-----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, M0Rq9rUnMrPDptUwTCd6FRFPkC3PcfapMtqrXKZNXRjWGHAznGcDs3r8+jnMzztm ajdSauA4Wu45uWb3260V+w== 0000912057-97-026363.txt : 19970808 0000912057-97-026363.hdr.sgml : 19970808 ACCESSION NUMBER: 0000912057-97-026363 CONFORMED SUBMISSION TYPE: S-3/A PUBLIC DOCUMENT COUNT: 2 FILED AS OF DATE: 19970807 SROS: NYSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: FRONTIER INSURANCE GROUP INC CENTRAL INDEX KEY: 0000797496 STANDARD INDUSTRIAL CLASSIFICATION: SURETY INSURANCE [6351] IRS NUMBER: 141681606 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: S-3/A SEC ACT: 1933 Act SEC FILE NUMBER: 333-31365 FILM NUMBER: 97652929 BUSINESS ADDRESS: STREET 1: 195 LAKE LOUISE MARIE RD CITY: ROCK HILL STATE: NY ZIP: 12775 BUSINESS PHONE: 9147962100 MAIL ADDRESS: STREET 1: 195 LAKE LOUISE MARIE RD CITY: ROCK HILL STATE: NY ZIP: 12775 FORMER COMPANY: FORMER CONFORMED NAME: FRONTIER FINANCIAL CORP /DE/ DATE OF NAME CHANGE: 19860904 S-3/A 1 FORM S-3/A AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON AUGUST 7, 1997. Registration No. 333-31365 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ AMENDMENT NO. 2 TO FORM S-3 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 ------------------------ FRONTIER INSURANCE GROUP, INC. (Exact name of registrant as specified in its charter) DELAWARE 14-1681606 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number)
195 LAKE LOUISE MARIE ROAD ROCK HILL, NEW YORK 12775-8000 (914) 796-2100 (Address, including zip code, and telephone number, including area code, of Registrant's principal executive offices) SIDNEY TODRES, ESQ. EPSTEIN BECKER & GREEN, P.C. 250 PARK AVENUE NEW YORK, NEW YORK 10177 (212) 351-4735 (Name, address, including zip code, and telephone number, including area code, of agent for service) ------------------------ COPY TO: PETER J. GORDON, ESQ. SIMPSON THACHER & BARTLETT 425 LEXINGTON AVE. NEW YORK, NEW YORK 10017-3909 (212)455-2605 ------------------------ APPROXIMATE DATE OF PROPOSED COMMENCEMENT OF SALE TO THE PUBLIC: AS SOON AS PRACTICABLE AFTER THIS REGISTRATION STATEMENT BECOMES EFFECTIVE. ------------------------ If the only securities being registered on this Form are being offered pursuant to dividend or interest reinvestment plans, please check the following box. / / If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, other than securities offered only in connection with dividend or interest reinvestment plans, check the following box. / / If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. / / If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. / / If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box. / / - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SUBJECT TO COMPLETION PRELIMINARY PROSPECTUS DATED JULY 21, 1997 PROSPECTUS INFORMATION CONTAINED HEREIN IS SUBJECT TO COMPLETION OR AMENDMENT. A REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE SECURITIES AND EXCHANGE COMMISSION. THESE SECURITIES MAY NOT BE SOLD NOR MAY OFFERS TO BUY BE ACCEPTED PRIOR TO THE TIME THE REGISTRATION STATEMENT BECOMES EFFECTIVE. THIS PROSPECTUS SHALL NOT CONSTITUTE AN OFFER TO SELL OR THE SOLICITATION OF AN OFFER TO BUY NOR SHALL THERE BE ANY SALE OF THESE SECURITIES IN ANY STATE IN WHICH SUCH OFFER, SOLICITATION OR SALE WOULD BE UNLAWFUL PRIOR TO REGISTRATION OR QUALIFICATION UNDER THE SECURITIES LAWS OF ANY STATE. 4,000,000 SHARES [LOGO] FRONTIER INSURANCE GROUP, INC. COMMON STOCK ------------ All of the 4,000,000 shares of common stock, $.01 par value (the "Common Stock"), of Frontier Insurance Group, Inc. (the "Company") offered hereby (the "Offering") are being sold by the Company. The Common Stock is traded on the New York Stock Exchange ("NYSE") under the symbol "FTR." On August 6, 1997, the last reported sale price of the Common Stock on the NYSE was $32.69 per share. See "Price Range of Common Stock." SEE "RISK FACTORS" BEGINNING ON PAGE 13 FOR A DISCUSSION OF CERTAIN FACTORS THAT SHOULD BE CONSIDERED BY PROSPECTIVE PURCHASERS. --------------- THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
PRICE TO UNDERWRITING PROCEEDS TO PUBLIC DISCOUNT (1) COMPANY (2) Per Share................................................ $ $ $ Total (3)................................................ $ $ $
(1) The Company has agreed to indemnify the several Underwriters against certain liabilities, including liabilities under the Securities Act of 1933, as amended. See "Underwriting." (2) Before deducting expenses payable by the Company estimated at $600,000. (3) The Company has granted the several Underwriters an option, exercisable within 30 days of the date hereof, to purchase up to an additional 600,000 shares to cover over-allotments, if any. If such option is exercised in full, the total Price to Public, Underwriting Discount and Proceeds to Company will be $ , $ and $ , respectively. See "Underwriting." ---------------- The shares of Common Stock are offered by the several Underwriters, subject to prior sale, when, as and if issued to and accepted by them, subject to the approval of certain legal matters by counsel for the Underwriters and to certain other conditions. The Underwriters reserve the right to withdraw, cancel or modify such offer and to reject orders in whole or in part. It is expected that delivery of shares of Common Stock will be made in New York, New York on or about , 1997. ---------------- MERRILL LYNCH & CO. DONALDSON, LUFKIN & JENRETTE SECURITIES CORPORATION OPPENHEIMER & CO., INC. SMITH BARNEY INC. STEPHENS INC. ---------------- The date of this Prospectus is , 1997. SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS This Prospectus and the documents incorporated herein by reference contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 (the "Securities Act") and Section 21E of the Securities Exchange Act of 1934 (the "Exchange Act") which are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. Such risks and uncertainties include, but are not limited to, the following: (i) general economic conditions; (ii) conditions specific to the property and casualty insurance industry, including its cyclical nature, regulatory changes, rating agency policies and practices, competitive factors and claims development and the impact thereof on loss reserves, the Company's reserving policies and the adequacy of the Company's reinsurance programs; (iii) developments in the securities markets and the impact thereof on the Company's investment portfolio; (iv) the success of the Company's acquisition program; (v) changes in generally accepted accounting principles; and (vi) the risk factors set forth in this Prospectus. Accordingly, there can be no assurance that the actual results will conform to the forward-looking statements in this Prospectus or in the documents incorporated herein by reference. The words "believes," "anticipates," "expects" and similar expressions are intended to identify forward-looking statements. ------------------------ NOTICE TO INVESTORS THE COMPANY OWNS, DIRECTLY OR INDIRECTLY, ALL OF THE SHARES OF STOCK OF FIVE PROPERTY AND CASUALTY INSURANCE COMPANIES WHICH ARE DOMICILED IN THE STATES OF NEW YORK, CALIFORNIA, WISCONSIN, NORTH CAROLINA AND MISSOURI, TWO LIFE INSURANCE COMPANIES WHICH ARE DOMICILED IN LOUISIANA AND ARIZONA, AND ONE-THIRD OF THE VOTING SECURITIES OF A TITLE INSURANCE COMPANY DOMICILED IN THE STATE OF LOUISIANA. THE INSURANCE LAWS OF SUCH STATES REQUIRE PRIOR APPROVAL BY THE STATES' RESPECTIVE INSURANCE DEPARTMENT OF ANY ACQUISITION OF CONTROL OF A DOMESTIC INSURANCE COMPANY OR OF ANY COMPANY WHICH CONTROLS A DOMESTIC INSURANCE COMPANY. "CONTROL" IS PRESUMED TO EXIST THROUGH THE OWNERSHIP OF 10% OR MORE OF THE VOTING SECURITIES OF A DOMESTIC INSURANCE COMPANY OR OF ANY COMPANY WHICH CONTROLS A DOMESTIC INSURANCE COMPANY. THEREFORE, ANY PURCHASER OF 10% OR MORE OF THE OUTSTANDING SHARES OF THE COMPANY'S COMMON STOCK WILL BE PRESUMED TO HAVE ACQUIRED CONTROL OF THE COMPANY'S INSURANCE SUBSIDIARIES AND THE LOUISIANA TITLE INSURANCE COMPANY UNLESS THE INSURANCE DEPARTMENTS OF NEW YORK, CALIFORNIA, WISCONSIN, NORTH CAROLINA, MISSOURI, LOUISIANA AND ARIZONA, FOLLOWING APPLICATION BY SUCH PURCHASER IN EACH OF SUCH STATES, DETERMINE OTHERWISE. ACCORDINGLY, ANY PURCHASE OF 10% OR MORE OF THE OUTSTANDING SHARES OF THE COMPANY'S COMMON STOCK WOULD REQUIRE PRIOR ACTION BY THE INSURANCE DEPARTMENTS OF NEW YORK, CALIFORNIA, WISCONSIN, NORTH CAROLINA, MISSOURI, LOUISIANA AND ARIZONA. ------------------------ NOTICE TO NORTH CAROLINA RESIDENTS THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE COMMISSIONER OF INSURANCE FOR THE STATE OF NORTH CAROLINA, NOR HAS THE COMMISSIONER OF INSURANCE RULED UPON THE ACCURACY OR THE ADEQUACY OF THIS DOCUMENT. ------------------------ CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS THAT STABLILIZE, MAINTAIN OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK. SUCH TRANSACTIONS MAY INCLUDE STABILIZING, THE PURCHASE OF SHARES OF COMMON STOCK TO COVER SYNDICATE SHORT POSITIONS AND THE IMPOSITION OF PENALTY BIDS. FOR A DESCRIPTION OF THESE ACTIVITIES, SEE "UNDERWRITING." 2 AVAILABLE INFORMATION The Company is subject to the information requirements of the Exchange Act and, in accordance therewith, files periodic reports, proxy statements and other information with the Securities and Exchange Commission (the "Commission"). Such material can be inspected and copied at the public reference facilities maintained by the Commission at Room 1024, Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, and at the regional offices of the Commission located at Seven World Trade Center, 13th Floor, New York, New York 10048 and Citicorp Center, 500 West Madison Street (Suite 1400) Chicago, Illinois 60661. Copies of all or part of such materials may also be obtained at prescribed rates from the public reference facilities maintained by the Commission at Room 1024, Judiciary Plaza, 450 Fifth Street N.W., Washington, D.C. 20549. Such materials can also be inspected at the offices of the New York Stock Exchange, 20 Broad Street, New York, New York 10005. The Commission maintains a Web site that contains reports, proxy and information statements and other information of registrants that file electronically with the Commission pursuant to the EDGAR system. The address of the Commission's Web site is http://www.sec.gov. The Company has filed with the Commission a Registration Statement (which term shall encompass any amendments thereto) on Form S-3 under the Securities Act with respect to the Common Stock offered by this Prospectus (the "Registration Statement"). This Prospectus, which constitutes a part of the Registration Statement, does not contain all of the information set forth in the Registration Statement, certain items of which are contained in exhibits to the Registration Statement as permitted by the rules and regulations of the Commission. For further information with respect to the Company and the Common Stock offered by this Prospectus, reference is made to the Registration Statement, including the exhibits thereto, and the financial statements and notes thereto filed or incorporated by reference as a part thereof, which are on file at the offices of the Commission. Statements made in this Prospectus concerning the contents of any document referred to herein are not necessarily complete and, in each instance, are qualified in all respects by reference to the applicable documents filed with the Commission. The Registration Statement and the exhibits thereto filed by the Company with the Commission may be inspected and copied at the locations described above. ------------------------ INCORPORATION OF CERTAIN DOCUMENTS BY REFERENCE The Company's (i) Annual Report on Form 10-K for the fiscal year ended December 31, 1996, (ii) Quarterly Report on Form 10-Q for the quarter ended March 31, 1997, (iii) Definitive Proxy Statement for the May 22, 1997 Annual Meeting of Stockholders, (iv) Current Reports on Form 8-K and 8-K/A for an event (the acquisition of Lyndon Property Insurance Company and its subsidiaries) which occurred on June 3, 1997, and (v) Current Report on Form 8-K for an event (the issuance of a press release announcing the Company's unaudited results for the quarter and six months ended June 30, 1997) which occurred August 5, 1997, heretofore filed with the Commission, are incorporated in this Prospectus by reference. All reports and proxy statements filed by the Company with the Commission pursuant to Sections 13(a), 13(c), 14 and 15(d) of the Exchange Act after the date of this Prospectus and prior to the termination of this Offering shall likewise be deemed to be incorporated in this Prospectus by reference from the respective dates of filing of such documents. Any statements contained herein or in a document incorporated or deemed to be incorporated by reference herein shall be deemed to be modified or superseded for purposes of this Prospectus to the extent that a statement contained herein or in any other subsequently filed document which also is or is deemed to be incorporated by reference herein modifies or supersedes such statement. Any such statement so modified or superseded shall not be deemed, except as so modified or superseded, to constitute a part of this Prospectus. Upon oral or written request, the Company will provide without charge a copy of any document incorporated in this Prospectus, exclusive of exhibits, to each person to whom this Prospectus is delivered. Requests for such documents should be directed to the Investor Relations Department at the corporate headquarters of the Company, 195 Lake Louise Marie Road, Rock Hill, New York 12775 (telephone no. 914-796-2100). 3 PROSPECTUS SUMMARY THE FOLLOWING SUMMARY IS QUALIFIED IN ITS ENTIRETY BY, AND SHOULD BE READ IN CONJUNCTION WITH, THE MORE DETAILED INFORMATION AND FINANCIAL DATA APPEARING ELSEWHERE IN THIS PROSPECTUS OR INCORPORATED HEREIN BY REFERENCE. EXCEPT AS OTHERWISE INDICATED, THE FINANCIAL STATEMENTS, RATIOS AND STATISTICAL DATA ARE PRESENTED IN ACCORDANCE WITH GENERALLY ACCEPTED ACCOUNTING PRINCIPLES ("GAAP"). UNLESS THE CONTEXT OTHERWISE REQUIRES, ALL REFERENCES TO THE "COMPANY" REFER TO FRONTIER INSURANCE GROUP, INC. AND ITS SUBSIDIARIES (AND, EXCEPT AS OTHERWISE INDICATED, EXCLUDE LYNDON PROPERTY INSURANCE COMPANY AND ITS SUBSIDIARIES). ALL INFORMATION PRESENTED HAS BEEN ADJUSTED TO GIVE EFFECT TO A TWO-FOR-ONE STOCK SPLIT EFFECTED AS A 100% STOCK DIVIDEND PAID ON JULY 21, 1997 TO STOCKHOLDERS OF RECORD AS OF THE CLOSE OF BUSINESS ON JUNE 30, 1997, AND ASSUMES THAT THE UNDERWRITERS' OVER-ALLOTMENT OPTION IS NOT EXERCISED. THE COMPANY Frontier Insurance Group, Inc. is an insurance holding company which, through its subsidiaries, conducts business on an admitted and non-admitted basis as a specialty property and casualty insurer. The Company's business strategy is to achieve an underwriting profit by identifying niche markets and specialty insurance programs which it believes afford favorable opportunities for profitability due to (i) limited potential competition and (ii) the Company's innovative underwriting and value added services, including coverage enhancements, risk management, loss control and specialized claims management. The Company currently underwrites in excess of 130 specialty insurance programs, including (i) malpractice insurance for physicians, dentists, psychiatrists and chiropractors, (ii) general liability, (iii) surety (performance bonds, bail bonds, customs bonds and license and permit bonds), (iv) commercial earthquake, (v) workers' compensation and (vi) other miscellaneous lines. The Company's alternative risk division underwrites excess workers' compensation and excess medical stop loss coverages, and provides custom designed insurance programs through captive and rent-a-captive facilities for both the Company's workers' compensation and other insurance lines. See "Business." On June 3, 1997, the Company completed the acquisition of Lyndon Property Insurance Company and its subsidiaries (collectively, "Lyndon") for $92.0 million in cash. Lyndon underwrites credit-related and other specialty insurance products for financial institutions and specialty insurance markets. See "Business--Acquisition of Lyndon." The following table sets forth the Company's net premiums written by principal lines of insurance and the related percentages of the total net premiums written represented thereby for the three months ended March 31, 1997 and the year ended December 31, 1996:
THREE MONTHS ENDED YEAR ENDED DECEMBER MARCH 31, 1997 31, 1996 -------------------- --------------------- (DOLLAR AMOUNTS IN THOUSANDS) Medical malpractice (including dental malpractice and social services)........................ $ 22,516 28.4% $ 119,653 38.4% General liability......................... 32,329 40.8 93,980 30.1 Surety.................................... 12,098 15.3 56,632 18.2 Commercial earthquake..................... 2,085 2.6 11,904 3.8 Workers' compensation..................... 1,743 2.2 6,253 2.0 Other..................................... 8,542 10.7 23,441 7.5 --------- --------- ---------- --------- Total............................... $ 79,313 100.0% $ 311,863 100.0% --------- --------- ---------- --------- --------- --------- ---------- ---------
4 The Company relies on multiple distribution channels to market its insurance products. Malpractice insurance and license and permit bonds are marketed both directly through Company-owned agencies and by independent brokers and agents. Bail bonds are marketed through a nationwide network of bail bondsmen by a 50%-owned subsidiary of the Company. Sales of the Company's other lines of business are generated primarily by independent insurance agencies and insurance brokerage firms. See "Business-- Marketing." For the five years ended December 31, 1996, the Company's net premiums written and its net income increased at compounded annual rates of 28.0% and 20.6%, respectively, during which period it realized an average statutory combined ratio of 94.2%, as compared to the property and casualty insurance industry average of 108.7%. The Company has realized a statutory combined ratio of less than 100% in every year since its formation in 1986. See "Selected Consolidated Financial Data." For the six months ended June 30, 1997, the Company's net premiums written and net income were $168.5 million and $27.3 million, respectively, and its statutory combined ratio was 89.5%, which results include those of Lyndon from June 3, 1997, the date of its acquisition, as compared to $133.4 million, $19.0 million and 91.9%, respectively, for the comparable 1996 period. At June 30, 1997, following the acquisition of Lyndon on June 3, 1997, the Company's total assets were $1.7 billion, its total investments were $1.1 billion and its total shareholders' equity was $294.8 million. The Company's insurance company subsidiaries consist of Frontier Insurance Company ("Frontier Insurance"), which is licensed as a property and casualty insurer in 50 states, the District of Columbia, Puerto Rico and the Virgin Islands, Frontier Pacific Insurance Company ("Frontier Pacific"), United Capitol Insurance Company ("United Capitol"), Regency Insurance Company ("Regency"), and Lyndon Property Insurance Company ("Lyndon Property") and its two active life insurance subsidiaries (collectively, the "Insurance Subsidiaries"). Frontier Insurance, Frontier Pacific, United Capitol and Regency currently are rated A- (Excellent) by A.M. Best Company, Inc. ("A.M. Best"), and Standard & Poor's Insurance Rating Services ("S&P") has given Frontier Insurance and Frontier Pacific an Insurer Claims-Paying Ability Rating of A+ (Good). Lyndon Property and its two active life insurance subsidiaries currently are rated B++ (Very Good) by A.M. Best. See "Business--Ratings." GROWTH STRATEGY The Company's growth strategy includes (i) the acquisition of profitable specialty insurance operations which are non-dilutive to earnings, (ii) the addition of new specialty insurance programs and (iii) the expansion of existing business through enhanced products, additional coverages and geographic expansion. The Company continuously reviews possible acquisitions and currently is in active discussions with a number of potential acquisition candidates. Since April 1994, the Company has completed seven strategic acquisitions for an aggregate consideration to the sellers of approximately $138.5 million, the most recent of which were: AN UNDERWRITER OF CREDIT-RELATED INSURANCE. On June 3, 1997, the Company acquired Lyndon for $92.0 million in cash. Lyndon underwrites credit-related and other specialty insurance products for financial institutions and specialty insurance markets. A NON-STANDARD AUTOMOBILE INSURANCE COMPANY AND A PREMIUM FINANCE COMPANY. In September 1996, the Company acquired Regency, which writes non-standard automobile insurance policies in North Carolina, and Emrol Installment Premium Discount, Inc. ("Emrol"), which provides premium financing to insureds of the policies written by Regency. 5 A SPECIALTY EXCESS AND SURPLUS LINES INSURANCE COMPANY. United Capitol, whose parent was acquired by the Company for $31.0 million in May 1996, is a specialty excess and surplus lines underwriter which writes asbestos abatement, product and general liability, commercial property, directors' and officers' liability and various classes of errors and omissions insurance policies. Previously, the Company had acquired (i) a 33% ownership interest in a title insurance company licensed in 29 states, (ii) a realtors' errors and omissions line of business, (iii) a 50% interest in a surety bail bond and immigration bond agency and (iv) a surety bond agency which places and services license and permit bonds in California and other western states. Since 1994, the Company has added an average of ten specialty insurance programs per annum (net of programs discontinued) to its lines of insurance, including marine and energy programs, manufactured housing written on a surplus lines basis, and errors and omissions for title insurance agents and architects and engineers. The Company also expanded its existing business during such period by, among other things, offering a lead abatement liability program to complement its asbestos abatement liability program, expanding its pest control program into North Carolina and expanding its social service programs into California. See "Business--General." ACQUISITION OF LYNDON On June 3, 1997, the Company acquired Lyndon from Mercury Finance Company ("Mercury") for $92.0 million in cash, which amount was $30.0 million (net of tax) less than Lyndon's total shareholder's equity on such date. Lyndon, based in St. Louis, Missouri, provides credit-related and specialty insurance products for financial institutions and specialty insurance markets through a variety of distribution channels, including other insurance companies, general agents, third-party administrators, and joint venture relationships, with the particular channel designed to fit the specific product. Credit-related products include collateral protection, credit property, involuntary unemployment insurance, auto physical damage, credit life, and credit accident and health coverages. Specialty insurance products include residual value, non-standard auto and mechanical breakdown. Lyndon was formed in 1978 by ITT Financial Corporation ("ITT") primarily to insure credit-related exposures in ITT's consumer and commercial finance businesses. In October 1995, Mercury acquired Lyndon from ITT to offer credit-related insurance products in conjunction with Mercury's sub-prime auto lending business. For the year ended December 31, 1996, Lyndon's revenues were $96.8 million and its net income was $27.0 million. During 1996, its operating results were beneficially impacted by run-off business from ITT, which business will be inconsequential in subsequent years, and from a collateral protection coverage program marketed through Mercury, which was discontinued prior to the Company's purchase of Lyndon. Accordingly, such results are not indicative of future operating results. For the three months ended March 31, 1997, Lyndon had revenues of $26.4 million and net income of $4.5 million, compared to revenues of $19.2 million and net income of $7.3 million for the three months ended March 31, 1996. At March 31, 1997, Lyndon's total assets were $395.8 million and its total investments were $214.8 million. See "Unaudited Pro Forma Consolidated Financial Information" and "Business--Acquisition of Lyndon." 6 THE OFFERING Shares Offered by the Company................ 4,000,000 shares of Common Stock Shares Outstanding after the Offering (1).... 33,471,924 shares of Common Stock Use of Proceeds.............................. Approximately $62.0 million to repay bank indebtedness and the balance of approximately $ million for general corporate purposes, including possible strategic acquisitions and support of the Company's continued internal growth. NYSE Symbol.................................. FTR
- ------------------------ (1) Does not include 7,358,038 shares issuable upon conversion of the Company's 6 1/4% Convertible Subordinated Debentures and 1,239,898 shares issuable upon exercise of outstanding stock options as of June 30, 1997. RISK FACTORS See "Risk Factors" for a discussion of certain factors that should be considered by prospective purchasers. 7 SUMMARY CONSOLIDATED FINANCIAL DATA (DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED MARCH 31, YEAR ENDED DECEMBER 31, -------------------- ----------------------------------------------------- 1997 1996 1996 1995 1994 1993 1992 --------- --------- --------- --------- --------- --------- --------- (UNAUDITED) INCOME STATEMENT DATA: Revenues: Gross premiums written................. $ 105,812 $ 74,860 $ 402,799 $ 264,314 $ 198,892 $ 148,750 $ 149,504 --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Net premiums written................... $ 79,313 $ 61,729 $ 311,863 $ 220,757 $ 187,288 $ 118,819 $ 116,248 --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Net premiums earned.................... $ 77,807 $ 58,294 $ 265,989 $ 196,220 $ 156,755 $ 116,372 $ 105,171 Net investment income.................. 11,893 7,786 37,226 30,035 24,453 22,523 19,875 Realized capital gains (losses)........ 721 691 1,707 20 (1,478) (152) 333 Gross claims adjusting income.......... 15 25 55 130 255 424 1,356 --------- --------- --------- --------- --------- --------- --------- Total revenues..................... 90,436 66,796 304,977 226,405 179,985 139,167 126,735 Expenses: Losses and loss adjustment expenses.... 45,674 35,443 155,991 119,255 110,918 77,581 74,933 Amortization of policy acquisition costs, underwriting, and other expenses............................. 25,182 18,172 88,080 62,975 47,737 31,293 26,604 Minority interest in income of consolidated subsidiary trust........ 2,732 -- 2,277 -- -- -- -- Interest expense....................... -- 441 1,970 895 -- -- -- --------- --------- --------- --------- --------- --------- --------- Total expenses..................... 73,588 54,056 248,318 183,125 158,655 108,874 101,537 --------- --------- --------- --------- --------- --------- --------- Income before income taxes and cumulative effect of change in accounting principle.............................. 16,848 12,740 56,659 43,280 21,330 30,293 25,198 Income taxes............................. 4,944 3,476 16,592 12,069 4,350 7,130 6,236 --------- --------- --------- --------- --------- --------- --------- Income before cumulative effect of change in accounting principle......... 11,904 9,264 40,067 31,211 16,980 23,163 18,962 Cumulative effect of change in accounting for income taxes............ -- -- -- -- -- 708 -- --------- --------- --------- --------- --------- --------- --------- Net income......................... $ 11,904 $ 9,264 $ 40,067 $ 31,211 $ 16,980 $ 23,871 $ 18,962 --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- SUPPLEMENTAL PER SHARE DATA: Operating income (fully diluted) (1)..... $ .36 $ .31 $ 1.33 $ 1.08 $ .62 $ .92 $ .77 Net income (fully diluted)............... .38 .32 1.37 1.08 .59 .94 .79 Book value (at end of period)............ 9.25 8.10 9.17 8.02 6.66 6.52 4.50 Cash dividends........................... .07 .06 .25 .24 .23 .20 .20 BALANCE SHEET DATA (AT END OF PERIOD): Total investments........................ $ 833,115 $ 564,703 $ 838,320 $ 552,714 $ 407,618 $ 343,591 $ 262,010 Total assets............................. 1,275,920 798,649 1,246,407 773,348 599,117 527,657 406,149 Reserves for gross unpaid losses and loss adjustment expenses........... 569,147 383,231 539,073 367,436 312,637 274,035 238,942 Total liabilities........................ 837,743 566,513 810,880 543,615 408,853 341,963 299,400 Guaranteed preferred beneficial interest in the 6 1/4% Convertible Subordinated Debentures............................. 166,979 -- 166,953 -- -- -- -- Total shareholders' equity............... 271,198 232,136 268,574 229,733 190,264 185,694 106,749 COMBINED STATUTORY DATA:(2) Statutory net income..................... $ 11,092 $ 9,605 $ 28,874 $ 26,407 $ 6,623 $ 17,713 $ 12,803 Policyholders' surplus (at end of period)................................ 276,181 181,014 268,004 171,362 104,871 101,418 76,438 Available for dividends from the insurance subsidiaries (3)............. 27,618 18,101 26,800 17,136 10,487 10,142 7,644 Ratio of net premiums to surplus (4)..... 1.2x 1.3x 1.2x 1.3x 1.8x 1.2x 1.5x
(CONTINUED ON FOLLOWING PAGE) 8
THREE MONTHS ENDED MARCH 31, YEAR ENDED DECEMBER 31, -------------------------------- ----------------------------------------------------- 1997 1996 1996 1995 1994 1993 1992 --------------- --------------- --------- --------- --------- --------- --------- (UNAUDITED) SELECTED RATIOS: GAAP combined ratio...................... 91.0% 91.9% 91.6% 92.8% 101.0% 93.2% 95.4% Statutory combined ratio................. 93.9 91.3 90.9 91.1 98.1 94.2 96.8 Industry statutory combined ratio (5).... N/A 106.8 105.9 106.4 108.4 106.9 115.7 Ratio of earnings to combined fixed charges and preferred stock dividends (6)...... 6.8x 24.9x 13.2x 39.1x -- -- --
- ------------------------ (1) Represents net income excluding the effect of net realized capital gains and losses and cumulative effect of a change in accounting principle. (2) Compiled from the Annual Statements of Frontier Insurance, Frontier Pacific, United Capitol and Regency as filed with the insurance departments of New York, California, Wisconsin and North Carolina, respectively. (3) 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 "Business--Regulation--Restrictions on Dividends and Distributions." (4) Represents the ratio of statutory net premiums written during the period to statutory policyholders' surplus at the end of such period. The ratios as of March 31, 1997 and 1996 were calculated using statutory net premiums written during the four quarters which precede the interim date. (5) Compiled by A.M. Best. (6) For the purposes of the ratio of earnings to combined fixed charges and preferred stock dividends, earnings were calculated by adding interest expense and amortization of debt issuance costs to income before income taxes and cumulative effect of change in accounting principle. Combined fixed charges consist of interest expense payable on the 6 1/4% Convertible Subordinated Debentures and bank debt. 9 UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL INFORMATION The following unaudited pro forma condensed consolidated balance sheet at March 31, 1997 gives effect to the Company's acquisition of Lyndon as if the acquisition and the related borrowing of $62.0 million under a revolving loan credit facility had occurred at March 31, 1997, and the unaudited pro forma condensed consolidated income statements for the three months ended March 31, 1997 and for the year ended December 31, 1996 give effect to such acquisition and borrowing and the Company's 1996 acquisitions of Regency, Emrol and United Capitol Holding Company ("United Capitol Holding") as if all such events had occurred at January 1, 1996. Unaudited pro forma financial data do not purport to be indicative of either the results of future operations or the results of operations that would have occurred if the transactions had been consummated on the dates indicated. Moreover, for the reasons discussed under "Business--Acquisition of Lyndon," among others, the historical operating results of Lyndon are not indicative of its future operating results. UNAUDITED PRO FORMA CONDENSED CONSOLIDATED BALANCE SHEET AT MARCH 31, 1997 (DOLLAR AMOUNTS IN THOUSANDS)
HISTORICAL HISTORICAL PRO FORMA NOTE COMPANY LYNDON ADJUSTMENTS CONSOLIDATED REFERENCE ---------- ----------- ----------- ------------ --------------- ASSETS: Total investments............................... $ 833,115 $ 214,815 $ (29,832) $1,018,098 1 Cash............................................ 15,688 3,868 19,556 Agents' balances and premiums receivable........ 78,283 29,979 108,262 Net reinsurance recoverables.................... 209,569 98,353 307,922 Deferred policy acquisition costs............... 36,834 43,503 (43,503) 36,834 2 Deferred federal income tax asset............... 29,540 -- 9,336 38,876 3 Present value of future profits................. -- -- 5,768 5,768 4 Intangible assets, less accumulated amortization.................................. 11,311 -- 11,311 Other assets.................................... 61,580 5,326 (2,890) 64,016 5 ---------- ----------- ----------- ------------ Total assets.................................. $1,275,920 $ 395,844 $ (61,121) $1,610,643 ---------- ----------- ----------- ------------ ---------- ----------- ----------- ------------ LIABILITIES AND SHAREHOLDERS' EQUITY: Unpaid losses and LAE........................... $ 569,147 $ 49,344 $ 618,491 Unearned premiums............................... 180,891 178,106 358,997 Revolving loan credit facility.................. -- -- $ 62,000 62,000 6 Funds withheld under reinsurance contracts...... 72,112 -- 72,112 Other liabilities............................... 15,593 49,663 (4,390) 60,866 4 ---------- ----------- ----------- ------------ Total liabilities............................. 837,743 277,113 57,610 1,172,466 Guaranteed preferred beneficial interest in the 6 1/4% Convertible Subordinated Debentures.... 166,979 -- 166,979 Total shareholders' equity...................... 271,198 118,731 (118,731) 271,198 ---------- ----------- ----------- ------------ Total liabilities and shareholders' equity.... $1,275,920 $ 395,844 $ (61,121) $1,610,643 ---------- ----------- ----------- ------------ ---------- ----------- ----------- ------------
See notes to unaudited pro forma condensed consolidated information. 10 UNAUDITED PRO FORMA CONDENSED CONSOLIDATED INCOME STATEMENT FOR THE THREE MONTHS ENDED MARCH 31, 1997 (DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
HISTORICAL HISTORICAL PRO FORMA NOTE COMPANY LYNDON ADJUSTMENTS CONSOLIDATED REFERENCE ----------- ----------- ------------- ------------ --------------- REVENUES: Net premiums written.............................. $ 79,313 $ 13,634 $ 92,947 ----------- ----------- ------------ ----------- ----------- ------------ Net premiums earned............................... $ 77,807 $ 23,220 $ 101,027 Net investment income............................. 11,893 3,023 $ (491) 14,425 7 Realized capital gains............................ 721 29 750 Other income...................................... 15 100 115 ----------- ----------- ------------- ------------ Total revenues.................................. 90,436 26,372 (491) 116,317 EXPENSES: Losses and LAE.................................... 45,674 11,434 57,108 Amortization of policy acquisition costs.......... 15,951 3,053 19,004 Amortization of present value of future profits... -- 2,229 (1,632) 597 8 Underwriting and other expenses................... 9,231 2,911 12,142 Minority interest in income of consolidated subsidiary trust................................ 2,732 -- 2,732 Interest expense.................................. -- -- 964 964 9 ----------- ----------- ------------- ------------ Total expenses.................................. 73,588 19,627 (668) 92,547 ----------- ----------- ------------- ------------ Income before income taxes........................ 16,848 6,745 177 23,770 Income taxes...................................... 4,944 2,219 62 7,225 10 ----------- ----------- ------------- ------------ Net income........................................ $ 11,904 $ 4,526 $ 115 $ 16,545 ----------- ----------- ------------- ------------ ----------- ----------- ------------- ------------ Fully diluted earnings per share.................. $ .38 $ .50 ----------- ------------ ----------- ------------
UNAUDITED PRO FORMA CONDENSED CONSOLIDATED INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 1996 (DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
HISTORICAL HISTORICAL 1996 HISTORICAL PRO FORMA NOTE COMPANY ACQUISITIONS LYNDON ADJUSTMENTS CONSOLIDATED REFERENCE ----------- --------------- ----------- ----------- ------------ --------------- REVENUES: Net premiums written............. $ 311,863 $ 6,043 $ 96,614 $ 414,520 ----------- ------- ----------- ------------ ----------- ------- ----------- ------------ Net premiums earned.............. $ 265,989 $ 5,463 $ 83,277 $ 354,729 Net investment income............ 37,226 3,911 12,082 $ (4,262) 48,957 11 Realized capital gains........... 1,707 647 606 2,960 Other income..................... 55 -- 833 888 ----------- ------- ----------- ----------- ------------ Total revenues................. 304,977 10,021 96,798 (4,262) 407,534 EXPENSES: Losses and LAE................... 155,991 2,972 27,553 186,516 Amortization of policy acquisition costs............. 57,540 (292) 10,999 (4,039) 64,208 8 Amortization of present value of future profits................ -- -- 11,080 (7,500) 3,580 8 Underwriting and other expenses.. 30,540 1,653 7,172 422 39,787 12 Minority interest in income of consolidated subsidiary trust......................... 2,277 -- -- 2,277 Interest expense................. 1,970 -- -- 3,856 5,826 9 ----------- ------- ----------- ----------- ------------ Total expenses................. 248,318 4,333 56,804 (7,261) 302,194 ----------- ------- ----------- ----------- ------------ Income before income taxes....... 56,659 5,688 39,994 2,999 105,340 Income taxes..................... 16,592 2,018 13,012 1,155 32,777 10 ----------- ------- ----------- ----------- ------------ Net income....................... $ 40,067 $ 3,670 $ 26,982 $ 1,844 $ 72,563 ----------- ------- ----------- ----------- ------------ ----------- ------- ----------- ----------- ------------ Fully diluted earnings per share......................... $ 1.37 $ 2.42 ----------- ------------ ----------- ------------
See notes to unaudited pro forma condensed consolidated financial information. 11 NOTES TO UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL INFORMATION (1) Total investments decreased primarily due to the sale of $30.0 million of investments, the proceeds of which, together with $62.0 million drawn down under the revolving loan credit facility, were used to acquire Lyndon. (2) Deferred policy acquisition costs of $43.5 million have been eliminated as the result of a purchase accounting adjustment. (3) The net increase in deferred federal income tax asset was the result of the purchase accounting adjustments related to deferred taxes associated with deferred policy acquisition costs, the excess of net assets acquired over the purchase price, reclassification of deferred tax liabilities, and the present value of future profits ("PVFP"). (4) PVFP was the result of a purchase accounting adjustment establishing $47.7 million of estimated future profits less the $41.9 million excess of the net assets acquired over the purchase price. (5) The net decrease in other assets was the result of the reduction of certain assets to their estimated fair value at the date of acquisition. (6) The $62.0 million represents the amount drawn down under the revolving loan credit facility used to acquire Lyndon. (7) Net investment income has been decreased to reflect the reduction in investment income from the sale of $30.0 million of investments to fund the acquisition of Lyndon, assuming a pre-tax yield of 6.5%. (8) Amortization of policy acquisition costs and PVFP have been adjusted to reflect estimated amortization expense based on a valuation of business in force as of the purchase date. PVFP was offset by the excess of net assets acquired over the purchase price and is being amortized in relation to the earned premiums. (9) Interest expense has been increased to reflect the $62.0 million drawn down under the revolving loan credit facility, assuming an interest rate of 6.04%. (10) Federal income taxes have been increased to reflect the net tax effect of the pro forma adjustments. (11) Net investment income has been decreased to reflect the sale of investments to fund the acquisitions of Lyndon and United Capitol Holding and to pay dividends to their previous parent companies, assuming pre-tax yields ranging from 6.4% to 6.9%. (12) Underwriting and other expenses have been increased to reflect the amortization of the excess cost over net assets acquired arising from the acquisitions of United Capitol Holding, Regency and Emrol. 12 RISK FACTORS Prospective purchasers should consider carefully the following risk factors in addition to the information set forth or incorporated by reference in this Prospectus prior to making an investment in the Common Stock being offered hereby. COMPETITION The property and casualty insurance business is highly competitive with respect to a number of factors, including overall financial strength of the insurer, ratings by rating agencies, premium rates, policy terms and conditions, services offered, reputation and broker compensation. Although the Company's business strategy is to achieve an underwriting profit by identifying niche markets and specialty programs which it believes afford favorable opportunities for profitability due to limited potential competition, it nevertheless encounters competition from carriers engaged in insuring risks in the broader lines of business which encompass the Company's niche markets and specialty programs, and such competition is expected to increase as the Company expands its operations. See "Business--Competition." ADEQUACY OF LOSS RESERVES The liabilities for unpaid losses and loss adjustment expenses ("LAE") are estimated by management utilizing methods and procedures which they believe are reasonable and in compliance with regulatory requirements. These liabilities are necessarily subject to the impact of loss development and changes in claims severity, as well as numerous other factors, such as judicial and legislative trends and actions, economic factors and estimates of future trends in claims frequency. Most or all of these factors are not directly quantifiable, particularly on a prospective basis. Although management believes that the estimated liabilities for losses and LAE are reasonable, because of the extended period of time over which such losses are reported and settled, the subsequent development of these liabilities may not conform to the assumptions inherent in their determination and, accordingly, may vary significantly from the estimated amounts included in the accompanying financial statements. To the extent that the actual emerging loss experience varies from the assumptions used in determining these liabilities, the liabilities are adjusted to reflect actual experience. Such adjustments, to the extent they occur, are reported in the period recognized. In 1994, the Company's prior years' reserves for unpaid losses and LAE, net of related reinsurance recoverables, were increased by approximately $13.9 million. In 1995, a net $7.5 million decrease in the Company's prior years' reserves included an increase in such reserves of approximately $19.0 million, offset by subrogation recoverables of $19.0 million recognized in connection with a favorable court ruling related to litigation between the Company and the State of New York. In 1996, the Company's prior years' reserves for unpaid losses and LAE decreased by approximately $4.5 million, which included an approximately $13.0 million increase in prior years' reserves which was offset by subrogation recoverables of $13.0 million related to the New York State litigation. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Results of Operations," "--Litigation with the State of New York," "Business--Loss and LAE Reserves" and Note C of the notes to the consolidated financial statements included elsewhere in this Prospectus. RATINGS Increased public and regulatory concerns with the financial stability of insurers have resulted in greater emphasis by policyholders upon insurance company ratings, with a resultant potential competitive advantage for carriers with higher ratings. Frontier Insurance, Frontier Pacific, United Capitol and Regency currently are rated A- (Excellent) by A.M. Best. In addition, S&P has given Frontier Insurance and Frontier Pacific an Insurer Claims-Paying Ability Rating of A+ (Good). Lyndon Property and its two active life insurance subsidiaries currently are rated B++ (Very Good) by A.M. Best. There can be no assurance, however, that the Insurance Subsidiaries will maintain their ratings; any downgrade could materially adversely affect their respective operations. A.M. Best's and S&P's ratings are based on an analysis of the financial condition and operations of an insurance company as they relate to the industry in general, are not designed for the protection of investors and do not constitute recommendations to buy, sell or hold any security. See "Business--Ratings." 13 DEPENDENCE UPON MANAGEMENT The Company's business involves the selection, development and innovative underwriting of insurance coverage for niche markets and the continuing evaluation of the programs insured; the Company is dependent upon its executive management to perform such services. See "Management." FLUCTUATIONS IN INDUSTRY RESULTS The financial results of property and casualty insurers historically have been subject to significant fluctuations. Profitability is affected significantly by volatile and unpredictable developments (including catastrophes), changes in loss reserves resulting from changing legal environments as different types of claims arise and judicial interpretations develop relating to the scope of insurers' liability, fluctuations in interest rates and other changes in the investment environment which affect returns on invested capital, and inflationary pressures that affect the size of losses. Further, underwriting results have been cyclical in the property and casualty insurance industry, with protracted periods of overcapacity adversely impacting premium rates, resulting in higher combined ratios, followed by periods of undercapacity and escalating premium rates, resulting in lower combined ratios. REINSURANCE To moderate the impact of unusually severe or frequent losses, the Insurance Subsidiaries cede (i.e., transfer) a portion of their gross premiums to reinsurers in exchange for the reinsurers' agreements to share covered losses with the subsidiaries. Although reinsurance makes the assuming reinsurer liable to the extent of the risk ceded, the ceding insurance company is not relieved of its primary liability to its insureds and therefore bears a credit risk with respect to its reinsurers. Although the Insurance Subsidiaries place reinsurance only with reinsurers they believe to be financially sound, there can be no assurance that such reinsurers will pay all reinsurance claims on a timely basis, if at all. At March 31, 1997, the Company had net reinsurance recoverables of $209.6 million. Further, although the Company has reinsurance it believes to be adequate, there can be no assurance it will continue to be able to obtain such reinsurance on satisfactory terms. See "Business--Reinsurance." DEPENDENCE ON INVESTMENT INCOME The Company, similar to other property and casualty insurance companies, depends on income from its investment portfolio for a substantial portion of its earnings. A significant decline in investment yields could have a material adverse effect on the Company's financial results. See "Business--Investments." LIMITATIONS ON CHANGE IN CONTROL Mr. Walter A. Rhulen, the Company's founder, Chairman of the Board, President and Chief Executive Officer, members of Mr. Rhulen's family and directors and officers of the Company who are not family members of Mr. Rhulen collectively will own approximately 21.9% of the outstanding shares of Common Stock following the Offering. As a result, such persons are in a position to influence the management and affairs of the Company and, collectively, may be able to prevent a proposed change in control of the Company. See "Principal Stockholders." 14 REGULATION The Company is subject to regulation under applicable insurance statutes, including insurance holding company statutes, of the various states in which the Insurance Subsidiaries write insurance. Insurance regulation is intended to provide safeguards for policyholders rather than to protect shareholders of insurance companies or their holding companies. Regulators oversee matters relating to trade practices, policy forms, claims practices, mandated participation in shared markets, types and amounts of investments, reserve adequacy, insurer solvency, minimum amounts of capital and surplus, transactions with related parties, changes in control and payment of dividends. The rates that the Insurance Subsidiaries can charge for certain lines of business are also subject to regulation and, therefore, may not keep pace with inflation. Any changes in these laws and regulations could materially adversely affect the Company's operations. See "Business--Regulation." HOLDING COMPANY STRUCTURE Because the Company is a holding company, its ability to pay dividends on the Common Stock will be dependent, to a significant degree, on the ability of the Company's subsidiaries to pay dividends to the Company. The jurisdictions of incorporation of the Insurance Subsidiaries place limitations on the amount of dividends or other distributions payable by insurance companies in order to protect their solvency. At March 31, 1997, $27.6 million was available from the Insurance Subsidiaries for payment of dividends. However, the Company's current policy is for its Insurance Subsidiaries to retain their capital for growth and not to pay any dividends. See "Business--Regulation" for restrictions on the payment of dividends by the Insurance Subsidiaries. 15 USE OF PROCEEDS The net proceeds from the sale of the Common Stock offered hereby are estimated at $ million. Approximately $62.0 million of the net proceeds will be used to repay bank indebtedness, bearing interest at an average interest rate of 6.04% per annum, which was incurred in June 1997 to finance the acquisition of Lyndon. The balance will be added to working capital for general corporate purposes, including possible strategic acquisitions and support of the Company's continued internal growth. PRICE RANGE OF COMMON STOCK The Common Stock is traded on the NYSE under the symbol FTR. The following table sets forth the high and low closing sales prices for the Common Stock, as reported by the NYSE, for each calendar quarter during the periods indicated, as adjusted to reflect stock dividends and stock splits:
HIGH LOW --------- --------- 1995: First Quarter......................................................... $ 10.97 $ 9.32 Second Quarter........................................................ 12.22 10.85 Third Quarter......................................................... 14.55 11.53 Fourth Quarter........................................................ 15.06 12.56 1996: First Quarter......................................................... $ 15.00 $ 13.01 Second Quarter........................................................ 17.44 13.87 Third Quarter......................................................... 20.37 16.32 Fourth Quarter........................................................ 19.94 18.44 1997: First Quarter......................................................... $ 22.13 $ 18.50 Second Quarter........................................................ 32.75 21.69 Third Quarter (through August 6, 1997)................................ 32.91 29.19
On August 6, 1997, the last reported closing sale price of the Common Stock on the NYSE was $32.69 per share. DIVIDEND POLICY Holders of Common Stock are entitled to receive cash dividends as may be declared from time to time by the Company's Board of Directors. The Company has paid quarterly cash dividends on the Common Stock since April 1992. Currently, the Company's quarterly cash dividend is $.07 per share. The timing and amount of future dividends will depend upon the Company's earnings and cash requirements and other factors deemed relevant by the Board of Directors. Additionally, the agreement establishing the Company's revolving loan credit facility limits (i) the payment of cash dividends in any year to 5.0% of the Company's consolidated net worth and (ii) prohibits the payment of cash dividends in the event the Company is in default thereunder. As a holding company, the Company is dependent upon, among other things, dividends from its subsidiaries to pay such dividends. See "Business--Regulation" for restrictions on the payment of dividends by the Insurance Subsidiaries. 16 CAPITALIZATION The following table sets forth the consolidated capitalization of the Company at March 31, 1997: (i) actual, (ii) pro forma to give effect to the acquisition of Lyndon on June 3, 1997 and the related borrowing by the Company of $62.0 million on such date under a revolving loan credit facility and (iii) pro forma and as adjusted to give effect to the issuance of the Common Stock being offered hereby, the receipt by the Company of the estimated net proceeds of approximately $ million therefrom and the application of the estimated net proceeds. See "Use of Proceeds," the consolidated financial statements, including the notes thereto, and the unaudited pro forma consolidated financial statements included elsewhere in this Prospectus.
