and be bound by this agreement. 9. Term. This agreement shall apply to the taxable year ending December 31, 1997 and all subsequent taxable periods unless the Parent and the subsidiaries agree to terminate the agreement. Notwithstanding such termination, this agreement shall continue in effect with respect to any payment or refund for all taxable periods prior to termination. 10. Application to Successors in Interest. This agreement shall be binding upon and inure to the benefit of any successor, whether by statutory merger, acquisition of assets or otherwise, to any parties hereto, to the same extent as if the successor had been an original party to the agreement. 11. Arbitration. Any dispute arising out of or relating to this Tax Sharing Agreement("Agreement") or the breach thereof between Parent and any of the subsidiaries signatory hereto shall be settled by arbitration in accordance with the Commercial Arbitration Rules of the American Arbitration Association. Arbitration may be initiated by any party to a dispute, giving notice to each other party two copies of such notice with the American Arbitration Association and by complying with other applicable provisions of the Association's Rules. 12. Modification of Agreement. No party has the authority to change any provisions of this Agreement or waive any of its provisions. No change in this Agreement shall be binding, unless first expressed in writing and signed by each party hereto. 13. Superseding Agreement. The parties hereto acknowledge that this agreement shall supersede all other agreements, oral or written, between the parties. 14. Exchange of Information. The parties hereto acknowledge that the exchange and flow of information is critical to the operation of this agreement. Having acknowledged this fact, the parties hereby agree to grant free and unrestricted access, at reasonable times, to those books and records necessary for the operation of this agreement. 80 IN WITNESS WHEREOF, the parties hereto have caused this agreement to be executed by their duly authorized representatives. ALLIED Group, Inc. By /s/ Jamie H. Shaffer Date --------------------------- -------------------------- Jamie H. Shaffer Senior Vice President Treasurer Chief Financial Officer AMCO Insurance Company By /s/ Randall J. Covey Date --------------------------- -------------------------- Randall J. Covey Assistant Vice President ALLIED Property and Casualty Insurance Company By /s/ Randall J. Covey Date --------------------------- -------------------------- Randall J. Covey Assistant Vice President Depositors Insurance Company By /s/ Randall J. Covey Date --------------------------- -------------------------- Randall J. Covey Assistant Vice President Western Heritage Insurance Company By /s/ Scott A. Wilson Date --------------------------- -------------------------- Scott A. Wilson Treasurer/Assistant Secretary 81 ALLIED Group Mortgage Company By /s/ Randall J. Covey Date -------------------------- -------------------------- Randall J. Covey Assistant Vice President ALLIED General Agency Company By /s/ Randall J. Covey Date -------------------------- --------------------------- Randall J. Covey Assistant Vice President ALLIED Group Information Systems, Inc. By /s/ Randall J. Covey Date -------------------------- --------------------------- Randall J. Covey Assistant Vice President The Freedom Group, Inc. By /s/ Randall J. Covey Date -------------------------- --------------------------- Randall J. Covey Assistant Vice President Midwest Printing Services, Ltd. By /s/ Randall J. Covey Date -------------------------- --------------------------- Randall J. Covey Assistant Vice President EX-10 3 10.36-4TH AMENDMENT TERM CREDIT AGREEMENT 82 FOURTH AMENDMENT TO TERM CREDIT AGREEMENT AND GUARANTY THIS AMENDMENT dated as of November 17, 1997 is entered into by and among ALLIED Group, Inc. ("Company"), State Street Bank and Trust Company, not in its individual capacity but as trustee for The ALLIED Group Employee Stock Ownership Trust ("ESOP Trustee"), Bank of Montreal, Chicago Branch ("BOM"), and Norwest Bank Iowa, National Association ("Norwest") to amend the Term Credit Agreement and Guaranty dated March 13, 1995, as amended October 12, 1995, March 5, 1996, and September 26, 1997 ("Agreement"). 1. This Amendment shall be effective as of November 1, 1997. 