Allied Group: Form 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 Form 10-K --------- ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1996 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 28, 1997 the number of Registrant's Common Stock, no par value, outstanding was 20,398,117. The aggregate market value of the Common Stock of the Registrant held by nonaffiliates at February 28, 1997 was $668,516,603. Documents Incorporated By Reference The Registrant's definitive proxy statement (1997 Proxy Statement), which will be filed with the Securities and Exchange Commission within 120 days after December 31, 1996, is incorporated by reference under Part III. The index to the exhibits is located on page 74. This document contains 142 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 Stockholder 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......................28 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.......................................57 Part III Item 10.Directors and Executive Officers of the Registrant..................58 Item 11.Executive Compensation..............................................58 Item 12.Security Ownership of Certain Beneficial Owners and Management......58 Item 13.Certain Relationships and Related Transactions......................58 Part IV Item 14.Exhibits, Financial Statement Schedules, and Reports on Form 8-K....59 Index to Financial Statement Schedules.......................................59 Signatures...................................................................73 Index to Exhibits............................................................74 3 Part I Item 1. Business ALLIED Group, Inc. (ALLIED) was incorporated in 1971 as an Iowa corporation and operates as a regional insurance holding company headquartered in Des Moines, Iowa. ALLIED and its subsidiaries (collectively, the Company) operate exclusively in the United States and primarily in the central and western states. At year-end 1996, The ALLIED Group Employee Stock Ownership Trust owned 26.5% and ALLIED Mutual Insurance Company (ALLIED Mutual), an affiliated property-casualty insurance company, controlled 18.3% of the outstanding voting stock of ALLIED. The Company has two reportable business segments: property-casualty insurance and excess & surplus lines insurance. Property-casualty insurance was the most significant segment in 1996, accounting for 86.5% of consolidated revenues. The Company's segment information is contained in note 17 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 property-casualty subsidiaries and to ALLIED Mutual for 1996 with respect to their financial strength and their ability to meet policyholder and other contractual obligations based on the review of the pool's 1995 statutory results and operating performance. The profitability of the property-casualty segment is affected by many factors, including industry price competition, the severity and frequency of weather-related claims, 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 2,250 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, 1996, 66.8% 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. 4 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 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 contingent 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 1996, 1995, and 1994. As of December 31, 1996, the statutory capital and surplus of ALLIED Mutual and AMCO was $231.5 million and $223.3 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, ------------------------------------------- 1996 1995 1994 ----------- ---------- ----------- (dollars in thousands) Reinsurance pool percentage 64% 64% 64% Net written premiums $ 488,189 $ 440,838 $ 403,066 =========== ========== ========== Earned premiums $ 466,211 $ 425,838 $ 386,732 Losses and loss adjusting expenses 335,615 295,583 268,302 Underwriting expenses 124,622 114,511 110,259 ----------- ---------- ---------- Statutory underwriting gain 5,974 15,744 8,171 GAAP adjustments 3,965 1,943 1,637 ----------- ---------- ---------- GAAP underwriting gain 9,939 17,687 9,808 Investment income excluding realized gains 42,296 39,110 35,279 Realized investment gains 180 236 2,956 Other income 7,020 6,850 6,143 ----------- ---------- ---------- Income before income taxes $ 59,435 $ 63,883 $ 54,186 =========== ========== ========== Statutory combined ratio 97.7 95.7 97.1 Wind and hail losses, net of reinsurance $ 39,111 $ 28,664 $ 24,383 Impact of wind and hail losses on combined ratio 8.4 6.7 6.3 Invested assets $ 710,629 $ 658,044 $ 565,490 Loss and loss adjusting expense reserves, net of reinsurance $ 297,343 $ 277,819 $ 252,608 Statutory capital and surplus $ 285,854 $ 257,845 $ 233,407 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, ------------------------------------------------------------------------------ 1996 1995 1994 ------------------------ ------------------------ ------------------------- 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 $ 229,894 98.9 $ 208,873 96.5 $ 192,712 97.4 Homeowners 81,617 102.4 71,035 99.2 60,204 107.4 ----------- ---------- ---------- Personal lines 311,511 99.8 279,908 97.2 252,916 99.8 ----------- ---------- ---------- Commercial automobile 25,272 98.8 23,873 95.2 22,384 98.4 Workers' compensation 25,499 76.5 29,443 70.2 28,251 83.3 Other property and liability 101,591 97.3 90,302 100.2 80,908 94.0 Other lines 2,338 45.7 2,312 50.2 2,273 66.6 ----------- ---------- ---------- Commercial lines 154,700 93.5 145,930 92.7 133,816 92.0 ----------- ---------- ---------- Total $ 466,211 97.7 $ 425,838 95.7 $ 386,732 97.1 =========== ========== ========== 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, ------------------------------- 1996 1995 1994 ----- ----- ----- Statutory combined ratio - ------------------------ Loss ratio 62.6 60.1 60.1 Loss adjusting expense ratio 9.4 9.3 9.3 Underwriting expense ratio 25.5 26.0 27.3 Dividend ratio 0.2 0.3 0.4 ----- ----- ----- Total 97.7 95.7 97.1 ===== ===== ===== Impact of wind and hail losses on the statutory combined ratio - --------------------------------- Personal automobile 3.9 1.8 2.1 Homeowners 23.6 21.7 21.5 Personal lines 9.1 6.8 6.7 Commercial lines 7.1 6.5 5.5 Total 8.4 6.7 6.3 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, ----------------------------------------- 1996 1995 1994 ---------- ---------- ---------- (dollars in thousands) Direct written premiums by distribution system ---------------------------------------------- Independent agency system $ 549,598 $ 503,922 $ 479,351 Exclusive agency system 210,648 180,799 148,777 Direct response marketing system 28,437 22,136 18,418 ---------- ---------- ---------- Total direct written premiums, excluding crop hail premiums 788,683 706,857 646,546 Crop hail premiums (non-pooled) 7,049 7,781 6,024 ---------- ---------- ---------- Total direct written premiums $ 795,732 $ 714,638 $ 652,570 ========== ========== ========== Agency counts ------------- Independent agencies 2,000 1,968 1,910 Exclusive agencies 257 192 164 Net written premiums $ 773,593 $ 699,608 $ 638,301 Net earned premiums $ 739,251 $ 676,169 $ 612,799 The following table sets forth the geographic percentage distribution of property-casualty pool (including ALLIED Mutual) direct written premiums for the years indicated. 1996 1995 1994 ------ ------ ------ California 24.5% 24.0% 24.0% Iowa 21.7 23.3 24.6 Kansas 8.1 8.4 8.4 Nebraska 7.4 7.9 8.1 Minnesota 7.3 7.6 7.9 Missouri 4.8 4.8 4.8 Colorado 3.6 3.6 3.5 Illinois 3.5 3.1 2.8 Utah 2.9 2.5 2.2 Tennessee 2.7 2.4 2.2 Washington 2.3 2.1 1.7 Other * 11.2 10.3 9.8 ------ ------ ------ 100.0% 100.0% 100.0% ====== ====== ====== *Includes all other states, none of which accounted for more than 2% in 1996. 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 1996 based on the review of their 1995 statutory results and operating performance. For 1996, Western Heritage's net earned premiums were 64.1% specialty commercial casualty, 9.2% commercial property, 23.9% commercial transportation, and 2.8% 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; agricultural and contractor equipment; and protection against vandalism. 7 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, -------------------------------------------- 1996 1995 1994 ----------- ----------- ----------- (dollars in thousands) Net written premiums $ 28,417 $ 30,606 $ 27,026 =========== =========== =========== Earned premiums $ 27,314 $ 29,661 $ 25,786 Losses and loss adjusting expenses 17,484 22,357 18,568 Underwriting expenses 8,106 8,202 7,536 ----------- ----------- ----------- Statutory underwriting gain (loss) 1,724 (898) (318) GAAP adjustments 86 43 100 ----------- ----------- ----------- GAAP underwriting gain (loss) 1,810 (855) (218) Investment income excluding realized gains 6,241 5,830 5,241 Realized investment gains (losses) 2 (135) (24) ----------- ----------- ----------- Income before income taxes $ 8,053 $ 4,840 $ 4,999 =========== =========== =========== Statutory combined ratio 92.5 102.2 99.9 Invested assets $ 104,403 $ 96,435 $ 79,588 Loss and loss adjusting expense reserves, net of reinsurance $ 49,319 $ 47,120 $ 40,066 Statutory capital and surplus $ 33,478 $ 27,770 $ 23,896 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, ---------------------------------------------------------------------------- 1996 1995 1994 ------------------------ ------------------------ ----------------------- Net Statutory Net Statutory Net Statutory earned combined earned combined earned combined premiums ratio premiums ratio premiums ratio ----------- --------- ----------- --------- ----------- --------- (dollars in thousands) Commercial casualty $ 17,508 92.1 $ 22,031 103.9 $ 20,800 103.5 Commercial property 2,513 70.2 2,676 91.2 2,579 80.5 Commercial transportation 6,538 103.7 4,254 98.6 1,682 101.8 Personal lines 755 86.9 700 115.1 725 60.4 ----------- ----------- ----------- Total $ 27,314 92.5 $ 29,661 102.2 $ 25,786 99.9 =========== =========== =========== 8 The following table sets forth the geographic percentage distribution of excess & surplus lines direct written premiums for the years indicated. 1996 1995 1994 ----- ----- ----- Texas 25.0% 23.3% 23.9% Illinois 8.6 9.9 10.9 California 8.0 8.8 11.9 Florida 5.5 7.2 8.4 Oklahoma 4.0 4.3 4.0 Alabama 3.9 3.1 1.5 Missouri 3.9 3.0 1.2 Louisiana 3.2 3.0 3.6 Hawaii 3.0 3.7 3.7 Colorado 2.9 2.8 2.5 Mississippi 2.9 2.6 1.2 Connecticut 2.8 0.6 --- Ohio 2.7 2.9 2.4 Arkansas 2.0 2.5 1.6 Indiana 2.0 1.9 2.1 Other* 19.6 20.4 21.1 ----- ----- ----- 100.0% 100.0% 100.0% ===== ===== ===== *Includes all other states, none of which accounted for more than 2% in 1996 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 ALLIED Mutual and American Re-Insurance Company property catastrophe reinsurance agreement. 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 1996, the pool liability limit of the cover is 90% of $120,000,000 with retention of $10,000,000. 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, purchases surplus share 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 purchases 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 purchases 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. 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, 1996, there were no past due amounts from reinsurers. 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 arisen. 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, 1996. Management continues to monitor legal developments as they relate to the Company's exposure to environmental claims. The following table presents the development of losses and loss adjusting expense reserves for 1986 to 1995 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 10 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, ------------------------------------------------------------------------------------------------------------ 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- -------- (dollars in thousands) Reserves for losses and loss adjusting expenses, net $126,150 $160,152 $210,746 $248,870 $280,443 $312,089 $355,092 $386,936 $424,595 $471,247 $503,638 Paid (cumulative) as of (1) 1 year later 42.7% 47.5% 41.7% 43.6% 44.2% 43.6% 40.1% 40.8% 39.9% 43.1% 2 years later 68.8 70.8 64.0 65.8 67.2 66.3 61.9 60.7 61.7 3 years later 84.0 85.8 77.2 79.3 80.4 79.8 72.6 73.2 4 years later 93.3 93.6 84.1 86.3 88.5 86.0 78.8 5 years later 98.2 97.9 87.7 91.5 92.5 89.6 6 years later 100.7 101.0 90.2 94.1 95.2 7 years later 103.3 102.8 92.1 96.0 8 years later 104.8 104.3 93.6 9 years later 106.7 106.0 10 years later 108.5 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 102.7 103.6 98.3 100.4 101.0 100.2 97.7 98.3 100.1 100.0 2 years later 104.2 