EX-13 8 dgi-ex13_53044.txt DONEGAL ANNUAL REPORT
FINANCIAL INFORMATION Management's Discussion and Analysis of Results of Operations and Financial Condition.. 10 Consolidated Balance Sheets ........................................................... 15 Consolidated Statements of Income and Comprehensive Income ............................ 16 Consolidated Statements of Stockholders' Equity ....................................... 17 Consolidated Statements of Cash Flows ................................................. 18 Notes to Consolidated Financial Statements ............................................ 19 Independent Auditors' Report .......................................................... 31 Corporate Information ................................................................. 32
9 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Donegal Group Inc. ("DGI" or the "Company") is a regional insurance holding company doing business in the Mid-Atlantic and Southern states through its four wholly owned property-casualty insurance subsidiaries, Atlantic States Insurance Company ("Atlantic States"), Southern Insurance Company of Virginia ("Southern"), Southern Heritage Insurance Company ("Southern Heritage") and Pioneer Insurance Company of Ohio ("Pioneer-Ohio") (collectively "Insurance Subsidiaries"). The Company has three operating segments: the investment function, the personal lines of insurance and the commercial lines of insurance. Products offered in the personal lines of insurance consist primarily of homeowners and private passenger automobile policies. Products offered in the commercial lines of insurance consist primarily of commercial automobile, commercial multiple peril and workers' compensation policies. The Insurance Subsidiaries are subject to regulation by Insurance Departments in those states in which they operate and undergo periodic examination by those departments. The Insurance Subsidiaries are also subject to competition from other insurance carriers in their operating areas. DGI was formed in September 1986 by Donegal Mutual Insurance Company (the "Mutual Company"), which owns 63% of the outstanding common shares of the Company as of December 31, 2001. Atlantic States participates in an intercompany pooling arrangement with the Mutual Company and assumes 70% of the pooled business (65% prior to July 1, 2000). Southern cedes 50% of its business to the Mutual Company. Because the Mutual Company places substantially all of the business assumed from Southern into the pool, from which the Company has a 70% allocation, the Company's results of operations include approximately 85% of the business written by Southern. In addition to the Company's Insurance Subsidiaries, it also owned all of the outstanding stock of Atlantic Insurance Services, Inc., ("AIS"), an insurance services organization. The Company sold all of the outstanding shares of AIS on October 1, 1999. During 2000, the Company acquired 45% of the outstanding stock of Donegal Financial Services Corporation ("DFSC"), a bank holding company. The remaining 55% of the outstanding stock of DFSC is owned by the Mutual Company. On January 3, 2001, the Company announced that it had purchased all of the outstanding stock of Pioneer Insurance Company of New York ("Pioneer-New York") from the Mutual Company effective January 1, 2001. The purchase price was $4,441,311, representing Pioneer-New York's adjusted statutory equity at December 31, 2000. The acquisition has been accounted for as a reorganization of entities under common control, similar to a pooling of interests, as both Pioneer-New York and the Company are under the common management and control of the Mutual Company. As such, the Company's financial statements have been restated to include Pioneer-New York as a consolidated subsidiary. In connection with this transaction, the Company issued the Mutual Company a $4,441,311 note, which bears a 6% rate and was due in one year. The due date was subsequently extended to January 2003. The 6% rate was based upon commercial market rates in effect as of January 1, 2001. Delaware Atlantic Insurance Company ("Delaware"), previously a wholly owned subsidiary, and Pioneer-New York were merged into Atlantic States Insurance Company on August 1, 2001 and September 30, 2001, respectively. The mergers were accounted for as statutory mergers and had no financial impact on the consolidated entity. TRANSACTIONS WITH AFFILIATES The Company's insurance subsidiaries have various reinsurance arrangements with the Mutual Company, which include a pooling agreement with Atlantic States, a 50% quota share contract with Southern, catastrophe reinsurance agreements with each of the subsidiaries and excess of loss reinsurance agreements with Southern, Southern Heritage and Pioneer-Ohio. The Mutual Company also has 100% retrocessional agreements with Southern, Southern Heritage and Pioneer-Ohio. Each contract is reviewed by a Coordinating Committee comprised of two board members of the Company and two board members of the Mutual Company. This committee reviews the business purpose and terms of each agreement based on degree of risk, fairness to the participating companies and market conditions. The committee must unanimously approve all agreements and all changes to existing agreements between the Company's subsidiaries and the Mutual Company. The pooling agreement between the Mutual Company and Atlantic States is intended to produce a more uniform and stable underwriting result from year to year for the participants in the pool than they would experience individually and to spread the risk of loss 10 among the participants. Each company participating in the pool has at its disposal the capacity of the entire pool, rather than being limited to policy exposure of a size commensurate with its own capital and surplus. In addition, the ability of the Company to raise capital, and infuse that capital into Atlantic States, provides the participants of the pool with an ability to grow their total direct premiums at a greater rate than would be possible without the existence of the pool. Premiums, losses, loss expenses and underwriting expenses are shared proportionately by each of the participants, with Atlantic States currently assuming 70% of the pooled business and the Mutual Company retaining 30% of the pooled business. The 50% quota share reinsurance contract between Southern and the Mutual Company provides additional capacity for direct premium growth to Southern during periods of growth that exceeds Southern's ability to finance that growth through internal equity. Premiums, losses and loss expenses are shared equally by the participants with the Mutual Company paying commissions to Southern to reimburse its costs related to the underwriting process. The excess of loss and catastrophe reinsurance agreements are intended to lessen the effects of a single large loss, or an accumulation of losses arising from one event, to a level that is more in line with each company's size, underwriting profile and equity position. The retention levels of these contracts are more appropriate for each company than the retention levels included within reinsurance contracts with outside reinsurers, which may be appropriate for the insurance companies taken as a whole but would be excessive for any individual company within the group. The 100% retrocessional agreements are intended to provide the subsidiaries with the same A.M. Best rating (currently "A") as the Mutual Company, which these companies could not achieve without these contracts in place. The Mutual Company provides facilities, management and other services to the Company, and the Company reimburses the Mutual Company for such services on a periodic basis under usage agreements and pooling arrangements. The charges are based upon the relative participation of the Company and the Mutual Company in the pooling arrangement, and management of both the Company and the Mutual Company consider this allocation to be reasonable. Charges for these services totalled $29,298,569, $26,985,080 and $27,466,898 for 2001, 2000 and 1999, respectively. CRITICAL ACCOUNTING POLICIES The Company's financial statements are combined with those of its subsidiaries and presented on a consolidated basis in accordance with U.S. generally accepted accounting principle. The Company uses estimates and assumptions that can have a significant effect on the amounts that are reported in its financial statements. The Company believes the following are its most significant accounting policies as they may require a higher degree of judgment and estimation. LIABILITY FOR LOSSES AND LOSS EXPENSES The most significant estimates relate to reserves for losses and loss expenses. The liability represents estimates of the ultimate unpaid cost of claims incurred, including claims incurred but not reported to the Company as of the close of the reporting period. The estimates of losses for reported claims are based on reviews of the individual claims considering known information and the policy provisions relating to the loss. Estimates of losses and loss expenses for unreported claims are established based on historical data by line of insurance as adjusted for current conditions considering factors such as inflation, recent trends and other analysis of costs. The Company continually reviews and analyzes its estimates, but actual losses may turn out to be significantly different than expected when the estimates were made. INVESTMENTS In the Company's investment portfolio, the difference between cost and the fair value of investments is monitored regularly. The Company evaluates significant declines in fair value below cost on an individual investment basis. This evaluation considers the magnitude of the decline below cost, the period of time the investment has been significantly below cost and the prospects for the fair value to recover in the near term. If any investment experiences a decline in value that is believed to be other than temporary, the cost basis of the investment is written down and a realized loss is recorded in earnings. REINSURANCE Reinsurance accounting is followed when risk transfer requirements have been met. These requirements may involve significant assumptions being made related to the amount and timing of expected cash flows, as well as interpretation of the underlying contract terms. POLICY ACQUISITION COSTS Policy acquisition costs, consisting primarily of commissions, premium taxes and certain other variable underwriting costs, are deferred and amortized over the period in which the premiums are earned. Anticipated losses and loss expenses, expenses for maintenance of policies in force and anticipated investment income are estimated in the determination of the recoverability of deferred acquisition costs. Future changes in estimates, the most significant of which is expected loss and loss expenses, may require adjustment to policy acquisition costs. 11 RESULTS OF OPERATIONS 2001 COMPARED TO 2000 Total revenues for 2001 were $185,163,623, which were $14,582,036, or 8.5%, greater than 2000. Net premiums earned increased to $167,769,854, an increase of $16,123,655, or 10.6%, over 2000. The change in Atlantic State's share of the pooling arrangement with the Mutual Company from 65% to 70% effective July 1, 2000, accounted for $4,273,297 of the increase in net premiums earned. Direct premiums written of the combined pool of Atlantic States and the Mutual Company increased $23,152,222 or 13.2%. A 4.0% increase in the direct premiums written of Southern, an 8.6% increase in the direct premiums written of Pioneer-Ohio and a 9.6% increase in the direct premiums written of Southern Heritage accounted for the majority of the remaining change. The Company reported net realized investment losses of $880,254 in 2001 compared to net realized investment gains of $170,852 in 2000. During 2001 and 2000, certain investments trading below cost had declined on an other-than-temporary basis. Losses of $1,462,913 and $436,943 were included in net realized investment gains (losses) for these investments in 2001 and 2000, respectively. The remaining realized gains and losses in both years resulted from normal turnover of the Company's investment portfolio. As of December 31, 2001, 100.0% of the Company's bond portfolio was classified as Class 1 (highest quality) by the National Association of Insurance Commissioners' Securities Valuation Office. Investment income decreased $509,203 in 2001. An increase in the average invested assets from $278,677,748 to $294,988,999, offset by a decrease in the average yield to 5.3% from 5.9% in 2000, accounted for the change. The GAAP combined ratio of insurance operations was 103.8% in 2001, compared to 101.8% in 2000. The combined ratio is the sum of the ratios of incurred losses and loss expenses to premiums earned (loss ratio), underwriting expenses to premiums earned (expense ratio) and policyholder dividends to premiums earned (dividend ratio). The loss ratio in 2001 was 70.5% compared to 68.8% in 2000. The increased loss ratio reflected the impact of loss and loss expense reserve strengthening of approximately $4.2 million in the commercial automobile and workers' compensation lines of business. The commercial lines loss ratio increased significantly to 72.7% in 2001 compared to 67.0% in 2000. The personal lines loss ratio decreased from 70.3% in 2000 to 69.2% in 2001. The commercial automobile and workers' compensation loss ratios showed considerable deterioration in 2001 with the commercial automobile loss ratio