-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, BfxiyzKleBB2t3mVrOnu16qyyWtP9Kl0y47IyJCyX2hiitXS/YDLo2LQWXbEAOKb 4w6EpxacW6voXrmNw+kFlg== 0000950144-98-003771.txt : 19980401 0000950144-98-003771.hdr.sgml : 19980401 ACCESSION NUMBER: 0000950144-98-003771 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980331 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: MCM CORP CENTRAL INDEX KEY: 0000275710 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 561171691 STATE OF INCORPORATION: NC FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-08678 FILM NUMBER: 98580600 BUSINESS ADDRESS: STREET 1: 702 OBERLIN RD STREET 2: BOX 12317 CITY: RALEIGH STATE: NC ZIP: 27605 BUSINESS PHONE: 9198331600 MAIL ADDRESS: STREET 1: 702 OBERLIN ROAD STREET 2: P O BOX 12317 CITY: RALEIGH STATE: NC ZIP: 27605 10-K405 1 MCM CORPORATION 10-K405 12-31-1997 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED) For the Fiscal Year Ended December 31, 1997 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED) For the transition period from ________ to ________. Commission File Number: 0-8678 McM Corporation ----------------------------------------------------- (Exact name of registrant as specified in its charter) North Carolina 56-1171691 - ------------------------------- ------------------- (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) Box 12317, 702 Oberlin Road, Raleigh, North Carolina 27605 ------------------------------------------------------------- (Address of principal executive office) (Zip Code) Registrant's telephone number, including area code (919) 833-1600 Securities registered pursuant to Section 12(b) of the Act: Name of each exchange Title of each class on which registered - ------------------- --------------------- NONE Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value - $1.00 per share ----------------------------------------- (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months, and (2) has been subject to such filing requirements for the past ninety (90) days. Yes X No --- --- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K. [X] State the aggregate market value of the voting stock held by non-affiliates of the registrant as of March 16, 1998. ---------------------------------------------------------- Common Stock, $1.00 par value -- $2,217,857 At December 31, 1997, 4,695,621 shares of common stock of the registrant were outstanding. Documents Incorporated by Reference Portions of the annual report to shareholders for the year ended December 31, 1997, are incorporated by reference into Parts I, II and IV. Portions of the annual proxy statement for the year ended December 31, 1997, are incorporated by reference into Part III. 2 PART I Item 1. Business McM Corporation ("McM" or the "Company") is an insurance holding company conducting its business through insurance and non-insurance subsidiaries. The following schedule identifies the subsidiaries of McM and the abbreviations by which they are identified in this document. Subsidiary Abbreviation ---------- ------------ PROPERTY AND CASUALTY Occidental Fire & Casualty Company of North Carolina OF&C Wilshire Insurance Company Wilshire OTHER: Equity Holdings, Inc. Equity Holdings In connection with and because it desires to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, McM would like to caution readers regarding certain forward-looking statements in the following discussion and elsewhere in this Form 10-K. While McM believes in the veracity of all statements made herein, forward-looking statements are necessarily based upon a number of estimates and assumptions that, while considered reasonable by McM are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond McM's control, and many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause its actual results to differ materially from those expressed in any forward-looking statements made by or on behalf of McM. The forward looking statements are especially difficult for lines of business that are longer tail in nature such as the Company's commercial automobile liability line of business which is inherently subject to considerable variability and volatility. Item 1. (a) General Development of the Business McM was organized as a North Carolina corporation on May 27, 1977, and subsequently acquired or organized a number of insurance corporations and other subsidiaries. From 1977 to 1991, McM operated as a multi-line holding company with both life and health and property and casualty insurance operations. The McMillen Trust, controlling shareholder of McM, currently owns 65.8% of the outstanding stock of McM. A petition was filed on behalf of the McMillen Trust in the Chancery Court of Delaware on December 2, 1986, seeking relief from the requirement that the Trust own at least 1 3 65% of the shares of McM. The Court, on December 10, 1987, determined that the Trust must divest itself of its ownership of the shares of McM and invest the proceeds in a diversified portfolio for the benefit of present and future beneficiaries of the Trust. The Board of Directors of McM and the Trust believed that the interests of all shareholders would be best served by a coordinated sales process by which potential purchasers could be qualified and due diligence reviews scheduled with minimal disruption to ongoing operations. In 1991, McM decided to discontinue its life and health insurance segment. On October 24, 1991, Occidental Life Insurance Company and Peninsular Life Insurance Company were sold to Pennsylvania Life Insurance Company. On June 22, 1992, Atlantic Southern Insurance Company was sold to Global Life Assurance Company Limited. The sale of Atlantic Southern Insurance Company completed the disposition of the Company's life and health segment. In January 1993, McM's Board of Directors announced that it had decided to discontinue efforts to sell the remaining companies in the McM group, including OF&C and Wilshire. The Board's decision was prompted by market and economic conditions as well as other factors which had an adverse effect on the general sale process being conducted by PaineWebber, Incorporated ("PaineWebber"). However, PaineWebber has continued to serve the McM group as its financial advisor. In April 1993, the Chancery Court granted the petition of the Wilmington Trust Company, Trustee of the McMillen Trust, for a clarification of existing orders to make clear, among other things, that the timing and terms of any disposition of the Trust's shares shall be determined in the sound discretion of the Trustee. On February 3, 1997, McM received a copy of an SEC Form 3 filing made by McM Acquisition Corporation ("MAC"), controlled by local real estate developer and private investor M. Roland Britt, and by Mr. Britt himself. The Form 3 indicated that MAC had acquired an option to purchase all of the McM shares owned by the Trust for $6.20 per share exercisable until March 1, 1998. The next day, February 4, 1997, McM received a copy of an SEC Schedule 13D filed by MAC and Mr. Britt. This Schedule 13D provided further information in connection with the option. Attached to the Schedule 13D were written agreements dated November 22, 1996, and January 24, 1997, between the Trust and MAC relating to the option and to a possible merger between McM and MAC. Also attached was a copy of an agreement entered into between McM and MAC on January 31, 1997, in a separate, independent action wherein McM agreed to provide MAC with confidential access to the Company's records and information to enable MAC to conduct due diligence reviews and pursue appropriate financial arrangements for a possible acquisition of all of McM's shares. This agreement, which was to expire May 31, 1997, also granted to MAC an exclusive period during which McM would continue its policy in effect at 2 4 that time of not soliciting acquisition offers. In May 1997, the Board agreed to extend the period covered by the agreement until September 28, 1997, at which time it expired. On September 22, 1997, a suit purporting to be a shareholder's derivative action was brought against the Company, its directors, the McMillen Trust and Wilmington Trust Company as Trustee of the McMillen Trust. MAC was also named as a defendant. The suit was filed in the Guilford County Superior Court by two shareholders of McM on behalf of all McM shareholders except for the McMillen Trust. The suit complained, among other allegations, that because the Trust owns approximately two-thirds of the shares of the corporation, it effectively exercised control of the corporation. It challenged the composition of the McM Board of Directors and the actions of the Board as being controlled by the majority shareholder. The complaint asked that the Court void the action of the Trustee in connection with the McMillen Trust's grant of the option to sell its shares to MAC. The suit also complained that the corporation had inappropriately allowed MAC an exclusive due diligence period which expired by its terms on September 28, 1997. On December 23, 1997, the Superior Court approved an agreement to terminate MAC's option and related agreements between the Trust and MAC (the "Release"). The Release was signed by all parties to the pending litigation and contained a mutual release between the remaining parties and MAC of any claims which could have arisen from the option and related agreements and dismissed MAC as a defendant in the litigation. On February 20, 1998, the Superior Court approved a settlement of the litigation. The settlement agreement, executed by all parties to the litigation, provides that the Company, the current directors, the McMillen Trust and Wilmington Trust Company will use their best efforts to nominate and elect Mr. Jesse Greenfield to the McM Board of Directors at McM's 1998 annual shareholders' meeting. The settlement agreement also contains provisions for nominal monetary concessions by the Plaintiffs and the Company and mutual releases between all parties. In connection with McM Corporation's continuing efforts to consider all strategies and alternatives available to maximize shareholder value, the Company has authorized PaineWebber to explore all reasonable methods to increase the capital position of McM, including a possible sale of the Company. There were 147 employees of McM and its subsidiaries at December 31, 1997, all of which are directly employed by the property and casualty subsidiaries. Item 1. (b) Financial Information About Industry Segments As a result of discontinuing its life and health insurance segment, 3 5 McM, through its subsidiaries, is engaged only in the marketing and underwriting of property and casualty insurance. Information concerning industry segments, therefore, is no longer applicable. Item 1. (c) Narrative Description of Business PROPERTY AND CASUALTY INSURANCE McM's property and casualty insurance business is conducted through two insurance companies, OF&C and Wilshire. The business is concentrated in liability, physical damage and cargo coverages for the trucking transportation industry as well as non-standard private passenger automobile coverages. These insurance policies are generally marketed through general and independent agents who have no authority to alter any terms of the policies. The agents who produce business for OF&C and Wilshire are not exclusive agents of the companies and generally have affiliations with other insurance companies which may compete with McM. One agent accounts for approximately 16% of premium income of the property and casualty business of McM. OF&C is licensed in the District of Columbia and all states other than Connecticut and Hawaii. Certain states have placed restrictions on the amount of premium that OF&C may write in those states. Wilshire is licensed in nineteen states comprised of Arizona, California, Colorado, Hawaii, Idaho, Iowa, Kansas, Minnesota, Montana, Nebraska, Nevada, New Mexico, North Carolina, Ohio, Oregon, South Dakota, Utah, Washington and Wisconsin. Wilshire is also approved, as a non-admitted carrier, to write coverages in the states of Alabama, Alaska, Florida, Georgia, Illinois, Indiana, Kentucky, Louisiana, Maryland, North Dakota, Oklahoma, Pennsylvania, Texas and Wyoming. A non-admitted carrier may write coverages at rates in excess of the rates approved by the various states, provided that licensed carriers in those states are unwilling to provide coverages at the approved rates. Wilshire's premium writings are not restricted by any state. Also see "Geographic Distribution of Premiums Received." Competition. The property and casualty insurance business is highly competitive. In most jurisdictions in which McM's property and casualty insurance subsidiaries market their policies, there are numerous large standard lines stock and mutual companies as well as other specialty companies competing for the same business. Many of the companies have greater financial resources, larger marketing organizations and broader diversification of risks than the McM companies however, McM believes that the policies, rates, commissions and services of its companies are competitive with other companies writing these types of business. Regulation. All insurance companies are subject to regulation and supervision by the jurisdictions in which the companies are authorized to transact business. These regulatory bodies have broad administrative 4 6 powers relating to the standards of solvency which must be met and maintained by insurance companies, minimum capital and surplus requirements, limitations on the investments of capital and surplus, granting and revoking of licenses, licensing of agents, filing and approval of policy forms and rates, maintenance of required reserves, unfair discrimination, form and content of financial statements and other reporting forms, issuance and sale of stock, types of allowable investments, and numerous other matters pertaining to insurance. Insurance companies must keep assets equal to the minimum capital required by law plus the accumulated reserves invested in certain classes of investments as specified in the statutes applicable to such companies. In addition, the National Association of Insurance Commissioners ("NAIC") has adopted Risk-Based Capital ("RBC") requirements for property and casualty insurance companies. RBC was developed to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks. The RBC formula serves as an early warning tool for state insurance regulators to help identify, for the purpose of initiating regulatory action, companies which may be inadequately capitalized. OF&C, as a result of the need to significantly strengthen reserve adequacy of the property and casualty companies during 1997, triggered the first RBC regulatory action threshold defined as Company Action Level RBC ("CAL"). Triggering the CAL threshold requires that an insurer prepare and submit to its domiciliary state a comprehensive financial plan. Among other items, the plan should identify the conditions in the insurer that contributed to the CAL event and contain proposals for corrective actions that the insurer intends to take that are expected to result in the elimination of the company action level event. The Company has identified specific areas of its business contributing to the decline in profitability and statutory capital and surplus and has implemented remedial steps designed to improve the overall profitability of property and casualty operations and eliminate the RBC deficiency. OF&C, working within the framework of RBC guidelines, will submit its plan of action to the state of North Carolina in the near future and believes that its indicated RBC deficiency will be corrected through this plan. The capital and surplus for Wilshire is well in excess of any regulatory action thresholds defined by the NAIC. The reporting practices for McM's property and casualty subsidiaries are prescribed or permitted by state regulatory authorities ("statutory accounting") and may differ from generally accepted accounting principles ("GAAP"). OF&C (which includes Wilshire on a statutory equity basis) reported to insurance regulatory authorities combined statutory capital and surplus of $11.5 million and $18.2 million at December 31, 1997 and 1996, respectively. Combined capital and surplus on a GAAP basis was $15.5 million and $23.6 million at December 31, 1997 and 1996, respectively. 