Allied Group: 10-Q for Quarter ended 9/30/97 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 Form 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 1997 Commission File Number 0-14243 ALLIED Group, Inc. (Exact name of registrant as specified in its charter) Iowa (State or other jurisdiction of incorporation or organization) 42-0958655 (I.R.S. Employer Identification No.) 701 Fifth Avenue, Des Moines, Iowa (Address of principal executive offices) 50391-2000 (Zip Code) 515-280-4211 (Registrant's telephone number, including area code) 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 the number of shares outstanding of each of the issuer's classes of common stock, as of October 31, 1997: 20,375,535 shares of Common Stock. 2 PART I Item 1. Financial Statements ALLIED Group, Inc. and Subsidiaries Consolidated Balance Sheets September 30, December 31, 1997 1996 -------------- ------------- (in thousands) Assets Investments Fixed maturities at fair value (amortized cost $780,998 in 1997 and $775,166 in 1996) $ 803,462 $ 792,268 Equity securities at fair value (cost $56,230 in 1997 and $17,880 in 1996) 64,460 20,384 Short-term investments at cost (note 2) 10,101 6,993 -------------- ------------- Total investments 878,023 819,645 Cash 1,515 1,067 Accrued investment income 11,448 11,563 Accounts receivable 92,612 84,706 Current income taxes recoverable 2,592 2,878 Reinsurance receivables for losses and loss adjusting expenses 26,838 18,183 Mortgage loans held for sale (note 3) 24,119 12,054 Deferred policy acquisition costs 51,056 46,671 Prepaid reinsurance premiums 8,866 7,838 Mortgage servicing rights 34,851 33,094 Other assets 33,646 39,960 -------------- ------------- Total assets $ 1,165,566 $ 1,077,659 ============== ============= . See accompanying Notes to Interim Consolidated Financial Statements. 3 ALLIED Group, Inc. and Subsidiaries Consolidated Balance Sheets September 30, December 31, 1997 1996 -------------- ------------- (in thousands) Liabilities Losses and loss adjusting expenses $ 373,338 $ 362,191 Unearned premiums 241,559 220,596 Indebtedness to affiliates 1,827 2,130 Notes payable to nonaffiliates (note 3) 42,293 31,744 Notes payable to affiliates (note 2) 4,475 2,350 Guarantee of ESOP obligations 24,180 24,370 Deferred income taxes 4,540 2,244 Other liabilities 61,836 61,443 -------------- ------------- Total liabilities 754,048 707,068 -------------- ------------- Stockholders' equity Preferred stock, no par value, issuable in series, authorized 7,500 shares 6-3/4% Series, 1,827 shares issued and outstanding 37,812 37,812 Common stock, no par value, $1 stated value, authorized 80,000 shares, issued and outstanding 20,327 shares in 1997 and 20,383 shares in 1996 (note 4) 20,327 20,383 Additional paid-in capital 122,188 126,078 Retained earnings 230,609 195,276 Unrealized appreciation of investments (net of deferred income tax of $10,840 in 1997 and $6,907 in 1996) 19,854 12,699 Unearned compensation related to ESOP (19,272) (21,657) -------------- ------------- Total stockholders' equity 411,518 370,591 -------------- ------------- Total liabilities and stockholders' equity $ 1,165,566 $ 1,077,659 ============== ============= See accompanying Notes to Interim Consolidated Financial Statements. 4 ALLIED Group, Inc. and Subsidiaries Consolidated Statements of Income Three Months Ended Nine Months Ended September 30, September 30, ------------------------------ ------------------------------- 1997 1996 1997 1996 ------------ ------------ ------------ ------------ (in thousands, except per share data) Revenues Earned premiums $ 137,816 $ 124,246 $ 405,559 $ 364,229 Investment income 12,968 12,444 38,494 36,608 Realized investment gains 17 26 17 65 Other income (note 2) 15,365 14,003 44,547 39,737 ------------ ------------ ------------ ------------ 166,166 150,719 488,617 440,639 ------------ ------------ ------------ ------------ Losses and expenses Losses and loss adjusting expenses 94,725 89,279 277,414 265,317 Amortization of deferred policy acquisition costs 30,298 27,063 89,005 79,888 Other underwriting expenses 5,151 4,359 15,033 14,226 Other expenses 12,801 9,356 38,749 29,451 Interest expense 454 381 1,217 1,151 ------------ ------------ ------------ ------------ 143,429 130,438 421,418 390,033 ------------ ------------ ------------ ------------ Income before income taxes and minority interest 22,737 20,281 67,199 50,606 ------------ ------------ ------------ ------------ Income taxes Current 6,182 5,579 20,791 13,485 Deferred 341 243 (1,630) 1,166 ------------ ------------ ------------ ------------ 6,523 5,822 19,161 14,651 ------------ ------------ ------------ ------------ Income before minority interest 16,214 14,459 48,038 35,955 Minority interest in net income of consolidated subsidiary 147 --- 374 --- ------------ ------------ ------------ ------------ Net income $ 16,067 $ 14,459 $ 47,664 $ 35,955 ============ ============ ============ ============ Net income applicable to common stock $ 15,188 $ 13,580 $ 45,028 $ 32,724 ============ ============ ============ ============ Earnings per share Primary $ .75 $ .67 $ 2.22 $ 1.71 ============ ============ ============ ============ Fully diluted $ .75 $ .67 $ 2.22 $ 1.61 ============ ============ ============ ============ See accompanying Notes to Interim Consolidated Financial Statements. 5 ALLIED Group, Inc. and Subsidiaries Consolidated Statements of Cash Flows Nine Months Ended September 30, ------------------------------- 1997 1996 ------------ ------------ (in thousands) Cash flows from operating activities Net income $ 47,664 $ 35,955 Adjustments to reconcile net income to net cash provided by operating activities Realized investment gains (17) (65) Depreciation and amortization 9,586 8,037 Indebtedness with affiliates (303) 1,825 Accounts receivable, net (16,561) (7,604) Accrued investment income 115 (496) Deferred policy acquisition costs (4,385) (4,835) Mortgage loans held for sale, net (1,826) (4,859) Other assets 1,467 (2,837) Losses and loss adjusting expenses 11,147 13,443 Unearned premiums, net 19,935 22,544 Cost of ESOP shares allocated 2,385 1,709 Current income taxes 279 (23) Deferred income taxes (1,630) 1,166 Other, net (2,420) 3,576 ------------ ------------ Net cash provided by operating activities 65,436 67,536 ------------ ------------ Cash flows from investing activities Purchase of fixed maturities (114,061) (173,170) Purchase of equity securities (38,696) (7,824) Purchase of equipment (5,023) (7,079) Sale of fixed maturities 45,087 64,168 Maturities, calls, and principal reductions of fixed maturities 64,017 81,263 Sale of equity securities 354 554 Short-term investments, net (3,108) (295) Sale of equipment 284 116 ------------ ------------ Net cash used in investing activities (51,146) (42,267) ------------ ------------ Cash flows from financing activities Notes payable to nonaffiliates, net 310 1,810 Notes payable to affiliates, net 2,125 (545) Issuance of common stock 4,500 1,638 Repurchase of common stock (7,354) (16,525) Minority interest in additional paid-in capital (1,092) --- Dividends paid to stockholders, net of income tax benefit (12,331) (11,561) ------------ ------------ Net cash used in financing activities (13,842) (25,183 ------------ ------------ Net increase in cash 448 86 Cash at beginning of year 1,067 1,465 ------------ ------------ Cash at end of quarter $ 1,515 $ 1,551 ============ ============ See accompanying Notes to Interim Consolidated Financial Statements. 6 ALLIED Group, Inc. and Subsidiaries Notes to Interim Consolidated Financial Statements (1) Summary of Significant Accounting Policies The accompanying interim consolidated financial statements include the accounts of ALLIED Group, Inc. (the Company) and its subsidiaries. The interim consolidated financial statements have been prepared in conformity with generally accepted accounting principles (GAAP) and include all adjustments which are, in the opinion of management, necessary for fair presentation of the results for the interim periods. All such adjustments are of a normal and recurring nature. All significant intercompany balances and transactions have been eliminated. The accompanying interim consolidated financial statements should be read in conjunction with the following notes and with the Notes to Consolidated Financial Statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 1996. At September 30, 1997, The ALLIED Group Employee Stock Ownership Trust (ESOP Trust) owned 25.3% and ALLIED Mutual Insurance Company (ALLIED Mutual), an affiliated property-casualty insurance company, controlled 18.4% of the outstanding voting stock of the Company. Minority interest The minority interest in a consolidated subsidiary represents the minority common stockholders' proportionate share of the net assets and results of operations of the majority-owned mortgage banking subsidiary. Options exercised by key employees of the mortgage banking subsidiary resulted in a 20% ownership in the outstanding common stock of the subsidiary on January 2, 1997. No additional options are outstanding. The minority interest in the subsidiary was $2.2 million at September 30, 1997 and is included in other liabilities. This transaction did not have a material impact on the Company's financial position, results of operations, or liquidity. Earnings per share The Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) 128, "Earnings per Share" in February of 1997. SFAS 128 specifies the computation, presentation, and disclosure requirements for earnings per share (EPS) for entities with publicly-held common stock effective for annual periods ending after December 15, 1997. Early application is not permitted, but pro forma disclosure is allowed under SFAS 128. Presented below are the pro forma EPS that the Company would have reported for the period ended September 30, 1997 and 1996. Three Months Ended Nine Months Ended September 30, September 30, -------------------------- -------------------------- 1997 1996 1997 1996 ----------- ----------- ----------- ----------- Basic EPS $ .75 $ .67 $ 2.22 $ 1.71 Diluted EPS $ .74 $ .65 $ 2.18 $ 1.58 7 (2) Transactions with Affiliates Pursuant to the terms of the Intercompany Operating Agreement, the Company leases employees to ALLIED Mutual and certain of its subsidiaries. Each company that leases employees is charged a fee based upon costs incurred for salaries, related benefits, taxes, and expenses associated with the employees it leases. For the nine months ended September 30, 1997 and 1996, the Company received revenues of $1.9 million and $1.9 million for employees leased to affiliates, respectively, which are included in other income. Subsidiaries of the Company provide data processing and other services for ALLIED Mutual and its subsidiaries. Included in other income are revenues of $1.9 million and $1 million relating to services performed for ALLIED Mutual and its subsidiaries for the first nine months of 1997 and 1996, respectively. Effective January 1, 1997, the Company's property-casualty subsidiaries entered into a property catastrophe reinsurance agreement with ALLIED Mutual and a nonaffiliated reinsurer. ALLIED Mutual's participation in the agreement is 90%. The reinsurance agreement is an aggregate catastrophe program that covers the property-casualty segment's share of pooled losses up to $30 million in excess of $20 million in the aggregate for any one quarter or in excess of $50 million in the aggregate for any one year. Premiums paid by the property-casualty segment to ALLIED Mutual were $2.2 million in the first nine months of 1997. The segment had recoveries of $2 million from ALLIED Mutual under the agreement in the first nine months of 1997. Prior to 1997, ALLIED Mutual participated with a nonaffiliated reinsurance company in a property catastrophe reinsurance agreement that covered the property-casualty segment's share of pooled losses up to $5 million in excess of $5 million. ALLIED Mutual's and the reinsurance company's participation in such agreement was 90% and 10%, respectively. Effective December 31, 1996, this agreement was canceled. Premiums paid by the property-casualty segment to ALLIED Mutual were $2.2 million in the first nine months of 1996. There were recoveries from ALLIED Mutual under this agreement of $3.3 million in the first nine months of 1996. The Company and its subsidiaries invests excess cash in a short-term investment fund with other affiliated companies. The fund was established to concentrate short-term cash in a single account to maximize yield. AID Finance Services, Inc., a wholly-owned subsidiary of ALLIED Mutual, is the fund administrator. At September 30, 1997, the Company and its subsidiaries had $6 million invested in the fund and had several short-term unsecured notes payable to the fund totaling $4.5 million. The interest rate on the borrowings was 8.8%. The Company had interest income from affiliates of $372,000 and $360,000 in the first nine months of 1997 and 1996, respectively. Interest paid to affiliates was $281,000 and $211,000 in the first nine months of 1997 and 1996, respectively. (3) Notes Payable to Nonaffiliates At September 30, 1997, the mortgage banking subsidiary had borrowed $31.5 million under the terms of three separate mortgage loan warehousing agreements with different commercial banks. These notes payable are not guaranteed by the Company. Under the terms of the agreements, the subsidiary can borrow up to the lesser of $67 million or 98% of the mortgage credit borrowing base. The outstanding borrowings were secured by $24.1 million of pledged mortgage loans held for sale, mortgage servicing rights on loans with a principal balance of $2.9 billion, and foreclosure loans. Interest rates applicable to the mortgage loan warehousing agreements vary with the level of investable deposits maintained at the respective commercial banks. 