EX-99.13 5 ex-13.txt FINANCIAL INFORMATION Management's Discussion and Analysis of Results of Operations and Financial Condition ................ 10 Consolidated Balance Sheets .......................................................................... 14 Consolidated Statements of Income and Comprehensive Income ........................................... 15 Consolidated Statements of Stockholders' Equity ...................................................... 16 Consolidated Statements of Cash Flows ................................................................ 17 Notes to Consolidated Financial Statements ........................................................... 18 Independent Auditors' Report ......................................................................... 29 Corporate Information ................................................................................ 30
page 9 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION OVERVIEW Donegal Group Inc. ("DGI" or the "Company") is a regional insurance holding company doing business in the Mid-Atlantic and Southern states through its two wholly owned property-casualty insurance subsidiaries, Atlantic States Insurance Company ("Atlantic States") and Southern Insurance Company of Virginia ("Southern") (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 64% of the outstanding common shares of the Company as of December 31, 2002. Atlantic States participates in an intercompany pooling arrangement with the Mutual Company and assumes 70% of the pooled business. As of January 1, 2002, the Company's results of operations include 100% of the business written by Southern. Prior to January 1, 2002, Southern ceded 50% of its business to the Mutual Company. Because the Mutual Company placed 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 included approximately 85% of the business written by Southern prior to January 1, 2002. During 2000, the Company acquired 45% of the outstanding stock of Donegal Financial Services Corporation ("DFSC"), a thrift holding company. The remaining 55% of the outstanding stock of DFSC is owned by the Mutual Company. On January 1, 2001, the Company purchased all of the outstanding stock of Pioneer Insurance Company of New York ("Pioneer-New York") from the Mutual Company. 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 bore a 6% rate and was due in January 2002. The 6% rate was based upon commercial market rates in effect as of January 1, 2001. The date was subsequently extended to January 2004, and the rate adjusted to 5.5%, based upon commercial market rates in effect as of January 1, 2003. Southern Heritage Insurance Company ("Southern Heritage"), previously a wholly owned subsidiary, was merged into Southern on May 1, 2002. Pioneer Insurance Company of Ohio ("Pioneer-Ohio") and Delaware Atlantic Insurance Company ("Delaware"), previously wholly owned subsidiaries, and Pioneer-New York were merged into Atlantic States on May 1, 2002, 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, catastrophe reinsurance agreements with each of the Insurance Subsidiaries, an excess of loss reinsurance agreement with Southern, and, prior to January 1, 2002, a 50% quota share contract with Southern. The Mutual Company also has a 100% retrocessional agreement with Southern. A Coordinating Committee exists that is comprised of two board members of the Company and two board members of the Mutual Company who do not serve on the other board. All agreements and all changes to existing agreements between the Company's subsidiaries and the Mutual Company are subject to approval by the Coordinating Committee. In order to approve an agreement or a change in an agreement, the Company's members on the Coordinating Committee must conclude that the agreement or change is fair to the Company and its stockholders, and the Mutual Company's members on the Committee must conclude that the agreement or change is fair to the Mutual Company and its policyholders. 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 among the participants based on their relative amounts of surplus and relative access to capital. 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 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 surplus position. The retention levels of these contracts are less than the retention levels included within reinsurance contracts with outside reinsurers, where the retention levels are appropriate for the insurance companies taken as a whole but would be too great a level of risk for an individual company within the group. page 10 Prior to January 1, 2002, the 50% quota share reinsurance contract between Southern and the Mutual Company provided additional capacity for direct premium growth to Southern during periods of growth that exceeded Southern's ability to support that growth through its own surplus. Premiums, losses and loss expenses were shared equally by the participants with the Mutual Company paying commissions to Southern to reimburse its costs related to the underwriting process. The 100% retrocessional contract is intended to provide Southern with the same A.M. Best rating (currently "A") as the Mutual Company, which Southern could not achieve without this contract 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 $28,586,888, $29,298,569 and $26,985,080 for 2002, 2001 and 2000, respectively. CRITICAL ACCOUNTING POLICIES The Company's financial statements are combined with those of the Insurance Subsidiaries and presented on a consolidated basis in accordance with U.S. generally accepted accounting principles. 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 accounting policies are the most significant 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 claims incurred but not reported to the Company are established based on historical data by line of insurance as adjusted for current conditions. Significant components of estimates used to establish reserves for both reported claims and unreported claims include a variety of factors such as medical cost inflation trends, regulatory and judicial rulings, legal settlements, property replacement and repair cost trends, the propensity of policyholders to litigate and the willingness of courts to expand causes of loss and the size of awards. In recent years, certain of these component costs such as medical inflation trends and legal settlements have experienced significant volatility that contribute to incurred amounts higher than our original estimates. The Company continually reviews and analyzes these trends and factors them into its loss estimates. The Company believes its estimates are appropriate but the ultimate amounts may differ from the estimates provided. INVESTMENTS The Company regularly monitors estimates related to the valuation of its investment portfolio and the recognition of other than temporary declines in the value of those investments. All investments are individually monitored for other than temporary declines. When a decline in value of an individual investment is considered to be other than temporary, the investment is written down to its estimated net realizable value and reflected as a realized loss in the statement of income. The Company makes judgments about when there are other than temporary declines in its investments. Generally, if an individual equity security has depreciated in value by more than 20% from its cost basis and has been in such unrealized loss position for more than six months, or if it is likely that contractual payments will not be received on debt securities, the Company assumes there has been an other than temporary decline in value. In addition, the Company may write-down other securities in an unrealized loss position depending on the existence of certain other factors such as the significance of the decline in fair value to the cost basis, deterioration in financial condition of the issuer, downgrades in the ratings of securities or specific industry events. POLICY ACQUISITION COSTS Policy acquisition costs, consisting primarily of commissions, premium taxes and certain other underwriting costs that vary with and are directly related to the production of business, are deferred and amortized over the period in which the premiums are earned. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, losses and loss expenses, and certain other costs expected to be incurred as the premium is earned. RESULTS OF OPERATIONS 2002 COMPARED TO 2001 Total revenues for 2002 were $203,803,561, which were $18,639,938, or 10.1%, greater than 2001. Net premiums earned increased to $185,841,193, an increase of $18,071,339, or 10.8%, over 2001. Direct premiums written of the combined pool of Atlantic States and the Mutual Company increased $22,510,292 or 11.0%. A 3.3% increase in the direct premiums written of Southern accounted for the majority of the remaining change. The Company reported net realized investment gains of $144,190 in 2002 compared to net realized investment losses of $880,254 in 2001. During 2002 and 2001, certain investments trading below cost had declined on an other-than-temporary basis. Losses of $378,672 and $1,462,913 were included in net realized investment gains (losses) for these investments in 2002 and 2001, respectively. The remaining realized gains and losses in both years resulted from normal turnover of the Company's investment portfolio. As of December 31, 2002, 93.3% 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 $1,304,292 in 2002 compared to 2001. In 2002, an increase in average invested assets from $294,988,999 to $316,466,225 was more than offset by a decrease in the average yield to 4.6% in 2002 from 5.3% in 2001. page 11 The GAAP combined ratio of the Insurance Subsidiaries was 99.6% in 2002, compared to 103.8% in 2001. 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 2002 was 69.6% compared to 70.5% in 2001. The commercial lines loss ratio decreased significantly to 61.5% in 2002 compared to 72.7% in 2001. The personal lines loss ratio increased from 69.2% in 2001 to 73.3% in 2002. The commercial automobile and workers' compensation loss ratios showed considerable improvement in 2002 with the commercial automobile loss ratio decreasing to 61.6% in 2002 compared to 85.0% in 2001 and the workers' compensation loss ratio decreasing to 73.1% in 2002 compared to 82.5% in 2001. Net losses and loss expenses for 2002 and 2001 included adverse development of prior accident year losses amounting to $6.8 million and $8.0 million, respectively. In 2001, the adverse loss development was primarily in commercial lines of business with workers' compensation representing $3.2 million, commercial auto liability $1.7 million and commercial multi-peril $1.3 million of the total loss development. Included in those amounts were $4.2 million of reserve strengthening primarily in the workers' compensation and commercial auto lines of business. In 2002, the adverse loss developments in commercial lines were lower with workers' compensation representing $1.6 million, commercial multi- peril $1.4 million and commercial auto liability $0.1 million of the total loss development. Private passenger auto liability's loss development worsened in 2002, representing $2.2 million of the development in 2002 compared to $1.3 million in 2001, with auto physical damage representing approximately $1 million in 2002 compared to $0.2 million in 2001. The loss development in 2002 resulted principally from accident year 2001 claims and resulted primarily from the normal claims review process and not from any change in key assumptions or changes in reserving philosophy. The expense ratio for 2002 was 29.5% compared to 32.3% in 2001, primarily due to the Company's cost reduction program, with the dividend ratio decreasing slightly to 0.6% in 2002 compared to 1.0% in 2001. The expense ratio in 2001 included a guaranty fund assessment of approximately $543,000 resulting from the insolvency of Reliance Insurance Company. This assessment also contributed to the change in the expense ratio from 2001 to 2002. Income tax expense was $4,491,862, an effective rate of 27.2%, compared to $1,273,598, or an effective rate of 18.0% in 2001. Tax exempt interest represented a smaller proportion of net income before taxes in 2002 compared to 2001, and accounted for most of this difference. 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 in 2001. Direct premiums written of the combined pool of Atlantic States and the Mutual Company increased $23,152,222 or 13.2% in 2001. 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 compared to 2000. An increase in the average invested assets from $278,677,748 to $294,988,999 was more than offset by a decrease in the average yield to 5.3% from 5.9% in 2000, and accounted for the change. The GAAP combined ratio of the Insurance Subsidiaries 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. 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. Net losses and loss expenses for 2001 included adverse loss development of prior accident year losses amounting to $8.0 million compared to $0.7 million in 2000. In 2001, the loss development was primarily in commercial lines of business with workers' compensation representing $3.2 million, commercial auto liability $1.7 million and commercial multi-peril $1.3 million of the total loss development. Those amounts included $4.2 million of reserve strengthening primarily in workers' compensation and commercial auto lines of business and due primarily to severity. 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 in 2001 compared to 2000. Income tax expense was $1,273,598 for 2001, an effective rate of 18.0%, compared to $2,906,248, or an effective rate of 24.7% in 2000. Tax exempt interest represented a larger proportion of net income before taxes in 2001 compared to 2000, and accounted for most of this difference. page 12 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, 2002, the Company had no material commitments 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, 2002, 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 $19.8 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, 2002, the Company may borrow up to $24 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, 2002, the interest rates were 3.45% on an outstanding Eurodollar rate balance of $4.8 million and 3.46% on another Eurodollar rate balance of $15 million. In addition, the Company pays a fee 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, is then 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 that may further impact their ability to pay dividends. At December 31, 2002, the Insurance Subsidiaries' 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 2003 are $10,646,804 from Atlantic States and $2,493,398, from Southern. Net unrealized gains resulting from fluctuations in the fair value of investments reported in the balance sheet at fair value (net of applicable federal income tax) were $4,911,953 and $2,861,765 at December 31, 2002, and 2001, respectively. 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 major authorized reinsurers, as described in Note 8 of the financial statements. The Company monitors the financial strength of its unaffiliated reinsurers, requiring that companies rated by A.M. Best Company maintain a rating of A- or higher and that foreign reinsurers not rated by A.M. Best Company maintain a level of financial strength equivalent to companies qualifying for an A.M. Best Company rating of A- or higher. 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. 