106.3 97.6 99.6 101.1 101.1 96.8 98.9 98.9 3 years later 106.9 106.8 97.3 99.6 102.6 102.4 97.2 97.4 4 years later 107.9 107.1 97.5 101.5 104.6 103.1 96.3 5 years later 107.8 107.8 98.1 103.4 105.7 102.9 6 years later 108.7 108.9 99.3 104.5 105.7 7 years later 109.9 110.5 100.4 104.8 8 years later 111.7 111.8 100.7 9 years later 113.2 112.1 10 years later 113.2 Net cumulative redundancy (deficiency) Dollars $(16,694) $(19,400) $ (1,370) $(11,872) $(16,098) $ (8,953) $ 13,043 $ 9,887 $ 4,875 $ (187) Percentage (13.2)% (12.1)% (0.7)% (4.8)% (5.7)% (2.9)% 3.7% 2.6% 1.1% (0.0)% Gross reserves - end of year $373,958 $400,912 $447,311 $492,304 $522,366 Reinsurance recoverables 18,866 13,976 22,716 21,057 18,728 -------- -------- -------- -------- -------- Net reserves - end of year $355,092 $386,936 $424,595 $471,247 $503,638 ======== ======== ======== ======== ======== Gross re-estimated reserves - latest (2) 98.3% 100.1% 100.2% 100.5% Re-estimated recoverables - latest (2) 135.7% 173.9% 125.6% 110.2% Net re-estimated reserves - latest (2) 96.3% 97.4% 98.9% 100.0% Gross cumulative redundancy Dollars $ 6,315 $ (435) $ (942) $ (2,341) Percentage 1.6% (0.1)% (0.2)% (0.5)% (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. 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, ---------------------------- 1996 1995 ---------- ---------- (in thousands) Loss and loss adjusting expense reserves for the property-casualty pool and Western Heritage $ 503,638 $ 471,247 Less: Loss and loss adjusting expense reserves of ALLIED Mutual 156,975 146,308 ---------- ---------- 346,663 324,939 Add: Reinsurance recoverables 15,528 16,925 ---------- ---------- Loss and loss adjusting expense reserves (GAAP) $ 362,191 $ 341,864 ========== ========== 11 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, ----------------------------------------- 1996 1995 1994 ---------- ---------- ---------- (in thousands) Net reserves for losses and loss adjusting expenses at beginning of year $ 324,939 $ 292,674 $ 268,050 ---------- ---------- ---------- Incurred losses and loss adjusting expenses Provision for insured events of current year 353,675 315,956 288,574 (Decrease) increase in provision for insured events of prior years (680) 1,984 (1,630) ---------- ---------- ---------- Total incurred losses and loss adjusting expenses 352,995 317,940 286,944 ---------- ---------- ---------- Payments Losses and loss adjusting expenses attributable to insured events of current year 194,735 169,254 151,479 Losses and loss adjusting expenses attributable to insured events of prior years 136,536 116,421 110,841 ---------- ---------- ---------- Total payments 331,271 285,675 262,320 ---------- ---------- ---------- Net reserves for losses and loss adjusting expenses at end of year $ 346,663 $ 324,939 $ 292,674 ========== ========== ========== 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, the Resolution Trust Corporation, 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 1996, its servicing portfolio included 51,125 mortgages for a total value of $2.8 billion. ALLIED Mortgage is an approved seller-servicer of mortgages guaranteed by Government National Mortgage Association, Federal National Mortgage Association, and 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. ALLIED'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, affiliated and nonaffiliated, insurance companies. Prior to March 1, 1996, AGIS provided management information services to ALLIED Mutual, ALLIED Life Insurance Company (ALLIED Life), ALLIED 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. 12 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 stock is 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 96.7% 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, 1996. The portfolio contained no real estate or mortgage loans. At year-end 1996, 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, 1996, the fair value of the Company's fixed maturity portfolio was $17.1 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. The table below shows the classifications of the Company's investments at December 31, 1996. Carrying Percent value of total ---------- -------- (dollars in thousands) Fixed maturities U.S. Government obligations (1) $ 102,819 12.5% U.S. Government corporations and agencies 129,328 15.8 State municipalities and political subdivisions 336,720 41.1 Foreign governments 2,086 0.3 Public utilities 11,956 1.5 All other corporate bonds 209,359 25.5 ---------- ----- Total fixed maturities 792,268 96.7 Equity securities 20,384 2.5 Short-term investments at cost 6,993 0.8 ---------- ----- $ 819,645 100.0% ========== ===== (1) All such securities are backed by the full faith and credit of the United States Government. 13 The following table sets forth the composition of the Company's fixed maturity investment portfolio by rating at December 31, 1996. Carrying Percent of value portfolio ---------- ---------- Rating (1) (dollars in thousands) --------- AAA $ 538,846 68.0% AA 113,653 14.4 A 128,120 16.2 BBB 8,952 1.1 Nonrated 2,697 0.3 ---------- ----- Total $ 792,268 100.0% ========== ===== (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, 1996. 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 $ 52,335 6.6% Over 1 year through 5 years 267,058 33.7 Over 5 years through 10 years 285,887 36.1 Over 10 years 16,759 2.1 ---------- ------ 622,039 78.5 Mortgaged-backed securities 170,229 21.5 ---------- ------ Total $ 792,268 100.0% ========== ====== Investment results of the Company for each year in the three years ended December 31, 1996 are shown in the following table. 