8 The mortgage banking subsidiary also had $10.5 million of 8.4% senior secured notes outstanding as of September 30, 1997. The notes are payable to a nonaffiliated life insurance company and are secured by pledged mortgage servicing rights. The notes are payable in equal annual installments of $1.5 million each September 1, with interest payable semi-annually. The final installment and interest is due September 1, 2004. The Federal Home Loan Bank of Des Moines provides a $3 million committed credit facility through a line of credit agreement with AMCO Insurance Company (AMCO) that expires February 27, 1998. Interest on any outstanding borrowings is payable at an annual rate equal to the federal funds unsecured rate for Federal Reserve member banks, which was 6.5% at September 30, 1997. AMCO had an outstanding balance under this line of credit of $310,000 at September 30, 1997. The borrowings were secured by United States Government securities with a carrying value of $16.3 million. (4) Common Stock During the first nine months of 1997, the Company canceled 206,700 shares of its common stock purchased on the open market at an average price per share of $35.58. The first 57,000 shares were repurchased under a program approved by the Board of Directors (Board) on July 15, 1996 and completed on March 13, 1997. The remaining 149,700 shares were repurchased under a program approved by the Board on March 4, 1997, whereby an additional 250,000 shares of common stock were authorized to be repurchased pursuant to SEC Rule 10b-18. The actual number of shares to be repurchased is dependent upon market conditions, and the program may be terminated at the Company's discretion. (5) Segment Information The Company's principal products, services, and effect on revenues, income before income taxes and minority interest, and assets are identified by segment. Property-casualty -- Predominantly private passenger automobile, homeowners, and small commercial lines of insurance. Excess & surplus lines -- Primarily commercial casualty and commercial property lines of insurance coverage that standard insurers are unable or unwilling to provide. Eliminations and other -- Eliminations between segments plus other noninsurance operations not reported as segments (including mortgage banking, data processing, and employee leasing to affiliates). 9 Nine Months Ended September 30, ----------------------------------- 1997 1996 ---------------- --------------- (in thousands) Revenues * Property-casualty $ 418,506 $ 381,715 Excess & surplus lines 29,901 24,423 Eliminations and other 40,210 34,501 ---------------- --------------- Total $ 488,617 $ 440,639 ================ =============== Income before income taxes and minority interest * Property-casualty $ 59,543 $ 41,432 Excess & surplus lines 7,359 5,274 Eliminations and other 297 3,900 ---------------- --------------- Total $ 67,199 $ 50,606 ================ =============== September 30, December 31, 1997 1996 ---------------- --------------- (in thousands) Assets Property-casualty $ 989,410 $ 917,537 Excess & surplus lines 142,536 131,405 Eliminations and other 33,620 28,717 ---------------- --------------- Total $ 1,165,566 $ 1,077,659 ================ =============== * Including realized investment gains or losses. (6) Subsequent Event At its October meeting, the Board of Directors approved a 3-for-2 stock split to be distributed November 28, 1997 to shareholders of record on November 14 and declared a fourth-quarter dividend of $0.12 on the post-split shares. The split will increase the Company's common shares outstanding to approximately 30.6 million. 10 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview The following analysis of the consolidated results of operations and financial condition of ALLIED Group, Inc. (the Company) should be read in conjunction with the interim consolidated financial statements and related footnotes included elsewhere herein, and with the Company's Annual Report on Form 10-K for the year ended December 31, 1996. The Company, a regional insurance holding company, and its subsidiaries operate exclusively in the United States and primarily in the central and western states. The largest segment includes three property-casualty insurance companies that write personal lines (primarily automobile and homeowners) and small commercial lines of insurance. The other reportable segment is excess & surplus lines insurance. The property-casualty insurance segment, accounted for 85.7% and 86.6% of consolidated revenues for the nine months ended September 30, 1997 and 1996, respectively. The property-casualty segment participates in a reinsurance pooling agreement with ALLIED Mutual Insurance Company (ALLIED Mutual), an affiliated property-casualty insurance company. The agreement generally provides that the property-casualty insurance business is combined and then prorated among the participants according to predetermined percentages. Participation percentages are based on certain factors such as capitalization and business produced by the respective companies. The segment's participation in the reinsurance pool has been 64% since January 1, 1993. The operating results of the property-casualty insurance industry are subject to significant fluctuations from quarter to quarter and from year to year due to, but not limited to, the effect of competition on pricing, the frequency and severity of losses incurred in connection with weather-related and other catastrophic events, adequacy of reserves, general economic and business conditions, and other factors such as changes in tax laws and the regulatory environment. Results of Operations Consolidated revenues for the first nine months of 1997 were $488.6 million, up 10.9% over the $440.6 million reported for the first nine months of 1996. For the third quarter, consolidated revenues increased 10.2% over the same period in 1996. The increase occurred primarily because of the growth in earned premiums for the nine and three months ended September 30, 1997. Income before income taxes and minority interest for the first nine months of 1997 was up 32.8% to $67.2 million from $50.6 million for the same period in 1996. For the three months ended September 30, 1997, income before income taxes and minority interest was up 12.1% to $22.7 million. The increase was due to higher revenues combined with an improved loss experience for the nine and three months ending September 30, 1997. Wind and hail losses for the first nine months of 1997 were down 25.7% to $26.2 million compared to $35.3 million for the same period in 1996. For the third quarter wind and hail losses were down 8.9% to $10.6 million. Net income was up 32.6% to $47.7 million, bringing fully diluted earnings per share to $2.22 for the nine months ended September 30, 1997, from $36 million ($1.61 per share) for the corresponding period in 1996. Fully diluted earnings per share before realized investments gains and losses were $2.22 for the first nine months of 1997 compared with $1.61 for the same period of 1996. For the three months ended September 30, 1997 and 1996, fully diluted earnings per share before realized gains were $0.75 and $0.66, respectively. Book value per share at September 30, 1997 increased to $19.33 compared to $17.39 at December 31, 1996. Growth in the book value per share was primarily the result of higher net income for the first nine months of 1997. The fair value of investments in fixed maturities was $22.5 million above cost at 11 September 30, 1997 compared to $17.1 million above cost at December 31, 1996. If the investments in fixed maturities were reported at amortized cost, the book value would have been $18.61 at September 30, 1997 compared to $16.85 at December 31, 1996. Property-casualty Net written premiums for the pool (including ALLIED Mutual) totaled $628 million, a 9% increase over production in the first nine months of 1996. The average premium per policy for personal lines was up 6.2% from the first nine months of 1996 to $631 while the policy count grew 6.5%. The average premium per policy for commercial lines excluding crop-hail increased 5.1% from the first nine months of 1996 to $1,149 and the policy count was up 1.4%. Earned premiums for the property-casualty segment were 68.1% personal lines and 31.9% commercial lines in the first nine months of 1997. The business mix for the first nine months of 1996 was 66.6% personal lines and 33.4% commercial lines. Revenues for the property-casualty segment increased to $418.5 million from $381.7 million for the nine months ended September 30, 1997 and 1996, respectively. Revenues for the three months ended September 30, 1997, increased 8.3% to $142.7 million. Direct earned premiums for the segment were $420.1 million for the first nine months of 1997 compared with $365.5 million one year earlier. Earned premiums increased 10.6% for the first nine months of 1997 to $380.8 million from $344.4 million; earned premiums for the third quarter increased 8.9% to $129.4 million from $118.8 million for the same period in 1996. The increase resulted from growth in insurance exposure and increase in average premium per policy. Investment income for the first nine months of 1997 was $33.3 million compared to $31.4 million for the same period in 1996. For the three months ended September 30, 1997, investment income increased 4.1% to $11.2 million compared to $10.8 million for the same period in 1996. The increase was the result of a larger average balance in invested assets. The pretax yield on invested assets was 6.1% and 6.3% for the nine months ended September 30, 1997 and 1996, respectively. Realized investment gains were $16,000 in the first nine months of 1997 compared with realized gain of $197,000 in the first nine months of 1996. Other income for the first nine months of 1997 and 1996 was $4.4 million and $5.7 million, respectively. Income before income taxes increased 43.7% to $59.5 million from $41.4 million in the first nine months of 1996. A 9.6% growth in revenues, combined with an improved loss experience in the first nine months of 1997 contributed to the increase. The growth in revenues more than offset the 5.5% growth in expenses for the nine month period ended September 30, 1997. The statutory combined ratio (after policyholder dividends) for the first nine months of 1997 was 94.0 compared to 98.5 reported in the first nine months of 1996. The improvement in the combined ratio was primarily attributed to a 4.4-point decrease in the nine month loss and loss adjusting expense ratio. The segment also realized a slight improvement in its underwriting expense ratio (0.1 point). The impact of wind and hail losses on the combined ratio was 6.9 points and 10.3 points for the nine months ended September 30, 1997 and 1996, respectively. The generally accepted accounting principles (GAAP) underwriting gain was $21.8 million compared with a gain of $4.1 million for the first nine months of 1996. On a fully diluted basis, the impact of wind and hail losses on the results of operations was $0.84 per share versus $1.11 per share in the first nine months of 1996. 