UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 Form 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1997 Commission File Number 0-14243 ALLIED Group, Inc. (Exact name of registrant as specified in its charter) Iowa (State or other jurisdiction of incorporation or organization) 42-0958655 (I.R.S. Employer Identification No.) 701 Fifth Avenue, Des Moines, Iowa 50391-2000 Address of principal executive offices) (Zip Code) 515-280-4211 (Registrant's telephone number including area code) Securities registered pursuant to Section 12(b) of the Act: Common Stock, no par value (Title of Class) Securities registered pursuant to Section 12(g) of the Act: None (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days. Yes [ X ] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] As of February 27, 1998 the number of Registrant's Common Stock, no par value, outstanding was 30,549,214. The aggregate market value of the Common Stock of the Registrant held by nonaffiliates at February 27, 1998 was $944,868,332. Documents Incorporated By Reference The Registrant's definitive proxy statement (1998 Proxy Statement), which will be filed with the Securities and Exchange Commission within 120 days after December 31, 1997, is incorporated by reference under Part III. The index to the exhibits is located on page 76. This document contains 93 pages. 2 TABLE OF CONTENTS Part I Item 1. Business..........................................................3 Item 2. Properties.......................................................18 Item 3. Legal Proceedings................................................18 Item 4. Submission of Matters to a Vote of Security Holders..............18 Part II Item 5. Market for Registrant's Common Equity and Related Stockholders' Matters...........................................19 Item 6. Selected Financial Data...........................................20 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.......................................21 Item 8. Financial Statements and Supplementary Data.......................29 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure........................................58 Part III Item 10.Directors and Executive Officers of the Registrant...................59 Item 11.Executive Compensation...............................................59 Item 12.Security Ownership of Certain Beneficial Owners and Management.......59 Item 13.Certain Relationships and Related Transactions.......................59 Part IV Item 14.Exhibits, Financial Statement Schedules, and Reports on Form 8-K.....60 Index to Financial Statement Schedules........................................60 Signatures....................................................................75 Index to Exhibits.............................................................76 3 Part I Item 1. Business ALLIED Group, Inc. (the Company) was incorporated in 1971 as an Iowa corporation and operates as a regional insurance holding company headquartered in Des Moines, Iowa. The Company and its subsidiaries operate exclusively in the United States and primarily in the central and western states. At year-end 1997, The ALLIED Group Employee Stock Ownership Trust owned 24.9% and ALLIED Mutual Insurance Company (ALLIED Mutual), an affiliated property-casualty insurance company, controlled 18.2% of the outstanding voting stock of the Company. The Company has two reportable business segments: property-casualty insurance and excess & surplus lines insurance. Property-casualty insurance was the most significant segment in 1997, accounting for 85.7% of consolidated revenues. The Company's segment information is contained in note 18 of Notes to Consolidated Financial Statements. Property-casualty Insurance The property-casualty segment operates through three subsidiaries: AMCO Insurance Company (AMCO), ALLIED Property and Casualty Insurance Company (ALLIED Property and Casualty), and Depositors Insurance Company (Depositors), which write personal lines (primarily automobile and homeowners) and small commercial lines. The segment and ALLIED Mutual pool their property-casualty business. See notes 4 and 6 of Notes to Consolidated Financial Statements and "Business Relationship with ALLIED Mutual--Pooling Agreement." A.M. Best has assigned a rating of A+ (Superior) to each of the property-casualty subsidiaries and to ALLIED Mutual for 1997 with respect to their financial strength and their ability to meet policyholder and other contractual obligations based on the review of the pool's 1996 statutory results and operating performance. The profitability of the property-casualty segment is affected by many factors, including, but not limited to, industry price competition, the frequency and severity of losses incurred in connection with weather-related and other catastrophic events, the adequacy of prior-year estimates of loss and loss adjusting expense reserves, insurance laws and regulations, fluctuations in the financial markets, interest rates, reinsurance costs, and general business and economic conditions. The property-casualty segment pursues a strategy of growth in personal lines of insurance primarily through a system of more than 2,300 independent agencies, a growing number of which represent the property-casualty subsidiaries on an exclusive basis for their personal lines of insurance. For the year ended December 31, 1997, 68.1% of the property-casualty subsidiaries' net earned premiums were attributable to personal lines of insurance. While the majority of the revenues are attributable to personal lines, the segment also writes commercial lines of insurance for small businesses through such agents. Because the primary focus, and the primary market served by the segment's independent agency force, is personal lines of insurance and because management perceives the risks to be greater in commercial lines, the property-casualty segment has been conservative in the types of commercial risks it underwrites and in the pricing of the commercial risks. Historically, this has resulted in writing less commercial business than the segment might otherwise have if a more aggressive strategy in commercial lines was adopted. It has also resulted in a lower combined ratio for the commercial lines compared with its core personal lines business. The property-casualty segment markets its products through three distribution systems: independent agencies, exclusive agencies, and direct response marketing. Generally, AMCO writes, through independent agencies, personal and commercial property-casualty insurance lines, consisting primarily of private passenger automobile and homeowners, with lesser emphasis on special multiple peril, workers' compensation, inland marine, and other miscellaneous lines of business. ALLIED Property and Casualty generally writes personal lines insurance products through agents who sell ALLIED Property and Casualty personal lines exclusively, and Depositors generally writes personal lines through a direct mail and telemarketing agency, ALLIED Group Insurance Marketing Company, an affiliate of ALLIED Mutual. Neither the insurance subsidiaries in the property-casualty segment nor ALLIED Mutual appoint managing general agents, and each retains all underwriting, claims, and reinsurance authority. While the insurers provide contractual binding authority to most agents, such authority is subject to express limitations on the nature, type, and extent of each risk. With respect to the 4 ability of the agents to bind the insurers, the insurers have no right to reject any contracts entered into by the agents even if the agent exceeds the express limitations; however, such instances occur infrequently and constitute no material financial risk to the Company. The pooling agreement provides that ALLIED Mutual, ALLIED Property and Casualty, and Depositors cede to AMCO (pool administrator) premiums, losses, allocated loss adjusting expenses, commissions, premium taxes, service charge income, and dividends to policyholders and assume from AMCO an amount of this pooled property-casualty business equal to their participation in the pooling agreement. ALLIED Mutual's crop hail business is not pooled. AMCO pays certain underwriting expenses, unallocated loss adjusting expenses, and premium collection expenses for all of the pool participants and receives a fee equal to a specified percentage of premiums as well as a performance fee based on the attainment of certain combined ratios from each of the pool participants. The pooling arrangement provides ALLIED Mutual, ALLIED Property and Casualty, and Depositors more predictable expense levels by limiting such expenses to a specified percentage of their premiums. AMCO has opportunities to profit from the efficient administration of such underwriting, loss adjusting, and premium collection activities and to provide similar services to nonaffiliated insurance companies in the future. The property-casualty segment's participation in the pool was 64% for 1997, 1996, and 1995. As of December 31, 1997, the statutory capital and surplus of ALLIED Mutual and the Company's property-casualty segment were $259.6 million and $335.7 million, respectively. The following table sets forth statutory and generally accepted accounting principles (GAAP) basis information for the property-casualty subsidiaries for the years indicated. At or for the year ended December 31, ------------------------------------------ 1997 1996 1995 ----------- ---------- ---------- (dollars in thousands) Reinsurance pool percentage 64% 64% 64% Net written premiums $ 531,679 $ 488,189 $ 440,838 =========== ========== ========== Earned premiums $ 514,303 $ 466,211 $ 425,838 Losses and loss adjusting expenses 357,841 335,615 295,583 Underwriting expenses 131,071 124,622 114,511 ----------- ---------- ---------- Statutory underwriting gain 25,391 5,974 15,744 GAAP adjustments 1,411 3,965 1,943 ----------- ---------- ---------- GAAP underwriting gain 26,802 9,939 17,687 Investment income excluding realized gains 44,258 42,296 39,110 Realized investment gains 97 180 236 Other income 10,718 7,020 6,850 ----------- ---------- ---------- Income before income taxes $ 81,875 $ 59,435 $ 63,883 =========== ========== ========== GAAP combined ratio 94.8 97.9 95.8 Wind and hail losses, net of reinsurance $ 27,886 $ 39,111 $ 28,664 Impact of wind and hail losses on combined ratio 5.4 8.4 6.7 Invested assets $ 845,751 $ 710,629 $ 658,044 Loss and loss adjusting expense reserves, net of reinsurance $ 309,008 $ 297,343 $ 277,819 Statutory capital and surplus $ 335,694 $ 285,854 $ 257,845 The underwriting experience of the pool is indicated by the statutory combined ratio, a measure of underwriting profitability which excludes investment income and income taxes. Generally, a ratio below 100 indicates underwriting 5 profitability and a ratio exceeding 100 indicates an underwriting loss. The following table sets forth the net earned premiums and the statutory combined ratios (after policyholder dividends) by line of insurance business for the property-casualty segment for the years indicated. Year ended December 31, ------------------------------------------------------------------------------ 1997 1996 1995 ------------------------- ------------------------ ------------------------- Net Statutory Net Statutory Net Statutory earned combined earned combined earned combined premiums ratio premiums ratio premiums ratio ----------- --------- ----------- --------- ----------- --------- Line of business (dollars in thousands) ---------------- Personal automobile $ 256,398 94.5 $ 229,894 98.9 $ 208,873 96.5 Homeowners 93,833 96.7 81,617 102.4 71,035 99.2 ----------- ---------- ---------- Personal lines 350,231 95.1 311,511 99.8 279,908 97.2 ----------- ---------- ---------- Commercial automobile 25,991 90.3 25,272 98.8 23,873 95.2 Workers' compensation 23,838 93.6 25,499 76.5 29,443 70.2 Other property and liability 111,812 94.3 101,591 97.3 90,302 100.2 Other lines 2,431 59.7 2,338 45.7 2,312 50.2 ----------- ---------- ---------- Commercial lines 164,072 93.1 154,700 93.5 145,930 92.7 ----------- ---------- ---------- Total $ 514,303 94.4 $ 466,211 97.7 $ 425,838 95.7 =========== ========== ========== The following table sets forth the components of the statutory combined ratio and wind and hail loss information for the property-casualty segment for the years indicated. Year ended December 31, -------------------------------- 1997 1996 1995 ---- ----- ---- Statutory combined ratio Loss ratio 58.7 62.6 60.1 Loss adjusting expense ratio 10.8 9.4 9.3 Underwriting expense ratio 24.7 25.5 26.0 Dividend ratio 0.2 0.2 0.3 ---- ---- ---- Total 94.4 97.7 95.7 ==== ==== ==== Impact of wind and hail losses on the statutory combined ratio - --------------------------------- Personal automobile 1.9 3.9 1.8 Homeowners 15.4 23.6 21.7 Personal lines 5.5 9.1 6.8 Commercial lines 5.2 7.1 6.5 Total 5.4 8.4 6.7 Wind and hail losses are calculated by adding together all claims with a cause of loss from wind or hail and then deducting the related reinsurance recoveries. The information provides an indication of how weather-related losses impact the property-casualty segment's operating results for the years presented. Losses not resulting from either wind or hail are excluded from these calculations. 