5 7 There are two major reconciling differences between the statutory accounting and GAAP capital and surplus balances of McM's property and casualty subsidiaries. In GAAP accounting, costs which vary with and are primarily related to the production of property and casualty business are deferred to the extent recoverable and are amortized over the lives of the policies in proportion to the recognition of premium earned. Statutory accounting does not permit this deferral and requires property and casualty companies to fully recognize these expenses in the period they were incurred. At December 31, 1997, McM's property and casualty subsidiaries recorded $2.8 million in deferred policy acquisition costs as an asset on the GAAP balance sheet compared to $4.0 million at December 31, 1996. Statutory accounting also requires property and casualty companies to record as a liability and restriction to capital and surplus the uncollateralized portion of balances receivable from non-admitted reinsurers ("Schedule F Penalty"). The combined Schedule F Penalty recorded by McM's property and casualty subsidiaries totalled $261,200 and $269,000 at December 31, 1997 and 1996, respectively. Insurance holding company laws grant additional powers to insurance regulators with respect to acquisitions and control of insurance companies by holding companies and the requirements of disclosure relating to transactions with affiliated companies. Each company files a detailed annual report with the insurance department of each state or governmental jurisdiction in which it is licensed to do business. Insurance companies are also subject to periodic examinations by these regulatory bodies. Some of the jurisdictions in which OF&C is licensed to do business have, for various reasons, instituted restrictions or limitations on the amount of business written in that state. These restrictions were imposed years ago when the property and casualty companies were generating substantial losses and experiencing financial difficulties. Generally they involved states in which the Company was not actively writing business nor had intentions to write business. These restrictions have no current effect on liquidity, capital resources or results of operations. In the future, should the Company desire to further expand its market presence into any state with such restrictions, it will then pursue the lifting of such restrictions by providing current financial and operational information as required by individual state regulatory authorities. Reinsurance As with other property and casualty insurance companies, the McM property and casualty insurance companies reinsure a portion of the insurance they write in order to control their exposure on large individual risks or in the event of catastrophic losses. The companies remain contingently liable on that portion of the risk reinsured should the reinsurer be unable to meet its obligations under the reinsurance agreements. See Note C of the Notes to Consolidated Financial Statements. The largest liability exposure insured for any one risk is 6 8 $2,000,000. Reinsurance is in place to reduce the companies' exposure on premiums earned subsequent to January 1992, to $100,000 of loss per risk. The retention per risk on premiums earned prior to January 1, 1992, generally is $100,000 with the exception of 1991 when the loss retention was $250,000. Premiums payable under certain of the companies' liability reinsurance treaties prior to January 1, 1990, are based in part on actual loss experience. Premiums for the liability treaties subsequent to 1990 are calculated on a flat rate based on policy limits. Separate physical damage (excluding theft and collision) and motor cargo catastrophe reinsurance treaties provide reinsurance on any one catastrophic occurrence. Coverages under these treaties are limited to a maximum of 95% of $4,000,000 in excess of the first $500,000 of losses paid. Quota share reinsurance coverages, by which the companies and their reinsurers share risk on a proportionate basis, are also in place for both commercial and private passenger automobile business. The companies cede 5% of the retained commercial auto liability coverages. Prior to 1996, private passenger automobile business was ceded at a rate of 40%, however, the cession rate was reduced to 30% in 1996 and 20% in 1997. These quota share arrangements allow the companies to better control premium growth. The principal reinsurers of the companies for current business are Zurich Reinsurance, Ltd., Unionamerica Insurance Company, CNA International Reinsurance Company, Ltd., Murray Lawrence & Partners Underwriters, AXA Reassurance Company and Sphere Drake Insurance. Reinsurance agreements cover commercial and private passenger automobile liability, physical damage (excluding theft and collision), motor cargo and ancillary coverages. In addition to the reinsurers named above, principal reinsurers of the companies for prior years' reinsurance treaties are Employers Reinsurance Corporation, National Reinsurance Company and Reinsurance Corporation of New York. Loss Reserves and Loss Adjustment Expenses The consolidated financial statements include the estimated liability for unpaid losses and loss adjustment expenses ("LAE") of the property and casualty insurance subsidiaries. The liabilities for losses and LAE are determined using case basis evaluations and statistical projections and represent estimates of the ultimate net cost of all unpaid losses and LAE incurred through December 31 of each year. These estimates give effect to trends in claims severity and other factors which may vary as the liabilities are ultimately settled. The estimates are continually reviewed and as adjustments to these liabilities become necessary such adjustments are reflected in current operations. The following table provides a reconciliation of beginning and ending liability balances for 1997, 1996 and 1995. 7 9 Reconciliation of Net Liability for Losses and Loss Adjustment Expenses
1997 1996 1995 ---- ---- ---- (Thousands of dollars) GAAP Reserves for losses and settlement expenses, net of reinsurance recoverables, at beginning of year $26,532 $29,997 $ 38,415 Provision for insured events of the current year 42,243 37,651 31,282 Increase (decrease)in provision for insured events of prior years 5,774 1,559 (248) ------- ------- ------- Incurred losses and settlement expenses during current year, net of reinsurance 48,017 39,210 31,034 Payments for: Losses and settlement expenses attributable to insured event of the current year 26,123 22,853 18,113 Losses and settlement expenses attributable to insured events of prior years 19,267 19,822 21,339 ------- ------- ------- 45,390 42,675 39,452 ------- ------- ------- Reserves for losses and settlement expenses, net of reinsurance recoverables, at end of year 29,159 26,532 29,997 Reinsurance recoverable on unpaid losses and settlement expenses at end of current year 28,124 28,768 36,155 ------- ------- ------- Gross reserves for losses and settlement expenses at end of year $57,283 $55,300 $ 66,152 ======= ======= ========
The reconciliation above reflects the emergence of a $5,774,000 deficiency in the December 31, 1996, reserve during 1997. This deficiency included adverse reserve development of approximately $844,000 in private passenger auto liability reserves, $813,000 in private passenger auto and commercial auto physical damage and inland marine reserves, and $3,531,000 relating to the commercial auto liability line of business. In addition, approximately $586,000 of this 8 10 deficiency relates to discontinued lines of business and participation in involuntary pools and other residual market mechanisms in which OF&C and Wilshire are required to participate by the various states in which the companies write insurance. The increase in overall reserve levels for 1997 resulted from prior year reserve deficiencies, particularly for the 1995 and 1996 accident years and increased claim costs in the current underwriting year for commercial and private passenger automobile physical damage coverages. The anticipated effect of inflation is implicitly considered when estimating liabilities for losses and settlement expenses. While anticipated cost increases due to inflation are considered in estimating the ultimate claim costs, the increase in average severity of claims is caused by a number of factors that vary with the individual type of policy written. Future average severity is projected based on historical trends adjusted for anticipated changes in these trends and general economic conditions. These anticipated trends are monitored based on actual development and are modified as necessary. The liability for losses and LAE of $57,283,000 reported in the accompanying financial statements in accordance with generally accepted accounting principles (GAAP) is reported on a gross basis, i.e., without reduction for reinsurance, and differs from that reported in the annual statements filed with state insurance departments in accordance with statutory accounting practices (SAP), which are reported net of reinsurance. See Note A of the accompanying 1997 financial statements. THIS SPACE LEFT BLANK INTENTIONALLY 9 11 ANALYSIS OF LOSS AND LOSS ADJUSTMENT EXPENSE DEVELOPMENT NET OF REINSURANCE WITH SUPPLEMENTAL GROSS DATA
(Thousands of dollars) YEAR ENDED 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 - ----------------- -------- ------- ------- ------- ------- ------- ------- ------- ------- ------- ------- Liability for Unpaid Claims and Claim Adjustment Expense $103,115 $96,308 $78,120 $64,002 $64,304 $59,580 $51,625 $38,415 $29,997 $26,532 $29,159 Paid (Cumulative) as of: One year later $45,676 $48,461 $42,731 $41,726 $29,635 $28,500 $27,034 $21,338 $19,822 $19,267 $0 Two years later 75,454 72,353 63,893 47,833 44,905 44,659 39,119 31,096 $28,469 Three years later 90,546 84,912 67,649 56,343 54,980 51,326 44,649 35,177 Four years later 99,200 87,368 72,305 61,006 58,364 54,561 46,668 Five years later 101,072 90,495 75,568 62,341 60,459 55,699 Six years later 103,242 93,146 76,350 63,728 61,215 Seven years later 105,555 93,769 77,562 64,459 Eight years later 105,791 94,930 78,084 Nine years later 106,916 95,451 Ten years later 107,423 Liability Reestimated as of: One year later $108,844 $97,562 $77,625 $68,679 $64,175 $60,849 $51,643 $38,167 $31,556 $32,306 $0 Two years later 109,955 95,362 78,970 66,266 64,686 59,881 50,184 $38,060 34,207 Three years later 108,203 96,354 79,861 67,429 64,167 58,563 49,874 $38,966 Four years later 109,058 96,874 80,345 67,540 63,204 58,713 50,131 Five years later 109,164 97,453 80,695 66,357 63,939 59,138 Six years later 109,198 97,619 79,909 67,115 64,278 Seven years later 109,415 97,251 80,698 67,465 Eight years later 109,226 98,054 81,067 Nine years later 110,008 98,428 Ten years later 110,394 -------- ------- ------- ------- ------- ------- ------- ------- ------- ------- ------- Cumulative Deficiency (Redundancy) $7,279 $2,120 $2,947 $3,463 ($26) ($442) ($1,494) $551 $4,210 $5,774 $0 ======== ======= ======= ======= ======= ======= ======= ======= ======= ======= ======= Gross Data at End of Year Gross Liability $55,300 $57,283 Reinsurance Recoverable 28,768 28,124 ------- ------- Net Liability $26,532 $29,159 ======= =======
10 12 The table above presents the development of balance sheet liabilities for 1987 through 1997. The top line of the table shows the estimated liability for unpaid losses and LAE recorded at the balance sheet date for each of the indicated years. This liability represents the estimated amount of losses and LAE for claims arising in all prior years that are unpaid at the balance sheet date, including losses that had been incurred but not yet reported to the Company. The lower portion of the table shows the re-estimated amount of the previously recorded liability based on experience as of the end of each succeeding year. The estimate is increased or decreased as more information becomes known about the frequency and severity of claims for individual years. The deficiency/(redundancy) totals as set forth in the table represent the aggregate change in the estimates over all prior years. For example, through 1997, the 1988 liability has developed a $2,120,000 deficiency which has been recognized in operations over the nine year period. The effects on income of the past three years of changes in estimates of the liabilities for losses and LAE is shown in the preceding table, "Reconciliation of Net Liability for Losses and Loss Adjustment Expenses". The upper section of the table, "Analysis of Loss and Loss Adjustment Expense Development", shows the cumulative amount paid with respect to the previously recorded liability as of the end of each succeeding year. For example, as of December 31, 1997, the Company paid $107,423,000 of the current re-estimated reserve for losses and loss adjustment expenses at December 31, 1987, of $110,394,000. Thus an estimated $2,971,000 of losses incurred through 1987 remain unpaid as of the current financial statement date. In evaluating this information, it should be noted that each amount includes the effects of all changes in amounts for prior periods. For example, the amount of the deficiency related to losses settled in 1989, but incurred in 1987, will be included in cumulative redundancy (deficiency) amount for years 1987 and 1988. This table does not present accident or policy year development data. Conditions and trends that have affected development of the liability in the past may not necessarily occur in the future. In addition, the Company has entered into numerous reinsurance commutations and assumption transactions, as discussed below, which are included in the information presented. Accordingly, it may not be appropriate to extrapolate future deficiencies or redundancies based on this table. On March 5, 1987, the Company entered into a commutation agreement with Omaha Indemnity Company (OIC), a subsidiary of Mutual of Omaha, whereby OIC remitted $26 million of cash to the Company in satisfaction of all liabilities due under various reinsurance treaties. Of this amount, $5.5 million reimbursed existing paid loss recoverables leaving $20.5 million available to cover future loss payments on the commuted 11 13 block of reserves. Based on a review of the commuted reserves by the Company's actuary and by an independent actuarial consulting firm, the projected ultimate value of commuted reserves and paid loss recoverables exceeded the commutation proceeds by $5.5 million. This transaction was recorded in the 1986 consolidated financial statements. Remaining loss and loss adjustment expense reserves related to this block of business at December 31, 1997, are not material. During 1985 McM entered into a commutation agreement with Universal Reinsurance Corporation and Northwestern National Insurance Company, whereby they remitted $15.5 million of cash to McM's property and casualty subsidiaries in satisfaction of all liabilities due under the various reinsurance treaties. This cash settlement was supplemented by $1 million in development recorded during 1986. An additional $1.7 million in development was recorded during 1987. The Company has experienced no significant development on this business since 1987 and remaining loss and loss adjustment expense reserves at December 31, 1997, are not material. Additionally, the Company experienced adverse development of $1.2 million during 1987 on reserves commuted with several other reinsurers. No significant development has been experienced on these reserves since 1987. Effective December 31, 1985, OF&C assumed the liabilities on business previously written by Peninsular Fire Insurance Company ("PFICO"), a former subsidiary of McM. The coverages, which were primarily workers' compensation and commercial multi-peril, are being run off and no new coverages have been underwritten. Adverse development on the PFICO reserves was $2.5 million in 1985, $3.1 million in 1986, $3.9 million in 1987, and $3.1 million in 1988. Development since 1988 has not been material. The information below the table is a reconciliation of the data in the table, which is reported net of reinsurance, to the reserves in the balance sheet which are stated gross of reinsurance. Geographic Distribution of Direct Written Premiums The following is a summary of property and casualty direct written premiums written in 1997 by geographic location. States accounting for less than five percent (5%) of premiums are combined in "Other".
