ITEM 1. BUSINESS.
GENERAL
First Central Financial Corporation (referred to herein as "First Central" or the "Registrant"), a corporation incorporated under the laws of the State of New York on May 18, 1983, is the parent company of First Central Insurance Company ("First Central Insurance") and Mercury Adjustment Bureau, Inc. ("Mercury"). Until March 10, 1997 First Central Insurance wrote multiple lines of property and casualty insurance including Commercial Multiple Peril, Workers' Compensation, General Liability, Automobile Liability and Physical Damage, Products Liability, Fire, Allied Lines, Boiler and Machinery, Glass, Burglary and Theft, and Inland Marine. On March 10, 1997, First Central Insurance ceased to write any new business. First Central continues to process renewals and service its existing business and expects to cease renewals on private passenger automobile policies. Mercury is a licensed insurance adjuster and represents the interests of a number of property and casualty insurers and self-insurers who conduct insurance business in the State of New York. Unless otherwise indicated, references to First Central include its subsidiaries.
During 1996, First Central Insurance encountered intense competition and experienced a reduction in premiums written while at the same time, loss and loss adjustment expenses increased significantly. For the quarter ended December 31, 1996, First Central Insurance incurred a charge to earnings of $11.5 million for the purpose of increasing loss reserves, the primary reason First Central reported a loss of $13.1 million or $2.19 per share (after tax benefits) for the year ended December 31, 1996. See "--Loss and Loss Adjustment Expense Reserves."
First Central Insurance's losses from operations resulted in its statutory surplus declining from $25.7 million at December 31, 1995 to $12.3 million at December 31, 1996 with earned surplus declining from $8.9 million (excluding unrealized gains) to a deficit of $4.3 million (excluding unrealized gains) during the same period. Primarily as a result of First Central Insurance's current financial condition, in February 1997, A.M. Best & Co., Inc. ("Best") reduced the B++ (Very Good) rating it assigned to First Central Insurance in June 1996 to D (Very Vulnerable). See "-- Best Rating."
First Central Insurance is precluded from paying dividends to First Central while it has a deficiency in earned surplus. Since the only material source of income to First Central is dividends from First Central Insurance, First Central will not declare any further dividends on its common stock for the foreseeable future. In addition, unless First Central obtains another source of funds, First Central will be unable to pay its $1.8 million sinking fund obligation under its 9% Convertible Subordinated Debentures due 2000 (the "Debentures") on August 1, 1997. Failure to pay the August 1, 1997 sinking fund obligation will constitute a default under the Debentures entitling the holders to accelerate the entire $4.9 million outstanding principal balance.
In informal discussions with the New York State Insurance Department (the "Insurance Department"), the Insurance Department requested that First Central Insurance submit and implement a plan designed to improve operations and raise additional capital. Such a plan will involve, among other things, the revision of operations to attain future profitability by raising underwriting standards, curtailing operating expenses, revising agreements to achieve a reduction in loss adjustment expenses, restructuring
the claims department to achieve more favorable settlements of claims and restructuring management positions. First Central Insurance has engaged outside consultants to review the activities of the various operating departments and make recommendations, where necessary, for changes within those departments. The plan also requires First Central Insurance to raise additional capital and First Central has engaged an investment banker to assist in this effort. Without the additional capital, First Central Insurance's surplus may be insufficient to enable it to remain in operation. Pending implementation of the plan and the raising of additional capital, First Central Insurance has ceased the writing of new insurance business.
The events and uncertainties discussed above raise substantial doubt about First Central's ability to continue as a going concern. There can be no assurance that First Central will be successful in its attempt to revise operations, or raise additional capital and resume normal operations.
In October 1996, Andrew W. Attivissimo was engaged as President and Chief Operating Officer of each of First Central and First Central Insurance. In February 1997, Mr. Attivissimo was also appointed as Chairman and Chief Executive Officer of First Central and First Central Insurance, succeeding Martin J. Simon, the founder of First Central.
BEST RATING
In February 1997, Best reduced First Central Insurance's Best rating to D (Very Vulnerable). From June 1996 to February 1997, First Central Insurance was rated B++ (Very Good) by Best. Best is one of the predominant services engaged in the industry-wide rating of insurers and reinsurers. Best's ratings are based on an analysis of the financial condition and operating performance of an insurance company. The ratings are classified in fifteen levels: A++ and A+ (Superior), A and A- (Excellent), B++ and B+ (Very Good), B and B- (Adequate), C++ and C+ (Fair), C and C- (Marginal), D (Very Vulnerable), E (Under State Supervision), F (In Liquidation). According to Best, the ratings constitute Best's opinion of the relative financial strength of insurance companies in comparison to industry performance and the ability of such companies to discharge their responsibilities to policyholders, and are based upon twelve factors, i.e., profitability, leverage/capitalization, liquidity, spread of risk, quality and appropriateness of the reinsurance program, quality and diversification of assets, adequacy of policy/loss reserves, adequacy of surplus, capital structure, management's experience and objectives, market presence and policyholder's confidence. Best does not rate securities issued by insurers and insurance holding companies. The ratings assigned by Best are not indicative of any determination by Best concerning the relative value or performance of the rated company's securities.
According to Best's Insurance Reports for Property and Casualty Insurers, the D (Very Vulnerable) rating received by First Central Insurance is assigned to those insurers who have demonstrated poor overall performance when compared to the standards established by Best. D companies have current ability to meet their policyholder obligations, but their financial strength is extremely vulnerable to unfavorable changes in underwriting or economic conditions.
LINES OF BUSINESS
On March 10, 1997, First Central Insurance ceased to write any new business. First Central Insurance continues to process renewals and service its existing business and expects to cease renewals on private passenger automobile policies. The lines of insurance written by First Central Insurance in 1996 and 1995 were:
Commercial Multiple Peril: This line represented 57.5% of total direct premiums written in 1996 (53.4% in 1995) and 53.6% of net premiums earned (50.7% in 1995). Losses incurred represented 61.0% of premiums earned (70.2% in 1995) for this line of business.
Workers' Compensation: This line represented 12.7% of total direct premiums written in 1996 (12.5% in 1995) and 13.5% of net premiums earned (13.8% in 1995). Losses incurred represented 7.2% of premiums earned (50.9% in 1995) for this line of business. Losses incurred for 1996 would have been 46.9% of premiums earned but for the reduction of previously established reserves. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Losses and Loss Adjustment Expense Reserves."
General Liability: This line represented 15.7% of total direct premiums written in 1996 (23.2% in 1995) and 19.7% of net premiums earned (23.5% in 1995). Losses incurred represented 155.5% of premiums earned (62.0% in 1995) for this line of business.
Automobile Liability: This line represented 10.5% of total direct premiums written in 1996 (7.7% in 1995) and 9.8% of net premiums earned (8.5% in 1995). Losses incurred represented 137.9% of premiums earned (80.7% in 1995) for this line of business.
Automobile Physical Damage: This line represented 2.6% of total direct premiums written in 1996 (2.2% in 1995) and 2.4% of net premiums earned (2.6% in 1995). Losses incurred represented 49.2% of premiums earned (47.7% in 1995) for this line of business.
Other Lines: Products liability, fire, allied lines, boiler and machinery, glass, burglary and theft, and inland marine were the other lines written in 1996. They represented 1.0% of total direct premiums written (1.0% in 1995) and 1.0% of net premiums earned (0.9% in 1995). Losses incurred represented 28.6% of premiums earned (26.6% in 1995) for these lines of business.
In lines written as a percentage of direct premiums written, i.e., increases in commercial multiple peril, workers' compensation, automobile liability and decreases in general liability and automobile physical damage, during 1996, First Central Insurance did not effect any material changes in the location of business, the geographic mix thereof or the types of risks insured.
INSURANCE RISK RATING
First Central Insurance's minimum premium rates for commercial multiple peril, workers' compensation, general liability, automobile liability, automobile physical damage, products liability, fire, allied lines, glass, burglary and theft, and inland marine insurance heretofore have been established in accordance with rates recommended by the Insurance Services Office ("ISO"), a bureau engaged in the nationwide publication of premium rates recommended for use by property and casualty insurers.
Management believes that by strictly adhering to a policy of charging minimum rates which did not fall below ISO recommendations, it maximized First Central Insurance's potential for achieving profits from underwriting operations. ISO has, however, begun to phase out the publication of such rates and instead has begun to publish certain other data that may assist insurance companies in establishing rates. Management intends to continue to set its rates based, in part, on ISO rate recommendations for as long as such recommendations are disseminated, and thereafter, to set its rates based on data provided by ISO.
PREMIUMS WRITTEN, REINSURANCE CEDED AND PREMIUMS EARNED
The following table sets forth direct premiums written, reinsurance ceded, net premiums written, decrease (increase) in unearned premiums, and net premiums earned by First Central Insurance for five years ended December 31, 1996. Direct premiums written are the total premiums written less cancellations. Reinsurance ceded is the premiums written applicable to reinsured risks which First Central Insurance has ceded to other insurers. Net premiums written are the direct premiums written less all premiums ceded. Net premiums earned are the net premiums written attributable to those portions of the policies expiring within the accounting period. The decrease (increase) in unearned premiums represents the deficiency (excess) of net premiums written over net premiums earned during the accounting period.
PREMIUMS WRITTEN, PREMIUMS EARNED AND LOSSES EXPERIENCED
One means of measuring the underwriting experience of a property and casualty insurer is by its "combined ratio." This ratio is the sum of (1) the ratio of losses incurred to net premiums earned (the "loss ratio"), (2) the ratio of loss adjustment expenses incurred to net premiums earned (the "loss adjustment expense ratio"), (3) the ratio of underwriting expenses incurred to net premiums written (the "underwriting expense ratio"). The insurance industry attains the combined ratio of an insurance company based on ("SAP") Statutory Accounting Principles. Based on SAP, the combined ratio for First Central Insurance for the year ended 1996 is 133.3%. The combined ratio reflects the underwriting experience of an insurer but does not reflect loss of premium balances, federal or state income taxes nor income from investments. The actual profitability of property and casualty insurers also depends on net income from investments. The insurance industry considers a combined ratio under 100% to indicate underwriting profitability and a combined ratio over 100% to indicate an underwriting loss. This
consideration is based on industry data and not accounting principles since a combined ratio under 100% can mathematically show an underwriting loss due to the fact that the underwriting expense ratio is based on net written premiums and the loss and loss adjustment expense ratios are based on net earned premiums.
The following table shows for First Central Insurance, on the basis of Generally Accepted Accounting Principles ("GAAP"), net premiums written, net premiums earned, losses incurred and the loss ratio for each of the five years ended December 31, 1996, by line of business written. The table also includes, on a GAAP basis, loss ratio, loss adjustment expense ratio, underwriting expense ratio and combined ratio information as reported on a consolidated basis by First Central.
RELATIONSHIP BETWEEN NET PREMIUMS AND SURPLUS
Insurance industry practices generally suggest that property and casualty insurance companies maintain net premiums written at a level no more than 300% of "surplus to policyholders" as calculated in accordance with Statutory Accounting Principles. See " -- Regulation". For the five years ended December 31, 1996, First Central Insurance's percentages of net premiums written to statutory surplus, based upon the annual statements filed by it with the Insurance Department were as follows:
YEARS ENDED DECEMBER 31,
- -------------------------------------------------------------------------------- 1996 1995 1994 1993 1992 ---- ---- ---- ---- ---- 380% 192% 272% 211% 194%
The significant increase in First Central Insurance's percentage of net premiums written to statutory surplus during 1996 was primarily due to the decrease in statutory surplus resulting from First Central Insurance incurring a charge to earnings of $11.5 million in the quarter ended December 31, 1996 for the purpose of increasing loss reserves. See " -- General" and " -- Loss and Loss Adjustment Expense Reserves." First Central Insurance expects that the reduction in its statutory surplus will result in significantly reduced premium volume for the foreseeable future.
LOSS AND LOSS ADJUSTMENT EXPENSE RESERVES
First Central Insurance maintains reserves for unpaid losses and unpaid loss adjustment expenses for all lines of insurance written. These reserves are intended to cover the probable ultimate cost of settling all losses incurred and unpaid, including those not yet reported. First Central Insurance establishes reserves on a case by case basis by evaluating reported claims based upon the type of risk involved, knowledge of the circumstances surrounding each claim, the severity of injury or damage and the potential for ultimate exposure, the policy provisions relating to the type of loss, and by estimating unreported claims on the basis of statistical information with respect to the probable number and nature of claims arising from occurrences which have not yet been reported. In addition to case basis reserves, loss and loss adjustment expense reserves also include incurred-but-not-reported ("IBNR") reserves. IBNR reserves are reserves for insured losses that have occurred but have not been reported to the insurance company and losses that have not been adequately reserved for with case based reserves.
Loss reserves are estimates only at a given point in time of what the insurer expects to pay on losses, based on facts and circumstances then known, and it is possible that the ultimate liability may exceed or be less than such estimates. The estimates are not precise inasmuch as, among other things, they are based on predictions of future events, estimates of future trends in claim severity and frequency and other variable factors. During the loss settlement period, which may be as long as several years, it often becomes necessary to refine and adjust the estimates of liability on a claim either upward or downward, and even then the ultimate liability may exceed or be less than the estimates. Inflationary pressures and escalations of repair costs, medical expenses and the sizes of injury awards have necessitated periodic upward adjustments in reserves over the loss settlement periods by most casualty and property insurers.
Loss adjustment expense reserves to cover the ultimate cost of investigating all losses and defending lawsuits arising from such losses are established each year based on historical data such as the
ratio of loss expenses paid to claims paid over the preceding years and on the basis of currently available information. Adjustments required to be made in the amount of outstanding loss reserves each year may require corresponding changes in the loss adjustment expense reserves.
The following factors are taken into consideration in determining current year adjustments to loss and loss adjustment expense reserves recorded in prior years; (1) the accumulation of individual case estimates for losses reported prior to the close of the accounting period; (2) estimates for unreported losses based on past experience modified for current trends; and (3) estimates of expenses for investigating and adjusting claims based upon past experience. First Central Insurance makes implicit provisions for the effects of inflation and for the combined effects of a number of factors (including inflation) which may cause future changes in severities. It does not, however, employ any significant reserving assumptions in determining its loss reserves other than the foregoing developed facts. The Insurance Department requires, pursuant to Statutory Accounting Principles, that loss ratios in each of the three most recent years be not less than 60% of its annual net earned premiums for general liability line of business, (65% in the case of workers' compensation line of business and 75% for automobile line of business), and to establish, to the extent necessary, reserves which conform to such assumptions ("Excess Statutory Reserves"). That assumption is only employed by First Central Insurance with respect to the filing of such annual statements. Excess Statutory Reserves are not utilized in connection with the development of loss reserves employed in the actual operation of First Central Insurance's business nor are such Excess Statutory Reserves required to be established under GAAP.
The year to year estimation and re-estimation of loss and loss adjustment expense reserve requirements is an inexact science. Reserves do not represent an exact calculation of liability, but rather are estimates involving actuarial and statistical projections at a given time of First Central Insurance's expectations of the ultimate costs of the settlement and administration of claims based on facts and circumstances then known, predictions of future events, estimates of future trends in claims frequency and severity and other variable factors such as inflation and new theories of liability. It is First Central Insurance's practice to maintain reserves at or near the middle point of an "actuarial reasonableness range" established by its independent actuary to evaluate the adequacy of reserves. To the extent that future changes in known data do not take place precisely in accordance with an insurer's historically developed loss reserving assumptions, such reserves, when viewed as of a particular point in time, most likely will be either deficient, i.e., lower than the amount needed to cover known loss and loss adjustment expenses, or redundant, i.e., greater than the amount required with respect thereto.
During 1995 and 1996, First Central Insurance increased total net reserves by $18.1 million and $20.9 million, respectively, to maintain its total loss reserves at or near the middle point of the actuarial reasonableness range.
The primary cause of the reserve increase in each of 1995 and 1996 was significant adverse development stemming from poor loss experience on policies written from 1992 through 1995, a period during which First Central Insurance substantially increased premium writings. In particular, beginning in 1993, First Central Insurance wrote policies for two large customers which resulted in extremely poor loss experience. Such business accounted for approximately $355,000, $3.3 million and $3.3 million of First Central Insurance's total written premiums in 1993, 1994 and 1995, respectively.
Based on First Central Insurance's past loss experience, prior management responsible for claims policy increased total net reserves by approximately $2.0 million, $2.5 million and $3.3 million in the first, second and third quarters of 1995, respectively, including increases in IBNR reserves of $1 million, $960,000 and $370,000 during such periods, respectively. However, after a review of case files during the fourth quarter of 1995, First Central Insurance's independent actuary recommended a substantial IBNR reserve increase for the fourth quarter of 1995 because of the adverse development mentioned above. The $8.95 million increase in IBNR reserves in the fourth quarter of 1995 brought First Central Insurance's total reserves at December 31, 1995 in line with the estimate of First Central Insurance's independent actuary. Accordingly, First Central Insurance believed that total reserves had been adequately strengthened during 1995 for 1995 and years prior thereto.