6 The following table sets forth premium information and agency counts for the property-casualty pool (including ALLIED Mutual) for the years indicated. At or for the year ended December 31, ----------------------------------------- 1997 1996 1995 ---------- ---------- ---------- (dollars in thousands) Direct written premiums by distribution system Independent agency system $ 562,202 $ 549,598 $ 503,922 Exclusive agency system 263,046 210,648 180,799 Direct response marketing system 33,436 28,437 22,136 ---------- ---------- ---------- Total direct written premiums, excluding crop hail premiums 858,684 788,683 706,857 Crop hail premiums (non-pooled) 7,038 7,049 7,781 ---------- ---------- ---------- Total direct written premiums $ 865,722 $ 795,732 $ 714,638 ========== ========== ========== Agency counts Independent agencies 2,038 2,000 1,968 Exclusive agencies 293 257 192 Net written premiums $ 841,833 $ 773,593 $ 699,608 Net earned premiums $ 814,682 $ 739,251 $ 676,169 The following table sets forth the geographic percentage distribution of property-casualty pool (including ALLIED Mutual) direct written premiums for the years indicated. 1997 1996 1995 ----- ----- ----- California 23.7% 24.5% 24.0% Iowa 21.4 21.7 23.3 Kansas 8.0 8.1 8.4 Nebraska 7.4 7.4 7.9 Minnesota 7.1 7.3 7.6 Missouri 5.1 4.8 4.8 Illinois 3.7 3.5 3.1 Colorado 3.6 3.6 3.6 Utah 3.0 2.9 2.5 Tennessee 3.1 2.7 2.4 Washington 2.5 2.3 2.1 Other * 11.4 11.2 10.3 ----- ----- ----- 100.0% 100.0% 100.0% ===== ====== ====== *Includes all other states, none of which accounted for more than 2% in 1997. Excess & Surplus Lines Western Heritage Insurance Company (Western Heritage) is an excess & surplus lines insurance subsidiary, which primarily underwrites commercial lines. A.M. Best has assigned a rating of A- (Excellent) to Western Heritage for 1997 based on the review of their 1996 statutory results and operating performance. For 1997, Western Heritage's net earned premiums were 58.1% specialty commercial casualty, 9.5% commercial property, 29.3% commercial transportation, and 3.1% personal lines coverages. Specialty commercial casualty lines include general liability, multiple peril, and product liability coverages for special events, such as concerts, fairs, exhibitions, and parades as well as coverages for merchants and artisan contractors. Specialty commercial property lines include coverages for buildings that are older, in higher risk locations, or vacant; 7 agricultural and contractor equipment; and protection against vandalism. Commercial transportation coverages include liability, physical damage, and garagekeepers insurance written for used car dealers and repair shops. The personal lines consist primarily of basic property coverages for dwellings. Western Heritage agents are accorded contractual binding authority for risks which meet the insurer's written underwriting guidelines and rules. Western Heritage appoints no managing general agents, however, and retains all underwriting, claims, and reinsurance authority. With respect to the ability of the agents to bind Western Heritage, Western Heritage has no right to reject any contracts entered into by the agents even if the agent exceeds the express limitations; however, such instances occur infrequently and constitute no material financial risk to the Company. The following table sets forth statutory and GAAP basis information for the excess & surplus lines segment for the years indicated. At or for the year ended December 31, -------------------------------------------- 1997 1996 1995 ----------- ----------- ----------- (dollars in thousands) Net written premiums $ 34,056 $ 28,417 $ 30,606 =========== =========== =========== Earned premiums $ 33,294 $ 27,314 $ 29,661 Losses and loss adjusting expenses 20,369 17,484 22,357 Underwriting expenses 9,884 8,106 8,202 ----------- ----------- ----------- Statutory underwriting gain (loss) 3,041 1,724 (898) GAAP adjustments 169 86 43 ----------- ----------- ----------- GAAP underwriting gain (loss) 3,210 1,810 (855) Investment income excluding realized gains 6,803 6,241 5,830 Realized investment gains (losses) (4) 2 (135) ----------- ----------- ----------- Income before income taxes $ 10,009 $ 8,053 $ 4,840 =========== =========== =========== GAAP combined ratio 90.4 93.4 102.9 Invested assets $ 113,521 $ 104,403 $ 96,435 Loss and loss adjusting expense reserves, net of reinsurance $ 50,984 $ 49,319 $ 47,120 Statutory capital and surplus $ 40,501 $ 33,478 $ 27,770 The following table sets forth the net earned premiums and statutory combined ratios of the commercial casualty, commercial property, commercial transportation, and personal lines written by Western Heritage for the years indicated. Year ended December 31, ---------------------------------------------------------------------------- 1997 1996 1995 ------------------------- ------------------------ ----------------------- Net Statutory Net Statutory Net Statutory earned combined earned combined earned combined premiums ratio premiums ratio premiums ratio ----------- --------- ----------- --------- ----------- --------- (dollars in thousands) Commercial casualty $ 19,329 88.6 $ 17,508 92.1 $ 22,031 103.9 Commercial property 3,158 95.6 2,513 70.2 2,676 91.2 Commercial transportation 9,768 91.9 6,538 103.7 4,254 98.6 Personal lines 1,039 86.0 755 86.9 700 115.1 ----------- ----------- ----------- Total $ 33,294 90.2 $ 27,314 92.5 $ 29,661 102.2 =========== =========== =========== 8 The following table sets forth the geographic percentage distribution of excess & surplus lines direct written premiums for the years indicated. 1997 1996 1995 ----- ----- ----- Texas 21.3% 25.0% 23.3% California 8.6 8.0 8.8 Illinois 7.8 8.6 9.9 Florida 6.0 5.5 7.2 Alabama 4.5 3.9 3.1 Connecticut 4.2 2.8 0.6 Louisiana 3.8 3.2 3.0 Missouri 3.7 3.9 3.0 Oklahoma 3.1 4.0 4.3 Colorado 2.7 2.9 2.8 Hawaii 2.5 3.0 3.7 Ohio 2.4 2.7 2.9 Washington 2.3 1.8 1.8 Indiana 2.1 2.0 1.9 Mississippi 2.1 2.9 2.6 Michigan 2.0 1.7 1.4 Other* 20.9 18.1 19.7 ----- ----- ----- 100.0% 100.0% 100.0% ===== ===== ===== *Includes all other states, none of which accounted for more than 2% in 1997. Reinsurance The insurance subsidiaries follow the industry practice of reinsuring a portion of their insured risks, paying to the reinsurer a portion of the premiums received on all policies. Insurance is ceded principally to reduce the net liability on individual risks and to protect against catastrophic losses. The subsidiaries monitor the availability of replacement coverages in the reinsurance market, and believe that replacement coverages from financially responsible reinsurers is available and accordingly do not deem existing reinsurance arrangements to be material. The basic reinsurance treaties benefiting the parties to the pooling agreement insure risks in excess of specific amounts. Except for crop-hail reinsurance, all reinsurance is obtained by the pool participants directly and the pool administrator does not have any additional or special reinsurance arrangements other than as a pool participant. The financial stability of each participating reinsurer is independently monitored by the pool participants and by their reinsurance intermediaries. See "Business Relationship with ALLIED Mutual Other Relationships" for the pooled property catastrophe reinsurance agreement with ALLIED Mutual and a nonaffiliated reinsurance company. With the exception of Western Heritage, all retentions discussed in this section are for the entire pool. The property-casualty subsidiaries are allocated a portion of the stated pool retentions based upon their respective pool participation percentage. The parties to the pooling agreement are covered by a property treaty which provides per risk property reinsurance in excess of a retention of $500,000 to a maximum limit of $5,000,000 per risk. Such parties are also covered by a property treaty that provides coverage on a facultative basis in excess of a retention of $5,000,000 to a maximum limit of $15,000,000. The pool participants purchase property catastrophe reinsurance from a large number of reinsurers each of which provides a relatively small percentage of the total cover. For 1998, the pool liability limit of the cover is 90% of $120,000,000 with retention of $11,000,000. A reinstatement agreement exists allowing purchases of reinsurance for an additional catastrophe occurring in the same year. 9 The pool's retention for most casualty risks is $375,000, with a reinsurance limit of $1,000,000 per occurrence. Other treaties provide reinsurance for each workers' compensation loss over $375,000 and up to $5,000,000. Catastrophe workers' compensation treaties increase the reinsurance to $35,000,000. Western Heritage, which is not a participant in the property-casualty pool, purchased surplus reinsurance on property risks covering 75% of the risk with limits in excess of $50,000 to a maximum of $1,000,000, which is the largest property risk insured. Western Heritage also purchased casualty reinsurance covering 92.5% of the risk in excess of $200,000 to a maximum of $1,000,000, the largest casualty risk insured. Western Heritage also purchased two layers of reinsurance, each of which covers $1,000,000 in excess of the underlying layers for both property and casualty coverages. Each of the layers contain a reinstallment provision. Western Heritage does not write workers' compensation or primary auto coverage. For 1998, Western Heritage's reinsurance program provides for all property and casualty risks on a loss event basis. The first excess per event contract provides reinsurance for an event in excess of $300,000 in loss and loss adjusting expenses up to a maximum of $1 million. The second excess per event contract provides reinsurance for an event in excess of $1 million in loss and loss adjusting expenses up to a maximum of $5 million. The largest amount insured by Western Heritage is $2 million. If limits exceed $1 million, Western Heritage purchases facultative reinsurance for the limits in excess of $1 million. Also in place is an aggregate stop loss treaty, which provides reinsurance for 10 percentage points of loss and loss adjusting expenses in excess of 62.5% of net earned premiums. Although reinsurance does not legally discharge an insurer from its primary liability for the full amount of the policies, it does make the assuming reinsurer liable to the insurer to the extent of the reinsurance ceded. As of December 31, 1997, the property-casualty subsidiaries had no past due amounts from reinsurers and Western Heritage had $76,000 in dispute. Historically, the Company has had no adverse collection experience with its reinsurers. Losses and Loss Adjusting Expense Reserves In many cases, several years may elapse between the occurrence of an insured loss, the reporting of the loss to the insurer, and the insurer's payment of that loss. To recognize liabilities for unpaid losses, the insurance subsidiaries establish reserves, which are balance sheet liabilities representing estimates of future amounts needed to pay claims and related expenses with respect to insured events which have occurred. The insurance subsidiaries do not discount loss reserves for financial statement purposes. When a claim is reported, a case reserve for the estimated amount of the ultimate payment is established. The estimate reflects an informed judgment based on general corporate reserving practices and the Company's experience and knowledge regarding the nature and value of the specific type of claim. Reserves are also established on an aggregate basis to provide for losses incurred but not yet reported to the insurer and the overall adequacy of case reserves. The insurance subsidiaries also establish reserves representing the estimated expenses of settling claims, including legal and other fees and general expenses of administering the claims adjustment process. As part of the reserving process, historical data is reviewed and consideration is given to the anticipated impact of various factors such as known and anticipated legal developments, changes in social attitudes, inflation, and economic conditions. This process relies on the basic assumption that past experience, adjusted for the effect of current developments and likely trends, is an appropriate basis for predicting future events. Reserve amounts are necessarily based on management's informed estimates, and as other data becomes available and is reviewed, these estimates and judgments are revised, resulting in increases or decreases to existing reserves. While the methods for setting the reserve structure are well tested, some assumptions about loss patterns have changed. In particular, recent higher jury verdicts and judicial decisions which expand coverage to new theories of liability have increased the demands against the loss and loss adjusting expense reserves of the insurance subsidiaries. Not only have anticipated claims increased in severity, but unanticipated claims have risen. In establishing reserves, management considers exposure the Company may have to environmental claims. Because reported claim activity levels are minimal and the emphasis of the Company's property-casualty business is primarily on personal lines and small commercial business, management believes exposure to material liability on environmental claims to be remote as of December 31, 1997. Management continues to monitor legal developments as they relate to the Company's exposure to environmental claims. 