1996 1995 1994 ---------- ---------- ---------- (dollars in thousands) Average invested assets $ 784,247 $ 714,720 $ 627,677 Investment income (1) 49,222 47,242 41,070 Average annual yield on total investments 6.3% 6.6% 6.5% Tax equivalent yield on total investments (2) 7.4% 7.8% 7.9% Realized investment gains $ 49 $ 505 $ 2,888 (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 industry is highly competitive. The insurance subsidiaries compete 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 14 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 (approximately 40 states 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 $2.8 billion at December 31, 1996. The largest competitors service in excess of $205 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 ALLIED 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" and note 13 of Notes to Consolidated Financial Statements for a discussion of dividend limitations. Until January 1997, AMCO and ALLIED Property and Casualty were also commercially domiciled insurers within the State of California and subject to regulation (including limitations on dividend payments) as California domiciled insurers by the California Insurance Commissioner. California was 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. ALLIED is also subject to statutes governing insurance holding company systems in various jurisdictions. Typically, such statutes require ALLIED 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 ALLIED'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 ALLIED is subject, requires disclosure of transactions between the ALLIED 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. 15 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 ALLIED 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, ALLIED effected an initial public offering which then resulted in public ownership of approximately 22% of its common stock. As of December 31, 1996, ALLIED Mutual controlled 18.3% of the outstanding voting stock of ALLIED. The operations of the Company are interrelated with the operations of ALLIED Mutual. ALLIED and ALLIED Mutual share common executive officers, and three directors of ALLIED are also directors of ALLIED Mutual. For the year ended December 31, 1996, ALLIED Mutual reported, in accordance with Statutory Accounting Practices, net income of $6.7 million, a statutory combined ratio of 107.0, and admitted assets and surplus at December 31, 1996 of $524.1 million and $231.5 million, respectively. As of December 31, 1996, ALLIED Mutual's invested assets were $474.1 million. Invested assets included a fixed maturity portfolio of $347 million (at amortized cost), of which over 98.3% was rated "BBB" or higher by Standard & Poor's or a recognized equivalent rating agency. Invested assets also included $77 million in equity investments in affiliates (which includes ALLIED, ALLIED Life Financial Corporation (ALFC), which is a 54.4% 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. ALLIED and ALLIED Mutual formalized their relationship by entering into an Intercompany Operating Agreement, a Pooling Agreement, and a Stock Rights Agreement. Intercompany Operating Agreement ALLIED, 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, ALLIED 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 ALLIED and ALLIED Mutual were not affiliated and had 16 agreed upon rates following arm's length negotiation. See "Relationship with ALLIED Mutual-Pooling Agreement" for a discussion of changes that impact expense sharing arrangements between ALLIED Mutual and ALLIED. ALLIED 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. ALLIED 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 ALLIED. In 1996, 1995, and 1994, ALLIED Mutual and its subsidiaries paid ALLIED $2.5 million, $2.5 million, and $2.4 million, respectively, for leased employees, substantially all of which represented cost reimbursement. The Intercompany Operating Agreement also provides for the leasing by ALLIED Mutual to the Company of substantially all of the office space utilized by the Company. ALLIED Mutual and ALLIED's property-casualty subsidiaries share agency forces as well as other services and facilities. The Intercompany Operating Agreement contains a covenant not to compete that binds each of ALLIED, ALLIED Mutual, and ALFC not to engage in a business Intercompany Operating Agreement and five years thereafter. The Intercompany Operating Agreement 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. In addition, ALLIED Mutual, ALLIED, and ALFC have certain rights under the Pooling Agreement and the Intercompany Operating Agreement 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, ALLIED, 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. 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 contingent 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 $61.3 million, $55.7 million, and $50.4 million from ALLIED Mutual in 1996, 1995, and 1994, respectively. 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 in lieu of the prior arrangement, where such expenses were allocated based on the pool participation percentages. 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. 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." 17 Stock Rights Agreement ALLIED 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 ALLIED's common and preferred stock. This Agreement expires in 2005. Pursuant to the Stock Rights Agreement, ALLIED Mutual is entitled to nominate, and ALLIED is required to use its best efforts to cause the election or retention of, a number of members of ALLIED's Board of Directors in proportion to ALLIED Mutual's percentage ownership of the total number of shares of ALLIED's voting stock outstanding at the time of nomination. In addition, ALLIED 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 ALLIED. Under the Stock Rights Agreement, ALLIED Mutual is prohibited from initiating or accepting a tender offer for shares of ALLIED's common stock except under certain conditions. ALLIED has a right of first refusal with respect to any sale by ALLIED Mutual of ALLIED'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 ALLIED'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 ALLIED terminate upon a consolidation or merger of the ALLIED with another corporation in which ALLIED 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 ALLIED then outstanding. The 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 ALLIED. The Coordinating Committee Under the Intercompany Operating Agreement, ALLIED, ALLIED Mutual, and ALFC have formed a Coordinating Committee comprised of two independent directors of ALLIED, two directors of ALLIED Mutual, and two independent directors of ALFC, none of whom serve on other ALLIED boards. All disputes arising under the Intercompany Operating Agreement 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. ALLIED 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 ALLIED Mutual participates with American Re-Insurance Company in a property catastrophe reinsurance agreement covering the property-casualty segment's share of pooled losses. In 1996, 1995, and 1994, 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. See notes 4 and 6 of Notes to Consolidated Financial Statements for additional information concerning transactions between the Company and ALLIED Mutual. Employees At December 31, 1996, ALLIED was the direct employer of personnel for all subsidiaries of ALLIED and of ALLIED Mutual and its subsidiaries other than ALFC, employing 2,398 persons. None of ALLIED's employees are members of a collective bargaining unit. Management believes that its employee relations are good. 18 Item 2. Properties The majority of the real property occupied by the Company 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 Santa Rosa, California regional office building is leased by ALLIED Mutual. 