Total net reserves were increased by approximately $2.2 million, $2.5 million and $3.8 million in the first, second and third quarters of 1996, respectively, including increases in IBNR reserves of $250,000, $2 million and $1.35 million during such periods, respectively. However, 1996 witnessed continuing adverse loss development and, accordingly, during the fourth quarter of 1996, First Central Insurance performed an intensive evaluation of its case files, particularly those claims with low initial case reserves. The claims file evaluation consisted of a review of approximately 750 sample files identified by the independent actuary. In the fourth quarter of 1996, First Central Insurance transferred approximately $14 million in IBNR reserves to case reserves as a result of the case reserve file review and to compensate for further adverse loss development. It had been believed that the level of IBNR reserves would be sufficient to absorb such a transfer, but the continuing 1996 adverse loss development, which became apparent during the actuarial review, necessitated a further strengthening of IBNR reserves. The actuarial estimate of the required increase was $7.6 million. By this time, new management was in office and increased IBNR reserves by a further $3.8 million over that recommended by First Central Insurance's independent actuary based upon new management's evaluation of recent loss experience. Total net reserves at December 31, 1996 are above but near the middle point of the actuarial reasonableness range.
The reserve strengthening in the fourth quarters of 1995 and 1996 resulted from significant adverse development stemming from extremely poor loss experience on policies written from 1992 through 1995, and prior management that was responsible for claims policy basing quarterly reserve estimate adjustments on historical loss experience.
In connection with the Insurance Department's triennial audit, First Central Insurance is in discussions with the Insurance Department concerning a number of issues including the adequacy of First Central Insurance's reserves at December 31, 1996. It is new management's and First Central Insurance's independent actuary's estimate that total net reserves at December 31, 1996 are adequate.
The following table presents the development of First Central Insurance's reserves for losses and loss adjustment expenses (net of reinsurance receivables) of its underwriting activities for the years ended December 31, 1986 through December 31, 1996:
(1) Includes reserves for loss adjustment expenses with respect to estimates of losses sustained and reported in the subject year, but not reported until a subsequent year net of reinsurance recoverables.
The amounts of First Central Insurance's reserves for losses and loss adjustment expenses for the year ended December 31, 1996, determined on the basis of GAAP, were less than the amounts of such reserves determined in accordance with Statutory Accounting Principles ("SAP"). Such variance resulted from the following fundamental differences in the manner in which reserves are determined under GAAP and SAP: (a) as a result of adjustments for intercompany eliminations required in connection with the preparation of First Central's GAAP basis financial statements, the GAAP basis reserves for expected loss adjustment expenses payable to Mercury were reduced by $571,367; and (b) conforming to the Insurance Department statutory accounting principles, First Central Insurance did have an "Excess Statutory Reserve" of $2,580,000 in 1996.
First Central Insurance does not discount its loss and loss adjustment expense reserves for financial reporting purposes.
RECONCILIATION OF LOSS RESERVES
First Central Insurance's aggregate reserves for insurance losses and loss adjustment expenses as of December 31, 1996, 1995 and 1994, as determined on the basis of GAAP but presented net of reinsurance recoverables, and the changes made therein during such years were as follows:
The reserves at the end of 1996, 1995 and 1994 are net of reinsurance recoverables of $18,768,000, $19,542,000 and $24,589,000 respectively.
The year to year increases in loss reserves are a result of significant adverse developments from both case reserve strengthening and poor loss experience emanating from accident years 1992 through 1995, a period during which First Central Insurance substantially increased premium writings. During
that period, First Central Insurance wrote certain business which resulted in extremely poor loss experience.
Although management, after consultation with its independent actuary, believes that First Central Insurance's overall reserve levels are adequate to provide for its obligations under existing policies, actual losses and loss adjustment expenses paid may deviate, perhaps substantially, from reserves reflected in the Company's financial statements. For example, volatile and unanticipated adverse loss and expense developments may occur particularly with respect to policies insuring liability, such as general liability, personal injury and workers' compensation for which losses may not emerge for several years following the year in which coverage was underwritten. See " -- Loss and Loss Adjustment Expense Reserves" and "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Loss and Loss Adjustment Expense Reserves."
First Central Insurance is a member of certain "assigned risk" reinsurance pools, mainly for automobile insurance, under which all insurers doing business in a particular state provide coverage for insureds who could not otherwise secure insurance in the open market. Participation in such pools (or direct writing of insurance for assigned risks) is a condition to writing the applicable lines of insurance in New York. Pool participants issue insurance for assigned risks on a pro rata basis which compares the volume of their voluntary insurance written in a state to all voluntary insurance written therein. Such assigned risk writings are made as and when requests are made for the same by the Insurance Department. First Central Insurance became a pool participant in 1981. First Central Insurance wrote approximately $1,288,000, $1,411,000, and $412,000 of assigned risk business in 1996, 1995 and 1994, respectively.
GEOGRAPHICAL DISTRIBUTION
First Central Insurance is licensed to conduct insurance business in Connecticut, New York and Pennsylvania. However, all of the business previously conducted by First Central Insurance and the income derived therefrom, except for approximately $90,000, $183,000 and $300,000 of direct premiums written in Pennsylvania and Connecticut in 1996, 1995 and 1994, respectively, has resulted from policies issued in New York.
REINSURANCE CEDED
A reinsurance transaction takes place when an insurance company transfers (cedes) a portion or all of its exposure on insurance directly written by it to another insurer which assumes the exposure in return for a portion or all of the premium. Insurance is ceded principally (a) to reduce net liability on individual risks, (b) to protect against catastrophic losses and (c) to maintain desired ratios of net premiums written to statutory surplus. Most reinsurance is written under contracts (treaties) in which the coverage is either on a "quota share" basis, where the reinsurer shares proportionately in premiums and losses, or on an "excess" basis where only losses above a fixed point (retention) are reinsured. First Central Insurance is a party to reinsurance contracts under which certain types of policies are automatically reinsured without the need for further approval of the reinsurers which have agreed to cover the types of risks involved ("treaty" reinsurance). First Central Insurance also is a party from time to time to reinsurance contracts which relate to an individual policy or type of risk and require the specific agreement of the reinsurer as to each risk with respect to which reinsurance is assumed ("facultative" reinsurance).
The ceding of reinsurance does not discharge the original insurer from its primary liability to the policyholder and the ceding company is required to pay the loss if the assuming company fails to meet its obligations under the reinsurance agreement. For regulatory reporting purposes, the practice of insurers, subject to certain statutory limitations and as permitted by regulatory authorities, is to account for reinsured risks to the extent of the reinsurance ceded as though they were not risks for which the original insurer is liable and to deduct the portion of unearned premiums related to ceded reinsurance from the liability for unearned premiums. While this practice is prescribed for regulatory purposes, it is not in accordance with generally accepted accounting principles as established by FASB Statement No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." Statement No. 113, which First Central adopted on January 1, 1993, requires reporting of estimated reinsurance receivables arising from reinsurance contracts and amounts paid to the reinsurer relating to the unexpired portion of reinsured contracts (prepaid reinsurance premiums) separately as assets, with reserves for losses and loss adjustment expenses and the liability for unearned premiums stated at their gross amounts.
The following table shows the amount of reinsurance premiums ceded by First Central Insurance for five years ended December 31, 1996:
Since July 1988, National Reinsurance Corp. ("Nat Re") has reinsured a portion of every risk underwritten by First Central Insurance. On October 4, 1996 General Reinsurance Corp. ("Gen Re") acquired National Reinsurance Corp. ("Nat Re"). First Central Insurance has reinsurance agreements with either Nat Re or Gen Re as specifically identified herein. As of January 1, 1996, First Central Insurance's retention is $250,000 per loss for all lines of property and casualty insurance. Under the terms of the reinsurance treaty, Nat Re will assume up to $750,000 of any loss in excess of First Central Insurance's retention on any one loss not exceeding $1.0 million. In addition to the $1.0 million limit, as of January 1, 1994, First Central Insurance, pursuant to an excess agreement with Nat Re is reinsured for an additional $1.0 million (for a total of $2.0 million limit) for workers' compensation coverage and as of January 1, 1992, First Central Insurance, pursuant to automatic facultative arrangements with Munich American Reinsurance Company and as of January 1, 1993, Swiss Reinsurance, is reinsured for an additional $3.5 million (for a total of $4.5 million limit) on a pro rata basis for property coverage. Additionally, there are other reinsurance companies with which First Central Insurance has facultative arrangements on an individual risk basis. In April 1995, First Central Insurance's treaty with Nat Re was changed so that the reinsurance premiums ceded to Nat Re would be based on written premiums rather than earned premiums and the premium rate was increased prospectively with First Central Insurance being entitled to a commission on the reinsurance premium. The treaty change caused First Central Insurance to record a liability, "Funds held for reinsurance treaty," for amounts due Nat Re. This liability is paid as the reinsurance premiums are earned. Effective December 8, 1995, with respect to losses occurring on or after December 1, 1994, First Central Insurance entered into a quota share commercial umbrella liability reinsurance agreement, in which First Central Insurance will cede 90% of applicable policy premiums written to CNA and, in which CNA will assume 90% of applicable losses. In addition, First Central Insurance also has an excess of loss commercial reinsurance umbrella liability agreement with CNA, in which 100% of the premiums that are allocated to the limits in excess of
$1,000,000 are to be ceded to CNA and, in which CNA will assume 100% of applicable losses in excess of $1,000,000. First Central Insurance has not effected any significant additions to or changes in its reinsurance retention other than as hereinabove described.
INVESTMENTS AND INVESTMENT PORTFOLIO
As is customary in the insurance industry, an insurer seeks to derive income from underwriting and investments, with most of its net income attributable to investment income. New York law regulates the types, quality and concentration of investments that may be made by First Central Insurance. First Central Insurance is generally permitted to invest, within specified limits and subject to certain qualifications, in federal, state and municipal obligations, corporate bonds, preferred stocks and common stocks, real estate mortgages and real estate.
First Central Insurance has not heretofore realized any unusually large gains, nor has it suffered any unusually large losses with respect to the disposition of its investments. As of January 1, 1994, First Central adopted FASB Statement No. 115 "Accounting for Certain Investments in Debt and Equity Securities," which requires that management classify its investments in debt securities and equity securities, with readily determinable fair values. In accordance with FASB Statement No. 115, securities other than those classified as "held to maturity," are stated at fair value. Unrealized gains and losses on securities stated at fair value will, depending on their character, affect First Central's statement of income or shareholders' equity. Realized and unrealized gains and losses on securities classified as "held for trading" are recognized in First Central's income statement. Unrealized gains and losses on securities classified as "available for sale" are reported, net of the related deferred tax effect, as increases or decreases in shareholders' equity and realized gains and losses on such securities are included in earnings.
Statutory accounting principles require that investments in equity securities be reported at market value and that investments in debt securities be reported at amortized cost, unless a writedown below cost is prescribed by the National Association of Insurance Commissioners Securities Valuation Office. Insurance industry practices oblige First Central Insurance to maintain net premiums written at a level of no more than 300% of "surplus to policyholders". See "Business -- Regulation." Accordingly, First Central Insurance's ability to write additional premiums is subject to increases and decreases in such surplus which is significantly dependent upon investment results. Except for three fixed income securities with an aggregate market value of $684,100, First Central's investments in fixed income securities are of investment grade quality. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Net Investment Income; Realized Gains." The value of First Central Insurance's fixed income securities is affected by the fluctuation of interest rates, among other factors. The value of First Central Insurance's equity investments is affected by conditions prevailing in equity markets from time to time, among other factors.
The following tables summarize First Central's investments and the results therefore during the five years ended December 31, 1996, as reported on the basis of GAAP:
(1) Investments based on average of beginning and ending period balances. (2) After deduction of investment expenses and before federal income taxes.
RISK-BASED CAPITAL
The computation of risk-based capital is a method of evaluating the minimum amount of capital which is appropriate for an insurance company to maintain in order to support its overall business operations considering its size and risk profile. Risk-based capital is calculated by applying a formula promulgated by the National Association of Insurance Commissioners which incorporates various asset, premium and reserve items. First Central Insurance's risk-based capital at December 31, 1996 is at the "regulatory action level" requiring First Central Insurance to submit a comprehensive plan to the Insurance Department. First Central Insurance is preparing a comprehensive plan designed to improve
operations and raise additional capital. The plan will address First Central Insurance's risk-based capital position.
REGULATION
First Central Insurance is subject to regulation and supervision by the Connecticut, New York and Pennsylvania Insurance Departments and by the insurance commissioners or similar officials in any other jurisdiction in which it will be licensed to transact business. Such regulation and supervision includes, among other things, requirements of capital and surplus, solvency standards, granting and revoking licenses to transact business and the licensing of agents, approval of policy forms and rates, restrictions on the amount of risks assumed, deposits of securities, methods of computing reserves and the types and concentration of investment permitted. First Central Insurance is required to file detailed annual and other reports on its financial condition, affairs and management with such regulatory agencies and is subject to periodic examinations.
First Central Insurance is subject to regulation under the insurance holding company statutes of Connecticut, New York, and Pennsylvania. These regulations generally require subsidiaries of insurance holding companies and insurers which are subsidiaries of holding companies to register and file certain reports, and require prior regulatory agency approval of changes in control of an insurer and of intercorporate transfers of assets within the holding company structure. In many states, including New York, where First Central Insurance is incorporated, "control" is presumed to exist if 10% or more of the voting securities of the insurer are owned or controlled by a party, although the regulatory authority may find that "control" in fact does or does not exist where a person either owns or controls a lesser or greater amount of securities. The New York Insurance Law provides that no corporation or other person, except an insurer already licensed by the Insurance Department, may acquire control of First Central, unless it has given notice to First Central Insurance and obtained prior written approval of the Insurance Department for such acquisition. Such requirements may affect First Central's ability to obtain a capital investment as will be required for First Central to pay its sinking fund obligation under the Debentures and to provide First Central Insurance with such additional capital as will enable it to resume normal operations.
Most states require insurers licensed by their respective insurance regulatory authorities to participate in insurance guaranty associations. These associations assess insurance companies a percentage of premiums written for the relevant line of insurance to fund claims of policyholders of insolvent insurance companies. First Central Insurance is required to pay to the New York Property/Casualty Insurance Security Fund (the "Guaranty Fund") one half of one percent of its net direct written premiums on policies insuring property or risks located in New York. However, no contributions are required to be made whenever the net value of the Guaranty Fund is at least $150,000,000. As of December 31, 1992 the Guaranty Fund's net value exceeded $150,000,000 therefore, no contributions by First Central Insurance were required after February 15, 1993.
As of December 31, 1996 in accordance with regulatory guidelines, a $300,000 par value U.S. Treasury Note, was held on deposit by the Insurance Department.
INVESTIGATION AND SETTLEMENT OF CLAIMS
Upon the reporting of claims by policyholders First Central Insurance first verifies coverage and then the claim is investigated by adjusters retained by First Central Insurance. These adjusters estimate the initial reserves for non-bodily injury claims and issue a report on all claims. The report is then reviewed by First Central Insurance's Claims Department. First Central Insurance attempts to settle claims as quickly as possible. If the claim cannot be settled and results in litigation, First Central Insurance may retain outside legal counsel. Legal defense law firms are assigned on the basis of venue and severity of the case. Presently, First Central Insurance uses approximately 30 law firms. Since the inception of First Central Insurance's business operations, the law firm of Simon, Drabkin & Margulies ("Simon, Drabkin") has performed subrogation and defense services required by First Central Insurance. Martin J. Simon, and Ralph Drabkin, each a director of First Central, are senior partners of Simon, Drabkin. During the years ended December 31, 1996 and 1995, approximately 17.0% and 23.1%, respectively, of all litigation assigned by First Central Insurance to legal defense firms were defended by Simon, Drabkin.
In September 1988, First Central acquired Mercury, a claim adjustment and investigation company. Mercury represents the interests of First Central Insurance and a number of other casualty insurers and self insurers. First Central Insurance employs the services of other adjusters and will continue to employ the services of other adjusters in addition to Mercury. During the years ended December 31, 1996 and 1995, approximately 75.4% and 79.1%, respectively, of all claim adjustments and investigations were assigned to Mercury.
No changes have been effected in First Central Insurance's claim payment patterns due to portfolio loss transfers, structured settlements or any other transactions or circumstances.
