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 June 30, 2005
Commission File Number 2-39621
UNITED FIRE & CASUALTY COMPANY
(Exact name of registrant as specified in its charter)
118 Second Avenue, S.E.
Cedar Rapids, Iowa
Registrant’s telephone number, including area code: (319) 399-5700
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 (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). YES x NO ¨
As of July 26, 2005, 23,594,298 shares of common stock were outstanding.
UNITED FIRE & CASUALTY COMPANY AND SUBSIDIARIES
INDEX
Part I.Financial Information
Item 1.Financial Statements
Consolidated Balance Sheets as of June 30, 2005 (unaudited) and December 31, 2004
Consolidated Statements of Income (unaudited) for the three-month periods ended June 30, 2005 and 2004
Consolidated Statements of Income (unaudited) for the six-month periods ended June 30, 2005 and 2004
Consolidated Statements of Cash Flows (unaudited) for the six-month periods ended June 30, 2005 and 2004
Notes to Unaudited Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.Quantitative and Qualitative Disclosures about Market Risk
Item 4.Controls and Procedures
Part II.Other Information
Item 4.Submission of Matters to a Vote of Security Holders
Item 5.Other Information
Item 6.Exhibits
Signatures
Certification Pursuant to Section 302 - CEO
Certification Pursuant to Section 302 - CFO
Certification Pursuant to Section 906 - CEO
Certification Pursuant to Section 906 - CFO
PART I: FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
(Dollars in Thousands Except Per Share Data and Number of Shares)
ASSETS
Investments
Fixed maturities
Held-to-maturity, at amortized cost (fair value $86,662 in 2005 and $92,659 in 2004)
Available-for-sale, at fair value (amortized cost $1,702,048 in 2005 and $1,542,015 in 2004)
Equity securities, at fair value (cost $48,185 in 2005 and $45,417 in 2004)
Trading securities, at fair value (amortized cost $6,219 in 2005 and $10,044 in 2004)
Mortgage loans
Policy loans
Other long-term investments
Short-term investments
Cash and Cash Equivalents
Accrued Investment Income
Premiums Receivable
Deferred Policy Acquisition Costs
Property and Equipment (primarily land and buildings, at cost, less accumulated depreciation of $30,333 in 2005 and $30,959 in 2004)
Reinsurance Receivables and Recoverables
Prepaid Reinsurance Premiums
Income Taxes Receivable
Other Assets
TOTAL ASSETS
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities
Future policy benefits and losses, claims and settlement expenses
Property and casualty insurance
Life insurance
Unearned premiums
Accrued expenses and other liabilities
Income taxes payable
Deferred income taxes
TOTAL LIABILITIES
Redeemable Preferred Stock
6.375% cumulative convertible preferred stock - Series A, no par value
Stockholders’ Equity
Common stock, $3.33 1/3 par value; authorized 75,000,000 shares; 23,594,098 shares issued and outstanding in 2005 and 20,132,556 shares issued and outstanding in 2004
Additional paid-in capital
Retained earnings
Accumulated other comprehensive income, net of tax
TOTAL STOCKHOLDERS’ EQUITY
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
The Notes to Unaudited Consolidated Financial Statements are an integral part of these statements.
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UNAUDITED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data and number of shares)
Revenues
Net premiums earned
Investment income, net of investment expenses
Realized investment gains
Other income
Benefits, Losses and Expenses
Losses and settlement expenses
Increase in liability for future policy benefits
Amortization of deferred policy acquisition costs
Other underwriting expenses
Interest on policyholders’ accounts
Income before income taxes
Federal income tax expense
Net income
Less preferred stock dividends and accretions
Earnings available to common shareholders
Weighted average common shares outstanding (1)
Basic earnings per common share (1)
Diluted earnings per common share (1)
Cash dividends declared per common share (1)
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UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Cash Flows From Operating Activities
Adjustments to reconcile net income to net cash provided by operating activities:
Net bond premium (discount) accretion
Depreciation and amortization
Net cash flows from trading investments
Deferred income tax expense (benefit)
Changes in:
Accrued investment income
Premiums receivable
Deferred policy acquisition costs
Reinsurance receivables
Prepaid reinsurance premiums
Income taxes receivable
Other assets
Other, net
Total adjustments
Net cash provided by operating activities
Cash Flows From Investing Activities
Proceeds from sale of available-for-sale investments
Proceeds from call and maturity of held-to-maturity investments
Proceeds from call and maturity of available-for-sale investments
Proceeds from short-term and other investments
Purchase of available-for-sale investments
Purchase of short-term and other investments
Net purchases and sales of property and equipment
Net cash used in investing activities
Cash Flows From Financing Activities
Policyholders’ account balances:
Deposits to investment and universal life contracts
Withdrawals from investment and universal life contracts
Issuance of common stock pursuant to stock option exercises
Redemption of preferred stock
Payment of cash dividends
Net cash provided by financing activities
Net Change in Cash and Cash Equivalents
Cash and Cash Equivalents at Beginning of Period
Cash and Cash Equivalents at End of Period
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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Basis of Presentation
The terms “United Fire,” “we,” “us,” or “our” refer to United Fire & Casualty Company or United Fire & Casualty Company and its consolidated subsidiaries and affiliate, as the context requires. In the opinion of the management of United Fire, the accompanying unaudited Consolidated Financial Statements contain all adjustments (consisting of normal recurring adjustments) necessary to present fairly the financial position, the results of operations and cash flows for the periods presented. The results for the interim periods are not necessarily indicative of the results of operations that may be expected for the year. The Consolidated Financial Statements contained herein should be read in conjunction with our annual report on Form 10-K for the year ended December 31, 2004. The review report of Ernst & Young LLP as of and for the three- and six-month periods ending June 30, 2005 accompanies the unaudited Consolidated Financial Statements included in Item 1 of Part I.