10 The following table presents the development of losses and loss adjusting expense reserves for 1987 to 1996 for the pool (which includes ALLIED Mutual) and Western Heritage. The top line of the table shows the estimated reserve for losses and loss adjusting expenses at the balance sheet date for each of the indicated years. These figures represent the estimated amount of losses and loss adjusting expenses, net of reinsurance recoverables, for claims arising in the current and all prior years that were unpaid at the balance sheet date, including losses that had been incurred but not yet reported. The lower portion of the table shows the re-estimated amount of net reserves as a percentage of the previously recorded net reserves based on experience as of the end of each succeeding year. The re-estimated reserves change as more information becomes known about the frequency and severity of claims for individual years. At or for the year ended December 31, ------------------------------------------------------------------------------------------------------------ 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- (dollars in thousands) Reserves for losses and loss adjusting expenses, net $160,152 $210,746 $248,870 $280,443 $312,089 $355,092 $386,936 $424,595 $471,247 $503,638 $522,317 Paid (cumulative) as of (1) 1 year later 47.5% 41.7% 43.6% 44.2% 43.6% 40.1% 40.8% 39.9% 43.1% 43.2% 2 years later 70.8 64.0 65.8 67.2 66.3 61.9 60.7 61.7 63.4 3 years later 85.8 77.2 79.3 80.4 79.8 72.6 73.2 73.9 4 years later 93.6 84.1 86.3 88.5 86.0 78.8 79.6 5 years later 97.9 87.7 91.5 92.5 89.6 82.8 6 years later 101.0 90.2 94.1 95.2 92.2 7 years later 102.8 92.1 96.0 96.9 8 years later 104.3 93.6 97.4 9 years later 106.0 94.4 10 years later 106.7 Net reserves re- estimated as of end of year (1) 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 1 year later 103.6 98.3 100.4 101.0 100.2 97.7 98.3 100.1 100.0 99.7 2 years later 106.3 97.6 99.6 101.1 101.1 96.8 98.9 98.9 99.1 3 years later 106.8 97.3 99.6 102.6 102.4 97.2 97.4 98.1 4 years later 107.1 97.5 101.5 104.6 103.1 96.3 97.4 5 years later 107.8 98.1 103.4 105.7 102.9 96.4 6 years later 108.9 99.3 104.5 105.7 102.8 7 years later 110.5 100.4 104.8 105.6 8 years later 111.8 100.7 104.6 9 years later 112.1 100.2 10 years later 111.9 Net cumulative redundancy (deficiency) Dollars $(19,031) $ (476) $(11,400) $(15,725) $ (8,637) $ 12,773 $ 10,247 $ 8,230 $ 4,039 $ 1,284 Percentage (11.9)% (0.2)% (4.6)% (5.6)% (2.8)% 3.6% 2.6% 1.9% 0.9% 0.3% Gross reserves- end of year $373,958 $400,912 $447,311 $492,304 $522,366 $544,696 Reinsurance recoverables 18,866 13,976 22,716 21,057 18,728 22,379 -------- -------- -------- -------- -------- -------- Net reserves- end of year $355,092 $386,936 $424,595 $471,247 $503,638 $522,317 ======== ======== ======== ======== ======== ======== Gross re-estimated reserves - latest (2) 99.0% 100.6% 100.0% 100.3% 100.9% Re-estimated recoverables - latest (2) 148.6% 191.1% 136.0% 126.1% 131.0% Net re-estimated reserves - latest (2) 96.4% 97.4% 98.1% 99.1% 99.7% Gross cumulative redundancy (deficiency) Dollars $ 3,612 $ (2,483) $ 43 $ (1,449) $ (4,518) Percentage 0.9% (0.6)% 0.0% (0.3)% (0.9)% (1) Shown as a percentage of reserves for losses and loss adjusting expenses. (2) Shown as a percentage of gross reserves, reinsurance recoverables and net reserves. The cumulative redundancy or deficiency represents the aggregate change in the estimates over all prior years. It should be emphasized that the table presents a run-off of balance sheet reserves rather than accident or policy year loss development. Therefore, each amount in the table includes the effects of changes in reserves for all prior years. 11 The following table reconciles the reserves for losses and loss adjusting expenses from the previous table to the amount shown on the Company's consolidated balance sheets. Year ended December 31, ---------------------------- 1997 1996 ---------- ---------- (in thousands) Loss and loss adjusting expense reserves for the property-casualty pool and Western Heritage $ 522,317 $ 503,638 Less: Loss and loss adjusting expense reserves of ALLIED Mutual 162,324 156,975 ---------- ---------- 359,993 346,663 Add: Reinsurance recoverables 18,033 15,528 ---------- ---------- Loss and loss adjusting expense reserves (GAAP) $ 378,026 $ 362,191 ========== ========== The next table sets forth a reconciliation of beginning and ending GAAP reserves for losses and loss adjusting expenses for the years indicated, net of reinsurance recoverables. The table includes property-casualty and excess & surplus lines insurance loss and loss adjusting expense reserves. Developments for losses and loss adjusting expenses on prior years is immaterial to the Company's consolidated financial statements taken as a whole. Year ended December 31, ----------------------------------------- 1997 1996 1995 ---------- ---------- ---------- (in thousands) Net reserves for losses and loss adjusting expenses at beginning of year $ 346,663 $ 324,939 $ 292,674 ---------- ---------- ---------- Incurred losses and loss adjusting expenses Provision for insured events of current year 379,952 353,675 315,956 (Decrease) increase in provision for insured events of prior years (1,853) (680) 1,984 ---------- ---------- ---------- Total incurred losses and loss adjusting expenses 378,099 352,995 317,940 ---------- ---------- ---------- Payments Losses and loss adjusting expenses attributable to insured events of current year 216,920 194,735 169,254 Losses and loss adjusting expenses attributable to insured events of prior years 147,849 136,536 116,421 ---------- ---------- ---------- Total payments 364,769 331,271 285,675 ---------- ---------- ---------- Net reserves for losses and loss adjusting expenses at end of year $ 359,993 $ 346,663 $ 324,939 ========== ========== ========== Noninsurance Operations ALLIED Group Mortgage Company (ALLIED Mortgage), purchases, originates, and services single-family residential mortgages. It acquires mortgage servicing rights from savings and loan associations, banks, other mortgage companies, and other financial institutions. The market in which ALLIED Mortgage originates mortgages is primarily Polk County, Iowa, which includes the Des Moines area. ALLIED Mortgage purchases and services mortgages on a nationwide basis. See "Business Competition." ALLIED Mortgage began operations in 1987, and by year-end 1997, its servicing portfolio included 53,078 mortgages for a total value of $2.9 billion. ALLIED Mortgage is an approved seller-servicer of mortgages guaranteed by Government National Mortgage Association, Federal National Mortgage Association, and 12 Federal Home Loan Mortgage Corporation. See "Business--Regulation." Working capital requirements are managed through short-term financing with commercial banks. See note 8 of Notes to Consolidated Financial Statements. The Company's data processing segment consists of The Freedom Group, Inc. (Freedom) and its subsidiary ALLIED Group Information Systems, Inc. (AGIS), which have a line of property-casualty and life insurance software products and data processing services which are marketed under the name "Freedom Group" primarily to nonaffiliated insurance companies. Prior to March 1, 1996, AGIS provided management information services to ALLIED Mutual, ALLIED Life Insurance Company (ALLIED Life), the Company and other company subsidiaries. These services included the processing of policies and claims, billing, rating, statistical and regulatory reporting, and recordkeeping. AGIS also provided automated systems to the property-casualty segment's agency force. Prior to March 1, 1996, the majority of the AGIS's revenues and operating profits came from affiliated companies. See note 4 of Notes to Consolidated Financial Statements. Through its direct sales force, AGIS licenses property-casualty insurance software to property-casualty insurance companies generally on a national basis. AGIS also provides certain consulting services and software maintenance services. On a nationwide basis, Freedom licenses statutory accounting insurance software to property-casualty and life insurance companies on primarily a direct sales basis. Investments The Company uses its investments to generate the majority of its operating profit and provide liquidity. Investments in fixed maturities are classified as available for sale. See note 1-"Investments" of Notes to Consolidated Financial Statements. The Company's invested assets are managed by Conning & Company, subject to restrictions on permissible investments under applicable state insurance codes and the Company's investment policies. Those policies require that the fixed maturity portfolio be invested primarily in debt obligations rated "BBB" (investment grade) or higher by Standard & Poor's Corporation (Standard & Poor's) or a recognized equivalent at the time the security is acquired by the Company. The policy also states that equity securities are to be of United States and Canadian Corporations listed on established exchanges or publicly traded in the over-the-counter market. Preferred stocks are to be comprised primarily of issues rated at least A3/A- by Standard & Poor's Corporation or Moody's. The Company monitors the investment quality of the fixed maturity portfolio subsequent to acquisition by reviewing on a quarterly basis the current debt ratings assigned to each of the securities in the fixed maturity portfolio. Fixed income securities comprised 90.1% of the Company's invested assets, 99.7% of those had a "BBB" rating or higher from Standard & Poor's (or the equivalent from Moody's) at December 31, 1997. Equity Securities comprised 8.7% of the invested assets at December 31, 1997. The portfolio contained no real estate or mortgage loans. At year-end 1997, the Company held $2.7 million of nonrated securities. Evaluation of the issuers' rating and ratings for the issuers' other securities supports management's view that the nonrated securities are investment grade. At December 31, 1997, the fair value of the Company's fixed maturity portfolio was $26.3 million over amortized cost. The carrying values of all the Company's investments in fixed maturities are reviewed for impairment on an ongoing basis. If this review indicates a decline in fair value below cost is other than temporary, the Company's carrying value in the investment is reduced to its estimated realizable value and a specific write-down is taken. Such reductions in carrying value are recognized as realized losses and charged to income. 