2. Subsection (ii) of Section 6.1.25 of the Agreement is amended to read as follows: (ii) the sum of the Company's consolidated real estate, mortgages and non-affiliated equity securities not to exceed 10% of the Company's consolidated Total Assets. IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be executed by their respective officers as of the day and year first above written. ALLIED Group, Inc. The ALLIED Group Employee Stock Ownership Trust By: /s/ Douglas L. Andersen By State Street Bank and Trust Company, ------------------------------ not individually, but solely in its Douglas L. Andersen capacity as ESOP Trustee ------------------------------ Title: President By: /s/ Kelly Driscoll ------------------------------------ Bank of Montreal, Chicago Branch Kelly Driscoll Title: Vice President By: /s/ K. Daniel Streiff --------------------------------- ------------------------------ K. Daniel Streiff Title: Managing Director --------------------------- Norwest Bank Iowa, National Association By: /s/ John D. Landry ------------------------------- John D. Landry Title: Assistant Vice President ---------------------------- EX-10 4 10.63 - SHORT TERM MANAGEMENT INCENTIVE PLAN 83 EXHIBIT 10.63 ALLIED GROUP SHORT TERM MANAGEMENT INCENTIVE PLAN 1. PURPOSE This ALLIED Group Short Term Management Incentive Plan (the "Plan") is effective January 1, 1998. The purpose of this Plan is to encourage outstanding performance by certain key employees of ALLIED Group, Inc. ("AGI") in the attainment of annual financial and operating goals of AGI, ALLIED Mutual Insurance Company, and all of their subsidiaries except for ALLIED Life Financial Corporation and its subsidiaries (collectively, the "ALLIED Group"). 2. DEFINITIONS The capitalized terms used throughout the Plan have the following meaning: (a) "AGA" means ALLIED General Agency Company. (b) "AGIMC" means ALLIED Group Insurance Marketing Company. (c) "AGIS" means ALLIED Group Information Systems, Inc. (d) "AGMC" means ALLIED Group Mortgage Company. (e) "ALLIED Group Net Income" means net income after income taxes (including net realized investment gains/losses) for the consolidated group of companies comprising the ALLIED Group (excluding crop-hail business) computed in conformity with generally accepted accounting principles ("GAAP"). (f) "Base Award" is defined in Paragraph 5(c). (g) "Base Salary" is the annualized weekly base pay of the Participant in effect as of the last day in the position for which the bonus is being calculated, which in no event shall be later than December 31 of the Plan year. (h) "Committee" shall mean the Compensation Committee of the Board of Directors of AGI in consultation with the Joint Compensation Committee of the Board of AGI and ALLIED Mutual Insurance Company. (i) "Consolidated TFG" shall mean TFG and AGIS. (j) "Discretionary Award" is defined in Paragraph 5(d). (k) "Discretionary Tier Award" is defined in Paragraph 5(j). 84 (l) "DPW" is direct premiums written, net of return premiums, as reported in the 1998 Planning Package for a particular regional office or company. For ALLIED Group, it includes all property-casualty companies but excludes (i) Western Heritage Insurance Company, (ii) crop-hail business, and (iii) flood program. For AGIMC, DPW shall exclude any premiums generated from business that is purchased by AGIMC from another entity, unless the Committee determines otherwise. (m) "Eligible Award Percentage" is defined in Paragraph 5(b). (n) "Eligible Individual Award" is defined in Paragraph 5(c). (o) "Eligible Tier Award" is defined in Paragraph 5(h). (p) "Goal" is the expected level of performance used to establish targeted awards as approved by the Committee. (q) "Growth" is defined in Paragraph 4. (r) "Maximum" is the level of performance at which the maximum eligible award could be made. (s) "Midwest Printing" is Midwest Printing Services, Ltd. (t) "Operating Profit" is calculated on a GAAP basis, includes net realized investment gains/losses, and is after income taxes. (u) "Participant" is a key employee of AGI recommended by the President of AGI and approved by the Committee to participate in this Plan. (v) "Persistency" for AGIMC is the year-end persistency percentage as shown on the ALLIED Group AGIMC Production Report B, which shall include any business that is purchased by AGIMC from another entity. (w) "Profit" is defined in Paragraph 4. (x) "Regional Office Operating Profit" is the Regional Office Operating Statement GAAP net income. (y) "TFG" means The Freedom Group, Inc. (z) "Threshold" is the minimum level of performance that will warrant an award. (aa) Total Award" is defined in Paragraph 5(e). (bb) "WHIC" means Western Heritage Insurance Company. 3. PARTICIPATION AND TIERS Participation in the Plan is tiered by responsibility level and the short-term impact of the management position. 