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, 2002 are as follows: PRINCIPAL WEIGHTED-AVERAGE CASH FLOWS INTEREST RATE ------------------------------------------------------------------------- Fixed maturities and short-term investments: 2003 $ 46,729,420 2.85% 2004 15,700,000 5.81% 2005 30,250,156 5.27% 2006 37,872,512 5.63% 2007 36,687,380 5.49% Thereafter 132,547,410 5.37% ------------------------------------------------------------------------- Total $299,786,878 ========================================================================= Market value $313,546,396 ========================================================================= Debt 2003 $ 3,800,000 3.46% 2004 8,000,000 3.46% 2005 8,000,000 3.46% ------------------------------------------------------------------------- Total $ 19,800,000 ========================================================================= Fair value $ 19,800,000 ========================================================================= Actual cash flows from investments may differ from those stated as a result of calls and prepayments. EQUITY PRICE RISK The combined total of realized and unrealized equity investment losses were $515,320, $131,146, and $650,229 in 2002, 2001, and 2000, respectively. During these three years, the largest total equity investment gain and (loss) in a quarter was $829,914 and $(440,947), respectively. page 13 Donegal Group Inc. CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2002 2001 --------------------------------------------------------------------------------------------------------------------------- ASSETS Investments Fixed maturities Held to maturity, at amortized cost (fair value $89,785,318 and $86,939,393) $ 86,701,556 $ 85,322,965 Available for sale, at fair value (amortized cost $187,495,949 and $170,269,584) 194,731,660 173,718,844 Equity securities, available for sale, at fair value (cost $21,587,317 and $16,630,618) 21,836,460 17,517,346 Short-term investments, at cost, which approximates fair value 29,029,418 24,074,200 --------------------------------------------------------------------------------------------------------------------------- Total investments 332,299,094 300,633,355 Cash 1,124,604 4,075,288 Accrued investment income 3,815,449 3,765,076 Premiums receivable 26,286,482 24,143,531 Reinsurance receivable 83,207,272 67,853,174 Deferred policy acquisition costs 14,567,070 13,604,215 Federal income taxes receivable -- 292,618 Deferred tax asset, net 6,955,707 7,474,730 Prepaid reinsurance premiums 27,853,996 29,593,467 Property and equipment, net 4,430,394 4,568,652 Accounts receivable--securities 146,507 50,023 Other 531,589 578,243 --------------------------------------------------------------------------------------------------------------------------- Total assets $ 501,218,164 $ 456,632,372 =========================================================================================================================== LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Losses and loss expenses $ 210,691,752 $ 179,839,905 Unearned premiums 121,002,447 114,079,264 Accrued expenses 6,583,825 7,186,107 Reinsurance balances payable 1,100,443 839,156 Federal income taxes payable 357,547 -- Cash dividend declared to stockholders 887,315 869,877 Borrowings under line of credit 19,800,000 27,600,000 Accounts payable--securities 2,121,619 -- Due to affiliate 4,080,415 4,015,074 Other 1,409,951 1,274,640 --------------------------------------------------------------------------------------------------------------------------- Total liabilities 368,035,314 335,704,023 --------------------------------------------------------------------------------------------------------------------------- Stockholders' Equity Preferred stock, $1.00 par value, authorized 2,000,000 shares; none issued -- -- Class A common stock, $.01 par value, authorized 30,000,000 shares, issued 6,269,093 and 6,097,214 shares and outstanding 6,187,569 and 6,015,690 shares 62,691 60,972 Class B common stock, $.01 par value, authorized 10,000,000 shares, issued 3,024,742 and 3,021,965 shares and outstanding 2,983,980 and 2,981,203 shares 30,247 30,220 Additional paid-in capital 60,651,751 58,887,715 Accumulated other comprehensive income 4,911,953 2,861,765 Retained earnings 68,417,956 59,979,425 Treasury stock, at cost (891,748) (891,748) --------------------------------------------------------------------------------------------------------------------------- Total stockholders' equity 133,182,850 120,928,349 --------------------------------------------------------------------------------------------------------------------------- Total liabilities and stockholders' equity $ 501,218,164 $ 456,632,372 ===========================================================================================================================
See accompanying notes to consolidated financial statements. page 14 Donegal Group Inc. CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
YEAR ENDED DECEMBER 31, 2002 2001 2000 ------------------------------------------------------------------------------------------------------------------------ STATEMENTS OF INCOME Revenues Net premiums earned (includes affiliated reinsurance of $86,195,962, $71,989,136 and $63,989,424) $ 185,841,193 $ 167,769,854 $ 151,646,199 Investment income, net of investment expenses 14,581,252 15,885,544 16,394,747 Installment payment fees 2,447,229 1,587,396 1,532,792 Lease income 789,697 801,083 836,997 Net realized investment gains (losses) 144,190 (880,254) 170,852 ------------------------------------------------------------------------------------------------------------------------ Total revenues 203,803,561 185,163,623 170,581,587 ------------------------------------------------------------------------------------------------------------------------ Expenses Net losses and loss expenses (includes affiliated reinsurance of $54,684,955, $50,283,481 and $36,767,436) 129,267,686 118,177,549 104,383,176 Amortization of deferred policy acquisition costs 29,473,000 27,194,000 25,319,000 Other underwriting expenses 25,331,777 27,000,485 23,355,781 Policy dividends 1,056,790 1,691,759 1,330,330 Interest 1,119,204 2,247,465 3,285,036 Other 1,060,520 1,760,636 1,165,236 ------------------------------------------------------------------------------------------------------------------------ Total expenses 187,308,977 178,071,894 158,838,559 ------------------------------------------------------------------------------------------------------------------------ Income before income tax expense 16,494,584 7,091,729 11,743,028 Income tax expense 4,491,862 1,273,598 2,906,248 ------------------------------------------------------------------------------------------------------------------------ Net income $ 12,002,722 $ 5,818,131 $ 8,836,780 ======================================================================================================================== Net income per common share Basic $ 1.32 $ .65 $ 1.01 ======================================================================================================================== Diluted $ 1.31 $ .64 $ 1.01 ======================================================================================================================== STATEMENTS OF COMPREHENSIVE INCOME Net income $ 12,002,722 $ 5,818,131 $ 8,836,780 ------------------------------------------------------------------------------------------------------------------------ Other comprehensive income, net of tax Unrealized gains on securities: Unrealized holding gain arising during the period, net of income tax expense of $1,148,224, $1,277,504, and $1,057,179 2,144,813 2,479,860 2,020,267 Reclassification adjustment for (gains) losses included in net income, net of income tax expense (benefit) of $49,565, $(299,286), and $58,090 (94,625) 580,968 (112,762) ------------------------------------------------------------------------------------------------------------------------ Other comprehensive income 2,050,188 3,060,828 1,907,505 ------------------------------------------------------------------------------------------------------------------------ Comprehensive income $ 14,052,910 $ 8,878,959 $ 10,744,285 ========================================================================================================================