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. Item 4. Submission of Matters to a Vote of Securities Holders During the fourth quarter of 1996 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 Effective February 11, 1997, ALLIED Group, Inc.'s common stock began trading on The New York Stock Exchange under the symbol GRP. During 1996, the Company's common stock traded on The Nasdaq Stock Market under the symbol ALGR during 1996. As of December 31, 1996, there were 1,179 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 29, 1996 3-for-2 stock split and rounded to the nearest 1/64. - -------------------------------------------------------------------------------- First Second Third Fourth 1996 Quarter Quarter Quarter Quarter --------- ---------- ---------- ---------- ---------- High $ 29- 1/2 $ 29 $ 28-53/64 $ 33- 1/4 Low 23-11/32 23-21/32 22-11/32 25-11/32 Dividends 0.14-2/3 0.14-2/3 0.14-2/3 0.15 First Second Third Fourth 1995 Quarter Quarter Quarter Quarter --------- ---------- ---------- ---------- ---------- High $ 19-11/64 $ 20-11/64 $ 22 $ 24- 1/2 Low 15-17/32 18-11/64 18-11/32 21 Dividends 0.11-1/3 0.11-1/3 0.11-1/3 0.11-1/3 - -------------------------------------------------------------------------------- There are certain regulatory restrictions relating to the payment of dividends (see note 13 of Notes to Consolidated Financial Statements). 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, -------------------------------------------------------------------------- 1996 1995 1994 1993 1992 ------------ ----------- ---------- ---------- ---------- (in thousands, except per share data) Income Statement Data Premiums earned Personal $ 311,511 $ 279,908 $ 252,916 $ 225,594 $ 191,059 Commercial 154,700 145,930 133,816 118,728 101,364 ------------ ----------- ---------- ---------- ---------- Total property-casualty 466,211 425,838 386,732 344,322 292,423 Excess & Surplus Lines 27,314 29,661 25,786 24,014 27,738 ------------ ----------- ---------- ---------- ---------- Total 493,525 455,499 412,518 368,336 320,161 Investment income 49,222 47,242 41,070 39,030 32,716 Realized investment gains 49 505 2,888 1,396 1,975 Other income 53,558 49,519 50,888 73,680 91,739 ------------ ----------- ---------- ---------- ---------- Total revenues 596,354 552,765 507,364 482,442 446,591 Losses and expenses 525,043 478,917 440,665 425,685 407,584 ------------ ----------- ---------- ---------- ---------- Income from before income taxes 71,311 73,848 66,699 56,757 39,007 Income taxes 20,227 21,471 19,074 16,835 10,332 ------------ ----------- ---------- ---------- ---------- Net income $ 51,084 $ 52,377 $ 47,625 $ 39,922 $ 28,675 ============ =========== ========== ========== ========== Fully diluted earnings per share Net income $ 2.31 $ 2.35 $ 2.12 $ 1.74 $ 1.29 ============ =========== ========== ========== ========== Realized investment gain $ .01 $ .02 $ .09 $ .04 $ .06 ============ =========== ========== ========== ========== Property-casualty wind and hail losses $ 1.23 $ .90 $ .77 $ .60 $ .49 ============ =========== ========== ========== ========== Dividends paid $ .59 $ .45 $ .40 $ .34 $ .29 ============ =========== ========== ========== ========== Balance Sheet Data Total investments $ 819,645 $ 772,299 $ 655,906 $ 606,511 $ 460,038 Total assets 1,077,659 1,010,598 892,751 855,525 688,488 Notes payable 34,094 39,465 43,541 82,459 66,543 Guarantee of ESOP obligations 24,370 26,270 28,150 29,500 30,590 Other Data Pool percentage 64% 64% 64% 64% 60% Book value per share $ 17.39 $ 16.16 $ 13.12 $ 11.98 $ 9.56 Closing stock price per share $ 32.63 $ 24.00 $ 16.50 $ 17.50 $ 14.11 Return on average book value per share 14.0% 16.1% 16.9% 15.9% 14.2% Pretax investment yield 6.3% 6.6% 6.5% 7.1% 7.6% Pretax profit on revenues 12.0% 13.4% 13.1% 11.8% 8.7% Effective tax rate 28.4% 29.1% 28.6% 29.7% 26.5% Cash dividends to closing stock price 1.8% 1.9% 2.4% 1.9% 2.0% Closing stock price to earnings ratio 14.1 10.2 7.8 10.1 10.9 Property-casualty statutory combined ratio 97.7 95.7 97.1 99.3 102.5 Shares outstanding Preferred shares 1,827 4,820 4,981 5,070 5,141 Common shares 20,383 9,445 9,000 9,026 4,469 * Per share data has been restated to retroactively reflect the 3-for-2 stock split issued in 1996. 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, of 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. (ALLIED) 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 ALLIED'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 ALLIED's other reports. Overview The following analysis of the consolidated results of operations and financial condition of ALLIED should be read in conjunction with the Selected Financial Data and Consolidated Financial Statements and related footnotes included elsewhere herein. ALLIED, a regional insurance holding company, and its subsidiaries (collectively, the Company) 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 86.5% of consolidated revenues in 1996 and 85.4% in 1995. At December 31, 1996, The ALLIED Group Employee Stock Ownership Trust (ESOP Trust) owned 26.5% and ALLIED Mutual Insurance Company (ALLIED Mutual), an affiliated property-casualty insurance company, controlled 18.3% of the outstanding voting stock of ALLIED. The Board of Directors authorized a 3-for-2 stock split issuable November 29, 1996 to common stockholders of record on November 15, 1996. 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. 1996 Compared to 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. 