increasing to 85.0% in 2001 compared to 78.1% in 2000 and the workers' compensation loss ratio increasing to 82.5% in 2001 compared to 64.2% in 2000. The expense ratio for 2001 was 32.3% compared to 32.1% in 2000 with the dividend ratio increasing slightly to 1.0% in 2001 compared to 0.9% in 2000. The expense ratio in 2001 included a guaranty fund assessment of approximately $543,000 resulting from the insolvency of Reliance Insurance Company. This assessment accounted for most of the increase in the expense ratio. Income tax expense was $1,273,598, an effective rate of 18.0%, compared to $2,906,248, an effective rate of 24.7% in 2000. Tax exempt interest represented a larger proportion of net income before taxes in 2001 as compared to 2000, accounting for most of this difference. RESULTS OF OPERATIONS 2000 COMPARED TO 1999 Total revenues for 2000 were $170,581,587, which were $8,842,251, or 5.5%, greater than 1999. Net premiums earned increased to $151,646,199, an increase of $6,128,742, or 4.2%, over 1999. The change in Atlantic State's share of the pooling arrangement with the Mutual Company from 65% to 70% effective July 1, 2000, accounted for $4,113,078 of the increase in net premiums earned. Direct premiums written of the combined pool of Atlantic States and the Mutual Company increased $13,851,692 or 9.0%. A 5.1% increase in the direct premiums written of Southern, a 2.1% decrease in the direct premiums written of Delaware, a 13.2% increase in the direct premiums written of Pioneer-New York, a 25.4% increase in the direct premiums written of Pioneer-Ohio and a 15.6% decrease in the direct premiums written of Southern Heritage accounted for the majority of the remaining change. The Company reported net realized investment gains of $170,852, compared to net realized investment losses of $38,702 in 1999. During 2000, certain investments trading below cost had declined on an other-than-temporary basis. Losses of $436,943 were included in net realized investment gains for these investments in 2000. Net realized gains and losses in 1999 resulted from normal turnover of the Company's investment portfolio. As of December 31, 2000, 100.0% of the Company's bond portfolio was classified as Class 1 (highest quality) by the National Association of Insurance Commissioners' Securities Valuation Office. Investment income increased $2,804,052 in 2000. An increase in the average invested assets from $264,758,816 to $278,677,748, and an increase in the average yield to 5.9% from 5.1% in 1999, accounted for the change. 12 The GAAP combined ratio of insurance operations was 101.8% in 2000, compared to 106.5% in 1999. The GAAP combined ratio is the sum of the ratios of incurred losses and loss expenses to premiums earned (loss ratio), underwriting expenses to premiums earned (expense ratio) and policyholder dividends to premiums earned (dividend ratio). The loss ratio in both 2000 and 1999 was 68.8%. The commercial lines loss ratio decreased from 68.8% in 1999 to 67.0% in 2000. The personal lines loss ratio increased from 69.7% in 1999 to 70.3% in 2000. The expense ratio for 2000 was 32.1%, compared to 36.8% in 1999, with the dividend ratio remaining unchanged at 0.9%. The expense ratio in 1999 was adversely affected by a charge to earnings resulting from a restructuring charge of $1.6 million which increased the expense ratio by 1.1%. Income tax expense (benefit) was $2,906,248, compared to $(2,950,556) in 1999. The Company benefited from a federal income tax law change in 1999. LIQUIDITY AND CAPITAL RESOURCES The Company generates sufficient funds from its operations and maintains a high degree of liquidity in its investment portfolio. The primary source of funds to meet the demands of claim settlements and operating expenses are premium collections, investment earnings and maturing investments. As of December 31, 2001, the Company had no material commitment for capital expenditures. In investing funds made available from operations, the Company maintains securities' maturities consistent with its projected cash needs for the payment of claims and expenses. The Company maintains a portion of its investment portfolio in relatively short-term and highly liquid assets to ensure the availability of funds. As of December 31, 2001, pursuant to a credit agreement dated December 29, 1995, and amended as of July 27, 1998, with Fleet National Bank, the Company had unsecured borrowings of $27.6 million. Such borrowings were made in connection with the acquisitions of Delaware, Pioneer-Ohio and Southern Heritage and various capital contributions to the subsidiaries. As of December 31, 2001, the Company may borrow up to $32 million at interest rates equal to the bank's then current prime rate or the then current London interbank Eurodollar bank rate plus 1.70%. At December 31, 2001, the interest rates were 4.75% on an outstanding prime rate balance of $2.6 million, 3.825% on an outstanding Eurodollar rate balance of $10 million and 3.6375% on another Eurodollar rate balance of $15 million. In addition, the Company pays a rate of 3/10 of 1% per annum on the average daily unused portion of the bank's commitment. On each July 27, the credit line is reduced by $8 million. Any outstanding loan in excess of the remaining credit line, after such reduction will then be payable. The Company's principal sources of cash with which to meet obligations and pay stockholder dividends are dividends from the Insurance Subsidiaries which are required by law to maintain certain minimum surplus on a statutory basis and are subject to regulations under which payment of dividends from statutory surplus is restricted and may require prior approval of their domiciliary insurance regulatory authorities. The Insurance Subsidiaries are also subject to Risk Based Capital (RBC) requirements which may further impact their ability to pay dividends. At December 31, 2001, all four companies' statutory capital and surplus were substantially above the RBC requirements. Amounts available for distribution as dividends to DGI without prior approval of the insurance regulatory authorities in 2002 are $8,612,490 from Atlantic States, $1,086,348, from Southern, $552,447 from Pioneer-Ohio and $3,514,487 from Southern Heritage. Net unrealized gains (losses) resulting from fluctuations in the fair value of investments reported in the balance sheet at fair value were $2,861,765 (net of applicable federal income tax benefit) at December 31, 2001, and $(199,063) (net of applicable federal income tax) at December 31, 2000. CREDIT RISK The Company provides property and liability coverages through its subsidiaries' independent agency systems located throughout its operating area. The majority of this business is billed directly to the insured, although a portion of the Company's commercial business is billed through its agents, who are extended credit in the normal course of business. The Company's Insurance Subsidiaries have reinsurance agreements in place with the Mutual Company, as described in Note 2 of the financial statements, and with a number of other major authorized reinsurers, as described in Note 8 of the financial statements. IMPACT OF INFLATION Property and casualty insurance premiums are established before the amount of losses and loss expenses, or the extent to which inflation may impact such expenses, are known. Consequently, the Company attempts, in establishing rates, to anticipate the potential impact of inflation. 13 QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK INTEREST RATE RISK The Company's exposure to market risk for changes in interest rates is concentrated in its investment portfolio and, to a lesser extent, its debt obligations. The Company monitors this exposure through periodic reviews of asset and liability positions. Estimates of cash flows and the impact of interest rate fluctuations relating to the investment portfolio are modeled regularly. Principal cash flows and related weighted-average interest rates by expected maturity dates for financial instruments sensitive to interest rates at December 31, 2001 are as follows: Principal Weighted-Average Cash Interest Flows Rate -------------------------------------------------------------------------------- Fixed maturities and short-term investments: 2002 $ 37,038,816 3.84% 2003 19,700,000 5.74% 2004 24,025,000 5.79% 2005 28,632,768 5.91% 2006 48,879,557 5.83% Thereafter 119,957,853 5.93% -------------------------------------------------------------------------------- Total $278,233,994 ================================================================================ Market value $284,732,437 ================================================================================ Debt 2002 $ 3,600,000 3.81% 2003 8,000,000 3.81% 2004 8,000,000 3.81% 2005 8,000,000 3.81% -------------------------------------------------------------------------------- Total $ 27,600,000 ================================================================================ Fair value $ 27,600,000 ================================================================================ Actual cash flows may differ from those stated as a result of calls and prepayments. EQUITY PRICE RISK The Company's portfolio of equity securities, which is carried on the balance sheet at market value, has exposure to price risk. Price risk is defined as the potential loss in market value resulting from an adverse change in prices. Portfolio characteristics are analyzed regularly and market risk is actively managed through a variety of techniques. The portfolio is diversified across industries, and concentrations in any one company or industry are limited by parameters established by management. The combined total of realized and unrealized equity investment losses were $131,146, $650,229, and $394,931 in 2001, 2000, and 1999, respectively. During these three years the largest total equity investment gain and (loss) in a quarter was $829,914 and $(730,481), respectively. 14 Donegal Group Inc. CONSOLIDATED BALANCE SHEETS
December 31, 2001 2000* --------------------------------------------------------------------------------------------------------------------------------- ASSETS Investments Fixed maturities Held to maturity, at amortized cost (fair value $86,939,393 and $144,662,436) $ 85,322,965 $143,181,718 Available for sale, at fair value (amortized cost $170,269,584 and $114,524,472) 173,718,844 114,611,183 Equity securities, available for sale, at fair value (cost $16,630,618 and $12,500,558) 17,517,346 12,112,236 Short-term investments, at cost, which approximates fair value 24,074,200 19,439,505 --------------------------------------------------------------------------------------------------------------------------------- Total investments 300,633,355 289,344,642 Cash 4,075,288 5,182,988 Accrued investment income 3,765,076 4,002,464 Premiums receivable 24,143,531 21,758,502 Reinsurance receivable 67,853,174 54,543,884 Deferred policy acquisition costs 13,604,215 12,284,214 Federal income taxes receivable 292,618 259,962 Deferred tax asset, net 7,474,730 7,690,886 Prepaid reinsurance premiums 29,593,467 24,712,384 Property and equipment, net 4,568,652 5,236,483 Accounts receivable-securities 50,023 234,817 Other 578,243 757,554 --------------------------------------------------------------------------------------------------------------------------------- Total assets $456,632,372 $426,008,780 ================================================================================================================================= LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Losses and loss expenses $179,839,905 $156,476,124 Unearned premiums 114,079,264 99,940,381 Accrued expenses 7,186,107 5,877,475 Reinsurance balances payable 839,156 1,634,975 Cash dividend declared to stockholders 869,877 797,282 Borrowings under line of credit 27,600,000 40,000,000 Accounts payable-securities -- 959,652 Due to affiliate 4,015,074 4,528,996 Other 1,274,640 1,664,304 --------------------------------------------------------------------------------------------------------------------------------- Total liabilities 335,704,023 311,879,189 --------------------------------------------------------------------------------------------------------------------------------- Stockholders' Equity Preferred stock, $1.00 par value, authorized 2,000,000 shares; none issued Common stock, $1.00 par value, authorized 20,000,000 shares, issued 0 and 8,980,977 shares and outstanding 0 and 8,858,689 shares -- 8,980,977 Class A common stock, $.01 par value, authorized 30,000,000 shares, issued 6,097,214 and 0 shares and outstanding 6,015,690 and 0 shares 60,972 -- Class B common stock, $.01 par value, authorized 10,000,000 shares, issued 3,021,965 and 0 shares and outstanding 2,981,203 and 0 shares 30,220 -- Additional paid-in capital 58,887,715 46,969,840 Accumulated other comprehensive income (loss) 2,861,765 (199,063 Retained earnings 59,979,425 59,269,593 Treasury stock, at cost (891,748) (891,756 --------------------------------------------------------------------------------------------------------------------------------- Total stockholders' equity 120,928,349 114,129,591 --------------------------------------------------------------------------------------------------------------------------------- Total liabilities and stockholders' equity $456,632,372 $426,008,780 ================================================================================================================================= *Restated - see note 1 See accompanying notes to consolidated financial statements.