13 The table below shows the classifications of the Company's investments at December 31, 1997. Carrying Percent value of total ---------- -------- (dollars in thousands) Fixed maturities U.S. Government obligations (1) $ 95,312 10.5% U.S. Government corporations and agencies 117,727 13.0 State municipalities and political subdivisions 400,490 44.1 Public utilities 9,747 1.1 All other corporate bonds 194,940 21.4 ---------- ----- Total fixed maturities 818,216 90.1 ---------- ----- Equity securities Common stock Public utilities 798 0.1 Banks, trusts, and insurance companies 7,534 0.8 Industrial, miscellaneous and all other 28,162 3.1 ---------- ----- 36,494 4.0 Preferred stock 42,688 4.7 ---------- ----- 79,182 8.7 Short-term investments at cost 10,846 1.2 ---------- ----- $ 908,244 100.0% ========== ===== (1) All such securities are backed by the full faith and credit of the United States Government. The following table sets forth the composition of the Company's fixed maturity investment portfolio by rating at December 31, 1997. Carrying Percent of value portfolio ---------- ---------- Rating (1) (dollars in thousands) --------- AAA $ 542,556 66.3% AA 144,456 17.7 A 116,584 14.2 BBB 11,945 1.5 Nonrated 2,675 0.3 ---------- ----- Total $ 818,216 100.0% ========== ===== (1) Ratings are assigned primarily by Standard & Poor's with remaining ratings assigned by Moody's and converted to the equivalent Standard & Poor's ratings. The following table sets forth contractual maturities in the fixed maturity investment portfolio at December 31, 1997. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Carrying Percent of value portfolio ---------- ---------- Maturity (dollars in thousands) One year or less $ 23,499 2.9% Over 1 year through 5 years 314,202 38.4 Over 5 years through 10 years 276,560 33.8 Over 10 years 42,979 5.2 ---------- ------ 657,240 80.3 Mortgaged-backed securities 160,976 19.7 ---------- ------ Total $ 818,216 100.0% ========== ====== 14 Investment results of the Company for each year in the three years ended December 31, 1997 are shown in the following table. 1997 1996 1995 ----------- ---------- --------- (dollars in thousands) Average invested assets $ 856,008 $ 784,247 $ 714,720 Investment income (1) 51,124 49,222 47,242 Average annual yield on total investments 6.0% 6.3% 6.6% Tax equivalent yield on total investments (2) 7.2% 7.4% 7.8% Realized investment gains $ 391 $ 49 $ 505 (1) Investment income is net of investment expenses and does not include realized investment gains or losses or provision for income taxes. (2) Assuming an effective tax rate of 35%. Competition The insurance subsidiaries compete in a highly competitive industry with numerous insurance companies, many of which are substantially larger and have considerably greater financial resources. Because the insurance subsidiaries operate through independent agents and such agents represent more than one company, they face competition within each agency. The insurance subsidiaries compete by underwriting criteria, pricing, automation, service, and product design. The Company believes that its management information systems and procedures for selecting and rating risks accord it a competitive advantage. Competition in the excess & surplus lines market stiffened in recent years as standard market capacity increased and prices decreased. Western Heritage competes in its chosen market (primarily in the Midwest, West, and South) with numerous insurers on the basis of service, price, and financial strength. ALLIED Mortgage, in originating residential mortgages in central Iowa and servicing residential mortgages nationally, competes through competitive pricing and service. Nationally, ALLIED Mortgage is a small-sized company servicing mortgages with remaining principal balances aggregating $2.9 billion at December 31, 1997. The largest competitors service in excess of $214 billion of mortgages. With greater capital and greater efficiencies, the larger companies have an advantage in originating and purchasing mortgages to obtain the servicing rights. ALLIED Mortgage has access to capital due to its association with the Company and competes in the purchase of servicing on the basis of price and in mortgage originations on the basis of price and quality of service. Regulation The insurance subsidiaries are subject to varying degrees of regulation and supervision in the jurisdictions in which they transact business under statutes which delegate regulatory, supervisory, and administrative powers to state insurance commissioners. Such regulation is designed generally to protect policyholders rather than investors and relates to such matters as the standards of solvency which must be met and maintained; the licensing of insurers and their agents; the nature of and examination of the affairs of insurance companies, which includes periodic market conduct and financial examinations by the regulatory authorities; annual and other reports, prepared on a statutory accounting basis, required to be filed on the financial condition of insurers for other purposes; establishment and maintenance of reserves for unearned premiums and losses and loss adjusting expenses; and requirements regarding numerous other matters. In general, the insurance subsidiaries must file all rates for insurance directly underwritten with the insurance department of each state in which they operate; reinsurance generally is not subject to rate regulation. Further, state insurance statutes typically place limitations on the amount of dividends or other distributions payable by insurance companies in order to protect their solvency. See "Management's Discussion and Analysis of Financial Condition and Results of Operations Regulations". 15 California has been the source of approximately 25% of the pool's direct written premiums for the past ten years. Proposition 103, approved by California voters in 1988, provides for a rollback of rates on premiums collected in calendar year 1989 to the extent that the insurer's return on equity for each Proposition 103 line of business exceeded 10%. The rollback liability, if any has not been finalized. Management of the Company continues to believe that the insurance subsidiaries will not be liable for any material rollback of premiums. The Company is also subject to statutes governing insurance holding company systems in various jurisdictions. Typically, such statutes require the Company periodically to file information with the state insurance regulatory authority, including information concerning its capital structure, ownership, financial condition and general business operations. Under the terms of applicable state statutes, any person or entity desiring to acquire more than a specified percentage (commonly 10%) of the Company's outstanding voting securities is required first to obtain approval from the applicable state insurance regulators. Chapter 521A of the Iowa Code relating to holding companies, to which the Company is subject, requires disclosure of transactions between the Company and its insurance subsidiaries or between an insurer and another subsidiary, that such transactions satisfy certain standards, including that they be fair, equitable, and reasonable and that certain material transactions be specifically non-disapproved by the Iowa Insurance Division. Further, prior approval by the Iowa Insurance Division is required of affiliated sales, purchases, exchanges, loans or extensions of credit, guarantees, or investments, any of which involve 5% or more of the insurer's admitted assets as of the preceding December 31st. Under insolvency or guaranty fund laws in most states in which the insurance subsidiaries and ALLIED Mutual operate, insurers doing business in those states can be assessed, up to prescribed limits, for losses incurred by policyholders as a result of the insolvency of other insurance companies. The amounts and timing of such assessments are beyond the control of the Company and generally have an adverse impact on the Company's earnings. Additionally, the insurance subsidiaries are required to participate in various mandatory pools or underwriting associations in amounts related to the amount of direct writings in the applicable state. Recently, the insurance regulatory framework has received increased scrutiny by various states, the federal government, and the National Association of Insurance Commissioners (NAIC). The NAIC has recommended to the states for adoption and implementation several regulatory initiatives designed to reduce the risk of insurance company insolvencies. None of these are expected to be significant to the Company. ALLIED Mortgage is subject to the rules and regulations of, and examination by, the United States Department of Housing and Urban Development, Federal National Mortgage Association (FNMA), and Government National Mortgage Association (GNMA) with respect to originating, processing, selling, and servicing mortgage loans. These rules and regulations, among other things, prohibit discrimination, provide for inspection and appraisals of properties, require credit reports on prospective borrowers, and sometimes fix maximum interest rates, fees, and loan amounts. GNMA requires the maintenance of specified amounts of net worth that vary with the amount of GNMA mortgage-backed securities issued by ALLIED Mortgage. There are also various state laws affecting mortgage banking operations. Relationship with ALLIED Mutual The Company is operated as a part of the ALLIED Group of insurance companies. ALLIED Mutual has operated as a mutual property-casualty insurance company since 1929. In 1971, it organized the Company as a wholly owned subsidiary and transferred to it certain assets, including the stock of AMCO, which had operated as a subsidiary of ALLIED Mutual since 1959. In 1985, the Company effected an initial public offering which then resulted in public ownership of approximately 22% of its common stock. As of December 31, 1997, ALLIED Mutual controlled 18.2% of the outstanding voting stock of ALLIED. The operations of the Company are interrelated with the operations of ALLIED Mutual. The Company and ALLIED Mutual share common executive officers, and three directors of the Company are also directors of ALLIED Mutual. For the year ended December 31, 1997, ALLIED Mutual reported, in accordance with Statutory Accounting Practices, net income of $13.7 million, a statutory combined ratio of 101.1, and admitted assets and surplus at December 31, 1997 of $576.2 million and $259.6 million, respectively. As of December 31, 1997, ALLIED Mutual's invested assets were $520.6 million. Invested assets included a fixed 16 maturity portfolio of $367.8 million (at amortized cost), of which over 98.5% was rated "BBB" or higher by Standard & Poor's or a recognized equivalent rating agency. Invested assets also included $83.7 million in equity investments in affiliates (which includes the Company, ALLIED Life Financial Corporation (ALFC), which is a 56.2% owned subsidiary of ALLIED Mutual, and AID Finance Services, Inc.). ALLIED Mutual files its statutory-basis financial reports with the state insurance departments in the territories in which it operates. The Company and ALLIED Mutual formalized their relationship by entering into an Intercompany Operating Agreement, a Pooling Agreement, and a Stock Rights Agreement. Intercompany Operating Agreement The Company, ALLIED Mutual, ALFC, and each of their respective subsidiaries are parties to an Intercompany Operating Agreement providing for the sharing of employees, office space, agency forces, data processing, and other services and facilities. The Company receives from and pays to ALLIED Mutual and its subsidiaries fees and cost reimbursements for the employees, services, and facilities provided. In determining the allocated costs to the companies, each provider of the various services (e.g., ALLIED Mutual leases office facilities, the Company leases employees etc.) attempts to set fees on a basis consistent with that which would apply in an arm's length transaction with nonaffiliates. However, there can be no assurance that the actual rates charged reflect those which would be obtained if the Company and ALLIED Mutual were not affiliated and had agreed upon rates following arm's length negotiation. See "Relationship with ALLIED Mutual Pooling Agreement" for a further discussion of expense sharing arrangements between ALLIED Mutual and the Company. The Company leases to ALLIED Mutual and certain of its subsidiaries all of the