22 Net income for the year ended December 31, 1996 was down 2.5% to $51.1 million, lowering fully diluted earnings per share to $2.31 from $2.35 in 1995. Fully diluted earnings per share excluding net realized investment gains were $2.30 for 1996 compared with $2.33. On a fully diluted basis, the impact of wind and hail losses was $1.23 per share versus $0.90 in 1995. Book value per share at December 31, 1996 increased to $17.39 from $16.16. The increase in book value was constrained by higher dividend payments, increased wind and hail losses, and the share 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 $16.85 compared with $15.29 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 one year earlier. Earned premiums 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) 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. The pretax yield on invested assets was 6.3%, down from 6.4% one year earlier. Investment income increased due to a larger average balance of invested assets in 1996, which more than offset the decrease experienced in the pretax yield. Realized investment gains for 1996 were $180,000 compared with $236,000. Other income increased slightly to $7 million from $6.9 million in 1995. Income before income taxes decreased 7% to $59.4 million from $63.9 million. The decrease was due primarily to higher losses and loss adjusting expenses in 1996, brought on by higher wind and hail losses in the second and third quarters. 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 underwriting gain (on a generally accepted accounting principles basis) 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 in 1995. The statutory combined ratio for commercial lines increased to 93.5 from 92.7 for the previous 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. 23 The subsidiary'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 30 basis-point decline in the pretax yield to 6.4% from last 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. The increase was primarily due to favorable loss development. Noninsurance Operations Revenues for the noninsurance operations (including investment services, data processing, and employee lease fees from affiliates) decreased 8.8% to $147.2 million from $161.3 million in 1995. The decrease was primarily due to a decline in data processing revenues from affiliates. Income before income taxes was $3.8 million for the year ended December 31, 1996 compared with $5.1 million in 1995. Effective March 1, 1996, certain personnel of ALLIED 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 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, 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 7.4% compared with 7.8% one year earlier. The aftertax yield for 1996 and 1995 was 4.8 and 5%, respectively. Income Taxes The Company's effective income tax rate 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 for 1996 decreased 5.8% to $20.2 million. 1995 Compared to 1994 Consolidated revenues for 1995 were $552.8 million, up 8.9% over the $507.4 million reported for 1994. Excluding realized investment gains, revenues grew 9.5% for 1995. The increase occurred primarily because of the 10.4% growth in earned premiums. Income before income taxes was up 10.7% to $73.8 million from $66.7 million for 1994 primarily because of revenue growth and improved underwriting margins for the property-casualty segment. The property-casualty segment was the dominant contributor, generating operating income of $63.9 million. 24 Net income for the year ended December 31, 1995 was up 10% to $52.4 million, raising fully diluted earnings per share to $2.35 from $2.12. Fully diluted earnings per share before net realized investment gains were $2.33 for 1995 compared with $2.03 in 1994. Book value per share increased to $16.16 from $13.12. Property-casualty Revenues for the property-casualty segment increased to $472 million from $431.1 million for 1994. Direct earned premiums for the segment were $435.2 million for 1995 compared with $383.5 million one year earlier. Earned premiums increased 10.1% to $425.8 million from $386.7 million. The increase resulted from growth in insurance exposures as well as higher rates. Net written premiums for the pool (including ALLIED Mutual) totaled $692.6 million, a 9.4% increase over 1994 production. The average premium per policy for personal lines was up 3.4% to $586 while the policy count grew 6.5%. The average premium per policy for commercial lines increased 2% to $1,086, and policy count was up 5.3%. Earned premiums for the property-casualty segment were 65.7% personal lines and 34.3% commercial lines. The business mix for 1994 was 65.4% personal and 34.6% commercial lines. Income before income taxes increased to $63.9 million from $54.2 million primarily as a result of lower underwriting expenses in 1995 and an increase in earned premiums. Investment income was $39.1 million compared with $35.3 million. The pretax yield on invested assets was 6.4%, down from 6.6% one year earlier. Realized investment gains were $236,000 compared with $3 million. Realized investment gains for 1994 included $2.6 million from the sale of the segment's 20% interest in a savings and loan holding company. Other income increased to $6.9 million from $6.1 million in 1994. The statutory combined ratio (after policyholder dividends) improved to 95.7 from the 97.1 reported in 1994. Improvement was attributed primarily to a 1.3-point decrease in the underwriting expense ratio. The decrease was the result of the Company's continuing efforts to improve efficiency and productivity. Wind and hail losses for 1995 increased to $28.7 million from $24.4 million in 1994. The impact of wind and hail losses on the statutory combined ratio was 6.7 points for the year ended December 31, 1995 and 6.3 points for 1994. The underwriting gain (on a generally accepted accounting principles basis) was $17.7 million compared with $9.8 million for 1994. On a fully diluted basis, the impact of wind and hail losses on the results of operations was $0.90 per share versus $0.77 in 1994. The personal auto statutory combined ratio improved to 96.5 for 1995 from 97.4 for 1994. The improvement was due to a 1.4-point decrease in the underwriting expense ratio that more than offset the increase in the loss and loss adjusting expense ratio. The statutory combined ratio for the homeowners line was 99.2 compared with 107.4 for 1994. The impact of wind and hail losses on