AT MARCH 31, 1997 ------------------------------------- PRO FORMA ACTUAL PRO FORMA AS ADJUSTED ---------- ------------ ----------- (DOLLAR AMOUNTS IN THOUSANDS) Revolving loan credit facility (1).......................... $ -- $ 62,000 $ -- Guaranteed preferred beneficial interest in the 6 1/4% Convertible Subordinated Debentures....................... 166,979 166,979 166,979 Shareholders' equity: Preferred stock, par value $.01 per share; 1,000,000 shares authorized; none outstanding........... -- -- -- Common stock, par value $.01 per share; 50,000,000 shares authorized; 29,407,936 shares outstanding (2)....................... 294 294 Additional paid-in capital................................ 222,142 222,142 Net unrealized losses..................................... (2,873) (2,873) (2,873) Retained earnings......................................... 52,423 52,423 52,423 Less treasury stock--at cost (91,080 shares).............. 788 788 788 ---------- ------------ ----------- Total shareholders' equity.............................. 271,198 271,198 ---------- ------------ ----------- Total capitalization.................................. $ 438,177 $ 500,177 $ ---------- ------------ ----------- ---------- ------------ -----------
- ------------------------ (1) On June 3, 1997, the Company obtained a five-year $100.0 million revolving loan credit facility from Deutsche Bank AG under which the Company drew down $62.0 million on such date. (2) Since March 31, 1997, the Company has issued 63,988 shares of Common Stock upon exercise of stock options. 17 SELECTED CONSOLIDATED FINANCIAL DATA (DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) Except as noted below, the following selected consolidated financial data are derived from the Company's consolidated financial statements. The unaudited financial data for the three months ended March 31, 1997 and 1996 include all adjustments, consisting of normal recurring accruals, which in the opinion of management are necessary for a fair presentation of the Company's consolidated financial position and the consolidated results of operations for these periods. Operating results for the three months ended March 31, 1997 are not necessarily indicative of the results that may be expected for the year ending December 31, 1997. The data should be read in conjunction with the consolidated financial statements, related notes and other financial information included elsewhere in this Prospectus.
THREE MONTHS ENDED MARCH 31, YEAR ENDED DECEMBER 31, -------------------- ----------------------------------------------------- 1997 1996 1996 1995 1994 1993 1992 --------- --------- --------- --------- --------- --------- --------- (UNAUDITED) INCOME STATEMENT DATA: Revenues: Gross premiums written..... $ 105,812 $ 74,860 $ 402,799 $ 264,314 $ 198,892 $ 148,750 $ 149,504 --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Net premiums written....... $ 79,313 $ 61,729 $ 311,863 $ 220,757 $ 187,288 $ 118,819 $ 116,248 --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Net premiums earned........ $ 77,807 $ 58,294 $ 265,989 $ 196,220 $ 156,755 $ 116,372 $ 105,171 Net investment income...... 11,893 7,786 37,226 30,035 24,453 22,523 19,875 Realized capital gains (losses)................. 721 691 1,707 20 (1,478) (152) 333 Gross claims adjusting income................... 15 25 55 130 255 424 1,356 --------- --------- --------- --------- --------- --------- --------- Total revenues......... 90,436 66,796 304,977 226,405 179,985 139,167 126,735 Expenses: Losses and LAE............. 45,674 35,443 155,991 119,255 110,918 77,581 74,933 Amortization of policy acquisition costs, underwriting, and other expenses........... 25,182 18,172 88,080 62,975 47,737 31,293 26,604 Minority interest in income of consolidated subsidiary trust.................... 2,732 -- 2,277 -- -- -- -- Interest expense........... -- 441 1,970 895 -- -- -- --------- --------- --------- --------- --------- --------- --------- Total expenses......... 73,588 54,056 248,318 183,125 158,655 108,874 101,537 --------- --------- --------- --------- --------- --------- --------- Income before income taxes and cumulative effect of change in accounting principle.................. 16,848 12,740 56,659 43,280 21,330 30,293 25,198 Income taxes................. 4,944 3,476 16,592 12,069 4,350 7,130 6,236 --------- --------- --------- --------- --------- --------- --------- Income before cumulative effect of change in accounting principle....... 11,904 9,264 40,067 31,211 16,980 23,163 18,962 Cumulative effect of change in accounting for income taxes...................... -- -- -- -- -- 708 -- --------- --------- --------- --------- --------- --------- --------- Net income............. $ 11,904 $ 9,264 $ 40,067 $ 31,211 $ 16,980 $ 23,871 $ 18,962 --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- SUPPLEMENTAL PER SHARE DATA: Operating income (fully diluted)(1)................ $ .36 $ .31 $ 1.33 $ 1.08 $ .62 $ .92 $ .77 Net income (fully diluted)... .38 .32 1.37 1.08 .59 .94 .79 Book value (at end of period).................... 9.25 8.10 9.17 8.02 6.66 6.52 4.50 Cash dividends............... .07 .06 .25 .24 .23 .20 .20
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THREE MONTHS ENDED MARCH 31, YEAR ENDED DECEMBER 31, -------------------- ----------------------------------------------------- 1997 1996 1996 1995 1994 1993 1992 --------- --------- --------- --------- --------- --------- --------- (UNAUDITED) BALANCE SHEET DATA (AT END OF PERIOD): Total investments............ $ 833,115 $ 564,703 $ 838,320 $ 552,714 $ 407,618 $ 343,591 $ 262,010 Total assets................. 1,275,920 798,649 1,246,407 773,348 599,117 527,657 406,149 Reserves for gross unpaid losses and LAE............. 569,147 383,231 539,073 367,436 312,637 274,035 238,942 Total liabilities............ 837,743 566,513 810,880 543,615 408,853 341,963 299,400 Guaranteed preferred beneficial interest in the 6 1/4% Convertible Subordinated Debentures.... 166,979 -- 166,953 -- -- -- -- Total shareholders' equity... 271,198 232,136 268,574 229,733 190,264 185,694 106,749 COMBINED STATUTORY DATA: (2) Statutory net income......... $ 11,092 $ 9,605 $ 28,874 $ 26,407 $ 6,623 $ 17,713 $ 12,803 Policyholders' surplus....... 276,181 181,014 268,004 171,362 104,871 101,418 76,438 Available for dividends from the insurance subsidiaries (3)........................ 27,618 18,101 26,800 17,136 10,487 10,142 7,644 Ratio of net premiums to surplus (4)............. 1.2x 1.3x 1.2x 1.3x 1.8x 1.2x 1.5x SELECTED RATIOS: GAAP combined ratio.......... 91.0% 91.9% 91.6% 92.8% 101.0% 93.2% 95.4% Statutory combined ratio..... 93.9 91.3 90.9 91.1 98.1 94.2 96.8 Industry statutory combined ratio (5).................. N/A 106.8 105.9 106.4 108.4 106.9 115.7 Ratio of earnings to combined fixed charges and preferred stock dividends (6)........ 6.8x 24.9x 13.2x 39.1x -- -- --
- ------------------------ (1) Represents net income excluding the effect of net realized capital gains and losses and cumulative effect of a change in accounting principle. (2) Compiled from the Annual Statements of Frontier Insurance, Frontier Pacific, United Capitol and Regency as filed with the insurance departments of New York, California, Wisconsin and North Carolina, respectively. (3) 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 "Business--Regulation--Restrictions on Dividends and Distributions." (4) Represents the ratio of statutory net premiums written during the period to statutory policyholders' surplus at the end of such period. The ratios as of March 31, 1997 and 1996 were calculated using statutory net premiums written during the four quarters which precede the interim date. (5) Compiled by A.M. Best. (6) For the purposes of the ratio of earnings to combined fixed charges and preferred stock dividends, earnings were calculated by adding interest expense and amortization of debt issuance costs to income before income taxes and cumulative effect of change in accounting principle. Combined fixed charges consist of interest expense payable on the 6 1/4% Convertible Subordinated Debentures and bank debt. 19 UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION The following unaudited pro forma consolidated balance sheet at March 31, 1997 gives effect to the Company's acquisition of Lyndon as if the acquisition and the related borrowing of $62.0 million under a revolving loan credit facility had occurred at March 31, 1997, and the unaudited pro forma consolidated income statements for the three months ended March 31, 1997 and for the year ended December 31, 1996 give effect to such acquisition and borrowing and the Company's 1996 acquisitions of Regency, Emrol and United Capitol Holding as if all such events had occurred at January 1, 1996. Unaudited pro forma financial data do not purport to be indicative of either the results of future operations or the results of operations that would have occurred if the transactions had been consummated on the dates indicated. Moreover, for the reasons discussed under "Business--Acquisition of Lyndon," among others, the historical operating results of Lyndon are not indicative of its future operating results. UNAUDITED PRO FORMA CONSOLIDATED BALANCE SHEET AT MARCH 31, 1997 (DOLLAR AMOUNTS IN THOUSANDS)
HISTORICAL HISTORICAL PRO FORMA NOTE COMPANY LYNDON ADJUSTMENTS CONSOLIDATED REFERENCE ----------- ----------- ----------- ------------ --------------- ASSETS: Investments: Fixed maturities, available for sale............ $ 707,199 $ 192,936 $ 8,215 $ 908,350 Fixed maturities, held to maturity.............. -- 8,047 (8,047) -- Equity securities............................... 20,351 -- 20,351 Short-term investments.......................... 102,547 13,832 (30,000) 86,379 Investment in limited liability corporation..... 3,018 -- 3,018 ----------- ----------- ----------- ------------ Total investments............................. 833,115 214,815 (29,832) 1,018,098 1 Cash............................................ 15,688 3,868 19,556 Agents' balances due, less allowances for doubtful accounts......................... 50,794 29,979 80,773 Premium receivable from insureds, less allowances for doubtful accounts.............. 27,489 -- 27,489 Net reinsurance recoverables, less allowances for doubtful accounts.............. 209,569 98,353 307,922 Accrued investment income....................... 9,778 3,322 13,100 Federal income taxes recoverable................ 1,165 -- 1,165 Deferred policy acquisition costs............... 36,834 43,503 (43,503) 36,834 2 Deferred federal income tax asset............... 29,540 -- 9,336 38,876 3 Present value of future profits................. -- -- 5,768 5,768 4 Home office building, property and equipment--less accumulated depreciation and amortization.................................. 40,130 -- 40,130 Intangible assets, less accumulated amortization.................................. 11,311 -- 11,311 Other assets.................................... 10,507 2,004 (2,890) 9,621 5 ----------- ----------- ----------- ------------ Total assets.................................. $ 1,275,920 $ 395,844 $ (61,121) $1,610,643 ----------- ----------- ----------- ------------ ----------- ----------- ----------- ------------ LIABILITIES AND SHAREHOLDERS' EQUITY: Unpaid losses and LAE........................... $ 569,147 $ 49,344 $ 618,491 Unearned premiums............................... 180,891 178,106 358,997 ----------- ----------- ------------ Total policy liabilities...................... 750,038 227,450 977,488 Federal income taxes payable.................... -- 2,184 2,184 Deferred federal income tax liability........... -- 4,390 $ (4,390) -- Revolving loan credit facility.................. -- -- 62,000 62,000 6 Funds withheld under reinsurance contracts...... 72,112 -- 72,112 Other liabilities............................... 15,593 43,089 58,682 ----------- ----------- ----------- ------------ Total liabilities............................. 837,743 277,113 57,610 1,172,466 Guaranteed preferred beneficial interest in the 6 1/4% Convertible Subordinated Debentures.... 166,979 -- 166,979 Total shareholders' equity.................... 271,198 118,731 (118,731) 271,198 ----------- ----------- ----------- ------------ Total liabilities and shareholders' equity.... $ 1,275,920 $ 395,844 $ (61,121) $1,610,643 ----------- ----------- ----------- ------------ ----------- ----------- ----------- ------------
See notes to unaudited pro forma consolidated financial information. 20 UNAUDITED PRO FORMA CONSOLIDATED INCOME STATEMENT FOR THE THREE MONTHS ENDED MARCH 31, 1997 (DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
HISTORICAL HISTORICAL PRO FORMA NOTE COMPANY LYNDON ADJUSTMENTS CONSOLIDATED REFERENCE ----------- ----------- ----------- ------------ --------------- REVENUES: Net premiums written.............................. $ 79,313 $ 13,634 $ 92,947 ----------- ----------- ------------ ----------- ----------- ------------ Net premiums earned............................... $ 77,807 $ 23,220 $ 101,027 Net investment income............................. 11,893 3,023 $ (491) 14,425 7 Realized capital gains............................ 721 29 750 Other income...................................... 15 100 115 ----------- ----------- ----------- ------------ Total revenues.................................. 90,436 26,372 (491) 116,317 EXPENSES: Losses and LAE.................................... 45,674 11,434 57,108 Amortization of policy acquisition costs.......... 15,951 3,053 19,004 Amortization of present value of future profits... -- 2,229 (1,632) 597 8 Underwriting and other expenses................... 9,231 2,911 12,142 Minority interest in income of consolidated subsidiary trust................... 2,732 -- 2,732 Interest expense.................................. -- -- 964 964 9 ----------- ----------- ----------- ------------ Total expenses.................................. 73,588 19,627 (668) 92,547 ----------- ----------- ----------- ------------ Income before income taxes........................ 16,848 6,745 177 23,770 Income taxes...................................... 4,944 2,219 62 7,225 10 ----------- ----------- ----------- ------------ Net income........................................ $ 11,904 $ 4,526 $ 115 $ 16,545 ----------- ----------- ----------- ------------ ----------- ----------- ----------- ------------ Fully diluted earnings per share.................. $ .38 $ .50 ----------- ------------ ----------- ------------
UNAUDITED PRO FORMA CONSOLIDATED INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31, 1996 (DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
HISTORICAL HISTORICAL 1996 HISTORICAL PRO FORMA NOTE COMPANY ACQUISITIONS LYNDON ADJUSTMENTS CONSOLIDATED REFERENCE ----------- --------------- ----------- ----------- ------------ --------------- REVENUES: Net premiums written............. $ 311,863 $ 6,043 $ 96,614 $ 414,520 ----------- ------- ----------- ------------ ----------- ------- ----------- ------------ Net premiums earned.............. $ 265,989 $ 5,463 $ 83,277 $ 354,729 Net investment income............ 37,226 3,911 12,082 $ (4,262) 48,957 11 Realized capital gains........... 1,707 647 606 2,960 Other income..................... 55 -- 833 888 ----------- ------- ----------- ----------- ------------ Total revenues................. 304,977 10,021 96,798 (4,262) 407,534 EXPENSES: Losses and LAE................... 155,991 2,972 27,553 186,516 Amortization of policy acquisition costs.............. 57,540 (292) 10,999 (4,039) 64,208 8 Amortization of present value of future profits.............. -- -- 11,080 (7,500) 3,580 8 Underwriting and other expenses....................... 30,540 1,653 7,172 422 39,787 12 Minority interest in income of consolidated subsidiary trust.. 2,277 -- -- 2,277 Interest expense................. 1,970 -- -- 3,856 5,826 9 ----------- ------- ----------- ----------- ------------ Total expenses................. 248,318 4,333 56,804 (7,261) 302,194 ----------- ------- ----------- ----------- ------------ Income before income taxes....... 56,659 5,688 39,994 2,999 105,340 Income taxes..................... 16,592 2,018 13,012 1,155 32,777 10 ----------- ------- ----------- ----------- ------------ Net income....................... $ 40,067 $ 3,670 $ 26,982 $ 1,844 $ 72,563 ----------- ------- ----------- ----------- ------------ ----------- ------- ----------- ----------- ------------ Fully diluted earnings per share.......................... $ 1.37 $ 2.42 ----------- ------------ ----------- ------------
See notes to unaudited pro forma consolidated financial information. 21 NOTES TO UNAUDITED PRO FORMA CONSOLIDATED FINANCIAL INFORMATION (1) Total investments decreased primarily due to the sale of $30.0 million of investments, the proceeds of which, together with $62.0 million drawn down under the revolving loan credit facility, were used to acquire Lyndon. (2) Deferred policy acquisition costs of $43.5 million have been eliminated as a result of a purchase accounting adjustment. (3) The net increase in deferred federal income tax asset was the result of the purchase accounting adjustments related to deferred taxes associated with deferred policy acquisition costs, the excess of net assets acquired over the purchase price, reclassification of deferred tax liabilities, and PVFP. (4) PVFP was the result of a purchase accounting adjustment establishing $47.7 million of estimated future profits less the $41.9 million excess of the net assets acquired over the purchase price. (5) The net decrease in other assets was the result of the reduction of certain assets to their estimated fair value at the date of acquisition. (6) The $62.0 million represents the amount drawn down under the revolving loan credit facility used to acquire Lyndon. (7) Net investment income has been decreased to reflect the reduction in investment income from the sale of $30.0 million of investments to fund the acquisition of Lyndon, assuming a pre-tax yield of 6.5%. (8) Amortization of policy acquisition costs and PVFP have been adjusted to reflect estimated amortization expense based on a valuation of business in force as of the purchase date. PVFP was offset by the excess of net assets acquired over the purchase price and is being amortized in relation to the earned premiums. (9) Interest expense has been increased to reflect the $62.0 million drawn down under the revolving loan credit facility, assuming an interest rate of 6.04%. (10) Federal income taxes have been increased to reflect the net tax effect of the pro forma adjustments. (11) Net investment income has been decreased to reflect the sale of investments to fund the acquisitions of Lyndon and United Capitol Holding and to pay dividends to their previous parent companies, assuming pre-tax yields ranging from 6.4% to 6.9%. (12) Underwriting and other expenses have been increased to reflect the amortization of the excess cost over net assets acquired arising from the acquisitions of United Capitol Holding, Regency and Emrol. 22 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this Prospectus. RESULTS OF OPERATIONS The following table sets forth the Company's net premiums earned by principal lines of insurance for the periods indicated and percentage of change therein from period to period:
PERCENTAGE INCREASE (DECREASE) ----------------------------------- THREE MONTHS ENDED THREE YEAR MARCH 31, YEAR ENDED DECEMBER 31, MONTHS ---------------------- ------------------------ ------------------------------- 1996 TO 1995 TO 1994 TO 1997 1996 1996 1995 1994 1997 1996 1995 ----------- ----------- --------- --------- --------- ----------- --------- ----------- (DOLLAR AMOUNTS IN THOUSANDS) Medical malpractice (including dental malpractice and social services).......... $ 27,907 $ 24,098 $ 105,217 $ 88,295 $ 74,877 15.8% 19.2% 17.9% General liability........... 28,010 16,910 78,641 50,026 28,631 65.6 57.2 74.7 Surety...................... 12,720 11,648 51,369 39,756 30,344 9.2 29.2 31.0 Commercial earthquake....... 1,744 512 8,257 249 -- 240.6 N/M N/A Workers' compensation....... 808 3,049 7,025 10,320 16,671 (73.5) (31.9) (38.1) Other....................... 6,618 2,077 15,480 7,574 6,232 218.6 104.4 21.5 ----------- ----------- --------- --------- --------- ----- --------- ----- Total................... $ 77,807 $ 58,294 $ 265,989 $ 196,220 $ 156,755 33.5% 35.6% 25.2% ----------- ----------- --------- --------- --------- ----- --------- ----- ----------- ----------- --------- --------- --------- ----- --------- -----
The following table sets forth the components of the Company's combined ratio calculated as a percentage of net premiums earned on the basis of generally accepted accounting principles ("GAAP Combined Ratio") for the periods indicated:
THREE MONTHS ENDED MARCH 31, YEAR ENDED DECEMBER 31, ------------------------ ------------------------------- 1997 1996 1996 1995 1994 ----------- ----------- --------- --------- --------- Losses................................. 40.0% 45.5% 36.5% 45.6% 54.1% LAE.................................... 18.7 15.3 22.2 15.2 16.7 --- --- --- --- --------- Losses and LAE......................... 58.7 60.8 58.7 60.8 70.8 Policy acquisition, underwriting, interest and other expenses.......... 32.3 31.1 32.9 32.0 30.2 --- --- --- --- --------- GAAP Combined Ratio.................... 91.0% 91.9% 91.6% 92.8% 101.0% --- --- --- --- --------- --- --- --- --- ---------
THREE MONTHS ENDED MARCH 31, 1997 COMPARED TO THREE MONTHS ENDED MARCH 31, 1996 A variety of factors accounted for the 33.5% growth in net premiums earned, the principal factors being increases in the Company's core and new program business and the acquisition of United Capitol and Regency in the second and third quarter of 1996, respectively. This increase was partially offset by (i) a decrease in workers' compensation, particularly the cotton gin program that the Company discontinued during 1996, (ii) a decrease in the workers' compensation component of social services programs due to price competition, and (iii) an increase in reinsurance costs associated with the aggregate excess of loss reinsurance contract. The increase in medical malpractice net premiums earned was primarily attributable to an increase in the number of physicians insured in the programs for psychiatrists and alternative risks, geographical expansion in Ohio, Texas, Michigan and Illinois, and growth in the dental program endorsed by the Academy of General Dentistry, partially offset by the reclassification of certain net premiums written in the social services programs to the general liability line of business. 23 Net premiums earned for the general liability line increased primarily because of increases in various programs, including continued growth in the social services, alarms and guards, demolition contractors and excess employers' liability programs, and as a result of the acquisition of United Capitol in May 1996. These increases were partially offset by a decrease in net premiums earned in the umbrella and crane liability programs. Growth in surety net premiums earned continued in 1997, primarily attributable to expanded writings of license and permit bonds, small contractors bonds and miscellaneous bonds. Net premiums earned for the workers' compensation line decreased primarily as a result of decreases in the specialty niche programs for cotton gins and feed lots, decreases in social services programs due to price competition, and lesser required participation in the National Workers' Compensation Reinsurance Pools. The decrease was partially offset by increases in workers' compensation premiums written in the alternative risk program which the Company initiated in 1996. Net premiums earned for the commercial earthquake program increased primarily due to the growth in the number of policies written in 1996, which are earned pro rata in 1997, partially offset by the planned 1997 decrease in net written premiums in this line of business. Net premiums earned for the other lines of business increased primarily due to increased volume in commercial package policies in the social services programs, and increased volume in the mobile homeowners' and auto physical damage programs as a result of the acquisition of Regency in September 1996. These increases were partially offset by decreases in other miscellaneous small programs. Net investment income before realized capital gains and losses increased 52.7% due principally to increases in invested assets resulting from the proceeds of the issuance of Convertible Trust Originated Preferred Securities ("Convertible TOPrS") in October 1996, cash inflow from regular operations, and the contribution to net investment income by United Capitol and Regency, partially offset by the interest charge on funds held by the Company for the benefit of the reinsurer of the Company's aggregate excess of loss reinsurance contract. Total net investment income increased 48.8% due to the aforementioned increase in net investment income and a significantly lower increase in realized capital gains of 4.3%. The average annual pre-tax yield on investments, excluding the charge for funds held under the aggregate excess loss of reinsurance contract and realized capital gains and losses, was 6.5%, unchanged from the previous year. The average annual after-tax yield on investments, excluding the charge for funds held under the aggregate excess of loss reinsurance contract and realized capital gains and losses, was 5.1%. Gross claims adjusting income decreased 40.0% primarily as a result of a decrease in claim services provided to outside companies, partially offset by an increase in the rates charged for certain services. Total revenues increased 35.4% as a result of the above. Total expenses increased by 36.1% compared to the 33.5% increase in net premiums earned. Losses and LAE increased at a 28.9% rate as a result of a 17.4% increase in losses and a 63.0% increase in LAE. The increase in losses and LAE was disproportionate to that of net premiums earned due to the aggregate excess of loss reinsurance contract which provides coverage for losses and LAE in excess of 64.0% and 65.0% for the 1997 and 1996 accident years, respectively, which resulted in a loss and LAE component of the GAAP Combined Ratio 2.1 percentage points lower than in the comparable 1996 period. The 63.0% increase in LAE resulted from a change in the lines of business mix to those having a higher percentage relationship of LAE to losses. The 38.6% increase in the amortization of policy acquisition costs, underwriting and other expenses was attributable primarily to an increase in direct commission expense resulting from growth in programs with higher commission rates, increased staffing and marketing expenses related to expansion, salary increases and the expenses associated with the acquisition of United Capitol and Regency in 1996. The $441,000 decrease in interest expense was primarily the result of the repayment and termination of the line of credit in the fourth quarter of 1996. The Company also incurred approximately $2.7 million of expenses in 1997 associated with the Convertible TOPrS. As the non-claim related component of the GAAP Combined Ratio increased at a greater rate than premiums earned, the non-claim component was 1.2 percentage points higher than in the comparable 1996 period. The total GAAP Combined Ratio decreased by 0.9 percentage points to 91.0% as a result of the above. 24 The foregoing changes resulted in income before taxes of $16.8 million for the 1997 quarter, a 32.2% increase from the comparable 1996 quarter. Net income for the period increased by $2.6 million, or 28.5%, over the comparable 1996 quarter. CALENDAR YEAR 1996 COMPARED TO CALENDAR YEAR 1995 A variety of factors accounted for the 35.6% growth in net premiums earned, the principal factors being increases in the majority of the Company's core and new program business, partially offset by a decrease in workers' compensation, particularly the cotton gin program, and by the increased ceding of net premiums earned under the Company's aggregate excess of loss reinsurance contract effective January 1, 1995, pursuant to which 13.5% and 14.0% of net premiums earned in 1996 and 1995, respectively, were ceded for all lines of business, except certain classes of surety bonds, realtors' errors and omissions and all of the net premiums earned by United Capitol and Regency. The increase in medical malpractice net premiums earned was primarily attributable to an increase in the number of physicians insured, principally those associated with mental health, home care and other social service organizations, growth in the programs for psychiatrists and alternative risks, geographical expansion in Ohio, Texas, Michigan and Illinois, growth in the dental program endorsed by the Academy of General Dentistry, and rate increases in Florida. Net premiums earned for the general liability line increased primarily because of increases in various programs, including social services, alarms and guards, demolition contractors, pest control, and excess employers' liability programs, and as a result of the acquisition of United Capitol in May 1996. These increases were partially offset by a decrease in net premiums earned in the umbrella and crane operator liability programs. Growth in the surety net premiums earned continued in 1996, primarily attributable to expanded writings of license and permit bonds, small contractors bonds, miscellaneous bonds, custom bonds and bail bonds. Net premiums earned for the workers' compensation line decreased primarily as a result of decreases in the specialty niche program for cotton gins and feed lots, decreases in the social services programs due to price competition, and a lesser required participation in the National Workers' Compensation Reinsurance Pools. These decreases were partially offset by increases in workers' compensation from the alternative risk program which the Company initiated in 1996. Net premiums earned for the commercial earthquake program increased primarily due to the growth in the number of policies written in 1996 over the comparable period in 1995, when the program was initiated. Net premiums earned for the other lines of business increased primarily due to increased volume in commercial package policies in the social services programs, and increased volume in the mobile homeowners' and auto physical damage programs as a result of the acquisition of Regency in September 1996. These increases were partially offset by decreases in other miscellaneous small programs. Net investment income before realized capital gains and losses increased 23.9% due principally to increases in invested assets resulting from the proceeds of the issuance of Convertible TOPrS in October 1996, cash inflow from regular operations, and the contribution to net investment income by United Capitol and Regency, partially offset by the interest charge on funds held by the Company for the benefit of the reinsurer of the Company's aggregate excess of loss reinsurance contract. Total net investment income increased 29.5% due to the aforementioned increase in net investment income and an increase in realized capital gains. The average annual pre-tax yield on investments, excluding the charge for funds held under the aggregate excess of loss reinsurance contract and realized capital gains and losses, was 6.4%, unchanged from the previous year. The average annual after-tax yield on investments, excluding the charge for funds held under the aggregate excess of loss reinsurance contract and realized capital gains and losses, was 4.8%. 25 Gross claims adjusting income decreased 57.7% primarily as a result of a decrease in claim services provided to outside companies, principally Markel Corporation. Total revenues increased 34.7% as a result of the above. Total expenses increased by 35.6%, similar to the 35.6% increase in net premiums earned. Losses and LAE increased by 30.8% which included a 8.5% increase in losses and a 97.5% increase in LAE. The increase in losses was substantially lower than for net premiums earned as a result of a one-time reallocation of loss reserves to LAE reserves, favorable reserve development in accident years prior to 1996 for general liability and workers' compensation and recoveries under the aggregate excess of loss reinsurance contract which provides coverage for certain losses and LAE in excess of 65.0% of the net premiums earned for the 1996 accident year, partially offset by higher loss and LAE ratios for business written in 1996. The Company also increased prior years' reserves by approximately $13.0 million, which was entirely offset by an increase in the same amount of the subrogation recoverable recognized in conjunction with the favorable December 1995 ruling in the New York Court of Appeals, described in Note C of the notes to consolidated financial statements. Such increase in the subrogation recoverable resulted from further documentation and verification in the second quarter of 1996 of claims already paid by the Company and reserves held by the Company that the Company believes are reimbursable by the State of New York. The 97.5% increase in LAE resulted from, a one-time reallocation of loss reserves to LAE reserves, partially offset by a change in the lines of business mix to those having a lower percentage relationship of LAE to losses and the allocation of recoveries under the aggregate excess of loss contract. Due to the disproportionate relationship of losses and LAE to net premiums earned, the loss and LAE component of the GAAP Combined Ratio was 2.1 percentage points lower than in the comparable 1995 period. The 40.0% increase in the amortization of policy acquisition costs, underwriting and other expenses was attributable primarily to an increase in direct commission expense resulting from growth in programs with higher commission rates, a decrease in reinsurance contingent commissions, increased staffing and marketing expenses related to expansion, a reduction in assessment recoveries from the Texas Workers' Compensation Insurance Facility, and salary increases. The 120.1% increase in interest expense was primarily the result of increased interest expense associated with the borrowing under the line of credit. The Company also incurred approximately $2.3 million of expenses in 1996 associated with the Convertible TOPrS. See Note M of the notes to the consolidated financial statements included elsewhere in this Prospectus. As the non-claim related component of the GAAP Combined Ratio increased at a greater rate than premiums earned, the non-claim component was 0.9 percentage points higher than in the comparable 1995 period. The total GAAP Combined Ratio decreased by 1.2 percentage points to 91.6% as a result of the above. The foregoing changes resulted in income before income taxes of $56.7 million for the year ended 1996, a 30.9% increase from the comparable 1995 period. Net income for the year increased by $8.9 million, or 28.4%. CALENDAR YEAR 1995 COMPARED TO CALENDAR YEAR 1994 A variety of factors accounted for the 25.2% growth in net premiums earned, the principal factor being increases in the majority of the Company's core and new program business, partially offset by a decrease in workers' compensation, particularly the cotton gin program, and by the increased ceding of earned premiums under the Company's aggregate excess of loss reinsurance contract effective January 1, 1995, pursuant to which 14.0% of earned premium for all lines of business, except bail, customs, license and permit, and miscellaneous surety bonds is ceded. The increase in medical malpractice net premiums earned was primarily attributable to an increase in the number of physicians insured, principally those associated with mental health, home care, and other social service organizations, growth in the program for psychiatrists, greater penetration of the Ohio physician market, growth in the dental program endorsed by the Academy of General Dentistry, and rate increases in Florida and other geographic areas. 26 Net premiums earned for the general liability line increased primarily because of increases in various programs, including social services, alarms and guards, pest control and excess employer's liability. These increases were partially offset by a decrease in net written premiums earned in the umbrella and in the crane operator liability programs. Growth in the surety net premiums earned continued in 1995, primarily attributable to expanded writings of license and permit bonds, with bonds for small contractors, miscellaneous bonds, and bail bonds also showing substantial percentage increases. The increase in license and permit bonds was primarily attributable to the Company's acquisition in April 1994 of the license and permit bond business of a California insurance agency. Net premiums earned for the workers' compensation line decreased primarily as a result of decreases in the specialty niche program for cotton gins caused by a weather-related reduction in the cotton crop, and decreases in other smaller programs due to the Company's decision not to renew accounts deemed unprofitable, and decreased required participation in the National Workers' Compensation Reinsurance Pools. These decreases were partially offset by increases in workers' compensation premiums written in the social services programs. Net premiums earned for the other lines of business increased primarily due to increased volume in commercial package policies in the social services programs, and the recent start-up of an earthquake program. These increases were partially offset by decreases in other miscellaneous small programs. Net investment income before realized capital gains and losses increased 22.8% due principally to increases in invested assets resulting from the proceeds of the $25.0 million borrowing under a line of credit facility, the January 1995 commutation of certain medical malpractice reinsurance treaties, and cash inflow from regular operations, partially offset by the interest charge on funds held by the Company for the benefit of the reinsurer of the Company's aggregate excess of loss reinsurance contract. Total net investment income increased 30.8% due to the aforementioned increase in net investment income and a decrease in realized capital losses. The average annual pre-tax yield on investments, excluding the charge for funds held under the aggregate excess of loss reinsurance contract and realized capital gains and losses, decreased to 6.4% from 6.6%. This decrease is primarily the result of generally lower interest rates available for funds invested in 1994 and 1995, and a decrease in the Company's holdings of higher yielding investments, as a result of maturities and calls for redemption. The average annual after-tax yield on investments, excluding the charge for funds held under the aggregate excess of loss reinsurance contract and realized capital gains and losses, decreased to 4.9% from 5.4%, primarily for the reasons described above. Gross claims adjusting income decreased 49.0% primarily as a result of a decrease in claim services provided to outside companies, principally Markel Corporation. Total revenues increased 25.8% as a result of the above. Total expenses increased by 15.4% compared to the 25.2% increase in net premiums earned. Losses and LAE increased by 7.5% as a result of a 5.5% increase in losses and a 14.1% increase in LAE. The increase in losses and LAE was substantially lower than that for net premiums earned as a result of the one-time addition of $17.5 million to the 1994 loss reserves applicable to the Company's medical malpractice business in Florida, subrogation recoveries in the surety line of business in excess of expectations, favorable reserve development in accident years prior to 1995 for general liability and workers' compensation and recoveries under the aggregate excess of loss reinsurance contract which provides coverage for certain losses and LAE in excess of 66.0% of the net earned premium for the 1995 accident year. These decreases were partially offset by carrying higher loss and LAE ratios to premiums earned for 1995 business. The Company also increased prior years' reserves by approximately $19.0 million, offset by subrogation recoverables of like amount, recognized in conjunction with the favorable ruling in the New York Court of Appeals as more fully described in Note C of the notes to consolidated financial statements. The 14.1% increase in LAE resulted from the increase in loss and LAE ratios, 27 partially offset by a change in the lines of business mix to those having a lower percentage relationship of LAE to losses and the allocation of recoveries under the aggregate excess of loss contract and the favorable court ruling mentioned above. Due to the disproportionate relationship of losses and LAE to earned premium, the loss and LAE component of the GAAP Combined Ratio was 10.0 percentage points lower than in the comparable 1994 period. The 38.7% increase in the amortization of policy acquisition costs was attributable primarily to an increase in direct commission expense resulting from growth in programs with higher commission rates, a decrease in reinsurance contingent commissions, increased staffing and marketing expenses related to expansion, and salary increases, partially offset by a decrease in assumed commission expense resulting from the continued decrease in assumed written premiums. The 25.1% increase in underwriting, other expenses and interest expense was primarily the result of the interest expense associated with the borrowing under the line of credit facility, an increase in the additions to allowance for bad debts, increased staffing, increased facilities, equipment and materials expense necessitated by the Company's growth, a reduction in assessment recoveries from the Texas Workers' Compensation Insurance Facility, and salary increases, partially offset by a decrease in policyholder dividends. As the non-claim related component of the GAAP Combined Ratio increased at a greater rate than premiums earned, the non-claim component was 1.8 percentage points higher than in the comparable 1994 period. The total GAAP Combined Ratio decreased by 8.2 percentage points to 92.8% as a result of the above. The foregoing changes resulted in income before income taxes of $43.3 million for the year ended 1995, a 102.9% increase from the comparable 1994 period. Net income for the year increased by $14.2 million, or 83.8%. The comparative results were significantly impacted by the $17.5 million addition to loss reserves in the third quarter of 1994 reflected above, which resulted in a disproportionately lower net income for the 1994 period. ASSET PORTFOLIO REVIEW At March 31, 1997, the Company's total assets of $1.3 billion consisted of the following: cash and investments, 66.5%; reinsurance recoverables, 16.4%; premiums receivable and agents balances, 6.1%; deferred expenses (policy acquisition costs and deferred federal income taxes), 5.2%; home office building, property and equipment, 3.1%; and other assets, 2.7%. The Company generally invests in securities with fixed maturities with the objective of providing reasonable returns while limiting liquidity and credit risk. As a result, its investment portfolio consists primarily of government and governmental agency securities and high-quality marketable corporate securities which are rated at investment grade levels. At March 31, 1997, the Company held rated, or better-than-investment grade, fixed income debt securities with a carrying amount of $707.2 million, constituting 100.0% of the Company's fixed maturity investments. At March 31, 1997 and 1996, the Company's fixed maturity securities included mortgage-backed bonds of $280.5 million and $201.2 million, respectively, which are subject to risks associated with variable prepayments of the underlying mortgage loans. Prepayments cause those securities to have different actual maturities than expected at the time of purchase. Securities that have an amortized cost greater than par that are backed by mortgages that prepay faster than expected will incur a reduction in yield or loss, while securities that have an amortized cost less than par that are backed by mortgages that prepay faster than expected will generate an increase in yield or gain. The degree to which a security is susceptible to either gains or losses is influenced by the difference between its amortized cost and par, the relative sensitivity of the underlying mortgages backing the assets to prepayments in a changing interest rate environment and the repayment priority of the securities in the overall securitization structure. The Company limits the extent of its credit risk by purchasing securities that are backed by stable collateral and by concentrating on securities with enhanced priority in the securitization structure. Such securities with reduced risk typically have a lower yield (but higher liquidity) than higher-risk mortgage-backed bonds (i.e., mortgage-backed bonds structured to share in residual cash flows or which cover interest only payments). At selected times, higher-risk securities may be purchased if they do not 28 compromise the safety of the Company's general portfolio. There are negligible default risks in the Company's mortgage-backed bond portfolio as the vast majority of these bonds are either guaranteed by U.S. government-sponsored entities or are supported in the securitization structure by junior securities resulting in the bonds having high investment grade status. The following table provides a profile of the Company's fixed maturities investment portfolio by rating at March 31, 1997:
AMOUNT MARKET REFLECTED ON PERCENT S&P'S/MOODY'S RATING(1) VALUE BALANCE SHEET OF TOTAL - --------------------------------------------------------- ---------- ------------- ----------- (DOLLAR AMOUNTS IN THOUSANDS) AAA/Aaa (including U.S. Treasuries of $22,339)........... $ 409,984 $ 409,984 58.0% AA/Aa.................................................... 111,734 111,734 15.8 A/A...................................................... 138,207 138,207 19.5 BBB/Baa.................................................. 47,250 47,250 6.7 All other................................................ 24 24 -- ---------- ------------- ----- Total............................................ $ 707,199 $ 707,199 100.0% ---------- ------------- ----- ---------- ------------- -----