MARKETING
Prior to 1996, First Central Insurance's programs were marketed almost exclusively through its general agents. During 1996, First Central Insurance marketed its programs primarily through its approximately 45 general agents and commenced marketing of its programs through insurance brokers. First Central Insurance pays competitive commission rates to its general agents and brokers.
On March 10, 1997, First Central Insurance ceased to write any new business. First Central Insurance continues to process renewals and service its existing business and expects to cease renewals on private passenger automobile policies. First Central Insurance has held meetings with its agents to explain its efforts to improve operations and raise additional capital and keeps them informed of recent developments. Other than the termination by First Central Insurance of one agent, no general agent has discontinued conducting business with First Central Insurance since March 10, 1997.
During the years ended December 31, 1996 and 1995, approximately 14.2% and 12.7% respectively, of all insurance written by First Central Insurance was sold through Simon Agency of New York ("Simon New York"), a licensed insurance agency, the stock of which is owned by Joan Dollinger and Audrey Goodman (the respective wives of Joel Dollinger and Allan Goodman, former Vice Presidents and former directors of First Central and First Central Insurance each of whom resigned in March 1997) and Sheryle Harwood, who are Mr. Simon's daughters. Commissions earned by Simon New York from business placed with First Central Insurance during 1996 and 1995 was approximately $1.6 million and $1.8 million,
respectively. Such commissions were paid at a rate comparable to those paid by First Central Insurance to other agents.
COMPETITION
The insurance industry is highly competitive. First Central Insurance is subject to intense competition from insurers offering insurance programs similar to those offered by First Central Insurance, from insurers offering other types of insurance programs and from other segments of the financial services industry. In order to compete more effectively, First Central Insurance has adopted ISO Rates. (See "Business -- Insurance Risk Rating"). Many of First Central Insurance's competitors have well established agency systems or numerous sales agents which afford them a competitive advantage over smaller companies possessing limited resources, such as First Central Insurance. First Central Insurance is a minor factor in the insurance industry and is more vulnerable than its larger competitors due to its relatively small capital and surplus.
Primarily as a result of First Central Insurance's current financial condition, in February 1997, Best reduced First Central Insurance's rating to D (Very Vulnerable). See "-- Best Rating." The change in rating has adversely impacted policy renewals. The continuation of a D rating will severely affect First Central Insurance's future ability to compete with other insurers.
During 1996, First Central Insurance marketed its insurance programs primarily through its approximately 45 general agents and commenced marketing its programs through insurance brokers. On March 10, 1997, First Central Insurance ceased to write any new business. First Central Insurance continues to process renewals and service its existing business and expects to cease renewals on private passenger automobile policies. First Central Insurance has held meetings with its agents to explain its efforts to improve operations and raise additional capital and keeps them informed of recent developments. Other than the termination by First Central Insurance of one agent, no general agent has discontinued conducting business with First Central Insurance since March 10, 1997.
EMPLOYEES
At December 31, 1996, First Central Insurance employed approximately 106 people, of whom seven were executive personnel. At December 31, 1996, Mercury employed approximately 38 people. Management believes that its relationship with its employees is satisfactory.
CERTAIN CONSIDERATIONS
The operating results and financial condition of First Central as a whole and, in particular of First Central Insurance, are affected by numerous factors and circumstances peculiar to the property and casualty insurance industry, some of which First Central can neither predict nor control. Revenue and profitability trends of First Central Insurance, both generally and within individual business lines, are affected by factors such as (1) volatile and unanticipated adverse loss and expense developments, particularly within lines of business for which losses may not emerge for several years following the year in which the coverage was underwritten; (2) legally-imposed regulatory capital requirements and related limitations on the ability of First Central Insurance to underwrite new insurance business and renew desirable business currently written; (3) the ability of First Central Insurance to enter into suitable reinsurance arrangements; (4) competitive pressures on the pricing of product lines offered by First
Central Insurance and the historical cyclicality of its industry as a whole; (5) fluctuations in interest rates, which affect the market value of First Central Insurance's investment portfolio, the income yield of the portfolio and the default and prepayment rates of the portfolio; (6) inflationary pressures which affect the magnitude of losses and loss adjustment expenses; (7) emerging legal precedents and trends which, among other things, may have a significant specific impact on settlement amounts and other circumstances affecting the development of losses and expenses for environmental and other liability lines of business; (8) the occurrence of natural disasters and catastrophic losses of other origin; (9) financial condition ratings of First Central Insurance as announced and published by industry rating organizations; and (10) general economic conditions and trends which have both direct and indirect affects on the demand for property and casualty insurance.
In addition to the above-described risks and uncertainties affecting property and casualty insurers, First Central and, in particular, First Central Insurance are directly and specifically affected by certain other risks and uncertainties related to and resulting from the present financial condition of First Central Insurance.
ITEM 2.

ITEM 2. PROPERTIES.
First Central Insurance owns its home office building, located at 266 Merrick Road, Lynbrook, New York, (the "Building"). The Building consists of approximately 30,000 square feet of office space and 2,000 square feet of retail space. Management believes that the Building is suitable for First Central's purposes for the foreseeable future. Approximately 8,900 square feet of office and retail space is leased to seven unaffiliated tenants who paid approximately, $203,000 and $205,000 in rent during 1996 and 1995, respectively. Effective December 1, 1995 through November 30, 1996 Simon New York had a lease for 3,900 square feet of office space in the Building. Since December 1, 1996, Simon New York has occupied such space on a month-to-month basis. Rent received from Simon New York in 1996 was approximately $76,800.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS.
There are no material pending legal proceedings to which First Central, First Central Insurance or Mercury is a party or of which any of their property is the subject, except for claims arising in the ordinary course of business of First Central Insurance. First Central Insurance has established reserves with respect to such claims that, in the opinion of its management, make adequate provision for the ultimate amount of losses and adjustment expenses incurred.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of security holders during the fourth quarter of 1996.
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT.
The following table sets forth certain information concerning all executive officers of First Central. Executive officers are elected by the Board of Directors to serve at the pleasure of the Board.
ANDREW W. ATTIVISSIMO was elected as President and Chief Operating Officer of First Central and First Central Insurance and as a director of First Central Insurance on October 31, 1996. On February 12, 1997, Mr. Attivissimo was elected as Chairman and Chief Executive Officer of First Central and First Central Insurance and on March 26, 1997, Mr. Attivissimo was appointed as a director of First Central. For five years prior to joining First Central, Mr. Attivissimo was President of Empire Insurance Group.
HARVEY MASS has been a director of First Central Insurance since August 1980 and a director of First Central since June, 1983. On October 11, 1985 he was elected as a Vice President of both First Central and First Central Insurance. From 1973 to December 31, 1991, Mr. Mass served as Vice President and production manager of Simon New York.
JOAN M. LOCASCIO served as both First Central Insurance's and First Central's Controller from October 1986 to November 1993. On June 12, 1990 she was elected Treasurer and a director of First Central and First Central Insurance. On April 10, 1992 she became Vice President of First Central and First Central Insurance. Mrs. Locascio oversees the financial accounting operations of First Central and is First Central's Chief Financial Officer.
RAYMOND F. BRANCACCIO has been a director of First Central Insurance since June 1989. He was elected Vice President of First Central on March 18, 1992, and of First Central Insurance in January 1988. Mr. Brancaccio has been Secretary of First Central Insurance since June 1990 and of First Central since February 1992. Mr. Brancaccio oversees First Central Insurance's Underwriting and Processing sections.
Martin J. Simon resigned as Chairman and Chief Executive Officer of First Central and First Central Insurance on February 12, 1997. Mr. Simon is a director of First Central and First Central Insurance and has entered into a consulting agreement with First Central. Joel I. Dollinger and Allan R. Goodman resigned from their positions with First Central and First Central Insurance effective March 12, 1997. Mr. Dollinger was a director and Executive Vice President of both First Central and First Central Insurance and Mr. Goodman was a director and Vice President of both First Central and First Central Insurance. See "Executive Compensation -- Employment/Termination Agreements."
PART II
ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
First Central's common stock, par value, $.10 per share ("Common Stock"), is listed on the American Stock Exchange. The high and low sales prices of the Common Stock, presented on a quarterly basis during 1996 and 1995, are shown below.
As of December 31, 1996, there were approximately 481 holders of record of First Central's Common Stock.
DIVIDENDS
As the principal asset of First Central, First Central Insurance provides the only material source of cash for the payment of dividends by First Central. Under the insurance laws of the State of New York, cash dividends to shareholders may be declared or distributed by First Central Insurance only from earned surplus. In addition, among other statutory restrictions, dividends are limited in any twelve month period to the lesser of ten percent of policyholders' surplus as shown in the insurer's last annual statement on file with the Insurance Department, or one hundred percent of adjusted net investment income during such twelve month period, unless the Insurance Department authorizes a greater dividend. Any payment of dividends by First Central Insurance to First Central would result in a reduction in its capacity to write new insurance business, since the volume of insurance that can be written is determined by the available surplus of First Central Insurance. Any payment of dividends by First Central Insurance may be further limited to maintain the acceptable industry standard relationship of net premiums written not to exceed three times surplus. First Central Insurance's total Surplus to Policyholders as of December 31, 1996 amounted to $12.3 million (computed on the basis of SAP). However, by reason of the foregoing statutory restrictions, First Central Insurance cannot distribute dividends to First Central due to a deficiency in earned surplus of approximately $4,276,000 excluding unrealized gains of $775,126.
First Central declared dividends on the Common Stock of $0.12, $0.12 and $0.105 per share respectively in 1996, 1995 and 1994. The declaration and payment of dividends in the future will depend, subject to the discretion of the Board of Directors, upon First Central's and First Central Insurance's earnings, financial condition, business needs, capital and surplus requirements, government
regulations, and other relevant factors. First Central does not expect to declare any further dividends on the Common Stock in the foreseeable future.
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA.
The following selected financial data should be read in conjunction with the consolidated financial statements of First Central and related footnotes appearing elsewhere herein and Management's Discussion and Analysis of Financial Condition and Results of Operations. The selected financial data, with the exception of the ratio of earnings to fixed charges for each of the five years in the period ended December 31, 1996, are derived from First Central's audited consolidated financial statements for such years.
* Restated to reflect adoption of Statement of Financial Accounting Standards No. 113, effective January 1, 1993.
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RECENT DEVELOPMENTS
During 1996, First Central Insurance encountered intense competition and experienced a reduction in premiums written while at the same time, loss and loss adjustment expenses increased significantly. For the quarter ended December 31, 1996, First Central Insurance incurred a charge to earnings of $11.5 million for the purpose of increasing loss reserves, the primary reason First Central reported a loss of $13.1 million or $2.19 per share (after tax benefits) for the year ended December 31, 1996.
First Central Insurance's losses from operations resulted in its statutory surplus declining from $25.7 million at December 31, 1995 to $12.3 million at December 31, 1996 with earned surplus declining from $8.9 million to a deficit of $4.3 million during the same period. Primarily as a result of First Central Insurance's current financial condition, in February 1997, A.M. Best & Co., Inc. ("Best") reduced the B++ (Very Good) rating it assigned to First Central Insurance in June 1996 to D (Very Vulnerable). See "Business -- Best Rating."
First Central Insurance is precluded from paying dividends to First Central while it has a deficiency in earned surplus. Since the only material source of income to First Central is dividends from First Central Insurance, First Central will not declare any further dividends on its common stock for the foreseeable future. In addition, unless First Central obtains another source of funds, First Central will be unable to pay its $1.8 million sinking fund obligation under the Debentures on August 1, 1997. Failure to pay the August 1, 1997 sinking fund obligation will constitute a default under the Debentures entitling the holders to accelerate the entire $4.9 million outstanding principal balance.
In informal discussions with the Insurance Department, the Insurance Department requested that First Central Insurance submit and implement a plan designed to improve operations and raise additional capital. Such a plan will involve, among other things, the revision of operations to attain future profitability by raising underwriting standards, curtailing operating expenses, revising agreements to achieve a reduction in loss adjustment expenses, restructuring the claims department to achieve more favorable settlements of claims and restructuring management positions. First Central Insurance has engaged outside consultants to review the activities of the various operating departments and make recommendations, where necessary, for changes within those departments. The plan also requires First Central Insurance to raise additional capital and First Central has engaged an investment banker to assist in this effort. Without the additional capital, First Central Insurance's surplus may be insufficient to enable it to remain in operation. Pending implementation of the plan and the raising of additional capital, First Central Insurance has ceased the writing of new insurance business.
The events and uncertainties discussed above raise substantial doubt about First Central's ability to continue as a going concern. There can be no assurance that First Central will be successful in its attempt to revise operations to attain future profitability, raise additional capital and resume normal operations.
In October 1996, Andrew W. Attivissimo was engaged as President and Chief Operating Officer of each of First Central and First Central Insurance. In February 1997, Mr. Attivissimo was also appointed as Chairman and Chief Executive Officer of First Central and First Central Insurance, succeeding Martin J. Simon, the founder of First Central. See "Executive Officers of the Registrant."
RESULTS OF OPERATIONS
PREMIUMS WRITTEN AND EARNED
The following table illustrates First Central Insurance's direct premiums written and net premiums earned on a category-by-category basis for 1996, 1995, and 1994.
Direct premiums written decreased for the year ended December 31, 1996 when compared to the year ended December 31, 1995 by 21.6% due primarily to the termination of two significant customers with extremely poor loss experience, premium rate competition and the lead paint exclusion placed on First Central Insurance's general liability and commercial multiple peril policies for eight months during 1996. Direct premiums written increased from 1994 to 1995, by 10.2% primarily due to the expansion of First Central Insurance's markets and concentrated efforts by First Central Insurance's marketing department.
Net premiums earned decreased from 1996 to 1995 and increased when comparing 1995 to 1994 by 7.8% and 5.9%, respectively. The decrease experienced in 1996 was attributable to the aforementioned factors effecting direct premiums written. The 1995 increase in earned premiums was attributable to the increases in premiums written due to an expansion of First Central Insurance's markets.
Net premiums written decreased 7.4% in 1996 when compared to 1995, the decrease was attributed to the aforementioned factors affecting direct premiums written, offset by the decrease in ceded premiums written in 1996 of 54.4% when compared to 1995.
Although direct premiums written increased, net premiums written decreased approximately $4,900,000 in 1995 when compared to 1994 because ceded premiums increased by approximately $11,600,000 during the same period. The increase in ceded premiums was the result of a change in First Central Insurance's reinsurance treaty as of April 1, 1995. The treaty with Nat Re was changed so that premiums ceded would be based on direct written premiums rather than earned premiums and the premium rate was increased prospectively with First Central Insurance being entitled to a commission on the ceded premiums. The treaty change caused First Central Insurance to record a liability, "Funds held for reinsurance treaty," for amounts due the reinsurer of $2,610,641 and $3,704,947 at December 31, 1996 and 1995, respectively. This liability is paid as the ceded premiums are earned.
NET INVESTMENT INCOME; REALIZED GAINS
During 1996, First Central reduced its holdings of equity securities by approximately $10,000,000 to 17.4% of investments from 28.5% of investments in 1995. During 1996, First Central also increased its holdings in fixed maturities by approximately $10,000,000 to 73.3% of investments from 68.6% in 1995. The increase was principally in U.S. Government securities while holdings in municipal bonds and mortgage backed securities were decreased in 1996. Holdings of municipal bonds were decreased in part because of a change in tax planning strategy and in part to increase portfolio yields. As of December 31, 1996, short-term investments, principally money market accounts, was 9.4% of total investments, an increase from 2.9% of total investments in 1995. In 1996, net investment income increased 2.0% when compared to 1995 primarily due to a decline in investment expenses of approximately $89,000. First Central recognized a net realized gain of $1,909,211 in 1996 as compared to the net realized gain of $1,100,200 in 1995. The increase in net realized gain in 1996 was primarily a result of favorable market conditions experienced during 1996.
During 1995 First Central Insurance sold approximately $16,400,000 of preferred stock and corporate debt securities and purchased government securities, therefore showing an increase in interest received on government securities while a decrease in corporate bond interest and dividends on preferred stock. In 1995, net investment income increased 2.5% when compared to 1994. This increase was due to the 22.7% (approximately $18,600,000) increase in invested assets during 1995. First Central Insurance recognized a net realized gain of $1,100,200 in 1995 as compared to the net realized gain of $950,898 in 1994. The increase in realized gains in 1995 was principally due to an increase in the market value of First Central Insurance's investment portfolio resulting from favorable stock and bond market conditions evident in 1995.