See accompanying notes to consolidated financial statements. page 15 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, 2000 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 -------------------------------------------------------------------------------------------------- Issuance of common stock 166,972 1,670 Net income Cash dividends Exercise of stock options 4,907 2,777 49 27 Grant of stock options Other comprehensive income -------------------------------------------------------------------------------------------------- Balance, December 31, 2002 -- 6,269,093 3,024,742 -- $ 62,691 $ 30,247 ================================================================================================== ACCUMULATED ADDITIONAL OTHER TOTAL PAID-IN COMPREHENSIVE RETAINED TREASURY STOCKHOLDERS' CAPITAL INCOME (LOSS) EARNINGS STOCK EQUITY ------------------------------------------------------------------------------------------------ Balance, January 1, 2000 $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 ------------------------------------------------------------------------------------------------ Issuance of common stock 1,641,547 1,643,217 Net income 12,002,722 12,002,722 Cash dividends (3,526,157) (3,526,157) Exercise of stock options 84,455 84,531 Grant of stock options 38,034 (38,034) -- Other comprehensive income 2,050,188 2,050,188 ------------------------------------------------------------------------------------------------ Balance, December 31, 2002 $60,651,751 $4,911,953 $68,417,956 $(891,748) $133,182,850 ================================================================================================
See accompanying notes to consolidated financial statements. page 16 Donegal Group Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31, 2002 2001 2000 -------------------------------------------------------------------------------------------------------- Cash Flows from Operating Activities: Net income $ 12,002,722 $ 5,818,131 $ 8,836,780 -------------------------------------------------------------------------------------------------------- Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 1,236,592 1,127,510 982,926 Realized investment (gains) losses (144,190) 880,254 (170,852) Changes in Assets and Liabilities: Losses and loss expenses 30,851,847 23,363,781 12,296,118 Unearned premiums 6,923,183 14,138,883 7,788,243 Accrued expenses (602,282) 1,308,632 (165,997) Premiums receivable (2,142,951) (2,385,029) (3,296,815) Deferred policy acquisition costs (962,855) (1,320,001) (316,463) Deferred income taxes (579,654) (1,360,633) 499,976 Reinsurance receivable (15,354,098) (13,309,290) (8,970,330) Accrued investment income (50,373) 237,388 (455,059) Amounts due to/from affiliate 65,341 (513,922) 350,639 Reinsurance balances payable 261,287 (795,819) 262,686 Prepaid reinsurance premiums 1,739,471 (4,881,083) (3,156,232) Current income taxes 650,165 (32,656) 374,620 Change in pooling participation -- -- 3,322,031 Other, net 181,965 (271,364) 268,316 -------------------------------------------------------------------------------------------------------- Net adjustments 22,073,448 16,186,651 9,613,807 -------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 34,076,170 22,004,782 18,450,587 -------------------------------------------------------------------------------------------------------- Cash Flows from Investing Activities: Purchase of fixed maturities Held to maturity (35,867,577) (45,201,470) (17,340,175) Available for sale (75,783,783) (71,700,918) (30,355,507) Purchase of equity securities (18,325,041) (12,440,994) (28,286,533) Sale of fixed maturities Held to maturity 415,000 -- -- Available for sale 461,965 16,250,109 8,719,165 Maturity of fixed maturities Held to maturity 34,967,828 51,313,296 13,490,715 Available for sale 58,798,825 50,781,533 11,928,622 Sale of equity securities 13,394,123 7,089,532 24,572,288 Net purchase of property and equipment (552,005) (161,269) (275,982) Net sales (purchases) of short-term investments (4,955,218) (4,634,695) (2,850,343) -------------------------------------------------------------------------------------------------------- Net cash used in investing activities (27,445,883) (8,704,876) (20,397,750) -------------------------------------------------------------------------------------------------------- Cash Flows from Financing Activities: Issuance of common stock 1,727,748 1,386,746 2,756,540 Borrowings (payments) under line of credit, net (7,800,000) (12,400,000) 3,000,000 Cash dividends paid (3,508,719) (3,394,352) (3,126,959) -------------------------------------------------------------------------------------------------------- Net cash provided by (used in) financing activities (9,580,971) (14,407,606) 2,629,581 -------------------------------------------------------------------------------------------------------- Net increase (decrease) in cash (2,950,684) (1,107,700) 682,418 Cash at beginning of year 4,075,288 5,182,988 4,500,570 -------------------------------------------------------------------------------------------------------- Cash at end of year $ 1,124,604 $ 4,075,288 $ 5,182,988 ========================================================================================================
See accompanying notes to consolidated financial statements. page 17 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND BUSINESS Donegal Group Inc. ("DGI" or 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") and Southern Insurance Company of Virginia ("Southern") (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. Prior to January 1, 2002, Southern ceded 50% of its business to the Mutual Company. At December 31, 2002, the Mutual Company held 64% of the outstanding common stock of the Company. 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 1, 2001, the Company purchased all of the outstanding stock of Pioneer Insurance Company of New York ("Pioneer-New York") from the Mutual Company. The purchase price was $4,441,311, representing Pioneer-New York's adjusted statutory equity at December 31, 2000. The acquisition was accounted for as a reorganization of entities under common control, similar to a pooling of interests, as both Pioneer-New York and the Company were under the common management and control of the Mutual Company. As such, the Company's financial statements were 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 5.5% rate and is due in January 2004. The Company classifies this note in Due to Affiliate. Pioneer Insurance Company of Ohio ("Pioneer-Ohio"), Delaware Atlantic Insurance Company ("Delaware") and Pioneer-New York, previously wholly owned subsidiaries, were merged into Atlantic States on May 1, 2002, August 1, 2001 and September 30, 2001, respectively. Southern Heritage Insurance Company, previously a wholly owned subsidiary, was merged into Southern on May 1, 2002. 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 DGI 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. 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. page 18 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. 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. page 19 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 grants prior to that date 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: 2002 2001 2000 ------------------------------------------------------------------------ Net income: As reported $12,002,722 $ 5,818,131 $ 8,836,780 Pro-forma 11,767,787 5,617,773 8,071,825 Basic earnings per share: As reported 1.32 .65 1.01 Pro-forma 1.30 .63 .92 Diluted earnings per share: As reported 1.31 .64 1.01 Pro-forma 1.28 .62 .92 The weighted-average grant date fair value of options granted for the various plans during 2000 was $2.23. 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 an expected dividend yield of 4.5% for 2000. 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. 