We maintain our records in conformity with the accounting practices prescribed or permitted by the insurance departments of the states in which we are domiciled. To the extent that certain of these practices differ from U.S. generally accepted accounting principles (“GAAP”), we have made adjustments to present the accompanying Consolidated Financial Statements on the basis of GAAP.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The financial statement categories that are most dependent on management estimates and assumptions include the valuation of investments, the valuation of reserves for losses, claims and settlement expenses, the valuation of reserves for future policy benefits, the calculation of deferred policy acquisition costs, and the valuation of pension and post-retirement benefit obligations.
We are a defendant in legal actions arising from normal business activities. Management, after consultation with legal counsel, is of the opinion that any liability resulting from these actions will not have a material impact on our financial position and operating results.
For purposes of reporting cash flows, cash and cash equivalents include cash, money market accounts and non-negotiable certificates of deposit with original maturities of three months or less. We made payments for income taxes of $32.9 million for the six-month period ended June 30, 2005, compared to $15.5 for the six-month period ended June 30, 2004. We made no significant payments of interest for the six-month periods ended June 30, 2005 and 2004, other than interest credited to policyholders’ accounts.
Note 2. New Accounting Standards
In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 123(R), “Share-Based Payment”. Statement No. 123(R) is a revision of Statement No. 123, “Accounting for Stock Based Compensation”, and supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”. Statement No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized as expense in the financial statements based on their grant date fair values. The pro forma disclosures previously allowed under Statement No. 123 no longer will be an alternative to financial statement recognition. Statement No. 123(R) is effective for public companies for the first annual reporting period beginning after June 15, 2005, with early adoption allowed.
The transition methods for adopting Statement No. 123(R) include the modified-prospective and modified-retroactive methods. The modified-prospective method requires that compensation expense be recorded for all unvested stock options and restricted stock that exist upon the adoption of Statement No. 123(R). Under the modified-retroactive method, prior periods may be restated for the recognition of compensation expense either as of the beginning of the year of adoption or for all periods presented. We are currently evaluating the requirements of Statement No. 123(R) and expect that the adoption of Statement No. 123(R) will not have a material impact on our Consolidated Financial Statements.
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Note 3. Stock Options
We have a nonqualified employee stock option plan that authorizes the issuance of up to 1,000,000 shares of United Fire common stock to employees. Through June 30, 2005 we have granted options for 462,042 shares of United Fire common stock, of which options for 100,622 shares have been exercised. Pursuant to Statement No. 123, we elected to apply Accounting Principles Board Opinion No. 25, and related interpretations in accounting for stock options issued under our stock-based compensation plan. Opinion No. 25 prescribes the use of the intrinsic value method of accounting for our employee and director stock-based compensation awards. Accordingly, we have not recognized compensation expense for these awards. If the stock options had been accounted for under Statement No. 123, compensation cost would have been recorded based on the grant-date fair value attributable to the number of options that eventually vest. This cost would then be recognized over the period in which the options vest, with the amount recognized at any date being at least equal to the value of the vested portion of the award at that date.
In accordance with the disclosure requirements of Statement No. 123, the pro forma effects of recognizing compensation expense on net income and income per share, had we applied the fair value method of accounting for stock options is as follows:
(Dollars in Thousands, except per share amounts)
Net income, as reported
Deduct compensation expense determined under the fair value based method for all awards, net of related tax effects
Pro forma net income
Basic EPS
Diluted EPS
Note 4. Employee Benefit Plans
Among the employee benefit plans we offer, the two most significant plans are a non-contributory defined benefit pension plan and an employee/retiree health and dental benefit plan.
All of our employees are eligible to participate in the non-contributory defined benefit pension plan after they have completed one year of service and attained twenty-one years of age. Under our pension plan, retirement benefits are a function of the number of years of service and the level of compensation. Our policy is to fund this plan on a current basis to the extent that the contribution is deductible under existing tax regulations.
We offer the health and dental benefit plan to all of our eligible employees and retirees. The plan is composed of two programs: (1) the Self-Funded Retiree Health and Dental Benefit Plan and (2) the Self-Funded Employee Health and Dental Benefit Plan. The employee plan provides health and dental benefits to our employees who are regularly scheduled to work for us for 24 or more hours per week and their covered dependents. The retiree plan provides health and dental coverage benefits to retired employees and their covered dependents provided the retired employees have attained at least age 55 and have continuously participated in the employee plan for at least 10 consecutive years immediately prior to retirement. Both health care plans provide a prescription drug benefit.