employees utilized in their operations for a fee and reimbursement of personnel costs based on certain allocation methods. The Company is obligated to provide the entire requirements for employees of ALLIED Mutual and certain of its subsidiaries, but ALLIED Mutual reserves the right to hire employees independently rather than leasing them from the Company. In 1997, 1996, and 1995, ALLIED Mutual and its subsidiaries paid the Company $2.6 million, $2.5 million, and $2.5 million, respectively, for leased employees, substantially all of which represented cost reimbursement. The Intercompany Operating Agreement (IOA) also provides for the leasing by ALLIED Mutual to the Company of substantially all of the office space utilized by the Company and its subsidiaries. ALLIED Mutual and property-casualty subsidiaries share agency forces as well as other services and facilities. The IOA contains a covenant not to compete that binds each of the Company, ALLIED Mutual, and ALFC not to engage in a business Intercompany Operating Agreement and five years thereafter. The IOA is in effect to December 31, 2004 and continues thereafter subject to any party providing two years notice that such party intends to cease participation. Termination prior to December 31, 2004 requires the Coordinating Committee's approval. Pooling Agreement The Pooling Agreement provides that ALLIED Mutual, ALLIED Property and Casualty, and Depositors cede to AMCO premiums, losses, allocated loss adjusting expenses, commissions, premium taxes, service charge income, and dividends to policyholders and assume from AMCO an amount of this pooled property-casualty business equal to their participation in the Pooling Agreement. ALLIED Mutual's crop hail business is not pooled. AMCO pays certain underwriting expenses, unallocated loss adjusting expenses, and premium collection expenses for all of the pool participants and receives a fee equal to a specified percentage of premiums as well as a performance fee based on the attainment of certain combined ratios from each of the pool participants. AMCO charges each of the other pool participants 12.85% of written premiums for underwriting services, 7.25% of earned premiums for unallocated loss adjusting expenses, and 0.75% of earned premiums for premium collection services. AMCO received pool administrative fees of $66.8 million, $61.3 million, and $55.7 million from ALLIED Mutual in 1997, 1996, and 1995, respectively. In 1997, AMCO also received a performance fee of $4.2 million from ALLIED Mutual. The administrative fees are subject to renegotiation during the term of the pooling agreement upon five years notice. The pooling agreement provides ALLIED Mutual, ALLIED Property and Casualty, and Depositors more predictable expense levels by limiting such expenses to a specified percentage of their premiums. These arrangements give AMCO opportunities to profit from the efficient administration of such underwriting, loss settlement, and premium collection activities and to provide similar services to nonaffiliated insurance companies in the future. 17 The Pooling Agreement may be terminated by a participant to the agreement on or after December 31, 2004 upon giving notice at least five years prior to the date of termination. Termination of the Pooling Agreement prior to December 31, 2004 must be approved by the Coordinating Committee. The Pooling Agreement may also be terminated or extended by ALLIED Mutual upon the occurrence of certain events. See "Relationship with ALLIED Mutual--Intercompany Operating Agreement." In addition, ALLIED Mutual, the Company, and ALFC have certain rights under the Pooling Agreement and the IOA in the event a nonaffiliated party acquires the ownership of 50% or more of the voting stock of the Company or ALFC. If such an event were to occur, ALLIED Mutual, the Company, or ALFC, as the case may be, have the right to (i) terminate such agreements upon six months notice (ii) extend the term such agreements for up to ten additional years beyond December 31, 2004, upon six months notice, or (iii) allow such agreements to continue in effect. Stock Rights Agreement The Company and ALLIED Mutual are parties to a Stock Rights Agreement, which grants certain rights to, and imposes certain restrictions on, ALLIED Mutual in respect of its holdings of the Company's common and preferred stock. This Agreement expires in 2005. Pursuant to the Stock Rights Agreement, ALLIED Mutual is entitled to nominate, and the Company is required to use its best efforts to cause the election or retention of, a number of members of the Company's Board of Directors in proportion to ALLIED Mutual's percentage ownership of the total number of shares of the Company's voting stock outstanding at the time of nomination. In addition, the Company is required to elect to its Executive Committee at least one director who has been nominated by ALLIED Mutual but who is not an officer or employee of ALLIED Mutual. The Stock Rights Agreement also restricts the ability of ALLIED Mutual to grant proxies and solicit other shareholders of the Company. Under the Stock Rights Agreement, ALLIED Mutual is prohibited from initiating or accepting a tender offer for shares of the Company's common stock except under certain conditions. The Company has a right of first refusal with respect to any sale by ALLIED Mutual of the Company's common stock, subject to certain exceptions, including a distribution of such stock to the public in a registered public offering or sale pursuant to Rule 144. ALLIED Mutual has incidental registration rights and three demand registration rights with respect to the Company's common and 6-3/4% Series preferred stock (6-3/4% Series) it owns. The limitations on ALLIED Mutual's ability to initiate, or tender shares, in a tender offer as well as the limitations on its ability to grant proxies and solicit other shareholders of the Company terminate upon a consolidation or merger of the Company with another corporation in which the Company is not the surviving corporation, a sale of substantially all of its assets, or the holding, by any person other than ALLIED Mutual, of 50% or more of the voting securities of the Company then outstanding. The Stock Rights Agreement will be suspended for as long as ALLIED Mutual holds less than 10% of the outstanding common stock and 6-3/4% Series stock of the Company. The Coordinating Committee Under the IOA, the Company, ALLIED Mutual, and ALFC have formed a Coordinating Committee comprised of two independent directors of the Company, two directors of ALLIED Mutual, and two independent directors of ALFC, none of whom serve on other ALLIED boards. All disputes arising under the IOA as well as other intercompany agreements are to be submitted to the Coordinating Committee for resolution. Decisions of this Coordinating Committee must be unanimous and are binding on the parties. Historically, all issues that have been submitted to the Coordinating Committee have been resolved by the Committee. The Company anticipates that any future issues would be similarly resolved. If an issue is not resolved by the Coordinating Committee, it will be submitted to arbitration. In such arbitration, each party to the dispute selects one arbitrator, and if such dispute involves only two parties, such arbitrators select a third arbitrator. Other Relationships Effective January 1, 1997, the Company's property-casualty subsidiaries entered into a property catastrophe reinsurance agreement with ALLIED Mutual and a nonaffiliated reinsurer. ALLIED Mutual's participation in the agreement was 90%. 18 The reinsurance agreement was an aggregate catastrophe program that covers the property-casualty segment's share of pooled losses up to $30 million in excess of $20 million in the aggregate for any one quarter or in excess of $50 million in the aggregate for any one year. See notes 4 and 6 of Notes to Consolidated Financial Statements for additional information concerning transactions between the Company and ALLIED Mutual. Prior to 1997, ALLIED Mutual's and American Re-Insurance Company's respective participation in the reinsurance agreement were 90% and 10% and covered the property-casualty segment's share of pooled losses up to $5,000,000 in excess of $5,000,000. This agreement was canceled effective December 31, 1996. Employees At December 31, 1997, the Company was the direct employer of personnel for all subsidiaries of the Company and of ALLIED Mutual and its subsidiaries other than ALFC, employing 2,646 persons. None of the Company's employees are members of a collective bargaining unit. Management believes that its employee relations are good. Item 2. Properties The majority of the real property occupied by the Company and its subsidiaries are owned or leased by ALLIED Mutual. A portion of the costs of the properties is paid by the Company. See "Relationship with ALLIED Mutual--Intercompany Operating Agreement." Management considers the properties to be adequate for its needs. The primary properties owned by ALLIED Mutual are the home office in Des Moines, Iowa, a data processing facility and claims center in Urbandale, Iowa, and regional offices in Denver, Colorado and Lincoln, Nebraska. The Company and its subsidiaries lease office space in Des Moines and Cedar Rapids, Iowa, Minneapolis, Minnesota, Lincoln, Nebraska, and Scottsdale, Arizona. Item 3. Legal Proceedings The Company is party to various lawsuits arising in the normal course of business. The Company believes the resolution of these lawsuits will not have a material adverse effect on its financial condition, results of operations, or liquidity. For a description of certain lawsuits pending against the Company, see item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," of this report which is incorporated herein by reference. Item 4. Submission of Matters to a Vote of Securities Holders During the fourth quarter of 1997 no matters were submitted to a vote of holders of ALLIED Group, Inc. stock. 19 PART II Item 5. Market for Registrant's Common Equity and Related Stockholders' Matters ALLIED Group, Inc.'s common stock traded on The New York Stock Exchange under the symbol GRP. As of December 31, 1997, there were 1,252 stockholders of record. The following table shows the high and low market prices and dividends paid per share for each calendar quarter for the two most recent years. The prices and dividends per share have been restated for the November 28, 1997 3-for-2 stock split and rounded to the nearest 1/64. First Second Third Fourth 1997 Quarter Quarter Quarter Quarter --------- ------------ ------------ ------------ ------------ High $ 25- 3/4 $ 27- 1/2 $ 35-51/64 $ 33-53/64 Low 20- 2/3 22- 5/32 25- 5/32 26- 1/4 Dividends 0.11- 1/3 0.11- 1/3 0.11- 1/3 0.12 First Second Third Fourth 1996 Quarter Quarter Quarter Quarter --------- ------------ ------------ ------------ ------------ High $ 19- 2/3 $ 19- 1/3 $ 19- 7/32 $ 22- 5/32 Low 15- 9/16 15-49/64 14-57/64 16-57/64 Dividends 0.09- 3/4 0.09- 3/4 0.09- 3/4 0.10 There are certain regulatory restrictions relating to the payment of dividends (see Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources). It is the present intention of the Board of Directors to declare quarterly cash dividends. 