15 Donegal Group Inc. CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
Year Ended December 31, 2001 2000* 1999* --------------------------------------------------------------------------------------------------------------------- STATEMENTS OF INCOME Revenues Net premiums earned (includes affiliated reinsurance of $71,989,136, $63,989,424 and $60,234,261) $167,769,854 $151,646,199 $145,517,457 Investment income, net of investment expenses 15,885,544 16,394,747 13,590,695 Installment payment fees 1,587,396 1,532,792 1,456,918 Lease income 801,083 836,997 819,474 Service fees -- -- 393,494 Net realized investment gains (losses) (880,254) 170,852 (38,702) --------------------------------------------------------------------------------------------------------------------- Total revenues 185,163,623 170,581,587 161,739,336 --------------------------------------------------------------------------------------------------------------------- Expenses Net losses and loss expenses (includes affiliated reinsurance of $50,283,481, $36,767,436 and $38,549,795) 118,177,549 104,383,176 100,080,616 Amortization of deferred policy acquisition costs 27,194,000 25,319,000 24,931,000 Other underwriting expenses 27,000,485 23,355,781 28,648,951 Policy dividends 1,691,759 1,330,330 1,341,294 Interest 2,247,465 3,285,036 1,535,249 Other 1,760,636 1,165,236 1,357,585 --------------------------------------------------------------------------------------------------------------------- Total expenses 178,071,894 158,838,559 157,894,695 --------------------------------------------------------------------------------------------------------------------- Income before income tax expense (benefit) 7,091,729 11,743,028 3,844,641 Income tax expense (benefit) 1,273,598 2,906,248 (2,950,556) --------------------------------------------------------------------------------------------------------------------- Net income $ 5,818,131 $ 8,836,780 $ 6,795,197 ==================================================================================================================== Net income per common share Basic $ .65 $ 1.01 $ .82 ==================================================================================================================== Diluted $ .64 $ 1.01 $ .82 ==================================================================================================================== STATEMENTS OF COMPREHENSIVE INCOME Net income $ 5,818,131 $ 8,836,780 $ 6,795,197 --------------------------------------------------------------------------------------------------------------------- Other comprehensive income (loss), net of tax Unrealized gains (losses) on securities: Unrealized holding gain (loss) arising during the period, net of income tax expense (benefit) of $1,277,504, $1,057,179, and $(1,804,294) 2,479,860 2,020,267 (3,459,669) Reclassification adjustment for (gains) losses included in net income, net of income tax expense (benefit) of $(299,286), $58,090, and $(13,159) 580,968 (112,762) 25,543 --------------------------------------------------------------------------------------------------------------------- Other comprehensive income (loss) 3,060,828 1,907,505 (3,434,126) --------------------------------------------------------------------------------------------------------------------- Comprehensive income $ 8,878,959 $ 10,744,285 $ 3,361,071 ==================================================================================================================== *Restated - see note 1 See accompanying notes to consolidated financial statements.
16 Donegal Group Inc. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
` Common Stock -------------------------------------------------------------------------- Prior Class A Class B Prior Class A Class B Shares Shares Shares Amount Amount Amount ----------------------------------------------------------------------------------------------------------- Balance, January 1, 1999* 8,325,221 $8,325,221 $ $ ----------------------------------------------------------------------------------------------------------- Issuance of common stock 248,989 248,989 Net income Other comprehensive loss Cash dividends ----------------------------------------------------------------------------------------------------------- Balance, December 31, 1999* 8,574,210 $8,574,210 $ $ ----------------------------------------------------------------------------------------------------------- Issuance of common stock 406,767 406,767 Net income Other comprehensive income Grant of stock options Cash dividends ----------------------------------------------------------------------------------------------------------- Balance, December 31, 2000* 8,980,977 $8,980,977 $ $ ----------------------------------------------------------------------------------------------------------- Issuance of common stock 61,830 60,144 3,758 61,830 601 38 Recapitalization (9,042,807) 6,027,975 3,013,987 (9,042,807) 60,280 30,140 Net income Cash dividends Exercise of stock options 9,095 4,220 91 42 Grant of stock options Other comprehensive income ----------------------------------------------------------------------------------------------------------- Balance, December 31, 2001 -- 6,097,214 3,021,965 $ -- $60,972 $30,220 ===========================================================================================================
Accumulated Additional Other Total Paid-In Comprehensive Retained Treasury Stockholders' Capital Income (Loss) Earnings Stock Equity ---------------------------------------------------------------------------------------------------------- Balance, January 1, 1999* $42,330,011 $ 1,327,558 $49,824,144 $(891,756) $100,915,178 ---------------------------------------------------------------------------------------------------------- Issuance of common stock 2,265,426 2,514,415 Net income 6,795,197 6,795,197 Other comprehensive loss (3,434,126) (3,434,126) Cash dividends (2,998,330) (2,998,330) ---------------------------------------------------------------------------------------------------------- Balance, December 31, 1999* $44,595,437 $(2,106,568) $53,621,011 $(891,756) $103,792,334 ---------------------------------------------------------------------------------------------------------- Issuance of common stock 2,349,773 2,756,540 Net income 8,836,780 8,836,780 Other comprehensive income 1,907,505 1,907,505 Grant of stock options 24,630 (24,630) -- Cash dividends (3,163,568) (3,163,568) ---------------------------------------------------------------------------------------------------------- Balance, December 31, 2000* $46,969,840 $ (199,063) $59,269,593 $(891,756) $114,129,591 ---------------------------------------------------------------------------------------------------------- Issuance of common stock 1,200,202 1,262,671 Recapitalization 8,949,361 8 (3,018) Net income 5,818,131 5,818,131 Cash dividends (3,466,947) (3,466,947) Exercise of stock options 126,960 127,093 Grant of stock options 1,641,352 (1,641,352) -- Other comprehensive income 3,060,828 3,060,828 ---------------------------------------------------------------------------------------------------------- Balance, December 31, 2001 $58,887,715 $ 2,861,765 $59,979,425 $(891,748) $120,928,349 ========================================================================================================== *Restated - see note 1 See accompanying notes to consolidated financial statements.
17
Donegal Group Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended December 31, 2001 2000 1999 ------------------------------------------------------------------------------------------------------------ Cash Flows from Operating Activities: Net income $ 5,818,131 $ 8,836,780 $ 6,795,197 ------------------------------------------------------------------------------------------------------------ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 1,127,510 982,926 1,078,594 Realized investment (gains) losses 880,254 (170,852) 38,702 Changes in Assets and Liabilities, net of acquisition: Losses and loss expenses 23,363,781 12,296,118 7,452,899 Unearned premiums 14,138,883 7,788,243 2,395,965 Accrued expenses 1,308,632 (165,997) 1,166,287 Premiums receivable (2,385,029) (3,296,815) 1,477,671 Deferred policy acquisition costs (1,320,001) (316,463) 64,545 Deferred income taxes (1,360,633) 499,976 (3,783,354) Reinsurance receivable (13,309,290) (8,970,330) (3,809,600) Accrued investment income 237,388 (455,059) (311,975) Amounts due to/from affiliate (513,922) 350,639 (1,133,037) Reinsurance balances payable (795,819) 262,686 (499,423) Prepaid reinsurance premiums (4,881,083) (3,156,232) (4,041,033) Current income taxes (32,656) 374,620 (388,577) Change in pooling participation -- 3,322,031 -- Other, net (271,364) 268,316 508,807 ------------------------------------------------------------------------------------------------------------ Net adjustments 16,186,651 9,613,807 216,471 ------------------------------------------------------------------------------------------------------------ Net cash provided by operating activities 22,004,782 18,450,587 7,011,668 ------------------------------------------------------------------------------------------------------------ Cash Flows from Investing Activities: Purchase of fixed maturities Held to maturity (45,201,470) (17,340,175) (23,782,305) Available for sale (71,700,918) (30,355,507) (32,890,963) Purchase of equity securities (12,440,994) (28,286,533) (14,258,861) Sale of fixed maturities Available for sale 16,250,109 8,719,165 503,895 Maturity of fixed maturities Held to maturity 51,313,296 13,490,715 15,563,638 Available for sale 50,781,533 11,928,622 19,049,880 Sale of equity securities 7,089,532 24,572,288 11,767,268 Sale of Atlantic Insurance Services, net -- -- (48,810) Net purchase of property and equipment (161,269) (275,982) (461,669) Net sales (purchases) of short-term investments (4,634,695) (2,850,343) 14,619,107 ------------------------------------------------------------------------------------------------------------ Net cash used in investing activities (8,704,876) (20,397,750) (9,938,820) ------------------------------------------------------------------------------------------------------------ Cash Flows from Financing Activities: Issuance of common stock 1,386,746 2,756,540 2,514,415 Borrowings (payments) under line of credit, net (12,400,000) 3,000,000 (500,000) Cash dividends paid (3,394,352) (3,126,959) (2,946,170) ------------------------------------------------------------------------------------------------------------ Net cash provided by (used in) financing activities (14,407,606) 2,629,581 (931,755) ------------------------------------------------------------------------------------------------------------ Net increase (decrease) in cash (1,107,700) 682,418 (3,858,907) Cash at beginning of year 5,182,988 4,500,570 8,359,477 ------------------------------------------------------------------------------------------------------------ Cash at end of year $ 4,075,288 $ 5,182,988 $ 4,500,570 ============================================================================================================ *Restated - see note 1 See accompanying notes to consolidated financial statements.