Net periodic pension cost totaled $.7 million for the second quarter of 2005, compared to $.2 million in the second quarter of 2004. Net periodic postretirement benefit cost totaled $.4 million for the second quarter of 2005 and 2004. Net periodic pension cost totaled $1.3 million in the first half of 2005, compared to $.9 million in the first half of 2004. Net periodic postretirement benefit cost totaled $.8 million in the first half of 2005 and 2004. Due to the timing of the completion of our annual benefit plan valuations by our benefits actuary, these second quarter benefit costs are estimates. Upon receipt of the current year benefit plan valuations, we update the current year benefit expenses accordingly. We previously disclosed in our annual report on Form 10-K for the year ended December 31, 2004 that we expected to contribute $5.5 million to our pension plan in 2005. In the first six months of 2005, we contributed $1.7 million to the pension plan. We do not anticipate that the total contribution for 2005 will vary significantly from the expected contribution.
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Note 5. Segment Information
We have two reportable business segments in our operations: property and casualty insurance and life insurance. Our property and casualty insurance segment conducts business from our home office in Cedar Rapids, Iowa and from two other locations. All three locations are aggregated because they target a similar customer base, market the same products and use the same marketing strategies. The life insurance segment operates from our home office in Cedar Rapids, Iowa. Because all of our insurance products are sold only domestically, we allocate no revenue to foreign operations. Our management evaluates the two segments both on the basis of accounting practices prescribed by our states of domicile and on the basis of GAAP. We analyze results based on a variety of factors, including profitability, expenses and return on equity. The bases we use to determine and analyze segments and to measure segment profit have not changed from that reported in our annual report on Form 10-K for the year ended December 31, 2004.
We report the following analysis on the basis of GAAP. We have reconciled the analysis to our unaudited Consolidated Financial Statements to adjust for inter-segment eliminations.
(In Thousands)
Inter-segment Eliminations
Total Revenues
Net Income
Assets
Six Months Ended June 30, 2004
Realized investment gains (losses)
Note 6. Trading Securities
Our investment portfolio includes trading securities with embedded derivatives. These securities, which are primarily convertible redeemable preferred debt securities, are recorded at fair value. Income or loss, including the change in the fair value of these trading securities, is recognized currently in earnings as a component of realized investment gains and losses. Our portfolio of trading securities had a market value of $6.5 million at June 30, 2005, compared to $10.5 million at December 31, 2004.
Note 7. Comprehensive Income
Comprehensive income includes all changes in equity during a period except those resulting from investments by shareholders and dividends to shareholders. The major components of our comprehensive income are net income and the change in net unrealized investment gains and losses on available-for-sale securities as adjusted for amounts that have been reclassified as realized investment gains and losses. Comprehensive income was $53.4 million and $28.5 million for the six months ended June 30, 2005 and 2004, respectively. Comprehensive income was $36.6 million and $2.6 million for the three months ended June 30, 2005 and 2004, respectively.
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Note 8. Earnings Per Share
We compute earnings per share in accordance with Statement of Financial Accounting Standard No. 128, “Earnings per Share.” Accordingly, we compute basic earnings per share by dividing earnings available to common stockholders (net income or loss less dividends to preferred stockholders and accretions of preferred stock issuance costs) by the weighted-average number of common shares outstanding during the period. Diluted earnings per share gives effect to all potentially dilutive common shares outstanding during the period. The potentially dilutive shares we consider in our diluted earnings per share calculation relate to our convertible preferred stock and our outstanding stock options.
We determine the dilutive effect of our convertible preferred stock using the “if-converted” method. Under this method, we add to the denominator of the earnings per share calculation a number determined by multiplying the number of convertible preferred shares outstanding by the stated conversion rate. We add to the numerator of the earnings per share equation the amount of preferred stock dividends and accretions to reflect the assumed conversion to common stock of all the convertible preferred stock. If the effect of the if-converted method is anti-dilutive, the effect on diluted earnings per share of our convertible preferred stock is disregarded. Because of the acceleration of the accretion of our preferred stock issuance costs in the second quarter (pursuant to the conversion and redemption of our preferred stock), the effect of the if-converted method was anti-dilutive for the quarter ended June 30, 2005, and was therefore disregarded in the computation of dilutive earnings per share for the quarter.
We determine the dilutive effect of our outstanding stock options using the “treasury stock” method. Under this method, we assume the exercise of all of the outstanding options whose exercise price is less than the weighted-average fair market value of our common stock during the reporting period. This method assumes that the proceeds from the hypothetical stock option exercises are used to repurchase shares of common stock at the weighted-average fair market value of the stock during the period. The net of the assumed options exercised and assumed common shares repurchased represents the number of potentially dilutive common shares, which we add to the denominator of the earnings per share calculation.
The components of basic and diluted earnings per share are displayed in the following table. All share and per share amounts reflect the retroactive effects of our December 15, 2004 one-for-one stock dividend.
Three months ended
June 30,
Six months ended
(In thousands, except per share data)
Weighted average common shares outstanding
Potentially dilutive common shares
Weighted average common and potential shares outstanding
Basic earnings per common share
Diluted earnings per common share
Note 9. Preferred Stock
On May 16, 2005, we redeemed all shares of Preferred Stock which had not been converted to common stock by holders of Preferred Stock. Of the 2,760,000 shares of Preferred Stock issued, 2,754,674 shares were converted into shares of common stock prior to the Redemption Date. The remaining 5,326 shares were redeemed by the company. The issuance costs generated by the preferred stock offering were initially recorded as an offset to the carrying value of our preferred stock and accreted to retained earnings through the mandatory redemption date. Both the accretion of preferred stock issuance costs and the dividends on the preferred stock are recorded as offsets to net income in arriving at earnings available to common shareholders, the basis of the earnings per share calculation. Pursuant to the conversion and redemption of our preferred shares, the remaining unaccreted issuance costs of $2.9 million were accreted in the second quarter.