20 Item 6. Selected Financial Data * At or for the year ended December 31, ------------------------------------------------------------------------- 1997 1996 1995 1994 1993 ----------- ----------- ----------- ----------- ----------- (dollars in thousands, except per share data) Income Statement Data Premiums earned Personal $ 350,231 $ 311,511 $ 279,908 $ 252,916 $ 225,594 Commercial 164,072 154,700 145,930 133,816 118,728 ----------- ----------- ----------- ----------- ----------- Total property-casualty 514,303 466,211 425,838 386,732 344,322 Excess & Surplus Lines 33,294 27,314 29,661 25,786 24,014 ----------- ----------- ----------- ----------- ----------- Total 547,597 493,525 455,499 412,518 368,336 Investment income 51,124 49,222 47,242 41,070 39,030 Realized investment gains 391 49 505 2,888 1,396 Other income 65,570 53,558 49,519 50,888 73,680 ----------- ----------- ----------- ----------- ----------- Total revenues 664,682 596,354 552,765 507,364 482,442 Losses and expenses 572,770 525,043 478,917 440,665 425,685 ----------- ----------- ----------- ----------- ----------- Income from before income taxes and minority interest 91,912 71,311 73,848 66,699 56,757 Income taxes 25,973 20,227 21,471 19,074 16,835 ----------- ----------- ----------- ----------- ----------- 65,939 51,084 52,377 47,625 39,922 Minority interest in net income of consolidated subsidiary 503 --- --- --- --- ----------- ----------- ----------- ----------- ----------- Net income $ 65,436 $ 51,084 $ 52,377 $ 47,625 $ 39,922 =========== =========== =========== =========== =========== Diluted earnings per share Net income $ 2.01 $ 1.51 $ 1.54 $ 1.40 $ 1.17 =========== =========== =========== =========== =========== Realized investment gain $ .01 $ --- $ .01 $ .06 $ .02 =========== =========== =========== =========== =========== Balance Sheet Data Total investments $ 908,244 $ 819,645 $ 772,299 $ 655,906 $ 606,511 Total assets $ 1,201,233 $ 1,077,659 $ 1,010,598 $ 892,751 $ 855,525 Notes payable $ 56,938 $ 34,094 $ 39,465 $ 43,541 $ 82,459 Guarantee of ESOP obligations $ 22,380 $ 24,370 $ 26,270 $ 28,150 $ 29,500 Shares outstanding (in thousands) Preferred shares 1,827 1,827 4,820 4,981 5,070 Common shares 30,532 20,383 9,445 9,000 9,026 Other Data Book value per share $ 13.44 $ 11.59 $ 10.77 $ 8.75 $ 7.99 Closing stock price per share $ 28.63 $ 21.75 $ 16.00 $ 11.00 $ 11.67 Property-casualty wind and hail losses $ .59 $ .82 $ .60 $ .51 $ .40 Dividends paid $ .46 $ .39 $ .30 $ .27 $ .23 Return on average book value per share 16.3% 13.7% 15.9% 16.8% 16.1% Pretax investment yield 6.0% 6.3% 6.6% 6.5% 7.1% Effective tax rate 28.3% 28.4% 29.1% 28.6% 29.7% Cash dividends to closing stock price 1.6% 1.8% 1.9% 2.4% 1.9% Closing stock price to earnings ratio 14.2 14.4 10.4 7.9 10.0 Property-casualty statutory combined ratio 94.4 97.7 95.7 97.1 99.3 * Per share data have been restated to retroactively reflect the 3-for-2 stock split issued in 1997. 21 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Forward-looking Information The Private Securities Litigation Reform Act of 1995 provides a safe harbor to encourage companies to provide prospective information so long as it is identified as forward-looking and accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those discussed. Forward-looking statements are related to the plans and objectives of management for the future operations, economic performance, or projections of revenues, income, earnings per share, capital expenditures, dividends, capital structure, or other financial items. In the following discussion and elsewhere in this report, statements containing words such as expect, anticipate, believe, goal, objective, or similar words are intended to identify forward-looking statements. ALLIED Group, Inc. (the Company) undertakes no obligation to update such forward-looking statements, and it wishes to identify important factors that could cause actual results to differ materially from those projected in the forward-looking statements contained in the following discussion and elsewhere in this report. The risks and uncertainties that may affect the operations, performance, development, and results of the Company's business include but are not limited to the following: (1) heightened competition, particularly intensified price competition; (2) adverse state and federal legislation and regulations; (3) changes in interest rates causing a reduction of investment income; (4) general economic and business conditions which are less favorable than expected; (5) unanticipated changes in industry trends; (6) adequacy of loss reserves; (7) catastrophic events or the occurrence of a significant number of storms and wind and hail losses; and (8) other risks detailed herein and from time to time in the Company's other reports. Overview The following analysis of the consolidated results of operations and financial condition of the Company should be read in conjunction with the Selected Financial Data, Consolidated Financial Statements, and Notes to Consolidated Financial Statements included elsewhere herein. The Company, a regional insurance holding company, and its subsidiaries operate exclusively in the United States and primarily in the central and western states. The Company's largest segment includes three property-casualty insurance companies that write personal lines (primarily automobile and homeowners) and small commercial lines of insurance. The other reportable segment is excess & surplus lines insurance. The property-casualty insurance segment accounted for 85.7% of consolidated revenues in 1997 and 86.5% in 1996. At December 31, 1997, The ALLIED Group Employee Stock Ownership Trust (ESOP Trust) owned 24.9% and ALLIED Mutual Insurance Company (ALLIED Mutual), an affiliated property-casualty insurance company, controlled 18.2% of the outstanding voting stock of the Company. The Board of Directors authorized a 3-for-2 stock split issuable November 28, 1997 to common stockholders of record on November 14, 1997. All fractional shares were paid in cash. All share and per share amounts included throughout this report have been restated to reflect the stock split. On December 31, 1997, the Company adopted Statement of Financial Accounting Standard 128, "Earnings per Share." The adoption of SFAS 128 changed the way earnings per share are calculated and required restatement of amounts in prior periods. All per share amounts included throughout this report have been restated to reflect the adoption of SFAS 128. See notes 1 and 17 of Notes to Consolidated Financial Statements for a further discussion of earnings per share. The operating results of the property-casualty insurance industry are subject to significant fluctuations from quarter to quarter and from year to year due to the effects of the competition on pricing, the frequency and severity of losses incurred in connection with weather-related and other catastrophic events, the general economic conditions, and other factors such as changes in tax laws and the regulatory environment. 22 1997 Compared with 1996 Consolidated revenues for 1997 were $664.7 million, up 11.5% over the $596.4 million reported for 1996. The increase was primarily due to the 11% growth in earned premiums and in other income, which rose 22.4%. Other income includes service charges and other miscellaneous income in the property-casualty segment and total revenues generated by noninsurance operations. Income before income taxes increased 28.9% to $91.9 million from $71.3 million for 1996. The improvement was due primarily to revenue growth and only a slight increase in losses for the year ended December 31, 1997. Wind and hail losses decreased 28.7% to $27.9 million from $39.1 million in 1996. Net income for the year ended December 31, 1997 was up 28.1% to $65.4 million, raising diluted earnings per share to $2.01 from $1.51 in 1996. Diluted earnings per share excluding net realized investment gains were $2.00 for 1997 compared with $1.51. On a diluted basis, the impact of wind and hail losses was $0.59 per share versus $0.82 in 1996. Book value per share at December 31, 1997 increased to $13.44 from $11.59 at year-end 1996. Higher dividend payments and the stock repurchase program had a dilutive effect on book value during 1997 that was ameliorated by larger unrealized gains in the investment portfolio. The fair value of investments in fixed maturities was $26.3 million above amortized cost compared with $17.1 million above amortized cost at December 31, 1996. If investments in fixed maturities were reported at amortized cost, book value per share at December 31, 1997 would have been $12.88 compared with $11.23 at December 31, 1996. Property-casualty Pooled net written premiums (including ALLIED Mutual's) totaled $835.4 million, an 8.9% increase over 1996 production. Growth in personal lines net written premiums was 11.2% for 1997. The average premium per policy for personal lines was up 3.5% to $618 while the policy count grew 6%. Commercial lines premiums grew by 4.1%. The average premium per policy for commercial lines increased 3.7% to $1,152, and policy count was up 3%. Earned premiums for the property-casualty segment were 68.1% personal lines and 31.9% commercial lines in 1997. The business mix for 1996 was 66.8% personal and 33.2% commercial lines. Revenues for the property-casualty segment increased 10.4% to $569.4 million from $515.7 million for 1996. Direct earned premiums for the segment were $568.2 million for 1997 compared with $497.1 million one year earlier. Earned premiums increased 10.3% to $514.3 million from $466.2 million. The increase resulted primarily from growth in insurance exposure as well as from a larger average premium per policy. Investment income for 1997 was $44.3 million compared with $42.3 million for 1996. The pretax yield on invested assets was 6%, down from 6.3% one year earlier. Investment income increased due to a larger average balance of invested assets in 1997, which more than offset the decrease experienced in the pretax yield. Realized investment gains for 1997 were $96,000 compared with $180,000. Other income increased to $10.7 million from $7 million in 1996. The 1997 amount included a $4.2 million performance fee paid by ALLIED Mutual to AMCO as pool administrator. See note 4 of the Notes to Consolidated Financial Statements for a discussion of the reinsurance pooling agreement. Income before income taxes increased 37.8% to $81.9 million from $59.4 million in 1996. The improvement was due to revenues that increased faster than losses, which increased only slightly because of lower wind and hail loss experience in 1997. Since 1996 wind and hail experience was the worst on record, the 1997 improvement was anticipated. The statutory combined ratio (after policyholder dividends) improved to 94.4 from the 97.7 reported in 1996, primarily due to a 2.5-point decrease in the loss and loss adjusting expense ratio. The Company's underwriting expense ratio also improved 0.8 points. Wind and hail losses decreased to $27.9 million from 23 $39.1 million in 1996, which accounted for a 3-point improvement in the loss and loss adjusting ratio. The impact of wind and hail losses on the statutory combined ratio was 5.4 points for 1997 and 8.4 points for 1996. The 1997 underwriting gain, on a generally accepted accounting principles basis (GAAP), rose to $26.8 million from the previous year's $9.9 million. The personal auto statutory combined ratio decreased to 94.5 from 98.9 for 1996, reflecting a 3.4-point improvement in the loss and loss adjusting expense ratio. The statutory combined ratio for the homeowners line was 96.7 compared with 102.4 for 1996. The impact of wind and hail losses on the homeowners combined ratio was 15.4 points in 1997 and 23.6 points in 1996. Overall, the personal lines statutory combined ratio improved to 95.1 from 99.8 in 1996. The statutory combined ratio for commercial lines decreased slightly to 93.1 from 93.5 for the previous year. Excess & Surplus Lines Earned premiums for 1997 increased to $33.3 million from $27.3 million for 1996. Net written premiums were up 19.8% to $34.1 million from $28.4 million. The segment's major product lines all experienced increases in net written premiums due to intensified marketing efforts and the addition of 19 new agencies (a 27.1% increase) over the last 24 months. The segment's 1997 book of business was comprised of 3.1% personal and 96.9% commercial lines; the 1996 business mix was 2.8% personal and 97.2% commercial lines. The segment's invested assets rose 8.7% from the previous year-end to $113.5 million at December 31, 1997. Investment income increased 9% to $6.8 million from $6.2 million because a larger average balance of invested assets more than offset a 20 basis-point decline in the pretax yield to 6.2% from the previous year's 6.4%. Realized investment losses were $4,000 compared with gains of $2,000 for the year ended December 31, 1996. The statutory combined ratio (after policyholder dividends) was 90.2, which produced a GAAP underwriting gain of $3.2 million. The statutory combined ratio of 92.5 for 1996 resulted in a GAAP underwriting gain of $1.8 million. The 1997 growth in earned premiums outpaced the increase in losses and loss adjusting expenses, resulting in a 2.8-point improvement in the loss and loss adjusting expense ratio. Income before income taxes for 1997 increased 24.3% to $10 million from $8.1 million. The increase was primarily due to top line growth. Noninsurance Operations Revenues for the noninsurance operations (including mortgage banking, data processing, and employee leasing to affiliates) after eliminations increased 17.2% to $55.2 million from $47.1 million in 1996. The increase was primarily due to a 35.4% increased in data processing revenues to $23 million from $17 million. In 1997, outside sales increased $1.8 million and license fees to nonaffiliates were up $ 4.3 million . On a consolidated basis, revenues from nonaffiliates for the noninsurance operations are reported as other income. Income before income taxes was $29,000 for the year ended December 31, 1997 compared with $3.8 million in 1996. The increase in operating costs, primarily in the data processing operations and the holding company, more than offset the increase in revenues for the noninsurance operations. Investments and Investment Income The investment policy for the Company's insurance segments requires that the fixed maturity portfolio be invested primarily in debt obligations rated investment grade (BBB) or higher by Standard & Poor's Corporation or a recognized equivalent at the time of acquisition. The policy also states that equity securities are to be of United States and Canadian corporations listed on established exchanges or publicly traded in the over-the-counter market. Preferred stocks are to be comprised primarily of issues rated at least A3/A- by Standard & Poor's Corporation or Moody's. At December 31, 1997, the Company's investment portfolios consisted almost exclusively of fixed income securities and equity securities 90.1% and 8.7%, respectively. The ratings on 99.7% of the fixed income securities were investment grade or higher at December 31, 1997. The portfolios contained no real estate or mortgage loans at December 31, 1997. 