18 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND BUSINESS Donegal Group Inc. (the "Company") was organized as a regional insurance holding company by Donegal Mutual Insurance Company (the "Mutual Company") and operates in the Mid-Atlantic and Southern states through its wholly owned stock insurance companies, Atlantic States Insurance Company ("Atlantic States"), Southern Insurance Company of Virginia ("Southern"), Southern Heritage Insurance Company ("Southern Heritage") and Pioneer Insurance Company of Ohio ("Pioneer-Ohio") (collectively "Insurance Subsidiaries"). The Company has three operating segments: the investment function, the personal lines of insurance and the commercial lines of insurance. Products offered in the personal lines of insurance consist primarily of homeowners and private passenger automobile policies. Products offered in the commercial lines of insurance consist primarily of commercial automobile, commercial multiple peril and workers' compensation policies. The Insurance Subsidiaries are subject to regulation by Insurance Departments in those states in which they operate and undergo periodic examination by those departments. The Insurance Subsidiaries are also subject to competition from other insurance carriers in their operating areas. Atlantic States participates in an intercompany pooling arrangement with the Mutual Company and assumes 70% of the pooled business (65% prior to July 1, 2000). Southern cedes 50% of its business to the Mutual Company. At December 31, 2001, the Mutual Company held 63% of the outstanding common stock of the Company. In addition to the Company's Insurance Subsidiaries, it also owned all of the outstanding stock of Atlantic Insurance Services, Inc. ("AIS"), an insurance services organization. The Company sold all of the stock of AIS on October 1, 1999. During 2000, the Company acquired 45% of the outstanding stock of Donegal Financial Services Corporation ("DFSC"), a bank holding company, for $3,042,000 in cash. The remaining 55% of the outstanding stock of DFSC is owned by the Mutual Company. On January 3, 2001, the Company announced that it had purchased all of the outstanding stock of Pioneer Insurance Company of New York ("Pioneer-New York") from the Mutual Company effective January 1, 2001. The purchase price was $4,441,311, representing Pioneer-New York's adjusted statutory equity at December 31, 2000. The acquisition has been accounted for as a reorganization of entities under common control, similar to a pooling of interests, as both Pioneer-New York and the Company are under the common management and control of the Mutual Company. As such, the Company's financial statements have been restated to include Pioneer-New York as a consolidated subsidiary. In connection with the transaction, the Company issued the Mutual Company a $4,441,311 note, which bears a 6% rate and is due in January 2003. The Company classifies this note in Due to Affiliate. Delaware Atlantic Insurance Company ("Delaware"), previously a wholly owned subsidiary, and Pioneer-New York were merged into Atlantic States Insurance Company on August 1, 2001 and September 30, 2001, respectively. The mergers were accounted for as statutory mergers and had no financial impact on the consolidated entity. BASIS OF CONSOLIDATION The consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America, include the accounts of Donegal Group Inc. and its wholly owned subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation. The term "Company" as used herein refers to the consolidated entity. USE OF ESTIMATES In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the liabilities for losses and loss expenses. While management uses available information to provide for such liabilities, future changes to these liabilities may be necessary based on changes in trends in claim frequency and severity. INVESTMENTS The Company classifies its debt and equity securities into the following categories: Held to Maturity--Debt securities that the Company has the positive intent and ability to hold to maturity; reported at amortized cost. Available for Sale--Debt and equity securities not classified as held to maturity; reported at fair value, with unrealized gains and losses excluded from income and reported as a separate component of stockholders' equity (net of tax effects). Short-term investments are carried at amortized cost, which approximates fair value. If there is a decline in fair value below amortized cost which is other than temporary, the cost basis for such investments in the held to maturity and available for sale categories is reduced to fair value. Such decline in cost basis is recognized as a realized loss and charged to income. 19 Premiums and discounts on debt securities are amortized over the life of the security as an adjustment to yield using the effective interest method. Realized investment gains and losses are computed using the specific identification method. Premiums and discounts for mortgage-backed debt securities are amortized using anticipated prepayments. FAIR VALUES OF FINANCIAL INSTRUMENTS The Company has used the following methods and assumptions in estimating its fair value disclosures: Investments--Fair values for fixed maturity securities are based on quoted market prices, when available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments or values obtained from independent pricing services through a bank trustee. The fair values for equity securities are based on quoted market prices. Cash and Short-Term Investments--The carrying amounts reported in the balance sheet for these instruments approximate their fair values. Premium and Reinsurance Receivables and Payables--The carrying amounts reported in the balance sheet for these instruments approximate their fair values. Borrowings Under Line of Credit--The carrying amounts reported in the balance sheet for the line of credit approximate fair value due to the variable rate nature of the line of credit. REVENUE RECOGNITION Insurance premiums are recognized as income over the terms of the policies. Unearned premiums are calculated on a daily pro-rata basis. POLICY ACQUISITION COSTS Policy acquisition costs, consisting primarily of commissions, premium taxes and certain other variable underwriting costs, are deferred and amortized over the period in which the premiums are earned. Anticipated losses and loss expenses, expenses for maintenance of policies in force and anticipated investment income are considered in the determination of the recoverability of deferred acquisition costs. PROPERTY AND EQUIPMENT Property and equipment are reported at depreciated cost that is computed using the straight-line method based upon estimated useful lives of the assets. LOSSES AND LOSS EXPENSES The liability for losses and loss expenses includes amounts determined on the basis of estimates for losses reported prior to the close of the accounting period and other estimates, including those for incurred but not reported losses and salvage and subrogation recoveries. These liabilities are continuously reviewed and updated by management, and management believes that such liabilities are adequate to cover the ultimate net cost of claims and expenses. When management determines that changes in estimates are required, such changes are included in current earnings. The Company has no material exposures to environmental liabilities. INCOME TAXES The Company and its subsidiaries currently file a consolidated federal income tax return. The Company accounts for income taxes using the asset and liability method. The objective of the asset and liability method is to establish deferred tax assets and liabilities for the temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. CREDIT RISK The Company provides property and liability coverages through its Insurance Subsidiaries' independent agency systems located throughout its operating area. The majority of this business is billed directly to the insured, although a portion of the Company's commercial business is billed through its agents, who are extended credit in the normal course of business. The Company's Insurance Subsidiaries have reinsurance agreements in place with the Mutual Company and with a number of other authorized reinsurers with at least an A.M. Best rating of A- or an equivalent financial condition. REINSURANCE ACCOUNTING AND REPORTING The Company relies upon reinsurance agreements to limit its maximum net loss from large single risks or risks in concentrated areas, and to increase its capacity to write insurance. Reinsurance does not relieve the primary insurer from liability to its policyholders. To the extent that a reinsurer may be unable to pay losses for which it is liable under the terms of a reinsurance agreement, the Company is exposed to the risk of continued liability for such losses. However, in an effort to reduce the risk of non-payment, the Company requires all of its reinsurers to have an A.M. Best rating of A- or better or, with respect to foreign reinsurers, to have a financial condition which, in the opinion of management, is equivalent to a company with at least an A- rating. 20 STOCK-BASED COMPENSATION Effective July 1, 2000, the Company adopted Financial Accounting Standards Board Interpretation No. 44 (FIN No. 44), "Accounting for Certain Transactions involving Stock Compensation," and Emerging Issues Task Force Issue No. 00-23 (EITF 00-23), "Issues Related to the Accounting for Stock Compensation under Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and FIN No. 44, Accounting for Certain Transactions involving Stock Compensation." FIN No. 44 states that APB Opinion No. 25 does not apply in the separate financial statements of a subsidiary to the accounting for stock compensation granted by the subsidiary to employees of the parent or another subsidiary. EITF 00-23 states that when employees of a controlling entity are granted stock compensation, the entity granting the stock compensation should measure the fair value of the award at the grant date and recognize that fair value as a dividend to the controlling entity. These provisions apply to the Company, as the Mutual Company is the employer of record for all employees that provide services to the Company. Prior to July 1, 2000, the Company's stock-based compensation plans were accounted for under the provisions of APB Opinion No. 25 and related interpretations. As such, compensation expense was recorded on the date of stock option grant only if the current market price of the underlying stock exceeded the exercise price. Additionally, the Company provides the pro-forma net income and earnings per share disclosures required by Statement of Financial Accounting Standards (SFAS No. 123), "Accounting for Stock-Based Compensation," for grants prior to the adoption of FIN No. 44. EARNINGS PER SHARE Basic earnings per share are calculated by dividing net income by the weighted-average number of common shares outstanding for the period, while diluted earnings per share reflects the dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. RECLASSIFICATIONS Certain amounts in these financial statements have been reclassified from those previously presented. Gross and ceded premiums earned and losses and loss expenses are no longer presented in the statements of income. Reinsurance receivable, prepaid reinsurance premiums, unearned premiums, and the liabilities for losses and loss expenses have been reduced in the consolidated balance sheet as they no longer include the amounts under the agreements discussed in the last paragraph of note 2a. The amounts in note 6 as well as the consolidated statements of cash flows have been revised to conform to the changes in the consolidated balance sheets. Note 2a has been expanded to include the purpose of the various agreements and to separately disclose amounts under the various arrangements versus the aggregate disclosure previously provided. These reclassifications had no effect on total revenues, total expenses, net income, net income per share, cash flows provided by operating activities, or stockholders' equity. 2--TRANSACTIONS WITH AFFILIATES The Company conducts business and has various agreements with the Mutual Company which are described below: A. REINSURANCE POOLING AND OTHER REINSURANCE ARRANGEMENTS Atlantic States cedes to the Mutual Company all of its insurance business and assumes from the Mutual Company 70% (65% prior to July 1, 2000) of the Mutual Company's total pooled insurance business, including that assumed from Atlantic States and substantially all of the business assumed by the Mutual Company from Southern and Delaware (prior to January 1, 2000). The Mutual Company and Atlantic States write business with different risk profiles. Through the pooling arrangement, each is able to share proportionately in the results of all policies written by the other. Atlantic States ceded premiums earned of $37,345,259, $30,414,395 and $23,745,989 and ceded losses and loss expenses incurred of $29,094,804, $22,966,106 and $15,625,894 under this arrangement during 2001, 2000 and 1999, respectively. It also assumed premiums earned of $126,769,521, $110,943,962 and $101,017,767 and assumed losses and loss expenses incurred of $93,470,958, $75,007,089 and $68,563,183 under this arrangement during 2001, 2000 and 1999, respectively. Atlantic States had prepaid reinsurance premiums of $20,942,093, $16,251,612 and $12,978,863 and a ceded liability for losses and loss expenses of $39,321,214, $31,068,101 and $24,025,502 under this arrangement as of December 31, 2001, 2000 and 1999, respectively. It also had assumed unearned premiums of $63,636,858, $54,578,621 and $46,283,485 and an assumed liability for losses and loss expenses of $99,664,285, $84,805,937 and $80,258,589 under this arrangement at December 31, 2001, 2000 and 1999, respectively. The Mutual Company and Southern have a quota share agreement whereby Southern cedes 50% of its direct business, less reinsurance, to the Mutual Company. The business assumed by the Mutual Company from Southern becomes part of the pooling arrangement between the Mutual Company and Atlantic States. Southern ceded premiums earned of $14,995,606, $14,413,261 and $13,517,603 and ceded losses and loss expenses incurred of $9,898,422, $9,885,436 and $9,986,718 under this agreement during 2001, 2000 and 1999, respectively. Southern had prepaid reinsurance