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders of United Fire & Casualty Company
We have reviewed the consolidated balance sheet of United Fire & Casualty Company as of June 30, 2005, and the related consolidated statements of income for the three-month and six-month periods ended June 30, 2005 and 2004, and the consolidated statements of cash flows for the six-month periods ended June 30, 2005 and 2004. These financial statements are the responsibility of the Company’s management.
We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the consolidated interim financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of United Fire & Casualty Company as of December 31, 2004, and the related consolidated statements of income, stockholders’ equity, and cash flows for the year then ended, not presented herein, and in our report dated February 28, 2005, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2004, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
/s/ Ernst & Young LLP
July 27, 2005
Chicago, Illinois
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD LOOKING STATEMENT
This discussion may contain forward-looking statements about our operations, anticipated performance and other similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor under the Securities Act of 1933 and the Securities Exchange Act of 1934 for forward-looking statements. The forward-looking statements are not historical facts and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. Such forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry in which we operate, management’s beliefs and assumptions made by management. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “continues,” “seeks,” “estimates,” “predicts,” “should,” “could,” “may,” “will continue,” “might”, “hope” and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed in such forward-looking statements. Among the factors that could cause our actual outcomes and results to differ are the following: inherent uncertainties with respect to loss reserving; the occurrence of catastrophic events or other insured or reinsured events with a frequency or severity exceeding our estimates; the actual amount of new and renewal business and demand for our products and services; the competitive environment in which we operate, including price, product and service competition; developments in domestic and global financial markets that could affect our investment portfolio and financing plans; impact of regulatory actions on our Consolidated Financial Statements; uncertainties relating to government and regulatory policies; additional government and NASDAQ policies relating to corporate governance, and the cost to comply; legal developments; changing rates of inflation, interest rates and other economic conditions; worsening of global economic conditions; our relationship with our agencies; the valuation of invested assets; the recovery of deferred acquisition costs; the resolution of legal issues pertaining to the World Trade Center catastrophe; the occurrence of terrorist activity; or our relationship with our reinsurers. These are representative of the risks, uncertainties and assumptions that could cause actual outcomes and results to differ materially from what is expressed in forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their dates. Except as required under the federal securities laws and the rules and regulations of the Securities and Exchange Commission, we do not have any intention or obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.
REGULATION G COMPLIANCE MEASURES
In response to disclosure regulations adopted by the Securities and Exchange Commission as part of its implementation of the Sarbanes-Oxley Act of 2002 (specifically Regulation G, which became effective in March 2003), measures used in this discussion that are not based on GAAP (Non-GAAP) are defined and reconciled to the most directly comparable GAAP measures and operating measures in the “Non-GAAP Financial Measures” section at the end of this discussion.
CRITICAL ACCOUNTING POLICIES
Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties and that potentially may result in materially different results under different assumptions and conditions. Our discussion and analysis of our results of operations and financial condition are based upon our Consolidated Financial Statements, which we have prepared in accordance with GAAP. As we prepare these financial statements, we must make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We evaluate our estimates on an on-going basis. We base our estimates on historical experience and on other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from those estimates. Our critical accounting policies most sensitive to estimates include the valuation of investments, the valuation of reserves for losses, claims and settlement expenses, the valuation of reserves for future policy benefits, the calculation of the deferred acquisition cost asset, and the valuation of pension and post-retirement benefit obligations. These critical accounting policies are more fully described in our Management’s Discussion and Analysis of Results of Operations and Financial Condition presented in our annual report on Form 10-K for the year ended December 31, 2004.
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OVERVIEW AND OUTLOOK
United Fire operates property and casualty and life insurance businesses, marketing its products through independent agents. Although it maintains a broad geographic presence that includes most of the United States, more than half of its property and casualty premiums and more than two-thirds of its life insurance premiums are written in five states. Our primary focus is on our core property and casualty commercial lines. Through disciplined underwriting and strong agency relationships, we have traditionally emphasized writing good business at an adequate price, preferring quality to volume. Our goal of consistent profitability is supported by these business strategies.
Our 2005 property and casualty earnings have been marked by a decrease in losses and settlement expenses and an increase in net earned premium. The decrease in losses and settlement expenses is attributable to a significant decrease in claims frequency experienced in 2005. However, we are mindful of the Midwest storm and Atlantic hurricane seasons, which generally produce increased claims activity. The increase in net premium earned was generated by pricing and other underwriting initiatives that we have pursued in recent years, from which we continue to realize benefits as the related premium is earned. However, moderation in pricing is evident as rate increases have diminished in several lines of business. Many lines have actually experienced a decrease in rates.
Our overall pricing is affected by rate levels and discretionary underwriting pricing (individual risk premium modifications). On our commercial lines business, we have taken rate decreases averaging in the low to mid single digits in most states and lines. Commercial property, Business Owners Programs and commercial umbrella have decreased the most. Our commercial rates in the coastal areas have remained fairly flat, while rate levels in the Midwest have fallen. Within discretionary pricing, average underwriting credits have increased, but only by low single digit percentages. We expect our commercial premium levels to be down, on average, by mid to upper single digits. We are also seeing diminishing pricing in the Personal Automobile line of business. We have taken low single digit rate reductions in a few selected states in response to the increased competition in this line. In the property lines (Homeowners and Dwelling) we are seeing a generally stable pricing environment. We have continued to strengthen pricing in states with coastal exposures while pricing in the Midwestern states has been generally flat.