GAAP and SEC Staff Accounting Bulletin No. 59 require the portion of the unrealized loss of an individual security to be recognized as a realized loss in the accounting period when the holder determines that such portion of the decline in the market value is other than temporary. Temporary
declines in the market value of First Central Insurance's debt securities classified as held-to-maturity at December 31, 1995 did not effect First Central Insurance's carrying value of such securities, since First Central Insurance had the ability and the intent to hold these investments to maturity, at which time their full face value was expected to be received at no loss to First Central Insurance. Temporary fluctuations in the market value of available-for-sale securities are reflected in shareholders' equity as unrealized holding gains or losses net of applicable deferred income taxes; however, any decline in the value of the security below its cost considered to be "other than temporary" is accounted for as a realized loss. Once an investment is written down to reflect an other than temporary decline, the write-down establishes a new cost basis for the security.
As of December 31, 1996, First Central had three available-for-sale securities that experienced a decline in market value considered other than temporary. As discussed below, in 1995 the carrying amount of Discovery Zone Inc. Subordinated Notes due 2000 was reduced to the December 31, 1995 market value of $772,500. During 1996, First Central Insurance sold $1,058,000 par value of such notes for $166,708, realizing a loss on disposal of $256,492, and reduced the carrying amount of the notes to the December 31, 1996 market value of $97,100. Additionally, First Central's holdings in Masco Technology Inc. Convertible Subordinated Debentures and its interest in Boston Financial Qualified Housing L.P. were written down to their December 31, 1996 market value of $415,000 and $172,000, respectively. The aggregate loss attributed to the write down of the Discovery Zone, Masco and Boston Financial investments was $472,136 in 1996.
During 1995, one security experienced a decline in market value considered other than temporary. As of December 31, 1995, First Central Insurance held $3,000,000 par value of the Discovery Zone Inc. Subordinated Notes due 2000 and realized a loss of $555,281 on this security, lowering the carrying amount to the December 31, 1995 market value of $772,500.
At December 31, 1996, fixed maturity securities with an amortized cost of $45,284,608 and an estimated market value of $45,019,345 were reclassified from the "held-to-maturity" classification to the "available-for-sale" classification because of uncertainties about First Central Insurance's ability to hold these securities until their maturity. The change in classification did not materially affect total shareholders' equity as of December 31, 1996, but it resulted in 100% of First Central's Insurance's fixed maturities portfolio being classified as available-for-sale. In the opinion of management, available-for-sale classifications of the fixed maturities portfolio is appropriate in the present circumstances. At December 31, 1996, the net unrealized appreciation applicable to First Central Insurance's available-for-sale securities amounted to $768,517, net of deferred taxes of $532,000. Unrealized holding gains amounted to $3,079,854 and unrealized holding losses totaled $1,779,337 before deferred taxes. At December 31, 1995, the net unrealized appreciation applicable to First Central Insurance's available-for sale securities amounted to $759,808, net of deferred taxes of $392,000. Unrealized holding gains amounted to $3,005,195 and unrealized holding losses totaled $1,853,387 before deferred taxes.
LOSSES AND LOSS ADJUSTMENT EXPENSE RESERVES
The amount of losses and the related loss adjustment expenses are dependent upon a number of factors, including claims frequency and the number and type of policies written. These factors may fluctuate from year to year, and not necessarily in any relationship to the amount of premiums written or earned.
The year to year estimation and re-estimation of loss and loss adjustment expense reserve requirements is an inexact science. Reserves do not represent an exact calculation of liability, but rather are estimates involving actuarial and statistical projections at a given time of First Central Insurance's expectations of the ultimate costs of the settlement and administration of claims based on facts and circumstances then known, predictions of future events, estimates of future trends in claims frequency and severity and other variable factors such as inflation and new theories of liability. It is First Central Insurance's practice to maintain reserves at or near the middle point of an "actuarial reasonableness range" established by its independent actuary to evaluate the adequacy of reserves. To the extent that future changes in known data do not take place precisely in accordance with an insurer's historically developed loss reserving assumptions, such reserves, when viewed as of a particular point in time, most likely will be either deficient, i.e., lower than the amount needed to cover known loss and loss adjustment expenses, or redundant, i.e., greater than the amount required with respect thereto. See "Business -- Loss and Loss Adjustment Expense Reserves."
During 1995 and 1996, First Central Insurance increased total net reserves by $18.1 million and $20.9 million, respectively, to maintain its total loss reserves at or near the middle point of the actuarial reasonableness range.
The primary cause of the reserve increase in each of 1995 and 1996 was significant adverse development stemming from poor loss experience on policies written from 1992 through 1995, a period during which First Central Insurance substantially increased premium writings. In particular, beginning in 1993, First Central Insurance wrote policies for two large customers which resulted in extremely poor loss experience. Such business accounted for approximately $355,000, $3.3 million and $3.3 million of First Central Insurance's total written premiums in 1993, 1994 and 1995, respectively.
Based on First Central Insurance's past loss experience, prior management responsible for claims policy increased total net reserves by approximately $2.0 million, $2.5 million and $3.3 million in the first, second and third quarters of 1995, respectively, including increases in IBNR reserves of $1 million, $960,000 and $370,000 during such periods, respectively. However, after a review of case files during the fourth quarter of 1995, First Central Insurance's independent actuary recommended a substantial IBNR reserve increase for the fourth quarter of 1995 because of the adverse development mentioned above. The $8.95 million increase in IBNR reserves in the fourth quarter of 1995 brought First Central Insurance's total reserves at December 31, 1995 in line with the estimate of First Central Insurance's independent actuary. Accordingly, First Central Insurance believed that total reserves had been adequately strengthened during 1995 for 1995 and years prior thereto.
Total net reserves were increased by approximately $2.2 million, $2.5 million and $3.8 million in the first, second and third quarters of 1996, respectively, including increases in IBNR reserves of $250,000, $2 million and $1.35 million during such periods, respectively. However, 1996 witnessed continuing adverse loss development and, accordingly, during the fourth quarter of 1996, First Central Insurance performed an intensive evaluation of its case files, particularly those claims with low initial case reserves. The claims file evaluation consisted of a review of approximately 750 sample files identified by the independent actuary. In the fourth quarter of 1996, First Central Insurance transferred approximately $14 million in IBNR reserves to case reserves as a result of the case reserve file review and to compensate for further adverse loss development. It had been believed that the level of IBNR reserves would be sufficient to absorb such a transfer, but the continuing 1996 adverse loss development, which became apparent during the actuarial review, necessitated a further strengthening of IBNR reserves. The actuarial estimate of the required increase was $7.6 million. By this time, new management was in office and increased IBNR reserves by a further $3.8 million over that recommended by First Central Insurance's independent actuary based upon new management's evaluation of recent loss experience. Total net reserves at December 31, 1996 are above but near the middle point of the actuarial reasonableness range.
The reserve strengthening in the fourth quarters of 1995 and 1996 resulted from significant adverse development stemming from extremely poor loss experience on policies written from 1992 through 1995, and prior management that was responsible for claims policy basing quarterly reserve estimate adjustments on historical loss experience.
In connection with the Insurance Department's triennial audit, First Central Insurance is in discussions with the Insurance Department concerning a number of issues including the adequacy of First Central Insurance's reserves at December 31, 1996. It is new management's and First Central Insurance's independent actuary's estimate that total net reserves at December 31, 1996 are adequate.
In 1996, incurred losses increased approximately $4,058,000, 11.7%, when compared to 1995 despite the decrease in net premiums written of approximately $3.8 million. Components of the increase included an increase of approximately $1,835,000 in the amount of additional unpaid loss reserves established, an increase in paid losses net of subrogation recoverables of approximately $1,184,000 and a decrease in paid losses ceded of approximately $1,040,000.
In 1995, incurred losses increased approximately $11,210,000, 47.7% when compared to 1994. This increase was due primarily to an approximate $7,400,000 increase in IBNR reserves and approximately $3,800,000 increase in paid losses during the 1995 year when compared to 1994. During 1995, IBNR reserves were increased $8,400,000 in the fourth quarter for a total annual increase of approximately $11,300,000.
In 1996, incurred loss adjustment expenses increased 35.4% when compared to 1995. The increase was due to the rising legal fees associated with settling cases during 1996. To reduce legal fees, during the second quarter of 1996 First Central Insurance implemented pretrial fixed fees for certain categories of cases and negotiated lower hourly rates for legal services. In 1995 incurred loss adjustment expenses increased 20.1% over the corresponding period in 1994. This increase was due primarily to the increase in expenses relating to increased losses resulting from higher premium volume.
First Central Insurance's loss ratios (losses incurred to earned premium) on its commercial multiple peril line of insurance were 61.0% in 1996, 70.2% in 1995 and 43.1% in 1994. The decrease in loss ratio experienced in 1996 was primarily due to greater underwriting selectivity. The increased loss ratio in the 1995 year was due primarily to an approximately $6,800,000 increase in IBNR reserves when compared to 1994.
In 1996, First Central Insurance's loss ratio on its workers' compensation line decreased to 7.2%. This decrease is the result of a reduction in previously established workers' compensation reserves for the 1993 policy year. Were it not for the reduction in previously established reserves, the 1996 loss ratio would have been 46.9%. In 1995 First Central Insurance's loss ratio on its workers' compensation line of business increased to 50.9% primarily due to approximately $1,600,000 increase in IBNR reserves when compared to 1994.
First Central Insurance's loss ratios on its general liability line of insurance were 155.5% in 1996, 62.0% in 1995, and 47.6% in 1994. The 155.5% loss ratio in 1996 was due principally to an increase in unpaid loss reserves and paid losses and the decrease in paid losses ceded and subrogation receivables discussed under 1996 incurred losses above. The loss ratio in 1995 increased primarily due to an increase in IBNR reserves of approximately $2,400,000 when compared to 1994.
First Central Insurance's loss ratio on its automobile liability line of insurance increased to 137.9% in 1996 from 80.7% in 1995 and 77.8% in 1994, primarily due to adverse underwriting experience and lack of a rate increase since December 1993 in the private passenger portion of the automobile liability line of business.
First Central Insurance's loss ratio on automobile physical damage line of business did not vary significantly as it was: 49.2% in 1996, 47.7% in 1995, and 50.4% in 1994.
UNDERWRITING EXPENSES AND UNDERWRITING EXPENSE RATIO
Underwriting Expenses are a combination of policy acquisition costs and other operating expenses as shown on the statement of operations.
In 1996 First Central's underwriting expenses increased 6.4% when compared to 1995. This increase was a result of other operating expenses increasing 33.3% offset by policy acquisition costs decreasing 3.0% during 1996 when compared to 1995. The decrease in policy acquisition costs were primarily due to the decrease in commission and premium tax expenses associated with the reduced premium volume. On a ceded basis, commissions were reduced as a result of the January 1996 and April 1995 reinsurance treaty endorsements described in "Reinsurance Ceded" above. The increase in other operating expenses was primarily due to statutory assessments on workers' compensation lines and an increase in amortization expense resulting from the write-off of goodwill.
In 1995 First Central's underwriting expenses decreased 0.9% when compared to 1994. This was a result of First Central Insurance's policy acquisition costs decreasing 1.0% and other operating expenses decreasing 0.7% when compared to the same period in 1994. The decrease in underwriting expenses was primarily due to an increase in ceded commissions and a decrease in rent offset by increases in commissions, premium taxes, real estate expenses, payroll and depreciation.
INTEREST EXPENSE
First Central's interest expense in 1996, 1995 and 1994 was approximately $513,000, $607,000, and $642,000, respectively. Interest expense was attributable primarily to interest paid on the Debentures. The interest expense decrease is due to First Central's retiring $1,430,000, $425,000 and $1,060,000 principal amount of debentures in 1996, 1995 and 1994, respectively.
PROVISION FOR DOUBTFUL ACCOUNTS
The provision for doubtful accounts during 1996, 1995 and 1994 was $3,592,223, $695,865 and $1,056,557, respectively. The 1996 increase in doubtful accounts resulted from a comprehensive review of outstanding balances and First Central Insurance's determination that the collectability of certain auditable workers' compensation and commercial packaged policy receivables is questionable. The 1995 decrease in the provision was due to a smaller percentage of auditable policies issued effecting the 1995 year.
OTHER OPERATING EXPENSES
1996 operating expenses increased by 33.2% when compared to 1995, primarily due to statutory assessments on workers' compensation lines and an increase in amortization expense resulting from the write-off of goodwill. Operating expenses remained consistent for 1995 when compared to 1994.
NET INCOME (LOSS)
During 1996, First Central incurred a net loss of approximately $13,100,000 compared to net income of approximately $361,000 in 1995. During 1996, First Central Insurance experienced a reduction in premiums written. At the same time, loss and loss adjustment expenses increased primarily as a result of an increase in loss reserves of approximately $18,798,000 over 1995. See "-- Losses and Loss Adjustment Expense Reserves." Net investment income, realized gain on investments, claims adjusting revenues increased and earned premiums, interest expense and policy acquisition costs decreased; doubtful accounts and other operating expenses increased.
Net income decreased 93.7% in 1995 when compared to 1994. This was a result of an increase in IBNR reserves and paid losses (see "-- Losses and Loss Adjustment Expense Reserves") as offset by increases in earned premiums, net investment income, realized gains, and claims adjusting revenue and a decrease in interest expense, underwriting expenses and doubtful accounts and income taxes.
REINSURANCE
First Central Insurance reinsures a portion of substantially all of the risks which it underwrites. First Central Insurance has entered into reinsurance treaties with Nat Re covering all risks underwritten by First Central Insurance. First Central Insurance also maintains an automatic facultative property loss reinsurance facility with Munich American, Gen Re, and Swiss Re. See "Business - -- Reinsurance Ceded" and Note 4 of the Notes to First Central's Consolidated Financial Statements for a discussion of those treaties.
In 1996, First Central Insurance ceded premiums of $9,908,347 on $56,712,187 of direct written premium whereas, in 1995, premiums of $21,725,782 were ceded on $72,293,513 of direct written premium. The decrease in ceded premiums for 1996 resulted from a change in First Central Insurance's reinsurance treaty as of April 1, 1995 which changed the method in which ceded premiums are calculated from earned to written premiums. Paid losses recovered by First Central Insurance in 1996 and 1995 amounted to approximately $5,553,000 and $6,592,000, respectively. Incurred losses on a ceded basis amounted to approximately $4,754,000 and $1,479,000 for 1996 and 1995, respectively.
As of January 1, 1996, First Central Insurance's retention per loss under its reinsurance treaty with Nat Re was increased from $200,000 to $250,000. This change had the effect of reducing First Central's ceded written premium percentage from 16.92% to 12.31% from January 1, 1996 through June 30, 1996. Beginning July 1, 1996, the ceded written premium percentage increased to 13.85%. In addition, First Central received a contingency commission payment from Nat Re in the amount of $242,798.
The reinsurance treaty between Swiss Re and First Central Insurance provides for a contingent commission based on favorable loss ratios. The 1996 and 1995 loss ratios produced contingent commissions of $50,777 and $62,110, respectively.
Although First Central Insurance believes it will be able to maintain its heretofore satisfactory relations with its reinsurers, the ability of First Central Insurance to directly underwrite increased volumes of insurance could be materially adversely affected in the event that one or more of its reinsuring arrangements is terminated and First Central Insurance is unable to replace or increase its reinsurance coverage.
LIQUIDITY AND CAPITAL RESOURCES
The business capacity of an insurance company is based on its liquidity and capital resources. Insurance statutes and regulations which apply to insurers require maintenance of prescribed amounts in capital and surplus as well as statutory deposits with insurance authorities. The assets of insurers are maintained in statutorily prescribed investments. Insurers are also required to set up and have reserves for losses and loss adjustment expenses. Furthermore, substantial statutory and regulatory restrictions are imposed upon an insurer's ability to declare and pay cash dividends. See "-- Investments and Investment Portfolio", "Business -- Regulation," "Market for Registrant's Common Equity and Related Stockholder Matters -- Dividends" and "Business -- Losses and Loss Adjustment Expense Reserves" for a discussion of the foregoing factors as they relate to First Central Insurance. See also "-- Reinsurance."
In 1996, First Central's liquidity and capital resources relative to its assets decreased significantly primarily as a result of First Central Insurance's losses from operations during 1996. First Central's Shareholder's Equity at December 31, 1996 declined to approximately $19.5 million.
First Central Insurance's losses from operations resulted in its earned surplus declining to a deficit of $4,276,000 (excluding unrealized gains). First Central Insurance will be precluded from paying dividends to First Central by reason of its earned surplus deficiency. Since the only material source of income to First Central are dividends from First Central Insurance, First Central will not declare any further dividends on its common stock for the foreseeable future. Management anticipates that Mercury will be able to pay a dividend to First Central sufficient for it to pay the August 1, 1997 interest of $220,500 due on the Debentures. However, unless First Central obtains another source of funds, First Central will be unable to pay the August 1, 1997 sinking fund obligation of $1.8 million on the Debentures. First Central is not currently in default under such Debentures but failure to pay either the aforementioned interest or sinking fund obligation will constitute a default under the Debentures entitling the holders to accelerate the outstanding amount, currently $4.9 million.