premiums of $7,310,471, $7,084,729 and $6,683,001 and a ceded liability for losses and loss expenses of $10,068,604, $7,924,750 and $7,054,012 under this agreement at December 31, 2001, 2000 and 1999, respectively. This agreement was terminated as of January 1, 2002. Atlantic States, Southern, Pioneer-Ohio and Southern Heritage each have a catastrophe reinsurance agreement with the Mutual Company which limits the maximum liability under any one catastrophic occurrence to $400,000, $300,000, $200,000 and $400,000 (effective January 1, 2000), respectively, and $1,000,000 ($700,000 in 1999) for a catastrophe involving more than one of the companies. Prior to merging into Atlantic States, Delaware and Pioneer-New York each had a catastrophe reinsurance agreement with the Mutual Company which limited the maximum liability under any one catastrophic occurrence to $300,000 and $400,000, respectively. Prior to merging into Atlantic States, Delaware and the Mutual Company had an excess of loss reinsurance agreement in 21 which the Mutual Company assumed up to $250,000 of losses in excess of $50,000 and prior to January 1, 2000, a workers' compensation quota share agreement whereby Delaware ceded 70% of that business. The Mutual Company and Pioneer-Ohio have an excess of loss reinsurance agreement in which the Mutual Company assumes up to $250,000 ($200,000 in 2000 and 1999) of losses in excess of $50,000. The Mutual Company and Southern have an excess of loss reinsurance agreement in which the Mutual Company assumes up to $50,000 ($25,000 in 2000 and 1999) of losses in excess of $100,000. Prior to merging into Atlantic States, Pioneer-New York and the Mutual Company had an excess of loss reinsurance agreement in which the Mutual Company assumed up to $250,000 ($200,000 in 2000 and 1999) of losses in excess of $50,000. Effective October 1, 2000 the Mutual Company and Southern Heritage have an excess of loss reinsurance agreement in which the Mutual Company assumed up to $175,000 ($125,000 in 2000) of losses in excess of $125,000. The Mutual Company has agreements in place with Southern and Pioneer-Ohio (and Delaware prior to merging into Atlantic States) to reallocate the loss results of workers' compensation business written by those companies as part of commercial accounts primarily written by the Mutual Company or Atlantic States. These agreements provide for the workers' compensation loss ratios of each company to be no worse than the average workers' compensation loss ratio for all of the companies combined. The Mutual Company and Pioneer-New York also had an aggregate excess of loss reinsurance agreement, entered into as part of the sale of Pioneer-New York from the Mutual Company to Donegal Group Inc., in which the Mutual Company agreed to assume the adverse loss development of claims with dates of loss prior to December 31, 2000, as developed through December 31, 2002, and to assume losses in excess of a 60% loss ratio through December 31, 2002. The subsidiaries ceded premiums earned of $2,439,520, $2,126,882 and $3,519,914 and ceded losses and loss expenses incurred of $4,194,251, $5,388,111 and $4,400,776 under these various agreements during 2001, 2000 and 1999, respectively. The subsidiaries had prepaid reinsurance premiums of $0, $0 and $733,183 and a ceded liability for losses and loss expenses of $5,395,528, $4,941,116 and $2,689,825 under these various agreements at December 31, 2001, 2000, and 1999, respectively. Southern, Pioneer-Ohio and Southern Heritage (and Delaware and Pioneer-New York prior to merging into Atlantic States) each have agreements with the Mutual Company under which they cede, and then reassume back, 100% of their business net of reinsurance. The primary purpose of the agreements is to provide these subsidiaries with the same A.M. Best rating (currently "A") as the Mutual Company, which these subsidiaries could not achieve without these contracts in place. These agreements do not transfer insurance risk. While these subsidiaries ceded and reassumed amounts received from policyholders of $41,142,936, $25,790,126 and $22,486,490 and claims of $23,348,952, $15,325,638 and $13,177,186 under these agreements in 2001, 2000 and 1999, respectively, the amounts are not reflected in the consolidated financial statements. The aggregate liabilities ceded and reassumed under these agreements were $36,494,487 and $26,572,959 at December 31, 2001, and 2000, respectively. B. EXPENSE SHARING The Mutual Company provides facilities, management and other services to the Company, and the Company reimburses the Mutual Company for such services on a periodic basis under usage agreements and pooling arrangements. The charges are based upon the relative participation of the Company and the Mutual Company in the pooling arrangement, and management of both the Company and the Mutual Company consider this allocation to be reasonable. Charges for these services totalled $29,298,569, $26,985,080 and $27,466,898 for 2001, 2000 and 1999, respectively. C. LEASE AGREEMENT The Company leases office equipment and automobiles to the Mutual Company under a 10-year lease dated January 1, 2000. D. LEGAL SERVICES Donald H. Nikolaus, President and a director of the Company, is also a partner in the law firm of Nikolaus & Hohenadel. Such firm has served as general counsel to the Company since 1986, principally in connection with the defense of claims litigation arising in Lancaster, Dauphin and York counties. Such firm is paid its customary fees for such services. E. PROVINCE BANK As of December 31, 2001, the Company had $3,585,566 in checking accounts with Province Bank, a wholly owned subsidiary of DFSC. The Company earned $6,350 in interest on these accounts during 2001. 3--INVESTMENTS The amortized cost and estimated fair values of fixed maturities and equity securities at December 31, 2001 and 2000, are as follows:
2001 ---------------------------------------------------------------------------------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Fair HELD TO MATURITY Cost Gains Losses Value ---------------------------------------------------------------------------------------------------------------------------- U.S. Treasury securities and obligations of U.S. government corporations and agencies $23,808,841 $ 336,288 $ 27,500 $ 24,117,629 Canadian government obligation 498,894 36,106 -- 535,000 Obligations of states and political subdivisions 24,981,562 690,700 53,312 25,618,950 Corporate securities 27,423,039 659,961 121,021 27,961,979 Mortgage-backed securities 8,610,629 113,541 18,335 8,705,835 ---------------------------------------------------------------------------------------------------------------------------- Totals $85,322,965 $1,836,596 $ 220,168 $ 86,939,393 ============================================================================================================================
22
2001 ---------------------------------------------------------------------------------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Fair AVAILABLE FOR SALE Cost Gains Losses Value ---------------------------------------------------------------------------------------------------------------------------- U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 67,468,897 $1,755,874 $ 249,306 $ 68,975,465 Obligations of states and political subdivisions 53,962,895 1,269,340 85,535 55,146,700 Corporate securities 34,094,195 828,344 115,939 34,806,600 Mortgage-backed securities 14,743,597 78,666 32,184 14,790,079 Equity securities 16,630,618 1,270,239 383,511 17,517,346 ---------------------------------------------------------------------------------------------------------------------------- Totals $186,900,202 $5,202,463 $866,475 $191,236,190 ============================================================================================================================
2000 ---------------------------------------------------------------------------------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Fair HELD TO MATURITY Cost Gains Losses Value ---------------------------------------------------------------------------------------------------------------------------- U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 38,779,230 $ 343,819 $ 255,049 $ 38,868,000 Canadian government obligation 498,559 11,441 -- 510,000 Obligations of states and political subdivisions 66,831,090 1,499,955 45,904 68,285,141 Corporate securities 21,621,472 228,851 195,287 21,655,036 Mortgage-backed securities 15,451,367 47,120 154,228 15,344,259 ---------------------------------------------------------------------------------------------------------------------------- Totals $143,181,718 $2,131,186 $ 650,468 $144,662,436 ============================================================================================================================
2000 ---------------------------------------------------------------------------------------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Fair AVAILABLE FOR SALE Cost Gains Losses Value ---------------------------------------------------------------------------------------------------------------------------- U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 68,007,634 $ 544,135 $ 650,339 $ 67,901,430 Obligations of states and political subdivisions 17,965,179 327,256 36,885 18,255,550 Corporate securities 22,902,588 312,426 306,664 22,908,350 Mortgage-backed securities 5,649,071 14,790 118,008 5,545,853 Equity securities 12,500,558 880,419 1,268,741 12,112,236 ---------------------------------------------------------------------------------------------------------------------------- Totals $127,025,030 $2,079,026 $2,380,637 $126,723,419 ============================================================================================================================
The amortized cost and estimated fair value of fixed maturities at December 31, 2001, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. -------------------------------------------------------------------------------- Estimated Amortized Fair Cost Value -------------------------------------------------------------------------------- HELD TO MATURITY Due in one year or less $ 1,000,081 $ 1,012,500 Due after one year through five years 33,277,659 33,857,210 Due after five years through ten years 38,671,342 39,626,349 Due after ten years 3,763,254 3,737,500 Mortgage-backed securities 8,610,629 8,705,834 -------------------------------------------------------------------------------- Total held to maturity $ 85,322,965 $ 86,939,393 ================================================================================ AVAILABLE FOR SALE Due in one year or less $ 11,815,944 $ 12,046,000 Due after one year through five years 79,085,686 81,151,668 Due after five years through ten years 56,670,691 57,971,097 Due after ten years 7,953,666 7,760,000 Mortgage-backed securities 14,743,597 14,790,079 -------------------------------------------------------------------------------- Total available for sale $170,269,584 $173,718,844 ================================================================================ The amortized cost of fixed maturities on deposit with various regulatory authorities at December 31, 2001 and 2000, amounted to $5,667,959 and $6,056,374, respectively. Net investment income of the Company, consisting primarily of interest and dividends, is attributable to the following sources: 2001 2000 1999 -------------------------------------------------------------------------------- Fixed maturities $15,145,949 $15,180,008 $13,046,603 Equity securities 546,243 635,049 440,268 Short-term investments 920,538 1,221,724 809,949 Other 255,250 255,250 316,139 -------------------------------------------------------------------------------- Investment income 16,867,980 17,292,031 14,612,959 Investment expenses 982,436 897,284 1,022,264 -------------------------------------------------------------------------------- Net investment income $15,885,544 $16,394,747 $13,590,695 ================================================================================ Gross realized gains and losses from investments and the change in the difference between fair value and cost of investments, before applicable income taxes, are as follows: 2001 2000 1999 -------------------------------------------------------------------------------- Gross realized gains: Fixed maturities $ 554,560 $ 237,748 $ -- Equity securities 323,451 1,813,242 586,745 -------------------------------------------------------------------------------- 878,011 2,050,990 586,745 -------------------------------------------------------------------------------- Gross realized losses: Fixed maturities 28,618 20,597 6,083 Equity securities 1,729,647 1,859,541 619,364 ------------------------------------------------------------------------------- 1,758,265 1,880,138 625,447 ------------------------------------------------------------------------------- Net realized gains (losses) $ (880,254) $ 170,852 $ (38,702) =============================================================================== Change in difference between fair value and cost of investments: Fixed maturities $ 3,498,259 $ 7,300,279 $(11,668,991) Equity securities 1,275,050 (603,930) (362,312) -------------------------------------------------------------------------------- $ 4,773,309 $ 6,696,349 $(12,031,303) ================================================================================ 23 Income taxes (benefit) on realized investment gains (losses) were $(299,286), $58,090, and $(13,159) for 2001, 2000 and 1999, respectively. Deferred income taxes (benefits) applicable to net unrealized investment gains (losses) included in shareholders' equity were $1,474,242 and $(102,548) at December 31, 2001 and 2000, respectively. During 2001 and 2000, certain investments trading below cost had declined on an other-than-temporary basis. Losses of $1,462,913 and $436,943 were included in net realized investment gains (losses) for these investments in 2001 and 2000, respectively. The Company has no derivative instruments or hedging activities. On January 1, 2001, the Company transferred investments with an amortized cost of $51,640,154 and fair value of $52,444,675 from the held to maturity classification to the available for sale classification under the provisions of SFAS No. 133 and 138. The unrealized holding gain of $804,521 at January 1, 2001 was reported in other comprehensive income. The transfer had no impact on net income. 