85 General Responsibility Levels Tier I President Vice Presidents Subsidiary Presidents and Officers Tier II Regional Office Managers and Subsidiary Officers Tier III Primary Corporate Staff Vice Presidents Tier IV Subsidiary Officers and Managers Corporate Staff Vice Presidents and Officers Tier V Subsidiary Managers Tier VI Subsidiary Managers Regional Office Managers A participation list specifying the Participants in each tier shall be approved by the Committee prior to each fiscal year. The Committee may amend such list from time to time to add or delete Participants. Each tier level of participation will have varying award opportunity at the Threshold, Goal, and Maximum performance levels for each of the performance indicators. 4. PERFORMANCE INDICATORS Two performance indicators, Profit and Growth, will be used to measure the success of ALLIED Group and the level of bonus to be paid under this Plan. "Profit" is defined as a performance indicator and shall be defined based on the particular area for which a Participant provides services: Regional Offices - "Regional Office Operating Profit" Bonds - Bond Operating Profit" AGIMC - "Persistency" AGI subsidiaries - "Operating Profit" Staff areas/all other areas - "ALLIED Group Net Income" Consolidated TFG - net income after tax including subsidiaries TFG - net income after tax excluding subsidiaries AGIS - net income after tax "Growth" is defined as a performance indicator and is the increase in revenue from the prior year stated in terms of a percentage increase or dollar target. Generally, revenue is expressed in DPW, except as follows: Consolidated TFG - total revenues for TFG and AGIS TFG - total revenues for TFG AGIS - total revenues for AGIS Midwest Printing - percentage increase in total revenues The Threshold for Profit must be attained before any award will be made based on Growth. However, with respect to AGIMC, the Threshold for Growth must be attained before any award will be made based on Profit. 86 Profit is the only indicator used to measure performance for AGMC, WHIC, and AGA, and the total bonus amount is paid based upon results of Profit. 5. AWARDS Individual Calculations (a) A Participant may receive an Eligible Individual Award under the Plan. "Eligible Individual Award" is defined as the award potential for a Participant based on Profit and Growth results. Eligible Individual Award is the sum of (i) the Eligible Award Percentage for Profit multiplied by the Base Salary for the Participant and (ii) the Eligible Award Percentage for Growth multiplied by the Base Salary for the Participant. The Eligible Individual Award is the amount used to determine the Base Award and the Discretionary Award. (b) "Eligible Award Percentage" is defined as the percentage amount used to determine the potential Eligible Tier Awards and Eligible Individual Award. The amount of the Eligible Award Percentage is tied to tier and performance level attained (Threshold, Goal, or Maximum), as set forth in Exhibit B. Example for Eligible Award Percentage for Profit for a Participant Step 1: Compare actual profit results for the fiscal year to the goals specified in Exhibit A. If the actual Profit results for the fiscal year do not meet the Threshold, then the Eligible Award Percentage is 0, and no further calculations are necessary. Step 2: Determine the percent by which the profit results exceeded the Threshold value (or the goal value as the case may be). There is no need for a calculation if the Maximum results were achieved or exceeded. Step 3: Identify the Eligible Award Percentage for the Profit indicator in the tier at the Threshold level, as shown in Exhibit B. Multiply the Eligible Award Percentage by the percent calculated in Step 2. This will calculate the actual Eligible Award Percentage available based on the profit results attained. Repeat Steps 1 through 3 using Growth to compute the Eligible Award Percentage for Growth. (c) Upon meeting the Threshold for Profit, a Participant will receive a Base Award. "Base Award" is defined as the award to a Participant when a minimum performance level is met. The Base Award is 60% of the Eligible Individual Award. (d) Depending on the determination of the Committee, a Participant may or may not receive a Discretionary Award. "Discretionary Award" is defined as an amount separate from the Base Award which is awarded to a Participant based on the discretion of the Committee. The Discretionary Award is calculated as a percentage of the Eligible Tier Award. 