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 (prior to January 1, 2002) 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 $45,229,457, $37,345,259 and $30,414,395 and ceded losses and loss expenses incurred of $34,471,381, $29,094,804 and $22,966,106 under this arrangement during 2002, 2001 and 2000, respectively. It also assumed premiums earned of $134,236,778, $126,769,521 and $110,943,962 and assumed losses and loss expenses incurred of $96,517,930, $93,470,958 and $75,007,089 under this arrangement during 2002, 2001 and 2000, respectively. Atlantic States had prepaid reinsurance premiums of $26,517,322, $20,942,093 and $16,251,612 and a ceded liability for losses and loss expenses of $47,862,627, $39,321,214 and $31,068,101 under this arrangement as of December 31, 2002, 2001 and 2000, respectively. It also had assumed unearned premiums of $69,208,310, $63,636,858 and $54,578,621 and an assumed liability for losses and loss expenses of $113,850,952, $99,664,285 and $84,805,937 under this arrangement at December 31, 2002, 2001 and 2000, respectively. Prior to January 1, 2002, the Mutual Company and Southern had a quota share agreement whereby Southern ceded 50% of its direct business, less reinsurance, to the Mutual Company. The business assumed by the Mutual Company from Southern became part of the pooling arrangement between the Mutual Company and Atlantic States. Southern ceded premiums earned of $0, $14,995,606 and $14,413,261 and ceded losses and loss expenses incurred of $488,055, $9,898,422 and $9,885,436 under this agreement during 2002, 2001 and 2000, respectively. Southern had prepaid reinsurance premiums of $0, $7,310,471 and $7,084,729 and a ceded liability for losses and loss expenses of $6,399,727, $10,068,604 and $7,924,750 under this agreement at December 31, 2002, 2001 and 2000, respectively. This agreement was terminated as of January 1, 2002. Atlantic States and Southern each have a catastrophe reinsurance agreement with the Mutual Company which limits the maximum liability under any one catastrophic occurrence to $400,000 and $450,000, respectively, and $1,000,000 for a catastrophe involving both of the companies. Prior to merging into Atlantic States, Pioneer-Ohio, 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 $200,000, $300,000 and $400,000, respectively. Prior to merging into Southern, Southern Heritage had a catastrophe reinsurance agreement with the Mutual Company which limited the maximum liability under any one catastrophic occurrence to $400,000. Prior to merging into Atlantic States, Delaware and the Mutual Company had an excess of loss reinsurance agreement in 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. Prior to merging into Atlantic States, Pioneer-Ohio 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) 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 $175,000 ($50,000 in 2001 and $25,000 in 2000) of losses in excess of $125,000 ($100,000 in 2001 and 2000). 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) of losses in excess of $50,000. Effective October 1, 2000 and prior to merging into Southern, Southern Heritage and the Mutual Company had 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 page 20 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 Southern 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 DGI, 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 $2,811,359, $2,439,520 and $2,126,882 and ceded losses and loss expenses incurred of $6,873,539, $4,194,251 and $5,388,111 under these various agreements during 2002, 2001 and 2000, respectively. The subsidiaries had a ceded liability for losses and loss expenses of $6,397,326, $5,395,528 and $4,941,116 under these various agreements at December 31, 2002, 2001, and 2000, respectively. Southern (and Delaware, Pioneer-Ohio, Southern Heritage and and Pioneer-New York prior to mergers) has an agreement with the Mutual Company under which it cedes, and then reassumes back, 100% of its business net of reinsurance. The primary purpose of the agreement is to provide Southern with the same A.M. Best rating (currently "A") as the Mutual Company, which this subsidiary could not achieve without this contract in place. This agreement does not transfer insurance risk. While these subsidiaries ceded and reassumed amounts received from policyholders of $48,921,377, $41,142,936 and $25,790,126 and claims of $28,859,644, $23,348,952 and $15,325,638 under these agreements in 2002, 2001 and 2000, respectively, the amounts are not reflected in the consolidated financial statements. The aggregate liabilities ceded and reassumed under these agreements were $43,541,766 and $36,494,487 at December 31, 2002, and 2001, 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 $28,586,888, $29,298,569 and $26,985,080 for 2002, 2001 and 2000, 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, 2002, the Company had $122,295 in checking accounts with Province Bank, a wholly owned subsidiary of DFSC. The Company earned $39,118 in interest on these accounts during 2002. 3--INVESTMENTS The amortized cost and estimated fair values of fixed maturities and equity securities at December 31, 2002 and 2001, are as follows:
2002 ------------------------------------------------------------------------------------ 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 $ 12,641,126 $ 407,958 $ -- $ 13,049,084 Canadian government obligation 499,250 40,750 -- 540,000 Obligations of states and political subdivisions 33,891,385 574,768 66,463 34,399,690 Corporate securities 29,551,491 1,745,990 12,103 31,285,378 Mortgage-backed securities 10,118,304 393,857 995 10,511,166 ------------------------------------------------------------------------------------ Totals $ 86,701,556 $ 3,163,323 $ 79,561 $ 89,785,318 ====================================================================================
2002 ------------------------------------------------------------------------------------ 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 $ 56,344,340 $ 1,943,229 $ 337 $ 58,287,232 Obligations of states and political subdivisions 78,515,340 3,083,256 152,996 81,445,600 Corporate securities 34,848,807 2,016,526 2,783 36,862,550 Mortgage-backed securities 17,787,462 363,649 14,833 18,136,278 Equity securities 21,587,317 1,007,030 757,887 21,836,460 ------------------------------------------------------------------------------------ Totals $209,083,266 $ 8,413,690 $ 928,836 $216,568,120 ====================================================================================
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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 ====================================================================================
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 ====================================================================================
The amortized cost and estimated fair value of fixed maturities at December 31, 2002, 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 $ 2,705,133 $ 2,767,000 Due after one year through five years 29,998,375 31,448,150 Due after five years through ten years 19,563,775 20,636,662 Due after ten years 24,315,969 24,422,340 Mortgage-backed securities 10,118,304 10,511,166 -------------------------------------------------------------------- Total held to maturity $ 86,701,556 $ 89,785,318 ==================================================================== AVAILABLE FOR SALE Due in one year or less $ 15,008,947 $ 15,298,500 Due after one year through five years 80,418,332 84,023,582 Due after five years through ten years 42,212,603 44,707,600 Due after ten years 32,068,605 32,565,700 Mortgage-backed securities 17,787,462 18,136,278 -------------------------------------------------------------------- Total available for sale $187,495,949 $194,731,660 ==================================================================== The amortized cost of fixed maturities on deposit with various regulatory authorities at December 31, 2002 and 2001, amounted to $5,400,597 and $5,667,959, respectively. Net investment income of the Company, consisting primarily of interest and dividends, is attributable to the following sources: 2002 2001 2000 ---------------------------------------------------------------- Fixed maturities $14,285,049 $15,145,949 $15,180,008 Equity securities 804,087 546,243 635,049 Short-term investments 564,738 920,538 1,221,724 Other 29,249 255,250 255,250 ---------------------------------------------------------------- Investment income 15,683,123 16,867,980 17,292,031 Investment expenses 1,101,871 982,436 897,284 ---------------------------------------------------------------- Net investment income $14,581,252 $15,885,544 $16,394,747 ================================================================ 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:
2002 2001 2000 ----------------------------------------------------------------------------------- Gross realized gains: Fixed maturities $ 128,714 $ 554,560 $ 237,748 Equity securities 911,994 323,451 1,813,242 ----------------------------------------------------------------------------------- 1,040,708 878,011 2,050,990 ----------------------------------------------------------------------------------- Gross realized losses: Fixed maturities 106,789 28,618 20,597 Equity securities 789,729 1,729,647 1,859,541 ----------------------------------------------------------------------------------- 896,518 1,758,265 1,880,138 ----------------------------------------------------------------------------------- Net realized gains (losses) $ 144,190 $ (880,254) $ 170,852 =================================================================================== Change in difference between fair value and cost of investments: Fixed maturities $ 5,253,785 $ 3,498,259 $ 7,300,279 Equity securities (637,585) 1,275,050 (603,930) ----------------------------------------------------------------------------------- $ 4,616,200 $ 4,773,309 $ 6,696,349 ===================================================================================
Income taxes (benefit) on realized investment gains (losses) were $49,565, $(299,286), and $58,090 for 2002, 2001 and 2000, respectively. Deferred income taxes applicable to net unrealized investment gains included in shareholders' equity were $2,572,901 and $1,474,242 at December 31, 2002 and 2001, respectively. During 2002, 2001 and 2000, certain investments trading below cost had declined on an other-than-temporary basis. Losses of $378,672, $1,462,913 and $436,943 were included in net realized investment gains (losses) for these investments in 2002, 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. page 22 4--DEFERRED POLICY ACQUISITION COSTS Changes in deferred policy acquisition costs are as follows: 2002 2001 2000 -------------------------------------------------------------------- Balance, January 1 $13,604,215 $12,284,214 $11,445,572 Acquisition costs deferred 30,435,855 28,514,001 26,157,642 Amortization charged to earnings 29,473,000 27,194,000 25,319,000 -------------------------------------------------------------------- Balance, December 31 $14,567,070 $13,604,215 $12,284,214 ==================================================================== 5--PROPERTY AND EQUIPMENT Property and equipment at December 31, 2002 and 2001, consisted of the following: -------------------------------------------------------------------- ESTIMATED USEFUL 2002 2001 LIFE -------------------------------------------------------------------- Cost--office equipment $ 5,441,882 $ 5,012,290 5-15 years automobiles 785,572 992,412 3 years real estate 3,105,851 3,063,646 15-50 years software 561,146 561,146 5 years -------------------------------------------------------------------- 9,894,451 9,629,494 Accumulated depreciation (5,464,057) (5,060,842) -------------------------------------------------------------------- $ 4,430,394 $ 4,568,652 ==================================================================== Depreciation expense for 2002, 2001, and 2000 amounted to $690,263, $829,100 and $899,750, respectively. 6--LIABILITY FOR LOSSES AND LOSS EXPENSES Activity in the liability for losses and loss expenses is summarized as follows: 2002 2001 2000 --------------------------------------------------------------------- Balance at January 1 $179,839,905 $156,476,124 $144,180,006 Less reinsurance recoverable 65,295,790 53,766,710 44,945,908 --------------------------------------------------------------------- Net balance at January 1 114,544,115 102,709,414 99,234,098 --------------------------------------------------------------------- Incurred related to: Current year 122,433,653 110,142,467 103,671,401 Prior years 6,834,033 8,035,082 711,775 --------------------------------------------------------------------- Total incurred 129,267,686 118,177,549 104,383,176 --------------------------------------------------------------------- Paid related to: Current year 67,655,902 63,289,736 61,848,261 Prior years 46,869,466 43,053,112 39,059,599 --------------------------------------------------------------------- Total paid 114,525,368 106,342,848 100,907,860 --------------------------------------------------------------------- Net balance at December 31 129,286,433 114,544,115 102,709,414 Plus reinsurance recoverable 81,405,319 65,295,790 53,766,710 --------------------------------------------------------------------- Balance at December 31 $210,691,752 $179,839,905 $156,476,124 ===================================================================== The Company recognized an increase in the liability for losses and loss expenses of prior years of $6.8 million, $8.0 million and $0.7 million in 2002, 2001 and 2000, 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, 2002 and 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 $19.8 million and $27.6 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, 2002, the Company may borrow up to $24 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, 2002, the interest rates were 3.45% on an outstanding Eurodollar rate balance of $4.8 million and 3.46% on another Eurodollar rate balance of $15 million. In addition, the Company pays a fee 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, is then payable. 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 Company monitors the financial strength of its unaffiliated reinsurers, requiring that companies rated by A.M. Best Company maintain a rating of A- or higher and that foreign reinsurers not rated by A.M. Best Company maintain a level of financial strength equivalent to companies qualifying for an A.M. Best Company rating of A- or higher. The following amounts represent ceded reinsurance transactions with unaffiliated reinsurers during 2002, 2001 and 2000: 2002 2001 2000 ---------------------------------------------------------------------- Premiums written $10,772,473 $ 9,348,853 $ 8,241,416 ====================================================================== Premiums earned $10,776,702 $ 9,440,035 $ 8,026,478 ====================================================================== Losses and loss expenses $13.693,184 $ 6,907,947 $ 3,027,810 ====================================================================== Prepaid reinsurance premiums $ 1,336,674 $ 1,340,903 $ 1,376,043 ====================================================================== Liability for losses and loss expenses $20,745,639 $10,510,444 $ 9,832,743 ====================================================================== page 23 TOTAL REINSURANCE The following amounts represent the total of all ceded reinsurance transactions with both affiliated and unaffiliated reinsurers during 2002, 2001 and 2000: 2002 2001 2000 ---------------------------------------------------------------------- Premiums earned $58,817,518 $64,220,420 $54,981,016 ====================================================================== Losses and loss expenses $55,526,159 $50,095,424 $41,267,463 ====================================================================== Prepaid reinsurance premiums $27,853,996 $29,593,467 $24,712,384 ====================================================================== Liability for losses and loss expenses $81,405,319 $65,295,790 $53,766,710 ====================================================================== The following amounts represent the effect of reinsurance on premiums written for 2002, 2001 and 2000: 2002 2001 2000 ----------------------------------------------------------------- Direct $111,767,756 $110,298,533 $ 99,042,235 Assumed 139,814,138 135,830,624 119,217,433 Ceded 57,078,047 69,101,503 58,137,248 ----------------------------------------------------------------- Net premiums written $194,503,847 $177,027,654 $160,122,420 ================================================================= The following amounts represent the effect of reinsurance on premiums earned for 2002, 2001 and 2000: 2002 2001 2000 ---------------------------------------------------------------- Direct $110,412,498 $105,214,059 $ 95,671,588 Assumed 134,246,213 126,776,215 110,955,627 Ceded 58,817,518 64,220,420 54,981,016 ---------------------------------------------------------------- Net premiums earned $185,841,193 $167,769,854 $151,646,199 ================================================================ 9--INCOME TAXES The provision for income tax consists of the following: 2002 2001 2000 ----------------------------------------------------------------- Current $ 5,071,516 $ 2,634,231 $ 2,406,272 Deferred (579,654) (1,360,633) 499,976 ----------------------------------------------------------------- Federal tax provision $ 4,491,862 $ 1,273,598 $ 2,906,248 ================================================================= The effective tax rate is different than the amount computed at the statutory federal rate of 34% for 2002, 2001 and 2000. The reason for such difference and the related tax effect are as follows: 2002 2001 2000 ---------------------------------------------------------------------------- Income before income taxes $ 16,494,584 $ 7,091,729 $ 11,743,028 ============================================================================ Computed "expected" taxes at 34% 5,608,159 2,411,188 3,992,630 Tax-exempt interest (1,304,197) (1,399,238) (1,347,959) Dividends received deduction (31,830) (21,908) (25,423) Other, net 219,730 283,556 287,000 ---------------------------------------------------------------------------- Federal income tax provision $ 4,491,862 $ 1,273,598 $ 2,906,248 ============================================================================ The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2002 and 2001, are as follows: 2002 2001 ---------------------------------------------------------------- Deferred tax assets: Unearned premium $ 6,438,461 $ 5,778,529 Loss reserves 5,786,195 5,433,005 Net operating loss carryforward - Southern Heritage 1,744,081 2,032,094 Other 1,133,488 1,013,899 ---------------------------------------------------------------- Total $15,102,225 $14,257,527 ================================================================ Deferred tax liabilities: Depreciation expense $ 343,362 $ 379,594 Deferred policy acquisition costs 5,007,431 4,625,433 Salvage recoverable 222,824 303,528 Unrealized gain 2,572,901 1,474,242 ---------------------------------------------------------------- Total $ 8,146,518 $ 6,782,797 ================================================================ Net deferred tax assets $ 6,955,707 $ 7,474,730 ================================================================ 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, 2002, 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. At December 31, 2002, the Company has a net operating loss carryforward of $5,073,691, 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 page 24 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, 2002, the Company has 5,000 unexercised options under these plans. Additionally 2,100, 1,947 and 1,947 shares of restricted stock were issued on January 2, 2002, 2001 and 2000, 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, 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 Granted - 2002 10,000 14.00 Exercised - 2002 7,684 8.00 Forfeited - 2002 18,334 14.36 Expired - 2002 524,448 $ 13.50 --------------------------------------------------------------------- Outstanding at December 31, 2002 1,394,001 $ 13.43 ===================================================================== Exercisable at: December 31, 2000 1,190,004 $ 16.68 ===================================================================== December 31, 2001 1,321,905 $ 13.89 ===================================================================== December 31, 2002 1,085,000 $ 13.29 ===================================================================== Options available for future grants at December 31, 2002 are 1,228,900. The following table summarizes information about fixed stock options at December 31, 2002: NUMBER OF WEIGHTED-AVERAGE NUMBER OF EXERCISE OPTIONS REMAINING OPTIONS PRICE OUTSTANDING CONTRACTUAL LIFE EXERCISABLE ------------------------------------------------------- $ 8.00 445,334 2.0 years 445,334 $ 9.00 9,500 3.5 years 5,499 $14.00 457,500 3.5 years 152,500 $18.00 481,667 0.25 years 481,667 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. 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, 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 January 1, 2002 $8.84850 12,769 July 1, 2002 $8.77200 10,520 On January 1, 2003, the Company issued an additional 9,425 shares at a price of $9.13750 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 DGI 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 2002, 2001 and 2000, 16,310, 16,557, and 46,603 shares, respectively, were issued under this plan. Expense recognized under the plan was not material. page 25 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): 2002 2001 2000 -------------------------------------------------------------------------- ATLANTIC STATES Statutory capital and surplus $ 95,405,603 $ 91,649,362 $ 94,431,695 ============================================ Statutory unassigned surplus $ 46,744,739 $ 42,988,498 $ 45,770,831 ============================================ Statutory net income (loss) $ 10,646,804 $ (676,125) $ 7,958,124 ============================================ -------------------------------------------------------------------------- SOUTHERN Statutory capital and surplus $ 31,243,897 $ 30,730,757 $ 26,057,758 ============================================ Statutory unassigned surplus $ (6,373,688) $ (6,886,828) $(11,559,827) ============================================ Statutory net income $ 2,505,891 $ 5,180,964 $ 3,029,826 ============================================ 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 and Southern are also subject to Risk Based Capital (RBC) requirements which may further impact their ability to pay dividends. At December 31, 2002, the companies' statutory capital and surplus were substantially above the RBC requirements. Amounts available for distribution as dividends to DGI without prior approval of insurance regulatory authorities in 2003 are $10,646,804 from Atlantic States and $2,493,398 from Southern. The National Association of Insurance Commissioners (NAIC) 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 was as follows: Atlantic States - $6,482,380 increase and Southern -$2,254,558 increase. 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, -------------------------------------------- 2002 2001 2000 ---------------------------------------------------------------------------- Statutory net income of Insurance Subsidiaries $ 13,152,695 $ 4,504,839 $ 10,987,950 Increases (decreases): Deferred policy acquisition costs 962,855 1,320,001 838,642 Deferred federal income taxes 579,654 1,360,633 (499,976) Salvage and subrogation recoverable (863,313) 155,088 305,918 Consolidating eliminations and adjustments (11,264,732) (13,783,695) (4,318,624) Parent-only net income 9,435,563 12,261,265 1,522,870 ---------------------------------------------------------------------------- Net income as reported herein $ 12,002,722 $ 5,818,131 $ 8,836,780 ============================================================================ DECEMBER 31, ----------------------------------------------- 2002 2001 2000 ------------------------------------------------------------------------------- Statutory capital and surplus of Insurance Subsidiaries $ 126,649,500 $ 122,380,119 $ 120,489,453 Increases (decreases): Deferred policy acquisition costs 14,567,070 13,604,215 12,284,214 Deferred federal income taxes (3,499,656) (820,313) 7,690,886 Salvage and subrogation recoverable 7,334,635 8,197,948 8,042,860 Statutory reserves -- -- 2,623,921 Non-admitted assets and other adjustments, net 735,946 334,092 911,370 Fixed maturities 7,517,290 3,793,048 493,055 Consolidating eliminations and adjustments (40,891,418) (39,693,089) (40,973,097) Parent-only equity 20,769,483 13,132,329 2,566,929 ------------------------------------------------------------------------------- Stockholders' equity as reported herein $ 133,182,850 $ 120,928,349 $ 114,129,591 =============================================================================== 14--SUPPLEMENTARY INFORMATION ON STATEMENT OF CASH FLOWS The following reflects income taxes and interest paid during 2002, 2001 and 2000: 2002 2001 2000 --------------------------------------------------- Income taxes $4,410,000 $2,666,887 $2,031,652 =================================================== Interest $1,047,237 $3,049,844 $2,731,048 =================================================== page 26 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, 2002, 2001 and 2000: WEIGHTED- AVERAGE EARNINGS NET SHARES