- ------------------------ (1) Ratings are assigned by S&P or, if no S&P rating is available, by Moody's Investors Service Inc. Prior to January 1, 1994, the Company classified fixed maturity securities in accordance with the then existing accounting standards and, accordingly, those fixed maturity securities that were not intended to be held-to-maturity were designated as actively managed and were carried at fair value, with unrealized holding gains and losses reported in a separate caption in shareholders' equity. Other fixed maturity securities were carried at amortized cost since the Company had both the ability and intent to hold those securities until maturity. As of January 1, 1994, the Company adopted FASB Statement 115 and reclassified a portion of its fixed maturity securities portfolio as "available-for-sale," with the remainder being classified as "held-to-maturity." Under the reclassification, the fixed maturity securities classified as "available-for-sale" are carried at fair value and changes in fair values, net of applicable income taxes, are charged or credited directly to shareholders' equity. "Held-to-maturity" securities are reported at amortized cost. The adoption of Statement 115 increased shareholders' equity by $3.7 million at January 1, 1994. In December 1995, the Company reclassified all of its previously held securities classified as held-to-maturity to available-for-sale as permitted by FASB's Special Report, A GUIDE TO IMPLEMENTATION OF STATEMENT 115 ON ACCOUNTING FOR CERTAIN INVESTMENTS IN DEBT AND EQUITIES--QUESTIONS AND ANSWERS. The reclassification increased shareholders' equity by $2.8 million at December 31, 1995. LIQUIDITY AND CAPITAL RESOURCES The Company is a holding company, receiving cash principally through sales of equities, borrowings, and dividends from its subsidiaries, certain of which are subject to dividend restrictions described in Note I of the notes to the consolidated financial statements. The ability of insurance and reinsurance companies to underwrite insurance and reinsurance is based on maintaining liquidity and capital resources sufficient to pay claims and expenses as they become due. The primary sources of liquidity for the Company's subsidiaries are funds generated from insurance and reinsurance premiums, investment income, commission and fee income, capital contributions from the Company and proceeds from sales and maturities of portfolio investments. The principal expenditures are for payment of losses and LAE, underwriting and other operating expenses, commissions, and dividends to shareholders and policyholders. The Company's subsidiaries maintain liquid operating positions and follow investment guidelines that are intended to provide for an acceptable return on investment while preserving capital, maintaining sufficient liquidity to meet their obligations and, as to the Insurance Subsidiaries, maintaining a sufficient margin of capital and surplus to ensure their unimpaired ability to write insurance and assume reinsurance. 29 Cash flow generated from operations for the three months ended March 31, 1997 and 1996 and for the years ended December 31, 1996, 1995 and 1994 was $18.9 million, $15.8 million, $116.5 million, $105.0 million and $81.9 million, respectively, amounts adequate to meet all of the Company's obligations. In January 1994 and 1995, investment funds were increased by $9.0 million and $3.9 million, respectively, from the commutation of the 1990 and 1991 treaty years under the medical malpractice reinsurance treaties, resulting in the receipt of $6.1 million and $3.9 million, respectively, in cash and a concomitant increase in reserves for unpaid losses and LAE, with the balance received from the collection of contingent commissions earned by the Company for the 1994 treaty year. In April 1994, the Company completed the acquisition of SDIA, Inc. ("SDIA"), a California license and permit bond insurance agency, for $3.2 million and entered into a five-year consulting agreement with the owner/principal of the agency. Personnel of the agency involved in placing and servicing the acquired business have become employees of the Company, operating from their respective locations in Phoenix, Arizona; Reno and Las Vegas, Nevada; and San Jose, Orange County and La Jolla, California. All new and renewal policies with respect to the approximately $5.0 million to $6.0 million of license and permit bond business acquired are issued by the Company. On November 10, 1994, the Company authorized a stock repurchase program to purchase up to 1.0 million shares of its Common Stock, in compliance with SEC Rule 10b-18, at the discretion of the Chairman of the Board. There is no commitment or obligation on the part of the Company to purchase any particular number of shares and the program may be suspended at any time at the Company's discretion. The Company has not purchased any shares since 1995. In 1995 and 1994, the Company purchased the present equivalent of 13,200 and 77,880 shares of its Common Stock at a cost of $134,000 and $654,000, respectively. In May 1995, the Company and R. Spencer Douglas III ("Douglass") formed a California limited liability corporation, Douglass/Frontier, LLC ("Douglass/Frontier"), a bail bond insurance agency to which the Company contributed $2.4 million in cash and Douglass contributed the assets of his wholly-owned existing bail bond agency. The Company and Douglass share equally in the ownership of Douglass/ Frontier. On June 29, 1995, the Company obtained a 4 1/2 year, $35.0 million line of credit facility from The Bank of New York, under which it borrowed $25.0 million at an interest rate of 6.87% per annum, payable quarterly. In June and September 1996, the Company borrowed an additional $4.2 million and $2.9 million from The Bank of New York (outside of the line of credit) at annual interest rates of 6.13% and 6.31%, respectively, payable quarterly, due October 1996. In the fourth quarter, the Company repaid all borrowings and terminated the facility. As a result of a review by A.M. Best of Frontier Insurance's A- (Excellent) rating, the Company agreed with A.M. Best to make a $45.0 million capital infusion to Frontier Insurance by June 30, 1995 in order to fund its projected growth and retain its A- (Excellent) rating. At June 30, 1995, the Company had completed the $45.0 million capital infusion, utilizing a combination of funds previously held by the Company and loan proceeds from The Bank of New York credit facility. In November 1995, the Company acquired the realtors' errors and omissions book of business from Bankers Multiple Line Insurance Company ("BMLIC") for $400,000. The personnel of BMLIC involved in placing and servicing the acquired business have become employees of the Company, operating from their location in Louisville, Kentucky. In May 1996, the Company completed the acquisition of United Capitol Holding, the direct or indirect parent of United Capitol, United Capitol Managers, Inc. (renamed Olympic Underwriting Managers, Inc.) and Fischer Underwriting Group, Inc., for $31.0 million. United Capitol Holding, through its subsidiaries, underwrites specialty risks, such as asbestos abatement, product and general liability, environmental liability and directors' and officers' liability. 30 In September 1996, the Company completed the acquisition of Regency and Emrol in exchange for 476,174 shares of Common Stock. Regency underwrites non-standard automobile insurance, principally in North Carolina, and Emrol finances premiums primarily for policyholders of Regency. In October 1996, the Company completed a $172.5 million offering of Convertible TOPrS, issued through Frontier Financing Trust, a Delaware business trust formed by the Company for the purpose of the transaction. The Convertible TOPrS have a dividend rate of 6 1/4% and are convertible into 2.1328 shares of Common Stock, equivalent to a conversion price of $23.44 per share. See Note M of the notes to the consolidated financial statements included elsewhere in this Prospectus. Net proceeds to the Company from this offering were $166.9 million, of which $32.1 million was applied to repay bank debt, $60.0 million was contributed to the surplus of Frontier Insurance, $30.0 million was utilized to fund, in part, the acquisition of Lyndon and the balance was available for general corporate purposes, including dividend payments. Through March 31, 1997, the Company expended $2.8 million in connection with the construction of an addition to its home office building. The Company expects to expend an additional $8.5 million to complete the addition, which it plans to occupy in the fourth quarter of 1997. Cash dividends declared in the three months ended March 31, 1997 and 1996 and the years ended December 31, 1996, 1995 and 1994 were $1.9 million, $1.6 million, $7.3 million, $6.2 million and $6.0 million, respectively. On June 3, 1997, the Company completed the acquisition of 100.0% of the stock of Lyndon Property and its six subsidiaries, Lyndon Life Insurance Company, Twin Mercury Life Insurance Company, Gulfco Life Insurance Company, Lyndon Southern Insurance Company, Lyndon--DFS Warranty Services, Inc. and Lyndon General Agency of Texas, Inc., at a purchase price of $92.0 million in cash. On June 3, 1997, the Company obtained a five-year $100.0 million revolving loan credit facility from Deutsche Bank AG pursuant to which it borrowed $62.0 million at an initial floating interest rate of 6.04%, based upon Eurodollar interest rates, payable quarterly, to fund a portion of the Lyndon purchase price. REINSURANCE Effective January 1, 1995, the Company entered into a stop loss reinsurance contract with Centre Reinsurance Company of New York ("Centre Re") for accident years 1995, 1996 and 1997. Under the agreement, Centre Re provides reinsurance protection within certain accident year and contract aggregate dollar limits for losses and LAE in excess of a predetermined ratio of these expenses to net premiums earned for a given accident year for all lines of business, except selected programs and certain classes of surety bonds, and net premiums earned from Lyndon, United Capitol and Regency. The loss and LAE ratio above which the reinsurance provides coverage is 66.0%, 65.0% and 64.0% for accident years 1995, 1996 and 1997, respectively. The amount recoverable is subject to a single accident year limit of 175.0% of the premium paid for such accident year and an aggregate limit equal to the lesser of (i) 175.0% of the premium paid for all three accident years or (ii) $162.5 million. The Centre Re stop loss reinsurance contract expires December 31, 1997. The Company is evaluating whether to negotiate a renewal of the contract or explore other reinsurance alternatives. See "Business--Reinsurance." LITIGATION WITH THE STATE OF NEW YORK In December 1990, the New York State Court of Claims rendered a decision in favor of the Company holding that a State University of New York ("SUNY") medical school faculty member engaged in the clinical practice of medicine at a SUNY medical facility, corollary to such physician's faculty activities, was within the scope of such physician's employment by SUNY and was protected against malpractice claims arising out of such activity by the State of New York and not under the Company's medical malpractice policy. The decision was affirmed on appeal by the New York State Appellate Division in November 1991 and not appealed by the State. In July 1992, the State of New York enacted legislation eliminating medical school faculty members of SUNY engaged in the clinical practice of medicine at a SUNY medical facility 31 from indemnification by the State with respect to malpractice claims arising out of such activity, retroactive to July 1, 1991. In an opinion filed on September 3, 1993 the Court of Claims of the State of New York held, INTER ALIA, that the July 1992 legislation by the State of New York eliminating SUNY medical school faculty members engaged in the clinical practice of medicine, as part of their employment by SUNY, from indemnification by the State with respect to malpractice claims arising out of such activity was not to be applied retroactively. This decision was affirmed by the New York State Appellate Division in April 1994. Subsequently, in February 1995, the Appellate Division granted leave to the Company and the State of New York to have the issues of the Company's entitlement to recover its costs of defense and its costs of settlement ruled on by the State's highest Court, the New York Court of Appeals. In December 1995, the New York Court of Appeals ruled on this issue and concluded that the Company was entitled to recoveries from the State for such medical malpractice claims. As a result of this decision, the Company believes that it will benefit economically by not being ultimately responsible for certain claims against SUNY physicians for whom it presently carries reserves and by being entitled to reimbursement of certain claims previously paid; accordingly, effective June 30, 1996 and December 31, 1995, the Company recorded subrogation recoverables of approximately $13.0 million and $19.0 million, respectively, representing the amount of claims already paid and the reserves currently held by the Company on open cases that management believes are reimbursable by the State of New York. In January 1997, the New York Court of Claims rendered a decision granting summary judgment to the Company on three SUNY cases that were previously paid by the Company. This decision has been appealed by the State of New York. To the extent that the amount of the actual recovery varies from the recorded recoverable, such difference will be reported in the period recognized. The Company is continuing to defend all SUNY faculty members against malpractice claims that have been asserted and is maintaining reserves therefor adjusted for the anticipated recoveries. REGULATION In its ongoing effort to improve solvency regulation, the National Association of Insurance Commissioners ("NAIC") and individual states have enacted certain laws and financial statement changes. The NAIC has adopted Risk-Based Capital ("RBC") requirements for property/casualty insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, mortality and morbidity, asset and liability matching, benefit and loss reserve adequacy, and other business factors. The RBC formula is used by state insurance regulators as an early warning tool to identify, for the purpose of initiating regulatory action, insurance companies that potentially are inadequately capitalized. In addition, the formula defines new minimum capital standards that supplement the current system of low fixed minimum capital and surplus requirements on a state-by-state basis. Regulatory compliance is determined by a ratio of the enterprise's regulatory total adjusted capital, as defined by the NAIC, to its authorized control level RBC, as defined by the NAIC. Companies below specific trigger points or ratios are classified within certain levels, each of which requires specific corrective action. The levels and ratios are as follows:
RATIO OF TOTAL ADJUSTED CAPITAL TO AUTHORIZED CONTROL LEVEL RBC REGULATORY EVENT (LESS THAN OR EQUAL TO) - -------------------------------------------------------------- ----------------------------------- Company action level.......................................... 2.0* Regulatory action level....................................... 1.5 Authorized control level...................................... 1.0 Mandatory control level....................................... 0.7
- ------------------------ *Or, 2.5 with negative trend. The ratios of total adjusted capital to authorized control level RBC for the Insurance Subsidiaries (excluding Lyndon) were all in excess of 3:1 at December 31, 1996, 1995 and 1994. The ratios of total adjusted capital to authorized control level RBC for Lyndon Property and its two active life insurance subsidiaries were all in excess of 3:1 at December 31, 1996, 1995 and 1994. 32 The NAIC currently is in the process of codifying statutory accounting practices, the result of which is expected to constitute the only source of "prescribed" statutory accounting practices. Accordingly, that project, which is expected to be completed in 1998, will likely change, to some extent, prescribed statutory accounting practices, and may result in changes in the statutory surplus of the Insurance Subsidiaries. The thrust of these regulatory efforts at all levels is to improve the solvency of insurers. These regulatory initiatives, and the overall focus on solvency, may intensify the restructuring and consolidation of the insurance industry. While the impact of these regulatory efforts on the Company's operations cannot be quantified until enacted, the Company believes it will be adequately positioned to compete in an environment of more stringent regulation. See "Business--Regulation" for other regulatory matters applicable to the Company. IMPACT OF INFLATION Property and casualty insurance premiums are established before the amount of losses and LAE, or the extent to which inflation may affect such expenses, are known. Consequently, the Company attempts, in establishing its premiums, to anticipate the potential impact of inflation. However, for competitive and regulatory reasons, the Company may be limited in raising its premiums commensurate with anticipated inflation, in which event the Company, rather than its insureds, would absorb inflation costs. Inflation also affects the rate of investment return on the Company's investment portfolio with a corresponding effect on the Company's investment income. ENVIRONMENTAL ISSUES The Company, through its subsidiary, United Capitol, in the ordinary course of business, writes insurance on accounts which have hazardous, unique or unusual risk characteristics. Since United Capitol's organization in 1986, its liability policies have included an absolute pollution coverage exclusion, except for policies expressly providing such coverage. In addition, United Capitol's product liability and other primary general liability policies contain exclusions for coverage of claims for bodily injury or property damage caused by exposure to asbestos, except for policies expressly providing such coverage. Although the Company believes that such policies, together with the Company's general, professional and other liability policies, do not subject it to material exposure for environmental pollution claims, there can be no assurance of the Company's continued protection in view of the expansion of liability for environmental claims in recent litigation in the insurance industry. SHAREHOLDER LITIGATION The Company is a defendant in a class action alleging violations of federal securities laws by the Company and certain of its officers and directors. The complaint relates to the Company's November 5, 1994 announcement of its third quarter financial results and alleges that the Company previously had omitted and/or misrepresented material facts with respect to its earnings and profits. The Company believes the suit is without merit and has retained special legal counsel to contest the suit vigorously and believes that the Company's exposure to liability under such lawsuit, if any, would not have a material adverse effect on the Company's financial condition. 33 BUSINESS GENERAL The Company is an insurance holding company which, through its subsidiaries, conducts business on an admitted and non-admitted basis as a specialty property and casualty insurer. The following chart sets forth the organizational structure of the Company's subsidiaries: [CHART] Frontier Insurance, the Company's principal Insurance Subsidiary, commenced business in August 1966, and was acquired by the Company in April 1986. Med Pro, which underwrites the majority of the Company's medical and dental malpractice programs, commenced business in July 1986 and was acquired by the Company in June 1987. Pioneer, which performs claims adjusting and claims management services for the Company's insurance lines, was organized and commenced business in October 1989 as the successor to a claims adjusting company. Frontier Pacific, the Company's California Insurance Subsidiary, commenced business in December 1982, was acquired by Frontier Insurance in October 1991, and changed its name from Contractors' Surety Company in September 1993. SDIA was acquired by the Company in April 1994 and is involved in placing and servicing license and permit bonds in California and other western states. Douglass/Frontier is a joint venture formed in May 1995 and is involved in placing and servicing bail bonds. United Capitol Holding was acquired by Frontier Insurance in May 1996, together with its subsidiaries, United Capitol, a specialty excess and surplus lines insurer, Olympic, an underwriting management company, and Fischer, an underwriter of directors' and officers' liability and various classes 34 of errors and omissions. Regency Financial Corp. was organized by the Company in June 1996 for the purpose of acquiring Regency, a non-standard automobile insurer, and Emrol, a premium finance company, which were acquired by the Company in September 1996. In February 1996, the Company acquired a 33.3% ownership interest in Townsquare Title Insurance Services, which owns United General Title Insurance Company ("United General"). In June 1997, the Company acquired Lyndon Property and its subsidiaries which underwrite programs for credit-related, residual value, and collateral protection coverage. Frontier Insurance is licensed as a property and casualty writer in 50 states, the District of Columbia, Puerto Rico and the Virgin Islands; Frontier Pacific is licensed as a property and casualty writer in California, Nevada and New York; United Capitol is licensed as a property and casualty writer in Arizona, Illinois and Wisconsin and is an approved excess and surplus lines insurer in 46 states; Regency is licensed as a property and casualty writer in North Carolina and South Carolina; United General is licensed as a title insurer in 29 states; and Lyndon Property is licensed as a property and casualty writer in 47 states. ACQUISITION OF LYNDON On June 3, 1997, the Company acquired all of the issued and outstanding capital stock of Lyndon from Mercury for $92.0 million in cash, which amount was $30.0 million (net of tax) less than Lyndon's total shareholder's equity on such date. Lyndon, based in St. Louis, Missouri, provides credit-related and specialty insurance products for financial institutions and specialty insurance markets through a variety of distribution channels, including other insurance companies, general agents, third-party administrators, and joint venture relationships, with the particular channel designed to fit the specific product. Credit-related products include collateral protection, credit property, involuntary unemployment insurance, auto physical damage, credit life, and credit accident and health coverages. Specialty insurance products include residual value, non-standard auto and mechanical breakdown. Lyndon's products are designed to protect lenders and borrowers against financial losses relating to death, disability, involuntary unemployment, mechanical breakdown (extended service contracts), failure by the borrower to maintain adequate insurance or, at the end of a lease, the loss of value beyond normal wear and tear. Individual claims associated with credit insurance are typically limited to the amount of the associated loan and the loss ratio is generally lower than that of many other insurance product lines. Lyndon's strategy is to produce superior underwriting results by focusing on selected niche, low loss ratio credit-related products sold through financial institutions and maintaining a flexible low cost infrastructure by utilizing joint ventures and partnerships to assist in the distribution of its products. Similar to the Company's business strategy, Lyndon focuses on products and market opportunities where it believes there is less competition due to a perception that the business is difficult to write profitably. As a result of its acquisition by the Company, Lyndon is cross-marketing its products in conjunction with the Company by utilizing the Company's multiple distribution channels. In addition, Lyndon is seeking to acquire profitable, complementary blocks of business or companies where consolidation savings and other synergies may exist. 35 The following table represents Lyndon's net premiums written by line of business for the periods indicated:
THREE MONTHS ENDED MARCH 31, YEAR ENDED DECEMBER 31, -------------------- --------------------------------- 1997 1996 1996 1995 1994 --------- --------- --------- ---------- ---------- (DOLLAR AMOUNTS IN THOUSANDS) Auto physical damage..................................... $ 6,992 $ 12,737 $ 58,008 $ 13,407 $ 915 Warranty................................................. 3,766 1,067 11,531 292 -- Credit property.......................................... 1,576 1,573 6,411 2,638 199 Private passenger automobile............................. 588 -- 1,311 -- -- Credit accident and health............................... 563 4,544 12,341 58,538 (18,061) Credit life.............................................. (315) 2,423 5,939 34,129 10,835 Auto residual value...................................... 251 290 1,891 1,886 137 Involuntary unemployment................................. 212 201 1,193 3,476 (2,068) Fire..................................................... 1 (1,493) (2,011) 2,665 (254) Ordinary life............................................ -- -- -- 20,296 24,846 --------- --------- --------- ---------- ---------- Total............................................ $ 13,634 $ 21,342 $ 96,614 $ 137,327 $ 16,549 --------- --------- --------- ---------- ---------- --------- --------- --------- ---------- ----------
The following table sets forth the components of Lyndon's GAAP Combined Ratio calculated as a percentage of net premiums earned for the periods indicated:
THREE MONTHS ENDED MARCH 31, YEAR ENDED DECEMBER 31, -------------------- ------------------------------- 1997 1996 1996 1995 1994 --------- --------- --------- --------- --------- Losses............................... 47.1% 25.7% 30.1% 52.0% 35.3% LAE.................................. 2.1 2.3 3.0 .4 .2 --------- --------- --------- --------- --------- Losses and LAE....................... 49.2 28.0 33.1 52.4 35.5 Policy acquisition, underwriting, and other expenses................. 35.3 24.3 35.1 65.9 47.6 --------- --------- --------- --------- --------- GAAP Combined Ratio.................. 84.5% 52.3% 68.2% 118.3% 83.1% --------- --------- --------- --------- --------- --------- --------- --------- --------- ---------
Lyndon was formed in 1978 by ITT primarily to insure credit-related exposures in ITT's consumer and commercial finance businesses. In October 1995, Mercury acquired Lyndon from ITT to offer credit-related insurance products in conjunction with Mercury's sub-prime auto lending business. For the year ended December 31, 1996, Lyndon's revenues were $96.8 million and its net income was $27.0 million. During 1996, its operating results were beneficially impacted by run-off business from ITT, which business will be inconsequential in subsequent years, and from a collateral protection coverage program marketed through Mercury, which was discontinued prior to the Company's purchase of Lyndon. Accordingly, such results are not indicative of future operating results. For the three months ended March 31, 1997, Lyndon had revenues of $26.4 million and net income of $4.5 million, compared to revenues of $19.2 million and net income of $7.3 million for the three months ended March 31, 1996. At March 31, 1997, Lyndon's total assets were $395.8 million and its total investments were $214.8 million. 36 INSURANCE LINES The following table sets forth the gross and net premiums by principal lines of insurance written by the Company and the related percentages of the total of such premiums written represented thereby for the three months ended March 31, 1997 and the year ended December 31, 1996:
THREE MONTHS ENDED MARCH 31, 1997 YEAR ENDED DECEMBER 31, 1996 ------------------------------------------ ------------------------------------------ GROSS PREMIUMS NET PREMIUMS WRITTEN GROSS PREMIUMS NET PREMIUMS WRITTEN WRITTEN WRITTEN -------------------- -------------------- -------------------- -------------------- (DOLLAR AMOUNTS IN THOUSANDS) Medical malpractice (including dental malpractice and social services)..... $ 27,156 25.7% $ 22,516 28.4% $ 139,233 34.6% $ 119,653 38.4% General liability...................... 39,045 36.9 32,329 40.8 113,423 28.2 93,980 30.1 Surety................................. 14,587 13.8 12,098 15.3 65,381 16.2 56,632 18.2 Commercial earthquake.................. 3,465 3.3 2,085 2.6 16,541 4.1 11,904 3.8 Workers' compensation.................. 5,564 5.2 1,743 2.2 25,429 6.3 6,253 2.0 Other.................................. 15,995 15.1 8,542 10.7 42,792 10.6 23,441 7.5 --------- --------- --------- --------- --------- --------- --------- --------- Total............................ $ 105,812 100.0% $ 79,313 100.0% $ 402,799 100.0% $ 311,863 100.0% --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- ---------
The Company's business strategy is to achieve an underwriting profit by identifying niche markets and specialty programs which it believes afford favorable opportunities for profitability due to (i) limited potential competition, and (ii) the Company's innovative underwriting and value added services, including coverage enhancements, risk management, loss control and specialized claims management. The Company currently underwrites in excess of 130 specialty insurance programs, including (i) malpractice insurance for physicians, dentists, psychiatrists and chiropractors, (ii) general liability, (iii) surety (performance bonds, bail bonds, customs bonds and license and permit bonds), (iv) commercial earthquake, (v) workers' compensation and (vi) other miscellaneous lines. The Company's alternative risk division underwrites excess workers' compensation and excess medical stop loss coverages, and provides custom designed insurance programs through captive and rent-a-captive facilities for both the Company's workers' compensation and other insurance lines. On June 3, 1997, the Company completed the acquisition of Lyndon for $92.0 million in cash. Lyndon underwrites credit-related and other specialty insurance for financial institutions and specialty insurance markets. 37 The following chart provides examples of typical niche market/specialty programs underwritten by the Company for specific types of customers:
COVERAGE/LINE OF CUSTOMER TYPE BUSINESS ILLUSTRATIVE CLAIM Doctors and dentists professional liability malpractice - ---------------------------------------------------------------------------- Day care providers general liability child injured on premises - ---------------------------------------------------------------------------- White water raft general liability rafter injured through operators operator's negligence - ---------------------------------------------------------------------------- Social service agencies professional liability, client sues agency or general liability, professional fire - ---------------------------------------------------------------------------- Crane operators general liability crane damages a third party's property - ---------------------------------------------------------------------------- Alarm installers general liability house is burglarized through faulty alarm installation - ---------------------------------------------------------------------------- Small-construction surety bonds electrician or plumber contractors fails to complete job - ---------------------------------------------------------------------------- Self-insured employers general liability workers' compensation loss exceeds employers' self-insured retention - ---------------------------------------------------------------------------- Importers customs bonds importer fails to pay duty - ---------------------------------------------------------------------------- Commercial property earthquake (difference earthquake damage to owners in conditions) building and contents - ---------------------------------------------------------------------------- Financial institutions collateral protection automobile damage where borrower's insurance has lapsed
MEDICAL MALPRACTICE Frontier Insurance commenced underwriting medical malpractice insurance in 1981 under programs developed for physicians with varied practices, which currently include part-time physicians, internists, physicians and other health care professionals providing medical services to clients of social service agencies (mental health, home care, etc.), family practitioners, psychiatrists, chiropractors, dermatologists and other specialists. Physicians covered under the Company's programs generally must be members of a national, state, or county society for their particular specialty and must limit their practice to such specialty, be employed by a social services agency, or be in practice or employed on a part-time basis. The Company has implemented strict underwriting guidelines in an attempt to screen out undesirable risks and reduce its exposure. The Company's medical malpractice insurance is written on both an occurrence and a claims made basis, predominantly in New York, Florida, Illinois, Ohio, Texas and Michigan. Additionally, the Company markets a specialty program for physicians unable to obtain traditional malpractice coverage as a result of excessive malpractice claims, professional disciplinary proceedings and/or drug or alcohol abuse. Coverage under this program is written on a claims made basis with a deductible and is priced substantially higher than the Company's standard medical malpractice programs. 38 At March 31, 1997, approximately 18,400 physicians were insured by the Company, of whom 650, or 3.5%, were employed as faculty members at medical schools of SUNY, 13,900, or 75.6%, were physicians who were members of 19 medical associations which endorsed or approved the Company's medical malpractice insurance program, and 3,850, or 20.9%, were physicians and other health care professionals providing medical services covered by the Company's social services insurance program. Since December 31, 1990, the number of SUNY physicians insured by the Company has decreased by approximately 380, attributable to increased competition and other factors, including a 1990 decision by the New York State Court of Claims relating to SUNY physicians in favor of the Company. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Litigation with the State of New York." In August 1987, the Company commenced underwriting dental malpractice insurance for dentists viewed by the Company as preferred risks. Dentists who practice oral surgery or who utilize anesthesia to render their patients unconscious are, among others, not viewed as preferred risks and, accordingly, are not eligible for coverage. As with medical malpractice, the endorsement of related professional organizations is a key element in marketing, and the Company has benefitted significantly from the 1994 endorsement by the Academy of General Dentistry. Dental malpractice is written by the Company predominantly in New York, Florida and Ohio. At March 31, 1997, approximately 4,900 dentists were insured by the Company under its dental malpractice program. GENERAL LIABILITY The Company underwrites general liability coverages for day care centers, crane operators, white water raft operators, health and social services agencies, pest control operators, fire protection equipment dealers and installers, security guards, excess workers' compensation/employers' liability for self-insured employers, and a variety of other programs. The Company also underwrites umbrella coverage up to $5.0 million over an underlying $1.0 million Company general liability coverage. The Company's specialty insurance programs include environmental policies covering enumerated hazards with stated policy limits. Although the Company believes that such policies, together with the Company's general, professional and other liability policies, do not subject the Company to material exposure for environmental pollution claims, there can be no such assurance in view of the expansion of liability for environmental claims in recent litigation. SURETY The Company underwrites surety bonds for small contractors, customs bonds, contractor license bonds, bail bonds, license and permit bonds and self-insured workers' compensation bonds. According to the Surety Association of America, the Company was the 13th largest writer of surety bonds in the United States during 1996 based on net premiums written. COMMERCIAL EARTHQUAKE In July 1995, the Company commenced underwriting difference in conditions ("DIC") commercial earthquake policies under an agreement with Associated International Intermediaries, Inc., a subsidiary of Associated International Insurance Company ("Associated"). Pursuant to the agreement, the Company and Associated underwrite DIC commercial earthquake policies through a companion carrier facility with combined limits of $7.5 million, with two-thirds of new and renewal policies being underwritten by Associated and one-third by the Company. The agreement may be terminated by either party upon 90 days' notice. The agreement expires December 31, 1997 and the Company is evaluating its various alternatives. 39 WORKERS' COMPENSATION The Company underwrites workers' compensation coverage for jockeys, feed lots and other specialty niches. Additionally, the Company assumes workers' compensation business as a result of its required participation in the National Workers' Compensation Reinsurance Pool and other residual market mechanisms. Due to adverse underwriting results, the Company substantially reduced its workers' compensation business in 1993, except for its feed lot programs in Texas, its New Jersey jockey program, its social services program, and its excess workers' compensation lines which are classified under general liability. OTHER The Company underwrites other lines of insurance, including commercial multi-peril, inland marine, property, specialty homeowners, non-standard auto, and excess of loss group accident and health. In 1996, the Company also began writing, on a direct basis, marine, energy and commercial property insurance. ALTERNATIVE RISKS In 1995, the Company established an alternative risk division to write excess workers' compensation insurance and excess medical stop loss coverages. In the fall of 1996, the division's activities were expanded to provide custom designed insurance programs through captive and rent-a-captive facilities for new and existing clients in the Company's workers' compensation and other insurance lines. The business offers the opportunity to generate both risk sharing and fee income. REINSURANCE REINSURANCE ASSUMED The Company assumes reinsurance under reinsurance treaties and through mandatory participation in various states' residual market pools and reinsurance facilities. As part of its acquisition of BMLIC's realtors' errors and omissions business, the Company will reinsure related policies issued by BMLIC until such time as the Company's realtors' errors and omissions program is approved and can be written directly by the Company. In 1996, the Company began to assume, on a quota share basis, mobile homes and homeowners' business underwritten by Omega Insurance Company. In January 1997, the Company entered into a series of reinsurance treaties with Vesta Insurance Group and some of its subsidiaries to assume certain property and liability business on a quota share basis. In August 1995, the Company assumed a quota share portion of a pool of environmental liability policies from Underwriters Reinsurance Company, which were produced by URC Environmental Specialty Underwriters on behalf of Commercial Underwriters Insurance Company and the Company (the "URC Environmental Policies"). The related treaty currently is in run-off. REINSURANCE CEDED Effective January 1, 1995, the Company entered into a coinsured aggregate excess of loss reinsurance agreement with Centre Re covering accident years 1995, 1996 and 1997. Under the terms of the agreement, Centre Re provides reinsurance protection, after all applicable underlying reinsurance has been exhausted, for losses and allocated LAE in excess of a predetermined ratio of these expenses to net premiums earned for a given accident year. The agreement reinsures all lines of business except those for which the Company has determined that its exposure to loss is insufficient in relation to the added cost of inclusion in the reinsurance agreement. The following policies and insurance types are excluded from the reinsurance agreement: bail, customs, license and permit and miscellaneous surety bonds effective prior to January 1, 1997, mobile home and homeowners' policies effective on or after July 1, 1996, the URC Environmental Policies, medical, dental and social service medical malpractice insurance policies in excess of $1.0 million, realtors' errors and omissions insurance policies, commercial earthquake policies effective on or after January 1, 1996, and insurance policies written by Lyndon, United Capitol and Regency. The loss and allocated LAE ratio above which the reinsurance provides coverage is 66.0%, 65.0% and 64.0% for accident years 1995, 1996 and 1997, respectively. 40 Effective July 15, 1995, the Company implemented a reinsurance program for its DIC commercial earthquake program. The program is reinsured through a per risk excess of loss agreement and four layers of catastrophe reinsurance. The Company retains $50,000 per risk and $2.5 million per occurrence. The catastrophe layers attach at $2.5 million per occurrence and allow one full reinstatement per year after the limits have been exhausted. The program provides for a maximum ceded loss of $37.5 million per occurrence. Effective January 1, 1997, an additional $10.0 million of catastrophic coverage was added, providing for a maximum ceded loss of $47.5 million. Effective January 1, 1996, the Company entered into a reinsurance agreement (including clash coverage) with Medical Assurance, Inc., The Doctors' Insurance Company, and Reliance Insurance Company, with respect to its medical malpractice business. Under the terms of the agreement, reinsurance is provided for occurrences involving multiple physicians for $3.0 million in excess of $2.0 million per occurrence, subject to an aggregate of $6.0 million. Effective July 1, 1996, the Company entered into a catastrophe excess reinsurance program with respect to its mobile home and homeowners' business. The program currently is reinsured for $28.5 million in excess of $1.5 million per occurrence. The Company reinsures selected classes of its surety bond business with NAC Reinsurance Corporation and Transatlantic Reinsurance Company through two excess of loss agreements providing coverage for losses per principal of up to $10.0 million. The Company has a retention of $1.0 million per principal with coinsurance percentages in all excess layers. Effective April 1, 1997, the Company entered into a 30.0% quota share reinsurance treaty, on a funds withheld basis, to cede to Alpine Insurance Company business produced by an Alpine affiliate. The Company reinsures its marine, energy and commercial property insurance under multiple layers of excess reinsurance. Coverage is provided up to $9.95 million excess of $50,000 per occurrence, excess of an aggregate retention of $200,000 of loss occurrences in excess of $50,000. The following table is a summary of net reinsurance recoverables and funds withheld and other offsets relating to the Company's reinsurers at March 31, 1997:
NET REINSURANCE FUNDS WITHHELD/ A.M. BEST REINSURER RECOVERABLES OTHER OFFSETS RATING - --------------------------------------------- --------------- --------------- --------------------- (DOLLAR AMOUNTS IN THOUSANDS) Centre Reinsurance Company of New York....... $ 92,505 $ 70,037 A (Excellent) Munich American Reinsurance Company.......... 21,346 0 A+ (Superior) Generali, U.S. Branch........................ 16,630 0 A (Excellent) Swiss Reinsurance America Incorporated....... 14,349 0 A (Excellent) Commercial Risk Re-insurance Company......... 11,300 11,707 A (Excellent) John Hancock Group........................... 8,734 0 A++ (Superior) Markel Insurance Company..................... 6,266 232 A (Excellent) Everest Reinsurance Company.................. 5,305 0 A (Excellent) Transatlantic Reinsurance Company............ 4,687 0 A+ (Superior) All other reinsurers......................... 28,447 1,843 N/A --------------- ------- Total.................................. $ 209,569 $ 83,819 --------------- ------- --------------- -------
41 The following table is a summary of the maximum amount of loss typically retained and ceded by Frontier Insurance, Frontier Pacific and United Capitol (exclusive of facultative reinsurance and the Centre Re aggregate excess of loss reinsurance agreement):
MAXIMUM RETAINED LOSS MAXIMUM CEDED LOSS PER OCCURRENCE/ PER OCCURRENCE/ RISK/PRINCIPAL (1) RISK/PRINCIPAL (1) ---------------------- -------------------- (DOLLAR AMOUNTS IN THOUSANDS) Property lines................................. $ 500 $ 9,500 Mobile home and homeowners'.................... 1,500 28,500 Casualty lines (excluding medical malpractice, health specialties and social services)......................... 1,000 4,000 Medical malpractice, health specialties and social services.............................. 1,000(2) 1,000 Workers' compensation.......................... 1,000 49,000 Surety......................................... 1,000(3) 4,000(3) Customs bonds.................................. 3,000(4) N/A Umbrella liability............................. 1,000 4,000 Group accident and health...................... 250 750 Excess workers' compensation and employers' liability..................... 1,000 9,000 Commercial earthquake.......................... 2,500 47,500 Marine, energy and commercial property......... 250 9,950
- ------------------------ (1) Amounts presented represent those amounts which are generally the maximum retained or ceded by the Company, but which are occasionally exceeded. (2) The maximum retained loss amount of $1.0 million relates only to losses on policies effective during 1994 and reinsurance ceded treaty years 1985 through 1991 which have been commuted. For all other years, the maximum retained loss per occurrence is $500,000 except, on a limited basis, where the maximum retained loss per occurrence is $2.0 million. (3) Effective December 31, 1995, a layer of excess reinsurance was added on a limited basis for a maximum limit of $10.0 million per principal on a direct basis, $2.1 million on a net basis. (4) Amount indicated is the maximum face amount (limit) on the bond issued, which represents the value of goods being imported that are subject to U.S. Customs duty. The actual exposure to the Company is the amount of any unpaid duty on the goods imported, which is generally approximately 15.0% of the face value of the goods, and any penalties associated with late payment of the duty. MARKETING The Company relies on multiple distribution channels to market its insurance products. Malpractice insurance is marketed both directly by Med Pro and by independent brokers and agents. License and permit bonds are marketed directly by SDIA and by independent brokers and agents. Bail bonds are marketed by Douglass/Frontier through a nationwide network of bail bondsmen. The Company relies primarily on independent insurance agencies and insurance brokerage firms to generate sales of its remaining lines of business. General liability, workers' compensation, multi-peril and property policies are produced on a brokerage basis through general agents, principally in California, Florida, New Jersey, New York, Pennsylvania and Texas, and selected small agencies in New York. Surety bonds for small contractors are produced through independent insurance agents acting as retail brokers, and general agents and several small insurance companies which also act as reinsurers on the business they produce. Customs bonds are produced through a specialty agency in New York which derives the business from a nationwide network of customs brokers located in the various ports of entry. 42 Approximately 21.6% of the Company's net premiums written for the three months ended March 31, 1997 were generated directly by the Company. No outside producer accounted for in excess of five percent of the gross or net premiums written by the Company during such period and the years ended December 31, 1996, 1995 and 1994. OPERATING RATIOS STATUTORY COMBINED RATIO The statutory combined ratio is the traditional measure of underwriting experience for insurance companies. Generally, if the statutory combined ratio is below 100.0%, an insurance company has an underwriting profit and if it is above 100.0%, the insurer has an underwriting loss. The following table reflects the consolidated statutory loss ratios, expense ratios and combined ratios of Frontier Insurance, Frontier Pacific, United Capitol and Regency, determined in accordance with statutory accounting practices, together with the property and casualty industry-wide statutory combined ratios after policyholders' dividends compiled by A.M. Best, for the periods indicated:
YEAR ENDED DECEMBER 31, THREE MONTHS ENDED ----------------------------------------------------- MARCH 31, 1997 1996 1995 1994 1993 1992 --------------------- --------- --------- --------- --------- --------- Loss ratio........................... 58.7% 58.7% 60.0% 69.9% 66.4% 71.9% Expense ratio........................ 35.2 32.2 31.1 28.2 27.8 24.9 ----- --------- --------- --------- --------- --------- Combined ratio....................... 93.9% 90.9% 91.1% 98.1% 94.2% 96.8% ----- --------- --------- --------- --------- --------- ----- --------- --------- --------- --------- --------- Industry combined ratio after policyholders' dividends..... N/A 105.9% 106.4% 108.4% 106.9% 115.7% --------- --------- --------- --------- --------- --------- --------- --------- --------- ---------
PREMIUM-TO-SURPLUS RATIO The following table sets forth the ratio of net premiums written during the year to policyholders' surplus at the end of the year for Frontier Insurance, Frontier Pacific, United Capitol and Regency for the years indicated:
YEAR ENDED DECEMBER 31, ---------------------------------------------------------- 1996 1995 1994 1993 1992 ---------- ---------- ---------- ---------- ---------- (DOLLAR AMOUNTS IN THOUSANDS) FRONTIER INSURANCE: Net premiums written during the year............... $ 255,446 $ 205,614 $ 179,058 $ 115,028 $ 113,508 Policyholders' surplus at end of year.............. $ 262,899 $ 171,362 $ 104,871 $ 101,418 $ 76,438 Ratio.............................................. .97/1 1.20/1 1.71/1 1.13/1 1.48/1 FRONTIER PACIFIC: Net premiums written during the year............... $ 32,040 $ 15,143 $ 8,230 $ 3,791 $ 2,740 Policyholders' surplus at end of year.............. $ 25,985 $ 17,155 $ 16,127 $ 15,108 $ 6,522 Ratio.............................................. 1.23/1 .88/1 .51/1 .25/1 .42/1 UNITED CAPITOL: Net premiums written during the year............... $ 25,930 $ 10,981 $ 17,051 $ 17,708 $ 17,640 Policyholders' surplus at end of year.............. $ 53,355 $ 68,026 $ 61,750 $ 65,676 $ 62,387 Ratio.............................................. .49/1 .16/1 .28/1 .27/1 .28/1 REGENCY: Net premiums written during the year............... $ 4,489 $ 4,441 $ 4,804 $ 5,587 $ 6,047 Policyholders' surplus at end of year.............. $ 5,105 $ 4,667 $ 4,521 $ 4,308 $ 4,070 Ratio.............................................. .88/1 .95/1 1.06/1 1.30/1 1.49/1
43 LOSS AND LAE RESERVES Significant periods of time, ranging up to several years, may elapse between the occurrence of an insured loss, the reporting of the loss to the Company and its payment of such loss. Medical malpractice and general liability lines usually have a much longer period of time between occurrence of a loss and payment than property lines. To recognize liabilities for unpaid losses, the Company establishes reserves, which are balance sheet liabilities representing estimates of amounts needed to pay claims and related expenses with respect to insured events which have occurred, including those not yet reported ("IBNR"). The reserves for losses and LAE are estimated using loss evaluations and actuarial projections, and represent estimates of the ultimate net cost of all unpaid losses and LAE incurred through the end of each period. These estimates are subject to the impact of loss development and changes in claims severity, as well as numerous other factors, such as judicial and legislative trends and actions, economic factors and estimates of future trends in claims frequency. As part of this process, historical data are reviewed and consideration is given to the anticipated impact of various factors, such as legal developments, changes in social attitudes, economic conditions, including the effects of inflation, and anticipated subrogation recoveries with respect to the surety line of business. As experience develops and other data become available, these estimates are revised, as required, resulting in increases or decreases in reserves for insured events of prior periods. Future adjustments, if any, will be reflected in the results of operations in the period in which recognized. When a claim is reported, the Company's claims adjusting personnel establish a formula case reserve, which is based on historical average claim costs, for the estimated amount to be paid. As more pertinent information becomes available on a claim, adjusting personnel change the reserve from a formula reserve to a case basis reserve. This case basis reserve is an estimate of the amount of ultimate payment, which reflects the informed judgment of such personnel, based on the Company's reserving practices and the experience and knowledge of such personnel regarding the nature and value of the specific type of claim. Additionally, reserves are established by the Company on an aggregate basis to provide for IBNR losses and to maintain the overall adequacy of reserves. The Company also establishes a related LAE reserve on an aggregate basis representing the estimated expense of settling claims, including legal and other fees and general expenses of administering the claims adjustment process with respect to reported and unreported losses. Virtually all of the Company's LAE is classified as allocated LAE as a result of its method of handling claims through Pioneer. The Company does not discount its reserves either on the basis of GAAP or statutory accounting practices. 44 The following table sets forth a reconciliation of the beginning and ending loss and LAE reserve balances, net of reinsurance ceded, for each of the three years in the period ended December 31, 1996:
YEAR ENDED DECEMBER 31, ---------------------------------- 1996 1995 1994 ---------- ---------- ---------- (DOLLAR AMOUNTS IN THOUSANDS) Net reserves for losses and LAE, beginning of year...................................... $ 294,393 $ 263,202 $ 216,486 Total acquired reserves.................................. 53,008 5,500 -- Incurred losses and LAE for claims related to: Current year........................................... 160,470 126,769 97,044 Prior years............................................ (4,479) (7,514) 13,874 ---------- ---------- ---------- Total incurred losses and LAE............................ 155,991 119,255 110,918 ---------- ---------- ---------- Loss and LAE payments for claims relating to: Current year........................................... 27,626 13,057 7,216 Prior years............................................ 102,160 80,507 56,986 ---------- ---------- ---------- Total payments........................................... 129,786 93,564 64,202 ---------- ---------- ---------- Net reserves for losses and LAE, end of year............. 373,606 294,393 263,202 Total reinsurance recoverable on unpaid losses and LAE.................................. 165,467 73,043 49,435 ---------- ---------- ---------- Gross reserves for losses and LAE, end of year........... $ 539,073 $ 367,436 $ 312,637 ---------- ---------- ---------- ---------- ---------- ----------
The Company's reserves for unpaid losses and LAE, net of related reinsurance recoverable, at December 31, 1995 and 1994 were decreased in the following year by approximately $4.5 million and $7.5 million, respectively, and at December 31, 1993 were increased in the following year by approximately $13.9 million, for claims that had occurred on or prior to the balance sheet dates. No premiums have been accrued as a result of the changes to prior years' loss and LAE reserves. The net $4.5 million decrease in prior years' reserves in 1996 was the result of favorable claims development on the workers' compensation line of business. Included in the net development was an increase in prior years' reserves of approximately $13.0 million which was entirely offset by subrogation recoverables recognized in connection with a favorable court ruling in 1995. The significant increase in the reinsurance recoverables in 1996 resulted primarily from the acquisitions of United Capitol and Regency in 1996. The net $7.5 million decrease in the prior years' reserves in 1995 was the result of favorable claims development on the general liability and workers' compensation lines and to subrogation recoveries in the surety line of business in excess of expectations. Included in the net development was an increase in prior years' reserves of approximately $19.0 million which was entirely offset by subrogation recoverables recognized in connection with the favorable court ruling in 1995. The significant increase in the reinsurance recoverable in 1995 was due to the addition of an aggregate claim excess of loss reinsurance treaty for the majority of the Company's lines of business. See "--Reinsurance." The $13.9 million net increase in prior years' reserves in 1994 resulted from a $17.5 million increase in the reserves attributable to adverse medical malpractice claims development in Florida as a result of higher than anticipated dollar settlements partially offset by redundancies in other lines. 45 The following table reflects the Company's loss and LAE reserves development, net of estimated subrogation recoverable, from 1986 through December 31, 1996:
YEAR ENDED DECEMBER 31, ------------------------------------------------------------------------------------------------- 1986 1987 1988 1989 1990 1991 1992 1993 1994 --------- --------- --------- --------- --------- --------- --------- --------- --------- (DOLLAR AMOUNTS IN THOUSANDS) Reserves for unpaid losses & LAE........... $ 27,271 $ 43,813 $ 64,971 $ 92,384 $ 120,096 $ 161,263 $ 185,074 $ 216,486 $ 263,202 Reserves reestimated at December 31: 1 year later......... 28,495 46,385 67,486 93,419 119,875 162,121 188,387 230,360 255,689 2 years later........ 29,587 49,495 68,793 91,457 120,550 158,746 196,005 229,334 252,678 3 years later........ 31,906 50,890 66,532 91,527 115,310 163,537 191,401 214,712 -- 4 years later........ 33,425 49,694 66,656 86,508 114,790 154,217 172,654 -- -- 5 years later........ 32,730 49,895 64,254 87,795 107,907 133,768 -- -- -- 6 years later........ 32,740 49,492 64,700 79,459 88,803 -- -- -- -- 7 years later........ 33,563 48,749 55,300 63,667 -- -- -- -- -- 8 years later........ 32,357 43,099 42,687 -- -- -- -- -- -- 9 years later........ 30,720 32,391 -- -- -- -- -- -- -- 10 years later....... 23,375 -- -- -- -- -- -- -- -- Cumulative redundancy.... 3,896 11,422 22,284 29,717 31,293 27,495 12,420 1,774 10,524 Cumulative amount of liability paid through December 31: 1 year later......... 3,760 6,208 9,611 16,823 8,129 41,486 38,300 56,986 80,507 2 years later........ 7,477 12,946 20,006 13,230 35,864 62,175 74,113 113,471 148,513 3 years later........ 11,953 20,339 11,196 32,987 45,973 80,888 112,017 154,548 -- 4 years later........ 16,605 14,902 24,825 39,166 58,043 104,672 139,333 -- -- 5 years later........ 12,916 24,426 30,919 50,406 74,659 122,863 -- -- -- 6 years later........ 18,466 27,766 39,664 61,276 86,405 -- -- -- -- 7 years later........ 20,999 32,372 47,784 67,429 -- -- -- -- -- 8 years later........ 23,259 38,271 50,119 -- -- -- -- -- -- 9 years later........ 27,412 39,567 -- -- -- -- -- -- -- 10 years later....... 27,820 -- -- -- -- -- -- -- -- Net reserve -- December 31........ 263,202 Reinsurance recoverables....... 49,435 --------- Gross reserve........ $ 312,637 --------- --------- 1995 1996 --------- --------- Reserves for unpaid losses & LAE........... $ 294,393 $ 373,606 Reserves reestimated at December 31: 1 year later......... 289,914 2 years later........ -- 3 years later........ -- 4 years later........ -- 5 years later........ -- 6 years later........ -- 7 years later........ -- 8 years later........ -- 9 years later........ -- 10 years later....... -- Cumulative redundancy.... 4,479 Cumulative amount of liability paid through December 31: 1 year later......... 102,160 2 years later........ -- 3 years later........ -- 4 years later........ -- 5 years later........ -- 6 years later........ -- 7 years later........ -- 8 years later........ -- 9 years later........ -- 10 years later....... -- Net reserve -- December 31........ 294,393 373,606 Reinsurance recoverables....... 73,043 165,467 --------- --------- Gross reserve........ $ 367,436 $ 539,073 --------- --------- --------- ---------