87 (e) A Participant's Total Award" is defined as the sum of the Base Award and the Discretionary Award. The Discretionary Award combined with the Base Award cannot exceed 150% of the Participant's Eligible Individual Award. (f) In addition to the requirements in the foregoing paragraph, a pre-Threshold requirement will be applicable to Staff employees. "Staff employees" are defined to include those employees with overall corporate responsibilities, each of whom shall be identified as "Staff" on the participation list approved by the Committee. Staff employees must attain a 14% return on average equity based on AGI financial statements before they are eligible to meet the Threshold goal. "Return on equity" is defined as the "Return on Average Book Value per Diluted Share" as calculated for and as disclosed in the ALLIED Group, Inc. Annual Report to Stockholders. (g) In the event a Participant does not meet the Threshold for Profit, the Committee may, in unusual or extraordinary circumstances, award the Participant a special award under the Plan. This paragraph may only be invoked by the Committee in rare and extreme situations. Tier Calculations (h) "Eligible Tier Award" is defined as the award potential for a tier based on Profit and Growth results. Eligible Tier Award is the sum of the Eligible Individual Awards for all of the Participants in a particular tier. Total awards made to all of the Participants in a particular tier shall not exceed 100% of the Eligible Tier Award, but the total awards for a particular tier may be less than the Eligible Tier Award. (i) Notwithstanding the foregoing, if the Committee determines that a Participant has shown extraordinary performance in a calendar year, the Committee may exceed the Eligible Tier Award in order to increase the Discretionary Award for the Participant showing such extraordinary performance. (j) Discretionary Tier Award" is defined as the portion of the tier award potential that is not guaranteed to payout but may be awarded based on contribution and performance. This portion may equal up to 40% of the Eligible Tier Award. A Participant may receive a portion, all, or none of the Discretionary Tier Award. 6. PRORATED AWARDS Employees who become eligible for participation in this Plan after the beginning of the Plan year may receive a prorated award based on the time the employee was a Participant and based on active time employed during the Plan year. Prorated awards will be calculated by determining the number of calendar days that a Participant has been eligible for a tier and dividing that number by the calendar days in that Plan year. 7. DEATH, DISABILITY, OR RETIREMENT In the event that a Participant dies, becomes disabled, or retires due to age in accordance with AGI policy, a prorated award will be made based on active time employed as a Participant during the Plan year. 88 8. PLAN YEAR The Plan year will be AGI's fiscal year. 9. TRANSFERABILITY A Participant may not sell, pledge, donate, or otherwise assign any interest in this Plan. 10. EMPLOYMENT Nothing in this Plan confers upon a Participant any right to continued employment or interferes with or limits in any way ALLIED Group's right to terminate the employment of a Participant at any time. 11. TERMINATION OF EMPLOYMENT If a Participant terminates employment or is terminated by ALLIED Group for any reason other than death, disability, or retirement due to age in accordance with AGI policy, and if such termination date is prior to the payment date of an award under this Plan, any right to an award under this Plan is forfeited. 12. PLAN AMENDMENT OR TERMINATION The Committee may amend or terminate the Plan at any time. Participants will be notified of such action as soon as it is practical to do so. In the event of any change in the corporate structure of AGI affecting the goals set forth in Exhibit A or the eligible award percentages set forth in Exhibit B, and where such change in corporate structure would adversely affect a Participant, the Committee may adjust or amend the Plan so as not to disadvantage a Participant. In the event that a change in accounting rules or procedures would affect the goals set forth in Exhibit A or the eligible award percentages set forth in Exhibit B, and where such change in accounting rules or procedures would adversely affect or create a windfall for a Participant, the Committee may adjust or amend the Plan. 13. ADMINISTRATION All matters pertaining to the administration of this Plan will be the responsibility of the Committee, and any decisions of the Committee shall be conclusive and binding. This includes all matters of interpretation, areas not specified in the Plan, and any other issues that may affect the Plan. 14. GOVERNING LAW The Plan will be administered, enforced, construed, and interpreted in accordance with the laws of the State of Iowa. 89 EXHIBIT A GOALS Threshold Goal Maximum --------- ---- ------- PROFIT Regional Offices: DMRO $16,000,000 $18,500,000 $21,000,000 LRO $11,500,000 $13,000,000 $14,500,000 