12 The following table presents the property-casualty's statutory combined ratio by line of business for the three and nine months ended September 30, 1997 and 1996: Three Months Ended Nine Months Ended September 30, September 30, --------------------- ---------------------- 1997 1996 1997 1996 -------- -------- -------- -------- Personal automobile 92.6 97.4 92.9 98.0 Homeowners 98.3 101.8 99.8 108.1 Personal lines 94.2 98.6 94.8 100.7 Commercial automobile 85.6 92.8 89.9 98.5 Workers' compensation 90.8 81.0 89.0 75.1 Other property/liability 99.5 97.5 94.5 99.1 Other lines 61.8 40.3 61.0 46.9 Commercial lines 95.5 93.4 92.5 94.3 Total 94.5 96.8 94.0 98.5 The personal auto statutory combined ratio improved to 92.9 for the first nine months of 1997 from 98.0 for the same period in 1996. The improvement was largely due to a 4.7-point decrease in the loss and loss adjusting expense ratio; the underwriting expense ratio also improved 0.4-points. The statutory combined ratio for the homeowners line was 99.8 for the first nine months of 1997 compared with 108.1 for the same period of 1996. The improvement was due to a 8.7-point decrease in the loss and loss adjusting expense ratio, that more than offset the slight increase experienced in the underwriting expense ratio. The impact of lower wind and hail losses on the combined ratio for the homeowners line decreased to 19.6-points from 28.7-points for the first nine months of 1996. Overall, the personal lines statutory combined ratio decreased to 94.8 in the first nine months of 1997 from 100.7 in the same period of 1996. The statutory combined ratio for commercial lines decreased to 92.5 in the first nine months of 1997 from 94.3 for the first nine months of 1996. The improvement of personal and commercial lines combined ratio was attributable to higher earned premiums, combined with a favorable loss experience in the first nine months of 1997. Excess & Surplus Lines Earned premiums increased 25% to $24.8 million for the first nine months of 1997 from $19.8 million for the same period in 1996. For the three months ended September 30, 1997 and 1996, earned premiums were $8.5 million and $5.4 million, respectively. Net written premiums increased 27.8% to $25.8 million for the nine months ended September 30, 1997 from $20.2 million in the same period of 1996. The segment's major product lines all experienced increases in net written premiums due to the segment's intensified marketing efforts and the addition of 19 new agencies (a 26.8% increase) over the last 21 months. For the nine months ended September 30, 1996, net written premiums were adversely affected by higher reinsurance costs, which were retroactive to the beginning of the year. Direct earned premiums increased to $32.2 million for the nine months ended September 30, 1997 from $27.6 million for the same period in 1996. For the nine month period ended September 30, 1997, the segment's book of business was comprised of 3% personal lines and 97% commercial lines. The business mix for the first nine months of 1996 was 2.7% personal lines and 97.3% commercial lines. Investment income for the first nine months of 1997 increased 11.5% to $5.1 million from $4.6 million for the same period in 1996. For the third quarter only, investment income increased 10.9% to $1.7 million. Investment income 13 increased due to a larger average balance in the investment portfolio. The pretax yield on those assets was 6.3% in the first nine months of 1997 compared to 6.3% for the same period in 1996. Invested assets increased 7.8% to $112.5 million at September 30, 1997 from $104.4 million at year-end 1996. The statutory combined ratio (after policyholder dividends) was 90.6, which produced a GAAP underwriting gain of $2.2 million for the first nine months of 1997. The combined ratio for the first nine months of 1996 was 95.7 which resulted in a GAAP underwriting gain of $685,000. The combined ratio improved primarily because of a 4.8-point improvement in the loss and loss adjusting expense ratio in the first nine months of 1997, due to growth in earned premiums and an improved loss experience. The underwriting expense ratio also improved 0.3-points in the first nine months of 1997 over the same period in 1996. Income before income taxes for the nine months ended September 30, 1997 increased to $7.4 million from $5.3 million; for the quarter ended September 30, 1997, income before income taxes increased to $2.6 million from $1.7 million for the same quarter in 1996. The segment had realized losses of $4,000 for the first nine months of 1997 and had realized gains of $2,000 in the same period of 1996. Noninsurance Operations Revenues for the noninsurance operations (including mortgage banking, data processing, and employee leasing to affiliates) for the first nine months of 1997 increased to $40.2 million from $34.5 million for the same period last year. The increase was primarily due to a 26.2% increase in data processing revenues from unafiliated companies. Income before income taxes was $297,000 for the first nine months of 1997 compared to income before taxes of $3.9 million for the same period in 1996. The decrease was due to higher operating expenses in 1997 that were primarily the result of a larger percentage of overhead expenses being allocated to the holding company and higher employee costs and amortization expenses in the data processing segment. The data processing segment shortened the estimated life of its software products in 1997. The mortgage banking servicing portfolio at September 30, 1997 increased slightly to $2.9 billion from $2.8 billion at year-end 1996. Investments and Investment Income The investment policy for the Company's insurance segments require that the fixed maturity portfolio be invested primarily in debt obligations rated "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 and Poor's Corporation or Moody's. The Company's investment portfolio consisted primarily of fixed income securities and equity securities; 91.5% and 7.3%, respectively. The ratings on 99.5% of the fixed income securities at September 30, 1997 were investment grade or higher. The investment portfolio contained no real estate or mortgage loans at September 30, 1997. Invested assets were up 7.1% to $878 million from $819.6 million at year-end 1996. Nine-month consolidated investment income increased 5.2% to $38.5 million from $36.6 million through September 30, 1996. For the quarter ended September 30, 1997, investment income was up 4.2% to $13 million over the third quarter in 1996. The increase was due to a larger average balance of invested assets. The Company's pretax rate of return on invested assets was down to 6.1% from last year's 6.3%. The lower yield is due in part to a higher proportional share of investment income from tax-exempt securities 14 Income Taxes The Company's year-to-date effective income tax rate was 28.5% at September 30, 1997 and 28.4% for year-end 1996. The income tax expense for the first nine months of 1997 rose on higher operating income up to $19.2 million from $14.7 million for the same period in 1996. Regulations 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. New Accounting Pronouncements During June of 1997, the Financial Accounting Standards Board issued two new accounting standards; Statement of Financial Accounting Standards (SFAS) 130, "Reporting Comprehensive Income" and SFAS 131, "Disclosure about Segments of an Enterprise and Related Information." SFAS 130 establishes standards for the reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. SFAS 131 specifies the presentation and disclosure of operating segment information reported in the annual and interim reports issued to stockholders. The provisions of both statements will be effective for years beginning after December 15, 1997, but early adoption is permitted. Management of the Company believes that the adoption of these statements will not have a material impact on the Company's financial position, results of operations, or liquidity. Liquidity and Capital Resources Substantial cash inflows are generated from premiums, pool administration fees, investment income, and proceeds from maturities of portfolio investments. The principal outflows of cash are payment of claims, commissions, premium taxes, operating expenses, and income taxes and the purchase of fixed income and equity securities. In developing its investment strategy, the Company establishes a level of cash and highly liquid short and intermediate-term securities which, combined with expected cash flow, is believed adequate to meet anticipated short-term and long-term payment obligations. In the first nine months of 1997 and 1996, operating activities generated cash flows of $65.4 million and $67.5 million, respectively. For both years, the primary source of funds was premium growth in the Company's property-casualty insurance operations. The funds were used primarily to purchase equity securities and to repurchase the Company's common stock which accounted for the majority of the investing activities. Operating cash flows were also used to pay $13 million of dividends to stockholders in the first nine months of 1997. For the same period in 1996, the funds generated from the operating activities were used to pay dividends to stockholders of $12.3 million. Dividend payments to common stockholders totaled $10.4 million for the nine months ended September 30, 1997, up from $9.1 million for the same period in 1996. The increase in dividends to common stock shareholders is due to a higher dividend per share, 15.9% increase from September 30, 1996. In the first nine months of 1997 and 1996, the Company paid dividends of $2.6 million on the 6-3/4% Series preferred stock. The Company also paid dividends of $595,000 on the ESOP Series preferred stock (ESOP Series) in the nine months ended September 30, 1996. 15 The Company relies primarily on dividend payments from its property-casualty subsidiaries to pay preferred and common stock dividends to stockholders. During the first nine months of 1997, the Company received dividend payments of $12.2 million from the property-casualty subsidiaries and $57,000 from noninsurance subsidiaries. During the same period of 1996, the Company received dividend payments of $11.2 million from the property-casualty subsidiaries and $107,000 from noninsurance subsidiaries. During the first nine months of 1997, the Company canceled 206,700 shares of its common stock purchased on the open market at an average price per share of $35.58. The first 57,000 shares were repurchased under a program approved by the Board of Directors (Board) on July 16, 1996 and completed on March 13, 1997. An additional 149,700 shares were repurchased under a program approved by the Board on March 4, 1997, whereby an additional 250,000 shares of common stock were authorized to be repurchased pursuant to SEC Rule 10b-18. The Company can repurchase up to an additional 100,300 shares. During the nine months ended September 30, 1996, the Company had repurchased and canceled 443,000 of its common stock under the repurchase program approved by the Board on December 14, 1994. The shares were purchased at an average price per share of $37.30. The mortgage banking subsidiary has separate credit arrangements to support its operations. Short-term and long-term notes payable to nonaffiliated companies are used to finance its mortgage loans held for sale and to purchase mortgage servicing rights. The level of short-term borrowings fluctuates daily depending on the level of inventory being financed. At September 30, 1997, short-term borrowings amounted to $31.5 million to be repaid through the subsequent sale of mortgage loans held for sale and long-term borrowings amounted to $10.5 million to be repaid over the next seven years. These notes payable are not guaranteed by the Company. In the normal course of its business, the subsidiary 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. At its October meeting, the Board of Directors approved a 3-for-2 stock split to be distributed November 28, 1997 to shareholders of record on November 14 and declared a fourth-quarter dividend of $0.12 on the post-split shares. The split will increase the Company's common shares outstanding to approximately 30.6 million. Management anticipates that short-term and long-term capital expenditures, cash dividends, and operating cash needs will be met from existing capital and internally generated funds. As of September 30, 1997, the Company and its subsidiaries 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. 