In an increasingly competitive insurance marketplace characterized by decreasing premium rates, we feel it is important that we remain resolute in our philosophy of practicing disciplined underwriting. We feel this philosophy is reflected in our continued strong results. We are very encouraged by production increases from our higher-volume agents and continue to seek opportunities to add top-quality agents to our force. The main challenge in 2005 continues to be retention and acquisition of quality business while offering pricing that is adequate yet competitive for the risk.
We reported strong results in our life insurance segment in the second quarter. We are encouraged by the increase in sales levels of single premium whole life and term products, and we remain focused on improving our product line to help agents better match our product to the customer’s need. Through June 30, 2005, our overall annuity deposits and life insurance premiums remain strong, with an increase of nearly 24 percent over the first half of 2004.
On May 16, 2005, we redeemed all shares of Preferred Stock which had not been converted to common stock by holders of Preferred Stock. Of the 2,760,000 shares of Preferred Stock issued, 2,754,674 shares were converted into shares of common stock prior to the Redemption Date. The remaining 5,326 shares were redeemed by the company. The issuance costs generated by the preferred stock offering were initially recorded as an offset to the carrying value of our preferred stock, with subsequent accretions against retained earnings. Pursuant to the conversion and redemption of our preferred shares, the remaining unaccreted issuance costs have been accreted in the second quarter. Earnings per common share was somewhat offset by the accelerated amortization of our preferred stock issuance costs during the quarter. However, we are satisfied to have successfully completed the conversion and we welcome our new common stockholders.
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RESULTS OF OPERATIONS
Consolidated Financial Highlights
Financial Results (In thousands, except per share data)
Total revenues
Book value per common share
All per share amounts reflect the retroactive effects of our December 15, 2004 one-for-one stock dividend.
Second quarter 2005 net income totaled $26.9 million, or $1.08 per share (after providing for the dividend and accretion on convertible preferred stock.) Net income for the second quarter of 2004 was $20.1 million, or $.94 per share (after providing for the dividend and accretion on convertible preferred stock.) Second quarter diluted earnings were $1.08 per share and $.85 per share for 2005 and 2004, respectively. We achieved improvement in second quarter net income primarily as a result of an increase in net premium earned and decrease in losses and loss settlement expenses. Total revenues were $155.6 million in the second quarter of 2005, an increase of $6.0 million, or 4.0 percent, over the second quarter of 2004. Net premiums earned increased 3.5 percent to $124.5 million in the second quarter of 2005, compared to $120.3 million in the second quarter of 2004. Net realized investment gains (before tax) were $1.6 million in the second quarter of 2005, compared to $.7 million in the second quarter of 2004. Investment income was $29.3 million in the second quarter of 2005 compared to $28.5 million in the second quarter of 2004.
Pre-tax catastrophe losses, net of reinsurance, of $5.6 million for the second quarter of 2005 added 4.9 points to the combined ratio, resulting in a reduction in after-tax earnings of $.16 per share. In comparison, pre-tax catastrophe losses, net of reinsurance, of $5.0 million for the second quarter of 2004 added 4.5 points to the combined ratio, resulting in a reduction in after-tax earnings of $.16 per share. Subsequent to quarter end, we have incurred additional pre-tax losses totaling less than $1.0 million from Tropical Storm Cindy, Hurricane Dennis and Hurricane Emily. We do not believe we will incur significant additional losses related to these storms.
For the six months ended June 30, 2005 net income was $59.5 million, or $2.60 per share (after providing for the dividend and accretion on convertible preferred stock). For the six months ended June 30, 2004, net income was $38.5 million, or $1.80 per share (after providing for the dividend and accretion on convertible preferred stock). Diluted earnings for the first half of 2005 were $2.52 per share. Diluted earnings for the first half of 2004 were $1.64 per share. Total revenues were $309.0 million in the first half of 2005, an increase of $14.1 million, or 4.8 percent, over the first half of 2004. Net premiums earned increased 3.6 percent to $247.2 million in the first half of 2005, compared to $238.7 million in the first half of 2004. Net realized investment gains (before tax) were $3.4 million in the first half of 2005, compared to $1.0 million in the first half of 2004. Investment income was $58.0 million in the first half of 2005 compared to $55.0 million in the first half of 2004.
Pre-tax catastrophe losses for the six months ended June 30, 2005, net of reinsurance, were $6.0 million, which added 2.6 points to the combined ratio. These catastrophe losses resulted in an after-tax earnings impact of $.18 per share. For the same period of 2004, pre-tax catastrophe losses were $5.3 million, which added 2.4 points to the combined ratio. These catastrophe losses resulted in an after-tax earnings impact of $.17 per share.