RMRO $6,500,000 $7,500,000 $8,500,000 PCRO $17,000,000 $19,500,000 $22,000,000 CSRO $11,500,000 $13,000,000 $14,500,000 Bonds $450,000 $675,000 $800,000 Staff1 $70,000,000 $81,000,000 $92,000,000 AGMC $2,700,000 $3,100,000 $3,500,000 WHIC $6,000,000 $7,000,000 $8,000,000 ALLIED General Agency $30,000 $34,000 $50,000 TFG (2) $825,000 $900,000 $975,000 AGIS (2) $175,000 $250,000 $325,000 Consolidated TFG (2) $1,000,000 $1,150,000 $1,300,000 Midwest Printing Services $250,000 $325,000 $400,000 AGIMC 87.5% 89% 90.5% GROWTH Staff DPW 10% 12.5% 15% DMRO DPW 8.0% 10.0% 12.0% LRO DPW 8.0% 10.0% 12.0% RMRO DPW 17.0% 21.0% 25.0% PCRO DPW 10.0% 12.5% 15.0% CSRO DPW 14.0% 17.0% 20.0% Bonds DPW 12.0% 16.0% 20.0% AGIMC DPW 18% 23% 28% Midwest Printing Services 10% 14% 18% TFG (2) $10,000,000 $12,000,000 $14,000,000 AGIS (2) $16,000,000 $18,000,000 $20,000,000 Consolidated TFG (2) $26,000,000 $30,000,000 $34,000,000 - -------------------- (1) A pre-Threshold requirement will be applicable to Staff employees. Staff employees must attain a 14% return on equity based on ALLIED Group, Inc. financial statements before they are eligible to meet the Threshold goal. (2) In the event that either TFG or AGIS receives a capital contribution in the Plan year, the Threshold, Goal, and Maximum shall each be adjusted upwards by the addition of the dollar amount derived from the following formula: Dollar Amount of x 14% x Remaining / Total Number Capital Contribution Days in of Days in Plan Year Plan Year 90 EXHIBIT B ELIGIBLE AWARD PERCENTAGES Threshold Goal Maximum Weight --------- ---- ------- ------ Tier I: (1) Profit 19% 38% 56% 75% Growth 6% 12% 19% 25% Total 25% 50% 75% Tier II: (2) Profit 15% 30% 45% 75% Growth 5% 10% 15% 25% Total 20% 40% 60% Tier III: Profit 13% 27% 40% 75% Growth 5% 9% 14% 25% Total 18% 36% 54% Tier IV: (1,2,3) Profit 12% 24% 36% 75% Growth 4% 8% 12% 25% Total 16% 32% 48% Tier V: (4) Profit 9% 18% 27% 75% Growth 3% 6% 9% 25% Total 12% 24% 36% Tier VI: (5) Profit 6% 12% 18% 75% Growth 2% 4% 6% 25% Total 8% 16% 24% - ------------------- (1) AGMC and WHIC award percentages are weighted 100% Profit. (2) AGIMC award percentage is weighted 25% Persistency and 75% Growth. (3) TFG, AGIS, and Consolidated TFG award percentages are weighted 50% Profit and 50% Growth. (4) WHIC award percentage is weighted 100% Profit. (5) AGA award percentage is weighted 100% Profit. EX-21 5 21 SUBSIDIARIES OF THE REGISTRANT 91 Exhibit 21 SUBSIDIARIES OF THE REGISTRANT State of Name of subsidiary incorporation - ------------------------------------------------------------ ------------- I. AMCO Insurance Company Iowa A. Western Heritage Insurance Company Arizona B. ALLIED General Agency Company Iowa II. ALLIED Property and Casualty Insurance Company Iowa III. Depositors Insurance Company Iowa IV. ALLIED Group Mortgage Company Iowa V. The Freedom Group, Inc. Iowa A. ALLIED Group Information Systems, Inc. Iowa VI. Midwest Printing Services, Ltd. Iowa VII. Premier Agency Incorporated Iowa EX-23 6 23 CONSENT OF INDEPENDENT CPA 92 Exhibit 23 CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS The Board of Directors and Stockholders ALLIED Group, Inc. We consent to incorporation by reference in Registration Statement Nos. 33-48235, 33-6643, 33-6644, 33-48206, 33-24543, 33-28907, 33-48234, 33-76876, and 33-65037 on Form S-8 and Registration Statement Nos. 33-48233, 33-61090, and 333-19163 on Form S-3 of ALLIED Group, Inc. of our reports dated February 3, 1998, relating to the accompanying consolidated balance sheets of ALLIED Group, Inc. and subsidiaries as of December 31, 1997 and 1996, and related consolidated statements of income and comprehensive income, stockholders' equity, and cash flows and related schedules for each of the years in the three-year period ended December 31, 1997, which appear in the December 31, 1997 annual report on Form 10-K of ALLIED Group, Inc. KPMG Peat Marwick LLP Des Moines, Iowa March 10, 1998 EX-27 7 DECEMBER 31, 1997 -- FDS
7 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM ALLIED GROUP, INC.'S DECEMBER 31, 1997 FORM 10-K AND IS QUALIFIED IN ITS ENTIRETY BY SUCH FINANCIAL STATEMENTS 0000774624 ALLIED GROUP, INC 1,000 US DOLLARS 12-MOS DEC-31-1997 JAN-1-1997 DEC-31-1997 1 818,216 0 0 79,182 0 0 908,244 2,168 23,906 50,695 1,201,233 378,026 239,763 0 0 56,938 0 37,812 30,532 361,740 1,201,233 547,597 51,124 391 65,570 378,099 120,256 19,177 91,912 25,973 65,939 0 0 0 65,436 2.030 2.010 346,663 379,952 (1,853) 216,920 147,849 359,993 1,284 The Board of Directors authorized a 3-for-2 stock split issuable November 28, 1997 to shareholders of record on November 14, 1997.
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