the homeowners combined ratio increased slightly to 21.7 points from 21.5 points. Results for the homeowners line were favorably affected by better pricing in 1995. Overall, the personal lines statutory combined ratio improved to 97.2 in 1995 from 99.8 in 1994. The statutory combined ratio for commercial lines increased to 92.7 from 92.0 for the previous year. Excess & Surplus Lines Earned premiums increased to $29.7 million for 1995 from $25.8 million for 1994. Net written premiums increased 13.2% to $30.6 million from $27 million. Direct earned premiums were $37.2 million compared with $32.3 million. As of December 31, 1995, the segment's book of business was comprised of 2.4% personal and 97.6% commercial lines. For 1994, the business mix was 2.8% personal and 97.2% commercial lines. The statutory combined ratio (after policyholder dividends) was 102.2, which produced an underwriting loss (on a generally accepted accounting principles basis) of $855,000. The statutory combined ratio of 99.9 for 1994 resulted in an underwriting loss of $218,000. The 1995 combined ratio increased primarily because of a 20.4% increase in losses and loss adjusting expenses (3.4 points on the combined ratio). Income before income taxes for 1995 decreased 3.2% to $4.8 million from $5 million. The decrease was due primarily to poor loss development. Realized investment losses were $136,000 compared with losses of $24,000 for 1994. 25 Investment income increased 11.2% to $5.8 million from $5.2 million. Investment income increased because a larger average balance of invested assets more than offset a 10 basis-point decline in the pretax yield from the previous year's 6.8%. Invested assets rose 21.2% from the previous year-end to $96.4 million at December 31, 1995. Noninsurance Operations Revenues for the noninsurance operations (including investment services, data processing, and employee lease fees from affiliates) increased 4.5% to $161.3 million from $154.5 million in 1994. The increase was primarily the result of an increase in employee lease fees in 1995. The increase in revenues generated from employee lease fees more than offset the decreases in revenue from investment services and data processing. Investment services was affected by a decrease in investment income brought on by a low average balance of mortgage loans held for sale, and data processing was down primarily as a result of the reduction in revenues generated from the affiliated property-casualty segment. Income before income taxes was $5.1 million for the year ended December 31, 1995 compared with $7.5 million in 1994. Fees paid to data processing for processing and product maintenance services were lowered during 1995 to approximate more closely the cost for providing such services to the property-casualty segment's companies. Investments and Investment Income Invested assets were up 17.7% to $772.3 million from $655.9 million at year-end 1994. Fixed maturities at amortized cost increased 11.2%. In 1995, the Company reclassified all fixed maturities in held to maturity to available for sale. Therefore, all fixed maturities were marked to market at December 31, 1995. Consolidated investment income increased 15% to $47.2 million from $41.1 million in 1994. The increase was due primarily to a larger average balance of invested assets. The tax-equivalent yield was down in 1995 to 7.8% compared with 7.9% one year earlier. The aftertax yield for 1995 and 1994 was 5.1%. Income Taxes The Company's effective income tax rate was 29.1% compared with 28.6% for 1994. The income tax expense for 1995 rose to $21.5 million from $19.1 million due to higher operating income and a smaller percentage of tax-exempt investment income. Regulations The insurance subsidiaries are subject to regulation and supervision by the states in which they are admitted to transact business. State insurance laws generally establish supervisory agencies with broad administrative and supervisory powers related to granting and revoking licenses to transact business, establishing guaranty fund associations, licensing agents, regulating premium rates for some lines of business, establishing reserve requirements, prescribing the form and content of required financial statements and reports, determining the reasonableness and adequacy of statutory capital and surplus, and regulating the type and amount of permitted investments. Recently, the insurance regulatory framework has received increased scrutiny from 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. None of these is expected to be significant to the Company. California was 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. 26 Liquidity and Capital Resources Substantial cash inflows for the Company are generated from premiums, pool administration fees, investment income, and proceeds from 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 1996, operating activities generated cash flows of $95.1 million; in 1995, the total was $97.9 million; in 1994, the total was $85.5 million. For each year, the primary source of funds was premium growth in the property-casualty insurance operations. In each of the years, funds generated from operating activities were primarily used to purchase investment grade fixed income securities, accounting for the majority of cash used in investing activities. The net cash used in investing activities in 1996, 1995, and 1994 was $65.7 million, $88.8 million, and $69.5 million, respectively. In 1996, 1995, and 1994, ALLIED paid dividends of $16.3 million, $13.5 million, and $12.7 million, respectively. Dividend payments to common stockholders totaled $12.2 million for the year ended December 31, 1996, up from $6.3 million and $5.4 million in 1995 and 1994, respectively. In 1996, 1995, and 1994, dividends paid on the ESOP Series Preferred Stock (ESOP Series) were $595,000, $3.7 million, and $3.8 million, respectively. In each year, dividends of $3.5 million on the 6-3/4% Series Preferred Stock were paid. The increase in dividends to common shareholders and the decrease in 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, ALLIED and the ESOP Trustee entered into an agreement whereby ALLIED agrees to release additional shares held by the ESOP Trustee if the dividend paid on common stock is less than $0.20 per share per quarter, which calculates to $0.13 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 had they not been converted to common stock. ALLIED relies primarily on dividends from its insurance subsidiaries to pay preferred and common stock dividends to stockholders. 