The Insurance Department has requested that First Central Insurance submit and implement a plan designed to improve operations and raise additional capital. See "-- Recent Developments." Pending implementation of the operational and financial plan and the raising of additional capital, on March 10, 1997, First Central Insurance ceased to write new business. First Central Insurance continues to process renewals and service its existing business and expects to cease renewals on private passenger automobile policies. First Central has engaged an investment banker to assist in its effort to raise additional capital.
First Central Insurance's Statutory Surplus declined from $25.7 million at December 31, 1995 to $12.3 million at December 31, 1996. Based upon the required relationships between Net Premiums Written and Statutory Surplus, First Central Insurance expects that the reduction in Statutory Surplus will result in a significantly reduced premium volume for the foreseeable future. Primarily as a result of First Central Insurance's current financial condition, in February 1997, Best reduced First Central Insurance's rating to D (Very Vulnerable). See "Business -- Best Rating." The change in rating has adversely impacted policy renewals. The continuation of a D rating will severely affect First Central Insurance's future ability to compete with other insurers. It is anticipated that a reduced premium volume would have a further negative impact on First Central Insurance's liquidity and capital resources. Without additional capital, First Central Insurance's surplus may be insufficient to enable it to remain in operation.
The computation of risk-based capital is a method of evaluating the minimum amount of capital which is appropriate for an insurance company to maintain in order to support its overall business operations considering its size and risk profile. First Central Insurance's risk-based capital at December 31, 1996 is at the "regulatory action level" requiring First Central Insurance to submit a comprehensive capital plan to the Insurance Department. See "Business -- Risk-Based Capital."
The events and uncertainties discussed above raise substantial doubt about First Central's ability to continue as a going concern. There can be no assurance that First Central will be successful in its attempt to revise operations to attain future profitability, raise additional capital and resume normal operations.
INCOME TAXES
The Tax Reform Act of 1986 (the "1986 Tax Act"), and the Revenue Reconciliation Act of 1990 (the "1990 Tax Act"), contain provisions which significantly affect the taxation of insurance companies. Some of the major provisions of the 1986 Tax Act and the 1990 Tax Act are summarized below.
The 1986 Tax Act contained provisions which significantly increased the federal income tax liabilities of property and casualty insurance companies, including First Central Insurance. Under the 1986 Tax Act, the reserve deduction for unpaid losses previously allowed to property and casualty insurance companies was modified in a manner which has resulted in increases in First Central Insurance's taxable income. Although First Central Insurance still is able to establish reserves for the estimated amount of losses incurred, the amount of such reserves must be discounted to reflect the present value of its liability to pay anticipated claims (using a discount rate of 100% of the average of the applicable federal mid-term rates). Furthermore, with respect to investments acquired after August 7, 1986, the 1986 Tax Act reduced the loss reserve deduction of property and casualty companies by 15% of any tax exempt interest income and the deductible portion of dividends received. The 1986 Tax Act also requires property and casualty companies to reduce their annual deduction for unearned premiums by 20%.
For First Central Insurance, taxes payable increased due to a requirement of the 1990 Tax Act to reduce deductions for paid and unpaid losses by the estimated salvage and subrogation recoverable on those losses. That change was effective for First Central Insurance's 1990 tax year, but the 1990 Tax Act provided a fresh-start adjustment that permits 87% of the estimated salvage and subrogation recoverable as of December 31, 1990 to be excluded from taxable income.
In addition to the foregoing provisions of the 1986 Tax Act and the 1990 Tax Act, which specifically affects the tax treatment of property and casualty insurance companies, both Acts also contain provisions which are applicable to corporations generally, including First Central. Among such provisions are (1) a decrease of the maximum federal income tax rate on corporations to 34%; (2) a decline of the dividends received deduction for corporations to 70%; (3) a repeal of the investment tax credit; (4) a change in the depreciation rules; and (5) replacement of the 15% corporate add-on minimum tax with an expanded alternative minimum tax (imposed at a 20% rate) under which, among other items, (a) tax-exempt interest earned on certain newly issued bonds and (b) for years after 1989, 75% of the amount by which a corporation's pre-tax financial statement income exceeds the alternative minimum taxable income are treated as tax preference items.
Management does not believe that the provisions of either of such Acts have materially affected First Central's future liquidity. Management further believes that increases in First Central's federal income tax liability occasioned by reason of the Acts' provisions have not materially impacted upon First Central's future results of operations or its sources or uses of capital resources.
First Central had gross deferred tax assets of approximately $9,153,000 and $7,115,000 and gross deferred tax liabilities of approximately $2,175,000 and $2,650,000 as of December 31, 1996 and 1995, respectively. A $4,028,000 valuation allowance has been established with respect to the gross deferred tax asset at December 31, 1996. Management believes that it is more likely than not that the deferred tax asset may not be fully realized due to the uncertainties with respect to First Central's future profitability. A valuation allowance was not required at December 31, 1995.
CAPITAL COMMITMENTS
On January 17, 1995 First Central Insurance purchased the premises in which it's corporate offices are located for a purchase price of $4,000,000 in cash. Prior to purchasing the Building, management analyzed the relative benefits and costs of the purchase verses, among other things, the renewal of (i) First Central Insurance's lease which was to expire on November 30, 1995 and (ii) Mercury's lease in the same building which was to expire on March 31, 1995.
Neither First Central, First Central Insurance, nor Mercury made any material commitment for capital for 1996 and, does not anticipate any for 1997.
ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Information required by this item is submitted on pages 51 to 76.
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES.
There have been no changes or disagreements with accountants.
PART III
MANAGEMENT
ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
IDENTIFICATION OF DIRECTORS
The following table sets forth the names and ages and principal occupations of each of the First Central's directors and the year in which each was first elected a director. First Central's Board of Directors is comprised of three classes with four directors in each class. Directors serve three year terms. At April 10, 1997, there were one Class I and two Class III director positions vacant.
CLASS I DIRECTORS:
CLASS I DIRECTORS
SAUL ERDMAN became a director of First Central in September 1993. From 1982 to February 1993, Mr. Erdman was the sole stockholder and President of Seven-Up Bottling Co. of Rhode Island. Mr. Erdman is a consultant to major soft drink companies in the northeastern United States.
HERBERT V. FRIEDMAN became a director of the First Central Insurance in November 1981. Mr. Friedman was elected as a director of First Central in June 1991. Mr. Friedman is a retired insurance broker and formerly devoted his time to Herbert V. Friedman, Inc., a company wholly owned by the Friedman family which specializes in placing and administering group insurance coverage.
MARTIN J. SIMON served as the President and Chairman of First Central Insurance from August 1980 to October 1996 and as Chairman, President and Chief Executive Officer of First Central from June 1983 to February 1997. From 1943 through 1967, Mr. Simon practiced law as an individual practitioner. Since 1968 he has been a senior partner of the law firm of Simon, Drabkin & Margulies. Between 1947 and 1955, Mr. Simon co-owned and operated a New York licensed insurance agency. Since 1955, Mr. Simon has solely owned and operated several insurance agencies licensed by the State of New York. Included among them are: Simon General Agency, Inc., a general insurance agency, Simon Commercial Corp. a property and casualty agency which is the largest shareholder of First Central; Simon Agency International, Ltd., an excess and surplus lines insurance agency; and Simon Life Agency, Inc., a life insurance agency. Mr. Simon is a director of Continental Bank and Winston Resources Inc. See "Certain Relationships and Related Transactions."
CLASS II DIRECTORS
JOSEPH P. CIORCIARI became a director of First Central in June 1990. From September 1985 to June 1987, Mr. Ciorciari was employed by First Central Insurance as a commercial lines underwriter. In July 1993, Mr. Ciorciari was elected director of Mercury and is the President of Mercury. Mr. Ciorciari is the husband of Martin J. Simon's niece.
RALPH J. DRABKIN became a director of First Central in March 1987. Mr. Drabkin has engaged in the practice of law in New York City since his admission to the New York Bar in 1963. Mr. Drabkin is Mr. Simon's law partner and a member of the law firm of Simon, Drabkin & Margulies. Mr. Drabkin is the presiding Village Justice of the Village of Woodsburgh, New York. See "Certain Relationships and Related Transactions."
JOAN M. LOCASCIO became a director of First Central Insurance and a director of First Central in June 1990. Ms. Locascio oversees the financial accounting operations of First Central and is First Central's Chief Financial Officer. From July 1993 to April 1995 Ms. Locascio served as a director of Mercury. Ms. Locascio served as both First Central Insurance's and First Central's Controller from October 1986 to November 1993. In June 1990, she was elected Treasurer and a director of First Central
and First Central Insurance. In April 1992, she became a Vice President of First Central and First Central Insurance. Ms. Locascio served as Secretary of Simon Commercial Corp. from 1991 until April 1995.
HARVEY MASS has been a director of First Central Insurance since August 1980 and a director of First Central since June 1983. From September 1988 until June 1994, Mr. Mass served as a director of Mercury. In October 1985 he was elected as a Vice President of both First Central and First Central Insurance. From 1973 to December 1991, Mr. Mass served as Vice President and production manager of Simon General Agency, Inc.
CLASS III DIRECTORS
ANDREW W. ATTIVISSIMO was elected as President and Chief Operating Officer of First Central and First Central Insurance and as a director of First Central Insurance on October 31, 1996. On February 12, 1997, Mr. Attivissimo was elected as Chairman and Chief Executive Officer of First Central and First Central Insurance and on March 26, 1997, Mr. Attivissimo was appointed as a director of First Central. For more than five years prior to joining First Central, Mr. Attivissimo was President of Empire Insurance Group.
HARVEY JACOBS became a director of First Central and First Central Insurance in October 1996. For more than the past five years, Mr. Jacobs has practiced law as a sole practitioner.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
Louis V. Siracusano, who resigned as a director of First Central in March 1997, was a member of First Central's Compensation Committee. Mr. Siracusano is a senior partner of the law firm of McKenna, Siracusano, Fehringer & Chinese which performs subrogation and claims defense services for the Insurance Company. During 1996, the Insurance Company paid aggregate fees of $410,000 to this firm. Seymour D. Uslan, who resigned as a director of First Central in September 1996, was also a member of First Central's Compensation Committee. Mr. Uslan served without remuneration as Vice President of First Central and First Central Insurance from August 1980 and June 1983, respectively, until August 1985.
DIRECTOR NOMINATION ARRANGEMENT
Pursuant to an agreement between First Central and Mr. Simon dated February 12, 1997, if Mr. Simon is in good health and beneficially owns 75% of such number of shares of Common Stock as he owned on such date, the Board of Directors will nominate and recommend Mr. Simon for election to the Board at the 1998 Annual Meeting of Shareholders. See "Executive Compensation -- Employment."
IDENTIFICATION OF EXECUTIVE OFFICERS
See Item 4A. "Executive Officers of the Registrant."
COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT
Section 16(a) of the Securities Exchange Act of 1934, as amended, requires the Company's officers and directors, and persons who own more than ten percent of a registered class of the Company's equity securities to file reports of ownership and changes in ownership on Forms 3, 4 and 5 with the Commission and the American Stock Exchange. Officers, directors and greater than ten percent stockholders are required by the Commission's regulation to furnish the Company with copies of all Forms 3, 4 and 5 they file.
Based solely on the Company's review of the copies of such forms it has received, the Company believes that all of its officers, directors and greater than ten percent beneficial owners complied with all filing requirements applicable to them with respect to transactions during fiscal year 1996.
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION.
The Summary Compensation Table below sets forth certain information concerning compensation paid or accrued in 1996 to the Chief Executive Officer of First Central and the four executive officers whose total salary and bonus in 1996 exceeded $100,000.
- -------------------
(1) Company contribution made under First Central Financial's Profit Sharing Plan (2) As of February 12, 1997, no longer employed by First Central (3) As of March 12, 1997, no longer employed by First Central.
The following table sets forth the value of options and warrants to purchase Common Stock held by the executive officers identified in the Summary Compensation Table above at December 31, 1996.
FISCAL YEAR END OPTION/WARRANT VALUES
- ------------ (1) Based on the closing price of First Central's Common Stock on the American Stock Exchange on December 31, 1996.
EMPLOYMENT/TERMINATION AGREEMENTS
Martin J. Simon resigned as Chairman and Chief Executive Officer of First Central and First Central Insurance on February 12, 1997. On such date, Mr. Simon entered into a consulting agreement with First Central which also provided for the termination of his employment agreement with First Central. The consulting agreement provides for Mr. Simon to render consulting services to First Central for which he will be paid at the rate of $104,000 per annum during the period from March 1, 1997 through December 31, 1999. In the event of Mr. Simon's death such payments are to be paid to his beneficiary. Through December 31, 1999, First Central will pay for group medical insurance coverage for Mr. Simon and his family, and will provide Mr. Simon with an office. If Mr. Simon is in good health and beneficially owns 75% of such number of shares of Common Stock as he owned on February 12, 1997, the Board of Directors will nominate and recommend Mr. Simon for election to the Board at the 1998 Annual Meeting of Shareholders. Mr. Simon and First Central agreed to mutual releases not including acts constituting willful misconduct, intentionally wrongful acts, or conduct constituting criminal behavior.
Mr. Simon's employment agreement was effective January 1, 1994, and would have expired on December 31, 1998. The agreement provided for an annual base salary of $190,000, or such greater amount as the Board of Directors determined, and for Mr. Simon to receive amounts payable under incentive or bonus plans adopted by First Central for the benefit of senior executives. In the event of
Mr. Simon's disability, compensation at the above rate would have been payable for three years from the date of such disability. The agreement also provided for the payment of a benefit to Mr. Simon's beneficiary in the event of his death while employed by First Central.
Raymond F. Brancaccio and Harvey Mass each entered into employment agreements with First Central effective May 1, 1994. The term of each of the agreements is three years, expiring on April 30, 1997. The agreements each provide for an annual base salary and for such executives to receive amounts payable under incentive or bonus plans adopted by First Central for the benefit of senior executives. The base salaries for each executive during the years ended April 30, 1995, 1996 and 1997, respectively, are as follows: Mr. Brancaccio, $95,014, $105,414, $118,414; and Mr. Mass, $114,086, $124,486, $137,486. In the event of disability (defined as the inability to perform duties for a period of six consecutive months or for an aggregate of nine months in any consecutive twelve month period) compensation is payable for twelve months from the date of such disability. The agreements also provide for the payment of a benefit to the respective executive's beneficiary in the event of death while employed by First Central. Such benefit is payable periodically during the year after the executive's death (less any period that the executive received disability payments if he dies while disabled) and will equal the sum, during such period, of (i) the executive's then current base salary and (ii) an amount equal to the cost of health insurance under the Company's health insurance plans.
Joel I. Dollinger and Allan R. Goodman each resigned from their positions with First Central and First Central Insurance effective March 12, 1997. Mr. Dollinger and Mr. Goodman each entered into an agreement with First Central which provides for the termination of their respective employment agreement with First Central and for the continued payment of their base salary through April 30, 1997. The base salaries under their employment agreements during the years ended April 30, 1995, 1996 and 1997, respectively, were as follows: Mr. Dollinger, $130,256, $140,656, $153,656; Mr. Goodman, $127,402, $137,802, $150,802. The employment agreements were otherwise identical to those of Mr. Brancaccio and Mr. Mass described above.
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The following table sets forth certain information at April 10, 1997 (unless otherwise indicated), with respect to shares of Common Stock beneficially owned by each person known by the Company to be the beneficial owner of more than five percent of the outstanding Common Stock:
The following table sets forth certain information at April 10, 1997 as to shares of Common Stock beneficially owned by First Central's directors, the Chief Executive Officer, the other four executive officers identified in the Summary Compensation Table above and the directors and executive officers of First Central as a group:
- ----------------- * Less than one percent
(1) Except to the extent otherwise indicated, to the best of First Central's knowledge, each of the indicated persons or entities exercises sole voting and investment power with respect to all shares beneficially owned by him.
(2) Includes 934,382 shares owned by Simon Commercial Corp., 41,263 shares owned by Simon General Agency, Inc., 26,100 shares owned by Simon Agency International, Ltd. and 15,107 shares owned by Simon Life Agency Inc. Mr. Simon has sole voting and investment power with respect to such shares. Also includes 37,500 shares issuable upon exercise of currently exercisable stock options.
(3) Based upon data set forth in a Schedule 13G filed by FMR Corp. in February 1996 with the Securities and Exchange Commission. Various persons have the right to receive or the power to direct the receipt of dividends from, or the proceeds from the sale of such shares.