24 Consolidated invested assets were up 10.8% to $908.2 million from $819.6 million at year-end 1996. Fixed maturities at amortized cost increased 2.2%. Consolidated investment income increased 3.9% to $51.1 million from $49.2 million in 1996. The increase was due primarily to a larger average balance of invested assets. The tax-equivalent yield was down in 1997 to 7.0% compared with 7.2% one year earlier due to lower short- and intermediate-term interest rates on investments. The aftertax yield for 1997 and 1996 was 4.6% and 4.7%, respectively. Income Taxes The Company's effective income tax rate was down slightly to 28.3% from 28.4% for 1996. The decrease was the result of the decline in operating results of subsidiaries that have higher statutory tax rates. Higher 1997 consolidated operating income increased the income tax expense 28.4% to $26 million. 1996 Compared with 1995 Consolidated revenues for 1996 were $596.4 million, up 7.9% over the $552.8 million reported for 1995. The increase occurred primarily because of the 8.3% growth in earned premiums. Income before income taxes decreased 3.4% to $71.3 million from $73.8 million for 1995. The decrease was due primarily to the highest ever wind and hail losses for the year ended December 31, 1996. Wind and hail losses increased 36.4% to $39.1 million from $28.7 million in 1995. Net income for the year ended December 31, 1996 was down 2.5% to $51.1 million, lowering diluted earnings per share to $1.51 from $1.54 in 1995. Diluted earnings per share excluding net realized investment gains were $1.51 for 1996 compared with $1.53. On a diluted basis, the impact of wind and hail losses was $0.82 per share versus $0.60 in 1995. Book value per share at December 31, 1996 increased to $11.59 from $10.77. The increase in book value was constrained by higher dividend payments, increased wind and hail losses, and the stock repurchase program. The fair value of investments in fixed maturities was $17.1 million above amortized cost compared with $27.8 million above amortized cost at December 31, 1995. If the investments in fixed maturities were reported at amortized cost, book value per share at December 31, 1996 would have been $11.23 compared with $10.20 at December 31, 1995. Property-casualty Revenues for the property-casualty segment increased to $515.7 million from $472 million for 1995. Direct earned premiums for the segment were $497.1 million for 1996 compared with $435.2 million for 1995. Earned premiums in 1996 increased 9.5% to $466.2 million from $425.8 million. The increase resulted primarily from growth in insurance exposure as well as a larger average premium per policy. Pooled net written premiums (including ALLIED Mutual's) totaled $767.2 million, a 10.8% increase over 1995 production. The average premium per policy for personal lines was up 4.6% to $613 while the policy count grew 8.7%. The average premium per policy for commercial lines increased 2.2% to $1,110, and policy count was up 4.3%. Earned premiums for the property-casualty segment were 66.8% personal lines and 33.2% commercial lines in 1996. The business mix for 1995 was 65.7% personal and 34.3% commercial lines. Investment income for 1996 was $42.3 million compared with $39.1 million in 1995. The pretax yield on invested assets was 6.3%, down from 6.4%. Investment income increased due to a larger average balance of invested assets, which more than offset the decrease experienced in the pretax yield. Realized investment gains were $180,000 compared with $236,000 for 1995. Other income increased slightly to $7 million from $6.9 million. Income before income taxes decreased 7% to $59.4 million for 1996 from $63.9 million for 1995. The decrease was due primarily to higher losses and loss adjusting expenses brought on by higher wind and hail losses in the second and third quarters. 25 The statutory combined ratio (after policyholder dividends) deteriorated to 97.7 from the 95.7 reported in 1995, primarily due to a 2.6-point increase in the loss and loss adjusting expense ratio. Higher wind and hail losses accounted for 2.2 points of the deterioration. The deterioration was partially offset by a 0.5-point reduction in the Company's underwriting expense ratio achieved through improved efficiency and productivity. Wind and hail losses increased to $39.1 million from $28.7 million in 1995. The impact of wind and hail losses on the statutory combined ratio was 8.4 points for 1996 and 6.7 points for 1995. The 1996 GAAP underwriting gain was $9.9 million compared with $17.7 million for 1995. The personal auto statutory combined ratio increased to 98.9 from 96.5 for 1995, reflecting a 2.8-point increase in the loss and loss adjusting expense ratio. The statutory combined ratio for the homeowners line was 102.4 compared with 99.2 for 1995. Wind and hail losses increased the homeowners combined ratio 23.6 points in 1996 and 21.7 points in 1995. Overall, the personal lines statutory combined ratio deteriorated to 99.8 from 97.2. The statutory combined ratio for commercial lines increased to 93.5 from 92.7 for the prior year. Excess & Surplus Lines Earned premiums for 1996 decreased to $27.3 million from $29.7 million for 1995, primarily because of higher reinsurance costs. Direct earned premiums were nearly flat at $37.6 million compared with $37.2 million. Net written premiums were down 7.2% to $28.4 million from $30.6 million, reflecting a continuing soft market and management's decision not to sacrifice underwriting results for premium growth. For the year ended December 31, 1996, the segment's book of business was comprised of 2.8% personal and 97.2% commercial lines. For 1995, the business mix was 2.4% personal and 97.6% commercial lines. The segment's invested assets rose 8.3% from the previous year-end to $104.4 million at December 31, 1996. Investment income increased 7% to $6.2 million from $5.8 million because a larger average balance of invested assets more than offset a decline in the pretax yield of 30 basis points to 6.4% from the prior year's 6.7%. Realized investment gains were $2,000 compared with losses of $136,000 for 1995. The statutory combined ratio (after policyholder dividends) was 92.5, which produced an underwriting gain (on a generally accepted accounting principles basis) of $1.8 million. The statutory combined ratio of 102.2 for 1995 resulted in an underwriting loss of $855,000. The 1996 combined ratio improved primarily because of a 21.8% decrease in losses and loss adjusting expenses (11.4 points on the combined ratio). The decrease in the loss and loss adjusting expense ratio was primarily due to favorable loss development in 1996. Income before income taxes for 1996 increased 66.4% to $8.1 million from $4.8 million for the previous year. The increase was primarily due to favorable loss development. Noninsurance Operations Revenues for the noninsurance operations increased 3.8% to $47.1 million from $45.4 million in 1995. The increase was primarily due to higher data processing revenues. Income before income taxes was $3.8 million for 1996 compared with $5.1 million for 1995. Effective March 1, 1996, personnel of the Company previously providing computer-related services to a certain affiliate were employed by the affiliate. Since the effective date, those employees have been paid directly by the affiliate. Investments and Investment Income At December 31, 1996 the Company's investment portfolios consisted almost exclusively of fixed income securities; 99.7% were rated investment grade or higher. The portfolios contained no real estate or mortgage loans at December 31, 1996. Consolidated invested assets were up 6.1% to $819.6 million from $772.3 million at year-end 1995. Fixed maturities at amortized cost increased 6.7%. Consolidated investment income increased 4.2% to $49.2 million from $47.2 million in 1995. The increase was due primarily to a larger average balance of invested assets. The tax-equivalent yield was down in 1996 to 7.2% from 7.6% in 1995. The aftertax yield for 1996 and 1995 was 4.7% and 4.9%, respectively. 26 Income Taxes The Company's effective income tax rate for 1996 was 28.4% compared with 29.1% for 1995. The decrease in the effective rate was due primarily to a higher percentage of income from tax-exempt securities. The income tax expense decreased 5.8% to $20.2 million. Liquidity and Capital Resources Substantial cash inflows for the Company are generated from premiums, pool administration fees, investment income, and proceeds from sales and maturities of investments. The principal outflows of cash are payments of claims, commissions, premium taxes, operating expenses, and income taxes and the purchase of fixed income and equity securities. In developing its strategy, the Company establishes a level of cash and highly liquid short- and intermediate-term securities that, combined with expected cash flow, is believed adequate to meet anticipated short-term and long-term payment obligations. In 1997, operating activities generated cash flows of $94.2 million; in 1996, the total was $95.1 million; in 1995, the total was $97.9 million. For each year, the primary source of funds was from premiums written in the property-casualty insurance operations. In 1997, the funds generated from operating activities were primarily used to purchase fixed maturities and equity securities, repurchase the Company's common stock, and pay cash dividends. In 1996 and 1995, the funds generated from operating activities in those years were primarily used to purchase investment-grade securities and to repurchase the Company's common stock. The net cash used in investing activities in 1997, 1996, and 1995 was $79.2 million, $65.7 million, and $88.8 million, respectively. In 1997, 1996, and 1995, the Company paid dividends of $17.5 million, $16.3 million, and $13.5 million, respectively. Dividend payments to common stockholders totaled $14 million for the year ended December 31, 1997, up from $12.2 million and $6.3 million in 1996 and 1995, respectively. In each year, dividends of $3.5 million on the 6-3/4% Series Preferred Stock was paid. In 1996 and 1995, dividends paid on the ESOP Series Preferred Stock (ESOP Series) were $595,000 and $3.7 million, respectively. The increase in dividends to common shareholders and the decrease in dividends on the ESOP Series were due to the conversion of the ESOP Series completed on March 7, 1996. See note 10 of the Notes to Consolidated Financial Statements for a further discussion of the conversion. Prior to the conversion, the Company and the ESOP Trustee entered into an agreement whereby the Company agreed to release additional shares held by the ESOP Trustee if the dividend paid on common stock is less than $0.09 per share per quarter on a post-split basis. The agreement is in effect from March 7, 1996 through March 7, 2000. The agreement ensures that the allocated shares in the ESOP Trust receive at least the same amount of dividends that would have been paid on the ESOP Series shares had they not been converted to common stock. The Company relies primarily on dividends from its insurance subsidiaries to pay preferred and common stock dividends to shareholders. During 1997, the Company received dividend payments of $16.2 million from the property-casualty subsidiaries and $836,000 from noninsurance subsidiaries. During 1996 and 1995, the property-casualty subsidiaries paid the Company dividends of $23.7 million and $12 million, respectively; noninsurance subsidiaries paid dividends of $916,000 and $974,000, respectively. The Iowa state insurance regulations restrict the maximum amount of dividends the property-casualty subsidiaries can pay without prior regulatory approval. The maximum dividend allowed is the greater of either 10% of the subsidiary's statutory capital stock and surplus as of the preceding December 31 or net income of the preceding calendar year. In 1998 the maximum amount legally available for distribution to the Company without prior approval is $54.5 million. The excess & surplus lines subsidiary is domiciled in Arizona and operates under Arizona state laws. The maximum amount available for distribution as dividends from the excess & surplus lines subsidiary is limited to the lesser of 10% of stockholders' surplus as of the preceding December 31 or net investment income of the preceding year. The excess & surplus lines segment could pay $4 million in 1998 without prior notice to the insurance commissioner. The Company anticipates the excess & surplus lines segment will not pay dividends in 1998. 