4--DEFERRED POLICY ACQUISITION COSTS Changes in deferred policy acquisition costs are as follows: 2001 2000 1999 -------------------------------------------------------------------------------- Balance, January 1 $12,284,214 $11,445,572 $11,510,117 Acquisition costs deferred 28,514,001 26,157,642 24,866,455 Amortization charged to earnings 27,194,000 25,319,000 24,931,000 -------------------------------------------------------------------------------- Balance, December 31 $13,604,215 $12,284,214 $11,445,572 ================================================================================ 5--PROPERTY AND EQUIPMENT Property and equipment at December 31, 2001 and 2000, consisted of the following: -------------------------------------------------------------------------------- Estimated Useful 2001 2000 Life -------------------------------------------------------------------------------- Cost--office equipment $5,012,290 $4,981,970 5-15 years automobiles 992,412 947,865 3 years real estate 3,063,646 3,063,646 15-50 years software 561,146 561,146 5 years -------------------------------------------------------------------------------- 9,629,494 9,554,627 Accumulated depreciation (5,060,842) (4,318,144) -------------------------------------------------------------------------------- $4,568,652 $5,236,483 ================================================================================ Depreciation expense for 2001, 2000, and 1999 amounted to $829,100, $899,750 and $970,331, respectively. 6--LIABILITY FOR LOSSES AND LOSS EXPENSES Activity in the liability for losses and loss expenses is summarized as follows: 2001 2000 1999 -------------------------------------------------------------------------------- Balance at January 1 $156,476,124 $144,180,006 $136,727,107 Less reinsurance recoverable 53,766,710 44,945,908 40,712,330 -------------------------------------------------------------------------------- Net balance at January 1 102,709,414 99,234,098 96,014,777 -------------------------------------------------------------------------------- Incurred related to: Current year 110,142,467 103,671,401 100,573,192 Prior years 8,035,082 711,775 (492,576) -------------------------------------------------------------------------------- Total incurred 118,177,549 104,383,176 100,080,616 -------------------------------------------------------------------------------- Paid related to: Current year 63,289,736 61,848,261 59,434,306 Prior years 43,053,112 39,059,599 37,426,989 -------------------------------------------------------------------------------- Total paid 106,342,848 100,907,860 96,861,295 -------------------------------------------------------------------------------- Net balance at December 31 114,544,115 102,709,414 99,234,098 Plus reinsurance recoverable 65,295,790 53,766,710 44,945,908 -------------------------------------------------------------------------------- Balance at December 31 $179,839,905 $156,476,124 $144,180,006 ================================================================================ The Company recognized an increase (decrease) in the liability for losses and loss expenses of prior years of $8.0 million, $0.7 million and $(0.5 million) in 2001, 2000 and 1999, respectively. These developments are primarily attributable to variations from expected claim severity in the private passenger and commercial automobile liability, workers' compensation and commercial multiple peril lines of business. 7--LINE OF CREDIT At December 31, 2001 and 2000, pursuant to a credit agreement dated December 29, 1995, and amended as of July 27, 1998, with Fleet National Bank, the Company had unsecured borrowings of $27.6 million and $40 million, respectively. Such borrowings were made in connection with the acquisitions of Delaware, Pioneer-Ohio, and Southern Heritage and various capital contributions to the subsidiaries. As of December 31, 2001, the Company may borrow up to $32 million at interest rates equal to the bank's then current prime rate or the then current London interbank Eurodollar bank rate plus 1.70%. At December 31, 2001, the interest rates were 4.75% on an outstanding prime rate balance of $2.6 million, 3.825% on an outstanding Eurodollar rate balance of $10 million and 3.6375% on another Eurodollar rate balance of $15 million. In addition, the Company pays a rate of 3/10 of 1% per annum on the average daily unused portion of the bank's commitment. On each July 27, the credit line is reduced by $8 million. Any outstanding loan in excess of the remaining credit line, after such reduction, will then be payable. 24 8--REINSURERS UNAFFILIATED REINSURERS In addition to the primary reinsurance in place with the Mutual Company, the Insurance Subsidiaries have other reinsurance in place, principally with four unaffiliated reinsurers. The following amounts represent ceded reinsurance transactions with unaffiliated reinsurers during 2001, 2000 and 1999: 2001 2000 1999 ---------------------------------------------------------------------------- Premiums written $ 9,348,853 $ 8,241,416 $ 8,391,805 ============================================================================ Premiums earned $ 9,440,035 $ 8,026,478 $ 8,549,509 ============================================================================ Losses and loss expenses $ 6,907,947 $ 3,027,810 $ 5,537,410 ============================================================================ Prepaid reinsurance premiums $ 1,340,903 $ 1,376,043 $ 1,161,105 ============================================================================ Liability for losses and loss expenses $10,510,444 $ 9,832,743 $11,176,569 ============================================================================ TOTAL REINSURANCE The following amounts represent the total of all ceded reinsurance transactions with both affiliated and unaffiliated reinsurers during 2001, 2000, and 1999: 2001 2000 1999 ---------------------------------------------------------------------------- Premiums earned $64,220,420 $54,981,016 $49,333,015 ============================================================================ Losses and loss expenses $50,095,424 $41,267,463 $35,550,798 ============================================================================ Prepaid reinsurance premiums $29,593,467 $24,712,384 $21,556,152 ============================================================================ Liability for losses and loss expenses $65,295,790 $53,766,710 $44,945,908 ============================================================================ The following amounts represent the effect of reinsurance on premiums written for 2001, 2000, and 1999: 2001 2000 1999 ---------------------------------------------------------------------------- Direct $110,298,533 $ 99,042,235 $ 91,854,011 Assumed 135,830,624 119,217,433 105,392,426 Ceded 69,101,503 58,137,248 53,374,048 ---------------------------------------------------------------------------- Net premiums written $177,027,654 $160,122,420 $143,872,389 ============================================================================ The following amounts represent the effect of reinsurance on premiums earned for 2001, 2000, and 1999: 2001 2000 1999 ---------------------------------------------------------------------------- Direct $105,214,059 $ 95,671,588 $ 93,399,834 Assumed 126,776,215 110,955,627 101,450,638 Ceded 64,220,420 54,981,016 49,333,015 ---------------------------------------------------------------------------- Net premiums earned $167,769,854 $151,646,199 $145,517,457 ============================================================================ 9--INCOME TAXES The provision for income tax consists of the following: 2001 2000 1999 ----------------------------------------------------------------------------- Current $ 2,634,231 $ 2,406,272 $ 832,798 Deferred (1,360,633) 499,976 (3,783,354) ---------------------------------------------------------------------------- Federal tax provision $ 1,273,598 $ 2,906,248 $(2,950,556) ============================================================================ The effective tax rate is different than the amount computed at the statutory federal rate of 34% for 2001, 2000 and 1999. The reason for such difference and the related tax effect are as follows: 2001 2000 1999 ----------------------------------------------------------------------------- Income before income taxes $7,091,729 $11,743,028 $ 3,844,641 ============================================================================= Computed "expected" taxes at 34% 2,411,188 3,992,630 1,307,178 Recognition of net operating loss carryover of Southern Heritage -- -- (3,004,524) Tax-exempt interest (1,399,238) (1,347,959) (1,355,816) Dividends received deduction (21,908) (25,423) (83,948) Other, net 283,556 287,000 186,554 ----------------------------------------------------------------------------- Federal income tax provision $1,273,598 $ 2,906,248 $(2,950,556) ============================================================================= The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2001 and 2000, are as follows: 2001 2000 ----------------------------------------------------------------------------- Deferred tax assets: Unearned premium $ 5,778,529 $ 5,139,217 Loss reserves 5,433,005 4,878,850 Net operating loss carryforward - Southern Heritage 2,032,094 2,339,133 Unrealized loss -- 102,548 Other 1,013,899 174,886 ----------------------------------------------------------------------------- Total $14,257,527 $12,634,634 ============================================================================= Deferred tax liabilities: Depreciation expense $ 379,594 $ 464,235 Deferred policy acquisition costs 4,625,433 4,176,632 Salvage recoverable 303,528 302,881 Unrealized gain 1,474,242 -- ----------------------------------------------------------------------------- Total $ 6,782,797 $ 4,943,748 ============================================================================= Net deferred tax assets $ 7,474,730 $ 7,690,886 ============================================================================= A valuation allowance is provided when it is more likely than not that some portion of the tax asset will not be realized. Management has determined that it is not required to establish a valuation allowance for any deferred tax asset at December 31, 2001, since it is more likely than not that the deferred tax assets will be realized through reversals of existing temporary differences, future taxable income, carryback to taxable income in prior years and the implementation of tax planning strategies. A change in the federal income laws was enacted during 1999 which allows net operating loss carryforwards of an acquired company to be used to offset future taxable income of other affiliated companies filing as part of a consolidated tax return. Prior law allowed such net operating loss carryforward to be used to offset taxable income of the acquired company only. Due to this law change, the net operating loss carryforward, obtained as part of the acquisition of Southern Heritage, can now be used to offset taxable income generated by the other consolidated affiliates. This was the primary factor in management's determination that no valuation allowance was required at the end of 1999. Accordingly, the tax benefit of this carryforward, as adjusted for the 1998 tax return as filed, of $3,004,524 was recognized in 1999. 25 At December 31, 2001, the Company has a net operating loss carryforward of $5,976,747, which is available to offset taxable income of the Company. Such net operating loss carryforward will expire beginning in 2009. Federal income tax laws limit the amount of net operating loss carryforward that the Company can use in any one year to approximately $1 million. 10--STOCKHOLDERS' EQUITY On April 19, 2001 the Company's stockholders approved an amendment to the Company's Certificate of Incorporation. Among other things, the amendment reclassified the Company's common stock as Class B common stock and effected a one-for-three reverse split of the Company's Class B common stock effective April 19, 2001. The amendment also authorized a new class of common stock with one-tenth of a vote per share designated as Class A common stock. The Company's Board also approved a dividend of two shares of Class A common stock for each share of Class B common stock, after the one-for-three reverse split, held of record at the close of business April 19, 2001. The effect of the reverse split and the stock dividend taken together is that the Company had the same total number of shares outstanding after the reverse split and the stock dividend as it did before the reverse split and the stock dividend. Therefore, there is no change in the historical earnings per share of the Class A common stock and the Class B common stock after the reverse split and the stock dividend compared to before the reverse split and the stock dividend. Each share of Class A common stock outstanding at the time of the declaration of any dividend or other distribution payable in cash upon the shares of Class B common stock is entitled to a dividend or distribution payable at the same time and to stockholders of record on the same date in an amount at least 10% greater than any dividend declared upon each share of Class B common stock. In the event of a merger or consolidation of the Company with or into another entity, the holders of Class A common stock and the holders of Class B common stock are entitled to receive the same per share consideration in such merger or consolidation. In the event of any liquidation, dissolution or winding-up of the Company, any assets available to common stockholders will be distributed pro-rata to the holders of Class A and Class B common stock. 