16 PART II Item 6. Exhibits and Reports on Form 8-K (a) 10.29 The ALLIED Group Employee Stock Ownership Plan, as amended and restated effective January 1, 1996. 10.35 Third Amendment to the Term Credit Agreement and Guaranty, dated September 26, 1997. 11 Statement re Computation of Per Share Earnings. 27 Financial Data Schedule (b) The Company filed no reports on Form 8-K during the third quarter ended September 30, 1997. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. ALLIED Group, Inc. (Registrant) Date: November 6, 1997 /s/ Jamie H. Shaffer ----------------------------------------- Jamie H. Shaffer, Senior Vice President, Chief Financial Officer, and Treasurer 17 ALLIED Group, Inc. and Subsidiaries INDEX TO EXHIBITS EXHIBIT NUMBER ITEM PAGE 10.29 The ALLIED Group Employee Stock Ownership Plan, as amended and restated effective January 1, 1996. 18 10.35 Third Amendment to the Term Credit Agreement and Guaranty, dated September 26, 1997. 76 11 Statement re Computation of Per Share Earnings 77 27 Financial Data Schedule 78 18 Exhibit 10.29 Officer Adoption of Amendment and Restatement of The ALLIED Group Employee Stock Ownership Plan ---------------------------------------------- By virtue and in exercise of the amending power reserved to ALLIED Group, Inc. (the "Company") pursuant to section 12.1 of the ALLIED Group Employee Stock Ownership Plan (the "Plan"), and pursuant to resolutions to amend adopted November 21, 1996 and July 29, 1997 by the Compensation Committee of the Board of Directors, the Plan is hereby amended and restated, effective as of January 1, 1996, in the form attached hereto. IN WITNESS WHEREOF, the undersigned officers of the Company have caused these presents to be signed on behalf of the Company and its corporate seal affixed and attested, this 6th day of August, 1997. ALLIED Group, Inc. By: /s/ Douglas L. Andersen ------------------------------------- Douglas L. Andersen Its: President ------------------------------------- Attest: By: /s/ Sally J. Malloy ------------------------------------ Sally J. Malloy Its: Secretary ------------------------------------ 19 THE ALLIED GROUP EMPLOYEE STOCK OWNERSHIP PLAN ---------------------------------------------- (As Amended and Restated Effective as of January 1, 1996) 20 Certificate ----------- I, Sally J. Malloy, Secretary of ALLIED GROUP, INC., having in my custody and possession the corporate records and seal of said Corporation, do hereby certify that attached hereto is a true and correct copy of THE ALLIED GROUP EMPLOYEE STOCK OWNERSHIP PLAN, as in effect on the date hereof. WITNESS my hand and the corporate seal of the Corporation this 6th day of August, 1997. /s/ Sally J. Malloy -------------------------------- Sally J. Malloy as Aforesaid Secretary (Seal) 21 TABLE OF CONTENTS ----------------- Section Page - ------- ---- 1 General........................................................1 1.1 Purpose and Effective Date.............................1 1.2 Employers and Related Companies........................1 1.3 The Trust..............................................1 1.4 Plan Administration....................................2 1.5 Plan Year..............................................2 1.6 Accounting Date........................................2 1.7 Applicable Laws........................................2 1.8 Gender and Number......................................2 1.9 Notices................................................2 1.10 Evidence...............................................2 1.11 Action By Employer.....................................2 1.12 No Reversion to Employers..............................2 1.13 Plan Supplements.......................................3 1.14 Military Service.......................................3 1.15 Defined Terms..........................................3 2 Plan Participation.............................................3 2.1 Eligibility for Participation..........................3 2.2 Participation Not Guarantee of Employment...........................................4 2.3 Leased Employees.......................................4 2.4 Inactive Participation.................................4 3 Service........................................................4 3.1 Year of Eligibility Service............................4 3.2 Hour of Service........................................5 3.3 Years of Service.......................................5 3.4 One Year Period of Severance...........................6 3.5 One Year Break in Service..............................7 3.6 Year of Participation Service..........................7 3.7 Other Service..........................................7 4 Plan Contributions.............................................8 4.1 Mandatory Employer Contributions.......................8 4.2 Discretionary Employer Contributions...................8 4.3 Payment of Employer Contributions......................8 4.4 Participant Contributions..............................8 5 Plan Investments...............................................8 5.1 Investment in Company Stock............................8 5.2 Use of Loan Proceeds and Dividends.....................9 5.3 ESOP Loans.............................................9 5.4 Release of Company Stock from Suspense Account................................9 -i- 22 Section Page - ------- ---- 6 Plan Accounting................................................10 6.1 Participants' Accounts.................................10 6.2 Adjustment of Participants' Accounts...................10 6.3 Allocation and Crediting of Earnings and Losses..................................11 6.4 Minimum Required Allocation Amounts....................13 6.5 Allocation and Crediting of Employer Contributions and Forfeitures........................13 6.6 Compensation...........................................15 6.7 Eligible Participants..................................16 6.8 Stock Dividends, Splits and Other Capital Reorganizations..............................16 6.9 Statement of Plan Interest.............................16 6.10 Expenses...............................................16 7 Limitations....................................................17 7.1 Limitation on Allocations to Participant Accounts.................................17 7.2 Annual Additions.......................................18 7.3 Excess Annual Additions................................18 7.4 Highly Compensated Employees...........................18 7.5 Combined Plan Limitation...............................19 8 Vesting and Termination Dates..................................19 8.1 Determination of Vested Interest.......................19 8.2 Accelerated Vesting....................................19 8.3 Termination Dates......................................19 9 Distributions..................................................20 9.1 Distributions to Participants After Termination of Employment............................20 9.2 Revocation of Annuity Form of Benefit..................22 9.3 Retirement Election Information........................22 9.4 Distributions to Beneficiaries.........................23 9.5 Pre-Retirement Election Information....................25 9.6 Revocation of Pre-Retirement Surviving Spouse Annuity.......................................25 9.7 Limits on Commencement and Duration of Distributions........................................26 9.8 Beneficiary Designations...............................28 9.9 Diversification by Participants........................28 9.10 Forfeitures of Unvested Contributions..................29 9.11 Application of Forfeitures.............................30 9.12 Payment in Cash or Company Stock.......................30 9.13 Distribution and Transfer of Company Preferred Stock......................................30 9.14 Accrued Dividends......................................32 9.15 Facility of Payment....................................32 9.16 Interests Not Transferable.............................32 -ii- 23 Section Page - ------- ---- 9.17 Absence of Guaranty....................................33 9.18 Missing Participants or Beneficiaries..................33 9.19 Direct Rollovers.......................................33 9.20 Distributions Pursuant to a Qualified Domestic Relations Order.............................35 10 Shareholder Rights.............................................35 11 The Committee..................................................36 11.1 Membership.............................................36 11.2 Rights, Powers and Duties..............................36 11.3 Allocation and Delegation of Committee Responsibilities and Powers................37 11.4 Application of Rules...................................37 11.5 Information to be Furnished to Committee...............37 11.6 Committee's Decision Final.............................37 11.7 Remuneration and Expenses..............................37 11.8 Exercise of Committee's Duties.........................38 11.9 Indemnification of the Committee.......................38 11.10 Resignation or Removal of Committee Member.....................................38 11.11 Appointment of Successor Committee Member...............................................38 12 Amendment and Termination......................................38 12.1 Amendment..............................................38 12.2 Termination............................................39 12.3 Merger and Consolidation of Plan, Transfer of Plan Assets..............................39 12.4 Distribution on Termination and Partial Termination..................................39 12.5 Notice of Amendment, Termination or Partial Termination...............................40 12.6 Method of Plan Amendment or Termination................40 Appendix A - Defined Terms Supplement A (Top-Heavy Status) Supplement B (Non-Readily Tradeable Stock) Supplement C (Transfers from Employer Plans) Supplement D (Transfers to and from ALLIED Life Financial Corporation Employee Stock Ownership Plan) -iii- 24 THE ALLIED GROUP EMPLOYEE STOCK OWNERSHIP PLAN ---------------------------------------------- (As Amended and Restated Effective as of January 1, 1996) SECTION 1 --------- General ------- 1.1. PURPOSE AND EFFECTIVE DATE. Effective January 1, 1990 (the "Effective Date") ALLIED Group, Inc., an Iowa corporation (the "Company"), established THE ALLIED GROUP EMPLOYEE STOCK OWNERSHIP PLAN (the "Plan"), in order to promote the mutual interests of the Company, its shareholders, its eligible employees and the eligible employees of any Related Company (as defined in subsection 1.2) which adopts the Plan (i) by providing such employees with an opportunity to acquire equity interests in the Company and to exercise shareholder rights with respect thereto, (ii) by causing the Plan to be a long-term investor in stock of the Company, and (iii) by providing the Company and the eligible employees with the tax benefits and other benefits provided under applicable laws to employee stock ownership plans. The Plan is intended to meet the applicable requirements of sections 401(a) and 4975(e)(7) of the Internal Revenue Code of 1986, as amended (the "Code"). The following provisions constitute an amendment, restatement and continuation of the Plan effective as of January 1, 1996. The Plan is intended to be a combination stock bonus and money purchase plan. Except for cash or cash equivalents required to be maintained for administrative and other allowable purposes, the Plan shall be invested exclusively in shares of stock of the Company which qualify as "employer securities" under section 409(l) of the Code ("Company Stock"). 