The loss and LAE reserves of Frontier Insurance, Frontier Pacific, United Capitol and Regency as reported in their Annual Statements prepared in accordance with statutory accounting practices and filed with state insurance departments are identical with those reflected in the Company's financial statements prepared in accordance with GAAP included herein, before elimination of inter-company transactions and except for a change resulting from the rescission by Frontier Insurance in April 1986 of an offer to assume reinsurance under a proposed treaty with another insurer which has been given retroactive effect herein but was not reflected in the statutory filing with the New York Insurance Department until the March 31, 1986 quarterly statement, thereby reducing the GAAP reserves at December 31, 1985, by $861,000 from the statutory reserves at such date. Further, at December 31, 1986, Frontier Insurance's loss and LAE reserves under GAAP were lower by $138,000 than its 1986 statutory reserves as a result of the revision of certain estimates with respect to liquor law liability claims. CLAIMS MANAGEMENT The Company's philosophy is that claims management, from the initial stage of reported claims through adjudication and/or settlement, is a critical component for controlling underwriting losses and LAE. The Company investigates, supervises and adjusts all claims through Pioneer. When a claim is reported, the Company's claims adjusting personnel establish a formula case reserve, based on historical average claim costs and expenses, and continually review and modify such reserve as additional information with respect to such claim becomes available. 46 Pioneer personnel work closely with the Company's in-house legal staff of over 40 attorneys, assigned exclusively to managing and adjusting claims, to supervise, adjudicate and settle insurance claims. The Company's in-house attorneys are located in offices in Rock Hill, Garden City and White Plains, New York, and in Orlando and Fort Lauderdale, Florida. The Company intends to open additional offices for its in-house attorneys in Ohio and Texas. The Company also retains outside counsel when required under the particular circumstances of a claim. The Company maintains specific controls with respect to its claims management process. Such controls include the requirements that claims can remain on formula reserve only for a specified period of time; that any claim payment in excess of $50,000 must be approved by an officer of the Company; and that any claim in excess of $300,000 must be supervised by a committee comprised of the Company's claims, underwriting and legal personnel. INVESTMENTS Funds, including reserve funds, are invested until required for the Company's operations, subject to restrictions on permissible investments established by applicable state insurance codes. The Company's investment strategy is to maximize after-tax income while generally limiting investments to investment grade securities with high liquidity. Prior to 1996, the Company's investment portfolio was managed by Asset Allocation and Management Company ("Asset Allocation") and General Re New England Asset Management, Inc. ("New England"), registered investment advisors which specialize in insurance company portfolio management, pursuant to guidelines established by the Company. In 1996, the Company hired a Chief Investment Officer and the core fixed income portfolio is now managed internally. Asset Allocation and New England provide investment advisory and related services to the Company in asset classes such as mortgage-backed securities, sinking fund preferred stocks and other special classes of securities. The following table contains information concerning the Company's investment portfolio at March 31, 1997:
MARCH 31, 1997 ----------------------------------------------------- MARKET AMOUNT REFLECTED PERCENT COST (1) VALUE ON BALANCE SHEET OF TOTAL ---------- ---------- ---------------- ----------- (DOLLAR AMOUNTS IN THOUSANDS) AVAILABLE-FOR-SALE SECURITIES: Fixed maturity securities: U.S. Treasury securities and obligations of U.S. Government corporations and agencies........... $ 37,862 $ 37,210 $ 37,210 5.1% Obligations of states and political subdivisions........................ 199,839 199,432 199,432 27.4 Corporate securities.................. 191,718 190,098 190,098 26.1 Mortgage-backed securities............ 283,046 280,459 280,459 38.6 ---------- ---------- -------- ----- Total fixed maturity securities..... 712,465 707,199 707,199 97.2 Equity securities....................... 19,505 20,351 20,351 2.8 ---------- ---------- -------- ----- Total available-for-sale- securities........................ $ 731,970 $ 727,550 $ 727,550 100.0% ---------- ---------- -------- ----- ---------- ---------- -------- -----
- ------------------------ (1) Original cost of equity securities and, as to fixed maturities, original cost reduced by repayments and adjusted for amortization of premiums or accrual of discounts. 47 The following table sets forth a profile of the Company's fixed maturity investment portfolio by rating at March 31, 1997:
MARKET AMOUNT REFLECTED PERCENT S&P/MOODY'S RATING (1) VALUE ON BALANCE SHEET OF TOTAL - ------------------------------------------------------ ---------- ---------------- ----------- (DOLLAR AMOUNTS IN THOUSANDS) AAA/Aaa (including U.S. Treasuries of $22,339)........ $ 409,984 $ 409,984 58.0% AA/Aa................................................. 111,734 111,734 15.8 A/A................................................... 138,207 138,207 19.5 BBB/Bbb............................................... 47,250 47,250 6.7 All other............................................. 24 24 -- ---------- -------- ----- Total........................................... $ 707,199 $ 707,199 100.0% ---------- -------- ----- ---------- -------- -----
- ------------------------ (1) Ratings are assigned by S&P or, if no S&P rating is available, by Moody's Investors Service Inc. The following table sets forth the maturity profile of the Company's portfolio of fixed maturity investments at March 31, 1997:
MARKET AMOUNT REFLECTED PERCENT MATURITY VALUE ON BALANCE SHEET OF TOTAL - ------------------------------------------------------ ---------- ---------------- ----------- (DOLLAR AMOUNTS IN THOUSANDS) Due in one year or less............................... $ 3,415 $ 3,415 .5% Due after one year to 5 years......................... 102,478 102,478 14.5 Due after five years to 10 years...................... 109,687 109,687 15.5 Due after 10 years.................................... 211,160 211,160 29.9 Mortgage-backed securities............................ 280,459 280,459 39.6 ---------- -------- ----- Total........................................... $ 707,199 $ 707,199 100.0% ---------- -------- ----- ---------- -------- -----
The following table summarizes the Company's investment results for the three months ended March 31, 1997 and the five years ended December 31, 1996, calculated on the mean of total investments as of the first and last day of each calendar quarter:
YEAR ENDED DECEMBER 31, THREE MONTHS ENDED ----------------------------------------------------- MARCH 31, 1997 1996 1995 1994 1993 1992 ------------------- --------- --------- --------- --------- --------- (DOLLAR AMOUNTS IN THOUSANDS) Total net investment income.................. $ 12,614 $ 38,933 $ 30,055 $ 22,975 $ 22,371 $ 20,208 Average annual pre-tax yield................... 6.5% 6.4% 6.4% 6.6% 7.8% 7.9% Average annual after-tax yield................... 5.1% 4.8% 4.9% 5.4% 6.3% 6.2% Effective federal income tax rate on total net investment income....... 24.8% 24.8% 23.7% 19.8% 19.3% 21.2%
48 RATINGS Insurance companies are rated by rating agencies to provide insurers and consumers meaningful information with respect to specific insurance companies. Frontier Insurance, Frontier Pacific, United Capitol and Regency currently are rated A- (Excellent) by A.M. Best, the fourth highest of A.M. Best's fifteen ratings designations. Lyndon Property and its two active life insurance subsidiaries are rated B++ (Very Good) by A.M. Best. In assigning a rating to an insurance company, A.M. Best performs both quantitative and qualitative evaluations. The quantitative component measures profitability, leverage/ capitalization and liquidity. The qualitative component measures spread of risk, quality and appropriateness of reinsurance, quality and diversification of assets, adequacy of loss reserves, adequacy of surplus, capital structure/holding company, management experience and objectives and market presence. Insurance companies assigned an "A" or "A-" rating by A.M. Best are companies which, in A.M. Best's opinion, have demonstrated excellent overall performance when compared to the standards established by A.M. Best and have a strong ability to meet their obligations to policyholders over a long period of time. Insurance companies assigned a "B++" or "B+" rating by A.M. Best are companies which, in A.M. Best's opinion, have demonstrated very good overall performance when compared to the standards established by A.M. Best and have a good ability to meet their obligations to policyholders over a long period of time. In addition to their A.M. Best ratings, Frontier Insurance and Frontier Pacific have been given an A+ (Good) claims-paying ability rating by S&P. The "A" range (A+, A and A-) is the second highest of four ratings ranges within what S&P considers the "secure" category. An S&P claims-paying ability rating is S&P's opinion of an insurance company's financial capacity to meet the obligations of its insurance policies in accordance with their terms. Claims-paying ability ratings are assigned at the request of the insurance company. Ratings are based on current information furnished by the insurance company or obtained by S&P from other sources it considers reliable and on extensive quantitative and qualitative analysis, including consideration of ownership and support factors if applicable. Insurance companies assigned a claims-paying ability rating in the "A" range are believed by S&P to provide good financial security, but their capacity to meet policyholder obligations is somewhat susceptible to adverse economic and underwriting conditions. REGULATION GENERAL 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 generally is designed 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 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 or for other purposes; establishment and maintenance of reserves for unearned premiums and losses; 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 on an admitted basis; reinsurance generally is not subject to rate regulation. 49 RESTRICTIONS ON DIVIDENDS AND DISTRIBUTIONS State insurance statutes typically place limitations on the amount of dividends or other distributions payable by insurance companies in order to protect their solvency. New York, the jurisdiction of incorporation of Frontier Insurance, requires that dividends be paid only out of earned surplus and limits the annual amount payable without the prior approval of the New York Department of Insurance to the lesser of 10.0% of policyholders' surplus or 100.0% of adjusted net investment income. California, the jurisdiction of incorporation of Frontier Pacific, currently limits the annual amount of dividends payable without the prior approval of the California Insurance Department to the greater of 10.0% of policyholders' surplus at the end of the previous calendar year or 100.0% of net income for the previous calendar year. Wisconsin, North Carolina and Missouri, the jurisdictions of United Capitol, Regency and Lyndon Property, respectively, also have statutory restrictions on the payments of dividends. In addition, in connection with the Company's acquisition of United Capitol, the Office of the Commissioner of Insurance in Wisconsin has issued an order requiring United Capitol to seek regulatory approval of any dividend payment to shareholders. At March 31, 1997, $27.6 million was available for payment of dividends by the Insurance Subsidiaries. However, the Company's current policy is for its Insurance Subsidiaries to retain their capital for growth and not to pay any dividends. HOLDING COMPANY REGULATIONS The Company is subject to statutes governing insurance holding companies in various jurisdictions. Typically, such statutes require the Company to file information periodically with the state insurance regulatory authorities, 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 purchase more than a specified percentage (commonly 10.0%) of the Company's outstanding voting securities is required to obtain regulatory approval for the purchase. Article 15 of the New York Insurance Law relating to holding companies, to which the Company is subject, requires, INTER ALIA, disclosure of transactions between Frontier Insurance and the Company or any of its subsidiaries, 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 New York Department of Insurance. Further, prior approval by such Department is required for affiliated sales, purchases, exchanges, loans or extensions of credit, or investments, which involve 5.0% or more of Frontier Insurance's admitted assets as of the preceding December 31st. The laws of California, Wisconsin, North Carolina and Missouri, applicable to Frontier Pacific, United Capitol, Regency and Lyndon Property, respectively, are substantially equivalent to the laws of New York with respect to insurance holding companies. Further, under the laws of Louisiana, any person acquiring 10.0% of the voting securities of the Company would be deemed to be in control of United General, the title insurance company in which the Company has a 33.3% equity interest and, accordingly, such acquisition would require approval from the Louisiana Commissioner of Insurance. NAIC OVERSIGHT OF INSURANCE COMPANIES The NAIC has established twelve financial ratios to assist state insurance departments in their oversight of the financial condition of insurance companies operating in their respective states. The NAIC calculates these ratios based on information submitted by insurers on an annual basis and shares the information with the applicable state insurance departments. The ratios relate to leverage, profitability, liquidity and loss reserve development. Frontier Insurance's percentage increase in surplus exceeded the acceptable range during 1995 and 1996 due to capital infusions by the Company of $45.0 million and $64.2 million, respectively, to fund projected growth and to retain Frontier Insurance's A- (Excellent) rating. In 1995, Frontier Insurance's estimated reserve deficiency to surplus ratio exceeded the acceptable range primarily as a result of reserve strengthening; in 1996, the estimated reserve deficiency to surplus ratio was within the acceptable range. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources." 50 In their ongoing effort to improve solvency regulation, the NAIC and individual states have enacted certain laws and statutory financial statement reporting requirements. For example, NAIC rules require audit certification of statutory financial statements as well as actuarial certification of loss and LAE reserves therein. Other activities are focused on greater disclosure of an insurer's reliance on reinsurance and changes in its reinsurance programs, and tighter rules on accounting for certain overdue reinsurance. In 1994, the NAIC implemented a risk-based capital measurement formula to be applied to all property-casualty insurance companies, which calculates a minimum required statutory net worth, based on the underwriting, investment, credit loss reserve and other business risks applicable to the insurance company's operations. An insurance company that does not meet threshold risk-based capital measurement standards could be required to reduce the scope of its operations and ultimately could become subject to statutory receivership proceedings. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Regulation." STATUTORY SURPLUS AND CAPITAL In connection with the licensing of insurance companies, insurance regulators may limit or prohibit the writing of new business by an insurance company within its jurisdiction when, in the regulator's judgment, the insurance company is not maintaining adequate statutory surplus and capital. The Company currently does not anticipate that any regulator would limit the amount of new business that its Insurance Subsidiaries may write as a result of their current levels of statutory surplus and capital. INVESTMENT REGULATION The Insurance Subsidiaries are subject to state laws and regulations that require diversification of investment portfolios and limit the amount of investments in certain investment categories. Failure to comply with these laws and regulations would cause non-conforming investments to be treated as non- admitted assets for purposes of measuring statutory surplus and, in some instances, would require divestiture. As of March 31, 1997, the investments of the Insurance Subsidiaries complied with such laws and regulations in all material respects. GUARANTY FUNDS All fifty states have separate insurance guaranty fund laws requiring property and casualty insurance companies doing business within their respective jurisdictions to be members of their guaranty associations. These associations are organized to pay covered claims (as defined and limited by the various guaranty association statutes) under insurance policies issued by insolvent insurance companies. Such guaranty association laws, except in New York, create post-assessment associations which make assessments against member insurers to obtain funds to pay association covered claims after an insurer insolvency occurs. These associations levy assessments (up to prescribed limits) on all member insurers in the covered lines of business in that state. Maximum assessments required by law in any one year generally vary between 1% and 2% of annual premiums written by a member in that state. New York has a pre-assessment guaranty fund which makes assessments prior to an insolvency occurring. New Jersey, North Carolina and Pennsylvania have created, by statute, a separate guaranty association for workers' compensation business lines. Some states permit member insurers to recover assessments paid through surcharges on policyholders or through full or partial premium tax offsets, while other states permit recovery of assessments through the rate filing process. The property and casualty guaranty association assessments paid by Frontier Insurance, Frontier Pacific, United Capitol and Regency in the aggregate for the three months ended March 31, 1997 and 1996, and for the years ended December 31, 1996, 1995 and 1994 were $159,000, $142,000, $949,000, $477,000, and $1.3 million, respectively. 51 The Insurance Subsidiaries record guaranty assessments when such assessments are billed by the respective guaranty funds. In addition, each Insurance Subsidiary's policy is to accrue for any significant insolvencies when the loss is probable and the assessment amount can be reasonably estimated. In the case of most insurance insolvencies, the ability of each Insurance Subsidiary to reasonably estimate the insolvent insurer's liabilities or develop a meaningful range of the insolvent's liabilities is significantly impaired by inadequate financial data with respect to the estate of the insolvent company as supplied by the guaranty funds. Although the amount of any assessments applicable to guaranty funds cannot be predicted with certainty, the Company believes that future guaranty association assessments for insurer insolvencies will not have a material adverse effect on the liquidity or capital resources of the Insurance Subsidiaries. SHARED MARKETS As a condition of their respective licenses to do business, each of the Insurance Subsidiaries is required to participate in mandatory property and casualty shared market mechanisms or pooling arrangements which provide various insurance coverages to individuals or other entities that are otherwise unable to purchase such coverage in the commercial insurance marketplace. Each Insurance Subsidiary's participation in such shared markets or pooling mechanisms is generally proportionate to the amount of that Insurance Subsidiary's direct writings for the type of coverage written by the specific pooling mechanism in the applicable state. Commercial automobile insurance and workers' compensation lines have mandatory pooling arrangements on a state-by-state basis for segments of the market that have difficulty finding coverage from insurers. The shared market mechanisms for providing commercial automobile coverages are generally assigned risk plans, reinsurance facilities and joint underwriting facilities. For workers' compensation, the pooling in each state is generally in the form of a reinsurance type arrangement with servicing carriers providing the policy services and claims handling services. The National Council of Compensation Insurance provides services for calculating member pooling of losses and expenses in 32 states, with the remainder of the states having their own independent servicing plans. Certain of the Insurance Subsidiaries participate in the Florida Hurricane Catastrophe Fund, a state-mandated catastrophe reinsurance fund. Commercial properties are also subject to pooled insurance on a small scale through the various Fair Access to Insurance Requirements Plans which exist in most states. To date, participation by the Insurance Subsidiaries in such mandatory pools and underwriting associations has not materially affected the Company's results of operations. The amount of future losses or assessments from the shared market mechanisms and pooling arrangements described above cannot be predicted with certainty. Although it is possible that future losses or assessments from such mechanisms and pooling arrangements could have a material adverse effect on results of operations, the Company does not expect future losses or assessments to have a material adverse effect on liquidity or capital resources of the Insurance Subsidiaries. POSSIBLE LEGISLATIVE AND REGULATORY CHANGES Several committees of Congress have made inquiries and conducted hearings as part of a broad study of the regulation of insurance companies and legislation has been introduced from time to time in Congress which, if enacted, could result in the federal government assuming some role in the regulation of the insurance industry. Although the federal government does not regulate the business of insurance directly, federal initiatives often affect the insurance business in a variety of ways. Current and proposed federal measures which may significantly affect the insurance business include changes in environmental laws and tort reform. It is not possible to predict the outcome of any of the foregoing legislative or administrative activities or the potential effects thereof on the Company or its Insurance Subsidiaries. See "Risk Factors-- Regulation." 52 COMPETITION The property and casualty insurance business is highly competitive with respect to a number of factors, including overall financial strength of the insurer, ratings by rating agencies, premiums charged, policy terms and conditions, services offered, reputation and broker compensation. Although the Company's underwriting strategy is to achieve an underwriting profit by identifying niche markets and specialty insurance programs which it believes afford favorable opportunities for profitability due to limited potential competition, it nevertheless encounters competition from carriers engaged in insuring risks in the broader lines of business which encompass the niche markets or specialty programs, and such competition is expected to increase as the Company expands its operations. See "Risk Factors--Competition." EMPLOYEES At June 30, 1997, the Company (including Lyndon) had approximately 920 full-time employees, 16 of whom are executive management, and approximately 50 part-time employees. The Company is not a party to any collective bargaining agreement and believes its relationship with its employees to be good. PROPERTIES The Company owns a three-story office building at 195 Lake Louise Marie Road, Rock Hill, New York, in which its executive offices and insurance operations are located. A 50,000 square foot addition is under construction and is anticipated to be completed in September 1997. The Company also owns a one- story building in Rock Hill, New York, which it uses for storage and a portion of which is rented, and an airplane for which it leases facilities at a local airport. The Company leases office space at twelve locations in seven states at an aggregate monthly rental of approximately $133,000. In addition, Lyndon leases office space at five locations in four states at an aggregate monthly rental of approximately $35,000. The Company believes that upon completion of the addition at Rock Hill, New York, it will have adequate space for expansion of its existing operations. 53 MANAGEMENT The following table lists each director and each executive officer of the Company, together with his age and office(s) held:
NAME AGE OFFICE - ----------------------------------------- ----------- ----------------------------------------- Walter A. Rhulen......................... 65 Chairman of the Board, President and Chief Executive Officer Harry W. Rhulen.......................... 33 Executive Vice President, Chief Operating Officer and Director Peter H. Foley........................... 50 Executive Vice President Thomas J. Dietz.......................... 55 Vice President James E. Kroh............................ 53 Vice President--Human Resources Mark H. Mishler.......................... 38 Vice President--Treasurer and Chief Financial Officer Richard F. Seyffarth..................... 49 Vice President--Chief Investment Officer Peter L. Rhulen.......................... 58 Director Lawrence E. O'Brien...................... 56 Director Douglas C. Moat.......................... 65 Director Alan Gerry............................... 68 Director
WALTER A. RHULEN has been the Chairman of the Board, President and Chief Executive Officer of the Company since commencement of its operations in July 1986 and the President of Frontier Insurance since 1976. Mr. Rhulen was also the President of Rhulen Agency, a position he held for more than 22 years, which office he resigned in 1986. Mr. Rhulen has more than 40 years experience in the insurance business. HARRY W. RHULEN was elected Executive Vice President of the Company in October 1996, and Chief Operating Officer and a director in May 1997. Prior thereto, Mr. Rhulen had been a Vice President of the Company since June 1990 and an employee of the Company since June 1989. PETER H. FOLEY was elected Executive Vice President of the Company in October 1996, and prior thereto had been a Vice President of the Company since May 1995. Prior to joining the Company, Mr. Foley served as Vice President of Aegis Security Insurance Company from September 1993 to June 1995, Executive Vice President and co-founder of Connecticut Surety Insurance Company from May 1993 to September 1993, and Senior Vice President of E.W. Blanch, Inc. from November 1991 to May 1993. Mr. Foley has served in various executive officer positions in the insurance industry for more than 22 years, and has served as principal of his own consulting firm. THOMAS J. DIETZ has been a Vice President of the Company since July 1990 and President of Med Pro since its inception in 1986. For more than five years prior thereto, Mr. Dietz was a Vice President of Medical Quadrangle, Inc., an insurance agency which acted as a broker to the Company through February 1987. Mr. Dietz, has more than 28 years of experience in the insurance business. JAMES E. KROH was elected Vice President--Human Resources of the Company in May 1996, and joined the Company as an employee in 1995. Prior to joining the Company, Mr. Kroh served in excess of five years as Vice President for PHICO Insurance Company. 54 MARK H. MISHLER was elected Vice President--Treasurer and Chief Financial Officer of the Company in May 1997. Prior thereto, Mr. Mishler had been Vice President--Finance and Treasurer of the Company since October 1996, having joined the Company in 1987. Mr. Mishler has more than 15 years experience in the insurance business. RICHARD F. SEYFFARTH was elected Vice President and Chief Investment Officer in May 1997, having joined the Company in 1996. Prior thereto, Mr. Seyffarth served as Vice President of Home Insurance Company for over seven years. PETER L. RHULEN has been a director of the Company since commencement of its operations in August 1986 and a member of the Audit Commitee since May 1997. Mr. Rhulen was formerly Vice Chairman of Markel/Rhulen, a position he held from October 1989 to September 1992, and now acts as an independent insurance consultant. Mr. Rhulen is also Vice Chairman of the Board and President of RAI Partners, Inc. (formerly Rhulen Agency), a firm of which he had been an executive officer for more than 25 years. LAWRENCE E. O'BRIEN has been a director of the Company and a member of the Audit Committee since June 1990. Mr. O'Brien, a CPCU, is the President of O'Brien Management Company, Inc., an insurance consulting firm, a position he has held since January 1988, and co-founder and a director of Underwriter Management Associates, a managing general insurance agency with which he had been associated since its inception in 1983 until its sale in September 1990. From 1976 to 1987, Mr. O'Brien was Executive Vice President of Associated Risk Managers, a New York statewide affiliation of independent insurance agents marketing specialized insurance programs. DOUGLAS C. MOAT has been a director of the Company and a member of the Audit Committee since August 1994. Mr. Moat is Chairman of the Manhattan Group, Inc., an insurance and financial services firm. Mr. Moat has over 40 years' experience in insurance and financial services sales and management, including 13 years as a private consultant. During his career, he has held positions as Executive Vice President, The Home Group; Director--Financial Services Corporate Staff, ITT Corp.; Vice President, USLIFE Corp., and President of USLIFE's mutual fund subsidiary; and Vice President, The Glens Falls Group and the National Life Assurance Company of Canada. Mr. Moat is a member of the New York Bar Association, serves on several insurance and banking committees, and writes and speaks extensively on insurance topics, often acting as an expert witness. ALAN GERRY was elected a director of the Company in March 1996. Mr. Gerry is the founder of Cablevision Industries Corporation, the eighth largest multiple cable system operator in the United States and was its Chairman of the Board and Chief Executive Officer until its merger with Time Warner Entertainment in January 1996. Mr. Gerry is a member of the Board of Directors of Time Warner Entertainment, the National Cable Television Association, and C-SPAN. He was a founding member of the Board of the Cable Alliance for Education and is a past President of the New York State Cable Television Association. ------------------------ Messrs. Walter A. Rhulen and Peter L. Rhulen are brothers and Mr. Harry W. Rhulen is the son of Mr. Walter A. Rhulen. All directors hold office until the next annual meeting of shareholders and until their successors are elected and qualified. Officers are elected annually and serve at the pleasure of the Board of Directors, subject to rights, if any, under contracts of employment. 55 COMMITTEES OF THE BOARD OF DIRECTORS The Board of Directors has appointed an Audit Committee, a Compensation Committee and an Incentive and Non-Incentive Stock Option Committee. The Audit Committee, comprised of three independent directors, Messrs. Lawrence E. O'Brien, Douglas C. Moat and Peter L. Rhulen, meets with the Company's independent auditors to review the scope of their annual audit, the adequacy of the Company's system of internal controls, and the sufficiency of its financial reporting. The Compensation Committee, comprised of three independent directors, Messrs. O'Brien, Moat and Gerry, establishes the compensation program for Mr. Walter A. Rhulen, who is the Company's President, Chief Executive Officer and Chairman of the Board, and recommends to the Board of Directors, in consultation with Mr. Walter A. Rhulen, a general compensation program for all officers. The Incentive and Non-Incentive Stock Option Committee selects optionees and option terms in accordance with the Company's stock option plans. The Company does not have a standing nominating committee. COMPENSATION OF DIRECTORS The Company pays each director, other than executive officers, an annual retainer of $24,000, plus reimbursement of expenses, and each director who serves as a member of the Audit Committee an additional retainer of $2,000, plus reimbursement of expenses. EMPLOYMENT AGREEMENTS Mr. Walter A. Rhulen is employed under an agreement with the Company effective January 1, 1993 and expiring December 31, 1997, which provides for annual base compensation of $500,000 plus an annual bonus in the event the Company's earnings per share before extraordinary items ("EPS") exceeds its highest EPS during the five preceding years by at least 10.0%. In such event, Mr. Rhulen's bonus shall be $50,000, plus a multiple of $30,000 for each percentage point or fraction thereof by which the Company's EPS for the year exceeds the 10.0% threshold. In addition, in 1993, Mr. Walter A. Rhulen was granted an option to purchase the present equivalent of 825,000 shares of Common Stock at the present equivalent of $22.73 per share. On the date the option was granted, the closing price of the Common Stock on the NYSE was the present equivalent of $13.58. The Company is the beneficiary of a $5.0 million "keyman" life insurance policy on the life of Mr. Walter A. Rhulen. 56 PRINCIPAL STOCKHOLDERS The following table sets forth as of June 30, 1997 the beneficial ownership of the Common Stock by (i) each person known by the Company to own beneficially five percent or more of such shares, (ii) each director, (iii) certain executive officers of the Company (Messrs. Walter A. Rhulen, Thomas J. Dietz, Harry W. Rhulen, Peter H. Foley, and Mark H. Mishler), and (iv) all directors and executive officers as a group, together with their respective percentage ownership of the outstanding shares:
AMOUNT AND NATURE OF BENEFICIAL OWNERSHIP ---------------------------------------------- CURRENTLY ACQUIRABLE PERCENT OF NAME AND ADDRESS OWNED WITHIN 60 DAYS(1) OUTSTANDING - ----------------------------------------------------------- ---------- ----------------- --------------- Walter A. Rhulen (2)....................................... 2,154,998(3) -- 7.3% Peter L. Rhulen (2)........................................ 1,813,500(4) -- 6.2% Lawrence E. O'Brien........................................ 68,784 2,750 * Douglas C. Moat............................................ 8,526 2,750 * Alan Gerry................................................. -- 2,750 * Thomas J. Dietz............................................ 135,258 148,500 1.0% Harry W. Rhulen............................................ 177,104(5) 214,446(6) 1.3% Peter H. Foley............................................. 1,970 6,576 * Mark H. Mishler............................................ -- 6,380 * Estate of Jesse M. Farrow (2).............................. 1,694,902 -- 5.8% Denver Investment Advisors, LLC............................ 2,437,452(7) -- 8.3% 1225--17th Street, 26th Floor Denver, CO 80202 Wellington Management Company.............................. 2,278,142(8) -- 7.7% 75 State Street Boston, MA 02109 All directors and executive officers....................... 4,360,140 385,802 15.9% as a group (11 persons)
- ------------------------ * Less than 1.0% (1) Reflects number of shares of Common Stock acquirable upon exercise of options. (2) Address is 195 Lake Louise Marie Road, Rock Hill, NY 12775-8000. (3) Does not include 9,222 shares of Common Stock owned by the wife of Mr. Walter A. Rhulen, the beneficial ownership of which Mr. Rhulen disclaims. (4) Does not include 490,782 shares, 26,432 shares and 22,810 shares, respectively, of Common Stock owned by two children of Mr. Peter L. Rhulen, Mr. Rhulen's spouse and The Eileen and Peter Rhulen Foundation, Inc. for which Mr. Rhulen acts as President. Mr. Rhulen disclaims beneficial ownership of such shares. (5) Includes 8,076 and 1,054 shares owned by a daughter and son of Mr. Harry W. Rhulen, respectively, for whom he acts as custodian under the Uniform Gifts to Minors Act. Does not include 14,220 shares of Common Stock owned by Mr. Rhulen's wife, as to which Mr. Rhulen disclaims beneficial ownership. (6) Includes 206,250 shares purchasable at $22.73 per share upon exercise of options granted to Mr. Walter A. Rhulen, his father, and given to Mr. Harry W. Rhulen by his father. (7) Information is from Schedule 13G, dated February 10, 1997, filed by Denver Investment Advisors, LLC, which reflects sole dispositive power with respect to 2,437,452 shares. (8) Information is from a Schedule 13G, dated January 24, 1997, filed by Wellington Management Company, which reflects shared dispositive power with respect to 2,278,142 shares. 57 DESCRIPTION OF CAPITAL STOCK The Company's authorized capital stock consists of 50,000,000 shares of Common Stock and 1,000,000 shares of preferred stock, $.01 par value. COMMON STOCK Holders of the Common Stock are entitled to one vote per share on all matters to be voted upon by the stockholders generally, including the election of directors. Subject to the rights of holders of preferred stock, the holders of the Common Stock are entitled to receive such dividends as may be declared from time to time by the Board of Directors out of funds legally available therefor. In the event of the liquidation, dissolution or winding up of the Company, holders of the Common Stock are entitled to share ratably in all assets remaining after payment of liabilities of the Company, subject to the rights of holders of preferred stock. The holders of the Common Stock have no preemptive or conversion rights and are not subject to further calls or assessments by the Company. PREFERRED STOCK The Company's Certificate of Incorporation, as amended, authorizes the Board of Directors of the Company (without stockholder approval) to, among other things, issue shares of preferred stock from time to time in one or more series, each series to have such designations, preferences, relative, participating, optional and other special rights, and qualifications, limitations or restrictions (which may differ with respect to each series), as the Board of Directors may fix by resolution. LIMITATION ON DIRECTORS' LIABILITY The Company's Certificate of Incorporation provides that no director of the Company shall be personally liable to the Company's stockholders for monetary damages for the breach of any fiduciary duty as a director, except (i) for any breach of the director's duty of loyalty to the Company or its stockholders, (ii) for acts or omissions not in good faith or that involve intentional misconduct or a knowing violation of law, (iii) under Section 174 of the Delaware General Corporation Law, as amended from time to time, or (iv) for any transaction from which the director derived an improper personal benefit. The effect of these provisions is to eliminate the rights of the Company and its stockholders (through stockholders' derivative suits on behalf of the Company) to recover monetary damages against a director for breach of fiduciary duty as a director (including breaches resulting from grossly negligent behavior), except in the situations described above. These provisions do not limit the liability of directors under the federal securities laws. TRANSFER AGENT AND REGISTRAR American Stock Transfer & Trust Company, New York, New York is the transfer agent and registrar for the Common Stock. 58 UNDERWRITING Subject to the terms and conditions set forth in the purchase agreement (the "Purchase Agreement") among the Company and each of the underwriters named below (the "Underwriters"), the Company has agreed to sell to each of the Underwriters, and each of the Underwriters has severally agreed to purchase, the aggregate number of shares of Common Stock set forth opposite its name below. UNDERWRITERS NUMBER OF SHARES - ----------------------------------------------------------------------------------------------- ----------------- Merrill Lynch, Pierce, Fenner & Smith Incorporated......................................................................... Donaldson, Lufkin & Jenrette Securities Corporation............................................ Oppenheimer & Co., Inc......................................................................... Smith Barney Inc............................................................................... Stephens Inc................................................................................... ----------------- Total................................................................................ 4,000,000 ----------------- -----------------
Merrill Lynch, Pierce, Fenner & Smith Incorporated ("Merrill Lynch"), Donaldson, Lufkin & Jenrette Securities Corporation, Oppenheimer & Co., Inc., Smith Barney Inc. and Stephens Inc. are acting as representatives (the "Representatives") of the several Underwriters. In the Purchase Agreement, the several Underwriters have agreed, subject to the terms and conditions set forth therein, to purchase all of the Common Stock being sold pursuant to such Agreement if any of the Common Stock being sold pursuant to such Agreement are purchased. The Purchase Agreement provides that in the event of a default by an Underwriter, the purchase commitments of non-defaulting Underwriters may in certain circumstances be increased. The Underwriters propose initially to offer the Common Stock to the public at the public offering price set forth on the cover page of this Prospectus and to certain dealers (who may include the Underwriters) at such price less a concession not in excess of $ per share. The Underwriters may allow, and such dealers may re-allow, a discount not in excess of $ per share to certain other dealers. After the Offering, the public offering price, concession and discount may be changed. The Company has granted to the Underwriters an option to purchase up to an aggregate of 600,000 additional shares of Common Stock exercisable for 30 days after the date hereof, to cover over-allotments, if any, at the public offering price set forth on the cover page of this Prospectus, less the underwriting discount. To the extent that the Underwriters exercise this option, each of the Underwriters will have a firm commitment, subject to certain conditions, to purchase approximately the same percentage of such Common Stock that the number of shares of Common Stock to be purchased by it shown in the foregoing table bears to the total number of shares of Common Stock initially offered to the Underwriters hereby. The Company and certain officers and directors of the Company have agreed not to sell or otherwise dispose of any shares of Common Stock for a period of 90 days after the date of this Prospectus, except for gifts and the sale of an aggregate of 50,000 shares, collectively, without the prior written consent of Merrill Lynch. Upon the consummation of the Offering, it is expected that such lock-up agreements will cover an aggregate of approximately 6.1 million shares of Common Stock. There are no known formal or informal plans, arrangements, agreements or understandings regarding any intention to seek the consent of Merrill Lynch to release any of the foregoing restrictions at this time. It is generally the policy of Merrill Lynch to review any such requested consent on a case by case basis in light of the applicable circumstances. The Company has agreed to indemnify the Underwriters against certain civil liabilities, including liabilities under the Securities Act, or to contribute to payments the Underwriters may be required to make in respect thereof. 59 The Underwriters do not intend to confirm sales of the shares of Common Stock offered hereby to any accounts over which they exercise discretionary authority. Until the distribution of the Common Stock to be sold in the Offering is completed, rules of the Securities and Exchange Commission may limit the ability of the Underwriters to bid for and purchase the shares of Common Stock. As an exception to these rules, the Underwriters are permitted to engage in certain transactions that stabilize the price of the Common Stock. Such transactions may consist of bids or purchases for the purpose of pegging, fixing or maintaining the price of the Common Stock. If the Underwriters create a short position in the Common Stock in connection with the initial resale of the Shares to be sold in the Offering, i.e., if they sell more shares of Common Stock than are set forth on the cover page of this Prospectus, the Underwriters may reduce such short position by purchasing shares of Common Stock in the open market. The Underwriters may also elect to reduce any short position by exercising all or part of the over-allotment option described above. The Representatives may also impose a penalty bid on certain Underwriters and selling group members. This means that if the Representatives purchase shares of Common Stock in the open market to reduce the Underwriters' short position or to stabilize the price of the Common Stock they may reclaim the amount of the selling concession from the Underwriters and selling group members who initially resold such shares. In general, purchases of a security for the purpose of stabilization to reduce a short position could cause the price of the security to be higher than it might be in the absence of such purchases. The imposition of a penalty bid might also have an effect on the price of a security to the extent that it were to discourage resales of the security. This Offering is being made pursuant to the provisions of Section 2710(c)(8) of the Conduct Rules of the National Association of Securities Dealers, Inc. Neither the Company nor any Underwriter makes any representation or prediction as to the direction or magnitude of any effect that any transaction described above may have on the price of the Common Stock. In addition, neither the Company nor any Underwriter makes any representation that the Representatives will engage in such transactions or that such transactions, once commenced, will not be discontinued without notice. LEGAL MATTERS The validity of the shares of Common Stock offered hereby will be passed upon for the Company by Epstein Becker & Green, P.C., New York, New York. Members of Epstein Becker & Green, P.C., own an aggregate of 68,000 shares of Common Stock. Certain legal matters will be passed upon for the Underwriters by Simpson Thacher & Bartlett (a partnership which includes professional corporations), New York, New York. EXPERTS The consolidated financial statements (including schedules incorporated by reference) of the Company at December 31, 1996 and 1995, and for each of the three years in the period ended December 31, 1996, appearing or incorporated by reference in this Prospectus and Registration Statement have been audited by Ernst & Young LLP, independent auditors, as set forth in their reports thereon appearing elsewhere herein or incorporated by reference in the Registration Statement, and are included in reliance upon such report given upon the authority of such firm as experts in accounting and auditing. The consolidated financial statements of Lyndon at December 31, 1996 and 1995, and for each of the three years in the period ended December 31, 1996, incorporated by reference in this Prospectus and Registration Statement have been audited by Arthur Andersen LLP, independent auditors, as set forth in their report thereon incorporated by reference in this Registration Statement, and are included in reliance upon such report given upon the authority of such firm as experts in accounting and auditing. 60 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE --------- AUDITED CONSOLIDATED FINANCIAL STATEMENTS: Report of Ernst & Young LLP, Independent Auditors.......................................................... F-2 Consolidated Balance Sheets--December 31, 1996 and 1995.................................................... F-3 Consolidated Statements of Income--Years Ended December 31, 1996, 1995 and 1994............................ F-5 Consolidated Statements of Shareholders' Equity--Years Ended December 31, 1996, 1995 and 1994.............. F-6 Consolidated Statements of Cash Flows--Years Ended December 31, 1996, 1995 and 1994........................ F-7 Notes to Consolidated Financial Statements................................................................. F-8 Supplemental Data--Quarterly Results of Operations (Unaudited)............................................. F-30 Unaudited Consolidated Financial Statements: Consolidated Balance Sheets (Unaudited)--March 31, 1997 and December 31, 1996.............................. F-31 Consolidated Statements of Income (Unaudited)--Three Months Ended March 31, 1997 and 1996.................. F-33 Consolidated Statements of Cash Flows (Unaudited)--Three Months Ended March 31, 1997 and 1996.............. F-34 Notes to Consolidated Financial Statements (Unaudited)..................................................... F-35
F-1 REPORT OF INDEPENDENT AUDITORS Board of Directors and Shareholders Frontier Insurance Group, Inc. We have audited the accompanying consolidated balance sheets of Frontier Insurance Group, Inc. and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Frontier Insurance Group, Inc. and subsidiaries at December 31, 1996 and 1995, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. As described in Note B to the consolidated financial statements, effective January 1, 1994, the Company adopted Financial Accounting Standards Board Statement 115, "Accounting for Certain Investments in Debt and Equity Securities." /S/ Ernst & Young LLP New York, New York July 14, 1997 F-2 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (DOLLAR AMOUNTS IN THOUSANDS)
ASSETS DECEMBER 31 -------------------- 1996 1995 --------- --------- Investments--Note H: Securities, available for sale--at fair value: Fixed maturities (amortized cost: 1996--$680,281; 1995--$510,056)... $ 685,277 $ 521,402 Equity securities (cost: 1996--$13,871; 1995--$20,132).............. 16,271 21,024 Short-term investments................................................ 133,835 7,353 Investment in limited liability corporation........................... 2,937 2,935 --------- --------- TOTAL INVESTMENTS............................................... 838,320 552,714 Cash.................................................................. 8,332 5,115 Agents' balances due, less allowances for doubtful accounts (1996--$2,225; 1995--$3,346)........................................ 50,558 25,779 Premiums receivable from insureds, less allowances for doubtful accounts (1996--$60; 1995--$45)..................................... 26,225 24,177 Net reinsurance recoverables, less allowances for possible uncollectible amounts (1996--$517; 1995--$115)--Notes D and N....... 192,569 76,955 Accrued investment income............................................. 9,364 7,458 Federal income taxes recoverable...................................... 3,987 217 Deferred policy acquisition costs..................................... 32,871 18,797 Deferred federal income tax asset--Note E............................. 27,620 23,627 Home office building, property and equipment--at cost, less accumulated depreciation and amortization (1996--$11,184; 1995--$7,679)....................................................... 37,167 29,668 Intangible assets, less accumulated amortization (1996--$3,808; 1995--$2,370)....................................................... 11,738 3,082 Other assets.......................................................... 7,656 5,759 --------- --------- TOTAL ASSETS.................................................... $1,246,407 $ 773,348 --------- --------- --------- ---------