(4) Based upon data set forth in a Schedule 13G filed in February with the Securities and Exchange Commission by Dimensional Fund Advisors Inc. ("Dimensional"), a registered investment advisor. Dimensional is deemed to have beneficial ownership of 368,200 shares of First Central stock as of December 31, 1996, all of which are held in portfolios of DFA Investment Dimensions Group Inc., a registered open-end investment company, or in series of the DFA Investment Trust Company, a Delaware business trust, or the DFA Group Trust and DFA Participation Group Trust, investment vehicles for qualified employee benefit plans, all of which Dimensional Fund Advisors Inc. serves as investment manager. Dimensional disclaims beneficial ownership of all such shares.
(5) Jointly owned by Mr. Brancaccio and his spouse.
(6) Includes 1,076 shares which are jointly owned by Mr. Ciorciari and his spouse. Mr. and Mrs. Ciorciari may be deemed to share the voting and investment powers with respect to such shares. Also includes 135 shares held by Mr. and Mrs. Ciorciari as custodian for their children and 100 shares owned by a child of Mr. and Mrs. Ciorciari.
(7) Includes 200 shares held by Mr. Dollinger's spouse as custodian for Mr. and Mrs. Dollinger's children, as to which Mr. Dollinger disclaims beneficial ownership. Mr. Dollinger resigned from First Central effective March 12, 1997.
(8) Jointly owned by Mr. Drabkin and his spouse. Mr. and Mrs. Drabkin may be deemed to share the voting and investment powers with respect to such shares.
(9) Includes 1,300 shares held by Mr. and Mrs. Goodman as custodians for their children, as to which Mr. Goodman disclaims beneficial ownership. Mr. Goodman resigned from First Central effective March 12, 1997.
(10) Includes 39,362 shares jointly owned by Mr. Mass and his spouse. Mr. and Mrs. Mass may be deemed to share the voting and investment powers with respect to such shares. Also includes 820 shares owned by Mrs. Mass as to which Mr. Mass disclaims beneficial ownership.
(11) Includes 37,500 shares issuable upon exercise of a currently exercisable option.
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Simon Agency of New York ("Simon New York") is a general insurance agency owned by Sheryl Harwood, Joan Dollinger and Audrey Goodman who are Martin J. Simon's daughters. Mrs. Dollinger and Mrs. Goodman are the spouses of Joel I. Dollinger and Allan R. Goodman, respectively. Mr. Dollinger and Mr. Goodman resigned as Executive Vice President and Vice President respectively, of First Central and First Central Insurance in March 1997. During 1996, premiums written by Simon New York amounted to approximately 14.2% of the direct gross premiums written by First Central Insurance. At December 31, 1996, the commissions earned by Simon New York from business placed with First Central Insurance during 1996 were approximately $1,610,000. These commissions are at a rate comparable to those paid by First Central Insurance to unrelated agents. Effective December 1, 1995 through November 1996, Simon New York had a lease for 3,900 square feet of office space in the Building. Since December 1, 1996, Simon New York has occupied such space on a month-to-month basis. Rent received from Simon New York in 1996 was approximately $76,800.
Mr. Simon and Ralph J. Drabkin are senior partners of Simon, Drabkin & Margulies which performs subrogation and claims defense services for First Central Insurance. During 1996, First Central Insurance paid aggregate fees of approximately $792,000 to this firm.
Louis V. Siracusano resigned as a director of First Central in March 1997. Mr. Siracusano is a senior partner of the law firm McKenna, Siracusano, Fehringer & Chinese which performs subrogation and claims defense services for First Central Insurance. During 1996, First Central Insurance paid aggregate fees of $410,000 to this firm.
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) The following documents are filed as part of this report:
(1) Financial Statements:
Independent Auditor's Report
Consolidated Balance Sheets at December 31, 1996 and
Consolidated Statements of Operations for the Years Ended December 31, 1996, 1995 and 1994
Consolidated Statements of Shareholders' Equity for the Years Ended December 31, 1996, 1995 and 1994
Consolidated Statements of Cash Flows for the Years Ended December 31, 1996, 1995 and 1994
Notes to Consolidated Financial Statements
(2) Financial Statement Schedules:
The financial statement schedules filed as part of this report are as follows:
Independent Auditor's Report on Financial Statement Schedules
Schedule I Summary of Investments - Other than Investments in Related Parties
Schedule II Condensed Financial Information of Registrant
Schedule III Supplementary Insurance Information
Schedule IV Reinsurance
Schedule V Valuation and Qualifying Accounts
Schedule VI Supplemental Information Concerning Property-Casualty Insurance Operations
(3) Exhibits:
Exhibit No. Description --- ------------ 3.1 Certificate of Incorporation of First Central Financial Corporation ("First Central") a copy of which was filed with the Commission on December 6, 1984 as Exhibit 3.1 to First Central's Registration Statement on Form S-18 (Reg. No. 2-94804-NY) and is hereby incorporated herein by this reference).
3.2 Certificate of Amendment of Certificate of Incorporation of First Central dated the 30th day of November 1984 (a copy of which was filed with the Commission on December 10, 1984 as Exhibit 3.2 to First Central's Registration Statement on Form S-18 (Reg. No. 2-94804-NY) and is hereby incorporated herein by this reference).
3.3 Certificate of Amendment of Certificate of Incorporation of First Central dated July 23, 1993 (a copy of which was filed with the Commission on August 15, 1994 as Exhibit 3.1 to First Central's Quarterly Report on Form 10-Q and is hereby incorporated by this reference).
3.4 Amended and Restated By-Laws of First Central, dated as of May 18, 1994 (a copy of which was filed with the Commission on August 15, 1994 as Exhibit 3.2 to First Central's Quarterly Report on Form 10-Q and is hereby incorporated by this reference).
4.1 Specimen copy of First Central's common stock certificate (a copy of which was filed with the Commission on December 10, 1984 as Exhibit 4.1 to First Central's Registration Statement on Form S-1 (Reg. No. 2-94804-NY), and is hereby incorporated herein by this reference).
4.2 Specimen copy of First Central's 9% Convertible Subordinated Debenture Due 2000 (a copy of which was filed as Exhibit 4.2 to Registrant's Amendment No. 1 to its Registration Statement on Form S-1, Reg. No. 33-25264, and is hereby incorporated herein by this reference).
4.3 Indenture dated as of September 1, 1988 between First Central and United States Trust Company of New York as Trustee (a copy of which was filed with the Commission on October 31, 1988 as Exhibit 4.3 to First Central's Registration Statement on Form S-1 (Reg. No. 33-25264), and is hereby incorporated herein by this reference).
10.1 Facultative Reinsurance Agreement dated September 25, 1987 between Munich American Reinsurance Company and First Central Insurance (a copy of which was filed with the Commission on August 15, 1994 as Exhibit 10.8 to First Central's Quarterly Report on Form 10-Q and is hereby incorporated by this reference).
10.2 Addendum No. 1 to the Reinsurance Agreement between First Central Insurance and Munich American Reinsurance Company, dated July 28, 1988 (a copy of which was filed with the Commission on August 15, 1994 as Exhibit 10.9 to First Central's Quarterly Report on Form 10-Q and is hereby incorporated by this reference).
10.3 Addendum No. 2 to the Reinsurance Agreement between First Central Insurance and Munich American Reinsurance Company, dated January 1, 1989 (a copy of which was filed with the Commission on August 15, 1994 as Exhibit 10.10 to First Central's Quarterly Report on Form 10-Q and is hereby incorporated by this reference).
10.4 Addendum No. 3 to the Reinsurance Agreement between First Central Insurance and Munich American Reinsurance Company, dated January 1, 1992 (a copy of which was filed with the Commission on August 15, 1994 as Exhibit 10.11 to First Central's Quarterly Report on Form 10-Q and is hereby incorporated by this reference).
10.5 Addendum No. 4 to the Reinsurance Agreement between First Central Insurance and Munich American Reinsurance Company, dated June 18, 1993 (a copy of which was filed with the Commission on August 15, 1994 as Exhibit 10.12 to First Central's Quarterly Report on Form 10-Q and is hereby incorporated by this reference).
10.6 Form of Indemnity Agreement (a copy of which was filed with the Commission on August 15, 1994 as Exhibit 10.20 to First Central's Quarterly Report on Form 10-Q and is hereby incorporated by this reference).
10.7 Agreement of Tax Allocation between First Central and First Central Insurance (a copy of which was filed with the Commission on August 15, 1994 as Exhibit 10.21 to First Central's Quarterly Report on Form 10-Q and is hereby incorporated by this reference).
10.8 Property Facultative Automatic Reinsurance Agreement between First Central Insurance and North American Reinsurance Corp., effective January 1, 1993 (a copy of which was filed with the Commission on August 15, 1994 as Exhibit 10.22 to First Central's Quarterly Report on Form 10-Q and is hereby incorporated by this reference).
10.9 Stock Option, dated September 10, 1993, granted to Martin J. Simon by First Central (a copy of which was filed with the Commission on August 15, 1994 as Exhibit 10.31 to First Central's Quarterly Report on Form 10-Q and is hereby incorporated by this reference).
10.10 Software License Agreement, dated May 4, 1994, between the Wheatley Group, Ltd. and First Central Insurance (a copy of which was filed with the Commission on August 15, 1994 as Exhibit 10.33 to First Central's Quarterly Report on Form 10-Q and is hereby incorporated by this reference).
10.11 Multiple Line Excess of Loss Reinsurance Agreement between First Central Insurance and National Reinsurance Corporation, dated January 1, 1994 (a copy of which was filed with the Commission on August 15, 1994 as Exhibit 10.34 to First Central's Quarterly Report on Form 10-Q and is hereby incorporated by this reference).
10.12 Endorsement No. 1 of Agreement No. 3522-01002 Multiple Line Excess of Loss Reinsurance Agreement between First Central Insurance and National Reinsurance Corporation, dated January 1, 1994 (a copy of which was filed with the Commission on August 15, 1994 as Exhibit 10.35 to First Central's Quarterly Report on Form 10-Q and is hereby incorporated by this reference).
10.13 Investment Advisory Agreement, dated June 30, 1994 between First Central Insurance and Cramer Rosenthal McGlynn, Inc. (a copy of which was filed with the Commission on August 15, 1994 as Exhibit 10.36 to First Central's Quarterly Report on Form 10-Q and is hereby incorporated by this reference).
10.14 Contract of Sale, dated October 18, 1994 between Lynbrook Court Associates and First Central Insurance (a copy of which was filed with the Commission on March 31, 1994 as Exhibit 10.37 to First Central's Quarterly Report on Form 10-Q and is hereby incorporated by this reference).
*10.15 Stock Option, dated October 31, 1996, granted to Andrew W. Attivissimo by First Central.
*10.16 Employment Agreement, dated as of October 31, 1996 between Andrew W. Attivissimo and First Central.
*10.17 Endorsement No. 1 of Multiple Line Excess of Loss Reinsurance Agreement No. 3522-01003 between First Central Insurance and National Reinsurance Corporation.
*10.18 Endorsement No. 2 of Multiple Line Excess of Loss Reinsurance Agreement No. 3522-01003 between First Central Insurance and National Reinsurance Corporation.
*10.19 Commercial Umbrella Liability Quota Share and Excess of Loss Reinsurance Agreement, AR 6245, between First Central Insurance Company and Continental Casualty Company.
*11 Computation of Per Share Earnings.
*12 Computation of Ratio of Earnings to Fixed Charges.
21 List of Subsidiaries (incorporated by reference to Exhibit 22 to the Registrant's Amendment No. 1 to its Registration Statement on Form S-1 Reg. No. 33-25264).
*23 Consent of McGladrey & Pullen, LLP.
*27 Financial Data Schedule.
- ------------------------- * filed herewith
(b) Reports on Form 8-K.
There were no reports filed on Form 8-K during the last quarter of fiscal 1996.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
FIRST CENTRAL FINANCIAL CORPORATION
BY: /s/ Andrew W. Attivissimo ------------------------------------ April 14, 1997 Andrew W. Attivissimo, Chairman, President, Chief Executive Officer and Chief Operating Officer (Principal Executive Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
[McGladrey & Pullen, LLP Letterhead]
INDEPENDENT AUDITOR'S REPORT
To the Board of Directors and Shareholders First Central Financial Corporation Lynbrook, New York
We have audited the accompanying consolidated balance sheets of First Central Financial Corporation and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits 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 First Central Financial Corporation and subsidiaries as of December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles.
The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern. As discussed in Note 18 to the consolidated financial statements, the Company has incurred significant losses from operations and its capital has been reduced to a level which allows the New York State Insurance Department authority to take regulatory action. The Company, after discussions with the New York Insurance Department has agreed not to write any new business. In addition the New York Insurance Department has requested that the Company prepare a comprehensive plan detailing how the Company plans on improving its financial condition. A.M. Best & Co. Inc., one of the predominant services engaged in the industry-wide rating of insurers and reinsurers, amended the rating of First Central Insurance Company from a B++ to a D (very vulnerable). In addition, unless First Central Financial Corporation is able to obtain financial resources, the Company will be unable to satisfy its sinking fund requirement with respect to its 9% convertible subordinated
debentures. These issues raise substantial doubt about the Company's ability to continue as a going concern. Managements' plans in regard to these matters are also described in Note 18 to the consolidated financial statements. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ McGladrey & Pullen, LLP
New Haven, Connecticut February 25, 1997, except for Notes 1 and 18 as to which the date is March 24, 1997
FIRST CENTRAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
See Notes to Consolidated Financial Statements.
FIRST CENTRAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
See Notes to Consolidated Financial Statements.
FIRST CENTRAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1996, 1995, AND 1994
See Notes to Consolidated Financial Statements.
FIRST CENTRAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
See Notes to Consolidated Financial Statements.
FIRST CENTRAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1--ORGANIZATION
First Central Financial Corporation ("First Central" or the "Company") is a New York State corporation. First Central's wholly-owned subsidiaries are First Central Insurance Company ("First Central Insurance"), a property/casualty insurance company, and Mercury Adjustment Bureau, Inc. ("Mercury"), a claim adjustment and investigation company.
Revenues are derived principally through First Central Insurance, which is engaged in insuring property and casualty risks (principally commercial multiple peril, workers' compensation, general liability, automobile liability and physical damage in the State of New York). First Central Insurance cedes to reinsurers a certain portion of its coverages to limit its share of potential losses on individual claims (see Note 4).
As more fully described in Note 18 "Going Concern Uncertainty and Liquidity", the New York Insurance Department has requested First Central to submit and implement a plan designed to improve operations and raise additional capital. On March 10, 1997, pending implementation of the plan and raising additional capital, First Central Insurance has ceased the writing of new insurance business. However, First Central Insurance will continue to process renewals and service its existing business.
First Central Insurance receives a significant portion of its business from a general agent who is deemed to be a related party (see Note 7) and one other who is not a related party accounting for 9.9% in 1996, 11.4% in 1995 and 9.7% in 1994 of premiums written. The loss of the business relationship that First Central Insurance has with either of these two general agents could have a materially adverse effect upon its future operations.
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
A summary of the significant accounting policies applied in the preparation of the accompanying consolidated financial statements, which have been prepared in accordance with Generally Accepted Accounting Principles ("GAAP") and which, with respect to First Central Insurance, differ in some respects from the Statutory Accounting Principles ("SAP") prescribed or permitted by the regulatory authorities, follows:
Principles of Consolidation: The accompanying consolidated financial statements include the accounts and operations of First Central, First Central Insurance and Mercury after eliminating all significant intercompany balances and transactions.
Accounting Estimates: Management considers available facts and knowledge of existing circumstances when establishing estimated amounts included in the financial statements. While it does not generally expect significant near-term changes in estimated amounts reflected in the accompanying consolidated financial statements, operating in the insurance industry requires management to utilize historical experience and assumptions about future events and circumstances in order to develop estimates of material reported amounts and disclosures. Included among the material (or potentially material) reported amounts and disclosures that require extensive use of estimates are (1) salvage and subrogation, (2) fair values of investments in securities and other financial instruments, (3) policy liabilities, (4) deferred
policy acquisition costs, (5) allowance for doubtful accounts, (6) reinsurance recoverables, and (7) asset impairment. Estimates regarding all of the preceding are inherently subject to change and are reassessed by management as of each reporting date.