STATE PERCENT ----- ------- California 32 Florida 11 Nevada 14 Other 43 --- 100%
12 14 Item 1. (d) Financial Information About Foreign and Domestic Operations and Export Sales The information called for under this item does not apply. Item 2. Properties McM ant its subsidiaries lease home office properties in various locations. The major locations are set forth in the following table:
Square Book Annual Footage Value Rent ------- ----- ------ Raleigh, North Carolina OF&C 27,298 Not Owned $462,101 Wilshire McM Lancaster, California Wilshire 10,578 Not Owned $121,924 Scottsdale, Arizona OF&C 7,193 Not Owned $131,277 Wilshire
Item 3. Legal Proceedings On September 22, 1997, an action denominated as a shareholders' derivative action was brought against McM, the McMillen Trust, the Trustee of the McMillen Trust, McM's directors and McM Acquisition Corporation. This action settled on February 20, 1998. For more detailed information regarding this action, see Item 1(a). Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted to a vote of security holders during the fourth quarter of 1997. 13 15 PART II Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters The market information and related stockholder matters are incorporated by reference from the Annual Report to Shareholders for the year ended December 31, 1997. This information is included in the Annual Report to Shareholders and is on page 31 of this report. Item 6. Selected Financial Data The selected financial data is incorporated by reference from the Annual Report to Shareholders for the year ended December 31, 1997. See page 31 of this report. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Management's discussion is incorporated by reference from the Annual Report to Shareholders for the year ended December 31, 1997. See pages 37 through 45 of this report. Item 8. Financial Statements and Supplementary Data The consolidated financial statements of McM Corporation and subsidiaries and the report of independent auditors filed in response to Item 8 are incorporated by reference from the Annual Report to Shareholders beginning on page 46 of this report. A summary of the quarterly results of operations for the years ended December 31, 1997, and December 31, 1996, is incorporated by reference from the Annual Report to Shareholders on page 70 of this report. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure The information called for under this item does not apply 14 16 PART III Item 10. Directors and Executive Officers of the Registrant The information called for is incorporated by reference and will be filed with the Commission with the definitive proxy statement within the required 120-day period. Item 11. Executive Compensation The information called for is incorporated by reference and will be filed with the Commission with the definitive proxy statement within the required 120-day period. Item 12. Security Ownership of Certain Beneficial Owners and Management The information called for is incorporated by reference and will be filed with the Commission with the definitive proxy statement within the required 120-day period. Item 13. Certain Relationships and Related Transactions The information called for is incorporated by reference and will be filed with the Commission with the definitive proxy statement within the required 120-day period. THIS SPACE LEFT BLANK INTENTIONALLY 15 17 PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K Page ---- (a) The following documents are filed as a part of this report. 1. Financial Statements--The financial statements required by this item are incorporated by reference from the Annual Report to Shareholders. The following consolidated financial statements of McM and subsidiaries are filed in response to Item 8: Consolidated Balance Sheets - December 31, 1997 46 and 1996. Consolidated Statements of Operations - Years Ended December 31, 1997, 1996 and 1995. 47 Consolidated Statements of Shareholders' Equity Years Ended December 31, 1997, 1996 and 1995. 48 Consolidated Statements of Cash Flows - Years Ended December 31, 1997, 1996 and 1995. 49 Notes to Consolidated Financial Statements 50 Report of Independent Auditors 69 2. Financial Statement Schedules--The following schedules are filed in accordance with the requirements of Article 7 of Regulation S-X: Schedule 1 - Summary of Investments - Other than 21 Investments in Related Parties (In compliance with Schedule I of Rule 7-05): Schedule 2 - Condensed Financial Information of 22 Registrant (In compliance with Schedule II of Rule 7-05): Schedule 3 - Reinsurance (In compliance with 26 Schedule IV of Rule 7-05): 16 18 Page Schedule 4 - Valuation and Qualifying Accounts 27 (In compliance with Schedule V of Rule 7-05): Schedule 5 - Supplemental Information for Property 28 & Casualty Insurance Underwriters (In compliance with Schedule VI of Rule 7-05): All other schedules to the consolidated financial statements required by Article 5 or 7 of Regulation S-X are not applicable and, therefore, have been omitted. 3. The following exhibits are included in accordance with the requirements of Item 601 of Regulation S-K. Exhibit (3): Articles of Incorporation and the By-laws of McM Corporation are incorporated by reference from Form 10-K, dated December 31, 1995. Exhibit (9): McMillen Trust Agreement is incorporated by reference from Form 10, dated April 24, 1978. Exhibit (10): Material contracts: a) The 1986 Stock Option Plan (as amended) is incorporated by reference from the December 31, 1994, Form 10-K. The 1996 Stock Option Plan is incorporated by reference from the 1996 Proxy Statement. b) The Phantom Stock Plan is incorporated by reference from the December 31, 1994, Form 10-K. The first amendment to this plan dated August 6, 1996, is incorporated by reference from the December 31, 1996, Form 10-K. c) Employment and retention bonus contracts for certain executive officers are incorporated by reference from the December 31, 1989, 1992, 1993, 1994 and 1996 Forms 10-K. d) The Key Executive Incentive Compensation Plan is 17 19 incorporated by reference from the December 31, 1994 Form 10-K. e) The Equity Appreciation Rights Plan is incorporated by reference from the 1993 Proxy Statement. f) The 1996 Employee Stock Purchase Plan is incorporated by reference from the 1996 Proxy Statement. g) The 1996 Non-Employee Directors' Stock Purchase Plan is incorporated by reference from to 1996 Proxy Statement Page Exhibit (13): Annual Report to Shareholders for 29 year ended December 31, 1997. Exhibit (22): Subsidiaries of the Registrant. 73 Exhibit (23): Consent of Independent Auditors 74 Exhibit (27): Financial Data Schedule (for SEC use only) (b) The Company reported on Form 8-K dated October 3, 1997, the filing of an action denominated as a shareholders' derivative action against the Company, its majority shareholder, the Trustee of the majority shareholder McM's directors and McM Acquisition Corporation. Reference is hereby made to Part I, Item 1 (a) of this Form 10-K for more detailed information concerning the status of this action. (c) Exhibits--The response to this portion of Item 14 is submitted as a separate section of this report beginning on page 29. (d) Financial Statement Schedules--The response to this portion of Item 14 is submitted as a separate section of this report beginning on page 20. 18 20 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereto duly authorized. McM CORPORATION By: /s/ STEPHEN L. STEPHANO ----------------------- (Registrant) Stephen L. Stephano, President and Chief Operating Officer Date: 3/25/98 ------- Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. /s/ GEORGE E. KING 3/25/98 /s/ MICHAEL DIGREGORIO 3/25/98 - ---------------------------- -------------------------------- George E. King Michael A. DiGregorio Chairman Emeritus, Director Chief Executive Officer and Director /s/ STEPHEN L. STEPHANO 3/25/98 /s/ LAURENCE F. LEE, JR. 3/25/98 - ------------------------------- --------------------------------- Stephen L. Stephano Laurence F. Lee, Jr. President, Director Chief Operating Officer and Director /s/ KEVIN J. HAMM 3/25/98 /s/ LAURENCE F. LEE III 3/25/98 - --------------------------- --------------------------------- Kevin J. Hamm Laurence F. Lee III Vice President and Director Chief Financial Officer /s/ CLAUDE G. SANCHEZ, JR. 3/25/98 /s/ R. PEYTON WOODSON III 3/25/98 - ---------------------------------- ---------------------------------- Claude G. Sanchez, Jr. R. Peyton Woodson III Director Director 19 EX-13 2 ANNUAL REPORT 1 ANNUAL REPORT ON FORM 10-K Item 14 (c) - Exhibits and Item 14 (d) - Financial Statement Schedules Year Ended December 31, 1997 McM CORPORATION AND SUBSIDIARIES 20 2 SCHEDULE 1 -- SUMMARY OF INVESTMENTS McM CORPORATION AND SUBSIDIARIES December 31, 1997
AMOUNT SHOWN ON MARKET BALANCE TYPE OF INVESTMENT COST VALUE SHEET ------------------ ---- ------ -------- (Thousands of dollars) Fixed Maturity Secutities Available-for-Sale Bonds Mortgage-backed securities $ 2,572 $ 1,945 $ 1,945 U.S. Government, government agencies and authorities 22,714 22,874 22,874 Public utilities and other bonds 469 465 465 ------- ------- ------- Total Fixed Maturities Available-for-Sale 25,755 25,284 25,284 Short-term investments 21,522 21,522 21,522 ------- ------- ------- Total Securities Available-for-Sale 47,277 46,806 46,806 Held-to-Maturity U.S. Government, government agencies and authorities 2,940 3,013 2,940 States, municipalities and political subdivisions 194 222 194 ------- ------- ------- Total Securities Held-to-Maturity 3,134 3,235 3,134 ------- ------- ------- Total Investments $50,411 $50,041 $49,940 ======= ======= =======
21 3 SCHEDULE 2 - CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEETS McM CORPORATON (PARENT COMPANY) (Thousands of dollars)
December 31 1997 1996 ---- ---- ASSETS Short term investments 35 30 Cash 108 107 Other assets 99 80 -------- -------- 242 217 Investments in wholly-owned subsidiaries at equity * 15,331 24,005 -------- -------- TOTAL ASSETS $ 15,573 $ 24,222 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Accrued expenses $ 1,619 $ 1,562 Income taxes payable to wholly-owned subsidiaries * 387 387 Payable to wholly-owned subsidiaries * 799 618 -------- -------- TOTAL LIABILITIES 2,805 2,567 Shareholders' Equity: Common stock 4,696 4,678 Additional paid-in capital 1,530 1,489 Unrealized loss on securities available-for-sale, including unrealized (loss) gain on securities held by subsidiaries: 1997 - ($471); 1996 - $78 (471) (65) Retained earnings 7,013 15,553 -------- -------- TOTAL SHAREHOLDERS' EQUITY 12,768 21,655 -------- -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 15,573 $ 24,222 ======== ========
* Eliminated in consolidation See notes to condensed financial information. 22 4 SCHEDULE 2 - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF OPERATIONS McM CORPORATON (PARENT COMPANY) (Thousands of dollars)
Year Ended December 31 1997 1996 1995 ---- ---- ---- INCOME Administrative charges to subsidiaries * - Note B $ 650 $ 650 $ 650 Realized investment income (135) 8 5 ------- ----- ------- 515 658 655 General and administrative expenses 932 893 680 ------- ----- ------- LOSSES BEFORE TAXES AND EQUITY IN UNDISTRIBUTED (LOSS) INCOME OF SUBSIDIARIES (416) (235) (25) Income taxes (benefits) 0 (140) 8 ------- ----- ------- LOSS BEFORE EQUITY IN UNDISTRIBUTED (LOSS) INCOME OF SUBSIDIARIES (416) (95) (33) Equity in undistributed (loss) income of subsidiaries (8,124) (693) 2,243 ------- ----- ------- NET (LOSS) INCOME ($8,540) ($788) $ 2,210 ======= ===== =======
* Eliminated in consolidation. See notes to condensed financial information. 23 5 SCHEDULE 2 - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS McM CORPORATON (PARENT COMPANY) (Thousands of dollars)
Year Ended December 31 1997 1996 1995 ------- ----- ------- OPERATING ACTIVITIES Net (Loss) Income ($8,540) ($788) $ 2,210 Adjustments to reconcile net (loss) income to net cash (used by) provided by operating activities: Depreciation 1 4 4 Equity in loss (income) of subsidiaries 8,124 693 (2,243) Other assets (19) 33 (7) Other liabilities 57 53 (72) Income taxes payable to wholly-owned subsidiaries 0 182 126 Payables to wholly-owned subsidiaries 181 69 6 Permanent decrease in market value of fixed maturity 143 0 0 ------- ----- ------- CASH (USED BY) PROVIDED BY OPERATING ACTIVITIES (53) 246 24 INVESTING ACTIVITIES Disposals of fixed maturities 0 57 0 Increase in short-term investments (5) (30) 0 ------- ----- ------- CASH (USED) PROVIDED BY INVESTING ACTIVITIES (5) 27 0 FINANCING ACTIVITIES Employee stock purchases 59 15 0 Cash dividends paid 0 (282) 0 ------- ----- ------- CASH PROVIDED (USED) BY FINANCING ACTIVITIES 59 (267) 0 ------- ----- ------- INCREASE IN CASH $ 1 $ 6 $ 24 ======= ===== =======
See notes to condensed financial information. 24 6 SCHEDULE 2 -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO CONDENSED FINANCIAL INFORMATION McM CORPORATION (PARENT COMPANY) The accompanying condensed financial information should be read in conjunction with the consolidated financial statements and notes thereto of McM Corporation and Subsidiaries. NOTE A -- Significant Accounting Policies In the parent company financial statements, the Company's investments in wholly-owned subsidiaries are stated at cost plus equity in undistributed earnings of the subsidiaries. McM is actively engaged through certain of its subsidiaries in the property and casualty insurance business. NOTE B -- Administrative Charges McM is compensated by its subsidiaries in the form of management fees for providing management support, planning assistance, financial reporting and investment services. 25 7 SCHEDULE 3 - REINSURANCE McM CORPORATION AND SUBSIDIARIES Year Ended December 31, 1997, 1996, and 1995
Premiums Earned ------------------------------------------------------------------ Percentage Ceded to Assumed of Amount Direct Other From Other Net Assumed (Thousands of dollars) Amount Companies Parties Amount to Net --------------- ---------------- ---------------- -------------- ---------------- YEAR ENDED DECEMBER 31, 1997 $65,205 $20,071 $10,573 $55,707 18.98% =============== ================ ================ ============== YEAR ENDED DECEMBER 31, 1996 $63,163 $21,714 $10,405 $51,854 20.07% =============== ================ ================ ============== YEAR ENDED DECEMBER 31, 1995 $63,731 $23,901 $ 5,871 $45,701 12.85% =============== ================ ================ ==============
26 8 SCHEDULE 4 - VALUATION AND QUALIFYING ACCOUNTS McM CORPORATION AND SUBSIDIARIES (Thousands of dollars)
ADDITIONS -------------------------- (1) (2) Charged to Charged to Balance at (Recovery of) Other Beginning Costs and Accounts- Deductions- Balance at End DESCRIPTION of Period Expenses Describe Describe of Period ---------- ------------- ---------- ----------- -------------- YEAR ENDED DECEMBER 31, 1997 Deducted from asset account: Allowance for uncollectible accounts $ 345 $ 0 $0 $ 0 $ 345 ====== ===== == ==== ====== Included as liability account: Allowance for bad debts on liquidated reinsurers $ 158 $ 402 $0 $802 (1) ($ 242) ====== ===== == ==== ====== YEAR ENDED DECEMBER 31, 1996 Deducted from asset account: Allowance for uncollectible accounts $ 345 $ 0 $0 $ 0 $ 345 ====== ===== == ==== ====== Included as liability account: Allowance for bad debts on liquidated reinsurers $1,060 ($150) $0 $752 (1) $ 158 ====== ===== == ==== ====== YEAR ENDED DECEMBER 31, 1995 Deducted from asset accounts: Allowance for uncollectible accounts $ 315 $ 30 $0 $ 0 $ 345 ====== ===== == ==== ====== Included as liability account: Allowance for bad debts on liquidated reinsurers $1,349 $ 103 $0 $392 (1) $1,060 ====== ===== == ==== ======
(1) Write-off of paid recoverable balances for insolvent/liquidated reinsurers against provision established. 27 9 SCHEDULE 5 - SUPPLEMENTAL INSURANCE INFORMATION PROPERTY/CASUALTY INSURANCE SUBSIDIARIES YEAR ENDED DECEMBER 31, 1997, 1996 AND 1995 (Thousands of dollars)
RESERVES FOR DEFERRED UNPAID CLAIMS DISCOUNT POLICY AND CLAIM IF ANY ACQUISITION ADJUSTMENT DEDUCTED IN UNEARNED EARNED INVESTMENT COSTS EXPENSES RESERVES PREMIUMS PREMIUMS INCOME ------------------- ------------------ --------------- ------------ ---------- ------------- YEAR ENDED DECEMBER 31: Net of Reinsurance 1997 $2,802 $29,159 -- $ 9,363 $55,707 $2,977 1996 3,992 26,532 -- 13,857 51,854 3,151 1995 3,343 29,997 -- 12,291 45,701 3,492 Gross of Reinsurance 1997 $2,802 $57,283 -- $15,676 $75,778 $2,977 1996 3,992 55,300 -- 17,925 73,568 3,151 1995 3,343 66,152 -- 17,234 69,602 3,492
CLAIMS AND CLAIM ADJUSTMENT EXPENSES INCURRED RELATED TO AMORTIZATION ------------------------------------------- OF DEFERRED PAID CLAIMS (1) (2) POLICY AND CLAIM CURRENT PRIOR ACQUISITION ADJUSTMENT PREMIUMS YEAR YEAR COSTS EXPENSES WRITTEN --------------------- --------------------- --------------------- --------------------- -------- Net of Reinsurance 1997 $42,243 $ 5,774 $10,332 $45,390 $51,214 1996 37,651 1,559 9,116 42,675 53,420 1995 31,282 (248) 7,141 39,452 46,663 Gross of Reinsurance 1997 $54,266 $ 8,616 $10,332 $62,633 $73,529 1996 52,711 (930) 9,116 62,633 74,259 1995 45,395 660 7,141 71,403 72,025
28 10 McM CORPORATION 1997 ANNUAL REPORT 29 11 Corporate Mission and Profile Mission To market specialized insurance products within well defined market areas at competitive prices and with exceptional service to deliver better than average returns on investor capital. Profile McM Corporation is an insurance holding company headquartered in Raleigh, North Carolina, which owns these major operating subsidiary corporations: Occidental Fire & Casualty Company of North Carolina ("OF&C") Raleigh, North Carolina Wilshire Insurance Company ("Wilshire") Raleigh, North Carolina Contents - -------------------------------------------------------------------------------- IFC Corporate Mission and Profile Consolidated Financial Highlights Common Stock Report to Shareholders Market Overview Management's Discussion and Analysis of Financial Condition and Results of Operations Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Shareholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Report of Independent Auditors Summary of Quarterly Results of Operations Officers and Directors Corporate Information 30 12 SELECTED FINANCIAL DATA
- ------------------------------------------------------------------------------------------------------------------ McM CORPORATION AND SUBSIDIARIES 1997 1996 1995 1994 1993 - ------------------------------------------------------------------------------------------------------------------ (Thousands of dollars, except per share data) Assets $ 104,140 $ 112,870 $126,568 $137,665 $ 158,984 Liabilities 91,372 91,215 103,328 117,258 139,262 Retained earnings 7,013 15,553 16,623 14,413 13,059 Shareholders' equity 12,768 21,655 23,240 20,407 19,722 Net premiums earned 55,707 51,854 45,701 41,126 51,043 Net investment income 2,985 3,159 3,497 3,684 5,298 Realized investment gains 196 40 123 122 1,797 Total revenue 59,537 55,698 49,571 45,304 58,293 Net (loss) income (8,540) (788) 2,210 1,354 (295) Per share data: Shareholders' equity $ 2.72 $ 4.63 $ 4.97 $ 4.37 $ 4.22 Net (loss) income (1.82) (0.17) 0.47 0.29 (0.06) Net (loss) income - assuming dilution (1.82) (0.17) 0.47 0.29 (0.06) Cash dividends 0.00 0.06 0.00 0.00 0.00
Common Stock - ------------------------------------------------------------------------------ McM Corporation Common Stock is traded over-the-counter securities market, under the NASDAQ symbol, McMc. The number of record shareholders of McM Corporation is 858 as of December 31, 1997. The table below sets forth by quarters, for the years 1997 and 1996, the range of the high and low bid prices of McM Corporation's Common Stock as reported in The Wall Street Journal. No dividends were declared or paid during 1997. Dividends of $.02 per share were paid for the second, third, and fourth quarters of 1996. See Management's Disussion and Analysis and Note B to the consolidated financial statements for information regarding restrictions on the ability of McM's subsidiaries to transfer funds to McM and discussion regarding nonpayment of dividends.