See notes to the consolidated financial statements. F-3 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (CONTINUED) (DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
LIABILITIES AND SHAREHOLDERS' EQUITY DECEMBER 31 -------------------- 1996 1995 --------- --------- LIABILITIES Policy liabilities--Notes C and D: Unpaid losses..................................................... $ 429,506 $ 309,164 Unpaid loss adjustment expenses................................... 109,567 58,272 Unearned premiums................................................. 185,728 107,282 --------- --------- TOTAL POLICY LIABILITIES........................................ 724,801 474,718 Funds withheld under reinsurance contracts--Note N.................... 64,065 28,226 Cash dividend payable to shareholders................................. 1,904 1,568 Note payable--Note F.................................................. 25,000 Other liabilities..................................................... 20,110 14,103 --------- --------- TOTAL LIABILITIES............................................... 810,880 543,615 COMMITMENTS AND CONTINGENCIES--Notes L and O GUARANTEED PREFERRED BENEFICIAL INTEREST IN COMPANY'S CONVERTIBLE SUBORDINATED DEBENTURES--Note M..................................... 166,953 SHAREHOLDERS' EQUITY--Notes A, G, I, J, and O Preferred stock, par value $.01 per share; authorized and unissued-- 1,000,000 shares Common stock, par value $.01 per share; (shares authorized: 1996-- 50,000,000; 1995--20,000,000, shares issued: 1996--29,379,104; 1995-- 26,125,002)................................................ 294 260 Additional paid-in capital.......................................... 221,837 167,457 Net unrealized gains--Note H........................................ 4,807 7,955 Retained earnings................................................... 42,424 54,849 --------- --------- SUBTOTAL........................................................ 269,362 230,521 Less treasury stock--at cost (1996--91,080 shares; 1995--82,800 shares)............................................................. 788 788 --------- --------- TOTAL SHAREHOLDERS' EQUITY...................................... 268,574 229,733 --------- --------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY...................... $1,246,407 $ 773,348 --------- --------- --------- ---------
See notes to the consolidated financial statements. F-4 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED DECEMBER 31 ---------------------------------- 1996 1995 1994 ---------- ---------- ---------- REVENUES--Note D Premiums written.............................................................. $ 402,799 $ 264,314 $ 198,892 Premiums ceded................................................................ (90,936) (43,557) (11,604) ---------- ---------- ---------- NET PREMIUMS WRITTEN...................................................... 311,863 220,757 187,288 Increase in net unearned premiums............................................. (45,874) (24,537) (30,533) ---------- ---------- ---------- NET PREMIUMS EARNED....................................................... 265,989 196,220 156,755 Net investment income......................................................... 37,226 30,035 24,453 Realized capital gains (losses)............................................... 1,707 20 (1,478) ---------- ---------- ---------- TOTAL NET INVESTMENT INCOME--Note H....................................... 38,933 30,055 22,975 Gross claims adjusting income--Note B......................................... 55 130 255 ---------- ---------- ---------- TOTAL REVENUES............................................................ 304,977 226,405 179,985 EXPENSES Losses--Notes C and D......................................................... 97,058 89,422 84,777 Loss adjustment expenses--Notes C and D....................................... 58,933 29,833 26,141 Amortization of policy acquisition costs--Note B.............................. 57,540 42,258 30,463 Underwriting and other expenses............................................... 30,540 20,717 17,274 Minority interest in income of consolidated subsidiary trust--Note M.......... 2,277 Interest expense--Note F...................................................... 1,970 895 ---------- ---------- ---------- TOTAL EXPENSES............................................................ 248,318 183,125 158,655 ---------- ---------- ---------- INCOME BEFORE INCOME TAXES...................................................... 56,659 43,280 21,330 Income taxes--Note E State......................................................................... 723 1,173 554 Federal....................................................................... 15,869 10,896 3,796 ---------- ---------- ---------- TOTAL INCOME TAXES........................................................ 16,592 12,069 4,350 ---------- ---------- ---------- NET INCOME.............................................................. $ 40,067 $ 31,211 $ 16,980 ---------- ---------- ---------- ---------- ---------- ---------- PER SHARE DATA--Notes B and O Primary earnings per common share............................................. $ 1.39 $ 1.09 $ .60 ---------- ---------- ---------- ---------- ---------- ---------- Fully diluted earnings per common share....................................... $ 1.37 $ 1.08 $ .59 ---------- ---------- ---------- ---------- ---------- ---------- WEIGHTED AVERAGE COMMON SHARES OUTSTANDING (in thousands): Primary....................................................................... 28,906 28,626 28,582 Fully diluted................................................................. 30,438 28,810 28,802
See notes to the consolidated financial statements. F-5 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY THREE YEARS ENDED DECEMBER 31, 1996 (DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
NET UNREALIZED ADDITIONAL GAINS(LOSSES) TOTAL COMMON PAID-IN ON SECURITIES RETAINED TREASURY SHAREHOLDERS' STOCK CAPITAL AVAILABLE-FOR-SALE EARNINGS STOCK EQUITY ----------- ----------- ---------------- ---------- ---------- ------------- Balances at January 1, 1994.................... $ 172 $ 166,577 $ 55 $ 18,890 $ 185,694 Add (deduct): Net income................................... 16,980 16,980 Expenses associated with 1993 issuance of 2,816,000 shares of common stock........... (47) (47) Common stock split (3 for 2)................. 86 (86) Purchase of 70,800 shares as treasury stock...................................... $ (654) (654) Stock options exercised...................... 2 635 637 Cumulative effect of change in accounting principle--Note B.......................... 3,651 3,651 Net unrealized losses on securities available-for-sale (net of tax)............ (10,013) (10,013) Cash dividends paid and accrued ($.23 per share)..................................... (5,984) (5,984) ----------- ----------- -------- ---------- ---------- ------------- Balances at December 31, 1994.................. 260 167,079 (6,307) 29,886 (654) 190,264 ----------- ----------- -------- ---------- ---------- ------------- Add (deduct): Net income................................... 31,211 31,211 Purchase of 12,000 shares as treasury stock...................................... (134) (134) Stock options exercised...................... 378 378 Transfer of securities to available-for-sale (net of tax)--Note B....................... 2,753 2,753 Net unrealized gains on securities available-for-sale (net of tax)............ 11,509 11,509 Cash dividends paid and accrued ($.24 per share)..................................... (6,248) (6,248) ----------- ----------- -------- ---------- ---------- ------------- Balances at December 31, 1995.................. 260 167,457 7,955 54,849 (788) 229,733 ----------- ----------- -------- ---------- ---------- ------------- Add (deduct): Net income................................... 40,067 40,067 Common stock dividend (10%).................. 28 45,208 (45,236) Stock options exercised...................... 2 1,101 1,103 Issuance of 476,174 shares of common stock... 4 8,071 8,075 Net unrealized losses on securities available-for-sale (net of tax)............ (3,148) (3,148) Cash dividends paid and accrued ($.25 per share)..................................... (7,256) (7,256) ----------- ----------- -------- ---------- ---------- ------------- Balances at December 31, 1996.................. $ 294 $ 221,837 $ 4,807 $ 42,424 $ (788) $ 268,574 ----------- ----------- -------- ---------- ---------- ------------- ----------- ----------- -------- ---------- ---------- -------------
See notes to the consolidated financial statements. F-6 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLAR AMOUNTS IN THOUSANDS)
YEAR ENDED DECEMBER 31 ------------------------------------- 1996 1995 1994 ----------- ----------- ----------- OPERATING ACTIVITIES Net income............................................................... $ 40,067 $ 31,211 $ 16,980 Adjustments to reconcile net income to net cash provided by operating activities: Increase in policy liabilities....................................... 145,636 80,857 63,274 Decrease (increase) in reinsurance balances.......................... (35,473) 5,403 15,619 Increase in agents' balances and premiums receivable................. (21,402) (8,825) (6,950) Increase in deferred policy acquisition costs........................ (14,366) (5,584) (6,393) Increase in accrued investment income................................ (1,369) (2,380) (161) Deferred income tax expense (benefit)................................ 2,279 (175) (5,162) Depreciation and amortization........................................ 3,687 2,384 305 Realized capital losses (gains)...................................... (1,707) (20) 1,478 Other................................................................ (895) 2,110 2,871 ----------- ----------- ----------- NET CASH PROVIDED BY OPERATING ACTIVITIES............................................. 116,457 104,981 81,861 INVESTING ACTIVITIES Proceeds from sales of fixed maturities available-for-sale............... 129,523 46,650 26,245 Proceeds from sales of fixed maturities held-to-maturity................. 12,534 Proceeds from calls, paydowns and maturities of fixed maturities available-for-sale..................................................... 191,888 77,999 25,250 Proceeds from calls, paydowns and maturities of fixed maturities held-to-maturity....................................................... 33,783 19,175 Proceeds from sales of equity securities................................. 15,256 36,465 63,200 Purchases of fixed maturities available-for-sale......................... (430,713) (294,379) (35,994) Purchases of fixed maturities held-to-maturity........................... (33,327) (109,127) Purchases of equity securities........................................... (5,533) (4,559) (68,783) Purchases of wholly-owned subsidiaries, net of cash acquired............. (28,996) Net (purchases) sales of short-term investments.......................... (108,889) 5,534 4,001 Additions to home office building........................................ (1,178) (2,568) (2,191) Purchases of property and equipment...................................... (9,431) (328) (996) Proceeds from sales of property and equipment............................ 438 Purchase of renewal rights............................................... (8) (633) (3,427) Investment in limited liability corporation.............................. (2) (2,400) ----------- ----------- ----------- NET CASH USED IN INVESTING ACTIVITIES............................................. (247,645) (125,229) (82,647) FINANCING ACTIVITIES Proceeds from guaranteed preferred beneficial interest in Company's convertible subordinated debentures.................................... 166,914 Proceeds from borrowings................................................. 7,100 25,000 Repayment of borrowings.................................................. (33,792) Issuance of common stock................................................. 1,103 378 590 Cash dividends paid...................................................... (6,920) (6,243) (5,717) Purchase of treasury stock............................................... (134) (654) ----------- ----------- ----------- NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES............................................. 134,405 19,001 (5,781) ----------- ----------- ----------- INCREASE (DECREASE) IN CASH........................................ 3,217 (1,247) (6,567) Cash at beginning of year........................................ 5,115 6,362 12,929 ----------- ----------- ----------- CASH AT END OF YEAR................................................ $ 8,332 $ 5,115 $ 6,362 ----------- ----------- ----------- ----------- ----------- -----------
See notes to the consolidated financial statements. F-7 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS NOTE A--OPERATIONS AND ACQUISITIONS Frontier Insurance Group, Inc., and its subsidiaries (the "Company"), is principally a specialty property and casualty insurer operating in 50 states. The Company's principal lines of business are medical malpractice, general liability, surety, and commercial earthquake accounting for approximately 34.6%, 28.2%, 16.2% and 4.1% of gross premiums written in 1996, respectively. The medical malpractice programs are marketed principally through the Company's wholly-owned subsidiary, Medical Professional Liability Agency, Ltd ("Med Pro"). The Company also has a bail bond program, which is marketed through Douglass/Frontier LLC, a fifty percent owned entity (see below). The Company's remaining lines of business are marketed primarily through independent agents. In April 1994, the Company completed the acquisition of certain assets of SDIA, Inc. ("SDIA") constituting that company's California license and permit bond insurance agency business for $3,200,000 and entered into a five-year consulting agreement with the owner/principal. This acquisition was accounted for as a purchase. The purchase price of $3,200,000 exceeded by the same amount the net book value of the business acquired. In May 1995, the Company and R. Spencer Douglas III ("Douglass") formed a California limited liability corporation, Douglass/Frontier LLC ("Douglass/Frontier"), a bail bond insurance agency. The Company made an initial cash investment of $2,400,000, and Douglass contributed the assets and liabilities of his wholly owned existing bail bond agency. The Company and Douglass share equally in the ownership of Douglass/Frontier. All of the Company's bail bond business is written through Douglass/Frontier and for the years ended December 31, 1996 and 1995, was approximately $7,608,000 and $4,800,000, respectively. At December 31, 1996 and 1995, Douglass/Frontier had premium balances due the Company in the normal course of business of $2,358,000 and $1,271,000, and notes payable to the Company of $3,291,000 and $212,000, respectively. At December 31, 1996, the Company had an interest of $537,000 in the undistributed earnings of Douglass/Frontier. In December 1995, the Company purchased certain assets from Bankers Multiple Line Insurance Company ("BMLIC") constituting BMLIC's realtors' errors and omissions ("Realtors' E & O") business for $400,000. The purchase agreement provides that, if certain conditions cease to exist in future years, the purchase price may be reduced. In addition, the Company was paid approximately $8,000,000 to assume BMLIC's obligations under its existing Realtors' E & O policies consisting of $2,287,000 of unearned premium reserves and $5,713,000 of undiscounted loss and loss adjustment expense ("LAE") reserves at the acquisition date. The Company's maximum liability relative to its assumption of the loss and LAE reserves is $7,141,000 with BMLIC retaining the liability for any losses in excess of this amount. During 1996, the Company earned the previously assumed unearned premiums and paid $3,948,000 in losses and LAE, and at December 31, 1996 holds related reserves of $1,765,000. In May 1996, the Company completed the acquisition of United Capitol Holding Company ("United Capitol Holding") and its wholly-owned subsidiaries, United Capitol Insurance Company ("United Capitol"), United Capitol Managers, Inc. (renamed Olympic Underwriting Managers, Inc.) and Fischer Underwriting Group, Inc., for $31,020,000, which exceeded the fair value of the net assets acquired by approximately $7,700,000. From its headquarters in Atlanta, Georgia, these entities underwrite specialty risks such as asbestos abatement, environmental liability and directors' and officers' liability. This acquisition was accounted for as a purchase. In September 1996, the Company completed the acquisition of Regency Insurance Company ("Regency") and Emrol Installment Premium Discount, Inc. ("Emrol") in exchange for 476,174 shares of F-8 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE A--OPERATIONS AND ACQUISITIONS (CONTINUED) the Company's Common Stock, which had a market value per share of $16.96 on June 11, 1996, the effective date of the agreement. The purchase price, which is inclusive of $221,000 of capitalized acquisition costs, exceeded the fair value of the net assets acquired by approximately $2,400,000. Regency, an underwriter of non-standard automobile insurance is located in Charlotte, North Carolina. Emrol finances premiums primarily for policyholders of Regency. This acquisition was accounted for as a purchase. The assets acquired, liabilities assumed and the related goodwill of the companies purchased in 1996, are summarized in the following table (in thousands):
UNITED CAPITOL REGENCY AND HOLDING EMROL TOTAL ------------- ----------- ---------- Purchase Price...................................... $ 31,020 $ 8,296 $ 39,316 Assets acquired: Invested assets................................... 74,966 4,168 79,134 Other assets...................................... 49,797 11,833 61,630 ------------- ----------- ---------- Total assets acquired............................... 124,763 16,001 140,764 Liabilities assumed: Unpaid losses and LAE............................. 84,823 4,163 88,986 Other liabilities................................. 16,604 5,944 22,548 ------------- ----------- ---------- Total liabilities assumed........................... 101,427 10,107 111,534 ------------- ----------- ---------- Net assets acquired................................. 23,336 5,894 29,230 ------------- ----------- ---------- Excess of purchase price over net assets acquired... $ 7,684 $ 2,402 $ 10,086 ------------- ----------- ---------- ------------- ----------- ----------
F-9 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE A--OPERATIONS AND ACQUISITIONS (CONTINUED) The following schedule summarizes the Company's pro forma unaudited results of operations for the years ended December 31, 1996 and 1995, assuming the purchase of United Capitol Holding, Regency and Emrol had been consummated as of January 1, 1995 (in thousands, except per share data):
YEAR ENDED DECEMBER 31 ---------------------- 1996 1995 ---------- ---------- (UNAUDITED) Net premiums earned................................................ $ 271,452 $ 214,347 Net investment income (including net capital gains and losses)..... 41,385 33,831 Other revenues..................................................... 55 130 ---------- ---------- Total revenues................................................. 312,892 248,308 Losses and LAE..................................................... 158,963 130,068 Amortization of policy acquisition costs........................... 57,248 43,489 Underwriting and other expenses.................................... 32,615 25,991 Minority interest in income of consolidated subsidiary trust....... 2,277 Interest expense................................................... 1,970 895 ---------- ---------- Total expenses................................................. 253,073 200,443 ---------- ---------- Income before income taxes......................................... 59,819 47,865 Income tax expense................................................. 17,831 13,317 ---------- ---------- Net income..................................................... $ 41,988 $ 34,548 ---------- ---------- ---------- ---------- Per share data: Primary earnings per common share................................ $ 1.44 $ 1.19 ---------- ---------- ---------- ---------- Fully diluted earnings per common share.......................... $ 1.41 $ 1.18 ---------- ---------- ---------- ----------
The foregoing pro forma financial information has been prepared for informational purposes only and includes certain adjustments relating to investment income, amortization of goodwill, and also for 1995, loss and other expenses, together with the related income tax effects. The pro forma financial information is not necessarily indicative of the results of operations as they would have been had the transactions been consummated on the assumed dates. The Company's Preferred Stock may be issued from time to time by the Board of Directors in one or more series and classes and with such dividend rights, conversion rights, voting rights, redemption provisions, liquidation preferences, and other rights and restrictions as the Board of Directors may determine. On December 31, 1996, the Company held a Special Meeting of Stockholders and voted to adopt an amendment to the Company's Certificate of Incorporation to increase the authorized number of shares of the Company's Common Stock from 20,000,000 to 50,000,000. F-10 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE B--SIGNIFICANT ACCOUNTING POLICIES The significant accounting policies followed by the Company are summarized below. BASIS OF PRESENTATION AND PRINCIPLES OF CONSOLIDATION: The accompanying financial statements have been prepared in accordance with generally accepted accounting principles ("GAAP"), which, as to insurance companies, differ from the statutory accounting practices prescribed or permitted by regulatory authorities. The consolidated financial statements include the accounts and operations of Frontier Insurance Group, Inc. and all subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. USE OF ESTIMATES: The preparation of financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Such estimates and assumptions could change in the future as more information becomes known which could impact the amounts reported and disclosed herein. RECOGNITION OF PREMIUM REVENUES: Direct, assumed, and ceded reinsurance premiums written are recognized as earned pro rata over the terms of the related insurance policies. INVESTMENTS: Effective January 1, 1994, the Company adopted Financial Accounting Standards Board ("FASB") Statement 115, ACCOUNTING FOR CERTAIN INVESTMENTS IN DEBT AND EQUITY SECURITIES ("FASB 115"). Under FASB 115, investments in fixed maturities are classified in three categories: held-to-maturity, trading and available-for-sale; investments in equity securities are classified as either available-for-sale or trading. Held-to-maturity securities are reported at cost, adjusted for amortization of premium or discount; trading securities are reported at fair value, with unrealized gains and losses included in earnings; and available-for-sale securities are reported at fair value with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity, net of applicable income taxes. This change in accounting had no effect on net income; however, the accounting change increased shareholders' equity at January 1, 1994 by $3,651,000, net of applicable income taxes, representing the amount of unrealized gains on fixed-maturity investments classified as available-for-sale. Under the former rules, debt securities (principally bonds, notes and redeemable preferred stocks) were carried at cost, adjusted for the amortization of premium or discount and other-than-temporary market value declines. Unrealized gains and losses were excluded from both earnings and shareholders' equity. In December 1995, the Company reclassified all of its securities classified as held-to-maturity to the available-for-sale category as permitted by the FASB's Special Report, A GUIDE TO IMPLEMENTATION OF STATEMENT 115 ON ACCOUNTING FOR CERTAIN INVESTMENTS IN DEBT AND EQUITY SECURITIES--QUESTIONS AND ANSWERS. The securities reclassified had a carrying value of $190,474,000 and a market value of $194,709,000 at the date of transfer. This reclassification resulted in a $2,753,000 increase, net of applicable income taxes, in shareholders' equity. Fixed maturities available-for-sale (principally bonds and notes) are carried at fair value. Fair values for available-for-sale fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services. For mortgage backed securities, the Company considers estimates of future principal prepayments in the calculation of the constant effective yield necessary to apply the interest method. If a difference arises between the prepayments anticipated and actual prepayments received, the Company recalculates the effective yield to reflect the actual payments received and the anticipated future F-11 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE B--SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) payments. Equity securities (principally common and nonredeemable preferred stocks) are carried at fair value, based on quoted market prices. Short-term investments are carried at their principal balances, which approximates their fair value. Realized gains and losses from the sales or liquidation of investments are determined using the specific identification basis. Changes in the fair value of available-for-sale securities are reflected as unrealized gains or losses directly in shareholders' equity net of federal income tax. The investment in Douglass/Frontier is accounted for under the equity method based on Douglas/ Frontier's GAAP results of operations. HOME OFFICE BUILDING, PROPERTY AND EQUIPMENT: Home office building is stated at cost, net of accumulated depreciation computed, for both financial reporting and federal income tax purposes, on the straight-line basis over an estimated useful life of 31.5 years. Property and equipment is stated at cost net of accumulated depreciation and amortization computed, for financial reporting purposes, on the straight-line basis over estimated useful lives between three to ten years and, for federal income tax purposes, using accelerated methods and guideline lives ranging from three to seven years. During 1996, 1995, and 1994, depreciation and amortization expense was $3,413,000, $2,440,000, and $1,939,000, respectively. In April 1993 and in July 1996, the Company put into service and began to occupy its new home office facility and purchased a corporate jet, respectively. The cost of the facility's construction and purchase of the jet was financed internally by the Company. However, to receive favorable tax status, title to the facility and jet resides with the County of Sullivan Industrial Development Agency ("IDA") which, in turn, issued to the Company its twenty-year bonds with a face value equal to the total cost of the facility and jet. Under the provisions of related agreements, title to the facility and jet reverts to the Company on maturity of the bonds, or sooner for a nominal fee, should the Company so desire. Accordingly, as a result of these agreements, the home office facility and corporate jet are reported in the accompanying financial statements as, "Home office building, property and equipment." As of December 31, 1996, the outstanding, par value of the IDA bonds was $24,574,000; which approximates the carrying values of such assets. DEFERRED POLICY ACQUISITION COSTS: Recoverable policy acquisition costs that vary with and are directly related to the production of business, such as commissions and premium taxes, net of reinsurance allowances, are deferred and amortized to income as the related premiums are earned. Anticipated losses, LAE, and policy maintenance expenses, based on historical and current experience, are considered in determining the recoverability of such deferred policy acquisition costs. When the anticipated losses, LAE, acquisition and policy maintenance expenses exceed the related unearned premiums, without considering anticipated investment income, a provision for the indicated deficiency is recorded. INTANGIBLE ASSETS: Intangible assets are stated at cost, net of accumulated amortization computed on a straight-line basis over estimated useful lives ranging from two to seven years for insurance renewal rights and five to fifteen years for other intangible assets, including goodwill. The Company assesses the recoverability of intangible assets by determining whether the amortization of the balance over its remaining life can be recovered through the undiscounted future operating cash flows of the acquired operations. UNPAID LOSSES AND LAE: The liabilities for unpaid losses and LAE represent the estimated liabilities for reported claims, claims incurred but not yet reported ("IBNR"), and the related LAE. The liabilities for unpaid losses and LAE are determined using case-basis evaluations and actuarial analyses and represent estimates of the ultimate expected cost of all losses and LAE unpaid at the balance sheet dates. F-12 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE B--SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The liabilities for unpaid losses and LAE have been reduced by estimated salvage and subrogation recoverable and have not been reduced from their ultimate values by the effects of discounting estimated ultimate payments to their present value. REINSURANCE: Assumed reinsurance premiums written, commissions, and unpaid losses are accounted for based principally on the reports received from the ceding insurance companies and in a manner consistent with the terms of the related reinsurance agreements. Liabilities for unpaid losses, LAE and unearned premiums are stated gross of ceded reinsurance recoverables. Deferred policy acquisition costs are stated net of the amounts of reinsurance ceded, as are premiums written and earned, losses and LAE incurred, and amortized acquisition costs. CONTINGENT REINSURANCE COMMISSIONS: Contingent reinsurance commissions are accounted for on an earned basis and are accrued, in accordance with the terms of the applicable reinsurance agreement, based on the estimated level of profitability relating to such reinsured business. Accordingly, the profitability of the reinsured business is continually reviewed and as adjustments become necessary, such adjustments are reflected in current operations. Contingent reinsurance commissions are included in other assets and other liabilities. INCOME TAXES: Income tax provisions are based on income reported for financial statement purposes, adjusted for permanent differences between financial and taxable income. Deferred federal income taxes are recognized using the liability method, whereby tax rates are applied to the temporary differences between the financial reporting and tax bases of assets and liabilities. Deferred tax assets and liabilities are adjusted for changes in tax rates or laws, and the adjustment is reflected in income during the period in which such change is enacted. EARNINGS PER SHARE: Primary earnings per common share are computed by dividing net income by the weighted average common shares outstanding during the period. The weighted average shares outstanding have been adjusted retroactively to reflect the effects of stock splits and stock dividends. The effect of common stock equivalents (stock options) is excluded from the calculations because their effect is not material. Fully diluted earnings per common share assume the conversion of all securities whose contingent issuance would have a dilutive effect on earnings. GROSS CLAIMS ADJUSTING INCOME: Claims adjusting income is accounted for on an accrual basis, gross of related expenses. During 1996, 1995, and 1994, operating expenses included with underwriting and other expenses associated with claims adjusting income amounted to $637,000, $203,000, and $331,000, respectively. IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS: In June 1996, the Financial Accounting Standards Board issued Statement 125, ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES, which provides accounting and reporting standards for sales, securitizations, and servicing of receivables and other financial assets, secured borrowing and collateral transactions, and the extinguishments of liabilities. The Statement is to be applied to transactions occurring after December 31, 1996 including transfers of assets pursuant to securitization structures that previously were entered into. However, the FASB has issued a proposed amendment that would delay until 1998 the effective date of certain of the statement's provisions that deal with securities lending, repurchase and dollar repurchase agreements and the recognition of collateral. The Company will adopt Statement 125 in the first quarter F-13 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE B--SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) 1997, excluding the provisions that deal with securities lending, repurchase and dollar repurchase agreements, and the recognition of collateral, which will be adopted in 1998 pursuant to the proposed amendment. The Company does not believe the effect of the adoption will be material to its financial position or results of operations. RECLASSIFICATIONS: Certain prior year amounts have been reclassified to conform to the 1996 presentation. NOTE C--UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES The liabilities for unpaid losses and LAE are estimated by management utilizing methods and procedures which they believe are reasonable. These liabilities are necessarily subject to the impact of future changes in claim severity and frequency, as well as numerous other factors. Although management believes that the estimated liabilities for unpaid losses and LAE are reasonable, because of the extended period of time over which such losses are reported and settled, the subsequent development of these liabilities may not conform to the assumptions inherent in their determination and, accordingly, may vary from the estimated amounts included in the accompanying financial statements. To the extent that the actual emerging loss experience varies from the assumptions used in the determination of these liabilities, they are adjusted to reflect actual experience. Such adjustments, to the extent they occur, are reported in the period recognized. The anticipated effect of inflation is implicitly considered when estimating reserves for losses and LAE. Although anticipated price increases due to inflation are considered in estimating the ultimate claim costs, the increase in average severities of claims is caused by a number of factors that vary with the types of policies written. Average severities are projected based on historical trends adjusted for implemented changes in underwriting standards, policy provisions, and general economic trends. Those anticipated trends are monitored based on actual development and are adjusted as necessary. The effects of such adjustments are reported in the period recognized. In December 1990, the New York State Court of Claims rendered a decision in favor of the Company holding that a State University of New York ("SUNY") medical school faculty member engaged in the clinical practice of medicine at a SUNY medical facility, corollary to such physician's faculty activities, was within the scope of such physician's employment by SUNY and was protected against malpractice claims arising out of such activity by the State of New York and not under the Company's medical malpractice policy. The decision was affirmed on appeal by the New York State Appellate Division in November 1991 and not appealed by the State. In July 1992, the State of New York enacted legislation eliminating medical school faculty members of SUNY engaged in the clinical practice of medicine at a SUNY medical facility from indemnification by the State with respect to malpractice claims arising out of such activity, retroactive to July 1, 1991. In an opinion filed on September 3, 1993 the Court of Claims of the State of New York held, inter alia, that the July 1992 legislation by the State of New York eliminating SUNY medical school faculty members engaged in the clinical practice of medicine, as part of their employment by SUNY, from indemnification by the State with respect to malpractice claims arising out of such activity was not to be applied retroactively. This decision was affirmed by the New York State Appellate Division in April 1994. Subsequently, in February 1995, the Appellate Division granted leave to the Company and the State of F-14 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE C--UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES (CONTINUED) New York to have the issues of the Company's entitlement to recover its costs of defense and its costs of settlement ruled on by the State's highest Court, the New York Court of Appeals. In December 1995, the New York Court of Appeals ruled on this issue and concluded that the Company was entitled to recoveries from the State for such medical malpractice claims. As a result of this decision, the Company believes that it will benefit economically by not being ultimately responsible for certain claims against SUNY physicians for whom it presently carries reserves and be entitled to reimbursement for certain claims previously paid; accordingly, in 1996 and 1995, the Company recorded subrogation recoverables of approximately $13,000,000 and $19,000,000, respectively, representing the amount of claims already paid and the reserves currently held by the Company on the cases that management believes are reimbursable by the State of New York. In January 1997, the New York Court of Claims rendered a decision granting summary judgement to the Company on three SUNY cases that were previously paid by the Company. This decision has been appealed by the State of New York. To the extent the amount of the actual recovery varies, such difference will be reported in the period recognized. The Company is continuing to defend all SUNY faculty members against malpractice claims that have been asserted and is maintaining reserves therefor adjusted for the anticipated recoveries. The following table sets forth a reconciliation of the beginning and ending loss and LAE reserve balances, net of reinsurance ceded, for each of the three years in the period ended December 31, 1996 (in thousands):
YEAR ENDED DECEMBER 31 ---------------------------------- 1996 1995 1994 ---------- ---------- ---------- Net reserves for losses and LAE, beginning of year........................... $ 294,393 $ 263,202 $ 216,486 Total acquired reserves...................................................... 53,008 5,500 Incurred losses and LAE for claims relating to: Current year............................................................... 160,470 126,769 97,044 Prior years................................................................ (4,479) (7,514) 13,874 ---------- ---------- ---------- Total incurred losses and LAE................................................ 155,991 119,255 110,918 ---------- ---------- ---------- Loss and LAE payments for claims relating to: Current year............................................................... 27,626 13,057 7,216 Prior years................................................................ 102,160 80,507 56,986 ---------- ---------- ---------- Total payments............................................................... 129,786 93,564 64,202 ---------- ---------- ---------- Net reserves for losses and LAE, end of year................................. 373,606 294,393 263,202 Total reinsurance recoverable on unpaid losses and LAE....................... 165,467 73,043 49,435 ---------- ---------- ---------- Gross reserves for losses and LAE, end of year............................... $ 539,073 $ 367,436 $ 312,637 ---------- ---------- ---------- ---------- ---------- ----------
The Company's reserves for unpaid losses and LAE, net of related reinsurance recoverable, at December 31, 1995 and 1994 were decreased in the following year by approximately $4,479,000 and $7,514,000, respectively, and at December 31, 1993 the reserves were increased in the following year by approximately $13,900,000, for claims that had occurred prior to the balance sheet dates. No premiums have been accrued as a result of the changes to prior year loss and LAE reserves. The $4,479,000 decrease in prior years' reserves in 1996 was the result of favorable claims development on the workers' compensation line of business. Included in the net development is an increase in F-15 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE C--UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES (CONTINUED) prior years' reserves of approximately $13,000,000 which was entirely offset by subrogation recoverables recognized in connection with a favorable court ruling in 1995. The significant increase in the reinsurance recoverable in 1996 was due to the contribution to the recoverable by United Capitol and Regency, which were acquired in 1996, and the change in the type of reinsurance from an aggregate claim excess of loss, to a stop loss for the majority of the Company's losses. The $7,514,000 decrease in the prior years' reserves in 1995 was the result of favorable claims development on the general liability and worker's compensation lines and to subrogation recoveries in the surety line of business in excess of expectations. Included in the net development, was an increase in prior years' reserves of approximately $19,000,000, which was entirely offset by additional subrogation recoverables recognized in connection with the favorable court ruling in 1995. The significant increase in the reinsurance recoverable in 1995 was due to the change in the type of reinsurance from an aggregate claim excess of loss, to a stop loss for the majority of the Company's losses. The $13,874,000 increase in prior years' reserves in 1994 resulted from a $17,500,000 increase in the reserves attributable to adverse medical malpractice claims development in Florida from higher than anticipated dollar settlements and from redundancies in other lines. Because of the adverse development experienced in 1994, the Company has significantly restructured the manner in which it adjudicates its claims. The change in process included, among other things, placing more reliance on internal claim examiners and in-house attorneys than on third parties, especially for the Company's medical malpractice claims in Florida. Management believes that the revised process will result in better control over the ultimate costs to adjudicate its claims and the related indemnity costs enabling management to settle such claims for amounts reflected in the accompanying financial statements. However, management recognizes that many factors could impact the successful implementation of its revised process, and to the extent, future claim costs are not reduced from current levels as anticipated in the implementation plan, actual ultimate claim costs could vary, perhaps significantly, from those included in the accompanying financial statements. NOTE D--REINSURANCE The Company maintains reinsurance with various unrelated insurance companies, principally for its direct business written, whereby amounts written in excess of certain retention limits are ceded to those companies generally under reinsurance treaty arrangements. Beginning in 1995, the Company entered into a three-year stop loss reinsurance contract with Centre Reinsurance Company of New York ("Centre Re"). Under the terms of the agreement, Centre Re provides reinsurance protection within certain accident year and contract aggregate dollar limits for losses and LAE in excess of a predetermined ratio of these expenses to earned premiums for a given accident year for all lines of business except bail, customs, license and permit, and miscellaneous surety bonds. The loss and LAE ratio above which the reinsurance provides coverage is 66%, 65%, and 64% for accident years 1995 through 1997, respectively. Although the reinsurance companies are liable to the Company for the amounts reinsured, the Company remains liable to its insureds for the full amount of the policies written whether or not the reinsurance companies meet their obligations. Consequently, allowances are established for amounts deemed uncollectible. To minimize its exposure to significant losses from reinsurance insolvencies, the Company evaluates the financial condition of its reinsurers and monitors concentration of credit risk from similar geographic regions, activities or economic characteristics of the reinsurers. At December 31, 1996, F-16 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE D--REINSURANCE (CONTINUED) the Company has outstanding gross reinsurance recoverables of $74,002,000 from its largest reinsurer, Centre Re; however, under the terms of the reinsurance arrangements, the Company is withholding $63,766,000 of funds due Centre Re. Accordingly, the net outstanding recoverable from Centre Re is $10,236,000. Of the remaining net reinsurance recoverables balance, approximately 43% is due from three reinsurers; one rated A+ (Superior) and two rated A (Excellent) by A.M. Best Company, Inc. The following is a summary of the maximum amount of loss retained and ceded by the Company for new and renewal policies as of December 31, 1996, 1995, and 1994 (exclusive of facultative reinsurance and the Centre Re stop loss contract) (in thousands):
MAXIMUM RETAINED LOSS MAXIMUM CEDED LOSS PER OCCURRENCE/ PER OCCURRENCE/ RISK/PRINCIPAL RISK/PRINCIPAL ------------------------------- ------------------------------- DECEMBER 31 DECEMBER 31 ------------------------------- ------------------------------- 1996 1995 1994 1996 1995 1994 --------- --------- --------- --------- --------- --------- Property lines............................. $ 500 $ 200 $ 200 $ 9,500 $ 800 $ 800 Casualty lines (excluding medical malpractice, health specialties and social services)......................... 1,000 1,000 1,000 4,000 1,000 1,000 Medical malpractice, health specialties and social services.......................... 1,000(1) 1,000(1) 1,000(1) 1,000 1,000 1,000 Workers' compensation...................... 1,000 1,000 1,000 2,000 2,000 2,000 Surety..................................... 1,000(5) 1,000(5) 1,000 4,000(5) 4,000(5) 500 Custom bonds............................... 3,000(3) 3,000(3) 650(3) N/A N/A N/A Umbrella liability......................... 1,000 1,000 400 4,000 4,000 4,800 Group accident and health.................. 250 250 250 750 750 750 Excess workers' compensation/ employers' liability................................ 1,000(4) 1,000(4) 1,000(4) 9,000(4) 9,000(4) 9,000(4) Earthquake................................. 2,500(2) 2,500 47,500(2) 37,500 Homeowners................................. 1,000(6) 14,000(6) Ocean marine............................... 250 9,750 Directors' and officers' liability......... 1,000 4,000
- ------------------------ (1) For certain risks and policy years, the maximum retained loss per occurrence is $500,000. On a very limited basis, the maximum retained loss per occurrence is $2,000,000. (2) Amounts relate to the contract effective January 1, 1997, which catastrophe layers in excess of $2,500,000 are subject to 5% coinsurance. (3) Amount indicated is the maximum face amount (limit) on the bond issued, which represents the value of goods being imported that are subject to U.S. Customs duty. The actual exposure to the Company is the amount of any unpaid duty on the goods imported, which is generally approximately 15% of the face value of the goods, and any penalties associated with the late payment of the duty. (4) Subject to a catastrophe retention of $3,000,000 per occurrence and a maximum ceded loss of $40,000,000 per occurrence. (5) Effective December 1, 1995, two layers of excess reinsurance were added for a maximum limit of $10,000,000 per principal on a direct basis, $2,100,000 on a net basis. (6) Excludes the effect of the Company's 5% retention of $14,000,000 in losses in excess of $1,000,000. F-17 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE D--REINSURANCE (CONTINUED) Prior to 1994, the Company assumed reinsurance under various reinsurance treaty arrangements and through mandatory participation in various states' residual market pools and reinsurance facilities. The amount of risk assumed by the Company varies in amount by treaty and does not exceed $500,000 per occurrence/risk/surety bond principal after retrocessions. As part of its acquisition of BMLIC's realtors errors and omissions business, the Company is reinsuring policies issued by BMLIC until such time as the program is filed and can be underwritten on the Company's policies. In 1996, the Company began to assume, on a quota share basis, homeowners business underwritten by Omega Insurance Company. The Company also reinsured ocean marine business written by its subsidiary, United Capitol. The Company retained the first $250,000 per occurrence and ceded up to $9,750,000 excess of $250,000 per occurrence. The reinsurance program was led by underwriters at Lloyds on a losses occurring basis. Effective January 1, 1997, this program was replaced by a similar program written on a risks attaching basis by Munich American Reinsurance Company and Munich Reinsurance Company, U.S. branch. On July 1, 1996, the Company implemented a catastrophe reinsurance program for its homeowners business written in the state of Florida. The program provides coverage in the amount of $14,000,000 excess of a $1,000,000 retention. In 1996, the Company began assuming and writing on a direct basis ocean marine business. The Company reinsures its ocean marine and international risks under multiple layers of excess reinsurance. Coverage is provided up to $9,950,000 excess of $50,000 per occurrence, excess of an aggregate retention of $200,000 of loss occurrences in excess of $50,000. The Company cedes 100% of its environmental liability business to Underwriters Reinsurance Company. The Company reassumes 10% of this business, along with 10% of environmental liability business underwritten by Commercial Underwriters Insurance Company and Underwriters Reinsurance Company. In 1995 and 1994, the Company's medical malpractice reinsurers agreed to a commutation for treaty years 1991 and 1990, respectively. As a result of their commutation, the Company recaptured its liability for ceded unpaid losses and LAE of approximately $3,900,000 and $6,100,000 for treaty years 1991 and 1990, respectively, and received cash of an equal amount, resulting in no gain or loss. After the commutation, there was no change in the net incurred losses or loss ratios as a result of these transactions. In 1996, 1995, and 1994, the Company recognized and accrued (reduced) reinsurance contingent profit commissions earned of $773,000, ($783,000), and ($337,000), respectively. The components of the net reinsurance recoverable balances included in the accompanying balance sheets are as follows (in thousands):
YEAR ENDED DECEMBER 31 --------------------- 1996 1995 ---------- --------- Ceded paid losses & LAE recoverable................................. $ 7,519 $ 2,639 Ceded unpaid losses and LAE......................................... 165,467 73,043 Ceded unearned premiums............................................. 32,403 5,541 Ceded reinsurance payable........................................... (12,820) (4,268) ---------- --------- TOTAL............................................................... $ 192,569 $ 76,955 ---------- --------- ---------- ---------
F-18 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE D--REINSURANCE (CONTINUED) The reinsurance ceded components of the amounts reflected in the accompanying statements of income are as follows (in thousands):
YEAR ENDED DECEMBER 31 ------------------------------- 1996 1995 1994 --------- --------- --------- Ceded premiums earned........................................ $ 73,643 $ 42,086 $ 17,562 Ceded incurred losses........................................ 56,597 25,557 14,114 Ceded incurred LAE........................................... 18,240 11,700 3,664
The effect of reinsurance on premiums written and earned in 1996, 1995 and 1994 was as follows (in thousands):