Risks and Uncertainties: The operating results and financial condition of First Central as a whole and, in particular of First Central Insurance, are affected by numerous factors and circumstances peculiar to the property and casualty insurance industry, some of which First Central can neither predict nor control. Revenue and profitability trends of First Central Insurance, both generally and within individual business lines, are affected by factors such as (1) volatile and unanticipated adverse loss and expense developments, particularly within lines of business for which losses may not emerge for several years following the year in which the coverage was underwritten; (2) legally-imposed regulatory capital requirements and related limitations on the ability of First Central Insurance to underwrite new insurance business and renew desirable business currently written; (3) the ability of First Central Insurance to enter into suitable reinsurance arrangements; (4) competitive pressures on the pricing of product lines offered by First Central Insurance and the historical cyclicality of its industry as a whole; (5) fluctuations in interest rates, which affect the market value of First Central Insurance's investment portfolio, the income yield of the portfolio and the default and prepayment rates of the portfolio; (6) inflationary pressures which affect the magnitude of losses and loss adjustment expenses; (7) emerging legal precedents and trends which, among other things, may have a significant specific impact on settlement amounts and other circumstances affecting the development of losses and expenses for environmental and other liability lines of business; (8) the occurrence of natural disasters and catastrophic losses of other origin; (9) financial condition ratings of First Central insurance as announced and published by industry rating organizations; (10) general economic conditions and trends which have both direct and indirect affects on the demand for property and casualty insurance; and (11) geographic concentration of writing business primarily in New York.
In addition to the above-described risks and uncertainties affecting property and casualty insurers, First Central and, in particular, First Central Insurance are directly and specifically affected by certain other risks and uncertainties related to and resulting from the present financial condition of First Central Insurance. Such risks and uncertainties are disclosed in the accompanying Note 18 "Going Concern Uncertainty and Liquidity".
Recognition of Premium Revenues: Premiums are recognized as revenue ratably over the terms of the related insurance policies (generally one year). Unearned premiums are calculated using the daily pro-rata basis.
Investment in Debt and Marketable Equity Securities: First Central has investments in debt and marketable equity securities. Debt securities consist primarily of obligations of the U.S. government, state governments and domestic corporations. Marketable equity securities consist primarily of common and preferred stocks that are traded or listed on national exchanges.
FASB Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities", requires that management determine the appropriate classification of securities at the date individual investment securities are acquired and that the appropriateness of such classification be reassessed at each balance sheet date. The classification of these securities and the related accounting policies are as follows:
Securities held-to-maturity: Securities classified as held-to-maturity are those debt securities First Central has both the intent and ability to hold to maturity regardless of changes in market conditions, liquidity needs or changes in general economic conditions. These securities are carried at cost adjusted for amortization of premiums or discounts and other-than-temporary declines in fair value.
Securities available-for-sale: Securities classified as available-for-sale are those debt securities that First Central intends to hold for an indefinite period of time but not necessarily to maturity and equity securities not classified as held for trading. Any decision to sell a security classified as available-for-sale would be based on various factors, including significant movements in interest rates, changes in the maturity mix of the First Central's assets and liabilities, liquidity needs, regulatory capital considerations, and other similar factors. Securities available-for-sale are reported at fair value adjusted for other-than-temporary declines in fair value. Unrealized gains or losses are reported as increases or decreases in shareholders' equity, net of the related deferred tax effect. Realized gains or losses, determined on the first-in, first-out method, are included in earnings.
Securities held-for-trading: Trading securities, if any, which are generally held for the short term in anticipation of market gains, are recorded at their fair value. Realized and unrealized gains and losses on trading account assets are recognized in the income statement.
Premiums and discounts on investments in debt securities are amortized over their contractual lives. Interest on debt securities is recognized in income as accrued, and dividends on marketable equity securities are recognized in income when declared. Realized gains and losses including losses from declines in value of specific securities determined by management to be other-than-temporary, are included in income. Realized gains and losses are determined on the basis of the first-in, first-out method. Short-term investments are stated at cost, which appropriates market.
Policy Acquisition Costs: Commissions, premium taxes, and other costs that vary with and are primarily related to the production of new and renewal business are deferred and amortized over the terms of the policies or reinsurance treaties to which they relate. Deferred policy acquisition costs are limited to the amounts estimated to be recoverable from the related unearned premiums after giving effect to anticipated losses, loss adjustment expenses, and expenses necessary to maintain the premiums in force, which are based on reasonable groupings of business, consistent with the manner of acquiring, servicing, and measuring the profitability of such business. When the anticipated losses, loss adjustment expenses, and policy maintenance expenses exceed the related unearned premiums, and anticipated investment income, a provision for the indicated deficiency is recorded.
Insurance Liabilities: The liabilities for unpaid losses and loss adjustment expenses represent estimated amounts determined from loss reports and individual cases and an amount, based on past experience of First Central Insurance and comparable industry experience, for losses incurred but not reported. Such liabilities are necessarily based on estimates and, while First Central Insurance believes that the amounts included in the accompanying financial statements are adequate, the ultimate liabilities may vary from the estimated amounts provided. The methods for making such estimates and for establishing the resulting liabilities are continually reviewed by the claims department, and any adjustments are reflected in earnings in the year of change. As of September 1991, First Central Insurance retained an actuarial firm, Stergiou and Gruber Risk Consultants, who on a quarterly basis, reviews loss reserves and prepares annual reports. The liabilities for unpaid losses and loss adjustment expenses are reported net of estimated salvage and subrogation recoverable of approximately, $1,691,000 and $1,663,000 at December 31, 1996 and December 31, 1995, respectively.
Reinsurance: In the normal course of business, First Central Insurance seeks to reduce the losses arising from insured claims by reinsuring certain levels of risk among the various lines of business with reinsurers. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. The effects of subsequent changes to the estimates are recognized into earnings in the year of change.
FASB Statement No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts" requires First Central to report estimated reinsurance receivables arising from reinsurance contracts and amounts paid to the reinsurer relating to the unexpired portion of reinsured contracts (prepaid reinsurance premiums) separately as assets.
Income Taxes: First Central, First Central Insurance, and Mercury file a consolidated federal income tax return.
Deferred taxes are provided on a liability method which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carry forwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.
Amortization and Depreciation: Goodwill, included in other assets, was amortized on a straight-line basis over a period of 40 years. In 1996, due to an impairment in its value, the company expensed unamortized goodwill of approximately $275,000. Amortization of the costs associated with the issuance of the convertible subordinated debentures is provided using the effective interest method (see Note 12). Equipment is recorded at cost and is being depreciated using the straight-line method over periods ranging from five to seven years. Building and improvements are also recorded at cost and are being depreciated using that straight-line method over thirty-nine years.
Income (Loss) Per Share Data: Primary net income per share is based on the weighted average number of shares of common stock and common stock equivalents (warrants and options) outstanding during each year. Fully diluted net income (loss) per share assumes, the conversion of the convertible subordinated debentures (date of issue September l, l988) except when the effects of such conversion are antidilutive. For the years ended December 3l, 1996, 1995, and l994 the weighted average number of shares used in the primary earnings per share computation were 5,987,373, 6,037,606 and 5,926,401, respectively. For the years ended December 31, 1996, 1995 and 1994 weighted average number of shares used in the fully diluted earnings per share computation were 5,987,373, 6,037,606 and 6,836,758, respectively.
NOTE 3--INVESTMENTS
Since most of First Central's investments consist of securities that are traded in national, regional or secondary securities markets, they are subject to fluctuations in overall market performance and are potentially subject to heightened levels of market risk attributable to issuer, industry, geographic region or other concentrations. Investments in fixed maturity securities subject First Central to credit risk, and concentrations in such securities of single issuers, issuers located in the same geographic region, issuers operating in the same or similar industries, or securities backed by similar collateralizing assets potentially subject First Central to heightened levels of credit risk. First Central's investment portfolio is regularly reviewed and the extent of its diversification is considered in conjunction with other risk management and performance objectives. Management is of the opinion that First Central's investment portfolio as of December 31, 1996 is sufficiently diversified so that First Central is not subject to undue levels of market or credit risk associated with concentrations.
During 1996, First Central reduced its investment in mortgage-backed securities to less than 1% of the carrying amount of the investment portfolio. Other than its limited investment in mortgage-backed securities, First Central does not invest in or otherwise use derivative financial instruments in the management of its investment portfolio. First Central's equity securities portfolio is comprised of issues purchased based on their expected total return potential and not for the purpose of realizing gains on short-term price changes. As of December 31, 1996 and 1995, First Central's investment portfolio included no securities held for trading purposes.
At December 31, 1996, First Central reassessed its ability to hold certain securities to maturity and determined that fixed maturity securities with an amortized cost of $45,284,608 and an estimated market value of $45,019,345 should be reclassified from the "held-to-maturity" category to the "available-for-sale" category because of uncertainties about First Central's ability to hold these securities until their maturity date (see "Note 18 - Going Concern Uncertainty and Liquidity"). The change in classification resulted in the unrealized loss on these securities of $265,263 being recorded as a reduction of the unrealized appreciation on securities available-for-sale component of shareholders' equity.
At December 31, 1996 and 1995, the amortized cost, gross unrealized holding gains, gross unrealized holding losses and estimated market values of investments in available-for-sale securities and held-to-maturity securities are summarized as follows:
The amortized cost and estimated market value of fixed maturities at December 31, 1996, by contractual maturity are shown below. Actual maturities may be different because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
At December 31, 1996 and 1995, investments in fixed maturity securities carried at an amortized cost of approximately $300,000 were on deposit with regulatory authorities as required by law.
The change in the difference between cost (principally amortized cost of bonds and notes) and estimated market values for fixed maturities and equity securities for 1996, 1995 and 1994 is summarized below:
The major categories of net investment income are summarized as follows:
Purchases and proceeds from sales and redemptions of investment securities, and gross realized gains and losses on sales of investment securities during 1996 and 1995 were as follows:
Included in the gross realized losses for 1996 is $472,136 in other than temporary write-down of securities.
Included in gross realized losses for 1995 is $555,281 in other than temporary write-down of securities.
In December 1995, a One-Time Reassessment of the Classification of Securities under FASB Statement 115 was implemented, allowing an enterprise to reassess the appropriateness of the classifications of all securities held at that time and account for any resulting reclassification at fair value. This reclassification must have been completed no later than December 31, 1995. In accordance with this reclassification, on December 4, 1995, First Central Insurance transferred $10,391,000 par value of held-to-maturity securities to the available-for-sale category.
NOTE 4--REINSURANCE
The assets for future policy benefits and losses, claims, and loss adjustment expenses were $18,767,712 and $19,541,811 at December 31, 1996 and 1995, respectively, for estimated recoveries under reinsurance treaties. Reinsurance recoverable on unearned premium reserves were approximately $5,359,000 and $8,206,000 at December 31, 1996, and 1995, respectively.
Ceded reinsurance premiums were approximately $9,908,000, $21,726,000 and $10,163,000 in 1996, 1995 and 1994, respectively. Ceded reinsurance premiums earned were approximately $12,756,000, $15,493,000 and $9,454,000 for the years ended 1996, 1995, and 1994, respectively. Reinsurance recoveries on loss and loss adjustment expenses incurred were approximately $5,175,000, $1,824,000 and $21,067,000 for 1996, 1995, and 1994, respectively.
Effective January 1, 1993, through December 31, 1995, First Central Insurance reinsures business with limits up to $1,000,000 with a retention level at $200,000. Effective January 1, 1996, First Central Insurance increased its retention level to $250,000 continuing the same level of limits. First Central Insurance also has an excess agreement to reinsure worker's compensation coverage for a total of $2,000,000 and automatic facultative arrangements to reinsure property for a total of $4,500,000.
At December 31, 1996 and 1995, a loss contingency (after deducting funds deposited by or due to such reinsurers) exists with respect to reinsurance receivables and prepaid reinsurance premiums, part or all of which would become an actual loss in the event any of the reinsuring companies are unable, at some later date, to meet their obligations to First Central Insurance under the existing reinsurance agreements.
At December 31, 1995 under the terms of a reinsurance treaty, First Central Insurance was holding escrow trust funds of $13,374 which were included in short-term investments and used for the payment of all applicable reinsured losses and loss adjustment expenses.
At December 31, 1996 and 1995 reinsurance payable totaling $785,104 and $1,393,663, respectively, principally represents premiums due to reinsurance companies in connection with the arrangements described above.
Effective January 1, 1996, endorsement (no. 1) to the Nat Re excess of loss reinsurance agreement reduced First Central's rate used to calculate ceded written premiums and payments due to Nat Re, from 16.92% to 12.31%, for the period January 1, 1996 through June 30, 1996. Beginning July 1, 1996, the rate used to calculate premiums and payments increased to 13.85%, in accordance with the no. 2 endorsement to the policy. In addition, First Central received a contingency commission payment in the amount of $242,798.
During 1995 an endorsement to the reinsurance treaty changed the calculation of reinsurance premiums. The result of this endorsement was a decrease in net premiums written, a decrease in unearned premiums and a liability for funds held for reinsurance treaty of $2,610,641 and $3,704,947 at December 31, 1996 and December 31, 1995, respectively.
Contingent commissions based on First Central Insurance's loss ratio with Swiss Re were earned of $50,777, $62,110 and $91,226 in 1996, 1995, and 1994 respectively.
NOTE 5--POLICY ACQUISITION COSTS
The major components of policy acquisition costs charged to operations are summarized as follows:
NOTE 6--INCOME TAXES
Income tax expense consists of the following components:
The tax effects of temporary differences that give rise to significant components of the net deferred tax assets at December 31, are presented below:
A $4,028,000 valuation allowance has been established with respect to the deferred tax assets at December 31, 1996 because management believes it is more likely than not that the deferred tax assets will not be fully realized.
The following table reconciles the federal statutory income tax rate to First Central's effective income tax rate on income before income taxes:
NOTE 7--RELATED PARTY AND OTHER SIGNIFICANT TRANSACTIONS
During each of the years ended December 31, 1996, 1995, and 1994, approximately 14.2%, 12.7%, and 12.5% respectively, of all insurance written by First Central Insurance was sold through Simon New York, Inc. ("Simon New York") a licensed general insurance agency, which also writes insurance for other unrelated insurance companies, the stock of which is owned by Joan Dollinger and Audrey Goodman (the respective wives of Joel Dollinger and Allan Goodman, former Vice Presidents and former Directors of First Central) and Sheryl Harwood, who are Mr. Simon's three daughters. At December 31, 1996 and 1995 the premiums receivable from Simon New York were approximately $2.2 million and $3.3 million respectively. Simon New York is paid commissions ranging from 15% to 22.5% on the different lines of business produced. These commissions are comparable to those paid by First Central Insurance to unrelated agents. In accordance with the general agents' agreements with their subagents and brokers, approximately 75% of these commissions are paid to the subagents and brokers. A summary of the transactions with Simon New York and Simon Commercial is presented below:
Claims settlement legal services are provided by several law firms. The former President and a Director of First Central are partners in one of the firms; fees paid to this firm for 1996, 1995, and 1994 were approximately $792,000, 798,000 and $722,000 respectively. Another former Director is a partner in a law firm providing claim services; fees paid to this firm for 1996, 1995 and 1994 were $410,000, $323,000 and $341,000 respectively.
NOTE 8--LIABILITY FOR UNPAID CLAIMS AND CLAIM ADJUSTMENT EXPENSES
Activity in the liability for unpaid claims and claim adjustment expenses is summarized as follows:
As a result of changes in estimates of insured events in prior years, the provision for claims and claim adjustment expenses increased by approximately $19,783,000, $12,995,000 and $5,883,000 in 1996, 1995 and 1994, respectively. The increases are a result of significant adverse developments stemming from both case reserve strengthening and poor liability experience emanating from accident years 1992 through 1995, when the company substantially increased its premium writings. During the 1992 through 1995 policy years the Company wrote risk purchasing group and other business which resulted in extremely poor liability experience. Additionally, because of a high ratio of IBNR to case reserves and continuing poor loss experience in 1996, Stergiou & Gruber Risk Consultants ("S&G"), First Central Insurance's actuary, recommended that First Central Insurance perform a complete evaluation of its case reserves. During the third quarter of 1996, pursuant to this recommendation, First Central Insurance commenced a selected sample review of open claims. This review was done separately from First Central Insurance's normal claim adjustment activity. The review was completed in the fourth quarter of 1996 and resulted in First Central Insurance increasing its case reserves by approximately $14,000,000. The review also caused S&G to evaluate IBNR reserves using different methodologies than in prior years since First Central Insurance's emerging loss development patterns did not match industry-wide patterns. Based on S&G's actuarial report, management decided to increase IBNR reserves to near the middle point of the actuarial range of reasonableness used in the establishment of such reserves.
In establishing the liability for unpaid claims and claim adjustment expenses related to environmental claims management considers facts currently known and the current state of the law and coverage litigation, liabilities are recognized for known claims (including the cost of related litigation) when sufficient information has been developed to indicate the involvement of a specific insurance policy, and
management can reasonably estimate its liability. Estimates of the liabilities are reviewed and updated continually.