1997 1996 High Low High Low --------------------------------------------------------------------- First Quarter $4 5/8 $3 7/8 $4 3/4 $3 1/2 Second Quarter 3 7/8 3 1/8 6 1/8 5 1/2 Third Quarter 3 3/8 2 7/8 5 7/8 5 1/4 Fourth Quarter 3 1/4 2 1/8 5 3/4 5 1/4 ---------------------------------------------------------------------
31 13 REPORT TO SHAREHOLDERS McM Corporation's results for the year 1997 showed a net loss of $8,540,000. This loss is primarily the result of a significant increase in overall loss reserves during the latter part of 1997. The increase in overall loss reserve levels resulted from the deterioration in the commercial and private passenger automobile liability lines of business, particularly for the 1995 and 1996 accident years and increased claim costs in the current underwriting year for commercial and private passenger automobile physical damage coverages. The Company, after a comprehensive actuarial analysis of loss trends and projections at year end which confirmed this deterioration, increased prior year loss reserves for ongoing lines of business by approximately $5.1 million during 1997. As a result of these unfavorable loss trends, it was necessary to also increase loss reserves for the current accident year. As underwriting results for the 1995 and 1996 underwriting years deteriorated, the Company undertook an extensive review of its operations. As a result of this review management was able to isolate specific areas which were identified as being primary contributors to the property and casualty companies' performance decline. Significant strengthening of underwriting controls, increases in rate levels and a complete re-underwriting of a specific segment of the commercial automobile business was undertaken in mid 1997. Management believes that the reserve increases taken in 1997 were prudent and is confident in its course of action. The specific causes of the unfavorable results for 1997 have been identified and remedial actions are being taken to correct these problem areas. The actions taken to date have not yet had time to run their complete course, however, early indications show the desired positive impact. Consolidated gross revenues for the year 1997 were $59,950,000 compared to $56,155,000 for the same period in 1996. This increase in consolidated revenues reflects growth in private passenger automobile premium writings and a reduction in premiums ceded to the Company's reinsurers. Commercial automobile writings, which have shown declines over the last three years, reflect market conditions which continue to be highly competitive and price sensitive. The Company continues to utilize highly regarded and financially sound reinsurers which specialize in commercial and private passenger automobile coverages in its reinsurance program. Included in consolidated gross revenues for the year 1997 was gross investment income of $3,398,000 compared to $3,616,000 for the year 1996. In addition, realized investment gains of $196,000 and $40,000 were included in consolidated gross revenues for the years 1997 and 1996, respectively. Consolidated assets at December 31, 1997, totalled $104,140,000 compared to $112,870,000 at December 31, 1996. The decline in consolidated assets in 1997 relates directly to the decline in invested assets during the year. This decline in invested assets is attributable to 32 14 the deteriorated loss experience discussed above and the accelerated settlement of claim related liabilities. Shareholders' equity at December 31, 1997, totalled $12,768,000 compared to $21,655,000 at December 31, 1996. As discussed in prior years' reports to you, the McMillen Trust, which owns 65% of the outstanding stock of McM Corporation was ordered by the Chancery Court of Delaware on December 10, 1987, to divest itself of its ownership of the shares of McM Corporation and to invest the proceeds from such a divestiture in a diversified portfolio for the benefit of present and future beneficiaries of the Trust. In April 1993, the Court further clarified existing orders to make clear, among other things, that the timing and terms of any disposition or sale of the Trust's shares shall be determined in the sound discretion of the Trustee. In last year's report to you, it was discussed that on February 4, 1997, McM Corporation announced that the Trustee of the McMillen Trust, then holder of 65.9% of the stock of McM Corporation, had informed the Company that the Trustee had granted to McM Acquisition Corporation an option to purchase all the Trust's shares at $6.20 per share and that such option was to expire on March 1, 1998. The announcement also stated that McM Acquisition Corporation was controlled by a private investor and real estate developer who had also filed a Form 13D with the Securities and Exchange Commission reflecting that the possible purchase of the Trust's shares was subject to the ability of McM Acquisition Corporation to obtain the necessary financing for the transaction as well as the approval of the North Carolina Department of Insurance and other regulatory bodies. The announcement included the statement that McM Corporation was not a party to the option agreement and could not predict whether McM Acquisition Corporation would exercise its option or would be able to obtain the required approvals and financial arrangements. McM Corporation further announced on February 4, 1997, that in a separate, independent action it had extended an agreement with McM Acquisition Corporation to allow McM Acquisition Corporation confidential access to Company records and information to enable McM Acquisition Corporation to conduct due diligence reviews and to pursue appropriate financial arrangements for a possible acquisition of all of McM Corporation's shares. This agreement was to expire on May 31, 1997, and was subsequently extended until September 29, 1997, at which time it expired. On September 22, 1997, an action was brought against the Company, its directors, the McMillen Trust, Wilmington Trust Company as Trustee of the McMillen Trust and McM Acquisition Corporation. The suit was filed in Guilford County, North Carolina, Superior Court by two shareholders of McM on behalf of all McM shareholders except for the McMillen Trust. The suit complained, among other allegations, that because the Trust owned approximately two-thirds of the shares of McM, it effectively exercised control of the corporation. It challenged the composition of the McM Board of Directors and the actions of the Board as being controlled by the majority shareholder. The complaint asked that the Court void the action of the Trustee in connection with the McMillen Trust's grant of the option to sell its shares to McM Acquisition 33 15 Corporation. The suit also complained that the corporation had inappropriately allowed McM Acquisition Corporation the above described exclusive due diligence period. On December 23, 1997, the Court approved an agreement to terminate McM Acquisition Corporation's option and related agreements between the Trust and McM Acquisition Corporation (the "Release"). The Release was signed by all parties to the pending legal action and contains a mutual release between all parties and McM Acquisition Corporation of any claims which could have arisen from the option and related agreements and dismissed McM Acquisition Corporation as defendant in the legal action. On February 20, 1998, the Court approved a settlement of the legal action discussed above. The settlement agreement, executed by all parties, provides that McM Corporation, the current directors, the McMillen Trust and Wilmington Trust Company will use their best efforts to nominate and elect Mr. Jesse Greenfield to the McM Board of Directors at McM's 1998 annual shareholders' meeting. The settlement agreement also contains provisions for nominal monetary concessions by the Plaintiffs and McM and mutually releases all parties. With regard to McM Corporation's continuing efforts to consider all strategies and alternatives to maximize shareholder value, the Company has authorized PaineWebber, Incorporated to explore all reasonable methods to increase the capital position of McM, including a possible sale of the Company. The investment portfolios of Occidental Fire & Casualty Company and Wilshire continue to be comprised almost entirely of high quality government securities. McM and its subsidiaries have no investments in real estate. Though the conservative nature of these investments generally result in lower investment yields , the high level liquidity provided by these investments ensure that the Company's obligations to its policyholders are met in a timely manner. The stock of Wilshire Insurance Company, the wholly-owned subsidiary of Occidental Fire & Casualty Company, is the only stock investment in the investment portfolios of the insurance companies. Insurance regulators and other nongovernmental insurance rating entities continue their intensive oversight of an insurance company's financial stability and operating activities. In 1994 these actions culminated with the National Association of Insurance Commissioners (the "NAIC") adopting and implementing Risk-Based Capital requirements for property and casualty insurance companies. RBC was developed to evaluate the adequacy of an insurance company's statutory capital and surplus in relation to the risk environment in which the company operates. The RBC formulas serve as early warning tools for state insurance regulators to help identify, for the purpose of initiating various levels of regulatory action, companies which are potentially inadequately capitalized. Occidental Fire & Casualty Company, as a result of the increase in overall reserve levels of both Occidental and Wilshire, triggered the first RBC regulatory action threshold defined as Company Action Level RBC ("CAL") in 1997. Triggering this threshold requires the insurer to 34 16 prepare and submit to its domiciliary state a comprehensive financial plan. Among other items, the plan should identify the conditions in the insurer that contributed to the CAL event and contain proposals for corrective actions that the insurer intends to take that is expected to result in the elimination of the CAL event. As discussed previously, management has already identified the issues contributing to the decline in profitability and statutory capital and surplus and has implemented remedial actions designed to improve the overall profitability of the property and casualty companies' operations and eliminate the RBC deficiency. Occidental, working within the framework of RBC guidelines, will submit its plan of action to the Insurance Commissioner of the State of North Carolina in the near future and believes that its indicated RBC deficiency will be corrected under this plan. The statutory capital and surplus of Wilshire is well in excess of any regulatory action thresholds defined by the NAIC. The Board of Directors, on a quarterly basis, carefully reviews the financial position of the Company to determine the advisability of the declaration and payment of cash dividends to shareholders. In light of McM's results during 1997 and after careful consideration of all other relevant factors, the Board of Directors decided to forego quarterly dividend payments during 1997. The Board of Directors will continue to evaluate all relevant factors in the determination of future dividend payments. In summary, we are very disappointed with the overall results for the year 1997. An extensive actuarial review of loss trends has been completed and we believe we have taken the appropriate action regarding our companies' level of reserve adequacy that other companies have yet to realize in satisfying the well documented industry-wide concerns insurance regulators and other insurance rating entities have expressed. Also, after extensive reviews of the property and casualty operations we have been able to identify the specific issues contributing to the decline in profitability and have implemented remedial actions to correct these deficiencies. We believe the steps taken will position the Company for a return to profitability in 1998 and beyond. GEORGE E. KING Chairman Emeritus & Chief Executive Officer STEPHEN L. STEPHANO President & Chief Operating Officer 35 17 Market Overview McM Corporation provides its property and casualty products and services through two North Carolina domiciled subsidiaries, Occidental Fire & Casualty Company of North Carolina and Wilshire Insurance Company. The major focus of the companies is to the transportation insurance market providing commercial automobile liability, physical damage and inland marine insurance coverages to owner-operators and small fleet carriers in the trucking industry. The Companies also write nonstandard private passenger auto coverages in select geographical areas. Occidental Fire & Casualty Company of North Carolina actively markets insurance coverages to local, intermediate and long haul carriers in twenty-one states utilizing fifteen managing general agents. The majority of the Company's commercial auto premium volume is produced through the Company's annual bill program. The insureds of Wilshire Insurance Company are served by the Marketing and Service Center located in Lancaster, California, and four managing general agents supervised by the home office. The California marketing unit deals directly with selected local retail agents in the West Coast truck marketplace utilizing a specialized monthly direct bill policy. The managing general agents market intermediate and long haul coverages through an annual bill program. Occidental and Wilshire's non-standard auto coverages are marketed through a branch office located in Scottsdale, Arizona. The majority of this business is produced utilizing a semi-annual policy and direct-bill program. The home office located in Raleigh, North Carolina, provides general management for both Occidental Fire & Casualty and Wilshire Insurance Company operations including the corporate staff for claims, accounting, regulatory compliance, data processing, human resource and investment functions. Also located in the home office are the marketing, underwriting and service functions for all commercial automobile business written through managing general agents. 36 18 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS McM Corporation and Subsidiaries This section should be read in conjunction with the financial statements, notes to the financial statements and related financial data included in this annual report. REVIEW OF OPERATIONS McM Corporation reported a consolidated net loss for 1997 of $8,540,000 or a basic net loss per share of $1.82 compared to a net loss of $788,000 or a basic net loss per share of $.17 for 1996 and net income of $2,210,000 or basic net income per share of $.47 for 1995. Consolidated results for 1997 were significantly affected by the need to increase prior year loss reserves by approximately $5.8 million. This increase in reserves was necessary as a result of the Company's comprehensive review of its actuarial loss projections. These projections showed deterioration in the commercial and private passenger auto liability lines of business for the 1996 and 1995 accident years. In light of these unfavorable loss trends and higher than anticipated claim costs in commercial and private passenger physical damage coverages the Company also strengthened loss reserves for the current accident year by approximately $4.5 million. Consolidated revenues increased approximately 6.9% in 1997, 12.4% in 1996, and 9.4% in 1995. The trend of increasing revenues experienced in 1996 and 1995 was the result of controlled growth in overall property & casualty insurance premiums. The more moderate increase from 1996 to 1997 is the result of continued growth in private passenger automobile premium writings partially offset by a reduction in net retained commercial automobile premium writings. Net earned property and casualty insurance premiums for 1997 were $55.7 million, compared to $51.9 million in 1996, and $45.7 million in 1995. As mentioned above, the trend in increasing net premium revenue during 1996 and 1995 reflected the Company's commitment to controlled premium growth in all insurance coverages. The increase for 1997 is primarily the result of continued growth in private passenger automobile premium writings. Additionally, net earned premiums increased by approximately $1.8 million due to a reduction in the level of premiums ceded to the Company's private passenger quota share reinsurance program. Historically, the Company's property and casualty insurance writings emphasized liability, cargo and physical damage coverages associated with the transportation market with a primary emphasis on commercial automobile insurance. To diversify its premium 37 19 distribution, the Company entered the nonstandard personal automobile market in 1989. Gross written premium in the Company's commercial automobile lines of business totalled $55.6 and $59.3 million and comprised approximately 75.6% and 79.9% of gross written premiums in 1997, and 1996, respectively. Private passenger automobile premium writings increased 20% to $17.9 million in 1997, from $14.9 