PER INCOME OUTSTANDING SHARE ------------------------------------------------------------------ 2002: Basic $12,002,722 9,085,914 $ 1.32 Effect of stock options -- 107,199 (.01) ------------------------------------------------------------------ Diluted $12,002,722 9,193,113 $ 1.31 ------------------------------------------------------------------ 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 ================================================================== 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: 2002 2001 2000 ------------------------------------------------------------ Options excluded from diluted earnings per share 939,167 1,467,782 1,045,338 ============================================================ 16--CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY CONDENSED BALANCE SHEETS ($ in thousands) DECEMBER 31, 2002 2001 ------------------------------------------------------------------------- ASSETS Investment in subsidiaries (equity method) $156,684 $152,089 Cash 604 403 Property and equipment 1,640 1,623 Other 99 264 ------------------------------------------------------------------------- Total assets $159,027 $154,379 ========================================================================= LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Cash dividends declared to stockholders $ 887 $ 870 Line of credit 19,800 27,600 Due to affiliate 4,441 4,441 Other 716 540 ------------------------------------------------------------------------- Total liabilities 25,844 33,451 ------------------------------------------------------------------------- Stockholders' equity 133,183 120,928 ------------------------------------------------------------------------- Total liabilities and stockholders' equity $159,027 $154,379 ========================================================================= CONDENSED STATEMENTS OF INCOME ($ in thousands) YEAR ENDED DECEMBER 31, 2002 2001 2000 --------------------------------------------------------------------- Revenues Dividends-subsidiaries $ 10,400 $ 14,419 $ 3,900 Other 797 824 866 --------------------------------------------------------------------- Total revenues 11,197 15,243 4,766 --------------------------------------------------------------------- Expenses Operating expenses 1,057 1,761 1,165 Interest 1,139 2,288 3,304 --------------------------------------------------------------------- Total expenses 2,196 4,049 4,469 --------------------------------------------------------------------- Income before income tax benefit and equity in undistributed net income of subsidiaries 9,001 11,194 297 Income tax benefit (435) (1,067) (1,226) --------------------------------------------------------------------- Income before equity in undistributed net income (loss) of subsidiaries 9,436 12,261 1,523 Equity in undistributed net income (loss) of subsidiaries 2,567 (6,443) 7,314 --------------------------------------------------------------------- Net income $ 12,003 $ 5,818 $ 8,837 ===================================================================== CONDENSED STATEMENTS OF CASH FLOWS ($ in thousands) YEAR ENDED DECEMBER 31, 2002 2001 2000 ------------------------------------------------------------------------ Cash flows from operating activities: Net income $ 12,003 $ 5,818 $ 8,837 ------------------------------------------------------------------------ Adjustments: Equity in undistributed net loss (income) of subsidiaries (2,567) 6,443 (7,314) Other 788 252 1,123 ------------------------------------------------------------------------ Net adjustments (1,779) 6,695 (6,191) ------------------------------------------------------------------------ Net cash provided 10,224 12,513 2,646 ------------------------------------------------------------------------ Cash flows from investing activities: Net purchase of property and equipment (480) (122) (262) Investment in Donegal Financial Services Corp. -- -- (3,042) Other 38 38 38 ------------------------------------------------------------------------ Net cash used (442) (84) (3,266) ------------------------------------------------------------------------ Cash flows from financing activities: Cash dividends paid (3,509) (3,394) (3,127) Issuance of common stock 1,728 1,387 2,757 Line of credit, net (7,800) (12,400) 3,000 ------------------------------------------------------------------------ Net cash provided (used) (9,581) (14,407) 2,630 ------------------------------------------------------------------------ Net change in cash 201 (1,978) 2,010 Cash at beginning of year 403 2,381 371 ------------------------------------------------------------------------ Cash at end of year $ 604 $ 403 $ 2,381 ======================================================================== page 27 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: 2002 2001 2000 ----------------------------------- ($ in thousands) --------------------------------------------------------------------------- Revenues: Premiums earned: Commercial lines $ 66,003 $ 62,877 $ 54,581 Personal lines 119,838 104,893 97,065 --------------------------------------------------------------------------- Total premiums earned 185,841 167,770 151,646 --------------------------------------------------------------------------- Net investment income 14,581 15,886 16,395 Realized investment gains (losses) 144 (880) 171 Other 3,238 2,388 2,370 --------------------------------------------------------------------------- Total revenues $ 203,804 $ 185,164 $ 170,582 =========================================================================== Income before income taxes: Underwriting income (loss): Commercial lines $ 6,326 $ (3,037) $ 763 Personal lines (5,056) (5,090) (4,649) --------------------------------------------------------------------------- SAP underwriting income (loss) 1,270 (8,127) (3,886) GAAP adjustments (558) 1,833 1,144 --------------------------------------------------------------------------- GAAP underwriting income (loss) 712 (6,294) (2,742) Net investment income 14,581 15,886 16,395 Realized investment gains (losses) 144 (880) 171 Other 1,058 (1,620) (2,081) --------------------------------------------------------------------------- Income before income taxes $ 16,495 $ 7,092 $ 11,743 =========================================================================== 18--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 $2,970,182 and $3,605,090 at December 31, 2002 and 2001, respectively. These liabilities included $538,578 and $676,149 related to surcharges collected by the Company on behalf of regulatory authorities for 2002 and 2001, respectively. 19--INTERIM FINANCIAL DATA (UNAUDITED)
2002 --------------------------------------------------------- FIRST SECOND THIRD FOURTH QUARTER QUARTER QUARTER QUARTER --------------------------------------------------------------------------------- Net premiums earned $ 45,452,260 $ 46,110,512 $ 46,792,748 $ 47,485,673 Total revenues 50,034,046 50,736,803 51,085,417 51,947,295 Net losses and loss expenses 31,297,569 32,136,019 32,423,893 33,410,205 Net income 2,180,716 3,178,834 3,015,676 3,627,496 Net income per common share Basic .24 .35 .33 .40 Diluted .24 .35 .33 .39 ---------------------------------------------------------------------------------
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) ---------------------------------------------------------------------------------
page 28 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, 2002 and 2001, 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, 2002. 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, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. KPMG LLP Philadelphia, Pennsylvania February 20, 2003 page 29 CORPORATE INFORMATION ANNUAL MEETING April 17, 2003 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 2002 and 2001: Cash Dividend Declared Quarter High Low Per Share 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 2002 - Class A 1st 10.770 8.750 -- 2nd 12.250 9.050 .10 3rd 10.990 9.120 .10 4th 12.120 9.250 .20 2002 - Class B 1st 12.800 8.780 -- 2nd 11.000 9.750 .09 3rd 11.500 9.510 .09 4th 11.440 9.200 .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, 2002: Class A common stock 615 Class B common stock 514 page 30