1996 1995 1994 PREMIUMS PREMIUMS PREMIUMS ---------------------- ---------------------- ---------------------- WRITTEN EARNED WRITTEN EARNED WRITTEN EARNED ---------- ---------- ---------- ---------- ---------- ---------- Direct........................................... $ 394,057 $ 332,345 $ 259,222 $ 235,696 $ 195,614 $ 169,893 Assumed.......................................... 8,742 7,287 5,092 2,610 3,278 4,424 Ceded............................................ (90,936) (73,643) (43,557) (42,086) (11,604) (17,562) ---------- ---------- ---------- ---------- ---------- ---------- Net premiums..................................... $ 311,863 $ 265,989 $ 220,757 $ 196,220 $ 187,288 $ 156,755 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
NOTE E--INCOME TAXES State income taxes represent the amount of current state income taxes incurred. The Company files a consolidated federal income tax return, which includes the income and expenses of its subsidiaries from the dates of their acquisition. The components of federal income tax expense are as follows (in thousands):
YEAR ENDED DECEMBER 31 ------------------------------- 1996 1995 1994 --------- --------- --------- Federal income tax expense (benefit): Current.................................................... $ 13,590 $ 11,071 $ 8,958 Deferred................................................... 2,279 (175) (5,162) --------- --------- --------- TOTAL FEDERAL INCOME TAX EXPENSE............................. $ 15,869 $ 10,896 $ 3,796 --------- --------- --------- --------- --------- ---------
F-19 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE E--INCOME TAXES (CONTINUED) A reconciliation of federal income tax, based on the prevailing corporate income tax rate of 35%, to the federal income tax expense reflected in the accompanying financial statements is as follows (in thousands):
YEAR ENDED DECEMBER 31 ------------------------------- 1996 1995 1994 --------- --------- --------- Tax rate applied to pre-tax income........................... $ 19,831 $ 15,148 $ 7,465 Add (deduct) tax effect of: Tax-exempt interest income................................. (3,026) (2,754) (2,726) Dividend received deduction................................ (752) (634) (805) State income taxes......................................... (253) (410) (194) Other...................................................... 69 (454) 56 --------- --------- --------- FEDERAL INCOME TAX EXPENSE................................. $ 15,869 $ 10,896 $ 3,796 --------- --------- --------- --------- --------- ---------
Significant components of the Company's deferred tax assets and liabilities at December 31, 1996, 1995 and 1994 are as follows (in thousands):
DECEMBER 31 ------------------------------- 1996 1995 1994 --------- --------- --------- Deferred tax assets: Reserve discounting, including salvage and subrogation..... $ 30,515 $ 26,466 $ 26,341 Unearned premium reserve................................... 10,732 7,121 5,404 Net unrealized losses on available-for-sale securities..... 3,396 Other...................................................... 2,624 1,879 437 --------- --------- --------- Total deferred tax assets.................................... 43,871 35,466 35,578 Deferred tax liabilities: Deferred policy acquisition costs.......................... 11,504 6,579 4,625 Net unrealized gains on available-for-sale securities...... 2,588 4,284 Other...................................................... 2,159 976 186 --------- --------- --------- Total deferred tax liabilities............................... 16,251 11,839 4,811 --------- --------- --------- Net deferred tax assets...................................... $ 27,620 $ 23,627 $ 30,767 --------- --------- --------- --------- --------- ---------
F-20 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE E--INCOME TAXES (CONTINUED) Deferred federal income taxes result from timing differences in the recognition of certain income and expenses for tax and financial statement purposes and are summarized as follows (in thousands):
YEAR ENDED DECEMBER 31 ------------------------------- 1996 1995 1994 --------- --------- --------- Reserve discounting, including salvage and subrogation........ $ 119 $ (125) $ (4,997) Unearned premium reserve...................................... (3,211) (1,718) (2,137) Deferred policy acquisition costs............................. 4,666 1,954 2,258 Excess depreciation expense................................... 120 220 64 Bad debt expense (credit)..................................... 279 (404) (354) Other......................................................... 306 (102) 4 --------- --------- --------- TOTAL DEFERRED FEDERAL INCOME TAX EXPENSE (BENEFIT)....... $ 2,279 $ (175) $ (5,162) --------- --------- --------- --------- --------- ---------
The Company made income tax payments of $17,021,000, $12,829,000 and $9,330,000, in 1996, 1995, and 1994, respectively. NOTE F--CREDIT FACILITY AND OTHER DEBT In 1995, the Company obtained a variable rate line of credit for $35,000,000 with the Bank of New York. Under this arrangement, the Company borrowed $7,100,000 and $25,000,000 in 1996 and 1995, respectively. The credit facility agreement was terminated in 1996. The Company also extinguished approximately $1,700,000 of long-term debt in 1996, which was assumed in conjunction with the acquisition of Emrol. Interest incurred during 1996 and 1995 is as follows (in thousands):
1996 1995 --------- --------- Bank credit facility......................................................... $ 1,892 $ 895 Other long-term debt......................................................... 78 --------- --------- TOTAL........................................................................ $ 1,970 $ 895 --------- --------- --------- ---------
F-21 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE G--STATUTORY FINANCIAL INFORMATION A reconciliation of the consolidated amounts of insurance subsidiaries' policyholders' surplus as of December 31, 1996 and 1995, and net income for each of the years ended December 31, 1996, 1995 and 1994, on a statutory accounting basis ("SAP") as reported to insurance regulatory authorities, to the GAAP shareholders' equity and net income included in the accompanying consolidated financial statements, is as follows (in thousands):
1996 1995 1994 ------------------------- ------------------------- --------- NET NET NET SURPLUS/EQUITY INCOME SURPLUS/EQUITY INCOME INCOME -------------- --------- -------------- --------- --------- Insurance subsidiaries' consolidated SAP amounts........................................ $ 268,004 $ 28,874 $ 171,362 $ 26,407 $ 6,623 Add (deduct): Deferred policy acquisition costs.............. 32,871 14,365 18,797 5,585 8,139 Nonadmitted assets and unauthorized reinsurance.................................. 14,738 15,667 Investment valuation........................... 4,296 48 11,440 (24) Allowance for doubtful accounts................ (2,768) 875 (3,506) (1,154) (1,011) Intangible assets.............................. 3,255 (188) 495 (147) Deferred federal income taxes.................. 28,157 (2,062) 23,805 352 4,551 Other than temporary market decline............ (715) (225) (490) (490) Other additions (deductions)................... (864) (588) 394 393 -------------- --------- -------------- --------- --------- INSURANCE SUBSIDIARIES' CONSOLIDATED GAAP AMOUNTS........................................ 346,974 41,099 237,469 31,564 18,155 Shareholders' equity and net loss arising from activities of the parent company and its non-insurance subsidiaries................... (78,400) (1,032) (7,736) (353) (1,175) -------------- --------- -------------- --------- --------- CONSOLIDATED AMOUNTS--GAAP BASIS................. $ 268,574 $ 40,067 $ 229,733 $ 31,211 $ 16,980 -------------- --------- -------------- --------- --------- -------------- --------- -------------- --------- ---------
F-22 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE H--INVESTMENTS The major categories of total net investment income are summarized as follows (in thousands):
YEAR ENDED DECEMBER 31 ------------------------------- 1996 1995 1994 --------- --------- --------- Interest and dividends: Fixed maturities............................................................... $ 37,623 $ 28,338 $ 20,942 Equity securities.............................................................. 1,190 1,745 3,774 Short-term and other investments............................................... 3,830 2,529 695 Interest expense on funds held................................................... (4,307) (2,174) Limited liability corporation.................................................... 2 535 --------- --------- --------- Investment income before expenses.............................................. 38,338 30,973 25,411 Less investment expenses......................................................... 1,112 938 958 --------- --------- --------- Net investment income.......................................................... 37,226 30,035 24,453 --------- --------- --------- Realized capital gains (losses): Securities available-for-sale: Fixed maturities............................................................... 1,245 1,265 325 Equity securities.............................................................. 463 (1,920) (1,743) Short-term investments........................................................... (1) (1) Fixed maturities held-to-maturity................................................ 675 (59) --------- --------- --------- Total realized capital gains (losses).......................................... 1,707 20 (1,478) --------- --------- --------- TOTAL NET INVESTMENT INCOME...................................................... $ 38,933 $ 30,055 $ 22,975 --------- --------- --------- --------- --------- ---------
Gross realized capital gains on available-for-sale securities in 1996, 1995 and 1994 were $3,882,000, $2,509,000, and $987,000, respectively. Gross realized capital losses on available-for-sale securities in 1996, 1995 and 1994 were $2,175,000, $3,164,000, and $2,604,000, respectively. Also, gross realized capital gains in 1995 and 1994 on held-to-maturity securities were $675,000 and $27,000, respectively, and gross realized capital losses were $86,000 in 1994. The change in net unrealized gains/(losses) on fixed-maturity securities was $(6,350,000), $28,490,000 and $(25,177,000) in 1996, 1995 and 1994, respectively; the corresponding amounts for equity securities were $1,508,000, $4,704,000 and $(3,896,000). At December 31, 1996, bonds and notes with an amortized cost of $25,911,000 were on deposit with various regulatory authorities to meet statutory requirements. F-23 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE H--INVESTMENTS (CONTINUED) Investments in available-for-sale securities are summarized as follows (in thousands):
GROSS GROSS UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE ---------- ----------- ----------- ---------- At December 31, 1996: Fixed maturity securities: U.S. Treasury securities and obligations of U.S. government corporations and agencies.................................. $ 29,708 $ 409 $ 157 $ 29,960 Obligations of states and political subdivisions............. 191,311 2,485 741 193,055 Foreign governments.......................................... 30 6 24 Corporate securities......................................... 162,336 3,299 1,237 164,398 Mortgage-backed securities................................... 296,896 3,483 2,539 297,840 ---------- ----------- ----------- ---------- Total fixed maturity securities.................................. 680,281 9,676 4,680 685,277 Equity securities................................................ 13,871 2,702 302 16,271 ---------- ----------- ----------- ---------- TOTAL............................................................ $ 694,152 $ 12,378 $ 4,982 $ 701,548 ---------- ----------- ----------- ---------- ---------- ----------- ----------- ---------- At December 31, 1995: Fixed maturity securities: U.S. Treasury securities and obligations of U.S. government corporations and agencies.................................. $ 29,602 $ 1,519 $ 3 $ 31,118 Obligations of states and political subdivisions............. 189,363 4,154 611 192,906 Foreign governments.......................................... 20 20 Corporate securities......................................... 102,667 3,992 1,395 105,264 Mortgage-backed securities................................... 188,404 5,080 1,390 192,094 ---------- ----------- ----------- ---------- Total fixed maturity securities.................................. 510,056 14,745 3,399 521,402 Equity securities................................................ 20,132 1,191 299 21,024 ---------- ----------- ----------- ---------- TOTAL............................................................ $ 530,188 $ 15,936 $ 3,698 $ 542,426 ---------- ----------- ----------- ---------- ---------- ----------- ----------- ----------
At December 31, 1996, the amortized cost and estimated market value of debt securities, by contractual maturity, are shown below (in thousands). 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.
ESTIMATED AMORTIZED MARKET COST VALUE ---------- ---------- Due in one year or less............................................... $ 2,656 $ 2,656 Due after one year to five years...................................... 80,741 81,800 Due after five years to ten years..................................... 117,429 119,248 Due after ten years................................................... 182,559 183,732 Mortgage backed securities............................................ 296,896 297,841 ---------- ---------- TOTAL............................................................. $ 680,281 $ 685,277 ---------- ---------- ---------- ----------
F-24 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE I--DIVIDEND AND CAPITAL RESTRICTIONS The Company's insurance subsidiaries are subject to certain regulatory supervision by their respective domiciliary states. Such regulation is generally designed to protect policyholders and includes such matters as maintenance of minimum statutory surplus and restrictions on the payments of dividends. At December 31, 1996, the maximum dividend that may be paid to the Company in 1997 without regulatory approval is approximately $27,000,000. Additionally, the insurance subsidiaries are subject to certain Risk-Based Capital ("RBC") requirements as specified by the NAIC. Under those requirements, the amount of capital and surplus maintained by the insurance companies is to be determined based on the various risk factors related to it. At December 31, 1996, the Company met the RBC requirements. NOTE J--STOCK OPTIONS The Company has elected to follow Accounting Principles Board Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES (APB 25) and related interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under FASB Statement No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. The Company has adopted stock option plans (the "Plans") under which 1,600,102 shares of common stock are reserved for issuance upon exercise of options granted pursuant to the Plans. Under the Plans, incentive stock options may be granted to employees and nonqualified stock options may be granted to employees, directors, and such other persons as the Board of Directors (or a committee appointed by the Board) determines will assist the Company's business endeavors, at exercise prices equal to at least 100% of the fair market value of the common stock on the date of grant. Incentive stock options granted under the Plans are not exercisable until one year after grant and expire five years after the date of grant. In addition to selecting the optionees, the Board (or such committee) determines the number of shares subject to each option, the expiration date and vesting periods of nonqualified stock options and otherwise administers the Plans. Certain of the Company's officers are ineligible to participate in the Plans. Incentive stock options have been granted at various times and for varying amounts. During 1993, the Company granted the President and Chairman of the Board, and a Vice President, separate stock options outside of the Plans to purchase 825,000 and 148,500 shares, respectively, of the Company's Common Stock at $22.73 per share at any time through December 31, 1999, which options were outstanding at December 31, 1996. Pro forma information regarding net income and earnings per share is required by Statement 123, which also requires that the information be determined as if the Company has accounted for its employee stock options granted subsequent to December 31, 1994 under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions for 1996 and 1995, respectively: risk-free interest rates of 6.20% and 7.05%; a dividend yield of 1.25%; volatility factors of the expected market price of the Company's Common Stock of .25 and .25; and a weighted-average expected life of the option of 5 years. F-25 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE J--STOCK OPTIONS (CONTINUED) The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma information follows (in thousands, except per share data):
1996 1995 --------- --------- Pro forma net income.................................................... $ 39,813 $ 31,053 --------- --------- --------- --------- Pro forma primary earnings per common share............................. $1.38 $1.09 --------- --------- --------- --------- Pro forma fully diluted earnings per common share....................... $1.36 $1.08 --------- --------- --------- ---------
For purposes of pro forma disclosure, the estimated fair value of the options is amortized to expense over the options' vesting period and does not include grants prior to January 1, 1995. As such, the pro forma net income and earnings per share are not indications of future years. A summary of the Company's stock option activity, and related information for the years ended December 31 follows:
1996 1995 1994 ---------------------------- ------------------------------ --------- OPTIONS WEIGHTED- AVERAGE OPTIONS WEIGHTED- AVERAGE OPTIONS (000) EXERCISE PRICE (000) EXERCISE PRICE (000) --------- ----------------- ----- ----------------- --------- Outstanding-beginning of year......................... 698 $ 10 500 $ 9 678 Granted............................................... 138 17 350 10 4 Exercised............................................. (166) 7 (92) 4 (162) Canceled.............................................. (20) 11 (60) 12 (20) --- --- --- Outstanding-end of year............................... 650 12 698 10 500 --- --- --- --- --- --- Exercisable at end of year............................ 216 12 244 9 236 WEIGHTED- AVERAGE EXERCISE PRICE ----------------- Outstanding-beginning of year......................... $ 8 Granted............................................... 14 Exercised............................................. 4 Canceled.............................................. 12 Outstanding-end of year............................... 9 Exercisable at end of year............................ 7
The weighted average fair value of options granted during 1996 and 1995 were $5.13 and $3.08, respectively. Exercise prices for options outstanding as of December 31, 1996 ranged from $9.43 to $19.88. The weighted-average contractual life of those options is 3.8 years. NOTE K--EMPLOYEE BENEFIT PLANS The Company sponsors an employee savings plan (401(k)) whereby the Company contributes a base of 2% of the salary of all full-time employees and matches 50% of the employee's personal contribution up to 2% of the employee's salary. The maximum Company contribution, base and match, is 4% of an employee's salary. In addition, the Company has a noncontributory profit sharing plan. At the discretion of F-26 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE K--EMPLOYEE BENEFIT PLANS (CONTINUED) the Board of Directors, the Company may contribute up to 4% of the eligible salaries of full-time employees who have completed one year of service. The Company's total expense related to employee benefit plan contributions for 1996, 1995 and 1994 was $1,691,000, $1,221,000 and $1,030,000, respectively. NOTE L--COMMITMENTS AND CONTINGENCIES At December 31, 1996, the future minimum rental commitment for operating leases was as follows: 1997--$1,600,000; 1998--$1,356,000; 1999--$1,298,000; 2000--$857,000; 2001--$563,000, and 2002 and thereafter--$328,000. These leases are for the rental of office space, the initial terms of which run five years, with a negotiated renewal option at the end of the term. Total rental expense for 1996, 1995, and 1994 amounted to $1,112,000, $720,000 and $479,000, respectively. In 1996, the Company entered into certain contractual agreements with several contractors and vendors in connection with the construction of an addition to its home office building and the purchase of office equipment. The remaining commitments that will be paid in 1997 total approximately $11,300,000. The Company has been served with several purported class actions alleging violations of federal securities laws by the Company and, in some cases, by certain of its officers and directors; certain other actions also allege violations of the common law. The complaints relate to the Company's announcement of its third quarter, 1994 financial results and allege that the Company previously had omitted and/or misrepresented material facts with respect to its earnings and profits. The amount of potential loss is not possible to estimate as of the present due to the fact that these actions allege differing class periods, and until an actual class is certified in the consolidation action, the number of shares impacted by the claims cannot be ascertained. The Company believes the suits are without merit and has retained special legal counsel to contest them vigorously. The Company is involved in other unrelated litigation which is considered incidental to its business. The ultimate outcome of all litigation is not expected to be material in relation to the Company's financial position and results of operations. The insurance subsidiaries record guaranty fund assessments when such assessments are billed by the respective guaranty funds. In addition, each insurance subsidiary's policy is to accrue for any significant insolvencies when the loss is probable and the assessment amount can be reasonably estimated. In the case of most insurance insolvencies, the ability of each insurance subsidiary to reasonably estimate the insolvent insurer's liabilities or develop a meaningful range of the insolvent's liabilities is significantly impaired by inadequate financial data with respect to the state of the insolvent company as supplied by the guaranty funds. On November 10, 1994, the Company authorized a stock repurchase program to purchase up to 1,000,000 shares of its Common Stock at such times and prices the Company deems advantageous in compliance with SEC Rule 10b-18 at the discretion of the Chairman of the Board. There is no commitment or obligation on the part of the Company to purchase any particular number of shares, and the program may be suspended at any time at the Company's discretion. In 1995 and 1994, in conjunction with this repurchase program, the Company acquired 13,200 and 77,880 shares at a cost of $134,000 and $654,000, respectively. F-27 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE M--GUARANTEED PREFERRED BENEFICIAL INTEREST IN COMPANY'S CONVERTIBLE SUBORDINATED DEBENTURES In October 1996, the Company completed a $172,500,000 offering of 3,450,000 shares of 6 1/4% Convertible Trust Originated Preferred Securities ("TOPrS") through its wholly-owned consolidated subsidiary, Frontier Financing Trust, a statutory business trust formed by the Company for the sole purpose of issuing the TOPrS and investing the proceeds thereof in an equivalent amount of 6 1/4% Convertible Subordinated Debentures (the "Debentures") of the Company which mature on October 16, 2026. The initial purchasers' discount of $4,744,000 was deducted from the proceeds of the offering. The Company also incurred $842,000 of additional offering costs in connection with this transaction, resulting in net proceeds of $166,914,000 to the Company. The total offering costs have been capitalized and are being amortized on a straight-line basis over a 30 year period, in conjunction with the maturity date of the Debentures. The TOPrS are carried on the balance sheet net of the unamortized offering costs, which at December 31, 1996 amounted to approximately $5,500,000. The TOPrS are mandatorily redeemable under certain conditions and amounts due to holders are fully and unconditionally guaranteed by the Company. The Debentures (the sole assets of the trust) are subordinate to all Company debt and to the claims of creditors and policyholders of the Company's subsidiaries. The TOPrS are convertible into shares of the Company's Common Stock at an initial conversion rate of 2.1328 shares of Company Common Stock for each preferred share which is equivalent to a conversion price of $23.44 per common share (or 7,358,038 shares of Common Stock in total). Holders of the TOPrS have no voting rights. The Debentures are redeemable by the Company, at its option, in whole or in part at a redemption price on or after October 16, 1999, provided the closing price of the Company's Common Stock is at least 150% of the per share conversion price, for a minimum of 20 trading days within a period of 30 consecutive trading days ending on the fifth trading day prior to the notice of redemption or anytime on or after October 16, 2000. The Company has the right to defer interest payments on the Debentures at any time by extending the interest payment date for up to 20 consecutive quarters, but not beyond the maturity date of the Debentures. Holders of the TOPrS are entitled to receive cumulative cash distributions at an annual rate of 6 1/4% of the liquidation amount of $50 per share, accruing from the date of original issuance and payable quarterly in arrears. Such distributions are made from interest received on the Debentures, which have terms that parallel the terms of the TOPrS. During 1996, the Company accrued $2,246,000 payable to holders of the TOPrS and amortized a portion of the capitalized offering costs. The corresponding expenses are reported as "Minority interest in income of consolidated subsidiary trust" in the accompanying consolidated statement of income. NOTE N--CONCENTRATIONS The Company, which is licensed to conduct business in 50 states, attempts to diversify its exposures geographically, as well as across various types of risks. However, its medical malpractice business in the Florida marketplace comprises 7.2% of the Company's gross premiums written and its surety and bond business, which is focused primarily in the California marketplace, accounts for 16.2% of its gross premiums written in 1996. Also, the Company relies primarily on a small number of reinsurers. At December 31, 1996, the Company has outstanding gross reinsurance recoverables of $74,002,000 from its largest reinsurer, Centre Re; however, under the terms of the reinsurance arrangements, Frontier is F-28 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE N--CONCENTRATIONS (CONTINUED) withholding $63,766,000 of funds due Centre Re. Accordingly, the net outstanding recoverable from Centre Re is $10,236,000. NOTE O--SUBSEQUENT EVENTS On March 31, 1997, the Company announced that it executed a definitive agreement to acquire 100% of the stock of Lyndon Property Insurance Company and its six subsidiaries, Lyndon Life Insurance Company, Twin Mercury Life Insurance Company, Gulfco Life Insurance Company, Lyndon Southern Insurance Company, Lyndon--DFS Warranty Services,Inc. and Lyndon General Agency of Texas, Inc. (collectively "Lyndon"), subject to certain closing conditions and regulatory approvals, at a purchase price of approximately $92,000,000. On May 22, 1997, the Company declared a two-for-one stock split in the form of a 100% stock dividend payable on July 21, 1997 to shareholders of record at the close of business on June 30, 1997. Accordingly, all the related Common Stock and per share data included in the accompanying financial statements have been restated to give effect to this split. On June 3, 1997, the Company obtained a five year $100,000,000 revolving credit facility from Deutsche Bank AG, pursuant to which the Company borrowed $62,000,000 at an initial floating interest rate of 6.04% based upon Eurodollar interest rates, payable quarterly, to fund a portion of the Lyndon purchase price relating to its acquisition of Lyndon also on June 3, 1997. The Company intends to file a Registration Statement (Form S-3) with the Securities and Exchange Commission on July 15, 1997 to register 4,600,000 additional shares of its Common Stock. F-29 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES SUPPLEMENTAL DATA QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following is a summary of unaudited quarterly results of operations for 1996 and 1995 (in thousands, except per share data):
1996 1995 ------------------------------------------ ------------------------------------------ 1ST 2ND 3RD 4TH 1ST 2ND 3RD 4TH --------- --------- --------- --------- --------- --------- --------- --------- Net premiums earned.................. $ 58,294 $ 66,148 $ 70,327 $ 71,220 $ 45,754 $ 46,440 $ 49,873 $ 54,153 Total net investment income.......... 8,477 9,202 9,429 11,825 5,981 7,434 8,168 8,472 Net income........................... 9,264 9,769 9,513 11,521 6,886 7,785 8,245 8,295 Per share data: Primary earnings per common share.... .33 .34 .33 .40 .24 .28 .29 .29 Fully diluted earnings per common share.............................. .33 .34 .33 .37 .24 .28 .29 .29
Earnings per share information is based on the weighted average number of shares outstanding for the period and have been adjusted to reflect the effects of stock dividends and stock splits. Due to changes in the number of average common stock and equivalent shares outstanding, quarterly earnings per share may not add to the totals for the years. In the second quarter of 1996 and the fourth quarter 1995, the Company increased reserves related to prior years' by approximately $13,000,000 and $19,000,000, respectively, which was entirely offset by subrogation recoverable recognized in connection with the favorable Court of Appeals decision. F-30 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS ASSETS (DOLLAR AMOUNTS IN THOUSANDS)
MARCH 31, DECEMBER 31, 1997 1996 ------------ ------------ (UNAUDITED) Investments: Securities, available for sale--at fair value: Fixed maturities (amortized cost: 1997--$712,465; 1996--$680,281).................. $ 707,199 $ 685,277 Equity securities (cost: 1997--$19,505; 1996--$13,871)............................. 20,351 16,271 Short-term investments............................................................... 102,547 133,835 Investment in limited liability corporation.......................................... 3,018 2,937 ------------ ------------ TOTAL INVESTMENTS.............................................................. 833,115 838,320 Cash................................................................................. 15,688 8,332 Agents' balances due, less allowances for doubtful accounts (1997--$2,226; 1996--$2,225)...................................................................... 50,794 50,558 Premiums receivable from insureds, less allowances for doubtful accounts (1997--$55; 1996--$60)......................................................................... 27,489 26,225 Net reinsurance recoverables less allowances for possible uncollectible amounts (1997--$561; 1996--$517)........................................................... 209,569 192,569 Accrued investment income............................................................ 9,778 9,364 Federal income taxes recoverable..................................................... 1,165 3,987 Deferred policy acquisition costs.................................................... 36,834 32,871 Deferred federal income tax asset.................................................... 29,540 27,620 Home office building, property and equipment--at cost, less accumulated depreciation and amortization (1997--$12,158; 1996--$11,184).................................... 40,130 37,167 Intangible assets, less accumulated amortization (1997--$4,235; 1996-- $3,808)....... 11,311 11,738 Other assets......................................................................... 10,507 7,656 ------------ ------------ TOTAL ASSETS................................................................... $ 1,275,920 $1,246,407 ------------ ------------ ------------ ------------
See notes to consolidated financial statements (unaudited). F-31 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS--CONTINUED LIABILITIES AND SHAREHOLDERS' EQUITY (DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
MARCH 31, DECEMBER 31, 1997 1996 ------------ ------------ (UNAUDITED) LIABILITIES Policy liabilities: Unpaid losses.................................................................... $ 452,669 $ 429,506 Unpaid loss adjustment expenses.................................................. 116,478 109,567 Unearned premiums................................................................ 180,891 185,728 ------------ ------------ TOTAL POLICY LIABILITIES....................................................... 750,038 724,801 Funds withheld under reinsurance contracts......................................... 72,112 64,065 Cash dividend payable to shareholders.............................................. 1,905 1,904 Other liabilities.................................................................. 13,688 20,110 ------------ ------------ TOTAL LIABILITIES................................................................ 837,743 810,880 COMMITMENTS AND CONTINGENCIES GUARANTEED PREFERRED BENEFICIAL INTEREST IN COMPANY'S CONVERTIBLE SUBORDINATED DEBENTURES......................................................................... 166,979 166,953 SHAREHOLDERS' EQUITY-- Preferred stock, par value $.01 per share; authorized and unissued-- 1,000,000 shares Common stock, par value $.01 per share (shares authorized: 50,000,000, shares issued: 1997--29,407,936; 1996--29,379,104)...................................... 294 294 Additional paid-in capital......................................................... 222,142 221,837 Net unrealized (losses) gains...................................................... (2,873) 4,807 Retained earnings.................................................................. 52,423 42,424 ------------ ------------ SUBTOTAL......................................................................... 271,986 269,362 Less treasury stock--at cost (91,080 shares)....................................... 788 788 ------------ ------------ TOTAL SHAREHOLDERS' EQUITY..................................................... 271,198 268,574 ------------ ------------ TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY..................................... $ 1,275,920 $1,246,407 ------------ ------------ ------------ ------------ Book value per share................................................................. $ 9.25 $ 9.17 ------------ ------------ ------------ ------------
See notes to consolidated financial statements (unaudited). F-32 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) (DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED MARCH 31, --------------------- 1997 1996 ---------- --------- REVENUES Premiums written...................................................................... $ 105,812 $ 74,860 Premiums ceded........................................................................ (26,499) ( 13,131) ---------- --------- NET PREMIUMS WRITTEN.............................................................. 79,313 61,729 Increase in net unearned premiums..................................................... (1,506) (3,435) ---------- --------- NET PREMIUMS EARNED............................................................... 77,807 58,294 Net investment income................................................................. 11,893 7,786 Realized capital gains................................................................ 721 691 ---------- --------- TOTAL NET INVESTMENT INCOME....................................................... 12,614 8,477 Gross claims adjusting income......................................................... 15 25 ---------- --------- TOTAL REVENUES.................................................................... 90,436 66,796 EXPENSES Losses................................................................................ 31,116 26,512 Loss adjustment expenses.............................................................. 14,558 8,931 Amortization of policy acquisition costs.............................................. 15,951 12,381 Underwriting and other expenses....................................................... 9,231 5,791 Minority interest in income of consolidated subsidiary trust.......................... 2,732 Interest expense...................................................................... 441 ---------- --------- TOTAL EXPENSES.......................................................................... 73,588 54,056 ---------- --------- INCOME BEFORE INCOME TAXES.............................................................. 16,848 12,740 INCOME TAXES State................................................................................. 103 115 Federal............................................................................... 4,841 3,361 ---------- --------- TOTAL INCOME TAXES................................................................ 4,944 3,476 ---------- --------- NET INCOME........................................................................ $ 11,904 $ 9,264 ---------- --------- ---------- --------- PER SHARE DATA: Primary earnings per common share..................................................... $ .41 $ .32 ---------- --------- ---------- --------- Fully diluted earnings per common share............................................... $ .38 $ .32 ---------- --------- ---------- --------- WEIGHTED AVERAGE COMMON SHARES OUTSTANDING (in thousands):............................................................. Primary............................................................................... 29,390 28,704 Fully diluted......................................................................... 36,758 28,704
See notes to consolidated financial statements (unaudited). F-33 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (DOLLAR AMOUNTS IN THOUSANDS)
THREE MONTHS ENDED MARCH 31, -------------------- 1997 1996 --------- --------- OPERATING ACTIVITIES Net income................................................................................ $ 11,904 $ 9,264 Adjustments to reconcile net income to net cash provided by operating activities: Increase in policy liabilities.......................................................... 25,237 18,754 Increase in reinsurance balances........................................................ (8,953) (8,217) Increase in agents' balances and premiums receivable.................................... (1,500) (82) Increase in deferred policy acquisition costs........................................... (3,963) (2,358) (Increase) decrease in accrued investment income........................................ (414) 634 Deferred income tax expense............................................................. 2,220 278 Depreciation and amortization........................................................... 1,551 938 Realized capital gains.................................................................. (721) (691) Other................................................................................... (6,455) (2,675) --------- --------- NET CASH PROVIDED BY OPERATING ACTIVITIES............................................. 18,906 15,845 INVESTING ACTIVITIES Proceeds from sales of fixed maturities available-for-sale................................ 14,116 17,217 Proceeds from calls, paydowns and maturities of fixed maturities available-for-sale....... 22,918 21,825 Proceeds from sales of equity securities.................................................. 1,636 5,534 Purchases of securities................................................................... (75,891) (59,512) Net sales (purchases) of short-term investments........................................... 31,288 (2,193) Additions and improvement to home office building......................................... (1,682) (160) Purchase of property and equipment........................................................ (2,257) (75) Proceeds from sales of property and equipment............................................. 2 Investment in limited liability corporation............................................... (81) --------- --------- NET CASH USED IN INVESTING ACTIVITIES (9,951) (17,364) FINANCING ACTIVITIES Cash dividends paid....................................................................... (1,904) (1,568) Issuance of common stock.................................................................. 305 504 --------- --------- NET CASH USED IN FINANCING ACTIVITIES................................................. (1,599) (1,064) --------- --------- INCREASE (DECREASE) IN CASH........................................................... 7,356 (2,583) CASH AT BEGINNING OF YEAR............................................................. 8,332 5,115 --------- --------- CASH AT END OF PERIOD................................................................. $ 15,688 $ 2,532 --------- --------- --------- ---------
See notes to consolidated financial statements (unaudited). F-34 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X and, accordingly, do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements and should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 1996. In the opinion of management, all adjustments (consisting of only normal, recurring accruals) considered necessary for a fair presentation have been included. Certain amounts in the 1996 financial statements have been reclassified to conform to the 1997 presentation. All share and per share information presented in the accompanying financial statements and these notes thereto have been adjusted to give effect to stock dividends and stock splits. Operating results for the three-month period ended March 31, 1997 are not necessarily indicative of the results that may be expected for the year ending December 31, 1997. 2. Earnings per share information is presented on the basis of weighted average shares outstanding for the period. 3. Dividends have been declared by the Board of Directors and paid by the Company during the periods presented in the accompanying financial statements, as follows:
DECLARATION RECORD PAYMENT TYPE OF CASH NUMBER OF DATE DATE DATE DIVIDEND PAID SHARES ISSUED ------------ --------- --------- ------------------------- ------------- ------------- (IN THOUSANDS) 11/16/95........................ 12/29/95 01/18/96 $.06 per share cash $ 1,562 N/A 03/28/96........................ 04/08/96 04/30/96 $.06 per share cash $ 1,568 N/A 05/23/96........................ 06/28/96 07/19/96 10% stock $ 11(1) 2,622,356 05/23/96........................ 06/28/96 07/19/96 $.065 per share cash $ 1,870 N/A 08/15/96........................ 09/30/96 10/18/96 $.065 per share cash $ 1,903 N/A 11/21/96........................ 12/27/96 01/14/97 $.065 per share cash $ 1,904 N/A 02/27/97........................ 03/24/97 04/18/97 $.065 per share cash $ 1,905 N/A
- ------------------------ (1) Cash in lieu of fractional shares. 4. At March 31, 1997, options to purchase 642,882 shares of common stock, at per share exercise prices ranging from $9.43 to $19.88 were outstanding, compared to options to purchase 549,392 shares of common stock, at per share exercise prices ranging from $3.58 to $13.78, outstanding at March 31, 1996 under the Company's stock option plans (the "Plans"). Options to purchase 261,380 and 193,152 shares of common stock were exercisable at March 31, 1997 and March 31, 1996, respectively, under the Plans. During 1993, the Company granted the President and Chairman of the Board, and a Vice President, separate stock options outside of the Plans to purchase 825,000 and 148,500 shares, respectively, of the Company's common stock at $22.73 per share at any time through December 31, 1999, which options were outstanding at March 31, 1997. The number of shares subject to options and the per share option prices have been adjusted to reflect stock dividends. Exercisable options are nondilutive to earnings per share presented in the accompanying financial statements. 5. Contingent reinsurance commissions are accounted for on an earned basis and are accrued, in accordance with the terms of the applicable reinsurance agreement, based on the estimated level of profitability relating to such reinsured business. During the three months ended March 31, 1997 and 1996, F-35 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) such earned commissions accrued were $574,000 and $92,000, respectively. The estimated profitability of the reinsured business is continually reviewed and as adjustments become necessary, such adjustments are reflected in current operations. 6. Claims adjusting income is accounted for on an accrual basis, before deducting the related expenses. During the three months ended March 31, 1997 and 1996, claims adjusting expenses included with underwriting and other expenses amounted to $15,000 and $25,000, respectively. 7. The components of the net reinsurance recoverables balances in the accompanying balance sheets were as follows:
MARCH 31, 1997 DECEMBER 31, 1996 -------------- ----------------- (IN THOUSANDS) Ceded paid losses recoverable............................. $ 8,527 $ 7,519 Ceded unpaid losses and LAE............................... 189,042 165,467 Ceded unearned premiums................................... 26,059 32,403 Ceded reinsurance payable................................. (14,059) (12,820) -------------- -------- TOTAL................................................. $ 209,569 $ 192,569 -------------- -------- -------------- --------
The reinsurance ceded components of the amounts relating to the accompanying income statements were as follows:
THREE MONTHS ENDED MARCH 31, -------------------- 1997 1996 --------- --------- (IN THOUSANDS) Ceded premiums earned............................................. $ 32,842 $ 12,292 Ceded incurred losses............................................. 27,685 9,647 Ceded incurred LAE................................................ 4,705 3,218
The effect of reinsurance on premiums written and earned at March 31, 1997 and 1996 was as follows:
THREE MONTHS ENDED MARCH 31, -------------------------------------------- 1997 1996 PREMIUMS PREMIUMS ---------------------- -------------------- WRITTEN EARNED WRITTEN EARNED ---------- ---------- --------- --------- (IN THOUSANDS) Direct......................................... $ 104,244 $ 108,553 $ 73,395 $ 68,140 Assumed........................................ 1,568 2,096 1,465 2,446 Ceded.......................................... (26,499) (32,842) (13,131) (12,292) ---------- ---------- --------- --------- Net............................................ $ 79,313 $ 77,807 $ 61,729 $ 58,294 ---------- ---------- --------- --------- ---------- ---------- --------- ---------
8. In the first quarter of 1997, the Company adopted Financial Accounting Standards Board Statement 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities ("FASB 125"), which provides accounting and reporting standards for sales, securitizations, and servicing of receivables and other financial assets, secured borrowing and collateral transactions, and the extinguishments of liabilities. The adoption excluded the provisions that deal with securities lending, repurchase and dollar repurchase agreements, and the recognition of collateral, which will be adopted in 1998 pursuant to F-36 FRONTIER INSURANCE GROUP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) the proposed amendment. The adoption of FASB 125 did not have a material impact to the Company's financial position or results of operations. In February 1997, the Financial Accounting Standards Board issued Statement 128, "Earnings per Share," which is required to be adopted on December 31, 1997. At that time, the Company will be required to change the method currently used to compute earnings per share and to restate all prior periods. Under the new requirements for calculating primary earnings per share, the dilutive effect of stock options will be excluded. The impact is expected to result in no change in primary earnings per share in either of the quarters ended March 31, 1997 or 1996. The impact on the calculation of fully diluted earnings per share for these quarters is not expected to be material. 9. On March 31, 1997, the Company announced that it executed a definitive agreement to acquire 100% of the stock of Lyndon Property Insurance Company and its six subsidiaries, Lyndon Life Insurance Company, Twin Mercury Life Insurance Company, Gulfco Life Insurance Company, Lyndon Southern Insurance Company, Lyndon--DFS Warranty Services,Inc. and Lyndon General Agency of Texas, Inc. (collectively "Lyndon"), subject to certain closing conditions and regulatory approvals, at a purchase price of approximately $92,000,000. On May 22, 1997, the Company declared a two-for-one stock split in the form of a 100% stock dividend payable on July 21, 1997 to shareholders of record at the close of business on June 30, 1997. Accordingly, all the related Common Stock and per share data included in the accompanying financial statements have been restated to give effect to this split. On June 3, 1997, the Company obtained a five year $100,000,000 revolving credit facility from Deutsche Bank AG, pursuant to which the Company borrowed $62,000,000 at an initial floating interest rate of 6.04% based upon Eurodollar interest rates, payable quarterly, to fund a portion of the Lyndon purchase price relating to its acquisition of Lyndon also on June 3, 1997. The Company intends to file a Registration Statement (Form S-3) with the Securities and Exchange Commission on July 15, 1997 to register 4,600,000 additional shares of its Common Stock. F-37 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- NO DEALER, SALESMAN OR OTHER INDIVIDUAL HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR MAKE ANY REPRESENTATIONS NOT CONTAINED IN THIS PROSPECTUS IN CONNECTION WITH THE OFFERING COVERED BY THIS PROSPECTUS. IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED BY THE COMPANY OR THE UNDERWRITERS. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL, OR A SOLICITATION OF AN OFFER TO BUY, THE COMMON STOCK IN ANY JURISDICTION WHERE, OR TO ANY PERSON TO WHOM, IT IS UNLAWFUL TO MAKE SUCH OFFER OR SOLICITATION. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE AN IMPLICATION THAT THERE HAS NOT BEEN ANY CHANGE IN THE FACTS SET FORTH IN THIS PROSPECTUS OR IN THE AFFAIRS OF THE COMPANY SINCE THE DATE HEREOF. ------------------------ TABLE OF CONTENTS
PAGE ----- Available Information.......................... 3 Incorporation of Certain Documents by Reference.................................... 3 Prospectus Summary............................. 4 Risk Factors................................... 13 Use of Proceeds................................ 16 Price Range of Common Stock.................... 16 Dividend Policy................................ 16 Capitalization................................. 17 Selected Consolidated Financial Data........... 18 Unaudited Pro Forma Consolidated Financial Information.................................. 20 Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 23 Business....................................... 34 Management..................................... 54 Principal Stockholders......................... 57 Description of Capital Stock................... 58 Underwriting................................... 59 Legal Matters.................................. 60 Experts........................................ 60 Index to Consolidated Financial Statements..... F-1
4,000,000 SHARES [LOGO] COMMON STOCK ---------------- PROSPECTUS --------------------- MERRILL LYNCH & CO. DONALDSON, LUFKIN & JENRETTE SECURITIES CORPORATION OPPENHEIMER & CO., INC. SMITH BARNEY INC. STEPHENS INC. , 1997 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- PART II INFORMATION NOT REQUIRED IN PROSPECTUS ITEM 16. EXHIBITS. (A) EXHIBITS. 1 --Revised form of Purchase Agreement. II-1 SIGNATURES Pursuant to the requirements of the Securities Act of 1933, the Registrant certifies that it has reasonable grounds to believe that it meets all of the requirements for filing on Form S-3 and has duly caused this Amendment to the Registration Statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Rock Hill, State of New York, on the 6th day of August, 1997. FRONTIER INSURANCE GROUP, INC. By: * WALTER A. RHULEN ----------------------------------------- Walter A. Rhulen PRESIDENT AND CHIEF EXECUTIVE OFFICER Pursuant to the requirements of the Securities Act of 1933, this Amendment to the Registration Statement has been signed below by the following persons in the capacities and on the dates indicated.