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 1997 the maximum amount legally available for distribution to ALLIED without prior approval is $52.6 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 $3.3 million in 1997 without prior notice to the insurance commissioner. ALLIED anticipates the excess & surplus lines segment will not pay dividends in 1997. During 1996, ALLIED received dividend payments of $23.7 million from the property-casualty subsidiaries and $916,000 from noninsurance subsidiaries. During 1995 and 1994, the property-casualty subsidiaries paid ALLIED dividends of $12 million and $7.8 million, respectively; noninsurance subsidiaries paid dividends of $974,000 and $1.1 million, respectively. In 1996 and 1994, ALLIED also used funds to repurchase $16.5 million and $6.4 million of its common stock, respectively. No shares were repurchased in 1995. During 1996, ALLIED repurchased 443,000 shares of its common stock on the open market at an average price per share of $37.31, which, reflecting the November 1996 stock split, was 664,500 shares at $24.87 per share. Pursuant to SEC Rule 10b-18, the Board of Directors (Board) authorized stock repurchase programs on December 14, 1994 and July 16, 1996, each for 250,000 shares (375,000 shares on a post-split basis). The stock repurchase program the Board approved on December 14, 1994 was completed on July 15, 1996. The stock repurchase program the Board approved on July 16, 1996 is not complete; 57,000 shares remain to be repurchased. During 1994, ALLIED repurchased 250,000 shares (375,000 shares on a post-split basis) of its common stock at an average price per share of $25.44 ($16.96 on a post-split basis) under a stock repurchase program the Board approved on February 11, 1994, which was completed in November 1994. 27 ALLIED'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 ALLIED. At December 31, 1996, ALLIED Mortgage had short-term borrowings of $19.7 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 $12 million to be repaid over the next eight 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. In 1990, the ESOP Trust issued floating rate notes totaling $35 million (ESOP obligations) to acquire ESOP Series stock for the Employee Stock Ownership Plan (ESOP). In March 1995, the ESOP Trust refinanced the notes pursuant to a Term Credit Agreement and Guaranty (Agreement) with two separate commercial banks. ALLIED guaranteed the ESOP Trust's obligations under the Agreement. See note 9 of Notes to Consolidated Financial Statements for a discussion of ESOP obligations. At December 31, 1996, the balance of the obligations was $24.4 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 ALLIED to fund the amounts paid to the ESOP Trust. ALLIED made contributions to the ESOP Trust of $529,000 in 1996, $733,000 in 1995, and $35,000 in 1994. ALLIED paid dividends of $3.5 million in 1996, $2.8 million in 1995, and $2.8 million in 1994, which were used for such debt service. In connection with its guarantee of ESOP obligations, ALLIED 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, 1996, the property-casualty and excess & surplus lines segments' net written premiums were 173% and 85% 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. In 1994, additional funds of $9.4 million were generated from the sale of the 20% interest in a savings and loan holding company. In 1996, the Company received an additional $620,000 as the final payment on that 1994 sale. The payment represents the Company's share of the contingent purchase price that was distributed when all known claims were settled. As of December 31, 1996, 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. At its March 4, 1997 meeting, the Board of Directors approved a first-quarter 1997 common stock dividend of $0.17 per share. The dividend is $0.02 per share (13.3%) higher than the amount paid in the fourth quarter of 1996. 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. 28 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 of 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, 1996 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 29 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, 1996 and 1995 and the related consolidated statements of income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1996. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based upon our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ALLIED Group, inc. and subsidiaries as of December 31, 1996 and 1995 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1996 in conformity with generally accepted accounting principles. /s/ KPMG Peat Marwick LLP - ---------------------------------- KPMG Peat Marwick LLP Des Moines, Iowa February 3, 1997 30 ALLIED Group, Inc. and Subsidiaries Consolidated Balance Sheets (in thousands) December 31, ------------------------------ 1996 1995 ------------- ------------- Assets Investments (note 2) Fixed maturities at fair value (note 3) $ 792,268 $ 754,547 Equity securities at fair value (note 3) 20,384 7,948 Short-term investments at cost (notes 3 and 4) 6,993 9,802 Other investments at equity --- 2 ------------- ------------- Total investments 819,645 772,299 Cash 1,067 1,465 Accrued investment income 11,563 10,467 Accounts receivable 84,706 76,118 Current income taxes recoverable (note 16) 2,878 1,330 Reinsurance receivables for losses and loss adjusting expenses 18,183 19,293 Mortgage loans held for sale (notes 2 and 8) 12,054 13,673 Deferred policy acquisition costs 46,671 41,688 Prepaid reinsurance premiums 7,838 6,784 Mortgage servicing rights (note 8) 33,094 35,705 Other assets 39,960 31,776 ------------- ------------- Total assets $ 1,077,659 $ 1,010,598 ============= ============= See accompanying Notes to Consolidated Financial Statements. 31 December 31, ------------------------------ 1996 1995 ------------- ------------- Liabilities Losses and loss adjusting expenses (notes 5 and 6) $ 362,191 $ 341,864 Unearned premiums 220,596 196,461 Indebtedness to affiliates (note 4) 2,130 1,019 Notes payable to nonaffiliates (notes 2 and 8) 31,744 35,965 Notes payable to affiliates (notes 2 and 4) 2,350 3,500 Guarante