million in 1996, and comprised 24.4% and 20.1% of gross production in 1997, and 1996, respectively. Commercial auto premium writings decreased in 1996 and again during 1997 reflecting market conditions which continue to be highly competitive and price sensitive. The Company's continuing commitment to diversify its premium portfolio is reflected in the growth of private passenger auto premiums over the last several years. To help control the Company's statutory net writings to surplus ratios and premium growth in selected lines of business, the Company maintains quota share reinsurance arrangements for its commercial auto liability and private passenger automobile coverages. The Company maintained a 20% quota share reinsurance arrangement on its private passenger business during 1997. This rate was reduced from 30% and 40% in 1996 and 1995, respectively. Also maintained during 1997 was a 5% quota share arrangement on commercial auto liability business retained after excess of loss reinsurance coverage. The rate pertaining to this treaty has remained unchanged since 1995, at which time it was lowered from 10%. Management evaluates the necessity and levels of these quota share arrangements and makes adjustments when appropriate. Net investment income, excluding realized investment gains, decreased to approximately $3.0 million in 1997 from approximately $3.2 million in 1996 and $3.5 million in 1995. This gradual decline corresponds to the decrease in invested assets to $49.9 million in 1997, from $56.9 million in 1996, and $63.0 million in 1995. The decrease in invested assets is primarily attributed to the deteriorated loss experience discussed above and accelerated settlement of claim related liabilities. Claim liabilities totalled $47.7 million, net of the reserve increases discussed previously, at December 31, 1997, and $51.8 million, and $66.2 million at December 31, 1996 and 1995, respectively. Realized investment gains of $196,000 are included in 1997 revenues compared to $40,000 in 1996 and $123,000 in 1995. Underwriting results for cargo (inland marine) and commercial automobile physical damage coverages have historically been more profitable than commercial automobile liability. These coverages are generally easier to determine and claims settled more rapidly. Accordingly, the Company has implemented strategies to improve the ratio of these coverages to total commercial premium production. As mentioned previously, commercial automobile written premiums comprised 75.6% of gross written property & casualty premium in 1997 compared to 79.9% and 83.5% in 1996 and 1995, respectively. 38 20 The percentage of cargo and commercial automobile physical damage premiums to total commercial automobile premiums increased to 29.7% in 1997 compared to 27.9% and 26.6% in 1995 and 1994, respectively. At December 31, 1997, the market value of the total long-term fixed income portfolio was $370,000 less than amortized cost and $100,000 greater than its carrying value. The unrealized loss of $471,000 relates to those investments the Company intends to hold to maturity. The full value of these securities will be realized as they mature (see Note F to the consolidated financial statements). At December 31, 1996, the market value of the fixed income portfolio was $19,000 greater than its amortized cost and $84,000 greater than its carrying value. The overall ratio of net loss and settlement expenses to net premiums earned was 86.2% for 1997 compared to 75.6% for 1996 and 67.9% for 1995. As discussed previously, the increase in the loss ratio in 1997 resulted from the deterioration in the commercial and private passenger automobile liability lines of business, particularly for the 1995 and 1996 accident years and increased claim costs in the current underwriting year for commercial and private passenger automobile physical damage coverages. After a comprehensive actuarial analysis of loss trends and projections at year end 1997 which confirmed this deterioration and the need to increase prior year loss reserves, the Company determined it was also necessary to increase loss reserves for the current accident year. Current year loss reserves were increased approximately $4.5 and prior year loss reserves were increased approximately $5.8 million, for a total of $10.3 million, net of reinsurance. Of the $4.5 increase to current year reserves, approximately $1,925,000 related to commercial physical damage and inland marine coverages, $1.1 million related to commercial auto liability coverages, and $875,000 and $600,000 related to private passenger liability and physical damage coverages, respectively. Net losses and settlement expenses incurred in 1997 include total adverse development of $5,774,000 on reserves of prior accident years. This development includes adverse reserve development of approximately $844,000 in private passenger automobile liability reserves, $813,000 in private passenger and commercial physical damage and inland marine reserves and $3,531,000 relating to the commercial automobile liability lines of business. In addition, the Company experienced adverse prior year development of approximately $586,000 relating to discontinued lines of business and participation in involuntary pools and other residual market mechanisms. The increase in the 1996 ratio of net loss and settlement expenses to net premiums earned when compared to that of 1995 was 39 21 the result of an unusually high level of claims severity experienced by the Company, primarily in the fourth quarter of 1996, in the commercial auto liability line of business. In addition, property and casualty operations experienced increased frequency in its other lines of business including private passenger auto liability and commercial and private passenger auto physical damage coverages throughout 1996. These factors resulted in the strengthening of overall reserves for the 1996 accident year by approximately $3.5 million, net of reinsurance, at December 31, 1996, including $1.2 million relating to commercial auto liability, $1.5 million relating to commercial auto physical damage and approximately $800,000 relating to private passenger auto coverages. The ratio of net loss and settlement expenses to net premiums earned for 1995 reflected improved underwriting results and favorable or minimal adverse development on reserves of prior accident years. The Company's ratio of underwriting, acquisition and administrative expenses (including the provision for bad debts on liquidated reinsurance) to net earned premium ("expense ratio") showed a slight increase to 36.0% following declining trends over the last several years. Contributing to the increase in 1997 was the provision for liquidated reinsurance which totalled $401,000 representing an increase of $550,000 when compared to 1996. Increased production levels coupled with budgetary control and reduction measures emphasized by management, contributed to the declining trend in prior years. The expense ratio for 1996 declined 2.4 percentage points to 33.3% when compared to the expense ratio of 1995. The Company utilizes a reinsurance intermediary with which it has a long term relationship to assist in the development, placement and maintenance of the Company's reinsurance program. The Company's current reinsurance program has been placed with high quality and financially sound reinsurers specializing in personal and commercial auto business. The creditworthiness of the Company's reinsurers is continually reviewed by the Company and the intermediary. The majority of the Company's reinsurance is placed through the London reinsurance market. These participating reinsurers are generally very large international reinsurers with capital and surplus in excess of $100 million and hold A.M. Best ratings of B++ or better. Participating Lloyds syndicates are well regarded syndicates which have been approved by the National Association of Insurance Commissioners ("NAIC"). The Company's U.S. reinsurers are all rated A- or higher by A.M. Best. For those reinsurers not admitted by the Company's state of domicile, collateral is secured for the exposure ceded to them in the form of letters of credit or other reinsurer funds held by the Company. This collateral would minimize the impact of a potential reinsurer insolvency on the Company's operations. A schedule of the 40 22 Company's reinsurers whose balances are approximately 10% of McM's shareholders' equity or greater is provided below:
Ceded Reinsurer Balances Receivable --------- ------------------- (Thousands of dollars) Lloyds of London $ 8,998 CNA International 5,103 Unionamerica 4,685 AXA Reassurance 3,008 Zurich Re 2,976 Sphere Drake Insurance, PLC 2,004 All other 9,139 ------- Total $35,913
The allowance for bad debts on liquidated reinsurers relating to discontinued property and casualty programs was increased by $401,000 in 1997, decreased by $150,000 in 1996 and increased by $103,000 in 1995. Other than a $2.5 million litigation settlement in 1993, overall exposure to losses associated with discontinued property and casualty business has decreased significantly over the last several years and has not had a material impact on operations since 1990. In the second quarter of 1995, the Company resolved a long standing uncertainty concerning Proposition 103 by settling this issue with the California Department of Insurance. The Company fully recognized this settlement and its related cost in 1995 by including in consolidated results a $500,000 reduction of earned premiums attributable to this settlement. Offsetting this charge and also included in results for 1995 is a $539,000 favorable arbitration settlement related to discontinued property and casualty programs. Amortization of deferred policy acquisition costs from continuing operations was $10.3 million in 1997, compared to $9.1 million in 1996, and $7.1 million in 1995. Direct and assumed premiums earned increased by $2.2 million in 1997, $4.0 million in 1996, and $2.8 million in 1995 resulting in an increase in the related amortization of deferred policy acquisition costs. INCOME TAXES McM Corporation files a consolidated tax return. The Company had cumulative net operating loss tax carryforwards of approximately $98.0 million as of December 31, 1997 (See Note D to the consolidated financial statements). Subject to certain limitations and alternative minimum tax considerations, future operations can earn up to the amount of these loss carryforwards without being subject to federal income taxation. 41 23 IMPACT OF YEAR 2000 ISSUE The Year 2000 Issue is a worldwide problem relating to virtually all computer programs that were written using two digits rather than four to define the applicable year. Computer programs that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This problem could result in systems failures or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process premium transactions, pay claims or engage in similar normal business activities. The Company completed an assessment of its software applications and determined that the system managing the Company's specialized monthly commercial automobile direct bill program would have to be modified so that it would function properly with respect to dates in the year 2000 and thereafter. This modification was successfully completed in 1997 at an approximate cost of $96,000. Other Company computer applications, most of which are licensed from third party computer program vendors, were determined to be Year 2000 compliant or, based upon communication with these vendors, would be compliant within the Company's time estimate discussed below. The project, as it relates to all of the Company's computer platforms, is estimated to be completed not later than September 30, 1998, which is prior to any anticipated impact on its operating systems. The Company believes that with modifications to existing software, the Year 2000 Issue will not pose significant operational problems for its computer systems. However, if such modifications and conversions are not made, or are not completed timely, the Year 2000 Issue could have a material impact on the operations of the Company. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard No. 128, "Earnings Per Share" ("SFAS 128") in 1997. SFAS 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods presented have been calculated utilizing the new requirements of SFAS 128. In June 1997, the FASB issued the Statement of Financial Accounting Standards No. 130 "Reporting Comprehensive Income". Also during June, the FASB issued the Statement of Financial Accounting Standards No. 131 "Disclosures about Segments of an Enterprise and Related Information". In February 1998, the FASB 42 24 issued the Statement of Financial Accounting Standards No. 132 "Employers' Disclosures about Pensions and Other Postretirement Benefits". These new accounting pronouncements must all be adopted for years beginning after December 15, 1997. The impact of the adoption of these accounting standards on the Company's financial reporting and related disclosures is not expected to be material. LIQUIDITY AND CAPITAL RESOURCES By statute, the majority of the Company's investments are required to be held in investment grade securities which provide ample protection for both the policyholder and the shareholder. Significant amounts of short-term investments are held to meet the liquidity needs of the property and casualty insurance operations. As shown in the Consolidated Statements of Cash Flows, the Company experienced negative cash flows from operations on a consolidated basis of $5.5 million in 1997 compared to $4.4 million in 1996 and $4.0 million in 1995. The main source of the Company's cash flows is derived from its property and casualty subsidiaries. The Company's property and casualty subsidiaries experienced consolidated negative cash flows from operations of $4.9 million, $3.9 million and $2.2 in 1997, 1996 and 1995, respectively. The negative cash flows for the property and casualty operations can be primarily attributed to the settlement of claim liabilities, including settlements on discontinued run-off business. Short-term investments held at December 31, 1997, were $21.5 million compared to $14.1 million at December 31, 1996. This increase is due to the sale of long-term fixed maturities during the fourth quarter of 1997 which enabled the Company to recognize market gains in its fixed maturity portfolio. This increase in liquidity was partially offset by cash used for operations as discussed above, and the Company plans to invest remaining balances in other high quality instruments during 1998. Total cash and invested assets at December 31, 1997, were approximately $49.9 million compared to $56.9 million at December 31, 1996. The Company maintains a mix of high-quality investments which provides adequate returns, while limiting credit risk and providing necessary levels of liquidity to meet projected expenditures. At December 31, 1997, approximately 49.0% or $25.3 million of cash and invested assets were comprised of fixed maturities available-for-sale, 6.0% or $3.1 million were recorded as securities held-to-maturity and 45.0% or $23.2 million represented cash and short-term investments. Of the total cash and invested assets at December 31, 1996, approximately 62.9% or $36.9 million were comprised of fixed maturities available-for-sale and 10.1% or $5.9 million were classified as securities held-to-maturity. Cash and short-term investments totalling $15.8 million comprised the remaining 27.0% of the investment portfolio. The fixed maturity portfolio has a 43 25 range of expected maturities which, as mentioned previously, management believes are adequate to meet long- and short-term liquidity needs. Statutory capital positions of the property and casualty insurance companies are closely monitored by the Company. In addition, the NAIC has adopted Risk-Based Capital ("RBC") requirements. Annual statutory financial statements are filed with state insurance regulators on or before March 1 following each year's end. RBC was developed to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, asset and liability matching, loss reserve adequacy and other business environmental factors. The RBC formula is used by state insurance regulators as an early warning tool to identify, for the purpose of initiating regulatory action, insurance companies that may be inadequately capitalized. Regulatory compliance is determined by a ratio of the enterprise's regulatory total adjusted capital, as defined by the NAIC, to its authorized control level RBC, as defined by the NAIC. Enterprises below specific ratios are classified within certain levels, each of which requires specific corrective action. OF&C, as a result of the need to significantly strengthen reserve adequacy of the property and casualty companies during 1997, triggered the first RBC regulatory action threshold defined as Company Action Level RBC ("CAL"). Triggering the CAL threshold requires that an insurer prepare and submit to its domiciliary state a comprehensive financial plan. Among other items, the plan should identify the conditions in the insurer that contributed to the CAL event and contain proposals for corrective actions that the insurer intends to take that are expected to result in the elimination of the company action level event. The Company has identified specific areas of its business contributing to the decline in profitability and statutory capital and surplus and has implemented remedial steps designed to improve the overall profitability of property and casualty operations and eliminate the RBC deficiency. OF&C, working within the framework of RBC guidelines, will submit its plan of action to the state of North Carolina in the near future and believes that its indicated RBC deficiency will be corrected under this plan. The capital and surplus of Wilshire is well in excess of any regulatory action thresholds defined by the NAIC. Combined statutory capital and surplus of the property and casualty subsidiaries decreased by $6.7 million to $11.5 million at December 31, 1997, compared to $18.2 million at December 31, 1996. 44 26 At December 31, 1997, the Company had consolidated shareholders' equity of $12.8 million compared to $21.7 million at December 31, 1996. The Company's main source of funds from which dividends are paid to its shareholders is its insurance subsidiaries which are subject to certain restrictions as to the amount of dividends that can be paid in a given year. These restrictions are discussed in Note B to the consolidated financial statements. No dividends were declared or paid during 1997. During 1996 the Company paid three quarterly dividends of $.02 per share, and prior to that had not paid a dividend since the second quarter of 1987. The Board will continue to consider carefully the Company's earnings, capital requirements, financial condition and other relevant factors with regard to payment of dividends. 45 27 Consolidated Balance Sheets