NAME TITLE DATE ------------------------------ -------------------------- ------------------- Chairman Of the Board, * WALTER A. RHULEN President and Chief ------------------------------ Executive Officer August 6, 1997 Walter A. Rhulen (Principal Executive Officer) Vice President--Treasurer * MARK H. MISHLER and Chief Financial ------------------------------ Officer (Principal August 6, 1997 Mark H. Mishler Financial and Accounting Officer) Executive Vice President, * HARRY W. RHULEN Chief ------------------------------ Operating Officer and August 6, 1997 Harry W. Rhulen Director ------------------------------ Director August , 1997 Peter L. Rhulen * LAWRENCE E. O'BRIEN ------------------------------ Director August 6, 1997 Lawrence E. O'Brien * DOUGLAS C. MOAT ------------------------------ Director August 6, 1997 Douglas C. Moat ------------------------------ Director August , 1997 Alan Gerry /s/ WALTER A. RHULEN ------------------------------ Walter A. Rhulen Attorney-in-fact *By:
II-2 EX-1 2 PURCHASE AGREEMENT EXHIBIT 1 _______________________________________________________________________________ _______________________________________________________________________________ FRONTIER INSURANCE GROUP, INC. (a Delaware corporation) 4,000,000 Shares of Common Stock PURCHASE AGREEMENT Dated August 7, 1997 _______________________________________________________________________________ FRONTIER INSURANCE GROUP, INC. (a Delaware corporation) 4,000,000 Shares of Common Stock PURCHASE AGREEMENT August 7, 1997 MERRILL LYNCH & CO. Merrill Lynch, Pierce, Fenner & Smith Incorporated DONALDSON, LUFKIN & JENRETTE SECURITIES CORPORATION OPPENHEIMER & CO., INC. SMITH BARNEY INC. STEPHENS INC. As Representatives of the several Underwriters c/o Merrill Lynch & Co. Merrill Lynch, Pierce, Fenner & Smith Incorporated Merrill Lynch World Headquarters North Tower World Financial Center New York, New York 10281-1305 Ladies and Gentlemen: Frontier Insurance Group, Inc., a Delaware corporation (the "Company"), confirms its agreement with Merrill Lynch & Co., Merrill Lynch, Pierce, Fenner & Smith Incorporated ("Merrill Lynch") and each of the other Underwriters named in Schedule A hereto (collectively, the "Underwriters", which term shall also include any underwriter substituted as hereinafter provided in Section 10 hereof), for whom Merrill Lynch, Donaldson, Lufkin & Jenrette Securities Corporation, Oppenheimer & Co., Inc., Smith Barney Inc. and Stephens Inc. are acting as representatives (in such capacity, the "Representatives"), with respect to (i) the sale by the Company of an aggregate of 4,000,000 shares of its Common Stock, par value $.01 per share ("Common Stock"), and the purchase by the Underwriters, acting severally and not jointly, of the respective numbers of shares of Common Stock set forth in Schedule A hereto and (ii) the grant by the Company to the Underwriters, acting severally and not jointly, of the option described in Section 2(b) hereof to purchase all or any part of 600,000 additional shares of Common Stock to cover over-allotments, if any. The aforesaid 4,000,000 shares of Common Stock (the "Initial Securities") to be purchased by the Underwriters and all or any part of the 600,000 shares of Common Stock subject to the option 2 described in Section 2(b) hereof (the "Option Securities") are hereinafter called, collectively, the "Securities". The Company understands that the Underwriters propose to make a public offering of the Securities as soon as the Representatives deem advisable after this Agreement has been executed and delivered. The Company has filed with the Securities and Exchange Commission (the "Commission") a registration statement on Form S-3 (No. 333-31365) covering the registration of the Securities under the Securities Act of 1933, as amended (the "1933 Act"), including the related preliminary prospectus or prospectuses. Promptly after execution and delivery of this Agreement, the Company will, in connection with the offering of the Securities, either (i) prepare and file a prospectus in accordance with the provisions of Rule 430A ("Rule 430A") of the rules and regulations of the Commission under the 1933 Act (the "1933 Act Regulations") and paragraph (b) of Rule 424 ("Rule 424(b)") of the 1933 Act Regulations or (ii) if the Company has elected to rely upon Rule 434 ("Rule 434") of the 1933 Act Regulations, prepare and file a term sheet (a "Term Sheet") in accordance with the provisions of Rule 434 and Rule 424(b). The information included in any prospectus or in any Term Sheet, as the case may be, that was omitted from such registration statement at the time it became effective but that is deemed to be part of such registration statement at the time it became effective (a) pursuant to paragraph (b) of Rule 430A is referred to as "Rule 430A Information" or (b) pursuant to paragraph (d) of Rule 434 is referred to as "Rule 434 Information." Each prospectus used before such registration statement became effective, and any prospectus that omitted, as applicable, the Rule 430A Information or the Rule 434 Information, that was used after such effectiveness and prior to the execution and delivery of this Agreement, is herein called a "preliminary prospectus." Such registration statement, including the exhibits thereto, schedules thereto, if any, and the documents incorporated by reference therein pursuant to Item 12 of Form S-3 under the 1933 Act, at the time it became effective and including the Rule 430A Information and the Rule 434 Information, as applicable, is herein called the "Registration Statement." Any registration statement filed pursuant to Rule 462(b) of the 1933 Act Regulations is herein referred to as the "Rule 462(b) Registration Statement," and after such filing the term "Registration Statement" shall include the Rule 462(b) Registration Statement. The final prospectus, including the documents incorporated by reference therein pursuant to Item 12 of Form S-3 under the 1933 Act, in the form first furnished to the Underwriters for use in connection with the offering of the Securities is herein called the "Prospectus." If Rule 434 is relied on, the term "Prospectus" shall refer to the preliminary prospectus dated August 7, 1997, together with the applicable Term Sheet and all references in this Agreement to the date of the Prospectus shall mean the date of such Term Sheet. For purposes of this Agreement, all references to the Registration Statement, any preliminary prospectus, the Prospectus or any Term Sheet or any amendment or supplement to any of the foregoing shall be deemed to include the copy filed with the Commission pursuant to its Electronic Data Gathering, Analysis and Retrieval system ("EDGAR"). All references in this Agreement to financial statements and schedules and other information which is "contained," "included" or "stated" in the Registration Statement, 3 any preliminary prospectus or the Prospectus (or other references of like import) shall be deemed to mean and include all such financial statements and schedules and other information which is incorporated by reference or deemed to be incorporated by reference in the Registration Statement, any preliminary prospectus or the Prospectus, as the case may be; and all references in this Agreement to amendments or supplements to the Registration Statement, any preliminary prospectus or the Prospectus shall be deemed to mean and include the filing of any document under the Securities Exchange Act of 1934 (the "1934 Act") which is incorporated by reference or deemed to be incorporated by reference in the Registration Statement, such preliminary prospectus or the Prospectus, as the case may be. For purposes of this Agreement, "SUBSIDIARY" means, with respect to any person, any corporation, association or other business entity of which more than 50% of the total voting power of shares of capital stock, entitled (without regard to the occurrence of any contingency) to vote in the election of directors, managers or trustees thereof is at the time owned or controlled, directly or indirectly, by such person or one or more of the other subsidiaries of that person (or a combination thereof). SECTION 1. REPRESENTATIONS AND WARRANTIES. (a) The Company represents and warrants to each Underwriter as of the date hereof, as of the Closing Time referred to in Section 2(c) hereof, and as of each Date of Delivery (if any) referred to in Section 2(b) hereof, and agrees with each Underwriter, as follows: (i) COMPLIANCE WITH REGISTRATION REQUIREMENTS. The Company meets the requirements for use of Form S-3 under the 1933 Act. Each of the Registration Statement and any Rule 462(b) Registration Statement has become effective under the 1933 Act and no stop order suspending the effectiveness of the Registration Statement or any Rule 462(b) Registration Statement has been issued under the 1933 Act and no proceedings for that purpose have been instituted or are pending or, to the knowledge of the Company, are contemplated by the Commission, and any request on the part of the Commission for additional information has been complied with. At the respective times the Registration Statement, any Rule 462(b) Registration Statement and any post-effective amendments thereto became effective and at the Closing Time (and, if any Option Securities are purchased, at the Date of Delivery), the Registration Statement, the Rule 462(b) Registration Statement and any amendments and supplements thereto complied and will comply in all material respects with the requirements of the 1933 Act and the 1933 Act Regulations and did not and will not contain an untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary to make the statements therein not misleading. Neither the Prospectus nor any amendments or supplements thereto, at the time the Prospectus or any such amendment or supplement were issued and at the Closing Time (and, if any Option Securities are purchased, at the Date of Delivery), included or will include an untrue statement of a material fact or omitted or will omit to state a material fact necessary in order to make the statements therein, in the light of the circumstances under which they were made, not misleading. If Rule 434 is used, the Company will comply with the requirements of Rule 434. Notwithstanding 4 anything in this subsection to the contrary, the representations and warranties in this subsection shall not apply to statements in or omissions from the Registration Statement or Prospectus made in reliance upon and in conformity with information furnished to the Company in writing by any Underwriter through Merrill Lynch, expressly for use in the Registration Statement or Prospectus. Each preliminary prospectus and the Prospectus filed as part of the Registration Statement as originally filed or as part of any amendment thereto, or filed pursuant to Rule 424 under the 1933 Act, complied when so filed in all material respects with the 1933 Act Regulations and each preliminary prospectus and the Prospectus delivered to the Underwriters for use in connection with this offering was identical to the electronically transmitted copies thereof filed with the Commission pursuant to EDGAR, except to the extent permitted by Regulation S-T. (ii) INCORPORATED DOCUMENTS. The documents incorporated or deemed to be incorporated by reference in the Registration Statement and the Prospectus, at the time they were or hereafter are filed with the Commission, complied and will comply in all material respects with the requirements of the 1934 Act and the rules and regulations of the Commission thereunder (the "1934 Act Regulations"), and when read together with the other information in the Prospectus, at the time the Registration Statement became effective, at the time the Prospectus was issued and at the Closing Time (and, if any Option Securities are purchased, at the Date of Delivery), did not and will not contain an untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary to make the statements therein not misleading. (iii) INDEPENDENT ACCOUNTANTS. (a) Ernst & Young, LLP ("E&Y"), who certified the consolidated financial statements and supporting schedules included in the Registration Statement are independent public accountants as required by the 1933 Act and the 1933 Act Regulations and (b) Arthur Andersen LLP ("Arthur Andersen"), who certified the consolidated financial statements of Lyndon Property Insurance Company and its subsidiaries (collectively, "Lyndon") included in the Company's Current Report on Form 8-K/A-1 dated July 16, 1997, for an event which occurred on June 3, 1997 (the "Company's 8-K"), and incorporated by reference in the Registration Statement are independent public accountants as required by the 1933 Act and the 1933 Act Regulations (iv) AUTHORIZATION OF AGREEMENT. This Agreement has been duly authorized, executed and delivered by the Company. (v) FINANCIAL STATEMENTS. (a) The consolidated financial statements of the Company included in the Registration Statement and the Prospectus, together with the related schedules and notes, present fairly the consolidated financial position of the Company and its subsidiaries as of the dates indicated and the consolidated results of operations, stockholders' equity and cash flows of the Company and its subsidiaries for the periods specified. The consolidated financial statements of the Company 5 included in or incorporated or deemed to be incorporated by reference in the Registration Statement have been prepared in conformity with generally accepted accounting principles ("GAAP") applied on a consistent basis throughout the periods involved, and the supporting schedules, if any, included or incorporated or deemed to be incorporated by reference, in the Registration Statement present fairly in accordance with GAAP the information required to be stated therein. The selected consolidated financial data and the summary financial information of the Company included in the Prospectus present fairly the information shown therein and have been compiled on a basis consistent with that of the consolidated audited financial statements of the Company (to the extent so indicated) included in the Registration Statement. (b) The consolidated and combined financial statements of Lyndon incorporated by reference in the Registration Statement, together with the related notes, present fairly the consolidated and combined financial position of Lyndon at the dates indicated and the consolidated and combined results of operations, stockholder's equity and cash flows of Lyndon for the periods specified, and said financial statements have been prepared in conformity with GAAP applied on a consistent basis throughout the periods involved. The selected consolidated financial statements of Lyndon included in the Prospectus present fairly the information shown therein and have been compiled on a basis consistent with that of the audited financial statements and unaudited financial statements of Lyndon incorporated by reference in the Registration Statement. (c) The pro forma financial statements and the related notes thereto included in the Registration Statement and the Prospectus present fairly the information shown therein, have been prepared in accordance with the Commission's rules and guidelines with respect to pro forma financial statements and have been properly compiled on the bases described therein, and the assumptions used in the preparation thereof are reasonable and the adjustments used therein are appropriate to give effect to the transactions and circumstances referred to therein. (vi) GOOD STANDING OF THE COMPANY. The Company is a corporation duly incorporated, validly existing and in good standing under the laws of the State of Delaware with corporate power and authority under such laws to own, lease and operate its properties and conduct its business as described in the Prospectus and to enter into and perform its obligations under this Agreement; and the Company is duly qualified to transact business as a foreign corporation and is in good standing in each other jurisdiction in which it owns or leases property of a nature, or transacts business of a type, that would make such qualification necessary, except to the extent that the failure to so qualify or be in good standing would not have a Material Adverse Effect (as defined below). (vii) GOOD STANDING AND OWNERSHIP OF SUBSIDIARIES. Each subsidiary of the Company is a corporation or, in the case of Douglass/Frontier, LLC, a limited liability company, duly incorporated or organized, validly existing and in good standing under the laws of its jurisdiction of organization with all corporate and company power under such laws to own, lease and operate its properties and conduct its business. 6 Each subsidiary of the Company is duly qualified to transact business as a foreign corporation or limited liability company and is in good standing in each other jurisdiction in which it owns or leases property of a nature, or transacts business of a type, that would make such qualification necessary, except to the extent that the failure to so qualify or be in good standing would not have a Material Adverse Effect. All of the outstanding shares of capital stock of each subsidiary of the Company (other than (i) any director's or incorporator's qualifying shares or (ii) 49 shares of Class A common stock of Lyndon-DFS Warranty Services, Inc.) have been duly authorized and validly issued and are fully paid and nonassessable and are owned, directly or indirectly, by the Company (except that the Company has (i) a 95% ownership interest in Regency Financial Corp. and (ii) a 50% ownership interest in Douglas/Frontier, LLC) free and clear of any pledge, lien, security interest, charge, claim, equity or encumbrance of any kind; none of the outstanding shares of capital stock of any subsidiary was issued in violation of the preemptive or similar rights of any securityholder of such subsidiary. (viii) CAPITALIZATION. The authorized, issued and outstanding capital stock of the Company is as set forth in the Prospectus in the column entitled "Actual" under the caption "Capitalization" (except for subsequent issuances, if any, pursuant to this Agreement, pursuant to reservations, agreements or employee benefit plans referred to in the Prospectus or pursuant to the exercise of convertible securities or options referred to in the Prospectus). All of the outstanding shares of capital stock of the Company have been duly authorized and validly issued and are fully paid and nonassessable; and none of the outstanding shares of capital stock of the Company was issued in violation of the preemptive rights of any stockholder of the Company. (ix) AUTHORIZATION AND DESCRIPTION OF SECURITIES. The Securities to be purchased by the Underwriters from the Company have been duly authorized for issuance and sale to the Underwriters pursuant to this Agreement and, when issued and delivered by the Company pursuant to this Agreement against payment of the consideration set forth herein, will be validly issued and fully paid and nonassessable; and the Common Stock conforms to all statements relating thereto contained in the Prospectus and such description conforms to the rights set forth in the instruments defining the same; no holder thereof will be subject to personal liability by reason of being such a holder; and the issuance of the Securities is not subject to the preemptive or other similar rights of any securityholder of the Company. (x) TITLE TO PROPERTY. The Company and its subsidiaries have good and marketable title to all real property owned by the Company and its subsidiaries and good title to all other properties owned by them, in each case, free and clear of all mortgages, pledges, liens, security interests, claims, restrictions or encumbrances of any kind except such as (a) are described in the Prospectus or (b) do not, singly or in the aggregate, materially affect the value of such property and do not interfere with the use made and proposed to be made of such property by the Company or any of its subsidiaries; and all of the leases and subleases material to the business of the Company and its subsidiaries, considered as one enterprise, and under which the 7 Company or any of its subsidiaries holds properties described in the Prospectus, are in full force and effect, and neither the Company nor any subsidiary has any notice of any material claim of any sort that has been asserted by anyone adverse to the rights of the Company or any subsidiary under any of the leases or subleases mentioned above, or affecting or questioning the rights of the Company or such subsidiary to the continued possession of the leased or subleased premises under any such lease or sublease. (xi) INVESTMENT COMPANY ACT. Neither the Company nor any subsidiary of the Company is, and upon the issuance and sale of the Securities as herein contemplated and the application of the net proceeds therefrom as described in the Prospectus will not be, an "investment company" or an entity "controlled" by an "investment company" as such terms are defined in the Investment Company Act of 1940, as amended. (xii) NO MATERIAL ADVERSE CHANGE IN BUSINESS. Since the respective dates as of which information is given in the Registration Statement and the Prospectus, except as otherwise stated therein or contemplated thereby, there has not been (A) any material adverse change in the condition (financial or otherwise), earnings, business affairs or business prospects of the Company and its subsidiaries, considered as one enterprise (a "Material Adverse Effect"), whether or not arising in the ordinary course of business, (B) there have been no transactions entered into by the Company or any of its subsidiaries, other than those in the ordinary course of business, which are material with respect to the Company and its subsidiaries considered as one enterprise, and (C) any dividend or distribution of any kind declared, paid or made by the Company on its capital stock, except for regular quarterly dividends on outstanding shares of Common Stock. (xiii) ABSENCE OF DEFAULTS AND CONFLICTS. Neither the Company nor any of its subsidiaries is in violation of its charter or by-laws or is in default in the performance or observance of any obligation, agreement, covenant or condition contained in any contract, indenture, mortgage, loan agreement, note, lease or other agreement or instrument to which it is a party or by which it may be bound or to which any of its properties may be subject (collectively, the "Agreements and Instruments"), except for such defaults that would not have a Material Adverse Effect. The execution, delivery and performance of this Agreement by the Company and the consummation of the transactions contemplated herein and in the Registration Statement (including the issuance and sale of the Securities and the use of proceeds from the sale of Securities as described in the Prospectus under the caption "Use of Proceeds") and compliance by the Company with its obligations hereunder have been duly authorized by all necessary corporate action and do not and will not, whether with or without the giving of notice or passage of time or both, conflict with or constitute a breach of, or default or Repayment Event (as defined below) under, or result in the creation or imposition of any lien, charge or encumbrance upon any property or assets of the Company or any subsidiary pursuant to, the Agreements and Instruments (except for such conflicts, breaches or defaults or liens, charges or encumbrances that would not result in a 8 Material Adverse Effect), nor will such action result in any violation of the charter or by-laws of the Company or any subsidiary or any applicable law, statute, rule, regulation, judgment, order or decree of any government, governmental instrumentality or court, domestic or foreign, having jurisdiction over the Company or any subsidiary or any of their assets, properties or operations. As used herein, a "Repayment Event" means any event or condition which gives the holder of any note, debenture or other evidence of indebtedness (or any person acting on such holder's behalf) the right to require the repurchase, redemption or repayment of all or a portion of such indebtedness by the Company or any subsidiary. (xiv) ABSENCE OF FURTHER REQUIREMENTS. No authorization, approval, consent or license of any government, governmental instrumentality or court, domestic or foreign, is necessary or required for the performance by the Company of its obligations hereunder, in connection with the offering, issuance or sale of the Securities hereunder or the consummation of the transactions contemplated by this Agreement, except such as have been already obtained or as may be required under the 1933 Act or the 1933 Act Regulations or state securities laws. (xv) ABSENCE OF PROCEEDINGS. Except as disclosed in the Registration Statement, there is no action, suit or proceeding before or by any government, governmental instrumentality or court, domestic or foreign, now pending or, to the knowledge of the Company, threatened against the Company or any subsidiary, that is required to be disclosed in the Registration Statement, or that is reasonably expected by the Company to result in any Material Adverse Effect, or that is reasonably expected by the Company to materially and adversely affect the consummation of the transactions contemplated by this Agreement or the performance by the Company of its obligations hereunder. The aggregate of all pending legal or governmental proceedings to which the Company or any subsidiary is a party or of which any of their respective property is subject that are not described in the Registration Statement, including ordinary routine litigation incidental to the business of the Company or any subsidiary, is not reasonably expected by the Company to have a Material Adverse Effect. (xvi) POSSESSION OF INTELLECTUAL PROPERTY. The Company and its subsidiaries own or possess, or can acquire on reasonable terms, adequate copyrights, patents, patent licenses, trademarks, service marks and trade names necessary to carry on their respective business as presently conducted, and none of the Company and its subsidiaries has received any notice of infringement of or conflict with asserted rights of others with respect to any copyrights, patents, patent licenses, trademarks, service marks or trade names that, in the aggregate, if the subject of an unfavorable decision, ruling or finding, is reasonably expected to have a Material Adverse Effect. (xvii) ENVIRONMENTAL LAWS. Except as disclosed in the Registration Statement or except as would not individually or in the aggregate have a Material Adverse Effect (A) the Company and its subsidiaries are in compliance with all applicable Environmental Laws, (B) the Company and its subsidiaries have all permits, 9 authorizations and approvals required under any applicable Environmental Laws and are each in compliance with their requirements, (C) there are no pending or, to the knowledge of the Company, threatened Environmental Claims against the Company or its subsidiaries, other than under policies of insurance issued by the Company's insurance company subsidiaries, and (D) there are no circumstances with respect to any property or operations of the Company or its subsidiaries that the Company reasonably believes would form the basis of an Environmental Claim against the Company or any of its subsidiaries, other than under policies of insurance issued by the Company's insurance company subsidiaries. For purposes of this Agreement, the following terms have the following meanings: "Environmental Law" means any United States federal, state, local or municipal statute, law, rule, regulation, ordinance, code, policy or rule of common law and any judicial or administrative interpretation thereof, including any judicial or administrative order, consent decree or judgment, relating to the environment, health, safety or any chemical, material or substance, exposure to which is prohibited, limited or regulated by any governmental authority. "Environmental Claims" means any and all administrative, regulatory or judicial actions, suits, demands, demand letters, claims, liens, notices of noncompliance or violation, investigations or proceedings relating in any way to any Environmental Law. (xviii) CONDUCT OF BUSINESS. The Company and its subsidiaries are currently conducting their respective businesses as described in the Registration Statement. (xix) ACCURACY OF EXHIBITS. There are no contracts or documents which are required to be described in the Registration Statement, the Prospectus or the documents incorporated by reference therein or to be filed as exhibits thereto which have not been so described and filed as required. (xx) PAYMENT OF TAXES. The Company and each of its subsidiaries have filed all federal, state and local income and franchise tax returns required to be filed through the date hereof, or have filed extensions in accordance with applicable law, and have paid all taxes required to be paid through the date hereof thereon, except for such failures to file or pay that would not, individually or in the aggregate, be reasonably likely to have a Material Adverse Effect, and no tax deficiency has been determined adversely to the Company or any of its subsidiaries that has had (nor does the Company have any knowledge of any tax deficiency which, if determined adversely to the Company or any of its subsidiaries, would be reasonably likely to have) a Material Adverse Effect. (xxi) STATUTORY FINANCIAL STATEMENTS. The statutory financial statements of each of the Company's insurance company subsidiaries from which certain ratios and other statistical data included or incorporated or deemed to be incorporated by reference in the Registration Statement have been derived have been prepared for each relevant period in conformity with accounting practices prescribed or permitted by the National Association of Insurance Commissioners (the "NAIC") and the insurance 10 department of the state of domicile of each such subsidiary in effect at such time of preparation ("SAP"), except as otherwise stated therein. (xxii) POSSESSION OF LICENSES AND PERMITS. Each of the Company and each of its subsidiaries holds such licenses, certificates, consents, orders, approvals, permits and other authorizations from governmental authorities (including, without limitation, insurance licenses from the insurance regulatory agencies of the various states where it conducts business ("Insurance Licenses")) which are necessary to own or lease, as the case may be, and to operate its properties and to carry on its business as presently conducted, except for such licenses, certificates, consents, orders, approvals, permits or other authorizations the failure to hold which could not reasonably be expected to have a Material Adverse Effect; each of the Company and each of its insurance company subsidiaries has fulfilled and performed all obligations necessary to maintain such licenses, certificates, consents, orders, approvals, permits and other authorizations (including, without limitation, the Insurance Licenses), except where the failure to so fulfill or perform such obligations could not reasonably be expected to have a Material Adverse Effect. There is no pending, or to the best knowledge of the Company threatened, action, suit, proceeding or investigation (and, to the best knowledge of the Company, no facts exist which the Company believes could reasonably be the basis for any such action, suit, proceeding or investigation) that may reasonably be expected to lead to the revocation, termination or suspension of any such license, certificate, consent, order, approval, permit or other authorization (including, without limitation, the Insurance Licenses), except where such revocation, termination or suspension could not reasonably be expected to have a Material Adverse Effect; and no insurance regulatory agency or body has issued any order or decree impairing, restricting or prohibiting the payment of dividends by the Company's insurance company subsidiaries to the Company. (xxiii) All ceded reinsurance and retrocessional agreements to which the Company's insurance company subsidiaries are a party are in full force and effect and neither the Company nor any of such subsidiaries is in violation of, or in default in the performance, observance or fulfillment of, any obligation, agreement, covenant or condition contained therein, except for such violations or defaults which could not reasonably be expected, individually or in the aggregate, to have a Material Adverse Effect. Neither the Company nor any of such subsidiaries has received any notice from any of the other parties to such agreements that such other party intends not to perform in any material respect such agreement and none of the Company and such subsidiaries has any reason to believe that any of the other parties to such agreements will be unable to perform such agreements, except to the extent that (i) the Company or such subsidiary has established appropriate reserves on its financial statements or (ii) such nonperformance could not reasonably be expected, individually or in the aggregate, to have a Material Adverse Effect; and each of the Company and its insurance company subsidiaries is entitled to give effect in its underwriting results in its most recently filed statutory financial statements in conformity with SAP for reinsurance ceded pursuant to such agreements. 11 (xxiv) MAINTENANCE OF INSURANCE. The Company and each of its subsidiaries carry, or are covered by, insurance in such amounts and covering such risks as the Company believes to be adequate for the conduct of their respective businesses and the value of their respective properties. (xxv) MAINTENANCE OF BOOKS AND RECORDS. The Company (i) makes and keeps accurate books and records and (ii) maintains internal accounting controls which provide reasonable assurance that (A) transactions are executed in accordance with management's authorization, (B) transactions are recorded as necessary to permit preparation of its financial statements and to maintain accountability for its assets, (C) access to its assets is permitted only in accordance with management's authorization and (D) the reported accountability for its assets is compared with existing assets at reasonable intervals. (xxvi) COMPLIANCE WITH INSURANCE LAWS. Each insurance company subsidiary of the Company is in compliance with the requirements of the insurance laws of the jurisdiction of its incorporation or domicile and of each other jurisdiction that is applicable to such subsidiary, except where the failure to comply would not have a Material Adverse Effect. (b) OFFICER'S CERTIFICATES. Any certificate signed by any officer of the Company and delivered pursuant to this Agreement or in connection with the payment of the purchase price and delivery of the certificates for the Initial Securities or the Option Securities, to the Representatives, the Underwriters or counsel for any of the foregoing, shall be deemed a representation and warranty by the Company to the Representatives and the Underwriters as to the matters covered thereby. Section 2. SALE AND DELIVERY TO THE UNDERWRITERS; CLOSING. (a) INITIAL SECURITIES. On the basis of the representations and warranties herein contained, and subject to the terms and conditions herein set forth, the Company agrees to sell to each Underwriter, and each Underwriter agrees, severally and not jointly, to purchase from the Company, at the price per share set forth on Schedule B, the number of Initial Securities set forth in Schedule A opposite the name of such Underwriter, plus any additional number of Initial Securities which such Underwriter may become obligated to purchase pursuant to the provisions of Section 10 hereof, subject, in each case, to such adjustments among the Underwriters as the Representatives in their sole discretion shall make to eliminate any sales or purchases of fractional securities. (b) OPTION SECURITIES. In addition, on the basis of the representations and warranties herein contained and subject to the terms and conditions herein set forth, the Company hereby grants an option to the Underwriters, severally and not jointly, to purchase up to an additional 600,000 shares of Common Stock, at the price per share set forth in Schedule B, less an amount per share equal to any dividends or distributions declared by the Company and payable on the Initial Securities but not payable on the Option Securities. The option hereby granted will expire 30 days after the date hereof and may be exercised in whole 12 or in part from time to time only for the purpose of covering over-allotments which may be made in connection with the offering and distribution of the Initial Securities upon notice by the Representatives to the Company setting forth the number of Option Securities as to which the several Underwriters are then exercising the option and the time and date of payment and delivery for such Option Securities. Any such time and date of delivery (a "Date of Delivery") shall be determined by the Representatives, but shall not be later than seven full business days after the exercise of said option, nor in any event prior to the Closing Time, as hereinafter defined. If the option is exercised as to all or any portion of the Option Securities, each of the Underwriters, acting severally and not jointly, will purchase that proportion of the total number of Option Securities then being purchased which the number of Initial Securities set forth in Schedule A opposite the name of such Underwriter bears to the total number of Initial Securities, subject in each case to such adjustments as the Representatives in their sole discretion shall make to eliminate any sales or purchases of fractional shares. (c) PAYMENT. Payment of the purchase price for, and delivery of certificates for, the Initial Securities shall be made at the offices of Simpson Thacher & Bartlett, 425 Lexington Avenue, New York, New York, or at such other place as shall be agreed upon by the Representatives and the Company, at 9:00 A.M. (Eastern time) on the third (fourth, if the pricing occurs after 4:30 P.M. (Eastern time) on any given day) business day after the date hereof (unless postponed in accordance with the provisions of Section 10), or such other time not later than ten business days after such date as shall be agreed upon by the Representatives and the Company (such time and date of payment and delivery being herein called the "Closing Time"). In addition, in the event that any or all of the Option Securities are purchased by the Underwriters, payment of the purchase price for, and delivery of certificates for, such Option Securities shall be made at the above-mentioned offices, or at such other place as shall be agreed upon by the Representatives and the Company, on each Date of Delivery as specified in the notice from the Representatives to the Company. Payment shall be made to the Company by wire transfer of immediately available funds to a bank account designated by the Company, against delivery to the Representatives for the respective accounts of the Underwriters of certificates for the Securities to be purchased by them. It is understood that each Underwriter has authorized the Representatives, for its account, to accept delivery of, receipt for, and make payment of the purchase price for, the Initial Securities and the Option Securities, if any, which it has agreed to purchase. Merrill Lynch, individually and not as representative of the Underwriters, may (but shall not be obligated to) make payment of the purchase price for the Initial Securities or the Option Securities, if any, to be purchased by any Underwriter whose funds have not been received by the Closing Time or the relevant Date of Delivery, as the case may be, but such payment shall not relieve such Underwriter from its obligations hereunder. (d) DENOMINATIONS; REGISTRATION. Certificates for the Initial Securities and the Option Securities, if any, shall be in such denominations and registered in such names as the Representatives may request in writing at least one full business day before the Closing Time 13 or the relevant Date of Delivery, as the case may be. The certificates for the Initial Securities and the Option Securities, if any, will be made available for examination and packaging by the Representatives in The City of New York not later than 10:00 A.M. (Eastern time) on the business day prior to the Closing Time or the relevant Date of Delivery, as the case may be. SECTION 3. COVENANTS OF THE COMPANY. The Company covenants with each Underwriter as follows: (a) COMPLIANCE WITH SECURITIES REGULATIONS AND COMMISSION REQUESTS. The Company, subject to Section 3(b), will comply with the requirements of Rule 430A or Rule 434, as applicable, and will notify the Representatives immediately, and confirm the notice in writing, (i) when any post-effective amendment to the Registration Statement shall become effective, or any supplement to the Prospectus or any amended Prospectus shall have been filed, (ii) of the receipt of any comments from the Commission, (iii) of any request by the Commission for any amendment to the Registration Statement or any amendment or supplement to the Prospectus or for additional information, and (iv) of the issuance by the Commission of any stop order suspending the effectiveness of the Registration Statement or of any order preventing or suspending the use of any preliminary prospectus, or of the suspension of the qualification of the Securities for offering or sale in any jurisdiction, or of the initiation or threatening of any proceedings for any of such purposes. The Company will promptly effect the filings necessary pursuant to Rule 424(b) and will take such steps as it deems necessary to ascertain promptly whether the form of prospectus transmitted for filing under Rule 424(b) was received for filing by the Commission and, in the event that it was not, it will promptly file such prospectus. The Company will make every reasonable effort to prevent the issuance of any stop order and, if any stop order is issued, to obtain the lifting thereof at the earliest possible moment. (b) FILING OF AMENDMENTS. The Company will give the Underwriters timely notice of its intention to prepare any amendment to the Registration Statement (including any filing under Rule 462(b)), any Term Sheet or any amendment, supplement or revision to either the prospectus included in the Registration Statement at the time it became effective or any amendment, supplement or revision to either the prospectus included in the Registration Statement at the time it became effective or to the Prospectus, whether pursuant to the 1933 Act, the 1934 Act or otherwise, will furnish the Representatives with copies of any such documents a reasonable amount of time prior to such proposed filing or use, as the case may be, and will not file or use any such document to which the Representatives or counsel for the Underwriters shall object. (c) DELIVERY OF REGISTRATION STATEMENTS. The Company has furnished or will deliver to the Representatives and counsel for the Underwriters, without charge, signed copies of the Registration Statement as originally filed and of each amendment thereto (including exhibits filed therewith or incorporated by reference therein and documents incorporated or deemed to be incorporated by reference therein) and signed copies of all consents and certificates of experts, and will also deliver to the Representatives, 14 without charge, a conformed copy of the Registration Statement as originally filed and of each amendment thereto (without exhibits) for each of the Underwriters. The copies of the Registration Statement and each amendment thereto furnished to the Underwriters will be identical to the electronically transmitted copies thereof filed with the Commission pursuant to EDGAR, except to the extent permitted by Regulation S-T. (d) DELIVERY OF PROSPECTUS. The Company has delivered to each Underwriter, without charge, as many copies of each preliminary prospectus as such Underwriter reasonably requested, and the Company hereby consents to the use of such copies for purposes permitted by the 1933 Act. The Company will furnish to each Underwriter, without charge, during the period when the Prospectus is required to be delivered under the 1933 Act or the 1934 Act, such number of copies of the Prospectus (as amended or supplemented) as such Underwriter may reasonably request. The Prospectus and any amendments or supplements thereto furnished to the Underwriters will be identical to the electronically transmitted copies thereof filed with the Commission pursuant to EDGAR, except to the extent permitted by Regulation S-T. (e) CONTINUED COMPLIANCE WITH SECURITIES LAWS. The Company will comply with the 1933 Act and the 1933 Act Regulations and the 1934 Act and the 1934 Act Regulations so as to permit the completion of the distribution of the Securities as contemplated in this Agreement and in the Prospectus. If at any time when a prospectus is required by the 1933 Act to be delivered in connection with sales of the Securities, any event shall occur or condition shall exist as a result of which it is necessary, in the opinion of counsel for the Underwriters or for the Company, to amend the Registration Statement or amend or supplement the Prospectus in order that the Prospectus will not include any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements therein not misleading in the light of the circumstances existing at the time it is delivered to a purchaser, or if it shall be necessary, in the opinion of such counsel, at any such time to amend the Registration Statement or amend or supplement the Prospectus in order to comply with the requirements of the 1933 Act or the 1933 Act Regulations, the Company will promptly prepare and file with the Commission, subject to Section 3(b), such amendment or supplement as may be necessary to correct such statement or omission or to make the Registration Statement or the Prospectus comply with such requirements, and the Company will furnish to the Underwriters such number of copies of such amendment or supplement as the Underwriters may reasonably request. (f) BLUE SKY QUALIFICATIONS. The Company will use its best efforts, in cooperation with the Underwriters, to qualify the Securities for offering and sale under the applicable securities laws of such states and other jurisdictions as the Representatives may designate and to maintain such qualifications in effect for a period of not less than one year from the later of the effective date of the Registration Statement and any Rule 462(b) Registration Statement; PROVIDED, HOWEVER, that the Company shall not be obligated to file any general consent to service of process or to qualify as a foreign corporation or as a dealer in securities in any jurisdiction in which 15 it is not so qualified or to subject itself to taxation in respect of doing business in any jurisdiction in which it is not otherwise so subject. In each jurisdiction in which the Securities have been so qualified, the Company will file such statements and reports as may be required by the laws of such jurisdiction to continue such qualification in effect for a period of not less than one year from the effective date of the Registration Statement and any Rule 462(b) Registration Statement. (g) RULE 158. The Company will timely file such reports pursuant to the 1934 Act as are necessary in order to make generally available to its securityholders as soon as practicable an earnings statement for the purposes of, and to provide the benefits contemplated by, the last paragraph of Section 11(a) of the 1933 Act. (h) USE OF PROCEEDS. The Company will use the proceeds received from the issue and sale of the Securities in the manner specified in the Prospectus under the caption "Use of Proceeds". (i) LISTING. The Company will use its best efforts to effect the listing of the Securities on the New York Stock Exchange. (j) RESTRICTION ON SALE OF SECURITIES. During a period of 90 days from the date of the Prospectus, the Company (and the Company shall use its best efforts to ensure that, in accordance with written lock-up letters substantially in the form of Exhibit B hereto, executed by its officers, directors and certain stockholders and delivered to the Representatives, none of such officers, directors and stockholders, to the extent reflected therein) will not, without the prior written consent of Merrill Lynch, (i) directly or indirectly, offer to sell, pledge, sell, grant any option, warrant or other right to purchase, or otherwise transfer or dispose of (or agree to do any of the foregoing) any option or contract to sell, grant any option, right or warrant to purchase or otherwise transfer or dispose of any share of Common Stock or any securities convertible into or exercisable or exchangeable for Common Stock or file any registration statement under the 1933 Act with respect to any of the foregoing or (ii) enter into any swap or any other agreement or any transaction that transfers, in whole or in part, directly or indirectly, the economic consequence of ownership of any Common Stock, whether any such swap or transaction described in clause (i) or (ii) above is to be settled by delivery of Common Stock or such other securities, in cash, or otherwise. The foregoing sentence shall not apply to (i) the Securities to be sold hereunder, (ii) any issuance of Common Stock, or any grant of options to purchase Common Stock, and the exercise or vesting thereof, in each case pursuant to existing employee benefit plans and agreements of the Company described in the Prospectus or any of the documents incorporated by reference therein on the date hereof, (iii) transfers by will or the laws of descent and distribution, (iv) the making of gifts by such officers, directors and stockholders to any donee or (v) sales of up to an aggregate 50,000 shares of Common Stock by the stockholders, officers and directors named in Section 5(k), taken as a whole. 