1.2. EMPLOYERS AND RELATED COMPANIES. The Company and each Related Company which adopts the Plan are referred to below collectively as the "Employers" and individually as an "Employer". The term "Related Company" means any corporation, trade or business during any period which it is, along with the Company, a member of a controlled group of corporations as described in section 414(b) of the Code. Only for the purposes of determining the Termination Date under subsection 8.3, an Eligible Participant under subsection 6.7, and calculating Hours of Service for the purposes of determining rights to participation, allocations, and vesting, the term "Related Company" shall include ALLIED Life Insurance Company. 1.3. THE TRUST. All contributions made under the Plan, and all earnings with respect to such contributions, will be held, managed and controlled by a trustee acting under a trust which forms a part of the Plan. The terms of the trust and the trustee are set forth in a trust agreement known as THE ALLIED GROUP EMPLOYEE STOCK OWNERSHIP TRUST (the "Trust Agreement"). All rights which may accrue to any person under the Plan shall be subject to all of the terms and provisions of the Trust Agreement as in effect from time to time. -1- 25 1.4. PLAN ADMINISTRATION. The authority to control and manage the operation and administration of the Plan is vested in a Committee as described in section 11. Except as otherwise expressly provided in section 11, the Company shall be the "Administrator" of the Plan and shall have the rights, duties and obligations of an "administrator" as that term is defined in section 3(16)(A) of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), and of a "plan administrator" as that term is defined in section 414(g) of the Code. 1.5. PLAN YEAR. The term "Plan Year" means the calendar year. 1.6. ACCOUNTING DATE. The term "Accounting Date" means the last business day of each Plan Year. 1.7. APPLICABLE LAWS. The Plan shall be construed and administered according to the laws of the State of Iowa to the extent that such laws are not preempted by the laws of the United States of America. 1.8. GENDER AND NUMBER. Where the context admits, words in any gender shall include any other gender, words in the singular shall include the plural and the plural shall include the singular. 1.9. NOTICES. Any notice or document required to be filed with the Committee under the Plan will be properly filed if delivered or mailed by registered mail, postage prepaid, to the Committee, in care of the Company at its principal executive offices. Any notice required under the Plan may be waived by the person entitled to notice. 1.10. EVIDENCE. Evidence required of anyone under the Plan may be by certificate, affidavit, document or other information which the person acting on it considers pertinent and reliable, and signed, made or presented by the proper party or parties. 1.11. ACTION BY EMPLOYER. Any action required or permitted to be taken by an Employer under the Plan shall be by resolution of its Board of Directors, or by a person or persons authorized by resolution of its Board of Directors, subject to any prerequisites applicable to Board action required by law or regulation or pursuant to its charter, by-laws or agreement. 1.12. NO REVERSION TO EMPLOYERS. No part of the corpus or income of the Trust Fund shall revert to any Employer or be used for, or diverted to, purposes other than for the exclusive benefit of Participants and other persons entitled to benefits under the Plan, except as specifically provided in Article V of the Trust Agreement. -2- 26 1.13. PLAN SUPPLEMENTS. The provisions of the Plan as applied to any Employer or any group of employees of any Employer may, with the consent of the Company, be modified or supplemented from time to time by the adoption of one or more Supplements. Each Supplement shall form a part of the Plan as of the Supplement's effective date. In the event of any inconsistency between a Supplement and the Plan document, the terms of the Supplement shall govern. 1.14. MILITARY SERVICE. Notwithstanding any provisions of this Plan to the contrary, contributions, benefits and service credit with respect to qualified military service will be provided in accordance with Code section 414(u). 1.15. DEFINED TERMS. Terms used frequently with the same meaning are indicated by initial capital letters, and are defined throughout the Plan. Appendix A contains an alphabetical listing of such terms and the subsections in which they are defined. SECTION 2 --------- Plan Participation ------------------ 2.1. ELIGIBILITY FOR PARTICIPATION. Subject to the terms and conditions of the Plan, each employee of an Employer shall become a "Participant" in the Plan on the Effective Date or, if later, the January 1 coincident with or next preceding the date on which he has satisfied the following requirements: (a) he has completed one Year of Eligibility Service (as defined in subsection 3.1); (b) he has attained at least age 21 years; and (c) effective for Plan Years after December 31, 1995, he is employed by his Employer on a salaried basis or hourly basis. Notwithstanding the foregoing provisions of this subsection 2.1, if an employee or a Participant has a Termination Date following completion of one Year of Eligibility Service and attainment of age 21, he shall become a Participant on the later of his date of reemployment or the January 1 following his original date of employment if he had at least five Years of Service before his Termination Date or if he incurred fewer than five consecutive One Year Breaks in Service. If such a reemployed employee or Participant had fewer than five Years of Service before his Termination Date and he incurred five or more consecutive One Year Breaks in Service, he shall be considered a new employee for eligibility purposes upon reemployment. If a reemployed employee who did not complete a Year of Eligibility Service before his Termination Date incurs a One Year Break in Service, he shall be considered a new employee for eligibility purposes upon reemployment. The term "employee" as used herein and throughout the Plan refers to a common law employee of an Employer who is subject to income and employment tax withholding. -3- 27 2.2. PARTICIPATION NOT GUARANTEE OF EMPLOYMENT. Participation in the Plan does not constitute a guarantee or contract of employment, and will not give any employee or Participant the right to be retained in the employ of the Employers or Related Companies nor any right or claim to any benefit under the terms of the Plan unless such right or claim has specifically accrued under the terms of the Plan. 2.3. LEASED EMPLOYEES. If, pursuant to one or more agreements between an Employer or Related Company and one or more leasing organizations (within the meaning of section 414(n) of the Code), a person provides services to the Employer or Related Company on a substantially full-time basis for a period of at least one year and for years beginning after December 31, 1996, such services are performed under primary direction or control of the Employer or Related Company, such person shall be a "Leased Employee". No Leased Employee, who is not also an employee of an Employer and otherwise meets the requirements of subsection 2.1, shall be eligible to participate in this Plan. 2.4. INACTIVE PARTICIPATION. Once an eligible employee becomes a Participant in the Plan, he will remain a Participant for all purposes under the Plan except the contribution provisions of section 4 as long as he continues to have an Account balance under the Plan. SECTION 3 --------- Service ------- 3.1. YEAR OF ELIGIBILITY SERVICE. The term "Year of Eligibility Service" means, with respect to any employee or Participant, any Plan Year during which he completes at least 1,000 Hours of Service, subject to the following: (a) the term Year of Eligibility Service shall not include any Plan Year commencing prior to the date on which the employee first completes an Hour of Service; and (b) the 12-consecutive-month period commencing on the date on which the employee first completes an Hour of Service shall be deemed to be a Year of Eligibility Service if he completes at least 1,000 Hours of Service during such 12-consecutive-month period. No service shall be recognized under this subsection 3.1 prior to the date an entity first became a Related Company; except that an employee's last period of continuous employment with Square Deal Insurance Company (Mutual) shall be taken into account for purposes of determining on or after December 31, 1992 whether such employee has completed one Year of Eligibility Service. -4- 28 3.2. HOUR OF SERVICE. Subject to the following sentence, the term "Hour of Service" means, with respect to any employee or Participant, each hour for which he is paid or entitled to payment for the performance of duties for an Employer or a Related Company or for which back pay, irrespective of mitigation of damages, has been awarded to the employee or Participant or agreed to by an Employer or a Related Company. In the case of an entity that ceases or has ceased to be a Related Company, Hours of Service with such entity shall be recognized for any period during which such entity was a Related Company. An employee or Participant shall be credited with the number of Hours of Service which otherwise would normally have been credited to him (or in any case in which such hours cannot be determined, 8 Hours of Service per day, to a maximum of 40 Hours of Service per week) for any period during which he performs no duties for an Employer or a Related Company (irrespective of whether the employment relationship has terminated) by reason of a vacation, holiday, illness, incapacity (including disability), layoff, jury duty, military duty or leave of absence but for which he is directly or indirectly paid or entitled to payment by an Employer or a Related Company; provided, however, that an employee or Participant shall not be credited with more than 501 Hours of Service for any single continuous period during which he performs no duties for an Employer or a Related Company. Payments considered for purposes of the foregoing sentence shall include payments unrelated to the length of the period during which no duties are performed but shall not include payments made solely as reimbursement for medically related expenses or solely for the purpose of complying with applicable workmen's compensation, unemployment compensation or disability insurance laws. 3.3. YEARS OF SERVICE. The term "Years of Service" means, with respect to any employee or Participant employed on a regular full time basis, the number of years, including fractional portions thereof, elapsed since the first date for which he completes an Hour of Service (INCLUDING HOURS OF SERVICE PRIOR TO JANUARY 1, 1990), subject to the following: (a) A Participant's number of Years of Service accrued after five consecutive One Year Periods of Severance shall be disregarded for purposes of determining the nonforfeitable percentage of his benefit under the Plan derived from Employer contributions which accrued prior to such break. (b) For all purposes of the Plan: (i) if an employee's or Participant's employment with the Employers and the Related Companies is terminated and he incurs a One Year Period of Severance, he shall not be credited with service for the period between the date his employment is terminated and the date, if any, of his reemployment by an Employer or a Related Company; -5- 29 (ii) if an employee or Participant does not have a nonforfeitable right under the Plan to any portion of his Account balances, and he incurs five consecutive One Year Periods of Severance, then his number of Years of Service, if any, accrued prior to such break shall be disregarded and he shall be treated as a new employee; and (iii) in general, Years of Service shall not include any period of employment with an entity prior to the date it first became a Related Company; provided, however, that an employee's or Participant's period of continuous employment with Sierra Mutual Fire Insurance Company prior to July 1, 1975, and with Farmers Mutual Insurance Company prior to August 1, 1976, and Square Deal Insurance Company (Mutual) prior to December 31, 1992 shall be recognized, and further provided that Years of Service shall include an employee's or Participant's last period of continuous employment with any other business entity which is acquired by or merged into an Employer to the extent, if any, as the Company may determine by resolution of its Board of Directors. (iv) For purposes of determining the nonforfeitable percentage of a Participant's benefit under the Plan derived from Employer contributions, a Participant shall continue to accrue Years of Service while eligible for disability benefits under the Company's long-term disability plan. The term "Years of Service" means, with respect to any employee other than an employee employed on a regular full time basis, each Year of Eligibility Service until such employee completes one Year of Eligibility Service. Thereafter, each such employee shall be credited with Years of Service on the same basis as employees employed on a regular full time basis, commencing with the first day following the completion of one Year of Eligibility Service. 