- --------------------------------------------------------------------------------------------------------------------------- December 31 McM CORPORATION AND SUBSIDIARIES 1997 1996 - --------------------------------------------------------------------------------------------------------------------------- (Thousands of dollars) Assets Invested assets: Fixed maturity securities available-for-sale, at fair value (cost: 1997 - $25,755; 1996 - $36,938) $ 25,284 $ 36,873 Fixed maturity securities held-to-maturity, at amortized cost (fair value: 1997 - $3,235; 1996 - $6,022) 3,134 5,938 Short-term investments 21,522 14,061 - --------------------------------------------------------------------------------------------------------------------------- 49,940 56,872 Cash 1,698 1,776 Accrued investment income 531 803 Premiums receivable 8,552 9,380 Reinsurance balances recoverable on: Paid losses and settlement expenses 1,476 3,676 Unpaid losses and settlement expenses 28,124 28,768 Unearned premiums 6,313 4,068 Deferred policy acquisition costs 2,802 3,992 Equipment, at cost less accumulated depreciation (1997 - $1,954; 1996 - $1,699) 1,833 1,331 Other assets 2,871 2,204 - --------------------------------------------------------------------------------------------------------------------------- TOTAL ASSETS $ 104,140 $ 112,870 =========================================================================================================================== LIABILITIES and SHAREHOLDERS' EQUITY Liabilities: Reserves for losses and settlement expenses $ 57,283 $ 55,300 Unearned premiums 15,676 17,925 Other policyholder funds 6,380 6,580 Amounts payable to reinsurers 4,461 3,089 Accrued expenses and other liabilities 7,572 8,321 - --------------------------------------------------------------------------------------------------------------------------- 91,372 91,215 Commitments and contingencies - Notes A, B, C and H Shareholders' equity: Common Stock, par value $1 per share - authorized 10,000,000 shares, issued and outstanding: 1997 - 4,695,621; 1996 - 4,678,183 4,696 4,678 Additional paid-in capital 1,530 1,489 Unrealized loss on securities available-for-sale (471) (65) Retained earnings 7,013 15,553 - --------------------------------------------------------------------------------------------------------------------------- TOTAL SHAREHOLDERS' EQUITY 12,768 21,655 - --------------------------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 104,140 $ 112,870 ===========================================================================================================================
See notes to consolidated financial statements. 46 28 Consolidated Statements of Operations
- ------------------------------------------------------------------------------------------------------------------------ Year Ended December 31 McM CORPORATION AND SUBSIDIARIES 1997 1996 1995 - ------------------------------------------------------------------------------------------------------------------------ (Thousands of dollars, except per share data) Revenues Premiums earned $75,778 $73,568 $69,602 Premiums ceded (20,071) (21,714) (23,901) ---------------------------------------- Net premiums earned 55,707 51,854 45,701 Investment income, less investment expense (1997 - $413; 1996 - $457; 1995 - $474) 2,985 3,159 3,497 Realized investment gains 196 40 123 Other income 649 645 250 - ------------------------------------------------------------------------------------------------------------------------ TOTAL REVENUES 59,537 55,698 49,571 Losses and Expenses Losses and settlement expenses 62,882 51,781 46,055 Losses and settlement expenses ceded (14,865) (12,571) (15,021) ---------------------------------------- Net losses and settlement expenses 48,017 39,210 31,034 Underwriting, acquisition and administrative expenses 19,659 17,426 16,224 Provision for (recoveries of) bad debts on liquidated reinsurers 401 (150) 103 - ------------------------------------------------------------------------------------------------------------------------ TOTAL LOSSES AND EXPENSES 68,077 56,486 47,361 - ------------------------------------------------------------------------------------------------------------------------ NET (LOSS) INCOME ($8,540) ($788) $2,210 ======================================================================================================================== Per Share Data Net (loss) income per share ($1.82) ($0.17) $0.47 Net (loss) income per share - assuming dilution ($1.82) ($0.17) $0.47 Dividends per share declared by McM $0.00 $0.06 $0.00 ========================================================================================================================
See notes to consolidated financial statements. 47 29 Consolidated Statements of Shareholders' Equity
- --------------------------------------------------------------------------------------------------------------------------------- Net Additional Unrealized McM CORPORATION Common Paid-in Investment Retained AND SUBSIDIARIES Stock Capital Gain (Loss) Earnings - --------------------------------------------------------------------------------------------------------------------------------- (Thousands of dollars) BALANCES AT JANUARY 1, 1995 $4,675 $1,477 ($158) $14,413 Net income for 1995 2,210 Change in net unrealized loss or gain on securities available-for-sale 623 - --------------------------------------------------------------------------------------------------------------------------------- BALANCES AT DECEMBER 31, 1995 4,675 1,477 465 16,623 Net loss for 1996 (788) Change in net unrealized loss or gain on securities available-for-sale (530) Employee stock purchases 3 12 Dividends declared and paid (282) - --------------------------------------------------------------------------------------------------------------------------------- BALANCES AT DECEMBER 31, 1996 4,678 1,489 (65) 15,553 Net loss for 1997 (8,540) Change in net unrealized loss or gain on securities available-for-sale (406) Employee stock purchases 18 41 - --------------------------------------------------------------------------------------------------------------------------------- BALANCES AT DECEMBER 31, 1997 $4,696 $1,530 ($471) $7,013 =================================================================================================================================
See notes to consolidated financial statements. 48 30 Consolidated Statements of Cash Flows
- --------------------------------------------------------------------------------------------------------------------------------- Year Ended December 31 McM CORPORATION AND SUBSIDIARIES 1997 1996 1995 - --------------------------------------------------------------------------------------------------------------------------------- (Thousands of dollars) Operating Activities Net (loss) income ($ 8,540) ($ 788) $ 2,210 Adjustments to reconcile net (loss) income to net cash used by operating activities: Policy liabilities (466) (10,828) (12,461) Premiums receivable 828 555 (1,143) Accrued investment income 272 37 176 Net recoverable from reinsurers 1,971 6,128 6,625 Amortization of deferred policy acquisition costs 10,332 9,116 7,141 Policy acquisition costs deferred (9,142) (9,765) (7,249) Other (720) 1,150 673 - --------------------------------------------------------------------------------------------------------------------------------- CASH USED BY OPERATING ACTIVITIES (5,465) (4,395) (4,028) Investing Activities Fixed maturity securities available-for-sale: Purchases (10,499) (18,447) (109) Sales 19,506 0 3,377 Maturities 2,050 12,974 1,408 Fixed maturity securities held-to-maturity: Purchases 0 (1,118) (2,984) Maturities 2,777 11,362 120 Purchases of property and equipment, net (1,045) (757) (474) Change in short-term investments (7,461) 787 2,830 - --------------------------------------------------------------------------------------------------------------------------------- CASH PROVIDED BY INVESTING ACTIVITIES 5,328 4,801 4,168 - --------------------------------------------------------------------------------------------------------------------------------- Financing Activities Employee stock purchases 59 15 0 Cash dividends paid 0 (282) 0 - --------------------------------------------------------------------------------------------------------------------------------- CASH PROVIDED (USED) BY FINANCING ACTIVITIES 59 (267) 0 - --------------------------------------------------------------------------------------------------------------------------------- NET (DECREASE) INCREASE IN CASH ($ 78) $ 139 $ 140 =================================================================================================================================
See notes to consolidated financial statements. 49 31 Notes to Consolidated Financial Statements McM Corporation and Subsidiaries NOTE A Significant Accounting Policies Basis of Presentation: The consolidated financial statements have been prepared in accordance with generally accepted accounting principles (GAAP) which, as to the insurance subsidiaries, vary in some respects from statutory accounting practices which are prescribed or permitted by the various state insurance departments. The consolidated financial statements include the accounts and operations of McM and its wholly-owned subsidiaries. McM is actively engaged through certain of its subsidiaries in the property and casualty insurance business. All significant intercompany accounts and transactions have been eliminated. The Company's subsidiaries are as follows: Subsidiary Abbreviation - ---------- ------------ Property and Casualty: Occidental Fire & Casualty Company of North Carolina OF&C Wilshire Insurance Company Wilshire Other: Equity Holdings, Inc. Equity The property and casualty insurance subsidiaries are primarily involved in the sale of commercial automobile and private passenger automobile insurance. The commercial automobile insurance consists primarily of liability, physical damage and inland marine coverages. The commercial automobile lines of business represented 77%, 80%, and 84% of gross written premium in 1997, 1996 and 1995, respectively. Private passenger automobile insurance, which represents the remainder of gross written premiums, consists primarily of liability and physical damage coverages. The Company's products are generally marketed through general and independent agents. In 1997, premiums were written in 27 states throughout the U.S. Direct premiums written in California, all of which were for commercial automobile insurance products, represented 32%, 34% and 37% of total direct written premiums in 1997, 1996 and 1995, respectively. Investments: Fixed maturity securities are classified as either held-to-maturity or available-for-sale. Management determines the appropriate classification of fixed maturity securities at the time of purchase. The Company has identified and accounted for its investments as follows: 50 32 Securities held-to-maturity and available-for-sale: Debt securities are classified as held-to-maturity when the Company has the positive intent and ability to hold the securities to maturity. Held-to-maturity securities are stated at amortized cost. Securities not classified as held-to-maturity are classified as available-for-sale. Available-for-sale securities are stated at fair value, with the unrealized gains and losses reported as a separate component of shareholders' equity. The amortized cost of securities classified as held-to-maturity or available-for-sale is adjusted for amortization of premiums and accretion of discounts to maturity, or in the case of mortgage-backed securities, over the estimated life of the security. Such amortization is included in investment income. Realized gains and losses include any declines in value judged to be other-than-temporary. The cost of securities sold is based on the specific identification method. Short-term investments are comprised of corporate master notes and United States Treasury Notes and Bills maturing in twelve months or less. These investments are carried at fair value. The Company had fixed maturity securities with a face value of approximately $12.0 million and $11.8 million on deposit with various state insurance departments at December 31, 1997, and 1996, respectively. The Company also had $3.4 million in short-term investments held in a security trust as collateral for assumed reinsurance balances at December 31, 1997 and 1996. Cash: Cash represents cash balances deposited in banking institutions. Balances invested in corporate master notes and other interest bearing cash equivalents are included in short-term investments. Equipment: Equipment is stated at cost less allowances for accumulated depreciation which are computed principally on the straight-line method. Recognition of Insurance Revenues: Premiums for property and casualty insurance policies are recognized as revenues on a monthly pro rata basis over the terms of the policies. The Company utilizes a general agency force to market its annual commercial automobile business and a portion of its private passenger automobile business. As of December 31, 1997, agents' balances receivable of approximately $1.5 million were associated with one general agent. 