16 SECTION 4. PAYMENT OF EXPENSES. (a) EXPENSES. The Company will pay or cause to be paid all expenses incident to the performance of its obligations under this Agreement, including (i) the preparation, printing and filing of the Registration Statement (including financial statements and exhibits) as originally filed and of each amendment thereto, (ii) the printing and delivery to the Underwriters of this Agreement, any Agreement among Underwriters and such other documents as may be required in connection with the offering, purchase, sale, issuance or delivery of the Securities, (iii) the preparation, issuance and delivery of the certificates for the Securities to the Underwriters, including any stock or other transfer taxes and any stamp or other duties payable upon the sale, issuance or delivery of the Securities to the Underwriters, (iv) the fees and disbursements of the Company's counsel, accountants and other advisors, (v) the qualification of the Securities under securities laws in accordance with the provisions of Section 3(f) hereof, including filing fees and the reasonable fees and disbursements of counsel for the Underwriters in connection therewith and in connection with the preparation of the Blue Sky Survey and any supplement thereto, (vi) the printing and delivery to the Underwriters of copies of each preliminary prospectus, any Term Sheets and of the Prospectus and any amendments or supplements thereto, (vii) the preparation, printing and delivery to the Underwriters of copies of the Blue Sky Survey and any supplement thereto, (viii) the fees and expenses of any transfer agent or registrar for the Securities, (ix) the filing fees incident to the review by the National Association of Securities Dealers, Inc. (the "NASD") of the terms of the sale of the Securities and (x) the fees and expenses incurred in connection with the listing of the Securities on the New York Stock Exchange. (b) TERMINATION OF AGREEMENT. If this Agreement is terminated by the Representatives in accordance with the provisions of Section 5 and Section 9(a)(i) hereof, the Company shall reimburse the Underwriters for all of their out-of-pocket expenses, including the reasonable fees and disbursements of counsel for the Underwriters. SECTION 5. CONDITIONS OF UNDERWRITERS' OBLIGATION. The obligations of the several Underwriters hereunder are subject to the accuracy of the representations and warranties of the Company contained in Section 1 hereof or in certificates of any officer of the Company or any subsidiary of the Company delivered pursuant to the provisions hereof, to the performance by the Company of its covenants and other obligations hereunder, and to the following further conditions: (a) EFFECTIVENESS OF REGISTRATION STATEMENT. The Registration Statement, including any Rule 462(b) Registration Statement, has become effective and at Closing Time no stop order suspending the effectiveness of the Registration Statement shall have been issued under the 1933 Act or proceedings therefor initiated or threatened by the Commission, and any request on the part of the Commission for additional information shall have been complied with to the reasonable satisfaction of counsel to the Underwriters. A prospectus containing the Rule 430A Information shall have been filed with the Commission in accordance with Rule 424(b) (or a post-effective amendment providing such information shall have been filed and declared effective in accordance with the requirements of Rule 430A) or, if the Company has elected to 17 rely upon Rule 434, a Term Sheet shall have been filed with the Commission in accordance with Rule 424(b). (b) OPINION OF COUNSEL FOR THE COMPANY. At the Closing Time, the Representatives shall have received the favorable opinion, dated as of the Closing Time, of Epstein, Becker & Green, P.C., counsel for the Company, in form and substance satisfactory to counsel for the Underwriters, together with signed or reproduced copies of such letter for each of the other Underwriters to the effect set forth in Exhibit A hereto and to such further effect as counsel to the Underwriters may reasonably request. (c) OPINION OF COUNSEL FOR UNDERWRITERS. At the Closing Time, the Representatives shall have received the favorable opinion, dated as of the Closing Time, of Simpson Thacher & Bartlett, counsel for the Underwriters, together with signed or reproduced copies of such letter for each of the other Underwriters with respect to the matters set forth in clauses (i), (ii), (iv), (v) (solely as to preemptive or other similar rights arising by operation of law or under the charter or by-laws of the Company), (vi) through (viii), inclusive, (x), (xii) (solely as to the information in the Prospectus under "Description of the Capital Stock") and the second to last paragraph of Exhibit A hereto. In giving such opinion, such counsel may rely, as to all matters governed by the laws of jurisdictions other than the law of the State of New York, the federal law of the United States and the General Corporation Law of the State of Delaware, upon the opinions of counsel satisfactory to the Representatives. Such counsel may also state that, insofar as such opinion involves financial matters, they have relied, to the extent they deem proper, upon certificates of officers of the Company and certificates of public officials. (d) OFFICERS' CERTIFICATE. At the Closing Time, there shall not have been, since the date hereof or since the respective dates as of which information is given in the Prospectus, any material adverse change in the condition, financial or otherwise, or in the earnings, business affairs or business prospects of the Company and its subsidiaries considered as one enterprise, whether or not arising in the ordinary course of business, and the Representatives shall have received a certificate of the President or a Vice President of the Company and of the chief financial or chief accounting officer of the Company, dated as of the Closing Time, to the effect that (i) there has been no such material adverse change, (ii) the representations and warranties in Section 1(a) hereof are true and correct with the same force and effect as though expressly made at and as of the Closing Time, (iii) the Company has complied in all material respects with all agreements and satisfied in all material respects all conditions on its part to be performed or satisfied at or prior to the Closing Time, and (iv) no stop order suspending the effectiveness of the Registration Statement has been issued and no proceedings for that purpose have been instituted or are pending or are contemplated by the Commission. (e) ACCOUNTANT'S COMFORT LETTER OF E&Y. At the time of the execution of this Agreement, the Representatives shall have received from E&Y a letter dated such date, 18 in form and substance satisfactory to the Representatives, together with signed or reproduced copies of such letter for each of the other Underwriters containing statements and information of the type ordinarily included in accountants' "comfort letters" to underwriters with respect to the financial statements and certain financial information contained in the Registration Statement and the Prospectus. (f) ACCOUNTANT'S COMFORT LETTER OF ARTHUR ANDERSEN. At the time of the execution of this Agreement, the Representatives shall have received from Arthur Andersen a letter dated such date, in form and substance satisfactory to the Representatives, together with signed or reproduced copies of such letter for each of the other Underwriters containing statements and information of the type ordinarily included in accountants' "comfort letters" to underwriters with respect to the financial statements and certain financial information relating to Lyndon contained in the Registration Statement and the Prospectus. (g) BRING-DOWN COMFORT LETTER OF E&Y. At the Closing Time, the Representatives shall have received from E&Y a letter, dated as of the Closing Time, to the effect that they reaffirm the statements made in the letter furnished pursuant to subsection (e) of this Section, except that the specified date referred to shall be a date not more than three business days prior to the Closing Time. (h) BRING-DOWN COMFORT LETTER OF ARTHUR ANDERSEN. At the Closing Time, the Representatives shall have received from Arthur Andersen a letter, dated as of the Closing Time, to the effect that they reaffirm the statements made in the letter furnished pursuant to subsection (f) of this Section, except that the specified date referred to shall be a date not more than three business days prior to the Closing Time. (i) APPROVAL OF LISTING. At the Closing Time, the Securities shall have been approved for listing on the New York Stock Exchange, subject only to official notice of issuance. (j) LITIGATION. At the Closing Time, there shall not be any pending or threatened legal or governmental proceedings against the Company with respect to any of the transactions contemplated in this Agreement. (k) LOCK-UP AGREEMENTS. At the date of this Agreement, the Representatives shall have received an agreement substantially in the form of Exhibit B hereto and to the effect set forth in Section 3(j) hereof signed by each of Walter A. Rhulen, Peter L. Rhulen, Harry W. Rhulen, Thomas J. Dietz, Peter H. Foley, James Kroh, Mark Mishler, Lawrence E. O'Brien, Douglas C. Moat, Alan Gerry, Richard F. Seyffarth and the Estate of Jesse M. Farrow. (l) CONDITIONS TO PURCHASE OF OPTION SECURITIES. In the event that the Underwriters exercise their option provided in Section 2(b) hereof to purchase all or any portion of the Option Securities, the representations and warranties of the 19 Company contained herein and the statements in any certificates furnished by the Company, any subsidiary of the Company hereunder shall be true and correct as of each Date of Delivery and, at the relevant Date of Delivery, the Representatives shall have received: (i) OFFICERS' CERTIFICATE. A certificate, dated such Date of Delivery, of the President or a Vice President of the Company and of the chief financial or chief accounting officer of the Company confirming that the certificate delivered at the Closing Time pursuant to Section 5(d) hereof remains true and correct as of such Date of Delivery. (ii) OPINION OF COUNSEL FOR COMPANY. The favorable opinion of Epstein, Becker & Green, P.C., counsel for the Company, in form and substance satisfactory to counsel for the Underwriters, dated such Date of Delivery, relating to the Option Securities to be purchased on such Date of Delivery and otherwise to the same effect as the opinion required by Section 5(b) hereof. (iii) OPINION OF COUNSEL FOR UNDERWRITERS. The favorable opinion of Simpson Thacher & Bartlett, counsel for the Underwriters, dated such Date of Delivery, relating to the Option Securities to be purchased on such Date of Delivery and otherwise to the same effect as the opinion required by Section 5(c) hereof. (iv) BRING-DOWN COMFORT LETTERS. (a) A letter from E&Y, in form and substance satisfactory to the Representatives and dated such Date of Delivery, substantially in the same form and substance as the letter furnished to the Representatives pursuant to Section 5(g) hereof, except that the "specified date" in the letter furnished pursuant to this paragraph shall be a date not more than five days prior to such Date of Delivery and (b) A letter from Arthur Andersen, in form and substance satisfactory to the Representatives and dated such Date of Delivery, substantially in the same form and substance as the letter furnished to the Representatives pursuant to Section 5(h) hereof, except that the "specified date" in the letter furnished pursuant to this paragraph shall be a date not more than five days prior to such Date of Delivery. (m) ADDITIONAL DOCUMENTS. At the Closing Time and at each Date of Delivery counsel for the Underwriters shall have been furnished with such documents and opinions as they may reasonably require for the purpose of enabling them to pass upon the issuance and sale of the Securities as herein contemplated, or in order to evidence the accuracy of any of the representations or warranties, or the fulfillment of any of the conditions, herein contained; and all proceedings taken by the Company in connection with the issuance and sale of the Securities as herein contemplated shall be reasonably satisfactory in form and substance to the Representatives and counsel for the Underwriters. 20 (n) TERMINATION OF AGREEMENT. If any condition specified in this Section shall not have been fulfilled when and as required to be fulfilled, this Agreement, or, in the case of any condition to the purchase of Option Securities on a Date of Delivery which is after the Closing Time, the obligations of the several Underwriters to purchase the relevant Option Securities, may be terminated by the Representatives by notice to the Company at any time at or prior to the Closing Time or such Date of Delivery, as the case may be, and such termination shall be without liability of any party to any other party except as provided in Section 4 and except that Sections 1, 6, 7 and 8 shall survive any such termination and remain in full force and effect. SECTION 6. INDEMNIFICATION (a) INDEMNIFICATION OF UNDERWRITERS. The Company agrees to indemnify and hold harmless each Underwriter and each person, if any, who controls any Underwriter within the meaning of Section 15 of the 1933 Act or Section 20 of the 1934 Act as follows: (i) against any and all loss, liability, claim, damage and expense whatsoever, as incurred, arising out of any untrue statement or alleged untrue statement of a material fact contained in the Registration Statement (or any amendment thereto), including the Rule 430A Information and the Rule 434 Information, if applicable, or the omission or alleged omission therefrom of a material fact required to be stated therein or necessary to make the statements therein not misleading or arising out of any untrue statement or alleged untrue statement of a material fact included in any preliminary prospectus or the Prospectus (or any amendment or supplement thereto), or the omission or alleged omission therefrom of a material fact necessary in order to make the statements therein, in the light of the circumstances under which they were made, not misleading; (ii) against any and all loss, liability, claim, damage and expense whatsoever, as incurred, to the extent of the aggregate amount paid in settlement of any litigation, or any investigation or proceeding by any governmental agency or body, commenced or threatened, or of any claim whatsoever based upon any such untrue statement or omission, or any such alleged untrue statement or omission; PROVIDED that (subject to Section 6(d) below) any such settlement is effected with the written consent of the Company; and (iii) against any and all expense whatsoever, as incurred (including, subject to Section 6(d) hereof, the reasonable fees and disbursements of counsel chosen by Merrill Lynch), reasonably incurred in investigating, preparing or defending against any litigation, or investigation or proceeding by any governmental agency or body, commenced or threatened, or any claim whatsoever based upon any such untrue statement or omission, or any such alleged untrue statement or omission, to the extent that any such expense is not paid under subparagraph (i) or (ii) above; PROVIDED, HOWEVER, that this indemnity agreement shall not apply to any loss, liability, claim, damage or expense to the extent arising out of any untrue statement or omission or alleged 21 untrue statement or omission made in reliance upon and in conformity with written information furnished to the Company by any Underwriter through Merrill Lynch expressly for use in the Registration Statement (or any amendment thereto), including the Rule 430A Information and the Rule 434 Information, if applicable, or any preliminary prospectus or the Prospectus (or any amendment or supplement thereto); PROVIDED FURTHER that the foregoing indemnification with respect to any Prospectus shall not inure to the benefit of any Underwriter (or any person controlling such Underwriter) from whom the person asserting any such losses, claims, damages or liabilities purchased any of the Securities if a copy of the Prospectus (as then amended or supplemented if the Company shall have furnished any amendments or supplements thereto) was not sent or given by or on behalf of such Underwriter on the initial resale to such person, if such is required by law, at or prior to the written confirmation of the sale of such Securities to such person and if the Prospectus (as so amended or supplemented) would have cured the defect giving rise to such loss, claim, damage or liability. (b) INDEMNIFICATION OF COMPANY. Each Underwriter severally agrees to indemnify and hold harmless the Company, its directors and each of its officers who signed the Registration Statement, and each person, if any, who controls the Company within the meaning of Section 15 of the 1933 Act or Section 20 of the 1934 Act, against any and all loss, liability, claim, damage and expense described in the indemnity agreement in Section 6(a) hereof, but only with respect to untrue statements or omissions, or alleged untrue statements or omissions, made in the Registration Statement (or any amendment thereto), including the Rule 430A Information and the Rule 434 Information, if applicable, or any preliminary prospectus or the Prospectus (or any amendment or supplement thereto) in reliance upon and in conformity with written information furnished to the Company by such Underwriter through Merrill Lynch expressly for use in the Registration Statement (or any amendment thereto) or such preliminary prospectus or the Prospectus (or any amendment or supplement thereto). (c) ACTIONS AGAINST PARTIES; NOTIFICATION. Each indemnified party shall give prompt notice to each indemnifying party of any action commenced against it in respect of which indemnity may be sought hereunder, but failure to so notify an indemnifying party shall not relieve it from any liability that it may have otherwise than on account of this indemnity agreement. In the case of parties indemnified pursuant to Section 6(a) above, counsel to the indemnified parties shall be selected by Merrill Lynch. An indemnifying party may participate at its own expense in the defense of such action; PROVIDED, HOWEVER, that counsel to the indemnifying party shall not (except with the consent of the indemnified party) also be counsel to the indemnified party. In no event shall the indemnifying party or parties be liable for the fees and expenses of more than one counsel for all indemnified parties in connection with any one action or separate but similar or related actions in the same jurisdiction arising out of the same general allegations or circumstances. If it so elects within a reasonable time after receipt of such notice, an indemnifying party, jointly with any other indemnifying parties receiving such notice, may assume the defense of such action with counsel chosen by it (subject to the approval of the indemnified parties defendant in such action, which approval shall not be unreasonably withheld) unless such indemnified parties reasonably object to such assumption on the ground that there may be legal defenses available 22 to them which are different from or are in conflict with those available to such indemnifying party. If an indemnifying party assumes the defense of such action, the indemnifying parties shall not be liable for any fees and expenses of counsel for the indemnified party incurred thereafter in connection with such action. (d) SETTLEMENT WITHOUT CONSENT IF FAILURE TO REIMBURSE. If at any time an indemnified party shall have requested an indemnifying party to reimburse the indemnified party for reasonable fees and expenses of counsel, such indemnifying party agrees that it shall be liable for any settlement of the nature contemplated by Section 6(a)(ii) effected without its written consent if (i) such settlement is entered into more than 45 days after receipt by such indemnifying party of the aforesaid request, (ii) such indemnifying party shall have received notice of the terms of such settlement at least 30 days prior to such settlement being entered into and (iii) such indemnifying party shall not have reimbursed such indemnified party in accordance with such request prior to the date of such settlement. Notwithstanding the immediately preceding sentence, if at any time an indemnified party shall have requested an indemnifying party to reimburse the indemnified party for fees and expenses of counsel, an indemnifying party shall not be liable for any settlement of the nature contemplated by Section 6(a)(ii) hereof effected without its consent if such indemnifying party (i) reimburses such indemnified party in accordance with such request to the extent it considers such request to be reasonable and (ii) provides written notice to the indemnified party reasonably substantiating the unpaid balance as unreasonable, in each case prior to the date of such settlement. SECTION 7. CONTRIBUTION. If the indemnification provided for in Section 6 hereof is for any reason unavailable to or insufficient to hold harmless an indemnified party in respect of any losses, liabilities, claims, damages or expenses referred to therein, then each indemnifying party shall contribute to the aggregate amount of such losses, liabilities, claims, damages and expenses incurred by such indemnified party, as incurred, (i) in such proportion as is appropriate to reflect the relative benefits received by the Company on the one hand and the Underwriters on the other hand from the offering of the Securities pursuant to this Agreement or (ii) if the allocation provided by clause (i) is not permitted by applicable law, in such proportion as is appropriate to reflect not only the relative benefits referred to in clause (i) above but also the relative fault of the Company on the one hand and of the Underwriters on the other hand in connection with the statements or omissions, which resulted in such losses, liabilities, claims, damages or expenses, as well as any other relevant equitable considerations. The relative fault of the Company on the one hand and the Underwriters on the other hand shall be determined by reference to, among other things, whether any such untrue or alleged untrue statement of a material fact or omission or alleged omission to state a material fact relates to information supplied by the Company or by the Underwriters and the parties' relative intent, knowledge, access to information and opportunity to correct or prevent such statement or omission. The Company and the Underwriters agree that it would not be just and equitable if contribution pursuant to this Section 7 were determined by pro rata allocation (even if the 23 Underwriters were treated as one entity for such purpose) or by any other method of allocation which does not take account of the equitable considerations referred to above in this Section 7. The aggregate amount of losses, liabilities, claims, damages and expenses incurred by an indemnified party and referred to above in this Section 7 shall be deemed to include any legal or other expenses reasonably incurred by such indemnified party in investigating, preparing or defending against any litigation, or any investigation or proceeding by any governmental agency or body, commenced or threatened, or any claim whatsoever based upon any such untrue or alleged untrue statement or omission or alleged omission. Notwithstanding the provisions of this Section 7, no Underwriter shall be required to contribute any amount in excess of the amount by which the total price at which the Securities underwritten by it and distributed to the public were offered to the public exceeds the amount of any damages which such Underwriter has otherwise been required to pay by reason of any such untrue or alleged untrue statement or omission or alleged omission. No person guilty of fraudulent misrepresentation (within the meaning of Section 11(f) of the 1933 Act) shall be entitled to contribution from any person who was not guilty of such fraudulent misrepresentation. For purposes of this Section 7, each person, if any, who controls an Underwriter within the meaning of Section 15 of the 1933 Act or Section 20 of the 1934 Act shall have the same rights to contribution as such Underwriter, and each director of the Company, each officer of the Company who signed the Registration Statement, and each person, if any, who controls the Company within the meaning of Section 15 of the 1933 Act or Section 20 of the 1934 Act shall have the same rights to contribution as the Company. The Underwriters' respective obligations to contribute pursuant to this Section 7 are several in proportion to the number of Initial Securities set forth opposite their respective names in Schedule A hereto and not joint. SECTION 8. REPRESENTATIONS, WARRANTIES AND AGREEMENTS TO SURVIVE DELIVERY. All representations, warranties and agreements contained in this Agreement or in certificates of officers of the Company or any of its subsidiaries submitted pursuant hereto, shall remain operative and in full force and effect, regardless of any investigation made by or on behalf of any Underwriter or controlling person, or by or on behalf of the Company and shall survive delivery of the Securities to the Underwriters. SECTION 9. TERMINATION OF AGREEMENT. (a) TERMINATION; GENERAL. The Representatives may terminate this Agreement, by notice to the Company, at any time at or prior to the Closing Time (i) if there has been, since the time of execution of this Agreement or since the respective dates as of which information is given in the Prospectus, any material adverse change in the condition, financial or otherwise, or in the earnings, business affairs or business prospects of the Company and its subsidiaries considered as one enterprise, whether or not arising in the ordinary course of business, or (ii) if there has occurred any material adverse change in the financial markets in the United States or the international financial markets, any outbreak of hostilities or escalation thereof or other calamity or crisis or any change or development involving a prospective change in national or international political, 24 financial or economic conditions, in each case the effect of which is such as to make it, in the judgment of the Representatives, impracticable to market the Securities or to enforce contracts for the sale of the Securities, or (iii) if trading in any securities of the Company has been suspended by the Commission or the New York Stock Exchange, or if trading generally on the New York Stock Exchange, the American Stock Exchange or the Nasdaq National Market has been suspended, or minimum or maximum prices for trading have been fixed, or maximum ranges for prices for securities have been required, by such exchange or by order of the Commission or any other governmental authority or (iv) if a banking moratorium has been declared by either federal or New York State authorities. (b) LIABILITIES. If this Agreement is terminated pursuant to this Section, such termination shall be without liability of any party to any other party except as provided in Section 4 hereof, and provided further that Sections 1, 6, 7 and 8 shall survive such termination and remain in full force and effect. SECTION 10. DEFAULT BY ONE OR MORE OF THE UNDERWRITERS. If one or more of the Underwriters shall fail at the Closing Time to purchase the Securities that it or they are obligated to purchase pursuant to this Agreement (the "Defaulted Securities"), the Representatives shall have the right, within 24 hours thereafter, to make arrangements for one or more of the non-defaulting Underwriters, or any other underwriters, to purchase all, but not less than all, of the Defaulted Securities in such amounts as may be agreed upon and upon the terms set forth in this Agreement; if, however, the Representatives have not completed such arrangements within such 24-hour period, then: (a) if the number of Defaulted Securities does not exceed 10% of the number of Securities to be purchased on such date, each of the non-defaulting Underwriters shall be obligated, severally and not jointly, to purchase the full amount thereof in the proportions that their respective underwriting obligations hereunder bear to the underwriting obligations of all non-defaulting Underwriters, or (b) if the number of Defaulted Securities exceeds 10% of the number of Securities to be purchased on such date, this Agreement or, with respect to any Date of Delivery which occurs after the Closing Time, the obligation of the Underwriters to purchase and of the Company to sell the Option Securities to be purchased and sold on such Date of Delivery shall terminate without liability on the part of any non-defaulting Underwriter. No action taken pursuant to this Section shall relieve any defaulting Underwriter from liability in respect of its default. In the event of any such default which does not result in a termination of this Agreement or, in the case of a Date of Delivery which is after the Closing Time, which does not result in a termination of the obligation of the Underwriters to purchase and the Company to sell the relevant Option Securities, as the case may be, either (i) the Representatives or (ii) the Company shall have the right to postpone the Closing Time or the relevant Date of Delivery, as the case may be, for a period not exceeding seven days in order to effect any required changes in the Registration Statement or Prospectus or in any other documents or 25 arrangements. As used herein, the term "Underwriter" includes any person substituted for an Underwriter under this Section 10. SECTION 11. NOTICES. All notices and other communications under the Agreement shall be in writing and shall be deemed to have been duly given, upon receipt, if delivered, mailed or transmitted by any standard form of telecommunication. Notices to the Underwriters shall be directed to the Representatives at Merrill Lynch World Headquarters, North Tower, World Financial Center, New York, New York 10281-1201 (telecopier no.: (212) 449-2993), attention of Mr. Anthony Ursano, with a copy to Simpson Thacher & Bartlett, 425 Lexington Avenue, New York, New York 10017 (telecopier no.: (212) 455-2502), attention: Peter J. Gordon, Esq.; and notices to the Company shall be directed to it at Frontier Insurance Group, Inc., 195 Lake Louise-Marie Road, Rock Hill, New York 12775 (telecopier no.: (914) 796-1900), attention of Harry W. Rhulen, with a copy to Epstein, Becker & Green, 250 Park Avenue, New York, New York 10177 (telecopier no.: (212) 661-0989), attention: Sidney Todres, Esq. SECTION 12. PARTIES. This Agreement shall each inure to the benefit of and be binding upon the Underwriters, the Company and their respective successors. Nothing expressed or mentioned in this Agreement is intended or shall be construed to give any person, firm or corporation, other than the Underwriters, the Company and their respective successors and the controlling persons and officers and directors referred to in Sections 6 and 7 and their heirs and legal representatives, any legal or equitable right, remedy or claim under or in respect of this Agreement or any provision herein contained. This Agreement and all conditions and provisions hereof are intended to be for the sole and exclusive benefit of the Underwriters, the Company and their respective successors, and said controlling persons and officers and directors and their heirs and legal representatives, and for the benefit of no other person, firm or corporation. No purchaser of Securities from any Underwriter shall be deemed to be a successor by reason merely of such purchase. SECTION 13. REPRESENTATION OF UNDERWRITERS. The Representatives will act for the several Underwriters in connection with the transactions contemplated by this Agreement, and any action under or in respect of this Agreement taken by them as Representatives will be binding upon all the Underwriters. SECTION 14. GOVERNING LAW. THIS AGREEMENT SHALL BE GOVERNED BY AND CONSTRUED IN ACCORDANCE WITH THE LAWS OF THE STATE OF NEW YORK. SECTION 17. COUNTERPARTS. This Agreement may be executed in one or more counterparts and when a counterpart has been executed by each party, all such counterparts taken together shall constitute one and the same agreement. SECTION 15. EFFECT OF HEADINGS. The Article and Section headings herein are for convenience only and shall not affect the construction hereof. If the foregoing is in accordance with your understanding of our agreement, please sign and return to us a counterpart hereof, whereupon this instrument, along with all counterparts, will become a binding agreement among the Company and the several Underwriters in accordance with its terms. Very truly yours, FRONTIER INSURANCE GROUP, INC. By __________________________ Name: Title: Confirmed and accepted as of the date first above written: MERRILL LYNCH & CO. Merrill Lynch, Pierce, Fenner & Smith Incorporated DONALDSON, LUFKIN & JENRETTE SECURITIES CORPORATION OPPENHEIMER & CO., INC. SMITH BARNEY INC. STEPHENS INC. By MERRILL LYNCH & CO. Merrill Lynch, Pierce, Fenner & Smith Incorporated By _____________________________________ Name: Title: SCHEDULE A to PURCHASE AGREEMENT NUMBER OF NAME OF UNDERWRITER INITIAL SHARES - ------------------- -------------- Merrill Lynch, Pierce, Fenner & Smith Incorporated 639,000 Donaldson, Lufkin & Jenrette Securities Corporation 639,000 Oppenheimer & Co., Inc. 639,000 Smith Barney Inc. 639,000 Stephens Inc. 639,000 Credit Suisse First Boston Corporation 115,000 Deustche Morgan Grenfell Inc. 115,000 Conning & Company 115,000 Dowling & Partners Securities, LLC 115,000 EVEREN Securities, Inc. 115,000 Hoefer & Arnett Incorporated 115,000 Moors & Cabot, Inc. 115,000 --------------- Total . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000,000 --------- --------- SCHEDULE B to PURCHASE AGREEMENT 4,000,000 Shares of Common Stock FRONTIER INSURANCE GROUP, INC. (par value $.01 per share) 1. The public offering price per share for the Securities, determined as provided in Section 2, shall be $[ ]. 2. The purchase price per share for the Securities to be paid by the several Underwriters shall be $[ ], being an amount equal to the public offering price set forth above less $[ ] per share; PROVIDED that the purchase price per share for any Option Securities purchased upon the exercise of the over-allotment option described in Section 2(b) shall be reduced by an amount per share equal to any dividends or distributions payable after the Closing Time but before the relevant date of delivery to the Underwriter of the Option Securities. EXHIBIT A to PURCHASE AGREEMENT FORM OF OPINION OF COMPANY'S COUNSEL TO BE DELIVERED PURSUANT TO SECTION 5(b) As used in such opinion, (i) the term "Applicable Laws" means only the General Corporation Law of the State of Delaware and those laws, rules and regulations of the State of New York or the United States of America which are ordinarily applicable to transactions of the type contemplated by the Purchase Agreement; (ii) the term "Governmental Approval" means any consent, approval, license, authorization or validation of, or filing, qualification or registration with, any Governmental Authority pursuant to Applicable Laws; and (iii) the term "Governmental Authority" means any New York or United States federal legislative, judicial, administrative or regulatory body under Applicable Laws. (i) The Company is a corporation duly organized, validly existing and in good standing under the laws of the State of Delaware. (ii) The Company has corporate power and authority to own, lease and operate its properties and conduct its business, as described in the Prospectus and to enter into and perform its obligations under the Purchase Agreement. (iii) The authorized, issued and outstanding capital stock of the Company is as set forth in the Prospectus in the column entitled "Actual" under the caption "Capitalization" (except for subsequent issuances, if any, pursuant to the Purchase Agreement or pursuant to reservations, agreements or employee benefit plans referred to in the Prospectus or pursuant to the exercise of convertible securities or options referred to in the Prospectus); the shares of issued and outstanding capital stock of the Company have been duly authorized and validly issued and are fully paid and non-assessable; and none of the outstanding shares of capital stock of the Company was issued in violation of the preemptive rights of any stockholder of the Company arising by operation of law or under the charter or by-laws of the Company or any agreement of which we have knowledge. (iv) The Securities to be purchased by the Underwriters from the Company have been duly authorized for issuance and sale to the Underwriters pursuant to the Purchase Agreement and, when issued and delivered by the Company pursuant to the Purchase Agreement against payment of the consideration set forth in the Purchase Agreement, will be validly issued and fully paid and non-assessable and no holder of the Securities is or will be subject to personal liability by reason of being such a holder. (v) The issuance and sale of the Securities by the Company is not subject to the preemptive rights of any stockholder of the Company arising by operation of law or under the charter or by-laws of the Company or any agreement of which we have knowledge. 2 (vi) The Purchase Agreement has been duly authorized, executed and delivered by the Company. (vii) The Registration Statement has been declared effective under the 1933 Act; any required filing of the Prospectus pursuant to Rule 424(b) has been made in the manner and within the time period required by Rule 424(b); and, to the best of our knowledge, no stop order suspending the effectiveness of the Registration Statement has been issued under the 1933 Act and no proceedings for that purpose have been instituted or are pending or threatened by the Commission. (viii) The Registration Statement and the Rule 430A Information, as applicable, the Prospectus, excluding the documents incorporated by reference therein, and each amendment or supplement to the Registration Statement and Prospectus, excluding the documents incorporated by reference therein, as of their respective effective or issue dates (other than the financial statements and supporting schedules included therein or omitted therefrom, as to which we express no opinion) complied as to form in all material respects with the requirements of the 1933 Act and the 1933 Act Regulations. (ix) The documents incorporated by reference in the Prospectus (other than the financial statements and supporting schedules included therein or omitted therefrom, as to which we express no opinion), when they were filed with the Commission, complied as to form in all material respects with the requirements of the 1934 Act and the rules and regulations of the Commission thereunder. (x) The form of certificate used to evidence the Common Stock complies in all material respects with all applicable statutory requirements, with any applicable requirements of the charter and by-laws of the Company and the requirements of the New York Stock Exchange. (xi) To the best of our knowledge, other than the matters disclosed in the Prospectus, there is not pending or threatened any action, suit, proceeding, inquiry or investigation, to which the Company or any subsidiary is a party, or to which the property of the Company or any subsidiary is subject, before or brought by any court or governmental agency or body, domestic or foreign, which might reasonably be expected to result in a Material Adverse Effect, or which might reasonably be expected to materially and adversely affect the properties or assets thereof or the consummation of the transactions contemplated in the Purchase Agreement or the performance by the Company of its obligations thereunder. (xii) The information in the Prospectus under "Description of Capital Stock", "Business--Regulation" and "Management--Employment Agreements" and in the Registration Statement under Item 15, to the extent that such information constitutes matters of law, summaries of legal matters, the Company's charter and by-laws or legal proceedings, or legal conclusions, has been reviewed by us and is correct in all material respects. 3 (xiii) To the best of our knowledge, there are no statutes or regulations that are required to be described in the Prospectus that are not described as required. (xiv) All descriptions in the Registration Statement of contracts and other documents to which the Company or its subsidiaries are a party are accurate in all material respects; to the best of our knowledge, there are no franchises, contracts, indentures, mortgages, loan agreements, notes, leases or other instruments required to be described or referred to in the Registration Statement or to be filed as exhibits thereto other than those described or referred to therein or filed or incorporated by reference as exhibits thereto. (xv) To the best of our knowledge, (a) neither the Company nor any subsidiary is in violation of its charter or by-laws and (b) no default by the Company or any subsidiary exists in the due performance or observance of any material obligation, agreement, covenant or condition contained in any contract, indenture, mortgage, loan agreement, note, lease or other agreement or instrument that is described or referred to in the Registration Statement or the Prospectus or filed or incorporated by reference as an exhibit to the Registration Statement. (xvi) No Governmental Approval normally applicable to transactions of the type contemplated by the Purchase Agreement (other than under United States federal, state securities or "blue sky" laws and the rules and regulations of the New York Stock Exchange or the NASD, as to which we express no opinion) is required for the issuance and sale of the Securities by the Company to the Underwriters pursuant to the Purchase Agreement and the performance by the Company of its obligations under the Purchase Agreement. (xvii) The execution, delivery and performance of the Purchase Agreement and the consummation of the transactions contemplated in the Purchase Agreement and in the Registration Statement (including the issuance and sale of the Securities and the use of the proceeds from the sale of the Securities as described in the Prospectus under the caption "Use Of Proceeds") and compliance by the Company with its obligations under the Purchase Agreement do not and will not, whether with or without the giving of notice or lapse of time or both, conflict with or constitute a breach of, or default or Repayment Event (as defined in Section 1(a)(xi) of the Purchase Agreement) under or result in the creation or imposition of any lien, charge or encumbrance upon any property or assets of the Company or any subsidiary pursuant to any agreement or instrument to which the Company is a party and which is described or referred to in the Registration Statement or the Prospectus or filed or incorporated by reference as an exhibit to the Registration Statement (excluding insurance treaties as to which we express no opinion), nor will such action result in any violation of the provisions of (A) the charter or by-laws of the Company, (B) any Applicable Law, or (C) to our knowledge, any judgment, order or decree under Applicable Laws of any Governmental Authority having jurisdiction over the Company or any of its properties. We express no opinion, however, as to whether the execution, delivery and performance by the Company of any of the agreements 4 executed and delivered in connection with the transactions contemplated hereby will constitute a violation of or a default under any covenant, restriction or provision with respect to financial ratios or tests or any aspect of the financial condition or results of operations of the Company. (xviii) The Company is not an "investment company" or an entity "controlled" by an "investment company," as such terms are defined in the 1940 Act. In addition, such opinion shall include a statement that such counsel have participated in the preparation of the Registration Statement and Prospectus and in conferences with officers and other representatives of the Company, representatives of the independent public accountants for the Company, and with the Representatives and Underwriters' counsel at which the contents of the Registration Statement and Prospectus and related matters were discussed and, although such counsel need not pass upon or assume any responsibility for the accuracy, completeness or fairness of the statements contained in the Registration Statement or the Prospectus, on the basis of the foregoing, nothing has come to such counsel's attention that would lead such counsel to believe that the Registration Statement or any amendment thereto, including the Rule 430A Information (except for financial statements and schedules and other financial data included or incorporated by reference therein or omitted therefrom, as to which such counsel need make no statement), at the time such Registration Statement or any such amendment became effective, contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading or that the Prospectus or any amendment or supplement thereto (except for financial statements and schedules and other financial data included or incorporated by reference therein or omitted therefrom, as to which such counsel need make no statement), at the time the Prospectus was issued, at the time any such amended or supplemented prospectus were issued or at the Closing Time, included or includes an untrue statement of a material fact or omitted or omits to state a material fact necessary in order to make the statements therein, in the light of the circumstances under which they were made, not misleading. Such opinion shall be to such further effect with respect to other legal matters relating to the Purchase Agreement and the Securities as counsel for the Underwriters may reasonably request. In addition, in giving such opinion, such counsel may state that, insofar as such opinion involves factual matters, they have relied, to the extent they deem proper, upon certificates of officers of the Company and its subsidiaries and certificates of public officials and the Transfer Agent, PROVIDED that such certificates have been delivered to the Underwriters. In lieu of delivering the opinion of Epstein, Becker & Green, P.C. ("Epstein Becker"), the Company may deliver a written opinion addressed to the Underwriters of Marvin Tepper, Esq. with respect to insurance regulatory matters (which opinion is dated and furnished to the Representatives at the Closing Time and shall be satisfactory in form and substance to counsel for the Underwriters), PROVIDED that Epstein Becker shall state in their opinion that they believe that the Underwriters are justified in relying on such opinion. EXHIBIT B to PURCHASE AGREEMENT FORM OF LOCK-UP AGREEMENT _____________, 1997 MERRILL LYNCH & CO. Merrill Lynch, Pierce, Fenner & Smith Incorporated DONALDSON, LUFKIN & JENRETTE SECURITIES CORPORATION OPPENHEIMER & CO., INC. SMITH BARNEY INC. STEPHENS INC. As Representatives of the several Underwriters c/o Merrill Lynch & Co. Merrill Lynch, Pierce, Fenner & Smith Incorporated North Tower World Financial Center New York, New York 10281-1209 Re: PROPOSED PUBLIC OFFERING BY FRONTIER INSURANCE GROUP, INC. Ladies and Gentlemen: The undersigned officer, director or shareholder of Frontier Insurance Group, Inc., a Delaware corporation (the "Company"), understands that a Purchase Agreement (the "Purchase Agreement") will be executed by the Company and Merrill Lynch & Co., Merrill Lynch, Pierce, Fenner & Smith Incorporated ("Merrill Lynch") and each of the other Underwriters named in Schedule A thereto (collectively, the "Underwriters", which term shall also include any underwriter substituted as hereinafter provided in Section 10 therein), for whom Merrill Lynch, Donaldson, Lufkin & Jenrette Securities Corporation, Oppenheimer & Co., Inc., Smith Barney Inc. and Stephens Inc. are acting as representatives (in such capacity, the "Representatives"), with respect to (i) the sale by the Company of an aggregate of 4,000,000 shares of its Common Stock, par value $.01 per share ("Common Stock"), and the purchase by the Underwriters, acting severally and not jointly, of the respective numbers of shares of Common Stock set forth in Schedule A thereto ("Initial Securities") and (ii) the grant by the Company to the Underwriters, acting severally and not jointly, of the option described in Section 2(b) therein to purchase all or any part of 600,000 additional shares of Common Stock ("Option Securities", together with the Initial Securities, the "Securities") to cover over-allotments, if any. 2 This Lock-Up Letter Agreement is being entered into in accordance with Section 3(j) of the Purchase Agreement at the request of the Underwriters. Any capitalized term used and not defined herein shall have the meaning ascribed to it in the Purchase Agreement. In recognition of the benefit that such an offering will confer upon the undersigned as a stockholder, an officer and/or director of the Company, and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the undersigned agrees with each underwriter to be named in the Purchase Agreement that, during a period of 90 days from the date of the Purchase Agreement, the undersigned will not, without the prior written consent of Merrill Lynch, directly or indirectly, (i) offer, pledge, sell, contract to sell, sell any option or contract to purchase, purchase any option or contract to sell, grant any option, right or warrant for the sale of, or otherwise dispose of or transfer any shares of the Company's Common Stock or any securities convertible into or exchangeable or exercisable for Common Stock, whether now owned or hereafter acquired by the undersigned or with respect to which the undersigned has or hereafter acquires the power of disposition or (ii) enter into any swap or any other agreement or any transaction that transfers, in whole or in part, directly or indirectly, the economic consequence of ownership of the Common Stock, whether any such swap or transaction described in clause (i) or (ii) above is to be settled by delivery of Common Stock or other securities, in cash or otherwise. The foregoing sentence shall not apply to (i) the Securities to be sold under the Purchase Agreement, (ii) any issuance of Common Stock, or any grant of options to purchase Common Stock, and the exercise or vesting thereof, in each case pursuant to existing employee benefit plans and agreements of the Company described in the Prospectus or any of the documents incorporated by reference therein on the date hereof, (iii) transfers by will or the laws of descent and distribution, (iv) the making of gifts by such officers, directors and stockholders to any donee, or (v) sales of up to an aggregate 50,000 shares of Common Stock by the stockholders, officers and directors named in Section 5(k) of the Purchase Agreement, taken as a whole. The undersigned understands that the Company and the Underwriters will proceed with the sale of the Securities pursuant to the Purchase Agreement in reliance on this Lock-Up Letter Agreement. The undersigned hereby represents and warrants that the undersigned has full power and authority to enter into this Lock-Up Letter Agreement and that, upon request, the undersigned will execute any additional documents necessary or desirable in connection with the enforcement hereof. All authority herein conferred or agreed to be conferred shall survive the death or incapacity of the undersigned and any obligations of the undersigned hereunder shall be binding upon the heirs, representatives, executors and beneficiaries of the undersigned. Except as expressly provided above, the rights and obligations of the undersigned may not be assigned without the prior written consent of Merrill Lynch. This Lock-Up Letter Agreement has been entered into on the date first above written. Very truly yours, - ---------------------------- Name: -----END PRIVACY-ENHANCED MESSAGE-----