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Property and Casualty Insurance Segment Results
Property & Casualty Insurance Financial Results:
Net premiums written
Underwriting income
Investment income, net
GAAP Ratios:
Net loss ratio
Expense ratio
Combined ratio
Combined ratio (without catastrophes)
Personal and commercial* lines underwriting analysis:
Premiums earned - personal lines
Losses and settlement expenses incurred - personal lines
Personal lines net loss ratio
Premiums earned - commercial lines
Losses and settlement expenses incurred - commercial lines
Commercial lines net loss ratio
In the second quarter of 2005, our property and casualty insurance segment’s pre-tax income was $34.8 million, compared to $26.0 million in the second quarter of 2004. This improvement is attributable primarily to an increase in net premiums earned and a decrease in losses and settlement expenses.
Net premiums written in the second quarter of 2005 were $126.2 million, compared to $127.7 million in the second quarter of 2004. Net premiums earned in the second quarter of 2005 were $115.0 million, compared to $111.7 million in the second quarter of 2004. The growth in net premiums earned achieved during 2005 is attributable to pricing and other underwriting initiatives that we have pursued in recent years, from which we continue to realize benefits as the related premium is earned. However, moderation in pricing is evident, as rate increases have diminished in most lines of business. We have actually experienced a decrease in rates in several lines.
We analyze our property and casualty financial results through the review and comparison of financial measures common to the insurance industry, which include the loss and loss adjustment expense ratios (collectively referred to as the “net loss ratio”), the underwriting expense ratio (the “expense ratio”) and the combined ratio. The ratios used in this discussion have been prepared on the basis of GAAP.
The combined ratio, a commonly used financial measure of underwriting performance, is the sum of the net loss ratio and the expense ratio. A combined ratio below 100 percent indicates a profitable book of business. Our combined ratio for the second quarter of 2005 was 77.5 percent, compared to 83.8 percent for the second quarter of 2004. Our combined ratio for the first six months of 2005 was 73.3 percent, compared to 83.7 percent for the same period in 2004.
The catastrophe losses discussed previously negatively impacted these combined ratios. Without the effect of catastrophes, our combined ratios would have been as follows: second quarter of 2005 – 72.6 percent; second quarter of 2004 – 79.3 percent; six month period ended June 30, 2005 – 70.7 percent; and six month period ended June 30, 2004 – 81.3 percent.
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We review the net loss ratio to measure our profitability by line. We make pricing and underwriting decisions based upon these results. Our net loss ratio was 49.5 percent for the second quarter of 2005 versus 55.3 percent for the second quarter of 2004. Our net loss ratio was 44.6 percent for the first half of 2005 versus 54.3 percent for the first half of 2004. The decrease in the net loss ratio reflects the improved underwriting results achieved in commercial lines. This improvement is primarily attributable to the underwriting initiatives we have pursued in recent years and a decrease in claims. The commercial lines net loss ratios (including reinsurance) were as follows: second quarter of 2005 – 47.7 percent; second quarter of 2004 – 55.6 percent; six month period ended June 30, 2005 – 43.7 percent; and six month period ended June 30, 2004 – 54.5 percent. The personal lines net loss ratios were as follows: second quarter of 2005 – 66.5 percent; second quarter of 2004 – 52.5 percent; six month period ended June 30, 2005 – 52.1 percent; and six month period ended June 30, 2004 – 52.1 percent. The personal lines results had a limited impact on our overall net loss ratio because our personal lines business represents under 10 percent of our overall net premium volume. The table below displays our loss ratio experience on a by-line basis.
(Dollars in Thousands)
Commercial lines:
Fire and allied lines
Other liability
Automobile
Workers’ compensation
Fidelity and surety
Miscellaneous
Total commercial lines
Personal lines:
Total personal lines
Reinsurance
Total
The expense ratio was 28.0 percent for the second quarter of 2005, compared to 28.5 percent in the second quarter of 2004. The expense ratio was 28.7 percent for the first half of 2005, compared to 29.4 percent for the first half of 2004. The improvement in the expense ratio is attributable to our improved underwriting results in 2005. The method prescribed by GAAP to compute deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which takes into account the expected premium to be earned, expected losses and expenses to be incurred, and certain other costs expected to be incurred as the premium is earned. The improvement in our 2005 underwriting results has allowed us to defer a larger proportion of our underwriting expenses during 2005 than we deferred during 2004.
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Life Insurance Segment Results
Life Insurance Financial Results:
Interest on policyholders' accounts
Total Benefits, Losses and Expenses
In the second quarter of 2005, our life insurance segment recorded pre-tax income of $4.8 million, compared to $3.3 million for the second quarter of 2004. Several factors contributed to this change in pre-tax income, including a $.9 million increase in net premium earned (the result of marketing initiatives pursued in recent years that have led to increased sales of single premium whole life and term products) and a $.8 million increase in net realized investment gains (before tax). In addition, amortization of deferred policy acquisition costs and interest on policyholders’ accounts decreased by $1.5 million and $.4 million, respectively, from prior year, primarily as a result of our diminished levels of annuity writings in recent years. These factors were offset to some extent by an increase of $2.4 million in the provision for liability for future policyholder benefits, which was driven by the increase in sales levels of single premium whole life and term products.
The principal product of our life insurance segment is the single premium deferred annuity. Pursuant to GAAP, we do not report annuity deposits as net premiums earned. Rather, annuity deposits are recorded directly as liabilities for future policyholder benefits. In the second quarter of 2005, annuity deposits were $13.0 million, compared to $12.3 million in the second quarter of 2004. These deposits were more than offset by annuity surrenders and withdrawals of $23.0 million in the second quarter of 2005, compared to $15.7 million in the second quarter of 2004. The increase in surrenders and withdrawals is primarily attributable to our annuitants seeking alternative investment opportunities to a greater extent in 2005 than in 2004.