27 In 1997 and 1996, the Company repurchased $10.2 million and $16.5 million of its common stock, respectively. No shares were repurchased in 1995. During 1997, the Company repurchased 412,850 shares of its common stock on the open market at an average price per share of $24.77. The first 85,500 shares were repurchased under a program approved by the Board of Directors (Board) on July 16, 1996 and completed March 13, 1997. An additional 327,350 shares were repurchased under a program approved by the Board March 4, 1997 and completed December 4, 1997. During 1996, the Company canceled 664,500 shares of its common stock purchased on the open market at an average price per share of $24.87. The Company guaranteed the ESOP Trust's obligations under the terms of a Term Credit Agreement and Guaranty. See note 9 of Notes to Consolidated Financial Statements for a discussion of ESOP obligations. At December 31, 1997, the balance of the obligations was $22.4 million. Contributions plus dividends on leveraged shares held by the ESOP are used by the ESOP Trust to service the ESOP obligations. Dividends and payments for the employee lease fees from its subsidiaries are used by the Company to fund the amounts paid to the ESOP Trust. The Company made contributions to the ESOP Trust of $312,000 in 1997, $529,000 in 1996, and $733,000 in 1995. The Company paid dividends of $3.6 million in 1997, $3.5 million in 1996, and $2.8 million in 1995, which were used for such debt service. In connection with its guarantee of ESOP obligations, the Company is required to maintain minimum stockholders' equity and to comply with certain other financial covenants. Historically, the insurance subsidiaries have generated sufficient funds from operations to pay their claims. While the property-casualty and excess & surplus lines insurance companies have maintained adequate investment liquidity, they have in the past required additional capital contributions to support premium growth. Industry guidelines suggest that a property-casualty insurer's annual net written premiums should not exceed approximately 300% of statutory surplus. At December 31, 1997, the property-casualty and excess & surplus lines segments' net written premiums were 160% and 84% of their statutory surplus, respectively. Management anticipates that short-term and long-term capital expenditures, cash dividends, and operating cash needs will be met from existing capital and internally generated funds. As of December 31, 1997, the Company had no material commitments for capital expenditures. Future debt and stock issuance will be considered as additional capital needs arise. The method of funding will depend upon financial market conditions. Insurance premiums are established before the amount of losses and loss adjusting expenses or the extent to which inflation may affect such expenses is known. Consequently, the Company attempts to anticipate the impact of inflation in establishing premiums. Inflation is implicitly considered in the determination of reserves for losses and loss adjusting expenses since portions of the reserves are expected to be paid over extended periods of time. The importance of continually reviewing reserves is even more pronounced in periods of extreme inflation. The Company's mortgage banking subsidiary, ALLIED Group Mortgage Company (ALLIED Mortgage), has separate credit agreements to support its operations. Short-term and long-term notes payable to nonaffiliated companies are used by ALLIED Mortgage to finance its mortgage loans held for sale, to purchase servicing rights, and to purchase short-term investments. These notes payable are not guaranteed by the Company. At December 31, 1997, ALLIED Mortgage had short-term borrowings of $39 million, which are to be repaid through the subsequent sale of its mortgage loan inventory. The amount of short-term borrowings fluctuates daily depending on the level of inventory being financed. Long-term borrowings amounted to $10.5 million to be repaid over the next seven years. See note 8 of Notes to Consolidated Financial Statements for a further discussion of ALLIED Mortgage's finance arrangements. In the normal course of its business, ALLIED Mortgage also makes commitments to buy and sell securities that may result in credit and market risk in the event the counterparty is unable to fulfill its obligation. See note 14 of Notes to Consolidated Financial Statements for a further discussion of such commitments. At its March 3, 1998 meeting, the Board approved a first-quarter 1998 common stock dividend of $0.13 per share. The dividend is $0.01 per share (8.3%) higher than the amount paid in the fourth quarter of 1997. 28 Year 2000 The Company began converting its computer systems to be year 2000 compliant in 1996 and anticipates completion by the end of 1998. The Company actively monitors its progress and plans to start retesting applications in the spring of 1998. The costs associated with year 2000 are expensed as incurred; the Company does not expect such costs to have a material effect on its future financial position or results of operations. The Company's data processing segment has a line of property-casualty and life insurance software products which it markets to affiliated and nonaffiliated insurance companies. Management believes the segment's products are year 2000 compliant while operating in the Company's environment and will continue to retest the products throughout 1998. The segment's customers have been advised to test the software products in their operating environment for year 2000 compliance. Management believes any exposure to material liability was remote as of December 31, 1997. Contingencies California has been the source of approximately 25% of the pool's direct written premiums for the past ten years. Proposition 103, approved by California voters in 1988, provides for a rollback of rates on premiums collected in calendar year 1989 to the extent that the insurer's return on equity for each Proposition 103 line of business exceeded 10%. The rollback liability, if any, has not been finalized. Management continues to believe the insurance subsidiaries will not be liable for any material rollback of premiums. On December 31, 1997, a complaint was filed by Mary M. Rieff, a policyholder of ALLIED Mutual, in the Iowa District Court in and for Polk County Iowa, against the Company and certain other individuals who are or were officers and/or directors of ALLIED Mutual and the Company. The complaint, an alleged policyholder derivative action brought on behalf of ALLIED Mutual, asserts, among other things, (a) that the defendants were responsible for the inappropriate transfer of ALLIED Mutual's corporate assets, the seizure of certain corporate opportunities, and the implementation of an improper de facto demutualization without informing or compensating policyholders or receiving the appropriate approval from regulatory authorities; (b) that this allegedly wrongful demutualization began on or about January 1, 1985 and was accomplished through transfers of ALLIED Mutual's assets to the Company and to the individual defendants for inadequate consideration; (c) that the individual defendants breached fiduciary duties owed to ALLIED Mutual, wasted its corporate assets, and intentionally interfered with its contracts, prospective business advantage, and business relationships; and (d) that the defendants improperly transferred substantial ownership of and control over the Company and ALLIED Mutual's insurance business. The complaint further asserts that as a result of the foregoing, ALLIED Mutual and its policyholders have suffered damages in excess of $500 million. The complaint requests an accounting of the assets allegedly wrongfully transferred to the Company and compensation to ALLIED Mutual for the value of such assets, for the seizure of corporate opportunities, and for the de facto demutualization of ALLIED Mutual. The complaint also asks for certain other relief, including attorneys' fees and costs, equitable relief and interest, and restitution for any assets wrongfully transferred or conveyed. The Company believes the suit is without merit and intends to defend this action vigorously. As is the case in all pending actions, the ultimate outcome is uncertain. 29 Item 8. Financial Statements and Supplementary Data Management Representation The management of ALLIED Group, Inc. is responsible for the integrity and fair presentation of the consolidated financial statements, related notes, and all other information presented herein. The statements were prepared in accordance with generally accepted accounting principles and include amounts that are based on management's best estimates and judgments. Management maintains a system of internal control designed to provide reasonable assurance as to the integrity and reliability of the financial statements, the protection of assets from unauthorized use or disposition, the prevention and detection of fraudulent financial reporting, and the appropriate division of responsibility. In addition, the Company's internal audit department systematically reviews these controls, evaluates their adequacy and effectiveness, and reports thereon. Management has considered internal audit recommendations and those of KPMG Peat Marwick LLP and has in its opinion responded appropriately to those recommendations. Management believes that as of December 31, 1997 the Company's system of internal control is adequate to accomplish the objectives discussed herein. The Company's financial statements have been audited by KPMG Peat Marwick LLP, independent certified public accountants. The audit was conducted in accordance with generally accepted auditing standards, which included consideration of the Company's system of internal control to the extent necessary to form an independent opinion on the financial statements prepared by management. The audit committee of the Board of Directors, composed solely of outside directors, oversees management's discharge of its financial reporting responsibilities. The committee meets periodically with management, internal auditors, and representatives of KPMG Peat Marwick LLP to discuss auditing, financial reporting, and internal control matters. Both internal and independent auditors have access to the audit committee without management's presence. /s/ Jamie H. Shaffer - ------------------------------------- Jamie H. Shaffer Chief Financial Officer 30 Report of Independent Auditors The Board of Directors and Stockholders ALLIED Group, Inc. We have audited the accompanying consolidated balance sheets of ALLIED Group, Inc. and subsidiaries as of December 31, 1997 and 1996 and the related consolidated statements of income and comprehensive income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based upon o