NOTE 9--SHAREHOLDERS' EQUITY AND RESTRICTIONS
In June 1990, First Central's Board of Directors awarded a five-year warrant to an investment advisor, to purchase 50,000 shares of First Central's Common Stock at an exercise price of $6.97 per share. In conjunction with the issuance of this warrant, 50,000 shares of First Central's Common Stock were reserved for future issuance. This warrant expired in June of 1995.
In June 1990, First Central's shareholders approved a proposal authorizing First Central to issue warrants to non-employee directors of First Central to purchase an aggregate of not more than 250,000 shares of First Central's Common Stock. The Board of Directors is to determine the terms and conditions of the warrants, as well as the recipients, subject to the limitations that: (i) the exercise price of the warrants is not to be less than the market value of First Central's Common Stock at the date of Grant, (ii) the expiration date of the warrants is not to be more than five years from the date of grant, and (iii) the maximum number of shares of First Central's Common Stock issuable upon exercise of any warrant is not to exceed 10,000 shares. On March 18, 1992, the Committee awarded warrants to purchase up to an aggregate of 160,000 shares of Common Stock at an exercise price of $5.6875 per share to the non-employee Directors of First Central and First Central Insurance as a group. These warrants expired March 18,1997. No warrants have been awarded since 1992. 12,500 warrants were exercised in 1995. No warrants were exercised in 1996 and 1994.
During 1992, in connection with the private placement of common stock to an institutional investor, First Central issued a three year warrant to purchase 114,286 shares of common stock at an exercise price of $7.00 per share. In March 1993, in connection with another private placement of common stock to a second institutional investor, First Central issued a two year warrant ("Series A Warrant") to purchase 153,846 shares of common stock at an exercise price of $7.00 per share, and a three year warrant ("Series B Warrant") at an exercise price of $7.50 per share. In March 1993, the first placement was modified to conform to the terms of the second placement which resulted in cancellation of the warrant for 114,286 shares and issuance of one Series A Warrant and one Series B Warrant for 123,077 shares of common stock each. In December, 1993, in connection with a second private placement to the second institutional investor, First Central issued one Series B Three-Year Warrant for 153,846 shares of common stock. During 1994, in connection with private placements to two institutional investors and a reinsurance company, First Central issued a two year Series C common stock purchase warrant to each of these investors to purchase a total of 192,307 shares of common stock at an exercisable price of $7.50 per share. The Series A Warrant expired in 1995. The Series B and C warrants expired in 1996.
In September 1993 First Central issued to Martin J. Simon an option to purchase up to 50,000 shares of common stock at an exercise price of $5.31 per share. Such option is exercisable with respect to 25% of the shares covered by the option each year commencing in 1994 and expires in 1998. No options were exercised in 1996, 1995 and 1994.
In October 1996 subject to shareholder approval, First Central issued Andrew W. Attivissimo an option to purchase up to 50,000 shares of common stock at an exercise price equivalent to the lowest trading price of a share of common stock between issue and approval date. Such option is exercisable with respect to 25% of the shares covered by the option each year commencing on the first anniversary of the effective date and an additional 25% after each successive anniversary of the effective date.
At December 31, 1996, approximately $12,330,000 of consolidated shareholders' equity based on SAP represents net assets of First Central Insurance that cannot be transferred in the form of dividends, loans, or advanced to First Central without prior approval from the New York State Insurance Department. Generally, the net assets of First Central Insurance available for transfer to First Central are limited to the amounts that its net assets exceed minimum statutory requirements (approximately $1,233,000 at December 31, 1996), however, payments of such amounts as dividends must be paid out of earned surplus (as defined), are subject to statutory restriction, and may be subject to approval by the insurance regulatory authorities. At December 31, 1996 First Central Insurance had an earned surplus deficit of approximately $4,276,000; accordingly, First Central Insurance cannot pay any dividends to First Central at this time.
NOTE 10--STATUTORY-BASIS INFORMATION
The following is a reconciliation of the net income (loss) and shareholders' equity, as determined in accordance with Statutory Accounting Principles, to the corresponding GAAP amounts included in the accompanying financial statements:
NOTE 11--PRINCIPAL LINES OF BUSINESS
First Central Insurance offers various types of property and casualty insurance to its policyholders. The risks are geographically located principally in the State of New York. Revenues and earnings from operations, by principal line of business, are as follows:
In determining other revenues and income from operations before income taxes, certain significant items not directly associated with a line of business are allocated. Net investment income including realized gains and losses are allocated to lines of business on the basis of a formula. Claims Adjusting Reserves are also allocated on the basis of the same formula. Certain operating expenses are allocated on the basis of premiums written. Assets are generally not identifiable as to line of business. Periodically, the methods and allocation formulas are revised to more closely approximate the results of each principal line of business.
NOTE 12--CONVERTIBLE SUBORDINATED DEBENTURES
In 1988, First Central privately placed $10,300,000 of its convertible subordinated debentures and, in conjunction therewith, received net proceeds of approximately $9,111,000, of which $5,050,000 was contributed by First Central to the capital of First Central Insurance. In 1989, an additional $1,950,000 of convertible subordinated debentures were issued and net proceeds of approximately $1,600,000 were received by First Central.
The debentures were issued pursuant to a trust indenture, dated September 1, 1988, between First Central and United States Trust Company, as trustee. The debentures bear annual interest of 9%, payable semiannually, commencing February 1, 1989. In each of the years ended 1996, 1995 and 1994, interest paid amounted to approximately $560,000, $603,000 and $677,000, respectively.
The debentures are convertible at any time prior to maturity, unless previously redeemed, into shares of First Central's Common Stock at a conversion price of $7.50 per share prior to August 1, 2000, maturity, subject to adjustment under certain conditions. At December 31, 1996, 653,333 shares of First Central's Common Stock remain reserved for future issuance upon conversion. The debentures are redeemable, at any time, at the option of First Central.
Commencing August 1, 1993, mandatory annual sinking fund payments of 15% of the original principal amount plus accrued interest to maturity must be made to retire at least 75% of the debentures prior to maturity. Through August 1, 1997, the annual principal amount payable to the Trustee is $1,837,500. First Central may credit other redemptions of the debentures against the sinking fund requirements. As of December 31, 1996, First Central has satisfied its requirements through other redemptions of approximately $6,965,000 in principal and $385,000 in conversions. The debentures are subordinated to all existing and future senior indebtedness of First Central (none was outstanding at December 31, 1996 and 1995), as provided in the indenture (see "Note 18" -- regarding the company's ability to satisfy sinking fund requirements).
Future required principal payments for the convertible subordinated debentures are $1,837,500 in 1997 and $3,062,500 in 2000. (See Note 18 which discusses the Company's abilities to satisfy the sinking fund requirement).
NOTE 13--BUILDING PURCHASE AND OPERATING LEASES
On January 17, 1995, First Central Insurance purchased its home office building, located at 266 Merrick Road, Lynbrook, New York, (the "Building") for $4,000,000 in cash. The Building consists of approximately 30,000 square feet of office space and 2,000 square feet of retail space. The approval to acquire real estate required by the State of New York Insurance Department was obtained on December 27, 1994. The Company has assumed the leases of the tenants of the Building. Management believes that the Building is suitable for First Central's purposes for the foreseeable future.
Approximately 8,900 square feet of office and retail space is seven unaffiliated tenants who have paid $203,504 and $204,690 in rent during 1996 and 1995 respectively.
During 1996 and 1995, Simon New York paid $76,800 and $88,323, respectively to First Central Insurance for rent. Effective December 1, 1995 through November 30, 1996, Simon New York had a lease for 3,900 square feet of office space. Since December 1, 1996 Simon New York has occupied such space on a month-to-month basis. First Central Insurance subleased 3,900 square feet of its leased office space to Simon New York under a sublease agreement that expired November 30, 1995.
Minimum rentals receivable under operating leases for the next five years are as follows:
Years ending December 31:
1997 - $90,647 1998 - $58,082 1999 - $54,831 2000 - $53,361 2001 - $28,810
NOTE 14--STOCK OPTIONS
During 1990, First Central adopted the 1990 Stock Incentive Plan ("Plan"). The plan expired by its terms during 1995. The plan provided for up to 250,000 shares of First Central's common stock to be awarded and issued and/or for the award of options or stock appreciation rights. In 1992, options to purchase 125,000 shares of common stock at an exercise price of $5.6875 per share were awarded under the plan. The options are exercisable with respect to 25% of the shares covered by such options each year commencing in 1994 and expire in March 1997. No options were exercised in 1996. During 1995 options to purchase 12,500 shares of common stock were exercised. During 1994, options to purchase 5,000 shares of common stock were cancelled and no options exercised. No common stock or stock appreciation rights were issued under the plan.
In October 1996, subject to shareholder approval, First Central issued Andrew W. Attivissimo an option to purchase up to 50,000 shares of common stock at an exercise price equivalent to the lowest trading price of a share of common stock between issue and approval date. Such option is exercisable with respect to 25% of the shares covered by the option each year commencing on the first anniversary of the effective date and an additional 25% after each successive anniversary of the effective date.
In September 1993 First Central issued to Martin J. Simon an option to purchase up to 50,000 shares of common stock at an exercise price of $5.31 per share. Such option is exercisable with respect to 25% of the shares covered by the option each year commencing in 1994 and expires in 1998. No options were exercised in 1996, 1995 and 1994.
NOTE 15--PROFIT SHARING AND 401(k) PLANS
Profit Sharing Plan: The Company has a profit-sharing plan for those employees who meet the eligibility requirements set forth in the plan. The plan covers substantially all of the Company's full-time employees. The amount of the annual expense attributable to the plan is at the discretion of the Company's Board of Directors. The Company expensed $0, $62,800 and $90,000 to the plan for the years ended December 31, 1996, 1995 and 1994, respectively.
401(k) Plan: In 1993, the Company established a defined contribution 401(k) plan for its employees which generally allows participants who meet the eligibility requirements set forth in the plan to make contributions by salary deductions up to allowable IRS limits on a tax-deferred basis. The Company does not make or match contributions to the plan.
NOTE 16--COMMITMENTS AND CONTINGENCIES
During 1996, there were employment agreements with eight employees of the Company. One of the agreements was terminated on February 12, 1997, two of the agreements were terminated effective March 12, 1997 and four of the agreements expire on April 30, 1997. Such agreements provide or provided for terms ranging from three to six years, a base salary which is specified in each of the agreements and benefit payments in the event of death or disability during the term of the agreement. On February 12, 1997, the Company entered into a consulting agreement with a director of the Company which provides for compensation to be paid through December 31, 1999 notwithstanding such director's death, disability or inability to render consulting services. The minimum annual commitments under the agreements are: 1997 -- $579,092; 1998 -- $345,666; and 1999 -- $379,000.
NOTE 17--DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair values of cash, short-term investments, balances due on account from agents, reinsurers and others, and accounts payable approximate their carrying amounts as reflected in the consolidated balance sheets due to their short-term availability or maturity.
The fair values of debt and equity securities have been determined from nationally quoted market prices and by using values supplied by independent pricing services. These fair values are disclosed together with carrying amounts in Note 3.
The fair value of the Company's convertible debentures approximate its stated amount of $4,900,000 based on current interest rates and the Company's common stock price.
NOTE 18--GOING CONCERN UNCERTAINTY AND LIQUIDITY
The Company's consolidated financial statements for the year ended December 31, 1996 have been prepared on a going concern basis which contemplates the realization of assets and the settlement of liabilities and commitments in the normal course of business. As a result of the 1996 loss incurred First Central's Shareholders' Equity at December 31, 1996 declined to approximately $19.5 million and First Central Insurance's Statutory Surplus declined to approximately $12.3 million. Based upon the required relationships between Net Premiums Written and Statutory Surplus, First Central Insurance Company expects that the reduction in Statutory Surplus will result in a significantly reduced premium volume for the foreseeable future.
First Central Insurance company has a statutory deficiency in Earned Surplus resulting from its loss from operations. Therefore, it will be precluded from paying dividends to First Central by reason of such deficiency. The only material source of income to First Central are dividends from First Central Insurance Company and Mercury. Management anticipates that Mercury will be able to pay a dividend to First Central sufficient for it to pay the August 1, 1997 interest of $220,500 due on its 9% Convertible Subordinated Debenture. However, unless management is able to raise funds from other sources, First Central will not be able to pay the August 1, 1997 sinking fund obligation of $1,837,500 on the Debentures. First Central is not currently in default under such Debentures but failure to pay either the aforementioned interest or sinking fund obligation will constitute a default under the Debentures entitling the holders to accelerate the outstanding amount, currently $4,900,000.
Based on a preliminary release of First Central Insurance's operating results for the year ended December 31, 1996, A.M. Best & Company ("Best"), one of the predominant services engaged in the industry-wide rating of insurers and reinsurers, amended First Central Insurance's rating to D (Very Vulnerable). The change in rating is adversely impacting both policy renewals and new business written. Although, at this time a reduction in the volume of premiums written is necessary to comply with regulatory requirements, continuation of a D rating will severely affect First Central Insurance's future ability to compete with other insurers.
The New York State Insurance Department has required First Central Insurance to submit and implement a plan designed to improve operations and raise additional capital. Such a plan will involve the revision of operations to attain future profitability by raising underwriting standards, curtailing operating expenses, revising agreements to achieve a reduction in loss adjustment expenses, restructuring the claims department to achieve more favorable settlements of claims and restructuring management positions. First
NOTE 18--GOING CONCERN, UNCERTAINTY, AND LIQUIDITY--Continued
Central Insurance engaged outside consultants to review the activities of the various operating departments and make recommendations, where necessary, for changes within those departments. The plan also requires First Central Insurance to raise additional capital and First Central has engaged an investment banker to assist in this effort. Without the additional capital, First Central Insurance's surplus may be insufficient to enable it to remain in operation. Pending implementation of the plan and the raising of additional capital, First Central Insurance has ceased the writing of new insurance business.
The events and uncertainties discussed above raise substantial doubt about the Company's ability to continue as a going concern. There can be no assurance that the Company will be successful in its attempt to revise operations to attain future profitability; raise additional capital and resume normal operations. The financial statements do not include any adjustments that might result from the outcome of these uncertainties.
FIRST CENTRAL FINANCIAL CORPORATION
SUPPLEMENTARY DATA
QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of unaudited quarterly financial data for 1996 and 1995:
Primary net income (loss) per common share is based on the weighted average number of shares of common Stock and common stock equivalents (warrants and options) outstanding during each period. Fully diluted net income (loss) per common share assumes the conversion of the convertible subordinated debentures, common stock equivalents (warrants and options), outstanding during each period except when effect is fully diluted.
[Mc Gladrey & Pullen, LLP Letterhead]
INDEPENDENT AUDITOR'S REPORT ON THE SUPPLEMENTAL SCHEDULES
To the Board of Directors and Shareholders First Central Financial Corporation Lynbrook, New York
Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The consolidated supplemental schedules I, II, III, IV, V and VI are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in our audits of the basic consolidated financial statements and, in our opinion, are fairly stated in all material respects in relation to the basic consolidated financial statements taken as a whole.
Our report covering the basic consolidated financial statements indicates that there is substantial doubt as to the Company's ability to continue as a going concern, the outcome of which cannot presently be determined and that the consolidated financial statements do not include any adjustments, that might result from the outcome of this uncertainty,
/s/ McGladrey & Pullen, LLP
New Haven, Connecticut February 25, 1997, except for Notes 1 and 18 as to which the date is March 24, 1997
FIRST CENTRAL FINANCIAL CORPORATION AND SUBSIDIARIES SCHEDULE I - SUMMARY OF INVESTMENTS OTHER THAN INVESTMENTS IN RELATED PARTIES.
December 31, 1996
FIRST CENTRAL FINANCIAL CORPORATION (Parent Company)
SCHEDULE II
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEETS
See Note to Condensed Financial Statements
FIRST CENTRAL FINANCIAL CORPORATION (Parent Company)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF INCOME
See Note to Condensed Financial Statements
FIRST CENTRAL FINANCIAL CORPORATION (Parent Company)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF CASH FLOWS
See Note to Condensed Financial Statements
FIRST CENTRAL FINANCIAL CORPORATION (Parent Company)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
NOTES TO CONDENSED FINANCIAL STATEMENTS
The accompanying condensed financial statements should be read in conjunction with the consolidated financial statements and the related notes thereto of First Central Financial Corporation and Subsidiaries.
FIRST CENTRAL FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE III
SUPPLEMENTARY INSURANCE INFORMATION
FIRST CENTRAL FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE IV
REINSURANCE
FIRST CENTRAL FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE V
VALUATION AND QUALIFYING ACCOUNTS
FIRST CENTRAL FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE VI
SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY INSURANCE OPERATIONS