11--STOCK COMPENSATION PLANS EQUITY INCENTIVE PLANS During 1996 the Company adopted an Equity Incentive Plan for key employees. During 2001 the Company adopted a nearly identical plan that made a total of 1,500,000 shares of Class A common stock available. Each plan provides for the granting of awards by the Board of Directors in the form of stock options, stock appreciation rights, restricted stock or any combination of the above. The plans provide that stock options may become exercisable up to 10 years from date of grant, with an option price not less than fair market value on date of grant. The stock appreciation rights permit surrender of the option and receipt of the excess of current market price over option price in cash. No stock appreciation rights have been issued. During 1996 the Company adopted an Equity Incentive Plan For Directors. During 2001 the Company adopted a nearly identical plan that made 200,000 shares of Class A common stock available. Awards may be made in the form of stock options, and the plan additionally provides for the issuance of 175 shares of restricted stock to each director on the first business day of January in each year. As of December 31, 2001, the Company has 76,112 unexercised options under these plans. Additionally 1,947, 1,947 and 2,124 shares of restricted stock were issued on January 2, 2001, 2000 and 1999, respectively. All options issued prior to 2001 were converted to options on Class A and Class B common stock as a result of the Company's recapitalization. No further shares are available for plans in effect prior to 2001. Information regarding activity in the Company's stock option plans is presented below: Weighted-Average Number of Exercise Price Options Per Share -------------------------------------------------------------------------------- Outstanding at December 31, 1998 1,091,120 $15.73 Granted - 1999 433,500 8.00 Exercised - 1999 -- -- Forfeited - 1999 28,227 15.52 -------------------------------------------------------------------------------- Outstanding at December 31, 1999 1,496,393 $13.50 Granted - 2000 59,500 8.05 Exercised - 2000 -- -- Forfeited - 2000 39,555 12.84 -------------------------------------------------------------------------------- Outstanding at December 31, 2000 1,516,338 $13.19 Granted - 2001 459,000 13.93 Exercised - 2001 13,315 8.00 Forfeited - 2001 27,556 13.50 -------------------------------------------------------------------------------- Outstanding at December 31, 2001 1,934,467 $13.27 ================================================================================ Exercisable at: December 31, 1999 897,338 $15.99 ================================================================================ December 31, 2000 1,190,004 $16.68 ================================================================================ December 31, 2001 1,321,905 $13.89 ================================================================================ Options available for future grants at December 31, 2001 are 1,241,000. The following table summarizes information about fixed stock options at December 31, 2001: Number of Weighted-Average Number of Exercise Options Remaining Options Price Outstanding Contractual Life Exercisable -------------------------------------------------------------------------------- $ 8.00 457,685 3.0 years 305,123 $ 9.00 9,500 4.5 years 2,000 $13.50 524,448 0.1 years 524,448 $14.00 452,500 4.5 years -- $18.00 490,334 1.25 years 490,334 EMPLOYEE STOCK PURCHASE PLANS During 1996 the Company adopted an Employee Stock Purchase Plan. During 2001, the Company adopted a nearly identical plan that made 300,000 shares of Class A common stock available for issuance. 26 The new plan extends over a 10-year period and provides for shares to be offered to all eligible employees at a purchase price equal to the lesser of 85% of the fair market value of the Company's common stock on the last day before the first day of the enrollment period (June 1 and December 1) of the plan or 85% of the fair market value of the Company's common stock on the last day of the subscription period (June 30 and December 31). A summary of plan activity follows: Shares Issued --------------------------- Price Shares ------------------------------------------------------------------------------- January 1, 1999 $13.28125 10,227 July 1, 1999 $ 9.66875 11,876 January 1, 2000 $ 5.41875 23,906 July 1, 2000 $ 4.88750 21,714 January 1, 2001 $ 5.95000 16,438 July 1, 2001 $ 8.71250 11,377 On January 1, 2002, the Company issued an additional 12,769 shares at a price of $8.84850 per share under this plan. AGENCY STOCK PURCHASE PLANS On December 31, 1996, the Company adopted an Agency Stock Purchase Plan. During 2001, the Company adopted a nearly identical plan that made 300,000 shares of Class A common stock available for issuance. The plan provides for agents of affiliated companies of Donegal Group Inc. to invest up to $12,000 per subscription period (April 1 to September 30 and October 1 to March 31) under various methods. Stock is issued at the end of the subscription period at a price equal to 90% of the average market price during the last ten trading days of the subscription period. During 2001, 2000 and 1999, 16,557, 46,603, and 47,841 shares, respectively, were issued under this plan. Expense recognized under the plan was not material. PRO-FORMA DISCLOSURES The weighted-average grant date fair value of options granted for the various plans during 2000 and 1999 was $2.23 and $1.98, respectively. The fair values above were calculated based upon risk-free interest rates of 5.75% for the Stock Purchase Plans and the Equity Incentive Plans, expected lives of 6 months for the Stock Purchase Plans and 5 years for the Equity Incentive Plans, expected volatility of 54% for 2000 and 47% for 1999, and an expected dividend yield of 4.5% for 2000 and 5.0% for 1999. Through June 30, 2000, the Company applied APB Opinion No. 25 in accounting for its stock-based compensation plans. Accordingly, no compensation cost has been recognized for its fixed stock option plans and certain of its stock purchase plans. Had the Company recognized stock compensation expense in accordance with SFAS No. 123, net income and earnings per share would have been reduced to the pro-forma amounts shown below: 2001 2000 1999 -------------------------------------------------------------------------------- Net income: As reported $5,818,131 $8,836,780 $6,795,197 Pro-forma 5,617,773 8,071,825 5,595,851 Basic earnings per share: As reported .65 1.01 .82 Pro-forma .63 .92 .68 Diluted earnings per share: As reported .64 1.01 .82 Pro-forma .62 .92 .68 12--STATUTORY NET INCOME, CAPITAL AND SURPLUS AND DIVIDEND RESTRICTIONS The following is selected information, as filed with insurance regulatory authorities, for the Insurance Subsidiaries as determined in accordance with accounting practices prescribed or permitted by such insurance regulatory authorities (restated for mergers): 2001 2000 1999 ------------------------------------------------------------------------------ ATLANTIC STATES Statutory capital and surplus $ 86,124,896 $ 88,620,380 $ 82,401,227 ============================================ Statutory unassigned surplus $ 44,464,032 $ 46,959,516 $ 40,740,363 ============================================ Statutory net income (loss) $ (54,605) $ 8,134,135 $ 4,832,737 ----------------------------------============================================ SOUTHERN Statutory capital and surplus $ 10,863,481 $ 9,082,587 $ 7,293,856 ============================================ Statutory unassigned surplus $ 5,761,211 $ 3,980,317 $ 2,191,586 ============================================ Statutory net income $ 1,666,477 $ 1,543,128 $ 184,285 ----------------------------------============================================ PIONEER-OHIO Statutory capital and surplus $ 5,524,466 $ 5,811,315 $ 5,677,926 ============================================ Statutory unassigned deficit $ (1,475,534) $ (1,188,685) $ (1,322,074) ============================================ Statutory net income $ (621,520) $ (176,011) $ 108,322 ----------------------------------============================================ SOUTHERN HERITAGE Statutory capital and surplus $ 19,867,276 $ 16,975,171 $ 16,508,422 ============================================ Statutory unassigned deficit $(12,648,039) $(15,540,144) $(16,006,893) ============================================ Statutory net income $ 3,514,487 $ 1,486,698 $ 487,098 ============================================ The Company's principal source of cash for payment of dividends are dividends from its Insurance Subsidiaries which are required by law to maintain certain minimum capital and surplus on a statutory basis and are subject to regulations under which payment of dividends from statutory surplus is restricted and may require prior approval of their domiciliary insurance regulatory authorities. Atlantic States, Southern, Pioneer-Ohio and Southern Heritage are also subject to Risk Based Capital (RBC) requirements which may further impact their ability to pay dividends. At December 31, 2001, all four companies' statutory capital and surplus were substantially above the RBC requirements. Amounts available for distribution as dividends to Donegal Group Inc. without prior approval of insurance regulatory authorities in 2002 are $8,612,490 from Atlantic States, $1,086,348 from Southern, $552,447 from Pioneer-Ohio and $3,514,487 from Southern Heritage. The National Association of Insurance Commissioners (NAIC) has adopted the Codification of Statutory Accounting Principles with an effective date of January 1, 2001. The codified principles are intended to provide a basis of accounting recognized and adhered to in the absence of conflict with, or silence of, state statutes and regulations. The impact of the codified principles on the statutory capital and surplus of the Company's Insurance Subsidiaries as of January 1, 2001 is as follows: Atlantic States - $6,168,742 increase; Southern Heritage - $1,083,354 increase; Pioneer-Ohio - $313,638 increase; and Southern - $1,171,204 increase. 27 13--RECONCILIATION OF STATUTORY FILINGS TO AMOUNTS REPORTED HEREIN The Company's Insurance Subsidiaries are required to file statutory financial statements with state insurance regulatory authorities. Accounting principles used to prepare these statutory financial statements differ from financial statements prepared on the basis of generally accepted accounting principles. Reconciliations of statutory net income and capital and surplus, as determined using statutory accounting principles, to the amounts included in the accompanying financial statements are as follows: Year Ended December 31, ----------------------- 2001 2000 1999 -------------------------------------------------------------------------------- Statutory net income of Insurance Subsidiaries $ 4,504,839 $10,987,950 $ 5,612,442 Increases (decreases): Deferred policy acquisition costs 1,320,001 838,642 (64,545) Deferred federal income taxes 1,360,633 (499,976) 3,783,354 Salvage and subrogation recoverable 155,088 305,918 (226,617) Consolidating eliminations and adjustments (13,783,695) (4,318,624) (1,387,864) Parent-only net income (loss) 12,261,265 1,522,870 (908,987) Non-insurance subsidiary net income (loss) -- -- (12,586) -------------------------------------------------------------------------------- Net income as reported herein $ 5,818,131 $ 8,836,780 $ 6,795,197 ================================================================================ December 31, ------------------------------------------ 2001 2000 1999 -------------------------------------------------------------------------------- Statutory capital and surplus of Insurance Subsidiaries $122,380,119 $120,489,453 $111,881,431 Increases (decreases): Deferred policy acquisition costs 13,604,215 12,284,214 11,445,572 Deferred federal income taxes (820,313) 7,690,886 9,221,874 Salvage and subrogation recoverable 8,197,948 8,042,860 7,736,942 Statutory reserves -- 2,623,921 5,154,062 Non-admitted assets and other adjustments, net 334,092 911,370 942,170 Fixed maturities 3,793,048 493,055 (2,968,655) Consolidating eliminations and adjustments (39,693,089) (40,973,097) (41,072,150) Parent-only equity 13,132,329 2,566,929 1,451,088 -------------------------------------------------------------------------------- Stockholders' equity as reported herein $120,928,349 $114,129,591 $103,792,334 ================================================================================ 14--SUPPLEMENTARY INFORMATION ON STATEMENT OF CASH FLOWS The following reflects income taxes and interest paid during 2001, 2000 and 1999: 2001 2000 1999 -------------------------------------------------------------------------------- Income taxes $2,666,887 $2,031,652 $1,221,375 ================================================================================ Interest $3,049,844 $2,731,048 $1,370,155 ================================================================================ During 1999, the Company wrote off fixed assets with a net carrying value of $407,000 which was a non-cash charge to earnings. 