3.4. ONE YEAR PERIOD OF SEVERANCE. For purposes of subsection 3.3, the term "One Year Period of Severance" means, with respect to any employee or Participant, the 12-consecutive-month period commencing on the earlier of his Termination Date (as defined in subsection 8.3) or the first anniversary of the first date of a period in which the employee or Participant remains absent from service with the Employers and Related Companies for any reason other than a resignation, retirement, dismissal or death or a Family and Medical Leave Act -6- 30 Maternity or Paternity Absence (as defined below) if he is not paid or entitled to payment for the performance of duties for the Employer or a Related Company during that 12-consecutive-month period. Solely for purposes of determining whether a One Year Period of Severance has occurred, an employee or Participant who is absent from service beyond the first anniversary of the date on which his Family and Medical Leave Act Maternity or Paternity Absence began, shall be deemed to have terminated employment on the second anniversary of the date on which the Family and Medical Leave Act Maternity or Paternity Absence began. The Committee may require the employee or Participant to furnish such information as it considers necessary to establish that such individual's absence was a Family and Medical Leave Act Maternity or Paternity Absence. The term "Family and Medical Leave Act Maternity or Paternity Absence" means an employee's or Participant's absence from work because of the pregnancy of such individual, the birth of a child of such individual, the placement of a child with such individual in connection with the adoption of a child by such individual, or for purposes of caring for the child by such individual immediately following such birth or placement, determined in a manner consistent with the requirements of the Family and Medical Leave Act. 3.5 ONE YEAR BREAK IN SERVICE. For purposes of subsections 2.1 and 3.1, the term "One Year Break in Service" means, with respect to any employee or Participant, a Plan Year in which the employee or Participant is credited with fewer than 501 Hours of Service. Solely for purposes of determining whether a Break in Service has occurred, an employee or Participant who is on a Family and Medical Leave Act Maternity or Paternity Absence (as defined in subsection 3.4) shall receive credit for the Hours of Service which would otherwise have been credited to such individual but for such Absence to a maximum of 501 hours for any single continuous period of such Absence. The Hours of Service credited under this subsection shall be credited first in the Plan Year in which the Absence begins if the crediting is necessary to prevent a One Year Break in Service in that year, or if not, in the following Plan Year. 3.6 YEAR OF PARTICIPATION SERVICE. For purposes of subsection 6.7, the term "Year of Participation Service" means a Plan Year during which the Participant completes at least 1,000 Hours of Service. 3.7 OTHER SERVICE. Notwithstanding any provision of this section to the contrary and only for calculating Hours of Service for the purposes of determining rights to participation, allocations, and vesting, the service of an employee who was employed with ALLIED Mutual Insurance Company prior to January 1, 1990, and who terminated from that employment and was transferred to, or immediately employed by, an Employer, shall be treated as service for an Employer under the Plan. -7- 31 SECTION 4 --------- Plan Contributions ------------------ 4.1. MANDATORY EMPLOYER CONTRIBUTIONS. Subject to the conditions and limitations of the Plan, for each Plan Year beginning on or after the Effective Date, each Employer shall contribute to the Trustee, in cash or Company Stock, or any combination thereof, on behalf of each of its employees who is an Eligible Participant (as defined in subsection 6.7) under the Plan for such Plan Year, that amount which, after the allocation of Forfeitures that are to be allocated for that Plan Year in accordance with the provisions of subsection 9.11 and the allocation of dividends that are to be allocated for that Plan Year pursuant to the last sentence of paragraph 6.3(b), results in the allocation to Eligible Participants' Accounts of shares of Company Stock equal in value (determined as of the last day of the Plan Year) to the aggregate Minimum Required Allocation Amounts (as defined in subsection 6.4) for the Employer's participating employees. 4.2. DISCRETIONARY EMPLOYER CONTRIBUTIONS. In addition to the Contributions required under subsection 4.1 and subject to the conditions and limitations of the Plan, for each Plan Year, each Employer may contribute to the Trustee, in cash or Company Stock, or any combination thereof, such additional amounts, if any, as such Employer shall determine on or before the last day on which a Contribution for that Plan Year may be made in accordance with subsection 4.3. 4.3. PAYMENT OF EMPLOYER CONTRIBUTIONS. An Employer's Contributions ("Employer Contributions") for any Plan Year shall be due on the last day of that Plan Year and, if not paid by the end of such Plan Year, shall be payable to the Trustee as soon thereafter as practicable, but not later than the time prescribed by law for filing the Employer's Federal income tax return for that Plan Year, including any extensions of time, without interest. 4.4. PARTICIPANT CONTRIBUTIONS. Participants are neither required nor permitted to make contributions under the Plan. SECTION 5 --------- Plan Investments ---------------- 5.1. INVESTMENT IN COMPANY STOCK. Subject to the provisions of subsection 5.2 and to the retention in cash or cash equivalents of such reasonable amounts as may be necessary from time to time for the payment of expenses and obligations and the administration of the Plan and Trust, all Plan assets, including earnings thereon, shall be invested, within a reasonable time, primarily in Company Stock. Subject to and consistent with the provisions of -8- 32 section 409(l) of the Code, Company Stock may consist of common stock of the Company ("Company Common Stock") or convertible preferred stock of the Company ("Company Preferred Stock"). 5.2. USE OF LOAN PROCEEDS AND DIVIDENDS. The proceeds of an ESOP Loan (as described in subsection 5.3) shall be used within a reasonable time after receipt to acquire shares of Company Stock or to repay all or any portion of such ESOP Loan or any outstanding ESOP Loan. Cash dividends received on shares of Company Stock acquired with the proceeds of an ESOP Loan shall, after the payment of expenses of the Plan and the Trust as provided in subsection 6.10 or, unless otherwise directed by the Committee, be used to make payments on such ESOP Loan. Cash dividends received on shares of Company Stock which are not used to pay expenses or make payments on an ESOP Loan in accordance with the preceding sentence shall, at the direction of the Committee, either be distributed to Participants and Beneficiaries (to the extent attributable to shares of Company Stock allocated to their Accounts) no later than 90 days after the close of the Plan Year in which such dividend was paid or be reinvested in shares of Company Stock. Pending use in accordance with the foregoing provisions of this subsection 5.2, ESOP Loan proceeds and cash dividends may be retained in cash or cash equivalents. 5.3. ESOP LOANS. Under the terms of the Trust Agreement, the Trustee is authorized to incur debt (an "ESOP Loan") at the direction of the Committee for the purpose of acquiring Company Stock or for the purpose of repaying all or any portion of any outstanding ESOP Loan. The Trustee has the authority to refinance any existing ESOP Loan and such refinanced loan shall be the ESOP Loan from that date until repaid or refinanced. The terms of any ESOP Loan shall be subject to the conditions and restrictions set forth in Article III of the Trust. Shares of Company Stock acquired with the proceeds of an ESOP Loan shall be credited to a "Suspense Account" until released in accordance with subsection 5.4. 5.4. RELEASE OF COMPANY STOCK FROM SUSPENSE ACCOUNT. Subject to the following provisions of this subsection 5.4, for each Plan Year throughout the duration of an ESOP Loan, a portion of the shares of Company Stock acquired with the proceeds of such ESOP Loan shall be withdrawn from the Suspense Account and allocated to Participants in accordance with the provisions of paragraph 6.3(b) and subsection 6.5. As of the last day of each Plan Year, the number of shares of Company Stock which shall be released from the Suspense Account shall be equal to the product of the number of shares of Company Stock which are then held in the Suspense Account multiplied by a fraction, the numerator of which is the amount of principal and interest paid on the loan for that Plan Year and the denominator of which is the amount of principal and interest paid or payable on the loan for that Plan Year and for all future years. For purposes of determining the denominator of the fraction described in the preceding sentence for any Plan Year, if the interest rate under the ESOP Loan is variable, the -9- 33 interest rate to be paid in future years shall be assumed to be equal to the interest rate applicable as of the last day of that Plan Year. For purposes of determining the numerator of the fraction described in the second preceding sentence, (a) the amount of principal paid for any Plan Year shall be the sum of all principal payments made during such year, with Employer Contributions and with cash dividends paid on shares of Company Stock acquired with the proceeds of an ESOP Loan, not theretofore applied to release shares under this subsection 5.4, plus all principal payments made after the last day of such year (i) with Employer Contributions (and earnings thereon) made for such Plan Year in accordance with the provisions of subsection 4.3, and (ii) with cash dividends paid on shares of Company Stock acquired with the proceeds of an ESOP Loan, but only to the extent that such contributions or dividends are designated by the Committee to the Trustee as payments on account of such year, and (b) the amount of interest paid for any Plan Year shall be the sum of all interest payments falling due within such year and paid in accordance with the provisions of subsection 4.3. Notwithstanding the preceding provisions of subsection 5.4, if an ESOP Loan satisfies the requirements of Treas. Reg. section 54.4975-7(b)(8)(ii), the number of shares of Common Stock attributable to such ESOP Loan which are withdrawn from the Suspense Account may be proportionate to principal payments only. SECTION 6 --------- Plan Accounting --------------- 6.1. PARTICIPANTS' ACCOUNTS. The Committee shall cause an Account to be established and maintained in the name of each Participant, which Account shall be adjusted at the times and in the manner provided by the provisions of subsection 6.2. All accounting with respect to shares of Company Stock, including all adjustments and allocations under this section 6, shall be in whole and fractional shares of such stock, in accordance with such procedures and methods as are adopted from time to time by the Committee. 