Business context and reporting period
Donegal Group Inc. (NASDAQ: DGICA, DGICB) filed this Form 10-K for the year ended December 31, 2017. It is a regional property-and-casualty insurance holding company operating through independent agents in 22 states, primarily in personal and commercial lines. Donegal Mutual controls about 72% of combined voting power; DGI also owns 48.2% of Donegal Financial Services Corporation (DFSC), which owns Union Community Bank.
Financial results and condition
| Metric | 2017 | 2016 |
|---|---|---|
| Total revenue | $739.0 million | $688.4 million |
| Premiums earned | $702.5 million | $656.2 million |
| Net premiums written | $729.1 million | $682.0 million |
| Net income | $7.1 million | $30.8 million |
| Diluted EPS, Class A / Class B | $0.26 / $0.22 | $1.16 / $1.06 |
| GAAP combined ratio | 103.0% | 98.1% |
| Operating cash flow | $81.0 million | $60.0 million |
Revenue grew 7.4%, supported by premium growth and higher realized investment gains. Net income fell about 77%, chiefly as underwriting performance weakened and the Tax Cuts and Jobs Act (TCJA) caused a $4.8 million deferred-tax revaluation charge. The 2017 effective tax rate was 41.3%; excluding the TCJA charge, management reported 2.0%.
The loss ratio rose to 69.4% from 64.5%; the expense ratio was nearly flat at 32.9% versus 33.0%. The GAAP combined ratio above 100% indicates an underwriting loss. Commercial lines produced $13.3 million of SAP underwriting income, while personal lines recorded a $39.0 million loss. Investment income was $23.5 million, up 4.0%; realized investment gains increased to $5.7 million from $2.5 million.
At year-end, total assets were $1.738 billion, investments $1.006 billion, cash $37.8 million, and stockholders’ equity $448.7 million. Debt obligations totaled $64 million: $24 million drawn on the $60 million revolving facility, $35 million of Federal Home Loan Bank advances, and $5 million in subordinated debentures. The company reported $81.0 million of operating cash flow and $36 million of unused capacity on its revolving line. Book value per share was $15.95, down from $16.21; return on average equity was 1.6%, versus 7.3%.
Material changes versus the prior comparable period
- Net premiums written increased 6.9%; personal lines rose 7.6% and commercial lines 6.0%, reflecting rate increases and new business.
- Underwriting deteriorated: the combined ratio moved from profitable at 98.1% to 103.0%. Weather-related losses contributed 8.3 percentage points to the 2017 loss ratio, compared with 5.7 points in 2016.
- Unfavorable prior-year reserve development increased to $6.6 million from $3.0 million, mainly from commercial multi-peril and personal and commercial auto severity, partly offset by workers’ compensation.
- Cash flow from operations increased to $81.0 million from $60.0 million. Debt obligations declined from $74 million to $64 million.
- Donegal Mutual completed the merger of Mountain States Mutual into itself in May 2017. Business in four Southwestern states is excluded from the pooling agreement and does not contribute to DGI’s consolidated results.
Outlook, risks, contingencies, and unusual items
Management said its underwriting discipline and business strategy position the company well for 2018 and beyond, and stated a long-term goal of achieving a combined ratio below 100%. The filing provides no numerical earnings, premium, or combined-ratio guidance. Management generally expected the TCJA’s lower 21% corporate rate to reduce tax expense beginning in 2018, while noting the future impact could not yet be reasonably estimated.
- Insurance reserves are estimates subject to claims severity, litigation, medical-cost, inflation, and settlement-pattern uncertainty. A 1% change in net loss reserves would affect pretax results by approximately $3.8 million.
- Reinsurance does not remove the insurers’ primary obligation to policyholders. Third-party reinsurance receivables were approximately $119.4 million; MICO also had about $54.0 million due from the Michigan Catastrophic Claims Association.
- Business and earnings are exposed to catastrophe losses and regional concentration, competition and pricing cycles, investment-market and interest-rate risk, regulatory limits on insurer dividends, and dependence on independent agents and shared technology systems.
- Donegal Mutual’s voting control and shared management create potential conflicts of interest in pooling, reinsurance, expense allocations, and other related-party arrangements.
- The company recognized no investment impairment losses in 2017. Its A.M. Best rating was A (Excellent), and insurance subsidiaries exceeded statutory risk-based-capital minimums by a substantial margin.
- Fourth-quarter 2017 net loss was $2.8 million, versus net income of $5.6 million in fourth-quarter 2016. The filing attributes full-year tax expense in part to the TCJA deferred-tax revaluation.
Important facts for investors to verify
- Whether 2017’s elevated weather losses, personal-auto and homeowners results, and worsening combined ratio persisted or improved in subsequent reporting periods.
- Subsequent reserve development, particularly for commercial multi-peril and auto claims, and any revisions to the $383.4 million net loss reserve estimate.
- The realized effect of the TCJA and the treatment and future earnings volatility of equity-investment fair-value changes beginning in 2018.
- Reinsurance recoverability, including the MCCA exposure, and the company’s available liquidity, debt maturities, and regulatory capacity to upstream insurer dividends.
- Related-party pooling and service arrangements, and the implications of Donegal Mutual’s majority voting control for public stockholders.