Investment Results
We recorded net investment income (before tax) of $58.0 million for the six-month period ended June 30, 2005, compared to $55.0 million for the six-month period ended June 30, 2004. Our invested assets grew from $1,964.3 million at December 31, 2004 to $2,093.8 million at June 30, 2005.
Net realized investment gains (before tax) for the six-month period ended June 30, 2005 totaled $3.4 million, versus $1.0 million of net realized investment gains (before tax) for the six-month period ended June 30, 2004. During the first six months of 2005 we recorded $.8 million in investment write-downs, compared to none in the first half of 2004.
We continually monitor the difference between our cost basis and the estimated fair value of our investments. Our accounting policy for impairment recognition requires other-than-temporary impairment charges to be recorded when we determine that it is more likely than not that we will be unable to collect all amounts due according to the contractual terms of the fixed maturity security or that the anticipated recovery in market value of the equity security will not occur in a reasonable amount of time. Impairment charges on investments are recorded based on the fair value of the investments at the measurement date and are included in net realized investment gains and losses. Factors considered in evaluating whether a decline in value is other-than-temporary include: the length of time and the extent to which the fair value has been less than cost; the financial conditions and near-term prospects of the issuer; and our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery.
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LIQUIDITY & CAPITAL RESOURCES
Liquidity
Cash flow and liquidity is derived from three sources: 1) operating activities; 2) investing activities; and 3) financing activities.
Net cash provided by our operating activities was $58.8 million for the six months ended June 30, 2005 compared to $68.9 million for the six months ended June 30, 2004. The decrease in cash provided by operating activities was primarily attributable to the increased settlement of losses in the first half of 2005 as compared to the same period in 2004.
We also have significant cash flows from sales of investments and from scheduled and unscheduled investment security maturities, redemptions and prepayments. These cash flows totaled $149.6 million through June 30, 2005 and $126.5 million through June 30, 2004. We invest in fixed maturities that mature at regular intervals in order to meet our scheduled obligations to pay policy benefits, claims and claim adjusting expenses.
Financing activities provided cash of $2.0 million through the first six months of 2005 compared to $9.1 million through the first six months of 2004. Cash provided by financing activities included annuity and universal life deposits, less withdrawals, of $7.7 million through June 30, 2005 compared to $15.0 million for the same period of 2004.
If our operating, investment and financing cash flows are not sufficient to support our operations, we have additional short-term investments that we could utilize for this purpose. At June 30, 2005, our consolidated invested assets included $25.6 million of short-term investments, which consist primarily of fixed maturities that mature within a year. We may also borrow up to $50 million on a bank line of credit. Under the terms of our credit agreement, interest on outstanding debt is payable at the lender’s prevailing prime rate, minus one percent. We did not utilize our line of credit during 2004 or in the first six months of 2005.
Capital Resources
At June 30, 2005 our consolidated total assets were $2,647.3 million, compared to $2,570.4 million at December 31, 2004. Invested assets, comprised primarily of fixed maturity securities, increased $129.5 million, or 6.6 percent, from December 31, 2004. The increase in invested assets we have experienced this year is attributable to improvements in the investment environment. As interest rates have increased, we have realized an increase in the suitable investment opportunities available to us. As a result, we have purchased investments during the first six months of the year at a frequency exceeding sales, calls and maturities of investments. Somewhat offsetting this increase in invested assets during the first half of the year was a decline in the unrealized appreciation recorded on our available-for-sale investments. The primary factor leading to this decline was the impact that increasing interest rates had on the carrying value of our available-for-sale fixed maturity portfolio. Available-for-sale fixed maturities are carried at fair market value, which generally declines as interest rates rise. The net unrealized gain from these investments is reported net of tax as a separate component of stockholders’ equity. The changes in our total reported invested asset balance are summarized by the following table:
Invested Assets at 12/31/04
Purchases
Sales
Calls / Maturities
Reclassification of note receivable
Realized gain on sale
Mark to market adjustment (1)
Net bond discount accretion
Change in unrealized gain
Change in carrying value of invested assets
Invested Assets at 06/30/05
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The composition of our investment portfolio at June 30, 2005 is presented in the following table:
Fixed maturities(1)
Equity securities
Trading securities
At June 30, 2005 $1,783.5 million, or 95.2 percent, of our fixed income security portfolio was classified as available-for-sale, compared to $1,633.6 million, or 94.3 percent, at December 31, 2004. We classify our remaining fixed maturities as held-to-maturity or trading. Held-to-maturity fixed maturities are reported at amortized cost. Our trading securities consist primarily of convertible redeemable preferred debt securities, which are recorded at fair value, with any changes in fair value recognized in earnings. At June 30, 2005, cash and cash equivalents totaled $222.3 million compared to $305.6 million at December 31, 2004. The decrease was the result of our increased level of investment activity in the first six months of 2005.