51 33 Deferred Policy Acquisition Costs: Costs which vary with and are primarily related to the production of property and casualty policies are deferred to the extent recoverable and are amortized over the lives of the policies in proportion to the recognition of premiums earned. Anticipated investment income is considered in the evaluation of recoverability of unamortized deferred acquisition costs. Reserves for Losses and Settlement Expenses: Reserves for estimated losses are determined on a case basis for reported claims and on estimates based on Company experience for loss settlement expenses and incurred but not reported claims. These liabilities give effect to trends in claims severity and other factors which may vary as the losses are ultimately settled. Although considerable variability is inherent in such estimates for losses and loss settlement expenses, management believes that these liabilities are adequate. The estimates are continually reviewed and, as adjustments to these liabilities become necessary, such adjustments are reflected in current operations. The reserves for losses include amounts assumed from involuntary pools and other residual market mechanisms of the various states in which the Companies have written policies. The estimated liability for the assumed pools is recorded based on information provided to the Company by the pools. Reinsurance: McM assumes and cedes reinsurance and participates in various pools and associations. The reinsurance arrangements allow management to control exposure to potential losses arising from large risks, and provide additional capacity for growth. The reinsurance is effected under quota-share contracts and by excess-of-loss contracts. Amounts recoverable from reinsurers for unpaid losses and settlement expenses are estimated in a manner consistent with the related liabilities associated with reinsured policies. Income Taxes: The Company accounts for income taxes using the liability method. Deferred tax assets, net of a valuation allowance, and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Leases: The Company and its subsidiaries rent office space and equipment under various operating lease agreements. The 52 34 aggregate rental expense charged to operations was approximately $826,000 in 1997, $802,000 in 1996, and $737,000 in 1995. Future minimum lease commitments require payments of approximately $709,000 in 1998 and $461,000 in 1999. Use of Estimates: The preparation of financial statements requires management to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Such estimates and assumptions could change in the future as more information becomes known which could impact the amounts reported and disclosed herein. Earnings per Share: Basic earnings per share are based on the weighted-average number of common shares outstanding during the year. The weighted-average number of common shares outstanding was 4,688,364, 4,675,701 and 4,675,038 at December 31, 1997, 1996 and 1995, respectively. Diluted earnings per share were computed assuming that the weighted-average number of shares was increased by the conversion of fixed awards (employee stock options). The diluted per share computations reflect a change in the number of common shares outstanding (the "denominator") to include the number of additional shares that would have been outstanding if the potentially dilutive shares had been issued. In each year presented, net income or loss, the numerator is the same for both basic and dilutive per share computations. The denominator was unchanged for 1997 and 1996. However, for 1995 the weighted-average number of common shares outstanding was increased by 17,785 shares relating to potentially dilutive employee stock options. New Accounting Standards: The Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 128, "Earnings Per Share" ("SFAS 128") in 1997. SFAS 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. Earnings per share restated under amounts for all periods presented have been calculated utilizing the new requirements of SFAS 128. NOTE B Statutory Results and Dividend Restrictions The reporting practices for McM's insurance subsidiaries prescribed or permitted by state regulatory authorities ("statutory accounting") differ from generally accepted accounting principles. OF&C (which includes Wilshire on a statutory equity basis) reported to insurance regulatory authorities a net loss of $2.8 million in 1997, and net income of $49,000 and $2.0 million in 1996 and 1995, respectively. Combined capital and surplus reported to insurance regulatory 53 35 authorities totalled $11.5 million and $18.2 million at December 31, 1997 and 1996, respectively. McM's insurance subsidiaries are subject to regulation and supervision by regulatory authorities in the states in which they operate. The regulatory bodies have broad administrative powers relating to standards of solvency, minimum capital and surplus requirements, maintenance of required reserves, payments of dividends, statutory accounting and reporting practices, and other financial and operational matters. Generally, the net assets of the insurance subsidiaries available for transfer to the parent company are limited to the amounts by which the insurance subsidiaries' net assets, as determined in accordance with statutory accounting practices, exceed the minimum statutory capital requirement of $2,250,000. Also, by statute, dividends exceeding the lesser of 10% of statutory-basis capital and surplus or the previous year's net income, excluding net realized capital gains, require the prior approval of the Commissioner of the North Carolina Department of Insurance. OF&C and Wilshire are domiciled in the State of North Carolina and prepare their statutory-basis financial statements in accordance with accounting practices and procedures prescribed or permitted by the North Carolina Department of Insurance. "Prescribed" statutory accounting practices include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners ("NAIC"). "Permitted" statutory accounting practices may differ from state to state, may differ from company to company within a state, and may change in the future. The NAIC currently is in the process of codifying statutory accounting practices, the result of which is expected to constitute the only source of "prescribed" statutory accounting practices. The completion date of that project is currently undeterminable. However, upon completion, prescribed statutory accounting practices will likely change, to some extent, and may result in changes to the accounting that insurance enterprises use to prepare their statutory financial statements. The North Carolina Department of Insurance imposes minimum risk-based capital requirements on insurance enterprises that were developed by the NAIC. The formulas for determining the amount of risk-based capital ("RBC") specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio ("the Ratio") of the enterprise's regulatory total adjusted capital, as defined by the NAIC, to its authorized control level RBC as defined by the NAIC. Enterprises below specific trigger points or ratios are classified within certain levels, each of which requires corrective action. 54 36 OF&C, as a result of the need to significantly strengthen reserve adequacy of the property and casualty companies during 1997, triggered the first RBC regulatory threshold defined as Company Action Level RBC ("CAL"). OF&C, working within the framework of RBC guidelines, will submit its plan of action to the state of North Carolina in the near future and believes that its indicated RBC deficiency will be corrected through this plan. The capital and surplus of Wilshire exceeds any minimum RBC requirement. NOTE C Reinsurance The property and casualty insurance subsidiaries have entered into reinsurance agreements with various reinsurers in order to reduce their ultimate claim risk. Current reinsurance agreements provide for premium rates based on the amount of coverage in excess of the defined retention level. Generally, the Company's retention level for all accident years was $100,000 with the exception of the 1991 accident year which was $250,000. These retention levels are effected under the Company's casualty excess of loss reinsurance treaties. The Company is also party to quota share reinsurance arrangements on its private passenger automobile and commercial auto liability coverages. A quota share reinsurance treaty is maintained on the Company's private passenger automobile business which became effective in April 1993. The rates pertaining to this treaty were 20% during 1997, 30% during 1996, and 40% prior to 1996. An addendum to the private passenger quota share treaty provided for the ceding of 100% of the unearned premium to the reinsurers as of December 31, 1997. The quota share treaty was placed to help control the Company's statutory net writings to surplus ratios as well as future premium growth in that market. A 5% quota share reinsurance treaty is also maintained by the Company to help control future growth in this line of business. The effect of reinsurance on premiums written and earned in 1997, 1996 and 1995 was as follows:
For the Year Ended December 31 ------------------------------------------------------- 1997 1996 1995 Premiums Premiums Premiums Written Earned Written Earned Written Earned ------- ------ ------- ------ ------- ------ (Thousands of dollars) Direct $63,699 $65,205 $62,698 $63,163 $64,099 $63,731 Assumed 9,830 10,573 11,561 10,405 7,926 5,871 Ceded (22,315) (20,071) (20,839) (21,714) (25,362) (23,901) ------- ------- ------- ------- ------- ------- Net $51,214 $55,707 $53,420 $51,854 $46,663 $45,701 ======= ======= ======= ======= ======= =======
55 37 To minimize its exposure to losses from reinsurance insolvencies, OF&C and Wilshire evaluate the financial condition of their reinsurers and monitor concentration of credit risk arising from similar geographic regions, activities or economic characteristics of the reinsurers. At December 31, 1997, reinsurance recoverables of $5.1 million were associated with a single reinsurer. The remaining reinsurance recoverables were associated primarily with five reinsurers. OF&C and Wilshire's policy is to hold collateral under related reinsurance agreements in the form of letters of credit for all reinsurers not licensed to do business in North Carolina. To the extent that reinsuring companies may later be unable to meet obligations under the reinsurance agreements, the insurance subsidiaries would remain liable. NOTE D Income Taxes The Revenue Reconciliation Act of 1993 increased the U.S. Federal income tax rate to 35% for taxable income in excess of $10 million. Because of the large tax return net operating loss carryforwards of the Company and Company estimates that annual taxable income in the near future, before utilization of the carryforwards, will not exceed $10 million, a U.S. Federal income tax rate of 34% has been used to compute deferred tax assets and liabilities for the Company. There was no income tax expense attributable to income from continuing operations for the years ended December 31, 1997, 1996 and 1995. These amounts differed from the amounts computed by applying the U.S. federal income tax rate of 34 percent to pretax income from continuing operations as follows:
Year Ended December 31 1997 1996 1995 (Thousands of dollars) Pretax income (loss) from continuing operations $(8,540) $ (788) $2,210 ------- ------ ------ Computed "expected" tax expense (benefit) (2,904) (268) 751 Increase (decrease) in taxes resulting from: Change in valuation allowance 2,897 257 (2,768) Other 7 11 33 Net operating and capital losses not utilized - - 1,984 ------- ------ ------ Income Tax Expense $ 0 $ 0 $ 0 ======= ====== ======
56 38 The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities as of December 31, 1997 and December 31, 1996, are presented below.
December 31 --------------------- 1997 1996 (Thousands of dollars) Deferred tax asset: Unearned premium reserves $ 637 $ 942 Claim reserves 1,270 1,279 Tax return net operating and capital loss carryforwards 33,432 30,810 Unrealized losses on fixed maturity securities 160 22 Other 232 252 ------- ------- Total gross deferred tax assets 35,731 33,305 Less: Valuation allowance (34,521) (31,624) ------- ------- Net deferred tax assets $ 1,210 $ 1,681 Deferred tax liabilities: Deferred policy acquisition costs $ 953 $ 1,357 Agent balances 57 47 Other 200 277 ------- ------- Total liabilities $ 1,210 $ 1,681 ------- ------- Net deferred tax account $ 0 $ 0 ======= =======
McM and its subsidiaries file a consolidated income tax return. The Company had cumulative tax operating loss carryforwards of approximately $98 million as of December 31, 1997, with expiration dates of 1998 through 2012. No income taxes were paid in 1997, 1996, or 1995. NOTE E Pension Plan McM and its subsidiaries have a non-contributory defined benefit pension plan covering substantially all their employees. The plan provides for payments to qualified employees based on compensation and years of service. The Company and its subsidiaries make contributions to the plan, if necessary, equal to the amounts required by ERISA. 57 39 The following table sets forth the plan's funded status and amounts recognized in the Company's balance sheets at December 31:
December 31 ----------------------------- 1997 1996 ----------------------------- (Thousands of dollars) Actuarial present value of benefit obligations: Accumulated benefit obligation, including vested benefits of $2,339 in 1997 and $1,890 in 1996 $ 2,577 $ 2,027 ======= ======= Projected benefit obligation for service rendered to date $(3,356) $(2,816) Plan assets at fair value, primarily listed stocks, U.S. bonds, and money market accounts 2,476 1,819 ------- ------- Projected benefit obligation in excess of plan assets ( 880) ( 997) Unrecognized net loss 434 356 Deferred asset gain ( 271) ( 157) Unrecognized prior service cost ( 47) ( 52) Unrecognized net transition asset ( 63) ( 78) ------- ------- Net pension liability $( 827) $( 928) ======= =======
58 40 Net periodic pension expense included the following components:
Year Ended December 31 1997 1996 1995 ---------------------------- (Thousands of dollars) Service cost-benefits earned during the period $ 255 $ 257 $ 208 Interest cost on projected benefit obligation 227 206 176 Actual return on plan assets (442) (277) (135) Net amortization and deferral 251 157 40 ------ ----- ----- Net periodic pension cost $ 291 $ 343 $ 289 ====== ===== =====
The weighted average discount rate used to determine the actuarial present value of the projected benefit obligation was 7.25% and 7.75% at December 31, 1997, and 1996, respectively. The rate of increase in future compensation levels used to determine the actuarial present value of the projected benefit obligation was 4.75% at December 31, 1997, and at December 31, 1996. The expected long-term rate of return on plan assets was 9% for the years ended December 31, 1997, 1996, and 1995. The unrecognized prior service cost and the cumulative net recognized gains and losses in excess of the greater of the market value of plan assets and the projected benefit obligation are being amortized using the optional straight-line method over the average expected future service of active participants. NOTE F Investment Operations The sources of investment income are summarized as follows:
Year Ended December 31 ------------------------------ 1997 1996 1995 ------------------------------ (Thousands of dollars) Fixed maturities $2,694 $2,490 $3,155 Other long-term investments 44 48 36 Short-term investments 660 1,078 780 ------------------------------ 3,398 3,616 3,971 Investment expenses (413) (457) (474) ------------------------------ NET INVESTMENT INCOME $2,985 $3,159 $3,497 ==============================
59 41 The amortized cost and estimated market values of investments in fixed maturities at December 31, 1997 and 1996, are as follows:
Gross Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value ------------------------------------------ (Thousands of dollars) Fixed Maturity Securities Available-for-Sale: December 31, 1997: U.S. Treasury securities and obligations of U.S. governmental corporations and agencies $22,714 $ 178 $( 18) $22,874 Public utilities and other 469 2 ( 6) 465 Mortgage-backed securities 2,572 3 ( 630) 1,945 ------------------------------------------ Total $25,755 $ 183 ( 654) $25,284 ==========================================
Gross Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value ------------------------------------------ (Thousands of dollars) Fixed Maturity Securities Held-to-Maturity: December 31, 1997: U.S. Treasury securities and obligations of U.S. governmental corporations and agencies $2,940 $ 74 $( 1) $3,013 Obligations of states and political subdivisions 194 28 - 222 ------------------------------------------ Total $3,134 $ 102 $( 1) $3,235 ==========================================
60 42
Gross Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value ------------------------------------------ (Thousands of dollars) Fixed Maturity Securities Available-for-Sale: December 31, 1996: U. S. Treasury securities and obligations of U.S. governmental corporations and agencies $17,449 $ 33 $( 111) $17,371 Public utilities 665 - ( 162) 503 Mortgage-backed securities 18,824 291 ( 116) 18,999 ------------------------------------------ Total $36,938 $324 $( 389) $36,873 ==========================================
Gross Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value ------------------------------------------ (Thousands of dollars) Fixed Maturity Securities Held-to-Maturity: December 31, 1996: U.S. Treasury securities and obligations of U.S. governmental corporations and agencies $ 5,745 $ 58 $ (4) $ 5,799 Obligations of states and political subdivisions 193 30 - 223 ------------------------------------------ Total $ 5,938 $ 88 $ (4) $ 6,022 ==========================================
The amortized cost and estimated market value of fixed maturities at December 31, 1997, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities as certain borrowers have the right to call or prepay obligations without penalty. 61 43
Estimated Amortized Market Cost Value ----------------------- (Thousands of dollars) Fixed Maturity Securities Available-for-Sale: Due in one year or less $ 86 $ 86 Due after one year through five years 10,355 10,346 Due after five years through ten years 7,709 7,870 Due after ten years 5,033 5,037 ----------------------- 23,183 23,339 Mortgage backed securities 2,572 1,945 ----------------------- $25,755 $25,284 ======================= Fixed Maturity Securities Held-to-Maturity: Due in one year or less $ 1,002 $ 1,011 Due after one year through five years 910 921 Due after five years through ten years 1,222 1,303 Due after ten years - - ----------------------- $3,134 $3,235 =======================
Realized gains and losses from sales of investments in fixed maturities were as follows:
Year Ended December 31 1997 1996 1995 --------------------------- (Thousands of dollars) Realized gains and losses: Fixed maturity securities available-for-sale: Gross realized gains $ 367 $ 40 $ 123 Gross realized losses 171 - -
62 44 The carrying value of investments in persons (other than the U.S. Government or a Government Agency or Authority, State, Municipality, or Political Subdivision) exceeding 10% of total shareholders' equity is as follows:
December 31 --------------------- 1997 1996 --------------------- (Thousands of dollars) Southern Capital Corporation $ 3,431 $ 3,628 General Electric Capital Corporation $17,520 $ 8,903
NOTE G Reserves for Losses and Settlement Expenses The consolidated financial statements include the estimated reserve for losses and settlement expenses of the property and casualty insurance subsidiaries. The subsidiaries primarily write commercial auto liability, physical damage and cargo coverages and non-standard private passenger automobile coverages. The liabilities for losses and settlement expenses are determined using case basis evaluations and statistical projections and represent estimates of the ultimate net cost of all unpaid losses and settlement expenses incurred through December 31 of each year. These estimates give effect to trends in claims severity and other factors which may vary as the liabilities are ultimately settled. The estimates are continually reviewed and, as adjustments to these liabilities become necessary, such adjustments are reflected in current operations. The following table provides a reconciliation of the beginning and ending reserve balances for losses and settlement expenses, on a gross-of-reinsurance basis, for 1997, 1996 and 1995, to the gross amounts reported in McM's balance sheet. 63 45
Year Ended December 31 ------------------------------- 1997 1996 1995 ------------------------------- (Thousands of dollars) Reserves for losses and settlement expenses, net of reinsurance recoverables, at beginning of year $26,532 $29,997 $38,415 Provision for insured events of the current year 42,243 37,651 31,282 Increase (decrease)in provision for insured events of prior years 5,774 1,559 (248) ------------------------------- Incurred losses and settlement expenses during current year, net of reinsurance 48,017 39,210 31,034 Payments for: Losses and settlement expenses attributable to insured events of the current year 26,123 22,853 18,113 Losses and settlement expenses attributable to insured events of prior years 19,267 19,822 21,339 ------------------------------- 45,390 42,675 39,452 ------------------------------- Reserves for losses and settlement expenses, net of reinsurance recoverables, at end of year 29,159 26,532 29,997 Reinsurance recoverable on unpaid losses and settlement expenses at end of current year 28,124 28,768 36,155 ------------------------------- Gross reserves for losses and settlement expenses at end of year $57,283 $55,300 $66,152 ================================
The reconciliation above reflects the emergence of a $5,774,000 deficiency in the December 31, 1996, reserve during 1997. The deficiency at December 31, 1997, included adverse reserve development of approximately $844,000 in private passenger automobile liability reserves, $813,000 in private passenger and commercial automobile physical damage and inland marine reserves and $3,531,000 relating to the commercial 64 46 automobile liability line of business. In addition, approximately $586,000 of this deficiency relates to discontinued lines of business and participation in involuntary pools and other residual market mechanisms in which OF&C and Wilshire are required to participate by the various states in which the companies write insurance. The increase in overall reserve levels for 1997 resulted from prior year reserve deficiencies, particularly for the 1995 and 1996 accident years and increased claim costs in the current underwriting year for commercial and private passenger automobile physical damage coverages. The anticipated effect of inflation is implicitly considered when estimating liabilities for losses and settlement expenses. While anticipated cost increases due to inflation are considered in estimating the ultimate claim costs, the increase in average severity of claims is caused by a number of factors that vary with the individual type of policy written. Future average severity is projected based on historical trends adjusted for anticipated changes in these trends and general economic conditions. These anticipated trends are monitored based on actual development and are modified as necessary. NOTE H Contingencies Litigation: In the normal course of operations, certain subsidiaries of the Company have been named as parties to various pending and threatened litigation. While the outcome of some of these matters cannot be estimated with certainty, it is the opinion of management that the resolution of these matters will not have a material adverse affect on the Company's consolidated financial position or results of operations. Guaranty Associations: The insurance subsidiaries are required to be members of various state insurance guaranty associations in order to conduct business in those states. These associations have the authority to assess member companies in the event that an insurance company conducting business in that state is unable to meet its policyholder obligations. The Company recognizes the expense for these assessments in the year they are assessed. The Company incurred expenses of $25,000 in 1997, and received net refunds of $26,000 and 12,000 in 1996 and 1995, respectively, related to these assessments. NOTE I Stock Option Plan and Earnings Per Share At December 31, 1996, the Company adopted Statement of Financial Accounting Standards No. 123 "Accounting for Stock-Based Compensation" ("SFAS 123"). SFAS 123 introduces a fair-value based method of accounting for stock-based compensation and encourages, but does not require, compensation expense recognition for grants of stock, stock options and other equity 65 47 instruments to employees. In accordance with SFAS 123, the Company has elected to continue to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25) and related interpretations in accounting for its employee stock options. The Company had an Employee Incentive Stock Option Plan, the 1986 Employee Incentive Stock Option Plan ("1986 Plan"), which expired by its terms, May 16, 1996. The 1986 Plan provided that options could be granted to selected key employees at exercise prices equal to market value on the date the option is granted. Options were granted for a period not exceeding ten years and were exercisable at a rate of 20% per year starting one year from the date of grant. Depending upon the circumstances of an optionee's termination of employment, the optionee's options either a) remain exercisable for three or six months after termination to the extent they were exercisable at termination unless vesting is accelerated by the Compensation Committee, b) remain exercisable until a change in control of the Company, as defined in the 1986 Plan, c) remain exercisable for five years and one day from the date of the optionee's termination or d) terminate as of the termination of the optionee's employment. In 1996 the Company adopted the 1996 Employee Incentive Stock Option Plan ("1996 Plan"). The terms of the 1996 Plan are are generally the same as the 1986 plan. The Company had reserved 250,000 shares of common stock for distribution under the 1986 Plan, and 300,000 shares have been reserved for distribution under the 1996 Plan. The following options to purchase the Company's common shares were outstanding under the 1986 and 1996 Plans as of December 31, 1997 and 1996:
NUMBER OF SHARES UNDERLYING OUTSTANDING OPTIONS OPTION PRICE DATE OF GRANT 1997 1996 PER SHARE - --------------------------------------------------------------- January 15, 1988 1,000 1,000 $ 8.50 October 6, 1988 2,000 2,000 $10.00 January 15, 1993 42,962 42,962 $ 1.38 July 25, 1994 19,000 19,000 $ 2.25 August 17, 1994 81,000 81,000 $ 2.75 March 26, 1997 35,000 -0- $ 3.94 - --------------------------------------------------------------- 180,962 145,962 ===============================================================
At December 31, 1997, 97,070 options were exercisable. No options have been exercised under either Plan. The weighted- 66 48 average exercise price is $2.71 per share and the weighted-average remaining contractual life is 6.6 years at December 31, 1997. The Company has a phantom stock plan under which shares of "phantom stock" may be awarded to certain employees. A maximum of 250,000 shares of phantom stock may be awarded under the plan. Upon maturity of an award, shares of phantom stock are settled in cash equal to the market value of common shares at the maturity date plus the amount of cash dividends paid on an equal number of common shares over the life of the award. The awards generally vest over a five year period beginning five years after the award date and mature on the two year anniversary of the termination of the employee, or upon a change in control (as defined in the plan) of the Company. There were no shares of phantom stock granted in 1997. In 1996 and 1995, 50,000 shares of phantom stock were granted under the plan. Related expenses of $10,000, $44,000 and $26,000 were accrued at December 31, 1997, 1996, and 1995, respectively. Pro forma information regarding net (loss) income and earnings per share is required by SFAS 123, which also requires that the information be determined as if the Company has accounted for its employee stock options and awards granted subsequent to December 31, 1994, under the fair value method prescribed by SFAS 123. The estimated fair value of the options was calculated under the Black-Scholes valuation model using the following assumptions as of December 31:
1997 1996 1995 ----- ---- ---- Risk-free interest rate 6.96% 6.68% 6.10% Dividend yield 0.00% 0.00% 0.00% Volatility factor 63.5% 49.3% 33.5% Expected life (years) 10 10 10
The pro forma basic and diluted net (loss) income per share did not change from that which has been reported, for all periods presented, as a result of SFAS 123. Further, because SFAS 123 is applicable only to stock-based awards granted after December 31, 1994, the pro forma effect of the amortization of the estimated fair value of the Company's outstanding stock is not likely to be representative of the effects on the reported net (loss) income for future years. 67 49 NOTE J Summary of Fair Values The method of determining fair values for investments in fixed maturity securities is discussed in Note F. For all other financial instruments, carrying value approximates fair value. The following table summarizes the carrying value and fair value of financial instruments:
December 31 1997 1996 ---------------------------------------- Carrying Fair Carrying Fair Value Value Value Value ---------------------------------------- (Thousands of dollars) Financial Assets: Cash $ 1,698 $ 1,698 $ 1,776 $ 1,776 Short-term investments $21,522 $21,522 $14,061 $14,061 Fixed maturity securities available-for-sale (Note F) $25,284 $25,284 $36,873 $36,873 Fixed maturity securities held-to-maturity (Note F) $ 3,134 $ 3,235 $ 5,938 $ 6,022
68 50 Report of Independent Auditors ERNST & YOUNG LLP Board of Directors and Shareholders McM Corporation We have audited the accompanying consolidated balance sheets of McM Corporation and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of operations, shareholders equity and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of McM Corporation and subsidiaries at December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. Raleigh, North Carolina March 9, 1998 ERNST & YOUNG LLP 69 51 SUMMARY OF QUARTERLY RESULTS OF OPERATIONS The following is a summary of quarterly results of operations for the years ended December 31, 1997 and 1996.
- ------------------------------------------------------------------------------------------------------------------------------------ March 31 June 30 Sept. 30 Dec. 31 - ------------------------------------------------------------------------------------------------------------------------------------ (Thousands of dollars, except per share data) 1997 Premiums $13,848 $14,379 $13,892 $13,588 Investment Income, Less Investment Expense 740 764 768 713 Realized Gains 0 0 0 196 Losses and Expenses 14,377 15,230 19,432 19,038 Net Income (Loss) 308 27 (4,432) (4,443) Net Income (Loss) Per Share * $0.07 $0.01 ($0.94) ($0.95) Net Income (Loss) Per Share - assuming dilution * $0.07 $0.01 ($0.94) ($0.95) 1996 Premiums $12,758 $12,862 $12,883 $13,351 Investment Income, Less Investment Expense 890 717 764 788 Realized Gains 0 0 0 40 Losses and Expenses 13,038 13,087 13,305 17,056 Net Income (Loss) 671 598 423 (2,480) Net Income (Loss) Per Share $0.14 $0.13 $0.09 ($0.53) Net Income (Loss) Per Share - assuming dilution * $0.14 $0.13 $0.09 ($0.53)
* The sum of net income (loss) per share by quarter may not equal net income (loss) per share for the year due to rounding. Addtionally, the year 1996 and first three quarters of 1997 net income (loss) per share have been restated, where appropriate, to comply with the Statements of Financial Accounting Standards No. 128, "Earnings Per Share". 70 52 Officers and Directors Officers George E. King Chairman Emeritus and Chief Executive Officer Stephen L. Stephano President and Chief Operating Officer Michael D. Blinson Senior Vice President & Corporate Secretary Kevin J. Hamm Vice President & Chief Financial Officer Harold A. Strube Vice President & Assistant Corporate Secretary Directors Michael A. DiGregorio Vice President/Senior Trust Counsel Wilmington Trust Company Wilmington, DE George E. King Chairman Emeritus and Chief Executive Officer McM Corporation Raleigh, NC Laurence F. Lee, Jr. Retired Jacksonville, FL Laurence F. Lee III President Plan Analysts, Inc. Jacksonville, FL Claude G. Sanchez, Jr. Sun Construction and Real Estate Company Albequerque, NM Stephen L. Stephano President and Chief Operating Officer McM Corporation Raleigh, NC R. Peyton Woodson III President Enterprise Holdings Proprietary, Inc. Raleigh, NC 71 53 Corporate Information McM Corporation Corporate Office 702 Oberlin Road P.O. Box 12317 Raleigh, North Carolina 27605 Telephone: (919)833-1600 Registrar-Transfer Agent Wachovia Bank and Trust Company, N.A. Winston-Salem, North Carolina General Counsel Ragsdale, Liggett & Foley, PLLC Raleigh, North Carolina Independent Auditors Ernst & Young LLP Raleigh, North Carolina Form 10-K Annual Report for the year ended December 31, 1997, has been filed with the Securities and Exchange Commission. A copy will be made available to shareholders without charge upon request. Please write to Corporate Secretary at the Corporation's Corporate Office. Annual Meeting The Annual Shareholders' Meeting of McM Corporation will be held at the corporate offices of McM Corporation, 702 Oberlin Road, Raleigh, North Carolina, on May 21, 1998, at 10:00 a.m. 72 EX-22 3 SUBSIDIARIES OF THE COMPANY 1 CORPORATE ORGANIZATION CHART As of December 31, 1997, the organization chart of corporate structure and ownership is shown below. Percent figures show percent ownership of shares by parent. Jurisdiction of organization is shown in parentheses. McM CORPORATION (NC) 56-1171691 - - 100% - - Equity Holdings, Inc. (DE) 56-1651565 - - 100% - - Occidental Fire & Casualty Company of North Carolina (NC) 84-0513811 - - 100% - - Wilshire Insurance Company (NC) 56-1507441 Note: Two entities, Equity American Financial Service, Inc. and Equity American General Agency, Inc., have been formed as North Carolina corporations. Although neither company has been fully activated or capitalized, it is anticipated that they might be utilized in additional marketing programs in the future. 73 EX-23 4 CONSENT OF INDEPENDENT AUDITORS 1 Exhibit 23 - Consent of Independent Auditors We consent to the incorporation by reference in this Annual Report (Form 10-K) of McM Corporation and subsidiaries of our report dated March 9, 1998, included in the 1997 Annual Report to Shareholders of McM Corporation. Our audits also included the financial statement schedules of McM Corporation and subsidiaries listed in Item 14(a). These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. We also consent to the incorporation by reference in the Registration Statements (Forms S-8 No. 333-05991, 333-05989 and 333-05995) pertaining to the 1996 Non-Employee Directors' Stock Purchase Plan, the 1996 Employee Incentive Stock Option Plan and the 1996 Employee Stock Purchase Plan, respectively, of McM Corporation of our report dated March 9, 1998, with respect to the consolidated financial statements and schedules of McM Corporation and subsidiaries incorporated by reference, and our report included in the preceding paragraph with respect to the financial statement schedules included in this Annual Report (Form 10-K) of McM Corporation and subsidiaries. ERNST & YOUNG LLP Raleigh, North Carolina March 27, 1998 74 EX-27 5 FINANCIAL DATA SCHEDULE
7 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE FINANCIAL STATEMENTS OF MCM CORPORATION FOR THE TWELVE MONTHS ENDED DECEMBER 31, 1997, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 12-MOS DEC-31-1997 JAN-01-1997 DEC-31-1997 25,284 3,134 3,235 0 0 0 49,940 1,698 35,913 2,802 104,140 57,283 15,676 0 6,380 0 0 0 4,696 8,072 104,140 55,707 2,985 196 649 48,017 0 20,060 (8,540) 0 (8,540) 0 0 0 (8,540) (1.82) (1.82) 26,532 42,243 5,774 26,123 19,267 29,159 5,774
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