6.2. ADJUSTMENT OF PARTICIPANTS' ACCOUNTS. As of each Accounting Date on or after the Effective Date, the Committee shall: (a) FIRST, charge to the Account of each Participant all distributions and payments made to him, or on his account, since the last preceding Accounting Date that have not been charged previously; (b) NEXT, adjust each Participant's Account for dividends, shares of Company Stock, earnings and losses, if any, that are to be allocated or credited as of that date in accordance with the provisions of subsection 6.3, other than shares allocated pursuant to the last sentence of paragraph 6.3(b); -10- 34 (c) FINALLY, allocate and credit to each Participant's Account his portion, if any, of the amounts that are to be allocated and credited as of that date in accordance with the last sentence of subsection 6.3(b) and subsections 6.4 and 6.5. 6.3. ALLOCATION AND CREDITING OF EARNINGS AND LOSSES. Subject to subsection 6.10, Participant Accounts shall be adjusted for earnings and losses as follows: (a) As of each Accounting Date, each Participant's Account shall be adjusted to reflect any appreciation or depreciation in the fair market value of shares of Company Stock allocated to his Account. (b) If dividends paid on shares of Company Stock which were acquired with the proceeds of an ESOP Loan and credited to a Participant's Account, are used in accordance with subsection 5.2 to make payments of principal or interest on such ESOP Loan, the Participant's Account shall be allocated shares of Company Stock as of the last day of each Plan Year with a fair market value as of such date equal to the amount of such dividends. Shares of Company Stock released from the Suspense Account during the Plan Year shall be used first for this purpose. To the extent that additional shares are required, shares of Company Stock contributed by the Employers or acquired with Employer Contributions (other than Employer Contributions used to make payments of principal and interest on ESOP Loans) during such Plan Year shall be applied for such purpose. All other shares of Company Stock released from the Suspense Account during any Plan Year by reason of the use of dividends on allocated and unallocated shares of Company Stock to make payments of principal and interest on an ESOP Loan shall be allocated and credited to the Accounts of Eligible Participants on the same basis as shares released from the Suspense Account during any Plan Year on account of Employer Contributions in accordance with subsection 6.5. (c) As of each Accounting Date, each Participant's Account shall be credited with any cash dividends or in-kind dividends (or shares of Company Stock acquired on account of the reinvestment of such dividends) paid to the Trustee since the last preceding Accounting Date with respect to shares of Company Stock credited to the Participant's Account (other than dividends which have been, or will be, distributed in accordance with subsection 5.2 or which are used or are to be used to repay the ESOP Loan). -11- 35 (d) If, pending investment in shares of Company Stock, cash Contributions by the Employers are invested in cash equivalents, earnings, if any, accrued thereon prior to the last day of the Plan Year for which the contributions are made shall be allocated and credited to the Accounts of all Participants as of the same date and on the same basis as such Employer Contributions are allocated under the provisions of subsection 6.5. Notwithstanding the preceding sentence, if cash Employer Contributions to the Plan that are to be used to repay an ESOP Loan are invested in cash or cash equivalents, earnings, if any, accrued thereon shall also be used to repay such ESOP Loan. (e) Subject to subsection 6.10, all other Trust Fund earnings, if any, shall be allocated to Participant Accounts as of each Accounting Date, pro rata, according to their Account balances as determined as of the immediately preceding Accounting Date after adjustment in accordance with paragraph 6.2(a) to reflect distributions and payments. (f) The Account of a Participant, whose Termination Date occurs prior to the end of a Plan Year and who receives or elects to receive an immediate distribution of his Account in accordance with section 9, shall be credited through the last day of the month preceding the Account Liquidation date (as defined in subsection 9.13) with (i) any cash dividends or in-kind dividends (or shares of Company Stock acquired on account of the reinvestment of such dividends) paid or accrued to the Trustee since the last Accounting Date preceding the Participant's Termination Date with respect to shares of Company Stock credited to such Participant's Account as of that last Accounting Date (other than dividends which have been distributed in accordance with subsection 5.2 or which are used to repay the ESOP Loan) and (ii) any other Trust Fund earnings allocable to such Participant's Account. (g) The Account of a Participant, who terminates from employment and does not receive or elect to receive an immediate distribution of his Account, shall continue to be adjusted for earnings and losses in accordance with paragraphs (a) through (c) and (e) of this subsection until the Plan Year in which such Participant elects to receive distribution of his Account (the "Election Plan Year"). The Account of a Participant in his Election Plan Year shall be adjusted for earnings and losses through the last day of the month preceding the Account Liquidation Date. -12- 36 6.4. MINIMUM REQUIRED ALLOCATION AMOUNTS. (a) As of each Plan Year beginning on or after the Effective Date, the value (determined as of the last day of that Plan Year) of Company Stock allocated to each Eligible Participant's Account as a result of Employer Contributions made to the Plan for such Plan Year, dividends allocated for such Plan Year pursuant to the last sentence of paragraph 6.3(b) and Forfeitures arising during such Plan Year (pursuant to subsection 9.10) shall be at least equal to the following "Minimum Required Allocation Amount": the Eligible Participant's If the Eligible Participant's Minimum Required Years of Service are: Allocation Amount is: - ----------------------------- -------------------------- Less than 6, 6% of his Compensation. At least 6 but less than 11, 7% of his Compensation. At least 11 but less than 21, 8% of his Compensation. 21 or more, 9% of his Compensation. For purposes of this subsection 6.4, Years of Service shall have the meaning provided in subsection 3.3 and shall be determined as of the last day of the Plan Year; provided, however, that if an Eligible Participant incurs five consecutive One Year Periods of Severance, then his number of Years of Service, if any, accrued prior to such break shall be disregarded for purposes of this subsection. For purposes of this subsection 6.4, a Participant's "Compensation" shall have the meaning provided in subsection 6.6. (b) Notwithstanding the foregoing, the Minimum Required Allocation Amount for any Eligible Participant whose Termination Date occurs prior to the end of a Plan Year shall be determined using the Participant's Years of Service and Compensation up to his Termination Date. 6.5. ALLOCATION AND CREDITING OF EMPLOYER CONTRIBUTIONS AND FORFEITURES. Subject to the provisions of paragraph 6.3(b) and section 7, allocation of Employer Contributions and Forfeitures shall be made in accordance with the following provisions of this subsection 6.5. (a) Each Employer's Contributions for a Plan Year and any Forfeitures arising under the Plan during that year pursuant to subsection 9.10 less any expenses paid from the Trust pursuant to section 6.10 (hereinafter "Net Expenses") shall be allocated as of the last day of such Plan Year. (b) (i) Employer Contributions and Forfeitures less Net Expenses shall be allocated in shares of Company Stock. The number of shares of Company Stock to be allocated for any Plan Year shall be the sum of (A) the number of shares of Company Stock -13- 37 released from the Suspense Account by reason of Employer Contributions that are used to make payments of principal or interest on an ESOP Loan, PLUS (B) the number of shares of Company Stock contributed directly to the Plan in the form of shares of Company Stock, PLUS (C) the number of shares of Company Stock acquired with Employer Contributions made in cash and not used to make payments of principal or interest on an ESOP Loan or to pay expenses, PLUS (D) the number of shares of Company Stock forfeited during that year, MINUS (E) the number of shares of Company Stock used to pay Net Expenses. (ii) With respect to the Account of a Participant who dies or retires (within the meaning of paragraphs (a), (b), (c) or (d) of subsection 8.3) prior to the end of a Plan Year, or who elects to transfer the Participant's Account pursuant to subsection D-4 of Supplement D, the Committee may direct that the allocation to his Account for that year be in a form other than shares of Company Stock. (c) The shares of Company Stock to be allocated for any Plan Year shall be allocated and credited to the Accounts of Eligible Participants in the following manner: (i) FIRST, subject to the provisions of subparagraphs 6.5(c)(iii) and (iv), each Eligible Participant's Account shall be allocated and credited shares of Company Stock equal in value to his Minimum Required Allocation Amount for that Plan Year; (ii) NEXT, if after the application of the provisions of subparagraph 6.5(c)(i), additional shares of Company Stock remain to be allocated ("Extra Shares"), there shall be allocated and credited to each Eligible Participant's Account the number of shares of Company Stock equal to the product of (A) times (B), where (A) is the number of Extra Shares for that Plan Year, and (B) is a fraction, the numerator of which is the number of shares of Company Stock allocated for that Plan Year to the Eligible Participant's Account under subparagraph 6.5(c)(i), and the denominator of which is the aggregate number of shares of Company Stock allocated for that Plan Year to all Eligible Participants' Accounts under subparagraph 6.5(c)(i). -14- 38 (iii) Notwithstanding the foregoing, the Account of each Eligible Participant whose Termination Date occurs prior to the end of a Plan Year shall be allocated and credited as of that Termination Date with cash equal to the Participant's Minimum Required Allocation Amount as determined under paragraph (b) of subsection 6.4. (iv) Notwithstanding any provision contained herein to the contrary, if in any Plan Year, the foregoing formula would produce an allocation that would be inconsistent with the requirements of Code section 401(a)(4), then the amount which would have been allocated to a highly compensated employee, as that term is defined in section 414(q) of the Code, but for the fact that such allocation is inconsistent with the requirements of Code section 401(a)(4), shall be allocated among the highly and nonhighly compensated employees in a manner that after the allocation, the requirements of Code section 401(a)(4) will be satisfied. 