Our consolidated deferred policy acquisition costs increased $7.7 million, or 8.6 percent, to $96.9 million at June 30, 2005 from the deferred policy acquisition costs at December 31, 2004. Our property and casualty insurance segment’s deferred policy acquisition costs increased $5.3 million, or 11.3 percent, to $52.7 million at June 30, 2005 from the deferred policy acquisition costs at December 31, 2004. Our life insurance segment’s deferred policy acquisition costs increased $2.4 million to $44.2 million at June 30, 2005 from the deferred policy acquisition costs at December 31, 2004. This increase primarily resulted from the deferred policy acquisition costs related to universal life and annuity business, which is affected by the changes in unrealized gains and losses on certain available-for-sale securities. The net unrealized gains reported at June 30, 2005 reduced deferred policy acquisition costs by $36.2 million, compared to a decrease of $41.0 million at December 31, 2004.
Stockholders’ equity increased from $452.2 million at December 31, 2004 to $566.0 million at June 30, 2005 an increase of 25.2 percent. The significant components of the increase in stockholders’ equity were net income of $59.5 million, equity of $68.9 million derived from the conversion of preferred shares into common, and proceeds from the issuance of common stock pursuant to our employee stock option plan totaling $.9 million. The primary decreases to stockholders’ equity included a decrease in unrealized appreciation of $6.2 million, stockholder dividends of $6.2 million and preferred stock issuance cost accretion totaling $3.2 million. At June 30, 2005, book value was $23.99 per common share compared to $22.46 per common share at December 31, 2004.
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Non-GAAP Financial Measures
We believe that investor understanding of our financial performance is enhanced by disclosure of certain non-GAAP financial measures. The non-GAAP financial measures we utilize in this release are net premiums written, catastrophe losses and statutory combined ratio. These are statutory financial measures prepared in accordance with statutory accounting rules as prescribed by the National Association of Insurance Commissioners’ Accounting Practices and Procedures Manual.
Net premiums written: Net premiums written is a statutory accounting measure representing the amount of premiums charged for policies issued during the period. These premiums are reported as revenue as they are earned over the underlying policy period. Net premiums written applicable to the unexpired term of a policy are recorded as unearned premium. We evaluate net premiums written as a measure of business production for the period under review.
Second quarter
2005
2004
Year to date
Catastrophe losses: A catastrophe loss is a single incident or series of closely related incidents causing severe insured losses. Catastrophes are by their nature unpredictable. The frequency and severity of catastrophic losses we experience in any year impacts our results of operations and financial position. In analyzing the underwriting performance of our property and casualty insurance segment, we evaluate performance both including and excluding catastrophe losses. We define catastrophes as events that cause $25.0 million or more in industry-wide direct insured losses to property and that affect a significant number of insureds and insurers. This is the same definition utilized by the Insurance Services Office, a supplier of property and casualty statistical data. At United Fire, we also include in our catastrophe totals those events we believe are, or will be, material to our operations, either in amount or in number of claims made. These amounts totaled $.4 million and $2.4 million for the six month periods ended June 30, 2005 and 2004, respectively. A portion of these losses may be recoverable under our catastrophe reinsurance agreements.
Statutory combined ratio: The combined ratio is a commonly used financial measure of underwriting performance. A combined ratio below 100 percent indicates a profitable book of business. The combined ratio is the sum of two separately calculated ratios, the loss and loss adjustment expense ratio (referred to as the “net loss ratio”) and the underwriting expense ratio (the “expense ratio”). When prepared in accordance with U.S. generally accepted accounting principles, the net loss ratio is calculated by dividing the sum of losses and loss adjustment expenses by net premium earned. The expense ratio is calculated by dividing non-deferred underwriting expenses and amortization of deferred policy acquisition costs by net premiums earned. When prepared in accordance with statutory accounting principles, the net loss ratio is calculated by dividing the sum of losses and loss adjustment expenses by net premium earned. The expense ratio is calculated by dividing underwriting expenses by net premiums written.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We have exposure to market risk arising from potential losses due to adverse changes in interest rates and market prices. Our primary market risk exposure is changes in interest rates, although we have some exposure to changes in equity prices and limited exposure to foreign currency exchange rates.
Active management of market risk is integral to our operations. Our investment guidelines define the overall framework for managing our market and other investment risks, including accountability and controls. In addition, each of our subsidiaries has specific investment policies that delineate the investment limits and strategies that are appropriate given each entity’s liquidity, surplus, product and regulatory requirements. We respond to market risk by rebalancing our existing asset portfolio and by managing the character of future investment purchases.
There have been no material changes in our market risk or market risk factors from that reported in our annual report on Form 10-K for the year ended December 31, 2004.
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures as of the end of the period covered by this report were designed and functioning effectively to provide reasonable assurance that the information required to be disclosed by us in reports filed under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. We believe that a controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.
Changes in Internal Control Over Financial Reporting
As required by Rule 15d-15(e) under the Securities Exchange Act of 1934, our management, including our Chief Executive Officer and Chief Financial Officer, have evaluated our internal control over financial reporting to determine whether any changes occurred during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Based on this evaluation, no such change in our internal control over financial reporting occurred during the fiscal quarter to which this report relates.
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PART II - OTHER INFORMATION
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At United Fire’s Annual Stockholders’ Meeting on May 18, 2005, the following proposals were adopted by the margins indicated.
Casey D. Mahon
Scott McIntyre, Jr.
Byron G. Riley
Frank S. Wilkinson, Jr.
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS
Exhibits
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
(Registrant)
July 28, 2005
(Date)
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