15--EARNINGS PER SHARE The following information illustrates the computation of net income, outstanding shares and earnings per share on both a basic and diluted basis for the years ending December 31, 2001, 2000 and 1999: Weighted- Average Earnings Net Shares Per Income Outstanding Share -------------------------------------------------------------------------------- 2001: Basic $5,818,131 8,941,781 .65 Effect of stock options -- 136,669 (.01) -------------------------------------------------------------------------------- Diluted $5,818,131 9,078,450 .64 ================================================================================ 2000: Basic $8,836,780 8,715,899 $1.01 Effect of stock options -- 21,011 -- -------------------------------------------------------------------------------- Diluted $8,836,780 8,736,910 $1.01 ================================================================================ 1999: Basic $6,795,197 8,327,356 $ .82 Effect of stock options -- -- -- -------------------------------------------------------------------------------- Diluted $6,795,197 8,327,356 $ .82 ================================================================================ The following options to purchase shares of common stock were not included in the computation of diluted earnings per share because the exercise price of the options was greater than the average market price: 2001 2000 1999 -------------------------------------------------------------------------------- Options excluded from diluted earnings per share 1,467,282 1,045,338 1,496,393 ================================================================================ 28 16--CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY CONDENSED BALANCE SHEETS ($ in thousands) December 31, 2001 2000 -------------------------------------------------------------------------------- ASSETS Investment in subsidiaries (equity method) $152,089 $155,600 Cash 403 2,381 Property and equipment 1,623 1,997 Other 264 715 -------------------------------------------------------------------------------- Total assets $154,379 $160,693 ================================================================================ LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Cash dividends declared to stockholders $ 870 $ 797 Line of credit 27,600 40,000 Due to affiliate 4,441 4,441 Other 540 1,325 -------------------------------------------------------------------------------- Total liabilities 33,451 46,563 -------------------------------------------------------------------------------- Stockholders' equity 120,928 114,130 -------------------------------------------------------------------------------- Total liabilities and stockholders' equity $154,379 $160,693 ================================================================================ CONDENSED STATEMENTS OF INCOME ($ in thousands) Year Ended December 31, 2001 2000 1999 -------------------------------------------------------------------------------- Revenues Dividends-subsidiaries $14,419 $3,900 $ 820 Other 824 866 865 -------------------------------------------------------------------------------- Total revenues 15,243 4,766 1,685 -------------------------------------------------------------------------------- Expenses Operating expenses 1,761 1,165 938 Interest 2,288 3,304 2,463 -------------------------------------------------------------------------------- Total expenses 4,049 4,469 3,401 -------------------------------------------------------------------------------- Income (loss) before income tax benefit and equity in undistributed net income of subsidiaries 11,194 297 (1,716) Income tax benefit (1,067) (1,226) (807) -------------------------------------------------------------------------------- Income (loss) before equity in undistributed net income (loss) of subsidiaries 12,261 1,523 (909) Equity in undistributed net income (loss) of subsidiaries (6,443) 7,314 7,704 -------------------------------------------------------------------------------- Net income $ 5,818 $8,837 $6,795 ================================================================================ CONDENSED STATEMENTS OF CASH FLOWS ($ in thousands) Year Ended December 31, 2001 2000 1999 -------------------------------------------------------------------------------- Cash flows from operating activities: Net income $ 5,818 $ 8,837 $ 6,795 -------------------------------------------------------------------------------- Adjustments: Equity in undistributed net loss (income) of subsidiaries 6,443 (7,314) (7,704) Other 252 1,123 2,365 -------------------------------------------------------------------------------- Net adjustments 6,695 (6,191) (5,339) -------------------------------------------------------------------------------- Net cash provided 12,513 2,646 1,456 -------------------------------------------------------------------------------- Cash flows from investing activities: Net purchase of property and equipment (122) (262) (426) Sale of AIS -- -- 100 Investment in Donegal Financial Services Corp. -- (3,042) -- Other 38 38 (426) -------------------------------------------------------------------------------- Net cash used (84) (3,266) (752) -------------------------------------------------------------------------------- Cash flows from financing activities: Cash dividends paid (3,394) (3,127) (2,946) Issuance of common stock 1,387 2,757 2,514 Line of credit, net (12,400) 3,000 (500) -------------------------------------------------------------------------------- Net cash provided (used) (14,407) 2,630 (932) -------------------------------------------------------------------------------- Net change in cash (1,978) 2,010 (228) Cash at beginning of year 2,381 371 599 -------------------------------------------------------------------------------- Cash at end of year $ 403 $ 2,381 $ 371 ================================================================================ 29 17--SEGMENT INFORMATION As an underwriter of property and casualty insurance, the Company has three reportable segments which consist of the investment function, the personal lines of insurance and the commercial lines of insurance. Using independent agents, the Company markets personal lines of insurance to individuals and commercial lines of insurance to small and medium-sized businesses. The Company evaluates the performance of the personal lines and commercial lines primarily based upon underwriting results as determined under statutory accounting practices (SAP) for the total business of the Company. Assets are not allocated to the personal and commercial lines and are reviewed in total by management for purposes of decision making. Donegal Group Inc. operates only in the United States and no single customer or agent provides 10 percent or more of revenues. Financial data by segment is as follows: 2001 2000 1999 ------------------------------------- ($ in thousands) -------------------------------------------------------------------------------- Revenues: Premiums earned: Commercial lines $ 62,877 $ 54,581 $ 47,804 Personal lines 104,893 97,065 97,713 -------------------------------------------------------------------------------- Total premiums earned 167,770 151,646 145,517 -------------------------------------------------------------------------------- Net investment income 15,886 16,395 13,591 Realized investment gains (losses) (880) 171 (39) Other 2,388 2,370 2,670 -------------------------------------------------------------------------------- Total revenues $185,164 $170,582 $161,739 ================================================================================ Income before income taxes: Underwriting income (loss): Commercial lines $ (3,037) $ 763 $ (839) Personal lines (5,090) (4,649) (8,461) -------------------------------------------------------------------------------- SAP underwriting loss (8,127) (3,886) (9,300) GAAP adjustments 1,833 1,144 (184) -------------------------------------------------------------------------------- GAAP underwriting loss (6,294) (2,742) (9,484) Net investment income 15,886 16,395 13,591 Realized investment gains (losses) (880) 171 (39) Other (1,620) (2,081) (223) -------------------------------------------------------------------------------- Income before income taxes $ 7,092 $ 11,743 $ 3,845 ================================================================================ 18--RESTRUCTURING CHARGE On September 29, 1999, the Company announced a plan to consolidate certain subsidiary support functions into its Marietta, Pennsylvania office. As a result of this consolidation, the Company recorded a restructuring charge of $2,206,000 in 1999 for employee termination benefits, occupancy charges, lease cancellation costs, and asset impairments. The charge was included in other underwriting expenses. The consolidation was completed by the end of the first quarter of 2000. Employee termination benefits of $782,000 included severance payments, which were paid in a lump sum or over a defined period, and related benefits for approximately 60 employees. Of the terminated employees, approximately 50% were from subsidiary support functions and approximately 50% were from the Marietta, Pennsylvania office. By December 31, 1999, all of the terminated employees had left the employment of the Company. Included in occupancy charges of $488,000 were future lease obligations, less anticipated sublease benefits, for leased space which is no longer used by the Delaware and Southern Heritage subsidiary support functions. Also included in the restructuring charge was $529,000 related to contract cancellation costs that represented the estimated cost to buy out of the remaining term on printer, copier, and computer processing contracts that provided no future benefit to the Company as a result of the restructuring. All such assets have been taken out of service. Asset impairments, which were a direct result of the consolidation of subsidiary functions, amounted to $407,000. They consisted of capitalized programming and data center costs, voice systems, and leasehold and office improvements. These assets were written-down to zero. All such assets have been taken out of service. Activity in the restructuring accrual is as follows: Employee Termination Contract Benefits Occupancy Cancellations Total -------------------------------------------------------------------------------- Restructuring charge $ 782,000 $ 488,000 $ 529,000 $1,799,000 Cash payments (343,000) (47,000) (365,000) (755,000) Reversal of prior accrual (71,000) -- (91,000) (162,000) -------------------------------------------------------------------------------- Balance at December 31, 1999 $ 368,000 $ 441,000 $ 73,000 $ 882,000 -------------------------------------------------------------------------------- Cash payments (339,000) (155,000) (73,000) (567,000) Accrual adjustment -- 12,000 -- 12,000 -------------------------------------------------------------------------------- Balance at December 31, 2000 $ 29,000 $ 298,000 $ -- $ 327,000 Cash payments (10,000) (91,000) -- (101,000) -------------------------------------------------------------------------------- Balance at December 31, 2001 $ 19,000 $ 207,000 $ -- $ 226,000 ================================================================================ Based on revised estimates, $162,000 of the restructuring accrual was reversed by a reduction to the restructuring charge in other underwriting expenses in the fourth quarter of 1999. Employee termination benefits and contract cancellation costs were lower than original estimates. 19--GUARANTY FUND AND OTHER INSURANCE-RELATED ASSESSMENTS The Company accrues for guaranty-fund and other insurance-related assessments in accordance with Statement of Position (SOP) 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments." SOP 97-3 provides guidance for determining when an entity should recognize a liability for guaranty-fund and other insurance-related assessments, how to measure that liability, and when an asset may be recognized for the recovery of such assessments through premium tax offsets or policy surcharges. The Company's liabilities for guaranty-fund and other insurance-related assessments were $3,605,090 and $880,154 at December 31, 2001 and 2000, respectively. These liabilities included $676,149 and $397,832 related to surcharges collected by the Company on behalf of regulatory authorities for 2001 and 2000, respectively. 30 20--INTERIM FINANCIAL DATA (UNAUDITED) 2001 ------------------------------------------------------ First Second Third Fourth Quarter Quarter Quarter Quarter -------------------------------------------------------------------------------- Net premiums earned $40,040,902 $41,651,990 $ 42,598,703 $43,478,259 Total revenues 44,792,026 46,496,969 46,365,986 47,508,642 Net losses and loss expenses 26,158,684 27,931,189 30,026,448 34,061,228 Net income (loss) 2,954,595 2,697,269 1,023,422 (857,155) Net income (loss) per common share Basic .33 .30 .11 (.10) Diluted .33 .30 .11 (.10) 2000 ------------------------------------------------------ First Second Third Fourth Quarter Quarter Quarter Quarter -------------------------------------------------------------------------------- Net premiums earned $36,088,698 $36,447,134 $39,149,006 $39,961,361 Total revenues 40,357,333 41,333,363 44,229,060 44,661,831 Net losses and loss expenses 25,948,912 24,823,941 26,795,640 26,814,683 Net income 1,162,682 2,502,499 2,566,975 2,604,624 Net income per common share Basic $.14 $.29 $.29 $.29 Diluted .14 .29 .29 .29 -------------------------------------------------------------------------------- INDEPENDENT AUDITORS' REPORT The Stockholders and Board of Directors Donegal Group Inc. We have audited the accompanying consolidated balance sheets of Donegal Group Inc. and subsidiaries as of December 31, 2001 and 2000, and the related consolidated statements of income and comprehensive income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 2001. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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 financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Donegal Group Inc. and subsidiaries as of December 31, 2001 and 2000, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2001 in conformity with accounting principles generally accepted in the United States of America. KPMG LLP Philadelphia, Pennsylvania February 21, 2002 31 CORPORATE INFORMATION ANNUAL MEETING April 18, 2002 at the Company's headquarters at 10:00 a.m. FORM 10-K A copy of Donegal Group's Annual Report on Form 10-K will be furnished free upon written request to Ralph G. Spontak, Senior Vice President and Chief Financial Officer, at the corporate address. MARKET INFORMATION Donegal Group's Class A common stock and Class B common stock are traded on the Nasdaq National Market under the symbols "DGICA" and "DGICB." The Class A common stock and Class B common stock have traded on the Nasdaq National Market since April 20, 2001. All information given prior to that date relates to the Company's Common Stock, which previously traded on the Nasdaq National Market under the symbol "DGIC." The following table shows the dividends paid per share and the stock price range for each quarter during 2001 and 2000: CASH DIVIDEND DECLARED QUARTER HIGH LOW PER SHARE 2000 1st 8.625 5.750 -- 2nd 8.250 5.750 .09 3rd 8.000 5.750 .09 4th 13.938 7.125 .18 2001 - CLASS A 1st 12.750 8.688 -- 2nd 14.500 10.000 .10 3rd 14.590 12.170 .10 4th 13.880 9.100 .20 2001 - CLASS B 1st 12.750 8.688 -- 2nd 12.500 8.750 .09 3rd 13.100 11.010 .09 4th 11.750 9.000 .18 CORPORATE OFFICES 1195 River Road P.O. Box 302 Marietta, Pennsylvania 17547-0302 (717) 426-1931 E-mail Address: info@donegalgroup.com Donegal Web Site: www.donegalgroup.com TRANSFER AGENT EquiServe Trust Company, N.A. P.O. Box 2500 Jersey City, New Jersey 07303-2500 (800) 317-4445 Web Site: www.equiserve.com Hearing Impaired: TDD: 201-222-4955 DIVIDEND REINVESTMENT PLAN The Company offers a dividend reinvestment plan through its transfer agent. For information contact: Donegal Group Inc. Dividend Reinvestment Plan EquiServe Trust Company, N.A. P.O. Box 2500 Jersey City, New Jersey 07303-2500 STOCKHOLDERS The following represent the number of common stockholders of record as of December 31, 2001: Class A common stock 586 Class B common stock 532 32