6.6. COMPENSATION. A Participant's "Compensation" for any Plan Year means wages, salaries, and fees for personal services actually rendered in the course of employment with the Employer to the extent that the amounts are includable in gross income. Compensation shall also include any salary deferral contributions to a 401(k) plan or a section 125 cafeteria plan of the Employer. Compensation shall not include distributions from a plan of deferred compensation, amounts realized from the exercise of a non-qualified stock option or when restricted stock (or property) either becomes freely transferrable or is no longer subject to a substantial risk of forfeiture, or amounts realized from the sale, exchange or other disposition of stock acquired under a qualified stock option. Notwithstanding the foregoing, no Compensation in excess of $200,000 for any Plan Year (or such larger amount as may be permitted for any Plan Year under ss. 401(a)(17) of the Code) will be taken into account for any purpose under the Plan. Effective for Plan Years beginning after December 31, 1993, no Compensation in excess of $150,000 for any Plan Year (or such larger amount as may be permitted for any future Plan Year under section 401(a)(17) of the Code) will be taken into account for any purpose under the Plan. Effective for Plan Years beginning before January 1, 1997, in determining the limitation on Compensation under section 401(a)(17) of the Code, the rules of section 414(q)(6) of the Code ("family aggregation") shall apply, except the term "family" shall include only the spouse of the Participant and any lineal descendants of the Participant who have not attained age 19 before the close of -15- 39 the year. If the limit on Compensation is exceeded, then the limitation shall be pro-rated among the affected individuals in proportion to each such individual's Compensation determined without regard to the limitation under section 401(a)(17) of the Code. 6.7. ELIGIBLE PARTICIPANTS. (a) Subject to the following sentence, the term "Eligible Participant" for any Plan Year shall include any Participant who is employed by an Employer during the Plan Year exclusively on a regular full time basis, and is employed by an Employer, or a Related Company, on December 31 of that Plan Year. Notwithstanding the foregoing, the term "Eligible Participant" for any Plan Year shall include any such Participant who died or retired (within the meaning of paragraphs (a), (b), (c) or (d) of subsection 8.3) during such Plan Year. (b) The term "Eligible Participant" for any Plan Year commencing on or after January 1, 1996 shall also include any Participant who is not employed on a regular full time basis during the entire Plan Year but who satisfies the remaining requirements of paragraph (a); provided that such Participant completes a Year of Participation Service during such Plan Year. 6.8. STOCK DIVIDENDS, SPLITS AND OTHER CAPITAL REORGANIZATIONS. Any stock received by the Trustee as a stock split or dividend or as a result of a reorganization or other recapitalization of the Company shall be allocated by the Committee in the same manner as the Company Stock to which it is attributable is then allocated. 6.9. STATEMENT OF PLAN INTEREST. During each Plan Year the Committee shall provide each Participant with a statement of the Participant's account balance under the Plan as of the close of the immediately preceding Plan Year. 6.10. EXPENSES. Notwithstanding anything herein to the contrary, the reasonable and necessary expenses incurred by the Plan and the Trust in their operation, and incurred by the Trustee in the performance of its duties, including, but not limited to, fees for services provided to the Plan to value the assets in the Trust and in Participant accounts, service charges under any ESOP Loan, fees for legal services rendered to the Trustee, such compensation to the Trustee as may be agreed upon in writing from time to time by the Committee, and other proper charges and disbursements of the Trustee, shall be paid from the Trust, except to the extent, if any, that such expenses are paid by the Company. All taxes of any nature whatsoever that may be imposed under existing -16- 40 or future laws upon or in respect of the assets of the Trust or income therefrom shall be paid from the Trust. Unless otherwise directed by the Committee, dividends on allocated shares of Company Stock shall not be used to pay expenses. SECTION 7 --------- Limitations ----------- 7.1. LIMITATION ON ALLOCATIONS TO PARTICIPANT ACCOUNTS. Notwithstanding any other provision of the Plan, allocations to Participant Accounts shall be subject to the provisions of section 415 of the Code. Consistent with the limitations set forth in such section, a Participant's Annual Additions (as defined in subsection 7.2) for any Plan Year shall not exceed an amount equal to the lesser of: (a) 25 percent of the Section 415 Compensation (as defined below) paid to the Participant in that Plan Year; or (b) $30,000 (or, if greater, 25% of the limitation in effect under section 415(b)(1)(A) of the Code); REDUCED BY ---------- (c) the annual additions allocated to the Participant for that Plan Year under any other defined contribution plan of an Employer or a Related Company or Section 415 Affiliate. A Participant's "Section 415 Compensation" for any Plan Year means the Participant's wages, salaries, commissions, bonuses and other amounts received during the Plan Year from any Related Company or Section 415 Affiliate (defined below) for personal services actually rendered, including taxable fringe benefits, nonqualified stock options taxable in the year of grant, amounts taxable under a section 83(b) election and nondeductible moving expenses, but excluding distributions from any deferred compensation plan (qualified or nonqualified), amounts realized from the exercise of (or disposition of stock acquired under) any nonqualified stock option or other benefits given special tax treatment. "Section 415 Affiliate" means any entity that would be a Related Company if the ownership test of sections 414(b) and (c) of the Code was 50% rather than 80%. This subsection 7.1 shall be construed in accordance with section 415(c)(3) of the Code and applicable regulations thereunder. Notwithstanding anything herein to the contrary, for years beginning after December 31, 1997, a Participant's "Section 415 Compensation" shall include any elective deferral, as defined in section 402(g)(3) of the Code, and any amount -17- 41 which is contributed or deferred by any Related Company or Section 415 Affiliate at the election of the Participant and which is not includable in gross income by reason of section 125 of the Code. 7.2. ANNUAL ADDITIONS. Subject to the provisions of subsection 7.4, a Participant's "Annual Additions" for any Plan Year means the sum of (i) the amount of the Employer Contributions allocated to his Account for that Plan Year (determined, with respect to Employer Contributions made to enable the Trustees to make payments on an ESOP Loan, as if such contributions were allocated in cash, and not on the basis of the value of the Company Stock released from the Suspense Account); and (ii) the amount of Forfeitures allocated to the Participant's Account. The term Annual Additions shall also include employer contributions allocated for a Plan Year to any individual medical account (as defined in section 415(l) of the Code) of a Participant under a defined benefit plan and any amount allocated for a Plan Year to the separate account of a Participant for payment of post-retirement medical benefits under a funded welfare benefit plan (as described in section 419A(d)(2) of the Code), which was maintained by an Employer or a Related Company or a Section 415 Affiliate. Plan earnings shall not constitute Annual Additions. 7.3. EXCESS ANNUAL ADDITIONS. If, as a result of the allocation of Forfeitures, a reasonable error in estimating a Participant's Compensation or such other mitigating circumstances as the Commissioner of Internal Revenue shall prescribe, the Annual Additions for a Participant for a Plan Year exceed the limitations set forth in subsection 7.1, the excess amounts shall be treated, as necessary, in accordance with Treas. Reg. section 1.415-6(b)(6)(ii). Notwithstanding anything herein or in any other plan of the Employer to the contrary, to the extent that a Participant's Annual Additions exceed the limitations set forth in subsection 7.1, the excess amount shall first be reduced to the extent possible in such other plans of the Employer. 7.4. HIGHLY COMPENSATED EMPLOYEES. If not more than one-third of the Employer Contributions for any Plan Year are allocated to Highly Compensated Employees, as that term is defined in section 414(q) of the Code, then Annual Additions for such Plan Year shall not include: (i) Employer Contributions applied to the repayment of interest on an ESOP Loan and deductible for that Plan Year under section 404(a)(9) of the Code; or (ii) Forfeitures of Company Stock acquired with the proceeds of an ESOP Loan. For Plan Years beginning before January 1, 1997, the term Highly Compensated Employee shall be defined in accordance with the terms of the Plan as Amended and Restated Effective as of January 1, 1990. For Plan Years beginning after December 31, 1996, the term Highly Compensated Employee for any Plan Year shall include any employee of an Employer who: -18- 42 (a) during the Plan Year or the preceding Plan Year, was a 5 percent owner of an Employer or a Related Company; or (b) for the preceding Plan Year, had compensation, as defined in regulations promulgated under Code section 414(q), from the Employer or a Related Company in excess of $80,000 (as adjusted under Code section 414(q)), and if the Company elects, pursuant to regulations promulgated under Code section 414(q), was in the top-paid group of employees for such preceding year. 7.5. COMBINED PLAN LIMITATION. If a Participant participates or has participated in any qualified defined benefit plan maintained by an Employer, then for any Plan Year the sum of the defined benefit plan fraction (as defined in section 415(e)(2) of the Code) and the defined contribution plan fraction (as defined in section 415(e)(3) of the Code) for such Participant shall not exceed 1.0 (his "combined fraction"). If his combined fraction exceeds 1.0, then his defined contribution plan fraction shall be reduced by limiting Employer Contributions to the Plan to the extent necessary to reduce his combined fraction to 1.0. SECTION 8 --------- Vesting and Termination Dates ----------------------------- 8.1. DETERMINATION OF VESTED INTEREST. A Participant shall have a fully vested, nonforfeitable interest in his entire Account upon his completion of five Years of Service. 8.2. ACCELERATED VESTING. Notwithstanding the foregoing provisions of this section 8, a Participant shall have a fully vested, nonforfeitable interest in his entire Account when he dies while employed by an Employer or a Related Company. In addition, in the event of the Plan's termination (in accordance with subsection 12.2) or partial termination (as determined under applicable law and regulations), each affected Participant shall be fully vested in his Account. 8.3. TERMINATION DATES. A Participant's "Termination Date" shall be the date on which his employment with the Employers and the Related Companies is terminated because of the first to occur of the following events: (a) NORMAL OR LATE RETIREMENT. The Participant retires or is retired from the employ of the Employers and the Related Companies on or after his Normal Retirement Date. A Participant's "Normal Retirement Date" shall be the date on which he meets the following requirements: -19- 43 (i) he has attained age 65; and (ii) he has completed 5 Years of Service. (b) EARLY RETIREMENT. The Participant retires or is retired from the employ of the Employers and the Related Companies on or after the date he meets the following requirements: (i) he has attained age 55; and (ii) he has completed 5 Years of Service. (c) DISABILITY RETIREMENT. The Participant is retired from the employ of the Employers and the Related Companies at any age because of disability, as determined in accordance with the Company's long-term disability plan, on or after the date he has completed 5 Years of Service. (d) DEATH. The Participant's death. (e) RESIGNATION OR DISMISSAL. The Participant resigns or is dismissed from the employ of the Employers and the Related Companies. SECTION 9 --------- Distributions ------------- 9.1. DISTRIBUTIONS TO PARTICIPANTS AFTER TERMINATION OF EMPLOYMENT. If a Participant's Termination Date occurs (for a reason other than his death) under subsection 8.3, the vested portion of his Account shall be distributed in accordance with the following provisions of this subsection 9.1, subject to the rules of subsection 9.7: (a) If the value of the vested portion of the Participant's Account does not exceed $3,500 (and at the time of any prior distribution has never exceeded $3,500), determined in accordance with par